How to Pass Cost Accounting Teacher’s Guide Second and Third Levels

Transcription

How to Pass
Cost Accounting
Second and Third Levels
Teacher’s Guide
How to Pass
Cost Accounting
Second and Third Levels
Teacher’s Guide
Derek Skidmore
MSc FCCA ACMA FLCC
First published in 1998
 London Chamber of Commerce and Industry Examinations Board 1998
ISBN 1 86247 015 4
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CONTENTS
page
Introduction
vii
Lessons 1-3
Introduction to cost accounting
1
Lessons 4-6
Material cost
14
Lessons 7-9*
Further aspects of material cost
27
Lessons 10-12
Costing for labour
37
Lessons 13-15
Costing for overheads (1)
48
Lessons 16-18
60
Lessons 19-21*
More advanced aspects of costing for overheads
73
Lessons 22-24
Job, batch and contract costing
84
Lessons 25-27
Continuous process costing (1)
97
Lessons 28-30*
114
Lessons 31-33
Marginal costing (1)
132
Lessons 34-36*
148
Lessons 37-39*
163
Lessons 40-42*
Breakeven charts and profit graphs
181
Lessons 43-45
Budgeting and budgetary control
192
Lessons 46-48*
Budgeting (2)
204
Lessons 49-51
Standard costing (1)
218
Lessons 52-54*
235
Lessons 55-57
Costing systems (1)
254
Lessons 58-60*
Costing systems (2)
270
* Third Level only
v
About the author
Derek Skidmore is a former Head of the West Midlands School of Accountancy at Sandwell
College of Further and Higher Education, and has over 30 years of teaching experience in a
number of accountancy subjects at all levels.
His association with the LCCIEB extends over 20 years.
He now works on a freelance basis as a business consultant and as a visiting lecturer at the
University of Central England.
Acknowledgements
In the preparation of this book, my thanks are again due to Geoff Rhodes MSc ACMA, moderator
of LCCIEB, formerly Examiner of LCCIEB, and Senior Lecturer at the University of Derby,
for his careful reading of the draft of the book, and for his valuable suggestions for its
improvement. Any mistakes that remain are my own.
vi
INTRODUCTION
This text has been prepared to help teachers who are preparing candidates for the Second and
Third Level LCCI examinations in Cost Accounting.
Teachers are advised to use this in conjuction with:
1
The syllabus
2
The extended syllabus
3
The textbook How to Pass Cost Accounting
4
Past examination papers of the LCCI
5
Suggested answers to past examination papers of the LCCI
6
Examiners’ reports
It is the extended syllabus which is of most importance.
In writing this Teacher’s Guide I do not seek to dictate to teachers of Cost Accounting how they
should conduct their classes. However, many years of association with the LCCI, and over 35
years of teaching and lecturing in Cost Accounting perhaps mean that some, at least, of my
advice may be found useful.
There are 60 lessons in the book, arranged in 20 groups of 3. The 20 groups correspond to the
20 chapters of the textbook How to Pass Cost Accounting.
All 60 lessons will be needed to take a candidate having no knowledge of Cost Accounting at all
to a position where he or she could attempt the Third Level Cost Accounting paper with a
reasonable chance of success.
On average, the 60 lessons will need a minimum of 120 hours of class time. If your available
time is less than this, you will need to select some aspects of each lesson to cover in class time,
and then carefully direct the students to study privately those areas that you have not been able
to cover.
The amount of time needed to deal with the content of each lesson is left open. Certainly, most
lessons will need at least 2 class hours. Some lessons will perhaps need more; a few may need
fewer.
You are encouraged to develop understanding in your students. Rote learning is not
recommended. Neither is the development of artificial ways of remembering. Both of these
will let the student down at critical moments. The student who understands the subject has no
need for such aids.
Do emphasise to your students that question practice is important. Some of this may take place
in class time. However, the serious student will also need to devote private time to it.
vii
Note carefully the lessons that you will need to use:
If you are preparing candidates for the Second Level LCCI examinations:
Lessons 1, 2, 3, 4, 5, 6, 10, 11, 12, 13, 14, 15, 16, 17, 18, 22, 23, 24, 25, 26, 27, 31, 32, 33, 43, 44,
45, 49, 50, 51, 55, 56 and 57.
If you are preparing candidates for the Third Level LCCI examinations, who have already studied for, and
have passed, the Second Level examinations:
Lessons 7, 8, 9, 19, 20, 21, 28, 29, 30, 34, 35, 36, 37, 38, 39, 40, 41, 42, 46, 47, 48, 52, 53, 54, 58,
59 and 60.
If you are preparing candidates for the Third Level LCCI examinations, who have not previously studied
Cost Accounting, or who have not passed the Second Level examinations:
All Lessons from 1 to 60.
viii
LESSON 1
Main subject
Textbook reference Chapter 1: Page 1
Syllabus reference
1
General
Lesson topics
Introduction to Cost Accounting
Cost units
Cost centres
Extended syllabus reference
1.1
1.2
1.3
1.4
1.5
1.6
Understand the meaning of cost accounting terms as defined in the CIMA
Official Terminology
Understand the meaning and purpose of cost accounting
Explain the relationship between cost accounting, financial accounting
and management accounting
Explain cost centres and cost units
Select suitable cost centres for a particular industry or organisation
Select suitable cost units for given industries and organisations
Required for
Candidates for Second Level and Third Level
Aims of the lesson
• To introduce the subject of cost accounting
• To explain the nature of cost centres and cost units, and provide guidelines
for their selection
The lesson
▲ Begin by explaining the nature of business activity. Your examples should, if possible,
be drawn from the students' own local environment.
Explain that some businesses are owned and run by one person. Others may be owned
and run by a number of partners. Still others may be operated as limited companies.
Explain that limited companies may be quite small, family-owned companies in which
the owners – the shareholders – may also be the managers. Contrast this with larger
companies, with many shareholders. Point out that owner-shareholders of larger
companies may be other overseas companies, most of whom will play no part in the
daily management of the company. Ask the class to give a local example of each of these four
types.
1
Cost Accounting – Teacher’s Guide
▲ Now point to the different activities of these businesses.
Some will simply trade, buying goods at one price (sometimes importing them) and
selling them at a higher price. This category will include small, sole-trader retail
businesses, but may also include major companies which perhaps import, and then
wholesale goods. Again, encourage the class to identify local examples.
Other businesses will manufacture products. They will purchase raw materials and
components (perhaps imported) and apply skill, expertise and know-how to turn these
into finished products. Explain that this category could include small businesses (for
example, a family-owned bakery), or large companies (for example, a motor car
manufacturer). Again, encourage the class to identify local examples.
Finally, point out that some businesses provide services rather than goods. These might
be small, sole-trader businesses (such as a hairdresser), or partnerships (for example,
an accountancy firm), or large limited companies (for example, a haulage business or a
bank). Again, encourage the class to identify local examples.
▲ Now explain that most of these businesses are attempting to make a profit. This allows
sole traders and partners to take money out of the business as drawings. The more
profit they make, the more is available to be taken out. In the case of companies, the
profit is taken out as dividends, the level of these being decided by the directors of the
company.
Point out that financial accounts are prepared, therefore, to show (in the profit and
loss account) how much profit has been made in a particular year, and to show (in the
balance sheet) the position of the business at the end of the year. With large companies,
these reports have to be audited before being presented to the shareholders.
Explain that these historical reports are too late, and lack the necessary detail, to help
those who manage the business on a day-to-day basis. Managers need, every day, to
plan, make decisions, control, etc, and need financial information to help them.
▲ Now introduce the CIMA definition of cost accounting on page 2 of the textbook.
Make sure that the class understands every word in this definition, and what it is saying.
Take the class, point by point, through the explanation which follows the definition on
page 2.
Before continuing, make sure the class understands that cost accounting is needed for
small businesses and large businesses, for trading firms, for manufacturers and for
service industries.
▲ Cost centres and cost units
These terms are introduced at the bottom of page 2.
Take the class through the definitions at the top of page 3. Emphasise that cost centres are
organisational subdivisions. They reflect the way a business is organised. They do not
relate to the output or the service produced.
Cost centres identify parts of the organisation – a machine, a group of identical machines,
a department, a process, a depot, a sales team, etc. They exist, of course, because of
what the business produces. For example, a business would not have purchased an
oven, if it did not intend to bake bread.
2
The primary purpose of cost centres is to accumulate total costs for each centre, for
cost accounting. We can then decide how much of this cost is attributable to each unit
of output (or service) which the cost centre produces.
As an example, point out that the oven in a bakery is a production facility. It is a cost
centre, and the business must know what it costs to run in terms of labour, electricity,
maintenance, depreciation, and so on – but it is not the product. The product is bread,
perhaps of many different loaf-sizes and specifications.
The cost unit is a loaf of bread. This allows production costs to be expressed in terms of
the product (or output) – in this case, the cost per loaf of bread. It is most important that
this distinction between a cost centre and a cost unit is understood, as well as why each is needed.
Make sure that the class can follow Example 2 on page 4 of the textbook, and the way
in which a cost code is set up to define the cost centres.
It would be beneficial to get the class (or a number of workgroups within the class) to
choose a local manufacturing business, and to identify a number of likely cost centres
and appropriate cost units within it. Alternatively, as the teacher, you might want to choose the
local industry yourself, so that you will have some idea of the 'sense' of the answers offered by the
class.
Reminders
At the end of the lesson, re-state the main points again:
The meaning and purpose of cost accounting
The purpose of, and distinction between, cost centres and cost units
3
LESSON 2
Main subject
Syllabus reference
1
General
Lesson topics
Coding
Cost classification
1.7
1.8
1.9
Understand the principles of cost code design
Construct a simple cost code for a given situation
Classify costs by element, function, controllability, and normality
Required for
Aims of the lesson
• To explain how a cost code can be constructed, to allow costs to be identified
with the incurring cost centre, and so that the nature of the cost can be
identified
• To show how one cost can be classified in a number of different ways, and to
explain why this is important
The lesson
▲ Begin by reminding the class what a cost centre is, and that (for a number of reasons
including the control of cost) we need to know how much each cost centre spends,
and what a particular amount has been spent on.
For example, we might know that in Week 14, £1,569 was spent on repairing the doughmixing machine in a bakery. Part of the repair was carried out by an outside firm, and
part was done by the bakery's own maintenance team.
Ask the class how we know the figure of £1,569.
The answer is that – somehow – the invoice from the outside firm, and the time spent
by the bakery's maintenance staff, must have been recorded against the dough-mixing
machine. This can only have been done if we had a code to identify the dough-mixing
machine, and also a code to identify repair costs.
4
The first code could be (say) 346, and the second code could be (say) 27. Therefore
'34627 £1,569' tells the full story.
Emphasise the advantage of a code: 34627 £1,569 is quicker, and more accurate, than having
to say, '£1,569 has been spent on repairing the dough-mixing machine.'.
Point out that proper coding is essential for a computerised cost accounting system.
Take the class once again through Example 2 on page 4, through to page 6.
▲ Cost classification
Begin with the CIMA definition on page 6. Emphasise, with the example that follows
at the top of page 7, that we shall be looking at different ways of classifying the same
cost.
Students sometimes wonder why different classifications of the same cost are
needed – won't one do?
Use the textbook illustration to answer this:
The breakdown of the student group to male/female has implications for planning
college facilities.
The breakdown of the student group to those who have passed the Second Level and
those who have not, has implications for the teaching approach – and perhaps for the
need for extra classes for some students.
▲ Move on to the classification of cost by element as introduced on page 7.
Emphasise the CIMA definition of a direct cost. Make sure that each part of the prime
cost is understood, and that the class is aware that the sum of the indirect costs is
termed overhead.
Work carefully through Example 3 on pages 8-9 of the textbook, to show how the cost
of a good product must absorb the cost of those normally scrapped.
▲ Now ask the class to work through the following example:
A company has a particular product made by outworkers in their own home.
The outworkers are supplied with the materials. They are supplied with 5 square
metres of material to make each product.
The material costs the company £18 per square metre.
Each outworker is expected to return the offcuts that remain from the making
of each product, and the company can sell these for £6.
The outworker is paid £42 for each acceptable product made, but only £18 for
those that prove to be not of acceptable quality.
Questions:
(a) Which of the costs mentioned are direct costs, and which are overhead?
(b) What is the cost of each product made, if all products made are of acceptable quality?
(c) What is the cost of each acceptable product made if, when the production is returned,
10% are found to be unacceptable, and the material (in addition to the offcuts) can
be sold for £9 each?
5
You will need to allow the class some time to think about these, and discuss them, before periodically
checking to see what progress is being made.
The answers should be:
(a) All of the costs mentioned are direct costs. The material supplied to the outworkers
is direct material cost, and the saleable value of any offcuts is a reduction of this
cost. The payment made to the outworker is a direct expense. It is not direct labour
because, usually, outworkers are not employees of the company in a legal sense,
and are only given work when work is available.
(b)
£
Direct material 5 sq. metres × £18
less sale of offcuts
Direct material cost
90.00
(6.00)
84.00
42.00
126.00
Direct expense
Prime cost
(c)
£
Direct material cost of 10 products
10 × £84
Less sale of material from
one (10%) unacceptable product
Outwork cost of 10 products
10 × £42
Less outwork cost saving from one
unacceptable product £42 – £18
Cost of 9 acceptable products
Cost of 1 acceptable product:
Direct material £831/9
Outwork £396/9
Prime cost
840.00
(9.00)
831.00
420.00
(24.00)
396.00
1,227.00
92.33
44.00
136.33
Most of the class should manage to get the answer to (b) without too much trouble.
Almost certainly, they will need help with (c). There are, of course, other ways to the same
solution.
▲ Now explain the classification of cost by function. This will require some explanation of
the functions of business and, in particular, the dividing line between the production
function and the distribution function.
For example, a company making perfume may decide that the bottle, and the box in
which the bottle of perfume is put, will be counted as primary packaging and as the
final stage of production cost. In contrast, the carton into which (say) 200 individual
bottles are packed will be counted as secondary packaging, and as the first stage of
distribution cost.
6
Take the class through Example 4 on pages 9 and 10 of the textbook.
▲ Now take a local industry known to you and the class, and ask each member of the
class, in turn, to name a particular cost incurred by that industry, and to classify their
named cost by element and by function.
▲ Finally, explain the distinction between a normal and an abnormal cost. Emphasise that
the £136.33 cost, produced earlier in this lesson, assumes that it is normal for an
outworker to make one unacceptable product out of every 10 that he makes. Because it
is considered normal, the cost was increased from £126 to £136.33 to absorb the net
cost of the unacceptable item.
Emphasise the importance of this to management for control purposes.
If an outworker produces 100 products and 90 are acceptable, no management action
is needed. 10 rejects is normal.
If the outworker produces 100 products and 88 are acceptable, management action
may be required, because 2 products more than normal have been declared unacceptable.
There is an abnormal loss of 2 products.
If the outworker produces 100 products and 92 are acceptable, there is an abnormal gain
of 2 products. Management would want to reproduce the conditions that brought this
improvement about.
Take the class through Example 5 on page 11 of the textbook.
Reminders
A carefully-constructed, numerical cost code is used to define cost centres and
expense headings.
Costs can be classified by element, by function and by normality. Another
classification will be looked at in the next lesson.
7
LESSON 3
Main subject
Syllabus reference
1
General
Lesson topics
Cost classification by variability
Introduction to accounting entries
1.10 Classify costs by behaviour, i.e. into variable, semi-variable, semi-fixed
and fixed categories
1.11 Identify the behavioural classification for a cost, from a given total or
unit cost/volume graph
2.16 Make accounting entries for materials in an integrated accounting system
3.11 Make accounting entries for labour in an integrated accounting system
4.16 Make accounting entries for overhead in an integrated accounting system
Required for
Aim of the lesson
• To introduce the subject of cost behaviour
The lesson
▲ Begin by reminding the class that each cost can be classified in a number of ways, and
that the same cost can be looked at in different ways.
For example, the cost of maintaining the production process will include indirect
material cost and indirect labour cost. It is part of overhead cost. By function it is a
production cost. It may be normal or abnormal. For example, it could be much more
than the amount budgeted because of an unexpected process breakdown, the cause of
which should be investigated.
Explain that you are now introducing the classification by cost behaviour, that is, how the
cost behaves when something else changes. That 'something else' is usually the level of
activity, often output. We are saying, 'How does the amount spent on a particular cost
behave as output rises or falls – does the amount spent tend to rise, to fall, or stay the
same?'.
8
Point out that, although you have said the activity could be output (in the sense of
units of product), it could be other things.
For example, we could be asking,
'As the number of students in a class increases, what happens to the college bill for
paying lecturing staff?'
or
'As we increase the number of miles travelled in our car, what happens to the total
amount we spend on petrol?'.
Explain that in these examples, the number of students and the miles travelled are
perfectly good 'activity' measures.
To support this, point to the introduction on pages 12 and 13 of the textbook. Take the
class through it line by line – it is that important! Draw particular attention to the CIMA
definitions of variable cost, fixed cost and semi-variable cost.
Emphasise these points with the following:
▲ A company makes a product, and must pay the inventor of the product a royalty of £8
on every product manufactured.
Units made
1
50
100
Royalty each
Total cost
£
£
8
8
8
8
400
800
Point out that the royalty is an example of a variable cost. (It is common for students to
think that perhaps it is a fixed cost because it is fixed at £8 per unit.)
You must make it very clear that the reference to a cost in the CIMA definition of a
variable cost is to the total cost – in this case the total royalty cost – and not to the unit
figure. It is because the progression of the total royalty cost (£8, £400, £800) is exactly
in line with the output progression (1, 50, 100) that we can define this cost as a variable
cost.
▲ Another example is:
A machine can be set up ready for production at a cost of £380. It only has to be re-set
if more than 400 units are made in a run.
Production
units
1
30
70
Setting cost
£
380
380
380
Setting cost per unit
£
380.00
12.67
5.43
Again, it is common for students to think that this must be a variable cost because the
setting cost per unit changes as output changes.
9
Point out clearly that this is not the case. Setting is a fixed cost, because – as with the variable
cost – the reference to 'the cost' in the definition is to the total cost. In this case the total
cost is fixed at £380.
▲ Finally, explain the semi-variable cost, again pointing to the CIMA definition on
page 13.
Return to the royalty example, and explain that now the agreement with the inventor
is that he will be paid £300 per month, even if there is no production, plus £8 for each
unit manufactured.
Units made
in the month
Royalty each unit
Fixed royalty
£
8
8
8
£
300
300
300
1
50
100
Total cost
£
308
700
1,100
Point out that when the royalty was just £8 per unit, a doubling of the units
manufactured (from 50 to 100) resulted in a doubling of the cost (from £400 to £800).
Now, for a semi-variable cost, the doubling of the output only increases the cost from
£700 to £1,100; it hasn't doubled. Explain that this is why the CIMA definition says
'partly affected.'
You are advised to take particular care in ensuring that the class understands this section,
and the way in which individual costs react (behave) differently, in response to activity
changes.
▲ Emphasise that students must be able to recognise cost behaviour, from given figures for
a particular cost, or from a sketch graph showing either the total cost or the cost per unit.
As an example, give the class these figures for a particular cost:
Output
Cost
£
5
20
50
90
75
300
750
1,350
Ask the class what sort of cost this is.
Clearly, they should be able to eliminate the possibility of its being a fixed cost – all the
costs are different.
However, it could be a semi-variable cost.
An easy check is to work out the cost per unit. In each case this is £15. This should
allow the class to conclude that it is a variable cost.
10
You should now suggest to the class that, instead of giving the figures, you could have
given sketch graphs. Tell them that you could have given a graph showing the total cost
against different activity (output) levels. Sketch the graph on the board. It would appear
as follows:
Total
cost
Output
Make certain the class understands that this would be recognised as a variable cost
because it rises against output in a linear way, and because the line commences at the point of
origin, i.e. no output, no cost.
Point out that you could also have given a sketch graph showing cost per unit against
output. Because for a variable cost the cost per unit is a constant, the graph is a horizontal
line. The sketch graph would appear as follows:
Cost
per
unit
Output
Now show the class similar graphs for a fixed cost. They would appear as follows:
First for the total cost,
Total
cost
Output
11
and then for the cost per unit:
Cost
per
unit
Output
It is important that the class recognises that the curve for the fixed cost per unit falls
sharply, then begins to flatten out, but will never reach zero and will never become flat –
although it will get close to both of these. It is best to show this to the class with some
figures. For example:
Output
units
1
2
3
4,000
30,000
Cost
£
300
300
300
300
300
Cost per unit
£
300.00
150.00
100.00
0.08
0.01
Finally, ask the class if they can sketch graphs for a semi-variable cost – firstly, for the
total cost against output, and then for the cost per unit against output. Remind them
that a semi-variable cost is a bit of each of the other two – part variable and part fixed.
This should give them the necessary clue to produce the graphs.
Their answers should be:
Total
cost
Output
Cost
per
unit
Output
12
Emphasise that they would recognise these as a semi-variable cost – if given the graphs
– because the total cost line in the first graph does not proceed from the point of
origin, and because the cost per unit curve in the second graph does not run close to
the horizontal axis (since the cost per unit cannot be lower than the variable cost element
of the semi-variable cost).
▲ Finally, in this lesson, introduce the recording aspect of cost accounting by mentioning
the main control accounts that will be used in later chapters. These are introduced on
pages 15-18 of the textbook. You may want to ask the class to read these pages in their
own time, rather than disturb their thinking on cost behaviour, which has been the
main focus of this lesson.
Reminders
Costs can be classified by 'behaviour' – how they react to a change in activity
(output).
A variable cost is one for which the total cost incurred increases in proportion
to an output increase.
A fixed cost is one for which the total cost incurred is unchanged as output
increases (or, of course, decreases).
A semi-variable cost is one having both variable and fixed cost components.
The behaviour of a cost can be deduced from looking at a given table of output/
cost figures, or at cost graphs.
13
LESSON 4
Main subject
Material cost
Syllabus reference
2
Costing for materials
Lesson topics
Procedures for ordering, receiving, storing and issuing materials
Stock-carrying costs, costs of a stock-out
Perpetual inventory and continuous stock-taking
2.1
2.2
Understand the need to plan material requirements
Calculate material requirements, making allowance for sales, product stock
changes and material stock changes
2.3 Understand the procedures leading to the selection of a supplier
2.4 Explain and illustrate the various documents used in the process of
ordering and receiving materials
2.5 Understand the procedures to be followed upon the receipt of materials
from a supplier
2.6 List and explain various stock categories, and why such stocks are carried
e.g. raw materials, work-in-progress, finished stocks, fuel stocks,
consumable stocks etc.
2.7 List and explain costs of carrying stocks and of running out of stock
2.8 Prepare records of stock movement in quantity and value terms
2.9 Understand the meaning of perpetual inventory records and how they
relate to continuous stock-taking
2.10 Suggest reasons for discrepancies between the inventory record and
physical stock
2.11 Explain the meaning of allocated and free stock (Calculations will not be
required at Second Level.)
Required for
14
Material cost
Aims of the lesson
• To introduce the calculation of material requirements
• To describe all procedures, documentation, etc. associated with materials,
from their purchase to their use
• To explain the costs which arise from carrying stock, and from running out
of stock
• To emphasise the need to control the physical flow of materials
• To show that physical stock can be reserved for a particular customer
The lesson
Note: Much of the content of this lesson is descriptive, and should not present you (as
the teacher) with major preparation problems. The comments made here will mainly
focus on any calculations that are required for the lesson.
▲ Begin by pointing out that purchasing, stock-holding, and the other routines described
in Chapter 2, apply not only to the purchases of raw materials, components and other
items which might be needed for the manufacture of products. They apply also to the
purchase and stocking of general consumables, fuels, maintenance materials and spare
parts, stationery, and so on, which the company needs.
It would be useful, next, to spend some time taking the class through the diagram on
page 26 of the textbook. This will allow them to see the scope of the topic and,
particularly, the distinction between the physical flow of the materials and the flow of
value (cost). You should specifically draw the attention of the class to this aspect.
Point out that a company should only purchase materials that are required. This may
sound obvious, but it does mean the company needs to plan. Tell the class that this is
the first bit of budgeting they have met – a lot more will come later!
Emphasise that material requirements depend upon what products we intend to
produce, and that in turn, we only produce what, in time, we expect to sell.
Illustrate this with the example of a shopkeeper. He will only purchase and fill his
shelves with goods that he believes people will want to buy, at a price that they can
afford to pay, and at which he can make a profit.
Emphasise that you used the word ‘believes’. Goods are made by industry (and therefore
materials and components are bought to make them) in anticipation of being able to sell
them, that is, quantities are based upon sales forecasts and budgets.
▲ Take the class through the important Examples 1 and 2 on pages 27-30 of the textbook.
Example 2 is particularly important in showing that the materials needed for production
may not be the materials purchased, because of planned changes in the level of material
stocks.
Make certain that the class understands the change to just-in-time (JIT) purchasing
arrangements, since this is the first mention of this approach. Draw attention to the
CIMA definition of JIT on page 29.
15
Take the class carefully through the descriptive routines on pages 30-35. It may be that
some members of the class will be able to contribute, in observing how the routines at their business
differ (if differ they do) from those outlined in the textbook.
▲ Stocks
Explain why stocks may be carried, for example: as a safeguard against unexpected
demand, in case the supplier fails to deliver on time, because a better price makes it
worthwhile to buy more than will be immediately used. You may want to draw these
reasons from the class before you give them.
Identify the different categories of stock, including work-in-progress and finished goods.
Explain that there is a conflict between the benefits of carrying stock (and that such
benefits may be lost if stock is not carried) and the costs of carrying stock.
Take the class through the examples of stock-carrying costs on page 35, and of the
costs of not carrying stocks on page 36. Emphasise that they must be able to give
examples of both in the examination.
Point out, again, that there are two aspects to stock: the physical amount of stock
carried, for example 45 kg, or 16 packets, or 5 drums, and the value of stock carried.
Remind the class that a large amount of stock may have a low value, or a small amount
of stock may have a large value. As an example of the latter category, a jeweller may
carry small amounts of gold, but the stock will have a high value.
Concentrate, for the moment, on the quantity of stock carried. Take the class through
the 12 points under the heading ‘Stock records’ on pages 36 and 37, and then through
Example 3.
▲ Introduce the stock record itself, by referring to the one at the top of page 39. Relate
this to the CIMA definition of a perpetual inventory on page 38.
Explain how the balances on this record are ‘book balances’ only, and need to be
periodically checked against the physical stock – what is really there! This introduces
continuous stock-taking.
Draw particular attention to the reasons for any discrepancy, given at the top of page
40. The class may be able to suggest other reasons.
▲ Finally, point out that stock can be reserved for, or allocated to, a particular customer’s
order, leaving the rest of the stock to be considered free and therefore available for
other uses. This is explained on page 40.
Do point out, however, that if material on order is included in this model, then it goes
beyond the physical stock in hand, which has been the main emphasis of this lesson.
Note that Second Level students need only be concerned with the idea of allocated and
free stock, not with its working.
16
Material cost
Reminders
There are two aspects to materials – its physical quantity and its value. Although
the cost of carrying stocks and the cost of stock-out have been discussed, the
major focus of this lesson has been on the physical quantity of materials –
planning requirements, ordering, receiving, recording and verifying.
17
LESSON 5
Main subject
Material cost
Syllabus reference
2
Lesson topic
Methods of pricing materials from stock and the effect of each method on
production costs and upon stock valuation
2.12 Price issues from stock using FIFO, LIFO, Specific price, Weighted
average, and Standard price.
(Periodic weighted average prices will not be examined at Second Level.)
2.13 Explain and contrast the effect of alternative pricing methods on
production costs, stock values and reported profits
Required for
Aims of the lesson
• To introduce a number of pricing methods which can be used to charge
materials from stock to work-in-progress or to overhead accounts
• To emphasise that pricing methods are concerned with the flow of cost and
not with the physical flow of materials
• To show that each method has a residual effect on the value of stock remaining
The lesson
▲ Explain that the need to price an issue of materials applies to any material that is carried
in stock for use at a later date. Therefore, it applies to fuel stocks, general consumables,
stationery, and so on, as well as to raw materials and components to be used in
production, and to finished products. The nature of the stock makes no difference to
the principles to be explained.
18
Material cost
Also explain – at the outset – that any pricing method simply apportions the balance on
the stock account between the cost of materials used, and the cost of materials remaining
in stock. Illustrate this with:
Material RP9
Stock 1 January
Purchases between
1 January and 31 March
Materials used between
1 January and 31 March
Stock 31 March
kg
450
1,200
1,650
£
9,000
26,400
35,400
1,070
580
Make it clear to the class that the pricing problem is how to apportion £35,400 between
the 1,070 kg of material used, and the 580 kg remaining in stock.
For example, to be silly about it, if the 1,070 kg was charged to the user department for
£1 per kg, it would leave £34,330 as the value of the remaining 580 kg. The class should
easily see what is silly about this suggestion: a department is being charged £1 per kg
for materials when the most recent price has been £22 kg (£26,400/1,200), and the
opening stock was carried at £20 kg (£9,000/450 kg).
You should make it clear that the problem is to choose a pricing method which –
somehow – fairly relates the price charged (to the user of the material) to the price(s)
actually paid for the materials.
In this introduction, you should also explain that the pricing method is nothing to do
with the physical issue of the material. Good storekeeping practice may dictate that
material that has been in stock longest, should be used first. But this does not determine
the pricing method. Sometimes, when a later delivery has been placed on top of earlier
stock, the more recent deliveries might be used first. Again, this does not determine
the pricing method.
Finally, before illustrating the pricing methods, point out that if issues are priced, the
value of the remaining stock is the balancing figure. However, an equally valid approach
is to value the remaining stock, leaving the value on the materials issued as the balancing
figure. For example, in the preceding example, we could price the 1,070 kg issued, and
what remains of the £35,400 is the value applicable to the remaining stock . Or, we
could value the remaining stock of 580 kg, and the balance of the £35,400 is the value
applicable to the 1,070 kg issued.
▲ Now introduce the pricing methods needed for the Second Level candidate. These are covered in
the textbook between pages 42 and 52.
First explain the 3 categories into which pricing methods fall. These are given at the
top of page 43.
Explain that if 10 tonnes of material were purchased at £200 per tonne, and 5 tonnes
were purchased at £240 per tonne, then either £200 per tonne or £240 per tonne are
cost prices which could be prices at which material is issued.
19
Alternatively, ((10 × £200) + (5 × £240))/15 = £213.33 is a price derived from cost
(we have used cost prices to get it), but it is not actually a price that we have paid.
If someone says, ‘Why don’t we issue materials at £230 per tonne?’ – that is a notional
price. It is neither a price actually paid, nor derived from any price paid.
You should note that the pricing methods are illustrated in the textbook using the
same basic data (as given on page 43). This allows the class to compare the results of
the methods used.
It would be sensible to use new data here to introduce the subject. The class can then
use the examples in the textbook to reinforce their knowledge and understanding.
Preferably, use data with a distinct price trend (say, upwards), and for the purchase of a
product for retail sale at a fixed price. You could use the following data:
John Stone is a retailer. He purchases and sells one product. The selling price is
£75 each product.
Stock in hand, 1 January, 20 units, which were purchased for £30 each.
Purchases in the 3 months ended 31 March were:
10 February, 30 units for £32 each
15 March, 40 units for £40 each
Sales made were:
12 January, 13 units
19 February, 16 units
22 March, 46 units
Give these figures to the class. Point out that the trend of purchase prices is steadily
upwards (£30, £32 and £40) and that – because the selling price of the product is a
constant £75 – the trend of gross profit will be steadily downwards.
You could issue some blank pro-forma stock record sheets to the class, so that all they
have to do is enter the purchase and issue transactions, and the stock balances.
▲ Do ‘First In First Out’ (FIFO) with them first.
Date
1 Jan
12 Jan
10 Feb
19 Feb
15 Mar
22 Mar
Qty
30
40
Receipts
Price
£
£32
£40
Qty
Issues
Price
13
£30
£
390
960
16
498
46
1,672
1,600
Stock Balance
Qty
Price
£
20
£30
600
7
210
37
1,170
21
672
61
2,272
15
600
Carefully explain the issue pricing to the class. The February issue is (7 × £30) +
(9 × £32). The March issue is (21 × £32) + (25 × £40).
Point out, too, that the stock valuation under FIFO is easily checked. Here it is
15 × £40, the last price paid.
20
Material cost
Ask the class what gross profit John Stone has made in the 3 months to 31 March, if he
prices issues on a FIFO basis.
The answer is (Sales 75 units × £75) – (Costs £390 + £498 + £1,672) = Profit £3,065.
Now ask the class to work through Example 5 on page 44 of the textbook, either in
class, or in their own time. Ask them to pay particular attention to the Notes to the
solution.
▲ Now do ‘Last In First Out’ (LIFO) with them.
Date
1 Jan
12 Jan
10 Feb
19 Feb
15 Mar
22 Mar
Receipts
Qty
Price
£
30
40
£32
£40
Qty
Issues
Price
13
£30
390
16
£32
512
£
960
1,600
46
1,792
Stock Balance
Qty
Price
£
20
£30
600
7
210
37
1,170
21
658
61
2,258
15
466
Carefully explain the LIFO issue pricing to the class. The March issue is (40 × £40) +
(6 × £32).
Point out that the stock valuation under LIFO is not so easily checked. Here it is
(8 × £32) + (7 × £30).
prices issues on a LIFO basis.
Emphasise that this profit is £134 less than under FIFO, because the LIFO pricing
method allows the rising prices to come into costs more quickly. This also reflects the
closing stock value, which is £134 less under LIFO.
Ask the class to work through Example 6 on page 45 of the textbook, either in class or
in their own time. Ask them, again, to pay particular attention to the Notes to the
solution.
▲ Now tell the class that you are moving to a pricing method derived from cost, the
‘weighted average’ pricing method.
Date
1 Jan
12 Jan
10 Feb
19 Feb
15 Mar
22 Mar
Receipts
Qty
Price
£
30
40
£32
£40
Qty
Issues
Price
13
£30
390
16
£31.62
506
46
£37.11 1,707
£
960
1,600
Stock balance
Qty
Price
£
20
£30
600
7
210
37
£31.62 1,170
21
664
61
£37.11 2,264
15
557
21
prices issues on a weighted average basis.
Ask the class to work through Example 9 on page 47 of the textbook, either in class or
in their own time. Once again, ask them to pay particular attention to the Notes to the
solution.
▲ Finally, tell the class that you intend to illustrate one notional pricing method, namely
‘standard price’.
To illustrate this, you will need to set a standard price. Suggest that this should be £35,
and explain that the price variance (the difference between the standard price and actual
price paid) will be taken on purchase. Therefore, only standard price entries will appear
in the stock account.
Date
1 Jan
12 Jan
10 Feb
19 Feb
15 Mar
22 Mar
Qty
30
40
Receipts
Price
£
£35
£35
Qty
Issues
Price
13
£35
455
16
£35
560
46
£35
1,610
£
1,050
1,400
Stock balance
Qty
Price
£
20
£35
700
7
245
37
1,295
21
735
61
2,135
15
525
Point out that the opening stock has been re-valued on the new standard price of £35
per unit, so that all entries in the account are at £35 per unit.
prices issues on a standard price basis.
The answer is (Sales 75 units × £75) – (Costs £455 + £560 +£1,610) = Profit £3,000.
This could have been calculated 75 units × (£75 – £35).
Point out that this is not, however, the whole story:
Purchases have been put into stock at £35 unit, when different prices have actually
been paid. If these price variances are favourable, they will increase profits; if adverse,
they will decrease profits.
Applying these to the data:
Purchase 10 Feb, put into stock £1,050, actual cost £960; Favourable variance
£90
Purchase 15 March, put into stock £1,400, actual cost £1,600; Adverse variance
£200
Opening stock revaluation: Favourable variance £100
Therefore the profit is £3,000 + £90 – £200 + £100 = £2,990.
22
Material cost
Ask the class to work through Example 10 on page 49 of the textbook, either in class,
or in their own time. Again, ask them to pay particular attention to the Notes to the
solution, and especially to the second part of the Solution, where the price variance is
taken on issue, rather than on purchase.
Reminders
Pricing is concerned with the flow of costs.
Alternatives are cost prices, prices derived from cost and notional prices.
Any pricing method has an effect on cost of sales, on the remaining stock
valuation, and on the reported profit for the period.
23
LESSON 6
Main subject
Material cost
Syllabus reference
2
Lesson topic
Introduction to material stock control
2.14 Understand the principles of stock control
2.15 Calculate reorder level, maximum stock, minimum stock, average stock
and average stock investment
(Calculation of reorder quantity will not be required at Second Level)
Required for
Aims of the lesson
• To explain the principles of stock control
• To explain how to calculate specific measures for use in stock control
The lesson
▲ The topic of this lesson starts on page 52 of the textbook under the heading ‘Controlling
levels of stock’.
Draw the attention of the class to the CIMA definition of stock control on page 52.
Note the words ‘systematic regulation’ – stock levels should be planned.
Remind the class that in a previous lesson (Lesson 4), the planning of material
requirements was considered. If the purchasing of material is not precisely synchronised
with the usage of material, then stock movements will occur. The class has also been
told that carrying stock costs money. This must be justified.
Use simple figures to show stock relationships:
A material is purchased in 800 kg batches for £4.50 per kg. Stock-carrying costs
amount to 9% per annum. The material is used at the consistent rate of 40 kg
per day. The supplier takes 3 days to deliver an order.
24
Material cost
Explain to the class the implications of this small example:
It takes 20 days to use the amount delivered in one order (800 kg/40 kg).
After 17 days, the stock will be down to 120 kg. This is 3 days’ supply. A new order
must be placed after 17 days because the supplier takes 3 days to deliver. Stock will just
have run out when the new supply arrives.
Point out that if stock can be as high as 800 kg (when a delivery is made) and as low as
zero (just before an order arrives), then the average stock must be 400 kg.
Therefore, the investment in stock averages 400 kg × £4.50 = £1,800.
Make it clear that sometimes the stock will be 800 kg × £4.50 = £3,600, and sometimes
it will be nil. But it averages £1,800.
Next ask the class what the 9% means.
They should reply that it means that if stock costing £100 at purchase is carried in
stock for a year, then it will cost £9 to do so.
This £9 covers all the costs mentioned on page 35 of the textbook. The most significant
of these is likely to be interest on capital.
Go on to explain that, at this rate, an average stock investment of £1,800 will have
annual stock-carrying costs of £162.
Ask the class how this cost can be reduced.
They should suggest that the order quantity might be reduced from 800 kg, provided
the price per kg does not increase significantly as a result.
Now get the class to sketch the stock graph (similar to the one illustrated on page 56 of
the textbook).
▲ Now explain that this first example was too ‘neat and tidy’, mainly because we were
certain that 40 kg of material would be used every day, and that the supplier could be
relied upon to deliver in 3 days.
Tell the class that you are now changing this, as follows:
The rate of material usage varies between 32 and 46 kg per day, and the supplier
sometimes delivers in 2 days, but could take as long as 6 days.
We have now introduced uncertainty.
Explain that we are taking the supplier’s 2 days and 6 days to be the ‘lead times’. (Point
to the explanation of the meaning of lead time on page 54.)
Now take the class through the following calculations. The calculations use the formulae
set out on pages 57 and 58 of the textbook.
Reorder level
46 kg × 6 days = 276 kg
Point out that this takes the worst view both of material usage and of lead time. It
should mean that a material stock-out will not occur.
Maximum stock level
276 kg – (32 kg × 2 days) + 800 kg = 1,012 kg
25
Minimum stock level
276 kg – (39 kg × 4 days) = 120 kg
Average stock level
(800 kg/2) + 120 kg = 520 kg
Average stock investment
520 kg × £4.50 = £2,340
Annual stock-carrying costs
£2,340 × 9% = £211
When the class understands the calculations made from this illustration, take them
through Examples 11 and 12 on pages 55-59 of the textbook.
Reminders
Stock levels should be planned with an understanding of the benefits of carrying
stocks, and of the costs of doing so.
Candidates must learn the formulae used in this lesson, both for certain and
uncertain data.
26
LESSON 7
Main subject
Syllabus reference
1
Further aspects of the Second Level Cost Accounting syllabus
Lesson topic
The preparation of a Material Requirements Plan, making allowance for product
and process scrap
1.1
1.2
Calculate the amount and cost of materials needed to meet the production
plan, taking into account process wastage and products rejected at the
end of each operation
Understand the meaning of yield, by operation and overall
Required for
Candidates for Third Level only
Aim of the lesson
• To explain how product rejects and process scrap affect material requirements
The lesson
▲ Begin by pointing out that products can be made without some of them being rejected,
and without some material being lost in the production process.
A situation where both product rejects and process scrap arise can be illustrated as
follows:
Each product may be made from 5 kg of steel
In making the product, 1.5 kg of steel is machined away, leaving the finished
product weighing 3.5 kg. The 1.5 kg is called process scrap.
The products made, now weighing 3.5 kg, would be checked for quality, and
10% perhaps rejected. This is the product scrap or product rejects.
Make sure that the class understands the distinction between process scrap and product scrap.
27
Now show how this affects material requirements planning:
Suppose the firm makes just one product, the XX4.
Budgeted sales for Year 4
2,600 units
Budgeted finished stock increase
280 units
Material needed to make each XX4
4 kg
No products are rejected on completion.
No change is planned in material stock levels.
Explain that the materials required will simply be:
2,880 units × 4 kg = 11,520 kg
Now tell the class that 10% of all products made are rejected, and cannot be rectified.
They just have to be scrapped.
What are the material requirements now?
The answer is:
We need 2,880 good finished products – so more than this need to be made, to allow
for those that will be rejected.
We need to make 2,880/90% = 3,200, so that when 10% (320) of the 3,200 made are
rejected, it leaves 3,200 – 320 = 2,880 good products.
Go over this calculation several times until everyone understands it. The most common error is that
the answer is given as 2,880 × 1.1 = 3,168.
Material required now is 3,200 × 4 kg = 12,800 kg.
Use the same figures to illustrate process scrap:
Tell the class that 0.5 kg is process scrap, and therefore each finished product weighs
3.5 kg. Ask the class how much scrap is available for sale.
The answer is 3,200 × 0.5 = 1,600 kg.
However, the alert student will say, ‘What about the products that are rejected?’
If they can be sold as scrap, it is another 320 × 3.5 kg = 1.120 kg. (Emphasise the use
of 3.5 kg, and not 4 kg, in this calculation.)
▲ Now tell the class that we are going to suppose that the product XX4 is made in 2
consecutive operations. The products made are inspected after the first operation, and
20% are rejected and scrapped. The products are again inspected after the second
operation, and 10% are rejected and scrapped.
Now what are our material requirements?
The answer is:
Since 2,880 products are needed, 3,200 must come out of the first operation and into
the second operation. Therefore 3,200/80% = 4,000 products must be made in the
first operation. The material requirements will therefore be 4,000 × 4 kg = 16,000 kg.
28
Point out that the term ‘yield’ means output in relation to input. The yield of good products
from operation 1 is 80% and from operation 2 it is 90%, making an overall yield of
72%. Since we need 2,880 good products we must make 2,880/72% = 4,000 products.
Ask the class to calculate the total weight of scrap (process and product) available for
sale.
This is simply the difference between 4,000 × 4 kg = 16,000 kg, and the weight of the
finished good products, which is 2,880 × 3.5 kg = 10,080 kg. The scrap therefore
totals 5,920 kg.
Finally, point out that although 16,000 kg of material are needed to meet production
needs, it may be that the company is also planning to increase the amount of material
stock carried. This would further increase the 16,000 kg.
Now work through Examples 1, 2, 3, 4, and 5 on pages 69-77 of the textbook.
Reminders
This has been a particularly important lesson. The class should understand the
meaning of ‘yield’, and how to adjust the number of products to allow for
rejection rates.
29
LESSON 8
Main subject
Syllabus reference
2
Stock control – use of free stock balance; calculation and use of economic
order quantity (EOQ)
Lesson topics
The calculation of economic order quantity
Stock records to show allocated, free and ordered material
2.1
2.2
2.3
2.4
2.5
2.6
2.7
Explain the significance of just-in-time purchasing and its relationship
to average stock levels
Understand the influence of RQ (the reorder quantity) on average stock
levels and on average stock investment
Use the EOQ model to calculate economic reorder quantity (EOQ) at a
constant purchase price and where discount is given by the supplier for
larger order quantities
Construct a graph to show ordering costs, stock-carrying costs and total
costs
Tabulate items in 2.4 for discrete order quantities to select the optimal
order size without using the EOQ model
Apply the EOQ model to calculate the economic batch quantity for
production
Make calculations, and present a stock record showing for a particular
material, orders placed, stock on hand, and allocated and free stock
Required for
Aims of the lesson
• To show how the EOQ is calculated and what factors influence it
• To show how stock records can be maintained which allow for material to be
allocated to customers’ orders
30
The lesson
▲ Begin by reminding the class that the material to be purchased depends upon the
material needed for production (allowing for process scrap and rejects), and upon
planned changes in material stock levels.
If the material to be purchased in the year amounts to 50,000 kg, to be used over a 50week production year, the next question must be, ‘Is it an even production requirement,
or are there high points and low points?’
If 1,000 kg will be used each week over the 50 weeks of 5 days each week, then:
If ordered and delivered in 200 kg batches, the average stock carried is 100 kg.
If ordered and delivered in 1,000 kg batches, the average stock carried is 500 kg.
If ordered and delivered in 5,000 kg batches, the average stock carried is 2,500 kg.
Remind the class that this is using RQ/2 to determine the average stock, and assumes
that the stock of material reaches zero just as the next delivery arrives from the supplier.
Remind the class, also, that if orders and deliveries are 200 kg for example, it means
that deliveries must arrive from the supplier every day. The material must be there as
required at the start of each day (just-in-time) and will gradually be used during the
course of the day.
Tell the class that if the purchase price is assumed to be £12 per kg, the average stock
investment will be £1,200 (100 kg × £12), £6,000 (500 kg × £12), or £30,000 (2500 kg
× £12).
Remind the class that carrying stock has a cost, for example 9%, which means £9 to
carry stock costing £100 for one year.
So, if we want to minimise stock-carrying costs we should minimise average stock. In
this example, we should purchase in 200 kg lots every day.
Do emphasise that we are not referring to the cost of the average stock. We are referring
to the cost of carrying the average stock.
▲ Now introduce ordering costs.
Explain that each time an order is placed, there are costs involved in placing the order,
progressing it, receiving the delivery, and so on. This might be (say) £30 per order. So,
ordering in 200 kg lots may minimise stock-carrying costs but will cause the highest
order costs, since 250 orders (50,000/200) would be placed each year.
Explain that what we want to do, is minimise total costs – the aggregate of order costs
and stock-carrying costs.
We want to choose the order quantity that will do this. This is known as the economic
order quantity (EOQ).
Refer the class to the CIMA definition on page 84.
Now point to the EOQ formula on page 86 and tell the class that they must know this
and be able to use it.
31
Use it for the figures you have used in the earlier part of the lesson:
√ (2DCo)/Ch
= √ ((2 × 50,000 × £30)/(9% × £12)) = 1,666.66 recurring.
EOQ =
Explain that this means that:
£
Stock-carrying costs will be (1,666.666/2) × £12 × 9% = 900
Order costs will be (50,000/1,666.666) × £30
900
Aggregate of stock-carrying and order costs
1,800
Draw the attention of the class to the graph on page 87 of the textbook. You may want
to get the class to prepare such a graph using the figures you have been using in this
lesson.
▲ Tell the class that sometimes the examiner asks for figures to be tabulated for different
order quantities.
Point out that this approach can be used to get close to the EOQ, when the formula
cannot be remembered. For example:
Assume the EOQ is 1,000 kg:
£
Stock-carrying costs 500 kg × £12 × 9%
Order costs 50 × £30
540
1,500
2,040
Assume the EOQ is 2,000 kg:
Stock-carrying costs 1,000 kg × £12 × 9%
Order costs 25 × £30
£
1,080
750
1,830
Calculations like this will eventually locate the EOQ, or can be used as the basis of
producing a graph like the one on page 87, so that the EOQ could be visually estimated
from the graph.
▲ Now take the class through Example 9 on pages 87-89 of the textbook.
When you have explained the solution to parts (a) and (b) of the example, introduce
the effect of discounts which a supplier might offer on purchases of larger quantities.
Take the class carefully through the Solution to part (c), since this approach is adequate
for many examination questions. Emphasise that the approach compares the saving in
annual purchase costs (in terms of both the basic material cost and the ordering costs)
with the extra cost of carrying higher average stocks.
Using the figures from this lesson, you could say that the supplier will reduce the
price to £11.80 per kg, if orders are placed in 5,000 kg batches.
Saving in annual costs of material 50,000 kg × (£12.00 – £11.80) = £10,000
32
Saving in order costs 50,000/5,000 = 10 × £30 = £300 compared to £900 at present =
£600 saved
Total savings £10,600
Additional costs:
Average stock 2,500 × £11.80 = £29,500
Present average stock 1,666.666/2 × £12 = £10,000
Increase in average stock £19,500 × 9% = £1,755
It is worth spending £1,755 to save £10,600?
Remind the class, again, that the comparison is not between £10,600 and £19,500 – a
common error which causes candidates to say that the proposal is not worthwhile –
but between £10,600 and 9% of £19,500.
Finally, for this topic, take the class carefully through the addition to Example 9, which
commences on line 7 of page 89 in the textbook, and ends at the foot of that page.
▲ Stock records to deal with allocated and free stock
Explain why it might be prudent to reserve or allocate stock to a particular order, and
how this then leaves a balance of free, or available, stock.
The topic starts on page 77 of the textbook
Emphasise that the first example, Example 6, is only concerned with physical stock, in
other words, the stock in hand is either allocated or free.
Work carefully through each transaction with the class.
Then explain that it is possible to allocate material before it is even received from the
supplier. This is illustrated by Example 7 on pages 80 and 81.
Again, make sure that each transaction is understood by the class.
Example 8 requires a reasoning approach to the solution, and will only be understood when the
subject is familiar. This is an important example to work through with the class.
You could perhaps add additional data for December to give the class further practice.
Reminders
Emphasise the reasons for rising stock-carrying costs and for falling order costs
and that the aim is to establish the EOQ – the order quantity that minimises the
aggregate of these two costs.
The model needs to be adapted when discounts are offered for larger order
quantities.
Stock in hand, and sometimes stock on order, can be allocated to orders, leaving
a balance of free (available) stock.
33
LESSON 9
Main subject
The specific lesson topic commences on page 90 of the textbook.
Syllabus reference
1
Lesson topic
Pricing materials to production – further aspects
1.3
1.4
Price materials from stock using periodic weighted average price, where
the period may be a week, a month, a quarter or a year
Price materials from stock using replacement price, and understand how
this affects the value of the stock balance
Required for
Aims of the lesson
• To explain the calculation and use of periodic weighted average price
• To explain the calculation and use of replacement price
The lesson
▲ Begin by reminding the class that all pricing methods are simply ways of apportioning
material cost. The apportionment is made between the costs of a period and the stock
balance carried forward at the end of that period.
Also, remind the class that pricing methods fall into three categories – cost prices,
those derived from cost, and notional prices.
This lesson considers 2 pricing methods not introduced at Second Level: periodic
averages, which fall into the second category (prices derived from cost); and replacement
price, which falls into the third category (notional prices).
34
▲ Periodic averages
In practice, periodic averages are very common.
Begin by reminding the class that weighted average was studied for Second Level. The
approach used was that the weighted average price would be re-calculated each time a
new purchase of material was made. The resulting price would then be used for all
issues until another purchase was made.
Use the following figures to illustrate your lesson:
Kg
500
300
280
200
90
440
290
Stock 1 Jan
Purchases 10 Jan
Issues 15 Jan
Purchases 17 Jan
Issues 20 Jan
Issues 24 Jan
Purchases 28 Jan
£
21,000
12,000
8,600
13,050
Remind the class that if the issues were priced using the weighted average method as
learned in Second Level, the stock record would show:
Date
Qty
1 Jan
10 Jan 300
15 Jan
17 Jan 200
20 Jan
24 Jan
28 Jan 290
Receipts
Price £
Qty
Issues
Price £
280
41.25 11,550
90
440
41.74 3,757
41.74 18,366
12,000
8,600
13,050
Stock balance
Qty
Price £
500
21,000
800 41.25 33,000
520
21,450
720 41.74 30,050
630
26,293
190
7,927
480 43.70 20,977
Remind them that the average price has been re-calculated, on a weighted basis, each
time a purchase has been made.
Explain that if a periodic weighted average price is to be used, the period must be
decided. It could be a week, or a month, or a year.
A periodic average reduces the number of calculations made. This advantage may be
lost if a weekly periodic average is applied. A month is therefore more likely to be the
periodic basis of the calculation.
Tell the class that you are illustrating a periodic average based upon the calendar month.
This means that no pricing of issues can take place until the month has ended, unless
the issues of one month are priced at the average price of the previous month.
Using the above example, the periodic weighted average for January is (£21,000 +
£12,000 + £8,600 + £13,050)/(500 + 300 + 200 + 290) = £42.36.
Issues will be priced at (280 + 90 + 440) × £42.36 = £34,312.
35
Closing stock will be £54,650 – £34,312 = £20,338.
Get the class to compare this result with that obtained earlier for the basic weighted
average method.
You may want to give the class some purchase and issue figures for February. This
would then allow you to illustrate a periodic average for the 2 month period.
Finally, take the class carefully through Example 10 on pages 91-93 of the textbook.
▲ Replacement price
Explain that it is argued that the real cost of using a material is the cost of replacing it
on the day that it is used. Point out that this is a good argument but that its application
causes 2 specific problems:
(1) Every time material is issued from stock, there is the problem of establishing its
replacement price at that specific moment.
(2) The stock account is distorted by using a price for the issue which may never
actually have been paid for material.
Using the figures from the previous example, 90 kg of material were issued on 20
January, 3 days after paying £43 kg for material.
However, suppose that on 20 January (unlikely as it may be!) such material could only
be replaced at £62 kg.
It is valid to price the issue at this figure, but it would leave the stock at £30,050 – (90
kg × £62) = £24,470. This is for 630 kg, an average of £38.84, a price lower than any
price paid.
Take the class through Example 11 on pages 94 and 95 of the textbook.
Reminders
The main decision to be made in applying the pricing method of the periodic
weighted average is the length of the period – it can be weekly, monthly, quarterly,
annually. Monthly or quarterly are more likely to be used.
The method simplifies issue pricing in that the number of different prices used
is reduced to just one for each period.
The use of replacement price has theoretical merit but presents real problems
of application.
36
Costing for labour
LESSON 10
Main subject
Costing for labour
Syllabus reference
Second Level
3
Costing for labour
Lesson topic
Methods of remuneration
3.1
3.2
3.3
Identify the main costs incurred by a business as a result of employing
people
Understand various methods of remuneration for individuals and for
groups
Calculate earnings and remuneration for various remuneration methods
Required for
Aims of the lesson
• To introduce labour-costing principles and procedures
• To explain methods of remuneration
The lesson
▲ Begin by pointing out that because people are employed, various costs arise. Ask the
class to suggest what these might be. They may suggest:
Wages earned
Holiday pay
Sickness pay
Maternity and paternity payments
National Insurance contributions
Pension contributions
Subsidised meals
Protective clothing
Supervision
Training
37
These are just suggestions. Not all of these may be valid in your business environment.
You may have others, specific to your environment, not mentioned in this list.
Make it clear that many of these costs are overheads to the business, as a consequence of
employing people.
Point out that in an earlier lesson direct labour was distinguished from indirect labour.
Revise this by taking the class through Example 1 on page 105 of the textbook.
▲ Now begin to talk about remuneration methods, that is, the way people are paid.
Explain that remuneration may be on a basis of attendance (for example, a weekly wage
of £180 for 40 hours, or a salary of £14,400 a year paid at £1,200 per calendar month),
or based upon production (for example, £2.50 per unit made, making £120 for a week in
which 48 units are made, and £75 for a week in which 30 units are made), or based
upon both, some of the wage paid on attendance and some based upon output.
Then explain that there are some jobs that are suitable for payment on an output basis,
and others where this is unsuitable, and remuneration is best made on a time basis
only.
For example, a production worker could be remunerated on the basis of the number of
good units produced, but it would be wrong to remunerate a surgeon on the time he
can save in performing an operation. This might encourage carelessness.
Explain, also, that some jobs are done by a team rather than individuals, and perhaps it
would be better to look at team effort when thinking of how to remunerate team members.
Draw the attention of the class to pages 106-108 in the textbook.
▲ Remuneration calculations
Make sure that the class can quickly and accurately make remuneration calculations.
Time rate payments
An accountant is paid £25,920 per annum.
He is not paid overtime.
He is paid in 12 equal calendar monthly payments.
In Month 4 he works 24 overtime hours because of the monthly accounts.
What is his remuneration in Month 4?
The answer is £25,920/12 = £2,160.
A fork-lift truck driver is paid £313.50 for a basic 38-hour week.
All overtime is paid at time and a half.
He attends for 42 hours in Week 17.
What is his remuneration for Week 17?
The answer is £313.50 + (4 hours × £8.25 × 1.5) = £363.
38
Costing for labour
A factory cleaner is paid £4.40 per hour for a basic 4 hours per day for a 5-day
week.
Time and a half is paid for any hours above the basic weekly hours.
He was 1 hour late on one day; this hour is not paid.
He attended for 23 hours in Week 34.
What is his remuneration for Week 34?
The answer is (19 hours × £4.40) + (1 overtime hour at £4.40 and 3 overtime hours at
£4.40 × 1.5) = £107.80.
Payment by results (PBR)
Explain that some PBR schemes are based upon money, that is, prices are given for
jobs done.
For example, producing one unit of product DD9 may be worth £0.68 to the employee,
whereas producing one unit of product RS4 may be worth £1.76 to the employee.
Emphasise that if working at the same incentive rate, this implies that RS4 is expected
to occupy the worker for longer than DD9.
Further explain that some PBR schemes are based upon time. The employee is given
an allowed time to complete the job. If he works at incentive speed, he should complete
the job in less time and will be rewarded out of the time saved. Often he will only get
a part of the time saved – hence these schemes are called ‘sharing plans’ or ‘bonus
systems’.
Point out that in either type, the firm has to decide what will happen when the employee
produces unacceptable output. Will he still be paid or will he only be paid for good
work?
At this point, go through the section on page 113 of the textbook, ‘Remuneration on
an output basis’ and through Example 3. This will help the class to understand the
relationship between money-based and time-based incentives.
▲ Now do some remuneration calculations with the class.
A production worker is paid on ‘piece-work’ (based upon production).
He has no guaranteed basic remuneration.
In Week 14, in 38 hours, he produces 168 units of Job 45, and 7 units of Job 34.
The piece-work prices are £1.30 and £5.50 respectively.
What is his remuneration in Week 14?
The answer is (168 × £1.30) + (7 × £5.50) = £256.90. Emphasise that the hours
worked were not relevant to this answer.
In the same situation, the production worker is now guaranteed a minimum of
£220 for a 38-hour week.
What is his remuneration?
The answer is no different because his earnings (£256.90) exceed the minimum (£220).
39
In the same situation again, the production worker is guaranteed a minimum of
£260 for a 38-hour week.
What is his remuneration?
The answer now changes. Emphasise the difference between his earnings of £256.90
and his guaranteed remuneration of £260.
Point out that one possibility is being compared with another. Here, the earnings figure
of £256.90 is rejected and replaced with the guaranteed £260.
Tell the class to read questions on remuneration calculations carefully. An employee
might get some of his remuneration on a time-rate basis and some extra on output, for
example:
A worker does a normal 38-hour week, for which he is paid £8.70 per hour.
In addition, he is paid for his output.
In Week 19 he produced 180 units of Job 36, for which the piece-work price
was £0.42 per unit.
What was his remuneration for Week 19?
The answer is (38 × £8.70) + (180 × £0.42) = £406.20.
A worker is employed for a basic 38-hour week at £7.40 per hour.
A bonus of 40% of the time saved against standard allowed time is paid at basic
rate.
In Week 22 he produces 22 units of Job 316 (allowed time each unit 1.75 hours)
and 12 units of Job 63 (allowed time each unit 2.10 hours).
He worked no overtime, but 3 hours were unproductive, spent waiting for
materials.
These 3 hours are to be paid at average earnings.
What was his remuneration in Week 22
The answer is:
Basic hours 38 × £7.40
Allowed time (22 × 1.75) + (12 × 2.10) = 63.70
Time taken 38 – 3 = 35 hours
Time saved 63.70 – 35 = 28.70 × 40% × £7.40 =
Unproductive hours 3 × (£84.95/35) =
£
281.20
84.95
7.28
373.43
In going through this calculation with the class, emphasise the way in which the
unproductive hours have been compensated, on the assumption that it wasn’t the fault
of the worker that he was waiting for materials.
40
Costing for labour
▲ Now take the class carefully through Examples 4-9 on pages 116-133. This includes
the section on Group bonus schemes, and covers specific points such as overtime
treatment and shift allowances.
The graphs may be ignored as specific comment on them is reserved until the next
lesson.
Reminders
The emphasis of this lesson has been on the calculation of remuneration, whether
based upon time or upon output, and whether for the individual worker or for
a group.
41
LESSON 11
Main subject
Costing for labour
Syllabus reference
Second Level
3
Costing for labour
Lesson topic
The effect of remuneration method on unit cost
3.4
3.5
3.6
3.7
Appreciate the effect of each remuneration method on the unit cost of
output
Construct graphs to show total labour cost and the unit labour cost for
alternative remuneration methods
Distinguish between production and productivity
Measure changes in production and productivity
Required for
Aims of the lesson
• To show the effect of remuneration method on unit cost
• To explain graphs of total remuneration and unit cost
• To differentiate between an increase in production and an increase in
productivity
The lesson
▲ Begin by reminding the class of the previous lesson, in which the essential difference
between remuneration on a time-rate basis and remuneration on an output basis was
explained.
Remind the class that if a worker is paid exclusively on time, his remuneration for a
38-hour basic week may be £235.60 irrespective of output and effort. The only way
that he will be remunerated more than this is by doing overtime. What he produces,
and the effort made, is irrelevant to what he is paid.
Point out that if in the 38-hour week he only produces 1 unit of output, its unit cost is
£235.60, but that if he can produce 10 units, the unit cost will be £23.56. The benefit
of increased effort and output goes entirely to the employer!
42
Costing for labour
This will allow you to explain the graph on page 110 of the textbook.
Point out that although one scale is on the right of the graph, both are plotted and read
from left to right. Emphasise the horizontal remuneration line, and the cost per unit
curve.
The graph on page 112 should also be explained in relation to Example 2.
Now explain that if a worker is paid entirely on results, the remuneration line would
be as the earnings line on the graph on page 119. This means that if the operative
produces nothing, his remuneration is correspondingly zero. The cost per unit would
be a constant £1.68.
However, point out that the graph on page 119 illustrates what happens where
remuneration is on output, but the worker has a basic time-rate guarantee.
Explain that the cost per unit curve cannot fall below £1.68 but, as the graph shows, it
can certainly be more than £1.68.
The graph on page 122 illustrates 2 bonus schemes. It plots total remuneration.
Remind the class that bonus schemes pay an addition to the basic time-rate payment.
It would be a good exercise for the class to prepare a graph showing the cost per unit
curve for each of the 2 schemes.
▲ Explain to the class the difference between production and productivity:
Production is a quantity of output. For example, if 5 workers each produce 48 units of
product each week, the weekly output is 240 units.
If each worker is paid £312 per week, the total remuneration is £1,560 and the labour
cost per unit is £6.50.
There may be a need to increase output to 336 units per week, to meet demand. If 2
additional workers are taken on, and paid at the same rate, the total remuneration goes
to £2,184, and the labour cost per unit is £2,184/336 = £6.50.
There has been an increase in production (from 240 units a week to 336 units per
week).
There has been no change in productivity since unit labour cost is unchanged at £6.50.
Productivity is the relationship between the output and the cost of the labour.
If 2 additional workers cannot be taken on (for instance, there are none available, or
there is no room for them), then can the additional output come from the 5 workers?
We could offer each worker a weekly bonus of £124.80 if output per worker is increased
to 67.20 units. Total remuneration will then be 5 × (£312 + £124.80) = £2,184. The
labour cost per unit will be £2,184/336 = £6.50.
Again, therefore, there has been an increase in production but no increase in
productivity.
If the output increase can be achieved with a weekly bonus of (say) £90, then total
remuneration will be 5 × (£312 + £90) = £2,010, and the labour cost per unit will be
£2,010/336 = £5.98.
In this case there has been both an increase in production and an increase in productivity.
43
These important contrasts must be made clear to the class. This topic is further
illustrated on page 132 of the textbook. Example 9 on pages 132-133 should also be
reviewed with the class.
Reminders
The method of remuneration has an effect upon the unit labour cost.
Any method of remuneration with a time-payment element will allow for a
reduction in unit labour cost as production per hour increases.
There is a clear difference between an increase in production and an increase in
productivity.
44
Costing for labour
LESSON 12
Main subject
Costing for labour
Syllabus reference
Second Level
3
Costing for labour
Lesson topic
Payroll preparation and analysis
3.8
Correctly treat overtime premium, shift allowances (premium) and idle
time
3.9 Understand payroll preparation based upon time and/or output records
3.10 Understand the meaning of payroll analysis
Required for
Aims of the lesson
•
•
•
•
To describe the routines of payroll preparation
To explain the safeguards needed to prevent fraud in such a system
To explain payroll analysis
To show accounting entries for labour
The lesson
▲ Begin by referring the class to page 133 of the textbook, where CIMA definitions of
‘payroll’ and ‘payroll analysis’ are given.
Make certain that the class understands the distinction. Any business with employees
will need to prepare a payroll, to deal with deductions from gross pay in order to obtain
the net amount payable, and to account for the deductions which will later be paid
over on behalf of the employee – for example to the tax authorities,.
On the other hand, not all firms will have a cost accounting system. Those that do will
want to undertake payroll analysis, to decide how much of the gross wage is direct and
how much is indirect, and to determine the cost centres/cost units to which the wages
should be charged.
45
The gross wage earned by an employee will include any overtime which he has done.
Overtime is normally paid at an hourly rate greater than the basic rate. Explain that the
extra is called ‘overtime premium’.
For example, if an employee is paid at a basic rate of £4.20 per hour, and overtime is paid
at time and a third, then the premium is £1.40 per hour.
Explain that overtime premium is generally treated as an overhead cost.
However, point out that if the overtime has been done at the specific request of a
customer, to speed delivery of his job, then the overtime premium can be treated as
part of the direct labour cost.
National Insurance contributions are payable in the UK. The employee’s contribution
is deducted from the employee’s gross wage. The employer’s contribution is an additional
cost, over and above the gross wage. It is normally treated as overhead.
For the majority of firms, the payroll preparation and payroll analysis routines will be
computerised. This is an area of the syllabus where members of the class might be able
to contribute from their own experience.
Emphasise the importance of accurate time and output records when calculating wages.
Point out that even where all employees are paid on a time basis only, a reliable record
is needed of times of arrival and departure, overtime, absence through sickness, holiday,
and so on. Discuss with the class how this can be obtained.
Then discuss what information is needed if an employee is to be paid wholly, or partly,
on output. Again, encourage the class to draw on their own experience.
▲ Explain how the gross wage becomes the net wage.
In the UK this is by the deduction of employees’ national insurance contributions,
income tax, and other deductions such as contributions to pension schemes and
contributions to charity.
You should explain this in a local context, and it would be useful if the class could
make calculations for (say) 3 imaginary employees.
▲ For payroll analysis, emphasise that the wages analysed must agree in total with the
gross wage earned.
As an example, point out that if Month 7 comprises Weeks 13, 14, 15 and 16, then the
gross wages for those weeks must be analysed for cost accounting purposes, although
the net wages relating to Week 16 will not be paid until Week 17.
Take the class through Example 10 on page 135 of the textbook. In particular, emphasise
the use of the wages control account and the wages payable account.
If any of the class are weak on book-keeping principles, the debit and credit entries
may need more explanation.
▲ Explain the ways in which safeguards can be introduced to reduce the possibility of
fraud in payroll preparation. Again, it may be that members of the class can contribute
to this discussion.
46
Costing for labour
Reminders
Emphasise the difference between payroll preparation and payroll analysis, and
the sources and type of information needed for each.
47
LESSON 13
Main subject
Syllabus reference
Second Level
4
Costing for overheads
Lesson topic
Sources of overhead cost
4.1
4.2
4.3
Identify possible sources of overhead cost
Understand the purpose and content of a plant register
Understand procedures for the collection of overhead cost against cost
centres
Required for
Aims of the lesson
• To explain the various sources of overhead cost
• To explain the nature of a plant register
• To illustrate depreciation calculations by straight line, reducing balance, and
machine hour methods
• To explain how overhead costs are identified with incurring cost centres
The lesson
▲ Begin by stating that this lesson and the next two lessons are the most important so far,
for an understanding of cost accounting.
▲ Now draw the attention of the class to the CIMA definition of overhead on page 143
of the textbook. Emphasise 2 things:
Overhead, by definition, cannot be identified with a saleable cost unit. If we make
furniture, the cost of wood can be identified with a saleable cost unit, and it is therefore
direct material. The cost of materials used to repair a machine that planes wood for
furniture making cannot be identified with any particular saleable cost unit. This is
therefore indirect material. Indirect material is part of overhead cost.
48
Point to the word ‘economically’ in the definition. For example, glue used in furnituremaking is really direct material, because the glue ends up in the saleable cost unit.
However, it may not be worth the effort of treating it as direct, and it will be included
in overhead.
Tell the class that overhead cannot – or cannot economically – be identified with the
saleable cost units. However, it must be identified with the cost centre which has wholly or partly
incurred the cost. Overhead cost must be collected from its sources and charged to cost
centres.
Draw the attention of the class to the 6 sources of overhead cost given on pages 144145 of the textbook. Point particularly to Number 5, as depreciation must be seen as an
overhead cost, even though not incurred in the same way as gas, electricity, indirect
labour, etc.
Example 1 on pages 145-147 is an important example. Make sure the class understands
that all overhead incurred is debited to the production overhead account of the specific
cost centre – and that the production overhead control account is a total account which
carries the total debit for each expense.
Again, make sure that the class understands where the credit entries are. Remind the
class that each cost centre would be identified by a cost code as taught in an earlier
lesson.
▲ Explain that Note 3 to the solution (on page 147) introduces 2 important words
– allocation and apportionment.
At this stage, point out that we like to be able to allocate cost. If we know that a supervisor
only works in one cost centre, then – without any doubt – his salary can be allocated
(or charged) straight to that one cost centre.
We are not so keen on apportionment (sharing) because there will always be argument
over the basis to use. If a supervisor divides his time between 2 cost centres, what will
be the basis for sharing his salary between the 2 cost centres? That’s the problem!
Make sure that the class understands this difficulty. It is fundamental to further study.
▲ Take the class through the essential elements of the fixed asset register on page 148.
Point out that in times gone by this would have been a handwritten register. Today it is
more likely to be on a computerised database. However, its purpose and content remain
unchanged.
Explain the purpose of depreciation as a means of apportioning the cost of an asset
over its expected useful life. Explain that it is usually treated as part of fixed overhead
cost because machines often make many different products, often stand idle, and have
very variable workloads. It is usually not possible to properly identify depreciation
exclusively with a particular saleable cost unit.
49
Explain the depreciation calculations. Use the following figures to help understanding.
Afterwards, refer to Example 2 on pages 149-150 of the textbook to reinforce the topic.
Cost of machine
£60,000
Estimated residual value
£8,000
Estimated life
4 years
Expected use:
Year 1
4,000 hours
Year 2
6,000 hours
Year 3
5,000 hours
Year 4
1,000 hours
If straight line depreciation is used, the total depreciation will be £52,000, and will be
£13,000 in each of the 4 years.
If reducing balance method is used, the total depreciation will also be £52,000. The %
to be applied is 39.57%. (Use the formula on page 150 of the textbook). The rate is
being used to 2 decimal places so that the methods can be better compared.
Tell the class that the examiner may give the % or that, as here, they could be required
to calculate it.
Depreciation for Year 1
39.57% of £60,000
£
23,742
39.57% of (£60,000 – £23,742)
14,347
39.57% of (£60,000 – £38,089)
8,670
39.57% of (£60,000 – £46,759)
5,239
2
Rounding adjustment needed
Total depreciation
52,000
If the calculations are based on machine hour rate:
(Rate = £52,000/16,000 hours = £3.25 per hour)
£
4,000 × £3.25
13,000
6,000 × £3.25
19,500
5,000 × £3.25
16,250
1,000 × £3.25
3,250
Total depreciation
52,000
▲ Now confirm that the class understands both these methods, and their effect upon
annual overhead costs, by working through Example 2 on pages 149-150 in the textbook.
50
▲ Finally, explain that overhead costs from all sources must be charged to incurring cost
centres using cost centre codes and expense headings.
The cost codes will cover all functions of the business, including production,
administration, selling, distribution etc.
At the end of the exercise we must know the total overhead incurred by each cost
centre, and the breakdown of that total under expense headings of indirect labour, gas,
electricity, depreciation, etc. As much of the overhead as possible will have been allocated,
but some will have been apportioned.
Reminders
By definition, overhead cannot be immediately identified with any saleable cost
unit.
However, it must be identified with incurring cost centres, using the cost code.
Where possible, overhead should be allocated to the incurring cost centre.
Where costs are shared by more than one cost centre, cost apportionment may
be done, but this is always less satisfactory, since there will be debate as to an
appropriate basis for sharing the cost.
51
LESSON 14
Main subject
Syllabus reference
Second Level
4
Lesson topic
The overhead distribution sheet
4.4
4.5
Allocate overhead to production and service cost centres
Apportion overhead to production and service cost centres
Required for
Aim of the lesson
• To explain the use of an overhead distribution sheet for collecting overhead
against all production and service cost centres.
The lesson
▲ Begin by reminding the class that overhead must be collected from a number of sources,
and allocated or apportioned to cost centres.
The columns of the overhead distribution sheet must each represent a cost centre,
defined by the cost code.
When the overhead distribution sheet is complete, we not only want to know how
much each cost centre has incurred in total but, also, what the expenditure has been
on. For this reason, each row of the overhead distribution sheet represents a particular
expense heading, such as gas, electricity, insurance, etc.
Draw a pro-forma overhead distribution sheet on the whiteboard or blackboard, or
prepare one for showing on the overhead projector.
52
The following is a suitable example of a production overhead distribution sheet. All
figures are in £’000
Production Cost Centres
101 107 109 201 207
01
02
03
04
05
06
Expense:
Labour
Idle time
O’time prem
Supervision
Gas
Electricity
etc
etc
Total
10
2
1
5
2
4
12
8
3
3
5
3
4
1
1
45
32
32
19
209
Service Cost
Centres
300 500 600 Total
14
13
6
8
5
1
5
1
1
9
14
6
2
2
3
1
2
3
1
5
104
11
7
32
11
29
38
34
26
24
14
19
264
3
6
Remind the class that the 3-digit numbers over the columns define the cost centres. 6
of these are production cost centres and 3 are service cost centres.
The 2-digit numbers against the rows define expense headings.
Overhead has been collected to this summary from different sources – for example,
the payroll analysis has booked £3,000 of idle time to cost centre 109. The expense
would have been booked to ‘10902’, so defining the particular overhead item, and
identifying the incurring cost centre.
Explain that the £264,000 of total production overhead is analysed to incurring cost
centre (column totals), and to expense heading (row totals).
Point out that similar overhead distribution sheets would be done for administration
overhead, selling overhead, and so on.
Emphasise that some overhead items would have been allocated (supervision, perhaps)
but others would have been apportioned (electricity, perhaps).
▲ At this point it is worth discussing a number of overhead costs, whether or not they
could be allocated, and if not, what would be a suitable basis of apportionment. You
could discuss depreciation, supervision, rent and insurance.
▲ It is particularly important to emphasise that the cost of operating service departments
must be established before any attempt is made to charge the cost to the departments
which they serve.
As an example, point out that £24,000 was the cost of service department 300 in this
period. It is important to know this. In the next lesson, we will discuss how the cost of a
service department will be charged to the cost centres benefiting from that service
department. Stress that it is the total of £24,000 that will be charged out, not each expense
individually.
53
▲ You should now take the class through Examples 3, 4, and 5 on pages 151-158 of the
textbook.
Give particular attention to Example 5 and its solution. Note how the data given must
be used as the basis of apportioned costs. The apportioned costs are clearly indicated in
the Solution on page 155.
Reminders
An overhead distribution sheet may be manual or computerised. It uses columns
to define cost centres and rows to define expense headings.
Some overhead can be allocated from sources to cost centres. Less satisfactorily,
some has to be apportioned.
The total cost of running a service cost centre must be obtained before any
attempt is made to re-charge service department costs to cost centres receiving
the service.
54
LESSON 15
Main subject
Syllabus reference
Second Level
4
Lesson topic
The apportionment of service department costs
4.6
Re-charge actual overhead from service cost centres to production cost
centres using repeated distribution/continuous allotment method
Required for
Aims of the lesson
• To explain that the costs incurred by a service department may be charged to
other service departments, but that, eventually, all service department costs
must be charged to production departments.
• To explain ‘benefit received or receivable’ as a basis for re-charging service
department costs
The lesson
▲ Begin by explaining that service departments do not in themselves produce the goods
that a firm sells. Service departments are set up to assist and smooth the production
process.
For example, a maintenance department is established to carry out planned maintenance
in the hope that this will reduce, or prevent, major breakdowns of production
equipment. It will also carry out breakdown maintenance, to repair equipment that has
broken down as efficiently and quickly as possible, so as to return it to productive use.
For example:
A toolroom is established to make tools to be used in production, or to repair tools that
have broken, or to sharpen tools that have become blunt.
A canteen is established to provide food for employees at a reasonable price and quality.
A despatch department is established to ensure that orders are properly packed, and to
select the best means of delivering the orders to customers.
55
Emphasise that these departments do not produce saleable cost units. The cost of
running these departments must be charged to the departments which they serve.
One service department may serve another service department – for example, the
employees of the maintenance department may eat in the canteen.
Emphasise that, ultimately, all service department costs must be re-charged to
production departments – because only from the production departments can the
cost be charged to saleable cost units.
▲ Use the following example to explain the benefit basis for charging out the costs of a
service department:
A company has 3 production departments, A, B and C, and 1 service department, X:
If C receives no benefit from the existence of X, then it should not be charged with any
of X’s cost. For instance, if X is a maintenance department, and C is a department
where employees assemble a product by hand, using no equipment, then there is no
equipment in C to be maintained.
The alert student may suggest that the department itself may need some maintenance – such as
painting the walls or repairing the floor.
Point out that perhaps the cost of a service department should be charged to other
departments on the basis of benefit receivable, rather than benefit received.
You can illustrate this by pointing out that all citizens should pay towards the cost of
building and running hospitals, although as individuals we hope that we will never
have to use the services of one.
▲ Now take the class through Example 6 on page 159 of the textbook. Point out that the
canteen cost has been apportioned on a benefit receivable basis, and that this point is discussed
in the Notes to the solution.
Then take the class through Example 7. Draw particular attention to Note 1 to the solution
because, usually, the examiner will express the benefits received from service
departments as percentages.
Explain that if the examiner says that 20% of the costs of service department X should
be charged to production department B, it is because B obtains 20% of the benefit
arising from the existence of X.
▲ Now use the following figures to show the class how to deal with service department
costs:
Department
Allocated &
Apportioned
cost
56
A
£’000
B
£’000
C
£’000
X
£’000
Y
£’000
Total
£’000
280
430
170
40
80
1,000
Tell the class that A, B, and C are production departments and X and Y are service
departments. Remind them of the importance of the total column on the right-hand
side. It controls the accuracy of the apportionments, and must always be used.
Also remind the class of the meaning of ‘allocated’ and ‘apportioned’ cost.
Ask for an example of each for production department (cost centre) A. An example of
an allocated cost would be the salary of the manager of department A. An example of
an apportioned cost would be a share of the buildings insurance premium.
Now tell the class that service department X only does work for department A, and
service department Y only does work for department C.
Therefore A gets 100% of the benefit from the existence of X, and C gets 100% of the
benefit from the existence of Y.
Department
Allocated &
Apportioned
cost
Service depts
Total
A
£’000
B
£’000
C
£’000
X
£’000
Y
£’000
Total
£’000
280
40
320
430
–
430
170
80
250
40
(40)
–
80
(80)
–
1,000
–
1,000
Remind the class again of the importance of the total column.
Point out that all of the overhead cost has now been collected on the 3 production
departments, from where it can be charged to saleable cost units made in those
departments.
▲ Now tell the class that the benefits from the service departments are being changed:
The benefits from X are 40% for A, 20% for B, 35% for C and 5% for service
department Y.
The benefits from Y are 50% for A and 50% for C.
Point out that this means that the cost of service department X must be charged out
first, because service department Y benefits from service department X
Department
Allocated &
Apportioned cost
Charge out X
Subtotal
Charge out Y
Total
A
£’000
B
£’000
C
£’000
X
£’000
Y
£’000
Total
£’000
280
16
296
41
337
430
8
438
–
438
170
14
184
41
225
40
(40)
–
–
–
80
2
82
(82)
–
1,000
–
1,000
–
1,000
57
▲ When the class understands what has been done so far, explain that one more change is
being made:
The benefits from service department Y are now 50% for A, 40% for C and 10% for X.
Explain that we now have benefits from both service departments to each other to
consider. Service department X does work for service department Y, and service
department Y does work for service department X.
Further explain that one approach is to ignore the work between service departments.
This would result in the cost of service department X being charged 40/95 of the cost
to A, 20/95 of the cost to B and 35/95 of the cost to C.
Similarly, the cost of service department Y would be charged 50/90 to A and 40/90 to
C, with the following result:
Department
Allocated &
Apportioned
cost
Apportion X
Apportion Y
Total
A
£’000
B
£’000
C
£’000
X
£’000
Y
£’000
Total
£’000
280
17
44
341
430
8
–
438
170
15
36
221
40
(40)
–
–
80
–
(80)
–
1,000
–
–
1,000
(Apportionments have been made to the nearest £1,000.)
To confirm their understanding of this method, now take the class through part (a) of
Example 8 on page 163 of the textbook.
▲ Finally, you should explain that the work between service departments can be considered
by means of the repeated distribution, or continuous allotment, method, as follows:
Department
Allocated &
Apportioned
cost
Apportion Y
Sub-total
Apportion X
Sub-total
Apportion Y
Total
A
£’000
B
£’000
C
£’000
X
£’000
Y
£’000
Total
£’000
280
40
320
19
339
1
340
430
–
430
10
440
–
440
170
32
202
17
219
1
220
40
8
48
(48)
–
–
–
80
(80)
–
2
2
(2)
–
1,000
–
1,000
–
1,000
–
1,000
Ask the class to note how small the differences are in the figures for the last two solutions.
▲ Now take the class through part (b) of the Solution to Example 8.
58
Reminders
Service department costs should be charged to user departments on the basis of
benefit received or benefit receivable.
Work between service departments can be ignored unless it is significant.
All service department costs must ultimately be charged to production cost
centres, from where they can be charged to saleable cost units.
59
LESSON 16
Main subject
Syllabus reference
Second Level
4
Lesson topic
Introduction to the absorption of production overheads
4.7
4.8
4.9
4.10
Understand the purpose of overhead absorption
Understand the meaning of full cost absorption
Understand the reason(s) for using pre-determined absorption rates
Calculate and apply production overhead using a unit of output
absorption rate
Required for
Aims of the lesson
• To explain the meaning and purpose of overhead absorption
• To explain full cost absorption
• To contrast absorption rates based on production overhead incurred with
pre-determined rates based upon budgeted production overhead
• To emphasise that pre-determined rates are preferred.
The lesson
▲ Begin by reminding the class where the previous lesson concluded:
Production overhead, where possible, has been allocated to the cost centre incurring
the cost – either a production cost centre or a service cost centre.
Where allocation has not been possible, the overhead has been apportioned to the
production and service cost centres, on some equitable basis.
Finally, the total cost of each service department has then been apportioned to the cost
centres deemed to have received benefit from that service department. Sometimes that
has meant apportioning the cost of one service department to another service
department, but eventually all of the production overhead has been located on
production cost centres.
60
Do not proceed until you are satisfied that the class understands the processes that
have brought us to this point.
▲ Now introduce overhead absorption.
Begin by referring to the CIMA definition on page 167 of the textbook.
Emphasise the word ‘attributing’. This means that we want to decide the appropriate
amount of production overhead that belongs to each unit of product we make, or unit
of service that we give.
Give this example:
Prime cost of 1 unit of Product XP1
Direct material
4 kg
Direct labour
3 hrs
Direct expense
Prime cost
£
32.00
27.00
4.00
63.00
Remind the class that what makes these costs direct is our ability to identify them with
a saleable cost unit, in this case 1 unit of XP1.
Explain that there are still problems – a pricing method has had to be selected for the
materials, and a decision has had to be made on how to treat overtime premium. Despite
these difficulties, it is comparatively easy to establish the prime cost of a product or
service.
But what is the total cost of production for a unit of XP1?
To find that, we need to add something for electricity, gas, supervision, machine repairs,
canteen, depreciation and heating, and all the other production overheads that we have
been talking about.
A little bit of each of these costs has to be absorbed into the cost of each unit of XP1
made.
Point out that the meaning of ‘full cost absorption’ is that no items of production overhead
are left out. This will be contrasted later with an approach that does leave out some
items.
Suppose that XP1 is made in 3 production cost centres, and that when all of the
production overheads have been allocated and apportioned and the service department
costs apportioned, the overheads incurred for Year 9 were:
Production cost centre
Production overhead incurred
A
B
C
£
87,120
£
61,920
£
110,160
Emphasise to the class that the word ‘incurred’ has been used. These are historical
production overhead costs, amounts actually incurred in Year 9.
Now explain that in some way, the production overhead incurred must be related to
the cost of 1 unit of XP1.
61
As a first step, tell the class we will assume that this firm only makes one product, the
XP1, and that in Year 9, the output was 7,200 units of XP1.
Point out that this is a most unusual situation, and that it means – in effect – that the
production overheads could be considered to be direct costs, because if only one product
is made, than all costs incurred by the firm are attributable to that one product!
The full or total cost of a unit of XP1 was:
Direct material
4 kg
Direct labour
3 hrs
Direct expense
Prime cost
Production overhead:
A
£87,120/7,200
B
£61,920/7,200
C
£110,160/7,200
Full or total production cost
£
32.00
27.00
4.00
63.00
12.10
8.60
15.30
99.00
Explain that this ‘per unit’ approach to absorbing production overhead can only be
used if a single product is made, a rare situation indeed!
For additional reinforcement, take the class through Example 1 on page 168 of the
textbook.
Draw attention to Note 3 to the solution. This explains how full production cost can
be used for stock valuation purposes.
▲ Finally in this lesson, explain how inconvenient it is to have to wait until the actual
overhead has been collected at the end of the period, before any product costs can be
completed.
Tell the class that in many businesses, selling prices have to be quoted before orders are
obtained and it is therefore necessary to include an estimate of production overhead
cost in these price calculations.
For these reasons, pre-determined production overhead rates are usually used. These are based
on budgeted production overheads, not actual production overheads.
(Example 2 on page 169 of the textbook is based on historical costs. The examples
which follow it are based on budgeted production overheads and budgeted output.)
62
Reminders
The prime cost of a unit of product, or of service, can be established relatively
easily.
To find the full costs of production, production overhead must be charged or
attributed to the cost unit.
This can be done using the actual production overhead incurred, but this is
inconvenient. It is more usual to use pre-determined or budgeted production
overhead absorption rates.
A unit basis for absorption is possible only in the rare situation in which a single
product is made.
63
LESSON 17
Main subject
Syllabus reference
Second Level
4
Lesson topic
Comparison of alternative bases for the absorption of production overhead.
4.11 Calculate and apply production overhead absorption rates based upon
direct material cost, direct labour cost, prime cost
4.12 Calculate and apply production overhead absorption rates based upon
time – direct labour hours, machine hours, process hours
Required for
Aim of the lesson
• To explain how to calculate, and use, pre-determined production overhead
absorption rates
The lesson
▲ Tell the class that in this lesson it will be assumed that the firm makes just 2 products,
the DR6 and the DR7, and that production overhead rates will be budgeted or predetermined
Use the following data to illustrate your lesson:
Product
Direct material
Direct labour
Direct expense
Prime cost
6 hrs @
3 hrs @
£8
£7
DR6
£
20
48
13
81
DR7
£
50
21
10
81
The budgeted production overhead for Year 5 is £150,000.
Budgeted production is 1,000 units of DR6 and 600 units of DR7.
64
The products are made by machine, but the direct labour is also involved in setting up
the machine.
5 machine-running hours are needed to make a unit of DR6, and 2 hours to make a
unit of DR7.
Tell the class that you are going to use these figures to show the effect of using different
methods of absorption on the full, or total, production cost of the two products.
▲ First, tell the class that you will illustrate methods based on value. These are % on direct
material cost, % on direct labour cost and % on prime cost.
% on material cost
Calculate the cost of material which we expect to use in the year. This is:
(1,000 × £20) + (600 × £50) = £50,000
The production overhead absorption rate is therefore:
(£150,000/£50,000) × 100 = 300%
Using this, the production cost of each unit is:
Product
Direct material
Direct labour
6 hrs
3 hrs
Direct expense
Prime cost
Production overhead
Production cost
DR6
£
20
48
13
81
60
141
DR7
£
50
21
10
81
150
231
Remind the class that the absorption rate is calculated £150,000/£50,000 and not
£50,000/£150,000 – a common error made by students.
Point out that the production overhead on DR6 is £60 because £60 is 300% of £20. In
other words, £3 of production overhead is added to the cost of the unit for every £1 of
direct material cost.
% on direct labour cost
Calculate the cost of direct labour which we expect to use in the year. This is:
(1,000 × £48) + (600 × £21) = £60,600
(£150,000/£60,600) × 100 = 247.52%, say 248%
65
Product
Direct material
Direct labour
6 hrs
3 hrs
DR6
£
20
48
Direct expense
13
Prime cost
81
Production overhead (nearest £) 119
Production cost
200
DR7
£
50
21
10
81
52
133
Point out that now the production overhead on DR6 is £119, because £119 is 248% of
£48. In other words, £2.48 of production overhead is added to the cost of the unit for
every £1 of direct labour cost.
Even at this early stage, get the class to consider the results of the 2 methods used so
far, and to note how different the costs are.
% on prime cost
Calculate the prime cost which we expect to incur in the year. This is:
direct material £50,000 + direct labour £60,600 + direct expense (1,000 × £13) +
(600 × £10) = £129,600.
(£150,000/£129,600) × 100 = 115.74%, say, 116%.
Product
Direct material
Direct labour
6 hrs
3 hrs
DR6
£
20
48
Direct expense
13
Prime cost
81
Production cost
175
DR7
£
50
21
10
81
94
175
Point out that this time the production overhead on DR6 is £94, because £94 is 116%
of £81. In other words, £1.16 of production overhead is added to the cost of the unit
for every £1 of prime cost.
66
▲ When all members of the class understand the calculation and application of the 3
methods used so far, then – and only then – proceed to illustrate absorption rates based
on time.
Labour hour rate
Calculate the direct labour hours to be worked in the year. These will be:
(1,000 × 6) + (600 × 3) = 7,800 hours
The production overhead absorption rate will be £150,000/7,800 direct labour hours
= £19.23 per direct labour hour.
Product
Direct material
Direct labour
6 hrs
3 hrs
DR6
£
20
48
Direct expense
13
Prime cost
81
Production cost
196
DR7
£
50
21
10
81
58
139
Point out that the production overhead on DR6 is £115, because £115 is 6 hours ×
£19.23.
£19.23 of production overhead is added to the cost of the unit for every direct labour
hour used to make the unit.
Machine hour rate
Calculate the machine hours to be worked in the year. These will be:
(1,000 × 5) + (600 × 2) = 6,200 hours
The production overhead absorption rate will be £150,000/6,200 machine hours =
£24.19 per machine hour.
Product
Direct material
Direct labour
6 hrs
3 hrs
DR6
£
20
48
13
Direct expense
Prime cost
81
Production cost
202
DR7
£
50
21
10
81
48
129
67
Point out that the production overhead on DR6 is £121 because £121 is 5 hours ×
£24.19.
£24.19 of production overhead is added to the cost of the unit for every machine hour
used to make the unit.
▲ This lesson has been about how to calculate and apply production overhead absorption
rates.
Ask the class to look at the production costs per unit that result from each absorption
method. This comparison will be the basis of the next lesson.
▲ To finish this lesson, take the class through Examples 2, 3 and 4 on pages 169-181 of
the textbook.
Remember that Example 2 is based upon historical overhead, but that Examples 3 and
4 are based upon budgeted production overheads and budgeted output.
The important Example 4 should be particularly understood before proceeding further.
Reminders
Overhead absorption is used to transfer production overhead from the
production cost centres into the cost of the saleable cost unit.
Methods can be based upon value – direct material cost, direct labour cost, prime
cost – or upon time – direct labour hours, machine hours etc.
When calculating production overhead absorption rates, the production overhead
is always the numerator.
68
LESSON 18
Main subject
Syllabus reference
Second Level
4
Lesson topics
Comparison of unit costs arising from the use of different production overhead
absorption methods
Under- and over-absorptions of production overhead
4.13 Explain, in a simple way, why time-based rates are preferred to moneybased rates
4.14 Calculate and deal with any under- or over-absorption of overhead
4.15 Calculate a rate to absorb Administration, Selling and Distribution
overheads
4.16 Make accounting entries for overhead in an integrated accounting system
Required for
Aims of the lesson
• To explain why one method of overhead absorption may be more appropriate
than another
• To explain the meaning of, and treatment of, under and over-absorbed
overhead
69
The lesson
▲ Begin the lesson by comparing the unit production costs of each product based on
different absorption methods, as calculated earlier:
Product
DR6
DR7
£
141
200
175
196
202
231
133
175
139
129
£
Absorption method:
% on direct material
% on direct labour
% on prime cost
Labour hour rate
Machine hour rate
It is common for students to think that there must be a clear and definite cost of making
any product.
Emphasise that this is not so. We can be fairly confident up to the prime cost stage, but
the addition of production overhead takes on some arbitrary aspects.
Point out to the class that, depending upon the absorption method used, the cost of 1
unit of DR6 ranges from £141 to £202, and the cost of 1 unit of DR7 ranges from £129
to £231.
Point out, also, that the cost of DR6 is lowest when the cost of DR7 is highest. This is
because whichever method is used, the production overhead is £150,000 – and the
more of this that is charged to DR6, the less there is to be charged to DR7.
Is it fair to say that 1 unit of DR6 costs less than 1 unit of DR7 (as shown by the first
method used), or the same (as shown by the third method used), or more (as shown by
methods 2, 4 and 5)? You need to get the class discussing this.
Point out that a unit of DR6 uses much less material than a unit of DR7, and that this
is why method 1 (% on direct material) gives a production overhead cost of £60 for
DR6 compared to the higher £150 for DR7.
In all other aspects (except prime cost, which is identical at £81) DR6 uses more
resources than DR7: direct labour £48 compared with £21 for DR7; labour hours 6
compared with 3 for DR7; machine hours 5 compared with 2 for DR7.
▲ Now discuss whether production overheads are caused by using materials (purchasing
costs, stock-carrying costs, materials handling, etc), by using labour (employment taxes,
holiday pay, supervision, etc), or by using machines (electricity, maintenance,
depreciation, etc).
The conclusion should be that not many overheads are incurred because of the materials
used. This casts doubt on any method which includes direct materials i.e. on the
methods of % on direct material, % on prime cost.
Point out that whilst % on direct labour and labour hour rate will tend to give the same
result, in this case % on direct labour gives a production cost of £200 for 1 unit of DR6.
The labour hour rate method gives £196.
The cost of DR7 is £133 for % on direct labour, but £139 for labour hour rate.
70
These differences reflect the difference between labour time and labour cost. A unit of
DR6 uses twice the hours as a unit of DR7, but the direct labour cost of a unit of DR6
is more than twice the direct labour cost of a unit of DR7. This is because the direct
labour which makes DR6 gets £8 per hour, whereas the direct labour which makes
DR7 only gets £7 per hour.
Since many overheads accrue on a time basis, labour hour and machine hour rates are
considered to give more sensible results.
▲ To support this discussion, now take the class through pages 181-186 of the textbook.
▲ Over- and under-absorption of production overhead
Remind the class that whichever method of absorption is used, it will be based upon
budgeted overheads and budgeted output. Budgeted output, as we have seen, can be in
terms of budgeted direct material cost, budgeted direct labour cost, budgeted prime
cost, budgeted direct labour hours or budgeted machine hours.
Because the actual production overhead and the actual output will never be as budgeted,
costs will never be exactly absorbed.
Use the following figures to illustrate this point:
Budgeted production overhead
Budgeted machine hours
Therefore, budgeted or pre-determined production
overhead absorption rate
£84,000
7,000
£12
Emphasise that these figures are set in advance.
At the end of the budget period, actual figures are:
Actual production overhead
Actual machine hours
£81,600
6,300
Tell the class immediately that we don’t get the under- or over-absorbed overhead by
comparing the budget of £84,000 with the actual of £81,600. We get it by comparing
the absorbed overhead with the actual overhead.
Importantly, we get the absorbed overhead by applying the pre-determined absorption
rate to the actual output. In this case, our measure of actual output is the 6,300 machine
hours. Therefore the production overhead absorbed is:
6,300 × £12 = £75,600
and there is an under-absorption of £6,000.
Even at this early stage, get the class to see that the reason(s) for an under-absorption is
either excess spending on overheads, or a shortfall in production, or a bit of both.
▲ Take the class carefully through Examples 7 and 8 on pages 187-191. Take the
opportunity to reinforce the features of the production overhead account, and its
relationship with the work-in-progress account.
71
▲ Finally, explain what can be done with an under- or over-absorption of production
overhead. Emphasise that the most usual treatment is to write it off to the profit and
loss account.
Help the class see that this means the actual production overhead for a period is debited
partly to work-in-progress and partly (if an under-absorption) to profit and loss.
Take the class through, and discuss, Example 7 on pages 191 and 192 of the textbook.
Reminders
The use of absorption rates which use, or include, direct material in the output
base (% on direct material, % on prime cost) will usually give misleading results.
The % on direct labour and the labour hour rate methods will usually give
results that are quite close, but will differ because of different rates of pay.
Time based rates (labour hour and machine hour) are preferred.
The use of pre-determined overhead absorption rates give rise to under- and
over-absorptions, which are usually immediately written off to the profit and
loss account.
72
LESSON 19
Main subject
Syllabus reference
Third Level
Lesson topics
The use of simultaneous equations to deal with inter- service department
transfers
The use of service department absorption rates
1.7
1.8
Use simultaneous equations to deal with reciprocal service department
charges of actual or budgeted costs
Calculate and apply a pre-determined service department absorption rate
Required for
Aims of the lesson
• To show how to deal with inter- service department charges without using
the continuous allotment/repeated distribution method
• To explain that service departments can also use pre-determined absorption
rates, giving rise to under- or over-absorption
The lesson
▲ Begin by reminding the class of the earlier lesson in which inter-service department
charges were considered. If inter-service department charges were not significant they
could be ignored.
For example, if the following applied:
Cost centre
Overhead
A
£’000
160
B
£’000
250
X
£’000
60
Y
£’000
90
Total
£’000
560
A and B are production cost centres. X and Y are service cost centres.
Benefit obtained from X is A 40%, B 55% and Y 5%.
Benefit obtained from Y is A 30%, B 68% and X 2%.
73
Point out that the amount of inter- service department work is fairly small at 5% and
2%, and could be ignored.
The service department costs would then be apportioned:
Cost centre
Overhead
X
Y
A
£’000
160
25
28
213
B
£’000
250
35
62
347
X
£’000
60
(60)
–
–
Y
£’000
90
–
(90)
–
Total
£’000
560
–
–
560
Remind the class how these apportionments have been made. For example, X’s
apportionment to A is (40/95) × 60.
Now change the figures and tell the class that the following will apply:
Cost centre
Overhead
A
£’000
160
B
£’000
250
X
£’000
60
Y
£’000
90
Total
£’000
560
Point out that the % of work done by Y for X is still comparatively insignificant – even
though Y’s overhead is more than X’s overhead, but X does 20% of its work for Y,
which is far more significant.
Therefore deal with X first and then deal with Y, ignoring the work done by Y for X.
Cost centre
Overhead
X
Y
A
£’000
160
21
31
212
B
£’000
250
27
71
348
X
£’000
60
(60)
–
–
Y
£’000
90
12
(102)
–
Total
£’000
560
–
–
560
Remind the class how these apportionments have been made. For example, Y’s
apportionment to A is (30/98) × 102.
Now change the figures again and tell the class that the following will apply:
Cost centre
Overhead
A
£’000
160
B
£’000
250
X
£’000
60
Y
£’000
90
74
Total
£’000
560
The work done by X for Y, and by Y for X, is now significant, and neither should be
ignored.
Remind the class of the solution by repeated distribution/continuous allotment:
Cost centre
Overhead
Apportion
Apportion
Apportion
Apportion
Apportion
Y
X
Y
X
Y
A
£’000
160
18
29
3
1
–
211
B
£’000
250
50
37
9
2
1
349
X
£’000
60
22
(82)
4
(4)
–
–
Y
£’000
90
(90)
16
(16)
1
(1)
–
Total
£’000
560
–
–
–
–
–
560
▲ Now use the figures used for the last illustration to explain and illustrate the use of
simultaneous equations.
First, tell the class that the examiner might set a question with (say) 3 service
departments, but only 2 of these will do work for each other. Therefore, there will
only be two unknowns to deal with.
Emphasise that because this is a mathematical solution, great care must be taken with
plus and minus signs, so that accuracy is maintained.
Begin by emphasising that, at the start, there are 2 unknowns:
We don’t know the total overhead incurred by service department X, because it has to
include some of the overhead of service department Y.
Neither do we know the total overhead incurred by service department Y, because it
has to include some of the overhead of service department X!
First, give the unknowns a term or ‘label’.
Use x to represent the total overhead incurred by service department X.
Use y to represent the total overhead incurred by service department Y.
We can then say that:
x = £60,000 + 0.25y, and
y = £90,000 + 0.20x
Remind the class that this is saying, ‘We won’t know the total overhead of service
department X until we have added 25% of the total overhead of service department Y’,
and ‘We won’t know the total overhead of service department Y until we have added
20% of the total overhead of service department X’.
If we re-arrange one of the equations – say the first – we have:
-0.25y = £60,000 – x
y = £90,000 + 0.20x
Now, we can either multiply the first equation by 4 or multiply the second equation by
5. It doesn’t matter which.
75
We will multiply the first equation by 4.
-y = £240,000 – 4x
y = £90,000 + 0.20x
Explain that we can now add the equations so that y + (-y) = 0. This was why we
chose to multiply the first equation by 4.
So, adding the equations:
0 = £330,000 – 3.80x
Therefore, 3.80x
= £330,000
and
= £86,842.
x
This is the total overhead of service department X.
Therefore, since y = £90,000 + 0.20x, y must equal £90,000 + 0.20 (£86,842)
= £107,368.
The final apportionments, therefore, are:
Cost centre
Overhead
Apportion X
Apportion Y
In £’000
A
B
X
Y
£
Total
£
£
160,000
250,000
60,000
£
90,000
560,000
£
30,395
39,079
(86,842)
17,368
–
(107,368)
21,474
59,052
26,842
211,869
348,131
–
–
560,000
–
212
348
–
–
560
Point out to the class that this answer should be identical to that obtained from the use
of continuous allotment/repeated distribution. The slight differences are due to
rounding.
▲ Now take the class through Examples 1 and 2 on pages 211-215 of the textbook.
Make sure that these examples, and others which you can easily devise, are worked
through by the class using a blank sheet of paper. This topic is one that seems easy as it
is taught, and when following examples in the textbook. However, mistakes are easily
made under examination conditions.
▲ Finally in this lesson, point out that it may not be the actual costs incurred that are
apportioned from a service department. Just like a production cost centre, a predetermined or budgeted rate can be used.
Example 3 on pages 215-218 of the textbook was devised to illustrate this. Simultaneous
equations are still used in this example. It is important that you work through it carefully
with the class.
76
Reminders
Simultaneous equations are a way of dealing with inter- service department
charges between two service departments.
They offer an alternative method to continuous allotment/repeated distribution
Care is needed in solving the equations, particularly with regard to signs.
Pre-determined absorption rates can be used for service cost centres as well as
for production cost centres.
77
LESSON 20
Main subject
Syllabus reference
Third Level
Lesson topic
The use of normal capacity as a basis for overhead absorption and its effect
upon the interpretation of under- and over-absorptions
1.9
Understand and calculate the effect of absorbing production overheads
on a normal hours basis rather than on a basis of budgeted hours
1.11 Explain the causes of under- or over-absorbed production overhead in
terms of expenditure, volume and efficiency
Required for
Aims of the lesson
• To explain the concept of normal capacity and how it relates to overhead
absorption
• To explain how under- or over-absorbed overhead can be analysed by cause
The lesson
▲ Begin by reminding the class that any overhead absorption rate is calculated by
expressing the budgeted production overhead in relation to a budgeted measure of
output.
For example, if the budgeted production overhead is £150,000 and the budgeted material
cost is £20,000, then the absorption rate can be expressed as 750% on direct material.
Alternatively, if the budgeted machine hours are 12,000, then the absorption rate can
be expressed as £12.50 per machine hour.
▲ Now remind the class about principles of cost behaviour:
Some overhead costs, such as the electricity that drives the machines, could be
considered as variable – the more machine hours that are done, the more will be spent
on electricity. No machine hours – no electricity cost. Electricity cost for 4,000 hours
would be twice as much as the electricity cost for 2,000 hours.
78
On the other hand, some overhead costs, such as the supervisor’s salary, could be
considered as fixed. The supervisor may be paid £18,000, whether 8,000 machine hours
or 15,000 machine hours are worked.
Now explain the importance of this distinction.
First, suppose that all of the budgeted production overheads are considered to be variable.
Further suppose that the absorption method to be used is the machine-hour-rate basis.
Budgeted production overhead/budgeted machine hours = absorption rate
Therefore:
£150,000/12,000 = £12.50 per machine hour.
Now ask the class what the absorption rate would be if the budget was reconsidered,
and it was now thought that only 10,000 machine hours would be worked.
The incorrect answer will often be given as £150,000/10,000 = £15.00 per machine
hour.
The correct answer is that it won’t change, because the budgeted production overhead
will fall if the budgeted machine hours fall – because the costs are variable.
£125,000/10,000 = £12.50 per machine hour.
Now, suppose that all of the budgeted production overheads are considered to be
fixed. Further, suppose that the absorption method to be used is still the machine hour
rate basis.
Budgeted production overhead/budgeted machine hours = absorption rate
Therefore:
£150,000/12,000 = £12.50 per machine hour.
Now ask the class what the absorption rate would be if the budget was reconsidered
and it was now thought that only 10,000 machine hours would be worked.
This time the correct answer is £150,000/10,000 = £15.00 per machine hour.
Point out that if the budget was revised upwards, say to 15,000 machine hours the rate
would be £150,000/15,000 = £10.00 per machine hour.
Now explain that this is particularly important when costing a product, or when
estimating before quoting a price to a potential customer.
▲ Ask the class to consider a job which is estimated to have a prime cost per unit of
£36.00 per unit, and which takes 4.5 machine hours to make.
Point out that if the production overheads are all variable, it doesn’t matter whether
the budget is set on 10,000 machine hours, 12,000 machine hours, or 15,000 machine
hours. The rate per hour will always be £12.50 per machine hour, and the product cost
will be:
Prime cost
Production overhead
4.5 × £12.50
Production cost
£
36.00
56.25
92.25
79
Now show the class what happens if the budgeted production overheads are all fixed.
There are now 3 different absorption rates, depending on whether the machine hours
are expected to be 10,000, or 12,000 or 15,000. The absorption rate would then be
£15.00, or £12.50 or £10.00 per machine hour.
There would then be 3 possible product costs:
Prime cost
4.5 hrs × £15.00
4.5 hrs × £12.50
4.5 hrs × £10.00
Production cost
£
36.00
£
36.00
£
36.00
67.50
56.25
103.50
92.25
45.00
81.00
Point out that the highest production cost is when the machine hours are expected to
be low. This is the time when we would like to attract more work to increase machine
hours. The danger is that, if the higher cost is allowed to influence the price that we
quote to the customer, we may discourage orders.
One way around this problem is to always set absorption rates on normal machine
hours – a sort of average over a number of years.
For example, we might always use 12,000 machine hours to set the absorption rate at
£12.50 per machine hour, even though the budgeted machine hours for a particular
year may be as low as 10,000 machine hours, or as high as 15,000 machine hours.
Make sure that the class see the implications for budgeted under- or over- absorptions
of production overhead.
▲ Take the class through pages 218-223 of the textbook, particularly working carefully
through Example 4.
▲ In the final part of this lesson, give the class a better understanding of the causes of
under- or over-absorbed production overheads.
Use the following data:
Normal machine hours
Budgeted machine hours
Budgeted production overheads:
Variable
Fixed
Actual machine hours
Actual production overheads:
Variable
Fixed
10,000
8,000
£
28,000
20,000
9,100
£
32,098
19,750
Tell the class that we are going to find the under- or over- absorbed overhead, and
explain why it has occurred.
80
Remind them that the over- or under-absorbed overhead is found by comparing the
actual overhead with the absorbed overhead – not by comparing the actual overhead
with the budgeted overhead!
The actual overhead is clearly £32,098 + £19,750 = £51,848.
To get the absorbed overhead, we need an absorption rate.
Ask the class what it would be. Some may say (£28,000 + £20,000)/8,000 = £6 per
machine hour. This would be incorrect.
Tell the class that when normal machine hours are provided, it gives the clue that fixed
overheads are to be absorbed on this basis.
The absorption rate is therefore (£28,000/8,000) + (£20,000/10,000) = £5.50 per
machine hour. This could be split into £3.50 per hour for variable and £2.00 per hour
for fixed.
The absorbed overhead is then 9,100 + £5.50 = £50,050. This is compared with the
actual overheads of £51,848 to get the under-absorption of £1,798.
How much of this is due to overspending the overhead budget?
The answer is that the variable overheads should have been 9,100 × £3.50 (£28,000/
8,000) = £31,850. In fact it was £32,098, an overspending of £248.
The fixed overheads should have been £20,000, but were £19,750 – an underspending of
£250. Taking the variable and fixed together, there was an underspending of £2.
Since the under-absorption was £1,798, £1,800 of this must be caused by a loss of
output.
Although the normal machine hours were 10,000, only 8,000 were budgeted. However,
9,100 were worked, 900 fewer than normal, which at £2 per hour is £1,800.
This illustration will need to be carefully explained to the class. It is not an easy concept.
They will need to consider each step slowly.
▲ Now take the class through pages 223-226 of the textbook, particularly noting
Example 5.
Reminders
Fixed overheads can distort absorption rates when output levels vary from year
to year.
Normal capacity is used as a basis for absorbing fixed overheads even though
budgeted output may be more or less than this in a particular year.
As a result of this there may be a budgeted under- or over-absorption of fixed
overhead.
If cost behaviour is considered it is possible to analyse the under- or overabsorption to its spending and volume parts.
81
LESSON 21
Main subject
Syllabus reference
Third Level
Lesson topic
Activity Based Costing
1.12 Calculate and apply absorption rates based upon ABC principles
Required for
Aim of the lesson
• To describe the features of ABC and to explain the ways in which it might
improve traditional absorption methods.
The lesson
▲ Begin by looking at the CIMA definition of ABC on page 226 of the textbook. It is a
long definition and needs to be explained a phrase at a time:
‘It . . . involves tracing resource consumption . . .’ is saying that we need to find out
exactly where, and exactly why, resources are consumed.
‘Resources are assigned to activities . . .’ leads on from the first sentence, and is saying
that distinct activities need to be matched with the resources used.
For example, the traditional approach to overhead absorption might identify overhead
with a particular cost centre, to be absorbed (for example) on a basis of process hours.
But within that cost centre, there may be different distinct identifiable activities. For
example, process preparation, processing, and process cleaning may be 3 distinct
activities each of which consumes its own resources.
‘. . . and activities to cost objects based on consumption estimates.’ The cost of resources
consumed by each activity must be related in the end to the ‘output’ which benefits
from the existence of the activity. To do this, we must estimate the consumption level
from the activity. For example, how many purchase orders will the purchasing function
handle?
‘The latter utilise cost drivers to attach activity costs to output’
82
To explain this, refer also to the CIMA definition of a cost driver, at the top of page 227
of the textbook.
Put simply, what factor causes the cost of an activity to change? For example, would
the cost of running a personnel department be increased by higher numbers employed
in the company, or by higher labour turnover, or by the level of disputes, or by the
amount of new labour legislation, etc.?
The ABC definition is saying that the cost driver(s) for an activity are then related to
the cost of the activity, to give a basis for charging outputs.
For example, if the cost of a purchasing function is £200,000, and it is decided that the
number of orders placed and progressed is the single cost driver for this cost, then the
two can be linked by using the activity volume (say 10,000 orders) to give £20 per
order.
▲ Take the class through Example 6 on pages 227-228 of the textbook.
▲ It is important to draw attention to the section at the top of page 229.
The class must see ABC as just one of the ways that we constantly question the basis of
cost accounting methods. Technological change is just one of the reasons that must
make us ask if a different approach – e.g. to product costing – is needed.
▲ Example 7 is an important one, because it contrasts an absorption method using a
single rate (although based upon both labour hours and machine hours) with absorption
rates based upon cost drivers, for each pool. Make sure that the class understands the
meaning of a ‘cost pool’.
Reminders
Cost accounting methods and techniques cannot remain unchanged when so
much change is taking place in technology, manufacturing methods, pressure
of competition etc.
ABC has evolved to provide an expanded way of looking at where costs are
incurred, what causes them to be incurred, and how they should be reflected in
the cost of a product or service.
There are terms which must be understood. These are Activity Based Costing,
cost driver, and cost pool.
83
LESSON 22
Main subject
Syllabus reference
Second Level
5
Costing methods for specific orders – job (costing)
Lesson topic
Job costing
5.1
5.2
Distinguish between job costing, batch costing and process costing
Prepare a simple job cost
Required for
Aims of the lesson
• To explain the meaning of ‘job costing’
• To show how job costing relates to earlier lessons on material, labour and
overhead costing
• To show how job details are recorded in the costing system
The lesson
▲ Begin by explaining that job costing is a subdivision of specific order costing.
Jobs are completed to specific customer requirements. Each job will differ from other
jobs, although a number of units might be made to complete a job. For example,
customer A might order 1 unit of a particular product made specially for him, whereas
Customer B might order 8 units of a product made specially for him.
Often, the orders for all customers will be made in the same material, and using the
same production facilities, but the jobs will be quite different.
For example, a furniture maker will make all his products in wood. For all pieces of
furniture made, he will use the same skills, techniques and equipment. But each job
will be different, making one or a number of pieces of furniture to the design specified
by the customer.
Emphasise that each job must be identified, so that costs can be booked to it. Remind
the class that this will be for prime costs – to book the materials used, the direct labour
used on the job, and any direct expenses incurred.
Overhead will be charged to the job using pre-determined absorption rates.
Jobs are usually identified by a job number, allocated when the order is received.
84
▲ Explain why the cost of a job is needed. The reasons are given on page 238 of the
textbook.
▲ Candidates in the examination are often asked to calculate a job cost. Since this revises
the work of material, labour and overhead costing, it would be sensible to do some
calculations as part of this lesson:
Tell the class that XT Ltd is a jobbing firm:
Job number 2374 was produced in 2 cost centres.
The order was for 8 units of the product.
The hours booked to the order were 4 machine hours in cost centre X97 and 12
labour hours in cost centre X34.
In X97 one labour hour is needed for each machine hour.
The pre-determined production overhead absorption rates for the 2 cost centres
are:
Cost centre X97
£9.40 per machine hour
Cost centre X34
£6.20 per direct labour hour
Direct labour rates for X97 and X34 are £7.35 and £4.10 per hour respectively.
Material is priced out on a weighted average basis. When the job was made the
price was £3.90 per kilogram.
24 kilograms were issued at the start of the job.
Ask the class to prepare the job cost for the 8 units.
The answer should be:
Job number 2374
8 units of product
Material 24 kg × £3.90
Cost centre X97
Direct labour 4 hours × £7.35
Overhead
4 hours × £9.40
Cost centre X34
Overhead
12 hours × £6.20
Production cost
Cost per unit
£
93.60
29.40
37.60
160.60
49.20
74.40
284.20
£35.525
Remind the class of the benefit of the presentation of the job cost in such a way that
the £160.60 is brought out (the accumulated cost at the end of cost centre X97).
Point out how these figures relate to the accounts in the costing system.
The £284.20 is debited to work-in-progress. Ask the class where the corresponding credit
will be.
85
The answer is that the credit entries are in different places:
The £93.60 will be credited to the material stock account.
The £29.40 and the £49.20 will be credited to the wages control account. They are part
of the payroll analysis.
The £37.60 and the £74.40 will be credited to the production overhead account. These
figures are part of the absorbed production overhead, which is always credited to the
production overhead account and debited to work-in-progress.
Now ask the class how the job cost would appear if, although 8 units were made, 1
unit was not up to standard, and was rejected, and scrapped. Only 90% of its material
value can be recovered.
The answer is:
Job number 2374
8 units of product made
Material 24 kg × £3.90
Cost centre X97
Overhead
4 hours × £9.40
£
93.60
29.40
37.60
160.60
Cost centre X34
49.20
Overhead
12 hours × £6.20
74.40
Production cost
284.20
Less:
Material cost recovered from 1 scrapped unit
(£93.60/8) × 90%
10.53
273.67
Cost per good unit
£39.096
The class must understand that the cost of each unit has risen from £35.525 to £39.096,
because the net cost of the scrapped unit must be recovered on the 7 good units.
The cost of the scrapped unit is £35.525 - £10.53 = £24.995. Therefore each of the 7
good units must carry £24.995/7 = £3.571 of additional cost. This makes £35.525 +
£3.571 = £39.096, which agrees with the answer calculated above.
Make sure that the class understands this way of looking at the costs incurred on the
job.
▲ Point out the practical problems of job costing. The customer ordered 8 units. We now
only have 7 available to deliver. This is always a problem. Should we have made 9 in
the first place, so that when 1 was found to be below standard, we would still have had
the 8 that the customer wanted?
You will find this problem discussed in the Notes to the solution to Example 2, which
begins on page 242 of the textbook.
86
▲ Now refer the class to page 239 of the textbook. They must understand that the raw
material stock account, the work-in-progress account, the finished stock account, and
the production overhead account are all control accounts.
So, for example, the work-in-progress account summarises all jobs in progress whether
there are 3 or 1,003! As work on a job commences, the costs incurred will be added
(debited) to the work-in-progress account. Only when the job is completed will those
costs come out of work-in-progress and go to finished stock or, perhaps, straight to
cost of sales.
Explain that the examiner sometimes pretends that in a jobbing firm there are only
(say) 3 jobs in progress, because this allows for an examination question of manageable
size yet can still test knowledge and understanding.
▲ To end this lesson, use the following figures to illustrate the point just made:
On 1 May, there were 3 jobs in progress. Up to that date, the following costs had been
incurred:
Job 1261
£’00
27
Job 1272
£’00
12
Job 1273
£’00
8
Job 1272
£’00
19
12
Job 1273
£’00
21
14
Costs incurred in May were:
Job 1261
£’00
Materials
14
Direct labour
20
Job 1274
£’00
5
4
Production overhead is absorbed at 250% on direct labour.
During May, Job number 1272 was completed and sent to the customer.
Ask the class what the cost of each job is to date, or of the completed job in the case of
Job number 1272.
The answer is:
Job 1261
£’00
27
Job 1272
£’00
12
Job 1273
£’00
8
Job 1274
£’00
14
20
50
111
19
12
30
73
21
14
35
78
5
4
10
19
Balance b/f
May:
Materials
D Labour
O/hd absorbed
Finally, ask the class what the work-in-progress account will look like. Remind them
that it is a control account and will not show the detail of individual jobs. Only total
entries will appear.
87
The correct answer is:
Opening balance
Materials
Direct labour
Absorbed overhead
Work-in-progress
£’00
47
Cost of sales
59
Closing balance
50
125
281
£’00
73
208
281
▲ Now take the class through Examples 1 and 2 in the textbook.
Reminders
Jobs are identified by job numbers.
Job costs are calculated by adding actual prime cost details to absorbed overhead,
using pre-determined absorption rates.
Reject products present a particular problem in job costing.
A distinction must be made between the cost of individual jobs and the total
cost of all jobs which appears on control accounts in the costing system.
88
LESSON 23
Main subject
Syllabus reference
Second Level
5
Costing methods for specific orders – batch (costing)
Lesson topic
Batch costing
5.1
5.3
Prepare a simple batch cost
Required for
Aims of the lesson
• To explain the meaning of ‘batch costing’
• To show how batch costing relates to earlier lessons on material, labour and
overhead costing
• To explain factors relevant to the batch size
The lesson
▲ As with the preceding lesson, begin by pointing out that batch costing is a form of
specific order costing. However:
Units manufactured may not be identified with a particular job for a particular customer.
The continuous aspect of production associated with process costing might not be
present.
Nevertheless, a firm might make a particular product in batches, which can then be
put into stock and used to satisfy the demands of a number of customers.
Two important considerations are:
Fixed costs may be incurred specific to the batch, such as setting up machines ready
for a production run.
The larger the batch size, the more of the batch output will be carried in stock before
use or sale.
Point out that there are, therefore, features of batch production which are the same as
those we met earlier, when trying to decide whether to purchase materials in larger
quantities.
89
▲ Use the following data to illustrate your lesson:
A company uses 6,000 components evenly over each year.
These are made by the company in batches of 500 components and there are no
rejections.
Material costs for each batch are £1,500.
However, in addition to this, material costing £200 is used in setting up the
machine ready to produce the batch. This setting up also uses 5 labour hours
which are charged at the labour-only rate of £10.00 per hour.
To produce the batch takes 8 hours, and the combined labour and overhead rate
is £18.00 per hour.
Ask the class to calculate the cost of a batch, and the average cost per component.
The answer is:
£
Setting up machine:
Material
Labour 5 hours × £10
Production of the batch:
Material
Labour and overhead 8 hours × £18
Batch cost
Average cost per component
200
50
1,500
144
1,894
£3.788
Point out that these components could be used in jobs made to customers’ requirements,
so that in one business both job costing and batch costing could be in use.
For the production of the components, each batch made will be given its own batch
number, to which the costs incurred can be booked. Explain that in some businesses
batch numbers are important because they are used to trace faulty components back to
the batch in which they were made.
Make sure the class can see that the setting costs are fixed to the batch, and that if we
make the components in bigger batches than 500, this fixed cost per component will
fall.
Ask the class what the average cost per component would be if the batch size was
doubled to 1,000.
The answer is:
£250 + (£1,644 × 2) = £3,538/1,000 = £3.538.
Ask the class if this is a good idea. Hopefully – as a result of earlier lessons, and earlier
comments which you made in this lesson – someone will mention stock-carrying costs.
You can tell the class that stock-carrying costs are 10% per annum.
Can the class attempt a solution?
The annual saving would be 6,000 × (£3.788 - £3.538) = £1,500.
90
Another way of calculating this saving is to say that the fixed setting up costs of 6
batches would be saved, ie 6 × £250 = £1,500.
The average stock for a batch of 500 would be 250 × £3.788 = £947, for which the
annual stock-carrying costs would be £95.
The average stock for a batch of 1,000 would be 500 × £3.538 = £1,769, for which the
annual stock-carrying costs would be £177.
Since £1,500 is greater than £82 (£177 – £95) the batch size of 1,000 would be
worthwhile.
▲ Third Level students might like to apply the EOQ model to this example, to see if a
further increase of the batch size is justified.
▲ Take the class carefully through Examples 3 and 4 on pages 245-248 of the textbook.
Reminders
Batches are identified by batch numbers to which costs can be booked.
Costs are expressed as an average cost per unit made in the batch.
Batch production may give rise to fixed costs such as setting up costs, which
means that optimal batch size calculations may be required.
91
LESSON 24
Main subject
Textbook reference Chapter 8: page 237
Syllabus reference
Second Level
5
Costing methods for specific orders – contract (costing)
Third Level
1
Lesson topic
Contract costing
5.1
5.13
5.14
5.15
5.16
Distinguish job costing from contract costing
Prepare a simple contract account
Appreciate the prudence approach to contract profits and losses
Calculate the profit to be taken in an accounting period based upon an
estimate of profits earned on completion of the contract. Balance sheet
entries will not be required
Required for
Aims of the lesson
• To explain the circumstances in which contract costing is used
• To explain the source of entries in the contract account
• To explain how contract profit is determined
The lesson
▲ If you are taking a Second Level class, point out that pages 254-262 in this chapter are
for Third Level students only.
▲ Begin by explaining that contract costing is a specific order costing method, which was
also true of job costing and batch costing.
A contract can be thought of as a large job.
For example, a garage may perform a service on a customer’s car. A job number would
be issued to that customer’s service, and all parts used, and all of the mechanic’s time
can be booked to that order. The job would probably be finished in 2 or 3 hours.
92
On the other hand, a builder may build a new swimming pool for a customer. He
would ‘contract’ to do this, usually for a fixed contract price, and by a certain date. The
completion of this contract may take 6 months.
Some contracts will take much longer to complete, for example, building a motorway,
or a new hotel, or a new airport.
Explain to the class that there is a problem with long-term contracts. Because some of
them may take years to complete, we won’t know whether or not a profit has been
made until the contract is completed – or even later, if we have a responsibility to
repair any faults that develop in (say) the first 2 years after completion of the contract.
The problem is that if we undertake a contract that will take 4 years to complete, we
can’t say that no profit is made for 3 years, and then suddenly a profit is made in Year 4.
Tell the class that this is a problem that you will return to later in the lesson.
▲ Now explain some of the terms that are used in contract costing, and which appear in
questions on this topic:
1
Contractor
The business that will complete the contract. If XY Builders is the firm that will
build a new school, then XY Builders is the contractor.
2
Contractee
The customer who has asked for the work to be done is the contractee.
3
Contract price
The amount that the contractee has agreed to pay the contractor for satisfactory
completion of the work.
4
Site
The location of the contract is called the contract site. Questions may refer to ‘site
labour’ or to ‘materials delivered to the site’.
5
Progress payments
Amounts of money paid to the contractor by the contractee as the contract
proceeds. These are agreed in the contract terms. They are made because it is
unreasonable to expect the contractor to pay for all costs of the contract, with no
money coming in until the contract is completed – perhaps in 3 or 4 years’ time.
6
Work certified
An old term. It just means that someone has to say how the contract is progressing,
so that progress payments can be made. This will be done by an expert acting for
the contractee. Questions may refer to the ‘architect’ or the ‘engineer’.
7
Retention money
Even when the contract has been completed, part of the contract price may not be
paid to the contractor. This balance may not be paid to the contractor for perhaps
2 years – until the contractee is satisfied that the work is good and no faults in
the work have appeared.
93
▲ Now go through the 6 points on page 249 of the textbook.
Particularly emphasise points 1, 2, and 3:
There will be an account for each contract
No profit will be taken on a recently started contract
The profit we do take on an unfinished contract will be part of the profit we expect to
make when the contract is finished.
▲ Now use this illustration:
Budd Ltd is a building company.
Its financial year end is 31 December.
On 1 Jan Year 9 it started work on a contract for an agreed price of £850,000.
The contract was given the number B1274.
Contract costs were estimated at £800,000 and completion of the contract was
expected by December.
Budd Ltd completed the contract on 31 December Year 9.
The contractee was completely satisfied with the work.
Contract costs incurred amounted to £795,000.
Show the class what the contract account would look like:
Contract B1274
£
Costs incurred
Contract profit
£
795,000
55,000
850,000
Contract price
850,000
850,000
Point out that some knowledge of double entry book-keeping is needed for this topic.
Ask the class where the corresponding entry is for the debit of £795,000.
They should recognise that the £795,000 will include the cost of all materials used, all
labour paid and any other overheads incurred on the contract.
For materials used, for example, the corresponding credit could be on suppliers’ accounts,
or on stock accounts. It would be the latter if bricks, cement, etc, were purchased for
central stock by the company, and then issued as required to various contract sites.
Ask where the corresponding entry can be found for the £850,000 credit on the contract
account. The answer is that it will be on the contractee’s account. The contractee’s
account will be cleared when the contract price is paid.
Ask where the corresponding entry can be found for the £55,000 debit on the contract
account. The answer is, of course, that it is credited to the Profit and Loss Account.
94
▲ Make sure that the class understands the following points:
The £55,000 has been credited to the Profit and Loss Account for the year ended 31
December Year 9. This is acceptable because the contract has been completed (started
and finished) within the financial year.
We also know that ‘the contractee was completely satisfied with the work’, so there
seems to be no reason to make any provision for future repairs to the work done.
(However, prudence might suggest that we should do so – just in case!)
Now ask the class what would have happened if the financial year end of Budd Ltd had
been 31 March, and that by 31 March Year 9, £162,000 had been spent on the contract.
The class should recognise that only 3 months’ work has been done on the contract,
and that another 9 months’ work was expected. Only £162,000 had been spent, which
is 20.25% of budgeted expenditure.
It is too early in the contract to take any profit in the Profit and Loss Account for the
year ended 31 March Year 9. All of the profit will be taken in the Profit and Loss
Account for the year ended 31 March Year 10.
Emphasise, particularly, the way that central company overheads have been absorbed
to each contract.
▲ Now tell the class that you are going to change the information for Budd Ltd slightly.
Budd Ltd is a building company.
Its financial year end is 31 December.
On 1 Jan Year 9 it started work on a contract for an agreed price of £850,000.
The contract was given the number B1274.
Contract costs were estimated at £800,000 and completion of the contract was
expected by March Year 10.
Contract costs incurred up to 31 December Year 9 amounted to £654,000.
The contractor estimated that £115,000 would be incurred in completing the
contract.
Completion date was now estimated as the end of February Year 10.
The contractee’s representative assessed the contract as 85% complete on 31
December Year 9.
How much profit should be taken into the Profit and Loss Account for the year ended
31 December Year 9?
Point out to the class that the contract is expected to be completed early, and that costs
are expected to be £654,000 + £115,000 = £769,000. This compares to estimated costs
of £800,000.
Point out that the contract seems to be going well, and the contractee’s representative
considers it 85% complete.
95
Contract price
Estimated final contract costs
Estimated final profit
85% of £81,000
£
850,000
769,000
81,000
68,850
If the 85% had not been given, the calculation could have been done on a costs-todate/expected final costs basis, as follows:
£654,000/£769,000 × £81,000
£68,887
Budd Ltd would probably round down to the nearest £’000, bringing £68,000 into the
P & L account for Year 9.
▲ Now take the class carefully through Example 6. Remind the class about losses, referred
to in Note 4 to the solution on page 254.
▲ If you are taking a Third Level class, you should also take the class through Example 9 on
pages 259-262 in the textbook.
Reminders
Contract costing is a form of specific order costing.
Some book-keeping knowledge is required for this topic, as the preparation of
accounts is usually required.
Profits expected on a contract not yet completed, should only be taken when
the contract is reasonably advanced.
This is done by taking a proportion of the profits forecast on completion.
96
LESSON 25
Main subject
Syllabus reference
Costing methods for – continuous processes
Lesson topics
Process accounts and process statements
Normal and abnormal losses and gains
By-product treatment
5.1
5.4
5.5
5.6
5.7
Prepare a process account or process statement
Show the treatment of normal losses, abnormal losses and gains, and scrap
values
Understand the distinction between by-products and joint products
Correctly treat by-products in the process in which they arise
Required for
Aim of the lesson
• To explain process costing as a costing method, and to ensure that the students
can record inputs to, and outputs from a process, and can place a value upon
losses and gains arising from the process, and upon any by-product arising
from the process.
The lesson
▲ Begin by referring to the CIMA definition on page 268 of the textbook.
Particularly emphasise the last sentence – costs are initially charged to the process, and
costs are then averaged over the output.
Illustrate this with the following:
For the month of January, costs booked to Process X73 were:
£
Materials
400 tonnes
108,000
Processing costs
68,700
176,700
70,680 sacks of finished product resulted from the process in January.
97
(Don’t worry about debits and credits for the moment.) Ask the students where the
figure of £108,000 would have come from.
They should say that it is either the total of the invoices sent by suppliers for the
materials delivered to the process for immediate use in production – just-in-time
deliveries, or it is the total value of all the materials issued and priced from stock, where
the material is carried in stock for a period before its use. This means that a pricing
method must have been used such as FIFO, average, etc. to get the £108,000.
Next ask the students what the £68,700 would be.
They should describe the figure as conversion costs, including (direct) process labour
as well as overheads. Some will have been allocated to the process, some apportioned.
Ask for examples of each.
Emphasise that the cost of the process for January is £176,700, and that it is important
to know this.
Then explain that this cost is averaged over the output of 70,680 sacks of product:
£176,700/70,680 sacks = £2.50 per sack.
Make sure the students understand that in process costing we do not try to find the
cost of each individual sack of product. Many identical sacks are produced month after
month, and it is sufficient to calculate the average cost per sack for a period. In this case
the period is a month (January). It could be a week, or even 3 months.
Contrast this with job costing where each job is different. The cost of many different
jobs could not be averaged. The result would be meaningless.
Similarly, contrast process costing with batch costing, which you have taught in an
earlier lesson along with job costing.
▲ Now explain that the data can be presented in a process account or in a process statement:
Materials
Processing costs
Process X73 account
£
108,000
Finished stock
68,700
176,700
£
176,700
176,700
Explain how this process account conforms to normal debit and credit principles.
Explain where the credits are for the debits to the process account, and where the debit
is for the credit to the process account.
The amount of explanation needed will depend on whether students have already studied the
principles of book-keeping.
Explain how a process statement is presented in vertical form, with credits shown in
brackets. The solutions to Examples 1 and 2 on page 270 of the textbook can be used to
illustrate the different presentations.
Explain that quantity columns were not shown in the initial example for Process X73,
because the quantities could not be balanced – it started with tonnes but finished with
sacks.
98
Use the following figures as a class example.
Process X
Material issued 2,400 tonnes at a cost of £12,300.
Process labour £1,700.
Process overhead is to be absorbed at 480% on process labour.
Process Y
2,400 tonnes transferred from Process X.
120 tonnes of new material added at a cost of £900.
Process labour £1,400.
Process overhead is to be absorbed at 380% on process labour.
2,520 tonnes of finished product was passed to the packing department.
Ask the students to show (a) an account for each process and (b) a process statement.
The solutions are:
(a) accounts
Material
Process labour
Overhead
Tonnes
2,400
2,400
Trans. from X
Material
Process labour
Overhead
Tonnes
2,400
120
2,520
Process X
£
Tonnes
12,300
2,400
1,700
8,160
22,160
2,400
Process Y
£
Tonnes
22,160
2,520
900
1,400
5,320
29,780
2,520
Cost/tonne
£9.233
£
22,160
22,160
Cost/tonne
£11.817
£
29,780
29,780
99
(b) as a process statement:
Process X
Tonnes Cost/tonne
2,400
Material
Process labour
Overhead
2,400
Additional material
Process labour
Overhead
£9.233
Process Y
Tonnes Cost/tonne
120
2,520
£11.817
£
12,300
1,700
8,160
22,160
£
900
1,400
5,320
29,780
Emphasise the strengths and weaknesses of each presentation.
▲ Now teach the treatment of losses in process accounts (or statements), whether normal
or abnormal, and whether or not the losses have any value.
This topic is on pages 269-274 of the textbook. Note that the £890 should be a credit
entry to the first Abnormal gain account on page 274, and not a debit entry as printed.
To introduce the topic, use the following figures:
Process Z for January, Year 4
Materials used in the process: 1,200 litres at a cost of £9,600
Processing costs for the month: £16,008
Normal loss 3% of material input. The loss has no value.
Show the Process Z account to the class:
(a) If the good output is 1,164 litres
Process Z
Litres
Material
1,200
Processing
costs
1,200
£
9,600
16,008
25,608
N Loss
Output
Litres
36
Cost/litre
–
1,164
1,200
22.000
Emphasise that the £22.000 per litre has accounted for the normal loss.
100
£
–
25,608
25,608
(b) If the good output is 1,152 litres.
Process Z
Litres
Material
1,200
Processing
costs
1,200
£
9,600
N Loss
16,008
Ab loss
Output
25,608
Litres
36
Cost/litre
–
12
1,152
1,200
22.000
22.000
£
–
264
25,344
25,608
Emphasise that the normal cost per litre, £22.000, must be calculated before the cost of
the abnormal loss can be known.
Make sure the students understand where the debit is located to record the abnormal
loss of £264. Show them the abnormal loss account, and explain how the balance on
that account is dealt with.
(c) If the good output is 1,176 litres
Process Z
Material
Processing
costs
Ab gain
Litres
1,200
£
9,600
12
1,212
16,008
264
25,872
N Loss
Litres
36
Cost/litre
–
Output
1,176
22.000
1,212
£
–
25,872
25,872
Again, emphasise the importance of the normal cost per litre, as the starting point for
the calculation of the abnormal gain.
Show the students what the abnormal gain account would look like, and what would
happen to the balance on that account.
▲ Explain that process losses might have a value. For example, perhaps the material can
be sold as scrap, or as a ‘lesser product’ – a by-product. Refer to page 275 of the textbook
to explain the nature of a by-product.
You could ask the students to re-do the previous 3 illustrations, assuming that normal
loss has a saleable value of (say) £3 per litre. This would be a useful exercise, particularly
where the abnormal gain arises. NB The normal cost per litre will not now be a neat
figure. It will be £21.907 correct to 3 decimal places.
Now use the following example to illustrate these points:
101
Process Z44
Materials used: 1,400 tonnes at a cost of £137,600
Processing costs: £89,984
Normal losses:
1% of input is lost and has no value.
2% of input is saleable as scrap for £20 per tonne.
5% of input is a by-product, saleable for £70 per tonne, after spending £10 per
tonne on packing.
Prepare a process statement
Process Z44 Process statement for __________________
Tonnes
£
Materials
1,400
137,600
Processing
89,984
227,584
Loss
(14)
–
Scrap
(28)
(560)
(70)
(4,200)
By-product
1,288
222,824
The final product has a cost per tonne of £222,824/1,288 = £173 per tonne.
Reminders
The examiner might ask for a process account or for a process statement.
It is important to establish the normal cost of production.
Abnormal losses and abnormal gains can then be established by reference to
normal output.
Any value that a by-product might have is used to reduce the cost of the normal
production.
102
LESSON 26
Main subject
Syllabus reference
Lesson topic
Cost accounting for joint products
5.8
5.9
Understand the arbitrary nature of joint cost apportionment
Apportion joint costs on a basis of physical units, sales value, and net
sales value
5.10 Interpret the results obtained from 5.9
5.11 Evaluate a simple further processing proposal
Required for
Aims of the lesson
• To explain the nature of joint products, and the arbitrary nature of the
apportionment of common or joint costs between the products.
• To introduce the further processing decision, and show the effect of further
processing costs upon the basis of common or joint cost apportionment.
The lesson
▲ Begin by contrasting the definition of a by-product on page 269 of the textbook with
that for a joint product on page 280.
Explain that a process could produce 1 by-product and 1 main product, and that the
by-product is a usefully saleable product accidentally produced in trying to produce the
main product.
Further explain that a process could produce two equally important main products,
which are then called joint (main) products.
Explain also that a product is labelled as a joint product or a by-product by reference to
its sales value and not its quantity. Use Aye, Bee and Cee on page 280 to illustrate this.
103
▲ Now use the following examples to explain the principles of by-product and joint product
costing to the students.
Normal monthly input: 1,000 tonnes of material at a cost of £22,430
Normal monthly processing costs: £9,400
Normal output for one month:
Main product RT, 800 tonnes saleable at £45 tonne
By-product QS, 130 tonnes saleable at £11 tonne
Loss in processing with no value: 70 tonnes.
Show the process costs in the form of a process statement.
Process statement
Materials
Processing costs
Normal loss
By-product QS
Main product RT
Tonnes
1,000
Cost/tonne
1,000
(70 )
(130)
800
£31.83
£11.00
£38.00
£
22,430
9,400
31,830
––
(1,430)
30,400
Point out that the average input cost is £31.83 but the normal loss, and the low selling
price of the by-product, push the cost of the main product up to £38.00.
Ask the class how much profit is made by the process each month. The answer is (800
× £45) – £30,400 = £5,600.
This example hasn’t illustrated joint product costing because there is only one main
product, RT.
Now tell the students that you are going to change the example a little.
Let us make the output of 800 tonnes an output of two products, which are to be
regarded as joint (main) products. These are:
300 tonnes of RT saleable at £60 per tonne, and
500 tonnes of MJ, saleable at £36 per tonne.
All other figures remain the same.
Ask the class how much profit the process would now make in one month.
This would be:
300 tonnes of RT x £60 per tonne
500 tonnes of MJ x £36 per tonne
Less net costs of process
Profit
£
18,000
18,000
36,000
30,400
5,600
If any student has tried to work out the profit made by RT and MJ respectively, tell them
that you didn’t ask for that – only for the process profit.
104
▲ Now ask the students to imagine that, at the financial year end, there is a finished stock
of 8 tonnes of RT and 2 tonnes of MJ. How should these be valued – for example, to
include in stocks on the balance sheet?
They cannot be valued at selling price, so now we do need a cost per tonne for each of
the two products. Therefore the common or joint costs of £30,400 must somehow be
apportioned over the two products.
See if the class can suggest how this apportionment might be done.
The two suggestions you want to hear are (1) based on the quantity of each product
made, and (2) based on the value of the quantity of each product made:
Quantity or physical units basis
Total output is 800 tonnes, of which 300 tonnes is of RT and 500 tonnes is of MJ.
Therefore the cost is apportioned:
RT 300/800 × £30,400 =
MJ 500/800 × £30,400 =
£
11,400
19,000
30,400
Point out that this means that the cost per tonne for both products is £38.
Ask the class if this can be used for valuing the stocks referred to earlier.
The answer is ‘Yes’ for RT which can be sold for £60 tonne, but ‘No’ for MJ which can
only be sold for £36 tonne. The stock of MJ would have to be valued at £36 tonne i.e.
at cost or net realisable value, whichever is the lower.
Show the profit statement for a month:
RT
Sales
Costs
Profit/(Loss)
£
18,000
11,400
6,600
MJ
£
18,000
19,000
(1,000)
Total
£
36,000
30,400
5,600
It is most important to ask the class what can be done about the loss making product
MJ. The answer is nothing. One product cannot be made without the other. The
important thing is that there is an overall profit.
Value basis
Make clear to the class that this is just a different way of apportioning the common, or
joint, costs between the two products. It does not change the overall position.
Both products generate total sales of £18,000 per month. Therefore the joint cost can
be equally shared, £15,200 per product.
This is £15,200/300 = £50.667 per tonne for RT and £15,200/500 = £30.40 per tonne
for MJ.
105
Emphasise that both of these figures could be used to value the stocks referred to
earlier, because both costs are below the respective selling prices.
Show the profit statement for the month:
Sales
Costs
Profit
RT
MJ
Total
£
18,000
15,200
2,800
£
18,000
15,200
2,800
£
36,000
30,400
5,600
Now ask the class why they imagine that product RT sells at a much higher price than
MJ – £60 tonne compared with £36 tonne.
They might suggest that market conditions are more favourable for RT.
However, some might suggest that more work has to be done on RT before it can be
sold. In other words, MJ is sold as it leaves the process in which RT and MJ are separated,
whereas RT has to go into further processes to make it ready for sale.
Explain to the class that if these further costs are a cause of the higher selling price for
RT, then it is unfair to give RT a higher proportion of the joint costs on this basis.
Therefore we use a theoretical net selling price at the point of separation.
For example, suppose that after separation, £12 per tonne is spent in further processing
RT to the point where it can be sold for £60 tonne.
Explain that at the point of separation its theoretical net selling price is £48.
Sales are then:
RT 300 tonnes × £48
MJ 500 tonnes × £36
Joint costs are shared:
RT 14,400/32,400 × £30,400
MJ 18,000/32,400 × £30,400
Cost per tonne:
RT £13,511/300
MJ £16,889/500
Profit:
RT £60 – (£45.037 + £12) = £2.963 × 300 =
MJ £36 – £33.778 = £2.222 × 500 =
£
14,400
18,000
32,400
£
13,511
16,889
30,400
£45.037
£33.778
£
889
1,111
2,000
Get the class to compare the results from the two value-based approaches.
Explain that the £2,000 is, of course, £5,600 less the additional processing cost of 300
tonnes × £12 tonne.
106
▲ Finally explain that the theoretical net selling price of £48 need not be used if it is known
that RT can be sold for £45 at the point of separation, or for £60 after further processing.
The class can be asked, as an exercise, to re-apportion the joint costs using £45.
Explain also, that this additional information proves the worth of further processing. This
is because the additional cost is 300 × £12 = £3,600, but the additional revenue is 300
× (£60 – £45) which is £4,500.
▲ The class should carefully work through Examples 8 and 9 on pages 281-286 in the
textbook.
Reminders
The net benefit of a by-product is used to reduce the cost of the main product
or products.
Two or more main products are referred to as joint products.
The material and processing costs incurred prior to the point of separation are
called common or joint costs.
These can be apportioned to joint products on a quantity basis or a value basis.
The value basis uses selling prices which might be a theoretical net selling price
at the point of separation.
Both methods are arbitrary.
The important point is whether the whole process is profitable.
The test for further processing is whether the additional revenue exceeds the
additional cost.
107
LESSON 27
Main subject
Syllabus reference
Lesson topic
Valuing work-in-process using equivalent units
5.12 Use equivalent units to place a value upon work-in-process. Candidates
should be able to use either a FIFO or an average approach to the opening
stock.
At Second Level only the first process will be examined in respect of workin-progress valuation
Required for
Aim of the lesson
• To explain the nature of equivalent units and how they are used to place a
value on unfinished work
The lesson
▲ Explain that the terms work-in-process and work-in-progress can be used
interchangeably.
Explain that if £128,800 is spent on materials and processing costs, and 1,400 units of
finished product result, then the cost per unit is £92.
Ask the class what would happen if 1,400 units of finished product resulted, but that, in
addition, there were 200 units of work-in-progress.
Some might suggest re-calculating the unit cost as £128,800/(1,400 + 200) = £80.50
The finished output could then be valued at £112,700 and the work-in-process at
£16,100.
You should point out that this would be unfair, because it values unfinished work at the same
cost per unit as finished work, i.e. £80.50.
108
You should also point out that work-in-progress can be ignored if it is insignificant in
relation to the finished output. An example would be if finished output had been 1,400
units and work-in-progress had been 10 units. It can also be ignored if work-in-progress
is always constant at the start and end of a period – for example, if processing is
continuous, then at every month-end there may be 40 units in the course of processing.
If £16,100 gives an unfair valuation to work-in-process, how could a fair valuation be
obtained?
Explain that we need to know the degree of completion of the work-in-progress. Are
the units just started or nearly finished. Once this is known, the work-in-progress
units can be expressed as equivalent finished units.
Refer the class to the definition of equivalent units given on page 286 of the textbook.
Emphasise the word ‘notional’. They are not real units. 600 real units 30% complete
= 180 units 100% complete.This means that in the process there are 600 real unfinished
units but, notionally, this is equivalent to 180 completed units.
Now take the class carefully, step by step, through Examples 10 and 11 on pages 286288.
▲ Use the following new figures to illustrate the calculations:
Process 1 for January
There was no opening stock of work-in-process.
500 litres of material were put into process at a cost of £2,680.
Processing costs for the month were £8,658.
Normal loss is 4% of input, saleable at £2 per litre.
Finished output was 410 litres.
Work-in-process is 60 litres, 100% complete as to material and 40% processed.
Prepare the Process account for January
Remind the class of the 5 steps to an answer to a question of this kind, as listed at the
bottom of page 289 in the textbook.
Step 1
Materials
Processing
Process account – January
Litres
£
500
2,680 Normal loss
8,658 Finished stock
WIP
Abnormal loss
ooo
500
Litres
20
410
60
10
500
£
40
Point out that the abnormal loss is the balancing quantity figure on the account
i.e. 500 - (20 + 410 + 60).
109
Step 2
Material equivalent units: 410 + 10 + (100% of 60) = 480 litres
Processing equivalent units: 410 + 10 + (40% of 60) = 444 litres
Step 3
Material (£2,680 - £40)/480 litres = £5.50 per litre
Processing £8,658/444 litres = £19.50 per litre
Therefore the total cost of a finished litre of product is £25.
Step 4
Finished output 410 litres × £25 = £10,250
Abnormal loss 10 litres × £25 = £250
WIP (60 litres × £5.50) + (24 litres × £19.50) = £798
Step 5
Materials
Processing
Process account – January
£
2,680 Normal loss
WIP
Abnormal loss
500
11,338
Litres
500
Litres
20
410
60
10
500
£
40
10,250
798
250
11,338
Ask the class where the corresponding entries are for each entry in the process account:
Materials £2,680: Credited to Material stock account, or to Supplier’s account for justin-time deliveries
Processing £8,658: Various sources e.g. payroll analysis, cash book, suppliers’ accounts,
material stock, etc.
Normal loss £40: Debited to the normal loss account. This account will then be credited
with the proceeds of the sale of the material.
Finished stock £10,250: Debited to the finished stock account ready for sale
WIP £798: Carried down as a debit balance on the Process account to be the opening
WIP for February
Abnormal loss £250: Debited to the abnormal loss account. This account will be credited
with any proceeds from the sale of the abnormally lost material. The net balance will
then be debited to the profit and loss account.
Take the class through Example 12 on pages 289-291 of the textbook.
110
▲ Now explain that you are going to show the class how to deal with an opening stock of work-inprocess.
Remind them that there was no opening stock in January so the problem didn’t arise.
However, the closing work-in-process for January must automatically become the
opening work-in-process for February.
Give the class the figures you are going to use for February:
Opening WIP: 60 litres, 100% for material, and 40% processed, valued at £798
550 litres of material were put into the process at a cost of £2,948.
Processing costs were £9,450.
Normal loss is 4% of new input, saleable at £2 litre.
Finished output 508 litres.
Work-in-process, 80 litres, 100% complete as to materials and 70% processed
Before continuing with your illustration, explain the alternative views of the opening workin-process, as explained at the bottom of page 291 and the top of 292 of the textbook.
The FIFO assumption would be that the 60 litres of work-in-process has been finished
and is included in the 508 litres of finished output.
The average assumption says this might not be the case. The 60 litres of work-inprogress at the start of February might still be included in the 80 litres of work-inprogress at the end of February. Therefore it would be sensible to average the costs.
▲ Tell the class that you are going to illustrate the FIFO principle first.
Step 1
Op WIP
Material
Processing
Process account – February
Litres
£
60
798 Normal loss
550
9,450 Cl WIP
610
13,196
Litres
22
508
80
610
£
44
13,196
Step 2
This is the step that you should take particular care to explain. It deals with the
completion of the opening stock, and its separation from units entirely made in February.
Material (508 litres - 60 litres) + (80 litres × 100%) = 528 litres
Processing (508 litres - 60 litres) + (60 litres × 60%) + (80 litres × 70%) = 540 litres
Step 3
Material (£2,948 - £44)/528 litres = £5.50 per litre.
Point out to the class that this is the same as the material cost in January.
Processing £9,450/540 litres = £17.50
Point out to the class that processing has been cheaper in February than in January –
£17.50 per litre compared with £19.50 per litre.
111
Step 4
Ask the class to note particularly how the transfer to finished stock is valued when
using the FIFO approach. Do this first.
Finished stock (448 litres × £23) + £798 + (36 litres × £17.50) = £11,732
WIP (80 litres × £5.50) + (56 litres × £17.50) = £1,420.
Step 5
Op WIP
Material
Processing
Litres
£
60
798 Normal loss
550
9,450 Cl WIP
610
13,196
Litres
22
508
80
610
£
44
11,732
1,420
13,196
To confirm that the class understands the FIFO approach, take the students through
Example 13 on pages 292-295 in the textbook.
▲ Now tell the class that you are going to illustrate the average cost approach.
Emphasise that this can only be done if the opening stock value is given by the examiner
in its component parts.
In this case we do know the component parts because of our earlier calculations – the
£798 comprised £330 for materials and £468 for processing.
Show the calculation of the average costs per unit:
Material (£330 + £2,948 - £44)/(508 litres + 80 litres) = £5.50
Processing (£468 + £9,450)/(508 litres + 56 litres) = £17.585
Explain that the material cost remains at £5.50 because the material cost for January
and for February was the same – £5.50 per litre.
Value the output:
Finished stock 508 × (£5.50 + £17.585) = £11,727
WIP (80 litres × £5.50) + (56 litres × £17.585) = £1,425
Now complete the process account:
Op WIP
Material
Processing
Litres
£
60
798
Normal loss
550
2,948
Finished stock
9,450
Cl WIP
610
13,196
Litres
22
508
80
610
£
44
11,727
1,425
13,196
To confirm that the class understands the average approach, take the students through
Example 14 on pages 295-297 in the textbook.
112
Reminders
Equivalent units are used to apportion actual costs between completed output
and work-in-process.
Equivalent units are notional, not real, units.
There are 5 steps to be taken. (Remind the class of what they are.)
Opening work-in-process can be treated on a FIFO basis. This method clearly
separates the costs of the current period from those brought down from the
previous period.
Alternatively, an average cost approach can be taken, in which the costs brought
down from the previous period and those of the current period are averaged.
113
LESSON 28
Main subject
Syllabus reference
Third Level
Lesson topic
Joint cost apportionment
1.13 Apportion joint process costs using physical units as the basis for the
variable costs and contribution as the basis for the fixed costs
Required for
Aim of the lesson
• To explain the use of contribution for joint cost apportionment
The lesson
▲ Begin by emphasising the work done in Lesson 26 as a foundation for this Lesson. The
relevant sections of Chapter 9 in the textbook must also be understood before coming
to this lesson.
Point out the basic principles:
1
Any apportionment method is arbitrary. There can be no ‘accurate’ way of sharing
common or pre-separation costs.
2
The profitability of individual products arising in a common or joint process cannot
be ‘accurately’ assessed. Only the whole process and its total output can be assessed.
3
Products arising from a joint process can be looked at individually, only when
each has separated from the other products.
Further point out that although many of the principles of by-product and joint product
costing have been set out in a previous lesson (Lesson 26/Chapter 9), Third Level
students must be able to apply the principles to more difficult questions.
114
▲ Remind the class that they have already studied joint cost apportionment based upon
(1) physical units and (2) Sales value or net sales value.
Tell the class that you are now going to illustrate and explain a third method, which
will be done in 2 parts.
First, the variable costs of the common or joint process will be apportioned between
the joint products on a physical units basis.
Second, the contribution from each product can then be determined, and used to
apportion the fixed costs of the common or joint process.
Explain that you are using the terms ‘variable costs’ and ‘fixed costs’ as they were explained
in an earlier lesson which introduced cost behaviour.
For example, the cost of material introduced to the process is clearly a variable cost. If
material input is doubled, its cost is doubled – and output from the process will double.
On the other hand, the depreciation cost for the process might be a fixed cost – unaffected
in total by the rise and fall in the amount of material processed
Now explain that you have also used the term ‘contribution’. Members of the class who
have already passed the Second Level examination will recognise this term, but any
member of the class who has not previously studied for Second Level may not recognise
it.
Explain that it will be dealt with in more detail when Chapter 11 is considered, but that
for now it is sufficient to define it as Sales value minus the variable cost of sales.
▲ Continue your lesson using the following figures.
Process 1
Material introduced, 1,000 tonnes
Processing costs – Variable
Fixed
£
138,000
49,000
63,000
250,000
Halfway through processing, 400 litres of a by-product is drawn from the process,
and this is sold at £100 per litre.
At the end of the process, the normal output from 1,000 tonnes of input is 400
tonnes of JX1 and 300 tonnes of JX2.
These products are regarded as joint products and are sold immediately on leaving
the process for £360 per tonne for JX1 and £480 per tonne for JX2.
Before illustrating the new method, ask the class to calculate the profit made by each
product, using the methods they are familiar with: physical units basis and sales value
basis.
115
Physical units basis
Joint costs
Less by-product sales
Net cost
Output
Cost per tonne
Profit
JX1 (400 × £360) – (400 × £300) =
JX2 (300 × £480) – (300 × £300) =
£
250,000
40,000
210,000
700 tonnes
£300
£
24,000
54,000
78,000
Sales value basis
Joint net costs (as before)
Sales value
JX1 400 × £360
JX2 300 × £480
£
210,000
144,000
144,000
288,000
Therefore, since the total sales value of each product is the same, the joint costs are
shared equally.
Profit
JX1 (400 × £360) – £105,000
JX2 (300 × £480) – £105,000
£
39,000
39,000
78,000
Remind the class that the total profit is £78,000, and this could have been calculated:
(400 × £360) + (300 × £480) – £210,000
Point out that the apportionment of cost to product, to get individual product profits,
is an arbitrary exercise.
▲ Now illustrate the third method:
First, what are the variable costs?
They are £138,000 + £49,000 – £40,000 = £147,000
Explain to the class that the by-product income is treated as variable, because the more
materials that are processed, the greater the number of by-products that should arise
from the process.
These variable costs are to be apportioned on a physical units basis. Therefore £147,000/
700 tonnes = £210 per tonne.
116
This allows for the calculation of the total contribution earned by each product:
JX1 (400 × £360) – (400 × £210) =
JX2 (300 × £480) – (300 × £210) =
£
60,000
81,000
141,000
Finally, the fixed costs of £63,000 are apportioned in proportion to these contributions:
JX1 60,000/141,000 × 63,000
JX2 81,000/141,000 × 63,000
£
26,809
36,191
63,000
The profits can now be calculated:
JX1 £60,000 – £26,809 =
JX2 £81,000 – £36,191 =
£
33,191
44,809
78,000
Point out again that the overall profit is still £78,000, but that there are now 3 possible
answers to the question: ‘How much profit has each product made?’
Encourage the class to discuss what the figures mean, and whether any one method
produces the ‘correct’ result so that, therefore, the other 2 methods produce an
‘incorrect’ result. You will need to carefully control this discussion.
▲ Now take your lesson a step further.
Tell the class that in addition to the data already provided, we are now told that whilst
Product JX1 is sold immediately on leaving the joint process, Product JX2 is further
processed at a cost of £20 per tonne of input. During further processing, 10% of the
input weight is lost and has no value. The selling price of JX2 after further processing
is £550 per tonne.
Tell the class that we want to reconsider the apportionment of joint costs using the
new method taught in this lesson.
It would be wrong to use £360 a tonne for JX1 and £550 per tonne for JX2 as the basis
of apportioning pre-separation costs, if the selling price of the latter is higher than that
for JX1 – partly because it is further processed.
The 300 tonnes of JX2 that leaves the common process becomes 270 tonnes of saleable
product. This is sold for 270 × £550 = £148,500.
However, this is after incurring further processing costs of 300 × £20 = £6,000.
The theoretical net sales value of 300 tonnes of JX2 at the point of separation is therefore
£148,500 – £6,000 = £142,500.
117
The contribution for each product is then:
JX1 £144,000 – (400 × £210) =
JX2 £142,500 – (300 × £210) =
£
60,000
79,500
139,500
The fixed costs are then apportioned:
JX1 (60,000/139,500) × £63,000 =
JX2 (79,500/139,500) × £63,000 =
£
27,097
35,903
63,000
The profits then are:
£
JX1 144,000 – (84,000 + 27,097) =
32,903
JX2 148,500 – (63,000 + 35,903 + 6,000) = 43,597
76,500
▲ Now take the class through Examples 1, 2, and 3 on pages 304-312 of the textbook.
Example 2 is particularly important because it shows how, at Third Level, topics can be
combined in one question. The question is about joint products that are processed
after the separation point. However, the further processing costs are not given, but
have to be calculated, using equivalent units.
Example 3 is similar to the question used in this lesson. Losses are incurred after the
separation point. However, again, the further processing costs have to be calculated.
You are advised to make sure that the class gives adequate time to working through and
understanding these 3 Examples.
Reminders
All joint cost apportionment methods are quite arbitrary. Because of this, the
product costs and product profits arrived at by this process must be treated with
care.
The overall profit from the process is the only valid figure for assessing the
profitability of joint product manufacture.
Only after products have separated, can costs sensibly be attributed to individual
products.
118
LESSON 29
Main subject
Syllabus reference
Third Level
Lesson topic
The further processing decision
Third Level
3.19 Use marginal costing to evaluate proposals
Required for
Aim of the lesson
• To explain and illustrate how a further processing proposal should be
evaluated
The lesson
▲ Begin by pointing out that the extended syllabus reference comes under the heading
‘Marginal costing’. It says ‘Use marginal costing to evaluate proposals’
Tell the class that much more will be considered under this heading when Chapters
11, 12 and 13 are looked at later.
Further processing is looked at here specifically in the context of process costing.
Remind the class that an understanding of further processing does require a basic
knowledge of cost behaviour – the distinction between variable and fixed costs. This was
looked at in an earlier Lesson when classification of costs was considered, and
classification by cost behaviour was suggested as a possible classification.
Explain that the term ‘further processing’ implies that there is a choice between
processing material only to condition A, and doing some more work on it to take it to
condition B.
The options must be evaluated by comparing the costs incurred to reach condition B
rather than condition A, with the benefits of having the material in condition B instead
of condition A.
119
At its simplest:
20 kilograms of material costs £100. It costs £30 to process it to condition A, in which
it sold for £145. There is no loss in processing.
The same material can be processed beyond condition A to condition B for an extra
£20. It can then be sold for £173. There is still no loss of material in processing.
The increase in revenue is £173 – £145 = £28.
The increase in cost is £20.
It is worth processing the material to condition B.
This has been answered by first calculating the extra revenue. This is £28, and we call
this the marginal revenue (i.e. the extra revenue).
The extra cost is given as £20. This is called the marginal cost (i.e. the extra cost).
The difference, £8, is the extra profit we will make.
This is generally the best approach to further processing questions, but point out that
another approach is to look at each total position separately:
Present sales
Present costs
Present profit
£
145
130
15
Proposed sales
Proposed costs
Proposed profit
173
150
23
Therefore the profit for the proposal is £8 more. This approach gives the same answer.
Emphasise that generally it wastes some time.
▲ Point out that one thing that made this introductory example easy, was that the additional
processing did not cause any loss of the material being processed. The 20 kg remained
20 kg.
Take the class through Examples 4 and 5 on pages 313-314 of the textbook. Example 5
explains how lost material affects the problem.
Use the following data to illustrate how losses in further processing are dealt with in a
more detailed question:
Each year a company processes 15,000 tonnes of material X in batches of 500
tonnes. Material X costs £160 per tonne. It takes 80 hours to process each batch
in Process 19. Processing costs are £240 per hour.
From each batch, processing results in 50 tonnes of worthless residue, which
must be safely disposed of at a cost of £2,050.
450 tonnes of Product PR3 are also produced and can be sold for £260 per
tonne.
120
Two proposals are now being considered:
1 The residue could be re-processed by another company at a cost of £48 per
tonne. Each 50 tonnes would yield 38 tonnes of material X, which could be
used again in the process.
2 Product PR3 could be further processed in Process 23 to make PR4. Each
450 tonnes from Process 19 would be passed through Process 23. It would
take 40 hours and the hourly rate for Process 23 is £170 per hour. This
includes £90 per hour for the absorption of fixed process overheads, although
no additional fixed overheads would be incurred. Process 23 has been underutilised for some time. 10 tonnes would be lost, and the remaining 440 tonnes
of PR4 could be sold for £280 per tonne.
Advise the management on these 2 proposals
Explain to the class that because the question just says ‘Advise the management ...’ it
would be up to the candidate to decide the best approach. This is something you may
wish to discuss with the class.
You should also point out that in this case, the proposals are unrelated:
The company can continue to sell Product PR3 and can continue to dispose of the
residue
or
The company can continue to sell Product PR3 and can send the residue for reprocessing
or
The company can further process PR3 to make and sell PR4, and can continue to
dispose of the residue
or
The company can further process PR3 to make and sell PR4, and can send the residue
for re-processing.
▲ Before continuing, make sure that the class understands each alternative open to the
company.
Emphasise that at Third Level the approach taken by the candidate must be clear to the
examiner.
This is because there are often a number of equally acceptable ways to the answer, and
the examiner needs to be sure of the candidate’s reasoning. Unfortunately, different
acceptable approaches are often made unacceptable because they are mixed up!
121
▲ One approach to the question is to look at a year’s output:
15,000 tonnes = 30 batches of 500 tonnes.
Material 15,000 tonnes × £160
Processing:
80 hours × £240 × 30 batches
Disposal of residue 30 × £2,050
Sales 450 × 30 × £260
Present annual profit
£
2,400,000
576,000
61,500
3,037,500
3,510,000
472,500
Point out that others may look at one batch, because then figures are smaller, and less
prone to error as a result:
Material 500 tonnes × £160
Processing:
80 hours × £240
Disposal of residue
Sales 450 × £260
Present batch profit
£
80,000
19,200
2,050
101,250
117,000
15,750
£15,750 × 30 = £472,500, which agrees with the answer calculated on an annual basis.
▲ Continuing with the batch approach, what would the profit be if the residue were
recycled?
Each batch produces 50 tonnes of residue which can be re-processed to give 38 tonnes
of material X.
Explain that to obtain this, we have to pay another company 50 × £48 = £2,400.
Tell the class that the revised profit statement is:
Material 38 tonnes
500
Processing:
80 hours × £240
Sales 450 × £260
Proposed batch profit
£
73,920
2,400
76,320
19,200
95,520
117,000
21,480
Point out that if the residue is re-processed, the batch profit rises from £15,750 to
£21,480, an increase of £5,730.
This means that we can recommend the proposal to re-process the residue.
122
▲ Now explain that there is a quicker approach, which does not require the preparation
of 2 profit statements – either for a batch or for a year.
The quicker approach just looks at the things that change.
£
Additional costs
50 tonnes × £48 =
2,400
Savings
Disposal costs not paid
Material that won’t have to be bought
38 tonnes × £160
2,050
6,080
8,130
Net savings
5,730
Point out to the class that this is the same as the difference between the 2 profit
statements.
▲ Apply the same approaches to the proposal to further process PR3 into PR4:
Use the profit statement approach first. The class should be able to do this one for
you!
The present position is the same, of course, giving a profit of £15,750.
The revised profit statement will be:
£
Processing: Process 19
80 hours × £240
Disposal of residue
Processing: Process 23
40 hours × £80 (£170 – £90)
Sales 440 × £280
Proposed batch profit
80,000
19,200
2,050
3,200
104,450
123,200
18,750
Point out that if PR3 is further processed to give PR4, the batch profit rises from
£15,750 to £18,750 – an increase of £3,000.
This means that we can recommend the proposal to further process PR3.
Remind the class that there is a quicker approach, which does not require the preparation
of 2 profit statements – either for a batch or for a year. This quicker approach just
looks at the things that change.
123
Proposed sales 440 × £280
Present sales 450 × £260
Extra income
Extra cost 40 hours × £80 hour (£170 – £90)
Extra profit per batch
£
123,200
117,000
6,200
3,200
3,000
Again, emphasise that this agrees with the £3,000 difference between the 2 profit
statements, but has been obtained by a quicker and neater approach.
Point out that £80 per hour has been used to get the extra processing cost in process
23. The fixed costs are not included because there will be no increase in fixed costs and
because the process is under-utilised.
▲ Finally, take the class carefully through Example 6 on pages 314-317 of the textbook
Reminders
Further processing proposals are evaluated by comparing the additional revenue
that will arise with the additional costs of obtaining it.
Because there are often different ways of presenting the figures, the candidate’s
approach should always be made clear to the examiner.
124
LESSON 30
Main subject
Syllabus reference
Third Level
Lesson topic
Stock valuations for later processes, using equivalent units
Third Level
1.14 Value completed production and work-in-process using equivalent units,
and using a FIFO or average approach to the flow of costs. Candidates
could be asked to prepare an account or a statement for the first process
or any subsequent process
Required for
Aim of the lesson
• To explain how equivalent units are used for valuing stock in any process
which has a preceding process.
The lesson
▲ Begin by reminding the class that they have previously been taught how to use
equivalent units in a single process or in Process 1 where other processes follow.
Remind them also that 2 approaches were shown – one that used a FIFO approach
and one that used an average cost approach.
Take the class through Example 7 on pages 317-320 of the textbook as a reminder of
these principles.
125
▲ Now explain that you are going to introduce successive processes – a sequence of
processes through which the work passes to completion.
Begin by clarifying 2 terms that often confuse students:
1
Previous or preceding period
This is concerned with the calendar. If equivalent units are used to give a value of
£2,367 to work-in-process at 31 March Year 6, that is the closing stock value for
March.
Remind the class that £2,367 is also the opening stock value for April.
The use of the FIFO approach to stock valuation assumes that work that is in
process at the end of March will be the first to be completed in April, and passed
to the next process, or to finished stock.
March is therefore the period that precedes April.
If a product is made in a single process, there will always be a period which precedes
the current period. If the examiner asks for the Process account for the month of
July (as in Example 7 on page 317), then we must ask what has been brought
forward from June, because that is the preceding period. The answer is 80 tonnes
30% complete, and valued at £11,616.
2
Previous or preceding process
One or more products may be made by a succession of processes. These may be
continuous. This means that the material is introduced at the start of processing
and automatically passes through a number of stages before emerging as a finished
product. Although continuous, each ‘stage’ may be regarded as a distinct process.
On the other hand the part-processed product may be removed at the end of each
process, and later introduced to the next process.
If there are 3 distinct stages, they may be called Process 1, Process 2 and Process 3.
Process 1 is the previous or preceding process to Process 2. Process 2 is the previous
or preceding process to Process 3
Emphasise that this means that any work that is still in process in Process 3 at the
end of a period, must nevertheless be fully complete in respect of the work done
in Processes 1 and 2. If it isn’t, then what is it doing in Process 3?
▲ Make these important distinctions clear with the following:
A product is made in 2 consecutive processes, A and B
On 1 January Year 4 the following was the work-in-process:
Process A
400 tonnes, fully complete for materials, and 30% processed. It carried a value of £10,900.
Process B
700 tonnes, fully complete for materials, and 45% processed. It carried a value of £28,600.
126
In both cases, the preceding period is December of Year 3. Processing of the 400 tonnes
of work-in-process in Process A was certainly started before 1 January Year 4, sometime
in Year 3. This is also true of the 700 tonnes in Process B.
There is no preceding process to Process A. Process A is the first process.
Process A is the preceding process to Process B. Therefore any work that is in, or has
passed through, Process B, must have previously passed through Process A. Because of this,
the valuation of the work-in-process in Process B, £28,600, must include cost to reflect
the work done in Process A.
▲ Use the following data to illustrate your lesson:
A chemical product is made in 2 consecutive processes, A and B. Process A
precedes process B.
Process A
At 1 January:
Work-in-process was 1,200 litres, 100% complete in respect of materials, and
30% processed It carried a cost of £3,732.
During January:
48,000 litres of material, costing £121,680, were put into the process.
42,000 litres were transferred to Process B.
1,200 litres were lost in processing, but this was considered normal.
At 31 January:
Work-in-process was 5,200 litres, 100% complete in respect of material and
60% processed.
Process B
At 1 January:
Work-in-process was 2,700 litres, 40% processed. It carried a cost of £9,840.
During January:
42,000 litres were received from Process A.
At the start of processing, 14,000 litres of material were added at a cost of £14,000.
51,000 litres of finished chemical product were transferred to finished stock.
There were no losses, either normal or abnormal in this process.
At 31 January:
Work-in-progress was 75% processed.
127
Because Process A has no previous process, you may want to ask the class to do Process
A themselves.
If, however, you decide to work it through with them, it will give you the opportunity
to revise key points, such as: balance the physical units (litres) to detect losses, and start
to prepare the process account or statement:
WIP
Material
Processing
Process A account – January
Litres
£
1,200
3,732 Normal loss
48,000
121,680 Process B
77,452 WIP
Abnormal loss
49,200
Litres
1,200
42,000
5,200
800
49,200
£
–
Point out that the abnormal loss was not mentioned in the question. It was detected by
balancing the input and output of litres.
Now take the class through the calculation of the equivalent units. You can use the
table format as illustrated in an earlier lesson and in the textbook. The competent student
can do it as follows:
Material equivalent units:
Remind the class that we are using FIFO because the opening stock value has been
given as one figure.
(42,000 – 1,200) + 5,200 + 800 = 46,800 litres
Processing equivalent units:
(42,000 – 1,200) + (70% of 1,200) + (60% of 5,200) + 800 = 45,560 litres
Now calculate the cost per equivalent unit:
Materials £121,680/46,800 litres = £2.60 per equivalent litre
Processing £77,452/45,560 litres = £1.70 per equivalent litre
Total cost = £2.60 + £1.70 = £4.30 per equivalent litre
Now value the items for the completion of the Process account:
Process B (40,800 × £4.30) + (840 × £1.70) + £3,732 = £180,600
Abnormal loss 800 × £4.30 = £3,440
WIP (5,200 × £2.60) + (3,120 × £1.70) = £18,824
128
Now complete the Process A account or statement.
WIP
Material
Processing
Process A account – January
Litres
£
1,200
3,732 Normal loss
48,000
121,680 Process B
77,452 WIP
Abnormal loss
49,200
202,864
Litres
1,200
42,000
5,200
800
49,200
£
–
180,600
18,824
3,440
202,864
▲ Remind the class that, next, we have to do the account for Process B. For this process
there is both a previous period (the opening WIP was started before 1 January), and a
previous process (any work that has passed through or is still in, Process B must have
already passed through Process A).
Tell the class that the answer starts in exactly the same way as for Process A. The account
must be prepared as far as possible, and any losses or any other missing figure, detected.
Process B account – January
Litres
£
Litres
WIP
2,700
From Process A 42,000
180,600 WIP
Material added 14,000
14,000
Processing
66,834
58,700
271,274
£
51,000
7,700
58,700
271,274
Remind the class that the WIP figure of 7,700 litres is detected as the balancing figure,
because we are told that no losses of any kind have occurred.
Point out, in addition, that the new material is added as processing starts in Process B.
Therefore the opening WIP must already have been diluted with new material prior to
1 January i.e. in the previous period.
Now take the class through the calculation of the equivalent units. They can be set out
in a table as shown on page 322 of the textbook, or can be calculated as we did earlier
for Process A:
Input from Process A equivalent units:
(51,000 – 2,700) + 7,700 = 56,000 equivalent litres.
Point out that this is the calculation that ensures that the output from Process B will
bear cost for the work done in Process A.
Process B equivalent units:
Material added equivalent units:
(51,000 – 2,700) + 7,700 = 56,000 equivalent litres
Processing equivalent units:
(51,000 – 2,700) + (60% × 2,700) + (75% of 7,700) = 55,695 equivalent litres
129
Now calculate the cost per equivalent unit:
Input from Process A cost £180,600/56,000 = £3.225 per equivalent litre
Process B:
Material added cost £14,000/56,000 = £0.25 per equivalent litre
Processing £66,834/55,695 = £1.20 per equivalent litre
Total cost = £3.225 + £0.25 + £1.20 = £4.675 per equivalent litre
Now value the items for the completion of the Process account:
Finished stock (48,300 × £4,675) + (60% × 2,700 × £1.20) + £9,840 = £237,586.5
(say £237,587)
WIP (7,700 × £3.475) + (75% × 7,700 × £1.20) = £33,687.5 (say £33,687)
Now complete the process account:
Process B account – January
Litres
£
WIP
2,700
From Process A 42,000
180,600 WIP
Material added 14,000
14,000
Processing
66,834
58,700
271,274
Litres
51,000
7,700
£
237,587
33,687
58,700
271,274
Make sure the class understands this example in all respects before going on.
▲ You may also wish to use the example to go through the average cost approach. To do
this you will need the breakdown of the opening stock values. You should use:
Process A
Material
Processing
£
3,120
612
3,732
Process B
Input from Process A cost
Process B cost:
Material
Processing
£
8,320
604
916
9,840
▲ Now take the class carefully through Example 8 on pages 320-324 of the textbook.
▲ Finally, ensure that the class reads and works through Example 9 on pages 324-327,
although specific lesson time has not been allocated to this. It might be worth returning
to these pages later, when the class is more aware of standard costing.
130
Reminders
The difference between a previous period and a previous process must be clearly
understood.
Any work completed in Process B must include, in its valuation, an amount to
reflect the work done in the previous process, Process A.
This also applies to a work-in-process valuation in Process B.
131
LESSON 31
Main subject
Textbook reference Chapter11: Page 334
Syllabus reference
Second Level
6
Marginal costing
Elementary knowledge of the use of contribution for decisions and the
effect on stock values and reported profits
Lesson topics
The behaviour of variable costs and fixed costs in relation to output change
The meaning of, and calculation of, contribution per unit and total contribution
6.1
6.2
6.3
Appreciate marginal costing as a technique
Understand the terminology of marginal costing – marginal cost, variable
cost, out-of-pocket cost, fixed cost, contribution, break-even point,
contribution/sales (CS) ratio
Calculate contribution per unit and total contribution
Required for
Aims of the lesson
• To explain terms used in marginal costing
• To explain contribution and how it is calculated
The lesson
▲ Begin by reminding the class that in an earlier Lesson the subject of cost classification
was looked at.
Costs can be classified by element, by function, by controllability, by normality and –
important to the class now – by behaviour.
Continue by reminding the class that to define cost behaviour we asked the question,
‘If output increases by 10%, what happens to a particular cost?’
If the total amount of that cost also rises by 10% we say that the cost is a variable cost.
If the total amount of that cost is unchanged then we say that the cost is a fixed cost.
132
An example of a variable cost is direct material cost.
If it takes £20 of material to make 1 product, then to make 15 products we would need
£300 of material, and to make 130 products we would need £2,600 of material.
We can tabulate this:
Units of output
1
15
130
Total material cost
£
20
300
2,600
Cost per unit
£
20
20
20
Emphasise that a cost is described as variable if, as output increases, the total of that
cost rises in proportion to output. The cost per unit is constant.
Now contrast this with a fixed cost.
An example of a fixed cost is the salary paid to a supervisor or manager. If he is paid
£500 per week, he will be paid this if his department produces (say) 1,000 units of
output in the week.
But what if, because of machine breakdown or shortage of orders, his department only
produces 500 units in a particular week. Will the manager only be paid half his normal
salary? Of course not!
But nor will he be paid more when his department produces 1,200 units in a week.
If we tabulate this:
Units of output
500
1,000
1,200
Total salary cost
£
500
500
500
Cost per unit
£
1.00
0.50
0.42
Emphasise that a cost is described as fixed if, as output increases, the total of that cost
remains constant. The cost per unit is not constant.
Point out that because the fixed cost (in this case, salary) per unit fluctuates in this way,
and can be confusing, some prefer not to express fixed costs as a cost per unit. This
will be explained shortly.
As the meaning of variable and fixed costs is so important to later work, please don’t
continue until you are satisfied that the class understands clearly the points being made.
133
▲ Now explain that for most examination questions, prime cost per unit of output should
be considered to be a variable cost. Remind the class that prime cost is the sum of
direct material, direct labour and direct expense.
For a business that makes just one product, the cost per unit might be:
£
Direct material 3 kilograms @ £4 per kg
12.00
Direct labour 6 hours @ £8 per hour
48.00
Direct expense
10.00
Prime cost
70.00
Remind the class that the direct expense might be paid to another company for (say)
polishing each product.
Now tell the class we will suppose that the overheads of the business are all considered
fixed, and amount to £18,000 per month.
Ask the class to tabulate the costs for monthly outputs of 200 units, 300 units and 350 units.
£
2,400
9,600
2,000
14,000
18,000
32,000
Direct material
Direct labour
Direct expense
Prime cost
Fixed overheads
Total cost
£
3,600
14,400
3,000
21,000
18,000
39,000
£
4,200
16,800
3,500
24,500
18,000
42,500
Point out to the class that prime cost has been treated as a variable cost. The total
amount of prime cost has been increased in line with the increase in output.
Because of this, the figures can be summarised:
Variable cost
Fixed cost
Total cost
£
14,000
18,000
32,000
£
21,000
18,000
39,000
£
24,500
18,000
42,500
£
70.00
60.00
130.00
£
and cost per unit shown as:
£
Variable cost
Fixed cost
Total cost
70.00
90.00
160.00
70.00
51.43
121.43
Once again, don’t leave these 2 tables until the class is clear on the distinction between
total cost and unit cost, for each of variable cost, fixed cost and total cost.
134
▲ Now tell the class that, at this level of study, other terms that mean the same as variable
cost are marginal cost, avoidable cost, and out-of-pocket cost.
Refer the class to the CIMA definition of marginal cost on page 335 of the textbook.
Marginal cost is the amount of cost that we avoid by not producing a unit of output. It
is the amount of extra cost that we incur by producing one more unit of output.
Remind the class of the total cost of producing 300 units:
Direct material
Direct labour
Direct expense
Prime cost
Fixed overheads
Total cost
£
3,600
14,400
3,000
21,000
18,000
39,000
Now ask them to put alongside, the total cost of producing 299 units and 301 units.
Units
299
£
Direct material
Direct labour
Direct expense
Prime cost
Fixed overheads
Total cost
3,588
14,352
2,990
20,930
18,000
38,930
300
£
3,600
14,400
3,000
21,000
18,000
39,000
301
£
3,612
14,448
3,010
21,070
18,000
39,070
Point out clearly to the class that the cost of producing 1 extra unit is £39,070 – £39,000
= £70. This is the marginal cost.
The cost avoided by producing 1 unit fewer is £39,000 – £38,930 = £70.
Note that this figure, £70, is the variable cost of 1 unit of output. It is also called the
out-of-pocket cost because to produce 1 more unit, the business has to ‘dip into its
pocket’ for another £70, whereas no more is needed for fixed costs.
▲ Now introduce contribution.
Refer the class to the CIMA definition on page 337 of the textbook. Point out the 3
ways of referring to contribution: as total contribution, as unit contribution or as
contribution as a % of sales.
Tell the class that you are going to use a selling price of £150 per unit for the product
referred to earlier.
Point out that the definition of contribution refers to the variable cost of sales. In this
example, we only have prime cost as a variable cost because all the overheads are fixed.
In another question there could be variable production overheads, and variable selling
and distribution overheads. These must be taken into account in calculating the
contribution.
135
Using the same figures:
Contribution = £150 – £70 = £80. This is the unit contribution.
Total contribution depends upon how many units are made and sold. We looked at 3
possibilities: 200, 300 and 350.
Units
Direct material
Direct labour
Direct expense
Prime cost/Variable cost
Sales value
Total contribution
200
£
2,400
9,600
2,000
14,000
30,000
16,000
300
350
3,600
14,400
3,000
21,000
45,000
24,000
£
4,200
16,800
3,500
24,500
52,500
28,000
£
Point out that the total contribution is simply obtained by multiplying the units by the
unit contribution: 200 × £80 = £16,000; 300 × £80 = £24,000; and 350 × £80 =
£28,000.
Contribution as a % of sales is £80/£150 = 53.33% This is known as the C/S ratio, the
Contribution to Sales ratio.
The same answer would be obtained from £16,000/£30,000, or £24,000/£45,000, or
£28,000/£52,500.
▲ Finally, take the class through pages 334-341 of the textbook. Example 3 is very important
because it contrasts absorption costing and marginal costing. Point out, particularly,
that variable overhead has to be considered in arriving at the variable product cost, and
therefore at the contribution.
Reminders
Total variable cost increases in line with output increases, but unit variable cost
is a constant.
Total fixed cost remains constant as output increases, but unit fixed cost rises
and falls with output change.
Variable cost is also known as marginal cost, avoidable cost and out-of-pocket
cost.
Contribution is selling price minus variable cost of sales.
136
LESSON 32
Main subject
Syllabus reference
Second Level
6
Marginal costing
Lesson topics
The effect of stock valuations on reported profits
Simple break-even calculations
6.4
6.5
6.6
6.7
Make simple break-even calculations using F/C unit or F/CS ratio.
Break-even charts and profit graphs will not be examined at Second Level
Calculate require sales for a given profit using (F + P)/CS ratio
Prepare profit statements valuing stock on either a marginal cost or a full
absorption cost basis
Explain the profit variation resulting from 6.6
Required for
Aims of the lesson
• To explain how reported profits are affected by decisions about stock valuation
• To explain the use of break-even formulae
The lesson
▲ Begin by reminding the class that we have identified two types of cost:
(1) Those that are incurred because the product is made: the direct costs, and the
variable overheads. As more output is produced, the total amount spent on these
costs increases. We called these the variable costs.
(2) Those that are incurred in providing the facilities to make and distribute the
product. As more output is produced, the total amount spent on these facilites is
unchanged. We called these fixed costs.
137
▲ Explain that in an earlier lesson, the subject of overhead absorption was studied. Using
an absorption method such as a machine (or process) hour rate, all production overheads
were absorbed into the cost of each unit of production.
Point out that we didn’t ask whether the production overheads were fixed or variable.
All of the overheads were included in the absorption rate. Therefore both variable and
fixed production overheads were absorbed into the unit product cost.
In addition, Administration, Selling and Distribution overhead (all of it) was absorbed
in some examples.
Make it absolutely clear to the class that we were using absorption costing, and make sure that they
understand clearly what this is.
Go back again to Example 3 on page 337 of the textbook. Point out that at the top of
page 338, it makes clear that the budgeted overheads are £47,360 variable and £87,040
fixed, totalling to £134,400.
Then point to the first paragraph of the Solution, where the last sentence says: ‘The
fixed overheads as well as the variable overheads will be absorbed into the unit cost of
the product.’
Also, refer the class to Note 1 to the solution at the foot of page 338.
▲ So, we know what absorption costing means. What about marginal costing?
Refer the class back to the CIMA definition of marginal costing on page 334 of the
textbook: ‘The accounting system in which variable costs are charged to cost units and
fixed costs of the period are written off in full against the aggregate contribution.’
Here then is the difference. Make sure that the class sees the distinction:
With absorption costing, all costs are absorbed into the cost unit.
With marginal costing, only variable costs are absorbed into the cost unit.
So what do we do with the fixed costs under marginal costing?
The answer is that we work out the total (aggregate) contribution earned by our product
or products, and then deduct the fixed costs to get the profit.
Because under absorption costing fixed overheads are absorbed into the unit cost, any
unsold units will be valued inclusive of fixed overheads. However, these are only fixed
production overheads.
Under marginal costing, any unsold stocks will be valued at variable cost only. Again,
however, this will only be variable production cost, since – if the unit is still in stock –
the variable distribution cost has not yet been incurred.
Take the class through the paragraphs on pages 339-340 that contrast absorption and
marginal costing.
138
▲ Now use the following data to illustrate your lesson:
Company X starts production on 1 January Year 1
It makes one product and budgets to make and sell 1,000 units during Year 1.
The product will be sold direct to the public from its factory premises – so
there will be no distribution costs.
A selling price of £200 per unit has been set.
Prime costs have been forecast as:
Material 40 kg @ £0.50 kg
Direct labour 20 hours @ £5 hour
£
20
100
Overheads (all fixed) are budgeted at £50,000 for the year.
Tell the class that you will begin with an absorption costing approach.
The budgeted hours are 1,000 units × 20 hours per unit = 20,000 hours.
The absorption rate is therefore £50,000/20,000 hours = £2.50 per direct-labour hour.
The unit product cost is:
Prime cost
Fixed overhead 20 hours × £2.50 hour
Total cost
£
20
100
120
50
170
Therefore, on an absorption basis, the budgeted profit for the year is:
£200 – £170 = £30 × 1,000 units =
or
Sales 1,000 units × £200
Costs 1,000 units × £170
Profit
£30,000
£
200,000
170,000
30,000
▲ Now tell the class that you will illustrate the marginal costing approach.
Point out that, so far, contribution has not been mentioned. Now it should be calculated:
Selling price
Variable cost
Contribution
£
200
120
80
Remind the class that the definition of marginal costing, on page 334 of the textbook,
stated that profit is found by deducting the fixed costs from the aggregate contribution.
The aggregate contribution is 1,000 units × £80 per unit = £80,000
139
The profit is therefore found:
Contribution
Less fixed costs
Profit
£
80,000
50,000
30,000
Point out that the figures could be shown in full:
Sales
Variable costs £120 × 1,000 units
Contribution
Fixed costs
Profit
£
200,000
120,000
80,000
50,000
30,000
Tell the class that the absorption approach and the marginal approach have both reported
a profit of £30,000. This is because 1,000 units are to be made and 1,000 units are to be
sold. There is no stock at the year end. We will change this in a minute.
▲ First let us look at simple break-even calculations.
Break-even is where neither a profit nor a loss is made. The aggregate contribution
must just be enough to cover the fixed costs.
It can be calculated:
Fixed costs/Contribution per unit, which gives an answer in units sold
or
Fixed costs/CS ratio, which gives the answer in sales value.
Using F/Cunit, £50,000/£80 = 625 units
Using F/CS ratio, first calculate the CS ratio which is £80/£200 = 40%
Break even sales is then £50,000/40% = £125,000
625 units × £200 unit = £125,000.
Show the class that this is correct:
Sales 625 units × £200
Variable cost 625 × £120
Contribution
Fixed costs
Profit/Loss
£
125,000
75,000
50,000
50,000
Nil
Tell the class that sometimes the question is asked, ‘What do the sales need to be, to
make a profit of (say) £40,000?’
140
This answer is found by using F + P instead of just F.
(F + P)/Cunit = (£50,000 + £40,000)/£80 = 1,125 units
or
(F + P)/CS ratio = (£50,000 + £40,000)/40% = £225,000
1,125 units × £200 unit = £225,000 sales.
▲ Now, after that little diversion, tell the class that you are returning to the question of
reported profits.
Using the earlier example, explain that we are now going to assume that – although
the firm plans to make 1,000 units in its first year – it only expects to sell 900 units.
First, look at absorption costing:
Sales
900 units × £200
Cost of sales:
Material
1,000 × £20
Direct labour 1,000 × £100
Fixed overhead
Less stock 100 units × £170
Profit
£
180,000
20,000
100,000
50,000
170,000
17,000
153,000
27,000
Now look at marginal costing:
Sales
Variable cost of sales 900 × £120
Contribution
Fixed costs
Profit
£
180,000
108,000
72,000
50,000
22,000
It would also help class understanding if you showed the marginal costing approach in
its longer presentation:
Sales
Variable cost of sales:
Material 1,000 × £20
Direct labour 1,000 × £100
Less stock 100 × £120
Contribution
Fixed costs
Profit
£
180,000
20,000
100,000
120,000
12,000
108,000
72,000
50,000
22,000
141
Explain to the class that we now have different profits. The absorption approach says
£27,000. The marginal approach says £22,000. This is a £5,000 difference.
Point out that this is entirely due to a difference in the value of stocks: absorption
£17,000; marginal £12,000. The £5,000 difference is 100 units × fixed overhead per
unit £50.
▲ I would suggest that you now continue this example into Year 2. Tell the class that the
planned production is still 1,000 units but planned sales are 1,040 units.
▲ Finally, to revise the work of this lesson, take the class through the Examples on pages
342-353 of the textbook.
Reminders
Reported profits will depend on whether absorption or marginal principles are
used.
Using absorption costing, stocks are valued at full production cost, inclusive of
fixed production overheads
Using marginal costing, stocks are valued at variable production cost.
Which method reports the higher profits depends upon whether stocks are
rising or falling.
Break-even is the point where fixed costs are just covered by contribution.
142
LESSON 33
Main subject
Syllabus reference
Second Level
6
Marginal costing
Lesson topic
Contribution analysis for simple business decisions
6.8
Apply contribution analysis to simple business decisions, relating to
additional output, effect of price change and the use of a scarce resource
Required for
Aim of the lesson
• To explain how marginal costing helps to make better business decisions
The lesson
▲ Begin by referring the class to the definition of marginal costing which appears on
page 334 of the textbook.
Emphasise the last sentence: ‘Its special value is in recognising cost behaviour, and
hence assisting in decision making.’
This is saying, that because cost behaviour can be recognised, it is possible to identify
variable and fixed costs, and to calculate contribution. This allows for better decisions,
because the cost data is not confused with the treatment of fixed costs.
Now tell the class that you are going to illustrate the lesson by using the Company X
data from the previous lesson. However, we will now say that we are looking at Year 3,
and the company plans to make 900 units of its first product (now called X1), for
which the prime costs are still:
Prime cost
£
20
100
120
143
In addition, the company plans to make 400 units of a second product (called X2), for
which the prime costs will be:
£
50
25
75
Prime cost
X1 will continue to be sold for £200 per unit, and X2 will be sold for £135 per unit.
Fixed costs in total will be £50,000 for the year.
▲ Before using this data in the marginal costing sense, ask the class to prepare a product
cost for each of X1 and X2, using absorption costing principles.
The first thing the class should do, is to establish an absorption rate based upon direct
labour or direct labour hours. Any student attempting to calculate an absorption rate
based upon direct material or prime cost should be reminded of the weaknesses of
such an approach.
Budgeted direct labour hours:
X1 900 units × 20 hours =
X2 400 units × 5 hours =
Total
18,000 hours
2,000 hours
20,000 hours
Fixed overhead absorption rate £50,000/20,000 hours = £2.50 per hour
Point out to the class that this rate is the same as that for Year 1 in the previous lesson.
This is because, although fewer units of X1 are to be made, there are units of X2 being
made instead. The overall 20,000 hours is the same as in Year 1.
The class can now prepare the product costs:
Direct material
Direct labour
Fixed overhead:
20 hours × £2.50
5 hours × £2.50
Total cost
Selling price
Profit per unit
X1
£
20.00
100.00
X2
£
50.00
25.00
50.00
_____
170.00
200.00
30.00
12.50
87.50
135.00
47.50
Now explain that if a manager asks how much profit will be made in Year 3, the answer
is:
X1 900 units × £30.00 per unit =
X2 400 units × £47.50 per unit =
Total profit
144
£
27,000
19,000
46,000
The class should find this fairly clear to this point.
Now tell the class that the manager comes back and says, ‘I am a bit unsure of the
market and how many of each product we will sell. Am I right in thinking, that if we
make and sell 10% more of each product than we have budgeted, we will make a profit
of £50,600? And that if we make and sell 800 of X1 and 500 of X2, we will make a profit
of £47,750?’.
Before going on, make sure that the class can see where the manager has got these figures from.
When you have shown where the figures have come from, tell the class that both of his
statements are unsound. They illustrate the confusion produced by absorption costing,
when we try to make decisions.
▲ Now take the class into marginal costing routines.
First, calculate the contribution per unit for each product:
Direct material
Direct labour
Variable cost
Selling price
Contribution
X1
£
20
100
120
200
80
X2
£
50
25
75
135
60
Now remind the class how the profit statement is produced using marginal costing:
Contribution per unit
Units
Total contribution
Fixed costs
Profit
80
900
72,000
60
400
24,000
96,000
50,000
46,000
Point out to the class that this agrees with the profit under absorption costing. However,
under absorption costing, no attempt is made to put fixed costs against each product.
Now deal with the two questions that the manager came back with:
If the output of both products increases by 10%, then contribution will rise by 10%.
The new profit will be:
£46,000 + (10% of £96,000) = £55,600 (not the £50,600 suggested by the manager).
If we make and sell 800 units of X1 and 500 units of X2, then the profit will be:
(800 × £80) + (500 × £60) – £50,000 = £44,000 (not £47,750 as suggested by the
manager).
Emphasise to the class how neat and quick the contribution approach is, and how dangerous it is to
use costs based upon absorption costing.
145
Now show how easily selling price changes can be incorporated:
The manager says ‘Compared with the original budget for Year 3, we could sell 20%
more units of X1 if we reduced the selling price by 5%. Should we do this?’
This should be answered:
£
Present selling price
Reduced selling price
Revised contribution per unit £190 – 120 =
200
190
70
Revised total contribution 900 (1.20) × £70 = 75,600
Original contribution
72,000
Extra contribution
3,600
Yes, we should do it.
▲ Finally, show the class how contribution can be used to make sure that we make the
most profit we can, when a resource – e.g. materials, or a skill of labour – is in short
supply, so that it is not possible to make all of the budgeted output.
Tell the class that you will be using the budget for Year 3, which was to make 900 units
of X1 and 400 units of X2. This resulted in a budgeted profit of £46,000.
First tell the class that we now know that only £30,000 of material will be available for the whole
year. What is the best profit that we can make?
To answer this we need the contribution per £ of material:
Material used per unit
Contribution per £ of material
X1
£
80
20
4
X2
£
60
50
1.2
Explain to the class that this clearly shows that product X1 gives the best contribution
in relation to the scarce material used. It is preferred, and therefore we should allocate
scarce material to X1 first:
X1 needs £20 material per unit.
Therefore, 900 units needs 900 × £20 = £18,000 worth.
This leaves £30,000 – £18,000 = £12,000 for product X2.
This will make £12,000/£50 = 240 units of X2.
The best (or optimal) profit is therefore:
(900 × £80) + (240 × £60) – £50,000 = £36,400.
146
Now explain that we can get as much material as we need, but direct labour hours will be limited
to 16,000 hours. What is the best profit that we can make?
To answer this we need the contribution per direct labour hour (or per £ of direct
labour cost):
Direct labour hours per unit
Contribution per direct labour hour
X1
£
80
20
4
X2
£
60
5
12
Explain to the class that this clearly shows that product X2 gives the best contribution
in relation to the scarce labour used. It is preferred, and therefore we should allocate
scarce labour to X2 first:
X2 needs 5 labour hours per unit.
Therefore, 400 units needs 400 × 5 = 2,000 hours.
This leaves 16,000 – 2,000 = 14,000 for product X1.
This will make 14,000/20 hours = 700 units of X1
The best (or optimal) profit is therefore:
(700 × £80) + (400 × £60) – £50,000 = £30,000.
Reminders
Unit product costs which include fixed overheads are difficult to use in decisionmaking.
Contribution per unit of product can easily be adjusted to reflect change, for
example a change in selling price.
Total contribution is easily adjusted to reflect change, for example a change in
output.
Contribution in relation to a scarce resource can be used to allocate that resource
most profitably.
147
LESSON 37
Main subject
Syllabus reference
Third Level
3
Marginal costing
Lesson topic
Applications of the marginal costing technique: make/buy and route selection
3.18.a Choose between in-house manufacture and subcontracting (make or
buy), where in-house resources are without limit
3.18.b As 3.18.a, but where in-house resources are limited in supply
Multiple resource limitations requiring a graphical or linear programming
solution will not be set
3.20 Use marginal costing to choose between alternative internal methods of
manufacture
Required for
Aims of the lesson
• To show how marginal costing can be used to decide between in-house
manufacture and subcontracting
• To show how marginal costing can be used to select the most economical
route for manufacture
The lesson
▲ Begin by pointing out that many decisions are made with the aim of minimising cost.
For a constant level of sales, minimising costs is equal to maximising profit.
But – remind the class – ‘cost’ has different meanings. For example, it could be variable
cost or total cost.
One view might be that we should aim to minimise the extra cost arising from a
decision. Remind the class that the word ‘marginal’ could be used instead of ‘extra’.
Revise the motoring example again. This was first used as an illustration of a principle in Chapter
11 of the textbook:
163
A motorist may normally travel 16,000 kilometres each year.
His petrol bill for the year might be £800.
His cost per kilometre for petrol (a variable motoring cost) is £0.05.
Explain that he has fixed motoring costs for depreciation and insurances. These are
£3,600 and £400 respectively for a year. Therefore,
His cost per kilometre for fixed motoring costs is £0.25.
The total cost of his motoring is £0.30 per kilometre.
Tell the class that he has to make a journey of 160 kilometres to his destination, and
then make the return journey of 160 kilometres. He can make the journey by rail for
£82. What should he do?
By car the ‘cost’ is 320 kilometres × £0.30 = £96. By rail the cost would be £82. This
seems to say, ‘Use the train.’.
Can the class remember the argument?
The ‘marginal or variable cost’ of using the car is 320 kilometres × £0.05 = £16.
It isn’t worth spending £82 to save £16. Remember the fixed costs will not be saved.
The car is still depreciating, and is still insured, even whilst he is sitting on the train!
What you should now emphasise is that this is a ‘make or buy’ decision:
Shall I use my own available facilities, or shall I purchase in the service of another
business, the railway company?
▲ Continue using the following data per unit:
Product
A
£
Material
10
Other variable costs 12
Fixed cost
19
Total cost
41
Selling price
50
Profit
9
Annual production
and
sales (units)
1,200
B
£
8
28
26
62
70
8
C
£
4
15
14
33
40
7
D
£
7
17
17
41
45
4
1,200
100
50
Ask the class:
Should we be making and selling these products?
The answer is:
Yes – because each makes a profit on an absorption basis, and each therefore makes a
contribution.
More able members of the class may ask whether any problem exists with resources.
Point out that if there is, these products may displace others that cannot then be made.
164
In which case, should we let another firm make these products for us?
This depends on whether another firm could make them, and what they would
charge etc.
Suppose a firm could, and quotes per unit:
A
£
40
B
£
63
C
£
18
D
£
26
Can the class now apply the principles of the motor car illustration to this example?
Product A
Total internal cost of manufacture £41. This is irrelevant, because fixed costs will not
be saved if they are all general fixed costs.
Internal variable cost of manufacture £22.
It isn’t worth paying £40 to save £22. Carry on with internal manufacture.
Product B
Product C
It is worth paying £18 to save £19. Subcontracting Product C will minimise cost and
will maximise profit.
Ask the class about the dangers of subcontracting. For example, your customer and
your supplier could make contact and cut you out. Also important will be the
subcontractor’s ability to meet delivery dates, product quality and whether the price
will hold for a reasonable period of time.
Product D
Suggest now that a special gauge has to be purchased, at a cost of £250, to check each
completed Product D. The gauge loses accuracy after being used to test 50 products,
and a new gauge has then to be purchased. The gauge cost is included in fixed costs. If
an outside firm makes the product, it will have to purchase its own gauges. Does this
change the decision?
165
Yes – this is a directly attributable fixed cost. It would have to be purchased, even if the
customer only ordered 10 products. It would be usable for orders totalling 50 products
but, after that, additional orders could not be guaranteed. The cost only relates to
Product D.
The fixed costs will include £250/50 = £5 per unit. This will be saved if Product D is
subcontracted.
It is worth paying £26 to save £24 + £5.
Draw the conclusion that, on cost considerations alone, internal manufacture of Products
A and B should be continued, but Products C and D should be subcontracted.
▲ Now tell the class that even if this is done, a problem remains with a particular machine
used to make all four products. Other machines are used as well, but they do not have
the capacity problem of this particular machine. This machine has an annual capacity
of 1,500 hours and this cannot be increased.
The hours used on this machine are:
Product
Hours
A
0.5
B
1.0
C
1.0
D
2.0
C
100
D
100
Therefore, the annual hours needed are:
Product
Hours
A
600
B
1,200
Total
2,000
2,000 hours are needed but only 1,500 hours are available.
Remind the class that the problem has been partly solved by the decision to subcontract
the manufacture of Products C and D. This reduces the need to 1,800 hours.
Explain that, therefore, the manufacture of some of Product A, or of Product B, or
some of each, will have to be subcontracted. How do we decide which?
Draw the attention of the class to the ‘boxed’ rule on page 407 of the textbook.
So, if extra cost is to be incurred through subcontracting, it should be as little as possible
for each hour of limited capacity released.
Show the class the calculation:
Product
Variable cost
Subcontract price
Excess cost
Limited capacity hours
Excess cost per hour
A
£
22
40
18
B
£
36
63
27
0.5
£36
1.0
£27
Take care in explaining the meaning of these figures and how they are interpreted.
166
Although Product B has the highest excess cost (£27 compared to £18), it has the lowest
excess cost per machine hour. This is the decision criteria. It is Product B that should be
subcontracted.
300 units of Product B should be subcontracted, so saving the 300 hours.
▲ Now take the class through Examples 1 and 2 on pages 404-409 of the textbook. These
are important questions, and each step in the solutions should be carefully explained.
▲ Next, remind the class that the same principle of minimising additional cost can be
applied to any course of action for which alternatives exist.
For example,
If we have to deliver goods to a customer, should our delivery vehicle use Route A or
Route B?
If a product can be made on either Machine A or Machine B, how do we decide
which?
Use the following illustration:
An operation on a product can be done on either of 2 machines, TR5 or SK4. The
operation would take 6 hours on TR5, or 4.5 hours on SK4. Conversion cost rates per
hour for each machine are:
Variable
Fixed
TR5
£
3.70
4.65
8.35
SK4
£
4.30
7.20
11.50
At the end of the operation, the product is inspected.
20% of those made on TR5 have to go back onto TR5 for 1 hour each, to be rectified.
They are then acceptable.
10% of those made on SK4 have to go back onto SK4 for 2 hours each, to be rectified.
Both machines have adequate available time.
First, work out the hours to allow for rectification work. The class may find it easier to
work on 10 products.
TR5
10 products take 10 × 6 =
2 (20%) will need rectifying × 1
SK4
10 products take 10 × 4.5 =
60 hours
2 hours
62 hours
45 hours
2 hours
47 hours
167
Total costs
TR5 62 hours × £8.35
SK4 47 hours × £11.50
£
517.70
540.50
This suggests that Machine TR5 should be used. This would be an incorrect conclusion
since fixed costs will be incurred anyway.
On the assumption that both machines are being kept and both are available, only the
variable costs should be looked at:
TR5 62 hours × £3.70
SK4 47 hours × £4.30
£
229.40
202.10
Machine SK4 should be used.
▲ Take the class carefully through Example 3 on pages 410-412 of the textbook.
Reminders
The application of the marginal costing technique allows decisions to be made
on the basis of lowest additional cost.
If a subcontractor can carry out an operation or make a product at less than the
internal variable cost, then allowing the subcontractor to do the work will
minimise cost and maximise profit.
If subcontractors have to be used because of internal capacity problems, then a
decision should be made which minimises the additional cost in relation to the
release of the scarce internal resource.
168
LESSON 38
Main subject
Syllabus reference
Third Level
3
Marginal costing
Lesson topic
Applications of the marginal costing technique: further processing and product
and service pricing
3.16 Calculate value added
3.17 Use marginal costing to assist product and service pricing
3.17.a Calculate a selling price to recover long run average costs
3.17.b Calculate a selling price to recover short run marginal costs
3.17.c Explain why a selling price might be set at a level below marginal cost
3.17.d Explain why a selling price might be set to match that of a competitor
3.17.e Calculate a selling price to achieve a target rate of contribution or value
added
Required for
Aims of the lesson
• To show how marginal costing can be used to assess the value of further
processing
• To show how marginal costing can be used, with other measures, to assist in
setting prices for goods or services
The lesson
▲ Begin by pointing out to the class that the term ‘further processing’ is usually associated
with process costing. For example:
Andor Limited produces 18,000 litres of Product XP6 each month.
XP6 is sold for £22 per litre.
It is proposed to further process XP6 to make XP6 (Superior).
Further processing will cost £6.50 per litre of input, and there will be additional
fixed costs of £15,000 each month.
169
10% of input material will be lost in further processing. This will have no value.
XP6 (Superior) is expected to sell for £34 per litre.
Remind the class that this example is a typical Third Level problem.
Should XP6 be further processed into XP6 (Superior)?
Ask the class to work out some figures for you, as this is really revision. They should
start with extra revenue figures as follows:
The present monthly revenue is 18,000 × £22
The monthly revenue for XP6 (Superior)
will be (18,000 × 90%) × £34
Extra revenue
£
396,000
550,800
154,800
Remind the class that we do not know the cost of producing XP6. We do not need to.
We have calculated the increase in revenue from XP6 to XP6 (Superior). All we now
need is the extra cost:
The extra cost is:
Variable 18,000 × £6.50
Fixed
£
117,000
15,000
132,000
It is worth producing XP6 (Superior) because marginal revenue of £154,800 exceeds
the marginal cost of £132,000 by £22,800.
Emphasise what was said in an earlier lesson:
The fixed costs of £15,000 are relevant to the decision, as they will only be incurred if XP6
(Superior) is made. So, in this case, the fixed costs are relevant and are part of marginal
costs.
Point out that these principles apply in any situation where ‘one more step’ is being
considered, such as working overtime, putting on an additional shift, increasing
advertising, etc.
Another example is:
ABC Limited sells 12,000 units each month for £14 per unit. At present, the
company spends £10,000 per month on advertising.
The variable cost per unit is £6 per unit.
It is considered that if the amount spent on advertising were to be increased to
£13,000 per month, 13,500 units could be sold per month, although the average
selling price would fall to £13.80.
170
What would the class recommend?
Present
Monthly sales 12,000 × £14
Variable costs per month 12,000 × £6
Monthly contribution
£
168,000
72,000
96,000
Proposed
Monthly sales 13,500 × £13.80
£
186,300
81,000
105,300
Extra contribution £105,300 – £96,000
Additional advertising £13,000 – £10,000
Additional profit
9,300
3,000
6,300
The proposal is worth doing.
▲ Next, turn to the setting of selling prices for goods and services.
Begin with a single-product firm, whose budget for Year 6 is:
Product SR5
Units of production and sale
Manufacturing hours
Variable conversion costs
Fixed conversion costs
Total cost
Total cost per unit
8,000
12,000
£
10,000
9,000
13,000
32,000
£4.00
If the firm wants to breakeven it will set its selling price at £4 per unit.
If the firm wants to make £4,000 profit, it will set its selling price at £4.50 per unit.
If competitors are selling at £3.70 per unit, it may be decided that this lower price
should be matched, to avoid the loss of business. This will result in a loss of £0.30 per
unit, and an overall loss of £2,400.
Discuss these possibilities with the class. Emphasise, particularly, that a firm which
makes one product only must sell at a price which, in the long term, covers its average
costs. In this case the average costs are £4.00 per unit.
Ask the class how this figure of £4.00 per unit could be reduced. For example, if it
could be reduced to £3.50, then even a selling price of £3.70, to match competitors,
would make a profit.
171
The class should suggest:
Lower material prices from suppliers
Better use of material in production – reduce wastage etc
Lower wage rates
Improve productivity – labour could earn more but still reduce the unit
labour cost
Control and reduce spending on overheads
Hopefully, the class will also mention increased volume of output, so that the fixed
conversion cost per unit falls from its present level of £1.625 per unit.
Point out, also, that once the fixed costs are committed, each additional unit made and
sold has a marginal cost of £19,000/8,000 = £2.375.
Ask the class if the firm would ever sell some or all of its output at £2.600 per unit.
The answer is:
Yes – a price of £2.600 gives a contribution of £0.225 per unit. This is better than no
contribution at all.
The answer is:
Probably no, but possibly yes. A price of £2.100 is below the marginal cost and, therefore,
offers a negative contribution of £0.275. This would not seem sensible. However, a
firm might do this if the £0.275 could be more than made up on the sale of other
products to the same customer. A supermarket might adopt such a ‘loss-leader’ pricing
strategy on a few products but, obviously, not on many!
Now tell the class that the firm becomes a 2-product firm in Year 7, by adding SR6.
The budget is:
SR5
8,000
12,000
£
10,000
9,000
Fixed conversion costs have increased to £16,250.
Manufacturing hours
SR6
2,000
1,000
£
2,000
1,000
Traditional absorption costing would lead us to:
Material cost per unit
Variable conversion cost
per unit
Variable cost per unit
172
£
1.250
£
1.000
1.125
2.375
0.500
1.500
Total
10,000
13,000
£
12,000
10,000
From earlier studies, the class should know that time-based absorption rates are
preferred if absorption costing is to be practised at all.
Fixed conversion cost is £16,250/13,000 manufacturing hours = £1.25 per hour.
This makes the product costs per unit:
£
1.250
1.125
2.375
1.875
4.250
Material cost
Variable cost
Fixed cost (£1.25 per hour)
Total cost
£
1.000
0.500
1.500
0.625
2.125
Point out to the class that the fixed conversion costs have been absorbed into the
product costs on a basis of 1.50 manufacturing hours for SR5 and 0.50 hours for SR6.
It is worth noting that, on this basis, Product SR5 bears 8,000 × £1.875 = £15,000 of
the fixed conversion costs. It could be argued that this is unreasonable since, presumably,
the increase in fixed conversion costs from £13,000 to £16,250 was due to the
introduction of SR6.
Suppose the firm wants to make £5,750 profit in Year 7.
Remind the class that the budgeted total costs are:
£
12,000
10,000
16,250
38,250
5,750
44,000
Fixed conversion cost
Total cost
Profit required
Sales revenue required
The total profit of £5,750 as a % of total cost of £38,250 is 15.033%. Many businesses
make a first attempt at pricing by adding this target %, known as mark-up, to the total
absorption cost for each product, as follows:
Total cost per unit
Add mark up 15.033%
Target selling price
SR5
£
4.250
.639
4.889
SR6
£
2.125
.319
2.444
As discussed on page 414 of the textbook, this is only a starter because – in the real
commercial world – final selling prices are largely decided by competition and other
factors. Cost is only one of the factors to be considered.
Another approach is to say that the required contribution is £5,750 + £16,250 = £22,000.
As the planned hours are 13,000, this gives a required contribution per hour of £22,000/
13,000 = £1.692.
173
This would give required selling prices of:
per unit
Contribution at £1.692 per hr
Selling price
Contribution
Hours to make
Contribution per hour
SR5
SR6
£
1.250
£
1.000
1.125
2.375
2.538
4.913
0.500
1.500
0.846
2.346
2.538
1.50
1.692
0.846
0.50
1.692
Another approach would be to say that the required added value is £44,000 less material
of £12,000 = £32,000. This gives an added value per hour of £32,000/13,000 = £2.462
per hour. This would give required selling prices of:
Direct materials
Added value @ £2.462 hr
SR5
£
1.250
3.693
4.943
SR6
£
1.000
1.231
2.231
Help the class to compare and understand these results.
Reminders
Further processing decisions are made by comparing marginal cost with marginal
revenue. Remember that marginal costs can include fixed costs.
Selling prices are set with many factors being considered. These include total
absorption cost, target mark-up, marginal cost, target contribution, target value
added, limited resources, product mix and – perhaps most important of all –
competition from other suppliers in the market.
174
LESSON 39
Main subject
Syllabus reference
Third Level
3
Marginal costing
Lesson topic
Applications of the marginal costing technique: closure decisions and maximising
the return from scarce resources
3.18 Use marginal costing to maximise the return from a resource that in the
short term is limited in supply
3.19 Use marginal costing to evaluate proposals e.g. to expand output or
contract output, to change the product mix, to mount an advertising
campaign, to close a department, to remove a product from the range etc
Required for
Aims of the lesson
• To show that the marginal costing technique can be used to evaluate any
proposed change.
• To show that it can also be used to show the decision that will maximise
profits when resources are limited.
The lesson
▲ Begin by reminding the class that a decision results in change. For example:
It could be decided to close one of a company’s retail outlets. What change will this
cause. Costs will be saved – rent, rates, insurances, telephones, heating and lighting,
and wages and salaries. Remember that wages and salaries will be saved unless the
employees are retained and transferred to other branches.
However, sales will also be lost, although it is possible that customers may go instead
to another of the company’s retail outlets.
The decision to close will be because it is believed that the costs savings will exceed
the gross margin on the lost sales revenue.
175
The management of Company X are considering the closure of Branch 10.
Annual sales of this branch are £860,000. An average gross margin of 60% is
earned.
£345,000 is paid for staff wages and salaries. In addition, sales staff are paid a
commission of 2% of sales turnover.
Staff with salaries totalling £75,000 would be absorbed in other branches. The
remaining staff would be made redundant. This would involve one-off
redundancy costs of £36,700.
An amount of £80,000 is apportioned to Branch 10 from Head Office costs,
which would be unaffected in total by the closure of Branch 10.
Other expenses amount to £55,000, and these would be saved by the closure of
Branch 10.
It is estimated that sales of £340,000 normally made at Branch 10 would be
picked up at other branches. The rest of the sales would be lost.
How should this closure proposal be evaluated?
First, look at the sales revenue and gross margin.
Lost sales from Branch 10
Sales picked up at other branches
Net lost sales
Gross margin 60%
£
860,000
340,000
520,000
312,000
Now look at the cost savings
Staff wages and salaries
Less wages and salaries not saved
Other expenses
Commission 2% on £520,000
Net saving from closure of Branch 10
One-off redundancy payment
Net loss from closure
£
345,000
75,000
270,000
55,000
10,400
335,400
23,400
36,700
13,300
Point out that this suggests Branch 10 should not be closed – however, it reflects a
point which is included in many questions of this type: the redundancy payment is
only paid once. In all future years the company will be £23,400 better off if Branch 10 is
closed.
Point out, also, that it has been assumed that the staff transferred to other branches are
additional staff. If they are being placed in jobs for which people would otherwise have to be
recruited, then the £75,000 should not be deducted.
176
▲ Alternatively, it could be decided to reduce the amount of advertising done by a company.
Would this result in the loss of sales to competitors? Could anything be done to retain
sales?
A company makes two products for which the unit product costs are:
Product
Direct material
Advertising
Selling price
Profit
Annual units of production and sale
A
B
£
27.50
22.00
36.00
37.50
123.00
125.00
2.00
800
£
29.00
42.00
58.00
60.00
189.00
200.00
11.00
500
The company plans to cut its total advertising bill by 80%. The marketing
manager thinks that if this decision is made, the selling price of A and B would
have to be reduced by 4% and 5% respectively.
Even then he believes that volume for both products will fall by 12%.
Ask the class for their recommendation.
They should approach it along these lines.
Advertising
Total advertising must be (800 × £37.50) + (500 × £60) = £60,000.
80% of this will be saved, which is £48,000.
Lost contribution
Present contribution
Product A 800 × (£125 – £49.50) =
Product B 500 × (£200 – £71) =
Expected contribution
Product A (800 × 88%)(£120 – £49.50)
Product B (500 × 88%)(£190 – £71)
Lost contribution
Saving in advertising cost
Net benefit
£
60,400
64,500
124,900
£
49,632
52,360
101,992
22,908
48,000
25,092
177
When you come to maximising the return from scarce resources (page 420), you should
point out that this topic was introduced to Second Level students in Chapter 11 and in
the corresponding lessons.
▲ Third Level questions do not introduce any new principles with regard to this topic.
However, differences of application arise.
Begin with the following budgeted data:
Product
Material
Variable conversion @ £6 per hour
Fixed conversion @ £8 per hour
Total cost
Selling price
Units
X
Y
£
40.00
36.00
48.00
124.00
130.00
500
£
25.00
54.00
72.00
151.00
155.00
1,000
Ask the class what the budgeted profit is.
The answer is (500 × £6) + (1,000 × £4) = £7,000.
Now tell the class that only £35,000 of material is available for the budget period. Ask
them to calculate the optimal profit or loss
The answer is calculated:
Product
Material needed
Material available
Shortage
Material used
Ranking
X
£
20,000
Y
£
25,000
54
40
1.35
2
76
25
3.04
1
Total
£
45,000
35,000
10,000
£10,000 of material would make £10,000/£40 = 250 units of X.
These units would earn 250 × £54 = £13,500 contribution.
Therefore, optimal profit or loss is £7,000 – £13,500 = £6,500 loss.
Now tell the class that material is freely available, but production hours are limited to
10,000 hours in the budget period. Ask them to calculate the optimal profit or loss.
178
Product
Production hours needed
Hours available
Shortage
Hours used
Ranking
X
3,000
Y
9,000
54
6
£9.00
1
76
9
£8.44
2
Total
12,000
10,000
2,000
2,000 hours would make 2,000/9 = 222 units of Y.
▲ Explain that the illustrations have been quite simple so far, but they do show the
principles that Second Level should be able to apply. Third Level questions on the
same topic areas are likely to contain more detail. As an example:
Tell the class that the variable rate per hour, £6 per hour, includes £4.80 for labour cost.
990 hours of overtime could be available but productivity will fall in overtime, and
10% more time will be needed for each unit. Overtime will be paid at time and a third.
Ask the class to calculate the optimal profit or loss.
Explain that since the production time is rising, and the hourly rate is rising, the
contribution per hour must fall. The original preference for X therefore remains.
What would be the contribution per hour for units made in overtime?
Product
Material
Variable conversion
@ £7.60 per hour
Variable cost
Selling price
Contribution
Hours
X
£
40.00
Y
£
25.00
50.16
90.16
130.00
39.84
6.6
£6.04
75.24
100.24
155.00
54.76
9.9
£5.53
Of course, X remains the best product. However, all units of X are being made in
normal time. 990 hours of overtime allows 990/9.9 = 100 units of Y to be produced.
The additional contribution will be 100 × £54.76 = £5,476.
The optimal contribution becomes a loss of £9,872 – £5,476 = a loss of £4,396.
Now take the class carefully through Example 7 on pages 421-423 of the textbook.
179
Reminders
Marginal costing is a useful technique when considering closures. It identifies
the costs and revenue changes that result from the closure.
In such decisions many costs normally considered to be fixed become relevant.
The ‘closure’ principle is applied to other similar situations – for example,
‘closing’ advertising expenditure.
Maximising scarce factors means looking at the contribution earned in relation
to the consumption of the scarce factor. At Third Level some adjustment of the
basic contribution per unit is likely to be necessary.
180
LESSON 37
Main subject
Syllabus reference
Third Level
3
Marginal costing
Lesson topic
Applications of the marginal costing technique: make/buy and route selection
3.18.a Choose between in-house manufacture and subcontracting (make or
buy), where in-house resources are without limit
3.18.b As 3.18.a, but where in-house resources are limited in supply
Multiple resource limitations requiring a graphical or linear programming
solution will not be set
3.20 Use marginal costing to choose between alternative internal methods of
manufacture
Required for
Aims of the lesson
• To show how marginal costing can be used to decide between in-house
manufacture and subcontracting
• To show how marginal costing can be used to select the most economical
route for manufacture
The lesson
▲ Begin by pointing out that many decisions are made with the aim of minimising cost.
For a constant level of sales, minimising costs is equal to maximising profit.
But – remind the class – ‘cost’ has different meanings. For example, it could be variable
cost or total cost.
One view might be that we should aim to minimise the extra cost arising from a
decision. Remind the class that the word ‘marginal’ could be used instead of ‘extra’.
Revise the motoring example again. This was first used as an illustration of a principle in Chapter
11 of the textbook:
163
A motorist may normally travel 16,000 kilometres each year.
His petrol bill for the year might be £800.
His cost per kilometre for petrol (a variable motoring cost) is £0.05.
Explain that he has fixed motoring costs for depreciation and insurances. These are
£3,600 and £400 respectively for a year. Therefore,
His cost per kilometre for fixed motoring costs is £0.25.
The total cost of his motoring is £0.30 per kilometre.
Tell the class that he has to make a journey of 160 kilometres to his destination, and
then make the return journey of 160 kilometres. He can make the journey by rail for
£82. What should he do?
By car the ‘cost’ is 320 kilometres × £0.30 = £96. By rail the cost would be £82. This
seems to say, ‘Use the train.’.
Can the class remember the argument?
The ‘marginal or variable cost’ of using the car is 320 kilometres × £0.05 = £16.
It isn’t worth spending £82 to save £16. Remember the fixed costs will not be saved.
The car is still depreciating, and is still insured, even whilst he is sitting on the train!
What you should now emphasise is that this is a ‘make or buy’ decision:
Shall I use my own available facilities, or shall I purchase in the service of another
business, the railway company?
▲ Continue using the following data per unit:
Product
A
£
Material
10
Other variable costs 12
Fixed cost
19
Total cost
41
Selling price
50
Profit
9
Annual production
and
sales (units)
1,200
B
£
8
28
26
62
70
8
C
£
4
15
14
33
40
7
D
£
7
17
17
41
45
4
1,200
100
50
Ask the class:
Should we be making and selling these products?
The answer is:
Yes – because each makes a profit on an absorption basis, and each therefore makes a
contribution.
More able members of the class may ask whether any problem exists with resources.
Point out that if there is, these products may displace others that cannot then be made.
164
In which case, should we let another firm make these products for us?
This depends on whether another firm could make them, and what they would
charge etc.
Suppose a firm could, and quotes per unit:
A
£
40
B
£
63
C
£
18
D
£
26
Can the class now apply the principles of the motor car illustration to this example?
Product A
Product B
Product C
It is worth paying £18 to save £19. Subcontracting Product C will minimise cost and
will maximise profit.
Ask the class about the dangers of subcontracting. For example, your customer and
your supplier could make contact and cut you out. Also important will be the
subcontractor’s ability to meet delivery dates, product quality and whether the price
will hold for a reasonable period of time.
Product D
Suggest now that a special gauge has to be purchased, at a cost of £250, to check each
completed Product D. The gauge loses accuracy after being used to test 50 products,
and a new gauge has then to be purchased. The gauge cost is included in fixed costs. If
an outside firm makes the product, it will have to purchase its own gauges. Does this
change the decision?
165
Yes – this is a directly attributable fixed cost. It would have to be purchased, even if the
customer only ordered 10 products. It would be usable for orders totalling 50 products
but, after that, additional orders could not be guaranteed. The cost only relates to
Product D.
The fixed costs will include £250/50 = £5 per unit. This will be saved if Product D is
subcontracted.
It is worth paying £26 to save £24 + £5.
Draw the conclusion that, on cost considerations alone, internal manufacture of Products
A and B should be continued, but Products C and D should be subcontracted.
▲ Now tell the class that even if this is done, a problem remains with a particular machine
used to make all four products. Other machines are used as well, but they do not have
the capacity problem of this particular machine. This machine has an annual capacity
of 1,500 hours and this cannot be increased.
The hours used on this machine are:
Product
Hours
A
0.5
B
1.0
C
1.0
D
2.0
C
100
D
100
Therefore, the annual hours needed are:
Product
Hours
A
600
B
1,200
Total
2,000
2,000 hours are needed but only 1,500 hours are available.
Remind the class that the problem has been partly solved by the decision to subcontract
the manufacture of Products C and D. This reduces the need to 1,800 hours.
Explain that, therefore, the manufacture of some of Product A, or of Product B, or
some of each, will have to be subcontracted. How do we decide which?
Draw the attention of the class to the ‘boxed’ rule on page 407 of the textbook.
So, if extra cost is to be incurred through subcontracting, it should be as little as possible
for each hour of limited capacity released.
Show the class the calculation:
Product
Variable cost
Subcontract price
Excess cost
Limited capacity hours
Excess cost per hour
A
£
22
40
18
B
£
36
63
27
0.5
£36
1.0
£27
Take care in explaining the meaning of these figures and how they are interpreted.
166
Although Product B has the highest excess cost (£27 compared to £18), it has the lowest
excess cost per machine hour. This is the decision criteria. It is Product B that should be
subcontracted.
300 units of Product B should be subcontracted, so saving the 300 hours.
▲ Now take the class through Examples 1 and 2 on pages 404-409 of the textbook. These
are important questions, and each step in the solutions should be carefully explained.
▲ Next, remind the class that the same principle of minimising additional cost can be
applied to any course of action for which alternatives exist.
For example,
If we have to deliver goods to a customer, should our delivery vehicle use Route A or
Route B?
If a product can be made on either Machine A or Machine B, how do we decide
which?
An operation on a product can be done on either of 2 machines, TR5 or SK4. The
operation would take 6 hours on TR5, or 4.5 hours on SK4. Conversion cost rates per
hour for each machine are:
Variable
Fixed
TR5
£
3.70
4.65
8.35
SK4
£
4.30
7.20
11.50
At the end of the operation, the product is inspected.
20% of those made on TR5 have to go back onto TR5 for 1 hour each, to be rectified.
10% of those made on SK4 have to go back onto SK4 for 2 hours each, to be rectified.
Both machines have adequate available time.
First, work out the hours to allow for rectification work. The class may find it easier to
work on 10 products.
TR5
10 products take 10 × 6 =
SK4
10 products take 10 × 4.5 =
60 hours
2 hours
62 hours
45 hours
2 hours
47 hours
167
Total costs
TR5 62 hours × £8.35
SK4 47 hours × £11.50
£
517.70
540.50
This suggests that Machine TR5 should be used. This would be an incorrect conclusion
since fixed costs will be incurred anyway.
On the assumption that both machines are being kept and both are available, only the
variable costs should be looked at:
TR5 62 hours × £3.70
SK4 47 hours × £4.30
£
229.40
202.10
Machine SK4 should be used.
▲ Take the class carefully through Example 3 on pages 410-412 of the textbook.
Reminders
The application of the marginal costing technique allows decisions to be made
on the basis of lowest additional cost.
If a subcontractor can carry out an operation or make a product at less than the
internal variable cost, then allowing the subcontractor to do the work will
minimise cost and maximise profit.
If subcontractors have to be used because of internal capacity problems, then a
decision should be made which minimises the additional cost in relation to the
release of the scarce internal resource.
168
LESSON 38
Main subject
Syllabus reference
Third Level
3
Marginal costing
Lesson topic
Applications of the marginal costing technique: further processing and product
and service pricing
3.16 Calculate value added
3.17 Use marginal costing to assist product and service pricing
3.17.a Calculate a selling price to recover long run average costs
3.17.b Calculate a selling price to recover short run marginal costs
3.17.c Explain why a selling price might be set at a level below marginal cost
3.17.d Explain why a selling price might be set to match that of a competitor
3.17.e Calculate a selling price to achieve a target rate of contribution or value
added
Required for
Aims of the lesson
• To show how marginal costing can be used to assess the value of further
processing
• To show how marginal costing can be used, with other measures, to assist in
setting prices for goods or services
The lesson
▲ Begin by pointing out to the class that the term ‘further processing’ is usually associated
with process costing. For example:
Andor Limited produces 18,000 litres of Product XP6 each month.
XP6 is sold for £22 per litre.
It is proposed to further process XP6 to make XP6 (Superior).
Further processing will cost £6.50 per litre of input, and there will be additional
fixed costs of £15,000 each month.
169
10% of input material will be lost in further processing. This will have no value.
XP6 (Superior) is expected to sell for £34 per litre.
Remind the class that this example is a typical Third Level problem.
Should XP6 be further processed into XP6 (Superior)?
Ask the class to work out some figures for you, as this is really revision. They should
start with extra revenue figures as follows:
The present monthly revenue is 18,000 × £22
The monthly revenue for XP6 (Superior)
will be (18,000 × 90%) × £34
Extra revenue
£
396,000
550,800
154,800
Remind the class that we do not know the cost of producing XP6. We do not need to.
We have calculated the increase in revenue from XP6 to XP6 (Superior). All we now
need is the extra cost:
The extra cost is:
Variable 18,000 × £6.50
Fixed
£
117,000
15,000
132,000
It is worth producing XP6 (Superior) because marginal revenue of £154,800 exceeds
the marginal cost of £132,000 by £22,800.
Emphasise what was said in an earlier lesson:
The fixed costs of £15,000 are relevant to the decision, as they will only be incurred if XP6
(Superior) is made. So, in this case, the fixed costs are relevant and are part of marginal
costs.
Point out that these principles apply in any situation where ‘one more step’ is being
considered, such as working overtime, putting on an additional shift, increasing
advertising, etc.
Another example is:
ABC Limited sells 12,000 units each month for £14 per unit. At present, the
company spends £10,000 per month on advertising.
The variable cost per unit is £6 per unit.
It is considered that if the amount spent on advertising were to be increased to
£13,000 per month, 13,500 units could be sold per month, although the average
selling price would fall to £13.80.
170
What would the class recommend?
Present
Monthly sales 12,000 × £14
£
168,000
72,000
96,000
Proposed
Monthly sales 13,500 × £13.80
£
186,300
81,000
105,300
Extra contribution £105,300 – £96,000
Additional advertising £13,000 – £10,000
Additional profit
9,300
3,000
6,300
The proposal is worth doing.
▲ Next, turn to the setting of selling prices for goods and services.
Begin with a single-product firm, whose budget for Year 6 is:
Product SR5
Manufacturing hours
Fixed conversion costs
Total cost
Total cost per unit
8,000
12,000
£
10,000
9,000
13,000
32,000
£4.00
If the firm wants to breakeven it will set its selling price at £4 per unit.
If the firm wants to make £4,000 profit, it will set its selling price at £4.50 per unit.
If competitors are selling at £3.70 per unit, it may be decided that this lower price
should be matched, to avoid the loss of business. This will result in a loss of £0.30 per
unit, and an overall loss of £2,400.
Discuss these possibilities with the class. Emphasise, particularly, that a firm which
makes one product only must sell at a price which, in the long term, covers its average
costs. In this case the average costs are £4.00 per unit.
Ask the class how this figure of £4.00 per unit could be reduced. For example, if it
could be reduced to £3.50, then even a selling price of £3.70, to match competitors,
would make a profit.
171
The class should suggest:
Lower material prices from suppliers
Better use of material in production – reduce wastage etc
Lower wage rates
Improve productivity – labour could earn more but still reduce the unit
labour cost
Control and reduce spending on overheads
Hopefully, the class will also mention increased volume of output, so that the fixed
conversion cost per unit falls from its present level of £1.625 per unit.
Point out, also, that once the fixed costs are committed, each additional unit made and
sold has a marginal cost of £19,000/8,000 = £2.375.
The answer is:
Yes – a price of £2.600 gives a contribution of £0.225 per unit. This is better than no
contribution at all.
The answer is:
Probably no, but possibly yes. A price of £2.100 is below the marginal cost and, therefore,
offers a negative contribution of £0.275. This would not seem sensible. However, a
firm might do this if the £0.275 could be more than made up on the sale of other
products to the same customer. A supermarket might adopt such a ‘loss-leader’ pricing
strategy on a few products but, obviously, not on many!
Now tell the class that the firm becomes a 2-product firm in Year 7, by adding SR6.
The budget is:
SR5
8,000
12,000
£
10,000
9,000
Fixed conversion costs have increased to £16,250.
Manufacturing hours
SR6
2,000
1,000
£
2,000
1,000
Traditional absorption costing would lead us to:
per unit
172
£
1.250
£
1.000
1.125
2.375
0.500
1.500
Total
10,000
13,000
£
12,000
10,000
From earlier studies, the class should know that time-based absorption rates are
preferred if absorption costing is to be practised at all.
Fixed conversion cost is £16,250/13,000 manufacturing hours = £1.25 per hour.
This makes the product costs per unit:
£
1.250
1.125
2.375
1.875
4.250
Material cost
Variable cost
Fixed cost (£1.25 per hour)
Total cost
£
1.000
0.500
1.500
0.625
2.125
Point out to the class that the fixed conversion costs have been absorbed into the
product costs on a basis of 1.50 manufacturing hours for SR5 and 0.50 hours for SR6.
It is worth noting that, on this basis, Product SR5 bears 8,000 × £1.875 = £15,000 of
the fixed conversion costs. It could be argued that this is unreasonable since, presumably,
the increase in fixed conversion costs from £13,000 to £16,250 was due to the
introduction of SR6.
Suppose the firm wants to make £5,750 profit in Year 7.
Remind the class that the budgeted total costs are:
£
12,000
10,000
16,250
38,250
5,750
44,000
Total cost
Profit required
Sales revenue required
The total profit of £5,750 as a % of total cost of £38,250 is 15.033%. Many businesses
make a first attempt at pricing by adding this target %, known as mark-up, to the total
absorption cost for each product, as follows:
Total cost per unit
Add mark up 15.033%
SR5
£
4.250
.639
4.889
SR6
£
2.125
.319
2.444
As discussed on page 414 of the textbook, this is only a starter because – in the real
commercial world – final selling prices are largely decided by competition and other
factors. Cost is only one of the factors to be considered.
Another approach is to say that the required contribution is £5,750 + £16,250 = £22,000.
As the planned hours are 13,000, this gives a required contribution per hour of £22,000/
13,000 = £1.692.
173
This would give required selling prices of:
per unit
Contribution at £1.692 per hr
Selling price
Contribution
Hours to make
SR5
SR6
£
1.250
£
1.000
1.125
2.375
2.538
4.913
0.500
1.500
0.846
2.346
2.538
1.50
1.692
0.846
0.50
1.692
Another approach would be to say that the required added value is £44,000 less material
of £12,000 = £32,000. This gives an added value per hour of £32,000/13,000 = £2.462
per hour. This would give required selling prices of:
Direct materials
Added value @ £2.462 hr
SR5
£
1.250
3.693
4.943
SR6
£
1.000
1.231
2.231
Help the class to compare and understand these results.
Reminders
Further processing decisions are made by comparing marginal cost with marginal
revenue. Remember that marginal costs can include fixed costs.
Selling prices are set with many factors being considered. These include total
absorption cost, target mark-up, marginal cost, target contribution, target value
added, limited resources, product mix and – perhaps most important of all –
competition from other suppliers in the market.
174
LESSON 39
Main subject
Syllabus reference
Third Level
3
Marginal costing
Lesson topic
Applications of the marginal costing technique: closure decisions and maximising
the return from scarce resources
3.18 Use marginal costing to maximise the return from a resource that in the
short term is limited in supply
3.19 Use marginal costing to evaluate proposals e.g. to expand output or
contract output, to change the product mix, to mount an advertising
campaign, to close a department, to remove a product from the range etc
Required for
Aims of the lesson
• To show that the marginal costing technique can be used to evaluate any
proposed change.
• To show that it can also be used to show the decision that will maximise
profits when resources are limited.
The lesson
▲ Begin by reminding the class that a decision results in change. For example:
It could be decided to close one of a company’s retail outlets. What change will this
cause. Costs will be saved – rent, rates, insurances, telephones, heating and lighting,
and wages and salaries. Remember that wages and salaries will be saved unless the
employees are retained and transferred to other branches.
However, sales will also be lost, although it is possible that customers may go instead
to another of the company’s retail outlets.
The decision to close will be because it is believed that the costs savings will exceed
the gross margin on the lost sales revenue.
175
The management of Company X are considering the closure of Branch 10.
Annual sales of this branch are £860,000. An average gross margin of 60% is
earned.
£345,000 is paid for staff wages and salaries. In addition, sales staff are paid a
commission of 2% of sales turnover.
Staff with salaries totalling £75,000 would be absorbed in other branches. The
remaining staff would be made redundant. This would involve one-off
redundancy costs of £36,700.
An amount of £80,000 is apportioned to Branch 10 from Head Office costs,
which would be unaffected in total by the closure of Branch 10.
Other expenses amount to £55,000, and these would be saved by the closure of
Branch 10.
It is estimated that sales of £340,000 normally made at Branch 10 would be
picked up at other branches. The rest of the sales would be lost.
How should this closure proposal be evaluated?
First, look at the sales revenue and gross margin.
Lost sales from Branch 10
Sales picked up at other branches
Net lost sales
Gross margin 60%
£
860,000
340,000
520,000
312,000
Now look at the cost savings
Staff wages and salaries
Less wages and salaries not saved
Other expenses
Commission 2% on £520,000
Net saving from closure of Branch 10
One-off redundancy payment
Net loss from closure
£
345,000
75,000
270,000
55,000
10,400
335,400
23,400
36,700
13,300
Point out that this suggests Branch 10 should not be closed – however, it reflects a
point which is included in many questions of this type: the redundancy payment is
only paid once. In all future years the company will be £23,400 better off if Branch 10 is
closed.
Point out, also, that it has been assumed that the staff transferred to other branches are
additional staff. If they are being placed in jobs for which people would otherwise have to be
recruited, then the £75,000 should not be deducted.
176
▲ Alternatively, it could be decided to reduce the amount of advertising done by a company.
Would this result in the loss of sales to competitors? Could anything be done to retain
sales?
A company makes two products for which the unit product costs are:
Product
Direct material
Advertising
Selling price
Profit
Annual units of production and sale
A
B
£
27.50
22.00
36.00
37.50
123.00
125.00
2.00
800
£
29.00
42.00
58.00
60.00
189.00
200.00
11.00
500
The company plans to cut its total advertising bill by 80%. The marketing
manager thinks that if this decision is made, the selling price of A and B would
have to be reduced by 4% and 5% respectively.
Even then he believes that volume for both products will fall by 12%.
Ask the class for their recommendation.
They should approach it along these lines.
Advertising
Total advertising must be (800 × £37.50) + (500 × £60) = £60,000.
80% of this will be saved, which is £48,000.
Lost contribution
Present contribution
Product A 800 × (£125 – £49.50) =
Product B 500 × (£200 – £71) =
Expected contribution
Product A (800 × 88%)(£120 – £49.50)
Product B (500 × 88%)(£190 – £71)
Lost contribution
Saving in advertising cost
Net benefit
£
60,400
64,500
124,900
£
49,632
52,360
101,992
22,908
48,000
25,092
177
When you come to maximising the return from scarce resources (page 420), you should
point out that this topic was introduced to Second Level students in Chapter 11 and in
the corresponding lessons.
▲ Third Level questions do not introduce any new principles with regard to this topic.
However, differences of application arise.
Begin with the following budgeted data:
Product
Material
Variable conversion @ £6 per hour
Fixed conversion @ £8 per hour
Total cost
Selling price
Units
X
Y
£
40.00
36.00
48.00
124.00
130.00
500
£
25.00
54.00
72.00
151.00
155.00
1,000
Ask the class what the budgeted profit is.
The answer is (500 × £6) + (1,000 × £4) = £7,000.
Now tell the class that only £35,000 of material is available for the budget period. Ask
them to calculate the optimal profit or loss
Product
Material needed
Material available
Shortage
Material used
Ranking
X
£
20,000
Y
£
25,000
54
40
1.35
2
76
25
3.04
1
Total
£
45,000
35,000
10,000
£10,000 of material would make £10,000/£40 = 250 units of X.
Now tell the class that material is freely available, but production hours are limited to
10,000 hours in the budget period. Ask them to calculate the optimal profit or loss.
178
Product
Production hours needed
Hours available
Shortage
Hours used
Ranking
X
3,000
Y
9,000
54
6
£9.00
1
76
9
£8.44
2
Total
12,000
10,000
2,000
2,000 hours would make 2,000/9 = 222 units of Y.
▲ Explain that the illustrations have been quite simple so far, but they do show the
principles that Second Level should be able to apply. Third Level questions on the
same topic areas are likely to contain more detail. As an example:
Tell the class that the variable rate per hour, £6 per hour, includes £4.80 for labour cost.
990 hours of overtime could be available but productivity will fall in overtime, and
10% more time will be needed for each unit. Overtime will be paid at time and a third.
Ask the class to calculate the optimal profit or loss.
Explain that since the production time is rising, and the hourly rate is rising, the
contribution per hour must fall. The original preference for X therefore remains.
What would be the contribution per hour for units made in overtime?
Product
Material
Variable conversion
@ £7.60 per hour
Variable cost
Selling price
Contribution
Hours
X
£
40.00
Y
£
25.00
50.16
90.16
130.00
39.84
6.6
£6.04
75.24
100.24
155.00
54.76
9.9
£5.53
Of course, X remains the best product. However, all units of X are being made in
normal time. 990 hours of overtime allows 990/9.9 = 100 units of Y to be produced.
The additional contribution will be 100 × £54.76 = £5,476.
The optimal contribution becomes a loss of £9,872 – £5,476 = a loss of £4,396.
179
Reminders
Marginal costing is a useful technique when considering closures. It identifies
the costs and revenue changes that result from the closure.
In such decisions many costs normally considered to be fixed become relevant.
The ‘closure’ principle is applied to other similar situations – for example,
‘closing’ advertising expenditure.
Maximising scarce factors means looking at the contribution earned in relation
to the consumption of the scarce factor. At Third Level some adjustment of the
basic contribution per unit is likely to be necessary.
180
LESSON 40
Main subject
Syllabus reference
Third Level
3
Marginal costing
Breakeven charts involving traditional, contribution and profit volume (P/V)
presentations
Lesson topic
Traditional breakeven charts
3.22 Breakeven charts
(a) Apply principles of good chart construction
(b) Construct a traditional breakeven chart
(c) Construct a contribution breakeven chart (Lesson 41)
(d) Explain and identify relevant range
(e) Understand cost and revenue behaviour within the relevant range.
Required for
Aim of the lesson
• To explain the preparation of traditional breakeven charts.
The lesson
▲ Begin by drawing attention to the CIMA definition of a breakeven chart given on page
430 of the textbook.
Emphasise the word ‘approximate.’ It indicates that readings from a graph can never
have the accuracy of calculations.
Point out as well the reference to ‘a limited range.’ Tell the class that this means that –
when the graph is completed – only a small part of it may really hold good for the
distinctions drawn between variable and fixed costs.
Reinforce the comment made at the top of page 431 of the textbook. In the examination,
readings from the graph are often called for. When they are, calculations are not an acceptable
substitute.
181
▲ Before plotting a single graph or chart, please take the class through points 1-6 on
pages 431-432.
Emphasise that many errors on breakeven charts come from failing to observe the
principles of good chart construction.
Please ensure that the class is able to practise the preparation of breakeven charts on
proper graph paper.
Use the following data to demonstrate a breakeven chart in traditional format:
Company X makes one product, which it sells for £40 per unit.
The variable cost per unit is £30, and fixed costs in total are £30,000.
The maximum output is 5,000 units.
Tell the class that the very first step is to plan the use and range of scales appropriate to the
particular format required – in this case, the traditional one.
Use the x-axis (horizontal scale) to represent units of output. Use the y-axis (vertical
scale) to represent £.
Choose the maximum values on each scale.
The maximum output is 5,000 units. Therefore, scale the x-axis from 0 units (emphasise
this!) to 5,000 units, making best use of the full width of the graph paper.
The y-axis must therefore allow for the sales revenue from 5,000 units. This will be
5,000 × £40 = £200,000. Therefore, scale the y-axis from 0 (emphasise this!) to
£200,000, making use of the full height of the graph paper.
Explain to the class that the above procedure should be done for any graph or chart
before any plotting commences.
For a traditional chart, explain that the fixed costs are plotted first.
Find the £30,000 point on the vertical axis, and extend the fixed cost line parallel to the
base line. This shows that however many units are made and sold, the fixed costs will
still be £30,000.
Next, plot the variable costs over the fixed costs. Point out that it is the total cost line that is
therefore being plotted. If 0 units are made and sold, the cost will just be the £30,000
fixed costs.
Take any other output point. This could be 5,000 units. For 5,000 units the variable
cost will be 5,000 × £30 = £150,000. Add this to the fixed costs of £30,000, and the
total cost will be £180,000.
Draw the total cost line by connecting the points (x-axis 0, y-axis £30,000) and (x-axis
5,000, y-axis £180,000).
Finally draw in the sales revenue line. This will connect the points (x-axis 0, y-axis 0) and
(x-axis 5,000, y-axis £200,000) This is because if no units are sold there is no revenue
and if 5,000 units are sold the revenue is 5,000 × £40 = £200,000.
Refer to the CIMA definition of a breakeven point on page 433 of the textbook. Ask
the class to read the breakeven point from their graph. It will be in units in this case,
because the x-axis is scaled in units. An approximate reading will do. Its accuracy will
depend upon having made no errors in drawing the chart, and upon how neatly the
chart has been drawn. The reading can be checked. Breakeven is F/Cunit, which in this
case is £30,000/(£40 – £30) = 3,000 units.
182
Tell the class that if the example had said that the company normally makes and sells
between 2,500 and 4,000 units, then that would be the relevant range, that is, what
happens to the cost and revenue lines outside that range is less important.
Explain the meaning of margin of safety. If the company was planning to make and sell
3,800 units this year, the margin of safety would be 800 units ( 3,800 units minus 3,000
units).
▲ Now ask the class to do a second traditional breakeven chart, using the following:
Sales
Variable costs
48,000
Fixed costs
60,000
Profit
The firm makes one product.
£
120,000
108,000
12,000
Point out to the class that units are not mentioned. This means that the x-axis of the
chart cannot be in units, even though the firm only makes one product. Sales value has
to be used as a measure of output.
Explain that both the x-axis and the y-axis will be in £. Suggest that the class takes both
scales to £120,000.
When drawing the fixed costs line, draw it from £60,000 on the y-axis parallel to the xaxis.
Then get the class to draw the total cost line. This needs care. If there is no output, the
total cost will be the fixed costs of £60,000. When the output has a sales value of
£120,000, the total cost is £108,000. The line is drawn from (x-axis 0, y-axis £60,000)
through (x-axis £120,000, y-axis £108,000).
The sales revenue line is drawn from (x-axis 0, y-axis 0) to (x-axis £120,000, y-axis
£120,000).
Now ask the class to read the breakeven point from the graph. This time the reading
from the x-axis will be in £, and will be a sales figure.
Again, the reading can be checked by calculation. Breakeven sales = F/CS ratio.
The CS ratio is (£120,000 – £48,000)/£120,000 = 60%.
Breakeven sales = £60,000/60% = £100,000.
▲ The class must practise a number of graphs. They must be able to decide quickly what
scales are appropriate. They must then be able to accurately construct the chart, and
read information from it. They must also be able to interpret a given chart.
183
Reminders
Care is needed in the choice of a scale for each axis of the chart, and in its
construction.
A breakeven chart can have an x-axis labelled in units, or in the sales value of
output. There are other possible measures of output such as direct labour or
machine hours.
A traditional breakeven chart plots fixed costs first, and then overlays the variable
costs to get the total cost line.
184
LESSON 41
Main subject
Syllabus reference
Third Level
3
Marginal costing
presentations
Lesson topic
Contribution breakeven charts
(a) Apply principles of good chart construction
(b) Construct a traditional breakeven chart (Lesson 40)
(c) Construct a contribution breakeven chart
(d) Explain and identify relevant range (Lesson 40)
(e) Understand cost and revenue behaviour within the relevant range.
(Lesson 40)
(f) Explain the economist’s breakeven chart
Required for
Aims of the lesson
• To explain the preparation of contribution breakeven charts.
• To explain the economist’s breakeven chart
The lesson
▲ Begin by telling the class that the contribution breakeven chart is another way of
presenting the same information. However, the term ‘contribution breakeven chart’
has a particular meaning, and if a traditional chart is done when a contribution chart is
asked for, all marks may be lost!
Emphasise that a contribution breakeven chart has the same x and y axes as a traditional
chart, but draws the variable cost line first instead of the fixed cost line.
Use the same data as for Company X in Lesson 40.
The x-axis and y-axis must be scaled and labelled in exactly the same way.
185
Then tell the class that the variable cost line will be drawn first. If no units are made and
sold, then the variable costs will be zero.
Then choose any other output level. If 5,000 units are made and sold the variable costs
will be 5,000 × £30 = £150,000.
The plotting points for the variable cost line are therefore (x-axis 0, y-axis 0) and (xaxis 5,000, y-axis £150,000).
Next draw the sales revenue line. If no units are sold, the sales revenue is zero. If 5,000
units are sold the sales revenue is £200,000.
The plotting points are therefore (x-axis 0, y-axis 0) and (x-axis 5,000, y-axis £200,000).
Joining these points will give the sales revenue line.
Now tell the class why this unfinished chart is called a contribution breakeven chart.
It doesn’t yet show a breakeven point, but it does show the wedge of contribution as
the area between the sales revenue line and the variable cost line.
Finally, put on the fixed costs to show the total cost line. This time the fixed costs are
being added to the variable costs. When output was zero, no variable costs were incurred.
However, fixed costs are £30,000, so at zero output the total costs are £30,000.
When 5,000 units are made and sold, the variable costs are £150,000. If the fixed costs
are added the total cost is £180,000.
This gives the plotting points for the total costs line, (x-axis 0, y-axis £30,000) and (xaxis 5,000, y-axis £180,000).
If the class now marks the breakeven point, it must be in exactly the same position as
on the traditional breakeven chart produced in Lesson 40. However, this time emphasise
how the breakeven point is reached when the contribution wedge increases until the
contribution = fixed costs.
▲ Now take the class through Example 2 on page 434 of the textbook.
▲ Ask the class to take the second example in Lesson 40, and prepare an answer as a
contribution breakeven chart.
▲ Now use the following data to prepare a contribution breakeven chart:
Product
Sales
Variable costs
Contribution
Fixed costs
Profit
X
Y
Total
£
120,000
48,000
72,000
£
180,000
90,000
90,000
£
300,000
138,000
162,000
108,000
54,000
Fixed costs are general. That is, no fixed costs are incurred because of any one product.
Advise the class that no attempt must be made to produce separate charts for X and Y.
It must be one chart for the firm.
186
Tell the class that no units are given, so the x-axis must be in £ sales, as a measure of
output. Emphasise that this will also represent a mix of sales – that any level of sales
will consist of 40% X and 60% Y. Tell the class that the x-axis is scaled to £300,000. The
y-axis would have to be similarly scaled.
Now draw the variable cost line. Plotting points are (x-axis 0, y-axis 0) and (x-axis
£300,000, y-axis £138,000).
Now draw the sales revenue line. Plotting points are (x-axis 0, y-axis 0) and (x-axis
£300,000, y-axis £300,000).
Draw the attention of the class to the contribution wedge again.
Now draw the total cost line by overlaying the variable costs with the fixed costs. This
will give plotting points of (x-axis 0, y-axis £108,000) and (x-axis £300,000, y-axis
£246,000).
Ask the class to read off the breakeven sales £. When the answer is given, point out that
it is only true if the breakeven sales is made up of 40% sales of X and 60% sales of Y.
The answer can be checked by calculation:
Average CS ratio £162,000/£300,000 = 54%.
Breakeven sales £108,000/54% = £200,000.
▲ Now take the class through Example 3 on pages 435-436 of the textbook. Make sure
that the class carefully works through the Notes to the solution.
▲ Discuss with the class the factors that may affect the linear assumptions of the traditional
and contribution breakeven chart. Make sure that the class can say something about
each of selling prices, variable costs and fixed costs.
▲ Take the class through Example 5.
▲ Finally, work through Examples 6 and 7 with the class. Emphasise how important it is
to prepare neat graphs when information has to be read from the chart. This is
particularly so when more than one situation is to be shown on one chart – as in
Example 7.
Reminders
On contribution breakeven charts the variable cost line is drawn first.
When the sales revenue line is drawn, the contribution wedge can be seen.
Across the entire output range, lines on the breakeven chart would not be linear.
Candidates should be able to suggest reasons for this.
187
LESSON 42
Main subject
Syllabus reference
Third Level
3
Marginal costing
presentations
Lesson topic
Profit graphs
(g) Understand profit graphs or PV graphs
(j) Apply breakeven chart principles to less usual situations e.g. to show
overhead incurred and overhead absorbed.
Required for
Aim of the lesson
• To explain the preparation of profit/volume (PV) graphs
The lesson
▲ Begin by explaining that a PV graph or chart is a type of breakeven chart. It allows direct
readings of profit or loss. On a traditional or contribution breakeven chart, profit has
to be read as a space between the total cost line and the total revenue line.
▲ The class should practise the preparation of PV graphs. This is the only way to gain confidence
and increase the speed of accurate graph preparation.
Begin with the following example:
A company makes one product. Its results for the current year show:
Sales
Variable costs
Fixed costs
Profit
£
180,000
72,000
90,000
162,000
18,000
Prepare a profit graph for these figures.
188
Emphasise that, as with traditional and contribution breakeven charts, care is needed
in starting the graph. Scales must be carefully chosen and marked on the graph before
any plotting begins.
Explain that the profit graph has an x-axis which represents output. Output can be
measured in units (for a one-product firm), or in sales value, or in machine hours, or
in any other measure of output. Point out that units or sales £ are the most usual.
Emphasise that this horizontal scale must start at zero.
Next, explain that the profit graph has a y-axis which represents profit or loss. Above
the x-axis it represents profit and below the x-axis it represents loss.
Now explain to the class what will determine the choice of scale for this example.
First, no units have been mentioned, although the firm does only make one product.
Therefore, the x-axis will be scaled in Sales £. It will begin at zero. The sales given are
£180,000, so the x-axis should be taken to this figure.
For the y-axis, the maximum loss must be equal to the fixed costs. In this case that is
£90,000. Below the x-axis, the y-axis must go from zero to £90,000. The y-axis above
the x-axis is for profit. The given profit is £18,000, so the y-axis above the x-axis could
go to £20,000. Emphasise that the intervals on the y-axis scale must be identical for the
loss area and the profit area.
Point out that the x-axis and the y-axis should be labelled and scaled neatly, so that
when the graph is drawn, readings can easily be made.
Now draw the line. The plotting points are (x-axis 0, y-axis £90,000 loss) and (x-axis
£180,000, y-axis £18,000 profit).
Tell the class that the breakeven point is where the drawn line crosses the x-axis. This
is in £ sales. Ask the class to read the figure from their graph.
The figure can be checked by calculation:
The CS ratio is £108,000/£180,000 = 60%.
The breakeven sales = £90,000/60% = £150,000.
Tell the class that the gradient (slope) of the line reflects the CS ratio of 60%. Remember
that this means that as £1 is added to sales, £0.60 is added to contribution. Eventually,
there is enough contribution to meet the fixed costs, and at this point the line crosses
the x-axis.
The margin of safety in this case is £180,000 – £150,000 = £30,000.
▲ Now take the class through Examples 8 and 9 on pages 445-449 of the textbook. In
particular, spend some time on Example 9. It shows how 2 situations can be presented
on one graph. Emphasise that this means that both situations must be considered when
choosing the scales.
For example the y-axis must allow for fixed costs of £400,000 for Alternative 1, even
though scaling it just to £200,000 would have been sufficient for Alternative 2.
Also, emphasise the importance of neatness when 2 lines are to be drawn on one
graph, from which 3 readings have to be accurately made.
189
Point out that, in an examination question, the information can be given in a number
of ways. As an example, ask the class to produce a profit graph for the following
company:
£
Sales
240,000
Total costs
220,000
Profit
20,000
The company breaks even at sales of £190,000.
At first sight, the class may think that not enough information has been given. Where are the
fixed costs? Where are the variable costs? We only appear to know the total costs of
£220,000.
Point out that we have, however, been given the breakeven sales of £190,000. This is a
plotting point because we know that this point must lie on the x-axis (because there is
neither a profit nor a loss).
As the class tries this example, they will realise that one problem is scaling the graph.
How much needs to be allowed on the y-axis at the loss end. We don’t know the fixed
costs. The way round this is to put the x-axis first, scaled in £ sales from 0-£240,000.
Next, tentatively put in the scale on the y-axis for profit. This must go from 0-£20,000.
Now put the ruler through the 2 plotting points. These are (x-axis £240,000, y-axis
£20,000) and (x-axis £190,000, y-axis 0). The extension of this line to the y-axis will
point to the fixed costs. Remind the class that the second plotting point is the breakeven
point – hence 0 on the y-axis!
The fixed costs can be calculated, of course:
Sales
Profit
£
190,000
Nil
£
240,000
20,000
Therefore an increase in sales of £240,000 – £190,000 = £50,000, has resulted in an
increase in profit (and therefore contribution) of £20,000. (Profit has moved from zero
to £20,000).
This means the CS ratio is £20,000/£50,000 = 40%
When sales are £190,000, the contribution must be 40% × £190,000 = £76,000. Since
sales of £190,000 are breakeven sales, the fixed costs must be £76,000.
▲ Finally, work through Examples 10 and 11 with the class. These are on pages 449-452
of the textbook.
Example 11 illustrates a slight variation in presentation of a PV graph.
Example 12 shows how the basic structure of a breakeven graph can be applied to a
different problem, in this case to illustrate incurred and absorbed overhead.
190
Reminders
PV graphs are a version of the breakeven chart. They make direct profit/loss
readings possible.
The gradient (slope) of the line drawn on the graph reflects the CS ratio.
The preparation of PV graphs requires the same attention to scale choice,
neatness etc as was the case for traditional and contribution breakeven charts.
It is easier to plot and compare alternative situations on a PV graph than on
either a traditional or contribution breakeven chart.
NB Tell the class that a pocket ruler is not usually adequate for questions on
breakeven charts and profit graphs. Candidates should take a full 12-inch or
30-centimetre ruler into the examination.
191
LESSON 43
Main subject
Syllabus reference
Optional techniques – Elementary knowledge of budgeting
Lesson topic
Introduction to budgeting and its organisational framework
7.1
7.2
7.3
Understand the difference between budgeting and budgetary control
Explain the benefits expected to accrue from the use of budgets
Understand the meaning and importance of the principal budget factor
Required for
Aim of the lesson
• To explain the purpose and place of budgeting and budgetary control in an
organisation, whose responsibility it is, how it is organised, and what budgets
will be needed
The lesson
▲ Begin by pointing out that in the Second Level syllabus, this subject is under ‘7 Optional
Techniques’.
This allows you to remind the class of the difference between a costing method – such
as process costing – and a costing technique such as budgeting. If a particular firm makes
its product repeatedly, in a sequence of processes, then it needs a system of process
costing; this is the costing method applied. However, it doesn’t have to use budgets or
budgetary control. This is an option.
Point out that it would be difficult not to use some budgeting. For example, predetermined production overhead absorption rates need a budget for the production
overheads.
▲ Point to the definition of a budget on page 459 and emphasise ‘defined period of time’
and ‘planned’.
Tell the class that the defined period of time could be a year, but that shorter periods
might be used. A business experiencing cash difficulties might prepare monthly cash
flow budgets. Explain why this is.
192
Emphasise that the word ‘planned’ shows that, by definition, a budget is forward
looking.
This gives you a chance to explain that assumptions made when budgeting may not
turn out to be valid, and continuous adjustment may be needed.
To illustrate this, ask the class to imagine that a business is about to prepare its sales
budget for the coming year. (You might want to use a particular local business to help
the students.) Ask them to suggest assumptions which will affect the sales budget, but
which could later turn out to be invalid.
These could include:
Growth rates in the market
Strength of the currency if there are export sales
Efficiency of sales staff
Strength of competition
Production capacity
and so on.
Now explain that we can budget for sales for the coming year, for the wages and
salaries to be paid in the coming year, for the cash inflows and outflows for the coming
month, etc. Although this is budgeting, it isn’t budgetary control. Budgetary control
implies two things: comparison of actual and budget; action to correct unacceptable
deviations.
Explain that like must be compared with like. If the sales budget is £10,000 and the
actual sales are £3,000, what does this mean? If the budget is for one month and the
actual is for one week, then the figures mean nothing.
▲ You should now take the class through the points on page 460 of the textbook, and in
particular, those points dealing with the choice of short-term control period.
Discuss with the class the 6 important points under the heading ‘Why does a business
prepare budgets?’ on page 461.
▲ Now ask the class whose job it is to prepare budgets. They may suggest that it is the
accountant’s job. Point out that whilst this could happen in some firms, it isn’t really
the correct answer.
Point to the first paragraph on page 461 under the heading ‘Budget organisation’ and
emphasise the words ‘starting’, ‘progressing’ and ‘supervising’.
Explain that the starting point for budgeting depends upon the ‘principal budget factor’
(page 462). Explain this. Then get the class to see the usual order of budgeting:
A sales budget, to show what the Sales Department believes it can sell
A production budget, to show what the production department will have to
make in order to provide the planned sales and allow for any planned stock
changes
A materials usage budget, to show the materials needed to make the production
budget
193
A capacity budget, to show what manpower, machine, process time, etc, is needed
to meet the production budget
A labour budget, for direct and indirect labour
An overhead budget
etc etc
At this point – without involving any numbers – the idea is to get the class to understand
the nature of budgeting and budgetary control, and the broad direction in which the
budgeting process goes.
Reminders
The terms that must be known.
The difference between budgeting and budgetary control.
The organisation for budgeting.
The normal order in which budgeting takes place.
194
LESSON 44
Main subject
Syllabus reference
Lesson topic
The preparation of budgets (excluding cash budgets)
7.4
Prepare a sales budget analysed where necessary by product, area, salesman
etc
7.5 Prepare a production budget which takes into account planned product
sales and planned finished stock changes
7.6 Prepare a materials usage budget based upon the production budget
7.7 Prepare a materials purchasing budget based upon the materials usage
budget and planned material stock movements
7.8 Prepare a machine or process utilisation budget based upon the production
budget
7.9 Prepare a direct labour budget
7.10 Prepare a production overhead budget and calculate the budgeted
production overhead absorption rates
7.11 Summarise budgets to establish the budgeted profit, making stock
adjustments where necessary
Required for
Aim of the lesson
• To explain how individual budgets can be prepared, then summarised to
obtain the budgeted profit or loss.
The lesson
▲ Remind the class that budgeting is an orderly process. There has to be a starting point
which is determined by the principal budget factor, which usually is sales. The budgeting
process therefore begins with the sales budget.
195
Emphasise that other budgets then follow in a logical sequence:
Sales budget – what are we planning to sell?
Production budget – what, therefore, have we got to make?
Materials budget – to make this output, what materials do we need?
Purchasing budget – how much material do we need to purchase?
Capacity budget – what machine and manpower do we need to make the
production budget?
and so on.
Each budget depends on the preceding budget. In other words, there is an order.
Point out that the examiner may only ask for the preparation of one or two budgets –
for example, the materials usage budget and the purchasing budget. This is because
the time constraints of an examination prevent the examiner from setting a question
requiring all budgets.
However, tell the class, you are going to illustrate the whole sequence for understanding.
In addition you should point out the importance of understanding the Fenner Limited examples
in the textbook, which begin with Example 1 on page 463.
▲ Start with a very simple situation. Tell the class:
A business makes only one product, XP1.
It is made in 2 departments, taking 1 hour in Department A and 1 hour in
Department B.
It is made with 3kg of material which costs £2 per kg.
The sales budget for Year 6 has been prepared: 4,000 units of XP1 are to be sold
for £30 per unit.
Labour is paid £5 per hour in Department A: £6 per hour in Department B.
The overhead cost is £3 per hour + £16,000 fixed cost for Department A; £2
per hour + £8,000 fixed cost for Department B.
No stock changes are planned.
Now take the class steadily through the sequence of budget preparation in this situation.
Sales Budget
4,000 units × £30
£120,000
Production budget
No stock changes are planned so we must produce 4,000 units. This is the production
budget.
Materials usage budget
4,000 units × 3kg = 12,000 kg.
This will cost 12,000 × £2 = £24,000. Because there are no planned stock changes,
this is also the Purchasing budget for the year.
196
Labour budget
Department A: 4,000 units × 1 hour = 4,000 hours.
This is the budgeted utilisation of Department A. The labour will cost 4,000 hours ×
£5 = £20,000.
Department B: 4,000 units × 1 hour = 4,000 hours.
This is the budgeted utilisation of Department B. The labour will cost 4,000 hours ×
£6 = £24,000.
Overhead budget
Department A: (4,000 hours × £3) + £16,000 = £28,000
Department B: (4,000 hours × £2) + £8,000 = £16,000
All the budgets have been prepared.
Explain to the class that because there are no planned stock changes, the sales budget
and all cost budgets are based upon 4,000 units. Therefore the budgeted profit is simply
the budgeted sales minus the budgeted costs.
£
Sales
£
120,000
Material
Department A production costs:
Labour
Overhead
24,000
20,000
28,000
48,000
Department B production costs:
Labour
Overhead
24,000
16,000
40,000
Total cost
Budgeted profit
112,000
8,000
Make sure the class understands this example before continuing. Point out, also, that
the budget must be approved as a plan of action by the manager or managers who will
be responsible for the overall achievment of this plan.
▲ Now add two more pieces of information, and ask the class how they will change the
budgets already prepared. The additional information is:
1
By the end of Year 6, finished stocks of XP1 are to be increased by 500 units.
2
By the end of Year 6, stocks of material are to be decreased by 1,000 kg.
Let the class discuss this, and then ask which budgets will change. The answers are:
Sales budget – no change.
Production budget – this will now be 4,500 units. We must make 4,000 units to sell and a
further 500 units to increase the finished stock levels.
Materials usage budget – this will now be 4,500 units × 3kg = 13,500 kg. Its cost will be
13,500 kg × £2 = £27,000.
197
Materials purchasing budget – this will not now be the same as the material usage budget.
Although 13,500 kg are needed for production, 1,000 kg will be drawn from stock, so
purchases will be 12,500 kg × £2 = £25,000.
Labour budget: Department A. We now have to make 4,500 units. This will take 4,500 ×
1 hour = 4,500 hours. It will cost 4,500 × £5 = £22,500.
Labour budget: Department B. To make 4,500 units will take 4,500 hours. The cost will
be 4,500 × £6 = £27,000.
Overhead budget: Department A. This will now be (4,500 hours × £3) + £16,000 =
£29,500.
Overhead budget: Department B. This will now be (4,500 hours × £2) + £8,000 = £17,000.
Ask the class to note that every budget has changed, with the exception of the sales budget.
▲ Now ask the class to summarise the budgets, to get the new budgeted profit or loss.
Give them some time to think about this.
£
Sales
£
120,000
Material
Department A production costs:
Labour
Overhead
27,000
22,500
29,500
52,000
Department B production costs:
Labour
Overhead
27,000
17,000
44,000
Total cost
Budgeted loss
123,000
(3,000)
Some of the class might also include the purchasing budget. You can explain that it
would be wrong to have both the material usage budget and the materials purchasing
budget included.
Many are likely to say that we are now budgeting to make a loss of £3,000. You should
point out that this is wrong, because it comes from a comparison of the sales revenue
of 4,000 units and the cost of producing 4,500 units. This is not comparing like with
like. Explain that the 500 units haven’t been lost – they are in stock ready for sale. They
must be valued.
Ask the class how the 500 units might be valued.
Some might say that since the cost of producing 4,000 units was budgeted at £112,000
and the cost of producing 4,500 units is budgeted at £123,000, then it is reasonable to
say that the difference, £11,000, must be the cost of producing the extra 500 units.
If this is done, the unsold 500 units, valued at £11,000, would turn the budgeted £3,000
loss into a budgeted £8,000 profit – exactly as it was before! You can suggest that this is
reasonable, since 4,000 units are to be sold irrespective of how many are produced.
(You could take the opportunity, here, to revise some earlier work on marginal costing,
and in particular, absorption versus marginal cost stock valuations.)
198
Make sure the class understands that if the 500 units are valued at £11,000, this valuation
does not include any of the departmental fixed costs.
Some members of the class might suggest valuing the 500 units at 500/4,500 × £123,000
= £13,667. This, of course, includes 500/4,500 of the departmental fixed overheads of
£24,000 (£16,000 + £8,000). The effect of this, and how reasonable it is, can be
discussed.
Finally, point out that if the examiner asks for only one budget, rather than all of them,
it is likely to involve more than one product.
▲ Ask the class to imagine that we are now budgeting for Year 7, and that it has been
decided to introduce another product, XP2. The production budget for Year 7 has
been prepared and we are going to make 3,800 units of XP1 and 700 units of XP2.
Tell the class that each unit of XP2 will need 4kg of material (the same material as
XP1). To make a unit of XP2 will need 0.5 hours in Department A and 0.8 hours in
Department B.
Tell the class to suppose that the examiner asked for the materials usage budget and the
labour budget for Department B:
Materials usage budget
XP1 3,800 units × 3 kg =
XP2 700 units × 4kg =
This will cost 14,200 × £2 =
11,400 kg
2,800 kg
14,200 kg
£28,400
Labour budget for Department B
XP1 3,800 units × 1 hour =
XP2 700 units × 0.8 hrs =
3,800 hrs
560 hrs
4,360 hrs
These will cost 4,360 × £6 =
£26,160
Encourage the class to pay particular attention to working through pages 462-473 of
the textbook, and to work carefully through each Example.
Reminders
Budgets are prepared in a logical order.
The starting point is determined by the principal budget factor.
Usually the principal budget factor will be sales, so that the sales budget is the
starting point
Care needs to be taken over stock increases/decreases of finished products and/
or materials. These will usually be part of any budgeting question.
199
LESSON 45
Main subject
Syllabus reference
Lesson topics
The preparation of cash budgets
The use and interpretation of flexible budgets
7.12 Prepare a simple cash budget
7.13 Understand the reasons for preparing a cash budget and what can be
done to overcome cash difficulties
7.14 Prepare a simple flexed budget and make a comparison with actual costs
and/or income
Required for
Aims of the lesson
• To explain why and how a cash budget is prepared
• To explain why flexible budgets are useful aids for the control of cost, and
how they are prepared and interpreted
The lesson
▲ Simple cash budgets
Explain that the budgets prepared in the preceding lesson were mainly budgets for
income and expenditure, and that they were summarised to give the budgeted profit.
One exception was the material purchasing budget which was not used in the summary
to determine the profit.
Remind the class that a business can be budgeting to make a profit, yet could still
experience cash flow difficulties. Ask the class why this could be.
They should mention timing differences on normal operations – for example, profit is
recognised at the moment of sale when an invoice is raised. However, it may be several
months before the customer actually pays and the cash comes in.
200
They might also mention large one-off payments not directly related to current
operations, for example, capital expenditure in acquiring facilities to expand output in
the future, but not immediately.
Draw attention to the textbook: the second half of page 473 and the first half of page
474, and in particular points 1 and 2 under the heading ‘Cash budgets’.
Point out the pro-forma layout of a cash budget on page 474. This is the preferred
presentation, and students should be encouraged to use it from the start. On no account
should a cash budget be presented as a sequence of ‘T’-accounts.
Go through the pro-forma with the class, explaining each line, and referring to the
Notes at the top of page 475.
▲ Use the following figures to show the class how to prepare a cash budget:
A trader plans to commence in business on 1 January Month 1. On that date he
will open a business bank account with £5,400 taken from his private bank
account.
He budgets his sales for the first 4 months as £3,000, £3,800, £4,500 and £5,000
respectively. He budgets for a 40% gross margin.
Both sales and purchases are made on an immediate cash basis. No stocks are
carried.
He budgets monthly expenses (to be paid in cash) as £1,800. This includes
£100 a month depreciation of a motor van, which he intends to buy for cash in
Month 1 for £4,800.
Cash budget for Months 1-4
Month
Opening balance
Receipts from customers
Payments:
Suppliers
Expenses
Motor van
Net inflow/(outflow)
Closing balance
1
£
5,400
3,000
1,800
1,700
4,800
8,300
(5,300)
100
2
3
4
£
£
£
100
3,800
(80)
4,500
20
5,000
2,280
1,700
2,700
1,700
3,000
1,700
3,980
(180)
(80)
4,400
100
20
4,700
300
320
Explain that an overdraft facility will have to be arranged with the bank for Month 2.
Ask the class if they can suggest any other solution to the problem.
They may suggest buying the motor van on HP (Hire Purchase) terms instead of
making an outright cash purchase.
Point out that it is, however, a temporary cash problem. By Month 3 the cash is in
surplus.
201
▲ Now continue.
In Month 5, the trader plans to buy some goods to carry as a constant level of
stock. These goods will cost £950.
From Month 5, the trader plans to give all customers 1 month’s credit.
Sales for the 4 months starting with Month 5 are budgeted as £5,500, £6,000,
£6,200 and £6,500.
Because he will be buying more goods from his supplier, the trader budgets to
negotiate better prices – with the result that his gross margin can be budgeted as
45% instead of 40%, starting with the purchases made and paid for in Month 5.
Cash budget for Months 5-8
Month
Opening balance
Receipts from customers
Payments:
Suppliers
Purchase of stock
Expenses
Net inflow/(outflow)
Closing balance
5
6
7
8
£
320
–
£
(5,355)
5,500
£
(4,855)
6,000
£
(3,965)
6,200
3,025
950
1,700
5,675
(5,675)
(5,355)
3,300
3,410
3,575
1,700
5,000
500
(4,855)
1,700
5,110
890
(3,965)
1,700
5,275
925
(3,040)
Point out that this cash problem has been caused by planning to give 1 month’s credit
to all customers, and to carry level of stocks. You should also point out that the deficit
is steadily reducing.
Ask the class if the trader is planning to make a profit in Month 5.
They may be tempted to say, ‘No’, because a large deficit appears at the end of the
month. However, you should show the class these figures:
Sales
Cost of sales 55%
Expenses
Depreciation on van
Budgeted profit
£
5,500
3,025
1,700
100
4,825
675
Make sure that the implications of this are understood.
▲ Finally, with the class, work carefully through Example 6 on page 475 of the textbook.
Note that the net cash inflow for March on page 476 should be 14, not 13 as printed.
202
▲ Flexible budgets
Emphasise the definition of a flexible budget which appears on page 478 of the textbook.
Also emphasise that there is no budget which controls cost – only people do that.
However, budgets may help.
Department A has a budget for one month amounting to £18,800. When actual costs
are recorded they amount to £17,300. Is this a good cost performance by the
departmental manager?
Ask the class.
They should say that there is insufficient information to decide! We need to know both
the budgeted and actual level of production, and the expected behaviour of the
departmental costs.
Now tell the class that budgeted output was 1,500 hours of work, the actual output
was 1,200 hours of work, and that £8,000 of the budgeted cost is regarded as fixed, the
balance being variable.
The question asked can now be answered:
The output of the department was 80% of budget, (1,200/1,500), so the costs should
have totalled (80% × £10,800) + £8,000 = £16,640.
Since the costs incurred were £17,300, the flexible budget (not the original budget!)
has been overspent by £660. This should encourage the departmental manager to
investigate the reason(s) for the overspending, and to identify the cost, or costs, that
need particular attention. Corrective action can then be taken.
Reminders
Cash budgets are about the timing of cash flows.
Presentation in columns is important.
Cash budgets are needed to identify possible shortages or surpluses of cash at
future short term intervals – often monthly.
Management can take appropriate action now to cover for these future shortages/
surpluses.
Flexible budgets are needed to make a correct assessment of cost control by
managers.
Flexible budgets are output-adjusted budgets and therefore give a good
comparison with the actual costs.
203
LESSON 46
Main subject
Budgeting (2)
Syllabus reference
Third Level
4
Variance accounting – Preparation and co-ordination of functional, cash
and master budgets. Limiting factor. Fixed, flexible and rolling budgets.
Human behavioural considerations.
Lesson topic
Human behavioural considerations
Extended syllabus
4.5
Recognise the importance of management style: autocratic or participative
budgeting
4.6 Outline behavioural aspects of budgeting – planning and control aspects
4.31 Discuss the attitude of managers to variance reporting
4.32 Understand the purpose of budget padding in this context
Required for
Aim of the lesson
• To introduce the relationship between budgets and people.
The lesson
▲ Begin by referring to the reasons for preparing budgets given on page 461 of the
textbook. Emphasise particularly points 4, 5, and 6. These show how an individual
manager is affected by the existence of budgets:
1
He/she may (should) take part in the preparation of budgets
2
He/she may be motivated to achieve and improve the standards built into his/her
budget
3
His/her actual performance will be compared with his/her budget
4
His/her budget performance may be one way in which he/she is judged as a
manager.
Note to the teacher: There is a lot of research material on the relationship between
budgets and people. Candidates are not expected to know this material. For the LCCI
Third Level examination the awareness required is of a more general nature.
204
Budgeting (2)
Setting budgets
Emphasise the difference between an autocratic budget process and a participative
budget process.
With the former, budgets may be set by senior managers and ‘handed down’ to lower
levels of management. In this way, a manager could be asked to be responsible for
achieving a budget which he/she has had no part in preparing.
With participative budgeting, managers at all levels are involved in setting budgets.
Point out that participative budgeting tends to be a more time-consuming process.
Explain why this is.
Ask the class for their views on each approach. Remind them that budgeting is a process
which settles the claims made by different managers on the limited resources available.
Does a more ‘aggressive’ manager get a larger share of the resources – and should this
be the case?
Motivation
Some people suggest that budgets can motivate a manager to better performance. One
view is that even where budgets are imposed upon managers, they accept and are
challenged by the standards of achievement built into the budgets.
Another view is that there has to be self-motivation. Managers accept ownership of
budgets that they have had a part in setting. They will not accept imposed budgets.
It may also be that different managers have different attitudes. Some will accept or
give themselves difficult targets to achieve, knowing that they cannot all be met. Others
would be depressed by targets which are difficult to achieve, and particularly when
these targets are not met.
Again, ask the class to discuss these points in a simple way.
Comparisons with actual cost
Some managers may see this as a threatening situation. If actual costs are to be compared
with budget – why is it being done? Some managers fear that it is so that they can be
reprimanded for spending over budget. They may feel that praise for underspending
the budget is less likely. Whether this fear exists will depend partly upon the environment
created by senior management.
Fear of this kind is one reason for budget ‘padding’. A manager may feel that if he can
obtain approval, at the budgeting stage, for more resources than he really needs, then
he has a safeguard against higher than expected actual costs. When incremental
budgeting is practised instead of ZBB (Zero-Base Budgeting – see next lesson), this
padding leads to budgetary drift.
Budget performance
A manager knows that he will be appraised either continuously or at specific times. As
a result of the appraisals, he knows that he will be judged, fairly or unfairly, as good or
bad, competent or incompetent, effective or ineffective, and so on.
205
If he considers that performance against a budget will be one basis for appraisal, then
he will want to influence not only the setting of the budget, but also the collection of
actuals, any comparisons made and their interpretation.
Ask the class to look again at Example 1 on pages 485-488 of the textbook. Some of
these points are considered briefly from the viewpoint of the manager, R Jinks.
Reminders
Budgets affect people and people affect budgets.
Attitudes to budgets and the measurement of performance against budgets will
differ from manager to manager.
Where managers perceive threats, they will want to influence the budgeting
and budgetary control system, to minimise the dangers to themselves personally.
206
Budgeting (2)
LESSON 47
Main subject
Budgeting (2)
Syllabus reference
Third Level
4
Lesson topic
Zero Base Budgeting
4.8
Explain Zero Base Budgeting
Required for
Aim of the lesson
• To explain the nature of Zero Base Budgeting and how it may be applied.
The lesson
▲ Begin by emphasising the CIMA definition of ZBB given on page 489 of the textbook.
Explain some of the key elements of the definition:
Managers must justify each element of expenditure. A manager might have spent
£15,000 last year for a particular cost heading, for example, advertising. He might
consider that his budget for this year should at least be £15,000 + an allowance for
inflation. This approach is called incremental budgeting. (Last year + an increment).
ZBB says the expenditure must be justified for this year, whatever was spent last year.
The definition says: think of this year’s budget as relating to an activity being done for
the first time. So there is no last year which can be referred to. If expenditure is not
justified for this year, then the resource allocation is zero.
Explain to the class that almost all businesses have limited resources. Many individual
managers with budget responsibility are competing for those limited resources. Some
managers will be disappointed.
ZBB says to each manager, ‘Your resource allocation is zero unless you can justify your
claim for resources, and your claim is preferred to those of other managers.’.
207
▲ Take the class carefully through Note 2 on page 489. Emphasise the word ‘activity’ as
used in the CIMA definition in its plural form. Get the class to think of a number of
activities which could be approached in this way. For example, one could think of
maintenance, advertising, quality control, manufacturing, credit control – and so on.
Point particularly to 3(e). Even if the activity is thought to bring benefits to the firm,
those benefits could perhaps be obtained in a different way. The ‘different way’ might
be more economical, more reliable, for instance.
For example, the credit control activity would be considered beneficial. It seems sensible
to record what customers owe, and to chase them for outstanding debts. However,
this could be done by a specialist agency outside the firm.
Emphasise that part of the benefit of ZBB is that it encourages managers to challenge
assumptions. ‘Because we’ve always’ done something is no reason to carry on doing it,
and – even if we do – it doesn’t have to be in the same way.
Note that the textbook has not concentrated on the steps involved in ZBB. Candidates
only need to know what it means, and what advantages it might bring when compared
with traditional or incremental budgeting.
This lesson gives you the opportunity to remind the class of the traditional approach,
and how ZBB contrasts with this.
▲ Finally, take the class carefully through Example 2 on pages 489-492 of the textbook.
Again, this is a detailed practical example. It will benefit the class to understand the
steps taken. It is, however, a longer example than would be expected as an examination
question.
Reminders
ZBB is an approach to budgeting. It tells managers that their resource allocation
is zero, unless their claim for resources for this year is justified. Last year’s
allocation and actual spending are not relevant.
208
Budgeting (2)
LESSON 48
Main subject
Budgeting (2)
Syllabus reference
Third Level
4
Lesson topic
Budget preparation
4.9
4.10
4.11
4.12
4.13
4.14
4.15
4.16
4.17
4.18
4.19
4.20
4.21
4.22
Prepare a sales budget analysed where necessary by product, area, salesman
etc
Prepare a production budget which takes into account budgeted product
sales, budgeted WIP and finished stock changes, and finished and part
finished product rejections
Prepare a materials usage budget based upon the production budget
Prepare a materials purchasing budget based upon the materials usage
budget and planned material stock movements
Use the EOQ model to determine the order size and the number of
orders to be placed based upon the budgeted annual material requirement
Prepare a scrap sales budget
Prepare a capacity (machine, labour, process) utilisation budget based
upon the production budget
Compare the capacity needed with the capacity available for each
department, cost centre etc
Recognise a ‘bottleneck resource’ and whether it is long-term or shortterm
Suggest possible solutions to a shortage of capacity
Suggest possible actions to deal with excess or under-utilised capacity
Measure capacity utilisation
Prepare a direct labour budget based upon the production and capacity
utilisation budgets
Prepare a production overhead budget and calculate budgeted production
overhead absorption rates
209
4.23 Combine 4.21 and 4.22 to budget conversion costs and to calculate
conversion cost absorption rates
4.24 Summarise budgets to establish the budgeted profit, making stock
adjustments where necessary
4.25 Prepare a cash budget. Questions will normally involve greater complexity
in the terms of credit than found at Second Level
4.26 Make proposals to deal with a short-term cash deficit or surplus
4.27 Apply the rolling budget principle – particularly, but not exclusively, to
cash budgets
4.28 Contrast fixed budgets versus flexible budgets for control
4.29 Suggest a basis or bases of flexing
4.30 Prepare a flexed budget and make a comparison with actual costs/income,
and interpret the variances
Required for
Aim of the lesson
• To explain some of the major areas of budgeting which are important for the
Third Level candidate.
The lesson
▲ Remind the class that the ‘principal budget factor’ – usually sales – determines the
order of the budgeting process.
Explain that some examination questions ask for sales data to be presented as a budget
in different ways: perhaps analysed by product, by area, by sales staff, for example.
Use the following figures to illustrate this:
Sales for Year 12 have been budgeted as:
Product X 4,800 units to be sold at £65 each
Product Y 1,900 units to be sold at £120 each
Product Z 2,800 units to be sold at £90 each.
There are 4 sales staff, A, B, C, and D.
A only sells Product X and Product Y. He plans to sell 2,400 units of X and 700
units of Y.
B only sells Product Z. She plans to sell 2,100 units.
C only sells Product Y. He plans to sell 1,100 units.
D plans to sell Products X, Y and Z.
Prepare a sales budget for Year 12 analysed by (i) product and (ii) sales staff.
Explain to the class that this kind of analysis needs to be done quickly and accurately.
In practice, it would be done using a simple computer programme.
210
Budgeting (2)
(i) by product
Product X
Product Y
Product Z
(ii) by sales staff
Sales person A
Product X
Product Y
Sales person B
Product Z
Sales person C
Product Y
Sales person D
Product X
Product Y
Product Z
4,800 × £65
1,900 × £120
2,800 × £90
£
312,000
228,000
252,000
792,000
2,400 × £65
700 × £120
£
156,000
84,000
240,000
2,100 × £90
£
189,000
1,100 × £120
£
132,000
2,400 × £65
100 × £120
700 × £90
Total
£
156,000
12,000
63,000
231,000
792,000
Explain the use of the control Total to the class, the fact that both analyses total £792,000.
▲ The production budget
This was introduced for Second Level students in the lessons which accompanied
Chapter 15 of the textbook.
The production budget is in quantity terms. It states the production needed in each
production cost centre.
In a single-product firm, it will be in units of output. In the multi-product firm, it will
usually be in budgeted standard hours of production.
Emphasise the difference between the production budget which shows the quantity of
output, and the production cost budget, which shows the production cost of that output.
If the examiner asks for the production budget, he does not want material cost and
conversion cost!
Point out that the Third Level candidate must be able to deal with work-in-progress,
and rejected products in the production budget.
211
Use the following figures in illustration:
X Limited makes a single product.
Sales budget for Year 9 230 units
Finished stock at the start of Year 9 12 units
Planned stock at the end of Year 9 22 units
What is the production budget for Year 9?
The answer is 230 – 12 + 22 = 240 units. Alternatively it can be expressed as 230 +
stock increase of 10 = 240 units.
Ask the class what the production budget would be if, in addition to the finished stock,
there were 18 units of work-in-progress at the start of Year 9, which were 331/3%
complete, and work-in-progress at the end of Year 9 was to be increased to 32 units,
50% complete.
What is the production budget for Year 9?
The class should now call upon their process-costing knowledge.
The production budget is:
Sales budget
Stocks at end of Year 9:
Finished stock
Work-in-progress 32 × 50%
Stocks at start of Year 9:
Finished stock
Work-in-progress 18 × 331/3%
Production budget
230
22
16
12
6
38
268
18
250
Now go back to the illustration before work-in-progress was introduced. The
production budget was 240 units.
Ask the class what this would become if a 20% reject rate was expected. The finished products
are inspected at the end of the production process. Rejected products cannot be
recovered.
The answer is 240/80% = 300 units.
Make sure that the class understands this. The most common incorrect answer is 288
units i.e. 240 + 20%. This is wrong. Emphasise that we must say if 240 units = 80%,
what is 100%?
212
Budgeting (2)
Now use this example:
Y Limited makes one product.
It is made in 2 departments. It goes first into Department A and then into
Department Y.
The sales budget for Year 12 is 520 units.
At the start of Year 12 there is a stock of 40 finished units ready for sale.
At the end of Year 12, it is planned to have 60 finished units ready for sale.
When the work in Department A is completed, the products are inspected and
10% are rejected. They cannot be recovered.
When the work in Department B is completed, the products are inspected and
20% are rejected.. They cannot be recovered.
What is the production budget?
Point out that there is a catch in this question.
In fact there are 2 production budgets – one for Department A and one for Department
B.
Tell the class that we must begin with the completed products and work backwards.
We do Department B first.
Sales budget
Finished stock – end of year
Finished stock – start of year
Good units to be produced
520
60
580
40
540
540 = 80%. Therefore, production in
Department B must be
675
675 = 90%. Therefore, production in
Department A must be
750
Emphasise to the class that there are 2 production budgets. For Department A it is 750
units. For Department B it is 675 units.
Finally, use these figures:
Sales budget:
Product A 200 units
Product B 340 units
Product C 130 units
Planned finished stock increase:
Product A 30 units
Product C 10 units
What is the production budget?
213
The answer is:
Product A
Product B
Product C
200 units + 30 units =
230 units
340 units
140 units
130 units + 10 units =
This is cumbersome. The units cannot be added together to say 710 units because they
are 3 different products. We cannot read out a list of products. Although there are only
3 products in this example, there might be 103 products!
We need a common denominator. The one that is usually used is hours. If the standard
production hours to make 1 unit are:
Product A
Product B
Product C
2.5 hours
4.0 hours
5.5 hours
then we can say:
(230 × 2.5) + (340 × 4) + (140 × 5.5) = 2,705
The production budget is 2,705 standard hours.
▲ Production cost budgets
Point out that the production cost budgets depend upon what is to be produced.
Production cost budgets must follow the production budget(s).
Remind the class that production cost is direct materials + production conversion
cost. The direct material budget depends upon the products made. The conversion cost
depends upon how long it takes to make the products in departments and cost centres.
To illustrate this, use the figures from the earlier production budget:
750 units to be worked on in Department A
675 units to be worked on in Department B
Suppose each unit needs £45 material, and takes 40 hours in Department A and
36 hours in Department B
Point out that the direct material budget must be based on 750 units, as that is the
number of units which are initially made. They do not all reach finished stock, of
course.
Direct material cost budget 750 × £45 =
£33,750
Before the conversion cost (direct labour + production overhead) can be completed,
explain that we first need the budgeted utilisation hours.
These are:
Department A 750 × 40 =30,000 hours
Department B 675 × 36 =24,300 hours
214
Budgeting (2)
Explain that if participative budgeting is in use, the manager of Department A will be
asked to budget his costs, one by one – labour, electricity, consumables, etc – for 30,000
hours of work from his department. The manager of Department B will be asked to
do the same thing for 24,300 hours of work from his department.
Emphasise that this budgeting process will also provide the budgeted costs against
which the actual costs will be compared. Point out that the manager will also be expected
to define his costs as variable or fixed – in case fewer than, or more than, 30,000 hours
are worked. This will then be used as the basis of flexible budgets.
▲ Cash budgets
Remind the class that cash budgets were introduced in Chapter 15 and in one of the
lessons relating to that chapter. This means that it is a Second Level topic, and that
Third Level questions will include a greater degree of difficulty.
Explain that this ‘greater difficulty’ usually relates to 2 areas of the cash budget: first, in
working out the receipts from customers, and second, in working out the payments to
creditors (suppliers).
Use the following figures to show how receipts from debtors are calculated:
Month
Cash sales
Credit sales
1
£’000
65
120
2
£’000
45
130
3
£’000
58
140
4
£’000
69
160
5
£’000
72
150
6
£’000
58
140
40% of credit sales by value are received in the month of sale. This attracts a 2%
discount.
30% by value will be received after 1 month, 20% after 2 months and 8% after 3
months. The remaining 2% will not be received at all.
Ask the class to schedule the cash receipts expected from the sales of each month. Explain that
cash receipts should be scheduled on a working (spread) sheet:
215
Month
Cash sales
Credit sales
1
£’000
65
120
Cash receipts schedule:
Month
1
£’000
Cash sales
65.00
Credit sales:
40% received in
month of sale
48.00
2% discount
(0.96)
30% received after
one month
20% received after
2 months
8% received after
3 months
2
£’000
45
130
3
£’000
58
140
4
£’000
69
160
5
£’000
72
150
6
£’000
58
140
2
£’000
45.00
3
£’000
58.00
4
£’000
69.00
5
£’000
72.00
6
£’000
58.00
52.00
(1.04)
56.00
(1.12)
64.00
(1.28)
60.00
(1.20)
56.00
(1.12)
36.00
39.00
42.00
48.00
45.00
24.00
26.00
28.00
32.00
9.60
209.32
10.40
217.20
11.20
201.08
Emphasise to the class
1
This is a working sheet to get the 3 final figures for months 4, 5, and 6. These
are then taken into the cash budget.
2
Because it is a working sheet, it needs to be done neatly, but above all, quickly.
3
Cash receipts for Months 1, 2, and 3, cannot be completed because no
information was given as to the sales of Months 10, 11, and 12 (i.e. the months
before Month 1).
4
Expected bad debts are simply left out. The cash will not be received.
▲ Payments to suppliers depend upon purchases made. Purchases made depend, not
only upon materials needed for production, but also upon planned changes in material
stock levels.
Use the following figures to illustrate this:
Month
Budgeted sales
1
£’000
170
2
£’000
230
3
£’000
310
4
£’000
280
5
£’000
260
6
£’000
200
Selling prices are set so that value added is 70% of selling price.
Production in any month comprises 50% of the current months sales
requirements and 50% of the next months sales requirements.
Purchases in any month comprise the material production requirements of the
next month.
Suppliers are paid two months after purchase.
216
Budgeting (2)
Ask the class to calculate the amounts payable to creditors
Month
Budgeted sales
Material content 30%
Production materials
Purchases of materials
Payments to creditors
1
£’000
170
51.00
60.00
81.00
2
£’000
230
69.00
81.00
88.50
3
£’000
310
93.00
88.50
81.00
81.00
4
£’000
280
84.00
81.00
69.00
88.50
5
£’000
260
78.00
69.00
6
£’000
200
60.00
81.00
69.00
Again, you should point out why parts of this table cannot be completed.
Emphasise that it is a working sheet, and that it has given us the payments for months
3, 4, 5, and 6 which can now be entered in the cash budget.
Now take the class through Examples 4 and 5 on pages 499-503 of the textbook.
Reminders
Production budgets are prepared in quantity terms (units of product) or in a
term that can represent a number of products (standard hours).
A clear distinction must be drawn between the production budget and the
production cost budget.
Cash budgets at Third Level are usually more complex than those at Second
Level.
Because of this, workings become important and need to be prepared quickly
and accurately.
217
LESSON 49
Main subject
Syllabus reference
Elementary knowledge of budgeting and standard costing restricted to prime
cost variance analysis
Lesson topics
The nature and purpose of standard costing
The preparation of a standard cost
7.15
7.16
7.17
7.18
Understand the meaning of standard cost, standard costing and variance
Distinguish between an ideal standard and an attainable standard
Explain the uses to which a standard cost can be put
Prepare a simple standard cost
Required for
Aim of the lesson
• To explain what a standard cost is, what it is used for, how it is prepared, and
how a standard cost relates to standard costing
The lesson
▲ Begin by reading out the CIMA definition of standard costing on page 511 of the
textbook. Emphasise the first three words: ‘a control technique’. Explain how this
works: actual costs are compared with standard costs to get a variance, or difference.
The analysis of this variance should result in managers taking action to stimulate better
performance. For example:
Standard cost to make 1 product
150 products made
Therefore standard cost for 150 good products
Actual cost for making 150 good products
Therefore variance
218
£230
£34,500
£36,750
£2,250 Adverse
Ask the class to suggest why this overspending might have occurred.
They could suggest:
The material price has gone up.
More materials have been used than should have been used.
Some products had to be scrapped – because they were not up to standard.
A more expensive grade of labour was used.
Direct labour took longer than expected to produce the output.
and so on.
If analysis of the variance is used to stimulate better performance, ask the class to
suggest what a manager could do.
For example, if the variance is because the purchase price of the materials has risen, he
could look for another supplier, or he could suggest purchasing in larger amounts to
get a lower price. (Hopefully, the class might recognise that this will increase stockcarrying costs).
He could consider if an alternative, cheaper material could be used. Students might
correctly suggest that this might not be satisfactory to the customer, or might reduce
the quality of the product.
If the variance is because too much material has been used, the manager could investigate
to find out if this was because of poor supervision of employees, inadequate training of
employees, machine faults, and so on.
Emphasise that a variance can only be calculated if a standard cost has already been set.
So what is a standard cost?
Read out the CIMA definition of a standard cost. This is on page 513 of the textbook.
Emphasise that it is a planned unit cost. It is set before the product is made. Emphasise,
also, that it can be for a product, a component or a service.
As examples:
A standard cost can be set for a loaf of bread, but one can also be set for an audit. A
bakery can set a standard cost for producing a loaf of bread. It can then compare actual
costs to this standard. An accountant can set a standard cost for conducting an audit
for a client, and can then compare actual costs to this standard. The bakery makes a
product. The accountant gives a service.
▲ Draw the attention of the class to some other uses of a standard cost, given in the
definition:
Stock valuation
If 450 of the product already referred to are made at a cost of £110,700, but only 421
are sold, then 29 remain in stock. At the period end when a profit and loss account is
prepared, unsold stock must be valued.
On an actual cost basis, the valuation could be £110,700 × (29/450) = £7,134.
Where a standard cost exists it is easier to value the unsold stock at 29 × £230 =
£6,670.
219
Once the standard cost has been prepared, the £230 can be stored in a database. At
each period (month) end, the number of unsold units can be input, and multiplied by
the stored £230 to give the stock valuation.
The establishment of selling prices
Emphasise to the class that cost alone rarely determines selling prices.
Ask them why.
Ask them if a product that costs £230 to make would ever be sold for (say) £210. The
class should say ‘Yes, it might be’ and should mention strong competition, trying to get
a foothold in an export market, and so on.
A standard cost – an indication of what the product or service should cost in standard
circumstances – is helpful to a manager who has to set the selling price for a product,
but he will consider other things as well.
The level of attainment
This is covered on pages 517-518 of the textbook.
Ask the class if it will be easy to make a product for the £230 set as standard.
Hopefully, they will say that this depends upon how tightly or generously the standard
has been set. A very tight standard might challenge employees, but might almost always
give rise to adverse variances.
Draw the attention of the class to the CIMA definitions on page 518 of the textbook
and contrast them.
▲ Preparing a standard cost
This is covered on pages 513-517 of the textbook
Emphasise that all elements of a standard cost are a standard quantity multiplied by a
standard price.
For example, a standard material cost might be 10 kg × £14 per kg = £140. The standard
labour cost might be 3 hours × £8 per hour = £24.
The 10 kg and the 3 hours are both standard quantities.
The £14 kg and the £8 per hour are both standard prices (even though as we shall see
later, the standard price for labour is usually called a standard rate).
Put a simple standard cost on the whiteboard, blackboard or overhead projector:
Direct material
Direct labour
Production overhead
Production cost
10 kg × £14
3 hours × £8
3 hours × £12
£
140
24
36
200
Ask the class where each of the six numbers in bold would have been obtained from,
and what problems might exist in getting them. Relate this to the 8 points at the bottom
of page 513 and the top of page 514 in the textbook.
220
Explain that, these days, direct labour might not be given separately. It could be merged
with production overhead to give production conversion cost, and the standard cost
would just show:
Direct material
Production conversion cost
Production cost
10 kg × £14
3 hours × £20
140
60
200
Remind the class that the term conversion cost means the cost of converting the material
into a product.
Show how a standard cost could be presented where the product is made in more than
one department or cost centre:
To make one unit of product XRP:
30 kg of material costing £13 per kg is issued to Department J
4.50 hours work is done on the product in Department J
The product is then passed to Department K
12 kg of material costing £5 per kg is added to the product
6.75 hours work is done on the product in Department K, and the product is
then finished.
Cost rates are:
Department J: £8.30 for direct labour and £10.20 for production overhead
Department K: £6.40 for direct labour and £7.60 for production overhead
The standard cost should be presented as:
Quantity
Rate Material
£
Department J
Material 30 kg
£13 kg
Labour
4.50 hrs £8.30 hr
Overhead
4.50 hrs £10.20 hr
Overhead
£
390.00
37.35
51.30
97.20
60.00
43.20
51.30
627.75
43.20
80.55
£
45.90
45.90
60.00
450.00
Total
390.00
37.35
45.90
473.25
37.35
390.00
Department K
Material 12 kg
£5 kg
Labour
6.75 hrs £6.40 hr
Overhead
6.75 hrs £7.60 hr
Labour
£
Emphasise that this is a practical presentation, because it not only shows the cost of the
product after each department’s work – for example, the cost after Department J’s
work is £473.25, and after Department K’s work it has risen to £627.75 – but it also
accumulates each cost element separately. For example direct labour in the finished
product is £80.55.
221
Compare this with the Solution to Example 2 on page 515 of the textbook.The cost is
shown after the work of each cost centre, but the cost is not accumulated by element.
However, the examiner would be happy with that Solution, and it is far superior to
that given in Note 2 on page 516.
Make sure that the students understand the differences in presentation, and why the
one on page 516 is poor.
Reminders
Standard costing is a technique concerned principally with control.
Variances are differences between actual cost and standard cost – and they should
be analysed and used by managers as the basis for prompt appropriate action.
Standard costs can be set at an ideal level or at an attainable level.
Standard costs should be presented to show the build up of cost by cost centre
or department, and possibly by cost element.
Standard costs have a number of uses. These include the valuation of stocks
and guidance in the fixing of selling prices.
222
LESSON 50
Main subject
Syllabus reference
Lesson topic
The calculation of prime cost variances
7.19 Calculate a direct material total variance
7.20 Analyse the direct material total variance to direct material price variance
and direct material usage variance
7.21 Calculate direct material price variance whether based on purchases or
on issues
7.22 Calculate a direct labour total variance
7.23 Analyse the direct labour total variance to direct labour rate variance and
direct labour efficiency variance
7.24 Understand the measure ‘standard hours of the actual output.’
Required for
Aim of the lesson
• To explain how to calculate 6 specific variances. These are:
For direct material – total, price and usage variances
For direct labour – total, rate and efficiency variances
The lesson
▲ Please note that variance interpretation is not part of this lesson.
However, begin by reminding the class that a variance means nothing in itself – it must
be interpreted and used by management to stimulate action.
Emphasise that a variance is either favourable or adverse. In this lesson, we are only
concerned with cost variances. Therefore, in this context, a variance is adverse if the
actual cost exceeds the standard cost, and favourable if the actual cost is less than the
standard cost.
Tell the class they should use F to indicate a favourable variance and A to indicate an
adverse variance.
223
▲ The direct material total variance
Emphasise that this is the difference between the standard material cost of the actual
production, and the actual material cost of the actual production.
Also emphasise that the phrases used are standard material cost, actual material cost
and actual production. There is no mention of budgeted material cost or budgeted production
because they are not relevant.
Illustrate these points with the following:
Standard material cost for one unit of product YPR
Budgeted production of YPR
Actual production of YPR
Actual material cost
£6.80
1,200 units
1,350 units
£9,390
What is the direct material total variance?
What figures do we have to choose from?
Budgeted material cost 1,200 units × £6.80
Standard material cost 1,350 units × £6.80
Actual material cost
£8,160
£9,180
£9,390
The direct material total variance is the difference between £9,390 and £9,180 = £210.
Since the actual cost exceeds the standard cost it is £210 A.
Make sure the class understands that the budgeted cost of £8,160 is irrelevant. A
common error would be to say that the direct material total variance is the difference
between the budgeted material cost of £8,160 and the actual material cost of £9,390,
i.e. £1,230A. The class must appreciate why this would be a bad error to make.
Point out that the £9,180 is sometimes called the standard material cost of the actual
output or production.
Ask the class why this variance of £210 A has occurred. The class should suggest that
either the price of the material has changed from the standard, or the quantity of
material used has changed from the standard.
If they say that the price might have increased, you should point out that the price
might have decreased, but that the quantity of materials used has been much more
than standard, so eliminating the price savings and leaving an overall variance of £210
A.
▲ Now consider the need for further analysis of the direct material price and direct material usage
variances
Emphasise that price and usage variances are sub-variances of the total variance and
will therefore add up to the total variance, provided that the price variance is to be
based on the materials used in production. The meaning of this latter point will be
clearer later.
Ask the class what additional information they think we need to know before any subvariances can be calculated.
224
The answer is we need to know what quantity of material had an actual cost of £9,390,
and what quantity of material was needed to make each unit of YPR according to the
standard.
Now give this additional information:
Each unit of YPR needs 4 kg of material. This means that the standard price per
kg must be £1.70 so that 4 kg × £1.70 = £6.80.
The actual cost of £9,390 was for 5,300 kg of material actually used to produce
1,350 units of YPR
With this additional information we can show the class how to calculate the price and
usage variances. But first, ask how the £9,390 for the 5,300 kg of materials used has
been obtained. Where has the figure come from? Give the class a few moments to
think about this.
Usually, they will fail to relate this question to earlier work.
The answer is:
1
If JIT purchasing is in use, then £9,390 will be the total of the supplier’s invoices
for the 5,300 kg delivered for immediate use in production, i.e. because no stocks
are carried, then kgs purchased = kgs used.
2
If the material is purchased and carried in stock, then £9,390 will be the total cost
of the 5,300 kg issued from stock to work-in-progress. The £9,390 will have been
arrived at using the pricing method adopted by the company. It might be FIFO,
LIFO, average etc.
▲ You should now explain the calculation of price and usage variances.
Price variance
This compares the standard cost of the materials used in production with the actual
cost of the materials used in production. When calculating this variance the number of units
of YPR produced is not relevant.
How much material has been used? Answer 5,300 kg
What should this have cost? Answer 5,300 × £1.70 = £9,010
What did it cost? Answer £9,390
The material price variance is therefore £9,390 – £9,010 = £380 A.
Emphasise the warning given in Note 2 on page 522 of the textbook, with regard to an
unsatisfactory method of calculation. Here it would mean the actual cost per kg was
£9,390/5,300 kg = £1.77 (This is how the student normally rounds the figure!) The
price variance is then given as (£1.77 – £1.70) × 5,300 kg = £371 A This is incorrect!
Usage variance
Make sure your students know the correct spelling: usage not useage.
This variance is calculated by comparing the standard material usage for the actual
production with the actual usage, and multiplying the difference by the standard price.
225
How much material should have been used for the actual production of YPR? Answer
1,350 units × 4 kg = 5,400 kg
How much material was actually used to make 1,350 units of YPR? Answer 5,300 kg
We have therefore used 100 kg fewer than standard. This has saved us 100 kg × £1.70
= £170.
This is the usage variance and it is favourable.
Because both the price variance and the usage variance have been based upon the
materials issued, they should add up to the material total variance calculated earlier.
Thus, price £380 A and usage £170F, add up to £210 A, which agrees with the material
total variance calculated earlier.
▲ The direct labour total variance
Emphasise that this variance is the difference between the standard direct labour cost
of the actual production and the actual direct labour cost of the actual production.
As with direct material, the budgeted direct labour cost is irrelevant.
Use these figures to illustrate the direct labour variances:
Budgeted output of product YPR
Standard direct labour cost 5 hours × £8.20
Budgeted direct labour cost
Actual output of product YPR
Actual direct labour hours
Actual direct labour cost
1,200 units
£41
£49,200
1,350 units
6,300 hours
£52,200
After giving this information to the class, tell them that the principles to be applied to
labour variances are identical to those applied to material variances:
There are 3 labour variances, just as there were 3 material variances.
There is a direct labour total variance, and this subdivides to two other variances: the
labour rate variance, corresponding to the material price variance; and the labour efficiency
– or productivity – variance, corresponding to the material usage variance.
Ask the class to try to calculate the 3 labour variances by applying the same principles
as those used to calculate the 3 material variances.
What should they have done?
Direct labour total variance
Standard labour cost of actual output 1,350 × £41
Actual labour cost of actual output
Direct labour rate variance
Actual hours at standard rate 6,300 × £8.20
Actual labour cost
226
£
55,350
52,200
3,150 F
£
51,660
52,200
540 A
Direct labour efficiency variance
Standard labour cost of the actual output – as above
Actual hours at standard rate – as above
£
55,350
51,660
3,690 F
▲ Tell the class that there is an expression ‘standard hours produced’ or ‘standard hours
of the actual output.’ Explain that this is the number of hours that should have been
taken, to produce the actual output of 1,350 units.
In this case it is 1,350 × 5 = 6,750 standard hours
Go on to remind the class that actually only 6,300 hours were needed. This saved 450
hours which at the standard rate of £8.20 meant £3,690 labour cost saved. This shows
another way of calculating the labour efficiency or productivity variance.
▲ Only continue when you feel that all students understand how to calculate each of the
6 variances covered. You should emphasise the word ‘understand’. Sometimes a
question may be asked which gives variances and asks the candidate to work back to
the standard cost. Such questions present a real test of understanding, not because
they are particularly difficult, but because the approach is unusual.
For example:
In Period 9, a department produced 365 units of a product. The actual material
cost was £4,768.
A price variance of £298 A occurred on the issue of the 1,490 kg of material
used from stock. A total of 30 kg of material were used in excess of standard.
Prepare the standard material cost card for the product.
If the actual material cost was £4,768 and the price variance was £298 A, we can deduce
that £4,470 was the standard cost of the actual material used.
1,490 kg were used, so the standard cost per kilogram must have been £4,470/1,490 =
£3 per kilogram.
The 30 kg of excess material (the usage variance) indicates that 1,490 – 30 = 1,460 kg
should have been used. For 365 units, this is 4 kg per unit.
The standard cost card is therefore 4 kg × £3 = £12 per unit.
▲ For a similar example, take the class through Question 2 on page 532. The Solution
appears on page 535 of the textbook.
▲ Now consider material price variance based upon purchases instead of upon issues
from stock. This is explained on pages 524-526 of the textbook under ‘Material price
variance: issue or purchase?’.
Remind the class that the price variance calculated earlier compared the actual materials
used from stock at standard price, with the actual materials used from stock at actual
price. We emphasised that this actual cost could be based upon FIFO, LIFO, average
or any other pricing method.
227
There is a way around the bother of actual issue pricing, and that is to keep all material
stocks at standard. To do this the material price variance must be immediately calculated
when materials are purchased.
Use the following information to illustrate this:
Standard material per unit of product HYT
Standard price per kg of material
Purchases of material 20,000 kg for £78,200
Output of HYT
Material used
2 kg
£4
5,400 units
10,950 kg
A direct material total variance cannot be calculated, as price must be based on materials purchased,
whereas usage must be based on materials used.
Price variance
Standard cost of purchases 20,000 kg × £4
Actual cost of purchases
Usage variance
Standard usage of material 5,400 × 2 kg
Actual usage of material
Excess usage
at standard price
£
80,000
78,200
1,800 F
£
10,800
10,950
150
£4
600 A
Reminders
For Second Level candidates, 3 material variances and 3 labour variances must
be known.
For material, there is a total variance which can be subdivided to price and to
usage, except when the price variance is based upon purchases.
If the examiner says so, the price variance can be based on purchases, and stocks
of unused material will then be valued at standard.
For labour, there is a total variance which can be subdivided to rate and efficiency
(or productivity).
The expression ‘standard hours produced’ must be understood.
Variances may be given in some questions; candidates must be able to use them
to work back to other basic information.
Give the class plenty of practice by making up your own short questions using different
figures.
228
LESSON 51
Main subject
Syllabus reference
Lesson topics
Accounting entries for actual costs, standard costs, and variances
Elementary variance interpretation
7.25 Make accounting entries for standard prime costs and prime cost variances
in an integrated accounting system
7.26 Make simple interpretations of prime cost variances
Required for
Aims of the lesson
To explain how to make entries in the integrated ledger to record standard prime
costs, actual prime costs and variances
To encourage students to suggest simple explanations for specific prime cost
variances
Note: In itself, this is a comparatively short lesson, particularly in comparison to
Lesson 50. You may find that some of Lesson 50 will run over into this lesson,
or that time is available for some revision of the material in Lessons 49 and 50.
The lesson
▲ Second Level candidates are only concerned with integrated accounting systems. This
topic will be dealt with more fully in Lessons 55, 56 and 57, which relate to Chapter
19. This lesson is only concerned with a few of the accounts in the ledger system.
First introduce materials.
Remind the class that materials are purchased, are stocked, and then are issued to be
used in production. The output achieved from a given amount of material issued to
production may, or may not, be in line with standard.
229
Also remind the class that materials may be carried in stock at standard cost (in which
case the price variance is removed on purchase) or at actual cost (in which case the
price variance is removed a bit at a time as the materials are used).
Begin with the following example:
2,400 kg of Material X is purchased on credit for £12,480 in March Year 9.
No stock of Material X existed prior to this purchase.
At the start of Year 9, the standard price for Material X was set at £5 per kg.
Tell the class that the recording of this transaction will be in ‘T’ account form so that
the debit and credit entries are clear.
▲ First, show the entries if the price variance is taken on purchase:
Suppliers account
Material stock
Suppliers account
Material stock account
£
12,000
Suppliers account
Price variance account
£
480
£
12,480
Emphasise that the debits of £12,000 + £480 equal the credit of £12,480. Also, that the
entry in the material stock account is at standard price, i.e. 2,400 kg × £5 = £12,000.
Emphasise that the price variance is adverse and that it is a debit on the variance account.
This means that if the price variance account was given by the examiner, the candidate
must immediately recognise the £480 as an adverse variance, simply because it is a debit
on the variance account
▲ Next, show the entries if the price variance is to be taken on issue (use) of the materials:
Suppliers account
Material stock
Suppliers account
£
12,480
£
12,480
Explain that the stock is now carried in the material stock account at actual cost, and
that no variance account will be needed until some of the material is used.
230
Make sure the class understands that it is a matter of debate as to when the variance is
recognised in accounting terms. In the first illustration the price variance is recognised
when the materials are purchased. In the second illustration the price variance will be
recognised a bit at a time as the material is used.
▲ Issues of material to production
Explain that the account to record production activities will be the work-in-progress
account.
Suppose that 1,800 kg of the material is issued to production in April to make 450
units of a product. That is, according to the standard product cost 4 kg of material
should make 1 unit of product.
In the first illustration, the material is held in stock at £5 per kg because the price
variance was removed at the moment of purchase.
Explain that because of this the 1,800 kg must now be issued at standard price, making
£9,000. This is credited to material stock and debited to work-in-progress:
£
Suppliers account
12,000
Work-in-progress
£
9,000
Work-in-progress
£
Material stock
9,000
Remind the class that in the second illustration, the material is held in stock at its
actual cost of £5.20 per kg, (£12,480/2,400 kg).
The price variance of £0.20 per kg must be removed from the material stock account
for the kilograms issued to work-in-progress. This is 1,800 kg × £0.20 = £360. This is
an adverse price variance. The entries are:
Suppliers account
£
12,480
Material stock
Work-in-progress
£
9,000
Material stock
Price variance
£
360
Work-in-progress
Price variance
£
9,000
360
Ask the class to explain the balance on the material stock account. The balance is
£3,120 i.e. 12480 – (9000 + 360). There are 2,400 – 1,800 = 600 kg of material left.
These were purchased for £5.20 per kg, and 600 × £5.20 = £3,120.
231
▲The usage variance
Explain that this variance will only be known when production is complete and we see
how many units of product have actually been made with the 1,800 kg of material
issued. Remind the class that 1,800 kg should have made 450 units of product.
Now tell the class that the production records show that only 440 units of product
have been made from the material issued.
Ask the class to calculate the material usage variance.
The answer given should be £200 A. If a student says the usage variance is £200, say,
‘No, that is not correct. It is only correct if given as £200 Adverse’.
440 units should only have needed 1,760 kg of material, but 1,800 kg have been used.
This wastage of 40 kg is costed at standard price, i.e. £5 per kg.
This is credited to work-in-progress, along with the standard cost of the good finished
output. The standard cost for 1 unit of product is 4 kg × £5 = £20. The standard cost
of 440 units is therefore £8,800. The entries are:
Work-in-progress
Material stock
Work-in-progress
£
9,000
_____
9,000
Finished stock
Usage variance
£
8,800
200
9,000
Usage variance account
£
200
Finished stock account
£
Work-in-progress 8,800
Remind the class, once more, that the usage variance is an adverse variance, and this
has correctly ended up as a debit balance on the variance account.
▲ Now teach the entries for wages, which are more straightforward than those for materials.
Remind the class that the amount of wages paid for output will come from the payroll
analysis.
In line with the answer to Example 10 (b) on page 530 of the textbook, the work-inprogress account will be debited with the actual direct labour cost, and all labour
variances will come out of work-in-progress.
232
Tell the class that in a particular month, we have only made one type of product, for
which the standard labour cost is 6 hours × £8 hour = £48 per unit.
130 units were made in 750 hours for which the labour cost was £6,180.
Ask the class to calculate the labour variances. They should get:
Total: (130 units × £48) – £6,180 = £60 F
Rate: (750 hours × £8) – £6,180 = £180 A
Efficiency: (130 units × 6 hrs) – 750 = 30 hours × £8 = £240 F
If the class can remember the rule about variance postings they should be able to
suggest the entries needed. They are:
Wages payable
(See textbook p 592)
Efficiency variance
Work-in-progress
£
6,180
240
6,420
Work-in-progress
£
6,240
Work-in-progress
Rate variance account
£
180
Finished stock
Rate variance
£
6,240
180
6,420
Efficiency variance account
Work-in-progress
£
240
▲ Elementary prime cost variance interpretation
Ask the class to briefly discuss, and then reply to, the following questions:
Question: If, month after month, all variances are adverse, what does this suggest?
Answer: It suggests that the standard cost has been prepared as an ideal standard, which
is therefore impossible to achieve.
Question: If a material price variance is adverse, what could be the reason?
Answers: The material is in short supply, which has caused the market price to rise.
Smaller quantities have been purchased each time causing the loss of quantity discounts.
It has been necessary to change the supplier, and less favourable terms apply. The
customer has specified a substitute material which is more expensive.
233
Question: If a material usage variance is adverse, what could be the reason?
Answers: If it is a natural material, for example, timber, the material supplied may be of
a poorer quality. The production equipment could have broken down causing a loss of
material. Trainee operatives may be more wasteful with material than would be the
case with experienced operatives.
Question: If a labour rate variance is adverse, what could be the reason?
Answers: A scarcity of skilled labour could have caused the market rate of pay to rise. A
more expensive grade of labour might have been used in a particular period. If overtime
premium is treated as part of direct labour cost, then expensive weekend working
could increase the average hourly rate of pay.
Question: If a labour efficiency variance is adverse, what could be the reason?
Answers: Poor supervision. A difficult job or difficult materials to work with, meaning
slower working is necessary. Difficulties with equipment.
Question: Can any of these variances be inter-related?
Answer: Yes. For example, the buyer may find a cheaper source of supply for materials,
resulting in a favourable material price variance. However, the materials may be of a
lower quality, and cause production difficulties which could result in adverse variances
on both material usage and labour efficiency.
Reminders
Students should feel ‘comfortable’ about the book-keeping aspects of variance
accounting.
Adverse variances must be debit entries on the variance accounts. Favourable
variances will be credit entries on the variance accounts.
Students should be imaginative in trying to suggest why particular variances
might have occurred, and to recognise possible inter-relationships, for example,
the effect of purchasing poorer quality material at a lower price.
234
LESSON 52
Main subject
Syllabus reference
Third Level
4
Variance accounting
Comprehensive sales and production cost variance analysis, including mixture
variances
Lesson topic
Analysis of material usage and labour efficiency variances
4.33 Calculate ratios of production volume, efficiency or productivity, and
capacity
4.43 Analyse the material usage variance to material mix variance and material
yield variance
4.44 Understand the effect of losses and scrap on the usage variance and its
analysis
4.46 Understand the effect of idle time treatment on labour variances
Required for
Aim of the lesson
• To explain the sub-variances of the material usage variance and of the labour
efficiency variance
The lesson
▲ Remind the class that they should already know how to calculate a material usage
variance. The calculation is always based upon standard price. For example, if the
standard material cost per unit of output is 4 kg × £3 kg = £12, and 1,520 units of
output are made using 6,190 kg of material, then the usage variance is 110 kg × £3 =
£330 A.
Point out that because only one material is used in the manufacture of this product,
there can be no further sub-division of the usage variance.
235
▲ Once you are satisfied that the class is competent at calculating total, price and usage
variance, you can introduce material mix variance.
By definition, material mix variance can only arise when more than one material is
combined to make a product, and where the proportion of each material can be varied
without unacceptably affecting the quality of the product.
As an example, point out that a motor car is assembled from many different parts, but
mix doesn’t arise because an extra wheel cannot be substituted for a battery!
Emphasise at the start that mix is a variance of input. We do not need to know output
figures to calculate it.
Start with this example:
Standard cost to produce a chemical product, XM.
Material A
Material B
tonnes
60
40
100
price/tonne
£900
£900
£
54,000
36,000
90,000
In Period 9, 300 tonnes of A and 240 tonnes of B are used.
Ask the class to calculate the mix variance.
Material A
Material B
Std mix
tonnes
324
216
540
Act mix
tonnes
300
240
540
Variance
tonnes
( 24 )
24
Std price
£900
£900
Mix var.
£
21,600 F
21,600 A
Nil
Point out to the class that:
1
The overall mix variance is Nil. This is only because both materials, A and B,
have a standard cost of £900 per tonne.
2
No information was given on whether any loss of material was expected in
production – i.e. whether 100 tonnes of product XM arises from 100 tonnes of
input materials. This information was not required to calculate a mix variance!
3
No information was given on the actual production of XM. This information
was not required to calculate a mix variance.
Now tell the class that you are changing the standard price of material B to £750.
Everything else remains the same.
Immediately we know that there will be a mix variance!
Material A
Material B
236
Std mix
tonnes
324
216
Act mix
tonnes
300
240
Variance
tonnes
(24)
24
Std price
£900
£750
Mix var.
£
21,600 F
18,000 A
3,600 F
Ask the class why the change in mix might have occurred, and whether it is good for
the business.
It might have occurred because of a shortage of Material A. The company might have
had no choice. Material B has been substituted for Material A.
It seems to be good for the business. Favourable variances are welcomed. They increase
profits. But we need to know more:
The change in material mix could have affected the output, and this is a figure which
we haven’t got. The change could also have affected the quality of the output.
Emphasise that up to this point, the mix variance was calculated using 60/40 as the
standard mix i.e. it was based on the standard quantity, the mix of tonnes.
Tell the class that another approach is where materials are mixed in a standard batch
size. For example, in a bakery this could be be a mix of dough, from which a certain
number of loaves should be made.
To use another example, the examiner might say that 200 litres of X at a standard price
of £60 per litre and 40 kg of Y, at a standard price of £200 per kg, is considered to be a
standard batch. He might also say that the 1,900 litres of X and 420 kg of Y was the
actual material used for 10 batches.
It seems as if less of X has been used in relation to Y. Perhaps Material Y was not as dry
as normal when purchased, and required less of the liquid, Material X, to make the
mix ready for production.
The mix variance can be calculated as follows:
Standard cost of 1 batch:
Material X
Material Y
£
12,000
8,000
20,000
Standard cost of 10 batches:
Material X
Material Y
£
120,000
80,000
200,000
Standard cost of materials used:
Material X 1,900 litres × £60 litre
Material Y 420 kg × £200 kg
£
114,000
84,000
198,000
Therefore, mix variance:
Material X
Material Y
£
6,000 F
4,000 A
2,000 F
237
Before continuing, emphasise to the class that these mix variances have all been
calculated with no information on the actual cost of the material used, nor on the
output of product made with the materials. This information is not needed to calculate
a material mix variance.
▲ Now go through Examples 1 and 2 with the class. These are on pages 538-540 of the
textbook.
▲ Now introduce the calculation of the material yield variance. Tell the class that it is a subvariance of the material usage variance. Tell them, also, that it measures the relationship
between the total input of materials and the output of product.
Use the following data for this part of your lesson:
To make 1 tonne of product YT4, the standard cost is:
Material S
Material T
Tonnes
0.60
0.40
1.00
Std price
£120
£300
£
72
120
192
9.5 tonnes of YT4 were made, using:
5.8 tonnes of material S at a cost of £710, and
4.0 tonnes of material T at a cost of £1,179.
First, ask the class to calculate the total, price and usage variances.
Total (9.5 × £192) – (£710 + £1,179) = £65 A
Price S (5.8 × £120) – £710 = £14 A
Price T (4 × £300) – £1,179 = £21 F
Usage (9.5 × £192) – ((5.8 × £120) + (4 × £300)) = £72 A
Now work through the material mix variance with the class.
Total material input was 5.8 + 4 = 9.8 tonnes
60% should be S = 5.88 tonnes
40% should be T = 3.92 tonnes
Therefore mix variance:
S = (5.88 – 5.80) × £120 = £9.6 F
T = (3.92 – 4.00) × £300 = £24 A
Overall mix variance = £14.4 A
Emphasise again that for the mix variance, we weren’t concerned with output. But for
yield variance we are!
What should the output have been from 9.8 tonnes of input? The answer is 9.8 tonnes
of YT4, because the standard did not allow for any loss of material.
238
What was the output from 9.8 tonnes of input? The answer is 9.5 tonnes of YT4.
The yield variance is 9.8 tonnes – 9.5 tonnes = 0.3 tonnes.
In value the loss of output is 0.3 tonnes × £192 per tonne (from the standard). This is
£57.6 A.
Emphasise to the class that the mix variance of £14.4 A and the yield variance of £57.6
A adds up to £72 A, and this agrees with the usage variance.
Point out that no attempt should be made to calculate the yield variance separately for
material S and material T. It would have no meaning. Yield variance measures the gain
or loss of production – and we produce YT4, not Material S and Material T.
Point out, also, that if the material mix variance is calculated differently – for example,
on batches, then the calculation of the yield variance will be different.
Suppose that we look at the earlier example:
Material X
Material Y
200 litres
40 kgs
£60
£200
£
12,000
8,000
20,000
and suppose that we now say that this 1 batch should produce 25 kg of finished product,
and that the output of finished product from the 10 batches referred to earlier was 240
kg.
Ask the class what the material usage variance would be. The answer should be:
(240 kg × £800) – £198,000 (earlier calculation) = £6,000 A.
Point out that earlier, using the batch approach, the mix variance was calculated as
£2,000 F.
Tell the class that the yield variance is calculated as:
1 batch should produce 25 kg of output.
Therefore, 10 batches should produce 250 kg of output.
Actual output was 240 kg.
Therefore, the shortfall was 10 kg, which × £800, is £8,000 A.
The mix variance £2,000 F + yield variance £8,000 A = £6,000 A, which agrees with
the usage variance.
▲ Now take the class through Examples 3, 4, 5, and 6 on pages 541-549 of the textbook.
Give particular attention to Examples 5 and 6 which also illustrate variances relating to
losses.
▲ Finally, remind the class that when interpreting the meaning of variances, interrelationships must be considered. A mix variance may be favourable if a greater
proportion of cheaper material has been used. However, this may cause a fall in output,
giving an adverse yield variance which is greater than the favourable mix variance.
239
▲ With regard to direct labour variances, remind the class that they have already studied
the calculation of total, rate and efficiency variance.
▲ Point out that Examples 7 and 8 on pages 550-551are concerned with the effect of idle
time on the calculation of the efficiency variance.
Reminders
Material mix and material yield variances are sub-variances of the material usage
variance.
A material mix variance can be calculated for each input material.
The calculation of mix variances require no information on output.
The material yield variance looks at output in relation to input. It is not calculated
for each input material.
If idle time is treated as part of direct labour cost, it must be removed before
(pure) efficiency is measured.
240
LESSON 53
Main subject
Syllabus reference
Third Level
4
Variance accounting
variances
Lesson topic
Overhead variances
4.33 Calculate ratios of production volume, efficiency or productivity, and
capacity
4.47 Calculate the total variable overhead variance and analyse this to variable
overhead expenditure variance and variable overhead efficiency variance
4.48 Calculate the total fixed overhead variance and analyse this to fixed
overhead expenditure variance, and, where using absorption costing, to
fixed overhead volume variance
4.49 Analyse the fixed overhead volume variance to fixed overhead efficiency
variance and fixed overhead capacity variance
4.50 Understand how a budgeted fixed overhead volume variance can arise
4.51 Explain each variance in simple terms
4.52 Understand the importance of cumulative variance, trend of variance etc
4.53 Suggest possible inter-relationships between variances
Required for
Aim of the lesson
• To explain how overhead variances are calculated and interpreted
The lesson
▲ Begin by telling the class that overhead variances are not part of the Second Level
syllabus. Therefore this lesson assumes no prior knowledge.
Explain that the lesson will first consider variable overhead variances, and will then
consider fixed overhead variances.
241
Remind the class that overhead is incurred by a cost centre and not by a product.
Overhead is absorbed into a product cost on a pre-determined method based on budgets.
The one-product firm is quite rare in practice, although common in examinations.
Nevertheless, overhead must always be thought of as indirect costs, although in the
single-product firm it is incurred because of the one product.
Now ask the class to tell you the meaning of variable overhead.
They should reply that it is a term which covers those items on which more is spent as
output increases. Double the output and the spending on those items will double.
Give the class this product cost:
Direct material 3 kg × £12 kg
Direct labour 2 hrs × £8 hr
Prime cost
Variable overhead
£
36
16
52
9
61
Suppose that we are told that 620 units of this product have been made (no other
product is made), and £5,930 of variable overhead was incurred.
Point out to the class that it says that £9 should be spent on variable overhead for every
unit of product made.
Like any total variance, the total variable overhead variance is:
Standard cost for the output 620 × £9
Actual cost
£
5,580
5,930
350 A
Point out that no further analysis is possible and that this is also the variable overhead
expenditure variance.
Now point out that a cost can be variable, but may not vary with output.
For example, electricity varies with machine hours. The more machine hours that are
operated, the greater the amount that will be spent on electricity. There may be a close
link between machine hours and output. However, it is quite possible for machines to
be running but not producing output.
If the class find this difficult to understand, use the illustration of a motor car. We have
a motor car to take us from one place to another and this uses petrol. However, a car
engine can be running, and using petrol, but the car may be stationary, and not taking
us anywhere. It may be caught in a traffic jam! Petrol – a variable cost of motoring – is
being incurred, but the cost is being used inefficiently. It is not producing output.
242
Tell the class that the standard cost is now being changed slightly. It becomes:
£
36
16
52
9
61
Prime cost
Variable overhead 2 hrs × £4.50
Point out the difference. It now says that every direct labour hour worked should
incur variable overhead cost of £4.50, and that because it should take 2 hrs to make the
product, £9 is absorbed into the standard cost of the product.
Suppose we are now told that 620 products were made, 1,280 direct labour hours were
used, and £5,930 of variable overhead was incurred. Point out that the only additional
information is that 1,280 direct labour hours have been used.
Now show the class what the variances become:
Variable overhead total variance
Calculated exactly as before
£
350 A
Variable overhead expenditure variance
The allowed cost is 1,280 hrs × £4.50 =
Actual cost
Variable overhead efficiency variance
Standard hours 620 × 2 =
1,240
1,280
Actual hours
Excess hours
40
× £4.50
5,760
5,930
170 A
ooo
180 A
Point out to the class that the expenditure variance of £170 A and the efficiency variance
of £180 A add up to the total variance of £350 A. It would also be worth asking the class
to calculate the direct labour efficiency variance (£320 A), so that they can understand
the relationship between the efficiency variances.
Finally, explain that it only really makes sense to consider variable overhead in a multiproduct environment. However, the principle can be illustrated with 2 products, as
follows:
Product
Prime cost
Variable overhead:
4 hrs × £7
3 hrs × £7
A
£
40
B
£
60
28
ooo
68
21
81
243
Tell the class that in Period 3:
2,200 units of product A and 1,100 units of product B, were made.
12,500 hours were worked and £86,450 of variable overhead was incurred.
Take the class carefully through the variances:
Variable overhead total variance
Standard cost (2,200 × £28) + (1,100 × £21) =
Actual cost
Variable overhead expenditure
Allowed cost 12,500 × £7
Actual cost
Variable overhead efficiency
Standard hrs (2,200 × 4) + (1,100 × 3) = 12,100
Actual hrs
12,500
Excess hrs
400
× £7
£
84,700
86,450
1,750 A
£
87,500
86,450
1,050 F
£
2,800 A
Again, point out that the expenditure and efficiency variances add up to the total
variance.
▲ Now take the class through Example 9 on pages 552-554 of the textbook. Note the
reference to the efficiency ratio and its relationship with the efficiency variance.
Students often experience difficulties with overhead variances. You may wish to stop
at this point and work through the next section (fixed overhead variances) in another
lesson, after the class has practised and become familiar with variable overhead variances.
▲ Fixed overhead variances.
Refer to the CIMA definition of a fixed cost on page 554 of the textbook. Emphasise
that this introduces the simplest of the fixed overhead variances – the fixed overhead
expenditure variance.
Tell the class that the question is simply, ‘How much did we budget to spend, and how
much have we actually spent?’ The difference is the fixed overhead expenditure variance.
Then tell them that if we are using marginal costing, there are no other fixed overhead
variances. This is because, under marginal costing, fixed overheads are not attributed to
products.
For this reason, fixed overhead variances other than the expenditure variance, relate
only to absorption costing. Remind the class that this means that pre-determined
absorption rates must have been established using budgeted fixed overheads and a budgeted
level of output.
244
Tell the class that you will now add fixed overhead to the earlier examples:
£
36
16
52
9
16
77
Prime cost
Variable overhead 2 hrs × £4.50 hr
Fixed overhead 2 hrs × £8hr
The £8 per hour for fixed overheads was arrived at as follows:
Budgeted output
Standard hours per unit
Budgeted (standard) hours
Budgeted fixed overhead
Fixed overhead absorption rate
800 units
2 hours
1,600 hours
£12,800
£8 hour
Now tell the class that in addition to the information given earlier, we are told that the
actual fixed overhead incurred was £12,470.
The fixed overhead total variance is:
Standard cost of the actual output
620 units × £16 =
Actual fixed overhead
£
9,920
12,470
2,550 A
Make sure the class understands that the principle being used here (to calculate this
total fixed overhead variance) is exactly the same as that used to calculate the variable
overhead total variance.
The fixed overhead total variance is £2,550 A. This is quite a large variance. This can
happen on fixed overheads, particularly if the output achieved is significantly different
to that budgeted.
▲ What does this total variance break down to?
Fixed overhead expenditure variance
Budgeted fixed overheads
Actual fixed overheads
£
12,800
12,470
330 F
Tell the class that because absorption costing is in use, there is a volume variance i.e. fixed
overheads can be under- or over-absorbed because output differs from that budgeted.
Fixed overhead volume variance
Budgeted output 800 units
Actual output 620 units
Shortfall 180 units × £16 unit
£
2,880 A
245
Point out that the volume variance £2,880 A and the expenditure variance £330 F, add
up to £2,550 A, which agrees with the total variance.
Tell the class that the volume variance could have been calculated in hours:
Standard hours (620 × 2) = 1,240
Budgeted hours 1,600
Shortfall 360 hours × £8 hour =
£2,880 A
Now take the class through Example 11 on pages 557-560 of the textbook. Again,
particularly note the ratios and how they relate to the variances.
▲ Finally, show the class that it is possible to analyse the volume variance into 2 parts –
the volume capacity variance and the volume efficiency variance.
Volume capacity
This is best worked in hours.
Budgeted hours 800 units × 2
Actual hours (given in original data)
Lost hours
× £8 per hour =
1,600
1,280
320
£2,560 A
Volume efficiency
Emphasise to the class that the calculation for this variance follows the principles used
for direct labour efficiency and variable overhead efficiency:
Standard hours
Actual hours
Excess hours
× £8 per hour =
1,240
1,280
40
320 A
Point out that the efficiency variance £320 A and the capacity variance £2,560 A add up
to £2,880 A which agrees with the volume variance.
▲ Take the class through the remainder of the Solution to Example 11 on pages 560-562
of the textbook.
▲ Finally, take the class through the important Examples 12, 13 and 14 on pages 562-568.
246
Reminders
There are only 2 sub-variances for variable overhead: expenditure and efficiency.
The latter occurs when overheads vary with any factor other than output.
There are 2 sub-variances for fixed overhead: expenditure and volume. The
latter can only occur in absorption costing.
There are 2 sub-variances of the sub-variance volume: volume capacity and
volume efficiency. Volume capacity can be quite a large variance, because it is
possible for actual output to be significantly different from budgeted output.
247
LESSON 54
Main subject
Syllabus reference
Third Level
4
Variance accounting
variances
Lesson topic
Sales variances, cost variances and profit variances
4.39 Compare budgeted profit with actual profit to establish the profit variance
– whether using absorption costing or marginal costing
4.40 Calculate how much of the profit variance is due to selling price variance
and sales volume profit or contribution variance
Further analysis of the sales volume variance to mix and quantity will
not be required
Required for
Aims of the lesson
• To explain sales variances and their impact on profit
• To reconcile budgeted and actual profit
The lesson
▲ Begin by explaining that a company – which will make one product – has set its standard
cost per unit for Year 1, its first year of trading, as:
Direct labour 5 hours × £8 hr
Variable overhead 5 hours × £2
Fixed overhead 5 hours × £7
£
27
40
10
35
112
All of the costs are production costs. The firm will not incur any Administration or
Selling & Distribution costs.
248
In its first year it plans to make and sell 4,000 units. The selling price is expected to be
£120 per unit.
Point out that the budgeted gross profit (i.e. before administration, selling and
distribution overheads) is easily obtained as 4,000 × (£120 – £112) = £32,000.
Now ask the class why, at the end of Year 1, the company might find that it has not
made a profit of £32,000.
Their replies should include:
1
Material cost more than £9 per kg.
2
More than 3 kg of material has been used to make each unit of product.
3
More than £8 per hour has been paid to direct labour.
4
More than 5 hours has been needed to make each unit of product.
5
More than £2 has been spent on variable overhead for each hour worked.
6
More has been spent on fixed overhead than the £140,000 budgeted.
7
Fewer units might have been produced than budgeted.
Point out to the class that these are the points that should have occurred to them as a
result of their standard costing studies so far.
The 7 points made can all be identified with adverse cost variances. Any of them could
have been favourable, of course. For example, the company might have been able to
purchase material for less than £9 kg.
▲ Now (if they have not already been mentioned) introduce the sales variances:
1
The product might have been sold at a price below £120 unit.
2
Fewer than 4,000 units might have been sold.
Emphasise at this point that if budgeted and actual profits disagree, the difference will
be explained by both cost variances and sales variances.
To illustrate this, now tell the class that in Year 1:
3,800 units were made and sold.
The actual sales were £454,000.
11,700 kg of material were used at a cost of £104,800.
Direct labour worked 19,200 hours and were paid £152,700.
Variable overheads incurred were £38,090.
Fixed overheads incurred were £138,800.
Point out that because 3,800 units were made and sold there was no stock at the year
end. Because of this, cost of sales is the same as cost of production.
Therefore, the actual profit for Year 1 is simply £454,000 – (£104,800 + £152,700 +
£38,090 + £138,800) = £19,610.
The profit variance is the budgeted profit minus the actual profit, which is £32,000 –
£19,610 = £12,390 A.
249
This adverse variance must be explained by cost variances and sales variances.
▲ Ask the class to calculate the cost variances. This will give them some revision. Their
answers should be:
£
Material price (11,700 × £9) – £104,800
Material usage ((3,800 × 3) – 11,700) × £9
Labour rate (19,200 × £8) – £152,700
Labour efficiency ((3,800 × 5) – 19,200) × £8
Variable overhead expenditure (19,200 × £2) – £38,090
Variable overhead efficiency 200 excess hours × £2
Fixed overhead expenditure £140,000 – £138,800
Fixed overhead volume (4,000 – 3,800) × £35
500 F
2,700 A
900
1,600 A
310 F
400 A
1,200 F
7,000 A
F
The volume variance can then be analysed to:
£
5,600 A
1,400 A
Volume capacity (20,000 – 19,200) × £7
Volume efficiency 200 excess hours × £7
▲ Now explain the sales variances to the class.
There is a selling price variance. This is because the 3,800 units sold should have
produced a revenue of 3,800 × £120 = £456,000, but the actual revenue was £454,000.
Therefore, selling price variance is £2,000 A
There is a sales volume profit variance.
This is (4,000 – 3,800) × (£120 – £112) = £1,600 A
▲ Now summarise the variances to reconcile the budgeted and actual profit.
£
Budgeted profit
Favourable variances:
Material price
Labour rate
Variable overhead expenditure
Fixed overhead expenditure
Adverse variances:
Material usage
Labour efficiency
Variable overhead efficiency
Volume efficiency
Volume capacity
Selling price
Sales volume profit
Actual profit
250
500
900
310
1,200
2,700
1,600
400
1,400
5,600
2,000
1,600
£
32,000
2,910
34,910
15,300
19,610
▲ Now take the class through Example 15 on pages 569 – 570 of the textbook.
▲ Next, tell the class that for Year 2, the standard cost will not be changed. The budget
for Year 2 is to make and sell 4,000 units.
When the actual results for Year 2 were summarised, 3,900 units had been made, but
only 3,750 units had been sold, for £451,000. The actual costs of production totalled
£441,070.
Ask the class to tell you the budgeted profit for Year 2.
Their answer should be £32,000 because it must be the same as the budgeted profit for
Year 1.
Now ask them what the actual profit is for Year 2.
The answer is:
£
Sales
Actual costs
Less stock (3,900 – 3,750) × £112
Profit
441,070
16,800
£
451,000
424,270
26,730
Hopefully, no-one gave £9,930 as the answer. If they did, you should remind them that
the revenue from 3,750 units cannot be set against the cost of 3,900 units. Stocks must
be valued, and when standard costing is in use, stocks are always valued at standard.
The profit variance is £32,000 – £26,730 = £5,270 A
What has caused this? It is not possible to analyse cost variances for Year 2, because no
detail is given, such as material used, hours worked, etc.
The total cost variance is:
Standard cost of production 3,900 × £112
Actual cost
Variance
£
436,800
441,070
4,270 A
Point out that there is one variance within this figure that can be calculated: the fixed
overhead volume variance.
Fixed overhead variance
(4,000 – 3,900) × £35 =
3,500 A
No other detailed cost variances can be calculated.
What about the sales variances?
Selling price variance
(3,750 × £120) – £451,000 =
1,000 F
Sales volume profit variance
(4,000 – 3,750) × (£120 – £112) =
2,000 A
251
The reconciliation is:
£
32,000
Budgeted profit
Selling price variance
Sales volume profit variance
1,000 F
2,000 A
Cost variances
Actual profit
1,000 A
31,000
4,270 A
26,730
Now point out that the actual profit could have been presented in a different way from
that used earlier:
Sales
Less standard cost of sales
Standard profit
Less cost variances
Actual profit
£
451,000
420,000
31,000
4,270 A
26,730
3,750 × £112
Make sure that the class understands why this presentation gives the same result,
particularly as there is no mention of selling price variance and sales volume profit
variance.
▲ Now take the class carefully through Example 16 on pages 571-573 of the textbook.
▲ Finally, ask the class to consider how the answer would have differed if the company
had decided to give up absorption costing, and use marginal costing from the start of Year
2.
One additional bit of information is needed: the actual costs in Year 2. These comprised
£301,870 variable and £139,200 fixed, making the £441,070 in total.
The first point to note is that the budgeted profit for Year 2 would still have been
£32,000. This is because there was no opening stock, and no budgeted closing stock –
because the plan was to make and sell 4,000 units.
However, the actual profit will be different.
Sales
Actual variable costs
Less stock (3,900 – 3,750) × £77
Contribution
Actual fixed costs
Actual profit
£
451,000
301,870
11,550
The profit variance is now £32,000 – £21,480 =
252
290,320
160,680
139,200
21,480
10,520 A
This is explained by:
Variable production cost variance:
(3,900 × £77) – £301,870 =
Fixed overhead expenditure £140,000 – £139,200
Selling price – as before
Sales volume contribution variance:
(4,000 – 3,750) × (£120 – £77) =
1,570 A
800 F
1,000 F
10,750 A
10,520 A
Make sure that the class understands the difference between the absorption and marginal
costing solutions.
Reminders
Sales variances reflect the difference between the planned and actual selling
price of products, and the change in gross profit caused by selling fewer or
more units than planned.
The overall profit variance is caused by a combination of sales variances and of
cost variances.
253
LESSON 55
Main subject
Costing systems (1)
Syllabus reference
Second Level
8
Costing systems
Simple examples of integrated accounting systems. Basic understanding of
uniform costing
Lesson topic
An introduction to integrated accounting systems (1)
8.1
8.2
Understand the nature and function of an integrated accounting system
Understand the function and operation of control accounts, particularly
for material stocks, work-in- progress stocks, finished stocks and
production overheads
Required for
Aims of the lesson
• To describe the features of an integrated accounting system
• To reinforce the use of control accounts
The lesson
▲ Begin by pointing out that Chapter 19 is the last chapter in the textbook which is
specifically for Second Level candidates. Because of this, it uses much of the earlier
work already studied – for example, material pricing, payroll analysis, overhead incurred
and absorbed, but uses it in a context of formal accounting records.
Refer the class to the definition of integrated accounts given on page 580 of the textbook.
Emphasise each aspect of the definition:
‘a set of accounting records’ – formal, and based upon basic principles of debit and
credit.
‘provides financial and cost accounts’ – within a single system; with some compromise,
the users of both financial and cost accounts can be satisfied.
‘using a common input of data’ – the same data is used, although it may be differently
analysed; for example, under nominal headings for financial accounting, but under
cost centre headings for cost accounting.
254
Costing systems (1)
Explain that an integrated ledger can be recognised by the accounts it contains.
For example, we would see accounts for fixed assets (land, buildings, motor vehicles,
plant and machinery, etc.), for debtors and creditors, for share capital and reserves etc.
These would be seen in any set of financial accounts.
However, we would also see accounts for raw material stock, other stocks, work-inprogress, finished goods, and production, administration, selling and distribution
overheads. These are not typical of financial accounts. They are there to meet cost
accounting needs. This reflects a compromise in that the traditional financial accounts’
expense headings of rent, rates, insurance, etc. are not immediately obvious.
Ask the class, or individual members of the class, to state the debit and the credit for
each of the following transactions. For example, on the first one, simply say, ‘Purchase
of fixed assets’. The answer given should be ‘Debit, Fixed asset at cost account; Credit,
Bank or creditors’. Some answers will depend upon basic book-keeping knowledge.
Other answers will depend upon topics learned in an earlier lesson on this course.
1
2
3
4
5
6
7
Purchase of fixed assets
Debit
Fixed asset at cost account
Credit
Bank or creditors
Payments received from debtors
Debit
Bank
Credit
Debtors
Purchase of materials for stock, prior to use
Debit
Material stock
Credit
Bank or creditors
Purchase of components, delivered for production use on a Just-in-time basis
Debit
Work-in-progress
Credit
Bank or creditors
Issue of materials from stock, to production use
Debit
Work-in-progress
Credit
Material stock
Issue of materials from stock, for repair of a production machine
Debit
Production overhead
Credit
Material stock
Sales of finished output
Debit
Debtors
Credit
Sales
255
8
9
10
11
12
Payroll analysis
Debit
Work-in-progress (Direct wages)
Debit
Production overhead (Indirect wages)
Debit
Admin S & D overhead (Indirect wages)
Credit
Wages control
Production overhead absorbed
Debit
Work-in-progress
Credit
Production overhead
Payment of wages
Debit
Wages payable – net wages
Debit
Wages payable – deductions
Credit
Bank (Net wages)
Credit
Deductions creditors
Depreciation of fixed assets used in production
Debit
Production overhead
Credit
Accumulated provision for depreciation of fixed assets
Finished production delivered immediately to the customer
Debit
Cost of sales
Credit
Work-in-progress
You can make up more examples like this if you wish. It is beneficial to ask questions
like these, which require an oral answer, without reference to books, notes etc.
Emphasise that the answers contain the mix of accounts associated with integrated
accounts.
▲ Now take the class through pages 580-584 of the textbook.
▲ Finally, in this lesson, you should reinforce the nature of control accounts. Begin with
the comments near the top of page 584.
Use the Production overhead (control) account as an example.
Remind the class that it is debited with overhead incurred and credited with overhead
absorbed. The balance on the account is, then, either an under-absorption or an overabsorption of overhead.
Point out that it is a control account because it summarises the many different cost
centres that exist in the firm.
256
Costing systems (1)
To illustrate this, suppose that a firm has just 3 production cost centres. The details are,
for one month:
Cost centre
Overhead incurred
Direct labour hours
Machine hours
Process hours
Absorption basis
Absorption rate
1
2
3
£
£
£
13,200
39,450
21,600
2,400
1,600
1,680
–
3,400
–
–
–
860
Labour hrs Machine hrs Process hrs
£5.75
£10.80
£22.60
These figures provide a good opportunity for revision, before continuing with the
control account:
For example, you could ask what the term ‘Overhead incurred’ covers.
The answer is that it includes overhead allocated, and overhead apportioned, including
an apportionment of service department costs.
You could ask why there are 3 different bases of overhead absorption.
The answer is because, for each cost centre, the most appropriate method has been
used. Cost centre 1 is perhaps a hand-assembly department. Cost centre 2 clearly uses
machines. It has been decided that many of the overheads incurred relate to the
machines, so a machine hour rate is being used.
You can also point out that all 3 cost centres are using hourly rates. Remind the class that
these are generally considered better than money-based rates.
Now continue with the control account:
Cost centre
Overhead incurred
Direct labour hours
Machine hours
Process hours
Absorption basis
Absorption rate
1
2
3
£
£
£
13,200
39,450
21,600
2,400
1,600
1,680
–
3,400
–
–
–
860
Labour hrs Machine hrs Process hrs
£5.75
£10.80
£22.60
Calculate the:
Absorbed overhead
Under/(Over) absorption
£13,800
(£600)
£36,720
£2,730
£19,436
£2,164
257
Finally, show the class how the Production overhead (control) account would appear
in the integrated ledger:
Production overhead
Overhead incurred
£
74,250
Overhead absorbed
Under-absorbed
74,250
£
69,956
4,294
74,250
Emphasise that the debit of £74,250 would have corresponding credits on bank,
creditors, material stock, accumulated depreciation etc.
Show that it is the total of the overhead incurred by the 3 cost centres:
Show that the £69,956 is the total of the overhead absorbed by the 3 cost centres.
Emphasise that the absorbed overhead figure originates on each cost centre.
Finally, show that the under-absorbed £4,294 is made up of 2 under-absorptions and
an over-absorption.
▲ Now take the class through page 584 to the top of page 588.
Reminders
An integrated accounts system meets the needs of both financial accounts and
cost accounts.
This topic needs a good basic understanding of debit/credit book-keeping
principles.
Many accounts in the integrated ledger are control accounts, which summarise
detail for jobs, cost centres etc.
258
Costing systems (1)
LESSON 56
Main subject
Costing systems (1)
Syllabus reference
Second Level
8
Costing systems
uniform costing
Lesson topic
Ledger entries for integrated accounts
8.3
Make all entries in the integrated ledger to record the transactions of a
period
Required for
Aim of the lesson
• To show the preparation of a set of integrated accounts
The lesson
▲ Begin by explaining that it is not always possible, within the time available for a single
question, for the examiner to ask for a full set of accounts. For this reason, he may ask
for a selection of one or two accounts from the integrated ledger.
However, doing a full set of accounts is a good way to develop understanding of the
subject, so tell the class that this is what you are going to do.
Use the following example:
259
On 1 April Year 3 the following balances were in the integrated ledger of Simon
Jelford:
Raw material stock
Work-in-progress
Finished stock
Capital
Fixed assets at cost
Accumulated depreciation
Bank
Debtors
Creditors
£’000
12
8
9
£’000
105
90
36
14
22
155
14
155
During the year ended 31 March Year 4, the following transactions occurred
(all figures are in £’000).
1
Material purchased for stock on credit: £142
2
Material issues: £136 of which £122 was direct material, issued to workin-progress. The balance was production overhead.
3
Depreciation was provided as production overhead at 10% on the cost of
fixed assets.
4
Cash receipts during the year: £204 from customers.
5
Cash payments during the year: £136 to creditors for material purchases;
£29 for net wages; £11 for production overhead purchases.
6
£9 had been deducted from the gross wages, which were analysed to direct
wages £30 and indirect production £8
7
Production overhead was absorbed using a rate of 160% on direct labour
8
The cost of completed goods was £187
9
Sales on credit: £206
10
Cost of sales: £190
11
Cash drawings: £12
Explain that accounts must now be opened. The balances 1 April Year 3 must be entered.
Then the transactions for the year ended 31 March Year 4 must be posted, accounts
balanced, and a trial balance at the end of the year extracted.
260
£’000
1 Apr 3 Balance
Raw material stock
£’000
12
£’000
1 Apr 3 Balance
Work-in-progress
£’000
8
Costing systems (1)
Finished stock
£’000
9
1 Apr 3 Balance
£’000
Capital
£’000
1 Apr 3 Balance
£’000
90
1 Apr 3 Balance
£’000
105
£’000
£’000
1 Apr 3 Balance
£’000
36
£’000
1 Apr 3 Balance
Bank
£,000
14
£’000
1 Apr 3 Balance
Debtors
£’000
22
Creditors
£’000
1 Apr 3 Balance
£’000
14
Once the accounts have been opened and the opening balances entered, the transactions
for the year can then be entered:
1 Apr 3
31 Mar 4
1 Apr 3
31 Mar 4
Balance
Purchases
Balance
Dir material
Dir wages
O/hd absorbed
Raw material stock
£’000
12
31 Mar 4
142
Work-in-progress
£’000
8
31 Mar 4
122
30
48
WIP
Prodn O/hd
£’000
122
14
£,000
Finished stock 187
261
1 Apr 3 Balance
31 Mar 4 WIP
Finished stock
£’000
9
31 Mar 4 Cost of sales
187
Capital
£’000
1 Apr 3
1 Apr 3 Balance
Balance
£’000
90
1 Apr 3 Balance
31 Mar 4 Debtors
1 Apr 3 Balance
31 Mar 4 Sales – P&L
Debtors
£’000
22
31 Mar 4
206
31 Mar 4 Bank
31 Mar 4 Ind material
Depreciation
Ind labour
Bank
262
£’000
105
£’000
£’000
1 Apr 3 Balance
31 Mar 4 Prod O/hd
Bank
£,000
14
31 Mar 4
204
£’000
190
£’000
36
9
£’000
Creditors
136
Wages payable
29
Prodn O/hd
11
Drawings
12
Bank
£’000
204
Creditors
£’000
£’000
136 1 Apr 3 Balance
14
31 Mar 4 Mat purchases 142
Production overhead
£’000
14
31 Mar 4
9
8
11
£’000
WIP – O/hd
absorbed
48
Costing systems (1)
31 Mar 4 Bank
Deduction creditor
Wages payable
£’000
29
31 Mar 4 Wages control
9
38
£’000
38
38
Deductions creditor
£’000
£’000
31 Mar 4 Wages payable
9
Wages control
£’000
38
31 Mar 4 WIP
Prodn O/hd
38
£’000
30
8
38
31 Mar 4 Finished stock
Cost of sales
£’000
190 31 Mar 4 Profit & Loss
£’000
190
31 Mar 4 Profit and Loss
Sales
£’000
206 31 Mar 4 Debtors
£’000
206
31 Mar 4 Bank
Profit and Loss
£’000
190 31 Mar 4 Sales
Drawings
£’000
12
£’000
206
£’000
The accounts now show the opening balances and the transactions for the year.
Make sure that all of the class understand each transaction in terms of its debit/credit
entry.
You can now complete the example by balancing the accounts, and taking out a trial
balance as a test of accuracy.
263
Raw material stock
£’000
12
31 Mar 4 WIP
142
Prodn O/hd
Balance
154
18
1 Apr 3 Balance
31 Mar 4 Purchases
1 Apr 4 Balance
1 Apr 3 Balance
31 Mar 4 Dir material
Dir wages
O/hd absorbed
1 Apr 4 Balance
£’000
1 Apr 3 Balance
31 Mar 4 WIP
1 Apr 4 Balance
£’000
31 Mar 4 Drawings
Balance
1 Apr 3 Balance
£’000
264
Work-in-progress
£’000
8 31 Mar 4 Finished stock
122
Balance
30
48
208
21
Finished stock
£’000
9 31 Mar 4 Cost of sales
187
Balance
196
6
Capital
£’000
12
1 Apr 3 Balance
115 31 Mar 4 P&L net profit
127
1 Apr 4 Balance
£’000
90
£’000
1 Apr 3 Balance
31 Mar 4 Prod O/hd
£’000
122
14
18
154
£’000
187
21
208
190
6
196
105
22
127
115
£’000
36
9
45
Costing systems (1)
1 Apr 3 Balance
31 Mar 4 Debtors
1 Apr 4 Balance
1 Apr 3 Balance
31 Mar 4 Sales – P&L
1 Apr 4 Balance
31 Mar 4 Bank
31 Mar 4 Balance
31 Mar 4 Ind material
Depreciation
Ind labour
Bank
P&L Over abs
Bank
£’000
14
31 Mar 4 Creditors
204
Wages payable
Prodn O/hd
Drawings
Balance
218
30
£’000
136
29
11
12
30
218
Debtors
£’000
22
31 Mar 4 Bank
206
Balance
228
24
£’000
204
24
228
Creditors
£’000
136 1 Apr 3 Balance
20
31 Mar 4 Mat purchases
156
1 Apr 4 Balance
£’000
14
142
156
20
Production overhead
£’000
£’000
14
31 Mar 4 WIP – O/hd
9
absorbed
48
8
11
6
48
48
Wages payable
£’000
31 Mar 4 Bank
29
31 Mar 4 Wages control
Deduction creditor
9
38
Deductions creditor
£’000
£’000
38
38
£’000
9
265
Wages control
£’000
38
31 Mar 4 WIP
Prodn O/hd
38
£’000
30
8
38
31 Mar 4 Finished stock
Cost of sales
£’000
190 31 Mar 4 Profit & Loss
£’000
190
31 Mar 4 Profit and Loss
Sales
£’000
206 31 Mar 4 Debtors
£’000
206
Profit and Loss
£’000
190 31 Mar 4 Sales
22
Over abs O/hd
Net profit – capital
212
31 Mar 4 Bank
Drawings
£’000
12
31 Mar 4 Capital
£’000
206
6
212
£’000
12
Trial balance at 31 March/1 April Year 4
Material stock
Work-in-progress
Finished stock
Capital
Bank
Debtors
Creditors
Deductions creditor
£’000
18
21
6
£’000
115
90
45
30
24
189
20
9
189
▲ Now take the class through Examples 1, 2, 3 and 4 on pages 588-598 of the textbook.
266
Costing systems (1)
Reminders
An understanding of the principles of an integrated accounting system will only
come through practice, and through a clear appreciation of the underlying bookkeeping principles.
267
LESSON 57
Main subject
Costing systems (1)
Syllabus reference
Second Level
8
Costing systems
uniform costing
Lesson topic
Uniform costing
8.4
8.5
8.6
Understand the purpose of uniform costing
Make simple adjustments to achieve uniformity
Interpret simple cost comparisons made where uniform costing has been
applied
Required for
Aim of the lesson
• To explain the purpose and practice of uniform costing.
The lesson
▲ Begin by referring to the CIMA definition on page 598 of the textbook.
Point out that the word ‘uniform’ suggests ‘sameness’ or ‘having common elements’.
The definition says that it is the costing system that is the same. It goes on to say that
this means the same methods, principles and techniques.
Take the opportunity to introduce revision into this lesson:
Remind the class that costing methods include job costing, process costing, batch
costing, contract costing etc., and that these are selected to reflect the business, its
products and its customers.
For example, a printer may take many, often small, orders for printing. This would
suggest the need for a job costing system, with the ability to identify individual jobs,
and to book costs incurred to them. Such a printer could also have regular repeat
orders from some customers – which would make batch costing suitable for those
orders.
268
Costing systems (1)
A single firm could, therefore, use both job costing and batch costing methods.
Point out that whilst it might be tempting to imagine that similar firms will use the
same costing methods, there is a big difference between a small jobbing printer, and a
printing company that produces the same magazine every week.
Explain that there may be differences in principle between firms. Examples are
depreciation policy and the treatment of directors’ salaries.
Point out that depreciation methods can be the same, but there can still be differences
in assumed asset life, in residual value assumptions and in how to treat a fully-depreciated
asset.
With respect to directors’ salaries, some firms will treat them all as administration
overhead. Others will treat them functionally.
The third point in the CIMA definition relates to the ‘same techniques’.
An example that you can give the class is whether marginal costing is used – with
implications for stock valuations.
The list given on page 599, of points to be agreed in developing uniformity, should be
discussed with the class.
▲ Now explain to the class that the definition of uniform costing says nothing about the
reasons for using it.
Make the suggestion that if we know figures have been prepared and presented on a
common basis, then there is the opportunity to compare them.
Emphasise the benefits of comparison, given at the foot of page 599 and at the top of
page 600.
Explain the 2 ways in which uniformity may be applied: within a group; within an
industry.
▲ Take the class through the procedures of a trade-association-based comparison (pages
600-601).
▲ Finally, take the class through Example 5 on pages 601-603 of the textbook.
Reminders
Uniform costing is used to allow valid comparisons of cost between different
organisations. Such comparison should then encourage improved cost
performance.
269
LESSON 58
Main subject
Costing systems (2)
Syllabus reference
Third Level
Accounting Systems
Interlocking and integrated accounting systems
Use of control accounts. Reconciliation and causes of different profits
Notional costs
Lesson topic
Standard costing entries in the integrated ledger for historical and marginal
costing systems.
5.1
5.2
5.3
Distinguish between integrated and non-integrated accounting systems
Understand the importance of, and use of, control accounts, with
particular emphasis on material stock, work-in-progress, finished goods
and production overhead
Post entries in an integrated ledger for historical cost and standard cost
systems, and for absorption costing and marginal costing systems
Required for
Aim of the lesson
• To explain the entries needed in the integrated ledger to deal with standard
costs and variances
The lesson
▲ Remind the class that a previous lesson has explained the nature of an integrated
accounts system.
The importance of control accounts was also explained. They are total accounts. For
example, the production overhead control account summarises the many production
cost centres. Each cost centre has its own incurred overhead, its own absorbed overhead
– and therefore, its own under- or over-absorbed overhead.
270
Costing systems (2)
Third Level candidates must be able to handle more complex questions than would be
expected of Second Level candidates. However, you should point to the opening
comment on page 610 – it is unlikely that the examination will include a full question with all
transactions. This would require far too much within a 20-mark question. It is more
likely, therefore, that selected accounts will be asked for.
Explain that, nevertheless, the only way to really understand parts of the system is to do
questions which are comprehensive. This can be done in the time available in the class,
and will be done in this lesson.
▲ First, take the class through Example 1 on pages 611-615 of the textbook. This illustrates
the type of selective question that could be asked on the examination paper.
This example does not involve standard costing. The class could therefore do it as a
revision question.
▲ Now introduce standard costing
Emphasise that as a result of their work in earlier lessons, the class should have a working
knowledge of all variances.
In the examination, variances may have to be calculated before being posted to accounts
in the integrated system. Alternatively, variances may be given by the examiner. Either
way, time cannot be wasted on thinking how each variance has to be calculated.
For this reason, the class needs to come to this topic (integrated accounts) confident of
standard costing basics.
Now take the class through each element of cost to remind them of the accounting
entries. These will be given as journal entries. You might want the class to do them in
‘T’ accounts.
Materials
Material purchases 200 tonnes @ £180 tonne
Standard price fixed at £175 tonne
Material issues to production 90 tonnes.
Remind the class that there are 3 alternatives:
If standard costing does not exist:
Creditors account
–––––––––––––––––––––
Work-in-progress account
–––––––––––––––––––––
£
36,000
£
36,000
16,200
16,200
271
If standard costing exists, and the price variance is taken on purchase:
35,000
Material price variance account 1,000
Creditors account
–––––––––––––––––––––
15,750
36,000
15,750
–––––––––––––––––––––
If standard costing exists, and the price variance is taken on issue:
36,000
Creditors account
36,000
–––––––––––––––––––––
15,750
Material price variance account 450
16,200
–––––––––––––––––––––
Make sure the class understands the circumstance in which each answer would be
correct.
Also, make sure that they fully appreciate that these journal entries are instructions as
to which integrated ledger accounts will be debited, and which will be credited.
Labour
Actual gross wages for Month 4 £34,200. This comprised direct wages 3,200
hours for £25,100, and £9,100 indirect production wages.
Net wages paid were £27,150, and deductions creditors amounted to £7,050.
First, ask the class to do the journal entries for wages if standard costing is not in use.
This should not present a problem. The answer should be:
£
34,200
Wages control account
Wages payable account
––––––––––––––––––––
34,200
Bank account
Deductions creditors accounts
––––––––––––––––––––
25,100
Production overhead account 9,100
––––––––––––––––––––
272
£
34,200
27,150
7,050
34,200
Costing systems (2)
Again, make sure the class understands. Emphasise that these are all control accounts.
For example, the £9,100 indirect labour will be analysed to individual cost centres.
Now give the class additional information:
Standard costing is in use.
Standard rate per hour for direct labour £7.50
Standard hours produced 3,310
Emphasise that the class should, if possible, begin to ‘see’ variances as the information
is given. For example, as soon as you told them that 3,310 standard hours of output
had been produced, they should immediately have realised that there is a favourable
efficiency variance, because the actual direct labour hours were 3,200.
Point out that it is usual to extract the rate variance prior to work-in-progress, but to
bring the efficiency variance out of work-in-progress.
The required entries are:
£
34,200
––––––––––––––––––––
34,200
Bank account
Deductions creditors accounts
––––––––––––––––––––
3,200 hours @ £7.50
24,000
Rate variance account
1,100
––––––––––––––––––––
3,310 @ £7.50
24,825
Labour efficiency variance account
–––––––––––––––––––––
£
34,200
27,150
7,050
34,200
24,000
825
Remind the class that if they were asked to calculate the labour efficiency variance,
they would calculate it:
£
Standard hours
Actual hours
Hours saved
3,310
3,200
110
@ standard rate
£7.50
825 F
273
Overhead
Use the same data as for the labour illustration.
Give the following additional data:
Standard absorption rate (based upon 4,000 budgeted direct labour hours and
budgeted fixed production overheads of £25,000) is £6.25 per hour.
Actual fixed production overheads were £24,130, of which £20,130 was paid
from the bank, and £4,000 was depreciation of machinery.
Immediately the class should see 3 things which you can ask them about:
1
Standard hours and actual hours are well down on budget. This means there will
be a large volume variance, because all of the production overheads are fixed.
2
It is already known that the direct labour efficiency variance is favourable.
Therefore, there must be a favourable overhead efficiency variance
3
As the budgeted, and the actual, fixed production overheads are both known, the
class should be able to see the expenditure variance.
(Before taking the class through the overhead entries, point to the textbook author’s
preferred method, stated at the top of page 620 of the textbook.)
£
Bank account
Provision for machinery
depreciation
–––––––––––––––––––––––
3,200 hours x £6.25
20,000
Volume capacity variance
account
(4,000 – 3,200) x £6.25
5,000
Expenditure variance account
(£25,000 – £24,130)
Production overhead account
–––––––––––––––––––––––
3,310 x £6.25
20,687.5
Work-in-progress
Volume efficiency
–––––––––––––––––––––––
274
£
20,130
4,000
870
24,130
20,000.0
687.5
Costing systems (2)
Emphasise again, that the class needs to be sufficiently confident of variance analysis,
so that they can calculate variances as entries are made in the integrated ledger. There
is not sufficient time in an examination to calculate the variances and then to do the
accounts. They must be done together.
▲ Now take the class through Examples 2-9 on pages 615-626 of the textbook.
Example 9 is a very important example. It is more comprehensive than the others as it
deals with many variances. It also shows – in (a) – the presentation of the Profit & Loss
account using actual costs and a stock movement valuation at standard cost. In (b)(vi)
it shows the presentation using standard profit and variances. See also Note 11 to the
solution. Make sure that the class is aware of the difference in approach and presentation.
▲ Now take the class through the following example, which will be a complete set of
transactions for Binford Ltd.
Binford Ltd makes a single product. It commenced trading on 1 January Year 8,
and planned to make and sell 3,000 units of output in its first year.
The company decided to use standard absorption costing and an integrated
system of accounting.
The company commenced with £80,000 in ordinary share capital, and this
amount was paid into a company bank account.
The company operated from rented premises, but used £60,000 to purchase
plant and equipment.
No vehicles were purchased, because finished products are delivered to
customers by external carrier,
The standard cost per unit produced for Year 1 was:
Direct material
6 kg @ £15 kg
Direct labour
6 hours @ £8 hour
Fixed production overhead 6 hours @ £12
Production cost
£
90
48
72
210
The standard selling price per unit was £260.
Administration, Selling and Distribution costs were budgeted at £125,000.
Material stocks were to be valued at standard, i.e. the material price variance is
taken on purchase.
The transactions for the year ended 31 December Year 8 were:
1
Production was 2,800 units.
2
2,600 units were sold on credit for £685,000.
3
£672,000 was received from debtors.
4
19,000 kg of material were purchased on credit for £292,000.
5
£264,000 was paid to creditors for material supplied.
6
17,000 kg of material was issued and used in production.
275
7
Production wages totalled £177,000.
8
Production wages comprised Direct wages 18,000 hours for £146,000 and
Indirect wages £31,000.
9
Net wages paid to production employees totalled £138,000. Deductions were
£39,000, of which £31,000 had been paid to deduction creditors by 31
December.
10
Fixed production overheads incurred amounted to £211,000. £31,000 of this
was the indirect labour already referred to. A further £165,000 was incurred
in cash payments, and £15,000 was for plant and equipment depreciation.
11
Administration, Selling and Distribution overheads incurred, and paid in
cash, amounted to £109,000.
The solution in ledger accounts will now be shown, but no further explanations will be
given for this example. Dates will also be omitted because, except for the opening
entries, all dates will be 31 December.
Ordinary share capital
Bank
Capital
Debtors
Balance c/d
Material creditors
Balance b/d
Bank
Balance c/d
276
Bank
£’000
80 Fixed assets
672 Material creditors
15 Wages payable
Deduction creditors
Production overheads
Admin S & D
767
Balance b/d
Material Stock
£’000
285 WIP
Balance c/d
285
30
Material creditors
£’000
264 Material stock
28 Material price variance
292
Balance c/d
£’000
80
£’000
60
264
138
31
165
109
767
15
£’000
255
30
285
£’000
285
7
292
28
Costing systems (2)
Material creditors
Bank
Deduction creditors
Wages payable
18,000 x £12
Material price variance
£’000
7 Profit & Loss account
Wages payable
£’000
138 Wages control account
39
177
Wages control
£’000
177 WIP (18,000 x £8)
Labour rate variance
Production overhead
177
£’000
2 Profit & Loss Account
£’000
177
177
£’000
144
2
31
177
£’000
2
Work-in-progress
£’000
£’000
255 Finished stock account:
144 2,800 x £210
588
216
Material usage variance
Efficiency variance
615
Production overhead
£’000
Bank
165 Work-in-progress
Wages control
31
Provision for depreciation
15
Expenditure variance
5
216
Work-in-progress
£’000
7
£’000
3 Profit & Loss
3
24
615
£’000
216
216
£’000
3
277
Profit & Loss
Work-in-progress
Production overhead
£’000
15
£’000
5 Production overhead
£’000
5
Efficiency variance
£’000
24 Profit & Loss
£’000
24
Note: The £24,000 efficiency variance comprises direct labour efficiency of £9,600
and fixed overhead volume efficiency of £14,400. A separate variance account for each
could be presented.
Work-in-progress
Balance b/d
Sales
Balance b/d
Bank
278
Finished stock
£’000
588 Cost of sales
Balance c/d
588
42
£’000
546
42
588
Debtors
£’000
685 Bank
Balance c/d
685
13
£’000
672
13
685
Admin. Selling & Distribution
£’000
109 Profit & Loss
£’000
109
Finished stock
Cost of sales
£’000
546 Profit & Loss
£’000
546
Profit & Loss
Sales
£’000
685 Debtors
£’000
685
Costing systems (2)
Cost of sales
Admin S & D
Efficiency variance
Loss b/d
Profit & Loss
546 Sales
109 Fixed overhead exp
7 Loss c/d
2
3
24
691
1
685
5
1
691
Note: There is no fixed overhead volume capacity variance because budget and actual
hours were both 18,000.
Bank
Bank
Balance c/d
Plant & Machinery
£’000
60
Deduction creditors
£’000
31 Wages payable
8
39
Balance b/d
£’000
39
39
8
Finally, to check accuracy, a trial balance can be extracted:
£’000
Share capital
Bank
Material stock
Material creditors
Plant & Machinery at cost
Prov for Plant & Machinery depn
Finished stock
Debtors
Profit & Loss
Deduction creditors
£’000
80
15
30
28
60
15
42
13
1
146
8
146
Whilst this example will provide you with an excellent teaching aid, the length of the
solution shows why a complete question cannot be asked on an examination paper of
20-mark questions.
279
Reminders
Integrated accounts, of the type discussed in this lesson, require that the student
has a basic competence in variance analysis before starting.
280
Costing systems (2)
LESSON 59
Main subject
Costing systems (2)
Syllabus reference
Third Level
Accounting Systems
Notional costs
Lesson topic
Interlocking accounts
5.4
As 5.3 but for a non-integrated ledger system
Required for
Aim of the lesson
• To explain the entries needed in the non-integrated cost ledger to deal with
standard costs and variances.
The lesson
▲ Begin by referring the class to the CIMA definition on page 627 of the textbook. Note
that this definition emphasises that interlocking and non-integrated accounts are the
same thing.
Emphasise that the cost accounts are a distinct and separate system from the financial
accounts. In other words, there are 2 double-entry ledger systems.
The financial accountant can record transactions as he wishes. For example, the financial
accounts may record gross wages under the nominal account heading.
In the cost accounts, the gross wages will be analysed to direct and indirect, charged to
jobs and cost centres respectively.
Use the wages illustration on pages 627-628 to make this clear. Point out, particularly,
the problem of finding a credit entry in the cost ledger to correspond to the debit for
the gross wages.
Make sure that the class sees the financial ledger control account as the solution to this
problem.
281
Tell the class that, at any time, the balance on the financial ledger control account is
equal to the sum of all other balances on accounts in the cost ledger. It can be thought
of as the capital account of the cost ledger.
▲ Explain that sometimes the examiner does not mention the financial ledger control
account, but he expects the candidate to know that it exists.
For example, the examiner gives balances in the cost ledger at 1 August Year 5 as:
Raw material stock
Work-in-progress stock
Finished stock
Production overhead over-absorbed
£
12,650
8,967
10,760
768
Tell the class that the examiner would expect them to deduce that there must be a credit
balance of £31,609 on the financial ledger control account. This is because the 3 stock
accounts are asset accounts, and therefore must carry debit balances.
The production overhead over-absorbed, on the other hand, must be a credit balance.
▲ Now explain that Example 10 on pages 629-632 of the textbook is a complete example in
that it begins with a trial balance, records a month’s transactions, and then ends with a
trial balance. It is not, however, a standard costing question. The absence of standard
costing, together with the fact that it is a non-integrated system, makes the question shorter.
Point out that there are transactions which are only recorded in the financial ledger.
These include bank entries, payments to creditors, payments by customers etc.
Take the class through the Example. Point out that most of the accounts are almost the
same as they would be for an integrated system. These are Material stock, Work-in-progress,
Finished stock, Wages and salaries control, Production overhead, Cost of sales,
Administration, Selling and Distribution overhead and the Profit and Loss account.
The only difference is in the narrations, where there is regular reference to the FLC
(the financial ledger control account).
In addition, point out to the class that there is no bank account, capital account, debtors
account or creditors account etc. These are now in the separate financial ledger.
Ask the class to note which entries pass through the financial ledger control account.
For example, purchases of £47,115 is credited there, because there is no creditors account
in the cost ledger to take the entry.
Remind the class that it was said earlier that the financial ledger control account could
be thought of as the capital account of the cost ledger. Explain that the profit from the
profit & loss account in the cost ledger has been credited to the financial ledger control
account. This emphasises the similarity.
▲ Finally in this lesson, the standard costing example will be taken from the previous
lesson, and illustrated in a non-integrated form:
282
Costing systems (2)
Binford Ltd makes a single product. It commenced trading on 1 January Year 8,
and planned to make and sell 3,000 units of output in its first year.
The company decided to use standard absorption costing and a non-integrated
system of accounting.
The company commenced with £80,000 in ordinary share capital, and this
amount was paid into a company bank account.
The company operated from rented premises, but used £60,000 to purchase
plant and equipment.
No vehicles were purchased, because finished products are delivered to
customers by external carrier,
The standard cost per unit produced for Year 1 was:
Direct material
6 kg @ £15 kg
Direct labour
6 hours @ £8 hour
Fixed production overhead 6 hours @ £12
Production cost
£
90
48
72
210
The standard selling price per unit was £260.
Administration, Selling and Distribution costs were budgeted at £125,000
Material stocks were to be valued at standard, i.e. the material price variance is
taken on purchase.
The transactions for the year ended 31 December Year 8 were:
1 Production was 2,800 units.
2 2,600 units were sold on credit for £685,000.
3 £672,000 was received from debtors.
4 19,000 kg of material were purchased on credit for £292,000.
5 £264,000 was paid to creditors for material supplied.
6 17,000 kg of material was issued and used in production.
7 Production wages totalled £177,000.
8 Production wages comprised Direct wages 18,000 hours for £146,000 and
Indirect wages £31,000.
9 Net wages paid to production employees totalled £138,000. Deductions were
£39,000, of which £31,000 had been paid to deduction creditors by 31
December.
10 Fixed production overheads incurred amounted to £211,000. £31,000 of this
was the indirect labour already referred to. A further £165,000 was incurred
in cash payments, and £15,000 was for plant and equipment depreciation.
11 Administration, Selling and Distribution overheads incurred, and paid in
cash, amounted to £109,000.
283
The solution in ledger accounts will now be shown, but no further explanations will
be given for this example. Dates will also be omitted because – except for the opening
entries – all dates will be 31 December.
Before taking the class through this example, tell them that the question has been
reproduced exactly as it was given in the previous lesson, except for stating that nonintegrated accounts were used. Therefore some of the information is not needed for the preparation
of the cost ledger.
Ask the class to tell you what information is not needed.
They should say:
1
The £80,000 introduced as capital to open the bank account
2
The purchase of fixed assets for £60,000
3
Transaction 3. Receipt of £672,000 from debtors
4
Transaction 5. Payment of £264,000 to creditors
5
Transaction 9. Payment of net wages, and accounting for deductions
The entries will be:
Material – FLC
Balance b/d
Material stock
Gross wages – FLC
284
Material stock
£’000
292 WIP
___ Balance c/d
292
30
£’000
255
7
30
292
£’000
£’000
7
Wages control
£’000
177 WIP (18,000 x £8)
___ Production overhead
177
£’000
144
2
31
177
£’000
£’000
2
Costing systems (2)
Work-in-progress
£’000
£’000
144 2,800 x £210
588
18,000 x £12
216
___
615
Expenses – FLC
Wages control
– FLC
Work-in-progress
Profit & Loss
Work-in-progress
Work-in-progress
Balance b/d
Expenses – FLC
Efficiency variance
Production overhead
£’000
165 Work-in-progress
31
15
5
216
£’000
3 Profit & Loss
£’000
5 Production overhead
Efficiency variance
£’000
24 Profit & Loss
Finished stock
£’000
588 Cost of sales
___ Balance c/d
588
42
£’000
109 Profit & Loss
3
24
615
£’000
216
___
216
£’000
3
£’000
5
£’000
24
£’000
546
42
588
£’000
109
285
Finished stock
Cost of sales
£’000
546 Profit & Loss
£’000
546
Profit & Loss
Sales
£’000
685 FLC
£’000
685
Cost of sales
Admin S & D
Efficiency variance
Sales
Loss
Balance c/d
Profit & Loss
546 Sales
109 Fixed overhead exp
7 Loss – FLC
2
3
24
691
Financial Ledger Control Account
£’000
685 Material purchases
1 Gross wages
72 Expenses
Depreciation
___ Expenses
758
Balance b/d
685
5
1
___
691
£’000
292
177
165
15
109
758
72
Material stock
Finished stock
Financial Ledger Control
£’000
30
42
72
£’000
72
72
You should emphasise how much shorter the non-integrated accounts solution is.
However, do point out that work is also being done in a separate financial accounts
system.
Finally, point out that this example has been answered, in both the previous lesson and
in this lesson, as for a standard absorption costing system. This was correct, because the
company had chosen this.
286
Costing systems (2)
▲ Now ask the class what would change if it were a standard marginal costing question.
The class should know that if standard marginal costing was being used, the fixed
production overheads would be treated as a period cost, and not absorbed into the unit
cost of the product.
In addition, the standard cost would only be calculated as far as the prime cost (there
were no variable overheads), and no fixed overhead variances would be calculated.
The answer under standard marginal costing would be much easier. It would be:
Material – FLC
Balance b/d
Material stock
Gross wages – FLC
Material stock
£’000
292 WIP
___ Balance c/d
292
30
£’000
255
7
30
292
£’000
£’000
7
Wages control
£’000
177 WIP (18,000 x £8)
___ Production overhead
177
£’000
144
2
31
177
£’000
£’000
2
Work-in-progress
£’000
£’000
144 2,800 x £138
386.4
3.0
___ Labour efficiency variance 9.6
399
399
287
Expenses – FLC
Wages control
– FLC
15
211
£’000
211
211
Work-in-progress
£’000
3 Profit & Loss
£’000
3
Work-in-progress
Labour efficiency variance
£’000
9.6 Profit & Loss
£’000
9.6
Work-in-progress
Balance b/d
Expenses – FLC
288
Production overhead
£’000
165
Profit & Loss
31
Finished stock
£’000
386.4 Cost of sales
Balance c/d
386,4
27.6
£’000
109 Profit & Loss
£’000
358.8
27.6
386.4
£’000
109
Finished stock
Cost of sales
£’000
358.8 Profit & Loss
£’000
358.8
Profit & Loss
Sales
£’000
685 FLC
£’000
685
Costing systems (2)
Cost of sales
Admin S & D
Fixed overheads
Labour efficiency variance
Sales
Loss
Balance c/d
Profit & Loss
£’000
358.8 Sales
109.0 Loss – FLC
211.0
7.0
2.0
3.0
9.6
700.4
Financial Ledger Control Account
£’000
685.0 Material purchases
15.4 Gross wages
57.6 Expenses
Depreciation
Expenses
758.0
Balance b/d
£’000
685.0
15.4
700.4
£’000
292.0
177.0
165.0
15.0
109.0
758.0
57.6
Material stock
Finished stock
Financial Ledger Control
£’000
30.0
27.6
£’000
57.6
57.6
57.6
Reminders
Non-integrated accounts are accounts which have a double-entry ledger for
each of financial accounts and cost accounts.
As with the preceding lesson, the type of accounts discussed in this lesson require
that the student already has a basic competence in variance analysis.
289
LESSON 60
Main subject
Costing systems (2)
Syllabus reference
Third Level
Accounting Systems
Notional costs
Lesson topic
Reconciliations
5.5
5.6
5.7
Understand the need for reconciliation in a non-integrated system
Understand why certain items cause the need for reconciliation – stock
valuations, depreciation treatment, notional items, treatment of under/
over-absorbed overhead etc
Prepare a reconciliation statement
Required for
Aims of the lesson
• To explain the reason fo a reconciliation statement
• To explain how a reconciliation statement is prepared
The lesson
▲ Begin by looking at the example on page 632 of the textbook.
Point out that if separate cost and financial ledgers exist, each will produce a profit and
loss account. If the two profits are identical, no-one will be concerned. If they are
different, the question may be asked, ‘Which is correct?’. A reconciliation of the two
profits is therefore prepared, to show that both profits are correct – but the reconciliation
is done in different ways!
Take the class through the important notes on pages 633-634. Make sure that they
understand the difference between the 3 categories.
Explain that a reconciliation statement can start with either the profit from the profit
and loss account in the cost ledger, or from the profit and loss account in the financial
ledger, unless the examiner tells the candidate which profit to start with.
290
Costing systems (2)
Explain this, using the following:
The profit in the cost ledger is £45,346.
The profit in the financial ledger is £46,120.
Investment income of £774 has been credited in the financial profit and loss
account.
The reconciliation statement can be either:
Profit per the financial accounts
Less investment income
Profit per the cost accounts
£
46,120
774
45,346
Add investment income
£
45,346
774
46,120
or
Emphasise that the second answer would have been wrong if the examiner had
instructed candidates to ‘Prepare a reconciliation statement, starting with the profit per the
financial accounts.’
▲ Continue your lesson with this example:
The profit in the cost ledger of Jinks Ltd is £85,786.
The profit in the financial ledger of Jinks Ltd is £103,973.
Investment income of £1,087 has been credited in the financial profit and loss
account.
The company’s production buildings are all owned, but a notional rent of
£17,100 has been included in production overheads in the cost ledger.
less investment income
less notional rent
£
103,973
1,087
102,886
17,100
85,786
or
Add investment income
Add notional rent
£
85,786
1,087
86,873
17,100
103,973
291
▲ Continue your lesson with this example:
The profit in the cost ledger of Hermes Ltd is £346,612.
The profit in the financial ledger of Hermes Ltd is £381,334.
Investment income of £7,349 has been credited in the financial profit and loss
account.
The company’s production buildings are all owned, but a notional rent of
£28,560 has been included in production overheads in the cost ledger.
In the cost ledger, the stocks at the start of the financial year were brought forward
at cost £64,356, whereas in the financial ledger, they were brought forward at
cost, £73,180.
In the cost ledger, the stocks at the end of the financial year, valued at cost, amounted
to £46,734, whereas in the financial ledger, they were valued at cost, £54,371.
£
381,334
7,349
373,985
28,560
345,425
less investment income
less notional rent
less difference in closing stock values:
Financial accounts
Cost accounts
add difference in opening stock values:
Financial accounts
Cost accounts
54,371
46,734
73,180
64,356
7,637
337,788
8,824
346,612
or
£
346,612
7,349
353,961
28,560
382,521
add investment income
add notional rent
add difference in closing stock values:
Financial accounts
Cost accounts
less difference in opening stock values:
Financial accounts
Cost accounts
292
54,371
46,734
73,180
64,356
7,637
390,158
8,824
381,334
Costing systems (2)
Point out to the class that this last example includes one adjustment from each of the 3
categories which cause difference. These are given on page 633.
Now explain that the reconciliations illustrated were easy because both profits were given.
Not only could the candidate choose which profit to start with (provided the examiner
gave no instruction), but could also keep testing his answer until it reconciled one
given profit to the other given profit.
That makes it too easy! For this reason, the examiner doesn’t usually give both profits.
He usually gives only one. Therefore there is no choice of starting profit. This means
that the candidate must be able to reason out whether each adjustment is added or
subtracted.
For this reason, you need carefully to explain the reasoning behind the adjustments made
in this lesson.
▲ Now take the class through Example 11. You will see that the profit per the financial
accounts is given. However, it only says that this differs from the profit in the cost
ledger. We don’t know what that difference is. The answer, therefore, has to start with the
profit per the financial accounts.
Reminders
Managers are uneasy about being given 2 different profits for the same
accounting period. The reconciliation is produced to give assurance that both
sets of accounts are correct.
Candidates must be able to reason the adjustment required in working from
one known profit to the other – usually unknown – profit.
293

How to Pass Cost Accounting Teacher’s Guide Second and Third Levels

Transcription

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