Fundamentals of Management Accounting

Fundamentals of Management Accounting
Fundamentals
of
Management
Accounting
First Edition
By Zawadi. K. Ally
MSc. (Finance), MBA (Finance), CPA (T), B.Com (Hons)
27
About the Author

Zawadi. K. Ally received his B. com (Hons), MBA (finance) degrees from
the University of Dar-es-salaam and MSc. (finance) degree at the University of
Strathclyde (U.K). He was awarded a certificate of Certified Public Accountants
[CPA (T)].
He teaches management accounting and financial accounting at the

undergraduate and masters levels at The Institute of Finance Management also
is teaching management accounting and financial accounting for students
who are prepared for final stages in NBAAs exams. As a member of National
Board of Accountants and Auditors (NBAA), Mr. Zawadi has been involved in
management consulting work.
i
Preface
Management accounting may be seen as a practical tool aimed at solving the
day-to-day financial management problems facing decision makers in the
private and public sectors. We feel, however, that this is too narrow a view
of the potential of the subject. Accordingly, we have gone beyond this view.
In this book, while we have looked at the practical techniques that can help
managers and students solve management accounting problems, we have tried
to approach the subject in a way which ensures coverage of technical financial
topics in an accessible style while making appropriate reference to research.
In addition, the book goes beyond techniques to recognize qualitative issues
by attempting to identify analytical and critical issues of relevance to decision
makers at all levels in a variety of organizations in both the private and public
sectors.
While chapters contain illustrations and examples, we have introduced case

studies from each chapter. These can be approached on many levels such that
students from a wide range of backgrounds and experience can benefit from
working through them either in whole or in part. The case studies are intended
to be underpinned by reference to the research literature to gain maximum
benefit. We introduce some of this research literature in the practical context
of each chapter in order to encourage further reading. Readers can thus
contextualize the issues which they are studying within the wider environment
of the research literature and through the case studies before continuing their
studies in more depth. Indeed, the case studies are based on real business
situation.
In todays competitive world, managers from whatever background need an

understanding of the tools of management accounting when making financial
decisions, yet they must also be aware of the qualitative issues affecting such
decisions. Furthermore, they need to be aware of what is happening through
research into their competitors. In this context we believe managers and
students will find this book of value.
Pedagogy
Each chapter starts with chapter objectives and a set of learning outcomes.
The content is explained through suitable illustrations and examples. The
chapters contain theory, applications, and examples, either real world or
hypothetical. The book includes a number of real case studies for analyses
and discussion.
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This book is intended primarily for undergraduate and posts graduate
students reading Accounting, business studies and allied subjects where
Management Accounting is part of the curriculum and for students who
are preparing for themselves for the Professional Examinations bodies
such as ACCA, NBAA. NBMM, CIMA etc. The book also is useful for
Managers and other in industry, commerce, local authorities and public
corporation who wish to obtain a working knowledge of management
accounting to assist them in their own work and to facilitate in planning,
controlling and decision making
Structure of the book

The chapter wise structure is as follows:
Chapter one and two provide an introduction to management accounting
and cost accounting, chapter two focuses mainly on element of costs, the
components of costs and classification of costs.
Chapter three focuses on analyzing of cost behaviour, this chapter explains

the importance of the relevant and volume of activity in using a cost
behaviour pattern for cost prediction, also the focuses on the behaviour
of variable costs, fixed cost, step cost and mixed cost. This chapter also
describes and analyzes the cost estimation methods.
Chapter four, this chapter entitled income effects of alternative cost

accumulation systems, it focuses mainly on assigning costs to products
to separate the costs incurred during a period between costs of goods
sold and the closing inventory valuation for internal and external profit
measurement. The extent to which product costs accumulated for
inventory valuation and profit measurement for meeting decision making,
also overhead cost allocation and apportionment is detailed discussed.
Chapter five in this book focuses on the measurement of indirect relevant

costs for decision making using activity based costing (ABC) techniques,
the chapter compares the activity based costing system and tradition
(convention) costing system in computing the unit cost of the different
products.
Chapter six focuses on what will happen to the financial results if a

specific level of activity or volume fluctuates. This chapter examines
the relationship between changes in activity and changes in total sales
revenues, expenses and profit, the objectives is to establish what will
happen to the financial results if a specific level of activity fluctuates.
Chapter seven focuses mainly on an understanding of the principles
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that should be used to identify relevant costs and revenues for various
types of decisions, these managerial decisions include relevant costs on
make versus buy decisions, relevant costs on equipment replacement and
relevant cost of material requirement.
Chapter eight concentrates mainly on how accounting information can be

applied by management to different forms of short-term decisions. The
focus of the chapter is to consider the provision of financial information
both quantitative and qualitative that will help the management to
make better decisions. The concentration of the chapter will be mainly
on the short-term decisions based on the environment of today and the
physical, human and financial resources that are presently available to
the organization.
Chapter nine focuses mainly on an important methods of incorporating

uncertainty and risk into the decision making process. in this chapter the
impact of uncertainty and risk on decision models will be evaluated.
Chapter ten which consists of four parts and is entitled, The application
of Quantitative Methods to Management Accounting, the chapter focuses
mainly on the application of linear programming which is in part one,
the application of correlation and regression analysis in part two, the
application of learning curve in part three and the quantitative models
for planning and control of stocks in part four.
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Contents
CHAPTER
OVERVIEW TO MANAGEMENT ACCOUNTING

1
Chapter Objectives 1
Learning Outcomes 1
1.1 Introduction 2
1.2 Historical Background of Managerial Accounting 2
1.3 Factors Determining Management Accounting Change 8
1.4 Definitions of Management Accounting 9
1.5 The Importance of Management Accounting in an Organization 11
1.6 The role of Management Accountants within the Organization 13
1.7 Objectives of Management Accounting: 15
1.8 Functions of Management Accounting 15
1.9 Differences between Management Accounting and Financial Accounting 17
1.10 Management accountings role in business management 19
1.11 Current issues facing Management Accounting 21
1.12 Code of Conduct for Management Accountants: 22
1.13 Resolution of Ethical Conflicts: 24
Assessment Question 25
Summary 26
Key Terms and Concepts 26
Exercises Questions 27
Problems Questions 27
Examination Questions 28
Case Studies 29
Discussion questions 29
Further Readings 30
CHAPTER
CLASSIFICATIONS AND APPROACHES TO COST

ACCOUNTING
2
Learning Outcomes 31
2.1 Introduction 32
v
2.1.1 Scope of Cost Accounting 33
2.1.2 Objectives of Cost Accounting 34
2.1.3 Importance of Cost accounting 35
2.1.4 Concept of Cost 36
2.1.5 Cost objects 37
2.1.6 Elements of Cost 37
2.2 Components of Total Cost 39
2.3 Classification of Cost 42
2.4 Conversion Cost 52
2.5 Cost Unit and Cost Centre 52
2.6 Cost Estimation 54
2.7 Cost Ascertainment 54
2.8 Cost Allocation Vs Cost Apportionment 55
2.9 Cost Reduction Vs Cost Control 55
2.10 Installation of Costing System 56
2.11 Methods of Costing 58
2.12 Systems of Costing; 62
Assessment Questions 64
Summary 65
Exercises 67
Problems 67
Required 68
Case Studies 70
Discussion Questions 70
Further Readings 72
CHAPTER
ANALYZING COST BEHAVIUOR 3

3.1 Introduction 74
3.2 Level or Volume of Activity 75
3.3 Relevant range 75
3.4 Cost Behavior 76
3.5 Fixed cost 79
3.6 Variable Costs 83
3.7 Mixed costs or Semi-variable costs 85
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3.8 Step Variable Costs 87
3.9 Importance of cost behaviour 88
3.10 The economists approach to cost behaviour analysis 88
3.11 Comparison of cost behaviour assumptions in accounting model and
economic theory 89
3.12 Cost Estimation Techniques 89
3.13 Basic techniques of cost estimation 90
Summary 97
Exercises 99
Problems 99
Case Studies 103
Further Readings 104
CHAPTER
INCOME EFFECTS OF ALTERNATIVE COST

ACCUMULATION SYSTEMS 98
4
4.1 Introduction 106
4.2 Overhead allocation and apportionment 106
4.3 Overhead Absorption 108
4.4 Bases of Overhead Absorption Rate 108
4.5 Applying the overhead absorption rate 109
4.6 Choosing the most appropriate absorption base 110
4.7 Over and Under Absorbed Overheads 110
4.8 Marginal costing and contribution 112
4.9 Theory of Marginal Costing 113
4.10 Features of Marginal Costing System: 115
4.11 Advantages and Disadvantages of Marginal Costing Technique 115
4.12 Uses of marginal costing 116
4.13 Presentation of Cost Data under Marginal Costing 117
4.14 Absorption costing System 119
4.15 The features of absorption costing 120
4.16 Advantages and Disadvantages of Absorption Costing 121
4.17 Presentation of Cost Data under Absorption Costing 122
4.18 Reconciliation Statement for Marginal Costing and Absorption
Costing Profit 124
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4.19 Marginal Costing versus Absorption Costing 125
4.20 Summary of marginal and Absorption costing 126
Summary 129
Exercises 130
Problems 130
Further Reading 139
CHAPTER
ACTIVITY BASED COSTING (ABC)

5
5.2 Activity-based management (ABM) 142
5.3 Activity Based Costing 144
5.4 Cost drivers 144
5.5 Activity categories 146
5.6 Operation of the Activity Based Costing (ABC) System 147
5.7 Applications of Activity Based Costing (ABC) System 154
5.8 Non-manufacturing Costs and Activity Based Costing (ABC) System: 154
5.9 Manufacturing Costs and Activity Based Costing (ABC): 155
5.10 Plant wide Overhead Rate: 155
5.11 Departmental Overhead Rates: 156
5.12 The Cost of Idle Capacity and Activity Based Costing (ABC) 157
5.13 Service Organizations and Activity Based Costing (ABC) 157
5.14 Profitability Analysis Using Activity-Based Costing 158
5.15 Customer profitability (CP) 158
5.16 Determining Customer Profitability 159
5.17 Costing customer behaviour 163
5.18 Customer portfolio management 163
5.19 Advantages and Disadvantages of Activity Based Costing (ABC) System 164
5.20 Limitations of Activity Based Costing System 165
Summary 167
Exercises 170
Problems 170
Case studies 175
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CHAPTER
COST VOLUME PROFIT (CVP) ANALYSIS 6

6.2 Definitions of Cost-Volume-Profit (CVP) analysis 186
6.3 CVP analysis and Profitability 188
6.4 The uses of CVP Analysis 189
6.5 Cost-Volume-Profit (CVP) Analysis assumptions 189
6.6 Limitations of Cost-Volume Profit Analysis 190
6.7 The concept of contribution margin 191
6.8 Importance of the Contribution Margin 191
6.9 Contribution Margin Ratio (CM or P/V ratio) 192
6.10 Importance of P/V ratio 192
6.11 Improvement of P/V Ratio 193
6.12 Limitations of P/V Ratio 193
6.13 The Break-Even Analysis 194
6.14 The arithmetic of cost-volume profit analysis 195
6.15 Calculating the breakeven point 195
6.16 Target Profit Analysis 197
6.17 The Margin of Safety 200
6.18 How to improve the Margin of Safety 201
6.19 Graphical Presentation of Cost- Volume- Profit (C-V-P) Analysis 201
6.20 Limitations and Uses of Breakeven Charts 205
6.21 C-V-P considerations in choosing a cost structure 206
6.22 The concept of sales mix 210
6.23 Multi Products and Break-Even Analysis 210
6.24 The economists model 212
6.25 Cost- Volume-Profit (C-V-P) analysis and uncertainty 213
Summary 218
Exercises 219
Case studies 233
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CHAPTER
MEASURING OF RELEVANT COSTS AND REVENUE

7
7.2 Importance of qualitative factors in decision making 237
7.3 Characteristics of relevant information 237
7.4 Relevant Cost and Its Association with Decision 237
7.5 Relevant costs and its Operating decisions 238
7.6 Importance of Opportunity cost to Decision Making 240
7.7 The assumptions in relevant costing 241
7.8 Relevant Costs - Make Versus Buy Decision 241
7.9 Relevant Costs - Equipment Replacement 243
7.10 Relevant Cost of Material Requirement 244
7.11 Relevant Cost of labour 247
7.12 Misconception of relevant costs 247
7.13 Sunk Costs and decision making 248
7.14 Sunk cost application technique example 248
Summary 252
Exercises 253
Case Studies 259
Case study 7.2: Health Care Accounting Systems 261
CHAPTER
INFORMATION FOR DECISION MAKING 8

8.2 Strategic and Tactical Decisions 266
8.3 Short run versus Long-run Decision-making 267
8.4 Decision Making Models 268
8.6 Steps in Building a Decision Model 269
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8.7 Marginal Costing and Decision Making 269
8.8 Limiting factor analysis 269
8.9 Decisions involving a single limiting factor 270
8.10 Make or Buy Decision 274
8.11 Application of Marginal Costing Make or Buy Decision 277
8.12 Application of Marginal Costing, in case of Additional Fixed Costs 284
8.13 Accepting or Rejecting Special Orders Decision 287
8.14 Discontinuing product lines and other segments decisions 290
8.15 Continue or Shut Down Decisions 293
8.16 Extra shift decisions 295
Summary 298
Exercises 299
Problems 299
Case Studies 315
Discussion Question 320
CHAPTER
DECISION MAKING UNDER ENVIRONMENT OF

UNCERTAINTY AND RISK
9
9.2 Measuring Risk with Probability Distributions 324
9.3 Absolute Measure of Risk: The Standard Deviation 325
9.4 Relative Measure of Risk: The Coefficient of Variation 326
9.5 Decisions making Environment 327
9.6 Decisions making under the environment of certainty; 327
9.7 Decisions making under the environment of uncertainty 327
9.8 Decisions making under the Environment of Risk 331
9.9 Probability distribution and expected value 332
9.10 The expected monetary value (EMV) approach 332
9.11 The expected Opportunity loss (EOL) approach 332
9.12 Expected value of perfect information 335
9.13 Decision Tree and Influence Diagram 337
Summary 343
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Exercises 344
Problems 345
Case studies 351
CHAPTER
THE APPLICATION OF QUANTITATIVE METHODS

TO MANAGERIAL ACCOUNTING
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PART ONE 356
Part One Objectives 356
10.1.1 Introduction 357
1.1.2 Meaning Linear Programming Model 358
10.1.3 Contribution Margin 358
10.1.4 Contribution Income Statement 358
10.1.5 Assumptions of Linear Programming model 359
10.1.6 Linear Programming Terminology 359
10.1.6 Standard formulation of Linear Programming Model 361
Summary 367
Exercises 368
Problems 368
Cases Studies 369
PART TWO 372

APPLICATION OF CORRELATION AND REGRESSION ANALYSIS 372
10.2.2 Regression Analysis 373
10.2.3 Error terms and outliers 374
10.2.4 Regression equation 375
10.2.5 The Assumptions for Linear Regression Analysis 377
10.2.6 Major Purposes of Linear Regression Analysis 378
10.2.7 The significance of linear regression analysis in Management Accounting 379
10.2.8 Correlation coefficient (r) and coefficient of determination (r2) 380
10.2.9 Use of Computer Software for Regression analysis 382
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Summary 387
Exercises 388
Problems 389
Case studies 393
PART THREE 396

THE LEARNING CURVE THEORY 396
Learning outcomes 396
10.3.2 Meaning of Learning Curve theory 399
10.3.3 Fundamentals of Experience and Learning curves 400
10.3.4 Reasons for the effect of learning curve 402
10.3.5 The learning rate 403
10.3.6 Learning Curve Formulation 404
10.3.7 Learning Curve 405
10.3.8 Applications and Uses of learning and experience curve 406
10.3.9 Limitations of learning curve theory 407
Summary 409
Exercises 410
Problems 410
Case Studies 414
Discussion questions 414
PART FOUR 416

THE QUANTITATIVE MODELS FOR PLANNING AND CONTROL OF
STOCKS 416
10.4.2 Meaning of inventory 417
10.4.3 Types of Demand: 418
10.4.4 Functions of Inventory 418
10.4.5 Requirements for Effective Inventory Management 419
10.4.6 Advantages and Disadvantages of keeping Inventory 419
10.4.7 The objectives of inventory planning and control 420
10.4.8 Inventory Counting Systems 421
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10.4.9 Inventory Cost 422
10.4.10 Economic Order Quantity Models 422
10.4.11 Economic Order Quantity (EOQ) 422
10.4.12 Assumptions of Economic Order Quantity (EOQ) 423
10.4.13 Stock shown graphically 423
10.4.14 Developing EOQ Mathematical Model 425
10.4.15 The Total Cost function 425
10.4.16 Economic Order Quantity (EOQ) with Quantity Discount 428
10.4.17 Just-In-Time System 429
10.4.18 Meaning of Just-In- Time (JIT) 430
10.4.19 Advantages of Just-In-Time (JIT) System 431
10.4.20 Disadvantages of JIT 433
Summary 435
Exercises 436
Problems 436
Case studies 439
11.0 Answers to Assessment Questions 444
2
CHAPTER 1 OVERVIEW TO
MANAGEMENT ACCOUNTING
Chapter Objectives
The objective of this chapter is to provide the background knowledge that will
enable the leader of this book to achieve a more meaningful insight into the
issues and problems of management accounting. This chapter will focus on the
traditions and innovation in management accounting system.
Learning Outcomes
When you have finished studying the material in this chapter you will be
able to:
1. Explain the Historical Background of Managerial Accounting

2. Explain the meaning of management accounting
3. Describe the need of managerial accounting in organizations
and business firms
4. Distinguish between financial accounting and management
accounting
5. Understand the role of management accountant in an
organization
6. Identify and describe the objectives and functions of
management accounting
7. Understand the Management accountings role in business
management
8. Understand the standards of ethical conduct for practitioners
of management accounting and financial management
1
1.1 Introduction
Mangers in an organization make decisions to achieve the organizations
objectives. These decisions include how to make their organizations
translate their strategic goals or objectives into actions. To do so they need
information and accounting provides financial and cost information to
managers to assist them in making decisions. Cost and management
accounting system are expected to provide managers with such
information they need. In todays competitive operating environment
the organization needs non-costing or non financial information for
managers for managerial decisions.
1.2 Historical Background of Managerial Accounting

To understanding the role of management accounting today, it is
important to understand its history. Therefore, the overview of historical
background in management accounting from nineteenth century to
present day will be addressed in this section.
There has been extensive debate in recent years over the extent to
which management accounting is changing. Johnson and Kaplan (1987)
argued that management accounting had not changed since the early
part of the twentieth century and had lost its relevance for the purpose
of informing managers decisions. Since then, and possibly in response
to these criticisms, a number of innovative management accounting
techniques have been developed across a range of industries. The
most prominent contributions are activity based techniques1, strategic
management accounting and the balanced scorecard. These techniques
have been designed to prop up modern technologies and management
processes, such as total quality management (TQM) and just-in-time
(JIT) production systems, and the search for a competitive advantage to
meet up the challenge of global competition.
These recent techniques, it has been argued that, have affected the entire
process of management accounting and have shifted its spotlight from a
simple role of cost determination and financial control, to a sophisticated
role of creating value through improved exploitation of resources. It has
also been argued that the environment in which management accounting
is practiced has changed significantly - with advances in information
technology, more competitive markets, different organizational
structures and new management practices.
During the last two decades, the criticism of conventional cost and
management accounting practices for their lack of efficiency and
capability in dealing with the requirements of a changing environment
2
relate to the collapse of such practices to provide comprehensive
information on activities necessary for organizations (Askarany, 2004;
Baines & Langfield- Smith, 2003; Beng, Schoch, & Yap, 1994; Bork &
Morgan, 1993; Cavalluzzo & Ittner, 2003; Gosselin, 1997; Hartnett &
Lowry, 1994; Maiga & Jacobs, 2003; Lefebvre & Lefebvre, 1993; Spicer,
1992). Lawrence & Ratcliffe (1990) uphold this argument by providing
survey evidence of levels of dissatisfaction among both management
accountants and managers with the cost and management accounting
techniques afterward being used in industry. Bork & Morgan (1993)
reiterate this observation signifying that conventional cost and
management accounting systems have failed to keep up with the increasing
demands imposed on them by technological change in manufacturing
environments. Noticeably, for that reason, the management accounting
literature has witnessed a growing attention into the study of the flow
of cost and management accounting innovations (Anderson & Young,
1999; Askarany, 2003; Askarany & Smith, 2001; Askarany & Smith, 2003b;
Booth & Giacobbe, 1998; Chenhall & Langfield-Smith, 1998; Cooper &
Kaplan, 1991; Gosselin, 1997; Hartnett & Lowry, 1994; Maiga & Jacobs,
2003; Malmi, 1999).
Research on management accounting change mostly relates to

practices in developed countries. Literature has cautioned against the
transportability of these practices across nations (Kaplan, 1983; Johnson
and Kaplan, 1987; Bromwich and Bhimani, 1989; Wallace, 1990; Atkinson
et al., 1997). Bromwich and Bhimani (1989) argue that only shifting new
management accounting systems developed in foreign surroundings
for coping with a changing business environment is not absolutely
reasonable because of the divergent conditions under which different
companies operate. They further argue that consideration should always
be made of the political, economic, social and cultural environments that
surround the firm. In the viewpoint of developing countries insights
of the imported systems may be gained by commencing studies of
the manner in which foreign companies establishing operations in
developing countries adjust their management accounting systems
to the context of the developing world (Wallace, 1990; Peasnell, 1993;
Chow et al., 1994, 1999).
The International Federation of Accountants (IFAC), in 1998, describes

management accounting before 1950 as a technical activity required for
the pursuit of organizational objectives. It was predominantly oriented
towards the determination of product cost. Production technology
was comparatively simple, with products going through a series of
dissimilar processes. Labor and material costs were simply identifiable
3
and the manufacturing processes were mainly governed by the alacrity
of manual operations. Therefore, direct labor provided a natural basis
for assigning overheads to individual products. The spotlight on
product costs was supplemented by budgets and the financial control
of production processes.
According to Chandler (1977), management accounting systems (MAS)

first appeared in the United States during the nineteenth century.
These MAS employed both simple and complicated accounting
methods. For example, the early management accounting procedures
were simple but seemed to satisfy the needs of business owners and
managers. Simple managerial accounting procedures created during
the nineteenth century were used to observe and evaluate the output of
internally directed processes. Cost accounts were used to determine the
direct labor and overhead costs of converting raw materials into goods.
The use of sophisticated accounting procedures also dates back to the
nineteenth century.
As early as the first quarter of the nineteenth century, according to

Porter (1980), some companies in the USA used sophisticated sets of
cost accounts. New accounting systems were intended to control and
record the disbursements of cash during this period, which provided
management with timely and accurate reports on expenditures. During
the nineteenth century, a voucher system of bookkeeping which is
used for controlling and recording disbursements was also created
(Wood, 1895). In contrast, accounting was mainly used as a record
of the external relations between business units before the industrial
revolution. Information for decision-making and control was usually
acquired from market prices (Graner, 1954).
Cost accounting became more than just a utensil for evaluating internal
conversion processes during the nineteenth century, according to
Johnson and Kaplan (1987). It was also used as a means to evaluate the
performance of subordinate managers. Besides, internal accounting
systems for evaluating costs, throughput, and working capital were
developed during the nineteenth century. New cost measurement
techniques for analyzing productivity and relating profits to products
were developed during the late nineteenth and early twentieth century
(Askarany, 2004).
On twentieth century accounting practices, these techniques had a

significant impact. Some of these techniques provided the foundation
for the development of standards to monitor labor and material
4
efficiencies and costs. This was the time of the development of scientific
management that concentrated on gathering accurate information vis-
-vis the efficiency of workers affianced in specified tasks. Moreover,
the use of variance analysis of actual costs and standard costs for the
purpose of controlling operations was also developed.
Scientific management experts, during the nineteenth century, also

developed new cost accounting procedures to evaluate and control
physical and financial efficiency of tasks and processes in complex
machine-making firms and to assess the overall profitability of the
enterprise (Johnson & Kaplan, 1987). More or less the 1900s managers
started paying attention to the productivity and performance of capital.
The design of Du Pont management accounting procedures during that
period facilitated the evaluation of the performance of capital; these
gave momentous attention to the application of return on investment.
Such information helped managers in the allocation of new investments
among contending economic activities and the financing of new capital
requirements (Chandler & Salsbury, 1971).
Before World War I, according to Johnson and Kaplan (1987), the Du

Pont Company was using nearly all of the management accounting
procedures for planning and controlling purposes, known until the
1980s. As they reported, most of cost and management accounting
procedures were developed during the nineteenth and first quarter of
the twentieth century. They further stated that some organizations were
trying to develop and use accurate cost accounting systems to trace costs
exactly to dissimilar lines of products before World War I. This evidence
supports that even the thought and logic behind activity based costing
for designing an accurate costing method is not new (Askarany, 2004).
The application of non-accounting information (financial and non-
financial) in management accounting is not new either which has
attracted considerable attention in the last two decades. According to
Johnson (1992), as far back as the first half of nineteen century, businesses
owners and managers were using non-financial information to control
organizational operations. The idea of paying more attention to the
working people and customers of organizations as a long-term source
of profit also dates back to before the 1950s.
However, the demand for management accounting information for

the purpose of planning and control decisions is a much more recent
phenomenon although it might be argued that the logic behind most
of management accounting techniques dates back to the first half
of nineteenth century (Cooper & Kleinchmidt, 1990; Johnson, 1992;
5
Johnson & Kaplan, 1987; and Kaplan, 1984). Moreover, a comparison
between todays management accounting procedures and those used
before the 1950s would show a substantial number of innovations in
this field (Askarany, 2004)
The focus of management accounting shifted to the provision of

information for planning and control purposes in the 1950s and
1960s. In this phase, management accounting is seen by IFAC as a
management activity, but in a staff role. It involved staff (management)
support to line management through the use of such technologies as
decision analysis and responsibility accounting. Rather than strategic
and environmental considerations, management controls were oriented
towards manufacturing and internal administration (Kader and Luthar,
2004).
Management accounting tended to be reactive, identifying problems and

actions as part of a management control system only when deviations
from the business plan took place (Ashton et al., 1995). Since the 1950s
more than 30 popular cost and management accounting techniques
have been introduced. The majority of these innovations have been
introduced during the last two decades. According to Hagerty (1997)
and Smith (1999), the major developments in management accounting
since 1950s can be explained as follows:
The increased global competition in the early 1980s and the world
recession in the 1970s following the oil price shock threatened
the Western established markets. Increased competition was
accompanied and underpinned by rapid technological development
which influenced many aspects of the industrial sector (Kader
and Luther, 2004). For example, the use of robotics and computer-
controlled processes improved quality and reduced costs in many
cases. Also developments in computers, especially the emergence
of personal computers, obviously changed the nature and amount
of data which could be accessed by managers. Hence the design,
maintenance and interpretation of information systems became of
considerable importance in effective management (Ashton et al.,
1995).
The challenge of meeting global competition was met by introducing

new management and production techniques, and at the same time
controlling costs, often through reduction of waste in resources
used in business processes (IFAC, 1998). In many cases this was
supported by employee empowerment. In this environment there is
a need for management
6
information and decision making, to be diffused throughout the
organization. The challenge for management accountants, as the
primary providers of this information, is to ensure through the use of
process analysis and cost management technologies that appropriate
information is available to support managers and employees at all
levels (Kader and Luther, 2004). In brief, cost and management
accounting innovations in 1980s can be identified as: Activity
based costing, Target costing, Value-added management, Theory of
constraints, Vertical integration, Private labels and Benchmarking
(Hagerty, 1997 and Smith, 1999).
According to Hagerty (1997) and Smith (1999), cost and management

accounting innovations in 1990s can be identified as: Business
process reengineering, Quality functional deployment, Outsourcing,
Gain sharing, Core competencies, Time-based competition
and Learning organization. Reviewing cost and management
accounting innovations of the last two decades, Bjrnenak & Olson,
(1999) identify the major recently developed cost and management
accounting techniques in the literature as- activity based costing
(ABC); activity management (AM) and activity based management
(ABM); local information system (LS); balanced scorecard (BS); life
cycle costing (LCC) and target costing (TC); strategic management
accounting (SMA).
In the 1990s world-wide industry continued to face considerable

uncertainty and unprecedented advances in manufacturing
and information-processing technologies (Ashton et al., 1995).
For example the expansion of the world-wide web and allied
technologies led to the appearance of E-commerce which further
increased and emphasized the challenge of global competition.
The focus of management accountants shifted to the generation or
creation of value through the effective use of resources. This was
to be achieved through the use of technologies which check up the
drivers of customer value, shareholder value, and organizational
innovation (IFAC, 1998).
Therefore, we can conclude that, the practice of management accounting

stagnated, in the early part of the century, as product line expanded
operations became more complex, forward looking companies saw a
renewed need for management-oriented reports that was separate
from financial reports. But in most companies, management accounting
practices up through the mid-1980s were largely indistinguishable
from practices that were common prior to World War I. In recent years,
7
however, new economic forces have led to many important innovations
in management accounting. These new practices are discussed in other
chapters.
The figure below shows the evolution of Management accounting

practice
Source: Johnson (1983)
1.3 Factors Determining Management Accounting Change

Different people mentioned various factors determining management
accounting change but perhaps the most frequently quoted were the
competitive economic situation of the 1990s, and particularly global
competition. The degree to which the claims of increased competition are
metaphorical does not in fact matter rather than actual economic effects.
It is the perception of managers and accountants which is important, and
how they perceive the economic climate in which they operate. If there
is a perception of greater competition, then an increased focus is likely to
be given to markets and the customer. An added elementary change is
the advance in information technology which has taken place in recent
years. The momentum of technological change over the last 30 years
or so has had a profound effect on organizational life. Predominantly
significant over the last 5-10 years has been the extent of the dispersion
of computers and computing capacity around the organization. The
increased use of the computer has had major effects on the nature of
8
work, especially clerical work, and on information flows around the
organization (Burns and Scapens, 2000).
Besides, there have been other significant changes in organizational

structure although again whether they are generated by metaphorical or
real economic factors is not apparent. Whereas in the UK in the 1970s, for
example, there was a wave of acquisitions and mergers, with the creation
of conglomerates, by the 1990s organizations were moving in the reverse
direction. The trend was then for de-mergers, with companies focusing
on core competencies, and outsourcing non-core activities (Burns and
Scapens, 2000). These various changes - in competition, technology and
organizational structure - all have important connotations for the nature
of management accounting - particularly the way in which conventional
accounting techniques are now being used.
1.4 Definitions of Management Accounting

Management accounting is not a specific system of accounts, but could
be any form of accounting which enables a business to be conducted
more effectively and efficiently. Management accounting in the words of
Robert S. Kaplan (1987) (is a system that collects, classifies, summaries,
analyses and reports information that will assist managers in their
decision making and control activities. Unlike financial accounting,
where the primary emphasis is on reporting outsiders, management
accounting focuses on internal planning and control activities.
Therefore management accounting requires the collection, analysis and
interpretation not only financial or cost data, but also other data such as
sales, price, product demands and measures of physical quantities and
capacities. In the process, the system utilizes all techniques of financial
and cost accounting including marginal or direct costing, standard
costing, budgetary control, etc. Management accounting therefore
appears as the extension of the horizon of cost accounting towards
newer areas of management.
Management accounting is largely concerned with providing economic

information to managers for achieving organizational goals. The
information flow system is, therefore, extremely important while
designing the system. Managers at each level must have a clear
understanding about the objectives and goals assigned and receiving
flow of relevant information. It is important to note that overabundance
of irrelevant information is as bad as lack of relevant information.
Management accounting is an integral part of management concerned

with identifying presenting and interpreting information used for
9
formulating strategy, planning and controlling activities decision
making, optimizing the use of resources and safe guarding assets of the
firm.
The above definition of management accounting, involves participation

of management to ensure that there is effective.
(a) Formulation of plans to meet objectives (strategic planning)
(b) Formulation of short term operation plan
(c) Acquisition and use of finance and recording of transaction
(d) Communication of financial and operating information
(e) Corrective action to bring plans and results into line (financial
control)
(f) Reviewing and reporting on systems and operations
Management accounting is primary concerned with data gathering

(from internal and external source) analysis, processing, interpreting
and communicating the resulting information for use within the
organization so that management can more effectively plan, make
decisions and control operation.
According to the Chartered Institute of Management Accountants

(CIMA, 2005), Management Accounting is the process of identification,
measurement, accumulation, analysis, preparation, interpretation and
communication of information used by management to plan, evaluate
and control within an entity and to assure appropriate use of and
accountability for its resources. Management accounting also comprises
the preparation of financial reports for non management groups such as
shareholders, creditors, regulatory agencies and tax authorities (CIMA
Official Terminology).
The American Institute of Certified Public Accountants (AICPA, 2008)

states that management accounting practice extends to the following
three areas:
Strategic Management; advancing the role of the management

accountant as a strategic partner in the organization
Performance Management; developing the practice of business

decision-making and managing the performance of the
organization
Risk Management; contributing to frameworks and practices

for identifying, measuring, managing and reporting risks to the
achievement of the objectives of the organization.
10
The Institute of Certified Management Accountants (ICMA, 2005),
state A management accountant applies his or her professional
knowledge and skill in the preparation and presentation of financial
and other decision oriented information in such a way as to assist
management in the formulation of policies and in the planning
and control of the operation of the undertaking. Management
Accountants therefore are seen as the value-creators amongst the
accountants. They are much more interested in forward looking and
taking decisions that will affect the future of the organization, than
in the historical recording and compliance (scorekeeping) aspects of
the profession. Management accounting knowledge and experience
can therefore be obtained from varied fields and functions within an
organization, such as information management, treasury, efficiency
auditing, marketing, valuation, pricing, logistics, etc.
Therefore, Management accounting is concerned with the provisions

and use of accounting information to managers within organizations,
to provide them with the basis to make informed business decisions
that will allow them to be better equipped in their management and
control functions. In contrast to financial accounting information,
management accounting information is: usually confidential and used
by management, instead of publicly reported, forward-looking, instead
of historical, pragmatically computed using extensive management
information systems and internal controls, instead of complying
with accounting standards This is because of the different emphasis:
management accounting information is used within an organization,
typically for decision-making
1.5 The Importance of Management Accounting in an Organization

The demand for managerial accounting has increased dramatically
as the nature of the business entity has evolved into todays large,
geographically dispersed, and complex organization. Consider, for
example, the different information needs of the owner or manager of a
sole proprietorship and the manager of a large organization. The owner
or manager of a sole proprietorship is usually heavily involved with
the day-to-day operations of the business. They often make most (if
not all) of the operating decisions and generally observe most of the
transactions (such as purchases of inventory and receipt of customer
orders) that affect their business.
Through this involvement, they acquire a great deal of firsthand

knowledge about the events and transactions that affect the entity. As a
result, this owner or manager has very limited information needs with
respect to the entity.
11
In contrast, the manager of a large organization has only limited firsthand
knowledge of the day-to-day operations of the entity. The large size,
increased complexity, and geographic location of the entity makes it
almost impossible for the manager of a large organization to operate
the entity based on personal, firsthand knowledge. Therefore, he or she
must rely on summaries and reports of relevant information prepared
by other individuals within the organization. Thus, in making operating
decisions concerning the entity, it can be said that this manager has a
greater need for information provided through the process of managerial
accounting:
Hence, every organization - large and small-has managers. Someone

must be responsible for making plans, organizing resources, directing
personnel, and controlling operations. Everywhere mangers carry
out three major activities - planning, directing and motivating, and
controlling:
(i) Planning
Planning involves selecting a course of action and specifying how the
action will be implemented. The first step in planning is to identify
the alternatives and then to select from among the alternatives the
one that does the best job of furthering the organizations objectives.
While making choices management must balance the opportunity
against the demands made on the companys resources: The plans of
management are often expressed formally in budgets and the term
budgeting is applied to generally describe the planning process.
Budgets are usually prepared under the direction of controller, who
is the manager in charge of the accounting department. Typically,
budgets are prepared annually and represent managements plans
in specific, quantitative terms.
(ii) Directing and Motivating

In addition to planning for the future, managers must oversee day-
to-day activities and keep the organization functioning smoothly.
This requires the ability to motivate and affectively direct people.
Managers assign tasks to employees, arbitrate disputes, answer
questions, solve on-the-spot problems, and make many small
decisions that affect customers and employees. In effect, directing
is that part of the managers work that deals with the routine and
the here and now. Managerial accounting data, such as daily sales
reports are often used in this type of day-to-day decision making.
12
(iii) Controlling:
In carrying out the control function, managers seek to ensure that
the plan is being followed. Feedback, which signals operations are on
track, is the key to effective control. In sophisticated organizations,
this feedback is provided by detailed reports of various types.
One of these reports, which compares budgeted to actual results,
is called a performance report. Performance report suggests where
operations are not proceeding as planned and where some parts of
the organization may require additional attention.
(iv) The Planning and Control Cycle:

The work of management can be summarized in a model. The model,
which depicts the planning and control cycle, illustrates the smooth
flow of management activities from planning through directing
and motivating, controlling, and then back to planning again. All of
these activities involve decision making. So it is depicted as the hub
around which the activities revolve.
1.6 The role of Management Accountants within the Organization

Management accounting is generally concerned with informing
managers so that they stay up to date with relevant information so that
they can make informed business decisions. Management accounting
should not be confused with financial accounting (which is a common
misconception). Financial accounting tends to be more focused on
previous transactions, whereas management accounting is more towards
looking into the future. Financial account often involves information
for shareholders which is publicly released, whereas management
accounting deals with private, confidential information which is often
never released to the public.
As a management accountant in an organization, youll provide

operational and financial information to those inside the organization
who need it, and youll regularly report with the business and financial
teams for updates on their progress. Youre responsible for keeping
track of any new information and any changes, and then directing that
information to those who can deal with the new information or changes.
Youre activities will involve reviewing aspects of the business like costs,
forecasting ahead based on evidence, and checking previous forecasts
to see if they are correct, and if not, then youll have to understand why
they are not correct.
That said, this is a role which can vary considerably from one organisation
to the next, although the core principles remain the same. A large
13
business can even have many management accountants keeping track
of more specific parts of the business. Youd then be responsible for
overseeing and forecasting for just that section of the business.
Keeping records is a key skill; youll need to keep top quality records
so that you can quickly provide key information of specific issues that
may arise in the organisation. Moreover, youll be required to produce
summaries of the key information related to the business, so that
internally managers can track progress.
Often management accountants are also involved with controlling

activities and ensuring that they are being carried out. As youre
collecting so much information, chances are that youre often the first
one wholl notice an issue, so in some cases its your responsibility
to track down and resolve that issue (particularly in smaller business
where you cant just report to a manager and expect them to take care
of everything).
Some of the specific skills youll need will likely include:

Analysis of data, price modeling, profitability analysis, cost benefit
analysis, budgeting, planning, management advice, and financial
forecasting.
Overall youll have a key role in the organization which can be quite
varied, from helping with decision making to producing forecasts.
Consistent with other roles in todays organization, management

accountants have a dual reporting relationship. As a strategic partner
and provider of decision based financial and operational information,
management accountants are responsible to manage business team at
the same time also have reporting relationships and responsibilities to
the corporations finance organization.
The activities of management accountants provide inclusive of forecasting

and planning, performing variance analysis, reviewing and monitoring
costs inherent in the business are ones that have dual accountability
to both finance and the business team. Examples of tasks where
accountability may be more meaningful to the business management
team vs. the corporate finance department are the development of
new product costing, operations research, business driver metrics,
sales management score carding, and client profitability analysis.
Conversely, the preparation of certain financial reports, reconciliations
of the financial data to source systems, risk and regulatory reporting
14
will be more useful to the corporate finance team as they are charged
with aggregating certain financial information from all segments of the
corporation. One widely held view of the progression of the accounting
and finance career path is that financial accounting is a stepping stone to
management accounting. Consistent with the notion of value creation,
management accountants help drive the success of the business while
strict financial accounting is more of a compliance and historical
endeavor
1.7 Objectives of Management Accounting:

The objectives of management accounting are:
(a) To help the management in promoting efficiency
(b) To finalize budgets covering all functions of a business.
(c) To study the actual performance with plan for identifying
deviations and their causes
(d) To analyze financial statements to enable the management to
formulate future policies
(e) To help the management at frequent intervals by providing
operating statements and short-term financial statements
(f) To arrange for the systematic allocation of responsibilities for
the implementation of plans and budgets
(g) To provide a suitable organization for discharging the
responsibilities
1.8 Functions of Management Accounting

Management accounting performs the following functions
(i) Preparing Budgets:

A basic managerial accounting activity relates to the preparation of
budgets. Budgets are formal plans expressing courses of action in
quantitative terms, Budgets can encompass either a short- term or
long-term period of time. For example, accountants often prepare
budgets for management which determine how many units of
inventory need to be produced in a given period of time (usually a
month) in order to meet that periods expected demand. Accountants
can also prepare budgets encompassing longer periods of time. For
potential capital expenditures, accountants identify the expected
costs and cash savings associated with the expenditure to provide
management with an indication of the desirability of the expenditure.
This type of budgeting is referred to as capital budgeting.
(ii) Devising Standards

Performance standards are used by management to identify areas
15
where potential inefficiencies may exist. For example, assume that
performance standards suggest that 100 hours of labor are required
to produce a given number of units; if 200 hours are actually used
to produce this quantity, the difference may suggest that workers
are not performing up to their capabilities. Managerial accountants
often help establish performance standards for the entity and
assist management in interpreting the relationship between actual
performance and these standards.
(iii) Accumulating Data on Costs and Profits:

When an entity manufactures the inventory it sells to its customers,
a critical requirement of the accounting system is that all costs
associated with the production of the inventory (referred to as
product costs) are accurately accumulated. These costs should be
included with the inventory as it moves through the various stages
of production and are expensed (as cost of goods sold) when the
inventory is sold to customers. Accumulating the costs associated
with inventory is a central activity performed by managerial
accounting. In addition, managerial accountants also accumulate data
on profits. These data are used to provide reports on the profitability
of the entity. Information in these reports is used in making both
pricing decisions (how much do we need to charge for unit X to
break even if we sell 100 units?) as well as evaluation decisions
(does segment Y earn enough to cover its variable costs?). This latter
type of analysis is referred to as cost-volume-profit analysis and is
an important consideration in the organizations decision to sell its
products and/or services.
(iv) Comparing Actual Activity with Plans or Budgets:

In many instances, accounting data are used to evaluate personnel
and/or pinpoint areas that may require additional attention. Once
actual results have been achieved, they can be compared to planned
or budgeted results. Any unexpected differences between actual and
budgeted results may suggest the need for increased managerial
attention. In addition to identifying areas where additional attention
may be needed, individuals and/or departments within the
organization are often evaluated based upon how they perform in
relation to the budget. The managerial accountant often gathers this
information and prepares summary reports that present how actual
performance differs from planned (or budgeted) performance.
(v) Advising Management about Non-routine Decisions:

The four functions discussed above are related to the normal
16
day-to-day operations of the company. As a result, managerial
accountants frequently gather and summarize information related
to those types of activities. In other cases, management may request
assistance in making decisions of a less routine nature. Some of
these decisions include: (1) discontinuing an industry segment or
product line, (2) manufacturing components used in producing
inventory versus purchasing components from an external supplier,
and (3) purchasing long-term assets for use in production (capital
budgeting). The managerial accountant will gather information
about the consequences of alternatives in these decisions.
1.9 Differences between Management Accounting and Financial Accounting

Managerial accounting information is used internally by managers in
planning, organizing, directing, and controlling a firms activities.
Financial accounting information is accounting information that is

either mandatory or voluntarily disclosure by a firms management to
investors, financial and securities analysts, regulators, etc. and as such
constitutes public information.
This contrast in basic orientation results in a number of major differences

between financial and managerial accounting, even though both
financial and managerial accounting often rely on the same underlying
financial data. In addition to the to the differences in who the reports are
prepared for, financial and managerial accounting also differ in their
emphasis between the past and the future, in the type of data provided
to users, and in several other ways. These differences are discussed in
the following paragraphs
The principal differences between management and financial ac-

counting are described below:
(i) Legal requirements;

There is a statutory requirements for public limited companies to
produce annual financial accounts regardless of whether or not
management regards, this information as useful, management
accounting by contrast is entirely optional and information should
be produced only if it is considered that, the benefits from the use of
information by management exceed the cost of collecting it.
(ii) Focus on individual parts or segments of the business;

Financial accounting reports describe the whole of the business
whereas management accounting focuses on small parts of the
organization.
17
(iii) Generally accepted accounting principles;
financial accounting statements must be prepared to conform to the
legal requirements and the generally accepted accounting principles,
when providing managerial information for internal purposes there
is no need any accounting principles
(iv) Report frequency;

A detailed set of financial accounts is published annually and
less detailed accounts are published semi-annually. Management
requires information quickly if it is to act on it. Therefore management
accounting reports on various activities may be prepared at daily
weekly or monthly intervals.
(v) Necessity-
Financial accounting must be done. Enough effort must be expended
to collect data in acceptable form and with an acceptable degree
of accuracy to meet the requirements of the Financial Accounting
Standards Board (FASB) and other outside parties, whether or not
the management regards this information as useful. Management
accounting, by contrast, is entirely optional, no outside agencies
specify what must be done or indeed that anything need be
done. Because it is optional, there is no point in collect-ing a
piece of (management accounting information unless its value to
managements believed to exceed the cost of collecting it.
(vi) Purpose-
The purpose of financial accounting is to produce financial statements
for outside users. When the statements have been produced, this
purpose has been accomplished. Management accounting in-
formation, on the other hand, is only a- means to an end, the end
being the planning, implementing, and controlling functions of
management.
(vii) Users-
The users of financial accounting information (other than
management itself) are essentially a faceless group. The
managements of most companies do not personally know many
of the shareholders, creditors, or others who use the information in
the financial statements. Moreover, the information needs of most
of these external users must be presumed; most external users do
not individually request the information they would like to receive.
By contrast, the users of management accounting information are
known managers plus the people who help this managers-ana1yze
18
the information. Internal users information needs are relatively
well known because the controllers office solicits these needs in
designing or revising the management accounting system.
(viii) Time Orientation-

Financial accounting records and reports the financial history of an
organization. Entries are made in the accounts only after transactions
have occurred. Although financial accounting information is
used as a basis, for making future plans, the information itself is
historical. Management accounting includes, in its formal structure,
numbers that represent estimates and plans for the future as well as
information about the past. The objective of financial accounting is
to tell it like it was, not like it will be.
(ix) Information Content-

The financial statements that are the end product of financial
accounting include primarily monetary information. Management
accounting reports deal with no monetary as well as monetary
information. These reports show quantities of material as well as
its monetary cost, number of employees and hours worked as well
as labour costs, units of products sold as well as the amounts of
revenue, and so on.
1.10 Management accountings role in business management

Management accounting is very closely linked to cost accounting; so
closely, in fact, that it is difficult to say where cost accounting ends and
where management accounting begins. Cost accounting simply aims to
measure the performance of departments, goods and services. However,
management accounting is much, much more and involves:
(i) The provision or information for management:

Indeed, the role of the management accountant could well be
described as that of an information manager. The information
generated should be designed to assist management, to control
business operations and to help management with decision-making.
In fulfilling this role the management accounting department/ section
must consult with the users of the information, i.e. management, to
assess its needs in terms of precisely what information is required
and when, etc. The aim is, to provide management with a flow of
relevant information, e.g. reports, statements, spreadsheets, etc.
as and when required. A frequent flow of information (weekly
or monthly) should enable management to respond to emerging
problems/ situations as soon as possible. The early detection of
problems means earlier solutions & early action.
19
(ii) Advising management:
A key part of management accounting is to advise management
about the economic consequences and implications of its (proposed)
decisions and alternative course of action. In particular, this advice
should answer a frequently overlooked question: What happens if
things go wrong? (If interest rates group or if the sales target is not
achieved
(iii) Forecasting,
Planning and control: A lot of management accounting is concerned
with the future and predetermined systems such as budgetary control
and standard costing. Such systems investigate the differences
(i.e. variances) which arise as a result of actual performance being
different from planned performance in terms of budgets or standards.
In addition, the management accountant should also be involved in
strategic planning, e.g. the setting of objectives and the formulation
of policy. The forecasting process will involve accounting for
uncertainty (risk) via statistical techniques, such as probability, etc.
(iv) Communications:
If the management accounting system is to be really effective it is
essential that it goes hand in hand with a good, sound, reliable and
efficient communication system. Such a system should communicate
clearly by providing information in a form, which the user, i.e.
managers and their subordinates, can easily understand (reports,
statements, tabulations, graphs and charts). However, great
care should be taken to ensure that managers do not suffer from
information overload, i.e. having too much information much of
which they could well do without.
(v) Systems:
The management accounting department or section will also be
actively involved with the design of cost control systems and
financial reporting systems.
(vi) Flexibility:
Management accounting should be flexible enough to respond
quickly to changes in the environment in which the company/
organization operates. Where necessary information/ systems
should be amended/ modified. Thus, there is a need for the
management accounting section/ department to be involved with
the monitoring of the environment on a continuing basis.
20
(vii) An appreciation of other business functions:
Those who provide management accounting information need
to understand the role played by the other business functions. In
addition to communicating effectively with other business functions,
they also need to secure their cooperation and coordination, e.g.
the budget preparation process relies on the existence of good
communications, cooperation and coordination
(viii) Staff Education:

The management accounting department/ section needs to ensure
that all the users of the information it provides, e.g. managers and
their subordinates, are educated about the techniques used, their
purpose and their benefits, etc
1.11 Current issues facing Management Accounting

The following three factors will affect your study of management
accounting, these three major factors are causing changes in management
accounting today
(i) Shift from a manufacturing-based to a service-based economy:

The service sector now accounts for large part of the economy
for example in Tanzania economy the service based economy is
expanding rapidly and the percent of the employment come from
the service based economy is increasing rapidly, hence the Service
industries are becoming increasingly competitive and their use of
management accounting information is growing
(ii) Increased global competition:

Global competition has increased in recent years as many international
barriers to trade, such as tariffs and duties, have been lowered. In
addition, there has been a worldwide trend toward deregulation.
The result has been a shift in the balance of economic power in
the world. To regain their competitive edge, many companies are
redesigning their accounting systems to provide more accurate and
timely information about the cost of activities, products, or services.
Therefore to be competitive, managers must understand the effects
of their decisions on costs, and management accountants must help
managers predict such effects
(iii) Advances in technology:

By far the most dominant influence on management accounting
over the past decade has been technological change. This change has
affected both the production and the use of accounting information.
21
The increasing capabilities and decreasing cost of computers,
especially personal computers (PCs), has changed how accountants
gather, store, manipulate, and report data. Most accounting
systems, even small ones, are automated. In addition, computers
enable managers to access data directly and to generate their own
reports and analyses in many cases. By using spreadsheet software
and graphics packages, managers can use accounting information
directly in their decision process.
Thus, all managers need a better understanding of accounting

information now than they may have needed in the past. In addition,
accountants need to create database that can be readily under stood
by managers
1.12 Code of Conduct for Management Accountants:

Practitioners of management accounting and financial management
have an obligation to the public, their profession, the organization they
serve, and themselves, to maintain the highest standards of ethical
conduct. In recognition of this obligation, the Institute of management
Accountants has promulgated the following standards of ethical conduct
for practitioners of management accounting and financial management.
Adherence to these standards internationally is integral to achieving
objective of management accounting.
(i) Competence:
have a responsibility to:
Maintain an appropriate level of professional competence by

ongoing development of their knowledge and skills.
Perform their professional duties in accordance with relevant

laws, regulations and technical standards.
Prepare complete and clear reports and recommendations after

appropriate analysis of relevant and reliable information
(ii) Confidentiality:
(a) Refrain from disclosing confidential information acquired

in the course of their work except when authorized, unless
legally obligated to do so.
22
(b) Inform subordinates as appropriate regarding the
confidentiality of information acquired in the course of their
work and monitor their activities to assure the maintenance of
that confidentiality
(c) Refrain from using or appearing to use confidential information

acquired in the course of their work for unethical or illegal
advantage either personally or through third parties.
(iii) Integrity:
(a) Avoid actual or apparent conflicts of interest and advise all

appropriate parties of any potential conflict.
(b) Refrain from engaging in any activity that would prejudice

their ability to carry out their duties ethically.
(c) Refuse any gift, favour, or hospitality that would influence or

would appear to influence their actions.
(d) Refrain from either activity or passively subverting the

attainment of the organizations legitimate and ethical
objectives.
(e) Recognize and communicate professional limitations or other

constraints that would preclude responsible judgment or
successful performance of an activity.
(f) Communicate unfavorable as well as favorable information

and professional judgment or opinion.
(g) Refrain from engaging or supporting any activity that would

discredit the profession.
(iv) Objectivity:
(a) Communicate information fairly and objectively
(b) Disclose fully all relevant information that could reasonably
23
be expected to influence an intended users understanding of the
reports, comments, and recommendations presented.
1.13 Resolution of Ethical Conflicts:

In applying the standards of ethical conduct, practitioners of management
accounting and financial management may encounter problems in
identifying unethical behaviour or in resolving an ethical conflict.
When faced with significant ethical issues practitioners of management
accounting and financial management should follow the established
policies of the organization bearing on the resolution of such conflict. If
these policies do not resolve the ethical conflict, such practitioner should
consider the following course of action.
(a) Discuss such problems with immediate superior except when

it appears that superior is involved, in which case the problem
should be presented to the next higher managerial level. If a
satisfactory resolution cannot be achieved when the problem
is initially presented, submit the issue to the next higher
managerial level.
(b) If the immediate superior is the chief executive officer or

equivalent, the acceptable reviewing authority may be a
group such as the audit committee, executive committee,
board of directors, board of trustees, or owners. Contact with
a level above the immediate superior should be initiated only
with the superiors knowledge. Assuming the superior is not
involved. Except where legally prescribed, communication of
such problems to authorities or individuals not employed or
engaged by the organization is not considered appropriate.
(c) Clarify relevant ethical issues by confidential discussion

with an objective adviser to obtain a better understanding of
possible course of action
(d) Consult your own attorney as to legal obligations and rights

concerning the ethical conflict.
(e) If the ethical conflict still exists after exhausting all levels of
internal review, there may be no other recourse on significant
matters than to resign from the organization and to submit an
informative memorandum to an appropriate representative of
the organization. After resignation, depending on the nature
of the ethical conflict, it may also be appropriate to notify other
parties.
24
Assessment Question
The student should attempt to answer this question before looking up
the suggested solution at the end of the book
1.1
Majengo Co, a medium sized firm of architects, are about to absorb
Jambo & partners, a similar sized firm. They have engaged you as
management accountant. Part of your duties will be to review the cost
and management accounting function of the combined practice and to
recruit an assistant. You have an appointment with the senior partner
to discuss these issues.
Required
List down notes to use in tomorrows meeting which cover the following
points
(i) The functions of cost and management accounting
(ii) The personal attributes you would expect the assistant
management accountant to possess
ACCA Financial Management and Control
25
Summary
The understanding of the role of management accounting today, it is
important to understand its history. Therefore, this chapter has addressed
the overview of historical background in management accounting from
nineteenth century to present day. The chapter has also described some
definitions, objectives and functions of management accounting. We
have distinguished between management accounting (internal users)
and financial accounting (external users), the chapter also has addressed
the current issues facing management accounting which include: the
shift from a manufacturing-based to a service- based economy, increased
global competition and advances in technology. In conclusion, it is
therefore important that, where necessary, management accounting is
modified to meet the requirements of todays manufacturing and global
competitive environment.
Key Terms and Concepts

Code of conduct
Current issues
Ethical conflicts
Financial accounting
Management accounting
Performance management
Risk management
Strategic management
Value creators
26
Exercises Questions
1.1
(i) Describe the differences between financial accounting and
management accounting
(ii) Describe the different functions of management accounting
1.2
(i) How do management accountants support strategic decisions?
(ii) What role do management accountants perform?
1.3
Examine the extent to which the role and nature of management
accountants might differ within the public and private sectors.
1.4
Critically analyze the possible effects of e-commerce on the role of the
management accountant
Problems Questions
1.5
(i) Describe organization resource planning systems and their
impact on management accountants
(ii) Define the three major types of companies (based on their

revenue-generating activities). Which of these types of companies
utilize managerial accounting information?
1.6
Does management or the managerial accountant set the goals and
objectives of the organization? Does management or the managerial
accountant determine the means by which the chosen goals and
objectives will be achieved? Does management or the managerial
accountant determine what information should be reported, when it
should be reported, and how it should be reported?
1.7
Traditionally, management accounting, financial management and
financial accounting have been treated as largely separate disciplines.
Discuss the extent to which such a categorization is still valid and
comment upon the implications for todays management accounting
profession.
27
1.8
Analyze the potential effects of recent developments in the business or
public sector environments on the relevance of management accounting
systems.
1.9
Analyze the extent to which the management accounting information
system of a service-based organization of your choice would be likely
to differ from that of a manufacturing company
Examination Questions
1.10
Managerial AccountingGeneral: A small company producing parts for
the automobile industry is taking a hard look at its staff functions to
determine whether they have grown beyond their worth. The standard
functions of financial, tax, and managerial accounting are performed by
three men. The reason for having a managerial segment seems hazy. As
the president states, I handle any control problems. If someone needs a
push, I know it before the accountants tell me. All the accounting people
do is confirmed that I push the right one.
(a) If the president is right, should the managerial segment be

abolished?
(b) What could be done to improve the existing control function?
(c) If the president believes control is the only function of managerial

accounting, what could be done to expand his viewpoint?
(d) Do you think the president worked his way up to his position
through the financial side of the business? Is the presidents
background of any importance in ascertaining possible problems
between the financial side of the business and top management?
Explain.
1.11
Management accountants exist to ensure that the changing information
needs of managers are met. Management accountants are in the
fortunate position of being the brokers and guardians of information.
They may use this information to increase their own power and status.
Management accountants have a duty to serve all stakeholders of
their organization and a responsibility to ensure the reliability of the
information which they process. To what extent are these statements
contradictory or complementary?
28
Case Studies
Case 1: Daily Telegraph Ltd

Company buyers across Europe aim to cut the cost of procuring raw
materials, goods and services this year by 13%, the highest amount
in four years. The aggressive target coincides with the arrival of the
purchasing manager- once seen as an administrative function at the
finance directors right hand side. But many of the 225 purchasing heads
from financial services and manufacturing companies responding to an
annual survey by software company Ariba admitted they had little idea
what was being spent by other departments. For instance, 37% said they
could account for less than 10% of the amount that their companies spent
on services. Instead, to hit their cost saving target, more buyers than ever
said they will rationalize their supplier bases and pressurize those left
to deliver more cheaply. They would continue to renegotiate contracts
despite admitting that average year on year saving from contracted
suppliers had fallen from 10% to 7% in that past year, the growing use
of non- contracted supplier based on low-cost countries apparently
eroding the previous wide price difference between the two.
Discussion questions
1. What are the roles of purchasing manager?
2. What are the roles of management accountant in an organization?
3. What are the limitations of forcing cost savings onto suppliers

rather than looking to internal improvements in the buying
company?
29
Further Readings
Abdel-Kader, M. and Luther, R. (2006), IFACs Conception of the
evolution of management accounting,
Abdel-Kader, M. and Luther, R. (2006): Advances in management

accounting, Vol. 15, pp. 229-247.
Robert S. Kaplan (1984): The evolution of management accounting

Hugh Coombs, David Hobbs and Ellis Jenkins (2005), Management
Accounting, Principles and Applications
Loft, A. (1995) The history of management accounting,

D. Ashton, T. Hopper and R. Scapens (eds),Issues in Management
Accounting(2nd edition). Hemel Hempstead: Prentice Hall
30
CHAPTER 2
CLASSIFICATIONS AND
APPROACHES TO COST ACCOUNTING
Chapter Objectives
The term cost is a frequently used to reflect a monetary measures of the
resources forgone to achieve a specific objective such as acquiring a good or
service. Therefore, the objective of this chapter focuses mainly on element of
costs, the components of costs and classification of costs which are used for
profit measurement and inventory valuation, decision making, performance
evaluation and controlling the activities of the organization.
Learning Outcomes
When you have finished studying the material in this chapter you will
be able to:
1. Identify and give examples of each of the three basic

manufacturing costs categories
2. Understand different costs classification
3. Distinguish between product costs and period costs and give
examples of each
4. Prepare a schedule of cost of goods manufactured
5. Prepare and income statement including calculation of the cost
of goods sold
6. Define and give examples of cost classification used in decision
making
7. Understand cost estimation and ascertainment
8. Understand and identify the methods of costing
9. Cost Allocation and Cost Apportionment
31
2.1 Introduction
Cost accounting has long been used to help managers understand the
costs of running a business. Modern cost accounting originated during
the industrial revolution, when the complexities of running a large scale
business led to the development of systems for recording and tracking
costs to help business owners and managers make decisions. In the
early industrial age, most of the costs incurred by a business were what
modern accountants call variable costs because they varied directly
with the amount of production. Money was spent on labour, raw
materials, power to run a factory, etc. in direct proportion to production.
Managers could simply total the variable costs for a product and use
this as a rough guide for decision-making processes.
Some costs tend to remain the same even during busy periods, unlike
variable costs which rise and fall with volume of work. Over time,
the importance of these fixed costs has become more important to
managers. Examples of fixed costs include the depreciation of plant and
equipment, and the cost of departments such as maintenance, tooling,
production control, purchasing, quality control, storage and handling,
plant supervision and engineering. In the early twentieth century,
these costs were of little importance to most businesses. However, in
the twenty-first century, these costs are often more important than
the variable cost of a product, and allocating them to a broad range of
products can lead to bad decision making. Managers must understand
fixed costs in order to make decisions about products and pricing.
In management accounting, cost accounting is that part of management

accounting which establishes budget and actual cost of operations,
processes, departments or product and the analysis of variances,
profitability or social use of funds. Managers use cost accounting to
support decision making to reduce a companys costs and improve its
profitability. As a form of management accounting, cost accounting
need not follow standards such as GAAP, because its primary use is for
internal managers, rather than external users, and what to compute is
instead decided pragmatically
Previously, cost accounting was merely considered to be a technique for

the ascertainment of costs of products or services on the basis of historical
data. In course of time, due to competitive nature of the market, it was
realized that ascertaining of cost is not as important as controlling costs.
Hence, cost accounting started to be considered more as a technique for
cost control as compared to cost ascertainment. Due to the technological
developments in all fields, cost reduction has also come within the
ambit of cost accounting. Cost accounting is, thus, concerned with
32
recording, classifying and summarizing costs for determination of costs
of products or services, planning, controlling and reducing such costs
and furnishing of information to management for decision making.
According to Horngren, cost accounting is a quantitative method that
accumulates, classifies, summarizes and interprets information for the
following three major purposes:
(i) Operational planning and control

(ii) Special decisions
(iii) Product decisions
According to the Chartered Institute of Management Accountants,

London, cost accounting is the process of accounting for costs from
the point at which its expenditure is incurred or committed to the
establishment of the ultimate relationship with cost units. In its widest
sense, it embraces the preparation of statistical data, the application of
cost control methods and the ascertainment of the profitability of the
activities carried out or planned. Cost accounting thus, provides various
information to management for all sorts of decisions; it serves multiple
purposes on account of which it is generally indistinguishable from
management accounting or so-called internal accounting.
2.1.1 Scope of Cost Accounting

The terms costing and cost accounting are many times used
interchangeably. However, the scope of cost accounting is broader than
that of costing. Following functional activities are included in the scope
of cost accounting:
Cost book-keeping: It involves maintaining complete record of all costs
incurred from their incurrence to their charge to departments, products
and services. Such recording is preferably done on the basis of double
entry system.
Cost system: Systems and procedures are devised for proper accounting
for costs.
Cost ascertainment: Ascertaining cost of products, processes, jobs, services,

etc., is the important function of cost accounting. Cost ascertainment
becomes the basis of managerial decision making such as pricing,
planning and control.
Cost Analysis: It involves the process of finding out the causal factors of
actual costs varying from the budgeted costs and fixation of responsibility
for cost increases.
33
Cost comparisons: Cost accounting also includes comparisons between
cost from alternative courses of action such as use of technology for
production, cost of making different products and activities, and cost of
same product/ service over a period of time.
Cost Control: Cost accounting is the utilization of cost information for

exercising control. It involves a detailed examination of each cost in the
light of benefit derived from the incurrence of the cost. Thus, we can
state that cost is analysed to know whether the current level of costs is
satisfactory in the light of standards set in advance.
Cost Reports: Presentation of cost is the ultimate function of cost

accounting. These reports are primarily for use by the management at
different levels. Cost Reports form the basis for planning and control,
performance appraisal and managerial decision making.
2.1.2 Objectives of Cost Accounting

The main objectives of cost accounting can be summarized as follows:
Determining Selling Price; Business enterprises run on a profit-

making basis. It is, thus, necessary that revenue should be greater
than expenditure incurred in producing goods and services from
which the revenue is to be derived. Cost accounting provides various
information regarding the cost to make and sell such products or
services, of course, many other factors such as the condition of
market, the area of distribution, the quantity which can be supplied
etc. are also given due consideration by management before deciding
upon the price but the cost plays a dominating role.
Determining and Controlling Efficiency; Cost accounting involves a

study of various operations used in manufacturing a product or
providing a service. The study facilitates measuring the efficiency
of an organization as a whole or department-wise as well as
devising means of increasing efficiency. Cost accounting also uses
a number of methods, e.g., budgetary control, standard costing etc.
for controlling costs. Each item viz. materials, labour and expenses
is budgeted at the commencement of a period and actual expenses
incurred are compared with budget. This greatly increases the
operating efficiency of an enterprise.
Facilitating Preparation of Financial and Other Statements; the third

objective of cost accounting is to produce statements whenever is
34
required by management. The financial statements are prepared
under financial accounting generally once a year or half-year and are
spaced too far with respect to time to meet the needs of management.
In order to operate a business at a high level of efficiency, it is
essential for management to have a frequent review of production,
sales and operating results. Cost accounting provides daily, weekly
or monthly volumes of units produced and accumulated costs with
appropriate analysis. A developed cost accounting system provides
immediate information regarding stock of raw materials, work-in-
progress and finished goods. This helps in speedy preparation of
financial statements.
Providing Basis for Operating Policy; Cost accounting helps

management to formulate operating policies. These policies may
relate to any of the following matters:
1. Determination of a cost-volume-profit relationship

2. Shutting down or operating at a loss
3. Making for or buying from outside suppliers
4. Continuing with the existing plant and machinery or
replacing them by improved and economic ones
2.1.3 Importance of Cost accounting

The limitation of financial accounting has made the management to
realize the importance of cost accounting. The importance of cost
accounting areas follows:
Helps in ascertainment of cost: Cost accounting helps the management

in the ascertainment of cost of process, product, Job, contract,
activity, etc., by using different techniques such as Job costing and
Process costing.
Aids in Price fixation: By using demand and supply, activities of

competitors, market condition to a great extent, also determine the
price of product and cost to the producer does play an important role.
The producer can take necessary help from his costing records.
Helps in Cost reduction: Cost can be reduced in the long-run when
cost reduction programme and improved methods are tried to
reduce costs.
Elimination of wastage: As it is possible to know the cost of product

at every stage, it becomes possible to check the forms of waste, such
as time and expenses etc., are in the use of machine equipment and
material.
35
Helps in identifying unprofitable activities: With the help of cost
accounting the unprofitable activities are identified, so that the
necessary correct action may be taken.
Helps in checking the accuracy of financial account: Cost accounting

helps in checking the accuracy of financial account with the help of
reconciliation of the profit as per financial accounts with the profit
as per cost account.
Helps in fixing selling Prices: It helps the management in fixing selling

prices of product by providing detailed cost information.
Helps in Inventory Control: Cost furnishes control which management

requires in respect of stock of material, work in progress and finished
goods.
Helps in estimate: Costing records provide a reliable basis upon which

tender and estimates may be prepared.
2.1.4 Concept of Cost

Cost accounting is concerned with cost and therefore is necessary to
understand the meaning of term cost in a proper perspective. In general,
cost means the amount of expenditure (actual or notional) incurred on,
or attributable to a given thing. However, the term cost cannot be exactly
defined. Its interpretation depends upon the following factors:
1. The nature of business or industry

2. The context in which it is used
In a business where selling and distribution expenses are quite nominal

the cost of an article may be calculated without considering the selling
and distribution overheads. At the same time, in a business where the
nature of a product requires heavy selling and distribution expenses,
the calculation of cost without taking into account the selling and
distribution expenses may prove very costly to a business. The cost may
be factory cost, office cost, and cost of sales and even an item of expense.
For example, prime cost includes expenditure on direct materials, direct
labour and direct expenses. Money spent on materials is termed as cost
of materials just like money spent on labour is called cost of labour and so
on. Thus, the use of term cost without understanding the circumstances
can be misleading.
Different costs are found for different purposes. The work-in-progress

is valued at factory cost while stock of finished goods is valued at
36
office cost. Numerous other examples can be given to show that the
term cost does not mean the same thing under all circumstances and
for all purposes. Many items of cost of production are handled in an
optional manner which may give different costs for the same product
or job without going against the accepted principles of cost accounting.
Depreciation is one of such items. Its amount varies in accordance with
the method of depreciation being used. However, endeavour should be,
as far as possible, to obtain an accurate cost of a product or service.
2.1.5 Cost objects

A cost object is any activity for which a separate measurement of cost
is defined. In other words, if the users of accounting information want
to know the cost of something, this something is called a cost object,
(Drury, 2006). Examples of cost objects include the cost of a product, the
cost of rendering a service a supermarket customer.
2.1.6 Elements of Cost

Following are the three broad elements of cost:
1. Material: The substance from which a product is made is known

as material. It may be in a raw or a manufactured state. It can be
direct as well as indirect.
Direct Material: The material which becomes an integral part of a

finished product and which can be conveniently assigned to specific
physical unit is termed as direct material. Following are some of the
examples of direct material:
a. All material or components specifically purchased, produced

or requisitioned from stores
b. Primary packing material (e.g., carton, wrapping, cardboard,

boxes etc.)
c. Purchased or partly produced components
Direct material is also described as process material, prime cost

material, production material, stores material, constructional
material etc.
Indirect Material: The material which is used for purposes ancillary

to the business and which cannot be conveniently assigned to
specific physical units is termed as indirect material. Consumable
37
stores, oil and waste, printing and stationery material etc. are
some of the examples of indirect material. Indirect material
may be used in the factory, office or the selling and distribution
divisions.
2. Labour: For conversion of materials into finished goods, human

effort is needed and such human effort is called labour. Labour
can be direct as well as indirect.
Direct Labour: The labour which actively and directly takes part in
the production of a particular commodity is called direct labour.
Direct labour costs are, therefore, specifically and conveniently
traceable to specific products. Direct labour can also be described
as process labour, productive labour, operating labour, etc.
Indirect Labour: The labour employed for the purpose of carrying

out tasks incidental to goods produced or services provided,
is indirect labour. Such labour does not alter the construction,
composition or condition of the product. It cannot be practically
traced to specific units of output. Wages of storekeepers, foremen,
timekeepers, directors fees, salaries of salesmen etc, are examples
of indirect labour costs. Indirect labour may relate to the factory,
the office or the selling and distribution divisions.
Expenses: Expenses may be direct or indirect.
Direct Expenses: These are the expenses that can be directly,

conveniently and wholly allocated to specific cost centres or cost
units. Direct expenses are sometimes also described as chargeable
expenses; examples of such expenses are as follows:
a. Hire of some special machinery required for a particular contract
b. Cost of defective work incurred in connection with a particular

job or contract etc.
Indirect Expenses: These are the expenses that cannot be directly,

conveniently and wholly allocated to cost centres or cost units.
Examples of such expenses are rent, lighting, insurance charges
etc.
3. Overhead: The term overhead includes indirect material, indirect

labour and indirect expenses. Thus, all indirect costs are overheads.
38
A manufacturing organization can broadly be divided into the
following three divisions:
a. Factory or works, where production is done

b. Office and administration, where routine as well as policy
matters are decided
c. Selling and distribution, where products are sold and
finally dispatched to customers Overheads may be incurred in
a factory or office or selling and distribution divisions. Thus,
overheads may be of three types:
Factory Overheads: They include the following things:

a. Indirect material used in a factory such as lubricants, oil,
consumable stores etc.
b. Indirect labour such as gatekeeper, timekeeper, works
managers salary etc
c. Indirect expenses such as factory rent, factory insurance,
factory lighting etc.
Office and Administration Overheads: They include the following things:

a. Indirect materials used in an office such as printing and
stationery material, brooms and dusters etc.
b. Indirect labour such as salaries payable to office manager,
office accountant, clerks, etc.
c. Indirect expenses such as rent, insurance, lighting of the
office
Selling and Distribution Overheads: They include the following things:

a. Indirect materials used such as packing material, printing and
stationery material etc.
b. Indirect labour such as salaries of salesmen and sales manager etc
c. Indirect expenses such as rent, insurance, advertising expenses
etc.
2.2 Components of Total Cost

Prime Cost: Prime cost consists of costs of direct materials, direct labours
and direct expenses. It is also known as basic, first or flat cost.
Factory Cost: Factory cost comprises prime cost and, in addition, works
or factory overheads that include costs of indirect materials, indirect
labours and indirect expenses incurred in a factory. It is also known as
works cost, production or manufacturing cost.
39
Office Cost: Office cost is the sum of office and administration overheads
and factory cost. This is also termed as administration cost or the total
cost of production.
Total Cost: Selling and distribution overheads are added to the total cost
of production to get total cost or the cost of sales. Various components
of total cost can be depicted with the help of the table below:
Components of total cost

Direct material
Prime cost or direct cost or first
Direct labour
cost
Direct expenses
Works or factory cost
Prime cost plus works overheads or production cost or
manufacturing cost
Works cost plus office and administration Office cost or total cost of
overheads production
Office cost plus selling and distribution
Cost of sales or total cost
overheads
Cost Sheet: Cost sheet is a document that provides for the assembly of
an estimated detailed cost in respect of cost centres and cost units. It
analyzes and classifies in a tabular form the expenses on different items
for a particular period. Additional columns may also be provided to
show the cost of a particular unit pertaining to each item of expenditure
and the total per unit cost. Cost sheet may be prepared on the basis
of actual data (historical cost sheet) or on the basis of estimated data
(estimated cost sheet), depending on the technique employed and the
purpose to be achieved. The techniques of preparing a cost sheet can be
understood with the help of the following examples.
Illustration
Following information has been obtained from the records of left centre
corporation for the period from June 1 to June 30, 2008. ($)
40
Cost of raw materials on June 1, 2008 30,000

Purchase of raw materials during the month 450,000
Wages paid 230,000
Factory overheads 92,000
Cost of work in progress on June 1, 2008 12,000
Cost of raw materials on June 30, 2008 15,000
Cost of stock of finished goods on June 1, 2008 60,000
Cost of stock of finished goods on June 30, 2008 55,000
Selling and distribution overheads 20,000
Sales 900,000
Administration overheads 30,000
Prepare a statement of cost
Statement of cost of production of goods manufactured for the period

on June 30, 2008 ($)
Opening stock of raw materials 30,000

Add- purchase 450,000
Less-closing of raw material 15,000
Value of raw material consumed 465,000
Wages 230,000
Prime cost 695,000
Factory overheads 92,000
Add-- opening stock of work in progress 12,000
Less-- closing stock of work in progress -
Factory cost 799,000
Add-- Administration overhead 30,000
Cost of production of goods manufactured 829,000
Add--opening stock of finished goods 60,000
Less-- closing stock of finished goods 55,000
Cost of production of goods sold 834,000
Add-- selling and distribution overheads 20,000
Cost of sales 854,000
Profit 46,000
Sales 900,000
41
2.3 Classification of Cost
Cost classification refers to the process of grouping costs according to their
common characteristics, such as nature of expense, function, variability,
controllability and normality.
Cost classification can be done on the basis of time, their relation with
the product and accounting period. Cost classification is also made
for planning and control and decision making. Thus, classification is
essential for identifying costs with cost centres or cost units for the
purpose of determination and control of cost:
By nature of expenses: Costs can be classified into material, labour and

expenses as explained earlier.
By function: Costs are classified, as explained earlier, into production or

manufacturing cost, administration cost, selling and distribution cost,
research and development cost.
Production cost begins with the process of supplying material
labour and services and ends with primary packing of the
finished product.
Administration cost is the aggregate of the costs of formulating

the policy, directing the organization and controlling the
operations of an undertaking, which is not related directly to
production, selling, distribution, research and development
activity or function.
Selling cost refers to the expenditure incurred in promoting sales

and retaining customers.
Distribution cost begins with the process of making the packed

product available for dispatch and ends with making the
reconditioned returned empty package available for reuse.
Research and development cost relates to the costs of researching

for new or improved products, new application of materials, or
new or improved methods, processes, system or services, and
also the cost of implementation of the decision including the
commencement of commercial production of that product or by
that process or method.
Pre-production cost refers to the part of development cost incurred

42
in making trial production run preliminary to formal production,
either in a new or a running factory. In a running factory, this
cost often represents research and development cost also. Pre-
production costs are normally considered as deferred revenue
expenditure and are charged to the cost of future production.
By variability: Costs are classified into fixed, variable and semi-fixed /

semi-variable costs according to their tendency to vary with the volume
of output.
The cost which varies directly in proportion with every increase or

decrease in the volume of output or production is known as variable
cost. Some of its examples are as follows:
a) Wages of labourers
b) Cost of direct material
c) Power
The cost which does not vary but remains constant within a given period
of time and a range of activity in spite of the fluctuations in production
is known as fixed cost. Some of its examples are as follows:
a) Rent or rates
b) Insurance charges
c) Management salary
The cost which does not vary proportionately but simultaneously does
not remain stationary at all times is known as semi-variable cost. It can
also be named as semi-fixed cost. Some of its examples are as follows:
a) Depreciation
b) Repairs
Fixed costs are sometimes referred to as period costs and variable

costs as direct costs in system of direct costing. Fixed costs can be
further classified into:
a) Committed fixed costs
b) Discretionary fixed costs
Committed fixed costs consist largely of those fixed costs that arise from
the possession of plant, equipment and a basic organization structure.
For example, once a building is erected and a plant is installed, nothing
much can be done to reduce the costs such as depreciation, property
taxes, insurance and salaries of the key personnel etc. without impairing
an organizations competence to meet the long-term goals.
43
Discretionary fixed costs are those which are set at fixed amount for
specific time periods by the management in budgeting process. These
costs directly reflect the top management policies and have no particular
relationship with volume of output. These costs can, therefore, be
reduced or entirely eliminated as demanded by the circumstances.
Examples of such costs are research and development costs, advertising
and sales promotion costs, donations, management consulting fees etc.
These costs are also termed as managed or programmed costs. In some

circumstances, variable costs are classified into the following:
a) Discretionary cost
b) Engineered cost
The term discretionary cost is generally linked with the class of fixed cost.
However, in the circumstances where management has predetermined
that the organization would spend a certain percentage of its sales for
the items like research, donations, sales promotion etc., discretionary
costs will be of a variable character.
Engineered variable costs are those variable costs which are directly
related to the production or sales level. These costs exist in those
circumstances where specific relationship exists between input and
output. For example, in an automobile industry there may be exact
specifications as one radiator, two fan belts; one battery etc. would be
required for one car. In a case where more than one car is to be produced,
various inputs will have to be increased in the direct proportion of the
output.
Thus, an increase in discretionary variable costs is due to the authorization

of management whereas an increase in engineered variable costs is due
to the volume of output or sales.
By controllability: Costs can be classified under controllable cost and

uncontrollable cost.
Controllable cost can be influenced by the action of a specified
member of an undertaking.
Uncontrollable cost cannot be influenced by the action of a

specified member of an undertaking.
By normality: Costs can be divided into normal cost and abnormal cost.
Normal cost refers to the cost, at a given level of output in the
conditions in which that level of output is normally attained.
44
Abnormal cost is a cost which is not normally incurred at a

given level of output in the conditions in which that level of
output is normally attained.
On the basis of time: Costs may be classified into historical or actual cost
and predetermined or future cost.
Historical cost relates to the usual method of determining actual
cost of operation based on actual expenses incurred during
the period. Such evaluation of costs takes longer time, till the
accounts are closed and finalized, and figures are ready for use
in cost calculations.
Predetermined cost as the name signifies is prepared in advance

before the actual operation starts on the basis of specifications and
historical cost data of the earlier period and all factors affecting
cost. Predetermined cost is the cost determined in advance and
may be either estimated or standard.
Estimated cost is prepared before accepting an order for submitting

price quotation. It is also used for comparing actual
performance.
Standard cost is scientifically predetermined cost of a product or

service applicable during a specific period of immediate future
under current or anticipated operating conditions. The method
consists of setting standards for each elements of cost, comparing
actual cost incurred with the standard cost, evaluating the
variance from standard cost and finding reasons for such
variance, so that remedial steps can be taken promptly to check
inefficient performances.
In relation to the product: Costs may be classified into direct and indirect
costs.
Direct costs are those which are incurred for a particular cost
unit and can be conveniently linked with that cost unit. The
expenses incurred on material and labour which are economically
and easily traceable for a product, service or job are considered
as direct costs. In the process of manufacturing of production
of articles, materials are purchased, labourers are employed
and the wages are paid to them. Certain other expenses are
also incurred directly. All of these take an active and direct
part in the manufacture of a particular commodity and hence
45
are called direct costs. Direct costs are termed as product cost.
Costs which are a part of the cost of a product rather than an
expense of the period in which they are incurred. They are
included in inventory values. In financial statements, such costs
are treated as assets until the goods they are assigned to be sold.
They become an expense at that time. These costs may be fixed
as well as variable, e.g., cost of raw materials and direct wages,
depreciation on plant and equipment etc
Indirect costs are those which are incurred for a number of cost
units and also include costs which though incurred for a
particular cost unit are not linked with the cost unit. These
expenses are incurred on those items which are not directly
chargeable to production, for example, salaries of timekeepers,
storekeepers and foremen. Also certain expenses incurred for
running the administration are the indirect costs. All of these
cannot be conveniently allocated to production and hence are
called indirect costs. Since such costs are incurred over a period
and the benefit is mostly derived within the same period, they
are called period costs. The costs which are not associated with
production are called period costs. They are treated as an expense
of the period in which they are incurred. They may also be fixed
as well as variable. Such costs include general administration
costs, salaries salesmen and commission, depreciation on office
facilities etc. They are charged against the revenue of the relevant
period. Differences between opinions exist regarding whether
certain costs should be considered as product or period costs.
Some accountants feel that fixed manufacturing costs are more
closely related to the passage of time than to the manufacturing
of a product. Thus, according to them variable manufacturing
costs are product costs whereas fixed manufacturing and other
costs are period costs. However, their view does not seem to
have been yet widely accepted
Cost analysis for decision making: Decision-making costs are special

purpose costs that are applicable only in the situation in which they
are compiled. They have no universal application. They need not tie
into routine-financial accounts. They do not and should not conform
the accounting rules. Accounting costs are compiled primarily from
financial statements. They have to be altered before they can be used
for decision-making. Moreover, they are historical costs and show what
has happened under an existing set of circumstances. Decision-making
costs are future costs. They represent what is expected to happen under
46
an assumed set of conditions. For example, accounting costs may show
the cost of a product when the operations are manual whereas decision-
making cost might be calculated to show the costs when the operations
are mechanized.
Here costs are classified under relevant costs and irrelevant costs.
Relevant costs are those which change by managerial decision. Irrelevant
costs are those which do not get affected by the decision. For example,
if a manufacturer is planning to close down an unprofitable retail sales
shop, this will affect the wages payable to the workers of a shop. This is
relevant in this connection since they will disappear on closing down of
a shop. But prepaid rent of a shop or unrecovered costs of any equipment
which will have to be scrapped are irrelevant costs which should be
ignored. Examples of Decision-making costs are
Shutdown and Sunk Costs: A manufacturer or an organization may have

to suspend its operations for a period on account of some temporary
difficulties, e.g., shortage of raw material, non-availability of requisite
labour etc. During this period, though no work is done yet certain fixed
costs, such as rent and insurance of buildings, depreciation, maintenance
etc., for the entire plant will have to be incurred. Such costs of the idle
plant are known as shutdown costs. Sunk costs are historical or past
costs. These are the costs which have been created by a decision that
was made in the past and cannot be changed by any decision that will
be made in the future. Investments in plant and machinery, buildings
etc. are prime examples of such costs. Since sunk costs cannot be altered
by decisions made at the later stage, they are irrelevant for decision-
making. An individual may regret for purchasing or constructing an
asset but this action could not be avoided by taking any subsequent
action. Of course, an asset can be sold and the cost of the asset will be
matched against the proceeds from sale of the asset for the purpose of
determining gain or loss. The person may decide to continue to own the
asset. In this case, the cost of asset will be matched against the revenue
realized over its effective life. However, he/she cannot avoid the cost
which has already been incurred by him/her for the acquisition of
the asset. It is, as a matter of fact, sunk cost for all present and future
decisions.
Illustration
ABC Ltd. purchased a machine for $ 30,000. The machine has an
operating life of five year $ without any scrap value. Soon after making
the purchase, management feels that the machine should not have been
purchased since it is not yielding the operating advantage originally
contemplated. It is expected to result in savings in operating costs of
47
$18,000 over a period of five years. The machine can be sold immediately
for $ 22,000.
To take the decision whether the machine should be sold or be used,

the relevant amounts to be compared are $ 18,000 in cost savings over
five year $ and $ 22,000 that can be realized in case it is immediately
disposed. $ 30,000 invested in the asset is not relevant since it is same
in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold
the machinery for $ 22,000 since it would result in an extra profit of $
4,000 as compared to keeping and using it.
Controllable and Uncontrollable Costs: Controllable costs are those

costs which can be influenced by the ratio or a specified member of the
undertaking. The costs that cannot be influenced like this are termed as
uncontrollable costs.
A factory is usually divided into a number of responsibility centres, each

of which is in charge of a specific level of management. The officer in
charge of a particular department can control costs only of those matte $
which come directly under his control, not of other matte $ For example,
the expenditure incurred by tool room is controlled by the foreman
in charge of that section but the share of the tool room expenditure
which is apportioned to a machine shop cannot be controlled by the
foreman of that shop. Thus, the difference between controllable and
uncontrollable costs is only in relation to a particular individual or level
of management. The expenditure which is controllable by an individual
may be uncontrollable by another individual.
Avoidable or Escapable Costs and Unavoidable or Inescapable Costs:

Avoidable costs are those which will be eliminated if a segment of a
business (e.g., a product or department) with which they are directly
related is discontinued. Unavoidable costs are those which will not be
eliminated with the segment. Such costs are merely reallocated if the
segment is discontinued. For example, in case a product is discontinued,
the salary of a factory manager or factory rent cannot be eliminated. It
will simply mean that certain other products will have to absorb a large
amount of such overheads. However, the salary of people attached to
a product or the bad debts traceable to a product would be eliminated.
Certain costs are partly avoidable and partly unavoidable. For example,
closing of one department of a store might result in decrease in delivery
expenses but not in their altogether elimination. It is to be noted that
only avoidable costs are relevant for deciding whether to continue or
eliminate a segment of a business.
48
Imputed or Hypothetical Costs: These are the costs which do not involve
cash outlay. They are not included in cost accounts but are important
for taking into consideration while making management decisions.
For example, interest on capital is ignored in cost accounts though it is
considered in financial accounts. In case two projects require unequal
outlays of cash, the management should take into consideration the
capital to judge the relative profitability of the projects.
Differentials, Incremental or Decrement Cost: The difference in total cost

between two alternatives is termed as differential cost. In case the choice
of an alternative results in an increase in total cost, such increased costs
are known as incremental costs. While assessing the profitability of a
proposed change, the incremental costs are matched with incremental
revenue. This is explained with the following example:
Illustration
A company is manufacturing 1,000 units of a product. The present costs
and sales data are as follows:
Selling price per unit $ 10

Variable cost per unit $5
Fixed costs $ 4,000
The management is considering the following two alternatives:
i. To accept an export order for another 200 units at $ 8 per unit.

The expenditure of the export order will increase the fixed costs
by $ 500.
ii. To reduce the production from present 1,000 units to 600 units
and buy another 400 units from the market at $ 6 per unit. This
will result in reducing the present fixed costs from $ 4,000 to $
3,000.
Which alternative the management should accept?
Solution
Statement showing profitability under different alternatives is as
follows:
49
Present situation
Particulars Proposed situations
$ $
Sales. 10,000 6,000 11,600 5,400 10,000
Less: 5,000 9,000 4,500 10,500 3,000 8,400
Variable purchase costs 4,000 _____ ____ ____ ____ _____
Fixed costs Profit 1,000 1,100 1,600
Observations
i. In the present situation, the company is making a profit of $ 1,000.
ii. In the proposed situation (i), the company will make a profit of $
1,100. The incremental costs will be $ 1,500 (i.e. $ 10,500 - $ 9,000)
and the incremental revenue (sales) will be $ 1,600. Hence, there is
a net gain of $ 100 under the proposed situation as compared to the
existing situation.
iii. In the proposed situation (ii), the detrimental costs are $ 600 (i.e. $
9,000 to $ 8,400) as there is no decrease in sales revenue as compared
to the present situation. Hence, there is a net gain of $ 600 as compared
to the present situation.
Thus, under proposal (ii), the company makes the maximum profit and
therefore it should adopt alternative (ii).
The technique of differential costing which is based on differential cost

is useful in planning and decision-making and helps in selecting the
best alternative.
In case the choice results in decrease in total costs, this decreased cost
will be known as detrimental costs.
Out-of-Pocket Costs: Out-of-pocket cost means the present or future

cash expenditure regarding a certain decision that will vary depending
upon the nature of the decision made. For example, a company has its
own trucks for transporting raw materials and finished products from
one place to another. It seeks to replace these trucks by keeping public
carriers. In making this decision, of course, the depreciation of the trucks
is not to be considered but the management should take into account the
present expenditure on fuel, salary to drive $ and maintenance. Such
costs are termed as out-of-pocket costs.
Opportunity Cost: Opportunity cost refers to an advantage in measurable

terms that have foregone on account of not using the facilities in the
50
manner originally planned. For example, if a building is proposed to be
utilized for housing a new project plant, the likely revenue which the
building could fetch, if rented out, is the opportunity cost which should
be taken into account while evaluating the profitability of the project.
Suppose, a manufacturer is confronted with the problem of selecting
anyone of the following alternatives:
a) Selling a semi-finished product at $ 2 per unit

b) Introducing it into a further process to make it more refined and
valuable
Alternative (b) will prove to be remunerative only when after paying

the cost of further processing; the amount realized by the sale of the
product is more than $ 2 per unit. Also, the revenue of $ 2 per unit is
foregone in case alternative (b) is adopted. The term opportunity cost
refers to this alternative revenue foregone.
Traceable, Untraceable or Common Costs: The costs that can be easily

identified with a department, process or product are termed as traceable
costs. For example, the cost of direct material, direct labour etc. The
costs that cannot be identified so are termed as untraceable or common
costs. In other words, common costs are the costs incurred collectively
for a number of cost centres and are to be suitably apportioned for
determining the cost of individual cost centres. For example, overheads
incurred for a factory as a whole, combined purchase cost for purchasing
several materials in one consignment etc. Joint cost is a kind of common
cost. When two or more products are produced out of one material
or process, the cost of such material or process is called joint cost. For
example, when cottonseeds and cotton fibers are produced from the
same material, the cost incurred till the split-off or separation point will
be joint costs.
Production, Administration and Selling and Distribution Costs: A business

organization performs a number of functions, e.g., production,
illustration, selling and distribution, research and development. Costs
are to be curtained for each of these functions. The Chartered Institute
of Management accountants, London, have defined each of the above
costs as follows:
a) Production Cost; The cost of sequence of operations which begins

with supplying materials, labour and services and ends with the
primary packing of the product. Thus, it includes the cost of direct
material, direct labour, direct expenses and factory overheads.
51
b) Administration Cost ;The cost of formulating the policy, directing
the organization and controlling the operations of an undertaking
which is not related directly to a production, selling, distribution,
research or development activity or function.
c) Selling Cost; It is the cost of selling to create and stimulate demand

(sometimes termed as marketing) and of securing orders.
d) Distribution Cost ; It is the cost of sequence of operations beginning

with making the packed product available for dispatch and
ending with making the reconditioned returned empty package,
if any, available for reuse.
e) Research Cost; it is the cost of searching for new or improved

products, new application of materials, or new or improved
methods.
f) Development Cost ; The cost of process which begins with the

implementation of the decision to produce a new or improved
product or employ a new or improved method and ends with
the commencement of formal production of that product or by
the method.
g) Pre-Production Cost; The part of development cost incurred in

making a trial production as preliminary to formal production is
called pre-production cost.
2.4 Conversion Cost

The cost of transforming direct materials into finished products
excluding direct material cost is known as conversion cost. It is usually
taken as an aggregate of total cost of direct labour, direct expenses and
factory overheads.
2.5 Cost Unit and Cost Centre

The technique of costing involves the following:
(i) Collection and classification of expenditure according to cost

elements
(ii) Allocation and apportionment of the expenditure to the cost

centres or cost units or both
52
(i) Cost Unit:
While preparing cost accounts, it becomes necessary to select
a unit with which expenditure may be identified. The quantity
upon which cost can be conveniently allocated is known as a
unit of cost or cost unit. The Chartered Institute of Management
Accountants, London defines a unit of cost as a unit of quantity
of product, service or time in relation to which costs may be
ascertained or expressed.
Unit selected should be unambiguous, simple and commonly

used. Following are the examples of units of cost:
(i) Brick works per 1000 bricks made

(ii) Collieries per ton of coal raised
per yard or per lb. of cloth manufactured
(iii) Textile mills
or yarn spun
(iv) Electrical companies per unit of electricity generated
(v) Transport companies per passenger km.
(vi) Steel mills per ton of steel made
(ii) Cost Centre:

According to the Chartered Institute of Management
Accountants, London, cost centre means a location, person or
item of equipment (or group of these) for which costs may be
ascertained and used for the purpose of cost control. Thus, cost
centre refers to one of the convenient units into which the whole
factory or an organization has been appropriately divided for
costing purposes. Each such unit consists of a department, a sub-
department or an item or equipment or machinery and a person
or a group of persons. Sometimes, closely associated departments
are combined together and considered as one unit for costing
purposes. For example, in a laundry, activities such as collecting,
sorting, marking and washing of clothes are performed. Each
activity may be considered as a separate cost centre and all costs
relating to a particular cost centre may be found out separately.
Cost centres may be classified as follows:

a) Productive, unproductive and mixed cost centres
b) Personal and impersonal cost centres
c) Operation and process cost centres
53
Productive cost centres are those which are actually engaged in
making products. Service or unproductive cost centres do not
make the products but act as the essential aids for the productive
centres. The examples of such service centres are as follows:
a) Administration department
b) Repairs and maintenance department
c) Stores and drawing office department
Mixed costs centres are those which are engaged sometimes on

productive and other times on service works. For example, a tool
shop serves as a productive cost centre when it manufactures
dies and jigs to be charged to specific jobs or orders but serves
as servicing cost centre when it does repairs for the factory.
Impersonal cost centre is one which consists of a department,
a plant or an item of equipment whereas a personal cost centre
consists of a person or a group of persons. In case a cost centre
consists of those machines or persons which carry out the same
operation, it is termed as operation cost centre. If a cost centre
consists of a continuous sequence of operations, it is called
process cost centre. In case of an operation cost centre, cost is
analyzed and related to a series of operations in sequence such as
in chemical industries, oil refineries and other process industries.
The objective of such an analysis is to ascertain the cost of each
operation irrespective of its location inside the factory.
2.6 Cost Estimation

Cost estimation is the process of pre-determining the cost of a certain
product job or order. Such pre-determination may be required for
several purposes. Some of the purposes are as follows:
a) Budgeting
b) Measurement of performance efficiency
c) Preparation of financial statements (valuation of stocks etc.)
d) Make or buy decisions
e) Fixation of the sale prices of products
2.7 Cost Ascertainment

Cost ascertainment is the process of determining costs on the basis
of actual data. Hence, the computation of historical cost is cost
ascertainment while the computation of future costs is cost estimation.
Both cost estimation and cost ascertainment are interrelated and are of
immense use to the management. In case a concern has a sound costing
system, the ascertained costs will greatly help the management in the
process of estimation of rational accurate costs which are necessary for
54
a variety of purposes stated above. Moreover, the ascertained cost may
be compared with the pre-determined costs on a continuing basis and
proper and timely steps be taken for controlling costs and maximizing
profits.
2.8 Cost Allocation Vs Cost Apportionment

Cost allocation and cost apportionment are the two procedures which
describe the identification and allotment of costs to cost centres or cost
units. Cost allocation refers to the allotment of all the items of cost to cost
centres or cost units whereas cost apportionment refers to the allotment
of proportions of items of cost to cost centres or cost units Thus, the
former involves the process of charging direct expenditure to cost centres
or cost units whereas the latter involves the process of charging indirect
expenditure to cost centres or cost units. For example, the cost of labour
engaged in a service department can be charged wholly and directly
but the canteen expenses of the factory cannot be charged directly and
wholly. Its proportionate share will have to be found out. Charging of
costs in the former case will be termed as allocation of costs whereas
in the latter, it will be termed as apportionment of costs.
2.9 Cost Reduction Vs Cost Control

Cost reduction and cost control are two different concepts. Cost control
is achieving the cost target as its objective whereas cost reduction is
directed to explore the possibilities of improving the targets. Thus, cost
control ends when targets are achieved whereas cost reduction has no
visible end. It is a continuous process. The difference between the two
can be summarized as follows:
(i) Cost control aims at maintaining the costs in accordance with

established standards whereas cost reduction is concerned
with reducing costs. It changes all standards and endeavors to
improve them continuously.
(ii) Cost control seeks to attain the lowest possible cost under
existing conditions whereas cost reduction does not recognize
any condition as permanent since a change will result in
lowering the cost.
(iii) In case of cost control, emphasis is on past and present. In case

of cost reduction, emphasis is on the present and future.
(iv) Cost control is a preventive function whereas cost reduction is

a correlative function. It operates even when an efficient cost
control system exists.
55
2.10 Installation of Costing System
The installation of a costing system requires careful consideration of the
following two interrelated aspects:
Overcoming the practical difficulties while introducing a system

Main considerations that should govern the installation of such
a system
The important practical difficulties in the installation of a costing system

and the suggestions to overcome them are as follows:
(i) Lack of Support from Top Management:

Often, the costing system is introduced at the behest of the managing
director or some other director without taking into confidence other
members of the top management team. This results in opposition
from various managers as they consider it interference as well as an
uncalled check of their activities. They, therefore, resist the additional
work involved in the cost accounting system. This difficulty can be
overcome by taking the top management into confidence before
installing the system. A sense of cost consciousness has to be instilled
in their minds.
(ii) Resistance from the Staff:

The existing financial accounting staff may offer resistance to the
system because of a feeling of their being declared redundant under
the new system. This fear can be overcome by explaining the staff
that the costing system would not replace but strengthen the existing
system. It will open new areas for development which will prove
beneficial to them.
(iii) Non-Cooperation at Other Levels:

The foreman and other supervisory staff may resent the additional
paper work and may not cooperate in providing the basic data which
is essential for the success of the system. This needs re-orientation
and education of employees. They have to be told of the advantages
that will accrue to them and to the organization as a whole on
account of efficient working of the system.
(iv) Shortage of Trained Staff;

Costing is a specialized job in itself. In the beginning, a qualified staff
may not be available. However, this difficulty can be overcome by
giving the existing staff requisite training and recruiting additional
staff if required.
56
(v) Heavy Costs:
The costing system will involve heavy costs unless it has been suitably
designed to meet specific requirements. Unnecessary sophistication
and formalities should be avoided. The costing office should serve
as a useful service department.
In view of the above difficulties and suggestions, following should

be the main considerations while introducing a costing system in a
manufacturing organization:
Product;
The nature of a product determines to a great extent the type of
costing system to be adopted. A product requiring high value of
material content requires an elaborate system of materials control.
Similarly, a product requiring high value of labour content requires
an efficient time keeping and wage systems. The same is true in case
of overheads.
(vi) Organization;
The existing organization structure should be distributed as little
as possible. It becomes, therefore, necessary to ascertain the size
and type of organization before introducing the costing system. The
scope of authority of each executive, the sources from which a cost
accountant has to derive information and reports to be submitted at
various managerial levels should be carefully gone through.
(vii) Objective;
The objectives and information which management wants to achieve
and acquire should also be taken care of. For example, if a concern
wants to expand its operations, the system of costing should be
designed in a way so as to give maximum attention to production
aspect. On the other hand, if a concern were not in a position to sell
its products, the selling aspect would require greater attention.
(viii) Technical Details;

The system should be introduced after a detailed study of the
technical aspects of the business. Efforts should be made to secure
the sympathetic assistance and support of the principal members of
the supervisory staff and workmen.
(ix) Informative and Simple;

The system should be informative and simple. In this connection,
the following points may be noted:
57
It should be capable of furnishing the fullest information required
regularly and systematically, so that continuous study or check-
up of the progress of business is possible.
Standard printed forms can be used so as to make the information

detailed, clear and intelligible. Over-elaboration which will only
complicate matter should be avoided.
Full information about departmental outputs, processes and

operations should be clearly presented and every item of
expenditure should be properly classified.
Data, complete and reliable in all respects should be provided in a

lucid form so that the measurement of the variations between
actual and standard costs is possible.
(x) Method of Maintenance of Cost Records;

A choice has to be made between integral and non-integral accounting
systems. In case of integral accounting system, no separate sets of books
are maintained for costing transactions but they are interlocked with
financial transactions into one set of books. In case of non-integral system,
separate books are maintained for cost and financial transactions. At the
end of the accounting period, the results shown by two sets of books are
reconciled. In case of a big business, it will be appropriate to maintain a
separate set of books for cost transactions.
(xi) Elasticity;
The costing system should be elastic and capable of adapting to the
changing requirements of a business. It may, therefore, be concluded
from the above discussion that costing system introduced in any business
will not be a success in case of the following circumstances:
If it is unduly complicated and expensive

If a cost accountant does not get the cooperation of his/her staff
If cost statements cannot be reconciled with financial statements
If the results actually achieved are not compared with the expected
ones
2.11 Methods of Costing

Costing can be defined as the technique and process of ascertaining costs.
The principles in every method of costing are same but the methods of
analyzing and presenting the costs differ with the nature of business.
The methods of job costing are as follows:
58
(i) Job Costing;
The system of job costing is used where production is not highly
repetitive and in addition consists of distinct jobs so that the material and
labour costs can be identified by order number. This method of costing
is very common in commercial foundries and drop forging shops and
in plants making specialized industrial equipments. In all these cases,
an account is opened for each job and all appropriate expenditure is
charged thereto.
(ii) Contract Costing;

Contract costing does not in principle differ from job costing. A contract
is a big job whereas a job is a small contract. The term is usually applied
where large-scale contracts are carried out. In case of ship-builders,
printers, building contractors etc., this system of costing is used. Job or
contract is also termed as terminal costing.
(iii) Cost plus Costing;

In contracts where in addition to cost, an agreed sum or percentage
to cover overheads and fit is paid to a contractor, the system is termed
as cost plus costing. The term cost here includes materials, labour and
expenses incurred directly in the process of production. The system is
used generally in cases where government happens to be the party to
give contract.
(iv) Batch Costing;

This method is employed where orders or jobs are arranged in different
batches after taking into account the convenience of producing articles.
The unit of cost is a batch or a group of identical products instead of
a single job order or contract. This method is particularly suitable for
general engineering factories which produce components in convenient
economic batches and pharmaceutical industries.
(v) Process Costing;

If a product passes through different stages, each distinct and well
defined, it is desired to know the cost of production at each stage. In
order to ascertain the same, process costing is employed under which a
separate account is opened for each process.
This system of costing is suitable for the extractive industries, e.g.,

chemical manufacture, paints, foods, explosives, soap making etc.
(vi) Operation Costing;

Operation costing is a further refinement of process costing. The system
is employed in the industries of the following types:
59
The industry in which mass or repetitive production is carried out
The industry in which articles or components have to be stocked
in semi-finished stage to facilitate the execution of special orders,
or for the convenience of issue for later operations
The procedure of costing is broadly the same as process costing except

that in this case, cost unit is an operation instead of a process. For
example, the manufacturing of handles for bicycles involves a number
of operations such as those of cutting steel sheets into proper strips
moulding, machining and finally polishing. The cost to complete these
operations may be found out separately.
(vii) Unit Costing (Output Costing or Single Costing);

In this method, cost per unit of output or production is ascertained
and the amount of each element constituting such cost is determined. In
case where the products can be expressed in identical quantitative units
and where manufacture is continuous, this type of costing is applied.
Cost statements or cost sheets are prepared in which various items of
expense are classified and the total expenditure is divided by the total
quantity produced in order to arrive at per unit cost of production. The
method is suitable in industries like brick making, collieries, flour mills,
paper mills, cement manufacturing etc.
(viii) Operating Costing;

This system is employed where expenses are incurred for provision of
services such as those tendered by bus companies, electricity companies,
or railway companies. The total expenses regarding operation are
divided by the appropriate units (e.g., in case of bus company, total
number of passenger/kms.) and cost per unit of service is calculated.
(ix) Departmental Costing;

The ascertainment of the cost of output of each department separately is
the objective of departmental costing. In case where a factory is divided
into a number of departments, this method is adopted.
(x) Multiple Costing (Composite Costing);

Under this system, the costs of different sections of production are
combined after finding out the cost of each and every part manufactured.
The system of ascertaining cost in this way is applicable where a product
comprises many assailable parts, e.g., motor cars, engines or machine
tools typewrite, radios, cycles etc.
As various components differ from each other in a variety of ways such

as price, materials used and manufacturing processes, a separate method
60
of costing is employed in respect of each component. The type of costing
where more than one method of costing is employed is called multiple
costing. It is to be noted that basically there are only two methods of
costing viz. job costing and process costing. Job costing is employed in
cases where expenses are traceable to specific jobs or orders, e.g., house
building, ship building etc. In case where it is impossible to trace the
prime cost of the items for a particular order because of the reason that
their identity gets lost while manufacturing operations, process costing
is used. For example, in a refinery where several tons of oil is being
produced at the same time, the prime cost of a specific order of 10 tons
cannot be traced. The cost can be found out only by finding out the cost
per ton of total oil produced and then multiplying it by ten. It may,
therefore, be concluded that the methods of batch contract and cost plus
costing are only the variants of job costing whereas the methods of unit,
operation and operating costing are the variants of process costing.
(xi) Techniques of Costing;

Besides the above methods of costing, following are the types of costing
techniques which are used by management only for controlling costs
and making some important managerial decisions. As a matter of fact,
they are not independent methods of cost finding such as job or process
costing but are basically costing techniques which can be used as an
advantage with any of the methods discussed above.
(xii) Marginal Costing;

Marginal costing is a technique of costing in which allocation of
expenditure to production is restricted to those expenses which arise as a
result of production, e.g., materials, labour, direct expenses and variable
overheads. Fixed overheads are excluded in cases where production
varies because it may give misleading results. The technique is useful in
manufacturing industries with varying levels of output.
(xiii) Direct Costing;

The practice of charging all direct costs to operations, processes or
products and leaving all indirect costs to be written off against profits in
the period in which they arise is termed as direct costing. The technique
differs from marginal costing because some fixed costs can be considered
as direct costs in appropriate circumstances.
(xiv) Absorption or Full Costing;

The practice of charging all costs both variable and fixed to operations,
products or processes is termed as absorption costing.
61
(xv) Uniform Costing;
A technique where standardized principles and methods of cost
accounting are employed by a number of different companies and
firms are termed as uniform costing, Standardization may extend to the
methods of costing, accounting classification including codes, methods
of defining costs and charging depreciation, methods of allocating or
apportioning overheads to cost centres or cost units. The system, thus,
facilitates inter- firm comparisons, establishment of realistic pricing
policies, etc.
2.12 Systems of Costing;

It has already been stated that there are two main methods used to
determine costs. These are:
(i) Job cost method
(ii) Process cost method
It is possible to ascertain the costs under each of the above methods by

two different ways:
a) Historical costing
Historical costing can be of the following two types in nature:
(i) Post costing
(ii) Continuous costing
Post Costing; Post costing means ascertainment of cost after the production
is completed. This is done by analyzing the financial accounts at the
end of a period in such a way so as to disclose the cost of the units
which have been produced. For instance, if the cost of product A is to be
calculated on this basis, one will have to wait till the materials are actually
purchased and used, labour actually paid and overhead expenditure
actually incurred. This system is used only for ascertaining the costs but
not useful for exercising any control over costs, as one comes to know
of things after they had taken place. It can serve as guidance for future
production only when conditions in future continue to be the same.
Continuous Costing; In case of this method, cost is ascertained as soon

as a job is completed or even when a job is in progress. This is done
usually before a job is over or product is made. In the process, actual
expenditure on materials and wages and share of overheads are also
estimated. Hence, the figure of cost ascertained in this case is not exact.
But it has an advantage of providing cost information to the management
promptly, thereby enabling it to take necessary corrective action on time.
However, it neither provides any standard for judging current efficiency
nor does it disclose what the cost of a job ought to have been.
62
b) Standard costing
Standard Costing; Standard costing is a system under which the cost
of a product is determined in advance on certain pre-determined
standards. With reference to the example given in post costing, the
cost of product A can be calculated in advance if one is in a position
to estimate in advance the material labour and overheads that should
be incurred over the product. All this requires an efficient system of
cost accounting. However, this system will not be useful if a vigorous
system of controlling costs and standard costs are not in force.
Standard costing is becoming more and more popular nowadays.
63
Assessment Questions
2.1 (i) Costs may be classified in a number of ways including classification by

behaviour, by function, by expense type, by controllability and by
relevance.
(ii) Management accounting should assist in EACH of the planning,

control and decision making processes in an organization.
Discuss the ways in which relationships between statements (i) and

(ii) are relevant in the design of an effective management accounting
system. ACCA information for control and decision making
2.2 Classify each of the following as being usually fixed cost (F), variable
cost (V), semi-fixed cost (SF) or semi-variable (SV)
1. Direct labour
2. Depreciation on machinery
3. Factory rental
4. Supplies and other indirect materials;
5. Advertising;
6. Maintenance of machinery
7. Factory managers salary
8. Supervisory personnel
9. Royalty payment
64
Summary
Cost accounting is that part of management accounting which
establishes budget and actual cost of operations, processes, departments
or product and the analysis of variances, profitability or social use of
funds. Managers use cost accounting to support decision making to
reduce a companys costs and improve its profitability. Therefore, the
term cost has many meanings and different types of costs are applicable
in different scenario. A large terminology has emerged to show more
clearly the meaning of cost.
This chapter has described the following basic cost classification that is
used in management accounting, Cost can be classified as:
Fixed cost, variable cost and semi variable cost
Direct and indirect costs
Sunk costs and shut down costs
Avoidable and unavoidable costs
Period and product costs
Opportunity costs
Incremental and differential costs
Decision-Making Costs and Accounting Costs
Out-of-Pocket Costs
Controllable and uncontrollable costs
Imputed or hypothetical costs
Therefore, cost accounting system should generate information to meet the

following requirements:
1. To provide relevant information to assist the management makes

the right decisions;
2. To provide information for planning (strategic and operation) and

controlling the activities of the organization.
3. To allocate costs between cost of goods sold and inventories for

internal and external reporting
Therefore, this chapter has addressed all the above issues in order to provide
the relevant information for management to perform the above issues
65
Avoidable costs
Cost allocation
Cost objects
Differential cost
Direct cost
Direct labour
Direct materials
Fixed cost
Indirect cost
Indirect labour
Indirect materials
Job costing
Opportunity cost
Period costs
Prime costs
Product costs
Semi variable costs
Sunk cost
Unavoidable cost
Variable cost
66
Exercises
2.1 What are the three major elements of product costs in a manufacturing
company?
2.2 Distinguish between the following

(a) Direct materials
(b) Indirect materials
(c) Direct labour
(d) Indirect labour
(e) Manufacturing Overheads
2.3 Explain the difference between a period cost and a product cost
2.4 Why is production overhead considered an indirect cost of a unit

of product?
2.5 Define the following terms: differential costs, opportunity cost

and sunk costs
2.6 only variable costs can be differential costs. Do you agree?

Explain
Problems
2.7 The following cost and inventory data for the just year are taken
from the accounting records of ABC Company:

Cost incurred $
Advertising 100,000
Direct labour cost 90,000
Purchasing of raw materials 132,000
Rent, factory building 80,000
Indirect labour 56,000
Sales commissions 35,000
Utilities, factory 9,000
Maintenance, office equipment 24,000
Supplies, factory 700
Depreciation, office equipment 8,000
Depreciation, factory equipment 40,000
Inventories Beginning of year End of year
Raw material $8,000 $10,000
Work in progress $5,000 $20,000
Finished goods $70,000 $25,000
67
Required
1. prepare s schedule of goods manufactured
2. prepare the cost of goods sold section of ABC companys income
statement for the year
2.8. Distinguish between opportunity cost and out of pocket cost

giving a numerical example of each using your own figures to
support your answer. CIMA Stage 2 Cost Accounting
2.9 (a) Discretionary costs are troublesome because managers

usually find it difficult to separate and quantify the results
of their use in the business, as compared with variable and
other fixed costs.
You are required to discuss the above statement and include in

your answer the meaning of discretionary costs, variable costs
and fixed costs; give two illustrations of each of these three named
costs. ACCA
2.1 (a) A drug company has initiated a research project which

is intended to develop a new product. Expenditures to
date on this particular research total $500 000 but it is now
estimated that a further $200 000 will need to be spent before
the product can be marketed. Over the estimated life of the
product the profit potential has a net present value of $350
000.
You are required to advise management whether they should

continue or abandon the project. Support your conclusion with a
numerate statement and state what kind of cost is the $500 000.
(b) Opportunity costs and notional costs are not recognized by

financial accounting systems but need to be considered in
many decisions taken by management.
You are required to explain briefly the meanings of opportunity

costs and notional costs; give two examples of each to illustrate
the meanings you have attached to them.
(c) James travels to work by train to his 5-days a week job.

Instead of buying daily tickets he finds it cheaper to buy a
quarterly season ticket which costs $188 for 13 weeks.
68
Daniel, an acquaintance, who also makes the same journey, suggests
that they both travel in Jamess car and offers to give him $120 each
quarter towards his car expenses. Except for weekend travelling and
using it for local college attendance near his home on three evenings
each week to study for his CPA, the car remains in Jasons garage.
James estimates that using his car for work would involve him, each
quarter, in the following expenses:
($)
Depreciation (proportion of annual figure) 200
Petrol and oil 128
Tyres and miscellaneous 52
You are required to state whether James should accept Daniels offer
and to draft a statement to show clearly the monetary effect of your
conclusion. ACCA
69
Case Studies
Case 1: Southwest Flies High

Southwest Airlines reported a 14.3 percent increase in net profit and
a rise in passenger yield for the first quarter of 2003. During the first
quarter, revenues increased 7.5 percent to $1.35 billion. This was the
Dallas-based airlines 48th consecutive quarter of rising profits in an
industry that lost $7 billion last year. And the company expects to be
profitable during the second quarter as well even though revenues
are expected to be relatively flat. The main reason for the companys
success is its low-cost structure. The company has limited its capital
expenditures and tightened such costs as insurance expense. During
the first quarter, the airlines costs increased 2.6 percent to 7.5 cents per
available seat mile. When the effects of rising fuel costs are eliminated
from the computation, however, unit costs remained unchanged.
Southwests chief financial officer, Gary Kelly, said the carrier would
focus on adding frequencies in its existing markets this year, but did
not rule out opening routes to new cities should rivals go bankrupt or
discontinue service in some segments. United Airlines is currently under
bankruptcy protection, and American Airlines is considering the idea.
Source: Southwest Flies High
Discussion Questions
1. What is a cost object?
2. What are some of the possible cost objects used by Southwest

Airlines? What is the definition of direct costs? Cite some possible
examples of Southwest Airlines direct costs.
3. What is the definition of indirect costs? Cite some possible

examples of Southwest Airlines indirect costs.
4. Define variable costs. What are some of Southwests variable

costs?
5. Define fixed costs. What are some of Southwests fixed costs?
Case 2: ABC Pvt. Ltd

ABC Pvt. Ltd, a new comer in small manufacturing firm of formals and
casuals wears. Product range includes, shirts and T- Shirts (Full & Half
sleeves), trousers and jeans, cargos, etc
70
As it is a newly introduced firm, the burden is on the Finance Manager
of deciding the Accounting method for maintaining books of Account
in a factory.
By considering all the factors determining cost, such as cost structure,

condition of market, type of consumer, area of distribution, capacity of
supply, products demand & supply, etc Manager has to decided to
follow the Cost Accounting for maintaining factory A/c or Manufacturing
A/c. Cost Accounting does not includes physical stock-taking, but it
includes detailed & relevant cost figure of closing stock, raw material,
work-in-progress and Finished goods. This helped the manager to find
out most suitable and accurate cost per unit. These also helped him to
avoid material wastages, use of obsolete machinery, poor planning,
etc
They took control over material, labour and overhead expenses, and
started discussing day-to-day operations of business, so they can take
remedial actions. Moreover, introduction of a cost reduction programme
combined with operational research and value analysis leads to
improvement in economic as well as financial condition of the firm.
1. How cost Accounting helps the firm in determining the Selling

Price?
2. According to you, by adopting Cost Accounting method, Can a

firm prepare a Financial Statement?
3. Which kind of operating policy decision can we take by using

Cost Accounting Method?
4. From the case, what are the benefits/ Advantages enjoyed by a

firm, by adopting Cost Accounting?
71
Further Readings
Blanchard, Garth A., and Chee W. Chow, Allocating Indirect Costs
for Improved Management Performance, Management Accounting,
March 1983: 38-41.
Bost, Patricia, Do Cost Accounting Standards Fill a Gap in Cost

Allocation? Management Accounting, Nov. 1986: 34-36.
Brunton, Nancy M., Evaluation of Overhead Allocations, Management

Accounting, July 1988: 22-26.
Cardullo, J. Patrick, and Richard A. Moellenberndt, The Cost Allocation

Problem in a Telecommunications Company, Management Accounting,
July, 1987: 22-26.
Carman-Stone, Marie Sandra, Unabsorbed Overhead: What To Do

When Contracts are Canceled, Management Accounting, April 1987:
55-57.
Cook, Ian, and Angela M. Burnett and Paul N. Gordon, CMP and
Managing Indirect Costs in the Eighties, Journal of Cost Management,
Spring 1988: 18-28.
Cornick, Michael, William Cooper, and Susan B. Wilson, How Do

Companies Analyze Overhead? Management Accounting, April 1988:
41-43.
Johnson, Douglas, Steven Kaplan, and Bill B. Hook, Looking for

Mr. Overhead: An Expanded Role for Management Accountants,
Management Accounting, Nov. 1983: 65-68.
Schwarzbach, Henry R., The Impact of Automation on Accounting for

Indirect Costs, Management Accounting, Dec. 1985: 45-50..
Coombs, H.M. and Evans, A. (2001) Managing central support costs

in local authorities, Journal of Finance and Management in Public
Services, 2(1): 920
72
CHAPTER 3 ANALYZING COST

BEHAVIUOR CHAPTER OBJECTIVES
Chapter Objectives
This chapter introduces the concept of a cost and then discussion turns to the
different manner in which costs vary over changes in some level of activity
(known as cost behavior). Therefore, the chapter will examine in some depth
the theory of cost behaviuor.
Learning Outcomes
be able to:
1. Explain the importance of the relevant range in using a cost
behavior pattern for cost prediction
2. Define and describe the behavior of variable cost, step-
variable cost, fixed cost, step-fixed cost, semi variable (or
mixed) cost,
3. Analyze the Cost behaviuor
4. Use a scatter graph plot to diagnose cost behaviuor
5. Describe and Analyze the cost-estimation methods
6. Analyze the economists approach to cost behaviuor analysis
73
3.1 Introduction
In chapter one, we introduced the concept of managerial accounting and
discussed the basic function of management accounting. One of the most
important roles of the managerial accountant is to obtain and analyze
data related to the costs incurred by the organization. Management
uses information about costs in a variety of ways. For example, when
establishing a selling price for the organizations inventory products or
services, management uses information about the costs of manufacturing
that inventory or providing that service.
Management accounting contains a number of decision making tools

that require the conversion of all operating costs and expenses into
fixed and variable components. The responsibility for providing
this cost behavior information falls squarely upon the shoulders of
the management accountant. The conversion of ordinary financial
data as typically found in the general ledger accounts requires that
the management accountant have a thorough understanding of cost
behavior theory. The identification and measurement of fixed and
variable costs is somewhat complicated by the fact that some costs are
fixed or variable at the discretion of management, while other costs are
not. Furthermore, for those expenditures that are inherently variable,
management has the ability, within limits, to control the magnitude of
the variable cost factors. In order to exercise this control, management
also needs a solid understanding of the nature of cost behavior.
In management accounting, the classification and measurement of

fixed and variable cost is based on a body of knowledge that involves
a number of assumptions. In many cases, the usefulness of fixed and
variable cost data depends on the validity of these assumptions. In order
to avoid poor operating results and faulty decision-making that is likely
to occur when false cost assumptions are made, the ability to recognize
and measure cost behavior is essential.
A cost is an expenditure or allocation of a previous expenditure made

by the organization. Many students use the terms cost, expenditure, and
expense interchangeably. In distinguishing between these terms, it is
important to note that costs are more inclusive in nature than either
expenditures or expenses. Expenditure is an actual outlay of funds
for some purpose. While costs include outlays of funds, they also
include allocations of previous outlays of funds (such as depreciation
expense on manufacturing facilities). Expenses are limited to costs that
are recognized and matched with revenues under generally accepted
accounting principles. While some costs are considered to be expenses,
74
others are not. For example, when manufacturing inventory, companies
incur direct materials and direct labor costs; however, as noted in the
following section, these costs are not expensed unless the units of
inventory are sold to customers.
3.2 Level or Volume of Activity

The level of activity or cost driver is the item or factor that causes one or
more cost(s) to change. For example, as the number of beer produced by
Tanzania breweries Limited Company increases, the amount and cost of
direct materials and wages paid to workers (direct labor) also increases.
Therefore, the number of beer produced is the cost driver for Tanzania
breweries Limited Company raw material and direct labor costs.
Identifying the appropriate cost driver is important because this cost

driver will be used to determine the behavior of costs.
Note, that in each case, a cost driver is the activity that causes a particular
type of cost to change. Also notice that each type of cost has a different
cost driver.
It is important to note that for a given cost any number of cost drivers can
be identified, and the behavior of the cost depends upon the cost driver
selected by the organization. For example, since Tanzania breweries
Limited Company some of workers are paid hourly wages, the most
appropriate cost driver for Tanzania breweries Limited Companys
direct labor costs is the number of direct labor hours worked. However,
organizations often require information related to their primary
revenue-generating activity (for Tanzania breweries Limited Company,
the number of beer produced) for planning purposes. Thus, important
cost drivers used by organizations are the number of units produced
(for manufacturing companies), the number of units sold (for retail
companies), and the level of services provided (for service companies).
3.3 Relevant range

The relevant range may be defined as the operating range or activity
level over which a firm finds it practical to operate in the short-run.
For each firm, there is a floor of activity below which it is impractical to
operate.
These levels are either unrealistic (for example, firms cannot operate
using less than some minimum number of kilowatt hours of electricity)
or would not allow for adequate profits (firms could not manufacture less
than some minimum number of inventory units). In addition, because
75
of limited operating capacity, most firms have an upper level of activity
above which they cannot operate without significantly expanding their
current facilities. The unique characteristic of the relevant range is that
costs assume a linear (or nearly linear) relationship over that level of
activity.
Tanzania breweries Limited Company: (1) direct materials, (2) wages

paid to production workers (direct labor), and (3) depreciation on
manufacturing facilities (manufacturing overhead). If only one beer
is produced, the cost of that beer includes the cost of raw material for
that beer, the wages paid to production workers for manufacturing
that beer, and the entire amount of depreciation on the manufacturing
facilities. As additional beers are manufactured, the cost of these beers
rises slightly to reflect additional material and labor costs; however,
no additional depreciation costs are incurred. The depreciation cost is
classified as a fixed cost, since it does not change with changes in activity.
The materials and labor costs are known as variable costs because they
vary directly and proportionately with changes in activity.
For example, Tanzania breweries Limited Company can produce from

10,000 to 50,000,000 cases of beer per year. So, the relevant range for
Tanzania breweries Limited Company is the range of normal activity
from 10,000 to 50,000,000 units. Within this relevant range all fixed
costs, such as rent, equipment depreciation, and administrative salaries
remain constant. If Tanzania breweries Limited Company decides to
produce more cases of beer, they have to hire additional staff and rent
more equipment, which will result in an increase of fixed costs. On the
contrary, if the production level is reduced, Tanzania breweries Limited
Company has to reduce staff and rental expenses, so fixed costs will
decrease
The importance of the relevant range can be summarized by one

statement: the relationship between costs activity is assumed to be
linear within the relevant range. As a result, management can estimate
the total costs.
3.4 Cost Behavior

Cost behavior is defined as how costs react when the level of activity
(or volume) changes. Identifying how different costs react as the level
of activity changes is very important, since it allows management to
determine how the total costs will be affected by planned levels of
activity. While many costs vary directly with changes in activity,
others are not affected. In order to make various operating decisions,
76
management must consider how the level of activity will affect the total
costs incurred by the organization.
Hence, Cost behaviour is nothing more than the sensitivity of costs to

changes in production or sales volume. The range of output or sales
over which cost behaviour patterns remain unchanged is called the
relevant range. Therefore, Cost behaviour refers to the way in which
costs are varying with the level of activity to the organization. As we
have discussed above, the level of activity refers to the amount of work
done or the number of event done or the number of events that have
occurred. Depending on circumstances, the level of activity may refer
to the volume of production in a period, or the number of items sold, or
the value of items sold etc.
For example, consider two separate scenarios for the costs of renting a
car. Assume that you are planning a three-day vacation and have two
choices for renting a car. Company XA will charge you a flat rate of $100
per day with no charge for kilometer. Company XB charges a flat rate
of $50 per day and an additional charge of $0.60 per kilometer driven.
Based on this information, which option would you choose?
Illustration: cost behaviour Example

Level of Activity
Km. Driven
200 km 300 km
Company XA:
Flat Rental Charge (3 days x $100/day) $ 300 $ 300
Company XB:
Flat Rental Charge (3 days x $50/day) $ 150 $ 150
Kilometre Charge (at $0.60 per km) $ 120 $ 180
Total Charge $ 270 $ 330
The choice you make depends on the expected level of activity. The
total costs associated with two levels of activity (200 total km driven
and 300 total km driven) are presented in Illustration above. As shown
in Illustration, the total cost of renting from Company XA ($300) is less
than the cost of renting from Company B ($330) provided that you drive
300 km. If you drive more than 300 km, this difference will become larger
as the additional kilometer charged by Company XB increases. On the
other hand, if you plan on driving 200 km, it would be cheaper to rent
the car from Company XB. This outcome occurs because the additional
kilometer charges are not large enough to exceed the additional cost per
77
day charged by Company XA. Notice that in the above example some
of the costs (additional km charges) vary with changes in the level of
activity (km driven) and other costs do not vary with changes in the
level of activity (daily rental charge). The differences in the behavior
of these types of costs illustrate the concept of cost behavior. Two
important concepts in evaluating cost behavior are the level of activity
(or cost driver) and the relevant range. These concepts have been clearly
discussed above
Illustration of Cost Behavior

To illustrate cost behavior, assume that you are asked to identify the
budgeted level of costs for Mkuki Books Company, a publisher of
primary and secondary school textbooks. To assist you, Mkuki has
accumulated manufacturing cost data from 2011, which will be used to
determine estimated manufacturing costs for the first quarter of 2012.
While numerous costs exist, Mkuki Books is interested in determining
the expected level of the following costs:
1. Manufacturing equipment and facilities.

2. Paper and ink used in production.
3. Wages paid to machine operators.
4. Utility costs.
5. Wages paid for inspection of completed textbooks.
Mkuki Books has identified the number of textbooks manufactured

as its cost driver. More appropriate cost drivers may exist for some
of the above costs. For example, utility costs vary more closely with
the number of kilowatt hours used than with the number of textbooks
manufactured. However, manufacturing companies must often make
important decisions that are influenced by the level of manufacturing
activity. For example, before trying to set a selling price for its textbooks,
Mkuki Books needs to know the cost associated with manufacturing
these textbooks. Thus, Mkuki Books is interested in determining how
the five costs shown above vary with changes in manufacturing volume
(number of textbooks manufactured).
These costs can be classified into one of four categories, depending on

how they fluctuate with changes in the level of activity. If the number of
textbooks (units) manufactured is utilized as Mkuki Books cost driver,
the above costs can have one of four relationships to activity: (1) fixed,
(2) variable, (3) step, or (4) semi-variable (or mixed).
78
3.5 Fixed cost
Fixed costs do not change (in total) with changes in the organizations
level of activity. That is: Fixed costs are constant in total over the relevant
range. Fixed costs include things like rent, insurance premiums, salaries,
depreciation and property. Fixed costs should not be confused with
sunk costs. From a pure economics perspective, fixed costs may not be
fixed in the sense of invariant; they may change, but are fixed in relation
to the quantity of production for the relevant period. For example, a
company may have unexpected and unpredictable expenses unrelated
to production, and these would not be considered part of variable costs,
It is important to understand that fixed costs are fixed only within
a certain range of activity or over a certain period of time. If enough
time passes, all costs become variable. Similarly, not all indirect costs
are fixed costs; for example, advertising expenses or labour costs are
indirect costs that are variable over a slightly longer time frame, as
they may not be subject to change in the short term, but may be easily
adjustable over a longer time frame. For example, a firm may not be
able to vary the number of employees (and hence labour costs) in the
short term due to contract obligations, but be able to lay employees off
or otherwise change these costs.
In accounting terminology, fixed costs will broadly include all costs

(expenses) which are not included in cost of goods sold, and variable
costs are those captured in costs of goods sold. The implicit assumption
required to make the equivalence between the accounting and economics
terminology is that the accounting period is equal to the period in
which fixed costs do not vary in relation to production. In practice, this
equivalence does not always hold, and depending on the period under
consideration by management, some overhead expenses (such as sales,
general and administrative expenses) can be adjusted by management,
and the specific allocation of each expense to each category will be
decided under cost accounting In business planning and management
accounting, usage of the terms fixed costs, variable costs and others will
often differ from usage in economics, and may depend on the intended
use. For example, costs may be segregated into per unit costs (costs of
goods sold), fixed costs per period, and variable costs as a proportion
of revenue. Capital expenditures will usually be allocated separately,
and depending on the purpose, a portion may be regularly allocated
to expenses as depreciation and amortization and seen as a fixed cost
per period, or the entire amount may be considered upfront fixed costs.
Unlike variable costs, total fixed costs remain the same as the level of
activity (cost driver) changes. However, fixed costs per unit usually
change with changes in the activity base. Insurance costs, rent costs,
salaries of accounting department are typical examples of fixed costs
79
For example, assume that the depreciation on Mkuki Books typesetting
and manufacturing equipment is $75,000 per month. In addition, suppose
that Mkuki Books pays monthly rent on its manufacturing facilities of
$25,000. Thus, the total monthly costs of Mkuki Books manufacturing
facilities are $100,000. Since Mkuki Books uses the number of textbooks
manufactured as its cost driver, these costs are classified as fixed costs,
since they are not expected to change with changes in the number of
textbooks manufactured within the relevant range.
Fixed costs per unit often cause difficulties for students because of the
inverse relationship between fixed costs and increases in production. As
production increases, total fixed costs stay the same within the relevant
range, but since we are dividing a constant numerator [total fixed costs]
by a progressively larger denominator [total production or sales], the
resulting costs per unit become smaller and smaller. This decrease
reflects spreading a constant level of fixed costs over a greater number
of units.
For example, if Mkuki Books Company manufactured 10,000 textbooks

during the month, the fixed cost per textbook equals $10 ($100,000
10,000 textbooks = $10 per textbook). If production were increased
to 20,000 texts, fixed costs per textbook equal $5 ($100,000 20,000
textbooks = $5 per textbook): For either level, note that total fixed costs
equal $100,000. .
Illustration of Fixed Cost

For example, ABC Corporation pays $5,000 per year for property
insurance. It is a fixed cost that does not vary with the number of
produced DVDs. Although the total fixed cost remains the same as the
number of DVDs produced change, the fixed cost per DVD changes.
The more DVDs are produced, the less the fixed cost per unit is. This is
illustrated by the following table which shows this relationship
Illustration: Fixed cost of property insurance at different production

levels
Number of DVDs Total for Property Property Insurance
Produced Insurance per DVD Produced
100,000 $5,000 $0.05
200,000 $5,000 $0.025
300,000 $5,000 $0.0167
400,000 $5,000 $0.0125
500,000 $5,000 $0.01
80
The data from the table above can also be presented in the form of graphs
for total fixed cost and fixed cost per unit
Fig.1.1 Total fixed cost graph
Note that the property insurance cost line starts at $5,000 point and does
not change with the increase in the number of units produced. .
The following Illustration shows how the fixed cost of property insurance
behaves on per-unit basis as production changes.
Fig.1. 2 Unit fixed cost graph
The graph shows that, per-unit fixed costs decreases as the number of
DVDs produced increases
Types of fixed costs

Fixed costs may be classified as one of two types.
81
(i) Committed fixed costs:
Committed fixed costs: are those costs that are incurred on a
long-term basis and cannot be reduced in the short-term without
impairing the organizations ability to operate at current levels.
Committed fixed costs normally consist largely of those fixed costs
that arise from the possession of plant, equipment and a basic
organization structure. For example, once a building is erected
and a plant is installed, nothing much can be done to reduce the
costs such as depreciation, property taxes, insurance and salaries
of the key personnel etc. without impairing an organizations
competence to meet the long-term goals. Therefore committed
fixed cost relates to the investment in facilities equipment and the
basic organizational structure of a firm. Examples of such costs
include depreciation of buildings and equipment, taxes on real
estate, insurance and salaries of top management and operating
personnel
For example, if the organization wishes to reduce the depreciation

costs associated with its manufacturing facilities, it could sell its
facilities; however, doing so would require its operating activities
to be limited.
The two key characteristics of committed fixed costs are

(i) They are long term in nature
(ii) They cant be significantly reduced even for short period
of time without seriously impairing the profitability of
long-run goals of the organization.
(ii) Discretionary fixed costs

Discretionary fixed costs are costs that result from short-term
management decisions to undertake activities such as research
and development, training programs, advertising, and sales
promotions. Discretionary fixed costs are those which are set
at fixed amount for specific time periods by the management
in budgeting process. These costs directly reflect the top
management policies and have no particular relationship with
volume of output. These costs can, therefore, be reduced or entirely
eliminated as demanded by the circumstances. Examples of such
costs are research and development costs, advertising and sales
promotion costs, donations, management consulting fees etc.
These costs are also termed as managed or programmed costs.

Usually these cots arise from annual decisions by management
to spend in certain fixed cost areas. The planning horizon for a
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discretionary fixed cost is fairly short term; usually a single year.
Discretionary fixed costs can be cut for short periods of time
and result into minimal damage to the long-run goals of the
organization. Unlike committed fixed costs, discretionary fixed
costs may be modified in the short-term without impairing the
organizations operating activities to a great extent.
3.6 Variable Costs

Variable costs change in direct proportion to changes in some level of
activity. That is:
(i) As activity increases, variable costs increase (or conversely, as
activity decreases, variable costs decrease).
(ii) The increase or decrease in variable costs is the same for each
unit of change in activity.
Therefore, Variable costs vary in total with volume, but are constant per
unit within the relevant range. Total variable costs for a given situation
are equal to the number of units multiplied by the variable cost per unit
Therefore, Variable costs are expenses that change in proportion to the

activity of a business. In other words, variable cost is the sum of marginal
costs. It can also be considered normal costs. Along with fixed costs,
variable costs make up the two components of total cost. Direct Costs,
however, are costs that can be associated with a particular cost object.
Not all variable costs are direct costs, however; for example, variable
manufacturing overhead costs are variable costs that are not a direct
costs, but indirect costs. Variable costs are sometimes called unit-level
costs as they vary with the number of units produced.
For example, a manufacturing firm pays for raw materials. When

activity is decreased, less raw material is used, and so the spending for
raw materials falls. When activity is increased, more raw materials is
used and spending therefore rises. Note that the changes in expenses
happen with little or no need for managerial intervention.
A company will pay for line rental and maintenance fees each period
regardless of how much power gets used. And some electrical equipment
(air conditioning or lighting) may be kept running even in periods of
low activity. These expenses can be regarded as fixed. But beyond this,
the company will use electricity to run plant and machinery as required.
The busier the company, the more the plant will be run, and so the more
electricity gets used. This extra spending can therefore be regarded as
variable.
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In retail the cost of goods is almost entirely a variable cost; this is not
true of manufacturing where many fixed costs, such as depreciation, are
included in the cost of goods.
Although taxation usually varies with profit, which in turn varies with
sales volume, it is not normally considered a variable cost.
In most of the concerns, salary is paid on monthly rates. Though there
may exist a labour work norm based on which the direct cost (labour)
can be absorbed in to cost of the product, salary cannot be termed as
variable in this case.
Illustration of Variable cost

For example ABC Company produces valves. Each valve will require
a component part (i.e., raw material, variable cost). Component parts
are purchased from outside suppliers for $10 per part. ABC Companys
production capacity is 10,000 to 50,000 valves per year.
Illustration 1 shows material (component part) costs for valve production

in the range of 10,000 - 50,000 units per year:
Illustration: Variable cost of valves at different production levels

Valves Cost of One Total Cost of Calculation
Produced Valve Vales
10,000 $10 $100,000 10,000 x $10
20,000 $10 $200,000 20,000 x $10
30,000 $10 $300,000 30,000 x $10
40,000 $10 $400,000 40,000 x $10
50,000 $10 $500,000 50,000 x $10
From the table above you see that the total cost of valves changes in direct
proportion to the number of units produced. The unit cost, however,
stays the same and does not depend on the output volume
The variable costs from the preceding table can be easily presented in
a graph. Illustration 2 demonstrates how the variable costs for valves
behave as total production changes. The graph shows the same data,
but in a different way. Note that the variable cost line starts at zero cost
for zero production and increases gradually with the increase in the
number of valves produced:
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Illustration: Total variable cost graph,
The following illustration shows the graph of unit variable cost. In

the graph the variable cost per unit remains the same regardless of
production level, while in the above Illustration shows the total variable
cost increases as production increases. The reason is because regardless
of how many component parts ABC Company has to buy, the price is
the same: $10 per unit (we ignore the bulk discounts). At the same time,
if ABC Company produces more valves, the company will need to buy
more component parts and the total cost will increase.
In the graph below note that the unit cost line starts at the $10 point and
remains constant with the increase in the number of units purchased:
Illustration: Unit variable cost graph
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3.7 Mixed costs or Semi-variable costs
A mixed cost contains both fixed and variable elements. There are a
variety of procedures that can be employed to separate the fixed and
variable components. The easiest is to use two points on the total cost
line to derive the slope and intercept. This is rough and ready and may
yield inaccurate results. Regression analysis is a more accurate procedure
which also has the benefit of providing measures of goodness of fit;
these tell us how well the derived equation fits the observed data. The
Y-intercept of a mixed cost line is the total fixed costs. The slope is the
variable cost per unit, and any point on the line represents the total cost
at the indicated volume.
It should be noted that, the fixed component of a mixed cost is a minimum

cost of supplying a resource, and the variable component is the costs
that fluctuate depending on changes of activity levels.
Suppose ABC Corporation uses rented machinery. The rental charges

are $1,000 per year, plus $1 for each machine hour used. If the machinery
is used for 1,000 hours the total rental charge is $2,000 ($1,000+1,000 x
$1). The table below shows the relationship between the variable and
fixed costs, total cost and machine hours.
Mixed cost table

Number of Variable Cost Variable Fixed Total
Machine Hours per Unit, $ Cost, $ Cost, $ Costs, $
500 $1.00 $500 $1,000 $1,500
1,000 $1.00 $1,000 $1,000 $2,000
1,500 $1.00 $1,500 $1,000 $2,500
2,000 $1.00 $2,000 $1,000 $3,000
2,500 $1.00 $2,500 $1,000 $3,500
3,000 $1.00 $3,000 $1,000 $4,000
Illustration above graphically demonstrates this relationship. It can be

observed that the mixed cost line starts at the fixed-cost point of the
vertical axis ($1,000 in our case) and then increases to the right. The
minimal value of the mixed cost is equal to its fixed part. The variable
cost of the mixed cost is equal to the difference between the total mixed
cost and its fixed part.
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Fig.1.3 Mixed costs graph
More examples of mixed costs and their cost drivers are illustrated below;
Examples of mixed costs
Type of Business Cost Cost Driver
Manufacturing Equipment rental Number of machine hours
Consulting Company Consultants wage Number of clients
Hotel Maid wages Number of rooms cleaned
Print house Photocopier rental Number of pages printed out
3.8 Step Variable Costs
A step cost is one which is fixed over a certain range of activity, but
with increases by a fixed amount when activity rises above the given
range. Hence, these costs stay fixed over a range of activity, and then
change after this range is overcome. In other words, these costs change
in increments. To illustrate step-variable costs, let us again return to
our example with production of DVDs. One worker can supervise the
production of maximum 100 DVDs per day. If it is needed to produce
320 DVDs, ABC Corporation would hire four workers. If the number of
produced DVDs is increased up to 400 DVDs, four workers will still be
able to cope with this load. However, for 410 DVDs, it will be required
to hire an additional worker.
Fig.1.4 Step-variable cost graph
87
The above graph describes a step-variable cost, where the width of each
step represents the volume of activity (number of DVDs) needed before
the step-variable cost increases to the next level because additional
resources (workers) are required. Once the next level is achieved, the
cost of hiring workers remains constant until it increases again. Narrow
width means that cost is sensitive to fairly small fluctuations in related
activity.
Note: Material cost is one example of variable costs, the illustration
below provides more examples of variable costs along with their
cost drivers for various types of businesses:
Illustration: Example of variable costs
Type of Business Cost Cost Driver
Manufacturing Direct Materials Number of units produced
Restaurant Payroll Number of hours worked
Taxi Fuel Number of miles driven
Hotel Housekeeping costs Number of rooms occupied
Printing company Paper Number of pages printed
Hospital Food cost Number of patients served
3.9 Importance of cost behaviour

Cost behaviour patterns are needed in order to
Prepare budget; managers may estimate the budgeted cost of
their cost centres by building up total costs from the sum of
individual expenses items
Apply variance analysis in a system of budgeting control.
3.10 The economists approach to cost behaviour analysis
The entire approach to a cost behaviour analysis based on linear
assumptions, can be challenged. The justification for non-linear
assumptions of all costs is based in simple micro economic concepts of
average costs, marginal costs and increasing and diminishing returns
to scale we can call this, the economists approach to cost behaviour
analysis
The economists view of cost behaviour is that total costs vary with
the volume of output and sales, but unlike the traditional accounting
mode (which assumes constant prices of inputs and constant efficiency
levels so that the relationship between changes in total costs and total
out is directly positive) related, the economic theory model assumes a
curvilinear relationship between total costs and output. Therefore the
accounting model predicts y = a+ bx while, the economic theory model
might predict y= a + bx + c x2
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Where
y is total costs
x is the volume of output and sales
a is fixed costs and b is the variable cost per unit
3.11 Comparison of cost behaviour assumptions in accounting model and

economic theory
1. The marginal cost per unit in the accounting model is the variable
cost per unit, which is constant at all volume of output
2. The marginal cost per unit in economic theory is not the same
at all volumes of output. There might be a gradual reduction
in the marginal cost of extra units as output rises from zero but
eventually mere will be decreasing return to scale and then the
marginal cost per unit will then rises from zero but eventually
mere will be decreasing return to scale and then the marginal cost
per unit will then rise
3. The accounting model assumes that in the short run at least price
level and efficiency levels can be held constant by management
planning and control action.
4. The economic theory model assumes that if a wide output range

is considered there will be substantial changes in price level and
efficiency levels even in the short run.
3.12 Cost Estimation Techniques

Cost estimation is the process of pre-determining the cost of a certain
product job or order. Such pre-determination may be required for
several purposes. Some of the purposes are as follows:
(i) Budgeting
(ii) Measurement of performance efficiency
(iii) Preparation of financial statements (valuation of stocks etc.)
(iv) Make or buy decisions
(v) Fixation of the sale prices of products
Hence, Cost estimation is a term used to describe the measurement of

historical costs with a view to providing estimates on which to base
future expectations on cost.
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Historical costs can be assumed to have a mixed costs behaviour
pattern.
Mixed costs can be separated into fixed and variable elements, using a
variety of techniques.
3.13 Basic techniques of cost estimation

One of the critical steps in decision-making is the estimation of costs
to be incurred for the particular decision to be made. To be able to do
this, management must have a good idea as to how costs behave at
different levels of operations; i.e., will the cost increase if production
increases or will the cost remain the same? A common use of cost
behavior information is the attempt by management to predict the total
production costs for units to be manufactured in the upcoming month.
There are several methods used to estimate total product costs: Account
analysis, Engineering Analysis, the high-low method, a scatter-graph,
and least-squares regression. Each of these methods attempts to separate
costs into components that remain constant (fixed) in total regardless of
the number of units produced and those that vary in total in proportion
to changes in the number of units produced. Once the behavior of costs
is known, predictive ability is greatly enhanced.
(i) Account analysis

Way to measure cost behavior. It selects a volume-related cost
driver and classifies each account from the accounting records as
a variable or fixed cost. The cost accountant then looks at each cost
account balance and estimates either the variable cost per unit of
cost driver activity or the periodic fixed cost. Account analysis
requires a detailed examination of the data, presumably by cost
accountants and managers who are familiar with the activities of
the company, and the way the companys activities affect costs
(ii) Engineering Analysis

Way to measure cost behaviuor (or develop a Cost-Volume
Formula ) according to what costs should be, not by what costs
have been. It entails a systematic review of materials, labour,
support services, and facilities needed for product and services.
Engineers use time and motion studies and similar engineering
methods to estimate what costs should be from engineers
specifications of the inputs required to manufacture a unit of
output or to perform a particular service.
90
(iii) High-low method
Use of the high-low method requires the use of only two past data
observations: the highest level of activity (such as the number
of units produced during a time period) and the associated total
production cost incurred at that level, and the lowest level of
activity and its associated cost. All other data points are ignored
and even the two observations used must represent operations
that have taken place under normal conditions. The loss of input
from the unused data is a theoretical limitation of this method
The high-low method, as the name indicates, uses two extreme data
points to determine the values of a (the fixed cost portion) and b (the
variable rate) in the Cost-Volume When using the high-low method, the
highest point and the lowest point are used to create the cost formula.
The high point is defined as the point with the highest activity and the
low point as the point with the lowest activity. Using the lowest and
highest activity levels it is possible to estimate the variable cost per unit
and the fixed cost component of mixed costs. Formula y = a + bx. The
extreme data points are the highest and lowest x - y pairs.
The formula becomes
Variable cost = cost at the high activity cost at low activity level
High activity level low activity level
Variable cost = change in cost

Change in activity
Therefore, when the high-low method is used, the variable cost is

estimated by dividing the difference in the cost between the high and low
levels of activity by the change in activity between those two points.
Let us assume that ABC Corporation incurred the following costs during
the last 6 months:
Month Production Total Cost

July 10,000 $ 44,000
August 15,000 $ 60,000
September 23,000 $ 85,000
October 21,000 $ 75,000
November 19,000 $ 70,000
December 28,000 $ 98,000
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The lowest level of production was in July and the highest level of
production was in December. The difference between the number of
units produced and the difference between the total cost at the highest
and lowest levels of production are shown below:
Production Total Cost

Highest Level 28,000 units $ 98,000
Lowest Level 10,000 units $ 44,000
Difference 18,000 units $ 54,000
Since the total fixed cost does not change with changes in volume of
production, the difference in the total cost is the change in the total
variable cost. So, if we divide the difference in total cost by difference
in production, we will have an estimate of the variable cost per unit. In
our case
Variable Cost per Unit = $ 54,000 / 18,000 units = $ 3

Now we know that the variable cost per unit is $3. We know that the
fixed cost will be the same at both the highest and the lowest levels of
production. In order to estimate the fixed cost, we have to subtract the
estimated total variable cost from the total cost.
Total cost = (Variable Cost per Unit x Units of Production) + Fixed Cost
Highest level:
$ 98,000 = ($3 x 28,000) + Fixed cost
Fixed cost = $ 14,000
Lowest level:
$ 44,000 = ($3 x 10,000) + Fixed cost
Fixed cost = $ 14,000
(iv) The Scatter graph method

The scatter-graph method requires that all recent, normal data
observations be plotted on a cost (Y-axis) versus activity (X-axis)
graph. A line that most closely represents a straight line composed
of all the data points should be drawn. By extending the line to
where it intersects the cost axis, a company has a fairly accurate
estimate of the fixed costs for the period. The angle (slope) of
the line can be calculated to give a fairly accurate estimate of the
variable cost per unit. The inclusion of the effect of all data points
is strength of this method, but the unsophisticated eye-balling of
the appropriate line is a weakness.
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By this graphical method of cost estimation historical costs
from previous periods are plotted and from the resulting scatter
diagram a line of best fit can be drawn by visual estimation. The
scatter graph method (also called scatter plot or scatter chart
method) involves estimating the fixed and variable elements
of a mixed cost by a visual process. The scatter-graph method
requires that all recent, normal data observations be plotted on a
cost (Y-axis) versus activity (X-axis) graph. Vertical axis of graph
represents total costs and horizontal axis shows the volume of
related activity.
Two things should be noted about this scatter graph

The total cost is plotted on the vertical axis cost is known
as the dependent variable, since the amount of cost incurred
during the period depends on the level of activity for the
period.
The activity level is plotted on the horizontal axis, activity

is known as the independent variable, since it causes
variations in the cost
Let use the example of ABC Corporation and review their activities for
the last 6 months. First step is to plot the points, according to given
data. Then a line that most closely represents a straight line composed
of all the data points should be drawn. The graph is shown is shown
below.
Fig 1.5 Scatter graph
93
The point where this line intersects the vertical axis is our fixed costs
or $14,000 in this case. The angle (slope) of the line can be calculated to
give a fairly accurate estimate of the variable cost per unit. It can be seen
from the graph that production of 20,000 DVDs will cost the company is
$75,000 and production of 25,000 DVDs will cost $90,000. Knowing this
information the variable cost per unit can be calculated as follows; (fig
$ 000)
Y2 Y1 = $ 90 $ 75 = $15 = $3
X2 X1 25 20 5
When two variables are known, they may be used them in the regression
formula:
Y = a + bx, where a is fixed costs and b is variable cost per unit.
So, the cost formula for activity looks like this:
Y = $ 14,000 + $3 x
Using this formula we can predict the total cost of activity in the range of
10,000 to 28,000 DVDs per month and then separate them into fixed and
variable components. For example, assume that production of 24,000
DVDs is planned for the next period. Using the formula we can predict
that total costs would be equal to:
Y = $ 14,000 + $ 3 x 24,000 = $ 86,000
Of this total cost, $ 14,000 is fixed and $ 72,000 is variable.
This method is simple to use and provides clear representation of

correlation between costs and volume of activity. However, the
disadvantage of this method is difficulties that may appear when
determining the location of the best-fit line.
(v) Least squares method

Least squares method is a statistical method of estimating fixed
and variable costs using historical data from a number of previous
accounting periods. This is most robust method of separating
mixed costs is the least-squares regression method. This method
requires the use of thirty or more past data observations, both the
activity level in units produced and the total production cost for
each. The method of least squares identifies the line that best fits
the data points (the sum of the squared deviations is minimized).
94
This method is the most sophisticated and provides the user with
a measure of the goodness of fit, which can be used to assess the
usefulness of the cost formula.
Linear regression analysis is used to derived a linear cost function
y = a + bx
Where:
y, the dependent variable = total cost
x the independent variable = the level of activities
a is the fixed cost and b is the variable cost per unit of activity
Regression Formula:
Regression Equation(y) = a + bx
Slope(b) Variable cost per unit = (NXY - (X)(Y)) / (NX2 - (X)2)
Intercept(a) Total fixed cost = (Y - b(X)) / N
where
x and y are The level of activity (output) and Mixed cost
respectively
b = The slope of the regression line i.e. Variable cost per unit
a = The intercept point of the regression line and the y axis. i.e.
Total fixed cost
N = Number of values or elements
X = The level of activity (output)
Y = The mixed cost
XY = Sum of the product of output and mixed cost
X = Sum of output
Y = Sum of mixed cost
X2 = Sum of square of output
Example: Use the following data to find the variable cost per unit (b)
and total fixed cost (a)
To find the X (units) Y ($000)

60 3.1
61 3.6
62 3.8
63 4
65 4.1
Step 1: Count the number of values. N = 5
95
Step 2: Find XY, X2, See the below table
X Value Y Value X*Y X*X

60 3.1 60 * 3.1 = 186 60 * 60 = 3600
61 3.6 61 * 3.6 = 219.6 61 * 61 = 3721
62 3.8 62 * 3.8 = 235.6 62 * 62 = 3844
63 4 63 * 4 = 252 63 * 63 = 3969
65 4.1 65 * 4.1 = 266.5 65 * 65 = 4225
Step 3: Find X, Y, XY, X2.

X = 311
Y = 18.6
XY = 1159.7
X2 = 19359
Step 4: Substitute in the above slope formula given.

Slope (b) = (NXY - (X)(Y)) / (NX2 - (X)2)
= ((5)*(1159.7)-(311)*(18.6))/((5)*(19359)-(311)2)
= (5798.5 - 5784.6)/(96795 - 96721)
= 13.9/74
= 0.19
Step 5: Now, again substitute in the above intercept formula given.

Intercept (a) = (Y - b(X)) / N
= (18.6 - 0.19(311))/5
= (18.6 - 59.09)/5
= -40.49/5
= -8.098
Step 6: Then substitute these values in regression equation formula

Y = -8.098 + 0.19x.
Suppose if we want to know the approximate y value for the variable
x = 64. Then we can substitute the value in the above equation.
= -8.098 + 0.19(64).
= -8.098 + 12.16
= 4.06
96
The administrator of ABC Hospital would like a cost formula linking the
costs involved in admitting patients to the number of patients admitted
during a month. The admitting departments costs and the number of
patients admitted during the immediately preceding eight months are
given in the table below
Number of patients Admitting Dept. costs

Month
admitted ($)
May 1,500 14,700
June 1,900 15,200
July 1,700 13,200
August 1,600 14,000
September 1,500 14,300
October 1,300 13,100
November 1,100 12,800
December 1,500 14,600
Required
Use the high-low method to establish the fixed and variable components
of admitting costs
Express the fixed and variable components of admitting costs as a cost

formula in the linear equation form Y= a + bx
Summary
The chapter has addressed the knowledge to how costs will change
with different levels of activity is essential for decision making, it has
explained the importance of the relevant range and volume of activity
in using a cost behaviour pattern for cost prediction; it has also focused
on the behaviour of variable costs, fixed cost, step cost and mixed due
to the changes of the level of activity in an organization. The activity
may be measured in terms of units of production or sales or any other
appropriate measure of the activity of a firm. For each of decisions
management requires estimates of costs at different levels of activity
for alternative course of action. The term variable cost, fixed cost, semi
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variable cost and step cost which have been addressed in this chapter
describe how a cost reacts to changes in the level of activity.

Account analysis
Committed fixed cost
Cost behaviour
Cost estimation
Discretionary fixed cost
Engineering analysis
Fixed cost
Level of activity
Relevant range
Semi variable cost
Step cost
Variable cost
98
Exercises
3.1 Define cost behavior. Why is cost behavior important to the
organization?
3.2 Define relevant range and cost driver. How do these concepts
influence cost behavior?
3.3 Describe and provide examples of fixed costs, variable costs, and
semi-variable costs. What are the planning implications of each
type of cost?
3.4 How can increases in activity reduce the fixed cost per unit of
activity?
3.5 What is the relationship between fixed costs and levels of activity?
Variable costs and levels of activity?
3.6 Distinguish between committed fixed costs and discretionary

fixed costs.
3.7 Define step costs. Distinguish between step fixed costs and step
variable costs.
3.8 Describe the graphical method. How are fixed costs determined
using this method? How the variable cost per unit is determined
using this method?
3.9 What information is required when the two-point method is used

to identify the fixed and variable components of a semi-variable
cost? Is this information different when the semi averages method
is used?
3.9.1 Once the fixed and variable components of a semi-variable cost

are identified, how does the organization estimate total costs
Problems
3.11
Costs may be classified in several ways such as: fixed, variable, or
semi variable. Some fixed costs are classified for planning purposes as
committed costs and others as discretionary.
99
Required:
(i) What determines whether a cost is classified as fixed, variable, or
semi-variable?
(ii) What determines whether a fixed cost is committed or discretionary?
3.12
All costs can be variable, depending on the volume or type of company.
Specify whether each cost from the following list is normally fixed,
variable, or semi-variable. For costs classified as fixed costs, indicate
whether they are discretionary or committed fixed costs.
1. Plant depreciation
2. Advertising expense
3. Indirect labor
4. Superintendents salary
5. Foremans salary
6. Electricity and heat
7. Presidents salary
8. Rent
9. Research and development
3.13
Based on an analysis of historical cost relationships, ABC Company has
determined that its fixed operating costs are $10,000, and its variable
costs are $3.50 per unit produced. Compute the total costs incurred by
ABC Company for expected production of 1,000 units, 5,000 units, and
10,000 units.
3.14
What is the main difference in assumptions between the accounting
model of cost behaviour and the economic theory model, how can the
two models be reconciled?
3.15
ABC Company in connection with its cost accounting and budgeting
system classifies its cost as either fixed or variable. However, some of
the companys manufacturing costs are in fact semi-variable in nature.
In order to prepare a flexible budget for manufacturing expenses,
it is necessary to separate these costs into their fixed and variable
components. The cost accounting records for the year just ended showed
the following data.
100
Repairs and
Units of product Utilities expense
Maintenance Expense
1st quarter 10,000 $40,000 $ 82,000
2nd quarter 15,000 $56,000 $115,000
3rd quarter 18,000 $65,000 $133,000
4th quarter 8,000 $36,000 $ 64,000
Required:
Based on the above data, compute the fixed and variable cost components
of the above costs/expenses:
(i) Assuming the high-low method is used
(ii) Assuming the scatter-graph method is used
3.16
The administrator of Azalea hospital would like cost formula linking the
given in the table below:
Number of Patients Admitting Department

Months
Admitted Costs ($)
May 1,800 14,000,000
June 1,900 15,200,000
July 1,700 13,700,000
August 1,600 14,000,000
September 1,500 14,300,000
October 1,300 13,100,000
November 1,100 12,800,000
December 1,500 14,600,000
Required
(i) Use high-low method to establish the fixed and variable
components of admitting costs
(ii) Express the fixed and variable components of admitting costs as

a cost formula in the linear equation form Y= a + bX
101
3.17
One of Varic Companys products goes through a glazing process. The
company has observed glazing costs as follows over the last six weeks
Week Units Produced Total Cost ($)

1 8 270,000
2 5 200,000
3 10 310,000
4 4 190,000
5 6 240,000
6 9 290,000
For planning purposes the companys management must know the

amount of variable cost per unit and the total fixed cost per week
Required
1. Use high-low method to establish the fixed and variable
components of admitting costs
2. Express the fixed and variable components of admitting costs as

a cost formula in the linear equation form Y= a + bX
3. If the company processes seven units next week, what would be

the expected total cost?
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Case Studies
Case Study 3.1: DK Pizza House
The DK Pizza House has provided you with the following information
on its costs at various levels of monthly sales.
Monthly sales units 3,000 6,000 9,000

Cost of food 3,500 5,000 6,500
Supplies 600 1,200 1,800
Utilities 360 420 480
Other operating costs 1,500 3,000 4,500
Building rent 1,000 1,000 1,000
Depreciation 200 200 200
Source: Duncan 2000
1. Identify each cost as variable, fixed or mixed.
2. Develop an equation to estimate total cost at various levels of activity
3. Project total cost with monthly sales of 8,000 units
103
Further Readings
Awasthi, V. N. and C. W. Chow. 1998. Rosalind Enterprises: A mini-
case for ensuring student mastery of cost behavior concepts in short-
term decisions. Journal of Accounting Education 16(1): 139-145.
Barton, T. L. and F. M. Cole. 1994. Atlantic Dry Docks unique cost

estimation system. Management Accounting (October): 32-35, 38-39.
Battista, G. L. and G. R. Crowningshield. 2006. Cost behavior and

breakeven analysis - A different approach. Management Accounting
(October): 3-14.
Bisgay, L. 1980. Report on fixed and variable expense research.

Management Accounting (June): 43 and 56. (Survey of 233 companies).
Davis, C. E. 1997. Accounting is like a box of chocolates: A lesson in cost

behavior. Journal of Accounting Education 15(3): 307-318.
Kallapur, S. and L. Eldenburg. 2005. Uncertainty, real options, and

cost behavior: Evidence from Washington State hospitals. Journal of
Accounting Research (December): 735-752
104
CHAPTER 4
INCOME EFFECTS OF ALTERNATIVE COST
ACCUMULATION SYSTEMS
Chapter Objectives
The objectives of the chapter is to provide the extent to which product costs
are accumulated for inventory valuation and profit measurement for meeting
decision making, Also the chapter provides a thorough understanding of
overhead cost allocation and apportionment and examines the alternative
costing systems known marginal costing and absorption costing.
Learning Outcomes
be able to:
1. Understand the meanings Overhead allocation and
apportionment
2. Understand the meanings of marginal cost and marginal
costing
3. Understand the theory of marginal costing system
4. Distinguish between marginal costing and absorption costing
5. Prepare profits statements based on marginal (variable)
costing and absorption costing system
6. Explain the difference and reconcile the profits between
marginal and absorption costing
7. Explain the arguments for and against marginal and absorption
costing
105
4.1 Introduction
The main principles underlying the content of this chapter should be
familiar to you from your earlier studies of costing accounting. You
should already be able to apply a system of marginal costing and
understand how it differs from absorption costing. Whereas absorption
costing recognises fixed costs (usually fixed production costs) as part of
the cost of a unit of output and hence as product costs, marginal costing
treats all fixed costs as period costs
4.2 Overhead allocation and apportionment

An overhead cost is defined in the CIMA Terminology as expenditure
on labour, materials or services that cannot be economically identified
with a specific saleable cost unit. Overhead costs are also referred to as
indirect costs which we discussed in Chapter two
Therefore, overhead cost comprises indirect material, indirect labour

and indirect expenses. The indirect nature of overheads means that they
need to be shared out among the cost units as fairly and as accurately
as possible.
In this chapter, you will be learning how this sharing out, or attribution,
is accomplished for production overheads, using a costing method
known as absorption costing.
One of the main reasons for absorbing overheads into the cost of units
is for inventory valuation purposes. Accounting standards recommend
that inventory valuations should include an element of fixed production
overheads incurred in the normal course of business. We therefore have
to find a fair way of sharing out the fixed production overhead costs
among the units produced.
Overhead costs may be classified according to the function of the

organization responsible for incurring the cost. Examples of overhead
cost classifications include production overhead, selling and distribution
overhead, and administration overhead. It is usually possible to classify
the majority of overhead cost in this way, but some overhead costs
relate to the organization generally and may be referred to as general
overhead. In this chapter we shall focus mainly on production overhead.
Production is that function of the business which converts raw materials
into the organizations finished product. The production department is
usually divided into a number of departments or cost centres. Some of
these cost centres are directly involved with the production process.
106
These are called production cost centres and might include, for example,
the cutting department and the finishing department.
Other cost centres in the production department are not directly

involved with the production process but provide support services for
the production cost centres. These are called service cost centres, and
examples include the maintenance department and the stores.
The first stage in the analysis of production overheads is the selection

of appropriate cost centres. The selection will depend on a number of
factors, including the level of control required and the availability of
information.
Having selected suitable cost centres, the next stage in the analysis is
to determine the overhead cost for each cost centre. This is achieved
through the process of allocation and apportionment.
(i) Cost allocation

Cost allocation is possible when we can identify a cost as
specifically attributable to a particular cost centre. For example the
salary of the manager of the packing department can be allocated
to the packing department cost centre. It is not necessary to share
the salary cost over several different cost centres. Therefore
Allocation of overhead is the process of charging overhead costs
to a particular department or cost center. It is the allotment or
assignment of an overhead cost to a particular cost unit. If the
overhead cost is associated with a single department or cost
center, the whole amount is charged or distributed among the
units of output of that particular department. For example, the
whole amount of repair and maintenance expenses for a machine
is charged or allocated to that department where the machine has
been installed
(ii) Cost apportionment

Cost apportionment is necessary when it is not possible to allocate
a cost to a specific cost centre. In this case the cost is shared
out over two or more cost centres according to the estimated
benefit received by each cost centre. As far as possible the basis
of apportionment is selected to reflect this benefit received.
For example, the cost of rent and rates might be apportioned
according to the floor space occupied by each cost centre. Hence
the distribution of an overhead cost to several departments or cost
centers is known as apportionment of overheads. It is the process
107
of charging or apportioning costs to a number of cost centers or
cost units. If a given cost is common to two or more departments
or cost centers, such cost should be apportioned or divided among
these departments on an equitable basis. For example, the amount
of factory rent should be apportioned to all the departments.
Similarly, the amount of remuneration of the general manager
should be distributed to the production, administration and
marketing departments as the general manager is associated with
all these departments.
4.3 Overhead Absorption

This is the process by which overheads are included in total cost of a
product. The charging of overheads cost unit by means of rates separately
calculated for each cost centre in most cases the rate is predetermined
(CIMA)
The idea is that we want to reflect the load that the product or job places
upon the production. The overhead rate (OAR) is calculated by the
following formula
OAR ( overhead absorption rate) = Total Budgeted Overhead of Cost Centre

Base Applicable to the Cost Centre
Cost centre as discussed in chapter one is a location function or items

of equipment in respect of which costs may be ascertained in respect of
cost unit for control purpose, for example the planting shop, the sales
office
4.4 Bases of Overhead Absorption Rate

There are several different methods which can be used to absorb
overheads. The following data will be used to demonstrate the calculation
of various method of overhead absorption rate
Data relating to BM shop for December 2010

Total overhead $ 60,000
Total direct labour hours 8,000
Total direct wages $ 16,000
Total direct material used $ 30,000
Total machine hours 12,000
Total units produced 450 units
108
Calculation of overhead absorption rate
(i) Direct labour hour overhead absorption rate (OAR)
OAR = $ 60,000/ 8,000hrs = $ 7.50 per direct labour
(ii) Direct wages overhead absorption rate (OAR)

OAR= $ 60,000/$ 16,000 = 375% of wages
(iii) Direct Material overhead absorption rate (OAR)

OAR = $ 60,000/$ 30,000 = 200% of Material
(iv) Prime cost overhead absorption rate (OAR)

OAR= $ 60,000/$ 4,600 = 130% of prime cost
(v) Machine hour overhead absorption rate (OAR)

OAR = $ 60,000/12,000 hrs = $ 5.00 per machine hours
(vi) Cost unit overhead absorption rate (OAR)

OAR = $ 60,000/450 units = $ 133 per unit produced
4.5 Applying the overhead absorption rate

The above calculation illustrate the most common methods of calculating
overhead absorption rates but only one of them would be selected for
each cost centre. The example shown below will illustrate the application
of overhead absorption rate in the computation the cost of a product.
Unit XA in the BM shop

Direct material $ 23.00
Direct wages $ 27.50
Direct labour hours 12 hours
Machine hours 17 hours
To calculate the full manufacturing cost of unit XA using a direct labour

hours overhead absorption rate
$
Direct material 23.00
Direct labour 27.50
Prime cost 50.50
Overhead 12 x $ 7.50 90.00
Full manufacturing cost 140.50
109
Comparison of alternative base
Overhead
Absorption base OAR Cost Data Calculation absorption
per unit
Direct labour hour $ 7.50 12 12 x $ 7.50 $ 90.00
Direct wages 375% $ 27.50 3.75 x $ 27.50 $ 103. 13
Direct material 200% $ 23 2 x $ 23.00 $ 46
Prime cost 130% $ 50.50 1.3 x $ 50.50 $ 65.65
Machine hour $ 5.00 17 hrs 17hrs x $5.00 $ 85
Cost unit $ 133 1 unit 1unit x $ 133 $ 133
4.6 Choosing the most appropriate absorption base

A major factor in choosing the appropriate absorption rate to be used,
this requires judgment and common sense. It is generally accepted that a
time-based method should be used such as labour hours, machine hours
or direct wages; this is because many overhead costs increase with time,
for example, indirect wages, rent and rates. Therefore, it makes sense to
attempt to absorb overheads according to how long a cost unit takes to
produce.
Direct labour hour basis: suitable in a labour intensive cost centre which
has a good time recording system
Machine hour basis: suitable in a mechanized cost centre, a lot of the

overheads will relate to the use of machinery.
Direct wages basis: similar to direct labour basis, only suitable where
there are uniform wages rates in which case it will give the same amount
of overhead as direct labour basis
Direct material basis: only likely to be useful for absorbing material

handling expenses
4.7 Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly
because of difficulty in forecasting costs and volume of output. If these
balances of under or over absorbed/recovery are not written off to
costing profit and loss account, the actual amount incurred is not shown
in it.
Normally over or under absorption of overhead is occurred when the

actual production is differ from planned (budgeted) production during
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the period and this over or under absorption should be adjusted in the
income statement of that period.
Note that as long as planned level of activity and the actual level of
activity is not the same there is always an Over or Under Absorption
situation
This is because overhead absorption rate is set at the start of the period
based upon an expected level of production and that during the period,
the level of output and or overheads will be different from the planned
overheads and or output.
OVER-absorption occurs when the total overhead recovered or absorbed

is GREATER than the actual level of overheads for the period. UNDER-
absorption occurs when the total overheads recovered or absorbed is
LESS than the actual overheads incurred in the period.
Illustration
Company recovers its overheads based upon direct labour hours. The
planned overhead expenditure is $2,500 per month and the planned
direct labour hours are 1,000 per month. The results for the first 3 months
were as follows:
Month 1 Month 2 Month 3

Actual Overhead ($) 4,000 5,000 3,500
Direct labour hours 1,000 2,000 2,000
Required:
(a) Compute the overheads absorption rate in each month;
(b) Compute the total overheads over/under-absorbed
Solution:
(a) The pre-determined overhead absorption rate:
= Budgeted overhead per month/Budgeted direct labours per

month
= $2,500/1,000 hours=$2.50 per direct labour hour.
111

Actual Overhead ($) 4,000 5,000 3,500
Direct labour hours (a) 1,000 2,000 2,000
Overhead Recovery per direct labour
2.5 2.5 2.5
hour (b)
Overhead recovered or absorbed (a x b) 2,500 5,000 5,000

(b) The monthly over/under absorption of overheads is the difference
between the overhead recovered or absorbed and the actual level of
overhead for the period

Actual Overhead (a) 4,000 5,000 3,500
Overhead recovered (b) 2,500 5,000 5,000
Over/(under) absorbed overhead (a)-(b) (1,500) 0 1,500
4.8 Marginal costing and contribution

In product/service costing, a marginal costing system emphasises the
behavioural, rather than the functional, characteristics of costs. The
focus is on separating costs into variable elements (where the cost per
unit remains the same with total cost varying in proportion to activity)
and fixed elements (where the total cost remains the same in each period
regardless of the level of activity). Whilst this is not easily achieved
with accuracy, and is an oversimplification of reality, marginal costing
information can be very useful for short-term planning, control and
decision-making, especially in a multi-product business.
In a marginal costing system, sales less variable costs (regardless of

function) measures the contribution that individual products/services
make towards the total fixed costs incurred by the business. The fixed
costs (regardless of function) are treated as period costs and, as such,
are simply deducted from contribution in the period incurred to arrive
at net profit.
According to CIMA (2008), Marginal costing is an alternative method

of costing to absorption costing. In marginal costing, only variable costs
are charged as a cost of sale and a contribution is calculated which is
sales revenue minus the variable cost of sales. Closing inventories of
work in progress or finished goods are valued at marginal (variable)
production cost. Fixed costs are treated as a period cost, and are charged
in full to the income statement in the accounting period in which they
are incurred.
112
Therefore, Marginal costing is a method of cost accumulation where
by variable production costs are charged to cost units and the fixed
cost attributable to the relevant period is written off in full against the
contribution for that period. With marginal costing, it is only variable
costs that are charged to units of production, jobs or services etc. Fixed
costs are charged to costs absorbed into product costs, they are then
charged as an expense against profit for the time period to which they
relate.
It should be noted that, under this costing system fixed production

overheads are charged in the period incurred as expenses, only variable
production costs are charged to cost units. Under marginal costing only
those costs of production those vary with output are treated as product
costs. These would usually include the following:
1. Direct materials
2. Direct labour and
3. Variable portion of production overhead
However fixed production (manufacturing) overhead is not treated as

a product cost under this costing system, rather than fixed production
(manufacturing) overhead is treated as a period cost like selling and
administrative expenses against the aggregate contribution.
The term contribution mentioned above is the term given to the

difference between Sales and Marginal cost. Thus
Marginal cost = Direct labour

+
Direct materials
+
Direct expenses
+
Variable production overheads
The term marginal cost sometimes refers to the marginal cost per unit
and sometimes to the total marginal costs of a department or batch or
operation. The meaning is usually clear from the context. Marginal
costing is sometimes referred to as variable costing or direct costing.
4.9 Theory of Marginal Costing

The theory of marginal costing as set out in A report on Marginal
Costing published by CIMA, London is as follows:
113
In relation to a given volume of output, additional output can normally
be obtained at less than proportionate cost because within limits, the
aggregate of certain items of cost will tend to remain fixed and only
the aggregate of the remainder will tend to rise proportionately with
an increase in output. Conversely, a decrease in the volume of output
will normally be accompanied by less than proportionate fall in the
aggregate cost.
The theory of marginal costing can be understood by the following two

steps:
(i) If the volume of output increases, the cost per unit in normal
circumstances reduces. Conversely, if an output reduces, the cost
per unit increases. If a factory produces 1000 units at a total cost
of $3,000 and if by increasing the output by one unit the cost goes
up to $3,002, the marginal cost of additional output will be $2.
(ii) If an increase in output is more than one, the total increase in

cost divided by the total increase in output will give the average
marginal cost per unit. If, for example, the output is increased
to 1020 units from 1000 units and the total cost to produce these
units is $1,045, the average marginal cost per unit is $2.25. It can
be described as follows:
Additional cost = $45 = $2.25

Additional units 20
The ascertainment of marginal cost is based on the classification and

segregation of cost into fixed and variable cost. In order to understand
the marginal costing technique, it is essential to understand the meaning
of marginal cost. Marginal cost means the cost of the marginal or last
unit produced. It is also defined as the cost of one more or one less unit
produced besides existing level of production. In this connection, a unit
may mean a single commodity, a dozen, a gross or any other measure of
goods. For example, if a manufacturing firm produces X unit at a cost
of $ 300 and X+1 units at a cost of $ 320, the cost of an additional unit
will be $ 20 which is marginal cost. Similarly if the production of X-1
units comes down to $ 280, the cost of marginal unit will be $ 20 (300
280). The marginal cost varies directly with the volume of production
and marginal cost per unit remains the same. It consists of prime cost,
i.e. cost of direct materials, direct labour and all variable overheads. It
does not contain any element of fixed cost which is kept separate under
marginal cost technique.
114
4.10 Features of Marginal Costing System:
The main features of marginal costing are as follows:
Cost Classification: The marginal costing technique makes a sharp

distinction between variable costs and fixed costs. It is the variable cost
on the basis of which production and sales policies are designed by a
firm following the marginal costing technique.
Stock/Inventory Valuation: Under marginal costing, inventory/stock for

profit measurement is valued at marginal cost. It is in sharp contrast to
the total unit cost under absorption costing method.
Marginal Contribution; Marginal costing technique makes use of marginal

contribution for marking various decisions, Marginal contribution is
the difference between sales and marginal cost. It forms the basis for
judging the profitability of different products or departments.
4.11 Advantages and Disadvantages of Marginal Costing Technique
Advantages
a) Marginal costing is simple to understand.
b) By not charging fixed overhead to cost of production, the effect of

varying charges per unit is avoided.
c) It prevents the illogical carry forward in stock valuation of some

proportion of current years fixed overhead.
d) The effects of alternative sales or production policies can be more

readily available and assessed, and decisions taken would yield
the maximum return to business.
e) It eliminates large balances left in overhead control accounts

which indicate the difficulty of ascertaining an accurate overhead
recovery rate.
f) Practical cost control is greatly facilitated. By avoiding arbitrary

allocation of fixed overhead, efforts can be concentrated on
maintaining a uniform and consistent marginal cost. It is useful
to various levels of management.
g) It helps in short-term profit planning by breakeven and profitability

analysis, both in terms of quantity and graphs. Comparative
115
profitability and performance between two or more products
and divisions can easily be assessed and brought to the notice of
management for decision making.
Disadvantages
a) The separation of costs into fixed and variable is difficult and
sometimes gives misleading results.
b) Normal costing systems also apply overhead under normal

operating volume and this shows that no advantage is gained by
marginal costing.
c) Volume variance in standard costing also discloses the effect of

fluctuating output on fixed overhead. Marginal cost data becomes
unrealistic in case of highly fluctuating levels of production, e.g.,
in case of seasonal factories.
d) Application of fixed overhead depends on estimates and not on

the actual and as such there may be under or over absorption of
the same.
e) Control affected by means of budgetary control is also accepted

by many. In order to know the net profit, we should not be satisfied
with contribution and hence, fixed overhead is also a valuable
item. A system which ignores fixed costs is less effective since a
major portion of fixed cost is not taken care of under marginal
costing.
f) In practice, sales price, fixed cost and variable cost per unit may
vary. Thus, the assumptions underlying the theory of marginal
costing sometimes becomes unrealistic. For long term profit
planning, absorption costing is the only answer.
g) Under marginal costing, stocks and work in progress are

understated. The exclusion of fixed costs from inventories affect
profit and true and fair view of financial affairs of an organization
may not be clearly transparent.
4.12 Uses of marginal costing

(i) As a basis for providing information to management for planning
and decision making. It is particularly appropriate for short
run decisions involving changes in volume or activity and the
resulting cost changes.
116
(ii) It can also be used in the routine cost accounting system for the
calculation of costs and the valuation of stocks.
4.13 Presentation of Cost Data under Marginal Costing

Marginal costing is not a method of costing but a technique of presentation
of sales and cost data with a view to guide management in decision-
making. The traditional technique popularly known as total cost or
absorption costing technique does not make any difference between
variable and fixed cost in the calculation of profits. But marginal cost
statement very clearly indicates this difference in arriving at the net
operational results of a firm. The following presentation of Performa
shows the presentation of information according to marginal costing
techniques:
MARGINAL COSTING PRO-FORMA

$ $
Sales Revenue xxxxx
Less Marginal Cost of Sales
Opening Stock (Valued @ marginal cost) xxxx
Add Production Cost (Valued @ marginal cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ marginal cost) (xxx)
Marginal Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Marginal Cost of Sales (xxxx)
Contribution xxxxx
Less Fixed Cost (xxxx)
Marginal Costing Profit xxxxx
Illustration: marginal costing

To illustrate the computation of unit product costs and preparation of
income statement under the marginal costing, consider the following
example;
ABC Company, a small company that produces a single product and

has the following cost structure.
117
Number of units produced each year 6,000

Opening stocks (units) 500
Sales (units) 5,500
Unit selling price ($) 1,800
Variable cost per unit $

Direct materials 200
Direct labour 400
Variable production overhead 100
Variable selling and administrative expenses 300
Fixed costs per year $

Fixed production overhead 3,000,000
Fixed selling and administrative expenses 1,000,000
Required
(i) Compute the unit product cost using the marginal (direct) costing
(ii) Prepare the income statement using the marginal costing
Solution
(i) Computation of unit product cost
It should be noted here only variable production costs will be
considered in the computation of unit product cost while the
fixed production overhead will be excluded;

$
Direct material 200
Direct labour 400
Variable overhead (production) 100
Unit product cost 700
118
ABC Ltd
Income Statement for the year
$ 000 $ 000
Sales (5,500 x $ 1,800) 9,900
Less variable cost of sales
- Opening stock (500 x $ 700) 350
- Production cost (6,000 x $ 700) 4,200
Good available for sale 4,550
-Less closing stock (1,000 x $ 700) 700
Variable Cost of sales 3,850
Gross Contribution 6,050
Less variable selling & Administration 1,650
Total contribution 4,400
Less fixed costs
-Production 3,000
-Selling & Administrative 1,000 4,000
Operating profit 400

4.14 Absorption costing System
In product/service costing, an absorption costing system allocates
or apportions a share of all costs incurred by a business to each of its
products/services. In this way, it can be established whether, in the
long run, each product/service makes a profit. This can only be a guide.
Arbitrary assumptions have to be made about the apportionment of
many of the costs which, given that some costs will tend to remain
fixed during a period, will also be dependent on the level of activity. An
absorption costing system traditionally classifies costs by function. Sales
less production costs (of sales) measures the gross profit (manufacturing
profit) earned. Gross profit less costs incurred in other business functions
establishes the net profit (operating profit) earned.
Using an absorption costing system, the profit reported for a

manufacturing business for a period will be influenced by the level
of production as well as by the level of sales. This is because of the
absorption of fixed manufacturing overheads into the value of work-
in-progress and finished goods stocks. If stocks remain at the end of
an accounting period, then the fixed manufacturing overhead costs
included within the stock valuation will be transferred to the following
period.
119
Absorption costing means that all of the manufacturing costs are
absorbed by the units produced. In other words, the cost of a finished
unit in inventory will include direct materials, direct labour, and both
variable and fixed manufacturing overhead. As a result, absorption
costing is also referred to as full costing or the full absorption method.
The cost of a unit of product under the absorption costing system,
therefore consists of
1. Direct materials
2. Direct labour and
3. Both variable and fixed production (manufacturing) overhead
Thus, absorption costing allocates a portion of fixed production overhead

cost to each unit of product, along with the variable production costs.
Absorption Costing = Direct labour

+
Direct materials
+
Direct expenses
+
Variable production overheads
+
Fixed production overheads
4.15 The features of absorption costing

a) In absorption costing, items of inventory are costed to include
a fair share of fixed production overhead. In this case the value
of ending inventory will be higher in absorption costing than in
marginal costing.
b) As a consequence of carrying forward an element of fixed

production overheads in ending inventory values, the cost of
sales used to determine profit in absorption costing will include
some fixed production overhead costs incurred in a previous
period but carried forward into beginning inventory values of
the current period and exclude some fixed production overhead
costs incurred in the current period by including them in ending
inventory values.
c) In absorption costing, actual fully absorbed unit costs are reduced

by producing in greater quantities,). Thus, Profit per unit in any
period can be affected by the actual volume of production.
d) In absorption costing, however, the effect on profit in a period of

changes in both production volume and sales volume.
120
4.16 Advantages and Disadvantages of Absorption Costing
Advantages of absorption costing

a) Fixed production costs are incurred in order to make output; it is
therefore fair to charge all output with a share of these costs.
b) Closing inventory values, include a share of fixed production

overhead, and therefore follow the requirements of the
international accounting standard on inventory valuation (IAS 2)
c) Absorption costing is consistent with the accruals concept as a

proportion of the costs of production are carried forward to be
matched against future sales.
d) A problem with calculating the contribution of various products

made by an enterprise is that it may not be clear whether the
contribution earned by each product is enough to cover fixed
costs, whereas by charging fixed overhead to a product it is
possible to ascertain whether it is profitable or not. This is
particularly important where fixed production overheads are
a large proportion of total production costs. Not absorbing
production would mean that a large portion of expenditure is not
accounted for in unit costs.
e) In a job or batch costing environment absorption costing is

particularly useful in the pricing decision to ensure that the profit
mark-up is sufficient to cover fixed costs.
Disadvantages of Absorption Costing

The following are the disadvantages of absorption costing:
a) In absorption costing, a portion of fixed cost is carried over to

the subsequent accounting period as part of closing stock. This is
an unsound practice because costs pertaining to a period should
not be allowed to be vitiated by the inclusion of costs pertaining
to the previous period and vice versa.
b) Absorption costing is dependent on the levels of output which

may vary from period to period, and consequently cost per unit
changes due to the existence of fixed overhead. Unless fixed
overhead rate is based on normal capacity, such changed costs
are not helpful for the purposes of comparison and control.
121
c) The cost to produce an extra unit is variable production cost.
It is realistic to the value ending inventory items as this is a directly
attributable cost. The size of total contribution varies directly with
sales volume at a constant rate per unit. For the decision-making
purpose of management, better information about expected
profit is obtained from the use of variable costs and contribution
approach in the accounting system.
4.17 Presentation of Cost Data under Absorption Costing

The traditional technique popularly known as total cost or absorption
costing technique does not make any difference between variable and
fixed cost in the calculation of profits. Following presentation of Performa
shows the presentation of information according to absorption costing

ABSORPTION COSTING PRO-FORMA
$ $
Sales Revenue xxxxx
Less Absorption Cost of Sales
Opening Stock (Valued @ absorption cost) xxxx
Add Production Cost (Valued @ absorption cost) xxxx
Total Production Cost xxxx
Less Closing Stock (Valued @ absorption cost) (xxx)
Absorption Cost of Production xxxx
Add Selling, Admin & Distribution Cost xxxx
Absorption Cost of Sales (xxxx)
Un-Adjusted Profit xxxxx
Fixed Production O/H absorbed xxxx
Fixed Production O/H incurred (xxxx)
(Under)/Over Absorption xxxxx
Adjusted Profit xxxxx
Illustration of absorption costing (CPA (T) 2003 adapted)

The general Manager of Kazimoto Company has received the following
Income Statement for the month of May 2003 which was prepared on a
direct costing basis.
122
KAZIMOTO COMPANY
INCOME STATEMENT FOR THE MONTH OF MAY 2003
$
Sales 24,000,000
Less: Variable cost of Goods sold 12,000,000
Contribution Margin 12,000,000
Less: Fixed Manufacturing costs at budget 6,000,000
Gross Margin 6,000,000
Less: Fixed selling and Administrative costs 4,000,000
Net Income before tax 2,000,000
The following notes were attached to income Statement

$
(i) The unit sales price for May 2005 averaged 2,400
(i) The unit Manufacturing costs were
Variable costs 1200
Fixed costs applied 400
Total costs 1600
(ii) The unit fixed manufacturing overhead is based upon a normal

monthly production of 15,000 units
(iii) Variables costs per unit have been stable throughout the year.
(iv) Production for May 2006 was 4,500 units in excess of sales
(v) The inventory at May 30th 2006 consisted of 8,000 units.
Being the first time, the General Manager was presented with an Income
Statement prepared on a direct costing basis; he was not very comfortable
with the results and keep on wondering what the net income would
have been under the absorption costing basis.
Required
(a) Present the May 2003 Income Statement on an absorption costing

bases
(b) Reconcile and explain the differences in net income between the
two costing bases
123
Solution
KAZIMOTO COMPANY
INCOME STATEMENT FOR THE MONTH OF MAY 2003

$000 $ 000
Sales 24,000
Opening stock (3,500 x $ 1,600) 5,600
Production cost (14,500 x $ 1,600) 23,200
28,800
Less closing stock (8,000 x $ 1,600) 12,800
Cost goods sold 16,000
Gross profit 8,000
Less fixed selling & administrative 4,000
Profit 4,000
Less under absorption overheads 200
Adjusted profit 3,800
It should be noted that, there are some workings which should be done
before preparing the income statement as follows:
1. Actual production = sales (units) + 4,500

2. Sales (units) = $ 24,000,000/$ 24,000 = 10,000 units
3. Actual production (units) = 10,000 + 4,500 = 14,500 units
4. Actual production is less than planned production (15,000 units),
thus, there is under absorption of overhead and is calculated as
follows
5. Under absorption = (15,000 14,500) x $ 400 = $ 200,000, this
amount should deducted from the profit in the income statement
to obtain the adjusted profit.
6. Closing stock (units) = (opening stock + Actual production)
Sales = closing stock = (3,500 + 14,500) 10,000 = 8,000
7. Unit production cost = $ 1,200 + $ 400 = $ 1,600
4.18 Reconciliation Statement for Marginal Costing and Absorption

Costing Profit
The net profit reported by absorption and marginal costing systems may
not be the same owing to the differing treatment of fixed manufacturing
overheads. As has been demonstrated above, whilst marginal costing
systems treat fixed manufacturing overheads as period costs (i.e.
a charge against profit in the period incurred), in absorption costing
systems they are absorbed into the cost of goods produced and are only
charged against profit in the period in which those goods are sold.
As a result, if quantities produced and sold in a period are not the same
124
(i.e., if the levels of work-in-progress or finished goods stock change)
a different profit will be reported by the two systems. The differing
profits can be reconciled, and the difference explained, by an analysis of
the product of the stock change and the fixed manufacturing overhead
absorption rate
Hence the difference in the profit reported by the two costing systems
therefore results from the fixed production overhead that is carried
forward in inventory in an absorption costing system. However, the
profit can be reconciled as follows;

$
Marginal costing profit xxx
Add (Closing stock opening stock) x OAR (fixed) xxx
= Absorption costing profit xxx
By using example 2.2 above, the profits between marginal costing and
absorption costing can be reconciled as follows
$
Marginal costing profit 2,000,000
Add (8,000 3,500) x $ 400 1,800,000
Absorption costing profit 3,800,000
4.19 Marginal Costing versus Absorption Costing

After knowing the two costing techniques of marginal costing and
absorption costing, it is noted that, the net profits are not the same
because of the following reasons:
Over and Under Absorbed Overheads;

In absorption costing, fixed overheads can never be absorbed exactly
because of difficulty in forecasting costs and volume of output. If these
balances of under or over absorbed/recovery are not written off to
costing profit and loss account, the actual amount incurred is not shown
in it. In marginal costing, however, the actual fixed overhead incurred
is wholly charged against contribution and hence, there will be some
difference in net profits.
Difference in Stock Valuation;

In marginal costing, work in progress and finished stocks are valued
at variable cost, but in absorption costing, they are valued at total
production cost. Hence, profit will differ as different amounts of fixed
overheads are considered in two accounts. The profit difference due to
difference in stock valuation is summarized as follows:
125
a) When there is no opening and closing stocks, there will be no
difference in profit.
b) When opening and closing stocks are same, there will be no

difference in profit, provided the fixed cost element in opening
and closing stocks are of the same amount.
c) When closing stock is more than opening stock, the profit under
absorption costing will be higher as comparatively a greater
portion of fixed cost is included in closing stock and carried over
to next period.
d) When closing stock is less than opening stock, the profit unde
absorption costing will be less as comparatively a higher amount
of fixed cost contained in opening stock is debited during the
current period.
4.20 Summary of marginal and Absorption costing
a) Marginal costing is a costing technique where fixed and variable

costs are differentiated. Only variable costs are charged to cost
units and fixed costs are written off in full each period.
b) Contribution is the difference between sales and variable cost.

The pool of contribution is available to cover the fixed costs and
when the fixed costs have been covered, the balance remaining is
profit
c) Marginal costing can be used as the basis of the routine costing

accounting system or for management decision making.
d) Total absorption costing incorporates to the fixed and variable

costs into production and consequently into stock valuation.
Stocks under marginal costing are valued at marginal cost only
e) Because of the different methods of stock valuation the two

approaches produce differing profit figures when stocks exist at
the beginning or end of a period.
126
The student should attempt to answer these questions before looking
up the suggested solution at the end of the book
Using the information below, prepare profit statements for June and
July
Marginal costing
Absorption costing
ABC Company produces and sells one product only which sells for
$50 per unit. There were no inventories at the end of May and other
information is as follows.
Standard cost per unit $

Direct material 18
Direct wages 4
Variable production overhead 3
Budgeted and actual costs per month
Fixed production overhead 99,000
Fixed selling expenses 14,000
Fixed administration 26,000
Variable selling expenses 10% of sales value
Normal capacity is 11,000 units per month
The number of units produced and sold was
June (units) July (units)
Sales 12,800 11,000
Production 14,000 10,200
CIMA P2 Management accounting decision management
4.2 A manufacturing company has two production cost centres

(Departments A and B) and one service cost centre (Department
C) in its factory.
A predetermined overhead absorption rate (to two decimal places

of $) is established for each of the production cost centres on the
basis of budgeted overheads and budgeted machine hours.
The overheads of each production cost centre comprise directly

allocated costs and a share of the costs of the service cost centre.
127
Budgeted production overhead data for a period is as follows:
Department A Department B Department C
Allocated costs $217,860 $374,450 $103,970
Apportioned costs $45,150 $58,820 ($103,970)
Machine hours 13,730 16,110
Direct labour hours 16,360 27,390
Actual production overhead costs and activity for the same period are:
Department A Department B Department C

Allocated costs $219,917 $387,181 $103,254
Machine hours 13,672 6,953
Direct labour hours 16,402 27,568
70% of the actual costs of Department C are to be apportioned to

production cost centres on the basis of actual machine hours worked
and the remainder on the basis of actual direct labour hours.
Required:
(a) Establish the production overhead absorption rates for the period.
(b) Determine the under- or over-absorption of production overhead for
the period in each production cost centre. (Show workings clearly)
ACCA Management Information Paper 3
128
Summary
The chapter mainly has addressed on assigning costs to products to
separate the costs incurred during a period between costs of goods
sold and the closing inventory valuation for internal and external
profit measurement. The chapter provides the extent to which product
costs accumulated for inventory valuation and profit measurement for
meeting decision making, it also provide a thorough understanding of
overhead cost allocation and apportionment. The chapter has addressed
and compared absorption costing systems and marginal costing system.
With absorption costing system, fixed production overheads are allocated
to the products, and this are included in the inventory valuation. With
marginal costing system only variable production costs are assigned to
the product, fixed production overhead costs are regarded as period
cost and written off to the profit and loss account. Illustrations of the
inventories and profit calculation for both systems have been clearly
addressed.

Absorption costing
Marginal costing
Over absorption
Over absorption rate
Overhead allocation
Overhead apportionment
Under absorption
129
Exercises
4.1 What is the basic difference between absorption costing and
marginal costing?
4.2 Are selling and administration expenses treated as product costs

or as period costs under marginal costing?
4.3 What arguments can be advanced in favour of treating production

overhead costs as product costs?
4.4 If production and sales are equal, which method would you
expect to show the higher net operating income, marginal costing
or absorption costing? Why?
Problems
4.5 ABC Ltd makes and sells one product, which has the following
standard cost
$
Direct labour 3 hours at $ 6 per hour 18
Direct materials 4 kilograms at $ 7 per kg 28
Production overhead variable 3
Fixed 20
Standard production cost per unit 69
Normal output is 16,000 units per annum. Variable selling, distribution

and administration costs are 20 percent of sales value. Fixed costs are $
180,000 per year. There is no unit in finished goods stock at 1 October
20X2. The fixed overhead expenditure is spread evenly throughout the
year. The selling price per unit is $ 140 Production and sales budgets are
as follows.
Six months ending Six months ending

31 March 20X3 30 September 20X3
Sales 7,000 8,000
Required
Prepare profit statements for each of the six-monthly periods, using the
following methods of costing.
(a) Marginal costing
(b) Absorption costing
130
4.6 Lodi Lofa Ltd budgeted to make and sell 10,000 units of its product
in 20X1. The selling price is $ 10 per unit and the variable cost $ 4
per unit. Fixed production costs were budgeted at $ 50,000 for the
year. The Company uses absorption costing and budgeted and
absorption rate of $ 5 per unit. During 20X1, it became apparent
that sales demand would only be 8,000 units. The management,
concerned about the apparent effect of the low volume of sales
on profits. The company decided to increase production for the
year to 15,000 units. Actual fixed costs were still expected to be $
50,000 in spite of the significant increase in production volume.
Required
Calculate the profit at an actual sales volume of 8,000 units using the
following methods
(a) Absorption costing
(b) Marginal costing
4.7 Tumbi Motors Ltd assembles and sells motor vehicles. It uses an
actual costing system, in which unit costs are calculated on a
monthly basis. Data relating to the month of March, 2008 is as
given below:
Particulars Units $
Opening inventory 150
Production 400
Sales 520
Variable cost data
Manufacturing costs per unit 10,000
Distribution costs per unit sold 3,000
Fixed cost data
Manufacturing costs 2,000,000
Marketing costs 600,000
The selling price per motor vehicle is $ 24,000
Required
(a) Prepare an income statement for Tumbi Motors Ltd under
(i) Variable costing
(ii) Absorption costing
(b) Clearly explain the difference between (a) (i) and (ii) above for
the month of March
131
4.8 The general Manager of Kazimoto Company has received the
following Income Statement for the month of May 2006 which
was prepared on a direct costing basis.
Kazimoto Company
Income statement for the month of may 2006
$
Sales 24,000,000
Less: Variable cost of Goods sold 12,000,000
Contribution Margin 12,000,000
Less: Fixed Manufacturing costs at budget 6,000,000
Gross Margin 6,000,000
Less: Fixed selling and Administrative costs 4,000,000
Net Income before tax 2,000,000
The following notes were attached to income Statement

$
The unit sales price for May 2006 averaged 2,400
The unit Manufacturing costs were
o Variable costs 1200
o Fixed costs applied 400
o Total costs 1600
The unit fixed manufacturing overhead is based upon a normal
monthly production of 15,000 units
Variables costs per unit have been stable throughout the year.
Production for May 2006 was 4,500 units in excess of sales
The inventory at May 30th 2006 consisted of 8,000 units.
Being the first time, the General Manager was presented with an Income
Statement prepared on a direct costing basis; he was not very comfortable
with the results and keep on wondering what the net income would
have been under the absorption costing basis.
Required
(c) Present the May 2006 Income Statement on an absorption costing
bases
(d) Reconcile and explain the differences in net income between the
two costing bases
132
4.9 The following information relates to Product G, for quarter three,
which has just ended.
Production Sales Fixed overheads Variable costs

Units) (Units) ($ 000) ($000)
Budget 40,000 38,000 300 1,800
Actual 46,000 42,000 318 2,070
The selling price of product G was $ 72 per unit

The fixed overheads were absorbed at a predetermined rate per unit. At
beginning of quarter three, there was an opening stock of product G of
2000 units valued at $ 25 per unit variable costs and $ 5 per unit fixed
overheads.
Required
(a) Calculate the fixed overhead absorption rate per unit for the last
quarter
(b) Present profit statements using FIFO using

Absorption costing
Marginal costing
Reconcile and explain the difference between the profits or
losses
(c) Using the same data present similar statements to those required
in part (b), using the AVCO method of valuation, reconcile the
profit or loss figures, and comment briefly on the variations
between the profits or loses in (b) and (c)
4.10 DC Limited is an engineering company which uses job costing

to attribute costs to individual products and services provided
to its customers. It has commenced the preparation of its fixed
production overhead cost budget for 2008 and has identified the
following costs:
($000)
Machining 600
Assembly 250
Finishing 150
Stores 100
Maintenance 80
1 180
The stores and maintenance departments are production service

departments.
133
An analysis of the services they provide indicates that their costs should
be apportioned accordingly:
Machining Assembly Finishing Stores Maintenance

Stores 40% 30% 20% 10%
Maintenance 55% 20% 20% 5%
The number of machine and labour hours budgeted for 2008 is:
Machining Assembly Finishing

Machine hours 50 000 4 000 5 000
Labour hours 10 000 30 000 20 000
Requirements:
(a) Calculate appropriate overhead absorption rates for each
production department for 2008.
(b) Prepare a quotation for job number XX34, which is to be

commenced early in 2008, assuming that it has:
Direct materials costing $2400

Direct labour costing $1500
and requires:
Machine Labour
hours hours
Machining department 45 10
Assembly department 5 15
Finishing department 4 12
and that profit is 20% of selling price.
(c) Assume that in 2008 the actual fixed overhead cost of the assembly
department totals $300 000 and that the actual machine hours
were 4200 and actual labour hours were 30,700.
Prepare the fixed production overhead control account for the

assembly department, showing clearly the causes of any over-/under-
absorption.
CIMA Stage 2 Operational Cost Accounting
4.11 A company sells a single product at a price of $14 per unit.

Variable manufacturing costs of the product are $6.40 per unit.
Fixed manufacturing overheads, which are absorbed into the cost
of production at a unit rate (based on normal activity of 20 000
134
units per period), are $92 000 per period. Any over- or under-
absorbed fixed manufacturing overhead balances are transferred
to the profit and loss account at the end of each period, in order
to establish the manufacturing profit.
Sales and production (in units) for two periods are as follows:
Period 1 Period 2
Sales 15,000 22,000
The manufacturing profit in Period 1 was reported as $35,800.
Required:
(a) Prepare a trading statement to identify the manufacturing profit
for Period 2 using the existing absorption costing method.
(b) Determine the manufacturing profit that would be reported in

Period 2 if marginal costing was used.
(c) Explain, with supporting calculations:

(i) The reasons for the change in manufacturing profit between
Periods 1 and 2 where absorption costing is used in each period;
(ii) Why the manufacturing profit in (a) and (b) differs.
ACCA Management Information Paper 3
4.12 A company sells a single product at a price of $ 14 per unit.

Variable manufacturing costs of the product are $ 6.40 per unit.
Fixed manufacturing overheads, which are absorbed into the cost
of production at a unit rate (based on normal activity of 20,000
units per period), are $ 92,000 per period. Any over-absorbed
or under-absorbed fixed manufacturing overhead balances are
transferred to the profit and loss account at the end of each period,
in order to establish the manufacturing profit.
Sales and production (in units) for two periods are as follows:
Period 1 Period 2
Sales 15,000 22,000
The manufacturing profit in period 1 was reported as $ 35,800
135
Required:
(a) Prepare a trading statement to identify the manufacturing profit for
Period 2 using the existing absorption costing method.
(b) Determine the manufacturing profit that would be reported in

Period 2 if marginal costing was used.
(c) Explain, with supporting calculations, why the manufacturing profit

in (a) and (b) differs
4.13 The following budgeted profit statement has been prepared using
absorption costing principles

January to June 2010 July to Dec. 2010
$000 $000 $000 $000
Sales 540 360
Opening stock 100 160
Production costs:
Direct materials 108 36
Direct labour 162 54
Overhead 90 30
460 280
Closing stock (160) (80)
Cost of goods sold (300) 200
Gross profit 240 160
Production overhead:
(Over)/ Under absorption (12) 12
Selling costs 50 50
Distribution costs 45 40
Administration costs 80 (163) 80
Net profit 77 (22)
Sales units 15,000 10,000

Production units 18,000 6,000
The members of the management team are concerned by the significance

change in profitability between the two six-month periods. As
management accountant, you have analysed the data upon which the
above budget statement has been produced, with the following results.
The production overhead cost comprises both a fixed and a variable

element the latter appears to be dependent on the number of units
136
produced. The fixed element of the cost is expected to incurred at a
constant rate throughout the year
The selling costs are fixed
The distribution cost comprises both fixed and variable elements;

the latter appears to be dependent on the number of units sold. The
fixed element of the cost is expected to be incurred at a constant
rate throughout the year.
The administration costs are fixed
Required
(a) Present the above budgeted profit statement in marginal costing
format
(b) Reconcile each of the six monthly profit/loss values respectively
under marginal and absorption
4.14 BM Limited is considering its plans for the year ended 31

December 2010. It makes and sells a single product, which has
budgeted costs and selling price as follows:
$
Selling price 45
Direct materials 11
Direct labour 8
Production overhead:
Variable 4
Fixed 3
Selling overhead:
Variable 5
Fixed 2
Administration overhead:
Fixed 3
Fixed overhead cost per unit is based on a normal annual activity level
of 96,000 units. These costs are expected to be incurred at a constant rate
throughout the year.
Activity levels during January and February 2010 are expected to be:

137
January (units) February (units)
Sales 7,000 8,750
Assume that there will be no stocks held on 1 January 2010
Required:
(a) Prepare in columnar format, profit statements for each of the two
months of January and February 2010
(i) Absorption costing
(ii) Marginal costing
(b) Reconcile and explain the reasons for any differences between
the marginal and absorption profits for each month which you
have calculated in your answer to (a) above
4.15 A company with a financial year 1 September to 31 August

prepared a sales budget which resulted in the following cost
structure:
% of sales
Direct materials 32
Direct wages 18
Production overhead: variable 6
Fixed 24
Administrative and selling costs: variable 3
Fixed 7
Profit 10
After ten weeks, however, it became obvious that the sales budget was
too optimistic and it has now been estimated that because of a reduction
in sales volume, for the full year, sales will total $2 560 000 which is only
80% of the previously budgeted figure.
You are required to present a statement for management showing the

amended sales and cost structure in $s and percentages, in a marginal
costing format.
4.16 Marginal costs are those costs that are incurred only if a job or
activity is performed. Marginal costs are important in decision
making
Required
Discuss briefly, five arguments against marginal costing
138
Further Reading
Bernheim, Richard C., The Right Way to Design a Cost Accounting

System, Management Accounting, Sept. 1983: 63-65.
Cooper, Robin, and Robert S. Kaplan, The Design of Cost Management

Systems, Englewood Cliffs, New Jersey: Prentice-Hall, 1991.
Gauntt, James E., and Grover L. Porter, eds., Management Information

Systems, Management Accounting, April 1985: 74.
Grady, Michael W., Is Your Cost Management System Meeting Your

Needs? Journal of Cost Management, Summer 1988: 11-15.
Kaplan, Robert S., One Cost System Isnt Enough, Harvard Business
Review, Jan.-Feb. 1988: 61-66.
Sourwine, Darrel A., Does Your System Need Repair?, Management

Accounting, Feb. 1989: 32-36.
Blanchard, Garth A., and Chee W. Chow, Allocating Indirect Costs

for Improved Management Performance, Management Accounting,
March 1983: 38-41.
Bost, Patricia, Do Cost Accounting Standards Fill a Gap in Cost

Allocation? Management Accounting, Nov. 1986: 34-36.
Brunton, Nancy M., Evaluation of Overhead Allocations, Management

Accounting, July 1988: 22-26.
Cardullo, J. Patrick, and Richard A. Moellenberndt, The Cost Allocation

Problem in a Telecommunications Company, Management Accounting,
July, 1987: 22-26.
Carman-Stone, Marie Sandra, Unabsorbed Overhead: What To Do

When Contracts are Canceled, Management Accounting, April 1987:
55-57.
Cook, Ian, and Angela M. Burnett and Paul N. Gordon, CMP and
Managing Indirect Costs in the Eighties, Journal of Cost Management,
Spring 1988: 18-28.
139
Cornick, Michael, William Cooper, and Susan B. Wilson, How Do
Companies Analyze Overhead? Management Accounting, April 1988:
41-43
Johnson, Douglas, Steven Kaplan, and Bill B. Hook, Looking for

Mr. Overhead: An Expanded Role for Management Accountants,
Schwarzbach, Henry R., The Impact of Automation on Accounting for

Indirect Costs, Management Accounting, Dec. 1985: 45-50..
140
CHAPTER 5
ACTIVITY BASED COSTING (ABC)
Chapter Objectives
The objective of the chapter is mainly focusing on the assignment of indirect
costs to the product / service or department using Activity Based Costing (ABC)
system and compares the system with the tradition cost system (absorption
costing system), in addition the chapter evaluates the importance of customer
profitability in an organization.
Learning Outcomes
be able to:
1. Explain the strategic role of activity-based costing

2. Describe activity-based costing (ABC), the steps in developing
an ABC system, and the benefits of an ABC system
3. Determine product costs under both the traditional method
and the activity-based method and contrast the two
4. Explain activity-based management (ABM)
5. Describe how ABC/M is used in manufacturing companies,
non-manufacturing and services company
6. Use an activity-based approach to analyze customer
profitability
7. Identify key factors for successful ABC/M implementation
141
5.1 Introduction
Traditionally, in a job order cost system and process cost system,
overhead is allocated to a job or function based on direct labour hours,
machine hours, or direct labour. However, in some companies, new
technologies have changed the manufacturing environment such that the
number of hours worked or money earned by employees are no longer
good indicators of how much overhead will be needed to complete a job
or process products through a particular function. In such companies,
activity-based costing (ABC) is used to allocate overhead costs to jobs
or functions.
5.2 Activity-based management (ABM)

It is a method of identifying and evaluating activities that a business
performs using activity-based costing to carry out a value chain analysis
or a re-engineering initiative to improve strategic and operational
decisions in an organization. Activity-based costing establishes
relationships between overhead costs and activities so that overhead
costs can be more precisely allocated to products, services, or customer
segments. Activity-based management focuses on managing activities
to reduce costs and improve customer value, Kaplan and Cooper (1998).
Harvard Business School Press divides
ABM into operational and strategic:
Operational ABM is about doing things right, using ABC information

to improve efficiency. Those activities which add value to the product
can be identified and improved. Activities that dont add value are the
ones that need to be reduced to cut costs without reducing product
value.
Strategic ABM is about doing the right things, using ABC information
to decide which products to develop and which activities to use. This
can also be used for customer profitability analysis, identifying which
customers are the most profitable and focusing on them more.
A risk with ABM is that some activities have an implicit value, not
necessarily reflected in a financial value added to any product. For
instance a particularly pleasant workplace can help attract and retain
the best staff, but may not be identified as adding value in operational
ABM. A customer that represents a loss based on committed activities,
but that opens up leads in a new market, may be identified as a low
value customer by a strategic ABM process.
Managers should interpret these values and use ABM as a common,
142
yet neutral, ground this provides the basis for negotiation Kennedy
and Bull, (2000). ABM can give middle managers an understanding of
costs to other teams to help them make decisions that benefit the whole
organization, not just their activities bottom line.
In laymans terms, Activity-Based Costing (ABC) is a method for

estimating the resources required to operate an organizations business
processes, produce its products and serve its customers.
In a business organization, the ABC methodology assigns an

organizations resource costs through activities to the products and
services provided to its customers. It is generally used as a tool for
understanding product and customer cost and profitability. As such,
ABC has predominantly been used to support strategic decisions such
as pricing, outsourcing and identification and measurement of process
improvement initiatives, Wikipedia, (2008).
Traditionally cost accountants had arbitrarily added a broad percentage

of expenses onto the direct costs to allow for the indirect costs.
However as the percentages of indirect or overhead costs had risen,

this technique became increasingly inaccurate because the indirect costs
were not caused equally by all the products. For example, one product
might take more time in one expensive machine than another product,
but since the amount of direct labour and materials might be the same,
the additional cost for the use of the machine would not be recognized
when the same broad on-cost percentage is added to all products.
Consequently, when multiple products share common costs, there is a
danger of one product subsidizing another.
The concepts of ABC were developed in the manufacturing sector of

the United States during the 1970s and 1980s. During this time, the
Consortium for Advanced Manufacturing-International, now known
simply as CAM-I, provided a formative role for studying and formalizing
the principles that have become more formally known as Activity-Based
Costing.
Kaplan and Cooper (1998), described ABC as an approach to solve the

problems of traditional cost management systems. These traditional
costing systems are often unable to determine accurately the actual
costs of production and of the costs of related services. Consequently
managers were making decisions based on inaccurate data especially
where there are multiple products.
143
Instead of using broad arbitrary percentages to allocate costs, ABC
seeks to identify cause and affect relationships to objectively assign
costs. Once costs of the activities have been identified, the cost of each
activity is attributed to each product to the extent that the product uses
the activity. In this way ABC often identifies areas of high overhead
costs per unit and so directs attention to finding ways to reduce the
costs or to charge more for costly products.
Activity-based costing was first clearly explained by Bruns and Kaplan

(1987) by initially focused on manufacturing industry where increasing
technology and productivity improvements have reduced the relative
proportion of the direct costs of labour and materials, but have increased
relative proportion of indirect costs. For example, increased automation
has reduced labour, which is a direct cost, but has increased depreciation,
which is an indirect cost.
Like manufacturing industries, financial institutions also have

diverse products and customers which can cause cross-product cross-
customer subsidies. Since personnel expenses represent the largest
single component of non-interest expense in financial institutions,
these costs must also be attributed more accurately to products and
customers. Activity based costing, even though originally developed
for manufacturing, may even be a more useful tool for doing this. .
5.3 Activity Based Costing

Activity-based costing assumes that the steps or activities that must be
followed to manufacture a product are what determine the overhead
costs incurred. Each overhead cost, whether variable or fixed, is assigned
to a category of costs. These cost categories are called activity cost pools.
Cost drivers are the actual activities that cause the total cost in an activity
cost pool to increase. The number of times materials are ordered, the
number of production lines in a factory, and the number of shipments
made to customers are all examples of activities that impact the costs a
company incurs. When using ABC, the total cost of each activity pool
is divided by the total number of units of the activity to determine the
cost per unit.
Activity-Based Cost per Unit = Total Activity Cost

Total Number of Units for Activity
5.4 Cost drivers

A Cost Driver is any activity that causes a cost to be incurred. The Activity
Based Costing (ABC) approach relates indirect cost to the activities that
144
drive them to be incurred. In traditional costing the cost driver to allocate
indirect cost to cost objects was volume of output. With the change in
business structures, technology and thereby cost structures it was found
that the volume of output was not the only cost driver. Some examples
of indirect costs and their drivers are: maintenance costs are indirect
costs and the possible driver of this cost may be the number of machine
hours; or, handling raw-material cost is another indirect cost that may
be driven by the number of orders received; or, inspection costs that
are driven by the number of inspections or the hours of inspection or
production runs.
Generally, the cost driver for short term indirect variable cost may be
the volume of output or activity, however for long term indirect variable
costs, the cost drivers will not be related to volume of output or activity.
To carry out ABC, it is necessary that cost drivers are established for
different cost pool
It should be noted that, the number of activities a company has may be

small, say five or six, or number in the hundreds. Computers make using
ABC easier. Assume ABC, Inc., has identified its activity cost pools and
cost drivers (figure 5.1).
Figure: 5.1 activity cost pools and cost drivers

Activity Cost Pools Activity Cost Drivers
Purchasing Department Number of Purchase Orders
Receiving Department Number of Purchase Orders
Materials Handling Number of Materials Requisitions
Setup Number of Machine Setups Required
Inspection Number of Inspections
Engineering Department Number of Engineering Change Orders
Personnel Processing Number of Employees Hired or Laid Off
Supervisors Number of Direct Labour Hours
A per unit cost is calculated by dividing the total dollars in each activity
cost pool by the number of units of the activity cost drivers. As an
example to calculate per unit cost for the purchasing department, the
total costs of the purchasing department are divided by the number of
purchase orders. ABC, Inc. has determined that both the purchasing
and receiving departments costs are based on the number of purchase
orders; therefore, the two departments costs may be added together so
that one per unit cost is calculated for these departments. Once per unit
costs are all calculated, they are added together, and the total cost per
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unit is multiplied by the number of units to assign the overhead costs
to the units.
5.5 Activity categories

While using cost drivers to assign overhead costs to individual units
works well for some activities, for some activities such as setup costs,
the costs are not incurred to produce an individual unit but rather to
produce a batch of the same units. For other costs, the costs incurred
might be based on the number of product lines or simply because there
is a manufacturing facility. To assign overhead costs more accurately,
activity-based costing assigns activities to one of four categories:
a. Unit-level activities occur every time a service is performed or

a product is made. The costs of direct materials, direct labour,
and machine maintenance are examples of unit-level activities.
b. Batch-level activities are costs incurred every time a group (batch)

of units is produced or a series of steps is performed. Purchase
orders, machine setup, and quality tests are examples of batch-
level activities.
c. Product-line activities are those activities that support an entire

product line but not necessarily each individual unit. Examples
of product-line activities are engineering changes made in the
assembly line, product design changes, and warehousing and
storage costs for each product line.
d. Facility support activities are necessary for development and

production to take place. These costs are administrative in nature
and include building depreciation, property taxes, plant security,
insurance, and accounting, outside landscape and maintenance,
and plant managements and support staffs salaries.
The costs of unit-level, batch-level, and product-line activities are easily

allocated to a specific product, either directly as a unit-level activity
or through allocation of a pooled cost for batch-level and product-line
activities. In contrast, the facility-level costs are kept separate from
product costs and are not allocated to individual units because the
allocation would have to be made on an arbitrary basis such as square
feet, number of divisions or products, and so on.
In product costing it is relatively easy to charge direct costs to cost units

but the problem arises in relation to indirect costs (overheads). Overhead
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costs (resource costs) such as rent, rates, maintenance costs, cleaning
materials etc. which can be identified with a particular cost pool are
located there. Other overheads which cannot be identified with a cost
pool are apportioned to the cost pools by means of cost drivers which
are the main determinants of the cost of activities. These overheads are
pre-determined in that they are part of the budgeting process. These
cost drivers might include the number of production runs, the number
of customer orders received, the number of quality control tests, etc.
Figure: 5.3 different indirect costs and their possible costs drivers
Activity cost pool Activity cost driver

Advertising The value of sales in each sales area
Quality control The number of quality tests
Purchasing The number of purchase orders
Set-up costs The number of set-ups/production runs
Stores The number of material requisitions
Dispatch The number of dispatch notes
When the overheads are located in the cost pools an average cost per
transaction is calculated by dividing the total cost of an activity by the
number of transactions performed. This average cost is then used to
charge each product with the amount of service demanded from each
activity cost pool. Consequently, products are charged with a fairer share
of the overheads they have helped to create. The result is more accurate
product costing, better decision-making in respect to the product output
mix and product pricing
5.6 Operation of the Activity Based Costing (ABC) System

If the firm has more than one products/ departments, if the ABC system
is used, therefore the apportionment of indirect costs among those
products/ departments will be differ from the traditional (Absorption)
system, instead of using overhead absorption rate as calculated at the
beginning using appropriate activity such labour hours, machine hours,
output etc. the cost drivers which have identified will be used. However,
the allocation of direct costs, such direct materials, direct labour, direct
expenses and short run variable costs will be similar to traditional
method.
The following steps describe how the ABC system operates;

1. Identify the firms major activities
2. Identity the factors which determine the size of the costs and
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activity/cause the costs of an activity. These are known as cost
drivers.
3. Collect the costs associated with each cost driver into what are
known as cost pools.
4. Charge costs to products on the basis of their usage of the activity.
A products usage of an activity is measured by the number of the
activitys cost driver it generates
Illustration 1
The ABC Company produces two products X and Y and the following
information is given:
Product X Product Y Total

Production and Sales (units) 25,000 5,000 30,000
-------- ------- --------
Unit cost ($)
Direct labour 15 5
Direct materials 25 20
Operating data
Machine hours 1 2
Labour rate per hour ($) 1 1
Number of set-ups 4 20
Number of inspections 40 80
Overheads
Production processing $700,000
Set-up $120,000
Required;
Calculate the product costs using (a) Absorption costing (b) ABC.
(a) Assuming the overheads is absorbed on the basis of direct labour
hours.
Budgeted overheads $1,000,000

OAR = = = $2.50 per hour
Labour hours 400,000
All production overheads are located in one cost pool. The unit costs of
products X and Y are:
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$ $
X Y
Direct labour 15.00 5.00
Direct materials 25.00 20.00
Overhead (2.50 per d.l.h.) 37.50 12.50
77.50 37.50
(b) In ABC three cost pools are identified viz. production processing,
set-up and inspection costs. The cost drivers are also identified eg.
Cost Driver Basis

Production processing Number of machine hours
Machine set-ups Number of machine set-ups
Inspections Number of inspections
The overheads per cost pool and the rate per cost driver are computed.
Production processing costs:
Production overhead = $700,000 = $20 per mach.hr.

Machine hours 35,000
Set-up costs:
Cost per set-up Set-up cost $120,000

= = = $5,000 per set-up.
No. of set-ups 24
Inspection cost:
Cost per inspection = Inspection cost = $180,000 = $1,500 per

No. of inspections
The final stage of the process is to use the cost driver rates to assign
overhead cost to products.
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X Y
$ $
Direct labour 15.00 5.00
Production overhead 20.00 40.00
(1)
Set-up costs (2) 0.80 20.00
Inspection (3) 2.40 24.00
63.20 109.00
1. X =$20 x 1 machine hr. =$20; Y = $20 x 2 machine hours = $40

2. X = ($5,000 x 4 set-ups)/2,500 units = 80p; Y = ($5,000 x 20 set-ups)/5,000
units = $20

3. X = ($1,500 x 40 inspections)/ 25,000 units = $2.40; Y = ($1,500 x 80
inspections)/ 5,000 units = $24
The comparison of the two approaches is given:
Product X Product Y
Absorption costing $77.50 $37.50
ABC 63.20 $109.00
Illustration 2
Assume that BM factory uses forklifts in only two departments:
The first department is receiving, where large rolls of fabric are unloaded
from semi-trailers and moved into storage, and later moved from storage
to the cutting room.
The second department is shipping, where cartons of finished pants

are staged and then loaded onto semi-trailers for shipment to the
warehouse.
Costs associated with operating these forklifts consist of the following:
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Forklift costs: $
Operator salaries 80,000
Maintenance 8,000
Depreciation expense 7,500
Other 2,500
Total forklift costs 98,000
All other overhead 1,400,000
Total overhead for the factory 1,498,000
The factory operates two production lines. One line is for jeans, which
are made from denim fabric. The other production line is for casual
slacks, which are made from a cotton-twill fabric. Operational data for
the month is as follows:
Jeans Casual Slacks Total

Units produced 420,000 200,000 620,000
Direct labor hours 70,000 40,000 110,000
Rolls of fabric 1,750 640 2,390
Cartons shipped 52,500 20,000 72,500
The factory ships product to the companys warehouse, not directly to

customers. Hence, to facilitate stocking at the warehouse, each carton is
packed with jeans or casual slacks, but not both. An examination of the
information in the above table reveals that a carton holds more slacks
than jeans, and that fewer pants are cut from a roll of denim fabric than
from a roll of cotton-twill. These operational statistics are driven by the
fact that denim is a heavier-weight fabric than cotton-twill, and hence,
it is bulkier. The data also indicate that more direct labour minutes are
required for a pair of slacks than for a pair of jeans, which reflects greater
automation on the jeans production line.
Traditional costing
Under a traditional costing system, forklift costs are pooled with all
other overhead costs for the factory (electricity, property taxes, front
office salaries, etc.), and then allocated to product based on direct labor
hours (sewing operator time) for each product.
Overhead rate under traditional costing:
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Total overhead costs $ 1,498,000

Quantity of allocation base (direct labor hours) 110,000
Overhead rate per direct labor hour $ 13.62
of which the following is due to forklift costs:

Forklift overhead $ 98,000
Quantity of allocation base (direct labor hours) 110,000
Overhead rate for forklift costs per direct labor hour $ 0.8909
Forklift overhead applied to product using traditional costing:

Jeans Slacks
Overhead rate $ 0.8909 $ 0.8909
Quantity of allocation base (direct labor hours) x 70,000 x 40,000
Forklift costs allocated $ 62,363 $ 35,636
Units produced 420,000 200,000
Approximate cost per unit $0.15 $0.18
Note that all forklifts overhead are allocated: $62,363 + $35,636 = $97,999
(the difference due to rounding of the overhead rate).
If the casual slacks product manager asks why her product incurs more
forklift costs on a per-unit basis than jeans, even though casual slacks
use a lighter-weight fabric, the answer is that her product uses more
direct labor per unit, which perhaps is not a very satisfying explanation
from her perspective.
Activity-based costing
An ABC system might first allocate forklift costs into two cost pools: one
for the Receiving Department and one for the Shipping Department.
Then costs from each of these two departments would be allocated to
the two product lines.
ABC first-stage allocation

The first-stage allocation might use an estimate of the amount of time
the forklifts spend in each department. A one-time study indicates
that forklifts spend approximately 70% of their time in the Shipping
Department and 30% of their time in the Receiving Department. An
additional benefit of ABC is that if this information were collected
periodically, the managers of these two departments might be more
willing to share the forklifts with each other, since the reported costs of
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each department would then depend on the time the forklifts spend in
that department. In any case, the 70/30 allocation results in the following
first-stage allocation:
30% of $98,000 = $29,400 is allocated to the Receiving Department

70% of $98,000 = $68,600 is allocated to the Shipping Department
ABC second-stage allocation

Receiving Shipping
Total costs $29,400 $68,600
Quantity of allocation base 2,390 rolls 72,500 cartons
Overhead rate $12.30 per roll $0.946 per carton
Allocation to Jeans $12.30 per roll $0.946 per carton
Overhead rate x 1,750 rolls x 52,500 cartons
Quantity of allocation base $21,525 $49,665
Allocation to Slacks $12.30 per roll $0.946 per carton
Overhead rate x 640 rolls x 20,000 cartons
Quantity of allocation base $7,872 $18,920
Total forklift costs allocated to each product:
Jeans Slacks Total

From Receiving $21,525 $ 7,872 $29,397
From Shipping 49,665 18,920 68,585
Total $71,190 $26,792 $97,982
Units Produced 420,000 200,000
Approximate Cost per unit $0.17 $0.13
The $18 difference between total costs allocated of $97,982 and the
original costs of $98,000 is due to rounding.
The first-stage allocation allows the second-stage to allocate forklift

costs to product using rolls of fabric as the allocation base in Receiving,
and cartons of pants as the allocation base in Shipping. Since there are
no rolls of fabric in the shipping department, and no cartons in the
Receiving Department, without the first stage allocation, there would
be no obvious choice of an allocation base that would capture the cause-
and-effect relationship between the costs of operating the forklifts,
and the utilization of forklift resources by each product in the two
departments.
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Conclusion
The traditional costing method allocates more forklift costs to slacks than
to jeans on a per-unit basis because casual slacks require more sewing
effort. ABC allocates more forklift costs to jeans than to casual slacks, on
a per-unit basis, which is intuitive because denim is a heavier-weight
fabric than cotton twill.
5.7 Applications of Activity Based Costing (ABC) System
1. Planning: The activity-based approach may not produce the final

budget figures but it can provide the basis for different possible
planning scenarios.
2. Control: With ABC, it is possible to control or manage the costs by

managing the activities which underlie them by monitoring a number
of key performance measures.
3. Decision making: ABC assists the decision making in a number of ways

- Provide accurate and reliable cost information
- Establishes a long-run product cost
- Provides data which can be used to evaluate different ways of
delivering business
Therefore, Activity Based Costing (ABC) system is therefore particularly

suited to the following types of decision
a. Pricing decision
b. Make or Buy decision
c. Promoting or discontinuing products or parts of the business
d. Redesigning products and developing new products or new
ways to business
5.8 Non-manufacturing Costs and Activity Based Costing (ABC) System:

In traditional cost accounting system, only manufacturing costs are
assigned to products. Selling, general, and administrative expenses are
treated as period costs and are not assigned to products. However, many
of these non-manufacturing costs are also part of the costs of producing,
selling, distributing, and servicing products. For example commissions
paid to salespersons, shipping costs, and warranty repair costs can be
easily traced to individual products. The term overhead is usually used
to refer non-manufacturing costs as well as indirect manufacturing costs
under an ABC system. In activity based costing, products are assigned all
of the costs-manufacturing as well as non-manufacturing-that they can
reasonably be supposed to have caused. The entire cost of the product
is determined rather than just its manufacturing cost.
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5.9 Manufacturing Costs and Activity Based Costing (ABC):
In traditional cost accounting, all manufacturing costs are assigned to
products-even manufacturing costs that are not caused by the products.
For example, a portion of the factory security guards wages would be
allocated to each product even though the guards wages are totally
unaffected by which products are made or not made during a period.
In activity based costing, cost is assigned to a product only if there is
a good reason to believe that the cost would be affected by decisions
concerning the product.
5.10 Plant wide Overhead Rate:

Normally overhead rate, called plant wide overhead rate or
predetermined overhead rate, is used throughout an entire factory and
that the allocation base is direct labour hours or machine hours. This
simple approach to overhead assignment can result in distorted unit
product costs when it is used for decision making purposes.
When cost systems were collected in 1800s, cost and activity data had
to be collected by hand and all calculations were done with paper
and pen. Consequently, the emphasis was on simplicity. Companies
often established a single overhead cost pool for an entire facility or
department. Direct labour was the obvious choice as an allocation base
for overhead costs. Direct labour hours were already being recorded
for the purposes of determining wages and direct labour time spent on
tasks was often closely monitored. In the labour-intensive production
processes of that time, direct labour was a large component of product
costs--larger than it is today. Moreover, managers believed direct labour
and overhead costs were highly correlated. (Two variables, such as
direct labour and overhead costs, are highly correlated if they tend to
move together.) And finally most companies produced a very limited
variety of products that required similar resources to produce, so in fact
there was probably little difference in the overhead costs attributable to
different products. Under these conditions, it was not cost effective to
use a more elaborate costing system.
Conditions have changed. Many companies now sell a large variety of

products and services that consume significantly different overhead
resources. Consequently, a costing system that assigns essentially
the same overhead cost to every product may no longer be adequate.
Additionally, many managers now believe that overhead overhead
costs and direct labour are no longer highly correlated and that other
factors drive overhead costs.
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On an economy wide basis, direct labour and overhead costs have
been moving in opposite directions for a long time. As a percentage of
total cost, direct labour has been declining, whereas overhead has been
increasing. Many tasks that used to be done by hand are now done with
largely automated equipment--a component of overhead. Companies
are creating new products and services at an ever-accelerating rate that
differ in volume, batch size and complexity. Managing and sustaining
this product diversity requires many more overhead resources such
as production schedulers and production design engineers, and may
of these overhead resources have no obvious connection with direct
labour. Finally, computers, bar code readers, and other technology
have dramatically reduced the cost of collecting and manipulating data-
-making more complex (and accurate) costing systems such as activity
based costing much less expensive to build and maintain.
Nevertheless, direct labour remains a viable base for applying overhead

to products in some companies--particularly for external reports. Direct
labour is an appropriate allocation base for overhead when overhead
costs and direct labour are highly correlated. And indeed, most
companies throughout the world continue to base overhead allocations
on the direct labour or machine hours. However if factory wide costs do
not move in tandem with factory wide direct labour or machine hours,
some other means of assigning overhead costs must be found or product
costs will be distorted.
5.11 Departmental Overhead Rates:

Rather than use a plant wide overhead rate (predetermined overhead
rate), many companies have a system in which each department has
its own overhead rate (multiple predetermined overhead rates). The
nature of the work performed in each department will determine the
departments allocation base. For example, overhead costs in machining
department may be allocated on the basis of the machine-hours incurred
in that department. In contrast, the overhead costs in an assembly
department may be allocated on the basis of direct labour-hours incurred
in that department.
Unfortunately, even departmental overhead rates will not correctly

assign overhead costs in situations where a company has a range of
products that differ in volume, batch size, or complexity of production.
The reason is that the departmental approach usually relies on volume
as the factor in allocating overhead cost to products. For example, if
the machining departments overhead is applied to products on the
basis of machine-hours, it is assumed that the departments overhead
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costs are caused by, and are directly proportional to, machine-hours.
However, the departments overhead costs are probably more complex
than this and are caused by a variety of factors, including the range of
products processed in the department, the number of batch setups that
are required, the complexity of the products, and so on. Activity based
costing is a technique that is designed to reflect these diverse factors
more accurately when costing products. It attempts to accomplish this
goal by identifying the major activities such as batch setups, purchase
order processing, and so on, that consumes overhead resources and
thus cause costs. An activity is any event that causes the consumption
of overhead resources. The costs of carrying out these activities are
assigned to the products that cause the activities.
5.12 The Cost of Idle Capacity and Activity Based Costing (ABC)
In traditional cost accounting, predetermined overhead rates are
computed by dividing budgeted overhead costs by a measure of
budgeted activity such as budgeted direct labour hours. This results in
applying the costs of unused or idle capacity to products, and it results
in unstable unit product cost. In contrast to traditional cost accounting,
in activity based costing system, products are charged for the costs of
capacity they use and not for the costs of capacity they do not use. The
cost of idle capacity is not charged to products in activity based costing
system. This results in more stable unit costs and is consistent with
the objective of assigning only those costs to products that are actually
caused by the products. Instead of assigning the costs if idle capacity to
products, in activity based costing system these costs are considered to
be period costs that flow through to the income statement as an expense
of the current period. This treatment highlights the cost of idle capacity
rather than burying it in inventory and cost of goods sold.
5.13 Service Organizations and Activity Based Costing (ABC)

These organizations, such as banks, hospitals and government
departments, have very different characteristics than manufacturing
firms. Service organizations have almost no direct costs, most of the
costs are overheads and they do not hold stocks of service as the service
is consumed when it is produced. Absorption costing has generally
been considered inappropriate for these organizations, whereas ABC
offers the potential of benefits from improved decision making and cost
management. Drury and Tayles (2000), in a UK survey, found that 51%
of the financial and services organizations surveyed had implemented
ABC, compared with only 15% of manufacturing organizations
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5.14 Profitability Analysis Using Activity-Based Costing
In an economic environment where downsizing, reduced funding,
and budget cuts have become a necessity for many organizations, so
has the consequential need to identify where non value-add activities
really exist and where unnecessary costs in operational activities can
be eliminated in order to effectively reduce operating expenditures.
Todays economy has also spurred many businesses to place a greater
focus on their customers and on increasing overall product profitability,
yet many are finding that their largest customers or best-selling products
are not necessarily the most profitable ones until they perform activity-
based costing analysis.
5.15 Customer profitability (CP)

Knowing customer cost and customer profitability is critical for a
company today. Knowing your total costs for particular processes
and activities allows you to focus on reducing and controlling them.
Knowing costs for a specific customer allows you to reduce, change or
charge for activities/services provided to them.
The determination of customer costs and profitability should be
performed using activity based costing techniques. Although it
requires the availability of customer related data, the calculation is
straightforward. Customer cost and profitability information is so
important to a company that if the right data is not available or does not
exist, it must be made available or created. Although many companies
do not have customer cost and profitability systems, a growing number
are beginning to develop them and it is imperative that you develop the
information before your competitors do.
Therefore, Customer profitability (CP) is the difference between the

revenues earned from and the costs associated with the customer
relationship in a specified period.
According to Philip Kotler,(2004) a profitable customer is a person,
household or a company that overtime, yields a revenue stream that
exceeds by an acceptable amount the companys cost stream of attracting,
selling and servicing the customer.
Although CP is nothing more than the result of applying the business

concept of profit to a customer relationship, measuring the profitability
of a firms customers or customer groups can often deliver useful
business insights. Quite often a very small percentage of the firms best
customers will account for a large portion of firm profit. Although this
is a natural consequence of variability in profitability across customers,
firms benefit from knowing exactly who the best customer are and how
much they contribute to firm profit.
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At the other end of the distribution, firms sometimes find that their
worst customers actually cost more to serve than the revenue they
deliver. These unprofitable customers actually detract from overall firm
profitability. The firm would be better off if they had never acquired
these customers in the first place
The biggest challenge in measuring customer profitability is the

assignment of costs to customers. While it is usually clear what revenue
each customer generated, it is often not clear at all what costs the firm
incurred serving each customer. Activity Based Costing can sometimes
be used to help determine the costs associated with each customer or
customer group. For components of cost not directly related to serving
customers, the calculation of customer profit must use some method to
fully allocate these costs to customers if the total of customer profit is to
match the operating profit of the firm. If the firm decides not to allocate
these non-customer costs to customers, then the sum of customer profit
will be greater than the operating profit of the firm.
The ultimate profit centre in any company is the point of exchange

between you and your customers. If there is no transaction, there is no
revenue and ultimately no business. Central to customer profitability
analysis (CPA) is the ability to flow all relevant costs forward to the
point of exchange with the customer, where it is matched with customer
revenues. CPA is therefore able to identify true profitability and provide
drill-back to explain the reasons why. Conventional costing fails to do
this. Once customers that are costing more to serve than the margin they
generate the answer is simple; manage customers as a portfolio just as
you would a product portfolio.
5.16 Determining Customer Profitability

The following major categories should be included in the determination
of customer profitability:
(i) Customer Revenue

Revenue is generally the most straightforward category to determine.
Companies usually have information that captures sales/revenue
associated with specific customers. Other information needed may
include customer discounts, rebates and other deductions.
(ii) Customer Product Cost

Product cost is typically the largest cost category and is usually
calculated or estimated by every company. Sometimes companies
calculate product costs for analytical purposes which differ from those
159
used by accountants to value inventory. We generally find that many
companies have a product costing system in which there is a varying
degree of management confidence. Our approach assumes that product
costs are accepted by management and are appropriately calculated for
use in determining customer profitability. If not, the effort to determine
customer profitability must be expanded to include a potential revision
to product costing methods.
This review is necessary because there may be some cost types that have
been included in product costs that are related more to the customer
than to a product. These costs may include, for example, engineering
or design costs, special manufacturing equipment and practices, or
even invoicing and collection. If significant, some or all of these costs
may have to be removed from product cost and, instead, be directed or
assigned on a customer basis.
(iii) Customer-specific Costs

As already discussed, customer-specific costs are those costs that are
driven primarily by the needs or demands of a particular customer.
Besides the costs identified above which may have been incorrectly
classified as product costs, they include many of the costs which are
usually referred to as Selling, General & Administrative costs. However,
they are viewed from the customers perspective and the way in which
they add value to the customer. These would include sales, marketing,
distribution, advertising, legal and executive expenses.
(iv) Asset Opportunity Costs

Asset opportunity costs are those costs that can be assigned to customers
based on the assets of the company that a particular customer consumes.
They could include working capital such as inventory and accounts
receivable as well as non-current assets such as machinery & equipment.
For example, certain customers may demand inventory to be available
immediately, requiring the seller to keep stock on-hand. Or, another
customer may be very slow in paying its outstanding invoices, resulting
in high accounts receivable balances. The opportunity cost is calculated
by multiplying a companys cost of capital (or some appropriate interest
rate) times the average asset value utilized. This cost for capital amount
reduces overall customer profitability.
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Figure 5.4: Customer Profitability Framework
Illustration 3
Ferry Corporation makes a single product - a fire resistant commercial
filing cabinet - that it sells to office furniture distributors. The company
has a simple ABC system that it uses for internal decision making. The
company has two overhead departments whose costs are listed below:
Manufacturing overhead $500,000
Selling and administrative overhead $300,000
Total overhead costs $800,000
The companys activity based costing system has the following activity
cost pools and activity measures:
Activity Cost Pool Activity Measures

Assembling units Number of units
Processing orders Number of orders
Supporting customers Number of customers
Other Not applicable
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Costs assigned to the other activity cost pool have no activity measure;
they consist of the costs of unused capacity and organization-sustaining
costs - neither of which are assigned to products, orders or customers.
Ferris Corporation distributes the costs of manufacturing overhead and

of selling and administrative overhead to the activity cost pools based
on employee interviews, the results of which are reported below:
Distribution of Resource Consumption Across Activity Cost Pools

Assembling Processing Supporting
Other Total
Units Orders Customers
Manufacturing
50% 35% 5% 10% 100%
overhead
Selling and admin-
10% 45% 25% 20% 100%
istrative overhead
1,000 250 100
Total activity -- --
units orders customers
Required:
1. Perform the first stage allocation of overhead costs to the activity
cost pools.
2. Compute activity rates for the activity cost pools.
3. Office Mart is one of the Ferry Corporations customers. Last

year Office Mart ordered filing cabinets four different times. Office
Mart ordered a total of 80 cabinets during the year. Construct
a table showing the overhead costs of these 80 units and four
orders.
Solution:
1. The first stage allocation of costs to the activity cost pools appears
below:
Distribution of Resource Consumption Across Activity Cost Pools

Assembling Processing Supporting
Other Total
Units Orders Customers
Manufacturing
$250,000 $175,000 $25,000 $50,000 $500,000
overhead
Selling and admin-
30,000 135,000 75,000 60,000 300,000
istrative overhead
Total activity $280,000 $310,000 $100,000 $110,000 $800,000
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2. The activity rates for the activity cost pools are:
Activity Cost Pools Total Cost Total Activity Activity Rate
Assembling units $280,000 1,000 units $280 per unit
Processing orders $310,000 250 units $1,240 per order
Supporting customers $100,000 100 customers $1,000 per customer
3. The overhead cost for the four orders of a total of 80 filing

cabinets would be computed as follows:
Activity Cost Pools Total Cost Total Activity Activity Rate

Assembling units $280 per unit 80 units $22,400
Processing orders $1,240 per order 4 units $4,960
Supporting customers $1000 per customer Not applicable

4. The product and customer margin can be computed as follows:
Filing Cabinet Product Margin:

Sales ($595 per unit 80 units) $47,600
Cost:
Direct materials ($180 per unit 80 units) $14,400
Direct labour ($50 per unit 80 units) 4,000
Volume related overhead (above) 22,400
Order related overhead (above) 4,960 45,760
$1,840
Customer Profitability Analysis Office Mart
Product margin (above) $1,840
Less: Customer support overhead (above) 1,000
$840
5.17 Costing customer behaviour

There are often multiple points of contact between a supplier and their
customers.
At each contact point how you choose to serve your customers and how
your customers choose to behave can directly influence both the cost to
serve and customer profitability.
5.18 Customer portfolio management

This is the ability to modify the trading relationship between the
organization and its customers in such a way that the organizations
163
margins are enhanced to an acceptable level without taking undue
commercial risks and would include such techniques as:
a. Customer re-engineering
b. Activity based cost management
c. Commercial strategy review
d. Pricing analyticsis able to identify true profitability and provide
drill-b
5.19 Advantages and Disadvantages of Activity Based Costing (ABC) System

Advantages
1. More accurate costing of products/services, customers and
distribution channels
2. An improved, more accurate product cost enables an enterprise
to concentrate on a more profitable mix of products or
customers.
3. ABC extends the variable cost rationale to both short and long-
term costs by quantitatively addressing the cost behaviour
patterns in terms of both short-run volume changes as well as
long-term cost trends
4. Better understanding of overhead costs
5. Utilizes unit cost rather than just total cost
6. Integrates well with Six Sigma and other continuous improvement
programs
7. It helps to identify value added and non-value added costs so
that the non-value added items can be appraised effectively with
a view to elimination.
8. Activity Based Costing system supports performance management
and scorecards
9. Activity Based Costing (ABC) system enables costing of processes,
supply chains, and value streams
10. Activity Based Costing (ABC) system facilitates benchmarking
Disadvantages
1. Activity Based Costing system involves more time consuming to
collect data
2. Activity Based Costing System is more complex than Absorption
costing and should only be introduced if it provides additional
management information
164
3. Under this costing system, it might be difficult to identify
collectively the cost drivers
4. Even if the Activity Based Costing System is used by the
organization, however some measures of arbitrary overhead
costs apportionment is still needed for costs for example rent and
rates.
5. High cost of buying, implementing and maintaining activity
based system
5.20 Limitations of Activity Based Costing System

Activity based costing system help managers manage overhead and
understand profitability of products and customers and therefore is a
powerful tool for decision making. However activity based costing has
a number of limitations
These limitations or disadvantages are briefly discussed below:

1. Implementing an ABC system is a major project that requires
substantial resources. Once implemented an activity based
costing system is costly to maintain. Data concerning numerous
activity measures must be collected, checked, and entered into
the system.
2. ABC produces numbers such as product margins that are odds

with the numbers produced by traditional costing systems. But
managers are accustomed to using traditional costing systems
to run their operations and traditional costing systems are often
used in performance evaluations.
3. Activity based costing data can be easily misinterpreted and must

be used with care when used in making decisions. Costs assigned
to products, customers and other cost objects are only potentially
relevant. Before making any significant decision using activity
based costing data, managers must identify which costs are really
relevant for the decisions at hand.
4. Reports generated by this system do not conform to generally

accepted accounting principles (GAAP). Consequently, an
organization involved in activity based costing should have two
cost systems - one for internal use and one for preparing external
reports.
165
5. Even in activity-based costing, some overhead costs are difficult
to assign to products and customers, for example the chief
executives salary. These costs are termed business sustaining
and are not assigned to products and customers because there
is no meaningful method. This lump of unallocated overhead
costs must nevertheless be met by contributions from each of the
products, but it is not as large as the overhead costs before ABC
is employed.
6. Although some may argue that costs untraceable to activities

should be arbitrarily allocated to products, it is important to
realize that the only purpose of ABC is to provide information to
management. Therefore, there is no reason to assign any cost in
an arbitrary manner
166
Summary
Traditionally, in a job order cost system and process cost system, overhead
is allocated to a job or function based on direct labour hours, machine
hours, or direct labour. However, in some companies, new technologies
have changed the manufacturing environment such that the number
of hours worked or money earned by employees are no longer good
indicators of how much overhead will be needed to complete a job or
process products through a particular function.
In now days the large percent of costs in most of the organization

comprise of the overhead cost, however the apportionment of these
overhead costs become difficult to identify and measure. This chapter
has addressed how ABC systems can identify and measure relevant
overhead costs. The major difference features between ABC and
conventional traditional costing system were compared. ABC systems
are the models of resource consumption; therefore this chapter has
emphasized the conceptual aspects of ABC.

Activity categories
Activity based management (ABM)
Activity cost pool
Activity measures
Cost customers behaviour
Cost drivers
Customer profitability (CP)
Profitability analysis
167
BM Product Ltd manufactures two types of bean bags Standard and

Deluxe. Both beanbags are produced on the same equipment and use
similar processes. The following budgeted data has been obtained for
the year ended 31 December 2011
Product Standard Deluxe

Production (units) 25,000 2,500
Number of purchase order 400 200
Number of set up 150 100

Resources required per unit
Direct material ($) 25 62.5
Direct labour (hours) 10 10.0
Machine time (hours) 5 5
Budgeted production overheads for the year have been analyzed as

follows
$
Volume related overheads 275,000
Purchases related overheads 300,000
Set- up related overheads 525,000
The budgeted wage rate is $20.00 per hour.
The companys present system is to absorb overheads by product units

using rates per labour.
However, the company is considering implementing a system of activity

based costing. An activity based investigation revealed that the cost
drivers for the overhead costs are as follows:
Volume related overheads Machine hours

Purchases related overheads Number of purchase orders
Set- up related overheads Number of set-ups
Required
(a) Calculate the unit costs for each type of beanbag using
(i) The current absorption costing system
(ii) The proposed ABC system
168
(b) Compare your results in (i) and (ii) above and briefly comment
on your findings CIMA P2 Management accounting decision
making
5.2 Bondeni Garden Ltd manufactures a variety of garden tools for

many markets including one item, the EC Trimmer, a hedge
trimmer that is only sold through Gardened centres and DIY
chain shops. Currently three large chains (X, Y and Z) and several
smaller garden centres purchase this item. Bondeni Garden sells
this hedge trimmer at $40 per unit and the standard product cost
is $20 per unit. Assume 40 percent of the standard product cost
represents fixed overhead costs.
Delivery costs vary according to the distance travelled and costs

$5 per kilometer. In addition when a customers stocks are very
low, Bondeni Garden makes the occasional emergence delivery
which is outside its normal delivery schedule. These cost $500 per
delivery. Each customer also negotiates discounts on sales prices.
Order taking costs are $200 per order. Publicity costs are specific
to each customer as all publicity occurs in the shops and garden
centres. Data relating to each of the customers are as follows:
X Y Z Other Garden
Centre 10,000 5,000 3,000 6,000
Sales in units 1,000 500 1,200 7,500
Kilometers travelled
No. of emergence
0 0 2 0
Deliveries made
No. of orders taken 5 3 7 10
Discounts* 20% 15% 20% 6%
Sales commission* 10% 10% 10% 10%
Publicity costs $27,000 $19,000 $45,000 $57,000
* Discounts and sales commission are calculated as a percentage of the

sales value
Required
Comment on the profitability of each Bondeni Garden Ltds existing
customers and what action it should take. Your response should be
supported with suitable financial calculations
What factors should Bondeni Garden Ltd consider before deciding to

drop a customer?
169
Exercises
5.1 W hat are the key reasons for product cost differences between
traditional costing system and ABC system?
5.2 Describe four decisions for which ABC information is useful
5.3 What are the main costs and limitations of implementing ABC
systems?
5.4 ABC systems only apply to manufacturing companies Do you
agree? Explain
5.5 Activity based costing is the wave of the present and the future.
All companies should adopt it. Do you agree? Explain
Problems
5.6 Jambo Ltd manufactures four products W, X, Y and Z. Output
and cost data for the period just ended are as follows:
Number of Material Direct Machine

Units Production Runs cost per labour hrs hours per
in the period unit $ per unit unit
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14

Direct labour cost per hour $5

Overhead costs $
Short run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800
Required
Prepare unit costs for each product using conventional and ABC
5.7 A company manufactures two products, X and Y, using the

equipment and similar processes. And extract of the production
data for these products in one period is shown below:
170
X Y
Quantity produced (units) 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 2
Set- ups in the period 10 40
Orders handled in the period 15 60

Overheads costs $
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000
Required
Calculate the production overheads to be absorbed by one unit of each
of the products using the following costing methods.
(a) A traditional costing approach using a direct labour rate to absorb

overheads.
(b) An activity based costing approach, using suitable cost drivers to
trace overheads to products
5.8 Having attended a CPA review class on Activity Based Costing
(ABC), you decide to experiment by applying the principles
of ABC to the four products currently made and sold by your
company. Details of the four products and relevant information
are given below for one period
Product A B C D
Output in units 120 100 80 120
Cost per units in ($ 000)
Direct material 40 50 30 60
Direct labour 28 21 14 21
Machine hours (per unit) 4 3 2 3
The four products are similar and are usually produced in production
runs of 20 units and sold in batches of 10 units.
The production overhead for the period has been analysed as follows:
171
$ 000
Machine department costs (rent, business rates, depreciation 10,430
and supervision)
Set- up costs 5,250
Store receiving 3,600
Inspection/quality control 2,100
Materials handling and dispatch 4,620
You have ascertained that cost drivers to be used are as listed below for
the overhead costs shown:
Cost Cost Driver

Set up costs Number of production runs
Stores receiving control Requisitions raised
Inspection/Quality control Number of production runs
Materials handling and dispatch Orders executed
The number of requisitions raised on the store was 20 for each product
and the number of orders executed was 42, each order being for a batch
of 10 of a product.
Required
(a) Calculate the total costs for each product if all overhead costs are
absorbed on a machine hour basis.
(b) Calculate the total costs for each product, using ABC
(c) Calculate and list the unit product costs from your figure in (a)
and (b) above, to show the differences: and comment briefly on
any conclusions which may be down which could have pricing
and profit implications (CPA adapted)
5.9 ABC Company manufactures two products, Product C and

Product D. The company estimated it would incur $130,890
in manufacturing overhead costs during the current period.
Overhead currently is assigned to the products on the basis of
direct labor hours. Data concerning the current periods operations
appear below:
Product C Product D
Estimated volume 400 units 1,200 units
Direct labor hours per unit 0.70 hour 1.20 hours
Direct material cost per unit $10.70 $16.70
Direct labor cost per unit $11.20 $19.20
172
Management is considering using activity-based costing to apply
manufacturing overhead cost to products for external financial reports.
The activity-based costing system would have the following three
activity cost pools:
Estimated Overhead
Activity Cost Pool Activity Measure
Cost
Machine setups Number of setups $ 13,570
Purchase Orders Number of purchase orders 91,520
General Factory Direct labor hours 25,800
Activity Measure Product C Product D Total

Number of setups 100 130 230
Number of purchase orders 810 1,270 2,080
Number of direct labor hours 280 1,440 1,720
Required:
a) Compute the predetermined overhead rate under the current
method.
b) Determine the unit product cost of each product.
c) Determine the activity rate (i.e. predetermined overhead rate) for
each cost pool.
d) Compute the total amount of manufacturing overhead cost that
would be applied to each product using the activity-based
costing system. After these totals have been computed, determine
the amount of manufacturing overhead cost per unit of each
product.
e) Compute the unit product cost of each product.
f) Compute the overhead applied to work-in-process using both
traditional costing and ABC for a job with the following actual
activity:
Activity Measure Job

Number of setups 10
Number of purchase orders 40
Number of direct labor hours 60
5.10 Doto Ltd manufacture three products A, B and C. Data for the
period just ended is as follows;
173
Product A B C
Output in units 20,000 25,000 2,000
$/unit $/unit $/unit
Direct material cost 5,000 10,000 10,000
Total production overheads $ 190m
Information for overhead absorption on a labour hours basis
A B C
Labour hours per unit 2 1 1
Labour is paid at the rate of $ 5,000 per hour
Information for activity based costing
Cost data
$ 000
Machining 55,000
Quality control & Set-up costs 90,000
Receiving 30,000
Packing 15,000
190,000
Cost driver data A B C

Machine hours/unit 2 2 2
No. of production runs 10 13 2
No. of components receipts 10 10 2
No. of customer orders 20 20 20
Requered
Calculate the total cost per unit for each product using
(a) Traditional absorption costing assuming production overheads
are absorbed on the basis of labour hours
(b) Activity based costing
174
Case studies
Case study 5.1: Euclid engineering,
In Business Activity Based Costing (ABC) Changes the Focus.
Euclid engineering makes parts and components for the big automobile
manufacturers. As a result of its ABC study, Euclids managers
discovered that the company was spending more in launching new
products than on direct labour expenses to produce existing products.
Product development and launch expenses were 10% of expenses, where
as direct labour costs were only 9%. Of course, in the previous direct
labour cost system, all attention had been focused on reducing direct
labour costs. . . Product development and launch costs were blended
into the factory overhead rate applied to products based on direct
labour costs. Now Euclids manager realized that they had a major cost
reduction opportunity by attacking the production launch cost directly
The new information produced by the ABC study also helped Euclid
in its relations with customers. The detailed breakdown of the costs of
design and engineering activities helped customers to make trade-offs,
with the result that they would often ask that certain activities whose
costs exceeded their benefits be skipped
Source: Boston: Harvard Business School Press
1. What is an activity-based approach to designing a costing system?
2. What are the key reasons for product cost differences between
traditional costing systems and ABC systems?
3. Describe four decisions for which ABC information is useful
4. Describe four sign that help indicate when ABC systems are likely
to provide the most benefits
5. Explain the main costs and limitations of implementing ABC
systems
Case study 5.2: Kanthal

Kanthal is a global producer of electrical heating material and elements
that are used in industries including electronics, chemical, ceramics,
medical, and appliances. Headquartered in Sweden, Kanthal sells its
products throughout the world. In the mid-1980s, Kanthal implemented
an ABC project to help it realize its strategy for higher growth and
profitability. The specific goals of the company were to:
175
1. Achieve profit objectives by division, product line, and market;
2. Determine order and sales support costs, so that the sales force
could make better decisions about customer requests;
3. Increase sales without increasing overhead costs.

At the time of the initial analysis, Kanthal had about 10,000
customers and produced about 15,000 items.
The ABC analysis showed that, of Kanthals total Swedish

customer base, 30% contributed the majority of the profits, about
40% were break even, and 30% were not profitable. The analysis
also showed that two of the largest customers were among the
least profitable for the firm.
An activity analysis helped to focus on the root causes of the

low-margin customers. These were the customers that ordered
in small order sizes or in unpredictable amounts, changed their
orders frequently, ordered non stocked or customized products,
required additional technical advice and support either pre- or
post-sale, demanded large discounts, or were slow to pay invoices.
In a culture that focuses on building sales, many firms say yes to
one-off customer requests and demands; however, the additional
sales volume then comes at costs that very often are not directly
associated with the customers order.
Kanthal management used the ABC information to change

internal processes and also to change its relationships with
customers. The firm reduced the variation in product offerings,
and used distributors to stock smaller-volume items, enabling it
to meet more orders from stock rather than building to order. On-
line order entry systems were installed for the large customers.
Some customers were given a small discount as an incentive to
increase order sizes; for example, when one customer was given
a 5% discount to increase order lines by 50%, profitability for that
customer increased from 19% to 45%. In one division, average
order size increased by over 60%, the percentage of orders fulfilled
from stock increased from 36% to 63%, and profitability went
from a small loss to a 9% positive margin. For the company as a
whole, sales increased by 20% without a corresponding increase
in employees, leading to a 45% increase in profitability.
Source: Kanthal (1980)
176
1. Why is customer- profitability analysis a vitally important topic
to manager like Kanthal
2. A customer profitability profile highlights those customers that

should be dropped to improve profitability Do you agree?
Explain.
3. How ABC systems help Kanthal to improve the customer

profitability
Case study 5.3: A London Borough

A new department was set up in November 2002 to promote economic
development and regeneration in the Borough. The departments staff
manages partnership and corporate initiatives, provide information
and advice to businesses and developers and contribute to local policy
in the Borough.
Activity Based Costing

After 6 months in operation the departments manager Clara Bird decided
that the key activities need to be analyzed to identify opportunities for
improving service delivery. Clara believes a cost sampling or snapshot
approach is required to identify key activities and their costs. This
technique will help the department to develop estimates of how much
time is devoted to different activities and then by using an average
hourly rate for all staff Clara will be able to estimate the total annual
cost of an activity. The decision to use an average hourly rate for all staff
will save time with the first cost sampling.
Introducing a cost sampling approach has not been tried in the Borough
before and other managers have not been informed of Claras decision to
introduce this technique. Before she moved to her current post Clara was
aware that many managers were critical of the financial information they
received but they were also reluctant to try techniques such as activity
based costing. Managers in the Borough have described activity based
costing as a technique that is only suitable to other sectors or criticized
the complexity of the technique. Clara is hoping to demonstrate that the
snapshot approach is worthwhile.
Clara decided that about 6 to 8 activities need to be identified to give the

staff a good understanding of the key activities in the department. The
possibility of identifying 20-30 activities was considered but this was
rejected because there was very little time to do the work. For the whole
exercise it was felt that the information must not take too long to collect
and interpret and the snap shot should be repeated regularly.
177
Activity Analysis
The activities identified by Clara and her staff for the first snapshot are
given in appendix 1 and the cost drivers are given in appendix 2. For
the first 12 months the total annual staff related cost for the department
is 200,000 and the estimated total number of hours for all staff is 8,000.
Clara decided to include only staff related costs in her calculations as
this represented approximately 80% of total department costs.
Value-added activities
The chief executive has indicated that all managers will have to
contribute to a cost reduction exercise in the next 6 months. No details
are yet available but Clara believes managers will be asked to identify
value-added and non-value added activities for the exercise.
Appendix 1
Brief details of the key activities identified Clara and her staff are given
below:
Activity Brief description
Information packs have been prepared
for telephone enquiries or letters to
Requests for information standardize the response to requests for
from businesses information. Additional research may
be necessary but this is not a significant
activity.
Information packs are provided giving
Request for information
details of labour market, training, financial
from developers
information and further contacts.
The department develops and manages
a wide range of projects including
Project management and environmental improvements, seminars,
development. training projects and joint venture
developments. There is a lot of time taken
up by preparing reports for committees.
A policy contribution includes work for
Policy development different bodies such as the Government
departments.
It is difficult to define a typical request for
Work for other council
information but generally each request
departments.
involves a similar amount of activity.
This is time spent on various activities in
Other the department, which Clara will consider
in more detail in the future.
178
Appendix 2
Details of cost drivers
Estimated percentage of departments total hours by activity %

Estimated
percentage of
Activity Cost driver departments total
hours by activity
%
Requests for information Number of requests 21
from businesses for information from
businesses
Request for information Number of requests 14
from developers for information from
developers
Project management and Number of requests for 30
development. Committee reports.
Policy development Number of requests for 14
policy input.
Work for other council Number of requests for 6
departments. information or analysis.
Other Number of hours.
Total 100%

Estimated Estimated
Cost driver - estimated annual annual volume - annual volume -
minimum maximum
Number of requests for information
1,000 1,200
from businesses
550 650
from developers
Number of requests for Committee
70 120
reports.
Number of requests for policy input 140 180
170 240
or analysis
Number of hours 1,200 1,200
179
Discussion Question One
1. Evaluate the choice of cost drivers identified by Clara and discuss
how the accuracy of the costs can be improved.
2. Clara is hoping to use the information to compare the performance

of her department with similar departments nationally and also
identify potential areas for cost reduction. Discuss
Case study 5.4: Customer Profitability at Stoke plc

Introduction
Managers at Stoke plc have been using various teams to collect
activity-based data since 2000. Each team has consisted of one or more
management accountants working closely with department managers.
The teams typically work for 3-6 months on data collection and
developing spreadsheets. To date the teams have mainly focused on
product costing. Recently two teams have been set up to collect data to
improve the companys understanding of customer-related costs and
profitability. One team has looked at distribution costs and the second
at order related costs.
Only 3 customers were included in the analysis. Theses 3 customers

represent 10`% of total sales. The company has approximately 250
customers in total. Finally the teams only considered labour related
costs and direct costs for the cost pools.
The first objective for each team was to estimate the total annual
overhead cost and annual volume for each cost driver. As the company
only focused on three customers the data was quickly estimated. The
second objective was to estimate the percentage of each cost driver per
customer.
Collecting Data
The management accept that a cost sampling or snapshot approach
is the best way to identify key activities and their costs. This technique
helps the department to develop estimates of how much time is devoted
to different activities. Then by using an average hourly rate for all staff
managers will be able to estimate the total annual cost of an activity.
The decision to use an average hourly rate for all staff will save time.
Managers decided that between 4 to 8 activities should to be identified by

each team. The possibility of identifying 20-30 activities was considered
but this was rejected because there was very little time to do the work.
For the whole exercise it was felt that the information must not take too
long to collect and interpret.
180
Most of the managers involved with the new teams have little
experience of collecting data regarding activities and cost drivers. With
some activities several cost drivers were discussed. This confused some
managers who felt unclear why a cost driver was rejected or accepted.
The management accountants believed these problems would not affect
the accuracy of the data.
ABC data
Team 1 - Order related overheads
(Data based on 3 customers)
Annual Annual
overhead volume for
Activity cost pool Cost driver
cost for the 3 the 3
customers customers
Number of order
Changes to orders $50,000 3,000
amendments
Number of hours of
Pre-sales support $100,000 3,800
pre-sales support
Number of hours of
Post-sales support $100,000 2,200
post-sales support
Number of delayed
Delayed payments payments over 3 $70,000 1,250
months
Order processing Number of orders $60,000 20,000
Invoicing Number of invoices $25,000 22,500
Team 2 Distribution costs

(Data based on 3 customers)
Distribution related Cost driver Annual Annual
overhead costs overhead volume
cost for the for the 3
3 customers customers
Storage expenses Average cartons in $12,000 5,000
stock
Requisition handling Number of $8,500 10,000

requisitions
Standard deliveries Number of $5,000 3,000
standard deliveries
Special deliveries Number of special $12,800 500
deliveries
181
Customer sales and activity analysis
Customer North South East
Annual Sales $175,000 $178,000 $173,000
The following table summarizes the percentage of each cost driver per
customer.
North South East Total

Customer
% % % %
Number of order amendments 20 2 20 100
Number of hours of pre-sales support 16 10 30 100
Number of hours of post-sales support 10 15 20 100
Number of delayed payments 10 12 10 100
Number of orders 10 30 30 100
Number of invoices 20 30 50 100
Average cartons in stock 40 30 30 100
Number of requisitions 30 30 40 100
Number of standard deliveries 10 40 50 100
Number of special deliveries 20 60 20 100
1. Calculate the profit for each customer based on the ABC data
and discuss what steps the company should consider to improve
the profitability of individual customers.
2. Assume that the company has a complete analysis of all customer-

related revenues and costs. Discuss why such data is needed and
how it can be used to help a company compete profitably.
182
Further Readings
Anderson, Bridget M., Using Activity-Based Costing for Efficiency and
Quality, Government Finance Review, June 1993: 7-9.
Bleeker, Ron R., and Kenneth J. Euske (eds). Activity-based Cost

Management Design Framework: Getting It Right the First Time. Austin,
TX: Consortium of Advanced Management, International, 2004.
Brimson, James A. and John Antos, Activity-Based Management, New

York: John Wiley & Sons, Inc. 1994.
Cooper, Robin and Robert S. Kaplan, Activity-Based Systems:

Measuring the Costs of Resource Usage, Accounting Horizons, Sept.
1992: 1-13.
Cooper, Robin and Robert S. Kaplan, Lawrence Maisel, Eileen Morrissey,

and Ronald Oehm, Implementing Activity-Based Cost Management,
Montvale, NJ: Institute of Management Accountants, 1992.
Cokins, Gary. Activity-based Cost Management: An Executives Guide.

New York: Wiley, 2001
Kaplan, Robert S., and Steven R. Anderson. Time-driven Activity-based

Costing: A Simpler and More Powerful Path to Higher Profits. Boston,
MA: Harvard Business School Press, 2007.
Kaplan, Robert S., In Defense of Activity-Based Cost Management,

Haenlein, Michael and Kaplan, Andreas M. (2009), Unprofitable

customers and their management. Business Horizons, 52 (1), 89-97.
Kaplan, R.S. and V.G. Narayanan (2001), Measuring and Managing

Customer Profitability. Journal of Cost Management (September/
October): 5-15
Pfeifer, Phillip E., Haskins, Mark E., and Conroy, Robert M. (2005),
Customer Lifetime Value, Customer Profitability, and the Treatment
of Acquisition Spending, Journal of Managerial Issues, 17 (1), 11-25.
Helgesen, . (1999) Customer Accounting and Customer Profitability

Analysis - Some Theoretical Aspects and some Empirical Evidence,
SNF Working Paper, No. 67
183
Keys, David E., Tracing Costs in the Three Stages of Activity-Based
Management, Journal of Cost Management, Winter 1994: 30-37.
Rotch, William, Activity-Based Costing in Service Industries, Cost

Management, Summer 1990: 4-14.
Anderson, Bridget M., Using Activity-Based Costing for Efficiency and

Quality, Government Finance Review, June 1993: 7-9.
Brimson, James A. and John Antos, Activity-Based Management, New

York: John Wiley & Sons, Inc. 1994.
Cooper, Robin and Robert S. Kaplan, Activity-Based Systems:

Measuring the Costs of Resource Usage, Accounting Horizons, Sept.
1992: 1-13.
Cooper, Robin and Robert S. Kaplan, Lawrence Maisel, Eileen Morrissey,

and Ronald Oehm, Implementing Activity-Based Cost Management,
Montvale, NJ: Institute of Management Accountants, 1992.
Kaplan, Robert S., In Defense of Activity-Based Cost Management,

Keys, David E., Tracing Costs in the Three Stages of Activity-Based

Management, Journal of Cost Management, Winter 1994: 30-37.
Rotch, William, Activity-Based Costing in Service Industries, Cost

Management, Summer 1990: 4-14.
184
CHAPTER 6
COST VOLUME PROFIT (CVP)
ANALYSIS
Chapter Objectives
The objectives of this chapter is to provide a thorough understanding to the
reader on what will happen to the financial results if a specific level of activity
or volume fluctuates. Therefore, the chapter examines the effect of changes
in the activity level in an organization on total sales revenues, expenses and
profit.
Learning Outcomes
be able to:
1. Explain the meaning of cost- volume profit analysis
2. Identify and explain the assumptions on which CVP analysis
is based
3. Understand the concept of contribution margin
4. Use the contribution margin ratio (P/V) to compute changes
in contribution margin and net operating income resulting
from changes in sales volume
5. Show the effects on contribution margin of changes in
variable costs, fixed costs, selling price and volume
6. Compute the breakeven point
7. Determine the level of sales needed to achieve a desired
target profit
8. Compute the margin of safety and explain its significance
9. Prepare and interpret a cost-volume-profit (CVP) graphs
10. Compute the degree of operating leverage at a particular
level of sales and explain how the degree of operating leverage
can be used to predict changes in net operating income
11. Understand the meaning of sale mix
12. Compute the breakeven point for a multiple product company
13. Describe the differences between the accountants and
economists model of CVP analysis
14. Understand the concept cost- volume-profit (C-V-P) analysis
and uncertainty
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6.1 Introduction
Companies commonly face major uncertainties in their product markets,
particularly in the manufacturing industry where competition is often
fierce and consumer tastes change rapidly. Managers need to estimate
future revenues, costs, and profits to help them plan and monitor
operations and to decide the mix and volumes of goods or services to
produce and sell. They also use this information to evaluate profitability
risk.
The relation between costs of production, volume of production will

result in profit the organization will make. Because the relationship
is stable, it is then possible for it to be analyzed to enable
for decision making. The relationship between cost and profit must
be an inverse one, the higher the cost, the lower the profit. Profit is the
financial benefit or gain which a firm realizes from its transactions
and business dealings. Profit is an important factor in any business
transaction. The main motive of engaging in any business is to make
profit. There is the necessity therefore, to understand the exact
nature of this relationship in order to;
(i) Control the level of costs and
(ii) Manipulate volume
Cost-volume-profit analysis is a study of the inherent relationship

between cost and profit at various levels of volumes of activity.
Therefore, this chapter explains a planning tool called cost-volume-
profit (CVP) analysis. CVP analysis examines the behavior of total
revenues, total costs, and operating income (profit) as changes occur in
the output level, selling price, variable cost per unit, and/or fixed costs
of a product or service. The reliability of the results from CVP analysis
depends on the reasonableness of the assumptions
6.2 Definitions of Cost-Volume-Profit (CVP) analysis

Pierre (1987) defined cost-volume-profit analysis as a technique
for evaluating the effect of changes in cost and volume on profit,
cost includes variable and fixed costs that are expenses of the period,
volume represents the level of sales activity either in units or naira and
profit for the firm may be net income or operating income.
Morse and Roth (1986) also stated that in cost-volume-profit analysis,

the word cost
Is restricted to cost that is deducted from revenues to determine profit.

Normally these deductions are called expenses. Consequently all product
costs are charged against revenue in the period they are incurred
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Morse and Roth (1986) also stated, that in cost-volume-profit analysis,
the word cost is restricted to cost that are deducted from
revenues to determine profit. Normally these deductions are called
expenses. Consequently all product costs are charged against revenues
in the period they are incurred.
Ray (1999) also stated that an overview of cost-volume- profit

analysis begins with the study of cost behaviour patterns with the
contribution income. The contribution income statement has a number
of interesting characteristics that can be helpful to the manager in
, trying to judge the impact on profits of changes in selling price,
cost
Therefore, Cost-volume-profit (CVP) analysis is the technique used

to identify the levels of operating activity needed to avoid losses,
achieve targeted profits, plan future operations, decide on expansion
or contraction plans, monitor organizational performance and analyze
operational risk as they choose an appropriate cost structure to help in
the decision making process to sustain the firm. Cost volume profit (CVP)
analysis involves the analysis of how total costs, total revenues and total
profits are related to sales volume. Therefore CVP analysis is concerned
with predicting the effects of changes in costs and sales volume on
profits i.e. This is the term given to the study of the interrelationships
between costs, volume and profit at various level of activity.
CVP analysis is based on the relationship between volume and sales

revenue, costs and profit in the short run, the short run normally being
a period of one year, or less, in which the output of a firm is restricted
to that available from the current operating capacity. In short run, some
input can be increased, but others cannot. For example, additional
supplies of raw materials and semiskilled labour may be obtained at
short notice, but it takes time to expand the capacity of the plant and
machinery. Thus output is limited in the short run because of facilities
cannot be expanded. It also takes time to reduce capacity, and therefore
in the short run a firm must operate on a relatively constant stock of
production resources. In additional to that most of the costs and prices
of the firms products will have already been determined and major area
of uncertainty will be sales volume. Short run profitability will therefore
be most sensitive to sales volume.
CVP analysis is one of the most powerful tools that managers have at
their command. It helps them understand the interrelationship between
cost, volume and profit in an organization by focusing on interactions
among the following five elements.
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1. prices of products
2. volume of level activity
3. per unit variable costs
4. Total fixed costs
5. Mix of products sold
Because CVP analysis helps managers to understand the

interrelationships, among cost, volume, and profit, it is a vital tool in
many business decisions. These decisions include, for example
1. What products to manufacturer or sell
2. What pricing policy to follow
3. What marketing strategy to employ
4. What type of productive facilities to acquire
6.3 CVP analysis and Profitability

Profit depends on a large number of factors, most important of which are
the cost of manufacturing and the volume of sales. Both these factors are
interdependent. Volume of sales depends upon the volume of production
and market forces which in turn is related to costs. Management has no
control over market. In order to achieve certain level of profitability, it
has to exercise control and management of costs, mainly variable cost.
This is because fixed cost is a non-controllable cost. But then, cost is
based on the following factors:
1. Volume of production
2. Product mix
3. Internal efficiency and the productivity of the factors of production
4. Methods of production and technology
5. Size of batches
6. Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the

complete picture of the profit structure. This enables management to
distinguish among the effect of sales, fluctuations in volume and the
results of changes in price of product/services. In other words, CVP
analysis is a management accounting tool that expresses relationship
among sale volume, cost and profit. Cost-volume- profit analysis can
answer a number of analytical questions. Some of the questions are as
follows:
1. What is the breakeven revenue of an organization?

2. How much revenue does an organization need to achieve a
budgeted profit?
3. What level of price change affects the achievement of budgeted
profit?
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4. What is the effect of cost changes on the profitability of an
operation?
Cost-volume-profit analysis can also answer many other what if

type of questions. Cost-volume-profit analysis is one of the important
techniques of cost and management accounting.
6.4 The uses of CVP Analysis

CVP analysis may be helpful in
1. Budget planning; the volume of sales required to make a profit
(i.e. breakeven point and the safety margin for profit in the budget
can be measured).
2. Decisions affecting the cost structure and production capacity of

the company i.e. maximizing use of production facilities
3. Determining product mix or Sales mix decisions i.e. in what

proportions should each product to be sold.
4. In order to forecast profits accurately, it is essential to ascertain

the relationship between cost and profit on one hand and volume
on the other.
5. Cost-volume-profit analysis is helpful in setting up flexible budget

which indicates cost at various levels of activities.
6. Cost-volume-profit analysis assists in evaluating performance

for the purpose of control.
7. Such analysis may assist management in formulating pricing

policies by projecting the effect of different price structures on
cost and profit.
6.5 Cost-Volume-Profit (CVP) Analysis assumptions

1. The sale price per unit is constant (i.e. set by management
decision) over the entire relevant range of output.
2. There are not stock level changes, so that production output and
sales levels in units may be treated as the same volumes.
3. All costs can be resolved into fixed and variable elements.
4. That the only factor affecting costs and revenue is volume.
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5. That technology, production methods and efficiency remain
unchanged.
6. Fixed costs will remain constant and variable costs vary

proportionately with activity
7. Over the activity range being considered costs and revenues

behave in a linear fashion
8. The sales mix is constant at all level of activity, where more than
one product is included in the analysis.
6.6 Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with
certain assumed conditions, some of which may not occur in practice.
Following are the main limitations and assumptions in the cost-volume-
profit analysis:
1. It is assumed that the production facilities anticipated for the

purpose of cost-volume-profit analysis do not undergo any
change. Such analysis gives misleading results if expansion or
reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit

are manufactured, it is difficult to forecast with reasonable
accuracy the volume of sales mix which would optimize the
profit.
3. The analysis will be correct only if input price and selling price
remain fairly constant which in reality is difficult to find. Thus, if a
cost reduction program is undertaken or selling price is changed,
the relationship between cost and profit will not be accurately
depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs

are perfectly and completely variable at all levels of activity and
fixed cost remains constant throughout the range of volume being
considered. However, such situations may not arise in practical
situations.
5. It is assumed that the changes in opening and closing inventories

are not significant, though sometimes they may be significant.
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6.7 The concept of contribution margin
An important concept in CVP analysis is that of the contribution
margin (sometimes referred to simply as contribution). If we are able to
divide total costs into a component which is fixed and independent of
output over a particular range and a component which is variable and
proportionate to output over that range, then the contribution margin
is calculated by deducting variable costs from revenue. Over the output
range, the contribution margin will itself be proportionate to the volume
of output (assuming that the unit selling price of output is independent
of volume). We may compare the contribution margin at a particular
output level with the fixed costs to see whether a net profit or loss will
be made at that level: where the contribution margin exceeds the fixed
costs, a net profit arises, and vice versa. The point at which contribution
margin is equal to fixed costs is called the break-even point at this level
of output; the net profit is zero, and total costs equal total revenues.
Contribution margin is equal to sales minus variable costs. Because the

variable cost per unit and selling price per unit are assumed to be constant
the contribution margin per unit is also assumed to be constant.
Contribution margin = sales value - variable costs
6.8 Importance of the Contribution Margin

We have noted that, CVP analysis can be used to help find the most
profitable combination of variable costs, fixed costs, selling price and
sales volume. Therefore profits can be sometimes be improved by
reducing the contribution margin if fixed costs, can be reduced by a
greater amount. More commonly the profits can be improved by
increasing total contribution margin figure. Sometimes this can be done
by reducing the selling price and thereby increasing volume, sometimes
it can be done by increasing fixed costs ( such as advertising) and thereby
increasing appropriate changes in volume. Many other combinations of
factors are possible.
The size of the unit contribution margin (and the size of the P/V ratio) is
very important. For instance, the greater the unit contribution margin,
the greater is the amount that the company will be willing to spend
to increase unit sales. This conclude that why the firms with high unit
contribution margins such as automobile manufacturers advertise
so heavily, while firms with low unit contribution margins such as
dishware manufacturers tend to spend much less for advertising.
In short, the effect on the contribution margin holds the key to many
decisions
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6.9 Contribution Margin Ratio (CM or P/V ratio)
The contribution margin as a percentage of total sales is referred to as
the contribution margin ratio (P/V ratio). In this case the contribution
margin is expressed as the percentage of sales value. It shows the
relationship between contribution margins and the sales value. It
expresses relationship between contribution and sales. Better P/ V
ratio is an index of sound financial health of a companys product.
This ratio reflects change in profit due to change in volume. Broadly
speaking, it shows how large the contribution will appear, if it is
expressed on equal footing with sales. The statement that P/ V ratio
is 40% means that contribution is $.40, if size of the sale is $.100. One
important characteristic of P/ V ratio is that it remains the same at all
levels of output. P/ V ratio is particularly useful when it is considered
in conjunction with margin of safety.
P/V ratio is used in cost-volume profit calculations; this ratio is calculated

as follows;
P/V ratio = Contribution margin/ Sales revenue
Higher P/V ratio is an indication of better financial performance of the
companys product, this ratio reflects change in profit due to change in
volume.
6.10 Importance of P/V ratio

1. It assists management in determining the breakeven point
2. It assists management in determining profit at different sales levels
3. It assists management to calculate the sales volume to earn a
desired profit objectives
4. It helps management to determine relative profitability of different
products, processes and departments
Consider the following example of which the income statement of

Mapambo Ltd for the year ended at 31st March 2010
Total Per unit

$ 000 $
Sales (400 speakers) 100,000 250,000
Less variable expenses 60,000 150,000
Contribution margin 40,000 100,000
Fixed expenses 35,000
Net operating income 5,000
For Mapambo Ltd, the computations are

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P/V ratio = $ 40,000,000/$ 100,000,000 x 100
P/ V ratio = 40%
In a company such as Mapambo Ltd that has only one product the P/V
ratio can also be computed as follows;
P/V ratio = Unit contribution margin /Unit selling price
P/V ratio =100,000 /250,000 x 100 = 40%
The P/V ratio is extremely useful since it shows how the contribution
margin will be affected by a change in total sales. To illustrate, notice
that Mapambo Ltd has a P/V ratio of 40%. This means that for each $
increase in sales, total contribution margin will increase by 40 cents,
assuming the fixed costs do not change.
As this illustration suggests, the impact on net operating income of

any given $ change in total sales can be computed in second by simply
applying the P/V ratio to the $ change. For instance, if Mapambo Ltd
plans a $ 30 million increase in sales during the coming month, the
contribution should increase by $ 12 million ( $ 30m increase in sales x
P/V ratio of 40%)
6.11 Improvement of P/V Ratio

P/ V ratio can be improved, if contribution is improved. -
Contribution can be improved by any of the following steps:
1. Increase in sale price.
2. Reducing marginal cost by efficient utilization of men, material
and machines.
3. Concentrating on sale of products with relatively better P/ V
ratio. This will help to improve overall P/ V ratio
6.12 Limitations of P/V Ratio

There is a growing trend among companies to use the profit - volume-
ratio in deciding the product-worthy additional sale efforts and
productive capacity and host of other managerial exercises. Following
are the limitations of the use of P/ V Ratio
1. P/V ratio heavily leans on excess of revenues over variable cost.
2. The P/V ratio fails to take into consideration the capital outlays
required by the additional productive capacity and the additional
fixed costs that are added.
3. Inspection of P/ V ratio of products can suggest profitable
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product lines that might be emphasized and unprofitable lines,
which may be re-evaluated or eliminated. Mere inspection of
P/ V ratio will not help to take final decision. For this purpose,
analysis has to be broadened to take into consideration different
cost of the decision and opportunity costs, etc. Thus, it indicates
only the area to be probed.
4. The P/ V ratios has been referred to as the questionable device

for-decision-making because it only gives an indication of the
relative profitability of the products/ product lines that too if
other things are equal.
The above points highlight that P/V ratio should not be used
inconsiderately.
6.13 The Break-Even Analysis

It is important that managers are aware of the level of sales at which their
business makes neither a profit nor a loss, this is the break-even point.
The breakeven point is that quantity of output where total revenues
equal total costs i.e. that is where the operating income is zero. That is
the total contribution is equal to the total fixed cost and so the profit is
zero.
Break-even point may be expressed either in term of units of sale or in

terms of sales revenue. Managers would be interested in the break-even
point, mainly because they want to avoid operating losses. At the break-
even point, the contribution is just enough to provide for fixed cost, if
budgeted or actual sales level is above breakeven point the firm will
make profit, if budgeted sales or actual sales level is less than break -
even the firm will incur loss.
If the breakeven point is relatively high, it means that it is essential

that a good level of sales is maintained. High fixed costs may arise as
a result of heavy advertising and promotional expenditure, expensive
machinery with the corresponding high depreciation to be written off
and under these conditions, it is essential that the contribution margin
per unit should be large. If the contribution margin per unit is relatively
low, then very high level of sales will be required to reach the break-
even point
Knowing the break-even point will enable the management to be aware,

on a daily, weekly or monthly basis of the likely level of profitability. If
the sales level is level the break-even point, the managers will need to
re-consider the position and take remedial action.
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6.14 The arithmetic of cost-volume profit analysis
CVP analysis uses simple linear assumptions about costs and revenue.
Therefore Cost-Volume Profit (CVP) analysis is the study of the effects
on future profit of changes in fixed costs, variable cost, sales price,
quantity and mix (CIMA).
A common term used for this type of analysis is breakeven analysis,

that the level of activity which produces neither profit nor loss
6.15 Calculating the breakeven point

Calculating the break-even point indicates the minimum output level
needed for sales of a product to be profitable. Remember that several
assumptions underlie the determination of the break-even point:
1. Fixed costs are constant
2. Variable costs vary linearly with output
3. Sales revenues per unit of output are constant
4. Volume of output is the only factor affecting total cost.
These assumptions are often unrealistic in practice, so break-even

analysis must be regarded as a rough guide rather than a precise
one. The break-even chart is the most common way of presenting the
relationship between total costs and total revenues at different output
levels, and finding the break-even point. The break-even point occurs
where the profit line (the line representing profit as a function of output)
cuts the output axis: at this point, profit is zero. If you look closely at the
break-even chart you notice that it fails to show net profit or loss clearly
at different output levels. To remedy this, the profit volume chart has
been developed. This is a graph of volume against profit (or loss) at each
level of output. Profit volume charts and break-even charts may
As sales revenues grow from zero, the contribution also grows until it
just covers the fixed costs. This is the breakeven point where neither
profits nor losses are made. It follows that to break even the amount of
contribution must exactly match the amount of fixed costs
In calculating the break-even point the two methods, i.e. equation

method and contribution margin method will be used.
The following abbreviations are useful in the analysis

SP = unit selling price
VC = Unit variable costs
UCM = Unit contribution margin (SP-VC)
CM%, P/V ratio = (CM/SP)
195
TFC = Total Fixed Costs
Q = Quantity of Output unit sold (and produced)
OP = Operating profit
(i) Equation Method

The equation method centres on the contribution approach to the income
statement .Under this method; the income statement can be expressed
using the preceding terminology in the form of the following equation.
Profits = (Sales - Variable costs) - Fixed costs
Rearranging this equation slightly yield the following equation, which

is widely used in CVP analysis;
Sales = Variable costs + Fixed Costs + Profits
(SP x Q) = (VC x Q) +TFC + OP
At the breakeven point, profits are zero; therefore the breakeven point
can be computed by finding that point where sales just equal the total of
the variable costs plus the total fixed costs.
For Mapambo Ltd, the breakeven point in unit sales, Q can be computed
as follows;

Sales = Variable costs + Total Fixed costs + Profits
$ 250,000Q = $ 150,000Q + $ 35,000,000 + $ 0

$ 100,000Q = $ 35,000,000
Q = $ 35,000,000/ $ 100,000
Q = 350
The breakeven point in sales $ can be computed by multiplying the

breakeven level of unit sales by the selling price per unit:
350 speakers x $ 250,000 per speaker = $ 87,500,000
(ii) Contribution Margin method

The contribution margin method is actually just a shortcut version of
the equation method already explained. The approach centres on the
idea explained earlier that each unit sold provides a certain amount of
contribution margin that goes toward covering fixed costs. To find how
many units must be sold to break even, divide the total fixed costs by
the unit contribution margin;
196
Break even point in units sold = Total Fixed Costs/ UCM

Each speaker generates a contribution margin of $ 100,000 ($ 250,000
selling price, less $150,000 variable costs). Since the total fixed costs are
$ 35,000,000, the breakeven point is computed as follows;
Breakeven point in units (Q) = $ 35,000,000/$ 100,000

Break even points = 350 speakers
A variation of this approach uses the P/V ratio instead of the unit
contribution margin. The results is the breakeven point in total sales $
rather than in total units sold
Breakeven point in total sales $ = Total Fixed costs/PV ratio

In the Mapambo Ltd example the calculation are as follows;
Total Fixed Costs/ PV ratio
= $ 35,000,000/0.4
Breakeven point ($) = $ 87,500,000
This approach, based on the P/V ratio, is particularly useful in those

scenarios where a firm has multiple product lines and wishes to compute
a single breakeven point for the firm as a whole.
6.16 Target Profit Analysis

Cost -Profit-Volume (CVP) formulas can be used to determine the sales
volume needed to achieve a target profit. Now I introduce the profit
element in the calculation, by asking how many units must be sold to
earn a certain target of profits.
In this case two approaches will be used to answer the above equation;
the CVP equation and the contribution margin approach
(i) The CVP Equation

One approach is to use the equation method, instead of solving for the
unit sales where profits are zero, you instead solve for the unit sales
for targeted profits. Suppose the targeted profits of Mapambo are $
40,000,000, the units which should be sold to archive that target will be
computed as follows;
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Sales = Variable costs + Total fixed costs + Target profits
$ 250,000Q = $ 150,000Q + $ 35,000,000 + $ 40,000,000
$ 100,00Q = $ 75,000,000
Q = $ 75,000,000/$ 100,000
Q = 750 Speakers
Where;
Q = Number of Speakers sold

$ 250,000 = Unit sales price
$ 150,000 = Unit variable cost
$ 35,000,000 = Total fixed costs
$ 40,000,000 = Target profit
(ii) The Contribution Margin Approach

A second approach involves expanding the contribution margin formula
to include the target profit; the unit sales to achieve the targeted profits
can be computed by the following formula;
Unit sales to achieve target profit= Total fixed costs + Target profit/
UCM
= $ 35,000,000 + $ 40,000,000/$ 100,000
= 750 speakers
This method gives the same answer as the equation method since it is
simply a short cut version of the equation method, similarly, the sales in
$ needed to attain the target profit can be computed as follows;
Sales in $ to attain target profit = Total fixed costs + Target profit/ PV ratio
= $ 35,000,000 +$ 40,000,000/ 0.40
= $ 187,500,000
If the component of tax is introduced i the formula for computation of

breakeven point would expressed as follows;
Unit sales at target profit after tax = Total fixed costs + [Target profit/
(1- tc)]/UCM
tc = tax rate
If the taxation rate is 40% how many units will need to be sold by
Mapambo Ltd to make a target profit of $ 40,000,000?
Unit sales to achieve target profit = $ 35,000,000 + [$ 40,000,000/(1- 0.4)]/

$ 100,000
= 1,016.67 units
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Illustration
In its budget for next month, BK Company has revenues of $500,000,
variable costs of $350,000, and fixed costs of $135,000.
a. Compute contribution margin percentage.

b. Compute total revenues needed to break even.
c. Compute total revenues needed to achieve a target operating income
of $45,000.
d. Compute total revenues needed to achieve a target net income of
$48,000, assuming the income tax rate is 40%
Solution
a. Contribution margin percentage = ($500,000 $350,000) $500,000
= $150,000 $500,000 = 30%
Note, variable costs as a percentage of revenues = $350,000 $500,000

= 70%
b. Breakeven point = $135,000 0.30 = $450,000
Proof of breakeven point
Revenues $450,000
Variable costs, 315,000
Contribution margin 135,000
Fixed costs 135,000
Operating income $ -0-
c. Let X = Total revenues needed to achieve target operating income of

$45,000
X = $135,000 + $ 45,000 = $ 600, 0000

0.3
d. Two steps are used to obtain the answer. First, compute operating
income when net income is $48,000:
$ 48,000 = $80,000
1 0.4
Second, compute total revenues needed to achieve a target operating

income of $80,000 (that is, a target net income of $48,000), which is
denoted by Y:
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Y = $ 135,000 + $ 80,000 = $ 716,667
0-.3
6.17 The Margin of Safety

The Margin of safety is the excess of budgeted (or actual) sales over the
breakeven volume of sales. It states the amount by which sales can
drop before losses begin to be incurred. The higher the margin of safety,
the lower the risk of not breaking even
The larger the margin of safety, the more likely it is that a profit will
be made, that is, if sales start to fall there is more leeway before the
organization begin to incur losses. It indicates the extent to which a fall
in demand could be absorbed, before the firm begins to sustain losses.
Thus, soundness of a business can be measured by margin of safety.
This concept is very important to management in taking policy decision
like reduction in price to face the competitors. The margin of safety
indicates how much present sales level is able to keep the firm away
from the crucial point.
The formula for its calculation is;
Margin of safety = Total budgeted (or actual) sales - Break- even sales
The margin of safety can also be expressed in percentage form. This

percentage is obtained by dividing the margin of safety in value terms
by total sales value;
Margin of safety percentage = Margin of safety in monetary value

Total budgeted (or actual) sales
The calculations for margin of safety for Mapambo Ltd are as follows
Sales (at the current volume of 400 speakers) (a) $ 100,000,000
Break even sales (at 350 speakers) $ 87,500,000
Margin of safety (b) $ 12,500,000
Margin of safety as a percentage of sales (a b) 12.5%
This margin of safety means that at the current level of sales and with
the companys current prices and cost structure, a reduction in sales of
$ 12,500,000, or 12.5%, would result in just breaking even.
In a single- product firm like Mapambo Ltd, the margin of safety can
also be expressed in terms of the number of units sold by dividing the
margin of safety in monetary term by the selling price per unit. In this
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case, the margin of safety is50 speakers ($ 12,500,000 $ 250,000 = 50
speakers)
The margin of safety can also be used as one route to a profit calculation.
We have seen that the contribution goes towards fixed costs and profit.
Once breakeven point is reached the fixed costs have been covered.
After the breakeven point there are no more fixed costs to be covered
and all of the contribution goes towards making profits grow.
In our example, the profit from sales of 400 speakers would be $ 5,000,000
Margin of safety = 50 speakers
Profit = 50 x contribution per unit
= 50 x $ 100,000
= $ 5,000,000
6.18 How to improve the Margin of Safety

The margin of safety can be improved by the following ways;
1. By increasing the selling price, if it is not possible to increase sales

volume level, the selling price can be increased to improve the
margin of safety; however this can have a negative impact in the
sales volume, also this depend upon the price elasticity demand
of the product
2. By increasing the sales volume, this will increase the difference

between actual sales level and sales level at breakeven; however
this will have negative effect in selling price
3. By reducing the variable costs, it increases the margin of safety

by improving contribution margin ratio
4. By changing the product mix thereby increasing contribution

margin, this will lead to improvement in margin of safety, because
it increases the gap of sales at specified activity level and sales at
breakeven point.
6.19 Graphical Presentation of Cost- Volume- Profit (C-V-P) Analysis

Graphic charts furnish an effective means of presenting cost volume
profit relationship. In graphic presentation, a diagram of the relationship
among various factors, revenue, volume level, profit and cost is
presented. This pictorial presentation makes this relationship easy to
understand and interpret. The graphical presentation of C-V-P analysis
can be expressed into three ways
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(i) A basic breakeven charts
(ii) The contribution breakeven chart
(iii) The profit Volume (P/V) chart
(i) A basic break even chart

A basic break-even chart records costs and revenues on the vertical axis
and the level of activity on the horizontal axis. Lines are drawn on the
chart to represent costs and sales revenue. The breakeven point can be
read off where the sales revenue line cuts the total cost line.
To draw the basic breakeven chart, we should follow the following steps
1. Plot the total revenue line starting at zero activity level
2. Plot the total fixed cost by a horizontal line
3. Plot the total cost line start at the fixed cost line at zero activity
4. Determine the breakeven point from intersection of total cost line
and the total revenue line
Example of a basic breakeven chart of ABC Ltd which is small

manufacturing company can be shown as follows
1. Number of units produced is marked along the horizontal axis
and the total revenue expressed in dollars is set on the vertical axis.
2. The sales line is drawn to indicate the sales at each level of

production.
3. A horizontal line is drawn at the $12,000 level of sales to represent

the fixed costs for our sample business.
4. A total cost line is drawn from the point of intersection of the

fixed cost line and the vertical axis to the point of total costs as full
capacity --$28,000.
5. The intersection of the total cost line with the sales line represents
the break-even point, in this case $20,000. The dotted lines
represent the level of production and the total costs at this level
of operation.
6. Areas of net loss and of net profit are shaded
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Figure: 6.1 Basic breakeven chart of ABC Ltd
The interpretation of the breakeven is that, the actual (or projected)

sales volume is compared with the break-even volume. If the actual
volume is smaller or very close to the break-even volume, it indicates
that either the pricing strategy should be revised or the product should
be discontinued because it is not sufficiently profitable. If the actual
volume is only slightly above the break-even volume, the profitability
may be adequate or not depending on the sales stability. If sales are
unstable the actual sales must be significantly above the break-even
volume; otherwise, there is a good chance that falling revenues will
put the company in financial difficulty. The basic break-even point
graph helps the management to determine the levels of production
that will create profits for every level of sales. The management then
works to increase profits without investing extra funds. To do this, the
management should study the following important points:
1. A possible increase in utilization of existing capacity through

reduction of idle time.
2. Better repair and maintenance of equipment to reduce down
time --time elapsed from the moment the machine breaks down
to the time it gets back in service.
3. Improved working schedules and inventory levels.
4. Longer business hours.
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5. Improved production control.
6. Mark-up policy.
(ii) The contribution breakeven chart

One of the problems with the basic break-even chart is that it is not
possible to read contribution directly from the chart. A contribution
break even chart is based on the same principles but it shows the variable
cost line instead of the fixed cost line. The same lines for total cost and
sales revenue are shown so that, the breakeven point and profit can be
read off in the same way as with a basic break even chart. However it is
possible also to read the contribution for any level of activity
Using the same basic example as for the basic chart, the total variable
cost for an output of 400 speakers is $ 60,000,000, this the point can be
joined to the origin since the variable cost is zero at zero activity
The contribution can be read as the difference between the sales revenue
line and the variable cost line. This form of presentation might be used
when it is desirable to highlight the importance of contribution and to
focus attention on the variable costs.
Figure 6.2 Contribution breakeven charts
$ TR
TC
TVC
BEP
Output (Units)
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(iii) The Profit Volume (P/V) chart
Another form of break even chart is the profit-volume chart. This plots
a single line depicting the profit or loss at each level of capacity. The
break-even point is where this line cuts the horizontal axis. The vertical
axis shows profit and losses and the horizontal axis is drawn at zero
profit or loss. The advantage of P/V chart is that the profit can be read
directly from the chart, it is essential to deduct total costs from sales to
know the profit figure. Therefore the P/V chart is easy to understand
and their preparation involves drawing sales line and profit curve, the
point at which profit line cuts the sales line is called breakeven point
The profit volume chart involves the following steps;
1. Finding out profit at any two levels of activity

2. Draws the sales line
3. Draw the profit line
4. The intersection between the sale line and profit line is the break-
even point
Suppose Mlimani City Movie theater is incurred $48,000 monthly fixed

costs, the price per ticket is $8 and the variable cost per ticket is $2. Then,
the breakeven point in units, revenue and P/V chart are shown below;
BEunits = $48,000/ ($8 - $2)
BEunits = 8,000 tickets.
BErevenue = $64,000
Figure: 6.3 Profit-Volume (P/V) Chart
$000
(per month)
40
30
Profit 20
Break-even point: 8,000 tickets
10 Profit
area
0
-10 2,000 4,000 6,000 8,000 10,000
-20 Volume of
Loss area tickets sold
Loss
-30 in one
month
-40
-50
Fixed expenses = $48,000
The following important issues should be noted from the profit- Volume
chart;
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At breakeven point, the profit line intersects the sales line, the point
whereby there is no profit or loss. The company will break even at sales
of $ 64,000 or 8,000 tickets.
The profit line touches the vertical line at a loss of $ 48,000; the profit line
starts from point of fixed cost, because at zero sales, the total loss will be
represented by the fixed cost
6.20 Limitations and Uses of Breakeven Charts

A simple breakeven chart gives correct result as long as variable cost
per unit, total fixed cost and sales price remain constant. In practice,
all these factors may change and the original breakeven chart may give
misleading results. But then, if a company sells different products
having different percentages of profit to turnover, the original combined
breakeven chart fails to give a clear picture when the sales mix changes.
In this case, it may be necessary to draw up a breakeven chart for each
product or a group of products. A breakeven chart does not take into
account capital employed which is a very important factor to measure
the overall efficiency of business. Fixed costs may increase at some level
whereas variable costs may sometimes start to decline. For example,
with the help of quantity discount on materials purchased, the sales
price may be reduced to sell the additional units produced etc. These
changes may result in more than one breakeven point, or may indicate
higher profit at lower volumes or lower profit at still higher levels of
sales.
Nevertheless, a breakeven chart is used by management as an efficient

tool in marginal costing, i.e. in forecasting, decision-making, long term
profit planning and maintaining profitability. The margin of safety
shows the soundness of business whereas the fixed cost line shows
the degree of mechanization. The angle of incidence is an indicator
of plant efficiency and profitability of the product or division under
consideration. It also helps a monopolist to make price discrimination
for maximization of profit
6.21 C-V-P considerations in choosing a cost structure

Cost structure refers to the relative proportion of fixed and variable costs
in an organization. An organization often has some attitude in trading
off between these two types of costs. For example, fixed investments
in automated equipment can reduce variable costs. In this section the
discussion will be on the choice of a cost structure and its impact on
profit stability, in which the operating leverage plays an important role
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(i) Cost structure and profit stability
When a manager has some attitude in trading off between fixed and
variable costs, which cost structure is better high variable cost and
low fixed costs or the opposite? No single answer to this question is
possible; there may be advantages either way, depending on the specific
circumstances. To show what it mean by this statement, refer to the
income statements, given below for two companies. Urafiki Ltd and
KTM Ltd. KTM has higher variable costs, but Urafiki has higher fixed
costs (Hypothetical data).
KTM Urafiki
Amount % Amount %
$000 $000
Sales 100,000 100 100,000 100
Less variable costs 60,000 60 30,000 30
Contribution margin 40,000 40 70,000 70
Less fixed costs 30,000 60,000
Profit 10,000 10,000

The question as to which firm has the better cost structure depends
on many factors, including the long-run trend in sales, year to year
fluctuation in the level of sales and the attitude of the owners toward risk.
If sales are expected to be above $ 100m in the future then Urafiki

probably has the better cost structure. The reason is that its P/V ratio
is higher, and its profits with therefore increase more rapidly as sales
increases. To demonstrate, assume that each company experiences 20
percent increase in sales without any increase in fixed costs. The income
statements would be as follows; in ($ 000)

KTM Urafiki
Amount % Amount %
$000 $000
Sales 120,000 100 120,000 100
Less variable costs 72,000 60 36,000 30
Contribution margin 48,000 40 84,000 70
Less fixed costs 30,000 60,000
Profit 8,000 24,000
Urafiki has experience a greater increase in profit due its higher P/V ratio
even though the increase in sales was the same for both companies.
207
Now what happen if sales fall below $ 100 million from time to time?
The following computation of break-even points and margin of safety
of the two companies will answer the above question
KTM Urafiki
Fixed costs $ 30,000,000 $ 60,000,000
P/V ratio 40% 70%
Break-even in total sales $ $ 75,000,000 $ 85,714,000
Total current sales (a) $ 100,000,000 $ 100,000,000
Break-even sales 75,000,000 85,714,000
Margin of safety (b) $ 25,000,000 $ 14,286,000
Margin of safety in percentage (b a) 25.0% 14.3%
The computations above make it clear that KTM is less risk to downturn
than Urafiki. The main reasons for KTM to have less risk are as
follows;
1. Due to its lower fixed cost, KTM has lower break-even point and
higher margin of safety, as shown by the computations above;
therefore, it will not incur losses as quickly as Urafiki in a periods
of sharply declining sales
2. Due to lower its P/V ratio, KTM will not lose contribution margin
as rapidly as Urafiki when sales fall off, hence, KTMs income
will be less volatile
Therefore the conclusion is that, without knowing the future, it is

not obvious which cost structure is better. Both have advantage and
disadvantage. Urafiki with its higher fixed costs and lower variable
costs will experience wider swings in net income as changes take place
in sales, with greater profits in good years and greater losses in bad
year. KTM with its lower fixed costs and higher variable costs will enjoy
greater stability in net operating income and will be more protected from
losses during bad years, but at the cost of lower net operating income
in good years.
(ii) Cost structure and Operating Leverage

The cost structure of an organization is the relative proportion of its
fixed and variable costs, while the Operating leverage is the extent to
which an organization uses fixed costs in its cost structure. Operating
leverage is a measure of how sensitive net operating is to percentage
changes in sales. Operating leverage is act as a multiplier. If operating
leverage is high, a small percentage increase in sale can produce a much
208
larger percentage increase in net operating income. The organization
with High Operating Leverage has the following features;
a. Low variable costs

b. High fixed costs
c. High contribution margin
d. High break-even point
e. Sales after break-even have greater impact on profits
While the organization with low operating Leverage has the following
features
a. High variable costs

b. Low fixed costs
c. Low contribution margin
d. Low break-even point
e. Sales after break-even have lesser impact on profits
The degree of operating leverage at a given level of sales is calculated

by the following formula:

Degree of operating leverage = Contribution Margin
Net operating income
The degree of operating leverage is a measure, at given level of sales,
of how a percentage change in sales volume will affect profits. To
demonstrate the degree of operating leverage for two companies at
sales of $100 million would be computed as follows;

KTM Ltd = $ 40,000,000
$10,000,000
=4
Urafiki = $ 70,000,000
$ 10,000,000
=7
The interpretation is that, since the degree operating for KTM Ltd is 4,
and then the companys net Operating grows four times as fast as its
sales. Similarly Urafiki Ltds net operating income grows seven times as
fast as its sales. Thus if sales increase by 20 percent, then it is expected
that the net operating income of KTM to increase by four times this
amount, or by 80 percent and the net operating income of Urafiki to
increase by seven times this amount, or by 140 percent
209
This can be illustrated by the following example;
% increase in
% increase Degree of
Net operating
in sales Operating Leverage
Income
KTM 20% 4 4% (20% x 4)
Urafiki 20% 7 70% (20% x 7)

Now the question is what is responsible for the higher leverage for
Urafiki Ltd? The only difference between the two companies is their
cost structure. If the two companies have the same total revenue and
the same total costs but different cost structures, then the company with
higher proportion of fixed costs in its cost structure will have higher
operating leverage
6.22 The concept of sales mix

The term sales mix refers to the relative proportions in which a companys
products are sold.
The idea is to achieve the combination, on mix that yield the greatest
amount of profits. Most companies have many products and often
these products are not equally profitable. Hence, profits will depend
to some extent on the companys sales mix. Profits will be greater if
high contribution margin rather than low contribution margin products
make up a relatively large proportion of total sales.
Changes in the sales mix can cause interesting (and sometimes confusing)
variations in a companys profits. A shift in the sales mix from high-
contribution margin products to low- contribution margin products can
cause total profits to decrease even though total sales may increase. Also
shift in the sales mix from low- contribution margin products to high
contribution margin products can cause the reserve effect total profits
my increase even though total sales decrease
6.23 Multi Products and Break-Even Analysis

In real life, most of the firms turn out many products hence, CVP analysis
is more complicated if it focuses on the proposals that encompass more
than one products. Multi- products proposals introduce two major
kinds of problems
1. The contribution margin is likely to differ from product to product

2. A common physical measuring unit may be impossible to find
210
In calculating the breakeven point for multi products, however, the
assumption has to be made that the sales mix remains constant.
The calculation of breakeven point in a multi-product firm follows the
same pattern as in a single product firm. While the numerator will be
the same fixed costs, the denominator now will be weighted average
contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs

Weighted average contribution margin per unit
It should be always remembered that, weights are assigned in proportion

to the relative sales of all products. Here, it will be the contribution
margin of each product multiplied by its quantity.
To demonstrate the situation of multi products, let recall one of the

assumption of C-V-P analysis about a constant sales mix which, enables
to calculate the break-even point in a multi products situation.
Illustration
The management accountant of BM Ltd has prepared the following
information report for management
Product XA Product XB
Sales (units) 1,200 800
Price per unit $ 400 $ 800
Variable costs $ 390,000 $ 480,000
Fixed Costs $ 30,000 $ 40,000

Calculate the break even points in units for each product and the
company as a whole
Solution
Unit Contribution Margin (UCM)
Product XA = $ 400 - $ 390,000/1200 units =$75
Product XB= $ 800 - $ 480,000/800 units = $200
Breakeven point (units)
Product XA = $ 30,000/$75 = 400 units
Product XB = $ 40,000/$200 =200 units
The overall breakeven point in units at the forecast mix can be calculated
by diving total fixed cost by the average contribution margin out of that
mix
211
Product XA Product XB
Sales $ 480,000 $ 640,000
Variable costs $ 390,000 $ 480,000
Contribution margin $ 90,000 $ 160,000

Average contribution margin per unit = ($90,000 + $160,000)/ (1,200
units + 800 units)
Average contribution margin per unit = $ 125

Overall breakeven point = ($30,000 + $40,000)/$125 = 560 units
6.24 The economists model

In an earlier discussion of C-V-P analysis model, on cost behaviour a
comparison was made between the accountants view that that all units
are sold at a constant price, regardless of the quantity sold, and that
total costs can be expressed by the formula;
y = a + bx
Certain criticisms are of the opinion that accountant cost-volume-profit

analysis is only of theoretical importance due to its assumptions stated.
The views of accountants contradict with the views of economists, who
hold that
1. In order to sell higher quantities of a product, the unit selling price
will have to be reduced, therefore, sales line will not be a straight
line, it will be a concave to the base
2. Based on the phenomenon of diminishing marginal productivity,

the total cost function is curvilinear and might be expressed by
the equation y = a + bx + cx2
3. Therefore the decrease rate of sales line and behaviour of cost

line provides two break-even points
The economists model of C-V-P behaviour is illustrated in figure

3.4 below, the graph shows that the total revenue line is assumed to
be curvilinear, which indicates that the company is only able to sell
increasing output by reducing the selling price per unit, thus total
output does not increase proportionately with output
The total cost line shows that, they rise steeply at first as the company
operates at the lower level of the volume range and then the total cost
line begins to level out and rise less steeply.
212
Figure 3.4; the economist model graph
6.25 Cost- Volume-Profit (C-V-P) analysis and uncertainty

Another limitation of CVP analysis is the assumption that unit variable
cost, unit selling price and fixed costs are constant and also that budgeted
sales volume can be predicted with certainty. These factors which CVP
analysis regards as certain and constant are in reality variables with
expected values and standard deviations which can be estimated by
management (Jarrett).
Since future sales as well as price, fixed cost and variable cost are
uncertain, the management accountant must play on the role of
a statistical consultant in advising management on how to assess
probability distribution for these quantities
(i) Methods of analyzing uncertain
There are different methods of analyzing the uncertainty, these include
the following;
1. Estimating the probabilities that sales demand, unit variable cost

and fixed cost will be certain in different amounts
2. Sensitivity analysis
3. Simulation modeling
4. Estimating uncertain values as a continuous probability

distribution i.e. a normal distribution of values, with an estimated
mean and standard deviation
213
(ii) Sensitivity Analysis and Uncertainty
Sensitivity analysis is relatively a term which is used in management
accounting. It is a what if technique that managers use to examine
how a result will change if the original predicted data are not achieved
or if an underlying assumption changes. In the context of CVP analysis,
sensitivity analysis answers the following questions:
1. What will be the operating income if units sold decrease by 15%
from original prediction?
2. What will be the operating income if variable cost per unit
increases by 20%?
The sensitivity of operating income to various possible outcomes

broadens the perspective of management regarding what might actually
occur before making cost commitments. A spreadsheet can be used to
conduct CVP-based sensitivity analysis in a systematic and efficient way.
With the help of a spreadsheet, this analysis can be easily conducted to
examine the effect and interaction of changes in selling prices, variable
cost per unit, fixed costs and target operating incomes.
Illustration
Following is the spreadsheet of ABC Ltd.,
Statement showing CVP Analysis for ABC Software Ltd.
Revenue required at $ 200 Selling Price per

unit to earn Operating Income of
Variable
Fixed cost 0 1,000 1,500 2,000
cost
2,000 100 4,000 6,000 7,000 8,000
120 5,000 7,500 8,750 10,000
140 6,667 10,000 11,667 13,333
2,500 100 5,000 7,000 8,000 9,000
120 6,250 8,750 10,000 11,250
140 8,333 11,667 13,333 15,000
3,000 100 6,000 8,000 9,000 10,000
120 7,500 10,000 11,250 12,500
140 10,000 13,333 15,000 16,667
From the above example, one can immediately see the revenue that
needs to be generated to reach a particular operating income level,
given alternative levels of fixed costs and variable costs per unit. For
example, revenue of $ 6,000 (30 units @ $ 200 each) is required to earn
an operating income of $ 1,000 if fixed cost is $ 2,000 and variable cost
214
per unit is $ 100. You can also use exhibit 3-4 to assess what revenue
the company needs to breakeven (earn operating income of Re. 0) if, for
example, one of the following changes takes place: The booth rental at
the ABC convention rises to $ 3,000 (thus increasing fixed cost to $ 3,000)
The software suppliers raise their price to $ 140 per unit (thus increasing
variable costs to $ 140).
An aspect of sensitivity analysis is the margin of safety which is the
amount of budgeted revenue over and above breakeven revenue.
The margin of safety is sales quantity minus breakeven quantity. It is
expressed in units. The margin of safety answers the what if questions,
e.g., if budgeted revenue are above breakeven and start dropping, how
far can they fall below budget before the breakeven point is reached?
Such a fall could be due to competitors better product, poorly executed
marketing programs and so on.
Assume you have fixed cost of $ 2,000, selling price of $ 200 and variable
cost per unit of $ 120. For 40 units sold, the budgeted point from this
set of assumptions is 25 units ($ 2,000 $ 80) or $ 5,000 ($ 200 x 25).
Hence, the margin of safety is $ 3,000 ($ 8,000 5,000) or 15 (40 25)
units. Sensitivity analysis is an approach to recognizing uncertainty,
i.e. the possibility that an actual amount will deviate from an expected
amount.
Assume you have fixed cost of $ 2,000, selling price of $ 200 and variable
cost per unit of $ 120. For 40 units sold, the budgeted point from this set
of assumptions is 25 units ($ 2,000 $ 80) or $ 5,000 ($ 200 x 25). Hence,
the margin of safety is $ 3,000 ($ 8,000 5,000) or 15 (40 25) units.
215
6.1
A summary of a manufacturing companys budget profit statement for
its next financial year, when it expect to be operating at 75 percent of
capacity, is given below
$ 000 $ 000
Sales 9,000 units @ $ 32,000 288,000
Less; Direct materials 54,000
Direct wages 72,000
Production overhead-fixed 42,000
-variable 8,000
186,000
Gross profit 102,000
Less; Admin, selling and dist. Costs
- fixed 36,000
-variable with sales volume 27,000
63,000
Operating profit 39,000

It has been estimated that
(i) If the selling price per unit was reduced to $ 28,000, the increased
demand would utilise 90 percent of the companys capacity
without any additional advertising expenditure.
(ii) To attract sufficient demand to utilise full capacity would require

a 15 percent reduction in the current selling price and $ 5,000,000
special advertising campaign.
Required
(a) Calculate the breakeven point in units based on the original budget
(b) Calculate the profits and break even points which would result
from each of the two alternatives and suggest which alternative
should be implemented.
CIMA P2 Management accounting-Decision making
216
6.2
A Company produces and sells two products with the following costs:
Product X Product Y
Variable costs (per $ of sales) $0.45 $0.6
Fixed costs (per period) $1,212,000 $1,212,000

Total sales revenue is currently generated by the two products in the
following proportions:
Product X 70%
Product Y 30%
Required:
(a) Calculate the break-even sales revenue per period, based on the
sales mix assumed above
(b) Prepare a profit volume chart of the above situation for sales
revenue up to $4,000,000. Show on the same chart the effect of a
change in the sales mix to product X 50%, product Y 50%. Clearly
indicate on the chart the break-even point for each situation.
(c)
Of the fixed costs $455,000 are attributable to product X.
Calculate the sales revenue required on product X in order to
recover the attributable fixed costs and provide a net contribution
of $700,000 towards general fixed costs profit
ACCA level 1 costing
217
Summary
Cost Volume Profit (CVP) Analysis is dealing with evaluating the
relationship between changes in volume and changes in total revenue
and costs in the short term. In this chapter we have discussed the
CVP analysis and profitability, also this chapter has addressed the
assumptions and limitations of CVP analysis, in discussing the CVP
analysis the issues of contribution margin, contribution margin ratio,
break even analysis and margin of safety are very essential, therefore
this chapter has addressed these issues more clearly.
In this chapter also we have compared the economists and accountants

model of CVP analysis, the difference is curvilinear in the economists
model and linear relationship in the accountants model for the case of
total cost function and total revenue function

Break-even chart
Break-even point
Contribution graph
Contribution margin
Cost structure
Margin of safety
Operating leverage
Profit volume ratio
Sensitivity analysis
218
Exercises
6.1 Define cost-volume-profit analysis
6.2 Describe the assumption underlying CVP analysis
6.3 What is operating leverage? How is knowing the degree of
operating leverage is useful to managers?
6.4 Give an example of how a manger can increase variable costs
while decreasing fixed costs
6.5 What is meant by the term break-even point? How is the break-
even point computed?
6.6 How does an increase in the income tax rate affect the breakeven
point
6.7
(a) A company makes a single product with a sale price of $ 10 and
a marginal cost of $ 6. Fixed costs are $ 60,000 p.a.
Calculate
(i) Number of units to break even
(ii) Sales at breakeven point
(iii) C/S ratio
(iv) What number of units will need to be sold achieve a profit
of $ 20,000 p.a.
(v) What level of sales will achieve a profit of $ 20,000 p.a
(vi) Because of increasing costs the marginal cost is expected
to rise to $ 6.50 per unit and fixed costs to $ 70,000 p.a. if the
selling price cannot be increased what will be the number
of units required to maintain a profit of $ 20,000 p.a?
(vii) If the taxation rate is 40% how many units will need to be
sold to make a profit of $ 20,000 p.a?
(b) The ratio of variable cost to sales is 70%. The breakeven point
occurs at 60% of the capacity sales. Find the capacity sales when
fixed costs are $ 90,000,000.
Also compute profit at 75% of the capacity sales.
(c) A company sells its product at $ 15,000 per unit. In a period, if

it poduces and sells 8,000 units, it incurs a loss of $ 5,000 per unit.
If the volume is raised to 20,000 units, it earns a profit of $ 4,000
per unit. Calculate breakeven point both in terms of value as well
as in units
219
6.8
Country Ltd currently makes and sales 7,000 units of their product each
year. Fixed costs are $ 18,000 p.a. the variable cost of sale is $ 8 per
unit and sales revenue $ 11 per unit. By changing the organization of
production it is thought that variable costs could be reduced by $ 0.20
per unit, although fixed costs would rise as a consequence by $1, 300
(a) How would the change affect

(i) budgeted profit
(ii) The breakeven point and margin of safety, assuming that
there would be no alteration in the sales prices or budgeted
sales demand for the product
(b) At what level of sales volume would the changeover be profitable?

Ignore the risk
6.9
ABC Ltd achieved the following results in the year just ended
$
Sales 60,000
Less variable cost of sales 30,000
Contribution 30,000
Less fixed costs 25,000
Profit 5,000
In planning for next year, the companys management estimates that

variables costs will rise by 8% per unit that fixed costs will raise by $
3,500 and that sales will be in the same mix as last year. If there is to be
no increase in unit sales prices, so that all extra revenue must be earned
by increases in sales volumes, what amount of sales would be needed
next year to earn a profit of $ 6,000
Problems
6.10
A company manufactures three products that use the same production
facilities. The budget for 2008 for the products is
220
Product XA Product XB Product XC Total

Sales units 1,000 500 2000
$000 $000 $000 $000
Sales 50,000 20,000 15,000 85,000
Materials 2,000 14,000 6,000 22, 000
Labour 4,000 1,000 1,000 6,000
Fixed overheads 24,000 6,000 6,000 36,000
Profits/(Loss) 20,0000 (1,000) 2,000 21,000
Required
(a) Should the company continue to produce product XB
(b) What is the breakeven point of the firm if the products are always
sold in the proportion of 10XA: 5XB: 2XC
(c) What would be effect of increasing the unit selling price of the
three product by 10% if the number of units sold would decrease
by 5%
6.11
BM Ltd manufactures three products which have the following revenue
and costs ($ per unit)
Product A Product B Product C

Selling price 2.92 1.35 2.83
Variable costs 1.61 0.72 0.96
Fixed costs:
Product-specific 0.49 0.32 0.62
General 0.46 0.46 0.46

Unit fixed costs are based upon the following annual sales and production
volumes (thousand units)
Product A Product B Product C

98.2 42.1 111.8
Required
(a) Calculate
(i) The break-even point sales (to the nearest $ hundred) of
BM Ltd based current product mix
(ii) The number of units of Product B (to the nearest hundred)
at the breakeven point determined in (i) above
(iii) Comment upon the viability of product B
221
6.12
COMPANY ABC Ltd manufactures and sells only one product. The
demand in 2008 is expected to be 30,000 units, although the factory has
the capacity to produce 48,000 units. A budget was prepared recently
and shows the follow
$ Per unit 30,000 units

Sales 140 $ 4,200,000
Material & other variable costs 70 $ 2,100,000
Fixed costs 60 $ 1,800,000
The budget showed an operating profit of $ 300,000. However, as

the capital employed is $ 4,000,000 the return is only 7.5%. The
management has generated three different proposals to improve the
firms profitability
Proposal 1: increase the selling price of the product, it is expected that if

selling price were reduced to $ 120 per unit, the sales would increase to
40,000 units
Proposal 2: reduce the variable costs of production. The purchase of

new machine will increase the capital employed by $ 1,000,000. This
will increase the depreciation charge by $ 200,000. The new machine
will reduce the variable costs to $ 60 per unit. The sales will remain
unchanged at 30,000 units and the selling price per unit will also remain
at $ 140 per unit
Proposal 3: increase the spending on promotional activities. If an

additional amount of $ 1,200,000 was spent on promoting the product
and selling price was increased to $ 150, it is expected that sales would
increase to 45,000 units
(b) What was the breakeven point of the company when the selling
price was set at $ 140 per unit?
(c) Evaluate each of the three proposals and suggest which should
be adopted by the management
(d) After it had been decided to implement proposal 3, there has

been an enquiry for a special export order of 2,000 units. What
is the minimum selling price that could be quoted for the export
order to increase the return on the companys capital employed
to 16 percent
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6.13
A company manufactures two products. The budget for next year shows
the following
Product TV Product DVD Total
Sales-units 150,000 100,000
$000 $000 $000
Sales 22,500 12,000 34,500
Variable costs 9,000 4,400 13,400
Fixed costs 7,500 4,000 11,500
Profit 6,000 3,600 9,600
The estimated fixed overhead costs for the year were $ 11, 500,000. It
was expected that 575,000 direct labour hours would be worked. This
means that overheads are apportioned to products, using a company-
wide rate of $ 20 per direct labour hour.
(a) Assess each of the following two alternatives courses of action

(i) Increase the selling price of both products by 10% per unit
but this is expected to reduce the demand by 8%
(ii) Improve the quality of both products. It is expected that

this would increase the units sold by 5% but would increase
the variable costs by $ 1 per unit. The selling price would
not be changed
(b) Calculate the breakeven point of the company if the products are
always sold in the ratio of 3TV: 2DVD
6.14
An automobile manufacturing company produces different models of
car. The budget in respect of model 118 for month of September 20X6 is
under
Budget output (units) 40,000

$ 000 $ 000
Net Realization 70,000
Variable costs
Materials 26,400
Labour 5,200
Direct expenses 12,400 44,000
Specific fixed costs 9,000

Allocated fixed costs 11,250 20,250
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Total costs 64,250
Profit 5,750
Sales 70,000
Calculate:
(i) Profit with 10 percent increase in selling price with a 10 percent
reduction in sales volume.
(ii) Volume to be achieved to maintain the original profit after a 10
percent rise in material cost at originally budgeted selling price
per unit
6.15
ABC Ltd manufactures pressure cookers the selling price of which is $
300 per unit. Currently the capacity utilization is 60% with a sale turnover
of $ 1,800,000. The company proposed to reduce the selling price by
20% but desires to maintain the same profit position by increasing the
output. Assuming that the increased output could be made and sold,
determine the level at which the company should operate to achieve the
desired objective.
The following further data are available

(i) Variable cost per unit $ 60
(ii) Semi-variable cost (including a variable element of $ 10 per unit)
$ 180,000
(iii) Fixed cost $ 300,000 will remain constant up to 80% level. Beyond
this an additional amount of $ 60,000 will be incurred
6.16
The variable cost structure of a product manufactured by a company
during the current year is under
$ per unit
Material 120
Labour 30
Overheads 12
The selling price per unit is $ 270 and the fixed cost and sales during the current
year are $ 1,400,000 and $ 4,050,000 respectively. During the forthcoming
year the direct workers will be entitled a wage increase of 10 percent from
the beginning of the year and the material cost, variable overhead and
fixed overhead are expected to increase by 7.5%. 5% and 3% respectively
The following are required to be computed

(a) New sale price in the forthcoming year if the current P/V ratio is
to be maintained
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(b) Number of units that would require to be sold during the
forthcoming year so as yield the same amount of profit in the
current year , assuming that selling price per unit will not be
increased
6.17
The ABC Co. has the following budget for the year 20X6-X7
$
Sales (100,000 units @ $ 20) 2,000,000
Variable cost (1,000,000)
Contribution 1,000,000
Fixed cost (400,000)
Net profit 600,000
From the above set of information find out
(a) The adjusted profit for 20X6-X7 if the following two sets of
changes are introduced and also suggest which plan should be
implemented.
(b) The P/V ratio and break-even points under the two plans referred
to above
Plan A Plan B
Increase in price 20% Decrease in price 20%
Decrease in volume 25% Increase in volume 10%
Increase in variable cost 10% Decrease in variable cost 10%
Increase in fixed cost 5% Decrease fixed cost 5%
6.18
XYZ Ltd. Engaged in the manufacture of four products, has prepared
the following budget for 20X6
PRODUCTS
A B C D
Production Units 20,000 5,000 25,000 15,000
Selling price $/unit 21.75 36.75 44.25 64.00
Direct Material $/unit 6.00 13.50 10.50 24.00
Direct wages $/unit 7.50 10.00 18.00 24.00
Variable overheads $/unit 2.25 5.00 6.00 6.50
Fixed overheads $ per annum 75,000 25,000 225.000 180,000
225
When the budget was discussed, it was proposed that the production
should be increased by 10,000 units for which capacity existed in 20X6.
It was also decided that for the next year, i.e, 20X7, the production
capacity should be further increased by 25,000 units over and above
the increase of 10,000 units envisaged as above for 20X6. The additional
production capacity of 25,000 units should be used for the manufacture
of product B for which new production facilities were to be created at
an annual fixed overheads cost of $ 35,000. The direct material costs of
the four products were expected to increase by 10% in 20X7 while the
other costs and selling prices would remain the same.
Required
(a) Find the profit of 20X6 on the assumption that the existing
capacity of 10,000 units is utilized to maximize the profit
(b) Prepare a statement of profit for 20X7
(c) Assuming that the increase in the output of Product B may not
fully materialize in the year 20X7, find the number of units of
Product B to be sold in 20X7 to earn the same overall profit as in
20X6

226
6.19
In the year 2004, Mr. Maganga was engaged as a consultant to
ABC Stores and prepared some analysis of its Cost-Volume-Profit
relationship. Among his findings was the profit volume ratio was 40%
at the companys planned selling price of $ 500.
The company expects to sells 8,000 units at the price of $ 500 per unit
which will results in an income of $ 4,000,000, with expected annual
fixed costs of $ 720,000. In his report to the managing Director Mr.
Maganga stressed the point that profits would change at the rate of 40
cents per $ changes.
The Managing Director afterwards called Mr. Maganga to tell him

that the results did not come out as he told him. During the year 2005,
the Company generated profits of $ 1,231,250 on the sales volume of $
4,646,250.
Despite the fact that variable cost per unit were incurred as expected,
the company had higher fixed costs than expected because of massive
advertising campaign which costed the Company $ 40,000 during the
year. The Company was coupled with an increase in selling price and
Managing Director was very pleased with the results.
However Mr. Maganga is asked to explain why profit did not increase
by 40% of the added sales volume of $ 646,250, but rather somewhat
more
Required
(a) Reconstruct the income statement for the year 2005 based on the
actual results
(b) Determine
(i) The number of units sold
(ii) The Selling price per unit
(c) Explain to Managing Director Why the results were at variance

with the planned results
6.20
Mawenzi Manufacturing Company has prepared a draft budget for
sales of 10,000 units for the next year as follows;
227
$ $
Sales price per unit 300
Variable costs per unit
Direct material 80
Direct labour (2 hours @ $ 30) 60
Variable overheads (2 hours @ $ 5) 10 150
Contribution per unit 150
Budgeted contribution 1,500,000
Less; Budgeted Fixed Costs 1,400,000
Budgeted profit 100,000
The Board of Directors of the company is dissatisfied with the proposed

budget and therefore asks you in your capacity as the Management
Accounting of the company, to come up with an alternative budget with
a higher profit figure.
After critically studying the market environment in which the industry

is operating in, and taking into consideration both the companys past
performance and its future performance projections, you came up with
some suggestions which will lead to an improved budgeted profit of $
250,000. You further ascertain that in order for the company to be able to
realize the improved budget profit, it will have incurred an additional
$ 285,000 on advertising and put the sale price up to $ 320 per unit. In
spite of the price increase, it is expected that sales volume would rise to
12,000 units
In order to achieve the extra production capacity, however the work

force must be able to reduce the time taken to make each unit of the
product. It is proposed to offer a pay and productivity deal in which
the wage rate per hour is increased to $ 40. The hourly rate for variable
overhead will be unaffected
Required;
Prepare a revised budget of Mawenzi Manufacturing Company giving
effect to the above suggestions
6.21
Gift Ltd manufactures a single product using a labour intensive
production process.
Its Quality control Dept. test the final product before it leaves the factory
and at present 200 of its pre inspection output is rejected and scrapped.
Scrap units have no value and cannot be reworked. Gift builds the costs
of scrapped units into the cost of good production.
228
A standard cost card for Gifts product under its current production
method is given
below
$ per unit
Direct material 3 kgs at $ 500 per kg 1,500
Direct labour 1,000
Variable overhead 500
Cost of pre-inspection per unit produced 3,000
Cost of rejects 750
Variable cost per good unit 3,750
Selling price per good unit 6,000
Total fixed overheads are budgeted at $ 14,850,000 per month. Gift

currently sells 9,000 units per month, negligible stocks are held. Two
proposal are being considered to reduce the reject rate
Proposal 1: to automate the process by hiring a machine for $ 12,000,000

per month.
This would lead to 50% reduction in labour cost per unit and the quality
of manufacturing process would improve so that reject rates would fall
to 5% of pre-inspection output.
Variable overhead and material cost per unit (pre-inspection) would be

unchanged.
Existing fixed overhead would be unchanged.
Proposal 2: To continue with the present labour intensive operation and

to introduce, a total quality management programme. The aim of this
programme would to be to reduce the reject rate to zero within the
coming year.
Required
(a) Calculate the breakeven point in good units per month for the
current manufacturing process
(b) Calculate the breakeven point in good units per month for the
automated process under proposal 1
(c) Calculate the output level in good units per month at which
proposal 1 and current manufacturing process would have the
same total cost. Comment briefly on your results
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6.22
ABC Ltds accountant is preparing a budget for sales and profitability
of one of the Companys products XA. He has available the following
data for last year
Sales $, 20,000,000
Variable costs 60 percent of sales
Fixed costs $ 70,000,000
He is worried that costs will rise next year, and the estimated of inflation
that he has prepared is based on a probabilistic approach as follows:
Average inflation rate Probability

Compared with previous year
4% 0.2
6% 0.5
8% 0.3
Inflation would affect all variable costs and all fixed costs, except
(a) depreciation, which will remain $ 15,000,000 pa and
(b) factory rental costs, which are fixed by lease at $ 15,000,000
His estimates of sales demand
(a) At current price Sales ($) Probability

Pessimistic 200,000,000 0.3
Most likely 220,000,000 0.4
Optimistic 260,000,000 0.3
(b) If sales prices go up by 5%

Pessimistic 190,000,000 0.5
Most likely 210,000,000 0.4
Optimistic 250,000,000 0.1
The decision whether or not to raise sales prices be made at the beginning
of the year to allow the company to issue its price lists to dealers
You are required to analyse the foregoing information in a way which

will assist management with its budgeting problem. In your analysis
you should
230
(a) Calculate for each price level
(i) The probability of at least break even
(ii) The probability of achieving a profit of at least $ 10,000,000
(iii) The probability of achieving a profit of at least $ 20,000,000
(b) Comment on the validity of the approach to uncertainty analysis

that you have used
6.23
(a) You are required, using the accountants conventional break-
even chart as model to explain how and why a break-even
chart drawn by an economist differ. Illustrative diagrams should
be adjacent to your answer within your answer sheet.
(b)
A summary of ABCs budgeted profit statement, a manufacturing
company for next financial year, when it expects to be operating
at 75 percent of capacity, is given below:
$ 000 $ 000
Sales (9,000 units at $ 32,000) 288,000
Less:
Direct materials 54,000
Direct wages 72,000
Production overhead- fixed 42,000
Production overhead- variable 18,000 186,000
Gross profit 102,000
Less: admin, selling and dist. Costs
Fixed 36,000
Varying with sales volume 27,000 63,000
Net profit 39,000
It has estimated that

(i) If the selling price per unit were reduced to $ 28,000, the increased
demand would utilize 90 percent of the companys capacity
without any additional advertising expenditure;
(ii) To attract sufficient demand to utilise full capacity would require

a 15 percent reduction in the current selling price and a $ 5,000,000
special advertising campaign
Required
(a) Calculate the breakeven point in units, based on the original budget
(b) Calculate the profits and breakeven points which would result
from each of the two alternatives and compare them with the
original budget.
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6.24
The following data is available concerning Mambo Poa Ltds single
product BM
Shs (per unit) Shs (per unit)
Selling price 50
Variable cost
Direct material 7
Direct labour 8
Variable overhead 5 20
Contribution 30
Fixed overhead 15
Profit 15

A total of 1,000 units of product BM are produced and sold each month
Required
(a) Draw the following breakeven charts and mark on each the
breakeven point, the margin of safety and the monthly profit.
(i) Basic breakeven chart
(ii) Contribution breakeven chart
(iii) Profit volume chart
(b) Discuss the usefulness of each chart from a point of view of

management decision-making
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Case studies
Case study 6.1: Lucent Still
Lucent Technologies, a manufacturer of routers and switching gear,
warned of a larger-than-expected loss for the third quarter.
Lucent management had expected the company to begin breaking even

by the end of the current fiscal year, but now estimates to break even
sometime in the next fiscal year which begins this September. The
company, which has suffered from a collapse in telecommunications
spending, has struggled through 12 consecutive quarters of losses. The
reason for the current quarters loss is that revenues are 18 percent less
($2.4 million) than they were in the second quarter. According to Frank
DAmelio, Lucents chief financial officer, the revenue shortfall is due to
spending cuts by North American wireless carriers and an unexpected
delay in a network contract. Lucent management is struggling to
reduce its break-even point which is currently $2.4 billion. O ne way to
accomplish that goal is through further job cuts. The number of employees
at Lucent was 106,000 at one time; now, that number is being slashed
to 35,000. The company may be forced to rethink its strategy of being
a wide-ranging equipment supplier. Because of consecutive quarterly
losses, the announcement of the current quarters expected loss, and
the extension of the break-even target date, Standard and Poors has
threatened to further downgrade the companys credit rating, which is
already at junk status at B-minus !
Source: Lucent Still
233
1. What is meant by the term break-even point? How is the break-
even point computed?
2. Lucent warned of an 18 percent drop in quarterly revenues.

What effect does this expected drop in revenues have on the
break-even point?
3. The lowered revenue forecast raises the risk of further job cuts at
Lucent. What effect will job cuts have on the break-even point?
4. Explain three ways Lucent could lower its break-even point
Case study 6.2: Flying Brand Ltd Annual Report 2004

Flying Brand is a company which delivers goods to customers. The
business began some years ago by flying flowers from the Channel
Islands to the UK mainland.
The Group has continued to drive profits forward with profit before
tax up by 24%, and profit before tax and before all exceptional items
up by 10%. The business is focused on profitable growth, and although
sales in 2003 showed a fall on 2002 of 3%, the temptation to chase
marginal customers was resisted, and a greater emphasis was placed on
increasing customer spend and improving operational efficiency. This
reflected in the contribution margin for the two main brands improving
to 35% compared to 32% in 2002. Overheads increased during the year
by 5%, slightly above inflation, as the marketing team was considerably
strengthened. Corporate overheads comprise the costs of the chief
executive, the finance director, the non-executive directors and the
legal, professional and other fees connected with the running of a
public company. By driving increasing volumes of orders through
our existing operations, we will see economies of scale and substantially
improved of fixed overhead
Source: Flying Brand Ltd Annual Report 2004
1. How did the company improve its contribution margin to fixed
overheads and profits?
2. What was the alternative strategy for improving contribution

margin which the company rejects?
234
CHAPTER 7
MEASURING OF RELEVANT COSTS
AND REVENUE
Chapter Objectives
The objective of this chapter is mainly focusing on an understanding of the
principles that should be used to identify relevant costs and revenues for
various types of decisions. Also the chapter will consider in more detail the
specific problems that arise in assessing the relevant costs of materials, labour
and overhead.
Learning Outcomes
be able to:
1. Explain the meaning of relevant costs and revenue
2. Differentiate relevant costs and irrelevant costs
3. Evaluate the importance of qualitative factors in decision
making
4. Identify the characteristics of relevant information
5. Evaluate the importance of relevant costs and revenue in
decision making
6. Examine the misconception of relevant costs
235
7.1 Introduction
Managers are charged with the responsibility of managing organizational
resources effectively and efficiently relative to the organizations goals
and objectives. Making decisions about the use of organizational
resources is a key process in which managers fulfil this responsibility.
Accounting and finance professionals contribute to the decision-making
process by providing expertise and information. Many decisions can
be made using incremental analysis. This chapter introduces the topic
of relevant costing, which focuses managerial attention on a decisions
relevant (or pertinent) facts.
Relevant costing techniques are applied in virtually all business decisions

in both short-term and long-term contexts. In general these decisions
require a consideration of costs and benefits that are mismatched in
time; that is, the cost is incurred currently but the benefit is derived in
future periods.
In making a choice among the alternatives available, managers must

consider all relevant costs and revenues associated with each alternative.
One of the most important concepts discussed in this chapter is the
relationship between time and relevance. As the decision time horizon
becomes shorter, fewer costs and revenues are relevant because only
a limited set of them are subject to change by short-term management
actions. Over the long term, virtually all costs can be influenced by
management actions. Regardless of whether the decision is short or
long term, all decision making requires
In the context of decision-making managers need information to assist

in making the correct choice between alternatives, for these purposes
and ensure that valuable management time is not wasted. Then, only
those costs affected by managements decision are important, these are
classified as relevant costs and include opportunity costs.
Therefore, whenever a financial decision is made, it is essential that the

relevant costs are considered, the costs and benefits must be evaluated
and the decision taken should maximize the benefits. Sometimes, it is
necessary to take non-financial factors into consideration.
Only those costs and benefits that differ in total between alternatives are
relevant in a decision making. If the cost will unchanged regardless of
the alternative chosen, then the decision has no effect on the cost and it
can be ignored. For instant, if the manager is trying to decide whether
to purchase the machine or to lease it, then the cost of fitting machine
236
in the company premises is irrelevant, whether the machine is bought
or leased, the cost of fitting the machine will be exactly the same and
therefore irrelevant in the decision of the manager about the machine.
On other hand, the cost of purchasing the machine and the cost of leasing
would be relevant in the decision, since they are avoidable costs.
7.2 Importance of qualitative factors in decision making

So far we have seen how cost and benefits which can be quantified can
be used to evaluate a particular course of action. However, we must
recognize that there may be certain factors which cannot be easily
expressed in financial terms but may nevertheless be important for a
particular decision. These factors must not be excluded from the decision
making process simply because they cannot be quantified. It is quite
possible for certain qualitative factors to assume greater importance
when evaluating possible courses of action than the quantitative
factors
Qualitative factors can have a significant impact on profitability of

the organization in the longer term. For example a firm may decide to
buy the product from outside supplier instead of making it internally;
by comparing the cost of external supplier is cheaper than making it
internally, without examining the qualitative factors. However this
decision may result in redundancies and conflict with workforce. It
may also make the business heavily dependent on outside supplier
for ensuring high quality, a prompt and reliable delivering service of
the product to the company. If the services prove unreliable customers
goodwill and future sales may be lost. Then the risks of such a policy
must therefore be weighted against any quantifiable cost saving which
may be achieved.
7.3 Characteristics of relevant information

What factors are relevant in making decisions and why? For information
to be relevant, it must possess three characteristics.
1. It must be associated with the decision under consideration,
2. It must be important to the decision maker, and
3. It must have a connection to or bearing on some future endeavour.
7.4 Relevant Cost and Its Association with Decision

Costs or revenues are relevant when they are logically related to a decision
and vary from one decision alternative to another. Cost accountants can
assist managers in determining which costs and revenues are relevant
to decisions at hand.
237
To be relevant, a cost or revenue item must be differential or incremental.
An incremental revenue is the amount of revenue that differs across
decision choices and incremental cost (differential cost) is the amount
of cost that varies across the decision choices. To the extent possible
and practical, relevant costing compares the incremental revenues and
incremental costs of alternative choices. Although incremental costs can
be variable or fixed, a general guideline is that most variable costs are
relevant and most fixed costs are not. The logic of this guideline is that as
sales or production volume changes, within the relevant range, variable
costs change, but fixed costs do not change. As with most generalizations,
some exceptions can occur in the decision-making process.
The difference between the incremental revenue and the incremental cost
of a particular alternative is the positive or negative incremental benefit
[incremental profit] of that course of action. Management can compare
the incremental benefits of alternatives to decide on the most profitable
(or least costly) alternative or set of alternatives. Such a comparison may
sound simple; it often is not. The concept of relevance is an inherently
individual determination and the quantity of information available to
make decisions is increasing. The challenge is to get information that
identifies relevant costs and benefits.
Some relevant factors, such as sales commissions or prime costs of

production, are easily identified and quantified because they are
integral parts of the accounting system. Other factors may be relevant
and quantifiable, but are not part of the accounting system. Such factors
cannot be overlooked simply because they may be more difficult to
obtain or may require the use of estimates. For instance, opportunity
costs represent the benefits foregone because one course of action is
chosen over another. These costs are extremely important in decision
making, but are not included in the accounting records.
7.5 Relevant costs and its Operating decisions

Operating decisions imply an understanding of costs. Among cost
distinctions, relevant costs is broadly used for operating decision.
Relevant costs are the future, incremental cash flows that result from a
decision. Relevant costs specifically do not include sunk costs, i.e. costs
that have been incurred in the past, as nothing we can do can change
those earlier decisions. Relevant costs are avoidable costs because, by
taking a particular decision, we can avoid the cost. Unavoidable costs
are not relevant because, irrespective of what our decision is, we will
still incur the cost. Relevant costs may, however, be opportunity costs.
An opportunity cost is not a cost that is paid out in cash. It is the loss
238
of a future cash flow that takes place as a result of making a particular
decision.
An avoidable cost is a cost that can be eliminated in whole or in part

by selecting one alternative over the other. By selecting the alternative
of purchasing the machine, the cost of leasing of the machine will be
avoided. By choosing leasing of the machine, the cost of purchasing the
machine will be avoided. Hence, the cost of purchasing the machine and
the cost of leasing the machine are both avoidable costs. The manager
continues to incur the fitting cost under either alternative. Therefore
avoidable costs are relevant and unavoidable costs are irrelevant.
The relevant costs which are particularly applicable for short-term

decisions making process and also when making long-term decisions
comprise of the followings;
The costs which should be used for decision making are often referred
to as relevant costs. CIMA defines relevant costs as costs appropriate
to aiding the making of specific management decisions.
To affect a decision a cost must be:

1. Future: Past costs are irrelevant, as we cannot affect them by
current decisions and they are common to all alternatives that we
may choose.
2. Incremental: Meaning, expenditure which will be incurred or

avoided as a result of making a decision. Any costs which would
be incurred whether or not the decision is made are not said to be
incremental to the decision.
3. Cash flow: Expenses such as depreciation are not cash flows and are
therefore not relevant. Similarly, the book value of existing
equipment is irrelevant, but the disposal value is relevant.
Incremental costs; both variable and fixed costs may change as result
of the decision. Both of these costs elements should be taken into
consideration. However, costs and benefits should be ignored if they
remain the same; regardless of which decision is made also these costs
can be known as differential costs. To identify the costs that are avoidable
(differential) in a particular decision situation and therefore relevant,
these steps can be followed:
Eliminates costs and benefits that do not differ between alternatives.

These irrelevant costs consist of (i) sunk costs (iii) future costs
that do not differ between alternatives
239
Use the remaining costs and benefits that do differ between
alternatives in making the decision. These costs that remain are
the incremental (differential) or avoidable costs
7.6 Importance of Opportunity cost to Decision Making

How do opportunity costs affect decision making? The need for specific
information depends on how important that information is relative to
the objectives that a manager wants to achieve. Moreover, if all other
factors are equal, more precise information is given greater weight in
the decision making process. However, if the information is extremely
important, but less precise, the manager must weigh importance against
precision.
Relevant costs may also be expressed as opportunity costs. An

opportunity cost is the benefit foregone by choosing one opportunity
instead of the next best alternative. This concept includes the cost of
what has been given up if another course of action is taken. It is benefit
foregone by choosing one option instead of the next best alternative.
For example if labour is diverted from one job to another, the relevant
costs is not the amount paid to the worker but the contribution lost if
the original product cannot be made. Alternatively, if a material can be
sold for much more than its cost price, then the current realizable value
should be used in deciding on the best course of action. The offer of free
seats in a theatre that is having difficulty filling the seats is an example
of an opportunity costs. The seats would have been empty and so the
opportunity cost is zero. The free or low-priced tickets are offered to
groups, who would probably not have attended the performance and so
the alternative would have been empty seats, generating no income
Example A company is considering publishing a limited edition book

bound in special leather. It has in stock the leather bought some years
ago for $1,000. To buy an equivalent quantity now would cost $2,000. The
company has no plans to use the leather for other purposes, although it
has considered the possibilities:
1. Of using it to cover desk furnishings, in replacement for other
material which could cost $900
2. Of selling it if a buyer could be found (the proceeds are unlikely
to exceed $800).
In calculating the likely profit from the proposed book before deciding
to go ahead with the project, the leather would not be costed at $1,000.
The cost was incurred in the past for some reason which is no longer
relevant. The leather exists and could be used on the book without
incurring any specific cost in doing so. In using the leather on the book,
240
however, the company will lose the opportunities of either disposing of
it for $800 or of using it to save an outlay of $900 on desk furnishings.
The better of these alternatives, from the point of view of benefiting from
the leather, is the latter. Lost opportunity cost of $900 will therefore be
included in the cost of the book for decision making purposes.
Other terms:
Common costs: Costs which will be identical for all alternatives are
irrelevant, e.g. rent or rates on a factory would be incurred whatever
products are produced.
Sunk costs: Another name for past costs, which are always irrelevant,
e.g. dedicated fixed assets, development costs already incurred.
Committed costs: A future cash outflow that will be incurred anyway,

whatever decision is taken now, e.g. contracts already entered into
which cannot be altered.
7.7 The assumptions in relevant costing

Some of the assumptions made in relevant costing are as follows:
1. Cost behaviour patterns are known, e.g. if a department closes
down, the attributable fixed cost savings would be known.
2. The amount of fixed costs, unit variable costs, sales price and
sales demand are known with certainty.
3. The objective of decision making in the short run is to maximize

satisfaction, which is often known as short-term profit.
4. The information on which a decision is based is complete and

reliable.
Let now to demonstrate how to implement relevant costs into a three

strategic operating decision: Make vs Buy, Equipment replacement, and
material requirement with simplified case example.
7.8 Relevant Costs - Make Versus Buy Decision

A concern with subcontracting or outsourcing has dominated business
in recent years as the cost of providing goods and services in-house
is increasingly compared to the cost of purchasing goods on the open
market. The make versus buy decision should be based on which
alternative is less costly on a relevant cost basis that is taking into account
only future, incremental cash flows.
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Illustration
The costs of in-house production of a computer processing service
that averages 10,000 transactions per month are calculated as $25,000
per month. This comprises $0.50 per transaction for stationery and $2
per transaction for labour. In addition, there is a $10,000 charge from
head office as the share of the depreciation charge for equipment. An
independent computer bureau has tendered a fixed price of $20,000 per
month.
Based on this information, stationery and labour costs are variable costs
that are both avoidable if processing is outsourced. The depreciation
charge is likely to be a fixed cost to the business irrespective of the
outsourcing decision. It is therefore unavoidable. The fixed outsourcing
cost will only be incurred if outsourcing takes place.
The relevant costs for each alternative can be compared as shown in

below table:
Relevant costs - make versus buy

Cost to make Cost to buy
Stationery 5,000
10,000 @ 0.50
Labour 20,000 10,000
10,000 @ 2
Share of depreciation costs 10,000 10,000
Outstanding cost 20,000
Total relevant cost 35,000 30,000
Note: The $10,000 share of depreciation costs is not relevant as it is

unavoidable.
The relevant costs for this decision are therefore those shown in the next
table:
Relevant costs - make versus buy, simplified

Relevant cost Relevant cost
to make to buy
Stationery 5,000
10,000 @ 0.50
Labour 20,000
10,000 @ 2
Outstanding cost 20,000
Total relevant cost 25,000 20,000
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Note: Based on relevant costs, there would be a $5,000 per month
saving by outsourcing the computer processing service.
7.9 Relevant Costs - Equipment Replacement

A further example of the use of relevant costs is in the decision to replace
plant and equipment. Once again, the concern is with future incremental
cash flows, not with historical or sunk costs or with non-cash expenses
such as depreciation.
Illustration
BM Hotel Company replaced its kitchen one year ago at a cost of
$120,000. The kitchen was to be depreciated over five years, although
it will still be operational after that time. The hotel manager wishes to
expand the dining facility and needs a larger kitchen with additional
capacity. A new kitchen will cost $150,000, but the kitchen equipment
supplier is prepared to offer $25,000 as a trade-in for the old kitchen.
The new kitchen will ensure that the dining facility earns additional
income of $25,000 for each of the next five years.
The existing kitchen incurs operating costs of $40,000 per year. Due to
labour saving technology, operating costs, even with additional dining,
will fall to $30,000 per year if the new kitchen is bought. These figures
are shown below:
Relevant costs - equipment replacement

Retain old Buy new
kitchen kitchen
Purchase price of new kitchen -150,000
Trade-in value of old machine +25,000
Operating costs
40,000 p.a. x 5years -200,000
30,000 p.a. x 5years - 150,000
Additional income from dinning of + 125,000
25,000 p.a x 5years
Total relevant cost - 200,000 - 150,000
On a relevant cost basis, the difference between retaining the old kitchen
and buying the new kitchen is a saving of $50,000 cash flow over five
years. On this basis, it makes sense to buy the new kitchen.
The original kitchen cost has been written down to $96,000 (cost of
$120,000 less one years depreciation at 20% or $24,000). The original
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capital cost is a sunk cost and is therefore irrelevant to a future decision.
The loss on sale of $71,000 ($96,000 written down value [minus] $25,000
trade-in) will affect the hotels reported profit, but it is not a future
incremental cash flow and is therefore irrelevant to the decision.
However, there is a tension between a decision based on future

incremental cash flows and the reported financial position that will
show a significant (non-cash) financial loss in the year in which the old
kitchen is written off.
7.10 Relevant Cost of Material Requirement

As the definition of relevant cost is the future incremental cash flow,
it follows that the relevant cost of direct materials is not the historical
(or sunk) cost but the replacement price of the materials. Therefore it is
irrelevant whether or not those materials are held in inventory, unless
such materials have only scrap value or an alternative use, in which case
the relevant cost is the opportunity cost of the forgone alternative. The
cost of using materials can be summarized as follows:
1. If the material is purchased specifically the relevant cost is the

purchase price.
2. If the material is already in stock and is used regularly, the

relevant cost is the replacement price.
3. If the material is already in stock but is surplus as a result of

previous overbuying, the relevant cost is the opportunity cost,
which may be its scrap value or its value in any alternative use.
Illustration
BM Ltd has been approached by a customer who wants to place a special
order and is willing to pay $16,000. The order requires the materials
shown below:
Material requirements
Original Scrap Current
Total kg Kg in
Material purchase value purchase
required stock
price per kg per kg price per kg
A 750 0 - - 6.00
B 1,000 600 3.50 2.50 5.00
C 500 400 3.00 2.50 4.00
D 300 500 4.00 6.00 9.00
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Notes:
1. Material A would have to be purchased specifically for this order
2. Material B is used regularly and any inventory used for this order
would have to be replaced.
3. Material C is surplus to requirements and has no alternative use.

Material D is also surplus to requirements but can be used as a
substitute for material E.
4. Material E, although not required for this order, is in regular use

and currently costs $8.00 per kg, but is not in stock.
The relevant material costs are shown below:
Relevant material costs

Material Relevant cost
A 750 @ 6 (replacement price) 4,500
B 1,000 @ 5 (replacement price) 5,000
C 400 @ 2.50 (opportunity cost of scrap value) 1,000
100 @ 4 (replacement price) 400
D 300 @ 6 (opportunity cost of scrap value) 1,800
or
300 @ 8 (substitute for material E) 2,400
Total relevant material cost 13,300
Proceeds of sale 16,000
Incremental gain 2,700
As a result of the above, BM Ltd would accept the special order because
the additional income exceeds the relevant cost of materials.
Please note:
1. In the case of A, the material is purchased at the current purchase
price.
2. For B, even though some inventory is held at a lower cost price, it

is used regularly and has to be replaced at the current purchase
price.
3. For C, the 400 kg in inventory have no other value than scrap,

which is the opportunity cost of using it in this order. The 100
kg of C not in inventory have to be purchased at the current
replacement price.
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4. For D, the opportunity cost is either the scrap value or the saving
made by using material D as a substitute for material E.
As the substitution value is higher, this is what BM Ltd would do in the

absence of this particular order. Therefore, the opportunity cost of D is
the loss of the ability to substitute for material E. Relevant costs are a
useful tool in helping to make operational decisions. However, there are
other approaches to costing that are also valuable.
Illustration
BM Ltd is trying to identify the relevant costs of material to be used on
a certain special order. The material required on the special order have
been identified as follows
1. Material A, which is not in store. If the special order is to be

undertaken, the 200 kg required would have to be bought at a
price of $ 200 per kg
2. Material B, which is not in store either. Material B is very rarely

used by the company. The process of ordering and obtaining
material B is long and tedious, but since the quantities required
are not large, the company has placed a firm order for the 20 kg
that would be needed, at $ 500 per kg.
3. Material D, which is in stock. It was specifically bought for

another order which was completed five years ago. The company
has been contemplating selling this material, and reckons that it
could obtain at $ 20 per kg of this material although the material
was bought at $ 160 a kg several years ago. 90 kg, slightly more
than half of the material in store is required for the order under
review
4. Material E which like Material D, is material left over from another

order, there are currently 200 kg in the store, having been bought
at $ 300 per kg. the whole quantity could be sold at $ 80 a kg or it
could be used as an alternative for an equal quantity of material
Q which is required on another, on-going order, or it could be
reserved for order under consideration. The current costs of
Material E and Material Q are $ 380 and $190 per kg respectively.
There is no material Q in store
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The relevant material costs of each item are shown below:
Material A
If the special order is to be undertaken the company would have to
incur ($ 200 x 200kg =$ 40,000. In the event of the company deciding
not to undertake this special order the incurrence of $ 40,000 would be
avoided, therefore $ 40,000 is the relevant cost of these materials
Material B
If the company has already placed a firm order, the cost of the materials,
($ 500 x 20kg= $ 10,000) cannot be altered by the decision not to undertake
the project, this amount is irrelevant. If as it would appear to be the case,
the materials have no alternative use and cannot be resold, the relevant
cost of the material is 0
Material D
The historical cost of $ 160 per kg is irrelevant. If the company uses 90
kg of this material, it will sacrifice the revenue of $ 20 per kg which it
could earn on their disposal. Hence the relevant cost of the material is
($ 20 x 90 kg = $ 1,800)
Material E
If the material are sold the company will earn $ 80 x 200 = $ 16,000, but
will have then to buy Material Q at $ 190 x 200= $ 38,000. The company
would rather use material E as a substitute for material Q, avoiding
a cash outflow of $ 38,000. If the materials are used on the proposed
order, this benefit will be lost. The relevant of the 200 kg of material is
$ 38,000.
7.11 Relevant Cost of labour

If labour is to be specifically recruited for the purpose of a project and its
cost can, therefore be avoided if the project is not undertaken, then the
labour cost is a relevant cost in the evaluation of the project. On the other
hand, if the company can undertake a project using its existing labour
force, and without having to pay any additional costs, then the relevant
cost of labour is nil. If the labour has alternative use, then the relevant
cost of labour can be established using an opportunity cost approach
7.12 Misconception of relevant costs

Information can be based on past or present data, but is relevant only if
it pertains to a future decision choice. All managerial decisions are made
to affect future events, so the information on which decisions are based
should reflect future conditions. The future may be the short run [two
hours from now or next month] or the long run [three years from now].
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Future costs are the only costs that can be avoided, and a longer time
horizon equates to more costs that are controllable, avoidable, and
relevant. Only information that has a bearing on future events is relevant
in decision making. But people too often forget this adage and try to
make decisions using inapplicable data. One common error is trying
to use a previously purchased assets acquisition cost or book value in
current decision making. This error reflects the misconception that sunk
costs are relevant costs.
7.13 Sunk Costs and decision making

What are sunk costs and why are they not relevant in making decisions?
Costs incurred in the past for the acquisition of an asset [or a resource]
are called sunk costs. They cannot be changed, no matter what future
course of action is taken because past expenditures are not recoverable,
regardless of current circumstances. After an asset or resource is
acquired, managers may find that it is no longer adequate for the
intended purposes, does not perform to expectations, is technologically
out of date, or is no longer marketable. A decision, typically involving
two alternatives, must then be made: keep or dispose of the old asset. In
making this decision, a current or future selling price may be obtained
for the old asset, but such a price is the result of current or future
conditions and does not recoup a historical cost. The historical cost is
not relevant to the decision.
These decisions provide an excellent introduction to the concept of

relevant information. The following illustration makes some simplistic
assumptions regarding asset acquisitions, but is used to demonstrate
why sunk costs are not relevant costs.
7.14 Sunk cost application technique example

Assume that BM Technologies purchases a statistical process control
system for $2,000,000 on January 6, 2010. This system [the original
system] is expected to have a useful life of five years and no salvage
value. Five days later, on January 11, Mr. Phillip Morgan, vice president
of production, notices an advertisement for a similar system for
$1,800,000. This new system also has an estimated life of five years
and no salvage value; its features will allow it to perform as well as
the original system, and in addition, it has analysis tools that will
save $50,000 per year in operating costs over the original system. On
investigation, Mr. Morgan discovers that the original system can be sold
for only $1,300,000. The data on the original and new statistical process
control systems are shown below.
BM Technologies has two options:
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use the original system; or
Sell the original system and buy the new system.
Below figure presents the costs Mr. Morgan should consider in making
his asset replacement decisionthat is, the relevant costs.
Original System New System

(Purchased Jan. 6) (Available Jan. 11)
Cost $2,000,000 $1,800,000
Life in years 5 5
Salvage value $0 $0
Current resale value $1,300,000 Not applicable
Annual operating cost $105,000 $55,000
As shown in the computations, the $2,000,000 purchase price of the

original system does not affect the decision process. This amount was
gone forever when the company bought the system. However, if the
company sells the original system, it will effectively reduce the net cash
outlay for the new system to $500,000 because it will generate $1,300,000
from selling the old system. Using either system, BM Technologies will
incur operating costs over the next five years, but it will spend $250,000
less using the new system ($50,000 savings per year x 5 years).
The common tendency is to include the $2,000,000 cost of the old

system in the analysis. However, this cost is not differential between the
decision alternatives. If BM Technologies keeps the original system, that
$2,000,000 will be deducted as depreciation expense over the systems
life. Alternatively, if the system is sold, the $2,000,000 will be charged
against the revenue realized from the sale of the system. Thus, the
$2,000,000 loss, or its equivalent in depreciation charges, is the same
in magnitude whether the company retains the original or disposes
of it and buys the new one. Since the amount is the same under both
alternatives, it is not relevant to the decision process.
Mr. Morgan must condition himself to make decisions given his set of
future alternatives. The relevant factors in deciding whether to purchase
the new system are:
Cost of the new system ($1,800,000),
Current resale value of the original system ($1,300,000); and
Annual savings of the new system ($50,000) and the number of
years (5) such savings would be enjoyed.
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Alternative (1): Use original system
Operating cost over life of original system
($105,000 x 5 years) $ 525,000
Alternative (2): Sell original system and buy new
Cost of new system $1,800,000
Resale value of original system (1,300,000)
Effective net outlay for new system $ 500,000
Operating cost over life of new system
($55,000 x 5 years) 275,000
Total cost of new system (775,000)
Benefit of keeping the old system $(250,000)
The alternative, incremental calculation follows:

Savings from operating the new system for 5 years $ 250,000
Less: Effective incremental outlay for new system (500,000)
Incremental advantage of keeping the old system (250,000)
This example demonstrates the difference between relevant and

irrelevant costs, including sunk costs.
Assessment Question
Mboga Products Ltd has been offered a contract which, if accepted would
significantly increase next years activity levels. The contract requires
20,000 kg of products X and specifies a contract price of $ 10,000 per kg.
The resources used in the production of each kg. of X include:
Labour Grade 1 2 hours

Labour- Grade 2 6 hours
Material A 2 units
Material B 1 litre
Grade 1 labour is highly skilled and although it is currently under-

utilized it is a company policy to continue to pay grade 1 labour in
full. Acceptance of the contract would reduce the idle time of grade 1
labour
Grade 2 labour is unskilled and may be considered a variable cost. The
costs to Mboga Product Ltd for each type of labour are:
Grade 1 $ 400 per hour

Grade 2 $ 200 per hour
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The materials required to fulfill the contract would be drawn from
materials already in stock. Material A is widely used within the company
and usage for this contract will necessitate replacement. Material B was
purchased to fulfill and expected order which was not received and if
not used on this contract it will be sold. The various values and costs for
Material A and Material B are:
Material A Material B
$ per unit $ per litre
Original cost 800 3,000
Replacement cost 1,000 3,200
Net realizable value 900 2,500
A single recovery rate for fixed factory overheads is used throughout

the firm. The overhead is recovered per productive labour hour. Initial
estimated of next years activity, which exclude the current contract,
show fixed production overheads to be $ 60,000,000 and productive
labour hours of 300,000. Acceptance of the contract would increase fixed
production overheads by$ 22,800,000. Variable production overheads
are estimated at $ 300 per production labour hour.
Acceptance of the contract would be expected to encroach on the sales

and production of another product, Y which is also made by Mboga
Products Ltd. It is estimated that sales of Y would then decrease by 5,000
units in the next year only. However, this forecast reduction in sales of
Y would enable attributable fixed factory overheads of $ 5,800,000 to be
avoided.
Price and costs information of Y is as follows
Per unit
Selling Price $ 7,000
Labour Grade 2 4 hours
Material- relevant $ 1,200
Variable costs $ 1,200
Required
Advise the management of Mboga Products the viability of the
contract
CACA P2 Management Accounting
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Summary
Management is charged with the responsibility of managing
organizational resources effectively and efficiently relative to the
organizations goals and objectives. Making decisions about the use of
organizational resources is a key process in which managers fulfill this
responsibility. Accounting and finance professionals contribute to the
decision-making process by providing expertise and information. Many
decisions can be made using relevant information.
In this chapter we have addressed and describe the principles involved

in determining the relevant cost of alternative courses of action. The
chapter has indicated that a particular cost can be relevant in one
scenario but irrelevant in another scenario. The important issue to bear
in mind is that relevant costs represent those future costs which change
as a result of a particular decision, while irrelevant costs are those that
will not be affected by that decision.

Book value
Committed costs
Common costs
Current purchase price
Incremental cash flow
Misconception of relevant cost
Net realizable value
Opportunity cost
Original purchase price
Relevant cost
Replacement cost
Scrap value
Sunk cost
Qualitative factors
252
Exercises
7.1
Define relevant costs. Why are historical costs irrelevant?
7.2
Describe two potential problems that should be avoided in relevant cost
analysis
7.3
Cost written off as depreciation on equipment already purchased is
always irrelevant. Do you agree? Explain?
7.4
Explain the importance of qualitative factors in decision making.
7.5
Distinguish between qualitative and quantitative factors in decision
making.
Problems
7.6
BM Ltd. manufactures sophisticated products used in the agriculture
industry. The company has been approached by a customer who wants
to buy 400 identical products at $200 per unit over the next 12 months.
The data in respect of the production of each individual unit is as
follows:
1. Direct material requirements:

3kg -direct material X1 - see note a)
2kg- direct material X2 -see note b)
10 litres A687 -see note c)
Notes:
a) Direct material X1 is used continually by BM for manufacturing
of a number of different products. There are currently 1,00kg in
stock at a carrying value of $4.70 per kg. The replacement value
of this direct material is $5.00 per kg.
b) There are 1,200 kg of X2 in stock. The original cost of this direct

material was $4.30 per kg. As this direct material has not been
used in the past two years, it has been written down to $1.50 per
kg, the currents crap value. The only other alternative use for X2
253
is to use it as a substitute for direct material P4 (currently used
to manufacture other products). This, however, requires X2 to
be further processed at a cost of $1.60 per kg. The current cost of
direct material P4 is $3.60 per kg.
c) Direct material A687 currently costs $5 per litre
2. Labour Requirements:
Each unit requires 2 hours of skilled labour and 2.5 hours of semi-
skilled labour. There is a permanently appointed skilled labourer, who
is paid $50 per hour, who has enough spare time available to supply the
skilled labour requirements for the contract. An additional semi-skilled
labourer will have to be hired to carry out the contract. Skilled labourers
can be hired at $45 per hour and semi-skilled labour at $25 per hour.
3. Overheads
BM recovers overheads at a machine hour rate of $25 per machine hour.
$7 of this is for variable costs that vary directly with the production of
the components and $18 is for fixed overheads. If the contract with the
client is accepted, the fixed overhead costs will increase by $3,200 for the
period of the contract. There is currently idle capacity available and the
production of each unit will require 4 machine hours.
Required:
Prepare a calculation that shows whether or not BM should accept the
new order
7.7
For decision marking it is claimed that the relevant cost to use in
opportunity cost. In practice, management accountants frequently
consider costs such as marginal costs imputed costs and differential
costs as the relevant costs.
You are required
(a) to explain the terms in italics and to give an example of each;
(b) to reconcile the apparent contradiction in the statement;
(c) to explain in what circumstances, if any, fixed costs may be
relevant for decision making.
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8.8
Mr. Pepe has recently developed a new improved music CD and shown
below is a summary of a report by a firm of management consultants on
the sales potential and production costs of the new CD.
Sales potential: The sales volume is difficult to predict and will vary
with the price, but it is reasonable to assume that a selling price of
$10,000 per CD, sales would be between 7,500 and 10,000 units per
month. Alternatively, if the selling price was reduced to $9,000 per CD,
sales would between 12,000 and 18,000 units per month.
Production costs: If production is maintained at or below 10,000 units

per month, then variable manufacturing costs would be approximately
$8,250 per CD and fixed costs $12,125,000 per month. However, if
production is planned to exceed 10,000 units per month, then variable
costs would be reduced to $7,750 per CD, but fixed costs would increase
to $16,125,000 per month.
Mr. Pepe has been charged $2,000,000 for the report by the management
consultants, and, in addition, he has incurred $3,000,000 development
costs on the new CD.
If Mr. Pepe decides to produce and sell the new CD, it would be necessary
for him to use factory premises, which he owns, but are leased to a
colleague for a rental of $400,000 per month. Also, he will have to resign
from his current post in a Ngoma cultural group where he is earning a
salary of $1,000,000 per month.
Required
(a) Identify in the question examples of:
(i) Opportunity costs
(ii) Sunk costs.
(b) Analyse the report from the consultants and advice Mr. Pepe on
the potential profitability of the alternatives shown in the report.
Note: Any assumptions considered necessary or matters which may

require further investigation or comment, should be clearly stated.

8.9
Zimglass Industries Ltd. has been approached by a customer who would
like a special job to be done for him, and is willing to pay $60,000 for it.
The job would require the following materials.
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Total Units Book value

Realizable Replacement
Material units already of units in
value $/unit cost $/unit
required in stock stock $/unit
A 1000 0 - - 16.00
B 1000 600 12.00 12.50 15.00
C 1000 700 13.00 12.50 14.00
D 200 200 14.00 16.00 19.00
(a) Material B is used regularly by Zimglass Industries Ltd, and if

units of B are required for this job, they would need to be replaced
to meet other production demands.
(b) Materials C and D are in stock due to previous over-buying, and

they have restricted use. No other use could be found for material
C, but the units of material D could be used in another job as
a substitute for 300 units of material E, which currently costs
$15 per unit (of which the company has no units in stock at the
moment).
Required
Calculate the relevant costs of material for deciding whether or not to
accept the contract. You must carefully and clearly explain the reasons
for your treatment of each material.
8.10
Sinza construction Ltd has been asked to submit a quote for an extension
of office block. The company is pleased to have this enquiry as a job
has been cancelled recently and there is now spare capacity and some
material in stock, which can be used in this enquiry. The details are as
follows;
Units Realizable Replacement

Units Book value
in value per cost per unit
Require per unit ($)
Stock Unit ($) ($)
MaterialXA 20,000 0 0 0 1,000
Material XB 10,000 16,000 2,000 1,800 2,100
Material XC 5,000 4,000 3,000 1,500 1,700
Material XD 2,500 2,000 4,000 5,200 5,500
Skilled labour unskilled labour

Labour required 3,000 hours 1,000 hours
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Notes available
1. Material XB is used regularly in most job that the company
undertakes
2. Material XC was purchased specifically for the cancelled job and

is not likely to be used in any job in the near future
3. Material XD was purchased for the cancelled job but could be

used as a replacement material that currently cost $ 6,000 per unit.
4. The skilled workers have at least 3,000 hours of spare capacity

over the next month, which is the same time that it will take to
build the extension block.
5. Unskilled labour can be hired daily at a rate of $ 5,000 per hour
6. Overhead costs are added to all jobs at rate of $ 7,000 per hour
worked. This includes both skilled and unskilled labour hours.
7 The plans and specifications for the cancelled job cost $ 3,000,000
and the modifications plans will incur a further $ 1,000,000
You are required to compute the minimum price that the company can
quote for this job without making a loss
8.12
BM Ltd. manufactures sophisticated products used in the agriculture
industry. The company has been approached by a customer who wants
to buy 400 identical products at $200 per unit over the next 12 months.
The data in respect of the production of each individual unit is as

follows:
1. Direct material requirements:

3kg -direct material X1 - see note a)
2kg- direct material X2 -see note b)
10 litres A687 -see note c)
Notes:
a) Direct material X1 is used continually by BM for manufacturing of
a number of different products. There are currently 1,00kg in stock
at a carrying value of $4.70 per kg. The replacement value of this
direct material is $5.00 per kg.
257
b) There are 1,200 kg of X2 in stock. The original cost of this direct
material was $4.30 per kg. As this direct material has not been used
in the past two years, it has been written down to $1.50 per kg, the
currents crap value. The only other alternative use for X2 is to use it
as a substitute for direct material P4 (currently used to manufacture
other products). This, however, requires X2 to be further processed
at a cost of $1.60 per kg. The current cost of direct material P4 is
$3.60 per kg.
c) Direct material A687 currently costs $5 per litre
2. Labour Requirements:
Each unit requires 2 hours of skilled labour and 2.5 hours of semi-
skilled labour. There is a permanently appointed skilled labourer, who
is paid $50 per hour, who has enough spare time available to supply the
skilled labour requirements for the contract. An additional semi-skilled
labourer will have to be hired to carry out the contract. Skilled labourers
can be hired at $45 per hour and semi-skilled labour at $25 per hour.
3. Overheads
BM recovers overheads at a machine hour rate of $25 per machine hour.
$7 of this is for variable costs that vary directly with the production of
the components and $18 is for fixed overheads. If the contract with the
client is accepted, the fixed overhead costs will increase by $3,200 for the
period of the contract. There is currently idle capacity available and the
production of each unit will require 4 machine hours.
Required:
Prepare a calculation that shows whether or not BM should accept the
new order
258
Case Studies
Case 7.1: Southampton plc
Southampton plc has been negotiating a contract with a potential
customer in Austria. Before the negotiations started the Austrian
company agreed to pay $10,000 in advance to cover the expenses of
Southampton. These expenses were to cover the costs of sending out
technical staff to Austria. This is the first export order the company has
received since 1988. Unfortunately the previous export orders were not
profitable and managers decided the best strategy was to concentrate
on business in the UK.
The sales department has prepared the following statement showing

that the contract will make a profit. It is normal for the sales department
to prepare cost estimates as they have a lot of experience of this type of
work.
Occasionally the management accountant will also be asked to

comment on the estimates prepared by the sales department. As this
order is different and may lead to a lot more business in the future the
senior managers asked the management accountant to comment on the
statement below.
Statement prepared by sales department

$
Sales - including deposit of $20,000 (see note 1) 250,000
Labour (see note 2) 85,000
Supervisor (see note 3) 15,000
Design overheads (see note 4) 2,000
Administrative charge (see note 5) 25,000
Materials (see note 6) 110,000
Depreciation on machinery (see note 7) 5,000
Profit 8,000
After her investigation the management accountant prepared a brief

report. The main points are summarized below.
Comments from management accountant
Note 1 The deposit will not have to be refunded
Note 2 The labour costs include $15,000 of costs for work that has
already been incurred. This is the cost of sending engineers
to Poland to help with the negotiations.
259
Note 3 This is 50% of the cost of a supervisor. It is estimated that
the supervisor will spend about half his time on the
contract. This cost does not include a $2,000 bonus for the
supervisor if the contract is completed on time.
Note 4 These costs have already been incurred.
Note 5 This charge is equal to 10% of sales. This is levied on all

contracts to cover general administrative costs.
Note 6 Materials
40,000kg of material X at $1.5 per kg = $60,000
20,000kg of material Y at $2.50 per kg = $50,000
Material X is used regularly by the company. There is

20,000kg in stock but the market price has just increased
to $2 per kg.
Material Y is never used by the company. There is 30,000kg
in stock that cost $2.50 per kg. To buy it today would cost
$4 per kg. An alternative choice for the company is to sell
it for scrap at $2.10 per kg.
Note 7 Depreciation has been calculated at $5,000. However

the management accountant discovers that this charge is
for a machine that is currently not used. The management
accountant has received an offer of $100,000 for the
machine now but if the project goes ahead it will only be
sold for $50,000 at the end of the project.
Additional information
The statement above does not include the cost of additional training if
the contract goes ahead. The cost of the training has been estimated at
$10,000.
Source: Southampton plc
1. Advise managers whether or not this contract is profitable. All
assumptions must be clearly stated.
2. Identify and evaluate any additional information that managers

need to consider before accepting or rejecting this contract.
260
Case study 7.2: Health Care Accounting Systems
Managed care and an increased emphasis on cost management have
created an urgent need among healthcare providers for relevant cost
information, but organizations lack the necessary tools to gather the
information.
That was one of the key findings in a recent survey conducted by IDG
Research. The respondents were 200 senior finance, operations, and
information services executives from hospitals, integrated delivery
networks, and clinics. The healthcare market has shifted from a
revenue focus to a cost focus, but organizations havent yet acquired the
tools needed for success in this new environment, Doug Williams, a
partner with Arthur Andersens healthcare business consulting practice,
explained.
Here are other key findings:

Cost management is the dominant force in todays healthcare
environment. It was cited by 95 percent of the respondents and ran far
ahead of revenue generation, resource availability, and integration of
multiple facilities. There is a lack of actionable information for decision
making. Eighty percent of the respondents want to measure costs over
the entire episode of care, but only 33 percent are confident about the
quality of their cost data, and only 26 percent said their data are timely
for decision making. Less than a third thought they even had data they
could use for decision making.
There is a dramatic lack of tools for bidding, administering, and

evaluating managed care contracts. When respondents were asked
about their ability to project revenue, costs, volume/utilization, and
profit projections when bidding managed care contracts, 84 percent
called the information necessary and valuable, yet only 48 percent were
confident about their revenue projection abilities, 31 percent about
costs, 26 percent about volume/ utilization, and 20 percent about profit
projection abilities.
Source: Kathy Williams, (1997) Cost Management Is Biggest Healthcare

Issue, Management Accounting
261
1. Describe the concept of relevant cost
2. Explain the importance of relevance cost information in decision
making to the organization like health care
3. Explain the importance of cost management in an organization
like health care
4. Explain why the healthcare market has shifted from a revenue
focus to a cost focus
262
Further Readings
Horngren, Charles T., Srikant M. Datar and George Foster (2003) Cost
accounting: a managerial emphasis. (Prentice Hall Publishing,) eleventh
edition (international)
Hopper, T., T. Koga and J. Goto Cost accounting in small and medium
sized Japanese companies: an exploratory study, Accounting & Business
Research
(Winter 1999) Vol. 30, Issue 1: 7387.
Mike O (2009): Relevant Costs for Decision Making
Verdaasdonk, P. and M. Wouters( 2001) A generic accounting model

to support Operations management decisions, Production Planning &
Control Vol. 12 Issue 6: 605 21.
263
CHAPTER 8
INFORMATION FOR DECISION MAKING
Chapter Objectives
The objective of the chapter is to consider the roles of financial information both
quantitative and qualitative in the process of management decisions making
and the chapter will mainly focus on short-term decision making based on
the environment of today and resources that are presently available to the
organization.
Learning Outcomes
be able to:
1. Identify relevant and irrelevant costs and benefits in a
decision situation
2. Differentiate Strategic and Tactical Decisions
3. Distinguish short run versus Long-run Decision-making
4. Describe the Decision Making Models
5. Determine the most profitable use of a constrained resource
and the value of obtaining more of the constrained resource
6. Prepare a make or buy analysis
7. Prepare an analysis showing whether a special order should
be accepted
8. Prepare an analysis showing whether a product line or other
business segment should be dropped or retained
9. Prepare an analysis showing whether to conduct extra shift
decisions
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8.1 Introduction
Decision making in an organization is one of the basic functions of a
manager. Decision making is often a difficult and complicated function
for the most of managers in the organization, this is due to the existence
of numerous alternatives criteria and massive amount of data, only some
of which may be relevant for a particular decision. Managers spend
most of their time in the organization to make decision. Managers are
constantly faced with problems of deciding;
what products to produce and sell

what production methods to use
what cost structure to employ
whether to make or buy the components parts
what marketing strategies and distribution channels to employ
what prices to charge and whether to accept special orders at
special prices
whether to drop product or replacement of equipment and so
forth
Hence every decision making is concern with the future and involves
a choice among alternatives. Many factors, both qualitative and
quantitative are needed to be considered and for many decisions
financial information is a critical factor. It is important that relevant
information on cost and revenues is supplied; the relevant information
is information about
(a) Future costs and revenues. It is expected future costs and revenues
that are important to the decision maker. This means that past
costs and revenues that are only useful in so far as they provide a
guide to the future. Cost already spent, known as sunk costs, are
irrelevant for decision making.
(b) Differential costs and revenues. Only those costs and revenues
which alter as a result of the decision are relevant, where factors
are common to all alternative being considered they can be
ignored; only the differences are relevant
Hence in management accounting, decision-making may be simply

defined as choosing a course of action from among alternatives. If there
are no alternatives, then no decision is required. A basis assumption
is that the best decision is the one that involves the most revenue or
the least amount of cost. The task of management with the help of the
management accountant is to find the best alternative.
265
The process of making decisions is generally considered to involve the
following steps:
1. Identify the various alternatives for a given type of decision.
2. Obtain the necessary data necessary to evaluate the various
alternatives.
3. Analyze and determine the consequences of each alternative.
4. Select the alternative that appears to best achieve the desired
goals or objectives.
5. Implement the chosen alternative.
6. At an appropriate time, evaluate the results of the decisions
against standards or other desired results.
From the descriptive model of the basic features and assumptions of the
management accounting perspective of business, it is easy to recognize
that decision-making is the focal point of management accounting. The
concept of decision-making is a complex subject with a vast amount
of management literature behind it. How businessmen make decisions
has been intensively studied. In management accounting, it is useful to
classify decisions as:
1. Strategic and tactical
2. Short run and long-run
8.2 Strategic and Tactical Decisions

In management accounting, the objective is not necessarily to make the
best decision but to make a good decision. Because of complex interacting
relationships, it is very difficult, even if possible, to determine the best
decision. Management decision-making is highly subjective.
Whether a decision is good or acceptable depends on the goals and

objectives of management. Consequently, a prerequisite to decision-
making is that management has set the organizations goals and
objectives. For example, management must decide strategic objectives
such as the companys product line, pricing strategy, quality of product,
willingness to assume risk, and profit objective.
In setting goals and objectives, it is useful to distinguish between

strategic and tactical decisions.
Strategic decisions are broad based, qualitative type of decisions which

include or reflect goals and objectives. Strategic decisions are non
quantitative in nature. Strategic decisions are based on the subjective
thinking of management concerning goals and objectives.
266
Tactical decisions are quantitative executable decisions which result
directly from the strategic decisions. The distinction between strategic
and tactical is important in management accounting because the
techniques of management accounting pertain primarily to tactical
decisions. Management accounting does not typically provide techniques
for assisting in making strategic decisions.
Once a strategic decision has been made, then a specific management

tool can be used to aid in making the tactical decision. For example, if
the strategic decision has been made to avoid stock outs, then a safety
stock model may be used to determine the desired level of inventory
The classification of decisions as strategic and tactical logically results in

thinking about decisions as qualitative and quantitative. In management
accounting, the approach to decision-making is basically quantitative.
Management accounting deals with those decisions that require
quantitative data. In a technical sense, management accounting consists
of mathematical techniques or decision models that assist management
in making quantitative type decisions.
8.3 Short run versus Long-run Decision-making

The decision-making process is complicated somewhat by the fact
that the horizon for making decisions may be for the short run or long
run. The choice between the short run and the long run is particularly
critical concerning the setting of profitability objectives. A fact of the
real business world is that not all companies pursue the same measures
of success. Profitability objectives which management might choose to
maximize include:
1. Net income
2. Sales
3. Return on total assets
4. Return on total equity
5. Earnings per share
The decision-making process is, consequently, affected by the

profitability objective and the choice of the long-run versus the short-
run. If the objective is to maximize sales, then the method of financing a
new plant is not immediately important.
However, if the objective is to maximize short run net income, then

management might decide to issue stock rather than bonds to avoid
interest expense. In the short run, profits might suffer from expenditures
for preventive maintenance or research and development. In the long
267
run, the companys profit might be greater because of preventive
maintenance or research and development.
Although the interests of management and the organization may be

presumed to coincide, the possibility of making decisions for the short
run may cause a conflict in interests. An individual manager planning
to make a career or job change might have a tendency to make decisions
that maximize profitability in the short run. The motivation for pursuing
short run profits may be to create a favorable resume.
The tools in management accounting such as C-V-P analysis, variance

analysis, budgeting, and incremental analysis are not designed to deal
with long range objectives and decision. The only tools that look forward
to more than one year are the capital budgeting models. Consequently,
the results obtained from using management accounting tools should
be interpreted as benefits for the short run, and not necessarily the long-
run. Hopefully, decisions which clearly benefit the short run will also
benefit the long run. Nevertheless, it is important for the management
accountant, as well as management, to beware of possible conflicts
between short run and long run planning and decision-making.
8.4 Decision Making Models

Decision-making becomes complex, when numerous alternatives are to
be evaluated. Another problem is that many decisions are non-recurring
in nature and cannot be resolved by relying on past experience with
similar situations. Decision- making involves following phases:
1. Selection of measurement criterion such as a minimum cost,

maximum profit or maximum rate of return. The criterion permits
a quantitative comparison of alternatives, in terms of goodness or
desirability.
2. Preparation of forecasts of uncontrollable factors and identification

of the restrictions or constraints, that affect controllable factors
3. Formulation of alternative courses of action and evaluation of each

alternative using the measurement criterion referred to 1 above.
To facilitate this, a decision model can be prepared to guide the
formulation and evaluation of alternatives. A formal decision
model is a symbolic or numerical representation of the variables
and parameters that affect a particular decision. Variables are
factors controlled by management and parameters are operating
constraints or limitations.
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8.6 Steps in Building a Decision Model
1. Define the parameters of the project.
2. Identify possible alternative courses of action and select a
measurement criterion.
3. Develop information for each alternative.
4. Construct incremental analysis of alternatives.
5. Prepare formal report to management.
8.7 Marginal Costing and Decision Making

Marginal costing was introduced in chapter three of this book and its
usefulness for short-term decision. In this chapter we identify and focus
on a number of decision situations where marginal costing techniques
are particularly useful.
Many different decisions are made within an organization and most

have financial implications. Each decision requires the relevant costs and
benefits to be considered and in many short-term decisions, the process
will be simplified by the use of the contribution margin approach.
When the managers are dealing with the short-term decisions making
the following points should be noted
1. These are decisions which seek to make the best use of existing
facilities.
2. In the short run, fixed costs remain unchanged so that the marginal
costs, revenues and contribution margin of each alternative is
relevant
3. In these circumstances the selection of the alternative which

maximizes contribution is the correct decision rule
8.8 Limiting factor analysis

Managers are often faced with a short-term lack of resources. This is a
factor which is a binding constraint upon the organization, the factor
which prevents indefinite expansion or unlimited profits. That is, any
factor which is in scarce supply and which stops the firm from expanding
its level of activities indefinitely. The limiting factor for many firms is
demand for their products because they cannot sell as much as they
would like. However, other factors may also be limited, especially if the
period is too short, that is in the short- run period. These other liming
factors may include; availability of finance, skilled labour, supplies of
raw materials, lack of space or machine hours.
269
Therefore, the production plan should be made by the management
taking consideration of this limiting factor; the efforts should be directed
for maximum utilization of available resources
There are two distinct limiting factor problems, for a business with more
than one product, in such a manufacturing environment:
1. How to maximize contribution when the availability of a key

resource is insufficient to satisfy sales demand. This problem is
solved by establishing the mix of products to manufacture and
sell in order to best utilize the limited resource available, based
on the contribution each product makes per unit of the scarce
resource (limiting factor).
2. How to maximize contribution when the availability of a key

resource is insufficient to satisfy sales demand but the resource
limitation can be overcome by buying in components/ products
from another manufacturer. This problem is solved by minimizing
the incremental costs incurred in buying in, based on the difference
in costs (bought-in versus in-house) per unit of the scarce resource
(limiting factor) required in manufacture.
8.9 Decisions involving a single limiting factor

If a firm is faced with only one limiting factor, such labour hours or
machine capacity, then the management must ensure that a production
plan is established which maximize the profit of the firm from the use of
the available resources. Assuming that the fixed costs are constant, and
then the management decision should be directed to the products or
projects, which shows highest contribution margin per unit per limiting
factor.
Therefore as there is more than one product that uses the scarce labour
resource, the approach to determining the optimal production plan is
as follows:
1. Identify the scarce resource (limiting factor).

2. Establish the units of the scarce resource used by each product.
3. Calculate the contribution (sales fewer variables costs) per unit of
each product.
Note: As stated earlier, it is assumed that the allocation of available

resources is a short-term decision with the objective of maximizing
total profit (also made clear in the question). As such, fixed
costs can be assumed to be unaffected by the product mix and
270
thus irrelevant to the decision (also made clear in the question
scenario). The decision is based on contribution.
4. Calculate the contribution of each product per unit of the scarce

resource consumed.
Note: It can only be by prioritizing the allocation of resources to those

products that make the most contribution for every unit of the
key resource consumed that total contribution, and thus total
profit, will be maximized.
5. Establish production priorities by ranking products according to

the contribution per unit of the scarce resource
6. Allocate the available scarce resource according to the ranking
Illustration of a single limiting factor

BM Company manufactures three products (X, Y and Z). All direct
operatives are the same grade and are paid at $11 per hour. It is
anticipated that there will be a shortage of direct operatives in the
following period, which will prevent the company from achieving the
following sales targets:
Product X 3,600 units

Product Y 8,000 units
Product Z 5,700 units
Selling prices and costs are shown in table below:

Product X Product Y Product Z
$ per unit $ per unit $ per unit
Selling prices 100.00 69.00 85.00
Variable costs:
Production* 51.60 35.00 42.40
Non-production 5.00 3.95 4.25
Fixed costs:
Production 27.20 19.80 21.00
Non-production 7.10 5.90 6.20
* includes the cost of direct operatives 24.20 16.50 17.60
The fixed costs per unit are based on achieving the sales targets. There
would not be any savings in fixed costs if production and sales are at a
lower level.
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Required:
Determine the production plan that would maximize profit in the
following period, if the available direct operatives hours total 26,400
1. Limiting factor
It is already clear from the question that the shortage of direct operatives
is the limiting factor, ie the shortage will prevent the company from
achieving the sales targets. To prove the fact (because such calculations
may be required in answer to other such questions), and to provide
some of the figures that will be used in subsequent stages below, the
total direct operative hours required to achieve the sales targets are:
Product X $24.20/unit $11/hr = 2.2 hrs per unit 3,600 units = 7,920 hrs
Product Y $16.50/unit $11/hr = 1.5 hrs per unit 8,000 units = 12,000 hrs
Product Z $17.60/unit $11/hr = 1.6 hrs per unit 5,700 units = 9,120 hrs
29,040 hrs
Direct labour hours available are 2,640 less (26,400 - 29,040) than those required
to achieve the sales targets.
2. Units of the scarce resource used by each product

The amount of the scarce resource (in hrs) used by each product was
calculated in stage 1 above (2.2, 1.5 and 1.6 hours per unit for Products X,
Y and Z respectively). Alternatively, the amount of the scarce resource
used by each product expressed in $, which was given in the question
(ie $24.20, $16.50 and $17.60 for Products X, Y and Z respectively) could
be used.
3. Contribution per unit of product Contribution is sales revenue less variable

costs (both production and non-production). Thus:
Product X $100.00 - $56.60 (51.60 + 5.00) = $43.40 per unit

Product Y $69.00 - $38.95 (35.00 + 3.95) = $30.05 per unit
Product Z $85.00 - $46.65 (42.40 + 4.25) = $38.35 per unit
4. Contribution per unit of scarce resource

The contribution per unit of scarce resource can be calculated either as
a $ contribution per hour of direct operative time or as a $ contribution
per $ cost of direct operatives. Thus:
Product X $43.40/unit 2.2 hrs/unit =$19.73 per direct operative hour

Product Y $30.05/unit 1.5 hrs/unit =$20.03 per direct operative hour
Product Z $38.35/unit 1.6 hrs/unit =$23.97 per direct operative hour
or
272
Product X $43.40/unit $24.20/unit =$1.793 per $ cost of direct operatives
Product Y $30.05/unit $16.50/unit = $1.821 per $ cost of direct operatives
Product Z $38.35/unit $17.60/unit = $2.179 per $ cost of direct operatives
5. Production priority
On the basis of the contribution per unit of the scarce resource, Product
Z would be manufactured as the first priority ($23.97/hr or $2.179/$
cost), followed by Product Y ($20.03/hr or $1.821/$ cost) and finally
Product X ($19.73/hr or $1.793/$ cost).
The same conclusion would be reached whichever of the calculations

in stage 4 was used because the basis is the same. The contribution
per $ cost of the direct operatives multiplied by the hourly rate of pay
will equal the contribution per direct operative hour. For example, for
Product X $1.793 per $ cost $11 per hour = $19.73 per hour.
It should be noted that the priority, in this example, is quite different

from that indicated by using (incorrectly) the contribution per unit of
product. This would have indicated priority of Product X ($43.40/unit),
followed by Product Z ($38.35/unit) and finally Product Y ($30.05/unit).
Although Product X has the highest contribution per unit, it requires
disproportionately more direct operative hours to achieve it.
6. Allocate the scarce resource

The scarce resource of direct operative hours needs to be allocated
according to the production priority established in stage 5 above.
Product Z has first priority and so the direct operative hours will be
allocated up to the limit required to achieve the sales target of 5,700
units. This was calculated in stage 1 to be 9,120 hours. The next priority
is Product Y. The allocation of the 26,400 hours available can be set out
as follows:
Product Z 9,120 hours 5,700 units

Product Y 12,000 hours 8,000 units
21,120 hours
Product X 5,280 hours 2,400 units
(26,400 - 21,120) (5,280 hours 2.2 hours /unit)
It can be seen that demand for Products Z and Y can be fully satisfied
leaving the balance of labour hours available to be used for Product X.
Product X is restricted to 2,400 units with the remaining hours. This

is the production plan that would maximize total contribution and
273
total profit because it gives priority to those products that generate the
greatest contribution per unit of the scarce resource.
8.10 Make or Buy Decision

Management sometimes is faced with the decisions, whether to make
or to buy the components. Therefore, the decisions on whether to make
the components or provide the services within the company or to buy
them from external suppliers are known as make or buy (outsourcing)
decisions. There are has been much greater interest in outsourcing in
recent years, firms are focusing on their core competencies and this
means that Make or Buy decisions must be taken before any change
in policy is adopted, for example many airlines buy food from hotels
rather than own catering facilities of their own. Now Tanzania many
organizations outsource some of their activities.
Therefore make-or-buy decision is the act of making a strategic choice

between producing an item internally (in-house) or buying it externally
(from an outside supplier). The buy side of the decision also is referred
to as outsourcing. Make-or-buy decisions usually arise when a firm that
has developed a product or partor significantly modified a product
or partis having trouble with current suppliers, or has diminishing
capacity or changing demand.
Make-or-buy analysis is conducted at the strategic and operational

level. Obviously, the strategic level is the more long-range of the two.
Variables considered at the strategic level include analysis of the future,
as well as the current environment. Issues like government regulation,
competing firms, and market trends all have a strategic impact on the
make-or-buy decision. Of course, firms should make items that reinforce
or are in-line with their core competencies. These are areas in which the
firm is strongest and which give the firm a competitive advantage.
The increased existence of firms that utilize the concept of lean

manufacturing has prompted an increase in outsourcing. Manufacturers
are tending to purchase subassemblies rather than piece parts, and are
outsourcing activities ranging from logistics to administrative services.
In their 2003 book World Class Supply Management, Burt at el Starling
presents a rule of thumb for out-sourcing. It prescribes that a firm
outsource all items that do not fit one of the following three categories:
1. The item is critical to the success of the product, including
customer perception of important product attributes;
2. The item requires specialized design and manufacturing skills
274
or equipment, and the number of capable and reliable suppliers
is extremely limited; and
3. The item fits well within the firms core competencies, or within
those the firm must develop to fulfill future plans. Items that fit
under one of these three categories are considered strategic in
nature and should be produced internally if at all possible.
Make-or-buy decisions also occur at the operational level. Analysis in

separate texts by Burt, Dobler, and Starling, as well as Joel Wisner, G.
Keong Leong, and Keah-Choon Tan, suggest these considerations that
favor making a part in-house:
a) Cost considerations (less expensive to make the part)

b) Desire to integrate plant operations
c) Productive use of excess plant capacity to help absorb fixed
overhead (using existing idle capacity)
d) Need to exert direct control over production and/or quality
e) Better quality control
f) Design secrecy is required to protect proprietary technology
g) Unreliable suppliers
h) No competent suppliers
i) Desire to maintain a stable workforce (in periods of declining sales)
j) Quantity too small to interest a supplier
k) Control of lead time, transportation, and warehousing costs
l) Greater assurance of continual supply
m) Provision of a second source
n) Political, social or environmental reasons (union pressure)
o) Emotion (e.g., pride)
Factors that may influence firms to buy a part externally include:

a) Lack of expertise
b) Suppliers research and specialized know-how exceeds that of
the buyer
c) cost considerations (less expensive to buy the item)
d) Small-volume requirements
e) Limited production facilities or insufficient capacity
f) Desire to maintain a multiple-source policy
g) Indirect managerial control considerations
h) Procurement and inventory considerations
i) Brand preference
j) Item not essential to the firms strategy
275
The two most important factors to consider in a make-or-buy decision
are cost and the availability of production capacity. Burt, Dobler, and
Starling warn that no other factor is subject to more varied interpretation
and to greater misunderstanding Cost considerations should include
all relevant costs and be long-term in nature. Obviously, the buying firm
will compare production and purchase costs. Burt, Dobler, and Starling
provide the major elements included in this comparison. Elements of
the make analysis include:
a) Incremental inventory-carrying costs
b) Direct labour costs
c) Incremental factory overhead costs
d) Delivered purchased material costs
e) Incremental managerial costs
f) Any follow-on costs stemming from quality and related problems
g) Incremental purchasing costs
h) Incremental capital costs
Cost considerations for the buy analysis include:

a) Purchase price of the part
b) Transportation costs
c) Receiving and inspection costs
d) Incremental purchasing costs
e) Any follow-on costs related to quality or service
One will note that six of the costs to consider are incremental. By
definition, incremental costs would not be incurred if the part were
purchased from an outside source. If a firm does not currently have
the capacity to make the part, incremental costs will include variable
costs plus the full portion of fixed overhead allocable to the parts
manufacture. If the firm has excess capacity that can be used to produce
the part in question, only the variable overhead caused by production
of the parts are considered incremental. That is, fixed costs, under
conditions of sufficient idle capacity, are not incremental and should
not be considered as part of the cost to make the part
Therefore, the strategic aspects of the make or buy decision that is,
deciding whether to make a product or pay another organization to
make that product, the relevant costs of making and buying options
will be as follows;
the variable costs of production and fixed costs that would have
been saved if the outside supplier had been used, this will be the
relevant costs for make option
276
the price paid to the outside supplier will be the relevant costs of
the buying option
hence the decisions, whether to buy or make will be made by comparing

the above two relevant costs, the buying option will be made if the
price paid to the outside supplier is cheaper than the variable costs of
production and fixed costs that would have been saved if the outside
supplier had been used and the making option will be possible if the
price paid to the outside supplier is higher than the variable costs of
production and fixed costs that would have been saved if the outside
supplier had been used. However for those components which do not
have and external source of suppliers then the organization must make
the components
8.11 Application of Marginal Costing Make or Buy Decision

Marginal costing can be applied in the area of fixation of selling price.
The next important area is whether to make or buy decision. When
a company has unused capacity and wants to manufacture some
components, it has two alternatives:
1. To make within the organization or

2. To buy from the market
Often, firms face the question whether to outsource production of a

component or continue to make it in the factory. Comparison of the
relevant costs of both the alternatives in such cases will show whether to
continue the existing arrangement or change to buying it, discontinuing
the current production. The answer depends upon whether the firm has
the option to use the freed capacity, profitably, or not.
The decision to buy, discontinuing present production, depends on

whether the capacity that is released by the non-manufacture of the
component can be profitably utilized, elsewhere, or not.
(i) Role of Fixed Costs:

What is sunk cannot be retrieved in the same condition. Fixed costs
cannot be reversed, without loss. Machinery purchased, already, cannot
be sold, without loss, in terms of money. Fixed costs that are incurred
are not relevant for our decision-making. Costs that will be incurred, in
any event, should not be considered in the decision-making. In other
words, the existing fixed costs, which cannot be saved, do not influence
the decision as those costs are already incurred and cannot be reversed,
whether the firms makes or buys.
277
(ii) Decision-making between purchase and continuation of production:
Decision depends on whether the machinery that is freed would remain
idle or can be utilized profitably, elsewhere.
Machinery turns idle: Let us consider the first situation. If the machinery
remains idle, existing fixed costs related to that machinery is not to be
considered for decision-making. Compare variable costs only with the
market price of the material. If we stop making the component in the
factory and buy it from the market, what we can save is only future
variable costs, but not the fixed costs, already incurred. The firm would
continue to incur costs on the idle machine. In other words, we consider
those costs that can be saved or avoided.
Put the question, what costs are saved? Compare the saved costs
with the corresponding market price for decision-making to buy or
continue to produce. Costs that can be saved are only Variable Costs.
So, compare variable costs with market price for decision making, when
the machinery turns to be idle.
Machinery would be utilized profitably, elsewhere: The second situation

is that the existing machinery can be utilized, elsewhere, profitably.
Where the capacity freed can be utilized in an alternative When the
machine is not idle and can be profitably utilized, elsewhere, compare
total costs saved, both variable and fixed costs, with the market price
for decision making profitable way, the fixed costs can be considered
as saved. As the machinery is utilized in a profitable way, the existing
component does not bear the burden of fixed costs, as the machinery is
not utilized in producing that component and not remaining idle too.
In such an event, costs saved are both variable costs and fixed costs. So,
comparison is to be made between the aggregate costs saved with the
corresponding market price.
If saved costs are more than the market price, buying is cheaper rather
than producing.
Produce, if market price is more than saved costs.
Illustration No. 1
BM Ltd. is producing a part at a cost of $.11 per unit. The composition
of the cost is as follows:

278
($.)
Materials 3.00
Wages 4.00
OverheadsVariable 2.50
- Fixed 1.50
11.00
Presently, the firm has been incurring a total fixed cost of $.15, 000 for
manufacturing the current production of 10,000 units. An outsider is
offering the same component, in all aspects identical in features, for $.10
per unit. On enquiry, it is found from the firm that the machine that is
manufacturing the parts would remain idle as the machinery cannot be
utilized elsewhere.
a) Should the offer be accepted?

b) Would your answer would be different, if the outside firm reduces
the price to $. 9 after negotiation. What is the impact of the fixed
costs in the decision-making process?
Solution:
The variable cost of the product is as under:
($.)
Materials 3.00
Wages 4.00
OverheadsVariable 2.50
Total Variable Cost 9.50
a. Here, the additional costs (variable costs) for making are $. 9.50.
The outside market price is $. 10. The outside offer is on a higher
side by $. 0.50 per unit, so the offer is to be rejected. For every unit
bought outside, it results in a loss of $. 0.50 per unit.
b. Now, the outside firm is willing to reduce the price to $. 9, while

the variable cost is $ 9.50. The offer is to be accepted.
So far as the fixed costs $15,000 is concerned, the firm would incur,
whether the firm makes the product itself or buys it outside. In other
words, the existing fixed costs are not to be considered, while taking a
decision.
Illustration No. 2
BT and Co. manufactures automobile accessories and parts. The
following are the total processing costs for each unit.
279
($.)
Direct material cost 5,000
Direct labour cost 8,000
Variable factory overhead 6,000
Fixed cost 50,000
The same units are available in the local market. The purchase price of
the component is $ 22,000 per unit. The fixed overhead would continue to
be incurred even when the component is bought from outside, although
there would be reduction to the extent of $ 2,000 per unit. However, this
reduction does not occur, if the machinery is rented out.
Required:
a. Should the part be made or bought, considering that the present
capacity when released would remain idle?
b. In case, the released capacity can be rented out to another
manufacturer for $. 4,500 per unit, what should be the decision?
Solution
A: The present capacity when released would be remaining idle:
Statement showing the cost to make or buy

Cost element per unit Make ($) Buy ($)
Direct material 5,000
Direct labour 8,000
Variable production overhead 6,000
Purchase price 22,000
Reduction in fixed cost per unit 2,000
Total 19,000 20,000
Since the cost to make is less than the price to buy, it is desirable to
manufacture the component as the idle capacity is not, alternatively,
used.
B: Statement showing costs of two alternatives, when released

capacity is rented out
Statement showing the cost to make or buy
280
Cost element per unit Make ($) Buy ($)

Direct material 5,000
Direct labour 8,000
Variable production overhead 6,000
Purchase price 22,000
Related from alternative use per unit (4,500)
Total 19,000 17,500
In the above situation, the decision is in favour of buying from outside.
Illustration No. 3
BC Co. A radio manufacturing company finds that the existing cost of
a component, Z 200, is $. 6.25. The same component is available in the
market at $ 5.75 each, with an assurance of continued supply.
The breakup of the existing cost of the component is:
$.
Materials 2.75 each
Labour 1.75 each
Other Variables 0.50 each
Depreciation and other Fixed Cost 1.25 each
6.25 each
(a) Should the company make or buy? Present the case, when the firm
cannot utilize the capacity elsewhere, profitably, and when the
capacity can be utilized, profitably.
(b) What would be your decision, if the supplier has offered the
component at $. 4.50 each?
Solution:
(a) The decision to make or buy will be influenced by the fact whether
the capacity to be released, by not manufacture of the component,
can be utilized profitably, elsewhere, or not.
If the capacity would be idle:

Fixed costs are sunk costs. These fixed costs cannot be saved, as the
capacity cannot be utilized in an alternative way, profitably. Even if the
product is purchased, still the firm has to incur fixed costs.
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Variable costs per unit, ignoring fixed costs are:
$
Materials 2.75
Labour 1.75
Other variables 0.50
Total 5.00
By incurring $ 5, component, Z 200 can be manufactured by the firm,

while it is available in the market at $. 5.75 each. So, it is desirable for
the firm to make.
If the capacity would not be idle:

Capacity that is released would be utilized elsewhere, profitably. So,
the costs that can be avoided by buying are both variable costs as well
as fixed costs.
So, the total costs assume the character of variable costs. Costs that can
be saved are
$.
Materials 2.75 each
Labour 1.75 each
Other Variables 0.50 each
Depreciation and other Fixed Cost 1.25 each
Total 6.25
$ 0.50 per unit, so, if the capacity would not be idle, it is better to buy
rather than making.
(b) The marginal cost of the product (only variable expenses) is $.5. If
the price offered is $ 4.50 per unit, then the offer can be accepted as
there will be saving of $ 0.50 per unit, even if the capacity released
cannot be, profitably, employed. This is so because the price offered
is less than the marginal cost of the product.
Illustration No. 4
Cost of a component X and its market price are as under:
Direct Material $ 400
Direct Labour $ 200
Prime Costs $600
Overhead Cost $ 200 (Fixed $. 150 and Variable $ 50)
Total Cost $ 800
Market Price $ 700
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The firm is planning to discontinue the production of component X
and intends to manufacture component Y as current market price of
X is high. Advise the firm about the production if
(i) Capacity of the plant would remain idle, if X is not manufactured

and
(ii) Capacity of the plant, that would be freed, can be utilized profitably,
in making component Y. Advise for any other considerations.
Solution:
(i) Case when the capacity would remain idle:

The total cost is $ 800, while its market price is $ 700. Prima facie, it
looks it is cheap to buy rather than making the component.
However, analysis shows the correct picture is not so. Fixed costs are
sunk costs as they are already incurred and cannot be saved, in the short
run. In other words, firm would continue to incur fixed costs, whether
the firm makes the component or buys it from the market. Firm cannot
utilize the capacity that would be freed, elsewhere, and so remains
idle. Hence, fixed costs are permanent costs that cannot be saved, if not
utilized, elsewhere.
So, a real comparison is between the total costs ($ 800) and aggregate
of market price ($700) along with the fixed costs ($ 150) that cannot be
saved. The aggregate is $850. It is not wise to buy at $ 850, which can be
made at $ 800. So, it is desirable for the firm to continue to make.
There is another way to explain. Compare variable costs ($. 650) with
market price ($700). It is, now, Marginal Costing. Even in this type
comparison too, it is desirable for the firm to continue to make.
(ii) Case when the capacity can be utilized, elsewhere:

Here, the capacity can be utilized, profitably, elsewhere. In other words,
the existing fixed costs would be recovered by making component Y.
In other words, these fixed costs component of Rs. 150 also can be saved
if component X is not manufactured. So, total savings are:
Direct Material $ 400

Direct labour $ 200
Prime cost $ 600
Variable Overhead Cost $ 50
Fixed Cost $150
Total Cost $ 800
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Total costs that can be saved are $ 800. The market price is $ 700. So, it is
desirable to buy at $ 700 instead of incurring $ 800.
Other Consideration: Further, irregularity of supplies from the outside

source should also be taken into account, which is an important issue to
be considered, before a final decision. In case, the supplies from outside
are assured, the firm should go for purchase from outside agency.
When capacity can be alternatively utilized, even the fixed costs become
variable costs. Total costs that can be saved are to be compared with
the market price for deciding, whether to manufacture or buy the
component.
8.12 Application of Marginal Costing, in case of Additional Fixed Costs

We have dealt with cases, all along, when there is unutilized capacity,
with no increase in fixed costs. There may be cases when, the existing
infrastructure is not utilized, totally. For example, the present factory
shed may have some space remaining unutilized. With some incremental
additional machinery, firm may be getting opportunities to replace the
components, presently purchased, by making within the factory. In such
an event, the question is whether the firm should go for making or not.
It becomes essential to find out the minimum requirement of volume
that is guaranteed, in future, to justify making, instead of purchasing.
This volume can be calculated by the following formula:
Increase in Fixed Costs

Contribution per Unit (Market Price Additional Variable Cost of Production)
The following illustration would explain the above better.
Illustration No. 5
GM & Co purchases 20,000 units of a spare part from an outside source
@ $ 3.50 per unit. There is a proposal that the spare be produced in the
factory itself. For the purpose, an additional machine costing $50,000,
with a capacity of 30,000 units and a life of 5 years, will be required.
A foreman with a monthly salary of $ 2,000 p.m. will have to be engaged.

Materials required will be $ 0.60 per unit and wages $ 0.45 per unit.
Variable overheads are 150% of labour and fixed expenses are recovered
@ 200% of wages. Existing fixed costs of the firm are $ 10,000. The firm
can raise funds @ 18% p.a.
Advise the firm whether the proposal should be accepted.

284
Solution:
The decision should be based on the comparison of the price being paid
at present and the additional costs to be incurred, if manufacture is
undertaken. This comparison is made below:
$
(i) Price being paid at present (20,000 3.50) 70,000
(ii) Cost to be incurred if manufacture is undertaken:

Materials @ $ 0.60 12,000
Labour @ $ 0.45 9,000
Variable overheads 150% of labour 13,500
Additional foremans salary 24,000
Depreciation (50,000/ 5) 10,000
Interest (18% on $. 50,000) 9,000
77,500
The cost of making 20,000 units will be higher than the price being paid
at present. Hence, the proposal is not acceptable.
Notes:
i. Though the capacity of the equipment is 30,000 units, capacity
to the extent of 20,000 is utilized. Full depreciation is to be
considered as cost as non-utilization of balance capacity does not
result into any saving in depreciation.
ii. Existing fixed costs of the firm has no relevance for the decision-
making, hence ignored. Additional fixed costs to the extent of
foremans salary, depreciation and interest are relevant. Hence,
these three items have been added.
Illustration No. 6
Adam & Co. has been purchasing a separate part from an outside source
@ $ 11 per unit. Adams son, after completion of his CPA, has come up
with a proposal to improve profitability. He has put up a proposal that
the spare part be produced in the factory itself, utilizing the available
free space in the factory shed. For this purpose a machine costing $
80,000, with an annual capacity of 20,000 units and a life of 10 years, will
be required. A foreman with a monthly salary of $ 600 will have to be
engaged. Materials required will be $ 3.00 per unit and wages $ 2.00 per
unit. Variable overheads are 150% of direct labour. The firm can easily
raise funds @ 10% p.a. There is a guaranteed requirement for the part,
presently purchased, for a period of 12 years.
285
Advice the firm for purchase or making, based on the sons advice.
Solution:
Increase in Fixed Costs $
Depreciation of Machine 8,000
Salary of Foreman 7,200
Interest on Capital 8,000
23,200
Contribution per unit $

Purchase Price 11
Less: Variable Cost: $
Material 3.00
Wages 2.00
Variable Overheads 3.00
8
Contribution per unit 3
Minimum Volume = 23,200

3
= 7,733 units.
In order to accept the proposal, it is essential that the required volume

should be at least 7,733 units. In this case, the expected volume is 8,000
units. The firm has a guaranteed demand for a period of 12 years, which
is more than the life of the fixed asset, which is to be bought. So, firm
should go for manufacturing.
Other important qualitative factors

Apart from the short-tem quantitative factors which were discussed
above which favour the buying option from external supplier, there are
other qualitative factors which should be considered and which also
might affect in the operating results of the company. Some of these
factors are as follows;
1. The organization should consider the quality of the products of
the external supplier and make sure that, the company will get
the same quality or better throughout the period of contract of
buying option.
2. The organization should make sure that, the products from the
external supplier are delivered at the right time .i.e. the right time
of delivery of the items
286
3. The outside suppliers price could be a temporary price, for
example he need to get rid of surpluses stocks or to penetrate into
a new market, then after that the supplier may increase prices.
Hence the management should make sure that those prices given
from the external supplier persistent constant in the longer term.
4. The decision of the company, to outsource the product which it

was previously making it, it may cause the redundant in the
company, this may cause social and behaviuor effects within the
company
8.13 Accepting or Rejecting Special Orders Decision

Management must often assess and evaluate whether a special order
should be accepted or rejected, and if the special order is accepted, the
management should consider the price in which the order be charged.
The special order is the temporary order which is not considered as a
part of the organizations normal selling activities. Normally the special
order price is lower than the normal selling price. In general terms an
order will probably be accepted if it increases contribution and profit,
and rejected if it reduces profit.
In the special order decisions, the management can be faced with the
following two scenarios
1. Where the organization has spare capacity and the order could
be met from the available excess capacity of the organization. i.e.
the order would not have to turn away the existing business.
2. Where the organization has no sufficient spare capacity and

therefore meeting the order result, the existing business to be
turned away.
Therefore, for manager deciding, whether to accept the special order or

reject the following points should be noted
If the organization has excess capacity and able to meet the order,
without disrupt of existing sales, hence the order should be accepted
if the price offered makes some contribution margin to fixed costs
and profit, meaning that the variable costs of marking the order is
less than the price offered by the order. Remember that the fixed
costs are not relevant to such decision since they will be incurred
regardless of whether the order is accepted or rejected. However the
additional fixed costs incurred as a result of accepting such order
should be taken into account
287
If the organization does not have sufficient excess capacity and
the accepting the order would disrupt the existing sales, the order
should be accepted only if the contribution margin from the order
is greater than the contribution margin from the business which
must be sacrificed. Meaning that the order will be accepted only if,
the price of the order is greater than the variable costs of making
the order and loss on contribution margin of sacrificed business,
However any additional fixed costs incurred as a result of accepting
such order should be taken into account
Note: Sometimes when a company has spare production capacity, it is

willing to fulfill special orders for non regular customers; normally
the prices quoted are lower than those regular customers
So when do a Company Accept or Reject a Special Order?

Generally, the rule is to accept the order as long as the incremental revenue
is MORE than the incremental costs since this will result in incremental profit
Incremental Revenue = Special Order units x Special Order price
Incremental Costs = Variable costs + extra fixed overheads + opportunity
costs that relates to the production of that special order
Incremental Profit =Incremental Revenue - Incremental Cost
Illustration: where the company has spare capacity

BM Company has capacity to produce 100,000 units of product X. The
cost estimate per unit based on current capacity of 80% is as follows:
$ per unit
Direct material $2.00
Direct labour $5.00
Variable production overhead $3.00
Fixed production overhead $4.00
Total $14.00
The company sells the product X to its regular customer at $20.00.

However, a non- regular customer has approached the company to
purchase the excess capacity at $18 each.
Should Company A accept this special order?
288
Solution
Incremental revenue (20% x 100,000 x $18) $360,000
Less:
Incremental cost
Direct material ($2.00 x 20,000) $40,000
Direct labour ($5.00 x 20,000) $100,000
Variable production o/h ($3.00 x 20, 000) $60,000
Total incremental cost $200,000
Incremental profit $160,000
The special order should be accepted the analysis above show there is
increase an incremental profit. The above takes only the relevant costs
hence ignoring fixed production overheads as it is still below 100%
production capacity
It should be noted that, if the organization has sufficient spare capacity

to meet the order without disrupt of the existing business, then the
minimum price of the order which has been accepted should be equal
to the variable costs of producing that order. However, if there is any
fixed costs incurred in connection of that order should be considered in
the analysis
Suppose in the above illustration there is no spare capacity the above

20% (20,000) can be utilized full in the regular customers: should the
special order be accepted?
Solution
Incremental revenue (20% x 100,000 x $18) $360,000
Less:
Incremental cost
Direct material ($2.00 x 20,000) $40,000
Direct labour ($5.00 x 20,000) $100,000
Variable production o/h ($3.00 x 20, 000) $60,000
Opportunity costs ($ 20 - $10)20,000 $200,000
Total incremental cost $400,000

Incremental loss $40,000
The analysis above showed there is an incremental loss therefore the

should be rejected
289
Other important factors
There are other qualitative factors which should be considered by the
management before the final decision of accepting or rejecting the special
order is taken. The factors which should be considered are as follows;
1. Normally the special order price is lower than the normal selling
price, then accepting of the order at a lower price, could it result
the other customers to demand the lower prices as well?
2. If the company has sufficient excess capacity, then the accepting

of the special order is the most way of utilizing the excess capacity
of the company
3. May be the company to have the excess capacity is due to variation

of business such as economic recession, then the management
should ask that, accepting of special order now, will it lock up the
capacity which could be used for future, at a period of economic
boom of the business?
8.14 Discontinuing product lines and other segments decisions

Decisions relating to whether old product lines or other segments of
the organization should be discontinued or drop and new one should
be added are among the most difficult that a management has to make.
In those kinds of decisions the management should consider both
qualitative and quantitative factors, because any final decision whether
to drop the existing product line or segment or add a new product line
will have impact on the companys net operating profit. To analysis and
assess the impact of this decision on the company performance, it is
necessary to analyze and assess the relevant costs very carefully
Hence, deciding whether to drop old product line or segment, the

following points should be noted;
1. If the contribution margin for the existing product line or old

segment is positive, then the product line or segment should not
be dropped, even if the product or segment is making a loss, unless
the alternative product or segment can sold at profit, because
continuing producing that product line will tend to minimize the
loss, this due the fact that the fixed costs will be incurred even
if the product is dropped, therefore, the contribution margin
realized from selling this product, will cover part of the fixed cost
and hence the loss will be minimized
290
2. If the contribution margin of the existing product line or old
segment is negative, then dropping of the product is advantage
to the company, because the loss will be only the fixed cost, that
way the total loss will be minimized.
Therefore the following factors should be considered before taking a

decision about the discontinuance of a product line:
1. The contribution given by the product-- This contribution is

different from profit. Profit is arrived at after deducting fixed cost
from contribution. Fixed costs are apportioned over different
products on some reasonable basis which may not be very
much correct. Hence, contribution gives a better idea about the
profitability of a product as compared to profit.
2. The capacity utilization, i.e. whether the firm is working to full

capacity or below normal capacity, In case a firm is having idle
capacity, the production of any product which can contribute
toward the recovery of fixed costs can be justified.
3. The availability of product to replace the product which the firm

wants to discontinue and which is already accounting for a
significant proportion of the total capacity.
4. The long-term prospects in the market for the product
5. The effect on sale of other products, in some cases, discontinuance

of one product may result in heavy decline in sales of other
products affecting the overall profitability of the firm.
Illustration of dropping product lines

Consider three major product lines of Buzz Drug Company Ltd-
drugs, cosmetics and house-wares. Sales and cost information for the
preceding month for each separate product line and store in total are
given below;
Products Drugs Cosmetics House-wares Total

Sales (units) 400 500 600
$000 $000 $000 $000
Sales 40,000 25,000 36,000 101,000
Variable costs 10,000 7,500 12,000 29,500
Fixed costs 18,000 20,000 20,000 58,000
Profit/ (Loss) 12,000 (2,500) 4,000 13,500
291
The fixed overheads costs are apportioned to the products on the basis
of direct labour hours. On the basis of this information, should the
company stop selling cosmetics as it is impossible to increase the selling
price?
Solution
The first step is to compute, the contribution margin of the product
lines; as follows;
Products Drugs Cosmetics House-wares Total
$000 $000 $000 $000
Sales 40,000 25,000 36,000 101,000
Variable costs 10,000 7,500 12,000 29,500
Contribution margin 30,000 17,500 24,000 71,500
The company should continue with cosmetics as it is making a positive

contribution margin of $ 17,500,000 or $ 35,000 per unit sold. Unless an
alternative product can be sold at a profit, the company will be better
off by $ 17.5 million as it must be assumed that the total fixed cost will
remain at $ 58 million even if cosmetics is deleted from the product
range
Similarly, a new product should be introduced if it generates a positive

contribution margin but results in a loss after charging the apportioned
companys fixed costs.
For example airlines, often offer cheap seats on the basis that any
contribution towards the fixed costs put the company in a better position
than if there was an empty seat on the plane.
Other important factors

Other non-financial which should be considered under this decision are
as follows;
1. If the product line is dropped, there is possible redundancies
among the workers and facilities
2. The dropping of the product line, it can result the reaction from
customers, particularly those who may recently have purchased
the product
3. There is an indication, which may give competitors, who may

perceive the company as being unwilling to support its product
line.
292
4. The dropping of the product line might have negative impact on
the sales other product line, if the sales of the product depend on
the dropped product.
8.15 Continue or Shut Down Decisions

Sometimes in the organization, the management can be faced with
the problem, whether to continue or shut down the activities of the
organization, such as to close down a factory, department, product line
or any other activity.
Therefore, the shut down decisions are those decisions about;
1. Whether or not to shut down a whole factory, department, one of

the product line or any activity of the organization
2. If the decision is shut down, whether the shut down decision

should be temporary or permanent
Shutdown problems involve the following types of decisions:
1. Whether or not to close down a factory, department, product line

or other activity, either because it is making losses or because it is
too expensive to run.
2. If the decision is to shut down, whether the closure should be

permanent or temporary. Shutdown decisions often involve long
term considerations, and capital expenditures and revenues.
3. A shutdown should result in savings in annual operating costs

for a number of years in the future.
4. Closure results in release of some fixed assets for sale. Some assets
might have a small scrap value, but others, e.g. property, might
have a substantial sale value.
5. Employees affected by the closure must be made redundant or

relocated, perhaps even offered early retirement. There will
be lump sums payments involved which must be taken into
consideration. For example, suppose closure of a regional office
results in annual savings of $100,000, fixed assets sold off for
$2 million, but redundancy payments would be $3 million. The
shutdown decision would involve an assessment of the net capital
cost of closure ($1 million) against the annual benefits ($100,000
per annum).
293
It is possible for shutdown problems to be simplified into short run
decisions, by making one of the following assumptions
a. Fixed asset sales and redundancy costs would be negligible.
b. Income from fixed asset sales would match redundancy costs
and so these items would be self-cancelling.
In these circumstances the financial aspects of shutdown decisions

would be based on short run relevant costs.
The management should noted that, shut down decisions will involve
long-term considerations on capital expenditures and revenues. Thus,
the following issues will be prevail under the situation of shut down
decisions
1. A shut down decision should result in savings annual operating

costs for a number of years into the future.
2. Closure of a factory, department or product line will probably

release unwanted non-current assets for sale, some assets might
have a small scrap value, but other assets, in particular property,
might have a substantial sale value
3. Employees affected by the closure must be made redundant or

re-located perhaps after retraining, or else offered early retirement.
This result the lump sum payments involved which must be taken
into consideration in the financial calculation.
4. The organization will lose the revenue that would have received
when it remained operated
Therefore, in shut down decisions, the management should analysis and

assesses the relevant costs and benefits whether or not to shut down, and
then these costs and benefits of the two alternatives will be compared
before the final decision is made
Illustration of continue or shut down decision (CPA (T) 2006 adapted)

Mkanyageni Paint manufacturing Company produces 200,000 medium-
sized tins of Rungu Spray per annum when working at normal
capacity. It incur the following costs of manufacturing per unit
$
Direct material 780
Direct labour 210
Variable overhead 250
Fixed overheads 400
Production cost (per unit) 1,640
294
Each unit (tin) of Rungu spray is sold for $ 2,100 with variable selling
and administrative expenses of $ 60 per tin.
During the next quarter, only 10,000 units can be produced and sold.
Management plans to shut down the plant, estimating that the fixed
manufacturing costs can be reduced to $ 7,400,000 for quarter.
When the plant is operating, the fixed overheads are incurred at a

uniform rate throughout the year. Additional costs of the plant shut-
down are estimated at $ 1,400,000
As a management Accountant express your opinion, along with

calculation as whether the plant should be shut down during the
quarter
Solution
It should be noted that, when attempting this question only relevant
costs and benefits should be considered in the calculations and those
irrelevant costs should be ignored in the calculation.
Thus the computations are done as follows for the two alternatives
Operating the Shut-down
plant $ the plant $
Sales revenue 21,000,000 0
Variable costs;
Direct materials ($ 780 x 10,000) (7,800,000) 0
Direct labour ($ 210 x 10,000) (2,100,000) 0
Variable prod oh ($ 250 x 10,000) (2,500,000) 0
Variable sell & admin ($ 60 x 10,000) (600,000) 0
Fixed costs ($ 400 x 200,000/4) (20,000,000) (7,400,000)
Shut-down costs 0 (1,400,000)
Profit/ (loss) (12,000,000) (8,800,000)
According the computations above the management is advised to shut

down the plant as the shut-down loss is lower than the loss caused by
the operating the plant. It should be noted that those relevant costs and
benefits for each were taken into account while the irrelevant costs were
ignored in the computations.
8.16 Extra shift decisions

The management can be faced with the problems, whether to run an
extra shift or not. These decisions are concerned with whether or not it
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is worth operating up an extra shift for operations. An extra shift can
result due an increase in the demand of the product of the company, so
that normal working hours not sufficient to produce the product to meet
the demand or other stores opening on Sunday and some organizations
operate on Saturday and Sunday as example of extra shift.
In deciding whether to run an extra shift, or no the management should

note that, the decisions would be based on the relevant costs and
benefits only, the irrelevant costs should be ignored in the analysis of
these decisions
However apart from the financial relevant costs and benefits, other
qualitative factors should be taken into account before the final decision
is made. These qualitative factors comprise of the following;
1. Whether the workers would be willing to work the shift hours,

and if so what over time over their basic pay they would expect
to receive.
2. Whether extra hours have to be worked just to remain competitive,

for example supermarkets might decide to open Sunday, just to
match what competitors are doing and so keep the customers
3. Whether extra hours would result in more sales revenue, or

whether there would merely be a change in the demand pattern
from customers.
Assessment Question
8.1
Mtaalamu Manufacturing Company manufactures agricultural
equipment and currently is preparing its budget for the year 2002/3.
An initial review clearly shows that the company will not able to
manufacture all the requirements for components XA, XB, XC and XD
because of limited pressing capacity of 20,000 hours
The production manger has advised the company management to

choose between the alternative courses of action given below to obtain
the components in excess of the normal production capacity
(i) To buy entirely from outside suppliers
(ii) To buy from outside suppliers and or use a partial second shift
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The data below are for the year 2002/2003
Standard production Cost per unit

Components XA XB XC XD
Variable costs $ $ $ $
Direct Materials 740 540 500 880
Direct Labour 200 160 440 800
Direct Expenses 200 400 200 1,200
Fixed costs 100 80 220 400
Total production costs 1,240 1,180 1,360 3,280
Requirements in units 2,000 3,500 1,500 2,800
Direct expenses relate to the use of the mental presses, which cost $ 200
per machine hour to operate. Fixed overhead is absorbed as a percentage
of direct labour cost.
Quotation obtained by the purchasing department from outside

suppliers indicate a willingness to manufacture all or any part of the
total requirements at the following prices each delivered to the factory

Component $
XA 1,200
XB 1,180
XC 1,040
XD 3,360
Second shift operations would increase direct labour cost by 25% over
the normal shift and fixed overhead for $ 10,000 for each 1,000 units (or
part thereof) for the second shift hours worked
As a Management Account, using the information given above with

supporting calculations state
(a) Which components and in what quantities should be manufactured

in the 20,000 hours of the press time available
(b) Whether it would be profitable to make any the balance of the

components require on the second shift instead of buying them
from outside suppliers
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Summary
Decision making is often a difficult and complicated function for the
most of managers in the organization, this is due to the existence of
numerous alternatives criteria and massive amount of data, only some
of which may be relevant for a particular decision
Hence every decision making is concern with the future and involves
a choice among alternatives. Many factors, both qualitative and
quantitative are needed to be considered and for many decisions
financial information is a critical factor. It is important that relevant
information on cost and revenues is supplied. The chapter has focused
the short term decisions relating to the following
Product mix decision when capacity constraints exist

Buy or make decisions (outsourcing)
Discontinuation decisions
Special order decisions
The chapter has focused on providing an understanding of the principles

that should be used to identify relevant costs and revenues in order to
help management in various decisions.

Decision making
Decision model
Extra shift
Limiting factor
Long run decision
Outsourcing
Qualitative factors
Relevant costs
Short run decision
Shut down decision
Special order
Strategic decision
Tactical decision
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Exercises
8.1 Define relevant costs. Why are historical costs irrelevant?
8.2 All future costs are relevant Do you agree? Why?
8.3 Distinguish between quantitative and qualitative factors in

decision making
8.4 Variable cost are always relevant, and fixed costs are always
irrelevant Do you agree? Why?
8.5 Management should always maximize sales of the product with

the highest contribution margin per unit. Do you agree? Explain
8.6 A branch or business segment that shows negative operating

profit should be shut down. Do you agree? Explain briefly
Problems
8.7
A food producer manufactures only one product, but it sold in different
sizes of little, large and supper. The following details are provided
relating to the expected demand and the productive capacity for the
next quarter in respect of the three sizes that are manufactured by the
company;
Little Large Supper
$ $ $
Selling price per unit 6,500 11,000 18,000
Variable costs per unit 3,000 6,500 12,000
Fixed costs per unit 1,300 2,000 4,000
Profit per unit 2,200 2,500 3,000
Annual demand (units) 6,000 5,400 3,000
Machine time per unit 6 min 10 min 15 min
The sizes share the same production facilities of the plant of which total
machine hours available amount to 1,800 hours. Which sizes should be
produced to maximize the companys profit?
8.8
Mbagala Ltd manufactures a variety of products which need a number
of components. The details of the components are as follows;
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XA XB XC XD XE
Components
$ $ $ $ $
Materials per unit 1,000 5,800 3,000 2,000 8,500
Labour 1,400 6,200 3,500 10,000 5,500
Variable overhead 3,000 4,000 4,500 9,000 5,000
Apportioned fixed costs 2,400 3,000 4,000 6,000 6,500
Total cost per unit 7,800 19,000 15,000 27,000 25,500
The purchasing department has identified a reliable outside supplier,

who can supply identical components at the following delivered price
XA $ 6,000
XB $ 15,000
XC $ 12,000
XD $ 24,000
Advice the company which components should be made and which

should be bought from outside supplier
8.9
Bowyer Ltd is a small company that manufactures sportswear. Its
financial director is considering setting up a budgeting system. As a
starting point he needs to decide on monthly production levels for the
first three months of 2005.
Bowyer Ltds products are very popular and the firm expects to be able
to sell up to 20,000 units of each of its two products (shirts and shorts)
per month. However, for the first three months of 2005 production will
be constrained by a lack of direct labour. It is estimated that only 6,000
hours will be available each month.
For sales reasons production of either of the two garments must be at

least 25% of the production of the other. Because of building works in
the factory Bowyer is unable to carry any month end stock of finished
goods or raw materials in the first quarter (three months) of the year.
There will be no opening stocks at the beginning of January.
Estimated costs and revenues per garment are as follows:
300
$ per garment
Shirts $ Shorts $
Sales price 30 22
Raw materials
Fabric at $12 per square metre (12) (6)
Dyes and cotton (3) (2)
Direct labour at $ 8 per hour (4) (2)
Fixed overheads at $ 4 per hour (2) (1)
Profit $9 $11
Required:
Calculate the number of shirts and shorts to be produced per month in
the first quarter of 2005 to maximize Bowyer Ltds profit (ACCA)

8.10
The Dar es Salaam Lamp Factory produces a student reading table lamp
Annual production is 10,000 lamps. Currently sales are 8,000 lamps per
year. Per unit cost and revenue data are as follows:-
Price $2,400
Cost
Materials 900
Labour 300
Variable Overhead 300
Fixed Overhead 300
Sales Commissions 240
2,040
Profit per unit $360
Variable overhead varies directly with direct labour hours and overhead
rate equals the labour rate. Fixed overhead is applied at the rate of 100%
of direct labour costs and sales commissions are 10% of the selling price.
There is no sales commission s for special orders.
Required:
Treat each question below independently.
(i) Suppose Dar es Salaam Lamp Factory receives a special order
for 1,000 lamps from a new customer. This would not affect
current sales. Compute the minimum price the factory should
accept for this special order.
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(ii) Suppose Dar es Salaam Lamps Factory receives a special order for
3,000 lamps from a new customer. If the order is accepted, it must
be filled completely. Compute the minimum price the company
should accept.
(iii) Suppose that current excess capacity is used to repair lamps. The
repair business generates a total contribution margin of $300,000.
It is estimated that the existence of the repair business increases
sales of lamps by 2,000 units per year. If production exceeds 8,000
units, the repair business must be discontinued. How, if at all,
would this affect your answers to part (a) and (b) above?
8.11
A company is preparing its production budget for the year ahead. Two
of its processes are concerned with the manufacture of three components
which are used in several of the companys products. Capacity (machine
hours) in each of these two processes is limited to 2,000 hours.
Production costs are as follows:-

Component X Component Y Component Z
Direct materials 15.00 18.50 4.50
Direct labour 12.00 12.50 8.00
Variable overhead 6.00 6.25 4.00
Fixed overhead
Process M 6.00 6.00 4.50
Process N 10.50 10.50 3.50
49.50 53.50 24.50
Requirements for component X, Y and Z for the following year are:-

Component X 300 units
Component Y 300 units
Component Z 450 units
Fixed overhead is absorbed on the basis of machine hours, at the

following rates:-
Process M $3.00 per hour
Process N $3.50 per hour
Component X and Z could be obtained from an outside supplier at the

following prices:
Component X $44.00 per unit
Component Z $23.00 per unit
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Required:
(a) Demonstrate that insufficient capacity is available to produce
the requirements for Component X, Y and Z in the year ahead
and calculate the extent of the shortfall.

(b) Determine the requirements for bought-in components in order
to satisfy the demand for components at minimum cost.
(c) Consider briefly any other factors which may be relevant to

decisions regarding these components in the longer term.
8.12
APP Ltd is one of the most thriving manufacturing companies which
have sprung up as a result of the trade liberalization policy in Tanzania.
The Company produces a range of products and absorbs production
overhead using a rate of 200% on direct wages. This rate was calculated
from the following budgeted figures:-
Variable production costs - $64,000,000

Fixed production costs - $96,000,000
Direct labour costs - $80,000,000
The normal selling price of product X which is one of APP Ltds product
lines is $22,000, and with a production cost of 1 unit is as follows:-
Raw Material - $8,000
Direct Labour - 4,000
Production Overhead - 8,000
20,000
There is a possibility of supplying a special order of 2,000 units of product

X at $16,000 per unit. If the order is accepted, the normal budgeted sales
would not be affected and the Company has the necessary capacity to
produce the additional units.
You are further informed that the cost of making component Q, which
forms part of product Y is stated below:-
$
Raw Material - 4,000
Production Overhead - 16,000
28,000
Component Q could be bought from an outside supplier for $20,000.
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Required:
Assuming that fixed production cost will not change:-
(a) State whether the Company should:-
(i) Accept the special order of 2,000 units of product X
(ii) Continue making component Q or buy it from outside.
Both your statements must be supported by detailed cost analysis.
(b) Comment on the principle you have followed in your cost analysis
to arrive at your answers to (i) and (ii) above.
8.13
The Usambara Spinning Mill has two production departments;
Machining and Assembly. The Machining department has a monthly
capacity of 1,500 machine hours and the Assembly department a
monthly capacity of 3,000 direct labour hours. The production capacity
of either can be expanded within a period of 15 months.
At present the company makes 3 products all of which us the same

machining and assembly facilities. The expected demand, unit selling
price, the variable costs and the time which each unit takes in machining
and assembly are provided below:-
Product A B C
Unit Selling Price 1000 2,000 2,500
Variable Cost 400 1,200 1,240
Machine time 2 hrs 4 hrs 6 hrs
Assembly time 3 hrs 6 hrs 8 hrs
Monthly demand 200 units 200 units 100 units
The company has fixed overheads of $200,000 per month.
Required:
a) Calculate the mix of production and sales which will maximize
profits within the constraints under which the company operates.
Calculate the profit at this mix. State all the assumptions which
you have made in your calculations.
b) Mr. Mbwambo, the Managing Director has asked you as to which

is the most profitable product. Write a memo to him responding
to his question.
304
c) The Marketing Director has suggested that if a further $15,000
is spent on advertising product A, the sales could be increased
to 300 units per month without any reduction in selling price. Is
the additional advertising worthwhile if the company is already
short of production capacity? State all your assumptions.
8.14
The Pemaco Bevi Company manufactures a variety of electric motors.
The company is currently operating at about 70% capacity and is earning
a satisfactory return on investment.
The management of Pemaco Bevi has been approached by Beta

Industries with an offer to buy 120,000 units of an electric motor. Beta
Industries manufactures a motor that is almost identical to Pemaco
Bevis motor, however, a fire that razed the industries plant has rendered
the plant inoperative.
Beta Industries needs the 120,000 motors over the next four months to
meet commitments to its regular customers. The company is prepared to
pay $19,000 each for the motor which they will collect form the Pemaco
Bevi plant.
Pemaco Bevis product cost, based on current attainable standards, for

the motor is:
$
Direct material - 5,000
Manufacturing Overhead - 9,000
20,000
Manufacturing overhead is applied to production at the rate of $18,000

per standard direct labour hour. This overhead rate is made up of the
following components:
$
Variable factory overhead 6,000
Fixed factory overhead - direct 8,000
Fixed factory overhead - allocated 4,000
Applied manufacturing overhead rate 18,000
Additional costs usually incurred in connection with sales of electric

motors include sales commissions of 5% and freight expenses of $1,000
per unit.
305
In determining selling price, Pemaco Bevi adds a 40% mark-up to
product costs. This provides a suggested selling price of $28,000 for the
motor. The marketing department however, has set the current selling
price at $27,000 to maintain market share.
The order would, however, require additional fixed factory overhead of

$15,000,000 per month in the form of supervision and clerical costs. If
management accepts the order, 30,000 motors will be manufactured and
shipped to Beta industries each month for the next four months.
Required:
a) Prepare a financial evaluation report showing the impact of
accepting the Beta industries order. What is the minimum unit
price, management could accept without reducing its operating
profit?
b) State clearly any assumptions contained in the analysis of (a)

above and discuss any other organizational or strategic factors
which Pemaco Bevi should consider.
c) Discuss briefly how activity based Costing, in generating a long

runs average cost, may produce a different minimum price.
8.15
The Tabata Manufacturing Company in Dar es Salaam is a small
manufacturer of plastics components. The company has been deriving
its income form contract work for larger firms in the country.
The operation of a 5 years old plastic moulding machine has provided

the firm with annual sales revenue of $20,000,000. The cash operating
cost for the machine is $14,000,000 per annum and this is not expected to
change in the near future. The machine has a net book value of $9,000,000
and an estimated remaining life of 4 years. The expected salvage value
is 1,000,000.
The machine is presently operated at full capacity and if the company

is to expand its operations to meet the increased demand, it will have to
invest in new equipment.
After some inquiry, a salesman for moulding machines made the

following offer:-
Trade in the old machine for a high-speed plastic moulding machine
with 25% more output and an estimated 4 years life.
306
The annual sales revenue is expected to increase to $25,000,000.
New machine cost $22,000,000
Trade-in allowance for old machine $ 3,000,000
Cash payment $19,000 000
Annual cash operating costs for the new machine are $ 13,500,000.
Expected salvage value at the end of 14 years is estimated at $
2,000,000.
Required:
a) Calculate the average annual effect on net income before taxes if
the new machine is purchased.
b) By evaluating the proposal on the basis of total cash flow for the
4 years rather than on total net income before taxes, would the
results be the same or different? Explain.
c) List 3 other factors to be considered in deciding whether or not to

purchase the new machine.
Required:
Evaluate each of the above plans and recommend whether either of the
two alternatives should be adopted.
Advise management on the best course of action to take.
8.16
THE DOLLEX CO. manufactures and sells two product types namely
standard and deluxe. Both products pass through the same process
metal forming and plastic covering. The standard product sells at the
$1,500 while the deluxe sells at $2,000. There is an unlimited market
for the standard product, but the deluxe product has a market limit of
12,000 units per period. The factory operations limit the plastic covering
process to 2,000 hours per period. The variable cost per 100 products of
each type is as follows:-
Direct Materials Direct Wages Direct Expenses

Product
$ $ $
Standard 50,000 70,000 10,000
Deluxe 70,000 75,000 25,000
The labour force has agreed on new production methods which will
increase output in both processes by 20% in the same process hours.
307
Required:
(a) Calculate the production output that will maximize total
contribution:
(i) at existing production levels
(ii) at increased production levels
(b) Calculate the increased gross wages paid, if the agreement gave
the labourer force the extra direct wages for the extra production,
and 30% of the increased contribution and
8.17
Majengo Packaging Company specializes in the manufacturing of one
litre plastic bottles. The companys customers include dairy processors
fruit juice manufacturers and manufacturers of edible oils.
The bottles are produced by a process called blow moulding. A machine

heats plastic to the melting point. A bubble molten plastic is formed
inside a mould, and a jet of hot air is forced into the bubble. This blows
the plastic into the shape of mould. The machine releases the moulded
bottle, an employee trims off any flashing (excess plastic around the
edge), and the bottle is complete.
The Company has four moulding machines, each capable of producing

100 bottles per hour. The company estimates that the variable cost of
producing a plastic is shs 200. The bottles are sold for shs 500 each.
Toy Company would like the company to produce a moulded plastic toy
for them, has approached management. The Toy Company is willing to
pay shs 3,000 per unit for the toy. The variable cost to manufacture the
toy will be shs 2,400. In addition, Majengo Packaging Company would
have to incur a cost of shs 20 million to construct the needed mould
exclusively for this order.
Since the toy will use more plastic and is of a more intricate shape
than a bottle, a moulding machine can produce only 40 units per hour.
The customer wants 100,000 units. Assume that Majengo Packaging
Company has a total capacity of 10,000 machine hours available during
the period in which the toy company wants the delivery of toys.
The Companys fixed costs, excluding the costs to construct the toy
mould, during the same period will be shs. 200 million
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Required
a) If the management predicts that the demand for its bottles will
require the use of 7,500 machine hours or less during the period,
should the special order be accepted? give reasons
b) If the management predicts that the demand for its bottles will
be higher than its ability to produce the bottles, should the order
be accepted? Why?
8.18
Majengo Company can produce three products from main raw material
called BM from same labour, though different amounts are required
for each product. The source of raw material is mining area near the
company area and because of the nature of mining operations in that
area, the company will be able to purchase only 10,000 kgs of BM
monthly (all other resources will be fully available)
Management has hired you as a consultant to revise its plan for June
2008 to ensure that profits are maximised for that month.
The standard resource requirements costs and selling prices and the
customer demand for delivery in June 2008 (including those orders
already accepted) for each of the three products are as follows;

Products
Resources per unit Product Product Product
XA XB XC
Material BM 10 kgs 8 kgs 5 kgs
Direct labour 8 hours 9 hours 6 hours
Selling price and cost (shs per unit)
Selling price 14,500 3,400 9,900
Material BM 2,500 2,000 1,250
Other materials 1,000 400 850
Direct labour 4,000 4,500 3,000
Overheads:
Variable 1,000 1,125 750
Fixed (based on budgeted cost of
2,400 3,000 1,200
shs 9.5m Per month)
10,900 11,025 7,050
Customer demand (units) 1,100 950 1,450
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The company has already accepted customer orders for delivery in June
2008 as follows
Product XA 34 units
Product XB 75 units
Product XC 97 units
Given the shortage of material BM, the management team has now set
the following stock levels for June 2008
Material BM
Opening stock 621 kgs
Closing stock 225 kgs
Products (units) XA XB XC
Opening stock 29 33 46
Closing stock 19 25 20
Required
Prepare a production plan for December that clearly shows the number
of units of each product that should be produced to maximize the profit
of the Company.
8.19
Mwananchi Co. Ltd is considering the closure of its internal printing
department. The department prints all of the companys publicity
material and also carries out other printing jobs as required.
An external firm has offered to produce all of the companys printing
requirements for a total of $ 9,000 per month. The internal printing
departments costs are as follows:
(a) A total of 80,000 sheets of customized paper are used each month,
at cost of $ 50 per 1,000 sheets. The contract for supply of the
paper requires three months notice of cancellation. The company
does not hold stocks of the paper but any excess can be sold for a
net price of $ 20 per 1,000 sheets
(b) A total of 400 litres of ink are used each month, at a cost of $ 1.80
per litre. The contract for supply of this ink requires 1 months
notice of cancellation. No stocks of ink are held but any excess
can be sold for $ 0.50 net per litre.
(c) Other paper and materials costs amount to $ 2,850 per month
(d) The printing machinery is rented for $ 4,500 per month. It is

operated for 120 hours each month. The rental contract can be
cancelled with 2 months notice.
310
(e) The two employees in the department are each paid $ 1,000 per
month. The company has a no redundancy policy which means
that the employees are guaranteed employment even if the
department closes
(f) Overhead cost for the printing department is as follows
Variable overhead: $ 4 per machine hour

Fixed overhead: $ 3 per machine hour
Variable overhead varies in direct proportion to machine hours operated.

Fixed overhead represents an apportionment of central overhead which
would not alter as a result of printing departments closure.
Required
a) Calculate the long term monthly saving or extra cost which will
result from the closure of the printing department and advice the
management on the offer.
b) If you consider that the department should be closed, you are

asked to advice the management on the most appropriate timing
for its closure, clearly shows all the necessary calculations.
8.20
BM Ltd manufactures three products XA, XB and XC. The products are
all finished on the same machine. This is the only mechanized part of the
process. During the next period the production manager is planning an
essential major maintenance overhead of the machine. This will restrict
the available machine hours to 1,400 hours for the next period. Data for
the three products is:
Product XA Product XB Product XC

Selling price 30 17 21.00
Variable cost 13 6 9.00
Fixed production cost 10 8 6.00
Other fixed cost 3 1 3.50
Profit 5 2 2.50
Maximum demand (units) 250 140 130

311
No stocks are held
Fixed production costs are absorbed using a machine hour rate of $ 2
per machine hour.
Required
Determine the production plan that will maximize profit for the forth
coming period
8.21
The Anvil Company is presently operating at 80% of its maximum
capacity of 250 direct labour-hours per day. The company makes a single
product and is selling all of its regular production, and anticipates that
it will be able to maintain this level of sales in the foreseeable future.
The company is also seeking ways to fully utilize the excess capacity
and is considering a proposal to supply 10,000 units as a special order.
The order is due in exactly 60 days. The proposed price per unit is $7.50.
The regular selling price for this product is $10.50. The per-unit variable
costs are:
Direct materials $2.50

Direct labour (per 1/2 hour) $3.00
Variable manufacturing overhead $1.00
Sales commission $0.50
Annual fixed manufacturing cost is $72,000. The company will not

consider overtime production as a matter of policy and the production
manager must fill the special order, if it is accepted, from the available
capacity, even if it means having to divert regular production to the
special order. There will be no commission or any other administrative
costs associated with the special order. The customer will not accept the
order if it is delayed beyond the 60-day deadline and will not accept an
order quantity less than 10,000 units.
Required
(a) Indicate whether the special order should be accepted. Show all
calculations.
(b) Calculate at what price per unit for the special order Anvil would
be indifferent between accepting and rejecting the special order.
(c) Suppose that the customer is open to extending the deadline

in exchange for a reduction in the price of $0.01 per unit per day.
Explain whether Anvil should attempt to negotiate an extension
to the deadline.
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8.22
A company manufactures two products (X and Y) in one of its factories.
Production capacity is limited to 85 000 machine hours per period. There
is no restriction on direct labour hours.
The following information is provided concerning the two products:

Product X Product Y
Estimated demand (000 units) 315 135
Selling price (per unit) $11.20 $15.70
Variable costs (per unit) $ 6.30 $ 8.70
Fixed costs (per unit) $ 4.00 $7.00
Machine hours (per 000 units) 160 280
Direct labour hours (per 000 units) 120 140
Fixed costs are absorbed into unit costs at a rate per machine hour based
upon full capacity.
Required:
(a) Calculate the production quantities of Products X and Y which

are required per period in order to maximize profit in the situation
described above.
(b) Prepare a marginal costing statement in order to establish the total

contribution of each product, and the net profit per period, based
on selling the quantities calculated in (a) above.
(c) Calculate the production quantities of Products X and Y per

period which would fully utilize both machine capacity and
direct labour hours, where the available direct labour hours are
restricted to 55 000 per period. (The limit of 85 000 machine hours
remains.) ACCA Foundation Paper 3
8.23
PDR plc manufactures four products using the same machinery. The
following details relate to its products:
313
Product Product Product Product

A B C D
$ per unit $ per unit $ per unit $ per unit
Selling price 28 30 45 42
Direct material 5 6 8 6
Direct labour 4 4 8 8
Variable overhead 3 3 6 6
Fixed overhead* 8 8 16 16
Profit 8 9 7 6
Labour hours 1 1 2 2
Machine hours 4 3 4 5
Units Units Units Units
Maximum demand per week 200 180 250 1
*Absorbed based on budgeted labour hours of 1000 per week.

There is a maximum of 2000 machine hours available per week.
Requirement:
(a) Determine the production plan which will maximize the weekly
profit of PDR plc and prepare a profit statement showing the
profit your plan will yield.
(b) The marketing director of PDR plc is concerned at the companys

inability to meet the quantity demanded by its customers.
Two alternative strategies are being considered to overcome this:
(i) To increase the number of hours worked using the existing

machinery by working overtime. Such overtime would be paid
at a premium of 50% above normal labour rates, and variable
overhead costs would be expected to increase in proportion to
labour costs.
(ii) To buy product B from an overseas supplier at a cost of $19 per

unit including carriage. This would need to be repackaged at a
cost of $ 1 per unit before it could be sold
314
Case Studies
Case study 8.1: The Minnetonka Corporation
The Minnetonka Corporation, which produces and sells to wholesale a
highly successful line of water skis, has decided to diversify to stabiles
sales throughout the year. The company is considering the production
of cross-country skis.
After considerable research, a cross-country ski line has been developed.

Because of the conservative nature of the company management,
however Minnetonkas president has decided to introduce only one
type of the new skies for this coming winter. If the product is a success,
further expansion in future years will be initiated.
The ski selected is mass-market ski that comes with a special binding.
It will be sold to wholesalers for $ 80 per pair. Because of available
capacity, no additional fixed charges will be incurred to produce the
skis. A $ 100,000 fixed charges will be absorbed by the skis, however,
to allocate a fair share of the companys present fixed costs to the new
product. Using the estimated sales and production of 10,000 pair of skis
as the expected volume, the accounting department has developed the
following costs per pair of skis and bindings:
$
Direct labour 35
Direct material 30
Total overhead 15
Total 80
Minnetonka has approached a subcontractor to discuss the possibility

of purchasing the bindings. The purchase price of the bindings from
the subcontractor would be $. 5.25 per binding, or $. 10.5 per pair. If the
Minnetonka Corporation accepts the purchase proposal, it is predicted
that direct labour and variable costs would be reduced by 10% and
direct material costs would be reduced by 20%.
Source: Minnetonka Corporation
1. Should the Minnetonka Corporation make or buy the bindings?
Show calculations to support your answer.
2. What would be the maximum purchase price acceptable to the

Minnetonka Corporation for the bindings? Support your answer
with an appropriate explanation.
315
3. Instead of sales of 10,000 pair of skis, revised estimates show sales
volume at 12,500 pair. At this new volume, additional equipment,
at an annual rental of $. 10,000 must be acquired to manufacture
the bindings. This incremental cost would be the only additional
fixed cost required even if sales increased to 30,000 pair. Under
these circumstances, should the Minnetonka Corporation make
or buy the bindings? Show calculations to support your answer.
4. The company has the option of making and buying at the same
time. What would be your answer to requirement 3 if this
alternative were considered? Show calculations to support your
answer.
5. What numbers of quantifiable factors should the Minnetonka

Corporation consider in determining whether they should make
or buy the bindings?
Case study 8.2: Newshire School Closure
Background
The local residents in Newshire have started a campaign to try and
stop the closure of local schools. Councillors claim that their hands are
tied and next year there will have to be cuts in the education and social
services budgets.
School closure
All of the schools included in this case study are rural schools. New
bridge Primary and Old bridge Primary were originally 1 form entry
schools admitting 33-35 pupils a year with a school roll of approximately
260 pupils. The decision to expand to 1.5 forms of entry was to meet
increasing demand for places. As 1.5 form entry schools the maximum
class size was reduced to 30 with 45 pupils in each year group. With 1.5
forms of entry the school roll for each school increased to approximately
350 pupils. Black bridge Primary has always been a 2 form entry
school.
New bridge Primary and Old Bridge Primary report that with fewer
applications for places at the schools the head teachers estimate that they
will need fewer classes and teachers next year. Black bridge Primary
does not have any concerns over the number of applications next year.
A report has been prepared to discuss the possible closure of one of the
schools and the following options are to be considered.
316
(i) New bridge Primary will be closed.
(Old bridge Primary will become 2 form entry and Black bridge
Primary will not change.)
(ii) Old bridge Primary will be closed

(New bridge Primary will become 2 form entry and Black bridge
Primary will not change)
(iii) Black bridge Primary will be closed.

(New bridge Primary and Old Bridge Primary will become 2
form entry)
Pupils
Forecast school numbers are as follows:
Current Currently on Estimated
Capacity roll (2002-3) (2003-4)
New bridge Primary 350 280 230
Old bridge Primary 350 255 230
Black bridge Primary 500 470 480
Existing staffing
Deputy Assistant Part-time
Head
head teachers staff
New bridge Primary 1 1 11 5
Old bridge Primary 1 1 11 6
Black bridge Primary 1 2 16 6
One head is on long term sick leave and she has indicated that her health
will not improve and therefore is expected to seek early retirement. Two
of the deputy head teachers have applied for posts outside the borough.
The head teachers estimate that with a relatively high number of teachers
applying for posts elsewhere or seeking early retirements there will be a
need to recruit more staff after any of the options are implemented.
Example of possible organization for schools

The council has collected examples of typical staffing levels for schools
of different sizes.
Deputy Assistant Numbers of
Head
head teachers pupils
1 form entry 1 1 7 250
1.5 form entry 1 2 9 350
2 form entry 1 2 15 500
317
No information is available on the effect of the possible savings from
reducing the numbers of full-time staff under the above options. The
schools will have to consider the age of the staff and the length of
service before any estimates can be prepared. The initial appraisal of
the alternatives will not include full-time staff costs.
Expenditure required on schools

The necessary capital would be borrowed with total charges of $100 p.a.
per $1,000 borrowed
Cost of providing additional classroom accommodation.

(for 150 pupils - from 350 pupil capacity to 500 pupil capacity)
New bridge Primary $200,000

Old bridge Primary $250,000
Other expenditure
New bridge Primary Major refurbishment $400,000
Old bridge Primary New heating system $150,000
Black bridge Primary Roof and minor repairs $80,000
At New bridge Primary playground space is at a premium. The car park

can be utilized and, or a system of split play times might have to be
introduced. Extra toilets have not been included in the above costs and
may have to be considered.
Educational factors / staff views

The Education Committee has noted that schools with 1.5 form entry
are more likely to face opposition from parents who do not understand
how the system operates. Most school heads at 1.5 form entry schools
want to move to 2 forms of entry to avoid the problems of having a
mixed year group class.
New bridge Primary has recently received a very good OFSTED report.
Old bridge and Black bridge will be inspected in the near future.
Staffs at the schools have indicated that they are not very enthusiastic
about increasing the size of schools. Particular concerns are that the size
of the halls at New Bridge Primary and Old Bridge Primary are too
small. Planning for the mixed age group was obviously very difficult at
the beginning but staff feels that they can cope with the system better
now.
318
Cost of relocation for pupils and staff
Any relocated pupils will be able to claim for travel costs. It has been
estimated that the average cost will be $300 p.a. per pupil. The travel
costs will be available to all pupils at the schools in the future.
Teachers will also be allowed to claim for additional travel costs if their
school is closed. The costs have been estimated as follows:

Travel costs for teachers
Close New bridge Primary $15,000
Close Old bridge Primary $18,000
Close Black bridge Primary $32,000
Capital receipts from the sale of closed schools

To date no estimates have been prepared.
School budgets
(Based on current capacity)
The following excludes full-time teaching costs:

New bridge Old bridge Black bridge
Primary Primary Primary
Expenditure
Peripatetic teachers 9,000 9,900 14,000

Supply teachers 8,000 9,000 18,000
Administrative and manual 80,000 75,000 111,000
staff
Other 6,000 7,000 9,000
Premises Expenses
Non-domestic rate 3,000 3,000 4,000
Contents insurance 3,000 3,000 4,000
Supplies and services

Advertising 2,000 2,000 2,000
Travel 1,500 1,000 1,900
Maintenance contracts 4,000 4,000 5,000
319
Building insurance 2,800 2,900 3,800
Direct costs
Educational supplies 18,000 17,900 20,000
Gas / electric 7,000 7,100 9,100
Cleaning supplies 1,100 1,200 1,900
Repairs 4,500 3,300 6,500
Source: Newshire School
Discussion Question
1. Compare the cost of keeping all of the schools open and the
relevant costs and savings of closing each school and discuss
the problems of making a clear recommendation on financial
grounds. You should include all workings and assumptions in
your answer and identify any other financial information you
require.
2. Discuss the importance of non-financial information to decision

making in the public sector generally and to the decision to close
schools.
320
Further Readings
Balakrishnan, Jaydeep, and Chun Hung Cheng. The Theory of
Constraints and the Make-or-Buy Decision: An Update and Review.
Journal of Supply Chain Management: A Global Review of Purchasing
& Supply 41, no. 1 (2005): 4047.
Burt, David N., Donald W. Dobler, and Stephen L. Starling. World Class
Supply Management: The Key to Supply Chain Management. 7th ed.
Boston: McGraw-Hill/Irwin, 2003.
Gardiner, Stanley C., and John H. Blackstone, Jr. The Theory of

Constraints and the Make-or-Buy Decision. International Journal of
Purchasing & Materials Management 27, no. 3 (1991): 3843.
Wisner, Joel D., G. Keong Leong, and Keah-Choon Tan. Principles

of Supply Chain Management: A Balanced Approach. Mason, OH:
Thomson South-Western, 2005.
321
CHAPTER 9
DECISION MAKING UNDER ENVIRONMENT
OF UNCERTAINTY AND RISK
Chapter Objectives
The objective of this chapter is to evaluate the fundamentals theory of decision
making under the environment of uncertainty and risk, also the chapter
will evaluate different decision making models under the environment of
uncertainty and risk.
Learning Outcomes
be able to:
1. Evaluate Risk with Probability Distributions
2. Evaluate the impact of uncertainty and risk on decision models
3. Analyze risk and uncertainty by calculating expected values
tables and standard deviations together with probability
tables
4. Prepare expected values tables and ascertain the value of
information
5. Prepare decision trees
322
9.1 Introduction
Decision Making is the process through which managers identify
organizational problems and attempt to resolve them. There are a
variety of environments where the outcome is not known at the time
that the decision must be made. The environment is strategically
uncertain if the uncertainty comes from an agent not having perfect
information about the choices made by other economic agents (and
these choices affect the potential optimality of the decision makers
choice). An example of strategic uncertainty is coordination games
where there exists multiple equilibrium. A second example is extensive-
form games with imperfect information where the other player has
taken an action, but it is unobservable to the decision maker. A third
example of strategic uncertainty is when the opposing player selects
a mixed strategy. Selecting a mixed strategy results in each outcome
arising with a probability, which is less than one if the mixed strategy
is no degenerate.
Therefore, Managerial decisions are made under conditions of certainty,

risk, or uncertainty. Certainty refers to the situation where there is only
one possible outcome to a decision and this outcome is known precisely.
For example, investing in Treasury bills leads to only one outcome (the
amount of the yield), and this is known with certainty. The reason is
that there is virtually no chance that the federal government will fail
to redeem these securities at maturity or that it will default on interest
payments. On the other hand, when there is more than one possible out-
come to a decision, risk or uncertainty is present.
Risk refers to a situation where there is more than one possible outcome
to a decision and the probability of each specific outcome is known or
can be estimated. Thus, risk requires that the decision maker knows
all the possible outcomes of the decision and have some idea of the
probability of each outcomes occurrence. For example, in tossing a-coin,
we can get either a head or/a rail,
A strategy refers to one of several alternative courses of action that a

decision maker can take to achieve a goal.
States of nature refers to conditions in the future that will have a

significant effect on the degree of success or failure of any strategy, but
over which the decision maker has little or no control. For example, the
economy may be in boom, normal, or in a recession in the future. The
decision maker has no control over states of nature that will prevail in
the future but the future states of nature certainly affect the outcome of
any strategy that he or she may adopt.
323
A payoff matrix is a table that shows the possible outcomes or results
of strategy under each state of nature. For example, a payoff matrix may
show the level of profit that would result if the firm builds a large or a
small plant and if economy will be booming, normal, or recessionary in
the future.
9.2 Measuring Risk with Probability Distributions

Risk is the situation where there is more than one possible outcome to a
decision and the probability of each possible outcome is known or can
be estimated.
The concept of probability distributions is essential in evaluating and

comparing investment projects. In general, the outcome or profit of,
an investment project is highest when the economy is booming and
smallest when the economy is in a recession. If we multiply each possible
outcome or profit of an investment by its probability of occurrence and
add these products, we get the expected value or profit of the project.
That is,
n
Expected profit = E() = i.P
i=1
Where TT, is the profit level associated with outcome i, P, is the

probability that outcome will occur, and i = 1 to n refers to the number
of possible outcomes or states of nature. Thus, the expected profit of an
investment is the weighted average of all possible profit levels that
can result from the investment under the various states of the economy,
with the probability of those outcomes or profits used as weights. The
expected profit of an investment is a very important consideration in
deciding whether or not to undertake the project or which of two or
more projects is preferable.
Probability Distribution of States of the Economy
State of the Economy Probability of Occurrence

Boom 0.25
Normal 0.50
Recession 0.25
Illustration 1
The following details relate to project A and project B and the Expected
Profits of Two Projects are calculated below
324
(4)
(1) (2) (3)
Expected
State of economy Probability Outcome
value
(A) Boom 0.25 $600 $150
Normal 0.50 $500 $250
Recession 0.25 $400 $100
Expected profit from project A $500
Boom 0.25 $800 $200

Normal 0.50 $500 $250
Recession 0.25 $200 $50
Expected profit from project B $500
For example, Table presents the payoff matrix of project A and project
B and shows how the expected value of each project is determined. In
this case the expected value of each of the two projects is $500, but the
range of outcomes for project A (from $400 in recession to $600 in boom)
is much smaller than for project B (from $200 in recession to $800 in
boom). Thus, project A is less risky than and, therefore, preferable to
project B.
The expected value of a probability distribution need not equal any

of the possible outcomes (although in this case it does). The expected
value is simply a weighted average of all the possible outcomes if the
decision or experiment were repeated a very large number of times.
Had the expected value of project A been lower than of project B, the
manager would have had to decide whether the lower expected profit
from project A was compensated by its lower risk.
9.3 Absolute Measure of Risk: The Standard Deviation

We know that the tighter or the less dispersed is a probability
distribution, the smaller is the risk of a particular strategy or decision.
The reason is that there, is a smaller probability that the actual outcome
will deviate significantly from the expected value. We can measure the
tightness or the degree of dispersion of a probability distribution by
the standard deviation, which is indicated by the symbol , Thus, the
standard deviation () measures the dispersion of possible outcomes
from the expected value. The smaller the value of (T, the tighter or less,
dispersed is the distribution, and the lower the risk).
To find the value of the standard deviation () of a particular probability

distribution, we follow the three steps outlined below.
325
1. Subtract the expected value or the mean (X ) of the distribution
from each possible outcome (X ) to obtain a set of deviations (d)
from the expected value. That is,
di = Xi X (1)
2. Square each deviation, multiply the squared deviation by the

probability of its expected outcome, and then sum these products.
This weighted average of squared deviations from the mean is
the variance of the distribution (2), That is,
n
= (Xi X ) .Pi
2
Variance = 2
i =1
3. Take the square root of the-variance to find the standard deviation

(o-):
n
Standard deviation = 2 = (Xi X ) .Pi
i =1
2
If we calculate the standard deviation of the probability distribution

of profits for any two project A and project B, if the standard deviation
of the probability distribution of profits for project A is $ 100, while
that for project B is $ 200. These values provide a numerical measure
of the absolute dispersion of profits from the mean for each project and
confirm the greater dispersion of profits and risk for project B than for
project A.
9.4 Relative Measure of Risk: The Coefficient of Variation

The standard deviation is not a good measure to compare the dispersion
(relative risk) associated with two or more probability distributions with
different expected values or. means. The distribution with the largest
expected value or mean may very well have a larger standard deviation
(absolute measure of dispersion) but not necessarily a larger relative
dispersion. To measure relative dispersion, we use the coefficient of
variation (v). This is equal to the standard deviation of a distribution
divided by its expected value or mean. That is,

Coefficient of variation = v =
X
The coefficient of variation, thus, measures the standard deviation per
dollar of expected value or mean. As such, it is dimension-free, or, in
other words, it is a pure number that can be used to compare the relative
risk of two or more projects. The project with the largest coefficient of
variation will be the most risky
326
9.5 Decisions making Environment
Virtually all decisions are made in an environment of at least some
uncertainty. However, the degree will vary from relative certainty to
great uncertainty. There are certain risks involved in making decisions.
Therefore, the decision to be made by the management will depend on
the decision environment, because environment defer in the context of
information available to the managers. So, it is important for managers
to understand the decision environment as it assists to choose the
appropriate management technique corresponding to the environment
under consideration. Normally there are three decision environments,
which are explained below;
9.6 Decisions making under the environment of certainty;

In a situation involving certainty, people are reasonably sure about what
will happen when they make a decision. The information is available and
is considered to be reliable, and the cause and effect relationships are
known. Environment of certain is that situation which is characterized
by many decisions alternatives to consider and one state of nature. Since
there is only one state of nature, the mangers know exactly what will
happen, thus given that situation there is no problem in making decision
under this environment. Example of decision under this environment is
like routine tasks.
9.7 Decisions making under the environment of uncertainty

In a situation of uncertainty, on the other hand, people have only
a meager data base, they do not know whether or not the data are
reliable, and they are very unsure about whether or not situation may
change. Moreover, they cannot evaluate the interactions of the different
variables. Uncertainty exists where the future is unknown and so the
decision-maker has no previous experience and no statistical evidence
on which to base predictions. Therefore, the environment of uncertainty
is that one which is characterized with many decision alternatives to
consider many states of nature, apart from that the management has no
information that can help to assign the probabilities to those states of
nature. For examples, a corporation that decides to expand its operation
in a strange country may know little about the country culture, laws,
economic environment, and politics. The political situation may be
so volatile that even the experts cannot predict a possible change in
government.
Under this environment there are three criteria in which the manager
can use to make a decision, these criteria are;
327
(i) Maximax Criteria
The maximax criterion suggests that a decision maker should select
the alternative that offers the highest possible return. This means that
the decision maker would choose the opportunity that maximizes the
maximum profit. Thus under this criterion the following steps should
be followed;
1. Prepare the pay off table
2. Select the maximum pay off under each decision alternative
3. Take that decision that corresponding to the highest pay off
among those listed in the step 2 above
(ii) Maximin Criterion

The maximin criterion suggests that a decision maker should select the
alternative that offers the least unattractive worse outcome. The decision
maker assumes that the worst possible outcome will always occur and
therefore he should select the largest payoff under these situations. This
means that the manger would select the opportunity that maximizes the
minimum profit. Thus the following steps should be followed when this
criteria is used;
1. Prepare the pay off table
2. Select the minimum payoff under each decision alternative
3. Take that decision that corresponding to the highest pay off
among those listed in step 2 above
(iii) The minimax regret approach

Sometimes known simply as Regret, this approach makes a decision
today based upon how the trader might feel at the end of tomorrows
market (CIMA). Hence, under this decision rule the manager seeks to
minimize the maximum regret that there would be from selecting a
particular alternative.
Therefore, under this criterion it essential to construct an opportunity

loss table sometimes called regret matrix table based on the pay off table
given in the problem, the regret is the opportunity loss from taking
one decision given that certain contingency occurs. The procedure for
making a decision using this approach is as follows;
1. With the help of the pay off table develop an opportunity loss
table i.e. regret matrix
2. Select the maximum regret value under each decision under
consideration
3. The decision to take is the one which corresponds to the minimum
regret value among those listed in step 2 above
328
Illustration of decision under uncertainty (CIMA adapted)
A fruit trader plans to travel to market tomorrow. He has a small stall
at the market and only a limited amount of cash available to buy stock
to sell. Accordingly, he can select only one type of fruit to buy from the
wholesaler today ready for tomorrows market. There are four types of
fruit from which the trader can make his selection; apples, pears, orange,
and strawberries. From past experience, trader expects those trading
conditions tomorrow will fall into one of four headings; bad, poor, fair
or good and each of these trading conditions has the same likelihood
of occurring. Again using past experience, the trader has quantified
the profit or loss that he thinks he will earn tomorrow depending upon
his choice of fruit and the trading conditions that emerge. These are as
follows.
Fruit Apples Pears Orange Strawberries

Trading condition $ $ $ $
Bad (1000) (1,200) (300) (600)
Poor (200) (400) (100) (300)
Fair 600 700 200 100
Good 1,000 1,200 400 440
Advice the trader on the decision to take to determine which type of

fruit he will purchase and take to tomorrows market, depending on the
attitude to risk that is to prevail using
(i) The maximax criterion
(ii) The maximin criterion
(iii) The minimax regret
Solution
The fist step let redraft the pay off table in good order by putting the
decision on the left side of the table and the states of nature (events or
occurrences) on the top. It should be noted that the decisions are the
type of fruits and states of nature are the trading conditions. The table
is represented as follows;
329
States of nature
Bad Poor Fair Good
Decisions $ $ $ $
Apples (1000) (200) 600 1,000
Pears (1,200) (400) 700 1,200
Orange 300) (100) 200 400
Strawberries 600) (300) 100 440
(i) The maximax approach

The preparation of pay off table is already given above
To select the maximum pay off under each decision alternative
as follows;
Decisions Maximum pay off ($)

Apples 1,000
Pears 1,200
Orange 400
Strawberries 440
This would lead to select pears with the highest possible profit of
$ 1,200. In hoping that good trading conditions will emerge,
taking an optimistic out-look on the situation and not worrying
about the fact, if trading conditions are bad then pears will
lead to the largest loss of $ 1,200

To select the minimum pay off under each decision alternatives
as follows
Decisions Minimum pay off ($)

Apples (1,000)
Pears (1,200)
Orange (300)
Strawberries (600)
To select the alternative that has the highest pay of among the
four, that is select orange since the anticipated loss of $ 300
is the least worst of the four types of fruit. This approach is
focused on bad trading conditions only, meaning that the
criterion involves looking at the worst possible outcome only
for each of the four types of fruit.
330
(iv) The minimax regret approach
With the help of the pay off table, the opportunity loss table
will be developed as follows
Opportunity loss table

States of nature
Bad Poor Fair Good
Decisions $ $ $ $
Apples 700 100 100 200
Pears 900 300 0 0
Orange 0 0 500 800
Strawberries 300 200 600 760
To select the maximum regret value under each decision

alternative as follows
Decisions Maximum regrets ($)

Apples 700
Pears 900
Orange 800
Strawberries 760
To select the alternative which has the minimum regret value for
the our case above select the apples which has the minimum
value of regret i.e. $ 700
9.8 Decisions making under the Environment of Risk

In a risk situation, factual information may exist, but it may be incomplete.
To improve decision making, one may estimate the objective probabilities
of an outcome by using, for example, mathematical models. On the other
hand, subjective probability, based on judgment and experience, may
be used. Fortunately, there are a number of tools available that helps
make more effective decisions.
Risk exists where the decision-maker has knowledge, probably due

to previous experience, that several alternative outcomes are possible.
Previous experience enables the decision-maker to describe a probability
to the likely occurrence of each alternative (CIMA)
Hence, the environment of risk is that environment that has many

decisions situations and also many states of nature, however there is also
some information that can assist the manager to assign the probabilities
to all states of nature
331
9.9 Probability distribution and expected value
It should be noted by the management that, the presentation of
probability distribution for each alternative course of action can provide
useful additional information to management for decisions making
under the environment of risk. The probability distribution enables the
management to consider not only possible profits from each opportunity
but also the amount of uncertainty, which applies to each opportunity.
Under the decisions environment of risk, the manger can make decision
by using various approaches; the most common approaches which help
the manager to make decision under this environment are illustrated as
follows;
9.10 The expected monetary value (EMV) approach

Under this approach where, the probabilities are assigned to various
possible outcomes, it is common to evaluate the worth of the decision
as an expected value or weighted average, of these outcomes. The
expected value of an opportunity is equal to the sum of the probabilities
of the outcome occurring multiplied by the return expected if it does
not occur. Meaning that, for each type of decision, the decision maker
will calculate a single figure that represents all of the possible outcomes
for that decision and their respective probability distribution. Thus the
expected value will be calculate by the following formula
n
Expected Monetary Value (EMV) = E(( = i.P
i =1
Where i is the monetary value of each outcome and p is the associated

probability
In deciding, under this approach, the decision-maker will select that

alternative which corresponds with the highest expected monetary
value than the other alternative decisions.
9.11 The expected Opportunity loss (EOL) approach

Under this approach by the help of the pay off table the decision-maker
will be required to prepare the opportunity loss table as shown the
example 2.1 above,, then expected opportunity loss equal to the sum
of the probabilities of the outcome occurring multiplied by the return
expected opportunity loss. The following procedures can be followed
to compute the expected opportunity loss (EOL);
1. By the help of pay off table, the decision maker should develop a
regret matrix (opportunity loss ) table
332
2. To compute the expected opportunity loss for each decision
alternative
3. The optimal decision to take is the one which corresponds to that

alternative resulting into the least expected opportunity loss.
Illustration of decision making under risk (CPA adapted)

Quick Print Ltd is proposing to introduce to the market a new type of
laser printer. It has three possible models, which reflect speed of printing
and available fonts: Basics, Fast and Enhanced. (The model numbers are
QP200B, QP500P and QP700E respectively). However the company has
only sufficient capacity to manufacture one of these models. An analysis
of the probable market acceptance of each of the three models has been
carried out and the resulting profits estimated as follows:
Model Acceptance Profits (Millions) Model Type

Acceptance Probability QP200B QP500F QP700E
Excellent (E) 0.2 60 100 120
Moderate (M) 0.5 40 60 80
Poor (P) 0.3 20 0 -40
i) Using the expected monetary value (EMV) criterion, choose an

appropriate model to Introduce to the market.
ii) Using the expected opportunity loss (EOL) criterion, choose an

appropriate model to Introduce to the market.
iii) Use the tree diagram criterion; choose an appropriate model to

Introduce to the market.
Solution
The first step let redraft the pay off table in good order by putting the
decision on the left side of the table and the states of nature (events or
occurrences) on the top. It should be noted that the decisions are the
type of fruits and states of nature are the trading conditions. The table
is represented as follows
333
Model
STATES OF NATURE - Profits ($ Millions)
Acceptance
Decisions Excellent (0.2) Moderate (0.5) Poor (0.3)
QP 200B 60 40 20
QP 500F 100 60 0
QP700E 120 80 -40
(i) The expected monetary value (EMV) = px

QP 200B = ( 60m x 0.2) + (40m x 0.5) + (20 x 0.3) = $ 38m
QP 500F = (100m x 0.2) + (60m x 0.5) + (0m x 0.3) = $ 50m
QP 700E = (120m x 0.2) + (80m x 0.5) + (-40m x 0.3) = $ 52,
Based on expected value approach, the decision-maker will select the

type of model with the highest expected monetary value, hence the
model which will be selected here is QP 700E with an expected profit
value of $ 52 million
(ii) The expected opportunity loss (EOL)
By the help of the pay off table above,, a regret matrix (opportunity
loss ) table can be developed as follows;
Model
STATES OF NATURE - Profits ($ Millions)
Acceptance
Decisions Excellent (0.2) Moderate (0.5) Poor (0.3)
QP 200B 60 40 0
QP 500F 20 20 20
QP700E 0 0 60
The second step is the computations of the expected opportunity loss

for each decision alternative as follows;
QP 200B = ( 60m x 0.2) + (40m x 0.5) + (0m x 0.3) = $ 32m
QP 500F = (20m x 0.2) + (20m x 0.5) + (20m x 0.3) = $ 20m
QP 700E = (0m x 0.2) + (0m x 0.5) + (60m x 0.3) = $ 18m,
Then the optimal decision to take is the one which corresponds to that
alternative resulting into the least expected opportunity loss, therefore
the decision-maker will select model QP 700E with an least an expected
opportunity loss of $ 18 million.
It should be noted that, whether expected value approach or expected

opportunity approach used, both approaches will result into the same
conclusion.
334
9.12 Expected value of perfect information
The expected value of perfect information (EVPI) is the price that one
would be willing to pay in order to gain access to perfect information
The expected value of perfect information is the difference between
these two quantities,
EVPI = EV (PI) - EMV
This difference describes, in expectation, how much larger a value the

player can hope to obtain by knowing j and picking the best i for that j,
as compared to picking a value of i before j is known. Note: EV (PI) is
necessarily greater than or equal to EMV. That is, EVPI is always non-
negative.
EVPI provides a criterion by which to judge ordinary mortal forecasters.

EVPI can be used to reject costly proposals: if one is offered knowledge
for a price larger than EVPI, it would be better to refuse the offer.
However, it is less helpful when deciding whether to accept a forecasting
offer, because one needs to know the quality of the information one is
acquiring.
Illustration
Suppose you were going to make an investment into only one of three
investment vehicles: stock, mutual fund, or certificate of deposit (CD).
Further suppose that the market has a 50% chance of increasing, a 30%
chance of staying even, and a 20% chance of decreasing. If the market
increases the stock investment will earn $1500 and the mutual fund
will earn $900. If the market stays even the stock investment will earn
$300 and the mutual fund will earn $600. If the market decreases the
stock investment will lose $800 and the mutual fund will lose $200.
The certificate of deposit will earn $500 independent of the markets
fluctuation.
Required
Calculate the expected value of perfect information
Solution:
Let develop the pay off table for the investment
States of Nature
Decisions
Increasing (0.5) Staying (0.3) Decreasing (0.2)
Stock $1,500 $ 300 ($ 800)
Mutual $ 900 $ 600 ($ 200)
CD $ 500 $ 500 $ 500
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Expected Monetary Value (EMV) for each vehicle:
EMV stock = 0.5 x 1500 + 0.3 x 300 + 0.2 x ( 800) = $ 680
EMV mutual fund = 0.5 x 900 + 0.3 x 600 + 0.2 x ( 200) = $ 590
EMV certificate of deposit = 0.5 x 500 + 0.3 x 500 + 0.2 x 500 = $ 500
The maximum of these expectations is the stock vehicle. Not knowing

which direction the market will (only know the probability of the
directions), we expect to make the most money with the stock vehicle.
Thus, EMV = $ 680
On the other hand, consider if we did know ahead of time which way the
market would turn. Given the knowledge of the direction of the market
we would (potentially) make a different investment vehicle decision.
Expectation for maximizing profit given the state of the market:
EV (PI) = 0.5 x 1500 + 0.3 x 600 + 0.2 x (500) = $ 1030
That is, given each market direction, we choose the investment vehicle
that maximizes the profit.
Hence,
EVPI = EV (PI) EMV = $ 1030 - $ 680 = $ 350
Conclusion:
Knowing the direction the market will go (ie. having perfect information)
is worth $350.
Discussion:
If someone was selling information that guaranteed the accurate
prediction of the future market direction, we would want to purchase
this in only if the price was less than $350. If the price was greater than
$350 we would not purchase the information, if the price was less than
$350 we would purchase the information. If the price was exactly $350,
then our decision is futile.
Suppose the price for the information was $349.99 and we purchased it.
Then we would expect to make 1030 - 349.99 = 680.01 > 680. Therefore,
by purchasing the information we were able to make $0.01 more than if
we didnt purchase the information.
Then we would expect to make 1030 - 350.01 = 679.99 < 680. Therefore,
by purchasing the information we lost $0.01 when compared to not
having purchased the information.
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Then we would expect to make 1030 - 350.00 = 680.00 = 680. Therefore,
by purchasing the information we did not gain nor lose any money by
deciding to purchase this information when compared to not purchasing
the information.
9.13 Decision Tree and Influence Diagram

One of the best ways to analyze a decision is to use so-called decision
trees. Decision trees depict, in the form of the decision points, chance
events, and probabilities involved in various courses that might be
undertaken. A common problem occurs in business when a new product
is introduced. Managers must decide whether to install expensive
permanent equipment to ensure production at the lowest possible cost
or to undertake cheaper, temporary tooling that will involve a higher
manufacturing cost but lower capital investments and will result in
lower losses if the product does not sell as well as estimated, in its
simplest form. The decision tree approach makes it possible to see at
least the major alternatives and the fact that subsequent decision may
depend upon events in the future. By incorporating the probabilities
of various events into the tree, mangers can also comprehend the true
probability of a decision is leading to the desired results.
Hence, a decision tree is a chronological representation of the decision

process. It utilizes a network of two types of nodes: decision (choice)
nodes (represented by square shapes), and states of nature (chance)
nodes (represented by circles). Construct a decision tree utilizing the
logic of the problem. For the chance nodes, ensure that the probabilities
along any outgoing branch sum to one. Calculate the expected payoffs
by rolling the tree backward (i.e., starting at the right and working
toward the left).
You may imagine driving your car; starting at the foot of the decision
tree and moving to the right along the branches. At each square you
have control, to make a decision and then turn the wheel of your car. At
each circle, Lady Fortuna takes over the wheel and you are powerless.
Here is a step-by-step description of how to build a decision tree:
1. Draw the decision tree using squares to represent decisions and

circles to represent uncertainty,
2. Evaluate the decision tree to make sure all possible outcomes are
included,
3. Calculate the tree values working from the right side back to the left,
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4. Calculate the values of uncertain outcome nodes by multiplying
the value of the outcomes by their probability (i.e., expected
values).
On the tree, the value of a node can be calculated when we have the
values for all the nodes following it. The value for a choice node is the
largest value of all nodes immediately following it. The value of a chance
node is the expected value of the nodes following that node, using the
probability of the arcs. By rolling the tree backward, from its branches
toward its root, you can compute the value of all nodes including the
root of the tree.
Illustration of Decision Tree Analysis: A Manufacturing Proposal

BM Corporation has been presented with a new product development
proposal. The cost of the development project is $500,000. The probability
of successful development is projected to be 70%. If the development
is unsuccessful, the project will be terminated. If it is successful, the
manufacturer must then decide whether to begin manufacturing the
product on a new production line or a modified production line. If
the demand for the new product is high, the incremental revenue for
a new production line is $1,200,000, and the incremental revenue for
the modified production line is $850,000. If the demand is low, the
incremental revenue for the new production line is $700,000, and the
incremental revenue for the modified production line is $150,000. All of
these incremental revenue values are gross figures, i.e., before subtracting
the $500,000 development cost, $300,000 for the new production line
and $100,000 for the modified production line. The probability of high
demand is estimated as 40%, and of low demand as 60%.
The development of a decision tree is a multi step process. The first step
is to structure the problem using a method called decomposition, similar
to the method used in the development of a work breakdown structure.
This step enables the decision-maker to break a complex problem
down into a series of simpler, more individually manageable problems,
graphically displayed in a type of flow diagram called a decision tree.
These are the symbols commonly used:
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339
The second step requires the payoff values to be developed for each
end-position on the decision tree. These values will be in terms of the
net gain or loss for each unique branch of the diagram. The net gain/
loss will be revenue less expenditure. If the decision to not develop is
made, the payoff is $0. If the product development is unsuccessful, the
payoff is - $500,000. If the development is successful, the decision is to
build a new production line (NPL) or modify an existing production line
(MPL). The payoff for the NPL high demand is ($ 1,200,000 - $500,000
development cost -$300,000 build cost) or $400,000. For a low demand,
the payoff is ($700,000 - $500,000 development cost -$300,000 build cost)
or -$100,000. The payoff for the MPL high demand is ($850,000 -$500,000
development cost - $100,000 build cost) or $250,000. For a low demand,
the payoff is ($720,000- $500,000 development cost - $100,000 build cost)
or $120,000.
The third step is to assess the probability of occurrence for each outcome:
Development Successful = 70% NPL High Demand = 40% MPL High Demand = 40%
Development Unsuccessful = 30% NPL Low Demand = 60% MPL Low Demand = 60%
Probability Totals* 100% 100% 100%
*Probabilities must always equal 100%, of course.
The fourth step is referred to as the roll-back and it involves calculating

expected monetary values (EMV) for each alternative course of
action payoff. The calculation is (probability X payoff) = EMV This
340
is accomplished by working from the end points (right hand side) of
the decision tree and folding it back towards the start (left hand side)
choosing at each decision point the course of action with the highest
expected Monetary value (EMV)
Decision D2:
New Production Line vs. Modified Production Line
high demand + low demand = EMV high demand + low demand = EMV
(4 0% X $400,000) + (60%X -$100,000) = (40% X $250,000)+(60% X $120,000)
$100,000 $172,000
Decision Point 2 Decision: Modified Production Line with an EMV of

$172,000
Decision 1: Develop or Do Not Develop

Development Successful + Development Unsuccessful
(70% X $172,000) + (30% x (- $500,000))
$120,400 + (-$150,000)
Decision Point 1 EMV=(-$29,600)
Decision: DO NOT DEVELOP the product because the expected value

is a negative number.
When doing a decision tree analysis, any amount greater than zero
signifies a positive decision. This tool is also very useful when there
are multiple cases that need to be compared. The one with the highest
payoff should be picked
Assessment Question
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9.1
BM Ltd manufactures a hedge-trimming device which has been sold at
$16 per unit for a number of years. The selling price is to be reviewed
and the information is available on costs and likely demand.
The standard variable cost of manufacture is $10 per unit and analysis
of the cost variances for the past 20 months show the following pattern
which the production manager expects to continue in the future.
Adverse variances of +10% of standard variable cost occurred in ten of

the months.
Nil variances occurred in six of the months.

Favourable variances of -5% of standard variable cost occurred in four
of the months
Monthly data
Fixed costs have been $4 per unit on an average sales level of 20,000
units but these costs are expected to rise in the future and the following
estimates have been made for the total fixed cost:
$
Optimistic estimate (probability 0.3) 82,000
Most likely estimate (probability 0.5) 85,000
Pessimistic estimate (probability 02) 90,000
The demand estimates at the two new selling prices being considered
are as follows:
If the selling
Price/unit is $17 $18
Demand would be:
Optimistic estimate (probability 0.3) 21,000 units 19,000 units
Most likely estimate (probability 0.5) 19,000 units 17,500 units
Pessimistic estimate (probability 02) 16,500 units 15,500 units
It can be assumed that all estimates and probabilities are independent
Required
(a) Advise management, based only on the information given above,
whether they should alter the selling price and, if so price you
would recommend
(b) Calculate the expected profit at the price you recommend and
the resulting margin of safety, expressed as a percentage of
expected sales
(c) Criticize the method of analysis you have used to deal with the
probabilities given in the question
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(d) Describe briefly how computer assistance might improve the
analysis
CIMA stage 3 Management Accounting Techniques
Summary
In this chapter we have established the estimates those incorporating a
range of possible outcomes with probabilities attached to each outcome
are preferable to a single estimate based on the most likely outcome. We
have considered some of the important methods incorporating risk and
uncertainty into the decision making process. The chapter has addressed
clearly the criteria of maximax , maximin and minmax regret under the
environment of uncertainty.
The term expected value, expected opportunity value and the value of
perfect information were clearly addressed under this chapter, decision
trees are useful tool for analyzing each alternative each alternative,
this was addressed in this chapter. The expected values should be
supplemented by measures of dispersion such as the standard deviation
and coefficient of variation, this chapter has addressed them clearly

Coefficient of variation
Decision tree
Expected value
Expected value of perfect information
Expected opportunity loss
Maximax criterion
Maximin criterion
Minimax regret criterion
Outcomes
Payoff table
Probability
Probability distribution
Risk
Standard deviation
Uncertainty
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Exercises
9.1
The weekly demand and probabilities for one of the product of the ABC
company is as follow:
Demand Probability
100 0.4
150 0.1
200 0.1
250 0.2
300 0.1
350 0.1
Required
What is the expected value of the demand?
9.2
The manager is considering whether to make a product A or product
B, but only one can be produced. The estimated sales demand for each
product is uncertain and hence estimated profits are also uncertain. A
detailed investigation of possible sales demand for each product gives
the following probability distribution of profits for each product.
Product A
Outcome Probability
$6,000 0.10
$7,000 0.20
$8,000 0.40
$9,000 0.20
$10,000 0.10
Product B
Outcome Probability
$4,000 0.10
$6,000 0.20
$8,000 0.40
$10,000 0.20
$12,000 0.10
You are required to offer your comments based on your working

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Problems
9.3
A fruit trader plans to travel to market tomorrow. He has a small stall
at the market and only a limited amount of cash available to buy stock
to sell. Accordingly, he can select only one type of fruit to buy from the
wholesaler today ready for tomorrows market. There are four types of
fruit from which the trader can make his selection; apples, pears, orange,
and strawberries. From past experience, trader expects those trading
conditions tomorrow will fall into one of four headings; bad, poor, fair
or good and each of these trading conditions has the same likelihood
of occurring. Again using past experience, the trader has quantified
the profit or loss that he thinks he will earn tomorrow depending upon
his choice of fruit and the trading conditions that emerge. These are as
follows.
Fruit Apples Pears Orange Strawberries

Trading condition $ $ $
Bad (1000) (1,200) (300) (600)
Poor (200) (400) (100) (300)
Fair 600 700 200 100
Good 1,000 1,200 400 440
Advice the trader on the decision to take to determine which type of

fruit he will purchase and take to tomorrows market, depending on the
attitude to risk that is to prevail using
(i) The maximax criterion
(iii) The minimax regret
9.4
That well-known author D.C fields who wrote. Theres no Accounting
for Mathematics is about to publish his new book on computers called
The cumulating Accountant Due to rapid change in technology in the
computer industry, he does not direct his book to sell any copies after
three years
His publishers have carried out a market survey attempting to forecast

demand for his new book has produced the following probability
estimates:
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Year 1 Year 2 Year 3

Likely likely likely
probability probability probability
sales sales sales
5,000 0.2 5,000 0.4 5,000 0.8
10,000 0.5 10,000 0.6 10,000 0.2
20,000 0.3
Required
(a) Calculated the expected total sales
(b) The books price is fixed at $10 and the variable cost of producing
each book will be $2 in year 1, $3 in year 2 and $4 in year 3.
Calculate expected contribution for year 1, 2 and 3
9.5
Kisarawe Heath Centre specializes in the provision of sort/exercise and
medical/dietary advice to clients. The service is provided on residential
basis and clients stay for whatever number of days suits their needs.
Budgeted estimates for the year ending 30th June 2006 were as follows:
(a) The maximum capacity of the centre was 50 clients per day for
350 days in the year.
(b) Clients were invoiced at a fee per day. The budgeted occupancy
level varied with the client fee level per day and was estimated at
different percentages of maximum capacity as follows:
Occupancy as Percentage of
Client fee per day Occupancy level
maximum capacity
$180 High 90%
$200 Most likely 75%
$220 Low 60%
(c) Variable costs were also estimated at one of three levels per client
day. The high, most likely and low levels per client are $95, $85
and $70, respectively. The range of cost levels reflects only the
possible effect of the purchase price of goods and services.
Required:
(a) Prepare a summary which shows budgeted contribution earned
by Kisarawe Health Centre for the year ended 30th June 2006 for
each possible outcome.
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(b) State the client fee strategy for th3e year to 30th June 2006 which
resulted form the use of each of the following decision rules.
(Use your answer on (a) above as relevant input and show any
additional workings or calculations as necessary).
(i) Maxi maxi

(ii) Maximin
(iii) Minimax regret

(c) The probabilities of variable cost levels occurring at the high,
most likely and low levels provided in the question are estimated
as 0.1, 0.6 and 0.3, respectively.
Using information available, determine the client fee strategy which

will be chosen where maximization of expected value of contribution is
used as the decision bases

9.6
The research and development department of Kaole Limited has
produced specifications for two new products for consideration by
the companys production director. The director has received detailed
costing which can be summarized as follows:
Product A Product B
Direct costs:
Material $640 $380
Labour ($30 per unit) 180 60
820 440
Factory overheads ($30 per machine hour) 180 60

Total estimated unit cost 1,000 500
The sales department has provided estimates of the probabilities of

various levels of demand for two possible selling prices for each product.
The details are as follows:
Product A Product B
Low price alternatives:
Selling price $1,200 $600
Demand estimates
Pessimistic probability 0.2 1,000 3,000
Most likely probability 0.5 2,000 4,000
Optimistic probability 0.3 3,000 5,000
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Higher price alternatives:
Selling prince $1,300 $700

Demand estimates:
Pessimistic probability 0.2 500 1,500
Most likely probability 0.5 1,000 2,500
Optimistic probability 0.3 1,500 3,500
It would be possible to adopt the low price alternative for product A

together with the high price alternative for product B, or the high price
alternative for product A with the low price alternative for product B
(demand estimates are independent for the two products).
The factory ahs 60,000 machine hours available during the year. For
some years now it has been working at 90% of practical capacity making
a standardized product. This product is very profitable and it is only the
availability of 6,000 hours of spare machine capacity that has made it
necessary to search for additional product lines to use the machines fully.
The actual level of demand will be known at the time of production.
A statistical study of the behaviour of the factory overhead over the

past year has indicated that it can be regarded as a linear function of
factory machine time worked. The monthly fixed cost is estimated to
$100,000 and the variable cost at $10 per machine hour with coefficient
of correlation of 0.80.
Required:
(b) Identify the best plan for the utilization of the 6,000 machine
hours. Comment on the rational selling price alternatives that
exist for this plan and calculate the expected increase in annual
profit which would arise for each alternative;
(b) Discuss the relevance of regression analysis for problems of this

type.
9.7
Quick Print Ltd is proposing to introduce to the market a new type of
laser printer. It has three possible models which reflect speed of printing
and available fonts: Basic, Fast and Enhanced. (The model numbers are
QP200B, QP500F and QP700E respectively). However, the company has
only sufficient capacity to manufacture one of these models. An analysis
of the probable market acceptance of each of the three models has been
carried out and the resulting profits estimated as follows:-
348
Model Acceptance Profit (Millions)

Probability Model type
QP200B QP500F QP700E
Excellent (E) 0.2 60 100 120
Moderate (M) 0.5 40 60 80
Poor (P) 0.3 20 0 (40)
Required:
(i) Using the maximum expected profit criteria, choose an appropriate
model to introduce to the market.
(ii) Explain what is meant by the expected value of perfect

information. Calculate its value for this situation.
9.8
One Breweries Company Ltd is reviewing the price that it charges
for major product line. Over the past three years, the product has had
sales averaging 48,000 units per year at a standard selling price of $525.
Costs have been rising steadily over the past year and the company
is considering raising this price to $575 or 625. The sales manager has
produced the following schedule to assist with the decision.
Price $575 $625

Estimates of Demand:
Pessimistic Estimate 35,000 10,000
(Probability 0.25)
Most Likely Estimate 40,000 20,000
(Probability 0.60)
Optimistic Estimate 50,000 40,000
(Probability 0.15)
Currently the unit cost is estimated at $500 analysed as follows:
Variable Cost
Direct Material $250
Direct Labour 100
Overhead 200 450
Fixed Overhead Costs 50
Total Estimated per unit cost 500
349
The cost accountant considers that the most likely value for unit variable
cost over the next year, is $490 (subjective probability 0.75) but that it
could be as high as $520 (probability 0.15) and it might even be as low
as $475 (probability 0.10). Total fixed costs are currently $2,400,000,000
p.a. but it is estimated that the corresponding total for the ensuring year
will be:
$2,500,000 with a probability of 0.2

(Demand quantities, unit costs and fixed costs can be assumed to be

statistically independent).
Required:
(a) Analyze the foregoing information in a way you think will assist
management with the pricing problem and advise on the new
selling price. Calculate the expected level of profit that would
follow from the selling price that you recommend.
(b) It can be argued that the use of point estimate probabilities (as
above) can be dangerous because it unrealistically constrains the
demand and cost variable to taking just one of the three possible
values. Comment briefly on the above statement and suggest how
this problem might be solved.
(c) Discuss the problem of identifying and assessing the limiting

factor or factors of production.
350
Case studies
Case Study 9.1: Newcastle Division
A meeting of senior managers at the Newcastle Division has been called
to discuss the pricing strategy for a new product. Part of the discussion
will focus on the problem of forecasting sales volume. In the last year a
significant number of new products have failed to achieve their forecast
sales volumes. The financial accountant has already stated that the profit
for the year-end will be lower than budget and the main reason for this
is the disappointing sales of new products.
A new technique for estimating the probability of achieving target

sales and profits will be discussed. This requires managers to estimate
demand for the new product and assign probabilities. The management
accountant is in favour of this approach as she wants to avoid having a
single estimate for sales.
Details of pricing strategies

The first strategy is to set a selling price of $170 with annual fixed costs
at $22,000,000. A number of managers are in favour of this strategy as
they believe it is important to reduce costs.
The second strategy is to have a much higher expenditure on advertising

and promotions and set a selling price of $190. With the higher selling
price the annual fixed costs would increase to $27,000,000. The marketing
department are very clear that greater expenditure on advertising and
promotions is essential for this product.
The following probability distribution has been agreed with the managers
after consultation and is the same for both selling prices. A wide range
of managers from all departments have agreed to this estimate.
Estimated demand (units) Estimated probability (units)

150,000 0.1
160,000 0.4
180,000 0.3
200,000 0.1
210,000 0.1
Estimated standard deviation of sales 18,547 units
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Variable costs per unit
The managers estimate that the variable cost per unit is $35.
Target Profits
The target profits identified by the managers are given below. The
probability of the new product only achieving break-even is very
important. A profit greater than $4,000,000 is the required return for
the new product, If the product cannot achieve a profit greater than
$4,000,000 it is very unlikely that managers will accept it.
1. For both pricing strategies calculate the probability of:
a) A profit greater than $1,500,000
b) A profit of $0 (break-even)
c) A profit greater than $4,000,000
2. Assuming that the target profit for the new product is $4,000,000
discuss whether your answer to (1) helps managers choose
between the two pricing strategies.
3. Discuss how this technique can be applied to a large multinational

company with a wide range of products
352
Further Readings
Albers, Wulf, and Gisela Albers (1983) On the Prominence Structure of
the Decimal System, in Decision Making Under Uncertainty, edited by
R. W. Scholz, Amsterdam: Elsevier, 271-287. Keywords: experiments,
decisions, prominence. Email Contact: walbers@wiwi.uni-bielefeld.de
Bell, David E. (1982) Regret in Decision Making under Uncertainty,
Operations Research, 30:5 961-981. Keywords: experiments, decisions,
regret theory
353
CHAPTER 10
THE APPLICATION OF QUANTITATIVE
METHODS TO MANAGERIAL ACCOUNTING
Chapter Objectives
Quantitative techniques have become an indispensable tool of the modern
manager. Despite the pretended aloofness of mathematicians from the work a
day world of business and management implied in G.H. Hardys Celebrated
work. Heres to pure mathematics, may it never find an application
Quantitative techniques have been applied more than any other science or
discipline in the development of modern management Accounting models and
theories. Quantitative techniques have shown that the increasingly complex
technologies of today need nearly as much mathematics for their effective
utilization as was required for their initial creation. A case in point is that of the
product-mix problem. Given production facilities that can be used to produce
a wide diversity of items, each having different costs, revenues and market
demands, a manager will naturally wish to allocate the available capacity
to various products within the limits of market demands and production
constraints in such a way as to maximize his profit or bring about, in the case of
a welfare-oriented institution, some other utility or good. He cannot hope to do
so in any actual case by mere guesswork or intuition. To discover the optimal
allocation he will have to resort to the Quantitative techniques such as linear
programming, Simplex and so on.
Such permeation of management, business, industry and administration by

mathematics and quantitative techniques has come about in part because of
the pressures of growing competition in both the domestic and export markets.
But more importantly, it is a reflection of a new awareness on the part of
managers that their job has become so complex that to be truly effective no
man, however, gifted can rely solely on flair, intuition, an inspiration to see
him through. One simply cannot afford to neglect the new mathematical and
statistical tools now available for correcting what may be called an amateur
approach to management problems. An apt example is modern Risk Analysis
which corrects a simplistic approach to taking investment decisions.
Regression, Correlation and Forecasting Techniques, Statistical Decision-

making Theory, linear Programming, Quadratic Programming, Simulation,
Inventory Control Models, and other Quantitative Techniques are now very
extensively used in Management and Business Administration.
354
Hence in this chapter which deals with the Application of Quantitative Methods
to Managerial Accounting contains four (4) parts namely:, Application of linear
programming to Management Accounting: Application of Correlations and
Regression Analysis in Management Accounting: The Learning Curve Theory
and its applications in management Accounting and: The Quantitative models
for planning and control of stocks
355
PART ONE
APPLICATION OF LINEAR PROGRAMMING TO
MANAGEMENT ACCOUNTING
Part One Objectives

The objective of this part is to focus mainly on linear programming model
which is applied in various management accounting in solving the problems
of the scarce resources allocation.
Learning Outcomes
When you have finished studying the material in this part one you will
be able to:
1. Describe the meaning Linear Programming Model
2. Understand the assumptions of Linear Programming model
3. Understand the Linear Programming Terminology
4. Formulate the Linear Programming Model
5. Solve the Linear Programming Model
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10.1.1 Introduction
The problem of solving a system of linear inequalities dates back at least
as far as Fourier, after whom the method of Fourier-Motzkin elimination
is named. Linear programming itself was first developed by Leonid
Kantorovich, a Russian mathematician, in 1939. It was used during
World War II to plan expenditures and returns in order to reduce costs to
the army and increase losses to the enemy. The method was kept secret
until 1947 when George B. Dantzig published the simplex method and
John von Neumann developed the theory of duality. Postwar, many
industries found its use in their daily planning.
The linear-programming problem was first shown to be solvable in

polynomial time by Leonid Khachiyan in 1979, but a larger theoretical
and practical breakthrough in the field came in 1984 when Narendra
Karmarkar introduced a new interior-point method for solving linear-
programming problems.
Dantzigs original example of finding the best assignment of 70 people

to 70 jobs exemplifies the usefulness of linear programming. The
computing power required to test all the permutations to select the best
assignment is vast; the number of possible configurations exceeds the
number of particles in the universe. However, it takes only a moment to
find the optimum solution by posing the problem as a linear program and
applying the Simplex algorithm. The theory behind linear programming
drastically reduces the number of possible optimal solutions that must
be checked.
Linear programming is a considerable field of optimization for several

reasons. Many practical problems in operations research can be expressed
as linear programming problems. Certain special cases of linear
programming, such as network flow problems and multicommodity
flow problems are considered important enough to have generated
much research on specialized algorithms for their solution. A number of
algorithms for other types of optimization problems work by solving LP
problems as sub-problems. Historically, ideas from linear programming
have inspired many of the central concepts of optimization theory,
such as duality, decomposition, and the importance of convexity and
its generalizations. Likewise, linear programming is heavily used
in microeconomics and company management, such as planning,
production, transportation, technology and other issues. Although the
modern management issues are ever-changing, most companies would
like to maximize profits or minimize costs with limited resources.
Therefore, many issues can be characterized as linear programming
problems
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1.1.2 Meaning Linear Programming Model
Linear Programming Model is a mathematical technique concerned
with the allocation of scarce resource. It is a procedure to optimize
the value of some objective for example to maximize the contribution
margin when the factors involved are subject to constrain.
It is essentially a constrained optimization technique that encompasses

the general decision problem of allocating scarce resources between
competing activities so as to maximize or minimize some numerical
quantity such contribution margin or cost (CIMA 2005)
Horngren et al. (2000) describe linear programming as an optimization

technique used to maximize total contribution margin of a mix of
products, given multiple constraints. An LP model requires that all
costs of products be either variable or fixed with respect to the units
produced and sold within the relevant range. Consequently, a cost or
revenue that increases proportionately as the volume of units produced
increases is relevant in LP. Hence, variable costs for manufacturing and
for selling and administrative (S&A), and the selling price of a product
are relevant financial information when performing LP. On the other
hand, fixed costs or revenues that do not vary as units are produced or
sold are not relevant in an LP problem.
10.1.3 Contribution Margin

Contribution margin per unit is defined as the difference between
the selling price and the unit variable costs of a product being sold
(Garrison and Noreen 2003). Within the relevant range, the selling price
for each unit is assumed to be the same. Similarly, variable costs vary
proportionately with the number of units being sold and produced;
hence, variable costs have a constant unit cost. The variable costs of
a product consist of variable manufacturing and variable S&A costs.
Variable manufacturing costs include direct materials, direct labor and
variable manufacturing overhead. Variable S&A costs include sales
commissions and delivery costs.
Per unit information is especially useful for LP as the contribution

margin for each available product is included in the objective function
of a maximizing problem. Similarly, per unit variable cost for each
product is included in the objective function of a minimizing problem
(Hilton et al, 2003).
10.1.4 Contribution Income Statement

In managerial accounting, a contribution income statement first deducts
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total variable expenses from sales, and then deducts fixed expenses from
total. The contribution income statement complements the objectives
of LP. For example, increasing units sold, increasing the unit selling
price, or reducing a unit variable cost will increase contribution margin,
which will also increase operating income by the same amount within
the range as fixed expenses will not change. Hence, fixed manufacturing
overhead and other fixed selling and administrative expenses deducted
from total contribution margin are not relevant costs for LP because
they do not change within the relevant range.
10.1.5 Assumptions of Linear Programming model

It necessary that, in preparing or interpreting the linear programming
model, the decision-maker should consider the underlying assumptions
of the model, if these assumptions are not recognized may result
incorrect conclusions drawn from the analysis. These assumptions are
as follows;
1. Additivity; means that the activities of the model must be additive

in the objective functions and the constraints.
2. Divisibility; means that fractions of the model, decision variables

are acceptable in the solution
3. Deterministic model; means that all the model coefficients are

known and hence constant
4. Proportionality; means that the objective function and constraints

relationship must be linear
5. Non negativity; means that no negative solutions
10.1.6 Linear Programming Terminology

Decision variables: Decision variables describe the quantities that the
decision makers would like to determine. They are the unknowns of a
mathematical programming model. Typically we will determine their
optimum values with an optimization method. In a general model,
decision variables are given algebraic designations such as x1, x2, x3 ... xn The
number of decision variables is n, and xj is the name of the jth variable.
In a specific situation, it is often convenient to use other names such as
xij or yk or z(i,j) . In computer models we use names such as FLOW1 or
AB_5 to represent specific problem-related quantities. An assignment of
values to all variables in a problem is called a solution
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Objective function: The objective function evaluates some quantitative
criterion of immediate importance such as cost, profit, utility, or yield.
The general linear objective function can be written as
n
z = c1x1+c2x2 + ... + cnxn = cjxj
j=1
Here is the coefficient of the jth decision variable. The criterion selected
can be either maximized or minimized
Constraints: A constraint is an inequality or equality defining limitations

on decisions. Constraints arise from a variety of sources such as limited
resources, contractual obligations, or physical laws. In general, an LP is
said to have m linear constraints that can be stated as
n
aijxj = bi, for i = j ... m

j=1

One of the three relations shown in the large brackets must be chosen
for each constraint. The number aij is called a technological coefficient,
and the number b1 is called the right-side value of the ith constraint.
Strict inequalities (<, >, and ) are not permitted. When formulating a
model, it is good practice to give a name to each constraint that reflects
its purpose.
Simple upper bound: Associated with each variable, xj , may be a

specified quantity, uj , that limits its value from above;
xj uj, for j = 1 ... n
When a simple upper is not specified for a variable, the variable is said
to be unbounded from above.
Non-negativity restrictions: In most practical problems the variables

are required to be non-negative; xj 0, for j = 1 ... n
This special kind of constraint is called a non-negativity restriction.

Sometimes variables are required to be no positive or, in fact, may be
unrestricted (allowing any real value).
Parameters: The collection of coefficients for all values of the indices

i and j are called the parameters of the model. For the model to be
completely determined all parameter values must be known
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10.1.6 Standard formulation of Linear Programming Model
It should be remembered that, before attempting a solution, it is
necessary to express the problem in a standard manner. This means
that, determining the objective function and the constraints. Therefore
the following steps should be followed
1. Formulate the appropriate linear programming problem, by
clearly defining the objective function and the constraints
2. Construct the graph for the problem formulated
3. Draw a constraint line for each of the liming factors
4. Identify the feasible region, the feasible region is that space,
which satisfies all of the constraints simultaneously
5. Locate the solution points, this is done by identifying the corner
points of the feasible region
6. Evaluate the objective function at each of the solution points, that
were identified above
7. Identify the optimal solution
Thus mathematically the standard format of linear programming

model consists of the following three parts:
A linear function to be maximized
e.g. maximize c1x1 + c2x2
Problem constraints of the following form

e.g. a11x1 + a12x2 b1

a21x1 + a22x2 b2
a31x1 + a32x2 b3
Non-negative variables
e.g. x1 0
x2 0
Suppose that a farmer has a piece of farm land, say A square kilometres
large, to be planted with either wheat or barley or some combination of
the two. The farmer has a limited permissible amount F of fertilizer and
P of insecticide which can be used, each of which is required in different
amounts per unit area for wheat (F1, P1) and barley (F2, P2). Let S1 be
the selling price of wheat, and S2 the price of barley. If we denote the
area planted with wheat and barley by x1 and x2 respectively, then the
optimal number of square kilometres to plant with wheat vs barley can
be expressed as a linear programming problem:
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(maximize the contribution is the

maximize S1x1 + S2x2
objective function)
subject to x 1 + x2 A (limit on total area)
F1x1 + F2x2 F (limit on fertilizer)
P1x1 + P2x2 P (limit on insecticide)

x1 0, x2 0 (cannot plant a negative area)
Illustration 1
A company makes two products Standard and Deluxe which have the
following the standard costs and profit
Standard Deluxe
$ $
Materials 1,500 1,000
Direct labour 2,000 1,500
Variable overheads 1,000 1,000
Fixed overhead 1,000 500
Standard profit 500 500
Selling price 6,000 4,500
The production data per unit are as follows

Product Machining hours Labour hours Material (kgs)
Standard 40 40 10
Deluxe 20 60 10
Available per week 1,000 1,800 400
It is required to determine the optimum production mix of the company
Solution
it should be remembered here, the focus of the company is to
maximize the contribution margin per unit, by assuming that the
fixed cost is irrelevant, therefore the contribution the margin per
unit of Standard is $ 1,500 and $ 1,000 for Deluxe
then is to express the problem in a standard manner as follows;

Let X1 be the number units of Standard be produced to maximize
the contribution margin and X2 the number units of Deluxe be
produced to maximize the contribution margin
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Maximize Z = 1,500X1 + 1,000X2 (the objective function)
40X1 + 20X2 1,000 (machining hours constraints)
40X1 + 60X2 1,800 (labour hours constraints)
10 X1 + 10X2 400 (material constraints)
X 1 and X 2 0 (non-negativity)
The solution is always obtained on the edge of the feasible region and
this case is 15 units for Standard and 20 units for Deluxe, given the
contribution margin of $ (15 x $ 1,500) + $ (20 x $ 1,000) = $ 42,500
The solution uses the following quantities of the resources

machining hours (15 x 40) + (20 x 20) =1,000 all utilized
labour hours (15 x 40) + (20 x 60) = 1,800 all utilized
materials (15 x 10) + (20 x 10) = 350 (50kgs excess capacity)
Therefore, it should be noted here that materials is not a binding

constraint i.e. it is redundant.
Illustration 2
A calculator company produces a scientific calculator and a graphing
calculator. Long-term projections indicate an expected demand of at
least 100 scientific and 80 graphing calculators each day. Because of
limitations on production capacity, no more than 200 scientific and 170
graphing calculators can be made daily. To satisfy a shipping contract,
a total of at least 200 calculators much be shipped each day.
If each scientific calculator sold results in a $2 loss, but each graphing

calculator produces a $5 contribution margin, how many of each type
should be made daily to maximize net profits? (Stapel 2006)
The question asks for the optimal number of calculators, so my variables

will stand for that:
x: number of scientific calculators produced
y: number of graphing calculators produced
Since they cant produce negative numbers of calculators, I have the two
constraints, x 0 and y 0. But in this case, I can ignore these constraints,
because I already have that x 100 and y 80. The exercise also gives
maximums: x 200 and y 170. The minimum shipping requirement
gives me x + y 200; in other words, y x + 200. The revenue relation
will be my optimization equation: R = 2x + 5y. So the entire system is:
R = 2x + 5y, subject to:
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100 x 200
80 y 170
y x + 200
The feasibility region graphs as: ff Copyright Elizabeth St 2006-2011

All Rights Res
Figure 10.1.1
When you test the corner points at (100, 170), (200, 170), (200, 80), (120,
80), and (100, 100), you should obtain the maximum value of R = 650 at
(x, y) = (100, 170). That is, the solution is 100 scientific calculators and
170 graphing calculators.
364
Assessment Question
10.1.1
R&B consulting Ltd specialize in two types of consultancy project.
Each type A project requires twenty hours of work from qualified
researchers and eight hours of work from junior researchers
Each type of B project requires twelve hours of work from qualified

researchers and fifteen hours of work from junior researchers
Researchers are paid on an hourly basis at the following rates:

Qualified researchers $30 per hour
Junior researchers $14 per hour
Other data relating to the projects
Project type A B
$ $
Revenue per project 1,700 1,500
Direct project expenses 408 310
Administration* 280 270
*Administration costs are attributable to project using a rate per project

hour. Total administration costs are $28,000 per 4-week period
During the 4-week period ending on 30th June 2012, owing to holiday
and other staffing difficulties, the numbers of working hours available
are:
Qualified researchers 1,344
Junior researchers 1,120
An agreement has already been made for twenty type A project with
XYZ group. R&B consulting Ltd must start and complete these projects
in the 4-week period ending 30 June 2012.
A maximum of 60 type B projects may be undertaken during the 4-week

period ending 30 June 2012.
R&B consulting Ltd is preparing its detailed budget for the 4-week
period ending 30 June 2012 and needs to identify the most profitable
use of the resources it has available.
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Required
(a) (i) Calculate the contribution from each type of project.
(ii) Formulate the linear programming model for the 4-week
period ending 30 June 2012
(iii) Calculate using a graph, the mix of project that will maximize
profit for R&B consulting Ltd for the 4-week p e r i o d
ending 30 June 2012 (note: projects are not divisible)
(b) Calculate the profit that R&B consulting Ltd would earn from the
optimal plan.
(c) Explain the importance of identifying scarce resources when
preparing budgets and the use of linear programming to determine
the optimal use of resources
366
Summary
When there is more than one scarce input factor linear programming
can be used to determine the production programme that maximizes
total contribution. This information can be obtained by using either a
graphical approach or the simplex method. In this chapter the linear
programming has addressed in the application of various management
accounting problems. In particular for the case of maximizing
contribution in a give inputs, linear programming is a technique that
can be applied to establish the optimum allocation of scarce resources.
Hence, linear programming is only appropriate for short term allocation
decisions.

Constraints
Decision variables
Linear programming
Non-negativity
Objective function
Parameters
367
Exercises
10.1.2 Define and discuss the linear programming technique, including
assumptions of linear programming and accounting data used
therein.
10.1.3 What is meant by the unit cost in linear programming problems?
10.1.4 How might the optimal solution of a linear programming problem

be determined
10.1.5 Describe the steps in solving a linear programming
Problems
10.1.6
Hale Company manufactures products A and B, each of which requires
two processes, grinding and polishing. The contribution margin is $3
for A and $4 for B. A graph showing the maximum number of units of
each product that can be processed in the two departments identifies
the following corner points: A = 0, B = 20; A = 20, B = 10; A = 30, B = 0.
What is the combination of A and B that maximizes the total contribution
margin?
10.1.7
Company XYZ has two departments, machining and finishing.
This company makes two products A and B each of which requires
processing in each of two departments. Machining and Finishing. There
are 200 hours of Machining capacity and 120 hours of finishing capacity
available per day.
Product A requires 1 hour of Machining time per unit and one hour of
finishing time per unit. Product B requires 2 hours of Machining time
per unit but only 0.6 hours of finishing time per unit. The contribution
margin for A is $200 and that of B $250. Severe material shortage for
product B will limit its production to a maximum of 90 units per day.
Required:
(b) How many units of each product should be produced each day
to obtain the maximum profit?
(b) What are the major assumptions underlying the LP model.
368
10.1.8
The BM Company wants to maximize the profits on the products A, B,
C. The contribution margin for each product follows:
Product Contribution Margin
A $2
B $5
C $4
The production requirements and departmental capacities, by departments,

are as follows:
Departmental
Production Requirement By Product
Department Capacity
A B C Hours
Assembling 2 3 2 30,000
Painting 1 2 2 38,000
Finishing 2 3 1 28,000
Required
(i) Formulate the objective function and the constraints
(ii) How many units of each product should be produced each day
to obtain the maximum profit?
Cases Studies
Case study 1: Keano Macadamia Nut Company
Keano Macadamia Nut Company located on the Big Island of Hawaii
makes four different products chocolate covered whole nuts, chocolate
nut clusters, chocolate nut crunch bars, and roasted nuts. Keano has
a limited supply of nuts that are bought from local growers and it is
barely able to meet the steadily increasing demand for their products.
On the other hand, increases in the purchase cost of macadamia nuts and
increasing foreign competition make it difficult for Keano to maintain a
reasonable profit. The demand for macadamia nut products fluctuates
with seasonal tourist levels; therefore, production is budgeted on a
weekly basis.
Relevant Input Information

The selling price (SP) for Keanos four macadamia nut products Whole,
Cluster, Crunch, and Roasted are $5.00, $4.00, $3.20, and $4.50 per
pound, respectively. The minimum sales demand for its popular Whole
product is 1,000 pounds. The Cluster product is popular with locals and
its sales are estimated between 400 and 500 pounds. The only other sales
requirement is that Roasted cannot exceed 200 pounds.
369
During this time of the year, the local growers are able to harvest no
more than the equivalent of 1,100 pounds of hulled macadamia nuts.
The composition of macadamia nuts within one pound of a finished
product varies, Whole 60%, Cluster 40%, Crunch 20%, and Roasted 100%,
with chocolate making up the balance. The hulled macadamia nuts cost
$1.60 per pound, and chocolate costs $0.80 per pound. Therefore, the
direct material cost (DMC) for the Whole product is $1.28, computed as
$.96 (.6*$1.60) for nuts plus $.32 (.4*$.80) for chocolate, Cluster is $1.12,
Crunch is $0.96 and Roasted is $1.60.
The four machines used by Keano are old and rusty. And each product
requires time on each of the four different machines - Hull, Roast,
Chocolate, and Package, except for the Roasted product which does not
have chocolate. The number of minutes per pound of finished product
required on each machine is listed in Exhibit 2 (for example, the Whole
product requires 2 minutes on the Roast machine). Each machine is
available 60 hours or 3,600 minutes per week.
Variable labor costs in running the machines are $12 per hour or $0.20
per minute for the Hull, Roast and Chocolate machines, and $6 per hour
or $0.10 per minute for the Package machine. Therefore, the direct labor
cost for the Whole product is $1.05, Cluster is $0.80, Crunch is $0.64, and
Roasted is $0.65.
Variable manufacturing overhead costs (e.g., sugar, salt, oil and garlic)
are driven by direct materials costs (DMC) for the macadamia nuts and
chocolate; therefore, it is applied at a rate of 25% of DMC. The variable
S&A expense (e.g., commissions and delivery costs) is 10% of the selling
price (SP).
The total variable costs for the products are Whole $3.15, Cluster $2.60,
Crunch $2.16, and Roasted $3.10. Given the selling price for the four
products, the contribution margins are Whole $1.85, Cluster $1.40,
Crunch $1.04, and Roasted $1.40.
Source: Keano Macadamia Nut Company
Discussion Problem:
Solve this problem using linear programming model
370
Further Readings
Garrison, R. H. and Noreen, E. W. (2003) Managerial Accounting
McGraw-Hill/Irwin, New York
Hilton, R. W., Maher, M. W. and Selto, F. H. (2003) Cost Management:

Strategies for Business Decisions. McGraw-Hill/Irwin, New York
Horngren, C. T., Foster, G., and Datar, S. M. (2000) Cost Accounting: A

Managerial Emphasis. Prentice-Hall, Upper Saddle River, New Jersey
371
PART TWO
APPLICATION OF CORRELATION AND REGRESSION
ANALYSIS
Learning Outcomes
When you have finished studying the material in this part two you will
be able to:
1. Understand the meaning of Correlation
2. Understand the meaning of regression
3. Formulate the linear regression equation
4. Analyze a mixed cost using the least-squares regression method
5. Perform and interpret a least-squares regression analysis
with a single independent variable
6. Compute the Correlation coefficient (r)
7. Compute the coefficient of determination (r2)
8. Describe Correlation coefficient (r)
9. Describe coefficient of determination (r2)
10. Apply correlation coefficient (r) in managerial accounting
problem
11. Apply coefficient of determination (r2) in managerial
accounting problem
12. Use of Computer Software for Regression analysis
372
10.2.1 Introduction
Correlation quantifies the strength of a linear relationship between
two variables. When there is no correlation between two variables,
then there is no tendency for the values of the variables to increase
or decrease in tandem. Two variables that are uncorrelated are not
necessarily independent, however, because they might have a nonlinear
relationship.
We can use linear correlation to investigate whether a linear relationship
exists between variables without having to assume or fit a specific model
to the data. Two variables that have a small or no linear correlation
might have a strong nonlinear relationship. However, calculating linear
correlation before fitting a model is a useful way to identify variables
that have a simple relationship. Another way to explore how variables
are related is to make scatter plots of your data.
Covariance quantifies the strength of a linear relationship between two

variables in units relative to their variances. Correlations are standardized
covariance, giving a dimensionless quantity that measures the degree of
a linear relationship, separate from the scale of either variable.
The correlation coefficients range from -1 to 1, where values close to
1 indicate that there is a positive linear relationship between the data
columns, values close to -1 indicates that one column of data has a
negative linear relationship to another column of data (ant-correlation).
Values close to or equal to 0 suggest there is no linear relationship
between the data columns
10.2.2 Regression Analysis

One popular method for estimating the cost volume formula is regression
analysis. Regression analysis is a statistical procedure for estimating
mathematically the average relationship between the dependent
variable and the independent variable(s). Simple regression involves
one independent variable, e.g., DLH or machine hours alone, whereas
multiple regression involves two or more activity variables.
Therefore, linear regression analysis is a statistical method of estimating

fixed and variable costs using historical data from a number of previous
accounting periods. This is most robust method of separating mixed
costs is the least-squares regression method. This method requires the
use of thirty or more past data observations, both the activity level in
units produced and the total production cost for each. The method of
least squares identifies the line that best fits the data points (the sum
of the squared deviations is minimized). This method is the most
sophisticated and provides the user with a measure of the goodness of
fit, which can be used to assess the usefulness of the cost formula.
373
10.2.3 Error terms and outliers
Before discussing these, it is necessary to introduce the expression error
term. The regression equation derived from the method of least squares
allows us to calculate an estimated value of our dependent variable
(such as total cost) for any value of the independent variable (such as
total output).
If we compare the estimated value with the observed value y for that
level of activity x, the error term is simply the difference in y. Now,
the method of least squares mathematically forces the mean of the
error terms for all the observations to equal zero. This means that the
regression equation derived is very sensitive to isolated observations
lying far from the line of best fit, which are called outliers. If outliers
were not included, the regression equation could be quite different
(and the value of R2, measuring goodness of fit, would almost certainly
be higher). It is often the case that there are special factors explaining
the occurrence of specific outliers, which can be adjusted for, and it is
useful to try to identify potential outliers visually before the regression
calculations are performed. There are two further technical problems.
1. The method of least squares assumes that the error terms are
independent of each other, but in some cases they are not: this
is referred to as autocorrelation. An example arises where the
observations are affected by seasonal factors, which should
have been adjusted for before performing the regression. The
seasonal factors will leave the observations subject to a particular
underlying pattern in addition to any fundamental trend.
2. The method of least squares assumes that the likely size of the
error terms is independent of the value of the independent variable:
that is, the error term does not grow larger as the level of output
increases. Where the size of the error term does increase (referred
to as heteroscedasticity), the regression equation becomes less
reliable. The existence of heteroscedasticity is often an indication
that there is an underlying growth or inflation factor that has not
properly been adjusted for.
Standard statistical regression computer programs often determine

whether autocorrelation and heteroscedasticity are significant problems.
The use of regression analysis to estimate a cost function is a useful
technique, but it is more of a blunt instrument than the engineering
method, as it breaks total cost down only into fixed and variable elements.
For many purposes, this is enough, but where detailed estimates of all
the elements of total cost are needed, something like the engineering
374
method must be used. As already mentioned, standard costing is likely
to be based on engineering cost estimates, but any other detailed costing
will also need such an approach.
10.2.4 Regression equation

In this part, we will discuss simple (linear) regression to illustrate the
least-squares method, which means that we will assume the Y = a + bX
relationship. Unlike the high low method, in an effort to estimate the
variable rate and the fixed cost portion, the regression method includes
all the observed data and attempts to find a line of best fit. To find this
line, a technique called the least squares method is used.
To explain the least squares method, we define the error as the difference
between the observed value and the estimated one of some mixed cost
and denote it with u.
Symbolically, u = y y
where y = observed value of a mixed (semi variable) expense

y` = estimated value based on y` = a + bx
The least squares criterion requires that the line of best fit be such that
the sum of the squares of the errors (or the vertical distance in Figure 3
from the observed data points to the line) is a minimum, i.e.,
Minimum: u2 = (y - y`)2
= (y-a-bx)2
Figure: 3 (Y and X)
375
Using differential calculus we obtain the following equations
y = na + bx
xy = ax + bx2
Solving the equations for b and a yields
b = nXY - (X)(Y)
nX2 - (X)2
a = Y - bX
where Y = Y and X = X
n n
Illustration
All the sums required are computed and shown below. To illustrate the
computations of b and a, we will refer to the data in the following Table.
Table: 1
DLH (x) Factory Overhead (y) Xy x2 y2
9 hours $15 135 81 225
19 20 380 361 400
11 14 154 121 196
14 16 224 196 256
23 25 575 529 625
12 20 240 144 400
12 20 240 144 400
22 23 506 484 529
7 14 98 49 196
13 22 286 169 484
15 18 270 225 324
17 18 306 289 324
174 hours $225 3,414 2,792 4,359
From the table above: X = 174 Y = 225; XY = 3,414; X2 = 2,792
where Y = Y and X = X
n n
Substituting these values into the formula for b first
b = nXY - (X)(Y) = (12)(3,414) - (174)(225) = 1,818 = 0.5632

nX2 - (X)2 (12)(2,792)-(174)2 3,228
376
The cost-volume formula then is
y` = $10.5836 + $0.5632 x
or $10.5836 fixed, plus $0.5632 per DLH
Note: y2 is not used here but rather is computed for future use.
Assume that the direct labor hours of 10 are to be expended for next year.
The projected factory overhead for the next year would be computed as
follows:
y` = 10.5836 + 0.5632 x
= 10.5836 + 0.5632 (10)
= $16.2156
10.2.5 The Assumptions for Linear Regression Analysis

1. The sample taken must be representative of the population.
2. The general relationship between sampled points must be linear.

For a two-variable regression, a scatter plot of all sampled values
will visually show whether the sampled points generally fall near
a straight line or not. For multi-variable regression, the goodness
of fit (the degree of linearity or how well the sampled points fit
the Regression Equation Line) is displayed by a statistic called the
Standard Error of the Regression. This is part of the regression
analysis output. Much more on this later.
3. The independent variables must be error-free.
4. The independent variables must independent of each other. It

must not be possible to predict any independent variable from
the value of one or more of the other independent variables.
5. The independent variables should not be highly correlated with

each other. This will cause a condition known as multicollinearity.
6. If any of the input variables are categorical, then dummy variable

techniques must be included in the regression analysis. A
categorical independent variable would be, for example, set to 1
if a product color was red and set to 2 if a product color was blue.
7. The dependent variable must be continuous. Dependent variables

that are discontinuous or categorical require advanced regression
techniques such as logistic regression. These techniques are not
discussed in this course. An example of a categorical dependent
variable would be a regression in which the independent variables
377
(the Xs) measured attributes of customers and the dependent
variable (the Ys) were set to a value of 1 if the customer bought
and 0 if the customer did not buy. Logistic regression would be
used to create a regression equation for this problem.
8. The average residual value should be 0.
9. The variance the residuals of should be constant throughout all

input values. This is a condition called homoscedasticity. When
the variance of the residuals is not constant, this is a condition
called heteroscedasticity. Much more on this later.
10. All residuals should be independent.
11. All residuals should be normally distributed. This is an important

assumption and can generally be met if at least 30 sample points
are taken
10.2.6 Major Purposes of Linear Regression Analysis

1. To provide a method of estimating the values of dependent
variables from independent variables. The values of independent
variables can be plugged into the Regression Equation to provide
an estimate of the dependent variable.
2. To determine which independent variables have the greatest

effect upon the output (the dependent variable). The magnitude
of each regression coefficient indicates the degree of effect
that variable has upon the output. The scale upon which each
independent variable is measured must be accounted for when
stating which variables have the greatest effect upon the output
dependent variable.
3. To evaluate the error, or residual values, between the actual

sampled values of the independent variable (Y) and the estimated
values of the independent variable (Yest).
4. To evaluate how well the sampled points fit the linear regression
equation line. In other words, to evaluate the goodness of fit
between the actual sampled values of the independent variable
(Y) and their corresponding estimated values of the independent
variable (Yest), all of which fall on the regression line.
5. To evaluate how statistically significant the overall regression
378
equation is and also how statistically significantly significant each
regression coefficient is. An output is statistically significant if it
can be shown to not have occurred by chance
10.2.7 The significance of linear regression analysis in Management Accounting

Linear regression analysis is a useful technique in business mathematics,
among other spheres. In accountingspecifically cost and management
accountingregression analysis allows accountants to project costs
given a range of values over specific cost periods. It is far superior
to techniques such as expected values, scatter graphs and the high-
low method in projecting costs and separating the fixed and variable
components of semi-variable costs
Also known as the least squares method, regression analysis seeks to

establish values for a linear equationthe line of best fit. It is only one of
several methods of establishing the line of best fit. The linear equation,
in the form y= a + b(x) represents a cost relationship, where y is the total
cost, a is the fixed cost, b is the variable cost per unit and x is the level of
activity or output. As such, one can also represent the linear equation in
the following formula
Total Costs = Fixed costs + (Variable cost per unit x output/activity level).
Total costs and the activity level are the related variables in this equation,
while pairs of data for fixed and variable cost per unit are estimated
based on the pairs of data for Total Cost and activity level.
Regression analysis allows the accountant to glean more information

than correlation analysis. Correlation analysis provides a foundation
in assessing the strength of the relationship between costs and activity
levels. However, it does not provide a means of approximating values
on the basis of an assumed linear relationship.
Linear regression analysis uses historical variables as inputs in order to

establish the linear relationship between costs and the level of activity.
Accountants use the result of regression analysis to predict total costs
based on actual data. It is useful as a budgetary tool and can inform the
planning and decision-making process.
Linear regression analysis allows management to form estimates

of complex relationships, particularly where the relationship is not
immediately evident. Once the linear relationship is determined,
managers can estimate total costs for any level of activity by plotting
the information on a graph.
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Although linear regression analysis is a useful method of separating
semi-variable costs and forecasting, it has its limitations. Naturally, it is
based on assumptions of a linear relationship and that Y is exclusively
dependent on X. The reliability of predictions of linear regression
analysis is also predicated on the reliability and validity of the data
provided
10.2.8 Correlation coefficient (r) and coefficient of determination (r2)

The correlation coefficient r measures the degree of correlation between
y and x. The range of values it takes on is between more widely used,
however, is the coefficient of determination, designated r 1 and +1.2
(read as r squared).
Simply put, r2 tells us how good the estimated regression equation is.
In other words, it is a measure of goodness of fit in the regression.
Therefore, the higher the r2, the more confidence we have in our cost
volume formula.
More specifically, the coefficient of determination represents the

proportion of the total variation in y that is explained by the regression
equation. It has the range of values between 0 and 1.
It should be noted that, a low r2 is an indication that the model is

inadequate for explaining the y variable. The general causes for this
problem are:
1. Use of a wrong functional form
2. Poor choice of an x variable as the predictor
3. The omission of some important variable or variables from the model
Note: r2 is a measure of goodness of fit. Even though the line, obtained

by the use of the least-squared error rule, is supposed to be the line of
best-fit, it may still be inaccurate. The least-square line may have been
the best among the linear lines. The observed data, however, may exhibit
a curvilinear pattern, which cannot be visualized especially in multiple
regressions. In other words, since it is impossible to draw the scatter
diagram in a multi-variable situation, we must rely on a statistic such as
r2 to determine the degree of the goodness of fit. Note that low values of
r2 indicate that the cost driver does not fully explain cost behavior
Illustration
The statement Factory overhead is a function of direct labor hours with
r2 = 70 percent, can be interpreted as 70 percent of the total variation of
factory overhead is explained by the regression equation or the change
380
in direct labor hours and the remaining 30 percent is accounted for by
something other than direct labor hours, such as machine hours.
The coefficient of determination is computed as
R2 = 1 - (Y - Y')2
2
(Y - Y)

In a simple regression situation, however, there is a short-cut method
available:
[n XY - ( X)( Y]2
R2 =
[n X2 - ( X)2][n Y2 - ( Y)2]

Comparing this formula with the one for b, we see that the only additional
information we need to compute R2 is Y2.
Note: For computational ease, we often calculate r first, using:
[n XY - ( X)( Y]
R2 =
[n X2 - ( X)2] [n Y2 - ( Y)2]
and then square R i.e. R2= (R)2
Illustration
Using the shortcut method for R To illustrate the computations of
various regression statistics, we will refer to the data in Table 1.2,
(1,818)2 3,305,124 3,305,124

R2 = 2 = =
[3,228][(12)(4,359) - (225) ] [3,228][52,308 - 50,625] (3,228)(1,683)
= 3,305,124 = 0.6084 = 60.84%

5,432,724
This means that about 60.84 percent of the total variation in factory
overhead is explained by direct labor hours and the remaining 39.16
percent is still unexplained. A relatively low r2 indicates that there is a
lot of room for improvement in our estimated cost volume formula (y`
= $10.5836 + $0.5632x). Machine hours or a combination of direct labor
hours and machine hours might improve r2.
We can use a electronic spreadsheet program such as Excel in order to

develop a model and estimate most of the statistics we discussed thus
far.
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10.2.9 Use of Computer Software for Regression analysis
With a Regression, you have independent variables and a dependent
variable. The dependent variable is the variable whose behavior you are
trying to estimate (cost).
Independent variables are the explanatory variables (e.g., number of

units). If you only have one independent variable, this is called a Simple
Regression. If you have more than one independent variable, this is
called a Multiple Regression.
When you run a Regression using any statistical package (including

Excel), the Regression will provide you with: The coefficients that go
before the independent variable (e.g. Variable Cost per unit),
The y-intercept value (for Fixed Cost) With a Simple Regression, this
gives you the linear cost function:
Total Cost = [Coefficient x Independent Variable] + Y-Intercept

Coefficient With a Multiple Regression, you are no longer in a two
dimensional world [total cost (y) & 1 independent variable (x) as the
two axis]. Instead, you are now in a greater than two dimensional world.
The number of dimensions is equal to the number of dependent and of
independent variables in your cost function. The cost function given by
the regression reflects the increased number of dimensions.
When running a Regression, a key statistic given in the Regression output

is the R2. The R2 is referred to as the Coefficient of Determination. This
statistic gives the Goodness of the Fit of the model (or the percentage
of the dependent variables behavior that is explained by the model).
The higher the R2, the better the model fits the data. The best R2 would be
1.00. That means 100% of the data is explained by the model. When you
have a Multiple Regression, then the Adjusted R2 is looked at because it
adjusts the R2 value for the number of explanatory variables.
The Regression output also gives you the statistical significance

(t-Statistic) for the coefficient(s) of the explanatory variable(s) and the
y-intercept. This gives the likelihood that the coefficient or y-intercept is
significantly different than zero. Usually, people want these coefficients
to be significant at the 99%, 95%, or 90% level.
If you ever see a Multiple Regression with a high Adjusted R2, but low
t-Statistics for independent variable coefficients, this tells you that the
model is good, but you have chosen related independent variables.
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Having correlated independent variables is called Multi co-linearity.
The program is saying that your model is explaining the cost behavior,
but the model cannot figure out how much each variable is contributing
to the explanatory power of the model. If you see this, try dropping one
of the independent variables.
In order to run an OLS Regression using Excel, you need to have Data
Analysis added as a Tool. Click on Tools on the main Menu Bar, and
check to see if you have Data Analysis as an option. If not, click on
Add Ins and then check the Analysis ToolPak box, and then click
OK. You will now have Analysis ToolPak as an option under the
Tools Menu item.
You need to set up the data so that you can run the Regression. You
need to input the cost (the dependent variable) and the independent
variables. We will use two independent variables, hours and units:
Now, click on Tools on the main Menu Bar, and then click on Data
Analysis. The Data Analysis Dialog Box will open and you will click
on Regression. Now, the Regression Dialog Box will open. Click on
the Input Y Range Box, then, highlight the O/H Cost information on
the spreadsheet (E4:E15). Next, Click on the Input X Range Box. Then,
highlight the information under Hours (C4:C15). Now, click on OK.
A new worksheet should open that has the Regression output:
The following captures the Regression input dialog screen.
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Excel Regression Output
Figure 4 shows the Excel regression output.
Figure 4
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.7800
R Square 0.6084
Adjusted R Square 0.5692
Standard Error 2.3436
Observations 12
ANOVA*
Df SS MS F Significance F
Regression 1 85. 3243 85. 3243 15. 5345 0.0028
Residual 10 54.9257 5.4926
Total 11 140.25
Coefficients Standard t Stat P-value ** Lower Upper
Error 95% 95%
Intercept 10. 583643 2. 1796 4. 8558 0. 0007 5. 7272 15. 4401
DLH 0. 563197 0. 1429 3. 9414 0. 0028 0. 2448 0. 8816
**The P-value for X Variable = .0028 indicates that we have a 0.28% chance
that the true value of the variable coefficient is equal to 0, implying a
high level of accuracy about the estimated value of 0.563197.
The result shows:
Y` = 10.58364 + 0.563197 X (in the form of Y` = a + bX)

Where intercept (a) = 10.58364, b = 0.563197, and X = direct labor hours
(DLH)
with: R-squared (R2 = 0.608373 = 60.84%)
All of the above are the same as the ones manually obtained.
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Assessment Question
10.2.1
ABC Ltd manufactures a variety of products at its industrial site in
Nairobi. One of the products, the LT, is produced in a specially equipped
factory in which no other production takes. For technical reasons the
company keeps no stocks of either LTs or the raw material used in their
manufacture. The costs of producing LTs in the special factory during
the past four years have been as follows:
2009 2010 2011 2012 (estimated)

$ $ $ $
Raw materials 70,000 100,000 130,000 132,000
Skilled labour 40,000 71,000 96,000 115,000
Unskilled 132,000 173,000 235,000 230,000
Power 25,000 33,000 47,000 44,000
Factory overheads 168,000 206,000 246,000 265,000
Total production costs 435,000 583,000 754,000 786,000
Output (units) 160,000 190,000 220,000 180,000
The costs of raw materials and skilled labour have increased steadily
during the past four years at an annual compound rate of 20%, and the
costs of factory overheads have increased at an annual compound rate
of 15% during the same period. Powers prices increased by 10% on 1
January 2010 and 25% on 1 January of each subsequent year, all costs
expect power are expected to increase by a further 20% during 20ch
alloc13. Power prices are due to rise by 25% on 1 January 2013. The
directs of ABC Ltd are now formulating the companys production plan
for 2013 and wish to estimate the costs of manufacturing the product
LT. the finance director has expressed the view that the full relevant
cost of producing LTs can be determined only if a fair share of general
company overheads is allocated to them. No such allocation is included
in the table of costs above.
You are required

(a) Use linear regression analysis to estimate the relationship of
total production costs to volume for the products LT for 2013
(ignore general company overheads and do not undertake a
separate regression calculation for each item of costs)
385
(b) Discuss the advantages and limitations of linear regression
analysis for the estimation of cost-volume relationships
(c) Comment on the view expressed by the finance director

Ignore taxation ICAEW Elements of financial decisions
386
Summary
Total costs for a particular expense may be a function of the number of
units produced; the objective is to find the activity measure that exerts
the major influence on cost. Various test of reliability can be applied to
see how reliable each of these activity measures is in predicting specific
costs (Drury, 2006). Such tests include the coefficient of determination,
the standard error of the estimate and the standard error of the coefficient.
In this chapter the regression equation has been established using the
least square method. The focus of establishing the regression analysis is
to estimate the variable and fixed cost.

Coefficient of determination
Correlation
Correlation coefficient
Coefficient of determination
Least square method
Regression equation
387
Exercises
10.2.1
The administrator of Azalea hospital would like cost formula linking the
given in the table below
Number of Patients Admitting

Months
Admitted Department Costs ($)
May 1,800 14,000,000
June 1,900 15,200,000
July 1,700 13,700,000
August 1,600 14,000,000
September 1,500 14,300,000
October 1,300 13,100,000
November 1,100 12,800,000
December 1,500 14,600,000
Required
1. Using the least-squares regression method, estimate the variable
and fixed elements of the cost
2. Express the cost data in (1) above in the form of Y= a + bX
10.2.2
One of Varic Companys products goes through a glazing process. The
company has observed glazing costs as follows over the last six weeks
Week Units Produced Total Cost ($)

1 8 270,000
2 5 200,000
3 10 310,000
4 4 190,000
5 6 240,000
6 9 290,000
For planning purposes the companys management must know the

amount of variable cost per unit and the total fixed cost per week
388
Required
3. Using the least-squares regression method, estimate the variable
and fixed elements of the cost
4. Express the cost data in (1) above in the form of Y= a + bX
5. If the company processes seven units next week, what would be

the expected total cost?
Problems
10.2.3
A sales director of a large company wants to determine the relationship
between the amount of time her salespeople spend prospecting and the
amount of sales that they generate. She randomly sampled monthly
sales results and monthly hours of prospecting for 30 salespeople from
a sales force of over 1,000 salespeople. Below are the results of this
random sample:
a) Derive the linear regression equation relating monthly sales (Y) to

the monthly hours of prospecting (X). Predict the monthly sales
for each employees hours of prospecting listed above.
b) Estimate the monthly sales for a salesperson that has prospected

that month for 82 hours.
The random sample is as follows:

Prospecting Monthly
Salesperson Hours Sales
1 96 9
2 89 7
3 96 9
4 80 8
5 76 4
6 58 6
7 96 9
8 89 7
9 96 8
10 79 5
11 76 4
12 58 6
389
13 96 9
14 89 7
15 96 9
16 89 7
17 98 8
18 79 5
19 96 8
20 81 5
10.2.4
A production line station can be operated at different speeds produces
a varying number of defects every hour. With the station operating at
different speeds, a simple random sample of 50 hour-long observations
was selected.
X = speed of the production station in meters per second (mps)

Y = number of defects produced by the station during each observed
hour.
n = 50
X = 677
Y = 256
XY = 15799
X2 = 15888
Required
a) Derive the linear regression equation
b) the station was operating at 15 mps during one hour. Estimate the
number of defects during that hour.
390
10.2.5
An economist wants to determine how accurately a companys annual
marketing expenses can be predicted based upon the companys gross
sales over the past year. The economist surveyed a representative,
random sample of 15 firms and obtained their gross sales and marketing
expenses figures for the previous year. For this problem, at least 30
samples should have been taken, but, for brevity, only 15 were taken.
Required
Perform the following calculations based upon the sample data below:
a) Estimate the linear regression equation using gross sales as the
independent variable and marketing expense as the dependent
variable.
b) Calculate the standard error estimate, sy.x.
c) Obtain the 95% confidence interval for marketing expenses for
$130M of gross income.
d) Calculate Total Variance, Explained Variance, and Unexplained
Variance
Below is the sample data:

X Y
Gross Marketing
Firm Sales ($M) Exp. ($M)
1 280 115
2 125 45
3 425 180
4 250 115
5 180 77
6 245 88
7 90 55
8 240 195
9 357 157
10 150 69
11 77 38
12 210 104
13 100 47
14 120 52
15 210 89
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10.2.6
Q limited used and incremental budgeting approach to setting its
budgets for the year ending 30 june2013
The budget for the companys power costs was determined by analyzing
the past relationship between costs and activity levels and then adjusting
for inflation of 6%. The relationship between monthly cost and activity
levels, before adjusting 6% inflation, was found to be
y = $(14,000 + 0.0025x2)
Where y = total cost; and

x = machine hours
In April 2013, the number of machine hours was 1,525 and the actual
cost incurred was $16,423.
Required
The total power cost variance to be reported
CIMA management accounting-performance management
392
Case studies
Case study 10.2.1: Diana Catering Company
Diana owns a catering company that prepares banquets and parties for
business functions throughout the year. Danas business is seasonal,
with a heavy schedule during the summer months and the year-end
holidays. During peak periods, there are extra costs; however, even
during nonpeak periods Dana must work more to cover her expenses.
One of the major events Danas customers request is a cocktail party. He
offers a standard cocktail party and has developed the following cost
structure on a per-person basis.
Food and beverages: $14.00

Labor (0.6 hr. @ $11 per hour): $6.60
Overhead (0.6 hr. @ $14 per hour): $8.40
Total cost per person: $29.00
when bidding on cocktail parties, Dana adds a 15 percent markup to

this cost structure as a profit margin. Dana is quite certain about her
estimates of the prime costs but is not as comfortable with the overhead
estimate. This estimate was based on the actual data for the past
12 months presented in the following table. These data indicate that
overhead expenses vary with the direct-labor hours expended. The $14
per hour overhead estimate was determined by dividing total overhead
expended for the 12 months ($805,000) by total labor hours (57,600) and
Month rounding to the nearest dollar
Labor Hours Overhead ($)

January 2,800 59,000
February 2,500 55,000
March 3,000 60,000
April 4,500 67,000
May 4,200 64,000
June 6,500 74,000
July 5,500 71,000
August 7,000 75,000
September 7,500 77,000
October 4,500 68,000
November 3,100 62,000
December 6,500 73,000
393
Dana recently attended a meeting of the local chamber of commerce and
heard a business consultant discuss regression analysis and its business
applications. After the meeting, Dana decided to do a regression analysis
of the overhead data she had collected. The following results
Were obtained
Intercept a = 48,000
Coefficient b = 4
1. Calculate the Variable cost per person
2. Calculate the Absorption cost per person
3. Diana has been asked to prepare a bid for a 250-person cocktail

party to be given next month, Determine the minimum bid price
that Dana should be willing to submit
4. What factors should Diana consider in developing the bid price

for the cocktail party?
394
Further Readings
Abernethy, R. B. (2000). The New Weibull Handbook, Fourth Edition,
Subtitle, Reliability & Statistical Analysis for Predicting Life, Safety,
Survivability, Risk, Cost and Warranty Claims. Robert B. Abernethy.
Allison, P. D. (2001) Logistic Regression Using the SAS System: Theory

and Application. Wiley SAS.
Anderson, M. C., R. D. Banker and S. N. Janakiraman. (2003) Are selling,

general, and administrative costs Sticky? Journal of Accounting
Research (March): 47-63.
Awasthi, V. N. and C. W. Chow. (1998). Rosalind Enterprises: A mini-

case for ensuring student mastery of cost behavior concepts in short-
term decisions. Journal of Accounting Education 16(1): 139-145.
Barton, T. L. and F. M. Cole. (1994). Atlantic Dry Docks unique cost

estimation system. Management Accounting (October): 32-35, 38-39..
Chatterjee, S., A. S. Hadi and B. Price. 1999. Regression Analysis by

Example, 3rd Edition. Wiley-Interscience.
Benston, G. J. 2006. Multiple regression analysis of cost behavior. The

Accounting Review (October): 657-672.
Chatterjee, S., A. S. Hadi and B. Price. 1999. Regression Analysis by

Example, 3rd Edition. Wiley-Interscience
Colin Drury (2006), Management Accounting and Cost Accounting fifth

edition
Dielman, T. E. 2000. Applied Regression Analysis for Business and

Economics. Duxbury Press
Horngren, Foster & Datar (2000), Cost Accounting: A managerial

Emphasis, 10th Ed. Prentice-hall India
Garrison & Noreen (2003), Management Accounting, 10th Ed. McGraw-

Hill Irwin
395
PART THREE
THE LEARNING CURVE THEORY
Learning outcomes
be able to:
1. Understanding the meaning of Learning Curve theory
2. Describe the fundamentals of Experience and Learning
curves
3. Explain the reasons for the effect of learning curve
4. Understand the Learning Curve Formulation
5. Understand the applications and Uses of learning and
experience curve in managerial accounting
6. Describe the limitations of learning curve theory
396
10.3.1 Introduction
Experience and learning curve models are developed from the basic
premise that individuals and organizations acquire knowledge by
doing work. By gaining experience through repetition, organizations
and individuals develop relatively permanent changes in behavior or
learning. As additional transactions occur in a service, or more products
are produced by a manufacturer, the per-unit cost often decreases at a
decreasing rate. This phenomenon follows an exponential curve. The
organization thus gains competitive advantage by converting this cost
reduction into productivity gains. This learning competitive advantage
is known as the experience curve, the learning curve, or the progress
curve.
It is common for the terms experience curve and learning curve to be

used interchangeably. They do, however, have different meanings.
According to definitions by Hall and Starr, the experience curve is
an analytical tool designed to quantify the rate at which experience
of accumulated output, to date, affects total lifetime costs. Melnyk
defined the learning curve as an analytical tool designed to quantify
the rate at which cumulative experience of labor hours or cost allows
an organization to reduce the amount of resources it must expend to
accomplish a task. Experience curve is broader than learning curve
with respect to the costs covered, the range of output during which the
reductions in costs take place, and the causes of reduction.
The idea of learning by doing is intuitive. We often experience this

effect when we take up a new sport or start to keyboard. Our skill levels
increase rapidly with practice, up to a point, and then progress at a
slower rate. Eventually, our golf score levels off around some value and
our keystrokes per minute (without errors) levels off as well.
Organizational learning is complex in that we learn at many levels

simultaneously. In organizations, procedures, norms, rules, and
forms store knowledge. March states that managers of competitive
organizations often find themselves in situations where relative position
with regard to a competitor matters. This possible competitive advantage
through enhanced learning is the essence of the study of experience and
learning curves.
The analytical use of the concept for business purposes first surfaced in
1936 during airplane construction, when Wright observed that as the
quantity of manufactured units doubled, the number of direct labor
hours needed to produce each individual unit decreased at a uniform
rate.
397
The variation of labor cost with production quantity is illustrated by the
following formula:
F = log F /log N
where F equals a factor of cost variation proportional to the quantity N.

The reciprocal of F represents a direct percent variation of cost versus
quantity.
This insight shows that experience-based learning is closely correlated

with cumulative output, extending beyond changes in design and tooling.
Wright found empirical evidence that as unit volume increases there
are predictable corresponding reductions in cost. These data become
central concepts for strategic and operational planning. There has been
much discussion on the role of learning in business organizations. A
seminal work in learning theory is the 1963 A Behavioral Theory of the
Firm by Cyert and March. These authors viewed firms as adaptively-
rational systems. This means that the firm learns from its experience. In
its basic form, an adaptive system selects preferred states for use in the
future. With experience, management uses decision variables that lead
to goals and shuns those that do not lead to goals.
The learning curve model was expanded by Adler and Clark into a
learning process model. A key conceptual difference from the prior
model is that a significant part of the effect of experience on productivity
(captured in the learning curve model) might be due to the influence
of identifiable managerial actions. The authors present two orders of
learning. First-order learning refers to the classic learning curve model
where productivity is an exponential function of experience. Second-
order learning denotes that which is driven by changes in technology or
human capital that lead to goal attainment.
The speeding up of a job with repeated performance is known as the

learning effect or learning curve effect and the reduction in the required
direct labour time for a job may be quantified. As the operation is
repeated, the workers become familiar with the work, labour efficiency
increases and the labour cost per unit declines. This process continues for
some time and a regular rate of decline in cost per unit can be established
at the outset. This rate of decline can then be used in predicting future
labour costs.
The learning process starts from the point when the first unit comes off
the production line, from then on, each time cumulative production is
398
doubled, and the average time taken to produce each unit of cumulative
production will be a certain percentage of the average time per unit of
the previous cumulative production.
The improvement in labor time is generally referred to as resulting from

productivity. If the improvement is, however, repetitive and predictable,
it is considered as resulting from learning. In effect, progress depends on
people learning, and a conventional hypothesis in industry is that they
learn according to a predictable pattern often called the learning curve.
The learning curve describes the empirical relationships between output
quantities and quantities of certain inputs (mainly direct labor hours)
where learning inducement improvement is present. It portrays the
concept that the cumulative average unit cost decreases systematically
by a common percentage each time the volume of production increases
geometrically (that is, increases by doubling). The phenomenon is helpful
in the investigation of the cost behavioral patterns, cost estimation, and
decision making in general. In effect the forecasting of labor input and
its impact on various economic decisions has been a laborious and time-
-consuming job. The learning curve is intended to make such forecasting
easier, quicker, and much more accurate. In brief, learning curves are
applicable to all the aspects of production planning and control where
there are tasks subject to improvement
The theory of the learning curve or experience curve is based on the

simple idea that the time required to perform a task decreases as a
worker gains experience. The basic concept is that the time, or cost,
of performing a task (e.g., producing a unit of output) decreases at
a constant rate as cumulative output doubles. Learning curves are
useful for preparing cost estimates, bidding on special orders, setting
labour standards, scheduling labour requirements, evaluating labour
performance, and setting incentive wage rates.
The principle underlying learning curves is generally well understood:

if we perform tasks of a repetitive nature, the time we take to complete
subsequent tasks reduces until it can reduce no more. This is relevant
to management accounting in the two key areas of cost estimation and
standard costing.
10.3.2 Meaning of Learning Curve theory

Learning Curve Theory is concerned with the idea that when a new
job, process or activity commences for the first time it is likely that the
workforce involved will not achieve maximum efficiency immediately.
Repetition of the task is likely to make the people more confident and
399
knowledgeable and will eventually result in a more efficient and rapid
operation. Eventually the learning process will stop after continually
repeating the job. As a consequence the time to complete a task will
initially decline and then stabilize once efficient working is achieved. The
cumulative average time per unit is assumed to decrease by a constant
percentage every time that output doubles. Cumulative average time
refers to the average time per unit for all units produced so far, from
and including the first one made (Puthran2007)
According to CIMA (2008), learning curve is the mathematical expression

of the phenomenon that, when complex and labour-intensive procedures
are repeated, unit labour times tend to decrease at a constant rate. The
learning curve models mathematically this reduction in unit production
time
The learning curve effect applies to a group of workers doing the same
job repetitively with the same equipment and machinery. Improvement
in efficiency from better machinery or better materials would not be the
result of the learning effect.
Before we look at these we need to understand the maths. Imagine that

we have collected the following information for the production of eight
units of a product: it takes 1,000 hours to produce the first unit; 600
hours to produce the second unit; 960 hours to produce the third and
fourth units; and 1,536 hours to produce the remaining four units. There
is clearly a learning curve effect here, as the production time per unit
is reducing from the initial 1,000 hours. Learning curves are initially
concerned with the relationship between cumulative quantities and
cumulative average times (total cumulative time divided by cumulative
quantity). The relationship in this case is shown in table 1, notice that, as
the cumulative quantity doubles, the cumulative average time reduces
by 20 per cent. In other words, subsequent cumulative average times can
be obtained by multiplying the previous cumulative average time by 80
per cent. This is an example of an 80 per cent learning curve. A learning
curve is addressed in percentage terms, depending upon the relationship
between the cumulative average times when the cumulative quantities
are doubling. For example, if the cumulative average time were 1,000
hours at the production of the first unit, 700 hours at the production of
the second, 490 hours at the fourth, and 343 hours at the eighth and so
on, this would be a 70 per cent learning curve.
10.3.3 Fundamentals of Experience and Learning curves

Following a strategy of increasing market share, the experience curve
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focuses on cost leadership. Management attempts to increase market
share while simultaneously reducing costs. This is a detriment to
market entry as the firm can lower its price, which may further increase
its market share and place added pressure on potential competitors, as
found in a study by Lieberman. Learning through experience becomes
an important component of the increased market share strategy.
Quality learning is enhanced through the shared experience at the

worker and organizational levels. Quality increases as the firm moves
further along the experience curve, thus increasing productivity and
efficiency. As the individual employees and organization become more
efficient, there should be a corresponding increase in productivity.
More output for less input effectively increases capacity; taken together
with the increased efficiency and productivity, this should lead to a
reduction in unit cost. The business is investing in a cost-leadership
posture based on the assumption that price is a basis for competition. If
the firm is able to produce quality units and reduce market price, there
is the opportunity for increased market share (the business strategy).
Increased market share via reduced price may lead to the global goal of
improving profits.
Use of a cost leadership strategy based on the experience curve implies

several assumptions, according to Amit:
1. Price is a basis for competition.
2. If per unit cost is reduced, price may be reduced, which may lead
to increased market share.
3. As cumulative output increases, the firms average cost is reduced.

Therefore, for any production rate, there is a reduction in the per-
unit cost.
4. If market share is increased, profits will increase.
5. Another critical assumption of the experience curve, noted by

Lieberman, is that learning can be kept within the organization.
Where industry-wide dissemination of process technology is rapid,
the benefits of organizational learning through the experience
curve may be short-lived. The cost benefits, therefore, may not
lead to increased market share even though industry costs are
declining because all participants are learning at approximately
the same rate.
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10.3.4 Reasons for the effect of learning curve
The primary reasons for why learning curve effects apply, of course, is
the complex processes of learning involved. Learning generally begins
with making successively larger finds and then successively smaller
ones. The equations for these effects come from the usefulness of
mathematical models for certain somewhat predictable aspects of those
generally non-deterministic processes, which include
1. Labour efficiency - Workers become physically more dexterous.

They become mentally more confident and spend less time
hesitating, learning, experimenting, or making mistakes. Over
time they learn short-cuts and improvements. This applies to
all employees and managers, not just those directly involved in
production
2. Standardization, specialization, and methods improvements - As

processes, parts, and products become more standardized,
efficiency tends to increase. When employees specialize in a
limited set of tasks, they gain more experience with these tasks
and operate at a faster rate
3. Technology-Driven Learning - Automated production technology

and information technology can introduce efficiencies as they are
implemented and people learn how to use them efficiently and
effectively
4. Better use of equipment - as total production has increased;

manufacturing equipment will have been more fully exploited,
lowering fully accounted unit costs. In addition, purchase of
more productive equipment can be justifiable
5. Changes in the resource mix - As a company acquires experience,

it can alter its mix of inputs and thereby become more efficient
6. Product redesign - As the manufacturers and consumers have

more experience with the product, they can usually find
improvements. This filters through to the manufacturing process
7. Value chain effects - Experience curve effects are not limited to the
company. Suppliers and distributors will also ride down the
learning curve, making the whole value chain more efficient
8. Network-building and use-cost reductions - As a product enters

more widespread use, the consumer uses it more efficiently
402
because theyre familiar with it. One fax machine in the world can
do nothing, but if everyone has one, they build an increasingly
efficient network of communications. Another example is email
accounts; the more there are, the more efficient the network is, the
lower everyones cost per utility of using it
9. Shared experience effects - Experience curve effects are reinforced

when two or more products share a common activity or resource.
Any efficiency learned from one product can be applied to the
other products
10.3.5 The learning rate

The cumulative average time per unit produced is assumed to fall by a
constant percentage every time total output of the product doubles, this
constant percentage is known as the learning rate
An 80% learning curve will be used for illustration since appears to be a

learning factor which commonly applies. An 80 percent learning curve
means that the cumulative average time (and cost) will decrease by 20
percent each time output doubles. In other words, the new cumulative
average for the doubled quantity will be 80% of the previous cumulative
average before output is doubled
For example, assuming the first unit of output requires 1000 hours and
80% learning curve applied and assumes that direct labor cost is $20 per
hour then the cumulative average hours and cost as well as cumulative
total hours and cost are provided below for doubled quantities 1 through 8
Table: Example of an 80% learning curve

2 3 4 5
1
Cumulative Cumulative Cumulative Cumulative
Cumulative
Total Labor Average La- Total Labor Average
Output
Hours bor Hours Cost Labor Cost
X
XYh Yh XYc Yc
1 100 100 $2,000 $2,000
2 160 80 3,200 1,600
4 256 64 5,120 1,280
8 409.6 51.2 8,192 1,024
Note that the cumulative average columns, 3 and 5 decrease by 20% as

output is doubled, or the new cumulative average is 80% of the previous
cumulative average. The cumulative total columns 2 and 4 increase at
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a rate equal to twice the learning rate or 160% in this case. Since these
rates of change remain constant, tables for doubled quantities can be
developed easily. However, for quantities in between the doubled
quantities, the equations are required. For example, assume the firm
has produced eight units as indicated in the table. How much will it
cost to produce ten additional units? Any of the equations for Yh, Yc,
XYh or XYc may be used to solve the problem. However, working with
the equation for cumulative total cost is the fastest way to obtain the
solution
10.3.6 Learning Curve Formulation

The formula for the learning curve model is commonly shown either as
a margin-cost model or as a direct-labor-hour model. The direct-labor-
hours formula is more useful, as hourly compensation typically changes
over time and there may be inflation considerations as well. However,
both derivations will be presented here for clarity. Also, direct-labor
hours may be easily converted into costs if necessary, according to
Yelle. By convention, we refer to experience curves by the complement
of the improvement rate. For example, a 80 percent learning curve
indicates a 20 percent decrease in per-unit (or mean) time or cost, with
each doubling of productive output. Experience and learning curves
normally apply only to cost of direct labor hours
Marginal cost model

The cumulative-average learning curve formulation is:
Ycx = ax-b
where Ycx = average cost of the first x units,

a = the first unit cost,
x = the cumulative unit number output
and
b = the learning elasticity, which defines the slope of the learning curve.
This learning curve model indicates that as the quantity of units produced
doubles, the average cost per unit decreases at a uniform rate.
Direct labor hours model.

The direct labor hour model of the learning curve is:
Y = aXb
where Y = the number of direct labor hours required to produce the X

th unit,
a = the number of direct labor hours required to produce the first unit,
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X = the cumulative unit number,
b = log /log 2,
= the learning rate, and
1 - = the progress ratio.
These empirical models have been shown to fit many production

situations very well. One criticism is that many other undocumented
variables may be behind the benefits attributed to the experience
curve. There are intermingling variables that also may account for
cost reductions. Some of these variables might be economies of scale,
product design decisions, tooling and equipment selections, methods
analysis and layout, improved organizational and individual skills
training, more effective production scheduling and control procedures,
and improved motivation of employees. All of these variables play a
role in decreasing cost and increasing capacity.
Illustration
Example: Assume that the learning rate for a certain operation is 75% and
it took 90 hours to produce the first unit. Calculate the hours required
to produce the fifth unit
By substituting the given data value into C equation, we get

b = log 0.75/log 2 = -0.4150
Using the above value and the specified data in Y = axb yields
Y5 = 90(5)-0.4150
= 46.15 hour
It will take 46.15 hours to produce the fifth unit
10.3.7 Learning Curve

Chart line representing the efficiencies gained from experience. Basically,
it is a curve describing the relationship between the consecutive numbers
of units produced (x-axis) and the time per unit produced (y-axis). More
specifically, it is based on the statistical findings that as the cumulative
output doubles, the cumulative average labour input time required per
unit will be reduced by some constant percentage, ranging between
10% and 40%. The curve is usually designated by its complement. For
example, if the rate of reduction is 20%, the curve is referred to as an
80% learning curve.
The following data illustrate the 80% learning curve relationship:
405
As can be seen, as production quantities double, the average time per
unit decreases by 20% of its immediate previous time, it can be graphed
as follows;
Quantity (in Units) Time (in hours)

Total Average Time
Per Lot Comulative
(Comulative) per Unit
15 15 600 40.0
15 30 960 32.0 (40.0 . 0.8)
30 60 1536 25.6 (32.0 . 0.8)
60 120 2460 20.5 (25.6 . 08)
120 240 3036 16.4 (20.5 . 0.8)
Fig. 1.6 Learning curve
10.3.8 Applications and Uses of learning and experience curve

There are three general areas for the application and use of learning
curves; strategic, internal, and external to the organization.
Strategic uses include determining volume-cost changes, estimating

new product start-up costs, and pricing of new products.
Internal applications include developing labor standards, scheduling,

budgeting, and make-or-buy decisions.
External uses are supplier scheduling, cash flow budgeting, and
estimating purchase costs. The usefulness of experience and learning
curves depends on a number of factors; the frequency of product
406
innovation, the amount of direct labor versus machine-paced output,
and the amount of advanced planning of methods and tooling. All lead
to a predictable rate of reduction in throughput time.
Knowledge on the practical application of experience curves and

learning curves has increased greatly since 1936. Interest was renewed
in the early 1990s with the publication of The Fifth Discipline by Peter
Senge. Senge melded theories on mental models, the systems approach,
and learning curves in a way that made sense for executives.
These curves offer potential competitive advantage to managers who

can capitalize on the cost reductions they offer. The experience and
learning curves rely, however, on keeping the knowledge gained
within their organization. Given rapid communication, high manager
and engineer turnover, and skills in reverse engineering, this is harder
to accomplish with each passing year. However, Hatch and Dyer
found that in the case of the semiconductor manufacturing industry,
in particular, skills acquired in one firm are not necessarily effectively
transferable to another firm since knowledge is specific to the original
work environment. Therefore, even if the employee is hired away, there
is limited threat to the original firm.
Hatch and Dyer conclude that to truly maintain an advantage over the
competition, firms must employ effective human resource selection,
training, and deployment processes that facilitate learning by doing.
Those firms that meet this challenge may enjoy the only truly sustainable
advantagethe ability to learn (and improve) faster than competitors. As
manufacturing and service product lives become shorter, management
must be keenly on top of experience and learning curves to continue to
enjoy the advantages.
10.3.9 Limitations of learning curve theory

1. It assumes stable conditions at work, which will enable learning
curve to take place. This is not always practicable ( eg because of
labour turnover)
2. It must also assume a certain degree of motivation amongst

employees
3. It might be difficult to obtain enough accurate data to decide

what the learning curve is
4. There will be a cessation to learning curve eventually, once the

job has been repeated often enough
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Assessment Question
10.3.1
(a) Explain the learning curve concept and the importance of
recognizing the effects of the learning curve when preparing
performance reports
(b) It is argued that many areas of modern technology, the learning

curve effect is diminishing significance. An experience curve
effect would still be present and possibly strengthened in
importance. However, the experience curve has little to do with
the short term standard setting and product costing
Required
Discuss the validity of the above statement in particular the assertion
that experience curve has little relevance to costing
(c) Explain the extent to which the application of experience curve

theory can help an organization to prolong the life cycle of its
products or services.
408
Summary
Difficulties occur in estimating costs when technological changes take
place in the production process: past data is not very useful for estimating
costs. Example, changes in the efficiency of the labour force may
render past information unsuitable for predicting future labour costs.
A situation like this may occur when workers become more familiar
with the tasks that they perform, so that less labour time is required
for production of each unit. The phenomenon has been observed in
a number of manufacturing situations and is known as the learning-
curve-effect (Drury, 2006).
In this part three of chapter ten has addressed in detail the issues of
experience and learning curve. Experience and learning curve models
are developed from the basic premise that individuals and organizations
acquire knowledge by doing work. By gaining experience through
repetition, organizations and individuals develop relatively permanent
changes in behavior or learning. As additional transactions occur in a
service, or more products are produced by a manufacturer, the per-unit
cost often decreases at a decreasing rate. This phenomenon follows an
exponential curve. The organization thus gains competitive advantage
by converting this cost reduction into productivity gains. This learning
competitive advantage is known as the experience curve, the learning
curve, or the progress curve.

Experience curve
Labour efficiency
Learning curve
Learning curve theory
Learning rate
Value chain effect
409
Exercises
10.3.1 Discuss the application of Learning curve in management
accounting
10.3.2 What are the distinctive features of Learning curves theory in

manufacturing environment?
10.3.3 A company which has developed a new machine has observed

that the time taken to manufacture the first machine is 600 hours.
(a) Calculate the time which the company will take to

manufacture the second machine if the actual learning curve is
(i) 80%
(ii) 90%
(b) Explain which of the two learning rates will show faster learning
Problems
10.3.4
(a) Explain the learning curve concept and the importance of
recognizing the effects of the learning curve when preparing
performance reports
(b) It is argued that in many areas of modern technology, the

learning curve effect is diminishing significance. An experience
curve effect would still be present and possibly strengthened in
importance. However, the experience curve has little to do with
the short-term standard setting and product costing.
Required
Discuss the validity of the above statement, in particular the assertion
that the experience curve has little relevance to costing
(c) Explain the extent to which the application of experience curve

theory can help on organization to prolong the life cycle of its
products or services
10.3.5
a) Explain the theory of the Learning curve
b) Indicate the areas where learning curves may assist in management
accounting
c) Illustrate the use of learning curves for calculating the expected
average unit cost of making:
4 machines
8 machines
410
Using the data given below
Data
Direct labour needed to make the first machine 1,000 hours
Learning curve 80%
Direct labour Cost $ 3.00 per hours
Direct Materials Costs $ 1,800 per machine
Fixed cost for either size order $ 8,000
10.3.6
ABC Motors Ltd has designed a radically new concept in racing bikes
with the intention of selling them to professional racing teams. The
estimated cost and selling price of the first bike to be manufactured and
assembled is as follows:
Materials $ 1,000
Assembly Labour (50 hours at $10 per hour) $ 500
Fixed Overheads (200% of Assembly labour) $ 1,000
Profit (20% of total cost) $ 500
Selling Price $ 3,000
ABC Motors Ltd plans to sell all bikes at total cost plus 20% and the
material cost per bike will remain constant irrespective of the number
sold.
ABC Motors Ltd management expects the assembly time to gradually

improve with experience and has estimated an 80% learning curve. A
racing team has approached the company and asked for the following
quotations:
a) If we were to purchase the first bike assembled, and immediately

put in an order for the second, what would be the price of the
second bike?
b) If we waited until you had sold two bikes to another team, and
then ordered the third and fourth bikes to be assembled, what
would be the average price of the third and fourth bikes?
c) If we decided to immediately equip our entire team with the new

bike, what would be the price per bike if we placed an order for
the first eight to be assembled?

10.3.7
ABC Ltd manufactures a special product purely carried out by manual
labour. It has a capacity of 20,000 units. It estimates the following cost
structure;
411
$/unit
Direct Material 30.00
Direct labour (1 hour/unit) 20.00
Variable overheads 10.00
Fixed overhead at the maximum capacity is $ 150,000
It is estimated that at the current level of efficiency, each unit requires

one hour for first 5,000 units. Subsequently it is possible to achieve 80%
learning rate. The market can absorb the first 5,000 units at $ 100 per
unit.
Required
What should be the minimum selling price acceptable for order of 15,000
units for prospective client?
10.3 8
The following information is provided by a firm. The factory manager
wants to use the appropriate average learning rate on activities so that
he may forecast costs and prices on a certain level of activity
1. Set a very experience people fed data into the computer for
processing inventory records in the factory. The manager wishes
to apply 80% learning rate on daily entry and calculation of
inventory.
2. A new type of machinery is to be installed in the factory. This

is patented process and the output may take a year full fledged
production. The factory manager wants to use the learning rate
on the workers at the new machine.
3. An operation uses a contract labour. The contractor shifts people

among various jobs once in two days. The labour force performs
one task in 3 days. The manager wants to apply an average
learning rate for these workers
Required
Advice the manager with the reasons on the applicability of the learning
curve theory on the above information
10.3.10
Captain Gift Ltd has designed a new type of sailing boat, for which the
cost and sales price of the first boat to be produced has been estimated
as follows:
412
$
Materials 5,000
Labour (800 hrs @ $ 5 per hr) 4,000
Overhead (150% of labour cost) 6,000
Profit mark up (20%) 3,000
Sales price 18,000
It is planned to sell all the yachts at full cost plus 20%. An 80% learning
curve is expected to apply to the production work. A customer has
expressed interest in buying the yacht, but thinks $18,000 is too high a
price to pay. He might want to buy 2, or even 4 of the yachts during the
next six months.
He has asked the following questions

(a) If he paid $ 18,000 for the first yacht, what price would he have to
pay later for a second yacht
(b) Could Captain Gift Ltd quote the same unit price for two yachts
if the customers ordered two at the same time?
(c) If the customer bought two yachts now at one price, what would
be the price per unit for a third and a fourth yacht, if he ordered
them separately later on?
(d) Could Captain Gift Ltd quote a single unit price for
(i) Four yachts
(ii) Eight yachts
If they were all ordered now

Assuming that there are no other prospective customers for the yacht,
how would these questions be answered?
413
Case Studies
Case study 10.3.1: Marios Pizzeria
Mario, owner of Marios Pizzeria, opened his first pizza Parlor in
1950 in Palm Springs, California. Running and operating his store in
one of the local and busy malls, Marios pizzas became popular for its
fresh ingredients and authentic taste. In the given Pizza Store Layout
simulation, the students were given the opportunity to work as a
manager for two months to improve the service system by improving
the four elements of waiting line problems- a waiting line, a service
system, customer population, and a priority rule for determining
which customer is to be served next. Given that many customers are
dissatisfied with the wait times; my objective would be to comprehend
the learning curve concept of reducing the wait times and optimizing
the processes to maximize the benefits. In the next couple of paragraphs,
I will examine the process thoroughly and provide several points of the
process performance data for the performance metrics identified in the
simulation. Furthermore, I will apply the learning curve concepts to test
the alternative against the current process, and determine how good the
initial process data is in the organization
Process Performance Data

In the simulation, Marios Pizzeria begins with the flow process of a
customer entering the restaurant, waiting, being seated, order taken,
order processed, order received in kitchen, order served, eating time, bill
received and payment made, and the customer exiting the restaurant.
The simulation mentions Marios initial setup, which includes 14 tables
for four, four servers, and two kitchen staff. The entire process from
when a customer walks into the pizza parlor to the time the customer
leaves the parlor is 53 minutes. Acknowledging the pizza parlor is
experiencing a loss of sales due to the fact that customers are leaving
without being served, I made adjustments toward the distribution.
Discussion questions
1. Explain the concept of learning curve
2. Identify the areas in which the learning curve theory would be
useful in Marios Pizzeria
414
Further Readings
Bailey, C. D. (2000) Learning-curve estimation of production costs
and labor hours using a free Excel add-in. Management Accounting
Quarterly (summer): 25-31.
Bailey, C. D. and E. V. McIntyre (1992). Some evidence on the nature of

relearning curves. The Accounting Review (April): 368-378.
Bailey, C. D and E. V. McIntyre,(1997). The relation between fit and

prediction for alternative forms of learning curves and relearning
curves. IIE Transactions (29): 487-495.
Demeester, Lieven L., and Me Fontainebleu Qi. Managing Learning

Resources for Consecutive Product Generations. International Journal
of Production Economics 95, no. 2 (2005): 265283.
Hall, G., and S. Howell. (1985) The Experience Curve from the
Economists Perspective. Strategic Management Journal 6, no.: 197212.
Hatch, Nile W., and Jeffrey H. Dyer.(2004) Human Capital and

Learning as a Source of Sustainable Competitive Advantage. Strategic
Management Journal 25, no. 12 : 11551178.
Jaber, M. Y., and A. L. Guiffrida. Learning Curves for Processes

Generating Defects Requiring Reworks. European Journal of
Operational Research 159, no. 3 (2004): 663672.
Junginger, M., A. Faaij, and W. C. Turkenburg. Global Experience

Curves for Wind Farms. Energy Policy 33, no. 2 (2005): 133150.
Lieberman, Marvin B. (1989) The Learning Curve, Technology

Barriers to Entry, and Competitive Survival in the Chemical Processing
Industries. Strategic Management Journal 10, no. 5: 431447.
415
PART FOUR
THE QUANTITATIVE MODELS FOR PLANNING
AND CONTROL OF STOCKS
Learning Outcomes
be able to:
1. Describe the Meaning of inventory management
2. Explain the Functions of Inventory
3. Understand the requirements for Effective Inventory
Management
4. Describe advantages and disadvantages of keeping Inventory
5. Describe the objectives of inventory planning and control
6. Understand the Inventory Counting Systems
7. Describe the Economic Order Quantity (EOQ)
8. Formulate the EOQ Mathematical Model
9. Apply Economic Order Quantity (EOQ) with Quantity
Discount
10. Understand Just-In-Time System (JIT)
416
10.4.1 Introduction
One of the most common problems facing operations managers is
inventory planning. This is understandable since inventory usually
represents a sizable portion of a firm`s total assets and, more specifically,
on the average, more than 30% of total current assets. Excessive money
tied up in inventory is a drag on profitability. The purpose of inventory
management is to develop policies which will achieve an optimal
investment in inventory. This can be done by determining the optimal
level of inventory necessary to minimize inventory related costs.
Therefore, Inventory management involves making decisions concerning

how much inventory to order and when. The basic criterion in making
these decisions is to minimize total inventory costs, such as the cost to
carry inventory, the cost to order inventory, and the item cost, subject
to meeting demand for the items. Inventory control involves process,
procedures, and infrastructure to maintain the inventory at the desired
level.
The chapter discusses inventory (we use the word interchangeably with
the word stock) predominantly as accumulations of transformed input
resource. It does however mention the broader use of the word inventory
or stock to denote the organizations stock of people, machines, and
other assets. You often hear economists talking of a stock of resources in
this way. From here on however we use the word exclusively to mean
an accumulation of materials.
10.4.2 Meaning of inventory

Inventory can be classified as supplies, raw materials, work-in-process
and finished goods which are essential to a businesses operations.
Inventory management depends heavily on sales because inventory
is purchased earlier than sales can be made and poor inventory levels
leads to either lost sales or excessive carrying costs. Any changes in the
products demand should be worked into the companys purchasing
and manufacturing schedules thus coordination among the sales,
purchasing, production and finance departments is important.
The goal of inventory management is to:

1. Ensure that the inventories needed to sustain operations are
available
2. Hold the costs of purchasing and carrying inventories to the

lowest possible level
417
10.4.3 Types of Demand:
Dependent Demand: These are items that are typically subassemblies
or component parts that will be used in the production of a final or
finished product. Subassemblies and component a part is derived from
the number of finished units that will be produced. Example: Demand
for wheels for new cars.
Independent Demand: These are items that are the finished goods or
other end items. These items are sold or at least shipped out rather than
used in making another product.
10.4.4 Functions of Inventory

Meet anticipated customer demand: These inventories are referred to as
anticipation stocks because they are held to satisfy planned or expected
demand.
Smooth production requirements: Firms that experience seasonal

patterns in demand often build up inventories during off-season to meet
overly high requirements during certain seasonal periods. Companies
that process fresh fruits and vegetable deal with seasonal inventories
Decouple operation: The buffers permit other operations to continue

temporarily while the problem is resolved. Firms have used buffers of
raw materials to insulate production from disruptions in deliveries from
suppliers, and finished goods inventory to buffer sales operations from
manufacturing disruptions.
Protect against stock-outs: Delayed deliveries and unexpected

increases in demand increase the risk of shortages. The risk of shortages
can be reduced by holding safety stocks, which are stocks in excess of
anticipated demand.
Take advantage of order cycles: Inventory storage enables a firm to

buy and produce in economic lot sizes without having to try to match
purchases or production with demand requirements in short run.
Hedge against price increase: The ability to store extra goods also allows
a firm to take advantage of price discounts for large orders.
Permit operations: Production operations take a certain amount of time

means that there will generally be some work-in-process inventory
Hence, the basic function of inventory is to insulate the production

process from changes in the environment as shown below.
418
Note here that although we refer in this note to manufacturing, other

industries also have stock e.g. the stock of money in a bank available to
be distributed to customers, the stock of policemen in an area, etc).
One point to note from the above diagram is that most of the activities
are a cost - it is only at the final point (sales of finished goods) that
we get revenue to set against our costs and hopefully make a profit (=
revenue - cost). Hence if we have cost associated with stock we need to
deal with that stock in an Effective, Efficient and Economic manner.
10.4.5 Requirements for Effective Inventory Management

To be effective, management must have the following:
1. A system to keep track of the inventory on the hand on order.
2. A reliable forecast of demand that includes an indication of
possible forecast error.
3. Knowledge of lead times and lead time variability.
4. Reasonable estimates of inventory holding costs, ordering costs,
and shortage costs.
5. A classification system for inventory items
10.4.6 Advantages and Disadvantages of keeping Inventory

The problem with inventory management is that keeping stock has both
advantages and disadvantages.
The advantages include,

1. Inventory allows customers to be served quickly and conveniently
(otherwise you would have to make everything as the customer
requested it).
2. Inventory can be used so a company can buy in bulk, which is

usually cheaper.
419
3. Inventory allows operations to meet unexpected surges in demand.
4. Inventory is insurance if there is an unexpected interruption in

supply from outside the operation or within the operation.
5. Inventory allows different parts of the operation to be decoupled.

This means that they can operate independently to suit their own
constraints and convenience while the stock of items between them
absorbs short-term differences between supply and demand. In
many ways this is the most significant advantage of inventory.
The disadvantages of inventory include,

1. It is expensive. Keeping inventory means the company has to
fund the gap between paying for the stock to be produced and
getting revenue in by selling it. This is known as working capital.
There is also the cost of keeping the stock in warehouses or
containers.
2. Items can deteriorate while they are being kept. Clearly this is
significant for the food industry whose products have a limited
life. However, it is also an issue for any other company because
stock could be accidentally damaged while it is being stored.
3. Products can become obsolescent while they are being stored.

Fashion may change or commercial rivals may introduce better
products.
4. Stock is confusing. Large piles of inventory around the place need

to be managed. They need to be counted, looked after and so on.
10.4.7 The objectives of inventory planning and control

Generally the operations objectives of managing the companys
inventories include the following.
1. Quality products need to be maintained in as good a condition
as possible while they are being stored. For perishable products
this means not storing them for very long.
2. Speed inventories must be in the right place to ensure fast

response to customer requests.
3. Dependability the right stock must be in the right place at the

right time to satisfy customer demand. There is no point having
the wrong products in stock.
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4. Flexibility stock should be managed to allow the operation to
be flexible. For example, that may mean keeping sufficient stock to
allow the operations processes to switch to producing something
else and yet being able to satisfy customers during that period
from existing stock levels.
5. Cost if possible the total cost of managing stock levels should

be minimized. This is the objective of the various quantitative
models covered in the chapter.
10.4.8 Inventory Counting Systems

Periodic System: This is a physical count of items in inventory is made
at periodic intervals (e.g. weekly, monthly) in order to decide how much
to order of each item. Major users: Supermarkets, discounts stores, and
department stores.
Advantage
Orders for many items occur at the same time, which can result in
economies in processing and shipping orders
Disadvantages
a) Lack of control between reviews.
b) The need to protect against shortages between review periods by
carrying extra stock.
c) The need to make a decision on order quantities at each review
Perpetual Inventory System (also known as a continual system): This

keeps track of removals from inventory on a continuous basis, so the
system can provide information on the current level of inventory for
each item.
Advantages
1. The control provided by the continuous monitoring of inventory
withdrawals.
2. The fixed-order quantity; management can identify an economic

order size.
Disadvantage
The added cost of record keeping.
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10.4.9 Inventory Cost
There are Three Basic Costs of inventory costs which are explained
below:
1. Holding or Carrying Cost is the costs to carry an item in inventory
for a length of time usually a year. Cost includes interest,
insurance, taxes, depreciation, obsolescence, deterioration,
spoilage, pilferage, breakage, etc.
2. Ordering Cost is cost of ordering and receiving inventory. These

include determining how much is needed, preparing invoices,
inspecting goods upon arrival for quality and quantity, and
moving the goods to temporary storage.
3. Storage Cost is cost resulting when demand exceeds the supply

of inventory on hand. These costs can include the opportunity
cost of not making a sale, loss of customer goodwill, late charges,
and similar costs
10.4.10 Economic Order Quantity Models

Economic Order Quantity (EOQ) is the order size that minimizes
total cost. EOQ models identify the optimal order quantity in terms of
minimizing the sum of certain annual costs that vary with order size.
There are three order Size
1. The economic order quantity model.
2. The economic order quantity model with non instantaneous
delivery.
3. The quantity discount model.
Inventory Cycles begins with the receipt of an order of Q units, which

are withdrawn at instant rate over time. When the quantity on the hand
is just sufficient to satisfy demand during lead time, an order for Q units
is submitted to the supplier.
10.4.11 Economic Order Quantity (EOQ)

In order for inventory managers to make use of the classic EOQ Model to
determine how much inventory to order and when, they must be willing
to accept the assumptions. These assumptions may seem restrictive
but two points are important to consider. First, total inventory costs
are fairly insensitive to deviations from the optimal order quantity as
long as the deviations are not too drastic. Thus, while an assumption
may not be precisely met, the impact may not be too great. Second,
there are variations to the classic EOQ Model that allow us to relax the
assumptions. We make a note when this is possible in the following
brief discussion of each assumption.
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10.4.12 Assumptions of Economic Order Quantity (EOQ)
1. The daily demand rate, d, is constant and independent. We will
examine a way to work around this assumption when we
examine an extension to the EOQ model to consider variation in
the demand rate.
2. The order quantity, Q, is constant for each order and the entire
order is received at one time.
3. The cost per order, Co, is constant and does not depend on the
size of the order.
4. The unit cost, C, of the inventory item is constant and does not
depend on the size of the order.
5. The inventory holding cost per unit per time period, Ch, is
constant.
6. Shortages such as backorders and stock outs are not permitted.
7. The lead time for an order is constant. Lead time is the time
between when an order is placed until it is received.
8. The inventory level is reviewed on a continuous basis. This is

generally the case when we are considering relatively expensive
items. When the items are relatively inexpensive, the inventory
manager may often review the inventory level every fixed time
period, like once a month, and then place an order based on that
level.
9. The planning horizon consists of multiple time-periods. This

simply means that the item in inventory has shelf life and may be
inventoried for more than one period in time.
10.4.13 Stock shown graphically

A stock control chart is a graphical illustration of a simple approach
to stock management over time. This saw tooth shaped diagram is
normally shown as if sales were steady throughout each month. Whilst
this oversimplifies the situation for many businesses, the principles can
be adapted to most situations.
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The key features and terms are:
1. Maximum stock level this is the maximum amount of stock a
business would wish to hold. This could represent enough stock
for a month or a week, it might be as much as the warehouse has
space for, or it might depend on the order size needed to qualify
for a quantity discount known as the Economic Order Quantity
(EOQ).
2. Re-order level this acts as a trigger point, so that when stocks fall
to this level, the next order should be placed. This helps take
account of fluctuations in sales levels over time. When an order
is placed, there is a lead time that the supplier needs to meet that
order. Ideally this new order will arrive just before stocks fall
below the minimum stock level.
3. Lead time the amount of time between placing the order and
receiving the stock on the diagram below, just less than two
weeks
4. Minimum stock level this is the minimum amount of product

the business would want to hold in stock. Assuming the minimum
stock level is more than zero, this is known as buffer stock
5. Buffer stock an amount of stock held as a contingency in case of

unexpected orders so that such orders can be met and in case of
any delays from suppliers.
Then we need to decide Q, the amount to order each time, often called
the batch (or lot) size. With these assumptions the graph of stock level
over time takes the form shown below.
Figure: 10.4.1 The graph of stock level
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Consider drawing a horizontal line at Q/2 in the above diagram. If
you were to draw this line then it is clear that the times when stock
exceeds Q/2 are exactly balanced by the times when stock falls below
Q/2. In other words we could equivalently regard the above diagram as
representing a constant stock level of Q/2 over time.
10.4.14 Developing EOQ Mathematical Model

EOQ only applies when demand for a product is constant over the year
and that each new order is delivered in full when the inventory reaches
zero. There is a fixed cost charged for each order placed, regardless of
the number of units ordered. There is also a holding or storage cost for
each unit held in storage (sometimes expressed as a percentage of the
purchase cost of the item).
We want to determine the optimal number of units of the product to

order so that we minimize the total cost associated with the purchase,
delivery and storage of the product
The required parameters to the solution are the total demand for the
year, the purchase cost for each item, the fixed cost to place the order and
the storage cost for each item per year. Note that the number of times an
order is placed will also affect the total cost, however, this number can
be determined from the other parameters
Variables
Q = order quantity
Q * = optimal order quantity
D = annual demand quantity of the product
P = purchase cost per unit
S = fixed cost per order (not per unit, in addition to unit cost)
H = annual holding cost per unit (also known as carrying cost or
storage cost) (warehouse space, refrigeration, insurance, etc.
usually not related to the unit cost)
10.4.15 The Total Cost function

The single-item EOQ formula finds the minimum point of the following
cost function:
Total Cost = purchase cost + ordering cost + holding cost
Purchase cost: This is the variable cost of goods: purchase unit price
annual demand quantity. This is PD
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Ordering cost: This is the cost of placing orders: each order has a fixed
cost S, and we need to order D/Q times per year. This is S D/Q
Holding cost: the average quantity in stock (between fully replenished

and empty) is Q/2, so this cost is H Q/2

To determine the minimum point of the total cost curve, set the ordering
cost equal to the holding cost:

Solving for Q gives Q* (the optimal order quantity):
Therefore: .
Q* is independent of P; it is a function of only S, D, H.
Illustration
ABC Ltd expects to sell about 200 units of a product per year. The storage
space taken up in his premises by one unit of this product is costed at
$20 per year. If the cost associated with ordering is $ 35 per order what
is the economic order quantity given that interest rates are expected to
remain close to 10% per year and the total cost of one unit is $100. ABC
calculates the order quantity as follows
EOQ = [2 (Demand) (Ordering Cost) ] /(Holding Cost)
EOQ = [2 (200) ($ 35)] / ($30)
EOQ = [14,000] /$ 30
EOQ = 466.66 = 21.6 units

The economic order quantity is 21.6 units.
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We can illustrate this calculation by reference to the diagram below
which shows order cost, holding cost and total cost for this example.
Graph: Economic Order Quantity (EOQ)
With this EOQ we can calculate our total annual cost from the equation
Total annual cost = H Q/2 + S (D/Q)
Hence for this example we have that
Total annual cost = (30 x 22/2) + (35 x 200/22) = 330 + 318.2 = $ 648.2
Note: If we had used the exact Q value given by the EOQ formula (i.e.
Q=21.602) we would have had that the two terms relating to
annual holding cost and annual order cost would have been
exactly equal to each other
i.e. holding cost = order cost at EOQ point (or, referring to the diagram
above, the EOQ quantity is at the point associated with the Holding
Cost curve and the Order Cost curve intersecting).
i.e. H Q/2 = S (D/Q) so that
In other words, as in fact might seem natural from the shape of the
Holding Cost and Order Cost curves, the optimal order quantity
coincides with the order quantity that exactly balances Holding Cost
and Ordering Cost.
Note however that this result only applies to certain simple situations.
It is not true (in general) that the best order quantity corresponds to the
quantity where holding cost and ordering cost are in balance.
Note however that this result only applies to certain simple situations.
It is not true (in general) that the best order quantity corresponds to the
quantity where holding cost and ordering cost are in balance.
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10.4.16 Economic Order Quantity (EOQ) with Quantity Discount
The economic order quantity (EOQ) model does not take into account
quantity discounts, which is not realistic in many real-world cases.
Usually, the more you order, the lower is the unit price you pay.
Quantity Discounts are price reductions for large orders offered

to customers to induce them to buy in large quantities. If quantity
discounts are offered, the customer must weigh the potential benefits of
reduced purchase price and fewer orders that will result from buying in
large quantities against the increase in carrying costs caused by higher
average inventories
The buyer`s goal is to select the order quantity that will minimize
total costs, where total cost sum of carrying cost, ordering cost, and
purchasing cost is:
TC = Purchasing Cost + carrying cost + Ordering cost

Where: P = Unit price
Therefore, the computation of EOQ with quantity discounts is

summarized below.
1. Compute the economic order quantity (EOQ) when price
discounts are ignored and the corresponding costs using the new
cost formula given above
2. Compute the costs for those quantities greater than the EOQ at
which price reductions occur
3. Select the value of Q that will result in the lowest total cost.
Illustration
The maintenance department of a large hospital uses about 180 cases
of liquid cleanser annually. Ordering costs are $25, carrying costs are
$5 per case a year, and the new schedule indicates that orders of less
than 45 cases will cost $2.0 per case, 45 to 69 will cost $1.7 per case, and
more than 70 cases will cost $1.4 per case. Determine the optimal order
quantity and total cost.
Economic order Quantity is given by
EOQ = [2 (180) ($ 25)] / ($ 5) = 43 units
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Total Cost = PD + DS/Q + HQ/2 = ($ 2.0 x 43) + ($25x180)/43 + (43/2)
x $ 5= $ 298.15
If we order 45 unit we may get discount the price will be reduced from
$2 to $1.7 and the total annual cost will be:-

x $ 5= $ 289
If we order 70 unit we may get further reduction as the price will be

reduced from $1.7 to $1.4 the annual cost in this case would be :-

x $ 5= $ 337.28
We can note from the graph above that, at some range from 45 to 70
units annual cost will be appropriate even the EOQ state other range
due to discount effect.
It should be noted that, there are favorable and some unfavorable features
of buying in large quantities. The advantages are lower unit costs,
lower ordering costs, fewer stock-outs, and lower transportation costs.
On the other hand, there are disadvantages such as higher inventory
carrying costs, larger capital requirements, and a higher probability of
obsolescence and deterioration.
Whenever quantity (or price) discounts are offered, the purchasing

manager must weigh the potential benefits of reduced purchase price
and fewer orders that will result from buying in large quantities against
the increase in carrying costs caused by higher average inventories. He
or she should receive credit for overall savings resulting from quantity
buying.
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10.4.17 Just-In-Time System
The inventory control problem occurs in almost every type of
organization. It exists whenever products are held to meet some expected
future demand. In most industries, cost of inventory represents the
largest liquid asset under the control of management. Therefore, it is
very important to develop a production and inventory planning system
that will minimize both purchasing and carrying costs.
Effective purchasing and management of materials is a high priority in
most manufacturing firms. Material cost, as a proportion of total product
cost, has continued to rise significantly during the last few years and
hence is a primary concern of top management.
In recent years, the Japanese have demonstrated the ability to manage
their production systems effectively. Much of their success has been
attributed to what is known as the Just-In-Time (JIT) approach to
production and inventory control, which has generated a great deal of
interest among practitioners. The "Kanban" system-as they call it- has
been a focal point of interest, with its dramatic impact on the inventory
performance and productivity of the Japanese auto industry.
10.4.18 Meaning of Just-In- Time (JIT)
Just in time is a pull system of production, so actual orders provide
a signal for when a product should be manufactured. Demand-pull
enables a firm to produce only what is required, in the correct quantity
and at the correct time. This means that stock levels of raw materials,
components, work in progress and finished goods can be kept to a
minimum. This requires a carefully planned scheduling and flow of
resources through the production process. Modern manufacturing firms
use sophisticated production scheduling software to plan production
for each period of time, which includes ordering the correct stock.
Information is exchanged with suppliers and customers through EDI
(Electronic Data Interchange) to help ensure that every detail is correct.
Supplies are delivered right to the production line only when they are
needed. For example, a car manufacturing plant might receive exactly
the right number and type of tyres for one days production, and the
supplier would be expected to deliver them to the correct loading bay
on the production line within a very narrow time slot.
JIT production, in its purest sense, is buying and producing in very small
quantities just in time for use. The basic idea has its roots in Japan`s
densely populated industrial areas and its lack of resources, both of
which have produced frugal personal habits among the Japanese people.
The idea was developed into a formal management system by Toyota
in order to meet the precise demands of customers for various vehicle
models and colors with minimum delivery delays.
430
As a philosophy, JIT targets inventory as an evil presence that obscures
problems that should be solved, and that by contributing significantly
to costs, large inventories keep a company from being as competitive
or profitable as it otherwise might be. Practically speaking, JIT has as
its principal goal the elimination of waste, and the principal measure of
success is how much or how little inventory there is. Virtually anything
that achieves this end can be considered a JIT innovation. Inventory
activities are inherently non-value-adding. Non-value-adding activities
are those that do not add utility to the product. Thus, a system, such as
JIT, that simplifies production and reduces inventory and its attendant
procedures (storage, handling, etc.) also reduces non-value-adding
activities.
Furthermore, the little inventory that exists in a JIT system must be

of good quality. This requirement has led to JIT purchasing practices
uniquely able to deliver high-quality materials.
JIT systems integrate five functions of the production process-sourcing,

storage, transportation, operations, and quality control-into one
controlled manufacturing process. In manufacturing, JIT means that
a company produces only the quantity needed for delivery to dealers
or customers. In purchasing, it means suppliers deliver subassemblies
just in time to be assembled into finished goods. In delivery, it requires
selecting a transportation mode that will deliver purchased components
and materials in small-lot sizes at the loading dock of the manufacturing
facilities just in time to support the manufacturing process.
JIT manufacturing is a demand-pull, rather than the traditional "push"

approach. The philosophy underlying JIT manufacturing is to produce
a product when it is needed and only in the quantities demanded by
customers. Demand pulls products through the manufacturing process.
Each operation produces only what is necessary to satisfy the demand of
the succeeding operation. No production takes place until a signal from
a succeeding process indicates a need to produce. Parts and materials
arrive just in time to be used in production.
10.4.19 Advantages of Just-In-Time (JIT) System

Reduced Inventories: The primary goal of JIT is to reduce inventories
to insignificant or zero levels. In traditional manufacturing, inventories
result whenever production exceeds demand. Inventories are needed as
a buffer when production does not meet expected demand.
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Total Quality Control: JIT goes with it a stronger emphasis on quality
control. A defective part brings production to a grinding halt. Poor quality
simply cannot be tolerated in a stockless manufacturing environment.
In other words, JIT cannot be implemented without a commitment
to total quality control (TQC). TQC is essentially an endless quest for
perfect quality. This approach to quality is opposed to the traditional
belief, called acceptable quality level (AQL). AQL allows defects to
occur provided they are within a predetermined level.
Decentralization of Services: JIT requires easy and quick access to
support services, which means that centralized service departments
must be scaled down and their personnel assigned to work directly to
support production. For example, with respect to raw materials, JIT
calls for multiple stock points, each one near where the material will be
used. There is no need for a central warehouse location.
Suppliers as Outside Partners: The most important aspects of the JIT

purchasing concept focus on (1) new ways of dealing with suppliers,
and (2) a clear-cut recognition of the appropriate purchasing role in
developing corporate strategy. Suppliers should be viewed as "outside
partners" who can contribute to the long-run welfare of the buying firm
rather than as outside adversaries.
Better Cost Management: Cost management differs from cost accounting

in that it refers to the management of cost, whether or not the cost has
direct impact on inventory or the financial statements. The JIT philosophy
simplifies the cost accounting procedure and helps managers manage
and control their costs, JIT recognizes that with simplification come better
management, better quality, better service, and better cost. Traditional
cost accounting systems have a tendency to be very complex, with many
transactions and reporting of data. Simplification of this process will
transform a cost "accounting" system into a cost "management" system
that can be used to support management`s needs for better decisions
about product design, pricing, marketing, and mix, and to encourage
continual operating improvements.
Reduce carrying costs: JIT will reduce carrying costs by eliminating

inventories and increasing the deliveries made by suppliers. Ideally,
shipments are received just in time to be incorporated into the
manufacturing process. This system increases the risk of the stock
out costs because the inventory buffer is reduced or eliminated. The
potential benefits of JIT are numerous. First, JIT practice reduces
inventory levels, which means lower investments in inventories. Since
the system requires only the smallest quantity of materials needed
432
immediately, it reduces the overall inventory level substantially. Other
financial benefits JIT include:
1. Lower investments in factory space for inventories and production.

2. Less obsolescence risk in inventories
3. Reduction in scrap and rework
4. Decline in paperwork
5. Reduction in direct material costs through quantity purchases
10.4.20 Disadvantages of JIT
However the Just-In-System has got the following disadvantages
1. There is little room for mistakes as minimal stock is kept for re-
working faulty product
2. Production is very reliant on suppliers and if stock is not delivered

on time, the whole production schedule can be delayed
3. There is no spare finished product available to meet unexpected

orders, because all products are made to meet actual orders
however, JIT is a very responsive method of production
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10.4.1
The ABC Company has Uganda plant that manufactures transistor
radios. One key component is BT transistor. Expected demand for radio
production in March 2012 is 5,200 transistors. ABC purchases the BT
transistor from Nairobi Electronics. ABC estimates the ordering cost per
purchase order to be $250. The carrying cost for one unit of BT in stock
is $5.00
Required
(i) Compute the EOQ for the BT transistor
(ii) Compute the number of deliveries of BT that Nairobi

Electronics will make in April 2012
434
Summary
One of the most common problems facing operations managers is
inventory planning. This is understandable since inventory usually
represents a sizable portion of a firm`s total assets and, more specifically,
on the average, more than 30% of total current assets. Excessive money
tied up in inventory is a drag on profitability. The purpose of inventory
management is to develop policies which will achieve an optimal
investment in inventory. This can be done by determining the optimal
level of inventory necessary to minimize inventory related costs.
Therefore, this part four of chapter ten has focused in detain in inventory
management. Inventory management involves making decisions
concerning how much inventory to order and when. The basic criterion
in making these decisions is to minimize total inventory costs, such as
the cost to carry inventory, the cost to order inventory, and the item cost,
subject to meeting demand for the items. Inventory control involves
process, procedures, and infrastructure to maintain the inventory at the
desired level.
The part discussed inventory (we use the word interchangeably with
the word stock) predominantly as accumulations of transformed input
resource. It does however mention the broader use of the word inventory
or stock to denote the organizations stock of people, machines, and
other assets. You often hear economists talking of a stock of resources in
this way. From here on however we use the word exclusively to mean
an accumulation of materials.

Buffer stock
Dependent demand
Economic order quantity
Holding costs
Independent demand
Just in time (JIT)
Lead time
Maximum stock level
Minimum stock level
Ordering costs
Re-order point
Storage costs
Total costs
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Exercises
10.4.1 What assumptions are made when using the simplest version of
economic order quantity (EOQ) decision model?
10.4.2 Give three examples of opportunity costs that typically are not
recorded in accounting systems, although they are relevant to the
EOQ.
10.4.3 Give examples of costs included in annual carrying costs of

inventory when using EOQ decision model
10.4.4 Describe just in time (JIT) purchasing and its benefits
10.4.5 Describe how the internet can be used to reduce the costs of
placing purchase orders
10.4.6 What are the main features in a JIT production system?
Problems
10.4.7
A local distributor for a national tires company expects to sells
approximately 9600 steel belted radial tires of certain size and treated
design next year. Annual carrying cost is $16 per tire and ordering cost
is $ 75. The distributor operates 288 days a year.
a) What is EOQ Model?
b) How many times per year does the store reorder?
c) What is the length of order cycle?
d) What is the total annual cost if the EOQ quantity is ordered?
10.4.8
A large bakery buys flour in 25-pound bags. The bakery uses an average
of' 4,860 bags a year. Preparing an order and receiving a shipment of
flour involves a cost of $10 per order. Annual carrying costs are $75 per
bag.
a) Determine the economic order quantity.
b) What is the average number of bags on hand?
c) How many orders per year will there be?
d) Compute the total cost of ordering and carrying flour.
e) If ordering costs were to increase by $1 per order, how much that
would affect the minimum total annual cost?
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10.4.9
A large law firm uses an average of 40 boxes of copier paper a day.
The firm operates 260 days a year. Storage and handling costs for the
paper are $30 a year per box, and its costs approximate $ 60 to order and
receive a shipment of paper.
a) What order size would minimize the sum of annual ordering and
carrying costs?
b) Compute the total annual cost using your order size from part a?
c) Except for rounding, are annual ordering and carrying costs

always equal at EOQ?
d) The office manager is currently using an order size of 200 boxes.

The partners of the firm expect the office to be managed "in a
cost-efficient manner." Would you recommend that the office
manages use the optimal order size instead of 200 boxes? Justify
your answer.
10.4.10
Highland Electric Co. buys coal from Cedar Creek Coal Co. to generate
electricity.
CCCC can supply coal at the rate of 3,500 tons per day for $10.50 per
ton. HEC uses the coal at a rate of 800 tons per day and operates 365
days per year. HECs annual carrying cost for coal is $2 per ton, and the
ordering cost is $5,000.
a) What is the economical production lot size?
b) What is HECs maximum inventory level for coal?
c) What is Cycle time and run time for the optimum run size?
10.4.11
The friendly Sausage factory (FSF) can produce hot dogs at a rate of
5,000 units per day.
FSF supplied hot dogs to local restaurant at a steady state rate of 250
per day. The cost to prepare equipment for producing hot dog is $66.
Annual holding cost is 45 cents per hot dog. The factory operates 300
days a year. Find
a) The optimal run size.
b) The number of runs per year.
c) The length (in days) of a run.
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10.4.12
A chemical firm produces sodium bisulphate in 100-pound bags.
Demand for this product is 20 tons per day. The capacity for producing
the product is 50 tons per day. Setup cost
$100 and storage and handling cost are $5 per ton a year. The firm
operates 200 days a year. (Note 1 ton = 2000 pounds)
a) How many bags per run are optimal?
b) What would the average inventory be for this lot size?
c) Determine the approximate length of a production run in days?
d) About how many runs per year would there be?
e) How much could the company save annually if the setup cost
reduced to $25 per run?
10.4.13
A-1 Auto Parts has a regional tire warehouse in Atlanta. One popular
tire, the XRX75, has estimated demand of 25,000 next year. It costs A-1
$100 to place an order for the tires, and the annual carrying cost is $30
per unit. The supplier quotes these prices for the tire:
Number of boxes Price per box

1 to 490 $ 21.60
500 to 999 $ 20.95
More than 1000 $ 20.90
10.4.15
A mail order house uses 18,000 boxes a year. Carrying cost are 60 percent
of a box cost price and ordering cost are $96 per order. The following
price schedule applied. Determine:-
a) The optimal order quantity?
b) The number of orders per year?
Number of boxes Price per box

1000 to 1900 $ 1.25
2000 to 4999 $ 1.20
5000 to 9999 $ 1.15
10000 or more $1.10
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Case studies
Case study 10.4.1: Flame Electrical
Inventory management in some operations is more than just a part of
their responsibility; it is their very reason for being in business. Flame
Electrical, South Africas largest independent supplier and distributor
of lamps, is such a business. It stocks over 2900 different types of lamp,
which are sourced from 14 countries and distributed to customers
throughout the country.
In effect our customers are using us to manage their stocks of lighting

sources for them, says Jeff Schaffer, the Managing Director of Flame
Electrical. They could, if they wanted to, hold their own stock but
might not want to devote the time, space, money or effort to doing so.
Using us they get the widest range of products to choose from, and an
accurate, fast and dependable service.
Central to the companys ability to provide the service its customers

expect is its computerized stock management system. The system
holds information on all of Flames customers, the type of lamps they
may order, the quality and brand of lamps they prefer, the price to
be charged and the location of each item in the warehouse. When a
customer phones in to order, the computer system immediately accesses
all this information, which is confirmed to the customer. This leaves
only the quantity of each lamp required by the customer to be keyed
in. The system then generates an instruction to the warehouse to pick
up and dispatch the order. This instruction includes the shelf location
of each item. The system even calculates the location of each item in the
warehouse which will minimize the movement of stock for warehouse
staff.
Orders for the replenishment of stocks in the warehouse are triggered by

a re-order point system. The re-order point is set for each stocked item
depending on the likely demand for the product during the order lead
time (forecast from the equivalent periods orders the previous year),
the order lead time for the item (which varies from 24 hours to four
months) and the variability of the lead time (from previous experience).
The size of the replenishment order depends on the lamp being ordered.
Flame prefers most orders to be for a whole number of container loads
(the shipping costs for part-container loads being more expensive).
However, lower order quantities of small or expensive lamps may be
used. The order quantity for each lamp is based on its demand, its value
and the cost of transportation from the suppliers. However, all this
can be overridden in an emergency. If a customer, such as a hospital,
439
urgently needs a particular lamp which is not in stock, the company will
even use a fast courier to fly the item in from overseas all for the sake
of maintaining its reputation for high service levels.
We have to get the balance right, says Jeff Schaffer. Excellent service
is the foundation of our success. But we could not survive if we did not
control stocks tightly. After all we are carrying the cost of every lamp in
our warehouse until the customer eventually pays for it. If stock levels
were too high we just could not operate profitably. It is for that reason
that we go as far as to pay incentives to the relevant staff based on how
well they keep our working capital and stocks under control.
1. Define what you think the five performance objectives (quality,
speed, dependability, flexibility and cost) mean for an operation
such as Flame Electrical
2. What are the most important of these performance objectives for

Flame Electrical?
3. What seems to influence the stock replenishment policy of Flame

Electrical?
4. How does this differ from conventional economic order quantity

theory?
Case study 10.4.2: An Ideal Standard of inventory

Ideal Standard, part of American Standard Inc., are manufacturers of
bathroom and sanitary wear. Like many manufacturers of consumer
products, they must plan and control their operations so as to best
utilize their production resources, as well as give a good standard of
customer service. At one time the only way of doing this was thought to
be by the use of large finished goods inventories. But since the advent
of just-in-time type principles, manufacturers such as Ideal Standard
have managed to raise productivity, improve quality and dramatically
reduce inventory. The programme which was put in place throughout
American Standard Inc. was called Demand Flow Manufacturing.
All areas of inventory holding were scrutinized and driven down by
reducing batch sizes and making to demand rather than making to stock.
In some parts of the company, stock turns increased threefold and the
money tied up in inventories reduced by over 75 per cent; productivity
and quality have also improved significantly. Even at reduced inventory
levels, stocks can take up space
440
1 What do you think are the particular difficulties in inventory
management at Ideal Standard?
2 What are the major changes in attitude necessary in moving

from a make-to-stock to a make-to-order philosophy of planning
and control?
Case study 10.4.3: The Marks & Spencer approach

A special case of the How much to order? decision in inventory control
is the Should we order any more at all? decision. Retailers especially
need continually to review the stocked lines they keep on the shelves.
For example, Marks & Spencer (M & S) has a simple philosophy: if it
sells, restock it quickly and avoid stock-outs; if it doesnt sell, get it
off the shelves quickly and replace it with something which will sell.
The M & S approach often means putting a new line on the shelves
of a pilot store and watching customer reaction very closely. The store
most often used for these trials is the companys Marble Arch store in
London. Sometimes it is possible to make a restocking decision within
a few hours not surprising when the time-frame for stock rotation can
be as little as a week.
For more routine stock control decisions the company uses an automatic
stock-ordering system which it calls ASR (Assisted Stock Replenishment).
This helps always to have the right stock of textile products in the store at
the right time. The system, which is now installed in its flagship Marble
Arch store, takes into account all goods bought at the till through the
electronic point-of-sale (EPOS) system and automatically generates
an order to replenish that item. The system anticipates orders for each
item based on the previous weeks sales and delivers in advance.
The current days sales are continually reviewed and any extra items
required are delivered the next day. Orders arrive at the store from the
local distribution centre at Neasden in North London. New orders are
usually placed before 8.30 am and 85 per cent of these will arrive before
close of business that day. The remainder arrives the following morning
before opening time. The number of deliveries each day varies between
14 and 24 depending on the level of business.
On the sales floor, the main stock control tasks are to ensure that all the
clothing rails are fully stocked, that the stock tickets reflect the sales
information on display and that everything is neatly and correctly
arranged. During the day the area supervisor watches the stock levels
and the flow of customers around the displays in case any changes to
441
stock location need to be made. The store has a policy of not bringing
stock out onto the floor during opening hours; but in the case of fast-
moving items, this can at times be unavoidable
1. Why is it particularly important for retail operations such as
Marks & Spencer to make judgments quickly about how well a
product is likely to sell?
2. What do you see as the major advantages of using the electronic

point-of-sale (EPOS) system?
3. What kind of inventory policy seems to operate in Marks &

Spencers stores?
442
Further Readings
Donald and Waters (2006), Inventory control and management
Green J. H (1999), Production and Inventory Control Handbook (3rd
Ed.) New York Graw-Hill
Lewis C.D (1999), Demand Forecast and Inventory Control, Cambridge

wood lead publishing
Muller M (2002), Essential of Inventory Management, London Amacom
Zipkin P (2000), Foundation of Inventory Management, Home Wood

IL. Irwin
443
11.0 Answers to Assessment Questions
Chapter One
1.1
(a) Management accounting involves providing and interpreting
internal accounting information for management to use for the
following purposes
(i) Planning the organizations activities in the short, medium

and long term. For example the management accounting
system should provide information which will allow
management to plan the future activities of the new, larger
business.
(ii) Controlling the activities of the organization. Management

will have to learn to control a larger business. They will
therefore need control reports so that they can compare
actual results against plans or budgets. Action can then be
taken to correct any differences between actual and plan
and to help the organization to continue in the direction
set out by plans.
(iii) Making decisions. For example, information will be needed

for pricing architectural contracts for tendering purposes.
(iv) Performance appraisal, both financial and non-financial.

For example, information on the percentage of jobs
completed on time, percentage of successful tenders and
so on should be provided.
(b) The personal attributes you would expect the assistant

management accountant
(i) Be training for or already possess a professional

qualification in management accountancy.
(ii) Have excellent knowledge of the management accounting

information requirements of a large architects business
(iii) Have excellent communication skills, particularly because

of the uncertainty caused by the changes taking place. He/
she must be able to explain and interpret management
accounting information for employees who have little or
no financial background
444
(iv) Be flexible and self-motivating. For example he/she must
be willing to leave his/ her office desk and visit sites when
necessary.
(v) Possess management perspective as well as being

technically competent
(vi) Be able to critically appraisal the existing systems and

information to ensure their relevance to the future.

Chapter two
2.1
The question relates to how costs can be classified for meeting the
planning, control and decision making requirements
Planning relates to the annual budgeting and long term processes,

within these processes costs can be classified by
Behaviour- by classifying into fixed, variable, semi variable and

semi fixed categories the outcomes from different activity levels
can be examined
Function functions are the different responsibility centres within

the organization. The budget is built up by the functional levels
so that everyone in the organization has a clear understanding
of the role that their responsibility centre has in achieving the
annual budget.
Expense type - classifying by expense types provides useful

information on the nature, content and trend of different expense
categories that is useful for planning how much should be
authorized on spending within the different categories
Controllability- classifying expenses by responsibility centres

determine the individuals who are accountable for achieving the
budget and who should thus be involved in setting the budget
for specific responsibility centres
The management function of control consists of the measurement,

reporting and the subsequent correction of performance in an attempt
to ensure that a firms objectives and plans are achieved, within the
control process costs can be classified by
445
Behaviour - cost must be classified by behaviour for comparing
actual and budgeted performance using flexible budgets.
Function for control, cost and revenues should be traced to the

heads of the responsibility centres who are responsible for
incurring them.
Expense type - this will ensure that like items are compared with
one another when budget and actual performance are compared
and trends in revenues and different expenses categories are
monitored.
Controllability - costs and revenues must be assigned to the

responsibility heads who are made accountable for them so that
effective control can be exercised.
Relevance - attention should only be focused on those expense

categories where there are significance deviations from the
budget. Insignificant deviations are not relevant for cost control
Decision making involves choosing between alternative courses

of actions. The following classifications are important for decision
making
By behaviour - by classifying into fixed, variable, semi variable

and semi fixed is necessary for predicting future costs for
alternative courses of action.
By expense type - this is necessary to identify how different

cost categories will change as a result of pursuing alternative
course of action.
By relevance - for decision making it is necessary to distinguish

between relevant and irrelevant costs and revenues for alternative
course of action.
2.2
1. SV
2. F
3. F
4. V
5. F
6. SV
7. F
446
8. SF
9. V
Chapter Three
3.1
1. The first step in the high-low method is to identify the periods

of the lowest and highest activity. Those periods are November
(1,100 patients admitted) and June (1,900 patients admitted)
The second step is to compute the variable cost per unit using those two
points

Month number of patients admitting dept. costs
High activity level (June) 1,900 $15,200
Low activity level (Nov.) 1,100 $12,800
Change 800 $2,400
Variable cost = Change in cost = $2,400 = $3 per patient

Change in activity 800 patients
The third step is compute the fixed cost element by deducting the
variable cost element from the total cost at either the high or low activity
level. In the computation below, the high point of activity is used.
Fixed cost element = Total cost Variable cost element

= $15,200 ($3 per patient admitted x 1,900 patients
admitted)
= $9,500
3. The cost formula expressed in the linear equation form is

Y= $9,500 +$3X
447
Chapter Four
4.1 (i) Profit Statement using marginal costing

A marginal costing system will value units at the variable production
cost of $25 per unit ($18 + $4 + $3)
Profit statement using marginal costing

June July
$000 $000 $000 $000
Sales revenue 640 550
Less variable cost of sales:
Beginning inventories - 30
Production cost (14,000 x $25) 350 (10,200 x $25) 255
Ending inventories (1,200 x $25) (30) (400 x $25) (10)
Variable production cost 320 275
Variable selling expenses 64 55
Variable selling expenses 384 330
Contribution 256 220
Less fixed overhead
Fixed production overhead 99 99
Fixed selling expenses 14 14
Fixed administration expenses 26 26
139 139
Operating profit 117 81
(iii) Profit statement using absorption costing

Fixed production overheads are absorbed on the basis of normal capacity
which is often the same as budgeted capacity. You should remember
that predetermined rates are used partly to avoid the fluctuations in
unit cost rates which arises if production level fluctuate
Fixed production overhead per unit = $99,000/11,000 =$9 per unit

Full production cost per unit = $25 variable cost + $9 fixed prod cost = $34
This full production cost of $34 per unit will be used to value all units
under absorption costing
Since the production level is not equal to normal capacity in either June
or July there will be under or over absorbed fixed production overhead
in both months. These can be calculated as follows:
June July
($000) $000
Fixed prod Oh absorbed (14,000 x $9) 126 (10,200 x $9) 91.8
Fixed prod Oh incurred 99 99.0
Over/(under) absorption 27 (7.2)
448
Profit statement using Absorption costing
June July
$000 $000 $000 $000
Sales revenue 640 550
Less cost of sales:
Beginning inventories - 40.8
Production cost (14,000 x $34) 476.0 (10,200 x $34) 346.8
Ending inventories (1,200 x $34) (40.8) (400 x 34) (13.6)
Cost of sales 452.2 374
Gross profit 204.8 176
Less selling & administration exps
Variable selling exps 64.0 55.0
Fixed selling exps 14.0 14.0
Fixed administration exps 26.0 104.0 26.0 95.0
100.8 81.0
Over/ (under) absorption 27.0 (7.2)
Operating profit 127.8 73.8
4.2
(a) Department A Department B
Allocated costs $217,860 $374,450
Apportionment costs $ 45,150 $ 58,820
Total dept. overheads $263,010 $433,270
Overhead absorption rate $19.16 ($263,010/13,730) $26.89 ($433,270/16,110)
(b) Dept. A Dept. B Dept. C

$ $ $
Allocated costs 219,917 387,181 103,254
Apportionment of 70%a 32,267 40,011 (72,278)
Apportionment of 30%b 11,555 19,421 (30,976)
Total dept. overheads 263,739 446,613
Overheads charged to prod 261,956 c 446,613 d
Under/(over-recovery) 1,783 (9,253)
Notes
a. Allocated on the basis of actual machine hours
b. Allocated on the basis of actual direct labour hours
c. $19.16 x 13,672 actual machine hours
d. $26.89 x 16,953 actual direct labour hours
449
Chapter five
5.1
The fist step is to determine the overhead absorption rate/cost driver
rates for each activity.
These rates can then be applied to the data given for each product
Standard Deluxe Total

Production (units) 25,000 2,500
Direct labour hrs required 250,000 25,000 275,000
Total production overhead $1,100,000
Overhead absorption rate per hr $4.00
Machine hours required 125,000 12,500 137,500
Total purchase orders 400 200 600
Total set-ups 150 100 250
Cost per cost driver
Volume related overheads $275,000
Machine hours required 137,500
Volume related overheads/machine hr $2.00
Purchase related overheads $300,000
Total purchase orders 600
Purchases related overheads/order $500.00
Set- up related overheads $525,000
Total set-ups 250
Set-up related overheads per set-up $2.100.00
(a) (i) Unit costs using existing overhead absorption rate

$ $
Direct labour costs 200.00 200.00
Overheads (10 labour hrs x $4 40.00 40.00
Total cost per unit 265.00 302.50
(ii) Unit costs using ABC

$ $
Direct labour costs 200.00 200.00
Overheads
Volume related ($2 x 5 machine hrs) 10.00 10.00
450
Purchases related* 8.00 40.00
Set- up related* 12.60 84.00
Total cost per unit 255.60 396.50

(b) Cost per unit traditional method 265.00 302.50
Cost per unit ABC 255.00 396.50
Difference 9.40 -94.00
% change 3.55% -31.07%
A significant difference in the costing of the Deluxe beanbag. The ABC

approach attributes the cost of resources to each product which those
resources on a more appropriate basis than the traditional absorption
costing system. The price of the deluxe should be reviewed in the light
of the new unit cost
Notes:*
Purchaser related for Standard ($500 x 400 orders 25,000) = $8.00
Purchaser related for Deluxe ($500 x 200 orders 2,500) = $40.00
Set up related for Standard ($2,100 x 150 set-ups 25,000) = $12.60
Set up related for Deluxe ($2,100 x 100 set-ups 2,500) = $84.00
5.2 This is the straight question on customer profitability

Calculate the contribution margin per unit before attempting the
profitability of each customer
Calculate the C/S and profit/sales ratios and comment on your findings

(a) Contribution margin per unit of the EC Trimmer
$
Total product cost 20
Fixed overhead cost (40%) 8
Variable cost per unit 12
Selling price 40
Unit contribution margin 28
Customer account profitability statement

X Y Z Other
No. of units sold 10,000 5,000 3,000 6,000
$000 $000 $000 $000
Sales 400.0 200.0 120.0 240.0
Variable prod. Cost (120.0) (60.0) ( 36.0) ( 72.0)
Contribution margin 280.0 140.0 84.0 168.0
451
Delivery cost (5.0) (2.5) (6.0) (37.5)
Emergency delivery - - (1.0) -
Order costs (1.0) (0.6) (1.4) (2.0)
Discounts (80.0) (30.0) (24.0) (14.0)
Sales commission (40.0) (20.0) (12.0) (24.0)
Publicity costs (27.0) (39.0) (45.0) (57.0)
Profit before fixed OH 127.0 47.9 (5.4) 33.1
C/S% 70% 70% 70% 70%
Profit/Sales% 32% 24% (5) % 14%
The C/S ratio for all outlets is a constant 70 percent. However the
net profit to sales ratio varies from 32 percent for X to -5 percent for
Z. There are several reasons for this range in profitability. Z, though
a small customer compared to the other, has managed to negotiate
very favourable terms a 20 percent trade discount and high publicity
costs. It also places several small orders and is the only outlet in need of
emergency deliveries.
Customers X on the other hand (Bondeni Garden) is prudent in the

number of orders it places and publicity expenses are relatively low,
making it the most profitable of all the customers. The profitability of
Other Garden Centres is 14 percent as delivery costs are high. This could
be due to several deliveries being made to various garden centres rather
than to one central warehouse.
A customer profitability analysis highlights loss- making customers

such as Z and enables organizations to have the necessary information
when negotiating new contracts
(b) From the financial analysis above, Bondeni Garden may decide
to drop customer Z as it makes a loss. It should however consider
other qualitative factors before such a decision is taken. Can
it renegotiate its discount policy? Will it be able to reduce its
publicity costs? Should it start charging for emergency deliveries
outside its normal delivery schedule? Can the spare capacity
made available be put to better use? Bondeni Garden should also
consider the impact this decision will have on the sale of its other
products and its long term relationship with customer Z
452
Chapter Six
6.1 (a) First calculate the current contribution margin per unit
$000 $000
Sales revenue 288
Direct materials 54
Direct wages 72
Variable prod overhead 18
Variable administration 27 171
Contribution margin 117
Unit contribution ($117,000 9,000) $13
Now you can use the formula to calculate the breakeven point
Breakeven point = Fixed costs/unit contribution = ($42,000 + $36,000)/$13
= 6,000 units
(b) Alternative (i)

Budgeted contribution margin per unit $13
Reduction in selling price ($32 - $28) $4
Revised contribution margin per unit $9
Revised breakeven point = $78,000/$9 = 8,667 units

Revised sales volume = 9,000 x (90/75) 10,800 units

Revised contribution = 10,800 x $9 $97,200
Less fixed costs $78,000
Revised profit $19,200
Alternative (ii)
Budgeted contribution margin per unit $13.00
Reduction in selling price ($32 x 15%) $ 4.80
Revised contribution margin per unit $8.20
Revised breakeven point = ($78,000 + $5,000)/$8.20 = 10,122 units

Revised sales volume = 9,000 x (100/75) 12,000 units

Revised contribution = 12,000 x $8.20 $98,400
Less fixed costs $83,000
Revised profit $15,400
453
Comment: Neither of the two alternative proposals is worthwhile. They
both result in lower forecast profits. In addition, they will both increase
the breakeven point and will therefore increase the risk associated with
the companys operations
6.2
(a) Breakeven point = Total fixed costs/average contribution per $ of sale
= $1,212,000/$0.505 = $400,000
Average contribution per $ of sales

= [0.7 x ($1 - $0.45)] + [0.3 x ($1 -$0.6)]
= $0.505
(b) The graph is based in the following calculation

Zero activity: loss = $1,212,000 (fixed cost)
$4m existing sales: ($4m x $0.505) - $1,212,000 = $808,000 profit
$4m revised sales: ($4m x $0.475) - $1,212,000 = $688,000 profit
Existing breakeven point: $2,400,000
Revised breakeven point: $2,551,579 ($1,212,000/$0.475)
Revised contribution per $ of sales: (0.5 x $0.55) +(0.5 x $0.40) = $0.475
Fig. 6.2: Profit-volume chart
(Profit
$000)
Break even point

(Existing) Breakeven point (revised)
(Loss
$000)
454
Chapter Seven
Before attempting this question, all relevant costs and benefits should be
identified, whether are variable cost, fixed or opportunity costs. These
relevant costs and benefits are identified as follow;
Benefits
Total revenue from the contract $ 200 million ( $ 10,000 x 20,000 kg)
Avoided fixed cost due decreases in production of product Y $ 5,800,000
Relevant costs
Direct material A $ 40 million ( 2 units per kg x 20,000 kg x replacement
cost $ 1,000)
Direct material B $ 50 million (1 litre per kg x 20,000 kg x NRV $ 2,500)
Direct labour Grade 2 $ 24 million (6 hrs per kg x 20,000 kg X $ 200)
Variable overheads $ 48 million (8 hrs x 20,000 kg $ 300). It should

be noted here that, the variable overheads is assumed be varied with
the direct labour hours, that is the total labour hours for Grade 1 and
2 labour ( 2 hrs + 6 hrs = 8 hrs)
Incremental fixed cost $ 22,800,000
Opportunity cost, this will be the loss on contribution margin of

product Y for the amount which will not be produced and sold due
the accepting of the contract i.e. $ 19 million [ $ 7,000 ($ 800 + $
1,200 + $ 1,200)] x 5,000 units. It should be noted that, only variable
costs are relevant
Mboga Product Ltd

Income Statement for contract of 20,000 kgs of product X
$ 000 $ 000
Sales revenue 200,000
Avoided fixed cost 5,800
Less relevant costs
Direct material A 40,000
Direct material B 50,000
Direct labour Grade 2 24,000
Variable overhead 48,000
Incremental fixed costs 22,800
Opportunity cost (loss on contribution margin) 19,000 203,800
Incremental profit 2,000
455
Advice to the management
The contract is viable because it increases an incremental profit by $ 2
million, therefore the management can accept the contract. However,
before accepting the contract the management should consider other
qualitative factors.
Chapter eight
(a) The first part of the question is concerned with single liming
factor, which is the pressing time of 20,000 hours. Therefore
to calculate which component and what quantities should be
manufactured, the following steps should be followed;
To compute the contribution margin per unit and select for production
those components have positive contribution and then the contribution
margin per unit per pressing time, is done as follows
Hours required per component = Direct expense

Cost per machine
Then; XA = 200 = 1 hour

200
XB = 400 = 2 hours
200
XC = 200 = 1 hours
200
XD = 1,200 = 6 hours
200
The shortfall of pressing hours pressing hours are identified as follows;
The total pressing hours available 20,000 hours

The requirements of pressing hours;
XA 2,000 units x 1 hour 2,000
XB 3,500 units x 2 hours 7,000
XC 1,500 units x 1 hour 1,500
XD 2,800 units x 6 hours 16,800 (27,300) hours
The shortfall hours (7,300) hours
The above calculations show that the pressing time hours are insufficient
to produce all the components, the concept of the contribution margin per
unit per limiting factor i.e. machine pressing time should be applied
456
The contribution margin per unit per pressing time is calculated as
follows;
XA XB XC XD
Components
$ $ $ $
Selling price per unit 1,200 1,180 1,040 3,360
Variable cost per unit 1,140 1,100 1,140 2,880
Contribution margin per unit 60 80 (100) 480
UCM/limiting factor 60/1 80/2 (100)/ 1480/6
60 40 (100) 80
Ranking 2 3 1
It should be noted that component XC should not be produce because, it

has negative contribution margin per unit, and therefore the decision is
buy this component, because it is cheaper than to make it. In ranking the
components, component XD is the most profitable component because
it has highest contribution margin per unit per limiting factor, hence it
was ranked first, then component XA and finally component XB
The final step is to prepare the production plan; this is prepared as

follows;
Components Units Hours per unit Total hours

XD 2,800 6 16,800
XA 2,000 1 2,000
XB 600 2 1,200 balance
20,000
It should be noted that, only 600 units of component XB will be produced,

due insufficient of pressing time hours, the remaining balance 2,900
units (3,500 - 600) will either be produced in the second shift or buy
from outside supplier, by comparing the relevant costs and benefits of
the two alternatives.
(b) Costs of buying and second shift

It should be noted here that the relevant costs of buying and second
shift will only be considered to decide whether to buy or produce the
remaining balance in the second shift.
Costs of buying the component; the relevant costs is the price paid to
acquire the component and is calculated as follows;
Cost of purchase = $ 1,180 x 2,900 = $ 3,422,000
457
Cost of manufacturing the component from the second shift, the relevant
costs consist of variable costs of manufacturing this component and an
additional fixed costs resulted from the second shift, these costs are
calculated as follows;
$
Variable costs $ 1,140 x 2,900 3,306,000
Additional fixed cost (3 x $ 10,000) 30,000
Total 3,336,000

Based on the above analysis it is cheaper the company to manufacture
the component XB by the second shift, because the company will make
internal saving of $ 86,000 ($ 3,422,000 - $ 3,336,000)
458
Chapter nine
(a) The expected value calculations are as follows
(i) Variable cost ($) (ii) Fixed costs ($)

($10 + 10%) x 10/20 5.50 $82,000 x 0.3 24,000
$10 x 6/20 3.00 $85,000 x 0.5 42,000
($10 5%) x 4/20 1.90 $90,000 x 0.2 18,000
10.40 85,100
(iii) $17 selling price (units) (iv) $18 selling price (units)
21,000 units x 0.2 4,200 19,000 units x 0.2 3,800
19,000 units x 0.5 9,500 17,500 units x 0.5 8,750
16,500 units x 0.3 4,950 15,500 units x 0.3 4,650
18,650 17,200
Expected contribution
$17 selling price = ($17 - $10.40) x 18,650 = $123,090
$18 selling price = ($18 - $10.40) x 17,200 = $130,720
The existing selling price is $16, and if demand continues at 20,000 units per
annum then the total contribution will be $112,000 [($16 -$10.40) x 20,000
units]
Using the expected value approach, a selling price of $18 is recommended.
(b) Expected profit = $130,720 - $85,100 fixed costs = $45,620

Breakeven point = fixed costs ($85,100)/unit contribution ($7.60)
=11,197 units
Margin of safety = expected demand (17,200 units) 11,197 units = 6,003 units
% margin of safety = 6,003/17,200 =34.9% of sales
(c) An expected value approach has been used. The answer should
draw attention to the limitations of basing the decision solely on
the expected values. In particular, it should be stressed that risk
is ignored and the range of possible outcomes is not considered.
The decision ought to be based on a comparison of the probability
distributions for the proposed selling prices.
(d) Computer assistance would enable a more complex analysis to

be undertaken in particular; different scenarios could be
considered, based on different combinations assumptions
regarding variable cost, fixed cost, selling prices and demand.
459
Chapter Ten
Part one
10.1.1
(a) (i) The contributions margin per project are as follows
A B
$ $
Fee 1,700 1,500
Researchers:
Qualified (600) (360)
Junior (112) (210)
Expenses (408) (310)
Contribution 580 620
The objective function Max Z= 580A + 620B

(ii) The constraints used in the linear programming model
20A + 12B 1,344 (qualified researchers
8A + 15B 1,120 (junior researchers)
B 60 (maximum type B projects)
A 20 (Minimum type A projects)
A and B 0 (non negativity)
(iii) Profit- maximizing product mix
8A + 15B 1,120
B 60

A120
20A + 12B 1,344
The shaded are is feasible region and point A in the graph above shows
the most profitable point of the feasible region at point A, which relates
to production of 33 units of project A and 57 units of project B.
460
(b) Project contribution
$
Project A (33 units x $ 580) 19,140
Project B (57 units x $620) 35,340
Total contribution 54,480
Less fixed costs 28,000
Profit 26,480
(c) It is important to identify scarce resources when preparing

budgets because they restrict the activity of the organization.
If they are ignored, the budget is unattainable and is of little
relevance for planning and control.
If there is only one scarce resource its optimum use can be determined
by ranking in relation to the contribution generated by each product/
service per unit of the scarce resource consumed. When there is more
than one scarce resource, linear programming is used to identify the
most profitable use of resources.
Linear programming is a technique that considers the resources available

and thus identifies the possible combinations of those resources. It
assumes that all costs can be classified as either fixed or variable in
relation to a single activity measures. Based on this assumption, LP
maximizes the total contribution in respect of the resources available.
The solution may be found graphically by using all of the coordinates of
the corners of the feasible region, in each case calculating the contribution
that would result from such an output combination. An alternative is to
use and iso- contribution line to select the output combination which
has the greatest contribution. Where there are more than two types of
output a graphical solution is not possible, instead, the simplex method
is used.

Part two
10.2.1
(a) The first stage is to convert all costs to 2013 basis. The calculations
are as follows

461
2009 2010 2011 2012 (estimated)

$000 $000 $000 $000
Raw materials
Skilled labour 242(1.2)4 344(1.2)3 461(1.2)2 477(1.2)
Unskilled
Power 25(1.1) (1.25)3 33 (1.25)3 47(1.25)2 44(1.25)
Factory overheads 168(1.15)3 (1.2) 206 (1.15)2 (1.2) 246(1.15)(1.2) 265(1.2)
Raw materials
Skilled labour 500.94 595.12 663.84 572.4
Unskilled
Power 53.625 64.53 73.32 55.00
Factory overheads 306.432 326.304 339.48 318.00
Total (2013 prices) 861,000 986,000 1,077,000 945,000
Output (units) 160,000 190,000 220,000 180,000
The equation Y= a + bx is calculated from the above schedule of total

production costs (2013 prices) and output. The calculations are as
follows:
Output Total costs

Units (000) ($000)
x y y2 xy
160 861 25,600 137,760
190 986 36,100 187,340
220 1,077 48,400 236,940
180 945 32,400 170,100
x= 750 y=3869 x2=142,500 xy=732,140
Now solving the following simultaneous equations

y= Na + bx
xy=xa + bx2

Therefore 3,869= 4a + 750b
732,140 = 750a + 142,500b
Multiply equation (1) by 190 (142,500/750) and equation (2) by 1. Then

equation (1) becomes
735,110 = 760a + 142,500b
Subtracting equation (2) from equation (3)

2,970 = 10a
a = 297
462
Substitute for a in equation (1)
3,869= 4 x 297 + 750b
2681 = 750b
b =3.57
The relationship between total production costs and volume for 2013 is
y = $297,000 + 3.57x
Where y= total production costs (at 2013 price) and x = output level
(b) Read chapter ten part two of this book for the answer of this question
(c) General company overheads will still continue whether or not

product LT is produced. Therefore, the output of LT will not affect
general production overheads. Consequently, the regression
equation should not be calculated from cost data that includes
general company overheads. General company overheads will
not increase with increments in output of product LT. hence short
term decisions and cost control should focus on those costs that
are relevant to production of LTs. Common and unavoidable
general fixed costs are not relevant to the production of LT, and
should not be included in the regression equation.
463
Part Three
10.3.1
(a) In many production process, production process, production
efficiency increase with experience. As cumulative production
output increase, the average labour time required per unit decline.
This can be expressed in graphical form and is called learning
curve. See the graph below
Average
Hrs per unit

Cumulative quantity (units)

If the budgets and standards are set without considering the learning
effect, meaningless standards are likely to be set that are easy to attain.
Therefore favourable variances would be reported that are not due to
operational efficiency. Where learning effects are expected, management
should create an environment where improvements are expected.
(b) The statement refers to the fact that, with modern technology,
there is a dramatic decrease in direct labour content of most goods
and services. Recent studies suggest that direct labour represents
less than 10% of manufacturing cost and that overheads are more
closely related to machine hours than direct labour hours. With
modern technology output tends to be determined by machine
speeds rather than changes in labour efficiency. Consequently,
the presence of the learning effect as workers become more
familiar with new operating procedures is of considerably less
importance.

464
The question implies that the learning curve is being replaced
by an experience curve. The experience curve relates to the fact
that output and efficiency are determined by manufacturing
technologists such as engineers and production planners. As this
group of individuals gain experience from range of application of
the new technology, efficiency improve and costs are minimized.
It is therefore claimed that the experience curve has replaced
the learning curve. However, the experience curve is extremely
difficult to determine, and its impact is likely to take place over
a much longer time period. It is therefore extremely difficult to
capture the experience curve within short term standard setting,
budgeting and cost estimation activities
(c) The experience curve can be used as a means of obtaining strategic

advantage by forecasting cost reductions consequently the
selling price reduction of competitors. Early experience with a
new product can provide a means of conferring an unbeatable
lead over competitors. Through the experience curve the leading
competitor should be able to reduce its selling price for the product
which should further increase in volume and market share and
eventually force some lagging competitors out of the industry.
By exploiting the cost reduction of experience curve a firm can

lower its selling price and thus extent a products life cycle by
stimulating demand from existing customers and/or enticing new
customers by price reductions. Furthermore, knowledge of an
organizations experience curve relative to that of its competitors
will allow it to maximize market share and prolong the life cycle
of its products and services.
465
Part four
10.4.1
(i) EOQ = [2 (5,200) ($ 250)] / ($5)
= 721 transistors (rounded)
(ii) Number of deliveries = 5,200/721

= 7.2
Will make approximately 8 deliveries in March 2012
466
Index
A basic break even chart 202 Confidentiality 22
ABC first-stage allocation 152 Constraints 360
Accumulating Data on Costs and Contribution Margin method 196
Profits 16 Controllability 446
Activity-based costing 152 Controlling 13
Advances in technology 21 Cost Analysis 33
Advantages of absorption costing Cost analysis for decision making
121 46
Advising management 20 Cost ascertainment 33
Advising Management about Non- Cost book-keeping: 33
routine Decisions 16 Cost Centre 53
Aids in Price fixation 35 Cost classification 42
An appreciation of other business Cost Classification: 115
functions 21 Cost comparisons 34
Answers to Assessment Questions Cost Control 34
444 Cost objects 37
Asset Opportunity Costs 160 Cost Reports 34
Basic techniques of cost estimation Cost structure and Operating Lever-
90 age 208
Batch-level activities 146 Cost structure and profit stability
Behaviour 446 207
Better Cost Management 432 Cost system: 33
Better use of equipment 402 Cost Unit 53
Buffer stock 424 Cost-volume-profit 187
By behaviour 446 Cumulative quantity 464
By expense type 446 Customer Product Cost 159
By relevance 446 Customer Revenue 159
Cash flow 239 Customer-specific Costs 160
Changes in the resource mix 402 Decentralization of Services 432
Code of Conduct for Management Decision-making 278
Accountants 22 Decision variables 359
Communications 20 Decouple operation 418
Comparing Actual Activity with Definitions 9
Plans or Budgets 16 Dependent Demand 418
Competence 22 Determining and Controlling Effi-
Components of Total Cost 39 ciency 34
Concept of Cost 36 Determining Selling Price 34
467
Devising Standards 15 Integrity 23
Difference in Stock Valuation 125 Labour efficiency 402
Directing and Motivating 12 Lead time 424
Direct labor hours model 404 Legal requirements 17
Disadvantages of Absorption Cost- Management accountings role 19
ing 121 Marginal Contribution 115
Elimination of wastage 35 Marginal cost model 404
Equation Method 196 Maximax Criteria 328
Expenses 38 Maximin Criterion 328
Expense type 446 Maximum stock level 424
Facilitating Preparation of Financial Meet anticipated customer demand
and Other Statements 34 418
Facility support activities 146 Methods of analyzing uncertain
Factors 8 213
Flexibility 20 Methods of Costing 58
Focus on individual parts or seg- Minimum stock level 424
ments of the business 17 Necessity 18
Forecasting 20 Network-building 402
Function 446 Non-negativity restrictions 360
Future 239 Objective function 360
Generally accepted accounting prin- Objectives of Cost Accounting 34
ciples 18 Objectives of Management Ac-
Hedge against price increase 418 counting 15
Helps in ascertainment of cost 35 Objectivity 23
Helps in checking the accuracy of Opportunity Cost 50
financial accoun 36 Other important qualitative factors
Helps in estimate 36 286
Helps in fixing selling Prices 36 Out-of-Pocket Costs 50
Helps in identifying unprofitable Over and Under Absorbed Over-
activities 36 heads 125
Helps in Inventory Control 36 Overhead allocation and apportion-
Historical 2 ment 106
Historical costing 62 Parameters 360
Importance of Cost accounting 35 Performance Management 10
Increased global competition 21 Permit operations 418
Incremental 239 Planning 12
Independent Demand 418 Preparing Budgets 15
Index 467 Product-line activities 146
Information Content 19 Product redesign 402
468
Protect against stock-outs 418 The Planning and Control Cycle 13
Providing Basis for Operating The Profit Volume (P/V) chart
Policy 35 205
Purpose 18 The provision or information for
Reduce carrying costs 432 management 19
Reduced Inventories 431 The role of Management Accoun-
Relevance 446 tants 13
Re-order level 424 Time Orientation 19
Report frequency 18 Total Quality Control 432
Resolution of Ethical Conflicts 24 Traditional costing 151
Risk Management 10 Types of fixed costs 81
Role of Fixed Costs 277 Unit-level activities 146
Scope of Cost Accounting 33 Users 18
Sensitivity Analysis and Uncertain- Uses of marginal costing 116
ty 214 Value chain effects 402
Shared experience effects 403
Shift from a manufacturing-based
to a service-based economy 21
Shutdown and Sunk Costs 47
Simple upper bound 360
Smooth production 418
Staff Education 21
Standardization 402
Stock/Inventory Valuation 115
Strategic Management 10
Suppliers as Outside Partners 432
Systems 20
Take advantage of order cycles 418
Technology-Driven Learning 402
The contribution breakeven chart 204
The Contribution Margin Approach
198
The CVP Equation 197
The expected monetary value 334
The expected opportunity loss 334
The maximax approach 330
The maximin criterio 330
The minimax regret approach 328,
331
469

Fundamentals of Management Accounting

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Fundamentals of Management Accounting

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Fundamentals of Management Accounting

About the Author

He teaches management accounting and financial accounting at the

While chapters contain illustrations and examples, we have introduced case

In todays competitive world, managers from whatever background need an

Structure of the book

Chapter three focuses on analyzing of cost behaviour, this chapter explains

Chapter four, this chapter entitled income effects of alternative cost

Chapter five in this book focuses on the measurement of indirect relevant

Chapter six focuses on what will happen to the financial results if a

Chapter seven focuses mainly on an understanding of the principles

Chapter eight concentrates mainly on how accounting information can be

Chapter nine focuses mainly on an important methods of incorporating

OVERVIEW TO MANAGEMENT ACCOUNTING

CLASSIFICATIONS AND APPROACHES TO COST

ANALYZING COST BEHAVIUOR 3

INCOME EFFECTS OF ALTERNATIVE COST

ACTIVITY BASED COSTING (ABC)

COST VOLUME PROFIT (CVP) ANALYSIS 6

MEASURING OF RELEVANT COSTS AND REVENUE

INFORMATION FOR DECISION MAKING 8

DECISION MAKING UNDER ENVIRONMENT OF

THE APPLICATION OF QUANTITATIVE METHODS

PART TWO 372

Assessment Question 385

PART THREE 396

PART FOUR 416

1. Explain the Historical Background of Managerial Accounting

1.2 Historical Background of Managerial Accounting

Research on management accounting change mostly relates to

The International Federation of Accountants (IFAC), in 1998, describes

According to Chandler (1977), management accounting systems (MAS)

As early as the first quarter of the nineteenth century, according to

On twentieth century accounting practices, these techniques had a

Scientific management experts, during the nineteenth century, also

Before World War I, according to Johnson and Kaplan (1987), the Du

However, the demand for management accounting information for

The focus of management accounting shifted to the provision of

Management accounting tended to be reactive, identifying problems and

The challenge of meeting global competition was met by introducing

According to Hagerty (1997) and Smith (1999), cost and management

In the 1990s world-wide industry continued to face considerable

Therefore, we can conclude that, the practice of management accounting

The figure below shows the evolution of Management accounting

Source: Johnson (1983)

1.3 Factors Determining Management Accounting Change

Besides, there have been other significant changes in organizational

1.4 Definitions of Management Accounting

Management accounting is largely concerned with providing economic

Management accounting is an integral part of management concerned

The above definition of management accounting, involves participation

Management accounting is primary concerned with data gathering

According to the Chartered Institute of Management Accountants

The American Institute of Certified Public Accountants (AICPA, 2008)

Strategic Management; advancing the role of the management

Performance Management; developing the practice of business

Risk Management; contributing to frameworks and practices

Therefore, Management accounting is concerned with the provisions

1.5 The Importance of Management Accounting in an Organization

Through this involvement, they acquire a great deal of firsthand

Hence, every organization - large and small-has managers. Someone

(ii) Directing and Motivating

(iv) The Planning and Control Cycle:

1.6 The role of Management Accountants within the Organization