Preface

The Sure Start for Cost and Management Accounting is written primarily for
students at the undergraduate level. The text serves as an introduction of
traditional and contemporary approaches to cost accounting, cost management
accounting, quality control and decision making purposes. Sure Start for cost and
management accounting is full of pedagogy primarily designed specifically to
make studying productive and hassle-free. The text empowers students to ascend
to new heights by equipping them with not only the tools that every manager uses,
but also the critical thinking skills necessary to succeed in the business. The text
is concise and presents material in a clear, straight to the point and readable
manner that meet current students need. Again, students’ biggest concern of
making sure they can solve the end-of-chapter problems is adequately taken care
of. The illustrations in the text place students, even first time learners in cost and
management accounting, in a real world business problem and then walk them
through how to solve it. Besides, advanced and current relevant facets have been
included in order to cater for the needs of business students preparing for the
following examinations:

Bachelor of Management Studies (BMS)

Bachelor of Commerce (B.COM)
Bachelor of Science (Administration)
Ghana Accounting Technician Paper I
Institute of chartered Accountants

General certifications for cost and management accounting training and

development skills, competencies and requirements have been adequately covered
in this book. The book contains adequate standard questions, illustrative questions
and answers to facilitate easier teaching and learning of the subject. As a sure start
the book seeks to build a solid foundation for prospective students who may
desire to pursue advanced cost and management accounting beyond the level
specified above. Students offering the senior school certificate examination may
also find the book very useful in their quest to grasp the underpinning principles
of cost accounting as well as the major concepts in the overall syllabus for cost
accounting or business mathematics.

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Acknowledgement
I am most grateful to The Lord Almighty for the divine wisdom and opportunity
given me to write this book. My sincerest gratitude goes to Mr. Edward Y. Marfo
- The Dean of the School of Business, Mrs. Rosemond Boohene (PhD) and Mr.
Stephen K. Asante both Heads of Departments – Management Studies and
Accounting and Finance respectively for their unflinching support, advice and
encouragement towards my publication of this book.

I wish to acknowledge the assistance of students of Bachelor of Management

Studies and Bachelor of Commerce - University of Cape Coast over the years, for
their immense and useful contributions and suggestions offered in the course of
preparing this book.

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Dedication

3
CONTENTS Page

PREFACE
ACKNOWLEDGEMENT
DEDICATION
DETAILED CONTENTS

CHAPTER 1 : Overview of Cost and Management Accounting 1-

Nature and scope of Accounting; Meaning of Financial
Accounting; Meaning of Cost Accounting; Meaning of
Management Accounting; Purposes of installing cost accounting;
Problems of installing cost and management accounting systems;
Functions of cost and management accounting department;
Features of quality cost and management information; Difference
between financial, cost and management accounting systems;
Costing terminologies; Costing techniques and methods; Exercise
and examination questions with suggested answers; Exercise and
examination questions without answers

CHAPTER 2 : Classification of Cost

Introduction; Classification by elements of cost; Classification by
nature/relationship of cost; Classification by behaviour of cost;
Other forms of classification; Meaning and importance of cost
coding; Factors influencing cost behaviour; Limitations of cost
behaviour; exercises and examination questions with suggested
answers; exercises and examination questions without answers

CHAPTER 3 : Material Costing Simplified

Introduction; Material cost categories; material requisition;
material ordering and storing procedures; material issuance and
pricing; material inventory control; the concept of Just-In-Time
(JIT) inventory management; exercises and examination
questions with suggested answers; exercises and examination
questions without answers

CHAPTER 4 : Labour Costing Simplified

Introduction; meaning of labour; direct and indirect labour; object
of labour costing; basic means of tracking labour hours;
remuneration methods; payroll preparation; computation of
overtime earnings; minimum guaranteed wage; the concept of
idle time; Just-In-Time (JIT) labour management; labour

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 turnover; exercises and examination questions with suggested
answers; exercises and examination questions without answers

CHAPTER 5 : Overhead Costing Simplified

Introduction; collection and classification of overhead costs;
purpose of overhead cost accounting; meaning of overhead
allocation, apportionment, and absorption; basis of overhead
apportionment; basic approaches for overhead absorption;
allotment, distribution and re-distribution of service department
overhead; pre-determined overhead absorption rate; the concept
of blanket or plant wide rate vis-a-vis separate departmental rate;
under and over absorbed overhead; exercises and examination
questions with suggested answers; exercises and examination
questions without answers

CHAPTER 6 : Costing Methods - Job Costing

Introduction; job costing; purpose of job costing; features of job
costing; exercises and examination questions with suggested
answers; exercises and examination questions without answers

CHAPTER 7 : Contract Costing

Introduction; objects of contract costing; features of contract
costing; definition of basic terminologies in contract costing;
problems or challenges in contract costing; basic approaches of
contract costing; exercises and examination questions with
suggested answers; exercises and examination questions without
answers

CHAPTER 8 : Process Costing

Introduction; objects of process costing; features of process
costing; definition of basic terminologies in process costing; the
concept of equivalent units; joint product; by-product; split-off
point; problems in accounting for joint products; methods of
costing joint product; exercises and examination questions with
suggested answers; exercises and examination questions without
answers

CHAPTER 9 : Marginal and Absorption Costing

Introduction; meaning and purpose of marginal and absorption
costing; distinction between marginal and absorption costing;
uses of marginal and absorption costing; arguments in favour of

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 marginal costing; arguments in favour of absorption costing;
basic format for profit reporting using the two approaches;
exercises and examination questions with suggested answers;
exercises and examination questions without answers

CHAPTER 10: Break-Even Analysis

Introduction; meaning and purpose of breakeven analysis;
assumptions underpinning breakeven analysis; uses of breakeven
analysis; limitations of breakeven analysis; computational
approaches to breakeven analysis; the graphical approach or
representation; exercises and examination questions with
suggested answers; exercises and examination questions without
answers

CHAPTER 11: Activity-Based Costing (ABC)

Introduction; meaning and objects of ABC; definition of terms;
pre-requisites for ABC installation; advantages and disadvantages
of ABC exercises and examination questions with suggested
answers; exercises and examination questions without answers

CHAPTER 12: Relevant Cost and Decision Making

Introduction; exercises and examination questions with suggested
answers; exercises and examination questions without answers

CHAPTER 13: Budgeting and Budgetary Control

Introduction; meaning and objectives of budget; definition of
terms; types of budgets; classification by elements of cost;
features of good budget; limitations of budgeting; preparation of
functional, master and cash budgets; uses of cash budget;
meaning and purposes of budgetary control; behavioural aspect of
budgetary control; exercises and examination questions with
suggested answers; exercises and examination questions without
answers

CHAPTER 14: Standard Costing

Introduction; meaning and purpose of standard costing; types of
standards; variance analysis; calculation of variances; possible
practical causes of variances; the concept of mixed and yield
variances; exercises and examination questions with suggested
answers; exercises and examination questions without answers

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.
CHAPTER 15: Performance Evaluation
Introduction; meaning and purpose of performance evaluation;
the concept and calculation of return on capital employed
(ROCE) residual income costing; transfer pricing; exercises and
examination questions with suggested answers; exercises and
examination questions without answers

Glossary

BIBILIOGRAPHIES

7
 CHAPTER 1

Overview of Cost and Management Accounting

Introduction
We have come to believe that information is the life blood of every vibrant,
dynamic and successful organisation. That is, in as much as, businesses require
certain cogent information to run effectively and efficiently, businesses also must
serve the informational needs of various categories of stakeholders from time to
time.

Cost and management accounting is primarily concerned with providing

information to managers – that is people inside an organisation who direct and
control operations. In contrast, financial accounting is concerned with providing
information to shareholders, creditors, and others who are outside an organisation.

It is against this background that, sound accounting system came into existence.
So whereas cost and management accounting creates the essential data that are
required to plan, direct and motivate, and control organisations financial
accounting seeks to create the essential data that are required by outsiders to judge
organisations’ past financial performance.

As we are all aware, financial accounting is mainly concerned with the

preparation of three vital statements or reports for those purposes, which are:
 Income statement (profit and loss account)
 Balance sheet (positional statement)
 Cash flow statement
As it were, these statements served greatly only the needs of external users or
those who are not directly associated with the management of the business
organisation.

Internal Users
Therefore, the informational needs of the internal users, the stewards or
custodians of the shareholders wealth were woefully met. However, we know that
internal management also at any point in time require certain cogent information
to plan, organise, coordinate, control and make informed judgments or take
decisions.
.
So we could all see that financial accounting, by and large, failed to supply the
relevant or essential cost data or information to internal managers. Consequently,
the need for a new system which could capture, process and provide management

8
.with that internal report for effectiveness and efficiency was conceived and given
birth to (i.e. cost and management accounting)

Installing Cost Accounting System

The world has become much more intertwined over the last 20 years.
Improvements in global transportation and communication systems, explosive
expansion in internet usage, reduction in tariffs and other barriers to free trade
have created a truly global marketplace. In a global marketplace, an organisation
that has been very successful in its domestic market may suddenly find itself
facing competition from halfway around the globe. Traditionally, organisational
managers have sought to minimise costs of production on the general premise that
in the long run only the lowest cost producer will survive and prosper. These
theory or strategy led managers to maximise production to spread the fixed costs
of investment in plant and machinery over as many units as possible. Again,
managers have traditionally felt that an important part of their assignment was to
keep everyone busy with the notion that idleness waste money and resources.

These traditional views, often aided and abetted by traditional management

accounting practices, resulted in a number of business practices that have come
under severe criticism in recent times as may be studied in later chapters.
Although, globalisation leads to greater competition it also implies greater access
to new markets, customers, competent workers sophisticated tools and
technologies, and value and supply chain opportunities.

Bottlenecks of Financial Accounting Systems

The following are some of the limitations of financial accounting system:
i. It provides only past data
ii. It indicate only overall performance of the entire business
organisation
iii. Financial accounting tends to be static
iv. It fails to incorporate the impact of price level change (i.e.
inflation)
v. Possibility of manipulation of financial reports was inevitable
vi. It does not ensures proper control of recourses
vii. Lack adequate information for setting or determining prices
viii. Failure to meet management informational needs for effective and
efficient performance
ix. .Lacked the fair basis for inter and intra comparisons
x. Had difficulty in determining break-even points for short run
decision making

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Creation Cost .and Management Accounting Department
It is against this background that we deduce the need for cost and management
accounting unit as it takes organisations with sound costing and cost management
principles to leverage between the costs and benefits of the global economic
trends and take the appropriate advantages. Among the numerous factors that
account for the creation of cost and management accounting system installation
are to:
 eradicate the bottlenecks or the limitations of financial accounting
 gather cost information on organisational activities for management use
 analyse costs incurred in production in order to ascertain the true cost
 enable management make important decision about business performance
 control cost of running a business by keeping cost within the planned
limits
 establish standards for evaluation, predictions, and planning of future costs
 reduce cost of production by choosing the best alternative course of action.

Objectives of Cost and Management Accounting System

Considering the current spate of economic development, complexity and dynamic
nature of business environment and welfare activities, technological advancement,
and also unpredictable internal and external factors, cost and management
accounting system is essential tool if business organisations can achieve their
targets and corporate objectives. Several reasons may account for the use of cost
accounting methods and techniques. These include:
 cost analysis
 cost control
 cost reduction
 forecasting and planning
 decision making
 cost ascertainment

Cost Analysis
Cost analysis assists the organisation to ascertain the true and fair cost and prices
for its products and services.

Cost control
Cost and management accounting deals with controlling cost to be within the
prescribed or planned limit. As a means of cost control, responsible officials or
managers are put in charge of various sections of the organisation. These sections
or units are called cost centres or responsibility centres. The officials are made
answerable for over-spending or under-spending, the funds allocated to them.

10
They are also made answerable to management for any waste and inefficiencies in
their unit.

Cost Reduction
Cost and management accounting also involves reviewing existing production
methods with the view to eliminating inefficient activities. Methods of cost
reduction include conducting activity and value analysis. Whereas activity
analysis deals with the process of identifying, describing, and evaluating the
activities an organisation performs value analysis is concerned with finding out
what parts of the product consumers find unnecessary, and eliminating those parts
to reduce cost. Another approach of cost reduction is by adopting work study
techniques. Under work study methods, ways of doing a piece of work are
detailed out and the best way is subsequently selected and adopted in producing
organisational goods and services. The best way of doing a piece of work is
deemed to be the most efficient, effective and economical method of production.

Forecasting and Forward Planning

Cost data from the cost management unit can be used for forecasting and planning
for future costs and revenues. Such standard cost data are used for budgetary
planning, communications and control purposes.

Decision Making
Cost data are used in making cogent business decisions. Assume that a
prospective customer offers to buy a product at GHc.7 instead of the normal price
of GHc9, should the order be accepted? The answer to this question would be best
determined if the cost of production is known.

Cost Ascertainment
Cost of jobs and processes, products prices and services costs can best be set or
determined if their respective cost data is available. Cost management
departments assist in tracing all costs as an expense to cost units and cost centres.
It is by doing so that costs of jobs, processes, goods and services are known,
though not necessarily accurate.

Benefits of Cost and Management Accounting System

To set up an efficient and effective cost accounting department involves huge
sums of money. Nevertheless, the benefits to be derived from the cost accounting
system far outweigh the cost of creating such a unit. The benefits include:
 It helps in profitability determination
 It also facilitate budget preparation
 It enhances departmental or organisational performance appraisal

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  It helps in determining selling price with some regards to cost of sales
 It helps in stock valuation (raw materials, WIP, finished goods etc.)
 Cost accounting system help in determining future costs
 It also assists in controlling budgeted or actual costs (i.e. budgetary
control)
 It also helps management to reach effective and efficient decision-making
 It provides the tools that help in determining the effects on profits
resulting from accepting a job, order, increa.se or decrease in output or
shutting down of a product line or a department.

Limitations of Cost and Management Accounting Systems

Despite the numerous benefits associated with the creation of a separate cost
accounting department the cost and management accounting system has its own
related problems which are not far fetched. These include the following:
 The use of different costing techniques in similar or same situations.
Unlike financial accounting where there is consistency in the treatment of
accounting transactions, cost and management accounting systems can
utilise various approaches or methods in similar situations. It is therefore
possible to quote three different cost of production for producing the same
quantity of goods.
 Sometimes companies are forced to find a way of integrating the cost and
financial accounting systems for swift responses to important business
opportunities. Therefore, cost and management accounting system makes
it sometimes very difficult to take swift decisions for business advantage.
 A firm without sophisticated managers or competent staff cannot make
full use of information produced by a cost and management system. In
such instances the costing system becomes a mere duplication of the
financial accounting system.
 The cost of operating a cost accounting system can be too huge. Therefore
can be too high for especially small businesses to install. It requires huge
capital to run an efficient and effective cost accounting system
 Sometimes it tends to over emphasise costs, thereby stifling progress. Cost
and management accounting systems can bring about too much cost
consciousness which may be less beneficial in the long run. An example
may be postponing maintenance of plant machinery with the view of
cutting down cost but end up experiencing expensive machinery
breakdown in future.

Activities of Cost and Management Accounting Systems

The principal function of the cost and management accounting unit is to provide
information for management for making decisions as well as controlling the
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activities of the organisation. Cost accounting is concerned with ascertaining the
cost of goods, or services provided or cost of operating a department or
production line, and the revenues to be earned or earned. Fact is that, knowing
about the costs and revenues that are being incurred and earned enables
management to perform more effectively and efficiently.

Cost and management accounting unit also deals with the appropriation or
allocation of resources to cover expenditure with respect to material, labour and
overheads to enable management to ascertain its cost of production and also
identify areas of inefficiencies. Originally cost accounting dealt with ways of
accumulating cost and of charging these costs to units of output, or to department,
in order to establish stocks valuation, products costing, profits determination,
performance evaluations and pricing policy. Nevertheless, it has presently been
extended into areas such as planning, control and decision making, thereby
making it difficult to distinguish between cost and management accounting.

Management may need information from cost and management accounting unit
when they have to make a choice between producing one product or another, to
make or buy certain parts or to stop producing a particular product. Another
function of cost management department is the activities it engages in for the
purpose of reducing cost producing or procuring goods and services. For instance,
the cost management unit can determine which product is becoming more
expensive to produce, or which department is becoming more expensive to run. It
would then suggest ways and measures of reducing product or departmental cost.

The cost management department can determine whether it is cheaper to use more
labour hours, or more machine hours to process the goods produced by the
establishment. The cost management section is the best unit of an organisation to
cost and price the goods and services produced by an organisation.

Relationship between Types of Accounting

The relationship between financial, cost and management accounting can be
stated as follows:
 Financial Accounting is concerned with external reporting to
shareholders and the investing public at large. It also provide a system
whereby the operations of an organisation can be checked or audited to
confirm that the establishment is being managed in a proper and
responsible manner. Financial accounting has been commonly referred to
as ‘stewardship’ accounting because they are prepared to enable owners of
an organisation to assess the performance of the managers they have
appointed.

13
  Cost Accounting, on the other hand, is concerned with the provision of
information for internal management. It attempt to report the cost and
profitability of different products or services, and to enable management
to estimate future costs. With such ‘internally generated’ information
management can decide which product or service should be made and
sold, and in what quantities, what selling price should be set, etc.
 Management Accounting is also concerned with the provision of
information required by management for policies formulation, planning
and controlling of company’s activities, decision making, safeguarding
company’s assets to mention only a few.

Difference between Types of Accounting

Among the differences are:
 Legal Requirements: There is a legal obligation for public companies to
produce annual financial report regardless of whether management
considers such financial report as useful or not. Cost and management
accounting, by contrast, is entirely optional and such information are
produced only when management considers its application to be very
beneficial. In other words, public companies are required by law to
prepare annual financial statements for the investing public and all
stakeholders but cost and management accounting system only exist where
management believes that costing information will help managerial
planning, control and decision making.
 Focus on Individual Unit of the Organisation: Financial accounting
reports on the whole of the business entity whereas cost and management
accounting focuses on departments of the organisation. Cost and
management accounting information usually evaluates the economic
performance of department.
 Generally Accepted Accounting Principles (GAAP): Financial
accounting statements must be prepared in conformity with the generally
accepted accounting principles established by the regulatory bodies such
as the Accounting Standards Board (ASB) in the United Kingdom and
Financial Accounting Standards Board (FASB) in the USA. These
requirement are essential to ensure uniformity and consistency that is
needed for inter and intra firm comparison by the external users. In
contrast, cost and management accountants are not required to adhere to
any set of rules and conventions when providing managerial information
for internal purposes, therefore making it difficult in arriving at decision.
 Time Dimension: Whereas financial accounting reports on what is past in
an organisation, cost and management accounting report on past, present
as well as future events of an organisation.

14
  Reporting Frequency: A detail set of final account is usually published
annually (exceptionally published semi-annually or quarterly) but cost and
management information are provided daily, weekly, monthly in order to
ensure quick and swift actions to avert unnecessary delays and wastage.

Cost Accounting Terminologies.

An understanding of costing terms, concepts and classification is fundamental in
any study of cost and management accounting.

Cost
The word cost can have variety of meanings depending on the context in which it
is used. But for the purpose of our study the term cost may basically be defined as
the sacrifice made, usually measured by the resources given up to achieve a
specified purpose.

Cost Unit
By definition cost unit is quantitative unit of product or service in relation to
which costs are ascertained. The cost unit is the object or item for the costing
purposes. Examples of cost units in manufacturing firms may be the shoe in a
shoe factory or the pen in a pen factory. A cost unit in a service industry like
hospital might relate to the number of beds occupied or the number of patients
treated, a cost unit in a hotel, would be room/day occupied, in transport business
the obvious cost unit may be passenger/mile.

Cost Centre
A cost centre is defined as a location, function or place or items of equipment in
respect of which costs may be ascertained and related to cost units for control
purposes. Each cost centre acts as collecting point for certain costs before they are
analysed further. The total cost of a cost centre may either be related to the cost
units which have passed through the cost centre, or the total cost might be re-
allocated over other cost centres. Typical examples of cost centres includes the
various production or service departments in a organisation i.e. cutting,
machining, finishing, canteen, stores, administration or personnel, sales or
distribution, accounting and auditing departments.

Opportunity Cost
An opportunity cost is defined as the benefit that is sacrificed when the choice of
action precludes taking an alternative course of action. If banku and fufu are the
available choices for dinner, the opportunity cost of eating banku is the foregone
pleasure associated with taking fufu. In other words, the cost of using resources in

15
a particular venture expressed in terms of foregoing the benefit that could be
derived from the best alternative use of those same resources.

Differential/Incremental Cost
A differential cost is the difference between the costs of two alternatives course of
action. In short, a differential cost is the amount by which the cost differs under
two alternative courses of action. Suppose the University is considering two
competing sites for a waste recycling plant. If the new site is chosen, the annual
cost of transporting refuse to the site is estimated to be GH¢8,500. If the old site is
selected, annual costs in respect of waste transportation are expected to be
GH¢7,000. The annual differential cost of carrying the waste is as follows:
GHc
T/costs of transporting refuse to new site 8,500
T/costs of transporting refuse to old site 7,000
Annual Differential Cost 1,500

A differential cost is sometimes referred to as an incremental cost. Incremental

costs are found in a variety of economic decisions. Incremental cost usually refers
to additional cost arising only because of a particular project is moved from one
location to another. Incremental costs include both variable and additional fixed
cost acquired for undertaking the specified project.

Conversion Cost
A conversion cost is the cost of producing a product excluding the direct material
cost. It refers to the sum of direct labour and manufacturing overheads. It stems
from the notion that direct materials are converted into finished goods through the
input of direct labour and production overheads. In short, it is usually taken as the
aggregate of direct labour and production overheads consumed.

Relevant Cost
Relevant costs are those costs which change depending upon the decision made or
that are incurred because a decision is made. In other words, relevant costs are
those costs that will be used in arriving at a decision about a problem at hand, (i.e.
costs appropriate for decision making) irrelevant costs are costs that have been
incurred already and irrelevant for decision making. Whereas relevant costs relate
to future cost irrelevant costs relate to the past. A relevant cost is a future cash
flow arising as a direct consequence of decision under consideration.

Sunk Cost
Sunk costs are costs that have been incurred in the past and cannot be altered by
any current or future decision. Put differently, a sunk cost is any cost that has

16
already been incurred and cannot be reversed. Apart from its effects on income
taxes, a sunk cost is irrelevant for all decision-making purposes. For examples of
such costs include the acquisition cost of equipment already purchased and
manufacturing cost of stock on hand. Regardless of the usefulness of the
equipment or the stock, the costs of acquiring them cannot be changed by any
prospective action. Hence these costs are irrelevant to all future decisions.

Product Costs
A product cost is a cost assigned to goods that were either purchased or
manufactured for resale. These are costs associated with the actual production or
acquisition of the product itself. The product cost is used in stock valuation. The
product costs of a manufacturing establishment include cost of raw materials,
labour, and production overheads incurred in the production of the finished goods.
Product cost of retailers and wholesalers consist of the purchase cost plus the
shipping or freight charges. Product cost is similar to service cost depending on
the company’s business activity.

Period Costs
All costs that are not product costs are called period costs. These costs are
identified with the period of time in which they are incurred rather than with
goods produced or units purchased. These are costs incurred by the business
which are usually related to time for which the company is in business. They are
known as period costs because they are generally associated with a time period.
For example, all research and development, selling and distribution,
administrative costs such as rent and rates, telephone bills and managing
director’s salary are treated as period cost. None of these costs can be considered
to be directly attributable to the costs of producing any particular product.

Controllable Cost
Another cost classification that can be helpful in cost control involves the
controllability of a cost item by a responsible manager. A cost is controllable if a
responsible manager can directly control or heavily influence the level of such
cost i.e. can even vary the number of times or the time period over which the cost
is incurred.

Uncontrollable Cost
Uncontrollable costs, on the other hand, are costs items for which responsible
manger cannot influence significantly such cost items. For instance, whereas
maintenance expenses in a transport company can be regarded as controllable
cost, the cost such as vehicle licensing fees and the cost of fuel must be regarded
as uncontrollable.

17
Classification of Cost
Cost classification denotes the grouping of cost data to facilitate easy analyses,
evaluation and provision of information for management planning, control and
decision-making purposes. It is essential to recognise that costs can be classified
in a variety of ways, depending upon the personal orientation, nature and structure
of the business organisation. Among the different ways of grouping costs are:

Classification by Nature or Elements of Cost

In this case we look at costs in terms of cost elements i.e. material, labour and
expenses or overheads.

Classification by Function of Cost

By functional classification cost are analysed and grouped according to the
functions or departments operating within an organization. Below are some
examples of organisational units or departments.
- Production/Manufacturing - All costs incurred in producing the cost unit.
- Research and Development - All costs incurred in respect of research
- Administrative - All costs incurred in regards to administration.
- Marketing/Distribution Costs - All costs incurred in respect of selling.

Classification by Relationship of Cost

By this approach costs can be grouped into:
Direct Costs
Direct costs are those costs which can be directly identified with a particular
product or service which the business produces/provides. These can be seen as
direct materials – the raw materials and components which go into the finished
product, direct labour – the wages and salaries paid to production workers for
work directly related to the cost unit and direct expenses – expenses which are
incurred specifically in the making of a particular product, such as royalties or
hire of special equipment.

The total of all the direct costs is known as Prime Cost (i.e. direct materials +
direct labour + direct expenses)

Indirect Costs
Indirect cost are all those costs of materials, labour and expenses which are
incurred in the production process but which cannot be identified with one
particular product. Examples include the salaries of supervisors, cleaners, and
security men in a business producing a range of products, consumables materials
used to service machinery involved in the production process.

18
The total of all the indirect costs is also termed as Overheads (i.e. Indirect
materials + Indirect labour + Indirect expenses).

Classification by Behaviour of Cost

One common decision managers make involves how many units to produce or
how much service to provide during a certain time period. Making such decisions
requires an understanding of how cost changes with volume. Each product or
service and the corresponding method of production have different cost
components as the rate of output changes during a period of time.

Cost behaviour is the way a cost reacts to a change in business activity. As rightly
pointed out, it is essential for managers appreciate and understand cost-behaviour
patterns if they are to accurately predict how a cost will respond to a contemplated
change in business operation. Cost behaviour is best defined in relation to some
activity, such as the number of units produced, hours worked, miles driven, meals
served, and ounce of gold mined. While business managers are concerned with
what their costs have been in the past, they are naturally much more concerned
with what their costs will be in the future. Cost prediction (estimating future
costs) is therefore of crucial importance to business planning.

The classification of costs according to their behaviour is therefore the basis of

cost prediction and this is usually undertaken in relation to changes in the activity
level of the organisation. It is in this context that, costs are grouped into:

Fixed Costs
A fixed cost remains unchanged in total as the level of activity (cost drive) varies.
A fixed cost is one which is not dependent upon the level of activity but which
will be incurred on a recurring basis, no matter what level of activity the company
undertakes. Examples of fixed costs include buildings and machinery cost in an
organisation i.e. if plant is idle, expenditures such as property rates, insurance,
salaries of directors, security men must be paid. Fixed costs are relevant to time
periods rather than activity level. Therefore, in terms of cost predictions the fixed
costs behaviour can be predicted into the future without regard to the expected
activity level.

This can be depicted diagrammatically as follows: (figure 1)

F/Cost
Assumed to be Constant
Cost

Output
19
Various types of Fixed Costs - Fixed costs may be:
Committed Costs
Fixed costs that continue for long periods of time are called committed costs.
Committed costs are costs, once made, are not reversible in the short term.
Examples of committed costs may be the cost of constructing a factory building
or a long-term lease of an office building.

Discretionary Costs
These are also fixed costs incurred but reversible in the short term. They differ
from committed costs in that they are reversible after short periods of time.
Advertising is a good example of this kind cost because it is normally contracted
for over short periods of time. Other examples may include supervisor’s salary
and security guard’s salaries.

Step Change Fixed Costs

However, fixed costs are not fixed indefinitely for all activity levels, but at a
certain point in production or companies’ life additional fixed will be required.
For instance, if number of deliveries increases beyond a certain level in a
distribution company fixed costs will changed.

This behaviour of fixed cost is known as a step change in fixed costs and can be
shown diagrammatically as in figure 2

Cost

Output
Variable Costs
A variable cost changes in total in direct proportion to a change in the level of
activity (or cost drive). A variable cost is one which is directly related to the level
of activity of an organisation. Variable cost has direct relationship to volume of
production and can be predicted to increase or decrease in direct proportion to
output. For example the cost of aluminium sheets used by Ghana Aluminium
Company Ltd will increase by approximately 10 percent if roofing sheet
production increases by 10 percent.

This can be shown diagrammatically as follows (figures 3a & 3b).

20
As it were, variable costs cannot be predicted for the future without a
consideration of the estimated level of activity, as any changes in such parameters
will lead to a change in cost. Although, costs are predicted in total for a time
period, for variable costs it is useful to understand the cost behaviour in terms of
unit cost.

The concept of classifying costs into fixed and variable according to their
behavioural characteristics is an essential preliminary step to being able to
undertake any meaningful cost predictions into the future.

Various types of Variable Costs - Variable costs may be:

Curvilinear or Non linear Variable Costs
Again, the assumption that variable cost per unit will remain the same over a
period of time is not always true. But at times the relationship between variable
cost per unit can vary from one output level or batch to another resulting in
curvilinear representation or a curved line on a graph instead of straight line.

Two common types are:

 Convex: where extra unit of output causes less than proportionate
increase in unit costs.
 Concave: where extra unit of output causes more than proportionate
increase in unit costs.

Factors which Influences Costs Behaviour

A number of factors determine the behaviour of costs at any point in time. Among
these are:
 Volume of output
 Technology advancement and changes
 Product mix changes
 Methods of production
 Seasonal and climatic conditions
 Economic changes

Limitations of Cost Behaviour

Although cost behaviour provides the basis of cost prediction, one needs to
recognise the fact that it does it not without problems. Among the numerous
bottlenecks associated with cost behaviour are:
Mixed Cost
Not all costs can be classified as purely fixed or purely variable costs because the
show features of both. Such costs, because they contain both fixed and variable
cost elements, are generally referred to as mixed or semi-fixed or variable costs.

21
Put differently, mixed or semi-fixed or semi-variable costs are closely related to a
variable cost. It is made up of two components which are a basic fixed charge (usually a
monthly fee) and a variable charge based on the level of activity or consumption. Typical
examples include telephone, power and lighting charges and photocopying machine
which have fixed element of rent and variable element depending upon usage. These costs
are known as mixed, semi-fixed or semi-variable.

Step-Variable Costs
A step-variable cost consists of series of fixed cost increments over short ranges
of production within the relevant range. In other words a step-variable cost
increases in discrete jumps rather than the continuous pattern of semi-variable
costs. Typical examples of this kind of cost are the salaries of a foremen and
maintenance workers.

Short and Long Term Effects

Classifying costs into fixed and variable cost for predictions is basically only
valid for short-term predictions. The reason being that, in the long-term all fixed
costs can be regarded as variable, in that, the factory cost themselves can be
varied as existing factory structures can be disposed off and new structures built
given sufficient time. Therefore, cost predictions cannot be made indefinitely into
the future but only for fixed relatively short time period.

Linearity
In predicting cost, it is normally assumed that variable costs vary in direct
proportion to changes in the level of activity, but in reality this may not be strictly
true.

Relevant Range
Both fixed and variable costs relationship with output level only hold true within
a specific range of activities termed the relevant range and outside this range the
relationship no longer holds true.

Multiple Causes of Behaviour

It is often assumed that costs behaviour are influenced and determined by the
level or volume of activity, methods of production etc. however, in reality there
are a number of other factors that are equally important which are not captured in
the concept of fixed and variable cost.

22
Cost Accounting for Materials
Since materials make up a large part of the total cost of running an organisation, it
is essential that materials are properly accounted for and safeguarded in a good
stores to avoid wastage as well protect the huge investment in material stocks.

Material costing has two main aspects which are:

1. to determine the cost of raw materials components that are consumed as direct
or indirect materials, in the finished goods produced, the value of closing stock
of materials and materials in WIP or partially completed goods.
2. to keep material holding cost under control. Stock cost control here involves
having a system for keeping checks on physical stocks and keeping accurate
stock records, so that management know how much they are holding in stock, or
how quickly stocks are being consumed, having a system for re-ordering fresh
stocks as well as keeping the cost of carrying stocks and stock re-ordering at a
minimum level.

Storekeeping
It is both the physical task in handling the materials and the clerical task in
keeping records. These aspects may be put together under one roof or may be
regarded as a separate function. However, from time to time, the records of stocks
kept must be reconciled with physical stocks count and any difference recorded
and duly investigated.

Purpose of Storekeeping
Storekeeping involves storing materials to achieve the following objectives:
1. To ensure speedy issue and receipt of materials
2. For full and easy identification of all materials
3. To help correct location of all materials at all times
4. To facilitate provision of suitable storage conditions and security
5. To help maintain correct stock level
6. To keep correct and up-to-date records of receipts, issues, and stock levels.

Centralised and Decentralised Storekeeping

Each business will have factors peculiar to itself that may favour either centralise
or decentralise store system. In many cases management will decide to keep some
materials centrally especially those of high value and others on sub-stores.
Materials may be kept in either a centralised or in decentralised stores. Each of
these approaches has got its own advantages and disadvantages.

Advantages of Centralised Stores

Advantages of keeping centralised stores include:
1. Smaller stocks are required

23
 2. Smaller overall staff is required
3. Paper work drastically reduced.
4. Simplified controls for stocks levels as only one set of record is kept
5. It avoids keeping of several books.
6. Thereby reducing cost of stationery
7. Less risk of duplication
8. Stocktaking is facilitated tremendously
9. Easy to install more advance equipment to help control of stock.

Disadvantages of Centralised Stores

Disadvantages of centralized stores include:
1. Increased handling charges
2. Increased transport costs as stocks must be sent out over longer distances
3. Increased fire and other storage risk i.e. theft and pilfering
4. High related costs i.e. security, insurance, refrigeration etc.
5. Increased effects on other units due to breakdown and unnecessary delays
6. Inconvenience to personnel and department heads due to longer delays.

Ordering and Receipts of Materials Procedures

Proper records must be kept of the physical stock and this must also follow well
designed procedures for ordering and receiving a consignment of materials.

Typical procedures must include the following:

1. As current stock runs down to the level where a re-order is required, then the
storekeeper issues a purchase requisition (PR), to purchasing department.
2. The purchasing department draws up purchase order (PO), which is forwarded
to a prospective supplier. Supplier may be asked to acknowledge receipt, which
letter must indicate his acceptance of the offer.
3. Supplier delivers the consignment of materials and the storekeeper signs a
delivery note for the carrier.
4. The package must then be checked against purchase order to ensure that the
supplier has delivered the right brand/type, quantities, quality, etc of materials
which were ordered.
5. Discrepancies if any must be referred to the purchase department for the
necessary actions to be taken.
6. If the delivery is accepted the storekeeper prepares Goods Received Note (GRN).
Then a copy of the GRN is sent to the Accounts Section to enable processing of
payment voucher in respect of the material purchased or supplied.

Goods Received Note (GRN)

Every good GRN must show the following:
1. The name of supplier
2. Date of receipt of goods
24
 3. Quantities received of each stores item
4. Signature of the storekeeper, confirming that quantities received tally with
that of the order and that the goods have been duly inspected and passed.
5. The purchase order reference number to which the goods receipt
corresponds.

Stock Control
This refers to the management task of providing a system whereby the stock of
materials, WIP, and finished goods are controlled so as to control:
1. The cost of holding or carrying stock
2. The quantities of stocks held at any point in time
3. The time taken between placing an order for fresh stock and the eventual
delivery of goods into the stores (lead time or delivery period),
4. Investment in stocks and maintain all related costs at optimum level.

Main Objective of Stock Control

The main purposes of stock control are:
1. To maintain adequate stocks at any point in time
2. To avoid production stoppages and its consequent costs.
3. To avoid customer dissatisfaction in terms disappointments
4. To avoid loss of revenue due to failure to meet orders
5. To avoid unnecessary cost of emergency actions
6. To avoid excessive stock levels and its consequent tying up of capital

Cost Incurred for Holding Too Low a Level of Inventory

 Loss of sales, from being unable to provide the goods required
 Loss of goodwill, for being unable to satisfy customer demand promptly
 High transportation costs incurred to ensure stocks are replenished quickly
 Lost production owing to shortages of raw materials
 Inefficient production scheduling due to stock run outs
 Purchasing stock at a higher price than may otherwise have been
necessary in order to replenish stock quickly
 Wasted production runs in restart situations

Cost Incurred for Holding Too High a Level of Inventory

 Capital lock up
 High storage cost/ High cost of rent and warehousing
 Unnecessary interest payments
 High insurance cost
 Theft and pilfering and
 Risk of perishability and obsolescence

25
Methods of Stock Control
Two popular methods of stock control are:
1. demand and supply method
2. perpetual inventory method

Demand and Supply Method

Control of stock under this method is often achieved by collecting data on each
stores item, in respect of the amount used in average period, an exceptionally
busy period and an exceptionally slack period. These data is then used to establish
usage levels termed as the Average level, maximum level and minimum level
respectively. Suppliers’ delivery time would be similarly analysed and average,
maximum, and minimum delivery times established. With this information it is
therefore possible to calculate the stock level (re-order level) which will trigger
the need for a fresh stock to be placed or ordered to replenish stock.

Four Stock Levels

There are four critical control levels that can be used to maintain stocks at their
optimum level. These include:
Re-order Level
Re-order level is simply that level of stock at which, it is prudent to place an order
for a fresh stock. Technically it would not be prudent to allow raw materials
stocks to run out completely before placing order for new stock to replenish stock.
Moreover, because it takes time to process and receive fresh stock, the reorder
level should be set relatively over and above the minimum stock level but below
the maximum stock. In short, reorder level is that stock level which triggers off
the need to place an order for fresh stock to replenish stock.
This is set by considering the following important factors:
i. The maximum consumption, market demand, insurance cost
ii. The lead time (both maximum and minimum)
iii. The maximum level, available space, funds availability
iv. The minimum level, perishability, obsolescence
Reorder Quantity
Re-order quantity otherwise termed as Economic Order Quantity (EOQ) is simply
the most cost beneficial quantity of stock to order at a time. On the assumption
that, there are no bulk purchase discount for ordering stocks in large quantities
EOQ may be said to be the re-order quantity which minimises ordering and
carrying costs. In other words, it is the amount which minimises the combined
cost of stock holding and stock ordering.
This is set by considering the following important factors:
i. The rate of consumption (i.e. maximum, average and minimum)
ii. Availability of funds, storage facilities, ordering and holding costs
iii. The maximum lead times or delivery periods, supplier’s reliability

26
Minimum Level
Minimum level is also a warning level set to draw management attention to the
fact that stocks are approaching a dangerously low level.
It is essentially a buffer stock sort of, and is set by considering the following
important factors:
i. The re-order level, average lead time or delivery period,
ii. The rate of consumption, availability of funds, seasonal variations
iii. The market demand, stock levels themselves, etc.
Maximum Level
Maximum Level is the level for which stock must not exceed. It is the uppermost
limit. It acts as a warning point to management that stocks are reaching a
potentially wasteful level. Maximum stock level is usually set in order to ensure
savings of scarce financial resources or efficient application of funds, efficient
and effective utilisation of storage facilities (i.e. monitoring and controlling).
The maximum level is also set by considering the following important factors:
i. The re-order level, insurance cost, incidence, funds availability
ii. Storage space, future production plan, cost of capital or interest
rates
iii. Risk of perishability or obsolescence, the re-order quantity
iv. The minimum rate of consumption, the minimum delivery period.

Calculation of Control Levels

The following are the methods for calculating the above control levels:
1. Re-order Level = Maximum Usage x Maximum Lead Time.
2. Max. Level = Re-order Level + EOQ – (Min. Usage x Min. Lead Time)
3. Min Level = Re-order Level – (Average Usage x Average Lead Time)
4. Re-order Quantity or Economic Order Quantity (EOQ).
The General Formula for EOQ is given as:
2C.D
Ch
Where: 2 = is constant
C = is the cost of ordering a consignment from the supplier.
D = is the annual demand
H = is the cost of holding unit of stock

Illustration1. Component 007 is one of the thousands of items kept in the stores of
B.Com Ltd. Usage of the component is expected to be at the rate of about 30,000
units per year. Management believes that the maximum weekly usage is about 750
units and minimum weekly usage about 400 units. experience has shown that
supplies delivers on average 3 weeks after order is placed but it can be as much as 4

27
weeks or as little as 2 weeks. Assuming that six orders will be made during the year.
Suggests the Re-order, Maximum, and Minimum Levels of Component 007.

Solution: Assuming EOQ (30,000/6) = 5,000 units

1. Re-order Level = Max. Usage x Max. Lead Time = 750 x 4 = 3,000 units.

2. Max. Level = Re-order Level +EOQ – (Min. Usage x Min. Lead Time)
= 3,000 + 5,000- (400 x 2) = 8000 – 800 = 7,200 units.

3. Min. Level = Re-order Level – (Average Usage x Average Lead Time)

= 3,000 – (575 x 3) = 3,000 – 1,725 = 1,275 units

Q2. Annual demand of materials J600 is 100,000 units. One unit of item J600 cost
GHc4 per annum to hold in stock. Ordering cost of the item J600 are GHc20 per
order. What should the re-order quantity be in order to minimise stock
administrative cost.

Solution: Given: Cost of ordering (C) GHc20/per order

Annual demand (D) 100, 000 units
Cost of holding stock (H) GHc4/units p.a.
2C.D
EOQ = = √2 x GHc 20 x 100,000/GHc4 = 1,000 units
Ch

Q3. Find EOQ where the forecasted demand is 1,000 units per month; the
ordering cost is GHc350 per order. The unit cost GHc8 each and it is estimated
that carrying cost are 15% per annum.

Solution: Given: Cost of ordering (C) GHc350/per order

Annual demand (D) 12, 000 units
Cost of holding stock (H) £1.20/unit p.a.
2C.D
EOQ = = √2 x GHc350 x 12,000/£1.2 = 2,646 units
Ch

Q4. The following data relates to an item of raw material BMX5

Cost of raw material GHc1
Usage per day 100 units
Minimum lead time 20 days
Maximum lead time 30 days
Cost of ordering material GHc40 per order
Carrying costs 10% per annum
28
It is assumed that the year consists of 48 working weeks of 5 days per week. You
are required to calculate: a) the re-order level; b) the re-order quantity; c) the
maximum level; d) the minimum level and e) number of orders required in a year.

Solution: Given: Cost of ordering (C) GHc40/per order

Annual demand (D) 24,000 units (100 x 5 x 48)
Cost of holding stock (H) GHc0.1/unit p.a.
2C.D
a) EOQ = = √2 x GHc40 x 24,000/GHc0.1 = 4,382 units
Ch
b) Re-order Level = Max. Usage in Lead Time = 100 units x 30 = 3,000 units.

c) Max. Level = Re-order Level + EOQ – (Min. Usage x Min. Lead Time)
= 3,000 + 4,382 - (100 x 20) = 7,382 – 2,000 = 5,382 units.

d) Min. Level = Re-order Level – (Average Usage x Average Lead Time)

= 3,000 – (100 x 25) = 3,000 – 2,500 = 500 units

e) No. Of orders = Annual Demand/EOQ = 24,000/4,382 = 5.47 times

5. Salamatu uses 5,000 units of its materials per month. The material cost GHc4
per unit to buy, supplier’s delivery costs are GHc25 per order and internal
ordering costs are GHc2 per order. Total annual holding costs are GH1 per unit.
You are required to calculate the EOQ and the number of orders required in a
year.

Solution: Given: Cost of ordering (C) GHc25 +GHc2 = GHc27/per order

Annual demand (D) 12 x 5,000 = 60,000 units
Cost of holding stock (H) GHc1/unit p.a.
2C.D
i. EOQ = = √2 xGHc27 x 60,000/GHc1 = 1,800 units
Ch
ii. No. Of orders = Annual Demand/EOQ = 60,000/1,800 = 33.3 times

6. The following information is provided from the books of Carolyn concerning

her material stock code named ‘AM’: Average usage 10,000 kg per day;
Minimum usage 8,000 kg per day; Maximum usage 13,500 kg per day; Order
quantity 90,000 kg. The stock level is received at the end of each day and an order
placed the following day if there is the need to do so. Experience has shown that
suppliers delivers on average 3 days after order is placed but can be as much as 4
days or as little as 2 days. You are required to calculate the following levels: Re-
order level, Maximum level and Minimum level:
29
Solution:
1. Re-order Level = Max. Usage x Max. Lead Time = 13,500 x 4 = 54,000kg.

2. Max. Level = Re-order Level +EOQ – (Min. Usage x Min. Lead Time)
= 54,000 + 90,000 - (8,000 x 2); = 144,000 – 16,000 = 128,000 kg.

3. Min. Level = Re-order Level – (Average Usage x Average Lead Time)

= 54,000 – (10,000 x 3); = 54,000 – 30,000 = 24,000 kg

7. Calculate the re-order quantity and the number orders required where the
forecasted demand is 1,000 units per week, the ordering cost is GHc185 per order
and internal ordering costs are GHc15 per order. The unit cost GHc8 each and it is
estimated that carrying cost are 15% per annum. Assume that each year consists
of 48 working weeks of 5 days per week.

Solution: Given: Cost of ordering (C) GHc185 + GHc15 = GH¢200/per

order
Annual demand (D) 48,000 units (1,000 x 48)
Cost of holding stock (H) GHc1.2/unit p.a. (0.15 x GHc8)
2C.D
a) EOQ = = √2 x GHc200 x 48,000/GHc1.2 = 4,000 units
Ch
b) No. Of orders = Annual Demand/EOQ = 48,000/4,000 = 12 orders

Q7. Agronefam Ltd makes special carrier bags for Ghanaian Students. It
purchases 20,000 units of a particular wheels component, ‘G5’ each year at a cost
GHc8 per unit. Agronefam’s annual holding cost per year which includes cost for
insurance, material handling, required return on investment, damages is estimated
to be 15% of the purchase cost. The relevant costs per purchase order are
GHc120. Additional information: The purchasing lead time is 3 weeks and
assuming that each year consists of 50 working weeks of 5 days per week (i.e.
250 days a year). You are required to calculate:
i. the EOQ for ‘G5’ wheels component
ii. the number of orders that will be placed each year
iii. The reorder point for ‘G5’ wheels component.

Solution: Given: Cost of ordering (C) GHc120/per order

Annual demand (D) 20,000 units
Cost of holding stock (H) £1.2/unit p.a. (0.15 x £8)
Max usage = 20,000/50 = 400/week
Max lead time = 3 weeks.

30
 2C.D
a) EOQ = = √2 x GHc120 x 20,000/GHc1.2 = 2,000 Units
Ch
b) No of orders to be placed = 20,000/2,000 = 10 orders

c) Re-order Level = Max. Usage x Max. Lead Time = 400 x 3 = 1,200kg.

Q8. Louisa Ltd sells 2,000 units of product X each year. It has been estimated that
the cost of holding one unit of product for a year is GHc4. The cost of placing an
order for stock is estimated at GHc25. You are required to calculate the Economic
Order Quantity and determine the number of times to order for product X.

Q9. Wasters Ltd monthly demand for a material is 10,000 units. The purchase
price is GHc10/unit and the Company’s cost of finance is 15% per annum.
Warehouse storage costs per unit per annum are GHc2/unit. The supplier charges
GHc200/order for delivery. You are required to calculate the EOQ and the
number of orders in a year.

Q10. Deviators Ltd quarterly demand for a material is 48,000kgs. The purchase
price is GHc8/unit and the Company’s cost of finance is 12% per annum.
Warehouse storage costs per unit per annum are GHc2.04/unit. The supplier
charges GHc320/order for delivery. You are required to calculate the EOQ and
the number of orders in a year.

Q11. Madam Cecilia T uses two types of material A and B which are used in the
preparation of her product Y. Details of materials are given as follows:
Maximum usage - 500kgs per week
Minimum usage - 300kgs per week
Re-order quantity - A - 3,100kgs
B – 3,600kgs
Lead time - A – 5 – 7 weeks
B – 4 – 6 weeks
In order to avoid the shortage of raw material stocks, Madam T wants to adopt a
system of advance purchase of materials. From the above information calculate
for each material the following stock levels:
i. Re-order level
ii. Minimum stock level
iii. Maximum stock level
iv. Annual demand
v. Number of times to order per year

31
Q12. Assuming company P’s annual demand of material Z is 10,000 units. Fixed
re-order cost per order is GHc20 and holding cost per unit is also estimated to be
GHc1.6. You are required to calculate the Economic Order Quantity and
determine the number of times to order for product Z.

The Concept of Total Cost of Holding Stock

The aim of Economic Order Quantity (EOQ) is to minimize the total cost of
ordering and carrying/holding inventory. The relevant costs involved here are:
1. Variable cost of holding the inventory
2. Fixed cost of planning orders
Where the re-order quantity chosen minimizes the total cost of ordering and
holding inventory, it is known as Economic Order Quantity (EOQ).

Assumptions
The following assumptions are made:
1. Demand and lead time are constant and known.
2. Purchase price is constant
3. No buffer stock held or needed.

The total cost is made up of Holding Cost + Ordering Cost per annum.

Mathematically = Holding Cost/unit x Average Inventory (i.e. Ch x X/2)

Plus = Ordering cost/order x No. of orders = (Co x D/X)

Example
A company require 10,000units of material ‘A’ per month the cost per is GHc300
regardless of the size of the order. The holding costs are GHc2.88/unit pa.

You are required to determine the total cost of buying the material in quantities of
4,000; 5,000; 6,000 and 7,000 units at one time. What is the cheapest option?

Solution Order Quantity

Order/period 4,000 5,000 6,000 7,000
Average inventory 2,000 2,500 3,000 3,500
No. of orders 30 24 20 17.14
Annual H/cost (Av Inv x GHc2.88) 5,760 7,200 8,640 10,080
Annual O/cost (No. of Os x GHc300)9,000 7,200 6,000 5,142
Total cost 14,760 14,400 14,640 15,222
The best or cheapest option is to choose order quantity of 5,000.

32
Dealing With the Issue of Discounts – 5 Steps
1. Calculate EOQ – using formula, ignoring discounts
2. If this is below the level for discounts, calculate total inventory costs
3. Recalculate total inventory cost using the order size required to just
obtain the discount
4. Compare the cost of step 2&3 with the savings from the discount and
select the minimum cost alternative
5. Repeat for all discount level

Q1. Emptier Ltd is a retailer of empty crates. The company has an annual demand
of 30,000 crates. The crates cost GHc12 each. Fresh supplies can be obtained
immediately with ordering and transport cost amounting to GHc200 per order.
The annual cost of carrying one crate in stock is estimated to be GHc1.20. A
0.2% discount is available on orders of at least 5,000 creates and 0.25% discount
is also available if order quantity is 7,500 crates or above.

You are required to determine which option is the best for Emptier Ltd and
indicate the changes once the discount is taken into account.

Solution - Calculate EOQ - Given: Cost of ordering (C) GHc200/per order

Annual demand (D) 30,000 units
Cost of holding stock (H) GHc1.2/units p.a.
2C.D
EOQ = = √2 x GHc200 x 30,000/ GHc1.2 = 3,162 units. This is below
Ch
level for discounts. Therefore, calculate the annual total cost of inventory.
Order/period 3,162 5,000 7,500
Average inventory 1,581 2,500 3,750
No. of orders 9.5 6 4
Annual H/cost = Av Inv x GHc1.2/unit 1,897.20 3,000 4,500
A/Ordering = No. of orders x GHc200 1897.53 1,200 800
Total cost 3,794.73 4,200 5,300
GHc
Extra Cost to be incurred (GHc4,200 – GHc3,795) (405)
Savings (0.2% x GHc12 x 30,000) 720
Net savings 315

Q2. An annual demand for material A9 is 100,000 units. One unit of item A9
cost GHc4 per annum to hold in stock. Ordering cost of the item is GHc20 per
order. What would be the EOQ to minimize stock administration cost. Determine
various costs when orders in quantities of 10,000 units, 5,000 units, 2,000 units
and 1,000 units are made.
33
An Alternative Approach.
Q  CD
Total cost   h    
2   Q 
Given C = GHc20, h as GHc4 ,
(a) Thus if Q = 10,000
 10,000   20  100,000 
Then total cost   4   
 2   10,000 
20,000 + 200 = GHc20,200
 5,000   20  100,000 
(b) If Q = 5,000   4   
 2   5,000 
10,000 + 400 = GHc10,400
 2,000   20  100,000 
(c) If Q = 2,000   4   
 2   2,000 
4,000 + 1,000 = GHc5,000
 1,000   20  100,000 
(d) If Q =1,000   4   
 2   1,000 
2,000 + 2,000 = GHc4,000

Q3. Monthly demands for material ‘JOY’ is 5,000 tons. Cost per ton before any
discount is given as GHc3.6. Cost of carrying a unit of stock for a year is 10% of
purchase price. There is GHc12 fixed cost for each order placed. The following
discounts are available for bulk purchase.
a) 3,000 tons and above attracts 0.2% discount
b) 6,000 tons and above attracts 0.5% discount
You are required to determine which option is the best for ordering material
‘JOY’ and indicate the changes in terms of total cost to be incurred; net cost
savings once the discounts are taken into account.

Solution: Given: Cost of ordering (C) GHc12/per order

Annual demand (D) 60, 000 tons
Cost of holding stock (H) GHc0.36/ton p.a.
Calculate EOQ The General Formula for EOQ is given as:
2  12  60,000
2C.D 
0.36
Ch
 4,000,000

 2,000 Units

34
This is below level for discounts. Therefore, calculate the annual total cost of
inventory.
Q  CD
Total cost   h    
2   Q 
Given C = GHc12, h as GHc0.36,
(a) Thus if Q = 2,000
 2,000   12  60,000 
Then total cost   0.36    
 2   2,000 
360 + 360 = GHc720
 3,000   12  60,000 
(b) If Q = 3,000   0.36    
 2   3,000 
540 + 240 = GHc780
 6,000   12  60,000 
(c) If Q = 6,000   0.36    
 2   6,000 
1,080 + 120 = GHc1,200

Alternative solution EOQs

Order/period 2,000 3,000 6,000
Average inventory 1,000 1,500 3,000
No. of orders 30 20 10
Annual H/cost = Av Inv x GHc0.36/unit 360 540 1,080
A/Ordering = No. of orders x GH¢12 360 240 120
Total cost 720 780 1,200
Calculation of net savings GHc GHc
Extra Cost to be incurred (GHc780 – GHc720) (60) (480)
Savings (0.2% x GHc3.6 x 60,000) 432 540
Net savings 372 60

Q4. The annual demand of XYZ Ltd is 100,000 units. The costs per order are
GHc200 and holding costs represent 20% of the purchase price which GHc4
(excluding discounts). The following discounts are available for bulk buying:
2,000 - 2,500 0.2%
2,501 - 3,500 0.4%
Calculate the Economic Order Quantity (EOQ) and determine which option is the
best for ordering material for XYZ Ltd.

Q5. Annual demand for material KST 48,000 units. Cost per unit before any
discount is given as GHc4. Cost of carrying a unit of stock for a year is 15% of

35
purchase price. There is GHc120 fixed cost for each order placed. The following
discounts are available for bulk purchase.
c) 3,000 units and above attracts 0.2% discount
d) 4,000 units and above attracts 0.4% discount
e) 6,000 units and above attracts 0.5% discount
You are required to calculate the Economic Order Quantity and determine the
number of times to order for product KST. Also determine the total cost to be
incurred, discount received and cash payable per order.

Q6. During March 2008 demand for Dancing Wolfs is 500,000. The cost of
making one order is fixed at GHc10. This excludes the buyers time which, from
the annual salary is calculated at GHc5 per order. Storage space for Dancing
Wolfs is rented at GHc4 per sq ft, each Wolf requiring 0.5 sq ft of space. Other
holding costs comprise GHc1 per Wolf. What is the Economic Order Quantity
(EOQ) for Dancing Wolfs?

Concept of Just-In-Time (JIT) Inventory Management

JIT inventory management method seeks to eliminate any waste that arises in the
manufacturing process as a result of using material stock. JIT purchasing methods
apply the JIT principles to deliveries of materials from suppliers. With JIT,
production methods inventory levels of raw materials, WIP and finished stocks of
materials are reduced to barest minimum or completely eliminated by improved
work flow planning and closer relationship with suppliers.

Advantages of JIT
 JIT inventory management seeks to eliminate waste at all stages of
production/manufacturing by eliminating or minimizing inventory,
defects, breakdowns, accidents, and delays.
 JIT system fosters stronger relationship between buyers and suppliers.
 JIT system offers security to suppliers who benefit from regular orders,
continuing future business and more certain production planning
 buyers also benefit from lower inventory holding costs, lower investment
in inventory, WIP, and the transfer of inventory management problems
 Benefit from bulk purchase discount or lower purchase costs.
 JIT reduces buyer’s emphasis on quality control measures in production
processes thereby reducing scraps, reworking and setup costs.
 JIT avoid unnecessary material movements due to enhanced work flow
and production layout design.
Disadvantages of JIT
 JIT may not be smooth in practice as predicted by theory – for it has little
room for manoeuvre

36
  JIT also has little room for unforeseen delays emanating from errors on
delivery times
 JIT system is too much dependent on suppliers for quality controls
 JIT is very expensive in times of supplier downtime or production
standstill
 If suppliers increase prices the buyer finds it extremely difficult to find
alternative supplier who is able to meet orders at short notices.

Stocktaking
Stock taking involves counting the physical stock on hand at certain date, and
then checking it against the balance shown in the clerical records. There are two
methods of carrying out this process – periodic stocktaking and continuous
stocktaking

Periodic Stocktaking
This is usually carried out annually and the objective is to physically count all
items of stock on a specific date. As it is a very important exercise the following
steps must be strictly followed:
i. All staff involved must be served with the stocktaking instruction and
procedures well in advance. Often non-stores staff will be invited to take
part in the exercise.
ii. A cut-off time should be set after which no movement of stock is allowed
until the count has been completed
iii. The team of stock-checkers should be allocated to count all stock in one
area to ensure that all stock is counted once and that no omission or
duplication occur.
iv. stock-checkers should enter amounts on pre-printed stock sheets
v. Completed stock sheet should be collated and totalled in the office and
quantities checked against the stock records
vi. Any stock item showing discrepancies should be recounted and if not
resolved must be reported to management.
vii. Senior auditors or staff should perform sample checks on a number of
items.

Continuous Stocktaking
This involves a specialist team counting and checking a number of stock items
each day, so that each item is checked at least once a year. Valuable items could
be checked more frequently. The advantages of this system compared to periodic
stocktaking are as follows:
i. The annual stocktaking is unnecessary and its related disruption is also
avoided

37
 ii. Regular skilled stock takers can be engaged, reducing likely errors
iii. More time is available, reducing errors and allowing proper investigation.
iv. Deficiencies and losses are quickly disclosed
v. Production hold-ups are eliminated because stores staff is always
available.
vi. Staff morale is tremendously improved and thereby raise performance
standard.
vii. Control over stock level is also greatly improved, and there is less
likelihood of overstocking or running out of stock at any point in time.

Stock Discrepancies
There will be occasions when stock checks disclose discrepancies between the
physical count of an item in stock and the quantity shown on the stock records.
When this happens an investigation should be conducted to find out the causes of
such discrepancies and appropriate measures or actions taken to ensure that it
does not recur.

Possible Causes of Discrepancies

Possible causes of discrepancies include:
1. Supplier delivers a different quantity of goods than is shown on the GRN
2. When different quantity of stock is issued to production rather than that
shown on Material Requisition Note (MRN).
3. Excess stock returned form production without documentation
4. Clerical errors may occur in the stock records
5. Breakages in stores may go unrecorded
6. Breaking of bulk material and evaporation
7. Theft of stock by employees may be occurring.

The Benefits of Holding Stocks (Advantages)

 The need to meet customer demand, efficient space utilisation
 Taking advantage of bulk purchase, efficient application of funds
 Reducing total annual re-ordering cost, effective planning, and control.

How Internet Assist In Material Costing

Advance information about goods can be gathered electronically or
technologically through the use of internet browsing and this increases reliability
in placing order, avoid unnecessary time wasting enquiries and expensive phone
calls, increase assurance of delivery times, emails can serves as instantaneous
records of stock movement and monitoring etc and all such internet information
facilitate reducing costs of placing order as well as help in the management of the
purchasing, carrying, stockout and other related costs.

38
Material Cost Categories
Material costing can be looked at in five main dimensions in any business
organisation. These are namely:
 Purchasing costs
 Quality costs
 Ordering costs
 Carrying costs
 Stock out or Material shortage costs
Now let us consider in details the five cost categories of managing materials or
stores.

Purchasing Costs
These are the costs of goods bought or acquired from prospective suppliers
including freight or transportation costs. These costs usually constitute the single
largest cost category of materials/stocks for production or resale in an
establishment. It is worth mentioning here that discounts for bulk purchase,
suppliers credit facilities, etc do affect purchasing cost of materials.

Quality Costs
Quality costs denote that the quality of a product or material is its conformance
with preannounced or advertised standard. Quality costs can be assessed or
identified in four main ways namely prevention costs, appraisal costs, internal
failure costs, and external failure costs.

Ordering Costs
Ordering costs are the costs incurred in preparing, issuing, and paying for
purchase orders, as well as the cost of receiving and inspecting the items being
delivered. It is important to note that all purchase orders are associated with
purchase approval and special processing costs. The following are examples of
ordering costs; the clerical and administrative cost, telephone charges, salaries of
purchasing clerks, transportation charges.

Carrying/Holding Costs
Carrying costs arise when an establishment holds stocks for production and resale
purposes. These costs include the opportunity cost of the capital or investment
tied up in material stocks and the cost associated with storage, such as space
rental, insurance, security, theft, obsolescence, spoilage, interest on capital,
storage charges, refrigeration, rent/warehousing insurance, security services,
stores staffing, stores facilities/equipment, pilfering in small quantities to mention
only a few.

39
Stock out Costs
Occur when an organisation runs out or runs short of a particular material
component for which there is customer demand or production floor are in need of.
A company may react to the shortfall or stock out by expediting an order from a
prospective supplier. Expediting costs of a stock out include the additional
ordering costs plus any accompanying haulage or transportation costs. Again, the
establishment may loose one or more sales orders or prospective customers.
Opportunity costs, which are not recorded in most accounting systems, are so
great and play an important role in the management of these cost categories.

Pricing/Issues of Materials (Stock Valuation)

Stock must be valued in order to measure cost of production, cost of sales as well
as to provide a valuation for stocks on hold for the balance sheet. Several methods
of pricing/issuing materials are available to the cost accountant, but whichever
method is adopted must be applied consistently in order to avoid distorting costs
and profits by frequent change in the methods. In practice, store keeper may issue
the oldest stock price first (i.e. First In First Out - FIFO), the Last received stock
price first (i.e. Last In First Out - LIFO) or his price selection may be completely
at random, or may issue the stock price which are within easiest reach of the
stores.

Methods of Stock Valuation

The main methods of material pricing are:
1. FIFO – First In First Out
2. LIFO – Last In First Out
3. Simple or Weighted Average
4. Standard
5. Replacement

Q1. To illustrate the various methods pricing methods the following examples
will be used. There are various methods for pricing issues of stores. The following
is a copy of a tally card/bin card of Grace Manufacturing Company Ltd:
Particulars Date Quantity Unit Cost Total Cost
Balance b/d 1/5/05 1,000 GHc2 GHc2000
Receipts 3/5/05 4,000 GHc2.1 GHc8400
Issues 4/5/05 2,000
Receipts 9/5/05 3,000 GHc2.12 GHc6360
Issues 11/5/05 4,000
Receipts 18/5/05 1,000 GHc2.4 GHc2400
Issues 20/5/05 1,000
You are required to put a valuation on the issues of materials; and Closing stock.

40
Using FIFO, LIFO and Weighted Average methods.
FIFO Method
Receipts Issues Balance
Unit Total Unit Total Unit Total
Date Qty Cost Cost Qty Cost Cost Qty Cost Cost
GHc GHc GHc GHc GHc GHc
1/5/05 100 20 2,000 ------------------ 100 @ 20 = 2,000
3/5 400 21 8,400 ------------------ 100 @ 20 = 2,000
400 @ 21 = 8,400
4/5 ------------------ 100 @ 20 = 2,000 10,400
------------------ 100 @ 21 = 2,100 300 @ 21 = 6,300
4,100
9/5 300 21.2 6,360 ------------------ 300 @ 21 = 6,300
300 @ 21.2 =6,360
11/5 ------------------ 300 @21 = 6,300 12,660
------------------ 100 @21.2 =2,120
8,420 200 @21.2 = 4,240
18/5 100 24 2,400 ------------------ 200 @21.2 = 4,240
------------------ 100 @ 24 = 2,400
6,640
20/5 ------------------ 100 @ 2,120 = 212 100 @ 21.2 =2,120
100 @ 24 = 2,400
4,520

LIFO Method
Receipts Issues Balance
Unit Total Unit Total Unit Total
Date Qty Cost Cost Qty Cost Cost Qty Cost Cost
GHc GHc GHc GHc GHc GHc
1/5/05 100 20 2,000 ------------------ 100 @ 20 = 2,000
3/5 400 21 8,400 ------------------ 100 @ 20 = 2,000
400 @ 21 = 8,400
4/5 ------------------ 10,400
------------------ 200 @ 21 = 4,200 100 @ 20 = 2,000
200 @ 21 = 4,200
6,200
9/5 300 21.2 6,360 ------------------ 100 @ 20 = 2,000
200 @ 21 = 4,200
300 @ 21.2 =6,360
11/5 ------------------ 300 @21.2 = 6,360 12,560
------------------ 100 @21 = 2,100
8,460 100 @ 20 = 2,000
100 @ 21 = 2,100

41
 4,100
18/5 100 24 2,400 ------------------ 100 @ 20 = 2,000
------------------ 100 @ 21 = 2,100
------------------ 100 @ 24 = 2,400
6,500
20/5 ------------------ 100 @ 24 = 2,400 100 @ 20 =2,000
100 @ 21 =2,100
4,100

Weighted Av. Method

Receipts Issues Balance
Unit Total Unit Total Unit Total
Date Qty Cost Cost Qty Cost Cost Qty Cost Cost
GHc GHc GHc GHc GHc GHc
1/5/05 100 20 2,000 ------------------ 100 @ 20 = 2,000
3/5 400 21 8,400 ------------------ 100 @ 20 = 2,000
400 @ 21 = 8,400
4/5 ------------------ 100 @ 20 = 2,000 10,400
------------------ 100 @ 21 = 2,100 300 @ 21 = 6,300
4,100
9/5 300 21.2 6,360 ------------------ 300 @ 21 = 6,300
300 @ 21.2 =6,360
11/5 ------------------ 300 @21 = 6,300 12,660
------------------ 100 @21.2 =2,120
8,420 200 @21.2 = 4,240
18/5 100 24 2,400 ------------------ 200 @21.2 = 4,240
------------------ 100 @ 24 = 2,400
6,640
20/5 ------------------ 100 @ 2,120 = 212 100 @ 21.2 =2,120
100 @ 24 = 2,400
4,520

Q2. Abdulla Farouk has been in business for three months purchasing and selling
special compressor parts of automobile air conditions. The purchases and sales
have been as follows:
Year 06 Purchases Sales
November 1 40 units at GHc2/unit
12 30 units at GHc2.10/unit
26 50 units at GHG3/unit
December 1 20 units at GH2.30/unit
5 10 units at GHc2.40/unit

42
 16 24 units at GH2.50/unit
21 30 units at GHc3.60/unit
Year 07 January 3 12 units at GHc2.60/unit
15 50 units at GHc3/unit
16 70 units at GHc4/unit
You are required to calculate the gross profit for the three month’s operations
using FIFO, LIFO and Weighted Average Methods of stores pricing.

Q3. The following relate to the acquisition and issue of material – ‘Tongs’ by
Atongo Limited, a small Manufacturing Company, for the month of ended
31/3/12. Acquisitions Unit Cost Issues
Date Quantity GHc Quantity
02/03/06 1,000 3 -
05/03/06 2,000 4 -
09/03/06 - - 1,500
17/03/06 4,000 4.5 -
25/03/06 4,500
26/03/06 1,000 5 -
28/03/06 500
Note: There was no material ‘Tongs’ in stock as at 01/03/12
You are required to calculate the closing stock value of material ‘Tongs’ using
each of the following methods of pricing issues of stock to production:
i. First-in, first-out (FIFO);
ii. Last-in, first-out (LIFO);
iii. Weighted Average.

Q4. Erica Enterprise has been in business for only one month. The purchase and
sales of goods for the month ended 31/05/06 have been as follows:
Unit Cost Sales Sales
Date Purchases GHc Units Price/units (GHc)
01/05/06 4,000 2 - -
06/05/06 3,000 3.2 - -
09/05/06 5,000 4
12/05/06 2,000 3.6 - -
16/05/06 3,000 4.5
17/05/06 1,000 4.6 - -
20/05/06 2,400 4.8 - -
24/05/06 1,200 5.0 - -
28/05/06 5,000 5.2
31/05/06 7,000 5.5
You are required:

43
a) To calculate the closing stock value and gross profit for the three months
operations using each of the following methods of pricing issues of stocks for
sales:
i. First-in, first-out (FIFO);
ii. Last-in, first-out (LIFO);
iii. Weighted Average; and
b) In addition, comment on the effects upon costs of sales, stock values and
profits when using each of these methods of pricing issues from stores.

Q5. Adjei Mensah Enterprise has been in business for three months purchasing
and selling special compressor parts for automobile air conditions. The purchases
and sales have been as follows:
Year 06 Purchases Sales
November 1 4,000 units at GH¢2/unit
12 3,000 units at GH¢2.50/unit
26 5,000 @GH¢3/unit
December 1 2,000 units at GH¢3/unit
5 1,000 units at GH¢3.5/unit
16 2,400 units at GH¢4/unit
21 3,000 @ GH¢4.5/unit
Year 07: Jan. 3 1,200 units at GH¢4.5/unit
15 5,000 units at GH¢5/unit
27 7,000 @ GH¢6/unit
You are required to calculate the gross profit for the three month’s operations
using FIFO, Weighted and LIFO Methods of stores pricing.

Q6. California Ltd purchases and sales of mobile phones for the six months ended
31 December, 2011 were as shown below:
Purchases Sales
Date of Quantity Unit Quantity Unit
Receipt (Phones) price (GHc) (Phones) price (GHc)
July 2,000 10 1,500 14
August 1,500 12 1,800 15
September 2,500 13 1,600 16
October 2,000 14 2,100 17
November 2,500 15 1,700 18
December 3,000 16 2,800 20
You are required to:
a) Calculate the total value of material issues during the six month period and
the value of the closing stock at the end of December 2011 using LIFO
method

44
 b) Show the trading account for the period ended 31 December, 2011 under
the LIFO methods.

Features of FIFO Methods

Using this method, issues are priced at the oldest batch in stock until all units of
the batch have been issued then the price of the next oldest is used and so on.
 It is an actual cost system
 It is a good representation of sound storekeeping practice.
 Because it is actual cost system unrealised profits or losses do not arise
 The closing stock valuation is based on the more recently acquired
materials price and therefore more close to current market values.
 It is an acceptable system to the Inland Revenue and is in accordance to
Statement of Standard Accounting Practice (SSAP) 9 which deals with
Valuation of stocks/WIP. (What does IFRS say?)
 Product cost, being based on the oldest materials prices lag behind current
conditions. Hence in periods of rising prices (inflation) product costs are
understated and profits overstated and the opposite is true.
 The need to keep track of each batch makes the system is administratively
clumsy.
 Lack of uniformity in issue price makes cost comparison difficult between
jobs

Features of LIFO Methods

Using this method, issues are charged out at the price of the most recent batch
received and continue to be charged until a new batch is received.
 It is an actual cost system
 Product costs will tend to be based on fairly closely on current market
prices and therefore more realistic.
 In periods of rising prices LIFO tends to understated profits by overstating
product cost and the opposite is true.
 Renders cost comparison between jobs difficult
 It is generally not acceptable system to the inland revenue as well not
recommended by SSAP 9 (Valuation of stocks and WIP)
 Stocks are valued at the oldest prices
 The system is administratively cumbersome

Features of Average Price Methods (Weighted)

This method is a perpetual weighted average system where the issue price is
recalculated after each receipt taking into accounts both quantities and money
value.
 It is less complicated to administer than LIFO and FIFO.

45
  Although realistic, it is not an actual purchases price except by
coincidence.
 It acceptable to Inland Revenue and is one of the methods recommended
by SSAP 9.
 Its effects on product costs and stock valuation is somewhere between that
of LIFO and FIFO systems.
 It makes cost comparison between jobs, using similar materials somewhat
easier.
 It tends to provide more satisfactory results than LIFO and FIFO systems,
where purchases price keeps fluctuating.
 Because it is based on actual cost, no unrealised profits or losses occur

Labour Cost Accounting

By labour we refer to the human effort used in production. By definition, labour is
all the mental and physical effort needed for production to take place. Typical
examples of labour force required for production to take place are: shop floor
operatives, cleaners’ accountants, production engineers, etc.

Types of Labour
Labour for cost accounting purpose may be categorised into two groups namely,
direct labour and indirect labour. Direct labour refers to all mental and physical
effort used directly on the cost unit or item being produced. For example the work
of a machine operator (lathe operator) in a wood company. Indirect labour on the
other hand refers to all efforts that does not relate directly to the cost unit or item
being produced. For example the general purpose cleaners or gardeners.

Labour cost accounting can be looked at in two main categories namely:

1. Labour Costing – This is concerned with identifying the amount of labour
cost to be charged to individual jobs and overhead accounts
2. Payroll Accounting – This is concerned with recording the amount due to
employees, the Inland Revenue or Pension Funds etc. for labour services
or efforts in production processes.

Labour Cost Ascertainment

The labour costs are the charged to each of these activities. Hence, job cards, time
sheets, route cards, idle time cards are few of the source documents for analysing
productive labour cost to various job and overheads accounts. For non-productive
workforce such as supervisor and all general labourers, it may not be possible to
analyse the amount of time spent on various activities. In this respect, the labour
cost for these workers are generally obtained from their personal record cards and
charged to general factory overheads accounts as supervision and indirect labour

46
expenses. These costs are then allocated to products using the 3As procedures (i.e.
overheads allocation, apportionment, absorption).

Common Means for Tracking Hours Worked by Employees

The main object of labour cost accounting is to record the time spent by all
productive and non-productive workers on each activity on a separate job card or
time sheet and then to apply the appropriate hourly rate:

Daily Time Sheets

These are usually filled by the employee to indicate time spent on each job and
passed to the costing office each day. The total time on the time sheet should
correspond to time shown on the attendance record. Because times are recorded
daily there is less risk of time being forgotten or manipulated. However, they do
happen in some instances due to oversight or volume of paper work.

Weekly Time Sheets

These are similar to daily time sheets except that they are passed to the costing
office at the end of the week, though entries are made daily in order to avoid
error. Paper work is drastically reduced and therefore weekly cards are
particularly suitable where there are few job changes in a week.

Job Cards
Here cards are prepared for each job on which is recorded the time spent on the
job by each employee. Job cards also carry instructions to the operator on how the
job is to be carried out. Job cards lend themselves to mechanical accounting
systems and thereby reducing the amount of writing to be done by the employee
and possibility of errors.

Route Cards
These are similar to the job cards except that they follow the product or service
through the works and carry details of all operations to be carried out. They thus
carry the cost of all operations to be carried out on a job and are very useful for
control purposes.

Idle Time Cards

If a productive worker is unoccupied for short period because of a machine
breakdown, a stoppage because there is no work available or because the worker
is waiting to start a new job, an idle time card will be used to record the amount of
idle or waiting time incurred, the causes and reasons for the idle time and the
employee(s) involved

47
Payroll Accounting
The area of payroll accounting involves calculating the earnings of employees and
the related withholdings for tax and other deductions. Thus payroll accounting
requires the provision of certain information relating to employee’s attendance
time, details of absenteeism, overtime, bonus schemes hourly rate of pay, and
details of prevailing tax laws as well as other deductions such as national
insurance, salary advances etc.

Labour Remuneration
There are several methods of calculating the wages and salaries of employees.
The wages and salaries of workers together with other incentives are called
remuneration. The three broad systems for remunerating labour are time rate,
piece rate and, premium bonus system

Time Rate
Time rate system have fixed guaranteed rate for each day. It is often called day
rate system. Nevertheless, it could relate to hours instead of the day. Thus a
typical day may consist of 8 hours of work. Remuneration may accordingly be
expressed as rate per hour or rate per day. Work done beyond the usual or
stipulated hours is called overtime, which attracts more pay than the normal daily
or hourly rate. For example if the basic day rate of Mr. B is GHc5 per hour and
his schedule demands that he works 8 hours a day for five days in a week.
Calculate his weekly wage.

Wages = hours worked x rate per hour = 8hrs x GHc5 x 5days = GHc200

Piece Rate
Piece rate is directly related to output produced. Every unit produced attracts a
fixed rate of pay. Employee’s remuneration is therefore based on number of units
produced. For example, if A. produces 200 units and B. produces 300 units and
the piece rate is GHc4 per unit, then A receives GHc800 and B also receives
GHc120 as remuneration respectively. This is sometimes referred to the
Piecework system. In this case, the earnings of employees are ascertained by
multiplying the agreed rate per piece by the number units produced.

Exceptions: However, usually there is a guaranteed minimum wage, so that in an

event where an employee’s output falls below the minimum wages he/she will be
paid the guaranteed minimum wage rather than the piecework rate for that period.
For example Mr. Acquah is paid on the basic of GHc0.24 per piece with a GHc4
per hour guaranteed minimum wage rate and he works 40 hours during the week.

48
Assuming in a particular week his output was only 600 units. Calculate his wage
for the week.

Solution: Guaranteed minimum wage = 40 hours x GHc4 = GHc160

Piecework rate = GHc.24 x 600 units = GHc144
As it were, GHc160 will be acceptable weekly wage for Mr. Acquah but the
GHc16 difference will charged against overheads

Premium Bonus Scheme

Premium bonus scheme are schemes based on either time rate or piece rate but
with added incentive based on above average performance. One method is to pay
a guaranteed day rate together with the rate for one–half the time saved to do the
work for the period. The time saved could be used for further production activities
thereby increasing the output for the period and so labour must be rewarded
accordingly. For instance, where bonus scheme is in operation total payment will
be based on the attendance time (time rate) plus a bonus. Under a bonus scheme a
set time is allowed for each job and a bonus is paid based on the proportion of
time which is saved. For example the time allowed for a specific operation is 20
hours and the actual time taken by an employee was 16 hours, a bonus system is
in operation where employees receive a bonus of 50% of the time saved. The
hourly wage rate is GHc5 per hour. Calculate the wage of such employee.

Solution GHc
Normal time rate 16hrs x GHc5 = 80
Bonus payment ½ x 4hrs x GHc5 = 10
90

Incentive Schemes
They are systems deliberately put in place to entice or motivate workers to give
out their best so as to achieve company targets of increased productivity or
reducing cost per unit etc. Any wage incentive scheme set must be in such a
manner that both organisation and workers will benefit. Thus to the organisation,
the incentive must increase productivity and thereby reduce cost per unit
produced and to the employee to increase average earnings.

Factors to Consider when Establishing Incentive Schemes

1. There should be adequate participation of employers and employees in
setting the schemes.
2. The scheme should relate to the output of workers (individually or group)
3. The cost of operating a scheme should not exceed the benefit to be derived
from it.

49
 4. The scheme selected should be such that it should increased productivity,
reduce cost per unit and increase workers earnings.
5. There should be a guaranteed day wage to cushion workers in exceptional
situations.
6. Incentives must be adequate enough to stimulate workers interest or boost
their morale.
7. Both employees and employers must agree on the basis for revision of the
scheme
For instance a worker is paid GHc3 per hour and in an hour produce 10 units. To
stimulate productivity an incentive scheme is introduced where workers are paid
GHc0.25 per unit produced. Assuming, this results in an increase in production to
14 units in an hour by the worker. Calculate the effects on unit cost and wages.

Solution. Before Scheme After Scheme

Labour cost/unit GHc0.30 GHc0.25
Number unit/hour 10 14
Wages per hour GHc3 GHc3.5
It is clear from the above that whereas unit cost falls from GH¢0.30 to GHc0.25
productivity and wages increases accordingly (i.e. 10units – 14units and GHc3 –
GHc3.5 respectively).

Overtime
Overtime refers to hours of work done over and above the normal working hours
and usually paid at a premium rate (or attracts a higher rate). Hours of overtime
are usually worked at a premium rate. Thus if the basic day rate is GHc2 per hour
and overtime is paid time–and-quarter. How much would 8 hours of overtime
cost?

Solution: Overtime pay = 8 hours x GHc2 x 1.25 = GHc20

Or Overtime pay = 1.25 x 8 hours x GHc2 = GHc20

Similarly, consider a situation where an employee is paid time and a half for
weekly hours worked in excess of 40 hours. Assuming that the employee works
50 hours for which 10 hours of overtime was spent on job XYZ. The hourly rate
is GHc5. Calculate the employee’s weekly wage.
GHc
Solution: Normal time rate 40hrs x GHc5 = 200
Overtime premium 10hrs x GHc7.5 = 75
275
Alternatively
Normal time rate 40hrs x GHc5 = 200

50
Overtime premium 1½ x 10hrs x GHc5 = 25
275
Advantages of Piece Rate
1. It is based on output so encourages increased output
2. It tends to attract high calibre of workers
3. It ensures fairness by tying wages up with productivity,
4. It also ensures that inefficient workers are paid less
5. Hardworking staffs can double their earnings under piecework system
6. It requires little administrative work as it computations are based on units
produced

Disadvantages of Piece Rate

1. Shoddy goods are bound to be produced
2. Close supervision has to be given to ensure quality work schedule
3. It weakens trade union or labour unions and therefore may oppose it
4. It may create jealousies, greed, acrimony, pettiness among workers.
5. Speeding on the part of workers may lead to accidents, waste of materials
and cause undue wear and tear.

Advantages of Premium Bonus

1. They are easy to compute and administer
2. It reduces administrative and clerical cost as it is usually worked to affect
groups
3. It maintains and promotes team work and spirit especially where work is
done in a process
4. Inefficient staffs are assisted to increase their output

Disadvantages of Premium Bonus:

1. Difficult to identify inefficient staffs
2. Hard working labourers are not compensated accordingly as the same
scheme is used to reward both efficient and inefficient staffs
3. Individual motivation to increase output may dwindle drastically

Advantages of Time Rate:

1. They are easy to compute and administer
2. It provides at least a guaranteed minimum wage for employees
3. It require little administrative efforts
4. Workers who put in extra efforts can earn extra income in the form of
overtime
5. Workers can easily determine their earnings in advance.

51
 6. Organisations can accurately forecast future wage bills and plan
effectively

Disadvantages of Time rate

1. Cannot measure or do not tell individual contributions or productivity per
hour
2. Not fair as both efficient and inefficient workers are treated in the same
manner.
3. Costing of product is more cumbersome
4. Requires lot and lots of supervision and therefore very expensive to apply.

Advantages of Overtime
1. Meet orders on time
2. Boosting workers morale because of premium rate
3. Foster sales and profit
4. Reduces fixed cost due to increased output

Disadvantages of Overtime:
1. Increased labour cost
2. Promote lackadaisical attitude
3. Deliberate waste of time

Calculation of Wages and Remuneration – Payroll Format

Employee Name: Salary for Month Ending:
Department: Worker’s Position/Grade/Designation:
Bank Account Number: Staff Number:
Earnings: GHc GHc
Basic Pay/Salary (i.e. Hrs x rate) xxx
Overtime xx
Rent Allowance (i.e. 5% of Basic) xx
Canteen Allowance (if any) xx
Transport Allowance (if any) xx
Bonus/production incentive Allowance (if any) xx
Gross Salary xxx
Less Deduction:
Social Security Fund (SSF) xx
Trade Union dues (if any) xx
Staff welfare Fund (if any) xx
Canteen Allowance (if any) xx
Salary Advance/Loans (if any) xx
Others xx

52
Income tax (if any) xx
Total Deductions xxx
Net pay xxx
Other Format
Basic Allowance Gross Deduction Total
Net
Name Pay Rent Canteen Bonus Salary SSF Dues S/Adv Tax Dedn
Pay

Q1. Seed of Jews has five workers in its production department. Details of
production during the month of March 2012 are as follows:
Employees Units produced
Debora 475
Ruth 450
Naomi 360
Esther 315
Dorcas 470
The following additional information is also relevant
The guaranteed hourly minimum rate for all employees is GHc4.5; All work is
done on job request basis. The normal work week is 40 hours. All employees
contribute 5% to social security; Naomi and Esther belong to a Social Club for
which monthly dues of GHc5 are paid. Wages are paid on piecework basis at
GHc0.5 per unit subject to the guaranteed minimum wage. All employees worked
full 40 hours per week except Deborah who worked 50 hours and overtime is paid
time and a half. Income tax is also paid as follows: First GHc100 - Free; Next
GHc150 - 7½%; Next GHc250 - 12½%; and 15% thereafter. You are required to
prepare a payroll showing gross earning, total deductions and net earnings of the
above employees.

Q2. A, B, C, and D are workers of Kofi Asante Company Ltd, who produced the
following units 490, 520, 1,200, and 2,000 respectively in a particular week. They
are paid based on the following terms and conditions:
Units Rate/GHc
1 – 500 15
501 - 1,000 20
1,001 - 1,500 30
1,501 - 2,000 45
You are required to calculate the basic earnings of the above employees.

53
Q3. Asante Brothers Ltd employs four men in its cleaning department. They are
required to work on request basis. During the month of August 2011, a full 40
hour week productivity of each labourer was as follows:
Employee Min. Rate/Hr (GHc) Tons
Joy 3.8 206
Peace 4.0 184
Grace 4.4 295
Faith 4.6 250
Love 5.0 247
Wages are paid on a piecework basis at GHc0.68 per ton cleared subject to
guaranteed hourly minimum rate. You are required to calculate the acceptable
basic earnings to each employee and indicate its treatment in costing viewpoint.

Q4. The following relates to three employees of ABC Ltd

Name Time Allowed Time Taken Rate/Hour (GH¢)
Q 40 32 4
R 40 24 4
S 40 28 4
It is the policy of ABC Ltd to pay 50% of time saved as productive incentive to its
workers. You are required to:
a) Calculate the Gross Earnings of the above employees
b) Assuming ABC Ltd pays one third of time saved as an incentive what will
be the workers gross earnings
c) Assuming ABC Ltd decide to pay all time saved as an incentive at 75% of
normal hourly wage rate what will be the workers gross earnings

Workings: Gross Earnings = Basic Earnings + Bonus/incentives

(Hours Worked x Rate/hour) + ½ (time saved) x normal wage rate
Or ½ (normal wage rate) all time saved

Q5. A company pays GHc25 per hour for its employees who work eight hours
daily. Due to the growing demand for its products the workers in the Parking and
Distribution Sections were asked to work above the normal working hours which
attract overtime premium based on the following terms. The overtime payment for
Distribution is based on time and half and that of Parking based on time and
quarter. Below are the data on hours worked by the sections:
Sections Normal Hrs Actual Hrs Rate/Hour
Parking 80 132 GHc10
Distribution 80 116 GHc15

54
 You are required to calculate the Overtime payable to each Section, gross
earnings payable to each section and total wage bill of the company for the
period.

Q6. Mentors Company Ltd employs four workers and pays them GHc8 per hour.
Details of hours worked during a month are as follows:
Employee Hours worked
Sampson 160
Thomas 200
John 140
Barnabas 180
The expected monthly working period is 160 hours per worker and any overtime
is paid at time and half. In addition each worker receives a taxable rent allowance
of 20% of total hourly wages. All workers contribute 5% of total earnings to
social security and 5% to annual bonus scheme instituted by the workers union.
Income tax rates are: first GHc200 is tax free; the next GHc200 71/2% and the
remainder 15%. You are required to prepare a payroll for Mentors Company Ltd
showing all the necessary workings.
Mentors Company Ltd Payroll for The Month

Hours Rate/ Basic ALLOWANCE Gross Taxable DEDUCTIONS INVOLVED

Name Worked Hour Wage OT Rent Earnings Earnings SSF A/Bonus Tax

Sampson 160 8 1,280 0 256 1,536 1,459.2 76.8 76.8 173.8

Thomas 200 8 1,280 400 320 2,000 1,900 100 100 240

John 140 8 1,120 0 224 1,344 1,276.8 67.2 67.2 146.5

Barnabas 180 8 1,280 200 288 1,768 1,679.6 88.4 88.4 206.9

Total 680 4,960 600 1,088 6,648 6,315.6 332.4 332.4 767.3

COMPUTATION OF INCOME TAX

Sampson Thomas John Barnabas
1,459.2 1,900 1,276.8 1,679.6
200 200 200 200
1,259.2 1,700 0.075 1,076.8 1,479.6
200 0.075 15 200 0.15 15 200 0.075 15 200
55
1,059.2 0.15 158.88 1,500 225 876.8 0.15 131.52 1,279.6 0.0
173.88 240 146.52 0.

Q7. Assuming the basic day rate of Mr. BB, Mr. Say, and Mr. Lee is GHc3 per
hour and overtime rates are time and half for evenings and double time for
weekends. The following details have been recorded for the three workers:
Details Mr. BB Mr. Say Mr. Lee
Clock Hours Clock Hours Clock Hours
Normal time 480 220 150
Evening time 102 60 80
Weekend 10 30 16
592 310 240
You are required to calculate the cost chargeable to each of the jobs in the
following circumstances:
a) Where OT is worked occasionally to meet production requirements.
b) Where OT is worked at the customer’s request to bring forward lead time.
a) Mr. BB Mr. Say Mr. Lee
Wages cost GHc GHc GHc
592hrs x GHc3 1,776 (310hrs x GHc3) 930 (246hrs x GHc3) 738

b) Mr. BB Mr. Say Mr. Lee

Wages cost GHc GHc GHc
Normal time 1,440 660 450
Evening time 459 270 360
Weekends 60 180 96
1,959 1,110 906

Q7. Staff of K. K. Eyiah Ltd. presents the following information which relates to
a week work for 3 of its employees.
Details Amado Buganda Cassidy
Work issued (units) 400 600 120
Time allowed (hours /unit) 0.2 0.1 0.4
The basic working week is 40 hours. The first 6 hours overtime are paid at time
and a half and the next 10 hours at time plus three quarters. Hours worked by
Amadu, Busanga, and Cassidy were: 52 hours, 45 hours and 40 hours
respectively. Cassidy spent 8 hours on indirect work these hours being included in
the 40hours worked by him. The three employees basic hourly rate of pay were as
follows Amadu GHc3, Busanga GHc4 and Cassidy GHc2.5. Bonus is paid at one
half (½) of the basic rate for all time saved. From the above information, you are
required to present in a tabulated form for each employee:
56
  Number of bonus hours; Basic wages including overtime
 Amount of bonus earned; Gross income

Solution Amado Buganda Cassidy

Bonus hours N.1 28hrs 15hrs 16hrs
GHc GHc GHc
Basic Wages +Overtime N.2 178.5 190 100
Bonus Earned N.3 42.0 30 20
Gross Income for period 220.5 220 120

Note1. Amado Buganda Cassidy

Expected hours (0.2 x 400) 80hrs (0.1 x 600) 60hrs (0.4 x120) 48hrs
Less Actual hrs 52hrs 45hrs 32hrs
Time Saved 28hrs 15hrs 16hrs

Note2. GHc GHc GHc

Basic wage (40 x GHc3) 120 160 100
Overtime 12hrs:
6hrs x GHc4.5 27 (5 x GHc6) 30
6hrs x GHc5.25 31.5 0 0
178.5 190 100

Note3. ½ x GHc3 x 28hrs 42

½ xGHc4 x 15hrs 30
½ x GHc2.50 x 16hrs 20

The overtime paid to factory workers is usually considered to be part of

production overhead and part direct labour cost

For example a forklift operator in Sainsbury Ltd earns $24 per hour. If the
operator is paid for a normal 40-hour workweek but is idle for 3 hours during a
given week due to machine breakdowns, what would be the appropriate direct
labour cost to Sunbury Ltd? Answer direct labour cost is $888 and indirect
labour cost is $72.

A forklift operator in a plant earns £24 per hour. If the operator is paid time three
quarters for overtime (time in excess of 40 hours a week). During a given week,
the operator works 45 hours and has no idle time. What would be the appropriate
direct labour cost to the plant? Answer direct labour cost is £1080 and
manufacturing overhead to the plant is $90.

57
Christy Amoah is employed by a White Company where she writes executive
reports for the CEO’s Board meetings. Christy is paid £36 per hour for regular
time, and she is paid time and half for all work in excess of 40 hours per week.
Required
i. Assume that during a given week Christy is idle for two hours due to
power cuts and idle for four more hours due to material shortages. No
overtime is recorded for the week determine Christy’s wages for the week
analysed into direct labour cost and manufacturing overhead cost.
ii. Assume that during a following week Christy works a total of 50 hours.
She has no idle time for the week. Assign Christy’s wages for the week
between direct labour cost and production overhead cost.

Solution £
i. Direct labour (34 hours x £36 per hour) 1.224
Production overhead (idle time: 6 hours x £36 per hour) 216
Total wages for a week 1,440

Solution £
ii. Direct labour (50 hours x £36 per hour) 1.800
Production overhead (OT premium: 10 hours x £18 per hour) 180
Total wages for a week 1,980

Accounting for Overhead

Assigning the cost of direct material and direct labour to products poses no
particular challenge. The reason being that, material and labour costs can be
attributed to products using direct racing approach. Overhead costs, on the other
hand, pose a different problem. Fact is that, the physically observable input –
output relationship that prevails between direct materials, direct labour, and
products is simply not available when it comes to assigning overhead. This has
become one major problem for business organisations, thus how to effectively
deal with those costs incurred but are not directly attributable to the products or
services dealt in by the organisation. Therefore, assignment of overhead to
products relies on certain bases and perhaps direct allocation. Examples of costs
which cannot be easily attributable to particular output are:
1. manufacturing overheads may include depreciation and insurance of plant
and machinery, rent and rates, repairs and maintenance, lubricants
detergents etc;
2. Administrative overheads, these may include depreciation and insurance
of office equipment, lighting and heating, salaries of administrative staff
etc;
58
 3. Selling and distribution overheads may include the cost of advertising,
warehouse premises insurance, depreciation on delivery vans, salesman’s
commission etc.
The common feature of these types of costs is that, they usually accrue on time
basis hence, annual rent or depreciation charge is greater than six months charge
and this is different from the cost elements in prime costs as they accrue with
regard to the level of activity or output.
Overhead Allocation
Overhead allocation is the allotment in whole, an indirect expense to a single cost
centre or cost unit. It is applied where the incurrence of an indirect cost can be
traced to a particular cost centre or where a cost centre become the sole
beneficiary of such an indirect cost. This is done without splitting or further
splitting the cost to be allocated. As overheads are incurred, they are initially
allocated to an appropriate cost centre such as production, administration, and
services departments. In other words, if overheads have arisen solely because of a
particular cost centre, then such an overhead must be allocated to that cost centre
without distribution. For example the salary of a supervisor responsible for a
single department must be allocated to that department only. However, the salary
of a supervisor responsible for two or more departments must not be allocated to
one department rather must be apportioned accordingly using an appropriate
basis.
Overhead Apportionment
Overhead apportionment is simply the spreading of indirect expenses to two or
more cost centres or departments. Thus, where overhead costs cannot be allocated
to a particular cost centre because of they have been incurred on two or more
departments, then there must be equitable bases for splitting or distributing among
all the departments involved. Overhead apportionment is therefore, the charging
of overheads costs to various cost centres that has duly benefited from such an
expense. It can be said that apportionment is the next step after overhead
allocation. Overhead apportionment is also the process by which indirect costs
originally assigned to service departments are aggregated and eventually charged
to the production departments.
Overhead Absorption
Fact is that, the ultimate goal of accounting for overheads is to determine how
overheads costs must be assigned or absorbed into the cost units or finished
products or jobs or service in order to ascertain the true cost of production.
Overhead absorption, simply put, is the charging, spreading, or sharing of the total
departmental or factory overheads among the total units produced over a period.
As the final stage, overheads are charged to products using predetermined
overhead rate based on an appropriate unit level basis. Unit level bases available
for sharing overheads among cost units include direct labour hours, machine

59
hours, unit produced, direct labour percentage, direct material percentage and
prime cost percentage.

Predetermined Overhead Rate

This is calculated at the beginning of the period using the following formula:
Overhead Rate = Budgeted Annual Overhead/Appropriate Unit Level Basis
Predetermined rates are used because overhead costs and production often are
incurred non uniformly throughout the period, and it is not possible to wait until
the end of the year to compute the actual rate (as management may require unit
product cost information throughout the year for planning, control and decision
making).
Blanket/Plantwide Rates
For plantwide rates, all budgeted overhead costs are assigned to the entire
plantwide cost pool and this is divided by a single unit level basis which may be
direct labour hours or machine hours. Finally, overhead costs are charged to
products by multiplying the rate by actual labour/machine hours used by each
product.
Department Rates
For plantwide rates, overhead costs are assigned to individual production
departments, creating separate departmental overhead cost pools. Once overhead
costs are assigned to individual production departments, then appropriate unit
level basis such labour hours (for labour-intensive departments) and machine
hours (for machine or capital-intensive departments) are used to calculate
predetermined overhead rates for each department. Products passing through the
department are assumed to consume overhead facilities in proportion to the
departments’ unit-based drivers.
Bases of Apportionment
It is considered important that overhead cost should be shared out on a fair basis.
Due to the complexity of items of costs it is really possible to use only method of
apportioning overhead costs to various departments.

The bases of apportionment for most usual case are stated below:
Overhead Item Basis of Apportionment.
1. Rent and rates floor area of department
2. Heating and lighting floor area of department
3. Heating volume of space occupied
4. Lighting floor area occupied
5. Insurance of buildings floor area of department
6. Insurance of stock value of stock
7. Depreciation of machine/equipment cost/book value of machine
8. Depreciation of building floor area of department

60
9. Supervision no. of staff/working hours/floor area
10. Power horse power/machine hours
11. Maintenance maintenance hours/ wages paid
12. Canteen cost no. of employees
13. Personnel Office/Welfare Service no. of employees/labour hours
14. Material Handling/Store Keeping no. of requisitions/weight/values of
materials.

Q1. As an illustration, let’s consider the following data extracted from the books
of Fire Works Ltd.: GHc
Depreciation of factory 1,000
Factory repairs and maintenance 600
Factory office costs (treated as production overheads) 1,500
Depreciation of Equipment 800
Insurance of Equipment 200
Heating 390
Lighting 100
Canteen 900
5,490
Information relating to the production and service department in the factory is
follows:
Details Production Departments Service Departments
A B X Y
Floor Area (sq. met.) 12 16 8 4
Volume (cubic cm3) 30 60 24 16
Number of employees 30 30 15 15
Bk value of equipment GHc3,000 GHc2,000 GHc1,000 GHc2,000

Solution: Fire Works Ltd. Overheads Analysis Sheet

Basis of Total Production Service
Item of Cost Apportionment Costs A B X Y
GHc GHc GHc GHc GHc
Depr. of factory Floor area 1,000 300 400 200 100
Factory repairs Floor area 600 180 240 120 60
Factory office No. employees 1,500 500 500 250 250
Depr. of equip.Bk value 800 300 200 100 200
Insurance Bk value 200 75 50 25 50
Heating Volume 390 90 180 72 48
Lighting Floor area 100 30 40 20 10
Canteen No. of employees 900 300 300 150 150
5,490 1,775 1,910 937 868

61
Q2. Turndown Ltd has established the following budgeted fixed overheads for the
forthcoming year:
GHC
Indirect Materials 34,590
Indirect employees’ wages 56,460
Rent, rates light and heating 31,640
Welfare costs 74,400
Power 37,980
Supervision 62,550
Maintenance cost 7,516
Depreciation and insurance 18,750
Details of various characteristics of the cost centres are as follows:
Production Departments Service
Department Dept A Dept B Maintenance
Indirect Materials (GHC) 9,224 18,448 6,918
Indirect Labour (GHC) 15,056 30,112 11,292
Machine running hours 22,500 47,500 -
Labour Hour 27,500 42,500 -
Total employees 18 27 9
Kilowatt hour 12,000 32,000 4,000
Floor space (sq m) 4,000 5,000 1,000
Cost of Machines (GHC) 25,000 35,000 15,000
The maintenance department split its time between production department A and
B in the ratio of 2:3. You are required to calculate the:
i. Machine hour rates for the production departments.
ii. Labour hour rates for the production departments.

SUGGESTED SOLUTION.
First and foremost we need to allocate and apportion the overheads to product
cost centres as follows:
Basis of Total Production Production Maint
Cost items app’t Cost Dept A Dept B Unit
GHC GHC GHC GHC
Ind Mat Specifically 34,590 9,224 18,448 6,918
Ind Wages Specifically 56,460 15,056 30,112 11,292
Rent rates.
Light, & heat Floor space 31,640 12,656 15,820 3,164
Welfare costs Employees 74,400 24,800 37,200 12,400
Power kilowatt hrs 37,980 9,495 25,320 3,165
Supervision Employees 62,550 20,850 31,275 10,425

62
Maint. Cost Specifically 7,516 - - 7,516
Dep’n & ins. book value 18,750 6,250 8,750 3,750
323,886 86,675 166,925 58,630
Maint. Specified 2:3 - 23,452 35,178 (58,630)
323,886 110,127 202,103 -
Note: the maintenance overhead was reapportioned to the production cost centres
first because it renders services to the two departments.
Calculation of the Overhead Absorption Rate:
Using the Machine hours: Production Dept A Production Dept B
Budgeted Machine running hours 22,500 47,500
Machine hour OAR = GHC110,127/22,500 hrs; GHC202,103,000/47,500 hrs
GHC4.89/Mach hr GHC4.25/Mach hr

Using the Labour hours: Production Dept A Production Dept B

Budgeted Labour Hour 27,500 42,500
Labour hour OAR = GHC110,127/27,500 hrs; GHC202,103/42,500 hrs
GHC4.00/Lab hr GHC4.75/Lab hr

Q3. Abinga Ltd. has three production departments A, B, C and one service
department D. the cost budgeted for the year ending 31/12/05 are as follows:
GHc
Factory rent 10,000
Plant repairs 6,000
Property rates 2,000
Plant depreciation 12,000
Insurance of buildings 16,800
Power 7,750
Supervision 24,000
Indirect wages: A - GHc6,000; B – GHc4,000; C - GHc3,000; D - GHc2,000
Department D serves production departments in the following proportions;
departments A 50%, B 30%, and C 20%. The production capacities for the year
ending 31/12/05 are budgeted as follows: departments A - 10,000 machine hours;
B - 20,000 machine hours; and C - 20,000 direct labour hours. The following
additional information is also available:
Details Production Departments Service
Department A B C D
Floor Area (sq. feet) 150 110 90 50
Value of plant (GHc) 2,400 2,000 1,000 600
Aggregate Horse Power 144 256 124 96

Solution: Abinga Ltd. Overheads Analysis Sheet

63
 Basis of Total Production Service
Item of Cost Apportionment Costs A B C D
GHc GHc GHc GHc GHc
Wages Allocated 15,000 6,000 4,000 3,000 2,000
Factory rent Floor area 10,000 3,750 2,750 2,250 1,250
Plant repairs Value of plant 6,000 2,400 2,000 1,000 600
Property rates Floor area 2,000 750 550 450 250
Power Horse power 7,750 1,800 3,200 1,550 1,200
Insurance Floor area 16,800 6,300 4,620 3,780 2,100
Plant Depr. Value of plant 12,000 4,800 4,000 2,000 1,200
Supervision Floor area 24,000 9,000 6,600 5,400 3,000
153,550 34,800 27,720 19,430 11,600
Re-distribution Serv, Dept. 11,600 5,800 3,480 2,320 (11,600)
165,150 40,600 31,200 21,750 -
Overhead Cost recovery = Total Overhead Cost/Recommended Unit Level base
(i.e. Machine Hours, Direct Labour Hours, Labour %, etc)
Given Machine Hours and Direct Labour Hours in this question:
Dept. A -- OAR = 40,600/10,000 = GHc4.06 / Machine Hour
Dept. B -- OAR = 31,200/20,000 = GHc1.56 / Machine Hour
Dept. C -- OAR = 21,750/20,000 = GHc1.0875 / D/Labour Hour

Q4. Below is the budgeted overhead for a month together with relevant data
relating to cost centres of Nelson Ltd. Nelson has four cost centres all of which
are fully equipped with machines. You are required to apportion each of the costs
given to the four cost centres on a suitable basis and calculate their respective
recovery rate using machine running hours.

Budgeted Overhead GHc

Supervision 7,525
Indirect workers wages 6,000
Holiday pay and National Insurance 6,200
Factory building repairs 10,571
Machine maintenance labour cost 4,500
Power 1,944
Insurance of machinery 2,775
Insurance of building 2,250
Rent and rates 2,500
Depreciation of machinery 9,250
The following additional information relating to the cost centres is also available:
Machine Rooms A B C D
Floor Space (sq ft) 180 150 80 90

64
Kilowatt Hours 2,700 660 850 650
Cost of Machines (GHc) 30,000 20,000 8,000 16,000
Indirect Workers 3 3 1 1
Total Employees 19 24 12 7
Machine Maintenance Hours 3,000 2,000 3,000 1,000
Machine Running Hours 30,000 36,000 19,000 8,000

Solution: Nelson Ltd. Overheads Analysis Sheet

Basis of Total Production Departments
Item of Cost Apportionment Costs A B C D
GHc GHc GHc GHc GHc
Supervision T/Employees 7,525 2,306 2,913 1,456 850
Indirect wages I/Workers 6,000 2,250 2,250 750 750
H/pay & NI T/Employees 6,200 1,900 2,400 1,200 700
Building repairs Floor Space 10,571 3,806 3,171 1,691 1,903
Maint. Cost M/Hours 4,500 1,500 1,000 1,500 500
Power Kilowatt Hrs 1,944 1,080 264 340 260
Insurance Mach Bk Value 2,775 1,125 750 300 600
R/Rates Floor Space 2,500 900 750 400 450
Depreciation Bk Value 9,250 3,750 2,500 1,000 2,000
51,265 18,617 13,998 8,637 8,013
Given machine running hours in the question:
Dept. A -- OAR = GHc18,617/30,000 = GHc0.62 / Machine hour
Dept. B -- OAR = GHc13,998/36,000 = GHc0.388 / Machine hour
Dept. C -- OAR = GH¢8,637/19,000 = GHc0.454 / Machine hour
Dept. D -- OAR = GH¢8,013/8,000 = GHc1.00 / Machine hour

Q5. A factory uses two types of machine shops in its production department. The budget
for the production department for the year ending 30/6/12 includes the following
overheads:
Machine Shop power and lighting: GHc
Cutting 20,000
Fabricating 15,000
Maintenance:
Cutting 14,000
Fabricating 16,000
Consumable spare parts:
Cutting 65,000
Fabricating 45,000
Depreciation of Machinery 200,000
Depreciation of Buildings occupied by Machine Shops 180,000
Insurance of Machinery 400,000
Rent and Rates 360,000
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Supervisors’ salaries 250,000
Additional information on the shops is also available as follows:
Machine Cost of Area Working Machine Labour
Shops Machine (GHc) Occupied Hours H/Power Hours
Cutting 800,000 1,000sq metres 30,000 75,000kw 20,000
Fabricating 1,200,000 2,000sq metres 20,000 65,000kw 15,000
You are required to write up the overhead analysis sheet and calculate the machine-hour
rate for each of the machine shops showing the basis of apportionment.

Solution: Overheads Analysis Sheet

Basis of Total Production Depts
Item of Cost Apportionment Costs Cutting Fabricate
GHc GHc GHc
Power & Lighting Allocated 35,000 20,000 15,000
Maintenance Allocated 30,000 14,000 16,000
Consumable Spares Allocated 110,000 65,000 45,000
Depreciation of Mach. Cost of Machines 200,000 80,000 120,000
Depre – Buildings Area Occupied 180,000 60,000 120,000
Insurance – Machinery Cost of Mach. 400,000 160,000 240,000
Rent and Rates Floor space 360,000 120,000 240,000
Supervisor’s Salary Working Hours 250,000 150,000 100,000
Total Overheads 1,565,000 669,000 896,000
Given machine running hours in the question:
Dept. Cutting Dept - OAR = £699,000/30,000 = GHc22.3/ Machine hour
Dept. Fabricating - OAR = 896,000/20,000 = GHc44.8/Machine hour

Q6. Speed Ltd has three Production Departments (Copying, Cutting, and Pasting)
and three Service Departments, one of which – the Net Working Department –
serves the Copying and Cutting departments only in equal proportion.
The annual budgeted overhead costs for the year 2011 are:
Production Depts. Service Depts.
C1 C2 P1 S1 N1 D1
Item of Cost GHc GHc GHc GHc GHc GHc
Indirect Wages 186,080 165,360 64,880 32,800 21,360 30,080
Consumables 50,400 72,800 16,800 11,200 16,800 12,800
Other Costs: GHc
Depreciation of machinery 176,000
Insurance of machinery 32,000
Insurance of Building 14,400
Power 28,800
Light and heat 24,000
Rent and rates 56,400
Notes:

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 1. Because of special fire risks Copying unit is responsible for a special
loading of insurance on the building. This results in a total building
insurance Cost for Copying unit of one-third of the annual premium.
2. The Decoration unit is located in a building owned by Speed Ltd. It is
valued at GHc48,000 and is charged into costs at a notional value of 8%
per annum. This cost is additional to the rent and rates shown above.
3. The rate at which Saving unit stores data for production units are in the
same proportion as shown above for consumable supplies.
4. The Decorating unit – serves the production unit in the same proportion as
shown below for direct labour hours.
The following information is also relevant:
Items Copying Cutting Pasting Saving N/Working Decorating
GHc GHc GHc GHc GHc GHc
Machry Bk Value 480 360 120 48 144 48
Area (sq ft) 500 600 800 200 250 150
H/power hours (%) 50 331/3 4 1/6 - 121/2 -
D/Labour hours 20,000 15,000 30,000 - - -
Machine hours 40,000 50,000 - - - -
You are required to prepare an overhead analysis sheet showing the bases of any
apportionments of overhead to the various departments as well as the apportionment of
service department costs.

Apportionment of Service Department Overheads.

There are two basic approaches to dealing with the apportionment of service
department overheads. These are:
1. to apportion the cost of each service department to the respective
production department only.
2. to apportion the cost of each service department not only to production
department but also to other service department which make use of its
service and to eventually apportion all cost to production department alone
by a gradual process of repeated distribution (continuous distribution)

Example1. As an example consider the following data. Godwin Allotey Ltd.

incurred the following overhead costs:
Details Production Departments Service Department
A B Stores Maint.
GHc GHc GHc GHc
Allocated costs 6,000 4,000 1,000 2,000
Apportioned costs 2,000 1,000 1,000 500
8,000 5,000 2,000 2,500
Production department ‘A’ worked 5,000 direct labour hours and requisitioned
materials to the value of GHc12,000. Department ‘B’ worked 7,500 direct labour

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hours and requisitioned GHc8,000 worth of materials. What are the total
production overheads cost of departments ‘A’ and ‘B’.

Solution: Godwin Allotey Ltd. Overheads Analysis Sheet

Basis of Total Production Production
Details Apportionment Costs Dept. A Dept. B
GHc GHc GHc
Stores Dept Value of Requisition 2,000 1,200 800
Maint Dept. Lab hrs Worked 2,500 1,000 1,500
4,500 2,200 2,300
Add allocated & apportioned O/H 13,000 8,000 5,000
Totals 17,500 10,200 7,300

Example2. As an example for the continuous distribution approach consider the

following information relating to S & J Enterprise which has two production
departments (A and B) and two service departments (Stores and Maintenance).
The following information about the activity in recent costing period is available:
Details Production Departments Service Department
A B Stores Maint.
GHc GHc GHc GHc
Overheads Costs 10,030 8,970 10,000 8,000
Mat. Requisition (Cost) 30,000 50,000 - 20,000
Maint. Hrs Consumed 8,000 1,000 1,000 -
Given the fact that Stores and Maintenance Departments do work for each other,
the following additional information will be relevant:
Details Production Departments Service Department
A B Stores Maint.
Stores (100%) 30% 50% - 20%
Maintenance (100%) 80% 10% 10% -
Using simultaneous equation and repeated distribution methods of apportionment
show the total production departments overheads.

Solution: S & J Enterprise Overheads Analysis Sheet

Details Production Departments Service Department
A B Stores Maint.
GHc GHc GHc GHc
OH Cost Allocated 10,030 8,970 10,000 8,000
Apportion Stores OH 3,000 5,000 (10,000) 2,000
- 10,000
Apportion Maint. OH 8,000 1,000 1,000 (10,000)
1,000 -

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Apportion Stores OH 300 500 (1,000) 200
200
Apportion Maint. OH 160 20 20 (200)
20
Apportion Stores OH 6 10 (20) 4
4 - - (4)
Total O/Heads 21,500 15,500 - -

Using the Alternative Approach (i.e. The Simultaneous Equation)

Let x represent overheads for Stores and y represent overheads for Maintenance.
Therefore, the following equations can be deduced from the above
x = GHc10,000 + 0.1y (1) y = GHc8,000 + 0.2x (2). At this point one can either
use elimination or substitution which ever is convenient to solve the equation.
Using the elimination approach, re-arrange the above equations to become:
x – 0.1y = GHc10,000 (1)
-2x + y = GHc8,000 (2).
Multiplying through the above equations by 1 and 5 respectively, the two become:
x – 0.1y = GHc10,000 (1)
-x + 5y = GHc40,000 (2).
To eliminate one variable in this case x add equation 1 to equation 2
The outcome is 4.9y = GHc50,000
Therefore y = GHc50,000/4.9
y = GHc10,204.
You then solve for x by substituting the value of y in any of the equations (i.e.
equations 1 or 2 above). For instance using equation 1: x = GHc10,000 +
0.1(10,204); x = GHc11,020.

Note: Having ascertained the total overheads for both service departments you
then apply the ratios or percentages given as per the question, but less the
proportion of the service departments. In other words you have to use the ratios
or the percentages of the production departments only to apportion the cost of
each service department to the respective production departments.

Basis of Total Production Production

Details Apportionment Costs Dept. A Dept. B
GHc GHc GHc
Stores dept 30: 50 11,020 4,133 6,887
Maint dept. 80: 10 10,204 9,070 1,134
21,224 13,203 8,021
Add allocated O/H 19,000 10,030 8,970
Totals 40,224 23,233 16,991

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Q6. Amanda Manufacturing Company Ltd. has three production departments and
two service department. Overhead allocation for the period to 31/3/04 is as
follows:
Details Production Departments Service Department
A B C X Y
GHc GHc GHc GHc GHc
OH Cost Allocated 15,000 27,000 19,000 3,000 5,000
A technical assessment for the apportionment of the overhead cost of the service
departments shows the following:
A B C X Y
Dept. X 45% 15% 30% - 10%
Dept Y 60% 35% - 5% -
You are required to show the total overheads chargeable to the production
departments using: Continuous allotment and Simultaneous Equation Methods.

Solution: Amanda Manufacturing Limited Overheads Analysis Sheet

Details Production Departments Service
Department A B C X Y.
GHc GHc GHc GHc GHc
OH Cost Allocated 15,000 27,000 19,000 3,000 5,000
Apportion X OH 1,350 450 900 (3,000) 300
- 5,300
Apportion Y OH 3,180 1,855 - 265 (5,300)
265 -
Apportion X OH 119 38 80 (265) 28
- 28
Apportion Y OH 16 10 1 (28)
1 - (1)
Total O/Heads 19,666 29,353 19,980 -

Using the Alternative Approach (i.e. The Simultaneous Equation)

Let x represent total overheads for X and y represent total overheads for Y.
Therefore, the following equations can be deduced from the above:
x = GHc3,000 + 0.05y (1)
y = GHc5,000 + 0.1x (2)
At this point one can either use elimination or substitution which ever is
convenient to solve the equation. Using the substitution approach, i.e.
substituting y in equation 1 we can re-arrange the above equations to become
x = GHc3,000 + 0.05(GHc5,000 + 0.1x). Remove the bracket first to read
x= GHc3,000 + GHc250 + .005x. Group the like items

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 x – 0.005x = GHc3,250
0.995x = GHc3,250
x = GHc3,250/.995
x = GHc3,266
Substituting the value of x in any of the equations (i.e. equation 1 or 2 above).
For instance using equation (1) imply
GH¢3,266 = GHc3,000 + 0.05y
GHc3,266 – GHc3,000 = 0.05y
GHc266 = 0.05y
GHc266/0.05y
y = GHc5,320.

Note: Having ascertained the total overheads for both service departments you
then apply the ratios or percentages given as per the question, but less the
proportion of the service departments. In other words you have to use the ratios
or the percentages of the production departments only to apportion the cost of
each service department to the respective production departments.

Basis of Total Production

Details Apportionment Costs Dept. A Dept. B Dept.C
GHc GHc GHc GHc
X dept. 45:15:30 3,266 1,633 544 1,088
Y dept. 60: 35 5,320 3,640 1,960 -
8,586 5,273 2,504 1,088
Add allocated O/H 61,000 15,000 27,000 19,000
Totals 69,586 20,273 29,504 20,088

Overhead Absorption
Overhead absorption is the spreading or sharing of the overhead expenditure
among the cost unit. Thus having allocated and apportioned all overhead costs to
the respective cost centres, the next stage and perhaps the last stage in overheads
cost accounting process is to absorb or add them into the cost of production or to
the cost unit. As it were, the process of apportionment ends at where all the
overhead costs have been duly shared or spread among the respective production
departments.

Overhead Absorption Rates

To absorb overhead into the production cost there are a number of approaches or
methods to be adopted. Generally there are six common bases for overheads
absorption which are:
 Direct material percentage

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  Direct labour percentage
 Prime cost percentage
 Machine hour rate
 Direct labour hour rate
 Total units of production

The Formula for Calculating OAR

The general formula for overhead absorption rates calculation is as follows:

Total Overhead Cost/Recommended Unit Level base

(i.e. Machine Hours, Direct Labour Hours, Labour %, etc).
As an illustration consider the following information relating to the budgeted
production overheads and other budgeted data of Vicandy Enterprise:
Production Dept. A Production Dept. B
Budgeted Details GHc GHc
Overhead Costs 72,000 10,000
Direct Material Cost 64,000
Direct Labour cost 80,000
Machine Hours 20,000
Direct labour Hours 36,000
Total Production (Units) - 20,000

What would be the absorption rate, using the various bases of absorption?

Solution For department ‘A’

Percentage of direct material = GHc72,000/ GHc64,000 = 112.5%

Percentage of direct labour = GH¢72,000/ GHc80,000 = 90%

Percentage of prime cost = GHc72,000/ GHc144,000 = 50%

Percentage of machine hour rate = GHc72,000/20,000 = GHc3.60/Machine Hr

Percentage of direct labour hour rate = GHc72,000/36,000 GHc2.00/D/Lab Hr

For ‘B’ absorption will be based on the Total Budgeted Units (output):
Unit of production = GHc10,000/20,000 = GHc0.5/Unit

Material % Is Suitable Where

a) material constitute the larger part or component of the operational cost
b) material keeps the establishment running

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 c) a lot of production time is used to work or process the materials
d) there is high percentage normal loss of material input especially
through evaporation, breaking of bulk, theft, pilfering etc.
e) there is a high cost in relation to storage, security and so on.
f) There is high tendency of perishability of materials

Q7. Ceiling Professional Co Ltd. operates two production departments (Cutting

and Assemblying) and one service department (which is responsible for Stores).
The data below was extracted from the books of the company on July 2012.
Hours spent Cutting Assemblying Stores
Direct Labour Hours - 6,000 -
Machine Hours 3,000 - -
Expenses GHc GHc GHc
Indirect Wages 2,000 2,500 1,200
Indirect materials 4,200 4,500 5,000
Machine handling - - 800
House keeping 500 700 1,000
Air conditioning 300 300 500
Rent and rates 1,600 1,200 1,500
Supervision 2,400 1,800 2,000
Expenses of the Stores centre are subsequently re-apportioned to the two
production centres in proportion to the total expenses incurred by those
departments during the month. Predetermined overhead rates were established as
follows:
Cutting Assembling
Budgeted Monthly Overheads (GHc) 20,000 12,000
Planned Machine (Hours) 5,000 -
Planned Direct Labour (Hours) - 4,000
You are required to calculate:
i. overhead recovery rate which were in operation during July
ii. Prepare a statement showing the actual overhead borne by the
production departments for July,
iii. State the extent to which overhead was under-absorbed or over-
absorbed by the production units during the month of July.

Solution: i. Ceiling Professionals Company Limited.

Calculation of Predetermined OAR = Total OH/ Total Required Base
Cutting unit OAR = GHc20,000/5,000 = GHc4.00/Machine Hour
Assembling unit OAR = GHc12,000/4,000 = GHc3.00/Labour hour

ii. Ceiling Professionals Ltd Overhead Analysis Sheet for July 12

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 Cutting Assemblying Stores.
Details Total Dept Dept Dept
GHc GHc GHc GHc
Indirect wages 5,700 2,000 2,500 1,200
Indirect materials 13,700 4,200 4,500 5,000
Machine handling 800 - - 800
House keeping 2,200 500 700 1,000
Air conditioning 1,100 300 300 500
Rent and rates 4,300 1,600 1,200 1,500
Supervision 6,200 2,400 1,800 2,000
Sub totals 34,000 11,000 11,000 12,000
Apport Stores (1:1) 12,000 6,000 6,000 (12,000)
Actual OH Borne 46,000 17,000 17,000 -
Overheads Absorbed
Cutting (3,000 Hrs x GHc4) 12,000 -
Assemblying (6,000 Hrs x GHc3) - 18,000
Under/ (Over) Absorbed OH 5,000 (1,000)

Q8. Kofi Asante Engineering Ltd manufactures a single product, ‘Xerox’, in two
production department: a machine shop and a fitting section; it also has two
service departments: a canteen and a Stores unit. Shown below are next year’s
planned production data and manufacturing cost for the company.
Production (‘Xerox’) 20,000
Direct Material GHc5,040 per unit
Direct Labour:
Machine Shop GHc4,938 per unit
Fitting Section GHc9,876 per unit
Machine hours 4 hours per unit

Planned Overheads: Departments

Machine Fitting Canteen Stores Total
GHc GHc GHc GHc GHc
Allocated overheads 27,660 19,470 16,600 26,650 90,380
Rent, Rates,
Light & Heat 51,000
Depreciation & Insurance
of Equipment 45,000
Supervision 60,000
Additional Data:
No. of employees 18 14 4 4
Equipment Cost (GHc) 150 75 30 45

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Floor Space (sq m) 360 140 100 80
It has been estimated approximately 50percent of the stores unit’s cost are
incurred serving the machine shop and the remainder incurred serving the fitting
section. You are required to calculate:
a) the following planned overhead absorption rate for each department:
i. A Machine Hour Rate for the Machine Shop
ii. A Rate expressed as a percentage of Direct Wages for Fitting Section.
b) the planned full cost per unit of product ‘Xerox’

Solution: Kofi Asante Engineering Ltd. Overheads Analysis Sheet

Basis of Total Departments
Item of Cost App’t Costs Mach Fitting Cant Stores
GHc GHc GHc GHc GHc
Allocated OH Specifically 90,380 27,660 19,470 16,600 26,650
Rent, rate,
Light & heat. Floor space 51,000 27,000 10,500 7,500 6,000
Equipment Book value 45,000 22,500 11,250 4,500 6,750
Supervision No. of Empl 60,000 27,000 21,000 6,000 6,000
246,380 104,160 62,220 34,600 45,400
Re-distribution Cant, dept. - 17,300 13,456 (34,600) 3,844
246,380 121,460 75,676 - 49,442
Re-distribution Stores, dept. 24,721 24,721 - (49,442)
246,380 146,181 100, 397 - -

Given Machine Hours/Unit and Planned Output in this question as 4 and 20,000
Total budgeted machine hours is (4hrs x 20,000 units) = 80,000 hrs
Machine Shop OAR = 146,181/80,000 = GHc1.827/ Machine hour

ii. Given Direct Labour Cost in this question as: GHc9,876/unit and Planned
Output 20,000 means direct wages is = GHc197,520
Fitting section OAR = 100,397/197,520 = 50.8% or 51%
Computation of one Unit of X is as follows: GHc
Direct Material 5,040
Direct Labour: Machine Shop 4,938
Fitting section 9,876
Overheads: Machine Shop (4hrs x GHc1,827/hr) 7,308
Fitting Section GHc9,876 x 51%) 5,037
Estimated price 32,199

Q9. ‘Be at Ease’ Ltd has two service departments and two production
departments. Information for each department for the year is as follows:

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 Production Units Service Units
Cutting Assembly X Y
GHc GHc GHc GHc
Budgeted Overhead 600,000 800,000 160,000 300,000
Direct Labour Hours 40,000 50,000 16,000 2,000
Machine Hours 90,000 30,000 40,000 10,000
Number of Employees 140 160 10 20
Maintenance costs are apportioned based on machine hours and personnel costs
are allocated based on the number of employees. Predetermined overhead rates
for production units are based on direct labour hours.
You are required to allocate the service units overhead costs using the:
a) Direct approach and calculate OAR for the production departments.
b) Continuous approach and calculate OAR for the production departments.
c) simultaneous approach and calculate OAR for the production departments

Q10a. Godwin Ltd operates in a highly competitive market where jobs are
obtained by bids. Godwin Ltd uses a policy of 40% margin on bidding for all jobs
the company operates two support units and two production departments.
Budgeted costs and normal activity are as follows:
Production Units Support Units
A B X Y
GHc GHc GHc GHc
Budgeted Overhead 800,000 1,600,000 320,000 200,000
Maintenance Hours 11,200 4,800 4,000 1,600
Labour Hours 178,000 32,000 - -
Machine Hours 32,000 80,000 - -
Number of employees 20 30 8 10
The direct costs of department X are allocated on the basis of employees while
those of department Y are allocated on the basis of maintenance hours.
Department A uses labour hours to assign overhead costs to its products and
department B uses machine hours. You are required to allocate the service
departments costs using the direct approach and calculate OAR for the production
departments

Q10b Godwin Ltd is bidding on a job that is estimated to require GHc60 per unit
in direct materials and GHc100 per unit in direct labour. Each unit will require 5
labour hours in department A and four machine hours in department B. Determine
the bid selling price per unit for the job.

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Q11. The following information is extracted from the books of Vicandy
Enterprise. Below are estimated overheads and other data for the period ending
31/03/12: Production Dept. A Dept B
Budgeted Details GHc GHc
Overhead Costs 96,000 34,000
Direct material cost 64,000
Direct labour cost 80,000
Machine hours 200,000
Direct labour hours 360,000
Total production (in units) 20,000
You are required to compute overheads absorption rate using six different bases.

For department ‘A’ we can calculate five different alternative recovery rates
which include:
i. D/Material % = Total Overheads/Total Direct Material x100
GHc96,000/GHc64,000 = 150%
ii. D/Labour % = Total Overheads/Total Direct Material x100
GHc96,000/GHc80,000 = 120%
iii. P/Cost % = Total Overheads/Prime Cost x 100
= GHc96,000/GHc144,000 = 67%
iv. M/Hour Rate = Total Overheads/Machine Hours
= GHc96,000/200,000 = GHc0.48/M Hr
v. D/ Labour Hour Rate = Total Overheads/Total Labour Hour
= GHc96,000/360,000 = GHc0.27/DL Hr

vi. In the case of department ‘B’ the absorption will be based on the
production units’ and this is calculated as follows:
Production Units’ Rate = GHc34,000/20,000 = GHc1.7/Unit

Q12. The following data were extracted from the books of Afua Mansah Ltd -
beverages manufacturing company.
Cost Centres P1 P2 P3
Direct Material (GHc) 32,000 28,000 24,000
Direct Wages (GHc) 36,000 40,000 44,000
Direct Labour Hours 12,000 16,000 22,000
Machine Hours 5,600 8,400 11,200
Budgeted Output 32,000 40,000 48,000
Fixed overhead for the period amounted to GHc112,000.
You are required to calculate the six overheads absorption rates using six different
bases.

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Solution: For department ‘A’ we can calculate five different alternative recovery
rates which include:
i. D/Material % = Total Overheads/Total Direct Material x100
GHc112,000/GHc84,000 = 133.3%

ii. D/Labour % = Total Overheads/Total Direct Material x100

GHc112,000/GHc120,000 = 93.33%

iii. P/Cost % = Total Overheads/Prime Cost x 100

= GHc112,000/GHc204,000 = 54.9%

iv. M/Hour Rate = Total Overheads/Machine Hours

= GHc112,000/25,200 = GHc4.44/M Hr

v. D/ Labour Hour Rate = Total Overheads/Total Labour Hour

= GHc112,000/50,000 = GHc2.24/DL Hr

vi. In the case of department ‘B’ the absorption will be based on the
production units’ and this is calculated as follows:
Production Units’ Rate = GHc112,000/120,000 = GHc9.33/Unit

Job Costing
By definition job costing is that form of specific order costing which applies
where work is undertaken to customers’ special requirements or prescription and
each order is of comparatively short duration (i.e. compared with those to which
contract costing applies) the work is usually carried out within a factory or work
shop and moves through process and operations as a continuously identifiable
unit.

Batch Costing: Is also a special type of job costing defined as that form specific
order costing which applies where similar articles are manufactured in batches
either for sale or use within an establishment. The distinguishing feature of batch
costing is that the cost unit is a separate, readily identifiable group of units which
maintains their separate identity throughout the production processes.

Types of Job Costing

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Basically there are two types of job costing namely factory/workshop job costing
and contract or big job costing.

Factory/Workshop Job
By definition are services done or products produced within the factory premises
over a short period, to meet the customers’ special requirements. For example
repairs to cars, tailoring shop, shoe makers shop, etc.

Contract or Big Job

Contract or big job on the other hand are those jobs done outside the factory
premises over a period usually more than one year, to meet the customers’
description. For example ship building, road constructions, construction of school
complex etc.

Purpose of Job Costing

 To help the determination of cost of production of a job
 To determine profit or loss on operations
 To set prices for jobs done
 To assess the effects of insufficient jobs on the companies profitability.

Main Stages of Job Costing

 It requires recording cost and associating them to jobs that benefited from
the costs incurred as each job has its own unique features.
 It is requires distinguishing between direct and indirect cost
 All direct costs are charged directly to each job accordingly to ascertain
the prime cost.
 Indirect costs for all the various units and departments are gathered and
the total absorbed using an appropriate overhead recovery rates.

Building Block Concepts of Costing Systems

 A cost object (cost unit) is anything for which a separate measurement of
costs is desired.
 Direct costs of a cost object are costs that are related to the particular cost
object and can be traced to it in an economically feasible manner.
 Indirect costs of a cost object are costs that are related to the particular
cost object but cannot be traced to it in an economically feasible way.
 A cost pool is a grouping of individual cost items
 A cost allocation base is a factor that is the common denominator for
systematically linking an indirect cost or group of indirect costs to a cost
object.

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Job-Costing and Process Costing Systems
In a job-costing system, the cost object or unit is an individual unit, batch, or a lot
of a distinct product or service called a job. In process costing, the cost object or
unit is masses of identical or similar units or product or service. Process costing
allocates costs among all the products manufactured during that period.

General Approach to Job-Costing

The following seven-step approach may be very useful to students in helping to
assign actual costs to individual jobs:
 Identify the chosen cost object(s)
 Identify the direct costs of the job.
 Select the cost-allocation base(s)
 Identify the indirect costs associated with each cost allocation base
 Compute overhead absorption rate (OAR) the rate per unit of each cost-
allocation base used to allocate indirect costs to the job.
 Compute the indirect costs allocated to the job
 Compute the cost of the job by adding all direct and indirect costs
assigned or attributed to it.

Q1. Kwame Enterprise is a Factory dealing in the manufacture and sale of spare
parts to vehicles in the West African sub-region. It has two departments namely,
Cutting and Welding Departments. The following information relate to the year
ended 31/12/11:
Production Direct Labour Machine Wages
Depts Overheads Hours Hours Rates
Cutting GHc9,000 3,000 1,500 GHc2.0
Welding GHc6,000 1,000 3,000 GHc3.0
The overhead in the Cutting Department is absorbed on direct labour hour basis
and in the Welding Department on machine hour basis.
The information below relate to a certain spare part i.e. Job No. 045.
Materials used GHc600
Welding Department:
Hours spent on Machine 20
Labour Hours spent 5
Cutting Department:
Hours spent on Machine 2
Labour Hours spent 10
Hire of Special Machine GHc15
Administration overhead is to be 25% of the cost of production and profit margin
is also 25% of the selling price. You are required to prepare a detailed cost
estimate of the component.

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Solution: Kwame Asante Enterprise Cost Estimate for Job No. 045
GHc GHc
Direct Material 600
Direct Labour:
Welding Dept: 5Hrs x GHc3/Hr 15
Cutting department: 10Hrs x GHc2/Hr 20 35
Direct expense (Hire of Special Machine) 15
Prime Cost 650
Production Overheads:
Welding Dept: 20Hrs x GHc2/Hr 40
Cutting Dept: 10hs x GHc3/Hr 30 70
Cost of Production 720
Admin. Overheads (GHc720 x 25%) 180
Cost of Sale 900
Profit (Margin ¼ to Mark up 1/3 x GHc900) 300
Selling Price 1,200

Q2. Kyei Donkor Company Ltd. manufactures blankets according to the

description of the customer. A customer has asked for the price of a blanket and
you have been asked to prepare an estimate for that customer. The following
information is relevant
a) The blanket will use 26Kgs of wool @ GHc5/Kg; 8Kgs of cotton @
GHc10.50/Kg and GHc96 worth of Sundry Materials.
b) Direct Labour Cost will be:
In the Machine Room 36Hours @ GHc6/Hour
In the Assembly shop 12Hours @ GHc4/Hour
In the Packing department 8Hours @ GHc5/Hour
c) In the Machine Room the manufacture of the blanket will require a
10Hours work on the Machine
d) Overheads are absorbed as follows:
In the Machine Room, by a Machine Hour Rate of GHc13/Hour
In the Assembly Shop, by a Labour Hour Rate of GHc6/Hour
In the Packing Department @ 150% of its Direct Labour Cost
e) A profit Margin of 331/3% of the selling price is to be added. You are
required to prepare the estimated selling price which will be quoted to the
customer.

Solution: Estimated Selling Price for the Blanket GHc GHc

Direct Material: Wool 26kg x GHc5/Kg 130
Cotton 8kg x GHc10.5/Kg 84

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 Sundry Materials 96 310
Direct Labour: Machine Room 36Hrs x GHc6/Hr 216
Assembly Shop 12Hrs x GHc4/Hr 48
Packing Dept 8Hrs x GHc5/Hr 40 304
Prime Cost 614
Factory Overheads: Machine Room 10Hrs x GHc13/Hr 130
Assembly Shop 12Hrs x GHc6/Hr 72
Packing Dept. 150% x GHc40 60 262
Cost of Production 876
Profit 1/3 Margin to ½ Mark up x GHc876 438
Estimated Selling Price to be Quoted 1,314

Q3. The Saviour Company Ltd. is a jobbing factory with three departments. Set
out below are the budgeted data together with information relating to Job No. 300
for the year ended 30/11/03:
Budgeted Overheads Departments
(Allocated and Apportioned) A B C
Indirect materials (GHc) 120,000 20,000 70,000
Indirect Wages (GHc) 80,000 30,000 60,000
Other Indirect Expenses (GHc) 40,000 40,000 20,000
Other Budgeted Information:
Direct Wages (GHc) 40,000 200,000 50,000
Direct Labour Hours 20,000 100,000 50,000
Machine Hours 60,000 20,000 -
During the year, Job No. 300 incurred the actual costs and actual times in the
Departments as follows:
Direct Direct Direct labour Machine
Wages Materials Hours Hours
Dept A 200 240 20 40
Dept B 120 120 40 10
Dept C 20 20 20 -
After adding production overhead to prime cost, one fourth is added to production
cost for gross profit. You are required to calculate the overhead:
a) Absorption rate for each production department.
b) Consumed by each department in total that would apply to Job No. 300
and determine the selling price of the job.

Q4. Emptiers Ltd has been asked to provide a price quotation for a machine used
to manufacture toys for kids. The cost accountant has provided you with the
following data: Direct Materials:
Material X 200Kgs at GHc8.80

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 Material Y 12Kgs at GHc5.00
Direct Wages:
Cutting Dept 40Hours GHc2
Assembling Dept 16Hours at GHc4
Finishing Dept 8Hours at GHc3.60
Additional information from Company’s budget shows the following:
Cutting Dept.: Variable Overheads GHc900
Hours to be worked 6,000
Assembling Dept.: Variable Overheads GHc1,600
Hours to be worked 5,000
Finishing Dept: Variable Overheads GHc5,600
Hours to be worked 4,000
Fixed Overheads for the Company is GHc3,000

You are required prepare the cost estimate and to calculate the selling price of the
machine if the company normally adds a margin of 20% on all jobs.

Solution: Estimated Selling Price for the Toys

GHc GHc
Direct Material: X 200Kgs x GHc8.80/Kg 1,760
Y 12Kgs x GHc5.00/Kg 60 1,820
Direct Labour: Cutting 40Hrs x GHc2 80
Assembly 16Hrs x GHc4 64
Finishing 8Hrs x GHc3.60 28.80 172.80
Prime Cost 1,992.80
Variable Overheads: Cutting 40Hrs x GHc0.15 6.00
Assembly 16Hrs x GHc0.32 5.12
Finishing 8Hrs x GHc1.40 11.20 22.32

Fixed Overheads: Cutting 40Hrs x GHc0.20 8.00

Assembly 16Hrs x GHc0.20 3.20
Finishing 8Hrs x GHc0.20 1.60
12.80
OR Total F/Overhead (i.e. 64Hrs x GHc0.20) 12.80
Cost of Production 2,027.92
Profit 1/5 margin to 1/4 mark up x GHc2,027.92 506.98
Estimated Selling Price to be Quoted 2,534.90

Kate Ltd is a small Accounting firm that employs a job-order costing method to
accumulates costs chargeable to each client and operate in two departments
namely Job Negotiation and Audit and Reporting departments. The firm uses

83
separate departmental rates to charge the costs of departments to its clients. At the
commencement of year 2013 the firm’s management made the following
estimates: Departments
Negotiation Auditing
Job searching hours 20,000 -
Direct labour hours 9,000 16,000
Materials and consumables (GHC) 18,000 5,000
Direct labour cost (GHC) 430,000 800,000
Overhead cost (GHC) 700,000 320,000
The overhead absorption rate in the Negotiation department is based on job
searching hours and that of the Audit section is based on direct labour cost. The
costs charged to each client consist of three elements: materials and consumables,
direct labour cost and an applied amount of overhead from each department.
Job No. 618 was negotiated on March 31 and completed on June 30. During this
period the following costs and time were recorded: Departments
Negotiation Auditing
Job searching hours 18 -
Direct labour hours 9 42
Materials and consumables (GHC) 50 30
Direct labour cost (GHC) 410 2,100
You are required:
i. Compute the predetermined overhead rate used during the year in
the departments
ii. Using the rates calculate the total cost charged to Job No. 618

A predetermined rate is a rate used to charge production overhead cost to jobs

that is established in advance or prior to the commencement of the period. It is
computed by dividing the budgeted or estimated total overhead cost for the period
by the total amount of the allocation base or a recommended cost drive for the
period.
b) Workings
i. Calculation of overhead absorption rate – negotiation department
Total overhead cost/Job searching hours = GHS700,000/20,000
= GHS35/Search hour
ii. Calculation of overhead absorption rate – Auditing department
Total overhead cost/Direct labour cost = GHS320,000/GHS800,000 x 100
= 40% or 0.4
a) Calculation of total cost of Job No. 618 GHC GHC
Direct material and consumables:
Job Negotiation department 50
Auditing and reporting department 30 80

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 Direct labour cost:
Job Negotiation department 410
Auditing and reporting department 2,100 2,510
Prime Cost 2,590
Add production overhead
Job Negotiation department (GHS35 x 18hrs) 630
Auditing department (40% of GHS2,100) 840 1,470
4,060

Contract Costing
Contract costing is a type of specific order costing in which the job to be carried is
of such magnitude that a formal contract is made between the customer and the
supplier. Building and construction work, civil engineering, and ship building are
examples of industries where large contract works are undertaken.

Differences between Contract and Job Costing

1. Contracts are jobs of large magnitudes.
2. Contracts necessitate the signing of a formal contract between customer
and supplier.
3. Contracts are usually carried out on a construction sites away from
suppliers premises.
4. Contracts are usually of long duration over one year e.g. 5 years, 10 years
etc. thus contract span across several accounting periods of the contractor.
5. Contracts have different technique for determining profit or loss.
6. A retention fee is usually retained by customer, which is not the case with
small jobs.
7. There is the need to divide the profit between different accounting periods.
This procedure is strictly governed by the prudence concept.

Definition of Some Terms

Work In Progress
W.I.P, in short, is simply the total expenditure on uncompleted contract or partly
finished job.

Retention Fee
This is a percentage of the value of work certified which the contractee or the
client keeps or retains as a safeguard against shoddy work by the contractor. If
after a stated period the work is found to be absolutely well done, the amount
retained is paid to the contractor

Value of Work Certified

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This is the value of that part of work done by the contractor which the Architect
or the Engineer upon inspection has declared as completed for which payment
must be made by the contractee. The document of certification is generally termed
as Architect s Certificates or the client. In accounting terms the contractor will
only debit the account of the contractee or the client when architects certificates
are received.

Cost of Work not yet Certified

This is the cost of that portion of the work done by the contractor but which has
not been declared by the Architect as finished. This therefore does not result in a
debit entry to the contractee’s or the client’s account.

Apparent Profit
This is the seeming profit which has conceptually been earned by the contracting
firm. It is normally calculated by comparing the value of work certified with the
actual cost incurred in respect of the value of work certified. It is important to
note that the cost of the value of work certified will be the total cost to date less
the cost of work done but not yet certified.

Contract Price
This is the agreed total price for the contract. In the computation of the apparent
profit, the contract price normally takes the place of the value of work certified in
the formula where the contract is at the end or nearing completion.

Unrealized Profit
This is that portion of the apparent profit which is not taken by the contracting
firm because of prudence concept adherence but which is carried forward to the
next accounting period.

Problems with Contract Costing.

1. Identifying direct costs: many cost items which are planned as overheads
are changed as direct cost of contract e.g. supervision, hire of plant
depreciation sub – contractors fees etc.
2. Adding of overheads: because most of the costs are treated direct cost the
absorption of overheads should only apply if such costs have not already
been treated as direct costs.
3. Dividing the profit between different accounting periods. A more difficult
problem emerges when contract is incomplete at the end of accounting
period. Contractor may have spent considerable sums of money on the unit
and received substantial progress payments. Consequently, if the unit is
not finished the contractor would still want to draw some profit on the

86
 work done so far. This problem is a major problem and students are
advised to master how it is solved.

Methods of Sharing Profits for Different Accounting Period

The method of calculating profits on an uncompleted contract may vary
depending on:
1. Degree of completion of the contract
2. The choice of formula which will be based on the degree of completion or
on the policy of the contracting firm.

General Guidelines for Selecting Formula for Profit Sharing

1. If the contract is in its early stages no profit should be taken. Profit should
be taken only when the outcome can be assessed with reasonable
accuracy.
2. If substantial costs have been incurred on contract but it is not yet near
completion, thus between 35% and 85% complete, the formula which is
often suggested is 2/3 x Notional Profit. Notional Profit is sometimes
called Apparent Profit. Apparent profit is the value of work certified to
date minus the cost of work certified after adjusting cost of work not yet
certified.

Mathematically the notional or apparent profit is computed as follows:

GHc GHc
Value of Work Certified to date xxx
Less Cost of Work to date xxx
Less Cost of Work not yet certified xx
Actual Cost incurred in Respect of the Value of Work Certified xxx
Apparent Profit xxx

3. where the Contractee (i.e. the client) withholds a retention or where

progress payment are not made as soon as work certificates are issued, it
will be more prudent to reduce the profit to be taken by the proportion of
the retention to the value of work certified i.e.
2/3 x Apparent x Cash Rec’d
Profit Value of Work Certified.

4. If contract is nearing completion, the size of the eventual profit should be

foreseeable with reasonable certainty and there is no need to be
excessively prudent. The profit taken may be calculated by one of these
three methods:
i. The whole of the notional profit

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 ii. Cost of Work Done x Estimated Total Profit
Estimated Total Cost of Contract

iii. Value of Work Certified x Estimated Total Profit

Contract Price
Note: In an examination care must be taken to find out whether a specific method
or formula is required.

Example1. Where Contract Is Completed Within Same Accounting Period

Suppose that a Contract No. 3345 has the following cost. Direct materials less
returns GHc40,000; direct labour GHc35,000 direct expenses GHc8,000; plant
cost GHc6,000; overheads GHc11,000. The work began on 13/1/12 and was
completed on 15/5/12 in the same accounting period. The contract price was
GHc120,000 and on 4/6/12 the engineer issued his final certificate of work done.
As on that day the contractee had paid GHc90,000 and the remaining was still
outstanding at the end of the contractor’s accounting year which is 31/12/12
prepare the contract account and contractee’s account as at 31/12/12
Contract 3345 Account
GHc GHc
Materials 40,000 Balance c/d (cost to date) 100,000
Direct wages 35,000
Direct expenses 8,000
Plant cost 6,000
Overheads 11,000 0
100,000 100,000
Balance c/d (cost to date) 100,000 Contract Price
120,000
P & L a/c 20,000
120,000 120,000

Example2. Where Profit Is Taken on Uncompleted Contract

Contract No. 502 was started on 01/07/04. Cost to 31/12/04, when the Company’s
accounting year ends are derived from the following information: GHc
Direct Materials issued from Store 18,000
Materials returned to Store 400
Direct Labour 15,500
Plant issued at Book Value 1/7/04 32,000
Written down Value of Plant 31/7/04 24,000
Materials on Site 1,600
Overheads 2,000

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As at 31/12/04 certificates had been issued for work valued at GHc50,000, and
the Contractee made a progress payment of GHc45,000. The company has
calculated that that more work has been done since the last certificates were
issued and that the cost of work done but not yet certified is GHc8,000,000.
Required: Prepare Contract 502 Account, Contractee’s Account and W.I.P to be
shown in the Balance Sheet.

Method 1 Contract 502 Account

GHc GHc
Materials 18,000 Materials returned 400
Direct wages 15,500 Plant cost c/d 24,000
Plant cost 32,000 Materials c/d 1,600
Overheads 2,000 W.I.P c/d 51,400
67,500
P & L a/c (Note 1) 9,900 0
77,400 77,400
Plant cost b/d 24,000
Materials b/d 20,000
W.I.P b/d 51,400
Note1. Calculation of Profit to be Taken GHc GHc
Value of Work Certified to date 50,000
Less Cost of Work to date 41,500
Less Work not yet Certified 8,000 33,500
Apparent Profit 16,500

Profit to be Taken = 2/3 x Apparent x Cash Rec’d

Profit Value of Work Certified.

2/3 x GHc16,500,000 x GHc45,000,000

GHc50,000,000 = GHc9,900

Contractee’s Account
GHc GHc
Value of Work Certified 50,000 Cash Received 45,000
0 Balance c/d 5,000
50,000 50,000
W.I.P to Balance Sheet GHc
W.I.P b/d 51,400
Less Cash Received 45,000
W.I.P to Balance sheet. 6,400

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Method 2 Contract 502 Account
GH GHc
Materials 18,000 Materials returned 400
Direct Wages 15,500 Plant cost c/d 24,000
Plant Cost 32,000 Materials c/d 1,600
Work done not yet Certified 8,000
Cost of Work done c/d 33,500
67,500 67,500
Cost of Work done c/d 33,500 Value of Work Certified 50,000
P & L a/c (Note 1) 9,900
Unrealized Profit c/d 6,600 0
50,000 50,000
Plant cost b/d 24,000 Unrealized Profit b/d 6,600
Materials b/d 20,000
Work done but not certified 8,000

Computation of W.I.P to Balance Sheet GHc

Cost of Work not yet Certified 8,000
Add Retention Fee (i.e. balance on Contractee a/c) 5,000
13,000
Less Provision for Unrealized Profit 6,600
W.I.P to Balance Sheet. 6,400

NOTE: It should be appreciated that both methods are essentially similar.

Whereas the first method calculates the apparent profit using the formula
outside the Contract Account the second method has the formula built into the
Contract Account and therefore the Apparent Profit is determined in the
Contract Accounts. For example crediting the Contract Account with the Cost
of Work not yet Certified is similar to adjusting the cost to date with the cost not
yet certified in the formula. Study the methods critically.

Q2. The following balances relate to Contract No. 419 GHc

Contract Price 300,000
Direct Materials issued 55,000
Direct Materials returned to Stores 5,000
Direct Wages 48,000
Accrued Wages 31/12/04 2,000
Plant installed at cost 30,000
Establishment charges 25,000
Direct expenses 15,000
Direct expenses accrued 31/12/04 1,000

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Value of Work Certified 160,000
Cost of Work not yet Certified 10,000
Vale of Plant 31/12/04 20,000
Materials on Site 31/12/04 5,500
Cash Received from Contractee 150,000
Required: Show the Account for the Contractor, Contractee and the extract of the
contracting firm’s Balance Sheet as at 31/12/04

Solution: Method 1 Contract 419 Account

GHc GHc
Materials 55,000 Materials c/d 5,500
Less Returns 500 54,500 Plant cost c/d 20,000
Direct wages 48,000 W.I.P c/d 162,500
Add accrued 2,000 50,000
Plant cost 30,000
Establishment charges 25,000
Direct Exp 15,000
Add Accruals 1,000 16,000
175,500
P/l a/c (N1) 12,500
188,000 188,000
Materials c/d 5,500 Wages b/d 2,000
Plant cost c/d 20,000 Direct Exp b/d 1,000
W.I.P c/d 162,500
Note: Always calculate the profit to be taken in this case GHc12,500 before
deriving or balancing off the account for the difference which is the Work-In-
Progress to be carried down.

Note1. Calculation of Profit to be Taken GHc GHc

Value of Work Certified to date 160,000
Less: Cost of Work to date (GHc175,500 – GHc25,500) 150,000
Less: Work not yet Certified 10,000 140,000
Apparent Profit/Loss 20,000

Determination of Profit Realized or Taken to P & L Account.

Since there is retention and the question does not specify any percentage or
proportion we use the formula:
Profit to be Taken = 2/3 x Apparent x Cash Rec’d
Profit Value of Work Certified.

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 = 2/3 x GHc20,000 x GHc150,000
GHc160,000 = GHc12,500
.
Contractee’s Account
GHc GHc
Value of Work Certified 160,000 Cash Received 150,000
0 Balance c/d 10,000
160,000 160,000
Bal b/d 10,000

W.I.P to Balance Sheet

W.I.P b/d 162,500
Less Cash Received 150,000
W.I.P to Balance Sheet. 12,500

Method 2 Contract 419 Account

GHc GHc
Materials 55,000 Materials c/d 5,500
Less Returns 500 54,500 Plant Cost c/d 20,000
Direct Wages 48,000 Cost/Work not Certified c/d 10,000
Plant cost 30,000 Cost of Work to date c/d 140,000
Add Accrued 2,000 50,000
Establishment charges 25,000
Direct Exps 15,000
Add Accruals 1,000 16,000
175,500 175,500
Cost of Work to date c/d 140,000 Value of Work Certified 160,000
P/l a/c (N1) 12,500
Unrealized profit 7,500
160,000 160,000
Materials c/d 5,500 Wages b/d 2,000
Plant Cost c/d 20,000 Direct
Exp b/d 1,000
Cost/Work not Certified b/d 10,000 Unrealized Profit 7,500

Note1: Apparent Profit = GHc160,000 - GHc140,000 = GHc20,000

Contractee’s Account
GHc GHc
Value of Cork Certified 160,000 Cash Received 150,000
0 Balance c/d 10,000
160,000 160,000

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Computation of W.I.P to Balance Sheet GHc
Cost of work not yet certified 10,000
Add retention fee withhold on contractee a/c 10,000
20,000
Less Provision for Unrealized Profit 7,500
W.I.P to Balance Sheet. 12,500

Losses on Uncompleted Contracts

At the end of an accounting period it could happen that instead of finding that the
contract is profitable, a loss is expected instead. When this occurs the total
expected loss should be taken into account as soon as it is recognized even though
the contract is not yet completed. The treatment recommended by SSAP 9 is debit
P & L a/c and credit Contract Accounts. It is essential that the full amount of loss
on the total contract, if foreseeable, should be charged against the company’s
profit at the earliest opportunity even if the contract is uncompleted. This means
that in the next accounting period the contract should break even.

3. Contract 415 began on 6/3/03. By the end of the company’s accounting year
which was 31/12/03 cost incurred were as follows: GHc
Materials issued 240,000
Materials on site 31/12/03 20,000
Labour 360,000
Plant on site 6/3/03 400,000
WDV of plant 31/12/03 280,000
Overheads 60,000
The contract was expected to end July 04 and at 31/12/03 the Cost Accountant
estimated that the final cost of the contract would be GHc950,000. The full
contract price is GHc900,000. Work certified at 31/12/03 was valued at
GHc700,000. The Contractee has made progress payment up to 31/12/03 of
GHc630,000. You are required: Prepare Contract 415 Accounts, WIP to Balance
Sheet and Contractee’s Account.

Method 1 Contract 415 Account

GHc’000 GHc’000
Materials 240 Materials c/d 20
Direct Wages 360 Plant Cost c/d 280
Plant Cost 400 W.I.P c/d 700
Overheads 60 P/L c/d (N.1) 60
1,060 1,060

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Materials c/d 20
Plant cost c/d 280
W.I.P c/d 700

Note1. Calculation of Profit to be Taken: GHc’000 GHc’000

Value of Work Certified to date 700
Less Cost of Work to date 760
Less Work not yet Certified 0 760
Apparent Profit (Loss) (60)
Note: According to SSAP 9 Loss anticipated on Uncompleted Contract must be
carried in full to Profit and Loss Account for the period.

Contractee’s Account
GHc GHc
Value of Work Certified 700,000 Cash Received 630,000
0 Balance c/d 70,000
700,000 700,000

W.I.P to Balance Sheet

W.I.P b/d 700,000
Less: Cash Received 630,000
W.I.P to Balance Sheet. 70,000

Method 2 Contract 502 Account

GHc’000 GHc’000
Materials 240 Materials c/d 20
Direct wages 360 Plant cost c/d 280
Plant cost 400 Cost of Work to date c/d 760
Overheads 60 Work not cert.c/d 0
1,060 1,060
Cost/Work to date c/d 760 Value of Work Certified 700
P/L a/c c/d (Loss) 60
760 760
Materials b/d 20
Plant Cost b/d 280
Cost not yet Certified b/d 0

Contractee’s Account

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 GHc GHc
Value of Work Certified 700,000 Cash Received 630,000
0 Balance c/d 70,000
700,000 700,000

Computation of W.I.P to Balance Sheet GHc’000

Cost of Work not yet Certified 0
Add Retention Fee withhold on Contractee a/c 70
70
Less Provision for Unrealized Profit 0
W.I.P to Balance Sheet. 70

4. Habib Construction Company Ltd. secured a contract for the construction of a

National Health Center for Bolga District. Work commenced on April 1, 2011 and
the Contract was due to be completed by September 2012. The Contract Price was
GHc750,000. The financial year of the Company ended on March 2004, and on
that date the following balances were extracted from the Contractors books.
GHc
Value of Plant to the Site 250,000
Materials delivered to Site 58,000
Materials Purchased: Cement 125,000
Iron Rods 83,000
Sand 18,000
Fuel 25,000
Wages: Paid 125,000
Accrued 6,500
Materials at Site (31/3/11) 37,000
Establishment Expenses allocated to the Contract 18,000
Direct expenses: Paid 30,000
Accrued 1,800
Value of Plant on Site at 31/3/11 215,000
The following additional information was available:
1. Cash received on account was GHc450,000 and this represented the value
of work certified less 10% retention money.
2. It was estimated that to complete the contract on September 30/9/12:
i. the following additional expenditure would be incurred; Materials
GHc85,000, Wages GHc65,000 and Direct expense GHc12,000
ii. the value of Plant after the completion of the contract would be
GHc125,000
There were no accrual charges or unused materials as at 30/9/12. When final
account were prepared for the period ended 31/3/11 it was decided to credit P & L

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a/c with the portion of the total estimated profit which the Value of Work certified
bore to the contract Price. You are required to prepare Contract Account showing
clearly the amount of Profit to be transferred to P/L Account for the year ended
31/3/11. Complete the Contract Account to September 30, 2012.

Solution Method 1 Contract Account

GHc GHc
Plant to site 250,000 Plant c/d 215,000
Material to site (W1) 309,000 Material c/d 37,000
Direct wages a/c (W2) 131,500 P/L a/c c/d (W4) 27,300
Direct expenses (W3) 31,800 W.I.P c/d 455,000
Establishment charges (W5) 12,000 0
734,300 734,300
Plant c/d 215,000 Plant c/d 125,000
Material c/d 37,000 Contract Price 750,000
W.I.P c/d 455,000
Material purchased 85,000
Wages 65,000
Direct expenses 12,000
Establishment charges (W5) 6,000
875,000 875,000

Note: Always calculate the profit/loss to be taken in this case (GHc27,300)

before deriving or balancing off the account for the difference which is the
Work-in-progress to be carried down

Workings1. Materials to Site: GHc GHc

Materials from stores 58,000
Materials purchased: Cement 125,000
Iron Rods 83, 000
Sand 18,000
Fuel 25,000 309,000

Workings2. Wages a/c: GHc GHc

Cash paid 125,000
Accrued 6,500 131,500

Workings3 Direct Expenses: GHc GHc

Cash paid 30,000
Accrued 1,800 31,800

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Working4 Calculation of Profit to Be Taken: GHc GHc
Contract Price 750,000
Less: Cost of Work to date (GHc734,300 – GHc252,000) 482,300
Add: Estimated Cost (cost to completion W4a) 295,000 777,300
Apparent Profit/(Loss) (27,300)

Workings 4a Computation of Estimated Cost GHc GHc

Plant b/d 215,000
Plant c/d 125,000 90,000
Material b/d 37,000
Purchases Estimated 85,000 122,000
Wages 65,000
Direct Expenses 12,000
Establishment Charges (W5) 6,000
295,000
Working5 Establishment Charges Apportionment
18 months = GHc18,000
Therefore 1st 12 months implies 12/18 x GHc18,000 = GHc12,000.
Then, the next 6 months = GHc18,000 - GHc12,000 = GHc6,000

Determination of Profit Realized to P & L Account

Since there is retention and the question clearly stipulates company policy so you
follow instruction. But once a loss is declared or envisaged SSAP 9 must be your
guiding principles.

Company’s policy (i.e. Estimated Profit x Value of Work Certified/Contract

Price (if profit had been made)
Cash received on Account was GHc450,000 = 90%; Retention Money = 10%
Therefore Actual Value of Work Certified was = 100%
100/90 x GHc450,000 = GHc500,000

5. Nkwantabisa Constructions Ltd accepted a contract to build a student hostel at

University of Cape Coast. Work commenced on the 1/1/12 and it was expected that it
takes 18 months to complete. On 31/12/12 the following balances were extracted from
the books of the contractor: GHc
Cash received on account 139,500,000
Wages paid 32,000,000
Materials issued 66,797,250
Plant Installed 2,015,000
Direct Expenses 2,208,750
Administrative expenses 1,395,000
The following additional information is available:

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 a) The Contract Price is GHc232,500,000.
b) On 31/12/06 Wages accrued was GHc775,000
c) Value of Plant installed as at 31/12/12 was GHc1,209,000
d) Materials on hand at Site as at 31/12/12 was GHc1,186,500
e) Cash received during the year represent the Value of Work certified less 10%
retention money
f) Included in the material issued are some which had cost GHc1,860,000 but were
found to be unsuitable for the contract and later sold for GHc2,170,000
It was further estimated that:
i. to complete the contract in June 2007 the following additional expenditure would
be incurred: GHc
Materials 35,650,000
Wages 18,600,000
Direct expenses 930,000
Administrative expense 744,000
ii. The value of the plant installed will be GHc604,500 after the completion of the
contract. The contract was duly completed in June 2007. The actual expenditure
was as follows: GHc
Materials 37,200,000
Wages 17,050,000
Direct expenses 10,850,000
Administrative expense 775,000
iii. Value of plant after the completion of the contract was GHc620,000

There were no accrued charges, unused materials on site on 30th June, 2013. When the
final account were prepared for the year ended 31/12/12 it was decided to credit Profit
and Loss Account with that part of total estimated profit which the value of work
certified bears to the Contract Price. You are required to prepare a contract account
showing the profit to be transferred to the Profit and Loss account for year ended
31/12/12. Complete the contract account to June 30/2013.

6. Kwaku Boateng Plc has been engaged since 1st January 2010 on the
construction of an office complex for an electronic firm. The total contract price is
GHc15,000,000 and the office is expected to take 10 years to complete. At 31st
December 2010 plant on site was valued at GHc125,000 and unused materials on
site were valued at GHc258,000. Site wages of GHc17,000 and direct expense of
GHc23,000 had been accrued. The long term contract work in progress value of
the project was GHc653,000.

The following details apply to the contract for the 2010.

Cost Incurred Site Cash Paid
GHc’000 GHc’000
Site Wages 150 153

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Salaries 85 85
Sub Contracted Work 63 63
Direct expenses 40 40
Kwaku Boateng Plc absorbs production overhead into contract on a
predetermined percentage based on wages incurred.

The relevant budgeted figures for 2010 were as follows:

Production overheads GHc990,000; Wages GHc2,750,000. As at 31st December
2010, plant on site was valued at GHc97,000 and unused materials amounted to
GHc39,000. Kwaku Boateng Plc does not consider it appropriate to account for
any attributable profit until a contract is at least half-way through its total life
span. You are required to prepare a contract account for the Office Block project
for 2010.

2. Asemasa Construction Limited a general Building and Civil Engineering

Company was engaged in several construction works during the year ended 31st
December, 2011. The following information relates to two of such contracts at
Bekwai for the Awaso Bekwai District Assembly. The project was referred to as
Bekwaiman project.
Contract No AWABEK50 AWABEK100
Commencement date 1/1/11 1/7/11
GHc GHc
Approved Contract sum without variation 275,000 350,000
Expenditure: Materials 12,680 19,280
Wages 48,643 37,218
Site expenses 6,500 8,620
Plant purchases 150,000 65,000
Accrued wages 4,217 2,242
Materials on Site – 31/12/12 2,100 6,400
Cash received on work certified 93,500 63,750
Work completed but not certified 3,500 2,200
Additional information:
a) Head office charges of GHc222,500 are charged to contracts in proportion
to their prime costs.
b) The plant was installed at the commencement of the contracts and
depreciation is calculated at 20% per annum. Both contracts have been
estimated to give overall profit on completion.
c) The Cash received represents 85% and 75% of the Value of Work
Certified on AWABEK50 and AWABEK100 respectively.
You are required to prepare:
i) Columnar Contract Account for Asemasa Construction Works

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 ii) Contractee (i.e. Awaso Bekwai District Assembly) Account in the books
of Asemasa Construction Works
iii) WIP to the Balance Sheet for both Contracts

4. Stargazers Construction Company Ltd. secured a contract for the construction

of a Library Complex for Tyne District. Work commenced on April 1, 2009 and
the Contract was due to be completed by September 2010. The Contract Price was
GHc300,000. The financial year of the Company ended on 31st March 2010, and
on that date the following balances were extracted from the Contractors books.
GHc
Value of Plant to the Site 75,000
Materials issued from Store to Site 17,400
Materials Purchased 123,900
Wages: Paid 37,500
Accrued 1,950
Materials at Site (31/3/10) 11,100
Establishment Expenses allocated to the Contract 5,400
Direct expenses 9,540
Value of Plant on Site at 31/3/10 64,500
The following additional information was available:
1. Cash received on account was GHc135,000 and this represented the value
of work certified less 25% retention money.
2. It was estimated that to complete the contract on September 30/9/10:
i. the following additional expenditure would be incurred; Materials
GHc25,500, Wages GHs19,500 and Direct expense GHc3,600
ii. the value of Plant after the completion of the contract would be
GHc37,500
There were no accrual charges or unused materials as at 30/9/10. When final
account were prepared for the period ended 31/3/10 it was decided to credit P & L
a/c with the portion of the total estimated profit which the Value of Work certified
bore to the contract Price.

You are required to prepare Contract Account showing clearly the amount of
Profit to be transferred to P/L Account for the year ended 31/3/10. Complete the
Contract Account to September 30/2011.

Method 1 Contract Account

GHc GHc
Plant to site 75,000 Plant c/d 64,500
Material to site(W1) 141,300 Material c/d 11,100
Direct wages a/c (W2) 39,450 W.I.P c/d 204,216

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Direct expenses 9,540
Establishment charges (W3) 3,600
P/L a/c c/d (W6) 10,926 0
279,780 279,780
Plant c/d 64,500 Plant c/d 37,500
Material c/d 11,100 Contract Price 300,000
W.I.P c/d 204,216
Material purchased 25,500
Wages 19,500
Direct expenses 3,600
Establishment charges (W5) 1,800
P/L a/c Unrealised Profit c/d (W6) 7,284 0
337,500 337,500

Note: Always calculate the profit/loss to be taken (i.e. GHc10,926) before

deriving or balancing off the account for the difference which is the Work-in-
progress to be carried down (i.e. GHc204,216)

Workings1. Materials to Site: GHc GHc

Materials from stores 17,400
Materials purchased 123,900
141,300

Workings2. Wages a/c: GHc GHc

Cash paid 37,500
Accrued 1,950
39,450

Working3 Establishment Charges Apportionment

18 months = GHc5,400.
Therefore 1st 12 months implies 12/18 x GHc5,400 = GHc3,600.
Then, the next 6 months = GHc5,400 - GHc3,600 = GHc1,800
Working4. Calculation of Profit to Be Taken: GHc GHc
Contract Price 300,000
Less: Cost of Work to date (GHc268,890 – GHc75,600) 193,290
Add: Estimated Cost (cost to completion W5) 88,500 281,790
Apparent Profit/(Loss) 18,210

Workings 5 Computation of Estimated Cost: GHc GHc

Plant b/d 64,500
Plant c/d 37,500 27,000

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Material b/d 11,100
Purchases Estimated 25,500 36,600
Wages 19,500
Direct Expenses 3,600
Establishment Charges (W3) 1,800
88,500

Workings6. Calculation of Profit Realized or to be taken to P & L Account.

Profit to be Taken = Value of Work Certified/ Contract Price x Estimated Total Profit
= GHc180,000/GHc300,000 x GHc18,210 = GHc10,926
Unrealised Profit c/d to P/L a/c (GHc18,210 - GHc10,926)
= GHc7,284

Note: Cash received was GHc135,000 = 75% + Retention Money = 25% = 100%
Therefore Actual Value of Work Certified was = 100/75 x GHc135,000 = GHc180,000

Since there is retention and the question clearly stipulates company policy, you must
follow instruction. But once a loss is declared or envisaged SSAP 9 must be your guiding
principles. Company’s policy (i.e. Estimated Profit x Value of Work Certified/Contract
Price (if profit had been made)

Process Costing - Introduction

Process costing is applied when cost units are processed in stages from one
process to another. In process costing the cost units are in large number of items
that look so much alike that it is only expedient to find total cost of production
and then divide or spread among the number of units produced in order to
ascertain or arrive at the cost per unit. To understand a process costing system it is
essential to appreciate the underpinning operational principles. An operational
process costing system is characterised by a large number of homogeneous
products passing through a series of process, where each process is responsible
for one or more operations that brings a product one step closer to its completion.
Small mass produced manufactured items, chemicals, soap, paints and petrol
products are typical examples of items that utilises process costing systems.

Process Defined
By definition, a process is a series of operation (activities) that are linked to
perform a specific objective. In each process materials, labour, and overhead input
may be required in equal amounts for each unit of product. Upon completion of a
particular process, the partially finished goods are transferred to another process
(i.e. the finished goods of one process become the raw material of another
process). Costing systems for process system are basically the same as that of job-
order costing.

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Differences
 Whereas job-order costing accumulates production cost by job process
costing aggregates production costs by process.
 For manufacturing firms, job-order costing system uses a single WIP
account, while the process costing has a WIP account for every process.

Application
Process costing is used where it is not easy to identify separate units of production
or jobs usually because of the continuous nature of the production process
involved. It is common to identify process costing system with continuous
manufacturing firms such as oil refining, soap manufacturing, drug and chemical
manufacturing, paper, paint, textiles etc.

Service Organisation
Services that are basically homogeneous and repetitively produced can apply
process costing system to their advantage. For instance, processing tax returns,
sorting mails, changing oil, cheque processing in a bank, air travel between Accra
and The Garden City – Kumasi, laundering and pressing shirts. Process costing is
a form of operation costing used where production system follows a series of
sequential processes. Because each process incurs costs with respect to material,
labour and production overheads there is the need to open account for each
process so as to determine the cost incurred.

Although process costing has more WIP accounts than a job-order costing system
it is simpler and less expensive to operate. The reasons being that in a process
costing there are:
 No individual jobs to be accounted for
 No job-order cost sheets
 No need to track materials consumed in individual jobs
 No need to use time tickets or clock cards for assigning labour cost to
processes.

Main Objectives
1. To determine unit cost of finished
2. To control cost through cost comparisons
3. To determine the cost of Work-In-Progress/Closing stocks.

Characteristics of Process Costing System

Common features identified with process costing system are:
 There are homogeneous units pass through a series of similar process
 Each unit in each process receives a similar dose of production cost

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  Manufacturing costs are accumulated by a process for a given period
 Because of partly finished goods there is a work in process account for
each process
 Manufacturing cost flows and the related book entries are generally
similar to that of job-order costing system
 The departmental production report is the major document for tracking
manufacturing activity and costs.
 Unit costs are always determined by dividing the departmental cost of the
period by the output of the period.

Common Steps for Process Costing Installation

1. There should be clearly defined process cost centres
2. There should be proper maintenance of accurate records of units and parts
units produced and cost incurred by each process.
3. The averaging of total cost of each process over total production units of
that process including partly completed units.
4. There is often a waste or loss in process due to spoilage, bulk breaking
evaporation etc.
5. There will occasionally be closing WIP which must be valued.
As rightly pointed out the basic features seems relatively simple. The actual
details of process costing system are somewhat more complicated or complex. Let
us start with simple process costing with no WIP inventories. Understanding how
process costing works without WIP inventories is a good foundation to appreciate
the procedures where there are WIP inventories. It might also interest you to study
and know the no-inventories setting, in that, many firms operate in such a setting
or policy of late due to the JIT material inventory management.

Example1. A food processing company has two production processes and

provided you with the following details for the production of 200,000 packets
biscuits. Process1 direct material GHc400,000 wages GHc200,000 production
overhead is absorbed at the rate of 150% of the direct labour cost. Process 2 direct
labour GHc120,000 production overheads is absorbed at the same rate as process
one.
Process1 Account
Pkts’000 GHc’000 Pkts ’000 GHc’000
Materials 200 400 Output to P2 2,000 900
Wages 200
Prod. O/Heads 300 0 0
200 900 200 900

Process 2 Account
Pkts ’000 GHc’000 Pkts ’000 GHc’000

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Mat from P1 200 900 output to F/Gds 200 900
Wages 120
Prod. O/Heads 180 0 0
200 1,200 200 1,200

Accounting For Loss or Waste

During a production process a loss may occur through wastage, evaporation,
spoilage etc. Losses may be:
a) Expected in the normal course of operation for unavoidable reasons. The
total or average expected loss is known as normal loss or
b) Unexpected loss, usually known as abnormal loss.

Normal Loss
Simply put normal loss is the expected or anticipated loss. It is considered as
inherent part of the process. In other words, the cost of normal loss is considered
as part of the production cost. Therefore, the total cost incurred, irrespective of the
normal loss quantity, is shared among the expected units to arrive at a unit cost of
production.

Abnormal Loss
With abnormal loss, the case is different. It would be unreasonable and contrary
to SSAP 9 to include in the valuation of good units of output the cost arising from
poor workmanship, poor quality material, poor supervision, damage by accident
et. Instead the cost of abnormal loss should be written off to P & L account so that
they do not affect valuation of expected units of output.

Q2. Akonta Ltd operates a manufacturing process and during the year ended
31/12/11 the following too place:
Opening stock Nil
Units introduced 100,000 units
Cost incurred GHc450,000
Closing stock Nil
Output 90,000
Loss 10,000
What is the cost of output if:
a. Expected or Normal Loss is 10%
b. There is no Expected Loss.

Solution: a) Cost/Unit of Output = Total Cost Incurred/Total Expected Output

= GHc450,000/90,000 = GHc5/Unit

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Note: Normal Loss is not given any cost so that Process Account would appear as
follows
Process Account
Pkts’000 GHc’000 Pkts ’000 GHc’000
Total cost 100 450 Normal Loss 10 -
0 Output to F/gds 90 450
100 450 100 450

b) Cost/Unit of Output = Total Cost Incurred/Total Expected Output

= GHc450,000/100,000 = GHc4.5/Unit

Process Account
Units’000 GHc’000 Units ’000 GHc’000
Total Cost 100 450 Abnormal Loss 10 45
0 Output to F/gds 90 405
100 450 100 450

Abnormal Loss Account

Units’000 GHc’000 Units ’000 GHc’000
Process a/c 10 45 P & Loss a/c 10 45

Abnormal Loss (Gain) = Actual Loss – Normal Loss.

It is almost inevitable that when there is an expected loss in a process, the actual
loss which occurs will be exactly the same amount as the average or normal loss.
The difference between the normal loss and the actual loss is an abnormal loss or
abnormal gain. Thus:
 Where the actual loss is larger than the normal loss, the excess loss is
known as abnormal loss.
 Where the actual loss is smaller than the normal loss, the difference (or
saving) in loss is also termed as abnormal gain.

3. Paa Joe Enterprise operates a manufacturing process and during the 1st quarter
of 2008 the following took place. Input to process was 100,000 units at a cost of
GHc450,000. Normal loss is 10% and can be sold for GHc2.7 per unit. There is
no opening or closing stock. What would be the accounting entries for the cost of
output and the cost of loss if actual output were a) 86,000 & b) 92,000 units?

Note the following:

1. Normal loss is not given share of cost incurred.
2. Cost of output is always based on the expected units of output.

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 3. Abnormal loss is given part of the cost incurred, and is written off to P&L
a/c
4. Abnormal gain is treated the same way as abnormal loss except that being
a gain it appears as a debit entry in the process account.

a) If actual output is 86,000 units:

Then Actual Loss 14,000 - 10,000 Normal Loss = 4,000 is Abnormal Loss.
Cost/Unit of Output = Total Cost Incurred/Total Expected Output =
GHc500,000-27,000/90,000 = GHc4.7/unit.

Process Account
Units’000 GHc’000 Units ’000 GHc’000
Total Cost 100 450 Normal Loss 10 27.0
Abnormal loss 4 18.8
0 output to F/gds 86 404.2
100 450 100 450.0

Abnormal Loss Account

Units’000 GHc’000 Units ’000 GHc’000
Process a/c 4 18.8 Scrap Sale 4 2.8
P & Loss a/c 16.0

Scrap Account
Units’000 GHc’000 Units ’000 GHc’000
Process a/c 10 27.0 Scrap Sale (10+4) 14 37.8
Abnormal loss 4 10.8
37.8 37.8

b) If Actual Output is 92,000 units

Then, Actual Loss 8,000 - 10,000 = (2,000) is Abnormal Gain.
Cost/Unit of Output = Total Cost Incurred/Total Expected Output = GHc45,000-
27,000/90,000 = GHc4.7/unit

Process Account
Units’000 GHc’000 Units ’000 GHc’000
Total cost 100 450 Normal Loss 10 27.0
Abnormal Gain 2 9.4
0 Output to F/gds 92 432.4
102 459.4 102 459.4

Abnormal Gain Account

Units’000 GHc’000 Units ’000 GHc’000

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Scrap a/c (loss revenue) 5.4 Process a/c 2 9.4
P & Loss a/c 4.0

Scrap Account
Units’000 GHc’000 Units ’000 GHc’000
Process a/c 10 27.0 Scrap Sale (10-2) 8 21.6
Abnormal gain 2 5.4
27.0 27.0

Scrap Value of Loss.

Loss may have a scrap value. The accounting treatment of scrap in process
costing is somewhat unusual and students are advised to study it carefully. The
following basic rules are applied:
a) Revenue from scrap is treated not as an addition to sales revenue but as a
reduction in cost of production.
b) The scrap value of normal loss is therefore used to reduce the material cost
of the process i.e. credit process a/c and debit scrap a/c. (with the scrap
value of normal loss)
c) The scrap value of abnormal loss is used to reduce the cost of abnormal
loss, and therefore to reduce the write off cost to the P & L a/c i.e. credit
abnormal loss a/c debit scrap a/c. (with the scrap value of abnormal loss).
d) The scrap value of abnormal gain arises because the actual units sold as
scrap will be less than the scrap value of the normal loss. Credit scraps
account and debit abnormal gain. (With scrap value of abnormal gain).
e) Scrap account is completed by recording the cash received from sale of
scrap. Credit scrap a/c and debit cash or cost ledger control a/c. (with the
value of the actual number of units scrapped).

4. Wiseman Ltd. has a factory with 2 production processes. Normal loss in each
process is 10% and scrap units sell for GHc0.50 each from Process 1 and GHc3
each from Process 2. Relevant information for costing purposes relating to 1st
quarter is as follows. Process 1 Process 2
D/Material Added: Units 200,000 125,000
Cost GHc810,000 GHc190,000
Direct labour GHc400,000 GHc1,000,000
Production Overheads 150% of 120% of
Direct Labour cost Direct Labour cost
Output to Process 2/Finished goods a/c 175,000 units 280,000 units
Actual production overheads incurred was GHc1,780,000. You are required to
prepare the Accounts for Process1, Process2, Scrap, Abnormal Loss or Gain and
Production Overhead.

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Note: Where there is scrap, total cost incurred is reduced by the scrap value
before spreading the remaining cost incurred over the expected output.
Cost/Unit of Output = Total Cost Incurred – Scrap/Total Expected Output
= GHc1,810,000 - GHc10,000/180,000 = GHc10/Unit

Process 1 Account
Units’000 GHc’000 Units ’000 GHc’000
Direct Mat 200 810 Normal Loss 20 10
Direct Labour 400 Abnormal Loss 5 50
Prod. OH (150%400) 600 Output to F/gds 175 1,750
200 1,810 200 1,810

Abnormal Loss Account

Units’000 GH’000 Units ’000 GHc’000
Process 1 a/c 5 @GH¢10 50 Scrap a/c (sale of extra loss) 5 2.5
P & Loss a/c 47.5
50 50

Cost/Unit of Output = Total Cost Incurred – Scrap/Total Expected Output

= GHc4,140,000 - GHc90,000/270,000 = GHc15/Unit

Process 2 Account
Units’000 GHc’000 Units ’000 GHc’000
Direct Mat P1 175 1,750 Normal Loss 30 90
Added Mat 125 190
Direct Labour 1,000
Prod. Overheads 1,200
Abnormal gain 10 150 Transfer to F/gds 280 4,200
310 4,290 310 4,290

Abnormal Gain Account

Units’000 GHc’000 Units ’000 GHc’000
Scrap a/c (Loss of scrap revenue 30 Process 2 a/c (10 @ GH¢15) 150
P & Loss a/c 120
150 150

Scrap Account
Units’000 GHc’000 Units ’000 GHc’000
Scrap Value of N/loss: Proceed from Actual
Process 1 20 10 Units Sold P1 (N+AbN) 25 @ GHc0.50 12.5
Process 2 30 90 P2 (N -AbG) 20 @ GHc3 60

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Abnormal P1 5 2.5 Abnormal gain a/c
0 (Loss of Scrap Income) 10 @ GHc3 30
55 102.5 55 102.5

Production Overheads Account

GHc’000 GHc’000
Sundry a/c (Actual O/H) 1,780 Process 1 a/c 600
P & L a/c (Over absorption) 20 Process 2 a/c 1,200
1,800 1,800

5. ‘No Friction’ is an industrial lubricant which is formed by subjecting certain

crude chemicals to two successive processes. The output of process 1 is passed to
process 2 where it is blended with other chemicals. The process costs for 3rd
quarter of the 2004 were as follows:
Process 1
Direct Materials 3,000,000 Litres @ GHc2.5/litre
Direct Labour GHc1,200,000
Process Plant Time 12hrs @ GHc200/hr.
Process 2
Direct Materials 2,000,000 litres @ GH4/ litre
Direct Labour GHc840,000
Process Plant Time 20hrs @ GHc135/hr.
rd
General overheads for 3 quarter amounted to GHc3,590,000 and is absorbed into
process cost on a process labour basis. The normal output of process1 - 80% of
input and of process2 - 90% of input. Waste matter from process 1 is sold for
GHc2/litre and that from process 2 for GHc3/ litre. The 3rd quarter outputs were
as follows:
a) Process 1 2,300,000 litres;
b) Process 2 4,000,000 litres.
There was no stock of WIP at either the beginning or the end of the quarter and it
may be assumed that all available waste matter had been sold at the prices
indicated. You are required to show how the foregoing data would be recorded in
a system of cost account.

The Concept of Equivalent Units

At the end of any given period there are likely to be partly completed units. It is
crystal clear that some of the costs of the period are attributable to these units as
well as those that are fully completed. To be able to spread costs equitably over
partly finished and fully complete units the concept of equivalent units is
required. The number equivalent unit for cost calculation purposes is the number
equivalent to fully completed units which WIP represents. For Example, in a

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given period production was 13,200 complete units and 3,600 partly complete.
The partly complete units were deemed to be 80% complete.

Total equivalent production = complete units + Equivalent units in WIP

=13,200 + 80% of 3,600
= 13,200 + 2,880
= 16,080

Hence the total cost for the period would be spread over the equivalent production
for valuation of stock and finished goods

1. Tryton Ltd is a manufacturer of processed foods. In March 2008 in one process

there was no opening stock but 3,000,000 puddings of input were introduced to
the process during a night shift production at a cost of: GHc
Materials 680,000
Labour 400,000
Production overheads 300,000
Total cost 1,380,000
Of the 3,000,000 puddings introduced 2,400,000 were completely finished by the
night shift and transferred to the next process. Closing stock of 1,000 units was
only 50% complete with respect to materials and conversion costs. You are
required to prepare the account for process 1 for that night production in March
2008.

In order to apportion costs fairly, units of production must be converted into the
equivalent unit. Equivalent units then provide the basis for apportioning the costs.
Statement of Equivalent Units
Total Degree of Equivalent
Details Units Completion Units
Fully complete 2,400,000 100% 2,400,000
Stock 600,000 75% 360,000
3,000,000 2,760,000

Cost/pudding (for Closing Stock Valuation Purposes) Total Cost Incurred/Total

Expected Output: GHc1,380,000/2,760,000 = GHc0.50/pudding
Statement of Evaluation
Equivalent Cost/
Details Units Equivalent Unit Valuation
Fully complete 2,400,000 GHc0.5 GHc1,200,000
Stock (WIP) 600,000 GHc0.5 GHc 180,000

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 Process Account
Units’000 GHc’000 Units ’000 GHc’000
Direct Mat 3,000 680 Transfer to F/gds 2,400 1,200
Direct labour 400
Prod. Overheads 0 300 Stock (WIP) c/f 600 180
3,000 1,380 3,000 1,380

Equivalent Units and Cost Elements

Frequently, some overall estimate of completion is not possible or desirable and it
becomes essential to consider the percentage completion of each of the cost
elements i.e. materials, labour and overheads. The same principles is adopted to
calculate equivalent units but each cost element must be treated separately and
then the cost per unit of each element is added or summed up to give the cost per
a complete unit

Example2 Surprise Ltd. is a manufacturer of processed goods and that results in

process 2 for April 2012 were as follows:
Opening stock nil
Material input from process 1 4,000 units
Cost of input: Materials from process 1 GHc6,000
Added materials in process 2 GHc1,080
Conversion cost (labour and overheads) GHc1,720
Output is transferred into the next process, i.e. process 3. Closing stock amounted
to 800 units, complete as to process 1 material 100%
Added materials in process 2 50%
Conversion Costs 30%
You are required to prepare the account for process 2 for April 2012.
Statement of Equivalent Units
Total Process 1 Process 2 Conversion
Details Units Material Material Cost (Lab & O/H)
Fully Complete3,200 3,200 3,200 3,200
Closing Stock 800 800 400 240
4,000 4,000 3,600 3,440
Statement of Cost (Per Equivalent Units)
Cost Equivalent Cost/Unit
Input (GHc) Prod in Units GHc
Process 1 Mat 6,000 4,000 1.50
Process 2 Mat 1,080 3,600 0.30
Conversion cost 1,720 3,440 0.50
2.30

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 Statement of Evaluation Finished Goods and Closing Stock
Production Cost No. of Cost/Unit Total Cost
Details Elements Equiv. Units GHc GHc
Fully Complete 3,200 2.30 7,360
Closing Stock: (WIP) P1 Material 800 1.50 1,200
P2 Material 400 0.30 120
Conversion Cost P2 240 0.50 120 1,440
8,800
Process 2 Account
From P 1 Units GHc Units GHc
Direct Mat 4,000 6,000 Transfer to P3 3,200 7,360
Added Mat 1,080
Conv. (W & O/Hs) 0 1,720 Stock (WIP) c/f 800 1,440
4,000 8,800 4,000 8,800

Dealing With Opening WIP - FIFO Method of Valuation

The issues of FIFO are best explained with an illustration. Assuming information
relating to Process1 of a two–stage production processes is as follows for
December 2010:
Opening Stock 500units
Degree of Completion 60%
Cost to date GHc2,800
Cost Incurred in Dec 2010: GHc
Direct Materials (2,500 units introduced) 13,200
Direct Labour 6,600
Production O/Heads 6,600
26,400
Closing Stock 300units
Degree of completion 80%
There was no loss in the process.
You are required to prepare the process 1 account for 12/10.

Solution: Calculation of Total Output in December 08

Opening stock 500
Add Units Introduced 2,500
Less Closing Stock (300)
Total Output in December 2,700

Total work started and finished in December 2,700

Less opening 500

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Work started and finished in December 2,200

Here again equivalent units will be used as the basis for apportioning costs
incurred during December 2010.

Statement of Equivalent Units

Total Degree of Equivalent
Details Units Completion of Productions
Opening Stock 500 40% 200
Fully Worked Units 2,200 100% 2,200
Output to Process2 2,700 2,400
Closing Stock 300 80% 240
3,000 2,640

Calculation of Cost Per Equivalent Unit = Cost Incurred/Equivalent Units

= GHc26,400/2,640 = GHc10/unit

Statement of Evaluation Finished Goods Opening and Closing Stocks

Production No. of Cost/Unit Valuation
Details Equiv. Units GHc GHc
Opening Stock 200 10 2,000
Fully Complete units 2,200 10 22,000
Closing Stock: (WIP) 240 10 2,400
2,640 26,400

Process 1 Account
Units GHc Units GHc
Opening Stock 500 2,800 Transfer to P2:
Direct Mat 2,500 13,200 Opening Stock Compl. 500 4,800
Direct Labour 6,600 Fully Worked Units 2,200 22,000
P/Overheads 0 6,600 Closing Stock (WIP) 300 2,400
3,000 29,200 3,000 29,200

Dealing with Opening WIP – Weighted Average Cost Method of Valuation

An alternative approach to FIFO is the Weighted Average Cost method of stock
valuation. By this method no distinction is made between units of opening stock
and new units introduced to the process during the accounting period. The cost of
the opening stock is added to the cost of incurred during the month or period
specified, and completed units of the opening stock are each assigned a value of
one full equivalent unit of production. Similarly, the features of Weighted
Average Cost method are best explained with an illustration.

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Example. Northern Food Ltd produces Wedding Cakes which are manufactured
in two consecutive processes. Information relating to process two during the
month of September 2012 is as follows:
Opening Stock (units) 800
Degree of Completion: GHc
Process 1 Material 100% 9,400
Added Materials 40% 1,200
Conversion Cost 30% 2,000
12,600
During September 2008 3,000 units were transferred from Process1 at a valuation
of GHc36,200. Added material cost GHc19,200 and conversion cost were
GHc23,600. Closing Stock at 30th September 2008 amounted to 1,000 units which
were 100% complete with respect to Process1 materials, 60% complete with
respect to added materials and conversion cost work was 40% complete. Northern
Food Ltd uses Weighted Average Cost approach for the valuation of output and
closing stock. You are required to prepare Process 2 account for September 2012.

Solution: Calculation of Total Output in September 2012.

Opening Stock 800
Add Units Introduced 3,000
Total Work Available for the Month 3,800
Less Closing Stock 1,000
Total Output in September 2,800
Total Work Finished in September 2,800
Less Opening Stock 800
Work Started and Finished in September 2,000

Note: Under this approach opening stock units counts as a full equivalent units of
production when the weighted average method is adapted. Closing stock
equivalent units are assessed in the same manner. Again we will employ the
concept of Equivalent Units as our basis for apportioning costs incurred during
the month.
Statement of Equivalent Units
Total Process 1 Added Conversion
Details Units Material Material Cost
Opening Stock 800 (100%) 800 800 800
Fully Worked Units 2,000 (100%) 2,000 2,000 2,000
Output to F/Goods 2,800 2,800 2,800 2,800
Closing Stock 1,000 (100%) 1,000 60% 600 40% 400
3,800 3,800 3,400 3,200

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Note: The cost of the opening stock is added to cost incurred in September 2012
and a cost per equivalent units is then calculated.

Process 1 Added Conversion

Details of cost Material Material Cost
GHc GHc GHc
Opening Stock 9,400 1,200 2,000
Fully worked Units 36,200 19,200 23,600
Total Cost 45,600 20,400 25,600
Equivalent Units 3,800 units 3,400 units 3,200 units
Cost Per Equivalent Unit GHc12 GHc6 GHc8

Statement of Evaluation Finished Goods Opening and Closing Stocks - WIP

Process 1 Added Conversion Total
Details Material Material Cost Cost
GHc GHc GHc GHc
Output to F/Goods 33,600 16,800 22,400 72,800
Closing Stock (WIP) 12,000 3,600 3,200 18,800
91,600
Process 2 Account
Units GHc Units GHc
Opening Stock 800 12,600 Transfer to F/Gds 2,800 72,800
Direct Mat 3,000 36,200
Added Mat 19,200
Conv. Cost 23,600 Closing Stock (WIP) 300 18,800
3,800 91,600 3,800 91,600

2. In a given period the production data and costs for a process were:
Production 2,100 units fully complete, 700 units partly complete. The degree of
completion of the partly complete units was: Complete direct material 80% ,
direct labour 60%, Overheads 50%. The costs for the period were: Direct
material GHc24,800 Direct labour GHc16,750; Overheads GHc36,200. Calculate
the total equivalent production, the cost per complete unit and the value of the
WIP.

Solution: Statement of Equivalent Units

Details Totals Material Labour Overheads
Fully Worked Units 2,100 2,100 2,100 2,100
Closing Stock 700 560 420 350
2,800 2,660 2,520 2,450

Statement of Cost (Per Equivalent Units)

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 Total Equivalent Cost/Unit
Input Cost Prod in Units GHc
Material 24,800 2,660 9.32
Labour 16,750 2,520 6.65
Closing Stock 36,200 2,450 14.78
¢77,750 7,630 30.75

Therefore, Value of completed production = 2,100 x GHc30.75 = GHc64,575

Therefore, Value of WIP = Total Costs – Value of Completed production
= GHc77,750 - GHc64,575 = GHc13,175

Q1.Katanga Ltd manufactures soap from Cotton Seeds. The soap is manufactured
in batches passing through 3 distinct processes:
Pressing raw seeds to produce unrefined oil
Refining oil to produce bulk soap
Packing
The following details have been extracted from the accounting records of Katanga
Ltd for the month ended 31/4/12:
Pressing Refinery Packing
GHc GHc GHc
Direct labour 49,520 27,800 32,800
Electricity 2,280 400 2,800
Gas 4,560 12,960 -
Maintenance costs 1,200 1,600 1,920
Packing material - - 57,069
During the month ended 30/4/12:
Issues from central stores consisted:
i. 150 tonnes of cotton seeds to the Pressing plant at a standard cost of
GHc3,632 per tonne. Wastage in the Pressing process amount to 331/3%
of raw cotton input.
ii. Additional ingredients weighing 14 tonnes with a total cost of GHc8,064
to the Refinery. Wastage in the Refinery amount to 31/3% of unrefined
and added ingredients.
iii. 100 tonnes of unrefined oil were transferred to the Refinery, 110 tonnes of
bulk soap were transferred to packing section and 105 tonnes of finished
soap were transferred to trading department’s warehouse.
iv. Wastage in the packing amount to 10% of bulk soap transferred from
refinery.
v. Waste matter from pressing process is sold for GHc7.2/tonne, that from
Refinery for GHc406/tonne and that from Packing for GHc155/tonne.

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You are required to write up the necessary process accounts for the month ended
30/4/12 calculating in each process the production cost per tonne as well total
Conversion Cost.

Pressing: Cost/tonne = Total Cost Incurred – Scrap/Total Expected Output: =

GHc602,360 - GHc360/100 = GHc6,020/tonne; Conversion Cost: GHc57,560

Process 1 - Pressing Plant

Tonnes GHc Tonnes GHc
Direct Mat 150 544,800 Normal Loss 50 360
Direct labour 49,520
Prod. OH:
Electricity 2,280
Gas 4,560
Maintenance 1,200 Output to Refinery 100 602,000
150 602,360 150 602,360

Refining: Cost/tonne = Total Cost Incurred – Scrap/Total Expected Output: =

GHc652,824 - GHc1,624/110 = GHc5,920/tonne; Conversion Cost: GHc42,760

Process 2 Accounts – Refinery

Tonnes GHc Tonnes GHc
Direct Mat P/Plant 100 602,000 Normal Loss 4 1,624
Added Mat 14 8,064
Direct labour 27,800
Prod. OH:
Electricity 400
Gas 12,960
Maintenance 1,600 Output to Packing 110 651,200
114 652,824 114 652,824

M/Packing: Cost/tonne = Total Cost Incurred – Scrap/Total Expected Output: =

GHc745,789 - GHc1,705/99 = GHc7,516/tonne; Conversion Cost: GHc37,520.

Process 3 Account – Moulding and Packing

Tonnes GHc Tonnes GHc
Direct Mat P/Plant 110 651,200 Normal Loss 11 1,705
Packing Mat 57,069
Direct labour 32,800
Prod. OH:
Electricity 2,800

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Maintenance 1,920
Abnormal gain 6 45,096 Transfer to F/Gds 105 789,180
116 790,885 116 790,885

Abnormal Gain Account

Tonnes GHc Tonnes GHc
Scrap a/c (loss of scrap revenue 930 Process3 a/c 6 @ GHc7,516 45,096
P & Loss a/c 44,166
45,096 45,096

Scrap Account
Tonnes GHc Tonnes GHc
Scrap Value of N/loss: Proceed from actual
Process1 50 360 Process1 (N) 50 @ GHc7,200 360
Process 2 4 1,624 Process 2 (N) 4 @ GHc406 1,624
Process 3 11 1,705 Process 3 (N-ABN) 5 @ GHc155 775
Abnormal Gain
0 (Loss of scrap income) 6 @ GHc155 930
65 3,689 65 3,689

3. A company operates a process system to produce product Sinbad. The

following data apply to the month of July:
Units GHc
Materials introduced into process 800 3,150
Direct labour 2,380
Closing stock 100
Transferred to finished goods 600
The following additional information is also relevant:
1. Conversion costs include production overheads which are to be charged at
75% of direct labour cost.
2. Inspection takes place at the end of the process. A 10% loss of units
introduced into the process is expected.
3. Closing stock is 60% complete as regards conversion costs and 100%
complete as regards materials.
You are required to prepare a process account for the period.

4. BMS & B.Ed Ltd. manufacturing process has a normal wastage of 5% which
can be sold as animal feedstuff at GHc5 per tonne. In the given period of the
following data were recorded:

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 i. Input materials were 160 tonnes at GHc23 per tone. Labour and overheads
was GHc2,896. Losses were at the normal level. Compute the cost per
tone.
ii. Assume the same data as in note (i) except that actual production was 148
tonnes, show the necessary computations and the relevant accounts.
iii. Assume the same data as in note (i) except that actual production was 155
tonnes, show the necessary computations and the relevant accounts.

5. Sure Start Ltd produces a single product which undergoes three processes. The
following details relate to one period:
Details/Processes I II III
GHc GHc GHc
Raw Materials (60,000 units) 80,000
Materials Introduced 23,500 18,750 22,100
Direct Wages 15,600 12,000 13,400
Overhead allotted to Process 3,800 4,600 3,200
Other overheads total GHc27,000 Units Units Units
Output (in units) 55,200 53,800 49,600
A normal loss of 5% of the input to each process is anticipated. Units lost have
the following scrap values: GHc
After process 1 Nil
After process 2 1
After process 3 1.80
Prepare the ledger account for the period.

6. Maracas Ltd. produces an item which passes through two processes before it can be
sold. In the month of March 2011 the relevant data was:
Details Absorbing Bottling
GHc GHc
Raw material input (5,000) 75,000 -
Material added - 20,400
Direct labour 85,250 79,200
Direct expenses 59,750 46,650
Output (in units) 4,500 4,000
Normal loss percentage of input 12% 7%
Scrap value of each lost unit 10 15
There was no stock at the start or end of either process. You are required to prepare all
the relevant process accounts.

Solution: Given input = 5,000

Normal loss = 0.12 x 5,000 = 600
Expected Output = 5,000 – 600 = 4,400

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Actual output given = 4,500
Abnormal gain = 4,500 – 4,400 = 100

Note that: Where there is scrap, total cost incurred is reduced by the scrap value
before spreading the remaining cost incurred over the expected output.

Cost/Unit = Cost Incurred – Normal Loss - Scrap Value/Total Expected Output

= GHc220,000 – GHc6,000/5,000 – 600 = GHc48.63/Unit

Process A Account
Units GHc Units GHc
Direct Mat 5,000 75,000 Normal Loss 600 6,000
Direct Labour 85,250
Direct Expense 59,750 Output to F/gds 4,500 218,863
Abnormal Loss 100 4,863 - -
5,100 224,863 5,100 224,863

Abnormal Gain Account

Units GHc Units GHc
Scrap a/c (sale) 100 1,000 Process A a/c 100 @GH48.63 4,863
P & Loss a/c 3,863 -
4,863 4,863
Given input = 4,500
Normal loss = 0.07 x 4,500 = 315
Expected Output = 4,500 – 315 = 4,185
Actual output given = 4,000
Abnormal loss = 4,000 – 4,185 = 185

Process B Bottling Account would appear as follows:

Cost/Unit of Output = Total Cost Incurred – Scrap/Total Expected Output
= GHc365,113 – GHc4,725/4,500 - 315 = GHc86.11/Unit

Process B Account
Units GHc Units GHc
Direct Mat 4,500 218,863 Normal Loss 315 4,725
Added Mat 20,400
Direct Labour 79,200 Abnormal Loss 185 15,931
Direct Expense 46,650 Output to F/gds 4,000 344,457
4,500 365,113 4,500 365,113

Abnormal Loss Account

Units GHc Units GHc

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Process A a/c 185 @GHc86.11 15,931 Scrap a/c (sale)185 2,775
P & Loss a/c 13,156
15,931 15,931

Scrap Account
Units GHc Units GHc
Scrap Value of N/loss: Proceed from Actual
Process A 600 6,000 Units Sold PA (N-AbG) 500 @ GHc10 5,000
Process B 315 4,275 PB (N +AbL) 500 @ GHc15 7,500
Abnormal Loss 185 2,775 Abnormal gain a/c
0 (Loss of Scrap Income) 100 @ GHc10 1,000
1,100 13,500 1,100 13,500

Cost Management
Managers must be able to determine the long and short run costs of goods,
services, customers, suppliers, and other objects of interest. The cost of activities
and processes do not appear on financial statements. However, knowing these
costs and their underpinning causes is critical for businesses engaging in such
contemporary tasks as continuous improvement, total quality management,
environmental cost management, productivity enhancement and strategic cost
management. What makes cost management so vital is the fact that it
encompasses both the cost accounting and the management accounting
information systems. For instances, a firm’s profitability is of a great interest to
investors, but managers need to know the profitability of individual products. The
accounting system should be designed to provide both total profits and profits for
individual products/sections.
Purposes of Cost Management
 Facilitate budget preparation
 Inventory valuation (Materials, WIP, Finished goods)

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  Enable management to make decisions
 Enable management long term planning and controlling of the business
 Efficient use of resources
 Determine product pricing and profitability policy
Why Overheads Should Be Fairly Distributed In an Organisation
i. To remind profit centre managers about the existence of indirect costs
ii. To enhance control of service cost or support department costs
iii. To encourage efficient use of common services
iv. To fix accountability and responsibility
v. To evaluate profit centres
vi. To determine cost accurately
vii. To allocate cost per unit for usage
viii. To foster cost awareness or consciousness
ix. To promote more effective utilisation of resources
Non-Financial Factors to Consider when Setting Selling Prices
i. Competitors or degree of competition
ii. Availability of substitutes
iii. The targeted group or customers their income level perception
iv. Nature of demand and supply
v. Overall income levels
vi. Distribution channels
vii. The extent of the market
viii. The timing or seasons
ix. Nature of products.

Full/Absorption Costing
It is a costing method or technique that allocates fixed overheads to each cost unit.
Fixed overheads are traditionally spread or shared among cost units using the
3A’s allocation, apportionment and absorption. Common basis of allocating fixed
overhead under the conventional approach are labour hours and machine hours.
Based on that, budgeted OAR or predetermined overhead recovery rate(s) are
calculated (e.g. total overheads /total labour hours = OAR/labour hour, thus, the
traditional costing approach)
Problems with 3A’s
 Basis of allocation, apportionment, and absorption are usually arbitrary
 Distribution of fixed overheads are often inaccurate
 Absorption of fixed overheads cost may includes costs that are irrelevant
for decision-making
In fact, budgeted OAR can be assigned to individual jobs on an ongoing and
timely basis. But, budgeted OARs are usually based on estimates made up to 12
months before the actual costs incurred are ascertained. Adjustments may be

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required by the year end but it will also be too late by then for many decisions-
making purposes.
Basic Problems Arbitrary OAR
a) Under-absorbed overheads occur – thus, when the absorbed amount of
indirect costs in an accounting period is less than the actual overheads
incurred.
b) Over-absorbed overhead costs – thus, when the absorbed amount of
indirect costs in an accounting period is greater than the actual overheads
incurred.
c) Usually predetermined rates may mislead for costing purposes
d) In a minor tone, it is administratively and clerically cumbersome to deal
with as eventually, actual rate(s) will have to be calculated to contrast the
predetermined rate(s).
You might therefore ask why the problem of the under and over absorption is
worth mentioning. Certainly, it is in that, it would be better to use the actual
overhead cost incurred in order to avoid under or over absorption completely as
well as guarantee an accurate cost and profit determination over a period.
Example1. Mustapha Company Ltd makes two products in three departments X,
Y, and Z. Relevant product information for July, 2012 is given below:
‘Banku’ ‘Omotuo’
Material Cost (GHc) 15 25
Labour Cost in Dept X (GHc) 12 18
Labour Cost in Dept Y (GHc) 15 15
Labour Cost in Dept Z (GHc) 6 -
Budgeted number of units 10,000 8,000
‘Omotuo’ does not pass through department Dept Z. The labour rate is GHc6 per
hour in each department. The budgeted departmental overheads are; X
GHc55,000; Y GHc27,000 and Z GHc200,000. You are required to calculate the
cost per unit of ‘Banku’ and ‘Omotuo’ using:
a) individual departmental overhead absorption rate
b) a blanket overhead absorption rate
Calculation of Overhead Absorption Rates
Individual Department Rates ‘Banku’ ‘Omotuo’
Hours in X (i.e. GHc12/6) 2 (i.e. GHc18/6) 3
Hours in Y 2.5 2.5
Hours in Z 1 0
Total 5.5 5.5
Total Hours spent in X: 2 x 10,000 + 3 x 8,000 44,000
Total Hours spent in Y: 2.5 x 10,000 + 2.5 x 8,000 45,000
Total Hours spent in Z: 1 x 10,000 10,000
Total Hours Spent In Plant 99,000

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Dept X – OAR = GHc55,000/44,000 = GHc1.25 per labour hour
Dept Y – OAR = GHc27,000/45,000 = GHc0.60 per labour hour
Dept Z – OAR = GHc200,000/10,000 = GHc20.00 per labour hour
i. Calculation of Cost per Unit (Using the Departmental Rate):
‘Banku’ (GHc) ‘Omotuo’ (GHc)
Direct Material 15.00 25.00
Direct Wages (5.5hours x GHc6) 33.00 33.00
Overheads: DepartmentX: (GHc1.25 x 2hours) 2.50 (GHc1.25 x 3hours) 3.75
Department Y: (GHc0.60 x 2.5hours) 1.50 (GHc0.60 x 2.5hours) 1.50
Department X: (GHc20.00 x 1hour) 20.00 -
Cost Per Unit 72.00 63.25
Blanket OAR: = GHc55,000 + GHc27,000 + GHc200,000/99,000 = GHc2.85

ii. Calculation of Cost per Unit (Using the Blanket Rate):

‘B’ (GHc) ‘O’ (GHc)
Direct Material 15.00 25.00
Direct Wages (5.5hours x GHc6) 33.00 33.00
Overheads: (GHc2.85 x 5.5hours) 15.68 15.68
Cost/Unit 63.68 73.68
In recent times, technology provides managers with quick and accurate product-
cost information that facilitates the effective and efficient management decision
making and control of business. This brings us to the all important contemporary
concept of Activity-Based Costing (ABC).

Activity-Based Costing System (ABC)

Activity-Based Costing system is another method of cost allocation deemed to
provide a more accurate cost per unit or unit cost. It is a new innovative concept
just like ABM, JIT, TQM, process re-engineering or improvement, TOC all of
which are believed to be improvement programmes which, when properly
implemented will:
 Enhance quality
 Reduce operational cost
 Increase output or productivity
 Eliminate unnecessary delays in meeting customer need and satisfaction
 Increase profits the ultimate goal of every organisation.
It is believed that ABC systems help companies make better:
 pricing decision,
 product mix decisions
 inventory valuation
Accurate unit cost or standard cost is very critical for many decisions such as:

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  bidding decisions
 accept or reject special order decision
 add or drop continue or shutdown as well as
 Assists in cost management decisions by improving processes and product
designs and production layouts.
Predetermined overhead rates
The central concern of ABC is, whether there is a cause and effect relationship
between overheads cost and unit-based cost driver used (i.e. labour or machine
hours as traditionally accepted and applied in absorption or full costing method).
Note: For such allocation or cost attribution base to be correct, overhead costs
would need to be linearly variable with labour or machine hours.
This seems unlikely on the basis of the information usually provided or available.
For instance, predetermined rates are usually used instead of actual rate because
of the problem of accuracy and timeliness. Waiting until the end of the period to
ensure accuracy is usually rejected or not acceptable because of management need
for timely information. Timeliness of information based on actual overhead costs
also runs into difficulty because overhead is incurred non-uniformly and
production also may be non-uniformly.
Plant wide or blanket
Overhead is collected in a plant pool using direct tracing and then a single OAR is
computed and used to assign overhead to products.
Department overhead rates
First overhead is assigned to production department pools using direct tracing,
driver tracing and direct allocation. Second stage is to compute individual
department rates and used to assign overhead to products as they pass through the
department. Again, note that departmental rates will be chosen over plant wide
rate whenever some
 departments are more overhead-intensive than others and
 products spend more time in some departments than they do in others.
Plant wide overhead rates assign overhead to products in proportion to the
amount of the unit-based cost driver used. If the products consume some overhead
activities in different proportions than those assigned by the unit-based driver,
then, cost distortions can occur (i.e. the product diversity factor). This distortion
can be very significant if the non-unit level overhead costs represent or constitute
a significant proportion of total overhead costs.
Activity-based product costing is an overhead costing approach that first
assigns overhead costs to activities and then to products. The assignment is made
possible through the identification of activities, their costs and the use of cost
drives

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Thus ABC allocates overheads using a number of cost drives rather than just one
such as labour or machine hours. It attempts to identify a series of causes and
effects relationships. Thus, those in favour of ABC argue that:
 Activities generates transactions
 Transactions generates costs
 ABC traces costs to activities.
While cost are likely to be caused by multiple factors, the accuracy of any ABC
system will depend greatly on both the number of factors selected and the
appropriateness of each of these activities as a driver for costs. Each cost driver
should be appropriate to the pool of overheads to which it relates. As rightly
pointed out from the beginning, there should ideally be a direct cause and effect
relationship between the cost driver and the relevant overhead cost pool, but this
should also be a linear relationship (in other words costs increase proportionately
with the number of activities operated)
Cost Drivers - By definition are the important activities in a business that are
significant cost determinants. Cost drivers actually represent the allocation bases
in an ABC system, and always there will be more than one cost drive used to
assign costs to products in an organisation.
Activity-Based Costing System (ABC)
ABC has been developed from Professor Kaplan’s concept of effective and
efficient costing system. A number of companies are now adopting this system in
determining the cost of their operations. Examples include Dell Computers,
Siemens, and most Commercial Banks. The main import of ABC is that it is
activities which create cost, not products, and it products which consumes or
benefits from activities. That means if the cost of activities and their relationship
to products can be well defined, then, that would be a good basis for product
costing, performance evaluation and profitability determination.
Steps:
Identify all overheads (i.e. cost pools)

Identify cost driver of each overhead

Calculate the activity rate for each overhead type

Allocate overheads to each cost unit

ABC View of Costs

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Form the traditional costing view point, costs are categorised into fixed and
variable. ABC system, however, splits costs into short-term and long-term
variable costs. Short-term variable costs equate with variable costs under
traditional cost accounting system. Their main characteristic is that they are
directly related to volume and thereby change proportionately with the level of
output. Long-term variable costs, on the other hand, are equivalent to fixed costs
under the traditional cost accounting system. It should be noted here that, this is
not only a mere change in terminology. The long-term under the ABC system
reflects the fact that such costs do vary with level of activity but with a time lag.
Some key operational activities that should be identified are as follows:
i. Design of products and processes
ii. Set-up of moulding machine
iii. Operating machines to manufacture products
iv. Maintaining and cleaning the moulds
v. Set-up batches of finished products for shipment
vi. Material handling and distribution of products to customers
vii. Packaging and dispatching
viii. Administering and managing processes t
Implementing Activity-Based Costing (ABC)
 Step 1: Identify the chosen cost units or objects
 Step 2: Identify direct costs of the product or service
 Step 3: Select the cost-allocation bases to be used in allocating indirect
costs to the products.
 Step 4: Identify the indirect costs associated with each cost-allocation
base, having in mind the fact that, overhead costs incurred are assigned to
activities, as much as possible, on the basis of a cause-and-effect
relationship.
 Step 5: compute the rate per unit of each cost allocation base used to
allocate indirect costs to the products/services
 Step 6: Compute the indirect costs allocated to the products/services
 Step 7: Compute the costs of the products or services by adding all direct
and indirect costs assigned or allocated to them.

Direct costs may show the three main cost categories or element which includes
direct materials, direct labour or wages and direct expenses such as hire of special
tool, cleaning and maintenance, royalties, etc. However, indirect costs may show
six or more cost pools or cost drivers which includes design, moulding machine
setups, manufacturing operations, shipment setup, distribution, administration.
ABC and Department Indirect-Cost Rates
Of late, many companies have evolved their costing system from using single cost
pool to separate/individual indirect-cost rates for each department, e.g. design,

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manufacturing, selling etc. The reason being that, the cost drivers of resources in
each department or sub-department differ from the single, plant-wide, blanket
cost-allocation base. ABC systems are a further refinement of department costing
systems.
ABC Systems are More Beneficial When:
 Significant amount of indirect costs are allocated using only one or two
cost pools
 All or most cost are identified as output unit-level costs
 Products make diverse demands on resources because of differences in
volume, process steps, batch size, or complexity
 Products that a company is well-suited to make and sell show small profits
while products for which a company is less suited show huge profits
 Complex products appear to be profitable and simple products appear to
be losing money.
 Operations staffs have significant disagreements with accounting staff
about the cost of making and marketing products and services.
Limitations of ABC Systems
Among the limitations of ABC systems are:
 The main limitations are the measurements necessary to implement the
system
 ABC systems require management to estimate cost of activity pools and to
identify and measure cost drivers for those pools.
 Activity-cost rates also need to be updated regularly
 Very detailed or comprehensive ABC systems are costly to operate and
difficult to understand.
Advantages of ABC Systems
1. Organisations can concentrate on producing the most profitable items.
2. Control of overheads is easier, as responsibility for incoming costs must
be establish before ABC can be implemented.
3. Performance appraisal is more meaningful
4. Cost drivers rates can be monitored and used to identify areas of weakness
or efficiency
5. Budget setting and sensitivity analysis is made more accurate
6. New products can be designed to utilise efficient cost-drivers
Disadvantages of ABC Systems
1. ABC may be based on historical information but could be used for future
strategic decisions
2. Selection of cost-drivers may not be easy
3. Cost measurement may not be easy
4. Exclusion of non-production overheads can be difficult

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 5. Assessing the degree of completion of work in progress with respect to
each cost driver is difficult.
6. Variance analysis is complicated
For the purposes of ABC illustration consider the following data provided by
Seven Sister Enterprise:
Details/Product X Y
Quantity produced 8,000 2,000
Number produced per batch 250 50
Number of batches 32 40
Set-up time per batch 2 hours 5 hours
Total set-up hours 64 200
Assuming indirect costs of GHc2,900 are grouped into a single overhead cost
pool and 5,000 direct labour hours are used as the cost-allocation base. (i.e.
GHc2,900/5,000 hours = GHc0.58)
For the purposes of ABC analysis, it is estimated that, Seven Sisters Enterprise
uses 3,600 direct labour hours to produce X and 1,400 direct labour hours to make
product Y. Total set-up costs are GHc409.2.
What is the set-up cost per set-up? (GHc1.55 = GHc409.2/264). What is the set-
up cost per direct labour hour? (GHc0.08184 = GHc409.2/5,000).
Cost allocation using direct labour hours:
Product X: GHc0.08184 x 3,600 = GHc294.6
Product Y: GHc0.08184 x 1,400 = GHc114.6 = GHc409.2
Cost allocation using ABC:
Product X: GHc1.55 x 64 = GHc 99.2
Product Y: GHc1.55 x 200 = GHc310.0 = GHc409.2
How should Seven Sisters allocate set-up costs?

Comment: It is clear that set-up costs should be allocated on the basis of set-up
hours. The reason being that, there is a strong cause-and-effect relationship
between set-ups related costs and set-up hours than the labour hours.
Cost Structures
A categorisation of costs into cost pools on the basis of cost types or degree and
difficulty in determining cause-and-effect relationships usually poses problems.
Consequently ABC systems commonly use a four-part cost structure to identify
cost allocation bases which are namely:
1. Output unit-level costs: these are resources sacrificed on activities
performed on each individual unit of product or service, e.g. include
energy, machine depreciation, repairs etc
2. Batch level-costs: these are resources sacrificed on activities that are
related to a group of units of product(s) or service(s) rather than to each

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 individual unit of product or service, e.g. include set-up times,
procurement costs etc.
3. Product or Service-sustaining costs: these are resources sacrificed on
activities undertaken to support individual products or services, for
instances product design and development costs, engineering costs,
research, etc
4. Facility-sustaining costs: these are resources sacrificed on activities that
cannot be traced to individual products or services but support the entire
establishment or organisation as a whole for instances general
administration, rent, building security, etc.

Q1. XYZ Ltd manufactures the following products:

Product A Product B
Quantity produced 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set ups in period 10 40
Order made in period 15 60
Overhead costs GHc
Relating to machine activity 220,000
Relating production set ups 20,000
Relating to handling of orders 45,000
285,000
You are required to calculate the production overhead to be absorbed in each unit
of product A and B using:
i. Labour hours to absorb overheads
ii. ABC approach (i.e. using appropriate cost drivers)

Solution: Using Labour Hours

Total Overheads Cost = GHc285,000
Total Labour Hours - Product A: 1 x 5,000 = 5,000
Product B: 2 x 7,000 = 14,000 = 19,000 hours
OAR = GHc285,000/19,000 = GHc15/Labour hour
Details Product A Product B
Overheads (GHc15/hour) 75,000 210,000
Total Overhead Costs 75,000 210,000
Output (units) 5,000 7,000
Overhead Cost/unit GHc15 GHc30
Solution: Using ABC
Machine Activity GHc220,000/22,000 = GHc10/Machine hour
Set-ups GHc20,000/50 = GHc400

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Handling of orders GHc45,000/75 = GHc600

Details Product A Product B

Overheads: GHc GHc
Machine usage (GHc10 x 3 x 5,000) 150,000 70,000
Set-ups (GHc400 x 10) 4,000 16,000
Purchase orders (GHc600 x 15) 9,000 36,00
Total Overhead Costs 163,000 122,000
Divide by Output (units) 5,000 7,000
Overhead Cost/Unit GHc32.6 GHc17.43

Q2. Shocker Ltd produces three types of bread at the same factory: the Brown
Bread; the White Bread, the Tea Bread. It sells bread throughout the West African
Sub-region. In response to market pressures Shocker Ltd has invested heavily in
new baking technology in recent years and, as a result, has significantly reduced
the size of its workforce. Historically, the company has allocated all overheads
cost using total direct labour hours, but is now considering introducing Activity
Based Costing (ABC). Shocker Ltd’s accountant has produced the following
analysis.
Annual S/Price/ Mat
Products Output Lab Hrs Unit GHc Cost/unit GHc
Brown Bread 2,000 20,000 4 0.40
White Bread 1,600 22,000 6 0.60
Tea Bread 400 8,000 8 0.90
The three cost drivers that generate overheads are:
Deliveries to retailers - the number deliveries of bread to retail outlets
Set-ups - the number of times the assembly line process is re-set to
accommodate a production run of a different type of bread
Purchase orders - the number of purchase orders
The annual cost driver volumes relating to each activity and for each type of bread
are as follows:
Number of Number of Number of
Products Deliveries to Retailers Set-ups Purchase orders
Brown Bread 100 35 400
White Bread 80 40 300
Tea Bread 70 25 100

The annual overhead costs relating to these activities are as follows: GHc
Deliveries to retailers 2,400
Set-up costs 6,000
Purchase orders 3,600

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All direct labour is paid GHc0.05 per hour. The company holds no stocks.
At a board meeting there was some concern over the introduction of activity
based costing. The General Manager – Finance argued: ‘I very much doubt
whether selling the Tea Bread is viable but I am not convinced that activity based
costing would tell us any more than the use of labour hours in assessing the
viability of each product.’

The Marketing Manager argued: ‘I am in the process of negotiating a major new

contract with a popular hotel restaurant for the Brown Bread. For such a big order
they will not pay our normal prices but we need to at least cover our incremental
costs. I am not convinced that activity based costing would achieve this as it
merely averages costs for our entire production.’

The Managing Director argued: ‘I believe that activity based costing would be an
improvement but it still has its problems. For instance, if we carry out an activity
many times surely we get better at it and costs fall rather than remain constant.
Similarly some costs are fixed and do not vary either with labour hours or any
other cost driver.’ The Board Chairman argued: ‘I cannot see the problem. The
overall profit for the company is the same no matter which method of allocating
overheads we use. It seems to make no difference to me.’

You are required to calculate the total profit on each of Shocker Ltd’s three types
of product using each of the following methods to attribute overheads:
i) the existing methods based upon labour hours; and
ii) activity based costing

Solution: Using Labour Hours

Total overheads cost = GHc12,000
Total labour hours = 50,000 hours
Overhead Absorption Rate = GHc12,000/50,000 = GHc0.24/hour
Details B/Bread W/Bread T/Bread
GHc GHc GHc
Direct labour (GHc0.05/hour) 1,000 1,100 400
Materials (GHc0.4/0.6/0.9/unit) 800 960 360
Overheads (GHc.24/hour) 4,800 5,280 1,920
Total Costs 6,600 7,340 2,680

Output (units) 2,000 1,600 400

Cost/unit (GHc) 3.30 4.60 6.70

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Selling Price/unit (GHc) 4.00 6.00 8.00
Profit/ (Loss)/unit (GHc) 0.70 1.40 1.30
Total Profit / (Loss) 1,400 2,260 520
Total Profit 4,180

Using ABC
Deliveries to Retailers GHc2,400/250 = GHc9.60
Set-ups GHc6,000/100 = GHc60
Purchase orders (C/inwards) GHc3,600/800 = GHc4.5
Details B/Bread W/Bread T/Bread
GHc GHc GHc
Direct Labour (GHc0.05/hour) 1,000 1,100 400
Materials (GHc0.4/0.6/0.9/unit) 800 960 360
Overheads:
Deliveries (GHc9.6) 960 768 672
Set-ups (GHc60) 2,100 2,400 1,500
Purchase orders (GHc4.5) 1,800 1,350 450
Total Costs 6,660 6,578 3,382
Output (units) 2,000 1,600 400
Cost/unit (GHc) 3.33 4.10 8.50
Selling Price/unit (GH¢) 4.00 6.00 8.00
Profit/ (Loss)/unit (GH¢) 0.67 1.90 (0.50)
Total Profit / (Loss) 1,340 3,022 (182)
Total Profit 4,180

Q3. The IBM Company make four products and in determining the total costs of
production for all products have always used a simple method of overhead
allocation based on machine hours per unit. The new Cost Accountant is trying to
convince management of the benefits of using Activity-Based Costing (ABC) to
trace overhead costs to products more accurately. The budget for the next year has
already been prepared and is as follows:
A B C D
Details GHc GHc GHc GHc
Direct material 74 128 62 109
Direct labour 162 99 180 288
Direct machine hours/unit 6 9 4 3
Budgeted output in units 1,400 800 1,800 2,400
Labour is paid at a rate of GHc9 per hour. Under the traditional approach,
overheads are charged to each product at an appropriate rate per machine hour.
Total overheads are budgeted at GHc840,000 for the period.

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From an ABC perspective, the Cost Accountant has identified the following cost
pools and cost drivers:
Cost pool Cost GH¢ Cost driver
Set-up costs 131,520 Number of set-ups
Inspection 145,800 Number of inspections
Dispatch 125,600 Batches dispatched
Machining 437,080 Machine hours
On investigation the Cost Accountant discovers that goods are produced in
batches of 200, 10% of labour hours are physically monitored by quality
inspectors and that all goods are dispatched in batches which represent a sample
of normal output (in the ratio of 14:8:18:24 for A, B, C and D – a total of 64 units
in each batch )
You are required to:
i. Calculate the overhead charge for each product using the traditional basis
of overhead allocation using machine hours; use the ABC basis to
calculate overhead allocation between the four different products and
comment on your results.
ii. Critically assess the view point that product costs are the only appropriate
basis for determining selling prices in a competitive and fast-moving
business environment. Or
iii. Discus some of the factors, in addition to cost, that you might take into
account in setting selling prices.
iv. Explain why managers would want to allocate overheads to cost centres

Q4. Nana Akwasi Asante Company make two products and have always used
direct labour hours as the basis for absorbing overheads. Budgeted information for
the year 2012 is as follows:
Details/Products A B
D/material cost per unit (GHc) 29 16
D/ labour cost per unit (GHc) 16 8
Machine hours per unit 2 3
Budgeted units passing inspection 1,000 1,800
Budgeted overheads for the period are GHc306,000 and the budgeted labour rate
is GHc4 per direct labour hour. When overheads are analysed from an activity
based costing (ABC) perspective, the financial controller decides that GHc39,000
relates to set-up costs; GHc16,000 to stores issuing costs; GHc45,500 to
inspection costs; GHc30,000for dispatch of customers orders. In the current
production environment the remainder relate to machine activity.

The manufacturing process can only make one product at a time so the product
being produced is changed every 50 units, even if the units being produced are not

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fully complete. Stores issues take place at the start of the production process and
the budgeted total number of stores issues is 20 for A and 60 for B. The numbers
of batches of each product dispatched are 100 for A and 200 for B. Budgeted
normal losses are 20% of the units inspected for product A and 10% for product
B. inspection takes place at the end of the manufacturing process units are fully
complete. Assume there is no opening or closing work in progress.

You are required to calculate the overhead charge for each product using the
traditional basis of overhead allocation (i.e. machine hours) use the ABC basis to
calculate overhead allocation between the four different products and comment on
your results.
Q5. Hanson Ltd has a single production process for which the following costs
have been estimated for the period ending 31/12/12.
GHc
Material receipt and inspection costs 15,600
Power costs 19,500
Material handling costs 13,650
Three products – COM, BMS, and BED - are produced by workers who perform a
number of operations on materials, using hand held electrically powered tools.
The workers are paid GHc4 per hour. The following budgeted information has
been obtained for the period ending 31/12/08:
Products COM BMS BED
Production (units) 2,000 1,500 800
Batches of materials 10 5 16
Standard data per unit of output:
Direct material (square metres) 4 6 3
Direct material cost (GHc) 5 3 6
Direct labour (minutes) 24 40 60
Number of power drill operations 6 3 2
Overhead cost for material receipt and inspection, process power and material
handling are currently each absorbed by product units using rates per direct labour
hour.
An activity based costing investigation has revealed that the cost drivers for
overhead costs are as follows:
Material receipt & inspection costs Number of batches of materials
Power costs Number of power drill operations
Material handling costs Quantity of square metres handled
You are required to prepare a summary which shows the budgeted product cost
per unit for each product ate the overhead charge for each product of BCOM,
BMS, and BEDSS for the period ending 31/12/08 detailing the unit costs for each
cost element using:

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 i. the existing method for the absorption of overhead costs,
ii. An approach which recognises the cost drivers revealed in the activity
based costing investigation.
iii. Explain the relevance of cost drivers in activity based costing. Make use
of figures from the summary statement prepared in (a) to illustrate your
answer.
Q6. Rick Warren Plc has three product lines: P1, P2 and P3. Since its creation the
company has been using a blanket direct labour cost percentage to assign
overhead costs to its products.
Despite P3, a relatively new line, attracting additional business, increasing
overhead costs and loss of market share, particularly for P2, a major product have
convinced the management that the costing system is in need of some
development. A team, led by the cost accountant was established to develop an
improved system of costing based on activities. The team spent several weeks
collecting data (see table below) for the different activities and products. For the
accounting period in question, given in the tables below is data on Rick Warren
Plc’s three product lines and overhead costs:
Details P1 P2 P3
Production volume (units) 7,500 12,500 4,000
Direct labour cost per unit (GHc) 4 8 6.4
Direct material cost per unit (GHc) 18 25 16
Selling price per unit (GHc) 47 80 68
Material movement per unit 4 25 50
Machine hours per unit 0.5 0.5 0.2
Set-ups (in total) 1 5 10
Proportion of engineering work 30% 20% 50%
Orders packed (in total) 1 7 22
Activities Overhead Cost (GHc)
Material receiving and handling 150,000
Machine maintenance and depreciation 390,000
Set-up labour 18,688
Engineering 100,000
Packing 60,000
Totals 718,688
You are required to:
a) Calculate the overhead recovery rate and the product unit cost under the
existing costing system.
b) Identify for each overhead activity, an appropriate cost driver from the
information supplied, and then calculate the product unit costs using a
system that assigns overheads on the basis of the use of activities.
c) Comment the results of the two costing systems in (a) and (b) above.

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Existing System OAR = Total Overheads/Direct Labour Cost
GHc718,688/ *GH155,600 x 100 = 461.88% or 4.6188 of labour cost
*W1. D/Labour Cost = (7,500 x GHc4) + (12,500 x GHc8) + (4,000 x GHc6.4) =
GHc155,600
Calculation of Unit Cost Based on Existing System:
P1 P2 P3
Details GHc GHc GHc
Direct materials 18.00 25.00 16.00
Direct labour (i.e. for P1, P2, P3) 4.00 8.00 6.40
Production overhead (i.e. P1 4.6188 x GHc4) 18.48 36.96 29.56
Total Cost/unit 40.48 69.96 51.96
Activity Based Costing Approach
Mat/Handling Rate: = GHc150,000/542,500 = GHc0.2764976/Mat. Mov’nt
For P1 unit cost = 4 x GHC0.2764976 = GHc1.11/Unit same for P2 and P3.
Mach Maintenance Rate: = GHc390,000/10,800 = GHc36.11/Mach hr
For P1 unit cost = GHc36.11 x 0.5 = GHc18.06 per unit - same for P2 and P3.
Set-ups - Cost driver Rates: = GHc18,688/16 = GHc1,168/Set-up
For P1 unit cost = 1 x GHc1,168/7,500 units = GHc0.16 per unit same for P2 and P3.
Engineering - Cost driver Rates: = use proportions of engineering work
For P1 unit cost = 0.3 x GHc100,000/7,500 units = GHc4.00 per unit same for P2 and P3.
Packing - Cost driver rates: = GHc60,000/30 = GHc2,000 per order
For P1 unit cost = 1 x GHc2,000/7,500 units = GHc0.27 per unit same for P2 and P3.
Calculation of Unit Cost based on ABC system:
P1 P2 P3
Details GHc GHc GHc
Direct Materials 18.00 25.00 16.00
Direct labour (i.e. for P1, P2, P3) 4.00 8.00 6.40
PRIME COST 22.00 33.00 22.40
Production Overhead:
Material Handling 1.11 4.42 21.60
Machine Maint. & Depre 18.06 18.06 7.22
Set-up labour 0.16 0.47 2.92
Engineering 4.00 1.60 12.50
Packing 0.27 1.12 11.00
Total Cost/unit 45.50 58.05 79.77
Note: Apportioning the total overhead costs e.g. GHC150,000, between the three
product lines using the cost driver ratios (i.e. 4:25:50) would then find an
overhead cost per unit
The cost driver is the ‘root cause’, the causal link between the activity and the
cost unit. It describes exactly how the production of units incurs costs within the
activity. The overhead is linked to cost unit using a cost driver rate. Furthermore,
driver rate may be considered critical to control of overheads. By controlling or
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reducing the incidence of the cost driver, the amount of overhead can be
controlled.
7. The Kwasanty Company is a long established family firm making durable parts
for house hold appliances. Since ever anyone can remember, overheads have been
allocated on the basis of the number of direct labour hours used for each product.
Budgeted figures for the next accounting period are as follows:
Products Kettle Toaster C/Maker
Budgeted units of output 36,200 27,600 48,800
Standard data: GHc GHc GHc
Direct material 37 29 13
D/labour at GHc12 per hour 24 18 9
Machine hours per unit 7 hrs 3 hrs 5 hrs
Junior Kwasanty, the son of the present Managing Director has just completed his
degree programme in Business Administration and has come to work for the
company. His first job is to work in the accounting department looking at
overheads and how they are allocated to units of output. After studying the current
system he comes to the conclusion that it was probably okay years ago when the
company was very labour intensive. However, the company now uses much more
machinery and Junior believes that it is time to change the overhead allocation
system. He suggests that the overheads be divided into three cost pools as follows:
i. Machinery overheads GHc5,800,000 to be allocated on the basis of
machine hours per unit.
ii. Personnel related overheads - GHc2,600,000 to be allocated on the basis
of direct manufacturing labour hours per unit.
iii. General overheads - GHc1,300,000 to be allocated on the basis of number
of units produced.
You are required to:
Calculate the unit cost of each product using both the current method of allocating
overheads and the approach suggested by Junior Kwasanty

Solution: Existing method: Current OAR = Total Overheads/Direct Labour Hours

GHc5,800,000 + GHc2,600,000 + GHc1,300,000= GHc9,700,000/150,400 * =
GHc64.50/lab hr
*Total lab hrs = 24/12 x 36,200 + 18/12 x 27, 600 + 9/12 x 48,800 = 150,400 labour hrs
Calculation of unit cost based on existing system:
KT TT CM
Details GHc GHc GHc
Direct materials 37 29.00 13.00
Direct labour 24 18.00 9.00
Production OH (i.e. for KT 2 x GHc64.50) 129 96.75 48.38
Total Cost/unit 190 143.75 70.38
Activity Based Approach: Cost driver rates:
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Machinery overheads = GHc5,800,000/580,200 *= GHc9.997/Machine Hr
*Total Machine Hrs = 7 x 36,200 + 3 x 27, 600 + 5 x 48,800 = 580,200 Machine Hrs
Personnel Related OH = GHc2,600,000/150,400 *= GHc17.287/Labour Hr
*Total Labour Hrs = 24/12 x 36,200 + 18/12 x 27, 600 + 9/12 x 48,800 = 150,400 Lab Hrs
General Overheads = GHc1,300,000/112,600 *= GHc11.545/Unit
*Total Output = 36,200 + 27, 600 + 48,800 = 112,600 Units
General Overheads - GHc1,300,000
Calculation of unit cost based on ABC System:
KT TT CM
Details GHc GHc GHc
Direct materials 37.00 29.00 13.00
Direct labour 24.00 18.00 9.00
P/OHs: Machinery (i.e. for K 7 x GHc9.997) 69.98 29.99 49. 99
Personnel related (i.e. Kettle 2 x GHc17.287) 34.57 25.93 12.97
General (i.e. for all products GHc11.55) 11.55 11.55 11.55
Total Cost/unit 177.10 114.47 96.51
Workings1: Machinery overhead/Cost per unit
Kettle GHc9.997 x 7 hours = GHc69.98/unit
Toaster GHc9.997 x 3 hours = GHc29..99/unit
Coffee maker GHc9.997 x 5 hours GHc49.99/unit
Workings2: Personnel related overhead/Cost per unit
Kettle GHc17.287 x 2 hours = GHc34.57/unit
Toaster GHc17.287 x 1.5 hours = GHc25..93/unit
Coffee maker GHc17.287 x 0.75 hour GHc12.97/unit
Workings3: General overhead/Cost per unit: GHc11.55/unit for all products
Note: Alternatively you could apportion the total overhead costs e.g. GHc15,600,
etc between the three products using the cost driver ratios (i.e. 10:5:16) then find
an overhead cost per unit

8. Fireworks Ltd makes three main products, using basically the same production
methods and equipment for each. A traditional product costing system is used at
present, although an activity-based costing (ABC) system is being considered.
Details of the three products for a typical period are as follows:
Details Hours/unit Materials/ Volumes
Products Lab Machine Unit (GHc) Units
Joy 1 3 4.0 1,500
Hope 3 2 2.4 2,500
Love 2 6 5.0 14,000
Direct labour costs GHc1.2 per hour and production overheads are absorbed on
machine hour basis. The overhead rate for the period is GHc2.8/machine hour.

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Further analysis shows that the total production overheads can be divided as
follows: (%)
Set-ups costs 35
Machinery costs 20
Material handling cost 15
Inspection costs 30
The following activity volumes are associated with the product line for the period
as a whole. Total activities for the period:
Products Set-ups Mat Movements Inspections
Joy 75 12 150
Hope 115 21 180
Love 480 87 670
You are required to calculate the cost per unit for each product using the
conventional and ABC approaches.
Q8. Opaque Ltd produces two types of products in the same factory: products X
and Y. It sells products throughout Ghana. The product Y has a wider and studier
base and a variety of ingredients to help monitor the heartbeat and calories intake
etc. At the beginning, of the year the following 2010 the following data were
prepared for this factory:
Details Product X Product Y
Budgeted output 20,000 10,000
Selling price (GHc) 2.80 5.75
Prime cost (GHc) 30,000 35,000
Machine hours 20,000 30,000
Direct labour hours 35,000 15,000
Engineering support hours 9,000 21,000
Orders receiving and processing 2,000 3,000
Material handling (number of moves) 10,000 30,000
Purchasing (number of requisitions) 500 1,000
Inspection (hours used) 4,000 16,000
Paying suppliers (invoices processed) 3,000 2,000
Setting up batches (number of setups) 20 30
Additionally, the following overhead activity costs are reported:
Cost Pools GHc
Quality control 4,000
Engineering support 6,000
Material handling 8,000
Setups 5,000
Purchasing 3,000
Orders receiving 2,000
Paying suppliers 2,000

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 30,000
You are required to calculate the cost per unit for each product using:
i. Direct labour hours to assign all overhead costs.
ii. Activity-based costing to assign all overhead costs.
Q9. Ebenezer Ltd produces two types of household tissue in the same plant. The
budget committee has identified the following overhead activities, costs, and
activity drivers for the coming year:
Activity Expected Costs GHS
Setting up machines 240,000
Ordering costs 180,000
Machining costs 420,000
Receiving and inspection 200,000
Ebenezer produces two main products in the same factory with the following
expected prime costs and activity demands:
Model A Model B
GHc GHc
Direct materials 300,000 400,000
Direct wages 240,000 240,000
Output (Units) 80,000 40,000
Direct labour hours 30,000 10,000
Number of setups 200 100
Number of orders 3,000 6,000
Machine hours 12,000 9,000
Receiving and inspection hours 1,500 3,500
The company normal capacity is 40,000 direct labour hours.
a) You are required to determine the unit cost of each model using:
i. direct labour hours to apply overhead
ii. activity based costing approach to apply overhead
b) State three conditions that permit the application activity-based costing system.
c) State two limitations associated with activity-based costing system.

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Production Costing Techniques
Under costing technique two methods of computing income are identified. These
are commonly referred to as costing techniques because they depict various ways
by which product cost are determined for various purposes. These two forms of
product costing techniques are:
 Marginal or variable or direct costing, and
 Absorption or full costing.
The difference between variable and absorption costing hinges on the treatment of
one particular cost item namely fixed production overhead.

Marginal or Direct or Variable Costing

Variable costing stresses on the difference between fixed and variable
manufacturing cost. Variable costing assigns only variable manufacturing costs to
the product; these include direct material, direct labour, and variable production
overhead. Hence, in marginal costing, it is the responsibility of the accountant to
identify the marginal costs of production and sales, thus:
 The variable cost of production, consisting of direct materials, direct
labour and variable production overheads.
 The variable cost of administration, sales and distribution.
Fixed production overhead or cost is treated as a period cost or expense and is
excluded from the product cost. The rationale for this is that fixed overhead is a
cost of capacity or staying in business. Once the period is over any benefits
provided by the capacity have been expired and should not be inventoried or
added to stock or WIP valuation. Under variable costing fixed overhead of a
period is seen as expiring that period and is charged in total or full against the
revenue of the period.

Contribution
Contribution is the difference between the sales and the marginal or variable costs
of sales. Contribution is simply sales minus variable costs. Contribution is of
fundamental importance in marginal costing technique. Contribution is a short
form of contribution towards recovering fixed cost or overheads and making
profit. Therefore the only expense that can be charged against contribution is
fixed cost. No variable expense must be charged against contribution be it selling
and distribution, production or administrative expense, insofar a cost is variable; it
must be charge against sales revenue before you ascertain contribution.

Principles Underpinning Marginal/Variable Costing

Since period fixed costs remain unchanged no matter the level of production and
sales volume it follows that selling an additional unit of product/service means:
 Revenue will increase by the sales value of the item sold

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  Cost will increase only by variable cost per unit
 Increase in profit will always equal sales minus variable cost (i.e.
Contribution earned)
 Similarly if volume of sales falls by one item, profit will fall by the
amount of contribution earned
 Profit measurement or determination should be based on the analysis of
total contribution since fixed costs relate to the period of time.

Absorption or Full Costing

Absorption costing assigns all manufacturing cost to the product thus direct
material, direct labour, variable overhead and fixed overhead define the cost of a
product. Thus under absorption costing fixed overhead is viewed as a product cost
and not a period cost. Under this costing method, fixed overhead is assigned to
the product through the use of a predetermined fixed overhead rate and is not
expensed until the product is sold. Hence absorption costing system does not take
cognizance to whether the costs are fixed or variable. It is a costing principle
whereby both variable as well as fixed production costs are charged to cost units.
In absorption costing, both variable cost per unit and fixed overhead per unit are
charged to cost units. The total cost per unit is then multiplied by the total units
sold to ascertain total cost of sale which is deducted from sales revenue to arrive
the net profit.

Distinction between Absorption and Marginal Costing

Product cost Direct material Direct material
Direct labour Direct labour
Variable overhead Variable overhead
Fixed Production overhead -
Period cost Selling & Distribution Exp. Fixed production overheads
Administrative Expenses Selling & distribution Exp.
Administrative Expenses

Format of Marginal Costing GHc GHc

Sales (Units Sold x Selling Price/Unit) xxx
Less: Marginal Cost of Sales: Opening stock xxx
Production xxx
Closing stock (xxx)
Marginal Cost of Sales (all valued at MC/Unit) xxx
Add Variable Selling & Distribution Exp (if any) xxx
Variable Administrative Expenses (if any) xxx
xxx
CONTRIBUTION xxx

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Less: Fixed production Cost
Fixed Selling & Distribution
Fixed Administrative Expenses for the period xxx
Net Profit for the period xxx

Format of Absorption Costing GHc GHc

Sales (Units Sold x Selling Price/Unit) xxx
Less: Full Cost of Sales: Opening stock xxx
Production xxx
Closing stock (xxx)
Full Cost of Sales (all valued at AC/Unit) xxx
Adjustment for over/under absorbed fixed OH -+ xxx
Variable Selling & Distribution Exp (if any) xxx
Variable Administrative Expenses (if any) xxx
Fixed Selling & Distribution Exp (if any) xxx
Fixed Administrative Expenses (if any) xxx xxx
Net Profit for the period xxx

‘Same People’ Ltd makes and sells a single product. The following data relate to
periods 1 to 4. GHc
Selling price per unit 55
Variable cost per unit 30
Fixed costs per period 6,000
Normal activity is 500 units and production and sales for the four periods are as
follows: Period 1 Period 2 Period 3 Period 4
Units Units Units Units
Sales 450 450 550 450
Production 500 450 500 500
There were no opening stocks at the start of period 1.
Required:
a) Prepare profit statements for each of the periods 1 to 4, in a columnar
format, based on Variable costing principles
b) Prepare profit statements for each of the periods 1 to 4, in a columnar
format, based on Full costing principles.

c) Comment briefly on the results obtained in each period by the two system

2. Busybody Company Limited produces and sells furniture. The following data
were available for the year ended 31/07/12: Units
Opening Stock 1/08/11 12,000
Production for the year 24,000

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Sales (GHc20/unit) 28,000
Manufacturing costs (Totals): GHc
Variable 192,000
Fixed 144,000
Selling and distribution:
Variable 40,000
Fixed 64,000
The variable and fixed manufacturing cost per unit of the opening stock were
GHc6 and GHc8 respectively. You are required to prepare the profit and loss
statement in marginal and absorption costing format.

Profit Statement for Year Ended 31/07/12 - Marginal Costing Method

GHc GHc
Sales (28,000 @ GHc20) 560,000
Opening Stock (12,000 @ GHc6) 72,000
VC of Production (24,000 @ GHc8) 144,000
Closing Stock (8,000 @ GHc8) (64,000)
Variable Cost of Sales 152,000
Add Variable S/Distribution Expenses 40,000 192,000
Total Contribution 368,000
Less Fixed Cost: Production 144,000
Selling and Distribution 64,000 208,000
Profit (loss) 160,000

Profit Statement for Year Ended 31/07/12 - Absorption Costing Method

GHc GHc
Sales (28,000 @ GHc20) 560,000
Opening Stock (12,000 @ GHc14) 168,000
AC of Production (24,000 @ GHc14) 336,000
Closing Stock (8,000 @ GHc14) (112,000)
Variable Cost of Sales 392,000
Add Variable S/Distribution Expenses 40,000
Fixed Selling and Distribution 64,000 496,000
Profit (Loss) 64,000

Workings: MC/Unit = GHc192,000/24,000 = GHc8/unit

AC/Unit = GHc192,000 + GHc144,000/24,000 = GHc14/unit

Q3. The following data have been extracted from the budgets and standard costs
of “No Strings” Ltd, a company which manufactures and sells a single product.
Selling price per unit (GHc) 45
Direct materials cost per unit (GHc) 10
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Direct labour cost per unit (GHc) 4
Variable overhead cost per unit (GHc) 2.5
Fixed production overhead costs are budgeted at GHc400,000 per annum. Normal
production levels are thought to be 320,000 units per annum. Budgeted selling
and distribution costs are as follows:
Variable GHc1.50 per unit sold
Fixed GHc80,000 per annum
Budgeted administration costs are GH¢120,000 per annum. The following pattern
of sales and production is expected during the first six months of the year:
January – March April – June
Sales 60,000 90,000
Production 70,000 100,000
There is to be no stock on January.
You are required to prepare profit statements for each of the two quarters, in a
columnar format, using:
i. Variable costing
ii. Full costing
iii. Reconcile profits reported for April – June in your answer to (a) above.

Q4. Data collected from the books of Forward Company Limited for the year
ended 31/03/12 are as follows:
Units Produced 10,000
Units Sold 9,500
Selling Price per unit (GHc) 25
Direct Materials Cost (GHc) 80,000
Direct Wages (GH¢) 60,000
Production Overhead Cost: Fixed (GHc) 10,000
Variable (GHc) 30,000
S/Distribution Overheads: Fixed (GHc) 15,000
Variable (GHc) 2 per unit
You are required to calculate:
i. Cost per unit using absorption and marginal costing techniques
ii. The profit or loss for the year ended 31/03/12 using the two methods.
iii. Explain the difference in profit disclosed by the two methods

Calculation of production cost/unit: M/C A/C

GH¢ GH¢
Direct Material 8 8
Direct Wages 6 6
Variable Overheads 3 3
Fixed Overheads - 1

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Total Production Cost/Unit 17 18

Profit Statement for Year Ended 31/03/04 – Marginal Costing Method

GHc GHc
Sales (9,500 @ GHc25) 237,500
VC of Production (10,000 @ GHc17) 170,000
170,000
Less Closing Stock (500 @ GHc17) 8,500
Variable Cost of Sales 161,500
Add Variable S/Distribution (GHC2 @ 9,500) 19,000 180,500
Total Contribution 57,000
Less Fixed Cost: Production 10,000
Selling and distribution 15,000 25,000
Profit (loss) 32,000

Profit Statement for Year Ended 31/12/04 – Absorption Costing Method

GHc GHc
Sales (9,500 @ GHc25) 237,500
Total Production Cost (10,000 @ GHc18) 180,000
180,000
Less Total Cost of Closing Stock (500 @ GHc18) 9,000
Total Cost of Sales 171,000
Add Total Selling and Distribution Expenses 34,000 205,000
Profit (Loss) 32,500

iii) The profit under the marginal costing is GH¢500 less than the profit under absorption
costing. The reason being that the fixed production cost of (500 @ GH¢1) absorbed in
the closing stock was not charged to the trading account under the absorption costing
system whilst the total fixed production overhead was charged in full to the profit and
loss account under marginal costing system.

Q5. During the year 2011 Vicandy Enterprise had the following data associated
with the product it makes:
Opening stock -
Units produced 10,000
Units sold (GHc3 per unit) 8,000
Normal capacity 10,000
Variable cost per unit: GHc
Direct material 0.50
Direct labour 1.00
Variable overhead 0.50
Variable selling and distribution expenses 0.10

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Fixed costs:
Fixed production overhead 2,500
Fixed selling and distribution expense 1,000
Required:
a) Calculate cost per unit under Absorption costing and marginal costing.
b) prepare income statement using the two methods

Q6. The following data relates to Fausty Company Ltd in the years 2009, 2010
and 2011.
Variable cost per unit: GHc
Direct material 0.40
Direct labour 0.15
Variable overhead (est. and actual) 0.50
Variable selling and administrative expense 0.025
Estimated fixed overhead was GHc15,000. Actual Fixed overhead was also
GHc15,000. Normal production capacity/volume is 150,000. The sale price each
year was GHc1 per unit. Fixed selling and administrative expense were GHc5,000
per year. Other operating data were as follows:
2009 2010 2011
Opening stock - - 50,000
Production 150,000 150,000 150,000
Sales 150,000 100,000 200,000
Closing stock - 50,000 -
Required:
a) Calculate cost per unit under Absorption costing and marginal costing.
b) prepare income statement using the two methods

Q7. Mary Mart Company Ltd. produces and sells Lady’s Wallets. Selected data
for the past year were as follows:
Production unit 65,000
Sales (units) 50,000
GHc’000
Selling price 300
Direct labour 8,775
Direct material 7,800
Variable manufacturing cost 52
Depreciation 97
Royalties 91
Administration Overhead 780
Office rent 13
Variable Selling Overhead 39

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Required:
a) Calculate the cost per unit using Absorption and marginal costing
b) Prepare income statement for the Lady’s Wallet using the two methods
c) Prepare a reconciliation for the two income statements

Calculation of Cost per Unit using: MC AC

Direct Material 120 120
Direct Wages 135 135
Variable Overhead 0.8 0.8
Royalties 1.4 1.4
Fixed Overhead: Depreciation 1.5
Cost per unit 257.2 258.7

Income Statement for Mary Mart using Marginal Costing format

GHc’000 GHc’000
Sales (50,000 x GH¢300) 15,000
Less cost o f sales:
Production (65,000 @ GHc257.2) 16,718
COGAS 16,718
Less Closing Stock (15,000 @ GHc257.2) 3,858
COGS 12,860
Add Variable Selling & distribution (GH¢0.6 x 50,000) 30 12,890
CONTRIBUTION 2,110.0
Less: Fixed Production OH - Depreciation 97.5
Administrative Expenses 780.0
Office rent 13.0 890.5
Net Profit (Loss) 1,219.5

Income statement for Mary Mart using Absorption Costing Format

GHc’000 GHc’000
Sales (50,000 x GHc300) 15,000
Less cost of sales:
Production (65,000 @ GHc258.7) 16,815.5
COGAS 16,815.5
Less Closing Stock (15,000 @ GHc258.7) 3,880.5
COGS 12,935.0
Gross Profit 2,065.0
Less: Variable Selling & Distribution (GHc0.6x 50,000) 30.0
Administrative Expenses 780.0
Office rent 13.0 823.0
Net Profit (Loss) 1,242.0

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Reconciliation Statement GHc’000
Marginal Profit B/fwd 1,219.5
Add Fixed Overhead element in
Closing Stock (15,000 @ GHc1.5) 22.5
Absorption Costing Profit 1,242.0

The main reason hinges on the treatment of the fixed production overhead under
the two approaches as depicted above. (Whereas MC treats fixed production
overheads as a period cost i.e. fixed production overheads is written off in full
against the contribution of the period, AC consider fixed overheads as a product
cost and therefore the unsold stock under the AC carry with it fixed overhead
element and is not written off until the entire stock is totally disposed off)

Q8. Asempaneye Company Ltd. has just completed its first year of operations.
The unit costs based on normal costing principles are as follows:
Manufacturing cost (per unit) GHc
Direct material (2kg @ GHc2) 4
Direct labour (1.5hr @ GHc9) 13.5
Variable overhead (1.5hr @ GHc2) 3
Fixed overhead (1.5 hr @ GHc3) 4.5
Selling and distribution Costs:
Variable 5/unit
Fixed 190,000

During the year the company had the following activity:

Production (units) 24,000
Units sold 21,500
Unit selling price GH¢42
Direct labour hours worked 36,000

Actual fixed overhead was GHc12,000 less than budgeted fixed overhead.
Budgeted variable overhead was GHc5,000 less than the actual variable overhead.
The company used the expected and actual activity level of 36,000 direct labour
hours to compute the predetermined overhead rates. Any overhead variances are
closed to cost of goods sold.
You are required to:
a) Calculate cost per unit of product using Absorption costing and direct
costing.
b) Prepare income statement for Asempaneye Ltd using the two methods
c) Prepare a reconciliation for the two income statements

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Calculation of cost per unit using MC AC
Direct Material 4 4
Direct Wages 13.5 13.5
Variable Overhead 3 3
Fixed Overhead 4.5
Cost per unit 20.5 25

Income Statement for period 3 using Marginal Costing Format

GHc GHc
Sales (21,500 x GHc42) 903,000
Less Cost of Sales:
Production (24,000 @ GHc20.5) 492,000
COGAS 492,000
Less Closing Stock (2,500 @ GHc20.5) 51,250
COGS 440,750
Add: Variable Selling Expense (GHc5 x 21,500) 107,500
Under absorbed Variable Cost 5,000 553,250
CONTRIBUTION 349,750
Less: Fixed Overheads (GHc108 - GHc12 = GHc96) 96,000
Fixed Selling & Distribution Expenses 190,000 286,000
Net Profit (Loss) 63,750

Income Statement for period 3 using Absorption Costing Format

GHc GHc
Sales (21,500 x GHc42) 903,000
Less Cost o f Sales:
Production (24,000 @ GHc25) 600,000
COGAS 600,000
Less Closing Stock (2,500 @ GHc25) 62,500
COGS 537,500
Add: Under absorbed Variable Cost 5,000
Less: Over absorbed Fixed Cost (12,000) 530,500
Gross Profit 372,500
Less: Fixed Selling & Distribution Expenses 190,000
Variable Selling & Distribution Expenses 107,500 297,500
Net Profit (Loss) 75,000

Reconciliation Statement GHc

Marginal Profit B/fwd 63,750
Add Fixed Overhead Element in
Closing Stock (2,500 @ GHc4.5) 11,250
Absorption Costing Profit 75,000
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Note: The main reason hinges on the treatment of the fixed production overhead under
the two approaches as depicted above. (Whereas MC treats fixed production overheads
as a period cost i.e. fixed production overheads is written off in full against the
contribution of the period, AC consider fixed overheads as a product cost and therefore
the unsold stock under the AC carry with it fixed overhead element and is not written off
until the entire stock is totally disposed off)

5. Abba Ltd uses a standard costing system. The standard cost per unit of product
‘Be-Smart’ is as follows:
GHc
Direct material: 5kg at GHc1/ kg 5.00
Direct labour: 4 hours at GHc0.60/hour 2.40
Production OH: Variable (4 hours at GH¢0.30/hour 1.20
Fixed 1.00
Standard Production Cost 9.60
Standard Selling Price 15.00
The standard fixed production overhead absorption rate was based on a budgeted
activity of 100,000 units. During the period 3 productions was 100,000 units as
planned but sales were only 81,000 units. Budgeted fixed production overhead
was GHc12,000 less than the actual fixed overhead. All units were sold at
GHc15/unit. There was no opening stock at the beginning of the period. Other
costs incurred during the period were in relation to selling and administration.
These were as follows:
Item of Expenditure Variable Fixed
Selling and distribution 10% of sales GHc112,600
Administration: - GHc110,000
You are required to prepare:
i. income statement for period 3 using two main costing techniques
ii. reconciliation for the two income statements

Calculation of Cost per Unit using: M/C A/C

Direct Material (GHc) 5 5
Direct Wages (GHc) 2.40 2.40
Variable Overhead (GHc) 1.20 1.20
Fixed Overhead (GHc) - 1.00
Total Cost per unit (GHc) 8.60 9.60

Income Statement for Period 3 Using Marginal Costing Format

GHc GHc
Sales (81,000 x GHc15) 1,215,000
Less Cost of Sales:

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Production (100,000 @ GHc8.6) 860,000
COGAS 860,000
Less Closing Stock (19,000 @ GHc8.6) 163,400
COGS 696,600
Add Variable Selling & distribution (10% of Sales) 121,500 818,100
CONTRIBUTION 396,900
Less: Fixed Production Overheads 112,000
Selling & Distribution Expenses 112,600
Administration 110,000 334,600
Net Profit (Loss) 62,300

Income Statement for Period 3 Using Absorption Costing Format

GHc GHc
Sales (81,000 x GH¢15) 1,215,000
Less Cost o f Sales:
Openings Stock -
Production (100,000 @ GH¢9.60) 960,000
COGAS 960,000
Less Closing Stock (19,000 @ GH¢9.6) 182,400
COGS 777,600
Add: Under absorbed fixed overhead 12,000 789,600
G/Profit 425,400
Less: Selling & Distribution Expenses 112,600
Variable Selling & Distribution (10% of sales) 121,500
Administration 110,000 344,100
Net Profit (Loss) 81,300

Reconciliation Statement GHc

Marginal Profit B/fwd 62,300
Add: Fixed overhead element in
The closing stock (19,000 @ GHc1) 19,000
Absorption Costing Profit 81,300

Note: The main reason hinges on the treatment of the fixed production overhead
under the two approaches as depicted above. (Whereas MC treats fixed
production overheads as a period cost i.e. fixed production overheads is written
off in full against the contribution of the period, AC consider fixed overheads as a
product cost and therefore the unsold stock under the AC carry with it fixed
overhead element and is not written off until the entire stock is totally disposed
off)

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6. The following information is available for Mustapha Manufacturing Company
Limited, producing and selling smocks.
Budgeted cost (at normal activity) GHc’000
Direct materials and wages 79,200
Variable production overheads 14,400
Fixed production overheads 43,200
Variable selling and distribution expenses 7,200
Fixed selling and distribution expenses 28,800
The overhead absorption rates are based upon normal activity of 720,000
per period. During the period ending 31/3/12 780,000 units of smocks
were produced, and 690,000 units were sold at GHc300. At the beginning
of the period 120,000 units were in stock. These were valued at the
budgeted cost shown above. Actual costs incurred were as per budget.
You are required to:
i. Compute the production cost per unit using two costing techniques
ii. Prepare income statement for the year ended 31/12/12 using two costing
techniques.
iii. Explain the difference in profit disclosed by the two methods
iv. State the arguments in favour of absorption and marginal costing systems
respectively

Advantages of Marginal Costing System.

 It avoids the cost and time lost in apportioning overheads to departments
and absorbing them into cost units.
 It avoids charging fixed costs to production using arbitrary basis and
getting an unreal answers. The basis of absorption may charge more
overheads to a product which has really consumed less overheads and vice
versa.
 It basis decisions on the those costs which vary as a result of those
decisions, variable costs, thereby ensuring effective and efficient
management decision making.
 It simplifies management decision making by the use of the contribution
 It reveals the effects on profit when changes in sales volumes occur.
Hence, it enables the calculation of break even point and the margin of
safety.
 It shows stocks of WIP carried forward at direct cost, thus enabling the
fixed overheads in a period to be written off in full against the period in
which it has been incurred.

Disadvantages of Marginal Costing System.

 It is usually difficult to analyse overheads into fixed and variable cost.

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  Cost of production is understated since they exclude part of the costs. (i.e.
the fixed cost incurred in producing them).
 Profit is normally understated where there is closing stock. The reason
being that, the profit statement is charged with the fixed cost which relates
to the closing stock not sold in the period to which it is charged.
 Goods may be priced at marginal cost or marginal costs plus some
contribution and this may lead to losses or low profits as prices may be set
too low.
 Marginal costing does not relate contribution to capital outlay.
 There is the danger that some results revealed may not portray the true
picture of events and therefore can be misleading. For instance some items
such as the break even point are not usually exact due to the several
assumptions underpinning their calculations.

Advantages of Absorption Costing System

 The cost of production and sale are not understated because both fixed and
variable costs are included.
 It does not involve the problem of analysing costs into their fixed and
variable elements.
 Real profit is disclosed. Profit is neither understated nor overstated
because where there is closing stock the closing stock bears its own share
of the fixed costs of production and carries it to the following period.
 Absorption costing relates profits to capital outlay. More profitable
products or projects are therefore revealed.
 Fictitious losses cannot arise, as it occurs in marginal costing owing to
fixed cost being written off in a period when large quantity of goods are
produced and stocked for sale in a later season.

Disadvantages of Absorption Costing System

 It costs much money and much time is lost in apportioning overheads to
departments and to cost units.
 Fixed costs are charged to production on an unreal basis resulting in
inaccurate figures charged to departments and cost units.
 Decision making, using absorption and not based on contribution will be
difficult. Good decisions must exclude factors which do not vary with
output or activity.
 Because it does not base decisions on those factors which vary with
output. Decisions are therefore not properly made.
 This system does not reveal effects on profit when changes in sales
volume occur. It does not therefore facilitate the calculation of break even
point and margin of safety.

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  By including fixed costs in the closing stocks the system carries some cost
incurred in one period to another, thereby charging the later period with
costs not incurred in it.

Q1. The data below relates to Wiseman Company Ltd which makes and sells one
product. March April
Production (Units) 8,000 2,000
Sales (Units) 4,000 6,000
GHc GHc
Selling price per unit 8 8
Variable production cost/unit 4 4
Fixed production overhead incurred 9,600 9,600
Fixed production overhead/unit incurred
Being the predetermined recovery rate 1.2 1.2
Selling and distribution cost:
Fixed 4,000 4,000
Variable/unit 0.5 0.5
You are required to present a comparative profit statement for each month using
i. Variable costing
ii. Absorption costing

Calculation of Cost per Unit Using: MC AC

Variable production cost 4 4
Fixed Overhead: depreciation 1.2
Cost Per Unit (GHc) 4 5.2

Income Statement for March and April Using Marginal Costing Format
GHc GHc GHc GHc
Sales (4,000 x GHc8) 32,000 (6,000 @ GHc8) 48,000
Less Cost o f Sales:
Opening Stock - 4,000 @ GH¢4 16,000
Production (8,000 @ GHc4) 32,000 2,000@ GH¢4 8,000
COGAS 32,000 24,000
Less Closing Stock (4,000 @ GHc4) 16,000 -
COGS 16,000 24,000
Add Variable Sell. Exp (GHc0.5 @ 4,000) 2,000 18,000 3,000 27,000
CONTRIBUTION 14,000 21,000
Less: Fixed Production OH 9,600 9,600
Selling & Distribution costs 4,000 13,600 4,000 13,600
Net Profit (Loss) 400 7,400

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Income Statement for March and April using Absorption Costing Format
GHc GHc GHc GHc
Sales (4,000 x GHc8) 32,000 (6,000 @ GHc8) 48,000
Less Cost o f Sales:
Opening Stock - (4,000 @ GHc5.2) 20,800
Production (8,000 @ GHc5.2) 41,600 (2,000 @ GHc5.2) 10,400
COGAS 41,600 31,200
Less Closing Stock (4,000 @ GHc5.2) 20,800 -
COGS 20,800 31,200
Adjust: Under/over recovery of F/OH - 7,200
Add: Variable Sell. Exp. (GHc0.5 @ 4,000) 2,000 (GHc0.5 @ 6,000) 3,000
Fixed selling costs 4,000 26,800 4,000 45,400
Net Profit (Loss) 5,200 2,600

Reconciliation Statement GHc GHc

Marginal Profit B/fwd 400 7,400
Less Fixed Overhead Element in
Opening Stock (4,000 @ GHc1.2) (4,800)
Add Fixed Overhead Element in
Closing Stock (GHc1.2 @ 4,000) 4,800 -
Absorption Costing Profit 5,200 2,600

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Break Even Analysis and Cost-Volume-Profit Analysis (CVP)
Cost and management accounting is concerned not just with recording historic
costs and budgetary control but also with the provision of information which will
help managers to make decisions for the future. More importantly, the major
management decisions usually involve the determination of the behaviour of
sales, costs and profits under various production possibilities. Break even analysis
and Cost-Volume-Profit analysis are two basic managerial planning tools of
providing information about future sales, costs, and profit for management
decision-making.

Break-Even Analysis
Breakeven analysis is where cost accounting systems provides managerial
information in such a manner that, it bring into sharp focus the relationship
between sales and cost at various output levels such that the point at which neither
profit or loss is made is clearly depicted (i.e. the point where total cost equal total
revenue). It involves an application of marginal costing technique and is often
used in budget planning, by marketing managers as well as by accountants.
Sometimes management are not only interested in the profit likely to be made if
production targets are not achieved but also the point at which neither profit nor
loss occurs (i.e. the break-even point).

Cost-Volume-Profit analysis (CVP)

Cost-Volume-Profit analysis (CVP) is one of the most basic planning tools
available to managers for the examination of the behaviour of total revenues, total
costs and operating income as changes occur in the output level, selling price,
variable cost per unit or fixed costs. Cost-Volume-Profit analysis is where cost
accounting systems provides managerial information in such a manner that, it
bring into sharp focus the effects of different level or volume of sales, and costs
have on profits. In this regard, managers commonly use CVP analysis as a tool to
enable them answer questions such as how will revenues and costs be affected; if
sales increase by 1,000 more units; if selling price increase or decrease; if the
company expand business into overseas market; etc. Cost-Volume-Profit analysis
is wider than breakeven analysis.

The Break-Even Point (BEP)

The break-even point is the level of output or activity at which enough
contribution has been earned to just cover fixed cost. It is the level of output at
which total costs equal to its total sales and no profit or loss is made. It can be
expressed in units or sales value. Break-even point can be calculated using the
following three approaches:
 Equation method;

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  Contribution margin method;
 Graphical method.
The following illustration will be used to explain the three methods. Consider the
following data concerning the sales of cassettes: GHc
Selling price per unit 32
Variable cost of sales per unit 24
Contribution per unit 8
Total fixed cost 16,000
Budgeted sales units 3,000
Calculate the break-even point in units and sales values.

Equation method
Under this method the income statement can be expressed in the form of a basic
equation as:
Total Sales = Total Variable Costs + Total Fixed Cost + Profit.
Since, at break-even point there is neither profit nor loss, the equation changes to:

Total Sales = Total Variable Costs + Total Fixed Cost.

Therefore representing the total units of cassettes to be sold to break-even as x:
Then: GHc32x = GHc24x + GHc16,000
(GHc32 – GHc24) x = GHc16,000
GHc8x = GHc16,000
x = GHc16,000/8 = 2,000 Units
Therefore BEP in Sales Value will be:
2,000 units x GH¢32 (selling price) GHc64,000.

Contribution Margin Method

This approach simply uses the concept of the contribution margin to rework the
equation method. Thus:
BEP (in units) = Fixed Cost/Contribution per Unit
BEP (sales) = Fixed Cost/Contribution/Unit x Sales Price per Unit
BEP (in units) = Fixed Cost x 1/Contribution Sales ratio

Graphical method
This is done by means of a break-even chart which is used to determine the break-
even point graphically. A break-even chart indicates profit or loss at various
levels of output within a limited range. It shows clearly the break-even point and
thereby derives it name from it. There are two versions of the breakeven chart.
These are: the conventional break-even chart and the contribution break-even
chart.

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The Margin of Safety
It is difference between sales at a given level of an activity (i.e. budgeted sales)
and the sales at the breakeven point. In other words, this is the amount by which
budgeted or actual sales exceed the break-even sales. It can be expressed either as
an absolute figure or as a percentage of the budgeted or actual sales.

In the example above the Margin of safety is 1,000 units (i.e. 3,000 - 2,000) or
GHc32,000 or as a percentage it is 33.3% (1,000/3,000).

Note: The higher the margin of safety the more beneficial it is for an
establishment. It indicates the extent to which sales volume may fall before losses
are incurred.

1. Determine the break-even points in units and sales volumes for the two
manufacturing companies A and B respectively.
i. Company A, a small manufacturing enterprise, produces a single
product. The selling price is GHc4.8/unit, the variable costs are
GHc3.0/unit, and the company’s annual fixed cost totalled GHc90,000.
ii. Company B, a medium-sized manufacturing enterprise, compiled the
following budgeted operating data.
GHc
Budgeted sales for one year 15,000
Budgeted Variable Costs for one year 10,800
Budgeted Fixed Costs for one year 2,940

Company A:
Selling price = GHc4.8/unit
Variable costs = GHc3.0/unit
Fixed costs = GHc90,000
BEP (in units) GHc90,000/GHc4.8 - GHc3.0 = GHc90,000/GHc1.8 = 50,000 Units

Company B: GHc
Budgeted Sales 15,000
Budgeted Variable Costs 10,800
Budgeted Contribution = GHc15,000,000 - GHc10,800 = GHc4,200
Contribution/Sales ratio = GHc4,200/GHc15,000 x 100 = 28%
Budgeted Fixed Cost = GHc2,940
BEP (in Sales) = GHc2,940/0.28 = GHc10,500

Assumptions Underlying Break-Even Analyses

Break-Even analyses operate under the following assumptions:

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  That any quantity of goods produced can be sold at the same price.
 That average variable cost is constant per unit
 That fixed cost remains constant over a wide range of output.
 That variable cost fluctuates with the volume of output (variable cost has a
direct relationship with the level of activity)
 That efficiency and productivity during the production process remains
unchanged
 that opening and closing stocks are fairly stable

Uses of Break-Even Analyses

1. They enable management to know the break-even points
2. They enable management to know the profit to be made at different levels
of sales
3. They enable management to know volume of sale sales required to
achieve a certain amount of profit
4. They enable management to know the amount of sales required to
maintain the present level of profit if the selling prices were reduced by a
certain percentage.
5. Useful for short run decision in respect of pricing, choice of sales mix,
special order acceptance etc.

2. ABC Company Limited sells a certain standard product at GHc7.5 each. The
company cost analysis indicates that for each unit produced and sold, there is a
contribution of GHc4.5 to fixed cost and profit. Fixed cost for 2010 were
GHc27,000. The management of the company made great efforts to reduce fixed
costs and in 2011 succeeded in reducing them to GHc18,000.
You are required to calculate:
i. in 2010 how many units wee produced and sold to break-even
ii. how many units should be sold to in 2011 to break-even
iii. the units to be sold in 2011 in order to earn net profit equal to 10% of
sales
iv. prepare income statement to prove your answer to (iii) above.

Given that contribution/unit is GHc4.50

Given that Selling price/unit is GHc7.50
Given Fixed Cost of GHc27,000 and GHc18,000 for years 2010 2011 respectively

BEP (units) = Fixed Cost/Contribution per Unit = GHc27,000/ GHc4.5 = 6,000 Units

BEP (units) = Fixed Cost/Contribution per Unit = GHc18,000/ GHc4.5 = 4,000Units

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SP – VC = Contribution per unit i.e. GHc7.5 – GHc4.5 = GHc3.
Given VC/Unit, SP/Unit and FC = GHc18,000.

We agree that: Profit = SP – TC (i.e. TC = VC +FC)

Therefore Profit = SP – VC- FC. From the question we are asked to calculate
units sold to earn 10% Profit on Sales Proceeds. Since we know SP per unit let x
represent required units.

From the above we can start with the following equation:

P = SP - VC – FC;
10% (GHc7.5x) = GHc7.5x – GHc3x - GHc18,000
GHc0.75x = GHc7.5x – GHc3x - GHc18,000
GHc7.5x – GHc3x – GHc0.75x = GHc18,000
3.75x = GHc18,000 therefore x = GHc18,000/GHc3.75 = 4,800Units

Income Statement for Year Ended 2011 GHc

Sales (4,800 units @ GHc7.5) 36,000
Less cost of sales: (4,800 units @ GHc3) 14,400
CONTRIBUTION 21,600
Less Fixed Cost 18,000
Net Profit (10% of Sales i.e. GHc36,000) 3,600

4. Given that XYZ Company Limited has fixed cost of GHc12,000 for the year
2007 variable cost of GH¢1.6 per unit and a selling price per unit is GHc2.4.
Calculate for XYZ Company Limited:
1. The BEP in units and in sales
2. the BEP in units if fixed costs are increased by 10%
3. at fixed cost GHc12,000, determine the profit or loss at sales volume of
30,000 units
4. The BEP in units and sales if the original data are changed to variable cost
GHc2 and selling price per unit GHc3.

5. Below is the income statement of Danny Young Limited.

GHc
Net sales 26,240
Less expense:
Variable costs 15,744
Fixed costs 10,496 26,240
Net profit -
Assume that variable cost will always remain the same percentage of sales.
You are required to:

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 i. Calculate the amount of sales that will enable the firm to break-even if
fixed costs are increased by 25%.
ii. With the proposed increased in Fixed expenses what amount of sales will
yield a net income of GHc6,888.
iii. Show the net income statement using marginal costing approach to prove
your answer in (ii).

Given Original Fixed Costs as GHc10,496.

Then new Fixed Costs will be GHc10,496 x 125% = GHc13,120

Given that Variable Costs remains constant % of Sales:

Then GHc15,744/26,240 x 100 = 60% or 0.6

Therefore Using the Equation Method:

BEP Sales if Fixed Costs are increased by 25% would be:
S = VC + FC Therefore Let x represent Sales:
x = 0.6x + GHc13,120
x – 0.6x = GHc13,120
0.4x = GHc13,120
x = GHc13,120/0.4 Therefore x = GHc32,800

Calculation Sales to Earn a Targeted Profit of GHc6,888.

S = VC + FC + P Therefore Let x represent Sales again:
x = 0.6x + GHc13,120 + GHc6,888
x – 0.6x = GHc20,008
0.4x = GHc20,008
x = GHc20,008/0.4 Therefore x = GHc50,020

Income Statement using Marginal Costing GHc

Net Sales 50,020
Less Variable Cost o f Sales (0.6 x GHc50,020) 30,012
Contribution 20,008
Less Fixed Costs 13,120
Net Profit (Loss) 6,888

Using the Contribution Method other than Alternative Approach

Using the contribution Method one need to calculate the C/S ratio
Given that: Sales = GHc26,240
Variable Costs = GHc15,744
Contribution = GHc10,496

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Contribution/Sales Ratio = GHc10,496/GHc26,240 x 100 = 0.4 or 40%

Calculation of BEP Sales if Fixed Costs are increased by 25%

BEP Sales = Fixed Costs/ C/S Ratio
GHc13,120 /0.4 = GHc32,800

Calculation Sales to Earn a Targeted Profit of GHc6,888.

Sales = Fixed Cost + Targeted Profit /C/S Ratio
= GHc13,120 + GHc6,888/0.4
= GHc20,008/0.4 = GHc50,020

Income Statement Using Marginal Costing GHc

Net Sales 50,020
Less Variable Cost o f Sales (0.6 x GHc50,020) 30,012
Contribution 20,008
Less Fixed Costs 13,120
Net Profit (Loss) 6,888

The Cost-Volume-Profit Relationship

The CVP relationship is governed by the following major factors:
Selling price; Sales volume; Variable costs; Fixed costs
The relationship can be illustrated in the form of a profit-volume (P/V) graph
showing the effect on profit of various sales volumes.

The Link between CVP Relationship and BEP Analysis.

The CVP relationship is a further development of the BEP analysis. Both
techniques require the same basic factors and are subject to the same assumptions
and limitation. Whereas BEP analysis concentrate on showing break-even point
CVP tends to draw attention to profits at different level of activity as well as the
effect on profit due to changes in the factors which affect profit. The difference in
these two management tools can be shown in an equations as: BEP: Sales =
Variable Cost + Fixed Cost; CVP: Sales = Variable Cost + Fixed Cost + Profit.

The Profit –Volume Ratio (P/V Ratio)

The P/V ratio is just another name for the contribution sale ratio or the
contribution percentage. It is the same as C/S ratio. The main object of the P/V
ratio is to measure the contribution gained from each ¢1 of sales made. Hence, a
P/V ratio of 20% implies that for every GH¢1 of sales made a contribution of
GH¢0.20 is made towards recovery of fixed cost and profit. Like the BEP analysis
the P/V ratio is constant over the relevant range of activity.

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Uses of P/V Ratio
 To calculate BEP in sales value (i.e. total Fixed Cost/ P/V ratio = BEP in
sales).
 The P/V ratio when multiplied by the change in sales value gives the
change in profit resulting from that change in sales value. For example:
Original New Increase
Sales GHc5 GHc6 GHc1
Variable costs 4 4.8 0.8
Contribution per unit 1 1.2 0.2
Fixed Costs 0.6 0.6 -
Profit 0.4 0.6 0.2
Note: GH¢0.2 = GHc1 x 20% (i.e. The P/V ratio is GHc1/GHc5 = 20%). The
higher the P/V ratio, the greater the change in profit. Therefore given a higher
P/V ratio, changes in sales over and above the break-even point will earn higher
profits, while changes in sales below the BEP will results in greater losses.
 Variable cost ratio can also be determined from the P/V ratio (i.e. 100%
minus the P/V ratio = variable cost ratio).

P/V Chart
It is more or less a simple variation of the BE chart, in that, it indicates the
relationship of profit to volume and is made up of a single line drawn across the
face of the graph in contrast to the BE chart where three different lines are
depicted on the face of the graph.

Application of the CVP Relationship

Many managerial decisions are taken based on information provided by CVP
relationship. These include: Make or buy decision; Accept or reject special order
decision; Add, maintain or delete a product line decision; Pricing decision; Sales
mix decision; Special sales promotion and advertising decision; Entering into a
new market.

Changes in Factors and their Effects on Profit.

Changes in factors affecting profit will lead to either an increase or decrease in
profit. For instance:
 An increase in variables cost will result in a lower contribution/sales ratio,
lower profit and huge BE sales volume. The opposite is true.
 An increase in fixed cost will have no effect on contribution margin but
will reduce profit and result in huge BE sales volume. The reverse is also
true.

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  It is not easy to predict effect of changes in selling price on volume of
sales. a reduction in selling price does not necessarily imply that higher
sales units will be made or even if higher sales units are obtained, will
they be enough to increase the overall sales revenue. Nevertheless, when
we assume that selling price per unit is increased concurrently with the
contribution per unit, and then we can have lower BE sales volume, higher
contribution margin and higher profits. The opposite is also true.
 An increase in sales volume will lead to higher contribution margin as
well as higher profits, the reason being that all things being equal break-
even sales will remain unchanged. The reverse is true.

1. Damptey Ltd manufactures and sells one product only and for the last
accounting period the accountant produced an income statement which is shown
below:
Profit and Loss Account for Year Ended 31/7/12
GHc GHc
Sales 120,000
Costs: Direct material 24,000
Direct labour 16,000
Prime cost 40,000
Variable production overhead 4,000
Fixed production overhead 16,000
Fixed Administration overhead 24,000
Variable selling overhead 16,000
Fixed selling overhead 8,000 (108,000)
Net profit 12,000

You are required to construct a Profit –Volume graph from which you should
indicate the break-even point and margin of safety.

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Solution:
(Profit)
36,000 _

24,000 _ BEP (GHc96,000)

12,000 _

0 ! ! ! ! ! ! !
18 36 54 72 90 108 126
-12,00 _
-24,000 _
(Loss)
_
-48,000 _

Total Variable Cost GHc Total Fixed Cost GHc

Direct material 24,000 Fixed Overheads 16,000
Direct labour 16,000 Fixed Admin. Costs 24,000
Variable production O/H 4,000 Fixed selling OH 8,000
Variable selling overhead 16,000 48,000
60,000

T/Contribution = Sales – Variable Cost

GHc120,000 - GHc60,000 = GHc60,000
C/S Ratio = GHc60,000/GHc120,000 = 0.5
BEP = Fixed Cost /P/V Ratio; GHc48,000/0.5 = GHc96,000

2. Dorothy Company manufactures and sells pens. Currently, 500,000 units are
sold per year at a selling price of GHc5 per unit. Fixed costs are GHc90,000 per
year. Variable costs are GHc3 per unit. Consider each case separately,
You are required to:
i. Calculate the present operating income for a year
ii. Determine the present BEP in revenues
Compute the new operating income for each of the following changes:
i. A GHc0.40 per unit increase in variable costs.
ii. A 10% increase in fixed costs and 10% increase in units sold

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 iii. A 20% decrease in fixed costs, a 20% percent decrease in selling price, a
10% decrease in variable cost per unit, and a 40% increase in units sold.
Compute the new BEP in units for each of the following changes:
i. A 10% increase in fixed costs
ii. 7. A 20% increase in selling price and a GHc20,000 increase in fixed
costs.

Sales Mix and Multi-Product P/V Chart

So far the analysis has focused on a single product. But in the real world of
business, most firms will be dealing in the production and/or sales of more than
one product or service thereby resulting in a product mix. Sales mix is the relative
combination of quantities of products (or services) that constitutes total unit sales.
If the mix changes, the overall unit sales target may still be achieved. However,
the effect on operating income depends on how the original proportions of lower
or higher contribution margin have shifted. A P/V chart can be drawn to illustrate
a multi-product situation. A multi-product P/V chart is usually drawn from left to
right starting with the product with the highest P/V ratio and ending with the
product with the lowest P/V ratio.

As it were, you use the contribution towards fixed against the total sales revenue
to plot the dotted line and then draw a straight line from the total fixed point to the
cumulative sales point. For the company’s break-even point is where your straight
line intersects with the sales volume line. With more than one product, sales mix
is the relative combination in which such company’s products are sold. Different
products have different selling prices, cost structures, and contribution margins.

1. As an example, consider the following data for Smarty Limited and see how we
deal with CVP analysis
Products SP/Unit VC/Unit C/Unit P/V Ratio No. Units
GHc GHc GHc
A 8 4.8 3.2 0.4 6,000
B 4 2.8 1.2 0.3 4,000
Totals 12 7.6 4.4 10,000
The budgeted total fixed costs were GHc18,000. Budgeted sales mix in units was
6,000 and 4,000 for products A and B respectively.
You are required to determine the break-even point for Smarty Ltd., determine the
total operating income.

Using Equation Approach.

First we need to determine the sales mix ratio which according to question is the
Ratio of 3:2 (6,000: 4,000). Having established our profit equation as:

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Sales Revenue – Variable Cost – Fixed Cost = Operating Income

Let u be the number of units of each product to be sold in order to break even.
Therefore, putting the variables in our given equation above it becomes:
[(3u x GHc8) + (2u x GHc4)] – [(3u x GHc4.8) + (2u x GHc2.8)] - GHc18,000= profit
At BEP, operating income is zero so our equation becomes:
(GHc24u + GHc8u) – (GHc14.4u + GHc5.6u) - GHc18,000 = 0
GHc32u – GHc20u = GHc18,000
GHc12u = GHc18,000
GHc18,000/GHc12u
u = 1,500
Therefore, number of ‘A’ required to breakeven = 1,500 x 3 = 4,500
And number of ‘B’ required to breakeven = 1,500 x 2 = 3,000 (i.e. 7,500)

Using Weighted-Average unit Contribution

Details of products No. of Units % of Sales Mix
A 6,000 60% (6/10)
B 4,000 40% (4/10)
Total Sold 10,000 100%

Weighted-average unit Contribution Margin

Details of products C/Unit % Sales mix W/contribution
A GHc 3.2 60% GHc1.92
B GHc1.2 40% 0.48
Weighted-average Contribution Margin 2.40

BEP (units) = Fixed Cost/Weighted-average Contribution Margin

= 18,000/2.4 = 7,500 combined Units sales.

Analysis of the combined unit sales

Details of products Break-even sales % of Total Individual sales
A 7500 60% 4,500
B 7500 40% 3,000
Total units 7,500

Assumptions of CVP Analysis

1. Selling price is constant throughout the entire relevant range
2. Costs are liner over the relevant range
3. In multi-product companies the sales mix is constant
4. In manufacturing firms stocks do not change unit produced is equal to unit sold.

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2. A firm has fixed costs of GHc91,200 per annum and has three products, the
details of which are:
Products Sales Variable Cost
GHc GHc
A 128,000 64,000
B 208,000 144,000
C 96,000 57,600
Plot the above product on a single profit chart and show the break even sales.
Product Sales V/Cost T/Cont P/V Ratio
GHc GHc GHc
A 128,000 64,000 64,000 0.5
B 208,000 144,000 64,000 0.31
C 96,000 57,600 38,400 0.4
432,000 265,600 166,400

Contribution Margin = 166,400/432,000 = 0.3851851

BEP (Value) = Fixed Cost/Contribution Margin

= 91,200/0.385185 = GHc236,766

3. From the data given below you are required to present on graph paper a profit-
volume (P/V) chart to show the expected company performance based on a
budget for one year: Sales GHc96,000, Marginal Cost GHc56,000 Fixed Cost
GHc24,000
You are required to determine the break-even point and margin of safety. Discuss
briefly the limitations of a profit volume graph.

Solution: Sales V/Cost T/Cont P/V Ratio

GHc GHc GHc
96,000 56,000 40,000 0.42

Contribution Margin = 40,000/96,000 = 0.4166

BEP (value) = Fixed Cost/Contribution Margin

= 24,000/0.42 = GHc57,142

4. The following data relate to three products of a company with fixed costs of
GHc96,000 per period:
Products X Y Z
GHc GHc GHc
Units Selling Price 12.8 19.2 48

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Unit marginal cost 10.4 10.4 22.4
Sales volume (in units) 20,000 5,000 1,000
You are required to determine the breakeven point using the equation approach
for the company and draw up a multi-product profit chart using the above data.
Determine the operating income for the company.

5. Buffet Manufacturing Company produces a single product and sells for GHc20.
Fixed costs per period total GHc40,000, while variable cost is GHc12 per unit.
You are required to calculate the:
i. The break-even point in sales revenue and in units
ii. Margin of safety if Buffet has sales capacity of GHc150,000.

Given that: FC = GHc40,000 SP = GHc20 VC = GHc12

Contribution per unit = GHc20 - GHc12 = GHc8
Contribution Sales Ratio = GHc8/GHc20 = 0.4 or 40%

BEP (in units) = Fixed Cost/Contribution per unit

= GHc40,000/GHc8 = 5,000 Units
BEP (in sales) = Fixed Cost/C/S Ratio
= GHc40,000/0.4 = GHc100,000
BEP (in sales) = BEP Units x SP/Unit
= 5,000 x GHc20 = GHc100,000

MOS (in value) = Current Sales – Break-even Sales

= GHc150,000 - GHc100,000
= GHc50,000

MOS (rate) = Current Sales – Break-even Sales/Current Sales

= GHc150,000 - GHc100,000/GHc150,000 = 33 1/3%

6. Musing Manufacturing Company currently has a single product that sells for
GHc6. Variable cost per unit is 25% of selling price and fixed costs are
GHc270,000 per period.
You are required to calculate the:
i. break-even point in sales revenue and in units
ii. If the company increases its selling price by 25% while keeping variable
cost and fixed cost the same what will its new break-even point in units
and ales revenue.
Given that FC = GHc270,000; SP = GHc6; VC (25% of GHc6) = GHc1.5

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Contribution per unit = GHc6 - GHc1.5 = GHc4.5
Contribution Sales Ratio = GHc4.5/GHc6 = 0.75 or 75%
New SP = GHc7.5 and New Contribution per unit = GHc7.5 - GHc1.5 = GHc6
BEP (in units) = Fixed Cost/Contribution per unit
= GHc270,000/GHc4.5
= 60,000 Units

BEP (in sales) = Fixed Cost/C/S Ratio

= GHc270,000/0.75 or 75%
= GHc360,000
BEP (in sales) = BEP Units x SP/Unit
= 60,000 x GHc6.0
= GHc360,000

New BEP (in units) = Fixed Cost/Contribution per unit

= GHc270,000/GHc6
= 45,000 Units
New BEP (in sales) = Fixed Cost/C/S Ratio
= GHc270,000/0.80 or 80%
= GHc337,500
BEP (in sales) = BEP Units x SP/Unit
= 45,000 x GH¢7.5
= GHc337,500

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Decision Making
A managerial decision making is a choice between alternative options possibly
including the options of doing nothing. Below are the various types of decisions

Routine Planning Decision

Such decision commonly analyse fixed and variable cost together with revenue
over a specific period usually one year. E.g. is budgeting it is often concerned
with how to the best use of scarce resources.

Short-Run Problem Solving Decision

These are typically unforeseen (one of), special decision of non recurring nature
where the cost benefits are obtained within a relatively short period of time. E.g.
should a contract be accepted or rejected? What price should be quoted in a tender
for the contract to supply?

Investment or Disinvestment Decision

Decisions of this nature often have long-term consequences and therefore the time
value of money must be allowed or provided for, hence, appropriate discounted
cash flow technique must be applied.

Long Range Position

These are decision made once and review infrequently but which are intended to
provide a continuing solution to a continuing problem. These are mainly policy
decisions and include decisions about selling and distribution policies. E.g. what
type of customer should sales force attempt to attract or target, should goods be
sold through a middlemen or direct to customers etc.

Control Decisions
These are decisions emanating from variances analysis. In most cases variances
highlights and raises questions as to whether such variances should be
investigated or not. Such decision may depend on cost and benefit analysis on the
investigation. In decision making, some writers believe that decision making can
be categorised into two main groups:
 Accept or reject, thus a decision must be taken on the merit of a particular
opportunity under review without having compared it with other available
projects or alternatives.
 Ranking decision where a choice must be made between two or more
competing alternatives or opportunities because either there is scarcity of
resources or the opportunity involve different means to the same or similar
ends. For instances a decision for a new head office for Ghacem to be

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 located in Accra or Takoradi have the same end but different means and
cost requirements.

Why Categorise Decision

The nature of cost and benefit that are relevant to each type of decision is likely to
differ. Therefore when one knows the category of a particular problem then
he/she can design and develop measure to tackle or solve the problem. For
instance:
 Routine planning decisions are often based on estimate of fixed and
variable costs under the application of marginal costing techniques
 Short-run decisions call for the identification of incremental or differential
cost or the distinction between sunk cost and opportunity cost.
 Investments decisions are of a long term in nature and therefore the time
value of money becomes additional element in the decision.
 For Long range decisions it has been recognised, that in the long run, all
costs are variable and therefore costs that are fixed in the short run can be
made to change over time.
 Control decisions tend to make more use of retrospective information such
as the comparison of an actual cost or profit with budget. Variance
analysis might then indicate what control measures or decisions if any
should be taken.

Concept of Relevant Cost.

The cost which should be used in decision making is often referred to as relevant
cost. By definition relevant cost are those costs appropriate to the making of
specific management decision. The nature of relevant cost will depend on the type
of decision problem for which they are required. Every choice have its cost
implications but the magnitudes of the costs involve will differ depending upon
which option is selected.

1. Gawuga Ltd manufactures a single product which is marketed in three grades

of finish – primary, standard and special. The variable cost of the basic unit is
GHc0.90 and the cost of finishing and packing is as follows:
Primary GHc0.60
Standard GHc0.30
Special GHc0.15
The selling prices are:
Primary GHc2.25
Standard GHc1.80
Special GHc1.50

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The marketing manager has estimated demand for next year as follows:
Primary 20,000 units;
Standard 30,000 units;
Special 40,000 units.
The production manager has estimated the production capacity of the factory at
150, 000 units per annum. Fixed costs have been estimated at GHc15,000 for the
forthcoming year. An enquiry has been received from a manufacturer who is
considering using the basic unit as a raw material in his own product and who, at
an acceptable price would be willing to buy 30,000 units a year. The company’s
pre-taxation profit target for the next year is GHc45,000.
You are required to:
i. Calculate the lowest price which could be quoted for the supply of the
30,000 units.
ii. State any business policy matters that you consider relevant in these
circumstances.
Solution
The lowest acceptable price based on the company’s profit target for next year is
calculated as follows:
Details Contribution/Unit Estimated Sales T/Contribution
GHc (in units) GHc
Primary 0.75 20,000 15,000
Standard 0.60 30,000 18,000
Special 0.45 40,000 18,000
51,000
Less fixed cost 15,000
Estimated net profit 36,000
Balance required to meet target 9,000
Targeted profit 45,000
To achieve the profit target, the 30,000 additional units need to obtain a total
contribution of GHc9,000 (i.e. GHc0.30 per unit).

Thus, the lowest selling price that should be accepted will be:
GHc
Variable cost of the basic unit 0.90
Add contribution 0.30
Minimum acceptable price per unit 1.20

Some relevant matters to be considered would include:

 Any price in excess of GHc0.90 per unit would increase the net profit
 The demand for the company basic unit implies that the company faces a
possible competition with such manufacturer’s product.

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  The special order represents an increase of one third of the estimated
output – therefore such a substantial increase may call for reassessment of
estimated costs.
 The special order would raise production to 80% of capacity, which means
that should demand suddenly increase, the company (Gewgaw Ltd.) would
not be able to take advantage and would lose sales of it profitable
products.
 Others

2. Alcatel Ltd manufactures three components used in its finished product. The
component workshop is currently unable to meet the demand for component and
the possibility of sub-contracting part of the requirements is being examined on
the basis of the following data:
Component AComponent B Component C
GHc GHc GHc
Variable costs of production 4.50 6.00 10.50
Outside purchase price 3.75 9.00 19.50
Excess cost per unit (0.75) 3.00 9.00
Machine hours per unit 1 0.5 2
Labour hours per unit 2 2 4
You are required to:
i. decide which components should be bought out if the company is
operating at full capacity.
ii. decide which component should be bought if production is limited to
4,000 machine hours per week
iii. decide which component should be bought if production is limited to
4,000 labour hours per week
Solution
i. Component A should always be bought out regardless of any limiting
factors as its variable cost of production is higher than the outside
purchase price

ii. If machine hours are limited to 4,000 hours:

Component B Component C
Excess cost per unit GHc3.00 GHc9.00
Machine hours per unit 0.5 2
Excess cost per machine hour GHc6.00 GHc4.50

Component C has the lowest excess cost per limiting factor and should, therefore,
be bought out.

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Proof Component B Component C
Units produced in 4,000hours 8,000 2,000
Production cost GHc48,000 GHc21,000
Purchase cost GHc72,000 GHc39,000
Excess cost of purchase GHc24,000 GHc18,000

iii. If labour hours are limited to 4,000 hours:

Component B Component C
Excess cost per unit GHc3.00 GHc9.00
Labour hours per unit 2 4
Excess cost per labour hour GHc1.50 GHc2.25

Component B has the lowest excess cost per limiting factor and should, therefore,
be bought out.

Proof Component B Component C

Units produced in 4,000hours 2,000 1,000
Production cost GHc12,000 GHc10,500
Purchase cost GHc18,000 GHc19,500
Excess cost of purchase GHc6,000 GHc9,000

3. Dampare Ltd. manufactures and sells three products A B C for which budgeted
sales demand, unit selling price and unit variable cost are as follows;
A B C
Budgeted sales demand (units) 550 500 400
Unit selling price (GHc) 160 180 140
Unit variable cost (GHc):
Materials 80 60 20
Labour 40 60 90
Unit Contribution 40 60 30

The company has existing stock of 250 units of A and 200 units of C which is
likely to be used up to meet sales demand. The entire products need the same
direct materials and the same type of direct labour. In the next year the available
supply of materials will be restricted to GHc48,000 at cost and the available
supply of labour to GHc66,000 at cost. What production mix and sales mix will
maximise the company’s profit in the next year.

Solution A B C Totals
Required stock 550 500 400
Less stock available 250 200

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Stock to be purchased/manufactured 300 500 200
Real limiting factor
Value of materials to be used 24,000 30,000 4,000 58,000
Value of labour to be used 12,000 30,000 18,000 60,000

The limiting factor is materials because it has been restricted in the question to
GHc48,000, and this GHc48,000 cannot meet the needed GHc58,000. The labour
is limited to GHc66,000 and the needed labour cost is even GHc60,000. Hence
materials are the most limiting factor.

Determination of Contribution per Limiting Factor

A B C
Unit contribution 40 60 30
Materials/unit 80 60 20
Contribution per limiting factor 40/80 60/60 30/20
GHc0.50 GHc1.00 GHc1.50
Ranking 3rd 2nd 1st

Considering the limiting factor, resources have to be used on C first as that

option generates the highest contribution and if some resources are left then
should be applied on product B before product A.

Preparation of Production Plan

Products R/M Avail. R/M Used Idle R/M Cuml. R/M Used Prod Units
GHc GHc GHc GHc
C 48,000 4,000 44,000 4,000 200
B 44,000 30,000 14,000 34,000 500
A 14,000 14,000 - 48,000 175

Determination of Sales Mix to Maximise Profit

A B C
Unit in stock 250 200
Add production 175 500 200
Total sales (units) 425 500 400
Setting Total Contribution A B C Totals
Total Contribution 17,000 30,000 12,000 59,000

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4. Adwenpa Ltd. is currently preparing its budget for the year ending 31/12/07.
The company manufactures and sells three products X, Y and Z for which
budgeted unit selling price and unit variable cost are as follows:
X Y Z
Unit selling price (¢) 1,500 1,860 480
Unit variable cost:
Labour (¢) 360 720 90
Materials (¢) 390 105 120
Overhead (¢) 150 75 90
Unit Contribution 600 960 180
Direct labour rate is budgeted at ¢90 per hour, and fixed costs at ¢19.5 million per
annum. The company has a maximum production capacity of 228,000 direct
labour hours. A meeting of the board of directors has been convened to discuss
the budget and to resolve the problem as to the quantity of each product which
should be made and sold. The sales manager presented the results of a recent
survey which reveals that market demand for the company’s product will be as
follows:
Products X Y Z
Budgeted sales demand (units) 24,000 12,000 60,000
The production manager proposes that since product Z only contributes ¢180 per
unit, the product be dropped and the surplus capacity transferred to produce
additional quantities of products X and Y. the sales manager did not agree with
the proposal and contended that production of product Z is considered necessary
to compliment the product range and to maintain customer goodwill. If product Z
is dropped, the sales manager believes that sales of products X and Y will be
seriously affected. After a further discussion, the board decided that a minimum
of 10,000 units of each product should be produced. The remaining production
capacity would then be allocated so as to achieve the maximum profit possible.
You are required to prepare a budget statement which clearly shows production
mix and sales mix which could maximise the company’s profit in the next year.

Solution X Y Z Totals
Required stock 24,000 12,000 60,000
Less min. allowed stock 10,000 10,000 10,000
Stock to be purchased 14,000 2,000 50,000
Real limiting factor
Labour hours required 96,000 96,000 60,000 252,000
Hrs consumed allowed stock 40,000 80,000 10,000 130,000
Hours required for production 122,000
Available hours for production (228,000 – 130,000) 98,000

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The limiting factor is labour because it has been restricted in the question to
228,000, and this 228,000 cannot meet the needed 252,000. Based on the board
decision, the labour is limited to 98,000 and the needed labour hours are now
122,000.
Determination of Contribution per Limiting Factor
X Y Z
Unit contribution (GHc) 600 960 180
Labour/unit (GHc) 360 720 90
Contribution per limiting factor 600/360 960/720 180/90
GHc1.67 GHc1.33 GHc2.00

Ranking 2nd 3rd 1st

Considering the limiting factor, resources have to be used on Z first as that option
generates the highest contribution and if some resources are left then should be
applied on product X before product Y.

Preparation of Production Plan

Products Hrs Avail. Hrs Used Idle Hrs Cuml. Used Prod Units
Z 98,000 50,000 48,000 50,000 50,000
X 48,000 48,000 - 98,000 12,000
Y - - - - -

Determination of Sales Mix to Maximise Profit

X Y Z
Min Units Allowed 10,000 10,000 10,000
Add production 12,000 - 50,000
Total sales (units) 22,000 10,000 60,000

Determination- Total Contribution X Y Z Totals

GHc’000 GHc’000 GHc’000 GHc’000
Total Contribution 13,200 9,600 10,800 33,600
Less fixed cost 19,500
Budgeted net profit 14,100

5. Tahere Ltd. makes four components Q, R, S, and T for which cost on the
forthcoming year is expected to be as follows:
Q R S T Totals
Production (Units) 1,000 2,000 4,000 3,000
Marginal Cost:
Direct material (GHc) 40 50 20 40
Direct labour (GHc) 80 90 40 60

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Variable production overhead (GHc) 20 30 10 20
Unit contribution 140 170 70 120
Attributable Fixed Cost 10,000 50,000 60,000 78,000198,000
Other Fixed Cost 300,000
A sub-contractor has offered to supply units of components Q, R, S, and T for
GHc120, GHc210, GHc100, and GHc140 respectively. As the management
accountant of Tahere Ltd, advice management as to whether the company should
make or buy the components.

Solution: Relevant cost X Y Z T

Direct material (GHc) 40 50 20 40
Direct labour (GHc) 80 90 40 60
Variable overhead (GHc) 20 30 10 20
Attributable F/Cost (GHc) 10 25 15 26
Maximum Price 150 195 85 146
Sub-contractor Price 120 210 100 140
Decision buy make make buy

6. Damas Ltd manufactures and sells three components M, N, and O. The

components are kept using the same machines for each. These components are
used to assemble one particular product. The budget for next year calls for the
production and assembling of 4,000 units of each component. The following
information is available
Products M N O Total
Unit Marginal cost (GHc) 200 360 240 800
Machine hours/unit 3 2 4
Assembling cost/unit 200
1,000
Only 24,000 machine hours will be available in the coming year and sub-
contractor has approach you with the following unit prices for the supply of the
components M GHc290; N GHc400, and O GHc340. As a management accounting
consultant advice Damas Ltd.

Solution: Variable cost M N O

Unit Marginal cost (GHc) 200 360 240
Sub-contractor’s price (GHc) 290 400 340
Savings from manufacture 90 40 100
Machine hours/unit 3 2 4
Savings/Machine hours 30 20 25

Ranking 1st 3rd 2nd

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Because Damas Ltd is faced with the problem of limited machine hours he must
maximise profit by manufacturing the product with the highest saving per limiting
factor first. In this case M followed by O before N.

Preparation of Production Plan

Products Hrs Avail. Hrs Used Idle M/Hrs Cuml. M/Hrs Used Prod Units
M 24,000 12,000 12,000 12,000 4,000
O 12,000 12,000 - 24,000 3,000

Determination of Production Plan & Sales Mix to Maximise Profit

M N O
Make 4,000 - 3,000
Buy (Sub-contract) - 4,000 1,000
Total sales (units) 4000 4,000 4,000

Determination of Cost of Sales

M N O Total
Total Marginal cost (GHc) 800,000 1,600,000 1,060,000 3,460,000
Assembling cost (GHc200 x 4,000) 800,000
4,260,000

7. Posso Junior Ltd manufactures two models of baby buggy namely ‘Dodo’ and
‘Sure start’. There is currently a shortage of the special grade of aluminium
required for the buggy frame. This is unlikely to be a long term problem, but it
will affect production over the next three months. The cost and selling price
information for each model is as follows:
‘Dodo’ ‘Sure Start’.
Selling price £150 £165
Variable cost of materials (Aluminium £8.50/kg) 38.25 42.50
Other materials 12.50 15.00
Variable cost of labour 13.65 15.60
The company has 350kg of aluminium in stock and expects to able to buy no
more than a further 1,000kg per month for the next three months.
a) You are required to calculate the contribution per unit of limiting factor for
both models of baby buggy.
b) Advise the directors on the production plan they should follow, assuming that:
i. Demand for ‘Dodo’ will be 800 units over the next three months, with
demand for the ‘Sure Start’ at 300 units over the same period
ii. demand for ‘Sure Start’ will be 600 units over the next three months, with
demand for ‘Dodo’ at 400 units over the same period.

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Determination of Contribution per Unit Limiting Factor For:
Dodo Sure Start
Unit contribution (£) 85.60 91.90
Material/unit (£) 38.25 42.50
Contribution per limiting factor 85.60/38.25 91.90/42.50
£2.26 £2.16
Ranking 1st 2nd
Required stock 800 300

Determination of limiting factor

Materials required for production (Kg) 3,600 1,500 5,100
Available Aluminium for production (Kg) 3,350

The limiting factor is Aluminium materials because it has been restricted in the
question to 3,350Kg and this 3,350Kg cannot meet the needed 5,100Kg. Against
this background, the following production plan would be recommended based on
the contribution per unit limiting factor calculated above. Considering the
contribution per limiting factor calculated above, resources have to be used on
Dodo first as that option generates the highest contribution and if some resources
are left then should be applied on product Sure Start.

Preparation of Production Plan

Products AL/Avail. AL/Used Idle AL Cuml. AL Used Prod Units
Dodo 3,350 3,350 - 3,350 744
Sure Start - - - - -

Determination of Sales Mix to Maximise Profit

Dodo Sure Start
Production 744 -
Total sales (units) 744 -

Determination of Total Contribution Dodo Sure Start Totals

Total Contribution 63,686 - 63,686
Required stock 600 400

Determination of limiting factor

Materials required- production (Kg) 2,700 2,000 4,700
Available Aluminium- production (Kg) 3,350
The limiting factor is Aluminium materials because it has been restricted in the
question to 3,350 Kg and this 3,350 Kg cannot meet the needed 4,700Kg. Against
this background, the following production plan would be recommended based on

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the contribution per unit limiting factor calculated above. Considering the
contribution per unit limiting factor calculated above, resources have to be used
on Dodo first as that option generates the highest contribution and if some
resources are left then should be applied on product Sure Start.
Preparation of Production Plan
Products AL/Avail. AL/Used Idle AL Cuml. AL Used Prod Units
Deluxe 3,350 2,700 650 2,700 600
Super Deluxe 650 650 3,350 130
Determination of Sales Mix to Maximise Profit
Dodo Sure Start
Production/Sales units 600 130

Determination of Total Contribution Dodo Sure Start Totals

Total Contribution 51,360 11,947 63,307

Relevant Cost and Decision Making.

1. A garage has an old car standing around which it bought several months ago for
GHc15,000. The car needs a replacement engine before it can be sold. It is
possible to buy a reconditioned engine for GHc1,500. This would take seven (7)
hours to fit by a mechanic who is paid GHc20 an hour. At present the garage is
short of work, but the owners are reluctant to lay off any mechanics or even to cut
down their basic working week because skilled labour is difficult to find and an
upturn in repair work is expected soon. Without the engine the car could be sold
for an estimated GHc17,500. What is the minimum price at which the garage
would have to sell the car, with a reconditioned engine fitted to justify doing the
work.

Determination of Minimum Price GHc

Opportunity cost of the car 17.500
Cost of the reconditioned engine 1,500
19,000

2. Assuming exactly the same circumstances in illustration above except that the
garage is quite busy at the moment. If a mechanic is to be put on the engine
replacement job it will mean that other work which the mechanic could have done
during the seven hours, all of which could be charged to a customer will not be
undertaken. The garage labour charge GHc60 an hour. What is the minimum price
at which the garage would have to sell the car, with a reconditioned engine fitted
to justify doing the work under these altered circumstances.

The Minimum Price is: GHc

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Opportunity cost of the car 17.500
Cost of the reconditioned engine 1,500
Labour cost (7 x GHc60) 420
19,420
3. A company makes three products - A, B, and C. All three products require the
use of two types of machine: cutting machines and assembling machines.
Estimates for next year include the following:
Details A B C
Selling price/unit (₤) 25 30 18
Sales demand (units) 2,500 3,400 5,100
Material cost/unit (₤) 12 13 10
Variable cost/unit (₤) 7 4 3
Time required/unit- machines:
Cutting machines (hours) 1 1 0.5
Assembling machines (hours) 0.5 1 0.5
Fixed overhead costs for next year are expected to total ₤42,000. It is the
company’s policy for each unit of production to absorb these in proportion to its
total variable costs. The company has cutting machine capacity of 5,000 hours per
annum and assembling machine capacity of 8,000 hours per annum.
You are required to:
i. State, with supporting workings, the profitable production plan the company
should adopt on the basis of the above information.
ii. Suggest three factors that could be considered before adopting the plan in (i)
above

4. Danny Young Company manufactures three types of pastries – chips, pies and
rolls. Data on sales and expenses for the past half year is given below:
Details Total Chips Pies Rolls
GHc GHc GHc GHc
Sales 6,400 1,760 2,400 2,240
Less Variable exp. 3,600 760 1,440 1,400
Contribution 2,800 1,000 960 840
Less Fixed costs:
Advertising, traceable 704 208 256 240
Depr. Special Equip. 512 144 160 208
Salaries- line managers 392 112 136 144
Common fixed costs 800 220 300 280
Total Fixed costs 2,408 684 852 872
Net income (loss) (392) 316 108 (32)
The general factory fixed cost was allocated on the basis sales.

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Management is concerned about the continued losses shown by the spring rolls
and wants a recommendation as to whether or not the line should be discontinued.
The special equipment used to produce spring rolls has no resale value and does
not wear out.
You are required to determine whether the production and sale of the rolls be
discontinued? Show calculations to support your answer. Recast the above data in
a format that would be more usable to management in assessing the long run
profitability of the various product lines.

Solution: No, production and sale of rolls should not be discontinued. Calculation
to support this viewpoint follows:
Details GHc GHc
Contribution lost (840)
Less avoidable fixed costs:
Advertising – traceable 240
Salaries of product- line managers 144 384
Total decrease in net operating income (i.e. 64+392) (456)

Alternative solution: Maintain Drop Drop Drop

Total Chips Pies Rolls
GHc GHc GHc GHc
Sales 6,400 4,640 4,000 4,160
Less variable expenses 3,280 2,840 2,160 2,200
Contribution 3,120 2,200 1,940 1,960
Less Fixed Costs:
Advertising, traceable 704 496 448 464
Depr. Special Equipment 512 512 512 512
L/Supervisors’ salaries 392 280 256 248
General Fixed Costs 800 800 800 800
Total Fixed Costs 2,408 2,088 2,016 2,024
Net operating income (loss) 712 112 (70) (64)

5. Asante Brothers Company manufactures three types of electrical gadgets – K,

T, and M. Data on sales and expenses for the past quarter is given below:
Total K T M
GHc’000 GHc’000 GHc’000 GHc’000
Sales 1,000 140 500 360
Less variable expenses 410 60 200 150
Contribution 590 80 300 210
Less Fixed Costs:
Advertising, traceable 216 41 110 65
Depr. Special Equipment 95 20 40 35
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L/Supervisors’ salaries 19 6 7 6
General factory fixed costs 200 28 100 72
Total Fixed Costs 530 95 257 178
Net operating income (loss) 60 (15) 43 32
The general factory fixed cost was allocated on the basis sales.
Management is concerned about the continued losses shown by the kettles and
wants a recommendation as to whether or not the line should be discontinued. The
special equipment used to produce kettles has no resale value. If the kettle line is
dropped the two line supervisors would be discharge.
You are required to determine whether production and sale of K be discontinued?
You may assume that the company has no other use for the capacity now being
used to produce the K. Show calculations to support your answer. Recast the
above statement in a format that would be more usable to management in
assessing the long run profitability of the various product lines.

Solution
No, production and sale of K should not be discontinued. Calculation to support
this viewpoint follows:
Details GHc’000 GHc’000
Contribution lost (80)
Less avoidable fixed costs:
Advertising – traceable 41
Line supervisors’ salaries 6 47
Total decrease in net operating income (i.e. 27 + 5) (33)

Alternative solution: Maintain Drop Drop Drop

Total K T M
GHc’000 GHc’000 GH’000 GHc’000
Sales 1,000 860 500 640
Less variable expenses 410 350 210 260
Contribution 590 510 290 380
Less Fixed Costs:
Advertising, traceable 216 175 106 151
Depr special Equipment 95 95 95 95
Line supervisors’ salaries 19 13 12 13
General factory fixed costs 200 200 200 200
Total Fixed Costs 530 483 413 459
Net operating income (loss) 60 27 (123) (79)

Total Kettles Toasters Microwaves

GH¢’000 GH¢’000 GH¢’000 GH¢’000
Sales 1,000 140 500 360
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Less variable expenses 410 60 200 150
Contribution 590 80 300 210
Less fixed costs:
Advertising, traceable 216 41 110 65
DeprEquipment 95 20 40 35
Line supervisors’ salaries 19 6 7 6
Total traceable fixed 330 67 157 106
Product line margin 260 13 143 104
Less General fixed costs 200
Net income (loss) 60

Definition and Functions of Budgets

By definition, a budget is a plan, quantified in monetary terms showing the
income to be generated, the costs to be incurred and the resources to be utilised
for a defined future period of time. A budget provides a focus for the organisation,
aids coordination of activities and facilitates control. Usually budgets covering
financial aspects quantify management’s expectations regarding future income,
cash flows, and financial standing of the organisation. Therefore, budget
statements that forecast future performance, quantitatively for a set time period of
a proposed future plan of action comprise:
 Profit and loss account
 Cash budget
 Balance sheet

The Role and Objectives of Budgets

The functions or purposes of a good budget can be identified in six ways:
Planning - Corporate planning is a long term activity which shows how
organisational objectives are to be achieved over a three – ten year period.
Budgets are prepared for shorter periods of time, often a year. Budgets are usually
more detailed than strategic plans and aim to break the corporate objective down
into shorter more achievable parts. Thus budgeting is a planning device, in that,
budgeting process forces a business to look into the future. If a business does not
look to the future it will fail in the short, medium or long term. It will fail because
the organisation will become ‘out of kilter’ of its environment.

Control - Once a period has elapsed one can compare the actual results of the
organisation for the period with budgeted results to see how close it came to
achieving the plan. This will enable the company to potentially bring about
improvements for the future. The budget therefore acts as a comparator against
which the actual results may be compared.

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Communication - In large organisations, particularly if they are organised along
divisional lines, it is often difficult to communicate to people the broad objectives
and plans of the entire organisation. The budget is a plan of action expressed in
quantitative terms. Hence by providing people within the organisation with such a
plan it helps to disseminate the wishes and objectives of the entire organisation.
The budget may form the basis of the reporting hierarchy. It is a formal
communication channel that allows junior and senior managers to converse.

Co-ordination - In large organisations it is often difficult to co-ordinate the

activities of the various components to work for the common good of the entire
organisation. Therefore, by establishing a budget committee under the control of a
principal budget officer it should be possible to co-ordinate the plans and
objectives of the various sections of the organisation to ensure they compliment
one another and also work towards common organisational goals. Thus, the
budget allows the business to co-ordinate all diverse action towards a common
corporate goal.

Evaluation - The budget may be used to evaluate the results of a department of

the business organisation such as a cost centre, where a manager is held
responsible for the control of expenditure. It may further be used to evaluate the
actions of a manager within the organisation and therefore ensures effective and
efficient performance.

Motivation - It is generally accepted that corporate objectives are more likely to

be met if they are expressed as quantified targets, often in the form of budgets.
Because budgets are used as targets against which management performance are
measured, targets are usually set at the right level of difficulty to act as a
motivator. Both unrealistic and overgenerous targets will be demotivational.
Proper functional budgets normally takes care to reward success as well as
penalise failure, and is prepared in order that a benefit is perceived in bettering
rather than just achieving the proposed target.

Budget Period
The budget period is the time period to which the plan of action relates. A detailed
budget for each responsibility centre is normally prepared for one year. The
annual budget may be divided into either twelve monthly or thirteen four-weekly
periods.

Budget Manual
The procedures for preparing the budget are contained in the budget manual.
Accountants are usually charged with the responsibility issuing the budget

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manual. The manual will describe the objectives and procedures involved in the
budgeting processes and will provide a useful source of reference for managers
responsible for budget preparation. The manual must state among other things:
 which budgets must be prepared, when and by whom
 what each functional budget should contain
 directions on how to prepare budgets and where appropriate the standard
forms used etc
The use of a budget manual actually enables organisations to develop improved
techniques for forecasting sales and costs.

The Budget Committee

The preparation and administration of budget is usually the responsibility of a
budget committee, chaired by the managing director (chief executive). The other
members of the committee will be the high level executives or senior
departmental managers, who represent the major sections (segments) of the
business. The functions of a budget committee include:
 Instructing departments to carry out budget preparation procedures for
instance gathering historical cost data to facilitate budget preparation, to
produce draft budgets for their department, giving guidelines for budget
preparation.
 discussing foreseeable problems with departmental managers
 ensuring that the budgets are prepared on schedule
 co-ordinating the budgets of different departments and resolving
discrepancies and differences in opinion
 agreeing the final budgets and assembling the master budget
 issuing approved budgets to sectional managers.

The Principal Budget Officer

The committee should appoint a budget officer who will normally be the
accountant. The major role of the principal budget officer is to co-ordinate the
individual budgets into a master budget for the whole organisation. This must be
done in such manner that budget committee and budgetees can see the impact of
an individual budget on the organisation as a whole.

Master Budget
The master budget coordinates all the financial projection in the organisation’s
individual budgets in a single plant-wide set of budgets for a set time period.
Master budget embraces the impact of both operating decisions and financing
decisions. The term master in “master budget” only refers to it being a detailed,
organisation wide set budgets. (Horngren, forster, and Datar, 1997). Whereas

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operating decisions centre on the acquisition and use of scarce resources,
financing decisions centre on how to raise the needed funds to acquire resources.

Steps in Preparation of a Budget

The important stages are as follows:
1. Communicating Budget Aims
A meeting is held by the budget committee to establish the aims, policy
administration and underlying assumptions affecting the budget. The aims will be
general targets such as profit or market share linked to the longer term strategic
plan.
2. Determining the Principal Budget Factor
This factor limits the level activity at which the organisation can operate. It could
be a factor of production such as restricted machine capacity or labour hours, but
is more normally sales demand at least in the longer term, except for non-profit
making establishments where it is often cash resources. Prior to the preparation of
the budgets it is necessary for top management to identify the factor which
restricts performance as this factor becomes the pivot upon which the annual
budgeting process rotates.
3. Prepare Sales Budget
The most difficult budget to prepare because it involves considering the
relationship between price and demand. Every effort must be made to ensure this
is as accurate as possible as all other budgets will be affected by management
decisions at this point.
4. Prepare all Other Functional Budgets
Given the sales budget we can then work backwards through the production
process to prepare costs. Functional or departmental managers will prepare their
own budgets. The preparation of the budget should be a ‘bottom-up’ process. This
means that the budget should originate at the lower levels of management and be
refined and co-ordinated at higher levels. This approach will encourage managers
to participate in the preparation of their budgets and thereby increase the
probability that they will accept the budget and also strive to achieve the budget
targets. This participatory approach is considerably more time consuming than a
more centralised approach but has distinct advantages.
5. Negotiation of Budgets
The junior manager will meet with his/her senior manager to refine the budget
prepared. The senior manager will use his/her wider scope of experience to co-
ordinate the budget with other linked budgets. In addition, senior managers will
attempt to eliminate slack (excess cost) from the budget, to counter the inclination
of managers to make their targets easy to achieve.
6. Review

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The individual functional budgets are brought together to form a whole. The
budget is then assessed and reviewed. This is usually a management accounting
function. Initially the budget must be assessed for feasibility or ‘does it work’.
The budget will be reviewed to consider acceptability or ‘does it achieve the
budget aims’
7. Acceptance
The budget is summarised for the company or organisation as a whole in the
master budget and accepted by the budget committee as the target for the coming
year. It is expressed as budgeted financial statement and is also used to prepare
cash budgets and more detailed production and sales plan.

Stages in Budget Preparation: Stages 1

Isolate principal budget factor

Stage 2
Produce functional budgets

Stage 3
Produce master budgets

As rightly pointed out the principal budget factor is a factor that restricts the
organisation’s level of activity. It is a limiting factor. The principal budget factor
could relate to material or labour availability but is more likely to represent sales
demand. Sales demand is a limiting factor because there is no point in producing
more than customers are willing to buy.

Functional Budgets
The functional budgets (i.e. the budgets for each functional area in an
organisation) build up the various costs to arrive at the figure for inclusion in the
profit and loss account.
Building up the Functional Budgets: Sales budget

Production budget

Material usage budget

Material Purchase budget

Labour budget

Overhead budget

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Note the Logical Sequence or Order
1. Begin with the sales budget because sales in this case is assumed to be the
principal budget factor and the therefore the pivot upon which all other budgets
rotates.
2. Achieving a given sales level has implications for the required production
levels.
3. This in turn has implications for the amount of production materials required.
The next stage is therefore material usage budget followed by the labour budget
and others accordingly. A series of illustration now follow to show how a budget
is build up.

Illustration1. S & J Enterprise estimates that its sales of Product X in the coming
period will be 20,000 units and of Product Y 30,000 units. At these volumes
Product X is likely to sell for ¢60 per unit and Product Y for ¢50 per unit.
You are required to produce a sales budget for S & J Enterprise.

Solution Products X Y
Sales (units) 20,000 30,000
Selling price (GHc) 6 5
Total Sales (GHc) 120,000 150,000 270,000

The next budget to be compiled is the production. It is worth mentioning here that
production volumes will be different from sales volumes if stocks of finished
goods change over the time.

2. S & J Enterprise has 2,000 units Product X and 10,000 of Product Y in stock.
At the end of the coming year S & J wants to increase stocks of X by 10% and
reduce stocks of Y by 50%. You are required to produce a production budget for
S & J Enterprise

Solution Products X Y
Budgeted Sales (units) 20,000 30,000
Opening stocks (2,000) (10,000)
Closing stocks:X: 2,000 x 110% 2,200
Y: 10,000 x 50% 5,000
Budgeted Production 20,200 25,000

Once production volume is established then one can proceed to produce a

materials usage budget. Equally one could also add or subtract the increase or

194
decrease amount to or from the budgeted sales units. So the production budget
could also look like this:

Solution Products X Y
Budgeted Sales (units) 20,000 30,000
Add increase in stock X (2000 x 10%) 200
Less reduction in stock Y (10,000 x 50%) 5,000
Budgeted Production 20,200 25,000

3. Each unit product X requires 4kg of material M and 2kg of material N. Each
unit of product Y requires 5kg of M. Material M cost ¢10 per kg and N ¢8 per kg.
You are required to produce a material usage budget for S & J Enterprise

Solution Materials M (kg) N (kg)

Production of X 20,200 x 4 80,800
20,200 x 2 40,400
Production of Y 5,000 x 5 125,000
Budgeted Material Usage (units) 205,800 40,400
Price per kg (¢) 10 8
Total
Material Usage (in value) (¢) 2,058,000 323,200
2,381,200
Again, if opening stocks raw materials are different closing stocks then materials
usage and purchases are not the same.

4. S & J Enterprise opening stocks of material M are 12,000kg and of material N

10,000kg. Desired closing stocks are 50% higher for both materials. You are
required to prepare a material purchases budget for S & J Enterprise

Solution Material M (kg) N (kg)

Budgeted material usage 205,800 40,400
Opening stocks (given) (12,000) (10,000)
Closing stock: 12,000 x 150% 18,000
10,000 x 150% 15,000
Material usage (units) 211,800 45,400

Price per kg (¢) 10 8

Total
Material Purchase (¢) 2,118,000 363,200
2,481,200

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5. Labour Budget
The labour budget can only be prepared after the production budget. As an
example consider the following information. Each unit of product X requires 1
hour of skilled labour and 2 hours of unskilled labour. A unit of product Y takes
½ hour of skilled labour and 2 hours of unskilled labour. Skilled labour is paid at
¢12 per hour and unskilled at ¢8 per hour. You are required to prepare a labour
budget for S & J Enterprise.

Solution Labour Type Skilled Unskilled

Hours worked on X (20,200 x 1) 20,200 (20,200 x 2) 40,400
Hours worked on Y (25,000 x ½) 12,500 (25,000 x 2) 50,000
Total labour hours required 32,700 90,400
Labour rate per hour (¢) 12 8
Total
Labour costs (¢) 392,400 723,200
1,115,600
6. Overheads Budget
If absorption rates are used these are usually calculated after the labour budgets as
labour hours are often used for the calculation. S & J Enterprise absorbs variable
production overhead at ¢4 per skilled labour hour used and fixed overheads are
expected to be ¢50,000 for the period.
Solution Factory Overheads ¢
Variable overheads: (32,700 x ¢4) 130,800
Fixed overheads 50,000
Total Production Overhead 180,800
It is assumed here that S & J uses marginal costing and therefore, there was no
need for fixed overhead absorption rate as well as the determination of under or
over absorbed fixed cost.
Cash Budget
A cash budget is prepared to show the expected receipts of cash and payments of
cash during the next accounting period. The annual cash budget may be divided
into smaller time periods or control periods, commonly of one month or four
weeks.
Receipts of Cash
Receipts of cash may be from cash sales, payments by debtors, the sale of fixed
assets, the issue of fresh shares or loan stock, the receipt of interest and dividend
form investment outside the business etc. It is important to note that all these are
not profit and loss account items for instance the issue of new shares or loan stock
is a balance sheet items and the cash received from selling an asset also affect the
balance sheet. That portion of asset sale transaction, which appears in the profit

196
and loss account, is not the cash received but difference between cash received
and the written down value of the asset.
Payments of Cash
Payments of cash may be for purchases of stocks payment of wages or other
expenses, the purchase of capital items, payment interest, dividends, or taxation.
Again, not all payments are profit and loss account items (i.e. the purchase of
capital equipment or payment of VAT). It may be seen from the above description
that receipts and payments are not the same as sales and cost of sales because:
 not all receipts affect profit and loss account income ,
 not all payments affect profit and loss account cost
 some costs in the profit and loss account (i.e. loss or profit on sale of
assets, depreciation etc) are not cash items but are costs derived from
accounting conventions,
 the timing of receipts and payments does not coincide with the profit or
loss accounting period.
The approach to cash budget questions in an examination should be as follows.
 Use a sensible recognised format,
 insert the easy cash flows onto the schedule first to gain easy
marks,
 do not back up working for the more difficult cash flows
 never include depreciation, profit/loss on asset.
Format of Cash Budget
Inflows January February March
Cash received from: ¢ ¢ ¢
Cash sales xxx xxx xxx
Customers/Debtors xxx xxx xxx
Proceeds: asset disposal xxx xxx xxx
Proceeds: fresh share issues xxx xxx xxx
Total receipts xxx xxx
xxx
Outflows:
Cash paid to suppliers’ xxx xxx xxx
Wages xxx xxx xxx
Expenses xxx xxx xxx
Dividends xxx xxx xxx
Purchase of fixed assets xxx xxx xxx
Total payments xxx xxx xxx
Net inflow (outflow) xx xx xx
Balance b/f XX XX XX
Balance c/f XX XX XX

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1. Sparks Engineering Limited produces three-bathroom accessories namely Q. S.
T. for the building industry. The budget for the forthcoming year to 31 st
December 2007 is to be prepared. Expectations for the forthcoming year include
the following:
Budgeted Sales
Products Quantity Unit Price
Q 3,000 ¢60
S 7,000 ¢70
T 5,000 ¢80
Materials used in the manufacture of the company’s products are:
Components reference code A B C D
Components unit cost ¢2 ¢3 ¢4 ¢5
Quantities used: Q 5 3 1 2
S 4 4 2 3
T 3 2 1 5
Totals 12 9 4 10
Two main departments are, Styling and Decorating used in the production
processes, and the standard unit times for each product being:
Products Styling Department Decorating
Department
(Hourly wage rate ¢0.50) (Hourly wage rate ¢0.60)
Q 3 hours 1.5 hours
S 4 hours 2 hours
T 5 hours 2.5 hours

Production overhead, which is absorbed into product cost on a direct labour basis,
is budgeted as follows: ¢
Building occupancy 30,050
Equipment Utilisation 16,100
Personnel Service 12,150
Material handling 9,310
Production planning 9,790
Selling and distribution cost budgeted for the period are:
Representation 101,300
Sale office 30,100
Advertising 29,100
and are charged to products in proportion to the sales income of the period.
Stocks at the commencement of the year 1/1/07 are expected to be:

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F/goodsQuantity Raw Materials Quantity Unit Price
Q 1,000 A 40,000 ¢2
S 3,000 B 20,000 ¢3
T 2,000 C 10,000 ¢4
D 30,000 ¢5
The company plans an increase of 10% in the quantities of finished goods stocks
held by the end of the year and a reduction of 20% in the quantities of raw
materials components stocks.
a) You are required to prepare budget for the
i. sales (in units and value)
ii. production quantities
iii. material usage in quantities
iv. material purchases (in quantities and value)
v. direct labour utilisation and cost
b) Prepare a statement showing the valuation of finished good stocks at the year
end.
c) Prepare a budgeted profit statement for the period showing the amount of profit
contributed by each product.
Solution a) i. Sales Budget
Products Quantity Selling Price/Unit Sales Value
Q 3,000 ¢60 ¢180,000
S 7,000 ¢70 ¢490,000
T 5,000 ¢80 ¢400,000
Total Sales ¢1,070,000

ii. Production Budget (Quantities only)

Products Sales Budget Stock Increase Production
Required
Q 3,000 100 3,100
S 7,000 300 7,300
T 5,000 200 5,200

iii. Material Usage Budget (in Quantities)

Product Production Material Components
Type Requirement A B C D
Q 3,100 15,500 9,300 3,100 6,200
S 7,300 29,200 29,200 14,600 21,900
T 5,200 15,600 10,400 5,200 26,000
Totals 60,300 48,900 22,900 54,100

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iii. Material Purchase Budget (in Quantities and Value) Material
Components
Details A B C D
Budgeted usage 60,300 48,900 22,900 54,100
Less stock decrease 8,000 4,000 2,000 6,000
Materials to be purchased 52,300 44,900 20,900 48,100
Unit cost/price ¢2 ¢3 ¢4 ¢5
Material Purchases Value ¢104,600 ¢134,700 ¢83,600
¢240,100

iv. Direct Labour Budget

Product Production Styling Dept. Hours Decorating Dept. Hours
Total
Q 3,100 9,300 4,650
S 7,300 29,200 14,600
T 5,200 26,000 13,000
Totals Labour Hours 64,500 32,250 96,750
Budgeted labour rate/hour ¢0.50 ¢0.60
Total labour Cost 32,250 19,350 51,600
b) Calculation of Unit Product Cost:
Details Products
Direct material (¢) Q S T
A (usage & cost as/budget) 10 8 6
B 9 12 6
C 4 8 4
D 10 33 15 43 25 41
Direct labour cost (¢)
Styling Dept (hrs & rate as/budget) 1.5 2.0 2.5
Decorating 0.9 2.4 1.2 3.2 1.5 4.0
Prime Cost 35.4 46.2 45.0
Production overhead (0.8x4.5) 3.6 (0.8x6) 4.8 (0.8x7.5) 6
Cost/Unit 39.0 51.0 51.0
Production Overheads Workings
Total overheads ¢ (30,050 + 16,100 + 12,150 + 9,310 + 9,790) = 77,400
Total direct labour hours (64,500 + 32,250) = 96,750
Overhead Absorption Rate per hour (77,400 / 96,750) = 0.80

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Statement of Finished Stock Valuation
Opening Stock Closing Unit Stock
Products Stock Increase Stock Cost Value
Q 1,000 100 1,100 39 ¢42,900
S 3,000 300 3,300 51 ¢168,300
T 2,000 200 2,200 51 ¢112,200
Total Closing Stock Value. ¢323,400

Budgeted Profit Statement for Sparks Engineering Ltd. for Year Ended
31/12/07 Q S T Totals
Sales (Units) 3,000 7,000 5,000 15,000
Sales Revenue 180,000 490,000 400,000 1,070,000
Production cost 117,000 357,000 255,000 729,000
Selling & distribution exp. 27,000 73,500 60,000 160,500
Estimated Profit 36,000 59,500 85,000 180,500
Note: selling and distribution cost apportionment
Total Cost/ Sales Revenue = GH¢160,500/¢1,070,000 = 15%
Q S T
S/Price ¢60 ¢70 ¢80
Selling and Distribution Cost/Unit Sold (15%) ¢9 ¢10.5 ¢12

2. Bertha Enterprise Limited produces two products Nike and Adidas sports wear.
The budget for the year ending 31/03/2007 is currently under consideration for
approval. Expectation for the said period include the following
a) Bertha Enterprise Limited Balance Sheet as at 1/04/06
Fixed assets ¢’000 ¢’000 ¢’000
Land and buildings 45,000
Plant and Equipment at cost 187,000
Less: accumulated depreciation 75,000 112,000
157,000
Current Assets
Raw materials 7,650
Finished goods 23,600
Debtors 19,500
Cash 4,300 55,050
Less: Current Liabilities
Creditors 6,800
Taxation 24,500 31,300 23,750
Net Assets 180,750
Financed By:
Capital 150,000

201
Retained Profit 30,750
180,750
b) Finished products: Nike Adidas
The sales director has estimated the following:
i. demand for the company’s products will be 4,500 units 4,000
units
ii. They will market at a selling price per unit of ¢32,000
¢44,000
iii. Closing stock of finished goods at 31/3/07 is to be 400units 1,200 units
iv. Opening stock of finished products at 1/4/06 is 900units 200
units
v. Unit cost of this opening stock will be ¢20,000
¢28,000
vi. The amount of plant capacity required/Unit is:
Cutting and Pressing 15 minutes 24
minutes
Assembling and Packing 12 minutes 18
minutes
vii. The raw material component per unit is
Material A 1.5kg 0.5kg
Material B 2.0kg 4.0kg
viii. Direct labour hours required per unit is 6hours 9hours
Finished goods are value on a FIFO basis at full factory cost.
c) Raw materials: Material A
Material B
Closing stock requirement 31/03/07 600kg
1,000kg
Opening stock at 1/04/06 is made up 1,100kg
6,000kg
Budgeted cost of raw material per kilogram ¢1,500 ¢1,000
Actual costs per kilogram of opening stock are as budgeted cost for the coming
year.
d) Direct labour:
The standard wage rate of direct labour is ¢1,600 per hour.
e) Factory overhead:
Factory overhead is absorbed on the basis of machining hours, with a plant-wide
absorption rate for all departments.
The following overheads are anticipated in the production cost centre budgets:
Cutting & Pressing Assembling &
Packing
Details ¢’000 ¢’000

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Supervision 10,000 9,150
Power 4,400 2,000
Maintenance 2,100 2,000
Consumables 3,400 500
General expenses 19,600 5,000
39,500 18,650
Depreciation is taken at 5% reducing balance on plant and equipment. a machine
costing the company ¢20,000,000 is due to be installed on 1/10/06 in the Cutting
& Pressing department, which already has machinery installed to the tune of ¢100
million (at cost).
f) Selling and administration expenses: ¢’000
Sales commissions and salaries 14,300
Travelling and distribution 3,500
Office salaries 10,100
General expenses 2,500
30,400
g) There is no opening or closing work in progress and inflation is to be ignored.
h) You are required to prepare the following budgets for the year ended 31/03/07
for Bertha Enterprise Limited:
i. sales budget
ii. Production budget (in quantities)
iii. plant utilisation budget
iv. direct material usage budget
v. direct labour budget
vi. factory overhead budget
vi. direct material purchase budget
vii. cost of goods sold budget
viii. budgeted profit and loss account

Suggested Solution i. Sales Budget

Products Quantity Selling Price/Unit Sales Value
Nike 4,500 ¢32,000
¢144,000,000
Adidas 4,000 ¢44,000
¢176,000,000
Total Sales ¢320,000,000

ii. Production Budget (Quantities Only)

Products Sales Budget Stock Increase/Decrease Production
Required
Nike 4,500 (500) 4,000

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 Adidas 4,000 1,000 5,000

i. Plant Utilisation Budget

Hours Machining Hours Assembling
Product Production /Unit Dept. Hrs /Unit Dept. Hrs
Nike 4,000 0.25 1,000 0.20 800
Adidas 5,000 0.40 2,000 0.30 1,500
Totals Hours 3,000 2,300

iv. Material Usage Budget (in Quantities)

Product Production Material Components
Type Requirement A (kg) B (kg)
Nike: 4,000 x 1.5kg 6,000
4,000 x 2.0kg 8,000
Adidas: 5,000 x 0.5kg 2,500
5,000 x 4.0kg 20,000
Totals 8,500 28,000
Unit cost/price ¢1,500 ¢1,000
Cost of Material to be Used ¢12,750,000 ¢28,000,000

vii. Material Purchase Budget (in Quantities and Value)

Material Components
A (kg) B (kg)
Budgeted closing stock 600 1,000
Production requirement 8,500 28,000
9,100 29,000
Less opening stock 1,100 6,000
Purchase requirement 8,000 23,000
Unit cost/price ¢1,500
¢1,000
Material Purchases (in Value) ¢12,000,000
¢23,000,000
v. Direct Labour Budget
Product Production Hours/Unit Total Hours Rate/Unit Total
cost
Nike 4,000 6 24,000 ¢1,600
¢38,400,000
Adidas 5,000 9 45,000 ¢1,600
¢72,000,000
Totals labour hours/cost 69,000 ¢110,400,000

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vi. Factory Overhead Budget: Machining Dept. Assembling
Dept.
Overhead allocated (excluding depreciation) ¢39,500,000
¢18,650,000
Depreciation provisions:
Existing Plant (5% of ¢100,000,000 - Machining) 5,000,000
(5% of ¢87,000,000 – Assembling)
4,350,000 Proposed Plant (5% of ¢20,000,000 x 6/12) 500,000
0
Total Factory Overhead 45,000,000
23,000,000
Total Machine Hours (III) 3,000 2,300
OAR (using Machine hours) ¢15,000
¢10,000

viii. Calculation of Product Cost/Unit: Products Type

Details Nike Details
Adidas
D/Material: ¢ ¢
A 1.5kg x ¢1,500 2,250 0.5kg x ¢1,500
750
B 2.0kg x ¢1,000 2,000 4.0kg x ¢1,000
4,000
D/Labour cost 6 x ¢1,600 9,600 9 x ¢1,600 14,400
Prime Cost 13,850 19,150
P/Overhead:
Machining Dept. 15/60 x ¢15,000 3,750 24/60 x ¢15,000
6,000
Assembling Dept. 12/60 x ¢10,000 2,000 18/60 x ¢10,000
3,000
Factory Cost/Unit 19,600 28,150

viii. Cost of Goods Sold Budget

Products Type
Units Details Nike Units Details
Adidas ¢
¢

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O/Stock 900 x ¢20,000 18,000,000 200x ¢28,000
5,600,000
P/Cost 4,000 x ¢19,600 78,400,000 5,000 x ¢28,150
140,750,000
4,900 96,400,000 5,200
146,350,000
C/Stock 400 x ¢19,600 7,840,000 1,200 x ¢28,150
33,780,000
COS 4,500 88,560,000 4,000
112,570,000

NB: The cost of sales of Nike consist of 900 units at ¢20,000 and 3,600 at
¢19,600 each.
The cost of sales of Adidas consist of 200 units at ¢28,000 and 3,800 at
¢28,150 each.

ix. Budgeted Profit Statement for Bertha Enterprise Ltd. for Year Ended
31/12/07 Nike Adidas
Totals
Sales (Units) 4,500 5,000 9,500
Sales Revenue 144,000,000 176,000,000
320,000
Less cost of sales 88,560,000 112,570,000
201,130,000
Budgeted Gross Profit 55,440,000 63,430,000
118,870,000
Less Selling and Distribution Exp.
30,400,000
Budgeted Net Profit
88,470,000

Problems in Budgeting
1. The rate of inflation might be hard to predict so that budgeting for price
levels will be largely guess work
2. The volume of activity i.e. sales and production cannot be foreseen with
certainty so that a budget to produce and sell say 3,000 units of a product
might quickly be overtaken by events and sales demand could either
exceed or fall short of expectation.
3. The problems of organisational attempt to coordinate the plans of different
department into an optimal master budget

206
 4. Problems of motivation and where these exist, budgeted expenditure on
claims by cost centres or cost centre managers are likely to be excessive,
and where they are non-existent, individual participation or involvement
tends to dwindle.
Some Essentials Characteristics of a Good Budget
1. A good budget serves as a plan of action for the ensuing period. it
succinctly states the objects and policies to be pursued in order to achieve
the corporate objective in financial terms.
2. A good budget controls cost and organisational activities. It serves a yard
stick or criteria for measuring costs and activities undertaken. By
comparing the budget with actual excessive expenditures and shortfalls
can easily be traced so that where necessary effective action will be taken
to correct situation accordingly.
3. A good budget permits delegation of duties of managers to their
subordinates thereby encouraging management succession.
4. A good budget coordinates not only the activities of the organisation but
also promotes and ensures goal congruence. It brings all activities of the
organisation into agreement for the common good of the both the
workforce and the entity.
5. A good budget keeps cost to the minimum by creating constant cost
awareness in the organisation. Comparison of actual with budgeted costs
exposes managers who have spent excessively and therefore ineffective.
Managers therefore avoid blame by keeping every item of expenditure
within the confines of the budgeted estimates.
6. A good budget motivates. It is such that a hard working manager will
achieve targets in order to merit praises, so that motivate all managers to
work hard.

3. A product manager has a responsibility for a single product and is in the

process of submitting data to be compiled into budgets for 2008. The manager has
a performance targets set in relation to sales volume, profitability, levels and a
target cash surplus from the product.
Shown below are the agreed budgeted sales for the product for December 2007 to
May 2008.
Periods Dec. Jan Feb Mar Apr. May
Units 14,000 16,000 22,000 17,000 20,000 24,000
The company policy is that, at each month end the closing stock of finished goods
should be 25% of the following month’s forecast sales and the stock of raw
material should be sufficient for 10% of the following month’s production. Stock
levels currently conform to this policy. One unit of material makes one unit of
finished stock, there is no wastage. Raw materials purchases are paid for during

207
the month following the month of purchase. All other expenses are paid for as
incurred. All sales are made on credit and the company expects cash receipt for
50% of sales in the month of sale and 50% in the following month. The company
operates an absorption costing which is computed on a monthly basis. That is, in
addition to direct cost it recovers each month’s fixed and variable manufacturing
overhead expenses in product costs using the budgeted production and budgeted
expenditure in the month to establish an absorption rate. This cost is used to place
a value on the stock holding. Opening stock is valued at the unit cost which was
established in the previous month. At January 2008 finished stock should be
assumed at ¢600 per unit. A flow of cost based on FIFO is assumed. Sales are
made at a price of ¢870. Estimated costs to be used in the budgeted preparation
for the product are:
Manufacturing costs: ¢
Material
150/unit produced
Variable overhead and labour
240/unit produced
Fixed overhead costs (including ¢810,000 depreciation per month)
3,150,000/month
Selling costs
Variable 105/unit sold
Fixed
2,460,000/month
You are required to compute the monthly budgeted production and material
purchases for January to march 2008 and prepare a budgeted profit and loss
account as well as a statement of cash receipts and payments for January.

Suggested solution a) Production Budget (Units)

Periods Dec. Jan Feb Mar
Apr.
Sales 14,000 16,000 22,000 17,000 20,000
Closing stock 4,000 5,500 4,250 5,000 6,000
18,000 21,500 26,250 22,000 26,000
Opening stock 3,500 4,000 5,500 4,250 5,000
Production 14,500 17,500 20,750 17,750 21,000

b) Material Purchase Budget (Units)

Dec. Jan Feb Mar
Production 14,500 17,500 20,750 17,750
Closing stock 1,750 2,075 1,775 2,100
16,250 19,575 22,525 19,850

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Opening stock 1,450 1,750 2,075 1,775
Purchases 14,800 17,825 20,450 18,075

WORKINGS
Calculation of manufacturing cost/unit ¢
Material 150
Variable overhead and labour 240
Fixed overhead (¢3,150,000/17,500) 180
570
c) Budget Profit and Loss Account for January 2008 Based on Full Costing
and FIFO
¢’000 ¢’000
Sales (16,000 x 870) 13,920
Cost of sales:
Opening stock (4,000 x ¢600) 2,400
Production (17,500 x ¢570) 9,975
12,375
Less closing stock 5,500 x ¢570) 3,135 9,240
Gross Profit 4,680
Selling cost
Variable (16,000 x ¢105) 1,680
Fixed 2,460 4,140
Net profit 540

d) Cash Receipts and Payments for January 2008

¢’000 ¢’000
Total Receipts:
From December sales (50% x 14,000 x ¢870) 6,090
From January sales (50% x 16,000 x ¢870) 6,960 13,050
Total Payments:
Materials - December purchases (14,800 x ¢150) 2,220
Variable overhead and labour (17,500 x ¢240) 4,200
Fixed overhead (¢3,150,000 - ¢810,000) 2,340
Variable selling cost (16,000 x ¢105) 1,680
Fixed Selling cost 2,460 12,900
150
4. Numale Ltd owns a chain of 14 shops selling quality compact discs and
cassette tapes. At the beginning of June 2004 the company had an overdraft of
¢52,500,000 and the bank has asked for this to be eliminated by the end of

209
November 2004. As a result, the directors of the company have recently decided
to review their plans for the next six months in order to comply with this
requirement. The following forecast information was prepared for the business
some months earlier:
Periods May June July August Sept.
Oct. Nov.
¢’000 ¢’000 ¢’000 ¢’000 ¢’000 ¢’000
¢’000
Expected sales 270,000 345,000 480,000 375,000 210,000
180,000 165,000
Purchases 202,500 270,000 213,000 141,000 112,500 99,000
85,500
Admin. Exp. 78,000 82,500 84,000 79,500 72,000 69,000
67,500
Selling exp 33,000 36,000 42,000 39,000 31,500 28,500
27,000
Taxation 33,000
Fin. payments 7,500 7,500 7,500 7,500 7,500 7,500
7,500
Shop renovation 21,000 27,000 9,000
The following additional information is also available:
1. Stock held at 1/6/04 was ¢168,000,000. The company believes it is
necessary to maintain a minimum stock level of ¢60,000,000 over the
period to 30/11/04
2. Suppliers allow one month’s credit. The first three months purchases are
subject to a contractual agreement which must be paid.
3. the gross profit margin is 40%
4. All sales income is received in the month of sale. However, 50% percent
of customers pay with a credit card. The charge made by the credit card
company to Numale Ltd is 3% of the sales value. These charges are in
addition to the selling expenses identified above. The credit card company
pays Numale Ltd in the month sale.
5. The company has a bank loan which it is paying off in monthly
instalments of ¢7,500,000 per month. The interest element represents 20%
of each instalment.
6. Administration expenses are paid when incurred. This item includes a
charge of ¢22,500,000 each month in respect of depreciation.
7. Selling expenses are payable in the following month.
You are required to:
a) Prepare a cash budget for the six months ended 30/11/04 which shows the cash
balance at the end of each month

210
b) Compute the monthly stock levels for each of the six months to 30/11/04.
c) Prepare a budgeted profit and loss account for the six months ended 30/11/04 (a
monthly breakdown of profit is not required)

4. a) Explain three benefits and two problems associated with budgets.

b) McGill Ltd is a new business, which would start operations on the 1st May,
2007.
Planned sales for the next eight months are as follows:
Period Sales Units
June 5,000
July 6,000
August 7,000
September 8,000
October 9,000
November 9,000
December 9,000
January 8,000
February 7,000
The following additional information is also available:
a) The selling price per unit will be a consistent ¢16,000 and all sales will be
made on one month’s credit.
b) It is planned that sufficient finished goods stock for each month’s sales
should be available at the end of the previous month.
c) Materials purchase will be such that there will be sufficient materials stock
available at the end of each month precisely to meet the following month’s
planned production. This planned policy will operate from the end of May.
d) Purchase of materials will be on one month’s credit. The cost of raw
materials is ¢6,400 per unit of finished product.
e) The direct labour cost, which is variable with the level of production is
planned to be ¢3,200 per unit of finished production.
f) Production overheads are planned to be ¢3,200,000 each month, including
¢480,000 for depreciation.
g) Non-production overheads are planned to be ¢1,760,000 per month of
which ¢160,000 will be depreciation.
h) Various fixed asset costing ¢40,000,000 will be bought and paid for
during May.
i) The business will raise ¢48,000,000 in cash, from a share issue in April.
Except where specified, assume that all payments take place in the same month as
the cost is incurred.
Required:

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a) Draw up the following for the six months ending 31st October, 2007.
i. a production budget, showing just physical quantities,
ii. a raw materials stock budget showing both physical quantities and values
iii. a cash budget.
Suggested solutions McGill Ltd
a) The Production Budget for the Six Months Ending 31/10/07 (In Units)
May Jun Jul Aug Sept. Oct
Budgeted sales (note 2) 0 5,000 6,000 7,000 8,000 9,000
Closing stock (note 1) 5,000 6,000 7,000 8,000 9,000 9,000
GAS 5,000 11,000 13,000 15,000 17,000 18,000
Less sales (note 2) uuu 0 5,000 6,000 7,000 8,000 9,000
Production (note 3) 5,000 6,000 7,000 8,000 9,000 9,000

b) i The Raw Material Stock Budget for the Six Months Ending 31/10/07 (In
Units)
May Jun Jul Aug Sept. Oct
Production requirement (note 3) 5,000 6,000 7,000 8,000 9,000 9,000
Closing stock requirement (note 1) 6,000 7,000 8,000 9,000 9,000 9,000
MAP 11,000 13,000 15,000 17,000 18,000 18,000
Less Mat consumed (note 3) 5,000 6,000 7,000 8,000 9,000 9,000
Raw material stock (note 1) 6,000 7,000 8,000 9,000 9,000 9,000

b) ii The Raw Material Stock Budget for the Six Months Ending 31/10/07 (In
Value)
May Jun Jul Aug Sept. Oct
Production requirement (note 3) 5,000 6,000 7,000 8,000 9,000 9,000
Closing stock requirement (note 1) 6,000 7,000 8,000 9,000 9,000 9,000
MAP 11,000 13,000 15,000 17,000 18,000 18,000
Less Mat consumed (note 3) - 6,000 7,000 8,000 9,000 9,000
Raw material purchase (units) 11,000 7,000 8,000 9,000
9,000 9,000
Raw material price per unit ¢6,400 6,400 6,400 6,400 6,400
6,400
Total purchase (¢’000) s70,400 44,800 51,200 57,600
57,600 57,600

c) Cash Budget for the Six Months Ending 31/10/07

May Jun Jul Aug Sept. Oct
¢’000 ¢’000 ¢’000 ¢’000 ¢’000 ¢’000

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Receipts - debtors - - 80,000 96,000 112,000
128,000
80,000 96,000 112,000
128,000
Payments
Purchases - 70,400 44,800 51,200 57,600 57,600
P/Overheads 2,720 2,720 2,720 2,720 2,720
2,720
Wages 16,000 19,200 22,400 25,600 28,800
28,800
Non P/OH 1,600 1,600 1,600 1,600 1,600
1,600
F/Assets 40,000

60,320 93920 71,520 81,120 90,720

90,720
Cash Flow (60,320) (93920) 8,480 14,880 21,280
37,280
Opening Balance 48,000 (12,320) (97,760) (97,760) (82,880)
(61,600)
(12,320) (106,240) (97,760) (82,880) (61,600)
(24,320)
Notes: 1. this figure is given in the question
2. Opening stock balance is the same as the closing balance from the
previous month
3. This is a balancing figure
4. Non P/OH is the production figure given less depreciation which is not a
cash expense

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PERFORMANCE MEASURE/EVALUATION
Performance measures are a central component of management control system.
Making good planning and control decisions requires information about how
different sub units or divisions of an organisation have performed. To be
effective, both financial and non-financial performance measures must also
motivate managers and employees at all levels of the organisation to strive to
achieve organisation goals.
There should be a yardstick or standard to enable performance to be evaluated.
(i) The standard should be derived from the company itself
(ii) Standard cost from the approved budget
(iii) The standard should be the previous year’s results. Thus, the standard
must have actually happened in a normal year. Normal year is a year
which prices are relatively stable. Hence, this period can be used as a
basis to measure the current year performance.
(iv) It may be a standard taken from the total industry that the company is
concerned i.e., the average of the industry in which the company is
operating.
(v) The standard can be government established index e.g. Group
INDICATORS TO USE.
INVESTMENT – By definition is simply the assets or resources used/applied to
generate income. Management need to assess organisational performance by
looking closely at the overall income generated. However, the controversy then is
not the magnitude of operating income is per se, but how large it is in relation to
the investment made to earn it. Three main indicators approaches adopted in the
performance measures are: Return on Investment (ROI)/ Return on Capital
Employed (ROCE), Residual Income (RI) and Economic Value Added (EVA).

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These indicators are taken from the financial statement of the company, i.e. P&L
a/c and B/Sheet. These indicators are generally known as Ratios or Ratio
analysis. The major indicator is the ROI or ROCE. ROI or Return on Capital
Employed is an acting measure of income divided by an accounting measure of
investment.
Thus ROCE (ROI) = NP/ Investment (CE). It is the most popular indicator to
incorporate the investment base into a performance measure. ROI has a
conceptual appeal in that it blends all the ingredient of profitability (i.e. revenue,
cost, and investment) into a single percentage. It is sometimes referred to as
mother of all ratios. Nevertheless ROI should be used constantly and in
conjunction with other performance measures.

PROBLEMS ASSOCIATED WITH ROCE

i. Should the profit be net profit before tax or after tax – problem of defining
the profit/ income?
ii. Problem of Depreciation Investment – Depreciation has different policies
or methods.
iii. Stock valuation is a problem due to different approaches – such as FIFO,
LIFO, marginal and absorption costing, standard costing, replacement etc.
iv. Discount policies may impact on turnover as well as profit – i.e. Discount
received and allowed.
v. Bad debts and provision for bad debts may also impact on profit.
Provisions are mere estimates whereas Resources are made from
Appropriations, etc.
vi. Problem of defining capital employed – i.e. should CE – be Total Assets,
or working capital + fixed Asset or should it be only shareholders worth or
owner’s equity. Owner equity excludes preference shares while
shareholders worth includes preference shares.
vii. Also should the FA be at gross (cost) or net book value or replacement
cost.

ROI (ROCE) = NP/CE = Net Profit Margin x Capital Turnover

= NP/Sales x Sale/CE = NP/CE

ROCE

NP/Sales Sales/CE

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 OH/Sales
Cost of Sales Sales Sales
Sales FA W/Capital i) Stock Turnover
ii) Current Ratio
iii) Acid Test
D/L R/Mat. D/Exp. Av. Collection Period
Prdn OH S&D Adm.
Sales Sales Sales Av. Payment Period
Sales Sales Sales
MAIN PERFORMANCE MEASURES: There are 4 main categories namely;
(1) Profitability Ratios
(2) Liquidity Ratios
(3) Activity Ratios
(4) Gearing or Leverage Ratios

A. PROFITABILITY RATIO - Return on Capital Employed (ROCE)

- Net Profit Margin (NPM)
B. LIQUIDITY RATIO – It measures the ability of the company or an
organisation to meet its short-term financial obligations as and when they fall due.
This is made up of:
(i) Current Ratio = Current Asset (CA) / Current Liabilities (CL)
(ii) Acid Test /Quick Ratio = CA – Stock / CL
(iii) Average Collection Period = Trade Debtors x 365 days
Credit Sales
(i.e. it is used to determine the debt age or for debt ageing analysis. This helps to
determine how much should be provided against bad and doubtful debts.)
(iv) Average Payment Period = Trade Creditors x 365 days
Credit Purchases
This is used to determine why an establishment is not picking up cash discounts.
C. ACTIVITY RATIO – These ratios are concerned with the effectiveness in the
use of the resources of the business:
Total Asset Turnover or Capital Employed Turnover–This is calculated by the
formula Sales/CE. It is a measure of how much sales a unit of capital employed
produce.
(i) Fixed Assets Turnover Sales/FA–How much sales is generated by a
unit of FA.
(ii) Stock Turnover = Cost of Sales/Average Stock.
D. GEARNING OR LEVERAGE RATIO – It tells the extent to which
outsiders have provided funds to the organisation. It measures the financial risks
of the company. The proportion of outsiders funds to the total of the business
216
funds. Bankers/Lenders tend to be more interested in this ratio before granting
any loan application. Earning ratio reveals the extent of the business to risks of
falling into the hands of outsiders (i.e. debt financing)
1) From P & L = Interest Coverage Ratio EBIT/I (EBIT) = Earnings
before Interest.
2) From B/Sheet - Debt Ratio:
(i) Total Liabilities/Total Assets. This measures the overall risk of
the business/organisation.
(ii) Debt Ratio = Fixed Income Securities
Fixed Income + Equity Capital
Fixed Loan Securities / Equity Capital = Debt Ratio
(iii) Long-term Debts / Equity Capital.
Bankers are interested in liquidity ratio and gearing ratio. They want quick returns
on the loan given out.
SAMPLE QUESTION
Jackson & Jobson earnings in business as wholesalers of the same product. Their
respective accounts for the year ended 31/12/04 are as follows:
PROFIT AND LOSS ACCOUNT FOR YEAR ENDED 31/12/04
JACKSON JOHNSON
¢’000 ¢’000
Sales 144.000 140,000
Cost of Sales: opening stock 28,000 3,200
Purchase 124,000 121,600
152,000 124,800
Less closing stock 32,000 4,800
Cost of sales 120,000 120,000
Gross profit 24,000 20,000
Selling Exp. 7,200 2,800
Adm. Exp. 8,160 9,500
Net Profit 8,640 7,700

BALANCE SHEET FOR YEAR ENDED 31/12/04

JACKSON JOHNSON
FIXED ASSETS ¢’000 ¢’000
Freehold Properties 20,000 14,000
Fixture and Fittings 21,750 13,840
Motor Vans 12,000 6,000
53,750 33,840
CURRENT ASSETS
Stock 32,000 4,800
Debtors 28,800 11,200

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Bank 8,950 11,360
69,750 27,360
Total Assets 123,500 61,200
Represented BY:
Capital 108,000 30,800
Creditors 15,500 30,400
123,500 61,200
NOTE: (1) All sales are on credit as well as purchase
(2) The amount of creditors and debtors has not changed significantly over
the year. All fixed assets are at written down value.

Required: Compare the Profitability and Financial position of the 2 companies by:
(i) Calculating all relevant ratios
(ii) Comment on the significance of the results of the calculation.
Solution:
(A) PROFITABILITY RATIOS JACKSON
JOHNSON
ROCE = NP/CE x 100 8640/108 x 100 = 8% 7700/30800 x 100 =
25%
NPM = NP/Sale x 100 8640/144,000 x100 = 6% 7700/140,000 x100 =
5.5%
(B) LIQUIDITY RATIO
CA Ratio = CA/CL 69,750/15:500 = 4.5:1 27360/30,400 = 0.9:1
Acid Test = CA – Stk. /CL 37,750/15,500 = 2.44:1 22,560/30,400
= 0.74:1
Average Collection Period for Trade Debtors.
= Trade Debt/Cr. Sales 28800 x 365 =73days 11200 x 360 =
29days
144,000
140,000
Average Payment Period for Trade Creditors
= Trade Cr/Cr. Purchases 15,500 x 360 = 46days 30400 x 365
= 91days
124,000 121,600
(C) ACTIVITY RATIO
Asset Turnover = Sales/CE 144,000 = 1.33times 140,000 =
4.55times
108,000 30,800
Rate of Stock Turnover =
COS/Av. Stk. 120,000 = 4times 120,000
= 30times

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 (28,000+32,000) ÷2 (3,200+4,800)
÷2
Fixed Assets Turnover =
Sales/FA 144,000 = 2.68times 140,000
= 4.18times
53,750 33,840
(D) GEARING RATIO
Total Liability/ Total Assets 15.500 = 0.13:1 30,400
=0.5:1
123,500 61,200

Analysis of Overhead Ratio = Exp/Sales

S & D Expense to Sales 7200 x 100 = 5% 2,800 x 100 =
2%
144,000
140,000
Administrative. Exp. to Sales 8160 x 100 = 5.7% 9.500 x 100 =
6.8%
144,000
140,000

POINTS TO NOTE: In terms of financial risk Jackson is better as well as

liquidity but in respect of activity and profitability Johnson is performing better.
COMMENT: Unless we have facts to the contrary it is not good to compare
companies operating in different industries or different environment. For e.g. it is
not possible to compare GTP with Accra Brewery firm because they are not
operating in the same environment.

UNIFORM COSTING AND INTER FIRM COMPARISON

Uniform costing system enables the use of several undertakings of the same
costing systems for the purposes performance measurement. The reason being
that, an accurate comparison of performance of company’s is only possible where
the companies use the same achieving basis and conventions as well as establish
broadly similar costing system:
Examples include:
(1) Valuation of materials stock and for production by the use of same
method – LIFO; FIFO, standard cost, etc.
(2) Classifying fixed and variable cost in the same manner
(3) Classifying D/cost and indirect cost in the same way e.g. treatment of
overtime premium.

219
 (4) Valuation of assets in the same way as well as use exactly the same
method of depreciation and estimating life span of F.A.
(5) Establish similar cost centres for allocating cost
(6) Same basis of overheads apportionment.
(7) Use the same assumption rate or basis.

Uniform costing is rare in practice, yet it makes inter firm comparison exact and
reliable by setting uniform acting standards/yardsticks for all the participants in
the scheme.

GROSS VALUES VS. NET VALUES AND ROI/ROCE

Coy A has the following figures for production lines
A B
¢’000 ¢’000
Operating Income 50,000 40,000
Gross Value of FA 200,000 160,000
Depreciation 50,000 100,000
Net Book Value FA 150,000 60,000
Calculate return on investment using gross value of Fixed Asset and Net Value of
F/Assets
A B
ROCE (ROI) NP/CE (Gross) 50,000 X 100 40,000 X 100
200,000 = 25% 160,000 =
25%

ROCE (ROI) NP/CE (Net BK.V) 50,000 x 100 40,000 x 100

150,000 = 33.33% 60,000 =
66.7%
If the divisional manager in product B wants to buy new assets of ¢40,000,000
which will increase annual profit by say ¢10,000,000 (ignore depreciation in this
new investment). Calculate ROI using Gross and Net BK. value.
B
ROCE (ROI) NP/ CE (Gross FA) 50,000 /200,000 x 100 = 25%
ROCE (ROI) NP/CE (Net FA) 50,000 /100,000 x 100 =
50%

Implications:
Buying the new machine means ROCE unchanging when gross values of F/Assets
are used. Gross book value would not overcome the problem of continually using
worn out fully depreciated assets because the ROCE will be higher than with new
replacement assets cost as there will be no depreciation charge against profit.

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The point is even if a new asset offers a long-term savings in cost; management
will be tempted to avoid replacement so as to boost short term results.
RESIDUAL INCOME (RI) VS. ROCE (ROI)
In view of the disadvantage of ROI/ROCE, particularly its tendency to influence
under-investment, most management accounting writers recommend that the
performance of investment centres be assessed by calculating an absolute measure
of profitability or residual income as follows:
RI = Controllable profit – Imputed/Notional Interest Charge on Controllable
divisional Investment. Residual income can be defined as controllable profit less
a cost of capital on controllable investment.
ROCE is a ratio but RI is an absolute figure in the sense that, it is expressed in
monetary terms. RI is the excess of operating income over the Notional Interest
charge on capital.
As an example consider the following information.
Dept A of Coy XYZ has the following profit; Assets employed and imputed
interest charge:
¢’000
Operating profit 60,000
Assets Employed 200,000
Imputed Interest 12%
Compute the ROCE, and RI.

ROCE = NP/CE x 100 = 60,000/200,000 x 1000 = 30%

RI = NP – (NI x CE) = 60,000,000 – (.12 x 200,000,000) -

24,000,000
= 36,000,000
Suppose/Assume now that an additional investment of ¢20,000,000 is proposed
which will increase operating income of the Department by ¢2,800,000, what will
be the effect on income using ROCE and RI? Calculate the New ROCE and RI

ROCE = NP/CE x 100 = 62,800 / 220,000 x 100 =

28.8%

RI = NP – (NI x CE) = 62,800 – (.12 x 220,000) 26,400,000

= 36,400,000
When the ROCE is used it reduces the ROCE so it is not a good measure of
performance of managers. Hence if department A manager is made responsible
for the department’s performance he/she will resist the new investment if he
knows he will be assessed on the basis of ROCE but will welcome the new
investment if he or she is to be judged on the basis of RI since there will be a

221
marginal increase of ¢400,000 on residual income from the new investment but a
fall of 1.5% in ROI or ROCE.
Compute ROCE on the new investment alone: ¢2,800,000 / 20,000,000 = 14%,
which is less than old, established ROCE 30%. This is what is generally termed
as negative synergy.

For instance 2 + 1 = 4 effect (positive synergy)

2 + 1 = 3 effect (negative synergy)
Thus, if company A is making profit of ¢60,000,000
B is making profit of 140,000,000
200,000,000
When merged together, total profit increased to ¢300,000 (i.e. AUB =
¢300,000,000) – positive synergy. The benefit for merging is greater than the
benefit gained if they had stayed alone. However, if for e.g. when AUB produced
profit of synergy ¢180,000,000 that is a negative synergy.

NB: The marginal (additional) investment offers a return of 14% (¢2,800,000 or

an investment of ¢20,000,000) which is far lower than the original investment of
30%. This reducing the overall divisional performance.

Indeed any marginal investment offering an accounting rate of return of less than
30% will reduce the overall performance. Residual income should not be used as
a means of making (assessing capital investment) Asset purchasing decisions.
Nevertheless, RI may be a useful alternative to ROCE where there is a
conflict between purchasing decisions indicated by a positive NPV in discounted
cash flow and the resulting reduction in divisional ROCE which reflects sadly on
management performance or seems to portray dismal performance.

1. Arise Company Ltd has two fruit juice production lines, orange and pineapple.
Invested assets and condensed income statement data for each division for the past
year ended December 31 are as follows
DIVISIONS ORANGE PINEAPPLE
¢’000 ¢’000
Revenues 2,700.0
1,920.0
Variable cost 1,800.0
1,489.6
Fixed cost 360.0
200.0
Invested assets 2,400.0
1,536.0

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You are required to:
i. Prepare income statement for the past year for each division in a
columnar form.
ii. Determine the profit margin, asset turnover and return on investment for
each division.
iii. If management desires a minimum rate of return of 10%, determine the
residual income for each division.
Solution:
(A) Divisional income statement for the year ended December 31, 2006
Orange juice Pineapple juice
¢’000 ¢’000
Sales Revenue 2,700 1,920

Variable cost 1,800 1,489.6

Contribution 900 430.4
Fixed cost 360 200
Net income 540 230.4

(B) production lines orange juice pinapple juice

NPM = NP/Sale x 100 540,000/2,700,000 x100 = 20%

230,400/1,920,000 x100 = 12%

Asset Turnover = Sales/CE 2,700,000 = 1.125times 1,920,000 =

1.25times
2,400,000 1,536,000

ROCE = NP/CE x 100 540,000/2,400,000 x100 = 22.5%

230,400/1,536,000 x100 = 15% or

ROCE = NP/CE x Sales/CE 20% x 1.125times = 22.5% 12% x 1.25times =

15%

(C) Residual income:

ORANGE JUICE ¢540,000 – (0.1 x ¢2,400,000) ¢240,000 = ¢300,000

PINAPPLE JUICE ¢230,400 – (0.1 x ¢1,536,000) ¢153,600 = ¢76,800

2. Shine Company Ltd has a lighting division that is operated as an investment

centre. The division is operating at only 60% capacity. The results of operation for
2006 are

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Shine company limited lighting division statement of operating for the year
ended 31 december, 2006 ¢’000
Sales (120,000 x ¢20) 2,400
Variable costs (at ¢8) 960
Contribution margin 1,440
Direct Fixed cost 600
Division profit 840
Establishment charges from Head office 360
Operating income 480
Operating assets – January 1, 2006 920
Operating assets – December 31, 2006 1,000
The company’s minimum desired rate of return for residual income purposes is
15%.
You are required to calculate:
a) The net profit percentage
b) Asset turnover
c) ROCE
d) Residual income
e) For 2007, the lighting division expects its operations to be unchanged
from 2006. Nevertheless, it has an opportunity to accept an order from a
customer for 80,000 kilowatts at a price of ¢12. The order will not affect its
regular sales and will require an additional outlay of ¢200,000 for direct
fixed costs. Additional operating assets will be needed at a cost of ¢300,000.
Calculate the following for the special order only:
i. ROI
ii. RI
Would you expect the manager of the lighting division to accept the order if the
parameter used were residual income? Why?

Transfer Pricing
Transfer pricing comes in when there are holding companies. Holding companies
are those companies which owns or have more than 51% of another company’s
shares. That company whose majority shares are owned by the holding company
is therefore termed as subsidiary company. Holding companies transfer goods
among themselves. There may be the need to also transfer raw materials or the
finished product of one company may be the raw material of the other. The
question here is at what price the goods should be transferred among themselves.
State few examples of holding companies. Should the goods be transferable at
standard cost, marginal or absorption cost, marginal cost plus profit or full cost
plus profit? What should be the margin 5% or 10% or what? A transfer price is a
price related to goods to goods or services transferred from one process,

224
department or company to another or from one member of group to another. The
extent to which the cost and profit are covered by the price is a matter of policy.

Types of transfer pricing

Three main types of transfer pricing are:
 At cost price
 Market price
 Negotiated price

At cost
Under the cost approach, cost is used as the basis for determining or setting the
transfer prices. A variety of cost concepts may be used or considered among
which are standard marginal cost, standard full cost, actual cost (marginal or
absorption), standard marginal cost plus % profit, standard full cost plus % profit
actual cost(marginal + % profit or full + % profit)
Market price: under the market price approach, the transfer price is the price at
which the product or service transferred could be sold to the outside customers or
buyers. Market price should be used or applied especially when the supplier
division is able to sell to outsiders and is operating at capacity.
Negotiated price: with regards to the negotiated price approach the managers
involved (transferor and transferee) agree (negotiate) among themselves on a
common transfer price. Negotiated pricing is usually opted for when the
decentralised units is operating under (below) capacity

Standard costing
A standard cost is a carefully predetermined estimated unit cost. It is usually a
standard cost per unit of production or per unit of cost of services rendered.
Standard cost may simply be explained as expected cost under normal
circumstances.

Distinction between budgeted cost and standard cost

Anyway, in practice the term budgeted cost and standard cost are used
interchangeably. Standard cost might be used in both marginal costing and
absorption costing. The following are some of the differences between budgeted
cost and standard cost.
 Whereas budgeted costs are total costs of production, standard costs are
unit costs of production.

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  Whereas it is possible to have budgeted cost without standard cost, it is
impossible to have standard cost system without the total cost budgeting
system.

Setting standard cost

a) Direct material cost: direct material cost per unit may be estimated by the
purchasing department from their knowledge of:
i. Purchase contract already agreed or in existence.
ii. Pricing discussion with regular suppliers.
iii. The forecast movement of prices in the market.
iv. The availability of bulk purchase discount.
b) Direct labour: Direct labour rate per hour will be set by reference to the
payroll and to any agreement on pay increases with trade union
representatives of the employees from the following:
i. A separate hourly rate or weekly average will be set for each
different grade or type of employee.
ii. An average hourly rate will be applied for each grade even though
individual rates of pay may vary according to age, experience etc.
c) Overhead s: The overheads absorption rate is usually a direct labour hour
rate so that the standard cost per unit is usually standard labour hour
multiplied by standard absorption rate per hour. However, for selling and
distribution costs, standard might be absorbed as a percentage of the
standard selling price.

Why standard costing

As rightly pointed out, standard costing is simply expected cost under normal
circumstance. This means that, if costs change, then either a change in the
circumstances normal to the cost or the specification of the normal conditions to
the costs was incorrectly made. Normally, by a system of variance reporting, the
change in circumstances is analysed, or where the circumstances were fairly
stable, a revision of the standard is called for. Deviations may necessarily occur,
because standard costs are only expected costs and are not necessarily actual
costs. What is usually expected to happen does not always happen. In standard
costing the actual cost that is incurred is often referred to as the Historical cost.
Basically, standard costing is used for:
 Valuation of stocks
 Operational costs monitoring and control
 budgeting and budgetary control processes
 monitoring staff through standard setting and actual performance
 improving operational efficiency
 Exceptional reporting through the use of variance analysis.
226
Types of capacity or standard
There are four main types of standards namely:
 Expected or attainable
 Ideal or theoretical
 Current
 Basic
Standard cost is normally fixed with reference to capacity. Capacity here denotes
the maximum output of goods and services that could be produced under normal
circumstances. That means capacity and standard can be used interchangeably.
The four types of standard are assigned detailed explanation.

Attainable or expected standard

These are based on normal operating conditions after taking into consideration
(seasonal) wastage, inefficiencies etc. Well set attainable standard provides a
useful psychological incentive by giving employees a realistic but challenging
target of efficiency. Attainable standard could also be described as expected
standard and it is officially defined by CIMA as a standard which can be attained
if a standard unit of work is carried out efficiently, a machine is properly operated
or material properly used (used as target for managers in budgetary control).
Ideal or theoretical standard
These are based on perfect operating condition that is, no wastage, no
inefficiency, no idle time, and no machine breakdowns. Variances from the ideal
standard are used for pin pointing areas where a close examination may result in
large savings but they are likely to have an unfavourable motivational impact
because reported variances will always be adverse. (used as long-term goal or
objective).

Current standards
These are standards based on current working conditions i.e. current wastage,
current inefficiencies etc. The disadvantage of current standard is that they do not
attempt to improve on current level of efficiencies. Current standards are normally
established for use over a short period of time.

Basic standards
These are standards which are kept unaltered over a long period of time and may
be out of date. These are used to show changes in efficiency or performance over
a long period of time. Basic standards are perhaps the least useful and least
common of all the standards in use.

227
Factors to be considered in setting standard cost
Certain factors are pertinent to the development of standard cost. Among them
are:
1. Organization structure that would determine who does what in the
organization. It will also define the nature and structure of control and
would enable supervisors to build efficiency into worker effort.
2. Supervisors that are made responsible for their operations must be well
designated. For example, purchasing supervisor will be responsible for
material price variance and defective materials. The personnel manager
will be in charge of standard wage rate and standard hour of work.
3. Managers and supervisors must be invited by top management to defend
their estimates for standard output or sales. If the estimates are justified,
they would later be approved by management.
4. The level of efficiency that was built into the estimate must be modifiable.
That is it should be possible either to increased or decreased by top
management before they are approved.
5. In some institutions, management just does not make adjustments.
Therefore, provisions should be made to engage organizational methods
and experts to develop time and motion studies, and also value analysis for
the purpose of cost reduction and control.

Differences between standards costing and budgetary control

Their main difference, however appear to be their differing scope and techniques
adopted under each. Standard costing is usually employed in the analysis of
product cost, trying to predict before hand what a standard product or service is
likely to cost. As rightly pointed out in this definition, standard costing is
therefore a micro-concept which deals with the cost unit and appears to be more
accurate than predictions under budgeting. Budgetary control on the other hand is
a macro-concept. It therefore deals with the cost centres. It deals with the
aggregate of total costs of respective departments. Budgetary control therefore
could involve expenditure items that fall beyond those incorporated into the cost
of a cost unit.

Similarities between standards costing and budgetary control

The techniques of standard costing and budgetary control look alike. The
operation of these two techniques involves the creation of variances between
expected and actual results. They both seek to examine the causes of variances
and offer a means of reporting and correcting variances. They are both elements
of control.

Nature and causes of variances

228
A variance is the difference between actual and expected cost and revenue. Thus a
variance can only occur when there is a deviation from an expected event. When
actual cost is higher than expected cost there is said to be an adverse or
unfavourable variance. However, if actual cost is lower than expected cost, there
is said to be a favourable variance.

The analysis of variances from revenue is quite different. When actual revenue is
more than expected revenue, there is a gain and therefore the variance is
favourable. If on the other hand, the expected revenue is higher than the actual
revenue, there is an adverse or an unfavourable variance. Technically, variances
can be calculated for materials, labour, overheads expense and sales.

Direct material variance

Variances occur because of unexpected circumstances for instance, direct material
variance may be caused by several factors such as a change in the:
 price of materials
 rates of discount
 frequency of ordering of materials that lead to excessive ordering and
transport cost, which form part of the cost of purchases.
 price of substitute inferior material
 price of substitute superior material.
 extent of supervisory role over work.
 hours of production.

Advantages of standard costs

Standard cost systems have a number of advantages, which include:
 Standard costs are key element in a management by exception approach.
That is, if costs conform to the standards, managers can then concentrate
on other pressing issues of the organization. When costs are significantly
outside the standards, managers are alerted that problems may exist that
require attention. In this regards, managers are greatly assisted to focus on
important issues.
 Standards that are viewed as reasonable by employees and divisional
managers can promote economy and efficiency. Standards provide
benchmarks that individuals can use to measure their own performance.
 Standard costs can greatly simplify bookkeeping. Instead of recording
actual costs for each job, the standard costs for direct materials, direct
labour and overhead can be charged to jobs.
 Standard costs fit naturally in an integrated system of “responsibility
accounting”. The standards establish what costs should be, who should be
responsible for them and whether actual costs are under control.
229
Potential problems associated with the use of standard costs
The improper use of standard costs can present a number of potential problems
such as the following;
 Standard cost variance report are usually prepared on monthly basis and
often are released days or even weeks after the end of the month.
Consequently, the information in the reports may be so outdated that it is
almost irrelevant for decision making. Timely, frequent reports that are
approximately correct are far better than infrequent reports that are very
precise but out of date by the time they are released. It might interest you t
note that some companies are now reporting variances and other key
operating data daily or even more frequently.
 If managers are insensitive and use variance reports as a punishable tool,
morale will suffer greatly. Employees should receive positive
reinforcement for work well done. Management by exception, by its
nature, tends to focus on the negative.
 Too much stress on attaining the standards may overshadow other equally
important objectives such as maintaining and improving quality, on-time
delivery and customer satisfaction.
 Just meeting standards may not be sufficient for organizational success,
rather continual improvement in standards may be necessary to survive in
a competitive business environment. For this reason, some companies
focus on the trends in the standard cost variances and they are aiming for
continual improvements rather than just meeting the standards.

Calculation of material price variance

Material price variance is the difference between the purchase costs (i.e. actual
quantity purchased × actual purchase price of the goods) and how much it should
have cost (i.e. actual quantity purchased × the standard price of the goods).

Example 1
In the year 2012, 760kgs of materials X and 270kgs of material Y were
purchased. It was initially expected that material X would cost GHC15 and
material Y GHC30. However, material X cost GHC20 and material Y GHC40.
Calculate the material price variance.

Suggested solution
Price variance = STD cost of R/M purchased - Actual cost of R/M purchased.

Material X = Should have cost (760kg x GHC15) = GHC11,400

But did cost (GHC20 x 760kg) = GHC15,200 = GHC3,800 A (adverse)

230
Material Y = Should have cost (270 kg x GHC30) = GHC8,100
But did cost (GHC40 x 270kg) = GHC10,800 = GHC2,700 A (adverse)

OR
Material X Material Y
(i) Unit bought 760kgs 270kg
(ii) Expected Price GHC15 GHC30
(iii) Actual price GHC20 GHC40
(iv) Price differential + GHC5 +GHC10
(v) Mat. Price variance (i x iv)= GHC3,800A GHC2,700A

Detail illustration for the calculation of all the relevant variances.

2. Prempeh Ltd. manufactures goods for which the standard unit cost and
selling price are given below. Standard unit cost and selling price:
¢
Direct materials: X 3 units @ ¢5/unit 15
Y 1 unit @ ¢3/unit 3
Direct labour 1½ hour @ ¢4/hour 6
Variable prod O/H 1½ hour @ ¢2/hour 3
Fixed prod O/H 1½ hour @ ¢6/hour 9
Standard cost 36
Selling profit before selling and admin. Exp 48
Standard profits before selling and Admin. Exp
12
Budgeted production and sales for the year 2005 were 3,000 units
of A1. During the year 2005 actual results were as follows:
Production of A1 3,200 units
Sales of A1 2,850 units
Sales Revenue ¢141,000
Costs
Material X purchased 9,200 units
Cost ¢45,400
Material X used 9,750 units
Material Y (purchased and used 3130 units) ¢9,500
Direct labour. Hours paid for 5,850 hours.
Production time 5,100 hours
Labour cost ¢24,100
Variable production O/H ¢10,650
Fixed production o/H ¢31,500

231
 Stocks of materials are valued at standard cost and stocks of finished
goods are valued at standard full production cost. You are required to:
(a) Prepare an operating statement for 2005 reconciling budget and
actual profit and specifying all the relevant variances.
Suggested solution:
Total direct material variance:
Material X = should have cost (¢15 x 3,200) = ¢48,000
But did cost (¢45,400 + ¢2,750) = ¢48,150 = ¢150A
Price variance: = STD cost of R/M. purchased - Actual cost of R/M purchased.
Material X purchased = should have cost (9,200 units x ¢5) = ¢46,000
But did cost (¢45,400) = ¢45,400 = ¢600F
Material Usage Variance (STD qty in actual output – Act. Qty used) STD price
Material X = should have used (3 x 3,200) = 9,600
But did use (9,750) = 9,750 =150 units x ¢5 = ¢750A

Total Direct Material Variance. (a) Material Y:

Material Y = should have cost (¢3 x 3,200) = ¢9,600
But did cost (¢9,500) = ¢9,500 = ¢100F

Price Variance: = STD cost of R/M. purchased - Actual cost of R/M purchased.
Material Y purchased = should have cost (3,130 units x ¢3) = ¢9,390
But did cost (¢9,500) = ¢9,500 = ¢110A
Material Usage Variance (STD qty in actual output – Act. Qty used) STD price
Material Y = should have used (1 x 3,200) = 3,200
But did use (3,130) = 3,130 = 70 units x ¢3 = ¢210F

Total Direct Labour Variance: (STD labour cost in actual output

– Act. labour cost)
Labour in actual output = should have cost (¢6 x 3,200) = ¢19,200
But labour did cost (¢24,100) ¢24,100 = ¢4,900A

Rate Variance = STD cost of labour hours paid for – Actual cost paid for.
Labour hours paid = should have cost (¢4 x 5,850) = ¢23,400
But did cost (¢24,100) = ¢24,100 = ¢700 A

Efficiency Variance = STD hours for actual output – Actual hours

used) STD rate or wage Labour hours required = should have been
(1½ hrs x 3,200) = 4,800 hours
But actual hours used (5100) 5,100 hours = 300 x ¢4 = ¢1,200A

Idle Time Variance = (hours paid for – Actual production time used) STD wage

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Actual labour hours paid for was = 5,850
But Actual production time was = 5,100 = 750 hours x ¢4
= ¢3,000A

Total Variable Production Overhead = STD variable cost of output – Actual

variable cost
Variable overhead required for actual output should be (¢3 x 3,200) = ¢9,600
But Variable overhead labour did cost (¢10,650) =
¢10,650 = 1,050A

Expenditure Variance = Variable overheads absorbed or flexed variable cost –

Actual variable cost
Actual hours used in production x V/OAR (5,100 hours x ¢2) = ¢10,200
Actual variable expenditure (¢10,650)
¢10,650 = ¢450A

Efficiency Variance = STD hours for actual output – Actual hours

used) x variable absorption rate.
Variable hours required for actual output should be (1½ hrs x 3,200) = 4,800
But actual hours used in production was (5100) = 5,100 = 300
hours x ¢2 = ¢600A

Total Fixed Overhead Variance = std. fixed overhead of actual output – Actual
fixed overhead
Fixed production for actual output should be (3,200 x ¢9) = ¢28,800
But fixed production cost incurred was (¢31500) = ¢31,500 =
¢2,700A.
Fixed Overhead Expenditure Variance = Budget fixed overhead – Act fixed
overhead incurred
Budgeted fixed overhead should be (3,000 units x ¢9) = ¢27,000
Actual fixed overhead expended (¢31,500) = ¢31,500 =
¢4,500A
Fixed Overhead Efficiency Variance = (STD hours for actual
output – Actual hours used) x FOAR.
Fixed production hours for actual output should be (1½ hrs x 3,200) = 4,800
But actual production hours used was (5100) = 5,100 = 300 hours x ¢6
= ¢1,800A
Fixed Overhead Volume Variance = (budgeted hours – Actual hours) fixed
overhead absorption rate
Budgeted fixed overhead should be (1 ½ hrs x 3000) = 4500

233
But actual production hours used was (5100) = 5,100 = 600 hours x ¢6 =
¢3,600F

Note: This is because fixed cost is assumed to be fixed and does

not vary with the level of activity. Therefore beyond the limited capacity fixed
cost will not change and excess absorption is deemed to be over absorption and
considered a gain sort of and therefore favourable. On the other hand if
production output or time is lower than the expected level to cover all the
budgeted fixed overhead the net is considered under absorption and would be
termed as adverse.

Sales Variance:
Selling Price Variance = STD value actual sales – Actual sales value
Actual units sold should have generated (¢48 x 2,850) = ¢136,800
But did actually raised (¢141000) =
¢141,000 = ¢4,200F
Sale Volume Variance: (budgeted sales volume – Actual sales volume) STD
profit/unit
Budgeted sales volume was 3,000 units
But did sell 2,850 units = 150 x ¢12 =
¢1,800A

Reconciliation of Actual and Budgeted Operating Statement.

A F Totals
Budgeted price (3,000 x ¢12) ¢ ¢
¢36,000
Selling price variance 4200
Sales volume variance 1800
2,400F
Cost Variance
38,400
Material: X = Price variance 600
= Usage variance 750 150A
Y = Price variance 110
= Usage variance 210 100F
Labour: Rate variance 700
Efficiency variance 1200
Idle Time 3000 4,900A
Variable production overhead

234
Expenditure variance 450
Efficiency variance 600 1,050A
Fixed production overhead
Expenditure variance 4,500
Efficiency variance 1,800
Volume variance 3,600 2,700A
ACTUAL PROFIT
¢29,700

Operating Statement (Absorption Costing)

Sales
141,000
Less cost of sales:
Mat X opening stock (¢5 x 550) 2,750
Add Purchases 45,400
Mat X Total 48,150
Mat Y (purchases & consumed) 9,500
Total materials cost 57,650
Direct labour cost 24,100
Variable products overheads 10,650
PRIME COST 92,400
Fixed prod overheads 31,500
Factory cost of production 123,900
Less closing stock (350 x ¢36) 12,600
Production cost of sales
111,300
ACTUAL PROFIT
¢29,700

Marginal Costing System Format

Sales
141,000
Less cost of sales:
Mat. X Opening stock (¢5 x550) 2,750
Add purchases 45,400
48,150
Mat. Y (purchases & consumed) 9,500
57,650
Direct labour 24,100
Variable prod O/H 10,650
92,400

235
Less closing stock (350 x ¢27) 9,450
82,950
Total contribution to FPO
58,050
Less fixed prod O/Head
31,500
ACTUAL PROFIFT
26,550

Using the Same Information to Flex the Budget

Output levels: Budgeted Flexed Budget Actual Budget
Variance
3,000 units’ 3,200 units’ 3,200 units
¢ ¢ ¢
¢
Materials: X 45,000 48,000 48,150
150A
Y 9,000 9,600 9,500
100F
54,000 57,600 57,650
50A
Direct labour 18,000 19,200 24,100
4,900A
Variable O/H 9,000 9,600
10,650 1,050A
Fixed O/H 27,000 28,800
31,500 2,700A
Budgeted Cost allce 108,000 115,200 123,700
8,700A

Q4 (a) The standard cost card for ‘Be At Ease’ Ltd is as follows:
Standard material: $
2kg of A at $2 per Kg 4
1kg of B at $6 per kg 6
Direct labour (3 hours at $6 per hour) 18
Variable overheads 3hrs at $4 per direct hour 12
Total standard cost per unit 40
It is proposed to produce 10,000 units in the month of March.
The actual results are:
Direct material: $
19,000kg of A at $2.2 per Kg 41,800

236
 10,100kg of B at $5.60 per kg
$56,560
Direct labour (28,500 hours) at $6.40 per hour
$182,000
Variable overheads
$104,000
$3
Actual production was 9,000 units.
Required: Calculate

(i) Material price and usage variances

(ii) Labour rate and efficiency variance
(iii) Variable overheads expenditure and efficiency variance
(b) State two possible causes each of the variances calculated above

3. The Snappy Company Ltd produces and sells a single product. For control
purposes, a standard costing system was recently introduced and is now in
operation.
The standards set for the month of May were as follows:
Production and sales 16,000
Selling price per unit ¢14,000
Materials: Cosy 6kgs per unit @ ¢1,225 per kg
Kepi 3kgs per unit @ ¢320 per kg
Labour: 4.5 hours per unit @ ¢840 per hour
Overheads (all fixed) ¢8,640,000 per month they are absorbed into the product
cost.
The actual data for the month of May is as follows:
Produced 15,400 units which were sold at ¢13,825 each.
Materials: Used 98,560kgs of material Cosy at a total cost of ¢125,664,000 and
used 42,350 kg of material Kepi at a total cost of ¢13,297,900.
Labour: Paid an actual rate of ¢865 per hour to the labour force. The total
amount paid out amounted to ¢61,276,600.
Overheads (all fixed) ¢9,684,000
Required: Prepare an operating statement for the month based on the actual
figures for the month and all the relevant variances which reconciles the actual
profit with the budgeted profit or loss figure.
Suggested solution:
Total Direct Material Variance:
Material C = should have cost (¢7,350 x 15,400) = ¢113,190,000
But did cost (¢1,275 x 98,560kgs) = ¢125,664,000 =
¢12,474,000A

237
Price Variance: = STD cost of R/M. purchased - Actual cost of R/M purchased.
Material C purchased = should have cost (98,560kgs x ¢1,225/kg) = ¢120,736,000
But did cost (¢1,275/kg x 98,560kgs) = ¢125,664,000 = ¢4,928,000A
Material Usage Variance (STD qty in actual output – Act. Qty used) STD price
Material C = should have used (6kg x 15,400) = 92,400kgs
But did use (98,560kgs) = 98,560kgs = 6,160kgs x ¢1,225 = ¢7,546,000A

Total Direct Material Variance:

Material K = should have cost (¢960 x 15,400) = ¢14,784,000
But did cost (¢314 x 42,350kgs) = ¢13,297,900 =
¢1,486,100F
Price Variance: = STD cost of R/M. purchased - Actual cost of R/M purchased.
Material K purchased = should have cost (42,350kgs x ¢320/kg) = ¢13,552,000
But did cost (¢314/kg x 42,350kgs) = ¢13,297,900 =
¢254,100F
Material Usage Variance (STD qty in actual output – Act. Qty used) STD price
Material K = should have used (3kgs x 15,400) = 46,200kgs
But did use (42,350kgs) = 42,350kgs = 3,850kgs x ¢320 =
¢1,232,000F

Total Direct Labour Variance: (STD labour cost in actual output – Act. labour
cost)
Labour in actual output = should have been (¢3,780 x 15,400) = ¢58,212,000
But labour did cost (¢61,276,600) =¢61,276,600 = ¢3,064,600A
Rate Variance = STD cost of labour hours paid for – Actual cost paid for.
Labour hours paid = should have cost (¢840 x 70,840 hours) = ¢59,505,600
But did cost (¢865 x 70,840 hours) = ¢61,276,600 =
¢1,771,000A
Efficiency Variance = STD hours for actual output – Actual hours used) STD
rate or wage
Labour hours required:
= should have been (4.5 hours x 15,400) = 69,300 hours
But actual hours used (70,840 hours) = 70,840 hours = 1,540 hours x
¢840 = ¢1,293,600A

Total Fixed Overhead Variance = Std. fixed overhead of actual output – Actual
fixed overhead
Fixed overhead for actual output should be (15,400 x ¢540) = ¢8,316,000
But fixed production cost incurred was (¢9,684,000) = ¢9,684,000 =
¢1,368,000A.

238
Fixed Overhead Expenditure Variance = Budget fixed overhead – Actual fixed
overhead incurred
Budgeted fixed overhead should be (16,000 units x ¢540) =¢8,640,000
Actual fixed overhead expenditure (¢9,684,000) = ¢9,684,000 =
GHc1,044,000A

Note: Fixed overhead absorption rate should be calculated as usual. Thus

budgeted overheads /budgeted labour hours = ¢120/hour (¢8,640,000/72,000
hours)
Fixed Overhead Efficiency Variance = (STD hrs for actual output – Actual hrs
used) x FOAR Fixed production hours for actual output should be (4½ hrs x
15,400) = 69,300hrs
But actual production hours used was (70,840) =70,840hrs = 1,540hrs x ¢120 =
¢184,800A
Fixed Overhead Volume Variance = (budgeted hours – Actual hours) FOAR
Budgeted fixed overhead should be (4½ hours x 16,000) = 72,000
But actual production hours used was (70,840) = 70,840 = 1,160 hours x ¢120 =
GHc139,200A

Note: This is because fixed cost is assumed to be fixed and does not vary with the
level of activity. Therefore beyond the limited capacity fixed cost will not change
and excess absorption is deemed to be over absorption and considered a gain sort
of and therefore favourable. On the other hand if production output or time is
lower than the expected level to cover all the budgeted fixed overhead the net is
considered under absorption and would be termed as adverse. Thus overheads
absorption is usually related or tied up with labour hours such that if production
capacity is not fully utilized part of the fixed overhead will not be covered.
Sales variance:
Selling Price Variance = STD value actual sales – Actual sales value
Actual units sold should have generated (¢14,000 x 15,400) = ¢215,600,000
But did actually raised (¢13,825 x 15,400) = ¢212,905,000 = ¢2,695,000A
Sale Volume Variance: (budgeted sales volume – Actual sales volume) STD
profit/unit
Budgeted sales volume was 16,000 units
But did sell 15,400 units = 600 x ¢1,370 =
¢822,000A

Reconciliation of Actual and Budgeted Operating Statement.

(A) GHc (F) GHc Totals
GHc
Budgeted price (16,000 x GHc1,370) 21,920

239
Selling price variance 2,695
Sales volume variance 822
3,517A
Cost Variance
18,403
Material: C = Price variance 4,928
= Usage variance 7,546
12,474A
K = Price variance 254.1
= Usage variance 1,232.0
1,486.1F
Labour: Rate variance 1,771
Efficiency variance 1,293.6
3,064.6A
Fixed production overhead
Expenditure variance 1,044.0
Efficiency variance 184.8
Volume variance 139.2
1,368A
ACTUAL PROFIT
2,982.5
Operating Statement (Absorption Costing) GHc GHc
Sales
212,905
Less cost of sales:
Purchases: Mat C 125,664.0
Mat K 13,297.9
Direct labour cost 61,276.6
PRIME COST 200,238.5
Fixed production overheads 9,684.0
Production cost of sales
209,922.5
ACTUAL PROFIT
2,982.5

Marginal Costing System Format GHc GHc

Sales
212,905.0
Less cost of sales:

240
Purchases: Mat C 125,664.0
Mat K 13,297.9
Direct labour cost 61,276.6
Total Variable Cost of production
200,238.5
Total Contribution
12,666.5
Less Fixed production overheads
9,684.0
ACTUAL PROFIT
2,982.5

Using the Same Information to Flex the Budget

Output levels: Budgeted Flexed Budget Actual Budget
Variance
16,000 units’ 15,400 units’ 15,400 units
¢’000 ¢’000 ¢’000
¢’000
Materials: C 117,600 113,190 125,664
12,474A
K 15,360 14,784 13,297.9
1,486.1F
132,960 127,974 138,961.9
10,987.9A
Direct labour 60,480 58,212 61,276.6
3,064.6A
Fixed O/H 8,640 8,640 9,684.0
1,044.0A
Budgeted Cost allwce 202,080 194,826 209,922.5
15,096.5A
Sales 215,600 212,905 2,695A
Profit 20,774 2,982.5

3. Wood factor Ltd makes quality chairs for both outdoor and indoor use. Results
have not been encouraging in recent years and a new management accountant, Mr
Efa Asamoah, have been appointed to help raise production volumes. After an
initial assessment, Mr Efa Asamoah concluded that budgets had been set at levels
which are too easy for employees to achieve. He suggested that, employees would
be better motivated by setting budgets which challenged them more in terms of
higher expected output. Therefore, instead of changing the overall budgeted
output, Mr Efa Asamoah has not altered any part of the standard cost card. Yet,

241
budgeted output and sales for October 2006 was 40,000 chairs and the standard
cost card below was calculated on this basis:

¢
Wood 25 kg at ¢320 per kg 8,000
Labour 4 hours at ¢800 per hour
3,200
Variable overheads 4 hours at ¢400 per hour
1,600
Fixed overheads 4 hours at ¢1,600 per hour
6,400
19,200
Selling price
22,000
Standard profit
2,800
Overheads are absorbed on the basis of labour hours and the company uses
absorption costing system. There were no stocks at the beginning of October
2006. Stocks are valued at standard cost.
Actual Results for October 2006 were as follows: ¢’000
Wood 800,000 kg at ¢350 per kg
280,000
Labour 160,000 hours at ¢700 per hour
112,000
Variable overheads 60,000
Fixed overheads
196,000
Total production cost: (36,000 chairs)
648,000
Closing stock: (4,000 chairs at ¢19,200)
76,800

571,200
Sales (32,000 chairs)
720,000
Actual profit
148,800

The average monthly production and sales for some years prior to October 2006
had been 34,000 units and budgets had previously been set at this level and very
few operating variances had been generated by the standard costs used. Mr Efah

242
Asamoah has made some vital changes to the operations of the company.
Nevertheless, other directors are now worried that Mr Efah Asamoah has been too
ambitious in raising production targets.
Mr Efah Asamoah had also changed suppliers of raw materials to enhance quality,
increased selling price, begun to introduce less skilled labour, and significantly
reduced fixed overheads. Mr Efah Asamoah has also suggested that an absorption
costing system is sometimes misleading and that a marginal costing system
should be considered at some stage in the future to guide decisions-making.

Required:
a) Prepare an operating statement for October 2006. Show all operating
variances and reconcile budgeted and actual profit for the month for Wood
Factor Ltd.
b) State and explain three possible causes of variances.
Suggested solution:
Using the same information to flex the Budget
Output levels: Budgeted Flexed Budget Actual Budget
Variance
40,000 units’ 36,000 units’ 36,000 units
¢’000 ¢’000 ¢’000
¢’000
Materials: W 320,000 288,000
280,000 8,000F
Direct labour 128,000 115,200
112,000 3,200F
Variable O/H 64,000 57,600
60,000 2,400A
Fixed O/H 256,000 256,000
196,000 60,000F
Budgeted cost allowance 768,000 716,800
648,000 68,800

Total Direct Material Variance:

Material W = should have cost (¢8K x 36,000) = ¢288,000
But did cost (¢280,000) = ¢280,000 = ¢8,000F
Price Variance: = STD cost of R/M. purchased - Actual cost of R/M purchased.
Material W purchased = should have cost (800K x ¢320/kg) = ¢256,000
But did cost (800K x ¢350/kg) ¢280,000 = ¢24,000A
Material Usage Variance (STD qty in actual output – Act. Qty used) STD price
Material W = should have used (25kg x 36,000) = 900,000kgs
But did use (800,000kgs) = 800,000kgs = 100,000kgs x ¢320= ¢32,000F

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Total Direct Labour Variance: (STD labour cost in actual output – Act. labour
cost)
Labour in actual output = should have cost (¢3,200 x 36,000) = ¢115,200
But labour did cost (¢112,000) ¢112,000 = ¢3,200F
Rate Variance = STD cost of labour hours paid for – Actual cost paid for.
Labour hours paid = should have cost (¢800 x 160,000) = ¢128,000
But did cost (¢700 x 160,000) = ¢112,000 = ¢16,000F
Efficiency Variance = STD hours for actual output – Actual hours used) STD
rate or wage
Labour hours required = should have been (4 hours x 36,000) = 144,000 hours
But actual hours used (160,000) = 160,000 hours = 16,000 hours x ¢800 =
¢12,800A

Total Variable Production Overhead = STD variable cost of output – Actual

variable cost
Variable overhead required should be (¢1,600 x 36,000) = ¢57,600
But Variable overhead labour did cost (¢60,000) = ¢60,000 = ¢2,400A
Expenditure Variance = Variable overheads absorbed – Actual variable cost
Actual hours used in production x V/OAR (160,000 hours x ¢400) = ¢64,000
Actual variable expenditure (¢60,000) ¢60,000 = ¢4,000F
Efficiency Variance = STD hours for actual output – Actual hours used) x
variable absorption rate.
Variable hours required for actual output should be (4 hours x 36,000) = 144,000
hours
But actual hrs used in production was 160,000 hrs = 16,000 hrs x ¢400 =
¢6,400A
Total Fixed Overhead Variance = Std. Fixed OH of actual output – Actual
Fixed Overhead
Fixed production for actual output should be (36,000 x ¢6,400) = ¢230,400
But fixed production cost incurred was (¢196,000) = ¢196,000 =
¢34,400F.
Fixed Overhead Expenditure Variance = Budget Fixed Overhead – Act Fixed
OH incurred
Budgeted fixed overhead should be (40,000 units x ¢6,400) = ¢256,000
Actual fixed overhead expended (¢196,000) = ¢196,000 = ¢60,000F
F/Overhead Efficiency Variance = (STD Hours for Actual Output – Actual
Hours) x FOAR.
Fixed production hours for output should be (4Hours x 36,000) = 144,000Hours
But actual production hours used was (160,000Hours) = 16,000Hours x ¢1,600 =
¢25,600A

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Fixed Overhead Volume Variance = (Budgeted Hours – Actual Hours) FOAR
Budgeted fixed overhead should be (4Hours x 40,000) = 160,000Hours
But actual production hours used was (160,000Hours) = 160,000Hours = 0

Note: This is because fixed cost is assumed to be fixed and does not vary with the
level of activity. Therefore beyond the limited capacity fixed cost will not change
and excess absorption is deemed to be over absorption and considered a gain sort
of and therefore favourable. On the other hand if production output or time is
lower than the expected level to cover all the budgeted fixed overhead the net is
considered under absorption and would be termed as adverse.

Sales Variance:
Selling Price Variance = STD Value Actual Sales – Actual Sales Value
Actual units sold should have generated (¢22 x 32,000) = ¢704,000
But actual sales raised (32,000 x ¢22.5) = ¢720,000 = ¢16,000F
Sale Volume Variance: (Budgeted Sales Volume – Actual Sales Volume) STD
Profit/Unit
Budgeted sales volume was 40,000 units
But did sell 32,000 units = 8,000 x ¢2,800 = ¢22,400A

Reconciliation of Actual and Budgeted Operating Statement.

A F Totals
¢’000 ¢’000 ¢’000
Budgeted price (40,000 x ¢2,800) 112,000
Selling price variance 16,000
Sales volume variance 22,400 6,400A
Cost Variances
105,600
Material: X = Price variance 24,000
= Usage variance 32,000
8,000F
Labour: Rate variance 16,000
Efficiency variance 12,800 3,200F
Variable production overhead
Expenditure variance 4,000
Efficiency variance 6,400 2,400A
Fixed production overhead
Expenditure variance 60,000
Efficiency variance 25,600
Volume variance 0 34,400F

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ACTUAL PROFIT 148,800

Operating Statement (Absorption Costing) ¢’000

¢’000
Sales
720,000
Less cost of sales:
Material W 280,000

Direct labour cost 112,000

Variable products overheads 60,000
PRIME COST 452,000
Fixed prod overheads 196,000
Factory cost of production 648,000
Less Closing Stock (4,000 x ¢19,200) 76,800
Production Cost of Sales
571,200
ACTUAL PROFIT
148,800

Marginal Costing System Format ¢’000 ¢’000

Sales
720,000
Less cost of sales:
Material W 280,000

Direct labour cost 112,000

Variable products overheads 60,000
452,000
Less closing stock (4,000 x ¢12,800) 51,200
400,800
Total contribution
319,200
Less Fixed prod overheads
196,000
Variable cost of sales
596,800
ACTUAL PROFIT 123,200

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VARIANCES

There are six principal variances. The calculation of variances can also be
facilitated by the use of the following simple formulae:
A representing Actual
S “ Standard
P “ Price
R “ Rate
Q “ Quantity
H “ Hours
Variance Formula
Material Price Variance AQ (AP – SP) or (SP - AP) AQ

Material Usage Variance SP (AQ x SQ) or (SQ - AQ) SP

Labour Rate Variance AH (AR – SR) or (AR – SR) AH

Labour Efficiency Variance SR (AH – SH) or (AQ – SQ) SR (NB:

Wage Rate)

Overhead Efficiency Variance SR (AH – SH) or (AQ –AR) SR (NB:

OAR)

Overhead Volume Variance AH (SR - AR) or (SP – AP) AH

As an example consider the following questions

4. An extract of a standard cost card for one unit of a product called M11 is as
follows:
Direct material: 50kg @ ¢100 per kg ¢5,000
Direct labour: 10hours @ ¢800 per hour ¢8,000
¢13,000
During April 2006, 70 units of M11 was produced. Other actual results were:
Direct material: 3,200kg costing ¢384,000
Direct labour: 800 hrs costing ¢608, 000
You are required to calculate:
(a) Total material cost variance Workings: AP = ¢38,400/3,200 =
¢120/kg
(b) Direct material price variance AR = ¢608,000/800 =
¢760/hr
(c) Direct material usage variance

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(d) Total direct labour cost variance
(e) Direct labour rate variance
(f) Direct labour efficiency variance.

Suggested Solution
(a) (SQ x SP) – (AQ x AP) (b) (SP - AP) AQ
(3500 x ¢100) – (3200 x ¢120) (¢100 - ¢120) 3200
¢350,000 - ¢384,000 = ¢34,000A ¢20 x 3200 =
¢64,000A

(c) (SQ - AQ) SP d) (SH x SR) – (AH x

AR)
(3500 - 3200) ¢ 100 (700 x 800) – (800 x
760)
300 X ¢100 = ¢30,000 F ¢560,000 - ¢608,000
= ¢48,000A

(e) (SR - AR) AH (f) (SH - AH) SR

(¢800 - ¢760) 800HRS (700 - 800) ¢800
¢40 X 800 = ¢32,000F 100 x ¢800 =
¢80,000A

Q1. Joy Company Ltd manufactures one standard product called ‘yopoo’. The
standard cost of producing one unit is calculated as follows: ¢
Materials: 20kg @ ¢300/kg = 6,000
Labour: 6hours @ ¢250/ hour = 1,500
7,500
Production Overheads 2,500
10,000
For the month of October 1994, 800 units were produced. A total of 14,400kg of
material were bought and used at a total cost of ¢5,040,000. A total of ¢1,120,000
was paid as wages for the 4,000 labour hours used in the month. You are required
to calculate:
(a) Total materials cost variance analysed into price and usage variances
(b) Total labour cost variance analysed into rate and efficiency variances
(c) Total Overhead Variance analysed into efficiency and volume variances.
(Assuming normal output for a month is 1,000 units).

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(a) Total Material Cost Variance (b) Price Variance
(SQ x SP) – (AQ x AP) (SP - AR) AQ
(16000 x ¢300) – (14400 x ¢350) (¢300 - ¢350)
14,400kg
¢4,800,000 - ¢5,040,000 = ¢240,000A ¢50 x ¢14400 =
¢720,000A

(c) Usage Variance

(SQ - AQ) SP
(16000 - 14400) ¢300
1600 x ¢300 = ¢480,000F

Q2. Winners Ltd produces ready to serve vegetable salad using tomatoes and
green lettuce. To produce one unit of packed salad, the standard specifications of
Winners Ltd are as follows:
Direct material GHS
Lettuce: 9kg @ GHS0.20 per kg 1.80
Tomatoes: 1kg @ GHS0.26 per kg 0.26
Mixed material L and T: 10kg 2.06
On August 2, Winners Ltd produced a batch of 9,600 units of packed vegetable
salad with the following actual results:
Lettuce: 89,600kg
Tomatoes: 22,400
You are required to calculate the:
a. Material mix and material yield variances
b. Total material usage variance
Suggested Solution:
i. Computation of Direct Material Mix Variance (DMMV)
Material AQu SQa Difference SP (GHS)
DMMV
Lettuce 89,600 100,800 11,200 F 0.20 2,240 F
Tomatoes 22,400 11,200 11,200 A 0.26 2,912 A
Total 112,000 112,000 672 A
ii. Computation of Direct Material Yield Variance (DMYV)
Material AQu SQa Difference SP (GHS)
DMMV
Lettuce 89,600 86,400 3,200 A 0.206 659.2
A
Tomatoes 22,400 9,600 12,800 A 0.206 2,636.8
A
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Total 3,296.0
b. Computation of Total Usage Variance (TMUV)
Material AQu SQa Difference SP (GHS)
DMMV
Lettuce 89,600 86,400 3,200 A 0.20 640 A
Tomatoes 22,400 9,600 12,800 A 0.26 3,328 A
Total 3,968
A

Q3. Obinim Company Ltd manufactures children reading desks that are identical.
The standard cost of each desk is as follows: GH¢
Direct materials: Three pieces of wood @ GH¢0.20 0.60
Direct labour (1hour @ GH¢5 5.00
Variable overhead 0.40
Fixed overhead (GH¢18,000/60,000) 0.30
6.30
The standard overhead rate is based on a volume of 60,000 units per month. In
July 2010, 50,000 units were produced. Detailed data relative to production are
shown below:
Direct materials purchased: 160,000 pieces of wood @ GH¢0.22
Materials used: 152,000 pieces of wood
Direct labour: 49,000 hours @ GH¢5.10
Variable overhead: GH¢20,350
Fixed overhead: GH¢18,200
From the above data, you are required to calculate:
i. Total labour cost variance analysed into rate and efficiency variances.
ii. Total variable overhead variance analysed into spending and efficiency
variances.
iii. Total fixed overhead variance analysed into spending and volume
variances
Suggested Solution:
Material Price Variance Material Usage Variance
MPV = (SP - AP) AQ MUV = (SQ – AQ) SP
= (GH¢0.2 - GH¢0.22) 160,000 = (150,000 – 152,000)
GH¢0.2
= GH¢3,200 A = GH¢400 A
MCV = MPV + MUV:
= GH¢3,200 A - GH¢400 A = GH¢3,600 A
Labour Rate Variance Labour Efficiency Variance
LAV = (AR – SR) AH LEV = (AH – SH)
SR

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 = (GH¢5.1 – GH¢5.0) 49,000 = (49,000 - 50,000)
GH¢5
= GH¢4,900 A = GH¢5,000 F
LCV = LRV + LEV:
= GH¢4,900 A + GH¢5,000 F = GH¢100 F
Variable Overhead
V/Overhead Spending Variance V/Overhead Efficiency Variance
VOSV = (VOAR x AH) – (SVOR x AH) VOEV = (AH x SVOR) – (SH x
SVOR)
= GH¢20,350 – (GH¢0.4 x 49,000) = (49,000 x GH¢0.4) - (50,000 x
GH¢0.4)
= GH¢3,750 A = GH¢400 F
VOV = VOSV + VOEV:
= GH¢3,750 A + GH¢400 F = GH¢3,350 A
F/Overhead Spending Variance F/Overhead Volume Variance
FOSV = AFO - BFO FOVV = SFOR (AQ – BQ)
= GH¢18,200 - GH¢18,000 = GH¢0.3 (50,000 – 60,000)
= GH¢200 A = GH¢3,000 A
TFOV = FOSV + FOVV:
= GH¢200 A + GH¢3,000 A = GH¢3,200 A

Q4. The following data relates to the standard cost of ‘organza’ introduced
recently into the Ghanaian market by Koo Mintah for the month June 2009.
Standard cost per unit of product GH¢
Direct material: GH¢3.5 @ 4 Litres 14.0
Direct labour: GH¢5 @ 1 hour 5.0
Prime cost 19.0
Production overheads 6.0
Standard cost per unit 25.0
Actual results for June
Production 7,500 units
Direct material: Opening stock 6,500 litres
Purchased (29000 litres) GH¢84,100
Closing stock 3,000 litres
Direct labour cost (8,500 hours) GH¢38,250
Required:
i. Calculate and analyse material cost variance
ii. Calculate and analyse labour cost variance

Suggested solution: Calculation of material issued and used for the month of Jun
2009

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Opening stock 6,500
Purchased 29,000
Material available for production 35,500
Less closing stock 3,000
Materials issued and used 32,500
Standard quantity (materials) = 4 litres x 7,500 = 30,000 litres
Standard Hours (Labour) = 1 hour x 7,500 = 7,500 hours
Actual Cost (materials)/litre = GH¢84,100/29,000 = GH¢2.9/litre
Actual Rate (Labour)/hour = GH¢38,250/8,500 hours = GH¢4.5/hour
Material Cost Variance Material Price Variance
MCV = (SQ x SP) – (AQ x AP) MPV = AQ (SP – AP)
= (30,000 x GH¢3.5) – (32,500 x GH¢2.9) = 32,500 (GH¢3.5 – GH¢2.9)
= GH¢105,000 - GH¢94,250 = 32,500 (GH¢0.60)
= GH¢10,750 F = GH¢19,500
F

Material Usage Variance

MUV = SP (SQ – AQ)
= GH¢3.5 (30,000 - 32,500)
= GH¢3.5 (2,500)
= GH¢8,750 A
Labour Cost Variance Labour Rate
Variance
LCV = (SH x SR) – (AH x AR) LAV = AT (SR –
AR)
= (7,500 x GH¢5) – (8,500 x GH¢4.5) = 8,500 (GH¢5 –
GH¢4.5)
= GH¢37,500 - GH¢38,250 = 8,500 (GH¢0.50)
= GH¢750 A = GH¢4,250 F
Labour Efficiency Variance
LEV = SR (SH – AH)
= GH¢5 (7,500 - 8,500)
= GH¢5 (1,000)
= GH¢5,000 A

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Glossary

A
Absorption costing a costing approach that assigns all manufacturing costs,
including direct materials, direct labour, variable overhead and a share of fixed
overhead, to each unit of product.

Activity a basic unit of work performed within an organisation. It can also be

defined as an aggregation of series of actions within an organisation useful to
managers for purposes of planning, controlling, and decision making.

Activity analysis the process of identifying, describing, and evaluating the

activities an organisation performs.

Activity drivers measure the demands that cost objects place on activities.

Activity elimination the process of eliminating non value added activities.

Activity inputs resources consumed by an activity in producing its output (i.e.

they are the factors that enable the activity to be performed)

Activity rate the average unit cost obtained by dividing the resources expenditure
by the activity’s practical capacity.

Activity-based budgeting system budgeting the costs of resources at the activity

level.

Activity-based costing assigns costs to cost objects by first tracing costs to

activities and then tracing costs to cost objects.

Activity-based costing (ABC) system a cost accounting system that uses both
unit and non-unit-based cost drives to assign costs to cost units or object by first
tracing costs to activities and then tracing costs from activities to products.

Activity-based management (ABM) an advanced control system that focuses

management’s attention on activities with the objective of improving the value
received by the customer and the profit received by providing this value. It
includes driver analysis, activity analysis and performance evaluation and draws
on activity-based costing as a major source of information.

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Administrative costs all costs associated with the general administration of the
organisation that cannot be responsibly assigned to either marketing or
production.

Administrative expense budget a budget consisting of estimated expenditures

for the overall organisation and operation of the establishment or company.

Allocation assignment of indirect costs to cost units or objects

Applied overhead the overhead assigned to production using a predetermined

overhead rate

Asset a resource held by the business organisation which has certain

characteristics such as it has probable future benefits; the business has an
exclusive right to control the benefit,; the benefits must arise from some past
transaction or events and the asset must be capable of measurement in monetary
terms (i.e. unexpired cost).

B
Backflush costing a simplified approach for cost flow accounting that uses
trigger points to determine when manufacturing costs are assigned to key
inventory and temporary accounts.

Balance scorecard a strategic-based performance management system that

typically identifies objectives and measures for four different perspective: i.e. the
financial perspective, the customer perspective, the process perspective, and the
leaning and growth perspective.

Base period a prior period used to set the benchmark for measuring productivity
changes.

Batch production processes a process that produces batches of different products

that are identical in many ways but differ in others.

Benchmarking uses best practices as the standard for evaluating

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