MANAGEMENT ACCOUNTING

PART 1

CPA SECTION 2

STUDY TEXT

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MANAGEMENT ACCOUNTING

GENERAL OBJECTIVE
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her
to apply management accounting principles and concepts in business

LEARNING OUTCOMES

A candidate who passes this paper should be able to:

- Estimate the cost of goods and services

- Analyse product costs for manufacturing and non-manufacturing activities
- Prepare marginal and absorption cost statements
- Analyse an organisation's activities through budgetary control process
- Analyse variances for decision making
- Use computers in cost management

CONTENT

1. Nature and purpose of cost and management accounting

- The nature of cost accounting and costing terms

- The role of cost accounting in management
- The purposes of cost accounting information
- Scope of cost accounting
- Meaning of management accounting, scope, limitations, applications
- Relationship between cost, financial and management accounting
- Selection of an ideal cost accounting system

2. Cost classification

- Definition and purpose of cost classification

- Methods of cost classification: By nature/elements of manufacturing costs; Functional
classification; Behavioral classification; Controllability; Time; Financial accounting;
Identification with inventory; For decision making

3. Cost estimation

- Meaning of cost estimation

- Methods of estimating cost; non-mathematical methods like engineering method, accounts
analysis method and high-Iow method; mathematical methods like scatter graph method, OLS
regression method (simple linear regression only)

4. Cost accumulation

- Accounting for materials and inventory; material cost records, purchasing procedures, receipt and
issues of material, methods of valuing material issues, inventory control procedures; economic
order quantity (EOQ) and economic batch quantity(EBQ) models and back flush
- Accounting for labour: Methods of labour remuneration, labour control procedures, maintenance
of labour records

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 - Accounting for overheads: Types of overheads, manufacturing, distribution and administration,
service departmental cost allocation and apportionment, overheads analysis, overhead absorption
rates, over or under absorption
- Activity based costing

5. Cost bookkeeping

- The flow of costs in a business enterprise

- Cost bookkeeping- interlocking and integrated ledger systems

6. Costing methods

- Job order costing

- Batch costing
- Process costing (including work in progress; joint and by-products)
- Service costing
- Unit costing

7. Marginal and absorption costing.

- Distinction between marginal and absorption costing

- Valuation of products under marginal and absorption costing
- Preparation of marginal and absorption statements; cost of production and profit determination
- Applications of marginal costing: Break-even analysis and charts (single product)
- Simplified decision problems; accept or reject, special order, dropping a product, make or buy
- Operating statements

8. Budgeting and budgetary control

- Nature and purposes of budgets

- Preparation of budgets; master budgets, functional (department budgets, cash budgets), proforma
financial reports (income statements and balance sheets)
- Purpose of budgetary control; operation of a budgetary control system, organisation and
coordination of the budgeting function
- Distinction between budgeting and budgetary control in the private and public sectors

9. Standard costing

- Types of standards
- Principles of setting standards
- Standard cost card
- Behavioural aspects of standard costing
- Generation of standard cost information
- Materials, labour and overheads variances; price and efficiency variances

10. Cost management

- Value chain-research and development-design-production-marketing distribution and customer

care
- Just in time (JIT)

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 - Use of computers in costing; job costing, inventory management, labour costing, cost entre
analysis, coding, budgeting and decision making

11. Overview of Performance Measurement

- Purpose of performance measurements

- Financial performance measures: profitability, liquidity, activity and gearing
- Non-financial performance measures. The balanced score card perspective

12. Emerging issues and trends

CONTENT PAGE

Topic 1: Nature and purpose of cost and management accounting……………………..…….5

Topic 2: Cost classification…………………………………………………………………...25
Topic 3: Cost estimation…………………………………………………………………...…34
Topic 4: Cost accumulation………………………………………………………………..…50
Topic 5: Cost bookkeeping……………………………………………………………….…135
Topic 6: Costing methods.......................................................................................................149
Topic 7: Marginal and absorption costing..............................................................................195
Topic 8: Budgeting and budgetary control.............................................................................236
Topic 9: Standard costing.......................................................................................................263
Topic 10: Cost management...................................................................................................297
Topic 11: Overview of Performance Measurement...............................................................306

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 TOPIC 1

NATURE AND PURPOSE OF COST AND ACCOUNTING

THE NATURE OF COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Cost accounting is a type of accounting process that aims to capture a company's costs of
production by assessing the input costs of each step of production as well as fixed costs such as
depreciation of capital equipment. Cost accounting will first measure and record these costs
individually, then compare input results to output or actual results to aid company management
in measuring financial performance.

The nature of cost accounting can be brought out under the following headings:

1. Cost accounting is a branch of knowledge: Though considered as a branch of

financial accounting, cost accounting is one of the important branch of knowledge, i.e., a
discipline by itself. It is an organised body of knowledge consisting of its own principles,
concepts and conventions. These principles and rules vary from industry to industry.

2. Cost accounting is a science: Cost accounting is a science as it is a body of systematic

knowledge relating to not only cost accounting but relating to a wide variety of subjects
such as law, office practice and procedure, data processing, production and material
control, etc. It is necessary for a cost accountant to have intimate knowledge of all these
field of study in order to carry on his day-to-day activities. But it is to be admitted that it
is not a perfect science as in the case of natural science.

3. Cost accounting is an art: Cost accounting is an art in the sense it requires the ability
and skill on the part of cost accountant in applying the principles, methods and
techniques of cost accountancy to various management problems. These problems
include the ascertainment of cost, control of costs, ascertainment of profitability, etc.

4. Cost accounting is a profession: In recent years cost accounting has become one of the
important professions which has become more challenging.

While cost accounting is often used within a company to aid in decision making, financial
accounting is what the outside investor community typically sees. Financial accounting is a
different representation of costs and financial performance that includes a company's assets and
liabilities. Cost accounting can be most beneficial as a tool for management in budgeting and in
setting up cost control programs, which can improve net margins for the company in the future.

One key difference between cost accounting and financial accounting is that while in financial
accounting the cost is classified depending on the type of transaction, cost accounting classifies
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costs according to information needs of the management. Cost accounting, because it is used as
an internal tool by management, does not have to meet any specific standard and as result varies
in use from company to company or from department to department.

Development of Cost Accounting

Scholars have argued that cost accounting was first developed during the industrial
revolution when the emerging economics of industrial supply and demand forced manufacturers
to start tracking whether to decrease the price of their overstocked goods or decrease production.

During the early 19th century when David Ricardo and T. R. Malthus were developing the field
of economic theory, writers like Charles Babbage were writing the first books designed to guide
businesses on how to manage their internal cost accounting.

By the beginning of the 20th century, cost accounting had become a widely covered topic in the
literature of business management.

Types of Cost Accounting

Standard Cost Accounting

This type of of cost accounting uses ratios to compare efficient uses of labor and materials to
produce goods or services under standard conditions. Assessing these differences is called a
variance analysis. Traditional cost accounting essentially allocates cost based on one measure,
labor or machine hours. Due to the fact that overhead cost has risen proportionate to labor
cost since the genesis of standard cost accounting, allocating overhead cost as an overall cost has
ended up producing occasionally misleading insights.

Some of the issues associated with cost accounting is that this type of accounting emphasizes
labor efficiency despite the fact that it makes up a comparatively small amount of the costs for
modern companies.

Activity Based Costing

Activity based accounting is defined as, "an approach to the costing and monitoring of activities
which involves tracing resource consumption and costing final outputs, resources assigned to
activities, and activities to cost objects based on consumption estimates. The latter utilize cost
drivers to attach activity costs to outputs."

Activity based costing accumulates the overheads from each department and assigns them to
specific cost objects like services, customers, or products. The way these costs are assigned to
cost objects are first decided in an activity analysis, where appropriate output measures are cost
drivers. As result, activity based costing tends to be much more accurate and helpful when it
comes to helping managers understand the cost and profitability of their company's specific
services or products. Accountants using activity based costing will pass out a survey to

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employees who will then account for the amount of time they spend on different tasks. This
gives management a better idea of where their time and money is being spent.

Lean Accounting

Lean accounting is an extension of the philosophy of lean manufacturing and

production developed by Japanese companies in the 1980s. Most accounting practices for
manufacturing work off the assumption that whatever is being produced is done in a large scale.
Instead of using standard costing, activity based costing, cost-plus pricing, or other management
accounting systems, when using lean accounting those methods are replaced by value-based
pricing and lean-focused performance measurements, for example, using a box score to facilitate
decision making and create simplified and digestible financial reports.

Marginal Costing

Considered a simplified model of cost accounting, marginal costing (sometimes called cost-
volume-profit analysis) is an analysis of the relationship between a product or service's sales
price, the volume of sales, the amount produced, expenses, costs and profits. That specific
relationship is called the contribution margin. The contribution margin is calculated by dividing
revenue minus variable cost by revenue. This type of analysis can be used by management to
gain insight on potential profits as impacted by changing costs, what types of sales prices to
establish, and types of marketing campaigns.

Types of Costs

Fixed Costs are costs that don't vary depending ont he amount of work a company is doing.
These are usually things like the payment on a building, or a piece of equipment that is
depreciating at a fixed monthly rate.

Variable costs are tied to a company's level of production. An example could be a coffee roaster,
who after receiving a large order of beans from a far-away locale, has to pay a higher rate for
both shipping, packaging, and processing.

Operating costs are costs associated with the day-to-day operations of a business. These costs
can be either fixed or variable depending.

Direct costs is the cost related to producing a product. If a coffee roaster spends 5 hours roasting
coffee, the direct costs of the finished product include the labor hours of the roaster, and the cost
of the coffee green. The energy cost to heat the roaster would be indirect because they're inexact,
hard to trace.

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THE ROLE OF COST ACCOUNTING IN MANAGEMENT

Cost accounting is utilized for a number of purposes, some of which are briefly described in the
following points:

a) Accounting for costs

This may be seen as a record keeping or score-keeping role. Information must be
gathered and analyzed in a manner which will help in planning, controlling and decision
making

b) Planning and budgeting

This involves the quantification of plans for future operations of the enterprise; such
plans may be for the long or short term, for the enterprise as a whole or for the individual
aspects of the enterprise.

c) Control of operations of the enterprise

Control may be assisted by the comparison of actual cost information with that included
in the plan. Any differences between planned and actual events can be investigated and
corrective action implemented as appropriate

d) Decision making
Cost accounting information assists in the making of decisions about future operations of
the enterprise; such decisions making may be assisted by the information from cost
techniques and cost-volume-profit analysis.

e) Resource allocation decisions

For example product pricing in determining whether to accept or reject jobs. This is
based on cost and revenue implications of the relevant decisions

f) Performance evaluation
Cost accounting information is used to measure and evaluate actual performance so as to
make a decision of the degree of optimality or efficiency of resource utilization.

THE PURPOSES OF COST ACCOUNTING INFORMATION

Functions and objectives of cost and management accounting include the following:

1. Planning
2. Decision Making
3. Monitoring & Control
4. Accountability

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1. Planning

Planning is an important function of management accounting which is most effectively

performed by the preparation of budgets and forecasts.

Forecasting is the process of estimation of the expected financial performance and position of a
business in the future. Common types of forecasts include cash flow forecast, projected profit
and loss and balance sheet forecast. Forecasts assist in determining the likely change in the
financial performance and position of a business when considered in the context of the various
assumptions used in forming the projections. Forecasting is the starting point in determining the
resource requirements of a business which are quantified into budgets.

Budgets quantify the financial targets to be achieved by the management of an organization.

Budgeting process often begins with the preparation of a master budget which is then used as a
basis for the preparation of departmental and operational budgets. Budgeting helps in the
effective allocation of resources of an organization between competing needs (e.g. departments,
products, etc) in order to achieve the financial goals of a business. Budgets and forecasts help
businesses to deal with potential problems proactively and avoid foreseeable bottlenecks in
business resources.

2. Decision Making

Management accounting facilitates the provision of financial information to management for

decision making. Management accounting also involves the evaluation of alternative strategies
and actions by the application of techniques and concepts such as relevant costing, cost-volume-
profit analysis, limiting factor analysis, investment appraisal techniques and client / product
profitability analysis.

3. Monitoring & Control

Control process in management accounting system starts by defining standards against which
performance may be measured such as standard costs and budgets. Actual results are measured
and any variance between targets and results are analyzed and where necessary, corrective
actions are taken. Management accounting plays a vital role in the monitoring and control of cost
and efficiency of the routine processes and as well as one-off jobs and projects undertaken by an
organization.

4. Accountability

Management accounting lays great emphasis on accountability through effective performance

measurement. By setting targets for strategic business units and as well as for departments,
management accounting assists in the assignment of responsibility for the achievement of
business targets by individual managers. Responsibility accounting is achieved by appraising the
performance of managers responsible for their business units while giving due consideration for
factors not within their control or influence.

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 TOPIC 2
COST CLASSIFICATION

DEFINATION AND PURPOSE OF COST CLASSIFICATION

Definition
Cost classification is the process of grouping costs according to their common characteristics. A
suitable classification of costs is of vital importance in order to identify the cost with cost centres
or cost units. Cost may be classified accounting to their nature, i.e., material, labor and expenses
and a number of other characteristics. The same cost figures are classified according to different
ways of costing depending upon the purpose to be achieved and requirements of particular
concern.

Purpose of cost classification

1. Preparation of budget: classification of cost helps in preparation of the budget of the

organization. For preparing the budget of an organization one must know how and where
exactly the expenses have been incurred in relation to manufacturing the product. On the
basis of this classification of the cost an organization accordingly prepares its budget.

2. Helps in measuring efficiency: classification of cost helps in measuring the

efficiency of the organization. On the basis of the places where the costs have been
incurred and the amount of cost that has been incurred the efficiency of the organization
can be judged.

3. Controlling cost:

 Labour cost: with the help of classification of cost an organization can control its
labour cost as well. If the labour complete their task well in time and with much
efficiency then the organization would be able to reduce its labour cost.
 Material cost: material cost can be controlled if material wastage is avoided and
proper standardization of materials is used. Thus with the help of classification of
cost an organization is able to reduce the cost incurred on materials and thus able
to control material cost.
 Overhead cost: overhead comprises indirect expenditure incurred in
manufacturing. By knowing the amount that has been incurred under various
heads an organization can device ways to reduce the cost. Thus with the help of
classification of cost an organization is able to control overhead cost.

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 4. Expansion of the organization: if an organization knows where exactly it incurs
expenditure then it can device ways to control these costs. Once an organization is able to
control its cost then it can concentrate on its expansion. Thus with the help of
classification of cost an organization is able to device ways for its expansion.

Thus, classification of cost is of immense importance for an organization. With the help
of classification of cost an organization can make progress and also expand its production
by controlling its cost. Thus in the long run an organization can move towards higher
productivity and thus higher profits and can achieve its goals.

METHODS OF COST CLASSIFIICATION

MANUFACTURING COSTS

Definition and Explanation of manufacturing cost:

Manufacturing costs are those costs that are directly involved in manufacturing of products and
services. Examples of manufacturing costs include raw materials costs and salary of labor
workers. Manufacturing cost is divided into three broad categories by most companies.

1. Direct materials cost

2. Direct labor cost
3. Manufacturing overhead cost.

Direct Materials Cost:

The materials that go into final product are called raw materials. This term is somewhat
misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore.
Actually raw materials refer to any materials that are used in the final product; and the finished
product of one company can become raw material of another company. For example plastic
produced by manufacturers of plastic is a finished product for them but is a raw material for
Compaq Computers for its personal computers.

Direct Materials are those material that become an integral part of the finished product and that
can be physically and conveniently traced to it. Examples include tiny electric motor that
Panasonic uses in its CD players to make the CD spin. According to a study of 37 manufacturing
industries material costs averaged about 55% of sales revenue.

Sometimes it is not worth the effort to trace the costs of relatively insignificant materials to the
end products. Such minor items would include the solder used to make electrical connection in a
Sony TV or the glue used to assemble a chair. Materials such as solder or glue are called indirect
materials and are included as part of manufacturing overhead, which is discussed later on this
page.

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Direct Labor Cost:

The term direct labor is reserved for those labor costs that can be essentially traced to individual
units of products. Direct labor is sometime called touch labor, since direct labor workers
typically touch the product while it is being made. The labor cost of assembly line workers, for
example, is a direct labor cost, as would the labor cost of carpenter, bricklayer and machine
operator

Labor costs that cannot be physically traced to the creation of products, or that can be traced only
at a great cost and inconvenience, are termed indirect labor and treated as part of manufacturing
overhead, along with indirect materials. Indirect labor includes the labor costs of janitors,
supervisors, materials handlers, and night security guards. Although the efforts of these workers
are essential to production, it would be either impractical or impossible to accurately trace their
costs to specific units of product. Hence, such labor costs are treated as indirect labor.

In some industries, major shifts are taking place in the structure of labor costs. Sophisticated
automated equipment, run and maintained by skilled workers, is increasingly replacing direct
labor. In a few companies, direct labor has become such a minor element of cost that it has
disappeared altogether as a separate cost category. However the vast majority of manufacturing
and service companies throughout the world continue to recognize direct labor as a separate cost
category.

According to a study of 37 manufacturing industries, direct labor averaged only about 10% of
sales revenue.

Direct Materials cost combined with direct labor cost is called prime cost.

In equation form:

Prime Cost = Direct Materials Cost + Direct Labor Cost

For example total direct materials cost incurred by the company is $4,500 and direct labor cost is
$3,000 then prime cost is $7,500 ($4,500 + $3,000).

Manufacturing Overhead Cost:

Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct material and direct labor. Examples of manufacturing overhead
include items such as indirect material, indirect labor, maintenance and repairs on production
equipment and heat and light, property taxes, depreciation, and insurance on manufacturing
facilities. Indirect materials are minor items such as solder and glue in manufacturing industries.
These are not included in direct materials costs. Indirect labor is a labor cost that cannot be trace
to the creation of products or that can be traced only at great cost and inconvenience. Indirect
labor includes the labor cost of janitors, supervisors, materials handlers and night security
guards. Costs incurred for heat and light, property taxes, insurance, depreciation and so forth
associated with selling and administrative functions are not included in manufacturing overhead.

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Studies have found that manufacturing overhead averages about 16% of sales revenue.
Manufacturing overhead is known by various names, such as indirect manufacturing cost, factory
overhead, and factory burden. All of these terms are synonymous with manufacturing overhead.

Manufacturing overhead cost combined with direct labor is called conversion cost.

In equation form:

Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost

For example if total direct labor cost is $3,000 and total manufacturing overhead cost is $2,000
then conversion cost is $5,000 ($3,000 + $2,000).

Non-manufacturing Costs:

Definition and explanation of non-manufacturing cost:

Non-manufacturing costs are those costs that are not incurred to manufacture a product.
Examples of such costs are salary of sales person and advertising expenses. Generally non-
manufacturing costs are further classified into two categories.

1. Marketing and Selling Costs

2. Administrative Costs

Marketing or Selling Costs:

Marketing or selling costs include all costs necessary to secure customer orders and get the
finished product into the hands of the customers. These costs are often called order getting or
order filling costs. Examples of marketing or selling costs include advertising costs, shipping
costs, sales commission and sales salary.

Administrative Costs:

Administrative costs include all executive, organizational, and clerical costs associated with
general management of an organization rather than with manufacturing, marketing, or selling.
Examples of administrative costs include executive compensation, general accounting,
secretarial, public relations, and similar costs involved in the overall, general administration of
the organization as a whole.

FUNCTIONAL CLASSIFICATION

Production, Administration, Selling & Distribution are three important functions of a business
concern. Taking these functions into consideration, costs have been classified by:

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 a) Production or Manufacturing Cost: Manufacturing costs are those costs which are
incurred in the course of manufacture. It includes cost of raw material, cost of labour,
other direct cost and factory indirect cost. Example of production or manufacturing costs
may be power, lighting, heating, rent, depreciation etc.
b) Office and Administration Cost: These costs are incurred for the general administration
of the enterprise. It includes office costs as well as administration cost. For example,
salary of office staff, rent of office building, electricity charges, audit fee, printing and
stationeries etc.
c) Selling and Distribution Cost: It includes both selling cost as well as distribution cost.
Selling costs are those costs which are incurred in connection with the selling of goods
and services Distribution costs are those costs which are incurred on despatch of finished
goods to the consumers. Example of selling and distribution costs are: sales men salary,
packing charges, carriage, out ward, advertisement, ware house charges etc.

BEHAVIORAL CLASSIFICATION

Cost behavior means how costs will respond or react to changes in the activity level. ie. as we
increase output or sales, are the costs rising, dropping or remaining the same. Cost Behavior can
be used to produce various classifications of costs such as:

Costs will be classified according to nature or behavior in relationship to change in the levels of
production such as:

i) Variable costs
ii) Fixed costs
iii) Semi fixed costs

Variable costs

These are directly proportional to the level of activity.

If the number of units produced doubles, then variable production costs will double also. An
example would be the cost of material used to produce units.

If the number of units sold increases by 20% then variable selling and distribution costs would
increase by 20% also.

On a graph, variable costs would look like:

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 TOPIC 3

COST ESTIMATION

MEANING OF COST ESTIMATION

A cost estimate is the approximation of the cost of a program, project, or operation. The cost
estimate is the product of the cost estimating process. The cost estimate has a single total value
and may have identifiable component values. A problem with a cost overruncan be avoided with
a credible, reliable, and accurate cost estimate. An estimator is the professional who prepares
cost estimates.

METHODS OF ESTIMATING COST

Non mathematical methods

These include;
1. Engineering method
2. Accounts analysis
3. High-low method
Mathematical methods
These include;-
4. Scatter graph method
5. Ordinary Least Squares Regression Method

Cost estimation methods are necessary only for costs that are identified as mixed costs. There is
no need to apply an estimation method to break a cost into fixed and variable portions if you
have already determined it is solely fixed or solely variable. All four methods produce estimates
of amounts of fixed and variable costs.

The Goal of Cost Estimation

The ultimate goal of cost estimation is to determine the amount of fixed and variable costs to
create a cost formula to be used to predict future costs. The cost formula, or cost equation, is the
output of the cost estimation process. Because you have only one variable (number of units), the
formula will be a straight line, or linear equation. (You should remember the concept of
functions from your middle school math classes.1) The formula that represents the equation of a
line will appear in the format of:

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 𝑌 = 𝑚𝑥 + 𝑏
where Y = total cost
m = the slope of the line, i.e., unit variable cost
X = the number of units of activity
b = the y-intercept, i.e., total fixed costs

Recall that the 𝑌 = 𝑉𝐶𝑥 + 𝑇𝐹𝐶 is the equivalent equation used in accounting for estimating
costs. The total cost side of the equation (Y) can also be expressed as f(x) so that the formula
appears as:
𝑓(𝑥) = 𝑉𝐶𝑥 + 𝑇𝐹𝐶

As such, the equation is often referred to as a function. In accounting, it is referred to as a cost

function because the 'Y' equates to total cost.
Determining a linear function is useful in predicting cost amounts at different levels of activity.
This is useful because managers must be able to predict costs to plan for future operations. This
is often accompanied by what-if analysis that assists with the preparation of budgets, pricing of
products or services, and other key management functions.

Cost Equation Components

Your goal it to determine the cost equation for a particular cost, so that managers can estimate
'total' costs at various activity levels. The cost equation will contain the variable cost per unit and
total fixed costs. These two amounts remain the same at all levels of activity within the relevant
range.
The variable cost component of the cost equation is displayed with two decimals in standard
form because it is a unit cost (and unit costs are always displayed with two decimal places). The
total fixed cost component of the cost equation is displayed with no decimals.

1. ENGINEERING METHOD

The Engineering Cost Estimating method builds the overall cost estimate by summing detailed
estimates done at lower levels of the Work Breakdown Structure (WBS). It’s a technique where
the system being costed is broken down into lower-level components (such as parts or
assemblies), each of which is costed separately for direct labor, direct material, and other costs.
Engineering estimates for direct labor hours may be based on analyses of engineering drawings
and contractor or industry-wide standards.

Engineering estimates for direct material may be based on discrete raw material and purchase
part requirements. The remaining elements of cost (such as quality control or various overhead
charges) may be factored from the direct labor and material costs. The various discrete cost
estimates are aggregated by simple algebraic equations (hence the common name “bottoms-up”

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estimate). The use of engineering estimates requires extensive knowledge of a system’s (and its
components’) characteristics, and lots of detailed data.

Because of the high level of detail, each step of the work flow should be identified, measured,
and tracked, and the results for each outcome should be summed to make the point estimate.

The several advantages to the Engineering Cost estimating method include:

 The estimator’s ability to determine exactly what the estimate includes and whether
anything was overlooked,
 Its unique application to the specific program and manufacturer,
 That it gives good insight into major cost contributors, and
 Easy transfer of results to other programs.

Some disadvantages of the Engineering Cost estimating method include:

 It can be expensive to implement and it is time consuming

 It is not flexible enough to answer what-if questions
 New estimates must be built for each alternative
 The product specification must be well known and stable
 All product and process changes must be reflected in the estimate

2. ACCOUNT ANALYSIS

Under account analysis method, the accountant examines and classifies each ledger account as
variable, fixed or mixed. Mixed accounts are broken down into their variable and fixed
components. They base these classifications on experience, inspection of cost behavior for
several past periods or intuitive feelings of the manager.

This is with a view to develop a cost function in the form 𝑦 = 𝑎 + 𝑏𝑥

Illustration
Suppose a company ABC has the following costs with a value of 7000 units.
Amount Variable Fixed
Direct labour 150,000 150,000 -
Materials 125,000 125,000 -
Repairs and maintenance 5,000 5,000 -
Depreciation 15,000 - 15,000
Administration 1,000 - 1,000
overheads 4,000 - 4,000
Indirect labour 300,000 280,000 20,000

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Required;-
Determine the cost equation using account classification method and determine the cost of
producing 1,400 units

Solution
280,000
Variable cost b = =Shs 40
7,000

a = shs 20,000

Substituting in the Equation y= a +bx

Y= 20,000 + 40x
Hence the cost of producing 1400 units is

Y= 20,000 + 40(1,400)
Shs. 76,000

Illustration
In the year 2012 VIP incurred the following expenses to maintain 1500 lecturers.
Sh
Administration expenses (40% variable) 4,000,000
Lecturing pay (60% variable) 8,000,000
Airtime allowance (fixed) 1,000,000
Sundry expenses (50% fixed) 500,000
Soda allowance (variable) 300,000

Required;-
a) Using accounts analysis method, express an equation in form y = a + bx
b) Using the equation expressed above, estimate the total cost of 2000 lecturers incurred to be
employed in 2013.
Solution
Total cost Variable Fixed
Administration expenses 4,000,000 1,600,000 2,400,000
Lecturing pay 8,000,000 4,800,000 3,200,000
Airtime allowance 1,000,000 - 1,000,000
Sundry expenses 500,000 250,000 250,000
Soda allowance 300,000 300,000 ______
6,950,000 6,850,000

6,950,000
b= = 4633.33 a = 6,850,000
1500

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 TOPIC 4

COST ACCUMULATION
DEFINITION

Cost accumulation is the use of an accounting system to collect and maintain a database of the
expenses incurred by a business in the course of its operation.

The two main forms of cost accumulation are

a) a job order system where direct materials, staffing and overhead costs are collected under
assigned job number
b) A process costing system where costs are maintained and associated with a particular cost
center.

ACCOUNTING FOR MATERIALS AND INVENTORY

MATERIAL COSTING
Inventory consists of raw materials, W.I.P, consumer goods and spare parts etc.
Material costing entails the study of the inventory control systems of the items.

Stock costs

i) Purchase costs
Actual amount paid to the supplier of the stock item.

ii) Ordering costs

Costs of obtaining inventory Include
a) Clerical and admin cost associated with purchasing and receiving goods.
b) Transportation costs from supplier

iii) Holding costs

Are costs incurred as a result of keeping inventories of stores
It depends in quantities held may include:-
a) Cost of storage and stores operation e.g. rent and storage spares, salaries for staff.
b) Insurance costs – the higher the rate for inventory held the higher the premium.
c) Cost of capital – opportunity cost of capital held in the stocks
d) Risks of deterioration / deterioration cost.

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iv) Stock – out costs.
Arises where stocks kept are low which may lead to the company not being able to satisfy
demand since stocks are not enough
These costs include:-
a) Lost contribution due to unrealized sales.
b) Loss of future sales due to dissatisfied customers.
c) Loss of goodwill
d) Cost of production stoppage
e) Extra cost of urgent orders.

v) Optimal stock level

Stocks held should be maintained at optimal levels to help regulate the GNL of costs due to
problem of overstocking and undertaking.

This levels will help determine when the order, how much to order, the quantity to be held.
These levels include:-

a) The re-order level

This is that point once reached and order was to be placed with the supplier. It is the quantity in
stocks that goods will be ordered to avoid stock-outs. It is determined by considering the
expected the expected demand during re-order or lead time.

This is the amount that will be consumed during the time for waiting for deliveries. It should
satisfy the highest demand.

Recorder = max .consumption × max. Reorder period.

b) Maximum Stock level

The highest quantity of stock that can be held at any particular time .Stocks may not be allowed
to go beyond this level.

Max. Stock Level = re-order level + orderquantity - (Minimum consumption × Min.re-order

period)

c) Minimum stock levels

This is the lowest quantity of stocks that should be held. Stocks should not be allowed to fall
below this level. Also known as buffer level

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 TOPIC 5

COST BOOKKEEPING
Introduction
Bookkeeping involves the recording, storing and retrieving of financial transactions for a
company, nonprofit organization, individual, etc.

Common financial transactions and tasks that are involved in bookkeeping include:

 Billing for goods sold or services provided to clients.

 Recording receipts from customers.
 Verifying and recording invoices from suppliers.
 Paying suppliers.
 Processing employees' pay and the related governmental reports.
 Monitoring individual accounts receivable.
 Recording depreciation and other adjusting entries.
 Providing financial reports.

Today bookkeeping is done with the use of computer software.

COST Book keeping refers to a system of recording various cost information in the books of
account. There two main systems of cost book keeping. That is:

1. Integrated cost accounting system - A system of accounting where the cost and
financial accounts are kept in the same set of books. This system avoids the need for
separate set of books for financial and costing purposes

2. Interlocking cost accounting system. - Interlocking accounting system; this is an

accounting system where separate cost accounting and financial

THE FLOW OF COSTS IN AN A BUSINESS ENTERPRISE

Flow of costs refers to the manner in which costs move through a firm. Typically, the flow of
costs is relevant to a manufacturing environment where accountants must quantify what costs are
in raw materials, work in process, finished goods inventory and cost of goods sold. Flow of costs
does not only apply to inventory, but also to factors in other processes to which a cost is attached
such as labor and overhead.

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We say that costs flow through an accounting system. That is because they accumulate as the
product progresses through the various stages of production. Let's look at a typical product.
Before a product is started, no costs have been incurred. Workers stand ready to make the
product, inventory waits patiently in the warehouse, and the manufacturing plant contains all the
resources necessary to perform the manufacturing operation.
We first add materials into production, from the inventory. At the same time the accounting
department transfers the cost of inventory items to the Work in Process account, and the product
or job now has a value.
Next the workers start to convert the raw inventory into a product. As labor is added, the
accounting department transfers payroll costs to the Work in Process account, increasing the
value of the product or job.
Overhead costs are allocated to the product or job, based on the costing method used. As work
progresses on the product or job, it accumulates labor, materials and overhead costs. Finally, the
total finished product or job cost is transferred to Finished Goods, and when it is sold the cost is
transferred to cost of goods sold

COST BOOK KEEPING – INTERLOCKING AND INTEGRATED LEDGER SYSTEMS

There are two systems of cost book keeping

1. Non- integrated/inter locking system
2. Integrated system

INTERLOCKING LEDGER SYSTEMS

Interlocking accounting system is a system in which company records his transactions on the
basis of financial accounting principles and cost accounting principles separately. It means, there
will be two records of accounts. One is financial accounts record and second is cost accounts
record.

Features of Interlocking Accounting System

1. In interlocking accounting system, two set of accounts are prepared.

2. In interlocking accounting system, all big organisation, take benefits of cost accounts
separately from financial accounts. So, it can more control on cost.
3. In interlocking accounting ledger, cost accounts are maintained in cost ledger and
financial accounts are maintain in financial ledger.

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Advantages of Interlocking Accounting System

Main benefit of interlocking accounting system is for big companies. Big companies keep double
record by independent accountants. So, there is less chance of fraud and mistake because in
reconciliation process, such fraud and mistake can be found by auditor. So, both cost and
financial accountants will be more careful about this.

Disadvantages of Interlocking Accounting System

1. Because we keep double set of accounts, so there is more need of reconciliation of cost
and financial accounts for finding the reason of not matching cost accounts records with
financial accounts records. So, this time may be saved in integrated accounting system.
2. This is costly system because we need separate accounting staff for keeping separate set
of two accounts.
3. Sometime, all the users of our accounting records may be confused by seeing cost profit
and financial profit in our interlocking accounting system.

INTEGRATED LEDGER SYSTEMS

This is a system where cost accounts and financial accounts are combined in one set of accounts.

Features/Advantages

In integrated account, ledger system has a number of features which may be viewed as preferable
to the interlocking ledger system. In the recent decade, there has in fact been a movetowards
greater integration of accounting information requirements in a single unified system (an
integrated ledger system).

Such an integrated ledger system has the following advantages

1. Only one set of account is maintained and therefore there would be one profit results
hence no need of reconciling.
2. There is no duplication of work hence a saving in clerical cost.
3. Information obtained can be used by the management for decision making as well as for
financial reporting purposes.
4. Integrated account system help to coordinate the various forms of an organization.
5. It facilitates the use of IT systems.
6. Cost data can be obtained without delay as cost accounts are posted directly from the
basics of original entry.

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Disadvantages

1) Differences in the valuation of stock – In financial accounting stock is valued base on the
lower of cost and net realizable value whole in cost accounting stock is valued based on the
input cost. The difference in the valuation often brings a challenge in integrated accounts.
2) Problems associated with items appearing in cost accounting only e.g. overhead absorption,
notion cost and changing of depreciation based on the usage.

Items of expenditure that is unique to the two systems of accounting.

i. Appropriations of profits not dealt within the costing systems e.g. corporations tax,
dividends paid and proposed etc.
ii. Expenditure of a purely financial nature (i.e. nothing to do with manufacturing e.g. losses
on sale of fixed assets, interest on bank loans, bank charges etc.

In the financial Systems, the required ledgers are:

a) The General Ledger

b) Debtors Ledger (or Sales ledger)
c) Creditors Ledger (or Purchases ledger)

In the cost book-keeping system, the required ledgers are:

i) General Ledger Adjustment Account: It is sometimes called the cost ledger account.
ii) All the items extracted from the financial account are recorded in this account. The
balance in this account represents the total of all the balances of the impersonal accounts
extracted from the financial books. It completes the double entry in the cost accounts.
iii) Stores Ledger Control Account: This account shows all the transaction of materials e.g.
purchases, issuance of materials, returns to suppliers, etc. The balance of this account
represents in total the detailed balance of the stores account.
iv) Work in Progress Ledger Control Account: It shows the total work in progress at any
particular time.
v) Finished Goods Ledger Control Account: Receipts from production and transfer to
distribution department are entered in this account and the balance of this account shows
the total value of finished goods in stock.
vi) Production Overheads Control Account: It gives the total production overheads
incurred in the manufacture or production of goods in question.
vii) Wages Control Account: It shows the total wages incurred in the production of goods.

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 TOPIC 6

COSTING METHODS

Introduction
Manufacturing costing methods are accounting techniques that are used to help understand the
value of inputs and outputs in a production process. By tracking and categorizing this
information according to a rigorous accounting system, corporate management can determine
with a high degree of accuracy the cost per unit of production and other key performance
indicators. Management needs this information in order to make informed decisions about
production levels, pricing, competitive strategy, future investment, and a host of other concerns.
Such information is primarily necessary for internal use, or managerial accounting.

JOB ORDER COSTING

Job order costing or job costing is a system for assigning manufacturing costs to an individual
product or batches of products. Generally, the job order costing system is used only when the
products manufactured are sufficiently different from each other. (When products are identical or
nearly identical, the process costing system will likely be used.)

Since there is a significant variation in the products manufactured, the job order costing system
will create a job cost record for each item, job or special order. The job cost record will report
the direct materials and direct labor actually used plus the manufacturing overhead assigned to
each job.

An example of an industry where job order costing is used is the building construction industry
since each building is unique. The manufacturers of custom equipment or custom cabinetry are
also examples of companies that will keep track of production costs by item or job.

The job cost records also serve as the subsidiary ledger or documentation for the cost of the
work-in-process inventory, the finished goods inventory, and the cost of goods sold.

ACCOUNTING FOR JOB ORDER COSTING

The following journal entries relate to material procurement and issue from the store to the
production process.

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1. (a) Direct materials purchase
Dr Stores ledger control A/c XX
Cr Cash A/c XX
To record cash purchases

Dr Stores ledger control A/ c XX

Cr Creditors A/ c - for credit purchasers XX
To record credit purchases

(b) Return of materials to suppliers

Dr Cash A/ c or creditors control A/ c XX
Cr Stores ledger control A/ c XX
To record return of materials to suppliers

(c) Issue of materials from the store

Dr W.I.P. Control A/c X
Cr stores ledger control A/c for direct materials. XX
To record issue of direct materials from the store

Dr Factory overheads control A/ c XX

Cr Stores ledger control A/ c XX
To record issue of indirect materials from the store

Labour cost is measured and accumulated in the same way as material cost. It includes both
direct and indirect labour. Direct labour can be traced directly to the individual job where as
indirect labour cannot or if it has to be traced, it can only be done with expenditure of great
effort.

Labour costs are accumulated based on the time tickets prepared by workers. The worker needs
to indicate the duration of time he/she spent on a specific job or, when not assigned to a specific
job, what type of indirect labour task he was assigned to and the amount of time expended on the
task.

Total labour costs are calculated based on the time sheets submitted at the end of the day by all
the workers. An example of a time ticket is shown below STING

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Below are the journal entries passed to record direct and indirect labour.

2. (a) Direct Labor

Dr W.I.P. Control A/e XX
Cr Cash a/c XX
To record direct labour Paid in cash
(b) Accrued Direct Wages
Dr W.I.P. Control Ale XX
Cr Wages Control Ale XX
To record direct wages to be paid (accruing at a specific)
(c) Indirect Wages
Dr Factory overheads control AI c XX
Cr Wages Control Alc XX
To record indirect wages (labour cost) incurred

Production overheads go along with direct materials and direct labour in determining the cost per
unit or in batch processing or the cost of a particular job. However, it is difficult to
assignmanufacturing overheads because they cannot be traced directly to a particular job and it
consists of many unlike items with the variable and fixed cost components with fixed cost
constituting a large part of manufacturing overheads. Overheads are, therefore, assigned to units
of production through an allocation process.

The following journal entries are passed to record production overheads allocated for a
job.

3. Production Overheads

(i) (Not yet paid) Dr Factory overhead control A/ c XX

Cr Expenses/Creditor control A/c XX
To record unpaid production overheads

(ii) (When paid) Dr Expense / creditors Ale XX

Cr Cash A/c XX
To record payment of production overheads

After the allocation of manufacturing overheads, total cost for a job can then be determined and
summarized in a job Cost Sheet or job cost account. Examples of the above are shown below

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 TOPIC 7

MARGINAL AND ABSORPTION COSTING

Marginal and absorption costing are two different approaches to dealing with fixed production
overheads and whether or not they are included in valuing inventory.

Definition of Marginal Costing

Marginal Costing, also known as Variable Costing, is a costing method whereby decisions can be
taken regarding the ascertainment of total cost or the determination of fixed and variable cost in
order to find out the best process and product for production etc.

It identifies the Marginal Cost of production and shows its impact on profit for the change in the
output units. Marginal cost refers to the movement in the total cost, due to the production of an
additional unit of output.

In marginal costing all the variable costs are regarded as product related costs while fixed costs
are assumed as period costs. Therefore, fixed cost of production is posted to the Profit & Loss
Account. Moreover, fixed cost is also not given relevance while determining the selling price of
the product or at the time of valuation of closing stock (whether it is finished goods or Work in
Progress).

Illustration
Suppose company X makes two products A and B. A takes 2 labor hours each to make and B
takes 5 labor hours. What is the overhead cost per unit for A and B respectively if overheads are
absorbed on the basis of labor hours?

Solution

Step 1- Estimate overheads for the period.

X estimates it to be shs. 50,000

Step 2- Estimate activity level for the period

X estimates a total of 100,000 direct labor hours will be worked

Step 3- Divide the estimated overhead by budgeted activity level.

Absorption rate = Shs.50, 000
100, 000 hours
= shs.0.50 per direct labor hours

Step 4- Absorb overhead into the cost unit by applying absorption rate.

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 A B
Labor hours/unit 2 5
Absorption Rate(SHS) 0.5 0.5
Overhead absorbed/unit 1 2.5

Note: The activity level of 100,000 hours is the basis over which the overheads will be absorbed.
Different bases will used as shown in the table illustration previously.

Advantages of marginal costing

1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per unit is
avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current year’s
fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the difficulty of
ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed
overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost.
It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of
quantity and graphs. Comparative profitability and performance between two or more
products and divisions can easily be assessed and brought to the notice of management for
decision making.

Disadvantages of marginal costing

1. The separation of costs into fixed and variable is difficult and sometimes gives misleading
results.
2. Normal costing systems also apply overhead under normal operating volume and this shows
that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed
costs from inventories affect profit, and true and fair view of financial affairs of an
organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed
overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of
production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there
may be under or over absorption of the same.

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6. Control affected by means of budgetary control is also accepted by many. In order to know
the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a
valuable item. A system which ignores fixed costs is less effective since a major portion of
fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions
underlying the theory of marginal costing sometimes becomes unrealistic. For long term
profit planning, absorption costing is the only answer.

Definition of Absorption Costing

Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses
are allocated to the cost centers to recognize the total cost of production. These manufacturing
expenses include all fixed as well as variable costs. It is the traditional method for cost
ascertainment, also known by the name Full Absorption Costing.

In an absorption costing system, both the fixed and variable costs are regarded as product related
cost. In this method the objective behind the assignment of the total cost to cost center is to
recover it from the selling price of the product.

On the basis of function, the expenses are divided into Production, Administration and Selling &
Distribution. The following are the types of Absorption Costing:

 Activity Based Costing

 Job Costing
 Process Costing

Illustration
PQR limited is a manufacturer of sports shoes. The company uses a standard system. The
standard cost per pair of spots shoes is as follows:
Sh.
Direct materials 500
Direct labour: 4 hours × sh. 60 / hour 240
Production overheads
Variable 4 hours × sh. 30 / hour 120
Fixed 100
Standard production cost 960
Standard selling price 1,500

Additional information
1. During the month of March 2011, production was 10,000 units as planned but he sales
made were 8,000 units
2. The total fixed production overhead variance during the month was sh. 100,000 adverse

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 TOPIC 8

BUDGETING AND BUDGETARY CONTROL

Nature and Purposes of Budgets

A budget is a financial plan for the future concerning the revenues and costs of a business.
However, a budget is about much more than just financial numbers.

Budgetary control is the process by which financial control is exercised within an

organisation.

Budgets for income/revenue and expenditure are prepared in advance and then compared with
actual performance to establish any variances.

Managers are responsible for controllable costs within their budgets and are required to take
remedial action if the adverse variances arise and they are considered excessive.

A number of purposes of budgeting have been identified. They include:

1. Coordination
The budgetary process requires that visible detailed budgets are developed to cover each
activity, department or function in the organization. This is only possible when the effort
of one department’s budget is related to the budget of another department. In this way,
coordination of activities, function and department is achieved.

2. Communication
The full budgeting process involves liaison and discussion among all levels of
management. Both vertical and horizontal communication is necessary to ensure proper
coordination of activities. The budget itself may also act as a tool of communication of
what is expected of the departments and managers. High standards set calls for hard work
and more input in terms of labour, time and other resources.

3. Control
This is the process for comparing actual results with the budgeted results and reporting
upon variances. Budgets set a control gauge, which assists to accomplish the plans set
within agreed expenditure limits. The approach followed in the control process has five
basic steps:
i) Preparation of budgets based on the predetermined data on performance and prices.
ii) Measurement of actual performance and recording the data.
iii) Comparing the budget with the actual performance and recording the difference.
iv) Ascertaining reasons for the differences through, including others, variance analysis.
v) Taking corrective actions through administering of proper strategies and measures.

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 4. Motivation
Budgets may be seen as a bargaining process in which managers compete with each other
for scarce resources. Budgets set targets, which have to be achieved. Where budgetary
targets are tightly set, some individuals will be positively motivated towards achieving
them. Involvement of managers in the preparation of budgets motivates them towards
achieving the goals they have set themselves. However, imposing budgets on managers
will be discouraging as they may perceive the targets as unattainable.

5. Clarification of Responsibility and Authority

Budgetary process necessitates the organization of a business into responsibility and
budget centers with clear lines of responsibilities of each manager. This reduces
duplication of efforts. Each manager manages those items directly under his or her
control. To facilitate effective responsibility accounting, authority and responsibility
relationship must be balanced.

6. Planning
It is by Budgetary Planning that long-term plans are put into action. Planning involves
determination of objectives to be attained at a future predetermined time. When monetary
values are attached to plans they become budgets. Good planning without effective
control is time wasted. Unless plans are laid down in advance, there are no objectives
towards which control can be affected.

PREPARATION OF BUDGETS

MASTER BUDGET

A master budget is a set of interconnected budgets of sales, production costs, purchases,

incomes, etc. and it also includes pro forma financial statements. A budget is a plan of future
financial transactions. A master budget serves as planning and control tool to the management
since they can plan the business activities during the period on the basis of master budget. At the
end of each period, actual results can be compared with the master budget and necessary control
actions can be taken.

Components of Master Budget

Master budget has two major sections which are the operational budget and the financial budget.
They have following components:

Operational Budget
1. Sales Budget
2. Production Budget
3. Direct Material Purchases Budget
4. Direct Labor Budget
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 5. Overhead Budget
6. Selling and Administrative Expenses Budget
7. Cost of Goods Manufactured Budget

Financial Budget

1. Schedule of Expected Cash Receipts from Customers

2. Schedule of Expected Cash Payments to Suppliers
3. Cash Budget
4. Budgeted Income Statement
5. Budgeted Balance Sheet

Note that all of the above component budgets may not be included in the master budget of every
business. Some of these such as production budget and cost of goods manufactured budget are
not need by a non-manufacturing business.

FUNCTIONAL BUDGET

Functional budget are prepared for an individual function. For each operation in the organization a budget
is prepared
Sales budget, purchases budget, production budget, cash budget etc. are ex ample of functional budget.
This budget are consolidated to arrive at a master budget

Usefulness
a) A functional budget give target to the individual functional manager
b) Those who actually implement the budget prepare the functional budget. They are familiar with the
problems at the grassroots level. Therefore the budgets are more realistic and motivating.

Problems
(a) As the functional manager prepares the functional budget, the target may not be in line with the
strategic objectives or may conflict with the organizational objectives or inter departmental
objectives. This problem can be avoided by encouraging co-ordination between the functional
managers.
(b) Functional budgets are based on forecasts. There are many extern al as well as well as internal
environmental factors (such as a change in demand for a product, non-availability of a particular raw
material high attrition causing shortages of skilled labour, etc.)that affect the functional budgets. If
these factors behave differently than predicted, this may render the budgetary system ineffective

Production budget

The production budget is usually expressed in quantity and represents the sales budget adjusted for
opening closing finished stocks and work in progress.

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 TOPIC 9

STANDARD COSTING

DEFINITION

A standard, as the term is usually used in management accounting, is a budgeted amount for a
single unit of output. A standard cost for one unit of output is the budgeted production cost for
that unit. Standard costs are calculated using engineering estimates of standard quantities of
inputs, and budgeted prices of those inputs. For example, for an apparel manufacturer, standard
quantities of inputs are required yards of fabric per jean and required hours of sewing operator
labour per jean. Budgeted prices for those inputs are the budgeted cost per yard of fabric and the
budgeted labour wage rate.

Standard quantities of inputs can be established based on ideal performance, or on expected

performance, but are usually based on efficient and attainable performance. Research in
psychology has determined that most people will exert the greatest effort when goals are
somewhat difficult to attain, but not extremely difficult. If goals are easily attained, managers
and employees might not work as hard as they would if goals are challenging. But also, if goals
appear out of reach, managers and employees might resign themselves to falling short of the
goal, and might not work as hard as they otherwise would. For this reason, standards are often
established based on efficient and attainable performance.

Hence, a standard is a type of budgeted number; one characterized by a certain amount of rigor
in its determination, and by its ability to motivate managers and employees to work towards the
company’s objectives for production efficiency and cost control.

There is an important distinction between standard costs and a standard costing system. Standard
costs are a component in a standard costing system. However, even companies that do not use
standard costing systems can utilize standards for budgeting, planning, and variance analysis.

Uses of Standard Costing:

 Standard costing is for improving cost /cost control, simplify stock valuation and
improving costing and pricing of products.
 Can be applied to jobs, operations, processes and department and are used in
manufacturing, engineering, processing and service industries.

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Importance/ Advantages of standard costing

Standard costing systems provide cost information for various uses. These include:

(i) Setting of budgets

Standard costing systems assist in setting budgets and evaluating performance of the managers.
Standard costs are of particular importance for budgeting as they provide reliable and convenient
source of data to be used in the budgeting process. This, thus, reduces the budgetary time
because for instance, once the desired output units is known, then the budgeted cost is simply
derived by multiplying the budgeted cost per unit and the desired output in units.

(ii) Act as control devices and simplifies performance evaluation

Standard costing systems act as control devices by highlighting those costs or items that do not
conform to the budget or plan and thus alerts managers to those situations that need corrective
action. It acts as a yardstick against which costs and other items are measured to determine
whether the variance is favorable or unfavorable.

Once the budgets are prepared and agreed upon, the employees’ performance can be acceptably
measured against the set standards to determine whether the performance is acceptable or not.
Appropriate corrective measures can then be taken by the management.

(iii) Profit measurement and inventory valuation

Standard costing makes inventory valuation much easier as it simplifies the task of tracing costs
to products for inventory valuation and profit measurement purposes. If the actual number of
physical units in inventory is known then the value of inventory is simply obtained by
multiplying the standard cost per unit by the physical units. This is because, profit measurement
may be time consuming thus making it cumbersome to allocate costs as per the period incurred.
Variances are calculated later and written off in the books of account as period costs. This
enables the reflection of inventory at actual cost while at the same time determining the correct
profit figure.

(iv) Decision making

Standard costing provides a prediction of the future costs that can be used for decision making
purposes. Standard costs are preferable to estimates based on adjusted past costs because the
later may incorporate avoidable inefficiencies.

(v) Management by exception

Standard costing is an example of management exception. By studying the variances,
management’s attention is directed towards those items that are not proceeding as per the plan.
Most of management‟s time is saved and can be directed to other value adding activities.
Management only concentrates on the few exceptions reported.

(vi) Motivation
A standard costing system provides a challenging target that individuals are motivated to strive
and achieve. Involving the management and employees at all levels of operation in the setting of

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 TOPIC 10

COST MANAGEMENT
VALUE CHAIN RESEARCH AND DEVELOPMENT-DESIGN-PRODUCTION-
MARKETING DISTRIBUTION AND CUSTOMER CARE

VALUE CHAIN

A value chain is used to define the combination of all the activities and resources needed for
generating products and services. The value chain often consists of several operators
(manufacturing industry, wholesale trade, retail trade, customer, etc.) The value chain ends with
the customer.

Michael Porter introduced the value chain analysis concept in his 1985 book ‘ The Competitive
Advantage’ . Porter suggested that activities within an organisation add value to the service and
products that the organisation produces, and all these activities should be run at optimum level if
the organisation is to gain any real competitive advantage. If they are run efficiently the value
obtained should exceed the costs of running them i.e. customers should return to the organisation
and transact freely and willingly. Michael Porter suggested that the organisation is split into
‘primary activities’ and ‘support activities’.

Primary Activities

Inbound logistics : Refers to goods being obtained from the organisation's suppliers and to be
used for producing the end product.

Operations : Raw materials and goods are manufactured into the final product. Value is added to
the product at this stage as it moves through the production line.

Outbound logistics : Once the products have been manufactured they are ready to be distributed
to distribution centres, wholesalers, retailers or customers. Distribution of finished goods is
known as outbound logistics.

Marketing and Sales: Marketing must make sure that the product is targeted towards the correct
customer group. The marketing mix is used to establish an effective strategy, any competitive
advantage is clearly communicated to the target group through the promotional mix.

Services: After the product/service has been sold what support services does the organisation
offer customers?. This may come in the form of after sales training, guarantees and warranties.

With the above activities, any or a combination of them are essential if the firm are to develop
the "competitive advantage" which Porter talks about in his book.

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Support Activities

Support activities assist the primary activities in helping the organisation achieve its competitive
advantage. They include:

Procurement: This department must source raw materials for the business and obtain the best
price for doing so. The challenge for procurement is to obtain the best possible quality available
(on the market) for their budget.

Technology development: The use of technology to obtain a competitive advantage is very

important in today’s technological driven environment. Technology can be used in many ways
including production to reduce cost thus add value, research and development to develop new
products and the internet so customers have 24/7 access to the firm.

Human resource management: The organisation will have to recruit, train and develop the
correct people for the organisation to be successful. Staff will have to be motivated and paid the
‘market rate’ if they are to stay with the organisation and add value. Within the service sector
such as the airline industry, employees are the competitive advantage as customers are
purchasing a service, which is provided by employees; there isn't a product for the customer to
take away with them.

Firm infrastructure: Every organisations needs to ensure that their finances, legal structure and
management structure work efficiently and helps drive the organisation forward. Inefficient
infrastructures waste resources, could affect the firm's reputation and even leave it open to fines
and sanctions.

Types of value chain

There are various types of value chain:

i) Simple value chain: The value chain describes the full range of activities which are required
to bring a product or service from conception, through the different phases of production
(involving a combination of physical transformation and the input of various producer services),
delivery to final consumers, and final disposal after use.
ii) Extended value chain: In the real world, of course, value chains are much more complex
than this. For one thing, there tend to be many more links in the chain. Take, for example, the
case of the furniture industry. This involves the provision of seed inputs, chemicals, equipment
and water for the forestry sector. Cut logs pass to the sawmill sector which gets its primary
inputs from the machinery sector. From there, sawn timber moves to the furniture manufacturers
who, in turn, obtain inputs from the machinery, adhesives and paint industries and also draw on
design and branding skills from the service sector. Depending on which market is served, the
furniture then passes through various intermediary stages until it reaches the final customer, who
after use, consigns the furniture for recycling.

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 TOPIC 11

OVERVIEW OF PERFORMANCE MEASUREMENT

Introduction

Performance measurement and target-setting are important to the growth process. While many
small businesses can run themselves quite comfortably without much formal measurement or
target-setting, for growing businesses the control these processes offer can be indispensable.

The benefits of performance measurement

Knowing how the different areas of your business are performing is valuable information in its
own right, but a good measurement system will also let you examine the triggers for any changes
in performance. This puts you in a better position to manage your performance proactively.

One of the key challenges with performance management is selecting what to measure. The
priority here is to focus on quantifiable factors that are clearly linked to the drivers of success in
your business and your sector. These are known as key performance indicators (KPIs). See the
page in this guide on deciding what to measure.

Bear in mind that quantifiable isn't the same as financial. While financial measures of
performance are among the most widely used by businesses, nonfinancial measures can be just
as important.

For example, if your business succeeds or fails on the quality of its customer service, then that's
what you need to measure - through, for example, the number of complaints received. For more
information about financial measurement, see the page in this guide on measurement of your
financial performance.

The benefits of target-setting

If you've identified the key areas that drive your business performance and found a way to
measure them, then a natural next step is to start setting performance targets to give everyone in
your business a clear sense of what they should be aiming for.

Strategic visions can be difficult to communicate, but by breaking your top level objectives down
into smaller concrete targets you'll make it easier to manage the process of delivering them. In
this way, targets form a crucial link between strategy and day-to-day operations.

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FINANCIAL PERFORMANCE MEASURES

Financial performance exists at different levels of the organisation. This page is mostly
concerned with measuring the financial performance of the organisation as a whole, and of
measuring the performance of key projects. Furtehr measures are used as part of the particualr
problem of divisional performance appraisal.

Traditionally, financial performance measures are split into the following categories:

 Profitability
 Liquidity / working capital
 Gearing
 Investor ratios

Profitability measures

Return on capital employed (ROCE)

ROCE is a key measure of profitability. It shows the net profit that is generated from every $1
of assets employed.

 ROCE is sometimes calculated using PBIT instead of net profit. Use whichever figure is
given in the exam.
 Capital employed = total assets less current liabilities or total equity plus long-term debt.
 Capital employed may be based on net book value (NBV), gross book value or
replacement cost. (note to students: Use whichever figure is given in the exam.

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