Acc 310

ACC 310 Advanced Cost Accounting
Study Session 1
Cost Terms and Classifications
Introduction
The work of managers focuses on planning, which includes setting objectives and outlining how
to attain these objectives, and control, which includes the steps to take to ensure that the
objectives are realized. To carry out these planning and control responsibilities, managers need
ne
information about the organisation.
ation. From an accounting point of view, this information often
relates
es to the costs associated with a particular decision.
The term
erm cost is used in many different ways in Cost Accounting.. The reason is that there are
many types of costs, and these costs are classified differently according
cording to the immediate need of
management. For example, managers may want cost data to prepare external financial reports, to
prepare planning budgets, or to make decisions. Each different use of cost data demands a
different classification and definition of cost.
Learning Outcomess for Study Session 1
After completing this study session

session, you will be able to:
1. Define Cost Accounting,
2. Describe the interplay of Cost Accounting vis

vis-a-vis
vis Financial Accounting and
Management Accounting in Managerial decision
decision-making.
3. Identify the types and elements of costs.
4. Recognisethe desirable
able conditions for the establishment of good costing system.
1.0 The Domain of Cost Accounting
The two distinct areas served by cost accounting are sometimes called cost finding
andmanagement accounting. Cost finding was originally the sole interest of cost
co accounting.
Itspurpose is to calculate the average cost per unit of products produced by a manufacturer.
manu The
1
accounting rules for determining the average cost per unit are established to facilitatepreparation
of income statements and balance sheet
Generally, accepted accounting principles require that inventories be reported on the basis oftheir
costs. When the same units are sold, they are reported in the income statements as cost of goods
sold at this same cost. In a manufacturing organisation, this cost must be determined by an
averaging process which satisfies general accepted accounting principles.
Management Accounting is the newer interest of cost accounting. Its purpose is to

providemanagers with information, which aids decision making. There are no generally
acceptedprinciples which specify how management accounting information is to be reported.
Whilesystems such as direct costing and standard costing exist in management accounting,
eachaccounting report should be tailored to the needs of the decision and the decision maker.
Themost effective systems result when the manager-decision maker and the accountant
worktogether until the accountant understands the decision to be made and the
managerunderstands the source of the information that the accountant will report.
Generally, the service which the accounting function provides for the assistance ofmanagement
consists basically in presenting information bearing on the efficiency of pastoperations and
current activities, as well as projections of probable future results.
1.1 What is Cost?
The dress you wear costs you money. The biro you use in writing costs you money. Therefore
cost is an amount used or spent in obtaining a unit of product, service or time. It is the value of
economic activities.
1.2 What then is “Cost Accounting?
Put simply, it means keeping accounts of the costs of items of production of goods and services.
Cost Accounting is that part of Management Accounting which establishes budgets and standard
cost and actual costs of operations, processes, departments or products and the analysis of
variances, profitability or social use of funds (as defined by Chartered Institute of Management
Accountants, CIMA).
1.3 Uses of Costing
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Costing (or Cost Accounting) as defined, forms the basis of the internal financialinformation
system. It is used in:
- Ascertaining and estimating of costs;

- Planning and controlling of costs;
- Decision making;
- Fixing of selling prices;
- Inventory control;
- Measurement of efficiency.
1.4 Objectives of Costing
Cost accounting has the following objectives:
- For cost and profit determination

- Valuation of stocks and work – in – progress
- Preparation of budgets, forecasts and other controlled data for controlledperiods.
- Creation of reporting system which enables managers to take corrective action where
necessary.
- Provision of information for decision making.
1.5 Benefits of Cost Accounting
An organisation can derive the following benefits from Cost Accounting system:
- Disclosure of profitable and unprofitable activities.

- Identification of wastes, particularly in relation to usage of materials and labour
- Analysis of movement in profit
- Assistance in estimation of selling price
- Valuation of stocks
- Development of planning and controlling information
- Definition of responsibility to staff
1.6 Desirable Conditions for the Establishment of a good Costing System
The following conditions are necessary for the establishment of sound system of
Cost Accounting:
- There must be an official system of stores and stocks
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- There must be a well-designed wages procedure including methods of charging

labour cost to production.
- There must be a sound plan for the collection of all indirect expenses.
- The cost and financial accounting system should preferably be an integrated system if
not a separate system and must allow for easy reconciliation.
- The status of the Cost Accountant should be well defined and his responsibilities and
duties made clear.
1.7 Types of Cost
Cost may be classified in many ways namely: (a) by Nature; and (b) byfunction
(a) Classification of Costs by Nature:

(i) Direct Costs:
These are costs of materials, labour and expenses which can be traced to a particular activity,
Cost Unit or Cost Centre.
They are normally identified under three headings:
- Direct Materials
- Direct Labour
- Direct Expenses
Direct Material Costs: These are the costs of materials entering into and becoming constituent
element of a product or services. The term “Materials” cover raw materials like the quantity of
raw cotton used to produce a length of thread; components like those used in assembling a
Television set and finished products and the quantity of paper used in printing a book. They are
directly related to Cost Unit.
Direct Labour Cost: This is the cost of remuneration for work time applied directly to a product
or service. For example, the assembly time for the television set or the time spent in carrying out
the editing of a client’s book.
Direct Expenses Costs: These are costs which are incurred for a specific product or service.
Typical examples would be the hire of earth-moving equipment for particular public works
contract, or the cost of work sub-contracted to a third party.
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Note:-The total of the all direct costs is sometimes referred to as the PRIME COSTof the
productor activity concerned.
(ii) Indirect Costs:
These are costs of materials, Labour and Expenses which cannot be traced to a particular cost
unit or cost centre; but are apportioned over a number of cost units or cost centers. They are
indirectly related to cost units.
The elements of Direct and Indirect Costs can thus be summarized as follows:
MATERIAL = DIRECT + INDIRECT MATERIAL
LABOUR = DIRECT + INDIRECT LABOUR
EXPENSES = DIRECT + INDIRECT EXPENSES
TOTAL COST = PRIME COST + OVERHEAD COST
(b) Classification of Costs by Function:

(i) Fixed costs:-These are the costs that relate to time and are not influenced by production
or sales levels within a defined range of activity provided the overall capacity of the
business is not exceeded. They remain the same irrespective of the level of output.
Examples are Rent, Insurance and Salaries etc
(ii) Variable Costs: These are costs that vary or move with the level of production or
(sometimes) with the level of sales, e.g., direct material costs, wages and direct
expenses.
(c) Costs can be classified on the basis of FUNCTIONS. Thus, we have production costs,
selling & distribution costs and administration costs.
Terminologies
(i) Cost: This is the value of economic activities utilized. Cost is usage multiplied by
price.
(ii) Cost Unit: This is a unit of product, or service or time or a group of these to
which costs can be related for the purpose of cost control. The nature of the cost
unit depends on the type of goods being produced or the type of services being
offered by the business concern. Examples are barrels of beer, tones of chemicals,
hours spent on computer time-sharing.
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(iii) Cost Centre: This is a location, person or an item or a group of these to which
costs can be related for the purpose of cost control. Cost centers may either be
productive cost centers, or service cost centers linked with production and
administration selling cost centers. It is pertinent to state that cost unit is a sub-set
of cost centre while cost centre is a universal set.
1.8 Costing Methods and Techniques
A costing method is a method of costing which is designed to suit the way goods are processed
or manufactured or the way that services are provided. Thus, each firm will have a costing
method which has unique features. Nevertheless, there will be recognizably common features of
the costing systems of firms who are broadly in the same line of business.
1.8.1 Categories of Costing Methods
Two broad categories:
(i) Specific Order Costing and

(ii) Continuous Operation/Process Costing (Unit Costing)
Specific Order Costing: This is the basic costing method applicable where the work consists of
separate contracts, jobs or batches. In most cases the job or contract is the cost unit and
frequently, but not always, the jobs on contracts are different from each other. The main sub
divisions of specific order costing are:
(i) Job Costing

(ii) Contract Costing
(iii)Batch Costing
Continuous Operation/process/Unit Costing: This is the basic costing method applicable

where goods or services result from a sequence of conditions or repetitive operations or
processes to which costs are charged before being averaged over the units produced during the
period.
The key feature of this definition is that operation costing seeks to establish the average cost per
unit during a period for a number of identical cost units. The main Sub-divisions of operations
costing are:
(i) Process costing including Joint Product and by-product.
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(ii) Service/function costing. This type of costing although not relating to production cost
units uses similar principles whereby an average cost is established per unit of
service. For example, an average cost per meal supplied, could be calculated for the
canteen
nteen which is a service centre.
1.8.2 Costing Methods – Categories and Sub-Divisions
Figure 1.1
SPECIFIC ORDER CONTINUOUS

COSTING OPERATION COSTING
JOB BATCH PROCESS SERVICE/

COSTING CONTRACT COSTING COSTING FUNCTION
COSTING COSTING
Source: Costing, By LuceyT.
1.8.3 Costing Techniques:
Costing technique is a term used to describe the measurement of historical costs with a view to
help in the prediction of future costs for management decision making, that is historical
information is analyzed to provide estimates on which to base future expectations.
Examples
mples of costing techniques are
are:
- Total absorption costing

- Marginal Costing, and
- Standard Costing
1.9 Summary
In this study session we have looked at the definition of Cost Accounting, how cost accounting
information can be used, how cost accounting infor
information
mation forms the basis of financial
accounting. We also explained the objectives of cost accounting, the desirable conditions for
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establishing a good cost accounting system in a Company. The different types of Cost were
explained and the terminologies used in Cost Accounting were discussed.
Costing methods and Costing techniques were explained and the use of appropriate diagram to
aid understanding of these concepts was justified. Examples of Costing techniques used in Cost
accounting were given to buttress this module.
1.10 Self Assessment Questions
(a) Define Cost Accounting

(b) Explain and carefully distinguish between: Direct and Indirect Cost
(c) What are the benefits of Cost Accounting?
(d) What are the conditions for the establishment of good costing system?
(e) Explain how Cost Accounting vis-a-vis Financial Accounting and Management
Accounting aid Managerial decision-making.
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Study Session 2
Control of Direct Materials
Introduction
Inventories are the various items that are held in stock bby y an organization. Inventory
management is described as the method of ensuring that th thee right quantity of the right quality of
the relevant inventory is available at the right time and in the right place.
Good inventory management controls or minimizes cos
costs
ts that are directly associated with the
organizations inventory.
Learning Outcomes for Study Session 2
At the conclusion of this study session you should be able to:
1. Analysethe
the essentials of material control
2. Understand the material control process
3. Farmiliarise yourselfwith
with the control levels of calculations
4. Farmiliarisewith
with the economic Order Quantity (EOQ) computation.
2.0 The Essentials of Materials Control
The essentials of material control prior to actual use in production can be summarized as follows:
a. Materials of the appropriate quality and specification should be purchased only
on when
required and appropriately authorized.
b. The suppliers chosen should represent an appropriate balanc
balancee between quality, price
and delivery
c. Materials should be properly received and inspected.
d. Appropriate storage facilities should be provided and stock levels physically checked
on a regular basis.
e. Direct materials used in production should be charged to production
roduction on an appropriate
and consistent pricing basis.
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f. Indirect materials used in production and non production departments should be

appropriately charged to the correct cost centre and included in the overheads of the
centre.
g. The documentation, accounting systems and controls at each stage should be well
designed and effective.
h. Stock taking must be well organized to ensure that stock quantities on hand are
available when required.
2.1 Objectives of Holding Stocks
The principal reasons why the businesses hold stocks include:
1. It acts as buffer stock at a time when there are unusually high rate of consumption or
usage.
2. It enables the organization to take an advantage of quantity discount.
3. The organization can take advantage of seasonal & other price fluctuation.
4. It can be used as a reserve on those occasions when the time between when order is
placed and the goods are actually received into store is longer than average.
5. Any delay in production as a result of stock out can be kept to the minimum.
6. It can be used as a deliberate investment policy.
2.2 Cost of Holding Stock
The total cost of holding stock can be classified into four groups.
(i) The purchase cost of inventory
(ii) Ordering cost
(iii) Carrying/holding cost
(iv) Stock out cost = cost of being without stock
The Purchase Costs of Inventory: - These are the actual purchase costs of the stock items.
They are the supplier’s price for each of the stock items. The Unit cost of the items may be fixed
if no quantity discount is allowed and it may vary with quantity discount.
Ordering Cost: - These are the costs incurred in placing the order of item up to the point of
receiving the goods into the company’s store. Most of these costs are administrative in nature
and they include the following:
- Transportation cost
- Cost of getting payment to supplier
- The cost of communication with the supplier
- Cost of loading and off-loading
- Clearing and forwarding charges.
Total annual ordering cost increases as the number of order per annum increases. In other words,
the higher the number of order placed, the higher the total ordering cost.
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Carrying or Holding Costing:- These are Costs incurred whenever an item of stock is held by
an organization. They include the following:
a. Cost of breakages.
b. Interest on capital invested in stocks
c. Insurance premium of stock and security
d. Storage cost which may include heating, rent, and lighting.
e. Pilferage, evaporation and other damage.
f. Deterioration and obsolescence
g. Audit, stock taking, stock recording costs.
The annual carrying cost incurred by an organization increases as the quantity of stock held
increases.
Stock out Costs: These are the costs incurred when customers demand cannot be met because
the stock is exhausted. This may lead to loss of current sales in order to fulfill commitments.
Costly emergency procedure may be necessary in an attempt to maintain customer’s goodwill. If
the customer cannot wait for emergency delivery, shortages can lead to loss of customer’s
goodwill, hence, future sales will be affected.
The larger the stock held, the lower the possibility of running out of stock,therefore, the lower
the ordering cost. The decision making of an inventory control system is hard to make in order to
minimize the total inventory related costs that we have just discussed. Therefore, the inventory
policy consists of selecting the best value for two decision variables e.g.
1. When to order or produce (Re-order level)
2. How much to order or produce, that is the Economic Order Quantity (EOQ)
2.3 Stock Control Terminologies
i. Demand: This is total quantity of materials needed – demand could be per week,
month, or per year.
ii. Lead Time: This is the time interval between when an order is placed and when the
goods are received.
iii. Economic Order Quantity: This is the re-order quantity that is calculated to
minimize total relevant cost (inventory) each time a replenishment order is placed.
iv. Physical Stock: These are the items that can be physically observed in the store.
v. Free Stocks: These are physical stock plus orders that have been placed less
unfulfilled order(s) from customers.
vi. Buffer Stock: These are stock allowance reserved to bridge the gap of poor
forecasting.
vii. Maximum Stock: This is a level of stock above which the stock may not be
allowed to rise or a desirable level.
viii. Minimum Stock: This is a level of stock below which the stock level may not be
allowed to fall or a desirable level.
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2.4 Factors to Be Considered When Determining the Re-Order Level:

The two main factors to be considered are:
- Lead Time = LT
- Demand (rate of consumption) during the lead time.
2.5 Stock Levels

There are four predetermined critical levels for each item of material in store.
These are:
1. Maximum level = (Max L)
2. Minimum level = (Min L)
3. Re-order level = (R L)
4. Re-order Quantity = (R Q)
Maximum Level: The Maximum stock level is that above which stocks should not normally
be allowed to rise. It is set by:
1. The rate of consumption of material
2. Lead time or time necessary to obtain new deliveries
3. Re-order level of material.
4. The capital available and the opportunity to acquire items at low price
5. Re-order quantity of the material
6. The cost of storage and the availability of storage space.
7. The risk of obsolescence and deterioration
8. Insurance costs.
Maximum stock level can be calculated as follows:
Max level = RL + RQ - (Min usage x Min Lead time)
Minimum Stock Level: This is the stock level below which stock may not be allowed to fall. If
stocks go below this level, then there is the possibility of shortage of supplies which may lead to
production stoppage. It is set by considering two factors:
1. The rate of consumption of material in particular during lead time, and
2. Lead-time-which is the same thing as the period necessary to obtain delivery of new
materials.
This could be calculated as follow:
ML = RL - (Average usage x Average Lead Time)
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Re- Order Level: This is a level of stock at which a fresh order is placed or required. It lies
between the minimum level and the maximum level. It is set after considering:
a. Rate of consumption of material.
b. The delivery (or lead) time
c. The minimum level of stock.
Re-order level is calculated as follows:

RL = Max usage x Max LT) = (Maximum Usage x Maximum Lead Time)
Reorder Level Quantity: This is the quantity that is ordered each time a new order is placed. It
is usually referred to as the Economic Order Quantity. It is set by considering two major factors:
1. Carrying cost of the material which includes interest on capital used, cost of
deterioration and risk, insurance cost and cost of storage.
2. Ordering cost which includes costs like transportation, cost of preparing purchase
order, cost of receiving and inspecting materials and postage costs.
The other factor to be considered in fixing re-order quantity is the rate of consumption of the
material.
Re- order Qty is calculated as follows:
RQ = Max Level – RL + (Min usage x Min LT)
Average Stock Held: This is calculated as: Max level + Min level
2
OR
Alternative method: Average Stock = Min Stock + ½ RQ
2.6 The Economic Order Quantity (EOQ)
This is the optimum ordering quantity for an item of stock which will minimize the balance of
cost between carrying costs and ordering costs. In order words, EOQ is the fixed quantity that is
ordered at any point in time which minimises the total inventory related cost. It is used for
material planning and control.
Assumption:-
As a model, EOQ rely on certain assumptions under which it can operate. Some of these
assumptions are:
1. Purchase price per unit is known and constant, therefore quantity discount are not
allowed.
2. Annual demand is known and utilization rate is constant throughout the year.
3. Lead Time which is the time period between when an order is contracted and the items
are received is known and is constant.
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4. There is an instantaneous build-up of stock. In other words, all the units ordered are
delivered at the same time.
5. The ordering cost or cost per order is known and is constant.
6. At EOQ, ordering cost is equal to carrying costs.
With the inclusion of assumptions two and three, stock out costs arenot relevant under the basic
EOQ model. The purchase costs of inventory are also not relevant in the basic EOQ model
because of the inclusion of assumptions 1 and 2. This is so because unit costs per stock item
remain the same irrespective of the size of the purchase. The total inventory costs that can
therefore be minimized under EOQ model are those of the ordering cost and carrying cost. This
can be represented mathematically as:
Total Cost = Total Ordering Cost + Total Carrying Cost
2.7 Determination of EOQ

There are three methods of determining the EOQ of a given stock item. These methodsare:
1. Tabular method
2. Algebraic method, and
3. Graphical method
Tabular Method:- The objective is to determine the value of order quantity, Q that will
minimise total inventory related cost. For the purpose of our basic EOQ model, the following
notations could be used.
Let D = Annual demand
N = Number of order
O = Ordering cost or cost per order
Q = EOQ
C = Carrying cost per unit per year
Ordering Cost: = Number of order x Ordering cost per order
= Annual Demand x Ordering Cost per Order
Quantity per Order
= D X O = DO
Q Q
Carrying Cost = Average Stock x Carrying Cost per unit per year
Average Stock = Max Stock + Min Stock
2
Therefore Q + Zero x C = Q x C =QC
2 2 2
Total Relevant Cost = Ordering Cost + Carrying Cost
= DO + QC
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Q 2
ITQ
Using the information system below you are required to prepare a schedule showing the
associated cost of 1, 2,3,4,5 and 6 orders placed during a year for a single product. From the
schedule state the number of orders to be placed in a year and the EOQ. The Th following
information were provided.
1. Annual usage of the product = 600 units
2. Unit Cost of the product = N2.40k
3. Cost of placing an order = N6.00
4. Stock holding cost as a % of
Average stock value = 20%
Table 2.1: SOLUTION

No of orders 1 2 3 4 5 6
Qty per order (given) 600 300 200150 120 100
Ordering Cost = DO N N N N N N
Q 6 12 18 24 30 36
Carrying Cost = QC 144 72 48 36 28.8 24

2
Total Relevant Cost 150 84 66 60 58.8 60
Our EOQ is at 120 level =N

N58.8
58.8 in value terms. This is the level of least cost.
No of orders to be placed = 600 = 5

120
Workings
9. Ordering Cost of = N=
= 6 for order No. 1 is derived as follows:
600 x N66 = N6
15
600
Ordering Cost of = N=12 for order No. 2 is derived as follows:
600 x N6 = N12
300
10. Carrying Cost of =N=144 for Order No 1 is derived as follows:
600 x 20% of N2.40 = N144
2
11. Carrying Cost of N72 for Order No. 2 is derived as follows:
300 x 20% of N 2.40 = N72
2
Algebraic Method:
Under the algebraic method EOQ is determined by the following formula
EOQ = 2DO
C
Where:
D = Annual Demand
O = Cost per Order
C = Carrying Cost
From the above example, EOQ could be calculated as follows:
EOQ = 2DO
C
= 2 x 600 x 6 = 122
122 can approximate to 120. N0.48 = 20% of N2.40
The Graphical Method:
The higher the ordered quantity the lower the total annual ordering cost. The higher the ordered
quantity on the other hand, the higher the total annual carrying cost.
If both ordering cost and carrying cost functions are plotted on a graph sheet, the order quantity
that corresponds with the point of interception of the two cost curves is the EOQ. Alternatively,
if the total inventory related cost function is plotted on a graph sheet, it will decrease steadily to a
minimum point and then rise. The order quantity which corresponds with the minimum point of
the total cost curve is the EOQ.
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If our example 1 above is plotted graphically, making the horizontal axis for quantity and the
vertical axis as cost, we have a graphical representation as below:
t
C os
t
v an
l e
l Re st
ot a Co
T g
rryi n
Ca t
t al
C os
COST N To g
e rin
r d
t alO
To
QTY
EOQ
Figure 2.1
2.8 Derivation of EOQ Formula

Formula:
At EOQ, ordering cost is a approximated to carrying cost i.e

i.e. OC = CC
i.e. DO = QC
Q 2
Cross multiplying
We have: Q² C = 2DO
Thus Q² = 2DO
C
Therefore Q = 2DO
C
2.9 EOQ Model with Quantity Discount
We had stated earlier in this module that:
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Total relevant material cost = purchase costs +orderin

+orderingg costs + carrying costing + stock
out costs.
In the basic EOQ we do not inclu

include stock out cost because
ause it is zero and Purchase Cost because
it is constant. However, if quantity discoun
discounts are offered then purchase costs become relevant
since purchase costs now depend upon the price quoted.
The procedure is to calculate EOQ without any quantity

ntity discount. If the discount is granted at a
level above the EOQ, the question is whether it is worthwhile to buy the extra quantity above the
EOQ, and take advantage of the discount. When quantity discounts are offered we have two
savings in costt and one additional increase in costs.
The savings in cost arise from two sources. They are:
(i) Savings due to the discount itself. If for example, our annual requirement = 1,000
units and normal purchase cost is =N=10.00, if we ta
take
ke a discount of 5% so that the
new purchase cost is =N=9.50 then there is a saving of 1,000x0.50=N=500.00.
(ii) Savings due to reduced ordering cost. If we buy more than the EOQ at a time then
we have fewer numbers of orders to make. The extra cost is due to keeping a greater
level of stock and hence a higher carrying cost.
A firm’s requirement of material X is 1,200 units. For orders of 200 units or less the price per
unit is N 20.00. On orders exceeding 200 units, the price is reduced by 5%. Carrying cost
cos per
unit per annum is N4.00 and ordering cost per order is N5.00.
5.00. Determine the appropriate
order to take. (Adopted from “Coping
ing with Cost Accounting” By Eddy Omolehinwa).
EOQ = 2 x 1,200 x 50
4
= 173
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At a level of 173 units, discount cannot be taken because no discount until order quantity is
greater than 200. To qualify for the discount, the minimum order quantity =201.
Comparative Cost
Total purchase cost if 173 units are bought at a time
= 1,200xN20 = N24,000
Carrying cost = 173 x N4.00 = N346
2
Ordering cost = 1,200 x N50 =N347
173
Total cost = N24,000 + N346 +347 = N24,693
If 201 units are bought at every order,
Total purchase cost = 1,200 x N19.00 = N22, 800
Carrying cost = 201 x N4.00 =N402

2
Ordering cost = 1,200xN50.00 =N299

201
Total Cost = N23, 501
Net savings by buying 201 units at every order
= N 24, 693 – N 23, 501 = N 1, 192
Note:
The problem could have been solved by finding the net savings in cost as calculated below:
(a) Savings due to reduction in price
= 1,200 x N1.00 = 1,200
(b) Savings due to reduced number of orders
= 1,200 - 1,200 x N50.00 = 48

173 201 1,248
Gross savings in cost
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Less increase in carrying cost
= 201 - 173 x N4.00 = 56

2 2
Net saving in cost = 1,192
As long as we have a net cost savings, the discount should be accepted.
2.10 Summary
This study session discussed the essentials of materials control, the objectives of holding stocks,
costs of holding stocks with detailed explanation of purchase costs, ordering cost,
carrying/holding cost, and stock out cost. Different stock control termi
terminologies
nologies were explained.
We looked at the various stock levels and the economic order quantity (EOQ). Determination of
the EOQ using the Tabular, Algebraic and Graphical methods was explained.
The module concludes with EOQ model with quantity discount.
2.11 Self Assessment Question

Questions
(i) Justify the need for material control

(ii) Explain the material control process
(iii)Debasco
Debasco Motors Limited buys batteries from an overseas supplier at =N= 20 per
battery. Total annual requirement are 25,000 batteries per working day.
da The
following cost data are available.
- Desired annual return on stock investment is 10%
i.e. (10% x stock value)
= 10% x N20 = N2
- Sundry cost per unit per year is 50k
(Therefore total carrying cost per unit) per year is =N=2.50
= =N=2 + 50k
- Clerical cost, stationery, telephone etc is =N=50.00
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You are required to prepare in tabular from the total relevant cost for each of the
following order sizes:
(i) 250,500, 1,000, 2,000

2,000,4,000,8,000, 16,000, 20,000,25,000
(ii) What is the EOQ quantity for batteries at Debasco Mot
Motors
ors Ltd. Why? Confirm your
result by the use of EOQ formula.
(iii)Given
Given that the lead time, i.e. the time interval between placing an order and receiving
delivery is 3 weeks. At what level should a fresh orde
order be placed?
Should you require more explanation on this study session, please do not hesitate to contact your
e-tutor via the LMS.
Are you in need of General Help as regards your studies? Do not hesitate to contact
the DLI IAG Center by ee-mail or phone on:
iag@dli.unilag.edu.ng
08033366677
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Study Session 3
Material Pricing, Issue and Stocks
Introduction
Companies may have stocks or inventories held in the form of raw materials, work-in-progress,
work
finished goods, products bought for resale, and service items. Often the value of such
suc stock is
high, representing a considerable sum of money and so it is important that it is
valuedconsistently, and proper controls are kept oover the physical stock.
At the end of this study session you will be able to:
1. Explain the factors to be considered in the in

installation
stallation of efficient store keeping
system
2. State how to account

ccount for material stocks
3. Explain problems of material pricing
4. Solve problems on material pricing using all the pricing methods
3.0 Factors to Consider For the Installation of an Efficient Store Keeping System:
System
(a) Store Layout: The gangway should be made wide enough for appropriate handling
equipment and the location of each item should be determined logically e.g. by
basing it on code number for easy access.
(b) Issue: This should be based on material requisitions w
which
hich have been authorized on
first-in-first-out
out basis to ensure that old stocks are used first.
(c) Centralised/Decentralised
/Decentralised Stores: A decision should be made as to the
bestarrangement
arrangement to be used in a particular case.
22
(d) Goods Received: Adequate arrangement should be made to ensure that no delivery
is left without a signature from authorized officer to confirm receipt. Goods must be
checked to ensure quality and specification and also to ensure that claims are made
for breakages. Quantity received must be recorded on Goods Received Note (GRN)
so that stock record can be updated and purchase invoice cleared for payment.
(e) Containers / Shelves: These should be designed so as to minimize deterioration and
damages to Stocks. Appropriate Security arrangements should also be made for high
valued items.
(f) Continuous Stocktaking: This should be carried out by staff independent of the
stock keeper in order to ensure the accuracy of perpetual inventory record and to act
as a control over the store keeper.
(g) Perpetual Stocktaking: This is a system of stock-taking and knowing the quantity
of stock without actually resorting to physical stock count. It is a method of
recording stores balances after every transaction. There is the need for management
to know from time to time the stock level of every item. Perpetual inventory shows
records of movements of materials in and out of stores using the bin card located in
the stores Dept and the perpetual inventory record located in the Accounts Dept.
(h) Re-Order Level and Re-Order Quantity: This should be established for all stock
items in order to ensure that re-order and replenishment are carried out efficiently.
(i) Slow-Moving Items: Periodic check should be carried out for instance by
calculating stock turnover in order to identify and deal with slow-moving or obsolete
stocks.
3.1 Problems of Materials Pricing
In practice the problem of pricing material issues, which thus determines product costs, is
complicated by several factors:
(a) Rapidly changing prices for bought in materials and components.

(b) The stock of any given material is usually made up of several deliveries which may
have been made at different prices.
(c) The frequent impossibility (and undesirability from a costing viewpoint) of
identifying items with their delivery consignment.
23
(d) The sensitivity of profit calculations to the pricing method adopted particularly
where materials form a large part of total cost.
No one pricing method has all the advantages and it is necessary to use the most appropriate
system to fulfill the requirements of a particular situation.
3.2 Accounting for Material Stocks:
When an issue is made from stores, the materials requisition would be passed to the cost
department to be priced and extended for appropriate ledger entries to be made. At the simplest
these entries would be:
Table 3.1: Issues from Store Double Entry
Debit
Work-in-Progress Control A/C

(for direct material issues)
Or
Overhead Control A/C
(for indirect material issues)
Credit
Store Ledger Control A/C
To be able to use some of the pricing systems described below (e.g., the FIFO and LIFO
methods) the stock ordering system has to be comprehensive enough not only to record overall
quantities and prices, but also the number or quantity received in any one batch. This is so that
issues can be nominally identified against batches, which are necessary to establish the
appropriate price to be charged.
3.3 Pricing Systems
There are many methods, but only four will be considered here:
(a) First-In-First-Out (FIFO):
This method uses the price of the first batch received for all issues until all the units in this
batch are exhausted after which the price of the next batch becomes the issuing price.
Advantages
24
i. It is realistic, i.e., it ensures items are issued to shop floor or factory in order of
receipts.
ii. Valuation of stock balance is a fair commercial value of stock.
iii. No profit or loss arises on valuation, that is, value of issue after following
forunrealized profit or loss is equal to cost of purchase.
iv. The system is acceptable to the Inland Revenue and is acceptable according to SAS
4on stocks and work-in-progress.
Disadvantages:
i. The system is administratively clumsy because of the necessity to keep track of

each batch.
ii. It renders cost comparison between jobs difficult because the material issue price
may vary from batch to batch.
iii. Issuing price may not reflect current economic value.
(b) Last-In-First-Out (LIFO)
This method uses prices of the last batch received for issues until all units from the
batch has been exhausted or issued when the price of the previous batch becomes the
issuing price.
Advantages:
i. This method keeps value of issue close to current economic value.
ii. Valuation of stock is usually very conservative
iii. In periods of rising prices, LIFO, by keeping down disclosed profits, provides a
hedge against inflation.
Disadvantages:
i. It is cumbersome to apply
ii. It is not realistic because it assumes physical issue principle to be the opposite of
what is actually happening.
iii. The LIFO system is not recommended by SAS 4
iv. Renders cost comparison between jobs difficult
v. Should issue dip into “Old Stock”, then such issue will be valued at an out of the
date price.
25
(c) Weighted Average Method: This is a weighted average system where the issue price
is recalculated after each receipt taking into account both quantities and money value
Advantages:
i. It is less complicated to administer than LIFO and FIFO
ii. It makes cost comparison between jobs using similar materials somewhat easier.
iii. Because the method is based on actual costs, no unrealized stock profits and
losses occur
iv. Where purchase prices are constantly fluctuating, this method is likely to give
more satisfactory results than LIFO or FIFO as it will tend to even out the price
fluctuations.
v. It is acceptable to the Inland Revenue
Disadvantages:
i. It is not an actual buying in price, except by coincidence.
ii. Issues may not be at economic value
iii. Issuing price may run into a number of decimal places.
(d) Standard Price Method:

Standard price is defined as “a pre-determined price fixed on the basis of a
specification of a product or service and of all factors affecting that price”.
It is an average price predicted for future period and all issues and returns would be
made at the standard price for the period concerned.
A standard issue price for materials may be used even where a firm does not use a full
standard costing system.
Advantages:
i. It is administratively simple in that only quantities issued and received need be
recorded, not the money values as they are pre-determined.
ii. Manufacturing cost comparisons can be made more easily since material price
variations are eliminated:
iii. If a realistic standard can be established, some guidance to purchasing efficiency
may be obtained.
Disadvantages
26
i. Standard price is not an actual price, as such, stock profits and losses may arise.
ii. There is a very real practical difficulty in establishing an acceptable
cceptable and realistic
standard price.
We shall now present an example which will demonstrate the four pricing
methods explained above.
Data for a car spare part number 819 for October where the standard price is N4.50
per unit are as follows:
Table 3.2: Stores Data for a Car Space Part.
DATE RECEIPT PURCHASE PRICE ISSUES

N
1/10 1,500 units 4.00
5/10 1,000 units 4.00
6/10 800 units
12/10 1,000 units
20/10 900 units 4.80
24/10 800 units
Prepare the Stores Ledger Accounting using the four bases of issuing stocks discussed above.
Table 3.3: Illustration of FIFO on A Store Ledger Card
RECEIVED ISSUED BALANCE

Date Units Units Total Unit Total Total
Price Cost Units Cost Cost Units Cost
N N N N N
27
1/10 1,500 4.00 6,000 1,500 6,000

5/10 1,000 4.50 4,500 2,500 10,500
6/10 800 4.00 3,200 1,700 7,300
12/10 1000 4,150 700 3,150
20/10 900 4.80 4,320 1,600 1,470
24/10 800 3,630 800 3,840
Workings:
* 700 @ N4 each = N2,800

1000 @ N4.50 each = N4,500
1700 N7,300
** 700 @ N4 each = N2,800
300 @ N 4.50 each = N1,350
1000 N4,150
*** 700 @ N4.50 each = N3,150
900 @ N4.80 each = N4,320
1600 N7,470
**** 700 @ N4.50 each = N3,150
100 @ N4.80each = N480
800 N3,630
Total receipts = 1,500 + 1,000 + 900 = 3,400
Less: Total issues = 800 + 1,000 +800 = [2600]
Closing stock = 800
Since we are using FIFO method to price issues; the 800 units left are priced at the price of the
latest price of the latest receipts, that is 800 @ N4.80 = N3,840.
Lifo Method
Same method as FIFO, but instead of taking issues from the first receipt, you have to start from
the most current receipt and the procedure continues.
28
The
he above method on FIFO is the traditional approach to pricing issues and closing stocks.
There is an alternative method which can be adopted to arrive at the same answer. This is
presented below:
Alternative Method of Solution
Table 3.4: Store Ledger Account Using the FIFO Method
Recpt. GRN Qty. Price Total Issue Mat’1 Issue Balance N

Date No N N Date Reg. Details N
1/10 6,882 1,500 4.00 6,000 1,500@4.00) 6,000
5/10 6291 1,000 4.50 4,500 1,500@4.00) 10,000
1,000@4.00)
6/10 2570 800@ 4.00) 3,200 700@4.00) 7,300

1,000@4.50)
12/10 4920 700@4.00) 4,150 700@4.50) 3,150

300@4.50)
20/10 7057 900 4.80 4,320 700@4.50) 7,470
900@4.80)
800@4.80) 3,840
24/10 7940 700@4.50) 3,630

900@4.80)
Bal c/f 800@4.80) 3,840

3,400 14820 3,400 14820
Table 3.5: Store Ledger Account using the LIFO Method

1/10 6,832 1,500 4.00 6,000 1,500@4.00) 6,000
29
5/10 6291 1,000 4.50 4,500 1,500@4.00) 10,500

1,000@4.50)
6/10 2570 800@ 4.50) 3,600 1,500@4.00) 6,900

200@4.50)
12/10 4,920 200@4.50) 4,100 700@4.50) 2,800

800@4.50)
20/10 7057 900 4.80 4,320 700@4.50) 7,120

900@4.80)
24/10 7,940 800@4.80) 3,280 700@4.80) 3,280

100@4.80)
Bal c/f 800@4.80) 3,840
3,400 14820 3,400 14820
Table 3.6: Stores Ledger Account using the Weighted

Average Price Method
1/10 5,832 1,500 4.00 6,000 1,500@4.00) 6,000
5/10 6291 1,000 4.50 4,500 2,500@4.20) 10,500
6/10 2570 800@ 4.20) 3,360 1,700@4.20) 7,140

12/10 4,920 1,000@ 4.20) 4,200 700@4.20) 2,940
20/10 7057 900 4.80 4,320 1,600@4.5375) 7,260
24/10 7,940 800@4.5375) 3,630 800@4.5375) 3,630
Bal c/f 800@4.5375) 3,840
3,400 14820 3,400 14820
Average price calculations

* 1500 units @ N4 = N6,000
Plus 1000 units @ N4.5 = N4,500
“ 2500 units N10,500 :- Average price= N10500
2500 = N4.20
* 700 units @ N4.2 = N2940
30
Plus 900units
units @ N4.80 = N4320
“ 1600 units N7260 :- Average price = N7,260
N1600= N4.5375
4.5375
Table 3.7: Stores Ledger Account Using the Standard

Price Method
Recpt. GRN Qty. Price Total Issue Mat’1 Issue Balance
Date No N N Date Reg. Details N N
1/10 5,832 1,500 4.50 6,750 1,500@4.50) 6,750
5/10 6291 1,000 4.50 4,500 2,500@4.50) 11,250
6/10 2570 800@ 4.50) 3,600 1,700@4.50) 7,650
12/10 4,920 1,000@4.50 4,500 700@4.50) 3,150
20/10 7057 900 4.80 4,050 1,600@4.50) 7,260
24/10 7,940 800@4.50) 3,600 800@4.50) 3,600
Bal c/f 800 3, 600

3,400 15,300 3,400 15,300
Notes:
(a) The account using standard prices is shown fully completed for illustration purpose only.
If the standard price method was to be used then quantities only need to be recorded thus
saving clerical work.
(b) It will be noted that receipts, issues and balance are al at standard price. The gain/loss
on purchasing would be written off elsewhere in the accounts, the stores ledger being
entirely at standard price
Other Pricing Methods
Other pricing methods relevance are:
i. Specific or Unit Price: This is applicable where the item m issued can be identified with
the relevant invoice. Here the actual cost is being charged. T
This
his is applicable with special
purpose items bought for a particular job.
ii. Replacement Price:-This
This is also known as the market price method. The method charges
out issue at the buying price on the day of issue.
Advantages:
(a) Issues are priced at up to date values
31
(b) It is simple to apply.

Disadvantages:
(a) Replacement price is not an actual cost price, therefore stock profits andlosses
andlo may occur.
(b) It is difficult to continuously keep replacement prices up to date.
(c) The method is not acceptable to the Inland Revenue
(d) It makes cost comparison between jobs difficult.
iii. Average Price MethodMethod:: This method involves adding all the different prices and
dividing by the number of such prices to determine the issuing price.
Advantage:
Simplicity is one of its virtues.
Disadvantages:
(a) The effect of averaging can give very false issue and valuation figures.
(b) Profit or loss on stock valuation may ari
arise.
3.4 Summary
In this study session, we have looked at the factors to be considered for the installation of an
efficient store keeping system, the problems of material pricing, and how to account for material
stocks.
The methods of pricing systems, advantages and disadvantages of each system were explained in
detail coupled with illustrations to buttress the points and aid understanding.

Questions:
(i) What are the factors to be considered in the installation of efficient keeping store
keeping system?
(ii) Explain the process on how to account for material stocks
(iii) What are the factors militating effective material pricing

pricing?
(iv) Two basic raw materials, L and S, are used as follows:
32
Normal usage = 100kg each per week

Maximum usage = 150kg each per week
Minimum usage = 50kg each per week
Re-order Quantity = Type L 600kg
Type S 100kg
Re-Order Period = Type L = 4 to 6weeks
Type S= 2 to 4weeks
Required:
Calculate for each type of the materials:
a) i. Re-order level
ii. Minimum stock level
iii. Maximum stock level
iv. Average stock
b) Comment briefly on the difference in levels for the two types of materials.
(v)For each of the methods listed below and making use of the information detailed
below, you are required, for each method to show the stores ledger records
including the closing stock balance and stock valuation.
i. FIFO [first-in-first-out]
ii. LIFO (Last – in – First- out)
iii. Weighted Average
iv. Standard price
January 1 Revd. 1000 units @ N1 per unit
“ 10 Revd. 260 units @ N1.05 per unit
“ 20 Issued 700 units @ N per unit
February 4 Revd. 400 units @ N1.15 per unit
“ 21 Revd. 300 units @ N1.15 per unit
March. 16 Issued 620 units @ N per unit
April 12 Issued 240 units @ N per unit
May 10 Revd. 500 units @ N 1.10 per unit
“ 25 Issued 380 units @ N per unit
33
The standard price of the material is N1.15 per unit.
Should you require more explanation on this study session, please do not hesitate to contact
your e-tutor via the LMS.
Are you in need of General Help as regards your studies? Do not hesitate to
contact the DLI IAG Center by ee-mail
mail or phone on:
08033366677
34
Study Session 4
Cost Accounting for Labour
Labour(1)
Introduction
The remuneration for labour is wages. The workers put effort and get wages in exchange for
their labour.. On the basis of pay scale and other allowances which are prescribed in the terms of
employment, calculation of wages paid to direct or indirect workers is done. By the terms of
agreement between the employees and the employer, this may be modified from time
t to time. On
the basis of job evaluation, merit rating, incentive plans, profit sharing and labour contract, the
wages for the workers are determined.
Learning Outcome for Study Session 4
At the end of this study session, you should be able to

to:
1. Explain the principles of remuneration
2. Explain the
he methods of remuneration
3. Identify the
he various incentive schemes
4. Explain the trend in Labour costing
5. Solve questions on Labour Costing
4.0 The Role of Personnel Department in Labour Costing
Duties
ies connected with the engagement; discharge, and transfer of labour are normally carried out
by a separate Employment or Personnel Department to which requisitions for new employees are
sent, as necessary, by the production department. Requisitions for ne
new
w personnel are made on a
prescribed form. On receiving such a requisition, the employment officer will consult any
records he may have of persons available for employment, advertise, or take such other action as
will enable him to fill the vacancies. On engaging a newcomer, the employment officer will
make out an employee’s Records Card. This will show personnel details of the employee,
35
particulars of previous employment, medical category, and wage rate engagement. Normally,
spaces are also provided for the employee’s clock number, the subsequent recording of transfers
and promotions, wage rate amendments, details of attendance, merit and conduct reports, sick
and accidents reports and date and reason for leaving.
The clock number allotted to an employee upon engagement is normally retained by him
throughout his period of service and acts as a quick means of reference. It is usually shown on
clock cards, time sheets, payroll, and tool issue records.
The clock number is usually in two parts, the first being a prefix to designate the department to
which the employee is allocated, and the second giving the permanent identity number by which
the employee will be known. For example, the number 91472 might indicate that the employee is
allocated to department 9, and that his personal identity number is 1472. If an employee is
transferred from one department to another only the prefix of his clock number will be altered.
The scheme of numbering employees will depend upon the circumstances of each organisation
but a full list of clock numbers will be maintained by the Employment Department.
As each new employee is engaged, the employee department will receive the company’s
handbook and, where applicable, Income tax form.
These will be passed to the wages department together with a new engagement form on which
will be shown particulars of the new employee, including his clock number and commencing
wage rate. Similarly, the employment department will notify the wages department of any
discharges, transfer or changes in the rate of pay of existing employees.
Wages rate for manual workers are determined by national agreement between the appropriate
trade union and employers’ federation. In Nigeria, we have NECA, which caters for welfare of
employers after consulting with various trade unions.
The wages and salaries of management and clerical staff, and the wages of employees not
covered by formal agreements or statutory requirements, are determined by individual
employers, having regard to the nature and the responsibility of the work involved and to the
level of wages prevailing locally. Whatever the method adopted, the employment officer should
have standard rate for each grade of his company’s employees to obviate inequalities between
workers of similar grades and proficiency.
4.1 Methods of Remuneration
36
Methods of remuneration may be divided into the following categories:

• Time rates
• Piecework rates
• Premium bonus rates
• Collective (Group) bonus rates
(i) Time Rates

(a) Basic Systems
At the simplest level workers would be paid for the number of hours worked at a basic
rate up to, say 40 hours per week. Time worked in addition to 40 hours would be classed
as overtime and usually paid at a higher rate, for example, time a quarter’ (i.e.1¼ x basic
rate per hour), time and a half’ (i.e. 1½ x basic rate per hour) depending on the number of
extra hours worked and when the overtime was worked.
Advantages:
(i) Simple to understand and administer

(ii) Simplifies wages negotiations in that only one rate need to be determined unlike the
continuous complex negotiations over individual rates usual in some incentive
schemes.
Disadvantages:
(i) No real incentive to increase output

(ii) All employees in the grade paid the same rate regardless of performance
(iii)Constant supervision may be necessary
Most appropriate for:
(i) Work where quality is not important, e.g. Jig and tool making
(ii) Work where incentive scheme would be difficult or impossible to install e.g. indirect
labour stores assistants’ clerical
(iii)Work where the output level is not under the employee’s control e.g. power station
workers.
(b) High Day Rate System (A Variant of Time Rate)
This is a time based system which is designed to provide a strong incentive by

payingrates well above normal basic time rates in exchange for above average output
37
andperformance. For its suc

successful application it is necessary
y to ensure that the output
levels are the result of detailed work studies and that there is agreement from the labour
force and the unions involved on the required production level. A typicalapplication of
this system is on assembly line production in the car industry and in domestic appliance
manufacture.
Advantages:
(i) It is claimed to attract higher grade workers

(ii) Provides a direct incentive without the complications of individual piecework rates.
(iii)Simple
Simple to understand and aadminister.
Disadvantages:
(i) May cause other local employers to raise their rates to attract the betterworkers, thus
nullifying the original effect.
(ii) Problems occur when the original target production figured are not met.
Application
Easily measurable output to which groups of workers contribute, e.g. car assembly.
Note:
The system is also called Measured Day Work aand

nd in practice such schemes may well have quite
complex structures and rules
(ii) Piecework Rates
At its most basic the worker would be paid an agreed rate per unit for the number of units
produced. On Occasions the number of operations would be the basis of payment or,
where various types of articles are produced, a piecework time allowance per article
would be set and the worker paid for the pie
piecework hours produced.
Assume the following data:
Week No. 37 Employees No. 58107 Clock Hours 40

38
Output
300 units of A, Piecework time allowance 1.8 mins/unit
150 units of B, Piecework time allowance 1.5 mins/unit
100 units of C, Piecework time allowance 2.2 mins/unit
Piecework rate 10k per minute produced
Total production
[300 x 1.8] + [150 x1.5] + [100 x2.2] piecework minutes
= piecework minutes
Gross wages = 985 x 10k
= N98.50
Note:
It will be seen that the piecework time produced is not equivalent to actual clock hours.
Piecework time allowances are merely device for measuring the work content of dissimilar
items.
Rarely, if ever, is piecework found on its own. Usually it is accompanied by certain safeguards,
typical of which are guaranteed day rates and in lieu bonuses
(a) Piecework with Guaranteed Day Rates

Rates: If earnings from piecework fall below
normal day rates then there is a guarantee that day rates would bbee paid. This is to
safeguard earnings when there are delays, shortages, tool breakages, etc.
et which makes
it impossible for the employee to earn bonus pay.
(b) In Lieu Bonuses: where a worker is normally covered by an incentive scheme and is
transferred to ordinary day work, frequently an in lieu bonus is paid on top of normal
day rates. Such a bonus is often paid to support workers (fork lift truck drivers,
39
laborers etc) whose work is not amenable to the incentive scheme used for the rest of
the factory.
(c) Differential Piecework: One objection to straight piecework system is that, because
flat rate per unit is paid, the incentive effect at higher production levels declines.
Differential piecework seeks to overcome this by increasing the rate progressively at
various production levels, e.g.
Up to 100 units per day 10k/unit

101-150 units per day 12k/unit
151-200 units per day 15k/unit
Disadvantages of Piecework: While superficially attractive on the grounds that performance

pay are directly linked, piecework does suffer from the following disadvantages:
(a) Establishing piecework rates can involve protracted and expensive negotiations with
the employees
(b) Establishing allowances that management must give when the production rate falls as a
result of matters outside the control of employee [e.g. shortage of materials or machine
breakdowns] can also involve complicated negotiations.
(c) Piecework negotiations can lead to bad feelings between employees and management
(d) An error on the part of the rate fixer can prove very expensive
(e) Piecework often involves a much more complex recording system than is required for
straight day work
(f) Management is compelled to set up control systems to avoid abuse of the scheme.(It is
not for examples, unknown for employees to present the same work twice for payment;
book times incorrectly when claiming waiting-time allowance; disguise defective work
on which no payment would otherwise be made: or throw oil over work where payment
is based on weight, such as in washer production).
These disadvantages (which, incidentally, in the main apply to all incentive schemes) are often
so serious that many managers believe they outweigh the advantage. Many organizations then
can be found where piecework has been abandoned.
(iii)Premium Bonus Schemes
40
A premium bonus scheme is, in effect, a compromise betw

between the
he simple day work and
the straight piecework systems in that it relates earnings to the time worked and the
output achieved. Under such a scheme, the worker’s earnings are made up on:
(a) A day rate amount, based on the hours worked; and

(b) A bonus [which is added to the day rate figure] based on the quantity of output (or,
put in another way, the time saved in achieving the particular level of output)
The advantages of bonus schemes are:
(a) They provide a high incentive;

(b) The worker’s earnings are related to his effort
The disadvantages of such schemes are:
(a) They are often difficult to understand;

(b) They tend to require a large amount of clerical work to cope with the earnings
calculations
There are three main types of premium bonus schemes:
(a) The Halsey scheme

(b) The Halsey-Weir
Weir scheme
(c) The Rowan scheme
Halsey Scheme:: under this scheme, earning consists of the sum of the day rate plusa bonus
calculated on the basis of time saved. The relevant formula is:
Bonus = ½ time saved [in hours] x hourly day rate (the time saved = time allowed less time
taken)
A worker is paid N1.20 per hour. In an eight hour day he completes tasks for which the
standard time allowed is 12 hours. His pay would be:
41
Day rate 8 hours @ N1.20 = N9.60
Bonus [½ x 4 hours] @ N1.20 = 2.40

N12.00
Halsey – Weir scheme: This is modification of the basic Halsey scheme; except that the
relevant fraction applied to the time saved is one
one-third
third [33 1/3%] instead of one half [50%].
Rowan scheme: The chief weakness of the Halsey and Halsey

Halsey- Weirr schemes is that if the time
allowed is too generous, the bonus paid may be very much larger than the basic pay. For
example, suppose that in his eight
eight-hour
hour day our worker completed tasks for which the standard
time allowed was 26 hours. His bonus would tthen be [½ x 18 hours] @ N1.20
1.20 = N10.80, more
than his basic day rate.
The Rowan scheme is so designed that the bonus element cannot be as much as the basic
earnings for the time actually taken, because the bonus is based on the time saved as a fraction of
the time allowed.
Under the Rowan scheme the bonus payable in the foregoing example would be:
18 hours saved
26 hours allowed x 8 hours taken x N1.20
amounting to N6.65
6.65 approximately.
(iv) Collective Bonus Scheme
As mentioned earlier, it is often diff

difficult
icult to ascertain to what extent production efficiency
is solely attributable to performance of individuals, although it may be clear that there has
been increased productivity by the group of operatives working together although not
directly engaged on production,
roduction, the factory staff (or possible, all the company’s staff)
may over a period work efficiently that there is a marked saving in company costs:
Example of collective Bonus Schemes are:
(a) A group bonus scheme for gangs of operations;
42
(b) Priestman’sproduc
production
tion bonus, where all factory employees receive as bonus
apercentage increase to their basic wage equal tto
o the percentage increase in
output.
Group Bonus Scheme
10 workers are engaged as a team on producing item A. the standard of production set is 40
units of A per day, and the terms of employment provide that the team will receive a bonus of
N100 for every 20% increase in dai
daily production of 40 units. For increases other than
multiples of 20%, the bonus will be the corresponding proportion. On day 37, the team
produced 52 units. Assuming that the bonus is shared equally, each team will receive the
following bonus:
Increase in production = 52 – 40 =12 x 100 = 30%

40
The bonus is therefore 30/20 x N100 = N150, and each employee
will receive N150

10 = N15
Priestman’s Production Bonus
Factory X employed 500 employees, in respect of whom the Priestman’s production

bonus was applied on the basis of a standard weekly output represented by 200,000
points. In week 17, the output of the fact
factory
ory had a point’s value of 280,000.
43
For this particular week, the employees will each receive his or her basic wages, plus a bonus
of the following percentage thereof:
280,000 – 200,000 = 80,000 x 100 = 40%

200,000
4.2 Advantages and Disadvantages of Group Schemes
Advantages
(a) May engender closer cooperation in the group and a team spirit
(b) Administratively simpler with far less recording of la
labour
bour times, production rates,
etc.
(c) Support workers not directly associated with produ
production
ction can easily be included
includ in
the scheme
(d) Greatly reduces the number of rates to be negotiated
(e) May encourage more flexible working arrangements within the group.
Disadvantages
(a) Less direct than individual scheme

schemes, so may not provide the same incentive
(b) Less hardworking members of a group receive the same bonus and this may cause
friction]
(c) Not always easy to obtain agreement on the proportions of the bonus which group
members will receive
4.3 Conditions to be Satisfied

Satisfiedbyany Scheme
Whatever incentive scheme is used, it must satisf

satisfy certain conditions to operate successfully:
(i) Its objective should be clearly stated and within reach of employees’ reasonable
effort;
(ii) The rules and conditions of the scheme should be easy to understand and not prone
to misinterpretation.
(iii) It must win the full acceptance of everyone
veryone concerned, including of course,
44
Trade Union negotiators and officials;
(iv) It should be seen to be fair to employees and employers, other groups of employees
should not feel unjustly excluded from scheme, as their workmight be affected by
their dissatisfaction.
(v) The bonus should ideally be paid soon after the extra effort has been made by the
employees to associate the ideas of effort and reward;
(vi) Allowances should be made for external factors outside the employees’ control
which reduces their productivity [e.g. machine breakdowns, raw materials
shortages].
(vii) Only those employees who make the extra effort should be rewarded. It would not
be an incentive, for example, to institute a scheme in all factories in a country-wide
organisation and to pay a productivity bonus to employees in Lagos for work done
by employees in a factory in the Kaduna.
There are many possible types of incentive schemes which may be devised, some of which retain
the name of their originator. Broadly, the types of scheme are:
(a) High day-rate system;

(b) Piecework system;
(c) Individual bonus for exceeding efficiency standards;
(d) Group bonus for exceeding productivity or production targets
(e) Profit-sharing schemes
4.4 Advantages and Disadvantages of Incentive Schemes
Advantages
(a) Increase production thereby increasing wages but also reducing overheads per unit,
particularly where there are substantial fixed overheads
(b) May enable firm to remain competitive in inflationary conditions
(c) May improve morale by ensuring that extra effort is rewarded
(d) More efficient workers may be attracted by the opportunity to earn higher wages.
Disadvantages
(a) Frequently there are problems in establishing performance and rates with frequent
and continuing disputes.
45
(b) Some incentive schemes are complex and expensive to administer.

(c) Some group of workers, although relatively unskilled, may earn high wages through
incentive schemes whilst others engaged on skilled work may become resentful
when differentials are eroded.
4.5 Treatment of Overtime, Waiting Time, Holiday Pay, Etc.

For convenience of reference, the accounting treatment of certain special items in the
payroll is summarized below.
i. Overtime
Overtime is usually paid at the rate over the normal [time and a half, double time, etc.]
The excess over the normal rate is the overtime premium, which is shown in a separate
column in the payroll.
Allocation of the overtime premium will vary according to the circumstances.
Some examples of allocation are given below:

(a) To the job direct if the overtime is worked on customer’s specific instruction;
(b) To a separate standing order number as a general overhead item if arising from
general pressure of work;
(c) To the department where the work is done, if resulting from a fault arising in that
department
(d) To costing profit and loss account, if due to circumstances beyond the control of
any department [e.g. power failure, fire, national strike, etc]
ii. Work on Holidays

Work performed on days set aside for holidays is normally paid for at above normal
rates. Work on public holiday is often paid for at double time rate. The premium
included in such a payment should be shown in a separate column in the payroll and
treated either as a general overhead expense or as a direct charge to particular jobs if
the holiday work is done at the request of the customers concerned.
iii. Holiday with pay

Holiday pay is non-productive, but is nevertheless charged to the cost of production
by allocating the full year’s holiday pay to overhead and charging it to production for
the whole year
46
iv. Night shift premium

Night shift work is normally paid at a rate above the day rate. If a night-shift is
customary there is no need to segregate the premium element; the whole cost will
enter into the calculation of the general charge out-rate.
Where night shift working is a temporary feature because of general pressure of work,
it is charged against general factory overhead. If it is carried out at the customer’s
request it is charged to the job.
Notethat although a premium rate is paid this may not result in loss of profit, because of the
greater utilization of machines which would otherwise stand idle.
v. Idle time
Idle time should obviously be prevented as far as possible. It is important to analyse
the causes of idle time so that necessary corrective active can be taken. There are
three groups of causes of idle time:
(a) Productive causes [e.g. machine breakdown, power failure or time spent waiting
for work, tools, materials or instructions] a report of the cause of idle time must
be made to the appropriate department in order to effect control;
(b) Administrative causes [e.g. surplus capacity, policy changes, unforeseen drop in
demand].
(c) Economic causes [e.g. seasonal fluctuations in demand, cyclical fluctuations in
demand and changes in demand because of tax changes].
Some of these causes are controllable [and therefore ‘normal’], while others are uncontrollable
[and are regarded as being ‘abnormal’]. Controllable idle time is shown under a separate
standing order and charged as an overhead, although it may be charged to a department if it arose
through the fault of that department. Uncontrollable idle time is charged direct to the costing
profit and loss account.
Controllable idle time is the idle time which can be identified as the primary responsibility of a
specified person. It can be influenced by the action of a specified member of an undertaking.
Examples are:
- Break period when staff go out for lunch

- Too many workers manning a specific machine
47
- Setting too low a target of production

- Delay in supplies from the store to the factory floor.
Uncontrollable idle time is time lost through matters beyond labour control.
Examples are:
- Power failure
- Mechanical breakdown
- Shortage of materials
- Lack of orders
vi. Training time

Wages paid during a period of training may be charged partly to the job partly to
production overhead. The fact that learners work more slowly than trained employees is
offset by the learners’ lower rate of pay. Apprentices’ remuneration will be charged to a
separate account.
vii. Reworking of defective items

Where they do not form a major consideration, costs of reworking can be included in
direct wages and charged to the job. Where amount is considerable a separate standing
order is required and the cost treated as part of departmental overhead.
Supervisors’ wages
Normally supervisors’ wages are treated as part of depar
departmental
tmental overhead unless only a
particular job is concerned. Where instruction is being given, tthe
he remuneration of instructors and
supervisors may be included in training time
ITQ
What is in lieu bonus?
ITQ Answer
Where a worker is normally covered by an incentive sscheme

cheme and its transferred to ordinary day
work, frequently an in lieu bonus is paid on top of the normal day rates. Such a bonus is often
48
paid to support workers [e.g. fork li

lift truck drivers, labourers, etc] whose work is not amenable
to the incentive scheme
eme used for the rest of the factory.
Explain the difference between “PRODUCTION” and “PRODUCTIVITY”.
Production:This
This is quantity or volume of output produced
Productivity:
This is the effectiveness of the use of labour. It is a measur

measuree of the relative efficiency with which
output has been produced.
4.6 Some Common Forms Used In Connection With Wages
Table 4.1: Time Sheet
Employee No.......................... Date..........................
Employee Name.................... Office Code....................
Job Code No. =N=

From (time) To (time) Hours worked [Cost code]
Signed by.......................... Date..........................
Verified by.................... Date....................
The time sheet will

ill be filled in by the employee, for hour spent on each job (job code) or areaof
work (cost code). Idle time, lunch breaks etc. should also be recorded. The cost of thehours
worked will be entered at a later stage in the accounting department.
49
Table 4.2: Job Card
Employee N0.................................. Date.................................. ....................................
Employee Name............................ Department..................... Cost...........................
Job No Standard time Time Started Time finished Hours taken Cost
(hours)
345 2
348 1½
349 2 ½
352 1 1/4
Tea break (morning)..................... ................................. [Afternoon]..................... .......................

Lunch break ................................. ................................. ........................................ ........................
.................................
Idle reference No........................... ................................ .......................................... ........................
.................................
Signed by........................................ ................................ Date................................. .........................
Verified by (foreman)................... .............................. Date................................. .........................
A job card will be given to the employee, showing the work to be done and the expected time it
should be taking. The employee will record the time started and the time finished for each job.
Breaks for tea and lunch may be noted on the card, as standard times by the production planning
department. The hours actually taken and the cost of those hours will be calculated by the
accounting department.
Table 4.3: Idle Time Report Form
This period Cumulative
Production time paid for Hours Percentage Hours Percentage
Normal………………………
Overtime…………………….
50
Abnormal Time………………
1. Avoidable
i. awaiting materials
ii. awaiting instructions
iii. awaiting repairs
iv. awaiting set-up
v. Other (please specify)
2. Unavoidable
i. lose through power failure
ii. lose through machine
breakdown
iii. lose through strike action
iv. Other (please specify)
Idle time ratio
Idle hours x 100
Total hours
Prepared by Date
Table 4.4: Wages Analysis
……………….
Week commencing ……………….…………… and ending …………………………………
Cost centre of cost department Hours worked Basic pay Overtime Bonuses Employees Total
code =N= Premium =N= =N= NPF =N= wages=N=
Direct labour:
Dept. 1 610
2 602
3 603
Indirect labour:
Dept. 1 611
2 612
3 613
4 614
5 615
6 616
Administration 621
Sales office 631
Transport Dept. 641
51
Total
4.7 General Factors to Be Considered Before Embarking On Any Incentive Scheme
(i) Efficiency of Production

Production: whether volume of production
on is important or not which
calls for care and accuracy.
(ii) Effects on workers
workers:: attitude of workers to every wage system is important
(iii) Incidence of overhead
overhead: overhead is fixed within a range, thus if output falls, cost
c
per unit of output increases.
4.8 General Principles to Be Considered By an Incentive Scheme

(i) Fair and realistic rate
(ii) Reasonable demand
(iii) No artificial curbing of remuneration
(iv) Acceptability to workers
(v) Some form of minimum eearnings guaranteed
4.9 Summary
This study session explained the role of personnel department in LabourCosting,
Labour the
methods of remuneration, Advantages and disadvantages of group schemes. It also
explained the conditions to be satisfied by the Scheme to ensure effectiveness of the
scheme. It explained the treatment of overtime, holiday pay idle time, etc.
The module also explained the factors to be considered before embarking on any
incentive scheme and conclude with the principle to be considered by an incentive
scheme.

(i) What are the major categories of remuneration methods?
(ii) In what circumstances are group incentive schemes most appropriate?
(iii) Explain with examples the various incentive schemes
(iv) Explain critically the trends in labour costing
52
(v) Using the following figures as a basis, illustrate th

thee differing, effects of a 10%
increase in a [a] production, and [b] the productivit
productivityy of direct labour. In your
calculations, assume that labour is remuner
remunerated on a straight
ght piecework basis, and
that variable overheads are absorbed to production on a direct labour-hour
labour basis.
Production [units] 10,000

Labour hours 5,000
Production costs:
Direct materials 8,000
Direct labour 2,000
Factory overheads 3,000 [variable]
Factory overheads 4,000 [fixed]
08033366677
53
Study Session 5
Cost Accounting for Labour(11)
Introduction
Some employees will inevitably leave their job and go to work for another company or
organization, and replacements will be recruited. Labour turnover is a measure of the number of
employees leaving/being recruited in a period of time, [say, one year] expressed as a percentage
of the total labour force. Labour turnover rates in the region of 25%
25%-40%
40% or more per annum are
not uncommon. The costs of labour turnover can be large, and management should attempt to
keep labour turnover as low as possible so as to minimize these costs.
At the end of this study session,, you will be aable to, among other things:
1. Explain the termLabour

Labour Turnover
2. Know the
he cost of Labour Turnover
3. Note the
he reasons for Labour
LabourTurnover
4. Understand how to prevent high Labour Turnover
5. Solve questions on Labour Turnover
6. Understand wages
ages determination and control procedures
5.0. Cost of Labour Turnover
The cost of labour turnover may be divided into preventive costs and replacement costs:
54
(a) Preventive Costs: are the costs incurred in trying to keep employees in their jobs.
These comprise:
(i) Cost of personnel administration incurred in maintaining good relationships;

(ii) Cost of medical services including check-ups, nursing staff etc
(iii) Cost of welfare services, including sports facilities, laundry services, canteen
meals, etc
(iv) Pension schemes providing security to employees
(b) Replacement Costs: are the costs incurred as a result of hiring new employees.
This comprises:
(i) Cost of selection and placement;

(ii) Inefficiency of new labour; productivity will be lower;
(iii) Costs of training cost will include formal training courses plus the costs of on-the-
job instructors diverted from their own work to teach new recruits;
(iv) Loss of output due to delay in new labour becoming available;
(v) Increased wastage and spoilage due to lack of expertise among new staff;
(vi) The possibility of more frequent accidents at work;
(vii) Cost of tool and machine breakages;
5.1 The Prevention ofHigh Labour Turnover
Labour turnover will be reduced by:
(a) Paying satisfactory wages;

(b) Offering satisfactory hours and conditions of work;
(c) By creating a good informal relationship between fellow workers and between
supervisors and subordinates;
(d) Offering good training schemes and well-understood career or promotion ladder;
(e) Improving the content of jobs to create job satisfaction;
(f) Proper planning so as to avoid redundancies
5.2 Factors Fuelling Labour Turnover
55
It is impossible to prevent labour turnover from occ

occurring.
urring. Unavoidable reasons for employees
leaving include:
i) Personal betterment
ii) Illness or accident;
iii) Move from locality
iv) Discharge-unsuitable,
unsuitable, misconduct, bad timekeeping, etc
v) Marriage, pregnancy
vi) Retirement or death;
vii) Transport difficulties, or other reasons such as housing etc
5.3 Wages Procedures

The flowchart below (figure 5.1) shows in outline a ttypical
ypical wages procedure from the original
clock card to basic cost accounting entries
Figure 5.1: Flowchart of typical wage procedures
Clock
Card
Reconcile Alternative
time. Varity authorizations for
Quantities, Job Times
Employee Record Card
Calculate Gross Pay i.e. Rates

Time rates + Piecework Bonus Allowances
+ Alternatives etc. Tax Codes
And
Deductions
Gross to net
Computed Involving And for
Standard Deductions. Update
Income Tax etc. with latest
Information
Payroll/Payslip
Preparation
56
Wage payment Posting of Totals Wages Analysis using

Involving CashAnalysis from Payroll to Payroll and Job Cards/
Packet Preparation and Ledger Accounts
payment Resulting in
Timesheets Resulting
in
Credits to Debits of Gross Wages to

Cash A/C for net Wages W.I.P. A/C for direct wages
PAYE A/c (analysed to jobs etc.)
NHI A/c totals of Overhead A/cs as appropriate
Pensions A/c Deductions for indirect wages
Etc. made
Source: COSTING by T. Lucey
5.4 Labour Costing
Using job cards and/or times sheets and/or output records and the payroll, the cost department
carries out a detailed analysis of all wages paid to enable the labour costs for products, jobs, cost
centres and department to be established. This is done for cost ascertainment and cost control
purposes. Features of various aspects of labour costing are as follows.
a. Direct Wages: That proportion of the wages of production of employees directly

attributable to production (i.e. as ascertained from job cards and/or operation in which
he/she engaged and the total of direct wages for the period is charged to a
departmental Work-in Progress control A/c.
Direct wages would normally exclude overtime and shift premiums. The reason for
this is that such premium, if classed as direct, would be charged only against the job(s)
done during the overtime period which is unjust because it is fortuitous which jobs are
done during ordinary or overtime.
b. Indirect Wages: The wages of such people as inspectors, stores assistants, clerks and
labourers would be coded to the appropriate department to form part of the overheads
of the department. In addition, the proportion of production, workers’ wages which
cannot be classed as direct, e.g., idle time, overtime and shift premium would also be
57
classified as indirect, included in overheads and subsequently absorbed into production

costs via the appropriate overhead absorption rates.
c. Labour Cost Control: The cost department activities described above provide the raw
data for cost ascertainment and also for cost control purposes. Cost control at its
simplest will show various comparisons, for example, direct and indirect wages,
suitably analysed, compared with the same classifications for the last period for each
cost centre and department. It will also show various ratios. The simplest of these
would be the ratio of direct wages, compared period by period for each cost centre and
department. In this way, trends of labour costs will be shown and may give some
guidance to management on cost control.
5.5 Labour Related Factors

In addition to the recording and costing procedures described above, there are numerous other
matters which have an impact on labour and labour costs. Some of the more important of these
are wage determination, job evaluation and merit rating.
i) Wages Determination
This is a complex area where innumerable factors are involved. The factors vary in
importance from one organisation to another and the simplistic, generalized statements
can be made. Typical of the factors to be considered in wage determination are the
following:
(a) General economic climate of industry

(b) Government policy i.e. is there a wages norm or often income policy?
(c) Profitability of the firm. Is it able to pay higher than average wages?
(d) Extent of unionization and union strength locally and nationally.
(e) Extent of unemployment local and nationally.
(f) Cost structure of firm and industry e.g. a firm with high fixed costs of largely automatic
plant may be more willing to accede to high pay claim.
(g) Strategic importance of firm and industry e.g. electricity industry.
58
(h) Availability of workers with appropriate skills.

(i) Extent of hazardous or dangerous working conditions,
(j) Wage rate prevailing locally and nationally.
ii) Job Evaluation
This is a technique which seeks to show in a reasonably objective manner the relative
worth of jobs. It attempts to do this by analyzing the content of each job under various
categories, e.g. Training required. Degree of responsibility, Working conditions, types
of decisions involved and so on, and giving a point score for each factor. The total of
the points’ scores for each job is then used to establish the ranking of one job to another
and, by reference to pay scales, the normal salary for the job.
Advantages of job Evaluation
(a) Makes an attempt to be objective in ranking jobs

(b) Reasonably effective within an organisation at ranking jobs particularly relatively
low level ones.
Disadvantages of Job Evaluation
(a) Not suitable for ranking widely different jobs, particularly in different organizations
(b) Give a spurious air of objectivity to job comparison. The job Evaluation process
itself contains many subject element.
Notes:
(a) Job Evaluation studies the job not the person doing the job.
(b) Job Evaluation is only one factor among many in determining the actual pay for the
job.
iii) Merit Rating
Unlike job evaluation, merit rating is concerned with the individual employee. It
seeks to assist in determining whether a person should receive merit award,
promotion, demotion, etc. it does this by considering the performance and attributes
59
of an employee under various categories, for example, initiative, attendance, accuracy

willingness etc. and giving a number of points fo
forr each factor. Merit rating under
various guises is frequently encountered in staff appraisal schemes, particularly in
large firms, and is considered to be of value in providing a reasonably standardized
basis to the difficult task of individual appraisal.
The following information relates to a week’s wo

work for three employees:
ees:
Employees
A B C
Work issues (dozens) 150 264 60
Bonus time allowed (hrs/dozens) 0.5 0.25 0.75
Output rejected (dozens) 37 63 20
Basic hourly wages rate N1.40 N2.00 N1.00
Hours worked 48 hrs 54 hrs 42hrs
Hours on indirect work - - 12hrs
Bonus is paid at two-thirds

thirds of the base rate for all time saved. Faculty materials created
an abnormally high rate of reje
rejection
ction and it was agreed to credit all output for bonus
purposes.
The basic working week is 42 hours; the first six hours overtime are paid at time plus
one-third
third and the next six hours at time plus one
one-half.
Using the information given above, present in ta

tabulated
bulated summary form for each
employee:
a. Number bonus hours earned;

b. Basic wages including overtime premium;
c. Amount of bonus earned;
d. Gross wages;
60
e. Direct wages cost per dozen accepted when overtime is worked:

i. Regularly throughout the year as company policy due to labour shortage;
and
ii. Specifically at the customer’s request to expedite delivery
A B C
a. Work Issued [dozens] 150 264 60

Total time allowed
= work issued x time allowed 75 Hrs 66 Hrs 45 Hrs
45 Hrs 54 *30 Hrs
Time Saved [Time allowed –Time 27 Hrs 12 Hrs 15 Hrs
Taken]
*30 Hrs = 42 Hrs – 12 Hrs on

Indirect work
A B C
b. Time worked (Hrs) 48 54 42
Basic week (Hrs) 42 42 42
Overtime [Hrs] 6 12 0
N N N
Basic Pay = (Hrs worked x Basic rate] 67.20 108 42
Overtime premium: 2.80 4 -
1st 6 Hrs = [6 Hrs x1/3 x Basic rate] - 6 -
Next 6 Hrs = [6 Hrs x ½ x Basic rate] N70 N118
118 N42
Total including O/T( Overtime) N25.2 N16 N10
c. Bonus = [Time saved x 2/3x Basic rate] N95.2 N134
134 N52
d. [b +c] N95.2 N134
134 N52
e. Gross per [d] above - - 12
Less Indirect wages [12Hrs x N1] 95.2 134 40
Direct
ct wages required for [e [ii] ] 2.80 10 -
Less O/T premium 92.40 124 40
Direct wages required for [e [i] ] 113 201 40
Good units produced = [Total output
Less rejected] N0.82 N0.62
0.62 N1.00
61
(i) Cost per unit (cost)

output
N0.54 N0.67
0.67 N1.00
(ii) Cost per unit (cost)
Output
Pre-lean
lean Ltd. makes electrical components. The company has been producing 300
components per week; fixed production overhead was estimated to be N1,200 per week.
The following is a schedule of the hourly rates of pay of three direct employees:
Employees Hourly Rate
Ade N4.00
Olu N5.00
Tom N6.00
A major customer has been requesting tthe

he company for faster deliveries but
management does not want to introduce overtime to meet demand. The company works
a 40-hours-week.
week. In order to increase production, it is decided to institute an incentive
pay plan. The following schedule describes the ppay
ay plan formulated and started on a
trial basis.
Employee Hourly Rate Bonus [per unit]

Ade N2.75 N0.25
Olu N3.75 N0.25
Tom N4.75 N0.25
The first week the plan was put into operation production increased to 330 units. The
works manager studied the results and believed the plan too costly; production had
increased by approximately 16.25%. He wanted the Accountant to redesign the pay
plan to make labour cost increases proportionate to productivity increases.
Required:
62
Show by figures whether the works manager was correct in assuming the incentive
plan too costly.
Check for 16.20% increase in Direct Labour cost as follows:

Existing Labour Cost:
Ade = 40 Hrs x N
N4 = N160
Olu = 40 Hrs x N
N5 = N200
Tom = 40 Hrs x N
N6 = N240
N 600
Proposed Labour Cost: N
Ade = [40 Hrs x N2.75]

2.75] + [330 units x N0.25] = 192.5
Olu = [40 Hrs x N3.75]

3.75] + [330 units x N0.25] = 232.5
Tom = [40 Hrs x N4.75]

4.75] + [330 units x N0.25] = 272.5
697.5
Increase
rease in labour cost = [697.50 – N600] = N97.50
= N16.25%
Based on the labour cost only, the production manger is correct in assuming that cost has gone
up 16.25%.
However, this is only a part of the required analysis because where there is fixed production
overhead, increase in output is expected to reduce the total production cost per unit. If in this
analysis, the production cost per unit falls as a result of incentive plan, then the plan is desirable.
Calculation of Cost per Unit:
Exiting Position:
Total cost = N600 + N1,200 = N1,800
Production Units = 300
Cost per unit = N1,800
63
300 = N6.00
Proposed Position:
Total cost = [N697.50 + N1200] N1897. 50
Production (units) 300
Cost per unit = [1897.50]
300 = N5.75
Conclusion:
The new production plan is desirable because, though the labour cost had gone up by 16.25%,
the cost per unit of items produced had gone down from N6 per unit to N5.75 per unit.
5.6 Summary
This module explains Labour tur

turnover,
nover, the costs of Labour turnover and goes further by
explaining preventive and replacement cost. The reasons for Labour turnover were also
explained. Methods and procedures for wages determination were explained. The module
concludes with job evaluation,, its advantages and disadvantages.

Questions
(i) What do you understand by “Labour Turnover”?

How is it measured and reported to managemen
management?
t? What effect does it have on production
costs?
(ii) What are the reasons for Labour turnover?
(iii) Give some examples of management’s activities to prevent Labour Turnover
(iv) Explain to a production manager the effects of Labour turnover on production and
the company as a whole citing examples.
64
(v) Assuming you are dealing with a manufacturing concern which employs
em a
largelabour force in a factory with many departments an
andd different activities. You
are required to discuss the involvement of the cost department in the time-keeping
time
andpayroll preparation in such a manufacturing concern.
(vi) Jobs are issued to operato

operator X to make 189 units and to operator Y to make 204
units, for which a time allowance of 20 standard minutes and 15 standard minutes
per unit respectively is credited. For every hour saved, bonus is paid at 50% of base
rate, which is N2 per hour for both eemployees.
The basic working is 42 hours. Hours in excess are paid at time and a half. X completes his units
in 45hours and Y completes his in 39 hours [but works a full week].Because of defective
materials, six of X’s units and four of Y’s units are subseq
subsequently
uently scrapped although all units
produced are paid for.
You are required to calculate for each of X and Y:
a. The amount bonus payable;

b. The total gross wages payable;
c. The wages cost per good unit made
the DLI IAG
08033366677
65
Study Session 6
Accounting for Overhead [I]
Introduction
In an attempt to find the cost of a job or a group of units of product, we do not have much
problem because we can trace the direct material and direct costs to such jobs or units. Though
manufacturing overhead costs are not traceable to the jobs, they for
form
m part of the costs that are
necessary for the production of our jobs. Our primary concern in this session is to examine the
procedure involved in charging a reasonable part of the total manufacturing overhead to each
job.
In the world of manufacturing, as competition becomes more intense and customers

cu demand
more services, it is important that management not only control its overhead but also understand
how it is assigned to products and ultimately reported on the company's financial statements.
At the end of this study session,, you should be able to:
1. Explainof the term “Overhead

“Overhead”
2. Note thegroupings
groupings of overhead
66
3. Understand the stepsinvolved in establishing production overhead cost

4. Define overhead Allocation
5. Define overhead apportionment
6. Note the bases of overheads apportionment to cost centers
7. Apportion service cost centre costs to production department
8. Solve questions on Overhead allocation and apportionment
6.0 Definition
All material; labour and expense costs which cannot be identified as direct costs are termed
indirect costs. The three elements of indirect costs are: Indirect materials, indirect labour and
indirect expenses. These are collectively known as overheads.
Typical examples of indirect costs in the production area are the following:
- Indirect materials-Lubricating Oil, Stationery consumable materials, Spare parts for

machinery, etc.
- Indirect Labour-Factory Supervision, Maintenance wages, Store man’s wages, etc.
- Indirect Expenses-Rent and Rates for the Factory, Plant Insurance, etc
6.1 Main Grouping of Overhead

The main groupings are:-
a) Production Overhead
b) Administration Overhead
c) Selling Overhead
d) Distribution Overhead
Production Overhead
Production overhead may include:-
a) Power and Fuel
b) Factory rent and rates
c) Depreciation, repairs and insurance of plant
d) Wages and salaries of indirect labour e.g. supervisors
e) Indirect materials e.g. cleaning materials
f) Canteen and welfare facilities
Administration Overhead
67
Included in administration overhead are:
a) Office share of heating, lighting, rent and rates

b) Stationery, telephone, postage and insurance
c) Audit fees, bank charges and legal fees
d) Salaries of administration staff
Selling Overhead
Selling overhead may include:
a) Salaries and commission paid to representatives

b) Traveling expenses
c) Administrative costs of the Sales Department
d) Advertising including the cost of catalogues and price list
e) Market research
6.2 Steps Involved In Establishing Production Overhead Cost

[a] Establish cost centres- both production and service cost centre in the factory.
[b] Collect overheads – The collection of overheads is a continuing process and
ispart of the cost accountant work. The sources of this information are:-
i] Supplier Invoices: These will provide data on stationery consumption cleaning
materials and financial charges.
ii] Plant and Machinery Register: This will contain the valuation of all plant and
machinery written down, the method of depreciation and the means of calculating
the period charge.
iii] Wages Department: expenditure on indirect labour.
iv] Material Requisitions: Issue of indirect materials.
v] Meters: Consumption can be recorded in respect of gas, electricity, steam and
water. By applying current rate an expenditure figure can calculated.
[c] Classify the overheads to ensure correct apportionment.
Overhead can be classified:
- By nature e.g. materials; labour; depreciation etc
- By cost centre e.g. production dept; service dept
- By variability e.g. variable. Fixed or semi-fixed.
68
[d] Allocation: This is applicable to Direct Overheads. This is the process ofcharging
to a cost centre those overheads that result solely from the existence of that cost
centre. For example, the salary of the production foreman of a particular
department will be allocated to that department. The depreciation of computer
equipment will be allocated to the computer department.
[e] Apportionment: This is applicable to indirect or joint overheads. Most of the

overheads are not caused solely by one cost centre [they are joint costs] and it is
therefore not possible to allocate costs to individual cost centres. In these cases, it
is only possible to apportion these joint costs on a reasonable basis.
6.3 Basis of Overheads Apportionment to Cost Centres

There are various basis of overhead apportionment but any base selected should meet the
following tests:-
- It should be equitable
- It should be practicable
- It should be cost effective
Some of the common bases are discussed below:
Overheads to which the basis Basis

Applies
a] Rent, rates, heating and lightrepairs and Floor area occupied by each
depreciation of buildings. department.
Depreciation, Insurance of Equipment. Cost or book value or equipment

b]
Personnel office, canteen, welfare, wages Number of employees, or labour
c]
and cost offices, administration hours worked in each department
d]
Heating, lighting (see above] Volume of space occupied by each
department.
An examination question may be set which calls for the apportionment of overhead
items.In the majority of cases the basis to be used is obvious, but you may encounter one
69
or twoitems for which two (or more) bases may appear to be equally acceptable. In such
circumstances, do not waste time trying to weight up the merit of each; use the method
you prefer. Always indicate the basis of apportionment you have chosen, and in any case
of doubt explain why you chose basis in preference to another.
Fire Bases Limited incurred the following overhead costs:

N
Depreciation of factory 1,000
Factory repairs and maintenance 600
Factory office costs [treat as production overhead] 1,500
Depreciation of equipment 800
Insurance of equipment 200
Heating 390
Lighting/ Cooling 100
Canteen 900
5,490
Information relating to the production and service departments in the factory is:
DEPARTMENT
Production Production Service Service
A B X Y
Floor area [sqmetres] 1,200 1,600 800 400
Volume [cubic metre] 3,000 6,000 2,400 1,600
Number of employees 30 30 15 15
Book value of equipment 30,000 N20,000 N10,000 N20,000
How should the overhead costs be apportioned between the 4 departments?
70
Item of cost Basis of Total A B X Y
Apportionment cost NNNN
Factory depreciation [floor area] 1,000 300 400 200 100
Factory repairs [floor area] 600 180 240 120 60
Factory office [No of employees] 1,500 500 500 250 250
Equipment insurance [N.B.V] 200 75 50 25 50
Equipment depreciation [N.B.V] 800 300 200 100 200
Heating [Volume] 390 90 180 72 48
Lighting [floor area] 100 30 40 20 10
Canteen [No. of employee] 900 300300150150

5,490 1,7751,910937868
6.4 Apportionment of Service Cost Centers to Production Department:

Department:-
Once the overheads have been analysed to cost centers an

andd totaled, the next step is to charge
service cost centers costs to production cost center
centers. This is necessary since our ultimate object is
to charge overheads to units, and as no unit pass through service departments the cost of such
departments must be charged
ed to those cost centers where there are cost units, i.e. the production
cost centers.
There are three main methods for the apportionment of service cost centers to production
departments:
(i) Direct Apportionment

Under this method service department costs are apportioned directly to operating
departments, irrespective of whether one service ddepartment
epartment services another service
cost centre. This tends to be the most commonly used method in practice.
(ii) Step Method:
71
This method takes account of the services given to one service department by another.
The order in which the service departme
department cost should
ould be apportioned must first be
established. The most common solution is to apportion the costs first of that service
department which has
as the largest total cost to be apportioned. Once the cost of a
service cost centre is apportioned out, no cost is apportioned
ortioned to that department again.
This is the reason why this method is also called elimination method.
(iii) Continuous Allotment Method

In this method, the costs of the service cost centre [usually with the largest total costs]
are apportioned in the normal way. This “closes off” the first department. However,
subsequent allotment of the costs of other service cost centers results in new charges
to the first department and so “re
“re-opens”
opens” it. The total of these new charges is then
allotted back to the other ser
service
vice departments in the same manner as the original
costs. This in turn “re
“re-opens
opens the other service departments. This process is continued
until the amounts involved become insignificant.
(iv) Algebraic Method

This is an alternative method to the continuous allotment that makes use of
simultaneous equations. Here the total service costs of each department are expressed
as algebraic equations. The equations are then solved using any method
The overhead allocation to the three production cost centers and two service cost
centers of the manufacturing division of a company were:
Production cost centre: 1 40,000
2 48,000
3 72,000
Service Cost Centre A 27,000
B 19,000
72
After a study it is decided that the costs of the service costs centers should be
apportioned as follows:
Production Service
Cost Centers Cost Centers
1 2 3 A B
% % % % %
Service cost:
Centre: A NIL 55 35 - 10
B 45 35 15 5 -
You are required to calculate the total overhead chargeable to each of the fo
following
llowing methods:
[a] Ignoring the service that each of the two service cost centers gives to the other –
Direct Apportionment Method.
[b] Using a ‘Step” method of apportionment whereby costs of the service

costcentrethat
that serves most cost centers is apport
apportioned
ioned to the production cost
centers.
[c] Using the ‘repeated distribution’ or ‘continuous allotment’ method of

apportioning the costs of service cost centers.
[d] Using the Algebraic Method
[a] Direct Apportionment Method:

Method:-
1 2 3 A B
N N N N N
Cost Allocated 40,000 48,000 72,000 27,000 19,000
Apportion “A” [0:55:35] - 16,500 10,500 [27,000]
“ B”[45:35:15] 9,000 7,000 3,000 - [19,000]
Total overhead chargeable 40,000 71,500 85,500 -
Workings
Service Centre “A” 55 x 27,000 = 16,500

90
35 x 27,000 = 10, 500
90
73
Service Centre “B” 45 x 19,000 = 9,000

95
35 x 19,000 = 7,000
95
15 x 19,000 = 3,000
95
[b] Step Method
1 2 3 A B
N N N N N
Cost Allocated 40,000 48,000 72,000 27,000 19,000
Apportion “B” [45:35:15] 8,550 6,650 2,850 950 [19,000]
Apportion “A” [55:35] - 17,081 10,869 [27,950] -
48,550 71,731 85,719 - -
[c] Continuous Method:
(Repeated Distribution Method)
Focusing attention on Service Depts.
A B
Allocated Cost 27,000 19,000
Apportion “A” [charged to
B = 10% of 27,000] [27,000] 2,700
- 21,700
Apportion “B” [charged to
A = 5% of 21,700 1,085 [21,700]
Apportion “A” [charged to
B=10% of 1,085] 1,085 109
- 109
Apportion “B”[charged to
A = 5% of 109 5 [109]
5 0
Apportion “A” [charged to [5] 0
B is now insignificant 0 0
Total chargeable 28,090 21,809
N28, 090 = 27000 + 1085 +5 N21809 = 19000 + 2700 + 109
Summary
1 2 3 A B
Allocated 40,000 48,000 72,000 27,000 19,000
74
Apportion “A”
[N28, 090 on % basis] - 15,450 9,831 [28,090] 2,809
Apportion “B”
[N21, 809 on % basis] 9,814 7,633 3,272 1,09021,809
Total Cost 49,814 71,083 85,103 0 0
[d] Algebraic Method:-

Equation:-
Let A rep Cost of “A”
“ B “ “of “B”
A = 27,000 + 0.05B - - - - - - eq [1]
B = 19,000 + 0.1A - - - - - - eq [2]
Solve for A & B simultaneously

Substitute for B in eqn. 1
A = 27,000 + 0.05 [19,000 + 0.10A]
27,000 + 950 + 0.005A
A – 0.005 = 27,000 + 950
0.995 A = 27,950
Therefore A = 27,950
0.995
= 28,090
Substitute for A in eqn. [2]

B = 19,000 + 0.1A
= 19,000 + 0.1 [28, 090]
= 19,000 + 2,809
= 21,809
Note that the answer is the same as the summary in continuous or repeated method.
Then allocate the service centres overheads to production coat centres using the continuous
apportionment method. Using the continuous apportionment method we have:
1 2 3 A B
N N N N N
Cost allocated 40,000 48,000 72,000 27,000 19,000
Apportionment on percentage 15,450 9,831 [28,090] 2,809

Basis ‘A’ [0:55:35:10]
‘B’ [45:35:15:5]
9,815 7,633 3,271 1,090 21,809
Total overhead Chargeable 49,815 71,083 85,102 - -
75
6.5 Summary
This study session defined overhead, exp
explains each grouping of overhead. It also explained
overhead allocation and overhead Apportionment. Discussed the steps involved in establishing
production and overhead costs. Explained the basis of overhead apportionment to cost centers,
examined in detail how service cost centers can be apportioned to production cost department.

1. Explain the term overhead and list the main groups of overhead
2. What are the steps involved in the establishment of production overhead Cost
3. Explain thoroughly the correlation between overhead allocation and overhead
apportionment.
4. What is the basis of overheads apportionment to cost centers? Explain critically how
Apportionment of service cost centre costs to production department can be made.
5. Fire Bases Limited incurred the ffollowing overhead costs:
N
Depreciation of factory 1,000
Factory repairs and maintenance 600
Factory office costs [treat as production O/head 1,500
Depreciation of equipment 800
Insurance of equipment 200
Heating 390
Lighting 100
Canteen 900
5,490
Information relating to the production and services departments in the factory is:
DEPARTMENT
Production Service
A B X Y
Floor Area [m²] 1200 1600 800 400
Volume [3³] 3000 6000 2400 1600
Number of employees 30 30 15 15
76
Book value of
Equipment N30,000N20,000 N10,000 N20,000
20,000
How should the overhead costs be apportioned between the departments?
6. Maynard Ltd., an engineering company, has three ma

manufacturing
nufacturing and three service departments.
The floor area occupied by each and the de
departments’ expenses for last year were:
Floor Area Expenses
Sq. ft. N000

Manufacturing departments
departments:
Foundry 2,500 100
Machining 4,000 120
Assembly 2,000 50
Service department
department:
Utilities 1,500 11
Repairs 1,500 8
Stores 1,000 3
The Utilities department’s expense is allocated to the other five departments on a floor area
basis. The other two service departments’ expense is apportioned as follows:
follows:-
To: Repairs Dept. Store Dept.

% %
Foundry 30 30
Machining 25 10
Assembly 20 40
Repairs - 20
Stores 25 -
You are required to show the departmental accounts after the expenses apportionments have
been made. (Calculations should be to the nearest N)
Should you require more explanation on this study se

session,
ssion, please do not hesitate to contact your
77
the DLI IAG Center
08033366677
Study Session 7
Accounting for Overheads (II)
Introduction
The direct material, direct labour

labour, labour and direct expenses which form part of the prime cost
are all direct costs. They are capable of being allocated (attributed) to the manufacture of a
product directly.
Costs apart from the prime costs are collectively called overhead. These costs are not directly
d
attributed to products or service cost centers. They are attributed by the process of allocation and
apportionment of overheads, apportionment being done depending on some rational basis.
The basis chosen for estimating the overhead cost is depende

dependent
nt on the overhead cost in
consideration. The same bases need not be used for absorption of all types of overhead.
78
At the end of this study session you should be able to:
1. Explain Overhead absorption

2. Explain Over-absorption
ption of overheads
3. Explain Under-absorption
absorption of overheads
4. Make Accounting entries for overheads
5. Determine Blanket Absorption rate
6. Solve questions on over/under absorbed overheads
7.0 Definition of Overhead Absorption
Direct costs,, by definition, are readily identifiable to cost units, but overhead, which are often
considerable, nevertheless form part of the total cost of a product. Accordingly overheads must
be shared out in some equitable fashion among all of the cost units produced.
The process by which

hich this is done is known as overhead absorption or overheadrecovery.
overheadrecovery
Typically an overhead absorption rate, based on factors such as direct machine or labour hours is
calculated and the overheads shared out over the cost units or jobs according to the number
nu of
machine or labour hours involved.
Overhead absorption is a means of attributing overheads to a product or service based for

example on direct labour hours, direct labour cost or machine hours.
7.1 Computing Of Overhead Absorption
To be able to compute
mpute the overhead to be absorbed by a cost unit it is necessary to establish an
overhead absorption rate [OAR] which is calculated by using two factors; the overheads
attributable to a given cost centre and the nu
number of units of the absorption base [labour
[labo hours,
machine hours, etc] that is deemed most suitable; thus:
OAR for a centre = Total overhead of cost centre

Total No of units of absorption
ption base applicable to centre
79
The total overhead of a cost centre are established by the processes of cost allocation and cost
apportionment which were discussed in module 6.
7.2 Use of a Pre-Determined Absorption Rate
For various reasons, it is inconvenient to collect data about actual costs and to absorb overheads
on the basis of actual costs. The following reasons justify the use of a predetermined
absorption rate:
i) Goods are produced and sold throughout the year, but actual overheads are not known
until the end of the year. it would be inconvenient to wait until the year end in order
to decide what overhead costs should be.
ii) When full costing is being used and trade is seasonal in nature-production in the slack
period of the year might be burdened with an excessive proportion of the year’s
overheads. The use of predetermined absorption rates can spread fixed overhead
expenditure more equitably over the year’s production.
iii) Cost calculations for a cost centre can be affected by heavy blocks of expenditure
which arise in a given period solely because this is the way in which an external
supplier submits his account. The use of predetermined absorption rates should avoid
this.
iv) As an extension of [iii] efficient predetermined absorption rates should lead to
normalized [or average] cost figures which are affected relatively little by the
peculiarities of particular accounting periods. Such figures might seem particularly
appropriate for profit measurement purposes.
v) It will be appreciated that there can be advantages from the cost control viewpoint in
adopting predetermined rates, since the variations between planned and actual figures
can be very useful in pinpointing areas where performance is deviating from plan.
Businesses establish their overhead absorption for the forthcoming accounting year by:
(a) Estimating the overhead likely to be incurred during the coming year,
(b) Estimating the total hours, units, or direct costs on which the overhead absorption
rates are to be based [activity level]
(c) Dividing estimated overhead by the budgeted activity level. For instance, if the total
estimated overhead cost in a year = N150,000 and the estimated operating volume for
80
the same year = N100,000 direct labours, then the estimated average overhead cost
per direct labour hour is N1.50. A job requiring 3 hours of direct labour will be
charged an overhead cost of 3x N1.50 = N4.50 irrespective of the month [ of the same
year] the job was done.
7.3 Bases of Overhead Absorption
(a) Unit of Production

This is perhaps the simplest rate to use, calculated by dividing budgeted production
overhead by the number of units of output budgeted. It is also easy to apply, attaching
over heads to units produced. This method would be appropriate when the units of
production are either identical or very similar to each other and the overhead being
apportioned can be assumed to accrue evenly over production volume. An example of
such an overhead might be the cost of a quality control department which would vary
when treated as an indirect cost.
(b) Percentage of Materials Cost
The calculation of this second method is achieved by dividing the budgeted
production overhead by the budgeted materials cost. This percentage can then be
applied to every naira actually spent on materials to determine the overhead absorbed.
This method is best suited to organizations where material cost is a high percentage of
total cost and if each product is made from the same materials.
However, it has two weaknesses; firstly, most overheads are incurred through
thepassage of time, and thus have no connection with materials cost; and secondly, if
different materials are used in production, then the overhead absorbed will be
distorted according to the different prices of the materials
(c) Percentage of Direct Wages:

This is calculated by dividing budgeted overheads by the budgeted labour cost.
The method would be appropriate when the work done can be primarily related to the
direct labour input and the overhead being apportioned can be viewed as accruing
roughly in line with the direct labour cost. Provided the labour cost is roughly the
same per hour for all relevant employees then this method will approximate to a per
hour basis of apportionment. Specific examples of an overhead cost that should be
apportioned on this basis could include non- direct payroll costs such as employer’s
81
national insurance, pension costs, holiday pay and sick pay. Provided the cost to time
relationship is constant then time accruing overheads such as rent could be
apportioned on this method.
Major limitation is the fact that different grades of labo

labourr are paid at different rates
thereby distorting the overhead charge.
(d) Percentage of Prime Cost:

This is calculated by dividing the budgeted production overhead by the budgeted
prime cost. It is a combination of [b] and [c] above and so combines any advantages
advant
and disadvantages of each.
(e) Direct Labour Hour Rate:
This is calculated by dividing budgeted overhead by budgeted labours. Every time an
hour is worked, the overhead rate is applied.
Adoption of this method indicates that overheads are incurred because labour hours
are being worked. This is, therefore, suitable for a stage of production that is
predominantly manual. It will produce more accurate results than the labour cost
percentage method, where different rates of pay are used.
(f) Machine Hours Rate:

This would be appropriate when the work done is primarily machine work and the
overhead being apportioned can be viewed as accruing on a time basis. An example
would be where the overhead is comprised largely of depreciation of the machines
used and that depreciation
epreciation is itself based on machine hours. Another example could
be where the overhead concerned relates to a machine supervisor’s wages being
treated as an indirect rather than a direct cost.
7.4
The objective of the overhead absorption process is to include in the total cost of a
product an appropriate share of the firms total overhead. An appropriate share is
82
generally taken to mean an amount which reflects the effort and/or time taken to
produce a unit or complete a job.
Given that: Cost centre 15 for period 10
Total O/H for period N6, 000

Total Direct Labour hours 800
“ DW N1,600
“ D M used N3,000
“ Machine hrs 1,200
Units produced = 45 units
From the above, the following OAR can be calculated as follows:
i. DLH OAR = N6000 = N7.5

7.5 OH/ Labourhr
800 hrs
ii DW OAR = N6000 = N3.75

3.75 O/H per N of
N1600 wages or 375% of wages
iii DM OAR = N 6000 = N2 O/H per N of material

N3000 or 200% of materials
iv Prime Cost OAR = N6000 = N1.30 O/H per N

N4600 of prime cost
v. Machine Hour OAR = N6000 = N5 O/H per machine

N1200 Hr.
vi Cost Unit OAR = N6000 = N133

133 O/H per unit
45 units produced
Where DLH = Direct Labour Hour
7.5 Using the Calculated OAR
When it has been decided,the

the most appropriate rate to use for a given cost centre,theOAR
centre,t is used
to calculate the cost of a cost unit.
83
If a cost unit z has been produced in our cost centre 15 and the following details
recorded:
Cost Unit X
Direct Material used N23

Direct Wages N27.50
Direct Labour Hours 12
Machine Hours 17
Assuming that it has been decided that Direct Labour rate is the most appropriate
method to use, calculate the cost of the cost unit using the data given above.
Cost Unit X
Direct Labour N27.50
Direct Material 23.00
= Prime cost 50.50
+ O/H [12 hrs @ LH OAR of 7.5/hr] 90.00
Total cost of cost unit = N140.50
7.6 Blanket Absorption Rate
This is a single overhead rate computed for the entire factory i.e. total factory overheads divided
by total units of base throughout the factory.
Blanket absorption rate can be used under the following circumstances.
84
- Where the products being produced by the factory are homogeneous. The units
produced can be easily used as a basis of absorption.
- The rate makes pricing and control easier as the rate is only charged once in the year.
- Where the clerical cost will be greater than the benefit to be derived from individual
rate of absorption, the blanket absorption rate will be used.
The method is unsuitable for product costing purpose when each cost centre tends to have its
own characteristics and problems which would affect the amount of expenses incurred, typical
differences might be:
- Some cost centers will be heavily mechanized, whereas other will have little or no
machinery.
- Special costs may be incurred for some processes, e.g. extra brilliant lighting or air-
conditioning, which is necessitated by the nature of the technical process.
- Rejection costs may be extremely high in some cost centers and not in others.
- Some items of overhead may not be applicable to all cost centers.
7.7 Why Production Overheads Should Be Absorbed To Products
The following reasons are tenable:

i) As the basis of average cost pricing, so as to attempt to ensure that all fixed costs
are covered by sharing them out prior to setting prices. This procedure should
cover at the minimum the total cost of the product including fixed overheads.
ii) As a means of showing the costs of using capacity. In a sense the recovery rate
would act as a surrogate figure for the opportunity cost of capacity.
iii) As a means of complying with external reporting and taxation requirements where
stocks should be valued at their full production cost, inclusive of production
overheads.
iv) As a means for apportioning indirect costs as equitably as possible in non-profit
organizations.
It should be noted however that many cost accountants nowadays regard overhead absorption as
a discredited technique. Their objections are based on the fact that many overheads are
completely independent of whether an individual product is made or not. The sharing out of such
overheads among cost units does not therefore provide any useful information to management.
85
7.8 Relationship between Actual Overhead and Absorbed Factory Overhead
In practice, actual overhead cost is not used for the purpose of recovering overhead cost, instead
the usual practice is to use predetermined rate. The reasons for this are as contained in paragraph
7.4 above.
The actual overhead costs are accumulated in various overhead accounts while the predetermined
rates are used to change overhead that is changed to the various jobs or units. The total of
overhead that is charged to all jobs during a given period using the pre-determined rate is known
as the amount of overhead absorbed. For instance, if in a month a company records 3000 direct
labour hour and the predetermined overhead rates is N2 per direct labour hour, total overhead
cost absorbed into production during the month under consideration will equal to 3000 x N2 =
6000. The accounting entry for this in the book is as follows:
DR - Work-in-Progress a/c N6000

CR- Factory overhead a/c N6000
Being value of overhead absorbed into production during the month.
7.9 Over or Under Absorption of Overhead
As contained in paragraph 7.10 above, the pre-determined overhead rate used to absorb overhead
cost is normally determined in advance of the period for which the rate is applicable. By this
very fact, there is bound to be difference between the absorbed overhead and actual overhead
accumulated. This difference is known as over-absorbed or under-absorbed overhead depending
upon which is greater.
For instance, if more overhead cost is absorbed into production than the actual overhead cost,
overhead is said to be over-absorbed. On the other hand, overhead is said to be under-absorbed if
less overhead cost is absorbed into production vis-à-vis the actual overhead cost.
There are possible reasons for over or under-absorption of overhead. These are:
i) The actual overhead being different from the budgeted overhead leading to
expenditure variance.
ii) The actual volume of activity being different from the budgeted volume leading
to volume variance
86
EKA ltd. has the following = N40,000

Budgeted Output = 20000 units
Estimated overhead cost per
Unit of output = N40,000= N2
20000
Actual output = 18000 units
Actual overhead cost incurred = N38, 000
Required: Calculate the over – or under-absorbed
absorbed overhead with reasons.
Overhead absorbed into production = 18000 x N2

2 = N36, 000 that is, actual output x the
absorption rate. Actual overhead incurred = N38,
38, 000 thus leaving a difference of N2, 000 i.e.
[N38, 000 – N 36,000] the N2000
2000 difference is under
under-absorbed.
absorbed. This can be analysed as follows:
i) Expenditure variance = Actual overhead minus Budgeted overhead

= N38, 000 – N40, 000
= N2, 000 favorable
ii) Volume variance = Actual

ctual production minus Budgeted
production
= 18000 units – 20000 units
= 2,000 units adverse.
As a result, overhead cannot be absorbed to the tune of 2000 units x N2 = N 4000 (adverse)
The net effect is N2000

2000 favorable plus ((N4000) adverse variance gives N2000
2000 under-absorbed
under
overhead.
7.10 Treatment Of Over-Absorbed

Absorbed and Under- Absorbed Overhead
87
Over-absorption
absorption occurs when the amount absorbed [based on estimate] is more than actual
overhead cost incurred. As a result the over
over-absorption should be released [i.e. Credited] to
profit & loss account.
absorption is regarded as adverse because the amount absorbed is less than actual
Under-absorption
overhead cost incurred. As a result the under
under-absorption should
ould be charged against profit and
loss account.
In practice, the over-and

and under
under-absorbed
absorbed overhead is usually adjusted in cost of goods sold
account during the period concerned.
7.11 Accounting Entries for Overhead Cost
The actual production overhead costs incurred are debited to Production Overhead Control
Account and cash A/C credited if paid for. On the other hand, the total overhead absorbed into
production is debited to work-in
in-progress
progress a/c with the corresponding credit going to production
overhead a/c. Any over/under absorbed overhead is transferred to profit and loss account as
adjustment cost of goods sold.
In period 9 of the accounting year of COSIT Ltd., the actual production overhead
incurred and paid for amounted to N90,
90, 000 Depreciation during the period amounted
toN10,
10, 000. The absorbed production overhead was N95, 000. Prepare the major
accounts.
i) Production Overhead Account
N N
Cash (production O/H Work-in-Progress
Paid for) 90,000 (absorbed O/H) 95,000
Provision for Cost of goods sold
88
Depreciation 10,000 [under-absorbed O/H] 5,000

N100,
100, 000 N100,000
100,000
ii] Work-in-Progress
Progress Account
N N
Production Overhead 95,000
The work in progress account balance is cleared into the finished goods account at the end of the
period.
Huge Black Monster Ltd. uses a machine hour rrate

ate of overhead recovery in its
machinery department and direct labour hour ra
rate
te of recovery in its assembly
department. The budgeted overheads in the machinery department and the assembly
department are N40,000
40,000 and N64,000 respectively.
Machining Assembly
Department Department
Budgeted machine hours 10,000 -
Budgeted direct labour hours 25,000 25,600
Job no. 627 costs N400 in direct materials and N600 in direct labour. It requires 20
machines hours [80 direct labour hours] in the machinery department and 200 hours
in the assembly department.
Required:
(a) Calculate the full production costs of job 627 using the current bases of
overhead absorption;
(b) Calculate the full production cost of job 627 if the absorption rate in the
machinery department is changed to a direct labour hour rate.
89
(a) Current Bases

(b) Absorption Rates
Machinery Dept:
Basis of Overhead Absorption: Machine Hours

Therefore, Absorption Rate = Budgeted overhead
Budgeted machine Hours
= N40, 000
10000 hrs
= N4 per machine hour
Assembly Dept:
Basis of overhead absorption = Direct Labour Hours
Absorption Rate = Budgeted Overhead
Budgeted Direct Labourhrs
= N64, 000
25600 hrs
= N2.50per Direct Labourhr
Job 627: N
Direct Materials 400
Direct Wages 600
Production Overhead:
Machinery dept [20 x N4] = N80
Assembly Dept [200 x N2.50] = N500
580
Full cost = N1580
[b] New Bases
Machine Dept:
New Absorption rate = Direct Labour Hours
New Absorption Rate = Budgeted Overhead
Budgeted Direct Labour Hours
= N40, 000
25000 hrs
= N1.6 per Direct Labour Hour
Job 627
N
90
Direct Material 400

Direct wages 600
Production Overhead:
Machinery Dept [80 x N1.6] = 128
Assembly Dept [200 x N2.50] = 500
628
Full cost = N1628
The production cost of any product is a mixtu

mixture
re of science and subjective estimate.
Discuss.
The above statement is correct because the cost per unit of any product is made up of
basic facts and subjective estimates.
The basic facts are:
(a) The quantity and value of materials used

(b) The quantity
antity and value of labour used
The Subjective Elements are:
(a) Method of stock valuation [LIFO, FIFO, Average etc]

(b) Method of apportioning general overhead,
(c) Method of apportioning Service Dept Cost to the production cost centers.
(d) Basis of overhead absorption
(e) In a process industry, the method of accounting for by products, joint products,
work-in-progress
progress and losses.
The element of subjectivity is embedded in the fact that there are more than one way of
accomplishing the stated objective.
91
7.12 Summary
This study session builds on the foundation on overhea

overhead
d established in study session 6.
6 It defined
overhead absorption, explains how to compute overhead absorption, bases of overhead
absorption and blanket absorption rate. It also explains the reason why production
produ overheads
should be absorbed to products and the relationship between actual overhead and absorbed
factory overhead.
The treatment of over absorbed and under absorbed overhead were explained, and accounting for
overhead cost were discussed.
1. Explain the term overhead absorption
2. Distinguish between overall absorption of overhea

overheads
ds and under absorption of
overheads
3. Explain critically the accounting entries for overhead
4. Explain the term blanket Absorption rate
5. Big Lizards
ards Limited has a budgeted production overhead of N50,
50, 000 and a
budgeted activity of 25,000 direct labour hours [i.e. a recovery rate of N2per direct
labour hour].
Required:
Calculate the under/over absorbed overhead and the reasons for the under/over absorption,
ab if:
(a) Actual overheads cost = N47,000 and 25,000 direct labour hours are worked;
(b) Actual overheads cost = N50,000 and 21,500 direct labour hours are worked;
(c) Actual overheads cost = 47,000 and 21,500 direct labour hours are worked.
6. A draft budget for a company with four production centers included the following
data for the year:
Cost Directly allocated Apportioned Direct Labour

Centre Overhead Overhead Hours
92
N %
A 32,800 20 60,000
B 45,200 40 75,000
C 28,400 10 30,000
D 14,400 30 100,000
The total overhead to be apportioned amounted to N352,000
As a result of technical developments it was decided to reorganize the production centers. A

revised budget was therefore developed incorporating the following changes from the draft
budget:
1) A new cost centre – E- was established

2) N13,200 of overhead previously allocated directly to cost centre A is to be
transferred to cost centre E.
3) An additional N30,000 of overhead is to be allocated directly to cost centreE.
4) An additional N60, 000 of overhead will be incurred and should be apportioned as
follows:
Cost Centre: A B C D E
Percentage - 10 10 20 60
5) Overhead will be absorbed on a machine hour rate for all cost centresexcept A.
Revised budgeted hours are:
Cost Centre: A B C D E
Machine hrs - 40000 17400 60000 22500
Direct labour 50000 - - - -
Hours
You are required to calculate:

(a) Cost centre direct labour hour rates of overhead absorption based on the draft budget;
(b) Cost centre direct labour hour rates and/or machine hour rates of overhead absorption (as
relevant) based on the revised budget;
6) The overhead chargeable to/unit of product Z:
93
i) Under the ddraft budget
ii) Under the revised budget
7) The time taken in each cost centre for productio

productionn of one unit of product was budgeted as
follows:
Cost Draft Budget Revised Budget Machine
Centre Direct LabourHrs Direct LabourHrs Hours
A 5 5 -
B 10 - 3
C 5 - 2
D 7 - 3
E - - 5
iii] The budgeted production overheads and other budget data of Hairy Mammoth
Limited are as follows:
Production Production
Department A Department B
Overhead cost N36, 000 N5, 000
Direct materials cost N32, 000
Direct labour cost N40, 000
Machine hours 10,000
Direct Labour hours 18,000
Units of production 10,000
What would the absorption rate be using the va

various
rious bases of apportionment?
Are you in need of General Help as

regards your
iag@dli.unilag.edu.ng studies? Do not hesitate
08033366677
94
to contact the DLI IAG Center by ee-mail or phone on:
Study Session 8
Job Costing
Introduction
95
Job Costing makes it possible for the user to track employee hours under various levels. Job
Costing is generally used in businesses where employee labor costs are of special interest when
compared to the cost of finished goods such as manufacturing or production
pro related
organizations. Even though Job Costing adds a great deal of functionality to the InfiniTime
Application it is not used by all companies and as such is disabled by default. Job Costing related
fields such as Job and Task will not be displaye
displayedd within the application if Job Costing is
disabled. Job costing tracks all expenses you incur that directly or indirectly relate to the specific
arts or crafts product. Then you compare your expenses for the arts or crafts product to the
revenue produced by that product.
At the end of this study session,, you should be able to, among other things:
1. Identify the various costing methods

2. Identify the various costing techniques
3. Differentiate between costing methods and cost
costing techniques
4. Define Job Costing
5. State the requirements for effective Job Costing
6. Highlight the objectives of job costing
7. Explain Batch Costing and its relevance to Job Costing
8. Solve questions on Job Costing
8.0 Costing Method
“A costing method is a method of costing which is desi

designed
gned to suit the way goods are processed
or manufactured or the way services are provided” (Lucey).
There are two major costing methods each of which can be subdivided as per the following
diagram:
Fig 8.1
COSTING METHODS
96
SPECIFIC ORDER COSTING CONTINUOUS

OPERATIONS
COSTING
JOB BATCH CONTRACT PROCESS SERVICE

COSTING COSTING COSTING COSTING COSTING
8.1 Costing Techniques

Costing techniques refers to the method used in determining the valuation ooff finished goods.
Examples and breakdown
akdown are as contained in figure 8.2 below
Fig. 8.2
COSTING TECHNIQUES
ABSORPTION COSTING MARGINAL COSTING
HISTORICAL STANDARD HISTORICAL STANDARD

ABSORPRION ABSORPTION MARGINAL MARGINAL
MARGINA
COSTING COSTING COSTING COSTING
8.2 Definition of Job Costing
Job costing is defined as that form of specific Order Costing which applies when work is
undertaken to customer’s special requirement and each oorder
rder is of comparatively short duration
8.3 The Requirements of Effective Job Costing
The following requirements are relevant:
i) Sound system of production control
ii) Comprehensive work documentation. Typically this includes works order operation
tickets, bill of materials or material rrequisitions, job and tool requisitions
iii) An appropriate time booking system using either time sheet or piecework tickets.
iv) A well organized basis of costing system with cl clearly
early defined cost centers,
appropriate overhead absorption ra rates, etc
8.4 Objectives of Job Costing
i) To determine the profit or loss on individual job. This serves as a check on the
accuracy of the estimates on which prices have been quoted.
ii) To value work-in--progress for balance sheet purpose
97
8.5 Examples of Organisations Using Job Costing
i) Hair Dressing
ii) Fashion Design
iii) Accounting Firms
iv) Plumbing, etc.
v) Building, Contracting, Machine tool Manufacturing
vi) Foundries, printing, General Engineering
Fig 8.3 Procedures in Job Costing
Receipt of Customers Enquiry
Estimate Dept. prepares Estimate

Quotation sent to Customer
On receipt of Customer’s order an

internal Works Order is raised with
multiple copies for distribution to:
Production, Costing, Stores,
Invoicing Depts. etc.
Production Control Dept. raises

Routing Instruction, Bill of Materials
Piecework Tickets, etc
Manufacture of job using Labour,

Machine, Time and Material.
Vouchers sent to Costing Dept.
Compaction of job and Dispatch to

Customers
Invoicing with multiple copies for

distribution to: Costing Dept.
Customer, financial Accounting
Dept. etc.
Adapted from: Costing by Lucey
98
8.6 Recording/Accounting Entries
The following entries are relevant in job costing:
i) Materials Used
DR.: Job Ledger Control A/C (or WIP Ledger Control)
CR: Material stock Ledger Control A/C
ii) Labour
DR: Job Ledger Control A/c (or WIP Ledger Control)
CR: Payroll A/c
iii) Direct Expenses
DR: Job Ledger Control A/c
CR: Expenses Ledger A/c
iv) Overheads – Apportion using appropriate basis
99
8.9 fig. 8.4: Typical Job Cost Card
100
JOB COST CARD Job No.

Customer Start Date
Job Description Customers Order No. Delivery Date
Estimate Ref. Invoice No. Despatch Note No.
Quoted Price Invoice Price
Material Labour Overheads
Reg. Qty Price Cost Lab Cost Hrs Rate Bonus Cost Cost
Date Anal Centre
Date No N K Ref. N K N K
Total C/F Total C/F Total C/F
Expenses Job Cost Summary Actual Estimate

Date Ref Description Cost
Direct Materials B/F N K N K
N K Direct Expenses B/F
Direct Labour B/F
= Prime Cost
Factory Overheads B/F
=Factory Cost
selling& Admin Overheads
% on Factory cost
= Total Cost
Invoice Price
Total C/F Job Profit/Loss
Comments Job cost Card completed by.........................................

Adapted from: Costing by Lucey
101
EKA Ltd has the following budgeted overhead cost and related data for the year to 31 March
1998:
Machining Assembly Finishing

Overhead Cost N175, 500 N56, 450 N98, 750
No of Employees 16 7 12
LabourHrs 32,540 14000 26000
Machine Hrs 30000 2400 -
Wages Cost N142,400 N43,600 N91,500
Material Cost N 94,500 N32, 560 N43, 575
During January 1998, Jobs A B C were completed. The Direct Cost and related data were as
follows:
Machining Assembly Finishing
Material Cost N1, 369 N124 N 93
Labour Cost N 608 N 90 N251
Labour Hours 52 30 70
Machine Hours 147 25
Required:
(a) Calculate an appropriate overhead aabsorption rate for each of the 3 debts giving
reasons for your choice of method. of 40% on selling price is applied.
(b) Use these rates to calculate the total cost of job ABC and the selling price if gross profit
(a) i) Machining Dept – Use machine hours. This method is suggested because it is
expected that major component of the cost should be machine related such as
repairs of machine, insurance of machine and depreciation of machine.
Absorption Rate = Budgeted Prod. O/H = N175, 500
102
Budgeted Machine Hr = 30,000

= N5.85/m.hr
ii) Assembly Plant: - Use Labour hours. This method is suggested because in a
labour intensive dept, it is expected that majority of the cost will be labour related.
Such as overtime premium, staff canteen, Xmas bonus, idle time, maternity leave,
etc
Percentage of direct wages is not suggested because of the distortions that could
arise as result of possible differential pay rate.
Absorption Rate = BPOH = N56,450

BDL HRS = 14,000
= N4.03/DL Hr
iii) Finishing Dept - Use D/L Hrs also as suggested for the Assemble Plant and for the
same reason.
Absorption Rate = BP O/H = N98,750

Bud. DLHRS = 2,6,000
= N3.80/DL Hr
(b) Job ABC Cost Estimate

DM = N1,369 + 124 + 93 = N1,586
D/L = 608 + 90 + 251 = 949
PO/H:
Machine = 147 x N5.85 = N860
Assembly = 30 x N4.03 = N121
Finishing = 70 x N3.80 = N266
1247
Total production cost N3782
Gross profit (40 or 2 of cost) 40% of SP) = 2521
60 3
Selling Price = Production Cost profit
Gross Profit = N6303
= 3782 + 2521
Note: If gross profit is given a percentage of cost, then apply this relationship:
Say: Cost = 100%
103
GP = X
SP = 100 + X
Then use any appropriate relationship.
If
SP = 100
GP = 40
Cost = 60
Therefore GP = 40% of SP
= 40 = 2 = 66.7% of cost
60 3
Jobs No. 020 and 030 require the following materials and labour
020 030
Direct Material N23500 N2750
Direct Labour:
Dept. A 12hrs 5hrs
“ B 10hrs 3hrs
” C 14hrs 2hrs
The following additional information is available:
Direct wages at N2.50/hr
Overhead indirect lab
labour = N95,000,00
Maintenance Dept A = N25,000
B = N20,000
C = N15,000
Fixed Overheads:
Depreciation: 10% of plant valuation
Insurance, rent & rates = N45,000
Salaries = N19,000
PRODUCT PLANT FLOOR
104
Hrs Valuation Area

Dept. A 20,000 N75,00000 100m²
B 10,000 N100,00000 200m²
C 8,000 N185,00000 300m²
Required:
Calculate for each job the prime cost, the departmental factory O/H incurred the gross
profit which is 20% of selling price and the selling price.
Overhead Absorption rates (Working 1)

Depts. A B C
N N N
Allocated:
Maintenance 25,000 20,000 15,000
Depreciation [10% of value] 7,500 10,000 18,500
Apportioned:
Indirect labour [Prod.Hrs] 50,000 25,000 20,000
Insurance [Floor Area] 7,500 15,000 22,500
Salaries [Prod.Hrs] 10,000 50,000 4,000
N100,000N75,000 N80,000
Budgeted Prod.Hrs 20,000 10,000 8,000
Rate/Hour N100,000 N75,000 N80,000
20,000 10,000 8,000
= N5.0 = N7.50 = N10.0
10.0
* N50,000 = 20,00
20,000 x N95,000; N25,000 = 10,000 x 95,000
38,000 38,000
Overhead Absorbed to each Job [working 2]
Job 020 030
Depts.
A 12 x 5 = 60 5x5 = 25
B 10 x7.5 = 70 3 x 7.5 = 22.5
C 14 x 10 = 140 2 x 10 = 20
275 67.5
Estimation of Costs and SP of jobs
jobs:
020 030
D/M N235 N27.5
105
D/L N2,050 [ 12 +10 +14] = 90 25= N2.5 (5 + 3+2)

Prime Cost 325 52.50
Prod. O/H [working 2] 275 67.50
600 120.0
Gross Profit [25% of Cost] 150 30.0
Selling Price 750 150.0
Note: SP = 100
GP = [20]
Cost = 80
GP = 20
Cost = 80 = 25% of cost = 20% of SP
8.7 Batch Costing

As contained in Fig. 8.1 under paragraph 8.2 above, both job Costing and Batch Costing are
examples of specific order costing method. According toOmolehinwa, E. (2009), “They are
designed to keep track of costs of producing non-standardized products made to specific
requirements of the customers.” The only difference between the two of them is the quantity of
units involved. Job costing is concerned with a unit of job like producing an equipment, repair of
a car or painting a building. Batch costing is used when production involves the manufacturing
of a single product in lots of more than one as in printing where 1000 copies of a book may be
produced in a single batch.
The most common forms of batch are:
i) Where a customer orders a quantity of identical items, or

ii) Where an internal manufacturing order is raised for a batch of identical parts,
sub-assemblies or products to replenish stocks.
In general, the procedures for costing batches are similar to costing jobs. The batch would be
treated as a job during manufacture and the cost collected as described in this module. On
completion of the batch the cost per unit can be calculated by dividing the total batch cost by the
number of good units produced.
Batch costing is common in engineering component industry, footwear and clothing manufacture
and similar industries.
8.8 Service Costing
106
Service costing is that part of operation costing which is used in all organizations that provide
services instead of producing of goods. For calculating the price of each service, it is very
necessary to collect all the expenses relating to those services. We make a cost sheet in which we
show all the cost relating
lating to specific service. These costs are calculated on the time basis. The
following are main organisationwho provide services.
- Bus, Trucks and Rail – Transport Services
- Housing and Domain – IT services
- Electricity Companies – Electrical Services
- Gas and petrol Companies – Gas and petrol Services
Service costing examples includes; Salary, Insurance, Road Tax, Licence Fees, Interest on
capital, Repairs, Depreciation petroleum Expenses, IT service related cost.
8.9 Summary
This study sessionexplains the

he various costing methods and costing techniques. It defined job
costing and explains the requirements necessary for an effective job costing. The objectives of
job costing as well as the procedures involved in job costing were explained.
Batch Costing was

as explained and the most comm
common
n forms of batch were explained. This module
concludes by defining Service Costing and explains the organisation that uses service costing.

Questions:
1. Set out the features of job costing, and llist the features
atures needed within the job costing
system to ensure that it operates efficiently. Suggest two types of business where job
costing would be appropriate.
2.
i. Compare and contrast batch costing and job costing.

ii. Explain the relevance of batch costing to Job co
costing
3.
i. list and explain the various costing methods and techniques

ii. Differentiate between costing methods and costing techniques
107
4. Hancock receives an order to supply his local farmer with delivery of cattle feed.
The job passes through three departments, collecting costs as follows:

Mixing Department 100kg of Brend at N2 per kg(Type of Animal
Feed)
50kg of Cake at N1 per kg(Type of Animal Feed)
20kg of G/nut at 50k per kg(Type of Animal
Feed)
10 hours of labour at N4 per hr
Boiling Department 20 hours of the labour at N4 per hr
60 hours of the boiling machine
Cooling & skimming Dept 50 hours of labour at N2 per hr
Hire of giant thermometer and scoop N200.
The job does not disrupt normal activity level, which are as follows:
Department LaboursHrs Machine Hrs Budgeted O/H

Mixing 200 N1,600
Boiling 250 700 9,100
Cooling 550 4,950
Basis of absorption: Mixing: Labour hrs
Boiling: Machine hrs
Cooling: Labour hrs
Selling and administrative expenses are 30% of factory cost.
You are required to prepare a statement showing the profit or loss on the job, if the price agreed
is N2,500.
5. A specialist manufacturer of purpose-built plant engaged in three separate jobs in May

1986. The following costs were incurred:
Job A Job B Job C

N N N
Direct materials purchased 524 671 382
Direct labour:
108
Skilled [hours] 158 170 16

Semi-skilled [hrs] 316 190 30
Site expenses 118 170 25
Selling price of job 3,318 2,750 1,950
Completed at 31 May 1986 100% 80% 25%
The following information is available:

Direct materials for the completion of the jobs have been recorded.
Direct labour is paid – skilled N5 per hour semi-skilled N4 per hour.
Site expenses tend to vary with output.
Administration expenses total N440 per month and are to be allocated to the jobs.
On completion of the work the practice of the manufacturer is to divide the calculated profit on
each job 20% to site staff as a bonus, 80% to the company. Calculated losses are absorbed by the
company in total.
You are required to:
a) Calculate the profit or loss by the company on job A;

b) Project the profit or loss made by the company on Jobs B&C
c) Comment on any matters you think relevant to management as a result of your
calculations.
d) Advise management whether to accept job D which must be delivered by 30th June, 1986.
Job D is identical to job B, but the customer has agreed to accept a 10% increase in the
selling price. As jobs B and C must also be delivered by 30th June, Management is
concerned that there may be insufficient labour available as this cannot be increased, No
other orders are in prospect.
6. B. Idler commenced business on May 1, having obtained three orders for house extension the
costs of which during this first month’s trading were as follows:
Job 1 Job 2 Job 3
N N N
Direct wages 538 451 308
Materials issued from stores 2,752 2,341 1,478
109
Special materials bought in 215 - 46
Materials returned to stores 71 - -
Idler has estimated his overhead for the year ending on the following 30 April at N 10,500 and
the direct labour hours at 17,500hrs. Under a trade union agreement dated 1 may, all direct
workers were paid 110k per hour from that date. For costing purposes overhead’s absorbed on a
direct labour basis. The overhead incurred in May was N800.
Job No 1 was completed on 31st May and invoiced to the customer at the contracted amount of
N4,500.
Prepare:
a) Cost accounts for each of the three jobs;

b) Control accounts for overhead and work in progress for May;
c) Profit and loss account for May.
110
Study Session 9
Cost Behaviour IncludingDifferent Types of Fixed Costs
Introduction
Cost is the value of economic activity or the amount used or spent in obtaining a unit of product,
service or time. Cost is never static and it is not completely under control by any organization
from time to time. This is partly due to the dynamics of the environment itself. In the light of
this, it is necessary and even prudent to know the way a cost changes as changes take place in the
level of business activity. This is what is designated as cost behaviour. Knowledge of cost
behaviour is necessary across the whole range of cost and management accounting activities,
particularly in the area of cost control, planning and decision-making.
At the end of thisstudy session, you will be able to view cost from the perspective of variable and
Fixed Costs, and explain the following:
1. Cost behaviour and the volume of activity

2. Cost behaviour and time
3. Predicting cost behaviour
4. Variable cost: Definition and behaviour
5. Fixed Cost: Definition and categories
6. Establishing the appropriate cost characteristics
7. The effects of inflation on cost behaviour
8. Problems of cost behaviour prediction
9. Solving problems on cost behaviour
9.0 Cost Behaviour and Volume of Activity
111
There are many factors influencing costs, but the major factor is the level or volume of activity.
Many of the reasons for studying cost behaviour relate to changes or proposed changes in the
level of activity. The level of activity can be expressed in many ways e.g. tonnes produced, hours
worked, standard hours produced, invoices typed, sales, etc. Many alternative terms can be used
for the concept of “level of activity” e.g. capacity, output, volume throughout etc. Activity level
changes and the resulting cost changes form the basis of many practical decisions. The
accounting classification of cost into fixed and variable costs is as a result of the behaviour of
cost in relation to changes in the level of activity. This underscores the significance of cost
behaviour.
9.1 Cost Behaviour and Time
The use of cost behaviour for planning and decision making are short run in nature. It is
appropriate over a relatively short time span only. Short time depends on the particular
circumstances, it may be three months six months or one year; but it is unlikely to be as long as
five years. Over longer time periods unpredictable factors are bound to occur, methods will alter,
technology will improve, so that predictions of cost behaviour are likely to be increasingly
unreliable.
9.2 Predicting Cost Behaviour
Generally, predictions about cost levels and cost behaviour in the future are based on records of
past costs and their associated levels of activity. Thus many of the statistical techniques of
forecasting and extrapolation are of value when studying cost behaviour. We must bear in mind
that past conditions are indeed a guide to the future. Statistical forecasting techniques may not
produce valid predictions if conditions in the future are likely to be significantly different from
the past. Judgment will always play a part in cost prediction, but in many cases, relatively simple
statistical techniques can be of great assistance. Cost predictions should be based on the facts of
particular situations and not on arbitrary or general classifications.
9.3 Variable Cost
This is a cost which tends to vary with the level of activity of the organization in the short run.
It is commonly assumed that variable costs behave linearly in respect to volume changes. This is
not always the case as we have two types of variable cost patterns. These types are linear
variable cost or Non-Linear variable cost.
112
Linear Variable Cost:
This is a situation where the relationship between variable cost and output can be shown as a
straight line on a graph as contained in figure 99.1 below:
Fig. 9.1
.1 Examples of L
Linear Variable Cost
Cost Cost
Output Output
This linear relationship can be expressed algebraically as:
Cost = bx
Where x = Volume of output in units
b = a constant representing the variable cost per unit.
The materials contained in each assembly ST100 are:
6 Brackets @ N1.20 each

20 Screws @ N0.20 each
12 Pulleys @ N0.50 each
What is the expected variable cost of materials for producing 50 Assemblies?
113
MATERIAL COST/ASSEMBLY
N N
6 x 1.20 = 7.2
20 x 0.20 = 4.0
12 x 0.50 = 6.0
= N17.20
Cost = bx
= 17.20 x 50 = N860
Non- Linear or Curvilinear Variable Costs:
Where ever the relationship between variable cost and output can be shown as a curved line on a
graph, it is said to be curvilinear. Two main types curvilinear curves are as contained in fig 9.2.
Fig 9.2
.2 examples of curvilinear variable costs:
Convex
Concave
Cost
Cost
Output
Output
A convex curve is produced where extra unit of output causes a less than proportionate increase
in cost. A concave curve exists where each extra unit of output causes a more than proportionate
increase in cost.
An example of a cost which could result in a curvilinear cost function is that of piecework
scheme for individual workers with differential rates. Whenever the rates increased by small
amounts at progressively higher output levels the graphing of wages for a number of workers
would result in a concave cost function.
The curvilinear function can be represented as follows:
114
n
Cost = bx + cx² + dx³ + --- px
Where x = volume of output in units
b, c, d ------ p = Constants representing the va
variable cost per unit.
n= the last term.
The analysis of cost and activity records for the Human resources Board project show that the
variable cost can be represented by the following function:
Cost = N [bx + cx² + dx³]

Where b = 16; c = 0.5; And d = 0.03
Calculate
i) Variable cost when production is 20 units

ii) Variable cost when production is 30 units
iii) Is the function convex or concave?
(i) Cost = N16 x 20 + 0.5 x 20² + 0.03 x 20³
= N760
(ii) Cost = N16 x 30 + 0.5 x 30² + 0.03 x 30³
= N1,740
(iii)The increase in activity from 20 to 30 units results in more than a doubling of

variable cost. This shows that there is a more than proportionate increase in
the unit cost of extra production so that the function is concave.
9.4 Fixed Cost
This is “a cost which is incurred for a period, and which, within cert
certain
ain output and turnover
limits, tends to be unaffected by fluctuations in the levels ooff activity” [costing by Lucey]
115
Examples of fixed costs are Rent, Rates, Insurance, Executive sal

salaries,
aries, etc. Fixed cost
co is also
known as period cost. The main characteristics of fixed costs are:
i) They are time related

ii) Within a particular range, they are unaffected by changes in the level of activity.
This does not mean that fixed costs do not change

change; rent and rates, for example,
xample, change quite
frequently. The main point is that the change in the cost is not caused by changes in the volume
of activity. Fixed costss can be graphically represented as in fig 9.3
Fig. 9.3
.3 Fixed Costs
Costs Cost assumed to be constant at all

levels of activity.
Output
Fixed cost can be expressed algebraically as:

Cost = a
Where is a constant? Volume of output does not appear in this expression
Fig. 9.3
.3 is not realistic because it assumes that costs will be constant at all levels of activity. This
is not likely to be so. The realistic position is that at a particular level of activity, fixed costs will
be fixed. Once there is a change in this particular level of activity, fixed costs will also
a change.
Thus, what we have in practice is a stepped fixed cost. That is, different fixed costs at different
levels of activity. This is graphically
raphically represented in Fig. 9.4.
Figure 9.4
.4 Stepped Fixed Cost
116
Stepped Costs
Costs
0 1 2 3 4 5 6
Output
Explanation: At activity level 1, the fixed cost is FC1. Once the level of activity changes to level
2 the fixed costs move to FC2 and so on. This is the explanation behind the maxim which states
that on the long run all costs are variable. Fixed cost is fixed within a given range of activity
level.
9.5 Categories of Fixed Costs
For planning and decision making purposes, it is useful to subdivide fixed costs into five
categories. These are:
(a) The time period classification: These are fixed costs that are not likely to change
significantly in the short term, usually a year.
(b) The Volume Classification: These are costs which are fixed for small, but no
large changes in output or capacity.
(c) The Joint Classification: This is where a cost is incurred jointly with another
costand is only capable of being altered jointly. For example, if an organization
leases a showroom which has a warehouse attached then the fixed cost element
applies to both parts of the asset acquired whether or not they are both wanted.
(d) The policy Classification: These are costs which are fixed by management
policy and bear no casual relationship to volume or time. They are usually items
which are dealt with by appropriation budgets. Examples are expenditure on
advertising, research and Development. They are sometimes known as
programmed fixed costs and are generally reviewed annually.
(e) The Avoidable Classification: These are costs which are fixed in the normal
sense. They do not vary with activity, but they are avoidable if particular
decisions or events occur. For instance, the rent and rates for a branch office
117
would normally be classified as fixed yet they are avoidable if the branch is shut
down.
The implication of [a] to [e] above is that a cost may be classified as fixed for some purposes and
not others. The cost accountant must continually appraise the classification of a cost to ensure
that it is appropriate for the intended purpose.
9.6 Semi-Variable Costs
This is a cost containing both fixed and variable components. Thus it is partly affected by
fluctuation in the level of activity.
Rarely is a cost purely fixed or purely variable. Frequently there are elements of both
classifications in a cost. An example is electricity charges containing a fixed element, the
standing charge, and a variable element, the cost per unit consumed. Semi-variable costs can be
shown graphically as follows:
9.7 Establishing the Appropriate Cost Characteristics
The analysis of past cost and activity data leads to the establishment of appropriate cost
characteristics.
There are three methods available for this purpose. These methods are:
(a) High/Low Method

(b) The Scatter graph Technique and
(c) The Least Square Method
High/Low Method
This is a simple but crude technique which uses only the highest and lowest values contained in a
set of data to determine the rate of cost change and hence the variable cost. The variable costs so
determined are then used to estimate the fixed element.
Procedure:
- Identify the high output

- Identify the low output
- Obtain the difference
- Calculate variable cost per unit
118
- Calculate the Fixed Cost
The costs of operating the maintenance de

department of a computer assembly for the last four
months have been as follows:
Month Cost Production volume

N [Standard Hours}
1 100,000 7000
2 115,000 8000
3 111,000 7700
4 97,000 6000
What costs should be expected in month five when output is expected to be 7500 standard
hours?
High - Low = Difference

Output 8,000 6000 = 2000
Cost [N] 115000 97000 = 18000
Calculate the variable cost per unit
= Difference in Cost
Difference in Output
= N18000 = N9 per unit
2000
Then calculate the fixed cost as follows:
High Low
Output 8000 6000
Total Cost N115000 N97000
Variable Cost
[Output x N9] [N72000] [N54000]
Fixed Cost N43000 N43000
119
The implication of what we have done here is that once we obtain the variable cost per unit, we
can determine the fixed cost using either High or Low level.
Cost estimate for month 5 can now be calculated as follows:

Output 75000
N
Variable Cost [7500xN9] = 67,500
Add Fixed Cost 43,000
Expected Total Cost 110,500
Note: The determination of Fixed Cost can also be done using equation of a straight line
thus:
y = a + bx
y = Total Cost
a = Fixed Cost
x = Output
b = variable cost per unit
Using High Output level we have:
115000 = a+9 [8000]
= a + 72000
a = 115000 – 72000 = 43000
The Scattergraph Techniques
This is a simple visual techniques employed whereby costs are plotted against various output. A
line is drawn at an angle adjusted to be the best representation of the slope of the high and low
points. The Line is drawn to show the intersection with the vertical axis and thus gives an
estimate of the fixed cost content of the cost being considered. The slope of the line constitutes
the variable element.
Seun Ltd decides to relate to

total
tal factory overhead costs of direct hours (DLH) to
develop cost – volume formula in the form of y = a + bx twelve monthly observations are
collected. They are given in Table 4.1 below.
120
Month Direct Labour Factory overhead (y)

Hours (x) (‘000) (‘000)
January 9 hours N 15
February 19 20
March 11 14
April 14 16
May 23 25
June 12 20
July 12 20
August 22 23
September 7 14
October 13 22
November 15 18
December 17 18
Total 174 hours N225
Required:
Using the scattergraph technique, compute the variable rate per hour of Seun Ltd, and
develop the cost volume formula in the form Y = a + bx
Adapted from Ade Omolehinwa (Work out Management Accounting)
Figure 9.5
28
24
121
20
16
12
4
0 4 8 12 16 20 24
Since the regression line obtained by visual inspection strikes the factory overhead axis at the N6
point, that amount represents the fixed cost component. The variable cost component is
computed as
Factory overhead at 23 hours of direct labour N25
Less: Fixed cost component 6
Variable cost component N19
Therefore, the variable rate per hour is 19/23 = N0.8261 per DLH.
In summary, based on the scattergraph method, we obtain y = N6 + N0.8261x
Where y = estimated factory overhead, x = DLH.
The Least Squares Techniques
This is a statistical method for calculating a line of best fit to data and has a variety of uses
including that of establishing a cost function. The linear cost function can be represented by:
y = a + bx
Where y = Cost i.e. Total Cost
b = a constant representing the variable cost per unit
x = Volume of output
a = Fixed Cost
To find the values of the constant, a and b, two simultaneous equations need to be solved.
These are:
Y = an + bx…………………….Equation (1)
xy = a x+b x2 ……………...Equation (2)
Where n = number of pairs of cost and activity figures.
122
The following cost and activity data of EKA Ltd were given for the half year ended 31st March,
1998.
Cost Activity [Units]

[Y] [x]
N
112 8
124 10
160 14
144 14
176 18
188 20
You are required to calculate the Fixed and Variable elements of Cost.
y x xy x²
112 8 896 64
124 10 1240 100
160 14 2240 196
144 14 2016 196
176 18 3168 324
188 20 3760 400
y = 90 x = 84 xy = 13320 x² = 1280
n=6
Substituting in the equations given we have:
123
n
y = 904 = 6a + 84b ………………… Eq [1]
n
xy = 13320 = 84a + 1280b…………….. Eq [2]
Eliminating one of the constants by multiplying Equation [1] by 14 and deduct from Equation [2]
we have:
13320 = 84a + 1280b……………….[2]

12656 = 84a + 1176b……………….14 x [1]
664 = 104b
Therefore b = 664 = 6.385
104
Substituting in either equation to find a, we have:
13320 = 84a + [1280] [6.385]
13320 = 84a + 8173
13320 - 8173 = 84a
5147 = 84a
a = 5147 = 61.27
84
Therefore, the linear cost function is
y = a + bx
= 61.27 + 6.385x
y = Total cost
N61.27 = the fixed cost,
N6.385 = variable cost per unit of activity
9.8 The Effects of Inflation on Cost Behaviour
The effect of inflation is one of the major problems in trying to determine cost behaviourusing
past data. This inflationary effect has to be adjusted for in order to get an accurate breakdown of
costs into fixed and variable categories.
124
The general method of adjusting for the effects of infl

inflation
ation is highlighted using the following
example:
The production and cost data for EKA Ltd recorded over the past and present years are as
follows:
Last Year Current Year
Production 5000 units 5400 units
Total cost N170, 000 N183, 540
Between last year and current year, inflation has increased by 5% you are required to:
(a) Calculate the “real” fixed and variable costs, and

(b) Estimate what the total costs will be next year when it is expected there will be 4% cost
inflation and output will be 5600 units (Adapted from: Costing by Lucey)
a) Eliminate the inflation effects from the data supplied as follows:

Current Year costs in “real” terms.
= Current Year Actual Cost
Inflation rate + 1
= N183540 = N174,800
1.05
Find the fixed/variable costs from the real cost and production differences thus:
Production Costs
[Units] [N]
Current Year 5400 Units 174,800
Last year 5000 Units 170,000
400 Units N 4, 800
Therefore, the real variable cost per unit
= N4800 = N12
125
400 units
The “real” fixed cost = N174, 800 - [5400 x N12]
= N174, 800 - N64, 800
= N110, 000
The actual costs in the current year thus made up as follows:
[N110, 000 x 1.05] + [5400 x N12 x 1.05]
= N115,500 + N68,040 = N183,540
b) Cost estimate for the next year when inflation is expected to rise by 4% with 5600
units of output is computed as follows:
= [N110,000 x 1.05 x 1.04] + [5600 x N12 x 1.05 x 1.04]
= N109,200 + N73,382
= N182583
Note: If the inflation effects between periods are not allowed for, the cost
breakdown into FC and VC cannot be accurate.
Hydraulic Products Limited is temporarily operating at 60% capacity owing to a recessi n in

the industry. The costs of production of 11,500
,500 pumps manufactured in May were:
Direct materials [N20 x 1500] 30,000
Direct wages (N3 x 1500) 40,000
Variable overhead 5,500
Fixed overhead
10,000
The pumps are currently sold at an average price of N40.
A foreign government agency has invited tenders fo

forr the supply of 500 pumps per month to be
collected from the manufacturer’s factory in ordinary home tra
trading packing.
With a view of submitting a tender you ascertain the following facts:
126
(1) The variable overhe

overhead attribute to various activity levels is:
Per Month
% N
50 4,600
60 5,500
70 6,400
80 7,500
90 8,500
100 9,400
(2) The fixed overhead of N120,000 per annum is applicable to activity levels up
to 90%.
(3) The price charged to overseas customers is not expected to influence the
price in the home market in which the whole of the current production is
sold.
(a) Calculate the bidding pric

pricee which will yield a profit of 10% thereon
(b) Prepare a statement showing the effect on the monthly profit if the company’s
tender is accepted.
(c) Explain briefly the principle (s) you have applied in answering this question.
(a) Calculation of bidding price:
Variable costs of production – 2,000 pumps: N

Direct materials (N20 x 2000) 40,000
Direct wages (N3 x 2000) 6,000
Variable overhead [80 capacity] 7,500
Total cost 53,500
Variable costs of production -1,500 pumps 40,000
Extra costs of production – 500 pumps 13,500
Required profit 10/90 x 13500 = 1500 1,500
Total sales 15,000
127
Therefore the bidding price which will yield a profit of 10% thereon is N15,000.
Foreign Government Contract

Statement to show effect on monthly profit
Without Contract with Contract
N N
Sales 60,000 75,000
Variable costs 40,000 53,500
Contribution 20,000 21,500
Fixed Overhead 10,000 10,000
Profit 10,000 11,500
(b) Since 1,500 pumps represent 60% capacity, extra 500 pumps produced will result in
the company operating at 80%. At this level, variable overhead is N7,500 per month.
Fixed overhead is not affected.
Required II = 10% of price

i.e Sp= 100%
Cost =90%
II 10%
II 10 of Sp = 10 of Cost;
10 90 of 13500 in this case = N1500
= 11.11% of cost
The contribution currently earned is N20,000 on the sale of 1,500 pumps. At this level of sales,
therefore, fixed overhead is fully recovered. The bidding price in [a] above is based upon
contribution, assuming no change in fixed costs.
It has also been assumed that direct materials and direct wages are strictly variable over the range
of activity considered.
9.9 Problems of Cost Behaviour Prediction
128
There are many problems in cost prediction whic

whichh may militate against accurate prediction; these
problems need be highlighted with a view to knowing how to prevent them. Some of these
problems are:
i. Tendency to Classify Costs for all Time: There is a tendency to classify costs,
without too much regard to their actual behaviour, as fixed or variable according
to conventions. Any classification of costs into fixed and variable needs to be
continually reviewed in the light of their actual behaviour and in relation to the
purpose for which the classification is intended to serve.
ii. Uncritical Use of Historical Data: If past cost data are to be used for prediction
purposes, care must be taken to ensure that they are reasonably representative and
not subject to special conditions.
iii. Linearity Assumption: costs display a variety of forms. The assumption of
linearity for all variable costs may introduce unacceptable ina
inaccuracies.
ccuracies.
iv. Use of Statistical Methods
Methods:: If the base data are sound, a gain in accuracy may be
obtained by the use of appropriate statistical methods. E.g. the regression analysis
method
However, where several factors are known to have influenced costs, then more
advanced statistical methods [e.g. multiple regression analysis method] may be
required.
v. Oversimplification: Generally, it is assumed that all variable costs vary
according to a single activity indicator. In a manufacturing company this is
typically taken to be production volume. This is a gross over-simplification.
over
Different costs vary with different activity indicators.
9.10 Summary
This study session explains the Cost behaviour and Volume of activity, Cost behaviour and time,
how predictions can be made on Cost behaviour, fixed costs and stepped fixed cost as well as
categories of fixed costs were explained. The module also explained the methods that can be
used to analyse past methods and activity data which will establish appropriate cost
characteristics through the use of high and low method, scatter
scattergraph
graph technique, and the least
square method.
The effects of inflation on cost behaviour and the problems of cost behavior prediction were also
explained.

129
1. Explain the impact of Cost behaviour on the volume of activity and time
2. Define variable cost and explain its behaviourvis-a-vis predicting cost behaviour.
3. Define fixed cost, and explain the categories of fixed cost, discuss how to establish
the appropriate cost characteristic
4. Critically examine the effect of inflation on cost behaviour and list the problems
associated with cost behaviour prediction.
5. Up and Down Limited has recorded the following total costs during the last five
years:
Year Output Total Cost Average Price

(Units) N Level Index
1992 65,000 145,000 100
1993 80,000 179,200 112
1994 90,000 209,100 123
1995 60,000 201,600 144
1996 75,000 248,000 160
What should expected in 1997 if output is 85,000 units and the average price level
index is 180%
6. XY Limited is operating at a normal level of activity of 80% which represents an

output of 5,600 units. The statement shown below gives basic details of cost and sales
at three operating level of activity. In view of the depressed market in which the
company may have to operate in the near future, the production director believes that
it may be necessary to operate at 60% level of activity
Level of Activity
70% 80% 90%
N N N
Direct materials 73,500 84,000 94,500
Direct wages 44,100 50,400 56,700
Overhead 45,400 49,600 53,800
Sales 196,000 224,000 252,000
130
(a) As cost accountant of XY Limited, you are required to prepare a forecast

statement to show the marginal costs and contribution at the proposed level of
activity of 60%.
(b) Explain how you arrived at the calculation iin
n [a] and why it may not be
completely accurate.
Should you require more explanation on this study session, please do not he
hesitate
sitate to contact your
Are you in need of General Help as regards your studies? Do not hesitate to contact the
DLI
08033366677
Study Session 10
Marginal VersusFull or Absorption Costing
Introduction
The costs that vary with a decision should only be included in decision analysis. For many
decisions that involve relatively small variations from existing practice and/or are for relatively
131
limited periods of time, fixed costs are not relevant to the decision. This is because either fixed
costs tend to be impossible to alter in the short term or managers are reluctant to alter them in the
short term.
At the end of this study session, you should be able to explain the following:
1. Marginal Costing definition

2. Absorption Costing definition
3. Alternative
native concepts of Marginal Cost
Costing
4. The concept of contribution
5. The uses of Marginal Costing
6. Marginal costing vis-àà-vis Absorption Costing
7. Stocks valuation and Marginal Costing and the effect on profitability
8. Advantages of Marginal Costing
9. Disadvantages of Marginal Costing
10. Arguments justifying the use of total absorption in routine Costing
11. Solve questions on marginal and absor
absorption costing
10.0 Marginal Costing Defined
Marginal costing is defined as the ascertainment of marginal costs, and the effect on profit of
changes in volume or type of output by differentiating between fixed and variable costs.
This definition makes it clear that marginal costing goes further than the ascertainment of cost. It
also provides a means of calculating how profit will be affected by changes in volume, in cost, in
selling price, or in mixture of sales.
Marginal costing can also be defined as “t

“the
he accounting system in which variable costs are
charged to cost units and the fixed costs of the period are written
written-off
off in full against the aggregate
contribution”
The term “contribution” in the definition is the term given to the difference between sales and
Marginal Cost. Another name for Marginal Cost is Variable Cost. This is not always the case
132
because marginal cost may include fixed costs incurred solely because of the order or job under
consideration.
Variable Cost is the sum of Direct Labour Cost, Direct Material Cost, Direct Expense and
Variable Overheads.
10.1 Absorption Costing Defined
This is known as Total Costing System in which all costs are absorbed into production. Fixed
manufacturing overhead is included in the inventory costs. The traditional income statement uses
absorption costing and classifies expenses by management function, such as the manufacturing,
selling
lling and administrative expenses.
10.2 Alternative Concepts of Marginal Costing

To the economist, marginal cost is the additional cost incurred by the production of one extra
unit. To the accountant, marginal cost is average variable cost which is presum
presumed
ed to act in linear
fashion, i.e., marginal cost per unit is assumed to be constant in the short run, over the activity
range being considered. These views are presented graphically below:
Fig 10.1 Marginal Cost per Unit
Accountant’s View Economist’s View
Output Output
10.3 The Concept of Contribution
Contribution is defined as the difference between ssales

ales and marginal cost of a product. Thus
marginal cost = variable cost.
133
The more the number of units sold, the greater the contr
contribution
ibution towards the recovery of fixed
cost for the period. After the recovery of fixed cost, any additional contribution made is known
as profit.
10.4 The Uses of Marginal Costing
There are two main uses for the concept of margin

marginal costing:
(a) As a basis for providing information to management for planning and decision
making. It is particularly appropriate for short run decision involving changes in
volume or activity and the resulting cost changes.
(b) It can also be used in the routin
routine cost accounting system
tem for the calculation of costs
and the valuation of stocks.
10.5 Marginal Costing Vis-à--Vis Absorption Costing
Absorption costing is the basis of all financial accounting

nting statements. Under the absorption
costing system, all costs are absorbed into pr
production and thus operating statements do not
distinguish between fixed and varia
variable costs. Consequently the valuation of stocks and work-in-
work
progress contains both fixed and variable elements.
Under the marginal costing system, fixed costs are not absorbed into the cost of production. They
are treated as period costs and written off each period in the costing profit and loss account.
The effect of this is that finished goods and work

work-in-progress
gress are valued at marginal cost only,
that is, thee variable elements of cost, usually pr
prime cost plus variable overhead. At the end of a
period the marginal cost of sales
ales is deducted from sales revenue to show the contribution, from
which fixed costss are deducted to show net profit.
These two approaches are illustrated below:
ITQ
In a period, 20,000 units of supradene were produced and sold. Costs and revenues were as
follows:
N
Sales 1,000,000
134
Production Costs
Variable 350,000
Fixed 150,000
Administrative + selling overheads:
Fixed 250,000
You are to prepare operating statements based on both Absorption and Marginal Costing.
Table 10.1: Operating Statement
Absorption Costing Approach Marginal Costing Approach
N N
Sales 1,000,000 Sales 1,000,000
Less: Prod. Cost
of sale 500,000 Less: Marginal Cost 350,000
= Gross Profit 500,000 = Contribution 650,000
Less: Admin + Less Fixed Cost:
Selling O/H 250,000 N
Production 150,000
Admin S + D 250,000400,000
400,000
Net Profit N
N250,000 Net Profit N250,000
The key figure arising in the marginal statement is the contribution of N650, 000. The total
amount of contribution arising from product supradene forms a pool from which fixed costs are
met. Any surplus arising after fixed costs are met becomes the net profit.
It is pertinent to note that when changes occur in the level of ac

activity,
tivity, the absorption costing
approach many cause some confusion. This is principally due to the treatment of fixed cost under
the absorption costing method.
10.6 Stock Valuation and Marginal Costing
In example 10.1, both marginal and absorption costing methods produced the same net profit of
N250,000. This was because there wa
wass no stock at the beginning or end of the period. Because
135
the two methods differ in their valuation of stock, they produce different profit figures when
stocks arise. This can be illustrated in the example below:
In a period, 20000 units of supradene were produced but 18000 sold. Costs structure was as
contained in Example 10.1. You are to produce operating statement based upon marginal
costing and absorption costing principles.
Table 10.2: Operating Statements
Absorption Costing Marginal Costing
NN N N
Sales
Sales [18,000xN50] 900,000 900,000
Less Cost of sale 500,000 Less Marginal Cost 350,000
Less closing Less closing stock
[Stock = 2000 x N25] 50,000 [2000xN17.5] = 35,000
450,000 315,000
= Gross profit 450,000

Less Admin + Selling O/H 250,000 = Contribution 585,000
Less Fixed Costs:
Production 150,000
Admin, S +D 250,000
400,000
Net Profit 200,000 Net Profit 185,000
The following should be noted:
i] The Closing stock valuation using Absorption costing method
= N 500,000
136
20,000 Units
= N 25 = Average production cost including fixed costs.
ii] The closing stock valuation using Marginal costing approach
= N350,000
350,000
20,000Units
= N17.50
17.50 = Variable cost only.
iii] By including fixed costs in stock valuation, absorption costing transfers some of
this period’s fixed cost into period when they will be charged against the revenue
derived from the stock carried forward. Marginal costing always writes off all
fixed costs in the period as they are incurred.
iv] In a period with increasing stocks, absorption costing will show higher profits
than marginal costing. Conversely in a period of decreasing stocks, marginal
costing will show
w the higher profits. The difference is essentially due to the
different treatment of fixed costs in the stock valuation.
The following data were taken from the records of EKA Nig. Ltd
Period 1 Period 2 Period 3

Production 30,000 38,000 27,000
Sales 30,000 27,000 38,000
Opening Stock - - 11,000
Closing Stock - 11,000
All the above in kgs.
The company makes a single product the financial de

details
tails of which are as follows (based
( on a
normal activity level of 30,000 Kgs)
Cost per Kg (N)

Direct material 1.50
Direct labour 1.00
137
Production overhead = 300% of Labour 3.00

5.50
Selling price per kg = N9.00
Administrative overheads are fixed at N25,000

25,000 and one third of the production
overheads
eads are fixed.
You are required to prepare operating statements on marginal costing and absorption costing
principles for each of the three periods.
From the question, 1/3 of production overheads are fixed, i.e

i.e.. 1/3 of N3.00 is fixed, which N1.00
is per kg.
It then follows that the fixed overheads
=N1 x 30,000 = N30,000 while the marginal production cost is N4.50 per Kg
(N5.50 – N1)
Table 10.3: Operating Statement Using Marginal Costing

N N N N N N
Sales 270,000 243,000 121,500 342,000
Marginal production Cost 135,000 171,000 49,500
+ opening Stock - -
-Closing Stock - 49,500
= Marginal Cost of Slaes 135,000 121,500 171,000
= Cotribution Less Fixied 135,000 121,500 171,000
Costs 55,000 55,000 55,000
= Profit 80,000 66,500 116,000
Please not that stocks are valued at marginal cost.
138
Table 10.4: Operating Statement Using Absorption Costing
N N N N N N
Sales 270,000 243,000 148,500 342,000
Total production Cost 165,000 209,000 60,500
+ opening Stock - -
-Closing Stock - 60,500
= Total Cost of Slaes 165,000 148,500 209,000
= Gross profit less Admin 105,000 94,500 133,000
Overheads 25,000 25,000 25,000
= Profit over/(under) 80,000 69,500 108,000
Recovery of 8,000 (3,000)
Fixed Overheads
= Profit 80,000 77,500 105,000
Please note the followings on the above solution:
i) Stocks are valued at total cost at the normal production level of 30,000kgs
ii) Alternatively, the over
over/ [under] recovery of fixed overheads could be reconciled
at the year end.
10.7 Advantage of Marginal Costing
The advantages to be gained from the use of marginal costing may be summarized as follows:
i) The marginal costing technique brings out in clear and simple terms the exact
relationship between cost, selling price, and volume.
ii) It shows the relative contributions to profit which are made by each of a number of
products,
oducts, and shows where the sales effort should be concentrated;
iii) It provides information to show which goods sshould
hould be manufactured by the
organization and which should be purchased from outside sources;
iv) It discloses how the greatest overall profit can be made;
139
v) By separating the fixed and variable costs, marginal costing provides an excellent
means of controlling production and selling costs and the volume and mixture of
sales.
10.8 Disadvantages of Marginal Costing
Marginal Costing has a disadvantage where the costs form the basis on which prices are fixed.
Certain government and other contracts, for example, are placed on what is known as the cost
plus basis.
Under this arrangement the price is based on historical cost plus a fixed percentage for profit,
and it would obviously be to the producer’s disadvantage to employ a figure for cost which failed
to include any charge for fixed costs. It is often asserted by opponents of the technique that even
where prices are fixed by competition, Marginal Costing gives the impression that so long as
prices are in excess of marginal cost, production is profitable. It should be obvious, however, that
if too large a percentage of the sales is made at marginal prices the total contribution will be
insufficient to cover the fixed overheads, and that an overall loss will result.
It will be appreciated that when a company manufactures a variety of products certain of these
may involve the use of plant and facilities for which the capital cost is high, whereas in others
hand labour may predominate. It is clear that a larger contribution should be expected from the
former, but marginal costing does not give any indication as to the relative contribution required
in each particular case. While the lowest price at which work can be acceptable is readily
available, it is not generally clear just how much contribution should be made by each article,
and it is difficult to measure the equity of the selling prices.
Consider the case of a company which installs a very costly machine. The depreciation must be
recovered from sales and while it is still profitable to accept marginal work at any price in excess
of marginal cost, the main bulk of the output should be priced sufficiently high to absorb the
fixed costs of the machine and still provide a reasonable profit. This problem is sometimes
solved by analyzing the fixed costs between costcenters or product groups to show the amount of
contribution needed to absorb the fixed costs in each case.
10.9 Arguments for the Use of Marginal Costing:
Arguments for the use of marginal costing in routine costing can be delineated as follows:
(a) Simple to operate

140
(b) No apportionments, which are frequently on an arbitrary basis, of fixed costs to

products or departments. Many fixed costs are indivisible by their nature, e.g.
Managing Director’s salary.
(c) Where sales are constant, but production fluctuates (possibly an unlikely
circumstance) marginal costing shows a constant net profit whereas absorption
costing shows variable amounts of profit.
(d) Under or over absorption of overheads is avoided. The usual reason for
under/over absorption is the inclusion of fixed costs into overhead absorption
rates and the level of activity being different to that planned.
(e) Fixed costs are incurred on a time basis, e.g. salaries, rent, rates etc, and do not
relate to activity. Therefore it is logical to write them off in the period they are
incurred and this is done using marginal costing.
(f) Accounts prepared using marginal costing more nearly approach the actual cash
flow position.
10. 10 Arguments for the Use of Total Absorption of Routing Costing:-
(a) Fixed costs are a substantial and increasing proportion of costs in modern
industry. Production cannot be achieved without incurring fixed costs which thus
form an inescapable part of the cost of production, so it should be included in
stock valuations. Marginal costing may give the impression that fixed costs are
somehow divorced from production.
(b) Where production is constant but sales fluctuate, net profit fluctuations are less
with absorption costing than with marginal costing.
(c) Where stock building is a necessary part of operations, e.g., timber seasoning,
spirit maturing, firework manufacture, the inclusion of fixed costs in stock
valuation is necessary and desirable. Otherwise a series of fictitious losses will be
shown in earlier periods to be offset eventually by excessive profits when the
goods are sold.
(d) The calculation of marginal cost and the concentration upon contribution may
lead to the firm setting prices which are below total cost although producing some
141
contribution. Absorption cost makes this less likely because of the automatic
inclusion of fixed charges.
(e) SAS 4 (Stocks and Work in Progress) recommends the use of absorption costing
for financial accounts because costs and revenues must be matched in the period
when the revenue arises, not when the costs are incurred. Also it recommends that
stock valuations must include production overheads incurred in the normal course
of business even if such overheads are time related, i.e, fixed. The production
overheads must be based upon normal activity le
levels.
10.11 Summary
Marginal cost is the cost management technique for the analysis of cost and revenue
information and for the guidance of management. The presentation of information
through marginal costing statement is easily understood by all manger
mangers,
s, even those who
do not have preliminary knowledge and implications of the subjects of cost and
management accounting. This module explains marginal vis-à-vis absorption costing, and
justifies the use of total absorption in routine costing.
10.12 Self Assessment

sessment Questions
1. Define Marginal Costing and Absorption costing
2. What is contribution and how is it calculated?
3. Explain the alternative concepts of Marginal Cost and ddistinguish

istinguish between the
accountant’s and economist’s view of marginal cost
cost.
4. What are the main uses, advantages and disadvantages of marginal costing?
5. What are the arguments for absorption costing?
6. Critically explain the effect of Stocks valuation and Marginal Costing on

profitability and justify the arguments for the use of total absorption costing in
decision making
7. X Limited commenced business on 1st March making one product only the standard
cost of which is as follows:
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N
Direct Labour 5
Direct Material 8
Variable production overhead 2
Fixed production overhead 5
Standard production cost 20
The fixed production overhead figure has been calculated on the basis of a budgeted
normal output of 36,000 units per annum.
You are to assume that there were no expenditure or efficiency variances and that all the
budgeted fixed expenses are incurred evenly over the year. March and April are to be
taken as equal period months.
Selling, distribution and administration expenses are:
Fixed N120,000 per annum

Variance 15% of the sales value.
The selling price per unit is N35 and the numbers of units produced and sold were:
March April
Units Units
Production 2,000 3,200
Sales 1,500 3,000
a. Prepare profit statements for each of the months of March and April using:
i) Marginal Costing and
ii) Absorption Costing
b. Present a reconciliation of the profit or loss figures given in your answer to [a] [i],
and [a] [ii] accompanied by a brief comment;
143
c. Comment briefly on which costing principle, i.e. marginal or absorption, should be

used for what purpose [s] and why, referring to any statutory or other mandatory
constraints.
8. MessrsNduka and Raimi have just been employed by CRAFT LTD as Accountants
in Training. The first major assignment they were given was to use the underlisted
information to prepare profit statements to show the highest monthly growth in
profits. Mr. Nduka asserts that marginal costing approach will be more appropriate
while Mr. Raimi on the other hand believes in the absorption costing approach. You
have been asked to prepare statements using both approaches.
AUGUST SEPTEMBER
N/UNIT N/UNIT
Selling Price 50.00 60.00
Direct Materials Cost 20.00 21.00
Wages 5.00 5.00
Variable production cost 4.00 5.00
Fixed production per month 99,000 99,000
Fixed selling per month 14,000 14,000
Fixed Admin. Per month 26,000 26,000
Variable selling expenses/units is 10% of sales.
Normal capacity per month is 11,000 units but sales were 10,000 and 12,000 for August and
September and production units were 12,000 and 10,000 for August and September respectively.
iv] A new subsidiary of a group of companies was established for the manufacture and sale
of product X. during the first year of operations 90,000 units were sold at N20 per unit.
At the end of the year, the closing stocks were 8,000 units in finished goods store and
4,000 units in work in progress which were complete as regards material content but only
half complete in respect of labour and overheads. You are to assume that there were no
opening stocks.
The work in progress account had been debited during the year with the following costs:
N
Direct materials 714,000
Direct labour 400,000
144
Variable overhead
ead 100,000
Fixed overhead 350,000
Selling and administration costs for the year were:
Variable Cost Fixed Cost

per unit sold
N N
Selling 1.50 200,000
Administration 0.10 50,000
The accountant of the subsidiary company had prepared a profit statement in the absorption
costing principle which showed a profit of N11,000
The financial controller of the group, however, had prepared a profit statement on a marginal
costing basis which showed a loss.
Faced with these two profit statements, the director responsible for this particular subsidiary is
confused.
(a) Prepare a statement showing the equivalent units produced and the production cost of one
unit of product X by element of cost and in total;
(b) Prepare a profit statement on the absorption costing principle which agrees with the
company account’s statement;
(c) Prepare a profit statement on the marginal costing basis;
(d) Explain the differences between the two statements giv
given
en for [b] and [c] above to the
director in such a way as to eliminate his confusion and state why both statements may be
acceptable.
Are you in need of General Help as regards your studies? Do not hesitate to contact the
DLI
08033366677
145
Study Session 11
Marginal Costing and Decision Making
Introduction
Decision making is concerned with the future and involves a choice between alternatives. Many
factors, both qualitative and quantitative, need to be considered and for many decisions financial
information is a critical factor. It is therefore important that relevan
relevantt information on cost and
revenues is supplied.
Relevant information is information about future costs and revenues. It is information about
differential costs and revenues. It is the excepted future costs and revenues that are of importance
to the maker. Past costs and revenues are only useful in so far as they provide a guide to the
future. Costs already spent are known as sunk costs and they are irrelevant for decision making.
Differentially, only those costs and revenues which alter as a result of a dec
decision
ision are relevant.
Where factors are common to all the alternatives being considered they can be ignored; only the
differences are relevant. In many short run situations the fixed costs remain constant for each of
the alternatives being considered and thu
thuss the marginal costing approach showing sales, marginal
cost and contribution is particularly appropriate.
At the end of this study session, you should be able to explain the following:
1. Short run tactical decisions
2. Key factor
3. Steps in analyzing problems relating to key factor
4. Examples of decisions where marginal Costing can be used
5. Acceptance of a special Order
6. Dropping a product
7. Choice of a product where limiting factor exists
8. Make or buy decisions differential costing vis
vis-à-vis
vis marginal Costing
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9. Implications of differential Cost

10. Opportunity Cost
11. Solve questions on marginal costing and decision making
11.0 Short Run Tactical Decisions
These are decisions which seek to make the best use of existing facilities. Typically, in the short
run, fixed costs remain unchanged so that the marginal cost, revenue and contribution of each
alternative is relevant. In these circumstances, the correct decision rule is to select the alternative
which maximizes contribution.
In the long run [and sometimes in the short term] fixed costs do change and accordingly the
differential costs must include any changes in the amount of fixed costs. Where there is a
decision with no changes in fixed cost normal marginal costing principles apply. Where the
situation involves changes in fixed cost, differential costing method should be used.
11.1 Key Factor
“Key factor” is also known as “Limiting factor” or Principal budget factor” This is a
factor which is a binding constraint upon the organization. It is a factor which prevents
indefinite expansion or unlimited profits. It may be sales, availability of finance, skilled
labour, supplies of material or lack of space. Where a single binding constraint can be
identified, then the general objective of maximizing contribution can be achieved by
selecting the alternative which maximizes the contribution per unit of the key factor.
It is pertinent to note that in practice the key factor in an organization changes from time
to time.
For examples, a company may have a shortage of orders, it overcomes this by appointing
more sales men and then finds that there is a shortage of machine capacity. The
expansion of the productive capacity may introduce a problem of lack of space, etc.
The rule of maximizing contribution per unit of the limiting factor is useful only where
there is a single constraint and where the constraint can be altered is a single constraint
and where the several constraints apply simultaneously, the simple maximizing rule given
above cannot be applied. In such circumstance a more complicated mathematical model
such as Linear Programming and, or, sensitivity analysis can be applied in arriving at
optimum decision.
147
11.2 Steps in Analysis Problems Relating To Key Factor
The following steps are discernible:

(a) Check that fixed costs are expected to remain unchanged
(b) If necessary, separate out fixed and variable costs.
(c) Calculate the revenue, marginal costs and contribution of each of the alternatives.
(d) Check to see if there is a limiting factor which will be a binding constraint and if
so, calculate the contribution per unit of the limiting factor.
(e) Finally, choose the alternative which maximises contribution.
11.3 Examples of Decisions Where Marginal Costing Can Be Used
Many situations in which marginal costing can provide useful information for decision
making are given below:
(a) Acceptance of a special order

(b) Dropping a product
(c) Choice of product where a limiting factor exists.
(d) Make or buy
11.4 Acceptance of a Special Order
By this we mean the acceptance or rejection of an order which utilizes spare capacity but which
is only available if a lower than normal price is quoted. The procedure is illustrated by the
following example.
ITQFor several years demand for the product of Studywell Ltd, based in Lagos has fallen
steadily, and there is now considerable surplus capacity. The standard Cost Card for the
product of the company, the “Auto set,” is based on an output of 10,000 per annum. The
standard unit cost appears as follows.
N
Variable Costs:
Materials . . . . . 10
Wages . . . . . 5
Overheads . . . . . 5
20
Fixed Overheads . . . . 12
32
148
Selling Price 30
Loss per unit 2
A market exists for the product in the Northern States of Nigeria at a selling price of N23.50
each, and it is estimated that 40,000 units per annum could be sold at this price. The
additional cost of selling and distribution would be N1 per set. The sale of sets in the North
would not affect sales in Lagos. Would it be profitable to sell sets at this price
ITQ Answer
On the basis of the output at present budgeted the company will lose 10,000 x N2 per annum, i.e.
N20,000. This represents fixed costs of N120,000 less a contribution by sales of 10,000 x N10,
i.e., N100,000.since the Northern sales bring in a contribution of N23.50 less N21 [N20 +1] per
set, it will pay to make such sales, the total effect of which would be to increase the contribution
of sales by 40,000 x N2.50 i.e. N100,000, so turning a loss of N20,000 into a profit of N80,000.
This is demonstrated by the following comparative accounts:
Sales in Lagos Sales in the

Only North Lagos
N N
Materials 100,000 500,000
Wages 50,000 250,000
Variable Overheads 50,000 250,000
Fixed Overheads 120,000 120,000
Selling and Distribution [North} - 40,000
320,000 1,160,000
Sales 300,000 1,240,000
Profit/(Loss) (N20,000) N80,000
It sometimes pays to reduce selling prices all rounds to obtain the benefit of increased
turnover, and marginal costing provides the key to the problem of how much to reduce
them.
However, there are several other factors which would need to be considered before a final
decision is taken, viz
(a) Will the acceptance to sell in the North a lower price lead other customers to
demand lower prices as well?
(b) Is this special sale (in the North) the most profitable way of using the spare
capacity?
149
(c) Will this special sale lock up capacity which could bbee used in future, full price
business?
(d) Is it absolutely certain that fixed costs will not alter?
11.5 Dropping a Product
If a company has a range of products one of which is unprofitable, it may consider dropping the
item from its range.
An analysis of the cost of different products on marginal costing principles shows that:
(i) Products which appear to show the largest net profit do not necessarily make the
largest contribution to total profit.
(ii) It may be profitable to sell articles which appear by other costing methods to
show a loss.
iii. It may be advantageous in time of depression, or where there is surplus capacity,

to sell goods at below total cost.
Cosit Ltd. manufactures four pro

products,
ducts, A, B, C and D, the costs, profits and sales of
which are as follows:
Product Product Product Product Total

A B C D
N N N N N
Materials 15,000 20,000 25,000 10,000 70,000
Direct Wages 5,000 15,000 20,000 10,000 50,000
Variable
Overhead 8,000 20,000 20,000 10,000 58,000
Fixed Overhead 8,000 40,000 45,000 10,000 103,000
Net Profit/(Loss) 4,000 25,000 [10,000] 20,000 39,000

Sales 40,000 120,000 100,000 60,000 320,000
150
Percentage of Profit to sales 10% 20 5% -10% 331%

6 3
Management is thinking that the business would be better to cease production of product C
and make only A, B, and D. you are to advise management on this line as the consultant to the
company.
Ifproduct C was discontinued and no change took place either in the sales of other products or in
the level of fixed costs, the total profit and loss account would appear as follows:
N
Materials (N70,000
70,000 – N25,000) 45,000
Direct Wages (N50,000
50,000 – N20,000) 30,000
Variable Overhead ((N58,000 – N20,000) 38,000
Fixed Overhead 103,000
Net Profit 4,000
Sales (N320,000 – N100,000) 220,000
The reduction in net profit will be seen to be equal to the contribution of product C
(i.e. N35,000)
35,000) = (100,000 – N65,000 variable costs).
The contributions of the various

arious products are as follows:
Contribution P/V Ratio

N
A . . . . . . 12,000 30%
B . . . . . . 65,000 54 1 %
6
C . . . . . . 35,000 35%
D . . . . . . 30,000 50%
It will be seen from these figures that the “loss

“loss-making”
making” product C actually contributes to total
profit a greater amount per N11 of sales than product A, which on a total cost basis shows a
10percent profit. Similarly, item B which makes 20 per cent. Overa
Overall
ll profit contributes a greater
amount than item D, although the latter shows a much heavier profit on the total cost basis.
151
t will be seen from the foregoing example that in planning for the greatest overall profit
the emphasis must always be on the amoun
amountt of contribution made by each product. The
particular figures under consideration show that while efforts should be directed at an
increase in sales of articles B and D, the turnover of A and C should still be maintained as
high as possible to obtain maxi
maximum
mum profit. It would, however, clearly be profitable to
sacrifice N1,000
1,000 of sales of product A to obtain an additional N1,000
1,000 of sales of product
D, whereas it would be unprofitable if the increase in the case of product D were only,
say, N500. By using the
he figures intelligently it is possible to plan for the overall mixture
of sales which will yield the maximum net profit.
11.6 Choice of a Product Where a Limiting Factor Exists
This is where a firm has a choice between various ty

types of products which itt could manufacture
and where there iss a single, binding constraint.
Where a common limiting factor restricts sales of all prod

products,
ucts, maximum profitability is
achieved by comparing the contribution of each product pe
perr unit of limiting factor, and choosing
that
hat which provides the greatest return.
Tripods Ltd. manufactures three products, X Y, and Z, each of which passes through the same
proportion of total processing time undergoing each of the various operations. The company’s
operations are restricted solely
ely by its productive capacity
capacity-a
a ready market being available at
current prices for unlimited quantities of any one or more of the products.
The cost of producing each of the various products is as follows:
PRODUCT
X Y Z
Variable Costs: N
Material 4 10 25
Wages 6 5 15
Variable Overhead
(50k per hour) 5 10 15
15 25 55
Fixed Costs:
Fixed Overhead
(50k per hour) 5 10 15
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20 35 70
Profit 10 15 40
Selling Price N30 N50 N110
Ignoring any question of loss of goodwill, and assuming that productive facilities are
fully interchangeable as envisaged previously, and production working hours limited to
15000 hours, determine which product it pays the company to concentrate on.
The contribution per hour of the various products is:
X: N30 – N15
15 = N1.50
10hrs
Y: N50 – N25
25 = N1.25
20 hrs
Z: N110 – N5555 = N1.8333
30 hrs
Thus it would pay the company to concentrate on Z which has the hig
highest
hest contribution per unit
of limiting factor, that is, labour hour. This can be proved thus:
X Y Z
Contributed base on N N N
1500 hours 22,500 18,750 27,500
Less: Fixes Overhead
head 7,500 7,500 7,500
15,000 11,250 20,000
Note: (i) The N7,500

7,500 fixed overhead is obtained thus:
15000hrs x 50k
(ii) Total contribution per product
= contribution per hour of the various

arious product x 15000hrs each.
It is pertinent to note that where products have a positive contribu

contribution
tion and there is no constraint,
there is prima facie case for their production. However, when constraints exist, the products must
153
be ranked in order of contribution per unit of the constraint and the most profitable product mix
established.
The above process

cess of maximising contribution per unit of the limited factor can only be used
where there is a single binding constraint. Most practical problems have various constraints and
many more factors than the example illustrated. In such circumstances, we can use
u the linear
programming method in optimizing production.
11.7 Make or Buy Decision
In many cases a business may be in a position either to manufacture particular components or to

buy item outside, and the cost accountant is asked to advise which course ooff action should be
followed. It will be appreciated that where total cost of manufacture is compared with an
outside supplier’s price the cost included some absorption of the fixed expenditure which will be
incurred whether the goods are manufactured or not. The course of action decided upon should
obviously be the one which reflects the maximum overall profit, and the out
out-of
of-pocket out-lay
must therefore be considered in each case. In other words, fixed
fixed-cost
cost absorption should be
disregarded and a comparison
ison made between marginal cost and the outside supplier’s price.
Where, however a business is already operating at full capacity, the manufacture of the articles
would restrict saleable output, and it is then necessary to take into consideration the fixed costs
and also the profit on the saleable output which will be lost by applying the facilities elsewhere.
elsewhere
A business is considering whether to manufacture or purchase components type AB which can

be obtained from an outside source for N350 per 1,000. Thee marginal and total costs of the
component are, respectively, N240
240 and N400
400 per 1,000. The manufacture of these components
would involve work on a machine which is currently operating at full capacity, and figures
have been produced to show that for each thousand of component AB manufactured the sales
of a finished article CD will be restricted by 250. The marginal cost and selling price of CD
are N500 and N800
800 per 1,000, respectively. Is it more profitable to purchase or manufacture
the AB components?
154
Too solve this problem, we have to compare the net marginal cost of manufacture with outside
price thus:
N
Marginal Cost per, 1,000 AB 240
Add: Lost Contribution on CD: 250 x N0.30 75
Net Marginal Cost of Manufacture 315
Outside price 350
N350 – N315
315 = N35
The overall profit will be N35

35 per 1,000 greater if the components AB are manufactured rather
than bought from outside.
Note: Contribution of CD per unit is calculated as follows:
Selling price per 1000 units N800

Marginal Cost per 1000 units N500
Contribution per 100 units N300
Contribution per unit = N300
1000units
= N0.30
11.8 Differential Costing Vis

Vis-à-Vis Marginal Costing
This is a broader and more fundamental principle than margin

marginal
al costing and therefore has a much
wider application.
Differential costing examines all the revenue and cost differen

differences
ces between alternatives so as to
determine the most appropriate decision.
Marginal costing assumes that the only differences between alte

alternatives
rnatives are changes in variable
costs and revenues, i.e that fixed costs do not change. Because differential costing examines all
155
differences, it is suitable for situations where fixed costs do alter and thus becomes appropriate
for both short run and longg run decisions.
The general approach to decision making under marginal costing is also relevant under
differential costing with the proviso that even more care shoul
shouldd be taken to identify all the cost
changes, both fixed and variable, because there is no assumption
sumption that fixed costs will remain
unchanged.
Table 11.1:A useful way of presenting differential cost statements is as follows:
Alternative ‘A’ Alternative ‘B’ Difference ‘A’ – ‘B’
- - -
- - -
- - -
Wonderland Limited, currently operating at full capacity, manufactures and sells ashtrays at
N22 each. Current volume is 100,000 trays per annum with the following cost structure:
N
Sales (100,000 @ N2) 200,000
Less Marginal Cost: N
Labour 80,000
Material 50,000
130,000
Contribution 70,000
Less Fixed Cost 30,000
Net Profit 40.000
An opportunity has arisen to supply an additional 30,000 trays per annum at N1.80 each.
Acceptance of this order
rder would incure extra fixed costs of N8,000
8,000 per annum for the hire of
156
additional machinery and the payment of an overtime premium of 20% for the extra direct
labour required.
i. As the cost accountant to the compan

company,
y, you are to advise management whether
this order should be accepted or not.
ii. State other factors that need to be considered based on your advice
Table 11.2: Wonderland Limited: Differential Cost Statement
Present Level Projected Level Difference

Production
Units 100,000 Trays 130,000Trays 30,000 Trays
N N
Sales 20,000 254,000 54,000
Less Materials Cost 65,000 15,000
Materials 50,000 108,800 28,800
Labour80,000 173,800 43,800
130,000 80,200 10,200
Contribution 70,000 38,000 8,000
Less Fixed Costs 30,000
Net Profit 40,000 N42,200 2,200
Workings:
a] 28,800 is computed as follows:

N28,800
Labour per unit = N0.80 = (N80,000)

100,000 units
Add 20% of N0.8

0.8 = N0.16 x 30,000 extra units
N0.96
= N28,80
157
b] N108,800 = N80,000 + N28,800
c] N65,000 = N50,000 X 130,000UNITS
100,000units
Thus purely on the cost figures the special order would appear to be worthwhile. However, the
additional factors that would need to be considered include:
i Will the special order disturb the existing full price market?
ii. How accurate are the projected extra costs? The additional profit is small and
could easily be wiped out by slight cost increases
iii. Can administration, dispatch and other services departments cope with the 30%
increase in production without extra costs?
11.9 Implications of Differential Cost
The only relevant costs for decision making are those which will change as a result of the
decision. If costs are not expected to alter, they are irrelevant to the decision.
Examples of costs that are irrelevant are as follows:
i) Sunk Costs, i.e. costs which have already been incurred.

ii) Book values of assets
iii) Cost of fully utilized resource, i.e., if a limiting factor exists it will be used to the
full and will therefore cost the same whatever alternative is considered. The
differential cost between alternative is therefore zero.
iv) Conventionally prepared depreciation is not a differential cost and is therefore
irrelevant.
v) Fixed Costs: any item which is generally fixed and will remain the same
whichever alternative is chosen is not a differential cost and can be ignored in
choosing alternatives.
11.10 Opportunity Cost

Opportunity cost is an important concept for decision making purposes. It can be defined as the
value of the best alternative foregone. Although often difficult to measure, the concept is of great
importance because it emphasizes that decisions are concerned with alternatives and that the cost
158
of the chosen plan of action is the profit foregone from the best available alternative. The
following example will help to make the idea more concrete.
A firm rents a small workshop for N50

50 per week but at present does not use it. They could sub-
sub
let the workshop for N80
80 per week, but they are considering using it themselves for a new
project.
In assessing whether the new project is worthwhile, what is the appropriate cost to use the
workshop?
The recorded historical cost of N

N50
50 is inappropriate for this purpose, if the project is initiated the
firm will forgo the N80
80 rent they could obtain. This is the opportunity cost of the workshop and
is the value to be included in the project appraisal.
A firm manufactures component BK 200 and the costs for tthe

he current production level of
50,000 units are:
Cost/Unit
Materials 2.50
Labour 1.25
Variable overheads 1.75
Fixed overheads 3.50
Total cost 9.00
Component BK 200 could be bought in for N7.75 and, if so, thee production capacity utilized at
present would be unused. Assuming that there are no overriding technical considerations,
should BK 200 be bought in or manufactured?
159
This is a make or buys decision. In such a decision, what is relevant to consider is the avoidable
cost. The case of internal manufacturing the “Avoidable Costs” are:
(i) The variable cost
(ii) Any specific fixed cost
In the case of buying, the relevant cost to consid

consider
er would be the “Landing Cost”.
a) Manufacturing Decision:
Relevant cost of internal production
N
DM 2.50
DL 1.25
VOH 1.75
5.50
b) Buying Decision:
Landing Cost N7.75
Decision: The product should be produc

produced internally
A firm is considering whether to manufacture or purchase a particular component 2543. This

would be in batches of 10,000 and the buying in price would be N6.50.
6.50. The marginal cost of
manufacturing component 2543 is N4.75 per unit and the component would have to be made
on a machine which was currently at full capacity. If the component was manufactured,
manufactured it is
estimated that the sales of finished product FP97 would be reduced by 1,000 units. FP97 has a
marginal cost of N60/unit
60/unit and sells fo
for N80/units.
80/units. Should the firm manufacture or purchase
component 2543?
160
This is another cost internal productions that are made up to two categories:- these are:
(a) Avoidable costs
(b) Opportunity Cost
(i) Cost of Production Decision:
Avoidable Cost:
MC xQtyReqd = Cost of production
N4.75
4.75 x 10,000 = N47,500
Opportunity Costs:
Contribution x Qty lost
1000 (N80
80 – 60) = 20,000
Total production cost 67,500
Cost per unit 67,500
10,000 = N6.75
(ii) Buying Decision:
Landing Cost: = N6.50
Decision: Buy from outside
Belt and Braces Ltd. makes a single product which sells for N20
20 and for which there is great
demand. It has a variable cost of N12, made up as follows:
N
Direct material 4
Direct labour (22 hours) 6
Variable Overhead (2 hours) 2
12
161
The labour force is currently working at full capacity and no extra time can be made
available. A customer has approached the company with a request for the manufacture of a
special order,
der, for which he is willing to pay N5,500.
The costs of the order would be N2,000

2,000 for direct materials, and 500 labour hours will be
required. Should the order be accepted?
Calculation of the contribution

ution of Accepting the Order:
Selling Price N5,500
Less: Relevant Cost: N

DM 2,000
DL 500 x N3.00
3.00 (Labour rate per hr) 1,500
VOH (per hr2):
): 500 x 1 500
2
Lost contribution on labour
500 x 8 2000
2 6,000
Contribution in total (negative) (500)
Decision: Don’t accept the order
What we have done here is to consider the contribution, if aany,
ny, arising from accepting the special
order. This is now found to be negative; hence, the order should be rejected.
11.11Summary
Marginal costing is one of the techniques of costing which guides Management in pricing,
decision making and assessment of profitability; it differentiates the total cost of production into
variable expenses and fixed expenses. Variable expenses increase oorr decrease with the
proportional increase or decrease in output. Thus as the increase in variable expenses is
proportional to the increase in production per unit cost. In case of fixed expenses they remain
constant at certain level of production and they ggo
o on changing per unit with every increase in
output. Thus, Marginal costing by differentiating between the variable cost and fixed cost
162
explains managerial problems on the basis of the difference between Variable Overheads, Fixed
Overheads and Sales.
1. Explain the following: (i) short run tactical decision (ii) key factor
2. Describe the steps in analyzing problems relating to key factor and give examples
where marginal costing can be used.
3. Explain clearly what you understand by the term “Acceptance of a special order
and dropping a product
4. The stated cost for a particular product may vary according to the use to which
that cost is to be put. Illustrate three uses for which a cost may be required which
support the truth of the foregoing statement.
5. (a) Explain the meaning of the term ’limiting factor’ and give examples of how it
may be recognized
(b) How might the cost accountant assist management in overcoming problems
associated with the limiting factor?
(c) Compare and contrast opportunity cost and sunk cost
6. You have been asked to prepare a budget for three similar products which use the
same type of material and labour. The following details are available:
Product A B C
Details per unit N N N
Sales price 100 150 200
Direct material (N2 per 1b) 10 66 45
Direct wages (N4 per hour) 40 22 60
Variable overheads 20 11 30
Variable overheads are recovered at the rate of N2 per direct labour hour. Total
fixed overheads are estimated at N60,000.
(a) Calculate the priority ranking of the products:
163
i When the market for sales is limited by volume;
ii When the market for sales is limited by value;
iii When the supply of labour is limited
(b) Calculate the maximum profit and the sales in units when the total raw
r material
available is 30,000lbs
bs and the maximum sales potential for each product is as follows:
Product: A: N500,0000; B: N650,000; and C: N800,000.
7. Bourne View Manufacturing Company pro

produces
duces three independent products, RB, RS and RJ,
The selling prices, costs and other relevant data are as follows:
Table 11.3: Bourne View Manufacturing Companies: Sales and Cost Data.
Product RB RS RJ
N N N
Selling price – per unit 60 100 125
Direct materials 20 25 40
Variable overhead 50% of
Direct Labour 10 15 10
Material used- per unit 20bs 25bs 40 lbs

Direct labour – hours 4 3 5
Machine hours – per unit 2 3 1
Expected demand 20,000 20,000 20,000
(a) Should the company produce and sell all three products if adequate resources are
available?
(b) How much of each product should be produced if capacity is limited to 200,000
direct labour hours?
(c) How much of each product should be produc
produced
ed if only 1,500,000 1bs of material
are available?
(d) How much of each product should be produced if only 100,000 machine hours are
available
8. Big Banshee Ltd. produces a range of products, and absorbs production overhead into cost at
the rate of 300% of direct
ct labour costs. This rate was calculated from th
thee following budgeted
costs:
164
Variable production overhead 144,000

Fixed production overhead 216,000
360,000
Director labour costs 120,000
One of the company’s products, the Tot
Totem,
em, has a normal selling price of N35 and a unit
production cost of:
N
Direct materials 12
Direct labour 4
Total production overhead 12
Factory cost 28
A customer has offered to buy 3,000 units of Totem at a price of N22

22 each. If the order is
accepted, normal sales would be unaffected, and the company has the existing capacity to
make the extra units. Should the order be accepted?
08033366677
165
Study Session 12
Break-Even
Even Analysis AndCost-Volume-Profit
Profit Relationships
Introduction
Accountants are frequently faced with the problem of pred

predicting
icting the behaviour of costs.
Managers
anagers pose questions such as:
1) How will our costs be affected if we cut production of article A by 25 percent and
increase that of article B by 30 per cent?
2) Would it be worth our while to operate a system of two
two-shift
shift working?
3) Is it really profitable to work overtime to meet sales deman
demands
ds if we have to pay
time and half for it? Would it still pay if workers received double time?
4) If we could cut the selling price of this model by N5
5 the sales department believes
we could sell another 10,000. Would it pay us to do this?
5) Would it be a profitable proposition to replace this machine with another, capable
of producing twice as many articles per hours?
166
All these problems demand ability to assess the manner in which costs are likely to behave in
certain circumstances. Similar questions confronted cost accountant when he assists in the
preparation of budgets, and also when he attempts to assess what costs should have been in given
circumstance. The first step in dealing with any of these matters is to classify costs according to
t
their variability in relation to volume of output as:
- Fixed costs, which tend to be unaffected by variation in volume of output;
- Variable costs, which tend to vary directly with variations in volume of output;
and
- Semi-variable
variable costs, which are partly fi
fixed and partly variable.
Another name for semi

semi-variable costs is semi-fixed costs or mixed cost.
The break-even
even analysis, otherwise known as costs
costs-volume-profit
profit analysis acts as a veritable tool
in solving most of the posers above.
Learning Outcomes for S

Study Session12
At the end of the study session you should be able to:
1. Define of Breakeven Analysis
2. State the assumption
ssumptions of Break-even Analysis
3. List the uses
ses of Break
Break-even Analysis
4. Recollect the various
arious formula under Break
Break-even Analysis
5. Use graphical approach to Break
Break-even Analysis
6. Determine the
he margin of safety
7. Distinguish the
he Accountants and Economists’ View of break
break-even
even charts
8. State the limitations
imitations of break
break-even and profit charts
9. Solve
olve questions on break
break-even
even analysis and cost volume profit analysis
analys
12.0 Definitions of Break-Even

Even Analysis
Break-even analysis is the term given to the study of the inter

inter-relationships
relationships between costs,
volume and profit at various levels of activity. The break-even
even point is the point where a
company makes neither profit nor loss. It is a poin
pointt where sales equate costs. It is a point where
contribution equates fixed cost (please rec
recap study session 10)
167
12.1 Assumptions of Break-Even Analysis
The major assumptions underlying the break-even analysis are as follows:
a. All costs can be resolved into Fixed and Variable elements.

b. Fixed costs will remain constant and Variable costs vary proportionately with
activity.
c. Over the activity range being considered costs and revenues behave in a linear
fashion.
d. That the only factor affecting costs and revenue is volume.
e. That technology, production methods efficiency remains unchanged.
f. Particularly for graphical methods that the analysis relates to one product only or
to a constant product mix.
g. There are no stock level changes {or that stocks are valued at marginal cost only}.
It is pertinent to note that practically, these assumptions are over simplifying assumptions. As a
result of this, the break-even analysis can only be an approximate guide for decision making.
However, by highlighting the interaction of costs, volume, revenue and profit, useful guide can
be provided for managers making short run, tactical decisions.
12.2 Uses of Break-Even Analysis
i. The break-even analysis uses many of the principles of marginal costing, therefore, it
is an important tool in short-term planning.
ii. It explores the relationship which exists between costs, revenue, output levels and the
resulting profit to assist mangers in decision making.
Examples of short run decision where break-even analyses can be useful include:
- Choice of sales mix
- Pricing policies
- Multi-shift working
- Special order acceptance etc
12.3 Various Formulae under Break-Even Analysis
168
Breakeven analysis can be undertaken by graphical means or by simple formulaewhich

are listed below?
a) Break-even point (in units) = Total Fixed costs

Contribution/unit
b) Break-even point (N sales)
Total Fixed costs

= x Sales Price/unit
Contribution / unit
= Fixed Costs x 1
C/S ratio
c) C/S ratio: Contribution/unit x 100

Sales Price per unit
Definition of (C/S) Contribution to Sales/Ratio / OR Contribution Margin Ratio (CMR)
Contribution is the difference between sales revenue and variable costs. Contribution to sales
ratio otherwise known as contribution margin ratio is the process of expressing contribution as a
percentage of sales. The C/S ratio is used when you are required to fInd the sales revenue
required to breakeven or achieve a target profit. It is a measure of how much contribution is
earned on each Nsales.
d) Level of Sales to result in target profit (in units)
= Total Fixed costs + Target Profit

Contribution /unit
e) Level of Sales of to achieve a target profit after tax (in units)
= Fixed Cost + Target Profit

I – Tax Rate
Contribution per Unit
OR
The first step is to convert profit after tax (PAT) to profit before tax (PBT) as follows:
PBT = PAT
169
I – Tax Rate
Sales (Units) = TFC + Target Profit

C/U
f) Level of Sales to achieve a Target profit (N sales)
= (Fixed costs + Target Profit) x Sales price/ unit

Contribution/unit
OR
Sales ((N) = TFC + Target Profit

C/S
Note:
The above formulae relate to a single product firm or one with an unvarying mix of sales. With a
multi product firm it is possible to calculate the break
break- even point as follows:
Fixed costs x Sales Value

Break-even point (N sales) =
Contribution / unit
A company makes a single product with a sales price of N10

10 and a marginal cost of N6. Fixed
costs are N60,000 p.a.
Calculate
a) Number of units to break even

b) Sales at break-even
even point
c) C/S ratio
d) The number of units to be sold in order to achie
achieve a profit of N20,000
20,000 p.a.
e) The level of sales to achieve a profit of N20,000 p.a.
170
f) Because of increasing costs the marginal cost is expected to rise to N6.50

6.50 per unit
and fixed costs to N70,000
70,000 p.a. if the selling price cannot be increased what will be
the number of units required to maintain a profit of N20,000 p.a.?
g) If the taxation rate is 40% how many units will need to be sold to make a profit of
N20,000 p.a.?
Contribution = Selling price – marginal cost

= N10 – N6
= N4
N60,000
a) Break-even
even point (units) N4
= 15,000
b) Break-even
even point (N sales) = 15,000 x N10
= N150,000
N4 x 100
c) C/S ratio =
N10
= 40%
` d) Number of uunits for target profit = N60,000
60,000 + 20,000
N4
= 20,0000
e) Sales for target profit = 20,000 x N10
10
= N200,000
Alternatively, the sales for target profit can be deduced by the following reasoning. After
break-even
even point the contribution per unit becomes net profit per unit, so that as 15,000
units were required at break
break-even
even point 5,000 extra units would be required
require to make
N20,000.
20,000. Therefore total units.
= 15,000+ 5,000 = 20,000 x N10 = N200,000
f) Note that the fixed costs, marginal cost and contribution have changed.
171
Number of units for target profit = N70,000

70,000 + 20,000
N3.50
= 25,714 units
g) No. of units for target profit after tax is computed as follows:
Profit before tax = N20,000

20,000
1-0.4
= N20,000
20,000
0.6
= N33,333
33,333
Therefore Contribution required = FC + P
= N60,000
60,000 + N33,333
= N93,
93, 333
N4
Number of units = 23,333
The launch of a new product is being considered and four possible output levels are being
considered depending on customer reaction. The variable costs associated with these levels are
shown below:
Consumer reaction - Adverse Average Good Excellent

Variable costs (N000) 20 30 45 70
There are fixed costs of N36,000

36,000 and C/S or P/V ratio is expected to be 60%
a) The profit or loss at each of the four levels.
b) The break-even
even point in sales value
c) The level of sales at which a profit of N10,000 would be made.
172
(a) The C/S ratio is 60% therefore variable costs are 40% of sales. Given the variable
costs the sales for any level can be found as follows:
Variable Costs = Sales

0.4
Consumer reaction Adverse Average Good Excellent

N N N N
Sales (N000s) 50 75 112.5 175
Less Variable Costs 20 30 45 70
= Contribution 30 45 67.5 105
Less Fixed Costs 36 36 36 36
Profit (Loss) (6) 9 31.5 69
(b) Break-even
even point in sales value N36,000
0.6 = N60,000
60,000
(c) Level of sales for profit of N10,000
N36,000
36,000 + 10,000
0.6 = N76,667
Note:
i) Sales value of N50,000

50,000 = N20,000
40%
ii) Sales value of N75,000

75,000 = N30,000
40%
iii) Sales value of N112,5000

112,5000 = N45,000
40%
iv) Sales value of N175,000

175,000 = N70,000
40%
12.4 Graphical Approach to Break

Break-Even Analysis
This may be preferred
(a) Where a simple overview is sufficient?
173
(b) Where there is a need to avoid a detailed, numerical approach when, for example,
the recipients of the information have no accounting background. The basic chart
is known as a Break Even Chart which can be drawn in two ways. The first is
known as the traditional approach and the second the contribution approach.
approach
Whatever approach is adopted, all costs must be capable of separation into fixed
and variable elements, i.e. semi
semi-fixed or semi-variable
le costs must be analyzed into
their components. The contribution break
break-even
even chart is more amenable for
teaching purpose.
12.5 The Contribution Break

Break-Even Chart
Assuming that Fixed Variable costs have been resolved, the chart is drawn in the following
way:
(a) Draw the axes
Horizontal axis showing levels of activity expressed as units of output or as

percentages of total capacity.
Vertical axis showing values in N’s or N000s

000s as appropriate, for costs and
revenues.
(b) Draw the cost lines
Fixed Cost: This will be a point above the zero output level on the vertical
axis
Total Cost. This will start where the fixed cost line intersects the vertical axis
and will be a straight line slopping upward at an angle depending on the
proportion of Variable cost in total costs.
(c) Draw the revenue line
This will be a straight line from the point of origin sloping upwards at an angle
determined by the selling price
Fig. 12.1: Contribution Break-even Chart

TR TC
174
350 -
Profit
300 - Fixed
VC
BEP Cost
250 -
200 - Total Cost

Contribution
150 -
Variable
Fixed Cost 100- LOSS Cost
50-
0-
50 100 150 200 250 300 350 400
Output (000 units)
12.6 The Margin of Safety
One measure which is utilized in the analysis of the financial affairs of a company is the margin
of safety. This may be defined as the amount by which present sales exceed the Break-even
Point. It is an indication of the maximum tolerable drop in the budgeted or actual sales that will
not result into incurring losses. It is the difference between budgeted sales and break-even point
sales.
When two companies or two divisions of the same company are being compared their relative
margins of safety will indicate which is in the more vulnerable profit position.
There is a close connection between the derivation of break-even point, profit graph and the
margin of safety.
This is exemplified in figure 2.3 below.
175
Figure 12.3: Profit Graph
BEP
PROFIT
0
MARGIN
OF
LOSS SAFETY
-100 -
-200 - Budgeted or Actual Sales

SALES N/M
The P/V Ratio and Margin of Safety of a business are linked by the following formula:
P/V ratio x Margin of Safety = Net Profit
If a business is to be able to withstand normal trade depressions, its margin of safety must be
sufficient to ensure that losses are not inc
incurred
urred at the low output levels to be expected at the
depth of a depression. Consider the causes of a low margin of safety.
(1) A low margin of safety in conjunction with a high P/V ratio is usually a sign that
fixedCosts are too heavy in relation to normal sales;
(2) A low margin of coupled with a low P/V ratio generally indicates that unit
variableCosts are excessive in relation to the unit selling price.
12.6.1 The Accountant’s And Economist’s View Of Break

Break-Even Charts
For academic exercise purpose the account

accountant’s vis-à-vis
vis the economist’s view on break-even
break
analysis are compared and contrasted below:
176
Figure 12.4: The Accountant’s view on Break-even

Break
analysis
300 - TR
Profit
TC
Cost 200 - BEP
Variable
Cost
LOSS
100 - TC
Fixed Cost
0
50 100 150 200 250 300 350 400
Output
Figure 12.5: The economist’s view of Break-even

even analysis
Total Cost
BEP
2
BEP 1
Cost
Profit Total Revenue
LOSS
Activity
177
Figure 12.5
2.5 (The Economist’s BEP Chart) More correctly shows the point of profit
maximization.
The BEP No 2 on the chart is at the point where declining aggregate revenues equal increasing
aggregate
regate costs. BEP No. 1 in Fig 12.3
2.3 is similar, but not exactly equivalent, to the single BEP
shown on a typical
cal accountant’s chart in fig. 12.2.
2.2. The reason for the discrepancy is that the costs
included in the economist’s chart include an allowance for a normal level of profit, which is
deemed to be an economics cost, whereas the breakeven point on an accounting chart is simply
the balancing of accounting costs and revenues.
In Fig. 12.5, the cost line shows economies of scale at first, then turns upwards as diminishing
returns set in. still on Fig. 12.3,
2.3, the revenue line curve downward on the assumption that the
selling prices will have to be reduced to increase sales volume. Within the re
relevant
levant activity range
the difference between the economist’s and accountant’s chart are not great.
12.7 Limitations of Break-Even

Even and Profit Charts
The limitations of the breakeven analysis stem from the criticism of the assumptions underlying
the analysiss as contained in paragraph 12.4 of the study session.. The following limitations are
thus discernible:
i) The charts are reasonable pointers to perform within normal activity range.
Outside this relevant range the assumed relationship will not be correct.
ii) Fixed
ed costs are likely to change at different activity levels.
What we are likely to have in real situation is a stepped fixed cost line.
iii) Variable costs and sales are unlikely to be linear. Extra discounts, overtime
payments, special delivery charges, etc wil
willl affect the assumed linearity between
costs and sales.
iv) The charts depict relationships which are essentially short term. This makes them
inappropriate for planning purposes where the time scale stretches over several
years.
178
v) In arriving at any budgeted pro

profit,
fit, it is assumed that all units produced will be sold
in the period. In reality actual units sold may be different from the units produced,
therefore, actual profit will be different from budgeted profit.
vi) The assumption that production and sales are for one product only or to unchanged
mix of products is not realistic.
Practically, companies do sell more than one product and the mix can thus vary.
You have just been appointed as chief accountant to Brainteasers Ltd. A company which
manufactures and sells puzzles. You are given the following details for the year ended 31st
December 1987.
N Thousands
Sales A
Direct materials 800
Direct labour B
Variable manufacturing overhead 200
Fixed
ixed manufacturing overhead C
Variable selling expenses 120
Variable administrative expenses D
Fixed selling and administrative expenses 200
Contribution E
Gross profit F
Net profit 400
Break-even
even point in sales revenue 2,000
No stock is carried, and there are no other costs apart from those listed above. The gross profit
margin is 30% and the contribution margin ratio is 40%.
179
You are required to find the amounts represented by the lett

letters
ers A to F on the above list.
N Thousands
A 3,000
B 500
C 600
D 180
E 1,200
F 900
Workings
1. fixed costs
Contribution margin ratio = break-even
even point in sales revenue
i.e. fixed costs = contribution margin ratio
x break-even point
= 40% x N2,000 = N800,000
2. Fixed costs = fixed manufacturing overhead
+ fixed selling and administration expenses
i.e. fixed manufacturing overhead
= fixed costs – fixed
ixed selling and administration
expenses
= N800,000 – N200,000
= N600,000 = C
= fixed costs + net profit
3. Contribution = N800,000 + N400,000
= N1,200,000 = E
4. Contribution margin = Contribution
Sales
Sales = contribution = N1,200,000
180
Contribution margin ratio 40%

= N3,000,000 = A
5. Gross profit margin = gross profit
Sales
i.e. manufacturing = gross profit margin x sales
= 30% x N3,000,000
= N900,000 = F
6. Sales – manufacturing costs = gross profit
= sales – gross profit
= N3,000,000 – N900,000
= N2,100,000
7. Manufacturing costs = direct materials + direct labour
+ variable manufacturing overhead
+ fixed manufacturing overhead
i.e. direct labour = manufacturing costs – direct
materials – manufacturing overhead
= N2,100,000 – N800,000 – N200,000
- N600,000 = N500,000 = B
8. Gross profit – selling and administrative expenses = net profit
i.e. selling and administrative expenses = gross profit – net profit
= N900,000 – N400,000
= N500,000
9. Selling and administrative expenses = variable selling expenses
+ variable administrative
Expenses +fixed selling and administrative expenses
i.e. variable administrative expenses = N500,000 – N120,000 - N200,000
= N180,000
Note:
All the details may now be shown using two statements:
(i) Profit statements for the year ended 31st December,1987
N’000 N’000
Sales 3,000
181
Less: Cost of sales

Direct materials 800
Director labour 500
Variable manufacturing overhead 200
Fixed manufacturing overhead 600 (2,100)
900
Gross profit
Less: Variable selling expenses 120
Variable administrative expenses 180
Fixed selling and administration
Expenses 200 (500)
Net profit 400
(ii) Contribution statement for the year ended 31 December,1987

N’000 N’000
Sales 3,000
Less: Variable costs
Director materials 800
Director labour 500
Manufacturing overhead 200
Selling expenses 120
Administrative expenses 180 (1,800)
Contribution 1,200
Less: Fixed costs
Manufacturing overhead 600
Selling and administrative expenses 200
(400)
Net profit 400
182
Reprographics manufacture a document reproducing machine which has a variable cost

structure as follows:
N
Material 40
Labour 10
Overhead 4
And a selling price of N90
Sales during the current year are expected to be N1,350,000

1,350,000 and fixed overhead N140,000.
Under a wage agreement an increase of 10% is payable to all direct workers from the
beginning of the forthcoming year, whilst material costs are expected to increase by 7½%,
variable overhead costs by 5% and fixed overheads by 3%.
(a) The new selling price if the current C/S ratio is to be maintained; and
(b) The quantity to be sold during the forthcoming year to yield the same amount of
profit as the current year, assuming the selling price is to remain at N90.00
Note:
You may ignore the question of stocks and work in progress and may assume that the fixed
overhead
erhead is applicable to a production level up to 20,000 machines.
Current Situation
i) C/S ratio N
S.P. 90
V. costt (40 + 10 + 4) 54
183
Contribution per unit N36

C/s ratio = 36x 100 = 40%
90
ii) Current Profit
Total contribution = N1,350,000 x 40% =N540,000
Less: Fixed cost 140,000
Expected profit N400,000
Proposed situation
N
DM N40 x 1.075 43
DW N10 x 1.10 11
VOH N4 x 1.05 4.20
Total variable cost per unit 58.20
Fixed cost (FC) = N140,000 x 1.03 = N144,200
(a) Calculation of new selling
Let the new selling price = Np
Unit contribution = Np – 58.20
= p - 58.20
P
and this must equal to 40%. That is,
P – 58.20 = 0.4
P
i.e. 0.4p = p - 58.20
- 0.6p = - 58.20
p = - 58.20
- 0.60
= N97.00
(b) Quantity to be sold
N
Selling price 90
VC (see above) 58.20
184
New unit contribution N31.80

Quantity to be sold = FC + Profit desired
unit contribution
= 144200 + 400,000
31.80
= 544200
31.80
= 17,113 units
12.8Summary
This study session defined break even analysis, states tthe

he uses and assumption of break-even
break
analysis. The graphical approach to break
break-even
even analysis was discussed. It explained the
contribution break even chart, margin of safety and also the Account
Accountant
ant and Economist
Eco view of
break-even charts.
harts. The limitations of break
break-even
even and profits charts were also explained.
1. Define the term margin of safety and explain the graphical approach to break even
analysis and
2. What is the major purpose of Cost-volume-Profit analysis?
3. Differentiate between the Accountants vi

view
ew and Economists view of break-even
break
chart, and state the limitation of break-even and profit chart
4. What are the major assumptions behind cost

cost-volume-profit
profit analysis?
5. Define break-even
even analysis and list the various formular under break-even
break analysis
6. E Ltd has prepared a draft budget for the next year as follows:
Production and Sales 100,00 units

Sales price per unit N30.00
Variable Cost Per Unit
Direct material N8.00
Direct Labour (2hrs x N3) 6.00
Variable Overhead (2hrs x 0.5) 1.00
185
15,00
Contribution per unit 15,00
Budget contribution N150,000
Budget fixed costs N140,000
Budget profit N10,000
The board of directors is dissatisfied with the budget and asks a Working Committee to
come up with alternative budget with higher profit figure.
The Working Committee reports back with the following suggestions. The company should
spendN28,500 on advertising and put sales prices up to N32 per unit. It isexpected that sales
volume would also rise in spite of the price increases to 12,000 units. In order to achieve the
extra production capability, however, the work force must be able to reduce the time taken to
make each unit of product. It is proposed to offer a payment and productivity deal, in which the
wage rate per hour is increased to N4. The hourly rate for variable overhead will be unaffected.
What is the required time per unit of product the labour force must achieve if the company is to
budget for a profit of N25,000 in the year.
7. Show below is a typical volume profit chart:
N Total Revenue
Total Cost
Variable Cost
(a) Volume (b)
186
(a) Explain to a colleague who is not an accountant the reason for the change in result on
the above cost-volume
volume profit chart from a loss at point (a) to a profit at point (b);
(b) Identify and critically examine the underlying assumptions of the above type of cost-
cost
volume-profit
profit analysis and consider whether such analyses are useful to the
management of an organization.
The Curter group of companies is opening up a new works to produce Blue mantle
which will sell for N10
10 per unit. Preliminary market research show that demand will
be less than 100,000 units per year, but it is not as yet clear how much less. The group
has the choice of buying one to two machines, each of which has a capacity of
100,000 units per year. Machine A would have fixed costs of N300,000
300,000 per year and
would yield a profitt of N300,000
300,000 per year if sales were 100,000 per year. Machine B
has a fixed cost per year of N160,000 and would yield a profit of N240,000
N per year
with sales of 100,000 units. Variable costs behave linearly for both machines.
You are required:
(a) To find the break-even

even point for each machine
(b) To find the range of sales for which one machine is more profitable than the other.
(c) To produce a single profit

profit-volume graph showing these features.
Are you in need of General Help as regards your studie

studies?
s? Do not hesitate to contact
08033366677
187
Study Session 13
13: Process Costing
Introduction
188
In production, whenever the identity of individual orders is lost the method known as Process
Costing is used. This applies particularly to continuous and mass production processes and to
industries where a single product or a limited range of products is manufactured.
After completing this session, you should be able to:
1. Define process costing

1.1 Apply process costing
2. State the characteristics of process costing
3. State the basis of process costing
4. Distinguish between Normal and Abnormal process losses/gains
5. Use the concept of Equivalent Unit
6. apply the FIFO method of Valuation of Work-in-progress
7. Apply the Average cost method of valuation of Work-in-progress
8. Solve questions on process costing
13.0 Definition
In study session 8, fig. 8.1, we described process costing as part of the continuous operations
costing method. It is a form of operation costing used where production follows a series of
sequential processes (Costing by T. Lucey).
13.1 Application
Process costing may be applied either where a separate plant is set up for the production of a
single product, or where particular production facilities are employed at different times to
produce a variety of products.
It is used in a variety of industries including:
Oil refining
Food processing
Paper making
Chemical and Drug manufacture
Textile industries, etc
189
13.2 Characteristics
The main characteristics of process costing are as follows:
i. The setting up of process cost centres and the accumulation of the material cost,
wages, and overhead by these process cost centres.
ii. The charging of the output of one process as the raw material of a subsequent
process.
iii. The collection of accurate production statistics for each process.
iv. The averaging of the costs of all production in each process, and
v. The segregation of the costs where one product is split up into two or more different
products or where by-products arise at some stage of the production.
13.3 Basis Of Process Costing

The production system which employs process costing method breaks down the system into
stages known as processes.
Material passes through the various processes gathering costs as it progresses. A unit of
production is not complete until it has passed through all the stages. By this very fact the finished
product of a stage acts as the raw materials of the next stage.
It is only the first stage (process) that will not have opening work-in-progress. It is only the last
stage (process) that will not have closing work-in-progress. Additional fresh materials may or not
be added at the intermediate stages of production. At the end of the accounting year of the
company there is the likelihood of the presence of work-in-progress which has to be valued using
the concept of the equivalent unit.
13.4 Process Losses

In most production system, the quantity, weight or volume of the process output is less than
quantity, weight or volume of the material input. This may be due to some or all of the following
reasons:
i) Evaporation, residuals or ash

ii) Unavoidable handling, breakage and spoilage losses
iii) Withdrawal for testing and inspection.
190
As a result of increasing material costs, carefu

carefull records must be maintained of losses occurring
and the resulting cost implication.
If losses are in accordance with normal practice, that is, standard levels, they are termed
“NORMAL PROCESS LOSSES”. If they are above expectation, they are termed
“ABNORMAL PROCESS LOSSES”
LOSSES”. If they are below expectation, they are termed
“ABNORMAL PROCESS GAIN”
GAIN”.
13.5 Normal Process Losses

These are unavoidable losses arising from the nature of the production process. The cost of such
losses is included as part of the cost of good production. Any value realized from the sale of
imperfect articles is credited to the process account thereby reducing the overall cost. No value is
attached to Normal Loss except if the Normal Loss can be scrapped.
Tender Age Ltd food manufacturing process has a normal wastage of 5%

% which can be sold as
animal feedstuff at N55 per tonne. During the period ended 31st march, 1998 the following data
were recorded:
Input materials = 160 tonnes @ N23 per tonne
Labour and overheads = N2,896
Losses were at the normal level
You are required to compute the cost per tonne.
INPUT TONNES N
Materials 160 3,680
Labour and overhead - 2,896
160 6,576
Less normal loss of 5% 8 40 cr
Good production 152 6,536
Cost per tonne of good production = N6,536 = N43
191
152
The N40
40 credit to the process account will be debited to a scrap sales account which will
eventually be credited with the actual sale. Any balance on the scrap sales account will be
taken to P & L account. The balance in scrap value A/c is taken to cash A/c.
13.6 Abnormal Process Losses
Abnormal losses are those above the level deemed to be the normal loss rate for the process.
Abnormal loss = Actual Loss – Normal Loss. Abnormal losses can arise due to any or all of the
following factors:
Plant breakdown
Industrial accidents
Inefficient workin
working or unexpected defects in materials
Generally, abnormal losses cannot be foreseen. On the other hand, there can be abnormal gain as
a result of unexpectedly favourable conditions which make actual losses to be lower than normal
loss.
In costing principle,, abnormal conditions are excluded from routine reporting and only normal
costs should be charged to production. Accordingly, the cost effects of abnormal losses or gains
must be excluded from the Process Account. Abnormal losses or gains will be costed on the
same basis as good production thereby carrying a share of the cost of normal losses.
Assume the same data as in example 13.1 except that actual production was 148 tonnes. You
are required to compute the abnormal loss and show the relevant accounts.
Abnormal loss = Actual loss – Normal Loss
= (160-148) – (160-152)
152)
192
= 12 – 8 = 4 tonnes
Table 13.1: Process Account
TONNES N TONNES N
Material 160 3,680 Good Production 148 6,364
Labour/
Overheads - 2,896 Normal loss 8 40
Abnormal
Loss 4 172
160 6,576 160 6,576
Note:
The abnormal losses are valued at the same cost as good production, i.e. N43/tonne.
43/tonne. Therefore
N43 x 4 tonnes = N172
The other relevant accounts will be:
(i) Abnormal Losses A/C
N N
Process A/C 172 Scrap Sales 20
P&L 152
N172
172 N172
(ii) Scrap Sales A/C
N N
193
Process A/C 40 Cash A/c 60

Abnormal Losses 20
60 60
Note:
The sale of the 4 tonnes of abnormal losses at N5 per tonne is credited to the abnormal losses
account. This means that the net cost of N152 (i.e. N172 – N20)
20) is charged to the P & L account.
Assume the same data as in example 13.1 except that actual production was 155 tonnes you
are to calculate the abnormal gain
ain and show the relevant accounts.
Abnormal gain = Actual Loss - Normal Loss

= (160 -155) - (160 – 152)
= 5 - 8
= (3 tonnes)
These gains should be valued at the same rate as good production.
The relevant accounts are as follows:
Table 13.2: Process Account

(i)
TONNES N TONNES N
Material 160 3,680 Good

Production 155 6,665
Labour/ - 2,896 Normal loss 8 40

Overheads (Scrap Value)
Abnormal 3 129
194
Gains
163 6,705 63 6,705
(ii) Abnormal Gains A/C
N N
Scrap Sales A/C 15 Process A/C 129
P&L 114
N129 N129
(iii) Scrap Sales A/C
N N
Process A/C 40 Abnormal gains 15
Cash 25
40 40
Note the following:
(a) Although an improvement in performance has been made, the good production of
155 tones is still valued at N43 per tonne.
(b) The credit to the scrap sales A/C of N15 is necessary so that the account only
shows the effect of the 5 tonnes actually lost.
13.7 The Concept of Equivalent Unit

In a production process, there are likely to be partly completed units at the end of any given
period. Some of the costs of the period are attributable to these partly completed units as well as
those that are fully completed. In order for us to be able to spread cost equitably over partly
completed and fully completed units the knowledge of the concept of equivalent units is
required. Equivalent unit is a notional whole unit representing incomplete work, which is used to
share cost between completed or finished goods and work-in-progress.
The number of equivalent units is the number of equivalent fully complete units which the partly
complete units represent. Note that the partly complete unit is the same thing as work-in-
progress.
Example 13.4: Assume that in a given period production was 22000 complete units and 6000
partly complete. The partly complete units were deemed to be 75% complete. The, the total
equivalent production
195
= Completed Units + Equivalent Units in work

work-in-progress
= 22000 + ¾ (6000)
= 22000 + 4500 = 26500 units
The total cost for the period will be spread over the total equivalent production. That is,
cost per units = Total Costs
Tota
Total equivalent Production in units
13.8 Equivalent Units and Cost Elements
Elements of cost are made up of material, labour and overheads. Frequently it becomes necessary
to know thee percentage completion of work
work-in-progress
progress of each of the cost elements. The
principle of calculating equivalent units is adopted, but each cost element is treated separately
and then the cost per unit of each element is added to give the cost of complete units.
Danladi Ltd has the following production and cost data for the period ended 31-12-2008:
31
Materials 51,150
Labour 39, 520
Overheads 30, 000
Total Costs 120,670
Production was 14000 fully complete units and 2000 partly complete. The degree of completion of
the 2000 unit’s work-in-progress
progress was as follows:
Material 75% complete
Labour 60% complete
Overheads 50% complete
i) The total equivalent production,
196
ii) The cost per complete units, and,
iii) The volume of the work

work-in-progress.
Table 13.3: The Total Equivalent Product and Cost per Complete Units.
Units
Cost Equivalent + Fully Complete = Total Total Cost per

Element Units in W
W-I-P Units Effective Cost for Units
Production Period
N N
Material 2000 x 75% = 1500 + 14000 = 15,500 51,150 3.3
Labour 2000 x 60% = 1200 + 14000 =15,200 39,520 2.6

Overheads 2000 x 50% = 1000 + 14000 = 15,000 30,000 2.0
N120,670N7.90
7.90
From the solution above, the cost of a complete unit = 7.90. Therefore, the value of 14000 complete
production = 14000 x N7.90
7.90 = N110,600 the value of work-in-progress
progress will now be: Total costs-
costs
value of completed production = N120,670 – N110,600 = N10,070.
The value of work-in-progress

progress can be computed in another way by multiplying each element of cost
per unit by the number of equivalent units in the work-in-progress
progress of each cost element as follows:
Table 13.4: Computation of Work-In-Progress
Cost Elements No of Equivalent Cost Per Unit Value of W-I-P

W
Units in W
W-I-P N N
Material 1500 3.3 4,950

Labour 1200 2.6 3,120
Overheads 1000 2.0 2,000
N10,070
10,070
One basic thing you should note under this sub

sub-head
head is that total cost for the period equals value of
completed units plus value of work
work-in-progress.
197
13.9 Input Material and Material Introduced
According to the process costing outline, the output of one process forms the input material to the
next process. The full cost of the completed units transferred forms the input material cost of the
process and by its nature input material must be 100% complete.
Material introduced is extra material needed in the process and should always be shown separately
from input material. Whenever there are partly completed units at the end of the period, they may
contain two categories of material. These are: INPUT MATERIAL (which is always 100%
complete) and MATERIAL INTRODUCED (which may or not be complete)
The other names for input material are:
- Units transferred, or
- Cost of goods/units transferred, or
- Previous process costs.
That is, these four descriptions can be used inter-changeably
13.10 Opening Work-In-Progress
Partly completed units at the end of a period or process are known as work-in-progress. The
closing work-in-progress of one process forms the opening work-in-progress of the next process.
This opening work-in-progress will be partially completed and will have a value brought forward
from the previous period, sometimes subdivided into the various element of materials, labour and
overheads each a given degree of completion and value. In most practical situation, there is both
opening and closing work-in-progress and in such cases the problem arises of how to value the
closing work-in-progress and the completed units transferred out.
There are two methods to solving this problem:
(i) The FIFO method, and
(ii) The average cost method
13.11 FIFO Method of Valuation
198
Under this method, it is assumed that units are dealt with on a first
first-in-first-out
out basis. It is also
assumed that the first work done in a period is the completion of the opening work-in-progress.
work
The implication of this is that the closing work-in-progress is valued
alued at current period costs and
part of the previous periods cost brought forward in the opening work
work-in-progress
progress valuation is
included in the cost of completed units.
In the manufacturing process of Dunlop Elite Ltd, process 2 receives units from process 1.
After carrying out work on the units in process 2, they were transferred to process 3. During
the accounting period ended 31st March, 1999, the relevant data were as follows:
Opening work-in-progress
progress 2000 units (25% complete) valued at N25,000
25,000
8,000
,000 units were received from Process 1 valued at N43,000
8,400 units were transferred to Process 3
Closing work-in-progress
progress was 1,600 units (50% complete)
The costs for the period were N165,800 and no units were scrapped.
You are required to prepare the process accounts for process 2 using the FIFO method
of valuation.
First Step: Calculate the effective units of production thus:
Units
Completed units transferred out 8,400
+ Work contained in closing w w-i-p
(1600 x 50%) 800
9,200
- Work contained in opening w w-i-p
(2000 x 25%) 500
Effective units for the period - 8,700
Step 2:Calculate the period cost per unit
199
Period cost per unit = Total cost for period

Effective units for period
= N165,800 + 43,000
8,700
= N24
This figure will be used to value the closing work

work-in-progress
progress = 1,600 x 50% x N24 = N19,200.
The valuation of the number of complete units transferred to process 3 is found from the balance
on the process account.
Also note that the total cost for period is the addition of Process Costs and Transfers in.
The Process A/C can now be presented.
Table 13.5: Process 2 Accounts
Units N Units N
Opening w-i-p 2000 25,000 Transfers to

Process 3 8,400 214,600
Receipts from
Process 1 8000 43,000 Closing w-i-p 1,600 19,200
19,20
Process Costs - 165,000

10,000 233,800 10,000 233,800
Note that the transfer value of N214,600

214,600 is the balance on the account. If the period cost per
unit of N24
24 is used the value could have be
been (24 x 8400) = N201,600
201,600 which is N13,000 less
than the transfer value (214,600 – N201600 = N13,000).
This N13,000
13,000 is the amount by which the opening work
work-in-progress
progress valuation (based on
previous period’s costs) is greater than the current period’s cost
cost, i.e. N25,000 – (2000 x 25% x
N24) = N13,000.
200
It is now clear that only the current period cost levels, i.e. N24 per unit, are carried forward to the
next period in closing work-in-progress. That is why the value of the closing work-in-progress
carried forward = 1600 units x 50% x N24 = N19,200.
The transfer value of 214,600 can also be calculated as:
1.
Input % Completed Eq Unit Value

FG: OWIP 2000 75% 1500 36000
NFG 6400 100% 6400 153600
8400 7900 189600
CWIP 1600 50% 800 19200
10000 8700 208800
2. Cost / Unit = 43000 + 165800

8100 = 24/unit
3. Total Cost
FG: OWIP 2000 = Cost before + New Cost = 25000 + 36000 = 61000
NFG 6400 = 153600
8400 214600
CWIP 1600 19200
233800
Note:
That the value in step 1 is calculated as equivalent unit x cost / unit calculated in step 2 i.e.
OWIP = 1500 x 24 = 36000
NFG = 6400 x 24 = 153600
CWIP = 800 x 24 = 19200
201
• Also note that the 75% used as percent of completio

completionn for OWIP is the degree of work
left to be done to make the OWIP a finished product. Re
Re-call
call that 25% work has been
done in the previous period meaning that 75% more work is needed to complete it.
• The 8400 completed work in the period is assumed to be in two portion i.e.
8400
2000 6400
Being the first to be Being newly completed

completed units in the period
13.12 Average Cost Method of Valuation

Under this method, an average unit cost is calculated using the total of the opening work-in-
work
progress plus the current period costs. The effect of this is that both closing work-in-progress
work and
completed units are valued using the same average unit cost. This means that the previous
periods cost contained in the opening work
work-in-progress
gress valuation influence the closing work-in-
work
progress valuation which is carried forward to the next period.
Assume information and data as in example 3.6 However, you are required to prepare the
process accounts for process 2 using the Average Cost met
method of valuation.
Calculation of effective units of production.

Units
Completed units transferred out 8,400
+ Work contained in closing w
w-i-p
(1600 x 50%) 800
Total effective costs for the period = 9,200
The costs involved are the total of the opening work

work-in-progress
progress valuation + the valuation of
units transferred in + the process 2 costs = N25,000 + N43,000 + N165,800 = N233800
233800
202
Therefore average cost per unit = N233,800

9200 units
= N25.413
This average cost per unit of N25.413

25.413 will be used to value both the closing stock and transfers
out.
Closing work-in-progress
progress valuation will now be
1600 x 50% x N25.413 = N20,330
Transfers to process 3 will be 8400 x N25.413 = N213,470
The Process
rocess A/c for process 2 can now be presented thus:
Table 13.6: Process 2 Account
Units N Units N
Opening W-I-P b/f 2000 25,000 Transfers to

Process 3 8400 213,470
Receipts from 8000 43,000 Closing W-I-P c/f 160 20,330

Process 1
Process Costs - 165,000
10,000 233,800 10,000 233,800
The effect of the Average cost method in this example is to increase the value of closing
working-in-progress
rogress and reduce the value of transfers to process 3. This is because the previous
period cost levels (as contained in the opening work
work-in-progress
progress valuation) were higher than the
current cost levels. If the previous period cost levels were lower than cu
current
rrent levels the average
cost method would cause the closing work
work-in-progress
progress valuations to be lower than when using
the FIFO system.
13.13
203
Table 13.7: Difference between Process Costing and Job Costing
S/N JOB COSTING PROCESS COSTING

1. This is an example of specific Order This is an example of continuous operation
costing. costing.
2. Used when work is undertaken to Used for uniform product produced in such a
meet specific orders. large volume.
3. Job performed within the same Production required the full-time
full use of
Department. production department.
4. Cost gathering focused on each No attempts are made to trace costs to the
job performed. units.
5. Not easy to set standard costs for Easier to set standard costs for process
job costing. costing because products are uniform
and standardized.
6. More expensive to operate than Process costing is simpler and less expensive to
process costing as costs have to beoperate the job costing because one only has to
becharged
charged to specific job. worry about the relevant department to charge
for a particular material requisition.
13.14Summary
Process costing is used where production follows a number of sequential processes frequently of
an automatic nature. The cost unit chosen should be relevant to the organisation and the product.
Losses due to breakage, evaporation, machining testing and oth
other
er causes must be carefully
recorded.
Abnormal losses are losses above the normal anticipated level and should be costed on the same
basis as good production. The concept of equivalent units can be applied to the cost elements in
production; material and overheads.
verheads.
204
1. Define process costing and explain the characteristics of process costing system?
2. Explain the application of process costing in manufacturing companies
3. What are the reasons for process losses?
4. What is an equivalent unit?
5. Distinguish between “normal and abnormal gains/losses”
6. Distinguish between FIFO and Average cost valuation methods.
7. A company manufactures a product using two processing departments. Materials

areadded in the beginning of department A. labour and factory overhead costs are
applied evenly throughout the process. During January, department A was charged
the following costs: materials N52,650; LabourN42,000 and factory overheads
N39,600. January’s quantity schedule for Department A appears below:
Unit started in process 65,000
Units completed and transferred to
Department B 50,000
Ending units in process 15,000
65,000
All materials are 100% complete labour and factory overheads are 2/3 complete
Required:
(a) Calculate the equivalent units of production for materials and conversion costs.
(b) Calculate the unit cost of each cost element
(c) Calculate the total unit cost for a complete unit in Department A.
205
8. The following data relate to process A for period one:
Units
Work in progress b/f Nil
Units started 50,000
Units completed 30,000
Work in progress c/f 20,000
The degree of completion of the work in progress c/f was:
Material 100%
Conversion cost:
Batch 1 : 50% of the units were 50% completed
Cost: Materials N150,000: LabourN77,200; overhead N38,600
Required:
Prepare a production cost report showing cost of goods completed and cost of work in progress
carried forward.
9. Process B has the following information for period 9

Opening W.I.P 10,000 units
Materials 40% complete
Cost N13,900
Labour and overheads - 30% complete
Process – cost- N7,680
Completed and transferred to Process C-30,000 units
Closing W.I.P – 15,000 units
206
Materials: 80% complete

Labour and overheads: 20% complete
Process costs added during period 9:
Material - N152,000
Labour and overheads N 90,000
Required:
Prepare process account for process B for period 9 assuming the company uses:
(a) Weighted Average Method;
(b) FIFO Method
10. Product “Zed” passes through three processes to completion. In period 3 the costs of production
were as follows:
Table 13.8: Product Zed Processing Cost
Process
Element of cost Total 1 2 3
N N N
Direct material 8,482 2,000 3,020 3,462
Direct labour 12,000 3,000 4,000 5,000
Direct expense 725 500 225 -
Production overhead 6,000
400 units at N5 each were issued to process 1.
Output of each process was:

Process 1 920 units
“ 2 870 “
“ 3 800 “
Normal loss per process was estimated as:
Process 1 10%
Process 2 5%
“ 3 10%
The loss in each process represented scrap which could be sold to a merchant at a value as follows:
207
Process 1 N3 per units

“ 2 N5 per units
“ 3 N6 per units
There was no stock of materials or work in progress in any department at the beginning or end of
the period. The output of each process passes direct to the next process and finally to finished
stock. Production overhead is absorbed by each process on a basis of 50 per cent of the cost of
direct labour.
You are required to prepare all relevant Ledger Accounts
11. The following information is obtained in respect of process 3 for the month of August:
Opening stock: 1,000 units

Value: Direct material (1) N390. Direct material
(2) N75 Direct labourN112 Production overheadN118.
Process 2 transfer: 6,000 units at N2,360
Process 4 transfer: 4,700 units
N
Direct materials added in process: 520
Direct labour employed: 1,036
Production overhead absorbed: 1,541
Units scrapped: 300
Degree of completion:Direct material 100%
Direct labour 80%
Production overhead 60%
Closing stock: 2,000 units
Degree of completion:Direct material 60%
Direct labour 50%
Normal loss: 5% of production.
Units Scrapped realized N0.20 each
Required: prepare all relevant A/cs.
12. The following information is shown in respect of Process 2 for the month of September:
208
Opening stock: 1,000 units
Value: Direct materials (1) N400. Direct Materials (2) N200
Direct Labour N35. Production overhead N80
Process 1 transfer: 16,000 units at N8,100
Process 3 transfer: 14,500 units
Direct materials added in process: N4,375
Direct labour employed N1,430
Production overheads absorbed N 2,850
Units scrapped: 500

Degree of completion: Direct materials 100%
Direct labour 60%
Normal loss in process: 5% of production
Units scrapped realized 0.50 each
Closing stock: 2,000 units
Degree of completion: Direct materials 50%
Direct labour 20%
Required: Prepare all relevant accounts
13. The following information is obtained in respect of Process 2 for the month of July:
Opening stock 1,600 units N276
Degree of completion: Material 70%
Labour 60%
Overhead 60%
Transfer from Process 1: 10,200 units at N510
Transfer to Process 3: 9,200 units
209
Direct material added in process 2 = N224
Direct labour amounted to N657
Production overhead incurred: N876
Units scrapped: 800
Degree of Completion: Material 100%
Labour 70%
Overhead 70%
Closing stock = 1,800 units
Degree of completion: Material 60%
Labour 40%
Overhead 40%
There was a normal loss in the process of 10 per cent of throughput. Units scrapped realized
N0.05 per unit.
You are required to prepare all relevant accounts.
yo
the DLI
08033366677
210
Study Session 14
Costing Joint and By
By-Products
Introduction
By-product costingandjoint
joint product costing
costingare
are used in situations where multiple saleable
products are created as part of a production process, and there are no demonstrably clear-cut
clear
costs beyond those incurred for the main production process. Both by
by-product
product costing and joint
product costing require that you first determine the “split off”point, which is the last point in the
production process where you still cannot determine the final product. For example, a batch of
sugar, water, and corn syrup can be converted into any of a number of hard candy products, up
until the point where the slurry is shifted to a slicing machine that cuts up the work-in-process
into a final and clearly identifiable product. From this
his point onwards in the production process,
we can either have a main product and an incidental side product (known as a “byproduct”),
“byproduct” or
several major products (which are known as “joint”products).
). Accounting for these different
types of final products iss somewhat different.
211
This study session is continuation of the discussions on costing methods. At the end of the module,
you will be in a better position to:
1. Define and give examples of joint products

2. Define and give examples of by-product
3. Cost joint products
4. Apportion joint costs
5. State the accounting treatment of by-products
6. Cost joint products in service organizations
7. Use cost apportionment in decision making
8. Solve questions on joint and by-product costing.
14.0 Joint Products
Joint products are individual products, each with significant sales values which are
produced simultaneously as a result of a common process. Examples include:
- Petroleum products – where gasoline, kerosene, naphthalene, benzene are

produced jointly from crude oil;
- Tea products- where tea grades 1,2,&3 are produced from tea;
- Dairy products-where cream, butter, skim milk are produced from milk.
- Mining where the joint products frequently include the recovery of several metals
from the same crushing.
14.1 Main Characteristics Of Joint Products

(a) Joint products have a physical relationship that required simultaneous common
processing. Processing of one of the Joint Products simultaneously results in the
processing of the other joint products.
(b) Manufacturing of joint products always has a split-off or separation point at which
separate products emerge, to be sold or processed further. This can be represented
diagrammatically as follows:
Figure 1
Joint Product 1
Input
Joint Process Joint Product 1
212
Joint Product 2
1. Raw Material
2. Labour Split-off point. (Point where
3. Overhead Joint Product are
Separately identifiable)
(c) None of the joint products is significantly greater in value than other joint
products. This is the characteristic that distinguishes joint products from by-
products.
14.2 Joint Costs

Joint costs are those incurred up to the point in a given production process where individual
products can be identified. A major difficulty inherent in joint costs is that they are indivisible,
that is, joint costs are not specifically identifiable with any of the products being produced
simultaneously.
For example, the costs of a refining company to locate, mine, and process the ore are joint costs
that must be matched to the iron, zinc, or lead which are later extracted from the ore. Since the
joint costs cannot be specifically identified for iron, zinc, or lead, the joint costs must be
apportioned.
14.3 Reasons for Apportioning Joint Costs
Joint costs are apportioned to products for the following reasons:
(a) To value the closing stock of joint products;

(b) To put costs on units sold in order to determine costs of sales and gross profit.
(c) To some limited extent, to assist in pricing decision, especially when using the
full-cost plus formula.
14.4 Basis Of Joint Cost Apportionment
The various method of joint costs apportionment are:
(a) Physical output
(b) Relative sale value method-at separation point
213
(c) Weighted average method
The information below will illustrate the above methods:
A process produces three joint products and in a certain period the following results
were achieved:
N
Inputs: Direct Materials: 1,000 at N4 4,000
Direct Labour: 2,000 hours 4,000
Production Overhead 2,000
Total Joint Cost 10,000
Output Joint Product: X = 200 kilos
Y = 300 kilos
Z = 500 kilos
Additional information:
Products X Y Z
Selling price per kilo N15 N20 N12
Quantity sold – kilos 150 250 400
You are to apportion the joint cost based on each of the methods above.
Physical Output Method

Under this method, the quantity of output (net of sales) is used as a basis for apportioning costs.
The quantity of output is expressed in units which may be litres, kilos or any other appropriate
measurement. The joint costs appropriated to each product uunder
nder this method are computed by
dividing the quantity of output of all products produced and multiplying the result by the total
joint costs.
Using the above data, the joint costs apportioned to each product is computed as follows:
Product Output Apportionment Cost Apportioned

N
214
X 200 200 xN10,000 = 2,000

1000
Y 300 300 x N10,000 = 3,000
1000
Z 500 500 x N10,000 = 5,000
1000 1000 10,000
Profit Statement on Physical Output Basis
X Y Z TOTAL
N N N N
Sales Value 2,250 5,000 4,800 12,050
Less cost apportioned 1,500 2,250 4,000 10,000
Profit/(loss) 750 2,500 800 4,050
Profit/Sales % 33.33% 50% 16.67 33.33%
Note: Remember that basis of apportionment is the units produced and not units sold.
This method is unsuitable where the products separate during the process into different states e.g.
where one product is a gas and another is a liquid. Besides, the method does not take into
account the relative income earning potentials of the individual products.
(a) Relative Sales Value Method
Under this method, joint costs are apportioned according to sales values of the individual
products produced (net product sold). Advocates of this method argue that a direct relationship
exists between cost and selling price. They contend that selling price of products are determined
primarily by the costs involved in producing that product.
Therefore, joint product costs should be apportioned on the basis of the market value of the
individual product. The procedure to be used under this method will depend on whether:
i) The market value is known at separation point, or

ii) The market value is not known at separation point.
Market Value Known at Separation Point
This method apportions the joint costs on the basis of the final market value of each product.Using
the above data: as in Example 14.1 apportionment of joint cost will be.
PRODUCT OUTPUT x SELLING = SALES VALUE OF

KILOS PRICE PRODUCTION
N (N)
215
X 200 x 15 3,000
Y 300 x 20 6,000
Z 500 x 12 6,000
15,000
The apportionment of the joint costs is therefore:
X 3000 x N10,000 = N2,000

15000
Y 6000 x N10,000 = N4,000
15000
Z 6000 x N10,000 = N4,000
15000 10,000
The major limitation of the above method is that it fails to take account of the level of costs
incurred subsequent to joint process, and these can vary quite significantly.
Market Value Not Known at Separation Point
The market value of a joint product may not be readily determined at the split-off point,
especially if additional processing is required to put the product into salable condition. Under
this condition, a “hypothetical market value” or “market value at separate point” or “net
realizable value” is calculated. This is done by deducting subsequent processing costs from the
final sales value to arrive at the Notional sales value at the split-off point.
Continuing with the last example and assuming further processing cost of N750 for X, N750 for
Y and N500 for Z:
Product X Y Z Total
N N N N
Sales value production 3,000 6,000 6,000 15,000
Further processing costs
(Assumed) (750) (750) (500) (2,000)
Market value at
Separation point 2,250 5,250 5,500 13,000
The apportionment of Joint Costs will be:

N
X 2250 x N10,000 = 1,730
Y 5250 x N10,000 = 4,039
Z 5500 x N10,000 = 4,231
13000 10,000
216
Sales Value Basis

Format for presentation:-
Table 14.1: Sales Value Basis Format for Presentation.
PRODUCT SALES VALUE APPORTIONMENT COSTS
APPORTIONED
X X X X
Y X X X
Z X X X
XX XX
PROFIT STATEMENT PRODUCT TOTAL
Sales Value X Y Z
Less: Cost apportioned (x) (x) (x) 2 x3
Profit A B C D
=== === === ====
P/L Percentage x% x% x% x%
c) Weighted Average Method:
In many industries the methods described above do not give a satisfactory answer to the cost
apportionment problem. For this reason, weight factors are often assigned to a unit based upon
the size of the unit, difficulty of manufacture, time consumed in ma
making
king the unit, difference in
type of labour employed, amount of materials used, etc. Finished production of every kind is
multiplied by weight factors to apportion total costs to individual units.
Joint Ltd. produces the following products from the same process:
Product Units Produced

JPA 20,000
JPB 15,000
JPC 10,000
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JPD 15,000
The joint process cost is N120,000.

120,000. The joint process cost is to be apportioned on the basis of
weighted average method with the following weight factors attached to the products:
JPA 3 Point
JPB 12 Points
JPC 13.5 Points
JPD 15 Points
How much of the joint cost is apportioned to each of the products?
Products Units x Points = Weighted Fraction Joint

Produced Units of Total Cost (N)
JPA 20,000 3 60,000 0.10 12,000
JPB 15,000 12 180,000 0.30 36,000
JPC 10,500 13.50 135,000 0.225 27,000
JPD 15,000 15 225,000 0.375 45,000
600,000 1.00 120,000
The manager of the Milligan Manufacturing Company assigned the following relativeweights
to its three products.
Table 14.2: Material, Labour and OverheadAssignment
PRODUCTS OUTPUT PER UN

UNIT OUTPUT PER DIRECT FACTORY
OF MATERIAL INPUT LABOUR HR OVERHEAD
X 5 4 50% of weight given

to direct labour hours
Y 3 2
Z 2 2
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The following costs were incurred during the month of January:

Materials 400, 000
Labour 250, 000
Factory Overhead 200, 000
Total 850, 000
You are to apportion the joint costs to the three products using the weighted average method.
ITQ Answer
Cost of Products Using Weighted Average Methods
Table 14.3: Joint Cost Apportionment
Material Labour Overhead Total Apportioned

PRODUCT Point Point Point Point Cost
Factor Factor Factor Factor N
X 5 4 2 11 425,040
Y 3 2 1 6 231,840
Z 2 2 1 5 193,200
22 850,080
(Cost per point = 850,080 / 22 =

N850,080 N38,640
14.5 By – Products
A by-product is an incidental product from a process which has an insignificant value compared
to the main product. Where more than one product is output fr
from
om a production process, there
may be either joint products or by
by-products
products or both. The distinction between a joint product and
a by-product
product is usually made by a comparison of their respective sales value. A joint product
would be a product which has a rel
relatively
atively high sales value, and is therefore of comparable worth
with other joint products. A by
by-product,
product, however, would have a relatively low sales value in
comparison to the main products.
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14.6 Accounting Treatment of By-Products
There are wide variations in practice in relation to by-product accounting but three broad
treatments are common:
a) Treating by-product income as miscellaneous income.
b) Deducting by-product income from the costs of producing the main products.
c) Costing by-product at the separation point and adding separable costs to completion
if necessary.
All these are explained further below:
(a) By-Product Income as Miscellaneous Income
This treatment is regarded as particularly relevant where the by-product income is small or
uncertain. Normally, the income is recognized at the time of sale. Recognition of the revenue
would be matched by a corresponding debit entry to either cash or debtors.
As income is not recognized until sale, by-product inventories are not valued. All joint costs are
charged to the main products.
Journal Entries:
On production - no entry is made
On sales (of By-product) :
Dr. Cash/Debtors XX
Cr. Miscellaneous Income XX
Being the sales value of by-product sold
The above records give recognition to the by-product income at the point of sales. Examination
questions could also be set calling for recognition as miscellaneous income at the point of
production. If this is the case, the necessary entries are:
On production:
Debit By-product Stock XX
Credit Miscellaneous Income XX
Being the sales value of BP produced.
On sales:
Debit Cash/Debtors XX
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Credit BP Stock XX
Being the value of by product sold
If production is not equal to sales, the above will give rise to the recognition of by-product stock.
(b) By-Product Income as a Reduction in the Cost of the Main Product.
Where by-product is of significant value they would normally be valued at their net realizable
value. This reduces the cost of the main products and results in no recognition of by-product
sales.
On production at the separation point, by –product inventory would be debited at its net
realizable value and work-in-progress would be credited. On sales, By-product inventory would
be credited and cash or debtors debited. If differences arise between actual prices and prices used
in the costing system, these would be treated as gains or losses for the period and cleared to P&L
account.
Note:
You should observe that recognition of By-product income under this method is usually at the
point of production but once again examination questions could be set calling for the recognition
of By-Product income at the point of sales. If this is the case, the necessary accounting entries
are:
On Production:
No entry is made in respect of By-product and therefore, no inventory of By- Product is

recognized.
On sales of By-Products: Dr Cr
Cash/Bank XX
WIP (Joint Process) XX
Being the income from the sales of By-Product
(c) Apportionment of Joint Costs to By-Products
Given the definition of by-product, its relative immateriality would dictate against this treatment
which by nature should only be applied to the main products. There are however occasions, such
as justifying a price for a by-product using a full-cost formula where cost apportionment may be
used.
221
14.7 Joint Products in Service Organisations
The illustrations so far made in this module have been drawn from manufacturing industry but
joint products or joint products services also arise in service organizations. Wherever facilities
such as buildings, staff and equipment are used in common to provide a variety of products or
services then joint products may arise as in manuf
manufacturing.
For example, banks provide a range of financial services using, largely, a common pool of
facilities. The services include: current and deposit accounts, foreign transactions, investments,
insurance, trustee and so on. Although there are some ide
identifiable
ntifiable costs specific particular
services so that the cost accounting system in a bank has to deal with precisely the same
problems faced in, say, an oil refinery.
14.8 Cost Apportionment and Decision Making
The procedures outlined so far are accepta

acceptable
ble for stock valuation and conventional circulation
purposes, but may produce misleading information for particular types of decisions. A common
type of decision is whether to sell a joint product at the split
split-off
off point or whether to incur further
processing
ing costs and sell at an enhanced price. In such circumstances, the amount of the joint
costs and the method by which the joint costs are apportioned are irrelevant.
All that matters is a comparison of the increase in revenue with the increase in costs necessary
nec to
achieve that revenue. This is an example of the use of incremental costing which is important in
decision making.
A processed three products X, Y, Z Total joint costs were N12,000

12,000 and outputs, selling prices
and sales values were:
X: 200 Litres sold @ N25 per litre

Y: 400 Litres sold @ N15 per litre
Z: 100 Litres sold @ N30 per litre
222
The firm has the opportunity to process further product Y at an additional cost of N3 per litre
in which case the product could be sold at N20 per litre instead of N15
15 per liter. You are to
decide whether the company should seize this opportunity relating to product Y.
Incremental revenue possible = N5 x 400 litres = N2,000

Incremental cost necessary = N3 x 400 litres = N1,200
Extra profit = N 80
Conclusion: It is worthwhile incurring additional costs on product Y because the additional sales
value gained exceeds the additional costs:
14.9 Summary
When two or more products arise from a process and where each has a significant sales value,
they are termed joint products. When a product of relatively small value arises incidentally it is
termed a byproduct. The most common method of by product costing is where the net realizable
value of the by product is deducted from the total production cost. The point where joint
products are separately identifiable is the split off point.
1. What is a joint product?
2. What is a by-prod
product?
3. What are the common methods of costing joint products?
4. What is the split-off

off point? How do you decide on whether to sell at the split-off
split
point or perform further processing?
5. What are the methods of apportioning joint costs?
6. Explain the process of co

costing
sting joint products in service organisation, and cost
apportionment vis
vis-a- vis decision making
223
7. A company operates a chemical process which jointly produces four products A,

B, C and D. Product B is sold without further processing, but additional work is
necessary on the other three before they can be sold.
Budgeted data of production, stocks and sales, of selling prices and cost for the year were as
follows:
ProductionClosing Sales
Stocks
Kgs Kgs Kgs
Product A 150,000 10,000 140,000
B 110,000 15,000 95,000
C 160,000 5,000 155,000
D 180,000 NIL 180,000
There were no opening stocks of the four products. Closing stocks were ready for sale.
Selling Prices Cost of Additional Work to make Product Saleable per Kg
N N
Product A 0.70 0.10
B 0.60 -
C 0.60 0.20
D 1.35 0.35
N
Production costs of the joint process were 180,000
Other costs were: Adm. (fixed) 45,000
Selling (fixed) 35,000
Selling variable: 0.01 per Kg. sold.
A new customer has expressed interest in buying from the existing production 50,000 kgs each in
one year of any or all of products A, C and D before they have been further processed by the
company. He has offered to pay the following prices.
Product A C D
N N N
224
Price, per kg. 0.65 0.52 0.90
On such sales variable selling costs would be only N0.006 per kg. The fixed administration and
selling costs would remain as stated above.
The costs of the joint process are to be apportioned to the individual product costs on the
following three bases:
a) Weight of products produced;
b) Sales value of products produced;
c) Sales value of products produced less the cost of additional cost incurred to make
products saleable.
You are required for each of the above cases to calculate for the year:
a) The gross profit per product (i.e) before deducting administration and selling
overhead;
b) The total gross profit;
c) The total net profit.
d) State which products you would recommend the company to sell to the customer
before further processing at the prices quoted above in order to increase its net
profit;
e) Calculate the increase in the annual net profit of the company if your advice at (d)
above was followed and quantities sold were as offered by the customer.
8. A company received steel in strip form from a nearby steel-mill. On a specialized

machine, from one kind of steel strip, there are produced three products A, B and C.
Products A is taken from the machine and further processed to make it available for sales
at N1.25 each. The additional processing cost for product A is N176 per month. Products
B and C are run through a dipping vat to make them heat-resistant. The dipping material
costs are calculated at N0.07 per cubic foot of product. Product B will then sell at N1.80
each and product C at N3.00 each.
In the month of May, the costs of running the machine for the month were:
225
Materials 2,835
Direct Labour 600
Maintenance and depreciation 435
3,870
Production and sales for the month were: product A 600 units, product B 800 units
product C 1,000 units, and this can be regarded as a typical product mix.
Product B has a volume of ½ cubit ft. and product C of 4/5ths cubic ft.
The dipping vat is being depreciated at the rate of N24 per month. It requires three men
for its operation at a total cost of N540 per month and necessitates other operating costs
of N60 per month: these costs are regarded as fixed costs.
(a) Produce a cost statement for May assigning the joint costs to each product;
(b) Make your recommendations on the advisability of the company selling, on a

long-run basis, product B undipped at N1.70 each. (Take total costs to nearest
whole N).
9. Zar Limited produced 100, 000 units of main product A during the last period and 10,000
units of by-product B. Joint production costs were N500,000. Separable costs of A were
N5 per unit. At the end of the period 20,000 units of A and 5, 000 units of B were in
stock.
Product A sells at N15 per unit and by-product B at N4 per unit.
You are required to calculate the total income from both products for the last period
assuming the following policies for the treatment of by-product income. Also, show the
closing stock values for products A and B.
a) By-product income is recognized as miscellaneous revenues when the by-product

is produced.
b) By-Product income is recognized as miscellaneous revenues when the by product

is sold.
c) By-product income is recognized as a reduction in the cost of the main product

when the by-product is produced.
226
d) By-product
product income is recognized as a reduction in the cost of the main product
when the by-product
product is sold.
10. Spar Ltd. operates a process whereby inputs of 150,000 tonnes of Z yield 5,000
5,00 tonnes of
B and 15,000 tonnes of C. Spar Limited pays 50k per tonne for Z. Each joint product is
then subjected to further processing, which costs N50,000
50,000 in the case of B and N30,000
in the case of C for each input of 150,000 tonnes processed. Spar Limi
Limited
ted has been able
to sell B at N20
20 per tonne, but recent competition has led to competitive price-cutting
price in
the case of C. Recent market research suggests that C can only be sold at a price of N5
per tonne and confirms that there is no market for the unfi
unfinished
nished goods. Spar Limited
operates the net realizable value method of allocating joint costs to products.
You are required:
a) To compute the unit costs of B and C, using Spar Ltd’s accounting policies.
b) Assuming that stock of B and C amount to 500 tonnes and 5,000 tonnes respectively,
to calculate appropriate valuations for balance sheet purposes.
c) To recompute the stock value of B assuming that Spar Ltd. decided that C should be
treated as a by-product
product and the realizable value of C produced should be deducted
dedu
from the cost of B.
d) To criticize the results of the calculation in (C).
e) If the market price of C fell to N3.5

3.5 per tonne, to consider the implication for Spar
Ltd’s management.
Are you in need of General Help as regards your studie

studies?
s? Do not hesitate to contact
08033366677
227
Study Session 15
15: Standard Costing
Introduction
Cost accounting entails managing a business through accounting information. In this process,
management accounting is facilitating managerial control. It can also be applied to your own
daily/monthly expenses, if necessary. These measures should be applied correctly so that
performance takes place according to plans. Planning is the first tool for making the control
effective.
tive. The vital aspect of managerial control is cost control. Hence, it is very important to
plan and control costs. Standard costing is a technique which helps you to control costs and
business operations. It aims at eliminating wastes and increasing effi
efficiency
ciency in performance
through setting up standards or formulating cost plans.
Learning Outcomes of Study Session 15
By the time you complete this study session

session, you would have acquired in details the following
follo
tenets of standard costing that should enable you to:
1. Define standard costing

2. State the objectives of Standard Costing
3. State the advantages of Standard Costing
4. Recall the disadvantages of Standard Costing
5. Identify the process of Setting Standard Costs
6. Distinguish between Standards and Budgets
7. Explain Motivation and Standards
8. Carry out Variance Analysis
228
9. Use Chart of Common Variances

- Material
- Labour, and
- Overheads
10. State how to make variance analysis more useful
11. Solve questions on standard costing and variance analysis.
15.0 Definition
“Standard Costing is a technique which establishes predetermined estimates of the costs of

products and services and then compare these predetermined costs with actual costs as they are
incurred” – Costing by LuceyT.The predetermined costs are known as standard costs and the
difference between the standard cost and actual cost is known as a variance.
Costs may be divided into two broad classes: historical costs and predetermined costs.
Historical costs are the costs applicable to production already completed or to services already
rendered. Predetermined costs are those which are computed in advance of production on the
basis of a specification of all the factors affecting cost. Historical cost cannot be used for the
purpose of cost control in respect of the particular work to which they relate as this has already
been completed before the costing figures can become available to management. This may not
matter when the completion of a particular job takes only a few minutes or hours, but it is of
consequence when the work extends over a period of months or years.
Cost control is the guidance and regulation by executive action of the costs of operating an
undertaking. It involves not only the ascertainment of current costs, but also a comparison of
these with some reliable standard of measurement. Thus, in jobbing or contract work, the
specification, bill of quantities, detailed estimate, and final tender each provide a standard against
which actual performance can be measured for the purpose of cost control. Standard costing is
only an extension of this basic idea devised to operations, departments, processes, and jobs.
15.1 Objectives of Standard Costing:

The basic objectives of standard costing are:
229
i) To provide a formal basis for assessing performance.

ii) To control costs by establishing standards and analyzing variables.
iii) To enable the principle of management by exception to be practiced at
detailedoperational level.
iv) To assist in setting budgets.
v) To assist in stock valuation.
vi) To motivate staff and management.
vii) To provide the basis for estimate.
15.2 Types of Standard Costing
Standards can be divided into two main classes: basis standards and current standards.
A Basic Standardis one, which is established for use unaltered for an indefinite period which
may be a long time, i.e., it is one which remains unchanged from year to year unless some
physical feature the relevant operations is altered. Such a standard is not revised when material
prices and labour rates vary, but is maintained at its original level in order to show the trend
revealed by the computed variances.
By using the same basic standard for a period of years, it is possible to compare readily the
material usage at one time, with that of another. If the basic standard is changed such comparison
obviously becomes more difficult. It is evident, however, that as time passes basic standards are
likely to get more and more out of line with current prices and standards of efficiency, and that
costs based on an obsolete cost level are of little use. It is true that trends are of interest to
management, but only so over periods of, say, five to ten years, and it has rarely happened in
recent years that basic standards could be retained for so long because of frequent changes in
national wage rates and in world commodity prices. Furthermore, methods of manufacture have
improved, labour efficiency has increased, and new materials have come into use, all of which
factors have caused standards expected to remain effective for a period of years to be revised
earlier than was originally intended. For this reason the basic standard finds less favour than the
current standard.
A Current Standardis one established for over short period of time (usually a year), and is
related to current conditions.
230
The standards incorporated into a double entry accounting system are generally current
standards.
A standard may be an ideal standard; a normal standard; or an expected standard.
i) An Ideal Standardis one, which can be attained under the most

favourableconditions possible. Such standards make no allowance for accidents,
defective materials, machine breakdowns, or for any other avoidable and
undesirable condition. This being so, an ideal standard causes costs to be set at an
unrealistically low level and inventories to be consequently undervalued, whilst at
the same time production targets are set so high that workers become discouraged,
felling that they can never attain them. Ideal standards are not commonly used
because it is impossible to maintain ideal conditions at all times.
ii) A Normal Standardis an average standard, which it is anticipated can be attainted

over a future period of time, preferably long enough to cover one trade cycle. The
aim of such a standard is to eliminate the variations in cost, which arise out of the
trade regardless of change in current costs or selling prices. This generally results in
an incorrect valuation of inventories and consequent errors in the profit disclosed,
the tendency being to understate stock values in periods of high prices, and to
overstate them when prices are low. Normal standards are mainly used as a device
to solve the problem of absorbing fixed overheads rather than in connection with
material cost and wages. Their obvious weakness is that neither the length of the
business cycle nor future costs can be predicted well enough to ensure that a
reasonably accurate normal standard is arrived at. Since this type of standard also
provides no goal to which members of an undertaking can strive to attain, it is not
often used.
iii) An Expected Standardis one, which it is anticipated can be attainted during a

future specified budget period. A distinction may be drawn between a standard
based on expected actual conditions, i.e., one set by reference to records of past
performance modified in respect of expected changes in design, equipment, or other
conditions, and a standard based on attainable efficient production.
231
a. Standards based on expected actual conditions frequently represent nothing

more than estimated costs since they provide no real standard of efficiency.
Comparison with past performance may be worse than useless, for it provides
no incentive to improve upon a standard, which may itself be based upon
indifferent performance.
b. By far the most commonly used standard is the expected standard based on
attainable efficient production. Such standards are set by reference to current
business conditions and represent the costs anticipated if the expected prices are
paid for materials and services, and if the usage of each of these factors
corresponds to what is believed to be necessary to produce the planned volume
of production. Such a standard is not based on the total elimination of
inefficiency: rather, it allows for such waste and error as management believes
to be unavoidable in practice. This is the only type of standard that is being
considered under this module.
15.3 Advantages of Standard Costing
Standard costing has the following advantages:
i) Actual performance is readily comparable with the pre-determined

standards,showing separately favourable or adverse variances.
ii) The variances can be analysed in detail enabling management to investigate the
case.
iii) The principle of “Management by Exception” (MBE) can be applied.

Managementdo not spend time and effort searching for unnecessary information,
but canconcentrate their attention on important matters.
iv) Gains or losses due to market fluctuations in prices of raw materials as distinct
fromvariables due to manufacturing conversion are revealed.
v) The effects on cost of variations in the price and use of materials, the rate of
wages, the volume of production and the alterations in expenses are demonstrated
at short intervals.
15.4 Disadvantages of Standard Costing
232
i) It may be expensive and time consuming to install and to keep up to date.
ii) In volatile conditions with rapidly changing methods, rates and prices, standards
quickly become out of date and thus lose their control and motivational effects.
iii) Overly elaborate variances may be imperfectly understood thus losing their
controlpurpose.
15.5 Setting Standard Costs
The mode of setting standards varies with organizations. Some companies have a separate
standards department or division – some companies may establish a standards committee.
Whatever may be the method employed the preparation of standards call for liaison between
many departments. Much of the detailed work is carried out by clerks and engineers of the
purchasing, personnel, design, and production control departments. Thus, the purchasing
department advises on the standard cost of materials to be used during the period under review,
the production manager supplies details of routing, specifications operation lists, etc., the
personnel manager furnishes particulars of wage rates, and work study engineers set standard
times for specified operations. The cost accountant collates the information and sets up his
Standard Costs Cards. Basically, this is a relatively straightforward task. In practice, however,
numerous calculations are involved and sometimes difficulties arise where the departments
primarily responsible for supplying information are not competent to provide it without expert
guidance from the cost accountant.
15.6 Standard and Budgets
Both standards and budgets are concerned with setting performance and costs levels for control
purposes. They are therefore similar in principle although they differ in scope, standards are unit
concepts, and that is, they apply to particular products, to individual operations or processes.
Budgets are concerned with totals; they lay down cost limits for functions and departments and
for the firm as a whole. Further differences are that budgets would be revised on a periodic basis,
frequently as an annual exercise, whereas standards are revised only when they are inappropriate
for current operating conditions. Such revisions may take place more or less frequently than
budget revisions.
233
The accounting treatment of standards and budgets also differs. Budgets are memorandum
figures and do not form part of the double entry accounting system whereas standards and the
resulting variances form part of the accounting system’s double entry.
15.7 Motivation and Standards
One of the expected effects of standards is that people will be motivated to achieve the targets
represented by the standards.
Generally, people are likely to be motivated by standards if they accept them and do not feel
threatened by the system.
The following factors affect the way standards motivate or demotivate the people responsible for
achieving the standards:
i. Participation:Participation means that the people responsible for achieving the

standards are consulted and are part of the standard setting process. This suggests
that people would prefer participation in order that their performance could
improve.
However, for participation to have beneficial effect, it has to be used selectively with
due regard to the personalities of the people concerned.
ii. Attainment Levels:The attainment level is the level of difficulty at which the
standard is set. If very difficult targets are set, these are not likely to be accepted by
the people concerned. The people involved may give up and produce a performance
worse than if a less demanding target had been set.
On the other hand, if undemanding targets are set they may be achieved but the
individuals are not motivated to achieve their full potential. Therefore, as contained
in paragraph 15.4 [iii] above, the most commonly used standard is the expected
standard based on attainable efficient production. It is this type of standard that can
motivate.
iii. Feedback:Feedback is a situation whereby information on actual performance

against budget or standard and the resulting variance is reported to the individual
concerned. Prompt and accurate feedback of results has a positive motivated effect.
If feedback is delayed or is not understood or is inaccurate, confidence in the
234
system will be undermined and motivation reduced. Therefore, the costing system
of any reliable organisation should be able to produce speedy and relevant feedback
for effectiveness.
15.8 Variance Analysis: Avariance is the difference between standard cost and actual cost.
This term is rarely used unqualified. Thus we can have “direct material cost variances”; “direct
labour efficiency variance”, etc. The process by which the total difference between standard and
actual costs is subdivided is known as variance analysis. It can also be said to be the analysis of
performance by means of variances.
Variances arise from differences between standard and actual quantities and/or differences
between standard and actual prices. For effectiveness, the reasons for the differences have to be
established through investigation.
Variance may be ADVERSE or FAVOURABLE. Variances are ADVERSE where actual cost is
greater than standard. Variances are FAVOURABLE where actual cost is less than standard.
Alternatively these variances may be known as MINUS [ADVERSE] or PLUS
[FAVOURABLE] Variance respectively.
The main purpose of variance analysis is to provide practical pointers to the causes of off-
Standard performance to enable management improve operations, increase efficiency, utilize
resources more effectively and reduce costs.
It is pertinent to advise that variances should be detailed enough so that responsibility can be
assigned to a particular individual for a specific variance. Cost control is made much more
difficult if responsibility for a variance is spread over several managers.
In such a situation, no manager will like to accept responsibility for ADVERSE Variance.
15.9 Relationship of Common Variances

It is good for you to know that the overall objective of variance analysis is to subdivide the total
difference between budgeted profit and actual profit for the period into the detailed differences
relating to material, labour, overheads and sales which go to make up to total difference. The
particular variances, which are computed in any given organisation, are those, which are relevant
to its operations and which will aid control.
235
Figure 15.1 below shows typical variances, which are generally found useful. It is pertinent to
note that the list is not exhaustive and that relevance and appropriateness to management are the
only criteria that determine the type of variance to be considered for any organisation.
The chart of common variances as contained in Fig. 15.1 is arithmetically consistent, that is, the
total of the linked variances equals the senior variance shown.
Volume
Varianc
Quantit
Margin
Sales
e
y
Varianc
Margin
Total
Varianc
Varianc
Margin
Mix
Sales
Price
e
Efficiency
Variance
Variance
Volume
Overhead
Variance
Fixed
Variance
Capacity
RT OF COMMON VARIANCE FIGURE 15.1

Expendi
Varianc
eeeeeee
ture
(SOURCE: COSTING BY T LUCY

Efficienc
yVarianc
eeee
Overhead
Variance
Variance
Expendi
Varianc
ture
e
Variance
236
Total
nce
For example Price Variance + Usage Variance = Direct Material Total Variance. The price and
quantity aspects of each variance as shown on the chart can be summarized thus:
Table 15.1: Price and Quantity Aspects of Each Variance
COST ELEMENT PRICE VARIANCES QUANTITY VARIANCES
Direct Material Price Usage

Direct Labour Rate Efficiency
Fixed Overhead Expenditure Volume
Variable Overhead Expenditure Efficiency
In order to avoid complications and for proper understanding, we shall limit our discussion of
variances to those summarized above.
The operating profit variance

nce as contained in Table
Table15.1 is the difference between budgeted and
actual operating profit for a period. This variance can be calculated directly and it is the sum of
all variances that is cost variances and sales variances.
The operating profit variance is not entered in a ledger account because budgeted profit does not
appear therein. All other variances do appear in ledger accounts.
237
15.10 Material Variances
(i) Direct material total variance: This is the difference between the standard
direct material cost of the actual production volume and the act
actual
ual cost of direct
material. It is the sum of the Usage and Price Variances.
(ii) Direct Material Price Variance: This is the difference between the standard
sta
price and actual purchase price for the actual quantity of material.
(iii) Direct Material Usage Variance: This is the difference between the standard
quantity specified for the actual production and the actual quantity used, at
standard purchase price.
The above three variances can now be presented on formulae basis with a view to highlighting
the relationship.
Table 15.2: Price and Usage Variances
Actual Purchase Qty x Standard

Price Price
Variance
Minus Total
Direct
Actual Purchase Qty x Actual Price Material
(i.e. Total Purchase Cost) Variance
Standard Qty for Actual x StandardPrice Usage

Production Variance
Minus
ActualQty used for Actual x Standard Price
Production
Total Direct Material Variance = Standard Direct Material Cost

Minus
Actual Direct Material Cost
238
The standard cost card per unit for a spare part number x 2000 in a motor assembly plant is
given as follows:
Raw materials 50kgs @ N2.50/kg = N125.00
Direct Labour 14 hrs @ N4.75/hour = N 66.50
Standard unit cost = N191.50
During the month of May 1999, the actual result was as follows:
Production 150 units
Direct material
al purchases 7000kgs @ a cost of N18,200
18,200
Direct material opening stock 1300kgs
Direct Material closing stocks 850kgs
Wages paid for 2020 hours N9,898
You are required to calculate the material and labour variances
(a) Material variances are made up of

i. Material Price Variance
ii. Material Usage Variance
iii. The addition of (i) and (ii) gives Total Material Variance.
From the formulae above Price Variance

= ActualQty x Std Price Minus Actual Purchase Cost
= (7000kg x N2.50)–N18.200
= N
N17,500 –N18,200 = N700 Adverse
Usage Variance = StdQty X Std Price Minus Actual Qty x Std Price
= (150 x 50 x N2.50) – (7450kg x N2,50)
239
= N18,750 – N18,625 = 125 Favourable
Total material variance is made up of

= price variance + usage variance
= N700 (Adverse) + N125 favourable
= N575 Adverse
(b) Labour variance are made up of

i. Labour rate variance
ii. Labour efficiency variance
iii. The net of (i) and (ii) gives Total direct labour variance
From ITQ 1 the labour variance can be calculated thus:

Labour Rate Variance
This is calculated as
Actual Hours x Std Rate Minus Actual Wages Paid
= (2020hrs x 4.75)– N9898
= N9595 –N9898 = N303 Adverse
Labour Efficiency Variance

= StdLabourHrs x Standard Rate Minus
Actual Labour Hour x Std Rate
= ( 150 x 14 x N4.75) – (2020Hrs x N4.75)
= N 9975 – N9595 = N380 Favourable
Total direct Labour Variance

= Rate Variance + Efficiency Variance
= N303 Adverse +N380 Favourable
= 77 favourable
15.11 Material Mix and Yield Variances
240
In the chart of common variances in fig. 15.1 on page 215 on this Study Session,
Session material mix
and Yield Variances are sub-sets
sets of material usage variance. Typical circumstances in which
calculations
ns of Mix and yield variances are considered appropriate are where the production
process involves mixing different materia
material inputs to make the required output. Examples include
the manufacture of fertilizers, steel, plastics, food production etc.
A featuree of such processes is the existence of process losses through impurities, evaporation,
breakages, machine failure and such factors which affect the yield from the process.
Definition:
Direct Material Mix Variance is the difference between total quantity in standard proportion,
priced at the standard price and the actual quantity of material used at actual mix price at the
standard price.
Direct Material Yield Variance is the difference between the standard yield of
o the actual
material input and the actual yield, both valued at the standard material cost of the product.
Formulae:
Direct material Mix Variance:
= Standard Cost of the Standard Cost of the

Actual quantity of the minus Actual Quantity of the
Actual mixture Standard Mixture
Direct material Yield Variance:
= Standard Cost of the Standard Cost of the

Actual Quantity of the minus the Standard Quantity of the
Standard Mixture Standard Mixture
A soil activator is made by mixing and processing three ingredie

ingredients,
nts, P, N, and Q. The
Standard Cost data are as follows:
Table 15.3: Soil Activator:: Standard Cost Data
241
INGREDIENTS STANDARD PROPORTION STANDARD COST

P 50% N20 per Tonne
N 40% N25 per Tonne
Q 10% N42 per Tonne
A standard process loss of 5% is anticipated, in January 1999, the output was 93.1 tonnes and
the inputs were as follows:
Table 15.4: Soil Activator: Actual Cost Data
ACTUAL PRICE ACTUAL COST

INGREDIANTS ACTUAL USAGE
N N
P 49 Tonnes N16 per Tonne 784
N 43 Tonnes N27 per Tonne 1161
Q 8 Tonnes N48 per Tonne 384
2329
Calculate the material variances using the individual price method.
The total variance is calculated thus:
Standard cost for! tonne
Ingredient P 0.5 tonne @20 = 10
N 0.4 tonne @25 = 10
Q 0.1 tonne @42 = 4.2
N24.2
I tonne of input at standard produce 0.95 tonnes of output so the standard cost per tonne of
output is:
24.2 x 100 = 25.473684

95
242
Therefore Standard cost of actual output = 93.1 x N25.473684
= N2371.6
= N2329
N42.6 (Fav.)
The three relevant variances are: Price, Mix and Yield which are to be calculated inthat order.
The usage variance is merely the total of the mix and yield variance.
The summary of the variance is given below followed by explanatory notes for (a) to (d).
Individual Method
Working Notes
1. AQAM: as given
P 49
N 43
O 8
100
2. AQSM: Note that this will give the same total of 100 tonnes actually consumed that
the mix will not be the same.
• The std says we should mix in the following proportion

P = .5
N = .4
O = .1
AQ of 100 at SM will be:
P = .5 of 100 = 50
N = .4 of 100 = 40
O = .1 of 100 = 10
100
3. SQAM: Due to process loss, the quantity needed to achieve 93.1 tonnes will be more
than the output of 93.1. Therefore, there is need to gross 93.1 up by the % of good
units which is 95%. The stdqty to achieve 93.9 =
93.1
243
95% = 98 tonnes
If this is mixed according to the std, it will give SQSM of:
P = .5 x 98 = 49
N = .4 x 98 =39.2
O = .1 x 98 = 9.8
98
Solution
1. Material Total Variance

Std DMC – Act DMC
Std DMC
P 49 x 20 = 980
N 39.2 x 25 = 980
O 9.8 x 42 = 411.6
2371.6
Actual DMC as given in the question = N2,329

Material total variance
= 2371.6 – 2329 = 42.6 (F)
2. Material Price Variance
AQ (SP – AP)
P 49 (20 – 16) = 196 (F)
N 43 (25 – 27) = 86 (A)
O 8 (42 – 48) = 48 (A)
62 (F)
3. Material Usage Variance

SP (SQ – AQ)
P 20 (49 – 49) =0
N 25 (39.2 – 43) = 95 (A)
244
O 42 (9.8 – 8) = 75 .6 (F)
19.4 (A)
4. Material Mix Variance (W2 – W1) SP
SP (AQSM – AQAM)
P 20 (50 – 49) = 20 (F)
N 25 (40 – 43) = 75 (A)
O 42 (10 – 8) = 84 (F)
29 (F)
5. Material Yield Variance (W3 – W2) SP
SP (SQSM – AQAM )
P 20 (49 – 50) = 20 (A)
N 25 (39.2 – 40) = 20 (A)
O 42 (9.8 – 10) = 8.4 (A)
48.4 (A)
Note:
a. Actual usage, actual mix, actual price is the cost given in the question, i.e.
N2,329.
b. The actual usage in the proportions is evaluated at the standard price, i.e. (N49 x
20) + (43 x 25) + (8 x 42) = N2,391.
c. The standard mix is found by putting the actual total quantity (100 tonnes) into
the standard proportion (50%, 40% and 10%), i.e. 50P, 40N, 10Q. these are
evaluated at the standard prices and compared with the values from b.
Table 15.5: Standard Usag

Usage Vs Actual Usage
Ingredient Actual Usage Total Usage is Difference Standard Variance

245
Standard
Proportion
Tonnes Tonnes Tonnes N N
P 49 50 +1 20 20Fav
N 43 40 -3 25 75Adv.
Q 8 10 -2 42 84Fav.
100 100 Total Mix Variance 29Fav
The standard usage is found by working back from the actual output (93.1 tonnes) to determine
what the standard total quantity of input should be, assuming a normal process loss of 5%, i.e.
standard output quantity = 95% of standard in put quantity.
Therefore, input quantity = 100 x actual output quantity

95
= 100 x 93.1
95
= 98 tonnes
This value is pro-rated

rated in the standard proportion, calculated at the standard price and compared
with the values from c. thus:
Table 5.6: Standard Usage Vs Standard Price
Standard
Total Usage in Usage for
Standard
Ingredient Standard Output in Difference Variance
Price
proportion Standard
Proportion
Tonnes Tonnes Tonnes N N
P 50 (98 x 50%) 49 -1 20 20Adv.
N 40 (98 x 40%) 39.2 -0.8 25 20Adv.
Q 10 (98 x 10%) 9.8 -0.2 42 8.4Sdv.

100 98 Total Yield Variance 48.4Adv.
The Mix variance plus the yield variance equal the usage variance, thus:
= N29 Fav + 48.4 Adv = N

N19.4 Adv
246
If required, this latter figure can be proved by calculating the individual Usage variance for each
ingredient and totaling them. It will be recalled that the material Usage variance is calculated as
follows:
(Standard quantity for actual production – Actual quantity) x Standard price = Usage variance.
The formula gives:
Ingredient
P (49 – 49) x 20 = Nil

N (39.2 – 43) x 25 = N95 Adv.
Q (9.9 – 8) x 42 = N75.6Fav.
Total Usage variance = N19.4 Adv. as above
The following standards were compiled for the manufacture of product “Swift” for the
material and labour elements of cost:
Material
2 grams of P at
atN1 per gram
4 grams of Q at N2 per gram
Labour
5 hours of skilled labour at N1.50 per hour
10 hours of unskilled labour at N0.80 per hour.
Actual production in week 10 was 40 units and the remaining actual results were as follows:
Material
75 grams of P at
atN1.40 per gram
170 grams of Q at N1.80 per gram
Labour
Skilled: 190 hours at N1.60 per hour
247
Unskilled:
lled: 450 hours at N0.90 per hour
Required:
Calculate the following for Product “Swift”
(a) Material price variance

(b) Material usage variance
(c) Material total cost variance
(d) Labour rate variance
(e) Labour efficiency variance
(f) Labour total cost variance
Solution on Material Variances [a, b, c]
Material cost variance

Expected material cost of 40 units: N
- P 2 x 40 x N1 = 80
- Q 4 x 40 x N2 = 320
400
Actual Cost:
- P = 75 x N1.40
1.40 = 105
- Q = 175 x N1.80
1.80 = 306 411
Material cost variance 11 [A]
i] Price variance
Actual Quantity [SP -AP]
P 75 [1 - 1.40] 30 [A]
Q 170 [2 - 1.80] 34 [F]
Total price variance N4 [F]
ii] Usage variance
SP [Quantity allowed
248
[for actual minus Actual Qty]

[production used]
P = N1 [(2 x 40) - 75] = 5 [F]
Q = N2 [(4 x 40) - 170] = 20 [A]
Total usage variance N15 [A
Check:
Price variance 4 [F]
Usage variance N15 [A]
Cost variance as above 11 [A]
SP = Standard Price; AP = Actual Price
From the example above, you should note the following
(i) A minus variance is always adverse and a plus is favourable.
(ii) It is easier and less error prone to determine the direction of the variance by
common sense, that is, if the price/usage is less than standard the variance is
favourable; if more, then the variance is adverse.
(iii) The price variance is based on the actual quantity purchased and is extracted first.
Thereafter the actual price is never used for variance calculations.
(iv) A price variance could arise even if there was no usage, provided that there were
purchases during the period.
Causes of Price Variance
The following causes are worthy or note:

(i) Paying higher or lower prices than planned.
(ii) Losing or gaining quantity discounts by buying in smaller or larger quantities than
planned.
(iii) Buying lower or higher quality than planned.
(iv) Buying substitute material due to unavailability of planned material.
Causes of Usage Variance

(i) Gains or losses due to use of substitute or higher/lower quality than planned.
(ii) Greater or lower rate of scrap than anticipated
249
15.12 Labour Variances
(i) Direct Labour Total Variance: This is the difference between the standard
direct labour cost and the actual direct labour cost in
incurred
curred for the production
achieved.
(ii) Direct Labour Rate Variance: This is the difference between the standard and
actual direct labour hour rate per hour for the total hours worked.
(iii) Direct Labour Efficiency Variance: This is the difference between the standard
stand
and actual production achieved and the hours actually worked, valued at the
standard labour rate.
The formulae for these variances can now be schematically presented thus:
Table 15.7: Rate and Efficiency Variance
Actual Hours x Actual Rate x Std Rate

Rate
Minus Variance
Actual Labour Hours x Actual Rate

(i.e. Total Labour Costs)
Total
StdLabour
Labour Hours x Std Rate Direct
Labour
Minus Efficiency Variance
Variance
Actual Labour Hours x Std Rate
Please refer to the ITQ 3 above but now with reference to questions d, e and f on Labour
Variance.
250
Labour Cost Variance:
Expected labour cost of 40 units: N

Skilled = 5 x 40 x N1.50 = 300
Unskilled = 10 x 40 x N0.80 = 320
620
Actual labour cost:
Skilled = 190 xN1.60 = 304
Unskilled = 450 xN0.90 = 405 709
89 (A)
i) Rate Variance
Actual hours (SR - AR)
Skilled = 190 (N1.50 -N1.60) = 19 (A)
Unskilled = 450 (N0.80 -N0.90) = 45 (A)
64 (A)
ii) Efficiency (Productivity) Variance
(Hours allowed Actual)
SR (for actual - hours)
(production used)
40 x 5
skilled = N1.50 (200 - 190) = 15 (F)
10 x 40
unskilled = N0.80 (400 - 450) = 40 (A)
25 (A)
Proof:
Rate Variance = 64 (A)
Efficiency Variance = 25 (A)
Total = Labour Cost Variance = 89 (A)
Note: SR = Standard Rate
AR = Actual Rate
Causes of Labour Rate Variance
i. Higher rates being paid than planned due to wage award
251
ii. Higher or lower grade of workers being used than planned

iii. Payment of unplanned overtime or bonus
Causes of Labour Efficiency Variance
i. Use of incorrect grade of labour

ii. Poor workshop organisation or supervision
iii. Incorrect materials and/or machine problems
iv. Unexpectedly favourable conditions
An important general principle you should note at this stage is that actual prices or rates are
never used in variance analysis, except to calculate the price or rate variance, which is always
done first.
15.13 Overhead Variance Analysis
In Study Session 7, you learnt that overheads are absorbed into costs by means of predetermined
Overhead Absorption Rates (OAR) which are calculated by dividing the budgeted overheads for
the period by the activity level anticipated. The activity level can be expressed in various ways,
such as units, weights, sales, etc. However, the most useful concept is that of the standard hour.
The standard hour is a unit measure of production and is the most commonly used measure of
activity level.
Total overhead absorbed = OAR x SHP
Where SHP is the number of the Standard Hour of Production.
Where a company adopts the standard costing system using total absorption costing principles
(i.e where both fixed and variable overheads are absorbed into production costs) the total
overheads absorbed can be sub-divided into Fixed Overhead Absorption Rates (FOAR) and
Variance Overhead Absorption Rates (VOAR) as follows:
Fixed Overheads Absorbed = FOAR x SHP
Variable Overheads Absorbed = VOAR x SHP
Total Overheads Absorbed = (FOAR + VOAR) x SHP
252
If a company adopts the standard Marginal Costing System, only variable overheads are
absorbed into production costs and as a result only variances relating to variable overheads arise.
In this case, fixed overheads will be dealt with by the budgetary control system.
The following were the Budgeted and Actual figures for the month of Mar
March
ch for the serving
Dept of EKA Ltd.
Table 15.8: EKA Ltd: Budgeted and Actual Figure
BUDGET ACTUAL
Fixed Overheads N11,480 N12,100
Variable Overheads N13,120 N13,930
Labour Hours 3,280 Hrs 3,150 Hrs
Standard Hrs of Production 3,280 Hrs 3,230 Hrs
i) Fixed Overhead Absorption Rate (FOAR)

ii) Variable Overhead Absorption Rate (VOAR)
iii) Total Overhead Absorption Rate
i) F.O.A.R = Budgeted Fixed Overheads = N11,480

11,480
Budgeted Activity Level 3,280 StdHrs
= N3.5/Hr
3.5/Hr
ii) V.O.A.R =Budgeted

Budgeted Variable Overheads = N13,120
13,120
Budgeted Activity Level 3,280 StdHrs
253
= N4/Hr
iii) Total Overhead Absorption Rate = FOAR + VOAR
= N3.5 + N4
= N7.5 / Hour
15.14 Variable Overhead Variances:
These comprises - Variable Overhead Variance

- Variable overhead Expenditure Variance
- Variance overhead Efficiency Variance
(i) Variable Overhead Variance:
This is the difference between the actual variable overheads incurred and the
variable overheads absorbed. It is the over or under – absorption of overheads.
(ii) Variable Overhead Expenditure Variance:

This is the difference between the actual variable overheads incurred and the
allowed variable overheads based on the actual hours worked.
(iii) Variable Overhead Efficiency Variance:

This is the difference between the allowed variable overheads and the
absorbed variable overheads.
All the above can be presented in formulae form as follows:

Table 15.9: Overhead Expenditure and Efficiency Variances
Actual Variable Overheads Variable

Overhead
Expenditure
Minus Variance
Total
Actual Labour Hours x V.O.A.R Variable
Overhead
Variance
Actual Labour Hours x V.O.A.R
Variable
Minus Overhead
254
Efficiency
SHP x V.O.A.R Variance
Based on the data in ITQ 5 you are required to calculate:
i) Variable Overhead Expenditure Variance

ii) Variable Overhead Efficiency Variance, and
iii) Total Variable Overhead Variance
i) Variable Overhead Expenditure Variance

= Actual Variable Overhead VOH Expenditure Variance
Var
Minus AH (SR – AR)
Actual Labour Hours x V.O.A.R OR 3150 4 -
13930
3150
= N13,930
13,930 - (3150 x N4) = 1330 (A)
= N13,930
13,930 - N12, 600 = N1330 Adverse.
ii) Variable Overhead Efficiency Variance
= Actual Labour hours x V.O.A.R SR (SH – AH)
Minus OR = 4 [3230 – 3150]
S.H.P x V.O.A.R = 320 (F)
N12,600 - (3230 x N4)
N12,600 - N12,920
12,920 = N320 Fav.
iii) Total Variable Overhead Variance

= Variable Overhead Expenditure Variance
Plus
Variance Overhead Efficiency Variance
= N1,330
1,330 (Adv) + N320 (Favorable)
= N1,010
1,010 (Adverse)
255
This can be confirmed by calculating the difference between what variable overheads
actually cost and what the actual production absorbed in variable overheads.
= N13, 930 - N12, 920 = N1, 010 (Adverse)
15.15 Fixed Overhead Variance
The fixed overhead variance can be sub-divided into the following:
(i) Fixed Overhead (Total) Variance
This is the difference between the standard cost of fixed overhead absorbed in the
production achieved, whether complete or not, and the fixed overhead attributed
and charged to that period. This represents under, or, over-absorption. It is the net
of all other fixed overhead variances.
(ii) Fixed Overhead Expenditure Variance (FOEV)
This is the difference between the budget cost allowance for production for a
specified control period and the actual fixed expenditure attributed and charged to
that period.
This variance can also be defined as the difference between actual fixed
overheads and allowed or budgeted fixed overheads.
FOEV = Actual Expenditure on Fixed Overhead
Minus
Budgeted Fixed Overheads
(iii) Fixed Overhead Volume Variance (FOVV)
This is the difference between the standard cost absorbed in the production
achieved, whether completed or not, and the budget cost allowance for a specified
control period.
The volume variance arises from the actual volume of production differing from
the planned volume. The volume variance can be sub-divided because the total
difference in the volume of production can be due to either.
(a) Labour efficiency being greater or less than planned (the efficiency
variance), or,
256
(b) Hours of work being greater or less than planned (the capacity
variance) or some combination of both.
Thus, fixed overhead volume variance is the net of capacity variance and
efficiency variance.
(iv) Fixed Overhead Efficiency Variance (FOEV)
This is the difference between the standard cost absorbed and the actual direct
labour hours worked (valued at the standard hourly absorption rate)
That is, Efficiency Variance
= Actual Labour Hours x F.O.A.R.

Minus
SHP x F. O.A .R.
OR
SR (SH – AH)
(v) Fixed Overhead Capacity Variance (FOCV)
This is the difference between the budget cost allowance and the actual direct
labour hours worked (valued at the standard hourly absorption rate).
FOCV = Budget Expenditure

Minus
Actual hours x F. O.A .R
OR
SR (AH – BH)
It is that portion of the fixed production overhead volume, which is due to

working at higher or lower capacity than standard. Capacity is often expressed in
terms of average direct labour hours per day.
The relationship between these fixed overhead variances can be presented schematically as
below:
257
Table 15.10: Fixed Overhead Variances
Actual Expenditure
On fixed Overheads
Fixed Overhead
Minus Expenditure
Variance
Budgeted fixed Overheads
Capacity Fixed
Minus variance Fixed Overhead
Overhead Variance
Actual LabourHrs x F.O.A.R Volume
Variance
Minus Efficiency
Variance
SHP x F.O.A.R
Using the same data as per ITQ 5 compute the relevant fixed overheads variances.
i. Expenditure Variance
= Budgeted Expenditure Minus Actual Expenditure
= N11,480–N
N12,100 = N620 (Adv)
ii. Capacity Variance
= Actual Hrs x F.O.A.R
F.O.A.R– Budgeted Expenditure
= (3150 x N3.5) - N11,480
= N11,025 ––N11,480 = N455 (Adv)
iii. Efficiency Variance
258
= S.H.P. x F.O.A.R –Actual Hours x F.O.A.R

= (3,230 x N3.50) – (3,150 x N3.50)
= N11,305–N11,025 = N280 (Fav)
iv. Volume Variance = Net of Capacity Variance and
Efficiency variance
= N455 (Adv) + N280 (Fav) = N175 (Adv)
Formula Approach:
SR (SH – BH)
3.5 (3230 – 3280) = 175 (A)
v. Fixed Overhead (Total) Variance
= Net of Expenditure, Capacity and Efficiency Variance
= N620 (Adv) + 455 (Adv) + N280 (Fav)
= N795 (Adv)
Formula Approach:
SFOHC – AFOHC
(3230 X 3.5) – 12100
11305 – 12100 = 795 (A)
15.16 Total Overhead Variance
Where a company does not sub-divide its overheads into fixed and variable elements, the
following variances are to be calculated:
- Overhead Total Variance
- Overhead Expenditure Variance
- Overhead Efficiency Variance and
- Overhead Volume Variance
i. Overhead Total Variance
259
This is the difference between the standard overhead cost specified for the
production achieved and the actual cost incurred. It is the net of Expenditure,
Volume and Efficiency variances.
ii. Overhead Expenditure Variance
This is the difference between budgeted and actual overhead expenditure
iii Overhead Efficiency Variance
This is difference between the standard overhead rate for the production achieved
and the standard overhead rate for the actual hours taken.
Overhead Efficiency Varia

Variance
= (Standard Hrs Produced x O.A.R)

O.A.R)– (Actual Hours x O.A.R)
iv. Overhead Volume Variance
This is the difference between the standard overhead cost of the actual hours
taken and the flexed budget allowance for the actual hours taken.
i.e Over
Overhead Volume Variance
= Budgeted Total Overheads

Minus
Actual Hours x O.A.R
Using the same data as contained in the ITQ 5, you are to compute the relevant Overhead
Variances
i. Overhead Expenditure Variance

= Budgeted Overheads
260
Minus
Actual Total Overheads
= N24,080
24,080 –N26,030 = N1,950 (Adv)
ii. Overhead Efficiency Variance
= Standard Hours Produced x O.A.R

Minus
Actual Hours x O.A.R
= (3150 x N7.5)– (3230 x N7.5)
= N24,225
24,225– N23,625 = N600 (Fav)
iii Overhead Volume Variance
= Budgeted Overheads
Minus
Actual Hours x O.A.R.
= N24,080
24,080 – (3150 x N7.50)
= N24,080
24,080 – N23,625 = N455 (Adv)
iv. Overhead Total Variance
= Net of Expenditure variance, Efficiency variance and Volume

variance
= N1,950
1,950 (Adv) + N600 (Fav) + N455 (Adv)
= N1,805
1,805 (Adverse)
It is apparent that this method is nothing but a summary of variable and fixed
overhead variances calculated in Examples 15.4 and 15.5 above. This can be
summarized thus:
Table 15.11: Overhead Variances
EXPENDITURE EFFICIENCY CAPACITY TOTAL

N N N N
261
Variable Overheads
Variances (Example 1,330 (Adv) 320 (Fav) - 1,010 (Adv)
15.4)
Fixed overhead
Variances (Example 620 (Adv) 280 (Fav) 455 (Adv) 795 (Adv)
15.5)
Total overhead
variance as per 1,950 (Adv) 600 (Fav) 455 (Adv) 1805 (Adv)
(Example 15.6)
The following should be noted:
i. What was titled “Capacity Variance” is directly equivalent to “volume
Variance” when the Total Overhead approach is used.
ii. The Budgeted overheads of N24,080 are found from the usual process of flexing a
budget, that is, fixed overheads plus the actual hours at the Variable Overhead
Absorption Rate.
Therefore: N11,840 + (3150 x N4) = N24,080
15.17Causes of Overhead Variances
i. Overhead Absorption Rates used in these types of variances are calculated from
estimates of expenditure and activity levels. Estimates and actual are hardly the
same.
ii. When labour efficiency is greater than planned, overhead variance can also arise.
15.18Making Variance Analysis More Useful
It is not sufficient merely to be able to describe and calculate variances. To assist management, it
is necessary to probe and investigate the variances and the data used to calculate them. For
variance analysis to be useful, the followings are discernible:
i. Management should check if there is any relationship between the variances. For
instance, if favourable price variance is more than offset by adverse usage and
labour variances due to poor quantity material, then there is cause for a re-think.
262
ii. The Accountant should check whether further information than mere variances
can be provided for man
management. This is with a view to addressing
ressing the variances
and bring operations in line with plan.
iii. Check whether the variance is significant and worth reporting.
Management need not waste resources on trivial issues.
iv. The variances should be reported quick

quickly
ly enough, to the right people, in sufficient
or in much detail, with explanatory notes.
15.19 Summary
Variance analysis is the process of analyzing the total difference between planned and actual
performance into its constituents parts. The basic materials variances measure the difference
between actual and standard price and standard usage. The basic labour variances measure the
differences between actual and standard wage rates and actual and standard labour efficiency.
An important factor in overhead absorption and overhead variance analysis is the activity
ac level.
This is measured frequently in standard hours. A standard hour is a unit measure of production,
not time.
Using total absorption principles, both fixed and variable overheads are absorbed into
production, so,variances
variances relating to both fixed aand variable overheads will rise.
15.20Self-Assessment
Assessment Questions.
1. Explain the term standard stating its objectives, advantages and disadvantages
2. How do Organizations set standard Cost, Distinguish between standards and

budgets?
3. What is variance analysis? Ex

Explain
plain the effect of motivation and standards on
variance analysis.
4. What are the ways on making variance analysis more useful? Draw the chart of
variances.
263
5. The W.W. Co. uses standard costs and flexible budgets to control its
manufacturing costs. Actual costs are charged to a work-in-progress account and
finished stocks are valued at standard cost.
Operating data for the month of June, in which 8,000 finished units were produced, is as follows:
(a) Direct Material Usage: 8,500 kilos at N1.70 per kilo, which is 20k below standard
price. The standard material allowance per finished unit is 1 kilo. There was no
opening stock of raw materials.
(b) Direct Labour: the standard rate is N2 per hour. Standard time allowed per unit is
2 hours. Actual labour cost for the month was N34,850. Actual hourly rates
averaged N2.05.
(c) Variable Production Overhead: budget allowance is N1.20 per standard direct
labour hour, actual cost for the month were N20,100
(d) Fixed Production Overhead: actual fixed overhead for the month was N14,400.
The standard absorption rate is N0.75 per standard direct labour, based on a
monthly production budget of 10,000 units.
Stocks: 9,000 units were sold at a price of N11 each, in accordance with the budget.
Opening stock of finished goods was 4,000
You are required to prepare:
i) Ledger accounts for direct materials, wage control, variable production overhead,
fixed production overhead, work-in progress and finished stock; and
ii) An operating statement for the month of June to reconcile actual operating profit
with budget and to show an analysis of variances.
6. Compound XYZ is manufacturing in batches of 100 cylinders, the standard input

materials per batch being 250 litres on ABC at N1.20 per litreDuring November, 30
batches of XYZ were produced from an input of 7,450 litres of ABC which cost N9,076
Calculate the materials price and usage variances and show the relevant entries in the
work-in-progress account, assuming the materials are debited thereto at actual cost price.
264
(b) Discuss the limitations of materials price and usage variances as instruments of
management control, making reference to the variance you have calculated in (a)
7. KC Chemicals Ltd. produce an industrial purifying agent known as Kleenchem, the

budgeted weekly output/sales of which is 10,000 litres, the standard cost per 100 litres
being:
Material 250 kg costing 50k per kg
Labour 4 hours at N1.25 per hour
Overhead N5 (budgeted absorption of fixed cost)
The standard selling price is N1.50 per one-litre container.
During week ended 26 November, the output of Kleenchem was 9,860 litres all of which
was sold, the invoiced value being N14,750. The material input was 24,720 kg, which
cost N12,300. Production employees booked 380 hours to the process and were paid
N490. Overhead amounted to N525.
You are required to us the foregoing information to produce the operating statement for
the week ended 26 November in standard costing format.
8. The following data are available from the Joinery Department of MRIRISCOPR
LIMITED a furniture manufacturer which has established standard cost of producing a
cabinet styled “Madam Special”.
N
Labour 3 hours at N1.50 per hour 4.50
Material 15 metre board at N8 per metre 120.00
Indirect Costs
Variable charges:
3 hours at N1 per hour 3.00
Fixed charges:
3 hours at 50k per hour 1.50
N129.00
265
The actual costs of producing 400 of these cabinets during October 1984 are stated below:
Materials purchased 7,500 metres at N9 per metre 67,500

Materials used 7,200 metres:
Direct labour 1,100 at N1.70 per 1,870
Indirect Costs:
Variable charges 950
Fixed charges 600
Fixed charges rate has been set by using 1,400 direct labour hours of operation as the monthly
activity level.
There are no opening stocks of raw materials.

You are required to compute the following variances:
(a) Material purchase price variance
(b) Material usage variance
(c) i. Directlabour rate variance
ii. Direct labour efficiency variance
(d) i. Variable overhead total variance
ii.Variable overhead expenditure variance
iii. Variable overhead efficiency variance
(e) i. Fixed overhead expenditure variance
ii. Fixed overhead volume variance
9. From the records of PIONEER & Co. who produce an item in batches of 90 units using a
standard costing system, the information below had been extracted.
i) Prepare a statement which will contain a detailed explanation of the variations of

the actual costs from the standard costs showing ALL possible variances on
materials and Labour.
ii) Give two possible causes for each variation. Cost of production per batch:
Materials: A 40 Kgs at 50k each
B 50 Kgs at 14k each
C 10 kgs at N1.80 each
Direct labour: 20 hours at N3.00 per hour
266
The Budget output for the year is 264,000 units. During the month of April, 180 batches were
worked on from which 17,820 units resulted. The costing Department has provided the costs for
the month as follows:
Material purchased and used A: 6,300 kgs at 52k

B: 9,360 kgs at 13k
`C: 2,340 kgs at N1.50
Each batch took averagely 25 hours and total wages bill for the month was
N11,250.
(b) Accountants are not quite agreed on the way disposal of variances at the end of the period
should be treated. Describe the two methods most favoured.
10. The standard mix of a product is as follows:
Material % of input Standard price per kg.

A 10 50k
B 40 25k
C 20 15k
D 30 40k
From each mix of 200kgs of input, a standard output of 180kgs is obtained.
During the month of May, 20 mixes were processed from which the actual output was 3,500kg.
Actual consumption during May was a follows:
Material Consumption kgs Price per kg

A 420 45k
B 1,540 20k
C 880 17k
D 1,160 15k
4,000
There was no opening or closing work-in-progress stock.
267
(a) Calculate the following variances:
i. Direct materials cost
ii. Direct materials price
iii. Direct materials mixture
iv. Direct material yield
(b) Show the materials work-in-progress account in the cost ledger for the month of
May with issues at standard prices.
11. A product manufactured is an alloy consisting of 70% Material X and 30% Material Y. in
melting the pouring it is expected that a 4% loss of metal will occur. Standard prices are
N200 per tonne of Material X and 100 per tonne of Material Y. For the control period,
actual figures are as follows:
Actual output: 192 tonnes

Material issued and used by the process:
Material X: 200 tonnes
Material Y: 50 tonnes
Actual material prices:
Material X: N120 per tonne
Material Y: N85 per tone
Required:
Calculate the material cost variances that can be calculated from the data.
12. Consumer Durables Ltd. is a company engaged in the manufacture of a variety of

domestic electrical appliances, some of the components of which are manufactured and
some bought in.
Batch production is used, all products being available most of the time and productive
capacity is fully utilized. The company experiences fierce competition and there is
customer resistance to price increases; at the same time costs are increasing. The newly
268
appointed managing director believes that if more stringent control measures were to be
applied the company’s profitability could be improved.
As management accountant, write a report setting out and commenting upon the steps
involved in the installation of the standard costing system, and summarize the benefits
you would expect to be obtained from the use of such a system.
13. A company had a budget of 200,000 direct labour hours for a period. This was used as
the basis for establishing standard factory overhead absorption rate. Fixed factory
overhead was budgeted to be N400,000, and variable factory overhead N200,000.
Output was budgeted at 400,000 units. In the period 420,000 units were completed in
202,000 direct labour hours, at a labour cost of N787,800. No labour rate variance
occurred. The factory overhead incurred during the period was N620,000.
Required:
(a) Calculate the following variances:
i. labour efficiency,
ii. Overhead expenditure,
iii. fixed overhead volume,
iv. Variable overhead efficiency.
(b) Explain the meaning and significance of the fixed overhead volume variance.
How may the fixed overhead volume variance be further analysed?
i. Calculate the efficiency ratio in the situation outlined above.
ii. What are the implications for both unit costs and profit of such efficiency?
To answer part (c) (ii) you must assume, also, that a bonus scheme is in operation, and that this is
related to the level of efficiency.
269
References / Suggestions for Further Reading
Drury, C. (2008) Management and Cost Accounting

Accounting.Holborn
Holborn House, Bedford Row, London.
Centage Learning Press
Lucey, T. (1993) Costing. Vale, Guernsey, CI. The Guernsey Press Co Ltd
Lucey, T. (2005) Management Information S System. High Holborn House, Bedford, London.
DP Publications.
Omolehinwa, E. (2009) Coping with Cost Accounting
Accounting, Lagos Nigeria.Pumark
Pumark Press Limited.
Limited
Should you require more explanation on this study session, please do not hesitate
to contact your e-tutor

tutor via the LMS.
08033366677
270

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ACC 310 Advanced Cost Accounting

Learning Outcomess for Study Session 1

After completing this study session

1. Define Cost Accounting,

2. Describe the interplay of Cost Accounting vis

3. Identify the types and elements of costs.

1.0 The Domain of Cost Accounting

Management Accounting is the newer interest of cost accounting. Its purpose is to

1.1 What is Cost?

1.2 What then is “Cost Accounting?

1.3 Uses of Costing

- Ascertaining and estimating of costs;

1.4 Objectives of Costing

Cost accounting has the following objectives:

- For cost and profit determination

1.5 Benefits of Cost Accounting

- Disclosure of profitable and unprofitable activities.

1.6 Desirable Conditions for the Establishment of a good Costing System

- There must be an official system of stores and stocks

- There must be a well-designed wages procedure including methods of charging

1.7 Types of Cost

(a) Classification of Costs by Nature:

They are normally identified under three headings:

(ii) Indirect Costs:

MATERIAL = DIRECT + INDIRECT MATERIAL

LABOUR = DIRECT + INDIRECT LABOUR

EXPENSES = DIRECT + INDIRECT EXPENSES

TOTAL COST = PRIME COST + OVERHEAD COST

(b) Classification of Costs by Function:

1.8 Costing Methods and Techniques

1.8.1 Categories of Costing Methods

Two broad categories:

(i) Specific Order Costing and

(i) Job Costing

Continuous Operation/process/Unit Costing: This is the basic costing method applicable

(i) Process costing including Joint Product and by-product.

1.8.2 Costing Methods – Categories and Sub-Divisions

SPECIFIC ORDER CONTINUOUS

JOB BATCH PROCESS SERVICE/

1.8.3 Costing Techniques:

- Total absorption costing

1.10 Self Assessment Questions

(a) Define Cost Accounting

f. Indirect materials used in production and non production departments should be

2.4 Factors to Be Considered When Determining the Re-Order Level:

2.5 Stock Levels

Re-order level is calculated as follows:

2.7 Determination of EOQ

Table 2.1: SOLUTION

Qty per order (given) 600 300 200150 120 100

Carrying Cost = QC 144 72 48 36 28.8 24

Total Relevant Cost 150 84 66 60 58.8 60

Our EOQ is at 120 level =N

No of orders to be placed = 600 = 5

Under the algebraic method EOQ is determined by the following formula

O = Cost per Order

From the above example, EOQ could be calculated as follows:

122 can approximate to 120. N0.48 = 20% of N2.40

The Graphical Method:

2.8 Derivation of EOQ Formula

At EOQ, ordering cost is a approximated to carrying cost i.e

2.9 EOQ Model with Quantity Discount