CAF-08 CMA COMPLETE THEORY

CHAPTER 1 – INVENTORY VALUATION

Advantages & Disadvantages of FIFO

Advantages
 Logical (probably represents physical reality)
 Easy to understand and explain to managers
 Gives a value near to replacement cost

Disadvantages
 Can be cumbersome to operate
 Managers may find it difficult to compare costs and make decisions when they are charged with varying
prices for the same materials
 In a period of high inflation, inventory issue prices will lag behind current market value

Advantages & Disadvantages of AVCO

Advantages
 Smoothens out price fluctuations
 Easier to administer than FIFO and LIFO (Last in First Out)

Disadvantages
 Issue price is rarely what has been paid
 Prices tend to lag a little behind current market values when there is gradual inflation

CHAPTER 2 - INVENTORY MANAGEMENT

1) Definitions

(i) Stock out Costs:

These costs result from not having enough inventories in stock to meet customers' needs. These costs include lost
sales, customers’ ill will, and the costs of expediting orders for goods not in stock.

(ii) Lead Time:

The time period between placing an order till the receipt of the goods from suppliers is called lead time.

(iii) Reorder Point:

The point of time when an order is required to be placed or production to be initiated to replenish depleted stocks
is called reorder point. It is determined by multiplying the lead time and average usage.

(iv) Safety Stock:

To minimize stock outs on account of increased demand or delays in delivery etc., a buffer stock is often
maintained. Such a buffer stocks is called Safety stock.

(v) Inventory control:

Inventory control can be defined as the system used in an organization to control its investment in
inventory/stocks. I.e. the overall objective of inventory control is to minimize, in total, the costs associated with
stock. This includes; the recording and monitoring of stock levels, forecasting future demands and deciding
when and how many to order.

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CAF-08 CMA COMPLETE THEORY

2) The method of stock valuation which should be used in times of fluctuating prices:

Weighted Average stock valuation method should be used in times of fluctuating prices because this method is
rational, systematic and not subject to manipulation. It is representative of the prices that prevailed during the
entire period rather than the price at any particular point in time. It is because of this smoothening effect that this
method should be used for stock valuation in times of fluctuating prices.

3) The practical limitations/assumptions of EOQ

(i) The formula assumes that demand/usage is constant throughout the period. In practice, actual
demand/usage may be uncertain and subject to seasonal variations.
(ii) Holding cost per unit are assumed to be constant. Further, many holding costs are fixed throughout the
period and not relevant to the model whereas some costs (e.g. store keepers' salaries) are fixed but
change in steps.
(iii) Purchasing cost per unit is assumed to be constant for all purchase quantities and is ignored while
calculating order size in EOQ. In practice, quantity discounts can be available in case of bulk purchasing.
(iv) The ordering costs are assumed to be constant per order placed. In practice, most of the ordering costs
are fixed or subject to stepwise variation. It is therefore, difficult to estimate the incremental cost per
order.

4) Reasons of maintaining the safety stock:

(i) Protect against unforeseen variation in supply and/or demand.

(ii) Prevent disruption in manufacturing or deliveries.
(iii) Avoid stock-outs to keep customer service and satisfaction levels high.

5) Costs associated with holding of inventory:

(i) Cost of capital tied up

(ii) Insurance costs
(iii) Cost of warehousing
(iv) Obsolescence, deterioration and theft

CHAPTER 3 - ACCOUNTING FOR OVERHEADS

1) Treatment of under-absorbed and over-absorbed factory overheads.

The under or over applied overhead may be:

 treated as period cost by closing it to Cost of Goods Sold Account or directly to Income Statement.
 apportioned between inventories and cost of goods sold.

2) Reasons for under-absorbed / over absorbed factory overheads

 The actual hours worked may be more or less than the estimated hours.
 The estimates may not be accurate.
 Actual overhead costs and actual activity levels are different from budgeted costs and activity levels.
 Changes in the methods of production.
 Abnormal changes in the component prices of factory overheads.
 Extraordinary expenses might have been incurred during the accounting period.
 Major changes might have taken place. For example, replacement of general purpose machine with
automatic high speed machines.

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CAF-08 CMA COMPLETE THEORY

3) Factors affecting the predetermined overhead rate:

 In addition to the selection of bases, the following more factors are also considered:
 1. Activity level selection
 2. Inclusion or exclusion of fixed overheads
 3. Single rate or several rates

4) Definitions

Normal Capacity
The company expects that there is no change in the demand and therefore, the same number of units shall be
produced. This is called Normal Capacity.

Expected Actual Capacity.

If the company expects that the demand will increase or decrease and estimates a level at 90% or 70%, this is
called Expected Actual Capacity.

Direct expenses
Expenses that are fully traceable to the product, service or department that is being costed.
Examples:
 Raw Materials that are specifically used for the product in consideration,
 Labor which is directly involved in converting the raw material
 Other expenses that are specifically incurred for the product.

Indirect expenses (Production overheads)

Indirect expenses are those expenses that incur in the course of making a product, providing of service or running
department but which cannot be traced directly and fully to the product, service or department.
Examples:
 Labor which is not directly involved in the conversion of raw material but indirectly involved in
 making of the product. Such as supervisor who is responsible to supervise the production
 process is not directly involved and therefore treated as indirect cost,
 Tools, spares and materials that are used in the machinery or equipment used in the production,
 Factory rent if the factory premises are hired,
 Depreciation of machinery and equipment.
 Electricity and other utility expenses incurred for the production facilities

CHAPTER 4 – LABOUR COSTING

1) Types of labor cost:

a) Direct Labor Cost: Direct labor cost is any cost that is specifically incurred for or can be readily charged to
or recognized with any specific contract, job or work order. In cost accounting it is classified as direct labor
cost which becomes part of prime cost. For example: In a watch manufacturing factory, a worker operating
a molding machine to produce a part of wrist watch.

b) Indirect Labor Cost: Where the direct labor can be recognized with and charged to the job, the indirect
labor cannot be so charged and hence is treated as part of the factory overheads. For example: Wages paid
to supervisor of a factory or salary paid to driver of delivery van used for distribution of the product.

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CAF-08 CMA COMPLETE THEORY

2) Effective labor cost control

Effective labor cost control is achieved through different tools including;

 analyzing the targeted production,
 preparing labor budget and standardizing labor cost per unit,
 monitoring output, quality, wastage ratios, rework cost due to bad workmanship
 wage incentive systems

3) High Day Rate system

Advantages
 It is easier to calculate and understand.
 It assures the employee a consistently high wage.

Disadvantages
 Employees cannot go beyond the fixed hourly rate for the extra effort they put in. In the example given
above if the employee makes 280 units instead of 240 units in a 40 hours week, the cost per unit would
decrease even further but all the savings would go to the benefit of the employer and none would go to
the employee.
 The high wages might become the accepted wage level for normal working. Management might need to
keep checks on the productivity and efficiency levels of the employees.

4) Group Bonus Scheme

Advantages
 Group schemes reduce the clerical efforts to be put in for the calculations of individual incentive schemes.
 They are easy to be administered.
 Group schemes improve the team cohesion.

Disadvantages
 Employees might demand for minimum targets for accepting the scheme.
 Employees doing the best and the worst might fall victim to team’s politics

5) Profit sharing scheme

Advantages
 The biggest advantage is that the organization will pay only what it can afford to pay out of the actual
profits earned.
 Such schemes can be offered to indirect labor as well.

Disadvantages
 Employees may be putting in best of their efforts yet the organization might still incur losses on account
of issues beyond the control of the employees.
 It is a long term commitment that the organization is asking for. The employees have to wait for the
bonus until the year ends. The reward is not an immediate one

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CAF-08 CMA COMPLETE THEORY

CHAPTER 5 – MARGINAL COSTING AND ABSORPTION COSTING

1) Advantages and disadvantages of absorption costing

Advantages of absorption costing

 Inventory values include an element of fixed production overheads. This is consistent with the requirement in
financial accounting that (for the purpose of financial reporting) inventory should include production overhead
costs.
 Calculating under/over absorption of overheads may be useful in controlling fixed overhead expenditure.
 By calculating the full cost of sale for a product and comparing it will the selling price, it should be possible to
identify which products are profitable and which are being sold at a loss.

Disadvantages of absorption costing

 Absorption costing is a more complex costing system than marginal costing.
 Absorption costing does not provide information that is useful for decision making (like marginal costing
does).
 Assigning of Production overheads always include an element of discretion; and
 It might led to sub-optimal decision-making as a product might be discontinued due to loss which might be
caused by fixed production over head.

2) Advantages and disadvantages of marginal costing

Advantages of marginal costing

 It is easy to account for fixed overheads using marginal costing. Instead of being apportioned they are treated
as period costs and written off in full as an expense the income statement for the period when they occur.
 There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment
necessary in the income statement at the end of an accounting period.
 Marginal costing provides useful information for decision making.
Disadvantages of marginal costing
 Marginal costing does not value inventory in accordance with the requirements of financial reporting.
(However, for the purpose of cost accounting and providing management information, there is no reason
why inventory values should include fixed production overhead, other than consistency with the financial
accounts.)
 Marginal costing can be used to measure the contribution per unit of product, or the total contribution
earned by a product, but this is not sufficient to decide whether the product is profitable enough. Total
contribution has to be big enough to cover fixed costs and make a profit.

CHAPTER 9 – BUDGETING
1) Purpose of Budgeting
 Planning
 Control
 Decision making
 Resource allocation
 Coordination of Communication

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CAF-08 CMA COMPLETE THEORY

2) Types of Budgets

 Sales Budget
 Production budget
 Direct material budget
 Direct labor budget
 Manufacturing overhead budget
 Ending finished good inventory budget
 Cost of goods manufactured budget
 Cost of goods sold budget
 Selling and administrative budget
 Capital expenditure budget
 Cash budget
 Master Budget

3) Flexible and fixed budgets

Flexible budgets
Flexible budgets are, as their names suggest variable and flexible depending on the variability in the results
expected in the future. Such budgets are most useful for businesses that operate in an ever changing business
environment,

Fixed budgets
Fixed budgets are used in situations where the future income and expenditure can be known, with a higher
degree of certainty, and have been quite predictable over time. These types of budgets are commonly used by
organizations that do not expect much variability in the business or economic environment

CHAPTER 10 – STANDARD COSTING

1) Types of standard

Ideal standards.
These assume perfect operating conditions. No allowance is made for wastage, labour inefficiency or machine
breakdowns. The ideal standard cost is the cost that would be achievable if operating conditions and operating
performance were perfect. In practice, the ideal standard is not achieved.

Attainable standards.
These assume efficient but not perfect operating conditions. An allowance is made for waste and inefficiency.
However, the attainable standard is set at a higher level of efficiency than the current performance standard, and
some improvements will therefore be necessary in order to achieve the standard level of performance

Current standards.
These are based on current working conditions and what the entity is capable of achieving at the moment.
Current standards do not provide any incentive to make significant improvements in performance, and might be
considered unsatisfactory when current operating performance is considered inefficient.

Basic standards.
These are standards which remain unchanged over a long period of time. Variances are calculated by comparing
actual results with the basic standard, and if there is a gradual improvement in performance over time, this will be
apparent in an improving trend in reported variances.

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CAF-08 CMA COMPLETE THEORY

CHAPTER 11 – VARIANCE ANALYSIS

1) Comments on the difference between overhead variances under marginal and absorption costing:

All variable and fixed overhead variances under marginal and absorption costing are same, except for the fixed
overhead volume (efficiency and capacity) variances which can be calculated only under absorption costing.

In absorption costing, fixed overheads are allocated to the products and these are included in the inventory
valuations. Therefore, fixed overhead volume variances can be computed under absorption costing only.

In marginal costing, only variable overheads are assigned to the product; fixed overheads are regarded as period
costs and written off as a lump sum to the profit and loss account.
Therefore, fixed overhead volume variances cannot be computed under marginal costing.

CHAPTER 13 – RELEVANT COSTING

1) Definitions

Opportunity cost:
An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of one course
of action requires that an alternative course of action be given up.

Example
A company has an opportunity to obtain a contract for the production of Z which will require processing on
machine X which is already working at full capacity. The contract can only be fulfilled by reducing the present
output of machine X which will result in reduction of profit contribution by Rs. 200,000.
If the company accepts the contract, it will sacrifice a profit contribution of Rs. 200,000 from the lost output of
product Z. This loss of Rs. 200,000 represents an opportunity cost of accepting the contract.

Sunk cost
A sunk cost is a historical or past cost that the company has already incurred. These costs cannot be
changed/recovered in any case and are ignored while making a decision.

Example
A company mistakenly purchased a machine that does not completely suit its requirements. The price of the
machine already paid is a sunk cost and will not be considered while deciding whether to sell the machine or use it.

Relevant cost:
The predicted future costs that would differ depending upon the alternative courses of action, are called relevant
costs.

Example
A company purchased a raw material few years ago for Rs. 100,000. A customer is prepared to purchase it for Rs.
60,000. The material is not otherwise saleable but can be sold after further processing at a cost of Rs. 30,000.
In this case, the additional conversion cost of Rs. 30,000 is relevant cost whereas the raw material cost of Rs.
100,000 is irrelevant.
Incremental cost
An incremental cost is the additional cost that will occur if a particular decision is taken. Provided that this
additional cost is a cash flow.

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CAF-08 CMA COMPLETE THEORY

Example:
To produce 1,000 units, a company incurred variable cost of Rs. 1.2 million. At a normal capacity of 2,000 units,
fixed cost incurred was Rs. 0.6 million.
The incremental cost of making one extra unit would be Rs. 1,200 and it would not affect the fixed cost.

Avoidable and unavoidable costs

An avoidable cost could be saved (avoided), depending whether or not a particular decision is taken. An
unavoidable cost is a cost that will be incurred anyway.

Example:
A company is paying Rs. 0.5 million annually for a warehouse on a short term lease and incurring an annual cost of
Rs. 0.4 million on maintenance and security of the warehouse. One year of the lease is remaining and the
warehouse is no more required.
The rental cost of the warehouse is unavoidable cost; therefore, it should be ignored while taking any decision.
However, by closing down the warehouse the company can avoid annual maintenance and security costs of Rs. 0.4
million.

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