MA by Kayode Fatounbi

Practice and theory
of
Management Accounting
Kayode Farounbi
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CONTENTS
Page
Chapter 1 Introduction to Management Accounting 4
- Definition 5
- Attribute of an Effective Management Accountant 8
- Cost, Financial and Management Accounting in practice 10
Chapter 2 Cost Behaviour and Cost Estimation Techniques 13

- Types of Cost Behaviour 13
- Cost Estimation Techniques 17
Chapter 3 Cost Accounting System and Preparation Income Statement 37

- Costing Methods 37
- Preparation of Income Statement 52
Chapter 4 Cost Volume Profit Analysis 74

- Graphical Approach 83
- Multi-Product Organisation 86
- Expected Loss 90
- Sensitivity Analysis 91
Chapter 5 Relevant Costing Technique For Decision marking 107

- Make or Buy Decision 110
- Dropping or Retaining A Center 115
- Sell or Process Further 120
- Special/Minimum Pricing 122
- Product Optimal Mix 128
- Linear Programming Technique 133
Chapter 6 Learning Curve Theory 176
Chapter 7 Capital Budgeting Decision Under Certainty 185

- Capital Investment Appraisal Criteria 186
- Capital Rationing 188
- Effect of Inflation on Investment Appraisal 206
- Effect of Taxation on Investment Appraisal 209
- Lease or Buy Decision 216
- Replacement Analysis 222
Chapter 8 Capital Budgeting Decision Under Uncertainty 249
Chapter 9 Inventory Control 280
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Chapter 10 Pricing Decisions 293
- Quantitative Aspect of Pricing 296
Chapter 11 Performance Evaluation in a Divisionalised Organisation 306

- Responsibility Accounting 306
Chapter 12 Transfer Pricing System 320

- International Transfer Pricing 323
Chapter 13 Standard Costing Technique and Variance Analysis 338

- Simplified Approach to Variance Analysis 341
- Mix and Yield Variance 361
- Planning and Operational Variance 364
- Working Back From Variance 366
- Efficiency Level Ratios 368
Chapter 14 Budgetary System and Control 374

- Budgetary Process 376
- Budgetary Improvement Techniques 379
- Top Down and Bottom Up Budgeting 383
- Functional Budgets 383
Chapter 15 Other Costing and Management Accounting Concerns 429

- Flexible Manufacturing System 429
- Advanced Manufacturing Techniques 429
- Total Quality Management 430
- Just In Time 432
- Control System Theory 434
- Feedback 435
- Feed Forward 435
- The Law of Requisite Variety 435
- Noise 435
- Contingency Theory 436
- Cost Reduction and Value Analysis 437
- Non-Financial Performance Measures 439
- The Balance Scorecard 439
- Benchmarking 442
Chapter 16 Working Capital Management 445

- Working Capital Ratio 447
- Working Capital Cycle 452
Chapter 17 Revision Objectives and Short-Answer Questions 466

- Suggested Solutions 568
Definition Of Terminologies 575
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CHAPTER ONE
INTRODUCTION TO MANAGEMENT ACCOUNTING
It was 8.15am Monday morning and the road was busy everyone trying to make it to His or Her
offices early enough to start the day/week business with the resulting heavy traffic jam and within
this I was trying to strategize on the various reports demanded by management that were
pending on either my desk or expects from the subordinates and then my phone rang. Where are
you? Asked the secretary to the Managing Director, the Monday meeting for the week is about to
start, my boss is asking for the report He asked you to prepare and your own report for the
meeting.
Various financial report for diverse purposes form mountain of assignments that normally beset
accountants of average companies that needs to support the management for the attainment of
corporate goals and objectives either for short, middle or long run planning, controlling and
decision making and thereby calling for practical applications of the principles and knowledge to
be studied in this course.
Management Accounting otherwise known as Internal Accounting or Managerial Accounting

gained wide spread acceptance and recognition recently due to its sensitivity to the success or
otherwise of any set up either for profit or nonprofit making. Various definitions have been
propounded for the subject about to be studied. However, before looking at these definitions let us
understand the two-letter word ‘MANAGEMENT ACCOUNTING’.
Advanced Learner’s Dictionary defines ‘Management’ as the act of running and controlling a
business or similar organization or people who run or control a business or similar organization.
Any organization or set-ups, either for profit making or otherwise have resources in the form of
man-hours, materials, machineries and money put in place to ensure that such organizations attain
its set goals and objectives. These resources are entrusted into the hands of a set of people to run
and deliver. That is, to administer and ensure that the organization achieves its set goals and
objectives. These set of people are always referred to as ‘Management’. Therefore, in business
terms ‘Management’ could be defined as a set of people charged with the responsibility of
organizational objectives attainment using the available resources.
Saddled with the above challenges, management carries out various responsibilities or functions to
ensure commendable stewardship accounting. Some of these functions of management can be
briefly reviewed as follows:-
(a) Planning: - The establishment of objectives, and the formulation, evaluation and selection
of the policies, strategies, tactics and action required achieving these objectives. In other
words, planning is setting out things to be done in future, or taking a decision before taking
an action. It is an attempt at coping with uncertainties by thinking of what, how and when a
future course of action would be taken. Planning from another perception deals with
focusing or setting guidelines for future activities that ensure attainment of dream or
objective. It is the spreading of strategies in place for the achievement of laid down goals.
(b) Controlling: - this involves the co-ordination and directing of the resources available
towards the attainment of objectives. Resources are prudently managed through various
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policies that focus on the organizational dream. Management needs to institute controls to
ensure the operations are working in line with laid down plans.
(c) Decision Making: - This is broken down into strategic, tactical and operational. While the
top management is saddled with taken strategic decisions, middle management is
responsible for tactical decisions, leaving operational decisions in the hands of lower
management. Strategic decision is policies that will fundamentally influence long-term
corporate objectives of the organization. Common policies along this area will include
merger and acquisition, capital reconstruction, dropping a center, expansion of operations,
acquisition of major assets etc. Tactical decisions will involve breaking down the long term
corporate objectives of an organization into short-term achievable objectives. Therefore,
this will require being able to analyze the prevailing economic climate and also to be able
to establish the level of impact that such a climate will have on the organization vis-à-vis
the attainment of corporate objectives. While operational decisions will involve the day-to-
day running of the organization.
(d) Organizing: - It is the duty of management to achieve effectiveness and efficiency. This
phenomenon can only be achieved when plans and actions are properly organized. Apart
from planning and directing the actions of individuals, such actions need to be properly
organized, so that the objective will be achieved in its logical sequence.
(e) Directing: - It is the duty of management to specify a job schedule and control the daily
activities of the enterprises by directing actions of individuals in the organization. In other
words, directing involves providing necessary guidance, supervision and motivation of
employees.
(f) Communication: - All actions of management (including planning, controlling and decision
making activities) require adequate communication so that the duties of individuals
involved are properly spelt out for the purpose of adequate implementation.
Communication can be quantitative or non quantitative.
Accounting involves keeping, presenting or checking financial and other related records. It is a
formal means of gathering or analyzing financial and non-financial data to aid and coordinate
collective decisions in the light of the overall goals or objectives of an organization. The accounting
system is the major quantitative information system in almost every organization. An effective
accounting system provides information for two broad purposes or ends: (1) internal reporting to
managers in planning, controlling and decision making generally, and (2) external reporting to
stakeholders, government, and other interested outside parties. Therefore, from the above, the
accountant is somebody that is vast in the monetary value attached to goods and services and one
who can advise and assist on financial matters both to internal and external interested parties.
Accounting is technical and requires its own specialty or somebody that is vast in it, to keep,
present and advice on financial matters. At the same time, it is a discipline that features in all the
above-mentioned functions of management.
Although some define ‘Management Accounting’ as concerned with the accumulation,

classification, and interpretation of information that assists individual executives to fulfill
organizational objectives as revealed explicitly or implicitly by top management, others see it as an
integrated system involving cost identification, cost collation, cost summary, cost analysis and cost
reporting for the purpose of decision making. While to others it can be defined as the application of
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a professional knowledge and skill in the field of cost analysis and cost accounting in solving
managerial problem.
Review of various topics and practical experience lead to the support of a concise and precise
definition that defines ‘Management Accounting’ as the application of accounting skill or
profession towards assisting management in their functions or responsibilities or in planning,
controlling and decision making.
The various functions of management are as listed above but these can be summarized into the
three primary responsibilities as that of planning, controlling and decision-making. Various
principles to be learned are designed towards assisting management in one or more of its key
functions.
The study of ‘Management Accounting’ can be especially fruitful because it helps management to
understand and take a stand on accounting related subjects that have direct relationships with
planning, controlling and decision-making. The various functions of management and accounting
principles used to assist in these functions can be briefly reviewed as follows: -
a. Planning: - The Management Accountant is expected to prepare budgets, plans, forecast

through the use of cost estimation technique, break-even analysis, standard costing etc
which are future predictions of a financial expectation which form the major item of
planning.
b. Controlling: - Variance analysis, budgetary control reports, performance evaluation

reports etc are some of the reports prepared by the management accountant, which
compares actual performance with plans for purpose of management future corrective
action. The budget equally serves as a guide for future actions.
c. Decision Making: - principles such as, investment appraisal, pricing decision, marginal
costing for short-term or one-off decision, make or buy decision, special pricing decision,
dropping a center etc are designed to assist management in strategic as well as tactical
decision making processes.
d. Organizing: - This is done through the establishment of a sound accounting system and
preparation of budget or income statement presenting and unifying the whole organization
as a single entity and giving a global view of all organizational activities.
e. Directing: - This is done through the report of historical events such as contribution
statement, variance analysis, budgetary control, performance evaluation reports etc, which
present to management areas of strength and weakness thereby directing their attention to
areas that deserve attention or management by exception. Management by exception is a
situation where management gives more attention to areas where weakness is observed for
the overall benefit.
f. Communication: - Various report and information prepared and presented by the

management accountant to the management are meant to assist management in their
communication function. Because management is expected to communicate such report or
information to the operative manager or end user.
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However, for information provided by the management accountant to be of good use, it must fulfill
the characteristics of good information as highlighted below:
1. The information must be concise, that is, the information must be brief and straight to the
point.
2. Objectivity: - The information must be free from bias and should not satisfy the
subjectivity objective of any interest group at the expense of the group.
3. Relevance: - The information must be relevant to the need of the management at that point
in time.
4. Timeliness: - The information must be prepared in time to meet what is required currently
as late information will be irrelevant.
5. Understandability: - The information must be clear and unambiguous to the users and it
must easily understandable.
6. Comparability: - Where necessary the information must be comparable from time to time
with past information or alternative information so that management will be able to make
choices between alternatives.
7. Storage and retrieval: - The information must be capable of being easily stored and easily
retrievable. Storage and retrieval can be either manual or electro-mechanical.
The origins of modern management accounting can be traced to the development of complex
manufacturing processes, which make a vast majority to believe that management accounting is
associated or only relevant to the manufacturing industries.
This may be a wrong notion because one glance through the services or reports expected from a
management accountant shows that it is vital to all organizations or set-ups, either profit making or
non-profit making. The fact that planning, controlling and decision-making are prerequisite to the
attainment of corporate objectives or goals makes the job of the management accountant sensitive
to all organizations.
Management accounting is the broadest area of accounting that involves adequate and in-depth
knowledge of managerial accounting, cost accounting, financial accounting, cost management, tax
accounting, internal auditing etc.
Managerial accounting involves generating information for internal users including all levels of
management and others within the organization. This information will be tailored towards their
needs or requirement using knowledge of relevant disciplines. The relevant discipline may include
cost accounting, financial accounting, economic and quantitative techniques, operation research etc.
Cost Accounting deals with providing cost information regarding the financial aspects of
performance which aids the information provided by other aspects of accounting such as financial,
managerial, tax etc.
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Cost management is said to be a more comprehensive concept than cost accounting in that the
emphasis is on managing and reducing costs rather than reporting costs. In order words, it is a long
run proactive approach rather than a short run reactive approach.
Tax accounting and Financial accounting deals with external reporting in conformity with laid
down guidelines, while internal auditing maintains compliance with management rules and
regulation through internal audit and control.
While these disciplines may be viewed as a separate field of its own, their skill is required to
perform effectively as a management accountant. In the course of this study, understanding of these
subjects will be required in the discussion of some of the management accounting technique
principles. This may be the reason while small companies do not separate management accounting
function from other accounting functions.
THE ATTRIBUTES OF AN EFFECTIVE MANAGEMENT ACCOUNTANT
Management accountants, as mentioned earlier, need to display a different attitude from financial
accountants and require different skills. Ideally, management accountants should be:
 Sufficiently qualified, either by examination or experience

 Familiar with the industry within which they are working
 Highly numerate, which includes a high level of computer literacy
 Excellent verbal and written communicators
 Persistent, so that they will worry at an intractable problem until it is solved
 Able to relate to all levels within the organisation
 Tactful, as some managers may regard them as ‘top management’s police’.
 Aware of the wider context within which the organisation operates
 Forward-looking, i.e. innovative, prepared to use new methods
 Imaginative, able to invest or adapt method to fit the organisation.
Probably the most important of these attributes are imagination, numeracy, the ability to
communicate and industry knowledge. Certainly, without these the would-be management
accountant will have to struggle to become effective.
The single most important attribute, in my opinion, is imagination. Most of the problems that occur
in business are similar to previous ones and can be solved in the same way. But there will always
be some problems that don’t quite fit the pattern and so require imagination to solve. You will, I am
sure, discover this when you come to tackle the examination.
Numeracy and the ability to communicate are reasonably obvious prerequisites for an effective
accountant, whether financial or management. Industry knowledge is a key attribute if management
accountants are to be able to:
 Understand fully the problems that their managers may be facing.

 Recognize what information will be of use
 And know where the relevant information can be found.
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MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING INFORMATION
COMPARED
The motive here is to look at the major differences between management and financial accounting
information because as discussed above, financial accounting is part of management accounting,
but for the purpose of this discussion or going by the necessary statues regulating it, financial
accounting is for external users and management accounting is for internal users. Therefore, the
differences in their information are as follows: -
a. Users: - The users of financial accounting information include; Investors, Creditors,

Government, Researchers, the Public, Trade Union etc., while the only user of management
accounting information is the management of such organization.
b. Rules and Regulations: - In preparing financial accounting information there is the need to
comply with certain regulations (e.g. IAS, SAS, SSAP, etc.). Other regulations (e.g. the
accountant in the banking industry needs to comply with the regulations of the Chartered
Institute of Banker of Nigeria (CIBN)) and certain statutory laws (Acts and Decrees). While
preparation of management accounting information requires the principles and techniques of
management accounting and the ability to meet up with management requirement only.
c. Time Focus: - While financial accounting information is historical in nature, i.e. reporting
what had happened in the past, management accounting information on the other hand is
futuristic and predictive. Although management accounting information makes use of what
happened in the past, such is used to predict the future in line with the management
functions, which are future bias. It important to bear this fact in mind for a good
understanding of principles and techniques of management accounting.
d. Degree of details: - Financial accounting information are normally prepared to cover the
whole organization as a single entity, while management accounting information may be
prepared for a single product, department, section, region, division, segment and so on.
e. Objective: - The main objective of financial accounting information is to present the

financial position of an organization at a specific point in time in compliance with necessary
statues or in other words stewardship accounting. While the objective of management
accounting information is to assist management in carrying out their responsibilities or
managerial accounting.
f. Period cover: - By statues, financial accounting information is expected to cover 12 months,

that is, annually for a continuous company. Where as management accounting information
will be prepared in line with management requirement which may be, daily, weekly,
monthly, quarterly etc.
g. External Audit: - Financial accounting information, by relevant statues, requires external

verification inform of audit, where as management accounting information does not require
such.
h. Interdisciplinary relationship: - Preparation of financial accounting information require

only the knowledge of accounting, whereas management accounting makes use of the
knowledge of other well established disciplines and their theories, such as physiology,
economics, quantitative analysis, sociology, anthropology, etc.
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i. Format of Income Statement: - Financial accounting information makes use of gross profit
from trading activities, to present its income statement. Whereas, the management accounting
information income statement will be prepared using what is called a contribution statement.
COST ACCOUNTING, FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING IN PRACTICE
Our ability to differentiate these three disciplines in real life situation will enhance our
understanding of the principle or procedure of each field.
A cost Accountant identify, classify, code, allocate, apportion, absorb, document/store costs, that is
deals with proper and adequate documentation of the historical costs. In other words if what we do
at a particular point in time is to ensure that costs is adequately recorded or capture, we are acting
in the capacity of a cost Accountant. That is why in Cost Accounting we deal with identification of
cost, classification of costs, allocation of cost, apportionment of costs, absorption of costs, coding
of costs, storing of costs etc, that is, adequate and proper documentation of costs.
There is a need to know the financial position of a company from time to time, end of every week,
month or year, in other words, rendering stewardship accounting to the owner of a business.
Financial Accounting deals with preparation and presentation of the financial position of a
company at a particular date, that is, the truth and fair view. Therefore the preparation of
manufacturing, trading, profit/loss statement, balance sheet and cash flow statement as at a
particular date, is the task of a financial accountant. This could be achieved using the historical data
documented by cost accountant.
Management accounting involves generating information for internal users including all levels of
management and others within the organization. Constantly, management need to plan, control and
take decisions and requires financial information. An accountant that provides management
quantitative information to assist in their functions is refers to as Management Accountant.
In small organizations it is common for the same person to carry out these three functions, where
the assignment under consideration determine the type of accountant you are. If what you are
handling at a point is to ensure adequate and proper documentation of the historical cost, at the
moment you are a Cost Accountant. In another form, whenever you are preparing financial
information to aid management planning, controlling and decision making, at that moment you are
a Management Accountant. You qualify to be a Financial Accountant whenever you are using the
summary of costs, revenues, assets and liabilities for purpose of knowing the financial position of a
company at a particular point in time.
COST MANAGEMENT
Cost management is said to be a more comprehensive concept than cost accounting in that the
emphasis is on managing and reducing costs rather than reporting costs. In other words, it is a long
run proactive approach rather than a short run reactive approach. For example, a great deal of
attention is given to reducing costs at the design stage of a product’s life cycle rather than simply
attempting to measure and control cost during the production stage. It is defines as “the
management and control of activities to determine an accurate product cost, improve business
processes, eliminate waste, identify cost drivers, plan operations, and set business strategies.
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ACTIVITY MANAGEMENT
Activity management, or activity based management, places emphasis on continuously improving

the activities and tasks, or work that people perform in an organization. The main idea is to find and
eliminate waste. Conceptually, activity management is somewhat different from cost management
in that it focuses on the waste itself, not the cost of waste. It is a process oriented approach rather
than an accounting results oriented approach. Activity management also has a long run, rather than
a short run emphasis. It is important to make a distinction between managing costs (accounting
results) and managing activities (processes or work). This distinction is important because placing
too much emphasis on costs (or any other short run results oriented measurement) may cause
managers to make decisions that reduce costs, but are not in the best interest of the organization’s
long run performance and competitiveness. A few examples include a manager’s decision to reduce
research and development, employee training, and preventive maintenance just to improve short
term accounting results.
INVESTMENT MANAGEMENT
Investment management involves the planning and decision process for the acquisition and
utilization of an organization’s resources, including human resources as well as technology,
equipment and facilities. The concept of investment management includes the capital budgeting
decision and is more comprehensive in that the organization’s portfolio of interrelated investments
is considered as well as the projected effects of not investing. Investment management is more of a
holistic concept than capital budgeting in that it considers the effects of an investment decision on
the entire organization rather than simply the local areas such as individual departments or
individual divisions where the investments are made.
MULTINATIONAL MANAGEMENT ACCOUNTING
We live in a global economy. Those who work in the IT, electronics and chemical industry or in
financial services take this for granted. Those who work in the public sector will be less exposed to
international competitive pressures. Despite the efficiency of modern transport and communications
systems it is not always feasible to manufacture or source a product or service in one country and
deliver it to a customer in another. Consequently, many enterprises set up subsidiary companies and
branches abroad – the multinationals.
Although management accounting principles are universal, multinational companies may need to
adapt their management accounting practices to some extent to cater for local practices. Some
countries, such as France, advocate national systems of cost classification. A number of countries,
including India, have regulations that require certain enterprises to keep cost records. Others, such
as the USA, have national management accounting standards boards.
Other factors that may affect management accounting in multinationals are:
 Currency differences;
 Exchange rate fluctuations;
 Differing inflation rates
 Price controls;
 Different taxation regulations and rates;
 Cultural differences that impact on working practices and costs;
 Exchange controls that restrict capital transfers;
 Import duties;
 Anti-dumping regulations;
 Transfer pricing rules
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 Different accounting regulations/standards;
 The lack of a local management accounting profession.
International cost efficiency comparisons can be a particular problem, because of currency
fluctuations. A way round this problem is to use non-financial measures for performance
monitoring.
Budgets may be taken as a guideline by managers in some cultures, as a target in others, be
manipulated in others and treated as a constraint on spending in others. Therefore, budgetary
control systems may have to be adapted on a country-by-country basis if corporate aims are to be
achieved.
FUTURE OF MANAGEMENT ACCOUNTING
Demand for management accountants is expected to be on the increase in future as a result of

increased competitive pressures on business, resulting in profit and productivity squeezes, intense
complexity of organizations and projects, a shortened time-span for decisions, increased managerial
accountability within organizations in the public and private sectors, intensive use of new forms of
manufacturing technology and market globalizations.
It is expected that cost, (understanding cost structures, controlling or managing costs) more timely,
higher quality information (for decision-making, planning, project evaluation, control) would
become necessary and indeed, be seen as sources of competitive advantage. Coincidentally,
advances in information technology would enable more sophisticated forms of analysis and
interpretation, aided and abetted by new skills and technologies in the management accountant’s
repertoire in the future. It is expected that changing social philosophies (for example, the
recognition of a broader definition of stake holders) will require the adoption of new perspectives
by firms, and that conceptual and philosophical changes in management thought will drive changes
in management accounting, technologies/techniques.
Management accounting is seen as adapting to change, adjusting notions of control and control
system to alter locations of control (e.g. in terms, in operational areas) embracing information
sharing, bench marking and best practice notions, and assisting firms to develop and maintain
strategies and distinctive competences.
It is anticipated that growing competitive pressure and advances in information technology will
continue to drive change in the future. Additional factors are the lowering of impediments to world
trade, progressive large-scale integration of companies, advances in telecommunications, and the
need for profitability and worker empowerment. These will go a long way to enhance the need for
the management accountant making the profession more prominent among companies.
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CHAPTER 2
COST BEHAVIOUR AND COST ESTIMATION TECHNIQUES
Management accounting information must be futuristic and predictive to aid planning, controlling
and decision- making which are the primary responsibility of management. Costs are frequently
identified by their behaviour in relation to changes in an activity level. Projecting for the future
requires understanding the relationship between cost and activity.
Cost behaviour is the study of the relationship that exists between a given cost and level of activity.
In other words, it is the study of the responsiveness of cost to movement in activity level. Whilst
other factors influence costs, a major influence is the level or volume of activity, and many of the
reasons for studying cost behaviour relate to changes or proposed changes in the level of activity.
The level of activity is expressed in many varied ways e.g. units produced, number of clients,
number of students, labour hour, number of vehicles, etc. Accurate definition of activities will help
in identifying the types of cost behaviour.
TYPES OF COST BEHAVIOUR
1. Total variable cost: - Mostly refers to as variable cost, is a cost that varies with changes in
the level of activity, it moves in sympathy level with level of activity. In other words, total
variable cost will increase or decrease proportionately to the increase or decrease in the level
of activity. This can be graphically represented as follows.
Cost N
Total Variable Cost
Activities
Note that the variable cost per activity will be constant within the relevant range, no matter
the level of activity, in order to maintain a perfect total variable cost, it can be said that
variable cost per activity is uniform but the total fluctuates in direct proportion to the total of
the related activity or volume. For example N2 per unit is expected to be constant at either
2,000 or 10,000 units. This can be graphically demonstrated as follows: -
Cost N
Variable Cost/ Activity
Activities
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2. Total fixed cost: - Mostly refers to as fixed cost, is a type of cost that does not vary with
changes in the activity level within relevant range, i.e., this cost does not increase or decrease
with increase or decrease in activity level provided that the relevant range is not exceeded.
The inclusion of the word relevant range is important in the definition of total fixed cost,
because in real sense of it, no cost is fixed. For example, a printing machine has its maximum
capacity and if there is need to print beyond this capacity, there will be need for an additional
printing machine. Therefore the capacity of the machine in this case will be the relevant
range when considering fixed cost relating to it. This is generally applicable to all facilities or
activities to which total fixed cost is related.
Total fixed cost can be graphically represented as follows.
Cost N
Total Fixed Cost
Activity
*Note that fixed cost per activity will be reducing as activity increases, that is why it can be stated
that, total fixed cost does not change in total but becomes progressively smaller on per activity
basis as volume increases. This can be graphically represented as follows:
Cost N
Fixed Cost per Activity
Activity
*Examples of fixed costs may include, salaries, administration cost, rent, depreciation will be a
fixed cost if computation is based on straight line method, reducing balance method, sinking fund
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method etc but it is bound to be a variable cost when computation is based on output method, man
hours method and machine hours method.
Effective demarcation of cost into variable and fixed cost element is a great challenge faced by
most company of recent essentially when it is the activity in mind that determined whether a
particular cost is a variable or fixed cost. For example, fuelling cost will be variable cost when
activity under consideration is number of kilometer covered, whereas will be a fixed, if activity is
number of passenger. Therefore, it is important to understand activity and its relationship with the
cost before such cost is classified as variable or fixed and this is imperative to knowledge and
application of marginal costing technique and estimation of future expected costs to aid planning
and decision making.
3. Mixed costs: - Otherwise known as semi- variable or semi- fixed cost. This is cost that
combined the element of variable and fixed and it is the nature of total cost. This can be
represented graphically as follows:
Cost N
Mixed Cost
Activity
4. Step-fixed cost: - This is a type of cost that will be fixed within a given range and when the
range is exceeded it will increase by a lump-sum and keep at this level till a further lump sum
increase. Example of step-fixed cost include, rent, depreciation, salaries etc. This cost can be
graphically represented as follows:-
Step Fixed Cost

Cost N
Activity
Other Patterns of Cost Behaviour
Cost N
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a. This graph shows that the total purchase costs of a store item may change, as increasing
demand for a limited supply pushes up the unit cost.
Cost N
Quantity
Quantity
b. This graph shows how purchase costs of a store item are affected by bulk purchase discounts
on every unit bought, provided that total demand exceeds a certain quantity.
CostN
Quantity
c. The graph shows the effect on stores purchase of a discount per unit on quantities in excess of a
certain level of supply (e.g. unit cost of N2 per unit for the first 1,000units, at N1.90 per unit
for the next 1000units, N1.80 per unit for subsequent amounts)
Cost N
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d. This graph shows the cost behaviour pattern which would apply, for example, to an electricity
bill, where there is a fixed period charge plus a variable charge after aQuantity
certain number of
kilowatts are consumed
Cost N
Quantity
E. This cost pattern would apply to the rental of machine where the charge is a variable cost per
unit produced up to a maximum fixed rental.
COST ESTIMATION TECHNIQUES
This is a term used in management accounting to describe the usage of the historical cost with the
intention of assisting in the prediction of future cost for management planning, control and
decision-making. This, in other words, means that historical information is analyzed to serve as a
basis for future expectation.
While analyzing these historical costs, we often come across mixed cost, comprising element of
variable and fixed cost. This must be effectively separated into its fixed and variable element to aid
prediction of future cost. The techniques used in separating such mixed cost are:
1. Account classification method

2. High & low method
3. Scattered graph method
4. Linear regression analysis method
5. Multiple regression analysis method
ACCOUNT CLASSIFICATION METHOD
This is also known as Account Analysis Method or Rule of Thumb Method. It involves the use of a
well-experienced manager within an organization in separation of mixed cost into its variable and
fixed element, separating the cost based on prior knowledge of the cost. Account classification
procedure may be the most common and easy method of separating mixed cost because it makes
use of existing hands on the job which may have detailed knowledge of the cost but the
objectiveness in the cost separation may be questionable.
MERITS
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1. It is simple to use
2. It is cost and time effective.
DEMERITS
1. It is subjective and not scientific.

2. It may not be reliable
HIGH AND LOW METHOD
This is one of the objective methods of separating mixed cost. The method makes use of the cost
equation Y= a + bx. Where Y = total cost, b = variable cost per activity and x = activity level.
The historical or previous cost will be reviewed and the cost in two particular periods are selected
- The period with the highest activities
- The period with the lowest activities
Note that the period with the highest activities or lowest activities may not necessarily be the period
with highest or lowest cost respectively, but we use activity to pick the highest and lowest. The
difference between the cost of the highest and lowest activities will be divided by the difference in
the two activities to arrive at “b”. i.e.
b = the changes in cost
the changes in activities
Using the cost equation, “a” can be determined using either the highest activities and its cost or the
lowest activities and its cost.
Note that when inflation makes value within the periods chosen impossible to compare, cost should
be adjusted to the future expected value by making use of the price index, to provide us with future
applicable rate. This becomes imperative when there is changes in the price of resources within the
historical period given.
MERIT
1. It is objective, i.e. it can be proved mathematically

2. It is simple to compute
3. It is useful for other business mathematical calculations such as budgeting, cost of capital,
break even analysis etc.
WEAKNESS /CRITICISM/ DEMERIT
The main weakness of this method is that it relies on two extreme figures, the highest and the
lowest, which occur in exceptional periods. It will, therefore, not be a true representation of the
whole data. Hence, this may lead to a wrong estimation of future cost.
ILLUSTRATION 1
The total cost and output in units of a company for the past five months are as follows:-
Months Total Cost Output in Units
N
1 104,000 7,000
2 115,000 8,000
3 97,000 6,000
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4 111,000 7,700
5 114,500 8,200
Required- what is the total cost in month 6 likely to be, if expected output is expected to be 11,800
units?
SUGGESTED SOLUTION
Using high and low method, the period with highest and lowest activities will be selected, the
difference between the costs will be divided by the difference in activities, that is, the variable cost
per unit can be determined as follows
Output in Unit Total Cost
N
High point 8,200 114,500
Low point 6,000 97,000
Difference 2,200 17,500
Variable cost per unit or “b” = N17,500

2,200 Units = N7.95/unit.
The total fixed cost or “a” can be determined by using the highest activities and its cost or the
lowest activities and its cost. Note either of the two used will be give the same result.
Using high activities and cost and substituting for y, b & x in the cost equation, “a” can be
determined as follows N114,500 = a + N7.95 (8,200) or a = N114,500 – N7.95 (8,200), a =
N49,310.
The cost equation for the company can be stated as follows

Y = N49,310 + N7.95x
In month 6, if activity is 11,800 units, the expected cost will be
Y = N49,310 + N7.95 (11,800) = N143,120
Expected total cost = N143,120
ILLUSTRATION 2
Moyo Lace Ltd manufactures lace fabric. Cost behaviour patterns have not changed
significantly in the last year and prices and wage rates are expected to be stable for the
next few months. Moyo Lace Ltd uses just in time purchasing and production so its
stocks of materials, work in progress and finished goods are always kept to a minimum.
The last two months turnover and costs are:
Month January February

Turnover N600,000 N500,000
Total costs N400,000 N340,000
Required
Calculate the followings:
a. Variable cost per N1 of sales
b. Total variable costs incurred in January and February
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c. The fixed cost per month
d. The expected profit in March if turnover is N650,000.
SUGGESTED SOLUTION
a. Calculation of the proportion of variable cost to sales using high and low method
Activity (N) Cost (N)
High 600,000 400,000
Low 500,000 340,000
Proportion of variable cost to N1 sales = N60,000/N100,000 = 0.6 or 60% of sales
Note that variable cost cannot be computed per unit; instead it will be express as a proportion or
percentage of sales. This is always the case whenever activity is value instead of units.
b. The total variable costs for January and February

Total variable cost = Turnover - % of variable cost on turnover
January = N600,000 x .6 = N360,000
February = N500,000 x .6 = N300,000
c. Total fixed cost per month

Total fixed cost = Total cost – total variable cost
January = N400,000 – N360,000 = N40,000
February=N340,000 – N300,000 = N40,000
d. The expected profit in March

Profit = Turnover – total variable cost – total fixed cost
= N650,000 – (N650,000 x .6) – N40,000 = N220,000
ILLUSTRATION 3
ABC Limited has the following total cost information during the last five years.
Year Output Total Cost Average Price

(Units) (N) Index
1 65,000 145,000 100
2 80,000 179,000 112
3 90,000 209,100 123
4 60,000 201,600 144
5 75,000 248,000 160
What will be total cost in year 6 if output is 116,000 and the average price level index is 175.
SUGGESTED SOLUTION
In the illustration above, the changes in price level is indicated by the price level index. This cannot
allow us to use such data to project for the future without further adjustment. Therefore, there is
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need to adjust the total cost to bear the same future or expected ruling rate in year 6. To do this,
inflation is firstly discounted or removed from cost from year 2, so that costs are at ruling rate in
year 1 and when estimating for year 6 the inflation is compounded or added back.
Adjustment of total cost

Year Output Total Cost Average Price Workings Adjusted
(Units) (N) Index Cost ( N )
1 65,000 145,000 100 - 145,000
2 80,000 179,000 112 100/112 x 179,000 159,821
3 90,000 209,100 123 100/123 x 209,100 170,000
4 60,000 201,600 144 100/144 x 201,600 140,000
5 75,000 248,000 160 100/160 x 248,000 155,000
Calculation of variable cost per unit using high and low method.
Activities Cost (N)

High point 90,000 170,000
High point 60,000 140,000
Variable cost per unit = N30,000

30,000 units = N1 per unit.
Note that it is the highest and lowest activities and their respective cost that will be used in picking
the high and low point.
Calculation of total fixed cost or “a” using low point

“ a” = N140,000 – N1 ( 60,000) = N80,000
Total Fixed cost = N80, 000.
The company’s cost equation at year 1 rate will therefore be Y = N80, 000 + N1x
In year 6, when output is expected to be 116,000, the total cost at year 1 price index can be
determined as follows:- Y= N80,000 + N1(116,000) = N196,000
To convert this total cost to the cost expected in year 6, inflation will be compounded or added
using the price index of year 6, that is 175.
Therefore expected cost in year 6 will be N196, 000 x 175/100 = N343, 000
SCATTERED GRAPH METHOD
This method makes use of graph in separating mixed cost into its variable and fixed element. The
method equally use the cost function Y = a + bx. To determine “b”, the series of historical data
(cost and activities) will be plotted on the positive side of the graph. Based on the resulted
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“scattered graph” a line of “best fit” will be drawn. Using the slope of the line of best fit, the
changes in cost and activities can be determined,
“b” will therefore be equal to = the changes in cost
the changes in activities
It can be graphically demonstrated as follows:
Cost N
Line of best fit
* *
* * * * * *
Changes in * * * * * * * **
Cost * * * * *M
* ** * * * *
N
a
Activity
Changes in
activity
“b” = the changes in cost = M

the changes in activities N
The point at which the line of best fit intercepts the cost axis will represent the total fixed cost or
“a”.
The main criticism against this method is that drawing the line of ‘best fit’ is highly subjective or
discretional and will bring about non-uniformity. Therefore, the method is mostly theoretical and
not practical.
LINEAR REGRESSION ANALYSIS
This is otherwise known as least square method, quantitative technique or engineering method. It is
a quantitative method of separating mixed cost, which ensures equitable representative of all data
involved. The method believes that cost has a single linear relationship i.e. a single activity in
estimation of cost but all data will be subjected to the same arithmetic treatment to determine the
variable cost per unit and total fixed cost.
The cost equation Y= a + bx is equally applicable. There are various formulas available for
determining “a” and “b”. The following is commonly used.
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A table will be used for the calculation of each of the data and the value of “a” and “b” will be
determined.
Note that price level must be the same, before the above computation be carried out, that is, in a
situation of changes in prices of resources as a result of inflation within the historical data given,
such must be adjusted before separation of the cost into its variable and fixed element and
subsequent future projections.
MERITS
1. It makes use of all data involved, thereby providing for adequate representation of the
historical cost and activities.
2. It is objective and gives an accurate conclusion.
3. It can cope with multiple independent variables.
4. It is useful and valuable for further statistical analysis of cost such as co-efficient of
correlation and co-efficient of determination.
DEMERITS
1. The relationship between the variables may not be linear and therefore the technique may
not give the best result envisaged.
2. A large number of samples are required before the technique will work effectively.
3. The requirement of homogeneity may be fraught with practical difficulties.
4. Contradiction between accounting conventions for statistical techniques such as
regression analysis, e.g. data are recorded on historical cost basis whereas replacement
cost value is much more appropriate for statistical technique.
5. The method assumes cost has a single linear relationship or single activity, whereas at
times cost does have more than one linear relationship.
ASSUMPTIONS OF LINEAR REGRESSION ANALYSIS
i. There will be a linear relationship between cost and activities.

ii. A large sample of data will be used
iii. There will be homogeneity in the data used
iv. Data collection period is sufficiently long
v. Cost is linear with only a single activity.
CO-EFFICIENT OF CORRELATION
This indicates the extent to which past records reveal that there is a linear cost relationship. It
describes the extent to which the value of y is related to the value of x. Perfect positive correlation
means that all the pairs of data lies on the straight line, i.e., they are 100% correlated (this is given
as +1).
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Cost N
* *
* * *
* *
* * * *
*
Activity
Perfect negative correlation means that the pairs of data do not lie on a straight line, i.e., there is 0%
correlation (this is given as –1).
Cost N
*
*
* * *
* *
* * *
* *
Activity
Co-efficient of correlation has a value between –1 and +1. Under cost estimation, we should hope
for a value close to +1 e.g. 0.8, 0.9, 0.7 etc.
Co-efficient of variation (correlation co-efficient) measures the proportion of the value of one
variable that can be explained by the knowledge of the other. In other words, it means the
proportion at which our prediction of other variables might be right as a result of knowledge of the
first variable. It is normally calculated as follows:-
COEFFICIENT OF DETERMINATION
The co-efficient of determination is often used in place of the co-efficient of correlation for ease of
interpretation and it is measured by r2, that is, if r=0.972, r2=0.945 which is the coefficient of
determination. If r2=0.945 then immediately it can be said that 94.5% of the variations in y can be
explained by variation in x, where as r=0.972 has no such simple interpretation.
If r2 is close to 100%, it means that the activity used in the estimation is reliable and it is an
adequate indicator of cost.
If r2 is 0 (or near 0) it means that the activity is not reliable and as such another activity should be
used for the cost estimation.
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ILLUSTRATION 1
An Electrical Company engages in the batch production of switches used by the National Electrical
Power Authority in its Rural Electrification programme. An examination of its records shows that it
has had 10 production runs on similar types of switches over the past few months. The following
cost and production data are available
Switch Production Total Cost
Code No X ('000) Y (N'000)
KE11 10 120
KE18 16 210
KE24 12 150
KE47 36 410
KE50 20 256
KE54 26 296
KE75 18 200
KE78 14 180
KE80 14 185
KE83 11 130
You are required to

a. Obtain the least squares (y=a+bx) to the above data.
b. Interpret your answer in terms of fixed and variable cost of production
c. Provide for the company an estimate of the production cost, should NEPA place
an order for 14,500 switches in the coming month.
SUGGESTED SOLUTION
Calculating the variable and the fixed cost using linear regression analysis method, the formula can
be restated as follows:-
y = a + bx
Where
The table
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2
Switch X Y X-X Y – Y (X-X)(Y-Y) (X-X)
KE11 10 120 (7.70) (93.70) 721.49 59.29
KE18 16 210 (1.70) (3.70) 6.29 2.89
KE24 12 150 (5.70) (63.70) 363.09 32.49
KE47 36 410 18.30 196.30 3,592.29 334.89
KE50 20 256 2.30 42.30 97.29 5.29
KE54 26 296 8.30 82.30 683.09 68.89
KE75 18 200 0.30 (13.70) (4.11) 0.09
KE78 14 180 (3.70) (33.70) 124.69 13.69
KE80 14 185 (3.70) (28.70) 106.19 13.69
KE83 11 130 (6.70) (83.70) 560.79 44.89
Total 177 2,137 0 0 6,251.10 576.10
Mean 17.7 213.7
Variable cost per unit or “b” = N6,251,100
576,100 units = N10.85 per unit.
Total fixed cost or “a” = N213,700 – N10.85(17,700) = N21,655
a. The least square Y = N21,655 + N10.85x.

b. The total fixed cost per run is N21,655 and variable cost per switch is N10.85.
c. Estimated cost for 14,500 switches = N21,655 + N10.85(14,500) = N178,980.
ILLUSTRATION 2
A review of audit procedures is going on in the firm of chartered accountants you work for. The
partners are thinking of recommending a certain number of surprise checks as a means of saving on
substantive testing in annual audits.
No of surprise checks No of irregularities

1 15
2 10
3 12
4 5
5 5
6 4
7 2
8 1
9 2
a. Calculate the correlation coefficient for this data

b. Does the evidence in this data suggest that surprise checks could be used to save on
substantive testing?
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SUGGESTED SOLUTION
No of surprise checks will be taken as activities i.e. x.

No of irregularities will be taken as result i.e. y.
Correlation co-efficient
The table
2
X Y X-X Y-Y (X-X)(Y-Y) (X - X) (Y - Y)2
1 15 (4) 8.78 (35.11) 16 77.05
2 10 (3) 3.78 (11.33) 9 14.27
3 12 (2) 5.78 (11.56) 4 33.38
4 5 (1) (1.22) 1.22 1 1.49
5 5 - (1.22) - - 1.49
6 4 1 (2.22) (2.22) 1 4.94
7 2 2 (4.22) (8.44) 4 17.83
8 1 3 (5.22) (15.67) 9 27.27
9 2 4 (4.22) (16.89) 16 17.83
Total 45 56 - - (100.00) 60 195.56
Mean 5 6.22
r= -100
(60)(195.56) = -0.0085
b. The evidence in this data does not suggest surprise checks can be used to save on
substantive testing because the observed data shows a perfect negative correlation at –
0.0085 which means that the pairs of data do not lie on a straight line, i.e., there is 0%
correlation.
MULTIPLE REGRESSION ANALYSIS
This is a method of separating mixed cost, which is designed to cope with a situation where
estimation of cost has more than one linear relationship, that is, the dependable variable “y” can be
predicted from several independent variables “x”. In many practical situations, a dependable
variable may depend on several other variables. For example, consider the estimation of total
production overhead cost “y” of a manufacturing organization, that is, the dependable variable.
This may be influenced by several activities “x” or independent variables, such as
- x1= production unit or output

- x2 =quality of material used
- x3 =quality of productive machine
- x4 =quality of productive personnel etc
Using multiple regression analysis, all these variables will be taken into consideration for the
purpose of establishing the expecting production cost. This method is best suited for a
computerized environment where all the variables can be programmed and the estimation of cost
becomes easier despite the complexity involved.
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PRACTICE QUESTIONS
Q1.a. “All direct cost are variable costs and all variable costs are direct costs”. “Variable costs are
fixed and fixed costs are variable”. “Variable costs are acceptable and fixed costs are not”.
“Fixed cost has limitations because on the long run there is no cost that is fixed”. “Sunk
costs are irrelevant when providing decision-making information”.
Critically review the above excerpts given examples where necessary to clarify any doubt.
b. Why might a company find it useful to distinguish between fixed and variable costs?
Q2. Desola Ventures limited is a major distributor of one of the leading mobile companies in
Nigeria. The company operates in four major towns- Lagos, Port Harcourt, Abuja and
Kano, at which goods are purchased from the mobile company, are stored, repacked and
redistributed to various other retail outlets in their region. The company also maintains a
Head Office in Lagos at which the necessary central management and administrative
activities are performed. Apart from the central accounting, each region maintains its own
accounting system.
Required
a. A discussion of the type of information the management accountant could produce to assist
the management of Desola Ventures Limited, with particular reference to the provision of
information in respect of:
i. planning and decision-making activities
ii. controlling and evaluating activities.
b. Indicate the cost classifications required to support the provision of information in “a”.
Q3. The following data are the extracts from the budgets for department “2” of a factory for the
budget year:
Activity levels (hours) Budgeted Overhead Costs
8,000 N23,700
12,000 N30,900
18,000 N41,700
Standard overhead rate is N2.30 per direct labour hour.
Required
I. Calculate the fixed cost for department “2” using high- low method.
II. Calculate the standard activity on which the standard overhead rate has been fixed.
iii. Calculate the standard overhead rate per direct labour hour if the standard activity level has
been fixed at 31,000 direct labour hours.
Q4. Queen Limited can produce 10,000 units of a product per month when operating at 100%
capacity level. The following information is obtained from the records:-
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Month September October
Unit produced 8,800 7,300
N N
Production Labour 61,600 51,100
Air conditioning 39,000 39,000
Security salary 8,800 8,800
Repairs 64,800 55,800
Production Material 510,400 423,400
Depreciation 76,400 76,400
Supervisor's Salaries 68,800 59,800
Rent and Rates 63,000 63,000
Lighting 23,360 20,060
General Labour 36,960 30,660
The rate of production is 5 units per hour.
You are required to
a. Compute the cost of production at 100%, 80% and 75% capacity levels showing
separately variable cost, semi variable and fixed components of production overheads.
b. Show the overhead recovery rate per hour at 80% capacity level.
Q5. Shade, the Financial Controller of Shaddy Limited has a schedule of cost of goods
manufactured and profit and loss account for the immediate financial year ready for a
meeting of board of directors scheduled for the day. She worked very hard with her deputy
at the weekend to have them ready for the meeting but unfortunately her deputy traveled
out of the station afterwards and did not hand in all the relevant cost records to Shade. She
was able to determine the following facts about the last financial year.
a. Sales N900,000
b. Stock at the beginning of the year:
Work in progress N105,600
Finished goods N51,000
c. Work in progress and stock decreased by N17,000 and N7,000 during the year.
d. Gross profit during the year was equal to 45% of sales
e. Manufacturing overhead totaled N133,200 during the year.
f. Direct labour cost was equal to 40% of prime cost.
g. Net profit during the year was equal to half of the administrative expenses but was
two thirds of the figure for selling expenses.
Required
Assist Shade to prepare a schedule of cost of goods manufactured and profit and loss account for
the year.
Q6. Instant Limited manufactures and sells a single product. The product is highly perishable
and the company keeps virtually no stocks of either the product or raw materials. The
company’s results during the past years have been as follows:-
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Year 1 2 3 4
Output and Sales (Units) 18,100 17,500 18,800 19,600
N N N N
Sales Revenue 72,400 78,750 84,600 98,000
Labour (27,200) (29,600) (31,100) (39,800)
Materials (13,800) (14,700) (16,900) (20,600)
Overheads (18,500) (21,400) (25,300) (29,500)
Net Profit 12,900 13,050 11,300 8,100
During the last four years material costs have increased steadily at a compound annual rate
of 10% and overhead cost at a compound annual rate of 15%. Wage rates were increased
by 10% on 1st January, year 2 and by 20% on 1st January, year 4. During next year, year 5,
both materials and overhead costs are expected to increase by 10%. The company intends
to increase wage rates by 15% on 1st January, year 5.
The company is now considering its selling price and output level policy for year 5. Some
members of the board of directors believe that the existing selling price of N5 per unit
should be maintained. Others favour an increase to N6 per unit and one member believes
that a reduction to N4 per unit would be beneficial. Recent market research information
suggests that the likely quantity of the company’s product to be demanded during year 5 at
each of the three prices mentioned would be as follows:
Unit Selling Price Quantity Demanded

N4 34,000
N5 25,000
N6 15,000
You are required to:
a. Use linear regression analysis to estimate the cost-volume relationship of the company for
year 5.
b. Advice the directors on which of the three selling prices, N4, N5, or N6 they should adopt
for year 5.
SUGGESTED SOLUTION TO PRACTICE QUESTIONS
Q1. a. Variable and Fixed Costs
Variable cost is defined as that cost which moves in sympathy level with activities, i.e. this type of
cost increases or decreases proportionately with the increase or decrease in activities level. While
fixed cost is a type of cost that remains constant within the relevant range no matter the movement
in activity level, i.e., the cost does not increase or decrease with increase or decrease in activity
level provided that the relevant range is not exceeded.
Direct costs are those, which can be related specifically to a cost unit. They are normally identified
under three headings- direct materials, direct labour and direct expenses. Direct materials are costs
of materials entering into and becoming constituent elements of a product or service. Direct labour
Page 30
is the cost of remuneration for working time applied directly to a product or service. Direct
expenses are other costs, which are incurred or provided for a specific product or service.
To make a cost variable, it must be constant per a given unit of activity and in total moves in
sympathy level with activity.
Most direct costs move in sympathy level with activity and may be termed variable cost, but it may
not be right to say all direct costs are variable costs. For example, if a machine purchased directly
for production, the depreciation computed on such machine based on time is a fixed cost and a
direct cost. Equally most variable costs are direct cost, it may be wrong to say all variable costs are
direct cost. For example, sales commission on unit sold is a variable cost but not a direct cost.
While total variable cost is expected to move in sympathy level with activity, the variable cost per
activity is expected to be constant or fixed no matter the activity level. Therefore, variable cost per
activity is a fixed cost.
Equally total fixed cost is expected to be constant no matter the movement in activity level
provided the relevant range is not exceeded, while fixed cost per activity will be reducing as
activity increases. That is, fixed cost per activity varies or reduces with activity.
Variable cost is a generally relevant cost for planning and decision making, but becomes irrelevant
if the cost is already incurred or paid for, then we refer to it as sunk cost or irrelevant cost.
Therefore, it may not be right to say variable cost is generally acceptable. Fixed cost is generally
disregarded in planning and decision-making, but fixed overheads are classified into two major
areas, that is, relevant fixed cost and irrelevant fixed cost. The mere fact that some fixed costs are
considered as being relevant in decision making contradict the position that fixed cost is not
acceptable.
Fixed cost exists only within definable units or relevant range, that is, there is no fixed cost without
a blanket or limitation. For example, depreciation on production machine remains fixed when the
company is operating within the production capacity of the machine, supervisor salary is fixed only
within the workload for a single supervisor. Whenever there is the need to operate beyond this
capacity, fixed cost becomes step fixed cost.
Sunk costs are irrelevant in decision making because it represents an historical cost which does not
have any influence or effect on future decision.
b. It is essential to separate costs into fixed and variable costs for purpose of planning,
controlling and decision-making. To plan requires forecasting, knowledge of cost as either
variable or fixed will assist in forecast for planning purposes. Equally for controlling
purposes, standards are set and performance will be compared with set standards to reflect
efficiency or weakness in operation for the purpose of future corrective actions. Before
standards are established, cost must be effectively separated into variable and fixed
element.
Decision making is enhanced by projecting what expected future activity and/or cost will
be. This can only be accomplished through effective and correctly separation of cost into
variable and fixed element.
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Q 2 Desola Ventures Limited
a. This entails the function of management accountant at each of the major towns, which will
involve the collation of necessary data and preparation of information to assist the
management in their functions. These can be further analyzed under each of the categories
as follows-
Planning and Decision making activities

Information and analyses could be provided to assist in
- Performance evaluation
- Investment appraisal
- Product line and selling price decisions
- Stock level decisions
- Transportation and stock location decisions
- Promotion and advertising plans
- Budgetary planning information
- Cash planning and working capital management, etc.
Controlling and evaluating activities

Within this category would be a wealth of rapidly produced reports and analyses of current
operations and efficiencies.
- Budgetary control reports
- Operating statements analyzing performance and profitability
- Outlets operating returns
- Wages and labour returns showing costs/labour turnover
- Stock turnover reports, etc
b. To provide the full range of relevant information, which would be required, the cost
classifications would need to be detailed and flexible. Typical of the ways costs might be
classified are
- By Nature
- By location
- By period
- By behaviour
In addition to the above routine classification, for special planning and decision making
purposes costs would also have to be classified as to relevancy, controllability and
responsibility.
Q 3. DEPARTMENT 2
i. Separation of overhead into fixed and variable cost using high and low method.
Activity Costs (N)
High 18,000 41,700
Low 8,000 23,700
Variable overhead cost per hour =N18,000/10,000 = N1.80 per hour
The fixed cost = N41,700 – N1.80(18,000) = N9,300
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ii. The standard overhead rate of N2.30 per direct labour hour includes both variable and fixed
overhead. Since variable is determined above to be N1.80 per hour. Fixed overhead per hour
therefore will be N0.50 (i.e. N2.30 – N1.80). Standard activity can thereby be determined by
dividing the fixed overhead by the absorption rate.
The standard activity = N9,300/N0.50 = 18,600 hours
iii. The standard overhead rate at 31,100 direct labour hours

N
Variable overhead per hour 1.80
Fixed overhead per hour (N9,300/31,000) 0.30
Standard overhead rate/hour 2.10
Q 4. Q LIMITED
The variable costs

The rate per unit can be determined as follows
Production labour (N61,600/8,800) = N7/unit or (N51,100/7,300) = N7/unit
Production material (N510,400/8,800) = N58/unit or (N423,400/7,300) = N58/unit
General labour (N36,960/8,800) = N4.2/unit or (N30,660/7,300) = N4.2/unit
It is purely variable cost when total cost at high and low is divided by their respective rate
and gives the same cost per unit, otherwise it semi variable or fixed cost when the total cost
is the same.
Semi variable overhead

September October
Unit produced 8,800 7,300
N N
Repairs 64,800 55,800
Supervisor's salaries 68,800 59,800
Lighting 23,360 20,060
Total 156,960 135,660
Separation to variable and fixed cost using high and low method.
Activity Cost
N
High 8,800 156,960
Low 7,300 135,660
Variable cost per unit = N21,300/1,500 = N14.20
Fixed cost = N156,960 – N14.20(8,800) = N32,000.
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Fixed overheads N
Air conditioning 39,000
Security salary 8,800
Depreciation 76,400
Rent and Rates 63,000
Total 187,200
Cost of production for the given capacity levels

Capacity levels 100% 80% 75%
in Units 10,000 8,000 7,500
Variable cost:- N N N
Production labour @ N7/unit 70,000 56,000 52,500
Production material@ N58/unit 580,000 464,000 435,000
General Labour @ N4.2/unit 42,000 33,600 31,500
Semi- Variable Overheads:-
- variable @ N14.2/unit 142,000 113,600 106,500
- fixed 32,000 32,000 32,000
Fixed Overhead 187,200 187,200 187,200
Total Costs 1,053,200 886,400 844,700
b. The overhead recovery rate per hour at 80% capacity level
Total fixed overhead = N32,000 + N187,200 = N219,200

Total hours at 80% = 8,000units/5 hours = 1,600 hours
The overhead recovery rate per hour = N219,200/1,600 hours = N137/hours
Q 5. SHADDY LIMITED
The question is testing incomplete records, where the known figures will be used in determining the
unknown figures. But one needs to be conversant with income statement for a manufacturing
organization for an accurate solution.
From the question the following can be obtained

The gross profit = 45% x N900,000 = N405,000
This can be further divided into Admin Expenses, Selling expenses and profit using the ratio given.
Net profit was equal have admin expenses could be stated in ratio 1:2
Net profit was equal two third of selling expenses could stated in ratio 2:3
The ratio of net profit, admin expense and selling expenses combined becomes 2:3:4
Gross profit shared among the three using the ratio will give Profit = N90,000, Admin = N180,000
and Selling = N135,000.
The closing of work in progress = N105,600 – N17,000 = N88,600
Closing stock of Finished Goods = N51,000 – N7,000 = N44,000
The income statement for the year
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N N
Sales 900,000
Cost of goods manufactured
Opening work in progress 105,600
Material cost 139,800
Manufacturing Overhead 133,200
Direct labour 198,000
Less closing work in progress (88,600)
Cost of goods manufactured 488,000
Add opening stock of finished goods 51,000
Less Closing stock of finished goods (44,000)
Cost of sales (495,000)
Gross Profit 405,000
Less Expenses
Administration 180,000
Selling 135,000 (315,000)
Profit 90,000
Q 6. INSTANT LIMITED
a. To establish the cost-volume relationship of the company for year 5 using linear regression
analysis x = sales in units and y = total cost. Since there is inflation in the last four years, it
will be defective to use such a cost to project for year 5. Therefore, these historical costs
must be adjusted to what will be obtainable in year 5 for our projection to be accurate. This
will be done by compounding inflation to those costs incurred in the past and the expected
increase in year 5 will be added.
These should be adjusted as follows

Year 1 2 3 4
N N N N
Materials Cost – Given 13,800 14,700 16,900 20,600
- adjustment factor year 4 value 1.13 1.12 1.11 -
- adjustment factor year 5 value 1.1 1.1 1.1 1.1
- adjusted cost 20,205 19,566 20,449 22,660
Overheads Cost – Given 18,500 21,400 25,300 29,500

- adjustment factor year 5 value 1.1 1.1 1.1
- adjusted cost 30,950 31,132 32,005 32,450
Labour Cost – Given 27,200 29,600 31,100 39,800

- adjustment factor year 2 value 1.1 - - -
- adjustment factor year 4 value 1.2 1.2 1.2 -
- adjusted cost 41,290 40,848 42,918 45,770
Adjusted total costs 92,445 91,546 95,372 100,880
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Note that the reason for the exercise above is to convert the historical cost to current or future cost
by adding inflation to the cost already incurred and paid to reflect what is likely going to be in the
expected future we are forecasting for. This is always necessary practically in an economy that is
mars with inflation to make our forecasting reasonable.
Calculation of variable cost per unit and total fixed cost using linear regression analysis
The table
Year x y x-x y-y (x-x)(y-y) (x-x)2
1 18,100 92,445 (400) (2,616) 1,046,300 160,000
2 17,500 91,546 (1,000) (3,515) 3,514,750 1,000,000
3 18,800 95,372 300 311 93,375 90,000
4 19,600 100,880 1,100 5,819 6,401,175 1,210,000
Total 74,000 380,243 - - 11,055,600 2,460,000
Mean 18,500 95,061
The variable cost per unit = 11,055,600/2,460,000 = N4.49/unit

Total fixed cost = N95,061 – N4.49(18,500) = N11,996
The cost equation for the company = N11,996 + N4.49x
b. Calculation of optimum selling price.

Selling Price N4 N5 N6
Quantity demanded 34,000 25,000 15,000
N N N
Sales 136,000 125,000 90,000
Less total Variable cost @ N4.49/unit 152,660 112,250 67,350
Total Contribution (16,660) 12,750 22,650
From computation above, it is advisable to adopt N6 as selling price for year 5 and sell 15,000
units, that is, the selling price that gives the highest total contribution.
Note that, fixed cost was not considered above because it is common to the three options and
therefore, does not make any difference.
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CHAPTER 3
COST ACCOUNTING SYSTEM AND INCOME STATEMENT
This will be discussed in three parts as follows:
1. An input measurement basis

2. Costing methods and
3. Preparation of income statement.
INPUT MEASUREMENT BASES
The basis of a cost accounting system begins with the type of costs that flow into and through the
inventory accounts. There are three alternatives including: pure historical costing, normal historical
costing and standard costing. These concepts are discussed individually as bellow.
Pure Historical Costing
In a pure historical cost system, only historical costs flow through the inventory accounts.
Historical costs refer to the costs that have been recorded. The term actual costs are sometimes used
instead, but the term “actual” seems to imply that there is one true cost associated with a particular
output. But determining the cost of a product, or service requires many cost allocations, e.g.,
allocating the cost of fixed assets to time periods, and allocating indirect manufacturing costs, or
overhead to products. Since there are many alternative allocation methods, (e.g., straight line or
accelerated depreciation) the calculated cost of a unit of product or service simply represents an
attempt to approximate the true cost.
Normal Historical Costing
Normal historical costing uses historical costs for direct material and direct labour, but overhead is
charged, or applied to the inventory using a predetermined overhead rate per activity measure.
Typical activity measures include direct labour hours, or direct labour costs. The amount of factory
overhead charged to the inventory is determined by multiplying the predetermined rate by the
actual quantity of the activity measure. The difference between the applied overhead costs and the
actual overhead costs represents an overhead variance or under/over absorption (as will be
mentioned later).
Standard Costing
In a standard cost system, all manufacturing costs are applied, or charged to the inventory using
standard or predetermined prices, and quantities. The differences between the applied costs and the
actual costs are charged to variance accounts. The variances provide the basis for the concept of
accounting control.
COSTING METHODS
Traditional as well as advanced costing methods are as followings:
1. Throughput Costing
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2. Marginal/Variable/Direct Costing
3. Absorption Costing
4. Activity Based Costing
5. Target Costing
6. Life-cycle Costing
7. Back-flush Costing
THROUGHPUT COSTING
Tangible and verifiable are inventory cost put into production compared with conversion costs, that
is, addition of labour and overhead costs. Throughput costing method was developed to
complement a concept referred to as the theory of constraints. In this method only direct material
costs are charged to the inventory. All other costs are expensed during the period. Sales less direct
material costs is referred to as throughput which reflects how the method got its’ name. The
throughput method does not provide proper matching (as defined by general acceptance accounting
practice (GAAP)) because all manufacturing cost, other than direct material are expensed when
incurred rather than capitalized in the inventory. Therefore, the throughput method is not
acceptable for external reporting although advocates argue that it provides many advantages for
internal reporting.
Throughput is the rate of converting raw materials and purchased components into products sold to
customers or in money terms, throughput can therefore be defined as the extra money that is made
for an organization from selling its products.
Throughput = Revenue – total variable costs.
Since in this concept, total variable costs are normally just raw materials and bought-in
components, it is often convenient to define it as:
Throughput = Revenue – Inventory costs
Where inventory cost is money tied up in assets so that the business can make the throughput and
other costs classified as operating expenses, that is, all the money a business spends to produce the
throughput (i.e. to turn the inventory into output, such as conversion and other overhead costs).
ILLUSTRATION 1
Wale Tiles recorded a profit of N240,000 in the accounting period just ended, using marginal
costing. The contribution/sales ration was 40%. Material costs were 30% of sales value and there
were no other variable production overhead costs. Fixed costs in the period were N300,000.
Required:
What is the value of throughput for the period?
SUGGESTED SOLUTION
N
Profit 240,000
Fixed costs 300,000
Total contribution 540,000
Contribution/sales ratio 40%
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N
Sales (N540,000/.4) 1,350,000
Less Material costs (1,350,000 x .3) (405,000)
Throughput 945,000
Whenever there is a limitation in the availability or supply of a resource (under this concept refers
to as bottleneck resource), The Throughput Accounting Ratio (TPAR) can be computed as follows
for purposes of chosen optimal option for resources allocation.(Assuming factory hours is a
bottleneck resource).
Throughput(return) per factory hour = Throughput/Product’s time on the bottleneck resource
Cost per factory hour = Total factory cost/Total time on the bottleneck resource
Throughput Accounting Ratio = Return per factory hour/Cost per factory hour.
ILLUSTRATION 2
A business manufactures a single product that it sells for N10 per unit. The materials cost for each
unit of product sold is N3. Total operating expenses are N50,000 each month.
Labour hours are limited to 20,000 hours each month. Each unit of product takes 2 hours to
assemble.
Required
Calculate the throughput accounting ratio.
SUGGESTED SOLUTION
Throughput per unit = N10 – N3 = N7

Throughput per assembly hour = N7/2 hours = N3.50/hour
Operating expenses per assembly hour = N50,000/20,000 hours = N2.50/hour
Throughput accounting ratio = N3.50/N2.50 = 1.40
That is, the throughput of the product covers the operating expenses 140%.
MARGINAL COSTING
This is a traditional costing method for internal reporting, using this method, only the variable
manufacturing costs are capitalized, or charged into inventory. Fixed manufacturing costs flow into
expense in the period incurred. It is said to be “The accounting system in which variable costs are
charged to cost units and fixed costs of the period are written off in full against aggregate
contribution. Its special value is in recognizing cost behaviour, and hence assisting in decision
making. This method provides some advantages and some disadvantages for internal reporting.
However, it does not provide proper matching because the current fixed costs associated with
producing the inventory are charged to expense regardless of whether or not the output is sold
during the period. For this reason direct costing is not generally acceptable for external reporting.
The merits and demerits as well as different uses of this method is discussed in the subsequent
chapters.
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ABSORPTION COSTING
Absorption costing otherwise refers to as full costing is a traditional costing method acceptable for
external reporting. Using this method all manufacturing costs (variable and fixed) are capitalized
into inventory, i.e., charged to the inventory, capitalised as assets (current assets). This means that
these costs do not become expenses until the inventory is sold. In this way, matching is more
closely approximated. All selling and administrative costs are charged to expense to the period
incurred. Technically, full absorption costing is required for external reporting, although many
companies apparently use something less than a pure full absorption costing system. The full
absorption method is also frequently used for internal reporting (This is further discussed under
operating statement and pricing decision).
ACTIVITY BASED COSTING
Activity based costing is a relatively new type of procedure that can be used as an inventory
valuation method. The technique was developed to provide more accurate product costs. This
improved accuracy is accomplished by tracing costs to products through activities. In other words,
costs are traced to activities (activity costing) and then these costs are traced, in a second stage, to
the products that use the activities. Another way to express the idea is to say that activities consume
resources and products consume activities. Essentially, an attempt is made to treat all costs as
variable, recognizing that all costs vary with something, whether it is production volume or some
non-production volume related phenomenon. Both manufacturing costs and selling and
administrative costs are traced to products in an ABC system. Note that treating selling and
administrative costs in this way is not acceptable for external reporting.
In traditional full absorption costing and direct (or variable) costing systems, indirect
manufacturing costs are allocated to products on the basis of a production volume related
measurement such as direct labor hours. Thus, the fundamental differences between traditional
systems and activity based systems are: 1) how the indirect costs are assigned (ABC uses both
production volume and non-production volume related bases) and 2) which costs are assigned to
products (in ABC systems, an attempt is made to assign all costs to products including engineering,
marketing, distribution and administrative costs, although some facility related costs may not be
assigned).
At the present time, most of the companies that use the activity based method have developed stand
alone, micro-computer based systems separate from the company's mainframe cost accounting
system used for external reporting. The idea is to develop more accurate product costs than the
traditional cost accounting system provides so that management can make better strategic decisions
such as product introduction, pricing, mix and discontinuance. In these systems, ABC is not used as
an inventory valuation method. Activity based costs are not charged to the inventory accounts.
However, it is used to determine product costs once per year, or more frequently when changes are
made in the production process.
ILLUSTRATION 1
A company produces three different vacuum cleaners. These are coded BR1, BR2 and BR3. The
following budget data has been obtained for the year ended 30 June
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BR1 BR2 BR3
Direct materials cost per unit N25 N20 N18
Direct labour hours per unit 3 4 2
Direct wages per unit N24.60 N32.80 N16.40
Machine hours per unit 2 4 3
Production quantity 40,000 25,000 10,000
Number of production batches 5 10 25
Number of component orders 15 25 120
Number of sales orders 15 10 25
Budgeted production overheads for the year are:

Activity N
Inspection 170,000
Machining costs 930,000
Material handling 330,000
Packing 195,000
Set up costs 183,000
Total 1,808,000
At present the company absorbs production overhead costs to products by using a rate per machine hour
for machine costs and a rate per direct labour hour for the remaining overheads.
The company intends to introduce a system of activity-based costing. Cost drivers for the production
overheads have been identified as follows:
Activity Cost driver
Inspection Production batches
Machining Machine hours
Material handling Component orders
Packing Sales orders
Set up Production batches
Required
a. Calculate the unit costs for each product using absorption costing.
b. Calculate the unit costs for each product using activity based costing (ABC)
c. Compare the unit costs provided by each costing system and comment on their impact if selling
prices were BR1 N65, BR2 N80 and BR3 N90 per unit.
SUGGESTED SOLUTION
a. The products unit cost using absorption costing technique

Product BR1 BR2 BR3
N N N
Direct material (given) 25.00 20.00 18.00
Direct wages (given) 24.60 32.80 16.40
Machining costs (machine hours x absorption rate) 8.86 17.72 13.29
Other overheads (direct labour hours x absorption rate) 10.98 14.64 7.32
Product cost per unit 69.44 85.16 55.01
Page 41
Wi. Calculation of overhead absorption rate per machine hour
Budgeted hours BR1 2hrs x 40,000 = 80,000
BR2 4hrs x 25,000 = 100,000
BR3 3hrs x 10,000 = 30,000
Total hours = 210,000
Machine costs = N930,000
Absorption rate = N930,000/210,000hrs = N4.43 per machine hour.
Wii. Calculation of overhead absorption rate direct labour hour

Budgeted hours BR1 3hrs x 40,000 = 120,000
BR2 4hrs x 25,000 = 100,000
BR3 2hrs x 10,000 = 20,000
Total hours = 240,000
Total overheads, excluding machining costs = N1,808,000 - N930,000 = N878,000
Absorption rate = N878,000/240,000hrs = N3.66 per labour hour
b. The products unit cost using activity based costing

Product BR1 BR2 BR3
N N N
Direct material (given) 25.00 20.00 18.00
Direct wages (given) 24.60 32.80 16.40
Overhead per unit (wii) 12.20 24.87 69.85
Product cost per unit 61.80 77.67 104.25
Wi. Calculation cost per driver using activity based costing.

Actitity cost driver BR1 BR2 BR3 Total Overhaed Cost/driver
N N
Machining costs Machine hours 80,000 100,000 30,000 210,000 930,000 4.43
Inspection Production batches 5 10 25 40 170,000 4,250
Material handling Component orders 15 25 120 160 330,000 2,062.50
Packing Sales orders 15 10 25 50 195,000 3,900
Set up costs Production batches 5 10 25 40 183,000 4,575
Wii. Calculation of overhead cost per unit using activity based costing.
Product BR1 BR2 BR3
Activity N N N
Machining costs (Total machine hours x N4.43) 354,400 443,000 132,900
Inpection (production batches x N4,250) 21,250 42,500 106,250
Material handling (components order x N2,062.50) 30,938 51,563 247,500
Packing (sales orders x N3,900) 58,500 39,000 97,500
Set up costs (production batches x N4,575) 22,875 45,750 114,375
Total overhead costs 487,963 621,813 698,525
Production quantity (units) 40,000 25,000 10,000
Overhead cost per unit 12.20 24.87 69.85
c. Comparison of the unit costs.
Page 42
Product BR1 BR2 BR3
N N N
Absorption costing basis 69.44 85.16 55.01
Activity based costing basis 61.80 77.67 104.25
Absorption less ABC per unit 7.64 7.49 (49.24)
If selling prices are BR1 N65, BR2 N80 and BR3 N90 per unit, BR1 and BR2 would appear to be
loss making in an absorption costing system, while BR3 is very profitable. However, ABC
reveals that BR3 is, in fact, the loss maker while the other two products are profitable.
ILLUSTRATION 2
Bola Cycle Plc manufactures three types of racing bicycle: a training bicycle (BTB), a club racing bicycle
(BRB) and a competition racing bicycle (BCB).
At present, Bola Plc uses marginal costing for stock valuation, budgetary control and short-term decision
making, although the Financial Director is of the opinion that activity based costing would provide more
valuable management information. Bola plc’s budgeted product cost and output data for July is as
follows:
BTB BRB BCB
N N N
Selling price 380 600 650
Costs per bicycle:
Material costs 220 320 480
Assembly labour hours per bicycle 2 hrs 2.5 hrs 3.5 hrs
Welding labour hours per bicycle 0.25 hrs 0.25 hrs 0.3 hrs
Paint shop labour hours per bicycle 0.25 hrs 0.4 hrs 0.5 hrs
Budgeted output 240 180 100
Batch size 20 10 10
Material movements per batch 6 6 7
Average stockholding time per unit of
output, in months 2 4 5
Variable direct labour costs per hour are: Assembly N9, welding N12, and painting N14.
Budgeted overhead cost pools and cost drivers for July are as follows:
Cost pool N Cost drivers
Production management 26,000 Output
Setting 14,000 Number of batches produced
Material movements 4,000 Number of materials movements
Stockholding 3,400 Total stockholding time per product line
Required
a. Produce Bola cycle plc’s budgeted operating statement for July, showing product costs and
profitability in as much detail as the data allows, using:
i. The company’s traditional marginal costing approach.
ii. An activity based approach.
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b. Prepare a memorandum to the Financial Director setting out the advantages of using activity
based costing. You should refer to data from part (a) above to illustrate your arguments.
SUGGESTED SOLUTION
a.i. The budgeted operating statement for July using marginal costing approach.
Product BTB BRB BCB Total
N N N N
Selling price 380.00 600.00 650.00
Less variable cost per unit
- Material 220.00 320.00 480.00
- Labour - Assembly 18.00 22.50 31.50
- Labour - Welding 3.00 3.00 3.60
- Labour - Painting 3.50 5.60 7.00
Contribution margin 135.50 248.90 127.90
Output 240 180 100
Total contribution 32,520 44,802 12,790 90,112
Less total fixed overhead 47,400
Budgeted profit 42,712
a.ii. The budgeted operating statement for July using activity based costing approach.
Product BTB BRB BCB Total
N N N N
Total Contribution 32,520 44,802 12,790 90,112
Less fixed overhead per product (wi) 18,312 18,468 10,620 47,400
Budgeted profits 14,208 26,334 2,170 42,712
(wi). Calculation of fixed overhead per product using activity based costing approach.
Cost pools Prod. Mgt. Setting Mat. Mov. Stockhol. Total/product
Overhead costs (N) 26,000 14,000 4,000 3,400
Cost driver quantities (wii) 520 40 250 1,700
Overhead/cost driver (N) 50 350 16 2
Cost per model N N N N N
BTB 12,000 4,200 1,152 960 18,312
BRB 9,000 6,300 1,728 1,440 18,468
BCB 5,000 3,500 1,120 1,000 10,620
26,000 14,000 4,000 3,400
(wii). Calculation of budgeted total cost driver quantities

Budgeted output-
BTB 240
BRB 180
BCB 100
Total 520
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Budgeted number of batches produced – (output/batch size)
BTB 240/20 = 12
BRB 180/10 = 18
BCB 100/10 = 10
Total = 40
Budgeted number of materials movements – (number of batches x average number/batch)

BTB 12 x 6 = 72
BRB 18 x 6 = 108
BCB 10 x 7 = 70
Total 250
Budgeted total stockholding time per product line – (Output x average time)
BTB 240 x 2 = 480
BRB 180 x 4 = 720
BCB 100 x 5 = 500
Total 1,700
b. The memo should contain the following advantages of activity based costing (ABC), and should
be illustrated by examples from the statements in part (a):
 ABC helps a company to ascertain the profitability of each of the firm’s products by
attributing costs to them in a logical way.
 ABC aids budgeting as, by forecasting activity levels, it is possible to forecast costs.
 ABC, by identifying cost driver rates, provides an excellent basis for cost reduction
programmes.
 ABC improves managers’ understanding of the business as it focuses on the causes of
costs.
 Economy in the use of internal services can be obtained when users are charged “ABC
costs”, and can be see the direct link between use and cost.
ILLUSTRATION 3
Fly-sky Ltd is an airline catering company operating in the country. The company produces three high-
quality meal packs about which the following information is available for next year:
Pack Expected output Production staff time Total material costs

(numbers of packs) per pack (minutes) N
X 90,000 10 247,500
Y 70,000 12 250,000
Z 40,000 15 180,000
For next year the production staff budget is N187,200 with a pay rate of N5.40 per hour.
Apart from production staff and material costs, overheads are estimated at N1,010,000 and are made up as
follows:
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N'000
Ordering materials 300
Production run set ups 110
Quality control (Note 1) 90
Packing and dispatch of orders 60
Negotiation with customers 200
Central management costs (Note 2) 250
Total 1,010
Note 1 – The quality control costs are related to testing a random sample of orders dispatched.
Note 2 – The central management costs are not attributed to any activities and are to be absorbed on the
basis of production staff hours.
In the coming year, the activity volumes are expected to be:
Pack X Y Z
Set - ups 35 35 30
Orders for materials 85 110 105
Orders dispatched to customers 1,600 2,000 1,400
In the current year and in previous years, the company has absorbed overheads with production staff
hours as the absorption base. Prices have been based upon full cost plus 20%. In recent years, prices have
been steady using this approach. The costs and prices for the current year are as follows:
Product Full cost Price (full

cost + 20%)
X N7.80 N9.36
Y N9.50 N11.40
Z N12.10 N14.52
The primary customer for pack X takes 55,000 meals annually. Its purchasing manager has indicated that
he will be seeking a pack price below N9 next year.
Required
a. Determine the full cost of each pack for next year using:
i. An absorption approach with direct production staff hours as the absorption base.
ii. An activity based approach using the information given above.
b. Calculate the prices for next year under both total absorption costing and activity based costing.
Comment on the results of your calculations.
SUGGESTED SOLUTION
a.i. The full cost of each pack using absorption costing approach
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Product X Y Z
N N N
Direct costs -
- Direct materials 2.75 3.57 4.50
- Direct labour 0.90 1.08 1.35
Prime cost 3.65 4.65 5.85
Overhead absorbed 4.32 5.18 6.47
Full cost 7.97 9.83 12.32
Wi. Calculation of overhead absorption rate per hour

Budgeted hours
Products Output Hour/unit Total hours
X 90,000 10/60 15,000
Y 70,000 12/60 14,000
Z 40,000 15/60 10,000
Total budgeted hours 39,000
Overhead absorption rate per unit = N1,010,000/39,000 hrs = N25.897 per hour
Note- Overhead absorbed per unit e.g. X = N25.897 x 10/60 = N4.32 per unit.
a.ii. The full cost of each pack using activity based costing approach
Product X Y Z Total
N N N N
Overhead costs -
- Set-up 38,500 38,500 33,000 110,000
- Material orders 85,000 110,000 105,000 300,000
- Packing & dispatch 112,000 140,000 98,000 350,000
- Central costs 96,154 89,744 64,102 250,000
Total overheads 331,654 378,244 300,102 1,010,000
Output 90,000 70,000 40,000
Overhead cost per unit (N) 3.69 5.40 7.50
Prime cost per unt (N) 3.65 4.65 5.85
Full cost per unit (N) 7.34 10.05 13.35
Wi. Calculation of volume of each cost driver consumed and overhead cost per driver.
Product X Y Z Volume Total Cost per
Activity driver overhead (N) driver (N)
Set-ups 35 35 30 100 110,000 1,100
Material order 85 110 105 300 300,000 1,000
Packing & dispatch 1,600 2,000 1,400 5,000 350,000 70
Central costs 15,000 14,000 10,000 39,000 250,000 6.41
Page 47
Note: the packing and dispatch cost pool is made up of quality control of N90,000 plus packing
and dispatch of orders of N60,000 plus negotiation with customers of N200,000, since they used
same cost driver.
b. The prices for next year using full cost plus 20% mark-up
Products X Y Z
Absorption cost approach N N N
Full cost per pack 7.97 9.83 12.32
Sales price 9.56 11.80 14.78
Activity based costing approach
Full cost per pack 7.34 10.05 13.35
Sales price 8.81 12.06 16.02
The traditional absorption costing approach over-costs the high volume product X, and under-
costs the low volume product Z. The activity based costing approach demonstrates that it is
possible to meet the target price of our biggest customer for product X, as the of N9 is higher by
19 kobo than activity based costing plus 20% of N8.81.
TARGET COSTING
A target cost is a cost estimate derived by subtracting a desired profit margin from a competitive market
price. In effect it is the opposite of conventional ‘cost plus pricing’ and is sometimes referred to as ‘price
minus costing’.
It may be used in both manufacturing and service industries. It is the costing method crucial for today
competitive environment which require in-depth understanding by today’s management accountants.
The main theme behind target costing is not finding what a new product does cost but what it should or
need to cost. The firm can then focus on which costs can be reduced and which can not to see whether
such a target cost is achievable. Obviously cost reductions must be seen in the context of quality concerns
as well. This will involve product comparisons with the competitors used to set the competitive market
price in the first place.
Adopting this costing strategy involves the followings:
1. A product’s target market share is specified before it is designed.

2. The selling price necessary to capture the target market share is identified by market research.
3. The required profit margin is subtracted from the target price to obtain the maximum acceptable
cost per unit, i.e. the target cost.
4. Produce the target cost for product designer to meet especially removing the target cost gap.
Target cost gap is the difference between estimated cost and target cost of the product.
5. Technical effort, including value analysis and cost reduction techniques, is then concentrated on
designing the product and its production processes so as to achieve the target cost be eliminating
the target cost gap.
ILLUSTRATION 1
Page 48
Tejay Electronics Ltd wishes to capture 20 per cent of the market for a new type of cooling control unit.
The market size is 1,000,000 units. Market research has established that the selling price to achieve this
volume is N150 per unit. The company’s target profit margin for this type of product is 40 per cent.
Required
Calculate the target cost for the cooling control unit, and the planned profit for the product.
SUGGESTED SOLUTION
Target selling price is N150 and target profit margin is 40%, therefore, the target cost is 60% of N150 =
N90 per unit.
Target sales is 20% of 1,000,000 = 200,000 units, and target profit is N60 per unit (i.e. N150 x 40%),
therefore, planned total profit from the product = 200,000 x N60 = N12,000,000.
ILLUSTRATION 2
BT Financial Services have devised a new investment product. Total sales over the product’s life are
intended to be at least 15 per cent of the market for similar products. The total market for this category of
investment is estimated to be N80,000,000. Government regulations limit charges on financial products of
this type to 5 per cent of the amount invested. BT Financial Services will not launch the new product
unless a total profit of N250,000 can be achieved.
Required
What must be the target marketing and administration cost per N invested for the product, to the nearest
N0.01?
SUGGESTED SOLUTION
Target market = 15% x N80,000,000 = N12,000,0000

Maximum revenue = 5% x N12,000,000 = N600,000
Therefore, maximum cost must be N600,000 revenue – N250,000 target profit = N350,000.
Target cost per N invested = N350,000/N12,000,000 = N0.029 or N0.03.
LIFE CYCLE COSTING
Life cycle costing has two aspects. First, there is the prediction or budgeting of product life-costs against
which actual product costs are compared. Second, there is the budgeting of an asset’s costs and their
comparison with the actual costs incurred over the asset’s lifetime. The discussion here centered on the
first one.
The commitment of a high proportion of a product’s life cycle costs at the very early stages of the cycle
has led to the need for accounting systems that compare the revenues from a product with all the costs
incurred over the entire product life cycle. Traditional costing techniques based around annual periods
may give a misleading impression of the costs and profitability of a product.
Life cycle costing involved:

 The profiling of cost over a product’s life, including the pre-production stage.
 Tracking and accumulating the actual costs and revenue attributable to each product from
inception to abandonment.
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 Enables a product’s true profitability to be determined at the end of its economic life.
The costs involved at different stages in the product life cycle could be further discussed as follows:
1. Pre-Production/Product development stage – A high level of setup costs will be incurred in this
stage, including research and development, product design and building of production facilities.
2. Launch/Market development stage – Success depends upon awareness and trial of the product by
consumers, so this stage is likely to be accompanied by extensive marketing and promotion costs.
3. Growth stage – Marketing and promotion will continue through this stage. In this stage sales
volume increases dramatically, and unit costs fall as fixed costs are recovered over greater
volumes.
4. Maturity Stage – Initial profits will continue to increase, as initial setup and fixed costs are
recovered. Marketing and distribution economies are achieved, however, price competition and
product differentiation will start to erode profitability as firms compete for the limited new
customers remaining.
5. Decline stage – Marketing costs are usually cut as the product is phased out, production
economies may be lost as volumes fall. Meanwhile, a replacement product will need to have been
developed, incurring new levels of R&D and other product setup costs. Alternatively additional
development costs may be incurred to refine the model to extend the life cycle.
Using the life cycle cost of a product will give a better understanding of the product profitability and aid
management decision at the product launch phase.
ILLUSTRATION 1
The following details relate to a new product that has finished development and is about to be launched.
Development Launch Growth Maturity Decline

Time period Finished 1 year 1 year 1 year 1 year
R & D costs (N million) 20
Marketing costs (N million) 5 4 3 0.9
Production cost per unit (N) 1.00 0.90 0.80 0.90
Production volume (millions) 1 5 10 4
The launch price is proving a contentious issue between managers. The marketing manager is keen to
start with a low price of around N8 to gain new buyers and achieve target market share. The accountant is
concerned that this does not cover costs during the launch phase and has produced the following schedule
Launch phase N Million

Amortised R&D costs (N20/4 yrs) 5.0
Marketing costs 5.0
Production costs (1 million x N1 per unit) 1.0
Total costs 11.0
Total production (units) 1 million
Cost per unit N11.00
Page 50
Prepare a revised cost per unit schedule looking at the whole life cycle and comment.
SUGGESTED SOLUTION
Calculation of the product life cycle cost per unit

Life cycle costs N Million
Amortised R&D costs 20.0
Marketing costs (5 + 4 + 3 + 0.9) 12.9
Production costs ((1x1) + (5x0.9) + (10x0.8) + (4x0.9)) 17.1
Total life cycle costs 50.0
Total production (units) (1 + 5 + 10 + 4) 20 million
Life cycle cost per unit (50/20) N2.50
Considering the life cycle cost per unit, the product could be launched for N8 as the life cycle cost of
N2.50 is lower than the launch price, that is, the marketing manager’s proposal seems more reasonable.
BACK-FLUSH COSTING
The traditional approach is to track the cost of products through the sequential stages of production,
building up costing records for the direct materials consumed, the direct labour cost and the overhead
expense for each product or job. In this approach, the work-in-progress control account represents the
total costs of production for all the individual products, batches or jobs for which costing records are
maintained. However, if the production cycle is short and there is only a small amount of work-in-
progress at any time, it is questionable whether there is much value in building up detailed cost records as
items progress through production. This is key to back-flush accounting.
Back-flush accounting offers an abbreviated and simplified approach to costing by getting rid of
unnecessary cost records by calculating product costs retrospectively, at the end of each accounting
period.
Back-flush accounting is inappropriate for production systems where throughput is slow and the
production process is long. It is also inappropriate where the business holds high levels of inventory, and
inventory levels can increase or decrease substantially from one period to the next.
A back-flush accounting system will involve the following:
1. The cost of raw materials is allocated to a ‘raw materials and in progress’ (RIP) account.
2. Conversion costs (labour and production overheads) are allocated straight to the cost of goods
sold account.
3. At the end of the accounting period an inventory stock-take is carried out to determine closing
balances for raw materials, work-in-progress and finished goods. This is quick as there are few
inventories. Inventory values are based on budget/standard costs.
4. The closing inventory values for raw materials and work-in-progress are then ‘back-flush’ from
the cost of goods sold account into the RIP account.
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5. Similarly the closing inventory value for finished goods is ‘back-flush’ into the finished goods
account.
6. Thus with back-flush accounting there will be a significant reduction in accounting costs albeit at
the cost of reduced detail. (e.g. a split of conversion costs between production labour and
overhead is not available).
7. However, as noted above, if the production cycle is short and there is only a small amount of
work-in-progress at any time, it is questionable whether there is much value in building up
detailed cost records as items progress through production. This is key to back-flush accounting.
PREPARATION OF INCOME STATEMENTS
Marginal costing and absorption costing income statements have traditionally been the major
product of a management accounting system. In addition, the format of the income statement is
controlled by the inventory valuation component of the system. These two income statements will
be used for the purpose of this discussion.
Marginal costing technique income statement differs in presentation from that of Absorption
costing technique. Despite the differences in the format of their income statement, if the same data
is used, and there is neither opening stock nor closing stock or both, the two operating statement
will give the same profit. But if there is either opening stock or closing stock, or both, the two
operating statements will give different profit. This difference can be traced down to the difference
between their stocks. Their stocks will differ because of the difference treatment of “Fixed
Production Overhead Cost.
Marginal costing technique is an accounting system in which variable costs are charged to cost
units and the fixed costs of the period are written-off in full against the aggregate contribution, that
is, 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-in progress are valued at marginal cost only, that is, the variable elements of cost,
usually prime cost plus variable overhead. At the end of a period, the marginal cost of sales is
deducted from sales revenue to show the contribution, from which fixed costs are deducted to show
net profit.
Absorption costing, sometimes known as total absorption costing, is the basis of all financial
accounting statements. Using the technique, all costs are absorbed into production and thus
operating statements do not distinguish between fixed and variable costs. Consequently the
valuation of stocks and work-in-progress contains both fixed and variable elements. If there is an
opening part of previous year fixed production, cost will be brought forward and, and in the case of
closing stock, part of the year fixed production cost will be carried forward.
It therefore implies that stock valued using absorption costing technique is bound to higher in value
than stock valued using marginal costing technique, because while the earlier used full costs the
latter used only variable costs.
Using a manufacturing organization as a case study, an abridged format of income statement using
marginal costing technique may be presented as follows:
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ABRIDGED FORMAT OF INCOME STATEMENT USING MARGINAL COSTING
TECHNIQUE
N N
Sales XX
Less Variable costs
Variable cost of goods sold
Opening stocks XX
Add production costs(variables) XX
Less Closing stocks (XX)
XX
Add other variable costs XX XX
Total Contribution XX
Less Period Costs
Fixed production overheads XX
Fixed selling & distribution costs XX
Administration costs XX XX
Net Profit XX
Please note that, opening stock, production and closing stock will be valued using only the variable
costs of production.
Other variable costs will include variable selling expenses, sales commission and possibly variable
administration cost as may be given.
Fixed production overhead will be treated as period cost to be written off, in total to the period/year
that it is incurred. It will therefore be excluded from valuation of stock.
ABRIDGED FORMAT OF INCOME STATEMENT USING ABOSORPTION COSTING

TECHNIQUE
N N
Sales XX
Less Cost of goods sold
Opening stocks XX
Add production costs XX
Less Closing stocks (XX)
XX
Add/(less) under/(over) absorption XX/(XX) XX
Gross Profit XX
Less Expenses
Selling & distribution (fixed + variable) costs XX
Administration costs XX XX
Net Profit XX
Page 53
Please note that, opening stock, production and closing stock will be valued using full cost of
production, that is, both variable and fixed production cost.
UNDER/OVER ABSORBED FIXED PRODUCTION OVERHEAD
This will arise as a result of using what we earlier referred to as normal historical costs. To
understand this, some terms used in overhead absorption and recovery, such as the following must
be understood.
1. Budgeted fixed production overhead:- This is the estimated cost for fixed production
overhead as contained in the year’s budget based on prior experience and expected
activities.
2. Budgeted activities:- This is the estimated activities (e.g. units of production) as stated in
the budget for the given year.
3. Absorption rate:- This is the rate per activity of the budgeted fixed cost, it is otherwise
known as overhead recovery rate. It is determined by dividing the budgeted fixed
production overhead by the budgeted activities. This become necessary, since we can’t wait
till we know actual fixed production overhead before preparation of monthly income
statement and hence, the need to incorporate such gradually into the operating statement.
4. Actual activities:- This is the level of activities (e.g. units produced) attained at the point
of preparing the income statement.
5. Absorbed fixed production overhead:- This is the amount of fixed production charged or
provided for in the operating statement based on predetermined absorption rate and actual
activities attained. That is, absorbed fixed overhead = absorption rate x actual activities.
The fixed production overhead will be absorbed gradually; each time there is need for
income statement, till the end of the financial year when the actual cost will be known with
certainty.
6. Actual fixed production overhead costs:- At the end of a given period or year the actual
cost of fixed production overhead costs will be ascertained or known.
7. Under/over absorbed fixed production overhead:- When actual fixed production

overhead is compared with the absorbed, it will be clearly stated whether it is under or over
absorbed. If the absorbed fixed production overhead is higher than the actual, then it is over
absorbed, but in a situation where actual is higher than absorbed, it is under absorbed. Over
absorbed cost will be treated as a reduction from other costs or addition to income. While
under absorbed is treated as addition to cost or reduction from income.
Note that in most situations, budgeted fixed cost may be given without the actual fixed cost, since
we expect fixed cost to be constant or unchanged, the budgeted cost will be assumed to be actual,
however, there will be under or over absorbed fixed production overhead, if the actual activities is
lower or higher than the budgeted activities.
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Equally, where standard cost is used, adverse variance from expenses will be addition to such
expenses to arrive at actual costs and favourable variance will be a deduction from such expenses to
arrive at actual cost.
Despite the difference in the income statements using marginal and absorption costing, using the
same data to prepare income statement, the two techniques will give the same net profit under the
following conditions:
1. When stocks is not involved, that is, there is neither opening nor closing or both stocks.
2. When there are opening and closing stocks and the quantities are the same e.g. 5,000 units
each for opening and closing stock.
While their net profit will differ under the following conditions:
1. When there is opening and no closing stock, or there is closing no opening stock.
2. There are opening and closing stocks and the quantities differs.
The difference between the net profit of marginal and absorption costing technique when stock is
involved can be reconciled using the following format:-
1. Where there is a single stock (that is, either opening or closing stock but not both)
Profit Stock
N N
Marginal costing technique XX XX
Absorption costing technique XX XX
Difference XX XX
The difference must be the same to state that the difference in profit is as a result of difference in
stock and stock differs because of different treatment of fixed production overhead.
2. When there are opening and closing stocks

Stock Profit
N N N
Marginal costing technique
Opening stock XX
Closing stock XX XX X1 XX
Absorption costing technique
Opening stock XX
Closing stock XX XX X2 XX
Difference XX XX
X1 the difference between marginal costing opening and closing stock.

X2 the difference between absorption costing opening and closing stock.
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The difference between the differences in stocks (opening and closing) must be equal to the
difference in the profits for the comment as above. Please note that, in the calculation above all
figures will be treated in absolute term, that is, ignoring negative sign and make all figures positive.
EQUIVALENT UNITS
A measure of the number of production units being manufactured including completed units and
partially manufactured units comprising units in work-in-progress that are partially completed at
the beginning and end of a period. To ascertain unit cost, that is, average cost per unit, and then
using this unit cost to assign the cost to be accounted for to the units completed and the units
partially completed beginning and ending inventory. Within a period some units will be 100%
completed, while there will partially completed units in the opening and closing work-in-progress.
To calculate a cost per unit we must state all units in terms of a common denominator. This
common denominator is referred to as an equivalent whole unit, or equivalent unit for short. For
example, 100 units ½ complete represents 50 equivalent units. The stage of completion for the
beginning and ending inventories is used to calculate the equivalent units for those categories. This
stage of completion for a group of units is based on an estimate of the average level of completion
for all the units in the group.
ILLUSTRATION 1
The following information relates to the operation of A Company.
Per Unit N
Sales price 50
Direct material cost 18
Variable production overhead 3
Direct wages 4
Per Month
Fixed production overhead 99,000
Fixed selling expenses 14,000
Fixed administration expenses 26,000
Variable selling expenses are 10% of sales value normal capacity is 11,000 units per month.
Production and sales for the months of March and April for the year are as follows:
March April
Units Units
Sales 10,000 12,000
Production 12,000 10,000
Required:-
a. Prepare profit statement for each of the two months using

1. Marginal costing technique
2. Absorption costing technique
Page 56
b. Reconcile the profit of marginal costing between March and April
c. Reconcile the profit of absorption costing technique between March and April
d. Reconcile the profit between marginal costing technique and absorption costing technique
for the month of March and April.
SUGGESTED SOLUTION
Preliminary Workings
1. Closing stock in March, which will be opening stock in April = 12,000 – 10,000 = 2,000
units
2. Variable cost of production per unit N
Direct material cost 18
Direct wage 4
Cost per unit 25
3. Full cost of production per unit N

Variable cost 25
Add absorption rate (N99,000/11,000) 9
Cost per unit 34
4. Calculation of under/(over) absorbed fixed production overhead (FPO)

Month March April
Production Unit 12,000 10,000
Absorption rate N9 N9
Absorbed FPO (N) 108,000 90,000
Actual FPO (N) 99,000 99,000
Under/ (over) absorbed FPO (N) -9,000 9,000
Normal capacity is used here to determine the absorption rate because, that is the expected
production unit earlier referred to as budgeted unit.
(a) i. Profit statement for the two months using marginal costing technique
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Months March April
N N N N
Sales 500,000 600,000
Less variable costs
- variable cost of goods sold
Opening stock - 50,000
Add production cost 300,000 250,000
Less closing stock (50,000) -
250,000 300,000
-Add variable selling expenses 50,000 (300,000) 60,000 (360,000)
Total Contribution 200,000 240,000
Less Period Costs
Fixed production overhead 99,000 99,000
Fixed selling expenses 14,000 14,000
Fixed administration expenses 26,000 (139,000) 26,000 (139,000)
Net Profit 61,000 101,000
a. ii. Budgeted profit statement for the months using absorption costing technique.
Months March April

N N N N
Sales 500,000 600,000
Less cost of goods sold
Opening stock - 68,000
Add production cost 408,000 340,000
Less closing stock (68,000) -
340,000 408,000
(Less)/add(over)/Under Absorbed (9,000) (331,000) 9,000 (417,000)
Gross Profit 169,000 183,000
Less Expenses
Variable selling expenses 50,000 60,000
Fixed selling expenses 14,000 14,000
Fixed administration expenses 26,000 (90,000) 26,000 (100,000)
Net Profit 79,000 83,000
b. To reconcile two periods or months profit of marginal costing technique, the difference can
be traced to changes in the following.
(i) The increase or decrease in profit as a result of decrease or increase in variable cost rate per
unit:- When volumes increase or decrease, cost is expected to move in sympathy level with
volume but variable cost per unit is expected to be constant. In a situation where the
variable cost per unit increase or decrease, such increase or decrease will have a direct
Page 58
effect on the profit. But in this problem a constant variable cost per unit of N25 is
maintained, therefore, there will be no increase or decrease to affect the profit.
(ii) Increase or decrease in volume:- Volume increase or decrease will affect profit in relation
to the decrease in contribution. Any expected increase or decrease in contribution, as a
result of increase or decrease in volume will affect profit directly. For example units sold
increase from 10,000 units to 12,000 units between March and April, that is, an increase of
2,000 units. The contribution per unit = N50 – N30 = N20. The N30 total variable cost per
unit include variable selling expenses of 10% x N50 = N5. Therefore April contribution
and profit is expected to increase by 2,000 units x N20 = N40,000.
(iii) Increase or decrease in selling price:- If selling price increase or decrease it will lead
increase or decrease profit directly. The effect can be computed by comparing what the
sales value will be assuming at old rate, with what it is at the new rate. The difference will
increase or decrease profit directly. Illustration 2 below is a good example as a constant
selling price of N50 is used for the two months in the problem at hand.
(iv) Increase or decrease in fixed cost:- Any increase or decrease in fixed cost will affect profit
directly, as fixed cost is expected to be constant. In this problem the fixed cost is constant
and therefore has no effect on profit.
In conclusion, the difference in the two months profit using marginal costing technique could be
traced down to increase in volume as in ii above.
Reconciliation of the profits

N
March profit 61,000
Add increase in contribution as a result of increase in Volume 40,000
April profit 101,000
c. To reconcile the profit of absorption costing technique the two months, apart from
consideration of the four itemized point under marginal costing technique, fixed cost will
be reviewed from two dimensions, especially where fixed production overhead is absorbed
into production cost. The effect of fixed production overhead will be considered separately
from other fixed cost. The total fixed production overhead cost included or written off in
each month income statement will be determined by considering fixed cost included in
opening stock, production cost, closing stock and under/over absorption.
This can be determined as follows:-

March April
N N
Opening stock - (2,000 units x N9 ) 18,000
Add production (12,000 x N9) 108,000 (10,000 unit x N9) 90,000
Less closing stock (2,000 x N9) (18,000) -

Add/(less) under/(over) Abs. (9,000) 9,000
FPO written off to the month 81,000 117,000
Note N9 is the absorption rate of fixed production overhead.
The increase in fixed production overhead charged in April = N117,000- N81,000 =

N36,000
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Therefore, the difference in the two profits can be traced to increase in volume and fixed
production overhead written off or charged to each month.
Reconciliation of the profit N

March profit 79,000
Add increase in contribution as a result of increase in volume 40,000
Less increase in fixed production overhead written off (36,000)
April Profit 83,000
d. Reconciliation of marginal and absorption costing techniques profit for the months. Since
only a single stock is involve in the two months, that is, March opening stock, and April
closing stock, the first format will be used.
March Profit Stock
N N
Marginal costing technique 61,000 50,000
Absorption costing technique 79,000 68,000
The difference in profit is due to difference in stock and stock differs because of different
treatment of fixed production overhead.
April Profit Stock
N N
Marginal costing technique 101,000 50,000
Absorption costing technique 83,000 68,000
Comment same as above.
ILLUSTRATION 2
A Manufacturing business presents you with the income statement of the operation of the business
for the accounting years ended 31/12/97 and 1998 respectively as follows:-
1997 1998
N'000 N'000
Sales 2,000 3,500
Direct material 200 300
Direct labour 600 700
Variable production overhead 100 200
Sales commission 20 45
Advertisement 10 15
Other fixed cost 70 90
Total Cost 1,000 1,350
Net profit 1,000 2,150
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You are further provided with the following information.
i. Selling price of the Company’s product increase in 1998 by 40%
ii. 20% of direct material is fixed while 10% of direct labour and sales commission is also
fixed.
iii. There was no opening or closing stock as the product is internationally accepted and enjoys
the monopolistic market.
Required
Show the analysis of the difference in net profit over the 2 years.
SUGGESTED SOLUTION
The difference can be traced down to the following

(a) Increase in selling price
(b) Increase in volume of sales and contribution
(c) Increase in variable costs
(d) Increase in fixed costs.
a. Increase in profit as a result of increase in selling price.

N’000
1998 sales at 1998 selling price 3,500
1998 sales at 1997 selling price ( N3,500 x 100/140) 2,500
Increase in profit 1,000
b. Increase in profit due to increase in sales volume:- Since selling price and variable cost per
unit is not given, the effect can be determined by computing the contribution margin ratio
for 1997 which will be applied on the increase in sales value.
1997 contribution and contribution margin ratio.

N’000 N’000
Sales 2,000
less variable costs
Direct material (80% x 200) 160
Direct labour (90% x 600) 540
Sales commission (90% x 20) 18 -818
Total Contribution 1,182
Contribution margin ratio = N1,182/N2,000 x 100/1 = 59.1%
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The increase in sales value due to increase in sales volume
N’000
1998 sales at 1997 selling price N3,500 x 100/140 2,500
1997 sales at 1997 selling price 2,000
Increase in sales value due to volume increase 500
The increase in contribution and profit due to increase in sales volume will therefore =
N500 x 59.1% = N295.5
c. Decrease in profit due to increase in variable costs:- With increase in sales volume of
N500,000, variable cost is expected to increase by N500/N2,000 x 100/1 = 25%, that is,
1998 variable cost is expected to be 125% of 1997. Any increase above this level will
affect profit.
The excess increase can be determined as follows:-

Actual Expected Actual Difference
1997 1998 1998
N'000 N'000 N'000 N'000
Direct material 160 200 240 (40)
Direct labour 540 675 630 45
Variable production overhead 100 125 200 (75)
Sales commission 18 23 41 (18)
Increase in variable cost (88)
d. Decrease in profit as a result of increase in fixed cost. Fixed cost is expected to be constant
but any increase or decrease in the cost will directly affect profit.
Calculation of increase in fixed cost.

1997 1998 Difference
N'000 N'000 N'000
Direct material (20%) 40 60 -20
Direct labour (10%) 60 70 -10
Sales commission 2 4.5 -2.5
Advertisement 10 15 -5
Other fixed costs 70 90 -20
Increase in fixed cost -57.5
Reconciliation of the profits

N'000
1997 profit 1,000
Add increase due to selling price 1,000
Add increase due to sales volume 295.5
Less decrease due to variable cost -88
Less decrease due to fixed cost -57.5
1998 profit 2,150
Page 62
ILLUSTRATION 3
A new subsidiary of a group of companies was established for the manufacture and sales 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 material 714,000
Variable overhead 100,000
Fixed overhead 350,000
Selling and administration costs for the year were:-

Variable cost
Per unit sold Fixed cost
N N
Selling 1.50 200,000
Administration 0.10 50,000
The accountant of the subsidiary company had prepared a profit statement on the absorption costing
principle which showed a profit of N11, 000.
The financial controller of the group, however, had prepared profit statement on a marginal costing
basis, which showed a loss. Faced with these two profit statements, the director responsible for this
particular subsidiary company is confused.
a. Prepare a statement showing the equivalent units produced and the production cost of one
unit of product X by each element of cost and also in total.
b. Prepare a profit statement on the absorption costing principle, which agree with the
company accountant statement.
c. Prepare a profit statement on the marginal costing principle showing the loss.
d. Prepare the differences between the two statements given 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.
SUGGESTED SOLUTION
(a) i. The equivalent units produced

Direct material Direct labour Variable O/H Fixed O/H
Unit Sold 90,000 90,000 90,000 90,000
Closing Stock FG 8,000 8,000 8,000 8,000
Closing Stock WIP 4,000 2,000 2,000 2,000
Equivalent Unit 102,000 100,000 100,000 100,000
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Please note that, the problem of equivalent unit always arise whenever there is opening or
closing or both, stock of work-in-progress and in such situation we need to compute
equivalent unit by the cost element, for example material is 100% completed, therefore
4,000 units will be taken, while labour and overheads is half completed, that is, 50% x
4,000 = 2,000 units.
ii. The production cost of one unit of product X

N
Direct material (N714,000/102,000) 7.00
Direct Labour (N400,000/100,000) 4.00
Variable overhead (N100,000/100,000) 1.00
Fixed overhead (N350,000/100,000) 3.50
Total cost per unit 15.50
(b) The profit statement for the company using the absorption costing technique.
N'000 N'000
Sales (90,000 x N20) 1,800
Less Cost of goods sold
Production Cost (714 + 400 + 100 +350) 1,564
Less closing stock ( w1) -169 -1,395
Gross Profit 405
Less Expenses
Variable selling (N1.50 x 90,000) 135
Fixed selling 200
Variable administration (N0.10 x 90,000) 9
Fixed administration 50 -394
Net Profit 11
(w1) Calculation of the value of closing stock

N
Closing stock FG (8,000 x N15.50) 124,000
Closing stock WIP- Material (4,000 x N7) 28,000
- Labour (2,000 x N4) 8,000
- Variable O/H (2,000 x N1) 2,000
- Fixed O/h (2,000 x N3.50) 7,000
Value of closing stock 169,000
(c) The profit statement for the company using the marginal costing technique
N'000 N'000
Sales (90,000 x N20) 1,800
Less Variable costs
variable cost of goods sold
Production Cost (714 + 400 + 100) 1,214
Less closing stock ( w2) -134
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1,080
Add other variable costs
Variable selling (N1.50 x 90,000) 135
Variable administration (N0.10 x 90,000) 9 -1,224
Total Contribution 576
Less Period Cost
Fixed Overhead 350
Fixed selling 200
Fixed administration 50 -600
Net Profit -24
(w2). Calculation of the value of closing stock

N
Closing stock FG (8,000 x N12) 96,000
Closing stock WIP- Material (4,000 x N7) 28,000
- Labour (2,000 x N4) 8,000
- Variable O/H (2,000 x N1) 2,000
Value of closing stock 134,000
(d) Reconciliation of the profit/loss of the two techniques.

Profit Stock
N'000 N'000
Absorption Costing Technique 11 169
Marginal Costing Technique -24 134
Difference 35 35
From the reconciliation above, the difference in their profit or loss is as a result of difference in
stocks. Stocks differ because using absorption costing fixed overhead is included in the valuation of
closing stock, whereas, marginal costing excludes such in the valuation of its stock.
ILLUSTRATION 4
Assume the following information is available for the Hollow Company for February 200X.
Beginning inventories: N
Direct materials 15,000
Work in process 38,000
Finished goods 26,000
Ending inventories:
Work in process 40,000
Finished goods 28,000
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Direct materials purchased 90,000
Direct labor used 100,000
Indirect manufacturing costs:
Indirect material 15,000
Indirect labor 40,000
Depreciation 50,000
Electric power 60,000
Property taxes & Insurance 5,500
Repair and maintenance 25,000
Miscellaneous 8,500
Selling and Administrative expenses 45,000
Sales 625,000
Required
Assume full absorption costing is used and calculate the following amounts.
a. Cost of direct material used.

b. Total manufacturing costs.
c. Cost of goods manufactured.
d. Cost of goods sold.
e. Gross profit (or gross margin).
f. Net income.
g. Prepare an Income Statement and separate Schedule of Cost of Goods Manufactured for
the Hollow Company for February.
SUGGESTED SOLUTION
Hollow Company.
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N N
Beginning Inventories 15,000
Add Purchases of Inventories 90,000
Less Ending Inventories (20,000)
a. Cost of Raw Materials Purchases 85,000
Add beginning Work in Progress 38,000
Add Labour Cost used 100,000
Add Indirect Manufacturing Costs
- Indirect Materials 15,000
- Indirect Labour 40,000
- Depreciation 50,000
- Electric Power 60,000
- Property Taxes & Insurance 5,500
- Repairs & Maintenance 25,000
- Miscellaneous 8,500 204,000
Less Ending Work in Progress (40,000)
b. Total Manufacturing Costs 387,000
Add Beginning Finished Goods 26,000
Less Closing Finished Goods (28,000)
c. Cost of Goods Sold 385,000
Sales 625,000
d. Gross Profit (or Gross Margin) 240,000
Selling & Administrative Expenses (45,000)
e. Net Income 195,000
f. Income Statement for Hollow Company

N N
Sales 625,000
Less Cost of Goods Sold
Beginning Finished Goods 26,000
Cost of Goods Manufactures 387,000
Cost of Goods Available for Sales 413,000
Less Ending Finished Goods (28,000) 385,000
Less Selling & Administrative Expenses (45,000)
Net Income 195,000
ILLUSTRATION 5
The Pot Company produces two products A and B. The annual quantities produced in a recent
period were 500 units of A and 2,000 units of B. Product A requires 2 direct labour hours per unit
and product B requires 1 direct labour hour per unit. Activity overhead cost pools and activity
measurements for activity based costing calculations are presented below:
Activity Cost of Activity Activity measure Quantity Used Quantity Used
N by Product A by Product B
Purchasing 400,000 Ordering hours 100 60
Material handling 600,000 number of times handled 50 200
Engineering 600,000 Engineering work orders 50 50
Total 1,600,000
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Required
a. Calculate the unit overhead costs for product A and B using activity based costing
method.
b. Calculate the unit overhead costs for product A and B using the traditional method. Do
not use the number of units produced as the allocation basis.
c. By how much will the traditional methods over/under states the overhead cost of each
product when compared with activity based costing method.
a. What is the concept of activity based all about?
SUGGESTED SOLUTION
a. Activity cost rate using activity based costing
Purchasing = N400,000/160 = N2,500 per ordering hour
Material handling = N600,000/250 = N2,400 per handling
Engineering = N600,000/100 = N6,000 per engineering work
ABC cost traced to Products

Activity workings Product A workings Product B
Purchasing 100 x N2,500 250,000 60 x N2,500 150,000
Material handlings 50 x N2,400 120,000 200 x N2,400 480,000
Engineering 50 x N6,000 300,000 50 x N6,000 300,000
Total Overhead Cost 670,000 930,000
Number of Units 500 2,000
Cost per Unit 1,340.00 465.00
b. Traditional Overhead rate
Total direct labour hours = (500 x 2hr) + (2000 x 1hrs) = 3,000 hours
Cost per hour N1,600,000/3,000 = N533.33 hours.
Cost traced to Products using Traditional approach
Product A = N533.33 x 2hrs = N1,066.66 per unit
Product B = N533.33 x 1hr = N533.33 per unit
c. Under/(Over) statement by the traditional method

Product A Product B
N N
Traditional Method Cost per Unit 1,066.66 533.33
ABC Method Cost per Unit 1,340.00 465.00
Under/(over) Statement 273.34 (68.33)
d. Activity based costing is a relatively new type of procedure that can be

used as an inventory valuation method. The technique was developed
to provide more accurate product costs. This improved accuracy is
accomplished by tracing costs to products through activities. In other
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words, costs are traced to activities (activity costing) and then these
costs are traced, in a second stage, to the products that use the
activities. Another way to express the idea is to say that activities
consume resources and products consume activities. Essentially, an
attempt is made to treat all costs as variable, recognizing that all costs
vary with something, whether it is production volume or some non-
production volume related phenomenon. Both manufacturing costs and
selling and administrative costs are traced to products in an activity
based costing system.
FURTHER PRACTISING QUESTIONS
1. How does activity-based costing (ABC) differ from the traditional approach? What is the
underlying difference in the philosophy of each?
2. The use of activity-based costing in helping to deduce full costs has been criticized. What has
tended to be the basis of this criticism?
3. Tiwa Ltd makes a range of suitcases of various sizes and shapes. There are 10 different models of
suitcase produced by the business. In order to keep inventories of finished suitcases to a
minimum, each model is made in a small batch. Each batch is costed as a separate job and the
cost for each suitcase is deduced by dividing the batch cost by the number of suitcases in the
batch.
At present, the business derives the cost of each batch using a traditional job-costing approach.
Recently, however, a new management accountant was appointed, who is advocating the use of
activity-based costing (ABC) to deduce the cost of the batches. The management accountant
claims that ABC leads to much more reliable and relevant costs and that it has other benefits.
Required:
a. Explain how the business deduces the cost of each suitcase at present.
b. Discuss the purposes to which the knowledge of the cost for each suitcase, deduced on a
traditional basis, can be put and how valid the cost is for the purpose concerned.
c. Explain how ABC could be applied to costing the suitcases, highlighting the differences
between ABC and the traditional approach.
d. Explain what advantages the new management accountant probably believes ABC to have
over the traditional approach.
4. Suzzy Ltd is a business engaged in the development of new products in the electronics industry.
Subtotals on the spreadsheet of planned overheads reveals:
Electronics Testing Service
Department department department
Overheads: variable (N’000) 1,200 600 700
Fixed (N’000) 2,000 500 800
Planned activity: Direct labour hours (N’000) 800 600
The three departments are cost centres.

For the purposes of reallocation of service department’s overheads, it is agreed that variable
overhead costs vary with the direct labour hours worked in each cost centre. Fixed overheads of
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the service cost centre are to be reallocated on the basis of maximum practical capacity of the two
product cost centres, which is the same for each.
The business has a long-standing practice of making up full manufacturing costs by between 25
per cent and 35 per cent in order to establish selling prices.
It is hoped that one new product, which is in a final development stage, will offer some
improvement over competitors’ products, which are currently marketed at between N90 and
N110 each. Product development engineers have determined that the direct material content is N7
a unit. The product will take 2 labour hours in the electronics department and 1.5 hours in testing.
Hourly labour rates are N20 and N12, respectively.
Management estimates that the fixed costs that would be specifically incurred in relation to the
product are: supervision N13,000, depreciation of a recently acquired machine N100,000, and
advertising N37,000 a year. These fixed costs are included in the table above.
Market research indicates that the business could expect to obtain and hold about 25 per cent of
the market or, optimistically, 30 per cent. The total market is estimated at 20,000 units.
Note: It may be assumed that the existing plan has been prepared to cater for a range of products
and no single product decision will cause the business to amend it.
Required:
a. Prepare a summary of information that would help with the pricing decision for the new
product. Such information should include marginal cost and full cost implications after
allocation of service department overheads.
b. Explain and elaborate on the information prepared.
SUGGESTED SOLUTIONS
1. ABC is a means of dealing with charging overheads to units of output to derive full costs in a
multi-product (job or batch costing) environment.
The traditional approach tends to accept that once identifiable direct costs, normally labour and
materials, have been taken out, all of the other costs (overheads) must be treated as common costs
and applied to jobs using the same formular, typically on the basis of direct labour hours.
ABC takes a much more enquiring approach to overheads. It follows the philosophy that
overheads do not occur for no reason, but they must be driven by activities. For example, a
particular type of product may take up a disproportionately large part of supervisors’ time. If that
product were not made, in the long run, supervision costs could be cut (fewer supervisors would
be needed). Whereas the traditional approach would just accept that supervisory salaries are an
overhead, which needs to be apportioned along with other overheads, ABC would seek to charge
that part of the supervisors’ salaries which is driven by the particular type of product, to that
product.
2. One criticism is on the issue of the cost/benefit balance. It is claimed that the work necessary to
analyse activities and identify the cost drivers tends to be more expensive than is justified by the
increased quality of the full costs that emerge.
Linked to this is the belief of many that full cost information is of rather dubious value for most
purposes, irrespective of how the full costs are deduced. Many argue that full cost information is
flawed by the fact that it takes no account of opportunity costs.
ABC enthusiasts would probably argue that deducing better quality full costs is not the only
benefit which is available, if the overhead cost drivers can be identified. Knowing what drives
costs can enable management to exercise more control over them. This benefit needs to be taken
into account when assessing the cost/benefit of using ABC.
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3. Tiwa Ltd
a. The business makes each model of suitcase in a batch. The direct materials and labour costs
will be recorded in respect of each batch. To these costs will be added a share of the
overheads of the business for the period in which production of the batch takes place. The
basis of the batch absorbing overheads is a matter of managerial judgment. Direct labour
hours spent working on the batch, relative to total direct labour hours worked during the
period, is a popular method. This is not the ‘correct’ way, however. There is no correct way.
If the activity is capital-intensive, some machine hour basis of dealing with overheads might
be more appropriate, though still not ‘correct’. Overheads might be collected, cost centre by
cost centre (department by department), and charged to the batch as it passes through each
product cost centre. Alternatively, all of the overheads for the entire production facility might
be totaled and the overheads dealt with more globally. It is only in restricted circumstances
that overheads charged to batches will be affected by a decision to deal with them by cost
centres, rather than globally. Once the ‘full costs’ (direct costs plus a share of indirect costs)
has been ascertained for the batch, the cost per suitcase can be established by dividing the
batch cost by the number in the batch.
b. The uses to which full cost information can be put have been identified as:
 For pricing purposes: In some industries and circumstances, full costs are used as
the basis of pricing. Here the full cost is deduced and a percentage is added on for
profit. This is known as cost-plus pricing. A solicitor handling a case for a client
probably provides an example of this.
In many circumstances, however, suppliers are not in a position to deduce prices
on a cost-plus basis. Where there is a competitive market, a supplier will probably
need to accept the price that the market offers – that is, most suppliers are ‘price
takers’ not ‘price makers’.
 For income-measurement purposes: To provide a valid means of measuring a
business’s income, it is necessary to match expenses with the revenue realized in
the same accounting period. Where manufactured products are made or partially
made in one period but sold in the next, or where a service is partially rendered in
one accounting period but the revenue is realized in the next, the full cost
(including an appropriate share of overheads) must be carried from one
accounting period to the next. Unless we are able to identify the full cost of work
done in one period, which is the subject of a sale in the next, the profit figures of
the periods concerned will become meaningless.
Unless all related production costs are charged in the same accounting period as
the sale is recognized in the income statement, distortion will occur that will
render the income statement much less useful. Thus it is necessary to deduce the
full cost of any production undertaken completely or partially in one accounting
period but sold in a subsequent one.
 For budgetary planning and control: Often budgets are set in terms of full costs. If
budgets are to be used as the yardsticks that actual performance is to be assessed,
the information on actual performance must also be expressed in the same full-
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cost terms. Knowing the full cost of the suitcases might be helpful in these
activities.
 General decision making: Knowing the full cost of the suitcases might be helpful
in making a decision as to whether to continue to make all or some of the models.
It is argued, however, that relevant costs, which might be just the variable costs,
would provide a more helpful basis for the decision.
c. Whereas the traditional approach to dealing with overheads is just to accept that they exist
and deal with them in a fairly broad manner, ABC takes a much more enquiring approach.
ABC takes the view that overheads do not just ‘occur’, but that they are caused or ‘driven’ by
‘activities’. It is matters of finding out which activities are driving the costs and how much
cost they are driving.
For example, a significant part of the costs of making suitcases of different sizes might be
resetting machinery to cope with a batch of a different size from its predecessor batch. Where
a particular model is made in very small batches, because it has only a small market, ABC
would advocate that this model is charged directly with its machine-setting costs. The
traditional approach would be to treat machine setting as a general overhead that the
individual suitcases (irrespective of the model) might bear equally. ABC, it is claimed, leads
to more accurate costing and thus to more accurate assessment of profitability.
d. The other advantage of pursuing an ABC philosophy and identifying cost drivers is that, once
the drivers have been identified, they are likely to become much more susceptible to being
controlled. Thus assessment by management of the benefit of certain activities against their
cost becomes more feasible.
4. Suzzy Ltd.
a. Overheads analysis per direct labour hour
N’000 N’000 N’000
Variable overheads 1,200 600 700
Apportionment of service dept (800:600) 400 300 (700)
1,600 900 -
Direct labour hours (‘000) 800 600
Variable overheads per direct labour hour N2.00 N1.50

N’000 N’000 N’000
Fixed overheads 2,000 500 800
Apportionment of service dept (equally) 400 400 (800)
2,400 900 -
Direct labour hours (‘000) 800 600
Variable overheads per direct labour hour N3.00 N1.50
The estimation of the sales price
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N
Direct materials 7.00
Direct labour: Electronics (2 x N20) 40.00
Testing (1.5 x N12) 18.00
Variable overheads: Electronics (2 x N2) 4.00
Testing (1.5 x N1.50) 2.25
Total variable cost 71.25
Fixed overheads: Electronics (2 x N3) 6.00
Testing (1.5 x N1.50) 2.25
Average full cost 79.50
Add mark-up (say 30%) 23.85
Sales price 103.35
On the basis of the above, the business could hope to compete in the market at a price
that reflects normal pricing practice.
b. At this price, and only taking account of incremental fixed overheads, the break-even point
(BEP) would be given by: BEP = Fixed costs/Contribution per unit = N150,000/N103.35 – N71.25
= 4,673 units (N13,000 + N100,000 + N37,000, namely the costs specifically incurred).
As the potential market for the business is around 5,000 to 6,000 units a year, the new product
looks viable.
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CHAPTER 4
COST VOLUME – PROFIT ANALYSIS
I was relatively new in a company that deal in buying and supplying of computers and computer
accessories, the managing director made a request on me one day that as the company accountant I
need seat down and come up with figure on the volume and value of transactions we as a company
must execute to be able to meet our costs and achieve the profit target given to us by the board of
directors. I sat for some hours before I could connect that what I need to apply is the principle of
cost volume profit analysis. It is principle that is well known and of high demand by management
to aid planning.
This is one of the principles used in management account to forecast or predict future activity level
either in volume or in value. It is one of the techniques used by management accountant to assist
management in its planning and decision-making responsibility. Commonly used in today’s
business environment where every manager needs to know the break-even point and or the
expected sales to achieve expected return.
Cost Volume-profit analysis otherwise known as break-even point analysis, involves the study of
the relationship that exists between costs, level of activity and profit, for the main purpose of
projecting future activities. The method makes use of the behavioural classification of costs, that is,
a given cost should either be a variable or fixed cost. Therefore, costs must be effectively separated
into fixed and variable element before the application of the principle.
Using this principle, organizations are broadly categorized into two as: -
1. Single product organization

2. Multi product organization
There are two methods used for projecting future activities, they are
1. Mathematical method
2. Graphical method
Using the technique, the following projection can be made
1. The sales or revenue or income in volume or value that equates total costs, that is, break-
even point.
2. The sales or revenue or income in volume or value with a predetermined or desired profit.
Using mathematical method for a single product organization, the above can be projected using the
following:-
Volume of sales/revenue/income that equates total costs by
BEP (V) = FC/CM or (FC/CMR)/SP
Value of sales/revenue/income that equates total costs by
BEP (N) = FC/CMR or (FC/CM) X SP
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Volume of sales/revenue/income at a predetermined or desired profit by
BEP (V) (P) = (FC+P)/CM or ((FC+P)/CMR)/SP
Value of sales/revenue/income at a predetermined or desired profit by
BEP (N) (P) = (FC+P)/CMR or (FC+P)/CM X SP
These equations can be easily memorized but the most important is the ability to define each of the
variable accurately, therefore it is necessary we note the definition as follows:
BEP = break-even point,
FC = total fixed cost, that is, the organizational total fixed cost, both relating to production,
distribution, marketing and administration, remember this, total fixed cost for the
company as a whole.
CM = Contribution Margin, that is, contribution per volume of the given product, drivable
by deducting variable cost per volume from the unit selling price i.e. SP –VC =
CM.
CMR = Contribution Margin Ratio, otherwise known as profit volume ratio (P/V ratio), it
is the proportion or percentage of contribution on sales/revenue/income. It can be
determined as follows:
CMR= (SP-VC)/SP X 100/1, where SP = selling price & VC = variable cost/activity or
CMR= (TR-TVC)/TR X 100/1, where TR= total revenue & TVC = Total variable cost or
CMR= TC/TR X 100/1, where TC = total contribution & TR = total revenue or
CMR= (FC+P)/TR X 100/1, where FC= total fixed cost, P=profit & TR=total revenue
SP = Sales price per a given activity.
P= Desired/predetermined profit. Note that this profit must be profit before tax, where
profit after tax is given, this must be converted to profit before tax using
PBT=PAT/(1-TR), where PBT=profit before tax, PAT=profit after tax & TR=tax
rate.
ASSUMPTIONS OF COST VOLUME PROFIT ANALYSIS
There are some basic requirements for the application of this principle. These are sometimes
referred to as the conditions or what must be in place before the theory becomes applicable. Of
these assumptions the first three, are the primary assumptions or principal necessities in applying
the principle to any organizations. These conditions are as follows: -
1. Sales price must be known and it must be constant.

2. Variable cost per activity must be known and it must be constant, i.e., there will be
neither quantity nor cash discount.
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3. Total fixed cost to the organization is known and should be constant, i.e., activities must
be within the relevant range, within which fixed cost is expected to be constant.
4. All unit produced is expected to be sold, i.e., there will be neither opening nor closing
stock.
5. All factors of production are assumed to be expressed mathematically and are expected to
be available at all time.
6. Costs maintain only a single linear relationship with volume, or in other words volume is
the only cost driver.
7. Level of technology, production methods and efficiency remain unchanged.
8. No inflation in prices is expected.
9. The sales mix will remains unchanged during the period.
LIMITATION OF COST VOLUME PROFIT ANALYSIS
1. The method assumes constant variable cost per unit. This may not be attainable because
of quantity and cash discount.
2. Innovation and development bring about changes in the level of technology.
3. The method ignores other market determinants, which may be a constraint to production
and sales.
4. The method assumes no labour turnover, which is impracticable because of labour
rotation and labour changing jobs.
5. There are many other factors affecting production and sales, which cannot be expressed
mathematically.
6. The theory emphasis is in the short term. This makes it inappropriate for planning
purposes where the time scale stretches over several years.
MARGIN OF SAFETY
Margin of safety is the sales in excess of break-even point sales, or in another words the sale above
the break-even point. It is that portion of sales from which profit can be earned. For example, if a
company turnover is N200m and break-even point is N150M, the margin of safety will be N50m,
that is N200m – N150m = N50m.
ILLUSTRATION 1
Jayeola Company produces dairy size calculators that are sold for N120 per unit. The costs
associated with each unit are as follows: Direct material = N30, Direct labour = N25, Variable
overhead N20, and Variable selling and administration cost = N5. Total fixed costs are N500,000
for manufacturing and N200,000 for selling and administrative functions. The company’s tax rate is
40%.
In a recent meeting, the board of directors asked the following questions. How many dairies do we
need to produce and sell to accomplish each of the following requirements?
a. Break-even.
b. Earn a net income before tax of N300, 000.
c. Earn a net income after tax of N240, 000.
d. Earn a 20% return on sales before tax.
e. Earn a 15% return on sales after tax.
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SUGGESTED SOLUTION
To answer these questions, we start by calculating the contribution per unit as follows:
CM= N120-N30-N25-N20-N5 = N40
Total fixed costs =N500,000 + N200,000 = N700,000
a. The expected sales units = BEP(V)= FC/CM = N700,000/N40 = 17,500 units
b. The expected sales units at profit before tax of N300,000 = BEP(V)(P)=(FC+P)/CM =

(N700,000+N300,000)/N40 = 25,000 units
c. The profit should be converted to profit before tax i.e. PBT= N240,000/(1-.4) = N400,000
The expected sales units= BEP(V)(P)= (N700,000+N400,000)/N40 = 27,500 units.
d. Let the expected sales units be represented by X, the expected profit will be 20% x N120X
The formula for expected sales units at a profit i.e. BEP(V)(P)= (FC+P)/CM, substituting,
The equation becomes X=(N700,000+ .2(N120X))/N40
N40X=N700,000 + N24X
X= N700,000/N16 = 43,750 units
e. Using the same basis as in d above, but this time around converting profit
after tax to before tax. X=(N700,000+(.15(N120X)/(1-.4))/N40
N40X=N700,000+N30X
X= N700,000/N10 = 70,000 units
ILLUSTRATION 2
Universal Limited has recently leased manufacturing facilities for the production of its one single
product. Studies carried out by the cost analysis revealed the following:-
Per
Estimated Costs Amount Unit
N N
Direct materials 96,000 4.00
Direct Labour 14,400 0.60
Factory overhead 24,000 1.00
Administrative expenses 28,800 1.20
163,200 6.80
Estimated annual sale is 24,000 units. Marketing expenses are expected to be 15% of sales, and
profit is to amount to N1.02 per unit.
a. Calculate the selling price per unit.

b. Prepare a statement showing the projected contribution and net income for the year.
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c. Calculate the break-even point expressed in naira and units, assuming that 50% of
the factory overhead and all of the administrative expenses are fixed but that all
other costs are fully variable.
SUGGESTED SOLUTION
a. The cost per unit of N6.80 is given, apart from the fact that, it excludes marketing
expenses, which is 15% of sales or selling price. The expected profit per unit is equally
given as N1.02 per unit. This will be stated in an equation and the selling price will be
determined as follows.
Selling price = total cost/unit + profit/unit
SP = N6.80 + 15%SP + N1.02
SP-.15SP = N6.80 + N1.02
SP= N7.82/.85 = N9.20
b. Calculation of the projected contribution and net income for the year.
N N
Sales (24,000 x N9.20) 220,800
Less Variable Costs
Direct material (24,000xN4) 96,000
Direct labour (24,000xN0.6) 14,400
Variable factory overhead (50% x N24,000) 12,000
Sales commission (15% x N220,800) 33,120 (155,520)
Less Period Cost
Fixed factory overhead (50% x N24,000) 12,000
Administrative expenses 28,800 (40,800)
Net Income 24,480
(c) The expected sales units at break-even point BEP(V)= (FC/CMR)/SP =

(N40,800/.29565)/N9.20 = 15,000 units and
The expected sales value at break-even point BEP(N) = FC/CMR =
N40,800/.29565 = N138,000
Contribution margin ration = N65,280/N220,800 x 100/1 = 29.565%.
ILLUSTRATION 3
Union Manufacturing Company Limited forecast a net profit of 5% on annual sales of 20,000 units
at N20 each and with variable costs estimated at N15 per unit. The Managing Director of the
company regards this forecast unsatisfactory and has put forward four proposals to improve the
situation.
(a) Calculate for each proposal separately:-

i. The new net profit achieved
ii. The percentage return on sales value
iii. The new break-even sales volume in units.
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(b) State very briefly the key problems likely to be encountered in achieving each proposal.
The four proposals are:-
1. Administration presently on a geographical basis to be centralized and so reduce fixed

cost by N12,000.
2. Institute a cost reduction programme to save N1 per unit of variable cost.
3. Increase the number of units sold by 20% by means of a 5% reduction of selling price.
4. Increase selling price by 10% although this would reduce the number of units sold by
5%.
SUGGESTED SOLUTION
The initial forecast profit statement could be presented as follows:-

N
Sales (20,000 units x N20) 400,000
Less total variable cost (20,000 units x N15) (300,000)
Less total Fixed cost (80,000)
Net Profit 20,000
Note that, fixed cost = total contribution – desired profit i.e. N100,000 – N20,000 =
N80,000.
PROPOSAL 1

N
Sales 400,000
Less total variable cost (300,000)
Less total Fixed cost (N80,000 - N12,000) (68,000)
Net Profit 32,000
ii. Percentage returns on sales value N32,000/N400,000 x 100/1 = 8%
iii. The break-even point in units = (N68,000/.25)/N20 = 13,600 units

Note that, CMR = N100,000/N400,000 x 100/1 = 25%
PROPOSAL 2
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N
Sales 400,000
Less total variable cost (20,000 x N14) (280,000) (.i.e N15-N1 =N14)
Net Profit 40,000
ii. Percentage returns on sales value N40, 000/N400,000 x 100/1 = 10%
iii. The break-even point in units = (N80, 000/. 3)/N20 = 13,333 units
Note that, CMR = N120, 000/N400, 000 x 100/1 = 30%
PROPOSAL 3

N
Sales ((20,000 x 1.2)x(N20 x 95%) 456,000
Less total variable cost ((20,000 x N15)x 1.2) (360,000)
Net Profit 16,000
ii. Percentage returns on sales value N16,000/N456,000 x 100/1 = 3.5%

Note that, CMR = N96,000/N456,000 x 100/1 = 21.05%
PROPOSAL 4
i. The new net profit achieved.

N
Sales ((20,000 x 95%)x(N20 x 1.1) 418,000
Less total variable cost ((20,000 x N15)x .95) (285,000)
Net Profit 53,000
ii. Percentage returns on sales value N53,000/N418,000 x 100/1 = 12.68%
Note that, CMR = N133,000/N418,000 x 100/1 = 31.82%
(b) Limitation to the proposals.

i. Centralization may lead to lower coverage and reduce market capacity
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ii. Cost reduction programme may lead to purchasing of low quality material, reduce the
quality of the company’s product
iii. The reduction in selling price of 5% may not be enough to accommodate volume increase
of 20%
iv. The reduction of volume by 5% may not be enough to meet expected increase in selling
price of 10%.
ILLUSTRATION 4
Electrical Appliances Limited records and sells video films at N30 each. The results for 1993 and
1994 are summarized below:
Sales in Units Profit (N)
1993 6,800 23,800
1994 8,400 39,400
In 1993 and 1994 the company operated at an average of 80% of the available capacity. In 1995 the
company has budgeted to operate at 100% capacity. In 1996 the company proposes to acquire
additional equipment worth N150,000. The equipment will have an effective life of 10 years with
no residual value. With the introduction of the new equipment the company proposes to operate at
150% of present capacity. Variable cost will decrease by 10% and selling price will be reduced by
5% to enable all units produced to be sold.
Using the above information you are required to calculate:-
(a) The break-even point of the company for 1995.

(b) The forecast break-even point of the company for 1996.
(c) The forecast profit of the company for 1995 and 1996
(d) The expected rate of return on the additional capital employed in 1996.
SUGGESTED SOLUTION
(a). To determine the break-even point in 1995, the total fixed cost and contribution margin
ratio for 1993 and 1994 will be determined and since we do not expect increase in fixed
and variable cost in 1995, the break-even point for 1993, 1994 and 1995 will be the same.
Note that, to determine break-even point requires knowledge of fixed cost, selling price and
variable cost per unit. If there is no change in any of these three variables, then the break-
even point will be constant. But in a situation where there is a change in any of the
variables the break-even point will equally change. In this problem, the selling price, total
fixed cost and variable cost per unit were constant for 1993, 1994 and 1995 but will only
change in 1996. Therefore, the break-even point for 1993, 1994 and 1995 will be the same
while 1996 will differ.
Using High and Low method, the fixed and variable cost for 1993 and 1994 can be
determined as follows.
Sales in Selling Total

Units Price Sales Profit Cost
N N N N
1993 6,800 30 204,000 23,800 180,200
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1994 8,400 30 252,000 39,400 212,600
Calculation of variable cost per unit and total fixed cost

Activity Total Cost
(Units) (N)
High 8,400 212,600
Low 6,800 180,200
Variable cost per unit = N32,400/1,600 units = N20.25/unit
Total fixed cost = N212,600 – N20.25(8,400) = N42,500
The contribution margin ratio for the 3 years, therefore, can be determined as follows-
CMR = (N30 – N20.25)/N30 x 100/1 = 32.5%
Therefore, the break-even points for 1995 will be-
BEP (V) = N42,500/(N30 – N20.25) = 4,359 units
BEP (N) = N42,500/.325 = N130,769.23
(b). The break-even points for 1996
With the expected acquisition of additional equipment in 1996, the fixed cost will increase
by N15, 000 ( i.e yearly depreciation of N150,000/10 years), that is total fixed cost will be
N57,500 i.e N42,500 + N15,000.
The revised variable cost per unit = N20.25 x 90% = N18.225
The revised selling price per unit = N30 x 95% = N28.50
The revised CMR = (N28.50 – N18.225)/N28.50 x 100/1 = 36.05%
BEP (V) = N57,500/(N28.50 – N18.225) = 5,596 units
BEP (N) = N42,500/.3605 = N159,500.69
(c). The forecast profit of the company for 1995 and 1996
The average units sold for 1993 and 1994 = (6,800 + 8,400)/2 = 7,600 units
Expected sales units in 1995 = 7,600/.8 = 9,500 units
Expected sales units in 1996 = 9,500 x 1.5 = 14,250 units
The forecast income statement for the two years
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Year 1995 1996
N N
Sales (9,500 x N30) 285,000 (14,250 x N28.50) 406,125
Less variable costs(9,500 x N20.25) (192,375) (14,250 x N18.225) (259,706)
Total Contribution 92,625 146,419
Less total fixed cost (42,500) (57,500)
Net Profit 50,125 88,919
(d). The expected return on the additional capital employed in 1996
The increase in profit between 1995 and 1996 = N88,919 – N50,125 = N38,794
The increase in capital = N150,000 i.e. the injection into capital asset.
Return on capital employed = N38,794/N150,000 x 100/1 = 25.86%.
GRAPHICAL METHOD OF DETERMINING BREAK-EVEN ANALYSIS
Equally, graph can be used in determining the break-even point and for this purpose, there are two
types of graph that can be used, namely; Profit chart and Contribution chart.
Profit Chart:- This involves the use of profit and loss axis and activity in volume or value axis.
That is, using this graph, we can only determine either activity in value or in volume, but not the
two simultaneously. To use this type of graph requires activity when there is profit and activity
when there is loss. With this, the profit line can be drawn, where the profit line intercepts the
activity axis, will determine the break-even point in value or volume depending on the activity
used. Alternatively the graph can also be used, when we have knowledge of activity at profit and
the total fixed cost. Because, it is assumed that the maximum loss a company can have is its total
fixed cost, therefore, the profit line will be drawn from maximum loss i.e. total fixed cost along the
loss axis to the activity at profit and the point of interception will be the break-even point. This can
be illustrated as follows: -
Profit Profit Line
Sales (N)
BEP (N)
Loss
Contribution Chart: - This involves the use of total cost/activity in value axis and activity in
volume axis. Using this type of graph, the break-even point in value and volume can be determined
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simultaneously. With this graph, the activity line and total costs line can be drawn, the point at
which the total cost line intercepts the activity line is break-even point in value, when traced down
to activity in value/total costs axis, and break-even point in volume when traced down to activity in
volume axis. On the graph the total variable cost line can also be drawn and the difference between
total variable cost line and activity line refers to as contribution. This can be illustrated as follows: -
Total Cost Sales Total Cost

Sales (N)
Total Variable Cost

BEP (N)
Total Fixed Cost
BEP (units) Sales (units)

ILLUSTRATION 1
A Company makes a single product with a total capacity of 100,000 units per annum, cost and sales
data are as follows: -
Selling Price N10 per unit

Variable Costs N5 per unit
Fixed Costs N200,000 per annum
Using graphical method, determine the break-even volume and value
SUGGESTED SOLUTION
To plot the graph, at least two activity levels, which must be within the relevant range of 100,000
units, must be used to predict sales value, total cost and total variable cost to draw these lines using
the contribution chart.
Total
Activity Sales TVC FC cost
N N N N
Low 20,000 200,000 100,000 200,000 300,000
High 80,000 800,000 400,000 200,000 600,000
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The graph
Sales/ N’000
TC 1000
900 Sales
800
700 Total Cost
600
500
BEP (N)
400 TVC
300
BEP (units)
200
100
Sales (units)
10 20 30 40 50 60 70 80 90 100
ILLUSTRATION 2
A firm has fixed costs of N500,000 per annum, and has three products, the sales and contribution of
which are shown below:-
C/S
Product Sales Contribution ratio
N N
X 1,500,000 300,000 20%
Y 400,000 200,000 50%
Z 600,000 250,000 42%
Total 2,500,000 750,000
Plot the products on a profit chart and show the break-even sales value.
SUGGESTED SOLUTION
The chart involved a multi-product organization, as will be discussed below. The break-even for all
the products will be determined together. To draw the profit line, the maximum loss possible when
there is no sale will be projected. The maximum loss will be the total fixed cost, this will be drawn
to a profit position of N250,000, i.e., total contribution minus total fixed cost i.e. N750,000-
N500,000 = N250,000.
The graph
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Profit
N’000
500 Profit Line
250
0
500 1000 1500 2000 2500 3000 Sales N’000
-250
-500
-750
Loss
The graph is expected to show break-even point at = N500,000/.3 = N1,666,666.67. That is, the
joint fixed cost divided by joint contribution margin ratio.
BREAK-EVEN POINT FOR A MULTI-PRODUCT ORGANISATION
Break-even point analysis is a marginal costing technique, which believes in separable cost, and
disregard arbitrary absorption or allocation or apportionment of cost. Therefore, when it involves
multi-product organization there some fixed costs that will be jointly incurred by all the products,
which will be very difficult to be identified separately. Since computation of the break-even point is
based on separate identification of selling price, variable cost and fixed cost. The fixed cost in a
multi-product organization cannot be effectively separated without absorbing, apportioning or
allocating contrary to marginal costing principle. Whenever it involves a multi-product
organization therefore, the following extra steps will be required in addition to the method already
studied.
1. Identify/computation of joint or weighted contribution margin or contribution margin ratio.

2. Identify the total fixed costs for the company as a whole.
3. Determine the percentage of each product sales to the total sales.
4. Compute the break-even point in sales value for the whole organization by dividing the total
fixed cost by the contribution margin ratio computed in “1” above. Or the joint break-even in
sales units by dividing the joint fixed cost by the joint contribution margin.
5. Share among the product the computed break-even sales value or units, as in “3” above using
the percentage computed in “2” above.
6. If the computed break-even point for each product is in sales value, determine the break-
even in units of each product by dividing the break-even sales value, as in “4” above, using
their respective selling prices.
Page 86
ILLUSTRATION 1
Unique Plastic Limited sells four grades of a product

Unit Variable
Grade Quantity Unit Selling Price Cost
1 8,000 N40 N32
2 12,000 N30 N20
3 7,000 N25 N19
4 9,000 N50 N44
Fixed overhead of the company amount to N160,000. The company has recently been allowed a
25% increase in its market share in value of sales. The company is in a position to meet the
additional demand, without any change in its present cost structure.
You are required to calculate:-
a. The volume of sales at which the company breaks even now.

b. The amount of profit the company is earning now.
c. The amount of profit the company can earn if the additional demand is distributed among
the four grades of products in the ratio of present sales.
d. The amount of profit if 60% of the additional demand is allocated to the most profitable
product and the balance of 40% to the next profitable product.
SUGGESTED SOLUTION
(a). The expected sales in units of each product will be determined using earlier stated steps.
i. Calculation of total contribution and contribution margin ratio.

Grade Quantity Unit Selling Unit Variable Contr. Total Sales Total Contr.
Price N Cost N Margin N N N
1 8,000 40 32 8 320,000 64,000
2 12,000 30 20 10 360,000 120,000
3 7,000 25 19 6 175,000 42,000
4 9,000 50 44 6 450,000 54,000
Total 1,305,000 280,000
Contribution margin ration = N280,000/N1,305,000 x 100/1 = 21.46%
ii. Calculation of percentage sales of each product to the total sales.

Grade Sales N Workings % Sales
1 320,000 N320,000/N1,305,000 x 100/1 24.52%
2 360,000 N360,000/N1,305,000 x 100/1 27.59%
3 175,000 N175,000/N1,305,000 x 100/1 13.41%
4 450,000 N450,000/N1,305,000 x 100/1 34.48%
1,305,000 100%
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iii. The break-even sales value for the company = N160,000/.2146 = N745,573.14
iv. The break-even sales value and units for each product.
Grade % Sales Workings BEP(N) SP (N) BEP(Unit)
1 24.52% N745,573.14 x .2452 182,815 40 4,570
2 27.59% N745,573.14 x .2759 205,704 30 6,857
3 13.41% N745,573.14 x .1341 99,981 25 3,999
4 34.48% N745,573.14 x .3448 257,074 50 5,141
(b). The amount of profit the company is earning now.
Since total contribution is already compute in “a” above, the total fixed cost will be
deducted to arrive at the said profit.
N
Less Total Fixed Cost (160,000)
Net Profit 120,000
(c). The increase of 25% in market share value, if is shared among the products in equal
proportion to their contribution to total sales, will bring an equal increase in their total
contribution. If sales increase, selling price and variable cost remain constant, we expect
contribution to increase in sympathy level with the increase in volume. Therefore, the
revised total contribution will be to add 25% to the initial total contribution.
The revised net profit

N
Total Contribution (N280,000 x 1.25) 350,000
Less Total Fixed Cost (160,000)
Net Profit 190,000
(d). When the increase in market share is shared among the two most profitable product. We
need to rank the product, in order to pick the first two profitable. The ranking as follows:-
Contribution
Grade Selling Price Margin CMR Ranking
1 40 8 0.2 3rd
2 30 10 0.33 1st
3 25 6 0.24 2nd
4 50 6 0.12 4th
The expected increase in sales value 25% x N1,305,500 = N326,375. This will be shared
between the two most profitable products and the contribution from it will be determined.
The revised net profit.
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N
Initial total contribution 280,000
Add additional contribution from grade 2 (60% x N326,375 x N10/N30) 65,275
Add additional contribution from grade 3 (40% x N326,375 x N6/N25) 31,332
Less total fixed cost (160,000)
Net Profit 216,607
ILLUSTRATION 2
Gbenga Company produces and sells three types of creams, High grade (A), Moderate grade (B)
and Simple grade (C). Budgeted data relating to these products is given below.
Sales Price Variable cost Per Unit Proportion of sales
Product (N) (N) (%)
A 30 15 0.1
B 20 12 0.5
C 40 30 0.4
Budgeted total fixed costs is N700,000.
Required
a. Calculate the break-even point in sales value and volume

b. Determine the expected sales value and volume to achieve an after tax profit of N245, 000.
Assume a 50% tax rate.
c. Determine the expected sales value and volume at 15% after tax on sales value.
SUGGESTED SOLUTION
To answer the questions, the weighted average contribution margin must be determined. This will
be done by multiplying each product by contribution margin ratio by the proportion of sales and
added together.
The weighted contribution margin ratio

CM %
Product SP(N) VC(N) (N) CMR Sales WCMR
A 30 15 15 0.5 0.1 0.05
B 20 12 8 0.4 0.5 0.2
C 40 30 10 0.25 0.4 0.1
Total 0.35
(a). The expected sales for the company = BEP(N)=N700,000/.35 = N2,000,000
The expected sales of each product in value and volume.
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Product % Sales Workings BEP (N) SP (N) BEP(Units)
A 0.1 2,000,000 x .1 200,000 30 6,667
B 0.5 2,000,000 x .5 1,000,000 20 50,000
C 0.4 2,000,000 x .4 800,000 40 20,000
(b). The expected sales for the company
= BEP(N)(P) = (N700,000 + (245,000/(1-.5)))/.35 = N3,400,000

A 0.1 3,400,000 x .1 340,000 30 11,333
B 0.5 3,400,000 x .5 1,700,000 20 85,000
C 0.4 3,400,000 x .4 1,360,000 40 34,000
(c) The expected sales for the company = BEP(N)(P) =(FC+P)/CMR or

S = (FC+P)/CMR = S = (N700,000 + (.15S/(1-.5))/.35
.35S = N700,000 + .3S or S = N14,000,000.

A 0.1 14,000,000 x .1 1,400,000 30 46,667
B 0.5 14,000,000 x .5 7,000,000 20 350,000
C 0.4 14,000,000 x .4 5,600,000 40 140,000
BREAK POINT WITH EXPECTED LOSS
It is a fact of business life that most firms will go through periods when losses rather than profits
are made. Provided a firm has sufficient reserves and is able to minimize costs, and it can see the
prospect of profit in the not too distant future, it will serve. However, it will be necessary to
target losses rather than profits for one or more trading periods.
To obtain the required sales volume or turnover to achieve the target loss we must subtract the
target loss from fixed costs in our equation or formulae.
ILLUSTRATION 1
Bayus Limited is planning to go into importations and sales of a low price mobile phone hand
sets. As introduction price, it planned to sell at N1,200 per set and variable cost of sales is
established to be N1,100. Budgeted fixed costs are N8,500,000 per month. Demand is expected
to be poor for the next few months. Bayus Ltd must limit its losses to N1,500,000 per month if it
is to survive.
Required
What is the minimum number of sets that the company must sells per month to do this?
SUGGESTED SOLUTION
Page 90
The expected sales units i.e. BEP(units)(L) = (FC – L)/CM = (N8,500,000 – N1,500,000)/N100
= 70,000 sets.
ILLUSTRATION 2
Blue Components Ltd has a C/S ratio of 40%. Fixed cost N8,000,000 per month. Trading
conditions have deteriorated and the company is now making losses. The company can survive
for six months, after which trading conditions are expected to improve, provided accumulated
losses for the period are less than N3,000,000.
Required
What is the average turnover per month that the company needs to achieve for the next six
months assuming that cost behaviour, selling prices and sales mix do not change?
SUGGESTED SOLUTION
The average expected loss per month must not exceed = N3,000,000/6 mths = N500,000/mth.
Expected Turnover i.e. BEP(N)(L) = (FC – L)/CMR = (N8,000,000 – N500,000)/.4 =
N18,750,000.
COST VOLUME PROFIT ANALYSIS WITH SENSITIVITY ANALYSIS
Cost Volume Profit (CVP) analysis is unlikely to provide absolutely reliable results as it depends
on estimated figures. Even if the figures used were correct at the time CVP calculation was
carried out, any one of the variables involved could change in the future. Managers need to know
how ‘robust’ the results obtained from a CVP analysis are before they make a decision based on
the figures provided. If the result of a CVP calculation still shows a profit, even if selling prices
or sales volume were to halve, or variable or fixed costs double, then it would seem that there is
little risk in proceeding on the basis of the calculation. However, if a tiny change in one of the
variables will change the results of the calculation from profit to loss then it would be wise to
proceed with caution. Note, a variable in mathematics is a quantity that is able to assume
different numerical values.
ILLUSTRATION 1
BB Electronic Ltd produces electronic plugs. Selling prices are N3 per plug, packaging and
royalty costs are N2 per plug and fixed costs are N29,000 per month. Forecast sales are 30,000
plugs per month.
Required
a. What is BB Electronic Ltd’s forecast profit per month?
b. What is the breakeven point?
c. What effect would a 5 per cent fall in sales volume have?
SUGGESTED SOLUTION
Page 91
a. The forecasted profit = ((N3 – N2) x 30,000) – N29,000 = N1,000 per month.
b. The break-even sales units i.e. BEP(units) = FC/CM = N29,000/N1 = 29,000 units.
c. A 5 per cent fall in sales would reduce profits by (30,000 x 5%) x N1 contribution per
unit = N1,500, resulting in a loss of N500 per month.
ILLUSTRATION 2
Thompson Ltd produces handmade children’s cots. Forecast sales the forthcoming year are
10,000 cots at a selling price of N60 per cot. Material costs are N18 per cot and direct labour
costs are N22 per cot. Forecast fixed costs for the year are N80,000.
Required
Calculate the per cent change in each of the following variables, which will result in breakeven:
a. unit selling price
b. unit material costs
c. unit labour costs
d. volume, i.e. the margin of safety
e. fixed costs
SUGGESTED SOLUTION
We need to produce a forecast profit statement with total figures for each variable. We can then
calculate by how much each variable, taken separately, can change before the profit disappears.
The forecasted profit.

N
Turnover 10,000 x N60 600,000
Less Variable costs:
Materials 10,000 x N18 180,000
Direct labour 10,000 x N22 220,000
Contribution 200,000
Less Fixed costs 80,000
Profit 120,000
a. If the profit is N120,000. The average profit per cot is N120,000/10,000 = N12.
Therefore, the selling price can fall by N12 per cot before a loss is made, assuming the
volume remains constant. The per cent reduction in selling price that will result in
breakeven = (N12/N60) x 100/1 = 20%.
b. If selling prices can fall by N12 before breakeven is reached then variable costs for the
same volume can also rise by N12 per cot before breakeven. Therefore, material costs can
Page 92
rise by N12 per cot before breakeven is reached. The per cent increase in material costs
that will result in breakeven = (N12/N18) x 100/1 = 67%.
c. Similarly, labour costs can rise by N12 per cot before breakeven is reached. The per cent
increase in labour costs that will result in breakeven = (N12/N22) x 100/1 = 55%
d. Sales volume or margin of safety = ((Turnover – BEP)/Turnover) x 100/1 = ((N600,000 –

N240,000)/N600,000) x 100/1 = 60% or The margin of safety, expressed in number of
units = budgeted volume(10,000) – Breakeven volume (4,000) = 6,000 units.
This means that the company’s sales volume can fall by 60 per cent before breakeven is
reached. If the sales volume falls by more than 60 per cent a loss will be incurred. So the
margin for error in the estimated sales volume is 60 per cent.
e. The fixed cost can increase by the amount of profit, i.e. N120,000, without the company
incurring a loss. The per cent increase in fixed cost that will result in breakeven =
(N120,000/N80,000) x 100/1 = 150%.
FURTHER PRACTICE QUESTIONS
1. AP Systems manufactures 5 -inch diskettes that are used in the computer industry. AP faces
the following price and cost structure:-
Average price per diskette N0.80

Variable manufacturing cost per unit N0.25
Variable selling and shipping cost per unit N0.05
Fixed manufacturing costs (annual) N4,000,000
Fixed selling and administration cost (annual) N2,000,000
Management has the following questions about the upcoming year:-
a. What is the anticipated level of profit, if diskette sales are 15,000,000 units?
b. At what level of units will AP break-even?
c. A special one-time order has been received to manufacture 1,000,000 diskettes under a
private brand label. Capacity is available, and the order will not affect AP’s other
sales. Special ordering and shipping costs of N150,000 will be incurred. The variable
manufacturing costs will remain at N0.25 per diskette and no variable selling and
shipping costs will be required. What is the minimum price per diskette that AP can
accept in order to gain N0.25 per diskette on this special order?
2. Pear manufactures and sells a line of product. Three models are produced; Economy,
Standard, and Premium. Unit cost and revenue data, as well as fixed costs, for Pear are as
follows: -
Page 93
Economy Standard Premium
N N N N N N
Selling Price 10.00 15.00 25.00
Variable Costs
Direct Material 2.00 3.00 5.00
Direct Labour 2.00 4.00 6.00
Variable Overheads 1.00 2.00 3.00
Variable Selling 2.00 (7.00) 2.00 (11.00) 2.00 (16.00)
Contribution Margin 3.00 4.00 9.00
Product % of total Sales 10% 50% 40%
Fixed manufacturing costs N200,000

Advertising N100,000
Fixed administrative costs N100,000
Total expected sales (all products) (units) 80,000
Capacity (total all products) (units) 100,000
You have been asked by management to prepare a report analyzing each of the following
issue: -
a. What is the projected profit given the initial data?
b. Management is considering altering the advertising budget by N100,000 to increase total

unit sales from 80,000 to 100,000. The mix of products would remain the same. Is the
advertising campaign desirable?
c. Management is considering altering the manufacturing budget, so that more effort will be
placed on selling the premium model. The advertising budget could be increased by
N150,000. While this would not increase the total unit sales, the campaign would result in
the mix of economy, standard and premium model being 5%, 30% and 65%. Is this
change desirable?
d. Management is considering increasing the selling commission paid to the sales force. The
marketing manager believes that if the selling commission of each product is increased by
2%, the total level of sales will rise to 90,000 units. Is the change desirable?
e. Management is considering altering the production process. By installing new

manufacturing equipment, the direct materials, direct labour and variable overhead costs
can be reduced to 75% of their current levels for all products. Fixed manufacturing costs
would rise by N200,000, reflecting depreciation on the new equipment. What is the
minimum level of total sales for which this change would be desirable?
3. The Queen Company operates and services photocopying machines located in college
dormitories, libraries, hotels and various public places. The machines are rented from the
manufacturer. In addition, Queen must rent the space occupied by the machines. Queen has
an opportunity to place some machines in ten branch libraries of a large city. The following
expenses and revenue relationship pertain to a contemplated expansion program of ten
machines, which are rented by Queen from a manufacturer at a flat rate per month plus ten
kobo per copy:-
Page 94
Fixed monthly expenses:-
N
Machine rental 10 machines 1,300
Space rental; 10 locations 400
Wages, including fringe costs to service the
additional 10 machines 500
Other fixed costs 200
Total 2,400
Per Per 100 of

Other data copy sales
N %
Selling price 0.1 100%
Cost of paper, toner, repairs, parts and
change per copy 0.06 60%
Contribution margin 0.04 40%
Required
a. Compute the monthly break-even point in number of copies and in naira sales.
b. Compute the company’s net income, if 70,000 copies were sold.
c. Suppose the space rental were doubled, compute the monthly break-even point in
number of copies and naira sales.
d. Suppose the manufacturer increased the rent from ten to twenty kobo per copy,
compute the monthly break-even point in number of copies.
e. Suppose the libraries were paid two kobo per copy for each unit sold in excess of the
break-even point, compute the company’s net income if 70,000 copies were sold.
4. A friend of yours has come to you for financial advice. He is about to set up a business
manufacturing and selling personal computers. He provides you with the following budgeted
information concerning his total costs:-
N
Material costs 280,000
Labour costs 300,000
Production overheads 150,000
Selling & distribution overhead 140,000
Administration overhead 60,000
The above figures are based upon production of 3,500 computers, although there is
production capacity for 4,000 computers. The budgeted selling price is N300 per computer.
Page 95
You ascertain that N125,000 of labour costs, 100% of administration overheads, 30% of
production overheads and 50% of selling and distribution overheads are fixed in nature. All
other costs are variable with the level of production.
Required
a. Prepare a cost statement showing the contribution per computer and for the budgeted
level of production.
b. What is the profit at the budgeted level of production?
c. Construct a break-even chart in good format, clearly showing the break-even point in
units and sales revenue as well as the margin of safety in units at the budgeted level of
production.
d. Your friend has had an offer to utilize his existing spare capacity by making 500
computers for a price of N225 per computer. He intends to reject this offer as the price
is well below his total cost of making a computer. Advise him upon this course of
action, giving reasons for your advice.
5. Budgeted information for A Ltd for the following period, analysed by product, is shown
below:-
Product Product Product
1 2 3
Sales units ('000) 225 376 190
Selling Price (N) 11.00 10.50 8.00
Variable costs (N per unit) 5.80 6.00 5.20
Attributable fixed costs (N'000) 275 337 296
General fixed costs, which are apportioned to products as a percentage of sales, are budgeted at
N1,668,000.
Required
a. Calculate the budgeted profit of A Ltd, and of each of its products.
b. Recalculate the budgeted profit of A Ltd on the assumption that product 3 is

discontinued, with no effect on sales of the other two products. State and justify other
assumption made.
c. Additional advertising, to that included in the budget for product 1, is being considered.
Calculate the minimum extra sales units required of product 1 to cover additional
advertising expenditure of N80,000. Assume that all other existing fixed costs would
remain unchanged.
d. Calculate the increase in sales volume of product 2 that is necessary in order to

compensate the effect on profit of a 10% reduction in the selling price of the product.
State clearly any assumptions made.
Page 96
Q6. Jumoke Lawson operates a Joint selling all brands of bottled beer at a contribution margin
of N40 per beer. Jomuke is considering also selling hamburgers. His reasons are twofold.
First, sandwiches would attract daytime customers. A hamburger and a beer are a quick
lunch. Second, he has to meet competition from other local bars, some of which provide
more extensive menus.
Jumoke analyzed the costs of the addition as follows:

Monthly fixed expenses:
Wages of cook N100,000
Others N20,000
Total N120,000
Variable expenses per hamburger

Rolls N5
Meat N20
Others N5
Total N30
Jumoke planned a selling price of N55 per hamburger to have many customers.
For all questions, assume a 30 days month.
a. What are the monthly and daily break-even points, in number of hamburgers?
b. What are the monthly and daily break-even points in naira sales?
c. At the end of two months, Jumoke finds She has sold 13,600 hamburgers, what is the
net profit per month on hamburgers?
d. Jumoke thinks that at least 600 extra beers are sold per day because he has these
hamburgers available. This means that 600 extra people come to the bar or that 600
buy an extra beer because they are attracted by the hamburgers. How does this affect
Jumoke’s monthly income?
e. Refer to requirement 3. How many extra beers would have to be sold per day so that
the overall effects of the hamburger sales on monthly operating income would be zero?
Q7. Most law firms have two broad ranks of attorneys: associates, who work for salaries, and
partners, who share any income generated before taxes. You are an experienced associate
of James Milne and Company, a small but prestigious law firm. James Milne, the senior
partner, has asked you to analyze the following budget data with the aim of setting a fee
structure for next year.
Page 97
Department
probate tax Total
Number of partners 2 3 5
Budgeted partners-hours billable to clients 3,200 4,500 7,700
Number of associates 2 6 8
Budgeted associates-hours billable to client 3,000 8,400 11,400
Total hours 6,200 12,900 19,100
Budgeted expenses for the firm: N
Secretariat staff and receptionist 110,000
Library services 40,000
Rent 52,000
Janitorial services 14,000
Supplies and photocopying 30,000
Telephone 11,000
General expenses 15,000
272,000
Associates receive salaries and benefits of N40,000 per person per year. James Milne kept
abreast of the general pricing practices of other law firms. The billing rate for associates was
N40 per hour, and he said it would be unthinkable for his firm to do otherwise. However,
because of the general high quality of the work performed by his firm, the senior partner was
confident that a partner could be billed out at N80 to N125 per hour. Milne also told you that,
on an average, the partners expected an income after all expenses, but before income taxes,
of N100,000 each.
a. Compute the average billing rate per partner-hour for next year.
b. All expenses for next year were exactly the same as budgeted. You have been asked to
repeat for year 2, what you did in requirement 1. All expenses are expected to be the same
as the actual expense for next year. However, because of their superior work in year 1, the
associates will be provided greater responsibility and greater breadth of experience. What
that entailed, you learned, was that the associates would work more hours and the partners
would work fewer. The budgeted billable hours for year 2 were:
Department
probate tax Total
Partners 2,400 3,300 5,700
Associates 3,800 9,600 13,400
Total hours 6,200 12,900 19,100
You also learned that the partners still expected to receive N100,000 each on the average.
The market remained such that an associate could still only be billed out at N40 per hour.
Q8. The Dolphin Corporation has the following cost behaviour patterns:
Production range in
units 0 - 10,0000 10,000 - 20,000 20,001 - 30,000 30,001 - 40,000
Fixed costs N400,000 N560,000 N670,000 N760,000
Page 98
Maximum production capacity is 40,000 units per year. Variable costs per unit are N50 at
all production levels.
Required
Each situation described below is to be considered independently.
a. Production and sales are expected to be 21,000 units for the year. The sales price is N80
per unit. How many additional units need to be sold, in an unrelated market, at N70 per unit
to show a total overall net income of N60,000 for the year?
b. A company has orders for 45,000 units at N80. If it desired to make a minimum overall net
income of N500,000 on these 45,000 units, what unit purchase price would it be willing to
pay s subcontractor for 5,000 units? Assume that the subcontractor would act as Dolphin’s
agent, deliver the units to customer directly, and bear all related costs of manufacture,
delivery, and so forth. The customers, however, would pay Dolphin directly as the goods
were delivered.
c. Production is currently expected to be 12,000 units for the year at a selling price of N80.
By how much may advertising or special promotion costs be increased to bring production
up to 25,000 units and still earn a total net income of 3 percent of naira sales?
Q9. Rosebay plc makes perfume, which it sells in 250 ml bottles. Budgeted sales for next year
are 60,000 bottles at N65 per bottle. Ingredients cost N7 per bottle and packaging costs are
N8 per bottle. All other production costs are fixed, and the budget for the year is N300,000.
The marketing budget for next year is N1,600,000. Administration costs for the year are
expected to be N500,000.
Required
a. Calculate the percentage change in each of the following variables, which will result in
breakeven:
i. selling price;
ii. ingredients costs;
iii. packaging costs
iv. volume,
v. production, marketing and administration fixed costs.
b. Once you have calculated the percentage change to breakeven, rank your results and
comment on what they reveal.
c. Calculate and rank the effect on profit of a 10% change in each component of the profit
calculation.
1. AP SYSTEM MANUFACTURER
a. The anticipated profit = Sales – total variable costs – total fixed costs
=(15,000,000 x N0.80) – (15,000,000 x N0.30) – N6,000,000 =N1,500,000
b. The break-even sales units i.e. BEP (V) = N6,000,000/N0.50

= 12,000,000 diskettes
Page 99
c. The expected selling price can be determine using the formula for break-even volume at a
desired profit i.e. BEP(V)(P) = (FC + P)/(SP-VC) =
1,000,000 = (N150,000 + N250,000)/(SP – N0.25)
1,000,000(SP – N0.25) = N400,000
SP = N0.65.
2. PEAR MANUFACTURER
It is quite easy to answer these questions (independently of each other) once the behaviour
of costs is understood. Using this assumption, only the revenue and the variable costs will
change with changes in volume. The fixed costs will remain constant within the relevant
range, unless otherwise stated.
The average contribution margin can therefore be computed:-

(0.1 x N3) + (0.5 x N4) + (0.4 x N9) = N5.9
The profit = (80,000 x N5.9) – N400,000 = N72,000
a. Total fixed cost will increase to =N400,000 + N100,000 = N500,000
The revised net profit = (100,000 x N5.9) – N500,000 =N90,000
This alternative increase profit from former value of N72,000 is N90,000. Therefore, the
increase in advertising cost is desirable.
b. The revised average/weighted contribution margin=

(.05 x N3) + (.3 x N4) + (.65 x N9) = N7.2
The revised total fixed costs = N400,000 + N150,000 = N550,000
The revised net profit = (N7.2 x 80,000) – N550,000 = N26,000
This alternative causes profit to decrease from initial level of N72,000 to N26,000. Thus,
the change is undesirable.
c. The revised contribution margin

Economy = N3 – (2% x N2) = N2.96
Standard = N4 – (2% x N2) = N3.96
Premium = N9 – (2% x N2) = N8.96
Average or weighted contribution margin=
(.1 x N2.96) + (.5 x N3.96) + (.4 x N8.96) = N5.86
The revised net profit = (N5.86 x 90,000) – N400,000 = N127,400
This alternative causes profit to increase from the initial level of N72,000 to N127,400.
Thus, the change is desirable.
d. The revised contribution margin will be determined, taken the 75% reduction in variable
costs.
Page 100
Economy Standard Premium
N N N N N N
Selling Price 10.00 15.00 25.00
Less Variable Costs
Direct Material 1.50 2.25 3.75
Direct Labour 1.50 3.00 4.50
Variable overhead 0.75 1.50 2.25
Variable selling 2.00 (5.75) 2.00 (8.75) 2.00 (12.50)
Average/weighted contribution margin =
(.1 x N4.25) + (.5 x N6.25) + (.4 x N12.50) = N8.55
The expected sales units at a profit i.e. BEP (V) (P) = (FC + P)/CM
V = (N600, 000 + N72, 000)/N8.55
N8.55V = N672, 000
V = 78,596 units
Where V = expected sales units. Total Fixed Cost = N400,000 + N200,000 = N600,000.
3. THE QUEEN COMPANY

a. The break-even point
BEP (N) = N2,400/.4 = N6,000
BEP (V) = N2,400/N0.04 = 60,000 copies.
b. The net income from 70,000 copies =

(N0.04 x 70,000) – N2,400 = N400
c. If space rental doubled, there will be additional N400 to fixed cost. Therefore, total
fixed costs become N2,800.
The break-even point

BEP (V) = N2,800/N0.04 = 70,000 copies
BEP (N) = N2,800/.4 = N7,000
d. If rental is increased from ten to twenty kobo, there will be an increase in fixed cost of
additional N1,300. The total fixed cost will therefore become N3,700
The break-even point

BEP (V) = N3,700/N0.04 = 92.500 copies
BEP (N) = N3,700/.4 = N9,250
e. The Net Profit

(N0.04 x 70,000) – (N0.02 x 10,000) – N2,400 = N200
4. A FRIEND
Page 101
a. Separation of costs into variable and fixed element.
Total Fixed Variable
N N N
Material Cost 280,000 280,000
Labour Cost 300,000 125,000 175,000
Production Overheads 150,000 45,000 105,000
S & D Overhead 140,000 70,000 70,000
Admin. Overhead 60,000 60,000 -
Total 930,000 300,000 630,000
The variable cost per unit = N630,000/3,500 = N180/computer
Contribution per computer = N300 – N180 = N120/computer
b. The profit from budgeted level

= (N120 x 3,500) – N300,000 = N120,000
c. The break-even chart
Sales/
Cost
N’000
1200
1000
800 BEP N750,000
600
400 BEP 2500 units

Fixed Cost
200
Margin of Safety
‘000 units
0 500 1000 1500 2000 2500 3000 3500
Sales/output in units
d. The special order will be appraised using margin cost. That is, that margin cost of extra
production, which is the variable cost per unit.
The extra contribution from this special sales = (N225 – N180) x 500 = N22,500
From computation above, the offer should not be rejected, because it is promising an
additional contribution of N22,500 if accepted.
5. A LIMITED
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a. The budgeted profit.
Product 1 Product 2 Product 3 Total
N'000 N'000 N'000 N'000
Sales 2,475 3,948 1,520 7,943
Less Relevant Costs
Variable Costs (1,305) (2,256) (988) (4,549)
Attributable F. C. (275) (337) (296) (908)
Total Contribution 895 1,355 236 2,486
Less General fixed costs (520) (829) (319) (1,668)

Net Profit 375 526 (83) 818
b. Discontinued product 3.
Net Profit from product 1 & 2 N'000
Contribution from product 1& 2 2,250
Less General fixed costs (1,668)
Net Profit 582
If product 3 is discontinued, the company’s profit will be reduced by
= N818,000 – N582,000 = N236,000 i.e. the present positive contribution of product 3
(c). To determine the increase in sales of product, to cover additional advertising costs. The
extra cost will be divided by the difference between selling price and variable cost per unit
i.e. N80,000/(N11 – N5.80) = 15,385 units.
We do assume that all other costs relationship remains constant.
(d). The effect of 10% reduction in sales price of product 2.

The revised selling price = N10.50 x 90% = N9.45.
The initial contribution from product 2 with the attributable fixed cost=
N1,355,000 + N337,000 = N1,692,000.
The expected increase in sales volume to compensate for reduction in price

= N1,692,000/(N9.45 – N6) = 490,435 units
6 JUMOKE LAWSON
a. The monthly and daily break-even number of hamburgers.

Contribution margin = N55 – N30 = N25
Monthly breakeven numbers = N120,000/N25 = 4,800 hamburgers
Daily breakeven numbers = 4,800/30 days = 160 hamburgers
(b). The monthly and daily break-even in sales value.

Monthly breakeven value = 4,800 x N55 = N264,000
Daily breakeven value = 160 x N55 = N8,800.
c. The net profit per month.
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Partners N
Monthly sales (N55 x 13,600)/2 374,000
Less Total variable costs (N30 x 13,600)/2 204,000
Less Total fixed costs 120,000
Monthly profit 50,000
d. The monthly net income is expected to increase by N40 x 600 = N24,000. That is, the
contribution margins of beer (N40) multiply by the increase in sales quantity of beer (600).
e. The extra quantity of beers to sell to bring effect of monthly sales of hamburger as stated in
“d” above to zero would be obtained by dividing the presently monthly contribution of
hamburger by the contribution per unit of beer. That is, N170,000/N40 = 4,250 beers.
7. JAMES MILNE
a. The average billing rate for senior partner for coming year.
N
Total fixed overhead expenses 272,000
Add estimated salary to associate (N40,000 x 8) 320,000
Add sharing by partners (N100,000 x 5) 500,000
Total estimated disbursement 1,092,000
Less estimate income from associate (N40 x 11,400) 456,000
Income expected from partners billing 636,000
Budgeted partner's hours billable 7,700
The average billing rate per hour (N) 82.60
b. The average billing rate for senior partner for year 2.

N
Total fixed overhead expenses 272,000
Add estimated salary to associate (N40,000 x 8) 320,000
Add sharing by partners (N100,000 x 5) 500,000
Total estimated disbursement 1,092,000
Less estimate income from associate (N40 x 13,400) 536,000
Income expected from partners billing 556,000
Budgeted partner's hours billable 5,700
The average billing rate per hour (N) 97.54
8. a. The contribution margin from normal sales = N80 – N50 = N30

Contribution margin from additional sales = N70 – N50 = N20
Total Contribution expected = N670,000 + N60,000 = N730,000 (that is, the total fixed
cost for the range plus the expected profit).
The expected additional sales units will be ass follows
N30(21,000) + N20(x) = N730,000, Therefore x (sales units) = 5,000 units
b. The special purchase cost for the additional units to be purchased
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N
Budgeted sales (45,000 x N80) 3,600,000
Less cost of 40,000 (40,000 x N50) 2,000,000
Less total fixed costs 760,000
Less expected profit 500,000
Maximum costs for the additional 5,000 units 340,000
The additional units 5,000
Unit purchase price N68
c. The additional advertising/promotion costs that can be incurred.
N
Budgeted sales (25,000 x N80) 2,000,000
Less variable cost (25,000 x N50) 1,250,000
Less total fixed costs 670,000
Less expected profit (3% x N2,000,000) 60,000
Additional advertising/promotion costs 20,000
9 ROSEBAY PLC
a. Computation of the budgeted profit, sensitivity of each variable and ranking of the variable
in order of sensitivity for the year.
N'000 Sensitivity Variable Ranking

(Profit/X) x 100
Turnover 60,000 x N65 3,900 15% i. Selling price 1
Variable costs:
Ingredients 60,000 x N7 420 143% ii. Unit ingredient cost 6
Packaging 60,000 x N8 480 125% iii. Unit packaging cost 5
Contribution 3,000 20% iv. Sales volume 2
Fixed costs:
Production 300 200% v. Production costs 7
Marketing 1,600 38% vi. Marketing costs 3
Administration 500 120% vii. Administration costs 4
Profit 600
b. The most sensitive components in the next year budget is the selling price (15%), follow by
sales volume (20%) and marketing (38%). All other costs have very low sensitivities,
ranging between 120% (administration) and 200% (fixed production costs). The company’s
management should concentrate their attention on monitoring the selling price, sales
volume and marketing spending during the year.
c. The effect and ranking of 10% changes in each variable.
Page 105
N'000 10 per cent of Variable Ranking
value (N'000)
Turnover 3,900 390 Selling price 1
Variable costs:
Ingredients 420 42 Unit ingredient cost 6
Packaging 480 48 Unit packaging cost 5
Contribution 3,000 300 Sales volume 2
Fixed costs:
Production 300 30 Production costs 7
Marketing 1,600 160 Marketing costs 3
Administration 500 50 Administration costs 4
Profit 600
Page 106
CHAPTER 5
RELEVANT COSTING TECHNIQUE FOR DECISION MAKING
We were in a Monday management meeting one morning when I was working with an assets
management company. While we were deliberating and making various suggestions on how to
move the company forward, one of the divisional head raised a suggestion that since our company
is new and it is glaring that not much people knows about us, it will be a nice thing if we can bring
people together inform of a seminar or conference to educate them at a fees about our products.
The suggestion was well accepted and the managing director requested that I, as the company
accountant should come up with the financials to see the impact of this seminar on the company’s
profitability.
After making necessary consultations, I came up with figures showing that the company will be
better off financially if the seminar is organized and all the projections realised. While reviewing
my figures the managing director had a doubt on my position because to him there are some costs
that I should have included but were omitted, for example the rent of office we are using, salary of
the managing director, and my salary as the company accountant and so on. When he raised this
issue I saw the need to quickly educate him on the application of relevant costing technique for a
decision of this nature.
The need for a decision arises in business because a manager is often faced with problems and
alternative courses of action are available. Any of the alternatives to choose from will depend on
the level of relevant information to such decision made available and it is important to have some
criteria or basis in place on which the best alternative can be chosen.
Fundamentally, relevant or marginal costing is a decision-making technique. This makes it

prominent or the applicable technique to use when decisions are short-term or one off nature.
Generally, to decide the best alternative action two cogent factors are normally taken into
consideration. These are:-
a. Quantitative factor
b. Qualitative factor
QUANTITATIVE FACTOR
This is the computation or analysis of the net benefit or loss from the alternative under
consideration. The computation or analysis of data that can be quantified in terms of money value,
in other words, goods or services that can be valued. This is done using relevant or marginal
costing technique with the understanding of the following:-
1. Relevant Income:- This is the gross income expected/budgeted or accruable from the
alternative under consideration. It is the expected gross income, if the alternative is accepted.
This is easily identifiable because it is the same to both marginal and absorption costing
technique.
2. Relevant Costs:- These are costs that make difference between two or more alternatives.
They are future cost that will be necessary or avoidable depending on the acceptance or
rejection of an alternative. The relevant costs are expected future costs/loss that will differ
Page 107
among alternatives. It can therefore be said that, only those costs that are futuristic, differ
among alternatives and traceable directly to the alternative under consideration are relevant.
In marginal costing, these costs are broadly categorized into four, as follows:-
a. Variable Costs: In line with earlier knowledge of this term, these are costs that move in
sympathy level with activity. By this, it implies therefore that, variable costs are future cost,
costs that are necessary because of decision to accept an alternative and if such alternative is
rejected these costs will be avoided or will no longer be necessary. Generally, there are some
costs that are commonly referred to as variable, such as; material costs, labour cost and variable
overheads. Further discussion of these costs will be necessary to understand the treatment of
these in marginal costing.
 Material Costs:- Material cost is generally relevant if no further information is provided.

But in marginal costing material can be valued using any of the following; purchase cost,
replacement cost or net realizable value. Which one to use depends on the position of the
material at that point in time. We use purchased cost only if the material is not yet
purchased. While for material already purchased, we can use either replacement cost or net
realizable value. Replacement cost will be used if the material is of continuous usage, that
is, alternative usage of current stock will necessitate replacement. Material already
purchased but can be sold, will have its disposable cost relevant. Note that, if there is a
need to incur any cost before disposal such cost will be deducted before arriving at the net
realizable value. Any material that can be substituted for another material will maintain
cost of that other material less conversion cost relevant. Any material already purchased
and cannot be sold, nor converted to another material will not have any relevant cost.
 Labour costs:- Relevant labour cost includes wages, overtime premium to be paid and
opportunity cost of labour. Salary is generally regarded as a fixed cost and irrelevant cost.
The remuneration to unskilled staff is expected to be wages and relevant cost, while the
remuneration to skilled staff is salary and irrelevant cost. If labour remuneration is based
on time e.g. salary, it is a fixed and irrelevant cost, but when labour remuneration is based
on activity, it is a variable cost and relevant cost. But note that, the rules above however is
not applicable in a situation where labour is to be engaged specifically for the alternative
under consideration, either the remuneration is based on time or activity not material, it is
perfectly a future cost and a relevant cost.
 Variable overheads:- Variable production overheads, variable expenses and other variable
costs as it may be given, is assumed to be a future cost and therefore, a relevant costs,
unless otherwise stated.
b. Opportunity Costs:- This is a benefit forgone on one alternative because of accepting another
alternative, which must be included as part of relevant cost of the alternative accepted. For
example a Company acquired land some 10 years ago for N2 million, presently the company is
contemplating whether to build a factory on the land. The N2 million would be ignored quite
all right, using marginal costing, as a sunk cost. However, if the land could be sold currently for
N10 million, although there would be no direct cash flow relating to the land, we would be
loosing N10 million by building the factory, which could have been otherwise realized by
selling the land. Therefore, the N10 million would be treated as a cost known as opportunity
cost while estimating the cost of the factory. Opportunity cost is always applicable whenever a
resource has alternative usage. For example, again, if a direct labour hour cost N5 per hour, and
it is currently used for a product that is given a contribution of N8 per hour. If there is
Page 108
alternative project that require the same labour hour, the relevant cost will be N13 per hour.
That is, the cost per hour (N5) plus the opportunity cost per hour (N8).
c. Savings:- Using marginal cost technique another term and relevant income normally take into
consideration is what is called “savings”. This instead of been a cost is an income. It is an
income drivable from alternative qualification of cost. Savings is defined as an expected cost
which will no longer be necessary if the alternative under consideration is accepted. For
example, let’s assume that a company bought some amount of material some years ago which
is now obsolete and is contemplating disposing of the said material at a cost of N10,000. But
there is an alternative, been considered now, which if accepted we make use of this already
condemned material, to the effect that the disposal cost envisaged will no longer be necessary.
The disposal cost that will be avoided will therefore be treated as a saving while computing the
net benefit or loss of the alternative. Savings should be deducted from other relevant costs or
added to the relevant income.
d. Relevant Fixed Costs:- For fixed costs to be relevant, it must possess the characteristic of
relevant costs, that is, it must be futuristic, it must be traceable to the alternative and make
difference among alternatives. The costs will be incurred as a result of acceptance of an
alternative, such that if the alternative is rejected the costs will no longer be necessary. The
table below shows some qualifications that can make fixed cost relevant and irrelevant.
RELEVANT FIXED COST IRRELEVANT FIXED COST
1 Traceable fixed cost 1 Sunk fixed cost
2 Relevant fixed cost 2 Absorbed fixed cost
3 Incremental fixed cost 3 Apportioned fixed cost
4 Avoidable fixed cost 4 Absorption rate
5 Separable fixed cost 5 Porated fixed cost
6 Eliminable fixed cost 6 Allocated fixed cost
7 Attributable fixed cost 7 Unavoidable fixed cost
8 Additional fixed cost 8 Uncontrollable fixed cost
9 Controllable fixed cost 9 General/Joint fixed cost
10 Future fixed cost 10 Fixed cost without further qualification
3. Irrelevant Costs:- These are costs that do make a difference between two or more
alternatives. These can either be historical costs or costs that are jointly incurred by two or
more alternatives and therefore could not be traced directly to a single alternative without
necessarily taken the other alternatives into consideration. As mentioned earlier, irrelevant
costs include:-
a. Sunk Costs:- Otherwise known as historical or past costs. In marginal cost, costs already
incurred are generally disregarded in deciding on future alternatives. Since the funds had
already been committed and cannot be reversed, therefore such committed funds would
be disregarded unless it has a realizable value where the opportunity cost will be
considered as a replacement of the sunk cost.
b. Irrelevant Fixed Costs:- These are fixed costs that do not make a difference between
two or more alternatives. The table above shows some qualifications that make fixed to
be irrelevant. It is pertinent to note that fixed cost is generally irrelevant. It must be
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qualified as relevant before we should treat it as relevant. Just as variable costs are
generally relevant, it needs to be qualified as irrelevant before we treat it as such.
QUALITATIVE FACTORS
This involves the consideration of factors that are not quantifiable in nature but pertinent to future
decisions. By this we refer to other variables affecting decisions, which cannot be valued. These
factors may include political situations, government legislation, availability of market, nature of
market, trade survey, technical personnel, level of technology, goodwill, availability of material,
availability of funds etc. These will still be discussed further while considering some of the
decisions that knowledge of marginal costing techniques can aid.
With our understanding of the quantitative and qualitative factors as discussed above, marginal
costing techniques should be used in assisting management whenever deciding on alternatives such
as:-
1. Make or buy decision

2. Dropping or retaining a center
3. Sell or process further
4. Special pricing
5. Optimal product mix.
MAKE OR BUY DECISION
In a multi-product organization, where the production process is more than one stage, management
may be contemplating whether to produce part of its production process or sub-assembly internally,
or to buy from outside vendor in order to concentrate and improve on finishing process. Taking
decisions such as these require the principle of marginal costing technique. Therefore, management
needs to involve the management accountant to prepare the quantitative factor using marginal
costing technique where the following future relevant costs will be compared.
a. The supplier quotation
b. The relevant cost of making internally
Where “a” is greater than “b” it is advisable to make internally. And when “a” is lower than “b” it
is advisable to sub-contract to the external supplier. In a situation where “a” is equal to “b” the
qualitative factor will determine the rational options. It is equally important to note that sometimes
the quantitative factor may favour buying from outside, but consideration of the qualitative factor
may change such a decision.
Note that relevant costs include; variable costs, opportunity cost, savings and relevant fixed cost as
discussed above.
Some of the qualitative factors to be considered may include;
1. The secrecy of the trade, by the time competitors know that they can produce part of a
product cheaper, this can prompt them to go into production of the finished part and take
over the market.
2. Availability of a competent supplier.
3. The ability of the supplier to supply to specification and timely.
4. The capacity of the supplier and ability to meet future increase in demand.
Page 110
5. There is need to consider if the company has technical know-how to produce the
component or fund the purchase fast and efficiently.
6. The need for quality control.
7. Relative merits of other outside suppliers.
8. Ability to renew production if price is unsatisfactory.
ILLUSTRATION 1
A Company is at present assembling one of the components needed for a final product. The annual
quantity required is 20,000 units, and the annual cost at present is reported as follows:
N'000
Direct material 600
Direct wages 400
Supervisor - avoidable it manufacture discontinued 100
Floor space occupancy 70
The assemblies could be purchased for N61.00 each from an outside supplier. If this were done, the
floor space vacated could be used for storage purposes, saving warehouse rent and transport costs
of N180,000 p.a.
Should the company continue to assemble the component, or buy it from the outside supplier?
SUGGESTED SOLUTION
The cost of floor space occupied is probably mere apportionment of cost for the factory. The whole
cost will continue whether or not this particular component is manufactured. It is therefore
irrelevant to this decision. The opportunity cost of the alternative uses of the floor space is relevant,
however, since it is directly affected by the decision taken. The cost of supervision, being avoidable
if manufacture is discontinued, is a relevant fixed cost of the decision.
Supplier quotation with relevant cost of making compared:

N'000
a. Supplier quotation (20,000 x N61) 1,220
b. Relevant cost of making

Direct material 600
Direct wages 400
Supervision costs 100
Opportunity cost of floor space 180
1,280
From the computation above, it is advisable to purchase from outside supplier, this will save
N60,000 per annum.
ILLUSTRATION 2
Page 111
Bolu Limited is considering next year’s production and purchase budgets, one of the components
produced by the company, which is incorporated into another product before being sold, has a
budgeted manufacturing cost as follows:-
N
Direct materials 40
Direct labour (4hrs @ N5) 20
Variable overhead (4hrs @ N4) 16
Fixed Overhead (4hrs @ N10) 40
Cost per unit 116
Tolu Limited has offered to supply the above component at a guaranteed price of N90 per unit.
Required:
a. Considering cost criterion only, advise management whether the above component
should be purchased from Tolu limited. All calculations should be shown and
assumptions made on aspects, which may require further investigation, should be clearly
stated.
b. Explain how your above advice would be affected by each of the separate situations
shown below:-
c. As a result of government legislation, if Bolu Limited continues to manufacture this
component the company will incur an additional inspection cost of N98,000 per annum,
which is not included in the above budgeted manufacturing costs.
d. Additional labour cannot be derived and if the above component is not manufactured by
Bolu limited the direct labour released will be employed in increasing the production of
an existing product which is sold for N120.00 and has a budgeted manufacturing cost as
follows:-
N
Direct labour (4hrs @ N10) 40.00
Variable overhead (4hrs @ N10) 40.00
Fixed overhead (4hrs @ N5) 20.00
Cost per unit 120.00
e. The Production Director of Bolu Limited recently said we must produce the product
because we just purchased some special grinding equipment to be used exclusively by
this component. The equipment costs N25,000. It cannot be resold or used elsewhere and
if we seize production of this component we will have to write off the asset at written
down book value of N120,000.
SUGGESTED SOLUTION
a. Supplier quotation and relevant cost of making compared.

N
Supplier quotation per unit 90.00
Relevant cost of making per unit

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76.00
From computation above, it is cheaper to make internally, the company will be saving N14
(N90-N76) per unit from making.
b.1. The additional inspection cost is a relevant cost, if it is resolved to manufacture the
component internally and if otherwise, it is no longer required. The problem here is that,
the question above only gives information on per unit basis without the knowledge of
annual requirement of the component. To render necessary advice in this situation the
“indifference point” will be determined. This will be the point at which the supplier
quotation equates the relevant cost of making. This will be done by dividing the relevant
fixed cost (here, the inspection cost) by the difference between supplier quotation per unit
and variable cost of making per unit.
The question of indifference point always arises whenever fixed cost is included in the
relevant cost of making. Because, from our knowledge of fixed cost per activity in chapter
2, the cost per activity will be reducing as activity increases and will be increasing as
activity reduces. Therefore, there will be a level of activity at which the two costs equate
each other whenever there is relevant fixed, this point is referred to as the indifference
point.
The difference between supplier quotation and relevant cost of making = N14
The indifference point = N98,000/N14 = 7,000 units
From computation above, therefore, it is advisable for management of Bolu Limited to

make the component internally, if annual requirement of the component is more than or
equal to 7,000 units. Otherwise, they should subcontract.
Note that, at any quantity below 7,000 units the supplier quotation will be lower than
relevant cost of making and vice visa.
b.(2). The instruction here is indirect way of stating that labour hours have alternative usage;
either for producing the component or for producing the existing product. Whenever a
resource has alternative usage, using margin costing technique, optimal usage can be
obtained by either using contribution per key limiting factor or opportunity cost approach.
Despite the difference in approach of the two principles, the two will end up
recommending the same option.
Using contribution per key limiting factor approach
Contribution/saving from making =N90-N76 = N14.

Contribution per hour N14/4 hrs = N3.5/hrs
Contribution margin from existing product = N120-N20-N40-N40 = N20

Contribution per hour = N20/4 hrs = N5/hrs
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From the computation above, the contribution per labour hour from the existing product is
higher than that of the contribution from making the component internally. Therefore, it is
advisable to engage the labour hours available on the production of the existing product,
and sub-contract the production of the component.
Using opportunity cost approach
Opportunity cost will be added to the relevant cost of making internally and compared with
supplier quotation. Before this however, it is important to know the contribution per hour
that will be lost by failing to produce the existing product. This is already determined
above as N5 per hour. Comparison of Supplier quotation and relevant cost of making:
N
Supplier quotation per unit 90.00
Relevant cost of making per unit

Opportunity cost (4hrs @ N5) 20.00
96.00
The conclusion, as stated above
Alternatively, opportunity cost can be included in computation of contribution from the

existing product. This, of course must take into consideration the contribution per hour that
will be lost by not producing the component internally. The contribution margin from the
existing product will appear thus: -
N N
Selling Price 120.00
Less variable costs
Opportunity cost (4hrs @ N3.5) 14.00 -114.00
Contribution margin 6.00
The computation above shows that the existing product can accommodate what may be lost
from not making the component internally and still give an addition contribution, making it
an attractive option. Hence, the conclusion will still be as earlier passed.
(c). Marginal costing technique believes in future cost or future loss, and therefore, takes into
consideration future cost such as variable cost, and relevant fixed cost and the future loss
such as opportunity cost of alternative forgone, in deciding future course of action. The
sunk cost or historical costs are generally disregarded because these costs have already
been incurred and the decision becomes irreversible and should therefore have no influence
on future course of action.
Page 114
Using marginal costing technique for decisions of this nature, sunk or historical cost should
be disregarded, unless such equipment has a market value or realizable value, which will
then be considered as the opportunity cost of the equipment.
As far as purchase cost and net book value of the said equipment is concerned, it is an
irrelevant cost, and such must not have any influence on decisions of this nature for the
optimal decision.
DROPPING OR RETAINING A CENTER
A center to this effect, may be a person, product, department, division, region, segment, section, etc
to which cost as well as revenue can be separately identified i.e. a profit center. Management may
be contemplating to drop a particular center based on the financial information prepared by a
financial accountant showing that the center is continuously making a loss.
Taken a decision to retain or drop a center should not be based on information prepared by a
financial accountant becomes such information would have been prepared with arbitrary absorption
of fixed overhead. Instead a quantitative factor prepared by a management accountant using
marginal cost technique will be of help. Because such information would have considered the
relevant cost of the center and equally considered the relevant costs to determine whether there will
be a net benefit or loss from the center. If it is a net benefit, it is advisable to retain the center, but if
it is a net loss, it is advisable to drop the center.
The information prepared by the management accountant using, marginal costing technique, will
differ from that of a financial accountant, using absorption costing technique, because marginal
costing will only take into consideration the relevant, separable, and future cost of the center and
avoid un-necessary absorption, apportionment or allocation of fixed overhead, which will remain
constant whether we drop or retain the center. Joint or general fixed overheads will be un-affected
by our decision to drop a particular center, to the extent that, if a center is having a positive
contribution and is dropped, the company profit will be reduced by the quantum of the positive
contribution.
The statement above, only considers the quantitative factors. There are some qualitative factors that
must be considered in deciding to retain or drop a center. These may include:-
a. The alternative uses of the center.

b. Re-action of the investors and creditors of the company.
c. Re-action of employees and trade unions.
d. Redundancy cost or terminal benefit to the employees if required.
e. Nature of demand for the product, that is, is it joint demand or derived demand.
f. The effect on goodwill of the company.
g. The elasticity of demand of the product and other products in the competitive market.
h. Nature of product and the stage of the product in the product life cycle.
i. Faith of employees producing the product/engaged in the department etc.
ILLUSTRATION 1
A company provides you with the following information about its three products line
Page 115
Product A B C
N N N
Sales 200,000 300,000 28,000
Cost of goods sold 180,000 220,000 19,000
Selling expenses 10,000 20,000 3,000
Sales Volume (Units) 500,000 300,000 400,000
Fixed Costs N100,000
The company is considering a discontinuation of product A because it is not generating sufficient

profit. You are further informed that the variable cost of each product is given as follows:-
Product A B C
Variable cost of goods sold 70% 80% 60%
Variable selling expenses 20% 30% 40%
If product A is dropped, general fixed cost will be reduced by N20,000, while the fixed element of
cost of goods sold of product “B” will increase by 5% and selling expenses of product “C” will
increase by 2% in its variable cost.
Required:
Should product A be dropped?
SUGGESTED SOLUTION
In order to advise on whether product A should be dropped or not, the relevant cost of the product
will be computed and deducted from relevant income. But firstly, mixed cost must be split into its
fixed and variable element as follows:-
Product A B C
N N N
Total cost of goods sold 180,000 220,000 19,000
Variable cost of goods sold 126,000 176,000 11,400
Fixed cost of goods sold 54,000 44,000 7,600
Total selling expenses 10,000 20,000 3,000
Variable selling expenses 2,000 6,000 1,200
Fixed selling expenses 8,000 14,000 1,800
The drop in general fixed cost of N20,000 is relevant to product A, because, it is an indirect way of
saying that the cost is incurred mainly by the product.
The increase in fixed cost element of cost of goods sold for product B will be avoided if product A
is not eliminated. It is therefore a savings if product A is maintained. So also is the anticipated
increase in variable selling expenses of product C. Both will be treated as savings in determining
the present contribution from product A.
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Calculation of net contribution or loss of product A
N N
Sales 200,000
Less relevant costs
Variable cost of goods sold 126,000
Variable selling expenses 2,000
Decrease in general fixed cost 20,000
Increase in fixed cost of B (5% x 44,000) (2,200)
Increase in variable cost of C (2% x 1,200) (24) (145,776)
Net benefit 54,224
From the above computation, it is not advisable to eliminate product A, because the product is
presently contributing N54,224 towards recovery of general fixed cost and profit of the company,
in another words, if the product is eliminated, the company’s profit will be reduced by N54,224.
ILLUSTRATION 2
Green PLC produces three products, the Alpha, Beta and Gamma. Draft budgeted figures have
been prepared for the forth coming financial year as follows:-
Products A B G Total
N'000 N'000 N'000 N'000
Sales revenue 1,152 1,290 528 2,970
Variable costs 1,038 1,026 396 2,460
Fixed costs (allocated) 58 96 165 319
Net profit/(loss) 56 168 (33) 191
The figures were presented at a recent board meeting and it was decided that because of the
pessimistic forecast for the Gamma, a number of different options should be examined with a view
to improving the profitability of the company. The options are:-
OPTION A
To substitute the Gamma product with a new product, the Delta. Forecasts relating to the Delta for
the first year are:-
Sales N460,000
Variable costs N250,000
The fixed costs of N32,000 directly attributable to the Gamma product will be eliminated.
However, additional fixed costs directly attributable to the Delta product of N52,000 will be
incurred.
OPTION B
To update the appearance of the Gamma product by using the latest finishing techniques. It is
anticipated that this will lead to a price increase of 16%. Additional variable costs of 10% of the
new price will result from using the new finishing techniques.
OPTION C
To reduce the selling price of the Gamma product by 5% which should generate a 20% increase in
unit sales of the Gamma product?
OPTION D
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To discontinue production of the Gamma product and transfer the labour force to increase
production of both the other products. It is estimated that the saving of fixed costs directly
attributable to the Gamma product will be the same as the additional fixed costs directly
attributable to the increased production of the Alpha and the Beta products.
The direct labour element included in the original draft budgeted figures is as follows:-
Alpha: N390,000 Beta: N130,000 Gamma: N160,000
It is anticipated that N120,000 of the transferred labour will switch to producing the Alpha product
and the remainder to producing the Beta product. It is expected that the cost/selling price
relationships of the Alpha and the Beta products will remain constant.
Required:-
a. A critical analysis of each of the options under examination clearly demonstrating any
effect on the profit of the company. State any assumptions made.
b. Prepare a short report for the board of Green Plc summarizing your findings in “a” and
ranking the options in order of preference.
SUGGESTED SOLUTION
The financial information on which the above position was expressed was prepared using
absorption costing technique. A better review of this position is to use marginal costing technique
to determine whether or not the product is contributing towards recovery of general fixed cost and
profit of the company.
Calculation of contribution or loss from Gamma product using Marginal Costing

N’000
Sales Revenue 528
Less variable costs (396)
Contribution 132
The options can hereby be analysed and compared with the position above.
Option A
The contribution from the new product to substitute Gamma
N'000 N'000
Sales Revenue 460
Less Relevant Costs
Variable Costs 250
X1 Attributable fixed cost 52
X2 Saving in fixed cost -32 -270
Net Contribution 190
X1. The fixed cost increased as a result of introducing Delta product, will be a relevant cost to the
product.
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X2. The attributable fixed cost to Gamma will be saved if Delta product is introduced.
With introduction of Delta product, the company’s profit will increase by N58,000 (i.e. N190,000 –
N132,000).
Option B
Improving Gamma product, revised contribution from improvement.
N'000 N'000
Sales Revenue (528,000 x 1.16) 612.480
Less Relevant Costs
Initial variable cost 396
Additional variable cost (10% x 612,480) 61.248 -457.248
Net Contribution 155.232
Improving Gamma product will increase the company profit by N23,232 (i.e. N155,232 –
N132,000). That is, the difference between contribution of Gamma before and after the
improvement.
Option C
To increase volume and reduce selling price of Gamma product, the revised total contribution.
N'000
Sales Revenue (528,000 x 120% x 95%) 601.92
Less Variable Costs (396,000 x 120%) -475.2
Net Contribution 126.72
95% for reduction in selling price, 120% for volume increase, is used in the above computation.
This option will lead to reduction in profit by N5,280 (i.e. N126,720 – N132,000).
Option D
To determine the effect of discontinuing product Gamma, the contribution of the company before
and after, based on the conditions given in option D will be computed.
The initial total contribution

Products A B G Total
N'000 N'000 N'000 N'000
Sales Revenue 1,152 1,290 528 2,970
Less Variable costs -1,038 -1,026 -396 -2,460
Total Contribution 114 264 132 510
The total contribution, if Gamma is discontinued.

Products A B Total
N N N
Sales Revenue 1,548,000 1,422,000 2,970,000
Less Variable costs -1,394,813 -1,130,986 -2,525,799
Page 119
Total Contribution 153,187 291,014 444,201
The increase in sales of Alpha = N120,000/N160,000 x N528,000 = N396,000
The increase in sales of Beta = N40,000/N160,000 x N528,000 = N132,000
Since it is expected that the cost/selling price relationship of Alpha and Beta will remain constant,
therefore the total variable cost is determined as follows:-
Alpha = N1,038,000/N1,152,000 x N1,548,000 = N1,394,813
Beta = N1,026,000/N1,290,000 x N1,422,000 = N1,130,986
The option will reduce the company profit by N65,799 (i.e. N510,000 – N444,201).
b. In presenting the report to the board, it is necessary to inform the Board that the present
contribution from Gamma is N132,000 and only two options of the four options are promising
a better higher contribution. That is, option A N58,000 and option B N23,232. Option C and D
will lead to reduction in profit. The order of preference will be to adopt option A, followed by
B or to leave product Gamma based on its present contribution.
SELL OR PROCESS FURTHER
If the organizational production process involves more than one stage and the finished produce of
each stage has a market value, Management may be contemplating whether it will be profitable to
sell at the earlier stage of production or process further. Taking such a decision requires the
application of marginal costing technique, where the incremental cost of processing further will be
compared with incremental income. If incremental income is higher than the incremental cost, it
will be advisable to process further and vice visa. The key to the correct decision is to only consider
the differences between the alternative courses of action. Following this decision rule, the joint
costs are not relevant because they will not be different regardless of the decision to sell at the split-
off point or to process the products beyond this point. The decision should be based on a
comparison of the additional market value created by further processing, with the additional cost
required beyond the split-off point.
ILLUSTRATION 1
Quality Industries Nigeria Ltd is a chemical manufacturing company, producing joint products
namely A, B and C. C can be further processed to produce another product D. The result of a recent
research carried out by the company’s laboratory department indicates that they can process D
further to produce another product E.
An examination of the company’s records shows that the joint costs of production of products A, B
and C are N800,000 and the selling prices are A = N12, B = N10, C = N15, D = N25 and E = N30.
Under normal production the company can produce 30,000 units of A, 20,000 units of B and
10,000 units of C. Further processing of C would yield 10,000 units of D if further processed 8,000
units of E would be produced.
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The additional costs of production if further processes are undertaken would be N70,000 for
product D and N40,000 for product E.
You are required to prepare a statement for presentation to management, to indicate clearly whether
C should be further processed and if so, to what stage, if profit is to be maximized.
SUGGESTED SOLUTION
The incremental income and cost of processing further will be compared as follows:-
Incremental benefit/loss from D N
Sales of D (10,000 x N25) 250,000
Less sales of C (10,000 x N15) 150,000
Incremental income 100,000
Less incremental cost 70,000
Incremental benefit 30,000
Incremental benefit/loss from E N

Sales of E (8,000 x N30) 240,000
Less sales of D (10,000 x N25) 250,000
Incremental income -10,000
Less incremental cost 40,000
Net loss -50,000
From the computation above, it is economical to process C further into D and sell at that point.
ILLUSTRATION 2
The Raymond Company manufactured three joint products at a joint cost of N600,000. These
products were processed further and sold as follows-
Additional processing cost
Product Sale (N) (N)
X 400,000 100,000
Y 700,000 320,000
Z 300,000 130,000
1,400,000 550,000
If the company had pursued its opportunity to sell at split-off directly to other processors, sales
would have been X = N250,000, Y = N400,000 and Z = N100,000.
The company expects to operate at the same level of production and sales in the forthcoming year.
Consider all available information, and assume that all costs incurred after split-off are variable.
Which products should be processed further and which should be sold at split-off?
SUGGESTED SOLUTION
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Calculation of net benefit or loss from processing further
Products X Y Z
Sale after further processing 400,000 700,000 300,000
Less Sale at split-off 250,000 400,000 100,000
Incremental income 150,000 300,000 200,000
Less additional processing cost 100,000 320,000 130,000
Net benefit or (loss) 50,000 (20,000) 70,000
From the computation above, it is economical to process products X and Z further, while product Y
should be sold at split-off.
ACCEPTANCE OR REJECTION OF SPECIAL ORDER OR SPECIAL PRICING

DECISION
The selling price of goods and services can be determined using either marginal or absorption
costing technique. Which of the technique to use depends on the organization policy and the market
factors? Below is a brief review pricing method using each of the technique while in-depth
knowledge of the topic will be discussed later in this text under pricing decision.
MARGINAL COSTING TECHNIQUE FOR PRICING DECISION
Using this technique for pricing decision, the price attached to goods and services will be
determined after taken into consideration the relevant costs (i.e. variable costs, opportunity cost,
relevant fixed cost and savings) unto which contribution will be added. This contribution will be
determined based on the level of competition, the level of the product in the product’s life cycle,
nature of the market or type of the offers. The method if used effectively, will ensure that the future
or incremental costs of products or services are recovered plus a reasonable contribution, after due
consideration of above qualitative factors.
MERITS
1. It provides a better basis for short-term decision-making.

2. More contracts could be won using this method because it offers competitive pricing.
3. It avoids the need to artificially allocate among products, a share of fixed indirect costs.
4. It is a useful method of setting prices in a competitive environment.
5. It is useful for setting price for product at different stages in the product life cycle.
6. It encourages acceptance of a special contract and on the long-run leads to maximization
of profit.
DEMERITS
1. The method encourages low pricing and on the long-run full cost may not be recovered.
2. In oligopolistic markets, cutting price close to variable cost may lead to similar action by
competitors with the result that no one benefits except the customers.
3. The method discourages price stability.
4. There may be difficulty in shaking off low price production when trade improves.
5. The method does not guarantee adequate return on investment.
Page 122
ABSORPTION COSTING TECHNIQUE FOR PRICING DECISION
Using this technique for pricing decision, the price to be attached to goods and services will be
determined by cumulating or summing up the historical cost plus future cost, or variable costs and
absorption of fixed costs plus margin or mark-up. This will be in line with management policy.
The average total or full costs will be the addition of productions and/ or related costs. This will
include relevant and irrelevant, fixed and variable costs, past or future costs. The margin or mark-
up will be added to average cost as established from the routine costing method to arrive at an
appropriate selling price for goods and services.
MERITS
1. It is easy to operate
2. It can be easily delegated to less experienced staff.
3. It is useful when placing tender for contract in a less competitive environment (quotation)
4. It may lead to price stability.
5. It allows for a specific profit target in a monopolistic market.
6. It guarantees the survival of the firm if expected profit is attained.
7. Since total cost is the starting point, it is possible to adjust a cost plus element (profit
margin element) from time to time.
DEMERITS
1. If used in an uncritical way, it may lead to lack of consideration of the elasticity of

demand and other market factor.
2. The technique is not useful for bidding for a competitive contract.
3. The use of cost plus may lead to lack of incentive to adequately control the cost element
of the pricing equation.
4. Cost plus method does not recognize different products with different stages in the life
cycle.
5. The method does not encourage acceptance of special or one-off contract, which does not
promise the routine profit but guarantees additional profit.
From the study of the advantages and disadvantages of the two pricing methods, it can be observed
that marginal costing techniques will assist in reaching an optimal decision whenever it involves
acceptance or rejection of a special order, often referred to as special pricing. Special pricing is
applicable whenever we are deciding on orders that are not part of planned work for a period, in
other words, considering an assignment that is not part of a routine job. The relevant costing
technique will take into consideration the incremental costs of the alternative and the income, to
determine whether or not there will be a net benefit from such a special contract or order. If the
result is positive contribution, such an order is advisable to be accepted, because the said positive
contribution will be an addition to normal profit. If it resulted in negative contribution, then such an
order should be rejected.
Apart from the computation of net benefit or loss as discussed above, there are other qualitative
factors to be taken into consideration in setting prices for goods and services, some of which
include the following:-
a. The firm’s objective, does it maximizes profit or maximizes revenue?
Page 123
b. The elasticity of demand of the firm’s product, is it derived demand or joint
demand?
c. The nature of the market; competitive, monopoly or an oligopolistic market.
d. The cost structure of the firm’s product, i.e. what is the % of variable cost to
fixed cost.
e. The level of competition of the firm’s environment and its product.
f. The stage of the product in the life cycle.
g. The firm’s position in the market.
h. The level of inflation.
i. The level of activity of the product or planned capacity.
j. Can the firm operate at full capacity?
k. What is the extent of availability of the product that can be adequately
substituted?
ILLUSTRATION 1
A manufacturing company has recently received an order from a special customer to produce 2,000
units of product X for N300,000.
The company’s financial accountant has prepared the following statement based on absorption
costing method on the basis of which the rejection of the order has been recommended.
Re-Special Order 2,000 units cost statement N N

Materials: A - (N2 x 3 kgs x 2,000) 12,000
B - (N5 x 2 litres x 2,000) 20,000
C - (N9 x 4 units x 2,000) 72,000
D - (N2 x 6 kgs x 2,000) 24,000 128,000
Direct Labour
Grade 1 (N8 x 2 hrs x 2,000) 32,000
Grade 2 (N2 x 4 hrs x 2,000) 16,000
Grade 3 (N1 x 3 hrs x 2,000) 6,000 54,000
Variable Overhead (N5 x 18,000) 90,000
Fixed Overhead (N6 x 18,000) 108,000
Total Costs 380,000
Projected net loss 80,000
Total quotation by customer 300,000
The following additional details were provided
1. Material A:- This material is currently held in stock at a book value of N2.00 per kg, but
it is known that the future purchase will cost N2.75 per kg, and net realizable value is
N10.20 per kg. Material A is in continuous use.
2. Material B:- Original purchase price of this material also held in stock is N5.00 per litre.
The current price is N3.00 per litre. If this material is not used for this order it can be sold
externally for N1.50 per litre as it has no other internal use.
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3. Material C:- This was originally purchased for N9.00 per unit. It is of no use to the
company and would otherwise have to be disposed off at a cost of N2,000 to the
manufacturing company.
4. Material D:- This is not in store and the cost stated is the estimate it could be bought from
outside.
5. Grade 1-labour:- This grade of labour is currently busy on other work and therefore a
replacement would have to be obtained at a rate of N6 per hour for the work which would
otherwise be done by this grade of labour.
6. Grade 2 – labour:- This grade of labour is currently idle. They must be retained due to
difficulty in recruiting this special grade of labour when they are needed.
7. Grade 3 – labour:- This grade of labour is essentially made up of casual workers who are
hired when needed at the rate stated in the estimate.
8. Variable Overheads:- The company absorbs variable overhead on the basis of labour
hours at the rate of N5 per hour.
9. Fixed Overheads:- This is also normally absorbed on the basis of direct labour hours at
the rate of N6 per hour. It is however believed that if this contract is undertaken, the fixed
cost would increase for the duration of the contract by N21,000.
10. In view of the fact that the productive capacity of the company is limited, acceptance of
the contract would necessitate cutting back on the level of production of other products
produced by the company. It is estimated that this would lead to a loss of N50,000.
You are required to redraft the financial accountant’s statement in the light of the additional facts
available and recommend whether the order should be accepted or rejected.
SUGGESTED SOLUTION
Before the budgeted income statement is prepared using marginal costing technique, it is essential
to buttress on relevant cost as indicated in the notes.
1. Material A:- The relevant cost will be the replacement cost of N2.75 per unit, since the
material is of continuous usage and usage of the available quantity will necessitate
replacement.
2. Material B:- The relevant cost of the material is the re-sale value of N1.50 since the
material has no alternative usage at present, but can only be sold. The opportunity cost of
using the material, will be benefit of selling that will be foregone.
3. Material C:- This material is already obsolete, to be disposed-off at a cost. This expected
cost, that will no longer be necessary if the order is accepted, would therefore be treated
as a savings to the contract.
4. Material D:- This material is to be purchased, therefore, the purchase cost becomes
relevant.
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5. Grade 1 Labour:- The replacement cost of N6 per hour is relevant because it is
necessitated by the order.
6. Grade 2 labour:- Since the labour is paid whether or not the order is accepted, the cost is
therefore not relevant.
7. Grade 3 labour:- Since the workforce will be hired as required, it is a relevant cost.
8. Variable overhead :- This is generally a relevant cost, unless otherwise stated.
9. Fixed Overheads:- The increase in fixed cost of N21,000 is a relevant cost, while the
absorption rate will be disregarded.
10. The loss on sales of other product as a result of accepting the order will be recognized as
opportunity cost of the order.
Based on the analysis above, the financial statement can be re-presented using marginal costing
technique as follows:-
Re-Special Order 2,000 units cost statement N N

Materials: A - (N2.75 x 3 kgs x 2,000) 16,500
B - (N1.5 x 2 litres x 2,000) 6,000
Savings (2,000)
D - (N2 x 6 kgs x 2,000) 24,000 44,500
Direct Labour
Grade 1 (N6 x 2 hrs x 2,000) 24,000
Grade 2 - -
Grade 3 (N1 x 3 hrs x 2,000) 6,000 30,000
Variable Overhead (N5 x 18,000) 90,000
Incremental fixed cost 21,000
Opportunity cost 50,000
Minimum cost 235,500
Quotation from Customer 300,000
Net Benefit 64,500
From the computation above, it is desirable to accept the order, because acceptance of the order
will increase the company’s profit by N64,500.
ILUSTRATION 2
Oluola Limited is a small specialist manufacturer of electronic components. Makers of handset use much
of its output. One of the handset makers has offered a contract to Oluola Limited for the supply, over the
next 12 months, of 400 identical components. The data relating to the production of each component are
as follows:
i. Material requirements:
3 kgs of material M1 (see Note 1 below)
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2 kgs of material P2 (see Note 2 below)
1 bought-in component (part number 678) (see Note 3 below)
Note 1: Material M1 is in continuous use by the business; 1,000 kgs are currently held by the
business. The original cost was N4.70/kg, but it is known that future purchases will cost
N5.50/kg.
Note 2: 1,200 kgs of material P2 are currently held. The original cost of this material was
N4.30/kg. The material has not been required for the last two years. Its scrap value is N1.50/kg.
The only foreseeable alternative use is as a substitute for material P4 (in constant use) but this
would involve further processing costs of N1.60/kg. The current cost of material P4 is N3.60/kg.
Note 3: It is estimated that the components (part number 678) could be bought in for N50 each.
ii. Labour requirements: Each component would require five hours of skilled labour and five hours
of semi-skilled. A skilled employee is available and is currently paid N14/hour. A replacement
would, however, have to be obtained at a rate of N12/hour for the work which would otherwise
be done by the skilled employee. The current rate for semi-skilled work is N10/hour and an
additional employee could be appointed for this work.
iii. General manufacturing costs: It is Oluola Limited’s policy to charge a share of the general costs
(rent, heating and so on) to each contract undertaken at the rate of N20 for each machine hour
used on the contract. If the contract is undertaken, the general costs are expected to increase as a
result of undertaking the contract by N3,200. Spare machine capacity is available and each
component would require four machine hours. A price of N200 a component has been offered by
the potential customer.
Required:
a. Should the contract be accepted? Support your conclusion with appropriate figures to present to
management.
b. What other factors ought management to consider that might influence the decision?
SUGGESTED SOLUTION
Oluola Limited
The Contract Income Statement using Relevant Costing Technique

N Notes
Material M1 400 x 3 x N5.50 6,600 1
Material P2 400 x 2 x N2 (i.e. N3.60 - N1.60) 1,600 2
Part number 678 400 x 1 x N50 20,000
Labour - Skilled 400 x 5 x N12 24,000 3
Labour - Semi-skilled 400 x 5 x N10 20,000
Overheads 3,200 4
Total relevant cost 75,400
Expected Revenue 400 x N200 80,000
Net Contribution 4,600
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Clearly, on the basis of positive contribution above it would be beneficial for the business to
undertake the contract.
Notes:
1. The original cost is irrelevant since any inventories used will need to be replaced.
2. The best alternative use of this material is as a substitute for P4 – an effective opportunity
cost of N2.00/kg.
3. The effective cost is N12/hour.
4. It is only the additional cost which is relevant; the method of apportioning total overheads is
not relevant.
b. There are many possible answers to this part of the question, including:
 If material P2 had not already been held, it may be that it would not have been possible to
buy it in and still leave the contract as a beneficial one. In this case the business may be
unhappy about accepting a price under the particular conditions that apply, which could
not be accepted under other conditions.
 Will the replacement for the skilled worker be able to do the normal work of that person
to the necessary standard?
 Is Oluola Limited confident that the additional semi-skilled employee can be made
redundant at the end of this contract without cost to the business?
OPTIMAL PRODUCT MIX
In a multi-product organization, where some or all the product are using the same resources,
questions always arise, on what quantity of each product to produce in order to maximize profit or
otherwise attain the set objective of the organization. In other words, optimal product mix is the
determination of the economical or profitable or optimal combination of products in a multi-
product organization where all the products are using the same resources. Resources here refer to
the 4m’s of management, that is, man-hours, materials, machine hours and money. In optimal
product mix we equally consider market capacity as the 5th m. Therefore, when an organization is
producing various lines of products that are sharing the same man-hour, machine hour, material,
fund and market, it is imperative for such an organization to determine the units of each product to
produce and sell in order to maximize the organization’s profit. The availability or otherwise of
these resources will be taken into consideration in order to know which principle or approach to
use, to arrive at optimal solution, and for this purposes three situations are always considered. They
are:-
a. When there is no constraint.
b. When there is one constraint.
c. When there are two or more constraints.
WHEN THERE IS NO CONSTRAINT
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Constraint is limitation or restriction in the supply or availability of resources. In order words,
when the quantity of the resources available is limited and will restrict further production of the
product.
If there is any organization that is operating without restriction or constraint in any of its resources,
then the optimum mix will be to continue producing the product as far as those products are given
positive contribution. This is recommended, because the more the contribution, the more the profit.
In practical situations, there is rarely no organization that can operate without any constraint. It is
practically impossible for an organization to operate with abundant and limitless man-hours,
machine hours, materials, fund and market at the same time. It can therefore be stated that the idea
of an organization operating without a constraint is more of theoretical than practical.
WHEN THERE IS ONE CONSTRIANT
When there is limitation in the supply or availability of one of the resources that an organization
use for its productions or sales, one of the resources has maximum quantity available for a given
period and hinders further production and sales. If the limitation is experienced only on one
resource, then, there is one constraint and optimum allocation can be done through the use of
“contribution per key limiting factor”. The limiting or restricting factor will be that resource that is
limited in quantity.
CONTRIBUTION PER KEY LIMITING FACTOR
This is contribution per a measure of the resource that is limited, which may restrict future further
production and sales of products. Using the method may require the following steps.
a. Calculate the contribution margin or per unit of the competing product by deducting the
variable cost per unit from the unit selling prices or as may be otherwise derived.
b. Determine the per unit requirement of the limiting factor or the resource that is limited in
quantity.
c. Compute the contribution per limiting factor by dividing the contribution margin per unit,
as stated in “a” above, by the limiting factor per unit, as mentioned in “b” above.
d. Rank the product, in order of, the higher the contribution per key limiting factor, the
higher the ranking. That is, ranking in order of profitability.
e. Prepare allocation table and allocate the available resources among the products in order
of ranking as in “d” above.
f. Recommend optimum mix, based on the allocation done in “e” above.
ILLUSTRATION
Original Carpet Manufacturing Limited produces three types of carpet, Red, Blue and Green. The
three brands of carpet are made from a special fibre imported directly from the sole supplier in
Europe. As a result of scarcity of foreign exchange, supplies of the fibre have been disrupted and it
now seems likely that the company will be unable to obtain not more than half of its normal
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requirements in the coming year. The budget for the coming year had been prepared based on the
following information provided by sales and production staff:-
Type of Carpet Red Blue Green Total

Unit Sold (Estimates) 14,000 8,000 9,000 31,000
N'000 N'000 N'000 N'000
Materials 56 22 64 142
Wages 12 20 25 57
Overheads – Fixed 15 10 10 35
,, - Variable 10 11 7 28
Total Costs 93 63 106 262
Sales 120 80 138 338
Profit 27 17 32 76
You are required to:-
a. Advise the board on the best mix of products to produce for the coming year in the light
of the restricted availability of special fibre.
b. Prepare a revised budget for the coming year on the basis of the advice given.
SUGGESTED SOLUTION
The best mix or optimum mix of products for the coming year, in the light of the restriction will be
determined using contribution per key limiting factor approach. Noting that material is the only
limiting factor and total available for next period, by the instruction above will be N142,000 x 50%
= N71,000. This will be allocated in order of profitability as follows
(a). 1 Calculation of contribution per key limiting factor and ranking of the products
Type of Carpet Red Blue Green
N N N
Sales 120,000 80,000 138,000
Less Variable Costs
Materials -56,000 -22,000 -64,000
Wages -12,000 -20,000 -25,000
Variable overheads -10,000 -11,000 -7,000
Total Contribution 42,000 27,000 42,000
Units Sold 14,000 8,000 9,000
Contribution per unit (N) 3 3.38 4.67
Material cost per unit (N) 4 2.75 7.11
Contribution per limiting factor (%) 0.75 1.23 0.66
Ranking 2nd 1st 3rd
2. Allocation table, to allocate the available material cost in accordance with the ranking.
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Rank Product Units Optimum material materials material bal. Of
demanded Units costs per unit required (N) available (N) Material (N)
1st Blue 8,000 8,000 N2.75 22,000 71,000 49,000
nd
2 Red 14,000 12,250 N4.00 49,000 49,000 -
From the table above, the optimum mix is to produce and sell 8,000 units of blue and
12,250 units of red in order to maximize profit.
b. The revised budget based on the best mix:

Red Blue Total
N N N
Sales 105,000 80,000 185,000
Less variable costs
Material costs (49,000) (22,000) (71,000)
Wages (10,500) (20,000) (30,500)
Variable overhead (8,750) (11,000) (19,750)
Total contribution 36,750 27,000 63,750
Less Fixed overhead (35,000)
Net Profit 28,750
Note that the sales and variable cost of product Red is based on sales units of 12,250 out of
14,000.
ILLUSTRATION 2
Carlton – Gate Plc produces four products, A, B, C and D. The operating budget for the month of
January, 2001 is stated below:-
Products A B C D
N,000 N'000 N'000 N'000
Direct material 1,500 2,500 750 500
Direct labour 400 600 700 600
variable cost 200 300 350 600
2,100 3,400 1,800 1,700
Sales (units) 4,000 5,000 7,500 5,000
Unit sales price N650 N800 N250 N350
Total machine hours required 500 500 300 400
The operation of the company is purely machine driven and can only be expanded to provide
additional 400 hours. The company envisages increase in demand of its product to the tune of 50%
in the forth-coming month due to festivities but has problem of increasing its machine capacity
beyond the new capacity.
In order to cope with the demand upsurge, it has made arrangement with its foreign suppliers to
take care of the production shortfall at the following suppliers’ prices: A at N520, B at N700, C at
N300 and D at N300.
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You are required to:-
Advice the company on the maximum profit it can make:-
a. If the suppliers fail to honour the agreement
b. If the suppliers are certain to honour the agreement.
SUGGESTED SOLUTION
a. To recommend the optimum mix if the suppliers fail to honour the agreement, the hours
available (i.e. 1,700 + 400 = 2,100 hrs) must be economically allocated among the products
using the contribution per key limiting factor.
1. Calculation of the contribution per limiting factor and ranking of the products.
Products A B C D
N N N N
Selling price 650 800 250 350
Less variable cost per unit -525 -680 -240 -340
Contribution margin 125 120 10 10
machine hour per unit 0.125 0.1 0.04 0.08
contribution per limiting factor (N) 1000 1200 250 125
nd
Ranking 2 1st 3rd 4th
2. The revised quantity demanded.

Products A B C D
Budgeted sales (units) 4,000 5,000 7,500 5,000
Increase factor 1.50 1.50 1.50 1.50
Revised sales (units) 6,000 7,500 11,250 7,500
3. Allocation table, to allocate total hours available among the project.
Rank product quantity Optimum machine hours hours

demanded Quantity hour/unit required Available
1 B 7,500 7,500 0.1 750 2,100
2 A 6,000 6,000 0.125 750 1,350
3 C 11,250 11,250 0.04 450 600
4 D 7,500 1,875 0.08 150 150
The optimum mix is to produce and sell 7,500 units of B, 6,000 units of A, 11,250 units of
C and 1,875 units of D.
The maximum profit.
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Optimum Total
Product mix Contribution Contribution
Margin (N) (N)
A 6,000 125 750,000
B 7,500 120 900,000
C 11,250 10 112,500
D 1,875 10 18,750
Total 1,781,250
b. If the suppliers are certain to honour the agreement, then first of all, the supplier quotation
will be compared with cost of making internally.
Products A B C D
N N N N
Supplier quotation 520 700 300 300
Cost of making 525 680 240 340
From comparison, it can be observed that it is cheaper to make product C and B, while it
will be cheaper to allow the supplier to supply product A and D, but since the agreement
with the supplier is to take care of the production shortfall. The supplier may be asked to
supply the shortfall in product “D”, that is, 7,500 units – 1,875 units = 5,625 units.
The maximum profit.

Total Contr.
Products Qty CM (N) (N)
A 6,000 125 750,000
B 7,500 120 900,000
C 11,250 10 112,500
D 1,875 10 18,750
D 5,625 50 281,250
2,062,500
WHEN THERE ARE TWO OR MORE CONSTRAINTS
In a multi-product organization, where the various products of the company are sharing or using the
same resources and there are limitations in the availability or supply of two or more of its
resources, a more advance technique called “Linear Programming Technique” is used to determine
the optimum/profitable/economical combination of products.
LINEAR PROGRAMMING TECHNIQUE FOR OPTIMAL PRODUCT MIX
Linear programming is a quantitative or operational research technique used to solve problems such
as mixing, job assignment, capacity allocation, production scheduling, transportation, purchasing,
investment, location, and other problems. The technique is equally useful in determining the
optimum combination of products when there are two or more restricted resources in the attainment
of some objective, which is usually of economic nature e.g. maximization of profit or minimization
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of costs. Using linear programming requires the formulation of the objective equation and the
constraint equation.
In optimal product mix, the objective can either be maximization of contribution or minimization of
cost. If the objective is to maximize contribution, the contribution margin of the competing product
must be determined and used in formulating the objective equation. If the objective is to minimize
costs, the average cost of the alternatives will be used in formulating the objective.
The constraints equations will be stated, in the form of inequality equation. The number of the
equations will depend on the number of the resources that are limited. Sequel to the formulation of
the objective as well as the constraints equation, any of the following methods can be used to
determine the optimum mix.
1 Graphical Method
2 Simplex method
LINEAR PROGRAMMING ASSUMPTIONS
 A single quantifiable objective

 Each product always uses the same quantity of the scarce resource per unit. This ensures that
the constraints are linear, giving straight lines on the graph.
 The contribution (and cost) per unit is constant for each product. This ensures that the objective
function is a straight line and that its gradient doesn’t change as it moved out (in) on the graph.
 Products are independent.
 The scenario is short-term.
GRAPHICAL METHOD
This involves the use of the two positive sides of a graph (x & y axis) in the determination of the
optimum mix. Using this method, all the constraint equations will be plotted on the positive side of
the graph in the form of a straight line, using the inequality sign of the constraint equation, the
feasible region will be determined. The feasible region is an area in the graph that obeys all the
inequalities sign of the constraint equations. The interceptions of lines on the feasible region will be
used to determine the optimum point, which will be the point at which contribution is maximize, if
the objective is to maximize contribution and cost is minimized, if the objective is to minimize
cost. The quantity of X and Y at the optimum point, will be the optimum mix.
The main weakness of this method is that, it can only accommodate problem involving two
variables, no matter the number of constraints. Where variables are the products line or alternative
under consideration. The method can only accommodate two variables because graph has two
positive sides and only the two positive sides are used in product optimum mix. This is in
conformity with the non-negativity constraint, that is, the recommendation should can only be zero
or greater than zero.
MERITS OF GRAPHICAL METHOD
1. It is a simple pictorial method, which can be easily followed.

2. Little alteration to one or more of the constraint can easily be read from the graph.
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LIMITATIONS OF GRAPHICAL METHOD.
1. The method can only accommodate problems involving two variables

2. If results are to be read from a graph, a small degree of accuracy may be lost.
3. As with all methods of solution, the relationships must be strictly linear for the results to be
accurate.
4. Too many constraints may lead to an over complicated graph.
DEFINATION OF TERMS
1. Shadow Price/Dual Value:- This is an extra contribution derivable from a quantity increase of
a binding constraint. If a limited resource fully utilized at the recommended optimum mix can
be increased by a quantity at the initial cost, the extra benefit the company can derive from
such an increase is referred to as shadow price. This goes in a long way to determine extra cost
we can afford to add to ordinary cost of a binding constraint to get additional quantity.
2. Binding Constraint:- These are resources that are fully used or utilized at the optimum
production level. They are resources that prevent organization from further production, because
the quantity available would have being fully used with the recommended quantity. Only
binding constraints can have a shadow price and the shadow price can be determined using any
of the following methods.
a. Dual method
b. Increase number of constraints by one method.
ILLUSTRATION 1
A company manufactures two products X and Y. The following is relevant on the two products
Products X Y
Selling price (N) 280 290
Raw materials (N) 70 75
Components (N) 60 75
Labour (number of hours)
Electrical 3 3
Construction 2 4
Assembly 6 3
The cost per hour for labour is as follows

Electrical N7
Construction N6.50
Assembly N6
There is no restriction on the supply of raw materials or components, but the number of man-hours
available is restricted as follows.
Electrical 180
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Construction 180
Assembly 300
Required:
Using the graphical method of solution

a. Find the quantities of X and Y that maximizes total contribution and calculate the maximum
contribution.
b. Calculate the excess units of unused resource(s) if any.
c. Calculate the shadow price of scarce resources if any.
d. What are the maximum additional scarce resource(s) economically obtainable and the
maximum premium advisable?
SUGGESTED SOLUTION
(a). The objective of this problem is to maximize contribution, subject to three constraints.
These constraints are hours available in the three departments these will be stated in an
equation form before further calculations.
Calculation of contribution per unit.

X Y
N N
Selling Price 280 290
Less Variable Costs
Raw Materials -70 -75
Components -60 -75
Labour cost- Electrical (N7/hr) -21 -21
- Construction (N6.5/hr) -13 -26
- Assembly (N6/hr) -36 -18
Contribution Margin 80 75
The Linear Programming

The objective is to maximize contribution at N80x + N75y, subject to the following constraints.
1. Hours available in Electrical department = 3x + 3y < 180
2. Hours available in Construction department = 2x + 4y < 180
3. Hours available in Assembly department = 6x + 3y < 300
4. Non-negativity constraint = x, y > 0
The three main constraints will be plotted on a graph inform of a straight line, by drawing from the
maximum quantity of X when Y= 0, to maximum quantity of Y when X = 0.
These can be determined as follows-

X Y X Y
1 3x + 3y = 180 0 60 60 0
2 2x + 4y = 180 0 45 90 0
3 6x + 3y = 300 0 100 50 0
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The table above is prepared based on value of x any y when the other variable is zero.
The graph
y 110
100
90 6X + 3Y < 300 ……………3
80
70
60 3X + 3Y < 180 …………….1
50
40 A
30 B 2X + 4Y < 180 …………….2
20 Feasible C
10 Region D
x
10 20 30 40 50 60 70 80 90 100 110
The feasible region will be determined based on the inequality sign in the constraints equations.
Since all the constraints sign are less than or equal to, the feasible region will be an area that obeys
these inequality signs. The interceptions of lines on the feasible region, already labeled as points A,
B, C and D, will be used in determining optimum point with the aid of the objective function. This
will be done by determining the quantities of X and Y and multiply by the contribution margin. The
point at which total contribution is maximized will be the optimum point.
Calculation of optimum point.

The objective 80x + 75y
Total Contribution
Point A 80(0) + 75(45) 3,375
Point B 80(30) + 75(30) 4,650
Point C 80(40) + 75(20) 4,700
Point D 80(50) + 75(0) 4,000
The optimum point is point C, therefore the optimum mix is to produce and sells 40 units of
product X, and 20 units of product Y in order to maximize contribution or profit. The maximum
contribution at this point is N4,700.
Note that point B and C are interception of two constraint lines, if the graph is drawn to scale, the
quantity of X and Y at these points can be read from the graph. For accuracy purposes, the two
equations that meet at these points should be solved using simultaneous equations principle.
Therefore at point B 3x + 3y = 180 _________ 1 x 2

2x + 4y = 180 __________ 2 x 3
multiply 1 x 2 and 2 x 3
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6x + 6y = 360 ___________ 3
6x + 12y = 540___________ 4
deduct 3 from 4
6y = 180
y = 30
substitute y = 30 in equation 1
3x + 3(30) = 180
x = 30
and at point C 3x + 3y = 180 ____________ 1
6x + 3y = 300 _____________ 2
deduct 1 from 2
3x = 120
x = 40
substitute x = 40 in equation 1
3(40) + 3y = 180
y = 20
(b). To calculate the excess units of unused resource(s) if any, in other words this will assist to
confirm if a resource is binding or otherwise. This can be done, by substituting the
optimum units in each of the constraints and see if the quantities available are fully used. If
fully used, it is a binding constraint and vice visa
constraint 1 3x + 3y = 180
substitute x = 40, and y = 20 3(40) + 3(20) = 180
180 = 180
The resource is fully used and therefore a binding constraint.
160 < 180
The unused hours are 20 hrs in the Construction department and therefore not a binding
constraint.
300 = 300
The resource is fully used and therefore a binding constraint.
(c). To determine the shadow price of a scarce resource, it is important for us to note that only
the binding constraints can have shadow price. Equally, using the graphical approach, only
two of the constraints will be binding, to enable us to determine the shadow prices of the
constraints. After the identification of the two binding constraints any of the following
methods can be used to determine the shadow price. These are
i. Dual method
ii. Increase number of constraint by one method
Any of the methods used, will give the same result.
Using Dual method
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A letter will be used to represent the shadow price to be determined.
Let “A” represent the shadow price of an hour increase in Electrical department, and
Let “B” represent the shadow price of an hour increase in Assembly department
The two binding constraints and contribution per unit will be re-stated as follows:
3x + 3y = 180 _________________ A
6x + 3y = 300 _________________ B
80x + 75y
The equation will be reformulated, by ignoring the earlier variables (x & y) and use new
variables (A & B) for the new equation
3A + 6B = 80 _______________ 1
3A + 3B = 75 _______________ 2
These equations will be solved simultaneously to determine value for “A” and “B”
Deduct equation 2 from 1 3B = 5

B = 1.67
Substitute B = 1.67 in equation 1
3A + 6(1.67) = 80
A = N23.33
Therefore, the shadow price of an hour increase in the Electrical department is N23.33,
while that of an hour increase in the Assembly department is N1.67.
OR, Using increase in number of constraints by one method
The binding constraints

3x + 3y = 180 Electrical department.
6x + 3y = 300 Assembly department.
To determine shadow price of an hour in the Electrical department, the number of hours
available will be increased by one, while the hours available in the Assembly department
will remain unchanged. Based on this increase, units of X and Y will be determined and the
total contribution from such mix computed. This contribution will be compared with the
initial total contribution. Any increase in contribution will be as a result of the hour
increase in the Electrical department and therefore, the shadow price. The same process
will be repeated for the Assembly department, while the available hour of the Electrical
department is held constant.
The shadow price of an hour in the Electrical department

3x + 3y = 181 _____________ 1
6x + 3y = 300 _____________ 2
The quantities of x and y, solving simultaneously, deduct equation 1 from 2
3x = 119
x = 39.67 appr.
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Substitute x = 39.67 in equation 1
3(39.67) + 3y =181
y = 20.67
N
Revised total contribution (39.67 x N80) + (20.67 x N75) 4,723.33
Initial total contribution 4,700.00
Shadow price of an hour in Electrical department 23.33
The shadow price of an hour in Assembly department

3x + 3y = 180 _____________ 1
6x + 3y = 301 _____________ 2
The quantities of x and y, solving simultaneously, deduct equation 1 from 2
3x = 121
x = 40.33 appr.
Substitute x = 40.33 in equation 1
3(40.33) + 3y =180
y = 19.67
N
Revised total contribution (40.33 x N80) + (19.67 x N75) 4,701.67
Initial total contribution 4,700.00
Shadow price of an hour in Assembly department 1.67
(d). To determine the maximum additional scarce resources economically advisable. The scarce
resources are the binding constraint, that is, Electrical and Assembly department’s hours.
Therefore to determine the additional hours for these departments that is economical
desirable, since it is applicable to all binding constraints, the following will be necessary: -
We will assume that these binding constraints are no longer limited, and therefore should
not appear on the graph. That is, they are available for those binding constraints that we
intend to determine the extra units.
In line with the above, it meant that only constraint 3 will appear on the graph. Based on
this, a revised optimum unit will be determined and the number of hours required for such
a revised mix will be computed and compared with initial hours available. The excess will
be the additional hours advisable.
Using the above, the graph can be re-drawn as follows
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y 110
100
90
80
70
60
50
40 A 2X + 4Y < 180 …………….2
30 Feasible
20 Region
10 B
x
10 20 30 40 50 60 70 80 90 100 110
With the graph above, we have only two interceptions out of which, we will determine the
optimum point with the aid of the objective equation 80x + 75x
Point A 80(0) + 75(45) = N3,375

Point B 80(90) + 75(0) = N7,200
The revised optimum mix will therefore be, to produce and sell 90 units of X and none for
y.
Electrical department
Total hours required for the revised mix = 3(90) + 3(0) 270 hrs
Initial total hours available 180 hrs
Additional hours economically desirable 90 hrs
Assembly department
Total hours required for the revised mix = 6(90) + 3(0) 540 hrs
Initial total hours available 300 hrs
Additional hours economically desirable 240 hrs
The computation above shows that the electrical and assembly department hours could be
increased by 90 hrs and 240 hrs respectively before the available hours in the Construction
department would be exhausted. The maximum premium advisable is the shadow price,
additional cost per hour that can be accommodated, will be N23.33 and N1.67 per hour for
Electrical and Assembly department respectively.
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ILLUSTRATION 2
A factory manufactures two qualities of roofing sheet called Standard and Deluxe. Both require
tarring and pressing and the time for a length are as follows:
PROCESS HOUR
Tarring Pressing
Standard ½ 1
Deluxe 2 3
It has been agreed with the local trade union branch that the process should be each operated at
least 2,400 hours during the period. In addition the company is committed to supply 1,200 lengths
of standard quality and all output of which ever quality could be sold.
The cost of production per production –length is N20 for Standard and N30 for Deluxe quality.
At what mixture of products is the cost at a minimum? Use the graphical approach.
SOLUTION
The objective is to minimize production cost of Standard and Deluxe product.

Let x represent the quantity of Standard product
Let y represent the quantity of Deluxe product
The objective is to minimize cost at N20x + N30y, subject to the following constraints.
1. Tarring process hours 1/2x + 2y > 2,400

2. Pressing process hours x + 3y > 2,400
3. Committed supply x > 1,200
These constraints will be drawn on a graph by determining the highest quantity for x and y.
X Y X Y
1 1/2x + 2y = 2,400 0 1,200 4,800 0
2 x + 3y = 2400 0 800 2,400 0
3 x = 1,200 1,200 0 0 0
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The graph
Y 4400
4000
3600 X=2400
3200
2800
2400
2000 Feasible
1600 Region 1/2X + 2Y = 2400
1200 A X + 3y = 2400
800
400 B
X
400 800 1200 1600 2000 2400 2800 3200 3600 4000 4400 4800
The feasible region is determined taken into consideration the inequality signs of the constraints,
which are stated as “greater than or equal to” therefore the feasible region is the area that is greater
or equal the constraint lines. The point at which cost is minimized can be determined considering
the quantity of x and y at point A and B and multiplied by the standard cost per quantity.
Objective 20x + 30y
Total Cost (N)
Point A 20(1,200) + 30(900) 51,000
Point B 20(4,800) + 30(0) 96,000
Total cost is minimized at point A that is point A is the optimum point. It is advisable to produce
1,200 lengths of Standard and 900 lengths of Deluxe, in order to minimize cost.
Note that at point “A” the two equations intercepted should be solved using simultaneous equation
principle, to derive the accurate figure for x and y
These equations are:
x = 1,200 _______________ 1
½x + 2y = 2,400 _______________ 2
substitute x= 1,200 in equation 2
½(1,200) + 2y = 2,400, y = 900
SIMPLEX METHOD
This is a more comprehensive solution, which deal with any number of variables and constraints.
Using the method the inequality in the constraint equation will be changed to equality through the
introduction of the “slack-variable”. The Slack-variable represents un-used resource(s) at optimum
production level, that is, if there is any un-used out of the limited resources available, it will be
represented by its slack variable. Simplex method, which can cope with any number of variables
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and, since, it is an iterative technique is best suited for a computerized environment. In addition to
being an extremely powerful tool of analysis, the simplex method yields a considerable amount of
useful information, reading from the final tableaus, the optimum mix, total contribution, shadow
price of binding constraint, un-used resources if any, are various information that can be obtained.
MERIT OF SIMPLEX METHOD
a. It can accommodate problems with any number of variables

b. The final tableaus give a lot of useful information.
c. The method is suitable for both maximization and minimization problems
d. Since simplex is an iterative method, which can be broken down into a few simple steps,
it is easily adaptable to solution by computer.
ILLUSTRATION
A manufacturing company produces product A, B, C and D, which make use of the same four
grade of raw material G1, G2, G3 and G4. To produce a unit of each product required the following
proportions of the materials are required:
Materials G1 G2 G3 G4
Product A 1 2 1 3
B 2 1 2 4
C 2 2 1 2
D 1 1 2 1
The weekly profits per unit on the various products are N4, N6, N4 and N3 for products A, B, C
and D respectively. The maximum quantities of materials available on weekly basis are:
Materials G1 G2 G3 G4
Quantity 70 kgs 56 kgs 70 kgs 92 kgs
Using the simplex method, determine which products mix maximize profit and explain the final
tableau.
SOLUTION
Let w, x, y and z represent the quantities of product A, B, C and D made per week respectively.
The objective is to maximize profit at 4w + 6x + 4y + 3z, subject to the following constraints.
1 Material G1 w + 2x + 2y + z < 70
2 Material G2 2w + x + 2y + z < 56
3 Material G3 w + 2x + y +2z < 70
4 Material G4 3w + 4x + 2y + z < 92
To change the inequality in the constraint equation to equality, a slack variable will be introduced.
Let a, b, c and d represents the slack variable for materials G1, G2, G3 and G4 respectively.
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The equation will therefore become:
1 Material G1 W + 2x + 2y + z + a = 70
2 Material G2 2w + x + 2y + z + b = 56
3 Material G3 W + 2x + y +2z + c = 70
4 Material G4 3w + 4x + 2y + z + d = 92
The initial table can be determined or tabulated by creating a column each for the variables plus a
column for the solution. Thereafter, the gradient or figure of the constraint will be stated under each
of the variables starting with the first constraint to the last constraint. There after the contribution
row will be stated in negative form. The idea is that there are opportunities available but not yet
tapped. The initial table will be:
Constraint W x y z A b c d Solution
1 1 2 2 1 1 0 0 0 70
2 2 1 2 1 0 1 0 0 56
3 1 2 1 2 0 0 1 0 70
4 3 4 2 1 0 0 0 1 92
Contrib. -4 -6 -4 -3 0 0 0 0 0
To prepare the next table the following steps will be necessary.
a. Find the column with the largest negative indicator on the bottom row.
b. Divide all positive entries in this column into the corresponding entries of the final column
(Solution column).
c. Choose the entry that gives the smallest answer in step 2 as the pilot element.
d. Use an elementary row transformation to change the values of the pivot element to 1 (i.e.
multiply or divide all values in the row by an appropriate constant).
e. Use elementary row transformations to change the other values in the pivot column to zero by
adding or subtracting the pivot element by the appropriate number of times.
f. Examine the resultant values in the bottom row. If there are no negative indicators, the final
solution has been, otherwise return to step 1 and repeat the procedure all over again until the
resultant values in the bottom row (contribution row) do not give negative indicators.
Column 2 is the pivot column since it has the largest negative indicator.
The pivot element is determined as follows:
70/2 = 35, 56/1 = 56, 70/2 = 35 92/4 = 23
The pivot element will be the figure on the row with least result i.e. row 4. Therefore the pivot
element is 4 that is the figure at the interception of pivot column and row.
Elementary row transformation operations to obtain the second solution are:-
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R4 = 1/4R4, R1 = R1 – 2R4, R2 = R2 – R4, R3 = R3 – 2R4, R5 = R5 + 6R4
The second table

Constraint w x y z a B c d Solution
1 1/2 0 1 1/2 1 0 0 -1/2 24
2 5/4 0 3/2 3/4 0 1 0 -1/4 33
3 1/2 0 0 3/2 0 0 1 -1/2 24
4 3/4 1 1/2 1/4 0 0 0 1/4 23
Contrib. 1/2 0 -1 -3/2 0 0 0 3/2 138
Repeating the step in the second solution above, column 4 is the pivot column, with the pivot
element on the 3rd row.
Required row transformation to next solution is:
R3 = 3/2R3, R1 = R1 – 1/2R3, R2 = R2 – 3/4R3, R4 = R4 – 1/4R3, R5 = R5 + 3/2R3
Third solution
Constraint w x Y z a B C d Solution
1 1/3 0 1 0 1 0 -1/3 -1/3 16
2 2/3 0 3/2 0 0 1 -1/2 0 21
3 -1/2 0 0 1 0 0 2/3 -1/3 16
4 5/6 1 1/2 0 0 0 -1/6 -1/3 19
Contrib. 0 0 -1 0 0 0 1 1 162
Since there is still negative value in contribution row, the process will be repeated again.
The pivot element is in 2nd row of column 3

Elementary row transformations are:
R2 = 2/3R2, R1 = R1 – R2, R4 = R4 –1/2R2, R5 = R5 + 3/2R2
The final table

Constraint w x Y z a b C d Solution
1 -4/3 0 0 0 1 -2/3 0 -1/3 2
2 1 0 1 0 0 2/3 -1/3 0 14
3 -1/3 0 0 1 0 0 2/3 -1/3 16
4 1/3 1 0 0 0 -1/3 0 1/3 12
Contrib. 1 0 0 0 0 2/3 2/3 1 176
This tableau gives the optimum solution since it has no negative values.
Reading from the tableau the results are:
W = 0, x = 12, y = 14, z = 16, C = 176, a = 2, b = 0, C = 0, d = 0.
The optimum solution is therefore to make, 12,14 and 16 units of products B, C, and D
respectively, with total contribution of N176. The un-used material G1 is 2 kgs.
Page 146
PRACTICE QUESTIONS
1. Omoti Limited has been offered a contract for which there is available production capacity. The
contract is for 20,000 identical items, manufactured by an intricate assembly operation, to be
produced and delivered in the next few months at a price of N80 each. The specification for one
item is as follows:
Assembly labour 4 hours
Component X 4 units
Component Y 3 units
There would also be the need to hire equipment, for the duration of the contract, at an outlay cost
of N200,000.
The assembly is a highly skilled operation and the workforce is currently underutilized. It is the
business’s policy to retain this workforce on full pay in anticipation of high demand next year, for
a new product currently being developed. There is sufficient available skilled labour to undertake
the contract now under consideration. Skilled workers are paid N15 an hour.
Component X is used in a number of other subassemblies produced by the business. It is readily
available, and 50,000 units of Component X are currently held in inventories. Omoti Limited
made a special purchase of Component Y in anticipation of an order that did not in the end
materialize. It is, therefore, surplus to requirements and the 100,000 units that are currently held
may have to be sold at a loss. An estimate of various values for Component X and Y provided by
the materials planning department is as follows:
Component X Y
N/unit N/unit
Historic cost 4 10
Replacement cost 5 11
Net realizable value 3 8
It is estimated that any additional relevant costs associated with the contract (beyond the above)
will amount to N8 an item.
Required:
Analyse the information and advise Omoti Limited on the desirability of the contract.
2. Ronto Ltd, a small business that specializes in building electronic-control equipment, has just
received an order from a customer for eight identical robotic units. These will be completed using
Ronto’s own labour force and factory capacity. The product specification prepared by the
estimating department shows the following material and labour requirements for each robotic
unit.
Component X 2 per unit
Component Y 1 per unit
Component Z 4 per unit
Other miscellaneous see below
Assembly labour 25 hours per unit (but see below)
Inspection labour 6 hours per unit
As part of the costing exercise, the business has collected the following information:
 Component X: This item is normally held by the business as it is in constant demand. The 10
units currently held were invoiced to Ronto at N150 a unit, but the sole supplier has
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announced a price rise of 20 percent effective immediately. Ronto has not yet paid for the
items currently held.
 Component Y: 25 units are currently held. This component is not normally used by Ronto but
the units currently held are because of a cancelled order following the bankruptcy of a
customer. The units originally cost the business N4,000 in total, although Ronto has recouped
N1,500 from the liquidator of the bankrupt business. As Ronto Ltd can see no use for these
units (apart from the possible use of some of them in the order now being considered), the
finance director proposes to scrap 25 units (zero proceeds).
 Component Z: This is in regular use by Ronto ltd. There is none in inventories but an order is
about to be sent to a supplier for 75 units, irrespective of this new proposal. The supplier
charge N25 a unit on small orders but will reduce the price to N20 a unit for all units on any
order over 100 units.
 Other miscellaneous items: These are expected to cost N250 in total.
Assembly labour is currently in short supply in the area and is paid at N10 an hour. If the order is
accepted, all necessary labour will have to be transferred from existing work, and other orders
will be lost. It is estimated that for each hour transferred to this contract N38 will be lost
(calculated as lost sales revenue N60, less materials N12 and labour N10). The production
director suggest that, owing to a learning process, the time taken to make each unit will reduced,
from 25 hours to make the first one, by one hour a unit made.
Inspection labour can be provided by paying existing personnel overtime which is at a premium
of 50 per cent over the standard rate of N12 an hour.
When the business is working out its contract prices, it normally adds an amount equal to N20 for
each assembly hour to cover its general costs (such as rent and electricity). To the resulting total,
40 per cent is normally added as a profit mark-up.
Required:
a. Prepare an estimate of the minimum price that you would recommend Ronto Ltd to charge for the
proposed contract such that it would be neither better nor worse off as a result. Provide
explanations for any items included.
b. Identify any other factors that you would consider before fixing the final price.
4. A business makes three products, A, B and C. All three products require the use of two types of
machine: cutting machines and assembling machines. Estimates for next year include the
following:
Product A B C
Selling price (N per unit) 25 30 18
Sales demand (units) 2,500 3,400 5,100
Material cost (N per unit) 12 13 10
Variable production cost (N per unit) 7 4 3
Time required per unit on cutting machines (hours) 1.0 1.0 0.5
Time required per unit on assembly machines (hours) 0.5 1.0 0.5
Fixed cost for next year is expected to total N42,000. It is the business’s policy for each unit of
production to absorb these in proportion to its total variable cost.
The business has cutting-machine capacity of 5,000 hours a year and assembling-machine
capacity of 8,000 hours a year.
Required:
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a. State, with supporting workings, which products in which quantities the business should plan to
make next year on the basis of the above information. Hint: First determine which machines will
be a limiting factor.
b. State the maximum price per product that it would be worth the business paying to a sub-
contractor to carry out that part of the work that could not be done internally.
5. Intermediate Products Ltd produces four types of water pump. Two of these (A and B) are sold by
the business. The other two (C and D) are incorporated, as components, into another of the
business’s products. Neither C or D is incorporated into A and b. Costing (per unit) for the
products are as follows:
Product A B C D
N N N N
Variable materials 15 20 16 17
Variable labour 25 10 10 15
Other variable costs 5 3 2 2
Fixed costs 20 8 8 12
65 41 36 46
Selling price (per unit) N70 N45
There is an outside supplier who is prepared to supply unlimited quantities of product C and D to
the business, charging N40 per unit for product C and N55 per unit of product D.
Next year’s estimated demand for the products, from the market (in the case of A and B) and
from other production requirements (in the case of C and D), is as follows:
Units
A 5,000
B 6,000
C 4,000
D 3,000
For strategic reasons, the business wishes to supply a minimum of 50 percent of the above
demand for products A and B.
Manufacture of all four products requires the use of a special machine. The products require time
on this machine as follows:
Hours per unit
A 0.5
B 0.4
C 0.5
D 0.3
Next year there are expected to be a maximum of 6,000 special-machine hours available. There
will be no shortage of any other factor of production.
Required:
a. State, with supporting workings and assumptions, which quantities of which products the
business should plan to make next year.
b. Explain the maximum amount that it would be worth the business paying per hour to rent a
second special machine.
c. Suggest ways, other than renting an additional special machine that could solve the problem
of the shortage of special-machine time.
Page 149
6. Fadeke Company making a single product has a factory in the South, and distributes its
products through three depots situated in the South, Midlands and North.
It is estimated that during the coming year, 100,000 units will be manufactured and sold at
a price of N20 per unit, the sale being spread as follows:
South 70,000 units

Midlands 20,000 units
North 10,000 units
Standard costs of production are:
Direct materials N4.80 per unit

Direct wages N3 per unit
Factory variable overheads 140% on direct wages
Factory fixed overheads N400,000 per annum
The costs of selling and distribution incurred by the depots are estimated as follows:
Fixed costs
South N80,000 per annum

Midlands N50,000 per annum
North N30,000 per annum
Variable Costs
South 5% of sales value

Midlands 8% of sales value
North 10% of sales value
From the budget for the business prepared from these figures, management is considering
the desirability of closing the depots and selling organizations in the Midlands and/or
North. If this is done, it is expected that all sales in these areas will be lost, but that sales in
the South will remain unaffected.
Required:
a. Prepare a budget for the business from the figures provided, indicating why
management is thinking of closing the depots in the midlands and/or North.
b. Present additional information to help management make a decision in regards to this

problem and make recommendations from your figures.
7. Kemo Limited produces 3 products AL, BL and CL. The following data relates to the 3
products:
Products AL BL CL
N N N
Sales 500,000 300,000 250,000
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Total costs 290,000 180,000 280,000
Net profit 210,000 120,000 -30,000
Sales units 100,000 200,000 125,000
Fixed costs (% of total costs) 20% 28% 10%
Since CL is currently generating a net loss the company is considering the following courses
of action
a. Discontinue CL, this will lead to reduction in the sales of AL by 2% and fixed cost by
1%.
b. Increase the selling price of CL by 20%. This will however reduce it sales volume to
100,000 units only.
c. Discontinue CL and use the present plant capacity of CL to produce DL, which will
sell at N3/unit at 95,000 units of sales volume. Variable cost will be 70% of sales for
the first 80% sold and 60% of the remainder.
Required:
Determine the net effect on profit of each of the above proposal and recommend the best
line of action. What other factors would you like the management to consider in its present
circumstances.
8. Sola Adekoya is a practicing accountant. He enjoys his work, is very skilled and is in heavy
demand. Sola has raised his fees considerably during the past two years, but he is un-able
to accept all clients who want his accounting services.
Sola has worked an average of nine hours daily, six days a week, for forty-eight weeks a
year. His fees average N125 per hour, his variable costs are negligible and may be ignored
for decision purposes. Ignore income taxes.
Required:
(a). Sola wants to reduce his hours. He is considering not working on Saturdays, but instead
working ten hours daily on Mondays through Fridays. What would be his annual income:
i. If he continues to work the same schedule as before, and
ii. If he adopts the new schedules?
(b). What would be his opportunity cost for the year of not working the extra hours?
(c). Suppose that Sola has definitely decided to adopt the new schedule. He loves to play golf.
If he plays golf during half a Saturday when he otherwise would have be doing work for
clients, what is his opportunity cost of playing golf?
9. Abiola Limited has been invited to quote a price for a special contract for the manufacture
of product W. The firm’s accountant has prepared the following statement of the price that
should be charged.
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Direct Costs
Material Costs N
A - 900 tons at actual cost N2.50 per ton 2,250
B - 1,500 kgs at actual cost N0.40 per kg 600
C - 1,000 kgs at expected cost N0.90 per kg 900
Labour Costs
Grade 1 - 1,500 hours at N2 per hour 3,000
Grade 2 - 750 hours at N1 per hour 750
Grade 3 - 2,000 hours at N0.50 per hour 1,000
8,500
Overheads - 60% of direct costs 5,100
13,600
Add profit margin - 10% 1,360
Contract price 14,960
You have obtained the following information:
a. Material A is frequently used by Abiola Limited because of a world-wide shortage of the

material. The current buying price has increased to N3.50 per ton although the company
could only realize N3.25 per ton from sales of the material after deducting selling costs.
Abiola Limited’s buyer forecast the rise in price, and purchased large stocks of the
material some months ago – 5,000 tons are currently held by the firm.
b. 2,000 kgs of material B have been ordered for another contract, which has been
cancelled, delivery is expected in a day’s time. Abiola Limited has no alternative uses for
the material. The current buying price is still 40k per kg, but the material could be sold
for only 30k per kg.
c. Material C is not in stock or on order.
d. Grade 1 labour has special skills. A considerable amount of the time of these employees
is un-used at present because of a fall in demand for the products, which they
manufacture. However Abiola expects demands to revive next year and has therefore
decided not to dismiss any of the employees. The current wage for grade 1 labour is N80
for a 40 hours week.
e. Grade 2 labour is used to capacity and no additional supplies are available. Moreover,
there is no possibility of using other grades of labour as substitutes. The current wage rate
is N1 per hour. If the contract for product W is accepted a special machine will be
purchased at a cost of N10,000 and use it on the contract for six months. For normal
accounting purposes, the firm depreciates such machines at 10% per annum. The machine
could not be used on any other work in the firm and so it would be sold on completion of
the contract for an estimated N8,500.
f. Grade 3 labour may be considered variable cost and other variable overhead costs would
amount to N1.
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Required:
Calculate the minimum cost of the contract.
10. Excess TV is a small, regional, television programme-making company that was set up five
years ago with the assistance of a government grant. The main aims of the company, when
it was first established, were to produce programmes of local interest. The programmes
were screened at off-peak periods by local broadcasters, for example at the end of the local
news. In the last few years, the company has been successful and has grown considerably.
It now employs a full range of qualified staff, and makes larger productions. In addition, it
contracts with other programme-making companies to make productions on their behalf,
which are often screened nationally. You are employed as the Management Accountant.
Excess TV has recently been approached by a television company in the country, which
wants it to record and produce a short documentary-drama. The company is currently very
busy, and has little spare capacity with which to fulfill the contract. However, the
Managing Director believes that if it makes this production, the television company may
award it more lucrative contracts in the future. The Managing Director has put together
some initial costs, and these are outlined below:
Camera operators – The production will require seven weeks of filming. It is estimated that
four camera operators will be required for the full period, three of whom will be employed
on a freelance basis and will cost the company N860 each per week. However, there are no
other freelance operators available, and so it will be necessary to take one camera operator
from another job. This camera operator is a full-time employee, and is paid an annual
salary of N52,000. This will mean a loss of contribution of N6,600 from the other job. The
camera operator’s wages for the seven-week period are the only variable costs of the other
job.
Manufacture of scenery – The scenery required will have to be specially made. Two
painters are employed by the company, each being paid N350 for a guaranteed 40-hour
week. It is anticipated that each will have to work 24 hours a week on this production, for a
period of three weeks. At the present time, each painter has enough work to occupy 20
hours per week. In order to meet the deadline, each will be required to work overtime, at
time and a half, for four hours per week during each of the three weeks.
The paint required is in stock. It cost N420, and was due to be used on another production.
It would cost N470 to replace. Other materials have a cost of N520. Half of these will have
to be purchased for the production, but half of them can be taken from leftover materials
from previous jobs. The original cost of the materials in stocks was N180. This half could
be sold for N60, and has no alternative use.
Lighting and sound – The lighting and sound technicians are employed by the company.
The lighting technician is paid a salary of N30,000 per annum, and the sound technician is
paid N32,000 per annum. It is anticipated that they will be required for the full seven-week
filming period. Both are always fully employed within the business, and the contribution
lost if they worked on this job would be N13,500. Alternatively, the company could
employ lighting and sound technicians from an agency, for a joint cost of N1,500 per week.
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Editing costs – The editing costs of the production, including hardware, are N4,700. This
includes N300 depreciation charges on the editing equipment.
Studio costs – The company will need to hire studio time in order to make the production.
The studio is priced at N1,200 per day to hire. It is estimated that the production will
require 18 days’ studio recording. The remainder is to be filmed outdoors, for which there
is no charge.
Overheads – All productions are charged with overheads at 25% of cost. This is to cover
general fixed costs.
Income – The income for the production would be N72,000.
Required
Using the principles of relevant costing, calculate whether it would be worthwhile
financially for Excess TV to make the production.
11. A multi-product company manufactures four products W, X, Y and Z, all of which have
100% import content for materials. The budget for the month of July 1987 is given as
follows:-
Product W X Y Z
N N N N
Material Cost 32 60 60 30
Direct Labour 12 18 12 12
Period costs 4 12 12 6
Profit 36 30 56 27
Sales 210,000 264,000 420,000 202,500
The budget may not be achieved because the company now faces shortage of fund to import
all the required raw materials. Based on its cash flow projection which has been prepared
using the average SFEM rate for the past two months, the company can only afford to
purchase N450,000 worth of the required materials. The company’s management has decided
to produce at least 2,000 units of each product and the balance of the fund, if any, to be
utilized for the products that give the highest contribution to their profits.
Required:
a. Advise management on the quantities of each of the products to produce.
b. Prepare the revised income statement showing the total profit from each product based
on “a” above.
12. The Richard Paint Company is a privately owned manufacturing firm specializing in the
production of industrial varnish. The selling prices and the associated unit variable costs for
High Gloss varnish and Matt varnish are shown in the table below:-
Unit Variable
Product Selling Price Costs
per gallon (N) per gallon (N)
Page 154
Matt 13.00 9.00
High gloss 16.00 10.00
Each gallon of Matt varnish requires 6 minutes of skilled labour and each of High Gloss
requires 12 minutes of skilled labour available. In a given day there are 400 man-hours of
skilled labour available. Also there are 100 ounces of an important blending chemical
available each day, where each gallon of Matt varnish needs 0.05 ounces of the blending
chemical and each gallon of High gloss varnish needs 0.02 ounces of the chemical. The
processing capacity at the plant is limited to 3,000 gallons of varnish per day.
The company is committed to supplying a leading retailer with 5,000 gallons of matt
varnishes and 2,500 gallons of high gloss varnish each week (consisting of five days). In
addition there is an agreement with the unions that at least 2,000 gallons are produced each
day. Richard Company management would like to determine the daily production volume of
each of the two varnishes that maximize total contribution.
Required:
a. Develop a linear programming of the production problem facing Richard Paint

Company.
b. Using a graphical approach, determine the optimum daily production plan and the
consequent contributions.
c. The union is pressing for overtime wage rate of N20 per hour above the wage rate for
skilled labour:-
i. Justify whether Richard Paint Company finds this profitable or not?

ii. If it was profitable to pay the overtime, how many overtime hours per day would
it be worth employing?
13. Consider the following details of the income statement of the Emma Company for the last
year ended 31st December.
Sales N10,000,000
Less manufacturing cost of goods sold 6,000,000
Gross profit or gross margin 4,000,000
Less selling and administrative expenses 3,100,000
Operating income 900,000
Emma’s fixed manufacturing costs were N2.4 million and its fixed selling and
administrative costs were N2.3 million. Sales commissions of 3 percent of sales are
included in selling and administrative expenses.
The company had sold 2 million pens. Near the end of the year, Emole Corporation, the
well-known seller of fast food, had offered to buy 150,000 pens on a special order. To fill
the order, a special clip bearing Emole’s emblem would have had to be made for each pen.
Emole’s intended to use the pens in special promotion early next year. Even though Emma
had some idle plant capacity, the president rejected the Emole’s offer of N660,000 for the
150,000 pens. He said:
Page 155
The Emole’s offer is too low. We will avoid paying sales commissions, but we have to
incur an extra of 20 kobo per clip for the emblem and its assembly with the pens. If Emma
sells below its regular selling prices, it will begin a chain reaction of competitors’ price
cutting and of customers wanting special deals. I believe in pricing at no lower than 8
percent above our full costs of N9,100,000/2,000,000 units = N4.55 per unit plus the extra
20 kobo per chip less the savings in commissions.
a. Using the contribution approach, prepare an analysis using four column showing, without
the special order, with the special order, and the special order difference shown in total and
per unit.
b. By what percentage would operating income increase or decrease if the order had been
accepted? Do you agree with the president’s decision? Why?
14. A local Woolworth’s store sells many products. It has a restaurant with a counter that
extends almost the length of the store. Management is considering dropping the restaurant,
which has consistently shown an operating loss. The predicted income statements, in
thousands of naira, follow (for ease of analysis, only three product lines are shown):
General Garden
Total Merchandise Products Restaurant
Sales 5,000 4,000 400 600
Variable expenses 3,390 2,800 200 390
Contribution margin 1,610 32% 1,200 30% 200 50% 210 35%
Fixed expenses
(compensation, depreciation,
property taxes, insurance, etc) 1,110 750 50 310
Operating income 500 450 150 (100)
The N310,000 of fixed expenses include the compensation of restaurant employees of

N100,000. These employees will be released if the restaurant is abandoned. All counters
and equipment are fully depreciated, so none of the N310,000 pertains to such items.
Furthermore, their disposal values will be exactly offset by the costs of removal and
remodeling.
If the restaurant is dropped, the manager will use the vacated space for either (a) more
general merchandise or (b) more garden products. The expansion of general merchandise
would not entail hiring any additional salaried help, but more garden products would
require an additional person at an annual cost of N25,000. The manager thinks that sales of
general merchandise would increase by N300,000, garden products, by N200,000. The
manager’s modest predictions are partially based on the fact that she thinks the restaurant
has helped lure customers to the store and thus improved overall sales. If the restaurant is
closed, that lure would be gone.
Required
Should the restaurant be closed? Explain, showing computations.
Page 156
15. The Lowe Company manufactures electronic subcomponents that can be sold at the end of
Process A or can be processed further in Process B and sold as special parts for a variety of
intricate electronic equipment. The entire output of Process A can be sold at a market price
of N2 per unit. The output of Process B has been generating a sales price of N5.50 for three
years, but the price has recently fallen to N5.10 on assorted orders.
Helen Tobin, the vice-president of marketing, has analysed the markets and the costs. She
thinks that the B output should be dropped whenever its price falls below N4.50 per unit.
The total available capacity of A and B is interchangeable, so all facilities should currently
be devoted to producing B. She cited the following data:
Output of A
Selling price, after deducting N N
relevant selling costs 2.00
Direct labour 0.20
Manufacturing overhead 0.60
Cost per unit 1.80
Operating profit 0.20
Output of B
Selling price, after deducting N N
relevant selling costs 5.10
Transferred-in variable cost from A 1.20
Additional direct materials 1.50
Direct labour 0.40
Manufacturing overhead 1.20
Cost per unit 4.30
Operating profit 0.80
Direct-materials and direct-labour costs are variable. The total overhead is fixed, it is
allocated to units produced by predicting the total overhead for the coming year and
dividing this total by the total hours of capacity available.
The total hours of capacity available are 600,000. It takes one hour to make 60 units of A
and two hours of additional processing to make 60 units of B.
Required
a. If the price of B for the coming year is going to be N5.10, should A be dropped and all
facilities devoted to the production of B? Show computations.
b. Prepare a report for the vice-president of marketing to show the lowest possible price for B
that would be acceptable.
c. Suppose that 50 percent of the manufacturing overhead were variable. Repeat requirements
1 and 2. Do your answers change? If so, how?
Page 157
16. Dutse Nig. PLC is considering the profitability of the company’s four products and the
potential effect of major proposals for varying the product mix. The following income
statement for the year and other data were extracted from the company’s books:
Total Products
A B C D
N N N N N
Sales 125,200 20,000 36,000 25,200 44,000
Cost of goods sold 88,548 9,500 14,112 27,936 37,000
Gross Profit/Loss 36,652 10,500 21,888 (2,736) 7,000
Operating Expenses 24,028 3,980 5,956 5,652 8,440
Net Income/Loss 12,624 6,520 15,932 (8,388) (1,440)
Units Sold 1,000 1,200 1,800 2,000

N N N N
Sales Price per unit 20.00 30.00 14.00 22.00
Variable cost of goods sold/unit 5.00 6.00 13.00 12.00
Variable operating expenses/unit 2.34 2.50 2.00 2.40
The fixed costs are not expected to fluctuate as a result of changes under consideration.
You are required to show:
(a). The effect on net income if product C is discontinued.
(b). The effect on net income if product C is discontinued and if a consequent loss of customers
caused a decrease of 200 units in the sales of product B.
(c). The effect on net income if product C’s sales price is increased to N16.00 with a decrease
in the number of units sold to 1,500 units with no effect on other products.
(c). The effect on net income if a new product E is introduced and Product C is discontinued
with no effect on the other products. The total variable costs per unit of product E would be
N16.10 and 1,600 units can be sold at N19.00 per unit. The plant in which Product C is
produced can be utilized to produce product E.
17. The local authority of a small town maintains a theatre and arts centre for the use of a local
repertory company, other visiting groups and exhibitions. Management decisions are taken by a
committee which meets regularly to review the accounts and plan the use of the facilities.
The theatre employs a full-time staff and a number of artists at costs of N4,800 and N17,600 per
month respectively. They mount a new production every month for 20 performances. Other
monthly expenditure of the theatre is as follows:
N
Costumes 2,800
Scenery 1,650
Heat and light 5,150
Apportionment of administration costs of local authority 8,000
Casual staff 1,760
Page 158
Refreshments 1,180
On average the theatre is half full for the performances of the repertory company. The capacity
and seat prices in the theatre are:
200 seats at N6 each

In addition, the theatre sells refreshments during the performances for N3,880 per month.
Programme sales cover their costs but advertising in the programme generates N3,360.
The management committee has received proposals from a popular touring group to take over the
theatre for one month (25 performances). The group is prepared to pay half of their ticket income
for the booking. They expect to fill the theatre for 10 nights and achieve two-thirds full on the
remaining 15 nights. The prices charged are 50 kobo less than those normally applied in the
theatre.
The local authority will pay for heat and light costs and will still honour the contracts of all artists
and pay full-time employees who will sell refreshments and programmes, etc. The committee
does not expect any change in the level of refreshments or programme sales if they agree to this
booking.
Note: The committee includes allocated costs when making profit calculations. They assume
occupancy applies equally across all seat prices.
Required
a. On financial grounds should the management committee agree to the approach
from the touring group?
b. What other qualitative factors should be considered in taking this decision?
18. The managing director of Peterson Limited, a small business, is considering a one-off contract.
She has asked her inexperienced accountant to advise on what costs are likely to be incurred so
that she can price at a profit. The following schedule has been prepared:
Cost for special order Note N

Direct wages 1 28,500
Supervisor costs 2 11,500
General overheads 3 4,000
Machine depreciation 4 2,300
Machine overheads 5 18,000
Materials 6 34,000
Notes
1. Direct wages comprise the wages of two employees, particularly skilled in the labour
process for this job. They could be transferred from another department to undertake the
work on the special order. They are fully occupied in their usual department and sub-
contracting staff would have to be brought in to undertake the work left behind. Sub-
contracting costs would be N32,000 for the period of the work. Other sub-contractors
Page 159
who are skilled in the special order techniques are also available to work on the special
order. The costs associated with this would amount to N31,300.
2. A supervisor would have to work on the special order. The cost of N11,500 is made up of
N8,000 normal payments plus a N3,500 additional bonus for working on the special
order. Normal payments refer to the fixed salary of the supervisor. In addition, the
supervisor would lose incentive payments in his normal work amounting to N2,500. It is
not anticipated that any replacement costs relating to the supervisors’ work on other jobs
would arise.
3. General overheads comprise an apportionment of N3,000 plus an estimate of N1,000

incremental overheads.
4. Machine depreciation represents the normal period cost, based on the duration of the
contract. It is anticipated that N500 will be incurred in additional machine maintenance
costs.
5. Machine overheads (for running costs such as electricity) are charged at N3 per hour. It is
estimated that 6,000 hours will be needed for the special order. The machine has 4,000
hours available capacity. The further 2,000 hours required will mean an existing job is
taken off the machine resulting in a lost contribution of N2 per hour (before overheads
are charged).
6. Materials represent the purchase costs of 7,500kg bought some time ago. The materials
are no longer used and are unlikely to be wanted in the future except for the special order.
The complete stock of materials (amounting to 10,000kg), or part thereof, could be sold
for N4.20 per kg. The replacement cost of material used would be N33,375.
Because the business does not have adequate funds to finance the special order, a bank overdraft
of N20,000 would be required for the project duration of three months. The overdraft would be
repaid at the end of the period. The company uses a cost of capital of 20% to appraise projects.
The bank’s overdraft rate is 18%.
The managing director has heard that for special orders such as this, relevant costing should be
used that also incorporates opportunity costs. She has approached you to create a revised costing
schedule based on relevant costing techniques.
Required
Produce a revised costing schedule for the special project based on relevant costing principles.
Fully explain and justify each of the costs included in the costing schedule.
1. Omoti Limited
Relevant costs of undertaken the contract is:
Page 160
N Notes
Equipment costs 200,000
Component X (20,000 x 4 x N5) 400,000 1
Component Y (20,000 x 3 x N8) 480,000 2
Additional costs (20,000 x N8) 160,000
1,240,000
Total Revenue (20,000 x N80) 1,600,000
Thus, from a purely financial point of view the project is acceptable.
NOTES:
1. Component X: Any of these components used will need to be replaced.
2. All of the required units will come from inventories and this will be an effective cost of the
net realizable value.
3. There is no relevant labour cost since the staff concerned will be paid irrespective of whether
the contract is undertaken.
2. Ronto Ltd
a. The minimum price for the proposed contract would be

N Notes
Materials : -
Component X (2 x 8 x N180) 2,880 1
Component Z ((75 + 32) x N20) - (75 x N25) 265 2
Other miscellaneous items 250
Labour - Assembly (25 + 24 + 23 + 22 + 21 + 20 + 19 + 18) x N48 8,256 3
Inspection (8 x 6 x N12 x 150%) 864
Total 12,515
Thus the minimum price is N12,515
NOTES:
1. Component X: If the 16 units of this component are used on the proposed contract, the
business will need to buy an additional 16 units at the new price.
2. Component Z: The relevant cost here is how much extra the business will pay the supplier as
a result of undertaken the contract.
3. Labour – Assembly: The assembly labour cost is irrelevant because it will be incurred
irrespective of which work the members of staff do. The relevant cost is based on the sales
revenue per hour lost if the other orders are lost less the material cost per hour saved, that is
N60 – N12 = N48.
4. Component Y: The history of the components held in inventories is irrelevant because it
applies irrespective of the decision made on this contract. Since the alternative to using the
units on this contract is to scrap them, the relevant cost is zero.
b. Other factors include:

 Competitive state of the market.
Page 161
 The fact that the above figure is unique to the particular circumstances at the time – for
example, having component Y available but having no use for it. Any subsequent order might
have to take account of an outlay cost.
 Breaking even (that is, just covering the costs) on a contract will not fulfill the business’s
objective.
 Charging a low price may cause marketing problems. Other customers may resent the low
price for this contract. The current enquirer may expect a similar price in future.
4. A Business
a. Total time required on cutting machine is:

(2,500 x 1.0) + (3,400 x 1.0) + (5,100 x 0.5) = 8,450 hours
Total time available on cutting machines is 5,000 hours. Therefore, this is a limiting factor.
Total time required on assembling machines is:
(2,500 x 0.5) + (3,400 x 1.0) + (5,100 x 0.5) = 7,200 hours
Total time available on assembling machine is 8,000 hours. Therefore, this is not a limiting
factor.
The optimum production:
Product A B C
(per unit) (per unit) (per unit)
N N N
Selling price 25 30 18
Variable materials -12 -13 -10
Variable production costs -7 -4 -3
Contribution 6 13 5
Time on cutting machines (hour) 1 1 0.5
Contribution per hour on cutting machines (N) 6 13 10
Ranking 3rd 1st 2nd
Therefore, produce:
3,400 product B using 3,400 hours
1,600 product C using 1,600 hours
5,000 hours
b. Assuming that the business would make no saving in variable production costs by sub-
contracting, it would be worth paying up to the contribution per unit (N5) for product C, which
would therefore be N5 x (5,100 – 3,200) = N9,500 in total.
Similarly it would be worth paying up to N6 per unit for product A – that is, N6 x 2,500 =
N15,000 in total.
5. Intermediate Products Ltd
a. Calculation of the optimum product mix
Page 162
Product A B C D
Total costs per unit (N) 65 41 36 46
Less fixed costs (N) 20 8 8 12
Variable cost per unit (N) 45 33 28 34
Buying/Selling price per unit (N) 70 45 40 55
Contribution per unit (N) 25 12 12 21
Hours on special machine 0.5 0.4 0.5 0.3
Contribution per hour (N) 50 30 24 70
Ranking 2nd 3rd 4th 1st
Optimum use of hours on special machine Balance of hours

D 3,000 x 0.3 = 900 5,100 (that is 6,000 – 900)
A 5,000 x 0.5 = 2,500 2,600 (that is 5,100 – 2,500)
B 6,000 x 0.4 = 2,400 200 (that is 2,600 – 2,400)
C 400 x 0.5 = 200
6,000
Therefore, make all of the demand for D, A and B plus 400 (of 4,000) C.
c. The contribution per hour from Cs is N24, and so this is the maximum amount per hour that it
would be worth paying to rent the machine, for a maximum of 1,800 hours (that is, 3,600 x 0.5,
the time necessary to make the remaining demand for Cs).
d. Other possible actions to overcome the shortage of machine time include the following:
 Alter the design of the products to avoid the use of the special machine.
 Increase the selling price of the product so that the demand will fall, making the available
machine time sufficient but making production more profitable.
6. FADEKE COMPANY
a. The budgeted income statement using absorption costing technique

Regions South Midland North Total
N'000 N'000 N'000 N'000
Sales 1,400 400 200 2,000
Less Total costs
Direct material (336) (96) (48) (480)
Direct wages (210) (60) (30) (300)
Factory variable overhead (294) (84) (42) (420)
Factory fixed overhead (280) (80) (40) (400)
Fixed selling and distribution cost (80) (50) (30) (160)
Variable selling and distribution cost (70) (32) (20) (122)
Net profit/loss 130 (2) (10) 118
The computation above shows that, the Midland and North have a net loss, which is the
reason why management is contemplating to drop.
Page 163
Please note that factory fixed overhead is absorbed based on sales units, that is,
N400,000/100,000 = N4 per unit.
b. Computation of net contribution or loss for the regions, using marginal costing
technique is:
Regions Midland North Total
N'000 N'000 N'000
Sales 400 200 600
Less Relevant costs
Direct material (96) (48) (144)
Direct wages (60) (30) (90)
Factory variable overhead (84) (42) (126)
Fixed selling and distribution cost (50) (30) (80)
Variable selling and distribution cost (32) (20) (52)
Net profit/loss 78 30 108
From the computation above, it is not advisable to drop neither the Midland nor the North,
because they are presently contributing N108,000 towards the recovery of general fixed
cost and profit of the company. In other words, if the regions are dropped the company
profit will reduced by N108,000.
7. KEMO LIMITED
The initial data, showing total contribution and contribution per unit.
Products AL BL CL
N N N
Sales 500,000 300,000 250,000
Less total variable costs (using the %) (232,000) (129,600) (252,000)
Total contribution 268,000 170,400 (2,000)
Sales units 100,000 200,000 125,000
Contribution per unit (N) 2.68 0.85 -0.016
Total fixed costs (using the %) N58,000 N50,400 N28,000
a. The net effect of discontinuing product CL.

N
Current loss from CL that will be eliminated 2,000
Decrease sales/contribution of AL (2% x N268,000) -5,360
Decrease in general fixed cost (1% x N136,400) 1,364
Net decrease in profit -1,996
b. The net effect of increasing selling price of product CL

N
The proposed selling price (250,000/125,000) x 120% 2.40
Less variable cost per unit (252,000/125,000) -2.02
Page 164
Contribution Margin 0.38
Revised sales units 100,000
Revised contribution 38,000
The initial loss eliminated 2,000
Net increase in profit 40,000
C. Replacing product CL with DL

N
Sales (N3 x 95,000) 285,000
Less total variable cost of DL (70% x 80% x N285,000) +
(60% x 20% x N285,000) -193,800
Contribution from product DL 91,200
Add loss from CL eliminated 2,000
Net increase in profit 93,200
Other qualitative points to be considered include:-
1. Is product DL an adequate substitute for CL?

2. What is the elasticity of demand, nature of demand and supply of the product?
3. What is market acceptability of the product?
4. To what extent is the forecast sales of DL adequately forecast?
5. The effect of discontinuation on the goodwill of the organization?
6. The re-action of customer, employee and investor on the decision?
8. SOLA ADEKOYA
a. The annual salary

i. Working as before = (9 hrs x 6 days x 48 weeks x N125) = N324,000 p.a.
ii. Working as newly proposed = (10 hrs x 5 days x 48 weeks x N125) = N300,000 p.a.
b. The opportunity cost of not working the extra time is the reduction in income from
N324,000 to N300,000, that is N24,000 p.a.
c. The opportunity cost of playing golf, as stated above, is the income foregone of N24,000 p.a.
9. ABIOLA LIMITED
The minimum cost of the contract using marginal costing technique is:
Material costs N
Material A (900 tons x N3.50) 3,150
Material B (1,500 kg x 30k) 450
Material C (1,000 kg x 90k 900
Labour costs
Grade 1 (1,500 x 0) -
Page 165
Grade 2 (750 x N1) 750
Grade 3 (2,000 x 50k) 1,000
Fixed overhead (N10,000 - N8,500) 1,500
Variable overhead (3,400 x N1) 3,400
The minimum cost 11,150
10. EXCESS TV
The net contribution or loss from the contract using relevant costs principle.
N N N
Expected income 72,000
Less relevant costs
Camera operators -To employ (N860 x 3men x 7weeks) 18,060
- opportunity cost of camera man 6,600 24,660
Painter overtime - (N350/40 x 1.5 x 4hrs x 3wks x 2men) 315
Paint replacement cost 470
Other material to be purchased (half) (N520/2) 260
Other material net realisable value (half) 60 320
Lighting -replacement cost cheaper (7wks x N1,500) 10,500
Relevant cost of editing (N4,700 - N300) 4,400
Studio cost (18days x N1,200) 21,600 62,265
The contract is worthwhile since it gives a positive net contribution.
11. A MULTI-PRODUCT COMPANY
a. Calculation of selling price, sales units, contribution margin, contribution margin ratio and
ranking of products.
Products W X Y Z
i. Material cost (N) 32.00 60.00 60.00 30.00
ii. Direct labour (N) 12.00 18.00 12.00 12.00
iii. Period costs (N) 4.00 12.00 12.00 6.00
iv. Profit (N) 36.00 30.00 56.00 27.00
v. Selling price (N) ( sum of the above) 84.00 120.00 140.00 75.00
vi. Sales value (N) 210,000 264,000 420,000 202,500
vii. Sales units (units) (vi/v) 2,500 2,200 3,000 2,700
viii. Contribution margin (N) (iii. + iv.) 40.00 42.00 68.00 33.00
ix. Contribution per material cost (viii/i) 1.25 0.70 1.13 1.10
th rd
x. Ranking 1st 4 2nd 3
Page 166
Calculation of material cost required for the least quantity of each products and the balance
of material cost for optimum allocation.
N N
Total material cost available 450,000
Required for minimum quantity
W (2,000 x N32) 64,000
X (2,000 x N60) 120,000
Y (2,000 x N60) 120,000
Z (2,000 x N30) 60,000 364,000
Balance available for optimum allocation 86,000
Allocation table
Rank product additional optimum Material material material bal. Of
quantity quantity cost/unit Allocat. Avail. mat. Cost
1 W 500 500 32 16,000 86,000 70,000
2 Y 1,000 1,000 60 60,000 70,000 10,000
3 Z 700 333 30 10,000 10,000 -
The optimum quantity is to produce and sell 2,500, 2,000, 3,000 and 2,333 units of product
W, X, Y and Z respectively.
b. The revised income statement based on the recommendation above.

Products W X Y Z
Optimum quantity 2,500 2,000 3,000 2,333
Contribution margin (N) 40 42 68 33
N N N N
Less period costs (10,000) (26,400) (36,000) (16,200)
Net profit 90,000 57,600 168,000 60,789
12. THE RICHARD PAINT COMPANY
a. The linear programming

Let x represent the quantity of Matt varnish and
Let y represent the quantity of High Gloss varnish.
The objective is to maximize contribution at N4x + N6y, subject to the following constraints
i. Labour hour available 0.1x + 0.2y < 400
ii. Material available 0.05x + 0.02y < 100
iii. Maximum capacity x + y < 3,000
iv. Committed supply x > 1,000, y > 500
v. Union agreement x + y > 2,000
b. The product optimum mix using graphical method.

The maximum quantity
X Y X Y
Page 167
I. 0.1x + 0.2y < 400 0 2,000 4,000 0
ii. 0.05x + 0.02y < 100 0 5,000 2,000 0
iii. x + y < 3,000 0 3,000 3,000 0
iv. x > 1,000, Y > 500 1,000 500 0 0
v. x + y > 2,000 0 2,000 2,000 0
The graph
5000
4500
x > 1,000
4000
3500
3000 0.05x 0.02y < 2,000
2500
2000 x + y > 2,000
1500 A x + y < 3,000

C Feasible B 0.1x + 0.2y < 400
1000 Region
D E y > 500
500
500 1000 1500 2000 2500 3000 3500 4000 4500 5000
Calculation of the optimum point

Total
Objective 4x + 6y Contribution
point A 4(1,000) + 6(1,500) = N13,000
point B 4(1,500) + 6(1,250) = N13,500
point C 4(1,800) + 6(500) = N10,200
point D 4(1,500) + 6(500) = N9,000
The optimum quantity is to produce and sell 1,500 and 1,250 of products Matt and High Gloss
respectively.
The quantities of x and y at the points.
Point A, the two equations are x = 1,000 and 0.1x + 0.2y = 400,
Therefore y = (400 – (0.1 x 1,000))/0.2 = 1,500
Point B, the two equations are 0.1x + 0.2y = 400
Page 168
0.05x + 0.02y = 100
multiply equation one by .1 and two by 1
0.01x + 0.02y = 40
0.05x + 0.02y = 100
The difference 0.04x = 60 , x = 1,500
Y = (400 – (0.1 x 1,500))/.02 = 1,250
Point C, the two equations are y = 500 and 0.05x + 0.02y = 100
Y = (100 – (0.02 x 500))/0.05 = 1,800
Point D, the two equations are y = 500 and x + y = 2,000. therefore x = 1,500.
C. i. To determine whether overtime working is worthwhile or not, the shadow price of labour
must be determined.
The binding constraints

Labour 0.1x + 0.2y = 400
0.1(1,500) + 0.2(1,250) = 400
400 = 400 binding
Material 0.05x + 0.02y = 100

0.05(1,500) + 0.02(1,250) = 100
100 = 100 binding
Let A represent shadow price of an hour of labour

Let B represent shadow price of a kg of material
0.1x + 0.2y = 400 ____________ A
0.05x + 0.02y = 100 ___________ B
4x + 6y
Reformulation of the constraint

0.1A + 0.05B = 4…..1
0.2A + 0.02B = 6……2
multiple one by 2 and two by 1
0.2A + 0.1B = 8
0.2A + 0.02B = 6
0.08B = 2, B = N25, A = (4 – (0.05 x 25))/0.1 = N27.50
The shadow price of an addition hour increase is N27.50 per hour.
From the comment above, overtime working is profitable because the extra benefit is
N27.50 with extra cost of N20, therefore that will be N7.50 net benefit from an hour
increase.
c. ii. If labour is no longer a constraint, the new points that can be read from the initial graph are
point F and G
The two equations at point F are, x = 1,000 and x + y = 3,000 therefore y = 2,000
Total contribution 4(1,000) + 6(2,000) = 16,000
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The two equation at point G are, x + y = 3,000 and 0.05x + 0.02y = 100
Multiply equation one by .05 and two by 1
.05x + .05y = 150
.05x + .02y = 100
the difference .03y = 50 y = 1,667
x = 3,000 – 1,667 = 1,333
Total contribution (4 x 1,333) + (6 x 1,667) = 15,334
If labour is no longer a constraint, the optimum point, will be point F and optimum mix is
1,000 units of x and 2,000 units of y
The hours required for the revised mix (0.1 x 1,000) + (0.2 x 2,000) = 500 hrs
Less initial hours available = 400 hrs
Extra hours economically advisable = 100 hrs
13. EMMA COMPANY
a. The analysis of income using contribution approach

without the with special difference difference
special order Order in total per unit
N N N N
Sales value 10,000,000 10,660,000 660,000 4.4
Less variable expenses
Manufacturing 3,600,000 3,870,000 270,000 1.8
Selling and administrative 800,000 867,500 67,500 0.45
Total contribution 5,600,000 5,922,500 322,500 2.15
Less fixed expenses
Manufacturing 2,400,000 2,400,000 - -
Selling and administrative 2,300,000 2,300,000 - -
Operating income 900,000 1,222,500 322,500 2.15
b. The expected percentage increase in operating income statement with the acceptance of the
special order will be = N322,500/N900,000 x 100/1 = 36%.
14. A LOCAL WOOLWORTHS
The net contribution or loss from operating the restaurant for the two options as follows
The alternatives a. b.
N’000 N’000
Present contribution from operating Restaurant 210 210
Less compensation salary that will be avoided (100) (100)
Less opportunity cost from other products (90) (75)
Net contribution 20 35
Where alternative “a” considered maintaining Restaurant instead of General Merchandise

and, alternative “b” considered maintaining Restaurant instead of Garden Products
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Opportunity cost of General Merchandise = N300,000 x 30% = N90,000
Opportunity cost of Garden Products = (N200,000 x 50%) – N25,000 = N75,000.
Without taken into consideration the other qualitative factor of operating the Restaurant,
the quantitative factor above shows that it advisable to continue to operate the Restaurant.
15. THE LOWE COMPANY
a. Calculation of the optimal option

The products A B
N N
Selling price 2.00 5.10
Less relevant costs
Direct material 1.00 1.50
Direct labour 0.20 0.40
Variable cost transfer from A - 1.20
Contribution per unit 0.80 2.00
Minutes per unit 1 2
Contribution per minutes (N) 0.80 1.00
From computation above it is advisable to process to product B before sales.
b. The minimum price of product B

The product B
N
Direct material cost 1.50
Direct labour cost 0.40
Variable cost from A 1.20
Opportunity cost of A (N2 - N1.20) 0.80
The minimum price 3.90
c. (i). Contribution per minutes of the options
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The products A B
N N
Less relevant costs
Direct material 1.00 1.50
Direct labour 0.20 0.40
Relevant Manu. Overheads (50%) 0.30 0.60
Variable cost transfer from A - 1.50
Contribution per unit 0.50 1.10
Minutes per unit 1 2
Contribution per minutes (N) 0.50 0.55
(ii). The minimum price of product B

The product B
N
Direct material cost 1.50
Direct labour cost 0.40
Relevant Manu. Overhead (50%) 0.60
Variable cost from A 1.50
Opportunity cost of A (N2 - N1.50) 0.50
The minimum price 4.50
16. DUTSE NIG. PLC

a. The contribution margin/net loss from product C = N14 – N13 – N2 = (N1)/ unit.
Loss that will be avoided by discounted product C = N1 x 1,800 units = N1,800.
b. Contribution margin from product B = N30 – N6 – N2.50 = N21.50

Contribution loss from Product B (N21.50 x 200 units) =(N4,300)
Saving from discounted product C = N1,800
Net loss to the Company =(N2,500)
c. Contribution from the revised sales units =((N16.10 – N13 – N2) x 1,500 units)
= N1,500
Initial loss avoided = N1,800
Net increase in contribution/profit = N3,300
d. Contribution from product E = ((N19 – N16.10) x 1600) =N4,640

Initial loss avoided =N1,800
Net increase in contribution/profit =N6,440
17. The Local Authority
a. Calculation of net benefit or loss from acceptance of the Touring Group offer using relevant
costing.
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Revenue from Repertory performances N N N
(200 x N6 x 20 x 50%) 12,000.00
(500 x N4 x 20 x 50%) 20,000.00
(300 x N3 x 20 x 50%) 9,000.00
Total revenue 41,000.00
Revenue to the Theatre from the Touring Group

Per performance
(200 x N5.50) 1,100.00
(500 x N3.50) 1,750.00
(300 x N2.50) 750.00
3,600.00
Monthly return based on the agreement
10 Nights Full Capacity (3600 x 10 x 50%) 18,000.00
15 Nights 2/3 Capacity (3600 x 15 x 2/3 x 50%) 18,000.00
Total revenue 36,000.00
Loss in revenue (5,000.00)
Saving in relevant cost if Touring Group is accepted
- Costumes 2,800.00
- Scenery 1,650.00
- Casual Staff 1,760.00
Total Savings 6,210.00
Net Savings/ Contribution 1,210.00
From the computation above, therefore, the committee should accept the touring company’s offer
as it results in a net benefit to the theatre of N1,210 for that month.
NOTE: Non-relevant costs were full time salaries, heat and light, apportionment of
administration costs and refreshments. ‘Re non-relevant benefits were refreshment sales and
advertising revenue. All of the above were non-relevant because they were unaffected by the
decision (i.e. they were the same whether the repertory or the touring company occupied the
theatre for the month).
b. The qualitative factors that might apply to this decision include:
The desirability of offering a range of activities in the theatre and thus to cater for a wider
audience fulfils an important social role.
The opinions of the artists who are employed by the theatre should be consulted. They may
welcome some months for rehearsal or personal development. But if this were regular, the more
talented people who were in demand may seek opportunities elsewhere.
A different number of performances may have implications for predicted cost levels and
the accuracy of the theatre occupancy predictions should be confirmed.
18. Peterson Limited
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Revised cost schedule for the special contract
Costs for special order Notes N

Direct wages 1 31,300
Supervisor costs 2 1,000
General overheads 3 1,000
Machine depreciation 4 500
Machine overheads 5 22,000
Materials 6 31,500
Interest charges 7 900
88,200
Notes
1. Direct Wages: There are two options. We can take the workers from their usual
department, where it would cost N32,000 to replace them. Or we could hire sub-
contractors to do the special order at a cost of N31,300. Both of these costs are
future costs that will be affected by the decision and are therefore relevant. The
choice between the two alternatives is relatively straightforward – either incurs a
N32,000 costs or a N31,300 costs. As an accountant you will want to minimize
costs and will choose to hire the sub-contractors at N31,300
2. Supervisor costs: The supervisor’s normal salary is N8,000 and this will be paid
whether or not we take on the special contract. This is a fixed cost to the business
and is unaffected by the decision. However, the N3,500 additional bonus is
relevant as it is dependent on the decision to take the special contract. In addition,
if we take the special contract we will not have to pay the N2,500 incentive
payments. Therefore, the net relevant cost to the business is N3,500 less N2,500 =
N1,000.
3. General Overheads: Regardless of the decision, general fixed overheads remain

constant. The apportioned rent, rates, power etc, will be incurred whether the
special contract is undertaken or not. Therefore, these are not relevant costs and
can be ignored for decision-making purposes. However, incremental overheads are
extra overheads, incurred as a direct result of undertaking the special project. These
could include additional costs of power or premises. They are relevant costs to the
project of N1,000.
4. Machine depreciation: The machine depreciation has been charged at N2,300

which is what the accountant would normally charge for depreciation for this
period of time. The accountant will charge this time-based depreciation if we use
the machine for the special contract and also if we do not. It is only a book value
and does not represent a true cash flow to the business. Therefore it is not a
relevant cost. However, if we do take the special contract and use the machine, we
will incur maintenance costs of N500. These future costs are a direct result of the
decision and should be included within the costs.
5. Machine overheads: Taking the special contract will mean that the machine will
run for 6,000 hours and as each hour incurs a running cost of N3, the relevant
future cost will be N18,000. In addition, there is an opportunity cost. If we choose
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to take the contract we will have to choose not to work on an existing job as
machine hours are a scarce resource and we only have enough hours free to do one
job. Therefore, a relevant cost to the special contract will be the benefit forgone
from choosing the special contract over the existing job. This cost if the lost
contribution of N2 per hour for 2,000 hours. We will lose N4,000 contributions if
we take the special contract. The total relevant cost therefore is N18,000 plus
N4,000 = N22,000.
6. Materials: The 7,500kg of materials is already in stock. We do not know how

much it cost and if we did it would not be useful as this is a sunk cost and therefore
irrelevant. Neither is the replacement cost of N33,375 relevant as it is not a future
cost that will be incurred as a result of the decision (if we already have it we will
not need to but it). However, this would be relevant if the material was in constant
use by the company. There is an opportunity cost, as we have two courses of action
to choose from. We can either use the material for the special contract or we can
sell it and receive N4.20 per kg. The relevant cost is 7,500 x N4.20 = N31,500 as
this represents the benefit sacrificed by choosing to take the contract rather than
selling the materials.
7. Overdraft interest: If the company chooses to undertake the special project it will
incur finance charges for the three month duration. This is a future cost due to the
decision being made and therefore should be included as a relevant cost. N20,000 x
18% x 3/12 = N900.
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CHAPTER 6
LEARNING CURVE THEORY
Learning curve theory states that whenever a repetitive task is being performed, the average labour
time committed per unit falls by a specific percentage as the level of activities doubles. Thus, if the
average time falls by 10%, then we are experiencing 90% learning curve, and if it falls by 20%,
then, we have 80% learning curve. The whole idea of the theory is rooted in the assumption that
human beings unlike machines acquire a lot of skills or dexterity, whenever a repetitive task is
performed, consequently, this would lead to a reduction in the average time taken as workers
overcome the initial teething problems.
The theory is prominent or useful in budgeting, especially in establishing realistic labour hours
thereby ensuring accuracy in the labour cost estimate and other costs associated with labour hour.
The study of the theory will be of great assistance to organizations operating under a competitive
environment, where each of the participants in the market is trying to edge-out each other through
cutting price, as the theory may lead to lower pricing, since labour hour per activity is expected to
be reducing as activity increases, leading to reduction in labour cost and other costs based on labour
hours. Such costs may include variable and fixed overhead.
The theory can be experienced in virtually all organizations but are more pronounced in the
following industries.
 Construction industries
 Manufacturing industries
 Agricultural industries
 Aviation industries
 Service rendering industries e.g. Banking, Audit firms etc.
The cumulative average hour per a given activity produced is expected to fall by a constant
percentage every time activities double. The learning rate is the constant percentage at which the
cumulative average hour per activity falls. Thus if average hour falls by 10%, then the organization
is experiencing 90% learning curve, where the learning rate will be 10%. Average hour, using the
principle of learning curve refers to hour per a quantity of the given activity.
EFFECT OF LEARNING CURVE
Otherwise, it can be referred to as why studying the learning curve theory. It is important to
appreciate this principle in estimating, realistic and reliable data for the following.
a. Direct labour hours and costs: - the theory has a direct bearing on estimating realistic
labour hours and costs if based on labour hours.
b. Variable and fixed overheads: - The theory will affect the estimation of variable and fixed
overhead if computation is based on labour hours
c. Material costs: - Although material cost is not directly affected by the theory, it can be
agreed that as a result of repetitive performance, an improvement in material handling and
wastage/damage will lead to the reduction in wastage costs, thereby reducing material cost.
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d. Average total cost: - Average total cost is bound to be reducing as activities increases, this
is due to the fact that labour cost as well as other costs, where computations are based on
labour cost will reduce per activity, as activities increases.
e. Selling price: - Knowledge of the theory may assist in competitive pricing since total cost
will be reducing as activities increases, the selling price will be reducing if the computation
is based on average total cost.
ASSUMPTIONS OF LEARNING CURVE
For any organization to experience learning curve in its operations the following conditions must
exist or in other words the following are the factors that stimulate the learning curve theory. They
are: -
1. The task must be performed repetitively or continuously.

2. The task must be labour intensive
3. There must be continuous production.
4. The labour cost per hour must be constant
5. Workers must be positively motivated.
6. No labour turnover or labour rotation.
USES OF LEARNING CURVE THEORY
1. It is useful for production planning, scheduling and preparation of labour budgets.
2. Useful in preparation of realistic standards to be used in standard costing techniques.
3. Useful in bidding for competitive contracts.
LIMITATION OF LEARNING CURVE THEORY
1. The theory expects repetitive performance of task, but there will be cessation to learning
eventually when the job has been repeated more than enough, the task then becomes
monotonous and instead of the learning curve the average hour may be increasing.
2. The theory assumes labour intensive tasks. Presently productive activities or service
rendering is highly automated where hour requirement will be based on speed of the
machines.
3. Continuous production is assumed before the learning curve theory can be experienced.
This depends on the nature of task and the acceptance of goods or service in the market.
4. Motivation of workers is a function of the economic situation of the organization and the
entire environment within which the company operates, which may be very difficult to
influence.
5. The theory assumes stable condition at work before the learning curve can be experienced.
This is not possible because of labour turnover and labour rotation.
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6. It is always difficult to obtain enough and accurate data to determine the learning rate/curve
of labour for an organization.
7. Motivation of worker by paying incentives for increased or improved performance negates

the assumption of constant labour rate.
METHODS OF DETERMINING AVERAGE HOURS
Listed bellows are the method available to estimate average labour hours for a given activity if such
an organization is experiencing the learning curve.
1. Tabular method
3. Graphical method.
ILLUSTRATION 1
A company provides you with the following data concerning the production of a machine.
Direct labour hours needed to make the first machine is 1,000 hours. Direct labour cost is N20 per
hour.
Direct material N12,000 per machine
Learning curve 80%
Fixed cost N64,000
Required
1. Illustrate the use of the learning curve for calculating the expected average unit cost of
making,
a. 4 machines
b. 16 machines
c. 20 machines
2. Calculate the extra hours required producing 16 machines after the first production of 16
machines.
SUGGESTED SOLUTION
In order to determine the average hours for each cumulative output, tabular or mathematical
methods can be used. It is essential to note that the tabular method can only be used when the
cumulative units double the previous cumulative units. For example the average hours for the first
batch of 1 machine is 1,000 hours, the cumulative trend will therefore be production of
2,4,8,16,32,64 etc. For determining the average and cumulative hours within this range, the tabular
method can be used. Only the mathematical method can be used without restriction.
The average hour and cumulative hours can be determined for cumulative units as follows, using
the tabular method;
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Additional Cumulative Workings Average hrs Cumulative Additional
Quantity Quantity per machine hours hours
1 1 given 1,000 1,000 1,000
1 2 80%x1000 800 1,600 600
2 4 80% x 800 640 2,560 960
4 8 80% x 640 512 4,096 1,536
8 16 80% x 512 410 6,560 2,464
16 32 80% x 410 328 10,496 3,936
Note that the average hours for the production of 4 and 16 machines can be read from the above
table, while the mathematical method will be used in determining the average hours for 20
machines, since the tabular method can not be used to determine such.
a. Calculation of average cost of making 4 machines

N
Direct labour cost (640 hrs x N20) 12,800
Direct material per machine 12,000
Fixed cost (64,000/4 machines) 16,000
Cost per machine 40,800
b. Calculation of average cost of making 16 machines

N
c. The mathematical method will be used to determine the average hours for producing 20
machines. Since this cannot be read from the table above:
The formula is y = axb , where
y = Average hours at a defined cumulative output
a = Average hour of the first batch
x = cumulative units in the batch/ number of unit in the first batch and
b = log. of learning curve/ log. of 2
Once again, the strength or merit of the mathematical approach is that it can be used to
compute the average hours at a defined cumulative output without the necessity of activity
being doubled unlike the tabular method.
The average hours for 20 machines using the mathematical method:

y= 1,000 (20/1) (Log .8/log 2)
y = 1,000 x 0.381 = 381 hrs
The average hours for 20 machines is 381 hrs
Calculation of average cost of making 20 machines
N
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2. The extra hours for the additional 16 machines after the initial 16 machines can be read from
the table above as 3,936 hours.
ILLUSTRATION 2
Taiwo Company Limited has been making annual purchases of 80,000 water pumps from Water
Engineering Nigeria Limited. The price has increased each year, reaching a level of N136 per unit
last year. Because purchase price has increased significantly, Taiwo Company Limited
management has asked that an estimate be made of the cost to manufacture the pumps internally
with its own facilities. The company has no experience with products requiring assembly.
The engineering, manufacturing and accounting departments have prepared a report for
management which includes the estimates shown below for an assembly run of 10,000 units.
Additional production employees would be hired to manufacture the sub-assembly. However, no
additional equipment space or supervision would be needed.
The report states that, total cost for 10,000 units would be N1,914,000 or N191.40 a unit. The
current purchase price is N136 a unit, so the report recommends a continued purchase of the
product.
N
Component (outside purchase) 240,000
Assembly labour (I.) 600,000
Factory overhead (ii) 900,000
General & Administrative overhead (iii) 174,000
(i) Assembly labour consists of hourly production workers.
(ii) Factory overhead is applied to products on a direct labour cost basis. Variable overhead costs
vary closely with direct labour costs. Fixed factory overheads are 50% of direct labour.
Variable factory overheads are 100% of direct labour.
(iii). General and administrative overhead is applied at 10% of the total cost of material, (or
components) assembly labour and factory overhead.
Required
(i) Assuming an 80% learning curve, what would be the cumulative labour cost for producing
the 80,000 pumps during the first year?
(ii) Compute the total incremental cost for each pump produced with the 80% learning curve, if
80% pumps are eventually produced.
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(iii) Should Taiwo Company Limited buy or make the pump? Support your decision with
relevant figures and computation.
SUGGESTED SOLUTION
In the above problem, the average labour cost will be determined because number of hours is not
given.
(i) Mathematical method will be used to determine the average and cumulative labour cost at
80,000 pumps using y = axb where
y = the average labour cost at cumulative units of 80,000 pumps.
A = cost per pumps at production of 10,000 pumps i.e N600,000/10,000 = N60 per pump.
X = cumulative unit of 80,000 pumps divided by the number in the first batch 10,000 i.e.
80,000/10,000 = 8
b = log of learning curve divide by log 2
Average labour cost = 60 (8)(log .8/log 2) = N30.72
The cumulative labour cost = (N30.72 x 80,000 pumps) = N2,457,600
(ii). The total and average incremental cost

N
Component ((240,000/10,000) x 80,000) 1,920,000
Assembly labour (as computed above) 2,457,600
Variable factory overhead (100% of direct labour cost) 2,457,600
Total incremental cost 6,835,200
Average cost (6,835,200/80,000) N85.44
(iii). Comparison of supplier quotation with relevant cost of making

a. The supplier quotation N136
b. Relevant cost of making N85.44
From the above, it is advisable to make the pump, because the relevant cost of making is
lower than the supplier quotation.
ILLUSTRATION 3
A company wishes to determine the minimum price it should charge a customer for a special order.
The customer has requested a quotation for 10 machines, but might subsequently place an order for
a further 10. Material costs are N30 per machine. It is estimated that the first batch of 10 machines
will take 100 hours to manufacture and an 80% learning curve is expected to apply. Labour plus
variable overhead costs amount to N3 per hour. Set-up costs are N1,000 regardless of the number
of machines made.
Required
a. What is the minimum price the company should quote for the initial order if there is no
guarantee of further orders?
b. What is the minimum price for the follow-on order?
c. What would be the minimum price if both orders were placed together?
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d. Having completed the initial orders for a total of 20 machines (price at the minimum levels
recommended in (a) and (b)), the company thinks that there would be a ready market for
this type of machine if it brought the unit selling price down to N45. At this price, what
would be the profit on the first 140 ‘mass-production’ models (i.e. after the first 20
machines) assuming that marketing costs totaled N250?
SUGGESTED SOLUTION
a. If there is no guarantee of a follow-up order, the setup costs must be recovered on the
initial order. Costs are, therefore, as follows:
N
Material (10 x N30) 300
Labour and variable overhead (100 x N3) 300
Setting-up cost 1,000
Total costs 1,600
Minimum price each (N1,600/10) N160
b. The minimum price for the follow-on order.

N
Labour and variable overhead (60 x N30 ) 180
Total costs 480
Minimum price each (N480/10) N48
The set-up costs have been recovered on the initial order. Output is doubled, therefore,
average time for each group of 10 machines is reduced to:
Average hour per machine = 100/10 x 80% = 8 hours per machine
Cumulative hours for 20 machine 8 x 20 = 160 hours
Less cumulative hours for the initial 10 machines = 100 hours
Additional hours for the additional 10 machines = 60 hours
c. The minimum price for both orders together.

N
Labour and variable overhead (160 x N3) 480
Set-up cost 1,000
Total costs 2,080
Minimum price each (N2,080/20) N104
d. The profit from mass production

N
Material cost (140 x N30) 4,200
Labour and variable overhead (495.36 x N3) 1,486
Marketing 250
Total costs 5,936
Revenue (140 x N45) 6,300
Profit 364
The time spent on the first 140 mass production models is calculated as follows:
To produce additional 140 machine, cumulative production will be 160 machines
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The total hours required for the first 20 machines is already known to be 160 hours.
The hours required for 160 machines could be determine using mathematical method.
The average hours y =axb = 10(160/1)(log .8/log 2) = 4.096 hours
Total hours for the 160 machines = 160 x 4.096 = 655.36 hours
Hence total hours for the 140 machines = 655.36 – 160 = 495.36 hours.
ILLUSTRATION 4
A Company is considering investment in a project that will produce one type of product whose
total budgeted sales are 120 units at a selling price of N8,500 per unit.
Sales are to be 20 units in the year to 31 December 19X1, 40 units in each of 19X2 and 19X3, and
the balance in 19X4. Production will be in line with sales.
Budgeted costs are:

Direct wages:- The first unit will take 2,335 man hours work at a wage rate of N5.50 per
man hour. An 80% learning curve is expected to operate.
Direct materials :- N2,000 per unit.
Variable production overhead:- 60% of direct wages.
Fixed overhead relating to the project is N47,500 per annum including depreciation on the
new plant to be purchased for the project which is charged on a straight line method over
its life.
The new plant will cost N110, 000 payable on 31st December 19X0. It will have a life of four years
after which it will have no resale value.
For investments of this type, the company requires a return of 16% DCF on the fixed cost
investment only.
You are required to recommend, with supporting calculations, whether the company should
proceed with the project if either of the following basis of calculations were used over the four
years.
a. The total quantity of 120 units produced/sold or
b. A year-by-year production/sales schedule.
SUGGESTED SOLUTION
The difference between the assumptions in requirement ‘a’ and ‘b’ above can be traced into the
computation of average hours for the years. While requirement ‘a’ expects the average hour on
cumulative units of 120 units, ‘b’, on the other hand, expects additional hours for the year of
production having taken into consideration the previous years of production.
a. The average hour on cumulative of 120 units = y = 2,335(120)(log .8/Log 2) = 500 hrs
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Fixed cost relating to the project less depreciation = N47,500 – (N110,000/4 yrs) = N20,000
The net cash flow of the project
Year S.P lab cost/ Mat cost/ VPO/unit Contrib Units Total fixed net cash
N unit (N) unit (N) N margin (N) Sold contrib (N) cost (N) flow (N)
1 8,500 2,750 2,000 1,650 2,100 20 42,000 20,000 22,000
2 8,500 2,750 2,000 1,650 2,100 40 84,000 20,000 64,000
3 8,500 2,750 2,000 1,650 2,100 40 84,000 20,000 64,000
4 8,500 2,750 2,000 1,650 2,100 20 42,000 20,000 22,000
The net present value of the project

Year Net cash flow DCF@(16%) Present Value
0 (110,000) 1 (110,000)
1 22,000 0.8621 18,966
2 64,000 0.7432 47,565
3 64,000 0.6407 41,005
4 22,000 0.5523 12,151
Net present value 9,687
From the computation above, which is based on assumption a, it is advisable to accept the project.
b. Computation of average hours and total hours for each year based on year-to-year production.
Year Units Cum units Average hour Cum additional
b
Product/sold y = ax Hours hours
1 20 20 890 17,800 17,800
2 40 60 625 37,500 19,700
3 40 100 530 53,000 15,500
4 20 120 500 60,000 7,000
From above, the additional hours as determined in the last column will be used to compute the total
labour cost, because assumption in “b” is based on year-to-year production.
The net cash flow of the project

Year Sale (N) Total lab. Total Mat. TVPO Fixed Net cash
cost (N) cost (N) (N) cost (N) flow (N)
1 170,000 97,900 40,000 58,740 20,000 (46,640)
2 340,000 108,350 80,000 65,010 20,000 66,640
3 340,000 85,250 80,000 51,150 20,000 103,600
4 170,000 38,500 40,000 23,100 20,000 48,400
Computation of net present value of the project.
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Year Net cash flow DCF@(16%) Present Value
0 (110,000) 1 (110,000)
1 (46,640) 0.8621 (40,208)
2 66,640 0.7432 49,527
3 103,600 0.6407 66,377
4 48,400 0.5523 26,731
Net present value (7,574)
Based on the computation above, using assumption ‘b’, it is not advisable to accept the project.
In conclusion, it is not advisable to accept the project because assumption “a” under which the
project is gives a positive net present value, making it considered acceptable is not in line with the
learning curve theory. The theory expects average hours to be reducing as activities increases, but
in contrary, a constant average hour is used. In solution to “b” above the principle is applied and it
shows that the project is not worthwhile because it gives a negative net present value. Therefore,
the project should be rejected.
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CHAPTER 7
CAPITAL BUDGETING DECISION UNDER CERTAINITY
Capital budgeting is management’s investment decision to expend a given sum of money on a

capital project with the intention of generating a stream of income over the project’s life and
maximizing the organization’s wealth. Capital budgeting decision-making is an integral part of the
investment management. Investment management is considered to be the core of the organization’s
operations because the success or failure of an organization will depend on quality investment
decisions. Such quality is sometimes guaranteed through various policies of management with
respect to the initial purchase of investment. The broad view of the policies may comprise;
 Justification:- There is the need to justify the need to incur the expenditure or the forecasted
expenditure and the forecasted income to the best interest of the organization. Management
should be able to justify the expected increase in the organization’s wealth as a result of the
expenditure.
 Authentication:- Standard authorization procedure must be in place for accepting and

monitoring progresses on capital expenditure. To this effect capital expenditure will be
categorized, with various monitoring levels.
 Control:- A formidable policy must be in place to control expenditure at the execution stage to
monitor the actual expenditure with forecast and control excessiveness. After the project is
completed a controlling policy must be in place for the identification of continuous returns.
 Follow-up:- On completion, the total cost should be compared with actual and when the
equipment is put to effectual usage, the inflows from the project should be obtained and
compared with forecast estimate for the purpose of future plans.
Important attention is attached to investment decision for some of the following reasons:-
1. Many investments require huge sum of money to execute. Management therefore, must justify
the investment in terms of its economic viability. They must also ensure that the organization
fund is being put to optimal or economical use.
2. Many capital projects are of long-term nature. Any wrong decision made by the management
will exist with the organization for as long as such projects exist. Wrong investment decisions
may lead to the ultimate winding-up of a business, especially if such an investment is of a
significant size.
3. Most investment decisions are irreversible. Once decisions are made and the fund committed
into the project, such funds become sunk cost that may not be recoverable.
TYPES OF CAPITAL INVESTMENT DECISION
 Decision to replace an old asset that has outlived its useful life with another asset of the same
type.
 Decision to replace an active asset with another asset considered to be operational efficient.
 Decision to expand existing production facilities
 Decision to introduce a new product or service
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 Decision to produce components internally, which is previously procured from outside.
STEPS REQUIRED IN MAKING CAPITAL INVESTMENT DECISION
1. Establish the firm’s objective

2. Generate alternative investment opportunities
3. Define and co-ordinate the alternative investment projects
4. Collection and analysis of economic data to determine project viability
5. Selection of projects on the basis of the result of economic analysis as stated above
6. Obtain authorization to execute the selected project.
CAPITAL INVESTMENT APPRAISAL CRITERIAS
These are techniques available for determining the economic/viability or otherwise of a capital
investment. These techniques are:-
1. The Traditional or non-discounting cash flow technique:- This can be sub-divided into
a. Payback period method (PBP)
b. Accounting rate of return method (ARR)
2. The discounted cash flow technique:- This can be sub-divided into

a. Net present value method (NPV)
b. Internal rate of returns method (IRR)
c. Discounted payback period method (DPBP)
PAYBACK PERIOD (PBP)
The PBP of a project refers to how long it will take to recover the entire fund invested on a project.
Using PBP, emphasis is placed on those items that actually involve the flow of cash for the purpose
of establishing each period’s income/profit. Those items of expenditure that will not involve the
outflow of cash (e.g. depreciation and other notional charges) are to be ignored. This implies that
conventional accounting principles are not used to establish profit or income otherwise known as
the net cash inflow.
If the annual incomes/profits are to be constant, the payback period can be calculated as follows;
PBP = Io/At where
Io = Initial cash outlay (Project cost)
At = Constant periodic income/net cash inflow
For example, if a project cost N200, 000 and the project useful year is 5 years after which it will be
scrapped. The firm uses a straight-line method of depreciation. The annual profit after charging
depreciation is N10, 000.
Determine the project payback period.
SUGGESTED SOLUTION
Since the annual profit is constant and depreciation is on a straight line, the annual net cash inflow
will equally be constant. Annual net cash inflow can be determined as follows;
N
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Profit after depreciation 10,000
Add depreciation (200,000 -0)/5yrs 40,000
Annual net cash income 50,000
The PBP = N200,000/N50,000 = 4 years
If the annual income/profit is not constant, the above formula cannot be used. In such situations the
payback period can be determined using a project amortization schedule.
Example, X limited is to execute a project which requires initial cash outlay of N100,000 with the
following cash income over its useful life.
Year 1 2 3 4 5 6
Cash Income 40,000 35,000 20,000 30,000 10,000 18,000
Determine the project payback period.
SOLUTION
Using the table

Yrs Net cashflow Cum. Cashflow
0 -100,000 -100,000
1 40,000 -60,000
2 35,000 -25,000
3 20,000 -5,000
4 30,000 25,000
The PBP = 3 + (5,000/30,000) years = 3.17 years
At the end of year 3 the project still has N5,000 outstanding which is redeemed with the inflow for
year 4, therefore 3 years plus outstanding as at end of year 3 divides by inflow for year 4 will be the
payback period.
Note the answer will be stated in decimals places, unless specifically instructed to state it in nearest
months.
ACCEPTANCE OR REJECTION RULES
 Independent projects:- The management is expected to establish a cut-off period which would
represent the maximum period within which all projects within a given class of investment
must fully recover its cost. If a project payback period is less than or equal to the cut-off period,
the project is considered acceptable and vice visa
 Mutually exclusive project:- Mutually exclusive projects are alternative projects among which
one must be accepted, the acceptance of one deters the acceptance of the other, i.e. acceptance
of one precludes the acceptance of other. The project with the lowest or lower payback period
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will be considered acceptable. The PBP of such a project must however be less than or equal to
the management set, cut-off period.
MERITS OF PAYBACK PERIOD
1. It is very simple and easy to understand

2. It makes use of cash income, which is less subjective than profit
3. It emphasis the safety of investment thereby minimizing the firm’s risk exposure
4. It is suitable for firms operating under a technological changing environment, because it will
ensure the acceptance of a project that can have its cost fully recovered before such a project
becomes obsolete.
5. By emphasizing project cost recovery, the cost recovered can be put on other available
investment even before the expiration of the project’s life.
DEMERITS OF PAYBACK PERIOD
1. The method ignores the time value of money by assuming that a given unit of money expended
in year zero will be equal to the same unit of money to be generated in subsequent years.
2. The method does not make use of those cash flows generated after the payback period. This can
lead to sub optimal decision.
3. The method does not indicate relative profitability of the project.
4. The method does not give a clear acceptance or rejection view because management must
determine the cut-off rate before a decision can be made.
ACCOUNTING RATE OF RETURN (ARR)
This is the ratio of average profit generated throughout the life of a project to the average
investment value. It is another version of returns on investment. The periodic profit from the
project will be determined using the conventional accounting principles. This implies that all items
of expenditure and revenue will be considered in determining the profit. Depreciation and other
notional charges will be taken into consideration. ARR is the only method of investment appraisal
that uses accounting net profit, others use net cash flows. ARR is determined using the following;-
ARR = Average profit/Average Investment x 100/1
where average profit = Summation of annual profit/ number of years and
Average investment = (initial outlay + Residual value)/2
Other versions of computing ARR are as follows;
(a). ARR = Average profit/initial investment x 100/1 or

(b). ARR = Total profit/initial investment x 100/1 or
(c). ARR = Total profit/average investment x 100/1
Note that the earlier formula is more acceptable.
ILLUSTRATION
You are given the following cash income concerning a particular projects
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Years 1 2 3 4 5
Cash income 20,000 40,000 30,000 20,000 20,000
The initial cost of the project is N80, 000 and the scrapped proceed expected at end of the 5th year
is N5,000. Depreciation is provided on a straight-line basis
Determine the project accounting rate of return.
SUGGESTED SOLUTION
The income given is cash flow and accounting rate of return makes use of profit. Therefore
depreciation per annum will be determined and deducted to arrive at profit.
Depreciation per year = (N80, 000 + N5, 000)/5 years = N15, 000
Annual and total profit

Years 1 2 3 4 5 Total
Cash income 20,000 40,000 30,000 20,000 20,000 130,000
Less depreciation 15,000 15,000 15,000 15,000 15,000 75,000
Net profit 5,000 25,000 15,000 5,000 5,000 55,000
Average profit = N55,000/5 years = N11,000
Average investment = (N80,000 + N5,000)/2 = N42,500
The ARR = N11,000/N42,500 x 100/1 = 25.88%
DECISION RULES
 Independent project:- Management must establish or set a cut-off rate, which serves as a
minimum return expected from a given class of investment. Any investment that is able to
generate an ARR up to or more than the management set cut-off rate is considered acceptable
and vice visa.
 Mutually exclusive project:- The project with the highest or higher ARR is considered
acceptable but such project ARR must be higher than or equal to the management set cut-off
rate.
MERITS OF ACCOUNTING RATE OF RETURN
1. It is easy to calculate and understand.

2. It makes use of readily available accounting data.
3. It presents the analysis in terms of a familiar percentage figure.
4. It considers profits of a project throughout its working life.
5. It could be used to compare performance of many companies.
DEMERITS OF ACCOUNTING RATE RETURN
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1. It does not give a clear acceptance or rejection decision.
2. There is no clear definition in accounting of profit and capital employed.
3. It makes use of subjective accounting profit.
4. It takes no account of the time value of money.
5. It ignores working capital requirement.
6. In the case of mutually exclusive projects, it favours a 10% return on N10,000 to an 8% return
on N100,000.
NET PRESENT VALUE (NPV)
The net present value of a project refers to the comparison of discounted value of cash in-flow with
that of cash out-flow. It is one of method that adjust for time value of money by discount future
cash flow to the present value to know if or otherwise the present value is higher than that of out-
flow. In another words the method revealed net present gain or loss after the adjustment for
changes in value of money due to inflation or uses of fund on future cash inflows and outflows of a
particular project.
In order words, NPV represents unrealized capital gain or loss on a project under consideration for
acceptance or rejection decision. It views an investment as worth undertaking, if it gives a return
that is greater than the outflow required in present value. NPV can be positive or negative. It is
positive where the present value of all inflows (both capital and revenue) is greater than the present
value of all outflows (both capital and revenue). When this is the case, it means that the project
under consideration produces a return in excess of the cost of capital.
In other words, the positive NPV represents immediate increase/unrealized increase in

shareholder’s wealth if such a project is accepted. It is equivalent to an unrealized capital gain,
which would be realized if the expected cash flow materializes. The method makes use of cash
flow, i.e. all items of expenditure that do not involve actual flow of cash will be disregarded (e.g.
depreciation and other notional charges). The method makes use of both capital and revenue flows
that are relevant to the given project.
Choosing the discounting rate, the sources of the funding for the project is normally considered. If
it is a project that is financed from the organization’s pools of fund, the appropriate discounting rate
for such company’s projects is the cost of capital. In a situation where a company needs to borrow
specifically to finance the project, the cost of borrowing will be used to discount such a project.
The NPV of a project is determined using the following

NPV = Io + A1(1 + r)-1 + A2(1 + r)-2 …………… An(1 + r)-n
Where Io = the investment or cash out flow in year 0
A1…… An = the relevant cash flow for the number of years involved.
R = discounting rate e.g. cost of capital
(1 + r)-n = discounting factor
For ease of calculation, a table is used.
ILLUSTRATION
You are given the following details concerning a particular project.

N'000
Outlay - year 0 -80
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Profit - year 1 10
Profit - year 2 30
Profit - year 3 20
Loss - year 4 -10
Loss - year 5 -5
The disposable value of the asset is N5,000. The profits above are calculated after providing
depreciation on a straight-line basis. Assume cost of capital to be 15% per annum.
Determine the NPV of the project.
SUGGESTED SOLUTION
The Net present value method uses net cash flow and not profit, therefore the depreciation already
deducted will be reconsidered and added back to the profit or loss, to determine the net cash flow.
Year 1 2 3 4 5
Net profit/(loss) 10,000 30,000 20,000 (10,000) (5,000)
Add depr. (N80,000-N5,000)/5 15,000 15,000 15,000 15,000 15,000
Residual value - - - - 5,000
Net cash flow 25,000 45,000 35,000 5,000 15,000
The NPV of the project.
Year NCF DCF @15% Present value

0 (80,000) 1 (80,000)
1 25,000 0.8696 21,740
2 45,000 0.7561 34,025
3 35,000 0.6575 23,013
4 5,000 0.5718 2,859
5 15,000 0.4672 7,008
Net present value 8,645
MERITS OF NET PRESENT VALUE METHOD
1. It gives a clear accept or reject decision

2. It takes into consideration the time value of money
3. Changes in interest rate over a period of time can easily be incorporated into the calculation
4. It makes use of cash flow, which is less subjective than profits
5. Risk can readily be incorporated into the discounting factor calculation by adjusting the
discounting rate.
6. The method makes use of all the periods or years cash flow.
7. NPV is an absolute measure of profitability and hence immediately shows the changes in
shareholder’s wealth due to an investment decision.
8. It is objective and highly favoured by investors because it reflects addition to wealth.
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DEMERITS OF NET PRESENT VALUE METHOD
1. The method makes use of unpractical assumptions e.g. cash flow in year 0 or at end of a year
only.
2. It involves cumbersome or over-complicated calculations especially on the need to compute the
cost of capital.
3. Discounted cash flow as a concept is more difficult for a layman to understand.
4. Additional un-certainty is introduced by the need to calculate the cost of money
5. Unlike accounting rate of returns, the method disregards committed funds and thereby may not
indicate relative profitability of a project partially completed.
INTERNAL RATE OF RETURN (IRR)
The IRR can be defined as that rate which equates the present value of cash inflows with the
present value of cash out flows of an investment. It is otherwise known as yield method, showing
the maximum returns from a project. It indicates a rate above which is not advisable to fund the
project. IRR is the rate at which NPV is zero. Calculating IRR involves two stages;
The first step involves appraising the project using an arbitrary rate, one of which must give a
positive NPV and the other a negative NPV. This stage is called trial and error.
Step two, involves interpolating the two NPVs in step one together with the two opposing rates to
determine the internal rate of returns. This is referred to as interpolation.
This can be done using the following

IRR = R1 +( P ) R2 – R1
( P + N)
Where R1 = the discounting rate that gives a positive NPV
R2 = the discounting rate that gives a negative NPV
P = the positive NPV and
N = the negative NPV
Note that P + N should be added in absolute term that is without treating N in negative form.
ILLUSTRATION
A project costs N100,000 with a useful life of 4 years through which the following cash returns will
be generated from year 1 to 4, which are N40,000, N30,000, N50,000, and N20,000.
Determine the project’s IRR
SUGGESTED SOLUTION
Note that no discounting factor is given, any rate can be used and the end result will determine
whether the rate should be increased or decreased in other to derive a positive or negative NPV
Calculation of positive and negative NPV
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Year NCF DCF@ 15% PV DCF@ 17% PV
0 (100,000) 1 (100,000) 1 (100,000)
1 40,000 0.8696 34,784 0.8547 34,188
2 30,000 0.7561 22,683 0.7305 21,915
3 50,000 0.6575 32,875 0.6244 31,220
4 20,000 0.5718 11,436 0.5337 10,674
Net present value 1,778 (2,003)
The project’s IRR = 15 + ((1,778/(1,778+2,003)) x (17 – 15) = 15.94%.
DECISION RULES
 Independent projects:- If the project’s IRR is greater than or equal to the firm’s cost of capital.
It may be considered acceptable and vice visa.
 Mutually exclusive projects:- The project with the highest IRR is considered acceptable. Such
an IRR must however be greater than the firm’s cost of capital.
MERITS OF INTERNAL RATE OF RETURN
1. The IRR provides a margin for error because it takes into consideration the least expected
return from the investment within which the investment will still be acceptable.
2. The IRR is presented in the form of a familiar percentage figure for ease understanding.
3. It makes use of all the years’ cash flows
4. It takes into consideration the time value of money
5. Risk can readily be incorporated into the discounting factor calculation by adjusting the
discounting rate.
6. The method makes use of cash flow, which is less subjective than profit.
DEMERITS OF INTERNAL RATE OF RETURN
1. It is not useful for choosing between two or more investments.

2. The method makes use of un-practical assumptions.
3. It involves cumbersome or over-complicated calculations.
4. Additional uncertainty is introduced by the need to calculate the cost of money.
5. The method does not indicate a clear accept or reject decision.
DISCOUNTED PAYBACK PERIOD METHOD
This is a modification on ordinary payback period. Using this method, all cash flows will be
discounted using the company’s cost of funding before the project’s amortization table is used to
determine the project’s payback period. The method eliminates the major criticism against ordinary
payback period by taken into consideration the time value of money in the determination of the
payback period.
ILLUSTRATION
A Company is considering a project which requires immediate investment of N50,000 and

promises the following net cash flows, N15,000, N20,000, N15,000, N20,000 and N20,000 for
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years 1 to 5 respectively. No residual value is expected from the project at the end of 5 years of its
useful life. Assume the company’s cost of capital to be 20%.
Determine the project’s discounted payback period.
SUGGESTED SOLUTION
The project’s amortization table
Year NCF DCF@ 20% PV CUM. PV

0 (50,000) 1 (50,000) (50,000)
1 15,000 0.8333 12,500 (37,501)
2 20,000 0.6944 13,888 (23,613)
3 15,000 0.5787 8,681 (14,932)
4 20,000 0.4823 9,646 (5,286)
5 20,000 0.4019 8,038 2,752
The DPBP = 4 + (5,286/8,038) years = 4.66 years.
IMPORTANT TO NOTE
When undertaking an investment appraisal, there are several practical points that we should bear in mind:
 Past cost: As with all decisions, we should take account only of relevant costs in our analysis. This
means that only costs that vary with the decision should be considered. Thus, all past costs should be
ignored as they cannot vary with the decision. In some cases, a business may incur costs (such as
development costs and market research costs) before the evaluation of an opportunity to launch a new
product. As those costs have already been incurred, they should be disregarded, even though the
amounts may be substantial. Costs that have already been committed but not yet paid should also be
disregarded. Where a business has entered into a binding contract to incur a particular cost, it
becomes in effect a past cost even though payment may not be due until some point in the future.
 Common future costs: It is not only past costs that do not vary with the decision; some future costs
may also be the same. For example, the cost of raw materials may not vary with the decision whether
to invest in a new piece of manufacturing plant or to continue to use existing plant.
 Opportunity costs: Opportunity costs arising from benefits forgone must be taken into account.
Thus, for example, when considering a decision concerning whether or not to continue to use a
machine already owned by the business, the realizable value of the machine might be an important
opportunity cost.
 Taxation: Owners will be interested in the after-tax returns generated from the business, and so
taxation will usually be an important consideration when making an investment decision. The profits
from the project will be taxed; the capital investment may attract tax relief and so on. Tax is levied at
significant rates. This means that, in real life, unless tax is formally taken into account, the wrong
decision could easily be made. The timing of the tax outflow should also be taken into account when
preparing the cash flows for the project.
 Cash flows not profit flows: We have seen that for the NPV, IRR, PBP and DPBP methods, it is
cash flows rather than profit flows that are relevant to the assessment of investment projects. In an
investment appraisal requiring the application of any of these methods we may be given details of the
profits for the investment period. These need to be adjusted in order to derive the cash flows. We
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should remember that the operating profit before non-cash items (such as depreciation) is an
approximation to the cash flows for the period, and so we should work back to this figure.
When the data are expressed in profit rather than cash flow terms, an adjustment in respect of
working capital may also be necessary. Some adjustment should be made to take account of changes
in working capital. For example, launching a new product may give rise to an increase in the net
investment made in trade receivables and inventories less trade payables, requiring an immediate
outlay of cash. This outlay for additional working capital should be shown in the NPV calculations as
part of initial cost or presented in the year it is required. However, at the end of the life of the project,
the additional working capital will be released. This divestment results in an effective inflow of cash
at the end of the project; it should also be taken into account at the point at which it is received.
 Year-end assumption: In the examples and activities that we have considered so far in this chapter,
we have assumed that cash flows arise at the end of the relevant year. This is a simplifying
assumption that is used to make the calculations easier. (However, it is perfectly possible to deal more
precisely with the cash flow.) As we saw earlier, this assumption is clearly unrealistic, as money will
have to be paid to employees on a monthly basis and credit customers will pay within a month or two
of buying the product or service. Nevertheless, it is probably not a serious distortion. We should be
clear, however, that there is nothing about any of the four appraisal methods that demands that this
assumption be made.
 Interest payments: When using discounted cash flow techniques, interest payments should not be
taken into account in deriving the cash flows for the period. The discount factor already takes account
of the costs of financing, and so to take account of interest charges in deriving cash flows for the
period would be double counting.
 Other factors: Investment decision making must not be viewed as simply a mechanical exercise. The
results derived from a particular investment appraisal method will be only one input to the decision-
making process. There may be broader issues connected to the decision that have to be taken into
account but which may be difficult or impossible to quantify.
The reliability of the forecasts and the validity of the assumptions used in the evaluation will also
have a bearing on the final decision.
ILLUSTRATION 1
Clock Limited is considering the selection of one pair of mutually exclusive projects. Both would
involve purchase of machinery, it will last for 5 years.
Project 1 would generate annual cash flows (receipt less payment) of N200,000. The machinery
would cost N556,000 and has a scrap value of N56,000.
Project 2 would generate annual cash flow of N500,000. The machine would cost N1,616,000 and
has a scrap value of N301,000. Clock Limited uses the straight-line method for providing for
depreciation. The company’s cost of capital is 15% per annum.

a. Calculate
(i). The ARR to the nearest 1%
(ii). Payback period to 1 decimal place
(iii). The net present value
(iv). The internal rate of return to the nearest 1%
(v). The discounted payback period to 1 decimal place.
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b. State which project you would select for acceptance if any. Give reasons for your choice of
criterion to guide your decision.
SUGGESTED SOLUTION TO ILLUSTRATION 1
Workings
Project 1 Project 2
Annual cash flow 200,000 500,000
Less Depreciation (556,000-56,000)/5 100,000 (1,616,000-301,000)/5 263,000
Average profit 100,000 237,000
Average investment (556,000+56,000)/2 306,000 (1,616,000+301,000)/2 958,500
a. (i) Project 1 ARR = (N100,000/N305,000) x 100/1 = 33%

Project 2 ARR = (N237,000/N958,500) x 100/1 = 25%
a. (ii) Project 1 PBP = N556,000/N200,000 = 2.8 years

Project 2 PBP = N1,616,000/N500,000 = 3.2 years
(iii) The NPV of the projects
Project 1 Project 2
Year NCF DCF@ 15% PV NCF DCF@ 15% PV
0 -556,000 1 -556,000 -1,616,000 1 -1,616,000
1-5 200,000 3.3522 670,440 500,000 3.3522 1,676,100
5 56,000 0.4972 27,843 301,000 0.4972 149,657
142,283 209,757
Cumulative discounting factor determined using CDCF = 1 – (1 + r)-n = 1-(1.15)-5

r .15 = 3.3522
(iv). The IRR of the project

Positive NPV already determined above, Calculation of the negative NPV
Project 1 Project 2
Year NCF DCF@ 30% PV NCF DCF@ 30% PV
0 (556,000) 1 (556,000) (1,616,000) 1 (1,616,000)
1-5 200,000 2.4356 487,120 500,000 2.4356 1,217,800
5 56,000 0.2693 15,081 301,000 0.2693 81,059
(53,799) (317,141)
The IRR of project 1 = 15 + (142,283/(142,283+53,799))x(30-15) = 26%
The IRR of project 2 = 15 + (209,757/(209,757+317,141))x(30-15) = 21%
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(v). The discounted payback period of the projects.
Project 1
Year NCF DCF @15% PV CUM. PV
0 (556,000) 1 (556,000) (556,000)
1 200,000 0.8696 173,920 (382,080)
2 200,000 0.7561 151,220 (230,860)
3 200,000 0.6575 131,500 (99,360)
4 200,000 0.5717 114,340 14,980
Project 2
Year NCF DCF @15% PV CUM. PV
0 (1,616,000) 1 (1,616,000) (1,616,000)
1 500,000 0.8696 434,800 (1,181,200)
2 500,000 0.7561 378,050 (803,150)
3 500,000 0.6575 328,750 (474,400)
4 500,000 0.5717 285,850 (188,550)
5 801,000 0.4972 398,257 209,707
Summary
Project 1 Project 2
I ARR 33% 25%
ii. PBP 2.8 years 3.2 years
iii. NPV N142,283 N209,757
iv. IRR 26% 21%
v. DPBP 3.9 years 4.5 years
(b). Project 2 should be selected because it gives a higher NPV. When choosing between
investments, the investment favoured by the discounting method should be selected and of
all the methods of investment appraisal, only NPV gives a clear acceptance or rejection
decision. The reason being that, the method makes use of the organization’s cost of funding
to determine the project that will maximize wealth. Despite the fact that it is only NPV that
favours project 2, the project will be selected because of the priority of the method over
other methods of investment appraisal.
ILLUSTRATION 2
The directors of Banufe (Steel) Ltd are considering closing one of the business’s factories. There has been
a reduction in the demand for the products made at the factory in recent years, and the directors are not
optimistic about the long-term prospects for these products. The factory is situated in the north of the
country, in an area where unemployment is high.
The factory is leased, and there are still four years of the lease remaining. The directors are uncertain
whether the factory should be closed immediately or at the end of the period of the lease. Another
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business has offered to sub-lease the premises from Banufe at a rental of N40,000 a year for the
remainder of the lease period.
The machinery and equipment at the factory cost N1,500,000, and have a statement of financial position (
balance sheet) value of N400,000. In the event of immediate closure, the machinery and equipment could
be sold for N220,000. The working capital at the factory is N420,000, and could be liquidated for that
amount immediately, if required. Alternatively, the working capital can be liquidated in full at the end of
the lease period. Immediate closure would result in redundancy payments to employees of N180,000.
If the factory continues in operation until the end of the lease period, the followings operating profits
(losses) are expected:
Year 1 Year 2 Year 3 Year 4
N’000 N’000 N’000 N’000
Operating profit/(loss) 160 (40) 30 20
The above figures include a charge of N90,000 a year for depreciation of machinery and equipment. The
residual value of the machinery and equipment at the end of the lease period is estimated at N40,000.
Redundancy payments are expected to be N150,000 at the end of the lease period if the factory continues
in operation. The business has an annual cost of capital of 12 per cent. Ignore taxation.
a. Determine the relevant cash flows arising from a decision to continue operations until the end of the
lease period rather than to close immediately.
b. Calculate the net present value of continuing operations until the end of the lease period, rather than
closing immediately.
c. What other factors might the directors take into account before making a final decision on the timing
of the factory closure?
d. State, with reasons, whether or not the business should continue to operate the factory until the end of
the lease period.
SUGGESTED SOLUTION TO ILLUSTRATION 2
a. The relevant cash flow for the years

Years 0 1 2 3 4
N’000 N’000 N’000 N’000 N’000
Operating profit/(loss) 160 (40) 30 20
Add depreciation 90 90 90 90
Operating cash flows (Note 1) 250 50 120 110
Sales of machinery (Note 2) (220) 40
Redundancy costs (Note 3) 180 (150)
Sub-lease rentals (Note 4) (40) (40) (40) (40)
Working capital invested (Note 5) (420) 420
Net cash flow (460) 210 10 80 380
Notes:
1. Each year’s operating cash flows are calculated by adding back the depreciation charge for the
year to the operating profit for the year. In the case of the operating loss, the depreciation charge
is deducted
2. In the event of closure, machinery could be sold immediately. Thus an opportunity cost of
N220,000 is incurred if operations continue.
3. If operations are continued, there will be a saving in immediate redundancy costs of N180,000.
However, redundancy costs of N150,000 will be paid in four years’ time.
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4. If operations are continued, the opportunity to sub-lease the factory will be forgone.
5. Immediate closure would mean that working capital could be liquidated. If operations continue,
this opportunity is foregone. However, working capital can be liquidated in four years’ time.
b. The Net Present Value of the project

Years 0 1 2 3 4 NPV
Net Cash Flow ('000) (460) 210 10 80 380
Discounting rate @ 12% 1.0000 0.8929 0.7972 0.7118 0.6355
Present value ('000) (460) 187.51 7.97 56.94 241.49 33.92
c. Other factors that may influence the decision include:
 The overall strategy of the business: The business may need to set the decision within a broader
context. It may be necessary to manufacture the products at the factory because they are an
integral part of the business’s product range. The business may wish to avoid redundancies in an
area of high unemployment for as long as possible.
 Flexibility: A decision to close the factory is probably irreversible. If the factory continues,
however, there may be a chance that the prospects for the factory will brighten in the future.
 Creditworthiness of sub-lease: The business should investigate the creditworthiness of the sub-
lessee. Failure to receive the expected sub-lease payments would make the closure option far less
attractive.
 Accuracy of forecasts: The forecasts made by the business should be examined carefully.
Inaccuracies in the forecasts or any underlying assumptions may change the expected outcomes.
d. The NPV of the decision to continue operations rather than close immediately is positive. Hence,
shareholders would be better off if the directors took this course of action. The factory should
therefore continue in operation rather than close down. This decision is likely to be welcomed by
employees and would allow the business to maintain its flexibility.
CAPITAL RATIONING
Capital Rationing is the calculation or determination of optimum, economic or profitable

combination of investment projects. In a situation where there are many profitable projects
competing for limited funds available, capital rationing is used after the various alternative projects
are appraised and these projects give a positive NPV but the fund available is inadequate to meet
the funding requirement of these projects. The funding constraint may be as a result of reluctance
of management to dilute control by financing projects with additional issues of capital, high cost of
borrowing, restriction in the capital market etc. The capital rationing is broadly classified as
follows:-
1. Single period capital rationing.

2. Multi-period capital rationing
SINGLE PERIOD CAPITAL RATIONING
This occurs when the finance constraint exists for only a single period or year. When there is a
single capital rationing, the optimum allocation of funds can be done using any of the following
methods:
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(a). Cost Benefit Analysis (CBA): This is the net present value per naira invested. It is
determined by dividing the net present value of each project by their initial investment, i.e.
CBA. = NPV/I0, where NPV = Net present value, I0 = Initial outlay.
Note that initial outlay in capital rationing refers to cash outflow requirement of the project
in the year of rationing.
Using CBA may require the followings:
1. Determine the NPV of each of the competing project.

2. Identify the cash outflow requirement in the year of rationing that is initial outlay.
3. Determine the CBA by dividing NPV by the initial outlay.
4. Rank the project in order of the higher the PI the higher the ranking.
5. Allocate the limited fund available among the projects in accordance with ranking in 4
above.
6. Recommend optimum project mix based on allocation done in 5 above.
(b). Profitability Index (PI): This is the present value of inflows per naira invested. This is
determined by dividing the present value of the future cash inflows by the initial outlay,
that is PI = Present value of inflow/initial outlay.
From above, PI uses present value of inflows instead of net present value used by CBA. It
can therefore be stated that,
CBA = PI - 1
PI = CBA+ 1
Using either PI or CBA will result in the same conclusion, since projects ranking under the
two will follow the same pattern.
The steps required using PI is similar to what we have under CBA, except that we make
use of NPV instead of present value of inflow as used in CBA.
DEFINITION OF TERMS
The following terms are commonly used in capital rationing. They are:
1. Mutually exclusive projects:- These are projects that can not be accepted together. In
another words acceptance of one, denies the accepting of the other. When two or more
projects are mutually exclusive they cannot be accepted together. Therefore, the projects
will be grouped in such a way that the two mutually exclusive projects will not be in the
same group. Based on this grouping, projects will be ranked and funds will be allocated
and total NPV computed. The group with the higher total NPV will be considered
acceptable.
2. Mutually dependent projects: These are projects that go together, i.e., if one is accepted,
the other must equally be accepted. The initial outlay and NPV of such projects will be
added together for the purpose of ranking and allocation of funds. That is, two projects will
be treated together as if it is a single project for the purpose of ranking and allocation of
funds. So that if the projects are to be accepted, they will be accepted together and vice
versa.
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3. Divisible projects: Projects are divisible when it can be partly financed, i.e., when
fractional projects can be accepted.
4. Indivisible Projects: These are projects that cannot be divided for execution. That is, part
of the project cannot be executed. That is, either accept completely or reject completely.
5. Independent projects: That is the projects are neither mutually exclusive nor dependent.
The projects stand on their own merit for the purpose of capital rationing.
CAUSES OF CAPITAL RATIONING
1. Raising money through the stock market may not be possible if the share prices of the
companies are at a depressed level.
2. There may be restriction on bank lending due to government control
3. The company may not be willing to make additional issues if the amount is small and the cost
of issue is high.
4. Lending institutions may consider a company too risky to be given any more loan as capital.
5. Management of a company may impose its own restriction on capital to limit the rate of its
growth to what it can handle.
6. When management decides to maintain constant dividends, rather than using available cash for
the profitable project.
7. When there are other factors such as material, labour, machine capacity etc., which restricts the
acceptance of any profitable project.
8. Many companies do not yet have full access to the capital market either because they are too
small or their profit record is not good enough.
9. Shareholders in a small company may not favour the company in issuing its equity capital for
fear of loosing control.
LIMITATION OF CAPITAL RATIONING
1. An assumption that projects are divisible will not always hold.

2. It follows from (1) above that linearity assumption could also be faulted, i.e. fraction of a
project given the same fraction of a profit.
3. The technique ignores the interdependence of projects
4. It ignores management’s attitudes to risk.
ILLUSTRATION
A company has N3.0 million available for investment in projects. The following projects are under
consideration.
Project
No Initial Annual net Life
Investment Cash Inflow
1 800,000 230,000 6 years
2 600,000 190,000 6 years
3 700,000 210,000 6 years
4 900,000 280,000 6 years
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5 300,000 92,000 6 years
6 950,000 300,000 6 years
The projects are divisible and the company expects a minimum rate of return of 18%.
You are required to :
1. Using cost benefit analysis determines the projects to be accepted in order to maximize profit.
2. Assume projects Nos 2 and 5 are mutually dependent and that projects Nos 2 and 6 are
mutually exclusive. Advise the company on selections of projects to maximize profitability
bearing in mind that only N3.0 million capitals is available.
SUGGESTED SOLUTION
1. Calculation of the cost benefit analysis and ranking of the projects
Project Initial Annual net CDCF@ Present NPV CBA Rank

No Investment Cash inflow 18%(6years) Value inflow
1 800,000 230,000 3.498 804,540 4,540 0.0057 6th
2 600,000 190,000 3.498 664,620 64,620 0.1077 1st
3 700,000 210,000 3.498 734,580 34,580 0.0494 5th
4 900,000 280,000 3.498 979,440 79,440 0.0883 3rd
5 300,000 92,000 3.498 321,816 21,816 0.0727 4th
6 950,000 300,000 3.498 1,049,400 99,400 0.1046 2nd
Allocation of capital among the competing projects in order of ranking:

Rank Project Initial Fund Fund Balance NPV
Outlay Allocated Available of fund
st
1 2 600,000 600,000 3,000,000 2,400,000 64,620
nd
2 6 950,000 950,000 2,400,000 1,450,000 99,400
rd
3 4 900,000 900,000 1,450,000 550,000 79,440
th
4 5 300,000 300,000 550,000 250,000 21,816
th
5 3 700,000 250,000 250,000 - 12,350
TOTAL 3,000,000 277,626
It is advisable to accept projects 2, 6, 4, 5 and 35.7% of 3 (i.e. 250,000/700,000 x 100/1) in

order to maximize profit.
Cumulative discounting factor for 6 years = (1-(1.18-6))/.18 = 3.498 approx.
2. For mutually dependent projects their initial outlay will be added together and their NPV added
together to determine the joint cost benefit analysis and ranking of the project. While for
mutually exclusive projects, the projects will be grouped in such a way that the two mutually
exclusive projects will not be in the same group. Each group’s CBA, rank, allocation of fund
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and total NPV will be computed and the group with the higher or highest total NPV will be
considered acceptable.
Grouping the projects
Group A Projects 1, 3, 2&5, and 4

Group B Projects 3, 4 and 6
The two factors aiding the grouping above are mutually exclusive and dependent.
Calculation of cost benefit analysis and ranking of projects in group A

Project Initial NPV CBA Rank
No Investment
1 800,000 4,540 0.0057 4th
2&5 900,000 86,436 0.0960 1st
3 700,000 34,580 0.0494 3rd
4 900,000 79,440 0.0883 2nd
Allocation of fund and total NPV for group A projects

Outlay Allocated Available of fund
1st 2&5 900,000 900,000 3,000,000 2,100,000 86,436
nd
2 4 900,000 900,000 2,100,000 1,200,000 79,440
rd
3 3 700,000 700,000 1,200,000 500,000 34,580
th
4 1 800,000 500,000 500,000 - 2,838
TOTAL 3,000,000 203,294
Calculation of cost benefit analysis and ranking of projects in group B
Project Initial NPV CBA Rank

No Investment
1 800,000 4,540 0.0057 4th
3 700,000 34,580 0.0494 3rd
4 900,000 79,440 0.0883 2nd
6 950,000 99,400 0.1046 1st
Allocation of fund and total NPV for group B projects

Project Initial Outlay NPV PI Rank
1 800,000 4,540 0.0057 4 th
Outlay Allocated Available
rd of fund
3
st 700,000 34,580 0.0494 3
1 6 950,000 950,000 3,000,000
nd 2,050,000 99,400
nd4 900,000 79,440 0.0883 2
2 4 900,000 900,000 2,050,000
st 1,150,000 79,440
6
rd
950,000 99,400 0.1046 1
3 3 700,000 700,000 1,150,000 450,000 34,580
th
4 1 800,000 450,000 450,000 - 2,554
TOTAL 3,000,000 215,974
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From the computation above, the projects in group B give the higher total NPV. It is therefore
advisable to accept project nos 6, 4, 3 and 56.25% of 1 in order to maximize profit/NPV.
Note that in the calculation of NPV for fractional projects, the percentage of fund allocated to total
fund requirement is taken into consideration.
MULTI-PERIOD CAPITAL RATIONING
Whenever funding or finance constraint persist for more than a single period or year, such is
referred to as multi-period capital rationing. The allocation of fund can be done through the use of
linear programming technique.
Using the linear programming technique for multi-period capital rationing requires the formulation
of the objective. Where the objective will be to maximize the net present value of each project
involved and the net present value of surplus fund, in a situation where we are informed that
surplus fund can be re-invested.
The constraint equations will be stated, which will be the fund requirement of each project
compared with total funds available for the years there are funding constraints. The numbers of
constraints will depend on the number of period or years the finance scarcity persists. After the
formulation of the objective and constraint equations, graphical or simplex methods can be used to
determine the optimum allocation of funds. Note that graphical method can be used only if the
problem involves two variables and the simplex method can cope with problems with two or more
variables.
ILLUSTRATION
A company has four investments available, with the following cash flows:
Year A B C D
N N N N
0 -10,000 -18,000 -20,000 -10,000
1 -5,000 -10,000 -20,000 -10,000
2 -6,000 5,000 -5,000 -10,000
3 15,000 15,000 30,000 10,000
4 20,000 22,000 30,000 40,000
Capital is rationed in each of the first three years and the amount available is N30,000 at year 0,
N30,000 at year 1, and N8,000 at year 2. The projects are all infinitely divisible and cost of capital
is 10% per annum. Formulate the linear programming.
.
SUGGESTED SOLUTION
In order to formulate the objective, the NPV of the projects must be determined. This can be
determined using straight line method of computing net present value as follows:
A= -10,000(1.1)0 + -5,000(1.1)-1 + -6,000(1.1)-2 + 15,000(1.1)-3 + 20,000(1.1)-4 = N5,426

B= -18,000(1.1)0 + -10,000(1.1)-1 + 5,000(1.1)-2 + 15,000(1.1)-3 + 22,000(1.1)-4 = N3,337
C= -20,000(1.1)0 + -20,000(1.1)-1 + -5,000(1.1)-2 + 30,000(1.1)-3 + 30,000(1.1)-4 = N716
D= -10,000(1.1)0 + -10,000(1.1)-1 + -10,000(1.1)-2 + 40,000(1.1)-3 +40,000(1.1)-4 = N7,478
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Let a = the proportion of project A invested
a = the proportion of project B invested
c = the proportion of project C invested
d = the proportion of project D invested
The linear programming.
The objective is to maximize NPV at N5,426a + N3,337b + N716c + N7,478d
Subject to the following constraint

1. Fund available in year 0, N10,000a + N18,000b + N20,000c + N10,000d < N30,000
2. Fund available in year 1, N5,000a + N10,000b + N20,000c + N10,000d < N30,000
3. Fund available in year 2, N6,000a + N5,000c + N10,000d < N8,000 + N5,000
In constraint 3 above it is assumed that inflow from project b can be re-invested in the year of
rationing. Note that the said inflow of N5,000 may be excluded, but the assumption that inflow will
not be re-invested in the year if rationing must be stated.
EFFECT OF INFLATION ON INVESTMENT APPRAISAL
Inflation is the rise in future cost or price of an item. It is an additional factor, which will increase
the difficulties of investment appraisal calculation. The impact of inflation is to depreciate the real
value of money. Wrong investment decision can be taken if the impact of inflation is ignored
because both the cash flow and cost of capital are affected by inflation.
INFLATION AND INTEREST RATE
For the purpose of incorporating inflation to investment appraisal, interest rate is broadly
categorized into two, as follows:
(a). Real Interest Rate: It is the interest rate that excludes the increase due to inflation. It is the
current rate or rate in real terms without any adjustment for increase due to inflation. Real
interest rate can be determined from money interest rate using the following:
Real interest rate = ((1+m)/(1+i)) –1
Where m= money interest rate and i = inflationary rate
(b). Money interest rate: Otherwise known as market or nominal interest rate, it is the interest
rates that incorporate the effect of inflation. That is, it is the rate that includes anticipated
increase due to inflation. If an interest rate is given without otherwise stated, it is money
interest rate. Money interest rate can be determined from real interest rate using the
following:
Money interest rate (MIR) = (1+R)(1+i) – 1
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Where R = Real interest rate and i = inflationary rate or rate of inflation.
INFLATION AND CASHFLOW
To incorporate inflation into investment appraisal, cash flows are broadly categorized into two as
follows:
(a). Real Cash flow: This is cash flows in real term, i.e., cash flows without taken into
consideration future increase due to inflation. It is cash collectable or payable immediately
or in the future without taken into consideration the future increase that will be due to
inflation. The real cash flows can be determined from money cash flow using the
following:
Real cash flow (RCF) = MCF(1+i)-n
Where MCF= money cash flow i = inflationary rate and n = number of years
(b). Money Cash Flow: This is an amount collectable or payable now or in the future that
incorporate or includes expected future increase due to inflation. If inflation is added into
cash flow, it is referred to as money cash flow. Any cash flow given, and can not qualify
with either real or current, it is right to assume it to be money cash flow. Money cash flow
can be determined from real cash flow using the following:
Money cash flow (MCF) = RCF(1+i)n
Where RCF = real cash flow, i = inflationary rate, n = number of years.
The demarcations above are necessary because we use money interest rate to discount money cash
flow and real interest rate to discount real cash flow. Therefore, it either all cash flow is in money
form, so that money interest rate can be used to discount it, or all cash flow is in real form and we
use real interest rate to discount it.
ILLUSTRATION 1
A company just acquires equipment that will require replacement in five years at a cost of
N500,000. Annual rate of inflation is 8% and nominal interest rate is 20% per annum.
Calculate the present value of the replacement cost, using
(a). Calculation based on money cash flow

(b). Calculation based on real cash flow
SUGGESTED SOLUTION
(a). Money interest rate is 20% and Money cash flow is N500,000
The present value of the replacement cost = N500,000(1.2)-5 = N200,938.79
(b). Real cash flow = N500,000(1.08)-5 = N340,291.60

Real interest rate = (1.20/1.08) – 1 = .1111111
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Present value of the replacement cost = N340,291.60(1.111111)-5 = N200,938.79
The two methods are expected to give the same results, subject to rounding up errors.
ILLUSTRATION 2
A machine will cost N120,000 in year 0, we expect to produce and sell 10,000 units per annum. A
standard cost card has been produced as follows:
N
Materials 5.00
Labour 3.00
Variable overheads 2.00
Fixed overheads (excluding depreciation) 1.00
Depreciation 2.50
13.50
We have fixed the selling price for year 1 at N15 per unit, giving a budgeted profit of N1.50 per
unit. We intend to increase the selling price by 12% per annum on 1st January of each year.
The machine is expected to last four years at the end of which period we expect scrap proceeds of
N2,000 (this is an estimate of the actual cash to be received). With the exception of the selling price
and scrap proceeds, all estimates are in current prices, and we estimate that the costs will be
inflated at the following rates.
Materials 5% per annum
Labour 20% per annum
Overheads in line with the retails price index, which is expected to rise at the
rate of 10% per annum.
Our year end is 31st December each year, and all flows are to be assumed to occur at the ends of
each year with the exception of the purchase price payable immediately. The cost of capital is 15%
per annum.
Should we accept or reject the project?
SUGGESTED SOLUTION
The net present value of the projects must be determined in order to know whether it should be
accepted or rejected. The cash flows must be converted to money cash flows by adding inflation to
the real cash flow; there after money interest rate of 15% will be used to discount the money cash
flow as determined.
Calculation of money net cash flow of the project:
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Year 0 1 2 3 4
N N N N N
Initial Outlay (120,000) - - - -
Sales - 150,000 168,000 188,160 210,739
Material costs - (52,500) (55,125) (57,881) (60,775)
Labour cost - (36,000) (43,200) (51,840) (62,208)
Variable overhead - (22,000) (24,200) (26,620) (29,282)
Residual Value 2,000
Net cash flow (120,000) 39,500 45,475 51,819 60,474
Note that selling price of N15 is used for year 1, because the question specifically mentions that the
selling price is already determined. In other words, the increase in selling price will be effective
from year 2. While for the variable cost is from year 1, because it is stated that it is in current value,
that is year 0.
The computations:
Sales N Material costs N
Year 1 10,000 x 15 150,000 Year 1 10,000 x 5 x 1.05 52,500
Year 2 10,000 x 15 x 1.12^1 168,000 Year 2 10,000 x 5 x 1.05^2 55,125
Year 3 10,000 x 15 x 1.12^2 188,160 Year 3 10,000 x 5 x 1.05^3 57,881
Year 4 10,000 x 15 x 1.12^3 210,739 Year 4 10,000 x 5 x 1.05^4 60,775
Labour costs N Variable overhead costs N

Year 1 10,000 x 3 x 1.2 36,000 Year 1 10,000 x 2 x 1.1 22,000
Year 2 10,000 x 3 x 1.2^2 43,200 Year 2 10,000 x 2 x 1.1^2 24,200
Year 3 10,000 x 3 x 1.2^3 51,840 Year 3 10,000 x 2 x 1.1^3 26,620
Year 4 10,000 x 3 x 1.2^4 62,208 Year 4 10,000 x 2 x 1.1^4 29,282
The NPV of the project.

Year NCF DCF @ 15% PV
0 (120,000) 1 (120,000)
1 39,500 0.8696 34,349
2 45,475 0.7561 34,384
3 51,819 0.6575 34,071
4 60,474 0.5718 34,579
NPV 17,383
The computation above gives a positive NPV, it is therefore advisable to accept the project.
EFFECT OF TAXATION ON INVESTMENT APPRAISAL
The primary objective of investment is to generate profit. The profit is expected to attract tax
liability. The additional cash payable/paid is part of the incremental cash outflow consequential to
the acceptance of a project. Taxation will affect cash flow in the following ways:
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1. Tax payable on regular profit: To determine the regular profit, depreciation must be disallowed
with capital allowance given in its place. If depreciation rate and capital allowance rates are
given, depreciation rate should be ignored and capital allowance used. In a situation where the
capital allowance rate is not given, the depreciation rate should be used in place of the capital
allowance for the purpose of determining the taxable profit on which the tax liability/payable
should be computed. Note that tax is always pay one year in arrears, this must be applied
accordingly.
2. Tax savings result from balancing allowance at the time of initiating the project or at the
terminal life of the project: Balancing allowance will be the excess of tax written down value
(TWDV) of a qualified capital expenditure over the disposable value of the assets:
Bal. Allow. = TWDV – Disposable value
Where TWDV > Disposable value
Tax savings = Balancing Allow. x Tax rate
3. Additional tax payment resulting from balancing charges: This may be at the time of initiating
the project or at the end of the project useful life span. The balancing charge is the excess of
disposable value over the tax written down value of the asset.
Bal. Charge = Disposable value – TWDV
Where Disp. Value > TWDV
Additional tax payable = Bal. Charge x Tax rate
ILLUSTRATION 1
Tolu Limited is considering an investment proposal which would require an outlay of N200,000 on
a machinery. Cash benefits are as follows:
Year 1 2 3 4 5
Net Cash Flow (N) 40,000 100,000 100,000 70,000 60,000
Additional cash expenses to be incurred by the company will be N20,000 and N30,000 in years 1
and 2 respectively. Capital allowances are provided at 45% in the first year and 20% on reducing
balance method thereafter. There is no scrap value at the end of the useful life.
If the company’s cost of capital is 15% and the company’s tax rate is 35%.
Is the project worthwhile?
SUGGESTED SOLUTION
The capital allowance for the relevant years

Year 1 45% x N200,000 = N90,000
Year 2 20% x (N200,000 – N90,000) = N22,000
Year 3 20% x (N200,000 – N112,000) = N17,600
Year 4 20% x (N200,000 – N129,600) = N14,080
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Year 5 N200,000 – N143,680 = N56,320
Note, since the asset disposable value at end of its useful life is zero, the TWDV in year 5 will be
the capital allowance, that is, addition of annual allowance and balancing allowance, which have
the same treatment.
Calculation of net cash flow, taxable profit and tax liability.
Year 1 2 3 4 5
Cash inflow 40,000 100,000 100,000 70,000 60,000
Less cash expenses (20,000) (30,000) - - -
Net inflow 20,000 70,000 100,000 70,000 60,000
Less capital allowance (90,000) (22,000) (17,600) (14,080) (56,320)
Taxable profit/(loss) (70,000) 48,000 82,400 55,920 3,680
Tax payable/(Savings) 35%) (24,500) 16,800 28,840 19,572 1,288
Calculation of the present value of the project:
Year Initial Outlay Cash flow Tax saving Tax payable NCF DCF@15% PV
0 (200,000) (200,000) 1 (200,000)
1 20,000 20,000 0.8696 17,392
2 70,000 24,500 94,500 0.7561 71,451
3 100,000 (16,800) 83,200 0.6575 54,704
4 70,000 (28,840) 41,160 0.5718 23,535
5 60,000 (19,572) 40,428 0.4972 20,101
6 (1,288) (1,288) 0.4323 (557)
NPV (13,373)
From the computation above, the project gives a negative NPV, therefore, it is not a worthwhile
project.
ILLUSTRATION 2
Doing-well Communication Ltd is considering investing N200,000 to equip a recording studio. The
project is expected to generate an annual contribution of N75,000 for each of the next four years.
The equipment will be scrapped at the end of the fourth year and is expected to have a disposal
value of N40,000
The rate of corporation tax is 30%. Equipment such as this is entitled to annual allowance of 25%
on straight-line basis, while, the company’s after tax cost of capital is 10%.
Required
a. Calculate the payback period
b. Calculate the NPV of the proposed project.
SUGGESTED SOLUTION
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a. The payback period
Year NCF CNCF
0 (200,000) (200,000)
1 75,000 (125,000)
2 67,500 (57,500)
3 67,500 10,000
Payback period = 2 + (57,500/67,500) = 2.85 years.
b. The NPV of the proposed project

Year NCF DCF@10% PV
0 (200,000) 1.0000 (200,000)
1 75,000 0.9091 68,183
2 67,500 0.8264 55,782
3 67,500 0.7513 50,713
4 107,500 0.6830 73,423
5 (19,500) 0.6209 (12,108)
NPV 35,992
wi. The annual capital allowance = N200,000/4years = N50,000 per year, except for year 5
which is going to be TWDV – Disposal value i.e. N50,000 – N40,000 = N10,000.
Note: 4 years is used because rate of capital allowance is given as 25% i.e. 100/25 = 4
years.
wii. Calculation of taxable profit and tax payable for the years
Years 1 2 3 4
N N N N
Annual contribution 75,000 75,000 75,000 75,000
Less capital allowance 50,000 50,000 50,000 10,000
Taxable profit 25,000 25,000 25,000 65,000
Tax payable@30% 7,500 7,500 7,500 19,500
Wii. The net cash flow of the project.
Years 0 1 2 3 4 5
N N N N N N
Initial cost (200,000)
Disposal value 40,000
Annual contribution 75,000 75,000 75,000 75,000
Tax payable (7,500) (7,500) (7,500) (19,500)
Net cash flows (200,000) 75,000 67,500 67,500 107,500 (19,500)
ILLUSTRATION 3
Page 212
ABC PLC intends to acquire a new production plant to replace the existing one, which has outlived
its useful life. The new machine is to cost N550,000 with a useful life of 5 years. The old machine,
which was purchased 4 years ago can be sold for N30,000 though the book value is N20,000.
Normal production capacity is 20,000 units per annum but the firm, however, estimates the
following production levels for the relevant years.
Year production level

1 80% of normal capacity
The revenue and cost profile for production in the first year will be as follows:
N N
Selling price 45.00
Material (5 kg @ N2.50) 12.50
Labour ( 3 hrs @ N7) 21.00
Variable O/H (3 hrs @ N1.50) 4.50
Fixed O/H (3 hrs @ N2) 6.00 44.00
Profit 1.00
The fixed overhead represents the absorption rate, on the basis that the total production will equal
normal capacity. The total overhead however includes the first year depreciation on the assumption
that, the asset will be equally or evenly used throughout its life span, after which it can be sold for
N50,000. The sales price and labour rate will be increasing at the rate of 10% effectively beginning
year 2. At the fifth year when production is expected to be above the normal capacity a machine
overhauling expense is expected to cost N25,000 to accommodate the excess production.
The machine is qualified for initial allowance of 30% and annual allowance of 20% (which would
be calculated on straight line method). The income tax is 40%. The project will require additional
working capital of N22,000 in the first year. This will increase to N40,000 at beginning of year 3
and it will be maintained at this level throughout the project life. The firm’s cost of capital is 15%.
Using the NPV criterion of project appraisal, advise on whether the project should be accepted.
SUGGESTED SOLUTION
The question above is aimed at testing; treatment of proceeds from sales of old asset when
considering replacement of asset, treatment of inflation, taxation, working capital and capacity
utilization in investment appraisal.
In replacement of an old asset with a new one, the proceeds from the old asset is considered as cash
inflow in year 0 or immediately, and deductible from the cost of the new asset. Therefore, the
expected cash out flow in year 0 will be
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N
Cost of the new machine 550,000
Less resale-able value of old asset (30,000)
Net cash outflow 520,000
Equally since the company is in a taxable position, the profit expected on disposal will be taxable
and for this purpose the book value of the asset will be used as the tax written down value, since
there is no information on the latter. The additional tax payable on disposal will be
N
Resale-able value of old asset 30,000
Less the book value of the asset (20,000)
Balancing charge 10,000
Tax payable (40%) 4,000
Note that this tax payable will be cash outflow in year 2. Although the proceeds are treated as cash
inflow in year 0, in financial terms, there is nothing as year 0. Year 0 is a capital budgeting term for
all cash inflows and cash outflows occurring immediately, that is, the time of taken the decision,
and whatever occurred immediately will form part of the operating income statement for year 1,
assessable for tax and tax payable in year 2, in line with PYB basis of taxation.
The Fixed overhead cost is generally disregarded in the computation of net cash inflow, unless it is
specifically stated that there will be an incremental or relevant fixed cost associated with the project
at hand. Whenever taxation is involved, all allowable costs must be deducted before arriving at
taxable profit. Allowable cost will include other fixed cost/ overheads, apart from depreciation.
Remember capital allowance will be used to replace depreciation; it is therefore necessary to

determine other fixed overheads that is separable from depreciation, so that such cost is deducted
for accurate tax estimate.
The other fixed overhead N

Total fixed overhead (20,000 x N6) 120,000
Less annual depreciation ((N550,000-N50,000)/5 years (100,000)
Other fixed overhead 20,000 per annum
Capital allowance for the relevant years

Year 1 Initial allowance (30% x N550,000) N165,000
Annual allowance(N550,000-N165,000)/5 years N77,000
Capital allowance N242,000
Year 2 – 5 Capital/Annual allowance (N550,000-N165,000)/5 years N77,000 per annum
The balancing charge on the new asset at end of the 5th year will be N50,000, since based on the
capital allowance computed above, the tax written down value will be zero at the end of year 5.
Additional tax payable = N50,000 x 40% = N20,000
Calculation of net cash flow, taxable profit and tax payable for the years.
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Year 1 2 3 4 5
Sale quantity (units) 16,000 16,000 20,000 18,000 22,000
Selling price (N) 45.00 49.50 54.45 59.90 65.89
Less variable cost per unit
Material (12.50) (12.50) (12.50) (12.50) (12.50)
Labour (21.00) (23.10) (25.41) (27.95) (30.75)
Variable overhead (4.50) (4.50) (4.50) (4.50) (4.50)
Contribution margin 7.00 9.40 12.04 14.95 18.14
Total contribution 112,000 150,400 240,800 269,100 399,080
Less overhauling expense (25,000)
Net inflow operation 112,000 150,400 240,800 269,100 374,080
Less capital allowance (242,000) (77,000) (77,000) (77,000) (77,000)
Less other fixed overhead (20,000) (20,000) (20,000) (20,000) (20,000)
Taxable profit/(loss) (150,000) 53,400 143,800 172,100 277,080
Tax (savings)/payable (40%) (60,000) 21,360 57,520 68,840 110,832
Working capital in capital budgeting using the discounting method, will be treated as cash outflow
in the year it is introduced; this is assumed to be recoverable at the end of the project life, thereby
treated as cash inflow. Therefore N22,000 will be outflow in year 1 and N18,000 in year 2.
Inflation is included as well in the computation of labour cost per unit.
Note that in capital budgeting decision using the discounting method, if a cash inflow or outflow is
expected in advance or at a beginning of a year, for purpose of out or inflow, it is treated to the end
of earlier year. For example the additional working capital will be at beginning of year 3, it is to be
treated as cash outflow in year 2. The whole essence of discounting is to remove a whole year’s
interest. It will be abnormal to remove a year’s interest from cash flow arising at the beginning of a
year.
Calculation of the project net cash flow for the years
Year 0 1 2 3 4 5 6
Outlay/Disposal V (520,000) 50,000
Additional tax liab. (4,000) (20,000)
Net inflow operat. 112,000 150,400 240,800 269,100 374,080
Tax saving/payable 60,000 (21,360) (57,520) (70,840) (110,832)
Working capital (22,000) (18,000) 40,000
Net cash flow (520,000) 90,000 188,400 219,440 211,580 393,240 (130,832)
The NPV of the project
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Year NCF DCF @ 15% PV
0 (520,000) 1 (520,000)
1 90,000 0.8696 78,264
2 188,400 0.7561 142,449
3 219,440 0.6575 144,282
4 211,580 0.5718 120,981
5 393,240 0.4972 195,519
6 (130,832) 0.4323 (56,559)
NPV 104,937
From the computation above, the project gives a positive NPV, it is therefore advisable to accept
the project.
LEASE OR BUY DECISION
A lease is a contractual agreement between the owner of an asset, known as Lessor, granting the
use of the asset, to the user known as Lessee, for a consideration called lease rental. There are two
types of lease as follows:
a. Finance lease:- this is a type of lease in which the Lessor acquire an asset for main use of the
leasee. Leasee Companies usually go for such an agreement when there is a productive
machine or equipment required for operations and there is inadequate fund to purchase.
Arrangements will be made with a Financial Institution, to buy the asset on behalf of the leasee
and the buyer or leasor, subsequently lease the asset pending repayment of the loan (that is the
fund used in purchasing plus interest) on instalmental basis for the duration of the lease
agreement. Other characteristic of this type of lease include:
1. The lease agreement covers the life of the asset or the period of repayment of interest
and principal.
2. Such agreement cannot be cancelled at short notice.
3. The leasee with be entitled to benefit associated with acquisition of asset e.g. capital
allowance.
4. The leasee will responsible for the liability associated with acquisition of asset e.g.
Insurance and maintenance cost.
5. The leasee has the option of buying the asset at residual value at the end of the lease
agreement period.
b. Operating lease:- This is a type of lease that exists between two companies in a parallel
market. Such lease is normally common with assets jointly used by many companies, so that if
a company acquires the asset and the installed capacity is not fully utilised, part of the un-
utilised capacity can be leased to another company operating within the same market. Other
characteristic of this type of lease include:
1. The agreement is always of short time nature.

2. The agreement can be cancelled at short notice.
3. The leasor will be entitled to benefit associated with acquisition of asset.
4. The leasor will be responsible for the liability associated with acquisition of asset.
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5. The leasee does not have the purchase option at end of the lease agreement period.
Whenever considering a lease or buy decision, it is the operating lease that is under
consideration and not a finance lease, because a finance lease is as good as borrowing to
finance the purchase of an asset, therefore the lease rental is repayment of capital and non-
allowable expenses for taxation purpose. Whereas operating lease rental is an allowable
expense.
In a lease or buy decision, there are indeed two decisions in one. These are:-
a. Investment decision:- This is the determination of the economic viability or otherwise of

an asset by using any of the investment appraisal criteria as discussed earlier.
b. Financing decision:- This is the determination of the optimal, economic or profitable

method of financing the asset, that is either by outright purchase or lease. The net present
cost of the alternatives, if it is the only factor that makes difference between the alternatives
available, will be computed. The annual equivalent cost will be used when the alternatives
do not maintain the same life span. To compute the net present cost or annual equivalent
cost, the following will be taken into consideration:
Buying option
The cash flow to be discounted are:
1. The initial outlay or the cost of the asset.
2. The year-to-year running/operating/maintenance cost of the asset.
3. The scrapped proceeds of the asset after the end of it’s useful life.
4. If the company is in a taxable position, tax saving on capital allowance for the asset,
running cost and balancing allowance or tax payable on balancing charge, as may be
applicable.
Tax savings on running cost, capital allowance and balancing allowance will be treated as cash
inflow equally in arrears, while tax payable on balancing charge will be treated as cash outflow in
arrears.
Note that if an organization needs to borrow funds in order to finance the purchase, the annual
instalmental payment and interest will be disregarded, for the purpose of calculating the net present
cost, while cost of borrowing (that is, interest rate) will be used as the discounting factor/rate, cost
of borrowing before tax, if the company is in a non-taxable position and cost of borrowing after tax
if the company is in a taxable position.
Lease option
The cash flows to be discounted are:
1. The lease instalmental payment or lease rental.
2. If the company is in a taxable position, the tax saving on lease rental. In other words, lease
rental is an allowable expense that will reduce taxable profit as well as tax payable,
therefore, the tax savings on lease rentals will be a function of the lease rental multiplied by
the tax rate. To be treated as cash inflow in arrears.
As discussed earlier, the lease referred to above is an operating lease, because finance lease is as
good as borrowing to finance the purchase of an asset in which case the lease rental is repayment of
capital and a non-allowable expense. The lease option will be discounted using the organisation’s
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cost of capital, since it is expected that the lease rental will be paid out of the organization pool of
fund where the appropriate cost is the cost of capital.
ILLUSTRATION 1
The management of Anchor Product Nigeria Limited, manufacturers of Anchor vegetable Oil, has
decided to install a desktop portable computer for word processing for its secretariat work. It is
estimated that the machine IBM compatible, will cost N35,000 and it is anticipated that it will
attract an initial capital allowance of 25% and annual allowance of 15%. As an alternative to
purchasing the machine, leasing terms are available thereby the company would pay N7,500 per
annum for 5 years and thereafter a nominal lease of N1 per annum. Lease payments are to be made
yearly in advance and they include all maintenance and servicing of the desktop computer if the
computer is purchased. The company will need to enter into a maintenance agreement which will
cover all labour and replacement of parts over the first 5 years at a cost of N2,400 per annum, paid
annually in advance.
You are required to prepare a statement, which will show whether is it more profitable to purchase
or lease the computer.
Notes:
 The computer, whether purchased or leased will be scrapped after 6 years.
 The company’s cost of capital can be assumed to be 30%
 Company tax can be taken as 40%
 You may assume that taxable profits are sufficient to take advantages of any annual
allowance available if the machine is purchased.
SUGGESTED SOLUTION
The cash flows of each option will be identified and discounted. Note that the company is in a
taxable position, since rate of tax is given. The option that gives the least net present cost, will be
the optimal financing option.
Buying option
Calculation of capital allowance and tax savings for the relevant years
Year 1
Initial allowance = 25% x N35,000 = N8,750
Annual allowance = (N35,000 – N8,750)/6.7 = N3,918
Capital allowance =N12,668
Tax saving (40% x N12,688) = N5,067
6.7years is obtained by dividing the 100% life span by rate of capital allowance, that is, the tax man
expect the asset to last for 100/15 = 6.7years
Year 2 – 5
Capital/annual allowance = (N35,000 – N8,750)/6.7 = N3,918 p.a.
Tax saving = (40% x N3,918) = N1,567 p.a.
Year 6
TWDV beginning of year 6 = N35,000 – N12,688 – (N3,918 x 4) = N6,660
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Capital allowance for year 6 = N6,660
Tax saving = N6,660 x 40% = N2,664
Running cost per annum = N2,400

Tax savings on running cost per annum N2,400 x 40% = N960
Calculation of the net present cost of buying

Year Initial Running Tax saving Tax saving DCF
Outlay cost on R.C. on C.A. NCF 30% PC
0 35,000 2,400 37,400 1 37,400
1 2,400 2,400 0.7692 1,846
2 2,400 (960) (5,067) (3,627) 0.5917 (2,146)
3 2,400 (960) (1,567) (127) 0.4552 (58)
4 2,400 (960) (1,567) (127) 0.3501 (44)
5 (960) (1,567) (2,527) 0.2693 (681)
6 (960) (1,567) (2,527) 0.2072 (524)
7 (2,664) (2,664) 0.1594 (425)
NPC 35,370
Lease option
Lease rental year 1 to 5, N7,500 and year 6, N1

Tax savings on lease rental years 1 to 5 = N7,500 x 40% = N3,000 and year 6, N1 x 40% = N0.40.
Calculation of the net present cost of leasing

Year Lease Tax saving DCF
rental on L. R. NCF 30% PC
0 7,500 7,500 1 7,500
1 7,500 7,500 0.7692 5,769
2 7,500 (3,000) 4,500 0.5917 2,663
3 7,500 (3,000) 4,500 0.4552 2,048
4 7,500 (3,000) 4,500 0.3501 1,575
5 1 (3,000) (2,999) 0.2693 (808)
6 (3,000) (3,000) 0.2072 (622)
7 (0) - 0.1594 -
NPC 18,126
From the computation above, it is advisable to lease the machine since the leasing option gives the
lower net present cost.
Please not that in the above computation inflows are treated with a negative sign and net present
cost is used instead of net present value. This is optional. The most essential fact is that we need to
know the net cash outflow of each option and that any option that minimizes net present cost will
ensure maximization of profit.
ILLUSTRATION 2
Page 219
ABC Limited wishes to lease equipment, which costs N1 million and assumes to have zero residual
value at the end of 5 years. The management is satisfied that the equipment will be an attractive
project with positive NPV. The company approaches a Lessor with regards to the equipment and
the Lessor agrees to lease the equipment at annual rental of N300,000 over 3 years payable
annually in advance. Alternatively, the company can finance the purchase by borrowing N1 million
at an interest rate of 20%. Other terms are payable in 5 years on 5 installments including principal
and interest. Assume capital allowance to be 20% per annum. Income tax rate to be 40%.
Required
Should the company buy or lease the equipment if
a. The company has other highly profitable operations.
b. The company is permanently in a non-taxable position. Cost of capital is 12%.
SOLUTION
The solution to “a” will be to appraise the optimal option between buying and leasing when the
company is in a taxable position, while in “b” the optimal option will be determined assuming the
company is in a non taxable position.
If the asset is purchased it will last for 5 years. That is, the life span of the purchase option is 5
years, whereas lease option is only for 3 years. To make the two options comparable therefore,
annual equivalent cost will be used. Where the annual equivalent cost is the expected yearly cost of
each option, it is determined as follows:
Annual equivalent cost (AEC) = Net present cost/Cumulative discounting factor.
The cumulative discounting factor will be the addition of discounting factor from year 1 to the
year-end of the life span of the option.
Note, equally, that the company needs to borrow in order to finance the purchase option. Therefore,
the appropriate discounting factor will be cost of borrowing after tax for “a” and before tax for “b”.
The cost of borrowing after tax = 20% x 60% = 12%.
a. (i) The net present cost of buying when the company is in a taxable position.
Initial outlay N1,000,000

Capital allowance per annum = N1,000,000/5 years = N200,000 p.a.
Tax savings N200,000 x 40% = N80,000 p.a.
Calculation of net present cost of buying

DCF@
Year NCF 12% PC
0 1,000,000 1 1,000,000
2 -6 -80,000 3.2186 -257,488
NPC 742,512
The AEC = N724,512/3.6048 = N205,978
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wi. Cumulating discounting factor years 2-6 = ((1-(1.12-2))/.12) – (1.12-1 )= 3.2186
wii. Cumulating discounting factor for years 1 to 5 = (1-(1.12-5))/.12 = 3.6048
a.(ii) The net present cost of leasing when the company is in a taxable position.
Lease rental of N300,000, payable annually in advance for 3 years. It will be treated as cash out
flow for years 0 to 2.
Tax saving on lease rental N300,000 x 40% = N120,000
Calculation of net present cost of leasing:

DCF@
Year NCF 12% PC
0 -2 300,000 2.69 807,000
2 -4 -120,000 2.144 -257,280
NPC 549,720
The AEC = N549,720/2.4018 = N228,878.34
wi. Cumulative discounting factor for years 0 to 2 = 1 + (1-(1.12-2))/.12 = 2.69

Above,1 for discounting factor of year 0.
wii. Cumulative discounting factor for years 2 to 4 = ((1-(1.12-4))/.12) – (1.12-1 )= 2.144
wiii. Cumulative discounting factor for years 1 to 3 = (1-(1.12-3))/.12 = 2.4018
From the computation above, when the company is in a taxable position, it is advisable to buy,
because the purchase option gives a lower annual equivalent cost.
b.(i). The net present cost of buying when the company is in a non-taxable position:
The relevant cash flows will be the initial outlay of N1 million. Since there is no running cost and
there will be no capital allowances there is no tax saving, because the company is in a non-taxable
position.
The discounting rate is 20% (that is cost of borrowing before tax)
The net present cost will be N1 million, since the amount is required immediately.
The AEC = N1,000,000/2.9906 = N334,381.06
wi. Cumulative discounting factor for years 1 to 5 = (1-(1.2-5))/.2 = 2.9906
b.(ii). The net present cost of leasing when the company is in a non-taxable position:
The only cash flow is the yearly rental of N300,000 to be discounted for year 0 to 2, using the cost
of capital of 12%. Note that cost of capital is always used to discount the lease option, as it is
abnormal to borrow to pay lease.
The net present cost of lease rental = N300,000 x (1 + ((1-(1.12-2))/.12) = N807,015
Page 221
The AEC = N807,015/2.4018 = N336,004.37
From the computation above, when the company is in a taxation position, it is advisable to buy the
machine, because buying gives a lower annual equivalent cost.
REPLACEMENT ANALYSIS
One of the problems encountered in the daily operations of any organization, is the question of
aging assets. With the passage of every year the average operating or maintenance cost of most
assets increases. In addition, heavy repair costs notwithstanding, the operating capability of such
assets falls with increase in age, leading to inefficiency in operations and other non-quantifiable
damage to the organization, therefore it is imperative to carry out the replacement analysis of an
asset.
Replacement analysis is the determination of the optimal/economical/profitable replacement period

of an asset. That is, the period that ensures cost is minimized in order to maximize profit. For the
purpose of determining the optimum replacement period of an asset, assets are broadly categorized
into two as follows:
i. Sudden failure assets
ii. Gradual failure assets
ASSETS THAT FAILS SUDDENLY
These are assets that do not give notice of failure and once failed, such assets require immediate
replacement. The most common examples of such assets include: bulbs, components, tubes, sub-
assembly items, etc. To determine the optimum replacement period of such assets the following
quantifiable costs are always taken into consideration.
The purchase cost.

The replacement cost, that is, labour and incidental cost of replacing the assets.
With the knowledge of the above, consideration will be given to whether to replace individual item
as it fails or to replace at the end of a specified period. Various computations will be carried out to
determine the option that will minimize the average cost. Either of the option that minimizes the
average cost will be the optimal option.
Apart from the quantitative factor as stated above, other qualitative factors may include the damage
done as a result of the failure and effect of the failure on the company’s goodwill etc.
ILLUSTRATION
Ebenezer Limited is in the iron foundry business. One of the machines in the foundry department
requires a special component. The total population of the component is 500, it has a limited life and
the following data have been collected on failures:
Week after replacement 1 2 3 4

Percentage of component which have failed by
the end of that week (cumulative) 20 50 80 100
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(i). Components are in use at any time, they can be replaced on a mass replacement basis for N2
per component.
(ii). If they are replaced individually as they fail, the cost is N10, representing N1 for the
component and N9 labour charges.
You are required to advise on the best replacement policy the company should follow.
SOLUTION
To advise on the best replacement policy, the average weekly cost of replacement of each of the
policies will be computed and the option with the lower average cost chosen. Considering the first
policy, that is mass replacement, the fixed period will be, replace at end of every week, every two
weeks, every three weeks and end of every four weeks (which is the maximum period, since all the
components are expected to fail by end of every four weeks).
(i). The average weekly cost of replacing in mass at the specified periods
Week 1 2 3 4
Prob. 0.2 0.3 0.3 0.2
Week Prob.
1 0.2 100 20 34 43
2 0.3 150 30 51
3 0.3 150 30
4 0.2 100
Total 100 170 214 224
Cum. Total 100 270 484 708
replace cost/unit (N) 2 2 2 2
Total cost (N) 200 540 968 1,416
Average cost (N) 200 270 323 354
(ii). The average weekly cost of replacement individually as they fail

The average life/week
Week Prob. PW
1 0.2 0.2
2 0.3 0.6
3 0.3 0.9
4 0.2 0.8
Average life/week 2.5
Average number of failure per week = 500/2.5 = 200 component

Average weekly cost = N200 x N10 = N2,000
From computation above, it is advisable to replace in mass, at end of every week, which is the
period the average weekly cost is minimized.
Page 223
ASSETS THAT FAIL GRADUALLY.
These are assets that fail overtime. In other words, assets that fails gradually. For such assets, the
longer they stay the more costs are incurred on repairs, maintenance, and the more the decline in
operational efficiency. Example of gradual failure assets include; Motor Vehicle, Equipment,
Furniture, Machinery etc. There are at least two types of replacement.
a. Identical replacement:- This exists when an existing asset is replaced with a new asset
having identical financial characteristics i.e. same initial outlay, same annual cash flow,
same life span or when a single asset is being considered in replacing an existing asset no
longer useful or the asset is introduced to the company for the first time.
b. Non-identical replacement:- This exists when an existing asset is replaced by another

asset having different financial characteristics.
To determine optimum replacement of a gradual failure asset, it is imperative to know if is with or

without discounting.
Replacement without discounting
If the data available for determining the optimum replacement period of an asset excludes cost of
capital or discounting rate, such is referred to as replacement without discounting. The following
will be identified:
 The running/operating/maintenance cost
 Depreciation cost, that is, the difference between the resale value of the asset at the
beginning and end of the year otherwise known as loss in value of the asset within the year.
The above will be added together for each year. The cumulative and the average cost will be
computed using tabular method. The year in which the average cost is minimized will be the
optimum replacement period.
ILLUSTRATION
A company is presently considering the replacement policy for its major equipment costs N600,000
to purchase. Estimates of the annual maintenance charges, together with estimates of the resale
value at the end of year for the equipment are as follows:
Year 1 2 3 4 5 6
N'000 N'000 N'000 N'000 N'000 N'000
Annual maintenance charges 80 100 120 180 260 340
Resale value 520 430 300 180 50 0
For how many years should the company operate the equipment before replacing it with a new one?
SOLUTION
To determine the optimum replacement period of the asset a table will be used.
Page 224
Year Running cost Depreciation Total cost Cum. Cost Average cost
N'000 cost N'000 N'000 N'000 N'000
1 80 80 160 160 160
2 100 90 190 350 175
3 120 130 250 600 200
4 180 120 300 900 225
5 260 130 390 1290 258
6 340 50 390 1680 280
From the computation above, it is advisable to replace the equipment at the end of every year, that
is, the year the average cost is minimized.
REPLACEMENT WITH DISCOUNTING
If discounting rate or cost of capital is given in the analysis of replacement period, such is referred
to as replacement with discounting. This will enable us take into consideration the time value of
money in determining the optimum replacement period, by eradicating the major weakness of
replacement without discounting.
To determine the optimum replacement period, the following should be identified

 The initial outlay
 The running cost
 The residual/scrap value.
The above will be identified for each year, noting that, running costs will be cumulative, initial
outlay will be constant and scrap/resale value specific. These costs will be discounted and the net
present cost determined for each of the years. To make the net present cost comparable, the annual
equivalent cost will be computed. The year in which the annual equivalent cost is minimized will
be the optimum replacement period.
ILLUSTRATION 1
A company is considering the purchase of a machine with the following financial characteristics.
Year 1 2 3 4
N N N N
Running cost 15,000 16,000 19,000 21,000
Scrap value 150,000 130,000 100,000 70,000
Initial outlay is N200,000 and cost of capital is 15%.
Required:
Calculate the optimum replacement policy of the machine and advise when the machine should be
replaced.
SSUGGESTED SOLUTION
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The net present cost and annual equivalent cost for each year involved will be determined. The year
with the lowest annual equivalent cost will be the optimum replacement period.
Alternative 1 – Replace at end of every year
Item Year NCF DCF (15%) PV

Outlay 0 200,000 1 200,000
Running cost 1 15,000 0.8696 13,044
Scrap value 1 (150,000) 0.8696 (130,440)
NPC 82,604
Annual equivalent cost = N82,604/0.8696 = N94,990.80
Alternative 2 -Replace at end of every two years:
Item Year NCF DCF (15%) PC

Outlay 0 200,000 1 200,000
Running cost 1 15,000 0.8696 13,044
Running cost 2 16,000 0.7561 12,098
Scrap value 2 (130,000) 0.7561 (98,293)
NPC 126,849
Alternative 3 - Replace at end of every three years
Item Year NCF DCF (15%) PC

Outlay 0 200,000 1 200,000
Running cost 1 15,000 0.8696 13,044
Running cost 2 16,000 0.7561 12,098
Running cost 3 19,000 0.6575 12,493
Scrap value 3 (100,000) 0.6575 (65,750)
NPC 171,885
Alternative 4: Replace at end of every four years
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Item Year NCF DCF (15%) PV
Outlay 0 200,000 1 200,000
Running cost 1 15,000 0.8696 13,044
Running cost 2 16,000 0.7561 12,098
Running cost 3 19,000 0.6575 12,493
Running cost 4 21,000 0.5718 12,008
Scrap value 4 (70,000) 0.5718 (40,026)
NPC 209,617
From the computation above, it is advisable to replace the machine at the end of every four years.
That is, the year that gives the least annual equivalent cost.
ILLUSTRATION 2
The following information is supplied by Todal Limited, which is considering the purchase of two
machine tools, X and Y and has a cost of capital of 10%. Both machines can produce the same
component at an identical rate per working hour and the relevant data on each machine is as
follows:
Machine X Machine Y
N N
Capital cost 100,000 160,000
Operating cost per working hour:
Energy 3 5
Consumables 6 8
Variable overheads 6 7
Maintenance overheads:
Service intervals 12 p.a. 10 p.a.
cost of services (N) 1,000 800
Random breakdowns 3 times p.a. 1 time p.a.
Cost of each breakdown (N) 2,000 3,000
Expected availability working hours per annum 1,500 2,000
Contribution from production per hour (excluding
machine costs) 50 50
Net salvaged value at the end of year 5 10,000 25,000
You are required to advise the management on which of the machines to purchase. Below is the
applicable NPV at 10%.
Year DCF
1 0.909
2 0.826
3 0.751
4 0.683
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5 0.621
SUGGESTED SOLUTION
To select between the two machines, the net present value of the machines will be computed and
since the Assets have different initially outlay, profitability index will be used to make them
comparable. The asset with higher cost benefit analysis will be the optimal option.
The net cash flow of the machines

Machine Machine
X Y
N N
Total contribution before machine cost 75,000 100,000
Less machine cost
Energy cost 4,500 10,000
Consumable cost 9,000 16,000
Variable overheads 9,000 14,000
Service cost 12,000 8,000
Breakdown cost 6,000 3,000
Net cash flow (NCF) 34,500 49,000
The NPV of machine X

DCF
Year NCF (10%) PV.
0 -100,000 1 (100,000)
1–5 34,500 3.790 130,755
5 10,000 0.621 6,210
NPV 36,965
Cost Benefit Analysis = 36,965/100,000 = 0.36965
The NPV of machine Y

DCF
Year NCF (10%) PV.
0 -160,000 1 (160,000)
1–5 49,000 3.790 185,710
5 25,000 0.621 15,525
NPV 41,235
Cost Benefit Analysis = 41,235/160,000 = 0.25772
If the objective is to maximize net present value, it is advisable to select project Y, if the objective
is to maximize profit it is advisable to select project X.
Note that the cumulative discounting factor is addition of the given NPV at 10% for years 1 to 5.
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PRACTICE QUESTIONS
1. Why is the net present value (NPV) method of investment appraisal considered to be theoretically
superior to other methods that are found in practice?
2. The payback method has been criticized for not taking the time value of money into account. Could
this limitation be overcome? If so, would this method then be preferable to the NPV method?
3. Research indicates that the IRR method is extremely popular even though it has shortcomings when
compared to the NPV method. Why might managers prefer to use IRR rather than NPV when
carrying out discounted cash flow evaluations?
4. Why are cash flows rather than profit flows used in the IRR, NPV, PBP and DPBP methods of
investment appraisal?
5. Tola Limited has been offered a five year contract to supply a large quantity of school chalk to
a major private institution. An additional plant will be required costing N5.5 million, which
will be payable in two installments, N4 million when the machinery is installed and working
and the balance when the plant has been successfully operated for a year.
Material cost will be N1 million per annum, labour costs N1.2 million per annum and other
running costs N0.3 million, all in current prices. The selling price for the first year’s supply of
chalks has been agreed at N4.5 million. All cash flows inflationary rate is expected to occur at a
rate of 10% per annum whilst labour costs will rise at a rate of 12% per annum.
An inflation cost has been built into the contract allowing a rise of 8% in the selling price of the
chalk. If Tola’s money cost of capital is 25%.
You are required to evaluate the viability of the project.
6. Everest Limited is considering the replacement of a group of machines used exclusively for the
manufacture of one of its products, the Yetis. The existing machines have a book value of
N65,000, after deducting straight line depreciation from historical cost, however, they could be
sold only for N45,000. The new machines would cost N100,000. Everest expects to sell Yetis
for four more years. The existing machines could be kept in operation for that period of time, if
it were economically desirable to do so. After four years, the scrap value of both the existing
machines and the new machines would be zero.
The current costs per unit of manufacturing Yetis on the existing machines and the new
machines are as follows:-
Existing machine New machine
N N
Materials 22.00 20.00
Labour (32 hrs at N1.25) 40.00 (16 hrs at N1.44) 23.00
Overheads (32 hrs at N0.60) 19.20 (16 hrs at N1.80) 28.80
81.20 71.80
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Overheads are allocated to products on the labour hour rate method. The hourly rates of 60
kobo and N1.80 comprise 25 kobo and 62.5 kobo for variable overheads and 35 kobo and
N1.175 for fixed overheads, including depreciation. Apart from depreciation, fixed overheads
for the organization as a whole are not expected to change if the new machines are used.
Current sales of Yetis are 1,000 units per annum at N90 each. If the new machines were
purchased, output would be increased to 1,200 units and selling price would be reduced to N80.
Everest requires a minimum rate of return on investment of 20% per annum in money terms.
Material costs, labour costs and overhead costs are expected to increase in line with the retails
price index of 20% per annum. Assume that annual receipts and payments would rise annually
on the anniversary of the installation of the new machinery.

a. Give calculations to show whether purchase of the new machine would be worthwhile or
not.
b. Briefly explain your treatment of inflation.
7. Gbotomo Limited wishes to acquire the services of a limpo machine to expand its production
facilities. It is considering whether it is preferable to lease or buy the machine.
Purchase would cost N450,000. The machine would have a lifespan of eight years and a
terminal scrap value of N4,500. In event of purchase, the Spreading machine would claim a
first year capital allowance of 100%. Taxable income will be sufficient to accommodate this
allowance and the machine will not be replaced. The machine could be leased for eight years at
an annual rental of N9,500 payable annually in advance.
The money cost of capital of Binta is 15% per annum after corporation tax. Assume rate of
corporation tax is 50%, and that corporation tax would be payable one year after the end of the
financial year.
You are required to prepare calculation to show whether Binta should lease or buy the machine.
8. M & M Limited has decided to install a new milling machine. The machine costs N20 million,
and it was estimated that it would have a useful life of five years with a trade- in- value of N4
million at the end of the fifth years. Additional cash profits from the machine would be N8
million per annum for five years. A decision has now been taken on the method of financing
the project. Three methods of finance are being considered.
a. Purchase the machine by utilizing bank loan facilities on which the current rate of interest
is 14% before tax.
b. Lease the machine under an agreement, which would entail payment of N4.5 million at the
end of each year for the next five years.
c. Purchase the machine under a hire purchase agreement. This would require an initial
deposit of N6.5 million and payments of N4.4 million per annum at the end of each of the
next five years. The interest part of the payments, for tax purposes, would be N2.22 million
at the end of year 1 and N1.78, N1.7, N1.3 and N1 million at the end of each of years 2, 3,
4 and 5 respectively.
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The company’s weighted average cost of capital is 12% after tax. The rate of company income
tax is 40%. If the machine is purchased, the company will be able to claim a capital allowance
of 20% initial and 10% annual allowance.
You are required to determine the most economical method of financing the machine.
9. Investment Options Limited has been looking for a suitable investment, which will give a target
internal rate of return of 17% to 20%. An investment adviser has offered the company a project
the details of which are given below:
Pineapple Squash Bottling Project

Initial investment involves purchase of machinery for N180,000 and installation expenses of
N31,000. The plant can produce 10,000 cartons of pineapple squash per annum during the first
two years, rising to 12,500 cartons per annum for the next three years. Cost of production of
each carton, excluding depreciation cost is N21 and the selling price will be N27.
The plant will be scrapped at the end of the 5th year and is expected to have a negligible scrap
value.
You are required to calculate the actual internal rate of return of the above project. Ignore the
effect of taxation.
10. The Bhotti Company is considering the purchase of a computerized printing press for
N750,000. The equipment would be depreciated over a five-year period on a straight-line basis
with no consideration of salvage value. The current income tax rate is 30 per cent.
Research conducted by the company indicates that if the equipment is purchased, company
officials should expect incremental cash savings of N400,000 for the first year, N300,000 for
each of the second and third years, N200,000 for the fourth and N150,000 for the final year.
The company’s required rate of return is 16 per cent.
Required:
Determine the payback period and internal rate of return.
11. The Ballistic Division of Gastos Limited has a capital budget of N0.75m for 2000. The
following capital investment proposals are submitted to its capital investment budgeting
committee:
Project Profitability index Outlay (N)
1 1.2 150,000
2 1.18 150,000
3 1.17 75,000
4 1.10 225,000
5 1.15 150,000
6 1.13 150,000
7 1.19 300,000
8 1.21 75,000
9 1.22 75,000
10 1.16 75,000
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The company’s cost of capital is 5%. Projects 2 and 8 are mutually exclusive. Projects 1 and
5 are mutually dependent.
Required:
a) Which project should the capital budgeting committee choose?

b) What is the opportunity cost of the accepted project?
12. Zeneko Milk Company Ltd. Owns a fleet of mill Tricycle each of which, costs N600 to
purchase. Estimates of the annual maintenance charges, together with estimates of the trade-in
prices of second hand tricycles are as follows:
Age of Tricycles 1 2 3 4 5 6
N N N N N N
Annual maintenance charge 100 120 140 180 280 300
Estimated trade-in price 300 200 100 80 40 -
For how many years should the company operate a tricycle before replacing it with a new
one?
13. Niger Delta Steel Ltd is the main steel producer in the Niger Delta Area. The company is
divisionalised, and its Steel Production Division is considering the construction of a new blast
furnace that would replace the existing plant which currently produces 500,000 tons of steel per
year at a variable cost of N50 per ton, and an average cost of N80 per ton. The existing blast
furnace has come to the end of its life as its production costs are high and its techniques
outdated, and it is proposed to replace it. The Steel Production Division transfers 400,000 tons
per year to the Tinplate Division at full cost of production, and it is assumed by the Steel
Production Division that this arrangement will continue in the future. The remainder of its
output is sold on the open market at N100 per ton.
Design work has already taken place for the new blast furnace and has cost N120,000. If the
new blast furnace is constructed, then the existing blast furnace will be closed, and one year
after the new blast furnace is commissioned and seen to be producing steel reliably, the existing
blast furnace will be demolished and the scrap parts sold for N500,000. The new blast furnace
will cost N40 million to construct and equip, and its annual output will be 720,000 tons.
400,000 tons will be transferred to the Tinplate Division at the new plant’s average cost, and
the remainder will be sold on the open market at N100 per ton. Its annual costs of production
are estimated as follows:
N'000 N'000
Variable costs:
Materials 11,000
Other variable costs 21,000 32,000
Fixed costs:
Depreciation 4,000
Other fixed costs 14,760 18,760
Total costs 50,760
Depreciation is based on straight-line calculation over ten years. The blast furnace is
expected to have a productive life of ten years.
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It is intended to run down the stocks of raw materials in the existing plant. In consequence,
it will be necessary to spend an additional N500,000 on stocks of raw materials before steel
can start being produced in the new plant. At the end of the project, it is estimated that the
additional stock of raw materials will generate cash proceeds of N500,000.
The company’s profits are taxed at 20%, payable one year in arrears of the profits being
earned. There are no capital allowances, but straight-line depreciation is accepted as a
legitimate taxation expense by the authorities.
The company’s cost of capital is 10%, and it requires all investments to be evaluated using
net present value.
Recently, the Managing Director (MD) of Niger Delta Steel has completed an MBA course
and, following this, has written the following memorandum to the Managing Directors of
the Steel Making Division and the Tinplate Division:
Memorandum
To: S. Davies, MD Steel Division
H. Lovely, MD Tinplate
From: T. Okoro, MD
Subject: Transfer Pricing
Date: 3 May 2010
Currently, steel is transferred to the Tinplate Division at the budgeted full cost of
production. However, I can see company-wide benefits in using a different transfer price,
for example, the variable cost of production.
Can you let me have your views on this?
Required
a. Carry out an appraisal of the new plant over a ten-year period using net present
value (NPV). Assume that 400,000 tons of steel are transferred to Tinplate at full
cost.
b. Determine the impact on the NPV if steel is transferred to the Tinplate Division at
the variable cost of production.
c. Write a reply to the MD of Niger Delta Steel, on behalf of the Steel Production’s
MD, dealing with the issues that he refers to in his memorandum above.
14. A successful professional football club, Idealplus, plays in a small stadium that is always full to
capacity for its 25 home games. The capacity of the ground is 10,000. The club’s profit and loss
account for the year just ended is as follows:
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N'000
Revenues
Ticket sales (note 1) 7,125
Sponsorship 1,000
8,125
Less Expenses
Players' wages 2,200
Management costs 1,000
Rent for ground 500
Other overheads 1,000
4,700
Net profit 3,425
Less Taxation (20%) 685
Net profit after tax 2,740
Note 1 – Ticket sales were made up of 5,000 season tickets of N675 each and 5,000 match
game tickets of N30 per game.
The rent for the ground was agreed five years ago and the annual rent is now due for re-
negotiation. A new alternative stadium has become available that will seat 15,000. The
leasehold for the new stadium is on the market at N10,000,000, but the local authority’s
plans indicate that the stadium will need to be demolished in five years’ time in order to
construct a sports village on the site.
The club’s marketing manager judges that advertising of N230,000 per year will produce
the following sales for the new stadium:
i. Season tickets: 8,000 at N600 each

ii. Tickets per game: 7,000 at the following prices:
 25% at N30 each
 60% at N25 each
 15% at N15 each
There will continue to be 25 home games per year. Sponsorship will increase to N1.25
million per year due to the increased capacity.
Additional security will be required and this, along with additional running costs, will
increase “other overheads” to N1.5 million.
At its current ground, there is a gymnasium that the club uses. The new stadium does not
contain such a facility so the club would need to invest N250,000 in building and equipping
a new gym at the commencement of the move.
The current ground also has an associated training ground, but if the move to the new
stadium goes ahead, the club will also have to lease a training ground for N100,000 per
year.
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The capital expenditure on the purchase of the stadium and the construction of the gym will
all attract capital allowance at the rate of 25% per year on reducing balance basis.
The club pays taxation at 20% on its taxable profits with annual taxation payable one year
in arrears.
The club intends to appraise the project using net present value. Its discount rate is 15%.
Required
a. Calculate the club’s annual pre-tax profit as a result of playing its home matches at
the new stadium. In its accounts, the company’s policy is to depreciate all capital
investments in the project over five years using straight-line depreciation.
b. Appraise the move to the new stadium using the net present value technique.
c. The owners of the existing ground have indicated that they are prepared to renew
the rental agreement to Idealplus for a five-year period at a revised rent of
N600,000 per year. You have calculated that this will produce an annual profit of
N3,325,000 before taxation and also produces an after tax net present value of
N9,210,250 over the five-year period. Taking account of these figures and those
that you have previously calculated with respect to the new stadium, make a
reasoned recommendation to management on the choice of stadium.
SUGGESTED SOLUTIONS TO PRACTICE QUESTIONS
1. Net present value is usually considered the best method of assessing investment opportunities because
it takes account of:
 The timing of the cash flows: By discounting the various cash flows associated with each project
according to when it is expected to arise, it recognizes the fact that cash flows do not all occur
simultaneously. Associated with this is the fact that, by discounting using the opportunity cost of
finance (that is, the return which the next best alternative opportunity would generate), it is
possible to identify the net benefit after financing costs have been met (as the NPV).
 The whole of the relevant cash flow: NPV includes all of the relevant cash flows irrespective of
when they are expected to occur. It treats them differently according to their date of occurrence,
but they are all taken account of in the NPV and they all have, or can have, an influence on the
decision.
 The objectives of the business: NPV is the only method of appraisal where the output of the
analysis has a direct bearing on the wealth of the business. (Positive NPV’s enhance wealth;
negative ones reduce it). Since most private sector businesses seek to increase their value and
wealth, NPV clearly is the best approach to use, at least out of the methods we have considered so
far.
NPV provides clear decision rules concerning acceptance/rejection of projects and the ranking of
projects. It is fairly simple to use, particularly with the availability of modern computer software
that takes away the need for routine calculations to be done manually.
2. The payback method, in its original form, does not take account of the time value of money.
However, it would be possible to modify the payback method of accommodate this requirement. Cash
Page 235
flows arising from a project could be discounted, using the cost of finance as the appropriate discount
rate, in the same way as with the NPV and IRR methods. The discounted payback period approach is
used by some businesses and represents an improvement on the original approach described in the
chapter. However, it still retains the other flaws of the original payback approach that were discussed:
for example, it ignores relevant data after the payback period. Thus, even in its modified form, the
payback cannot be regarded as superior to NPV.
3. The IRR method does appear to be preferred to the NPV method among practicing managers. The
main reasons for this seem to be as follows:
 A preference for a percentage returns ratio rather than an absolute figure as a means of expressing
the outcome of a project. This preference for a ratio may reflect the fact that other financial goals
of the business are often set in terms of ratios (for example, return on capital employed).
 A preference for ranking projects in terms of their percentage return. Managers feel it is easier to
rank projects on the basis of percentage returns (though NPV outcomes should be just as easy for
them). We saw in the chapter that the IRR method could provide misleading advice on the
ranking of projects, and the NPV method was preferable for this purpose.
4. Cash flows are preferred to profit flows because cash is the ultimate measure of economic wealth.
Cash is used to acquire resources and for distribution to shareholders. When cash is invested in an
investment project an opportunity cost is incurred, as the cash cannot be used in other investment
projects. Similarly, when positive cash flows are generated by the project it can be used to reinvest in
other investment projects.
Profit, on the other hand, is relevant to reporting the productive effort for a period. This measure of
effort may have only a tenuous relationship to cash flows for a period. The conventions of accounting
may lead to the recognition of gains and losses in one period and the relevant cash inflows and
outflows occurring in another period.
5 TOLA LIMITED
(i). Calculation of net cash flow of the project for the relevant years.
Years 0 1 2 3 4 5
N'm N'm N'm N'm N'm N'm
Selling price - 4.50 4.86 5.25 5.67 6.12
Less- Material costs - (1.10) (1.21) (1.33) (1.46) (1.61)
Labour costs - (1.34) (1.51) (1.69) (1.89) (2.11)
Running costs - (0.33) (0.36) (0.40) (0.44) (0.48)
Net inflows - 1.73 1.78 1.83 1.88 1.92
Capital cash outflows (4.00) (1.50) - - - -
Net cash flows (4.00) 0.23 1.78 1.83 1.88 1.92
(ii) The net present value of the project.
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Yr. NCF DCF(25%) PV
N'm N'm
0 -4 1 (4.000000)
1 0.23 0.8 0.184000
2 1.78 0.64 1.139200
3 1.83 0.512 0.936960
4 1.88 0.4096 0.770048
5 1.92 0.3277 0.629184
NPV (0.340608)
From the computation above, the project is not worthwhile because it gives a negative net
present value. Note that, the increase in selling price is effected from year 2, this is inline
with the question which says that the selling price for year 1 has been determined, while
inflation is added to the costs in year 1, because the estimates are stated to be in current
prices, which may not be obtainable in year 1 due to inflation.
6 EVEREST LIMITED
(a). To determine whether it is worthwhile or not to acquire the new machine, incremental cost and
benefit can be used. The incremental cost of the new machine will be as follows:
N
Cost of the new Machine 100,000
Less disposable value of old Machine 45,000
Incremental cost of new Machine 55,000
The incremental benefit of the new machine will be as follows:
N N N N
Less - Material costs 22.00 20.00
Labour costs 40.00 23.00
Variable overhead(N0.25 x 32 hrs) 8.00 (70.00) 10.00 (53.00)
Contribution margin 20.00 27.00
Expected sales units 1,000 1,200
Total contribution (N) 20,000 32,400
The incremental benefit of the new machine = N32,400 – N20,000 = N12,400.
The incremental benefit computed above is in real or current value, which has to be converted to
money cash flow using inflationary rate of 20%. Incidentally, the cash flows will be subsequently
discounted using the money cost of capital of 20%, that is the compounding rate (inflation rate
equals the discounting rate (cost of capital). Therefore the N12,400 can be treated as present value
of inflows per year.
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Based on the above, the net present value of the new machine will be:
NPV = - N55,000 + (N12,400 x 4 years) = (N5,400).
From our computation above, it is not advisable to purchase the new machine, since it gives a
negative net present value. In order words, the continuation of the use of the existing machine is
recommended.
(b). The inflation rate of 20% is common to selling price, material cost, labour cost and
overheads, at the same time the discounting rate (cost of capital) happens to be 20%. That is,
the real cash flow of N12,400 will be compounded by the inflation rate of 20% and
subsequently discounted by the cost of capital. Therefore the compounding rate or inflation
rate nil-outs the discounting rate or cost of capital.
7 GBOTOMO LIMITED
Calculation of net present cost of the alternatives
To Buy
Initial outlay = N450,000 year 0

Scrap value = N45,000 year 8
Tax savings on capital allowance, Year 1 capital allowance = 100% x N450,000 = N450,000
Tax savings = N450,000 x 30% = N135,000 year 2
Tax payable on balancing charge
Tax written down value (N450,000 – N450,000) = 0
Disposable value = N45,000
Balancing charge = N45,000
Tax payable on balancing charge = N45,000 x 30% = N13,500 year 9
The net present cost of buying
Yr. NCF DCF(15%) PC

0 450,000 1 450,000
8 (45,000) 0.3269 (14,711)
2 (135,000) 0.7561 (102,074)
9 13,500 0.2843 3,838
NPC 337,053
To Lease
Lease rental N95,000 for years 0 – 7

Tax savings on lease rentals = N95,000 x 30% = N28,500 for years 2 – 9
The net present cost of leasing
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Yr. NCF DCF(15%) PC
0-7 95,000 5.16 490,200
2-9 (28,500) 3.902 (111,207)
NPC 378,993
From the computation above, it is advisable to buy the limpo machine because buying gives a
lower net present cost.
Note:
(i). Cumulative discounting factor for years 0 –7 = 1 +((1-(1.15-7))/.15) = 5.16
(ii). Cumulative discounting factor for years 2 – 9 = ((1-(1.15-9))/.15) – (1.15-1) = 3.902
8. M & M LIMITED
The capital allowance for the years

Year 1
Initial allowance N20m x 20% = N4m
Annual allowance ((N20m-N4m)/10years) = N1.6m
Capital allowance = N5.6m
Years 2-4
Capital/Annual allowance ((N20m-N4m)/10years) = N1.6m per annum
Year 5
Annual allowance = N1.6m
TWDV = ( N20m – N5.6m –(N1.6m x 4) = N8m
Disposable value = N4m
Balancing allowance = N4m
Capital allowance = N5.6m
(a). To Buy
(i). Calculation of taxable profit and tax payable for the years.
Years 1 2 3 4 5
N'm N'm N'm N'm N'm
Cash profit 8.00 8.00 8.00 8.00 8.00
Less capital allowance 5.60 1.60 1.60 1.60 5.60
Taxable profit 2.40 6.40 6.40 6.40 2.40
Tax liability (40%) 0.96 2.56 2.56 2.56 0.96
(ii). The net cash flow of the project
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Years 0 1 2 3 4 5 6
N'm N'm N'm N'm N'm N'm N'm
Initial outlay/Trade in value (20.00) 4.00
Cash profit 8.00 8.00 8.00 8.00 8.00
Tax payable (0.96) (2.56) (2.56) (2.56) (0.96)
Net cash flow (20.00) 8.00 7.04 5.44 5.44 9.44 (0.96)
(iii). After tax cost of borrowing = 14% x 60% = 8.4%
(iv). The net present value of buying

Yr. NCF DCF(8.4%) PV
N'm N'm
0 -20 1 (20.000000)
1 8 0.9225 7.380000
2 7.04 0.851 5.991040
3 5.44 0.7851 4.270944
4 5.44 0.7242 3.939648
5 9.44 0.6681 6.306864
6 -0.96 0.6163 (0.591648)
NPV 7.296848
(b). To lease
(i). Calculation of taxable profit and tax liability.
Years 1 2 3 4 5
N'm N'm N'm N'm N'm
Cash profit 8.00 8.00 8.00 8.00 8.00
Lease rental 4.50 4.50 4.50 4.50 4.50
Taxable profit 3.50 3.50 3.50 3.50 3.50
Tax liability (40%) 1.40 1.40 1.40 1.40 1.40
(ii). The net cash flow for the years
Years 1 2 3 4 5 6
N'm N'm N'm N'm N'm N'm
Cash profit 3.50 3.50 3.50 3.50 3.50
Tax payable (1.40) (1.40) (1.40) (1.40) (1.40)
Net cash flow 3.50 2.10 2.10 2.10 2.10 (1.40)
(ii). The net present value of leasing
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Yr. NCF DCF(12%) PV
N'm N'm
1 3.5 0.8929 3.125150

2 2.1 0.7972 1.674120
3 2.1 0.7118 1.494780
4 2.1 0.6355 1.334550
5 2.1 0.5674 1.191540
6 -1.4 0.5066 (0.709240)
NPV 8.110900
(c). Hire Purchase
(i). Calculation of taxable profit and tax liability.
Years 1 2 3 4 5
N'm N'm N'm N'm N'm
Cash profit 8.00 8.00 8.00 8.00 8.00
Less Interest on hire purchase 2.22 1.78 1.70 1.30 1.00
Less Capital allowance 5.60 1.60 1.60 1.60 5.60
Taxable profit 0.18 4.62 4.70 5.10 1.40
Tax liability (40%) 0.07 1.85 1.88 2.04 0.56
(ii). Calculation of net cash flow of the project.
Years 0 1 2 3 4 5 6
N'm N'm N'm N'm N'm N'm N'm
Cash profit ( year plus scrap value) 8.00 8.00 8.00 8.00 12.00
Hire purchase installment (6.50) (4.40) (4.40) (4.40) (4.40) (4.40)
Tax cash flow (0.07) (1.85) (1.88) (2.04) (0.56)
Net cash flow (6.50) 3.60 3.53 1.75 1.72 5.56 (0.56)
(iii). The net present value of hire purchase
Yr. NCF DCF(12%) PV

N'm N'm
0 -6.5 1 (6.500000)
1 3.6 0.8929 3.214440
2 3.528 0.7972 2.812522
3 1.75 0.7118 1.245650
4 1.72 0.6355 1.093060
5 5.56 0.5674 3.154744
6 -0.56 0.5066 (0.283696)
NPV 4.736720
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From the computation above, it is advisable to lease the machine, which is the option that
gives the highest net present value.
9. INVESTMENT OPTIONS LIMITED
(i). Calculation of net cash flow for the years
Years 0 1 2 3 4 5
Selling price(N) 27.00 27.00 27.00 27.00 27.00
Less variable cost (N) 21.00 21.00 21.00 21.00 21.00
Contribution margin (N) 6.00 6.00 6.00 6.00 6.00
Expected volume 10,000 10,000 12,500 12,500 12,500
Total contribution 60,000 60,000 75,000 75,000 75,000
Initial Outlay (211,000)
Net cash flow (211,000) 60,000 60,000 75,000 75,000 75,000
(ii). Calculation of positive and negative net present value.

Yr NCF DCF(10%) PV DCF(30%) PV
0 (211,000) 1 (211,000) 1 (211,000)
1 60,000 0.9091 54,546 0.7692 46,152
2 60,000 0.8264 49,584 0.5917 35,502
3 75,000 0.7513 56,348 0.4552 34,140
4 75,000 0.683 51,225 0.3501 26,258
5 75,000 0.6209 46,568 0.2693 20,198
NPV 47,270 (48,751)
(iii). The IRR of the project = 10 + ((47,270/(47270+48,751))x(30-10) = 19.85%.
10. THE BHOTTI COMPANY
(i). Calculation of taxable profit and tax payable.

Year 1 2 3 4 5
N N N N N
Cash savings 400,000 300,000 300,000 200,000 150,000
Less depreciation 150,000 150,000 150,000 150,000 150,000
Taxable profit 250,000 150,000 150,000 50,000 -
Tax liability 75,000 45,000 45,000 15,000 -
(ii). Calculation of the net cash flow of the project.
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Year 1 2 3 4 5
N N N N N
Cash savings 400,000 300,000 300,000 200,000 150,000
Tax payable - -75,000 -45,000 -45,000 -15,000
Net cash flow 400,000 225,000 255,000 155,000 135,000
The payback period of the project

Yr. NCF DCF(16%) PV Cum. PV
0 -750,000 1 (750,000) (750,000)
1 400,000 0.8621 344,840 (405,160)
2 225,000 0.7432 167,220 (237,940)
3 255,000 0.6407 163,379 (74,562)
4 155,000 0.5523 85,607 11,045
The payback period = 3 + (74,562/85,607) years = 3.87 years
The internal rate of return
Yr NCF DCF(16%) PV DCF(25%) PV

0 (750,000) 1 (750,000) 1 (750,000)
1 400,000 0.8621 344,840 0.8 320,000
2 225,000 0.7432 167,220 0.64 144,000
3 255,000 0.6407 163,379 0.512 130,560
4 155,000 0.5523 85,607 0.4096 63,488
5 135,000 0.4761 64,274 0.3277 44,240
75,319 (47,713)
The internal rate of return = 16 + ((75,319/(75,319+47,713)) x (25-16)) = 21.5%
11. GASTOS LIMITED
Grouping of project and computation of the total NPV.

a). Group A (project 2 inclusive)
Project DPI Ranking
1,5 1.175 4th
2 1.18 3rd
3 1.17 5th
4 1.10 8th
6 1.13 7th
7 1.19 2nd
9 1.22 1st
10 1.16 6th
Allocation of capital of N750, 000 and the resulting NPV
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Rank. Project Capital Cum Cap. Bal of NPV
Utilized Utilized Capital
- - - 750,000 -
1st 9 75,000 75,000 675,000 16,500
nd
2 7 300,000 375,000 375,000 57,000
rd
3 2 150,000 525,000 225,000 27,000
th
4 1,5 225,000 750,000 - 39,375
Total NPV 139,875
b). Group B (project 8 inclusive)

Project DPI Ranking
1,5 1.175 4th
3 1.17 5th
4 1.10 8th
6 1.13 7th
7 1.19 3rd
8 1.21 2nd
9 1.22 1st
10 1.16 6th
Allocation of capital of N750, 000 and the resulting NPV
Ranking Project Cap. Cum Cap. Bal of NPV

Utilized Utilized Capital
- - - - 750,000 -
1st 9 75,000 75,000 675,000 16,500
nd
2 8 75,000 150,000 600,000 15,750
rd
3 7 300,000 450,000 300,000 57,000
th
4 1,5 300,000 750,000 - 52,500
Total NPV 141,750
Comment:
The management of Ballistic division of Gastos Ltd should accept projects 9,8,7,1 & 5 resulting in
NPV of N141, 750.
B). The opportunity cost of the accepted projects is the NPV of the projects not accepted which
is detailed below:
Project NPV
2 27,000
3 12,750
4 22,500
6 19,500
10 12,000
93,750
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Working:
Determination of NPV:
NPV = (DPI – 1) x outlay
Project 1 = (1.20-1) 150,000 = 30,000
2 = (1.18-1) 150,000 = 27,000
3 = (1.17-1) 75,000 = 12,750
4 = (1.10-1) 225,000 = 22,500
5 = (1.15-1) 150,000 = 22,500
6 = (1.13-1) 150,000 = 19,500
7 = (1.19-1) 300,000 = 57,000
8 = (1.21-1) 75,000 = 15,750
9 = (1.22-1) 75,000 = 16,500
10 = (1.16-1) 75,000 = 12,000
Calculation of joint DPI of project 1 and 5

DPI = Pv of Inflow/ Pv of outflow =180,000+172,500/150,000+150,000
12. ZENEKO MILK COMPANY LIMITED

The Optimum replacement period
Year Depreci. Maint. Total Cumulat. Average
Cost (N) Cost (N) Cost (N) Cost (N) Cost (N)
1 300 100 400 400 400
2 100 120 220 620 310
3 100 140 240 860 287
4 20 180 200 1,060 265
5 40 280 320 1,380 276
6 40 300 340 1,720 287
From the computation above, it is advisable to replace the Tricycle at the end of every four
years, which is the year the average operating cost is at minimum that is N265.
13. NIGER DELTA LIMITED

a.i. The annual net cash inflow and tax payable of the project.
N N
Sales - External (320,000 x N100) 32,000,000
- Transfer (400,000 x N70.50) 28,200,000 60,200,000
Less other costs (minus depreciation) (46,760,000)
Net cashflow per annum 13,440,000
Less Depreciation (4,000,000)
Taxable profit 9,440,000
Tax payable (20%) 1,888,000
Note: full cost per unit = N50,760,000/720,000 = N70.50
ii. The net present value of the project.
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Year Description NCF DCF@10% PV
0 Construction costs (40,000,000) 1.0000 (40,000,000)
Additional stock (500,000) 1.0000 (500,000)
1 Sales of existing plant 500,000 0.9091 454,550
1-10 Net inflow from operation 13,440,000 6.1446 82,583,424
2-11 Tax payable (1,888,000) 5.5860 (10,546,368)
10 Ending stock value 500,000 0.3855 192,750
NPV 32,184,356
b.i. The annual net cash inflow and tax payable of the project.
N N
Sales - External (320,000 x N100) 32,000,000
- Transfer (400,000 x N44.44) 17,776,000 49,776,000
Less other costs (minus depreciation) (46,760,000)
Net cashflow per annum 3,016,000
Less Depreciation (4,000,000)
Taxable profit (984,000)
Tax savings (20%) (196,800)
ii. The net present value of the project
Year Description NCF DCF@10% PV

0 Construction costs (40,000,000) 1.0000 (40,000,000)
Additional stock (500,000) 1.0000 (500,000)
1 Sales of existing plant 500,000 0.9091 454,550
1-10 Net inflow from operation 3,016,000 6.1446 18,532,114
2-11 Tax savings 196,800 5.5860 1,099,325
10 Ending stock value 500,000 0.3855 192,750
NPV (20,221,262)
c. The points that should be raised in the memo include: Using variable cost to
transfer will negate the four characteristic of a good transfer pricing method. It may
as well lead to inefficiency in production. For example in this case, it turned the
project from a positive NPV of N32.184 million to negative N20.221 million
making the project unviable. It may encourage sub-optimal decision.
14. IDEALPLUS CLUB
a. Profit and loss account for next year.
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N
Revenues
Ticket sales (note 1) 9,131,250
Sponsorship 1,250,000
10,381,250
Less expenses
Players' wages 2,200,000
Management costs 1,000,000
Training ground rent 100,000
Other overheads 1,500,000
Advertising 230,000
Depreciation (note 2) 2,050,000
7,080,000
Net profit before tax 3,301,250
Note 1 – Total ticket sales comprised of:-

N
Season tickets (8,000 x N600) 4,800,000
Game tickets (7,000 x 25% x N30 x 25 games) 1,312,500
(7,000 x 60% x N25 x 25 games) 2,625,000
(7,000 x 15% x N15 x 25 games) 393,750
Total ticket sales 9,131,250
Note 2 – Annual depreciation

N
Cost of stadium 10,000,000
Gymnasium 250,000
Total cost 10,250,000
Annual depreciation = N10,250,000/5 years = N2,050,000 per annum.
b. The net present value of the new stadium.
Annual net cash flow = N3,301,250 (profit) + N2,050,000(add back depreciation) =

N5,351,250.
Calculation of annual capital allowance and tax savings on capital allowance
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cost b/f allwce@25% Bal. c/f Tax savings@20%
N N N N
10,250,000 2,562,500 7,687,500 512,500
7,687,500 1,921,875 5,765,625 384,375
5,765,625 1,441,406 4,324,219 288,281
4,324,219 1,081,055 3,243,164 216,211
3,243,164 3,243,164 - 648,633
10,250,000 2,050,000
The net present value (NPV) of the project.
Years 0 1 2 3 4 5 6 NPV
N N N N N N N N
Capital costs (10,250,000)
Annual net cash flows 5,351,250 5,351,250 5,351,250 5,351,250 5,351,250
Tax on net cash flows (1,070,250) (1,070,250) (1,070,250) (1,070,250) (1,070,250)
Tax savings on CA 512,500 384,375 288,281 216,211 648,633
Net cash flows (10,250,000) 5,351,250 4,793,500 4,665,375 4,569,281 4,497,211 (421,617)
DCF@15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
Present value (10,250,000) 4,653,447 3,624,365 3,067,484 2,612,715 2,236,013 (182,265) 5,761,760
c. The new stadium produces a positive NPV of N5,761,760, and does seem to be an
attractive proposition. However, the offer to renew the rental agreement on the existing
stadium, albeit at a higher rent, places a different complexion on things:
 The existing stadium produces a higher NPV over 5 years, and should be preferred. It does
however, produce a slightly lower annual net profit than the new stadium, N3,325,000
compared with N3,331,250. Yet, in project appraisal, the DCF approach is superior to
annual net profit comparisons.
 The existing stadium is a less risky alternative as it does not require the club to engage in a
high level of capital expenditure. The existing stadium is filled to capacity, but there is no
guarantee that the projected ticket sales in the new stadium would actually be realised.
However, the new stadium provides an opportunity for the club to grow.
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CHAPTER 8
CAPITAL BUDGETING DECISION UNDER UNCERTAINTY
It would be unrealistic to assume that the future events expressed in yearly cash flows will occur
exactly as predicted. The nature of investment appraisal is such that we are dealing with an
uncertain future with the risk that one or more of either income, costs, tax, inflation or project life
may vary from our estimates.
Risk occurs where it is not known what the future outcome will be, but where the various possible
outcomes may be expected with, some degree of confidence from knowledge of past or existing
events. In other words, probabilities of alternatives outcomes can be estimated.
Uncertainty occurs where the future outcome cannot be predicted with any degree of confidence
from knowledge of past or existing events, to the level that probability estimates are not available
for possible outcomes.
When projects are overwhelmingly profitable it does not matter which appraisal techniques are
used as they are viable on any test we care to apply. Most projects, however, are more marginal and
subject to a greater degree of uncertainty. It is here that discounting techniques serve as a more
acceptable method. Because yearly cash flows, over the project whole life span, will be taken into
account, this allows for manipulation of data in order to answer “what if” questions and generally
apply financial modeling techniques. Computers have an obvious role here when we are dealing
with reiterative calculations on raw data.
The more substantial a project is, relative to the size of the firm, the more stifling should be done
before approval is given. We will examine various approaches to risk and uncertainty ranging from
a crude payback criterion at one extreme to portfolio theory at the other.
The methods are:
1. Payback period method
2. Probability theory
3. Decision trees
4. Risk premium
5. Portfolio theory
6. Sensitivity analysis
7. Expected value method
8. Standard deviation and correlation co-efficient
9. Capital asset pricing model
10. Conservative estimate method
11. Simulation technique
PAYBACK PERIOD METHOD
This was described in the previous chapter as a relatively crude technique used to test the viability
of projects. This is achieved by counting the number of years it takes to recover the original
investment using either undiscounted or discounted cash flows.
Sometimes firms use payback in a slightly different context to reduce the risk element in a project
by setting a maximum allowable payback period. When this is applied to cash flows discounted at
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the firm’s cost of capital it ensures that the minimum required return is always achieved and that
cash is quickly generated for re-investment in a new project.
If we can assume that events in the coming year or two are more capable of being forecast with a
high degree of certainty, then it also reduces the risk element. This is because distant cash flows are
multiple by relatively small present value factors and conversely a higher weighting is given to
more immediate cash flows.
These advantages are sufficient for many firms, and payback remains one of the most popular
appraisal techniques. We should be aware, however, of its potential weakness in selecting less
profitable projects by its concentration on quick returns.
TRIPPLE ASSESSMENT METHOD
Instead of pinning all their faith on the DCF yield resulting from the expected cash flows, firms
sometimes calculate two further sets of cash flows based on pessimistic and optimistic assumptions
respectively. At one extreme, will be the combination of the pessimistic assumptions. This will
assume lowest selling price and demand, higher operating costs and the likes. The DCF yield
prepared from this data will be the lowest return envisaged.
At the other extreme, will be cash flows resulting from everything being favourable at the same
time. This situation will incorporate higher selling price, higher demand, lower operating cost and
the likes. The resultant DCF yield will be the highest possible return that could be achieved. In
effects the pessimistic and optimistic forecast sets the center limits, or parameters, within which we
would expect to find the actual DCF yield. They therefore give a better perspective of the range
within which the return on investment will fall. The main drawback of this method is apparent; it
does not quantify the degree of optimism or pessimism assumed in the sets of cash flows.
ILLUSTRATION
Kay Industries Limited is to undertake a project having the following data.

Outlay N300,000
Cash inflows are not certain but the following forecast has been given for the next three years.
N N N
Year 1 250,000 200,000 185,000
Year 2 200,000 195,000 180,000
Year 3 160,000 100,000 50,000
If the cost of capital is 20% applying the triple assessment method, is the project worthwhile to
undertake?
SUGGESTED SOLUTION
The NPV or DCF yield of the project will be assessed based on the optimistic, most likely and
pessimistic level and based on the assessment, if the project gives a positive NPV at all these levels,
then it is perfectly worthwhile. Some do suggest that if a project gives a positive NPV in at least
two, i.e., the optimistic and most likely level, such a project should be considered acceptable,
because the pessimistic level measures the worst possible situation.
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Calculation of the NPV
(i) Optimistic level
Yr NCF DCF(20%) PV
0 -300,000 1 -300,000
1 250,000 0.8333 208,325
2 200,000 0.6944 138,880
3 160,000 0.5787 92,592
NPV 139,797
(ii) Most likely

Yr NCF DCF(20%) PV
0 -300,000 1 -300,000
1 200,000 0.8333 166,660
2 195,000 0.6944 135,408
3 100,000 0.5787 57,870
NPV 59,938
(iii) Pessimistic level

Yr NCF DCF(20%) PV
0 -300,000 1 -300,000
1 185,000 0.8333 154,161
2 180,000 0.6944 124,992
3 50,000 0.5787 28,935
NPV 8,088
From the above computations, the project is worthwhile. Note that in other problems, the different
initial outlay may be given with different costs of capital. The same procedure will be applied as
above using the data given, in determining the viability or otherwise of the project.
PROBABILITY THEORY
It is a statistical technique that can be used to overcome the risk and uncertainty in investment
proposals when it is possible to assign various probabilities to expected future investment variables.
The variable may be cash inflow, cash outflow, initial outlay or cost of capital.
The method encourages making various predictions with the degree of certainty in order to estimate
the likely possible outcome. It therefore follows that the initiator of the projects will look at
possible future situations and degree of occurrences and forecast the variables with probability of
its occurrence.
DECISION TREE
Sometimes managers are faced with a choice between alternative courses of action with possibility
of further alternative courses of action in later years depending on which original choice was made.
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A technique known as a decision tree is used to set out all possible alternatives and to show the
further alternatives they lead to in further years.
A decision tree could be defined as a pictorial or a diagrammatic representation of various

alternatives associated with a complex problem situation involving interrelated events. In other
words, decision trees can be defined as an attempt at coping with risk and uncertainty inherent in
complex investment decision.
Steps Involved in Decision Tree
1. Identification of the various nodes that make up the problem, these nodes will be joined
together to form the tree diagram. These nodes are:
(a) Decision node: This is represented by and is normally used when a

decision maker is aware or can influence the various alternatives or outcome of a decision.
For example, if the decision is either to buy or not to buy, the decision maker can influence
such a decision. Therefore, a decision node in the diagram will represent this.
(b) Chance node: This is represented by and this node will be applicable when
the decision maker has no control or the decision maker cannot influence the outcome of a
decision. Such decisions are normally characterized by probabilities. For example, bidding
for a competitive contract, the decision maker may not be sure of winning or loosing, such
will be represented by a chance node on the diagram.
2. The identified nodes as specified above will be joined together in the form of a diagram and all
the relevant pay-offs and their associated probabilities will be stated on the diagram.
3. The terminal value of each of the routes on the decision tree diagram will be determined by
removing the cost of the route from the expected income.
4. The value of each of the nodes will be determined by using the technique of rolling backward
the terminal value of each of the routes using either the expected value criterion when it is a
chance node and higher or highest pay-off when it is a decision node.
5. The optimal decisions will be reached based on the value of each of decision nodes. That is, the
route that gives the higher or highest terminal value.
ILLUSTRATION
A manager of a research department is considering what to do about an on going project. He can

either abandon it or keep the expenditure at the same level or increase it substantially to improve
the likelihood of success. Abandoning will result in costs of N20,000: maintaining the present level
of activity will cost N50,000, doubling the present effort to improve the chances of success will
cost N100,000. By the end of the year it will be known whether the project has succeeded or failed.
Failure brings no further costs with it. Whilst success would result in the sale of know-how for
N300,000
At the present level of research activity the success/failure ratio is put at 40 per cent/60 per cent but
the enhanced effort would improve the prospects to about 80 per cent/20 per cent.
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Advise on the optimum course of action.
SUGGESTION SOLUTION
The nodes
1. To increase effort, maintain effort or abandon project - decision node
2. Success or failure for increase in effort and maintain effort - chance node
The decision tree diagram as follows
Terminal Value
C =N200,000
=N -100,000
A B =N250,000
Maintain effort
N50,000 = N -50,000
=N -20,000
The terminal value is determined by deducting the cost along the route from the gross expected
cost. For example route 1 = N300,000 – N100,000 = N200,000
The value of each node will be determined using the rolling backward technique. If it is a decision
node, we use higher or highest pay-off and for chance node we use the expected value approach.
The nodes are already labeled as A, B, and C in the above diagram.
Nodes Workings Value
B (-N50,000 x 0.6) + (0.4 x N250,000) N70,000
C (-N100,000 x 0.2) + (0.8 x N200,000) N140,000
A N140,000 or N70,000 or -N20,000 N140,000
Remark: The advice will be limited to the outcome of the decision nodes only, because as earlier
stated, the decision maker can not influence the outcome of a chance node, but can influence that of
a decision node where an advise is required. The only decision node above is node A, the
alternatives are: increase effort with terminal value of N140, 000, maintain effort with N70, 000
and abandon effort with –N20, 000, the highest N140,000 is picked.
It is therefore advisable for the company to increase effort.
ILLUSTRATION 2
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Risk Limited is considering a project which it can invest either N500,000 or N1 million in the
project. If it invests N500,000 it has a 60% chance of receiving net cash flow of N220,000 per
annum for the following 5 years and 40% chance of receiving nothing. If it invests N1 million, it
has a 50% chance of receiving N300,000 for the 1st year. With this, it has a choice of investing a
further N1 million, or not to invest at the end of the 1 st year. If it invests a further N1 million the
cash flows will be N600,000 p.a. for the remaining years. If it does not, cash flows will continue at
N300, 000 per annum for years 2-5, and 50% chance of receiving N200, 000 for year 1-5
Using decision tree with NPV, if cost of capital is 10%, what decision should Risk Limited take?
SOLUTION
The decision tree diagram
NPV Pay off
N220,000 =N333,800….i
B 0.6 1-5
0.4 Nil
=N-500,000….ii
1-5
A
N200,000
= N-242,000…iii
1-5
C =N91,000…iv
=N137,000…v
Calculation of NPV of the terminal
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i. Yr. NCF DCF(10%) PV ii. Yr NCF DCF(10%) PV
0 (500,000) 1 (500,000) 0 (500,000) 1 (500,000)
1-5 220,000 3.79 833,800 1-5 - 3.79 -
NPV 333,800 NPV (500,000)
iii. Yr. NCF DCF(10%) PV iv. Yr NCF DCF(10%) PV

0 (1,000,000) 1 (1,000,000) 0 (1,000,000) 1 (1,000,000)
1-5 200,000 3.79 758,000 1 (1,000,000) 0.9091 (909,100)
NPV (242,000) 1 300,000 0.9091 272,730
2-5 600,000 2.88 1,728,000
NPV 91,630
V Yr. NCF DCF(10%) PV

0 (1,000,000) 1 (1,000,000)
1-5 300,000 3.79 1,137,000
NPV 137,000
Value of each node

Node Workings Value
D N91,880 or N137,000 =N137,000
C (0.5 x N137,000) + (0.5 x -N242,000) = -N52,500
B (0.6 x N333,800) + (0.4 x -N500,000) = N280
A N280 or -N52,500 = N280
From the computation above, it is advisable for Risk Limited to invest N500, 000 only in the first
year.
RISK PREMIUM
Another approach to risk is to recognize that different kinds of investment carry different degrees
of risk and should therefore be set at different targeted rates of return. A simple approach to this
idea is to add an extra discount rate called “risk premium” to the basic cost of capital. It is possible
to set different targeted rates of return for different risk categories investment may be set. The risk
premium may vary according to the risk category of the investment under review and is based on a
subjective assessment of the risks involved as the following examples illustrate:
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Risk Types of project Cost of Risk Target rate
Category capital (%) premium(%) of return (%)
No risk Financial decision 15 - 15
Low risk Cost saving on existing technology 15 3 18
Medium risk Expansion e.g. New markets,
replace existing technology 15 10 25
High risk Expansion e.g. New markets,
New Technology 15 20 35
In practice, investors demand a higher return on more risky investments than on less risky ones. By
using the risk premium approach, firms are giving recognition in their individual investment
appraisal to what investors practice when investing in individual companies.
PORTFOLIO THEORY
The aim here is to briefly touch this principle. An extension of risk premium is found in what is
referred to as the portfolio theory, where an investor diversifies into a collection of investments it is
described as a portfolio. Many portfolios can be constructed from a different combination of
investments.
The risk level of each portfolio is measured by the variability of possible returns about the means,
expressed in standard deviations.
Portfolio theory goes to say that it is not the individual project risk that matters but its effect on the
overall portfolio’s risk. Therefore when we evaluate a risky project, we need to correlate the
individual project risk to that of the existing portfolio it would join if accepted. A branch of
portfolio theory called the “capital asset pricing model” states that we should calculate the net
present value on a new project at a composite discount rate comprising:
a. a rate of interest representing the risk free cost of capital, and
b. a risk premium or discount determined by the correlation of the risk on the individual
projects to the risk on the whole existing portfolio it would join. The size of this correlation
is referred to as the beta factor and can vary from –1.0 to +1.0
ILLUSTRATION
XYZ Limited has an existing portfolio of capital investments yielding an expected return of 20 per
cent. They are considering a new project with an expected yield of 15%. The beta factor for this
new project has been calculated at 0.42. The current risk free return on long-dated government
stocks is 11 per cent.
Should the investment be accepted?
SUGGESTED SOLUTION
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Instead of taking a weighted average cost of capital as the criterion for judging this new project, the
CAPM approach will be used, that is, a discount rate comprised of the risk-free cost of capital plus
the portfolio risk premium when multiplied by the beta factor as follows:
Risk free rate = 11%

Risk premium = portfolio return – risk free rate = 20% - 11% = 9%
Beta factor = 0.42
Required rate of return = 11% + (9 x 0.42) = 14.78%
Promising return = 15%
The project is promising a marginal return, which may not be encouraging enough to accept.
SENSITIVITY ANALYSIS
Sensitivity analysis measures the level of changes in any of the variables (Cash inflow, cash
outflow, Initial Outlay, and Cost of Capital) that can be accommodated before the project becomes
unviable. It indicates how sensitive a project’s NPV is to changes and in particular variables. It is
normally used to determine the expected changes in variables and assess if the project will still be
worth while, i.e. if a project is presently reporting a positive NPV based on the forecasted cash
flows, sensitivity analysis can be used to determine the percentage increase or decrease in any of
the variables to make the NPV to be zero.
ILLUSTRATION
Success Limited is considering a project with the following data:
Year 0 1 2 3
Outlay -49,000 - - -
Running cost - 14,000 17,500 7,000
Savings - 42,000 49,000 7,000
If cost of capital is 10%
You are required to calculate the sensitivity of the project to changes in the levels of expected;
(i) Initial outlay

(ii) Running costs and
(iii) Savings
SUGGESTED SOLUTION
Calculation of the NPV of the project.
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Yr Out flows Savings DCF(10%) PV out flows PV inflows
0 (49,000) - 1 (49,000)
1 (14,000) 42,000 0.9091 (12,727) 38,182
2 (17,500) 49,000 0.8264 (14,462) 40,494
3 (7,000) 7,000 0.7513 (5,259) 5,259
(81,449) 83,935
NPV 2,486
The sensitivity to
(i) Initial Outlay: This is measured by = NPV/initial Outlay x 100/1

= N2,486/N49,000 x 100/1 = 5.07%
The outlay of N49,000 will need to increase by more than 5.07% before the project becomes
un-viable.
(ii) Running costs: This is determined by = NPV/PV of running cost x 100/1

= N2,486/(N81,449 – N49,000) x 100/1 = 7.66%
The running cost will to increase by more than 7.66% for the project to become un-viable.
(iii) Savings: This is computed by = NPV/PV of inflows x 100/1

= N2,486/N83, 935 x 100/1 = 2.96%
i.e. savings can be reduced by 3.12% and the project will still be worthwhile, but if
reduced by more than this, it will no longer be viable.
EXPECTED VALUE METHOD
Also known as Bayesian Decision Rules, it is an expression of mathematical expectations of a

further analysis of probability, which makes it possible to establish the expected level of activity,
cost of capital, cash outflows/inflows etc. based on variables that are surrounded by probabilities.
The occurrence will be multiplied by the probability to arrive at the expected figure.
ILLUSTRATION
Bobosco Nig. Ltd needs to invest N50, 000 now on new machinery with expected cash flow over
two years as stated below:
Year 1 Year 2
Initial Probability Conditional Probability
cash flow (N) P (1) cash flow (N) P (2)
20,000 0.3 10,000 0.3
20,000 0.5
30,000 0.2
30,000 0.4 20,000 0.3
30,000 0.5
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40,000 0.2
40,000 0.3 30,000 0.3
40,000 0.4
50,000 0.3
The probabilities of the streams of cash flow for year 2 are conditional upon the achievement of the
initial probabilities of year 1. Assuming that the first year probabilities were achieved, calculate:
(i) The expected present value of this project if the firm’s cost of capital is 12% at the end of year
2 will be.
(ii) The expected net present value.
SUGGESTED SOLUTION
(I & ii) The expected present value and the expected net present value of the project can be
determined as follows:
Yr Cash flow Probability DCF(12%) Expected PV
0 (50,000) - 1 (50,000)
1 20,000 0.3 0.8929 5,357
1 30,000 0.4 0.8929 10,715
1 40,000 0.3 0.8929 10,715
2 10,000 0.3 x 0.3 = 0.09 0.7972 717
2 20,000 0.3 x 0.5 = 0.15 0.7972 2,392
2 30,000 0.3 x 0.2 = 0.06 0.7972 1,435
2 20,000 0.4 x 0.3 = 0.12 0.7972 1,913
2 30,000 0.4 x 0.5 = 0.20 0.7972 4,783
2 40,000 0.4 x 0.2 = 0.08 0.7972 2,551
2 30,000 0.3 x 0.3 = 0.09 0.7972 2,152
2 40,000 0.3 x 0.4 = 0.12 0.7972 3,827
2 50,000 0.3 x 0.3 = 0.09 0.7972 3,587
Expected net present value 145
ILLUSTRATION 2
Two components are assembled to make a finished product. There is a 0.2 probability that the first
component will cost N50 and 0.8 probability it will cost N60, while there is a 0.3 probability the
second component will cost N90 and 0.7 probability it will cost N120. The assembly cost is N21.
(a). Compute the expected cost of the finished product.
(b). A Company ABC has predicted its costs and sales in respect of a product selling for N10 as
follows:
(i) Marginal cost per unit Probability
N6 0.6
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N7 0.4
(ii) Fixed cost Probability

N15,000 0.8
N20,000 0.2
(iii) Sales units Probability

4,000 0.5
6,000 0.5
Compute the profit expectation.
SGGESTED SOLUTION
(a) The expected cost of the finished product

N
1st component (0.2 x N50) + (0.8 x N60) 58
2nd component (0.3 x N90) + (0.7 x N120) 111
Assembly cost 21
Total cost of finished product 190
(b) Calculation of the expected profit
Sales unit (4,000 x 0.5) + (6,000 x 0.5) = 5,000 units

Marginal cost per unit (N6 x 0.6) + (N7 x 0.4) = N6.4 per unit
Fixed cost (N15,000 x 0.8) + (N20,000 x 0.2) = N16,000
Profit statement N N
Sales (5,000 x N10) 50,000
Less costs
Marginal cost (N6.4 x 5,000) 32,000
Fixed cost 16,000 -48,000
Profit 2,000
ILLUSTRATION 3
Ajoda cleaning services Ltd provides street-cleaning services for local councils in Lagos south west of
Nigeria. The work is currently labour-intensive and few machines are used. However, the business has
recently been considering the purchase of a fleet of street-cleaning vehicles at a total cost of N540,000.
The vehicles have a life of four years and are likely to result in a considerable saving of labour costs.
Estimates of the likely labour savings and their probability of occurrence are set out below:
Estimated savings Probability of
N occurrence
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Year 1 80,000 0.3
160,000 0.5
200,000 0.2
Year 2 140,000 0.4
220,000 0.4
250,000 0.2
Year 3 140,000 0.4
200,000 0.3
230,000 0.3
Year 4 100,000 0.3
170,000 0.6
200,000 0.1
Estimates for each year are independent of other years. The business has a cost of capital of 10 per cent
Required:
a. Calculate the expected net present value of the street-cleaning machines.
b. Calculate the net present value of the worst possible outcome and the probability of its
occurrence.
SUGGESTED SOLUTION
Ajoda Cleaning Services Ltd

a. The project’s expected annual cash flows:
Year 1 (80,000 x 0.3) + (160,000 x 0.5) + (200,000 x 0.2) = N144,000
Year 2 (140,000 x 0.4) + (220,000 x 0.4) + (250,000 x 0.2) = N194,000
Year 3 (140,000 x 0.4) + (200,000 x 0.3) + (230,000 x 0.3) = N185,000
Year 4 (100,000 x 0.3) + (170,000 x 0.6) + (200,000 x 0.1) = N152,000
The expected net present value (ENPV) of the project:

Period ENCF DCF@ 10% EPV
N N
0 (540,000) 1.0000 (540,000)
1 144,000 0.9091 130,910
2 194,000 0.8264 160,322
3 185,000 0.7513 138,991
4 152,000 0.683 103,816
Expected net present value (5,961)
b. The worst possible outcome can be calculated by taking the lowest values of savings each year, as
follows:
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Period ENCF DCF@ 10% EPV
N N
0 (540,000) 1.0000 (540,000)
1 80,000 0.9091 72,728
2 140,000 0.8264 115,696
3 140,000 0.7513 105,182
4 100,000 0.683 68,300
Expected net present value (178,094)
The probability of occurrence can be obtained by multiplying together the probability of each of
the worst outcomes above, which is 0.3 x 0.4 x 0.4 x 0.3 = 0.014. Thus, the probability of
occurrence is 1.4%, which is very low.
STANDARD DEVIATION AND CO-EFFICIENT OF VARIATION
Although, through the calculation of the expected net present value, risk is explicitly incorporated
into the capital budgeting analysis, yet a better insight into the risk analysis will be obtained if we
find out the dispersion of cash flows i.e. the difference between the possible cash flows that can
occur and their expected value. The dispersion of cash flow indicates the degree of risk. A
commonly used measure of risk is the standard deviation or variance. Simply stated, variance
measures the deviation of the expected cash flow of each of the possible cash flows. Standard
deviation is the square root of variance. The formulae to calculate variance and standard deviation
are as follows:
SD =
Where SD = Standard Deviation, P = probability of the distribution, x = possible annual cash flow,
x = expected value (mean) and E = summation
Coefficient of Variation:- A relative measure of risk is the coefficient of variation. It is defined as

the standard deviation of the probability distribution divided by its expected value.
Coefficient of variation = CV = standard deviation/Expected value
The coefficient of variation is a useful measure of risk when comparing projects having (i) same
standard deviations but different expect value, or (ii) different standard deviations but same
expected values or (iii) different standard deviations and different expected values.
ILLUSTRATION 1
Yinkus Limited has two investment decisions, each of which involves an initial outlay of N30,000
and an expected life of 3 years. Annual net cash flows from each project beginning from one year
after the initial investment is made and have the following probability distributions.
Project Probability Annual net cash flows

N
A 1 0.2 24,000
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2 0.6 30,000
3 0.2 36,000
B 1 0.2 -
2 0.6 30,000
3 0.2 75,000
Required:
(a) What is the expected value of the annual cash flow for each project?
(b) What is the risk-adjustment net present value of each project if the company has decided to
evaluate the riskier project at 10% and the less risky project at 8%.
(c) If it was known that project B was negatively correlated with other cash flows of the
company while project A was positively correlated how would this knowledge affect the
decision?
SUGGESTED SOLUTION
(a) Expected value of the annual cash flow

Project A
Pr. ANCF PX
1 0.2 24,000 4,800
2 0.6 30,000 18,000
3 0.2 36,000 7,200
X 30,000
Project B
Pr. ANCF PX
1 0.2 - -
2 0.6 30,000 18,000
3 0.2 75,000 15,000
X 33,000
(b) Project A is not as risky as project B, in that in the first probability while project A
promises N24,000 project B fetches nothing at the same probability of 20%. If a project
generates nothing, the level of loss is increased or enhanced. However, in the second
probability the two projects turn-in the same inflow at the same probability level but there
is a disparity wide enough in the third probability. A is to turn in N36,000 compared to the
expectation from B of N75,000, which is too optimistic a value.
The risk adjustment net present value will be
Project A
Yr Cash flows DCF (8%) PV
0 -30,000 1 (30,000)
1-3 30,000 2.5771 77,313
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NPV 47,313
Project B
Yr Cash flows DCF (10%) PV
0 -30,000 1 (30,000)
1-3 33,000 2.4869 82,068
NPV 52,068
(c) From the above computation, after taking care of the risk in project B, the project is still
worth while and for an investor to be aware that such a project is positively correlated will
enhance the acceptance of the project.
ILLUSTRATION 2
Jay Nig. Limited has been presented the following data based on the investigation conducted.
Capital outlay is N10,000.
Net cash inflow
Probability Yr. 1 Yr. 2 Yr. 3
0.1 3,000 2,000 1,000
0.2 4,000 3,000 2,000
0.4 5,000 4,000 3,000
0.2 6,000 5,000 4,000
0.1 7,000 6,000 5,000
(a) You are required as a financial manager to calculate the expected NPV, if the cost of
capital is 5%. Note that the outcomes in years two and three are not dependent on the
outcomes in the previous years.
(b) What is the standard deviation and co-efficient of variation in each of the 3 years .
SUGGESTED SOLUTION
(a) Calculation of the expected value
Year 1 Year 2 Year 3

Prob. x Px x Px x Px
0.1 3,000 300 2,000 200 1,000 100
0.2 4,000 800 3,000 600 2,000 400
0.4 5,000 2,000 4,000 1,600 3,000 1,200
0.2 6,000 1,200 5,000 1,000 4,000 800
0.1 7,000 700 6,000 600 5,000 500
Expected value 5,000 4,000 3,000
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The NPV of the project
Yr. NCF DCF(5%) PV

0 -10,000 1 (10,000)
1 5,000 0.9524 4,762
2 4,000 0.907 3,628
3 3,000 0.8638 2,591
NPV 981
(b) The standard deviation and co-efficient of variation

Year 1
X Prob. Px (x - x) P(x - x)2
3,000 0.1 300 (2,000) 400,000
4,000 0.2 800 (1,000) 200,000
5,000 0.4 2,000 - -
6,000 0.2 1,200 1,000 200,000
7,000 0.1 700 2,000 400,000
X 5,000 1,200,000
Standard deviation (SD) = 1,200,00 = N1,095
With an expected value of N5,000 and standard deviation of N1,095, the actual figure in the final
analysis will definitely be between N5,000 (+) or( -) N1,095.
Co-efficient of variation = N1,095/N5,000 x 100/1 = 21.9%
With co-efficient of variation of 21.9% the dispersion about the mean value of N5,000 is (+) or (–)
21.9% of N5,000.
Year 2
2,000 0.1 200 (2,000) 400,000
3,000 0.2 600 (1,000) 200,000
4,000 0.4 1,600 - -
5,000 0.2 1,000 1,000 200,000
6,000 0.1 600 2,000 400,000
X 4,000 1,200,000
Co-efficient of variation = N1,095/N4,000 x 100/1 = 27.38%
Year 3
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1,000 0.1 100 (2,000) 400,000
2,000 0.2 400 (1,000) 200,000
3,000 0.4 1,200 - -
4,000 0.2 800 1,000 200,000
5,000 0.1 500 2,000 400,000
X 3,000 1,200,000
Co-efficient of variation = N1,095/N3,000 x 100/1 = 36.5%.
ILLUSTRATION 3
Mr. I. K. Bisi who recently won a lottery wants to invest his N40,000 winning for a period of one
year. He was considering two proposals, both of which have discrete probability distributions of
cash flows as listed below for the year:
Proposal A Proposal B
Probability cash inflow Probability Cash flow
0.10 30,000 0.10 20,000
0.20 35,000 0.25 30,000
0.40 40,000 0.30 40,000
0.20 45,000 0.25 50,000
0.10 50,000 0.10 60,000
However, his friend, a stock broker, strongly recommends that Bisi should invest the N400,000 in
treasury certificates recently issued by the Federal Government. The treasury certificate bears an
interest rate of 10%. Bisi is uncertain about what course of action to take. He has called on you to:
(a) Compute the expected value of the value of the cash inflows, the standard deviation of the
probability distribution and the co-efficient of variation for the three proposals.
(b) Advise on which of the three proposals has the greatest degree of risk and why?
SUGGESTED SOLUTION
(a) (i) The expected cash inflow of the proposals
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Proposal A Proposal B
x Pr. Px X Pr. Px
30,000 0.1 3,000 20,000 0.1 2,000
35,000 0.2 7,000 30,000 0.25 7,500
40,000 0.4 16,000 40,000 0.3 12,000
45,000 0.2 9,000 50,000 0.25 12,500
50,000 0.1 5,000 60,000 0.1 6,000
Expected value 40,000 Expected value 40,000
(ii) The standard deviation of the two proposals

Proposal A
X Pr Px (x - x) P(x - x)2
30,000 0.10 3,000 -10,000 10,000,000
35,000 0.20 7,000 -5,000 5,000,000
40,000 0.40 16,000 0 -
45,000 0.20 9,000 5,000 5,000,000
50,000 0.10 5,000 10,000 10,000,000
40,000 30,000,000
Standard deviation of proposal A = 30,000,000 = N5,477
Proposal
A
X Pr Px (x - x) P(x - x)2
20,000 0.10 2,000 -20,000 40,000,000
30,000 0.25 7,500 -10,000 25,000,000
40,000 0.30 12,000 0 -
50,000 0.25 12,500 10,000 25,000,000
60,000 0.10 6,000 20,000 40,000,000
40,000 130,000,000
Standard deviation of proposal B = 130,000,000 = N11,402
(iii) The co-efficient of variation of the two proposals
Proposal A = N5,477/N40,000 x 100/1 = 13.69%
Proposal B = N11,402/N40,000 x 100/1 = 28.51%
The cash inflow for proposal three is certain because it is a risk-free investment i.e.,
Government treasury certificates with a fixed return of 10%. Therefore the expected cash
Page 267
inflow is 10% or N4,000 with no standard deviation and co-efficient of variation, sincere the
return is certain.
(b). Of the three proposals, proposal B has the highest risk because the dispersion from
expected inflow of 28.51% is higher than that of A, 13.69% of the government treasury
certificate which is zero percent or nil risk.
CONSERVATIVE ESTIMATE
The idea is borrowed from the accounting concept called the prudential or conservative concept,
which implies that we need to be very strict when projecting the future cash inflow. Using the
method, the expected future cash out flow will be generously estimated but when considering the
inflow a lot of factors that can bring about reduction in the inflow will be considered with the
resultant effect that inflow will be under estimated or prudently estimated. In other words, expected
inflows may be reduced to say between 80 to 60% of what ordinarily should have been budgeted.
SIMULATION TECHNIQUE
A simulation technique is a means whereby the features of a problem to be studied are imitated, this
applies not only to the items involved, but also to their patterns of behaviour. The variations of the
system being investigated are estimated from samples, the results of the sampling will be converted
into some form of probability distribution. Random numbers technique is then used to show the
results of trial runs under different hypothetical operating conditions. The results of these trials are
recorded and are examined in order to arrive at the best solution.
Simulation techniques are normally used for the following:
(a) Determining the optimum number of facilities in complex sequencing situations e.g.
production scheduling and cargo-handling situations.
(b) Analysing the internal workings of a dynamic system.
(c) Evaluating alternative investment policies for strategic planning.
(d) Economic forecasting.
(e) Training managers in decision making
(f) Predicting optimum stock levels in situations involving variations of supply and /or
demand.
(j) Determining staff requirement.
ILLUSTRATION 1
Risco Limited is considering the following investment opportunity. The project is expected to have
a life of two years. Estimate of initial outlay is as follows:
Page 268
Estimated outlay Probability
N
200,000 0.25
250,000 0.40
300,000 0.35
The volume of sales in the two years is estimated as follows:

Year 1 Year 2
Unit/Volume Probability Unit/Volume Probability
500,000 0.24 400,000 0.30
600,000 0.60 560,000 0.50
800,000 0.16 600,000 0.20
The volume in year 2 is independent of volume achieved in year 1. The contribution per unit is also
subject to uncertainty and the following probability distribution is estimated.
Contribution per
unit Probability
N0.30 0.15
N0.50 0.58
N0.80 0.27
Cost of capital is 10%
Required
Carry out a simulation of the above project and determine whether or not the project should be
accepted. Random number digits is to be used for the various outcomes, starting with the first are
93 53 81 03. The use of these random numbers is to start with the initial cost, followed by volume
in year 1, followed by volume in year 2 and then contribution, strictly in that order.
SUGGESTED SOLUTION
In order to simulate the initial outlay, volume of sales and contribution margin, and the probability
will be cumulated based upon which random number is developed. Random number digits will be
allocated in accordance with the instruction and thereby simulate the variables as follows
The initial outlay
Outlays Prob. Cum. Prob. Random No. Random No. Simulated
Digits Outlay
200,000 0.25 25 0 - 24
250,000 0.40 65 25 - 64
300,000 0.35 100 65 - 99 93 300,000
NOTE
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Cumulative probability above, is the addition of the previous cumulative with probability of the
forecast treated as a whole figure, i.e. the whole number is used instead of a decimal number. This
will aid the formulation of the random number.
Random number: This is formulated by starting with the previous cumulative probability figure and
stopping at a figure before the cumulative probability of the range. For example, with outlay of
N200,000, the previous cumulative figure is zero, since there is no figure before it, and the
cumulative probability of the range is 25, then the random number will therefore be 0 – 24.
Random number digit: The lump figures given as 93 53 81 03, will be broken down into two
significant figures, since the probability is in two decimal figures. In situation where the probability
is in one decimal place, the random number digit will equally be broken down into one significant
figure. The whole essence of this is to simulate future outcomes. In this situation, starting with the
initial outlay, the first two figures, that is “93” will be the random number digit for it, and we will
find the range within the random number already determined where we can find 93, i.e. range 65 –
99, and the outlay for the range is N300, 000. Therefore the simulated outlay is N300, 000. The
same operation will be carried out for other variables as well.
Simulation of sales volume for year 1

Volume Prob. Cum. Prob. Random No. Random No. Simulated
Digits Volume
500,000 0.24 24 0 - 23
600,000 0.60 84 24 - 83 53 600,000
800,000 0.16 100 84 - 99
Simulation of sales volume for year 2

Volume Prob. Cum. Prob. Random No. Random No. Simulated
Digits Volume
400,000 0.30 30 0 - 29
560,000 0.50 80 30 - 79
600,000 0.20 100 79 - 99 81 600,000
Simulation of contribution per unit

Contribution Prob. Cum. Prob. Random No. Random No. Simulated
Margin (N) Digits CM
0.30 0.15 15 0 - 14 3 0.30
0.50 0.58 73 15 - 72
0.80 0.27 100 73 - 99
Total contribution for the years
Year 1 = 600,000 x N0.30 = N180,000

Year 2 = 600,000 x N0.30 = N180,000
The net present value of the project

Year NCF DCF(10%) PV
0 -300,000 1 (300,000)
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1–2 180,000 1.7355 312,390
NPV 12,390
From computation above, it is advisable to accept the project.
ILLUSTRATION 2
Mr. Taiwo runs a high-class restaurant and boasts that he makes the finest individual ice cream in
the country. These are prepared each morning and displayed on the sweet trolley at the Piece de
Resistance. Owing to their perishable nature, any un-used items must be thrown away at the end of
the day. Each ice cream costs N50 to make and is priced at N100 on the menu. If a customer orders
one when there is none left, Mr. Taiwo estimates the loss of goodwill of N20.
The records of supply and demand over the past 300 days are as follows:
Number of items Number of Number Number of
Available for purchase Days Demanded Days
10 30 10 45
20 60 20 75
30 90 30 90
40 75 40 60
50 45 50 30
The random number digit for quantity available and demand in that order are 51 77 27 46 40 42 33
12 90 44 46 62 16 28 98 93 into two significant figures.
Simulate 8 days demand and supply and determine the profit or loss for the period.
SUGGESTED SOLUTION
The number of days of the occurrence will be used to determine the probability of the occurrence.
Random number for supply

Number of items Number of Probability Cum. Prob. Random
available for purchase days number
10 30 0.1 10 00 - 09
20 60 0.2 30 10 - 29
30 90 0.3 60 30 - 59
40 75 0.25 85 60 - 84
50 45 0.15 100 85 - 99
Total 300
Probability = number of days divide by total number of days
Random number for demand
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Demand Number of Probability Cum. Prob. Random
days number
10 45 0.15 15 00 - 14
20 75 0.25 40 15 - 39
30 90 0.3 70 40 - 69
40 60 0.2 90 70 - 89
50 30 0.1 100 90 - 99
Total 300
Simulation of 8 days demand and supply

Days Random number Simulated Random number Simulated
digits for supply Supply digits for demand Demand
1 51 30 77 40
2 27 20 46 30
3 40 30 42 30
4 33 30 12 10
5 90 50 44 30
6 46 30 62 30
7 16 20 28 20
8 98 50 93 50
The profit or loss for the period.

Days Supply Demand Total Loss of Loss of Profit
Contribution Stock Goodwill
1 30 40 1,500 200 1,300
2 20 30 1,000 200 800
3 30 30 1,500 1,500
4 30 10 500 1,000 (500)
5 50 30 1,500 1,000 500
6 30 30 1,500 1,500
7 20 20 1,000 1,000
8 50 50 2,500 2,500
Total 8,600
Total contribution is a function of demand that is supply multiply by contribution per unit of N50
(i.e. N100 – N50).
Loss of stock is excess of supply over demand multiply by purchase cost per unit of N50.
Loss of goodwill is determined by multiplying the excess of demand over supply by N20 per unit
of the un-met demand.
FURTHER ILLUSTRATION QUESTIONS
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1. OBJ Ltd. is considering the production of a new product. Investment in the new plant
would be N12, 000,000 with a residual Value of N6, 000,000 at the end of the 3-year life of
the project.
Sales cannot be forecast with accuracy and the following probabilities have been assigned
to various levels of sales in each year.
Sales Unit Probability Sales Unit Probability Sales Unit Probability
10,000 0.3 9,000 0.2 8,000 0.3
15,000 0.5 14,000 0.6 13,000 0.4
20,000 0.2 18,000 0.2 15,000 0.3
The sales forecasts for the years two and three are independent of those for the previous
year or years. The selling price has been set at N580 per unit. Standard costs for the
products are:
N per unit
Direct Materials 180
Direct Wages 90
Variable overheads 30
Fixed overheads are budgeted at N1, 000,000 per annum excluding depreciation. The rate
of taxation on the company’s accounting profit is 20%.
Required:
Prepare the expected operating results for each year and in total.
Show all workings.
2. Technocom Nigeria Limited is considering the opportunity of taking up the dealership of

one of the two leading Telecommunication GSM providers in the distribution of its
recharge cards, NTL and MTL cards.
The Managing Director, Mr. Simplice a “risk averse” entrepreneur has engaged you as the
Management Accountant to provide cost management information and advise where
necessary.
The operating information for the first three months of the year made available is as given
below:
NTL CARD MTL CARD
Profit Probability Profit Probability
N N
10,000 0.4 6,000 0.2
11,000 0.3 13,000 0.7
14,000 0.3 16,000 0.1
Required:
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Which of the “GSM” providers will you recommend for Mr. Simplice, considering the fact
that EV profits of each project is within 10% of each other and the project with lower
coefficient of variation is selected.
3. ORON NIG. LTD. is currently considering two mutually exclusive investment projects.
Both projects are concerned with the purchase of new plant. The company made available
the following data for each project:
PROJECT
A B
N N
Cost (immediate outlay) 200,000 120,000
Expected annual net profit/ (loss)
Year 1 58,000 36,000
Year 2 (2,000) (4,000)
Year 3 4,000 8,000
Expected residual Value 14,000 12,000
ORON NIG. LTD. has an estimated cost of capital of 10% and employs the straight-line
method of depreciation for all fixed assets when calculating net profit. Neither project
would increase the working capital of the company. The company has sufficient funds to
meet all capital expenditure requirements.
Required:
a) Calculate for each project:

i. The net present value.
ii. The approximate internal rate of return.
iii. The payback period.
b) State, which, if any, of the two investment projects the company should accept,
and why.
4. BARO PHARMACEUTICAL NIG. LTD. can purchase the patents and the manufacturing
rights of any one of the three drugs. The costs of the rights are:
Drug X - N260,000
Drug Y - N380,000
Drug Z - N400,000
At the company’s board meeting, the management accountant declared that it was general
knowledge that the venture is a very short-term project. The fixed manufacturing and
advertising cost of each venture will be:
X Y Z
N’000 N’000 N’000
Fixed manufacturing costs 240 40 40
Advertising costs 100 60 40
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Sales and production will, once known, dovetail and therefore, there will be no stock build
up. The sales price and variable costs per units are:
X Y Z
N N N
Sales price per unit 680 630 260
Variable cost per unit 280 220 140
However, the sales volume is the key factor. The company does not know what the sales
level will be but it knows the various probabilities of what the sale level could be. Drug X,
could be a complete flop, it could sell well, or it might sell very well.
Drug Y is also quite variable whereas with Drug Z, the range of outcome is very small. The
various possible sales volumes and their associated probabilities are as follows:
DRUGS
X Y Z
Sales volume in Probabilit Sales volume Probability Sales volume Probability
units y in units in units
0 0.1 3,000 0.1 7,000 0.8
2,500 0.4 4,000 0.3 8,000 0.1
4,000 0.5 6,000 0.3 9,000 0.1
8,000 0.3
The company now wishes to decide on which of the drugs it should manufacture and sell.
Required:
Calculate the expected money value of each drug and on the basis of this, advise the board
of which drug to produce.
SUGGESTED SOLUTION
1. OBJ LTD
EXPECTED OPERATING RESULT FOR EACH YEAR AND IN TOTAL

Year 1 2 3 Total
Expected Sales (Units) 14,500 13,800 12,100 40,400
N’000 N’000 N’000 N’000
Sales 8,410 8,004 7,018 23,432
Less Variable Cost:
Direct Material (2,610) (2,484) (2,178) (7,272)
Direct Wages (1,305) (1,242) (1,089) (3,636)
Variable Overheads (435) (414) (363) (1,212)
Contribution 4,060 3,864 3,388 11,312
Less Fixed Cost:
Depreciation (2,000 (2,000) (2,000) (6,000)
Other Fixed Overheads (1,000) (1,000) (1,000) (3,000)
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Profit Before Taxation 1,060 864 388 2,312
Taxation (212) (172.8) (77.6) (462.4)
Profit After Taxation 848 691.2 310.4 1,849.6
Working:
(i). Annual Depreciation:= Cost-Scrap Value/Estimated Useful Life
= 12,000,000-6,000,000/3 = 2,000,000
(ii) Expected Sales Units

0.3 x 10,000 = 3,000 0.2 x 9,000 = 1,800 0.3 x 8,000 = 2,400
0.5 x 15,000 = 7,500 0.6 x 14,000 = 8,400 0.4 x 13,000 = 5,200
0.2 x 20,000 = 4,000 0.2 x 18,000 = 3,600 0.3 x 15,000 = 4,500
14,500 13,800 12,100
2. TECHNOCOM NIGERIA LIMITED

NTL CARD
Profit Pr EV Profit
X P Px x-x (x-x) 2 P (x-x) 2
10,000 0.4 4,000 -1,500 2,250,000 900,000
11,000 0.3 3,300 -500 250,000 75,000
14,000 0.3 4,200 -2,500 6,250,000 1,875,000
X 11,500 2,850,000
S.D ()= 2,850,000 = 1,688
Coefficient of variation = Standard Deviation/Expected Value Profit

= 1,688/11,500 = 0.15
MTL CARD
Profit Pr EV Profit
X P Px x-x (x-x) 2 P (x-x) 2
6,000 0.2 1,200 -5,900 34,810,000 6,962,000
13,000 0.7 9,100 1,100 1,210,000 847,000
16,000 0.1 1,600 4,100 16,810,000 1,681,000
X 11,500 9,490,000
S.D ()= 9,490,000 = 3,081
Coefficient of variation = Standard Deviation/Expected Value Profit

= 3,081/11,900 = 0.26
From the computation above it is advisable for the Management of Technocom Nigeria Limited to
accept the distribution of NTL card because it has the lower coefficient of variation of 0.15
3. ORON NIG. LTD

a) (i) The net present value
Project A
Year Cash Flow DF @ 10% PV
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0 (200,000) 1.0000 (200,000)
1 120,000 0.9091 109,092
2 60,000 0.8264 49,584
3 66,000 0.7513 49,586
8,262
Project B
0 (120,000) 1.0000 (120,000)
1 72,000 0.9091 65,455
2 32,000 0.8264 26,445
3 44,000 0.7513 33,057
4,957
(ii). The Internal rate of return
The negative net present value
Project A
0 (200,000) 1.0000 (200,000)
1 120,000 0.8696 104,352
2 60,000 0.7561 45,366
3 66,000 0.6575 43,395
(6,887)
IRR = 10 + ((8,262/(8,262 + 6,887)) x (15 – 10)) = 12.73%
Project B
0 (120,000) 1.0000 (120,000)
1 72,000 0.9091 62,611
2 32,000 0.7561 24,195
3 44,000 0.6575 28,930
(4,264)
IRR = 10 + ((4,957/(4,957 + 4,264)) x (15 – 10)) = 12.69%
(iii). The payback period

Project A
Year Cash Flow Cumulative Cash Flow
0 (200,000) (200,000)
1 120,000 (80,000)
2 60,000 (20,000)
3 66,000 -
PBP = 2 +(20,000/66,000) yrs =2.3 years
Project B
Year Cash Flow Cumulative Cash Flow
0 (120,000) (120,000)
1 72,000 (48,000)
2 32,000 (16,000)
3 44,000 -
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= 2+(16,000/44,000)yrs =2.36 years
(b) i. Summary of the results

Method Project A Project B
NPV N 8,262 N 4,957
IRR 12.73% 12.69%
PBP 2.3yrs 2.36yrs
ii. From the computation above it is advisable to select project A, which gives a higher
NPV.
Workings:
(i). Annual Depreciation = Cost – Scrap Value/Estimated Cash Flow
Project A: = 200,000 -14,000/3 = N 62,000
Project B: = 120,000 -12,000/3 = N 36,000
(ii). Calculation of expected cash flow:

Project A
Year 1 2 3
Net Profit / (Loss) 58,000 (2,000) 4,000
Add back:
Depreciation 62,000 62,000 62,000
120,000 60,000 66,000
Project B
Year 1 2 3
Net Profit / (Loss) 36,000 (4,000) 8,000
Add back:
Depreciation 36,000 36,000 36,000
72,000 32,000 44,000
4. BARO PHARMACEUTICAL NIG LTD

Drug X Y Z
Expected Sales Units 3,000 5,700 7,300
N’000 N’000 N’000

Sales Value 2,040 3,591 1,898
Less: Variable Cost 840 1,254 1,022
Contribution 1,200 2,337 876
Fixed Cost:
Manufacturing Right (260) (380) (400)
Manufacturing Cost (240) (40) (40)
Advertising Cost (100) (60) (40)
Expected Profit 600 1,857 396
Decision:
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Based on the above calculation, the board of Baro Pharmaceutical Nig Ltd. is advised to consider
producing Drug Y as it has the highest expected money value of N1, 857,000
Working:
Expected Sales units:
Drug X Drug X Drug Z
0 X 0.1 = 0 3,000 X 0.1 = 300 7,000 X 0.8 = 5,600
2,500 X 0.4 = 1,000 4,000 X 0.3 = 1,200 8,000 X 0.1 = 800
4,000 X 0.5 = 2,000 6,000 X 0.3 = 1,800 9,000 X 0.1 = 900
3,000 8,000 X 0.3 = 2,400 7,300
5,700
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CHAPTER 9
INVENTORY CONTROL
Much more emphasis is today placed on stock or Inventory Control because this constitutes
relatively 70% to 80% of cost of production or sales. Large amounts of capital investment are
locked up in stocks of materials. Little wonder why most manufacturing organizations spend a lot
of money and time in designing and implementing an efficient and effective inventory control
policy, these are the various policies organizations put in place to ensure as far as possible that
inventory costs are minimized towards maximization of profit. Inventory control can be categorized
into two
1. Inventory costs control
2. Inventory physical control
While inventory costs control deals with policies and procedure established to ensure inventory
costs are at reasonable levels that will enable the organization to attain its goals, inventory physical
control is about arrangement of stocks in the warehouse and how to issue stocks with the intention
of minimizing inventory costs. More emphasis will be placed on inventory cost control.
STOCK LEVELS
One of the major objectives of a stores control system is to ensure that “stock-outs” do not occur,
and that surplus stocks are not carried. Stock- outs occur when there is insufficient stock to meet
production demands and this can lead to loss of customer goodwill and reduce profits. Other costs
associated with stock- outs include: idle time payment, cost of emergency ordering of stock, loss of
sales etc. On the other hand, surplus stocks result when an organization is holding more than
necessary stock leading to increase in storage costs and reduction of profits. Other costs associated
with excess stocks include: cost of capital tied down, pilferages, damage and obsoleteness costs,
etc.
To bring the above-referred cost under bearable levels, various stock levels are quantitatively
derived and these are as follows:
MAXIMUM STOCK LEVEL
This is the level above which stocks should not be allowed to grow or rise in order to minimize
excess stock costs. It is desirable that the level should be as low as possible, but of course it must
allow for forecast usage of materials and time lags in deliveries. Setting this level, the following
factors must be taken into account.
1. The rate of consumption of the material
2. The time necessary to obtain delivery of the material
3. The re-order quantity of the material.
It is determined as follows:
Maximum stock level = Re-order level + Re-order quantity – (Minimum delivery period x
minimum usage).
MINIMUM STOCK LEVEL
This is the level below which stocks should not be allowed to decline or fall in order to minimize
costs associated with stock out costs. If stock levels go below this level, there is the danger of a
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stockout resulting in production stoppages. This stock is a “buffer stock” which would be
available in emergencies. It can be determined as follows:
Minimum stock level = Re-order level – (average delivery period x average usage)
RE-ORDER LEVEL
This is the point at which it is essential to initiate purchase requisition for fresh supplies of the
stock. This point will be higher than the minimum stock level, so as to cover such emergencies as
abnormal usage of the material or unexpected delays in delivery of fresh supplies. It will also be
lower than the maximum stock level, otherwise excess stocks would be carried. It is determined as
follows:
Re-order level = Maximum usage x maximum delivery period.
RE-ORDER QUANTITY
This is the volume/quantity of stock ordered each time a fresh order is made for the replenishment
of stocks. When it is economically determined, it is known as Economic Ordering Quantity (EOQ).
It can be economical determined by taken into consideration the controllable costs associated with
purchase, ordering and holding stocks. This can be viewed from two headings as:
1. When there is no purchase quantity discount.

2. When there is purchase quantity discount.
EOQ WITH NO PURCHASE QUANTITY DISCOUNT
This assumes a constant rate for stock no matter the quantity purchased. When this is obtainable the
controllable costs of stock are:
1. Ordering costs
2. Holding costs.
Ordering costs: These are costs incurred from the point we initiate the purchase of stock till such
stock is received in the warehouse excluding the purchase cost. It may difficult to really quantify all
the costs, but examples of such costs include:
 Stationery costs
 Telephone, telex, postage etc. costs
 Freight, demurrage, delivery etc. costs
 Loading and off- loading costs
 Insurance on goods- in- transit cost
 Salaries & wages of personnel in purchasing department.
In order to minimize ordering, the ordering quantity must be increased. Therefore it is stated that
the higher the ordering quantity the lower the number of order, the lower the ordering cost. The
total annual ordering cost can be determined using the following:
Total annual ordering cost = Annual demand/EOQ x ordering cost per order.
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Holding costs: This is otherwise known as carrying/storage costs. They are costs incurred from
reception of stock until such stock is used for production of goods or services. These are cost
incurred for keeping the material in the store. Holding costs include:
 Warehouse rent costs.

 Salaries and wages of warehouse personnel
 Healing, cooling and maintenance costs
 Obsolete, wastage, damage and pilferage costs
 Insurance of material in store costs
 Stationeries and other utilities costs
 Interest on capital tied-down
In order to minimize holding costs, we need to reduce the ordering quantity that is why it is stated
that, the lower the ordering quantity, the lower the tendency of keeping stock items in store, the
lower the holding cost.
The idea of minimizing the holding cost gives birth to what we call “Just in time purchase” which
is a theory that believes in total elimination of holding costs, as materials will only be purchased to
meet production requirement without stock piling. This will be subsequently discussed in detail.
Total annual holding cost = EOQ/2 x holding cost per stock.
The EOQ will be (when there is no purchase quantity discount) the ordering quantity, where total
annual ordering and holding inventory is minimized. This can be determined using the following:
2. Tabular method
3. Graphical method
The mathematical method will be used when no range is specified, but the tabular method will be
used if a range is indicated.
Using the mathematical method, the EOQ can be determined as follows
EOQ = 2DC/H
Where D= Annual demand of the material, C= ordering cost per order and H= holding cost per
stock.
ILLUSTRATION 1
Tolu Limited is a manufacturing company and uses a specialized material for the production of one
of its products. From the record of the company, the following data was extracted concerning the
material:
Annual demand 200,000 units
Cost per unit N20
Cost of placing an order N800
Storage cost of the material per inventory cost 12%
Maximum delivery period when an order is placed is 4 weeks, minimum delivery period of 2
weeks.
Maximum usage for a week 6,000 units and minimum usage 2,000 units.
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From the above data you are required to determine for the company the following stock levels.
a. Economic order quantity (EOQ)

b. Re-order level
c. Minimum stock level
d. Maximum stock level
e. The annual total controllable cost of the material.
SUGGESTED SOLUTION
(a). Economic order quantity (EOQ) = 2DC/H =  (2x200,000xN800)/(12%xN20) = 11,547

units.
(b). Re-order level = maximum usage x maximum delivery period

6,000 units x 4 weeks = 24,000 units
(c) Minimum stock level = Re-order level – (Average usage x average delivery period)
Average usage = (6,000+2,000)/2= 4,000 units, Average delivery period = (4+2)/2 = 3 weeks
Minimum stock level = 24,000 – (4,000 units x 3 weeks) = 12,000 units
(d) Maximum stock level = Re-order level + Re-order quantity –(minimum usage x minimum
delivery period)
= 12,000 units + 11,547 units – (2,000 units x 2 weeks) = 19,547 units
(e) When there is no quantity discount, the controllable costs are holding and ordering costs.
The total annual costs of each will be determined using the formula already given.
N
Total annual holding cost 11,547/2 x (12% x N20) 13,856.40
Total annual ordering cost 200,000/11,547 x N800 13,856.40
Total controllable cost 27,712.80
If the EOQ is mathematically determined, the holding cost will be equal to the ordering cost at the
EOQ quantity.
ILLUSTRATION 2
A Limited has the following data in relation to its material:

Material cost per unit N4.00
Present ordering level is in batches of 200 units, Demand is constant at 10 units a day for each 250
working days in a year.
Ordering cost per batch is N25.00
Carrying cost per unit is 121/2 % of material cost.
You are required to calculate:
a. Economic order quantity

b. Calculate annual savings, which would be made over the current policy of ordering
200 units per batch.
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SUGGESTED SOLUTION
(a). Economic order quantity =  2DC/H =  (2x2,500xN25)/N0.5 = 500 units

Annual demand 10 x 250 = 2,500 units, holding cost = 121/2 % x N4.00 = N0.5
(b). In order to determine annual savings which would be made over the current policy of
ordering 200 units per batch by ordering 500 units per batch, the controllable costs (that is,
holding and ordering costs) of inventory will be determined for the two ordering quantities,
the difference between these costs at 200 units and 500 units will be the expected saving.
The computation as follows:
At 200 units N N
Total annual holding cost 200/2 x N0.5 50.00
Total annual ordering cost 2,500/200 x N25 312.50 362.50
At 500 units
Total annual holding cost 200/2 x N0.5 125.00
Total annual ordering cost 2,500/500 x N25 125.00 250.00
Savings 112.50
ILLUSTRATION 3
The Megagate Company is a restaurant supplier, which sells a number of products to various
restaurants in the area. One of their products is a special meat cutter with disposable blade.
The blades are sold in packages of 12 blades for N1,600. After a number of years it has been
determined that the demand for the replacement blades is at a constant rate of 2,000 packages per
month. The packages cost the Megagate Company N800 each from the manufacturer and require a
three-day lead-time from date of order to date of delivery. The ordering cost is N96 per order and
the carrying cost is 10 per cent per annum.
(a). Calculate
i. The economic order quantity
ii. The number of orders needed per year.
iii. The total cost of buying and carrying blades for the year.
(b). Assuming that there is no safety stock and that the present inventory level is 200 packages,
when should the next order be placed? (Use 360 days for one year).
SUGGESTED SOLUTION
(a). i. Economic order quantity (EOQ) = 2DC/H

=  (2x24,000x N96)/(10%xN800) = 240 packages.
ii. The numbers of orders per year = Demand/EOQ

= 24,000/240 = 100 times.
iii. The total cost of buying and carrying blades
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Purchase cost (24,000 x N800) 19,200,000
Total ordering cost (100 x N96) 9,600
Total holding cost ((240/2) x N80) 9,600
Total buying and holding costs 19,219,200
(b). The re-order level or point will be determined and compare with stock available. Where re-
order level is function of maximum usage x maximum delivery period = 24,000/360 x 3
days = 200 packages.
Since the current stock level is 200 packages, which equate the re-order level, the next
order should be placed immediately.
ILLUSTRATION 4
KDK Limited is in the process of establishing standard ordering policy for one of the major raw
materials used in the production of its products. The annual consumption of this material is 25,000
units and each unit cost N20, no matter the ordering size. The annual carrying cost per unit is 8% of
the inventory cost while the ordering cost is N600 per order.
The materials are packaged in such a way that the possible ordering sizes are 2,500, 5,000, 10,000,
15,000 or 25,000 units per order.
You are required to calculate the ordering size most economical to order.
SUGGESTED SOLUTION
The economic order size in this situation can only be determined using tabular method, the total
annual ordering and holding cost will be computed using the earlier stated formula. The two costs
will be added together and the ordering sizes where the total controllable cost is minimized will be
the economic ordering size required.
The EOQ
Ordering sizes 2,500 5,000 10,000 15,000 25,000
N N N N N
Total annual ordering costs 6,000 3,000 1,500 1,000 500
Total annual holding costs 2,000 4,000 8,000 12,000 20,000
Total controllable cost 8,000 7,000 9,500 13,000 20,500
From the computation above, the EOQ is 5,000 units per order, which is the ordering size where the
total ordering and holding cost is minimized.
EOQ WITH PURCHASE QUANTITY DISCOUNT
If a supplier offers a quantity discount, which is commonly obtainable as the ordering quantity is
increasing, this will lead to reduction in purchase cost per unit, as the ordering quantity is
increasing, and therefore the purchase cost becomes controllable. Since the higher the ordering
quantity the lower the average purchase cost. The controllable costs therefore increase to three
where there is quantity discount, which are:
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1. Purchase costs
2. Ordering costs
3. Holding costs
To compute the EOQ the following methods can be used

a. Tabular method only
b. Mathematical and tabular method
This will be buttressed along with the following illustration questions.
ILLUSTRATION 1
Bari Nigeria Limited is into production and sales of gift items, which require the usage of a
specialized material purchased from a distance town. The material, which is used evenly
throughout the year, is currently used to produce 12,000 units per annum of the company’s
products, each unit containing 0.4 kg of the material. The material costs N10 per kg. Purchases can
only be made in multiple of 2,500 kg.
The supplier has indicated the following discount, for the stated ordering sizes
Ordering quantity (Kg) Discount
2,500 Nil
5,000 2%
7,500 5%
10,000 7%
12,500 and above 10%
Cost of placing and handling each order are N900 of which N400 is an apportionment of costs,
which are not affected, in the short term by the number of orders placed. Annual holding costs of
stock are N6 per unit of average stock held, of which N2 is expected to be un-affected in the short-
term by the amount of stock held.
Required
Assume the above are the only variables to be considered, determine the economic order size.
SUGGESTED SOLUTION
The total annual purchase, holding and ordering cost will be computed for each of the ordering
sizes. The ordering sizes at which the total of the costs is minimized will be the EOQ.
Since a range is already specified, i.e., the ordering size must be divisible by 2,500, only the tabular
approach can guarantee this. Therefore the tabular method must be used.
Note, annual demand = 12,000units x 0.4kg = 4,800 kg.
The computation of total annual purchase cost will be based on this quantity. For example at the
ordering size of 2,000 = (4,800 x N10) = N48,000. Discount will be given for those order sizes with
discount. Only the controllable cost of ordering (N4) and holding (N500) will be considered in the
computation.
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The total annual controllable cost for various ordering sizes:
Ordering sizes 2,500 5,000 7,500 10,000 12,500
N N N N N
Total annual purchase costs 48,000 47,040 45,600 44,640 43,200
Total annual ordering costs 960 480 320 240 192
Total annual holding costs 5,000 10,000 15,000 20,000 25,000
Total annual costs 53,960 57,520 60,920 64,880 68,392
From the above computation, the economic ordering size is 2,500 kg per order, which is the
ordering size that minimizes the total annual costs.
ILLUSTRATION 2
Tom Ventures Limited annual requirement of its material is 4,500 per annum, the purchase cost per
unit is N450 with quantity discount of 5% for ordering 1,001 to 3,000, 7% discount for ordering
3,001 to 5,000 units and 10% discount for ordering 5,001 and above.
The ordering cost per order is N5,000 and cost of carrying stock is 8% per average stock held.
Required
Determine the ordering size most economical to order.
SUGGESTED SOLUTION
To determine the EOQ, the mathematical approach will be used to find the feasible region by
computing the EOQ for each range as follows:
Range 1 to 1,000, when there is no discount.

Annual demand = 4,500
Ordering cost per order = N5,000
Holding cost per stock = 8% x N450 = N36
EOQ =  (2 x 4,500 x N5,000)/N36 = 1,118 units
1,118 units is outside the range of 1 to 1,000 units, therefore it is not feasible.
Range 1,001 to 3,000, 5% discount.

Holding cost per stock = 8% x N450 x 95% = N34.20
EOQ = (2 x 4,500 x N5,000)/N34.20 = 1,147 units
1,147 units falls within the range of 1,001 to 3,000 units, therefore it is feasible.
Range 3,001 to 5,000, 7% discount

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EOQ =  (2 x 4,500 x N5,000)/N33.48 = 1,159 units
1,159 units is outside the range of 3,001 to 5,000 units, therefore it is not feasible.
Range 5,001 and above, 10% discount.

EOQ =  (2 x 4,500 x N5,000)/N32.40 = 1,179 units
1,179 units is outside the range of 5,001 units and above, therefore it is not feasible.
The tabular method will be thereafter used to determine the total annual cost for the feasible units
and the lower class boundary for the ranges that are not feasible.
The total annual costs

Ordering sizes 1 1,147 3,001 5,001
N N N N
Total annual purchase costs 2,025,000 1,923,750 1,883,250 1,822,500
Total annual ordering costs 22,500,000 19,616 7,498 4,499
Total annual holding costs 18 19,614 50,237 83,717
Total annual costs 24,525,018 1,962,980 1,940,985 1,910,716
From the computation above, it is advisable to order 5,001 units per order, which is the ordering
size that minimizes the total annual costs.
EOQ WITH PROBABILITY IN THE COMPUTATION OF SAFETY STOCK
At times, computation of safety stock will involve probability. This probability must be established
and used appropriately in the computation of safety stock otherwise referred to as minimum stock
level.
ILLUSTRATION
BQ Company inventory’s related records for a particular raw material revealed the following:
annual usage 821,300 units, the company works for 350 days in a year. The interval between
placing and receiving an order is 25 days and 15 days respectively. The annual cost of holding one
unit of material is N4.00 and the ordering cost per order is N16.00.
The pattern of usage in the past years is given below:
Lead time usage Number of times
8,000 5
7,600 9
8,500 12
8,100 17
8,300 23
8,700 19
7,800 15
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The management has estimated that the stock is N20.00 for each unit of shortage. The present
safety stock is 8,100 units.
(a). Determine the optimum safety stock.
(b). What is the savings in cost from the decision to change to the optimum safety stock.
SUGGESTED SOLUTION
(a). Obtain the average usage: using weighted average method after arranging usage in
ascending order.
Usage Workings Probability Exp.Usage
7,600 9/100 0.09 684
7,800 15/100 0.15 1,170
8,000 5/100 0.05 400
8,100 17/100 0.17 1,377
8,300 23/100 0.23 1,909
8,500 12/100 0.12 1,020
8,700 19/100 0.19 1,653
Total 8,213
The average stock is 8,213 units. If the firm decides to maintain its stock level at 8,213
units, it will only face stock shortage when usage is above this level that is when it is 8,300,
or 8,500 units or 8,700 units.
From the above, the possible situation that can occur which may lead to stock out are:-
i. To maintain an average stock of 8,213 units and the usage is either 8,300 units or 8,500
units or 8,700 units.
ii. To maintain stock of 8,300 units and usage is either 8,500 or 8,700 units.
iii. To maintain stock of 8,500 units and the usage is 8,700 units.
Each of these situations cannot occur together, they can only occur differently. Each
situation is known as state of nature. They can be shown as follows:
Situation I Stock level = 8,213

Demand = 8,300 or 8,500 or 8,700
Situation ii Stock level = 8,300

Demand = 8,500 or 8,700
Situation iii Stock level = 8,500

Demand = 8,700
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None of these situation has100% assurances of occurring, therefore we can say they are not
certain to occur. However, one can convert them to certainty by multiplying them with
their probability of occurrence:
Thus, Situation I
Demand = 8,300 8,500 8,700
Stock level = 8,213 8,213 8,213
Shortage in units = 87 287 487
Probability of occurrence 0.23 0.12 0.19
Expected units = 20.01 34.44 92.53 = 146.98
Excess stock = 0
This is because all possible demand is higher than the quantity stored.
Situation II
Demand = 8,500 8,700
Stock level = 8,300 8,300
Shortage in units = 200 400
Probability of occurrence 0.12 0.19
Expected units = 24 76 = 100
Excess stock = 8,300 – 8,213 = 87 units
Situation III
Demand = 8,700
Stock level = 8,500
Shortage in units = 200
Probability of occurrence 0.19
Expected units = 38 = 38
Situation IV
Demand = 8,700
Stock level = 8,700
Shortage in units = 0
The total inventory cost at the various stock level
Situations I II III IV
Stock levels 8,213 8,300 8,500 8,700
Stock-out units 146.98 100 38 0
Excess stock units 0 87 287 487
N N N N
Stock out cost @ N20/unit 2,939.60 2,000.00 760.00 -
Excess stock costs @ N4/u - 348.00 1,148.00 1,948.00
Total costs 2,939.60 2,348.00 1,908.00 1,948.00
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The optimum safety stock is the one at which the stock out cost plus excess stock cost is at
minimum, which is 8,500 units at that stock level the total cost is N1,908.
b. To determine the effect of the optimum stock level on present safety stock of 8,100 units, the
stock out and excess stock quantity when Demand are 8,300 or 8,500 or 8,700 will be
computed. The excess and stock out:
Thus, Situation I
Demand = 8,300 8,500 8,700
Stock level = 8,100 8,100 8,100
Shortage in units = 200 400 600
Probability of occur. 0.23 0.12 0.19
Expected units = 46 48 114 = 208 units
Excess stock =0
Total cost at 8,100 units = 208 x N20 = N4,160

Cost at optimum level = N1,908
Savings in cost = N2,200
ILLUSTRATION 2
Storage Limited operates a 50-week working year. It produces a product called “GENERAL” for
which demand any week in the year is described by the probability distribution below:
Demand Probability
0 .07
1 .10
2 .11
3 .13
4 .15
5 .17
6 .17
7 .08
8 .04
9 .02
Demand can only be satisfied (if at all) from stocks. The stock-holding costs are 34 per item per
year. Fixed costs per re-order are N16 and the variable re-order costs are N30 per unit. Lead-time is
one week. The costs of being out of stock are N12 per unit short.
You are required to calculate:
(i) the average weekly demand

(ii) the average annual demand
(iii) the economic order quantity; and
(iv) the number of ordering cycles in the year.
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SUGGESTED SOLUTION
STORAGE LTD
(i) The average weekly demand:
Pr Demand Expected Demand
0.07 0 0
0.10 1 0.1
0.11 2 0.22
0.13 3 0.39
0.15 4 0.60
0.17 5 0.85
0.13 6 0.78
0.08 7 0.56
0.04 8 0.32
0.02 9 0.18
4 units
(ii) The average annual demand:
= Average weekly demand X No of week in the year
= 4 X 50 = 200 units
(iii) The economic order quantity:

= (2 X200 X 16)/4 = 40units
(iv) The number of ordering cycles in the year:

= Annual Demand/EOQ = 200/40 = 5 times.
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CHAPTER 10
PRICING DECISIONS
This involves the determination of the appropriate value to be attached to goods and services of a
company for the purpose of exchanging the goods and services with customers or between/among
sister divisions. For many products, services and commodities, the price is the most important
determinant of demand. Even where other factors, such as quality, reliability and availability are
important, price will still be an important determinant of demand. Pricing decision can therefore be
said to be a crucial decision that management must give its due attention. As a good pricing
decision can make a company, so also a bad pricing decision can mar a business.
Pricing decision is a routine and strategic decision because, in the first place, price must be able to
respond to market pressure to ensure continuity, and, equally pricing must be in line with the
organization’s set objective or goal, in other words, it must lead to accomplishment of the set
overall objective of the organization.
Pricing decision can be broadly categorized into two as follows:
1. Internal pricing, otherwise known as transfer pricing. This will be discussed latter.
2. External pricing that is selling price or the price it is desirable to exchange the goods and
services. This is the focus of our discussion here.
Determining external price of our goods and services, two cogent factors are normally considered
for an appropriate pricing. These are:
1. The Qualitative factors

2. The Quantitative factors
The qualitative factors are price influencers that cannot be quantified in terms of value but goes a
long way to determine the appropriateness of our pricing system. Some of the factors that are
imperative to pricing decisions include:
1. The company’s goals or objectives, that is, is it a profit maximizing or service

organization?
2. The elasticity and nature of the firm’s product as well as the stage of the product in the
product’s life cycle.
3. The nature of market, perfect or imperfect market, level of competition or nature of
competition.
4. The cost structure of the company’s product, that is, percentage of variable cost to fixed
cost.
5. The firm position in the market e.g. market leader or otherwise.
6. The level of activities, i.e. production capacity.
7. Consideration of the possibility of working at full capacity.
8. The level and nature of inflation
9. What is the extent of availability of substitute products?
10. The effects of government policies on the company’s operations.
11. Availability of resources and their costs
12. The general environment as relating to the standard of living of customers etc.
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In pricing decisions, due consideration is normally given to the qualitative factors, although it can
be stated that one is not more important than the other, but the qualitative factors at times carry
more weight, for example when using a product as a loss center. In any case, the two factors must
be accorded the same weight because any price set, should be able to recover all costs (except as
cited above) and make adequate returns to ensure the continuity of the company.
IMPORTANT FACTORS IN PRICING
Three important factors that influence the pricing of a product or service are:
 Costs
 Customers
 Competition
COSTS-BASED PRICING : THE ACCOUNTANT’S APPROACH
Cost plus pricing is a much favoured traditional approach to establishing the selling price by
calculating the unit cost and adding a mark-up or margin to provide for profit. The unit cost may
reflect: full cost, manufacturing cost, variable cost.
The mark-up or margin is equally subjective and often reflects: the risk involved in the product,
competitors’ mark-ups/margins, desired profit and return on capital employed (ROCE), type of cost
used, type of product, etc.
Note that profit mark-up is the profit quoted as a percentage of the cost, while, profit margin is the
profit quoted as a percentage of the selling price.
ILLUSTRATION
If the full cost of a product is N640, calculate the selling price per unit using 20% mark-up and a
20% profit margin.
SUGGESTED SOLUTION
Selling price using 20% mark up = N640 x 1.2 = N768
Selling price using 20% margin = N640/.8 = N800
CUSTOMER BASED PRICING – THE MARKETER’S APPROACH
Customer-based pricing reflects customers’ perceptions of the benefits they will enjoy (e.g.
convenience, status, etc.). This approach has regards to costs – customer-based pricing must ensure
that financial objectives are met but exploit the willingness of customers to pay a multiple of the
cost price if they perceive the benefits to be substantial, has as its first step the production of a
profile of the target customer and reflects a belief that the greater the understanding of the wants,
needs and values of your customer the better placed you are to price the product.
COMPETITION-BASED PRICING
Competition-based pricing means setting a price based upon the prices of competing products.
Competing products can be classified as:
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 The same type of product – easily distinguished from one’s own products - price changes
by competitors will not have a material impact.
 The same type of product – not easily distinguished from one’s own products – price
changes by competitors will have a material impact.
 Substitute products that may be bought instead of your type of product (e.g. buy ice cream
instead of soft rinks on a hot day).
 Impact of price changes will depend on relative price/performance of substitute.
PRICING STRATEGIES
1. Cost-plus pricing strategy – This is widely used and simple to calculate if costs are
known, the full cost of production will be determined to which margin or mark-up will be
added. Realisation of the target profit is dependent upon: accurate knowledge of costs, the
selling price arrived at being one which customers are prepared to pay and selling the
planned volume of goods.
2. Market-skimming pricing strategy – is an attempt to exploit those sections of the market

which are relatively insensitive to price changes. Initially high prices may be charged to
take advantage of the novelty appeal of a new product when demand is initially inelastic. A
skimming policy offers a safeguard against unexpected future increases in costs and a large
fall in demand after the novelty appeal has declined. Once the market becomes saturated
the price can be reduced to attract that part of the market that has not been exploited.
3. Penetrating pricing strategy – is the charging of low prices when a product is initially
launched in order to gain rapid acceptance of the product. Once market share is achieved,
prices are increased. The circumstances which favour a penetration policy are as follows:
 If the firm wishes to discourage new entrants from entering the market.
 If the firm wishes to shorten the initial period of the product’s life cycle in order to
enter the growth and maturity stages as quick as possible.
 If there are significant economies of scale to be achieved from high-volume output, and
so a quick penetration into the market is desirable in order to gain those unit cost
reductions.
 If demand is highly elastic and so would respond well to low prices.
For penetration pricing to be effective, the total market in which the firm is operating must
be substantial and the anticipated market share must be significant.
Penetrating pricing, if exploited to the full, becomes predatory pricing; its objective is to
eliminate competition through use of unsustainably low prices. Predatory pricing is illegal.
4. Complementary-product pricing – is one that is normally used with another product. An

example is razors and razor blades – if sales of razors increase more razor blades will also
be bought. Other examples of complementary products are: games consoles and associated
games, printers and printer cartridges. Complementary goods:
 Provide suppliers with additional power over the consumer.
 Potentially enable suppliers to lock consumers into an ongoing stream of purchases by
ensuring that only proprietary consumables (e.g. printer cartridges) can be used in their
products.
 Enable suppliers to increase the consumer’s switching cost – in order to use cheaper
cartridges the consumer would have to abandon his original printer and purchase one
that allowed him to use non-proprietary cartridges.
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5. Product-line pricing strategy – is a range of products that are intended to meet similar
needs of different target audiences. Thus all products within a product line are related but
may vary in terms of style, colour, quality, etc. Product-line pricing works by:
 Capitalizing on consumer interest in a number of products within a range.
 Making the price entry point for the basic product relatively cheap.
 Pricing other items in the range more highly – in order to complete the set the
consumer has to pay substantially more for the additional matching items.
6. Volume-discounting pricing strategy – this is offering customers a lower price per unit if
they purchase a particular quantity (volume) of product. It takes two main forms: Quantity
discounts – for customers that order large quantities and cumulative quantity discounts –
the discount increases as the cumulative total ordered increases. This may appeal to those
who do not wish to place large individual orders but who purchase large quantities over
time. The volume discounter may enjoy the following benefits from this strategy:
 Increased customer loyalty – cumulative quantity discounts lock in the customer since
further purchases can be made at a lower cost per unit.
 Attracting new customers – an exceptional level of discount can be offered to new
customers on a one-off basis, enabling the supplier to get his foot in the door.
 Lower sales processing costs – an increased proportion of his sales take the form of
bulk orders.
 Lower purchasing costs – his increased sales volumes enable him to enjoy discounts
from his suppliers, creating a virtuous circle.
 Discounts help to sell items that are bought primarily on price.
 Competitive advantage – the discounts encouraging customers to concentrate their
orders rather than try out new suppliers.
 Clearance of surplus stock – the discount level can be increased to clear unpopular
items.
 Increased use of off-peak capacity – discounts are geared to particular off-peak periods.
7. Price-discrimination pricing strategy – is where a company sells the same products at

different prices in different markets. This is possible if the seller can determine the selling
price, customers can be segregated into different markets and customers cannot buy at the
lower price in one market and sell at the higher price in the other market. Segmentation
will usually be on the basis of one or more of the followings: time, age, gender, type of
service, geographical location, quantity, type of customer, etc.
8. Minimum pricing strategy – here relevant costs are used to arrive at a minimum tender
price for a one-off order or contract. The use of relevant costs is only suitable for a one-off
decision since:
 Fixed costs may become relevant in the long run.
 There are problems estimating incremental cash flows
 There is a conflict between accounting measures such as profit and this approach.
QUANTITATIVE ASPECT OF PRICING
The quantitative factor is the accumulation of cost and addition of expected returns in order to
establish appropriate selling price using either the Accountant’s point of view or the Economist’s
approach.
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Using the Accountant’s approach, the price of goods and services can be determined using either
the,
1. Absorption costing technique, or the,
2. Marginal costing technique
These have been discussed in detail under marginal costing technique for short or one off decisions
specifically when considering special/minimum pricing.
Economists believe that price is at the optimal when marginal revenue equate marginal costs, that is
MR = MC. This optimal selling price can be determined using either:
(a). Tabular method
(b). Mathematical method
TABULAR METHOD FOR PRICING DECISION
Using this approach, the various demands at the different prices will be tabulated by determining
the total sales value and total cost. The point at which the profit is maximized will be the optimal
price and the quantity at this price will be the optimum quantity. The Economists’ general
statement of the lower the price, the higher the quantity demanded and the higher the price the
lower the quantity demanded, is generally observed in this computation.
ILLUSTRATION
Tolu Company Limited presents you with the following data about its product.
Variable cost per unit N75.00
Total fixed costs N800,000
The company is considering the following alternatives of selling prices and the corresponding
demand level :
Selling Price Demand
(N) (kgs)
180 0
150 3,000
140 3,500
132 4,000
118 5,000
101 5,500
92 6,300
88 7,000
57 10,000
0 16,000
You are to determine the optimal selling price, the output and the profit, using the tabular method.
SUGGESTED SOLUTION
Calculation of the optimal selling price
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Selling Demand Total Total Total Fixed Net profit
Price (N) (kgs) Sales(N) Variable (N) Cost (N) /(loss) (N)
180 - - - 80,000 (80,000)
150 3,000 450,000 225,000 80,000 145,000
140 3,500 490,000 262,500 80,000 147,500
132 4,000 528,000 300,000 80,000 148,000
118 5,000 590,000 375,000 80,000 135,000
101 5,500 555,500 412,500 80,000 63,000
92 6,300 579,600 472,500 80,000 27,100
88 7,000 616,000 525,000 80,000 11,000
57 10,000 570,000 750,000 80,000 (260,000)
- 16,000 - 1,200,000 80,000 (1,280,000)
From the computation above, profit is maximized at selling price of N132. Therefore the optimal
selling price is N132 and the optimal quantity is 4,000 kgs.
MATHEMATICAL METHOD FOR PRICING DECISION
Differential calculus is used in the determination of the optimal selling price and quantity. To use
this, the total cost function must be derived, that is Y = a + bx or re-written as TC = a + bQ
Where a = Total fixed cost, or constant cost
b = Variable cost per unit, or rate of variability
Q = Quantity demanded or sold
Using differential calculus, the marginal cost equation will be derived as MC = dTC/dQ
Equally, total revenue function will be obtained as follows: TR = P x Q
Where TR=Total Sales/Revenue, P= Selling Price, Q = Quantity Demanded or Sold.
To obtain the total revenue function as stated above, it is necessary to first of all obtain the price
function (otherwise known as demand function). In line with the Economist’s theory, the price
function is given as P = a + bQ
Where P = Price Level, a = Constant Income, b = Gradient or slope of the demand curve i.e. rate of
variability. Q = Quantity Demanded/Sold.
With the above, the revenue function can therefore be stated as TR = (a+bQ) x Q or
TR = aQ + bQ2
Using differential calculus the marginal revenue will be derived as: MR = dTR/dQ
The optimal selling price is obtained at the demand level where MR = MC
ILLUSTRATION 1
Using the same data in Tolu Company Limited in our last illustration above.
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Determine the optimal selling price and quantity, using mathematical method.
SUGGESTED SOLUTION
As earlier stated, the profit is maximized where the marginal cost equates the marginal revenue i.e.
MR = MC
The marginal cost
TC = a + bQ , a = N80,000 and b = N75,
TC = N80,000 + N75Q using differential calculus MC = dTC/Q, dTC/Q = N75 i.e. MC = N75
The marginal revenue

TR = P x Q and P = a + bQ
At the highest price level

P = N180 Q = 0 substituting these in equation two
N180 = a + b(0) and a = N180
At the lowest price level

P = 0 Q = 16,000 substituting these in P equation
0 = a + b (16,000), substitute for value a = N180 as determined above
0 = N180 + b(16,000) therefore b = (0 – N180)/16,000 b = -0.01125 i.e. the gradient of income
Therefore P = N180 – 0.01125Q and TR = P x Q

TR = (N180 – 0.01125Q) x Q TR = N180Q – 0.01125Q2
MR = dTQ/Q = N180 – 0.0225Q
Calculation of optimum quantity

MR = MC
N180 – 0.0225Q = N75
-Q = (N75 – N180)/0.0225 = 4,667 units
The optimal selling price

P = N180 – 0.01125(4,667), P = N127.50
The maximum profit

Profit = TR – TC = (180Q – 0.01125Q2) – (80,000 + 75(4,667))
= (180(4,667) – 0.01125(4,667)2) – (80,000 + 75(4,667)) = N165,000
ILLUSTRATION 2
Okeke & Sons Limited operates a company that produces to order and carries no inventory. Its
demand function is estimated to be:
P = 4,000 – 2Q (where P = unit selling price in Naira and Q = quantity demanded in thousands of
units).
Its total cost function is estimated to be:
C = Q2 + 1,000Q + 50,000 ( where C = total cost in N’000 and Q is as above).
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You are required in respect of this company to:
(i). Calculate the output in units, which will maximize profit, and the corresponding unit selling
price, total profit and total sales revenue.
(ii). Calculate the output in units, which will maximize revenue and the corresponding unit selling
price, total loss and sales revenue.
SUGGESTED SOLUTION
(i). The demand price function P = 4,000 – 2Q

Revenue function could be derived from the above as R = (4,000 – 2Q) x Q
= 4,000Q – 2Q2 and the marginal revenue using differential calculus will be:
MR = 4,000 – 4Q
The cost function C = Q2 + 1,000Q + 50,000,

using differential calculus marginal cost: MC = 2Q + 1,000
Profit is maximized where marginal cost equates marginal revenue.

2Q + 1,000 = 4,000 – 4Q
6Q = 3,000 and Q = 500 x 1,000units = 500,000 units
Unit selling price P = 4,000 – 2(Q) = 4,000 – 2(500) = N3,000
Profit = ((500 x 3,000) – (5002 + 1,000(500) + 50,000)) x 1,000 = N700,000,000
Total revenue = (500 x 3,000) x 1,000 =N1,500,000,000
(ii) Revenue is maximized where marginal revenue is equal to zero in accordance with
economic principles i.e. MR = 0, substituting this in the marginal revenue equation, 0 =
4,000 – 4Q therefore Q = 1,000 x 1,000 = 1,000,000 units
Selling price = 4,000 – 2(1,000) = N2,000
Net loss = ((1,000 x 2,000) – (1,0002 + 1,000(1,000) + 50,000)) x 1,000 = -N50,000,000
Sales revenue = (1,000 x 2,000) x 1,000 = N2,000,000,000.
ILLUSTRATION 3
A company market survey undertaken by the research department reveals the following
Price (N) Daily demand (units)
90 400
98 340
106 280
114 220
The daily total cost function is estimated at C = 0.06Q2 + 30Q + 750
Required:
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(a). Find the equation of the demand curve.
(b). Calculate the output in units per day, which maximizes profit.
(c). Calculate the output in units per day, which maximizes total revenue
(d). Find the equation of the profit curve.
SUGGESTED SOLUTION
(a). In order to determine the demand curve, the price at which quantity will be zero and the
quantity at which price will be zero will be determined using the slope of the price and the
high and low method of separating costs.
Demand Price
High point 400 90
Low point 220 114
Difference 180 -24
Rate of variability in price = -N24/180 = -N0.1333. In other words, as price reduces by 13
kobo, a unit will increase by one, therefore at N90 + (4,000 x N0.1333) = N143 per unit,
demand will be zero.
Equally as a unit increases by one, the price will reduce by 13 kobo, the unit at which price
will be zero can be determined as follows = 400 + N90/N0.1333 = 1,075 units.
The price function P = a + bQ at maximum price P = 143 and Q = 0

143 = a + b(0) a = 143
At minimum price P = 0 and Q = 1,075

0 = 143 + b(1,075) b = -0.1333Q
Therefore equation of the demand curve P = 143 – 0.1333Q
(b). Profit is maximized where marginal cost equates marginal revenue. The revenue function
will be TR = P x Q = 143Q – 0.1333Q2
MR = 143 – 0.266Q
Cost function = TC = 0.06Q2 + 30Q + 750

MC = 0.12Q + 30
The daily quantity that maximizes total profit will be derived where marginal revenue
equates marginal cost = 0.12Q + 30 = 143 – 0.266Q
0.12Q + 0.266Q = 143 –30
Q = 293 units.
(c). Output in units that maximized revenue, this will be the point where marginal revenue is
zero. = 143 – 0.266Q = 0 and Q = 143/.266 = 538 units.
(d). The equation of the profit curve. Profit = TR –TC
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= (143Q – 0.133Q2) – (0.06Q2 + 30Q + 750)
= 143Q – 0.133Q2 – 0.06Q2 + 30Q + 750
=-0.133Q2 – 0.06Q2 + 143Q + 30Q +750
= -0.193Q2 +113Q – 750
ILLUSTRATION 4
Michael Wax Industries Limited sells a product, which has a variable cost of N8 per unit. The sales
demand at the current sales price of N14 is 3,000 units. It has been estimated by the marketing
department that the sales volume would fall by 100 for each addition of 25 kobo to the sales price.
Required:
Is the current price of N14 price the optimal price, which maximizes contribution?
SUGGESTED SOLUTION
MICHAEL WAX INDUSTRIES LIMITED

Calculation of optimum selling price.
Selling Variable Contribution Total Total
Price (N) Cost (N) Margin (N) Quantity Contrib.(N)
14.00 8.00 6.00 3,000 18,000
14.25 8.00 6.25 2,900 18,125
14.50 8.00 6.50 2,800 18,200
14.75 8.00 6.75 2,700 18,225
15.00 8.00 7.00 2,600 18,200
15.25 8.00 7.25 2,500 18,125
15.50 8.00 7.50 2,400 18,000
15.75 8.00 7.75 2,300 17,825
16.00 8.00 8.00 2,200 17,600
16.25 8.00 8.25 2,100 17,325
From the computation above the optimum selling price is N14.75, which is the selling price at
which contribution is maximized.
ILLUSTRATION 5
XYZ Ltd is introducing a new product. Details of the costs are as follows:
Hire costs – hiring the machinery to manufacture the product will cost N200,000 per annum. This
machine will enable 60,000 units per annum to be produced. Additional machines can be hired at
N80,000 per annum. Each machine hired enables capacity to be increased by 20,000 units per
annum, but it is not possible to increase production beyond 90,000 units because of shortage of
space.
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The minimum rental period is for one year and the variable cost is estimated to be N6 per unit
produced. There are no other fixed costs that can be specifically traced to the product.
Marketing management has estimated the maximum selling prices for a range of output from
50,000 units to 90,000 units. The estimates are as follows:
Units sold 50,000 60,000 70,000 80,000 90,000 90,000x

Selling price (N) 22 20 19 18 17 15
x at N15, demand will be in excess of 90,000 units but production capacity will limit the sales.
Required
What is the optimum selling price?
SUGGESTED SOLUTION
Calculation of the total profit for each of the selling prices.

N N N N N N
Selling price per unit 22 20 19 18 17 15
Variable cost per unit -6 -6 -6 -6 -6 -6
Contribution per unit 16 14 13 12 11 9
Number of units sold 50,000 60,000 70,000 80,000 90,000 90,000
Total contribution (N) 800,000 840,000 910,000 960,000 990,000 810,000
Less fixed costs (N) (200,000) (200,000) (280,000) (280,000) (360,000) (360,000)
Net profit (N) 600,000 640,000 630,000 680,000 630,000 450,000
From the computation above, it is advisable to produce and sell 80,000 units at N18 per unit, that is
the selling price at which profit is maximized
ILLUSTRATION 6
Mr. Smith has been asked to quote a price for a special contract. He has already prepared his tender
but has asked you to review it for him. He has pointed out to you that he wants to quote the
minimum price as he believes this will lead to more lucrative work in the future.
Mr. Smith’s tender:
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N
Materials: A 2,000 kgs @ N10 per kg 20,000
B 1,000 kgs @ N15 per kg 15,000
C 500 kgs @ N40 per kg 20,000
D 50 litres @ N12 per litre 600
Labour: Skilled 1,000 hrs @ N25 per hr 25,000
Semi-skilled 2,000 hrs @ N15 per hr 30,000
Unskilled 500 hrs @ N10 per hr 5,000
Fixed overheads 3,500 hrs @ N12 per hr 42,000
Costs of preparing the tender:
Mr. Smith's time 1,000
other expenses 500
Minimum profit (5% of total costs) 7,955
Minimum tender price 167,055
Other information:
Material A – 1,000 kgs of this material is in stock at a cost of N5 per kg. Mr. Smith has no
alternative use for this material and intends selling it for N2 per kg. However, if he sold any he
would have to pay a fixed sum of N300 to cover delivery costs. The current purchase price is N10
per kg.
Material B – There is plenty of this material in stock at a cost of N18 per kg. The current purchase
price has fallen to N15 per kg. This material is constantly used by Mr. Smith in his business.
Material C – The total amount in stock of 500 kgs was bought for N10,000 some time ago for
another one-off contract that never happened. Mr. Smith is considering selling it for N6,000 in total
or using it as a substitute for another material, constantly used in normal production. If used in this
latter manner it would save N8,000 of the other material. Current purchase price is N40 per kg.
Material D – There are 100 litres of this material in stock. It is dangerous and if not used in this
contract will have to be disposed of at a cost to Mr. Smith of N50 per litre. The current purchase
price is N12 per litre.
Skilled labour – Mr. Smith only hires skilled labour when he needs it. N25 per hour is the current
hourly rate.
Semi-skilled labour – Mr. Smith has a workforce of 50 semi-skilled labourers who are currently
not fully employed. They are on annual contracts and the number of spare hours currently available
for this project are 1,500. Any hours in excess of this will have to be paid for at a time-and-a-half.
The normal hourly rate is N15 per hour.
Unskilled labour – These are currently fully employed by Mr. Smith on jobs where they produce a
contribution of N2 per unskilled labour hour. Their current rate is N10 per hour, although extra
could be hired at N20 an hour if necessary.
Fixed overheads – This is considered by Mr. Smith to be an accurate estimate of the hourly rate
based on his existing production.
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Costs of preparing the tender – Mr. Smith has spent 10 hours working on this project at N100 per
hour, which he believes is his charge-out rate. Other expenses include the cost of travel and
research spent by Mr. Smith on the project.
Profit – This is Mr. Smith’s minimum profit margin which he believes is necessary to cover
general day-to-day expenses of running a business.
Required
Calculate and explain for Mr. Smith what you believe the minimum tender price should be.
SUGGESTED SOLUTION
Calculation of the minimum tender price for the job.

N N
Materials: A (1,000 kgs @ N2)- N300 1,700
A 1,000 kgs @ N10 10,000 11,700
B 1,000 kgs @ N15 15,000
C opportunity cost 500 kgs 8,000
D 50 litres @ N50 - Savings (2,500)
Labour: Skilled 1,000 hrs @ N25 25,000
Semi-skilled 500 hrs @ N15 x 1.5 11,250
Unskilled 500 hrs @ N12 - opportunity cost 6,000
Minimum tender price 74,450
NOTES TO THE SOLUTION
1. Material A – The 1,000 kgs already in stock could only be sold for N2,000 less N300
selling cost, therefore, the benefit that will be for gone is N1,700 relevant to the job, while
the balance of 1,000 will be purchase at N10 per kg.
2. Material B – As this material is constantly used, the replacement cost therefore becomes
relevant.
3. Material C – It is either to sell for N6,000 or used as a substitute to save N8,000, the latter
will be preferred and the opportunity cost of the material.
4. Material D – the material is already obsolete and the cost of disposing will be saved.
5. Skilled labour – It is incremental cost and therefore relevant.
6. Semi-skilled labour – the excess required above what is currently available i.e. 2,000 –
1,500 = 500 hours to be paid at time-and-a half.
7. Unskilled labour – since it is fully engaged, the opportunity cost will be the labour rate of
N10 plus contribution that will loss from current engagement of N2 per hour.
8. Fixed overheads, costs of preparing the tender and profits element are irrelevant cost and
should be ignored.
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CHAPTER 11
PERORMANCE EVUALUATION IN A DIVISIONALISED ORGANISATION
Organizational structure can be classified according to the nature and complexity of a particular
organization but generally this classification may be based on the diversity of the product range or
services and the experience of the management team. However, organizational structure may be
properly classified as follows:
(a). Centralized structure: This is a situation where the decision making process is vested in
the hands of an individual or a group of people. This structure is normally adopted
mostly by private companies or what can be properly referred to as a one-man business
(sole proprietorship).
(b). Decentralized structure: Under this method, the decision-making machinery is

demarcated according to the hierarchy of management in the organization. In most
organizations, this demarcation will be in the following order. Top Management; for
strategic decisions, Middle Management; for tactical decisions and Lower Management;
for operational decisions.
(c). Divisionalised structure: This can be described as an independent decision making unit
incorporated out of a central organization for the purpose of an effective, efficient
decision process in the organization. Initially, a decision affecting operations arising
from a division will be settled within the division without un-necessarily waiting for top
management actions. This method is best suited for multi-national organizations.
RESPONSIBILITY ACCOUNTING
Responsibility accounting is an underlying concept of accounting performance measurement

systems. The basic idea is that large diversified organizations are difficult, if not impossible to
manage as a single segment, therefore they must be decentralized or separated into manageable
parts. These parts or segments are referred to as responsibility centers. These centers are made
accountable, thus responsibility accounting is the term used to describe the measurement of the
performance of a decentralized unit in terms of an accounting result. Responsibility accounting,
profitability accounting and activity accounting recognizes various decision centers and trace
revenue, costs, assets and liabilities to the manager responsible for them. It is officially defined in
accounting as “a system of accounting that segregates revenue and cost into areas of personal
responsibilities in order to assess the performance attained by persons to whom authority have been
assigned.” A responsibility center is a unit of an organization headed by a manager and having
direct responsibility for its performance. Responsibilities centers include:
 Revenue centers
 Cost centers
 Profit centers and
 Investment centers
REVENUE CENTERS
These are segments or centers that mainly generate revenue with relatively little costs. These are
mostly marketing divisions, whose main responsibilities are to drive sales and thereby major in
revenue generation with very little costs. Performance measurement of revenue centers is done
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through the use of variance analysis, specifically, sales variances, sales price variances and sales
volume variances.
COST CENTRES
These are departments or sections or functions over which a designated individual has
responsibility for expenditure. Cost centers are relatively simple and consist mainly of locations at
which costs can be separately identified and collected. Such include production and service
functions or departments. They form the most widely spread basis for cost control and can consist
of a single person or machine. Provided a cost number or job number is allocated, costs can be
broken there to and separately recorded. For interdepartmental performance comparison a unit of
measurement of output is required although in its absence the absolute total cost can be compared.
It is necessary at each cost centers to separate those costs directly responsible and those costs which
may be apportioned to the centers. Performance measurement of cost centers is done using variance
analysis broken down into various items.
PROFIT CENTERS
These are centers or segments that generate both revenue and costs. These are segments of a
business entity by which both revenue and expenditures are controlled. It thus differs from cost
centers because revenue also is accumulated and thereby profit or loss is established within the
given segment.
The prime need therefore is the ability to segregate a definable amount of sales generated by the
particular segment. The person responsible for a profit center should have control over both the
sales policy and the production facilities. Profit centers generally are likely to be larger than cost
centers and may include a number of cost centers. Gross profit or contribution margin, operating
income and net income plus variance analysis generally are the methods used to appraise profit
centers.
INVESTMENT CENTERS
These are segments or centers such as divisions of a company where the managers control the
acquisition and utilization of assets, as well as revenue and costs. The managers control what to
produce and how to produce i.e. they have autonomy unlike profit center managers. Typical
investment centers are divisions of large companies. The centers are profit centers controlling
revenues and costs but also in addition, the profit is related to the asset employed in earning that
profit.
The prime need is the identification of the assets employed in the particular business segment or
product line. This is because many assets may be in common use by several profit centers. For
example, a factory building, this may contain purchasing, transport, production etc. divisions. An
investment center may be larger than profit centers, at times such a center may comprise several
profit centers giving control at a higher stage in the management structure. The performance of an
investment center could be measured through the use of return on capital employed, absolute net
profit, residual income, variance analysis etc.
METHODS OF EVALUATING DIVISIONS
There are several methods available to evaluate the performance of divisional managers, these
include the following:
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1. Variance Analysis: This will be applicable in organizations that operate standard costing
techniques, where earlier standards set will be compared with actual, to show efficiency or
otherwise in operations and equally to constantly ensure activities moves in line with
projections for actualization of objectives or goals. Variance analysis will be discussed in
detail latter.
2. Absolute Profit: This can also be referred to as the net profit statement produced by a
Financial Accountant at the end of a financial year or total contribution/net profit produced
by a Management Accountant for that particular division. A divisional manager is assumed
to be effective if the financial statement reflects a positive contribution and vice-visa.
3. Return on Capital Employed (ROCE): Otherwise known as return on investment (ROI),

unlike the absolute profit, this method measures the rate of efficiency by dividing the net
profit with capital employed or total returns with total investment. If the expected result is
higher than the imputed cost of capital then the divisional manager is expected to be
commended at the end of the year or otherwise.
The advantages of this method are as follows:

 It is widely used and accepted.
 As a relative measure it enables comparisons to be made with divisions or companies
of different sizes.
 It can be broken into secondary ratios for more detailed analysis.
The disadvantages of the method are as follows:

 It may lead to dysfunctional decision making, e.g. a division with a current ROI of
30% would not wish to accept a project offering an ROI of 25%, as this would dilute
its current figure.
 Different accounting policies can confuse comparisons (e.g. depreciation policy).
 ROI increases with age of asset if net book values are used, thus giving managers an
incentive to hang on to possibly inefficient, obsolescent machines.
 It may encourage the manipulation of profit and capital employed figures to improve
results.
4. Residual Income (RI) : This is described as the difference between the absolute profit on
investment and the imputed cost of capital of the organization. This method is considered
to be the best when compared with other methods because the divisional manager is
expected to use his initiative in producing results and the reward of the divisional
manager’s initiative is the end product of this method known as residual income.
The advantages of this method are as follows:

 It encourages investment centre managers to make new investments if they add to RI.
A new investment might add to RI but reduce ROI. In such a situation, measuring
performance by RI would reduce the probability of dysfunctional behaviour.
 Making a specific charge for interest helps to make investment centre managers more
aware of the cost of the assets under their control.
 The notional interest charge might be a reasonably good measure of the economic cost
of the capital employed in the investment centre.
The disadvantages of the method are as follows:

 It does not facilitate comparisons between divisions.
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 It does not relate the size of a division’s profit to the assets employed in order to obtain
that profit.
 It is based on accounting measures of profit and capital employed which may be
subject to manipulation.
CHARACTERISTICS OF A GOOD PERFORMANCE EVAULATION METHOD
For a performance evaluation method to fulfill the purpose of establishing it, it must satisfy the
following characteristics:
1. Performance Evaluation: Any method chosen to evaluate the efficiency or other wise of
the divisional manager must be capable of reflecting the effect of various decisions or
policy statements issued by such a manager and the result on the divisional returns.
2. Uniformity of Objective: No matter the nature of the method chosen, organizational profit
must be considered paramount and such belief must not negate the corporate objective of
the central organization.
3. Autonomy: Any method chosen must maintain the autonomy, that is, the independent
nature of each division. The method must realize that each division is expected to take
appropriate decisions on what to produce on their own without any recourse to central
management.
4. Motivation: Any good performance evaluation method must be able to motivate Managers
to give their best and be committed to the growth of the organization as a whole.
ILLUSTRATION 1
Standard Limited currently uses the return on investment (ROI) method to measure the
performance of its two operating divisions A and B. A summary of the annual reports from the two
divisions for the past year is given below. The company’s cost of capital is 12%.
Division A Division B
Capital Invested (N) 240,000 400,000
Net Income (N) 48,000 72,000
R.O. I. 20% 18%
Required:
(i). As a management accountant, what performance measurement would you recommend that
will show more clearly the relative profitability of the two divisions and why?
(ii). Which division is more profitable? Support your answer with suitable calculations.
(iii). Assume that the manager of division A was offered a one year project that would increase
his investment base (for the year) by N100,000 and show a net profit of N15,000. Would
the manager accept this project if they were being evaluated on the basis of divisional
R.O.I?
Note: Both divisions are investment centers.
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SUGGESTED SOLUTION
(i). The residual income measurement of performance is recommended if there is no capital

rationing, because the method will show at a glance the addition to wealth of the company.
Using this method, the cost of funding or imputed cost of capital will be deducted from the
net income before determining the addition to wealth.
(ii). Calculation of the residual income.
Division A B
N N
Net Income 48,000 72,000
Imputed cost (12% of capital) 28,800 48,000
Residual income 19,200 24,000
Division B is more profitable because it gives a higher additional to fund.
(iii). The Division A manager will not be too willing to accept such a project because it will lead
to reduction in its return on investment (i.e. (48,000 + 15,000/ 240,000 + 100,000) x 100/1
= 18.5%). Therefore division A manager will not be willing to accept the project because it
will lead to reduction on ROI of the division. Only division B will be ready to accept such
a project.
ILLUSTRATION 2
X Limited has 4 divisions operating in Warri, Port Harcourt, Lagos and Kaduna. The following
data are in respect of them:
Warri P.H. Lagos Kaduna

Total Asset (N) 6 million 5 million 7 million 9 million
Total Sales (N) 10 million 15 million 18 million 14 million
Total cost (N) 9 million 13.5 million 16.8 million 13 million
Cost of Capital (%) 14 18 16 10
Required
(i). Calculate the annual return on investment.
(ii). Calculate the residual income.
SUGGESTED SOLUTION
(i). Calculation of the annual return on investment.
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Area Warri P.H Lagos Kaduna
N'm N'm N'm N'm
Total Sales 10.00 15.00 18.00 14.00
Total Costs 9.00 13.50 16.80 13.00
Profit 1.00 1.50 1.20 1.00
Total Assets 6.00 5.00 7.00 9.00
Return on Investment(profit/assets x 100/1) 17% 30% 17% 11%
(ii). Calculation of the residual income

Area Warri P.H Lagos Kaduna
N'm N'm N'm N'm
Net Profit 1.00 1.50 1.20 1.00
Imputed cost (cost of capital x total assets) 0.84 0.90 1.12 0.90
Residual Income 0.16 0.60 0.08 0.10
ILLUSTRATION 3
The following data have been collected in respect of one of your company’s divisions:
Mixing Division
N
Sales Revenue: external customer 60,000
Internal transfer 35,000
Variable operating cost: Labour 9,500
Material 16,000
Overheads 4,250
Fixed operating cost - controllable by division 7,800
controllable centrally 4,100
Division Management cost 2,650
Fixed Assets (at cost): Divisional Purchase 45,000
Total Central Administration and Management costs 68,421
The central administration and management costs are apportioned on the basis of sales revenue,
which was for the group as a whole.
The group’s weighted average cost of capital is estimated at 15% and it is the group’s policy to
calculate depreciation on a straight-line basis at 25% and to compute interest on gross investment
basis.
Required:
To present Mixing Division’s profit statement using the:

(a). Profit center approach
(b). Investment center approach
SUGGESTED SOLUTION
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(a). The Division’s profit statement using the profit center approach.
N N
Sales (60,000 + 35,000) 95,000
Less Relevant Costs
Labour Cost 9,500
Material Cost 16,000
Overhead Cost 4,250
Fixed controllable by division 7,800
Division Management Cost 2,650
Depreciation of division asset (N45,000 x 25%) 11,250 (51,450)
The Division's Net Profit 43,550
Note that sales, external and internal were added together and equally, only costs controlled
by the division were taken into consideration because the focus here is to consider only the
variables that can be influenced by the division, in the evaluation of the division.
(b). Calculation of the division’s profit statement using the Investment Center approach. The
little difference that may be considered here is to compute and deduct the imputed cost of
capital from the division’s net profit determined above.
N
Net profit 43,550
Less Imputed cost of capital (15% x N45,000) 6,533
Residual Income 37,017
In solution to “a” and “b”, the central cost is excluded because the motive is to appraise the
divisional manager based on activities within his control.
ILLUSTRATION 4
A holding company reviews the operations of its three subsidiaries through the use of ROCE,
whereby net profit before tax for the year is related to net assets at the start of the year. Fixed assets
are depreciated on a straight-line basis. The following transactions are proposed by the subsidiaries
for the coming year. Company JK invests N250,000 in a new product to yield a net profit of
N75,000 per annum.
Space for this will be made available by disposing off an existing product line whose net profit is
budgeted at N52,000 for the year ahead. The price will be the book value of the fixed assets bought
three years ago for N150,000 with an expected life of four years, plus the cost of stock which is
N15,500. The replacement value of the old equipment is N200,000.
Company LM investment of N150,000 is a project expected to yield a net profit of N30,000 per
annum.
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Company NP’s sales of a project is expected to produce N25,000 net profit in the year. Where the
original fixed assets cost N900,000 five years ago with an expected life of six years. The
replacement value of these fixed assets is N1,100,000. The selling price will be N170,000.
In connection with the above transactions.
a. All investments include incremental working capital.

b. Any sales or investments, if undertaken would be completed by the start of and included in
the coming year.
c. Assume that all results are as budgeted.
d. Proceeds from sales or disposal of current assets and profit on sale of fixed assets go to the
holding company.
Excluding the above transactions, the budgeted net profit for the subsidiaries for the ensuring year
would be:
Budgeted net
Company Capital employed at Replacement profit
start of year net book Value for year
value (N'000) N'000 N'000
JK 700 950 210
LM 800 1,150 200
NP 900 1,400 300
The company uses 12% as its cost of capital.
You are required:
On the assumption that each transaction goes ahead to:
(i). Calculate the new ROCE for each subsidiary for the coming year.
(ii). State, with explanations, which of the transactions will promote goal congruence between
the holding company and the subsidiary companies
SUGGESTED SOLUTION
(i). The revised ROCE for the subsidiaries

JK Subsidiary Capital Employed Net Profit
N'000 N'000
Budgeted 700 210
Addition 250 75
Reduction ((150,000/4)+15,500) -53 -52
Net balance 897 233
The ROCE = N233,000/N897,000 x 100/1 = 26%
LM Subsidiary Capital Employed Net Profit
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N'000 N'000
Budgeted 800 200
Addition 150 30
Net balance 950 230
The ROCE = N230,000/N950,000 x 100/1 = 24%
NP Subsidiary Capital Employed Net Profit

N'000 N'000
Budgeted 900 300
Addition (N900/6 yrs) 150 25
Net balance 1,050 325
The ROCE = N325,000/N1,050,000 x 100/1 = 31%
(ii). The initial ROCE

Project JK LM NP
Capital employed (N'000) 700 800 900
Net Profit (N'000) 210 200 300
ROCE (%) (NP/CE x 100/1) 30 25 33
Based on the computation above, none of the transactions will promote goal congruence
neither for the subsidiary nor holding company because the addition of the transaction
leads to reduction in ROCE. As computed above, the initial ROCE is higher than the
revised one.
1. What problems might be encountered when a business attempts to incorporate non-financial

measures into its management reports?
2. Sholly Supplies Ltd has an operating division that produces a single product. In addition to the
conventional Residual Income (RI) and Return On Investment (ROI) measures, central
management wishes to use other methods of measuring performance and productivity to help assess
the division.
Identify four possible measures (financial or non-financial) that top management may decide to use.
3. In divisionalised organizations, complete autonomy of action is impossible when a substantial level

of inter-divisional transfers take place.
Required:
a. In this context, explain what is meant by ‘divisionalised organisation’ and ‘autonomy of
action’.
b. What are the benefits of this autonomy?
c. Are there any dangers from permitting autonomy of action and in what ways do inter-divisional
transfers make complete autonomy impossible?
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4. Measures are required to assess the performance of divisions and of divisional managers. Three
financial measures are; ‘contribution’, ‘controllable profit’, and return on investment (ROI)’.
Required:
a. For each of the above measures explain
 The way in which each measure is calculated;
 For what purpose they are most suitably applied; and
 The weaknesses of each method.
b. Suggest three different non-financial measures of performance that may be appropriate to an
operating division and consider how such measures, in general, offer improvements when used
in conjunction with financial measures
5. The following information applies to the planned operations of Division A of ABC Corporation for
next year:
N
Sales revenue (100,000 units at N12) 1,200,000
Variable cost (100,000 units at N8) 800,000
Fixed cost (including depreciation) 250,000
Division A investment (at original cost) 500,000
The minimum desired rate of return on investment is the cost of capital of 20 per cent a year.
The business is highly profit-conscious and delegates a considerable level of autonomy to divisional
managers. As part of a procedure to review planned operations of Division A, a meeting has been
convened to consider two options:
Option X
Division A may sell a further 20,000 units at N11 to customer outside ABC Corporation. Variable
costs per unit will be the same as budgeted, but to enable capacity to increase by 20,000 units, one
extra piece of equipment will be required costing N80,000. The equipment will have a four year life
and the business depreciates assets on a straight-line basis. No extra fixed costs will occur.
Option Y
Included in the current plan of operations of Division A is the sale of 20,000 units to Division B
also within ABC Corporation. A competitor of Division A, from outside ABC Corporation, has
offered to supply Division B at N10 per unit. Division A intends to adopt a strategy of matching the
price quoted from outside ABC Corporation to retain the order.
Required:
a. Calculate Division A’s residual income based on:
 The original planned operation
 Option X only added to the original plan
 Option Y only added to the original plan
and briefly interpret the results of the options as they affect Division A.
b. Assess the implications for Division A, Division B and the ABC Corporation as a whole of
Option Y, bearing in mind that if Division A does not compete on price, it will lose the 20,000
units order from Division B. Make any recommendations you consider appropriate.
6. The following information applies to the budgeted operations of the Goodman division of the
Telling Company.
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N
Sales revenue (50,000 units at N8) 400,000
Variable cost (50,000 units at N6) (300,000)
Contribution 100,000
Fixed cost (75,000)
Divisional profit for the period 25,000
Divisional investment 150,000
The minimum desired return on investment is the cost of capital of 20 per cent a year.
Required:
a. 1. Calculate the divisional expected return on investment
2. Calculate the division’s expected residual income
3. Comment on the results of (1) and (2).
b. The division has the opportunity to sell an additional 10,000 units at N7.50. Variable cost per
unit would be the same as budgeted, but fixed costs would increase by N5,000. Additional
investment of N20,000 would be required. If the manager accepted this opportunity, by how
much and in what direction would the residual income change?
c. Goodman expects to sell 10,000 units of its budgeted volume of 50,000 units to Sharp, another
division of the Telling Company. An outside business has promised to supply the 10,000 units
to Sharp at N7.20. If Goodman does not meet the N7.20 price, Sharp will buy from the outside
business. Goodman will not save any part of the fixed cost if the work goes outside, but the
variable cost will be avoided completely.
1. Show the effect on the total profit of the Telling Company meets the N7.20 price.
2. Show the effect on the total profit of the Telling Company if Goodman does not meet the
price and the work goes outside.
SUGGESTED SOLUTION TO FURTHER QUESTION
1. Reporting non-financial measures may pose a number of problems. These include:

 resistance to the introduction of the measures (and, by implication, new ways of being
assessed);
 skepticism of proposed measures (the latest “flavor of the month’);
 the cost of reporting new measures;
 data integrity (the lack of common measurement bases and objectivity associated with many
non-financial measures);
 the difficulty of measuring the benefits (for example, establishing the link between a
particular non-financial measure and the achievement of business objectives).
2. Four possible measures may include:

 Sales per employee
 Output per employee
 Total output during the period
 Sales to assets employed
Other measures may have been suggested which are equally valid.
3. Divisionalised organizations
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a. A divionalised organisation is one that divides itself into operating units in order to deliver its
range of products or services. Divisionalisation is, in essence, an attempt to deal with the
problems of size and complexity.
Autonomy of action relates to the amount of discretion the managers of divisions have been
given by central management over the operations of the division. Two popular forms of
autonomy are profits centres and investment centres. Though divisionalisation usually leads
to decentralization of decision making, this need not necessarily be the case.
b. The benefits of allowing divisional managers autonomy include:
 Better use of market information.
 Increase in management motivation.
 Providing opportunities for management development.
 Making full use of specialist knowledge.
 Giving central managers time to focus on strategic issues.
 Permitting a more rapid response to changes in market conditions.
c. These are certain problems with this approach which include:

 Goal conflict between divisions or between divisions and central management.
 Risk avoidance on the part of divisional managers.
 The growth of management ‘perks’.
 Increasing costs due to inability to benefit from economies of scale.
Transfers between divisions can create problems for a business. Managers of the selling
division may wish to obtain a high price for the transfers in an attempt to achieve certain
profit objectives. However, the managers of the purchasing division may wish to buy as
cheaply as possible in order to achieve their own profit objectives. This can create conflict,
and central managers may find that they are spending time arbitrating disputes. It may be
necessary for central managers to impose a solution on the divisions where agreement cannot
be reached, which will, of course, undermine the divisions’ autonomy.
4. Financial performance measures
a. Contribution represents the difference between the total sales revenue of the division and the
variable expenses incurred. This is a useful measure for understanding the relationship
between costs, output and profit. However, it ignores any fixed expenses incurred and so not
all aspects of operating performance are considered.
The controllable profit deducts all expenses (variable and fixed) within the control of the
divisional manager when arriving at a measure of performance. This is viewed by many as
the best measure of performance for divisional managers as they will be in a position to
determine the level of expenses as being either controllable or non-controllable. This measure
also ignores the investment made in assets. For example, a manager may decide to hold very
high levels of inventories, which may be an inefficient use of resources.
Return on investment (ROI) is a widely used method of evaluating the profitability of

divisions. The ratio is calculated as ROI = Divisional profit/Divisional investment (assets
employed) x 100%. The ratio is seen as capturing many of the dimensions of running a
division.
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When defining divisional profit for this ratio, the purpose for which the ratio is to be used
must be considered. When evaluating the performance of a divisional manager, the
controllable contribution is likely to be the most appropriate, whereas for evaluating the
performance of a division, the divisional contribution is likely to be more appropriate.
Different definitions can be employed for divisional investment. The net assets or total assets
figure may be used. In addition, assets may be shown at original cost or some other basis such
as current replacement cost.
b. There are several non-financial measures available to evaluate a division’s performance.

Examples of these measures includes:
 Plant capacity utilized.
 Percentage of rejects in production runs.
 Ratio of customer visits to customer orders.
 Number of customers visited.
If a broad range of financial and non-financial measures covering different time horizons are
used, there is a better chance that all of the major dimensions of management and divisional
performance will be properly assessed. Focusing on a few short-term financial objectives
incurs the danger that managers will strive to achieve these at the expense of the longer-term
objectives. Clearly, ROI can be increased in the short term by cutting back on discretionary
expenditure such as staff training and research and development and by not replacing heavily
depreciated assets.
5. ABC Corporation
a. 1. Residual income computation – original plan:
N’000
Sales revenue 1,200
Variable costs (800)
Contribution 400
Fixed costs (250)
Divisional profit 150
Imputed cost (N500,000 x 20%) (100)
Residual income 50
2. Residual income calculation – original plan and option X:

N’000
Sales revenue ((100,000 x N12) + (20,000 x N11) 1,420
Variable costs (120,000 x N8) (960)
Contribution 460
Fixed costs (250,000 + (80,000/4)) (270)
Imputed cost (N580,000 x 20%) (116)
Residual income 74
3. Residual income computation – original plan and option Y:

N’000
Sales revenue ((80,000 x N12) + (20,000 x N10) 1,160
Variable costs (800)
Contribution 360
Fixed costs (250)
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Imputed cost (N500,000 x 20%) (100)
Residual income 10
We can see that the highest residual income for Division A arises when only option X is
added to the original plan and that the lowest residual income arises when only option Y is
added to the original plan.
b. Division A is unlikely to find the price reduction for Division B attractive. Division B, on the
other hand, will benefit by N40,000 (20,000 x N2) from the price reduction. However,
overall, the total profits of the business will be unaffected as the increase in Division B’s
profits will be cancelled out by the decrease in Division A’s profit.
If an outside supplier is used, the profits of the business overall will reduce by an amount of
the lost contribution (20,000 x (N10 – N8) = N40,000).
Another option would be to allow the outsiders to supply Division B and to use the released
production capacity to sell outside customers 20,000 units at N11 per unit. In this way,
additional equipment costs would be avoided.
6. Telling Company
a. 1. Return on Investment (ROI) = N25,000/N150,000 x 100/1 = 16.7%
2. Residual income
N
Divisional Profit 25,000
Required return (20% x N150,000) (30,000)
Residual income (loss) (5,000)
3. The results show that the return on investment is less than the required return of 20% and
the residual income is negative. The results must therefore be considered unsatisfactory.
b. The revised residual income:

N
Increase in sales revenue (N7.50 x 10,000) 75,000
Increase in variable costs (N6 x 10,000) (60,000)
Increase in contribution 15,000
Increase in fixed costs (5,000)
Increase in divisional profit 10,000
Increase in cost of capital (20% x N20,000) (4,000)
Increase in residual income 6,000
c. 1. Though the divisional profits of Goodman and sharp will be affected by a change in the
transfer price, the total profits of Telling Co. will be unaffected. The increase in profit
occurring in one division will be cancelled out by the decrease in profit in the other
division and so the overall effect will be nil.
2. If the work goes outside, Goodman would lose N20,000 in contribution (that is, 10,000 x
N2) and Sharp would gain N8,000 by the reduction in the buying-in price (that is, 10,000
x (N8 – N7.20)). The net effect on the business as a whole will therefore be a loss of
N12,000 (that is, N20,000 – N8,000).
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CHAPTER 12
TRANSFER PRICING SYSTEM
Also known as the internal pricing system, it determines the value attached to goods and services
exchanged between/among sister divisions in an organization. In other words, Transfer pricing can
be described as a price attached to goods and services being exchanged among divisions operating
under the canopy of a central management. This policy relates to internal running of the
organization as whole rather than external factors. Transfer pricing policy will only take place in
the first instance if the following conditions are present:
1. A division must be producing a special component required by another division for the
production of its own final product.
2. Each division must be classified as an autonomous profit/investment center.
3. The two divisional managers must be willing to transact business with each other.
QUALITIES OF A GOOD TRANSFER PRICING SYSTEM
1. Autonomy: A transfer price adopted by any division or organization at large must maintain
the individuality or autonomy of that division, that is, self-governing is ensured.
2. Goal Congruence or Uniformity of Objective: Good transfer pricing must not be

sacrificed for the divisional objective, that is, the transfer price should ensure that the
corporate objective of the entire organization is achieved.
3. Performance Evaluation: A good transfer pricing technique must ensure that the
divisional manager’s effectiveness or otherwise is properly determined. In fact, the pricing
policy must not allow divisional managers to hide their inefficiency under the transfer
pricing method.
4. Motivation: Where divisional managers have the feelings of self-government, it tends to

be positively motivated. Some managers even prefer self-government as a motivational
factor rather than monetary remuneration.
FACTORS TO BE CONSIDERED IN DETERMINING AN APPORPRIATE TRANSFER

PRICING SYSTEM
The following factors must be borne in mind in determining an appropriate transfer pricing. These
are:
a. The corporate objective of the central organization

b. The organizational structure.
c. Nature of the product and availability of the market.
d. Elasticity of demand of the product.
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e. Availability of substitute and their prices.
f. Activities of competitors and nature of competitions.
g. Accounting system being adopted by each division.
h. Level of exposure and experience of management members.
i. Demographic structure of the market.
j. Level of inflation.
k. Government’s taxation system.
TRANSFER PRICING METHODS
There are four methods of determining the transfer price for goods and services exchanged or being
transferred among sister divisions within a structure. These are as follows:
1. Cost based transfer pricing method.

2. Market based transfer pricing method.
3. Negotiated transfer pricing method.
4. Arbitrary transfer pricing method.
COST BASED TRANSFER PRICING METHOD
The appropriate value to use under this method will depend on the classification and understanding
of the word “cost”. Basically, there are four major areas in which cost based transfer pricing
method can be classified namely:
a. Marginal/Relevant Cost Transfer Pricing Method: Using this method, each division
will transfer the component to the other division based on the relevant cost of producing
that component, that is, the selling division is expected to charge only the relevant cost of
production e.g. Raw Material cost, Direct Labour cost, Variable Overheads, attributable
fixed overheads, Opportunity cost and Savings, if applicable.
b. Total Cost Transfer Pricing Method: Rather than transferring the product to buying
division at the relevant cost of production alone, the divisional manager using this method
will include all costs using absorption costing approach. The average total cost will be
determined by adding both variable and fixed cost, both direct and indirect cost, using the
principle of absorption costing techniques.
c. Total Cost Plus Margin: Transfer pricing under this method will be the addition of total
cost of production and a specific percentage for mark-up.
d. Standard Cost Transfer Price Method: This is to base the transfer price on an
established standard cost, that is, standard cost per activities will be pre-determined, goods
and services will be transferred at this cost and variances will be analyzed and possibly
investigated.
Finally, cost based transfer pricing is used when sister divisions transfer goods and services
possibly at relevant, standard, total cost or cost plus an established margin. This is expected to be
lower than the selling price.
ADVANTAGES OF COST BASED TRANSFER PRICING
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1. The method is definite and specific in nature.
2. The method aids planning.
3. Appropriate records are updated and are also being encouraged under this method.
4. It is not prone to market fluctuation.
5. It is less expensive to operate.
6. A considerable time is being saved using this method.
DISADVANTAGES OF COST BASED TRANSFER PRICING
1. The method violates the concept of autonomy.

2. Organizational goals may be sacrificed for individual goals.
3. Divisional managers can hide their inefficiency under this method.
4. It will discourage performance evaluation
MARKET BASED TRANSFER PRICING
Under this method, goods and services are exchanged among divisions using the prevailing market
value. Using this approach, the selling division will transfer goods or services to the buying
division at the same price the division would sell to external customers. In others words, the buying
and selling division will be operating at arm’s-length in transferring goods or services.
ADVANTAGES
1. The method guarantees the concept of autonomy.

2. It encourages healthy rivalry among divisional managers.
3. The corporate objectives are considered much more important under this method than the
divisional goal.
4. It is the only method that can guarantee effective evaluation of each divisional manager.
5. The method guarantees the expansion of both the division and the organization as a whole.
6. Market prices are objective and verifiable.
7. It cannot lead to controversy as to the efficiency or inefficiency of the selling division.
DISADVANTAGES
1. It is prone to market fluctuation.

2. The method may encourage sub-optimality in another division and this act will later reduce
the overall profit of the whole organization.
3. The method may encourage interdepartmental conflicts.
4. The elements of profit could complicate stock valuation when group accounts are being
prepared.
5. Accurate information about the market price may not be readily available.
6. The use of market price may act as a disincentive to the use of any spare capacity
especially in the selling division whenever there is excess capacity, even though the
marginal cost method would have been more desirable to be used in that situation.
ARBITRARY TRANSFER PRICING METHOD
This is a situation where the central management determines the appropriate value to transfer goods
and services among divisions. This value may be determined after several negotiations by both
divisional managers. The price so determined may be subject to a review periodically.
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ADVANTAGES
1. It is suitable for the budgetary system.

2. Divisional managers can use the price as a basis for their future planning.
3. The method eliminates unhealthy rivalry among the divisions.
4. Time consuming incessant negotiations is saved.
5. Uniformity and stability tends to prevail.
DISADVANTAGES
1. The method negates the concept of autonomy.

2. Divisional managers can easily reduce their efficiency to suit the method.
3. The organizational objective may not be achieved under this method.
4. It is time consuming.
5. It is expensive to operate.
NEGOTIATED TRANSFER PRICING METHOD
Using this method, both selling and buying divisions are allowed to negotiate the appropriate value
to charge for the exchange of their product. For this purpose, the buying divisions are given the
opportunity to determine the appropriate price they can afford in order to remain in business and
this factor will be considered by the selling division before the final price is agreed.
ADVANTAGES
1. The motivational impact is always stronger because it gives mangers a high degree of control
and involvement when prices are set.
2. It encourages friendship among divisional managers.
3. Divisional managers are allowed to use their initiative.
4. Autonomy can still be guaranteed under this method.
DISADVANTAGES
1. Effective evaluation of divisional performance may not be possible.

2. Divisional managers may sacrifice the corporate objective for personal motives.
3. A domineering divisional manager may use the method to defraud the organization.
4. It is time consuming and also expensive to operate.
INTERNATIONAL TRANSFER PRICING
The transfer prices used by a company that has foreign branches, divisions or subsidiaries may have
to overcome a number of possible legal and economic problems. The main problems are:
 Exchange rate fluctuations will make it difficult to maintain stable real transfer prices. This
problem can be minimized by charging in an internationally accepted currency, such as Pounds,
Euros or Us dollars.
 Taxation rates and rules will differ. Ideally transfer prices should be arranged so that the
divisions in countries with higher tax rates are charged high prices and divisions in lower taxed
countries are charged low prices. This will reduce profits in the higher tax countries while
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increasing profits in lower taxed countries. The result will be that the group’s overall tax bill is
minimized. Many countries are aware of this tactic and have passed legislation to outlaw the
practice. It will be necessary to conform to any such legislation and charge a fair price.
 The imposition of import tariffs will mean that the price paid by the buying division is higher
than that charged by the selling division. This problem could be circumvented by the selling
division charging the overseas divisions less than it would in its home market. However, many
countries have anti-dumping laws, which aim to prevent unfair competition by preventing firms
from charging less than they do in their home market. However, this legislation usually applies
to goods so it should not pose a problem if services are transferred. Also, import tariffs do not
normally apply to services.
ILLUSTRATION 1
A company has two divisions, division A and B, division A supplies division B with a part-finished
product. Division B completes the production and sells the finished units in the market for N35 per
unit. Budgeted data for the year:
Divisions A B
Number of units transferred/sold 10,000 10,000
Material costs per unit (N) 8 2
Other variable costs per unit (N) 2 3
Annual fixed costs (N) 60,000 30,000
Calculate the budgeted annual profit of each profit centre and the organisation as a whole if the
transfer price for components supplied by Division A to Division B is:
a. N20
b. N25
c. Explain why it is necessary to set a transfer price.
d. If division A can sell the part-finished components to external customers at N23 per unit,
explain why this is the optimum transfer price.
SUGGESTED SOLUTION
a. The Divisions and company profit if transfer is made at N20

Division A Division B The Company
N N N
External Sales - 350,000 350,000
Internal transfers 200,000 - -
Less costs
Internal transfers - (200,000) -
Material costs (80,000) (20,000) (100,000)
Other variable costs (20,000) (30,000) (50,000)
Fixed costs (60,000) (30,000) (90,000)
Profit 40,000 70,000 110,000
Note that transfer pricing is between sister divisions and will not affect the company as a
whole. While it is an income to Division A, it is treated as a cost to division B.
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b. The Divisions and company profit if transfer is made at N25.
Division A Division B The Company
N N N
External Sales - 350,000 350,000
Internal transfers 250,000 - -
Less costs
Internal transfers - (250,000) -
Material costs (80,000) (20,000) (100,000)
Other variable costs (20,000) (30,000) (50,000)
Fixed costs (60,000) (30,000) (90,000)
Profit 90,000 20,000 110,000
Note that this has increased the profit of Division A and decreased the profit of Division B
but the company’s position remains unaffected.
c. It is necessary to set a transfer price because if the part-finished product was transferred at
no cost Division A would earn no income. The purpose of transfer price include the
followings:
 Goal congruence objective
 Divisional performance evaluation
 Motivation and
 Divisional autonomy
d. If Division A can sell part-finished product in the external market, that price will be the
ideal transfer price to be used as market based transfer price is the only method of transfer
pricing the meet the four objectives of a good transfer price. Division B may argue that
certain savings can be made by trading internally rather than externally. For example, there
may be savings in packaging costs and in after-sales service. An adjusted market price may
therefore be agreed.
ILLUSTRATION 2
CB Division of the Meldon Group manufactures a single component, which it sells externally and
also transfers to other divisions within the group. CB Division has set the performance target for
the budgeted residual income as N300,000 for the coming financial year.
The following additional budgeted information relating to CB Division has been prepared for the
coming financial year:
i. Maximum production/sales capacity: 120,000 components.

ii. Sales to external customers: 80,000 components at N20 each
iii. Variable cost per component: N14.
iv. Fixed cost directly attributable to the division: N60,000
v. Capital employed: N1,600,000 with cost of capital as 15%
The XY Division of the Meldon Group has asked CB Division to quote a transfer price for 40,000
components:
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a. Calculate the transfer price per component which CB Division should quote to XY
Division in order that its budgeted residual income target will be achieved.
b. Explain why the transfer price calculated in (a) may lead to sub-optimal decision making
from a group viewpoint.
c. XY Division now establishes that it requires 50,000 components. External company L is

willing to supply 50,000 components at N15.50 each but is not willing to quote for only
part of the requirement of XY Division. External company M is willing to supply any
number of components at N18 each. For each of the cases below (taken separately), state
the source or sources from which XY Division should purchase the components in order to
maximize its own net profit and explain why the particular source or sources have been
chosen. Assuming that CB Division is willing to supply the components to XY Division:
i. At an average price per component for the quantity required, such that the
budgeted residual income of CB Division will still be achieved.
ii. At an average price per component which reflects the opportunity cost of the
components transferred.
iii. At price per component which reflects the opportunity cost of each component.
d. State which of the basis for transfer price in (c) should lead to group profit maximization
and calculate the reduction in group profit that would arise from the operation of each of
the other transfer prices for the component.
SUGGESTED SOLUTION
a. The transfer price to be determined for the Division here will be the price that will enable
the Division to attain its targeted profit. To achieve this, various methods can be used to
determine such a price. For example, the total costs plus the expected return plus residual
income less sales to external customer will give the expectation from internal transfer and
this will be divided by the units involved to derive the transfer price. That is:
N
Total variable costs (120,000 x N14) 1,680,000
Fixed costs 60,000
Returns on capital employed (N1,600,000 x 15%) 240,000
Residual Income 300,000
Expected sales 2,280,000
Less External Sales (80,000 x N20) 1,600,000
Internal Sales/Transfers 680,000
Sales/Transfer Units 40,000
Transfer price per unit N17/unit
b. XY Division may be able to purchase the component from an external source at a price
lower than that obtainable from CD Division unless the group dictates that it must purchase
from CD Division. If the external price is higher than the relevant cost of making N14, but
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lower that the computed transfer price above of N17 per units, in this case, it will choose
the external source of supply. Unless CD division has an external market for the 40,000
units that should have been transferred to XY Division at a price higher than that price
available from CD Division, If XY Division purchase from external supplier it is a sub –
optimal decision to the company. That is, XY Division will be purchasing at a cost higher
that the cost the company will incurred in producing the same thing.
c.i. Three alternatives are available for XY Division and the cheapest will be considered
acceptable.
1. To accept transfer from CB Division at N17 per component for 40,000 and purchase
10,000 from company M.
Total Cost
N
Transfer from CB (40,000 x 17) 680,000
Purchases from company M (10,000 x N18) 180,000
Total Cost 860,000
2. To purchase from company L

Total cost = (50,000 x N15.50) = N775,000
3. To purchase from company M

Total cost (50,000 x N18) = N900,000
It is advisable for Division XY to purchase from Company L in order to minimize the

division’s cost and maximize profit.
ii. Considering the opportunity cost for the transfer Division, CB will transfer 40,000
component at relevant cost of N14, since there is no external market for the units. But for
the addition units of 10,000, the appropriate transfer price will be N20, that is, variable cost
plus opportunity cost. The three alternatives can be reconsidered are as follows:
1. Transfer from CB (40,000 x N14) + (10,000 x N20) = N760,000
2. Purchase from Company L = N775,000
3. Purchases from company M = N990,000
It is advisable for Division XY to accept transfer from Division CB.
iii. Considering opportunity cost of each component, Division XY should be able to accept or
purchase from any of the options that presents the lowest cost. That is, the Division can
accept the 40,000 units from CB at N14, which will be the cheapest and purchase the
reminder 10,000 units from company M at N18 per unit. The total cost therefore will be =
(40,000 x N14) + (10,000 x N18) = N740,000. This is the cheapest option.
d. Group profit is maximized in the third option above at a total cost of N740,000.
If option (ii) is adopted, group profit will reduce by N760,000 – N740,000 = N20,000 and
If option (i) is implemented, group profit will reduce by N775,000 – N740,000 = N35,000.
Therefore method (i) and (ii) will lead to sub-optimal decisions because of communication
break down between the two divisions.
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ILLUSTRATION 3
Toyota PLC, manufacturer of specialized automotives is organized along decentralized lines with
each manufacturing division operating as a separate profit center. The Automotive Division (A)
normally purchases its engine requirements from Engineering Division (E) at a unit price of N175
per unit. Division E has informed A that the unit price will have to be increased to N200 in the
coming year as a result of escalating costs. An external supplier of engines of exactly the same
specifications has confirmed that it is own price will remain at N175 for some time. Data available
for next year are:
A's annual requirement of engines - 5,000 units
E's variable cost per engines - N140
E's fixed costs (allocated) per engines - N40
You are required to state, with appropriate computations whether in each of the following cases
should A purchase externally. State whatever additional assumptions you make.
a. There are no alternative uses for E’s production facility.
b. The external purchase price falls by a further N40 per engine.
SUGGESTED SOLUTION
a. If there are no alternative uses for E’s production facilities, the relevant cost of making is
N140 per engine and the alternative cost is for A to purchase at the price of N175. Both are
future costs put in order to attain the goal congruence objective, the lower cost of N140
will be advisable. In a decision of this nature, the alternative that benefits the company as a
whole is the alternative that should be considered acceptable. Therefore, it is advisable for
E to transfer to A. Reaching this decision we assume that there is no market for E’s end
product.
b. With the reduction in external market price by N40 of the purchase price, the revised
purchase cost per unit will be N135 (i.e. N175 – N40 = N135). This is lower than the
relevant cost of N140. Since both are future costs, it will be advisable for A to purchase
outside in order to minimize cost and maximize profit for the company, because the
company will be saving N5 on each unit purchased instead of making. Again, we do
assume that the external supplier will be able to meet division B’s annual requirement.
ILLUSTRATION 4
The battery division of Para Limited produces 12 – Volt batteries for automobiles. It has been the
sole supplier of batteries to the Automotive Division of the same company and charges N10 per
battery. Production capacity is for a maximum of 2,000,000 units per year, 30% of which is sold
intra-company while the remaining is sold to outsiders at N12.50 each. Typical data for a year for
the Battery Division is as follows:
N'000 N'000
Sales 21,500
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Variable cost @ N8 16,000
Fixed costs 2,000 18,000
Another battery manufacturer has offered to sell a comparative battery to the Automotive Division
up to its full requirements at N9 each. The manager of the Battery Division contends that he cannot
possibly match this price because he would only be able to recover cost of production and make no
margin whatsoever.
i. Comment on this contention
ii. What would be the effect on the Battery Division’s profit if the Automotive Division
purchased its batteries from outside. Assume that the Battery Division cannot expand
external sales beyond its present level.
iii. Market surveys have shown that the entire capacity output of the Battery Division can be
sold to outsiders if a major sales promotion which would increase variable cost by N1 per
battery and fixed costs by N1 million is undertaken provided that the selling price is
reduced by 50 kobo per battery.
Should the Division concentrate exclusively on outsides sales?
SUGGESTED SOLUTION
i. As a Management Accountant, the transfer price of N9 is still beneficial to the battery

division because the relevant cost of making to the division is N8. If transfer is made at N9
there will be a contribution of N1 per unit transferred to the division, which will equally
benefit the company as a whole.
ii. The Battery division will be losing contribution of N1 per unit i.e. N19 – N18, ( N18 being
relevant cost of making internally). The total contribution that the battery division will be
loosing = N1 x 2,000,000 x 30% = N600,000.
iii. The revised total contribution.

N'000 N'000
Sales (2,000,000 x N12) 24,000
Less Costs
Variable Cost (2,000,000 x N9) 18,000
Fixed Cost 3,000 -21,000
From the computation above, the divisional profit will reduce by N500,000 if the option is
chosen. It is therefore not advisable for the division to concentrate exclusively on outside
sales.
ILLUSTRATION 5
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Alex Limited, an Aluminum Extension company, has two divisions X and Y. Division X
manufactures a single uniform product, which is partly sold in the external market and partly
transferred to Division Y where it forms the major sub-assembly for that Division’s product.
The unit cost for each Division’s product is as shown hereunder

Division Division
X Y
N N
Bought-in component (from Division X) - 58
Direct material 8 46
Direct labour 4 6
Direct expenses 4 -
Variable Production Overhead 4 24
Fixed Manufacturing Overhead 8 24
Selling & Packing Expense (Variable) 2 2
30 160
Past data shows that averages of 10,000 units of its products are sold on the external market each
year by Division X at the standard price of N60.
In addition to the external sales, 5,000 units are transferred annually to Division Y at an internal
transfer price of N58 per unit (as above). This transfer price is derived by deducting variable selling
and packaging expenses from the external price since this expense is not incurred for internal
transfers.
Division Y’s manager disagrees with the basis used to set the transfer price. He contends that the
transfer price should be made at variable cost plus an agreed (minimal) mark-up. It is his view that
under the present set-up his division is taken output that division X would be unable to sell at the
price of N60.
A study commissioned by the Marketing Director consequent on this disagreement shows the
following:
CUSTOMER DEMAND AT VARIOUS SELLING PRICES

Division X
Selling Price/ Unit N40 N60 N80
Demand 15,000 10,000 5,000
Division Y
Selling Price/ Unit N160 N180 N200
Demand 7,200 5,000 2,800
Division Y’s manager maintains that the study has buttressed his case and calls for a transfer price
of N24 which he points out, would give Division X a reasonable contribution to its fixed overheads
as well as enable Y to earn a reasonable profit while also lead to an enhanced company-wide output
and profit performance.
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a. Calculate the contribution at alternative selling prices shown in the study for Division X.
Which price maximizes the Division’s profit?
b. Calculate the contribution as in (a) above, for Division Y and thus or otherwise show if Y’s
current selling price of N180 is optimal for the firm as a whole.
c. Show, assuming a transfer price equal to Division X’s variable costs, the contribution at
alternative selling prices for Division Y.
Comment briefly but concisely on how the whole firm is affected under this situation.
d. Calculate the unit contribution to X assuming a transfer price of N24/unit.
e. Establish the likely effect on company-wide profits of adopting the suggestion by Division
Y’s manager, of a transfer price of N24.
SUGGESTED SOLUTION
a. Calculation of the contribution at each of the alternative selling prices for Division X
N N N
Selling price per unit 40.00 60.00 80.00
Less Variable Costs
Direct material 8.00 8.00 8.00
Direct labour 4.00 4.00 4.00
Direct expenses 4.00 4.00 4.00
Variable production overheads 4.00 4.00 4.00
Variable selling & packing 2.00 2.00 2.00
Quantity demand (units) 15,000 10,000 5,000
Total contribution (N) 270,000 380,000 290,000
From the computation above, the selling price of N60 is the optimal price for the division
because, it is at this price that the division maximizes its contribution. Fixed cost is not
considered because the cost does not make a difference among the alternatives.
b. Calculation of the contribution at each of the alternative selling prices for Division Y.
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N N N
Less Variable Costs
Direct labour 46.00 46.00 46.00
From the computation above, the price of N180 is the optimal price to division Y as well as
to the company as a whole.
c. At a transfer price equal to X’s variable costs, the contribution to Division Y

N N N
Less Variable Costs
Direct labour 46.00 46.00 46.00
The company as a whole will be indifferent at this point, since transfer pricing is an
internal policy. Whichever transfer price is adopted between the sisters divisions it should
not jeopardize the over-all objective or goal congruence of the company.
d. The contribution to X = N24 – N20 = N4 / unit. N20 represents the relevant or variable cost
to division X.
e. See the comment in C (ii) above.
ILLUSTRATION 6
Two of the divisions of Sanco Limited are the Middle division and the Final division. The Middle
division produces three products – Arrow, Boat and Can. The products are sold to overseas
consumers as well as to the Final division at the same prices. The Final division uses products,
Arrow, Boat and Can. Consequently, the Middle division has been instructed by the Board of
Directors to sell all its products to the Final division.
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The price and cost data are as follows: Middle Division
Products Arrow Boat Can

N N N
Transfer price 20 20 30
Variable manufacturing cost per unit 7 12 10
Fixed costs 50,000 100,000 75,000
The Middle division has a maximum monthly capacity of 50,000 units. The processing constraints
are such that capacity production can only be maintained by producing at least 10,000 units of each
product. The remaining capacity can be used to produce 20,000 units of any combination of the
three products.
Final Division
Products Xe Ye Zed
N N N
Final selling price 56 60 60
Variable costs per unit: Internal purchase 20 20 30
Processing in Final division 10 10 16
Fixed costs 100,000 100,000 200,000
The Final division has sufficient capacity to produce up to 20,000 units more than it is now
producing, but shortage of products Arrow, Boat and Can, is limiting production. Further, the final
division is able to sell all the products that it can produce at the final selling prices.
Required:
a. From the viewpoint of the Middle division, compute the combination of products, which
would maximize its divisional profits and calculate the total company’s profit, given that
all Middle division’s production is transferred internally.
b. From the viewpoint of the Final division, compute the products and quantities purchased
from the Middle division, which would maximize its divisional profits and indicate the
effect on the total company profits.
c. Compute the product mix which would maximize the total company profits assuming all
transfers were internal.
SUGGESTED SOLUTION
a. The optimum quantities from Middle division perspective and profit to the company.
The optimum quantities
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Products Arrow Boat Can
N N N
Transfer price 20.00 20.00 30.00
Less variable costs 7.00 12.00 10.00
Ranking 2nd 3rd 1st
Optimum quantities 10,000 10,000 30,000
The profit to the company:
Products Xe Ye Zed Total

N N N N
Final selling price 56.00 60.00 60.00 -
Less variable cost - Middle division 7.00 12.00 10.00 -
Less Process cost - Final division 10.00 10.00 16.00 -
Contribution Margin 39.00 38.00 34.00 -
Optimum quantities 10,000 10,000 30,000 -
Total contribution 390,000 380,000 1,020,000 1,790,000
Less total fixed cost -Middle 225,000
Less total fixed cost -Final 400,000
Net profit 1,165,000
b. The optimum quantities from Final division perspective and profit to the company.

Products Xe Ye Zed
N N N
Final selling price 56.00 60.00 60.00
Less variable costs/ Internal transfer 20.00 20.00 30.00
Less process cost final division 10.00 10.00 16.00
Ranking 2nd 1st 3rd
The profit to the company
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N N N N
Total contribution 390,000 1,140,000 340,000 1,870,000
c. The optimum quantities from the Company perspective and profit to the company.

Products Xe Ye Zed
N N N
Final selling price 56.00 60.00 60.00
Less variable costs/ Internal transfer 7.00 12.00 10.00
Less process cost final division 10.00 10.00 16.00
Ranking 1st 2nd 3rd
The profit to the company

N N N N
Total contribution 1,170,000 380,000 340,000 1,890,000
Note that the additional 20,000 units are allocated to the products that are ranked first.
ILLUSTRATION 7
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Tulane Consulting Ltd is an oil industry consultancy. The company’s headquarters is located in the
United Kingdom and there are subsidiaries (divisions) in Kuwait, the USA and Indonesia. Each
subsidiary is incorporated in its country of residence and is liable for local taxation. The
subsidiaries bill their clients in US dollars but most costs are incurred in local currency. Tulane
Consulting Ltd uses an activity-based costing system for planning and control.
The headquarters provides credit management, accounting, computing, administrative and scientific
services to the remainder of the group. The cost of these services is recovered by charging each
subsidiary 12 per cent of its annual turnover. The headquarters also carries out consultancy
assignments and provides scientific services to some of the smaller independent, UK-based, oil
exploration companies.
You have recently been appointed as Tulane Consulting Ltd’s Management Accountant, at the
group’s headquarters. Ellie Jameson, the newly appointed Managing Director, is concerned that the
overseas subsidiary companies should be charged properly for each of the services provided by
Tulane Consulting Ltd’s headquarters.
Required
Write a memo to Ellie Jameson that:

1. Explains the behavioural matters that should be considered when setting up a transfer
system, and the features that are therefore required in a transfer system.
2. Sets out the legal and economic problems that should be considered when instituting an
international transfer pricing system, and explains how these may be minimized.
3. Recommends and justifies appropriate transfer pricing methods for each of the five services
provided to the divisions (credit management, accounting, computing, administration and
scientific services).
SUGGESTED SOLUTION
a. Behavioural matters to be considered when setting up a transfer pricing system include:

 Should aim to prevent or minimize dysfunctional decision-making by the divisions.
 Divisional autonomy should be balanced against the need for goal congruence.
 Therefore, Tulane Consulting Ltd needs to institute a transfer pricing system that motivates
the headquarters manager providing each of the services, but which does not discourage the
divisional managers purchasing the service.
 The transfer price for each service should permit the headquarters service managers to earn
a surplus over their costs for performance evaluation.
 Transfer prices should be set at a level which does not de-motivate purchasing division
managers, so it should not exceed the local market price.
The effects of these behavioural matters may have to be balanced, as it is unlikely that
suitable transfer pricing methods will be found to deal perfectly with each of the above
considerations.
b. Possible legal and economic problems and how these may be minimized.
 Exchange rate fluctuations will prove to be a problem, as the UK, Kuwait, the USA and
Indonesia have no common currency. This problem can be minimized by charging for
services provided in US dollars (as this will conform with the currency used for billing
clients) or by hedging.
 Taxation rates and rules will differ. Ideally transfer prices should be arranged so that the
branches in countries with higher tax rates receive high priced charges and branches in
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lower taxed countries receive low priced charges. This will reduce profits in the higher tax
countries while increasing profits in lower taxed countries. The result will be that the
group’s overall tax bill is minimized. Many countries are aware of this tactic and have
passed legislation to outlaw the practice. It will be necessary to conform to any such
legislation and charge a fair price.
 Anti-dumping legislation aims to prevent unfair competition by preventing firms from
charging less than they do in their home market. However, this legislation usually applies
to goods so it should not pose a problem for Tulane Consulting Ltd’s services.
 Exchange controls which prevent profits being remitted to the UK could be circumvented
by charging excessively high transfer prices for the headquarters’ services.
 Import tariffs are unlikely to be a problem, as normally these do not apply to services.
c. Appropriate transfer prices for headquarters’ services

 Credit control – suggest charging budgeted ABC per customer account. There is unlikely
to be an external market price for this type of service. (It may be necessary to increase the
price per account for countries that are a poor credit risk if more work is required).
 Accounting – suggest charging budgeted ABC per report and/or transaction. Alternatively,
try to establish what the charge would be if the services were provided by one of the
international firms of accountants and use their rate(s).
 Computing – it is difficult to set an appropriate price as marginal costs are virtually non-
existent. Can an ABC be established or a market price found? If not, use a dual price, or a
flat annual fee for providing the service plus so much per connect hour.
 Administration – there are few marginal costs, and no real market price. Use budgeted
ABC.
 Scientific services – it should be possible to charge market price for these on the same
basis as the UK headquarters charges its external clients. It could be argued that a slightly
lower price is acceptable as there are no bad-debts risks or marketing costs to recover.
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CHAPTER 13
STANDARD COSTING TECHNIQUES AND VARIANCE ANALYSIS
Standard Cost is defined as a predetermined calculation of how much costs should be under
specified working conditions. It is built up from assessment of the value of cost elements and
correlates technical specifications and the quantification of materials, labour and other costs to the
price and / or wages rates expected to apply during the period in which the standard cost is intended
to be used. Its main purposes are to provide bases for control through variance accounting, for the
valuation of stock and work- in- progress and, in some cases, for fixing selling prices.
Standard cost is therefore pre-determined, or forecast estimates of cost to manufacture a single unit,
or a number of units of a product during a specific immediate future period. It is used as a measure
with which the actual cost, as ascertained, may be compared. Standard costs are usually the planned
costs of the product under current and anticipated conditions, but sometimes they are the cost under
normal or ideal conditions of efficiency, based upon an assumed given output, and having regard to
current conditions.
TYPES OF STANDARDS
There are four types of standards, these are: basic, ideal, attainable and current standard, and are
discussed as follows:
BASIC STANDARDS
These are long-term standards, which would remain unchanged over the years. It is used to show a
trend over time for such items as material prices, labour rates and efficiency or inefficiency and
would not normally form part of the reporting system except as on a background or statistical
exercise.
IDEAL STANDARDS
These are based on the best possible operating conditions, that is, no breakdowns, no material
wastage, no stoppages or idle time, in short, perfect efficiency. Ideal standards, if used, would be
revised periodically to reflect improvements in methods, materials and technology. Clearly, ideal
standards would be unattainable in practice and accordingly are rarely used. However, their use
could be considered worthwhile for investigative and development purposes, but not for normal
day-to-day control of activities.
ATTAINABLE STANDARDS
This is by far the most frequently encountered standard, it is currently the attainable standard based
on efficient (but not perfect) operating conditions. The standard would include allowances for
normal material losses, realistic allowances for normal material losses, realistic allowance for
fatigue, machine break downs etc. It must be stressed however that an attainable standard must be
based on a high performance level so that its achievement is possible, but has to be worked for.
Attainable standards provide a rough, but realistic target and this can provide motivation for
management. They can be used for product costing, for cost control, for stock valuation and as a
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basis for budgeting. Attainable standards would be revised periodically to reflect the conditions
expected to prevail during the period where the standards would be applied.
CURRENT STANDARDS
This is a standard that is set for use over a limited period to reflect current conditions. Where stable
conditions and prices exist, then a current standard is equivalent to an attainable standard but where
for example, a temporary problem exists with material quality or there is an unexpected price rise
then a current standard could be set for a limited period to deal with the temporary problem.
OBJECTIVES/USES OF STANDARD COSTING TECHNIQUE
(i). It assists in cost reduction because the initial setting of standards involves a close
examination of the firm’s operations, which helps in removing inefficiency in operations.
(ii). The setting up of the standard costing system opens up various communication channels,
which should facilitate planning and control.
(iii). Standards can be used as performance targets and therefore form the basis of a
responsibility accounting system.
(iv). The feedback from the standard costing system can be an effective means of achieving
short-run corrections to performance.
(v). Standard costing data can be used in the firm for general accounting purposes including
stock valuation, pricing and financial reporting.
(vi). Standard costing is an aid to management by exception and as such, reduces management
time spent on random investigation and concentrates attention on potential areas of
unsatisfactory performance.
LIMITATIONS OF STANDARD COSTING TECHNIQUE
(i). It may be expensive and time consuming to install and keep up to date.
(ii). Virtually all aspects of setting standards involves forecasting and subjective judgment with
inherent possibilities of error.
(iii). All forms of variance analysis are post mortem on or past events. Obviously the past cannot
be altered so that the only value variance can have is to guide management if an identical
or similar circumstance occurs in the future.
(iv). The standard costing technique could lead to some behavioral problems especially when
management does not look at the negative variance constructively and when managers
affected by such standards are not duly consulted.
VARIANCE ANALYSIS
Variance analysis involves the identification of deviation between standards and actual and the
analysis of such deviation by cause and responsibility, which then forms the basis for
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recommending corrective measures and instituting control actions. This means that the standard
costing technique is a useful tool for controlling purposes in an organization.
Variance analysis involves the following:
(a). The standard cost
(b). The actual cost and
(c). The difference between these costs, which is termed the variance.
For detailed illustration of the in-depth analysis of variance analysis, a tree is presented below:
Profit Variance
Sales Variance Total Cost Variance
Sales Price Variance Sales Margin

Volume Variance
Sales Mix Variance Sales Yield Variance
Material Cost Labour Cost VPO Cost FPO

Variance Variance Variance Variance
Material Price Material Labour Labour Idle

Variance Usage Rate Efficiency Time
Material Mix Material Yield VPO Expenditure VPO Efficiency

FPO Volume Variance FPO Budget Variance
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FPO Capacity FPO Efficiency
Variance Variance
FACTORS TO BE CONSIDERED BEFORE INVESTIGATING VARIANCE
The following factors should be borne in mind when investigating variance for management
reporting purposes.
(i). Size: The larger the variance the more likely the investigation would be carried out because
it may satisfy the materiality level specified by management.
(ii). Cost: The cost of investigation should not be too prohibitive or else investigation would
not be carried out.
(iii). Benefit: The potential benefit that would be derived from taking corrective measures
should outweigh the cost of investigation.
(iv). Accuracy of standard used: How realistic are the standards? Any adverse variable from
an ideal standard may not warrant further investigation since from the beginning the
adverse variance would have been expected.
(V). Timing of the feedback: If the feedback/report comes in too late after the occurrence of
the events, investigation may not be carried out because circumstances have changed
drastically such that any corrective measure taken could aggravate the problem.
(vi). Degree of Analysis: Variances which apparently or ostensibly are immaterial could still be
analyzed into as much detail as possible because of the possibility of variances setting
each other off.
(vii). Trend: However relatively insignificant, a variance which has exhibited an increase in
size, may justify investigation. In other words current period variance should be viewed
along with cumulative variance when determining, perhaps the materiality shown by a cost
item.
SIMPLIFIED APPROACH TO VARIANCE ANALYSIS
MATERIAL VARIANCE
Direct Material total cost variance: This represents the difference between:
(a). The standard direct material cost of actual production, and
(b). The actual cost of direct material.
ILLUSTRATION
Kay Limited makes a single product with the following budgeted material costs per unit.
Material A is N10/kg at 2 kgs per unit.
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Actual details- Output 1,000 units, material purchased and used 2,200 kgs, material cost N20,900
Determine the material cost variance.
This can be determined by

N
Actual material cost xx
Less Standard Material cost (BOAO) xx
Material cost variance x(x)
BOAO = Based on Actual Output
For Kay Limited

N
Actual material cost 20,900
Less Standard Material cost (BOAO) 20,000
Material cost variance 900 (A)
(A) = Represents the adverse variance and this will be use when actual cost is higher that the
standard cost and when vice visa, it will be favourable (F).
A total material cost variance actually conveys very little useful information. It needs to be
analyzed further. It can be analyzed into two sub-variances:
(i). A direct material price variance, i.e. paying more or less than expected for materials, and
(ii). A direct material usage variance, i.e. using more or less material than expected.
DIRECT MATERIAL PRICE VARIANCE
This is the difference between the standard price and actual purchase price for the actual quantity of
material. It can be calculated either at the time of purchase or at the time of usage. Generally, the
former is preferable.
Possible Reasons.
(i). Wrong budgeting
(ii). Higher/Lower quality of material used.
(iii). Careful/Careless purchasing
(iv). Losing/gaining bulk discounts by buying smaller/ larger quantities.
Material price variance can be determined either by:
(Standard material price – actual price) x actual quantity used/purchased. Or,
N
Actual quantity at actual price xx
Less actual quantity at standard price xx
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Material price variance x(x)
This can be applied on Kay Limited by determining the material price variance as follows:
Standard price N10/kg and actual price (N20,900/2,200Kg) = N9.5/kg

The variance = (N10 – N9.50) x 2,200 kgs = N1,100 (F)
It is favourable because actual price is lower than standard price.

Or N
Actual quantity at actual price 20,900
Actual quantity at standard price (N10 x 2,200kg) 22,000
Material Price variance 1,100 (F)
DIRECT MATERIAL USAGE VARIANCE
The difference between the standard quantities specified for the actual production and the actual
quantity used, at standard purchase price.
Possible Reasons
(ii). Higher/Lower quality of materials used.
(iii). Higher/Lower grade of workers
(iv). Stricter quality control
(v). Theft
Material usage variance can be determined either by
(standard quantity BOAO – actual quantity) x standard price or
N
Standard quantity BOAO at standard price xx
Less actual quantity at standard price xx
Material usage variance x(x)
This can be applied to Kay Limited to determine the usage variance as follows:
Standard quantity (2kg x 1,000 units) = 2,000kgs. And Actual quantity = 2,200kgs
Usage variance = (2,000kgs – 2,200kgs) x N10 = N2,000 (A)
It is adverse because actual usage is higher than standard usage.
OR
N
Standard quantity at standard price (N10x2kgs x1,000) 20,000
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Actual quantity at standard price (N10 x 2,200kg) 22,000
Material usage variance 2,000 (A)
Note that price plus usage variance must equal to cost variance i.e. (+1,100 – 2,000) = 900 (A).
Material yield and mix variance will be discussed subsequently.
LABOUR VARIANCES
DIRECT LABOUR COST TOTAL VARIANCE
This represents the difference between:
(a). The standard direct labour cost of the actual production: and
(b). The actual direct labour cost.
This can be determined as follows:

N
Actual Labour Cost xx
Less Standard Labour Cost BOAO xx
Labour Cost Variance x(x)
ILLUSTRATION
Rose Ltd makes a single product and has the following budgeted information.
Budgeted production 1,000units

Budgeted Labour hours 3,000hours
Budgeted Labour cost N15,000
Actual results
Output 1,100 units
Hours paid for 3,400hours
Labour cost N17,680
Determine the labour cost variance.
The labour cost variance will be:

N
Actual labour cost 17,680
Less Standard Labour cost BOAO ((N15,000/1,000)x 1,100) 16,500
Labour cost variance 1,180 (A)
Just like material cost, total labour cost variance is not of much use for control purposes. It needs to
be analyzed further into its two sub-variances:
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(a). Direct Labour Rate variance, i.e. paying more or less per labour hour, and
(b). Direct Labour Efficiency variance, i.e. working more or less hours than expected.
DIRECT LABOUR RATE VARIANCE
The difference between the standard and actual direct labour rate per hour for the total hours paid
for.
Possible Reasons:
(ii). Higher rate being paid due to wage award.
(iii). Higher/Lower grade of worker.
(iv). Payment of unplanned overtime or bonus.
Direct labour rate variance can be determined using
(standard rate per hour – actual rate per hour) x Actual hour
or
N
Actual hours at standard rate xx
Less actual hours at actual rate xx
Labour rate Variance x(x)
This can be determined for Rose Limited as follows:
Standard rate = (N15,000/3,000hrs) = N5/hr and Actual rate = (N17,680/3,400hrs) = N5.2/hr

Labour rate variance = (N5-N5.2) x 3,400 hrs = N680 (A)
Or
N
Standard rate on hour hours (N5 x 3,400hrs) 17,000
Actual hours at actual rate 17,680
Labour rate variance 680 (A)
DIRECT LABOUR EFFICIENCY VARIANCE
The difference between the standard hours for the actual production achieved and the hours actually
worked, valued at the standard labour rate.
Possible Reasons:
(ii). Higher/Lower grade of worker
(iii). Higher/Lower grade of material to work with
(iv). More or less efficient working through motivation.
Direct labour efficiency variance can be determined using either
(standard hours BOAO – actual hours) x standard rate per hour
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or
N
Standard hours at standard rate xx
Less actual hours at standard rate xx
Labour efficiency variance x(x)
This can be determined for Rose Limited as follows:
Standard hours per unit = (3,000hrs/1,000uints) = 3hrs/unit
Labour efficiency variance = ((3hrs x 1,100) – 3,400) x N5 = N500 (A)

Or
N
Standard hours at standard rate (3,300hrs x N5) 16,500
Actual hours at standard rate (3,300hrs x N5) 17,000
Labour efficiency variance 500 (A)
IDLE TIME VARIANCE
This is the numbers of hours idle multiplied by the standard rate per hour. Idle time, in a normal
situation is not expected, therefore no provision will be made for idle time and whenever such
occurs, it is always an adverse variance.
ILLUSTRATION
Rose Limited again, but actual hours worked 3,200 hours out of 3,400 paid for.
Analysis of labour cost variances can therefore be broken down as follows:
(i). Labour rate variance = (N5 – N5.2)x 3,400hrs = N680 (A)
(ii). Labour efficiency variance (3,300 – 3,200) x N5 = N500 (F)
(iii). Labour idle time variance (3,400 – 3,200) x N5 = N1,000 (A).
Note that in both situations i.e. when there is no idle time and when there is idle time, the sub-
analysis of labour cost variance will always be equal to the total labour cost variance i.e.
(680A + 500A) = N1,180(A) or (680(A) + 500(F) + 1,000(A) = N1,180 (A).
VARIABLE OVERHEAD VARIANCES
VARIABLE OVERHEAD TOTAL VARIANCE
This represents the difference between:
(a). The standard variable overhead cost of the actual production, and
(b). The actual variable overheads incurred
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N
Actual variable production overhead cost xx
Less standard variable production overhead BOAO xx
Variable overhead total cost variance x(x)
ILLUSTRATION
The budgeted output for Carry Limited for May was 1,000 units of product A. Each unit requires 2
direct labour hours. Variable overheads are budgeted at N3/labour hour; actual results:
Output 900 units
Labour hours worked 1,980 hours
Variable overhead N5,544
Determine the total variable overhead cost variance.
The total variable overhead cost variance (where, VPO=variable production overheads)
N
Actual variable overheads cost 5,544
Less standard VPO BOAO (N3 x 2 hrs x 900 units) 5,400
Total variable overhead cost variance 144 (A)
It is assumed that variable overheads vary with direct labour hours of input and that the total
variable overheads variance will therefore be due to one or the followings:
(1). Actual expenditure may be different from budgeted expenditure (an expenditure variance).
(2). The actual direct labour hours of input may be different from the direct labour hours of
input, which should have been, used (an efficiency variance).
VARIABLE OVERHEAD EXPENDITURE VARIANCE
The difference between the standard variable overhead cost of the actual hours worked and the
actual overheads incurred.
Possible Reasons
(1). Wrong budgeting
(2). Overheads consist of a number of items, indirect materials, indirect labour, maintenance
costs, power, etc. which may change because of changes in rate or variations in consumption.
Consequently, any meaningful interpretation of the expenditure variance must focus on individual
cost items. Variable overhead expenditure variance can be determined either by:
(standard VPO absorption rate per hour – actual VPO absorption rate per hour) x actual hours
Or
N
Actual hours at standard rate per hour xx
Less actual hours at actual rate per hour xx
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Variable overhead expenditure variance x(x)
This can be determined for Carry Limited as follows:
Standard rate = N3/hr and Actual rate = N5,544/1,980hrs = N2.8/hr
VPO expenditure variance = (N3 – N2.8) x 1,980 hrs = N396 (F)
Or
N
Actual hours at standard rate (1,980 x N3) 5,940
Less actual hour at actual rate 5,544
VPO expenditure variance 396 (F)
VARIABLE OVERHEAD EFFICIENCY VARIANCE
This is the difference between the standard hours for the actual production achieved and the hours
actually worked valued at the standard variable overhead cost per labour hour.
We have assumed that variable overheads vary with the labour hours worked. They might just as
well vary with machine hours. The calculations would be similar.
Possible Reasons
As stated above for VPO expenditure variance
VPO efficiency variance can be determined either using:
(standard hours BOAO – actual hours) x standard VPO absorption rate per hour.
Or
N
Standard hours BOAO at standard rate xx
Less actual hours at standard rate xx
VPO efficiency variance x(x)
This can be computed for Carry Limited as follows:
VPO efficiency variance = ((2 x 900) – 1,980) x N3 = N540 (A)

Or
N
Standard hours at standard rate (1,800 x N3) 5,400
Actual hours at standard rate (1,980 x N3) 5,940
VPO expenditure variance 540 (A)
Again, the addition of VPO expenditure and efficiency variance will be equal to total VPO
variance, that is, N396(F) + N540(A) = 144 (A).
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FIXED OVERHEAD VARIANCES
TOTAL FIXED OVERHEAD COST VARIANCE
This is the difference between,
(a). The standard fixed overhead cost of actual production and
(b). The actual fixed overheads incurred.
N
Actual fixed production overhead cost xx
Less standard fixed production overhead BOAO xx
Total FPO cost variance x(x)
ILLUSTRATION
Gate Limited produces a single product, which requires 3 standard hours. Fixed overheads are
budgeted at N12,000 and are absorbed on a labour hour basis. Budgeted output is 1,000 units.
Actual results: Output 1,100 units, labour hours 3,080 hours, overheads incurred N13,000.
Determine the fixed production overhead variance.
The total FPO cost variance will be:

N
Actual FPO cost 13,000
Less standard FPO cost ((N12,000/1,000)x1,100) 13,200
Total FPO cost variance 200 (F)
The total fixed overhead cost variance is equivalent to the amount of over/under absorption and you
should remember that over/under absorption might be due to:
(i). The actual expenditure being different from the budgeted expenditure (an expenditure
variance) and
(ii). Actual production being different from budgeted production (a volume variance).
FIXED OVERHEAD EXPENDITURE VARIANCE
This is the difference between the budgeted fixed overhead and the actual fixed overheads incurred.
For this variance to have any meaning, the cost items, which make up fixed overheads must be
analyzed individually.
N
Actual fixed production overhead cost xx
Less budgeted FPO bonc xx
Page 349
FPO expenditure variance X(x)
BONC = based on normal capacity
This can be computed for Gate Limited as follows:

N
Actual FPO 13,000
Budgeted FPO 12,000
FPO expenditure variance 1,000 (A)
FIXED OVERHEAD VOLUME VARIANCE
This represents the difference between actual productions multiplied by the standard fixed overhead
rate. This can be determined by either:
(actual production – budgeted production) x absorption rate per unit

or
(actual hours – budgeted hours BOAO) x absorption rate per hour.
FPO Volume variance = (1,000 – 1,100) x N12 = N1,200 (F) or

FPO Volume variance = (3,000 – 3,300) x N4 = N1,200 (F)
Note, expenditure plus volume variance must be equal to total FPO variance, that is N1,000(A) +
N1,200 (F) = N200 (F).
The volume variance reflects the fact that fixed overheads do not fluctuate in relation to output in
the short-term. Whenever actual production is less than budgeted production, the fixed overhead
charged to production will be less than the budgeted cost and the volume. Variance will be adverse
if the actual production is greater than the budgeted production and the volume variance will be
favourable.
There are two possible reasons for a FPO (Fixed Production Overhead) volume variance. These
are:
(i). The hours worked are different from the budget, allowing more or less units to be made ( a
volume capacity variance) and,
(ii). The hours worked did not result in the output expected ( a volume efficiency variance).
FIXED OVERHEAD VOLUME CAPACITY VARIANCE
This is the difference between the actual hours worked and budgeted hours multiplied by the
standard fixed overhead absorption rate.
Possible Reasons
(ii). Machine breakdowns
(iii). Material shortage
Page 350
(iv). Poor production scheduling
(v). Increase/decrease in sales demand
FPO volume capacity variance can be determined as follows
(actual hours worked – budgeted hours) x absorption rate per hour.
FPO volume capacity variance = (3,080 – 3,000) x N4 = N320 (F).
FIXED OVERHEAD VOLUME EFFICIENCY VARIANCE
This is the difference between the standard hours of output and the actual hours worked multiplied
by the standard fixed overhead rate.
Possible Reasons
See the factors stated above for volume capacity variance.
It can be determined using
(standard hours BOAO – actual hours) x absorption rate per hour.
FPO volume efficiency variance = ((3 x 1,100)- 3,080) x N4 = N880 (F).
Note that capacity plus efficiency variance must equal volume variance, that is, N320(F) + N880(F)
= N1,200(F).
SALES VARIANCE
TOTAL SALES REVENUE VARIANCE
This represent the difference between the profits expected based on budgeted units compared with
actual profit based on actual quantity at standard cost.
(Budgeted quantity x budgeted profit per unit) – (actual selling price per unit – standard cost per
unit).
The difference in sales may be due to the following:
(i). Increase or decrease in selling price within the period (sales price variance) and
(ii). Increase or decrease in sales due to sales volume (sales volume variance).
SALES PRICE VARIANCE
Page 351
This represents the increase or decrease in profit as a result of increase or decrease in selling price.
This reflects the movement in selling price when compared with the standard price
It can be computed as follows
(Standard selling price – actual selling price) x actual quantity sold.
SALES MARGIN VOLUME VARIANCE
This is the increase or decrease in profit accountable to the increase or decrease in the actual
volume or activity level. This will be computed based on each unit of contribution to profit.
This can be computed as follows:
(budgeted sales quantity – actual quantity sold) x budgeted profit per unit.
ILLUSTRATION 1
Fox Limited manufactures a standard leather product model number J121 for which the standard
unit cost is as follows:
Direct material N
Leather 3 units at N5 per unit 15
Other materials 3
Direct labour 2 hours at N5 per hour 10
Variable overhead 2 hours at N3 per hour 6
Fixed overheads 2 hours at N6 per hour 12
Standard cost per unit 46
Budgeted productions for period 6 of 1999 were 3,000 units of J121.
During the same period, actual results were as follows:

3,200
Production of J121 units
Costs
Leather purchased 9,200 units for N45,400
Leather consumed 9,750 units
Other materials purchased and used N9,500
Direct Labour:
Hours paid for 5,850
Production time 5,100
Labour costs N25,000
Variable production overheads N14,750

Fixed production overheads N34,800
Page 352
Compute the following variances

(i). Raw material price variance
(ii). Raw material usage variance
(iii). Labour rate variance
(iv). Labour efficiency variance
(v). Labour idle time variance
(vi). Variable overheads – expenditure variance
(vii). Variable overheads – efficiency variance
(viii). Fixed overheads – volume variance
(ix). Fixed overheads – expenditure variance.
SUGGESTED SOLUTION
(i). Material price variance

Leather N
Actual cost of leather purchased 45,400
Actual leather purchase at standard cost (9,200 x N5) 46,000
Leather price variance 600 (F)
Other material N
Actual cost of other material 9,500
Standard cost (N3 x 3,200) 9,600
Other material price variance 100 (F)
(ii). Material usage variance

Leather N
Actual usage at standard cost (9,750 x N5) 48,750
Standard usage at standard cost (3 x 3,200 x N5) 48,000
Usage variance 750 (A)
Note, only leather material will have usage variance, as standard usage is not
predetermined for the other material.
(iii). Labour rate variance

N
Actual labour hour at actual rate 25,000
Actual labour hour at standard rate (5,850 x N5) 29,250
Labour usage variance 4,250 (F)
(iv). Labour efficiency variance

N
Actual labour hour worked at standard rate (5,100 x N5) 25,500
Standard labour hour at standard rate (2 hrs x 3,200 x N5) 32,000
Page 353
Labour rate variance 6,500 (F)
(v). Labour idle time variance
Idle time variance = (5,850 – 5,100) x N5 = N3,750 (A).
(vi). Variable overhead expenditure variance

N
Actual hour at actual rate 14,740
Actual hour at standard rate (5,100 x N3) 15,300
VPO expenditure variance 560 (F)
(vii). Variable overhead – efficiency variance

N
Actual hour at actual rate 15,300
Standard hour at standard rate (2 hrs x 3,200 x N3) 19,200
VPO efficiency variance 3,900 (F)
(viii). Fixed overheads – volume variance

N
(3,000 - 3,200) x N12 2,400 (F)
(ix). Fixed overheads – expenditure variance

N
Actual fixed overhead 34,800
Less Budgeted fixed overhead bonc (3,000 x N12) 36,000
FPO expenditure variance 1,200 (F)
ILLUSTRATION 2
The following information was provided by Tolu Limited:

Standard Actual
Sales/production units 150 160
N N
Selling price per unit 30 31
Direct material cost 1,300 1,529
Direct labour cost 970 1,110
Variable production overhead 320 325
Fixed production overhead 600 595
Total cost 3,190 3,559
Normal capacity is 200 units.
NOTES
Page 354
(i). 100 kgs of materials were estimated at standard price of N13 per kg. 110 kgs were actually
used in the process.
(ii). 1,940 labour hours of direct labour were estimated at 50 kobo per hour, 52 kobo per hour
was actually paid.
(iii). Fixed and variable production overhead are absorbed on the basis of labour hours.
Required:
Calculate the variances as far as the above data can assist and reconcile the budgeted actual profit.
Show all calculation.
SUGGESTED SOLUTION
Questions such as this required computation of all variance starting from profit variances and all
other variances of sales and costs as shown on the variance tree. The profit variance can be sub-
divided to sales variance and total cost variances etc. The detailed variances are as follows:
(i). Profit variance

N
Budgeted profit ((N30 x 150units) - N3,190) 1,310.00
Actual profit ((N31 x 160units) - N3,559) 1,401.00
Profit variance 91.00 (F)
(ii). Sales variance

N
Budgeted quantity at standard profit 1,310.00
Actual quantity at standard profit (160 x N31) - ((3190/150) x160) 1,557.33
Sales variance 247.33 (F)
(iii). Sales price variance

N
Actual quantity at standard price (160 x N30) 4,800.00
Actual quantity at actual price (160 x N31) 4,960.00
Sales price variance 160.00 (F)
(iv). Sales margin volume variance

N
Budgeted quantity at standard profit ((150 x (N1,310/150)) 1,310.00
Actual quantity at standard profit (160 x (N1,310/150)) 1,397.33
Sales margin volume variance 87.33 (F)
Note that volume variance plus price variance will be equal to sales variance i.e. N87.33 +
N160 = N247.33.
(v). Total cost variance
Page 355
N
Actual total cost 3,559.00
Standard total cost boao (160 x (N3,190/150)) 3,402.67
Total cost variance 156.33 (A)
Note that total cost variance plus sales variance should be equal to profit variance i.e.
N156.33(A) + N247.33(F) = N91(F).
(vi). Material cost variance

N
Actual material cost 1,529.00
Standard total cost boao (160 x (N1,300/150)) 1,386.67
Material cost variance 142.33 (A)
(vii). Material price variance

N
Actual quantity at actual rate 1,529.00
Actual quantity at standard rate (110kgs x N13) 1,430.00
Material price variance 99.00 (A)
(viii). Material usage variance

N
Actual quantity at standard rate (110kgs x N13) 1,430.00
Standard qty boao at standard rate ((100kg/150)x 160 x N13) 1,386.67
Material usage variance 43.33 (A)
(ix). Labour cost variance

N
Actual labour cost 1,110.00
Standard cost boao ((970/150) x 160) 1,034.67
Labour cost variance 75.33 (A)
(x). Labour rate variance

N
Actual hour at actual rate 1,110.00
Actual hour at standard rate (N1,110/.52) x .50) 1,067.31
Labour rate variance 42.69 (A)
(xi). Labour efficiency variance

N
Actual hour at standard rate (N1,110/.52) x .50) 1,067.31
Standard hour at standard rate ((N1,940/150) x 160 x .50) 1,034.67
Labour efficiency variance 32.64 (A)
Page 356
(xii). Variable production overhead cost variance
N
Actual variable overhead cost 325.00
Standard VPO cost boao ((N320/150) x 160) 341.33
VPO cost variance 16.33 (F)
(xiii). VPO spending/expenditure variance

N
Actual hour at actual VPO rate/hour 325.00
Actual hour at standard VPO rate ((1,110/.52) x (320/1,940)) 352.10
VPO expenditure variance 27.10 (F)
(xiv). VPO efficiency variance

N
Actual hour at standard VPO rate ((1,110/.52) x (320/1,940)) 352.10
Standard hour at standard rate ((1,940/150) x 160 x (320/1,940)) 341.33
VPO expenditure variance 10.77 (A)
(xv). Fixed production cost variance

N
Actual FPO cost 595.00
Standard FPO cost boao ((600/150) x 160) 640.00
FPO cost variance 45.00 (F)
(xvi). FPO budget variance

N
Actual FPO cost 595.00
Budgeted FPO bonc (200 x (600/150)) 800.00
FPO budget variance 205.00 (F)
(xvii). FPO volume variance

N
Budgeted hours boao at standard rate (1,940/150 x 160 x 600/1,940) 640.00
Budgeted FPO bonc at standard rate (1,940/150 x 200 x 600/1,940) 800.00
FPO volume variance 160.00 (A)
(xviii). FPO volume capacity variance

N
Budgeted FPO bonc at standard rate (1,940/150 x 200 x 600/1,940) 800.00
Actual hours at standard rate (1,110/.52) x (600/1,940) 660.19
FPO volume capacity variance 139.81 (A)
(xix). FPO volume efficiency variance
Page 357
N
Actual hours at standard rate (1,110/.52) x (600/1,940) 660.19
Standard hours boao at standard rate 640.00
FPO volume variance 20.19 (A)
Reconciliation of profit.
Adverse Favourable Total
N N N
Budgeted profit 1,310.00
Add/less variances
Sales price variance 160.00
Sales margin volume variance 87.33
Material price variance 99.00
Material usage variance 43.33
Labour rate variance 42.69
Labour efficiency variance 32.64
VPO expenditure variance 27.10
VPO efficiency variance 10.77
FPO budget variance 205.00
FPO volume capacity variance 139.81
FPO volume efficiency variance 20.19
388.43 479.43 91.00
Actual profit 1,401.00
ILLUSTRATION 3
Alpha Manufacturing Company produces a single product, which is known as Sigma. The product
requires single operation and the standard cost for this operation is presented in the following
standard cost card.
Standard cost card for product sigma N N

2 kg of A at N1 per kg. 2.00
1 kg of B at N3 per kg 3.00
Direct labour(3 hours at N3 per hour) 9.00
Overheads
Variable (3 hours at N2 per direct labour hour) 6.00
Fixed (3 hours at N4 direct labour hour) 12.00 18.00
Total standard cost 32.00
Standard selling price 40.00
Page 358
Alpha Limited, budgets production of 10,000 units of Sigma in the month of April and the
budgeted cost based on the information contained in the standard cost card is as follows:
The budget is based on the above standard cost and an output of 10,000 units.
N N
Sales (10,000 units of sigma) 400,000
Direct Materials
A: 20,000 kgs. At N1 per kg. 20,000
B: 10,000 kgs. At N3 per kg 30,000
Direct labour (30,000 hrs at N3 per hrs) 90,000
Variable overheads (30,000 hrs at N2 per DLH) 60,000
Fixed overheads 120,000 (320,000)
Budgeted fixed overheads are N120,000 per month and are charged on the basis of direct labour
hours, giving a fixed overhead rate of N4 per direct labour hour (120,000/30,000 direct labour
hours).
The actual results for April are:

N N
Sales (9,000 units at N42) 378,000
Direct Materials
A: 19,000 kgs. At N1.1 per kg. 20,900
B: 10,100 kgs. At N2.8 per kg 28,280
Direct labour (28,500 hrs at N3.20 per hrs) 91,200
Variable overheads 52,000
Fixed overheads 116,000 (308,380)
Manufacturing overheads are charged to production on the basis of direct labour hours. Actual
production and sales for the period were 9,000 units.
Required:
(a). Calculate the operating profit variance for the month of April.
(b). Analyze this difference into sub-variances, covering both sales and production cost
variances.
SUGGESTED SOLUTION
(a). The operating profits variance for the month of April

N
Actual profit 69,620
Operating profit variance 10,380 (A)
Page 359
(b). Analysis of the variance into sales and costs variances.
(i). Sales price variance

(N40 – N42) x 9,000 = N18,000 (F)
(ii). Sales volume margin variance

(10,000 – 9,000) x (N80,000/10,000)= N8,000 (A)
(iii). Material price variance

A (N1 – N1.10) x 19,000 kgs = N1,900 (A)
B (N3 – N2.80) x 10,000 kgs = N2,020 (F)
N120 (F)
(iV). Material usage variance

A ((2 x 9,000) – 19,000) x N1= N1,000 (A)
B ((1 x 9,000) – 10,100) x N3 = N3,300 (A)
N4,300 (A)
(v). Labour rate variance

(N3 – N3.20) x 28,500 = N5,700 (A)
(vi). Labour efficiency variance

((3 x 9,000) – 28,500) x N3 = N4,500 (A)
(vii). Variable overhead expenditure variance

((N2 – (N52,000/28,500)) x 28,500 = N5,000 (F)
(viii). Variable overhead efficiency variance

((3 x 9,000) – 28,500) x N2 = N3,000 (A)
(ix). Fixed overhead budget variance

Actual fixed overhead N116,000
Less budgeted bonc N120,000
Variance N4,000 (F)
(x). Fixed overhead capacity variance

budgeted bonc N120,000
actual hours at standard rate (28,500 x N4) N114,000
Variance N6,000 (A)
(xi). Fixed overhead efficiency variance

Standard hours at standard rate (3 x 9,000 x N4) N108,000
Actual hours at standard rate N114,000
Variance N6,000 (A)
Reconciliation of the actual profit:
Page 360
N N N
(F) (A) Total
Less/add variances
Sales price 18,000
Sales volume margin 8,000
Material price 120
Material usage 4,300
Labour rate 5,700
Labour efficiency 4,500
Variable overhead expenditure 5,000
Variable overhead efficiency 3,000
Fixed overhead budget 4,000
Fixed overhead capacity 6,000
Fixed overhead efficiency 6,000
27,120 37,500 (10,380)
Actual profit 69,620
MATERIAL MIX AND YIELD VARIANCE
In many industries, particularly process industries, input consists of more than one type of material
and it is possible to vary the mix. In many cases this would then affect the quantity of output
produced. Breaking it down into material mix and yield variances can do further analysis of
material usage variance for control purposes.
MATERIAL MIX VARIANCE
The material mix variance arises when the mix of materials used differs from the predetermined
mix included in the calculation of the standard cost of an operation. If the mixture is varied so that a
larger than expected proportion of a more expensive material is used, there will be adverse
variance. When a larger than expected proportion of a cheaper material is included in the mixture,
then a favourable variance occurs. Mix variance can be determined using
(standard mix based on input – actual mix) x standard price.
MATERIAL YIELD VARIANCE
The material yield variance arises when there is a difference between the standard output for a
given level of input and the actual output attained. This definition is logical in the way that it
considers the input. When we calculate the variance however, we will reverse the argument and
consider the implied effect on the input. It can be determined using:
(standard yield based on input – actual yield) x standard yield price.
ILLUSTRATION 1
Page 361
Rolyink Venture operates a standard costing system. The standard direct material mix is to produce
1,000 kilos of output is as follows:
Material grade Input quantity Standard price per

(kilos) kilo input (N)
A 600 1.10
B 240 2.40
C 360 1.50
During April, the actual output of the product was 21,000 kilos. The actual materials issued to
production were:
Material grade Quantity (kilos)
A 14,000
B 5,500
C 5,500
Determine the material usage variance and sub-analyze this into material yield and mix variance.
SUGGESTED SOLUTION
It is important to know that the addition of material yield and mix variance should be equal to usage
variance
(i). Material usage variance

A ((600/1000 x 21,000) – 14,000) x N1.10 = N1,540 (A)
B ((240/1000 x 21,000) – 5,500) x N2.40 = N1,104 (A)
C ((360/1000 x 21,000) – 5,500) x N1.50 = N3,090 (F)
Total usage variance = N446 (F)
(ii). Material mix variance

The standard kilo for 1,000 kilos of output is 1,200 kilos. The proportion of each grade can
be determined and used on actual kilos of 25,000 for output of 21,000 kilos.
A ((600/1200 x 25,000) – 14,000) x N1.10 = N1,650 (A)
B ((240/1200 x 25,000) – 5,500) x N2.40 = N1,200 (A)
C ((360/1200 x 25,000) – 5,500) x N1.50 = N3,000 (F)
Total mix variance N150 (F)
(iii). Material yield variance

To compute this, first, we must determine the standard yield cost per output by dividing the
total input cost for 1,000 by the output.
The cost of 1,000 kilos of output = (600 x N1.10) + (240 x N2.40) + (360 x N1.50) =
N1,776
Cost per kilo of output or yield = N1,776/1,000 kilos = N1.776
If 1,200 kilos input is expected to yield 1,000 kilos output, the yield variance will therefore
be: ((25,000 x 1,000/1,200) – 21,000) x N1.776 = N296 (F)
Mix + yield variance = usage variance, i.e. N150 (F) + N296 (F) = N446 (F).
Page 362
ILLUSTRATION 2
Details of the standard material costs of the output of a process are as follows:
Material Type Standard input N
X 30 litres at N50 per litre 1,500
Y 25 litres at N60 per litre 1,500
Z 45 litres at N40 per litre 1,800
100 4,800
Less Normal loss 4 -
Standard yield 96 litres at N50 per gallon 4,800
During the month of July, the following materials were introduced into the process:
Material Type Standard input N
X 270 litres at N52 per litre 14,040
Y 260 litres at N59 per litre 15,340
Z 470 litres at N43 per litre 20,210
1,000 49,590
The actual output for July was 964 litres.
Determine the following material variance.
(i). Price
(ii). Mixture and
(iii). Yield
SUGGESTED SOLUTION
(i). Material Price variance

X (N50 – N52) x 270 = N540 (A)
Y (N60 – N59) x 260 = N260 (F)
Z (N40 – N43) x 470 = N1,410 (A)
Material price variance N1,690 (A)
(ii). Material mix variance

X ((30/100 x 1,000) –270) x N50 = N1,500 (F)
Y ((25/100 x 1,000) – 260) x N60 = N600 (A)
Z ((45/100 x 1,000) – 470) x N40 = N800 (A)
Material mix variance = N100 (F)
(iii). Material yield variance

((96/100 x 1,000) – 964) x (N4,800/96) = N200 (F)
Page 363
PLANNING AND OPERATIONAL VARIANCE
Traditional variance analysis simply records the differences between the actual performance and
standard performance. No attempt is made to distinguish between controllable and uncontrollable
variances.
In order to calculate planning and operating variances, the original standard is first adjusted so that
it accurately reflects the current operating conditions. Planning variance is then calculated to show
the amount to show the amount of variance, which is caused by an un-necessary change in the
standard.
Operating variance, based on this revised standard is more meaningful because it highlights those
differences, which are potentially within management control, instead of combining them with
differences which are caused by planning errors.
Thus, instead of calculating variances from static standards and actual results, it is suggested that it
may be relevant to calculate variances arising from both original standard data (ex-ante budget)
and, with the benefit of hindsight, arising from what our expectations might have been, had we
known when standards were set, what we know at the end of the period (ex-post budget). In other
words, standards should reflect changes in conditions so that it can be established how changes in
the environment occurred, and how managers react to those changes.
ILLUSTRATION 1
A raw material, BEX-M is used in the production of JELLY and an extract from the standard cost
card for Jelly showing the rates of usage and expected price is as follows:
Jelly Standard Cost Card (Extracted)

Material per unit: 10kgs of BEX-M at N6 per kg = N60. During the current period 270 units of
Jelly were produced and usage was 2,850 kgs with an actual material cost of N16,530. Due to
world-wide price movements, BEX-M was freely available at N5.50 per kg during the period.
Calculate:
(i). The traditional variances

(ii). The planning and operating variances.
SUGGESTED SOLUTION
(i). The traditional variances

(a). Material usage variance = ((10kg x 270units) – 2,850) x N6 = N900 (A)
(b). Material price variance = ((N6 – N5.8) x 2,850 kgs = N570 (F)
(ii). The planning and operating variances

(a). Planning variance = (Ex-ante price – ex-post price) x actual quantity
(N5.50 – N6) x 2,850 = N1,425 (F)
Page 364
(b). Operating variances
(i). Price variance = (Ex-post price – actual price) x actual quantity
(N5.50 – N5.80) x 2,850 = N855 (A)
(ii). Usage variance = (2,700 – 2,850) x N6 = N900 (A)
Note, addition of planning and operating variance will give material price variance, it can
therefore be said that planning and operating variance is further analysis of material price
variance.
ILLUSTRATION 2
AB Limited is a producer of synthetic yarn. One of its products EO, can be span from either Nyon
or Cotel. Whichever raw material is used in the production of EO, 10 percent of the original bulk of
the material will be lost due to fibre spin-off.
The procurement officer forecasts that the average price AB Limited will have to pay for Nyon
during the next operating period will be N1 per kilo. This is slightly less than what Cotel would be
expected to cost during the same period. The company decides to use Nyon for the production of
10,000 kilos of EO in the next period and prepares a budget accordingly. At the end of the period
for which the budget has been prepared the weight of EO produced was exactly on target. However,
only 10,500 kilos Nyon had been required for the production process although the total cost of this
turned out to be N15,750. As the amount paid for Nyon seemed rather high, an investigation was
made into the cost of this. It was found that the efficient procurement prices of the two raw
materials that could have been used for the production of EO during the period concerned were:
Nyon N1.40 per kilo

Cotel N1.30 per kilo
Required:
Calculate the material cost, operational and planning variances for control purposes.
SUGGESTED SOLUTION
It is important to note that 10% of the original bulk of the material will be lost due to fibre spin-off
this must be provided for in arriving at standard usage.
(1). Material total cost variance

Standard cost boao (10,000 x 10/9 x N1) = N11,111
Actual cost of material = N15,750
Material total cost variance N4,639 (A)
(2). Material planning variance

(N1 – N1.30) x 10,500 = N3,150 (A)
(3). Direct material operational variance

(a). Price variance = (N1.30 – N1.50) x 10,500 = N2,100 (A)
Page 365
(b). Usage variance = ((10,000 x 10/9) – 10,500) x N1 = N611 (F)
WORKING BACK FROM VARIANCE
It is possible to be given predetermined variances and be requested to calculate the missing data or
missing figures. There are no special or specific formulae for determining such missing figures or
performing the required operation. The only technique is to be conversant with the formula of
standard costing technique and the application of common sense. When a missing figure is desired,
it is advisable to recall the related formula concerning such a specific item and determine which
one will eventually assist to provide the required data and this should be used appropriately.
ILLUSTRATION 1
The following was extracted from the records of a manufacturing company.
Budget/Standard
The standard material allowed per unit is 4kg at a standard price of 75 kobo per kg. The budgeted
direct labour hour period was 80,000 hours at a budgeted cost of N152,000. Budgeted variable
production overhead was N96,000 for the 80,000 hours at a budgeted cost of N152,000. Budgeted
variable production overhead was N96,000 for the 80,000 hours.
Details for the 4 weeks period are given as follows:

Variances:
Direct wage rate 20 kobo per hour – adverse
Direct material price (calculated on purchase at time of receipt at 5 kobo per kg.) N9,000 –
favourable.
Direct material usage N1,500 – adverse
Variable production overhead N2,200 – favourable
Variable production overhead efficiency N2,400 – adverse
Production 38,000 units.
There are no stocks at the beginning of the period, but there are 26,000 kgs of direct material in
store at the end of the month.
You are required to determine the following for the period.
(i). The number of kgs of direct material purchase.

(ii). The number of kgs of direct material used above the standard allowed.
(iii). The variable production overhead expenditure variance
(iv). The actual hours worked.
(v). The number of standard hours allowed for the production achieved.
SUGGESTED SOLUTION
(i). The number of kgs of direct material purchased.

Material price variance can be used in order to determine quantity purchased, since the
price variance is based on purchases. Therefore, the only unknown variable will be the
required purchases as follows:
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Material price variance = (std price – act price) x qty purchased, substituting for the
known = (N0.75 – N0.80) x QP = 9,000 or 0.05QP = 9,000 or QP = 9,000/0.05 =
180,000kgs.
That is, Material purchase = 180,000kgs.
(ii). Number of kgs of direct material used above the standard allowed.
Since the usage variance is given as N1,500 adverse, the excess can be determined by
dividing this figure by the standard price, i.e. excess usage = N1,500/N0.75 = 2,000kgs.
Alternatively, the actual usage can be determined and compared with standard usage using
the material usage equation.
Usage variance = (std Qty – Act Qty) x Std Cost
((38,000 x 4kgs) – AQ) x N0.75 = -N1,500 or 152,000kgs – AQ = -2,000kgs
AQ = 154,000 kgs
Excess usage = Std usage – Act usage = 152,000 – 154,000 = 2,000kgs.
(iii). Variable production overhead expenditure variance. The addition of variable overhead
expenditure and efficiency variance gives total variable overhead cost variance. Here, we
were given the total variable overhead cost variance and the efficiency variance. Therefore,
expenditure variance = total VPO cost variance – VPO efficiency variance, then
VPO expenditure variance = N2,200 - - N2,400 = N4,600 (F)
(iv). The actual hours worked:- In order to determine the actual hours worked, the direct wages
rate can be used. The standard rate will be (budgeted wages cost/budgeted hours, i.e.
N152,000/80,000hours) N1.90 per hour. Since there is adverse wage rate of 20 kobo, it
therefore implies that actual wage rate is higher than standard by 20 kobo. Actual wage rate
will be N1.90 + N0.20 = N2.10. The actual wages paid is N163,800.
Actual hours worked = N163,800/N2.10 = 78,000 hours
(v). The number of standard hours allowed for the product achieved:- There is little or less
information on labour efficiency variance to enable us determine the standard hours, but
the computation of variable production overhead efficiency variance involving the use of
standard hours and actual hours, may be applied in this situation.
Standard variable overhead cost per hour = budgeted cost/budgeted hours =
N96,000/80,000 hours = N1.20 per hour
The standard hours can therefore be determined by

VPO efficiency variance = (Std hrs – Act hrs) x Std rate
(SH – 78,000) x N1.20 = -2,400
SH – 78,000 = -2,000 Standard hours = 76,000 hours
ILLUSTRATION 2
The Global Company makes a variety of leather goods. It uses standard costs and a flexible budget
to aid planning and control. Budgeted variable overhead at a 60,000 direct labour hour level is
N36,000.
During April the company had an unfavourable variable overhead efficiency variance of N1,200.
Material purchases were N322,500. Actual direct labour costs incurred were N187,600. The direct
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labour efficiency variance was N6,000 unfavourable. The actual average wage price was N0.20
lower that the average standard wage price.
The company uses a variable overhead rate of 20 percent of standard direct labour cost for flexible
budgeting purposes. Actual variable overhead for the month was N41,000.
Required.
Compute the followings, and use (U) or (F) to indicate whether requested variances are
unfavourable or favourable.
i. Standard direct labour cost per hour.
ii. Actual direct labour hours worked.
iii. Total direct labour price variance
iv. Total flexible budget for direct labour costs.
v. Total direct labour variance
vi. Variable overhead price/rate variance in total.
SUGGESTED SOLUTION
i. The variable overhead price is N0.60, this is obtained by dividing N36,000 by 60,000
hours. Therefore the direct labour price must be N0.60/.20 = N3.00.
ii. Actual hours worked: Actual costs, N187,600/(N3.00 – N0.20) = 67,000 hours.
iii. Total direct labour price variance = 67,000 actual hours x N0.20 = N13,400 (F).
iv. Total flexible budget for direct labour: Efficiency variance was N6,000 unfavourable,
therefore, excess hours must have been N6,000/N3 = 2,000. Consequently, standard hours
allowed must be 67,000 – 2,000 = 65,000. Flexible budget = 65,000 x N3.00 = N195,000.
v. Total direct labour cost variance = N195,000 – N187,600 = N7,400 (F) or N13,400(F) –
N6,000(U) = N7,400 (F)
vi. Variable overhead price/rate variance in total: Flexible budget = 65,000 x N0.60 =
N39,000. Total variance = N41,000 – N39,000 = N2,000 (U). Price variance = N2,000 –
N1,200 (efficiency variance) = N800 (U).
EFFICIENCY LEVEL RATIO
These are the ratios available that give various activities level more meaningful interpretation and
understanding. These ratios are:
(a). Productive labour efficiency ratio:- This presents, in familiar percentage figures the
effective expected labour hours to be used for the production level attained to the actual
productive hours. This is achieved by:
Standard hour allowed for production achieved x 100

Actual hours worked 1
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(b). Productive Labour volume ratio:- This is the measurement of the standard hours for the
actual production attained to the total budgeted hours for the production. This is determined
by:
Standard hour allowed for actual production x 100

Budgeted hours for the production attained 1
(c). Productive capacity ratio:- This presents, in familiar percentage figures the usage of
available capacity. That is, the actual hours worked to the budgeted hours available. This is
determined as follows:-
Actual hours worked production attained x 100

Estimated/Budgeted hours 1
ILLUSTRATION 1
Using the information below you are required to calculate the productivity ratio, the production
volume ratio and the capacity ratio for each of the two-production departments X and Y.
Dept X Product D Product C

Budgeted production, in units 18,000 4,000
Standard minutes required produce one unit 20 30
Actual units produced 15,000 10,000
Total actual hours worked on both products is 11,111 hours
Dept Y
Budgeted standard hours 10,000
Actual 9,000
Standard hours produced 9,450
SUGGESTED SOLUTION
The initial calculations for department X

Budgeted standard hours ((18,000 x 20/60) + (4,000 x 30/60)) = 8,000 hours
Standard hours produced ((15,000 x 20/60) + (10,000 x 30/60)) = 10,000 hours
Actual hours worked 11,111 hours
(a). Labour efficiency ratio

Dept. X = 10,000/11,111 x 100/1 = 90%
Dept. Y = 9,450/9,000 x 100/1 = 105%
(b). Production volume ratio

Dept. X = 10,000/8,000 x 100/1 = 125%
Dept. Y = 9,450/10,000 x 100/1 = 94.5%
(c). Capacity utilization ratio

Dept. X = 11,111/8,000 x 100/1 = 139%
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Dept. Y = 9,000/10,000 x 100/1 = 90%
ILLUSTRATION 2
An engineering company planned to manufacture 5,000 components in a particular month. Each

component requires four standard hours to complete. For the 22 working days in the month, 120
workers were allocated to the job. The factory operates an 8-hour day.
When the actual results were analyzed, it was revealed that absenteeism had averaged 5%, an
average of 5 hours overtime had been worked by those present and 4,800 components had been
completed.
From the information given, you are required to calculate the following ratios for the month:
(i). The production volume ratio

(ii). The capacity ratio and
(iii). The productivity (or efficiency) ratio.
SUGGESTED SOLUTION
The initial calculations

(a). Budgeted standard hours = (5,000 x 4hrs) = 20,000 hrs
(b). Actual hours worked = (120 x 22 x 8 x 95%) x (120 x 5) = 20,664 hrs
(c). Standard hours of produced = (4,800 x 4 hrs) = 19,200
The ratios
(i). The production volume ratio = 19,200/20,000 x 100/1 = 96%
(ii). The capacity ratio = 20,664/20,000 x 100/1 = 103%
(iii). The efficiency variance = 19,200/20,664 x 100/1 = 93%
1. Universal Cosmetics Industries Limited produces special hair cream called “Hair Jelly
Cream’. The company uses Standard Marginal Costing. The Standard Cost card shows the
following details:
COST PER DRUM
Direct Materials: 20kgs of Jerry at N500 per kg 10,000

10kgs of cream line at N300 per kg 3,000
Direct Labour 100 hours at N400 per hour 40,000
Variable Overhead 100 hours at N25 per hour 2,500
55,500
Gross Contribution 14,500
Selling Price per Drum 70,000
During the month of April, the actual performance was as follows:
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Actual production and sales 1,000 drums.
25,000kgs of Jerry were purchased costing N13,750,000, 19,000kgs of Jerry were used.
12,000kgs of cream line were purchased costing N3,480,000. 10,100kgs were used in
production
Actual sales N73, 000,000
98,000 hours were worked and paid for at N37, 240,000.
Variable overhead incurred was N2, 600,000
1,200 drums of hair jerry cream were budgeted.
Required:
Calculate the following Variances:
i. Direct Material Price Variances

ii. Direct Material Usage Variances
iii. Direct Labour Rate Variances
iv. Direct Labour Volume Variances
v. Variable Overhead Expenditure Variances
vi. Variable Overhead Volume Variances
vii. Sales Price Variance
viii. Sales Volume Variance
2. Standard Chemicals Plc has established the following standards for producing one can of a
machine lubricant. A can contains 27 litres of the product.
15 litres of Material A at N140 per litre

15 litres of Material B at N180 per litre
No stocks of materials are kept. Purchases are made as needed so that all price variances
relate to materials actually consumed in production.
For the quarter ended 31st March 1997, actual results showed that 300,000 litres of the
material were used as follows;
135,000 litres of Material A at N160 per litre

165,000 litres of Material B at N190 per litre
10,230 cans of lubricants were produced during the quarter.
You are required to calculate the total materials variance and analyze it into its price,
usage, yield and mix components.
1. Universal Cosmetics Industries Limited
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i. Material Price Variance
Jerry (N500 – N550) x 25,000 = N1,250,000 (A)
Cream (N300 – N290) x 12,000 = 120,000 (F)
N1,130,000 (A)
ii. Material usage variance

Jerry ((20 x 1,000) – 19,000) x N500 = N500, 000 (F)
Cream ((10 x 1,000) – 10,100) x N300 = 30,000 (A)
N470,000 (F)
iii. Labour rate variance

(N400 – N380) x 98,000 =N1,960,000 (F)
iv. Labour efficiency variance

((100 x 1,000) – 98,000) x N400 =N800,000 (F)
v. Variable expenditure variance

(N25 – N26…..) x 98,000 =N150,000 (A)
vi. Variable efficiency variance

((100 x 1,000) – 98,000) x N25 =N50,000 (F)
vii. Sales Price variance

(N70,000 – N73,000) x 1,000 =N3,000,000 (F)
viii. Sales volume margin variance

(1,200 – 1,000) x N14,500 =N2,900,000 (A)
2. STANDARD CHEMICALS PLC
a). Total material cost variance

Standard costs Material A (10,230 x N140) = 21,483,000
Material B (10,230 x N180) = 27,621,000 49,104,000
Actual costs Material A (135,000 x N160) = 21,600,000
Material B (165,000 x N190) = 31,350,000 52,950,000
Material total cost variance 3,846,000 (A)
b). Material Price Variance

Standard Price Material A (135,000 x N140) = 18,900,000
Material B (165,000 x N180) = 29,700,000 48,600,000
Actual costs Material A (135,000 x N160) = 21,600,000
Material B (165,000 x N190) = 31,350,000 52,950,000
Material price variance 4,350,000 (A)
c). Material Usage Variance

Material A: Standard usage (10,230 x 15) x N140 = 21,483,000
Actual usage 135,000 x N140 = 18,900,000 2,583,000(F)
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Material B: Standard usage (10,230 x 15) x N180 = 27,621,000
Actual usage 165,000 x N180 = 29,700,000 2,079,000(A)
Material Usage variance 504,000 (F)
d). Material yield variance

Standard yield price
Standard cost (15 x N140) + (15 x N180) = N4,800
Standard yield (15 + 15) less 10% = 27
Standard yield price N4,800/27 = N177.77778
Actual input litres 300,000

Less 10% normal loss 30,000
Expected yield 270,000
Actual yield (27 x 10,230) 276,210
Variance 6,210 (F)
Material yield variances (6,210 x N177,7778) = N1,104,000 (F)
e). Material Mix Variance
Material Standard Actual Variance Standard Variance

Mix Mix Qty Price Cost
A 150,000 135,000 15,000 (F) 140 2,100,000 (F)
B 150,000 165,000 15,000 (A) 180 2,700,000 (A)
600,000 (A)
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CHAPTER 14
BUDGETARY SYSTEM AND BUDGETARY CONTROL
A budgetary system is made up of both budgetary planning as well as the budgetary control.
A budget may be defined as a plan quantified in monetary terms, prepared and approved prior to a
defined period of time, usually showing planned income to be generated and/or expenditure to be
incurred during that period and the capital to be employed to attain a given objective. A budget
therefore can be defined as a future plan of action either for the whole organization or a section
thereof. It could also be defined as a financial and/or quantitative statement prepared and approved
prior to a defined period of time of the policies to be pursued during those periods.
Budgetary control on the other hand emphasizes the control of plans by comparing actual results
against planned to identify variances upon which corrective actions can take place. It could also be
defined as the establishments of budgets relating the responsibilities of executives to the
requirements of a policy and the continuous comparison of actual with budgeted results either to
secure by individual action the objectives of the policy or to provide a basis for its revision.
BUDGETARY SYSTEM AND CORPORATE PLANNING
It is instructive to note that the budgetary process is only part of the whole corporate planning of an
organization. The budget translates the long-range plans (or the corporate plans) of an organization
into annual operating plans.
The budgeting process cannot be viewed as being purely concerned with the current year. It must
be considered as an integrated part of the long-term planning process. It is influenced by decisions,
which have been taken in the past, and it has implications for programmes, which will continue in
future periods.
Corporate planning is the formalized, long-range planning process used to define and achieve
organizational goals.
It could also be defined as a process by which an organization defines the reasons for its existence
and operations, establish its principal objectives and decide how it will work towards achieving
them.
USES OF BUDGETS
The reasons for producing a budget are as follows:-

(a). To aid the planning of annual operations.
(b). To co-ordinate the activities of various parts of the organization and to ensure that the
parts are in harmony with each other.
(c). To communicate plans to the various center managers
(d). To motivate managers to strive to achieve the organizational goals.
(e). To control activities.
(f). To evaluate the performance of managers.
(g). To authorize actions to be taken by managers.
These are further discussed below:
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PLANNING
The major decisions will normally be taken as part of the long-term planning process, however, the
annual budgeting process leads to the refinement of those plans, as managers must produce detailed
plans for the implementation of the long-range plans. Without the annual budgeting process that
preserves day-to-day operations, problems may tempt managers not to plan for future operations.
The budgeting process ensures that managers do plan for future operations and that they consider
how conditions in the next year might change and what steps they should take now to respond to
these challenges.
CO-ORDINATION
The budget serves as a vehicle through which actions of different parts of an organization can be
brought together and reconciled into a common plan, without any guidance, managers may each
make their own decisions believing that they are working in the best interest of the organization.
COMMUNICATION
Through the budget, top management communicates its expectations to lower-level management so
that all members of the organization may understand these expectations and can co-ordinate their
activities to attain them. It is not just the budget itself, which facilitates communications. Much
vital information is communicated in the actual act of preparing it.
MOTIVATION
A budget provides a standard, which, under certain circumstances a manager may be motivated to
strive to achieve it. If individuals have actively participated in preparing the budget, and it is used
as a tool to assist managers in managing their departments, it can act as a strong motivational
device by providing a challenge.
CONTROL
A budget assists managers in managing and controlling the activities for which they are
responsible, by comparing the actual results with the budgeted amounts for different categories of
expenses, managers can ascertain which costs do not conform to the original plan and thus require
their attention. This process enables management to operate a system of management by exception,
which means that a manager’s attention and effort can be concentrated on significant deviations
from the expected results.
PERFORMANCE EVALUATION
The budgetary system is also used as a basis of judging actual results. Budgeted goals and
performance are generally regarded as being more appropriate than past performances. The major
drawback of using historical data for judging performances is that inefficiencies may be concealed
in the past performance and above all there could be significant changes during the current period.
AUTHORIZATION
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The budget can be used to authorize the expenditure contained in it. For instance, departmental
managers may not require approval for expenditure contained in the budget. Bureaucratic delays or
procrastinations in execution of plans are thereby reduced to the barest minimum.
LIMITATIONS OF BUDGETS
(1). Responsibility Accounting:- A central feature of budgetary control is that variances (i.e.
differences between budget and actual performance) are the responsibility of an individual.
Budgets should be designed, as far as possible, to report variances only to managers who
have some responsibility over them. However, many variances will arise which carry joint
responsibility, or which any manager cannot actually control. Examples include: An
unpredictable rise in the price of imported raw material, design faults which cause
production overspending, production bottlenecks which cause a sales shortfall.
(2). Setting Targets:- The active budget process rests upon the idea that target can be set for
revenues and expenses in the firm. The question is what is a fair target? Budgets, which are
too tight and are perceived as unachievable, may be disregarded. Budgets which are very
generous will be easily achieved and provide no incentive for improved performance.
(3). Inter-Departmental Conflict:- If the preparation of budgets and the use of budgetary
control are not properly managed they can lead to serious interdepartmental conflict. This
can also result in sub-optimization.
(4). Volatile Environment:- Difficulty of updating the systems to harmonize with the
changing environment within which management operates. How, for example, can we cope
with inflation?
(5). Just A Tool:- No budgetary system, no matter the sophistication can replace the need for
superior executive ability in major business decisions.
(6). Costs:- Budgeting requires a considerable amount of time and effort. Many companies
maintain a twelve-month budget on a continuous basis by adding a future month as current
month expires. While this does not create a major expenditure for large or medium sized
organizations, smaller companies may find it difficult to justify the costs involved.
BUDGETARY PROCESS
The following are the basic steps needed in designing and implementing the budgetary control
system:
1. Establishment of Company’s Objective:- The short, medium and long-term objectives of the
business should be formally approved by top management without these objectives the
preparation of budgets will lack direction. Although the budgetary system emphasizes short-
term objectives of a business for it to be effective, it must operate within the contexts of the
corporate plans of an organization. Corporate planning is the formalized long-range planning
process used to define and achieve organizational goals.
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2. Top Management Support:- The involvement and support of top management is required in
order to encourage or elicit the support of all managers holding positions of responsibility in
the organization.
3. Participation and Motivation of Management:- Individual managers should be motivated to

participate actively in the preparation of budgets relating to their areas of responsibility. This
means that managers who are responsible for meeting the budgeted performance should
prepare the budget for those areas for which they are responsible. The preparation of the budget
should be a bottom-up process. The budget should then be negotiated by those who prepare the
budget and their superiors and eventually agreed by both parties.
4. Well-Designed Organization Structure:- A realistic organization structure with clearly

defined responsibilities, must be established. In general, managers should be responsible only
for those areas over which they have control. It is therefore important first to establish
responsibilities to the manager of those areas. This relationship can further be classified
through an organization chart.
5. Determining the Factor Which Restricts Performance:- In every organization there would
be a factor which restricts performance for a given period. This is known as a principal budget
factor. Prior to the preparation of the budgets, it is necessary for top management to determine
the factor, which restricts performance as this factor determines the point at which the annual
budgeting process should begin. For instance, in a manufacturing set up, the demand for the
business product may be the key factor, hence the sales budget may form the basis for the
whole budget.
6. Communicating Details of the Budget Policy:- Many decisions affecting the budget year will
have been taken previously as part of the long-term planning process. Thus, top management
must communicate the policy effects of the long-term plans to those who are responsible for
pre-planning the current year’s budgets. Policy effects might include planned changes in sales
mix or the expansion or contraction of certain activities.
7. Co-Ordination And Review By Budget Committee And Budget Officer:- Top management
should set up a budget committee to function as an overall review body for the budgeting
system and to decide any arguments between managers of different budget areas.
The members of a budget committee would vary dependent on size of the organization and the
nature of its business. However, in principle it should include representatives of three main
groups within the firm:
(i). Executive Management:- In order to provide decision making authority and to

reinforce corporate objectives.
(ii). Senior Budget Holders:- In order to establish meaningful and acceptable targets
on a participatory basis.
(iii). The Accounting Function:- In order to integrate the budgets, highlight

interdependencies and constraints and financial assistance to the committee.
Needless to say, other individuals and interest groups could be consulted as appropriate. The
major duties and functions of the budget committee are:
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(i). To act as an advisory committee to the chief executive and the budget officers
(ii). To direct executives on budgetary matters, largely via budget officers.
(iii). To receive and examine the profit budget and supporting budgets and to approve
them or call for amendments.
(iv). To interview budget holders concerning their budgets.
(v). To consider request for a budget during the course of the year.
In addition to the budget committee, a budget officer (invariably an accountant) must also be
appointed to carry out the following major functions in order to ensure that the co-ordination
and the review of the budget committee are very effective.
(i). To undertake detailed work in connection with the budgeting cycle and to
generally maintain the discipline of the system.
(ii). To collate the budgets and produce a draft master budget.
(iii). To detect errors and inconsistencies in the budget submission and to liaise with
those who prepare the budget.
(iv). To convene meetings of the budget committee.
8. Budget Manual:- A budget manual should be prepared by the accountant. The manual will
describe the objectives and procedures involved in the budgeting process and it will provide a
useful reference source for managers responsible for budget preparations. In addition the
manual may include a time-table which specifies the order in which the budgets should be
prepared and the dates when they should be presented to the budget committee. The manual
should be circulated to all individuals who are responsible for preparing the budgets.
9. Records: An appropriate accounting and information system should be established. This will
include records related to responsibility, a prompt and accurate reporting system showing
actual result against budget and the ability to provide more detailed information or advice on
request.
10. Final Acceptance:- When all the budgets are in harmony with each other, they are summarized
into a master budget which consists of a budgeted profit and loss account, a balance sheet and a
cash flow statement. After the master budget has been approved, the budgets are then passed
down through the organization to the appropriate responsibility centers. The approval of the
master budget is the authority for the managers of each responsibility center to carry out the
plans contained in each budgets.
11. Budget Review:- The budget process should not stop when the budgets have been agreed.
Periodically, the actual results should be compared with the budgeted results. These
comparisons should be made on a monthly basis and a report sent to the appropriate persons
before the middle of the month following, so that it would have the maximum motivational
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input. This will enable management to identify the items which are not proceeding according to
plan and to investigate the reasons for the differences and take corrective measures.
BUDGETARY IMPROVEMENT TECHNIQUES
TRADITIONAL/INCREMENTAL BUDGETING SYSTEM
Traditional government budgeting is known as incremental budgeting which places much emphasis
on narrowly defined control and accountability. The fundamental budget objective is to give due
consideration to existing or already started projects. The system gives priority to existing capital
expenditure in the current budget without necessarily concerned with the priority of current
challenges. Other features of incremental budgetary system are as follows:
1. This system of budgeting does not ensure continuous budgeting throughout the year and does
not encourage employment of full time staff. This is because this type of budgeting is
considered to be routine.
2. This system does not encourage prioritization of expenditure estimates.
3. The method does not encourage efficient, effectiveness and the economical use of funds.
4. It is based on financial inputs and not on the output of services, which these inputs are intended
to finance.
5. It is usually prepared for a short period e.g. one year only.
ADVANTAGES
 Quickest and easiest method
 Assuming that the historic figures are acceptable, only the increment needs to be justified.
 Avoids reinventing the wheel
DISADVANTAGES
 Builds in previous problems and inefficiencies, e.g. an overspend may result in a larger budget
allowance next year.
 Uneconomic activities may be continued, e.g. the firm may continue to make a component in-
house when it might be cheaper to outsource.
 Managers may spend unnecessarily to use up their budgeted expenditure allowance this year,
thus ensuring they get the same (or a larger) budget next year.
PERFORMANCE BUDGETING.
Performance budgeting could be defined as one, which presents the purposes and objectives for
which funds are requested, the costs of the programme proposed for achieving these objectives and
the quantitative data measuring the accomplishments and work performed under each program. It
therefore emphasizes the things, which government/companies do rather than the things, which
they buy. The following are the essential features of a full-fledged performance budgeting system.
(1). Classification of budgets in terms of function and activity.
(2). Measurement of work done or outputs provided by each activity.
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(3). Expression of the budget in a way which allows a direct comparison between cost of
leading and work to be performed for each program or activity.
(4). Monitoring of actual against budgeted cost and performance.
PLANNING PROGRAMMING BUDGETING SYSTEM (PPBS)
PPBS refer to the analysis of the output of a given program. The order here is that, just as business
provides goods to the consumers, so government departments provide services. It could also be
described as the analysis of alternatives to find the most effective means of reaching basic program
objectives. The following are the basic elements of PPBS:
(1). Identification and examination of goods and objectives in each major area of government
activities.
(2). Analysis of the output of a given program in terms of its objectives.
(3). Measurement of the total program cost not just for one but also for at least several years.
(4). Formulation of objectives and programmes extending beyond the single year of annual
budget.
(5). Analysis of alternatives to find the most effective means of reaching basic program
objectives.
(6). Establishment of these analytical procedures as a systematic part of the budget review.
ROLLING BUDGETS OR CONTINUOUS BUDGET
Continuous or rolling budget can be defined as the continuous up-dating of short-term budget by
adding say, a further month or quarter and deducting the earliest month or quarter so that the budget
can reflect current conditions.
Thus a rolling budget is a device, which attempts to help an organization over-come the problems
resulting from frequent unexpected or unforeseeable changes in activities and/ or costs. This is
therefore an attempt to prepare target and plans, which are more realistic and certain by shortening
the period between preparing budgets.
Suppose for example, that a continuous budgets is prepared every 3 months, the 1st 3 months will
be planned in great detail and the remaining nine months in lesser detail because of the greater
uncertainty about the longer future e.g.
January – December
January - March (Detailed)
April - December (Less Detailed)
April - June (Detailed)
July - March (Less Detailed)
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ADVANTAGES
1. At all times, figures for the next 12 months are available and management is made
continuously aware of the budgeting process.
2. Whereas 12 months budget becomes outdated when there is a rapid inflation, a continuous
budget system allows for more frequent re-assessment and revision in the light of
inflationary trends.
3. Management is able to concentrate on a suitable managerial time span, which it can
visualize and for which it can be more accountable.
DISADVANTAGES
1. Higher cost and effort required for continuous budgeting.
2. How does one decide on a period to be covered, i.e. a quarter or monthly? Will the shorter
period justify the extra work?
3. If the budget is built up from basic standard costs, there may be more changes each year in
standard product costs, as a result, valuation of closing stock, pricing of material issued,
may become more complicated.
ZERO BASED BUDGETING (ZBB)
ZBB implies starting the budget from a zero situation and justifying each segment of the budget
rather than merely adding to historical budgets or actual. Each activity is thought of as a mission, it
is challenged as to its needs, then as to the required level of activity. Conventionally, budgets are
only queried when they show increases in expenditure over previous year. In ZBB, there should be
positive attainment to eliminate inefficiency and shock from current expenditure. This structure is a
systematic budgeting, which requires four basic steps in implementation:
a. The formulation of an operational plan which identifies each decision unit.

b. The description of each decision unit as a decision package.
c. The appraisal and ranking of decision packages by using costs benefits analysis.
d. The allocation of resources to each of the decision packages.
A decision package is really the foundation of the ZBB system, a document that identifies and
describes a specific activity in such a manner that management can:
i. Evaluate it and rank it against other activities competing for the same or similar limited
resources.
ii. Decide whether to approve or disapprove it. ZBB was first introduced by Peter Pyhrr in
1969 at TEXAS Instrument in USA and made popular by ex-president Jimmy Carter.
ADVANTAGES
 Inefficient or obsolete operations can be identified and discontinued.
 It creates an inquisitorial attitude, rather than one which assumes that current practices
represent value for money.
 Wasteful expenditure is avoided
 Managers are forced to consider alternative methods of achieving their objectives.
 ZBB leads to increased staff involvement at all levels. This should lead to better
communication and motivation
 Attention is focused on outputs in relation to value for money.
 Knowledge and understanding of the cost behaviour patterns of the organisation will be
enhanced.
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 Resources would be allocated efficiently and economically.
DISADVANTAGES
 The time involved and the cost of preparing the budget is much greater than for less elaborate
budgeting methods. In some organisations because of the heavy paperwork involved ZBB has
become known as Xerox-based budgeting.
 It may emphasise short-term benefits to the detriment of long-term benefits.
 There is a need for management skills that may not be present in the organisation.
 Managers, staff and unions may feel threatened.
 The rankings of packages may be subjective where the benefits are of qualitative nature.
 It is difficult to compare and rank completely different types of activity.
 The budgeting process may become too rigid and the company may not be able to react to
unforeseen opportunities or threats.
 Incremental costs and benefits of alternative courses of action are difficult to quantify
accurately.
FIXED AND FLEXIBLE BUDGET
A flexible budget is one, which is designed to adjust the budgeted cost levels to suit the level of
activity actually attained. This is one, which is designed to adjust the budgeted cost levels to suit
the level of activity actually attained. This is achieved by analyzing each item of cost contained in
the budget into fixed and variable elements. By this, an estimate can be made of the expected costs
for the actual activity level experienced. This process is often known as “flexing” the budget. The
procedure for developing a flexible budget is in principle, quite simple but the results are only
Flexible budget should be distinguished from a fixed budget. Fixed budget is a budget with no
provision for adjustments should actual activity turn out to be different from that planned. The
major purpose of fixed budget is at the planning stage when it serves to define the broad objectives
of the organization. Unlike flexible budgets, which are useful for control purpose, fixed budgets are
only useful for planning purposes.
ACTIVITY BASED BUDGETING
Activity-based costing (ABC) can be used to produce more useful overhead budgets. Activity
budgets can be built up by multiplying the planned volumes of each product by the planned
quantity of each cost driver consumed and the expected cost per unit of cost driver. This is known
as Activity-Based Budgeting (ABB). Activity-based budgets can be used for planning, and control,
by combining flexible budgeting principles with activity-based costing. However, it is critical to
identify reliable service units (or cost drivers), otherwise you may alter the budget by wrong
factors.
The advantages of ABB are similar to those provided by ABC, which are:
 It draws attention to the costs of overhead activities. This can be important where overhead
costs are a large proportion of total operating costs.
 It provides information for the control of activity costs, by assuming that they are variable, at
least in the longer term.
 It provides a useful basis for monitoring and controlling overhead costs, by drawing
management attention to the actual costs of activities and comparing actual costs with what the
activities were expected to cost.
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 It also provides useful control information by emphasizing that activity costs might be
controllable if the activity volume can be controlled.
 ABB can provide useful information for a total quality management (TQM) programme, by
relating the cost of an activity to the level of service provided.
DISADVANTAGES
 A considerable amount of time and effort might be needed to establish an ABB system, for
example to identify the key activities and their cost drivers.
 ABB might not be appropriate for the organisation and its activities and cost structures.
 A budget should be prepared on the basis of responsibility centres, with identifiable budget
holders made responsible for the performance of their budget centre. A problem with ABB
could be to identify clear individual responsibilities for activities.
 It could be argued that in the short-term many overhead costs are not controllable and do not
vary directly with changes in the volume of activity for the cost driver. The only cost variances
to report would be fixed overhead expenditure variances for each activity.
TOP DOWN AND BOTTOM UP BUDGETING
Town down budget – A budget that is set without allowing the ultimate budget holder to have the
opportunity to participate in the budgeting process. Also called authoritative or non-participative.
Bottom up budget – A system of budgeting in which budget holders have the opportunity to
participate in setting their own budgets. Also called participative budgeting. Even here budgets
prepared by junior managers would be reviewed and challenged by senior management.
Advantages of participative budgets:

 Increased motivation (ownership of budget).
 Should contain better information, especially in a fast-moving or diverse business.
 Increases managers’ understanding and commitment
 Better communication
 Senior managers can concentrate on strategy.
Disadvantages of participative budgets:

 Senior managers may resent loss of control
 Bad decisions from inexperienced managers
 Budgets may not be in line with corporate objectives as managers lack a strategic perspective
and will focus just on divisional concerns.
 Budget preparation is slower and disputes can arise
 Figures may be subject to bias if junior managers either try to impress or set easily achievable
targets (budgetary slack)
 Certain environments may preclude participation, e.g. sales manager may be faced with long-
term contracts already agreed.
FUNCTIONAL BUDGET
A functional budget is one, which relates to any of the functions of an undertaking. Functional
budgets are subsidiaries to the master budget, which is the summary budget, incorporating its
component functional budgets, which is finally approved, adopted and employed.
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There are many types of functional budgets of which the following are frequently used.
(1). Sales budget
(2). Production budget
(3). Purchasing budget
(4). Production cost budget
(5). Plant utilization budget
(6). Capital expenditure budget
(7). Selling and distribution cost budget
(8). Cash budget.
(9). Budgeted income statement etc.
SALES BUDGET
This is probably the most difficult functional budget to prepare. It is not easy to estimate
consumers’ future demands, especially when a new product is being introduced. It is possibly the
most important subsidiary budget, because if the sales figure is wrong, then practically all the other
budgets will be affected, especially the master budget.
The sales budget is usually prepared in terms of quantities, then evaluated at budgeted unit prices. It
is classified under a number of headings of which the following are in common use: products,
territories, type of customer, salesmen and month.
The sales manager will be responsible for the preparation of the sales budget, particularly as
regards to the quantities part of the budget. He may have many aids in estimating sales, of which
the following may be considered; historical analysis of sales, business conditions, reports by
salesmen, market analysis and other special conditions.
Sales is mostly the principal budget factor for companies unless in special circumstance where
production, resources and so, may be the key budget factor.
PRODUCTION BUDGET
This shows the quantity of products to be manufactured. It is prepared by the production manager
and is based upon the following:
(a). The sales budget
(b). The factory capacity
(c). The budgeted stock requirements.
The production budget is classified under various headings:

(i). Product
(ii). Manufacturing departments
(iii). Months.
The production budget allows for a normal loss in production, so that net output will be sufficient
to meet sales’ requirements and forecast stocks. It will be sub-divided into months so that
production can be arranged over the year to meet possible seasonal demands, holiday periods, etc.
The budgeted production can be used as a basis for calculating the requirements of raw materials
and components, also for direct labour hours. The budget for direct labour is relatively simple to
prepare, once the production budget has been completed. It is a question of converting production
into labour hours and evaluating them. The direct material budget requires a similar treatment.
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Converting production into specified materials and evaluating them at standard prices. However,
the purchases budget necessitates a consideration of stocks of raw materials.
PURCHASING BUDGET
This is determination of quantities of raw material required for purchases within a given period and
will be determined having taken into consideration the following:
(a). The opening stock of raw material for the period.
(b). The material required for production within the period/year.
(c). The expected closing stock at the end of the period.
Material purchase will therefore be material required for production plus closing raw material less
opening raw material.
PRODUCTION COST BUDGET
This is the quantity of products to be manufactured, expressed in terms of cost. It is classified under
various headings such as:
(a). Product
(b). Manufacturing departments
(c). Months
(d). Element of cost
Many companies prepare a raw material budget, labour budget and overheads budget, which will be
summarized together to give the production cost budget.
PLANT UTILISATION BUDGET
This represents the plant requirements to meet the production budget. This budget may be very
important because:
(a). It details the machine load in every manufacturing department.
(b). It draws attention to any overloading in time for any corrective action to be taken e.g. shift
working, purchasing of new machinery, overtime working, sub-contracting, and
(c). It draws attention to any under- loading so that the sales manager can be requested to
investigate possible increased sales.
CAPITAL EXPENDITURE BUDGET
This represents the estimated expenditure on fixed assets during the budget period. It is based on
information such as the following:
(a). Over- loading shown in the plant utilization budget.
(b). Reports of the production manager requesting for new production machinery.
(c). Reports of the works engineers requesting for new service machinery.
(d). Reports of the distribution manager requesting for new transportation system.
(e). Reports of the accountant requesting for new office machinery.
(i). Decisions of the board to extend building etc.
SELLING AND DISTRIBUTION COST BUDGET
This represents the cost of selling and distributing the quantities shown in the sales budget. The
sales manager, advertising, public relations and sales office manager will co-operate with the
budget officer in the preparation of this budget.
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CASH BUDGET
This represents the cash receipts and payments, and the estimated cash balances for each month of
the budget period. Its main functions are:
(a). To ensure that sufficient cash is available when required.
(b). To reveal any expected shortage of cash, so that action may be taken e.g. bank overdraft,
loan arranged etc.
(c). To reveal any expected surplus of cash, so that if the management decides, cash may be
invested or loaned.
BUDGETED INCOME STATEMENT
Preparing the budgeted income statement involves combining the relevant amounts from the sales,
cost of goods sold and selling and administrative expense budgets and then subtracting interest, bad
debts and income taxes to obtain budgeted net income. The finance department provides these
amounts. In a comprehensive practice problem, the applicable amount for interest expense may
need to be calculated from information associated with the cash budget. Bad debt expense is based
on the expected proportion of un-collectibles stated in the information related to cash collections.
THE MASTER BUDGET
When the functional budgets have been completed the budget officer will prepare a master budget,
which will be the summary of all functional budgets into a budgeted profit and loss statement,
balance sheet and cash flow statement. The management will thereafter consider the budget and
pass it through all necessary approval stages and if they are not satisfied, they will call for
amendment. However, when the budget is finally approved it represents a standard, which will be a
target for attainment for the proposed period.
Adequate explanation would be given to management stating why the budgeted net profit for the
current budget period was lower or higher than for the corresponding budget period in the previous
year. Information would be readily available in the subsidiary budgets, which make up the master
budget for easy implementation.
It is essential to note that estimated cost can be categorized into three types of costs as;
discretionary, engineered and committed costs.
FEED-FORWARD CONTROL
Feed-forward control is defined as the forecasting of differences between actual and planned
outcomes and the implementation of actions before the event, to avoid such differences.
Whereas feedback is based on a comparison of historical actual results with the budget for the
period to date, feed-forward looks ahead and compares the target or objectives for the period, and
the actual results forecast.
Discretionary Costs
Many activities are viewed as beneficial to an organization, even though the benefits obtained, or
value added by performing the activities cannot be defined precisely, either before or after the
activity is completed. The costs of the inputs, or resources required to perform such activities are
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referred to as discretionary costs. These are discretionary in the sense that management must
choose the desired level of the activity based on intuition or experience because there is no well-
defined cause and effect relationship between cost and benefits. Discretionary costs are usually
generated by service or support activities. Examples include employee training, advertising, sales
promotion, legal advice, preventive maintenance, and research and development. The value added
by each of these activities is intangible and difficult, if not impossible to measure, where value
added refers to the benefits obtained by either internal or external customers. In terms of cost
behaviour, discretionary costs may be fixed, variable or mixed.
Engineered Costs
Engineered costs result from activities with reasonably well-defined cause and effect relationships
between inputs and outputs and costs and benefits. Direct material costs provide a good example.
Direct material costs provide a good example. Engineers can specify precisely how many parts
(inputs) are required to generate a specific output such as a microcomputer, a coffee maker, an
automobile, or a television set. Direct labour also falls into the engineered cost category as well as
indirect resources that vary with product specifications and production volume. Although the cause
and effect relationships are not as precise for indirect resources, these relationships can be
established using statistical techniques such as regression and correlation analysis. A key difference
between discretionary costs and engineered costs is that the value added by the activities associated
with engineered costs is relatively easy to measure. Engineered costs are variable in terms of cost
behaviour.
Committed Costs
Committed costs refer to the costs associated with establishing and maintaining the readiness to
conduct business. The benefits obtained from these expenditures are represented by the company’s
infrastructure. For example, the costs associated with the purchase of a franchise, a patent, drilling
rights and plant and equipment create long-term obligations that fall into the committed cost
category. These costs are mainly fixed in terms of cost behaviour and expire to become expenses in
the form of amortization and depreciation.
ILLUSTRATION 1
Functional Limited makes 3 products. Extracts from the standard cost records relating to these are
as follows:
Unit
Material Cost Unit of material in final product
N Product X Product Y Product Z
A 1.10 5 4 -
B 1.00 3 2 6
C 0.70 - 3 5
D 1.20 - 1 4
E 1.60 1 1 -
Although no losses occur in the use of materials A to D, the standard yield on materials E is only
90%. Moreover, this is an ideal standard, the expected yield is 80%. During the month of February
the following sales figures were budgeted:
Sales
Product (units)
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X 24,000
Y 30,000
Z 20,000
It is reckoned that 5% of the production of product Y will not pass the rigid quality control test
recently instituted by the company and will thus be disposed off immediately. Stocks on hand at the
beginning of February are projected to be:
Finished
Goods Units
X 3,600
Y 4,000
Z 3,200
Materials
A 40,000
B 60,000
C 30,000
D 10,000
E 18,000
The firm plans to increase finished goods stocks in order to satisfy orders more quickly. Thus,
production for February should be sufficient to raise stocks by 10% by the end of the period.
Material stocks, however, are considered to be too high and a reduction of 10% is planned by the
end of February.
Required: Prepare budgets for:

(a). Production (in quantity)
(b). Material usage (in quantity)
(c). Material purchases (in quantity and value).
SUGGESTED SOLUTION
(a). To determine the production in quantity, the closing stock will be added to sales units less
the opening stock. In a situation where there is normal loss this must be recognized in the
computation as follows:
Product X Y Z
* Closing stock (units) 3,960 4,400 3,520
Add sales (units) 24,000 30,000 20,000
Less opening stock 3,600 4,000 3,200
24,360 30,400 20,320
*Add Normal loss - 1,600 -
Production in quantity 24,360 32,000 20,320
Closing stock represent 110% of opening stock since we expect increase of 10%.
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Normal loss represents 5% of the production of product Y that will not pass the rigid
quality control test.
(b). The material usage quantity will be a function of production quantity multiplied by the
materials require per unit with provision for expected loss in yield.
Product X Y Z Total Usage

Production quantity 24,360 32,000 20,320 -
Material Usage Usage Usage
A 121,800 128,000 - 249,800
B 73,080 64,000 121,920 259,000
C - 96,000 101,600 197,600
D - 32,000 81,280 113,280
E 30,450 40,000 - 70,450
Provision is made for expected yield loss of 20% in material E.
(c). Material purchases in quantity and value.
Materials A B C D E
Closing stock (quantity) 36,000 54,000 27,000 9,000 16,200
Add usage (quantity) 249,800 259,000 197,600 113,280 70,450
Less opening stock (quantity) 40,000 60,000 30,000 10,000 18,000
Purchases (quantity) 245,800 253,000 194,600 112,280 68,650
Unit cost (N) 1.10 1.00 0.70 1.20 1.60
Purchases Cost (N) 270,380 253,000 136,220 134,736 109,840
ILLUSTRATION 2
Semko Engineering manufactures three products for the building industry. The budgeted sales of
the products A, B and T for the budgeted period are:
Product Quantity Price (N)
A 4,000 60
B 8,000 70
T 6,000 80
Materials used in the manufacture of the company’s products are:

Component Ref. No. 1922 2244 3366 4488
Component unit cost (N) 2.00 3.00 4.00 5.00
Quantities used:-
A 5 3 1 2
B 4 4 2 3
T 3 2 1 5
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Two types of labour are used, viz assemblers and wires, the standard unit times for each product
being:-
Product Assemblers Wires
Hourly rate 50k Hourly rate 60k
A 3 hrs 1.5 hrs
B 4 hrs 2 hrs
T 5 hrs 2.5 hrs
Production overhead which is absorbed into product costs on a direct labour hour basis, is budgeted
as follows:
N
Building occupancy 30,050
Equipment utilization 22,100
Personnel services 15,150
Materials handling 12,190
Production planning and control 12,310
Selling and distribution costs budgeted for the period are:

N
Representation 101,300
Sales office 30,100
Advertising and publicity 29,100
and are charged to products in proportion to the sales income of the period.
Stocks at the beginning of period 1 are expected to be:

Finished Goods Quantity Unit cost(N)
A 1,000 39
B 3,000 51
T 2,000 51
Components:
1922 40,000 2
2244 20,000 3
3366 10,000 4
4488 30,000 5
Closing stocks at the end of period 1 are expected to be an increase of 10% and reduction of 20%
on opening stocks of finished goods, and component parts respectively.
(i). Prepare budgets for:

(a). Sales in quantity and value
(b). Production quantities
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(c). Material usage quantities
(d). Material purchase quantity and value.
(e). Direct labour utilization and cost.
(ii). Prepare statement showing the valuation of finished stock at the end of period 1.
(iii). Prepare a budgeted profit for the period showing the amount of profit contribution by each
product.
SUGGESTED SOLUTION
(a). The sales in quantity and value:- The sales quantity given will be multiplied by selling
price to derive sales in value.
Product Sales (quantity) SP(N) Sales Value (N)

A 4,000 60 240,000
B 8,000 70 560,000
T 6,000 80 480,000
Total 1,280,000
(b). The production quantity:- This can be derived by adding closing stock to sales less the
opening stock for the period.
Product A B T
Sales units 4,000 8,000 6,000
Add closing stock units 1,100 3,300 2,200
Less opening stock units 1,000 3,000 2,000
Note that, the closing stock is derived by increasing the opening stock by 10%.
(c). Material usage quantities:- This will be determined by multiplying production quantities by
each of the component required for production as follows:
Component 1922 2244 3366 4488
Product A 20,500 12,300 4,100 8,200
B 33,200 33,200 16,600 24,900
C 18,600 12,400 6,200 31,000
Total 72,300 57,900 26,900 64,100
(d). Material purchases quantity and value:- This can be obtained by adding closing stock to
usage and deducting opening stock.
Component 1922 2244 3366 4488
Usage quantity 72,300 57,900 26,900 64,100
Add closing stock (qty) 32,000 16,000 8,000 24,000
Less opening stock (qty) 40,000 20,000 10,000 30,000
Purchases quantity 64,300 53,900 24,900 58,100
Unit cost (N) 2.00 3.00 4.00 5.00
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Purchases value (N) 128,600 161,700 99,600 290,500
(e). Direct labour utilization and cost:- This can be obtained by multiplying production quantity
by number of hours required.
Assemblers
Type of labour (hrs) Wires (hrs)
Product A 12,300 6,150
B 33,200 16,600
T 31,000 15,500
Direct labour utilization 76,500 38,250
Hourly rate (N) 0.5 0.6

Direct labour costs (N) 38,250 22,950
(ii). Statement showing the valuation of finished stock at the end of period 1
Product A B C
Variable cost/unit N N N
Component 1922 10.00 8.00 6.00
Component 2244 9.00 12.00 6.00
Component 3366 4.00 8.00 4.00
Component 4488 10.00 15.00 25.00
Labour – assemblers 1.50 2.00 2.50
Labour – wires 0.90 1.20 1.50
35.40 46.20 45.00
Production overheads 3.60 4.80 6.00
Production cost/unit 39.00 51.00 51.00
Value of Finished stock (N) 42,900 168,300 112,200
Production overhead is a function of total overhead of N91,800 divided by total direct

labour hours of 114,750 (addition of total hours for assembler and wires).
(iii). The budgeted profit for the period.

Product A B T Total
N N N N
Sales 240,000 560,000 480,000 1,280,000
Less variable costs of sales 141,600 369,600 270,000 781,200
Less Fixed Cost
Production overheads 91,800
Selling & Distribution cost 160,500
Net Profit 246,500
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ILLUSTRATION 3
A company produces two products for the tourist market. The management is now planning
production for the three months from July 1.
Estimates and other information relating to the three months in question are as follows:
Sales Units Price (N)

Product A 10,000 100
Product B 15,000 120
Stock of finished goods 30/06 30/09

Product A (units) 2,000 4,000
Product B (units) 3,000 6,000
Standard direct costs per unit Product A (N) Product B (N)

Material X 20 25
Material Y 10 10
Labour 40 50
Production and purchases are to be at a constant monthly rate throughout the period. Materials
stocks are not to be increased or decreased.
All sales are on 2 months’ credit.
All material purchases are on 3 months’ credit.
Work-in-progress remains at a constant level.
Overdraft facilities are available up to N1,000,000.
Overhead expenses for three months are estimated at
Manufacturing N300,000
Administrative and selling N200,000
These overhead expenses can be assumed to be paid in cash except for N40,000 depreciation on
fixed assets included in manufacturing overheads.
Summarized Balance Sheet as at June 30

N N
Fixed Assets
Cost 400,000
Depreciation 160,000
240,000
Stock at standard direct cost
Finished goods:- Product A (2,000 units) 140,000
Product B (3,000 units) 255,000 395,000
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Work in progress:-
Product A 28,000
Product B 51,000 79,000
Materials
X 50,000
Y 30,000 80,000
Debtor's for sales of products 300,000
Balance at Bank 100,000
1,194,000
Creditors for Materials 250,000
944,000
Share Capital 500,000

Reserves (retained profits) 444,000
944,000
You are required to prepare, for the management, the budgeted profit and loss statement, cash
budget for the three months and the budgeted balance sheet as at September 30. Stocks are to be
valued at standard direct cost.
SUGGESTED SOLUTION
The budgeted Profit and Loss to 30th September.

N'000 N'000
Sales:-
Product A (10,000 x N100) 1,000
Product B (15,000 x N120) 1,800 2,800
Less standard production cost
Product A (10,000 x N70) 700
Product B (15,000 x N85) 1,275 1,975
Total contribution 825
Less Overheads
Manufacturing 300
Administrative & Selling 200 500
Net Profit 325
The Cash Budget.

N'000 N'000
Opening cash balance 100
Add collection from Debtor (w1) 1,233
1,333
Less Payment
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Creditors (w3) 250
Labour (w4) 1,380
Manufacturing overhead (300,000 - 40,000) 260
Administrative & Selling 200 2,090
Net overdraft (757)
The Budgeted Balance Sheet as at 30/09

N'000 N'000
Fixed Assets
Cost 400
Acc. Depreciation (160,000 + 40,000) 200 200
Closing stocks
Finished Goods
Product A (4,000 x N70) 280
Product B (6,000 x N85) 510 790
Work in progress
Product A 28
Product B 51 79
Materials
X 50
Y 30 80
Debtors (2/3 x N2,800,000) 1,867
Less Current liabilities
Bank overdraft 757
Materials Creditors (w3) 990 1747
1,269
Share Capital 500

Reserves (Retained profit) (444 + 325) 769
1,269
(w1). A collection from debtors is N300,000 outstanding in the balance sheet and will be due
within the 3 month plus one month of sales out of the 3 month sales. It will equally be due
for collections in line with the credit policy. Amount collectible will be N300 + 1/3 x
N2,800 = N1,233 (N’000)
(w2). Calculation of units produces for the three months

Product A B
Sales units 10,000 15,000
Add closing stock 4,000 6,000
Less opening stock 2,000 3,000
Production units 12,000 18,000
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(w3). Creditors:- Since there is a three month purchase credit for raw materials, all materials
bought within the period will not be paid for, then only the outstanding balance of
N250,000 in the initial balance sheet will be considered for payment.
(w4). Labour payment will be based on production unit as follows:

N
Product A (12,000 units x N40) = 480,000
Product B (18,000 units x N50) = 900,000
1,380,000
ILLUSTRATION 4
Mambia state university has asked your assistance in developing its budget for the coming
academic year. You are provided with the following data for the current year.
Undergraduate Post-graduate
Division Division
Average number of students per class 30 25
Average salary of faculty member N7,000 N9,000
Average number of credit hours carried each
year per student 32 24
Enrolment including scholarship students 4,500 1,800
Average faculty teaching load in credit hours
per year (10 classes of 30 credit hours) 300 300
(i). For the year ahead, undergraduate division enrolment is expected to increase by 15% whilst
the post-graduate enrolment is expected to remain stable. Faculty salaries will be increased
by a standard 5%. Additional merit increases to be awarded to outstanding faculty members
will be N112,750 for the under-graduate division and N87,000 for the post-graduate
division.
(ii). The current budget is N320,000 for operation and maintenance of plant and equipment,
N120,000 for salaries and wages. Experience of the past three months suggests that the
current budget is realistic and that expected increases for the coming year are 8% in
salaries and wages and N22,500 in other expenditures for operation and maintenance of
plant and equipment.
(iii). The budget for the remaining expenditure for the coming year is as follows:
N
Administrative and general 420,000
Library 265,000
Health and recreation 40,000
Athletics 110,000
Insurance and retirement 375,000
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Interest 46,000
Academic prizes 9,000
Capital outlay 1,480,000
(iv). The University expects to award 175 tuition-free scholarships to under-graduate students
and 220 to post-graduate students. Tuition is N27 per credit hour and no other fees are
charged.
(v). Additional budgeted revenues for the forth coming year are as follows:
N
Endowments 212,000
Net profit from university bookshop 38,000
Athletics 114,000
Canteen services 1,500
Interest 46,000
Academic prizes 9,000
Capital outlay 1,480,000
The university’s remaining source of revenue is an annual fund raising campaign held
during the first semester.
Required
(a). Prepare a schedule computing for the coming year by division,

(i). The expected enrolment,
(ii). The total credit hours to be carried and
(iii). The number of faculty members needed.
(b). Prepare the revenue and expenditure budget for the coming year and state the amount
which must be raised during fund raising campaign in order to cover the year’s
expenditure.
SUGGESTED SOLUTION
The question is testing budget for a non-profit making organization where all data required for
preparing the budget are given awaiting interpretation and logical presentation. This can be
presented as follows:
(a). The expected enrolment for total credit hours and the number of faculty members required:
Undergraduate Post-graduate
(i). Enrolment (4,500 x 1.15) 5,175 1,800
Average credit hours/student 32 25
(ii). Total credit hours 165,600 45,000
Average faculty teaching load in credit hours 300 300
(iii). Number of faculty member 552 150
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(b)(i). Revenue and expenditure statement for coming year.
N N
Tuition fees income (w1) 5,386,500
Endowments 212,000
Net profit from university bookshop 38,000
Athletics 114,000
Canteen services 1,500
5,752,000
Faculty salaries (w2) 5,474,700
Merit awards (w3) 199,750
Operating and maintenance (w4) 352,100
Administrative general 420,000
Library 265,000
Health and recreation 40,000
Athletics 110,000
Interest 46,000
Academics prices 9,000
Capital outlays 1,480,000 (8,771,550)
Deficit (3,019,550)
(b)(ii). The amount that must be raised during the fund raising campaign is a minimum of
N3,019,550 in order to cover the expenditure for the coming year.
(w1). Calculation of expected income from tuition fees

Division Under-graduate Post-graduate
Total enrolment 5,175 1,800
Less tuition free scholarship 175 220
Tuition enrolment 5,000 1,580
Average credit hours/student 32 25
Total credit hours 160,000 39,500
Tuition fees per credit hour (N) 27 27
Total income from tuition (N) 4,320,000 1,066,500
Cumulative total 5,386,500
(w2). Salary of faculty members
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Division Under-graduate Post-graduate
Existing rate (N) 7,000 9,000
Increase factor 1.05 1.05
Revised rate (N) 7,350 9,450
Average number of faculty member 552 150
Salary of faculty staff 4,057,200 1,417,500
Cumulative salary 5,474,700
(w3). Merit Awards

N
Undergraduate 112,750
Post-graduate 87,000
Total 199,750
(w4). The total cost of operation and maintenance of plant and equipment.
N
Salaries & wages (N120,000 x 1.08) 129,600
Others (N320,000 + 22,500 - 120,000) 222,500
Total 352,100
ILLUSTRATION 5
A private school has the following student population
Grade No of student School fees per student

1 80 N600 per annum
2 70 N700 per annum
3 65 N900 per annum
4 60 N1000 per annum
The school employs 12 permanent staff, seven of whom are paid N600 per month and the other five
N400 per month. In addition, there is a Headmaster who is paid N1,000 per month. Consumables
cost on the average is N25 per student. Periodic costs amount to N120,000 per annum.
The school has worked out a plan to introduce mid-day meals for the students starting from the
current academic year. This will involve recruitment of two permanent employees at N300 per
month. Food materials will cost N2 per student per day. Other expenses will amount to 70K per
student per day. The school is in season for 34 weeks a year, Monday to Friday only.
The school does not propose to increase the school fees on account of the introduction of mid-day
meals. However, the school estimates that this will lead to a 10% general increase in the student
population in the future.
You are required to prepare statements to show:-
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(a). The effect that the introduction of mid-day meal will have on the current profit/loss of the
school.
(b). The effect it will have on the profit/loss of the school in the immediate future (use
incremental cost/revenue method for this section).
SUGGESTED SOLUTION
In order to determine the effect of the introduction of mid-day meals, the position before and after
the introduction will be prepared and compared, the difference between the two profit statements
will show the effect of the introduction of the mid-day meal on the over-all profit.
Initial income statement before mid-day meals:

N N
Fees income (w1) 215,500
Less Expenses
Salaries & wages (w2) 86,400
Consumables (w3) 6,875
Period costs 120,000 (213,275)
Net surplus 2,225
Income statement with mid-day meals

N N
Fees income (w1) 215,500
Less Expenses
Salaries & wages (w2) 86,400
Consumables (w3) 6,875
Period costs 120,000
Salaries & wages(catering) (w4) 7,200
Food cost (w5) 93,500
Other expenses 32,725 (346,700)
Net deficit (131,200)
With the introduction of mid-day meals, the school will be losing N131,200 + N2,225 =
N133.425 revenue.
(b). The effect of the mid-day meal in the immediate future will amount to increase in student
population by 10%. The increase in revenue will be 10% of the current revenue which will
be compared with increase in costs as follows:-
N
Increase in revenue (10% x N215,500) 21,550
Incremental expenditure (7,200 + 93,500 + 32,725) (133,425)
Net loss (111,875)
(w1). Calculation of fees income.
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Grade No of student Fees/student Total income
N N
1 80 600 48,000
2 70 700 49,000
3 65 900 58,500
4 60 1,000 60,000
215,500
(w2). The academic staff salaries and wages.

N
Staff - (7 x N600 x 12) 50,400
Staff - (5 x N400 x 12) 24,000
Headmaster (1 x N1,000 x 12) 12,000
Total 86,400
(w3). Calculation of consumables cost

Total number of students = 80 + 70 + 65 + 60 = 275
Consumable cost = 275 x N25 = N6,875
(w4). The salaries and wages of catering staff. = 2 x N300 x 12 = N7,000
(w5). Food and other expenses costs

Food costs = N2 x 275 x 5days x 34weeks = N93,500
Other expenses = N0.7 x 275 x 5days x 34weeks = N32,725.
ILLUSTRATION 6
Agro Chemical Limited is a newly established company, supplying chemicals for farming. The
turnover of the company is gradually growing. For the following year, the company has budgeted
for a turnover of N918,000. The turnover for each month is expected to be more than the turnover
of the previous month by 5%. The selling price includes a gross margin of 33 1/3% on sales.
Stocks usually lie in stores for 2 months. Supplies are of 2 months credit. Customers are allowed 2
months credit but 80% pay in time and balance pay one month late.
Tax payment of N3,000 is made at the end of each quarter. N10,000 needs to be provided for
dividends payable during the last month of the year.
In September, the company expects to receive money on 10,000 N5 ordinary shares to be issued at
5% premium. Monthly salaries and wages amount to N4,500 and other expenses N12,000 including
depreciation charge of N30,000 per annum. The company receives N4,000 investment incomes
early March and September.
You are required to prepare a cash budget for the company for the third quarter, July to September,
taking into account the projected cash balance of N7,000 on 1st July.
SUGGESTED SOLUTION
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The question is a cash budget, which requires initiative to determine sales and purchases.
The Cash Budget

N N
Opening cash balance 7,000
Add Receipts
Collection from Debtors (w2) 218,894
Proceeds from issue of shares 52,500
Investment income 4,000 275,394
282,394
Less Payment
Creditor (w3) 147,332
Taxation payment 3,000
Salaries and wages 13,500
Other expenses (w4) 28,500 (192,332)
Closing cash balance 90,062
(w1). The annual sales is given as N918,000, but this must be sub-divided into monthly sales in
order to determine collections from debtors and payment to the creditors. To determine the
monthly sales there is need to take into congnisance the growth in sales by 5%. Various
formulae are available to determine January sales upon which the other months can be
determined, but for this purpose a compound formula for constant cash flows will be used.
Stated as
FV = A(((1+r)-n – 1)/r)
Where FV = future value, for this purpose, total annual sales
r = is discounting rate, for this, growth rate
n = number of years, in this case, number of months
A = constant cash flow, for this, January sales
From above, January sales could be determined as follows

N918,000 = A(((1.05)-12 – 1).05), N918,000 = 15.91712652A A = N57,674.73
The subsequent month sales could be determined by increasing the monthly sales by 5%
effectively from January, as follows:
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Month Workings Sales (N) Workings Purchases (N)
2
January as above 57,674 57,674 x /3 38,449
February 57,674 x 1.05 60,557 60,557 x 2/3 40,371
2
March 60,557 x 1.05 63,585 63,585 x /3 42,390
2
April 63,585 x 1.05 66,765 66,765 x /3 44,510
2
May 66,765 x 1.05 70,103 70,103 x /3 46,735
2
June 70,103 x 1.05 73,608 73,608 x /3 49,072
July 73,608 x 1.05 77,288 77,288 x 2/3 51,525
August 77,288 x 1.05 81,153 81,153 x 2/3 54,102
2
September 81,153 x 1.05 85,210 85,210 x /3 56,807
2
October 85,210 x 1.05 89,471 89,471 x /3 59,647
2
November 89,471 x 1.05 93,944 93,944 x /3 62,629
2
December 93,944 x 1.05 98,642 98,642 x /3 65,761
(w2). Collection from debtors will be the balance of April sales (20%) and sales of May, June
and 80% of July sales which will be 2 months and 3 months old within the period. As
follows:
N
April sales (20% x N66,765) 13,353
May sales 70,103
June sales 73,608
July sales (80% x 77,288) 61,830
Total 218,894
(w3). Payment to creditors will be based on credit purchases that are two months old within the
period and the applicable months are May, June and July. = N46,735 + N49,072 +
N51,525 = N147,332.
ILLUSTRATION 7
Success Supermarket has N65,000 debtors and N48,000 creditors as at 31st December. 60% of the
debtors were for December sales, 35% for November sales and 5% for October sales. 80% of the
creditors were for December purchases and 20% for November purchases.
Expected sales from January are as follows:
January N48,000
February N44,000
March N52,000
April N55,000
20% of sales are for cash and the balance of 80% is on 1 1/2 months credit. A gross margin of 25%
of cost is expected.
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Every month purchases are made adequate enough to meet the sales for the following month.
Creditors are usually settled in the following month. Other expenses of N2,200 per month are paid
in the same month.
The following special items of receipt and payments are expected during the first quarter.
January February March
N N N
Tax payment - 3,000 -
Sales of fixed assets - - 5,000
Investment income 2,500 - -
Prepare a monthly cash budget for the first quarter assuming an opening cash balance of N23,000.
Debts more than two months old are to be treated as doubtful.
SUGGESTED SOLUTION
The question is basically on a cash budget where some reasonable assumptions with respect to
debtors and creditors will be required for an accurate solution.
The Cash Budget

January February March Total
N N N N
Opening cash balance 23,000 7,650 15,050 23,000
Add cash sale & collection from
debtor (w1) 32,350 47,800 48,800 128,950
Add sales of fixed assets - - 5,000 5,000
Add investment income 2,500 - - 2,500
57,850 55,450 68,850 159,450
Less Payments
Creditors 48,000 35,200 41,600 124,800
Other Expenses 2,200 2,200 2,200 6,600
Tax payment - 3,000 - 3,000
7,650 15,050 25,050 25,050
(w1). It is assumed that the outstanding debtors of November sales will be collectible in January,
December collectible in February, while October outstanding will not be due for collection.
The collection for the respective months, therefore, will be:
Jan. (N) Feb (N) March (N)

Cash sales (20%xN48,000) 9,600 (20%xN44,000) 8,800 (20%xN52,000) 10,400
Debtors (35%xN65,000) 22,750 (60%xN65,000) 39,000 (80%xN48,000) 38,400
Total collections 32,350 47,800 48,800
(w2). It is assumed that outstanding creditors will be paid in January, which of course includes
purchases of December for January sales. Since there is a mark up of 25% on cost,
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purchases to sales will be 100/125 x 100/1 = 80%. Therefore the purchases of the previous
month will be derived from sales of the month and payment assumed in the month the sales
are made. This is as follows:
Month December January February March April
N N N N N
Sales - 48,000 44,000 52,000 55,000
Purchases (80% of sales) 38,400 35,200 41,600 44,000 -
Month of payment - 38,400 35,200 41,600 44,000
Note that payment in January includes outstanding creditors as at the end of November.
ILLUSTRATION 8
You are contemplating leaving your full-time employment to concentrate your ability on the
marketing of a new low-energy portable heater. You have spoken to a group of manufacturers of
similar products , and you have produced the following data based upon the production of 1,200
heaters on the six months to December 31,2001.
N N
Unit selling price 160.00
Variable cost
Direct labour 30.00
Fixed Overheads
Admin 4.00
Rent 7.50
Rates 2.50
Depreciation 1.00 95.00
Mark-up 65.00
Your initial plan is to produce 200 units per month and to start selling in August 2001.
The forecast of sales you have calculated is:-
August September October November December
Units 50 80 120 180 200
All sales will be made on 30 days credit.
Machinery will cost you N24,000. This you propose financing on hire purchase terms. The deposit
payable July 1, 2001 will be N2,400, followed by 24 monthly installments of N1,000 each.
Raw materials suppliers will deliver equal amount of parts at the beginning of each month. They
will allow you 60 days credit.
Wages and administrative expenses will be paid in the month in which they are incurred. Rent and
rates of the premises will be paid quarterly in advance commencing on July 1, 2001.
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Prepare cash budget for the 6 months to December 31, 2001 for presentation to your bank manager
who you hope will be prepared to give you an overdraft facility to supplement the N20,000 you
intend introducing into your business.
SUGGESTED SOLUTION
The Monthly Cash Budget for the 6 Months to December 31, 2001
July Aug. Sept. Oct. Nov. Dec. Total

N N N N N N N
Opening cash balance 20,000 8,700 900 (8,900) (16,000) (14,600) 20,000
Add collections from Debtors - - 8,000 12,800 19,200 28,800 68,800
20,000 8,700 8,900 3,900 3,200 14,200 88,800
Less Payments
Raw material creditors - - 10,000 10,000 10,000 10,000 40,000
Install mental on Machinery 2,400 1,000 1,000 1,000 1,000 1,000 7,400
Direct Labour 6,000 6,000 6,000 6,000 6,000 6,000 36,000
Admin Expenses 800 800 800 800 800 800 4,800
Rental payment 1,500 - - 1,500 - - 3,000
Rates 600 - - 600 - - 1,200
Closing Cash Balance 8,700 900 (8,900) (16,000) (14,600) (3,600) (3,600)
Note:
(1). Collection from sales is a month after sales because of the 30 days credit period
(2). Payment for raw material usage is two months after purchase because of a 60 days credit.
(3). Wages and administrative expenses is assumedly paid on monthly basis and computation
based on production units, average 200 units per month.
(4). Rent is based on 6 months production of 1,200 units and shared into two for quarterly
payment as indicated in the question.
ILLUSTRATION 9
The budgeted level of output for a manufacturing department is 18,000 hours per period and it is
desired to produce a flexible budget for its factory overheads.
The following information is available.
N
Variable cost indirect labour per direct labour hour 1.00
Consumable supplies per direct labour hour 0.10
Power per direct labour 0.25
Holiday and sick pay 5% of direct labour cost
Fixed costs
Rent and Rates per period 6,000
Depreciation per period 3,000
Head office charge per period 2,000
Supervision per period 4,000
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Semi variable for the purpose of these costs may be regarded as partly fixed and partly variable.
The previous 4 months costs compared with direct labour hours worked were as follows:
Months Direct labour hours semi-variable cost
1 17,600 13,200
2 16,400 12,600
3 17,000 12,900
4 18,800 13,800
You are required to prepare a flexible budget for the department at 70%, 80%, 90%, 100% and
110% of the budgeted level of activity (hours).
SUGGESTED SOLUTION
In flexible budget, costs must be well separated into variable and fixed element. In a situation
where there is a mixed cost, this must be separated into variable and fixed element using any of the
methods discussed under cost estimation techniques. This separation is imperative because the
variable cost is expected to move in sympathy level with activities, while fixed cost is expected to
be constant within the relevant range.
From above, to estimate the expected overheads for the different activity levels, the mixed cost
must firstly be separated using high and low method.
Activity Cost (N)
High 18,800 13,800
Low 16,400 12,600
Variable cost per hour = N1,200/2,400hrs = N0.5/hr

Total fixed cost = N13,800 – (N0.5 x 18,800) = N4,400
The Flexible Budget for the various activity levels will be:
Level 70% 80% 90% 100% 110%
Numbers of hours 12,600 14,400 16,200 18,000 19,800
Overhead costs N N N N N
Direct labour
(N1.20/hr) 15,120 17,280 19,440 21,600 23,760
Indirect labour
(N1.00/hr) 12,600 14,400 16,200 18,000 19,800
Consumable
(N0.10/hr) 1,260 1,440 1,620 1,800 1,980
Power (N0.25/hr) 3,150 3,600 4,040 4,500 4,950
Rent & Rates 6,000 6,000 6,000 6,000 6,000
Depreciation 3,000 3,000 3,000 3,000 3,000
Head office charges 2,000 2,000 2,000 2,000 2,000
Supervision 4,000 4,000 4,000 4,000 4,000
Other variable cost
(N0.50/hr) 6,300 7,200 8,100 9,000 9,900
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Other fixed cost 4,400 4,400 4,400 4,400 4,400
57,830 63,320 68,800 74,300 79,790
ILLUSTRATION 10
Gojeh Nigeria limited had the following budgeted sales and production units for the first three
quarter of this year
Quarters
1st 2nd 3rd
Units Units Units
Sales 1,000 1,200 1,500
Productions 1,200 1,500 1,800
The standard selling price is N50 per unit, and the budgeted costs, based on the production output
figures for the first three quarters are:
Quarters
1st 2nd 3rd
N N N
Direct materials 12,000 15,000 18,000
Direct Labour 24,000 30,000 36,000
Production overheads 14,000 15,500 17,000
Selling and administration overheads 6,700 7,000 7,300
Depreciation included in overhead costs is:

Production overhead – N2,000 per quarter;
Selling and administration overhead – N500 per quarter.
In the fourth quarter, the unit cost for direct labour is budgeted to reduce to 80% of the unit cost in
the third quarter. The unit cost of direct materials in the fourth quarter is budgeted to increase by
10% over that of the third quarter. The variable portions of cost fluctuate with output; the fixed
portions are not affected by output levels.
Sales in the fourth quarter are uncertain and could be within the range of 2,000 to 2,500.
Customers are allowed a two-month credit period and suppliers of direct materials allow three
months credit. Wages and Overheads are paid as incurred.
Required:
(a). Prepare flexible budget figures for the fourth quarter showing Sales, Cost and Profit
figures, assuming Sales and Production to be:
(i). 2,000 units;
(ii). 2,200 units; and
(iii). 2,500 units.
Overhead costs should be analysed under variable and fixed headings with supporting
calculations.
(b). Show the budgeted cash flow figures for the fourth quarter for the three Sales and
Production levels in (a) above.
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SUGGESTED SOLUTION
(a). The flexible budgeted income statement for the fourth quarter under the three activity
levels
Activity level (Units) 2,000 2,200 2,500
N N N
Sales (N50/units) 100,000 110,000 125,000
Less variable costs
Direct materials @ N11/unit 22,000 24,200 27,500
Direct labour @ N16/unit 32,000 35,200 40,000
Variable production O/H @ N5/unit 10,000 11,000 12,500
Variable selling & Admin O/H @ N1/unit 2,000 2,200 2,500
Total contribution 34,000 37,400 42,500
Less Fixed costs
Production overheads 8,000 8,000 8,000
Selling and administration overheads 5,500 5,500 5,500
Net Profit 20,500 23,900 29,000
Workings
i. Direct material cost per unit = N12,000/1,200 x 110% = N11/units
ii. Direct labour cost per unit = N24,000/1,200 x 80% = N16/unit
iii. The variable production overhead cost per unit = ((N17,000 – N14,000)/(1,800 –
1,200)) = N5/units
iv. The variable selling & administration cost per unit = ((N7,300 – N6,700)/(1,800 –
1,200)) = N1/unit.
v. Fixed production overhead cost = N14,000 – (N5 x 1,200) = N8,000
vi. Fixed selling and admin overhead = N6,700 – (N1 x 1,200) = N5,500
(b). The budgeted cash flow figures for the fourth quarter
Activity level (Units) 2,000 2,200 2,500
N N N
Receipts from customers 60,000 60,000 60,000
Less payments
Direct materials 12,000 12,000 12,000
Direct labour 32,000 35,200 40,000
Variable production O/H 10,000 11,000 12,500
Variable selling & Admin O/H 2,000 2,200 2,500
Fixed production overhead (N8,000 - 2,000) 6,000 6,000 6,000
Fixed selling & admin O/H (N5,500 - N500) 5,000 5,000 5,000
Cash balance (7,000) (11,400) (18,000)
1. The Expando Company produces entertainment centers from a type of pressed Wood
referred to as particle board. Other materials, such as glue and screws are viewed as
Page 409
insignificant and are charged to overhead as indirect materials. Budgeted, or standard
quantities allowed per unit along with the budgeted prices and rates are as follows
Type of input Inputs per output Cost per input Cost per output
N N
Direct materials 2 particle board sheets* 10 20
Direct labour .4 hours 15 6
Factory overhead: Variable .4 hours 30 12
Fixed .4 hours 50 20
58
*Particle board is purchased in sheets that are ¾” by 4’ by 8’.
Overhead rates are based on 4,800 standard direct labour hours per month, or average
monthly production of 12,000 units, that is, (.4)(12,000) = 4,800 hours. Desired ending
inventories are 10% of next period’s material needs for direct material and 5% of next
period’s sales for finished goods. Unit sales are budgeted as follows for the first six months
of the year.
Jan. Feb. March April May June
9,000 10,000 11,000 12,000 14,000 14,500
The budgeted sales price is N100 per unit. Sales are budgeted as 50% cash and 50% credit
sales. Past experience indicates that 80% of the credit sales are collected during the month
of sale, 18% are collected in the following month, and 2% are uncollectible. A 1% cash
discount is allowed to customers who pay within the month the sale takes place including
cash sales.
Variable selling and administrative expenses are budgeted at 10% of sales naira. The
budget for fixed selling and administrative expenses is N50,000 per month. Cash payments
are made for all expenditures made during the month except for depreciation of N100,000
in manufacturing and N25,000 in the selling and administrative area. The budgeted
beginning cash balance for March is N100,000 and the tax rate is 40%. Budgeted income
taxes from January and February are N200,000. This amount is to be paid at the end of
March along with the current months taxes. A three month note for N50,000 is to be repaid
at the end of March. The interest rate on the note is 12 percent.
Some additional account balances budgeted for the end of February include: Land
N5,000,000, buildings and equipment N15,000,000, accumulated depreciation N6,000,000,
other current liabilities 0, long term liabilities 0, common stock N5,000,000 and retained
earnings N8,993,000.
Required
Prepare relevant budgets include: Sales, Collection, Production, Direct Materials, Direct
Labour, Factory Overheads, Ending Inventory and Finished Goods, Cost of Goods Sold,
Selling and Administrative budget for the month of March and The balance Sheet as at 31 st
March.
2. Barker Company produces and sells a single product with budgeted or standard costs as
follows:
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Inputs Standards
Direct materials 10 lbs at N10.00 per pound
Direct labour 8 hours at N12.50 per hour
Factory overhead:
Variable 8 hours at N20.00 per hour
Fixed 8 hours at N40.00 per hour
Overheads rates are based on 8,000 standard direct labour hours per month, i.e., this is the
master budget denominator activity level.
Desired ending inventories of materials are based on 10% of the next months materials
needed. Desired ending finished goods are based on 5% of next periods budgeted unit
sales.
Unit sales are budgeted as follows

January February March April
1,000 1,200 1,600 1,400
The budgeted sales price is N1,000 per unit. Sales are budgeted as 80% credit sales and
20% cash sales. Past experience indicates that 60% of credit sales are collected during the
month of sale, 38% are collected in the following month, and 2% are uncollectible. A 1%
cash discount is allowed to all customers (cash or credit) who pay within the month the sale
takes place. Selling and administrative expenses are:
Variable = 20% of sales nairas, Fixed = N250,000 per month. The budget assumption
concerning cash payment proportions is that all current purchases of direct material, direct
labour, factory overhead and selling and administrative items will be paid for during the
current period. The beginning cash balance for February is N10,000. Depreciation and
other non-cash fixed costs are: manufacturing = N100,000, selling and administrative =
N75,000
Required: Prepare a partial master budget for February as follows
a. Sales budget, including net sales naira

b. Collections.
c. Production budget, i.e., units to be produced.
d. Direct material quantity needed for production.
e. Direct material quantity to be purchased.
f. Budgeted cost of direct material purchases.
g. Budgeted cost of direct material used.
h. Direct labour needed for production.
i. Budgeted cost of direct labour used.
j. Budgeted factory overhead costs.
k. Budgeted cost of goods sold.
l. Prepare a simple budgeted income statement.
m. Prepare a cash budget.
Page 411
3. Grand Company produces and sells a single product with budgeted or standard unit costs as
follows:
Inputs Standards cost per unit(N)
Direct materials 3 lbs at N10.00 30
Direct labour 2 hours at N12.00 24
Factory overhead:
Variable 2 hours at N20.00 40
Fixed 2 hours at N40.00 80
Total unit costs 174
Overhead rates are based on a capacity level of 1,200 units per month, i.e., this is the
master budget denominator activity level.
needed. Desired ending finished goods are based on 10% of next periods budgeted unit
sales.
Unit sales are budgeted as follows:

800 1,000 1,200 1,400
The budgeted sales price is N300 per unit. Sales are budgeted as 60% credit sales and 40%
cash sales. Past experience indicates that 40% of credit sales are collected during the month
discount is allowed to all customers (cash or credit) who pay within the month the sale
takes place. Selling and administrative expenses are budgeted as follows: Variable
expenses are 10% of sales dollars, budgeted expenses are N50,000.
You are required to prepare partial master budget for February as follows
a. Sales budget, including net sales naira.
b. Collections for the month.
c. Production budget, i.e., units to be produced.
d. Direct material quantity needed for production.
e. Direct material quantity purchases.
f. Budgeted cost of direct material purchases
g. Budgeted cost of direct material used.
h. Direct labour needed for production.
i. Budgeted cost of direct labour used.
j. Budgeted factory overhead costs.
k. Budgeted cost of goods sold.
l. Budgeted selling and administrative expenses.
m. The amount of bad debts, which should appear in the income statement.
4. The microtable Company produces and sells special wood tables that are used with
microcomputers. The various parts of the table are cut and assembled by robots, thus direct
labour is not involved. Budgeted or standard costs for each table are as follows:
Input Standards Cost per unit (N)
Page 412
Direct materials 20 board feet at N3.00 60
Factory overhead:
Variable .1 hour* at N100.00 10
Fixed .1 hour* at N400.00 40
Total unit cost 110
*Robot (machine) hours.
Overhead rates are based on a capacity level 500 machine hours per month and overhead is
applied on the basis of robot (machine) hours.
needed for production. Desired ending finished goods are based on 15% of next periods
budgeted unit sales.
Unit sales are budgeted as follows for next year:

4,500 5,000 5,200 5,500
The budgeted sales price is N250 per table. Sales are budgeted as 90% credit sales and 10%
expenses are 20% of sales nairas, fixed expenses are N50,000.
You are required to calculate the budgeted amounts indicated below and then circle the
letter for the answer you choose.
i. The net naira sale budgeted for February

a. N1,250,000 b. N1,240,000 c. N1,241,000 d. N1,239,750 e. None of these
ii. The cash collections budgeted for February:

a. N891,000 b. N1,186,875 c. N1,014,750 d. N908,125 e. None of the above.
iii. Budgeted units (that is, tables) to be produced for February:

a. 5,000 b. 4,970 c. 5,030 d. 5,780 e. None of these
For the remainder of this problem ignore your answer to question 3 and assume that the
budgeted units to be produced for February are 5,030.
iv. The number of board feet of direct material to be purchased for February:
a. 100,600 b. 101,110c. 100,170 d. 101,030 e. Some other amount
v. The budgeted cost of direct material used for February:

a. N303,090 b. N301,800 c. N300,000 d. N300,510
e. None of these
vi. The budgeted total factory overhead costs for February:

a. N250,300 b. N251,500 c. N250,000 d. N201,200
e. Some other amounts.
Page 413
vii. The cost of goods sold for February stated at standard cost:
a. N551,200 b. N548,800 c. N550,000 d. N552,100
e. None of these.
viii. The amount and status (i.e., favourable or unfavourable) of the planned production volume
variance for February: a. zero b. 1,200 favourable c. 120 unfavourable d. 1,200
unfavourable. e. Some other amount
ix. The budgeted selling and administrative expenses for February:

a. N250,000 b. N297,950 c. N247,950 d. N300,000
e. None of these
x. During February no specific accounts receivable were determined to be uncollectible. The

amount of bad debt expense that should appear on the budgeted income statement for
February:
a. Zero b. N37,500 c. N33,750 d. N33,413 e. Some
other amount.
xi. The ending accounts receivable balance budgeted for February before subtracting the
allowance for bad debts: a. N191,250 b. N225,000 c.
N223,155 d. N189,682 e. none of above.
xii. Assume 100 additional units of production are budgeted for February with no change in
budgeted unit sales. What effect will this have on budgeted net income for February?
a. Budgeted net income will not change.b. Budgeted net income will increase by N11,000
c. Budgeted net income will increase by N4,000. d. Budgeted net
income will decrease by N11,000. e. None of the above.
5. The R.G. Phelps Company produces and sells a single product with budgeted or standard
unit costs as follows:
Input Standards Cost per unit (N)
Direct materials 6 gallons at N5.00 per gallon 30
Direct labour .5 hours at N10.00 per hour 5
Factory overhead:
Variable .5 hours at N100.00 per hour 50
Fixed .5 hours at N200.00 per hour 100
Total unit cost 185
Overhead rates are based on a capacity level of 2,000 units (or 1,000 direct labour hours)
per month, i.e., this is the master budget denominator activity level.
needed for production. Desired ending finished goods are based on 20% of next periods
budgeted unit sales.
Unit sales are budgeted as follows for next year:

January February March April May June
1,500 1,800 2,000 2,500 2,600 2,800
Page 414
The budgeted sales price is N240 per unit. Sales are budgeted as 75% credit sales and 25%
expenses are 10% of sales naira, fixed expenses are N100,000.
You are required to choose the best answer for the following questions.
i. The net sales naira budgeted for march is:

a. N480,000 b. N475,200 c. N475,560 d. N476,760
e. None above
ii. The cash collections budgeted for March are

a. N320,760 b. N439,560 c. N444,000 d. N465,480
e. None of these.
iii. Budgeted units to be produced for March are:

a. 2,000 b. 2,100 c. 1,900 d. 2,040 e. some other figure
For the remainder of this problem ignore your answer to question 3 and assume that the
budgeted units to be produced for March are 2,100.
iv. The number of gallons of direct material to be purchased for March is:
a. 12,600 b. 12,852 c. 12,900 d. 13,200 e. none of this figure
v. The budgeted cost of direct material used for March is:

a. N64,500 b. N64,260 c. N63,000 d. N60,000 e. none of these
vi. The budgeted cost of direct labour used for March is:
a. N10,500 b. N21,000 c. N10,000 d. N20,000 e. None of these.
vii. The budgeted total factory overhead costs for March are
a. N105,000 b. N315,000 c. N300,000 d. N305,000
e. None above
viii. Now, ignore your answers to questions 5, 6 and 7 and assume that budgeted total
manufacturing cost is N378,500. The budgeted cost of goods sold for March is
a. N388,500 b. N378,500 c. N370,000 d. N397,000
e. none of these.
ix. The amount and status (that is, favourable or unfavourable) of the planned production
volume variance for March is: a. Zero b. N10,000 unfavourable c.
N10,000 favourable d. 15,000 unfavourable e. some other amount.
x. The Budgeted selling and administrative expenses for march are:

a. N148,000 b. N147,556 c. N146,548 d. N100,000
e. None of these.
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xi. During March of the previous year N8,000 in actual receivables were written off as
uncollectible. The amount of bad debt expense that should appear on the budgeted income
statement for March is:
a. Zero b. N9,600 c. N8,000 d. N7,200 e. Some other amount.
xii. The ending accounts receivable balance budgeted for March before subtracting the
allowance for bad debts is: a. N48,000 b. N36,000 c.
N35,640 d. N28,800 e. None of these.
6. GSM Limited expects sales of its airtime to amount to N800 Million in January, N850
million in February and N95 million in March 2004.
Prepare an estimate of cash budget from these information for the three (3) months ended
31 March 2004 assuming the following:
a. 10% of sales are cash sales with 5% discount
b. 3% discount is also given for credit sales when payment is received with 10 days. 25%
of credit sales are paid within 10 days.
c. Half of the remaining debtors paid in the month following sales.
d. The remainder paid two months following sale with the exception of bad debtors, who
amount to 1% of total sales.
e. The following expenses were incurred during the period:
JAN FEB MAR

N’000 N’000 N’000
Salaries and wages 14,500 15,200 16,000
Printing of cards 2,500 4,200 4,500
Loan (principal due) 8,000 185,000 220,000
Interest on loan 8,500 9,000 10,000
The following notes relate to these expenses:

 10% of salaries are paid one month in arrears.10% salaries and wages due as at the
end of December 2003 not yet paid amounted to N1, 200,000.
 Loan is paid, as at when due while interest on loan is paid one month in arrears.
Loan interest for the month of December 2003 is N7, 900,000.
 Royalties are also paid one month in arrears. Royalties are 5% of total cash receipts
and total receipts for December 2003 is N210, 500,000.
 Administrative expenses are 5% of total sales and are paid in the month of sales.
7. The Sales Director of Toroya Box Fabricators has become aware of the disadvantages of
static budget. The director asks you, as the Management Accountant to prepare a flexible
budget for October2001 for its main brand of boxes.
The following data are available for the actual operation in September 2001.
Boxes produced and sold 4,500

Direct Materials costs N180, 000
Direct Manufacturing Labour costs N135, 000
Depreciation and other fixed
Manufacturing costs N101, 400
Average selling price per box N140
Page 416
Fixed marketing costs N162, 700
Assume no stock of boxes at the beginning or end of the period. A 10% increase in the
selling price is expected in October. The only variable marketing cost is a commission of
N0.50K per unit paid to the manufacturer’s representatives, who bear all their own costs of
traveling, entertaining customers, etc. A patent royalty of N2 per box manufactured is paid
to an independent design firm. Salary increases that will become effective in October are
N12, 000 per year for the production supervisor and N15, 000 per year for sales Manager.
A 10% increase in direct materials prices is expected to become effective in October. No
changes are expected in direct manufacturing labour wage rates or in the productivity of the
direct manufacturing labour personnel.
The company uses a normal costing system and does NOT have standard costs for any of
its inputs.
Prepare a flexible budget for October 2001 showing budgeted amounts at each of these
output levels of boxes, 4,000 units, 5,000 units and 6,000 units.
8. Union Manufacturing Plc has produced the following data for the ensuing budget period:
UNION Manufacturing Plc.

Balance Sheet as at 1st Jan.
Fixed Assets: Cost ACC. Depr. NBV
N N N
Land and Buildings 40,000 - 40,000
Plant and Equip. 90,500 30,000 60,500
Motor vehicles 100,000 90,000 10,000
230,500 120,000 110,500
Current Assets:
Stocks 41,500
Debtors 60,000 101,500
Total Asset 212,000
Liabilities:
Share Capital 100,000
Retained earnings 46,000
Current Liabilities:
Trade Creditors 6,000
Bank Overdrafts 60,000 66,000
Total Liabilities 212,000
Product X Product Y Product Z

Sales (‘000 units) 100 50 150
Unit selling price (N) 20 20 15
Production Costs per unit:

a). Direct Material:
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A (N1.50 per kg) 4 kg 8 kg -
B (N0.50 per kg) - - 8 kg
b). Direct Labour:
Dept. 1 (at N6 per hour) ½ hr 1 hr ½ hr
Dept. 2 (at N5 per hour) ½ hr ½ hr ½ hr
c). Variable overhead N1.50 N2.00 N0.50
Using the above data. You are required to calculate:-
i). The contribution per product (a) in unit, and (b) in total for the year.
ii). The production cost budget for the year. Ignore fixed overhead
iii). The materials cost budget
iv). The Labour cost budget.
NOTES
The following additional information is provided in respect of stock levels:
a). Raw materials – There were no opening stocks as at 1st January. However, it is
intended to stock the equivalent of 20% of current production requirements of each
material at the end of the year. This is borne out of recent experience of acute
material shortages.
b). Work-in-process – Assume no stocks at the beginning and end of period.
c). Finished Goods:
Product X Product Y Product Z
(Units) (Units) (Units)
As at 1st January 1,000 1,000 600
As at 31st December 2,500 1,750 2,000
Q1 THE EXPANDO COMPANY
a. The sale budget for March

Sales (11,000 x N100) N1,100,000
Less cash discount from cash sales (N1,100,000 x .5 x .01) -5,500
Less cash discount from credit sales (N1,100,000 x .5 x .8 x.01) -4,000
Net Sales N1,090,100
b. Collections for March

From March sales- Cash (N1,100,000 x .5 x .99) N544,500
From March sales- Credit (N1,100,000 x .5 x .8 x .99) 435,600
Or (N1,100,000 x .9 x .99) 980,000
From February sales (10,000 x N100 x .5 x .18) 90,000
Total collections N1,070,000
Note that .5 + (.8 x .5) = .9, this indicates that 90% of current sales are collected in the
current month and subject to the 1% cash discount and only 50% of February sales were
credit sales and only 18% of that amount is collected in march. The other 2% is budgeted
as uncollectible.
Page 418
c. Production budget for March
units to be produced = 11,000 + (.05 x 12,000) – (.05 x 11,000) = 11,050 units
Note that the desired ending inventory is based on April unit sales and the desired opening
inventory is based on March sales.
d. Direct Materials Budget for March

Direct material usage = (11,050 x 2) =22,100 sheets
Direct material purchased = 22,100 + (.10 x 24,200) – (.10 x 22,100) = 22,310 sheets
Direct material usage costs = 22,100 x N10 = N221,000
Direct material purchased costs = 22,310 x N10 = N223,100
Note that April units to be produced 12,000 + (.05 x 14,000) – (.05 x 12,000) = 12,100 and
April material usage = (12,100 x 2) = 24,200 sheets.
e. Direct labour requirement for production

in hours ( 11,050 x .4 hours) = 4,420 hours
costs (4,420 x N15) = N66,300
f. Budgeted factory overhead costs for March

Variable (N30 x 4,420 hours) = N132,600
Fixed (N50 x 4,800 hours) = 240,000
Total N372,600
Cash payments for overheads = N372,600 – N100,000 = N272,600.
Note that the overhead rates are based on 4,800 hours per month, but the planned hours
only 4,420. This causes standard fixed costs to be 19,000 less than budgeted fixed cost.
Graphically the standard amount is below the budget amount. Therefore we must add the
19,000 to standard factory overhead cost to obtain the budgeted amount.
g. Ending inventory budget for March

Budgeted standard unit cost = (2 x N10) + (.4 x N15) + (.4 x N80) = N58
Finished goods stock costs = (.05 x 12,000 x N58) = N34,800
Direct materials costs = (.10 x 24,200 x N200) = N24,200.
h. Budgeted cost of goods sold for March

Total manufacturing cost: (N221,000 + N66,300 + N372,600) = N659,900
Add opening stock of Finished Goods (.05 x 11,000 x N58) = 31,900
Less Closing stock of Finished Goods (.05 x 12,000 x N58) = 34,800
Budgeted cost of goods sold N657,000
i. Selling and Administrative Budget

Variable costs (.10 x 1,100,000) N110,000
Fixed costs 50,000
Total cost N160,000
j. Budgeted Income Statement

N
Page 419
Sales 1,100,000
Less cash discount 9,900
Net Sales 1,090,100
Less Cost of Goods Sold 657,000
Less Expenses
Selling and Administrative 160,000
Bad debts (1,100,000 x .5 x .02) 11,000
Interest (50,000 x .12)/12 500
Net Income Before Taxes 261,600
Less Provision for Taxes (.40 x 261,600) 104,640
Net Income after Taxes 156,960
k. The Cash Budget
N N
Opening cash balance 100,000
Collections from sales 1,070,100
Cash available 1,170,100
Less Payments:
Direct Labour 66,300
Factory overheads 272,600
Selling and administrative (160,000 - 25,000) 135,000
Income Taxes (200,000 + 104,640) 304,640
Repayment of borrowings (50,000 + (500 x 3)) 51,500 1,053,140
Closing Cash Balance 116,960
l. Budgeted Balance Sheet
Page 420
N N N
Fixed Assets:
Land 5,000,000 5,000,000
Buildings and Equipments 15,000,000 6,125,000 8,875,000
13,875,000
Current Assets:
Direct Materials 24,200
Finished Goods 34,800
Closing Debtors 110,000
Less Provision for uncollectible 11,000 99,000
Cash Balance 116,960
274,960
Current Liabilities - 274,960
Net Assets 14,149,960
Financed By
Common Stock 5,000,000
Retained Earnings (8,993,000 + 156,960) 9,149,960
14,149,960
Q2. BARKER COMPANY
a. Sales Budget for February

N
Sales (1,200 x 1,000) 1,200,000
Less Cash discounts (1,200,000 x (.2 + (.8 x .6 x .01) 8,160
Net Sales 1,191,840
b. Cash Collections for February:

N
From January (1,000 x 1,000 x .8 x .38) 304,000
From February - Cash (1,200,000 x .2 x .99) 237,600
From February - Credit (1,200,000 x .8 x .6 x.99) 570,240
Total Cash Collections 1,111,840
c. Budgeted production units

1,200 + (.05 x 1,600) – (.05 x 1,200) = 1,220 units.
d. Budgeted Direct Material Usage Qty.= (1,220 x 10 lbs) = 12,200 lbs.
e. Budgeted Direct Material Purchases Qty. = 12,200 + (.05 x 15,900) – (.10 x 12,200) =
12,570 lbs
Page 421
f. Direct Material Purchase Costs = (12,570 x N10) = N125,700
g. Direct Material Usage Costs = (12,200 x N10) = N122,000
h. Direct labour usage hours = (1,220 x 8hrs) = 9,760 hrs
i. Budgeted Direct Labour cost = (9,760 x N12.50) = N122,000
j. Budgeted factory overhead costs

N
Variable Overhead (N20 x 9,760 hrs) 195,200
Fixed Overheads (N40 x 8,000 hrs) 320,000
Budgeted Factory Overheads Costs 515,200
k. Budgeted Cost of Goods Sold

N
Total Manufacturing Cost (122,000 + 122,000 + 515,200) 759,200
Add Opening Stock Cost (.05 x 1,200 x N680) 40,800
Less Closing Stock Value (.05 x 1,600 x N680) -54,400
Budgeted Cost of Goods Sold 745,600
l. Budgeted Income Statement for February

N
Net Sales 1,191,840
Less Cost of Goods Sold 745,600
Less Selling and Admin Expenses
Variable (.20 x 1,200,000) -240,000
Fixed costs -250,000
Less Bed debts (1,200,000 x .8 x .02) -19,200
Net Income Before Taxes -62,960
m. Cash Budget
N N
Beginning Cash Balance 10,000
Add Collections 1,111,840
Total Cash Available 1,121,840
Less Payments:
Direct Materials 125,700
Direct Labour 122,000
Factory Overheads 415,200
Selling and Admin 415,000 1,077,900
Net Cash Balance 43,940
Page 422
Q3. GRAND COMPANY
a. Budgeted Net Sales Naira

N
Sales (1,000 x 300) 300,000
Less Cash Discount 300,000 x (.4 + (.6 x .4 x .01)) -1,920
Net Sales 298,080
b. Cash Collections for the Month:

N
From January (800 x 300 x .6 x .58) 83,520
From February - Cash (300,000 x .4 x .99) 118,800
From February - Credit (300,000 x .6 x .4 x.99) 71,200
Total Cash Collections 273,600
c. Budgeted production units

1,000 + (.10 x 1,200) – (.10 x 1,000) = 1,020 units.
d. Budgeted Direct Material Usage Qty.= (1,020 x 3) = 3,060 lbs.
e. Budgeted Direct Material Purchases Qty. = 3,060 + (.04 x 3,660) – (.04 x 3,060) = 3,084
lbs
f. Direct Material Usage Costs = (3,084 x N10) = N30,840
g. Direct Material Purchase Costs = (3,060 x N10) = N30,600
h. Direct labour usage hours = (1,020 x 2hrs) = 2,040 hrs
i. Budgeted Direct Labour cost = (2,040 x N12.00) = N24,480
j. Budgeted factory overhead costs

N
Variable Overhead (N20 x 2,040 hrs) 40,800
Fixed Overheads (N40 x 2,400 hrs) 96,000
Budgeted Factory Overheads Costs 136,800
k. Budgeted Cost of Goods Sold

N
Total Manufacturing Cost (30,600 + 24,480 + 136,800) 191,880
Add Opening Stock Cost (1,000 x .10 x N174) 17,400
Less Closing Stock Value (1,200 x .10 x N174) -20,880
Budgeted Cost of Goods Sold 188,400
l. Budgeted Selling and Admin Expense = N50,000 + (.10 x N300,000) = N80,000
Page 423
m. Budgeted provision for Bad debts = (N300,000 x .6 x .02) = N3,600.
Q4. MICROTABLE COMPANY
i. d ii. b iii. c iv. d
v. b vi. a vii. b viii. b
ix d x. c xi. b xii. c
Q5. R. G. PHELPS COMPANY
i. c ii. d iii. b iv. b
v. c vi. a vii. d viii. e
ix c x. a xi. d xii. b
Q6. GSM LIMITED

Jan. Feb. Mar.
Receipts N’000 N’000 N’000
Cash sales less disc. 76,000 80,750 90,250
Credit sales less disc 174,600 185,512 207,337
Payment the month follows sales 270,000 286,875
Payment two months after 262,000
Total cash receipts 250,600 536,262 846,462
Payments:
Royalties 10,525 12,530 26,813
Admin Exp. 40,000 42,500 47,500
Salaries & Wages 14,250 15,130 15,920
Printing of Cards 2,300 4,200 4,500
Loan Repayment 80,000 185,000 220,000
Interest on Loan 7,900 8,500 9,000
Total payment 154,975 267,860 323,733
Cash balance
Net Cash balance 95,625 268,402 522,729
Opening cash balance - 95,625 364,027
Closing cash balance 95,625 364,027 886,756
Workings:
a. Analysis of Sales
Page 424
Jan. Feb. Mar.
N’000 N’000 N’000
Total sales 800,000 850,000 950,000
10% Cash Sales (80,000) (85,000) (95,000)
Credit Sales 720,000 765,000 855,000
Payable within 10 days (25%) (180,000) (191,250) (213,750)
540,000 573,750 641,250
Payable one month after (50%) (270,000) (286,875) (320,625)
270,000 286,875 320,625
Bad Debt (1% of total sales) (8,000) (8,500) (9,500)
Payable two months after 262,000 278,375 311,125
(b) Receipt from Debtors
(i). Cash sales less discount

Jan Feb Mar
N’000 N’000 N’000
10% Cash Sales 80,000 85,000 95,000
Less 5% discount (4,000) (4,250) (4,750)
76,000 80,750 90,250
(ii). Credit sales less discount

Jan. Feb. Mar.
N’000 N’000 N’000
Credit sales within 10 days 180,000 191,250 213,750
Less 3% discount 5,400 5,738 6,413
Net credit 174,600 185,513 207,338
(c). Payment of salaries & wages

Jan Feb Mar
N’000 N’000 N’000
10% Arrears 1,200 1,450 1,520
Less 3% discount 13,050 13,680 14,400
14,250 15,130 15,920
(d) Administrative Expenses

Jan: = 5% X 800,000,000 = 40,000,000
Feb: = 5% X 850,000,000 = 42,500,000
Mar: = 5% x 950,000,000 = 47,500,000
(e) Royalties Paid:

Jan: = 5% X 210,500,000 = 10,525,000
Feb: = 5% X 250,600,000 = 12,530,000
Mar: = 5% x 536,262,000 = 26,813,000
Q7. TOROYA BOX FABRICATORS
Page 425
FLEXIBLE BUDGET FOR OCTOBER 2001
Sales (In Unit) 4,000 5,000 6,000
Selling price/unit N154 N154 N154
Sales 616,000 770,000 924,000
Less Variable Cost:

Direct Material (176,000) (220,000) (264,000)
Direct Labour (120,000) (150,000) (180,000)
Variable Marketing Cost (2,000) (2,500) (3,000)
Patent Royalty (8,000) (10,000) (12,000)
Contribution 310,000 387,500 465,000
Less Fixed Cost:
Manufacturing cost (102,400) (102,400) (102,400)
Marketing Cost (163,950) (163,950) (163,950)
Net Profit 43,650 121,150 198,650
Workings:
a) Selling price per unit = N140 X 110% = N154
b) Direct material cost per unit = N180, 000/4,500 = N40 =N40 X 1.1 = N44
c) Direct labour cost per unit = N135, 000/4,500 = N30
d) Selling price per unit = N140 X 1.1 = N154
e) Production supervisor salary increase per month = N12, 000/12 = N1,000
Total depreciation & other fixed manufacturing cost = N 101,400+N 1,000
= N 102,400
f) Sales manager salary increase per month = N15, 000/12 = N1,250
Total depreciation & other fixed manufacturing cost = N 162,700+N 1,250
= N 163,950
Q8. NION Manufacturing Plc
i). The Contribution per product.

Product X Y Z
N N N
Selling Price 20.00 30.00 15.00
Less Variable Costs
Direct material – A 6.00 12.00 -
Direct material – B - - 4.00
Direct labour - Dept 1 3.00 6.00 3.00
Variable Overhead 1.50 2.00 0.50
Contribution per unit 7.00 7.50 5.00
Sales (Unit) 100,000 50,000 150,000
Total Contribution (N) 700,000 375,000 750,000
ii). The production cost Budget
Page 426
Product X Y Z
N N N
Variable Costs
Direct material – A 6.00 12.00 -
Direct material – B - - 4.00
Variable Overhead 1.50 2.00 0.50
Production cost per unit 13.00 22.50 10.00
Production Units 101,500 50,750 169,400
Budgeted Production Costs 1,319,500 1,141,875 1,694,000
Ground Total 4,155,375
Calculation of budgeted production unit.

Product X Y Z
Closing Stock 2,500 1,750 2,000
Budgeted Sales Units 100,000 50,000 150,000
Less Opening Stock Units 1,000 1,000 600
iii). Material Cost Budget.

Product X Y Z
Material Usage
Material A 406,000 406,000 -
Material B - - 1,355,200
Total Usage 406,000 406,000 1,355,200
Add closing Stock (20%) 81,200 81,200 271,040
Material Purchases 487,200 487,200 1,626,240
Cost per Kg (N) 1.50 1.50 0.50
Material Cost Budget(N) 730,800 730,800 813,120
Cumulative Total(N) 2,274,720
iv). Budgeted Labour costs
Page 427
Product X Y Z
Budgeted Labour hours
Dept. 1 50,750 50,750 84,700
Dept. 2 50,750 25,375 84,700
Budgeted Labour costs N N N
Dept. 1 @ N6/hr 304,500 304,500 508,200
Dept. 2 @ N5/hr 253,750 126,875 423,500
Total Costs 558,250 431,375 931,700
Cumulative Total(N) 1,921,325
Page 428
CHAPTER 15
OTHER COSTING AND MANAGEMENT ACCOUNTING CONCERNS
MODERN MANUFACTURING
Traditional manufacturing is organized as a rigid set of departments, processes or machines through

which work flows, either following a ‘map’ or ‘route card’ for job or batch production, or along a
production line or series of linked processes for continuous production. The time taken to meet a
customer’s order can take days or weeks, unless the firm produces standard products, in which case
stocks of finished products makes it appear more economic to produce large batches – either by
waiting for sufficient customer orders to accumulate or by producing for stock. There is also great
pressure to standardize products to keep manufacturing costs down. Few workers are directly
responsible for the quality of the product in a traditional factory- it is always someone else’s job.
Consequently, there is a greater likelihood of poor quality output and of high scrap levels or rework
costs.
Until the 1970s a lack of effective international competition and the overhang from wartime
shortages, combined with less demanding customers, meant that manufacturers were able to operate
in a supplier-dominated market. Market conditions changed the 1980s to become customer-
oriented. The modern customer expects rapid responses from suppliers producing a wide variety of
high-quality, low-price products. This means that the traditional manufacturer cannot compete and
so has had to change.
Manufacturers have made series of responses to the changed market environment. Most of these
responses are described by three letter acronyms, such as Flexible Manufacturing System (FMS),
Advanced Manufacturing Techniques (AMT), Total Quality Management (TQM) and Just In
Time (JIT) purchasing and production.
FLEXIBLE MANUFACTURING SYSTEM (FMS)
FMS consist of a cluster of different types of machines surrounding a single workstation, usually
call a ‘cell’. Complete products are manufactured at a single cell by a worker who is trained to
operate a variety of machines. The worker is also responsible for the quality of the product.
Manufacturing with FMS is quicker because:
 The part-finished product does not have to be moved around the factory from machine to
machine.
 There is no need to wait until the next machine or worker is available.
FMS factory layouts have been credited with achieving a 90 per cent reduction in material
movements, a 75 per cent reduction in machine downtime, a 75 per cent defect reduction and a 50
per cent reduction in plant occupied; while personnel productivity has risen by an average of 30 per
cent (Roy L. Harmon and Leroy D. Petersen, Reinventing the Factory, The Free Press, 1990).
ADVANCED MANUFACTURING TECHNIQUES (AMT)
AMT refers to the use of information technology to achieve higher quality and cheaper products
more quickly. The techniques used include an information system called Materials Requirements
Planning (MRP 1), which explodes the materials specifications for finished products back-wards
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so that a production schedule can be designed which optimizes the ordering and production of the
parts and sub-assemblies required. Another AMT technique, which is sometimes combined with
MRP1 is Manufacturing Resource Planning (MRP II). MRP II is an information system that
provides an integrated decision support system for resource management. MRP II ties together the
interrelated activities of design, manufacturing, marketing, distribution, finance and human
resource management. Other AMT methodologies are Computer Aided Design (CAD) and
Computer Aided Manufacturing (CAM) in which IT is used to automate design and
manufacturing. Once CAD and CAM are linked together the whole process can be described as
Computer Integrated Manufacture (CIM). As you can see modern manufacturing involves a
large number of three letter acronyms.
TOTAL QUALITY MANAGEMENT
Total = Quality involves everyone and all activities in the company.
Quality = Conformance of requirement (Meeting Customer Requirement)
Management = Quality can and must be managed,
TQM = A process for managing quality, it must be a continuous way of life, a philosophy of
perpetual improvement in everything we do.
It is a structured system for satisfying internal and external customers and suppliers by integrating
the business environment, continuous improvement in everything we do.
It is a structured system for satisfying internal and external customers and suppliers by integrating
the business environment, continuous improvement, and breakthroughs with development, and
maintenance cycles while changing organizational culture.
One of the keys to implementing TQM can be found in this definition. It is the idea that TQM is a
structured system. In describing TQM as a structured system, I mean it is a strategy derived from
internal and external customer and supplier wants and needs that have been determined through
daily management and cross-functional management.
Pinpointing internal and external requirements allows us to continuously improve, develop, and
maintain quality, cost, delivery, and morale. TQM is a system that integrates all of this activity and
information.
When all of its elements are implemented properly, TQM is like a well-built house. It’s sold,
strong, and cohesive.
TQM is the foundation for activities, which include:
 Meeting customer requirements

 Reducing development cycle times
 Just in time/demand flow manufacturing
 Improvement teams.
 Reducing product and services training
The ten steps to TQM are as follows:
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i. Pursue new strategic thinking
ii. Know your customers
iii. Set true customer requirements
iv. Concentrate on prevention, no correction
v. Reduce chronic waste.
vi. Pursue a continuous improvement strategy
vii. Use structured methodology for process improvement
viii. Reduce variation
ix. Use a balance approach
x. Apply to all functions
The principles of TQM are as follows:
 Quality can and must be managed.

 Everyone has a customer and is a supplier.
 Processes, not people are the problem.
 Every employee is responsible for quality.
 Problems must be prevented, not just fixed.
 Quality must be measured.
 Quality improvements must be continuous.
 The quality standard is defect free.
 Goals are based on requirements, not negotiated.
 Life cycle costs, not front end costs.
 Management must be involved and lead.
 Plan and organize for quality improvement.
Process must be managed and improved. This involves:-
 Defining the process

 Measuring process performance (metrics)
 Review process performance
 Identifying process shortcomings
 Analyzing process problems
 Making a process change.
 Measuring the effects of the process change
 Communicating both ways between supervisor and user.
The key to improving quality is to improve processes that define, produce and support our
products.
All people work in processes.
People
Get processes “in control”
Work with other employees and managers to identify process problems and eliminate them.
 Managers and/or supervisors work on processes.

 Provide training and tool resources
 Measure and review process performance (metrics)
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 Improve process performance with the help of those who use the process.
JUST IN TIME
Just in time is about not having anywhere in the plant or outlet, more raw materials sub-assemblies
or products than the minimum required for a fluent operation.
Storage is usually a hidden enemy of a healthy operation. When raw materials, sub-assemblies or
finished products stay anywhere they represent a part of the assets of a company that is not
generating any profits. In addition to that loss of profit, it is at risk of floods, fires, market
depreciation and design obsolescence, are just some of those risks. In some cases, raw materials
used in products that have not moved, could have been used to manufacture other products that
would have sold faster.
Unless we are in the business of storage and whole, buying large volumes of raw material may not
be the best way we can use money. Our suppliers can become more efficient and give us the good
prices if we reach an agreement of buying all our requirements from them. The automobile
industry has established in many cases agreements for hourly or daily delivery of some materials
and parts. This can allow for them to operate in more compact areas, reducing time and movement
in the process.
This concept, when continued throughout the full operation will also allow for each work cell and
department of the plant to deliver products at the right pace to the customer and of course to the
final user. The JIT process has to be thoroughly coordinated with all the involved parties, and its
implementation should be done gradually. This planning and coordination will take most of the
effort, but the results will be impressive. JIT touches on two sections. They are:-
 Just in Time Purchasing

 Just in Time Production
JUST IN TIME PURCHASING
The most challenging area for most manufacturers in achieving JIT is the purchasing of raw
materials and parts. This is important because an internal JIT system can only operated successfully
when the material being fed into it are of sufficient quality and delivered on time. Therefore,
unless the quality and delivery of purchased material are not production issues, the purchasing
function should begin to establish a JIT supplier base. In JIT purchasing several tactics are being
used to achieve certain goals and objectives.
Goals
 Secure a steady flow of quality part/materials

 Reduce the lead-time required for ordering product
 Reduce the amount of inventory in the supply and production pipelines
 Reduce the cost of purchased material.
Objectives
 Improve purchasing efficiency
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 Improve quality and delivery performance of suppliers
 Isolate factors that influence the cost of material
 Remove unnecessary cost factors in the materials supply system.
Tactics
 Regard suppliers as an extension of the internal manufacturing process and cultivate them
as long-tem business partners.
 Established long term purchasing and supply commitments.
 Improve communication with suppliers
 Involve suppliers in early stages of new product planning.
 Use supplier expertise to improve design manufacturability and reduce product cost.
Material purchased in a JIT system should meet three requirements;-
1. An acceptable level of quality

2. On time delivery schedule, and
3. A reasonable cost.
JUST IN TIME PRODUCTION
Just in time production is a systems approach to developing and operating a manufacturing system.
It is based on the total elimination of waste. JIT is not a new concept. It has been part and parcel
of the Japanese manufacturing industry adopted approach for quite some time. It requires that
equipment, resources and labour are made available only in the amount required and at the time
required to do the job. It is based on production rates exactly in line with market demand. In short,
JIT means making what the market wants, when it wants it. JIT has been found to be so effective
that it increases productivity, work performance and product quality, while saving costs.
Requirements for JIT Production
The corporate commitment to developing the internal structures and the customer and supplier
bases to support JIT manufacturing is the primary requirement for developing a viable JIT system.
To be able to establish a JIT manufacturing system, every department should have some
commitment to align with a common goal. The company’s top management must support this goal
in order to have resources and time allocated to developing the necessary systems and procedures.
A significant financial commitment is necessary during the early stages of development and
implementation to change over to a JIT system. This system, however, needs to be methodically
developed on a scale that is within the employer’s means from both a financial and an applications
standpoint. Ultimately, the operation of a JIT system will require the unwavering support and
commitment of the entire company.
Management needs to come with grips during the early transaction phase of implementing JIT. The
prospect must be faced of some production loss and changes to management procedures and
operation policies while existing operations and manufacturing problems are being concurrently
resolved. JIT will require every department in a company to contribute to the overall success of the
system and patience is required as results are not instantaneous. In the long term, the rewards are
worth the initial setbacks.
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Trust and commitment between the supplier and the customer is a must, and it is essential to keep
commitments, as this is to ensure that customer’s confidence in a supplier’s ability to meet
production schedules.
CONTROL SYSTEMS THEORY
It is worth considering a little systems theory before examining management accounting’s

contribution to organizational control, if only to introduce the language and the broad concepts
used. This will be particularly relevant in the study of budgetary control and standard costing.
SYSTEMS
A system is an orderly, inter-connected arrangement of parts. This description fits any sort of
system, from a motor vehicle to health insurance. The key characteristics of a system are that it
takes input(s), which it then processes, to achieve an objective or a result. A car takes fuel, which it
converts into motion, to transport a load between two points. Health insurance converts premiums
into medical treatment.
The attributes of a system are:

 There are boundaries between the system and its environment. Each car is separate from
the highway, and from each other, health insurance is distinct from other forms of financial
system.
 It may be possible to break a system down into sub-systems, such as the car’s engine, or
the insurance premium collection process.
 A system can be connected to other systems, just as the car’s engine connects to its
transmission, or the premium collection process connects to the insurance company’s
investment process.
 A system may be deterministic (mechanistic), where a given input will generate a known
output. For example, a N10 per month premium may provide medical cover of N10,000,
while N20 per month buys N20,000 of cover.
 Or probabilistic (stochastic) systems, where a given input may generate a range of possible
outputs. For instance, the miles per gallon achieved by a car will depend on a whole host of
factors, such as traffic conditions, age of vehicle, load, the terrain and driving style.
CONTROL SYSTEMS
A control system is a communications network that monitors the activities of an organization and
provides the basis for corrective action. The elements of a control system are:
- monitoring of the inputs and outputs to or from the process;
- comparisons are made with predetermined values;
- if deviations from predetermined values occur, then corrective action is taken.
Closed or single-loop systems:- single-loop (closed) systems are self-regulating. They adapt to
their environment by altering their inputs after their outputs fail to match the system’s objectives.
The classic example is a refrigerator, which will go into its cooling cycle after the internal
temperature rises above its thermostat setting. The budget controls exerted by organizations in the
public sector are single-loop systems as they are intended to correct overspends in one period with
compensating underspends in the next.
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Open or double-loop systems:- double-loop (open) systems are designed to interact with their
environment. They do this by adjusting their objectives as well as, or instead of their inputs. For
example, when faced with a hill a car driver may put his or her foot down to increase speed before
reaching the hill, rather than waiting until the vehicle begins to slow down. A well-run business
will use its cash forecasts to identify future deficits so that borrowing can be arranged in advance,
rather than waiting until the bank account is overdrawn.
FEEDBACK
Feedback is the process whereby any disparity between the actual outputs from a system and the
system’s objectives are corrected by an adjustment to the system’s inputs. For example, if we
notice that our car is exceeding the speed limit we ease back on the accelerator. If a health
insurance’s premium income begins to fall below its payments to hospitals it will increase its
premiums.
A system employs negative feedback when it adjusts its inputs to bring future outputs closer to the
objectives of the system. Refrigerator controls and public sector budgets are both agents in a
negative feedback system.
Positive feedback occurs when a system adjusts its objectives in response to a disparity between
planned and actual outputs. For instance, if a particular product is generating higher than expected
profits management will provide it with extra resources. Managers are unlikely to cut back on sales
in an attempt to bring profits back down to their original planned level.
Feedback is an essential part of management accounting in that it closes the loop between the
provision of planning or decision-making information and the requirement for corrective action if
performance differs from plan. It assists control, directs attention to problems, provides motivation
and permits regular monitoring. Feedback management control system may be ‘negative’, i.e.
forcing the unit back onto plan, in which case managers will be expected to eliminate adverse
variances, or positive where favourable variations from plan are exploited and encouraged.
FEEDFORWARD
Feedforward occurs when a system is designed to compare projected (forecast) results with future
objectives so that corrective action may be taken in advance. Cash forecasting is part of a
feedforward cash management system. Obviously, a business proceeds far more efficiently if it
relies on feedforward rather than feedback in its control systems. The budget setting process is
often an iterative feedforward system in that both revenue and cost figures (inputs) and budget
objectives (sales targets, etc.) may be altered several times until a satisfactory budgeted profit
figure is reached.
THE LAW OF REQUISITE VARIETY
The law of requisite variety states that, for full control, a control system should contain a level of
variety that is at least equal to the variety in the system that it is intended to control. Hence, a
superior central heating system will have a thermostat in every room. While a simple monthly
departmental budget may contain insufficient numerical measures (objectives) to deal with the wide
variety of activities that the department’s manager is expected to control.
NOISE
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Noise is a feature of many control systems. System noise is described as irrelevant or insignificant
data which overload a feedback process. The presence of noise can confuse or divert attention from
relevant information. The financial accounting concept of materiality is an attempt to reduce noise.
One solution to the problems posed by noise and the law of requisite variety is to concentrate
control on the most important elements of an activity. For instance, ABC analysis is often used in
the control of stock or debtor balances. ABC analysis is based on Parento analysis (commonly
called the 80/20 rule) which recognizes that the vulnerability of the organisation to stock outs or
bad debts, for example, is concentrated on relatively few items or accounts. These are the ‘A’ items
or accounts and they must be constantly monitored. The ‘B’ items are less important and so they
can be monitored less frequently, while the ‘c’ items or accounts may well be ignored for control
purposes. For instance, you might class paper and toner as ‘B’ items because a stock out would be
inconvenient, while pencils would be classed as ‘C’ items because you can always use ballpoints
instead.
Managers may decide to ignore variances of less than +/- 5 per cent in a budgetary control or
standard costing system in an attempt to reduce noise. Where variance is defined as the difference
between a planned, budgeted or standard cost and the actual cost incurred. The same comparison
may be made for revenue. (An ‘adverse variance’ occurs when actual revenue is less than budget or
standard, or actual cost is higher than budget or standard. If the actual revenue is higher than budget
or standard, or the actual cost is below budget or standard the difference is described as a
‘favourable variance’.)
Yet another way of dealing with noise and variety is to push control down to as low a level as
possible in the organization. The idea is that when we reduce the scale of a control sub-system we
also restrict its scope for noise and variety. This approach is epitomized by worker empowerment
and by JIT purchasing and producing.
CONTINGENCY THEORY
Most modern management accountants now accept the precepts of contingency theory, which can
be summarized as ‘choose the most appropriate method for the purpose’. ‘The hypothesis that there
can be no universally applicable best practice in the design of organizational units or of control
systems such as management accounting systems. The efficient design and functioning of such
systems is dependent on an awareness by the system designer of the specific environment factors
which influence their operation, such as the organizational structure, technology base and market
situation’.
This is why management accounting can seem very difficult to those who are new to the subject.
Instead of a nice, consistent, logical and easy-to-follow set of rules, we have what appears to be a
mish-mash of principles, techniques and systems, from which you the student have to select the
most appropriate for the current problem. However, we should not be too hard on management
accountants. The nearest academic discipline to management accounting is economics, and, while
economists can usually explain what has happened, they are usually very poor at predicting what
will happen – and are even worse at providing workable solutions to problems. Fortunately,
management accountants have an advantage over economists, in that they work in business
organizations that offer a controllable, autonomous, internal environment, which should be capable
of reacting to changes in the external legal, economic and market environments.
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COST REDUCTION AND VALUE ANALYSIS
COST REDUCTION
Cost reduction is not simply a case of making the product (or delivering the service) in as cheap a
way as possible. Such a philosophy would result in substandard products being sold and no firm
will last very long if it continues to do that. Cost reduction is ‘the reduction in unit cost of goods
and services without impairing suitability for the use intended’ in other words, the impact of cost
saving actions on the quality of the product should not be ignored.
There may be some businesses at the top end of the luxury market, which do not need to consider
their costs, but such organizations are exceptional. Cost reduction should be a general policy aim
for almost all organizations and form part of the organization’s continuous improvement ethos. The
intention should be to seek ways in which costs can be reduced so that competitive advantage can
be obtained and/or profitability increased.
Particular ways in which costs can be reduced include the following:-

 changing a product’s design so that it is easier to manufacture;
 changing a product’s design so that its material content is reduced;
 changing a product’s design to make use of standard (i.e. cheaper) components;
 using work study to discover faster ways of performing tasks;
 improving factory layouts to speed up the flow of work and materials;
 using organization and methods techniques to eliminate paperwork or to improve
paperwork flow;
 introducing flexible manufacturing systems;
 installing total quality management procedures;
 reducing inventory by using JIT purchasing and manufacturing
 attacking particular areas of waste, such as energy losses,
 continuously updating equipment (and software);
 carrying out staff training to improve workers’ efficiency levels;
 carrying out planned maintenance in order to repair equipment before it breaks down;
 setting up staff incentive schemes, to encourage workers to identify better ways of working
and other ways in which costs can be saved.
All these are good modern ‘housekeeping’ and common sense combined with the appropriate
advanced manufacturing techniques.
VALUE ANALYSIS
According to some survey evidence, up to 90 per cent of a product’s cost is determined before
manufacture (or provision of the service) even begins. Hence, the scope for cost reduction once a
product has been launched is limited. Consequently, the time to concentrate on cost reduction is at
the product and process design stage. Cost reduction at this stage is best carried out within a value
analysis on the product or service, as this will discourage managers from concentrating purely on
cost savings to the detriment of the product’s marketability.
Value analysis is ‘a systematic interdisciplinary examination of factors affecting the cost of a

product or service, in order to devise means of achieving the specified purpose most economically
at the required standard of quality and reliability’. Value analysis aims to achieve a very clear
understanding of what it is that customers are paying for when they purchase a product, and thus
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which product attributes must be retained or enhanced and which attributes can be eliminated or
de-emphasised.
A product’s attributes are the features that it contains. For example, a car may have the following
broad attributes (within which there may be many more specific attributes):
 comfort (e.g. seating, noise level, temperature control, suspension)
 reliability (e.g. few breakdowns, fail-safe features)
 economy (e.g. fuel consumption, servicing intervals, price of spares)
 safety (e.g. braking, lights, strength, fail-safe features)
 style (e.g. classic, functional, distinctive)
 performance (e.g. acceleration, maximum speed, braking, suspension, steering).
Value analysis encourages innovation and a radical approach to cost reduction. It recognizes the
value of a product or service, and seeks to maintain or improve this at a lower cost.
The four aspects of value to consider in value analysis are:

1. Cost value – this is the cost of producing and selling a product. Value analysis attempts to
minimize unit costs, therefore, cost value should be the only aspect of value to be reduced.
Value engineering is one activity that contributes to the achievement of cost value. Value
engineering is ‘an activity which helps to design products which meet customer needs at
the lowest cost while assuring the required standard of quality and reliability’. Each aspect
or attribute of a product is examined in value engineering.
2. Exchange value – which is a product’s market value.
3. Use value – which is what a product does, i.e. its function. Value analysis aims to provide
the same or increased use value for a lower cost.
4. Esteem value – which is the value of the prestige attached to the product by its customers.
This is usually due to its appearance. Value analysis will try to preserve or to increase a
product’s esteem value while reducing unit costs.
Conflicts may occur as a result of trying to achieve all of these value aspects. Therefore, some
trade-offs between each of the four value aspects may be necessary. Value analysis will attempt to
achieve features such as:
 improved performance and reliability
 improved quality
 longer product life
 reduced lead times
 use of standard components
 careful use of scare resources
 innovation and creativity
The process of value analysis consist of the following steps:

 set up a skilled multidiscipline team, which may include the management accountant
 select the product or service for study
 obtain and record information
 analyse and evaluate the information
 evaluate alternative options to create value
 make recommendations
 implement the recommendations that are accepted
 follow-up, to establish whether the value analysis was effective
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Examples of the sort of questions that may be asked in value analysis are:
- Are there any attributes of the product that can be eliminated, without detriment to the
function or reliability of the product?
- Can any components be eliminated, without detriment to the function or reliability of the
product?
- Can standard parts be substituted for any of the components in the product, without
detriment to the function or reliability of the product?
- Is there a cheaper manufacturing method?
- Does the product provide more than the customer has specified?
- Is there something better that will perform the same function/job?
- Does an attribute cost more than its value to the customer?
The implementation of a value analysis programme will need the backing of senior management, as
the process may cut across several separate business functions.
A key part of the value analysis of a product is to identify the relevant value driver(s). A value
driver is ‘an activity or organizational focus which enhances the perceived value of a product or
service in the perception of the customer, and which, therefore, creates value for the producer.
Advanced technology, reliability or a reputation for customer care may be value drivers’.
NON-FINANCIAL PERFORMANCE MEASURES
Financial measures may be open to manipulation, as is can be observed from previous

computations. They are also the result of a number of organizational interactions and so may mask
what is really going on within a division. One solution to this problem is to use non-financial
performance indicators, this form an important element of balanced scorecard approach to
performance appraisal described below.
Non-financial measures that are suitable for divisional performance appraisal include:
 Labour productivity;
 Average delivery times;
 Division-wide defect rates, with zero defects as the theoretical target;
 Customer complaints, expressed as a percentage of the customer base;
 Warranty claims, expressed as a percentage of the items delivered, or services provided;
 Market share;
 Average or specific throughput rates or times;
 Average or specific response times;
 Customer accessibility, i.e. what proportion of the potential market are aware of the
division’s product(s) and have easy access to its order-taking processes.
These non-financial indicators can avoid much of the subjectivity that is inherent in the financial
accounting figures used to calculate ROCE, RI, sales margin and asset turnover.
THE BALANCED SCORECARD
WHAT GETS MEASURED GETS DONE

Conventional performance measures tend to concentrate on one figure, so management will
concentrate on maximizing this measure – be it output, customer response times, net margin,
ROCE or RI. Consequently, an organisation’s managers may ignore the organisation’s overall
goals and take actions that could damage the organisation’s profitability in the long term.
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There is now a tendency for firms to use a spread of non-financial indicators, as well as some
financial ratios, to measure divisional and departmental performance. This reduces the risk of
distorting a division or department’s performance through reliance on a single measure.
AIMS OF THE BALANCED SCORECARD APPROACH TO PERFORMANCE

APPRAISAL
The balance scorecard is a performance measurement approach that considers a number of

measures, rather than just one. It attempts to avoid some of the dysfunctional features of the more
conventional single value measures.
Balanced scorecard is defines as an approach to the provision of information to management to
assist strategic policy formulation and achievement. It emphasises the need to provide the user with
a set of information which addresses all relevant areas of performance in an objective and unbiased
fashion. The information provided may include both financial and non-financial elements, and
cover areas such as customer satisfaction, internal efficiency and innovation.
The balance scorecard approach to performance appraisal was developed in the early 1990s by
Robert Kaplan and David Norton. The technique is particularly useful for appraising the
performance of large and complex organizations, but the balanced scorecard can be used to monitor
the performance of any size or level of business unit. Managers of large organizations need a wider
range of measures than the traditional financial set – but they cannot risk being overwhelmed by
too large a number of measures. What top management need are measures that relate to their
organisation’s critical success factors.
A balanced scorecard will usually consider four different perspectives, or views of the organisation
(see below). The managers of the firm will ask themselves appropriate questions and set up a
number of measures that provide answers to these questions. These measures will be translated into
more detailed activity-specific measures (i.e. decomposed) so that employees at all levels can
respond to them. Non-financial measures are a particularly important component of the balanced
scorecard. The measures used in the balanced scorecard will be revised as the external and internal
environment alters.
THE COMPOSITION OF A BALANCED SCORECARD
The four perspectives that Kaplan and Norton identified are:

1. The financial perspective, or shareholders’ view: The questions managers may ask
concerning the firm’s shareholders are (a) how does the company appear to its
shareholders, and (b) how can the company increase shareholder value? Typical financial
measures that could be used to monitor a company’s response to its shareholders’ concerns
are ROCE, share price to earnings ratio and dividend cover. Clearly, the measures used will
depend on shareholders’ views.
2. The customer perspective, i.e. how the company’s customers see it. A company may
employ external researchers to discover (a) how its customers view the organisation and/or
(b) what its current and potential customers particularly value. These customer-based
measures should be translated into things that the organisation does. Typical measures of
how a business responds to its customers’ concerns are the number of warranty claims,
telephone response times and how quickly customers’ orders are delivered.
3. The internal business perspective, which aims to improve businesses processes. A business
will ask itself what the organisation should excel at, i.e. what are the manufacturing or
service processes that the company must be particularly good at? Typical internal measures
are labour efficiency, capacity utilization, process yield and unit cost.
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4. The innovation and learning perspective is concerned with how well the organisation is
developing its capability for the future. Managers must ask themselves how the
organisation can continue to improve and create value. Typical measures of whether the
business is improving and creating value are, (a) improvements in productivity levels, (b)
the number of new products developed and (c) the speed with which these new products
are developed.
The above four perspectives could be added to. Whether it would be worth monitoring additional
aspects depends on the type of organisation. There may be other perspectives that are particularly
appropriate to an organisation such as a bank or a rail operator.
One such perspectives is human resources, where the question managers should ask is ‘How can
the organisation get the best from its employees?’ Typical employee-related measures could be an
analysis of staff turnover (both numbers and reasons), days training per employee, and absence
rates.
However, organisations must take care not to overwhelm their managers with information. The
whole point of the balanced scorecard is to allow managers to focus on the key issues.
MAXIMISING THE IMPACT OF THE BALANCED SCORECARD ON BUSINESS

PERFORMANCE
A business will need a sophisticated real-time information system so that managers are able to
monitor rapidly their progress against targets and take any necessary action, if the balanced
scorecard approach to performance measurement is to be fully effective.
Even an excellent set of results against the balanced scorecard measures does not guarantee
continued financial success. After a time a firm that operates the balanced scorecard technique
successfully is likely to become more efficient. This will create surplus labour, equipment and
space. However, a company will not reap all the benefits of improvements in its productivity, etc. if
its divisions do nothing about the increased capacity and capability that the balanced scorecard
system has created. Financial success will only be assured if any excess labour is used productively
and if any extra capacity is fully utilized. Any spare labour or spare capacity in a division that
cannot be used elsewhere in the organisation should be dispensed with. The cost saving achieved
will then add to the organisation’s long-term profitability.
INTER-FIRM, INTER-DIVISIONAL AND INTER-DEPARTMENTAL COMPARISONS
One way of encouraging divisional and departmental managers to improve their performance is to
extend the ideas of inter-firm comparisons between divisions and between departments. Inter-firm
comparisons is defines as a systematic and detailed comparisons of the performance of different
companies generally operating in a common industry. Companies participating in such a scheme
normally provide standardized, and therefore comparable, information to the scheme administrator,
who then distributes to participating members only the information supplied by participants.
Normally the information distributed is in the form of ratios, or in a format which prevents the
identity of the scheme members from being identified.
Inter-divisional and inter-departmental comparisons are not restricted by the confidentiality
requirements of inter-firm comparisons. Therefore, as the identity of each participating division or
department is known, managers should be stimulated to compete more intensely.
Inter-divisional and inter-departmental comparisons can use financial ratios (including detailed cost
ratios) where products are similar, as well as non-financial performance measures, such as those
detailed above. It may also be worthwhile for divisions to compare their performance using some
other short and medium term non-financial performance measures.
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If inter-divisional and inter-departmental comparisons are to be worthwhile the ratios used must
cover areas where it is possible for managers to make improvements. If ratios measuring non-
controllable costs and activities are compared they could distract attention away from more
important controllable areas. For example, a ratio such as square metres per employee may have no
practical value – except to indicate conformity with health and safety regulations.
BENCHMARKING
Benchmarking is a refinement of the inter-firm comparison idea. A benchmark is a standard or

point of reference. It is the establishment, through data gathering, of targets and comparators,
through whose use relative levels of performance (and particularly areas of underperformance) can
be identified. By the adoption of best practices it is hoped that performance will improve. Types of
benchmarking include:
 Internal benchmarking – a method of comparing one operating unit or function with another in
the same industry.
 Functional benchmarking – in which internal functions are compared with those of the best
external practitioners of those functions, regardless of the industry that they are in (also known
as operational or generic benchmarking).
 Competitive benchmarking – in which information is gathered about direct competitors,
through reverse engineering.
 Strategic benchmarking – a type of competitive benchmarking aimed at strategic action and
organizational change.
Reverse engineering refers to as the decomposition and analysis of competitors’ products in order
to determine how they are made, costs of production, and the way in which future development
may proceed.
Benchmarking seeks to find out why performance differs, in order to initiate specific action.
Conventional inter-firm/inter-divisional/inter-departmental comparisons only indicate general areas
of difference and provide no clear reasons for the differences in performance. Benchmarking within
an organisation is comparatively easy to set up and does not require the loss of competitive
advantage that might occur in an inter-firm benchmarking exercise.
INTERNATIONAL COMPARISONS
International comparisons between firms or divisions are more difficult to make than those within
the same country. The following are some of the main reasons:
1. Currency differences – which require agreement on a suitable conversion rate. This can
sometimes be difficult if a currency is not fully convertible.
2. Exchange rate fluctuations – which add to the problem caused by currency differences.
3. Different inflation rates, and inflation itself, can make it hard to monitor comparative
performance. It is difficult to compare the costs of a division that is located in a country with a
high rate of inflation with those of another in a low inflation country because the comparisons
become rapidly out of date.
4. Taxation differences may affect the way that business is carried on. For instance, it may be
more advantageous for a division in one country to lease its fixed assets instead of purchasing
them.
5. Different interest rates, therefore, differing costs of capital.
6. Different working practices and levels of trade union activity may affect labour costs.
7. Different labour regulations (minimum wages, maximum working hours, holidays, health and
safety) will also affect labour costs.
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8. Different accounting policies necessitating adjustment to the financial figures used.
9. Difficulty in finding suitable firms to compare with based on other factors.
It is possible to adjust for inflation, exchange rate movements and interest rates by indexation. It is
also wise to avoid over concentration on financial measures such as return on investment, etc. when
making international comparisons. It is advisable to supplement financial ratios and measures with
non-financial indicators, such as throughput rates, productivity ratios, quality measures, market
share and delivery performance, which can be related to the division’s critical success factors.
MULTIPLE PRACTICE QUESTIONS
1. Which of the following statements is true? Both ABC and JIT

a. Place emphasis on simplification.
b. Provide more accurate product costs than traditional systems.
c. Emphasize quality improvements.
d. all of the above.
e. none of the above.
2. Which of the following concepts or techniques are (is) consistent with the JIT philosophy?
a. Using statistical control charts at the process level.
b. Using a team approach to performance measurements.
c. Using overhead variance analysis at the process level.
d. a and b.
e. a and c.
3. Which of the actions stated below is not consistent with JIT purchasing?
a. Reduced inspection of incoming materials.
b. More frequent deliveries from vendors.
c. Long-term agreements with vendors.
d. Vendor certification and education on quality requirements.
e. Increased number of vendors to obtain competitive prices.
4. A JIT production system would not include an emphasis on:

a. Maximizing the quantity of output at each stage of the production process.
b. Producing products as needed by the next stage of the production process.
c. Decentralization of support services.
d. a and b.
e. a and c.
5. Departmental overhead rates are likely to be

a. More accurate in a just-in-time production system than in a traditional production
system.
b. More accurate in a traditional production system than in a JIT system.
c. Equally accurate or inaccurate in both systems.
d. Used in a traditional system but not in a JIT system.
e. None of the above.
6. The value chain concept refers to the linked set of value adding activities performed.
a. within an organization.
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b. within an organization, plus the capital added by stockholders.
c. from suppliers through an organisation’s production activities.
d. from suppliers through an organisation’s distribution activities.
e. from suppliers through an organization’s customer service activities.
7. Rearranging a factory from a traditional layout to a cellular layout tends to

a. reduce the need for inventory buffers.
b. reduce the number of machine operators needed.
c. convert some indirect product costs to direct product costs.
d. a and b.
e. all of the above.
8. Activity based management (ABM) includes six elements: 1. Define activities, 2. identify
drivers and activity measures, 3. assign costs to activities, 4. assign costs to cost objects
such as products, 5. develop performance measurements and 6. manage processes and
work. Which of these elements are part of “activity management” framework?
a. 1 through 6.
b. 1 through 4.
c. all but 4.
d. all but 3 and 4.
e. only 5 and 6.
9. In the theory of constraints, throughput is

a. Sales less direct material costs.
b. Sales less bottleneck costs.
c. Sales less manufacturing costs.
d. Sales less operating expenses.
e. Sales less contribution margin.
10. Which of the accounting systems below tends to cause the greatest behavioral bias towards
creating excess resources within a company?
a. Throughput costing systems.
b. absorption costing.
c. direct costing.
d. job order costing.
e. process costing.
11. Which of the following production control systems is more appropriate in an environment
where jobs are produced to customers’ specifications?
a. Activity based costing systems.
b. Throughput costing systems.
c. Just in time systems.
d. Back flush systems.
e. Push systems.
SOLUTION
1. b 2. d 3. e 4 a 5. a
6. e 7. e 8. d 9. a 10. b
11. d
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CHAPTER 16
WORKING CAPITAL MANAGEMENT
Managing working capital is a matter of balance. A business must have sufficient cash on hand to
meet its immediate needs while ensuring that idle cash is invested to the organisation's best possible
advantage. To avoid tipping the scale, it is necessary to have clear and accurate reports on each of
the components of working capital and an awareness of the potential impact of outside influences.
The term working capital refers to the amount of capital, which is readily available to an
organisation. That is, working capital is the difference between resources in cash or readily
convertible into cash (Current Assets) and organisational commitments for which cash will soon be
required (Current Liabilities).
Current Assets are resources, which are in cash or will soon be converted into cash in "the ordinary
course of business".
Current Liabilities are commitments, which will soon require cash settlement in "the ordinary
course of business".
Thus: WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
For any given entity, these components of working capital are reported under the following
headings:
CURRENT ASSETS
 Liquid Assets (cash and bank deposits)

 Inventory
 Debtors and Receivables
 Other Short Term Assets
CURRENT LIABILITIES
 Bank Overdraft
 Creditors and Payables
 Other Short Term Liabilities
THE IMPORTANCE OF GOOD WORKING CAPITAL MANAGEMENT
If a Company is operating with more working capital than is necessary, this over-investment
represents an unnecessary cost to such entity.
From an entity’s point of view, excess working capital means operating inefficiencies. In addition,
inadequate working capital increases the amount of the charges which such a business needs to
bear.
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Good management of working capital is part of good financial management. Effective use of
working capital will contribute to the operational efficiency of a business; optimum use will help to
generate maximum returns.
APPROACHES TO WORKING CAPITAL MANAGEMENT
The objective of working capital management is to maintain the optimum balance of each of the
working capital components. This includes making sure that funds are held as cash in bank deposits
for as long as and in the largest amounts possible, thereby maximising the interest earned.
However, such cash may more appropriately be "invested" in other assets or in reducing other
liabilities.
Working capital management takes place on two levels:
 Ratio analysis can be used to monitor overall trends in working capital and to identify areas
requiring closer management.
 The individual components of working capital can be effectively managed by using various
techniques and strategies.
When considering these techniques and strategies, there is need to recognise that each company has
a unique mix of working capital components. The emphasis that needs to be placed on each
component varies according to the company in question. For example, some companies have
significant inventory levels; others have little if any inventory.
Furthermore, working capital management is not an end in itself. It is an integral part of the
organisational overall management. The needs of efficient working capital management must be
considered in relation to other aspects of the company's financial and non-financial performance.
Financial ratio analysis calculates and compares various ratios of amounts and balances taken from
the financial statements.
The main purposes of working capital ratio analysis are:
 to indicate working capital management performance; and

 to assist in identifying areas requiring closer management.
Three key points need to be taken into account when analyzing financial ratios:
 The results are based on highly summarised information. Consequently, situations which
require control might not be apparent, or situations which do not warrant significant effort
might be unnecessarily highlighted;
 Different departments face very different situations. Comparisons between them, or with
global "ideal" ratio values, can be misleading;
 Ratio analysis is somewhat one-sided; favourable results mean little, whereas unfavourable
results are usually significant.
However, financial ratio analysis is valuable because it raises questions and indicates directions for
more detailed investigation.
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The following ratios are of interest to those managing working capital:
 working capital ratio;

 liquid interval measure;
 stock turnover;
 debtors ratio;
 creditors ratio.
WORKING CAPITAL RATIO
Current Assets divided by Current Liabilities
The working capital ratio (or current ratio) attempts to measure the level of liquidity, that is, the
level of safety provided by the excess of current assets over current liabilities.
The "quick ratio" a derivative, excludes inventories from the current assets, considering only those
assets most swiftly realisable. There are also other possible refinements.
There is no particular benchmark value or range that can be recommended as suitable for all
government departments. However, if a department tracks its own working capital ratio over a
period of time, the trends-the way in which the liquidity is changing-will become apparent.
LIQUID INTERVAL MEASURE
Liquid Assets divided by Average Operating Expenses
This is another measure of liquidity. It looks at the number of days that liquid assets (for example,
inventory) could service daily operating expenses (including salaries).
STOCK TURNOVER
Cost of Sales divided by Average Stock Level
This ratio applies only to finished goods. It indicates the speed with which inventory is sold-or, to
look at it from the other angle, how long inventory items remain on the shelves. It can be used for
the inventory balance as a whole, for classes of inventory, or for individual inventory items.
The figure produced by the stock turnover ratio is not important in itself, but the trend over time is
a good indicator of the validity of changes in inventory policies.
In general, a higher turnover ratio indicates that a lower level of investment is required to serve the
business.
Most organisations do not hold significant inventories of finished goods, so this ratio will have only
limited relevance.
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DEBTOR RATIO
There is a close relationship between debtors and credit sales to third parties. If sales increase,
debtors will increase, and conversely, if sales decrease debtors will decrease.
The best way to explain this relationship is to express it as the number of days that credit sales are
carried on the books:
Credit Sales per period/Average Debtors x No of days per period
Where trading terms are 30 days net cash, and customers buy from day-to-day during the 30 day
period and pay 30 days after a statement is rendered, a collection period of 45 days (the average
between 30 and 60 days) would be satisfactory.
If the average collection period extends beyond 60 days, debtors are holding cash that should have
flowed into the business. This means that the company is unable to satisfy pressing liabilities or to
invest that cash.
The debtor ratio does not solve the collection problem, but it acts as an indicator that an adverse
trend is developing. Remedial action can then be instigated.
CREDITOR RATIO
This ratio is much the same as the debtor ratio. It expresses the relationship between credit
purchases and the liability to creditors. It can be stated as the number of days that credit purchases
are carried on the books.
Credit Purchases per period/Average Creditors x No of days per period
Note that non-credit purchases (such as salaries) and non-cash expenses (such as depreciation) need
to be excluded from "credit purchases" and any provisions need to be excluded from "creditors".
There is no need to pay creditors before payment is due. The Company's objective should be to
make effective use of this source of free credit, while maintaining a good relationship with
creditors.
As with debtors, if a company has been granted credit terms of 30 days net cash, credit purchases
should not be carried on the books for more than an average of 45 days. If payment is withheld for
60 days or more it is likely that creditors will become impatient and impose stricter and less
convenient trading terms-for example, "cash on delivery".
INVENTORIES
Inventories are lists of stocks-raw materials, work in progress or finished goods-waiting to be

consumed in production or to be sold.
The total balance of inventory is the sum of the value of each individual stock line. Stock records
are needed:
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 to provide an account of activity within each stock line;
 as evidence to support the balances used in financial reports.
A Company also needs a system of internal controls to efficiently manage stocks and to ensure that
stock records provide reliable information.
Business financial reports show only the total inventory balance. Analysts from outside the
company can examine this balance by using ratio analysis or other techniques. However, this gives
only a limited assessment of inventory management and is not adequate for internal management.
Good financial management necessitates the careful analysis of individual inventory lines.
Inventory management is an important aspect of working capital management because inventories

themselves do not earn any revenue. Holding either too little or too much inventory incurs costs as
discussed in the earlier chapter.
Carrying costs can be minimised by making frequent small orders but this increases ordering costs
and the risk of stock-outs. Risk of stock-outs can be reduced by carrying "safety stocks" (at a cost)
and re-ordering ahead of time.
The best ordering strategy requires balancing the various cost factors to ensure the business incurs
minimum inventory costs. The optimum inventory position is known as the Economic Order
Quantity (EOQ). There are a number of mathematical models (of varying complexity) for
calculating EOQ. (this already dealt with in the early chapter).
Analytical review of inventories can help to identify areas where inventory management can be
improved. Slow moving items, continual stockouts, obsolescence, stock reconciliation problems
and excess spoilage are signals that stock lines need closer analysis and control.
However, it is important to keep an overall perspective. It is not cost-effective to closely manage a

large number of low value inventory lines, nor is it necessary. A usual feature of inventories is that
a small number of high value lines account for a large proportion of inventory value. The "80/20"
rule (PARETO) predicts that 80% of the total value of inventory is represented by only 20% of the
number of inventory items. Those high value lines need reasonably close management. The
remaining 80% of inventory lines can be managed using "broad-brush" strategies.
The overall management philosophy of an organisation can affect the way in which inventory is
managed. For example, "Just In Time" (JIT) production management organises production so that
finished goods are not produced until the customer needs them (minimising finished goods carrying
costs), and raw materials are not accepted from suppliers until they are needed. (Large
organisations have the power to insist that suppliers hold stocks of raw materials and thereby pass
the carrying cost back to the supplier). Thus, JIT inventory strategies reduce bottlenecks and stock
holding costs.
In summary:
 There is a trade-off to be made between carrying costs, ordering costs, and stockout costs.
This is represented in the Economic Order Quantity (EOQ) model.
 Inventories should be managed on a line-by-line basis using the 80/20 rule.
 Analytical review can help to focus attention on critical areas.
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 Inventory management is part of the overall management strategy.
DEBTORS
Debtors (Accounts Receivable) are customers who have not yet made payment for goods or
services which that a company has provided.
The objective of debtor management is to minimise the time-lapse between completion of sales and
receipt of payment. The costs of having debtors are:
 opportunity costs (cash is not available for other purposes);

 bad debts.
Debtor management includes both pre-sale and debt collection strategies.
Pre-sale strategies include:
 offering cash discounts for early payment and/or imposing penalties for late payment;
 agreeing payment terms in advance;
 requiring cash before delivery;
 setting credit limits;
 setting criteria for obtaining credit;
 billing as early as possible;
 requiring deposits and/or progress payments.
Post-sale strategies include:
 Placing the responsibility for collecting the debt upon the center that made the sale;
 Identifying long overdue balances and doubtful debts by regular analytical reviews;
 Having an established procedure for late collections, such as, a reminder, a letter,
cancellation of further credit, use of a collection agency and or legal action.
CREDITORS
Creditors (Accounts Payable) are suppliers whose invoices for goods or services have been
processed but who have not yet been paid.
Organisations often regard the amount owing to creditors as a source of free credit. However,
creditor administration systems are expensive and time-consuming to run. The over-riding concern
in this area should be to minimise costs with simple procedures.
While it is unnecessary to pay accounts before they fall due, it is usually not worthwhile to delay all
payments until the latest possible date., Regular weekly or fortnightly payment of all due accounts
is the simplest technique for creditor management.
Electronic payments (direct credits) are cheaper than cheque payments, considering that transaction
fees and overheads more than balance the advantage of delayed presentation. Some suppliers are
reluctant to receive payments by this method, but in view of the substantial cost advantage (and the
advantages to the suppliers themselves) company may wish to encourage suppliers to accept this
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option. However, electronic payments are likely to be used in conjunction with, rather than as a
replacement for, cheque payments.
CASH AND BANK
Good cash management can have a major impact on overall working capital management.
The key elements of cash management are:
 cash forecasting;
 balance management;
 administration;
 internal control.
Cash Forecasting. Good cash management requires regular forecasts. In order for these to be
materially accurate, they must be based on information provided by those managers responsible for
the amounts and timing of expenditure. Capital expenditure and operating expenditure must be
taken into account. It is also necessary to collect information about impending cash transactions
from other financial systems, such as creditors and payroll.
Balance Management. Those responsible for balance management must make decisions about
how much cash should at any time be on call in the Company Bank Account and how much should
be on term deposit at the various terms available.
There are various types of mathematical model that can be used. One type is analogous to the EOQ
inventory model. Linear programming models have been developed for cash management, subject
to certain constraints. There are also more sophisticated techniques.
Administration. Cash receipts should be processed and banked as quickly as possible because:
 They cannot earn interest or reduce overdraft until they are banked;
 Information about the existence and amounts of cash receipts is usually not available until
they are processed.
Where possible, cash floats (mainly petty cash and advances) should be avoided. If, on review, the
only reason that can be put forward for their existence is that "we've always had them", they should
be discontinued. There may be situations where they are useful, however. For example, it may be
desirable for peripheral parts of company to meet urgent local needs from cash floats rather than
local bank accounts.
Internal Control. Cash and cash management is part of an organisation's overall internal control
system. The main internal cash control is invariably the bank reconciliation. This provides
assurance that the cash balances recorded in the accounting systems are consistent with the actual
bank balances. It requires regular clearing of reconciling items.
OTHER COMPONENTS
Working capital, defined as the difference between current assets and current liabilities, may also
include the following factors:
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 prepayments to creditors;
 current portions of long-term liabilities;
 revenue received before it has been earned;
 provisions.
However, decisions on working capital management usually exclude these factors, so they have not
been included in this consideration.
WORKING CAPITAL CYCLE/CASH OPERATING CYCLE
A working capital or cash operating cycle is the total length of time required to complete the
following sequence of events:-
 Conversion of cash into raw material

 Conversion of raw material into work-in-progress
 Conversion of work-in-progress into finished goods
 Conversion of finished goods into debtors through sales, and
 Conversion of debtors into cash.
Hence, the working capital cycle is the total length of time between investing cash in payment for raw
materials at the start of the production process and its recovery at the end in the collection of cash from
debtors. This can be estimated as follows:-
 Number of days raw materials is held = RM Stock/RM Purchases x 365 days
 Number of days credit is given by creditors = Trade Creditors/Credit Purchases x 365 days
 Number of days work-in-progress is held = WIP Stock/Cost of sales x 365 days
 Number of days finished goods is held = FG Stock/Cost of Sales x 365 days
 Number of days for Trade Debtor = Trade Debtors/Credit Sales x 365 days
The above assumed 365 days in a year which is not always constant? Any number of days can be given
and such must be applied in the calculation. It is equally pertinent to note that the cycle can be calculated
in months or weeks depending on the requirement.
At times the working capital cycle may be given, with the need to ascertain the working capital
requirement with some other variable stated, the reverse of above equation should be used in such
situation to determine such working capital requirement.
NEEDS FOR WORKING CAPITAL CYCLE
1. It gives an insight into the amount of cash investment required to finance working capital, the
larger the working capital cycle, the higher the investment in working capital.
2. It serves as an improvement on working capital ratios for control purposes
3. It provides a series of ways that can be used for budgeting or forecasting to translate sales and
costs budget into budgets of working capital values.
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4. The comparison of company’s working capital cycle with that of previous periods and with that
of other companies in the same industry may reveal areas where liquidity can be improved upon.
SOURCES OF ADDITIONAL WORKING CAPITAL
Sources of additional working capital include the following:
 Existing cash reserves

 Profits (when you secure it as cash!)
 Payables (credit from suppliers)
 New equity or loans from shareholders
 Bank overdrafts or lines of credit
 Long-term loans
If you have insufficient working capital and try to increase sales, you can easily over-stretch the
financial resources of the business. This is called overtrading. Early warning signs include:
 Pressure on existing cash

 Exceptional cash generating activities e.g. offering high discounts for early cash payment
 Bank overdraft exceeds authorized limit
 Seeking greater overdrafts or lines of credit
 Part-paying suppliers or other creditors
 Paying bills in cash to secure additional supplies
 Management pre-occupation with surviving rather than managing
 Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of
a cheque).
HANDLING RECEIVABLES (DEBTORS)
Cashflow can be significantly enhanced if the amounts owing to a business are collected faster.
Every business needs to know.... who owes them money.... how much is owed.... how long it is
owing.... for what it is owed.
Slow payment has a crippling effect on business; in particular on small businesses who can least
afford it. If you do not manage debtors, they will begin to manage your business as you will
gradually lose control due to reduced cashflow and, of course, you could experience an increased
incidence of bad debt. The following measures will help manage your debtors:
1. Have the right mental attitude to the control of credit and make sure that it gets the priority
it deserves.
2. Establish clear credit practices as a matter of company policy.
3. Make sure that these practices are clearly understood by staff, suppliers and customers.
4. Be professional when accepting new accounts, and especially larger ones.
5. Check out each customer thoroughly before you offer credit. Use credit agencies, bank
references, industry sources etc.
6. Establish credit limits for each customer... and stick to them.
7. Continuously review these limits when you suspect tough times are coming or if operating
in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
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10. Consider charging penalties on overdue accounts.
11. Consider accepting credit /debit cards as a payment option.
12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or
too old.
Recognize that the longer someone owes you, the greater the chance you will never get paid. If the
average age of your debtors is getting longer, or is already very long, you may need to look for the
following possible defects:
 weak credit judgments

 poor collection procedures
 lax enforcement of credit terms
 slow issue of invoices or statements
 errors in invoices or statements
 customer dissatisfaction.
Debtors due over 90 days (unless within agreed credit terms) should generally demand immediate
attention. Look for the warning signs of a future bad debt. For example.........
 longer credit terms taken with approval, particularly for smaller orders
 use of post-dated checks by debtors who normally settle within agreed terms
 evidence of customers switching to additional suppliers for the same goods
 new customers who are reluctant to give credit references
receiving part payments from debtors. The act of collecting money is one which most people
dislike for many reasons and therefore put on the long finger because they convince themselves
there is something more urgent or important that demands their attention now. There is nothing
more important than getting paid for your product or service. A customer who does not pay is not a
customer. Here are a few ideas that may help you in collecting money from debtors:
 Develop appropriate procedures for handling late payments.

 Track and pursue late payers.
 Get external help if your own efforts fail.
 Don't feel guilty asking for money.... its yours and you are entitled to it.
 Make that call now. And keep asking until you get some satisfaction.
 In difficult circumstances, take what you can now and agree terms for the remainder. It
lessens the problem.
 When asking for your money, be hard on the issue - but soft on the person. Don't give the
debtor any excuses for not paying.
 Make it your objective is to get the money - not to score points or get even.
MANAGING PAYABLES (CREDTORS)
Creditors are a vital part of effective cash management and should be managed carefully to enhance
the cash position.
Purchasing initiates cash outflows and an over-zealous purchasing function can create liquidity
problems. Consider the following:
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 Who authorizes purchasing in your company - is it tightly managed or spread among a
number of (junior) people?
 Are purchase quantities geared to demand forecasts?
 Do you use order quantities which take account of stock-holding and purchasing costs?
 Do you know the cost to the company of carrying stock?
 Do you have alternative sources of supply? If not, get quotes from major suppliers and
shop around for the best discounts, credit terms, and reduce dependence on a single
supplier.
 How many of your suppliers have a returns policy?
 Are you in a position to pass on cost increases quickly through price increases to your
customers?
 If a supplier of goods or services lets you down can you charge back the cost of the delay?
 Can you arrange (with confidence!) to have delivery of supplies staggered or on a just-in-
time basis?
There is an old adage in business that if you can buy well then you can sell well. Management of
your creditors and suppliers is just as important as the management of your debtors. It is important
to look after your creditors - slow payment by you may create ill-feeling and can signal that your
company is inefficient (or in trouble!).
Remember, a good supplier is someone who will work with you to enhance the future viability and
profitability of your company.
MANAGING INVENTORY
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash
resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.
The key is to know how quickly your overall stock is moving or, put another way, how long each
item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be
influenced by the nature of the business. For example, a fresh vegetable shop might turn over its
entire stock every few days while a motor factor would be much slower as it may carry a wide
range of rarely-used spare parts in case somebody needs them.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the
components to be assembled on a particular today, arrive at the factory early that morning, no
earlier - no later. This helps to minimize manufacturing costs as JIT stocks take up little space,
minimize stock-holding and virtually eliminate the risks of obsolete or damaged stock. Because JIT
manufacturers hold stock for a very short time, they are able to conserve substantial cash. JIT is a
good model to strive for as it embraces all the principles of prudent stock management.
The key issue for a business is to identify the fast and slow stock movers with the objectives of
establishing optimum stock levels for each category and, thereby, minimize the cash tied up in
stocks. Factors to be considered when determining optimum stock levels include:
 What are the projected sales of each product?

 How widely available are raw materials, components etc.?
 How long does it take for delivery by suppliers?
 Can you remove slow movers from your product range without compromising best sellers?
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Remember that stock sitting on shelves for long periods of time ties up money which is not
working for you. For better stock control, try the following:
 Review the effectiveness of existing purchasing and inventory systems.

 Know the stock turn for all major items of inventory.
 Apply tight controls to the significant few items and simplify controls for the trivial many.
 Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you
keep it.
 Consider having part of your product outsourced to another manufacturer rather than make
it yourself.
 Review your security procedures to ensure that no stock "is going out the back door!"
Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs
and interest charges.
ILLUSTRATION QUESTIONS
1. The following data relates to Ideal Company Limited manufacturing company.

Turnover for the year N1,500,000
Cost of Sales (%)
Direct Material 30
Direct Labour 25
Variable Overhead 10
Fixed Overhead 15
Selling and Distribution 5
On average:
a. Debtors take 21/2 months before payment.
b. Raw Materials are in Stock for 3 months
c. Work in progress represents 2 months half produced goods.
d. Finished goods represent 1 month productions.
e. Credit is taken as follows:
i. Direct materials 2 months.
ii. Direct labour 1 week
iii. Variable overheads 1 month
iv. Fixed overhead 1 month
v. Selling and distribution ½ month.
Work-in-progress and finished goods are valued at material, labour and variable expenses cost.
Compute the working capital requirements of Ideal Limited, assuming the labour force is paid for
50 working weeks.
Note that, number of days materials will be held in store can be derived by Raw Material in
store/Raw Material purchased x 365.
2. From the following information taken from the budget of APL Limited. Prepare a statement
showing the average amount of working capital required by the company. Annual sales are
estimated at 100,000 units at N1 per unit. Productive quantity coincides with sales and will be
carried on evenly throughout the year. The production cost is:
Materials N0.50 per unit
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Labour N0.20 per unit
Expenses N0.175 per unit
Customers are given 60 days credit and 50 days credit is taken from Suppliers. 40 days supply of
raw materials and 15 days supply of finished goods are kept. The production cycle is 20 days and
all materials are used at the commencement of this productive cycle. A cash balance equivalent of
20% of the average of other working capital requirement is kept for contingency.
3. ABC PLC has the following budget for the first half of the current year:
N’000 N’000
Sales (80% on credit) 6,000
Direct material 1,800
Direct labour 1,440
Production Overheads 1,350
Non-production overheads 450
5,040 5,040
Net Profit 960
You are provided with the following additional information.
a. 5% cash discount is given for payment within 15 days and 255 of credit Customers take
advantage of the cash discount. The remaining credit customer pays after 60 days.
b. Direct material is purchased net 45 days, stock of raw material sufficient for 45 days are held.
c. Labour and production overheads are pay two weeks in arrears
d. Non production overhead is pays 30 days in arrears.
e. The production cycle is 60 days.
f. Stock of finished goods and warehouse 48 days.
g. The company finances its working capital with an overdraft facilities given by a Commercial
Bank at an annual interest rate of 14%, last year the company pays total interest of N168,000 and
the facility was fully drawn down from the beginning of the year.
h. Assume 4 weeks in a month and 360 days in a year.
Required
a. Estimate the working capital requirement of the company.

b. Comment on any possible problems emanating from your calculation in “a” above and any
relevant information in the question. Itemise possible solution to the problem identified.
SUGGESTED SOLUTION
Q1. IDEAL COMPANY LIMITED
The working capital requirement

N N
Value of Raw Material = (3/12 x N450,000) 112,500
Work in Progress:
Material (100% completed) (2/12 x N450,000 75,000
Labour (50% completed) (2/12 x 375,000 x 1/2) 31,250
Variable O/D (50% completed) (2/12 x 75,000 x 1/2) 12,500 118,750
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Finished Goods:
Material (1/12 x N450,000) 37,500
Labour (1/12 x N375,000) 31,250
Variable Cost (1/12 x 150,000) 12,500 81,250
Debtors - (assume that all sales are on credit)
(2.5/12 x N1,500,000) 312,500
Total Current Assets 625,000
Less Current Liabilities- (at Average)
Material (2/12 x N450,000) 75,000
Labour (1/50 x N375,000) 7,500
Variable Overhead (1/12 x N150,000) 12,500
Fixed Overhead (1/12 x N225,000) 18,750
Selling & Admin O/H (1/24 x N75,000) 3,125 (116,875)
Working Capital Requirement 508,125
Calculation of the cost to be incurred.

Direct Materials 30% x N1,500,000 = 450,000
Direct Labour 25% x N1,500,000 = 375,000
Variable Overhead 10% x N1,500,000 = 150,000
Fixed Overhead 15% x N1,500,000 = 75,000
Q2 APL LIMITED
The working capital requirement.
N N
Value of Raw Material = (100,000 x N0.50) x (40/365) 5,479
Work in Progress:
Material (100,000 x N0.50) x (20/365) 2,740
Labour (1/2 x 100,000 x N0.20) x (20/365) 548
Expenses (1/2 x 100,000 x N0.125) x (20/365) 479 3,767
Finished Goods:
(N0.875 x 100,000 x 15/365) 3,596
Debtors - (assume that all sales are on credit)
(N100,000 x 60/365) 16,438
Total Current Assets 29,280
Less Creditors (100,000 x N0.50 x 50/365) (6,849)
Other Working Capital Requirement 22,431
Cash Retention (20% x N22,431) 4,486
Working Capital Requirement 26,917
Half of the conversion cost is assumed for work in progress
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Q3. ABC
a. The Working Capital Requirement of the Company.
N'000 N'000
Value of Raw Material = (N1,800 x 45/360) x 2 450.0
Work in Progress:
Material (N1,800 x 60/360) x 2 600
Labour (1/2 x N1,440 x 60/360) x 2 240
Production Overhead (1/2 x N1,350 x 60/360) x 2 225 1,065.0
Finished Goods:
(N1,800 + N1,440 + N1,350) x 48/360 x 2 1,224.0
Debtors:
With Discount (0.25 x 0.80 x 15/360 x 6,000 x 2) 100
Without Discount (0.75 x 0.80 x 60/360 x 6,000 x 2) 1,200 1,300.0
Total Current Assets 4,039.0
Less Current Liabilities
Creditors of RM (1,800 x 45/360 x 2) 450.0
Labour (1,440 x 15/360 x 2) 120.0
Production Overhead (N1,350 x 15/360 x 2) 112.5
Non-Production Overhead (N450 x 30/360 x 2) 75.0 (757.5)
Working Capital Requirement 3,281.5
b. The overdraft facility available is N1.2 million (N168,000/0.14), whereas the capital requirement
is about N3.2815 million. It then follows that the existing facility is not sufficient to finance
working capital. Possible options available are:
1. Ask for additional facilities from the existing Bank if possible.

2. If terms of the existing facility permit, seek addition facilities from other bank.
3. Exploit the possibility of additional permanent capital in form of equity and other long
term capital.
4. Exploit the use of other sources e.g. factoring, banker acceptance, commercial paper etc.
5. Take step to reduce investment in working capital.
1. Toni is the credit manager of Beverage Plc. He is concerned that the pattern of monthly cash
receipts from credit sales shows that credit collection is poor compared with budget. Beverage’s
sales director believes that Toni is to blame for this situation, but Toni insists that he is not. Why
might Toni not be to blame for the deterioration in the credit collection period?
2. How might each of the following affect the level of inventories by the business?
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a. An increase in the number of production bottlenecks by the business.
b. A rise in the level of interest rates.
c. A decision to offer customers a narrower range of products in the future.
d. A switch of suppliers from an overseas business to a local business.
e. Deterioration in the quality and reliability of bought-in components.
3. What are the reasons for holding inventories? Are these reasons different from the reasons for
holding cash?
4. Identify the costs of holding:

a. Too little cash;
b. Too much cash;
5. Deolu Wholesalers Ltd has been particularly concerned with its liquidity position in recent
months. The most recent income statement and statement of financial position (balance sheet) of
the business are as follows:
Income statement for the year ended 31 December last year
N’000 N’000
Sales revenue 452
Cost of sales
Opening inventories 125
Purchases 341
466
Closing inventories (143) (323)
Gross profit 129
Expenses (132)
Loss for the year (3)
Statement of financial position as at 31 December last year

N’000
Non-current assets
Property, plant and equipment
Premises at valuation 280
Fixtures and fittings at cost less depreciation 25
Motor vehicles at cost less depreciation 52
357
Current assets
Inventories 143
Trade receivables 163
306
Total assets 663
Equity
Ordinary share capital 100
Retained earnings 158
258
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Non-current liabilities
Borrowings – Loans 120
Current liabilities
Trade payables 145
Borrowings – Bank overdraft 140
285
Total equity and liabilities 663
The trade receivables were maintained at a constant level throughout the year.
Required:
a. Explain why Deolu Wholesalers Ltd is concerned about its liquidity position.
b. Calculate the operating cash cycle for Deolu Wholesalers Ltd based on the information
above. (Assume a 360-day year.)
c. State what steps may be taken to improve the operating cash cycle of the business.
6. Mayo Computer Ltd has annual sales of N20 million. Bad debts amount to N0.1 million a year.
All sales made by the business are on credit and, at present, credit terms are negotiable by the
customer. On average, the settlement period for trade receivables is 60 days. Trade receivables
are financed by an overdraft bearing a 14 per cent rate of interest per year. The business is
currently reviewing its credit policies to see whether more efficient and profitable methods could
be employed. Only one proposal has so far been put forward concerning the management of trade
credit.
The credit control department has proposed that customers should be given a 2.5 per cent
discount if they pay within 30 days. For those who do not pay within this period, a maximum of
50 days’ credit should be given. The credit department believes that 60 per cent of customers will
take advantage of the discount by paying at the end of the discount period. The remainder will
pay at the end of 50 days. The credit department believes that bad debts can be effectively
eliminated by adopting the above policies and by employing stricter credit investigation
procedures. Which will cost an additional N20,000 a year. The credit department is confident that
these new policies will not result in any reduction in sales revenue.
Required:
Calculate the net annual cost (savings0 to the business of abandoning its existing credit policies
and adopting the proposals of the credit control department. (Hint: To answer this question you
must weigh the costs of administration and cash discounts against the savings in bad debts and
interest charges.)
7. Boswell Enterprises Ltd is reviewing its trade credit policy. The business, which sells all of its
goods on credit, has estimated that sales revenue for the forthcoming year will be N3 million
under the existing policy. Credit customers representing 30 per cent of trade receivables are
expected to pay one month after being invoiced and 70 per cent are expected to pay two months
after being invoiced. These estimates are in line with previous years’ figures.
At present, no cash discounts are offered to customers. However, to encourage prompt payment,
the business is considering giving a 2.5 per cent cash discount to credit customers who pay in one
month or less. Given this incentive, the business expects credit customers accounting for 60 per
cent of trade receivables to pay one month after being invoiced and those accounting for 40 per
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cent of trade receivables to pay two months after being invoiced. The business believes that the
introduction of a cash discount policy will prove attractive to some customers and will lead to a 5
per cent increase in total sales revenue.
Irrespective of the trade credit policy adopted, the gross profit margin of the business will be 20
per cent for the forthcoming year and three months’ inventories will be held. Fixed monthly
expenses of N15,000 and variable expenses (excluding discounts) equivalent to 10 per cent of
sales revenue will be incurred and will be paid one month in arrears. Trade payables will be paid
in arrears and will be equal to two month’s cost of sales. The business will hold a fixed cash
balance of N140,000 throughout the year, whichever trade credit policy is adopted. Ignore
taxation.
Required:
a. Calculate the investment in working capital at the end of the forthcoming year under:
i. The existing policy;
ii. The proposed policy.
b. Calculate the expected profit for the forthcoming year under:
i. The existing policy;
ii. The proposed policy.
c. Advise the business as to whether it should implement the proposed policy. (Hint: The
investment in working capital will be made up of inventories, trade receivables and cash, less
trade payables and any unpaid expenses at the yearend.)
SUGGESTED SOLUTION
1. Although the credit manager is responsible for ensuring that receivables pay on time, Toni may
be right in denying blame. Various factors may be responsible for the situation described which
are beyond the control of the credit manager. These include:
 a downturn in the economy leading to financial difficulties among trade receivables;
 decisions by other managers within the business to liberalise credit policy in order to
stimulate sales;
 an increase in competition among suppliers offering credit, which is being exploited by
customers;
 disputes with customers over the quality of goods or services supplied;
 problems in the delivery of goods leading to delays. Etc.
2. The level of inventories held will be affected in the following ways.

a. An increase in production bottlenecks is likely to result in an increase in raw materials and
work in progress being processed within the plant. Therefore, levels of inventories should
rise.
b. A rise in interest rates will make holding inventories more expensive if they are financed by
debt. This may, in turn, lead to a decision to reduce inventory levels.
c. The decision to reduce the range of products should result in fewer inventories being held. It
would no longer be necessary to hold certain items in order to meet customer demand.
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d. Switching to a local supplier may reduce the lead time between ordering an item and
receiving it. This should, in turn, reduce the need to carry such high levels of the particular
item.
e. Deterioration in the quality of bought-in items may result in the purchase of higher quantities
of inventories in order to take account of the defective element in inventories acquired and,
perhaps, an increase in the inspection time for items received. This would lead to a rise in
inventory levels.
3. Inventories are held:

 to meet customer demand,
 to avoid the problems of running out of inventories, and
 to take advantage of profitable opportunities (for example, buying a product that is expected
to rise steeply in price in the future).
The first reason may be described as transactionary, the second precautionary and the third
speculative. They are, in essence, the same reasons why a business holds cash.
4. a. The costs of holding too little cash are:
 failure to meet obligations when they fall due which can damage the reputation of the
business and may, in the extreme, lead to the business being wound up;
 having to borrow and thereby incur interest charges;
 an inability to take advantage of profitable opportunities.
b. The costs of holding too much cash are:
 failure to use the funds available for more profitable purposes;
 loss of value during a period of inflation.
5. Deolu Wholesalers Ltd

a. The business is probably concerned about its liquidity position because:
 It has a substantial overdraft, which together with its non-current borrowings means that
it has borrowed an amount roughly equal to its equity (according to values in the
statement of financial position);
 It has increased its investment in inventories during the past year (as shown by the
income statement); and
 It has a low current ratio (ratio of current assets to current liabilities).
b. The operating cash cycle can be calculated as follows:

Number of days
Average inventories holding period = ((125 + 143/2)/323) x 360 = 149
Add Average settlement period for receivables (163/452) x 360 = 130
279
Less Average settlement period for payables: (145/341) x 360 = 153
Operating cash cycle 126
c. The business can reduce the operating cash cycle in a number of ways. The average
inventories holding period seems quite long. At present, average inventories held represent
almost five months’ sales. Reducing the level of inventories held can reduce this period.
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Similarly, the average settlement period for receivables seems long at more than four months’
sales revenue. Imposing tighter credit control, offering discounts, charging interest on
overdue accounts, and so on, may reduce this. However, any policy decisions concerning
inventories and receivables must take account of current trading conditions. Extending the
period of credit taken to pay suppliers would also reduce the operating cash cycle. However,
for the reasons mentioned in the chapter, this option must be considered carefully.
6. Mayo Computers Ltd

- New proposals from credit control department reduction in investment
N’000 N’000
Current level of investment in receivables (N20M x (60/365)) = 3,288
Proposed level of investment in receivables
((N20M x 60%) x (30/365)) 986
((N20M x 40%) x (50/365)) 1,096 (2,082)
Reduction in level of investment 1,206
The reduction in overdraft interest as a result of the reduction in the level of investment will
be N1,206,000 x 14% = N169,000.
- Net cost of the policy
N’000 N’000
Cost of cash discounts offered (N20M x 60% x 2.5%) 300
Additional cost of credit administration 20
320
Bad debt savings 100
Interest charge savings (see above) 169 (269)
Net cost of policy each year 51
These calculations show that the business would incur additional annual costs if it implemented
this proposal. It would therefore be cheaper to stay with the existing credit policy.
7. Boswell Enterprises Ltd

a. Investment in working capital
i.Current policy ii. New policy
N’000 N’000 N’000 N’000
Receivables
((N3M x 1/12 x 30%) + (N3M x 2/12 x 70%)) 425.0
((N3.15M x 1/12 x 60%) + (N3.15M x 2/12 x 40%)) 367.5
Inventories
((N3M – (N3M x 20%)) x 3/12) 600.0
((N3.15M – (N3.15M x 20%)) x 3/12) 630.0
Cash (fixed) 140.0 140.0
1,165.0 1,137.5
Payables
((N3M – (N3M x 20%)) x 2/12) 400.0
((N3.15M – (N3.15M x 20%)) x 2/12) 420.0
Accrued variable expenses
(N3M x 1/12 x 10%) 25.0
(N3.15M x 1/12 x 10%) 26.3
Accrued fixed expenses 15.0 (440.0) 15.0 (461.3)
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Investment in working capital 725.0 676.2
b. The expected profit for the year.
i. Current policy ii. New policy

N’000 N’000 N’000 N’000
Sales revenue 3,000.0 3,150.0
Cost of goods sold (2,400.0) (2,520.0)
Gross profit (20%) 600.0 630.0
Variable expenses (10%) 300.0 315.0
Fixed expenses 180.0 180.0
Discounts (N3.15M x 60% x 2.5%) - (480.0) 47.3 (542.3)
Profit for the year 120.0 87.7
c. Under the proposed policy we can see that the investment in working capital will be slightly
lower than under the current policy. However, profits will be substantially lower as a result of
offering discounts. The increase in sales revenue resulting from the discounts will not be
sufficient to offset the additional costs of making the discounts to customers. It seems that the
business should, therefore, stick with its current policy.
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CHAPTER 17
REVISION OBJECTIVES AND SHORT ANSWER QUESTIONS
1 INTRODUCTION TO MANAGEMENT ACCOUNTING
1. Information for decision making:

a. concerns the alternatives possible
b. deals with the future, not the past
c. is concerned with incremental costs and revenues
d. is all of the above
2. Double loop feedback:

a. is information designed to ensure that operations conform to plans
b. is designed to assess how well the control system operates and how relevant current plans
are.
c. Is information passed up two layers of the organization
d. Is information that is double checked for accuracy.
3. Management accounting is mainly concerned with providing information to:

a. Government agencies such as the Inland Revenue
b. Shareholders.
c. Managers within the firm.
d. Trade Unions on behalf of the workers.
4. The main objectives of management accounting information is

a. provide stewardship accounting
b. to plan, take decision and control organisation’s activities
c. to present monthly or yearly management accounts
d. to provide management with information useful for planning, controlling and decision
making.
5. The aims of Financial Accounting information is to provide information to all of the following
except:
a. creditors, banks and other financial institutions
b. government and its agencies
c. owners of the business
d. only management of the firm
6. The planning process includes:

a. setting objectives
b. identifying means of achieving the objectives
c. making decision before taking action
d. all of the above
7. The job of a management accountant is specifically required in:

a. Manufacturing companies
b. Service industries
c. Non-profit making organisations
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d. all of the above
8. One of the major characteristic of a good information is that the information must be:
a. prepared daily
b. prepared monthly
c. prepared quarterly
d. timely
9. Investigating production variances and adjusting the production process is an example of:
a. Decision making process
b. Planning organisation activities
c. Controlling
d. None of the above
10. Management Accounting is often refers to as:

a. Account of management
b. Account to management
c. Internal accounting
11. To be a management accountant, there is need for in-depth knowledge of one of the following:
a. cost accounting
b. financial accounting
c. cost management
d. all of the above
12. Setting the price your company’s product should sell for is an example of:
a. planning
b. controlling
c. decision making
d. none of the above
13. The word cost and management accounting are often use interchangeable because
a. cost accounting provide data for management accounting information.
b. To be a management accountant you must have in-depth understanding of cost
accounting
c. Cost accounting deals with documentation of the historical costs, which will be used
for management accounting information
d. All of the above
14. The need for management accountant is increasing daily because of the following
a. increased competitive pressures on business
b. inability of financial accountant to render useful information.
c. Increased managerial accountability
d. “a” to “c” above
e. “a” and “c” above
15. Management Accounting information is said to be futuristic and predictive because:

a. it uses future data
b. all the functions of management are futuristic bias
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c. it is expected to predict the future
d. all of the above
e. none of the above
16. Managerial accounting activity adds value to an organization by pursuing five major objectives
which include:
a. providing information for decision making and planning
b. assisting managers in directing and controlling operational activities
c. measuring the performance of activities within an organization
d. providing information for external users of financial reports
e. a, b and c
17. Which of the following might be a performance measure for the financial perspective of a
balanced scorecard?
a. percentage of market share held by the organization
b. return on assets
c. percentage of on-time deliveries by the organization
d. percentage of product defects
e. average time to learn new processes
18. The initiative to reduce non-value added activity is meeting which balanced scorecard
objective?
a. Financial perspective
b. Customer perspective
c. Internal operations perspective
d. Learning and growth perspective
e. a and b
19. Which of the following is not true?

a. Management accounting need not conform to GAAP
b. Financial accounting reports focus on subunits of the organization
c. Management accounting is required
d. Financial accounting is required
e. Management accounting focuses on the needs of internal users
20. Which of the following is not true?

a. Management accounting requires a separate accounting system
b. Financial accounting must conform to GAAP
c. Financial accounting reports are drawn from the basic accounting system.
d. Management accounting often focuses on subunits of the organization
e. Management accounting is not regulated.
21. Which of the following positions is most likely a staff position?

a. Production manager
b. Marketing manager
c. Treasurer
d. Chief Financial Officer (CFO)
e. c and d
22. Which management position is responsible for raising capital?
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a. Internal auditor
b. Treasurer
c. Controller
d. Chief Financial Officer
e. External auditor
23. Which of the following are ethical standards conduct for management accountants
a. Competence
b. Confidentiality
c. Integrity
d. Objectivity
e. All of the above
24. The parties who use accounting information for short-term planning and controlling routine
operations are:
a. production department managers.
b. top executives.
c. investors.
d. banks.
25. Accounting information helps users evaluate a company’s success or failure in achieving
performance targets. A question such as “Is the company doing well or poorly?” is an example of
a(n):
a. problem-solving question.
b. attention-directing question.
c. cost-accounting question.
d. scorekeeping question.
26. Useful internal accounting reports do not have to meet:

a. the needs of managers.
b. the needs of government agencies.
c. generally accepted accounting principles.
d. cost-benefit constraints.
27. A person’s perceptions of expected benefits in relation to expected costs is known as the:
a. problem solving approach.
b. value chain.
c. management by exception rule.
d. cost-benefit balance.
28. The difference between actual and planned results is referred to as a(n):
a. variance.
b. exception.
c. budget.
d. life cycle.
29. The value chain emphasizes functions that add quality to and improve an organization’s products
and services. Which of the following is NOT an example of a “value-added” function at a mail-
or web-order computer company?
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a. The computer company transfers customers’ phone calls to employees in three departments
before directing those calls to the technical support department.
b. The computer company offers a Web site for prospective buyers to research product
specifications and obtain price quotes for custom-configured systems.
c. Company field engineers provide service to the company’s customers at the customers’
location.
d. The computer company establishes technical agreements with Intel and Novell for the
purpose of jointly investigating and developing new products.
30. Accountants provide and analyze information for decision makers throughout the organization’s
value chain. Examine each business activity below and select the one where the accountant is
NOT adding value.
a. The accountant computes and analyzes costs for raw materials from various suppliers in
an attempt to purchase the highest quality materials at the best prices.
b. The accountant provides weekly cost reports to the production department. These reports
identify major variances and suggest strategies for cost reductions based on data from the
weekly marketing and sales plans.
c. The accountant receives sales orders from the sales department, checks to see that the
salesperson wrote his or her employee number on the sales form (used to determine
commission payments), then forwards the sales order to the billing department.
d. The accountant develops a cost-benefit balance to see if the planned increase in college
tuition revenues will be greater than the expected cost increases for the next academic
year. He or she analyzes this relationship at several different enrollment levels, then
comments on the proposed tuition increase in comparison to other colleges in a 200-mile
radius.
31. The authority to command in an organization is referred to as:

a. staff authority.
b. line authority.
c. managerial authority.
d. controlling authority.
32. Staff departments handle the:

a. direct production of the organization’s goods for sale.
b. support work for the line departments.
c. movement of work-in-process inventory from one manufacturing machine to the next
machine in the plant.
d. detailed finishing work after the product has been removed from the assembly line.
33. The position of the top accounting officer in an organization is occupied by the:
a. controller.
b. chief executive officer.
c. comptroller.
d. The position is referred to as either the controller or the comptroller.
34. The downward delegation by top management of authority and decision making to the individuals
who are closest to internal processes and customers is called:
a. centralization
b. outsourcing
c. responsibility
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d. decentralization
35. The Standards of Ethical Conduct for Management Accountants address the accountant’s
requirement to communicate information fairly and without bias, and to disclose relevant
information that could influence a user’s understanding of internal accounting reports. This is the
standard of:
a. objectivity.
b. integrity.
c. confidentiality.
d. competence.
36. Which of the following represents part of management accounting?

a. financial accounting.
b. tax accounting.
c. cost accounting.
d. managerial accounting.
e. all of the above
37. The broad conceptual definition of management accounting excludes:

a. public accounting.
b. financial accounting.
c. governmental accounting.
d. a & c.
e. all of the above
38. Conceptually, the difference between cost management and activity management is that:
a. cost management is proactive and activity management is reactive.
b. cost management places emphasis on costs while activity management places emphasis
on the work that causes the costs.
c. cost management is designed for external users while activity management is designed
for internal use.
d. a & b.
e. all of these
39. Managers in which type of economic system tend to place greater emphasis on long term growth?
a. communitarian capitalism.
b. individualistic capitalism.
c. both systems.
d. neither system.
40. In accounting, the matching concept refers to:

a. assigning costs to the type of production process in which the company is engaged.
b. assigning costs to the products that cause the costs.
c. assigning costs to expense in the time periods when the benefits associated with the costs
are recognized.
d. separating variable costs and fixed costs so that variable costs can be matched with
products and fixed cost can be matched with time periods.
e. non of these.
41. Theoretically, short term profit maximization is the main objective in:
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c. both system (a and b)
d. neither system.
42. An underlying assumption of the system is that work mainly provides disutility, thus workers will
tend to avoid work if possible.
c. both system (a and b).
d. neither system.
43. The hierarchy of an organization’s constituencies is: employees first, customers second, and
stockholder third. This is consistent with
c. both system (a and b)
d. neither system.
44. Which of these statements is true?

a. The matching concept requires that we distinguish between expired and unexpired costs.
b. To say that a cost has expired means that the benefits associated with the expenditure
have been recognized.
c. most costs that represent future benefits are classified as assets.
d. matching is required for external reporting.
e. all of the above
45. ……………… is a formal set of steps to gather, organize, and communicate quantitative
information about an organization’s activities.
46. If you were to prepare a plan of action in quantitative terms, you would be preparing a
…………...
47. ……………… is an investigation by management of the most significant variances listed on a

performance report.
48. The …………… is a set of business activities that enhance an organization’s services and
products.
49. The manufacturing philosophy to reduce waste and non-value added activities is called the
……………. philosophy.
Listed below are a number of terms that relate to organisations, the work of management, and the role of
management accounting relevant for answering questions 16 to 30. these are:
a. Budgets b. Decentralisation c. Feedback
d. Line e. Non-monetary data f. Planning
g. Staff h. Controller i. Directing and motivating
j. Financial accounting k. Management Accting l. Performance report
m. Precision n. Accounting o. Cost accounting
p. Benchmarking
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50. A position on the organisation chart that is directly related to achieving the basic objectives of an
organisation is called a………………..position.
51. ……………. is a manager’s function to oversee day-to-day activities and keep the organisation
functioning smoothly.
52. The plans of management are expressed formally in…………………………..
53. …………………. consists of identifying alternatives, selecting from among the alternatives the
one that is best for the organisation, and specifying what actions will be taken to implement the
chosen alternative.
54. A…………… position provides service or assistance to other parts of the organisation and does
not directly achieve the basic objectives of the organisation.
55. The delegation of decision-making authority throughout an organisation by allowing manager at

various operating levels to make key decisions relating to their area of responsibility is
called…………………..
56. Management accounting places less emphasis on……………..and more emphasis on……………
than financial accounting
57. ……………….. is concerned with providing information for the use of those who are inside the
organisation, whereas……………is concerned with providing information for the use of those
who are outside the organisation.
58. The accounting and other reports, coming to management that are used in controlling the
organisation are called…………………….
59. The manager in charge of the accounting department is generally known as the …………………
60. A detailed report to management comparing budgeted data against actual data for a specific time
period is called a ………………………………………
61. ………………………. is a language that communicates economic information to people who

have an interest in an organisation-managers, shareholders and potential investors, employees,
creditors and the government.
62. …………………….. is concerned with cost accumulation for stock valuation to meet the
requirements of external reporting, whereas…………….. relates to the provision of appropriate
data for people within the organisation to help them make better decisions.
63. The application of professional knowledge and skills in the preparation and presentation of
accounting information so as to assist management in the formulation of policies, and in planning
and controlling of activities of a business enterprise is called……………………..
64. ……………. is the study of organisation that are among the best in the world at performing a
particular task.
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2. COST BEHAVIOUR AND COST ESTIMATION TECHNIQUES
1. Direct costs are costs that:

a. are incurred directly when the factory is opened
b. are directly charged to a department
c. can be directly identified with a product or service
d. are directly under the control of a manager.
2. Prime cost includes:

a. direct labour, direct materials and direct expenses
b. all direct costs plus factory overheads
c. direct materials plus total overheads
d. direct labour plus factory overheads
3. Expenditure on steel used in the product would be classified into which of the following
categories:
a. direct material/cost unit
b. direct material/production overheads
c. indirect material/cost unit
d. prime cost/production overhead
4. Direct wages should always be classified:

a. as variable costs
b. as fixed costs
c. as semi-fixed costs
d. according to their actual behaviour.
5. Both nationally and internationally the wages paid to production workers are:
a. an increasing proportion of total costs
b. always equal to production overheads
c. a decreasing proportion of total costs
d. none of these.
6. If the total expenditure on cost type X was expressed as a cost per unit of the product, X would be
classified as variable if:
a. the cost per unit changed with the level of activity
b. the cost per unit was affected by inflation
c. the cost per unit remained constant with changes in the level of activity
d. the total expenditure on X remained the same.
7. Analysis has shown that the cost of a process is represented by the function: Cost=Nax + bx2 +
cx3 Where a = 7, b = 0.6, c = 0.04 . What will be the cost when output is 26
units? (nearest N)
a. N628
b. N1,291
c. N199
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d. N1,523
8. What type of cost function is shown in question 7

a. curvi-linear variable
b. semi-variable, curvi-linear
c. linear approximation
d. semi-variable, linear
9. Using the high/low method, what is the value of the slope based on the following data
Cost(N) Units
12,650 6,000
9,200 4,520
8,800 3,500
11,750 5,200
a. N1 per unit
b. N2.11 per unit
c. N2.51 per unit
d. N1.54 per unit
10. In the regression result, y = N280 + N2.6x

a. N2.6 is an estimate of the fixed costs per unit
b. x is the dependent variable
c. y is the dependent variable
d. there are two independent variables
The following data are to be used for questions 11 to 13

Last year This year
Output (units) 15,000 17,000
Total costs N112,500 N126,670
Cost inflation this year was 6%
11. What is the underlying real variable cost per unit?

a. N7.50
b. N7.34
c. N6.41
d. N3.71
12. What is the underlying fixed cost?

a. N63,600
b. N112,500
c. N16,025
d. It is not possible to calculate without more information.
13. What are the expected total costs for next year if inflation is forecast at 4% and output 18,500
units?
a. N141,304
b. N132,235
c. N137,524
d. N138,750
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14. Which of the following costs is not recorded in the company’s accounting system?
a. sunk cost
b. opportunity cost
c. direct cost
d. indirect cost
15. Which of following is not part of product costs

a. advertising expenditures
b. insurance on the office buildings
c. depreciation of salesman’s cars
d. depreciation of the production facilities
e. all the above
16. All of the following are production costs except:

a. direct materials
b. direct labour
c. manufacturing overhead
d. selling and administration costs
17. Depreciation of the corporate office building would be classified as:

a. direct materials
b. direct labour
c. manufacturing overhead
d. selling and administrative
The following data are to be used for question 18 to 22

At 80,000 units of production, A company expects costs to be as follows:
N
Depreciation of factory 80,000
Depreciation of production equipment 60,000
Production supervisor’s salary 30,000
Supplies 10,000
Indirect labour 20,000
Electricity 18,000
Assume all cost items are either strictly fixed or strictly variable.
18. The total cost of direct materials at 85,000 units would be:
a. N100,000
b. N106,250
c. N94,118
d. N106,875
19. The total cost of variable overhead at 85,000 units would be:
a. N48,000
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b. N51,000
c. N82,875
d. N78,000
20. Total cost of fixed overhead at 85,000 units would be:

a. N140,000
b. N180,625
c. N162,400
d. N170,000
21. At 80,000 units, the total cost per unit (rounded to 2 decimal places) would be:
a. N5.98
b. N3.25
c. N2.73
d. N2.13
22. The total cost per unit at 85,000 units would be:
a. N5.53
b. N5.85
c. N5.62
d. N5.75
23. Conversion costs consists of:

a. direct materials and direct labour
b. direct labour and manufacturing overhead
c. product costs and period costs
d. fixed and variable costs
24. The relevant range is:

a. a relatively narrow range of output where variable costs are expected to remain the
same
b. a relatively wide range of output where variable costs are expected to remain the
same.
c. a relatively narrow range of output where fixed costs are expected to remain the same
d. a relatively wide range of output where fixed costs are expected to remain the same
25. The followings are method of separating mixed cost except:

a. high and low method
b. break-even method
c. account analysis method
d. least square method
26. When managers use numbers to express their understanding of the way organization activities
affect costs levels, those managers are measuring
a. step costs.
b. product costs.
c. cost behaviors.
d. cost accumulation.
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27. When cost behavior over some relevant range of activities, or change in cost drivers, is assumed
to be fixed or variable, the behavior is referred to as
a. linear-cost behavior.
b. mixed-cost behavior.
c. best cost behavior.
d. a cost driver.
28. If there is a decrease in the demand for home furnishings and floor coverings, a flooring company
has certain fixed costs it cannot recover. These would include the cost of vinyl flooring
manufacturing equipment and the cost of warehouses built to store materials and finished goods.
These costs are examples of
a. incremental costs.
b. capacity costs.
c. contribution margin costs.
d. period costs.
29. Lenox, maker of dinnerware, stemware, and flatware, wants to expand its production capabilities.
It will incur certain fixed costs, such as the cost to finance the new production facilities or expand
its existing plants. Other fixed costs, such as advertising expense, will not be affected by the
increased level of production. Costs like advertising expense are referred to as
a. committed fixed costs.
b. mixed costs.
c. variable costs.
d. discretionary fixed costs.
30. Which of the following costs is not an example of a committed fixed cost?
a. Interest payments on a long-term loan
b. Property taxes on land and related buildings
c. Employee training
d. Lease payments on production equipment
31. Los Padres Clinic uses an algebraic formula to describe the relationship between medical costs
and the total number of patients. This formula is: total medical costs = N290,000 + N30 times
total medical patients. This formula is known as a:
a. planning function.
b. capacity function.
c. step-cost calculation.
d. mixed-cost function.
32. You cannot have a reliable, relevant cost function without understanding the activities underlying
the costs. The process of identifying appropriate cost drivers and their effects on production and
service costs is called a(n):
a. activity analysis.
b. cost behavior study.
c. cost measurement.
d. management audit.
33. Cost prediction is the

a. numerical expression of planned future activities.
b. application of cost measures to anticipated future activity levels to forecast future costs.
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c. application of step costs to the next relevant range of business activities in the current
period.
d. estimate of current period operating leverage.
34. Identifying reliable, plausible cost drivers is the most important task in an activity analysis. Costs
sometimes are affected by multiple activities. In other cases, costs are not driven by production
level or output quantities. It might take a tremendous amount of investigation to select the
appropriate driver(s). In such situations, the management accountant should remember the
…………… balance.
a. cost prediction
b. sales mix
c. cost-benefit
d. high-low
35. Western Architecture Magazine wants to create a cost function to represent the cost drivers for
monthly editorial costs. Management believes that the most realistic driver for these costs is the
number of pages in the magazine. The magazine’s management accountants have examined the
accounting records and listed the following costs: printing costs; writers’ salaries and benefits;
editors’ salaries and benefits; and computer leasing costs. After separating these costs into fixed
and variable components, the accountants solve for the algebraic, mixed-cost function. Western
Architecture Magazine is using …………….. to measure its cost function.
a. the visual fit method.
b. the high-low method.
c. account analysis.
d. a least-squares regression method.
36. The form of least squares regression analysis that uses one cost driver to measure a cost function
is known as:
a. simple regression.
b. multiple regression.
c. coefficient of determination.
d. standard error of the estimate.
37. A large coefficient of determination results in a(n) …………… connection between cost driver
changes and their ability to explain fluctuations in costs.
a. unexplained
b. weaker
c. less plausible
d. stronger
38. The process of collecting costs based on some natural classification is known as
a. cost accumulation.
b. cost accounting.
c. cost reporting.
d. activity-based costing (ABC).
39. Product costs are also called:

a. prime costs
b. inventoriable costs
c. conversion costs
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d. period costs
40. Each of the following is an example of a cost object, except

a. the southern sales region.
b. providing research services to attorneys in a law firm.
c. payroll checks processed.
d. rent expense.
41. Costs that are distinctly related to a particular cost object are known as
a. direct costs.
b. fixed costs.
c. indirect costs.
d. mixed costs.
42. Which one of the following describes a direct-material cost?
a. Wages of the worker who cleans and repairs the production equipment.
b. The cost of special lubricants that are applied weekly to the production equipment to
protect its mechanical parts from excessive wear.
c. The acquisition cost of plastic pellets used to mold cordless telephones.
d. Ongoing costs to maintain and upgrade software that directs 19 factory robots used in
building the company’s products.
43. A manufacturing company’s direct-labor cost plus its factory overhead cost is also referred to as
a. conversion cost.
b. prime cost.
c. direct cost.
d. contribution cost.
44. Which one of the following items is an example of a period cost?

a. Purchase price of parts used in making air conditioners
b. Legal fees
c. Work-in-process inventory
d. Manufacturing department supervisors’ salaries
45. Some manufacturers track costs based on their fixed and variable characteristics, while other
manufacturers identify costs as period or product costs. The one approach which classifies all
factory overhead costs as product costs and expenses them only as sales occur is called the
a. absorption approach.
b. variable costing approach.
c. direct costing approach.
c. contribution approach.
46. Activity-based-costing (ABC) systems produce more accurate cost measures than do traditional
cost accounting systems because ABC systems
a. only classify more costs as direct.
b. can only track more complex business activities.
c. only break down manufacturing overhead costs into several smaller costs, each of which
is associated with a key activity.
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d. all of the capabilities described above allow ABC systems to produce more reliable and
accurate cost measures.
47. Costs which can be reduced or removed from the company’s cost structure without affecting
product or service quality for the customer are referred to as
a. value-added costs.
b. variable costs.
c. non-value-added costs.
d. indirect costs.
48. Production cycle time is the

a. time from conception of the product idea to its introduction to the market.
b. time from starting product manufacturing to delivering the goods to the customer.
c. concept where an organization purchases its parts and materials just as it needs them for
production.
d. same concept as cellular manufacturing.
49. Just-in-time (JIT) manufacturing systems have very low levels of raw materials and work-in-
process inventories because
a. these inventory classifications are only used with retailers and wholesalers.
b. inventories are replenished only once each accounting period.
c. products are placed into production after customer sales orders are received, and then
shipped to customers upon completion.
50. When America Online’s (AOL) e-mail account activity reaches a certain level, it must add
another large computer to be able to provide services consistent with its quality standards. This
additional computer will support, to a limit, a broad range of e-mail account activity, however.
Yet when this activity capacity is reached, AOL will acquire yet another large computer. This
example demonstrates a type of cost called …………….
51. A labour-intensive business such as an automobile detailing and cleaning service would have a
……………… fixed-cost component to total costs when compared to a machine shop where the
majority of work is done by robots and computer-driven equipment.
52. …………….. is the process of evaluating costs as a function of appropriate cost drivers.
53. The ……………… method of cost measurement involves plotting data points on a graph and
fitting the cost function to only the top and bottom data points.
54. An engineering analysis of cost behavior measures costs based on what they should be, not what
they were in the past. But if the period under study was not representative of the activity in
general -- it incurred higher costs than usual -- cost predictions using the cost functions would be
………………...
55. ………………. is the subsystem of the accounting system that measures costs and provides this
information to internal managers for their decision-making needs.
56. ………………. costs cannot be identified directly and exclusively with a selected cost object.
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57. Activity-based-management uses a(n) ……………. to improve the organization’s operations.
58. Value-added costs …………….. be eliminated without changing a product or service’s value to
the customer.
Use the terms statement below in answering questions 59 to 68 by matching each statement with
the appropriate letter. These terms are:
a. Avoidable costs b. Controllable cost c. Conversion cost

d. Differential costs e. Direct costs f. Direct labour
g. Direct material h. Finished goods i. Fixed costs
j. Imputed cost k. Indirect labour l. Indirect
material
m. Manufacturing overhead n. Opportunity cost o. Period costs
p. Prime costs q. Product costs r. Raw materials
s. Sunk cost t. Variable costs u. Work in progress
59. …………….., Direct labour costs plus manufacturing overheads costs.
60. ……………… Direct materials costs plus direct labour costs.
61. ……………… Costs that can be eliminated under a particular alternative.
62. ……………… Costs that differ between alternatives.
63. ……………… Costs that vary per unit but remain constant in total.
64. ………………. A cost that can be influenced by a particular manager
65. ……………… Costs that are expensed as incurred rather than being charged to product.
66. …………….. Costs that remain constant per unit but vary in total.
67. …………….. Costs associated with inventory and expensed as the goods are sold.
68. ……………. A cost that is the result of a past decision and cannot be changed by current or
future action.
69. ……………… is incurred when a resource is used for some purpose.
70. Costs are sometimes collected into meaningful groups called…………………..
71. ……………. is the process of assigning costs to cost pools, or from cost pools to cost objects.
72. …………….can be conveniently and economically traced directly to a cost pool or cost object
73. …………….has no convenient or economical trace from cost pools to cost object
74. The assignment of indirect cost to cost pools and cost objects are often called…………
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75. The cost drivers used to allocate costs are often called…………………………….
76. ………….. include the cost of the materials in the product and a reasonable allowance for scrap
and defective units.
77. The cost of materials used in manufacturing that are not physically part of the finished product
are…………………………………………..
78. ……………….. includes the labour used to manufacture the product or to provide the service.
79. …………..includes supervision, quality control, inspection, purchasing and receiving, and other
manufacturing support costs.
80. All the indirect costs are commonly combined into a single cost pool called………….. or, in a
manufacturing firm,…………………..
81. Direct materials and direct labour are sometimes considered together and called…………..
82. Direct labour and overhead are often combined into a single amount, which is called……...
83. The range of the cost driver in which the actual value of the cost driver is expected to fall, and for
which the relationship is assumed to be approximately linear is called the…………
84. …………….. is the change in total cost associated with each change in the quantity of the cost
driver.
85. …………. is that portion of the total cost that does not change with a change in the quantity of
the cost drivers, within the relevant range.
86. ……….. is the term used to refer to total cost when total cost includes both variable and fixed
cost components.
87. A cost is said to be………. when it varies with the cost driver, but in discrete steps.
88. ………….. is the total of manufacturing costs (materials, labour and overheads) divided by units
of output.
89. ………….. is the additional cost incurred as the cost driver increases by one unit.
90. ……….. for a manufacturing firm include only the costs necessary to complete the product-direct
materials, direct labour and factory overhead.
91. All non-product expenditures for managing the firm and selling the product are called…………
92. …………. has two properties: (a) it differs for each decision option, and (b) it will be incurred in
the future.
93. …………… is a cost that differs for each decision option and is therefore relevant for the
decision maker’s choice, it is an expected future cost.
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94. …………. is the benefit cost when choosing one option precludes receiving the benefits from an
alternative option.
95. ……….. are costs that have been incurred or committed in the past, and are therefore irrelevant.
96. A cost is said to be a ………… if the manager or employee has discretion in choosing to incur the
cost or can significantly influence the amount of the cost within a given, usually short, period of
time.
97. Costs incurred after the manufacturing process is complete e.g. delivery costs and sales are
called………………
98. ………………… are costs incurred before the manufacturing process begins for example,
research and development costs.
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3 COST ACCOUNTING SYSTEM & INCOME STATEMENT.
1. Cost apportionment is carried out by:

a. charging each cost unit a realistic proportion of overheads
b. charging whole items of cost to cost centers
c. ensuring that each period carries its fair amount of costs by making accruals or
prepayments
d. dividing common costs among cost centers in proportion to the benefit received.
2. Overhead absorption is done so that:

a. common costs are shared among cost centers, in proportion to the benefit received.
b. The total amount of overheads for the firm can be calculated
c. The total overheads for a cost center can be calculated
d. Each unit of the product carries a share of overheads.
3. A firm uses direct labour as a basis for overhead absorption. If large fluctuations in labour hours
are experienced:
a. this is a reason to use predetermined overhead rate
b. this will mean that overheads will be under or over absorbed for the year
c. different amounts of overhead will be charged to jobs with the same labour hours
d. it will be better to use a machine hour rate
4. A predetermined overhead rate using machine hours as a basis:

a. is calculated by dividing actual overheads by budgeted machine hours
b. results in the over absorption of overhead
c. is inferior to a rate based on labour hours
d. results in charging similar overheads to jobs with similar machine hours
5. A firm recovers overheads on labour hours which were budgeted at 3500 with overheads of
N43,750. Actual results were 3620 hours with overheads of N44,535
a. overheads were underabsorbed by N785
b. overheads were overabsorbed by N715
c. overheads were overabsorbed by N1,500
d. overheads were underabsorbed by N715
6. A firm that uses departmental overhead rates as opposed to a single blanket rate:
a. might be better able to check the profitability of each job
b. will charge about the same overhead to each job
c. will make the departments more profitable
d. is more likely to have under-absorbed overheads
7. A firm that has underabsorbed overhead at the end of the period:

a. has been working inefficiently
b. would be better not using predetermined rates
c. incorrectly budgeted the absorption base and/or the amount of overheads
d. has overspent on overheads.
8. The simultaneous equation method of dealing with reciprocal servicing:

a. is more sophisticated and produces more accurate results
b. is a convention like all the other methods
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c. enables servicing department costs to be controlled
d. needs a computer to work out the results.
9. Marginal costing gives a different profit to absorption costing when

a. all production costs are fixed
b. opening and closing stocks are different
c. all production costs are variable
d. there are no opening or closing stocks
The following data relate to questions 10 to 13. A firm makes a single product and data for a
period are:
No opening stock
Sales 65,000 units @ N60 each
Production 73,500 units
Variable costs N23 per unit
Total fixed costs for the period N1,300,000
Fixed overheads are recovered on a unit basis and the normal production is 70,000 units
10. Using marginal costing the profit for the period is:
a. N2,445,000
b. N1,263,000
c. N1,105,000
d. N1,295,000
11. Using absorption costing the profit for the period is?
a. N2,445,000
b. N1,263,000
c. N1,105,000
d. N1,295,000
12. Using marginal costing the closing stock valuation is?

a. N353,357
b. N80,500
c. N345,840
d. N195,500
13. Using absorption costing the closing stock valuation is?

a. N353,357
b. N80,500
c. N345,840
d. N195,500
14. The main difference between marginal and absorption costing relates to how which one of the
following is recorded:
a. direct materials
b. direct labour cost
c. variable manufacturing overhead
d. fixed manufacturing overhead
15. Under absorption costing, fixed manufacturing overhead is recognized as an expense when:
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a. the cost is incurred
b. the product is sold
c. the product is completed
d. none of the above.
16. When marginal costing is used, the income statement is usually prepared using:
a. a contribution format
b. a functional format
c. an operational format
d. all of the above
17. Marginal costing can be used for:

a. external reporting
b. internal reporting
c. either external or internal reporting
d. neither external nor internal reporting
18. Absorption costing income will usually exceed marginal costing income when:
a. sales exceed production
b. production exceeds sales
c. production and sales are equal
19. Marginal costing income will usually exceed absorption costing income when:
a. sales exceed production
b. production exceeds sales
c. production and sales are equal
20. The level of production affects income under which of the following methods?
a. absorption costing
b. variable costing
c. both absorption and variable costing
d. neither absorption nor variable costing
21. Which of the following could be considered a segment?

a. division
b. product line
c. sales territory
d. all of the above
22. Segment margin is equal to

a. sales less variable costs
b. sales less variable costs and direct fixed costs
c. sales less variable costs and indirect fixed costs
d. sales less cost of goods sold
23. Which one of the following measures provides information that is useful in assessing short-run
operating decisions?
a. segment profit
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b. segment contribution margin
c. segment gross sales
24. Which of the following measures provides information that is useful in assessing the long-run
profitability of a segment?
a. segment profit
b. segment contribution margin
c. segment gross margin
Use the following data to answer questions 25 to 30
FB Ventures began operations on January 1, 2004. The company sells a single product for N20
per unit. During 2004, 40,000 units were produced and 30,000 units were sold. There was no
work in progress inventory at December 31, 2004.
Costs for 2004 were as follows:
Fixed Costs Variable Costs

Direct materials - N3.00 per unit produced
Direct labour - N2.00 per unit produced
Manufacturing overheads N24,000 N1.00 per unit produced
Selling and administrative expense N20,000 N0.70 per unit sold
25. The production cost per unit under variable costing would be:
a. N5.00
b. N6.00
c. N6.60
d. N6.70
e. N7.80
26. The production cost per unit under absorption costing would be:
a. N5.00
b. N6.00
c. N6.10
d. N6.60
e. N7.80
27. The cost of closing finished goods inventory under marginal costing would be:
a. N66,000
b. N50,000
c. N60,000
d. N78,000
28. The cost of closing finished goods inventory under absorption costing would be:
a. N66,000
b. N50,000
c. N60,000
d. N78,000
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29. Marginal costing income would be:
a. N399,000
b. N382,000
c. N379,000
d. N361,000
e. N355,000
30. Absorption costing income would be:

a. N399,000
b. N382,000
c. N379,000
d. N361,000
e. N355,000
31. When comparing the profits reported using marginal costing with those reported using absorption
costing in a period when closing stock was 1,400 units, opening stock was 2,000 units, and the
actual production was 11,200 units at a total cost of N4.50 per unit compared to a target cost of
N5.00 per unit, which of the following statements is correct?
a. absorption costing reports profits N2,700 higher
b. absorption costing reports profits N2,700 lower
c. absorption costing reports profits N3,000 higher
d. absorption costing reports profits N3,000 lower
e. there is insufficient data to calculate the difference between the reported profits.
32. When comparing the profits reported under marginal and absorption costing during a period when
the level of stocks increased:
a. absorption costing profits will be higher and closing stock valuations lower than those
under marginal costing.
b. absorption costing profits will be higher and closing stock valuations higher than those of
under marginal costing.
c. Marginal costing profits will be higher and closing stock valuations lower than those
under absorption costing
d. Marginal costing profits will be lower and closing stock valuations higher than those
under absorption costing
e. There is no difference in the profit reported or the valuation of closing stock between the
two systems
33. A company made 17,500 units at a total cost of N16 each. Three quarters of the costs were
variable and one quarter fixed. 15,000 units were sold at N25 each. There were no opening
stocks. By how much will the profit calculated using absorption costing principles differ from the
profit if marginal costing principles had been used?
a. The absorption costing profit would be N22,500 less
b. The absorption costing profit would be N10,000 greater
c. The absorption costing profit would be N135,00 greater
d. The absorption costing profit would be N10,000 less.
34. Over-absorbed overheads occur when:

a. absorbed overheads exceed actual overheads
b. absorbed overheads exceed budgeted overheads
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c. actual overheads exceed budgeted overheads
d. budgeted overheads exceed absorbed overheads.
35. How should Frito-Lay Company account for its fixed overhead for product costing and internal
income calculation purposes?
a. The company should use the full-costing approach
b. The company should use the variable approach.
c. Frito-Lay can use either the absorption approach or the contribution approach.
d. The company should use the functional costing approach.
36. External financial reports and reports presented to the Internal Revenue Service (IRS) can use all
of the following costing methods except the
a. full-costing approach.
b. variable approach.
c. absorption approach.
d. traditional approach.
37. Which of the following items is not used in the calculation of contribution margin on an income
statement using variable costing?
a. Raw material costs of goods manufactured and sold in the period.
b. Direct labor costs for goods manufactured and sold in the period.
c. Variable selling expenses.
d. Fixed administrative expenses.
38. When preparing income statements using the absorption approach, the amount of fixed
manufacturing overhead applied to each unit produced is determined by the fixed-overhead rate.
This rate is the budgeted dollar amount of fixed manufacturing overhead divided by
a. the expected volume of production.
b. the actual volume of production.
c. the budgeted sales revenue for the period.
d. the actual sales revenue for the period.
39. The difference between the budgeted and applied fixed overhead is referred to as the
a. practical capacity variance.
b. spending variance.
c. efficiency variance
d. production-volume variance.
40. What type of variance exists when budgeted volume exceeds actual volume?
a. A favorable variance.
b. Overapplied overhead variance.
c. An unfavorable variance.
d. There is no variance unless the absorption-costing approach is being used.
41. Absorption cost methods can be put into operation in three ways. The system that applies actual
direct materials and actual direct labor to products, and applies fixed factory overhead to actual
units produced using a budgeted fixed factory overhead rate, is known as the
a. actual costing system.
b. normal costing system.
c. standard costing system.
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42. Income statements prepared under the variable and absorption cost approaches differ in the way
each handles fixed factory overhead. Operating income calculated using the ………… approach
……….. the cost of fixed factory overhead ………… cost of goods sold.
a. variable, excludes, from
b. absorption, excludes, from
c. variable, includes, with
d. absorption, includes, with
43. If production exceeds sales in a given month, the …………. approach income statement will
report a higher operating income.
a. variable cost
b. absorption cost
c. normal cost
d. standard cost
44. The fixed overhead flexible-budget variance is the difference between

a. the fixed factory overhead applied and the budgeted fixed factory overhead.
b. the fixed factory overhead incurred and the fixed factory overhead applied.
c. the fixed factory overhead incurred and the budgeted fixed factory overhead.
45. DWD, a textile manufacturer, incurred N700,000 of fixed factory overhead in 2002. The fixed
factory overhead flexible budget for 225,000 bolts of fabric was N675,000. Actual production in
2002 was 230,000 bolts of fabric. The production-volume variance was
a. N25,000 unfavorable.
b. N25,000 favorable.
c. N15,000 favorable.
d. N10,000 unfavorable.
46. Use the information in Question above. The 2002 fixed overhead spending variance was
a. N25,000 unfavorable.
d. N10,000 unfavorable.
47. The ………….. approach includes fixed factory overhead costs in inventory, and then expenses
the costs when inventory is sold.
48. Revenue less costs of goods sold is known as …………………. .
49. The denominator in the fixed overhead application rate is the budgeted level of production
activity in units (or volume). This denominator can be one of several measures. If a company’s
managers decide to use the maximum or full capacity of its productive assets, they will be using
……………. as the denominator.
50. Operating income calculated under the variable and absorption cost approaches can be reconciled
by multiplying the fixed overhead rate by the change in …………………………...
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4 COST VOLUME PROFIT ANALYSIS
1. The break even point is:

a. sales level where profit is maximized
b. sales minus variable costs
c. sales minus total costs
d. sales that equate costs
2. The margin of safety is:

a. the difference between budgeted sales and the break even sales
b. the difference between actual sales and budgeted sales
c. sales minus variable costs
d. the difference between zero sales and break even sales
The following data are to be used for questions 3 to 5

A firm makes a single product with a marginal cost of N3 at a selling price of N5 and fixed costs
of N25,000.
3. What level of sales will produce a profit of N15,000

a. N120,000
b. N20,000
c. N100,000
d. N40,000
4. How many units will need to be sold to break-even?

a. 5,000
b. 25,000
c. 40,000
d. 12,500
5. If the taxation rate is 30% how many units will need to be sold to obtain a N20,000 profit after
tax?
a. 17,857
b. 26,785
c. 45,833
d. 33,333
6. Which of the following would increase the per unit contribution the most? Assume the other
variable remains constant.
a. a 5% decrease in total fixed costs
b. a 5% decrease in unit variable costs
c. a 5% increase in selling price
d. a 5% increase in unit volume
7. Cost volume profit analysis can be done on:

a. a pre-tax basis only
b. an after-tax basis only
c. a pre-tax or after-tax basis
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8. Contribution margin is calculated as
a. selling price minus cost of goods sold per unit
b. selling price minus total variable cost per unit
c. selling price minus total variable manufacturing cost per unit
d. selling price minus variable and fixed manufacturing cost per unit.
9. The contribution margin ratio is calculated as:

a. total contribution margin divided by total revenues
b. total contribution margin divided by total variable costs
c. total variable costs divided by contribution margin
d. income divided by contribution margin
10. Gross margin equals:

a. revenue minus variable manufacturing costs
b. revenue minus variable manufacturing and variable selling and administrative costs
c. revenue minus fixed costs
d. revenue minus cost of goods sold
11. Pre-tax profit equals:

a. after-tax profit multiplied by the tax rate
b. after-tax profit multiplied by 1 minus the tax rate
c. after-tax profit divided by the tax rate
d. after-tax profit divided by 1 minus tax rate
12. At break even contribution margin equals:

a. total variable costs
b. total fixed costs
c. total manufacturing costs
d. fixed manufacturing costs
13. Break even in units for a multi-product firm is calculated as fixed costs divided by:
a. the contribution margin percentage for the package
b. the weighted contribution margin per package
c. the sum of the individual product contribution margins
d. it is not possible to calculate break even in units for a multi-product firm
14. If fixed costs increase, the break even point in units will:
a. increase
b. decrease
c. remain the same
d. remain the same, however, contribution margin per unit will decrease
15. If variable costs per unit decrease, sales volume at break even will
a. increase
b. decrease
c. remain the same
16. If the selling price per unit increases, the break-even point in units will:
a. increase
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b. decrease
c. remain the same
17. AB Limited sells three products, A, B and C

Selling Maximum Variable Cost
Price demand of production
A N10 30,000 N8
B N15 10,000 N10
C N5 20,000 N4
Fixed costs are N26,000
If AB limited always sells its products in the same proportions as the maximum demand for each,
the amount made and sold of A when the company breaks even is:
a. 6,000
b. 6,545
c. 12,000
d. 13,000
18. If both the selling price per unit and variable cost per unit of a company rise by 10%, the break-
even point in volume will:
a. remain constant
b. increase
c. fall
d. is impossible to determine
19. Tolu Ventures sells a single product for N40 per unit. Fixed costs are N48,000 and variable costs
80% of revenue. If fixed costs increase by N8,000 the break-even number of units will increase
by:
a. 10,000 units
b. 5,000 units
c. 1,000 units
d. 200 units
20. A limited has fixed costs of N60,000 per annum. It manufactures a single product that it sells for
N20 per unit. Its contribution to sales ratio is 40%
A limited’s break-even point in units is
a. 1,200
b. 1,800
c. 3,000
d. 7,500
Selling price per unit N500

Variable manufacturing costs per unit N150
Fixed manufacturing costs per unit N180
Variable selling costs per unit N90
Fixed selling costs per unit N40
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Expected production and sales 1,000 units
21. Contribution margin per unit is

a. N260
b. N350
c. N170
d. N130
22. The contribution margin ratio is:

a. 70%
b. 66%
c. 52%
d. 48%
23. Break-even for the product (rounded to the nearest whole unit) is:
a. 514 units
b. 765 units
c. 846 units
d. 1,000 units
24. Rubbermaid’s managers want to control, and reduce if possible, the company’s production costs.
They must determine how production costs are related to and affected by various business
activities. These managers need to understand
a. variable costs.
b. cost behaviors.
c. fixed costs.
d. relevant ranges.
25. Accountants associate business activities to costs using:

a. budgets.
b. cost-volume-profit analysis.
c. cost-benefit balance.
d. cost drivers.
26. The break-even point is the:

a. point where total fixed costs equal total variable costs.
b. level of business activity where costs are no longer influenced by value chain activities.
c. volume of sales activity where total revenues equal total expenses.
d. point when a product’s life cycle has ended and there are no sales revenues from the
product.
27. MN Bank (MNB) sells services rather than tangible products. It makes auto and home loans,
processes other companies’ credit card transactions, and provides account services to individual
and commercial checking account customers. MNB managers want to determine how far service
revenues could fall below budgeted revenues before losses occur from operations. The managers
want to know the bank’s:
a. sales mix.
b. relevant revenue range.
c. margin of safety.
d. variable costs.
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28. Unit contribution margin can be expressed as an arithmetic formula. Which of the following best
represents this formula?
a. Unit sales price - unit variable cost = unit contribution margin.
b. Sales revenue - total expenses = contribution margin.
c. Sales revenue - total fixed costs = contribution margin.
d. Unit sales price - unit variable cost = contribution margin.
29. Fish-n-Things, a retailer of aquarium fish and pond supplies, wants to determine its monthly
break-even point (in units) for a new line of tropical fish. The tropical fish sell for N6.00 each.
The unit contribution margin for the tropical fish is N3.20, and Fish-n Things’ monthly fixed
costs related to this line of tropical fish are N7,000. How many fish must Fish-n-Things sell to
break even on this new line of fish?
a. I need more information to be able to calculate Fish-n-Things’ break-even point.
b. 2,188 fish.
c. 2,500 fish.
d. 1,167 fish.
30. Using the information provided in Question above, calculate Fish-n-Things’ break-even point in
sales nairas.
a. I need more information to be able to calculate Fish-n-Things’ break-even point.
b. N15,000 in sales.
c. N7,000 in sales.
d. N13,125 in sales.
31. The relative combinations of products that make up total company sales is known as the:
a. contribution margin.
b. sales mix.
c. value chain.
d. cost-volume-profit ratio.
32. Manko Designs, a Web page design firm, has monthly fixed expenses of N10,000. Through
innovations in technology, Manko is able to reduce monthly fixed expenses to N8,800. This
decrease in fixed expenses causes Manko’s break-event point in nairas to:
a. decrease.
b. increase.
c. I need more information to be able to calculate Manko Design’s new break-even point in
nairas.
d. remain unchanged.
33. The variable-cost percentage plus the contribution margin percentage equals:
a. gross margin.
b. operating leverage.
c. sales revenue.
d. target net income.
34. The expense for merchandise that is manufactured or purchased for resale to customers is known
as the:
a. best cost structure.
b. cost of goods sold.
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c. variable cost.
d. gross cost.
35. For-profit businesses must include the effect of ……………… when calculating their break-even
points.
a. rising costs
b. cost drivers
c. the relevant range
d. income taxes
36. Part of the cost of producing a product are the amounts paid to purchase raw materials necessary
to make the product. These costs are examples of ………………… costs.
37. The span of activities within which relationships between costs and their drivers are deemed
logical is called the ………………...
38. Cost-volume-profit relationships can be graphed by plotting total expenses, fixed costs, and total
revenues at two different sales volumes and extending these lines to the x and y axes. The total
expenses line and total revenues line cross at the company’s …………………..
39. The change in totals -- such as revenues, expenses, or income -- due to a set of circumstances that
are different from known conditions is referred to as the …………………….
40. Operating leverage is an organization’s ratio of fixed costs to variable costs. A company that has
low fixed costs and high variable costs experiences ………….. variations in net income with each
additional product sold.
41. Organisations are broadly categorized into………….. and ……………. Organization for the
purpose of break-even analysis.
42. Contribution margin ratio is otherwise known as…………….. or…………………
43. The point at which cost equate revenue is known as………………………….
44. The three primary variables for break-even point analysis are (1)………………….,
(2)…………….. and (3)…………………………..
45. Fixed cost is only fixed within…………………………………….
46. The excess of sales over break even point is known as…………………………..
47. Cost volume profit analysis is mostly appropriated for ………………………………..
48. Break-even chart that make use of profit and loss axis as well as sales axis is known as …………
49. A company selling prices for products A, B and C are N25, N30 and N15, while variable cost per
unit are N15, N18 and N10 respectively. If proportion of sales is 40%, 35% and 25% respectively
and total fixed cost is N250,000. The break-even units for the company is …………….
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50. Using the data in question above, the break even value for the company is ……………..
51. A company profit after tax is N5,400,000, if rate of tax is 35%. The profit before tax will
be…………………..
52. …………. is a chart that can be used to determine either break-even units or break-even value but
not the two simultaneously.
53. …………. is a chart that can be used to determine the break-even volume and value
simultaneously.
54. One of the condition for break-even point analysis is that selling price must be constant, this may
not be realistic because of …………… and ……………………
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5 RELEVANT COSTING TECHNIQUE FOR SHORT-TERM OR ONE-OFF
DECISIONS
1. Relevant information for decision making:

a. can include sunk costs
b. usually includes historical costs
c. is incremental to the decision in hand
d. includes all of the above
2. Opportunity cost cannot be

a. the replacement cost of an item
b. the next best operating value of an item
c. the net realizable values of the item
d. the original cost of the item
3. For a cost or revenue to be relevant to a particular decision, the cost or revenue must:
a. differ between the alternatives being considered
b. be a past cost
c. be a future cost
d. a and b
e. a and c
4. Which of the following costs is not relevant for special decisions?

a. incremental costs
b. sunk costs
c. avoidable costs
d. all of the above costs are relevant for special decisions
5. A firm can continue to manufacture a component or buy the component from an outside supplier
and rent the firm’s unused manufacturing facilities to another company. If the firm continues to
manufacture the component instead of buying it from an outside supplier, the rent the firm could
receive for its manufacturing facilities is:
a. a sunk cost
b. an opportunity cost
c. an avoidable cost
6. If making a part in a make or buy decision requires the acquisition of machinery and equipment,
then:
a. it is a short-run decision and the time value of money does not need to be considered
b. it is an intermediate-run decision and the time value of money does not need to be
considered
c. it is a long-run decision and the time value of money should be considered
7. Qualitative factors that should be considered when evaluating a make or buy decision are:
a. the quality of the outside supplier’s product
b. can the outside supplier provide the needed qualities
c. can the outside supplier provide the product when it is needed
d. all of the above
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8. Which of the following is not a sunk cost?
a. depreciation on existing asset
b. acquisition cost of an asset purchased one year ago
c. disposal value of an existing asset
d. all of the above are sunk cost
9. Which of the following costs is not relevant to a special order decision?

a. the direct labour costs to manufacture the special order units
b. the variable manufacturing overhead incurred to manufacture the special order units
c. the portion of the cost of leasing the factory that is allocated to the special order
d. all of the above costs are relevant
10. Which of the following costs is not relevant to a make or buy decision?
a. N10,000 of direct labour used to manufacture the parts
b. N30,000 of depreciation on the equipment used to manufacture the parts
c. The supervisor’s salary of N25,000 that would be avoided if the part is purchased from an
outside supplier
d. N15,000 in rent from leasing the production space to another company if the part is
purchased from an outside supplier
e. All of the above costs are relevant to the decision
11. Which of the following costs is not relevant to a decision to sell a product at split-off or process
the product further and then sell the product?
a. joint costs allocated to the product
b. the selling price of the product at split-off
c. the additional processing costs after split-off
d. the selling price of the product after further processing
12. If there is excess capacity, the minimum acceptable price for a special order must cover:
a. variable costs associated with the special order.
b. Variable and fixed manufacturing costs associated with the special order
c. Variable and incremental fixed costs associated with the special order
d. Variable costs and incremental fixed costs associated with the special order plus the
contribution margin usually earned on regular units.
13. If the firm is at full capacity, the minimum special order price must cover:
a. variable costs associated with the special order
b. variable and fixed manufacturing costs associated with the special order
c. variable and incremental fixed costs associated with the special order
d. variable costs and incremental fixed costs associated with the special order plus forgone
contribution margin on regular units not produced.
14. When there is one scarce resources, the product that should be produced first is the product:
a. with the highest contribution margin per unit of the scarce resource
b. with the highest sales price per unit of scarce resource
c. with the highest demand
d. with the highest contribution margin per unit
15. A joint product should be processed beyond split-off if:
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a. additional revenue from further processing exceeds joint costs
b. additional revenue from further processing exceeds allocated joint costs
c. additional revenue from further processing exceeds allocated joint costs and additional
costs of further processing
d. additional revenue from further processing exceeds additional costs of further processing
16. A segment should be kept if:

a. segment revenues exceed segment variable costs
b. segment revenues exceed segment variable costs and fixed costs
c. the segment’s revenues exceeds avoidable costs associated with the segment
d. segment operating profit is positive
Use the following information to answer questions 17 and 18
FB Limited manufactures 20,000 components per year. The manufacturing costs of the
components was determined as follows:
N
Variable manufacturing overhead 60,000
Fixed manufacturing overhead 80,000
Total 400,000
An outside supplier has offered to sell the component for N17.
17. If FB Limited purchases the component from the outside supplier, the effect on income would be:
a. a N60,000 increase
b. a N60,000 decrease
c. a N20,000 increase
d. a N20,000 decrease
18. Assume FB could rent their unused manufacturing facilities for N10,000 if they purchase the
component from the outside supplier. If FB purchases the component from the supplier instead of
manufacturing it, the effect on income would be:
c. a N10,000 decrease
d. a N30,000 increase
AB Company manufactures a product with the following costs per unit at the expected production
of 30,000 units
N
Direct materials 4
Direct labour 12
Variable manufacturing overhead 6
Fixed manufacturing overhead 8
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The company has the capacity to produce 40,000 units. The product regularly sells for N40. A
wholesaler has offered to pay N32 for 2,000 units.
19. If the special order is accepted, the effect on operating income would be:
c. a N4,000 increase
20. If the firm is at capacity and the special order is accepted, the effect on operating income would
be:
a. N0
b. a N20,000 increase
c. a N16,000 decrease
d. a N4,000 increase
21. A cost appropriate to a specific management decision is called:

a. a relevant cost
b. a sunk cost
c. a marginal cost
d. an opportunity cost
22. The value of the benefit sacrificed when one course of action is chosen in preference to an
alternative is called
a. a relevant cost
b. a sunk cost
c. a marginal cost
d. an opportunity cost
23. Which of the following cost would be used in cost plus pricing?
a. marginal cost only
b. full cost only
c. ABC cost only
d. All three of the above
24. A product estimate derived from subtracting a desired profit margin from a competitive market
price is called a:
a. shadow cost
b. target cost
c. marginal cost
d. joint cost
25. Which of the following is likely to exhibit a kinked demand curve?

a. perfect competition
b. imperfect competition
c. monopoly
d. oligopoly
26. The most relevant costs to be used in decision-making are:

a. costs already incurred which are known with certainty
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b. current costs
c. estimated future costs
d. notional costs
27. A sunk cost is:

a. a cost committed to be spent in the current period
b. a cost that is irrelevant for decision-making
c. the lower of step costs
d. a cost unaffected by fluctuations in the level of activity
28. A firm has some materials that originally cost N45,000. It has a scrap value of N12,500 but if
reworked at a cost of N7,500, it could be sold for N17,500. What would be the incremental effect
of reworking and selling the material?
a. a loss of N27,500
b. a loss of N2,500
c. a profit of N5,000
d. a profit of N10,000
29. An example of discretionary costs is

a. raw material purchases
b. charitable donations
c. head office salaries
d. distribution costs
30. In decision making , cost which need to be considered are said to be relevant costs. Which of the
following is characteristic associated with relevant costs?
a. joint costs
b. unavoidable costs
c. common costs
d. differential costs
31. Predicted future cost and revenue data that will differ among alternative courses of action is
known as
a. relevant information.
b. direct information.
c. marginal costs.
d. incremental costs.
32. A decision model is a

a. method of internal reporting that emphasizes the distinction between variable and fixed
costs.
b. hierarchical diagram showing the functional reporting relationships in a company.
c. method used to make choices.
33. Da-Glo Industries has the opportunity to accept or reject a customer’s special order. This order
will not affect any of Da-Glo’s short-run activities. Da-Glo would incur total variable costs per
unit of N10. Under absorption-costing, Da-Glo’s total manufacturing costs per unit are N14. Da-
Glo Industries should accept the customer’s special order as long as the customer is willing to pay
__________ per unit.
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a. more than N14
b. at least N10 but less than N14
c. less than N10
d. more than N10
34. Fixed expenses that will not continue if an activity, department, or business unit is abandoned are
referred to as
a. period costs.
b. committed costs.
c. step costs.
d. avoidable costs
35. Common costs are

a. manufacturing costs that are not easily associated with specific products.
b. facility or service costs that are shared by activities, departments, or business units.
c. variable costs related to sales and marketing activities.
d. the costs to convert raw materials into finished goods.
36. The goal in deciding whether to add or drop products, services, or departments is to obtain the
greatest
a. reduction in total costs.
b. contribution possible to cover unavoidable costs.
c. increase in sales revenues.
37. The number of times the average inventory is sold per year is called the
a. inventory turnover.
b. cost of goods sold.
c. inventory target.
c. contribution margin.
38. The condition that exists when all competitors sell the same product at the same price is known as
a. imperfect competition
b. perfect competition.
c. price elasticity.
d. predatory pricing.
39. As long as its marginal cost is lower than its marginal revenue, a company should
a. suspend additional production and sales activities.
b. perform a cost-benefit balance analysis before producing and selling additional products.
c. engage in additional production and sales activities.
d. examine cost behaviors and develop a cost function to measure the cost of future
production.
40. Badco, a clothing wholesaler, decides it will charge higher prices to smaller, independent clothing
retailers because of the nuisance involved in dealing with them. Badco is engaging in
a. discriminatory pricing.
b. predatory pricing.
c. marginal pricing.
d. contribution pricing.
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41. Tiger Products sells a toy for N14.95. Its cost to produce the toy is N8.15. The N6.80 difference
is Tiger’s
a. net income.
b. markup.
c. cost of goods sold.
d. marginal revenue.
42. The cost-plus pricing formula that takes into consideration all costs -- fixed, variable, and
manufacturing, as well as selling and administrative costs -- is called the percentage of
a. full costs.
b. variable manufacturing costs.
c. total variable costs.
d. absorption costs.
43. Opportunity cost is the

a. cash outlay required to do something.
b. difference in total costs between the alternatives.
c. maximum available contribution to profit that is given up when using limited resources
for another purpose.
d. fixed cost avoided when a product, department, or business unit is abandoned.
44. Brian Roberts wants to participate in his college’s culture travel program to Peru next summer.
There is no cost to Brian for this program; he will receive a N4,000 scholarship to cover the
program’s travel and tuition fees. Alternatively, Brian could spend the summer working at his
uncle’s law firm and earn N3,500. The opportunity cost of participating in the college’s culture
travel program is
a. N500.
b. N3,500.
c. zero.
45. Using opportunity cost to analyze the income effects of a given alternative is referred to as
a. engineering analysis.
b. mixed-cost analysis.
c. account analysis.
d. differential analysis.
46. Incremental costs are the same as

a. differential costs.
b. alternative costs.
c. marginal costs.
d. outlay costs.
47. Hamilton Company is faced with a make-or-buy decision. Hamilton should agree to buy the part
from a supplier provided the price is less than Hamilton’s
a. total costs.
b. variable production costs plus avoidable fixed production costs.
c. total manufacturing costs.
d. variable costs.
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48. Green Giant Foods has some excess manufacturing capacity that it can leave idle, use to produce
its own boxes for frozen foods, or use to process another company’s frozen foods. It will be more
profitable for Green Giant to process the competitor’s frozen foods as long as the net cost is
a. greater than both the cost to buy the boxes and the cost to leave the plant idle.
b. less than the cost to leave the plant idle and greater than the cost to buy the boxes.
c. greater than the cost to leave the plant idle and lower than the cost to buy boxes from a
supplier.
d. less than both the cost to leave the plant idle and the cost to make or buy the boxes.
49. Two or more manufactured products that have significant sales values and are not uniquely
identifiable as individual products until the split-off point are called
a. common products.
b. joint products.
c. co-mingled products.
d. cooperative products.
50. What are the manufacturing costs incurred beyond the split-off point called?
a. Separable costs.
b. Joint costs.
c. Severance costs.
d. Common costs.
51. Examples of irrelevant data for equipment replacement decisions include all of the following
except the
a. Irrelevant data is expected future data that will not differ between the alternatives.
b. loss on the sale of the old equipment.
c. cost of the new equipment.
d. cost of the old equipment.
52. The original cost of equipment less its accumulated depreciation is referred to as the equipment’s
a. disposal value.
b. book value.
c. depreciable value.
d. historical cost.
53. Unit costs can mislead decision makers. Which of the following situations dealing with unit costs
will result in a faulty analysis?
a. Unit costs used in make-or-buy decisions might include costs such as unavoidable fixed
costs.
b. Variable unit costs stay the same in the relevant range of 5,000 to 10,000 units of
production.
c. Total fixed costs stay the same as more units are produced within the relevant range.
54. Unit costs expressed on a volume basis will be …………… in actual practice if the unit costs
were based on production levels in excess of a company’s normal production volume.
a. higher
b. lower
c. the same
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d. I am unable to determine this without more information.
55. The role of the accountant in decision-making is to provide …………… information to the team
responsible for recommending a course of action to top management.
56. ……………… costs are the costs that continue even if an activity, department, or business unit is
discontinued.
57. Things that restrict or constrain production of goods or provision of services are referred to as
……………………..
58. When a company reduces prices to generate additional sales, the company operates in a market
where …………… exists.
59. ………………… is an inappropriate practice that sets selling prices below average variable costs,
causing the company to actually lose money on sales.
60. The typical cost recorded by accountants is the ………………. cost.
61. An important step in make-or-buy decisions is identifying the …………….. to make the part or
subassembly.
62. The …………………. is that place in the manufacturing process where joint products become
individually identifiable.
63. ………………….. is the periodic cost of equipment, which is charged to future periods in which
the equipment is expected to be used.
64. Sunk costs are …………………… to the decision making process.
65. ……………. is the extra contribution derivable from a unit increase of a binding constraint.
66. --------------- is the benefit forgone on one alternative because of accepting another alternative,
which must be included as part relevant cost of alternative accepted.
67. -------------- is an expected cost, which will no longer be necessary if the alternative under
consideration is accepted.
68. ------------- is an area in the graph that obey all the inequality signs of the constraint equations.
69. The computation of net benefit or loss from alternative under consideration, using marginal
costing technique is referred to as…………………………………….
70. The other non-quantifiable factors to be considered in decision making is often refers to as
………………….
71. If all resources available are fully utilized at the optimum level of production, such constraint is
said to be………………………….
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72. ------------------- is good for setting prices in a situation where we are considering special
assignment different from routine task.
73. …………………….. is used to recommend optimum production mix when there are two or more
constraints.
74. -------------------- can only accommodate problems involving two variables with any number of
constraints in the determination of product optimum mix.
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6. LEARNING CURVE THEORY
1. Learning curve theory is specifically designed to assist in the estimation of a realistic:

a. machine hours
b. labour hours
c. labour costs
d. b and c above
e. all of the above
2. Learning curve can be experienced in one or more of the following organization

a. Construction industries
b. Manufacturing industries
c. Agricultural industries
d. All of the above
e. None of the above
3. Example of organization that can not experience learning curve theory is

a. banking industries
b. Auditing firms
c. Aviation industries
d. Service industries
4. One or more of the following cost will be affected by learning curve if computation is based on
labour hour
a. material cost
b. variable overhead
c. fixed overhead
d. all of the above
e. b and c above
5. For an organization to experience learning curve, the following condition must exits, except.
a. labour rotation and labour turnover
b. repetitive performance of task
c. labour intensive task
d. continuous production/servicing
e. all of the above
6. One or more of the following are the factors hindering the application of learning curve.
a. inability to obtain enough and accurate data
b. inability to establish the factor that motivate labours
c. Payment of incentives for improved performance
d. All of the above
7. Learning curve theory is useful for

a. production planning, scheduling and preparation of labour budgets
b. preparation of realistic standards to be used in standard costing technique
c. bidding for a competitive contracts
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d. Pricing strategy, especially in a competitive market
e. All of the above
8. The equation Y= axb of learning curve, letter ‘Y’ is defined as………………
9. The equation Y= axb of learning curve, letter ‘a’ is defined as………………
10. The equation Y= axb of learning curve, letter ‘x’ is defined as………………
11. The equation Y= axb of learning curve, letter ‘b’ is defined as………………
12. Applying learning curve theory, tabular method can only be used to determine average hours in a
situation where subsequent activities ………………… earlier activities
A company estimates that the average hour of producing 2,000 units of its product to be 50 hours
per unit, with a learning curve of 80%
13. The cumulative hour of producing the 2,000 units is………………………..
14. The average hours of producing 3,000 units of the company’s product will be………….
15. The cumulative hour of producing 4,000 units is……………………..
16. The extra hours for the additional 4,000 units after the initial production of 4,000 units is
……………..
17. Learning curve theory expect the …………………… to reduce as activity increases
18. …………………… is the factor that hinders 100% labour intensive task.
19. Material cost can be influenced by the knowledge of learning curve because of the expected
reduction in …………… and ………………..
20. Selling price will be affected by learning curve theory if computation is based
on…………………..
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7. CAPITAL BUDGETING DECISION
1. A project has an IRR of 13% and the firm’s cost of capital is 15%. At the cost of capital the NPV
will be:
a. positive
b. zero
c. negative
d. equal to the IRR
2. The discounting rate at which present value of inflows equate that of outflow is known as:
a. NPV
b. DPBP
c. PBP
d. IRR
3. Another version of return on investment used in the determination of the viability or otherwise of
a project is known as
a. NPV
b. IRR
c. ARR
d. PBP
4. The method of investment appraisal that determine how far it will take to realize back the initial
outlay on a project is known as
a. NPV
b. IRR
c. ARR
d. PBP
5. Which of the following method make use of accounting profit

a. NPV
b. IRR
c. ARR
d. PBP
Use the following to answer questions 6 and 7
A firm with a cost of capital of 12% is considering project with the following cash flows:
0 1 2 3 4
-5,000 +2,500 +2,000 +2,000 +1,500
6. What is the NPV of the project?

a. N6,204
b. N1,204
c. N3,896
d. N5,000
7. What is the project’s IRR? (nearest %)

a. 15%
b. 28%
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c. 12%
d. 24%
8. Which of the following methods is a measure of liquidity and not a measure of profitability?
a. PBP
b. ARR
c. IRR
d. NPV
9. If the annual cash flows are not an annuity, payback is calculated by:
a. dividing the investment required by the average annual cash inflow
b. dividing the average annual cash inflow by the investment required
c. cumulating the net cash flow until they equal the initial investment
d. payback cannot be calculated for a project with unequal cash flows
Use the following to answer question 10 and 11
Project A Project B
N N
Year 1 10,000 30,000
Year 2 20,000 20,000
Year 3 30,000 10,000
Each project requires an investment of N25,000 and the same discounting rate to be used.
10. Which project will have the higher net present value?
a. Project A
b. Project B
c. Project A and Project B will have the same net present value
d. It is not possible to answer the question based upon the information provided
11. Using discounted payback period, which of the project will be first to repay back
a. Project A
b. Project B
c. Both will repay simultaneously
d. It is not possible to answer the question based upon the information provided
12. A Firm is evaluating a project that has a net present value of N0 when a discount rate of 10% is
used. A discount rate of 12% will result in:
a. a negative net present value
b. a positive net present value
c. a net present value of N0
d. The question cannot be answered based upon the information provided
13. Negative net present value implies that

a. present value of inflow is higher that outflow
b. present value of outflow is higher that inflow
c. the discounting factor is higher
d. the discounting factor is lower
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14. A firm is evaluating a project that has a net present value of N0 when a discount rate of 10% is
used. A discount rate of 8% will result in:
a. a negative net present value
b. a positive net present value
c. a net present value of N0
d. the question cannot be answered based upon the information provided
15. Firms may select projects with short paybacks because:

a. projects with longer paybacks may be riskier
b. shorter payback may help reduced liquidity problems
c. if the risk of obsolescence is high, the firm may want to recover the funds rapidly
d. all of the above
16. Investor favour more the net present value approach to investment appraisal because of the
following except
a. it considered the expected return on capital
b. It shows addition or reduction to wealth
c. It involves rigorous computation
d. It take into consideration time value of fund
17. Positive net present value represent

a. unrealized capital gain
b. realized capital gain
c. addition to capital
d. reduction from capital
18. The cost of equity capital for the Franklin Company is 10% and the cost of debt is 8%. Seventy
percent of its capital is in the form of common stock and the other thirty percent consists of debt.
The weighted average cost of capital would be:
a. 8.6%
b. 9.0%
c. 9.4%
d. 12.6%
19. A firm is considering a project requiring an investment of N100,000. The project would generate
annual cash inflows of N28,000 per year for the next 5 years. The approximate internal rate of
return for the project would be:
a. 9%
b. 13%
c. 15%
d. 28%
20. A firm is considering a project with annual flows of N50,000. The project would have a 7 year
life and the company uses a discount rate of 10%. What is the maximum amount the company
could invest in the project and the project still be acceptable?
a. N179,550
b. N243,400
c. N350,000
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21. A car with 20% rate would be classified for tax purposes as:
a. 3 year property
b. 5 year property
c. 7 year property
d. 10 year property
22. A pickup truck with 20% would be classified for tax purposes as:
a. 3 year property
b. 5 year property
c. 7 year property
d. 10 year property
23. Most manufacturing equipment with 10% is classified for tax purposes as:
a. 3 year property
b. 5 year property
c. 7 year property
d. 10 year property
24. When an assets is sold, tax law provide for the computation of:
a. gain or loss on disposal
b. balancing allowance or balancing charges
c. balancing allowance only
d. balancing charge only
25. If an asset is sold for more than its tax written down value
a. a gain results and additional taxes are incurred
b. a gain and tax savings result
c. a loss results and additional taxes are incurred
d. a loss and tax savings result
26. If an asset is sold for less than its tax basis:

a. a gain results and additional taxes are incurred
b. a gain and tax savings result
c. a loss results and additional taxes are incurred
d. a loss and tax savings result
27. Which of the following statements is true regarding working capital?

a. increases in working capital can be excluded from the capital budgeting analysis of a
project because it does not affect taxable income
b. investments in working capital represent an opportunity cost to the firm
c. for capital budgeting purposes, increases in working capital are shown as cash inflow
when they occur
28. Capital budgeting techniques can reflect the effects of inflation by:
a. adjusting future cash flows for the expected effects of inflation
b. adjusting depreciation for inflation
c. adjusting the cost of the investment for inflation
d. all of the above
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29. Assuming there are no mutually exclusive projects and that partial investments are possible, if a
company uses capital rationing, the company will:
a. accept all projects with positive net present values
b. accept only the projects with the highest net present values
c. accept projects with the highest net present value per naira of investment
30. A project required N200,000 initial outlay with NPV of N40,500 for the five years. The
profitability index of the project is:
a. 1.2025
b. .2025
c. .2500
d. 1.2500
31. Using the data in question 30 above, the present value of cash inflow for the five years is:
a. N40,500
b. N240,500
c. N240,000
d. N200,000
32. Profit on disposal of fixed asset to a tax man, is known as:

a. Balancing allowance
b. Additional taxable profit
c. Balancing charge
d. Additional tax payable
33. If a company is in taxable position and incurred allowable expenses but there is no income from
which such costs can be deducted. Applying the rate of tax on this expenses will resulted to:
a. Tax savings
b. Tax payable
c. Tax liability
d. Deferred tax
34. A company will result to capital rationing:

a. when there are many projects with positive net present value
b. when the positive net present value of projects are not the same
c. when there are many profitable project but limited fund
d. when selecting among projects
35. The followings can be adduced for capital rationing except

a. restriction on lending
b. unwillingness to raise additional capital
c. lending institution unwillingness to lend
d. lack of profitable project
36. In a lease agreement the owner of the asset is known as:

a. lessor
b. lessee
c. lesser
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37. In a lease agreement, the user of the asset is known as:
a. lessor
b. lessee
c. lesser
38. The type of lease that exist for the useful life of an asset is known as:
a. finance lease
b. investment lease
c. capital lease
d. operating lease
39. In a lease or buy decision, the lease under consideration is

a. finance lease
b. investment lease
c. capital lease
d. operating lease
40. For the purpose of determining the optimum replacement period of an asset, assets are broadly
categorized into:
a. capital and revenue assets
b. long-term and short-term assets
c. long-life and short-life assets
d. Gradual and sudden failure assets
41. Common examples of sudden failure assets are as follows except

a. bulbs
b. furniture
c. components
d. sub-assembly items
42. For the purpose of replacement analysis depreciation cost is defined as:
a. The spreading of the historical cost of the asset over the life span
b. The spreading of the future cost of the asset over its life span.
c. The difference between the resale value of the asset at beginning and end of the year
d. All of the above
43. The methods of coping with risk and uncertainty inherent in project appraisal include:
a. Risk premium
b. Expected value
c. Decision tree
d. All the above
44. Which of the following is not a method of coping with risk and uncertainty
a. payback period
b. simulation technique
c. high and low method
d. Portfolio method
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45. A company is not certain about the expected sales for next month, the probability of sales being
20,000 is 40%, or 30,000 is 25% or 35,000 is 35%. The expected sales units for the company is:
a. 85,000 units
b. 35,000 units
c. 27,750 units
d. non of the above
46. Which of the following is not a benefit of performing post-implementation audits of capital
budgeting decisions?
a. Planners can identify where their estimates were incorrect
b. Planners will be more reluctant to inflate their estimates of benefits.
c. Planners will be encouraged to take on more risky investments.
d. Managers can identify and reward those who are good at making these types of decisions.
47. Present value is

a. the value of a future cash flow at time zero
b. the equal amount, received or paid at the end of each period for n periods.
c. The amount a that today’s investment will be after a stated number of periods at a stated
periodic rate of return.
d. The monetary value of the assets that the organization receives up selling a long-term
asset.
48. An annuity is
a. the value of a future cash flow at time zero
b. the equal amount, received or paid at the end of each period for n periods
c. the amount a that today’s investment will be after a stated number of periods at a stated
periodic rate of return.
d. The monetary value of the assets that the organization receives up selling a long-term
asset.
49. The taxes of an organization

a. affect lump-sum payments, but not annuities
b. are increased as a result of depreciation
c. are decreased as a result of depreciation
d. are payments of cash expense
50. The long-term planning process for making and financing investments that affect a company’s
financial results over a number of years is referred to as
a. capital budgeting.
b. strategic planning.
c. master budgeting.
d. long-range planning.
51. Net present value models incorporate which of the following items?
a. Only the time value of money.
b. Only expected cash inflows and outflows.
c. Only a minimum desired rate of return.
d. All of the above items are incorporated into net present value models.
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52. The time value of money tables (present-value tables) can be used to streamline the present value
calculations related to a project’s future cash flows. If the project’s future cash flows each period
are equal in dollar amount over the life of the project, you can use the …………… table to
quickly determine the present value of the cash stream.
a. present value of N1
b. nature of interest
c. present value of an ordinary annuity of N1
d. compound interest
53. The net present value (NPV) model can be used to evaluate and rank two or more proposed
projects. The approach that computes the total impact on cash flows for each option and then
converts these total cash flows to their present values is called the
a. differential approach.
b. incremental approach.
c. contribution approach.
d. total project approach.
54. Relevant cash flows for net present value (NPV) models include all of the following except
a. outflows to purchase new equipment.
b. depreciation expense on the newly acquired piece of equipment.
c. reductions in operating cash flows as a result of using the new equipment.
d. cash outflows related to purchasing additional inventories for another retail store.
55. Capital budgeting decisions must consider the effect of income taxes on the discounted cash
flows. Which tax rate should be used in discounted cash flow models?
a. Average tax rate.
b. Marginal income tax rate.
c. Proportional tax rate.
d. Direct tax rate.
56. Circle B, a chain of grocery stores, has N7,000,000 in pre-tax income. The company pays 15
percent tax on the first N50,000 of income, 30 percent tax on the next N285,000 of income, and
36 percent tax on the remainder. Circle B’s average tax rate is
a. 27 percent.
b. 33 percent.
c. 35.6 percent.
d. 36 percent.
57. Which of the following items is excluded from the computation of cash inflows and outflows
from a proposed project, but is included in the cash effects of income taxes related to the
proposed project?
a. Depreciation.
b. Purchase of inventories.
c. Future disposal value of the project.
d. Purchase and installation of equipment for the project.
58. The number of years over which an asset is depreciated for tax purposes is referred to as the
a. useful life.
b. recovery period.
c. residual period.
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d. expected life.
59. The decline in the purchasing power of the naira is called

a. depreciation.
b. risk.
c. inflation.
d. devaluation.
60. There are several capital budgeting decision models that do not use discounted cash flows. What
is the name of the simple technique that calculates the total time it will take to recover, using cash
inflows from operations, the amount of cash invested in a project?
a. Recovery period.
b. Payback model.
c. External rate of return.
d. Accounting rate of return.
61. A follow-up evaluation of a capital project is performed to see that investment expenditures are
proceeding on time and on budget, to compare actual cash flows with those originally predicted,
and to evaluate continuation of the project. This follow-up is called a
a. postaudit.
b. performance evaluation.
c. management audit.
d. project review.
62. ……………. models focus on cash flows and take into account the time value of money.
63. The ……………. is the minimum acceptable rate of return on a project. It generally is based on
the organization’s cost of capital.
64. The net present value model can be used to analyze two projects, or the choice between accepting
and not accepting a project. The approach that computes the differences in cash flows between
the options and then applies present value factors to the cash flows is referred to as the
……………. approach.
65. Depreciation deductions can have a significant effect on the cash flows associated with taxes
paid. Tax laws and regulations permit companies to depreciate property using a pattern that
charges a larger proportion of an asset’s cost to the earlier years and less to later years. This
pattern is called ……………… depreciation.
66. The earlier you can take tax depreciation on a project, the ……………. the present value of the
income tax savings.
67. Important attention is always given to investment decision because its

a. …………………………..
b. …………………………..
c. …………………………..
68. The four basic steps involved in capital budgeting are:

a. …………………………..
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b. …………………………..
c. …………………………..
d. …………………………..
69. An investment appraisal technique that determines how far it will take to realize back the initial
outlay on a project is known as………………………………….
70. Payback period make use of ………………………………………………………..
71. ………………………. is a traditional investment appraisal technique that does not take into
consideration all the project’s cash flow.
72. Average profit divided by average investment is used in measuring …………….…………
73. Initial Outlay plus scrap value divided by two will give …………………………………….
74. …………………………… is the only method that make use of accounting profit
75. Ignoring time value of money generally is the major weakness of ………………………
76. ………………………… is the only method of investment appraisal that is objective in nature or
in other words, will give a clear accept or reject rule.
77. If A company finance it project through borrowing the appropriate discounting rate will
be……………………………..
78. Year 0, in capital budgeting referred to……………………………………………
79. Internal rate of return is otherwise known as………………………………………….
80. Computation of internal rate of return involves two steps, these are ……………………. and
………………………………
81. The method of determining how long to realize initial outlay of a project when cost of capital is
applied is known as …….………………………………….
82. When finance constraint exists for more than one planning period or year, then there is
………………………..
83. Using capital rationing, cash flow required in the year of rationing is termed
……………………………………………….
84. When acceptance of a project denies accepting the other, such projects is normally referred to as
………………………………..
85. Projects that must be accepted or rejected together is referred to as ………………………..
86. Optimum allocation of fund can be done when the funding constraint persist for more than one
planning period or year, through the use of ……………………………………………..
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87. ………………………. is a rate that exclude necessary increase due to inflation
88. Money interest rate is otherwise known as ……………………. or …………………………
89. …………………… is cash collectible or payable now or in the future that considered expected
future increase due to inflation.
90. When the disposable value of asset is less than the tax written down value of the asset, tax man
will refer to the difference as ……………………………………………………….
91. When rate of tax is applied on balancing charge, the resulting figure is referred to
as…………………..
92. The two common types of lease are………………………… and ………………………………
93. In a lease or buy decision, there are two decisions in one. These are ………………………. And
……………………………………
94. In capital budgeting when cash inflow or outflow is expected at beginning of a year or in
advance, it is expected that such cash flow should be deferred to …………………………
95. After tax cost of borrowing is used for discounting when…………………………………
96. The acceptable discounting rate for lease option is ……………………………………….
97. The expected yearly costs of an assets is known as ……………………………………….
98. The quantifiable costs to take into consideration in replacement analysis of a sudden failure asset
are …………………………………….. and ………………………………………..
99. When an existing asset is replaced with a new asset having identical financial characteristics i.e.
same initial outlay, same annual cash flow, same life span etc. such is referred to as
……………………………………..
100. Replacement analysis will be qualified as replacement with discounting in a situation where
……………………. is given
101. …………………………. are assets that fail overtime, as the assets ages more costs are incurred
on maintenance.
102. ………….. occurs where it is not known what the future outcome will be, but where the various
possible outcomes may be expected with some degree of confidence from a knowledge of past or
existing events.
103. …………….. occurs where the future outcome cannot be predicted with any degree of
confidence from knowledge of past or existing events, to the level that probability estimates are
not available for possible outcome.
104. Triple assessment method believes in making three various projections normally refers to as
………………., …………………. and……………………….
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105. Probability theory is used to overcome the risk and uncertainty in investment proposals by
assigning ………………… to expected future investment variables
106. …………………………. is a pictorial or diagrammatic representation of various alternatives

associated with complex problem situation involving interrelated events.
107. ……………………. is used when a decision maker has no control or the decision maker cannot
influence the outcome of a decision.
108. ………….………… is used when a decision maker can control or can influence the various
alternatives or outcome of a decision.
109. Using decision tree to cope with risk and uncertainty, the optimal decision will be reached based
on the value of ……………………………………………………..
110. The idea of adding an extra discount rate to the basic cost of capital after due consideration of
project involved is known as …………………………………………….
111. When an investor diversifies into a collection of investment for the purpose of minimizing risk
and uncertainty the study is normally referred to as ……………………………………..
112. The analysis of changes in investment variables to establish to what extent a variable can change
before project turns unviable is known as ……………………………………
113. The expression of mathematical expectations of a further analysis of probability, which makes it
possible to establish the expected level of activity, cost of capital, cash inflow and outflow is
known as …………………………………..
114. The standard deviation of the probability distribution divided by its expected value will give
………………………………………………………………….
115. The measure of the deviation of each cash flows to the expected cash flow is known as
……………………………………………
116. ……………………… is a concept that expects generosity when forecasting future cash flow but
strictness in projection of future cash inflow.
117. A technique whereby the features of a problem to be studied are imitated is referred to as
…………………………………..
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8. INVENTORY CONTROL
1. The perpetual inventory system is
a. where the stock levels are checked on a continuous basis
b. where stocks are always available to meet production demands
c. where the different stock records are continually compared to ensure agreement
d. where the stock balance is shown after each movement.
Use the following to answer questions 2 to 4
Lead-term 6 – 8 weeks
Reorder quantity 2,000 units
Average demand 300 units per week
Maximum demand 430 units per week
Minimum demand 220 units per week
2. What is the level at which the material would be reordered?

a. 2,580
b. 2,810
c. 3,440
d. 2,400
3. What is the minimum stock level?

a. 1.340
b. 1,640
c. 1,080
d. 2,580
4. What is the maximum stock level

a. 5,440
b. 3,440
c. 4,120
d. 5,580
5. What is the EOQ when demand is 10,000 units per year, ordering costs are N100 and it costs N10
to keep an item in stock for a year?
a. 1,414
b. 447
c. 316
d. 10,000
6. The EOQ is the order quantity that:

a. minimizes the total of carrying costs and ordering costs
b. minimizes the total of carrying costs and stockout costs
c. minimizes the total of ordering costs and stoctout costs
d. minimizes carrying costs
7. Which of the following is not a relevant cost in determining the EOQ

a. the cost of insurance based on the average level of stocks
b. the opportunity cost of capital invested in stocks
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c. quantity discounts for purchases over specified quantities
d. the salary of the buyer
8. The first in first out materials pricing system charges issues at:
a. the price of the most recent batch in stock
b. the price of the first component used in the period
c. the average price of goods in stock.
d. The price of the oldest batch in stock
9. The last in first out system will

a. value stocks at current values
b. understate product costs in times of rising prices
c. tend to produce realistic product costs
d. make cost comparisons between jobs easier
10. Using the average price issuing system:

a. is more complicated than LIFO and FIFO
b. the issue price is recalculated after each receipt
c. is not recommended by the standard
d. exaggerates price fluctuations
11. If inventory consist of goods produced internally, the inventory-related costs are:
a. ordering and carrying costs
b. set-up costs and carrying costs
c. ordering and set-up costs
12. If inventory consists of goods purchased from an outside supplier, the inventory related costs are:
13. Which of the following is not considered a carrying cost?

a. insurance on the inventory
b. the opportunity cost of funds invested in inventory
c. storage costs
d. transportation costs
14. The objectives of JIT are achieved by:

a. controlling costs
b. improving delivery performance
c. improving quality
d. all of the above
15. The reorder point for inventory depends upon which of the following factors:
a. the economic order quantity
b. the lead time between placing an order and its availability for use
c. the rate of usage during lead time
d. b and c
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e. a to c
16. JIT purchasing is done using:

a. short-term contracts emphasizing price
b. long-term contracts based on quality, reliability, and price
c. short-term contracts based on quality, reliability, and price
d. inventory to hedge against stock outs price increases
17. With JIT manufacturing: finished goods inventories are:

a. kept high to avoid stockouts
b. held in various locations for faster delivery to customers
c. insignificant
d. kept high to let the company take advantage of volume discounts
18. Maximum stock level must be maintained because of the followings except?
a. Storage costs
b. Loss of goodwill
c. Cost of emergency ordering of stock
d. Idle time payment
19. Minimum stock level must be maintained in order to minimize:

a. storage costs
b. loss of goodwill
c. cost of emergency ordering of stock
d. idle time payment
20. The controllable costs when there is no purchase quantity discount are
21. More attention are given to inventory control of recent because it constitute
……………………………….
22. Maximum usage multiple by maximum delivery period will give …………………………….
23. If annual demand of inventory is divided by the economic order quantity, we will obtain
………………………
24. ………………………. will be reducing as ordering quantity is increasing
25. ……………………... will be increasing as ordering quantity is increasing
26. When there is no purchase quantity discount, the ordering quantity at which total annual carrying
and ordering costs is minimized is known as……………………………………
27. If inventory is sourced outside, the purchase cost is classified as uncontrollable when there is
no………………………………………………..
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28. The JIT purchases is designed in order to eradicated/minimized ……………………………..
29. ……………………. is the period of time between ordering (externally or internally) and
replenishment, i.e. when the goods are available for use.
30. …………………… is a stock allowance to cover errors in forecasting the lead time or the
demand during the lead time.
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9. PRICING DECISION
1. Product costing is mainly concerned with
a. finding the cost of sales and valuing stock
b. analyzing cost behaviour
c. finding the total of production overheads
d. controlling product costs
At 50,000 units of production , A company expects costs to be as follows

N
Depreciation of factory 50,000
Depreciation of production equipment 40,000
Production supervisor’s salary 24,000
Supplies 5,000
Indirect labour 30,000
Electricity 15,000
Assume all cost items are either strictly fixed or strictly variable.
2. The total cost of direct materials at 40,000 units would be:

a. N116,000
b. N168,000
c. N112,000
d. N140,000
3. The total cost of variable overhead at 40,000 units would be:

a. N40,000
b. N50,000
c. N60,000
d. N75,000
4. The total cost of fixed overhead at 40,000 units would be:

a. N91,200
b. N103,200
c. N114,000
d. N129,000

a. N4.80
b. N5.08
c. N5.80
d. N8.08

a. N8.65
b. N7.25
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c. N10.10
d. N8.85
7. Assume A Company expects to produce 24,000 units during the year, with a variable cost per unit
of N3.50. Recently, another company ask the company to produce a special order of 5,000 units. No
selling or administrative costs would be incurred as a result of the special order.
At the production levels above 28,000 units, the company must rent additional production
facilities at a cost of N4,000. The incremental costs associated with the special order
would be:
a. N17,500
b. N21,500
c. N26,250
d. N30,250
8. The minimum price per unit the company should charge for the special order is:
a. N6.50
b. N5.25
c. N4.30
d. N3.50
9. A company’s product cost N150 per unit, if cost plus 20% mark-up is used, the selling price per
unit will be:
a. N187.50
b. N180
c. N170
d. N190
10. A company’s product cost N150 per unit, expected margin on sales is 20%, the selling price per
unit will be:
a. N187.50
b. N180
c. N170
d. N190
FB Ventures budgeted fixed overhead is N100,000 and expected to produced 10,000 units of its
product, estimated labour hours for this level is 20,000 while 25,000 machine hours is budgeted.
Other data about the product are as follows:
Variable production cost per unit N25

Expected profit on cost 25%
11. The average cost per product, if fixed overhead is absorbed based on production units is:
a. N43.75
b. N30
c. N35
d. N37.50
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12. The selling price per unit, if fixed overhead is absorbed based on production units will be:
a. N43.75
b. N30
c. N35
d. N37.50
13. The selling price per unit, if fixed overhead is absorbed based on labour hours is:
a. N43.75
b. N36.25
c. N35
d. N37.50
14. The selling price per unit, if fixed overhead is absorbed based on machine hours will be:
a. N43.75
b. N36.25
c. N35
d. N37.50
15. The data as above, but you are now informed that the expected margin on sale is 20% and fixed
overhead is absorbed based on units produced, the selling price per unit will be:
a. N42
b. N43.75
c. N37.50
AB Ventures has the following data in respect of one of its product
Variable costs per unit N20

Total fixed overhead N1,000,000
Expected production 100,000
Working capital employed per unit N10
Capital employed on fixed assets N1,500,000
Expected return on capital employed 20%
16. The expected return per unit is

a. N2
b. N3
c. N5
d. N4
17. The expected selling price per unit will be:

a. N30
b. N35
c. N20
d. N27.50
18. The selling price if actual volume is 80,000 units and other variable remained the same
a. N38.65
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b. N38.55
c. N38.75
d. N38.25
Use the following data to answer questions 19 and 20
You are presented with the following data for your company’s product
Variable cost per unit N40

Total fixed overhead N400,000
Units produced 40,000
Total labour hours 80,000
Expected contribution per labour hour N10
19. The expected profit per unit of the product will be:
a. N20
b. N10
c. N30
d. N25
20. The selling price per unit of the product is:

a. N60
b. N50
c. N70
d. N65
21. Transfer pricing is otherwise known as …………………………………………………
22. The two cogent factors to be considered in determining appropriate selling price for external sales
are ……………………………. and ……………………………………
Use the following to answer question 23 to 25
In the cost equation TC = a + bQ
23. Letter ‘a’ is referred to as ………………………………………………………………..
24. Letter ‘b’ is referred to as ……………………………………………………………….
25. Letter ‘Q’ is referred to as ……………………………………………………………….
26. Using Economist approach to pricing, price is at the optimal when …… …… ………
………………………………………………….
27. Using economist approach to pricing, revenue is maximized when ……………………
28. The method of establishing selling price by adding a specific percentage to cost per unit is known
as ………………………………………………………….
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29. Selling the same product in different market at different prices is often referred to as
………………………………………………………..
30. Pricing goods or services at incremental or relevant costs is referred to as

………………………………
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10. PERFOMANCE EVALUATION AND TRANSFER PRICING
1. A cost center is
a. a unit of production in relation to which costs are ascertained
b. a location which is responsible for controlling direct costs
c. part of the overhead system by which costs are gathered together
d. any location or department, which incurs cost.
2. Which of the following is the classification of organizational structure:

a. centralized structure
b. decentralized structure
c. divisionalised structure
d. all of the above
3. A division, will mostly be:

a. profit center
b. revenue center
c. investment center
d. a and c above
e. a to c above
4. Decentralization occur when

a. the firm’s operations are located over a large geographic area to reduce risk
b. authority for important decisions is delegated to lower segments of the organization
c. important decisions are made at the upper levels and the lower levels of the
organization are responsible for implementing the decisions.
5. Advantages of decentralization include all of the following except:

a. divisional management is able to react to changing market conditions more rapidly
than top management
b. divisional management is a source of personnel for promotion to top management
positions
c. decentralization can motivate divisional managers
d. decentralization permits divisional management to concentrate on firm-wide
problems and long-range planning.
6. Types of responsibility centers include all of the following except:

a. profit center
b. contribution center
c. investment center
d. cost center
7. Cost centers can be best be evaluated using:

a. standard variable costing income statement
b. budgets and standard cost
c. return on investment
d. residual income
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8. In order to promote goal congruence an investment center is best evaluated using:
a. standard variable costing income statements
b. budgets and standard costs
d. residual income
9. Profit center can best be evaluated using:

a. contribution income statement
b. budgets and standard costs
d. residual income
10. The objective of a transfer pricing system should be to:

a. maximize the transfer price
b. minimize the transfer price
c. maintain goal congruence between the divisions and the entire firm
11. Residual income is calculated as:

a. contribution margin less a minimum required rate of return
b. controllable margin less fixed costs
c. divisional income less a minimum required rate of return
d. divisional income less allocated fixed costs
12. Return on investment can be broken into two components:

a. profit margin and asset turnover
b. contribution margin and asset turnover
c. segment margin and asset turnover
d. profit margin and inventory turnover
13. When evaluating manager performance, it is assumed that:

a. the managers will attempt to maximize the control measures used to evaluate their
performance
b. the managers will attempt to maximize firm income
c. the managers will attempt to maximize their respective divisions income
14. Goal congruence refers to:

a. the goals of the firm being consistent with goal of its customers
b. the goals of the suppliers being consistent with the goals of the firm
c. the goals of the individual investment centers being consistent with the goals of the
firm
15. Asset turnover focuses on:

a. how often the assets of the company are replaced
b. the ability of assets to generate revenues
c. the ability of assets to generate profit
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16. To generate profits a discount store relies upon:
a. a high turnover and low profit margin
b. a high profit margin and low turnover
c. a high turnover and a high profit margin
d. a low turnover and a low profit margin
17. Return on investment is more meaningful when compared with:

a. budgeted ROI for the division
b. performance in the past
c. costs accounted for
d. costs incurred by previous departments
18. Which of the following types of transfer prices do not encourage the selling division to be
efficient?
a. transfer prices based upon market prices
b. transfer prices based upon actual costs
c. transfer prices based upon standard costs
d. transfer prices based upon standard costs plus a mark-up for profit
19. In a decentralization firm, when a selling division has excess capacity, a natural bargaining range
exists. The floor of the natural bargaining range is:
a. the selling division’s variable costs
b. the buying division’s outside purchase price
c. the transfer price which results in a zero contribution margin on the goods for the
buying division
d. the lower of b and c
20. In a decentralized firm, when a selling division has excess capacity, a natural bargaining range
exists. The ceiling of the range is:
a. the selling division’s variable costs
b. the buying division’s outside purchase price
c. the transfer price which results in a zero contribution margin on the goods for the
buying division
d. the lower of b and c
FB Venture’s computer division results for the first year of operation is as follows
N
Revenues 60,000
Variable costs 15,000
Contribution 45,000
Fixed expenses 20,000
Segment Income 25,000
The divisional assets are N100,000. The firm’s minimum required rate of return is 20%.
21. Profit margin for the division would be:

a. 25%
b. 42%
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c. 60%
d. 75%
22. Asset turnover for the division would be:

a. 25%
b. 41.67%
c. 60%
d. 75%
23. Return on investment for the division would be:

a. 25%
b. 41.67%
c. 60%
d. 755
24. Residual income for the division would be:

a. N5,000
b. N25,000
c. N40,000
d. N45,000

Project Income Investment
N N
A 55,000 550,000
B 112,500 750,000
C 66,000 330,000
Assume the division’s current ROI is 20% and the firm’s minimum required rate of return is 10%
25. If you were the division’s manager and you were evaluated based on ROI, which of the projects
would you accepts?
a. A, B and C
b. B and C
c. B only
d. C only
26. If you were the division manager and you were evaluated based on residual income, which
projects would you accept?
a. A, B and C
b. B and C
c. B only
d. C only
27. If you were the president of the company and division managers were evaluated based on ROI,
which projects would you want the division manager to accept?
a. A, B and C
b. B and C
c. B only
d. C only
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Use the following information to answer questions 28 to 30
AB company has two divisions, the A division and the B division. Information about the product
on a per unit basis is as follows
Revenue N90
Variable manufacturing costs N40
Fixed manufacturing overhead N25
Expected sales in units 10,000 units
The A division can produce up to 12,000 components per year. The B division needs 800 units of
the component for a product it manufactures.
28. The floor of the natural bargaining range for transfer pricing would be:
a. N90
b. N65
c. N40
d. N25
29. The ceiling of the natural bargaining range for transfer pricing would be:
a. N90
b. N65
c. N40
d. N25
30. If the selling division did not have excess capacity, the minimum transfer price selling division
would be willing to accept would be:
a. N90
b. N65
c. N40
d. N25
Debola Company is a decentralized company that evaluates its divisions based on ROI. Division
R has the capacity to make 5,000 units of a product. Division R’s variable costs are N100 per
unit.
Division J can use the product as a component in one of its products. Division J would incur N50
of variable costs to convert the component into its own product which sells for N250.
31. Division R can sell all that it produces for N180 each. Division J needs 200 units. What is the
correct transfer price?
a. N150
b. N180
c. N210
d. N100
e. N200
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32. Assume Division R can sell 4,000 units at N210. Any excess capacity will be unused unless the
units are purchased by the J division which could use up to 200 units. The floor of the natural
bargaining range would be:
a. N150
b. N180
c. N210
d. N100
e. N200
33. Using the information from the previous question, the ceiling of the natural bargaining range
would be:
a. N150
b. N180
c. N210
d. N100
e. N200
34. One of the main reasons for adopting a decentralized organization in preference to a centralized
organization structure is the:
a. improved goal congruence between the divisional manager’s goals and the goals of the
organization
b. availability of less subjective measures of performance
c. improved communication of information among the organisation’s managers
d. rapid response of management to environmental changes.
35. A harmonized collection of techniques to gather and use information for planning, controlling,
motivating, and evaluating activities is called a(n)
a. cost accounting system.
b. accounting system.
c. management control system.
d. financial planning model.
36. Key success factors are specific actions that must be done well to direct the organization toward
its goals. Which of the following is an example of a key success factor for Tolu Company, a
furniture manufacturer?
a. Achieving a 12% average rate of return on investments.
b. Reducing annual employee turnover in the factory to less than three percent.
c. Improving customer service.
d. Installing cushions on wooden frames.
37. Santa Maria Memorial Hospital is divided into many different departments. The managers of
these individual departments make decisions and are held accountable for performance results.
These departments might also be referred to as
a. responsibility centers.
b. critical processes.
c. line departments.
d. staff departments.
38. Responsibility accounting is a system where

a. everyone in the organization is accountable for achieving corporate goals.
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b. lower-level managers are responsible for meeting specific objectives and reporting on
their results.
c. the accounting department is responsible for all cost accounting and financial reporting
activities.
d. critical processes and key success factors are the primary activities for which accounting
data is gathered.
39. The responsibility center in which a manager is responsible for sales and their related costs is
called a(n)
a. revenue center.
b. profit center.
c. investment center.
d. cost center.
40. National Firm Censor Board wants to develop a performance-measurement system that draws
attention to financial and non-financial measures. It plans to evaluate managers on their success
in achieving these measures. These measures will be diverse and represent a variety of
organizational goals. The board should use a
a. flexible-budgeting system.
b. master budget.
c. strategic plan.
d. balanced scorecard system.
41. Ramona Latkins, a server at La Primera Restaurant, takes personal pride and satisfaction in doing
her very best to provide customers with outstanding service. Likewise, the owners of La Primera
have identified this as one of several organizational goals for the restaurant. When the
organization and its and employees share the same goals, they are said to have
a. a long-range plan.
b. total quality management.
c. goal congruence.
d. participative management.
42. Robert Bryant, manager of a cost center, cannot take actions to reduce one of the costs in his
responsibility center. This cost is defined as a(n)
a. uncontrollable cost.
b. fixed cost.
c. variable cost.
d. unaccountable cost.
43. Business units for which separate measures of revenues and expenses are desirable are called
a. segments.
b. responsibility centers.
c. detachments.
d. divisions.
44. The effort to ensure that products and services meet customer expectations is called
a. managerial effort.
b. a management control system.
c. benchmarking.
d. quality control.
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45. Allied Controls wants to monitor daily quality data related to a specific manufacturing process for
a specific product. This data can be used to identify potential problems and adjust the process.
Production managers decide to use a quality control chart. This chart displays
a. variable costs for the process under study.
b. product or activity characteristics for the factor being monitored.
c. total daily production quantities.
46. VIOP is a manufacturer of audio speakers and other audio products. One process in crafting audio
speakers is to assemble various components inside speaker boxes. If VIOP sets a goal to reduce
the time it takes to perform this process, we might say VIOP is trying to reduce assembly
a. cycle time.
b. costs.
c. time-to-market.
d. expenses.
47. A Company’s delegation of management decision making to managers throughout the

organization is called
a. controllability.
b. decentralization.
c. commissioning.
d. responsibility accounting.
48. Segment autonomy is the

a. independence of each of the organization’s business units from one another and the
corporate entity.
b. same as a profit center.
c. same as an investment center.
d. delegation of decision-making power to the managers of each of an organization’s
business units.
49. Assume that Tropicana buys soft drinks for its employee cafeterias from Pepsi. Both companies
are PepsiCo business units. The amount Pepsi charges Tropicana for the soft drinks is called the
a. transfer price.
b. raw materials cost.
c. cost of goods sold.
d. reciprocal price.
50. An organizational unit in which the manager is responsible for generating revenues, planning and
controlling costs, and acquiring, disposing of, and using plant assets to earn the highest feasible
rate of return on the investment base is known as:
a. cost centers
b. investment centers
c. revenue centers
d. profit centers
51. Transfer pricing policies of multinational companies are governed by factors different from those
of domestic companies. These include
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a. a desire to increase worldwide income taxes.
b. the motivation to increase import duties and tariffs.
c. avoiding financial restrictions imposed by some governments.
d. all of the above are factors driving multinational company transfer pricing policies.
52. Managers at Racine Paper Products need to focus their effort in areas where performance is
measured and where performance affects the system of rewards. In order to promote this
behavior, executives at Racine Paper Products should develop ………… that encourage goal
congruence.
a. strategies
b. incentives
c. plans
d. controls
53. Identifying the performance measures and the rewards to be received for successful performance
uses an area of economic thought called agency theory. This theory suggests executives and
managers balance three elements when developing managerial reward systems. These three are
a. incentives, risks, and the costs to measure managerial performance.
b. cost of capital, return on the investment, and profit center performance.
c. controllability, management by objectives, and profitability measures.
d. degree of decentralization, cost center performance, and uncontrollable risks.
54. A business unit of Altus Oil and Refining earned income of N30,000,000. The investment used to
obtain this income was N120,000,000. Revenues for the business unit were N90,000,000. This
unit’s return on investment (ROI) was
a. 400 percent.
b. 75 percent.
c. 50 percent.
d. 25 percent.
55. The number of times each year invested capital is used to support sales revenue-generating
activities is known as the
a. return on investment.
b. return on sales.
c. capital turnover.
d. residual income.
56. Simplicity Company, a maker of sewing and quilting products, wants to expand its production
facilities. What the firm must pay to acquire this capital, whether or not it actually has to borrow
funds or issue stock to proceed with the expansion, is referred to as
a. interest.
b. financing fees.
c. cost of capital.
d. debt.
57. Possible definitions of invested capital include

a. only total assets.
b. long-term debt plus stockholders’ equity.
c. total stockholders’ equity.
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d. all of the above definitions are acceptable for profitability measures using invested
capital.
58. The manner in which assets are allocated affects invested capital of a corporation’s individual
business units (divisions). One important issue related to asset allocation decisions is the
measurement of the asset. One approach to asset measurement is to use the amount of the original
cost of an asset before deducting any accumulated depreciation. This is called
a. current value.
b. net book value.
c. gross book value.
d. replacement value.
59. Providing exceptional customer service is a goal of many retailers, including Office Max. The
company defines a series of related actions that directly impacts the way it serves it customers.
These actions are known collectively as a(n) ………………..
60. A(n) ……………….. center is a series of business activities that are evaluated on their ability to
generate revenues, reduce costs, and efficiently use the financial capital assigned to the center.
61. ………………., significant measures that drive the organization to achieve its goals, are shown
on a balanced scorecard.
62. Poor ……………. can result in large opportunity costs because of internal delays due to rework
and forgone sales.
63. A measure of outputs divided by inputs is referred to as ……………..
64. Top management’s decision to group together a series of departments as a cost center or a profit
center must take into consideration the desired impact on the manager’s ………………...
65. ……………….. are formal and informal rewards that encourage managers to achieve
organizational goals.
66. One measure of profitability is the ratio of income to sales revenue. This measure is referred to as
………………… .
67. It is important to select carefully those assets and their values to be used for calculations
involving invested capital. Assets included at ……………. are reported at their original cost
minus any accumulated depreciation.
68. Farmer Jon’s, a producer of meat products, has decided to use a management control system
whereby a manager and the manager’s superior create goals for the next accounting period and
plans to meet those goals. Farmer Jon’s is using ……………….
69. ……………… is segment that generate revenue with relatively little costs.
70. ……………… is segment that has control on acquisition and utilization of assets, as well as
revenue and costs.
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71. …………………….. a system of accounting that segregates revenue and costs into areas of
personal responsibilities in order to assess the performance attained by persons to whom authority
have been assigned
72. The performance of a divisional Manager can be measure through the use of:
a. ……………………………………….
b. ………………………………………
c. ………………………………………
d. ………………………………………
73. ……………………………… is the difference between the total returns on investment and the
imputed cost of capital of the organization.
74. …………………………. is the measure of the rate of efficiency by dividing the net profit with
the capital employed or total returns with total investment.
75. The characteristics of good performance evaluation techniques are:

a. …………………………………………………..
b. ………………………………………………….
c. …………………………………………………
d. ………………………………………………….
76. ……………………. objective believes that corporate objective must not be scarified for segment
objectives.
77. ……………….. is the value attached to goods and services exchanged between sister divisions
within the same organization.
78. From the company global perceptive any transfer price to be adopted must ensure
…………………………………………………
79. ……………………... is the exchange of goods and services at the prevailing market rate.
80. The method where the central management determines the appropriate value to transfer goods
and services among divisions is referred to as………………………………………
81. If a transfer division variable cost per unit is N50 and is transferring its product at this rate, it can
be said that the division is transferring at…………………………………………….
82. When both buying and selling division mutually resolved the price at which goods and services
will be exchanged, such is referred to as ………………………………………
83. Transfer pricing is otherwise known as………………………………………………………
84. The ideal transfer price that guarantee the objective of a good transfer price system is
…………………………………….
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11. STANDARD COSTING TECHNIQUE AND VARIANCE ANALYSIS
1. A standard hour
a. is one where operatives work for 60 minutes
b. is the number of hours worked above normal time
c. is a measure of work content
d. is any hour in which standard labour rates are paid.
2. The operating profit variance is:

a. the only variable not entered in a ledger account
b. the total of all the cost variances
c. always equal to the largest variance
d. is the figure required to make the ledger accounts balance
3. When standard process costing is used:

a. transfers out and WIP are valued at standard
b. effective units = completed + units in closing WIP – units in opening WIP
c. the total variances do not appear in the process account
d. all of the above apply
4. In the accounting for standard costing, the costs recorded in the factory overhead account:
a. must be at standard
b. may be at actual or standard
c. must be at actual
d. depend on whether there is over or under recovery
5. The use of standard costing in factories employing Advanced Manufacturing Technology

a. concentrates on a narrow range of financial factors
b. means that some variances have little or no control value
c. over-emphasises direct labour
d. has all the above features
6. Participation by staff in standard and budget setting

a. always improves performance
b. is liked by all staff
c. needs to be done selectively
d. can only be done when zero-based budgeting is used
7. Variances indicate:
a. the cause of the variance
b. who is responsible for the variance
c. that actual performance is not going according to plan
d. when the variance should be instigated
8. Which of the following may result in variances

a. price increases beyond the influence of management
b. random causes
c. the production process is out of control
d. all of the above
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9. The purchase of inferior direct materials at a lower price might affect which of the following
variances?
b. direct materials price variance
c. direct materials usage variance
d. direct labour rate variance
e. a and b
f. a and c
10. Efficiency variances focus on the difference between:

a. actual quantity used and standard quantity allowed for units produced
b. actual costs of inputs and standard costs of inputs
c. actual quantity used and standard quantity allowed for budgeted production
11. All of the following are true of currently attainable standards except:
a. currently attainable standards are based on an efficiency operating working force
b. currently attainable standards are based on ideal conditions
c. currently attainable standards allow for downtime and rest periods
d. currently attainable standards are based on present production processes and technology.
12. There is a direct relationship between inputs of which the following and the output of finished
product?
a. direct materials and variable overhead
b. direct labour and variable overhead
c. direct materials and direct labour
d. direct materials, direct labour and variable overhead
13. Using highly skilled direct labourers might affect which of the following variances?
a. direct materials usage variance
b. direct labour efficiency variance
c. variable manufacturing overhead efficiency variance
d. b and c
14. A five percent wage increase for all factory employees would affect which of the following
variances?
a. direct materials price variance
b. direct labour rate variance
c. direct labour efficiency variance
d. variable manufacturing overhead efficiency variance
15. If variable manufacturing overhead is applied based on direct labour hours and there is an
unfavourable direct labour efficiency variance
a. the direct materials usage variance will be unfavourable
b. the direct labour rate variance will be favourable
c. the variable manufacturing overhead efficiency variance will be unfavourable
d. the variable manufacturing overhead spending variance will be unfavourable
16. Standard costing can be used for:

a. external reporting
b. internal reporting
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c. internal and external reporting
d. neither internal nor external reporting
17. When preparing a flexible budget, costs must be classified as:

a. variable
b. fixed
c. variable or fixed
d. variable, fixed or mixed
18. The fixed manufacturing overhead rate should be determined:

a. at the beginning of each month
b. at the end of each month
c. at the beginning of each year
d. at the end of each year
19. Manufacturing overhead in a standard costing system is applied based on:

a. standard hours allowed for budgeted production
b. standard hours allowed for production achieved
c. actual hours work for production achieved
d. actual hours required to achieve budgeted production
20. The two variances for variable manufacturing overhead are:

a. spending and efficiency variance
b. spending and budget variances
c. budget and volume variances
d. budget and efficiency variances
21. The two variances for fixed manufacturing overhead are:

a. spending and efficiency variances
b. spending and budget variances
c. budget and volume variances
d. budget and efficiency variances
22. The fixed manufacturing overhead budget variance is calculated as the difference between:
a. actual fixed manufacturing overhead and fixed manufacturing overhead budgeted for the
budgeted production level
b. actual fixed manufacturing overhead and fixed manufacturing overhead budgeted for the
production level achieved
c. actual fixed manufacturing overhead and fixed manufacturing overhead applied
d. fixed manufacturing overhead budgeted for the production level achieved and fixed
manufacturing overhead applied
23. The volume variance provides information to management about:

a. utilization of plant facilities
b. cost control
c. performance evaluation purposes
d. all of the above
24. If a company produces fewer units than expected production, there will be:
a. a favourable budget variance
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b. an unfavourable spending variance
c. a favourable volume variance
d. an unfavourable volume variance
25. During December 5,000 pounds of raw materials were purchased at a cost of N1.20 per pound. If
there was a favourable direct materials price variance of N500 for December, the standard cost
per pound must be:
a. N1.10
b. N1.20
c. N1.30
26. During April, 10,000 units were produced. The standard quantity of material allowed per unit was
4 kgs at a standard cost of N6.00 per kg. If there was an unfavourable usage variance of N15,000
for April, the actual quantity of materials used must be:
a. 9,375 pounds
b. 10,625 pounds
c. 37,500 pounds
d. 42,500 pounds
27. During October, 20,000 direct labour hours were worked at a standard cost of N10 per hour. If the
direct materials rate variance for October was N8,000 unfavourable, the actual cost per direct
labour hour must be:
a. N10
b. N10.40
c. N9.60
FB Ventures has developed the following standards for one of their products:
Direct Materials: 15 kgs @ N8 per kg.

Direct labour 4 hours @ N12 per hour
Variable manufacturing overhead: 4 hours @ N7 per hour
The following activity occurred during the month of October:
Materials purchased: 10,000 kgs costing N85,000

Materials used: 7,200 kgs
Units produced: 500 units
Direct labour: 2,300 hours at N11.80 per hour
Actual variable manufacturing overhead: N15,000
The company records materials price variances at the time of purchase.
28. The variable standard cost per unit would be:

a. N76
b. N148
c. N168
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d. N196
29. The direct materials price variance would be:

a. N5,000 favourable
b. N5,000 unfavourable
c. N25,000 unfavourable
d. N25,000 favourable
30. The direct materials usage variance would be

c. N20,000 favourable
d. N20,000 unfavourable
31. The direct labour rate variance would be:

32. If actual fixed manufacturing overhead was N54,000 and there was a N1,300 unfavourable
budget variance and a N1,000 unfavourable volume variance, budgeted fixed manufacturing
overhead must have been:
a. N51,700
b. N52,700
c. N53,000
d. N55,300
e. N56,300
33. Fixed manufacturing overhead was budgeted at N400,000 and 25,000 direct labour hours were
budgeted. If the fixed overhead volume variance was N16,000 favourable and the fixed overhead
budget variance was N12,000 unfavourable, fixed manufacturing overhead applied must be:
a. N384,000
b. N388,000
c. N404,000
d. N412,000
e. N416,000
Budgeted fixed overhead for the year N600,000

Budgeted direct labour hours for the year 30,000
Actual fixed manufacturing overhead for August N48,000
Actual variable overhead for August N20,000
Direct labour hours worked in August 2,600
Standard variable overhead cost per direct labour hour N8
Budgeted fixed overhead for August N50,000
Standard direct labour hours allowed for August production 2,750
34. The standard rate for total manufacturing overhead is:
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a. N8
b. N20
c. N26
d. N28
35. The variable manufacturing overhead spending variance would be:

a. N400 favourable
b. N800 favourable
36. The variable manufacturing overhead efficiency variance would be:

a. N400 favourable
b. N800 favourable
37. The fixed manufacturing budget variance would be:

38. The fixed manufacturing volume variance would be

39. During December 6,000 kgs of raw materials were purchased at a cost of N8 per kg. If there was
an unfavourable direct materials price variance of N3,000 for December, the standard cost per kg
must be
a. N7.50
b. N8
c. N8.50
40. During December 40,000 units were produced. The standard quantity of material allowed per unit
was 2 kgs at a standard cost of N5. per kg. If there was a favourable usage variance of N20,000
for December, the actual quantity of materials used must have been:
a. 38,000 kgs
b. 42,000 kgs
c. 76,000 kgs
d. 84,000 kgs
41. The master budget variance is best expressed by which one of the following mathematical
expressions?
a. Master budget - actual results = master budget variance.
b. Flexible budget - actual results = master budget variance.
c. Master budget - activity based flexible budget = master budget variance.
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d. Quantity of inputs that should have been used - quantity of inputs that were actually used
= master budget variance.
42. Bolu Company’s actual expenses are less than its expected expenses. Bolu has a(n)
a. favorable expense variance.
b. unfavorable profit variance.
c. unfavorable income variance.
d. favorable revenue variance.
43. Activity-based flexible budgets are frequently prepared by companies that use
a. traditional, volume-based costing systems.
b. units of product as their cost driver.
c. multiple cost drivers to predict future costs.
44. Tireni Textiles frequently attains its production goals and sales targets. Tireni’s operations are
a. efficient.
b. profitable.
c. modern.
d. effective.
45. Selected information for Vee Manufacturing follows: budgeted sales in units, 12,000; actual sales
in units, 13,500; selling price per unit, N6.00; contribution margin per unit, N3.90. Vee’s sales-
activity variance is
a. N3,150 favorable.
c. 1,500 units favorable.
d. N9,000 favorable.
46. Currently attainable standards are performance levels that can be reached through realistic effort
levels. These standards allow for all of the following except
a. normal defects.
b. spoilage.
c. non-productive time.
d. Currently attainable standards allow for all of the above-described situations.
47. The cost most likely to be attained is called the

a. standard cost.
b. unit cost.
c. expected cost.
d. direct cost.
48. The difference between actual input prices and standard input prices multiplied by the actual
quantity of inputs used is referred to as the
a. usage variance.
b. unfavorable expense variance.
c. price variance.
d. activity-level variance.
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49. Price variances can be computed for direct labor hours. Pam’s Chocolates expects direct labor
costs to be N11.00 per hour. Actual labor costs for the month were N10.85 per hour. Pam’s used
2,500 direct labor hours for production activities this month. Given the quantity of chocolate
made, Pam’s workers should have spent 2,600 direct labor hours in production activities. Pam’s
direct-labor price variance is
a. N15 favorable.
b. N375 favorable.
d. N27,500 favorable.
50. Please refer to the information in Question above. Pam’s direct-labor usage variance for the
month is
a. N27,500 favorable.
c. N375 favorable.
d. N15 favorable.
51. The variable-overhead efficiency variance measures the difference between

a. actual and standard direct-labor hours multiplied by the standard variable-overhead rate.
b. actual variable-overhead costs and flexible budgeted variable-overhead costs.
c. flexible budget variable overhead costs and master budget variable-overhead costs.
52. Variances themselves do not explain why budgeted operating income was not achieved.
However, variances
a. must be studied, no matter how small.
b. can be safely ignored until a positive or negative trend begins to emerge.
c. both raise questions about and direct attention to potential problem areas.
d. should not be examined unless they exceed 30% of the expected cost or N50,000,
whichever is lower.
53. A(n) …………….. occurs when actual expenses exceed budgeted expenses.
54. Flexible-budget variances are the variances between the …………… and …………………..
55. The fewer inputs used to create outputs, the more …………………… the business activity.
56. Standard cost systems value products based on ………………………… .
57. The ……………… variance is the difference between the actual variable overhead and the
amount of variable overhead budgeted for the actual level of cost-driver activity (for example,
direct-labor hours).
58. …………………….. is a predetermined or forecast estimates of cost to manufacture a single unit,

or number of units of a product during a specific immediate future period.
59. ………………………….. is a type of standard that is based on best possible operating

conditions, that is no breakdowns, no material wastage, no stoppages or idle time, in short, perfect
efficiency.
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60. …………………………… is a type of standard that is based on efficient ( but not perfect)
operating conditions, which include allowances for normal material loses, realistic allowances for
normal material losses, realistic allowance for fatigue, machine break downs etc.
61. Variance analysis is designed primarily to assist managers in their …………………………
62. Variance analysis involved the comparism of ……………………………………………..
63. Sales margin volume variance can be further analyzed into ……………………… ……
……………………………………….
64. Material usage variance can be further analyzed into ……………………………………

………………………………………
65. Fixed overhead volume variance can further be broke down into ………………………….
………………………………………………………………..
66. The difference between standard direct material cost of actual production and actual cost of direct
material is known as ……………………………………………….
67. ………………………… is the difference between the standard quantity specified for the actual
production and the actual quantity used at standard purchase price
68. Idle time variance is always …………………………… variance
69. The measure of the difference between the standard output for a given level of input of material
and actual output attained is known as ………………………………………..
70. Further analysis of material price variance into error in budgeting and operational lapses is known
as ………………………………………….
71. The expression of standard hour allowed for production achieved as a percentage of actual hours
worked is known as ………………………………………………………………..
72. …………………………….. is the percentage of actual hours worked for the production attained
to the budgeted hours.
73. Unfavourable material price variance implies that ……………………………………….
74. Favourable labour efficiency variance implies that ……………………………………….
75. Addition of variable expenditure variance and variable efficiency variance will give …..
………………………………………
76. Error in budgeting in the further analysis of material price variance is often referred to as
……………………
77. Operation lapses in the further analysis of material price variance is referred to as …………
……………………
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12. BUDGETARY SYSTEM AND BUDGETARY CONTROL
1. In a budgeting system goal congruence is achieved when:

a. the actual expenditure equals the budget
b. the budgeted allowance is agreed by the manager
c. management by exception is practised
d. personal and organizational objectives coincide
2. The major difference between budgeting and standard costing is

a. budgeting is applicable to all entity while standard costing is for manufacturing concern
b. budgeting is commonly used while standard costing is rarely used
c. Budgeting is used to assist in planning while standard costing is used to assist in
controlling
d. Budgeting is on total per period while standard is per a given activity.
3. A flexible budget is:

a. the only suitable budget for control purposes
b. a budget analysed to fixed and variable elements
c. designed to show the appropriate expenditure for the actual production level
d. all of the above
4. The total budgeted expenditure for 17,000 units was N58,500 and for 17,500 units was N59,875.
This means that fixed costs were estimated to be:
a. N11,750
b. N1,375
c. N58,500
d. N23,500
5. A firm exactly met its budgeted output of 42,500 litres but the total expenditure of N196,200 was
N12,000 over the budget. Analysis showed that fixed costs of N35,500 were exactly as budgeted.
What was the budgeted variable cost per litre?
a. N0.83
b. N3.50
c. N4.62
d. N1.12
6. A budget is:
a. a planning tool
b. a control tool
c. a means of communicating goals to the firm’s divisions
d. all of the above
7. The first step in the budgeting process is the preparation of the:

a. production budget
b. sales budget
c. sales forecast
d. cash budget
8. Which of the following is usually prepared before the direct materials purchases budgets?
a. production budget
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b. cash budget
c. pro forma income statement
d. pro forma balance sheet
9. Financial budgeting refers to:

a. all budgets of the firm
b. budgets for cash flows
c. budget for sales
d. budgets for production
10. Capital budgeting refers to:

a. a budgeting for investments in building equipment
b. a budget for obtaining investments of capital in the firm
c. a budget for investments of short-term funds in the capital markets
11. Depreciation on the production equipment would appear in which of the following budgets?
a. cash budget
b. production budget
c. selling and administrative expenses budget
d. manufacturing overhead budget
12. Bad debt expense would appear in which of the following budgets?
a. cash budget
b. direct materials purchases budget
c. selling and administrative expenses
d. manufacturing overhead budget
13. A pro forma financial statement:

a. is a financial statement for past periods
b. is a projected or budgeted financial statement
c. is presented for the form but contains no naira amounts
14. An income statement prepared using the contribution margin format classifies costs by:
a. function
b. behaviour
c. amount
d. relevance
15. Zero-based budgeting requires managers to:

a. justify expenditures that are increased over the prior period’s budgeted amount
b. justify all expenditures, not just increases over last year’s amount
c. maintain a full-year budget intact at all times
d. maintain a budget with zero increases over the prior period
AB sells a product for N10. Budgeted sales for the first quarter of 2006 are as follows:
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Budgeted Sales (N)
January 400,000
February 600,000
March 700,000
The company collects 70% in the month of sale and 25% in the following month. 5% of all sales
are uncollectable and written off.
16. Budgeted cash receipts for February are:

a. N420,000
b. N520,000
c. N540,000
d. N600,000
17. Budgeted cash receipts for March are:

a. N640,000
b. N490,000
c. N670,000
d. N700,000
Budgeted purchases for the AB Company for the first quarter of 2006 are as follows:
Budgeted Purchases (N)

January 250,000
February 300,000
March 500,000
The Company pays for 40% of their purchases in the month of purchase and 60% in the following
month.
18. Budgeted cash payments on accounts payable for February are:

a. N120,000
b. N180,000
c. N270,000
d. N100,000
19. Budgeted cash payments on accounts payable for March are:

a. N200,000
b. N380,000
c. N500,000
d. N680,000
20. When preparing a production budget, the quantity to be produced equals:

a. sales quantity + opening inventory + closing inventory
b. sales quantity – opening inventory + closing inventory
c. sales quantity – opening inventory – closing inventory
d. sales quantity + opening inventory – closing inventory
21. Which of the following can be identified as purposes of budgeting?

(i). Communication
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(ii). Authorisation
(iii). Sales Maximisation
(iv). Co-ordination
a. (ii) and (iv) only
b. (i) and (ii) only
c. (i), (ii) and (iv) only
d. all of them
22. An incremental budgeting system is:

a. a system which budgets only for the extra costs associated with a particular plan
b. a system which budgets for the variable manufacturing costs only
c. a system which prepares budgets only after the manager responsible has justified the
continuation of the relevant activity
d. a system which prepares budgets by adjusting the previous year’s values by expected
changes in volumes of activity and price/inflation effects.
23. The purpose of a flexible budget is:

a. to cap discretionary expenditure
b. to produce a revised forecast by changing the original budget when actual costs are
known
c. to control resource efficiency
d. to communicate target activity levels within an organization by setting a budget in
advance of the period to which it relates
24. A fixed budget is:

a. a budget for a single level of activity
b. used when the mix of products is fixed in advance of the budget period
c. a budget which ignores inflation
d. an overhead cost budget
25. If a company review its budget by the end of first quarter by deleting the quarter ended and the
remainder of the year’s budget is revised in the light of changes that have occurred and a further
quarter is then added to make it a year budget. The budgeting system is known as:
a. periodic budgeting
b. quarterly budgeting
c. continuous budgeting
d. long range budgeting
26. The term ‘budget slack’ refers to the:

a. extended lead time between the preparation of the functional budgets and the master
budget
b. difference between the budgeted output and the breakeven output
c. additional capacity available which can be budgeted for
d. deliberate over-estimation of costs and under-estimation of revenues in a budget.
27. A master budget comprises:

a. the budgeted profit and loss account
b. the budgeted cash flow, budgeted profit and loss account and budgeted balance sheet
c. the budgeted cash flow
d. the capital expenditure budget
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28. When calculating the material purchases budget, the quantity to be purchased equals:
a. material usage + material closing stock – material opening stock
b. material usage – material closing stock + material opening stock
c. material usage – material closing stock – material opening stock
d. material usage + material closing stock + material opening stock
29. Which of the following is to be excluded from cash budget

a. Provisions for doubtful debts
b. Wages and salary
c. Depreciation
d. a and c above
30. The principal budget factor is the

a. factor which limits the activities of the organization and is often the starting point in
budget preparation.
b. Budgeted revenue expected in a forthcoming period
c. Main budget into which all subsidiary budgets are consolidated
d. Overestimation of revenue budgets and underestimation of cost budgets, which operates
as a safety factor against risk
31. Which of the following statements are true?

(i). A flexible budget can be used to control operational efficiency
(ii). Incremental budgeting can be defined as a system of budgetary planning and
control that measures the additional costs that are incurred when there are unplanned
extra units of activity.
(iii). Rolling budgets review and, if necessary, revise the budget for the next quarter
to ensure that budgets remain relevant for the remainder of the accounting period.
a. (i) and (ii) only
b. (ii) and (iii) only
c. (iii) only
d. (i) only
32. In the context of budget preparation the term ‘goal congruence’ is

a. the alignment of budgets with objectives using feed-forward control
b. the setting of a budget which does not include budget bias
c. the alignment of corporate objectives with the personal objectives of a manager
d. the use of aspiration levels to set efficiency targets
33. Which of the following definitions best describes ‘zero-based budgeting’?

a. a method of budgeting where an attempt is made to make the expenditure under each cost
heading as close to zero as possible
b. A method of budgeting whereby all activities are re-evaluated each time a budget is
formulated
c. A method of budgeting that recognizes the difference between the behaviour of fixed and
variable costs with respect to changes in output and the budget is designed to change
appropriately with such fluctuations
d. A method of budgeting where the sum of revenues and expenditures in each budget
center must equal zero.
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34. Which of the following statements about imposed budgets are correct?
(i). Imposed budgets are likely to set realistic targets because senior management
have the best idea of what is achievable in each part of the business.
(ii). Imposed budgets can be less effective than budgets set on a participative basis, because it
is difficult for an individual to be motivated to achieve targets set by someone else.
(iii). Imposed budgets are generally quicker to prepare and finalise than participative budgets.
a. (i) and (ii) only
b. (i) and (iii) only
c. (ii) and (iii) only
d. (iii) only
35. In the context of a balanced scorecard approach to the provision of management information,
which of the following measures might be appropriate for monitoring the innovation and learning
perspective?
(i). Training days per employee
(ii). Percentage of revenue generated by new products and services
(iii). Labour turnover rate
a. (i), (ii) and (iii)
b. (i) and (iii) only
c. (ii) only
d. (ii) and (iii) only
36. Managers use budgets to

a. understand and evaluate operations.
b. plan operations.
c. control operations.
d. do all of the above.
37. When budgets are used to monitor business activities,

a. managers know they are doing a good job of running the business if current period
revenues are greater than last year’s revenues for the same time period.
b. managers have no need to supervise their subordinates or visit work areas to personally
observe daily activities.
c. managers can identify potential problems early and take corrective action.
38. The type of budget that is most forward-looking and that sets the overall goals and objectives of
the organization is called a
a. strategic plan.
b. capital budget.
c. master budget.
d. continuous budget.
39. An operating budget would contain all of the following individual budgets except the
a. purchases budget.
b. cash budget.
c. sales budget.
d. operating expenses budget.
40. The financial budget is

a. the part of the master budget that focuses on operations.
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b. the part of the master budget that focuses on how business activities affect cash.
c. the same as the capital budget.
d. the same as the long-range planning budget.
41. Which set of steps best describes a logical order of activities in preparing a master budget?
a. Capital budgeting, sales budgeting, income statement budgeting.
b. Purchases budgeting, cash budgeting, sales budgeting.
c. Operating expense budgeting, sales budgeting, balance sheet budgeting.
d. Income statement budgeting, cash budgeting, balance sheet budgeting.
42. The budget of cash collections from customers includes which of the following?
a. Current month cash sales plus collections from previous months’ credit sales.
b. Current month cash and credit sales.
c. Previous months’ credit sales.
d. Current month cash and credit sales plus previous months’ credit sales.
43. The calculation for total purchases (reported on the purchases budget) uses all of the following
data except
a. beginning inventory
b. desired ending inventory.
c. cash disbursements for last month’s purchases.
d. budgeted cost of goods sold.
44. A prediction of sales activity under a specific set of conditions is referred to as a(n)
a. relevant range.
b. income statement.
c. sales forecast.
d. sales budget.
45. The tool that allows managers to assess various business alternatives before final decisions are
made is called a
a. sales mix.
b. cost-benefit balance.
c. financial planning model.
d. cost-volume-profit analysis.
46. ………………… managers might view budgets as the sum and substance of obstructive,
disapproving ………….. management attitudes.
a. Top, middle-level
b. Lower-level, top
c. Middle-level, lower-level
d. Lower-level, middle-level
47. Spreadsheet software can be used to make organizational

a. flowcharts.
b. financial planning models.
c. policy and procedure manuals.
d. accounting forms.
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48. Budgets help not only in planning and controlling, but also in …………….. employee
performance
49. ………… is the process of generating forecasted financial statements for five- to ten-year
periods.
50. The …………….. budget is the starting point for operating budget preparation.
51. ……………… is the systematic varying of budget data input to a financial planning model to
determine the effects of each change on the budget.
52. Financial planning models can be constructed using personal computer ……………………. .
53. …………………………….. emphasises the control of plans by comparing actual results against
planned to identify variances upon which corrective actions can take place.
54. …………………………….. is the formalized long-range planning process used to define and
achieve organizational goals or objectives.
55. The use of budget for blanket approval of expenditure for departmental manager is referred to as
………………………………………….
56. The body that co-ordinates, carry-out overall review of the budgetary system and decide any
arguments between managers of different budget center is known as …………………
57. …………………………… is the factor which restricts performance for a given period and
equally limit the other budgeting center.
58. …………………………….. is a booklet prepared describing the objectives and procedures

involved in the budgeting process and provide useful reference sources for budget preparation.
59. The budgetary system that places more emphasis or consideration on existing or already started
projects is known as ……………………………………………………………
60. ………………………….. is a budgetary system, which presents the purposes and objectives for
which funds are requested, the costs of the programme proposed for achieving these objectives
and quantitative data measuring the accomplishments and work performed under each program.
61. PPBS is budgetary improvement system with full meaning as………………………………
62. ………………………………… can be defined as continuous up-dating of short-term budget by

adding say, a further month or quarter and deducting the earliest month or quarter so that the
budget can reflect current conditions.
63. ……………………….. is a budgetary system where all budgetary items must be justified without
given undue importance to projects commenced in the last planning period.
64. Fixed budget is designed mainly to assist in …………………………………………..
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65. Flexible budget assist in ………………………………………………………………..
66. The individual or various budgets for the varied budgets centers is referred to as
……………………………………………..
67. The summary of all functional budgets into a budgeted profit and loss statement, balance sheet
and cash flow statement is known as ………………………………………………
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13. WORKING CAPITAL MANAGEMENT
1. Working capital management is designed to assist in

a. performance evaluation
b. cash management
c. liquidity management
d. Treasury management
2. Working capital is the difference between

a. fixed assets and current asset
b. current assets and current liabilities
c. Long-term and current liabilities
d. Long-term liabilities and fixed assets
3. Which of the following is not a current asset

a. inventories
b. receivables
c. payables
d. prepayments
4. All of the following are current liabilities except

a. Creditors
b. Payables
c. Prepayments
d. Loan due
5. Excessive working capital may lead to

b. operating inefficiencies
c. wastage of cash
d. operational lapses
e. financial mismanagement
6. Current assets are

a. assets acquired during the current period
b. assets that can be converted to cash
c. Cash and assets convertible to cash within the planned period
d. Cash and assets already converted to cash
7. Current liabilities are

a. trade creditors
b. payables
c. amounts due within the planned period
d. all of the above
8. The working capital ratio can be derived by

a. deducting current assets from current liabilities
b. dividing current asset by current liability
c. comparing current assets and current liability
d. all of the above
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9. Stock turnover ratio is obtained by:
a. Cost of sales divided by average turnover
b. Cost of sales divided by average stock
c. Cost of sales divided by opening stock
d. Cost of sales divided by closing stock
10. Debtor ratio is derived by:

a. total sales divided by average debtor into number of days per period
b. credit sales divided by average debtor into number of days per period
c. credit sales divided by closing debtor into number of days per period
d. credit sales divided by opening debtor into number of days per period
11. The following are some of inventory policies aimed at minimizing inventory cost except
a. Economic order quantity
b. Re-order level
c. Minimum cost
d. Maximum stock level
12. Costs of having debtors includes

a. opportunity costs
b. bad debts
c. increased interest on overdraft
d. all of the above
13. Debtors management polices includes the following, except:

a. imposing penalties for late payment
b. cash discount
c. unlimited credit levels
d. cash and carry
14. To maintain a good credit rating from suppliers, companies must

a. increase the ordering quantity
b. increase the re-order level
c. endeavor to pay bills before they fall due
d. buy goods on cash and carry only
15. Cash management includes

a. cash forecasting
b. balance management
c. internal control
d. all of the above
16. Prompt lodgment of cash as soon as received is essential part of:

a. cash forecasting
c. cash administration
d. internal control
17. Preparation of cash budget is essential part of:

a. cash forecasting
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c. cash administration
d. internal control
18. Sources of additional working capital include the following, except:

a. using existing cash reserves
b. increase profits (when you secure it as cash)
c. reducing payables
d. new equity from shareholders
19. Which of the following can be regarded as part of early warning of overtrading
a. pressure on existing cash
b. exceptional cash generating activities e.g. offering high discounts for early cash payment
c. bank overdraft exceeding authorized limit
d. all of the above
20. Un-necessary over age of debtor may be as a result of the following except:
a. weak credit judgment
b. poor collection procedures
c. lax enforcement of credit terms
d. customer satisfaction
The following is extracted from the book of FB Ventures

N
Capital 550,000
Fixed Assets (NBV) 850,000
Debtors 650,000
Stocks 400,000
Prepayments 150,000
Creditors 700,000
Long term loan 800,000
21. The total current assets of the company is

a. N1,050,000
b. N1,200,000
c. N1,500,000
d. N1,020,000
22. The working capital requirement of the company is

a. N350,000
b. N150,000
c. N500,000
d. N700,000
23. The total liabilities of the company is

a. N800,000
b. N700,000
c. N1,500,000
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d. N2,050,000
AB Ltd’s expected production of one of its product is 60,000 units, each unit will be sold for
N20 and there will be regular production sales cycle.
The expected ratios of cost to sales are:
Raw materials 60%
Direct wages 20%
Overheads 10%
Raw materials are expected to remain in stores for an average of three months before it is issued
to production
Each unit of production is expected to be in process for two months
Finished goods will stay in the warehouse awaiting dispatch customers for approximately four
months.
Credit allowed by creditors is three months from date of delivery of raw materials.
Credit given to debtors is three months from date of dispatch
24. Value of closing raw material

a. N720,000
b. N240,000
c. N180,000
d. N200,000
25. Value of closing work-in-progress

a. N180,000
b. N150,000
c. N240,000
d. N200,000
26. Value of closing finished goods

a. N360,000
b. N300,000
c. N280,000
d. N320,000
27. Value of closing creditors

a. N220,000
b. N180,000
c. N240,000
d. N200,000
28. Value of closing debtors

a. N300,000
b. N360,000
c. N320,000
d. N340,000
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29. What is the name of any event that affects a company’s financial position and requires recording
in the company’s collection of accounts?
a. Transaction.
b. Sale.
c. Liability.
d. Expense
30. A business owned by its stockholders and organized as a legal entity separate from its
stockholders is referred to as a(n)
a. partnership.
b. proprietorship.
c. corporation.
d. entrepreneurship.
31. The balance sheet equation is best represented by

a. assets = capital.
b. liabilities = assets + owners’ equity.
c. capital = assets + liabilities.
d. assets = liabilities + owners’ equity.
32. The portion of a corporation’s earnings that are reinvested in the corporation rather than returned
to stockholders is called
a. dividends.
b. retained income.
c. stockholders’ equity.
d. liabilities.
33. Sears is a retailer of clothing, hardware, consumer electronics, and home appliances. When Sears
sells merchandise to customers, the retailer recognizes increases in ………. and ……………….
a. expenses, liabilities
b. revenues, assets
c. equity, expenses
d. assets, liabilities
34. Data from which financial statement helps explain the changes between a company’s June 30,
2001, and June 30, 2002, balance sheets?
a. The income statement.
b. The bank reconciliation
c. The general ledger.
d. The journal.
35. Adjustments are necessary if financial statements are to more accurately reflect economic
performance and financial position. They are classified into four types. Which of the following is
not one of those classifications?
a. Expiration of prepaid expenses.
b. Accrual of unrecorded revenues and expenses.
c. Recognition of dividends paid to stockholders.
d. Recognition of unearned revenues.
36. Which of the following is a source document?
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a. Written instructions prepared by a sick teacher for his substitute teacher.
b. A timecard filled out by a substitute teacher.
c. A list of buses that will have their oil changed today by the school district’s vehicle
maintenance workers.
d. An employment contract signed today by a new teacher.
37. Southern Hospitality collects subscription revenues from customers in advance of providing the
magazine. Suppose you prepaid a two-year magazine subscription. What kind of adjusting entry
would the accountant at Southern Hospitality make at the end of each month?
a. Accrue unrecorded expenses.
b. Recognize prepaid expenses.
c. Accrue unrecorded revenues.
d. Recognize earned revenues.
38. One kind of adjusting entry allocates the cost of long-lived property, plant, and equipment across
the years for which these assets are expected to provide future benefit. This adjustment is known
as
a. depreciation.
b. asset expiration.
c. deferred revenue.
d. residual value accrual.
39. A company’s “net worth” is the same as its

a. market value.
b. current value.
c. total assets less total liabilities.
d. total liabilities plus total owners’ equity.
40. ……………. are economic resources owned by a company that are expected to benefit its future
business activities.
41. Amounts owed to vendors and suppliers for goods and services purchased to keep a business
operating are called ……………...
42. Monaco Court Chocolates records revenue when cash is received and expenses when cash is paid.
The company uses the ……………… basis of accounting.
43. Pelham Industries periodically distributes cash or other resources to its owners. The amount
distributed is usually based on its net income for the quarter (a consecutive 3-month period of
time). These distributions are referred to as …………………...
44. ……………………… is the rate allowed on sales to encourage early payment of cash.
45. …………………….. is the rate allowed on sales to encourage buying in large quantity.
46. …………………….. is the difference between resources in cash or readily convertible into cash
and organizational commitments for which cash will soon be required.
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47. ………………………are commitments, which will soon require cash settlement in the ordinary
course of business within the planned period.
48. The ratios used in managing working capital include ……………………., ……………………,
………………………., …………………. ……and ……………………………………
49. The ratio that measures credit purchases to the liability to creditors is known as ………
………………………………….
50. The ratio that measures the cost of sales to average stock held is referred to as ……………..
……………………………………….
51. The process of ordering material directly for production in other to minimize or eliminate
carrying cost is known as ……………………………………………………
52. The ordering quantity at which the controllable costs of inventory is minimized is known as
………………………………………….
53. The additional value to cash denied because the cash is held by debtors is known as ………
……………………………………….
54. The process of agreeing the cash book and bank balance is known as ………………………
55. The determination of the length of time it will take between expending and realization of cash is
known as …………………………………………………….
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SUGGESTED SOLUTIONS TO MULTIPLE & SHORT-ANSWER QUESTIONS
1. INTRODUCTION TO MANAGEMENT ACCOUNTING
1. d 2. b 3. c 4. d
5. d 6. d 7. d 8. d
9. c 10. c 11. d 12. c
13. d 14. e 15. d 16. e
17. b 18. c 19. b 20. a
21. e 22. b 23. e 24. a
25. d 26. c 27. d 28. a
29. a 30. c 31. b 32. b
33. d 34. d 35. a 36. e
37. d 38. b 39. a 40. c
41. b 42. b 43. a 44. e
45. An accounting system 46. budget
47. Management by exception 48. value chain
49. just in time 50. d
51. i 52. a 53. f 54. g
55. b 56. m and e 57. k and j 58. c
59. h 60. l 61. n 62. o and k
63. k 64. p
2. COST BEHAVIOUR AND COST ESTIMATION TECHNIQUE
1. c 2. a 3. a 4. d
5. a 6. c 7. b 8. a
9. d 10. c 11. d 12. a
13. c 14. b 15. e 16. d
17. d 18. b 19. b 20. d
21. a. 22. b 23. b 24. d
25. b 26. c 27. a 28. b
29. d 30. c 31. d 32. a
33. b 34. c 35. c 36. a
37. d 38. a 39. b 40. d
41. a 42. c 43. a 44. b
45. a 46. d 47. c 48. b
49. c. 50. variable 51. relevant range
52. break-even point 53. incremental effect
54. small 55. cost accounting
56. indirect 57. product
58. activity based 59. c 60. p
61. a 62. d 63. i 64. b
65. o 66. t 67. q 68. s
69. cost 70. cost pools
71. cost assignment
72. direct cost 73. indirect cost
74. cost allocation 75. allocation bases
76. direct materials 77. indirect materials
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78. direct labour 79. indirect labour
80. overhead, factory overhead 81. prime costs
82. conversion cost 83. relevant range
84. variable cost 85. fixed cost
86. mixed cost 87. step-fixed cost
88. unit cost or average cost 89. marginal cost
90. product costs 91. period costs
92. relevant costs 93. differential costs
94. opportunity costs 95. sunk costs
96. controllable costs 97. expenses
98. committed costs
3. COST ACCOUNTING SYSTEM & INCOME STATEMENTS
1. d 2. d 3. b 4. a
5. b 6. a 7. c 8. a
9. b 10. c 11. b 12. d
13. a 14. d 15. b 16. a
17. b 18. b 19. a 20. a
21. d 22. b 23. b 24. a
25. b 26. d 27. c 28. a
29. e 30. d 31. e 32. b
33. b 34. a 35. c 36. b
37. d 38. a 39. d 40. c
41. b 42. a 43. b 44. c
45. c 46. a. 47. absorption
48. gross profit 49. practical capacity
50. beginning and ending inventory units.
4. COST VOLUME PROFIT ANALYSIS
1. d 2. a 3. c 4. d
5. b 6. c 7. c 8. b
9. a 10. d 11. d 12. b
13. b 14. a 15. b 16. b
17. a 18. c 19. c 20. d
21. a 22. c 23. c 24. b
25. d 26. c 27. c 28. a
29. b 30. d 31. b 32. a
33. c 34. b 35. d 36. variable
37. relevant range 38. break-even point
39. incremental effect 40. small
41. single and multi-product 42. Profit volume/Contribution sales ratio
43. Break-even point 44. Selling price per unit,
Variable cost per unit and Total fixed costs
45. relevant range 46. Margin of safety
47. decision making 48. profit chart
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49. 26,455 units 50. N641,534
51 N8,307,692.21 52. profit chart
53. contribution chart 54. cash and quantity discount
5. RELEVANT COSTING TECHNIQUE FOR SHORT-TERM OR ONE-OFF

DECISIONS.
1. c 2. d 3. e 4. b
5. b 6. c 7. d 8. c
9. c 10. b 11. a 12. c
13. d 14. a 15. d 16. c
17. d 18. c 19. a 20. c
21. a 22. d 23. d 24. b
25. d 26. c 27. b 28. b
29. b 30. d 31. a 32. c
33. d 34. d 35. b 36. b
37. a 38. b 39. c 40. a
41. b 42. a 43. c 44. b
45. d 46. a 47. b 48. d
49. b 50. a 51. c 52. b
53. a 54. a 55. relevant
56. unavoidable 57. limiting factor (scarce resources)
58. imperfect competition 59. predatory pricing
60. outlay 61. additional costs
62. split-off point 63. depreciation
64. irrelevant 65 shadow price
66. opportunity costs 67. savings
68. feasible region 69. quantitative factor
70. qualitative factor 71. binding
72. marginal costing 73. linear programming
74. graphical method
6. LEARNING CURVE THEORY
1. d 2. d 3. e 4. e
5. a 6. d 7. e
8. Average hours for the batch
9. Average hours for the first batch
10. Cumulative activity in the batch/number of activity in the first batch
11. log. of learning curve/log.2
12. doubles 13. 100,000 hours
14 43.88 hours 15 160,000 hours
16. 96,000 hours 17. average hour
18. uses of machine 19. damage and wastage costs
20. average costs
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7. CAPITAL BUDGETING DECISION
1. c 2. d 3. c 4. d
5. c 6. b 7. d 8. a
9. c 10. b 11. b 12. a
13. b 14. b 15. d 16. c
17. a 18. c 19. b 20. b
21. b 22. b 23. d 24. b
25. a 26. d 27. b 28. a
29 c 30. b 31. b 32. c
33. a 34. c 35. d 36. a
37. b. 38. a 39. d 40. d
41. b 42. c 43. d 44. c
45. c 46. c 47. a 48. b
49. c 50. a 51. d 52. c
53. d 54. b 55. b 56. c
57. a 58. b 59. c 60. b
61. a 62. discounted cash flow
63. required rate of return 64. differential
65. accelerated 66. greater, larger
67. huge sum, long-term nature and irreversible
68. justification, authorization, control and follow-up
69. payback period 70. net cash flow
71. payback period 72. Accounting rate of return
73. average investment 74. accounting rate of return
75. traditional technique 76. net present value
77. cost of borrowing 78. immediate commitment
79. yield method 80. yield method Trial & Error and Interpolation
81. discounted payback period 82. multi-period capital rationing
83. initial outlay 84. mutually exclusive project
85. mutually dependent project 86. linear programming
87. real interest rate 88. nominal/market interest rate
89. money cash flow 90. balancing allowance
91. tax payable 92. operating/finance lease
93. capital budgeting and finance decisions
94. end of earlier year 95. projects financed by borrowing
96. cost of capital 97. Annual equivalent costs
98. replacement and purchase costs 99. identical replacement
100. cost of capital 101. gradual failure assets
102. risk 103. uncertainty
104. optimistic, most likely and pessimistic level
105. probability of occurrence 106. decision tree
107. chance node 108. decision node
109. decision nodes 110. risk premium
111. portfolio theory 112. sensitivity analysis
113. expected value 114. coefficient of variation
115. variance 116. conservative estimate
117. simulation technique
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8. INVENTORY CONTROL
1. a 2. c 3. a 4. c
5. b 6. a 7. d 8. d
9. c 10. b 11. b 12. a
13. d 14. d 15. d 16. b
17. c 18. a 19. a 20. a
21. major proportion of product cost 22. re-order level
23. number of orders 24. ordering cost
25. holding/carrying costs 26. economic order quantity
27. purchase quantity discount 28. holding/carrying costs
29. lead/procurement time 30. buffer stock
9. PRICING DECISION
1. a 2. c 3. a 4. c
5. d 6. a 7. b 8. c
9. b 10. a 11. c 12. a
13. a 14. a 15. b 16. c
17. b 18. d 19. a 20. a
21. internal pricing 22. quantitative and qualitative factor
23. fixed cost 24. variable cost
25. quantity 26. marginal cost equate marginal revenue
27. marginal revenue equal zero 28. cost plus mark-up
29. differential pricing 30. minimum pricing/special pricing
10. PERFORMANCE EVALUATION AND TRANSFER PRICING
1. c 2. d 3. e 4. b
5. a 6. b 7. b 8. d
9. a 10. c 11. c 12. a
13. a 14. c 15. b 16. a
17. b 18. b 19. a 20. d
21. b 22. c 23. a 24. a
25. d 26. b 27. b 28. c
29. a 30. a 31. b 32. d
33. c 34. d 35. c 36. d
37. a 38. b 39. b 40. d
41. c 42. a 43. a 44. d
45. b 46. a 47. b 48. d
49. a 50. b 51. c 52. b
53. a 54. d 55. c 56. c
57. d 58. c 59. critical process
60. investment 61. key 62. quality 63. productivity
64. behaviour 65. incentives 66. return on sales/income percentage of revenue
67. net book value 68. management by objective
69. revenue center 70. investment center
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71. responsibility accounting
72. variance analysis, absolute profit, return on investment and residual income
73. residual income 74. return on investment
75. goal congruence, performance evaluation, autonomy and motivation
76. goal congruence 77. transfer pricing
78. goal congruence objective 79. market based transfer pricing
80. arbitrary transfer pricing 81. marginal/relevant costs
82. negotiated transfer pricing 83. internal pricing
84. market based transfer price
11. STANDARD COSTING TECHNIQUE
1. c 2. b 3. d 4. b
5. d 6. a 7. c 8. c
9. d 10. a 11. b 12. c
13. e 14. b 15. c 16. b
17. c 18. c 19. b 20. a
21. c 22. b 23. a 24. d
25. c 26. d 27. b 28. d
29. b 30. a 31. c 32. b
33. e 34. d 35. b 36. c
37. a 38. c 39. a 40. c
41. a 42. a 43. c 44. d
45. b 46. d 47. c 48. c
49. b 50. b 51. a 52. c
53. unfavourable expense variance 54. flexible budget, actual results.
55. efficient 56. standard costs 57. variable-overhead spending
58. standard costing 59. ideal standard
60. attainable standard 61. control function
62. standard costs with actual costs 63. mix and yield variance
64. mix and yield variance 65. capacity and efficiency variance
66. material cost variance 67. material usage variance
68. adverse 69. material yield variance
70. planning and operational variance 71. efficiency variance
72. capacity ratio 73. actual price higher than standard price
74. actual hour lower than standard hour 75. variable overhead cost variance
76. Ex-ante- planning variance 77. Ex-post- operational variance
12. BUDGETARY SYSTEM AND BUDGETARY CONTROL
1. d 2. d 3. d 4. a
5. b 6. d 7. c 8. a
9. b 10. a 11. d 12. c
13. b 14. b 15. b 16. b
17. a 18. c 19. b 20. b
21. c 22. d 23. c 24. a
25. c 26. d 27. b 28. a
29. d 30. a 31. b 32. c
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33. b 34. c 35. a 36. d
37. c 38. a 39. b 40. b
41. d 42. a 43. c 44. c
45. c 46. b 47. b 48. evaluating
49. long-range (long-term) planning 50. sales
51. sensitivity analysis 52. spreadsheet software
53. budgetary control 54. corporate plan
55. authorization 56. budget committee
57. principal budget factor 58. budget manual
59. incremental budgeting 60. performance budgeting
61. planning programming budgetary system
62. continuous/ rolling budget 63. zero based budgetary system
64. planning 65. controlling
66. functional budget 67. master budget
13. WORKING CAPITAL MANAGEMENT
1. c 2. b 3. c 4. c
5. a 6. c 7. d 8. b
9. b 10. b 11. c 12. d
13. c 14. c 15. d 16. c
17. a 18. c 19. d 20. d
21. b 22. c 23. d 24. c
25. b 26. a 27. b 28. a
29. a 30. c 31. d 32. b
33. b 34. a 35. c 36. b
37. d 38. a 39. c
40. assets 41. accounts payable
42. cash 43. dividends
44. cash discount 45. quantity discount
46. working capital 47. current liability
48. working capital, current assets, stock turnover, debtor and creditor ratios
49. creditor ratio 50. stock turnover
51. just in time purchases 52. economic order quantity
53. opportunity cost 54. bank reconciliation
55. working capital cycle
References
1. ICAN past questions

2. Revision kit, Cost and Management Accounting ACMA
3. Costing T Lucey
4. Management Accounting, Horn Green
5. Management Accounting for Decision Markers, Peter Atrill and Eddie Mclaney
5. Various Management Accounting site on the web
6. Management Accounting WEB.
Page 574
DEFINITION OF TERMINOLOGIES
Absorbed overhead – Overhead costs that are added to the direct costs of products or services using an absorption
rate based on budgeted overhead costs and budgeted activity.
Absorption costing – A method of costing that recognizes overhead costs (fixed) as part of product or service costs
using the overhead absorption rates.
Absorption rates – A means of attributing overhead to a product or service based on labour hours, machine hours,
labour costs, quantities etc as activity and using it to divide the budgeted overhead cost. ( i.e. absorption rate
= budgeted fixed overhead/budgeted activity).
Accept or reject decisions – It is one of the critical one-off decisions where the principle of relevant costing is
critical. This is a situation where a special job/contract/assignment which is not path of routine task is been
considered and is necessary to compare the relevant cost of the task with the promissory revenue in order to
advise management to accept or reject such opportunity.
Accounting rate of return (ARR) – A method of investment appraisal that compares the average annual profits
earned by an investment in that project. ARR is calculated as follows: ((sum of profits /life in years)/((initial
cost + residual value)/2)) x 100.
Activity – A distinct business operation, service or action.
Activity-based budgeting (ABB) – A method of budgeting based on an activity framework and utilizing cost driver
data in the budget-setting and variance feedback process.
Activity-based costing (ABC) – It is an approach to the costing and monitoring of activities which involves tracing
resources consumption and costing final outputs. Resources are assigned to activities otherwise refers to as
cost pool, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to
attach activity costs to outputs.
Advanced manufacturing techniques (AMT) – This is the use of information technology to produce higher
quality and cheaper products more quickly or timely.
Adverse variance – Occurs when actual revenue is less than budget or standard, or actual cost is higher than budget
or standard. Adverse variances are normally shown in negative form by using brackets.
Allocate – To assign the whole item of cost, or of revenue to a single cost unit, centre, account or time period.
Amortisation – An alternative term to depreciation. Generally used to describe the writing down or charging profit
and loss of the value of intangible fixed assets such as goodwill.
Annual report – A document published yearly by a company and distributed to its shareholders showing its
operations including financial performance during the fiscal year. The report, which is mandatory for public
companies, usually contains the financial statements, auditor’s report, chairman’s statement and directors’
report among others and normally refers to as financial accountant report.
Annuity – A regular payment of the same amount per year.
Annuity discount factor – Otherwise known as cumulative discount factor is an aggregate discount factor that is
used to obtain the present value of an annuity.
Appraisal costs – All the costs that a firm incurs in order to ensure raw materials, components and output all meet
the required quality standards.
Aspiration level – An individual’s personal goals or targets combined with the efforts they will make to achieve
them.
Asset turnover ratio – It is the proportion or percentage of turnover or sales over capital employed (Sales/Capital
employed) x 100.
Attainable standard – A standard that assumes an efficient level of operation. It also makes allowance for normal
levels of waste and machine downtime.
Attribute – A product’s attributes are the features that it contains.
Avoidable cost – The specific costs of an activity or sector of a business which would be avoided if that activity or
sector did not exist usually refers to as relevant cost.
Backflush costing – A method of costing associated with a JIT production system which applies cost to the output
of a process. Costs do not mirror the flow of products through the production process, but are attached to
output produced (finished goods stock and cost of sales) on the assumption that such backflushed costs are a
realistic measure of the actual costs incurred.
Balanced scorecard – An approach to the provision of information to management to assist strategic policy
formulation and achievement. It emphasizes the need to provide the user with a set of information which
Page 575
addresses all relevant areas of performance in an objective and unbiased fashion. The information provided
may include both financial and non-financial elements, and cover areas such as customer satisfaction,
internal efficiency and innovation.
Balancing allowance – The excess of an assets tax written down value over the disposable value for tax purposes.
Balancing charge – The excess of disposable value of assets over its tax written down value for tax purposes.
Basic hours – The normal contracted attendance hours excluding overtime.
Batch – a group of similar articles which maintains its identity throughout one or more stages of production and is
treated as a cost unit.
Batch costing – A form of specific order costing in which costs are attributed to batches of products.
Behavioural implications – The ways in which humans affect and are affected by the creation, existence and use of
accounting information.
Benchmarking – The establishment, through data gathering of targets and comparators, through whose use relative
levels of performance (and particularly areas of underperformance) can be identified. By the adoption of best
practices it is hoped that performance will improve.
Bottleneck – An activity within an organization which has a lower capacity than preceding or subsequent activities
thereby limiting throughput. Bottlenecks are often the cause of a build up of work in progress and of idle
time.
Breakeven point – The level of activity at which there is neither a profit nor loss, i.e. costs equate revenue.
Budget – A quantitative statement for a defined period of time which may include planned revenues, expenses,
assets, liabilities and cash flows.
Budget centre – A centre for which an individual budget is drawn up.
Budget holder – A manager who is responsible for the performance of a specific department in a budgetary control
system.
Budget manual – Sets out all the procedures, timetables and persons responsible for preparing the annual budget.
Budget slack – The intentional overestimation of expenses and/or underestimation of revenues in the budgeting
process.
Budgetary control – The establishment of budgets relating the responsibilities of executives to the requirements of
policies and the continuous comparison of actual with budgeted results, either to secure by individual action
the objectives of that policy or to provide a basis for its revision.
Budgeted capacity – Standard hours planned for the period, taking into account budgeted sales, supplier, workforce
availability and efficiency expected.
Capacity – The maximum output that can be achieved in a period. Capacity may relate to a process, a machine, the
labour force or more usually a department or factory.
Capital – Funding resources available for an entity for its operations or investment purposes
Capital allowances – Allowances against profits for the reduction in the value of fixed assets in place of
depreciation for tax purposes.
Capital employed – The total of the fixed and current assets of a company less any current liabilities.
Capital rationing – Is the economical allocation of fund in a situation where there is limited fund and many
profitable projects, i.e. the fund available is not adequate for all the profitable project.
Capital resources planning – The process of evaluating and selecting long-term assets to meet strategies.
Carrying cost – Otherwise known as holding cost, is the cost incurred from the delivery of inventory until it is used
for production or sell, examples of such costs include Storage costs, cooling and heating, pilferage,
obsoleteness, cost of capital tied down etc.
Cash budget – A detailed budget of estimated cash inflows and outflows incorporating revenue, expenses and
capital items.
Cash flows – The amount of cash that circulates through a business. The net amount of the cash inflows minus
outflows is call net cash flow or net revenue or cash profit.
Centre – Departments, areas or function to which costs and/or revenues are charged.
Changeover time – The period required to change a workstation from a state of readiness for one operation to a
state of readiness for another.
Closed system – System that adapt to their environment by altering their inputs after their outputs fail to match the
system’s objectives.
Committed cost – Costs arising from prior decisions which cannot, in the short run, be changed.
Common cost – Cost relating to more than one product, service, activity, department, division etc.
Components – Parts that are assembled to make a product.
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Contingency theory – The hypothesis that there can be no universally applicable best practice in the design of
organizational units or of control systems such as management accounting systems is dependent on an
awareness by the system designer of the specific environmental factors which influence their operation, such
as the organizational structure, technology base and market situation.
Continuous data – Connected, unbroken data, having no gaps in time or sequence, such as distance traveled.
Continuous production – The manufacture of homogeneous products in a series of processes without any break for
a considerable period of time.
Contract costing – A form of specific order costing in which costs are attributed to individual contracts.
Contribution – Sales value less variable cost of sales per unit contribution margin, in total, total contribution.
Contribution to sales (C/S) ratio – Otherwise known as Profit volume (P/V) or Contribution margin (CM) ratio is
the percentage or proportion of contribution on sales obtained by contribution/sales x 100.
Control limit – A range within which variances are acceptable. Those variances that fall within preset control limits
will be accepted and not investigated. Control limits may be arbitrary or based on past experience.
Control system – A communications network that monitors the activities of an organization and provides the basis
for corrective action.
Controllable cost – A cost which can be influenced by its budget holder for the purpose of responsibility
accounting.
Conversion costs – Addition of labour and overhead costs, i.e. the costs incurred in converting materials into
finished goods.
Corporate Planning – Otherwise known as strategic planning.
Corporation tax – A tax levied on the profits and gains of limited companies.
Cost accountant – This is a title given to a set of accountant that deals with identification, analysis, classification,
coding and recording of costs.
Cost accounting – The establishment of budgets, standard costs and actual costs of operations, processes, activities
or products and the analysis of variances, profitability or the social use of fund.
Cost attribution – The process of relating costs to cost centres or cost units using cost allocation or cost
apportionment.
Cost behaviour – The study of the relationship between cost and activity level, i.e. how costs response to changes
in the level of activity.
Cost benefit analysis (CBA) – Is net present value per initial investment. It is one of the methods used in single
period capital rationing.
Cost centre – A production or service location, function or activity or item of equipment for which costs are
accumulated.
Cost driver – Any factor which causes a change in the costs of an activity.
Cost estimation technique – These are the methods available for separating mixed cost into its variable and fixed
element for the purpose of estimating or forecasting future costs. The method included, account
classification, high and low, scattered graph, linear regression and multiple regression analysis method.
Cost experience curve – The cost experience curve concept is based on the same idea as the labour learning curve,
i.e. the cumulative average costs per unit will reduce by a fixed proportion each time the cumulative output
of a new product doubles. The applications and limitations of the cost experience curve are similar to those
of the learning curve.
Cost management – The application of management accounting concepts, methods of data collection, analysis and
presentation in order to provide the information required to enable costs to be planned, monitored and
controlled.
Cost object – A unit of product or service in relation to which costs are ascertained.
Cost of capital – The minimum acceptable return on investment incorporating the expected return from all source of
funding entity operations or returns to fund holders.
Cost of sales (i) – The cost of goods sold by a retailer, calculated by adjusting the purchases in a period by the
change in inventory during that period. Retail cost of sales is a variable cost.
Cost of sales (ii) – The sum of the variable cost of sales plus factory overhead attributable to the sales. In
management accounts this may be referred to as the production cost of sales or cost of goods sold.
Cost plus pricing – The determination of price by adding a mark-up which may incorporate a desired return on
investment to a measure of the cost of a product or service.
Cost pool – The point of focus for the costs relating to a particular activity in an activity-based costing system.
Cost reduction – The reduction in unit cost of goods or services without impairing suitability for the use intended.
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Cost tables – A database containing all the costs associated with the production of a product, broken down to
include the costs of functions and/or components or sub-assemblies. Cost tables also incorporate the cost
changes which would result from a number of possible changes in the input mix.
Cost unit – A unit of product or service in relation to which costs are ascertained.
Cost-volume-profit (CVP) analysis – This is the study of the relationship of the effects on profit of changes in
fixed cost, variable cost, sales price, quantity and mix to aid forecasting.
Critical success factors (CSFs) – An element of organizational activity which is central to its future success.
Critical success factors may change over time and may include items such as product quality, employees’
attitudes, manufacturing flexibility and brand awareness.
Cumulative average time taken (CATT) – This is the average time taken per unit for all units produced in a
product’s life to date. This is useful in learning curve calculations.
Current assets – Short-life assets suck as stock, debtors and cash.
Current liabilities – Sources of short-term finance such as creditors and bank overdrafts.
Customer profitability analysis (CPA) – The analysis of the revenue streams and service costs associated with
specific customers or customer groups.
Cycle time – The period required to complete an operation on one unit of a batch.
Data – Facts observations or measurements about physical phenomena and business transactions.
Decentralized Unit (division) – Self –managing sub-section of a business.
Decision model – A mathematical or accounting model of a business problem that is designed to assist in decision-
making by providing information on the effects of different assumptions.
Decision tree – Is a pictorial or diagrammatic representation of various alternatives inherent in risky investment. It
is one of the methods used in coping with risk and uncertainty.
Deductible expenses – Otherwise known as allowable expenses is an expense that is allowed when calculating
taxable profit.
Differential costing – A principle that identifies costs that make difference between/among alternatives. The use of
differential cost information is to aid planning and decision-making.
Differential cost – The difference in total cost between alternatives calculated to assist decision-making
Direct costs – Expenditure which can be economically identified with and specifically measured in respect of a cost
object, a product or service.
Direct labour – Workers who are closely identified with production. Their wages are a direct cost.
Discount factors – Factors used in discounted cash flow (DCF) calculations, which take into account the timing of
the cash flows to bring back to the equivalent value as at now.
Discount rate – The percentage used to discount future cash flows generated by a capital project, which in most
cases will reflect the expected returns from the fund holders.
Discounted cash flow (DCF) – Is the reduction of the future cash flows into equivalent value as at now using the
discount rate, this is done to aid decision making on a capital project.
Discrete data – Non-continuous data, taking only certain values in a range, such as number of staff employed in an
entity.
Discretionary cost – A cost whose amount within a time period is determined by and is easily altered by a decision
taken by the appropriate budget holder. (Marketing, research and training are generally regarded as
discretionary costs).
Discretionary expense centre – Multi-activity overhead units such as Research & Development, Finance and
Accounting, Personnel and Training.
Dividend – Is the amount payable or paid to equity holders out of an entity profit after interest and tax based on unit
holding which will is subjected to the discretion of the directors and approval of the shareholder at the
annual general meeting (AGM).
Dividend cover – The ratio of earnings per share to the dividend per share of an entity (i.e. EPS/DPS x 100)
Double-loop system – It is a system that is designed to interact with their environment. They do this by adjusting
their objectives as well as or instead of their inputs.
Downtime – The period for which a workstation is not available for production due to functional failure.
Dual pricing – A form of transfer pricing in which the two parties to a common transaction use different prices
EBITDA – Earnings before interest, tax, depreciation and amortization. EBITDA is a reasonably close
approximation to cash flow.
Economic order quantity (EOQ) – This is the ordering quantity where total annual relevant/controllable/variable
cost associated with inventory is minimized.
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Economies of scale – The way that in some industries large-scale production achieves lower unit costs than small-
scale production.
Entity – Any commercial organization, ranging from sole traders through to multinational corporations. The entity
is treated as separate from its owners.
Expected value – various values multiply by its probability added together. It is one of the methods of coping with
risk and uncertainty in which it occurrence is attached with the probability and the occurrence multiply by
the probability will gives the expected value.
Experience curve – Another name for the learning curve.
Factoring – An arrangement whereby an entity transfers collection of its debts to a financial institution or consultant
at a cost in exchange for immediate cash to fund its operations.
Failure costs – Internal failure costs relate to the costs caused by materials and output failing to meet quality
standards before the product is delivered to the customer. External failure costs are the costs incurred as a
result of delivering substandard goods and services to the customer.
Favourable variance – Occurs if actual revenue is higher than budget or standard, or actual cost is below budget or
standard.
Feedback – The process whereby any disparity between the actual outputs from a system and the system’s
objectives are corrected by an adjustment to the system’s inputs.
Feedforward – Occurs when a system is designed to compare projected (forecast) results with future objectives so
that corrective action may be taken in advance.
Feedforward control – The forecasting of differences between actual and planned outcomes, and the
implementation of action, before the event, to avoid such differences.
Finance lease – Is a type of lease where the leasor acquired the assets in its own name and gives the assets to the
leasee for its own use subject to payment of the agreed lease rental.
Financial accounting – This is the classification and recording of the monetary transactions of an entity in
accordance with established concepts, principles, accounting standards and legal requirements and their
presentation by means of profit and loss accounts, balance sheets and cash flow statements during and at the
end of an accounting period.
Financial management – The management of all the processes associated with the efficient acquisition and
deployment of both short and long-term financial resources.
First in, first out – The principle that the oldest items or costs are the first to be used. Most commonly applied to
the pricing of the issues of materials, based on using first the costs of the oldest materials in stock,
irrespective of the sequence in which actual material usage takes place. Closing stock is therefore valued at
relatively current costs.
Fixed budget – A budget which is normally set prior to the start of an accounting period and which is not changed
in response to subsequent changes in activity or costs/revenues. Fixed budgets are generally useful for
planning purposes.
Fixed costs – A cost which is incurred for an accounting period and which, within certain limit/range, tends to be
unaffected by fluctuations in the level of activity (output or turnover).
Flexible budget – A budget which by recognizing different cost behaviour pattern is designed to change as volume
of activity changes. This is the concept used in standard costing and useful for controlling and performance
evaluation purposes.
Flexible manufacturing systems (FMS) – A cluster of different types of machines surrounding a single
workstation, usually called a ‘cell’. Complete products are manufactured at a single cell by a worker who is
trained to operate a variety of machines. The worker is also responsible for the quality of the product.
Forecast – A prediction of future events and their quantification for planning purposes.
Freehold – Land and/or building that are owned outright by an entity or an individual, free of rents, tithes etc.
Full capacity – Output (expressed in standard hours) that could be achieved if sales orders, supplies and workforce
were available for all installed workplaces.
Full time equivalents (FTEs) – The total hours of a number of part time workers added together and divided by the
hours for a full-time worker to obtain the equivalent number of full timers.
Futuristic planning – Planning for that period which extends beyond the planning horizon, which cannot usefully
be expressed in quantified terms.
Goal congruence – This is a concept which expects each division objective to be in harmony with the overall entity
objective in a divisionalised or decentralized entity. That is whatever the action or in-action of each
divisional manager must be to the over all benefit of the entity as a whole.
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Gross profit – Turnover/sales less cost of sales.
High/low method – A method of estimating cost behaviour by comparing the total costs associated with two
different levels of output. The difference in costs is assumed to be caused by variable costs increasing,
allowing unit costs to be calculated. Following on from this, since total cost is known, the fixed cost can be
derived.
Hurdle rate – A discount rate used for investment appraisal calculations, which is based on a higher rate than the
firm’s current cost of capital to compensate for the risk of errors in estimated cash flows and capital costs.
Ideal standard – A standard that make no allowance for machine downtime or material waste.
Idle time – The period for which a workstation or workforce is available for production or service but there is no
work to be done due to e.g. shortage of material, machine breakdown etc.
Imputed cost – An alternative term for notional cost or expected return on investment.
Incremental budgeting – A method of budget setting in which the prior period budget is used as a base for the
current budget, which is set by giving priority to items in the prior budget and take account of any
anticipated changes.
Incremental cost – The increase or decrease in costs that results from a decision to choose one alternative over
another.
Independent variable – This is a variable whose value is not affected by another. It may affect the value of another
(dependent) variable. The classic example is time. The independent variable is usually notated as X and
shown on the horizontal axis of a graph or chart.
Indifferent point – The point at which a decision-maker is indifferent between/among the options available.
Indifference values – In a differential costing problem, the input quantities, or unit variable costs, or fixed costs,
that will result in the same total cost for a given output. Therefore, the decision-maker is indifferent as to
which option should be chosen.
Indifference volume – In a differential costing problem, the volume at which both options would cost the same,
therefore, the decision-maker is indifferent as to which option should be chosen.
Indirect costs – Expenditure on labour, materials or services which cannot be economically directly identified with
a specific saleable cost unit.
Indirect hours – The time worked by indirect labour and the time spent by direct labour on indirect activities such
as training and cleaning.
Indirect labour – Factory employees who are primarily engaged in support activities.
Information – Data that has been processed and/or transmitted so that it is useful to its intended user.
Intangible asset – Non-material assets, such as technical expertise, a trademark and a patent.
Internal rate of return (IRR) – Also known as yield method, it is the discounted return of a project or the
discounting rate at which net present value is zero.
Initial allowance – The first year’s capital allowance on a newly acquired asset.
Input tax – VAT incurred by a business on purchased goods and services.
Inter-firm comparison – Systematic and detailed comparisons of the performance of different companies generally
operating in a common industry.
Inventory – Stocks of raw materials, components, work in progress and finished goods.
Investment appraisal – The use of mathematical and accounting techniques to assist in decisions concerning the
acquisition and disposal of fixed assets, products, projects etc that are capital in nature.
Investment centre – Profit centres that (i) have the authority to manage their own working capital, and (ii) are
permitted to acquire their own fixed assets without reference to central management. Investment centres are
units within an organization which have authority to incur costs, generate income and have specified amount
investment to generate such income.
Irrecoverable costs – sunk, historical or commitment costs.
Iterative (process) – Searching for an optimum by making progressive changes to the inputs in a decision (or
planning) mode.
JIT production – A system for the scheduling of production to meet the requirements of customers. JIT production
is intended to produce components and products when customers require them, not in advance and where
holding finished goods inventory becomes unnecessary.
JIT purchasing – A system that aims to match the delivery of goods from suppliers with the consumption or sale of
those goods where holding raw material inventory becomes unnecessary.
Job costing – A form of specific order costing in which costs are attributed to individual jobs.
Job ticket – Used to record the labour time and/or machine time spent on each operation or process.
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Jobbing firms – These are Firms that manufacture one off jobs to the customer’s specification.
Just in time (JIT) – A system for the short-term scheduling of purchasing to meet consumption or sales or
production to meet customer’s specification or requirement.
Key factor – An alternative term for limiting factor.
Law of requisite variety – The law of requisite variety states that for full control, a control system should contain a
level of variety that is at least equal to the variety in the system that is intended to control.
Lead time – At times refers to as delivery time, is the time expected to elapse between the start of a process or
activity and its completion or the time between ordering and receiving delivery of inventory.
Learning curve – The mathematical expression of the phenomenon that when complex and labour-intensive
procedures are repeated, unit labour times/costs tend to decrease at a constant rate. The learning curve
models mathematically this reduction in unit production time.
Learning effect – The way in which any activity will be carried out more efficiently, and probably more quickly, if
it is repeated regularly.
Learning rate – The percentage by which the average time taken per unit for all the units produced to date will fall,
each time output doubles.
Lease – Is a contractual agreement between the owners of an asset known as leasor and the user of the assets known
as the leasee for a consideration called lease rental.
Leasee – This is the user of a leased asset.
Leasehold – Land or buildings that are owned (i.e. leased) for a defined period after which they revert to the lessor.
Leasor – The owner of the leased asset who collects lease rental
Life cycle costing – The maintenance of physical asset cost records over the entire asset lives, so that decisions
concerning the acquisition, use or disposal of the assets can be made in a way that achieves the optimum
asset usage at the lowest possible cost to the entity. The term may be applied to the profiling of cost over a
product’s life, including the pre-production stage (terotechnology) to declination stage, most essentially
aiding decision-maker at the product’s introductory stage.
Limiting factor – It is anything that limits the activity of an entity. An entity seeks to optimize the benefit it gets
from the limiting factor.
Linear Programming – Is a quantitative technique used to drive solution to diverse problems such as product
optimal mix, when there are more than two constraints, multi period capital rationing, flight scheduling,
transportation problems etc.
Liquidity – The ease at which a financial instrument can be converted into cash. An instrument which can be
quickly converted is said to be liquid while one which cannot be easily converted is regarded is illiquid.
Load factor – A term used in the transport industry to refer to the proportion of the available seats in a vehicle that
are occupied by paying passengers.
Logarithm – The power to which a fixed number or base must be raised to produce a given number. For example,
the logarithm of 1,000 to base 10 = 3.
Management accounting – The provision and application of accounting and other quantitative knowledge to assist
management in carrying out their functions. At times refers to as internal accounting.
Management by exception – A style of management in which it is considered to be more efficient for managers to
ignore performance which is in accordance with plan and instead to concentrate their attention on dealing
with significant deviations from plan (exceptions).
Management control – All of the process used by managers to ensure that organizational goals are achieved and
procedures adhered to, and that the organization responds appropriately to changes in its environment.
Management information system (MIS) – It is the combination of formal and informal data gathering, data
analysis and information transmission channels that provide the managers of an organization with the
information that they need.
Manufacturing resource planning (MRP II) – An information system that provides an integrated decision support
system for resource management. MRP II ties together the inter-related activities of design, manufacturing,
marketing, distribution, finance and human resource management.
Margin of safety – The difference between the current or forecast level of sales and the break-even point. It is the
region of sales/turnover/revenue where an entity drives or enjoys profit. This can be expressed in absolute
figure or proportion or percentage of revenue.
Marginal costing – The accounting system in which variable costs and at times relevant costs are charged to cost
units or total costs and fixed costs of the period are written off in full against the aggregate contribution. Its
special value is in recognizing cost behaviour, and hence assisting in decision-making.
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Margin – Gross profit as a percentage of turnover.
Mark-up – Gross profit as a percentage of cost, i.e. the percentage added to cost price to obtain the selling price.
Master budget – The budget into which all subsidiary budgets are consolidated, normally comprising budgeted
profit and loss account, balance sheet and budgeted cash flow statement. These budgets, and the supporting
subsidiary budgets, are used to plan and control activities in the following year.
Materials requirements planning (MRP I) – A production planning technique, which explodes the materials
specification for a finished product backwards so that a production schedule can be designed that optimizes
the ordering and production of the parts and sub-assemblies required.
Materials requisition – used to authorize the release from stores of the correct quantities of raw materials, parts,
components and sub-assemblies required for a manufacturing operation or process.
Material specification – A list of all the raw materials, components, parts and sub-assemblies required to convert a
design into a tangible product. The materials specification will also state the quantities required.
Multi-period capital rationing – This is when funding constraint of an entity for profitable project persist for more
than a planning period or year.
Mutually dependent projects – These are projects that must be accepted or rejected together under capital
rationing, i.e. if one project is accepted the other must be accepted as well. Such projects are normally
treated together as if it is a single project for purpose of ranking and allocation of fund.
Mutually exclusive projects – These are project that acceptance of one denies accepting the other, i.e. once one is
accepted the other must be rejected under capital rationing.
Negative feedback – Occurs when a system adjusts its inputs to bring future outputs closer to its objectives
Net margin – The proportion of net or operating profit over sales/turnover.
Net present value (NPV) – The difference between the sum of the discounted cash flows expected from an
investment and the amount originally invested.
Noise – Irrelevant or insignificant data which overload a feedback process. The presence of noise can confuse or
divert attention from relevant information.
Non-controllable cost – A cost that a manager cannot influence.
Non-financial performance indicators (NFPIs) – It is an alternative term for ‘non-financial performance
measures’.
Non-financial performance measures – Measures of performance based on non-financial information which may
originate in and be used by operating departments to monitor and control their activities without any
accounting input. Non-financial performance measures may give a more timely indication of the levels of
performance achieved than do financial ratios, and may be less susceptible to distortion by factors such as
uncontrollable variations in the effect of market forces on operations.
Normal capacity – A measure of the long-run average level of capacity that may be expected.
Normal distribution – Symmetric bell-shaped distribution that can be completely defined by its mean and standard
deviation
Normal loss – An expected loss, allowed for in the budget, and normally calculated as a percentage of the good
output from a process during a period of time.
Notional cost – A cost used in product evaluation, decision-making and performance measurement to represent the
cost of resources which have no conventional ‘actual cost’. Notional interest, for example, may be charged
for the use of internally generated funds.
Open system – Systems that are designed to interact with their environment. They do this by adjusting their
objectives as well as, or instead of, their inputs.
Operating profit – Profit before interest charges and taxation.
Operating lease – Is a lease agreement between two companies operating in a parallel market for the leasee to use
asset of the leasor for its operation for a short while, where the whole lease rental in the book of the leasee
will be an allowable expenses.
Operating statement – Regular profit and loss accounts prepared in format that is informative for managers.
Operation planning – The detailed planning of an organisation’s day-to-day activities.
Operations ticket – Used to record the labour time and/or machine time spent on each operation or process.
Opportunity cost – The value of the benefit sacrificed when one course of action is chosen, in preference to an
alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected
course of action.
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Ordering costs – These are costs incurred from the initiation of a purchase requisition for inventory until such
inventory is received into the store excluding purchase cost, such costs include, stationery cost, delivery
cost, transportation cost, insurance of goods on transit, demurrage etc.
Output tax – VAT added to the sales of a business.
Outsource – Close down an internal service and purchase it from an outside supplier of services or components.
Outworkers – Workers who work in their own homes rather than on the employer’s premises.
Overhead – Expenditure on labour, materials or services which cannot be economically identified with a specific
saleable cost unit.
Overhead absorption rates – See absorption rate above.
Overtrading – The condition of a business which enters into commitments in excess of its available short-term
resources. This can arise even if a company is trading profitably, and is typically caused by financing strains
imposed by a lengthy operating cycle or production cycle.
Pareto distribution – A frequency distribution in which a small proportion of the items accounts for a large
proportion of the value (also known as the 80:20 distribution).
Payback – A measure of how long it takes for an investment to generate enough cash to offset its initial cost.
Period costs – A cost which relates to a time period rather than to the output of products or services which in most
cases always takes a fixed nature.
Piecework – A payment system where workers are paid for what they produce at a fixed rate per unit.
Planning – The establishment of objectives, and the formulation, evaluation and selection of policies, strategies,
tactics and action required to achieve them.
Planning horizon – The furthest time ahead for which plans can be quantified. It need not be the planning period.
Planning period – The period for which a plan is prepared and used.
Positive feedback – This Occurs when a system adjusts its objectives in response to a disparity between planned
and actual outputs.
Practical capacity – Full capacity less an allowance for known unavoidable volume losses.
Present value (PV) – The cash equivalent now of a sum receivable or payable at a future date.
Prevention costs – All those costs that a firm incurs in order to avoid producing substandard goods and services.
Price skimming – A high initial price that may be set during the first stage of a product’s life cycle to cash in on the
product’s novelty value, which is due to reduce as level of competition increases.
Principal budget factor – A factor which will limit the activities of an undertakings and which is often the starting-
point in budget preparation.
Product life cycle – The period that begins with the initial specification for a product and ends with the product’s
withdrawal from the market.
Production cost of sales – The absorption costing cost of sales. The figure is made up of the opening stock
(including work in progress), valued at the previous period’s production cost per unit, plus the total of the
current period’s direct material and direct labour costs, plus the variable and fixed production overheads,
less the closing stock (including work in progress), value at the current period’s production cost per unit.
Note: the above definition assumes that stocks are valued on a first in first out (FIFO) basis.
Productivity – The output achieved from a unit of input.
Profitability index – The ratio of present value of all inflows to the initial investment of a project. It is one of the
methods used for single period capital rationing.
Profit centre – A responsibility centre that has authority to incur costs, generate revenue which performance can be
measured using absolute net profit or as a percentage of sales.
Ranking decisions – Decisions that involve a choice between several competing opportunities, not all of which can
be taken up.
Raw material – This is material which has not been processed or manufactured.
Realisation concept – The principle that increases in value should only be recognized on realization of assets by
arm’s length sale to an independent purchaser.
Rectification – Repairing or reworking defective production.
Reducing balance – This is a method of depreciating the value of tangible assets by removing the accumulated
depreciation from the value of the asset before determining the provision for the period or year.
Relevant cost – Is a future cost or loss that is traceable directly to the alternative under consideration. The cost or
loss is necessary only because of the alternative under consideration.
Relevant range – This can be otherwise refers as capacity, within which the assumption of constant cost in cost
behaviour remain valid.
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Residual income (RI) – The operating profit of an investment centre less the cost of the capital it employs. Profit
after a notional or imputed interest charge is made for the cost of capital employed.
Residual value – Resale value, scrap value or often call salvage value is the envisaged realizable value of a tangible
project at the end of the useful period.
Responsibility centre – A department or organizational function whose performance is the direct responsibility of a
specific manager.
Responsibility accounting – A system of accounting in which responsibility centres are established throughout an
organization and individual managers are held responsible for costs (cost centres), costs and revenues (profit
centres), or revenues, costs and investments (investment centres).
Return on capital employed (ROCE) – Otherwise refers to as return on investment (ROI) is the proportion or
percentage of net profit over capital employed/investment.
Revenue centre – A unit or division within an entity responsible for generating mainly revenue with minimal cost.
Reverse engineering – The decomposition and analysis of competitors’ products in order to determine how they are
made, costs of production, and the way in which future development may proceed.
Risk premium – An addition to the normal discounting factor of a project to provide for the risk inherent to the
project. It is one of the methods designed to cope with risk and uncertainty.
Rolling/continuous budget – A budget continuously updated by adding a further accounting period (month, quarter
or year) when the earlier accounting period has expired. Its use is particularly beneficial where future costs
and/or activities cannot be forecast accurately.
Route card – Lists the sequence of operations and processes that are required to convert raw materials, parts and
components into a product.
Semi-variable cost – A cost containing both fixed and variable components and which is thus partly affected by a
change in the level of activity, it is otherwise known as semi-fixed or mixed costs.
Sensitivity – The amount, or proportion by which an input to a decision model can change without causing the
prediction to switch from profit to loss. i.e. the margin for error.
Sensitivity analysis – A modeling and risk assessment procedure, in which changes are made to significant variable
in order to determine the effect of these changes on the planned outcome.
Service cost centre – A cost centre which provides a service to other costs centres.
Service level agreement – Contract between service provider and customer who specify in detail the level of
service to be provided over the contract period (quality, frequency, flexibility, charges, etc.) as well as the
procedures to implement in the case of default.
Set-up time – The period required to prepare a workstation from a standard condition of readiness to commence a
specified operation.
Shadow price – An increase in value which would be created by having available one additional unit of a limiting
resource at its original cost. This represents the opportunity cost of not having the use of the one extra unit.
Single period capital rationing – This is used in project appraisal, when the funding constraint exists for only a
single planning period or year.
Single-loop system – A self-regulating system that adapts to its environment by altering its inputs after its outputs
fail to match the system’s objectives.
Space costs – The costs of occupying factory or office space, e.g. rent, building insurance, heating, lighting and
cleaning.
Specific cost – A cost that is caused by or peculiar to a particular activity, cost unit, operation, product, centre or
time period.
Specific order costing – The basic accounting method applicable where work consists of separately identifiable
contracts, jobs or batches.
Standard cost – The planned unit costs of the products, components or services to be produced in a future period.
Standard cost card – A document or other record detailing, for each individual product, the standard inputs
required for production as well as the standard selling price. Inputs are normally divided into material,
labour and overhead categories and both price and quantity information is shown for each.
Standard costing system – A control technique which compares standard costs and revenues with actual results to
obtain variances which are used to stimulate improved performance.
Standard hour (minute) – This is the amount of work achievable, at standard efficiency levels, in an hour or
minute.
Standard time – The total time in which a task should be completed by employees working at standard levels of
efficiency.
Page 584
Stepped cost – A cost that increases by a reasonably constant sum each time volume or activity increases by a
predictable, constant, multiple.
Stock-out – When there is insufficient stock to meet current production/sales requirement.
Stochastic systems – These are systems, where a given input may generate a range of possible outputs.
Strategic decisions – Long-term decisions that commit a business to a particular course of action.
Strategic management accounting – A form of management accounting in which emphasis is placed on
information which relates to factors external to the firm, as well as non-financial information and internally
generated information.
Strategic planning – The formulation, evaluation and selection of strategies for the purpose of preparing a long-
term plan to attain objectives.
Sub-assembly – A number of components or parts joined together to make a distinct part of a complex product, for
example an engine in a car.
Supply chain – The materials procurement and delivery process, from the initial placing of a purchase order
through to the inspection of goods received from suppliers.
Sunk costs – Costs that have been irreversibly incurred or committed prior to a decision point and which cannot
therefore be considered relevant to subsequent decisions. Sunk costs may also be termed irrecoverable costs.
System – An orderly, inter-connected arrangement of parts.
Tactical decisions – Short to medium-term decisions concerning the implementation of strategies to achieve defined
objectives. Such decisions are continually reviewed and subject to change.
Tactical planning – Planning the utilization of resources to achieve specific objectives in the most effective and
efficient way.
Target cost – A product cost estimate derived from subtracting a desired profit margin from a competitive market
price. This cost may at times be higher than the estimated cost of the product calling for in dept review of
each cost element.
Tax period – The period used for calculating VAT payable/refundable.
Taxable profit – The entity profit subject to tax after the consideration of the allowable expenses from the gross
income accrued to the entity for the a period/year.
Tero-technology – The management of fixed assets over their lifetimes in such a way as to achieve the optimum
asset usage at the lowest possible cost to the entity. This can be achieved through a combination of
management, financial, engineering and other disciplines.
Throughput – The difference between sales/turnover and material costs.
Throughput accounting – A management accounting system which focuses on the difference between revenue and
the inventory costs. Throughput equals to revenue minus inventory costs.
Throughput costing – A costing system that believes that the only item to be capitalized is only the inventory cost,
while the conversion cost should be written off to the period incurred.
Time horizon – How far a firm considers it worthwhile to look into the future when conducting investment
appraisals – it is similar to, but not the same as, the planning horizon.
Total quality management (TQM) – An integrated and comprehensive system of planning and controlling all
business functions so that products and services are produced which meet or exceed customer expectations.
Total time taken (TTT) – This is the total labour hours taken to produce the output achieved in a particular
product’s life to date, used in learning curve calculations.
Trade creditors – The total amount owed to credit suppliers.
Trade debtors – The total amount owed by credit customers.
Transfer price – other wise known as internal pricing, is the rate at which goods and services are exchange between
sister division within the same organization.
Transit (or transfer) time – This is thee period between the completion of an operation and the availability of the
material at the succeeding workstation.
Turnover – Other wise known as total sales or total revenue is the gross sales achieved by a business in a specific
period.
Turnover tax – A tax on the sales of a business, which is usually included in a product’s selling price.
Unavoidable cost – The cost of an activity or sector that cannot be avoided.
Value added – Sales value less the cost of purchased materials and services.
Value added tax (VAT) – A tax added to the sales made by businesses.
Page 585
Value analysis – A systematic interdisciplinary examination of factors affecting the cost of a product or service, in
order to devise means of achieving the specified purpose most economically at the required standard of
quality and reliability.
Value driver – An activity or organizational focus which enhances the perceived value of a product or service in the
perception of the customer, and which, therefore creates value for the producer. Advanced technology,
reliability or a reputation for customer care may be value drivers.
Value engineering – An activity which helps to design products which meet customer needs at the lowest cost
while assuring the required standard of quality and reliability.
Variable – A quantity that is able to assume different numerical values.
Variable cost – This is a cost which moves in sympathy level with activity.
Variable cost of sales – The variable production cost of the goods or services sold in a period plus any variable
selling and distribution costs.
Variable production overhead – Overheads that alter with the level of manufacturing activity, such as machine
lubricants, disposable tools, some machine maintenance activities and factory power.
Variance – The difference between a planned budgeted or standard cost and the actual cost incurred. The same
comparison may be made for revenues.
Vat return – A return to the tax authorities of the output VAT charged and the input tax payable by a firm in a tax
period plus details of turnover, purchases, etc.
Venture capital – This is the funding requirement for a new entity.
Waiting time – The period for which an operator is available for production but is prevented from working by
shortage of material or tooling or machine breakdown.
Waste – Discarded material having no value.
Weighted average cost of capital (WACC) – The expected returns from all source of funding, equity, bond,
debenture, long term loan etc also known as cost of capital used as hurdle rate for capital project appraisal.
Work in process – Part finished contents of a continuous manufacturing process.
Work in progress – Part- finished manufacturing products.
Working capital – This is the capital available for conducting the day-to-day operations of an organisation,
normally the excess of current assets over current liabilities.
Working capital cycle – Otherwise known as cash operating cycle is the length of time between investment of cash
on inventory and realization of it inform of collection of cash from cash sales or debtor.
World class manufacturing – A position of international manufacturing excellence, achieved by developing a
culture based on factors such as continuous improvement, problem prevention, zero defect tolerance,
customer-driven JIT based production and total quality management.
Writing down allowance – An annual percentage capital allowance which is deducted from profits for corporation
taxation purposes.
Written down value (WDV) – Either the cost of an asset less its accumulated depreciation, or the cost of an asset
less accumulated capital allowances
Zero-based budgeting – A method of budgeting which requires each cost element to be specifically justified, as
though the activities to which the budget relates were being undertaken for the first time. Without approval,
the budget allowance is zero.
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Practice and theory

Chapter 2 Cost Behaviour and Cost Estimation Techniques 13

Chapter 3 Cost Accounting System and Preparation Income Statement 37

Chapter 4 Cost Volume Profit Analysis 74

Chapter 5 Relevant Costing Technique For Decision marking 107

Chapter 6 Learning Curve Theory 176

Chapter 7 Capital Budgeting Decision Under Certainty 185

Chapter 8 Capital Budgeting Decision Under Uncertainty 249

Chapter 9 Inventory Control 280

Chapter 11 Performance Evaluation in a Divisionalised Organisation 306

Chapter 12 Transfer Pricing System 320

Chapter 13 Standard Costing Technique and Variance Analysis 338

Chapter 14 Budgetary System and Control 374

Chapter 15 Other Costing and Management Accounting Concerns 429

Chapter 16 Working Capital Management 445

Chapter 17 Revision Objectives and Short-Answer Questions 466

Definition Of Terminologies 575

INTRODUCTION TO MANAGEMENT ACCOUNTING

Management Accounting otherwise known as Internal Accounting or Managerial Accounting

Although some define ‘Management Accounting’ as concerned with the accumulation,

a. Planning: - The Management Accountant is expected to prepare budgets, plans, forecast

b. Controlling: - Variance analysis, budgetary control reports, performance evaluation

f. Communication: - Various report and information prepared and presented by the

THE ATTRIBUTES OF AN EFFECTIVE MANAGEMENT ACCOUNTANT

 Sufficiently qualified, either by examination or experience

 Understand fully the problems that their managers may be facing.

a. Users: - The users of financial accounting information include; Investors, Creditors,

e. Objective: - The main objective of financial accounting information is to present the

f. Period cover: - By statues, financial accounting information is expected to cover 12 months,

g. External Audit: - Financial accounting information, by relevant statues, requires external

h. Interdisciplinary relationship: - Preparation of financial accounting information require

COST ACCOUNTING, FINANCIAL ACCOUNTING AND MANAGEMENT

Activity management, or activity based management, places emphasis on continuously improving

MULTINATIONAL MANAGEMENT ACCOUNTING

FUTURE OF MANAGEMENT ACCOUNTING

Demand for management accountants is expected to be on the increase in future as a result of

COST BEHAVIOUR AND COST ESTIMATION TECHNIQUES

TYPES OF COST BEHAVIOUR

Variable Cost/ Activity

Total fixed cost can be graphically represented as follows.

Total Fixed Cost

Fixed Cost per Activity

Step Fixed Cost

Other Patterns of Cost Behaviour

COST ESTIMATION TECHNIQUES

1. Account classification method

ACCOUNT CLASSIFICATION METHOD

1. It is subjective and not scientific.

HIGH AND LOW METHOD

1. It is objective, i.e. it can be proved mathematically

WEAKNESS /CRITICISM/ DEMERIT

Variable cost per unit or “b” = N17,500

The cost equation for the company can be stated as follows

Expected total cost = N143,120

Month January February

Proportion of variable cost to N1 sales = N60,000/N100,000 = 0.6 or 60% of sales

b. The total variable costs for January and February

c. Total fixed cost per month

d. The expected profit in March

Year Output Total Cost Average Price

Adjustment of total cost

Activities Cost (N)

Variable cost per unit = N30,000

Calculation of total fixed cost or “a” using low point