ACCT 219-Cost Accounting PDF

SCHOOL OF BUSINESS AND ECONOMICS
Department of Accounting, Finance& Investment
ACCT 219
COST ACCOUNTING
FREDRICK M.MUTEA
Open and Distance Learning Instructional

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Published by Kenya Methodist University

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Email: info@kemu.ac.ke
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Cost Accounting
ACCT 219
Fredrick Mutea 2014
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No part of this module may be reproduced, stored in any retrieval

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TABLE OF CONTENTS
LECTURE ONE....................................................................................................12
1.0
INTRODUCTION
TO
COST
ACCOUNTING......................................................12
1.1 Lecture overview..12
1.2 Objective...12
1.3 Definition and scope of costing accounting..12
1.4 Relationship of cost and other disciplines13
1.5 Distinction between financial accounting and cost accounting ...15
1.6 Purpose of cost accounting...17
1.7 Summary...20
1.8 Self-Assessment questions....21
LECTURE TWO22
2.0 COST CLASSIFICATION....22
2.2 Objective.......22
2.3 Classification of cost....24
2.4 Cost statement..30
2.5Work in progress32
2.6 Summary...34
2.7 Self-Assessment questions...36
LECTURE
THREE.................................................................................................................39
3.0 COST
ESTIMATION.......................................................................................................39
3.2 Objective...39
3.3 Cost estimation.... 39
3.4 High-low method.... 40
3.5 Regression analysis .... 44
3.6 Visual fit.. 47
3.7 Engineering method...47
3.8 Account analysis...48
3.9 Learning curve theory...48
3.10 Summary.48
3.11Self-Assessment questions..49
LECTURE
FOUR....................................................................................................................51
4.0 MATERIAL
COSTING...................................................................................................51
4.1 Lecture overview.51
4.2 Objective.....51
4.3 Purchasing procedure and issue of materials. 51
4.4 Store keeping and stock control. 54
4.5 Material Coding . 56
4.6 Stock Recording and Inventory Control.. 56
4.7 Methods of valuing material issues59
4.8 Stock levels...66
4.9 Summary..69
4.10 Self-Assessment questions..70
LECTURE FIVE...................................................................................................73
5.0 LABOR COSTING..73
5.2 Objective...73
5.3 Remuneration Methods... 73
5.4 Incentive Schemes in Practice..75
5.5 Procedure for preparing a payroll.....77
5.6 Allocating of labour costs...79
5.7 Summary...80
5.8 Self-Assessment questions...80
LECTURE SIX.82
6.0 OVERHEAD COSTING... 82
6.1 Lecture overview.....82
6.2 Objective..82.
6.3 Overhead .82
6.4 Bases of Absorption83
6.5 Service Departmental Costs87
6.6 Absorption of Overhead.94
6.8 Summary.100
6.9 Self-Assessment questions.100
LECTURE SEVEN103
7.0 COSTING Systems103
7.1 Lecture overview103
7.2 Objective.103
7.3 Specific order costing 103
7.4 Accounting for Job Order Costing..104
7.5 Job cost account.....105
7.6 Batch costing..107
7.7 Summary....108
LECTURE EIGHT.110
8.0 CONTRACT COSTING...110
8.1 Lecture overview110
8.2 Objective.....110
8.3 Contract account.110
8.4 Features of contract accounting..111
8.5 Proforma contract account....113
8.6 Summary....117
LECTURE NINE...119
9.0 PROCESS COSTING...119
9.1 Lecture overview.......119
9.2 Objective...119
9.3 Nature of process costing..119
9.4 Valuation of work in progress120
9.5 Process losses.123
9.6 Allocation of joint cost...128
9.7 Summary....131
9.8 Self-Assessment questions.131
LECTURE TEN....133
10.0 VARIANCE ANALYSIS... 133
10.1 Lecture overview...133
10.2 Objective133
10.3 Purpose of variance analysis.133

10.4 Material variance analysis.
137
10.5 Labour variance analysis..140
10.6 Overhead variance analysis..142
10.7 Summary..149
10.8 Self-Assessment questions..150
LECTURE ELEVEN 154

11.0 STANDARD COSTING.154
11.1 Lecture overview.154
11.2 Objective.154
11.3 Definition of budget154
11.4 Budget as a tool of planning155
11.5 Budgeting preparation process157
11.6 Typical problems with budgeting160
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COURSE OVERVIEW
I welcome you to the study of Cost Accounting. In this course we shall study important concepts
and techniques needed by managers in planning, control, management and decision making in
business organization. The course has 11(eleven) lectures and each lecture takes one or more weeks
depending on the topics depth.inn addition, each has its own objectives that you should achieve. At
the end of every lecture, you will find a series of SAQs that are meant to help you to evaluate your
understanding of the concepts presented. You should attempt all the questions and activities once
you have finished studying the relevant work. A summary of each lecture is also provided at the
end with a list of further resources that you are expected to read and make notes from.
Kindly, make sure that:
You complete each lecture at a time before proceeding to the next one.
Refer to the suggested additional resources to get further information on each topic
Make notes as to simplify your study
Complete all activities and questions as you progress
Spend at least 3(three) hours to complete each topic for you to understand and apply the
knowledge and skills acquired
Once again welcome and let us begin. Good luck!!!!
COURSE PURPOSE
This course is intended to equip you with knowledge; skills and attitudes that will enable
understand important concepts and techniques needed by managers in planning, control, management
and decision making in business organization.
Expected Learning Outcomes
By the end of the course, you should be able to:i.
Explain the importance of costing in the management of organizations
ii.
Apply costing techniques to account and accumulate input costs to various operating activities of
organizations
iii.
Differentiate the different types of costing systems and their applications to different
organizations and situations
iv.
Analyze an organizations activities through budgetary control process.and responsibility

accounting in management of organizations.
Course Content
The course will cover: Introduction to cost accounting, cost estimation, material costing, labour
costing, overhead costing, costing techniques and variance analysis.
Teaching Methods
a)
Tutorials
b)
Class presentations
c)
Discussions
Teaching Materials
a)
Chalkboard
b)
Instructional Materials
c)
Research papers, projects etc.
Assessment
a) Continuous Assessment Test(s)
40%
b) End of trimester examination
60%
Recommended Text Books:

1. Paresh, S. (2010). Cost Accounting. 3rd Edition, Tata McGraw-Hill, New Delhi.
2. T Lucy,T (2009) Costing. 9th Edition, Book Power, London
3. Saleemi,N.A (2009) Cost Accounting Simplified, N.A Saleemi Publishers, Nairob
4. Drury C., (2004) Management and Cost Accounting. 6th Edition, Book Power, London.
Text Books for further Reading:

Horngren C.T Sundrem G L and Stratton W. O; (2008), An introduction to Management Accounting,
Prentice Hall International Inc.
Other support materials: Various applicable manuals and journals; variety of electronic information
resources as prescribed by the lecturer
You will be expected to take responsibility of the learning process. The instructor will provide you
with the necessary support and facilitation in order to achieve the course objectives. You may be
expected to do assignments which will constitute 40% of the total marks. The final examination will
constitute 60% of the marks.
SYMBOLS
Objectives
Activity
Key note
Summary
Self-Assessment Questions (SAQs)
Further Reading
10
COURSE OUTLINE
Week
1
Topics
Introduction to Cost
Accounting
Content
1.1 Definition and Scope of Costing Accounting
1.2 Cost and Management Accounting
1.3 Relationship of Cost Accounting and Other
Accounting Disciplines
1.4 Role of cost accounting
Cost Classification
Cost Estimation
Material Costing
2.1 Cost Classification

2.2 Cost Behavior
2.3 Costs Decision Making and Planning
2.4 Cost Control and Cost Reduction
2.5 Cost Statement
3.1 Account Analysis
3.2 Engineering Estimates
3.3 The Scatter Graph Method
3.4 High-Low Method
3.5 Statistical Cost Estimation
4.1 The Material Control Process
4.2 Stocktaking
4.3 Changes in Production and Purchasing
Systems
4.4 Stock Recording And Inventory Control
4.5 Pricing Issues And Stocks
Labour Costing
6
7
CAT 1
Overhead costing
Costing systems
Contract costing
5.1 Remuneration Methods

5.2 General Features of Incentive Schemes
5.3 Incentive Schemes in Practice
5.4 Trends in Labor Costing
5.5 Labor Recording, Costing and Allied
Procedures
6.1 Overhead Absorption
6.2 Bases of Absorption
6.3 Service Departmental Costs
6.4 Overheads and Activity Based Costing.
7.1 Job costing
7.2 Accounting for Job Order Costing
7.3 Job cost account
7.4 Batch costing
8.1 Features of contract costing
8.2 Contract costing and job costing
8.3 Accounting procedures
8.4 Proforma contract account
8.5 Preparation of contractee account
11
Week
10
Topics
9.0 Process costing
11
10.0 Variance analysis
12
11.0 Standard costing
Content
9.1 Job costing and process costing
9.2 Costing procedures
9.3 Flow of cost in process costing
9.4 Normal loss and abnormal loss
9.5 Abnormal gain
10.1Definition of variance analysis
10.2The purpose of variance analysis
10.3Material cost variances
10.4Variable overhead variances
10.5Fixed overhead variances
11.1 Introduction
11.2 Features of a budget
11.3Purpose of standard costing.
11.4 Element of a successful budget
13
End of year adjustments
14
END OF TRIMESTER
EXAMS
11.3Budgetary control and standard

Revision
LECTURE ONE
1.0 INTRODUCTION TO COST ACCOUNTING
1.1 Lecture Overview
Welcome to cost accounting course. This course is important in every sector whether
manufacturing or service, and help in communicating financial information to management for
planning, evaluating and controlling performance, and also to assist management to make more
informed decisions in line with changing environment. Costing as is normally referred is one of the
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courses that you will always need in all aspect of your life and profession. That why cost accounting
is taught to all students irrespective of their profession and areas of specialization. It is therefore
important that as cost accounting students you understand the important concepts in this class. This
lecture will introduce you to what we mean by cost accounting.
1.2 Objectives
By the end of the topic, you should be able to:

a. Define cost accounting
b. Outline the relationships of cost accounting to management accounting and financial
accounting
c. Describe the role of a cost accounting department in an organization
d. Describe the various cost classifications and prepare a cost statement
1.3 Definition of and Scope of Cost Accounting

Cost accounting is concerned with the ascertainment of costs. It is that part of management
accounting which establishes budgets and standard costs and actual costs of operations, processes,
departments or products and the analysis of variances, profitability or social use of funds
Cost accounting identities, defines, measures, reports and analyses the various elements of direct
and indirect costs associated with producing and marketing goods and services. Cost accounting
also measures performance, product quality and productivity
Cost accounting systematic process of collecting, summarizing and recording data regarding the
various resources and activities in a firm so as to calculate the basis of production costs used in
financial accounting or making other relevant decisions in a firm
Cost accounting is broad and extends beyond calculating production costs for inventory valuation,
which government-reporting requirements largely dictate. However accountants do not allow
external reporting requirements to determine how they measure and control internal organizations
activities. Cost accounting focus is shifting from inventory valuation for financial reporting to
costing for decision making.
The main objective of cost accounting is communicating financial information to management for
planning, evaluating and controlling performance, and also to assist management to make more
informed decisions. Its data is used by managers to guide their decisions.
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1.4 The relationship of cost accounting and other accounting disciplines

Accounting can be described as a specialized information system that is used for purposes of
decision making by the management of the organization and other users such as tax authorities,
investors, creditors and the general public. Accounting is broadly divided into two:
i.
Financial Accounting
ii.
Management Accounting
1.4.1 Financial Accounting:

This is the analysis, classification, and recording of financial transactions and the ascertainment of
how such information will be reported to the various users. It involves the development of generalpurpose financial statements largely for external reporting. These statements are developed in
accordance with standards imposed by the public (through the professional accounting bodies such
as the Institute of Certified Public Accountants of Kenya ICPAK and the International Accounting
Standards Board IASB) as well as the requirements of the Companies Act Chapter 486.
Conditions for effective costing system

Costing system must be simple, economical and practical. The conditions for an effective and
successful costing system include:1. Proper system of stores and stock control.
2. Co-operation and co-ordination among the staff members.
3. Proper and satisfactory wage procedures.
4. Proper record keeping e.g. receipt of materials, issue of materials, labour hours worked,
wage calculations etc.
5. The overheads must be recorded accurately and these must be charged to the respective
production departments.
6. The cost accounting department must be established e.g. have cost accountants.
7. The cost accounts and financial accounts should be maintained in such away that their
results can be reconciled easily.
Examples of information provided by a typical costing system and how it is used are given in the
following table and the following paragraphs.
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Information provided by costing system
Possible uses by management
Cost per unit of production or service or for As a factor in pricing decisions, production
a process
planning and cost control
Cost of running a section, department of Organization planning, decisions
factory
alternative methods, wages cost control
on
Wages costs for unit of production or per Production

planning,
decisions
period of production.
alternative methods, wages cost control
on
Scrap/rectification costs
Material cost control, production planning
Cost behaviour with varying levels of Profit planning, make or buy decisions, cost
activity
Examples of costing information and uses
Activity 1.1
As you will realize as you go through this course, the characteristics of a good cost
accounting system should be simple,economical and practical. Identify what may be hindering good
costing systems in your organisation
An important part of the management task is to ensure that operations, departments, processes and
costs are under control and that the organization and its constituent parts are working efficiently
towards agreed objectives. Although there are numerous other control systems within an
organization, for examples production control, quality control, inventory control, the costing system
is the key financial control system and monitors and the results of all activities and all other control
systems. The detailed analysis and location of all expenditures, the calculation of job and product
costs, the analysis of losses and scrap, the monitoring of labour and departmental efficiency and
outputs of the costing system provide a sound basis of information for financial control. Cost
accounting and financial accounting Financial accounting can e defined as: The classification and
recording of the monetary transactions of an activity in accordance with established concepts,
principles, accounting standards and legal requirements and their presentation, by means of profit
and loss account, balance sheets and cash flow statements, during and at the end of accounting
period Financial accounting originated to fulfill the stewardship function of businesses and this is
still an important feature. Most of the external financial aspects of the organization, e.g., dealing
with accounts payable and receivables, preparation of final accounts etc., are dealt with by the
financial accounting system. Of course internal information is also prepared, but in general it can be
said that financial accounting presents a broader, more overall view of the organization with
primary emphasis upon classification according to type of transaction rather than the cost and
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management accounting emphasis on the function, activities, products and processes and on internal
planning and control information.
1.5 Distinction between financial accounting and cost accounting.
Financial accounting and management are two interrelated facets of the accounting system. They
are not exclusive of each other; they are supplementary in nature. Financial accounting provides the
basic structure for collecting data. The data collection structure is suitably modified or adjusted for
accumulating information for management accounting purpose. In a broader sense, management
accounting includes financial accounting. A distinction is drawn between financial accounting and
management accounting since they differ in their emphasis and approaches. Some of the
characteristics which distinguish management accounting and financial accounting are discussed
below;.
Focus. Financial accounting emphasizes the external use of accounting data. Management
accounting on the other hand, utilizes accounting data for internal use. The major objective of
financial accounting is to prepare balance sheet and profit and loss account to inform shareholders
and others about the firms profitability and the state of its resources and obligations. The propose
for which management accounting collects and repots relevant information is to make decisions to
ensure optimum use of the firms resources
.
Principles. The accounting profession has developed certain principles foe preparing and presenting
financial reports for external uses. Financial accounting adheres to these generally accepted
accounting principles. This introduces consistency and meaningfulness of data for the investors
point of view. They can make inter firm comparisons of performance and analysis performance
trend over years when some set of generally accepted principles are followed by all firms.
Management accounting, in contrast, is not based on any set of accepted rules of principles. Every
enterprise, depending on its requirements for facts, evolves its own procedures and principles for
preparing reports for internal uses. The following should be relevant and aid management in making
decisions.
Information. Financial accounting accumulates reports historical information to investors.
Financial accounting reporting tell what has happened in the past. Through balance sheet and profit
and loss account, to the investors is revealed the manner in which the resource entrusted by them to
the firm have been utilized. Management accounting, being a decision-making process, focuses on
the future. It analyses past data and adjusts them in the light of future expectations to make plans.
Need. Financial accounting is an outcome of statute. For example, in India under the companies Act
to prepare balance sheet and profit and loss account for submission to shareholders and others. The
financial statements are generally required to be prepared in the formats prescribed by the law.
Management accounting is the result of the managements needs of information for making
decisions. It is, therefore, optional. Management accounting functions would differ from firm to
firm. A firm may have a sophisticated elaborate and comprehensive system while another may have
a partial system only.
Timing.Financial accounting adopts twelve months (one year) period for reporting financial
performance to shareholders and other investors. In contrast, management accounting reports are for
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shorter durations. Some companies in India prepare daily budgets. Monthly and quarterly reports
are quite common. Management accounting expenditure plans, for example, cover a longer
duration.
Coverage.While reporting the state of affairs of a company, financial accounting covers entire
organization. Financial statement show revenue, expenses, assets and equities of the firm as a
whole. For management accounting purpose, however, organization is divided into smaller units, or
centres. These centres may be headed by responsible persons. Cost data and other informations are
collected and reported by the centres. Thus, the data requirements of management accounting are
more specific.
Reporting. Financial statement-balance sheet and profit and loss account are subject to the
verification of statutory audit. Therefore, financial accounting stresses accuracy and precision of
accounting data. Management accounting requires information promptly for decision-making.
Continuous and speedy flow of approximate information is more useful than the precise, but
delayed information.
1.5.1 Management Accounting

Management accounting is defined as: The application of professional knowledge and skill in the
preparation and presentation of accounting information in such a way as to assist management in the
formulation of policies and in the planning and control of operations of the undertaking. The
provision of information required by management for such purposes such as:
a) Formulation of policies
b) Planning and controlling the activities of the enterprise
c) Decision taking on alternative courses of action
d) ]disclosure to those external to the entity
e) Disclosure to employees
f) Safeguarding assets
Management accounting uses both financial and cost information to advise management in planning
and controlling the organization. The objectives of the various facets of accounting have been given
above and differences. And the differences discussed. However, it must be realized that all form
part of the financial information system of an organization and in many organizations the various
facets are totally integrated with no artificial divisions between them.
This is the part of accounting that provides special-purpose statements and reports to management
and other persons inside the organization. The information generated by management accounting is
therefore for internal uses and is not guided by any standards or legal requirements. Management
Accounting, unlike financial accounting, is proactive i.e. it is future-oriented. It is required in
making decisions that affect the organization.
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In a nutshell, cost accounting enables a business to not only find out what various jobs or processes
have cost, but also what they should have cost. It indicates where losses are occurring before the
work is finished and therefore corrective action can be undertaken.
From the foregoing discussion, it is then clear that cost accounting is very closely related to other
accounting subjects especially management accounting. In fact, most people make no distinction
between management accounting and cost accounting, as the dividing line between the two is
slimmer than thin!
1.5.2Relationship between cost accounting and management accounting
Referring to CIMAs definition of cost accounting, we can see that cost accounting is a part of
management accounting.
CIMA defines management accounting as provision of information required by the management
for such purposes as formulation of policies, planning and controlling the activities of the
enterprise, decision taking on the alternative courses of action, disclosure to those external to the
entity (shareholders and others), disclosure to employees and safeguarding assets. Cost accounting
and management accounting have basically the same functions.
1.6 Purpose of cost accounting information
Cost ascertainment
Costs relating to materials, labour and overhead costs must be ascertained accurately. They should
be kept at minimum level possible.
Disclosure of wastes
The costs incurred for the production of any commodity can be determined in advance in view of
the past experience. If the actual costs are higher than the expected or standard costs, then this
excessive cost can be analyzed e.g. it may be from wastage of raw materials, idle labour, time
wastage etc.
Decision making
Cost accounting provides necessary information to the management for decision making e.g. what
goods to produce and in what quantities.
Cost control
Materials costs, labour costs and overheads must be maintained at desirable levels. Cost accounting
principles are used to eliminate unnecessary costs.
. Planning
The cost data and past experience are used to prepare and implement future plans e.g. expansion of
business.
Measurement of efficiency
Departmental performance can be measured using the costs data. More efficient departments will be
given greater incentives and appropriate steps taken to improve the performance of less efficient
departments.
1.6.1 Settling selling prices
A business concern must ascertain its cost and then add its profit into cost of sales to avoid charging
high or low prices which can bring negative effects.
Evaluation of profitability
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Profitability can be measured in a number of ways e.g. profit as a percentage of sales, profit
percentage to capital employed, profit per unit of output etc.
The profitability information serves as a guide to the management to make some strategic decisions
regarding the introduction of new products and increasing or decreasing the volume of production
a) Accounting for costs
This may be seen as a record keeping or score keeping role. Information must be gathered
and analyzed in a manner which will help in planning, control and decision making
b) Planning and Budgeting
This involves the quantification of plans for the future operations of the enterprise; such
plans may for the long or short term, for the enterprise as a whole or for the individual
aspects of the enterprise.
c) The control of the operations of the enterprise
Control may be assisted by the comparison of actual cost information with that included in
the plan. Any differences between planned and actual events can be investigated and
corrective action implemented as appropriate
d) Decision Making
Cost accounting information assists in the making of decisions about the future operations
of the enterprise; such decisions making may be assisted by the information from cost
techniques and cost-volume profit analysis.
e) Resource allocation decisions
For example product pricing in determining whether to accept or reject jobs: This is based
on cost and revenue implications of the relevant decisions
f) Performance evaluation
Cost accounting information is used to measure and evaluate actual performance so as to
make a decision of the degree of optimality or efficiency of resource utilization.
1.6.2 The role of a cost accounting department in an organization

As part of their jobs, cost accountants interpret results, report them to management and
provide analysis that assist decision-making in the following departments:
a) Manufacturing
Cost accountants work closely with production personnel to measure and report
manufacturing costs. The efficiency of the production departments in scheduling and
transforming materials into finished units is evaluated for improvements.
b) Engineering
Cost accountants and engineers translate specifications for new products into estimated
costs; by comparing estimated costs with projected sales prices, they help management
decide whether manufacturing a product will be profitable.
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c) Systems design
Cost accountants are becoming more involved in designing computer integrated
manufacturing (CIM) systems and databases corresponding to cost accounting needs. The
idea is for cost accountants, engineers and system designers to develop a flexible production
process responding swiftly to market needs
d) Treasury
The treasurer uses budgets and related accounting reports developed by cost accountants to
forecast cash and working capital requirements. Detailed cash reports indicate where there
are excess funds to invest or where cash deficits exist and need to be financed.
e) Financial accounting
Cost accountants work closely with financial accountants who use cost information in
valuing inventory for external reporting and income determination purposes.
f) Marketing
Marketing involves the cost accountant during the product innovation stage, the
manufacturing planning stage and the sales process. The marketing department develops
sales forecast to facilitate preparing a products manufacturing schedule. Cost estimates,
competition, supply, demand, environmental influences and the state of technology
determines the sales price that the product will be offered and will command in the market.
g) Personnel
Personnel department administers the wage rate and pay methods used in calculating each
employees pay. This department maintains adequate labour records for legal and cost
analysis purposes.
At this point, it cannot be over-emphasized that cost accounting is simply an information
system designed to produce information to assist the management of an organization in
planning and controlling the organisations activities. It also assists the management to make
informed decisions so as to enable the organization to operate at maximum effectiveness and
efficiently.
1.6.3
Role of Cost Accounting In business management
A system is a set of interdependent parts which together form a unitary whole that performs some
functions. A number of sub systems make up the whole. In this context of the organization, a
management information system may be seen as the overall system with a number of sub systems
including the cost and management accounting system that provide the information to management
for purposes of planning, organizing, directing and controlling the organizations activities so as to
achieve corporate goals including profit maximization.
Information must be collected, processed and communicated in an organized manner if the
objectives of the enterprise are to be efficiently implemented and alternative strategies for their
implementations examined, so as to select the best strategy.
Information may be non mutually exclusive in nature. This means that information gathered as part
of the management information system may be used in two or more subsystems for differing
20
purposes. An example of this information is with regard to the amount and location of work in
progress: (work in progress refers to partly completed units of products where a product passes
through a number of operations and processes before being passed into finished goods store or to
the customer). Work in progress information may be used by:
a) Production planning department in order to monitor the progress of parts of an order
through the production process and to instigate action to speed up the completion of slow
moving parts of the order
b) Quality control department in comparing one batch of product with another in
highlighting the incidence of process losses and their location
c) Cost management department in the quantification and valuation of actual loses as
compared to the level originally allowed for in the business plan
d) Financial accounting department in the valuation of work in progress for balance sheet
purposes and for purposes of determining the cost of sales in the income statement.
Activity 1.1
Review ways in which you can use cost accounting in your home and organization i.e units
departments, products and process.
1.7 Summary
(i) Cost accounting is concerned with the ascertainment and control of costs
(ii) The purpose of cost accounting is to provide detailed information for control, planning and
decision making.
(iii) To be of use, costing information must be appropriate, relevant, timely, well presented and
sufficiently accurate for the purpose intended.
(iv) Cost accounting and management accounting are closely related.
(v) The emphasis of financial accounting is upon classification by type of transaction and type and
type of expenditure rather than the functional analysis of cost accounting.
(vi) Cost, financial and management accounting all contribute to the financial information system of
an organization and increasingly in practice are totally integrated.
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1.8 Self-Assessment Questions
1. Define cost accounting?

2. Give six examples of costing information and its uses
3. What is the relationship between costing, management accounting and financial accounting?
4. Describe the main purposes of cost accounting
5 Define the following terms
a) Cost Accounting
b) Financial Accounting
c) Management accounting
6 Briefly describe the purpose of Cost Accounting.
7 Compare and contrast Cost Accounting and financial Accounting
1.9 Further Reading
rd
1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.

2. T Lucy,T (2009) Costing 9th Edition, Book Power, London
3. Saleemi,N.A (2009) Cost Accounting Simplified, N.A Saleemi Publishers, Nairobi
th
4.Drury C., (2004) Management and Cost Accounting 6 Edition, Book Power, London.
LECTURE TWO
2.0 COST CLASSIFICATION
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2.1Lecture overview
To this point am sure you have learnt what cost is and you are able to check the bills you pay to
indentify some of these cost. Now is high time to take you through various methods of cost
classification and the reason behind these classifications.
2.2 Lecture Objectives
By the end of this lecture, you should be able to:

(i) Define the term cost classification and the explain the rational
(ii) Describe the various cost classifications
2.1Terminologies
a) Cost
This may be defined as: A cost is the value of economic resources used as a result of production of
any commodity or performing any service or The amount of expenditure (actual or notional)
incurred on, or attributable to, a specified thing or activity. At the simplest level, cost includes two
components, quantity used and price, ie, Cost = quantity used x price Cost units The cost unit to be
used in any given situation is that which is most relevant to the purpose of the cost ascertainment
exercise. This means that in any one organization numerous cost units may be used for particular
parts of the organization or for differing purposes.
The main elements of costs are:
a) Raw material
b) Labour
c) Overheads
b)Cost units
It is the quantitative unit of the product or service in relation to which costs are ascertained.
The cost unit will be determined by the nature of the business enterprise. It may be
- An individual job, batch or contract
- A unit of production expressed as a relevant quantity
- A service is provided to the customer
Refers to a unit of quantity of produce, service or time in relation to which costs may be ascertained
or expressed. E.g. a kg of sugar, a meter of cloth, a liter of milk, a passenger seat, a patient bed; one
labour hour; a consulting hour etc.
Mostly, costs are ascertained in terms of cost units e.g. cost of production per meter of cloth or cost
of providing service per patient bed in the hospital etc.
23
c)Cost centre
Refers to any particular part of enterprise e.g. a particular department; a function or items of
equipment in respect of which costs may be ascertained and related to cost units for control purpose.
Cost per department is ascertained hence each department in an enterprise becomes a cost centre.
A CostCenter Framework/Approach in Cost Accounting
Cost accounting is based on the concept or framework of cost centers, i.e. all the costs incurred
during the production process have to be identified and accumulated around certain points of the
production process, referred to as cost centers.
A cost center may be defined as any point at which costs are gathered in order to control cost, fix
responsibility and enable costs to be recharged on an equitable basis. We will use a cost flow
diagram to illustrate the principles of a cost center framework
Each rectangular box represents a cost center. Each cost will be the responsibility of one
management member and will have costs charged to it and also costs recharged from it if such costs
are incurred for purposes of offering a service to other cost centers.
Cost flow diagram of a typical manufacturing concern (Organization):
MAKING
POWER
MAINTENANCE
ADMINISTRATION
PACKING
FINISHING
FINISHED
GOODS
SELLING
DISTRIBUTION
Cost of sales
Note
There are three manufacturing centres (Making, Finishing and Packing). These are supported
by five support departments, namely Maintenance, Power, Administration, Selling and
24
Distribution. All the various costs incurred in those departments produce the cost of sale of the
finished product that is offered for sale in the market. It is possible that some departments
reciprocally support each other, for example, in the above diagram, the power department
provides power to the maintenance department; in return, the maintenance department maintains
the power department.
The departments can be viewed as cost centres as we can identify and accumulate costs in
regard to them. Also, the finished products could be viewed as cost centres under the same
logic.
Importance of cost classification
Analysis of cost behaviour is important to all organizations for effective management. This
is because many organizations have a unique cost structure. For example, fixed costs
account for 60 80% of all hospital costs. However, unlike many organizations of this type,
labour costs largely comprise the hospitals fixed costs.
Labour costs unlike depreciation require a cash outflow. This is characteristic of labour
intensive organizations. Capital-intensive organizations, on the other hand, have low labour
costs, e.g. computerized manufacturing organizations.
Some organizations e.g. hospitals allocate 10 15% of their space for standby emergency
events giving them built in idle capacity. This prevents them from enjoying advantages of
higher profits that a capital-intensive organization realizes at higher volumes beyond the
break-even volume. Thus the cost structure of healthcare institutions presents challenges to
accountants because of their labour intensive and capital-intensive characteristics
2.3 Classification of Costs
Classification is the process of grouping costs recording to their common characteristics.
Classification of cost is done in order to be concise of every cost incurred in the process of
manufacture so that such costs can be accurately recorded, monitored and controlled. They are
various ways of grouping cost:.
These different bases of cost classification are summarized in the diagram below:
Manufacturing/ Non-manufacturing
Fixed/Variable
incremental/sunk
25
Direct/indirect
historic/opportunity
Cost Behaviour
Functional Classification
Avoidable/unavoidable
Controllable/
Uncontrollable
Standard/actual
A) Functional classification
A business has to perform a number of functions e.g. manufacture, administration, selling,
distribution and research. On this basis costs are classified into the following;
a) Manufacturing /production / factory cost This are costs related to the
manufacturing process e.g. material cost, labour, cost and factory cost such
as rent, depreciation of machinery, power and lighting etc
b) Administrative costs include all expenditure incurred in formulating
policies, directing the organizations and controlling the operation of an
undertaking such as audit fee, office rent, salaries etc.
c) Selling cost are costs of seeking to create and stimulate demand and to
serve orders e.g. advertising, salaries and commission of salesmen etc.
d) Distribution expenses are cost incurred to avail the product to the final
consumer. E.g. packing cost, carriage outward, warehousing cost etc.
e) Research and development cost this is the cost of searching new and
improved products and methods. E.g. wages and salaries of research staff, payment
to outside research organizations etc
B) Classification according to behaviour or variability

Cost behavior refers to the change in costs (increase or decrease) as the output level changes, i.e. as
we increase output, are the costs rising, dropping or remaining the same.
Cost Behaviour can be used to produce various classifications of costs such as:
a) Variable Costs Vs. Fixed Costs
26
1) Variable costs:
Are costs that increase or decrease proportionately with the level of activity , i.e. that portion
of the cost of an activity that changes with the level of output.
Costs
Variable Costs
Activity Level
Note that with variable costs, the cost level is zero when production is zero. The cost
increases in proportion to the increase in the activity level, thus the variable cost function is
represented by a straight line from the origin. The gradient of the function indicates the
variable cost per unit.
2) Semi variable costs

Are costs with both a fixed and variable cost component. The fixed component is that
portion which is constant irrespective of the level of activity. They are variable within
certain activity levels but are fixed within other activity levels, as shown below:
27
Costs
Variable cost
Fixed
Cost
Activity Level
3) Fixed Costs
Are costs that do not change with of the level of output. It is also called autonomous cost, as
it remains the same irrespective of the activity level as shown below.
Costs
Fixed Cost
Activity Level
The classification of cost into fixed and variable costs would only hold within a relevant range
beyond which all costs are variable. The relevant range is the activity limits within which the
cost behaviour can be predicted.
4) Semi Fixed Costs
Are costs with both a fixed and variable cost component. The fixed component is that portion
which is constant irrespective of the level of activity. They are variable within certain activity
levels but are fixed within other activity levels, as shown below:
28
Costs
Variable component
Semi
Variable cost
Fixed component
Activity Level
C) Product cost and period cost

a) Product cost is costs necessary for production and can not be incurred in case there is no
production. They include; cost of direct materials, direct labour and some of the factory overhead.
They are called production costs because they are included in the course of production.
b) Period costs are costs which are not necessary for production and they are written as expenses in
the period in which they are incurred. They are incurred for a time period and are charged to the
income statement for the period e.g. rent salary of company executives, travel expenses etc.
D Classification according to identifiability with the product

a) Direct costs are costs which are incurred for and may be conveniently identified with a
particular cost unit process or department such as direct labour, direct materials etc.
Direct costs consist of costs that can be directly attributed to a specific output,
product or level of activity. Direct costs include direct raw materials and direct
labour also called prime costs in aggregate.
PRIME COST = Direct Material Cost + Direct Labour Cost
b) Indirect costs are costs which can not be conveniently identified with a particularly cost unit
process or department. They are general cost incurred for the benefit of a number of cost
unit or cost centres such as salary paid to a factory foreman.
Indirect costs are costs that will not be directly attributable to a specific product. They are regarded
as overheads. Identification of overheads to specific products is done through cost allocation and
apportionment. They include supervisors salaries, rent, electricity, depreciation of building etc.
E Classification according to controllability

a) Controllable costs are costs that may be directly regulated by a given level of managerial
influence. E.g. variable costs are generally controllable by department heads.
29
b) Uncontrollable costs are costs that cannot be influenced by the action of a specified member of
the enterprise e.g. fixed cost like rent are generally uncontrollable.
F. Special cost for managerial decision making
a) Relevant costs are costs which changes from one decision to the next and as such relevant cost
will be affected by the decision being made under different alternatives. In decision making
management will be concerned with those costs that differ from one decision to another.
b) Sunk or irrelevant cost These are cost which have been already been incurred in the past and
cannot be changed. They are relevant in decision making.
c) Incremental cost / differential costs This is an increase or decrease in cost as a result of an
alternative course of an action.
d) Marginal or variable cost It is the cost of producing an extra unit of a commodity.
e) Replacement cost This market value of replacing an existing asset.
f) Opportunity cost It is the sacrifice involved in accepting the alternative under consideration.
G. Classification according to time
a) Historical costs are costs ascertained after they have been incurred. They are the actual costs
which are only available after completion of the manufacturing process.
b) Predetermined costs They are future costs that are ascertained in advance of production on the
bases of all specified factors affecting cost.
H Special cost for managerial decision making
a) Relevant costs are costs which changes from one decision to the next and as such relevant cost will
be affected by the decision being made under different alternatives. In decision making management
will be concerned with those costs that differ from one decision to another.
b) Sunk or irrelevant cost These are cost which have been already been incurred in the past and cannot
be changed. They are relevant in decision making.
c) Incremental cost / differential costs This is an increase or decrease in cost as a result of an
alternative course of an action.
d) Marginal or variable cost It is the cost of producing an extra unit of a commodity.
e) Replacement cost This market value of replacing an existing asset.
f) Opportunity cost It is the sacrifice involved in accepting the alternative under consideration.
I. Classification according to time
30
a) Historical costs are costs ascertained after they have been incurred. They are the actual costs which
are only available after completion of the manufacturing process.
b) Predetermined costs They are future costs that are ascertained in advance of production on the bases
of all specified factors affecting cost.
Concepts of Cost accounting Cost per unit this may be unit of a product service all time in relation to
which cost may be ascertained all expressed. There are the things that the business is set up to provide
which cost to ascertained. E.g. kilowatt in case of power consumption meals in case of a hotel passages
in case of transport. Profit centre `this may be defined as subdivision within an organization operating
on a self contained bases. Usually it will be a cost and an income earning subdivision hence producing
profit measurable as a return on capital employed.
Activity 2.1
Now that you have known the different type of cost classification, can you indentify the different
cost in an organization and group them in each of the classification learnt above
2.4 Cost statement

This means the presentation of cost data in the form of a statement. The statement shows costs
incurred under appropriate headings.
Preparation of a cost statement
A cost statement can be prepared to show:1. Production cost or factory cost.
2. Total cost of sales.
3. Total cost of sales; profit and sales. In this case, it may be known as income statement.
FORMAT
Shs
Material cost
Labour cost
Direct expenses (if any)
Prime cost
x
x
x
Xx
Production overheads
Factory rent
Power
Supervision
shs
x
x
x
31
Depreciation
x
Cost of goods manufactured
x
xx
x
x
x
x
xx
Administration overheads
Selling and distribution overheads
Total cost of sales
Profit
Sales
EXAMPLE I
Prepare a cost statement from the following information.
Shs
Raw materials
600,000
Direct labour
160,000
Factory rent
30,000
Power
10,000
Supervisors salaries
40,000
Administration expenses
80,000
Selling and distribution expenses
30,000
Solution
Cost statement
Raw materials
Direct labour
Prime cost
Factory overheads
Factory rent
Power
Supervision
Shs
600,000
160,000
760,000
Shs
30,000
10,000
40,000
80,000
420,000
40,000
15,000
55.000
475,000
Total cost
EXAMPLE 2
From the following information, prepare a cost statement.
Shs
Raw materials
1,600,000
Direct labour
700,000
Factory rent
100,000
Power
60,000
Indirect wages
40,000
80,000
Selling & distribution expenses
60,000
32
Profit
25% of cost.
Solution
COST STATEMENT
Material cost
Labour cost
Prime cost
Factory overheads
Factory rent
Power
Indirect wages
Selling & distribution overheads
Shs
1600,000
700,000
1300,000
Shs
100,000
60,000
40,000
Total cost of sales

Profit (25% of cost)
Sales
200,000
2500,000
80,000
60,000
________
2,640,000
66,000
3300,000
2.5 Work In Progress (W.I.P)

Work in progress refers to the cost of those items which remain incomplete at the end of a specific
period. Thus are semi-finished goods. E.g. in the textile industry, thread is neither raw material nor
finished good so it is considered as W.I.P.
There may be opening and closing W.I.P. If the opening figure of W.I.P is greater than closing figure
then this difference is added to factory cost and vice versa.
Kemu ltd manufacturing company provides to you the following information for the month of
October 2014.
STOCKS ON 1ST OCTOBER 2014
Shs
Raw materials
800,000
Work in progress
240,000
Finished goods
400,000
STOCKS ON 31ST OCTOBER 2014
Raw materials
Work in progress
Finished goods
Purchases of raw materials for October
Factory wages
Salaries of supervisors
700,000
340,000
460,000
5,000,000
1,600,000
600,000
33
Factory rent
Power
Sundry factory expenses
Office salaries
Sundry office expenses
Salesmens salaries
Sundry selling expenses
Sales
200,000
100,000
300,000
260,000
140,000
360,000
120,000
10,000,000
REQUIRED
1. Prepare a production cost statement
2. Prepare a profit statement.
Solution
PRODUCTION COST STATEMENT
DIRECT MATERIALS
Opening stock
Purchases of raw materials
Less: closing stock
Cost of material used
Direct wages
Prime cost
800,000
5,000,000
5800,000
(700,000)
5100,000
1,600,000
6,700,000
FACTORY OVERHEADS
Supervisors salaries
Factory rent
Power
Sundry factory expenses
Ksh
600,000
200,000
100,000
300,000
WORK IN PROGRESS
Opening
Closing
Production for factory cost
240,000
(340,000)
(1200,000)
7,900,000
(100,000)
7,800,000
PROFIT STATEMENT
SHS
Sales
Less: cost of goods sold:
Opening stock
Add: production cost
Less closing stock
Gross profit
400,000
7800,000
8200,000
(460,000)
(SHS)
10,000,000
7,740,000
2,260,000
34
LESS: EXPENSES
Sundry office expenses
SELLING & DISTRIBUTION
Salesmens salaries
Sundry selling expenses
Net profit
Shs
260,000
140,000
400,000
360,000
120,000
480,000
880,000
1,380,000
2.6 Summary
Cost may be classified as under: Fixed and variable cost.

Direct and indirect cost
Cost classification by function.
Fixed and variable cost
Fixed cost is the cost which is constant at various levels of output. I.e. it doesnt change with
changes in output e.g. rent of premises, salaries to permanent employees etc.
Variable cost is that cost which changes with the level of production. The change is direct e.g. cost
of raw materials, wages of factory workers lighting and heating charges etc.
Direct and indirect cost
Direct cost is the cost which can be identified for the production of some specific goods e.g. raw
materials and labour costs.
Indirect cost is the cost which cannot be identified to the production of some specific goods e.g.
indirect materials, indirect wages, electricity, water, rent and rates etc.
Cost classification by function
This consists of:a) Production cost e.g. cost of raw material, labour, factory rent etc.
b) Administration cost e.g. office rent, depreciation of office machines etc.
c) Selling and distribution cost include all costs incurred to promote the sale of the goods
and deliver these goods to customers e.g. cost of advertisement, salesmans commission,
depreciation of delivery vans etc.
The Analysis of Total Costs.
These include:1. Prime costs i.e. Direct materials
Direct wages
Direct expenses
35
2. Production or factory costs. These include all prime costs plus overheads (production or
factory).
3. Total cost of sales. These include production cost plus the other overheads e.g. administration
and selling and distribution.
These are explained as under:Direct materials consists of the raw materials used in a product and some component which are
incorporated into the finished product.
Cost of direct materials = opening stock + purchases closing stock
NB: 1. Transport charges on material purchased are added.
2. Returns of material purchased are deducted.
Direct wages are remuneration paid to factory workers for converting the raw materials into
finished goods. They also include remuneration of construction workers, machine operation etc.
Direct expenses Include any expenditure other than direct materials and direct wages incurred on
the production of some specific product. E.g. hire charges of equipment for the production of a
specific product, costs of designs or drawings etc.
Prime cost = Direct material cost + direct labour costs + direct expenses (if any)
Over heads These are costs which cannot be identified to the production of any specific product.
They are also called indirect expenses and include:1. Production or factory overheads.
2. Administration overheads.
3. Selling and distribution overheads.
Production overheads (factory or works overheads)
These are factory expenses other than direct costs
They include: Indirect materials that cannot be charged directly to the production of a specific product.
Its normally required for operating and maintaining the plant and equipment e.g.
lubricating oil, spare parts for machinery etc. This is also called consumable materials.
Indirect wages These are wages which are paid to those workers who are required to
complete some process in respect of all the products e.g. factory supervision, wages of
maintenance of staff like cleaners and repairers, store mens wages etc.
Rent, rates, insurance, water, power and electricity charges for the factory.
Depreciation of factory plant and machinery, depreciation of factory buildings, maintenance
and repairs of factory plant and buildings.
Sundry expenses like canteen, entertainment and medical facilities provided to the workers.
Administration overheads.
These are expenses incurred in providing control, direction and management of the enterprise. They
include expenses related to secretarial, accounting and legal services. Others include: Rent, rates, insurance, water and electricity for the office.
Salaries of office staff e.g. accountants, clerks etc.
Depreciation of office furniture, office equipment and office buildings.
Office stationery and maintenance cost of office equipment.
Legal expenses e.g. fees of advocates.
Financial expenses e.g. interest on loans bank charges etc.
36

Selling overheads are the expenses incurred to secure orders and to increase sales of the enterprise.
They also include: Advertisement expenses.
Salaries of salesmen and commission of sales agents.
Sales correspondence expenses and cost of preparing catalogue and price lists.
Rent of salesrooms and offices, water and electricity expenses of salesrooms.
Distribution overheads are those expenses which are incurred on the movement of finished goods
from factory to warehouse and then in delivering these goods to the customers. These include: Transport charges (carriage outwards).
Cost of maintaining delivery vans e.g. fuel insurance and repair charges.
Salaries of delivery van drivers, mechanics and delivery clerks.
Rent, rates, insurance, water and electricity charges of warehouse.
NB: total cost + profit (or minus loss) gives the selling price.
QUESTION ONE
What is meant by the tem classification of costs? Explain various types of cost classifications. 2.
Write short notes on
a) Cost unit
b) Cost centre
c) Profit centre
d) Cost behavior
a) Explain the difference between the following terms
b)
i.
Product cost and period cost
ii.
Sunk cost and relevant cost
iii.
Incremental and sunk costs
iv.
Fixed and variable cost
v.
Avoidable and unavoidable costs
vi.
Controllable and uncontrollable costs
vii.
Direct and indirect costs
What is the relevance of cost classification? Is it merely an activity for the
37
sake of it? Explain

QUESTION TWO
Discuss the behavioural classification of costs, explaining all the terms
used therein.
QUESTION THREE
Discuss in detail what constitutes manufacturing costs as production costs, administration
costs as well asselling and administration costs.
QUESTION FOUR
The functional classification of costs classifies costs as production costs,
administration costs as well as selling and administration costs.
Explain what constitutes these costs in detail.
QUESTION FIVE
Papermaking Ltd. Makes paper which is cut and packed before being transferred into the finished
goods store. The paper is moved from department to department by a fork lift truck. Each pack of
finished product contains one ream of paper. The paper is loaded onto wooden pallets before
delivering to customers. The following cost information related to papermaking Ltd. For period
ended 31st March 2014
Pulp
Clay
Wrapping paper (used in packing dept.)
Spare knives for cutting machines
Cleaning rags for machines
Royalty payments
Making dept. wages to packages
Cutting dept. wages for machine crew
Packing dept. wages to packages
Fork lift truck driver wages
Factory managers salary
Wooden pallets
Dispatch dept. wages
Delivery vehicle driver wages
Sales managers salary
Advertising cost
Sales office wages
General Managers salary
Sh.
100,000.000
40,000.000
3,500.000
800.000
500.000
10,000.000
38,000.000
26,000.000
20,000.000
8,000.000
11,000.000
3,600.000
17,000.000
9,600.000
17,500.000
16,500.000
18,500.000
30,000.000
38
Production managers salary

Maintenance fitter wages
Maintenance workshop costs
Maintenance engineers salary
Administration salaries
Electricity costs (See note 1)
Administration office machine rental
21,500.000
25,000.000
17,000.000
18,000.000
45,000.000
18,000.000
1,000.000
Sundry other costs;

Production
Administration
Selling
Distribution
33,000.000
42,000.000
11,000.000
16,000.000
Note 1
Electricity is charged to each function area as follows; production 75%, administration 5%, selling
5%, distribution 15%.
Note 2
Maintenance costs should be totaled before a cost summary is prepared and charges to each function
making use of the maintenance service as follows; production 80%, administration 3%, selling 3%,
distribution 14%.
Required
Prepare a cost summary for the period ended 31 March 19x4 analyzing costs into
prime costs, production costs and total cost.
(Give all subtotals of classified costs).
2.7 Further Reading
rd

th
39
LECTURE THREE
3.0Cost Estimation and Forecasting
3.1Lecture Overview
After you have learnt what cost is, and the different classification it is vital to have knowledge on the
various techniques which can be used to separate mixed costs and to formulate linear prediction
equation the equation is to be used to estimate and forecast future cost.
3.2 Lecture Objectives

(i) Explain the terms cost estimation and forecasting
(ii) Describe the various methods of cost estimation
3.3 Cost estimation :

Cost estimation may be defined as a study which attempts to predict the between costs and the activity level
or cost driver that causes those costs. In practice, managers frequently encounter such cost drivers (what is a
cost driver?) as machine hours, number of transaction, work cells, labour hours, and units of output e.t.c.
The cost estimating function is
y = a + bx,
Where
Y represents Total cost
a represents cost fixed component of the total cost
bx represents the variable costs component of the total cost
b represents the unit variable cost (this is the gradient of the equation)
x represents output level
This is the usual straight line equation you have been encountering in elementary mathematics.
Cost estimation is a procedure used to measure costs of various items used in the process of production.
While cost forecasting is the process of accurately determining in advance the cost that will be incurred
in the process of manufacturing a particular product over a given future period
There are various methods that can be applied by management accounts in cost estimation and
forecasting.
3.3.1 The methods that can be used for this purpose are:a) Accounts classification (separating mixed costs) entails the examination of accounts and regards and
classifying each item of expenditure into fixed, variable and semi variable. Although the method is
quick and inexpensive and it is considerably subjective and inaccurate.
40
b) Industrial engineering (cost estimation and forecasting) this is considered is the most scientific
method of establishing a cost standard. Work study techniques are applied to determine levels of input
needed to satisfy given levels of outputs. Those, inputs are then turned into standards in order to
estimate product cost in the future.
Advantages
1. It enables an organization to determine the most effective way to apply resources.
2. Standard can be set using efficient usage.
3. There is control of operation by comparing actual results with the expected results
Disadvantages
1. It is costly to use as it involves experts.
2. It is not effective for controlling many types of overhead costs.
3. It is not easy to apply in non-manufacturing activities since relationship between cost and output
cannot be determined.
3.3.2
Methods of cost estimation
We will consider following cost estimation methods commonly utilized, namely:

a) High Low Activity method
b) Account Analysis
c) Engineering Analysis
d) Visual Fit (Scatter graph) method
e) Simple linear regression analysis
f) Learning curve Theory
3.4 High Low method

Here, cost estimation is based on the relationship between past cost and past level of activity. Variable
cost is based on the relationship between costs at the highest level of activity and the lowest level of
activity. The difference in cost between high and low activity level is taken to be the total variable cost
from which the unit variable cost can be computed by dividing it by the change in output level. This is
indicated below:
Steps involved
i) Select highest and the lowest activity level.
ii) Select corresponding highest cost and lowest corresponding cost.
iii) Obtain the difference in cost and the difference in activity level.
iv) Divide the difference in cost by difference in activity to get the rate of variable cost.
v) Compute fixed cost by subtracting variable from total cost.
41
vi) Formulate linear prediction equation

Total Variable Cost = Cost at high activity level Cost at low activity level
Therefore,
Unit Variable cost = Variable cost
Output Units
= Cost at high level activity cost at low level activity

Units at high activity level units at low activity level
The variable cost per unit so calculated forms the bof the straight line equation mentioned earlier. By
substituting b into the equation, we can obtain a, the fixed cost.
Illustration 1
Based on performance, you have been provided with the following information regarding ABC Ltd for
the year ended 31 December 2004 :
Labour hours
Highest activity level
Lowest activity level
Service cost (Shs)
800
300
200,000
150,000
Required
Develop a total cost function based on the above data using the high-low method.
Solution
Unit Variable cost = Variable cost = Cost at high level activity cost at low level activity
Output Units Units at high activity level units at low activity level
Variable Cost Per Unit = Shs.200,000 shs.150,000
800 hrs 300 hrs
= Shs.50,000
= shs.100/hr
500 hrs
Therefore b = 100
To get the fixed cost a, substitute b into the straight line equation as follows:
When labour hours (x) = 800, service cost (total cost, y) = shs.200,000
Therefore from the Straight Line equation, y = a + b x
200,000 = a + (100) 800
200,000 = a + 80,000
a = 200,000 80,000
42
a = 120,000
Therefore fixed costs = shs.120,000
NB: Even if we used the 2nd set of labour hours and service costs, were would still get he same answer i.e.
When labour hours (x) = 300, service cost (total cost, y) = Shs.150,000.
Therefore
150,000 = a + 100(300)
a =150,000 30,000 = Shs.120,000
Therefore the cost equation is:

y = 120,000 + 100x
This equation can be used to estimate or predict the total costs : for example, when the activity level is say at
1000 labour hours, then the total cost would be
Y= 120,000 + 1000(100)
=120,000 + 100,000
= Shs.220,000.
ILLUSTRATION 2
The production manager of Kemu ltd Company, is concerned abut the apparent fluctuation in efficiency and
wants to determine how labour costs (in Sh.) are related to volume. The following data presents results of
the 12 most recent weeks.
Week No.
1
2
3
4
5
6
7
8
9
10
11
12
Units Produced(X)
34
44
24
36
30
49
39
21
41
47
34
24
Labour Costs(Y)
340
346
287
262
220
416
337
180
376
295
215
275
Required:
Estimate the cost function using:
The high low method
Regression analysis
Assume that the Company intends to produce
45 units
34 units next period
43
Estimate the labour cost to be incurred.
SOLUTION
We will first use the high-low method to establish the cost function.
High low method
Highest point
416
Lowest point
Difference
21
28
180
236
Gradient/ slope
= 236
28
= 8.43
The function will be:

Y= a + bx
We can Substitute the lowest points (21,180)
180 = a + 8.43(21)
a = 2.97. This can be approximated to 3
The predicting equation is therefore Y = 3 + 8.43 x
i. if X=45 units
Y = 3 + 8.43*45
= Sh.382.35
ii. 34 Y = 3 + 8.43(34)
= Sh.289.62
Note:
The main problems of the high low method are:
Reliability is low
It Ignores all the other points except the highest and lowest which in most cases are outliners.
Advantages of the high low method

1. It is easy to use.
2. The lowest and the highest item will cover the relevant range.
3. It takes into account possible extremes of cost.
Disadvantages
1. It is not logical to use two points to represent all the points.
44
2. The estimated cost function poorly describes the actual cost relationship.
3. Costs are not properly matched with the independent variable.
3.5
REGRESSION ANALYSIS
A regression equation identifies an estimated relationship between a dependent variable (the cost) and one or
more independent variables (the cost driver). When the equation includes only one independent variable
then it is referred to as simple regression and its form is:
= a + bx
Where, is the predicted value of Y
a and b are Constant
x is the cost driver
When the equation includes 2 or more independent variables, it is referred to as multiple regression and is of
the form:
Y = a + b 1 x1 + b2 x2 + .bn xn for n independent variables.
SIMPLE REGRESSION
Regression analysis determines mathematically the regression line of best fit. It is based on the principle that
the sums of squares of the vertical deviation from the line established is the least possible
I.e.
(Y Y )
is minimised
where Y is the observed value of the dependent variable

is the predicted value of Y
The equation can be solved by the use of normal equations and these are:
1. y = na + b (x)
xy = a (x) + b (x2)
From these normal equations:
b = n xy x y
nx 2 (x)2
a=
Y - bx
n
n
Looking at illustration 2.1, then we first compute the sum of X, Y, XY, X2 and Y2
The table below shows these summations.
Week No.
Units X)
L.Costs(Y)
XY
X2
Y2
45
1
2
3
4
5
6
7
8
9
10
11
12
34
44
24
36
30
49
39
21
41
47
34
24
430
340
346
287
262
220
416
337
180
376
295
215
275
3549
11560
15224
8897
9432
6600
20384
13143
3780
15416
13865
7310
6600
132,211
1156
1936
961
1296
900
2401
1521
441
1681
2209
1156
576
16234
115600
119716
82369
68644
48400
173056
113569
32400
141376
87026
46225
75625
1104005
Value of b can be calculated as follows:

b=
12(132211) - 430(3549) = 6.10

12(16234) - (430) 2
a = 3549 - 6.10 ( 430) = 77.08

12
12
Therefore the predicting function is = 77.08 + 6.1X
b. i. If X = 45 units, then
= 77.08 + (6.1 x 45)
= Sh.351.58
ii. If X = 34 units, then
= 77.08 + (6.1 x 34)
= Sh.284.48
ILLUSTRATION
Assume that the company (in illustration 2.1) intends to spend Sh.400 on labour cost next period. Compute
the number of units that the company may produce.
SOLUTION
Note:
= a + bx is a regression of Y on X i.e. Y = f(x)
We require a regression of X on Y. i.e. X = g(Y) to answer the above question. The general format of the
equation is:
X = a1 + b1 Y
46
b = n xy x y
nY 2 (Y)2
a = X - bY
n
n
b1 = 12(132,211) - (430 x 3549)
12(1,104,005) - (3549)2
= 0.0926
a1 = 430 - 0.0926(3549)
12
12
a1 = 8.3286
Therefore the predicting equation is X = 8.33 + 0.093Y
Thus if the Company intends to spend Sh.400 on labour, the number of units to be produced will be:
X = 8.33 + 0.093(400)
= 45.56 units
Approximately 46 units
3.6 Visual fit (scatter graph method)

Cost estimation is based on past data regarding the dependent variable and the cost driver. The past data
on cost levels and the output levels) is plotted on a graph( called a scatter graph )and a line of best fit is
drawn as shown in the diagram . A line of best fit is a line drawn so as to cover the most points possible
on a scatter graph. Its intersection with the vertical axis indicates the fixed cost while the gradient
indicates the variable cost per unit.
Illustration:
Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are 400,000, 200,000 and
respectively. Estimate its cost equation using the visual fit method.
47
10
9
Dependant
Variable
(Total Cost)
X
X
X
X
X X X X X
1m X
X2
0
X3
200,000
400,000
Independent Variable
(Output Level)
Fixed Cost X
0 1m
Note :
Change in
Gradient
Change in
Y
X
Variable cost = Change in cost

=
Per unit
Change in activity level
Y3 - Y2
X3 X2
Variable Cost Per Unit
8m 4m
400,000 200,000
= 20
Total cost equation y = 1m + 20 x
On the basis of the existing data, fixed cost is Shs 1m and the variable cost per unit is 20. On the basis of the
developed model, estimates can be made regarding future cost. When the activity level is 600,000 units, total
cost will be estimated as:
TC = 1M + 20 (600,000) = 1M + 12M = 13 M
3.7 Engineering method

This method is based on a detailed study of each operation where careful specification is made for materials,
labour and equipment necessary to produce a product. It involves identifying the level of input required of an
activity in form of raw material and labour while total cost is based on the cost of each input. This approach
is applicable where no past data exists. The main setback of the approach is that it requires a complex
analysis of all the constituents of an activity and the requirements of an activity in terms of costs detailed
into materials, labour, overheads and time
48
3.8 Account Analysis (Inspection of Accounts)

Using account analysis, the accountant examines and classifies each ledger account as variable, fixed or
mixed. Mixed accounts are broken down into their variable and fixed components. They base these
classifications on experience, inspection of cost behaviour for several past periods or intuitive feelings of
the manager.
Activity 3.1
Using the knowledge acquired early in the unit think of a particular department in your
organization and classify cost into variable and fixed cost and predict the cost to be incurred in
the next month.
3.9
LEARNING CURVE THEORY
The first time a new operation is performed both workers and operating procedures are untried but as the
operation is replaced the workers becomes more familiar with the work so that less hours are required. This
phenomena is known as the learning curve effect.
This is also referred to as improvement curve theory. It occurs when new production methods are introduced,
new product s (either goods or services) are made or when new employees are hired. It is based on the
proposition that as workers gain experience in a task, they need less time to complete the job and productivity
increases.
The learning curve theory affects not only direct labour costs but also impacts direct labour related costs such as
supervision, and direct material costs due to reduced spoilage and waste as experience is gained.
3.10 Summary
Cost estimation is a procedure used to measure costs of various items used in the process of production.
While cost forecasting is the process of accurately determining in advance the cost that will be incurred
in the process of manufacturing a particular product over a given future period
There are various methods that can be applied by cost accounting in cost estimation and forecasting
a) High Low Activity method
b) Account Analysis
c) Engineering Analysis
49
d) Visual Fit (Scatter graph) method

e) Simple linear regression analysis
h)Learning curve Theory
QUESTION ONE
CB plc produces a wide range of electronic components including its best selling item, the Laser Switch.
The company is preparing the budgets for Year 5 and knows that the key element in the Master Budget is the
contribution expected from the Laser Switch. The records for this component for the past four years are
summarised below:
Year 1
Year 2
Year 3
Year 4
Sale (unit)
150,000
180,000
200,000
230,000
Sale revenue
Variable costs
Contribution
292,820
131,080
161,740
346,060
161,706
184,354
363,000
178,604
184,396
448,800
201,160
247,640
It has been estimated that sales in Year 5 will be 260,000 units.
Required:
As a starting point for forecasting Year 5 contribution, to project the trend, using linear regression;
To calculate the 95% confidence interval of the individual forecast for Year 5 if the standard error of the
forecast
is 14,500 and the appropriate t value is 4,303, and to interpret the value calculated;
To comment on the advantages of using linear regression for forecasting and limitations of the technique.
QUESTION TWO
The theory of the experience curve is that an organisation may increase its profitability through obtaining
greater familiarity with supplying its products or services to customers. This reflects the view that
profitability is solely a function of market share.
Required:
Discuss the extent to which the application of experience curve theory can help an organisation to prolong
the life cycle of its products or services.
50
3.12 Further Reading
rd

th
51
LECTURE FOUR
4.0 Material costing

4.1Lecture Overview
The lecture is to introduce you to various methods of accounting for material issue from the stores and
valuation of closing stock .
4.2 Objectives

(i) Describe the steps involved in purchasing of materials
(ii) Explain types of purchasing systems
(iii) Understand the principles of material control
(iv) Know the elements of storekeeping and stocktaking
4.3 PURCHASING PROCEDURE AND ISSUE OF MATERIALS

4.3.1 Material Control
This is the act of ensuring that the acquisition, storage, handling and usage of all types of materials
are fully controlled at all times.
Main aspects of material control include:1. Purchasing procedure
2. Receipt and inspection of materials
3. Storekeeping
4. Stores control
5. Issue of materials
6. Pricing of material issues
7. Allocation of material costs.
52
4.3.2 Purchasing procedure (STEPS)

This involves acquisition of goods/services done by the purchasing department. Its importance
depends on the nature of business e.g. in a manufacturing business, the department is very important
than in service industry. Purchases control is exercised to ensure that goods are purchased at right
time of right quality and in right quantity. Over purchasing, under purchasing or purchase of inferior
quality goods have negative effects to the business.
Purchasing procedure adopted by various organizations include:1. Purchase requisitions

2. Letter of inquiry
3. Quotations
4. The purchase order
5. Receipt of goods
6. Rejection or return of goods
7. Invoice
8. Payments
9. Recording of purchases
4.3.3 Purchases requisitions
Refer to the written requests by all departments for goods required by them, to the purchasing
department. These requisitions contain the description of goods required, quantity required, and
time when required. These forms are signed by an authorized person of the department that needs
these goods. E.g. head of stores department, works manager etc.
Letter of inquiry
The purchasing department sends a letter of inquiry to various suppliers after receiving the purchase
requisitions.
Quotation
These are received from different suppliers in response to letter of inquiry.
The purchase order
After receiving the quotations the purchasing department selects the best supplier and issues a
purchase order. E.g. a L.P.O (local purchase order)
Receipt of goods
53
Once the supplier receives the purchase order, he makes arrangements to deliver the goods. The
selling organization prepares and delivers the goods. The buying organization prepares and issues
goods received note and also signs the delivery note. Other documents involved in the receipt of
goods include advice note and a package sheet. Goods are mostly received by the stores
department.
If goods received are of inferior quality or not according to the description given in the purchase
order, then the receiving dept can refuse to accept them.
A rejection Note or goods returned note are issued.
Invoice this is a claim of money by the supplier from the purchases for the goods supplied. Its
send by the supplier to the buying firm.
Payment After receiving the invoice, the buyer checks the amounts due to the supplier and once
satisfied he makes arrangements to remit money e.g. through a cheque. On receipt of the cheque or
cash, the supplier issues a receipt as a proof that transactions have been completed.
Recording stock- Goods purchased are recorded in the accounting books of any organization. The
entries in the cost are made from goods received notes while the financial entries are made from
invoices. Both entries should be reconciled.
4.3.4 ISSUE OF MATERIALS

Purchased materials are issued by the storekeeper to the respective departments on presentation of a
material requisition note.
Material requisition note
Its an authorization to the storekeeper to issue raw materials, finished parts or other items of store.
Its signed by a responsible person of the department e.g. foreman. The note contains the name of
department that needs this material, the details of materials required, the purpose for which the
material is required and signatures of the persons who prepare and authorize this requisition note.
Material issue note
Its a document which is prepared by the store department containing the details of materials issued,
material requisition name; value of goods issued and signature of the persons receiving and
receiving the materials. This document is used by the costing department to prepare cost accounts.
Material return note
54
Its a document used to return some materials to the stores department incase they were in excess. It
contains:
Details of materials returned.
Reason for as return.
The job number to which it was originally charged.
Signatures of the person who returns from the department and the receiver in the stores
department.
Material transfer note

Its a document used to transfer materials from one job to another job or from one department to
another department.
It is used by the stores and costing depts to charge the value of materials to the correct jobs.
4.4 Store - Keeping And Stock Control
4.4.1 Store Keeping

Store keeping refers to keeping the store of materials and keeping the stores records. The stores
department receives materials; hold them centre they are required by the production department. It
also maintains records regarding receipts, issues and stock balances of materials.
Features of Effective and Good Storekeeping

1. Immediate location of materials
2. Speedy receipt and issue of materials.
3. Full identification of all materials at all times.
4. Keeping concept and up to date records of receipts, issues and stock balances of materials.
5. Protection of materials against pilferage and deterioration.
6. Protection of materials against fire and theft.
7. Economical use of storage space.
4.4.2 Types of Stores

o Centralized stores
55
o Decentralized stores
o Imprest stores
Centralized Stores
Centralized system In this case the duty and responsibility of purchasing is done by one purchaser is
purchasing department.
b)
Reduces risk since purchasing is spread to many department.

ii) It is specialized in terms of specific material requirement.
iii) There is accountability.
iv) Less bureaucratic.
v) There are 6 minimum production breakdown due to the short time required in having the materials.
N/B: The advantages of decentralized are the disadvantages of centralization
Decentralized Stores
These are stores where materials are held and issued by sub-stores in each department or branch.
The advantages are the disadvantages of centralized and vice versa.
. Decentralized system the duty and responsibility of purchasing is placed with individual branch department
or geographical department. Advantages of centralized system
i) Less expensive since few activities are concentrated in one department.
ii) There is better control because of effective and efficient monetary.
iii) There is more accountability.
iv) There is bulk buying hence economies of scale are enjoyed.
v) Fewer staffs are employed.
vi) There is expertise in buying due to specialization.
N/B: The advantages of centralization are the disadvantages of decentralization. Advantage
decentralization
Activity 4.1
56
Visit your organization purchasing department and indentify which method of store system it has
adopted.
4.5 Material Coding
A code is defined as a system of symbols designed to be applied to a classified set of items to give
a brief accurate reference facilitating entry, collation and analysis.
Materials are coded for immediate identification. The coding may be in terms of sizes or models.
Purposes of Coding
To avoid ambiguity in description
To minimize length in description.
Principle of Coding
a) Certainty
b) Elasticity flexibility
c) Brevity brief
d) Memorization easy and possible to remember and understand the code numbers.
e) Uniformity equal length and same structure codes.
f) Exclusive each item should have only one code and this code should not be used for
any other item.
4.6 Stock recording and inventory control

This refers to documents which give information regarding the movement of stock. These
documents include: - stores ledger and bin cards.
4.6.1 Stores Ledger
This is similar to the financial ledger. It contains three columns for receipts, issues and stock
balance in hand. Receipts and issues columns each have three columns for quantity, price and value
where as the balance column shows units and value columns.
57
STORES LEDGER
Date Receipts
G.R
Issues
Qty
Price
Value
note
M..K
Balances
Qty
Price Value
Units
Value
note No
NO
4.6.2 Bin Cards

A bin card is a stiff card which is kept where the relevant stock item is stored. Goods or materials
are stored in drawers, shelves or racks. A separate bin card is used for each kind of goods.
FORMAT
BIN CARD
DATE
RECEIPTS
G.R NO
ISSUES
Qty
M.R NO
BALANCE
QTY
REMARKS
QUANTITY
NB: GR. NO Goods received note number.

MR NO Material requisition note number.
Stock Taking
58
Stock taking means to check physically the stock items in order to ensure that stock quantities
shown on stock records and actual quantities are the same.
4.6.3 Systems of Stock Taking

Periodic Stocktaking
The objective of periodic stocktaking is to find out the physical quantities of materials of all types at a
given date. This is a substantial task even in a modest organization and becomes difficult if not
impossible task in a large firm. The following factors should be considered:
(i) Adequate number of staff should be available who should receive clear and precise instructions on
the procedures
(ii) Ideally the stock take should be done on a weekend so as not to interrupt with production
(iii) The stock take should be organized into clearly defined physical areas and the checkers should
count or estimate all materials in the area.
(iv) Adequate technical assistance should be available to identify materials, part nos etc. far greater
errors are possible because of wrong classification than wrong counting.
(v) Great care should be taken to ensure that only valid stock items are included and their correctness.
(vi) The quantities of each material should be checked against the stock record to expose any gross
errors which may be due to stocktaking errors or faults or error in recording system.
(vii) The pricing and extension of stock sheets, where done manually, should be closely controlled.
Frequently the pricing and value calculations are done by computer, the only action necessary being to
input quantities and stock and part numbers.
Continuous stock taking
To avoid disruptions caused by periodic stock taking and to be able to use better trained staff, many
organizations operate a system whereby a proportion of stock is checked daily so that over the year all
stock is checked at least once and many items particularly the major value of fast moving items, would
be checked several time. Where continuous stock taking is adopted, it is invariably carried out by staff
independent from the storekeepers. Continuous stock taking is absolutely essential when an organization
uses what is known as the perpetual inventory system. This is a stock recording system whereby the
stock balance is shown on the record after every stock movement, either issue or receipt. With this
system the balances on the stock record represent the stock on hand and the balances would be used in
monthly and annual accounts as the inventory system is functioning correctly and that minor stock
discrepancies are corrected.
Just-in-time (JIT) systems
JIT were developed in Japan, notably at Toyota, and are considered as one of the main contributions to
Japanese manufacturing success. The aim of JIT systems is to produce the required items, of high
quality, exactly at the time they are required. JIT systems are characterized by the pursuit of excellence
at all stages with a climate of continuous improvement. A JIT environment is characterized by:
a) A move towards zero inventory
b) Elimination of non-value added activities
59
c) An emphasis on perfect quality i.e. zero defects

d) Short set-ups
e) A move towards batch size of one
f) 100% on time deliveries
g) A constant drive for improvement
h) Demand- pull manufacture
Production only takes place when there is actual customer demand for the product so JIT works on a
pull-through basis which means that products are not made to go into stock. Benefits from JIT
(i) Lower investment required in all forms of inventory
(ii) Space savings from the reduction in inventory and improved layouts.
(iii) Greater customer satisfaction resulting from higher quality better deliveries and greater product
variety
(iv) The buffers provided by traditional inventories masked other areas of waste and inefficiency,
supplier unreliability and so on. Elimination of these problems improves performance dramatically.
(v) The flexibility of JIT and ability to supply small batches enables companies to respond more quickly
to market changes and to be able to satisfy market niches
Perpetual inventory involves recording all receipts, issues and running balances on bin card
4.7 Methods of Valuing Material Issues
To determine the material cost of different jobs or products, materials issued must be valued.
Valuation methods include.
a) First In, First Out (FIFO)
b) Last In, First Out (LIFO)
c) Weighted average
we will only consider FIFO, LIFOand Average Weight Cost methods.
To show the recording in the stores ledger cards under each case, the following example is used.
Example
May 2 received 500 units at Ksh20 each
8 received 300 units at ksh 22 each
10 issued 400 units
15 issued 200 units
20 received 600units at Ksh25
25 issued 300units
27 received 200units at Ksh26
30 issued 100 units
60
a) First In First Out (FIFO).

The method assumes that the goods issued are those which have been longest on hand and that those
remaining in stock represent the latest purchases or production.
The stocks whose cost is to be carried forward were acquired or produced most recently.
NB: materials are issued at the cost price of that consignment which was received first. When this
consignment is finished, then cost price of next consignment is finished, then cost price of next
consignment is charged to value the materials issued.
This method is based on the assumption that stock purchased first is issued first. Prices of stock
purchased first are used to determine the cost or value of inventory issued. Closing stocks are
carried at the latest costs.
Advantages
1. It is a realistic system: oldest items are usually issued first out.
2. Unrealized profits or losses do not arise
3. It is easy to calculate if prices of materials dont fluctuate
4. Closing stocks values reflect the latest costs thus tend to reflect the current market values.
5. It is acceptable to many tax authorities and is also consistent with accounting practices e.g.
IAS/IFRS.
Disadvantages
1. It involves tedious calculations if the price of materials fluctuate from time to time
2. Product costs, based on the oldest material prices, lag behind current conditions especially in
inflationary markets.
3. Comparison of one job with another may be difficult if materials are issued at different prices.
STORES LEDGER CARD

DATE
RECEIPTS
ISSUES
BALANCES
61
G.R
NO
May 2
8
QTY Price
Value
500
300
10,000
6,600
20
22
M.R
NO
QUANTITY Price
10
400
15
200
20
600
25
100
100
Value
Qty
Value
500
800
10,000
16,600
20
8,000
400
8,600
20
22
2,000
2,200
300
200
6,600
4,400
800
19,400
15,000
300
25
27
200
100
200
26
22
25
4,400
2500
600
500
700
15,000
12,500
17,700
26
2,600
600
15,100
5,200
30
100
500 units purchased on May 2, were first in and these must go first. These were issued as 400 units
on May 10 and 100unstis on May 15. These should be valued at Ksh20 per unit. 300 units
purchased on May 8, were issued as 100units on May 15 and 200 units or May 25.
These must be valued at Ksh22 each unit. From 600 units purchased on May 20, 100units were
issued on May 25 and 100 units on May 30. These were valued at Ksh25 each. Now 600 units in
stock are valued as under:400 units from May 20 purchases = 400x25 = 10,000
200 units purchased on May 27 = 200 x 26 = 5,200
15,200
b) Last In, First Out (LIFO)
This method assumes that the goods issued on any particular date are those which were most
recently acquired and therefore stocks whose cost is to be carried forward are those which were
acquired earliest. The materials are issued at the cost price of that consignment which was received
most recently. The advantage of the method is that it reflects the current economic value of goods
charged to production.
Is based on the assumption that the stock purchased last is issued first. Stock valuation should
therefore be based on the prices ruling on the acquisition of the last stocks.
62
Advantages
1. Product costs tend to be based on current market prices and is therefore realistic.
2. A charge to production is as closely related to current price levels as possible
Disadvantages
1. Stocks are valued at the oldest prices.
2. It involves tedious calculations if the price of materials fluctuate from time to time.
3. Comparison of one job with another may be unfair and difficult
Example
STORES LEDGER CARD
Date
May 2
8
10
15
20
25
27
30
Receipts
G.R Qty
No
500
300
Price Value
Shs
20
22
Issues
M.R Qty
NO
Price Value
Shs
10,000
6,600
Shs
Balance
Quantity Value
Shs
500
800
Shs
10,000
16,000
500
400
200
800
500
700
600
10,000
8,000
4,000
19,000
11,500
16,700
14,100
400
300
100
200
600
200
25
22
20
20
6,600
2,000
4,000
300
25
7,500
100
26
2,600
15,000
26
5,200
500 units were purchased on May 2 and 300 units on May 8. 400 units issued on May 10 must be
300 units from May 8, purchases and 100 units from May 2 purchases.
300 units are valued at Ksh22 each and 100 units at Ksh20 each. 200 units issued on May 15 will be
from first consignment because second consignment of May 8 is already finished. These must be
charged at Ksh20 each.
300 units issued on May 25 must be from last consignment of May 20 and these are charged at
Ksh25 each. 100 units issued on May 30 must be from last consignment of May 27 and these are
charged at Ksh26 each. Now 600 units in stock are valued as under:-
Ksh
100 units from May 27, purchases
= 100x26 = 2,600
63
300 units from May 20 purchases
= 300x25 = 7,500
200 units from May 2 purchases
= 200 x20 = 4,000

_____
14,100
C ) Average Weighted Cost Average

i.
This method is a perpetual weighted average system where the issue price is recalculated after each
receipt of stocks taking into account both quantities and money vale of the stocks received.
In this case stock used or unused is based on the average price per unit where the average price per unit
is calculated as follows:
= Total value of stocks = Average Price Per Unit
No. of units of stock
= (Money value of old stocks + Money Value of New Stocks)
(Quantity of old stocks + Quantity of New Stocks)
This means weighted average price under this method, the total value of goods in stock is divided
by the number of units of stock. The resultant figure is weighted average price.
NB:
The method is simple and logical but it is not close to current value of goods.
Profit and loss may arise on the materials issued.
STORE LEDGER CARD

DATE
May 2
8
10
15
20
25
27
30
RECEIPTS
ISSUES
G.R Qty Price Value M.R Qty
No
NO
Shs
Shs
500 20
10,000
300 22
6,600
400
200
600 25
15,000
300
200 26
5,200
100
Price
Value
20.75 8,300
20.75 4,150
23.94 7,181
24.53 2,453
BALANCE
Quantity Value
500
800
400
200
800
500
700
600
10,000
16,600
8,300
4,150
19,150
11,969
17,169
14,716
The formula for weighted average price is

= total value of goods in stock
64
No. of units
There for weighted average price is calculated as:
Date
weighted average price
May 10
Ksh16,600 = Ksh20.75
800
May 15
Kshs 8,300 = Ksh20.75

400
May 25
Ksh19,150 = Ksh23.94
800
May 30
Ksh17,169 =Ksh24.53
Stock Control
This means making sure that the business has the right quantity of goods, in the right place and at
the right time. Stock level must be maintained at a reasonable level.
Objectives of Stock Control.

1. To ensure the availability of goods when required.
2. To account for the goods which have been purchased
3. To reduce storage costs as much as possible
4. To minimize the risks of deterioration, waste and theft
5. To maintain accurate records
To avoid over-stocking and under stocking
Cost Minimization through Economic Order Quality (EOD)
There are four cost associated inventory
i) Purchase cost is the cost charged by the suppliers for the items purchased.
ii) Holding / carrying cost is the cost incurred as a result of having inventory item in the business. e.g. Opportunity cost of capital tied up in stock
- Insurance and security cost - Refrigeration and conditioning - Ware housing changes. - Maintenance of
machinery
iii) Ordering cost is the cost of bringing stock items into the store. They include loading and off loading
charges cost of purchasing department, transport etc.
65
iv) Stock out cost or shortage cost is the cost incurred as a result of not having inventory items in stock.
E.g. production disruption which may lead to lower production, lost discounts cost of speeding up orders
and deliveries, lost customer good will.
Economic Order Quality (EOQ) This refers to the optimum number of units should be ordered every
time an order is made so as to minimize total stock cost. Assumptions / limitation of EOQ
1. Replenishment is instantaneous (Q). There is no lead time. Lead time is the time taken between
ordering and delivery.
2. No safety stock.
3. Demand is known in advance and it is constant.
4. Purchasing cost and cost per order are constant i.e. there are affected by factors like discount.
5. Stock is replaced in equal batches.
6. Cost per order is constant irrespective of quality.
7. Stock holding / carrying cost is a function of average inventory.
8. No stock out cost.
Economic Order Quantity

This is the quantity at which the cost of having stock is minimum. The cost of having stock is
broken down into two:Holding costs which comprise:
Cost of capital tied up
Warehousing
Deterioration
Obsolescence
Insurance
Ordering costs which comprise:
Clerical costs
Telephone charges
Economic Order Quantity (E.O.Q) = 2CD

Where:
C = delivery cost per batch

D = Annual demand for product
66
P = Cost price per item

I = stock holding cost per annum (expressed as a fraction of stock value)
EXAMPLE
A company has an annual demand for material p of 25,000 tons per annum. The cost price per ton
is Ksh2, 000 and stock holding is 25% per annum of the stock value. Delivery cost per batch is
Ksh400.
Calculate the E.O.Q
E.O.Q = 2(400) (25,000)
25% of Ksh2000
= 2(400) (25,000)
500
= 40,000 = 200units
This means that 200units must be purchased at one time. If the batch size is more than or less than
200 units then stock holding and ordering costs will be higher
4.8 Stock Levels

Setting Material Levels
A business organization must not have too much of the stock or too little of it. Problems:
a) Tie up capital in the stock.
b) There is risk of obsolesce
c) Costly in terms of storage facilities
On the other hand, having too little of the stock may have the following problems
i) Lost customer goodwill.
ii) Costly in terms of speeding up orders.
iii) Low production which may lead to losses.
Too low stock level or too high stock levels are not beneficial to an organization. Too low stock
level means production demands are not met resulting to loss of customers and profits reduction.
67
High stock levels results in high storage costs, greater risk of deterioration of the stock hence
reduction in the enterprises profits.
Factors Affecting Stock Levels.
1.
Availability
2.
Lead time refers to the period between the date of order and date of delivery. If lead time is
more then stock must be maintained at high level and vice versa.
3.
Stock holding cost high stockholding cost calls for low stock level and vice versa.
4.
Consumption
5.
Trade discount, - if the benefits of trade discount (due to bulk purchases) is greater than
stockholding cost, then stock level must be maintained at high level.
6.
Durability.
Stock Level and its control

Management must make decisions about the control of stock levels with a view to minimizing the cost of the
company while achieving more efficiency in the availability of material to fulfill planned usage
requirements. Consideration should be given to the following control levels:
a) Minimum stock level
b) Maximum stock level
c) Re-order level
d) Re order quantity (Note the re-order quantity is not necessary the EOQ)
a) Minimum stock level

This is the level below which stock should not fall. It is essentially a base (buffer) stock level. If stock
falls below this point, there is a danger of stockout.
Minimum stock level = Reorder level (Normal consumption x normal reorder period)
b) Maximum stock level
This is the upper limit above which stock should not be allowed to rise. Each material to be kept in store
must have a maximum level and stock should not be allowed to go beyond this level
Maximum stock level = Re-order level +re-order Quantity - (Minimum consumption x minimum reorder period)
c) Re-order level
Is a point that lies between minimum and maximum stock levels at which purchase orders must be
placed to ensure that goods ordered are received before the minimum stock level is reached? It is the
level of stocks at which replenishment must be made to avoid a stock-out.
Re-order level = maximum consumption X maximum re-order period
68
d) Re-Order quantity
This is the quantity of stock ordered once the re-order point is reached. The quantity is such as to
minimize stock costs taking into consideration the cost of holding stocks and making an order. This is
also regarded as the Economic Order Quantity (EOQ). It is computed as follows:
Where
D is the annual demand (knits)

Co is the cost of making one order
Ch is the holding cost per unit per annum
EOQ 2DCO
Ch
Economic Order Quality (EOQ)

Define the EOQ model and the three methods of computing EOQ.
-
Assumptions of the model.
Formulae of Stock Levels
Re-Order Level = Max: Consumption x Max. Re-order /lead time Period
Minimum stock level = RL (NC x NRP)
Maximum stock level = MIN : SL (MIN : C x MIN.RP)
A.S.L =
Max stock + Min stock level

2
Where:
Max C = Maximum consumption
Min C = Minimum consumption
NC = Normal consumption i.e. average of max: C and Min C.
Max: RP Maximum re-order period or lead period
Min: RP Minimum re-order period
NRP Normal re-order period
RQ Re order quantity
Min: SL Minimum stock level
Max: SL Maximum stock level
EXAMPLE 1
69
Illustration
The following information was extracted from the books of Danex Holdings regarding its
stocks:
i.
ii.
iii.
iv.
v.
Vi
Vii
Reorder quantity
Reorder period
Maximum consumption
Normal consumption
Minimum consumption
Maximum reorder period
Minimum reorder period
1,800
4 weeks
450 units/week
300 units/week
150 units/week
5 weeks
3 weeks
Required
Determine the following stock levels for Danex Holdings:
i.
Re-order level
ii.
Maximum stock level
iii.
Minimum stock level
Solution
i)
Re-order level = Maximum consumption X maximum reorder period

= 450 units X 5 weeks
= 2,250 units
ii) Maximum stock level = reorder level + reorder quantity(Minimum consumption X minimum reorder period)
= 2250 + 1800 (150 X3) = 4050 450 = 3600 units
iii) Minimum stock level = Reorder level (Normal consumption X
normal reorder period)
= 2,250 (300 X 4) = 2250 1200 = 1050 units
4.9 Summary
700
70
From the costing perspective, the essentials of material purchase and control prior to actual use in
production can be summarized as follows:
i. Materials of appropriate quality and specification should be purchased only when required and
appropriately authorized.
ii. The suppliers chosen should represent an appropriate balance between quality, price and delivery.
iii. Materials should be properly received and inspected.
iv. Appropriate storage facilities should be provided and stock levels physically checked on a
regular basis.
v. Direct material used in production should be charged to production on an appropriate and
consistent pricing basis.
vi. Indirect material used in production and non production departments should be appropriately
charged to correct cost centre and included in the overheads of the cost centre.
vii. The documentation, accounting system and controls at each stage should be well designed and
effective
viii. Stock taking must be well organized to ensure that stock quantities on hand are available when
required.
QUESTION ONE
Assume the following purchases were made in Liz Ltd
Date of purchase
1st January
2nd January
3rd January
Units purchased
500
600
800
Price/unit
100
200
400
Units used on 4th January are 900. Determine the value/cost of units used by using FIFO, LIFO and weighted
average.
Required:
Determine the cost of units used and the value of the closing stocks using FIFO, LIFO and Weighted
Average.
QUESTION TWO
71
LATEX Ltd. are retailers who sell ceramic tiles. During the months of Jan to March 2012, there were
price fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 JAN
Opening stock was 5,000 tiles valued at Sh 825,000.
10 JAN
Orders placed with the company increased, so extra tiles had to be
obtained from Mombasa. Therefore 22,000 tiles were purchased at a cost Sh 140
each but in addition, there was a freight and insurance charge of Sh 5 per tile.
31 JAN
During the month 20,0000 tiles were sold at a price of Sh 220 each.
4 FEB
A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.
28 FEB
The sales for the month of August were 14,000 tiles at a selling price of Sh 230
each.
1 MARCH
A further 24,000 tiles were purchased at a cost of Sh 195 each.
30 MARCH
27,000 tiles were sold during September at price of Sh 240 each.
The cost accountant of LATEX Ltd decided he would apply first-in-first-out basis and weighted average
methods of material pricing for purposes of comparison.
Required:
(i)
A stores ledger account using the two methods and showing stock values at 30 MARCH 2012.
(14 marks)
(ii)
The trading accounts using each of the above methods.
QUESTION THREE
The following information is provided for material PQ 251. Maximum consumption = 12000 units
per week.
Minimum consumption =
8000 units per week
Reorder period or Lead time

Re-order quantity
4 - 6 wks
60,000 units
Required
1. Re order level
2. Minimum stock level
3. Maximum stock level
4. Average stock level
72
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1.Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.

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73
LECTURE FIVE
5.0 LABOUR COSTING
5.1Lecture Overview
Labour is the physical and mental energy applied by human beings in the process of manufacture of a
product or service. It is important to understand how the cost of labour is accounted for in this process.
This lesson introduces the learner to various method of labour costing.
5.2 Objectives

(i) Know the main categories of remuneration
(ii) Understand the feature of time based systems (i) Know the main categories of remuneration
(ii) Understand the feature of time based systems
(iii) Know the features of Incentive schemes
(iv) Be able to distinguish between straight and differential piecework
(iii) Know the features of Incentive schemes
(iv) Be able to distinguish between straight and differential piecework
5.3 Remuneration Methods
Trends in Employment and Remuneration
At present Manual workers are paid by some form of incentive scheme. This overall percentage masks
extremely wide variation from industry to industry. For example in general engineering around 80% of
the workers are paid wholly or partly by some form of incentive scheme, whereas in process industries
the figure is as low as 15%.
There has been a general tendency for larger firms to move away from direct incentive schemes to
schemes such as measured day work. There is also a tendency for workers to become salaried employees
which has clear costing implications as direct labor costs become more fixed in nature rather than
varying with output.
The trend evident in most parts of the world is that patterns of employment are changing from full time
employment to part time employment. There is less job security and more self employment. In Kenya,
the government is starting to move away from permanent employment schemes to renewable contractual
schemes. The ultimate goal is to have a flexible employment system where demand for labor is matched
with availability of work. However, this does not mean that full time employees will be eliminated.
Companies will want to maintain a small core of full time employees with a large pool of part-timers or
74
contractors. In effect firms will be operating Just in Time system for labor. The new developments are
not without disadvantages as it may result into social oppressions, low and irregular earnings, and biased
dismissals in the pretext of no work or poor performance.
The two main categories of remuneration are:

i. Time based
ii. Remuneration related to output or performance.
Within these two categories there are innumerable variations some of which have general applicability
whilst others are of a local and specialized nature. Remuneration systems are frequently complex and
administratively cumbersome, but because the system is the result of negotiations, disputes and
disagreements over the years, attempts to rationalize and simplify are frequently met with hostility and
suspicion.
The newer forms of production organization, such as Just In Time systems mean more and more workers
will be paid time rates and will not have their pay dependent on individual output levels. There are two
reasons for this: first, parts are only produced as and when required. This means that the repetitive
production of components that move into stock is avoided as one of the key objectives of JIT. Secondly,
what counts in JIT is the output of the group (known as a production cell) as a whole. As a consequence
workers have to be flexible and adaptable so that they can move from task to task according the demand.
In such circumstances individual incentive schemes are of little or no value.
In addition more and more wages and salaries, traditionally classified as overheads, are now being
traced to product lines and classed as direct. Support functions are also grouped around specific product
lines so that identification of costs is more direct. This has led to the development and use of activity
based cost system (ABC System)
Time Based Systems
Basic System
At the simplest level workers would be paid for the number of hours worked at a basic rate per hour up
to, say, 40 hours per week. Time worked in addition to 40 hours would be classed as overtime and is
usually paid at a higher rate.
Although workers pay is not related to output, this does not mean that the output and performance is
unimportant. Supervision and managerial control systems are employed so that workers are paid for
actually working and not merely attending.
Advantages
i. simple to understand and administer
ii. It simplifies wages negotiations because only the rate needs to be determined unlike incentive
schemes where negotiations are complicated.
Disadvantages
i. it has no real incentive to increase output
ii. all employees in the same grade are paid the same rate regardless of performance
iii. constant supervision may be necessary
The time based systems are most appropriate for:
i. Work where quality, safety, health care are all important e.g. tool making, nurses, signal operators
etc.
75
ii. Work where incentive schemes would be difficult or impossible to install e.g. direct labor, stores
assistants, clerical work etc.
iii. Work where output is not under the employees control e.g. power station workers, teachers, etc.
High Day Rate Pay System
This is a time system which is designed to provide a strong incentive by paying rates well above normal
basic time rates in exchange for above average output and performance. For its successful application it
is necessary to ensure that the output levels are the result of detailed work studies and that there is
agreement from the labor force and the unions involved on the required production level. A typical
application of this system is on assembly line production in the car industry and in the domestic
appliance manufacture.
Advantages
ii. It is claimed to attract higher grade workers.
iii. Provides a direct incentive without the complications of individual piecework rates
iv. Simple to understand and administer
Disadvantages
i. May cause other employers to raise their rates to attract better workers thus nullifying the original
effect.
ii. Problems occur when the original target production figures are not met
5.4 Incentive schemes in practice (Premium Bonus Schemes )

Premium bonus is paid to the workers according to hours saved.
The employers assign some jobs to the workers to complete within a specific number of hours. If
the workers complete those jobs less than time allowed then there are some savings to the employer.
The workers are paid according to hours worked. The employer saves some money because they are
not supposed to pay the worker for the hours saved by them.
According to premium bonus schemes, the savings accruing to the employers out of time saved by
the worker should be shared between the employers and the workers. The premium bonus is paid to
a worker on the basis of his individual efforts.
The premium bonus schemes include:i. Halsey scheme
ii. Halsey Weir schemes.
iii. Rowan scheme
The formula for the workers total pay is:Day rate wage + bonus based on time saved.
Time saved (T.S) = time allowed (T.A) Time taken (T.T)
76
Harsey Scheme
Bonus = (time saved x wage rate)
Halsey Weir
Bonus = 1/3 (time saved x wage rate)
Rowan: bonus = time taken x time saved x wage rates
Time allowed
Example 1
Total output of Mwangi for one week was 480 units. He was allowed 8 minutes per unit. He
completed these units in 52 hrs. His wage rate per hour is Ksh18.
Calculate his total wage according to:i. Halsey scheme
ii. Halsey weir scheme
iii. Rowan scheme
Answer
Units completed = 480 units
Time allowed per unit = 8 minutes
Time allowed for 480 units = (8/60 x 480) hrs = 64hrs
Time taken = 52 hours
Time saved = (64-52) hrs = 12 hrs
Basic wage rate = Shs (52x18)
= Shs936
i) Halsey scheme:
Bonus = x T.S x wage rate
= x 12 x Shs18
= shs108
Total wage = basic wage + bonus
= shs936 + 108 = shs1044
Ii) Halsey weir scheme
Bonus = 1/3 x T.S x wage rate
1/3 x 12 x 18
77
= shs72
Total wage = basic + bonus
= 936 + 72
= Shs1008
Iii.)Rowan scheme
Bonus = T.T x T.S x wage rate
T.A
= 52 x 12 x18
64
= shs175.50
Total wage = basic + bonus
= 936 + 175.50
=Shs1, 111.50
5.5 Procedure for Preparing a Payroll

1. Calculate gross wage of each employee.
Gross wage = No of hrs worked x wage rate + over time hrs x over time wage rate
2. Calculation of income tax payable by each employee under the P.A.Y.E system.
3. Contribution regarding N.S.S.F, N.H.I.F etc are determined
4. Total deductions each employee is shown.
5. Calculation of net wages = Gross wage Total deductions
6. Any advance taken by employees or loan repayments are subtracted to find out the wages
payable.
Example
From the following information, prepare a payroll for the month of May 2014.
Clock No.
Name
No of Hrs worked Rate of pay
Advance
paid
(shs)
MU1
Peter
180
Shs 200 per Hr
5000
MU2
Jane
200
280 per Hr
10,000
MU3
Mathew
190
240 per Hr
3000
MU4
Eunice
210
200 per Hr
1600
78
MU5
Joseph
200
320 per Hr
1600
MU6
Elizabeth
170
260 per Hr
10,000
Additional Information
1. Normal working hours per month are 180. Overtime payable for extra hours at the rate of
50% above normal pay rate.
2. P.A.Y.E to be deducted at the rate of 20% of gross wage.
3. N.S.S.F to be deducted Ksh200 for each employee.
4. N.H.I.F to be deducted Ksh400 for each employee.
PAYROLL MAY 2014
S.No Name
Total
Rate Gross
hrs
Deductions
Net
wage
Advance Bal
wage
worked
P.A.Y.E NSSF NHIF Total
deductions
Shs
Shs
Shs
Shs
Shs
Shs
Shs
Shs
Shs
5011 Alex
190
12
2,340
234
80
20
334
2,006
600
1,406
5012 Robert
180
10
1,800
180
80
20
280
1,520
500
1,020
5013 Wachira 200
16
3,360
336
80
20
436
2,924
800
2,124
5014 Paul
170
13
2,210
221
80
20
321
1,889
500
1,389
5015 Josphat
210
10
2,250
225
80
20
325
1,925
800
1,125
5016 Mwangi 200
14
2,940
294
80
20
394
2,545
700
1,846
480
120
2,090
12,810 3,900
14,900 1,490
8,910
Workings
Gross wage
1. Alex
Shs
=
180hrs xshs12 = 2160

10hrs x shs 18 = 180
2,340
2. Robert =
180hrs x shs 10
1,800
3. Wachira =
180hrs x shs16
2,880
20hrs x shs24
480
3,360
79
4. Paul
170hrs x Shs13
5. Josphat =
180hrs x shs10
6. Mwangi =
2,210
1,800
30hrs x shs15
450
180hrs xshs14
2,520
20hrs x shs21
420
2,250
2,940
NB: I. For overtime, payment is to be made at normal rate plus 50% of normal rate.
(ii) P.A.Y.E is taken 10% of gross pay.
Activity 2.6
Finally, we have come up with a pay roll; do you see any linkages or relationships between the pay
roll and the payslip. Look at your pay slip and compare.
5.6 Allocation of Labour Costs.
Labour cost is allocated to respective jobs or products. Labour cost being a direct cost can be
identified and charged to the products which are produced by a specific worker. The allocation of
labour cost to the right jobs or products is required to ascertain the total cost of those jobs or
products.
Example
Simon worked 360 hours during the month of June 2012 and he was paid at the rate of Ksh200 per
hour. During the month he completed three jobs. The following additional information was
provided.
Job
No of hrs
160
120
80
Calculate the labour cost chargeable to these three jobs on the assumption that these jobs were
completed only by Simon.
Answer
Total wages of Simon = 360hrs x shs200 = shs72000
Proportion of time for three jobs
80
160
120
80
OR 4:
3:
Therefore labour cost is apportioned as per these proportions.

Job A = shs72000x4/9 = shs800
B = shs72000x3/9 = shs600
C = shs72000x2/9 = shs400
5.7 Summary
In summary, the lecture aimed at explaining method of labour costing The two main categories of
remuneration are:
i. Time based
ii. Remuneration related to output or performance
Illustration 1
Under a premium bonus scheme, workers received a guaranteed basic hourly minimum rate of pay plus a
bonus of 50% of the time saved. No payment is paid beyond the time allowed but the bonus which is paid at
the basic hourly rate is applicable to the accepted output only. No penalty is imposed on rejected output. The
following details are available for the month of January 2003
Worker
Time allowed per unit (hrs)
1/6
Units produced
474
684
175
Units rejected
54
84
25
Time taken (hrs)
78
72
80
Basic Pay per hour (Kshs)
81
Required
From the above information calculate for each employee
a) Bonus hours and amount of bonus paid
b) Gross wages earned
c) Labour cost for each good unit sold
Illustration 2
Based on the data below you are required to calculate the remuneration of each employee as determined by
each of the following methods
i.
Hourly rate
ii.
Basic piece rate
iii.
Individual bonus scheme where the employee receives the bonus in proportion of the time saved
to time allowed
Name of employee
Salmon
Roala
Pike
Units produced
270
200
220
Time allowed in minutes per unit
10
15
12
Time taken (hours)
40
38
36
Rate per hour (Kshs)
125
105
120
Rater per unit (Kshs)
20
25
24
5.9 Further Reading

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82
LECTURE SIX
6.0 Overheads Costing
This lecture introduce you to production overheads and methods of charging overheads to products,
departments or processes.
6.2 Objectives

i) Define overheads
ii) Describe methods of charging overheads to the final product
iii) Explain different types of overheads .
6.3 OVERHEADS
Overheads refer to the total cost of indirect materials, indirect labour and indirect expenses.
Indirect costs are those costs which cannot be identified to the production of some specific goods.
Overheads May Be Classified As:-
Production Overheads include indirect materials, indirect wages, factory rent and rates,
depreciation of factory plant and other indirect expenses.
Administration overheads e.g. office salaries, office rent depreciation of office equipments and
other office expenses.
Selling and distribution overheads e.g. advertisement, salaries of salesmen, rent of sales
warehouse, delivery van expenses, depreciation of delivery van and other sundry selling and
distribution expenses.
Over heads may also be classified as fixed overheads, sums fixed over heads or variable overheads.
Overhead Allotment
This means the charging of overheads to cost units or cost centers. This is done so as to ascertain the
total cost of a job as a product.
83
Stages of Overhead Allotment
Collection of overheads
Overheads analysis
Overhead absorption
Collection of Overheads
This involves accumulation of overheads in a specified period under separate heading.
These are collected from costing and financial accounting records e.g. indirect wages are obtained
from wages analysis book, indirect materials from stores requisitions etc.
Overhead Analysis
This is an analysis that charges overheads to cost centers. A cost centre is a location, person or item
of equipment. (Or group of these) in respect of which cost may be ascertained and related to cost
units e.g. production department A is a cost centre. There are two ways of charging overheads to
cost centers via
Allocation of overheads.
Apportionment of overheads.
Allocation of overheads means to change those overheads to a cost centre which results solely from
the existence of that cost centre. E.g. salaries of supervisors of department A are expenses of this
department and must be charged to this cost centre only. This is possible only if:1. The cost centre has caused the overhead to be incurred and
2. The exact amount of the overhead is known.
Apportionment of overheads means to charge a cost centre a fair share of an overhead.
The overheads which are incurred for the organization as a whole must be charged to various cost
centers of the organization e.g. monthly rent shared among the departments in an organization in a
specified proportion.
Absorption of Overheads
This refers to the charging of overheads to cost units. The overheads of a particular cost centre are
absorbed into cost units produced during a specified period.
6.4 Bases of Apportionments.
84
The following bases are applied for apportionment of overheads to cost centers.
Basis of apportionment
Overheads to which basis applies
1. Area
Rent, rates, heat & light, depreciation of buildings, maintenance of

buildings, insurance of premises etc.
2. Book value
Depreciation of plant & machinery, insurance of plant, repairs, and

maintenance.
3. No of employees
Expenses of personnel office, canteen, welfare of staff, safety

measures, supervision etc
4. Weight of materials or Materials handling expenses, storekeeping, packages costs etc.

cost of materials used
5. Technical estimates
Power consumption, water usage, steel consumption etc
6. Sales revenue
Advertisement, selling & distribution expenses etc.
7. Direct wages
Staff training, provident, contributions etc
8. Machine hours or General overhead items

labour hours
9. No of radiators
Heating
NB: Appropriate basis of apportionment should be chosen. The basis should be equitable,
practicable, economical, reasonable and accurate.
Overhead Analysis Sheet

This sheet contains the following columns:1. Column 1 shows the name of overhead to be allocated or apportioned eg rent, depreciation, etc.
2. Column 2 shows the basis of apportionment or allocation.
3. Column 3 shows the total amount of the overhead which is to be apportioned.
4. Column 4 shows the No of total units in respect of any specific overhead eg area, book value
etc
5. Column 5 shows the rate of overhead per unit.
Thus rate of total overhead amt
Total no of units
85
6. Other columns depending on the No of departments or cost centre.
Example
The following information relates to a factory which has four departments.
A)
Overhead
shs
Rent
160,000
Repairs to plant
100,000
Depreciation of plant
80,000
Light & heat
40,000
Supervision
120,000
Repairs to buildings
60,000
B) Information in respect of four departments:
Departments
mixing
boiling
heating
packing
Area in Sq meters
3000
2400
1600
1000
No of employees
70
50
50
30
Value of plant (shs)
1000,000
600,000
400,000
X2
Required: prepare an overhead analysis sheet showing clearly the basis of apportionment.
Overhead Analysis Sheet

Overhead
Basis
Amt
Amt (shs)
Rate/unit
Dep. A
Dep B
Dep C
Dep D
4000m2
Shs
20 30,000
24,000
16,000
10,000
Shs 0.05 25,000
15,000
10,000
12,000
8,000
(shs)
Rent
Area
80,000
per m2
Repair
to Value
plant
plant
Depreciation
Value
of 50,000
Shs1,000,000
per shs
of 40,000
Shs1,000,000
Shs0.04
20,000
86
of plant
plant
Light & heat
Area
per shs
20,000
4000m2
Shs
per 7,500
6,000
4,000
2,500
600 21,000
15,000
15,000
9,000
11,250
9,000
6,000
3,750
114,750
81,000
59,000
25,250
5/m2
Supervision
No
of 60,000
employees
100
Shs
employees
per
employee
Repairs
to Area
30,000
4000m2
buildings
Shs7.5
per m2
280,000
WORKINGS
1.
Total area = 1500 + 1200 + 800 + 500 = 4000m2
2.
Total employees = 35 + 25 + 25+15 = 100
3.
Total value of plant = shs (500,000 + 300,000 + 200,000)

= shs 1,000,000
4.
Rent per Sq. M = shs80,000 = shs20 per m2

4,000
5.
Repairs to plant per shs = 50,000
= Shs0.05
1,000,000
6.
Depreciation of plant per shs. Shs40,000
= shs 0.04
Shs1, 000,000
7.
Light and heat per m2 = shs 20,000
= shs 5
4000
8.
Supervision per employee = shs 60,000 = shs600

100
9.
Repairs to buildings per m2 = shs30,000 = shs7.5

4,000
10.
Apportionment of rent e.g. Dep A = 1500 x shs20 = shs30,000
11.
repairs to plant e.g. dep. B = 300,000 x shs0.05
= 15,000
87
12.
Apportionment of depreciation of plant e.g. dep C = 200,000x shs0.04

= shs8,000
13.
14.
Apportionment of
light & heat e.g. dep D = 500 x shs5= shs 2,500
15.
Apportionment of supervision e.g. dep A = 35 x shs 600 = shs21,000
16.
Apportionment of repairs to buildings e.g. dep D = 500xshs7.5

= shs 3,750
6.5 Overheads of Service Departments

The overheads charged to service departments must be further charged to production departments.
Service departments are those which provide some services to the production departments. Service
departments are those which provide some services, to the production departments e.g. stores
departments, repairs department etc.
Example
A company operates a factory whose overheads for the year ending 31st Dec 2014 are as follows:-
Indirect Materials
Shs
Shop no 1
80,000
120,000
400,000
Tool room
24,000
Stores
32,000
Clerical services
12,000
Shs
308,000
Indirect Wages
Shop No 1
84,000
116,000
108,000
Tool room
74,000
88
Stores
30,000
Clerical services
44,000
Rent & rates
200,000
Insurance
Depreciation
456,000
40,000
600,000
Power
180,000
Light & heat
80,000
1,100,000
1,864,000
The following information is also provided.

Departments
area (m2)
Production
book value
of machinery
effective
H.P
(Shs)
Shop No 1
2000
10,00,000
100
Shop No 2
1,500
1,800,000
80
Shop No 3
3000
400,000
Tool room
1000
600,000
Stores
1500
100,000
Clerical services
1000
100,000
10000
4,000,000
Service
20
200
The service departments provide their services to production department as under:Service departments
Production departments
Tool room
Stores
clerical
services
Shop No 1
30%
50%
30%
Shop No 2
50%
30%
40%
Shop No 3
20%
20%
30%
89
Required: prepare an overhead analysis sheet for the departments of the factory for the year ending
31st Dec 2014 showing clearly the basis of apportionment.
90
Overheads
Basis
Amount
Units
(shs)
Rate
Shop No
Shop No
Shop No
Tool
Stores
Clerical
per
room
Shs
Shs
Shs
Shs
Shs
Shs
40,000
60,000
20,000
12,000
16,000
6,000
42,000
58,000
54,000
37,000
15,000
22,000
services
unit
Indirect
Allocation
154,000
material
Indirect wages
Rent & rates
Insurance
Area
Book
value
Depreciation
Power
H.P
Light & heat
Area
Service
228,000
100,000
500m2
20
20,000
15,000
30,000
10,000
15,000
10,000
20,000
2,000,000
0.01
5000
9000
2000
3000
500
500
300,000
2,000,000
0.15
75,000
135,000
30,000
45,000
7,500
7500
900
45,000
36,000
9,000
8,000
6,000
12,000
4,000
6,000
4,000
235,000
319,000
148,000
120,000
60,000
50,000
(120,000)
90,000
40,000
100
5000m2
Dept
overheads
apportioned
over
production
depts.
Ratios
Tool room
Technical
30:50:20
36,000
60,000
24,000
Stores
Estimate
50:30:20
30,000
18,000
12,000
30:40:30
15,000
20,000
15,000
316,000
417,000
199,000
Clerical
servicies
932,000
(60,000)
(50,000)
91
Service Departments Providing Service to Other Service Departments

When some service departments provide services to production departments as well to other
service departments then a part of the overhead cost of one service department should be charged
to other service department. E.g. assume the maintenance department provides some services to
the stores department and similarly, the stores department provides some services to the
maintenance department. In this case, the over head cost of the maintenance department should
be charged partly to the stores department and the over head cost of store department should be
charged partly to the maintenance department. Ultimately, the overheads of these service
departments must be charged to the production department only.
The methods of transferring the overheads of service departments to the production department in
respect of service departments providing services to other service departments include;
1) Repeated distribution or continued allotment method
2) Simultaneous equation
EXAMPLE 1
A manufacturing company has three production department and two service department.
Overheads of these departments for a period one as follows
Production Departments
Shs
150,000
270,000
190,000
Service departments
X
30,000
50,000
690,000
A technical assessment for the apportionment of the costs of the service department shows.
92
DEPARTMENTS
A
40%
20%
30%
10%
50%
20%
20%
10%
You are required to show the total overhead chargeable to the three production department by
using the method known as continued allotment of apportioning service department costs
between the two service departments.
DEPARTMENTS
A
270,000
190,000
30,000
50,000
O.H of X apportioned 12,000
6,000
9,000
(30,000)
3,000
O.H of Y apportioned
26,500
10,600
10,600
5,300
(53,000)
O.H of X apportioned
2120
1060
1590
(5300)
530
265
106
106
53
(530)
O.H of X apportioned
21
11
16
(53)
(5)
287778
211313
Overhead
150,000
190909
NB.
I. The appropriate portion of the overhead of one service department is charged to the
other service department. E.g. 10% of the O.H of X department is charged to Y
department and so on. The process is continued until all the amounts are transferred to
production department.
II. The final overheads of the production department are equal to the total of O.H of all
departments i.e. 190,109 + 287,778 + 211,311 = 690,000
EXAMPLE 2.
A company has three production departments and two service departments. Overheads of these
departments for a specific period are as follows:-
93
Production departments
(shs)
25,000
20,000
15,000
Service departments
A
10,000
7,800
77,800
The overheads of service center are charged out as under

DEPARTMENTS
P
Service Dep: A
30%
30%
20%
20%
Service Dep: B
40%
30%
20%
10%
Required: show the total overhead chargeable to the three production departments by using
simultaneous equation methods.
Answer:
Let x = Total overhead of Dep A
Y = Total overhead of Dep B
Then X = 10,000 + 0.1y ------------ (i)
Y = 7,800 + 0.2x ------------- (ii)
Eliminate decimals by multiplying both equations by 10.
10x = 10, 0000 + y
10y = 78,000 + 2x
Re- arranging the equations:
10x y =
10,000
-2x + 10y = 78,000
-------------- (iii)
------------- (iv)
Multiply equation (iv) by 5 and add the result to equation (iii)

10x y
= 100,000
94
-10x + 50y
= 390,000
49y
= 490,000
Y = 490,000
= 10,000
49
Substitute the value of y = 10,000 in equation (iii)
10x 10,000 = 100,000
10x = 110,000
X = 11,000
Now, Let see apportion the value of x = 11,000 and y = 10,000 to the production
departments on the basis of agreed percentages.
PRODUCTION DEPARTMENTS
P
TOTAL
shs
shs
shs
shs
Original O.H
25,000
20,000
15,000
60,000
Service Dep A
3,300
3,300
2,200
8,800
Service Dep B
4000.
3,000
2,000
9,000
32,300
26,300
19,200
77,800
Total
6.6 ABSORPTION OF OVERHEADS

Absorption of overheads means the charging of overheads to cost units. The overheads costs of a
cost centre are charged to cost units.
Overhead per cost units = total overheads
Units produced
The total overheads of a cost centre are established through allocation and apportionment of
overheads. The absorption of overheads is a process whereby the overhead is added to the direct
cost of each cost unit.
95
In order to charge overheads to cost units, overhead absorption rate (O.A.R) is calculated.
The O.A.R is that rate at which overheads are charged to each cost unit.
6.6.1 Overhead Absorption Methods.

These are also referred to as bases of absorption they include:-
Method
Units of output
Formula to calculate O.A.R

Overhead
Units of output
Direct labour hours
Overhead
Total direct labour hours
Direct machine hours
Overhead
Total direct machine hours
Percentage of material cost
Overhead
x 100
Total direct material cost

Percentage of direct wages
Overhead
x 100
Total direct wages

Percentage of prime cost
Overhead
x 100
Total prime cost

Standard hours
Overhead
Standard hours
6.6.2 Choice of the Absorption Method

The method to be used should be selected according to the circumstances. It may be based on the
following factors.
96
1. Units of output appropriate when all the units produced are identical and involve
identical time and production process.
2. Direct labour hour appropriate in those departments which are labour intensive.
3. Direct machine hour appropriate in those cost centers where machines are used to great
extend in order to complete the production process.
4. Direct wages percentage appropriate where wages paid are related to time.
5. Direct material percentage suitable for those organizations when material cost represents
a large portion of total costs and where the material cost is significant factor.
6. Prime cost percentage: - most appropriate where each jobs material and labour cost
proportions vary to great extent. Standard hours applicable in organizations where
standard costing technique is applied. Overheads are absorbed according to standard
hours.
Example
The following information is available from a manufacturing company:Total overhead
shs600, 000
Total direct wages
shs480, 000
Total direct material cost
shs500, 000
Direct labour hours
75,000
50,000
Units of output
shs750, 000
Calculate six overhead absorption rates.
Method
Overhead
O.A.R
Unit of output
Overhead
Shs600,000 = sh0.80 per unit
Units of output
750,000
Overhead
Shs600,000 = shs8 per labour
Direct labour
hour
Direct labour hours
75,000
Direct machine hour
Overhead
Shs600,000
shs12
per
97
machine hr
50,000
Percentage of material cost
Overhead
x 100
Material cost
Shs600,000 x 100 = 120% of

500,000
material
cost
Percentage of direct wages
Overhead
x 100
Direct wages
Shs600,000 x100 = 125% of

direct
480,000
Percentage of prime cost
wages
Overhead x 100
Shs600,000 x 100 = 61.2% of
Prime cost
prime
980,000
cost
6.6.3 Application of Absorption Rates

The overhead absorption rates are used to calculate the total cost of any particular job or cost unit.
Overhead absorption method is indicated in order to find out the total cost of a cost unit.
Example
The following information relates to the activities in a production department for a certain period.
Direct wages
shs100,000
Direct materials
shs200,000
Labour hours worked
shs20,000
Machine hours used
shs5,000
Total overhead chargeable to the department = shs150,000
On job number 1234 produced in the department during the period the relevant data was:Direct wages
shs5,000
Direct materials
shs12,000
Labour hours
shs900
Machine hours
shs250
Calculate the total cost of job No 1234 by five different methods of overhead absorption.
98
Answer
Method
Absorption rates
Direct labour hours
shs150,000 = shs7.5 per machine hour

20,000
shs 150,000 = shs30 per machine hour

5,000
Direct material percentage
shs150,000 x100 = 75% of material cost

200,000
Direct wages percentage
shs150, 000 x100 = 150% of direct wages

Shs100, 000
Prime cost percentage
shs150,000 x 100 = 50% of prime cost

300,000
Total cost of Job Number 1234

Direct labour hours method
shs
Direct materials
12,000
Direct wages
Prime cost
Over head = (900 x shs7.50)
5,000
17,000
6,750
(I.e. labour hours of this job x

labour rate per hour) Total cost
23,750
Direct machine hours method
shs
Direct materials
12,000
Direct wages
Prime cost
5,000
17,000
99
Overhead (250xshs30)
7,500
(I.e. machine hours of this job x

Machine hour rate) Total cost
24,500
Direct material percentage method

Shs
Direct materials
Direct wages
Prime cost
Over head 75% of shs12, 000)
12,000
5,000
17,000
9,000
26,000
Direct wages percentage method

Shs
Direct materials
12,000
Direct wages
5,000
Prime cost
17,000
Overhead (150% of shs5, 000)
7,500
Total cost
24,500
Prime cost percentage method
shs
Direct materials
12,000
Direct wages
5,000
Prime cost
17,000
Overhead (50% of 17,000)

Total cost
8,500
25,500
6.6.4 Under And Over-Absorption

Overheads are absorbed on predetermined rates in most cases. These are predetermined rates are
based on estimated (budgeted) production and estimated (budgeted) overheads.
100
The actual overheads may be different than the estimated overheads. This results to under or over
absorption. If absorbed overheads are less than the actual overheads, this is known as under
absorption.
On the other hand, if the absorbed overheads are greater than actual overheads, this is known as
over absorption.
NB: The amount of under absorbed overheads should be added to total costs before the profit is
calculated. Over absorbed overheads are subtracted.
6.8 Summary
There should be a direct cause-effect relationship between consumption of overheads and the
chosen cost driver. This relationship is not necessarily a short term one. Costs such as salaries
make up a significant portion of total overheads but are not easily adjusted in the short run. The
number and type of cost drivers chosen will depend on several factors such as:
i. the required accuracy of product costing
ii. The extend that a given cost driver captures the actual consumption of an activity by a
product.
iii. The extend to which a cost driver can be related to many activities or cost pools. The cost
pool should be homogenous (fairly represented by one cost driver). Where this is not
possible the pool may need to be subdivided and numerous cost drivers used. (of
course this will complicate the system).
iv. The extend that one cost can be fairly applied to diverse products. For example if the cost
driver, number of inspections were used to trace inspection costs to products,
distortions will occur if inspections take varying amounts of time for different
products.
101
Example.
a) Equator garments Ltd manufactures custom-made suits tailored to the requirements of each
customer. They use predetermined overhead absorption rates in allocating overheads to each job.
In the cutting department the rate is based on direct labour hours and in the stitching department
the rate is based on machine hours. The management of equator garments ltd wants to set
overhead absorption rates to help in determining prices in the next financial year. The cost
accountant has provided the following budgeted data for the financial year:Cutting
Stitching
Direct labour cost
shs1, 200,000
shs750, 000
Factory overhead
shs1, 500,000
shs1, 620,000
Direct labour hours
shs60, 000
shs30, 000
Machine hours
shs40, 000
Required: calculate the overhead absorption rates for each department.
b) The following data relates to Job No. A4.

Cutting
Stitching
Direct materials
shs500
shs750
Direct labour hours
shs30
shs10
Machine hours
shs20
Administration overheads are absorbed at 25% on factory costs. Profits mark up is 33 1/3% on
costs.
Required: prepare a cost statement for Job A4 showing the price that will be charged to the
customer.
c) At the end of the year, the following data was obtained.

Cutting
Stitching
Direct labour hours
68,000
30,000
Machine hours
17,000
Hours actually worked
102
Factory overhead cost incurred
1,600,000
760,000
Required: calculate the amount of under or over absorption of overhead for each department.
rd

th
103
LECTURE SEVEN
7.0 Costing Systems

This lecture is to introduce you to various methods of job order costing which is a form of specific
order costing which applies where the work is undertaken as per the customers specific requirements
.
7.2 Objectives

(i) Explain the steps involved in activity based costing
(i) Define and explain the features of the various costing methods,
(ii) Understand the environment under which the various product costing methods are applicable.
(iii) Perform product costing computations.
7.3 SPECIFIC ORDER COSTING

This is a broad costing system, which is applicable where work jobs consist of separate jobs, batches or
contracts. Each job, batch or contract is a cost unit and in most cases, it is different from another. Each
order made can be identified separately and the system is designed to find the cost of each order. Specific
order costing is subdivided into:
a) Job costing
b) Batch costing
c) Contract costing
7.3.1 JOB COSTING
This is a costing method which is applied when a job/cost unit is relatively of small size, is undertaken to
fit the customers specifications and is of comparatively short duration: Each job moves through the
operations continuously as an identifiable unit. The method is usually adopted by businesses, which
receives orders for work peculiar to the needs of individual customers.
a)
Features of Job costing
Product is against the customers order and not on job stocks
Each job has its own characteristics and requires special attention and skills.
104
b)
Procedures of Job Costing
The application of job costing method begins when a customers order is received. After accepting an
order, an individual work/job order number is assigned to each job for or separate order identification..
Production order is then made giving authority for the job to start. A job cost account for each job is then
opened. In this account, all costs relating to that particular job are recorded and this account closed only
when the job is complete. After completion of the job, an invoice is prepared and served to the customer.
Materials for each job are made using material requisition forms
Labour is charged on the basis of the amount of time used to complete that particular job as
recorded in time-keeping records.
Overheads are charged on the basis of an predetermined overhead absorption rate.
Applied Overhead absorption rate = Budgeted Overheads Denominator value

The Denominator value where the denominator value refers to units of some specified overhead
absorption base e.g. machine hours, direct labour hours.
7.4 Accounting for Job Order Costing
1. (a) Direct materials
(i) Dr Stores ledger control A/c Cr Cash A/c for cash purchasers
(ii) Dr Stores ledger control A/c Cr Creditors A/c for credit purchasers X
(b) Return of materials to suppliers
Dr Cash A/c or creditors control A/c
Cr Stores ledger control A/c
(c) Issue of materials from the store

Dr W.I.P. Control A/c
Cr stores ledger control A/c for direct materials.

Indirect materials: Dr Factory overheads control A/c
X
X
Cr Stores ledger control A/c

X
2. Direct Labor
Cr Cash A/c
3. Accrued Direct Wages

Cr Wages Control A/c
105
Indirect Wages
Dr Factory overheads control A/c
Cr Wages Control A/c
1. Production Overheads
(i) (not yet paid)
Dr Factory overhead control A/c

Cr Expenses/Creditor control A/c
(ii) (When paid)
Dr Expense/creditors A/c
Cr Cash A/c
Note
Overheads entries apply when there is an interlocking accounting system.
5. Finished goods transferred to the store:
Dr Finished goods stock control A/c
Cr W.I.P Control A/c
6. Sale delivery of finished goods to customers:
(i) On Credit: Dr Debtors control A/c Cr Sales A/c
(ii) In Cash: Dr Bank/Cash A/c Cr(Sales A/c
7. Cost of goods sold to customers:
Dr Cost of sales A/c
Cr Finished goods control A/c
8. (i) When there is over absorption of production overheads:
Dr Factory overheads control A/c
Cr P & L A/c
(ii) When there is under absorption of production overheads:
Dr P& L A/c
Cr Factory overheads control A/c
9. When there are non-manufacturing overheads:
Dr P & L A/c
Cr
Non-manufacturing overheads control A/c
or non-manufacturing
overheads/expenses are regarded as period costs & are therefore not changed To
W.I.P control A/c.
7.5 Job Cost Account
106
Dr
Direct materials issued from stock
Direct wages
Production overheads absorbed

Materials transferred from other jobs
X
X
XX
Cr
Materials returned to the store
Materials transferred to other jobs
X
X
Cost of completed jobs transferred to

finished goods A/c
X
Balance c/d (Total cost of that job)
X
XX
Illustrations:
The following transactions were made by Z limited in the month of December.
Direct Materials
8,000/= was bought on credit, out of these, materials worth 5,000/= were returned to the suppliers.
50,000/= was issued from the store
Indirect materials issued amounted to 5,000/=
Direct wages allocated to production amounted to 20,000/=
Goods worth 200,000/= were sold
Finished goods worth 100,000/= were transferred to the store.
The cost of goods sold was 140,000/=
Unpaid indirect expenses were 32,000/=
Indirect wages allocated amounted to 15,000/=
Non-manufacturing overheads incurred amounted to 20,000/=
Overhead expenses charged to the jobs 60,000/=
Required
a)
b)
c)
d)
Prepare the stores ledger control A/c

Factory overhead control A/c
W.I.P. control A/c
Costing P & L A/c
Creditors (material)
Stores Ledger (material)

Creditors (wages)
Incurred wages
P + LA/c
Overabsorption
Stores Ledger Control A/c

8,000
Creditors control
W.I.P
(Indirect materials)
Factory overheads
Factory Overheads Control A/c
5,000
W.I.P
32,000
15,000
8,000
5,000
50,000
5,000
60,000
_____
107
60,000
60,000
Control (D wages)
W.I.P Control A/c

50,000
Finished goods stock
control
20,000
Overhead expenses
60,000
Finished goods control

Non manufacturing
Overheads
Costing profit
Costing P and L A/c

140,000
Sales
Factor overhead
20,000
absorption
48,000
Stores Ledger (material)
100,000
200,000
8,000
7.6 BATCH COSTING

This is a type of job costing that is used when production consists of limited repetitive work and definite
number of item manufactured in one batch. A batch is defined as a cost unit consisting of a group of
identical item in particular sizes and colors of shoes, toys, spare parts etc. The total cost incurred in
production is spread on the number of units made when the batch is completed.
a) Procedures:
Allocation of batch number
Production order is made
Creation of batch costs account
Completion of the work and closure of the batch cost account
Allocation of costs to individual units in the batch
Determination of selling price/batch and unit.
Illustrations
The budgeted variable overheads of Githurai Ltd for the year 2001 are given as below:
Department
A
B
C
D
Overhead(shs.)
150,000
200,000
120,000
300,000
Absorption base
15,000 direct labour hours
30,000 machine labour hours
Selling and administering overheads are changed at 10% of total production costs while the profit
mark up is 25 of total costs:
108
An order for 2,000 units was received from a customer. The batch number of this order is 510.
The following additional information in respect of this batch is provided below:
Direct materials 87,000/=
Direct Labor Dept A (150 direct labor hrs) 12shs. Direct labor hour.
o
Dept B (40 direct labor hrs) @ 15shs. Per hr
Dept C (60 direct labor hrs) @20shs. Per hr
Dept D (100 direct labor hrs) @10shs. Per hr
A total of 50 machine hours were used in this job

Required
a) Calculated the total cost of the batch
b) Cost/Unit
c) Selling Price of the batch
d) Selling Price unit
Solution
Githurai Limited
Batch 510
Particulars
D Materials
D Labour:
Shs.
87,000
Dept A (150 x 12)
Dept B (40 x 50)
Dept C (60 x 20)
Dept D (100 x 10)
1,800
6000
1,200
1,000
Dept A 15,000/15,000 x 150

Dept B 200,000/25,000 x 40
Dept C 120,000/20,000 x 60
Dept D 300,000/300,000 x 50
1,500
320
360
500
Prime Cost
Variable Overheads:
Total Production Cost

Selling and admin costs 10% (94,280)
Total Costs
Mark-up: Mark-up @ 25% x 103,708
Cost/Unit = 103,708/2000 units = 51.854
4,600
91,600
2,680
94,280
9,428
103,708
25,927
Selling Price unit = 129,635/2,000 = 64.8175
7.7 Summary
109
Job costing is also known as job order costing, it is that form of specific order costing which
applies where the work is undertaken as per customers specific requirements and each order is of
comparatively short duration.
In job costing every job can be identified clearly and have their own costs. Work in progress
depends upon the number of job in hand at the end of the period. each job is a separate
accounting unit, and separate job number or production numbers are allotted to each job.
1.What do you understand by job order costing? Under what condition, is it suitable
2.Explain the procedure involved in job order costing
.
7.9 Further Reading

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110
LECTURE EIGHT
8.0 CONTRACT COSTING

This is a form of specific order costing that is applied to relatively large cost units, which normally take a
considerable length of time to complete e.g. building or construction works. Contract jobs are undertaken
in accordance with specific requirements of contractee/Customer. Contracts may be distinguished from
job orders by the following features:
The money value of a contract is much larger than that of a job order.
A contract consumes significantly larger amounts of resources than a job order.

For a contract, special progress reports are usually made while in job costing, reports are made
after the completion of the job.
For a contract, indirect costs are relatively smaller in relation to direct costs but the vice versa is
time for job order.
To second the progress of contract works, a special account known as a contract account is maintained.
8.2 Objectives

(i) Importance of contract costing in real-life situations
(ii) Understand the features of contact costing
(v) Describe the various stages and prepare contract accounts

8.3 CONTRACT ACCOUNTS
This is a form of specific order costing that is applied to relatively large cost units, which normally take a
considerable length of time to complete e.g. building or construction works. Contract jobs are undertaken
in accordance with specific requirements of contractee/Customer. Contracts may be distinguished from
job orders by the following features:
The money value of a contract is much larger than that of a job order.
111
A contract consumes significantly larger amounts of resources than a job order.

For a contract, special progress reports are usually made while in job costing, reports are made
after the completion of the job.
For a contract, indirect costs are relatively smaller in relation to direct costs but the vice versa is
time for job order.
To second the progress of contract works, a special account known as a contract account is maintained.
8..4 Features of contract accounting.

1. Direct expenses.
In addition to direct materials and direct labour, a high proportion of indirect expenses are
incurred. This includes hire charges of plant & machinery, site office expenses, site power usage
etc.
Most of the expenses are direct. Direct materials charged to a specific contract may be classified
as
1. materials issued from the store and
2. Materials purchased for a contract from the local market.
These materials are charged to the respective contract.
Incase of excessive materials, they are returned to the store and credited to the contract account.
The materials on site at the end of the accounting period are valued at cost and carried forward to
the next period.
Direct wages both paid and accrued are debited to the contract account.
2. Overheads.
Expenses like telephone, electricity, repairs, water etc are allocated to the respective contract
account. All other overheads incurred for the company as whole are apportioned on a suitable
basis to all contracts. The proper share of these overheads is charged to a specific contract.
3. Contract plant
The amount of plant used in a contract work is a key feature.
112
This includes :cranes, trucks, mixers, lorries etc. if plant is on lease basis, then the leasing charges
are directly charged to the contract, on the other hand, if plant is purchased then this plant is
charged to that contract for which it was purchased.
At the end of the year or on completion of the contract, the contract account is credited with the
value of plant at that time. Thus the depreciation of plant is charged to the respective contract.
If the plant is moved frequently from one contract to another contract, then each contract is
charged the depreciation of the plant at a specific rate.
4. Subcontracts:
If the contractor assigns some work to sub-contractors e.g. electrical or plumbing work, the
amount paid to subcontractors is charged to the respective contract.
5. The contract price
This is the price agreed upon by the contractor and the contractee after the tendering process.
6. Architects certificate.
The architect inspects the work done periodically and certifies the amount of work completed.
The contractor can claim the amount of work of work certified from the contractee. The architect
is appointed by the contractee.
7. Retention
A specific percentage of work certified is withheld by the contractee or client. This amount
withheld is known as retention money. The amount is paid to the contractor on the completion of
the contract.
The main purpose of this retention money is to ensure that the contract has been completed
according to the satisfaction of the client and all defects in the work have been rectified by the
contractor. If the contractor does not remove such defects, then the retention money is not
released by the contractee.
The retention money is shown as debtors in the books of the contractor.
8. Profits on uncompleted contracts.
113
When a contract extends over a number of years, it may be necessary to take profit each year in
order to avoid wide fluctuations in annual profits.
The following rules are applied:
a) Take no profits on the very early stage of contract.
b) When the contract is in its maturity, then:
Amount of profit taken = 2/3 x notional profit x cash received
Value of work certified
c) When the contract is nearing its completion, then:
Amount of profit taken = notional profit x value of work certified
Contract price
NB: Notional profit = value of work completed - cost incurred to date.
8.5 Proforma contract account
This is a separate account that is opened and maintained for each contract undertaken for the purpose of
accumulating cots. Each contract is given a number and all costs relating to that particular contract are
recorded in this account. A typical contract account is as shown below:
Contract No. XYZ Account
Materials b/f
Materials purchased
Direct wages
Indirect wages
Subcontractors fees
Cost of special plant
Machinery/Plant b/f
Cost of work done b/d

Notional Profit
x
x
x
x
x
x
x
Materials returned to store

Materials c/d
Machinery c/d
Balance c/d: Cost of work done
x
x
x
x
x
x
xx
Value of work certified

Cost of work done but not certified
x
x
xx
Contract Costing Terminology

Principles of profit income recognition in contracts
The Notional Profit
It is a component of 2 items:
a) Profit taken = Notional profit x 2/3 x cash received/work certified
114
This formula of calculating the part of national profit taken in the year is used when substantial
costs have been incurred on the contract but the contract is not near completion. But when the
contract is near completion the profit taken is calculated as:
Profit taken = Estimated profit x cash received/contract price.
Where Estimated profit = Contract price Estimated total cost and
Estimated total cost = Costs incurred to date and estimated future costs.
b) Profit not taken = refers to the part of the national profit that is not recognized in the current
period. It is profit carried forward to be recognized in the years that follow.
c) Retention Money
This is a portion of the value of work certified that is retained by the contractor to protect himself
from faulty work that might be evident at the time of progress payments or at the completion of
the contract. This amount is released after satisfactory performance under the contract.
Example.
Ideal construction company ltd won the contract for the construction of a multi story building at a
cost of sh.200 million. The data relating to the contract for the year ended 31st December 1998
were as under:
Sh (000)
Materials issued to the site
80,000
Materials purchased locally
15,700
Direct wages: paid

Accrued
Plant purchased and installed
5,800
350
48,800
Direct expenditure:
Paid
Accrued
Established charges
Materials returned to store
Work certified
1,780
70
180
850
150,000
Cost of work not certified
3,800
Materials on site on December 31
5,330
Value of plant on Dec 31
41,500
The company had received from the client, payments amounting to sh. 126 million
115
Required:
a) Prepare the contract account;
b) Prepare the contractee account;
c) Show how the various items will appear in the balance sheet as at dec 31 1998.
Answer.
CONTRACT ACCOUNT
Sh (000)
shs(000)
80,000
15,700
48,800
Materials returned from store

850
materials on site c/d
5,330
plant on site c/d
41,500
Cost to date c/d
105,000
Direct materials
Issued from store
Purchased locally
Plant installed
Direct wages:
(shs)
Paid
5,800
Accrued c/d 350
Direct expenses
Paid
1,780
Accrued c/d 701,850
Established charges
Cost to date b/d
6,150
180
152,680
105,000
Notional profit c/d
48,800
153,800
Profit & loss A/c (w1)

Profit provision c/d
27,328
21,472
48,800
5,330
41,500
Stock on site b/d

Plant on site b/d
Cost of work not yet
Certified b/d
3,800
152,680
contractee A/c
Work certified
cost of work not yet
certified c/d
150,000
3,800
153,800
notional profit b/d
48,800
_______
48,800
direct wages accrued b/d
350
direct expenses accrued b/d
70
profit provision b/d
21,472
116
CONTRACTEES ACCOUNT
Work certified
shs.(000)shs.(000)
150,000
bank A/c
126,000
_______
balance c/d
24,000
150,000
Balance b/d
150,000
24,000
BALANCE SHEET (EXTRACT)

Shs(000)
Plant on site
41,500
Stock on site
5,330
shs(000)
accrued wages
accrued direct expense
350
70
Workings
(w1) calculation of profit:
Amount of profit taken = notional profit x 2/3 x cash received
Work certified
= 48,800 x 2/3 x 126,000
150,000
= shs. 27,328
Profit provision c/d
= 48,800- 27,328
= sh. 21,472.
(w2) work in progress

Method 1
shs.(000)
Cost to date
105,000
Add profit taken
27,328
117
132,328
Less: cash received
126,000
W.I.P.
6,328
Method 2
shs.(000)
Contractees A/c balance c/d
24,000
Add: cost of work not

yet certified
3,800
27,800
Less: profit provision
21,472
W.I.P.
6,328
8.6 Summary
Contract costing, which is otherwise called terminal costing, is adopted by those business undertakings which
undertake long-term contracts, eg builders and contractors,civil engineering firms, ship building companies etc
In case of contract costing,the cost of each contract is ascertained by charging the expenses attributable to each
contract.Most of the expenses are of direct type and only the general and administrative overheads have to be
apportioned.
The profits of contract costing are generally recognized on an annual basis as the work progresses.A contact
ledger is kept in which a separate account for each contract is opened.
118
The following figures have been extracted from the records of China youn Ltd., for they year
ended 31 Dec. 2013 in respect of an office block commissioned by the Outer City Grabbers Ltd:
Expenditure during 2013:
Plant
Wages, etc.
Materials
Sub-contract work
Sundry Expenses
Contract overheads
Balances as at 31 Dec. 2013
Plant
Materials
Accrued wages
Other information
Value of work certified during 2013
Cost of work not certified during 2013
Progress payments during 2013
Progress payments receivable at 31 Dec. 2013
Retentions during 2013
ksh
150,000
260,000
330,000
200,000
30,000
240,000
100,000
50,000
60,000
ksh
1,550,000
20,000
1,100,000
300,000
150,000
Required:
(1) Contract A/C
(2) Outer Cities Grabbers Ltd. (Contractee)
(3) Architects Certificates A/C
(4) Retentions A/C
8.8 Further Reading

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th
119
LECTURE NINE
9.0Process costing
This lecture is to introduce you to costing used by those concerns which manufacture articles of
uniform standards. These firms manufacture articles on a continuous flow basis.
9.2 Objectives

(i) Understand features and characteristics of process costing
(ii) Describe the valuation in work in progress
iii)Accounting Treatment of Spoilage Costs
iv)Allocation of joint cost
9.3 Nature of process costing

This is a costing method that is applied where there are standard operations with continuous production of
homogeneous as identical units. Hence the output is the final product of a sequence of operations. In this
type of costing, costs are accumulated on the basis of process, and the cost per unit is arrived at by
dividing the total process costs by the number of input of the next process and further materials can be
added at each stage production. Therefore cost per unit for the second and subsequent processes is a
cumulative cost for example, the cost per unit for the output transferred from9.0 process 2 is the cost of
production for both process 1 and 2 and not for process 2 above. The fact that the output for the first
process becomes the input for the next process means that the process costing procedure strives to
maintain the cost of each process product and charge that with the first process. The aim is to transfer the
cost accumulated in the first process to the next process. This is illustrated below:
Process 1
Direct Material:
Direct Labour
Overheads
Shs
1,000
500
1,500
3,000
Shs
Transferred to
Process 2:
3,000
3,000
3,000
Process 2
Shs
Transfer from
Shs
Transfer to
120
Process 1:
Direct material
Direct labour
Overheads
3,000
1,500
1,000
500
6,000
Finished Goods:
6,000
____
6,000
Examples of Industries where process costing is applied

Process Costing Procedure
1. The production factory is divided into a number of processes.
2. An account is opened and maintained for each process.
3. Each process account is debited with materials, labor, direct expenses and overheads apportioned
to the process.
4. The output of a process is transferred to the next process input of that process.
5. The finished output of the last process is transferred to the finished goods account.
9.4 VALUATION OF WORK IN PROGRESS
The concept of Equivalent units
Equivalent Units
This is a notional quantity of completed goods in the production process. It is a collection of work
application (direct materials, direct labor and overheads) necessary to produce one complete unit of
output. They are the number of units that would have been produced during a period of all the
departments efforts had resulted into completed units.
The concept is used for purposes of translating the partially completed production into its completed units
equivalent. This enables cost accountants to value the work-in-progress in an objective, consistent,
reliable manner.
Illustration 1
Suppose there are 4,000 units of a product in ending inventory out of which 60% are fully complete
whereas the remaining are 70% complete. What are the equivalent units of the product?
Solution: 60% x 4,000 = 2,400 units fully complete.
40% x 4,000 = 1,120 units Equivalent units.
Total Equivalent units = 3,520 units
Assume we had total process costs of shs.7,040, then each unit would cost shs.7,040/3,520=shs.2
Illustration 2
Material A is added at the beginning of a production process. Labor and overheads are added continuously
during the production process. At the end of the process, 10,000 units were complete and 2,000 units were
60% complete as per labor and overheads. The cost of raw materials used during the period amounted to
shs.220,000, labour shs.150,000 and overheads shs.74,000. There was no opening inventory.
121
Required
Determine the cost per unit of both the completed units, and the units in the ending inventory.
Solution:
Conversion
(direct
Labour
and
Physical Units
Materials
overheads
Completed
10,000
10,000
10,000
Ending Inventory
2,000
2,000
1, 200
12,000
______
_______
Equivalent Units
12,000
11,200
Cost for the Period
220,000
224,000
Cost per Equivalent Unit:
Shs.18.33
220,000/1,200=sh18.33 224,000/11,200=sh20
Total Cost/Equivalent Unit
=18.33+sh.38.33
In the above illustrations, there is no opening work in process. When it exists, we need to adopt a method
of valuing it and incorporating it into the process accounts. The two main methods used for purposes of
valuing the opening work in progress:
1. Weighted Average Method
2. First In First Out (FIFO) Method.
Using these methods enables the cost of the opening work in progress to be appropriately assigned
to the finished goods an the closing work in process.
a) Weighted Average
When this method is used, all costs of production are considered in assigning costs to inventory. The
method puts together opening work in process inventory costs and cost of production. It mixes the
costs of previous period with those of current period in determining costs per unit.
Under this method, equivalent units are calculated as follows:
Equivalent Units = Units completed and Transferred + Ending work in progress inventory: (% completion)
Cost per Equivalent Unit = Previous Period costs + Current period costs
In beginning working process
Equivalent units of work done.
Under weighted average approach, we do not distinguish the units started and completed in the current
period from the `units completed and transferred ` and the `Ending working period`
a) First In First Out (FIFO)
This method considers only those costs incurred during the current period. Equivalent units are
calculated as follows:
Equivalent Units= Units completed and transferred + (Units in ending W.I.P x % of completion
Units in beginning )
122
% of completion
Cost/Equivalent Unit = Current Costs

Equivalent Units
Carefully Note that FIFO distinguishes the units started and completed in the current period from
the units completed and transferred. This is done by subtracting the beginning W.I.P. from the
units completed and transferred and the ending work in process.
Illustration
The following work in progress account relates to the blending department of ABC Limited, a softdrinks company for the month of January 2013. Raw materials were introduced at the start of the
work while labour and overheads were incurred through-out the blending process.
Blending Department: W.I.P A/C
Particulars
Shs
Particulars
Sh
Bal b/f = 5,000L (4/5) =
65,000
Completed and transferred out: 29,000L
Raw materials added (30,000L)
125,000
Ending W.I.P (2/3)
Direct Labour
145,000
Factor Overheads
201,000
6,000L
1. Beginning W.I.P. consists of the following:
- Raw materials
shs.15,000
- Direct Labor
shs.20,000
- Factory Overheads
shs.30,000.
Required
Calculate cost/equivalent units using:
a) Weighted average
b) FIFO
Weighted Average
Completed Transferred Out:
Ending W.I.P
Total
Units
29,000
6,000
______
Physical Materials
29,000
6,000
______
Conversion
29,999
4,000
(2/3 X 6,000)
123
35,000
35,000
33,000
Process Costs: In beginning Inventory:

Current Costs:
15,000
125,000
140,000
50,000
346,000
396,000
Cost per equivalent Unit:
Shs.140,000 Shs.396,000
35,000
33,000
= Shs.4
Shs.12
Total Cost per equivalent Unit: 4 + 12 = Shs.16

FIFO
Total Physical Units
5,000
Beginning W.I.P
Units started and completed
during
The current period
= (2,900 5,000)
24,000
Ending W.I.P
6,000
35,000
Equivalent Units
Current Costs:
Cost/Equivalent Units
Total Cost Per Equivalent Shs,16.10

Unit:
Materials
Conversion
1,000 = (1/5 X 500)
24,000
6,000
24,000
4,000 = (2/3 x 6,000)
30,000
125,000
125,000
30,000
= Shs.4.20
29,000
346,000
346,000
29,000
Shs.11.90
* Equivalent Units of 5,000 x (1 4/5) = 1,000 units was the work done in the period to complete the
beginning W.I.P.
Note that the previous period costs in the beginning W.I.P (Materials. shs.15,000 and converting
shs.50,000) have been excluded in *
9.5 PROCESS LOSSES

a) Most manufacturing processes result in some portion of the raw materials used not being converted
into a reliable half hence losses. These losses may take the form of waste, scrap, rework, and spoilt
units.
Waste: are materials lost in the process, which are irrecoverable or have no recoverable value.
124
Scrap: Material held after a productive process, which are irrecoverable or have no recoverable
value.
Rework: These are finished goods that do not meet quality standards but which with some
additional work can be sold.
Loss: Refers to finished or partially finished units, which cannot be reworked or used for their
intended purpose. They may be discarded or sold for minimal value. There are two types of
spoilage;
Normal Loss: is loss expected and unavoidable even under the most efficient systems of
production. Normal spoilage cost is normally included in product cost.
Abnormal Spoilage: This is loss that is avoidable with efficient operating conditions. The cost is
regarded as controllable and can be eradicated if due diligence and supervision are exercised. The
cost is normally treated as a loss and charged to profit and loss account.
b) Accounting Treatment of Spoilage Costs

1) Normal Spoilage Costs: These costs are assigned to the good output using two approaches:
(i)
(ii)
Omission Approach: Under this approach, the normally spoilt units are not included in the
calculation of equivalent units. This means that the cost of the normally spoilt units will
automatically be distributed to the good output. By excluding the normal spoilage in the
computation to the good output, a lower figure will be derived. The weaknesses of this
method are;
(a)
The cost of normal spoilage is spread equally into the finished goods and the
ending W.I.P regardless of whether the ending W.I.P. has passed the inspection
stage or not.
b)
It does not allow the manager to see the costs of spoilage because these costs are
not computed.
Recognition and Re-Assignment Approach In this approach, the normal spoilage is

included in the equivalent units computation; further, the normally spoilt units will be
assigned costs just like any other unit. The spoilage costs will then be reallocated to these
good units that have passed the inspection point. The steps to follow under this method are:
(a)
Compute equivalent units including normal spoilage.
(b)
Assign costs to all units including normal spoilage.
(c)
Reassign normal spoilage costs to good output.
2) Abnormal Spoilage Costs

These costs do not add any production benefit to the company and are treated as accounting
losses. The costs are written off directly as losses for the period in which they occur.
Illustration
Mombasa Limited manufacturer a product through two departments. The following is the data in
respect of department for the month of January:
125
Beginning W.I.P. (25% complete as to conversion):
10,000 units
Costs for beginning W.I.P:

Transferred in
Shs.82,900
Conversion costs
Shs.42,000
Units started in the current period.

Current costs:
70,000 units
Transferred in
Shs.645,100
Conversion
Shs.612,500
Additional Materials*
Units completed and transferred:
50,000 units
Units in ending W.I.P (95% complete as to conversion)
20,000 units
Spoilt Units
10,000 units
1. Normal spoilage is 10% of all good units that pass inspection
2. Inspection occurs when production is 80% complete.
3. Conversion costs are incurred evenly through-out the process.
Required
Prepare a process cost report using
(a)
Weighted Average
(b)
FIFO
Apply both the recognition re-assignment approach in dealing with the spoilage.
Solution
Mombasa Limited.
Process Cost Report (Dept 2)
Weighted Average Approach
Physical Units
Physical
Units
Beginning W.I.P.
10,000
Units started
Period
in
Units to Account for
Transferred In
Additional
Materials
Conversion
Current 70,000
80,000
126
Equivalent Units:
Finished Goods:
50,000
50,000
50,000
50,000
Ending W.I.P
20,000
20,000
20,000
19,000
7,000
7,000
5,600 - (80%x70)
(10,000 3,000)
3,000
3,000
Equivalent Units
80,000
80,000
70,000
77,000
Cost Determination
Total Cost
Transferred In
Additional
Materials
Conversion
Beginning W.I.P
124,900
82,900
4,200
Current Costs
1,908,600
645,100
651,000
612,500
Costs to Account for:
2,033,500
728,000
651,000
645,500
80,000
70,000
77,000
Shs.9.30
Shs.9.30
Shs.8.50
Normal Spoilage @ 10%

(50,000 + 20,000):
Abnormal Spoilage:
Divided by Equivalent Units

Cost per equivalent Unit
Shs.26.90
2,400 - (80%x30)
Cost Assignment
Transferred In Cost:
7,000 x 9.10 =
63,700
Normal Spoilage
Added Material:
7,000 x -
Conversion Costs:
5,600 x 8.50 =
Normal Spoilage
recognized
47,600
costs
111,300
(and to be assigned)
Finished Goods Costs
Excluding Normal Spoilage:
50,000 x 26.90
Normal spoilage costs assigned:
50,000 x 111,300 =
1,345,00
0
70,000
79,500
1,424,50
0
Ending W.I.P: Excluding Normal Spoilage:
Transferred in costs
20,000 x 9.1
182,000
127
Additional Material
20,000 x 9.3
186,000
Conversion Costs
19,000 x 8.5
161,500
Normal Spoilage costs =
20,000
70,000
111,300
31,800
561,300
Abnormal Spoilage:
Transferred in costs =
3,000 x 9.10 =
Additional Material =
20,400
Conversion Costs
2,400 x 8.5
27,300
47,700
Costs Accounted for
2,033,50
0
Mombasa Limited, Process Cost Report

Weighted Average Method (Omission Approval)
Physical Units:
Total
Beginning W.I.P
10,000
Started and Transferred
70,000
Units to account for
80,000
Transferred In
Material
Conversion
Equivalent Units
Finished Goods
50,000
50,000
50,000
50,000
Ending W.I.P
20,000
20,000
20,000
19,000
Normal Spoilage
7,000
Abnormal Spoilage
3,000
3,000
Units Accounted for
80,000
73,000
Cost Flow
Total Costs
Beginning W.I.P.
70,000
2,400
71,400
124,900
82,900
42,000
Current costs
1,908,600
645,000
651,000
612,500
Cost to Account for:
2,033,500
728,000
651,000
651,500
Cost per equivalent unit
28.44
9.97
9.3
9.167
128
Cost Assignment:
Finished Goods:
Ending W.I.P:
50,000x28.44
Transferred in:
Abnormal Spoilage:
1,422,000
20,000 x 9.97 =
199,460
Materials:
20,000 x 9.30 =
186,000
Conversion:
19,000 x 9.167 =
174,173
Transferred in:
3,000 x 9.97 =
29,919
Conversion:
2,400 x 9.167 =
22,000
559,663
51,919
Total Costs Accounted for
2,033,552
9.6 ALLOCATION OF JOINT COSTS

When two or more products of relatively high value emerge simultaneously from a single process, they are
called joint products. The process that gives rise to these products is called a joint process and the costs
involved are referred to as joint product costs. Joint products are not separately identifiable as individual
products until their split off point. Split-off point is the point at which joint products become separate
entities or are individually identifiable.
Allocation of joint costs involves assigning the costs of the joint process to the products emerging at the
split off point. Any costs beyond the split off point are referred to as separable costs.
Methods Used to Allocate Joint Costs

1) Physical/Unit Measure
2) Constant gross margin rate
3) Net realizable value.
1) Physical Measure/Unit
Joint costs are allocated to the joint products according to the ratio of physical measurement of the
outputs at the split off point.
2) Constant Gross Margin Rate

This method assumes that each product contributes an equal percentage of gross profit for every shilling of
sales. It works back from gross margin to the joint costs allocation. It involves the following steps:
(i)
Calculate the overall rate of gross margin for al the products
129
(ii)
Multiply the computed overall rate by the sales of every product to obtain the gross
margin of the product.
(iii)
Deduct the gross margin from the sales value of the product to determine the total costs
for each product.
(iv)
Deduct separable costs from the total costs to obtain joint costs allocated.
3) Net Realizable Value

Under this method, joint costs are allocated according to the net realizable*
Net Realizable Value = Ultimate Sales Value Separable Costs.
Illustration
A company produces three products, Y1, Y2, and Y3 in the same process. The data below reflects
average monthly results:
Y1
Y2
Y3
Monthly output (kg)
40,000
20,000
20,000
Sales Value at split off (shs.)
30,000
105,000
Sales Value after Split off
45,000
100,000
155,000
Costs of further processing
20,000
40,000
65,000
The joint costs were Shs.100,000

Required
Allocate the joint cost using the three methods used to allocate joint costs.
Solution
(i)
(ii)
Physical/Measurement/Unit Method
Y1
Y2
Y3
TOTAL
Physical Output: (Kg)
40,000
20,000
20,000
80,000
Proportion
50%
25%
25%
Joint costs allocated
50,000
25,000
25,000
Constant Gross Margin Rate Method
130
Total Sales Value after slit-off:
Y1 =
45,000
Y2 =
100,000
Y3 =
155,000
300,000
Less: Total Costs:

Joint Costs:
100,000
Further Processing Costs:
Y1
20,000
Y2
40,000
Y3
65,000
(225,000)
75,000
(iii)
Costs Allocated To:
Y1
Y2
Sales Value:
45,000
100,000
Less Gross Margin
(11,250)
(25,000)
Total Costs
33,750
75,000
Less Separate Costs
(20,000)
(40,000)
Joint Costs Allocated :
13,750
35,000
Y3
TOTAL
155,000
(38,750)
116,250
(65,000)
51,250
100,000
Net Realizable Value/Method

Net Realizable Value = Ultimate Sales Value Separable Costs
Y1
Y2
Y3
Ultimate Sales Value:
45,000
100,000
155,000
Less: Separable Costs
(20,000)
(40,000)
(65,000)
Net Realizable Value:
25,000
60,000
90,000
Proportion on Net Realizable Value
14%
34%
52%
Allocation of Joint Costs:
14,000
34,000
52,000
TOTAL
175,000
100,000
131
9.7 Summary
Process costing is used to determine the cost of a product at each operation, process, or stage of
manufacture. This method of costing is used in industries engaged in the manufacture of paints,
simple chemicals, textiles, steel etc
Manufacturing operation or process is continuous when the arrangement of plant and machinery
is such that the production of an item of standard nature continues for a long period of time
without any stoppages
QUESTION ONE
A company produces three products, A1, A2, and A3 in the same process. The data below reflects
average monthly results:
A1
A2
A3
Monthly output (kg)
80,000
40,000
40,000
Sales Value at split off (shs.)
60,000
210,000
Sales Value after Split off
90,000
200,000
210,000
Costs of further processing
40,000
80,000
130,000
The joint costs were Shs.200,000

Required
Allocate the joint cost using the three methods used to allocate joint costs.
7.9 Further Reading
132

rd

th
133
LECTURE TEN
10.0VARIANCE ANALYSIS

This lecture equip you with practical pointers to the causes of off-standard performance so that
management can improve operations, efficiency, utilize resources more effectively and reduce costs.
10.2 objectives

(i) Know what is meant by variance and analysis and its purpose
(ii) Understand the relationship of variances
(iii) Be able to calculate basic material, labour, and overhead variances
10.3 Purpose of variance analysis
This section describes how material, labour and overhead variances are calculated and what causes each of
those variances. A chart is also provided to describe how the variances add up to translate to a profit
variance.
In a typical organization, the planning process starts with a budget followed by actual performance. The
budget will usually be based on standard costs of the desired output units. But how does a budget actual
performance relate?
Budgets are followed by performance
Performance leads to preparation of a performance report, which compares the budgeted performance
and the actual performance, and therefore determines whether there is a favourable (F) or
unfavourable (U) variance. These variances are exceptions, thus the performance report (Variance
report) is an exceptions report.
Variance signals those areas that require managerial attention and these are usually areas with
problems. These variances lead to investigation in those problems areas and the appropriate corrective
action is determined, recommended and later on implemented.
!
Variance reporting concentrates on both favourable and unfavourable variances.
Usually,
unfavourable variances are punished on the responsible persons while favourable variances are
rewarded. However, this is a rule of thumb but not always the case. Remember that an
unfavourable variance might arise due to factors beyond the employees or managers control, in
134
which case you cant punish that person: rather, you need to explain the unfavourable variance in
terms of the uncontrollable factor of alternatively adjust the standard to incorporate the changed
circumstances. The same case can be argued for favourable variances.
a) Variance Analysis Defined
Variance analysis can simply be defined as the process of analyzing the difference between the
standard cost and the actual cost (this difference is called the variance) into its constituent parts. The
causes of variances are determined and management can take appropriate measures.
b) Why Perform Variance Analysis?
Variance analysis is aimed at obtaining practical pointers to the causes of off-the standard
performance so that management can improve operations, increase efficiency, utilize resources more
effectively and reduce costs. For this to be achieved, the following need to be met:
A simple standard costing system that is easily well understood by everyone in the organization.
Fast and timely reporting of variances at the point of incidence so as to attach responsibility for
favourable or unfavourable variance.
Rapid management action to correct adverse (unfavourable) variances and encourage favourable
variances.
Utmost commitment to the process of setting standards and performance evaluation by all
managers and employees.
However, not all variances are identified and acted upon. Only those types of variances, which fulfill
the cost control needs of the organization and meet performance evaluation purposes of the entity are
identified, calculated and acted upon. Thus, the only criterion for the calculation of a variance is its
usefulness to the organization: if it is not useful for management purposed, then it should not be
calculated!
c) Attaching the Variance to Responsible Persons
In calculating variances, the calculations need to be detailed enough so that the responsibility for the
variance can be assigned to a particular individual. This is necessary because it would be almost
impossible to control costs if the responsibility for a certain variance is spread between many
managers since each of them will pass the buck or refuse to accept personal responsibility for the
variance.
For example, the material cost variance can be analyzed into usage variance and price variance. The
usage variance is the responsibility of the foreman or production manager using those materials, while
the price variance is the responsibility of the purchasing manger.
The above example illustrates how variance analysis is utilized to attach responsibility for cost
variances to individuals. Such individuals cannot claim that they are not responsible for the variances
arising. However, to be able to attach such responsibility, the costs must be controllable by the
concerned individuals!
Due to tendency of budgetary control and standard costing variance analysis responsibilities to
individuals, it is usually referred to as responsibility accounting. But where departments are
135
interdependent, then responsibility accounting may not be straight forward due to inefficiencies or
efficiencies brought in from other departments.
d) Relationship between variances
We cannot over emphasize the central aim of variance analysis as outlined in the above paragraphs:
i.e. To assign responsibility for a particular variance to a specific individual, assuming there is
adequate independence between departments and the managers have full control of their departments
so that they can be held fully responsible for the resulting variances.
Variance analysis subdivides the total difference between the budgeted profit and actual profit for the
period into the detailed difference. This is illustrated in the figure below. Each of the managers
responsible for each of the detailed variances can then he held responsible. But remember that only
those variances useful for management controls are calculate.
At this point it is critical to understand that every variance has two aspects, a price aspect and a quantity
aspect: these two aspects combine to produce a cost variance. This is illustrated below:
COST ELEMENT
Direct Labour
Direct Materials
Variable Overheads
Fixed Overheads
PRICE VARIANCE
Rate
Price
Expenditure
Expenditure
QUANTITY VARIANCE
Efficiency
Usage
Efficiency
volume
For example, direct labour cost = Direct labour+ Direct Labour

Variance
Rate Variance
Efficiency Variance
Also, Direct Material cost = Direct Material +

Direct Labour
Variance
Price variance
usage variance
Etc.
Note that the operating profit variance, it follows, is then the sum of all the cost (labour, material, variable
overheads, fixed overheads) variances and sales variances. Remember that the operating profit variance is
simply the difference between the budgeted and actual profit. You then need to note that budgeted figures
do not form part of the double entry system, and thus the budgeted profit variance does not enter the
ledger accounts. The other reason why the operating profit variance is not entered in the ledgers is that it
is a resultant figure i.e. a sum of all the other variances.
But all the other variances are entered into the ledger system and form part of double entry. We will see
later
how
these
variances
are
treated
in
the
accounts
136
Variance Chart:
Operating profit
Variance
TOTAL SALES MARGIN

VARIANCE
TOTAL COST VARIANCE
Direct wages
Total Variance
Direct Materials
Total Variance
Variable
Overhead
Variance
Fixed Overhead
Variance
Sales
Margin
Sales Margin
Variance
Variance
Efficiency
Variance
Rate
variance
Price
Variance
Usage
Variance
Expendit
ure
Variance
Efficiency
Variance
Expendit
ure
Variance
Volume
Variance
Sales Mix
Variance
Mix
Variance
Yield
Variance
Capacity
Variance
Sales
Volume
Variance
Efficiency
Variance
137
!
Carefully note that when prices are being charged to production, this can be done at the actual or
standard price. For purposes of making variances analysis useful, instant and easily understood, we will
assume that the process of production changes the costs to production units at the standard costs. When
units are changed with standard costs, it is now very easily to compare the standard cost with the actual
costs and compute the variance immediately: consequently, the responsibility for the variances can also be
assigned immediately and corrective measures implemented.
We will look at variances in the following order:
a)
Direct Material Total Variance
b)
Direct Labour Total Variance
c)
Variable Overhead Total Variance
d)
Fixed Overhead Total Variance.
For purposes of our calculations, we will assume the following basic data for company ABC limited:
The standard cost for the production of a radio cassette model called stereo F262 is as follows:
Inputs
Direct materials:
Direct labour:
Standard quantity
3 kg
2.5 hrs
Standard price (shs)

4.00
14.00
During the month, 6,500 kg of raw materials were purchased at shs.3.80 per kilo and all of it was used to
produce 2000 units of finished products. Also, 4,500 hours of direct labour time were used at a total cost
of shs.64,350.
10.4 Direct Materials Total Variance

Direct materials total variances refers to the difference between the standard direct material cost of the
actual production volume and the actual cost of the direct material. The direct materials total
variances is a sum of two sub-variances, namely,
i.Direct Material Price Variance, and
ii.Direct Material Usage Variance.
i.
The Direct Material Price Variance Refers to the difference between the standard price and the
actual purchase price for the actual quantity of materials. It can be calculated at the time of
purchase or time of usage. The latter is specific to the quantity of material utilized in production.
But generally, in the calculation of direct material price variance, the quantity purchased is used as
the basis of the variance.
138
Diagrammatically, the direct material price variance can be illustrated as follows:
Direct Material Price Variance
Actual Quantity of
Direct Material Purchased x
Actual Price
Actual quantity of Direct Material

Purchased x Standard Price
The above diagram can be summarized in the form of an equation as follows:

Direct material = (Actual Quantity x Actual Price) (Actual Quantity x Standard Price)
Price Variance
= (AQ.AP) (AQ.SP)
Factoring out the actual quantity from the equation, we get,
Direct Material Price Variance = AQ (AP SP)
From the above equation, it is clear that the direct material price variance is as a consequence of the actual
purchase price of direct materials being different from the standard p rice of the direct materials.
ii.
Direct Material Usage (Efficiency) Variance: Refers to the difference between the actual quantity
used and the standard quantity specified for the actual production, all valued at the standard purchase
price.
Again this is represented as follows diagrammatically;
Direct Material Usage Variance
139
Actual Quantity x Standard Price
Standard Quantity x Standard Price
The above diagram can be represented as follows using equations:

Direct Material = (Actual Quantity x Standard Price) (Standard x Standard
Price Usage Variance Quantity
= (AQ x SP) (SP x SP)
Factoring out the standard price (SP) from the above equation gives us the following equation:
Direct material usage variance = (AQ SQ) SP
It is again clear that the direct material usage variance arises due to the production department using more
materials than expected (the standard).
Recap: The above two direct material price variances can now be summarized as follows:
Actual Purchase Quantity x Actual Price
Less:
Actual Purchase Quantity x Standard Price
Actual Purchase Quantity x Standard Price
Less
Standard Quantity used for the X Standard Price
Actual Production
Price Variance
Direct
Material
Total
Variance
Usage Variance
From our basic data first before the beginning of the discussion on variances, we can calculate:
i.
Direct Materials price variance = (AQ X AP) (AQ X SP)

= (6,500 X 3.80) (6,500 X 4)
= 6,500 (3.80 4)
= Kshs.1,300 Favourable
The variance is favourable since we used less costs than the standard cost.
Direct Materials usage variance = (AQ X AP) (SQ X SP)
140
= (6,500 X 3.80) (6,000 X 4)

= 24,700 24,000
= 700 Unfavourable
Note that the above equation (total materials variance) agrees with the following:
Total Materials Variance
= Price Variance + Usage (Efficiency) Variance

= 1300 (Favourable) + 2000 (Unfavourable)
= Kshs.700 unfavourable.
Tutorial Note Please make sure you follow the basics of the calculation of the direct material variances
calculations so that you can effectively follow the following variances sections.
10.5 Direct Labour Total Variance

This is the difference between the standard direct labour cost and the actual direct labour cost incurred
for the production achieved. It is a sum total of the direct labour rate variance and the direct labour
efficiency variance.
Direct Labour Rate Variance: This is the difference between the actual direct labour rate and the
standard direct labour rate for the total hours worked.
Using an equation, this can be shown as follows;
Direct labour rate =
Variance
Actual labour x Actual

hours
Rate
-
Actual
x
Labour Hours
Standard
Rate
= (AHrs x AR) (AHrs x SR)

= A HRs (AR SR).
It is clear from the above equation that the direct labour rate variance arises due to the actual rate paid for
the actual labour hours worked differing from the standard rate that was expected to be paid for those
labour hours.
Direct Labour Efficiency Variances This is the difference between the standard hours allowed for the
actual production achieved and the hours actually worked, all valued at THE standard labour rate. Using
an equation, this can be shown as follows:
Direct labour
Efficiency Variance
= Actual labour x Standard

hours
Rate
Standard
x
Labour Hours
Standard
Rate
= (AHrs x SR) (SHrs x SR)

Factoring SR out of the equation we get
141
Direct Labour efficiency variance = SR (AHrs SHrs).

Thus, the direct labour efficiency variance arises due to the actual hours used in production varying from
the standard hours expected to have been used.
NB: The direct labour efficiency variance is also called the direct labour usage variance.
Recap:
Actual Labour Hours x Actual Rate
Less:
Actual Labour Hours x Standard Rate
Actual Labour Hours x Standard Rate
Standard Labour hours x Standard Rate
Rate Variance
Total Direct
Labour variance
Efficiency Variance
From our basic data, we can calculate the labour variances as follows:
i.
Labour Rate Variance
= (AH x AR) (AH x SR)
= AH (AR SR)
NB: AH x AR = Shs.64,350
Labour Rate Variance = 64,350 (4,500 x 14)
= Shs.1,350 Unfavourable.
The rate is unfavorable because we spent more than expected.
ii.
Labour Efficiency (usage) variance: = (AH X SR) (SH x SR)

= (AH SH) SR
= (4,500 5,000) 14
= 7,000 Favourable
The variance is favourable because we spent less than the expected cots.
Note: Total Labour Variance
= Rate Variance + Efficiency Variance

= 1,350 (Unfavourable) + 7,000 (Favourable)
= Shs.5,650 Favourable.
Developing and Insight into Material and Labour Variance

The calculation of material and labour variances is not enough; we need to know how the variance could
have typically occurred in the first place, and whether there is any connection between one cause of the
variance to another. For example, a higher price of materials could have resulted in an unfavourable direct
material price variance: but, due to the high quality (though high priced) input materials; this could have
led to a favourable efficiency variance!
The above paragraph leads to an important question. What typically causes variances of direct labour and
direct materials? This question is answered in the sections that follow.
142
Typical Causes of Material Variances

Price Variances
a) Paying higher or lower prices than planned.
b) Losing or gaining quantity discounts by buying in smaller or larger quantities than planned.
c) Buying lower or higher quality than planned.
d) Buying substitute material due to unavailability of planned material.
Usage (Efficiency) Variances
a) Greater or lower field from material than planned.
b) Gains or losses due to use of substitute or gather/lower quality than planned.
c) Inefficiency or efficient machinery.
d) Grater or lower rate of scrap than anticipated.
e) Poorly trained workers or extremely high quality labour.
Typical Causes of Labour Variances
Labour Rate Variances
a) Higher rates being paid than planned due to wage (increase) awards.
b) Higher or lower grade of workers being used than planned.
c) Payment of unplanned overtime or bonus.
Labour Efficiency Variances
a)
b)
c)
d)
e)
Use of incorrect grade of labour e.g. poorly trained personnel.

Poor workshop organization or supervision.
Incorrect materials or machine problems.
Use of better quality labour
Increase labour or decrease labour efficiency.
10.6OVERHEAD VARIANCES
Introduction
This section will describe how the variable overhead total variance and the fixed overhead total variances
calculated. You can recall the overheads refer to production costs that cannot be categorized as direct
since they cannot be directly traced to an individual unit of production.
It is necessary to recall that overheads are absorbed into costs by means of Predetermined Overhead
Absorption Rates (OAR). The overhead absorption rate is predetermined as follows:
OAR
Budgeted overhead costs for the period

Budgeted Activity Level
The activity level so budgeted could be expressed as units, weight, sales etc: but the most useful concept
of the activity level is the standard hour. Thus, the total overhead absorbed = OAR x Standard hours of
production.
143
Where the standard costing system uses Total absorption costing principles (where both fixed and variable
overheads are absorbed into production costs), the total overheads absorbed can be sub-divided into Fixed
Overhead Absorption Rates (FOAR) and Variable Overhead Absorption Rates (VOAR).
Thus,
Fixed Overhead Absorbed
Variable Overhead Absorbed
Total Overheads Absorbed
= FOAR x Standard hours of production

= VOAR x Standard hours of production.
= (FOAR + VOAR) x Standard hours of production
But where the standard marginal costing principles are utilized by the standard costing system, only
variable overheads are absorbed into production costs and thus only variances relating to variable
overheads arise. This makes overhead variance analysis a bit easier in this case.
Again for purposes of our illustrations in overhead variance analysis, we will assume the following basic
data for company ABC Ltd in the production of a radio cassette model Stereo F262:
Budget for December 2003;
Fixed Overheads
Variable Overheads
Labour Hours
Standard Hours of Production
Shs.
11,480
13,120
3,280 hours
3,280 hours
Actual Results for December 2003

Fixed Overheads
Variable Overheads
Actual Labour Hours
Standard Hours of Production
Shs.
12,100
13,930
3,150/hours
3,280 hours
Note
Based on our budget above, the predetermined overhead absorption rates can be computed as follows:
F.O.A.R
Budget fixed overheads

Shs.11,480
Sh.3.5/h
budgeted activity Level 3,280 std hours
F.O.A.R
Budgeted Variable Overheads

Shs.13,120
Shs.4/h
Budgeted activity Level
3,280 std hrs
Total OAR FOAR VOAR Shs.3.5 Shs.4 Shs.7.5/hr.
Total OAR = FOAR + VOAR = Shs.3.5 + Shs.4 = shs.7.5/hr.
144
It is also notable from our budget that the budgeted labour hours and the budgeted standard hours of
production are the same: this is the normal planning basis, which assumes that the actual labour hours will
be the same as the standard hours actually produced. This would imply that efficiency is as initially
planned so that no efficiency variances would arise. However, this is rarely the case in practice and
therefore the efficiency variances in overhead variances analysis.
Start Note:
The total overhead variance can be broken down into its two constituent parts, namely:
i.
The variable overhead variance, and
ii.
The fixed overhead variance
We will look at each of these individually.
i.
Variable Overhead Variance

This is the difference between the actual variable overheads warned and the variable overheads
absorbed. It can therefore be described as the underabsorbed or overabsorbed variable overheads.
The variable overhead expenditure variance is made up of two components, namely:
a) The variable overhead expenditure variance,
b) The variable overhead efficiency variance
The variable overhead expenditure variable is the difference between the actual variable overheads
incurred and the allowed variable overheads based on the actual hours worked. This is calculated as
follows:
Variable Overhead
=
Expenditure variance
Actual Variable - (Actual Labour Hours x V.O. A. R).

Overheads
The variable overhead efficiency variance is the difference between the allowed variable overheads and
the absorbed variable overheads and the absorbed variable overheads. This is calculated as follows:
Variable Overhead Efficiency Variance
Actual Labour Standard Hours of
hours
x
V.O.A.R
Production
x
V.O.A.R
Shs.1,010 (U)
ii.
Fixed Overheads Variance
145
This is defined as the difference between the standard cost of fixed overheads absorbed in the
production achieved (whether completed or not), and the fixed overheads attributed and charged to
that period.
This is in fact the over or under absorbed overheads for the period under consideration.
The fixed overhead volume variance has two main components namely:
Fixed overhead expenditure variance, and
Fixed overhead volume variance
The fixed overhead expenditure variance is the difference between the budget cost allowance for
production for a specified control period and the actual fixed expenditure attributed to and charged to
the period. It is therefore the difference between the actual and budgeted fixed overheads.
The fixed overhead volume variance is the difference between the standard cost absorbed in the
production achieved and the budget cost allowed for the period. It arises due to the actual production
volume differing from the planned: this is in turn caused by volume differing form the planned: This
is in turn caused labour efficiency variance and or capacity variance (hours of working being less or
more than planned). The fixed overhead efficiency variance, and
The fixed overhead capacity variance.
The fixed overhead efficiency variance is the portion of the fixed overhead volume variance which is
the difference between the standard cost absorbed in the production achieved whether completed or
not, and the actual labour hours worked. (valued at the standard hourly absorption rate).
Recap:
146
The above discussion can be summarized as follows:

Actual expenditure on
Fixed overheads
Fixed overhead
Less:
Expenditure Variance
Budgeted fixed overheads

Less:
Capacity Variance
Fixed
Actual Labour Hours x F.O.A.R
Fixed overhead
LESS:
Standard Hours of x F.O.A.R
Volume Variance
Overhead
Variance
Efficiency variance
Production
Referring to our basic data, we can calculate the fixed overhead variances as follows:
Fixed Overhead Expenditure Variance:

= Actual Fixed Overheads Budgeted Fixed Overheads
= Shs.12,100 Shs.11,480 = Shs.620 (Unfavourable)
Fixed Overhead Capacity Variance:
= Budgeted fixed Overheads (Actual Hours x F.O. A. R)
= Shs.11,480 (3,150 x 3.5) = Shs.455 Unfavourable
147
Fixed Overhead Efficiency Variance:

= (Actual Hours x F.O.A.R) (Standard Production Hours x F.O.A.R)
= (3,150 X 3.5) - #,230 X 3.5) = Shs.280 Favourable.
Fixed Overhead Volume Variance

= Fixed Overhead Capacity Variance + Fixed Overhead Efficiency Variance.
= 455 (U) + 280 (F) = Shs.175 (Unfavourable)
Fixed Overhead Variance

= Fixed Overhead Expenditure Variance + Fixed Overhead Volume Variance
= Shs.620 (Unfavourable) + Shs.175 (Unfavourable)
= Shs.795 (Unfavourable).
The approach described so far is the most commonly used especially for examination. Another
purpose that the student should be confident enough with so far for further insights, the student could
proceed to the following section.
QUESTION THREE
Beauty Products Ltd. Are manufactures of a body lotion that is sold to retailers in packages of 24 onequarter litre bottles. In the month of July, 750 packages were produced and sold. Details regarding
production costs are given below:
Shs
148
Sales (750 packages @ Sh.360 each)
270,000
Production costs:
Direct materials:
Material A 15,000 litres @ Sh.1.60 per litre
24,000
Material B 16,500 litres @ Sh.2.90 per litre
47,850
Labour 3,200 hours @ Sh.15 per hour
48,000
Overheads
70,000
189,850
80,150
Gross profit
Operating expenses
Packaging costs 750 packages @ sh.20
15,000
Administrative costs
55,000
NET PROFIT
10,150
Beauty Products had budgeted to produce and sell 1000 packages for the month of July. At this production
level they anticipated a net profit of sh.90,500 as shown below:
Shs
Sales (1000 packages @ Sh.365 each)
365,000
Production costs:
Direct materials:
Material A 15,000 litres @ Sh.1.50 per litre
22,500
Material B 16,500 litres @ Sh.3.00 per litre
54,000
Labour 4,000 hours @ Sh.13.80 per hour
55,200
Overheads: based on 150% labour costs
82,800
214,500
150,000
Gross profit
149
Operating expenses:
Packaging costs 1000 packages @ sh.15
15,000
Administrative costs (all fixed)
45,000
NET PROFIT (budgeted)
90,500
Required
a) Prepare a flexible budget profit and loss statement for the production level achieved for Beauty
Products Ltd. For the month of July
b) Determine the effect (favourable or unfavourable) that the failure to achieve the target sales of 1000
units in July had no budgeted profit for each of the following items show your calculations)
i.
Sales
ii.
Materials
iii.
Material A and Material B
iv.
Labour
v.
Overheads
vi.
Packaging material
vii.
Administrative costs
c) Explain briefly TWO other major factors (apart from the failure to achieve target sales) which are
causes of the difference between budgeted and actual profit. (Calculations are not necessary)
10.7 Summary
The above discussion of variable overhead variances can be summarized as follows:

Actual Variable Overheads Incurred
Less:
Actual Labour hours x V.O.A.R.
Actual Labour Hours x V.O.A.R
Less: Efficiency Variance.
Standard Hours of Production x V.O.A.R
Variable Overheads
Total Variable
Overheads Variance
Variable Overheads
Using our basic data, we can then calculate the variable overheads variances as follows:
i.
Variable Overhead
= Actual Variable
Overheads
(Actual labour hours x V.O.A.R)
150
= Shs.13,930 (3,150 x 4)
= Shs.13,930 Shs.12,600
= Shs.1,330 Unfavourable
The variance is unfavourable because we spent more than allowed.
ii.
Actual Labour Standard Hours of
Variable Overhead Efficiency Variance

hours x V.O.A.R Production x V.O.A.R
= (3,150 x 4) (3,230 x 4)
= Shs.12,600 Shs.12,920
= Shs.320 Favourable
The variance is favourable because we spent less than the standard cost.
Note
The total variable overheads variances
= Variable Overhead Expenditure Variance + Variable Overhead Efficiency Variance
= Shs.1,330 (U) + Shs.320 (F) = Shs.1,010 (U)
This can also be directly obtained by calculating the difference between the actual variable overheads cots
incurred and the production cost absorbed in variance overheads;
i.e. shs.13,930 (3,230 x 4) = Shs.13,930 Shs.12,920
=
QUESTION FOUR
For a product the following data was given:
Standards per unit of product:
Direct material 4 kilogrammes at Sh.0.75 pr kilogramme
Direct labour 2 hours at sh.1.60 per hour
Actual details for a given financial period:
Output produced in units
38,000
151
Direct materials:
Shs
Purchased
180,000 kilogrammes for
Issued to production
154,000 kilogrammes
Direct labour
78,000 hours worked for
126,000
136,500
There was no work-in-progress at the beginning or end of the period.

You are required to
a) Calculate the following variances:
(i)
Direct materials costs;
(ii)
Direct materials price, based on issues to production;
(iii)
Direct material usage;
(iv)
Direct wages cost;
(v)
Direct wages rate;
(vi)
Direct labour efficiency;
b) State whether each of the following cases, the comment given and suggested as the possible reason for
the variance, is consistent or inconsistent with the variance you have calculated in your answer to (a)
above, supporting each of your conclusions with a brief explanatory comment.
Items in
a.
(i)
Direct materials price variance; the procurement manager has ignored the economic order
quantity and, by obtaining bulk quantities, has purchased material at less that the standard
price;
(ii)
Direct materials usage variance:

allowed for in the standard;
(iii)
Direct wages rate variance: the union negotiated wage increase was Sh.0.15 per hour lower
than expected;
(iv)
Direct labour efficiency variance: the efficiency of labour was commendable.
material losses in production were less than had been
QUESTION FIVE
Maridadi People Ltd., an exclusive cosmetic business, manufactures a popular perfume, known as Jasho,
which it sells in bottles, thorough its retail shops for Sh.2,000. During the latest quarter ending 30
September 20X1, the company budgeted to make a profit of Sh.875,000 before deducting fixed overheads
amounting to Sh.400,000. The standard cost per bottle is shown below:
Shs
Materials
- 10 Kg @ Sh.50 per Kg
500
152
Labour
- 10 hours @ Sh.60 per hour
600
Variable factory overheads
200
Marginal cost per bottle
1,300
Fixed factory overheads
320
Total cost per bottle
1,620
Factory overhead costs (variable and fixed) are absorbed into products on the basis of direct labour hours.
Actual results for the quarter as follows:Shs
Sales
- 1,100 bottles
Raw Materials (14,000 Kg)

Labour
2,365,000
784,000
(15,000 work hours)
997,500
Variable factory overhead incurred
320,800
Fixed factory overheads incurred
441,700
Production in the quarter amounted to 1300 units. Out of the total raw materials purchased, 2000 Kg. Are
still in stock. There were no operating balances of raw materials or finished goods stocks. It is the policy
of the company to value all stocks at standard cost.
Required
a) Calculate the following variances; indicting clearly whether they are favaourable (F) or unfavourable
(U): i.
Material price and usage.
ii.
Labour rate and efficiency
iii.
Variable factory overhead over or under absorbed
iv.
Sales price and sales margin quantity.
b) Independently calculate the operating profit variance; and explain its significance.
c) Why should management investigate favourable significant variances?
153
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154
LECTURE ELEVEN
11.0 BUDGET AND BUDGETARY CONTROL
Welcome once again to learn on budgeting, It is one of the primary objectives of cost accounting
to provide useful information to management for planning and control. Budgeting acts as a tool
for both planning and control.
11.2 Objectives

(i) Define budgeting
(ii) Understand the application of budgeting
(iii) Budgeting as a tool of management planning and control
(iv) Type of budgets
11.3 Definition of a budget.

A budget is a quantitive expression of a plan of action prepared in advance of the period which it
relates:Generally, its defined as A plan expressed in Money, It is prepared and approved prior to the
budget period and may show income, expenditure and the capital to be employed. It may be
drawn up showing intermental effects on former budgeted or actual figures or be compiled by
zero based budgeting - By: T. Lucy.
A budget may be prepared for the business as a whole, for departments, for functions such as
sales and production, or for financial and resources items such as cash, capital, expenditure,
manpower, purchase etc.
Advantages of a budget.
155
The general objective of a budget is to set some target to be achieved in a specific period, mainly
the advantages include:
(i) It provides clear guidance for managers and supervisors and is the major way in which
organizational objectives are translated into specific tasks and objectives related to
individual managers.
(ii) It helps to improve communication and co-ordination among the management and
employees.
(iii)These are used to determine and evaluate the performance of the business enterprise.
(iv)It helps to clarify the authority and responsibilities of the departmental manager and other
staff members.
(v) Because of the exception principal which is at the heart of budgetary control,
management time can be saved and attention directed to areas of most corners.
(vi)Its a tool for planning.
(vii) Involving lower & middle management with the preparation of budgets & the
establishment of clear target against which performance can be judged is a form of
Motivating factor.
11.4 Budget as a tool of planning.

Budgeting is a procedure which helps to achieve the targets of the organization more adequately.
It helps to plan in advance and implement these plans.
Reasons why budget is a planning tool include.
a) It helps to formulate the policy of a business.
b) It helps to co-ordinate the activities of a business e.g. production plan is based on sales
budget.
c) It helps proper control of an organizations activities in orders to achieve the targets of its
budgeted plans.
Budgetary Control.
156
Budgetary control is a management technique which is adopted to control the business more
effectively.
As defined by the institute of costal management Accountant (I.C.M.A), budgetary control refers
to:The establishment of departmental 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 that policy or to provide a firm basis for its revision
Budget differs from budget control in that, a budgetary control in that, a budget is a standard with
which to measure the actual achievement of people, departments, firms e.t.c. whereas. Budgetary
control is the planning in advance of the various functions of a business so that the business as a
whole can be controlled.
Objectives of Budgetary control

i)
to formulate the policy of the business
ii)
To co-ordinate the activities of the business in order to achieve a specific target.
iii)
To control each function so that the best possible results may be achieved.
Budget committee
Normally large organizations have budget committee comprising of:
i)
The chairman a senior members of the management e.g. C.E.O
ii)
Departmental heads
iii)
Budget officer
The budget committee formulates the general procedure of the budget preparation and
approves the budget for a specific period. The functions of the budget officer involve.
a) To issue the institution to various departments in respect of submitting budget estimates.
b) To receive and check budget estimate
c) To assist the departmental managers to the budget committee for the approval of budgets
d) To co-ordinate for the proper implementation of budgets.
e) To submits to the budget committee, the report relating to budget and actual results.
Budget Manual:
157
This is a rule book which lays down the budgeting procedures, organizational structure,
designations of responsibilities and budget time table
The Budget Period
The budget is prepared for a specific period e.g.
i)
Period Budgets
ii)
Continuous budgets
Period budget cover a fixed period of time e.g. 6 month, 1 year, 5years e.t.c. if the period is
long, then the period is divided into shorter period often called control periods.
Conditions budget is a process whereby budgets for a year are continuously extended by
another period i.e. one quarter or half year. The quarter or half year just ended is dropped and
next quarter or half year is included. This process is also called rolling budgeting.
Limiting Factor/Key Factors/ Principal Budget Factor.

This is that factor which, at any given time, effectively limits the activities of an organization.
This may be limited demand, limited production capacity, labour shortage, materials shortage,
less space or lack of finance.
Because such a constraint will have a pervasive effect on all plans and budgets, the limiting
factor must be identified and its effect on each of the budget carefully considered during the
budget preparation process.
Budget Centres.
This is a section of an entity for which control may be exercised and budget prepared.
This may be a cost centre, a group of cost centers or it may coincide with a profit centre.
11.5 Budgeting Preparation Process (Stages)
1. Budget committee meeting.
2. Derivation of key fore casts.
3. Preparation of quantity budgets with appropriate managers (e.g. Unit of materials
required, units to be produced or sold, No of labour hours required e.t.c)
4. Check feasibility and adherence to policies of quantity budgets.
5. Amendments to quantity budgets.
158
6. Produce financial budgets.

7. Produce master budget.
8. Submission of budget to chief executive or board of directors for approval or
amendments.
9.
Publish agreed budgets for ensuring period.
10. Recording of actual results.

11. Actual/ budget comparison and identification of variances.
12. Reporting to budget holders and senior management.
13. Variance investigation variance and their causes provide the link between budgetary
control and budgetary planning.
14. Developing solutions to problems revealed by budgetary control.
Master Budget.
This is a summary of al other budget and includes also a budgeted profit and loss account and a
balance sheet; it shows the overall picture of the budgeted targets for the next period.
It contains various subsidiary or functional budgets.
A functional budget is one which relates to any of the functions of an enterprise. This may
include:a) Sales budget.
b) Production budget.
c) Purchase budget.
d) Production cost budget.
e) Selling and distribution cost budget.
f) Cash budget
g) Budgeted profit and loss account and balance sheet.
Cash Budgeting.
This is prepared to show the expected cash receipts and cash payments in next few months or one
year period.
Functions Of A Cash Budget.
(i)
To ensure that cash is available for revenue expenditure.
159
(ii)
Indicate when, where and how much cash will be needed and whether this is
permanent or temporary.
(iii)
Preserve liquidity throughout the year.
(iv)
Reveal surplus cash for investments or expansion of facilities.
(v)
Guide management on financial capital expenditure internally or externally.
The cash budget is affected by the:(i)
Expansion or contraction of the investment in fixed assets.
(ii)
Increase or decrease in stocks and debtors.
(iii)
Rate of inflation anticipated.
(iv)
Policy decision like credit control, dividends and taxation.
Fixed And Flexible Budgets.

A fixed budget is defined as a budget which is designed to remain uncharged irrespective of the
volume of output or turnovers attained. It is a budget for a single level activity.
A flexible budget is a budget which is designed to adjust the cost according to actual level of
activity attained.
The process by which this is done is by analyzing cost into their fixed and Variable elements so
that the budget may be flexed according to the actual activity. This is shown in marginal
costing.
The main objective of a flexible budget is to provide an instrument of control. The actual results
should be compared with flexible budgets of the activity level achieved. This helps the
management to evaluate the performance of the organization.
Forecasting And Budgets.

The budgets are prepared on the basis of future. Forecasting without accurate and reliable
forecasting, it is not possible to achieve the targets of an organization.
Forecasting on sales volume and prices, wage rates, materials availability and their prices,
overhead expenses, inflation rates e.t.c are very crucial.
Forecasting techniques includes:-
160
Regression analysis Least squares method.

Time series analysis.
Exponential smoothing approach.
These are covered in statistics and Quantitative Techniques.
Benefits And Problems Of Budgeting.

The benefits of budgeting are related to the advantages of budgets already discovered. Other
benefits include:
(i)
The integration of budgets makes it possible better cash and working capital
management.
(ii)
Better control of current operations is helped by regular, systematic, monitoring and

reporting of activities.
(iii)
Provided there is proper participation, goal congruence is encouraged and motivation

increased.
11.6 Typical Problems Which May Arise With Budgeting.

(i)
Variances are just as frequently due to changing circumstances and poor forecasting as
due to managerial performance.
(ii)
Budgets are developed round existing organization structure which may be in

appropriate for current conditions.
(iii)
The existence of well documented plans may cause inertia and lack of flexibility in
adopting to change.
(iv)
Badly handled budgetary systems with undue pressure or lack of regard to behavioral
factors may cause antagonism and may lower morale.
Zero Based Budgeting (ZBB)

ZBB is defined as A method of budgeting whereby all activities are re-evaluated each time a
budget is formulated, each functional budget starts with the assumption that the functions does
not exist and is at zero cost. Increasments of cost are compared with the increaments of benefits,
161
culminating in the planning maximum benefit for a given budgeted cost CIMA its thus, a cost
benefit approach.
Activity Based Budgeting (ABB)
Also called activity cost management, is a planning and control system which seeks to support
the objective of continuous improvement.
The method recognizes that it is activities which causes cost and is a more focused method of
budgeting.
Examples;
1. Oshal Ltd manufactures two types of products for the printing industry. Budgeted sales of the
products, known as P and Q for 2014are.
Product
Quantity
Price (Shs)
3,000
80
7,000
70
Stocks of these products were as under:Product
Opening Stock
Closing Stock
2,000 units
1,500 units
1,800 units
2,500 units
Required:
(i)
Prepare sales budget.
(ii)
Prepare production budget.
i. Sales Budget.
Product
Quantity
Sale Price per unit (Shs)
Sales Value
3,000
80
240,000
7,000
70
490,000
730,000
ii. Production Budget.

Product
162
Sales (Units)
3,000
7,000
Increase (Decrease) in stock
(500)
700
Units to be produced
2,500
7,700
Example 2
The following information was extracted from the books of Box Ltd, a company which started
trading one year ago.
2014.
Month
Sales (Shs)
Purchases (Shs)
April
150,000
100,000
May
160,000
110,000
June
160,000
90,000
July
170,000
90,000
August
200,000
80,000
September
200,000
130,000
October
180,000
140,000
November
180,000
60,000
December
200,000
60,000
The Following Additional Information Is Available:

1. Cash in hand at the end of May 2014 will be Shs. 180,000.
2. 60% of the sales proceeds are received in the current month, 30% in the following months and
the balance is received two months after sale.
3. Suppliers are paid one month after delivery of goods.
4. Corporation tax for 2013 amounting to Shs. 20,000 will be paid on 31st September, 2014.
5. Contractors retention monies amounting to Shs. 50,000 will be paid on 30th June, 2014.
163
6. The share holders at their last Extraordinary general Meeting increased the share capital by
Shs. 70,000 and the first call of Shs. 40,000 will be received in October, 2014.
7. In October, 2014, the company is due to receive Shs. 20,000 as compensation for a civil suit.
8. The monthly administration expenses amounting to Shs. 33,000 include factory depreciation
charge of Shs. 4,000 and preliminary expenses of Shs. 3,000.
9. Office equipment worth Shs. 13,000 will be paid for in November, 2014.
Required:
Prepare a cash budget for the period 1st June to 31st December, 2014.
CASH BUDGET
June
July
August
Sept
Oct
Nov
Dec
Receipts:
Shs.
Shs.
Shs.
Shs.
Shs.
Shs.
Shs.
Balance b/f
180,000
153,000
203,000
274,000
345,000
437,000
440,000
Receipts from sales (w2)
159,000
166,000
187,000
197,000
188,000
182,000
192,000
Share Capital
40,000
Compensation received
20,000
Total Receipts
339,000
319,000
390,000
471,000
593,000
619,000
632,000
Payments to creditors (w1)
110,000
90,000
90,000
80,000
130,000
140,000
60,000
26,000
26,000
26,000
26,000
26,000
26,000
26,000
Corporation tax
20,000
Retention money
50,000
Office equipment
13,0000
186,000
116,000
116,000
126,000
156,000
179,000
86,000
153,000
203,000
274,000
345,000
437,000
440,000
546,000
Less:
Payments:
Balance c/f
Workings:
1) Supplies are paid one month after the delivery of goods e.g may purchases will be paid on
June, June on July and so on.
164
2) Receipts from sales

a) June
Shs
b) July
60% of June Sale =
96,000
60% of July sales = 102,000
30% of May sale =
48,000
30% of Sept sales =
48,000
10% of April Sale =
15,000
10% of May sale =
16,000
159,000
c) August
166,000
shs
d) September
120,000
60% of Sept sales =120,000
30% of July sales =
51,000
30% of Aug sales = 60,000
10% of June sales =
16,000
10% of July sale
October
shs.
60% of Oct sales =
= 17,000
197,000
November
shs.
108,000
60% of Nov sales =
108,000
30% of Sep sales =
60,000
30% of Oct sales =
54,000
10% of Aug sales =
20,000
10% of Sep sales =
20,000
188,000
(g)
shs.
60% of Aug sales =
187,000
(e)
shs.
December
shs
60% of Dec sale =
120,000
30% of Nov sales =
54,000
10% of Oct sales =
18,000
(f)
182,000
192,000
3. The monthly administration expenses are shs. 33,000 which include factory depreciation
charge of shs. 4,000 and preliminary expenses of shs. 3,000. these two charges (i.e shs. 7,000
= 3,000 + 4,000) do not include cash payments so cash paid every month is shs. 26,000 i.e
(shs. 33,000 7,000)
165
11.7 Summary
Budget can be explained as a financial and/or quantitative statement, prepared and approved prior to a
defined period of time, of the policy to be pursued during that period for the purpose of attaining a
given objective.
. 11.8 Self-Assessment Questions

A company has a cash balance of ksh 27,000 at the beginning of March and you are required to
prepare a cash budget for March, April and May having regard to the following information.
1. Creditors give 1 month credit.
2. Salaries are paid in the current month.
3. Fixed costs are paid one month in arrears and include a charge for depreciation of ksh
5,000 per month.
4. Credit sales are settled as follows: 40% in month of sale, 45% in next month and 125 in
the following month. The balance represents bad debts.
Month
Cash
Credit
sales
Sales
(ksh)
(ksh)
Purchases
Salaries
Fixed
over heads.
(ksh)
(ksh)
(ksh)
166
January
74,000
55,200
9,000
30,000
February
82,000
61,200
9,000
30,000
March
20,000
80,000
60,000
9,500
30,000
April
22,000
90,000
69,000
9,500
32,000
May
25,000
100,000
75,000
10,000
32,000
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167

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SCHOOL OF BUSINESS AND ECONOMICS

Department of Accounting, Finance& Investment

Open and Distance Learning Instructional

Published by Kenya Methodist University

No part of this module may be reproduced, stored in any retrieval

7.8 Self-Assessment questions....109

10.3 Purpose of variance analysis.133

LECTURE ELEVEN 154

Kindly, make sure that:

Make notes as to simplify your study

Complete all activities and questions as you progress

Once again welcome and let us begin. Good luck!!!!

Expected Learning Outcomes

By the end of the course, you should be able to:i.

Explain the importance of costing in the management of organizations

Analyze an organizations activities through budgetary control process.and responsibility

Research papers, projects etc.

b) End of trimester examination

Recommended Text Books:

Text Books for further Reading:

Self-Assessment Questions (SAQs)

2.1 Cost Classification

5.1 Remuneration Methods

10.0 Variance analysis

11.0 Standard costing

End of year adjustments

11.3Budgetary control and standard

By the end of the topic, you should be able to:

1.3 Definition of and Scope of Cost Accounting

1.4 The relationship of cost accounting and other accounting disciplines

1.4.1 Financial Accounting:

Conditions for effective costing system

Information provided by costing system

Possible uses by management

Wages costs for unit of production or per Production

Material cost control, production planning

1.5.1 Management Accounting

1.6.2 The role of a cost accounting department in an organization

Role of Cost Accounting In business management

1.8 Self-Assessment Questions

1. Define cost accounting?

1.9 Further Reading

1Paresh, S. (2010) Cost Accounting 3 Edition, Tata McGraw-Hill, New Delhi.

2.2 Lecture Objectives

By the end of this lecture, you should be able to:

B) Classification according to behaviour or variability

2) Semi variable costs

C) Product cost and period cost

D Classification according to identifiability with the product

E Classification according to controllability

2.4 Cost statement

Total cost of sales

2.5 Work In Progress (W.I.P)

Cost may be classified as under: Fixed and variable cost.

Selling and distribution expenses

2.6 Self-Assessment Questions

Product cost and period cost

Sunk cost and relevant cost

Incremental and sunk costs

Fixed and variable cost

Avoidable and unavoidable costs

Controllable and uncontrollable costs