Cost accounting lecture notes simplified for DBA, BAF & DPSM

UNIT ONE
INTRODUCTION TO COST ACCOUNTING
Overview of Accounting Branches
Accounting has got mainly three branches and these are as follows;

Financial accounting
Financial accounting deals with providing information to both internal and external users. It specifically deals
with maintenance of accounting records and preparation of final statement of accounts such as income
statement, balance sheet, cash flow statements and others.

Financial accounting prepares financial statements which summarizes the results of operations for selected
periods of time. It involves recording,summarizing,classifying, and analyzing business transactions in a fairly
subjective manner according to the nature of expenditure in order to facilitate the preparation of final reports of
statements. In summary, financial accounting measures the organizations level of financial stability and its
going concern.

Cost accounting
Cost accounting is a process of collecting, recording, classifying, analyzing, summarizing, allocating and
evaluating various alternative courses of action and control of costs. Its goal is to advise the management on
the most appropriate course of action based on the cost efficiency and capability. Cost accounting provides the
detailed cost information that management needs to control current operations and plan for the future.

Cost accounting is a system for recording data and producing information about costs for the products
produced by an organisation and/or the services it provides. It is also used to establish costs for particular
activities or responsibility centers. Cost accounting involves a careful evaluation of the resources used within
the enterprise.

The techniques employed in cost accounting are designed to provide financial information about the
performance of the enterprise and possibly the direction that future operations should take.
According to Arora (2000) cost accounting is the “application of accounting and costing principles, methods,
techniques in the ascertainment of costs and the analysis of savings and or excesses as compared with the
previous experience or with the standards”.

Cost accounting aims at proving cost information about a product, service or an activity provided by an
organization. It is concerned with careful evaluation of resources used in an organization.

Management accounting
This branch is concerned with provision with provision and use of confidential accounting information to
managers within an organization to assist management in decision making and in managerial control systems.

Management accounting is the application of accounting techniques for providing information designed to help
all levels of management in planning and controlling activities of business enterprise and in decision making. It
is also the accounting discipline that facilitates management functions of planning, controlling and decision
making that promote the growth of any enterprise if effectively carried out.

The Role or Functions of Cost and Management Accounting

1. Forecasting and planning
Planning is an important function of management accounting which is most effectively performed by the
preparation of budgets and forecasts.
Forecasting is the process of estimation of the expected financial performance and position of a business in the
future. Common types of forecasts include cash flow forecast, projected profit and loss and balance sheet
forecast. Forecasts assist in determining the likely change in the financial performance and position of a
business when considered in the context of the various assumptions used in forming the projections.

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Forecasting is the starting point in determining the resource requirements of a business which are quantified
into budgets.
Budgets quantify the financial targets to be achieved by the management of an organization. Budgeting helps
in the effective allocation of resources of an organization between competing needs (e.g. departments,
products, etc) in order to achieve the financial goals of a business. Budgets and forecasts help businesses to
deal with potential problems proactively and avoid foreseeable bottlenecks in business resources.
2. Organizing
Human and non-human resources are organized by managers where different functions and personnel are
assigned to different responsibilities. This helps to streamline authority, responsibility and specialization.
3. Coordinating and controlling.
Managers ensure that the plan is being followed and this is done through feedback and performance reports.
Control process in management accounting system starts by defining standards against which performance may
be measured such as standard costs and budgets. Actual results are measured and any variance between targets
and results are analyzed and where necessary, corrective actions are taken. Management accounting plays a
vital role in the monitoring and control of cost and efficiency of the routine processes and as well as one-off
jobs and projects undertaken by an organization
4. Directing and motivating.
Overseeing day-to-day activities and keeping the organisation functioning smoothly, requires the ability to
motivate and direct people. Mangers assign tasks to employees answer questions, solve problems, among
others.
5. Decision making.
Management accounting facilitates the provision of financial information to management for decision making.
It helps the management in making various decisions such as;
(a) Whether to make or buy a component
(b) Whether to retain or replace an existing machine
(c) Whether to process further or not
(d) Whether to shut down or continue operations
(e) Whether to accept orders below cost or not
(f) Whether to expand or not
(g) How much reduction in the selling price should be made in case of depression?

6. Management use cost and management accounting as a medium of communication through reporting results
to superiors. It provides useful information to different functional authorities and advice for price
determination and decisions. It helps the management in fixing selling prices of products or services by
providing detailed cost information.

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

8. Cost Accounting helps in the ascertainment of cost of each product, process, job, contract, activity etc. by
using different methods of costing such as Job Costing and Process Costing.

9. It helps in the control of material costs, labour costs and overheads by using different techniques of control
such as Standard Costing and Budgetary Control.

10. It helps in inventory control by using various techniques such as ABC analysis, Economic Order Quantity,
Stock levels, Perpetual Inventory system and Continuous Stock Taking, Inventory Turnover Ratio etc.
11. It helps in the introduction of cost reduction programme and finding out new and improved methods to
reduce costs.

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12. It helps in measurements of efficiency of operations through establishment of standards and variance
analysis.
13. It helps in identifying unprofitable activities so that the necessary corrective action may be taken.
14. It helps in Cost Comparisons such as;
(a) Comparison with Standard Figures: Comparison of actual figures with standard of budgeted figures for
the same period and the same firm;
(b) Intra-firm Comparison: Comparison of actual figures of one period with those of another period for the
same firm;
(c) Inter-firm Comparison: Comparison of actual figures of one firm with those of another standard firm
belonging to the same industry; and
(d) Pattern Comparison: Comparison of actual figures of one firm with those of industry to which the firm
belongs.

Objectives of Cost and Management Accounting

1. To estimate the selling price of goods and services being offered by the business or organization.
2. To disclose profitable and non-profitable activities within an organization.
3. To identify wastage and inefficiency in the organization.
4. To evaluate the balance of stock for balance sheet purposes.
5. To establish budgets and standard costs in order to enhance planning and control in an organization.
6. To evaluate cost effects of policy decision. For example whether to use labour or capital intensive
production methods.
7. To safe guard firms assets.
8. To acquire and use financial resources optimally.
9. To review the accounts systems and operations within organization (internal and management audits).
10. To communicate operating and financial information (cost information).
11. To establish major cost centers within an organization and to take action for regulating them.

Differences between Cost and Financial Accounting

1. Cost accounting reports information to internal users i.e. management whereas financial accounting
reports information to both internal and external users.
2. Cost accounting (information) is more detailed but limited in scope whereas financial accounting is not
detailed but covers a wider scope.
3. Cost accounting is done on a continuous basis therefore it can be done on a daily, weekly and monthly
basis. Financial accounting however prepares its statements periodically usually on annual basis.
4. Cost accounting is not based on any accounting rule or discipline whereas financial accounting is based
on and presented according to established rules such as GAAP, company Act, IASI and 2.
5. Cost accounting is optional therefore it is not a legal requirement for the organization to prepare cost
statements. Financial accounting on the other hand, is a statutory legal requirement to all organizations.
6. Cost accounting is not based on double entry principle when recording information, whereas financial
accounting is based on double entry principle when recoding transactions.
7. Cost accounting is not subjected to any external audit as the case with financial accounting where
external users subject it (financial accounting) to audits.
8. Cost accounting uses both monetary and non-monetary units of measurements for example labour
hours, machine hours, kilograms and others whereas financial accounting only uses both monetary
measurements when recording information.
9. Cost accounting information focuses on the present and the future whereas financial accounting
addresses past events.
10. Cost accounting is majorly addressed to the ascertainment of costs involved in carrying out a certain
activity or buying an item whereas financial accounting is focus on the performance of the business
over a given period of time

Difference between Cost and Management Accounting

1. Cost accounting uses relatively simple techniques compared to management accounting which uses
advanced techniques.
2. Cost accounting focuses mainly in cost ascertainment and cost control whereas management accounting
focuses on decision making.

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3. Cost accounting specifically provides cost information to management whereas management accounting
provides all types of information (cost and financial information).

However, despite of the above difference, both disciplines appears to be the same and it is hard to separate
them independently.

Development of Cost and Management Accounting

1. Continued changes in business environment such as a shift from manufacturing based economy to a
service based economy, increased global completion and advance in technology has created a growing
interest in cost and management accounting because of its ability to help organizations to adopt
changes.
2. Developments in modern factory, for example moving from greater automation and economies of scale
to computer integrated manufacturing that enable the manufacture of on-a- kind products in small
batches for specific customers at short notice .
3. Value analysis. This is a systematic inter-disciplinary examination of the factors affecting the cost of a
product or service in service in order to devise means of achieving the specified purpose more
economically at the desired quality.
4. Theoretically, there are costs which do not add valve to a product or service and these should be
eliminated. However, there are costs that do not add value to the product or service but their removal
would increase the costs.
5. Vetting of suppliers
6. Quality control of supplies received.
7. Material movement from one line to another.
8. Material storage
9. And others.

The Role Cost and Management Accountant

1. Cost information provided by the accountant helps in planning in order to formulate future decisions
regardingproducts, prices, markets and others.
2. The accountant assembles various plans from various sections (departments )into overall plan which is
quantified in monetary terms
3. The accountant helps profit measurement and assessment for a certain product or service.
4. Information provided by the accountant is used in stock evaluation for balance sheet purposes.
5. Information provided by the cost and management accountant helps managers in making decisions.
6. The accountant provides information which is used in the control process. This is done by preparing
performance reports that compares the actual and planned outcome.
7. Information provided by the accountant helps in the preparation of various budgets in an organization
by mangers.
8. The accountant helps in the cost ascertainment of carrying out a certain activity or producing a product.
9. The accountant provides information which helps managers to carefully organize the firm’s resources
to ensure effective performance.

COST ACCOUNTING SYSTEM

This is a system that accumulates costs; assign them to cost objects (products, services, activities and
processes) and reports cost information to management. The system helps in planning and control of business
activities. It is also used in analyzing product and proper allocation and use of business resources.

Factors Considered before Designing and Installing a Cost AccountingSystem

Size of the firm/ business
A big firm should develop a large volume of cost data regarding the various departments/ section of business in
order to meet management requirements. A small firm on the other hand does not require large volume of cost
data.

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Manufacturing process and methods

A firm has to analyze carefully every process and method employed during production of goods and services
before installing a cost accounting system. Issues such as production control methods, schedules, production
lay out and arrangement, wage payment methods, inventory control systems should be considered and
analyzed.
Management control needs.
Costing accounting system installation and designing is guided by the management control requirements. The
system should supply cost data to various persons in different departments of the firm.
Organizational structure
The system should match with the organizational structure of the firm such that responsibility personnel are
held responsible and accountable for the costs incurred at their sections and offices.
Staff involved.
Designing and installing a cost accounting system requires sufficient and efficient personnel.
Comparability
A cost accounting system should be able to produce data that can be compared with cost data from other firms
in the same industry and cost data produced for the industry
External factors
External factors influence the scope of the cost accounting system to be applied by the firm. Level of
technology for example affects the system to be designed and installed.
Challenges Faced an Installing a Cost Accounting System.
Lack of support from management
Line managers normally do not give support to people installing cost accounting system due to the fear that the
system will interfere with their routine activities and hence checking their efficiency.
Resistance from existing accounting staff
Accounting personnel often resist the installment of the cost accounting system on the grounds of engaging
them in extra work and threatening their job security.
Lack of trained and experienced cost accounting staff to engage in the process of installing the system in
the business enterprise
High cost of cost accounting system installation and maintenance
The system requires the establishment of cost accounting department and recruitment of staff in the department
which is expensive.
Features of a Good Cost Accounting System
i) The cost of operating the system should not be high compared to the value it offers to management
ii) The system should be introduced gradually especially after consultation from people who matter from the
business enterprise.
iii) The system should not change so much the existing organization structure.
iv) The system should be properly documented and supported with appropriate materials.
v) The system should be practical by suiting and helping the business
vi) The system should be simple to operate
vii) The system should be elastic i.e. it should be able to expand or contract in changing business conditions
and the needs of the business.
viii) The system should cater for accuracy i.e. it should provide accurate cost information to management in
order to avoid misleading management.
ix) The system must be capable of reconciling with financial accounting records so as to enable accuracy of
both accounting records and systems.

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UNIT TWO
INTRODUCTION TO COSTS
A cost is defined as a resource sacrificed or foregone to achieve a specific objective. According to CIMA, a
cost is the amount of expenditure actual (incurred) or national (attributable) relating to a specific activity or
item.

COST TERMS
 Cost behavior. This is the pertinent changes in costs during production process brought about by
changes in the level of production. E.g. when production increases, costs will also increase.
 Cost structure. This refers to the composition of costs which make up a unit cost. E.g. material costs,
labour costs and overhead costs.
 Cost object. This is anything for which a separate measurement of a cost is desired E.g.
product,service,process,department, project e.tc. Cost objects are chosen to guide decisions to be made.
 Cost unit. This is the quantification or attaching a measurement for which a cost can be expressed. E.g.
kilogram for solids like sugar.
 Cost driver. This is any factor that affects costs. The change in the cost driver causes a change in the
cost of the related cost of the distribution costs.
 Cost center. This is production or service department where costs are incurred for the production of a
product or provision of a service. Cost centers helps in the ascertainment of the total cost of a
department for a particular period of time.
 Profit center. This is production or service department where costs and revenues are accumulated.
Profit centre measures cost and revenue accumulated overtime to get profit earned by the center
overtime.
 Relevant range. This is the range of the cost driver in which a specific relationship between the cost and
cost driver is valid.
Classification of Costs
Classification refers to the process of grouping costs according to their common features such as nature and
purpose.

Importance of cost classification

 To identify methods used for accumulating cost data. It helps organization and individual producers to
access the various method used for accumulating cost data, so that a proper method can be used for
accounting purposes.
 Cost classification helps an organization to be able to allocate and apportion cost units and cost centers.
This will aid cost to be traced to their source where they were incurred.
 Cost classification will help the organization to neither understate cost nor overstate cost since the costs
are located to their rightful department. For instance, the cost incurred in running a machinery
department is separate from the spraying department. This helps the organization to know the actual
cost incurred in these separate department.
 Employing the data produced through classifying cost incurred by the organization by their behavior
facilities better informed decisions in areas such as choices in product line, pricing strategies, creating
realistic budgets and creation or adjustment of optional strategy.
 For effective supervision in an organization. It will help so that allocation of duties and responsibilities
to senior officers and supervisors of each cost center can be checked and monitored.
 Costs are thus classified whether they vary directly with output or sale or they do not. All costs that
vary directly with output or sales are called variable cost and those that remain constant irrespective of
the volume of output or sales are either fixed or semi-fixed cost or semi-variable cost or mixed cost.
 The ascertainment of right amount of overheads to be distributed among the various sections of the
organization. Base on classifying cost, prime cost are being separated from the overheads so that fair
distribution is made among the department.
 To ascertain accurate cost data to aid in the preparation of financial statement.  There is the need to
classify cost in order to obtain the right prime cost, overheads and other costs incurred in the
organization which is useful in the ascertainment of the total cost of production of an organization,
which aids in the preparation of the financial accounts.

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Costs are classified as follows;

Costs for stock valuation
Product costs.
These are costs which are associated with making or acquiring a particular product or provision of a service. In
manufacturing organizations, direct material costs, direct labour costs and direct expenses are regarded as
product costs.
Period costs.
These are costs which relate to a particular period. These costs usually remain constant at various levels of
output E.g. Rent, electricity, salaries of permanent workers etc.

Traceability to the final product

Direct costs
These are costs that can be directly traced on the final product or a cost center. Direct material costs.
Indirect costs or overheads
These are costs that cannot be directly traced on the final product E.g. Power.

Behavioral classification / Pattern of incidence as operations change.

Variable costs
These are costs that are expected to change with different levels of output or activity. E.g. Direct material
costs. It is assumed that variable costs are linear i.e. the cost per unit is constant at all levels of output (Y=bX)
where
Y= expected cost
B= constant
X= level of output or activity
Variable cost function

Costs (y) vc

0 Output (x)

However, a linear relationship between cost and output may not hold, and a curvilinear function may be better
to represent actual cost behavior.

Fixed costs

These are costs which remain constant regardless of the level of output or activity. It should be noted that the
term fixed relates primarily to short term decisions and in the long run few costs remain fixed.

FIXED COST FUNCTION.

Cost Fixed costs

Output

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Step costs.

These are costs which are constant according to the levels of activity. Such costs change as the level of output
or activity is adjusted. For example transport costs based on the distance.

Step cost function

Step costs

Costs

Level of activity

Semi variable costs

These are costs which have both fixed and variable elements. They are not 100% fixed or variable e.g. power
cost

Semi-variable cost function

Semi-variable cost

Costs

Level of activity

Illustration showing Behavioral classification of costs

Costs

C A

Level of activity / Output

Illustration showing total cost function

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TC

Costs VC

FC

Levelof activity

Costs for control purposes

Controllable costs
These are cots that can be influenced or controlled by the actions of a cost center or a manager of a firm. E.g.
Power, telephone costs etc.

Uncontrollable costs
These are costs that cannot be influenced by the actions of the cost center or a manager of the firm. E.g. taxes,
depreciation, rent, insurance etc.

Classification according to normality

Normal costs
These are costs incurred during the normal operation or production condition. E.g. Transport costs during the
normal distribution of goods and services.

Abnormal costs
These are costs that are incurred during unusual conditions of operations in the organization. Abnormal costs
are in most cases not budgeted for since they are incurred in unexpected situations. E.g. Costs associated with
power failure, strikes of workers etc.

Classification according to function

Production costs
These are costs associated with production of goods and services in an organization. E.g.Material, labour and
overhead costs.
Selling and distribution costs
These are costs incurred during the process of marketing, selling and distributing goods and services produced
by the organization. E.g. advertising costs.
Office and administration costs
These are costs incurred during the process of performing administrative and management tasks and duties in
an organization. E.g. office salaries.
Research and development costs
These are costs associated with creativity and innovation tasks in an organization. E.g. research costs,
consultation costs e.t.c.
Financing costs 
These are costs related to obtaining funds for the operation of the organization / company. They include the
cost of interest that the company must pay on loans, as well as the cost of providing credit to customers
(discount allowed) e.t.c.

Classification according to decision making

Sunk costs or irrelevant costs
These are costs which are already been incurred. These costs are not relevant to the decision making process.
E.g. book values of the existing assets.
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Avoidable or relevant costs

These are costs that can be saved by not adopting a given alternative. Relevant costs are expected future costs
that differ among alternative courses of action and may be eliminated if some economic activity is changed or
deleted.

Other Types of Costs

Opportunity cost
This refers to the benefits sacrificed when a course of action is adopted in preference to an alternative.
Conversion costs
These are costs incurred during the process of transforming raw materials into semi finished or finished goods.
E.g. wages paid to factory staff.
Marginal costs or incremental costs
These are additional costs arising from production of additional units of a product.

MIXED OR TOTAL COSTS

This is a combination of variable and fixed costs. However, for cost accounting purposes, mixed or total costs
should be separated into and fixed costs.
Methods of Separating Mixed Costs into Variable and Fixed Costs
 Range or high-low method
 Least squares method
 Scatter graph method.

Range or high –low method

This method considers two extreme levels of costs and activity (output) i.e. highest and lowest levels of mixed
costs and their corresponding levels of activity (output) when determining variable cost per unit.
The change in costs between two levels is divided by the change in the levels of activity. The resultant figure
represents variable cost per unit.
Variable cost per unit=Change∈costs ¿ ¿
However, this method may not give accurate results since only two extremes are used to represent the entire
activity levels.

Least squares method.

This is a statistical method used to establish the relationship of regression between two variables. In this case
the variables are the mixed or total costs and the activity level. The activity level is the independent variable
(x) whereas the mixed or total cost is the dependant variable (y) this method is more realistic and the results
obtained are more accurate compared to the range method. This is so because the method employs all activity
levels and mixed or total costs in the process of separating variable and fixed elements. When using this
method, the regression equation of Y= a+bx is applied where;
Y = dependant variable (mixed/total costs)
a = fixed costs
b = variable cost per unit
x = independent variable (activity level/output)

In order to find the values of a and b, the following formula is applied

a = ∑y∑x2-∑x∑xy
n∑x2- (∑x)2

∑ y (∑ X )
a= –b
n n

b = n∑xy - ∑x∑xy
n (∑x2) – (∑x)2

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Scatter graph method.

With this method, the activity level along with their corresponding mixed costs is plotted on the graph. Mixed
costs are on the y-axis and the activity level on the x-axis. a line of the best fit is then drawn joining all points
on the until it cuts the y-axis.
When using this method the scale is very important. The point where the line cuts the y-axis represents fixed
costs. The variable costs are represented by the difference between the fixed costs and mixed costs.

Example
Milk Coolers Company (U) Ltd is a private company dealing in the manufacture of high quality milk products.
You have ascertained information regarding the units produced and the corresponding costs per month during
the year 2016.
Month Total cost per month (Ugx) Number of units produced per month (liters)
January 2,000,000 10,000
February 3,000,000 20,000
March 3,500,000 25,000
April 5,000,000 40,000
May 7,500,000 65,000
June 4,000,000 30,000
July 4,500,000 35,000
August 10,000,000 90,000
September 8,000,000 70,000
October 6,000,000 50,000

Using High – Low method of cost separation, determine the following.

(i) Variable cost per liter
(ii) Total variable costs for each month
(iii) Fixed costs for each month
(iv) Assuming 120,000 liters were produced in November; calculate total production costs for the month
of November.

COST SHEET OR STATEMNT

This is detailed statement showing the cost of producing an item in a given period of time. It specifically
records the following major costs;
 Prime costs
 Production / works / ex-factory costs
 Total costs.

Prime costs
These are cost that must be incurred before a product can produced. These costs include all material costs,
direct labour costs and direct expenses.

Production costs
These are costs which includes prime costs and indirect or factory overheads.

Total costs.
These costs incurred by the firm during production and distribution of a product to the market.

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Format of a cost sheet

Direct Material costs

Opening stock of direct materials xx

Material purchases xx
Add transport cost on material purchases xx
Less scraped or defective materials xx
Less material returns xx
Net raw material purchases xx
Total Raw materials available for use xxx
Less closing materials xx
Cost of materials consumed / used xxx
Add direct labour costs
Direct labour /wages/factory wages xx
Total direct labour costs xx
Add direct expenses
Royalty costs / direct factory costs xx
Total Direct expenses xx
Prime costs xxx
Add factory overheads /indirect costs
Indirect wages xx
Indirect materials / loose tools xx
Factory rent xx
Factory insurance xx
Etc. xx
Total factory overhead costs xxx
Production / works / ex-factory costs xxx
Add office and administrative costs
Office salaries xx
Office transport xx
Etc. xx
Total office and administrative costs xxx
Add selling and distribution costs
Salesmen commission xx
Debt collection expenses xx
Advertising xx
Etc. xx
Total selling and distribution costs xxx
Add financial costs
Bank charges and ledger fees xx
Interest on loan xx
Bad debts written off xx
Etc. xx
Total financial costs xx
TOTAL COSTS xxxx

Example 1
The following cost accounts relate to Bunyatora Ltd for the year ended 31st Dec, 2015
Particulars Amounts in Ugx ‘000’
Indirect wages and salaries 45,000
Salaries to administrative staff 15,000
Salaries to administrative staff 26,000
Wages 105,000
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Opening stock of raw materials 11,000

Materials purchased during the year 200,000
Closing stocks on raw materials 15,000
Haulage costs on raw materials bought 600
Scrap /defective materials 200
Rent and rates to factory buildings 5,000
Rent for sales office and show room 1200
Rent for administrative offices 1500
Travelling expenses to staff in sales department 3,000
Travelling expenses to administrators 1,000
Depreciation on sales staff cars 1,000
Depreciation to administrators staff cars 500
Depreciation to factory Machinery 1,600
Depreciation to office computers and equipments 500
Debt collection expenses 300
Other Indirect factory expenses 5,000
Other selling expenses 2,000
Other non-categorized administrative expenses 3,000
Carriage on goods sold 4,000
Bank charges 3,000
Loose tools 4,000
Research and consultation fees 10,000

Required
As a company cost accountant, prepare BunyatoraLtd’s cost sheet for the year ended 31 st December 2015
showing
(i) Prime costs
(ii) Production costs
(iii) Total costs

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UNIT THREE
MATERIAL COSTING AND CONTROL

Materials refers to raw materials, components or spare parts and items used during the production process of
goods and services. Materials can be direct or indirect.
Materials constitutes a substantial part of the total production costs of manufacturing firms and therefore
effective control system over materials must be put in place to prevent and detect material losses. In this sense
therefore, proper accounting for and control over materials, consumption and storage are important for
effective management of materials.

PURCHASING FUNCTION AND PROCEDURE

Purchasing is the process of acquiring goods, works, materials and services to satisfy the identified need of the
organization through legal means.
Purchasing functions differs among various firms but all purchasing activities falls under procurement or
purchasing department.

PURCHASING PROCEDURE
Purchasing process involves the following steps.
1. Raising of the need or need identification.
The user department recognizes the need to use a particular item or service.
2. Purchasing requisition
This is a form document raised by the user department requesting the purchasing department to order for the
identified materials or goods.
3. Defining specifications
This is the statement that clearly explains what is exactly required by the user department.
4. Authorization or approval
This involves getting the opinion of no objection to buy from relevant office (accounts department) or any
other officer in charge.
5. Identification of potential suppliers.
This is the process of searching for suppliers of the supplies needed by the purchasing department.
This can be done through tenders, trade formals, Newspapers, advertising, inquiry letters etc.
6. Appraisal and selection of suppliers.
This involves evaluating the bids, quotations, proposals from suppliers responded basing on certain criteria
depending on the user’s speciation’s and the organization’s policy specification
7. Contract negotiation
This is discussion between the buyer and the supplier on issues such as quality, delivery schedules and modes,
installation, after sales services, transportation, dead time etc.
8. Placing orders or contract award
A purchase order is a written request to supplier to supply particular material(s) at agreed up on terms and
conditions.
9. Delivery, receipt and inspection of materials.
Materials are supplied by the supplier with the delivery note. The received materials are inspected and tested to
confirm whether the ordered materials are delivered.
After materials have been inspected, the officer in charge prepares goods received note and an inspection note.
An inspection note indicates items accepted or rejected with a reason.

10. Payment of the bills

Once the supplier’s invoice is received, its authenticity and accuracy is checked with reference to purchase
order, materials received note, delivery note etc by the accounting and stores department.

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Course work Question

Identify and explain the responsibilities of a purchasing manager or officer in an organization.

STORE KEEPING FUNCTION

Store keeping refers to the safe custody of materials and keeping records of stores in an organization.
Store keeping activities
 Issue requisitions for the purchase of materials
 Receives the purchased materials from the receiving department
 Storing of materials in proper and convenient places which are easily located and accessed
 Issuing of materials to production and service department in an authorized way.
 Regular taking of physical stock and stock control
 Classification and identification of materials by their nature size and value.
 Protecting materials against fire, theft, damage and other threats.
 Keeping proper record of inventory
 Arranging ways of disposing off of scrap and surplus materials which are no longer needed by the
organization.
 Proving material information to top management which is used in decision making.
OBJECTIVES OF STORE KEEPING
 To receive and issue of materials
 To ensure economical use of storage space
 To keep optimum level of stock ie avoiding over and under stocking
 To ensure proper storage of materials
 To ensure safety of materials
 To give relevant information or details on quantities held in stores
 To ensure correct record of materials
 To ensure regular supply of materials
 To ease accessibility to materials at all times

Functions of a Store-Keeper
The Store keeper is a responsible person and should be placed in a high position in the management hierarchy
since he has to control the stores from every point of view. He is expected to help the cost department for its
effective functioning.

Duties and responsibilities of a store keeper

 To receive the materials from receiving department.
 To maintain proper records of stores.
 To make arrangement for proper storage of materials and finished goods.
 To issue materials to production departments against proper and authorized requisition.
 To keep an eye on different stock levels and issue purchase requisition to the purchase department in
time.
 To report on waste, scrap and obsolete stock.
 To prevent unauthorized persons from entering the stores.
 Periodic comparison of physical stocks and book figures and to reconcile the discrepancies, if any.
 To keep stores clean, tidy.
 To make suitable arrangement for maintenance and preservation of the materials during storage.
 To take back surplus materials returned from departments or shops.

Methods of store keeping

Centralized Storage
Centralized storage refers to where the storage of materials is confined to one central store in an organization.
Advantages of centralized storage
 Close control and supervision is possible at a central store.
 It is cheaper in terms of clerical costs, stationary and record keeping.
 Reduction in duplication of purchasing procedures and plans

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 Attracts few store keeping staff which reduces costs in form salaries and wages
 Material items are acquired at discounted prices due to bulky purchases which lead to huge savings
 There is ability to coordinate purchasing plans and strategies among functional departments.
 Better security arrangement can be made.
 Concise reports on scrap, obsolete stocks can be prepared regularly.
 Better lay-out is possible.

Disadvantages of centralized storage

 It is associated with high transport costs of transporting heavy and bulky purchases.
 Delays and inconveniences in obtaining supplies by user departments from the central store.
 It is risky to keep all materials in one central store, in case of losses by fire, theft, floods etc, the
organization suffer more
 Position infighting by store keeping staff which interferes with stores’ work
 Disagreements between central administration and user departments due to mismatch in orders
delivered and sent.
 Breakdowns in transport in central store may cause production stoppage leading to increased cost.
Decentralized Storage
A decentralized store is that type of store which receives materials and issues them to only one department and
not to the whole company. The decentralized store may be many in numbers in the company, as each
department has its own store. Purchasing and handling of materials are undertaken by each department
separately. If the volume of material activities is large, this type of store is suitable because each branch has its
own store for facilitating smooth operations of their production activities.

Advantages of Decentralized Stores

1. Controlling and storing function can be accomplished easily.
2. Delay in material handling is eliminated.
3. Minimizes the chances of total loss by fire.
4. No need of internal transportation costs.
5. Specific needs of individual departments can be easily fulfilled.
6. Saving in material handling costs.

Disadvantages of Decentralized Stores

1.Higher cost of supervision.
2. More space is required for individual departments.
3. Higher amount of investment is required.
4. More time for stock taking and taking.
5. Higher cost of staff and stationary.

CLASSIFICATION OF MATERIALS
Materials classification ensures effective control and easy identification of materials or inventory.
Classification of materials can be done by either ABC analysis or coding system.

ABC ANALYSIS
This is classification where materials are grouped into three groups or categories basing on values of materials.
A Group. This group represents a substantial amount of funds invested in materials in the group.
A-materials are very critical to the functioning and operations of an organization. A-group items takes 70% of
investment in inventory and accounts for 10% of all inventory items.
B-group
The items in this group are important but not critical. These items take 20% of the investment in inventory and
accounts for 20% of all material items.
C-group
The items in this group are not important to the operations of the firm but necessary. These represents 10% of
investment in inventory and account for 70% of all material items.

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MATERIAL CODING SYSTEM

Coding refers to the assigning of some symbols, numeric or alphabetic for each classified item in accordance
with some suitable arrangements.

STOCK LEVELS
Stock levels are based on stock control resulting from pre-determined critical control level for each item of
inventory. These levels include the following.
 Maximum stock level
 Minimum stock level
 Re-order level
 Re-order quantity
 Average stock level.

Maximum stock level

This is the level beyond which stocks of materials should not be allowed to rise.
It is the upper most amount of stock the company can maintain at any time. This amount of stock indicates the
most optimum level.
It is calculated as follows;
(Re-order level + Economic order Quantity) – (Minimum usage x minimum lead time)
(ROL + EOQ – MUXMLT)

Factors considered when setting maximum stock level

 Rate of consumption of materials
 Re-order quantity
 Availability of storage and cost of storing stock
 Price fluctuations
 Risk of obsolescence

Minimum Stock Level or Safety Stock

This is the level below which stock of materials should not be allowed to fall. This level is maintained to
prevent stock-outs. If stocks fall below this level, then there is possibility of production stopping due to lack of
materials.
It is calculated as follows.
Minimum level = Re-order level-Average usage x Average lead time.

It is usually set after considering the rate of consumption and the lead time.
Re-order level (when to order)
This is a level at which it becomes necessary to initiate purchase orders for fresh supplies. This level is usually
higher than the minimum stock level but lower than the maximum stock level.

It is set after considering the following;

 Rate of consumption
 Lead time
 Minimum inventory or safety stock level
It is calculated as below.
Re-order level = Maximum daily usage x Maximum lead time

Re-order quantity or Economic order quantity.

It is the most favorable quantity that should be purchased each time the purchases are to be made.
This level is normally set after considering the following;
 Carrying material costs
 Ordering costs
 Rate of consumption
 Lead time

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In this case, it is the quantity where the costs of carrying inventory are equal to ordering costs.
It is calculated as follows;
EOQ =
√2 XDXC
M
where
D = Total annual demand or usage in units
C= Total ordering costs per order
M= Total carrying or holding costs per unit per annum (it is usually expressed as a fraction or percentage of
stock value).
ASSUMPTION OF ECONOMIC ORDER QUANTITY
 Ordering costs per order are constant
 The level of demand is known and constant.
 The lead time is known and fixed
 Purchase price is constant i.e. no discounts
 The whole batch of materials is delivered at once.

ADVANTAGES OF ECONOMIC ORDER QUANTITY

 Re- stocking process is simplified since when to order and how much to order is known
 Encourages continuous production since stocks are available at any time
 Helps in fore casting and planning for future activities since demand of stocks activities since demand
of stocks is estimated accurately.
 It is more economical since stocks are ordered for few times a year.
 This reduces ordering costs per order and stock holding costs
 It encourages bulk purchasing hence taking advantage of discounts.

DISADVANTAGES
 It does not account for seasonal and economic fluctuations in demand.
 Slow moving stocks and perishable stocks are exposed to expiry and destruction
 It requires enough storage space which many firms lack
 It is associated with high risks of stock obsolescence and storage costs.

Example I
Serene Center is a restaurant that deals in the sale of food staffs. The restaurant projected its annual demand in
2016 to be 50,000 plates of food. To have this demand met, the restaurant will incur the ordering cost of
Ugx.30, 000 every time it places an order and the holding cost of Ugx.6, 000

Required;
(i)Using the above information, determine restaurant's economic order quantity (EOQ)
(ii)Based on the results got in (i) above, calculate the number orders the restaurant will place in the year
2016
(iii)Determine the frequency in which the orders computed in (ii) above will be placed

Example 2
Kasubiparents primary school prepares lunch for its pupils every day from Monday to Friday. It uses a
minimum of 20,000 kilograms of posho per week and a maximum usage of 100,000 kilograms per week when
all pupils attend school. The supplier of posho to the School takes between 6 to 10 weeks to supply (Minimum
and maximum lead time respectively). The reorder quantity is 240,000 kilograms every time the school places
an order.
Required;Compute
(i) Re - order point
(ii) Minimum stock level
(iii) Maximum stock level
(iv) Average stock level

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AVERAGE STOCK LEVEL

This is the average of maximum and minimum stock levels in stores
Average stock level =Maximum + minimum level
2

MATERIAL ISSUES AND PRICING

Once materials have been purchased and sent to stores, they must be issued out to user departments. For
accounting purposes, the value of materials issued out must be determined. There are various methods of
pricing material issues and valuing of unused stock or closing stock.
The method selected depends on the nature of the organization, materials and the objective of valuation. These
methods include the following.
a) Historical cost methods
b) Methods relevant for decision making.
However, the most important methods are the historical cost based methods and they include the following;

a) FIRST-IN-FIRST-OUT (FIFO)
Under this method, materials are issued out at the costing price of the consignment which was received first.
When this consignment is finished then the cost price of the next consignment is used to value the material
issues.
This procedure is followed until all materials are issued out
In this case, the unissued materials are made up of materials which were most recently received in stores.

Advantages of FIFO
 Materials leave stores in chronological order according to their age or maturity. This avoids the risk
of stock obsolescence. It is a logical method because it takes into consideration the normal
procedure of utilizing first those materials which are received first. Materials are issued in order of
purchases, so materials received first are utilized first.
 The value of closing stock in final accounts will fairly reflect current market price value since it is
values at the most recent prices.
 It is simple to understand and to operate.
 Under this method, materials are issued at the purchase price; so the cost of jobs or work orders is
correctly ascertained as far as cost of materials is concerned. Thus, the method recovers the cost
price of the materials.
 This method is also useful when transactions are not too many and prices of materials are fairly
steady.
Disadvantages of FIFO Method:
 This method increases the possibility of clerical errors, if consignments are received frequently at
fluctuating prices and at the same time an issue of materials is made, the store ledger staff can easily
make a mistake.
 In situation of falling prices, cost of materials charged to production tends to be high.
 Issues to production may not reflect the current market value or cost especially during inflationary
period.
 It understates the cost of production and overstates the closing stock

b) LAST-IN-FIRST-OUT (LIFO)
Using this method, material issues are charged out at the price of the most recent batch or consignment
received and continues to be charged at this price until a new batch or consignment is received. This method
assumes that, materials issued-out at any date are those which were recently acquired and the closing stock is
made up of materials purchased earlier.
However this method of valuing stock was phased out in 2003 by accounting profession due to its associated
demerits.

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ADVANTAGES OF LIFO
 In time of rising prices, LIFO method of pricing issues is suitable because materials are issued at the
current market prices which are high. This method thus helps in showing a lower profit because of
increased charge to production during periods of rising prices and lower reduces burden of income tax.
 Production is charged at the recent prices because materials are issued from the latest consignment.
Thus, effect of current market prices of materials  is reflected in the cost of sales provided the materials
are recently purchased.
 The method recovers cost from production because actual cost of material is charged to production.
 It is simple to operate and is useful when transactions are not too many and the prices are fairly steady.

Disadvantages of LIFO
 The method is not recognized for taxation purposes.
 It is not recognized by international accounting standard 2 (1AS2).
 The stock in hand is valued at price which does not reflect current market price. Consequently, closing
stock will be understated or overstated in the Balance Sheet.

C) WEIGHTED AVERAGE COST METHOD (WAC)

Under this method, the issue price of materials is the weight average cost price.
The weight average price is obtained by the formula below;

WAC = Purchase cost of previous units + purchase cost of new units

Units previously purchased + units newly purchased
Advantages of WAC

 It is simple to operate since simple calculations are involved

 The averaging smoothens wide fluctuations in material issue prices and stock values
 It is logical and consistent as it absorbs cost while determining the average for pricing material issues
 Overstated profits do not arise
 Cost of materials issued and closing stock tend to reflect actual costs.

Disadvantages
 The issue price is not actual but merely an average
 Simplicity and convenience are lost when there is too much change in prices of materials.
Example I
The following records were extracted from the store-keepers books of Machachos Growers Tea Factory As at
30th June, 2015
Details Quantity (Units) Price per unit (Ugx)
June 1: Purchases 3,000 9,000
3: Purchase 2,500 9,800
11: Issues 4,000
15: Purchases 3,000 10,000
th
17: Returns of 200 units being items issued on 11 June
20: Issue 2,100
25: Purchases 1,200 11,000
27: Damaged units amounting to 120 units being part of the units purchased on 25 th June was
detected
29; Issue 2,300
30: Purchases 1,500 10,000

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Required
Using the FIFO pricing method, prepare a stores ledger account for the month of June 2015
highlighting;
(i) The cost of raw materials to be charged as a production cost in a cost sheet.
(ii) Total purchases made in the month on June 2014
(iii) Value of closing inventory as at 30th June 2014

Example II
The following records were extracted from the books of Muyenga Stores for May 2016.
May 1stopening stock was 300kgs of wheat at 5,000shs each.
May 5th purchased 200kgs of wheat at 5,500shs each
th
May 7 returned 50kgs to the supplier who supplied wheat on May 5th.
May 10th purchased more 350kgs at 6000shs each
th
May 15 issued to the user department 250kgs
May 20th issued to the user department 300kgs
nd
May 22 user department returned 80kgs to the store keeper. These were issued on 20th.
May 25th purchased 200kgs at 6,500shs each
th
May 27 issued 200kgs to user department
th
May 30 issued 150kgs to user department
Required
Prepared store ledger account using FIFO method.

MATERIAL CONTROL SYSTEM

This is a system which ensures the provision of sufficient materials needed at the required time with minimum
funds invested or tied up in materials. The system ensures that materials are efficiently purchased, transported,
stored and used in the right quantities and quality.

TYPES OF MATERIAL CONTROL SYSTEM

Quantity controls
This is a system put in place to ensure that minimum amount of materials are used during production of goods
and services.
Financial controls

This is a system put in place to ensure that minimum funds are invested in materials. This requires proper
budgeting for material usage and purchasing, monitoring stock levels and economical use of materials.
Quality controls
This is a system put in place to ensure that material quality standards are observed at all the time of handling
materials.
However, there are two opposing needs in material control i.e. keeping sufficient material quantities needed
during production and maintaining minimum cost of material investment.

Objectives of material control system

 To supply the required quantity of material to production departments through out the year.
 To purchase right quality, right quantity of materials at reasonable price and at the right time.
 To purchase reasonable quantities of materials in advance to avoid disruption in production.
 To ensure efficient utilization of materials by adopting proper methods of storing, handling etc.
 To ensure minimum materials losses.
 To ensure proper issue and use of materials in an authorized way.

How to achieve material control system objectives

 Proper selection of suppliers who are able to supply the required materials at reasonable price, quality
and at the right time.

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 Mentainance of proper stock records such as bin cards, material requisition notes, goods received note
etc.
 Regular stock taking and monitoring of stock use
 Provision of proper material storage facilities
 Regular monitoring of stock levels so as to indentify stock excesses and shortages
 Regular material audits in order to check loopholes in the system and shortages in stock balances
 Proper segregation of duties and responsibilities to stores staff and ensure proper coordination of the
staff.

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UNIT FOUR
LABOUR COST AND CONTROL

Labour is a very important resource to the successful operation of any business. Labour ensures that other
resources such as time, materials, finance etc are not mis-used.
Total labor cost is divided into two;
a) Direct labor costs
These are costs that are incurred in form of wages to individuals directly engaged in the production of finished
goods.
b) Indirect labor costs
These are costs that are incurred in form of wages to individuals indirectly engaged in the production process
for example wages paid to supervisors, store –keepers etc therefore these costs form part of the overhead costs.

LABOUR COST CONTROL

In an attempt to offer favourable and competitive prices to customers, the organization must ensure that
production costs and others are minimized. Since labor is part of production costs, it is important to have a
system which can enhance the control of labor costs. However to achieve this objective, there should
coordination among departments such as Human resource, time keeping, cost accounting, pay roll and
engineering.
Human resource department is responsible for
 Procurement of labor
 Orienting and inducting new employees
 Making regular labour reports eg reports on labour turnover, labor absenteeism, promotion reports etc
 Preparing the pay-roll or pay – sheets.

PAY-ROLL OR WAGE SHEET

This is a list of all employees showing their pay especially gross pay, deduction and net pay.

COMPUTATION OF GROSS WAGES

The gross wages of employees are computed by making reference to any of the following mdocuments or
records depending on the method of remuneration used.
1. Clock or time cards;
These have a record of the time engaged on duty for day hourly rate and premium bonus work.
2. Piece work tickets or cards
These cards or tickets give details of units produced by employees.
3. Job cards
These cards give the number of jobs done by each employee.
4. Employees record card
This is a document recording remuneration details of each individual employee. Eg incremental dates, rate of
pay etc.
In addition to the wages payable, some benefits may be added to the wage and these are;
a) Cost of living allowance
b) Housing
c) Leave taken etc.
When gross wages have been computed, the next stage is to compute deductions from the total gross wages in
order to obtain the net-pay or wage. The deductions may take the following forms;
 Fines and deductions for absence from duty.
 PAYE (pay as you earn)
 Social security fund
 Provided fund
 Deduction for advance provided
 Loan recoveries
 Income tax
 Deduction for damage or loss of goods or money expressly entrusted to the employee.

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 Insurance premium etc

PAY ROLL-ACCOUNTING
The pay roll is a list of employees showing their gross pay, deductions and the net pay.
The names of the workers can be arranged either alphabetically or according to their serial numbers of the
clock cards.
A separate wage sheet is prepared for each month.

Example
From the following information, prepare a pay roll for the month of November 2016 for workers in the
business department of Mawilak Business School.

Name Hours worked Hourly rate Advance

Katema 250 1000 100,000
Cathey 230 1400 120,000
Birungi 290 1200 600,000
Nkata 210 1000 800,000
Opio 300 1600 850,000
Ojambo 190 1300 500,000

Additional information
Normal working hours per month is 220 hours
Overtime is payable for extra hours at a rate of 50% above the normal pay rate
PAYE is to be deducted at a rate of 10% of gross age
NSSF is to be deducted from each employee at 100,000/= each
Housing fee is to be reduced from each employee of 250,000/= per month.
Every worker receives 400,000 shs for transport every month.

METHODS OF RECORDING ATTENDANCE TIME

Attendance time is a primary basis on which the wages of the worker other that piece rate worker are computed
The methods of recording attendance time include the following;
1. Hand written registers
This is the oldest method where each employee signs a manual register upon arrival and departure noting down
time in and out.
2. Time recording clocks
This is where each employee is given a clock card on which the employee punches the time at which he/she
comes in and leaves the place of work or factory. Each week or month, a new card is prepared for each
employee on the pay roll.
However, the clock card does not show how the employee spends time which is important.
1. Disc or taken or check method.
This is where each worker is allocated a metal disc or taken bearing his/her identification. On each disc, the
name and the number of the worker is engraved or painted. A board containing hooks on which employees’
discs are attached is kept near the entrance of the plant or factory.

On arrival, the employee removes his disc and places it in a box. Immediately after the scheduled time for
entering into the premises, the box and the board is removed and a list is prepared of all such disc not collected
and dropped into the box by the workers.
The list of late comers is prepared separately.
The taken not removed from the board represents workers absent.
The disadvantage of this method, a worker may remove a disc of his fellow worker to ensure his presence who
is either late or absent.

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2. Job time booking

This is a method which records time spent by a worker on each job, process or operation. The objective of this
method is to ensure that time paid for is properly utilized and to minimize idle time.

TREATMENT OF OVER TIME AND IDLE TIME

OVER TIME
This is time which is over and above the normal working time. If employees work beyond normal working
hours, they are entitled to extra pay (over time payment).

CAUSES OF OVERTIME
1. Increased level of production
2. Need to complete work urgently
3. Rush orders by clients
4. Unavailable interruptions such as power feature etc.
Treatment of over time
Overtime wages or premium should be treated in the cost accounts as follows;
a) When overtime is a regular feature undertaken for increasing production, normal wage rate should be
increased proportionately to include overtime premium. Over time premium should constitute part of
labor costs.
b) If overtime is directly charged to a client’s urgent, then overtime premium is charged directly to the job
c) If over time work is caused by loss of time which was avoidable, then over time wages are treated as a
loss and charged to profit and loss account.
d) If overtime work is caused by unavoidable situations or interruptions like power failure then it is
charged as a factory overhead.
However, overtime should be avoided since;
Overtime wages are paid at higher rate
Workers develop a tendency of post ponding the normal work to be done in over time
Other over heads increase during over time.

IDLE TIME
This is time spent by employees on other things other than work being engaged in.
However, this time is supposed to be paid for idle time represents unproductive time caused by, for example
machine break-down, power failure, material shortage etc. the cost of idle time is called an indirect cost.

TYPES OF IDLE TIME

a) Normal idle time.
This is time spent by employees not working for their own benefit or to the benefit of the organization. For
example,
Time spent in moving from gates to their respective departments
Time spent on receiving instructions
Time spent on booking materials or equipments
Lunch and break time

b) Abnormal idle time

This is where employees fail to work due to abnormal situations such as;
 Shortage of raw materials
 Strikes
 Power failure
 Sickness
 Insecurity
 Gossiping
 Stoppages etc.
The cost of abnormal idle time does not make a unit cost of the product instead it is treated as an operating loss
and hence treated in the profit and loss a/c.

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LABOUR REMUNERATION METHODS

Remuneration is a reward given to labor
The following are the common methods of labour remuneration.
1. Time rate system/ Hourly rate system
This is a method where the worker is paid on the basis of time engaged. An employee is paid at hourly, daily,
weekly or monthly rate.
Earnings= Days/hours worked x Rate per day/hour

Advantages of time rate system.

 It is easy to compute and understand.
 It avoids complex negotiations which are necessary with most incentive schemes or between the
employee and employer during fixing the rate.
 Workers feel secure and satisfied with it.
 Workers can depend upon a definite wage regardless of the amount of work done.
Disadvantages
 It does not provide an incentive for extra efficiency of employees.
 It requires constant supervision since wasted time may be paid for.
 Slow workers receive the same amount which slows down the morale of hard workers.

2. Piece rate system/payment by results/output.

This is where an employee is paid according to what he or she has done. This method has two sub-divisions.
a) Straight piece work method
this is where a fixed rate per unit or piece produced is established. It is multiplied by the number of units
produced to derive total earnings of the employee.
Earnings = Units produced x rate per unit.
Example
The following jobs were assigned to mark to make a common product.
Job Units
A 50Units
B 70units
C 90units
D 120uits
Total 330
A straight piece work method was employed and the rate per piece, is fixed at shs 175 each unit.
Calculate mark’s total earnings.
b) Differential piece work method
this is where the piece work rate increases as the rate of performance rises. Assuming mark was paid on the
basis of different piece work on the following terms.
The first 20units of each job are paid at 50/= each unit, rising by the same amount for subsequent 10 units.
Calculate total earnings of mark.

Advantages of piece rate system.

 The worker is motivated to work hard
 It results into increased production since the more one produce, the higher the earnings
 It is simple and easy to compute and understand.
 It is more equitable since payment is according to work done
 It does not require a lot of supervision
 Simplifies costing since wages are paid at a predetermined rate per unit.

Disadvantages;
 Poor quality of work since quantity is much emphasized.
 It creates inequalities in workers’ wages which may cause poor relationship among workers
 Earnings of workers are uncertain therefore no security of wages

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 There may be mis-use of materials and equipment

 It may create poor health to workers since workers force themselves to produce more in order to earn
more.

CONDITIONS UNDER WHICH PIECE RATE ARE EMPLOYED

 Where production is standardized and repetitive in nature.
 Where workers continue at the job for long periods
 Where the standard time for completing a job can be measured accurately
 When the aim is continuous maximum production
 Where the output of workers can be measured
3. PREMIUM AND BONUS PLANS (INCENTIVE SCHEMES)
Incentive schemes are schemes that relate remuneration to superior performance. This is intended to boost the
morale of employees and to induce them increase the productivity.
Companies naturally like to share the used revenue with employees as rewards or incentives.
This could be in form of bonus pay for the time saved in production, or giving higher rates of pay when
workers exceed standard rates of production for sustained periods of time.
Some schemes apply to individuals while others apply to the entire group of employees.
In addition, some schemes have a direct bearing on output while others are indirect.
OBJECTIVES OF INCENTIVE WAGE SYSTEM
1. To improve administration efficiency
2. To boost the morale of employees with sincerity and royalty
3. To achieve higher productivity of workers
4. To reduce or limit labor desputes with management.
5. To retain good services of good workers
6. To reduce labor absenteeism which reduces cost of production?
PRINCIPLES OR CANNONS OF A GOOD INCENTIVE SCHEME.
1. The incentive scheme should be understood by all employees before putting it in place.
2. Remuneration should reflect workers efforts and performance.
3. Performance targets should be reasonable to avoid demotivating the staff
4. The scheme should be reasonably permanent
5. The cost of operating the scheme should be reasonable]
6. There should be no artificial limits on earnings and employees should be safeguarded when problems
arise outside their control.
7. The basis for calculating the bonus must be clear
8. The scheme should be introduced after full consultation and agreement of the staff and trade unions.
ADVANTAGES OF INCENTIVE SCHEMES
1. Increases production and hence the unit cost.
2. Improves morale of employees since extra efforts are rewarded
3. More efficient employees are attracted and retained
4. Ensures good relationship between management and employees
5. Improves team work
6. Improves corporate image of the organization
7. Workers become more dedicated to the duties.

DISADVANTAGES OF INCENTIVE SCHEMES

1. Some schemes are complex and expensive to administer
2. Common bonus payments may bring disputes between skilled and un-skilled employees
3. It is difficult to fix the performance levels and rates of pay
When calculating total earningsof a worker, the following elements should be considered
Unit of output
Standard time/time allowed
Time taken or worked
Time saved.

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FORMS OF INCENTIVE SCHEMES

1. Halsey bonus scheme or plan
Under this scheme, standard time for doing each job is fixed. Workers are paid at a rate per hour for the actual
time taken by them. If a worker takes standard time or more than standard time to complete the job he/she is
paid wages basing on time allowed or standard time
But if a worker takes less than the standard time, he is paid a bonus equal to 50% of the time saved at the time
rate fixed. Thus total wages of a worker equal to wages for actual time taken plus a bonus.
Formula
Bonus = 50% of (time saved x time rate)
Total earnings = time taken x time rate + 50% of (TSXTR)

Example I
John of Kenjoy supermarket was assigned the following jobs for week ending 7th January 2010.
The hourly rate of pay was shs 500.
Job No Time allowed (HRS) Time Taken (HRS)
123 5 3
145 6 5
147 10 12
The company employs Halsey Bonus scheme in determining the bonus payable to an employee.
Required
a) Calculate the total wage payable to John for the week in question
b) Find out the effective rate of earnings
Note;
Effective rate of earnings or hourly rate is the most desired rate per hour.
Total wage
Formular = HER OR ERE = = X per hour
Total time taken

2) Halsey – weir bonus scheme

Formular
Bonus = 30% of (time saved x time rate)
Total earnings = Basic wage + Bonus
Basic wage= Time rate x time taken
Apply the above example

3) Rowan Bonus scheme

Under this scheme, the worker gets hourly rate for the actual time taken to complete the work.
He gets the bonus if he completes the work before the standard time. The bonus hours are calculated as a
proportion of the time taken which the time saved bears to the time allowed and paid for at a time work rates.
Formular
Time saved
Bonus = x time taken x time rate/Hour rate
Time allowed
Earnings = Basic wage + Bonus
Apply the above example.

GROUP BONUS SCHEMES

These should be employed in the following circumstances.
a) Where team-work is necessary eg in soccer. The main aim is to create collective interest in the work.
b) Where work – force flexibility is required
c) When production is on a continuous live such that any rise in production depends on all employees. Eg in a
textile industry.

Group bonus can be calculated using any method and then shared by all employees in that group.

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PROFIT SHARING AND CO-PARTNERSHIP

Under profit sharing, employees receive on additional package, according to the returns of the firm.
Under co-partnership, the bonus to employees is left in the firm as an investment. This may be in form of
shares bearing no voting rights but carrying a fixed divided or it may be in form of interest bearing loans.

LABOUR TURN-OVER ANALYSIS

Labourturn over is the rate of displacement of personnel employed in an organization. Or it is the rate at which
employees leave the employment and need to be replaced. The firm should try to keep this rate as low as
possible since it is associated with the following costs;
1. Reduction in production as new employees are being oriented
2. Cost of looking for replacements e.g.advertising interview costs etc
3. Cost of training and orienting new employees
4. Costs associated with disengagement of employees.

CAUSES OF LABOUR TURN-OVER

These are grouped into two i.e.
1) Those that can be controlled by management (avoidable causes).
(a) Low wages and allowances may induce workers to leave the organisationand join others where higher
wages and allowances are paid.
(b) Unsatisfactory working conditions e.g., bad environment, inadequate ventilation etc. leading to strained
relations with the employer.
(c) Job dissatisfaction on account of wrong placement of workers may become a cause of leaving the
organisation.
(d) Lack of accommodation, medical, transport and recreational facilities.
(e) Long hours of work.
(f) Lack of promotion opportunities.
(g) Unfair methods of promotion.
(h) Lack of security of employment.
(i) Lack of proper training facilities.
(J) Unsympathetic attitude of the management may force the workers to leave.

2) Those which are not controllable by management (un avoidable causes).

 Sickness
 Marriage obligations
 Maternity leaves
 Old age
 Change for the better job
 Misbehavior e.g.drunkardness, fighting etc
 Change in plant location.
 etc
Effects of Labour Turnover:
There must be some labour turnover due to personal and unavoidable causes. It has been observed by
employers that a normal labour turnover, which is between 3% and 5%, need not cause much anxiety. But a
high labour turnover is always detrimental to the organisation. The effect of excessive labour turnover is low
labour productivity and increased cost of production.

This is due to the following reasons:

i. Frequent changes in the labour force give rise to interruption in the continuous flow of production with
result that overall production is reduced.
ii. New workers take time to become efficient. Hence lower efficiency of new workers increases the cost
of production.
iii. Selection and training costs of new workers recruited to replace the workers who have left increase the
cost of production.

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iv. New workers being unfamiliar with the work give more scrap, rejects and defective work which
increase the cost of production.
v. New workers being inexperienced workers cause more depreciation of tools and machinery. Due to
faulty handling of new workers, breakdown of tools and machinery may also occur very often and
hamper production.
vi. New workers being inexperienced workers are more prone to accidents. Consequently, all costs
associated with accidents such as loss on account of output lost, compensation for the injured workers,
damage of materials and equipment due to accidents etc. increase the cost of production.

Reduction of Labour Turnover:

As already pointed out, normal labour turnover is advantageous because it allows injection of fresh blood into
the firm. But excessive labour turnover is not desirable because it shows that labour force is not contended.
Therefore, every effort should be made to remove the avoidable causes which give rise to excessive labour
turnover.

Following steps may be taken to reduce the labour turnover:

i. A suitable personnel policy should be framed for employing the right man for the right job and giving a
fair and equal treatment to all workers.
ii. Good working conditions which may be conducive to health and efficiency should be provided.
iii. Fair rates of pay and allowances and other monetary benefits should be introduced.
iv. Maximum non-monetary benefits (i.e., fringe benefits) should be introduced.
v. Distinction should be made between efficient and inefficient workers by introducing incentive plans
whereby efficient workers may be rewarded more as compared to inefficient workers.
vi. An employee suggestion box scheme should be introduced whereby workers who suggest
improvements in the method of production should be suitably rewarded.
vii. Men-management relationships should be improved by encouraging labour participation in
management.
In addition to the above steps, the personnel department should prepare periodical reports on the labour
turnover listing out the various reasons due to which workers have left the organisation. The report should be
sent to the management with the necessary recommendations so that corrective measures may be taken to
reduce labour turnover.

Cost of Labour Turnover:

The cost of labour turnover can be divided under two heads:
(i) Preventive Costs.
(ii) Replacement Costs.
(i) Preventive Costs:
These are costs which are incurred to prevent excessive labour turnover. The aim of these costs is to keep the
workers satisfied so that they may not leave the company / factory.

These costs may include:

1. Cost of providing good working conditions.
2. Cost of providing medical, housing and recreational facilities to workers.
3. Cost of providing educational facilities to the children of the workers.
4. Cost of providing free / subsidized meals.
5. Cost of providing other welfare facilities.
6. Cost of providing safety measures against working conditions.
7. Measures of security and retirement benefits such as pension, gratuity, employer’s contribution to provident
fund and other measures over and above the compulsory legal provisions.
As “prevention is better than cure” preventive cost should be incurred to prevent excessive labour turnover.
This cost of labour turnover should be apportioned among different departments on the basis of average
number of employees in each department and justifiably treated as overhead.

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If preventive cost is incurred for reasons of image or status of the employer or non-economical corporate goals,
it may be debited to the Costing Profit and Loss Account. If preventive cost is incurred for a particular
department, it may be taken as overhead of that department.

(ii) Replacement Costs:

These costs are associated with replacement of workers and include:
1. Cost of recruitment of new workers.
2. Cost of training new workers.
3. Loss of production due to
(a) Interruption in production, and
(b) Inefficiency of new workers.
4. Loss of profit due to loss of production.
5. Loss in fixed overhead cost because of less production on account of new inexperienced workers.
6. Wastage due to excessive spoilage on account of improper handling of machines, tools and materials by new
workers recruited as a result of labour turnover.
7. Cost of accidents because of new workers having more proneness to accidents.
These costs should be distributed among different departments on the basis of actual number of workers
replaced in each department and treated as overhead.

MEASUREMENT OF LABOUR TURN-OVER

There are basically 3 methods of measurement labour turn-over
a) Replacement method.
This takes into account only the actual replacement of labour irrespective of the number of persons leaving.
No. of workers ¿ a period
Formular = x 100
Average no . of workers∈the period

b) Separation method
This takes into account only those workers who have left during a given period. It is calculate as
No .of workers ¿ a period
x 100
Average no . of workers∈a period

c) Flux method
This denotes total change in the composition of labor force due to addition and separations of workers. It is
calculated as
No . of seperations+ No . of additions
x 100
Average No. of workers ∈a period

Example
From the following data given by the Personnel Department calculate the labour turnover rate by the
application of above three methods:

No. of workers on the Pay Roll:

At the beginning of the month Jan, 2015 were 900
At the end of the Jan 2015 were 1,100
During the month 10 workers left, 40 persons were discharged and 150 workers were recruited. Of these, 25
workers were recruited in the vacancies of those leaving, while the rest were engaged for an expansion scheme.

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Example 2
Mashwanku Company limited provides you with the following cost data relating to work done by its workers
during the year 2016.
Name Standard Time Units Time Rate of pay
Time in Taken in Produced Rate per unit
Hours Hours
James 100 90 800 5,000 2,500
John 300 280 900 5,000 3,000
Joseph 200 190 800 8,000 4,000
Joan 350 345 750 7,000 3,500
Joshua 400 410 950 6,500 4,000
Jane 200 220 800 4,500 3,000
Jonathan 250 240 350 5,500 4,000

Required: Compute total earnings of each employee under the following methods of pay

(a) Time rate system

(b) Piece rate / unit of output method
(c) Halsey bonus scheme
(d) Halsey Weir bonus Plan
(e) Rowan bonus scheme

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UNIT FIVE

COSTING OVERHEADS OR INDIRECT COSTS

Overheads are costs that are indirectly incurred during the production of goods and services. They are incurred
in the organisation as a whole though majorly to production. The overheads may include indirect material
costs, indirect labour costs, indirect expenses etc.
Accounting for overhead is a complicated area in cost accounting because of the failure cost centres or cost
unit is. However they constitute a product, service or job costs and hence they should be accounted for.

OVERHEAD SHARING PROCESS

This process involves the following steps.
i. Collection of overheads.
This is the gathering of common costs from different sources e.g. involves wages analysis sheet etc the
collected overheads are then grouped into various categories for better analysis and hence can be
grouped as fixed, semi-fixed and variable over heads.
ii. Allocation of overheads to particular sections or departments that has used them. Allocating means
assigning overheads to a cost centre or department.However, this can only be done if they can be
directly identified with the cost centre or department.
iii. Apportionment of overheads to their respective cost centres word departments. This means that over
heads should be distributed to different cost centres using appropriate bases. These bases will be
influenced by the nature of costs to be apportioned.
Appropriate apportionment bases may include the following;

Apportionment bases
Overhead costs Apportionment base
Rent and rates Floor are occupied
Depreciation costs Book value of machines/plant
Electricity or factory power Kilo-watts or units, number of lighting points, area
size, machine power
Staff welfare costs Number of staff
Insurance (staff) Number of staff
Insurance (plant/machines) Book value of machines

Cost centres or departments may include the following;

i) Production cost centres
These are departments which participate in converting raw-materials into semi-finished and finished goods.
ii) Service cost centres
These are departments which support the production cost centres
4. Absorption of overheads.
This is the process of ascertaining actual amount incurred per particular item or section.

APPORTIONMENT OF OVERHEADS
This is categorized into 2 kinds ie
Primary apportionment
Secondary apportionment

PRIMARY APPORTIONMENT OR DISTRIBUTION

This is the process of charging costs to all cost centres irrespective of whether they are production or service
cost centres. The purpose is that all indirect costs are directly identified with various cost centres involved in
the organisation.
Note: In primary apportionment, we use overhead apportionment / analysis sheet

Example I

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Man United group of companies’ Ltd manufacture and assemble product H. Product H passes through three
manufacturing sections ; A,B and C and two service sections of X and Y. X representing stores department and
Y representing maintenance department
The overhead costs for the year ended 30th June, 2015 were as follows

Indirect materials
Manufacturing section A 5,000,000
Manufacturing section B 2,000,000
Manufacturing section C 3,000,000
Stores department X 500,000
Manufacturing depart Y 1,000,000
Indirect labour
Manufacturing section A 8,000,000
Manufacturing section B 4,000,000
Manufacturing section C 1,000,000
Stores department X 800,000
Manufacturing depart Y 2,000,000
During the course of the year, the company spent other indirect costs as follows
Meals 600,000
Rent 1,200,000
Depreciation 3,000,000

The following information is also important

Details Area (m) No. of employees NBV
Manufacturing section A 08 04 10,000,000
Manufacturing section B 06 03 5,000,000
Manufacturing section C 05 02 3,000,000
Stores department X 02 01 1,000,000
Manufacturing depart Y 03 02 1,000,000

The following technical estimates were also availed as benefits received by each cost center.
Details Man.Sec A Man.Sec B Man.Sec C Stores Maint
Maintenance 40% 30% 20% 10% -
Stores 30% 40% 10% - 20%

Required
(i) Prepare an overhead analysis sheet
(ii) Apportion the services overheads using the direct method

SECONDARY APPORTIONMENT OR DISTRIBUTION

This is a process of re-distributing the service department costs to production cost centres where cost objects
exist.
This is done because service cost centres do not manufacture anything and it is the production cost centres
which are involved in producing items.
However, these costs are re-distributed to production cost centres depending on how each production cost
centres or department has benefited from the service cost centre or department. The purpose is to ensure that all
indirect cost incurred during the production process are directly identified with production cost centres or
sections.

METHODS USED IN SECONDARY APPORTIONMENT

The methods used include the following.
 Direct method or approach
 Step method or approach or Elimination method
 Repeated distribution or continuous allotment method
 Simultaneous equations or algebraic method.
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DIRECT METHOD/APPROACH
Under this, method, the inter-service costs are ignored ie costs associated with services offered to other service
departments by others. The apportionment of service department costs is direct to production cost centres
without service cost centre allocating costs to each other.

STEP/ELIMINATION METHOD
Under this method, the service cost department that seems to render most services than the others, distributes
out its costs first including charging out to others service departments.
Normally this service department has the highest cost compared to other service departments.
The rest of the service departments distribute their costs directly to the production departments. This method
assumes that once service department costs are apportioned, no more apportionment should be done to that
department.

REPEATED DISTRIBUTION OR CONTINEOUS ALLOTMENT METHOD

Under this method, service departments distribute their costs to production costs and to themselves until the
figures become insignificant. This method creates new charges which are re-distributed in a normal way until
the amounts involved becomes immaterial.

SIMULATANEOUS OR ALGEBRIC METHOD

This is a statistical method where simultaneous equations are used to determine the total over heads that have
been accumulated by each service department
This method begins by determining all the overheads that have been accumulated by each service department
by including the inter-service costs (i.e. costs incurred by the service department in the process of serving
another service department). This is done by solving the formulated simultaneous equations

Exercise I
The following costs were apportioned to 3 production departments and 2 service departments x and y
Primary apportionment
Department 1 2 3 x Y
12000,000 10,000,000 8,000,000 2400,000 3,000,000

The technical analysis for the service departments was as follows;

1 2 3 x y
X 50% 30% 20%
Y 30% 20% 40% 10%
Required; carry – out secondary apportionment using;
a) Direct method
b) Step method
c) Repeated method
d) Algebul method

ABSORPTION OF OVERHEADS
This is the charging of overheads to cost units or objects. After all departments’ overheads have been
apportioned to production departments, the next step is to spread the overheads to different products or cost
units
Absorption ensures that overheads incurred in production become part of the cost of a product or service
provided.
The absorption of overheads involves two processes ie
a) Calculation of overhead absorption rates or overhead recovery rates. (OAR/ORR)
b) Charging overheads to the cost units or objects.

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CALCULATION OF OVERHEAD ABSORPTION RATES

OAR is a rate at which overheads are charged to cost units or products. This rate is also known as recovery
rate.

TYPES OF ABSORPTION RATES

There are basically two types of absorption rates ie
a) Blanket absorption rates
b) Multiple absorption rates
BLANKET ABSORPTION RATE
This is where a single rate is used for the entire factory to absorb overheads to different cost units or products.
This means that regardless of the number of cost centres or departments in the factory, only one absorption rate
will be used for all cost centres
AOR in this case is computed by the formular
Total overheads of the factory
Blanket rate =
Total no . of units produced
However, blanket rates should not be used unless where the output is the unit of measurement.

MULTIPLE OVERHEAD ABSORPTION RATE

This is where different absorption rates are applied for each production cost centre or department.
Departmental overhead absorption rates are generally considered to be more suitable and fair because they
reflect work done on each item or product in each department.
Multiple overhead absorption rates in this case is given by.
Budget / Actual overheadof each section section
MOAR = each centre ¿
Budget / Actual base applicable ¿ cost
Note: When using the multiple absorption rates, bases of absorption must be established.

BASES OF ABSORPTION OR METHODS USED FOR CALCULATION OF OAR/ORR

Organisations or firms that use different absorption rates usually apply different bases in absorbing overheads.
Production overhead is absorbed to production on the bases selected by the organisation.
However, absorption bases should be appropriate for the particular product or service.

COMMON BASES OF OVERHEAD ABSORPTION

1.) Units of output method or number of cost objects. This method considers the total number of cost
objects produced within la cost centre. This method works properly if the firm produces a single
product or several homogeneous or standard products.
OAR = Total overheads of a cost centre or section
Number of units cost objects
This gives the rate per cost object or unit.
2.) Machine hour’s method. This considers machine hours worked in a department. It gives absorption
rate per machine hour worked; the method is suitable where all operations are mechanized.

OAR = Total overheads of a cost centre

Total number of machine hours
This give rate per machine hour.

3.) Direct labour hours method.

This method gives absorption rate per direct labour hour worked. It is used widely in organisations
during establishment of factory overheads. This is because of most overheads are time based than
activity based.
This method is however limited to situations where all tasks performed are carried out manually and
records are properly kept for all work done in respect of time taken.

OAR= total overheads of a cost centre

Direct labour hours worked in a cost centre

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This gives rate per direct labour hour.

4.) Direct material cost percentage method. This method is based on total direct material costs incurred on
an object as a base of overhead recovery .it is suitable where it is difficult to record time taken or where
units produced are not homogeneous.

OAR = Total overhead of a cost centre X 100

Total direct material costs
This gives the percentage of direct materials incurred on the job.

5.) Direct wages percentage method.

This method uses direct wages incurred on a cost object as a base of overhead recovery. Under this
method, production overheads are charged to products using direct labour costs percentage rate.
OAR = Total overheads of a cost centre X 100
Total direct wages of a cost centre
The result is the percentage of direct labour wages paid on the job.

6.) Prime cost percentage method.

This method normally apply to contract jobs as a base for overhead recovery,

OAR = Total overheads of a cost centre X 100

Total prime costs of a cost centre
The result is the percentage of prime costs of the job.
Note
The most common absorption bases are direct labour and machine hour’s methods.

ABSORBING OF OVERHEADS TO COST UNITS / PRODUCTS

This is the final step where overheads are allocated to products that pass through departments using the
calculated OAR. In this case, overheads are absorbed by individual cost units by multiplying OAR by the units
of the base that apply to each cost centre.
Example 1.
ABC LTD incurred the following costs in its production department Z for the month of March 2011.
Particulars Amount
Direct materials 20,000,000
Direct wages 10,000,000
Production overheads 10,000,000
Units produced 20,000 units
Direct labour hours 10,000 hours
Machine hours 2500 hours
During the same period, a job number 8012 made up of 20 units was made its cost data was as follows
Direct materials 21000
Direct wages 12000
Direct labour hours 12 hours
1
Machine hours 3 hours
2
REQURED
a) Compute OAR for the cost centre Z for period using the above six methods.
b) Compute overheads chargeable to the job No 8012 using the six methods above. .

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UNIT SIX
COSTING METHODS

These are ways or approaches used by firms or organisations in determining the unit cost of a product, service,
process or any job. Cost ascertainment will involve collecting and analyzing all the costs and then dividing the
total production costs by the number of units produced in order to get the unit cost.

Unit cost= Total production costs

Number of units produced

Production costs constitute the following elements.

a) Material costs
b) Labour costs
c) Overheads or indirect costs
All costs that constitutes production costs are summarized in a cost sheet .it can be defined as a detailed
periodical statement or document designed to show various elements of cost of goods produced .

DETERMINATS OF COSTING METHODS;

1. Nature of the product or service provided by the firm.
2. The stage or process products pass through before they become complete products. Products which
pass through different process cannot have the same treatment as those which are not subjected to any
stages hence calling for different costing methods.
3. The level of activity or output.
Identical and high – volume output requires a costing method which is different from the unique and
single units that are produced to meet customers’ needs.
4. Installation and maintenance costs required.
Systems that are required to capture and analyze production costs do not require the same cost.
Therefore the costing method to be used by a firm is influenced by cost involved.
5. Time required completing the product.
Products do not take the same time to be completed therefore firms design costing methods that suits
the time duration of every product.

CATEGORIES OF COSTING METHODS

Costing methods are broadly classified into 2 groups;
a) Specific order costing method (job costing )
b) Continuous operation

SPECIFIC ORDER COSTING METHOD

This covers approaches used in ascertaining the cost of products and service which are unique in nature and are
produced to meet customers’ requirements or orders. This method is applied where work consists of separate
contracts, jobs or batches. It is divided into the following sub divisions.
a) Job costing
b) Contract costing
c) Batch costing

JOB COSTING METHOD

Job costing is a method of costing applied in industries where production is measured in terms of completed
jobs. Industries where job costing is generally applied are Printing Press, Automobile Garage, Repair
workshops, Ship Building, Foundry and other similar manufacturing units which manufacture to customers’
specific requirements.

Job costing is a method of costing whereby cost is compiled for a job or work order. The production is against
customer’s orders and not for stock. The cost is not related to the unit of production but is a cost for the job, e.
g printing of 5000 ledger sheets, repairs of 50 equipment’s, instead of printing one sheet or repair of one
equipment.
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A job in this case may be a product, service, batch, project or contract etc. this approach is normally used in
industries such as textile, carpentry, printer, garages etc.
With job costing, the costs of each job are recorded on job cards or job cost sheets.

A job cost sheet records all the costs for a single cost unit or one job and a separate cost sheet is opened –up for
each customer order .
The cost sheet is used to record the cost of;
- Materials costs
- Direct expenses
- Overheads
The overheads can be variable or fixed. This sheet can also be used to record other expenses like selling,
administration expenses etc.

Objectives of Job Costing:

1. To maintain the development of each job, by providing a separate account for each and every process of the
job, so as to estimate the costs taken, when transitioning from one process to another.
2. Helps the management in estimating the price of a certain work based on the price of the previous jobs.
3. To identify profitable and non-profitable jobs and help and prevent profitless jobs taking place.
4. To differentiate departments from one another on the basis of the cost taken and the amount of materials
required.
5. Provide detailed information of what is happening in each department to the customer and move forward
with the plan with respect to the idea of the customer. Any sudden changes in the plan can be accommodated,
if congruent with the final cost estimation.
6. Job costing should be flexible and scalable enough to accommodate any kinds of industrial or commercial
jobs available for cost estimation.

ADVANTAGES OF JOB COSTING

1. More accurate costing is done since all costs are compiled and specifically identified with a specific
order.
2. It helps to identify profitable and non-profitable jobs since each job is specific.
3. It provides a basis for comparing one job cost to another.
4. It helps in preparation of estimates when submitting Quotations for similar jobs.
5. It provides the detailed analysis of the cost of material, labour and overheads for each job as and when
required.
6. Plant efficiency can be controlled by confining attention to costs relating to individual jobs.
7. Spoilage and defective work can be identified with a specific job and responsibility for the same may
be fixed on individuals.
8. Job costing is essential for cost-plus contract where contract price is determined directly on the basis of
cost.
9. It prevents duplication of work, because it helps in the estimation of a similar job. This helps in a
company quoting a price of a job, it can always depend on the pricing of a previous job as a reference.

DISADVANTAGES
1. It requires detailed record of documents and accounts since each job requires a separate record.
2. The record keeping for different jobs becomes complicated.
3. It is expensive to operate as it requires considerable detailed clerical work.
4. With the increase in the clerical work the chances of errors are increased.

Example 1
ABC Company Ltd produces timber products and most of them pass through departments A and B. the
company has received an order from a client of making a dining table. In an attempt to meet his order, the
management accountant estimated the following costs that are expected to be incurred.

Cots Department A
Department B
Materials 1500 units at 250/=@ 1200 units at 300/=@
Labour 1000 hours at 200 /=@ 500 hours at 150/@
Variable overheads 150, 0000/= 200,000.

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The total fixed overheads chargeable to the whole factory amount to 2400, 000/= based on 80,000 labour hours
worked for in factory in the period.
The company has a policy of absorbing fixed overhead to cost units on the basis of labour hours worked.

Required.

a) Determine the cost of the dining table.

b) What can the company charge the client if the company charges a profit of 20% on sales..
Note;

The price to be charged to a customer for a job is often derived as the estimated cost of the job plus the margin
for a profit. The profit in most cases is stated either as a mark- up percentage of total cost or as a percentage
margin on the sales price.

BATCH COSTING METHOD

This is a form of specific order costing used where identical items are manufactured as a batch or in a group. A
batch in this case is treated as a unit cost. The cost of each item in a batch is determined by dividing the total
batch costs by the number of units in a batch.

Unit cost = Total batch cost

Number of units in the batch

This approach is applied in industries such as foot wear, textiles, brick laying etc.
A cost sheet is used to record the costs incurred during the production of the batch. In this case the cost sheet is
called the batch cost sheet.
Example 1
Erimu company limited dealers in timber products received an order from MISD for 2000 chairs of the same
standard size. Erimu Company estimated that the following costs would be incurred if the order will be made
or met.
a) Materials
Timber 400 meters at 2000 per meter
Nails 200 kgs at 2500 per kg
Vanish 10 ltrs at 25000 per ltrs

b) Labour costs
Workers are to be got from departments A and B

Department A Department B
100 hours will be used at 5000/= per hour - 30 men working for 10 days at 2000 per day
Per man
c) Variable overheads
Department A Department B

Variable overheads are absorbed at a basis Offs are absorbed as 20% of prime costs
Of direct labour hours at a rate of 3000/= required for the order
perlabour hour

d) Fixed manufacturing costs per chair is 400/=

Required
Assuming the company would process it as batch number 20
a) Determine the unit cost of each chair
b) What price would be charge to MISD per chair if Erimu Company targets a profit of 25 % profit on
cost?

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c) What price should charged per chair if the company targets 25% gross profit on sales.

3. CONTRACT COSTING METHOD

This is a form of specific order costing that is used by firms or people who undertake work on contract basis.
This costing methid is commonly used by builders, public works contractors etc.
This method is specifically applied under the following situations;
a) Where work is undertaken to meet customer’s specific requirements, e.g. construction work
b) Where work takes considerable long time to be completed e.g. from six months to 5 years or even more
c) Where work is carried out away from the firm’s premises i.e. work is site based
d) Where work is frequently of constructional nature such as road, dam, bridge construction etc
The contract price is normally estimated in advance for the work. Additional work found necessary may be
charged on a cost plus basis.
In addition, sometimes a contractor is allowed to pass on to the customer additional costs incurred as a result of
increase in material, labour and other costs.
A contract account is opened up for each contract work.

It is debited with the following

All materials purchased or obtained from warehouse
Labour costs
Wages/salaries accrued at the end of the period
All direct expenses e.g. sub-contract charges
Overheads
Plant establishment costs

It is credited with the following

Un-used materials
Scrap materials sold
Materials returned to stores
Work certified
Work not certified

WORK IN PROGRESS
This includes the amount of work certified and work not certified. Work in progress will appear in the balance
sheet as a current asset.
Certified work is work valued at contract price
Work in progress is computed as follows;
Costs incurred to date xxx
Profit/loss xxx
Less invoked amount xx
Work in progress xxx

PROFIT ON INCOMPLETE CONTRACT.

The major problem is to ascertain and allocate revenues and related costs to accounting periods over the
duration of the contract.
Some contracts take more than one year (accounting period) and a problem arises whether profits on such
contracts should be worked out on the end of every year.
Profits to be computed will depend on the stage of completion the contract (job) has reached
According to IAS ii, profits can be recognized once the outcome of a contract can be estimated reliably as
profitable.
This requires to record revenue and related costs as contract activity progresses and the profit or loss is
recognized in the income statement.
Revenues and related costs/expenses are recognized according to the stage of completion of that contract.
The percentage of completion can be computed as below;

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certified work
Percentage of completion = x 100
contract price/revenue
OR
¿
Percentage of completion = costs ¿ date Total stimated contract cost x 100

Example
Zzimwe Construction Company had the information relating to road construction
Contract.
Materials sent to the site 85,349,000
Labour engaged on the site 74,375,000
Plant installation costs 15,000,000
Direct expenditure 3,167,000
Establishment charges 4,126,000
Materials returned to stores 549,000
Work certified 195,000,000
Work not certifies 4500,000
Materials at the end of the year 1,893,000
Wages accrued at the end of the year 2400,000
Unpaid expenditure at the end of the year 240,000
Agreed contract price 250,000,000
Cash received from the contract 180,000,000
Book value of plant at the end of the year 11000,000
Required
Prepare a contract account showing profit and show necessary entries in the balance sheet in the contractor’s
books

Note
certified work
Percentage of completion =
contract price

PROCESS COSTING METHOD

This is a form of operation costing that established the cost of products, services, activities or jobs that pass
through a series of clearly defined stages or processes before they become complete products.
Process costing is relevant where production is regarded as a continuous flow and it is applicable to industries
where production is continuous and repetitive in nature e.g. textile, soft drinks, cement, soap industries etc.
In this case, there is continuous and mass production of homogeneous products that undergo the same stages or
processes.

The major feature of process costing is that the finished output of one process becomes the in-put of the next
process until a product is completed
In this case, all direct and indirect costs are charged to each process and then absorbed in the cost objects
produced in that process

The cost per unit is therefore calculated as follows;

Total process costs−scrap value
Cost per unit =
Number of units produced∈each process (input−Normal loss)

Note;
At times, the word conversion costs in process costing are used. This means that the costs of converting raw
materials into finished goods (direct labor costs and production over heads).

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ELEMENTS OF PROCESS COSTING

1. Materials
Raw materials in process costing are issued to process I and after being processed, they are transferred to
process II and so on. At each process, some more materials are added to the original materials. Materials used
at each process are debited to respective process accounts
2. Labour
Direct labour of each process is debited to the respective process accounts.
3. Direct expenses
Direct expenses incurred in respect of any particular process are also debited to the process account
4. Production overheads
Each process is charged with a reasonable share of production overheads. For each process undertaken an
account is opened up. This account is used to build (establish) up costs of the process and at the same time
to work-out the value of the items produced from the process.
The cost of output of each process is eventually credited to the process account to be transferred to the next
process.
In summary, all costs of materials, labour direct expenses and overheads are debited to the process account.
The total costs of the process are transferred to the second process as raw materials for that process.

Example I
Coca-Cola limited produced a new brand Novida which passes through 4 identifiable processes.
During the 2010 production season, the following cost data was obtained.
At the beginning of process I, raw materials for 2000 crates were introduced costing 1000shs per crate
Additional costs were as follows;
Processes
Items I II III IV
Additional 1200,000 800,000
materials
Direct wages 1600,000 1200,000 800,000 400,000
Direct expenses 400,000 200,000 400,000

Production overheads for the entire factory for the period or season were 1000, 000shs. They are to be
absorbed into the processes on the basis of 25% of direct wages
Required
a) Assuming there was no stock of materials or work in progress either at the beginning or at the end of
the process, show the necessary process accounts.

PROCESS COSTING WITH PROCESS LOSSES

In manufacturing organizations, it is inevitable to have losses in various processes. Therefore whatever quality
control and other methods adopted, a certain loss does occur.
The nature of process operation is that the input volume rarely equals to the output volume ie input of that
process is greater than the output realized.

CAUSES OF PROCESS LOSSES

1. Careless handling of materials by employees
2. Thefty of materials
3. Use of low quality materials
4. Evaporation especially through gases, dust and smoke. Etc
Process losses may take form of the following
a) Waste
This is a portion of raw materials that is lost in processing and has no recovery value. Eg materials lost through
evaporation.
b) Scrap
This is a residue of materials from certain manufacturing operations that has a relatively minor recovery value.
Eg molasses etc
Process loss represents a short fall in input because the final output can not match with the input.
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CLASSIFICATION OF PROCESS LOSSES

1. Normal loss (Expected loss)
This is a process loss which is expected under normal circumstances. Normal losses can not be avoided or
controlled.
Normal losses are always provided for at the beginning of the process and this provision is based on post
experience and therefore calculated or established in advance
Normal loss is normally expressed as a percentage of the input volume.
The cost of normal loss constitutes the cost of good production (finished goods) because such costs or losses
are part of normal cost of production.

ACCOUNTING FOR NORMAL LOSS (WITHOUT SCRAP)

DR: Normal loss a/c where the loss has occurred,
CR: process a/c

NORMAL LOSS WITH SCRAP VALUE

When normal loss is represented by scrap which has some realizable value, the following is done;

DR: Normal loss a/c with amount realized from scrap

CR: process a/c

Note: Amount realized from the sale of scrap, reduces the over-all process costs
Example;
ABCUS Uganda ltd produces a product that passes through 2 processes 1 and 2. The following data has been
supplied regarding the 3processes
1000kgs of materials at 200/= per kg are to be supplied to the first process.

Labour costs required will be 150,000/=

Production overheads 123,000/=

The company provides for a normal wastage at 10% of total input. ½ of the normal wastage can be sold as
scrap at 1000/= per kilogram

Output of process I is transferred to process 2 for further processing and the conversion costs required at
process 2 will include;
Labour costs 30,000/=
Production overheads 60,000/=

The company normally provides for normal wastage of 5% input to process 2. The expected loss in this case,
does not attract any value.
Assuming there is no work in progress at the beginning and at the end of the process.
Required;
a) Prepare process a/cs I and 2 and other appropriate a/cs

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Example 2
Shangai Ltd processes through two (2) processes that is 1&2. Given below is the budgeted costs to be incurred.
Items Total Costs Ugx Process1 Process2
Direct materials 900,000 800,0000 100,000
Direct wages 200,000 120,000 80,000
Direct expenses 300,000 300,000 -

Additional information
i. Units introduced to process 1 are 20,000 units
ii. 10% normal loss of input materials is expected at each process and normal loss units are sold for 30 shs
per unit at process 1 and 40 shs per unit at process 2.
iii. There is no closing or opening stock or work in progress.

Required
Prepare:
(i) process 1 and 2 account to record the above cases
(ii) Normal loss account

ABNORMAL LOSSES
This is where the actual loss exceeds the expected loss (Normal loss)
The loss is unexpected and can be avoided and such loss is not always provided for at the start of the process
and therefore they are not part of the cost of good production cost.

CAUSES OF ABNORMAL LOSSES

1. Machinery break-down
2. Improper mixing of product ingredients
3. Use of inferior or defective materials
4. Industrial accidents etc
Abnormal loss is treated as an operational loss and therefore debited to profit and loss account.
Abnormal loss is valued on the basis of unit cost determined and the resulting amount is debited to the
abnormal loss a/c and credited to the corresponding process account.
Accounting entries;
a) DR: Abnormal loss a/c With the value of abnormal loss
CR: process a/c
b) DR: Profit and loss a/c
CR: Abnormal loss a/c
Where abnormal loss is represented with scrap value, the amount realized reduces on the value of abnormal
loss in the abnormal loss a/c.
Accounting entries
c) DR: Scrap sales a/c
CR: Abnormal loss a/c

Example I
The following data relates to one (I) process during the month of april 2010
Input materials 1000kgs at 9000/=
Labour costs 18000/=
Overheads (indirect costs) 13,500/=

Normal loss of 10% of input materials is expected and the actual output was 850kgs Normal loss is sold as
scrap for 9shs per kg
Required;
1) Prepare the process a/c and any other relevant account
Note: Abnormal loss = Expected output – Actual output

ABNORMAL PROCESS GAIN

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This is any units in excess of the expected output. It is a short fall in the expected loss (normal loss)

CAUSES OF ABNORMAL GAIN

1. Favorable conditions that were not anticipated at the planning stage
2. Faulty estimates made at the planning stage

Abnormal gain does not affect the cost of the product because the unit cost is computed in advance before the
actual production commences

The abnormal gain is values on the same basis as the good production and value involved is debited to the
process a/c and credited to abnormal gain a/c
DR: process a/c
CR: Abnormal gain a/c

If the abnormal gain is represented by scrap which has some realizable value, the amount of scrap which
would have been realized had there been no abnormal gain credited to abnormal gain a/c and credited to scrap
sales a/c so that these accounts show the effect of the amounts actually lost
The balance on the abnormal gain a/c is later transferred to the profit and loss a/c on the credit side
DR: Abnormal gain a/c]
CR: Profit and loss a/c

Example II
Hot loaf ltd processed 100,000 units of bread during the last half of 2009. Cost data was as follows;
Direct materials cost 12,000,000/=
Direct wages 4,000,000/=
Production overheads 2450, 000/=
Direct expenses 2,000,000/=
Normal loss is expected at 5% of input.
All the scraped units were sold to employees at a cost of 100/= each
The actual good production was 97,000 units of bread.

Required
Show relevant accounts
Exercise I

In the manufacture of product A, there are 3 identifiable processes 1,2 and 3. The following data relates to the
month of March 2010
Details 1 2 3
Additional materials 100,000 200,000 240,000
Labor costs 300,000 150,000 200800
Direct expenses 120,000 22500 107680
Production overheads 100,000 100,000 100,000
20000 units at 15/= each were introduced at the beginning of process I. Normal loss rate process I 10%,
process 2, 5% and process 3, 2%. Actual production; process I 17500units, process 2 16800 units and process 3
16400units.
Scrap sales: process I 10/= per unit, process 2: 20/= and process 3:50/= per unit

Required
Prepare relevant accounts.

UNIT SEVEN

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BUDGETING AND BUDGETARY CONTROL

Introduction
Budgeting plays a key role in business organizations of every size as it reduces the threat of uncertainties,
failure and future risks if properly carried out. In real sense, budgeting help to eliminate pressure of time as it
prepares for the future and foresees problems before they occur.

A budget is defined as a detailed plan of action based on agreed upon objectives relating to activities normally
expressed in financial terms for a future defined time period.

A budget can also be defined as a monetary and/or quantitative expression of business plans and policies,
prepared in advance, to be pursued in the future period of time.

Budget is a systematic plan for utilization of all types of resources, at itscommand. It acts as a barometer of a
business as it measures the successfrom time to time, against the standard set for achievement.

Budgeting is the process of preparing and using budgets to achieve management objectives.

Characteristics of a Budget
 A budget is a plan for the firm’s operations and resources.
 It is expressed in financial matters or terms
 It is a comprehensive and coordinated plan
 It is a plan of a firm’s future expectations
 Budgets are prepared for different segments or parts of the organization and all these individual budgets
prepared form a master budget.
 It requires full participation of all concerned members of the organization during its preparation and
implementation
 It should be based on established standards of performance
 It should be flexible in the changing circumstances
 It should constantly monitor the performance and report the feedback or results

Importance of Budgets
Budgeting performs a series of functions and achieves a number of objectives. The importance of budgets is
presented as below;

1. Budget guides action where it sets short term plans for meeting the business objectives.
Budgets enables the business to be operated as a unified whole rather than a group of separated departments.

2. Budgeting coordinates activities of various departments of the organization and ensures that each department
is in harmony with each other.It also compels managers to examine the relationship between the different parts
of an organization when making decisions and in assists in identifying and resolving conflicts. Examples of the
type of conflicts which could arise in a manufacturing setting for example would be between a purchasing
manager who buys in bulk to obtain large discounts, a production manager who wishes to avoid large stock
levels and an accountant who is concerned about the impact on the business’s cash resources. Budgeting aims
to reconcile these differences.

3. Budgeting communicates plans to various parts or responsibility centre managers. This is done through each
manager to participate in the budgeting process. All managers within the organization must have a clear
understanding of the role which they are required to play in ensuring budgetary compliance. This ensures that
the most appropriate individuals are made accountable for budget implementation. Senior management can
also use budgets to communicate corporate objectives downwards and ensure that other employees understand
them and co-ordinate their activities to attain them.

4. It motivates managers to strive to achieve the organizational goals. This is because managers’ actual
performance is measured against the set targets in the budget and this forces them to work hard in order to
realize the objectives.
5. Helps in controlling performance where the budget is used as a bench mark against which individual
performance and units is measured and this will reveal areas that do not conform to plan which attracts
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manager’s attention. Managers can also use budgets to control the activities for which they are responsible.
Analyses of variances allow managers to identify those costs which do not conform to the long term plan and
therefore may require alteration. By investigating the reasons for budget deviations managers may also be able
to identify inefficiencies.

6. Budgeting helps to clarify authority and responsibility for each manager responsible for the budget centre.

7. Budgeting helps managers to develop attitude of cost consciousness. This is so because effective use of
resources is stimulated

8. Budgeting helps to reduce situations of uncertainty in an organization

9. It helps in allocating capital and other resources into most profitable channels or activities

10. Proper budgeting is a tool in soliciting for funds.

11. Managers are required to produce detailed plans to enable the implementation of the long term or strategic
plan. The annual budgeting process encourages managers to plan for future operations, refine existing strategic
plans and consider how they can respond to changing circumstances. This encourages managers to anticipate
problems before they arise and ensures reasoned decision making. Without this incentive the pressures of day
to day operations may tempt managers not to plan for future operations and hasty decisions based on
expediency rather than reasoned judgment will be minimized.

12. Budgeting helps in measuring performance of the business over time.

Essentials of Effective Budgeting (Budgeting Environment)

 Effective budgeting depends on a sound organizational structure that clearly defines authority and
responsibility for all phases of operations.
 Budgets based on research and analysis should result in realistic goals that will contribute to a
company‘s growth and profitability.
 The effectiveness of a budget program is directly related to how well it is accepted by all levels of
management.
 Once the budget has been adopted, it should be an important tool forevaluating performance.
 Variations between actual and expected results should be systematically and periodically reviewed to
determine their cause(s).  

Types of Budgets
Different budgets are prepared depending on the nature and type of the organization. All various budgets are
co-ordinated through the master budget. Various budgets include the following

i) Sales budget
This is a budget which indicates the amount of sales in units and value the firm or company intends to sale in
the forth coming period.

Preparation of the sales budget involves the need to make sales forecasts and predictions of the economic
factors and market forces that will influence the sales budget to be prepared.

Sales budget generally forms the fundamental basis on which all other budgets are prepare or built. The sales
manager is directly responsible for the preparation of the sales budget and its implementation. Before preparing
a sales budget, there is a need to understand both the environmental and organizational factors that will affect
the sales of the organization.

Organizational factors
 Past sales figures and trends
 Plant production capacity
 Orders at hand
 Cost of product distribution
 Salesmen’s estimates and forecasts

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 Etc.
Environmental factors
 Seasonal or demand fluctuations
 Degree of competition
 Political situation and its impact on the market
 Government controls, policies, rules and regulations regarding the industry
 Potential market
 Etc

It is important to break up the sales on the basis of different products offered by the firm, time period and sales
territories or markets.
ii) Production budget
This budget shows the estimates of planned production for the immediate future period.
It is stated in physical units and it is prepared basing on the sales budget.
The production budget must provide production units to satisfy the sales forecasts and to achieve the desired
level of closing finished goods

Note:
Units to be produced = Budgeted sales (units) + desired closing stock of finished goods – opening stock of
finished goods.
iii)Production cost budget.
This is a budget which indicates the quantity of products to be manufactured expressed in terms of cost. This
budget summarizes materials utilization budget, labour budget and factory overheads budget
The cost of units to be produced is given by units needed multiplied by unit cost.

iv)Direct materials utilization budget.

This is a budget indicating the amount of materials in units that will be needed to meet production
requirements. This budget is based on information drawn from the production budget
Note:
Raw material units needed = Budgeted production (units) xUnits of materials needed to make a complete unit

v)Direct materials purchases budget.

This budget expresses direct materials utilization budget and closing level of inventory or stock in monetary
terms. This means that the units of materials to be purchased are expressed 3in terms of costs by multiplying
materials purchase price by units.
Units needed = Materials units needed for production + desired closing stock of raw materials-opening stock of
raw materials.

vi)Direct labour cost budget.

This estimates adequate labour in number and grades to enable the production budget to be realized.
Labour cost to be incurred in a period is obtained by multiplying number of labour hours needed for production
by the rate per direct labor hour.

Note:
Budgeted labour hours = Budgeted production units x number of hours per unit
Budgeted labour cost = Budgeted labour hours x rate per hour.

vii)The factory overhead cost budget.

This budget is prepared to accommodate all manufacturing factory costs that 3can not be traced to specific
product or service. This budget covers indirect 3labour costs, indirect 3material costs and indirect expenses.

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i i i ) The c a s h budget
This is a budget that shows a summary of the firm's future expected cash inflows (revenue/income) and
outflows (expenditures) over a particular period of time. It consists of projected cash receipts (cash inflows)
and planned cash disbursements (cash out flows).
Cash receipts or inflows may come from any of the following sources or activities;
• Cash sales
• Cash collected from debtors or accounts receivables
• Sale or disposal of non current assets
• Dividends and interest received
• Issue of new shares to the public or existing shareholders
• Introduction of cash into the business
• Receipts from loan payments
• Other incomes

Cash outflows or payments may include;

• Cash purchases
• Payments to creditors
• Loan repayments
• Purchase of non current assets
• Payment of expenses
• Payment of dividends and interest

Purposeor importance of the cash budget

 Cash budget ensures the availability of sufficient cash to carry out activities of the business at a future
date.
 It shows cash excess or shortage such that action can be taken. For example, if there is excess cash, the
business can invest it to generate more income and if there is a shortage of cash, the business can
borrow in order to meet the shortage or to delay some payments.
 It is used to solicit funds or credit from lending financial institutions.
 It establishes a sound basis for controlling finances in the business such that cash position is established
and maintained.
 It helps to identify activities that require cash in advance and where such cash will come from.
 It enables monitoring of cash in the business and thus regulating expenditure of the business.
 It acts as a standard for evaluating the financial performance of the business.

Ways of handling a deficit cash budget

A deficit cash budget is a cash budget where cash outflow is greater than cash inflows. Managers should get
ways of financing a deficit budget such that payments are either equal or less than cash inflow or receipts.

The following can be done to handle a deficit cash budget;

 Borrowing from lending institutions or individuals in order to secure enough cash to offset the deficit or
the shortage.
 Issue of shares to the public or to the existing shareholders in order to generate cash and offset the
deficit.
 Introducing more capital in form cash into the business.
 Encouraging credit purchases and discouraging credit sales
 Delaying payment of expenses
 Sale or disposal of old assets
 Obtaining a bank over draft
 Etc.

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Format of a cash budget

Particulars Periods
Period 1 period 2 period 3 period 4
Balance b/f ____ xx xx xx
Cash inflow/receipts
Cash sales xxx ___ ___ xx
Share capital xx xx xx xx
Receipts from debtors xx xx xx xx
Bank loan xx xx ___ ___
Interest received xx xx xx xx

Total cash outflows xxx xxx xxx xxx

Cash outflows/ payments
Cash purchases xx xx xx xx
Payments to creditors xx xx xx xx
Payment of expenses xx xx xx xx
Purchase of assets xx --- --- xx
Loan repayments xx xx xx xx

Total cash outflows xxx xxx xxx xxx

Balance c/d (surplus/deficit) xx xx xx xx

Note
Only cash items in form of expenses are considered in the cash budget. Expenses such as depreciation,
discount allowed, bad debts written etc. are not recorded in the cash budget because they are non-cash items.

Example 1
The management of Good stars limited has made the following forecast in respect of the last quarter of the
financial year 2014.
Sales Purchases wages Overheads
August 650,000 320,000 180,000 170,000
September 520,000 420,000 200,000 180,000
October 750,000 730,000 600,000 500,000
November 720,000 500,000 430,000 300,000
December 800,000 600,000 230,000 450,000

Additional information
I. Cash balance at the beginning of October is planned at 500,000.
II. 60% of sales are for cash, 20% is collected after one month and 20% is collected after two months of
sale.
III. 90% of the purchases is paid in the month of purchase and the balance one month later.
IV. Wages are paid in the month they are incurred.
V. Overheads include 100,000 per month depreciation and are payable one month in arrears.
VI. Interim dividends of 70,000 will be paid in November.
VII. Issue of 1000 shares at 2,000shs each will be done in December.

Required
Prepare cash budgets for each of the three months; October. November and December

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ix) Capital expenditure budget

Capital budget refers to the budget which summarizes the purchase of durable and fixed assets in the
organization. This budget requires frequent revision due to changes in the cost of durable assets over
time.
x) Master or comprehensive budget
This is a budget which summarizes and incorporates all the functional budgets. It takes the form of
budgeted profit and loss account, balance sheet and the cash flow statement.
xi) Rolling budget
Arolling budget is a budget that is continually updated to add a new budget period as the most recent
budget period is completed. A rolling budget adds a future period's budget to replace a budget for a
period that has past.
Rolling budgets repeatedly extend the original budget period. For example, if the organization prepares
a rolling budget for 12 months and the budget runs from January 1st to December 31st, at the end of
January, the budget period will change to February 1st to next year’s January 31st. This means that a
rolling budget is not static and continues perpetually. It incorporates information from experience to
build or renew the budget for the next period.

The advantages associated with the use of rolling budgets are

 Budgets are reassessed regularly and thus should be more realistic and accurate.
 Because rolling budgets are revised regularly, uncertainty is reduced.
 Planning and control is based on a recent updated plan.
 The budget is continuous and will always extend a number of months ahead.
The disadvantages are
 Rolling budgets are time consuming and expensive as a number of budgets must be produced
during the year.
 The volume of work required with each reassessment of the budget can be off-putting for
managers.
 Each revised budget may require revision of standards or stock valuations which is time
consuming.

Example 2
The following information relates to the books of K.K.L Company limited for the next six months of
2015.
Particulars Jan Feb March April May June
Budgeted sales in units 4000 4200 4500 5000 4800 4700
Closing stock in units 1000 1500 1300 800 1200 1400

K.K.L anticipated to sell each unit at 30,000/= every month. The company had opening stock of
finished goods amounting to 500 units. K.K.L planned to reserve closing stock of finished goods at the
end of the month and is part of the produced units.

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Information from the production manager indicates that each unit will require the following
composition of costs to be completed
Cost element Unit cost in shs
Raw materials 5 litres at 2000/= each 10,000/=
Labour 10 hours at 500/= each 5,000/=
Variable overhead costs 20% of labour costs 1,000/=
Total 16,000/=
The stores manager states that the company’s policy is to reserve raw materials of 10% of the next
month’s requirement due to unreliability of suppliers.
Closing inventory of raw materials in June will be the same as that in May.
Required: Prepare the following functional budgets
a) Sales budget
b) Production budget and production cost budget
c) Raw material utilization budget
d) Materials purchases budget
e) Labour cost budget.
f) Overhead cost budget

Budgeting Process
The budget process is the way an organization goes about building its budgets.  A good budgeting
process engages those who are responsible for adhering to the budget and implementing the
organizational objectives in creating the budget.  Both finance committee and senior staff participation
is built into the process and a timeline is established leaving adequate time for research, review,
feedback, revisions, etc. before the budget is ready for presentation to the full board.  The annual
budgeting process should be documented, with tasks, responsibility assignments and deadlines clearly
stated.  A good budgeting process also incorporates strategic planning initiatives and stipulates that
income is budgeted before expenses.  Fixed costs are identified and related to reliable revenue.  
Budgeting involves a series of sequential stages which need to be coordinated in order to achieve the
final budget.

According to Collin Drury (2000) stages of budgeting include the following;

1. Communicating details of budget objectives, policy and guidelines to people responsible for the
preparation of budgets.
2. Determining the factors that restrict performance. Management should identify the factor that
restrict performance such as space, labor hours, machinery etc. as this enables the allocation
resources in the most effective manner.
3. Preparation of revenue or sales budget after economic or market forecasts. This is because all
other functional budgets are built basing on the sales budget therefore should be prepared first
before any other budget is prepared.

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4. Preparation of other budgets by managers responsible. These budgets are prepared in line with
the sales or revenue budget i.e. functional budgets should not exceed the value of the sales
budget.
5. Negotiation of budgets with line managers and supervisors in order to ensure that all the issues
budgeted for are agreed upon and support the activities of the organization.
6. Co-ordination and review of budgets in order to ensure that they address the same objective.
7. Final acceptance of budgets and incorporating them into the master budget to serve the entire
organization.
8. Carrying out budget review on a continuous basis to ensure that the set targets are being
achieved.

Budget Organization and Administration

Budget organization and administration requires that certain items should be in place and incorporated
in the budgeting system and used carefully. This requires the following;
1. Budget Committee
This is a group of people (managers) responsible for the coordination and administration of the budget
process. Every department or section of the organization must be represented on the budget committee.
In this case, there should a representative of the key departments and sections such as marketing and
sales, production, purchasing, finance, human resource, technology and administration.
These managers set goals, develop plans and formulate budget policies.

Functions of the Budget Committee

 Committee members establish priorities, make financial policies and monitor implementation of
those policies on a periodic basis.
 Members also optimize the funds available by making the best use of those funds. The
committee evaluates any necessary changes throughout the life of the budget, increasing and
decreasing fund designation as necessary, and always making sure the budget is balanced.
 Provides general information and guidelines for preparing budgets
 Offers technical advice and suggest changes where necessary so as to come with good budgets
 Receives and reviews individual budgets from functional managers or department heads for
budget negotiation purposes
 Coordinates budgetary activities and communicates final budgets to managers
 Carry out budgetary functions and responsibilities (allocation of responsibilities to various
managers)
 Carry out disciplinary function in reference to budgets
 Formulates and communicates budget policies and issue budget manuals
 Compares actual results with budgets and investigates budget variances
 Assess budgeting and planning process regularly so as to improve performance.

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2. Budget Manual
Effective budgetary planning relies on the provision of adequate information to individuals involved in
the planning and budgeting process. Much of this information needed is contained in the budget
manual.

A budget manual is a collection of documents that contains key information to be used by those
involved in the planning and budgeting process. It is a booklet or file which provides information
guidance about budgeting process. It is a set of instructions and guidelines to be used during budget
preparation.

It defines responsibilities of different persons involved in the budgeting processand specifies the
procedures to be followed when preparing different budgets.
Contents of a budget manual

a) An introductory explanation of the budgetary planning and control process, including a statement of
the budgetary objective and thedesired results.
b) Theorganization chart showing who is responsible for the preparation of each functional budget and
the way in which the budgets are interrelated.
c) A timetable for the preparation of each budget. This will prevent the formation of a ‘bottleneck’ with
the late preparation of one budget holding up the preparation of all others.
d) Copies of all forms to be completed by those responsible for preparing budgets, with explanations
concerning their completion.
e) A list of the organization’s account codes for items of expenditure and income, with full explanations
of how to use them.
f) Information concerning key assumptions to be made by managers in their budgets, for example the
rate of inflation, key exchange rates, etc.

3. Budget Period
This refers to the period under which a particular budget is planned and drawn.

4. Key Factor / Budget Principal Factor / Restricting Factor

This is any factor that hinders the achievement of the set goals in the budget.It is the factor that limits
the activities of functional budgets of the organization.

The early identification of this factor is important in the budgetary planning process because it
indicates which budget should be prepared first.

In general, sales volume is the principal budget factor. So sales budget must be prepared first, based on
the available sales forecasts. All other budgets should then be linked to this sales budget.

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Alternatively, machine capacity may be limited for the forthcoming period and therefore machine
capacity is the principal budget factor. In this case the production budget must be prepared next and all
other budgets follow it.

Failure to identify the principal budget factor at an early stage could lead to delays later on when
managers realize that the targets they have been working with are not feasible or attainable. 

5. Budget Officer
A budget officer is a trained professional who works to keep the budget balanced for a company over a
set period. Budget officer controls the budget administration and work in line with budget committee
and managers responsible for budget preparation.
The budget officer is responsible for verifying how the funds are being spent, ensuring that the
company's plans that require funding are possible within the budget limits and that the annual report for
the company is created with truthful and reliable figures.
The budget officer is often expected to plan and makes changes to the budget if it needs to improve
over time.

Duties of a Budget Officer

 Directs and coordinates activities of personnel responsible for formulation, monitoring and
presentation of budgets.
 Directs compilation of data based on statistical studies and analysis of past and current years to
prepare budgets and to justify funds requested.
 Reviews operating budgets periodically to analyze trends affecting budget needs.
 Consults with unit heads to ensure adjustments are made in accordance with program changes in
order to facilitate long-term planning
 Directs preparation of regular and special budget reports to interpret budget directives and to
establish policies for carrying out directives.
 Administers personnel functions of budget department, such as training, work scheduling,
promotions, transfers, and performance ratings.
 Provide advice and technical assistance with cost analysis, fiscal allocation, and budget
preparation.
 Examine budget estimates for completeness, accuracy, and conformance with procedures and
regulations.
 Direct the preparation of regular and special budget reports.
 Summarize budgets and submit recommendations for the approval or disapproval of funds
requests.
 Perform cost-benefit analyses to compare operating programs, review financial requests, or
explore alternative financing methods.
 Educate people about budgetary planning and control.

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6. Budget Centers
A budget centre is a part of the organizationor a unit which is responsible for the preparation of
budgets. Budget center can be a department, section of a department or any other part of department.
Budget centers are necessary for the purpose of ascertaining cost, performance and its control

Budgeting Challenges
 Managers who set targets are different from those responsible for achieving targets.
 The overall organizational goals may not concide with personal aspirations of individual
managers.
 Control is applied at different stages by different people at different times
 Poor attitudes when setting budgets by different managers
 Poor attitudes when putting plans into action by managers
Note: For budgeting to be successful, managers must be ready to see congruence between their
personal goals and those of the organization.
It is important for all the stake holders to participate in the budgeting process as this improves morale,
initiative, better and more realistic plans, increased co-operation and coordination.

Budgetary Control
Introduction
Budgetary control is a control technique where actual performance results are compared with budgets.
Budgetary control is the process of determining various budgeted figures for the enterprise andthen
comparing the actual performance with the budgeted figures for calculating the variances,if any. In this
process, budgets are prepared first, actual results are recorded and then comparison is made between the
actual results with the planned action/ results for calculating thevariances. Once the discrepancies are
known, remedial measures are to be taken at proper time.

Budgetary Control is essential to ensure that the organisational objectives are achieved either on short,
medium or long term basis. Budgets need to be used by managers as a channel for the decision making
process so as to achieve optimum performance for the organisation. Actual reporting of results and
variances is used in evaluating and measuring the performance of managers.
Budgetary control is vital to enable attainment of organizational targets across the operations of the
business.

Objectives of Budgetary Control

The following are the objectives of a budgetary control system
 To plan for organisational activities
 To coordinate activities of the organisation
 To communicate plans and objectives of the organisation
 To motivate managers and other personnel to work hard and achieve the objectives of the
organisation
 To control performance of the organisation over time

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 To evaluate performance of the organisation

Objectives of budgetary planning are explained as below;

1. Planning: A budget provides a detailed plan of action for a business over definite period of time.
Detailed plans relating to production, sales, raw material requirements, labour needs, advertising
and sales promotion performance, research and development activities, capital additions etc., are
drawn up. By planning many problems are anticipated long before they arise and solutions can be
sought through careful study. Thus most business emergencies can be avoided by planning. In brief,
budgeting forces the management to think ahead, to anticipate and prepare for the anticipated
conditions.
2. Co-ordination: Budgeting aids managers in co-ordinating their efforts so that objectives of the
organisation as a whole harmonise with the objectives of its divisions. Effective planning and
organisation contributes a lot in achieving coordination. There should be coordination in the
budgets of various departments. For example, the budget of sales should be in coordination with the
budget of production. Similarly, production budget should be prepared in co-ordination with the
purchase budget, and so on.
3. Communication: A budget is a communication device. The approved budget copies are distributed
to all management personnel which provide not only adequate understanding and knowledge of the
programmes and policies to be followed but also give knowledge about the restrictions to be
adhered to. It is not the budget itself that facilitates communication, but the vital information is
communicated in the act of preparing budgets and participation of all responsible individuals in this
act.
4. Motivation: A budget is a useful device for motivating managers to perform in line with the
company objectives. If individuals have actively participated in the preparation of budgets, it acts as
a strong motivating force to achieve the targets.
5. Control: Control is necessary to ensure that plans and objectives as laid down in the budgets are
being achieved. Control, as applied to budgeting, is a systematized effort to keep the management
informed of whether planned performance is being achieved or not. For this purpose, a comparison
is made between plans and actual performance. The difference between the two is reported to the
management for taking corrective action.
6. Performance Evaluation: A budget provides a useful means of informing managers how well they
are performing in meeting targets they have previously helped to set. In many companies, there is a
practice of rewarding employees on the basis of their achieving the budget targets or promotion of a
manager may be linked to his budget achievement record.

Advantages of Budgetary Control

Budgetary control provides the following advantages:
1. Budgeting compels managers to think ahead i.e. to anticipate and prepare for changing conditions.
2. Budgeting co-ordinates the activities of various departments and functions of the business.
3. It increase production efficiency, eliminates waste and controls the costs.
4. It pinpoints efficiency or lack of it.

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5. Budgetary control aims at maximization of profits through careful planning and control.
6. It provides a yardstick against which actual results can be compared.
7. It shows management where action is needed to remedy a situation.
8. It ensures that working capital is available for the efficient operation of the business.
9. It directs capital expenditure in the most profitable direction.
10. It instills into all levels of management a timely, careful and adequate consideration of all factors
before reaching important decisions.
11. A budget motivates executives to attain the given goals.
12. Budgeting also aids in obtaining bank credit.
13. A budgetary control system assists in delegation of authority and assignment of responsibility.
14. Budgeting creates cost consciousness and introduces an attitude of mind in which waste and
efficiency cannot thrive.

Limitations of Budgetary Control

Budgetary control system suffers from certain limitations and those using the system should be fully
aware of them.
1. The budget plan is based on estimates: Budgets are based on forecasting cannot be an exact
science. Absolute accuracy, therefore, is not possible in forecasting and budgeting. The strength or
weakness of the budgetary control system depends to a large extent, on the accuracy with which
estimates are made.
2. Danger of rigidity: A budget programme must be dynamic and continuously deal with the
changing business conditions. Budgets will lose much of their usefulness if they acquire rigidity
and are not revised with the changing circumstances.
3. Expensive Technique: The installation and operation of a budgetary control system is a costly as it
requires the employment of specialised staff and involves other expenditure which small firms may
find difficult to incur. However, it is essential that the cost of introducing and operating a budgetary
control system should not exceed the benefits derived therefrom.

Essentials of Effective Budgetary control

A budgetary control system can be successful only when certain conditions and attitudes exist and such
conditions and attitudes which are essential for effective budgeting are as follows:
1. Support of Top Management: If the budget system is to be successful, it must be fully supported
by every member of the management and direction must come from the very top management. No
control system can be effective unless the organisation is convinced that the top management
considers the system to be important.
2. Reasonable Goals: The budget figures should be realistic and represent reasonably attainable
goals. The responsible executives should agree that the budget goals are reasonable and attainable.
3. Continuous Budget Education: The best way to ensure the active interest of the responsible
supervisors is continuous budget education in respect of objectives, potentials and techniques of
budgeting. This may be accomplished through written manuals, meetings etc., whereby preparation
of budgets, actual results achieved etc., may be discussed.

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4. Adequate Accounting System: There is close relationship between budgeting and accounting. For
the preparation of budgets, one has to depend on the accounting department for reliable historical
data which primarily forms the basis for many estimates. The accounting system should be
designed so as to set up accounts in terms of areas of managerial responsibility. In other words,
responsibility accounting is essential for successful budgetary control.
5. Constant Vigilance: Reports comparing budget and actual results should be promptly prepared and
special attention focused on significant exceptions i.e. figures that are significantly different from
those expected.
6. Maximum Profit: The ultimate object of realizing the maximum profit should always be kept
uppermost.
7. Cost of the System: The budget system should not cost more than its worth. Since it is not
practicable to calculate exactly what a budget system is worth, it only implies a caution against
adding expensive refinements unless their value clearly justifies them.

9. Proper Delegation of Authority and Responsibility:

The first step is to have clear organisation chart explaining the authority and responsibility of each
individual executive. There should be no uncertainty regarding the point where the jurisdiction of one
authority ends and that of another begins.

10. Proper Communication System:

The flow of information should be quick so that the budgets are implemented.
Two-way communications is important. What is required to be achieved and how it is to be achieved
should reach the lowest level. Similarly, upward communication in respect of implementation
difficulties should reach the top level to sort out, without loss of time. The performance reports at the
various levels help the management in monitoring and leading to the achievement of the budgeted goals

11. Participation of All Employees

Budget preparation and control are done at the top level. However, involvement of all persons,
including at the lower level, is necessary in framing the budget and its implementation for the success
of budgetary control. In practice, budgets are executed at the lower level. With experience, they can
offer practical suggestions that can lead to success.

12. Flexibility:
Future is uncertain. Despite the best planning and foresight, still there may be occurrences that may
require adjustments. Budgets should work in the changed circumstances. Flexibility in budgets is
required to make them work under changed circumstances.

13. Motivation:
Human beings execute Budgets.
There should be incentive in achieving the required targets. All persons should be motivated to improve
their working to achieve the goals set in the budgets

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Budgets Available for Budgetary control Purposes

1. FIXED BUDGETS
These are budgets designed not to change irrespective of the changes in the output.
The original budget at the planned output is compared with actual performance at any level of output.
Costs and revenue of two different levels of output are compared.
However, fixed budgets are misleading in nature and therefore irrelevant for control purposes.

2. FLEXED OR FLEXIBLE BUDGETS

This is a budget which recognizes cost behavior patterns and designed to change as output changes.
Flexible budget is the one designed to adjust the budgeted cost levels to suit the level of activity
obtained.
The flexible budget is designed for a range of activity levels
It is useful for control purposes.
Illustration I
XZY limited manufactures a single product
Budgeted results and actual results for July 2009 are shown as below.
Budgeted Actual Results
Production and sales (units) 2,000 3,000
Sales revenue 20,000 30,000
Direct materials 6,000 8500
Direct labour 4,000 4500
Maintenance 1,000 1400
Depreciation 2000 2200
Rent and rates 1500 1600
Other costs 3600 5,000
Total costs 18100 23200
Profit (sales-costs) 1900 6800
Assuming that, the following technical information is availed
1. Direct materials, direct labour and maintenance costs are variable
2. Rent and rates and depreciation are fixed
3. Other costs consist of fixed costs of 1600 plus variable cost of 1/= per unit made and sold.
Required
Prepare a useful budget for management control purposes.

Illustration II
Monalisa is an Egyptian financed NGO and has a project of five years. Its aim is to improve the health
and livelihood of the orphans living in Western Uganda. It has provided you with the following details
for the financial year 2016/2017.
Item Nature of the cost Budgeted amount Actual amount
Medical Fixed 10,000,000 14,000,000
Health and Sanitation 60% Variance 7,000,000 9,000,000
House hold items Variance 5,000,000 6,000,000
Transport Variance 3,000,000 7,000,000
Education Variance 15,000,000 30,000,000
Media production 40% Fixed 5,000,000 5,200,000
Additional information

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I. Expected number of beneficiaries is 100,000 persons

II. Actual number of beneficiaries is 150,000 persons
Required;
Prepare a flexible budget, determine budget variance and comment on the budget performance

APPROACHES TO BUDGETING
This refers to various methods or means used to formulate or originate budgets.
Approaches to budgeting include;
a) Incremental budgeting.
This is budgeting approach where adjustments are made to previous (original) budgets in order to
formulate the new budgets.

This is where the current budget and actual figures act as the starting point or base for the new budget.
The base is adjusted for forecast changes to, for example, the product mix, sales volume, sales price,
expenses and capital expenditure that are expected to occur over the next budget period. It is called
incremental budgeting as the approach does not focus on the base, but focuses on the increment (the
changes from the base).

Incremental budgeting is budgeting approach based on slight changes from the preceding period's
budgeted results or actual results. This is a common approach in businesses where management does
not intend to spend a great deal of time formulating budgets, or where it does not perceive any great
need to conduct a thorough re-evaluation of the business.

Advantages of incremental budgeting

 Relatively simple to use and easy to understand
 The budget is stable and change is gradual.
 Managers can operate their departments on a consistent basis.
 Conflicts should be avoided if departments can be seen to be treated similarly.
 Co-ordination between budgets is easier to achieve.
 The impact of change can be seen quickly.

However, this approach is not suitable due to its weaknesses such as.
 Unlike zero based budget, incremental budgeting assume that the activities and methods of
working will continue in the same way hence it fails to take into account changing
circumstances.
 As it is merely a marking up the previous year budget, it’s too simple a method where it does
not provide incentive for employees to develop new ideas/ to innovate.
 As it encourages spending up to the budget so that the budget is maintained next year. With this
spend it or lose it mentality, cost cannot be reduced.
 The budget may become out of date and no longer relate to the level of activity or type of work
being carried out.
 The priority for resources may have changed since the budgets were set originally.

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 There may be budgetary slack built into the budget, which is never reviewed-managers might
have overestimated their requirements in the past in order to obtain a budget which is easier to
work to, and which will allow them to achieve favourable results.

b) Zero based budgeting (ZBB)/Priority budgeting.

This is a budgeting approach where each cost centre budget is originating from zero or scratch. Zero
Based Budgeting is defined as a method of budgeting which requires each cost element to be
specifically justified, as though the activities to which the budget relates were being undertaken for the
first time.
CIMA defines it “as a method of budgeting whereby all activities are revaluated each time a budget is
set."

With Zero based approach, one can forget about last years, pretend that the program is brand new.
Zero based budgeting is so called because it requires each budget to be prepared and justified from
zero, instead of using last year’s budget as a base. Incremental level of expenditure on each activity is
evaluated according to the resulting incremental benefits. Available resources are then allocated where
they can be used most effectively. Zero based budgeting is a decision oriented approach.

Characteristics of Zero-base budgeting

1. Manager of a decision unit has to completely justify why there should be at all any budget allotment
for his decision unit. This justification is to be made fresh without making reference to previous level of
spending in his department.
2. Activities are identified in decision packages.
3. Decision packages are ranked in order of priority.
4. Packages are evaluated by systematic analysis.
5. Under this approach, there exist a frank relationship between superior and subordinates. Management
agrees to fund for a specified service and manager decision of the decision unit clearly accepts to
deliver the service.
6. Decision packages are linked with corporate objectives, which are clearly laid down.
7. Available resources are directed towards alternatives in order of priority to ensure optimum results.
Advantages of zero-base budgeting
1. It provides a systematic approach for the evaluation of different activities and ranks them in order of
preference for the allocation of scarce resources in the organization.
2. It ensures that the various functions undertaken by the organization are critical for the achievement
of its objectives and are being performed in the best possible way.
3. It provides an opportunity to the management to allocate resources for various activities only after
having a thorough cost-benefit-analysis. The chances of arbitrary cuts and enhancement are thus
avoided.
4. The areas of wasteful expenditure can be easily identified and eliminated.
5. Departmental budgets are closely linked with corporation or company objectives.
6. The technique can also be used for the introduction and implementation of the system of
‘management by objective.’ Thus, it cannot only be used for fulfillment of the objectives of traditional
budgeting but it can also be used for a variety of other purposes.
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7. Staff and managers will have enough knowledge of the operations and activities and this encourages
motivation.
8. Detects and avoids inflated budgets
9. Increases communication and coordination among members within the organization
10. Focuses attention on value of money and examines the relationship between input and output
benefits.
11. Derives managers to find out alternative activities or ways of improving operations of the business.

Disadvantage of ZBB:
1. The work involved in decision-making and subsequent ranking of activities is very tedious to
management hence it is not readily and always acceptable by staff because of much work involved.
2. The activity selected for the purpose of ZBB is on the basis of the traditional functional departments.
So the consideration scheme may not be implemented properly.
3. The approach is associated with time wasting and can generate a lot of paper work
4. Skilled managers are required to draw the decision packages and this is expensive to maintain at all
times.
c) Activity Based Budgeting
This is a budgeting approach where budgets are prepared basing on activities to be carried out by each
cost centre.
In this case therefore, it is activities that derive costs and cost centres consume activities.

Advantages of Activity based budgeting

 Promotes efficient use of resources since activities determines the costs to be incurred etc
 It draws attention to the costs of 'overhead activities' which can be a large proportion of total
operating costs.
 It recognises that it is activities which drive costs. If we can control the causes (drivers) of costs,
then costs should be better managed and understood.
 ABB can provide useful information in a total quality management (TQM) environment, by
relating the cost of an activity to the level of service provided.

Disadvantages
 A considerable amount of time and effort might be needed to establish the key activities and
their cost drivers.
 It may be difficult to identify clear individual responsibilities for activities.
 It could be argued that in the short-term many overhead costs are not controllable and do not
vary directly with changes in the volume of activity for the cost driver. The only cost variances
to report would be fixed overhead expenditure variances for each activity.

Budget slack
When budgets are used for performance evaluations, management often encounters the problem of
budget slack.

Budget slack is the intentional underestimation of revenues and/or overestimation of expenses. 

Slack can be incorporated into the budget during the development process in a participatory budget. A
participatory budget is developed through joint decision making by top management and operating
personnel. However, slack is not often found in imposed budgets.
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Imposed budgets are prepared by top management with little or no input from operating personnel.
After the budget is developed, operating personnel are informed of the budget goals and constraints.
Having budget slack allows subordinate managers to achieve their objectives with less effort than
would be necessary without the slack.

Slack also creates problems because of the significant interaction of  the budget  factors. For
example, if sales volumes are understated or overstated, problems can arise in the production,
purchasing, and personnel areas.

Business process re-engineering

Business process re-engineering is a business management strategyfocusing on the analysis and
designing of workflow and business processes within an organization.
BPR is aimed at helpingorganizations fundamentally rethink how they do their work in order to
dramatically improve customer service, cut operational costs, and effective competitors.
BPR seeks to help companies radically restructure their organizations by focusing on the ground-up
design of their business processes.
Re-engineering recognizes that an organization's business processes are usually fragmented into
subprocesses and tasks that are carried out by several specialized functional areas within the
organization.
Often, no one is responsible for the overall performance of the entire process. Re-engineering maintains
that optimizing the performance of sub-processes can result in some benefits, but cannot yield dramatic
improvements if the process itself is fundamentally inefficient and outmoded. For that reason, re-
engineering focuses on re-designing the process as a whole in order to achieve the greatest possible
benefits to the organization and their customers.
 

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UNIT EIGHT
COST VOLUME PROFIT ANALYSIS (CVP)

This chapter analyses the relationship between costs, volume of output or level of activity and profits.
The relationship helps firm to make viable and sound financial and production plans
CVP analysis is an analytical technique or tool that is used to study the behavior of profit in response to
changes in volume of output, costs and prices.

IMPORTANCE OF CVP ANALYSIS

1. It helps to determine the minimum sales volume required to avoid losses and the sales volume at
which the profit goal of the firm will be achieved
2. Helps management to predict and evaluate the implications of the firms short run decisions about
fixed costs, variable costs, volume and selling price for its profit plans on a continuous basis.
3. It helps the firm during the process of making pricing and sales volume decisions
4. It helps firms to formulate sales mix decisions where proportions of each product to be sold are
determined
5. Helps in formulating decisions regarding cost structure and production capacity of the firm.

BASIC PRINCIPLES OR ASSUMPTIONS OF CVP ANALYSIS

CVP analysis is based on the assumption of a linear total cost function (constant unit variable cost and
fixed costs) and therefore is an application of marginal costing principles which are summaries as
below;
i. Period fixed costs are a constant amount therefore if one extra unit of a product is made and
sold total costs will only rise by the variable cost (the marginal cost) of production and sales for
that unit.
ii. Total costs will fall by the variable cost per unit for each reduction by one unit in the level of
activity.
iii. The additional profit is earned by making and selling one extra unit.
iv. As the volume of activity uses, there will be an used in total profits or (a reduction in losses)
equal to total revenue minus total extra variable costs.
v. Total profit in a period is the total revenue minus total variable costs of goods sold minus fixed
costs of the period.
BASIS FOR CVP ANALYSIS
a) CONTRIBUTION
This is the difference between sales and the marginal cost of sales. It contributes towards fixed
expenses and profits.
It is the amount available to cover fixed costs and to provide profits foe the period
Contribution © = sales (s) – Variable costs (vc)
Or
C=FC +P

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Hence
C=FC =P
b) THE PROFIT –VOLUME RATIO/CONTRIBUTION RATIO
This is the relationship between contribution and sales
Contribution c
P/V ratio =
Sales s
Or
FC + P s−vc
or
S s
Or
Change∈profits∨contribution
Change∈sales
NB. The ratio can also be shown in form of percentages, if the above formulae are multiplied by 100.

c)BREAK – EVEN ANALYSIS

Break-even point represents that volume of production where total costs equal to total sales revenue
resulting into a no-profit no-loss situation.
If output of any product falls below that point there is loss; and if output exceeds that point there is
profit.

Break-even analysis establishes the relationship between revenues and costs with respect to volume. It
indicates the level of sales at which costs and revenues are in equilibrium.
The equilibrium point is known as Break even point (BEP)
BEP is a point at which total revenue is equal to total costs. It is a no profit no loss point.
¿ costs
Break even point =
Contribution
BEP can be ascertained using a chart
The BEP chart shows costs and revenue on Y –axis and the activity or output level on X-AXIS
The BEP chart can be used to show how total costs, fixed costs, variable costs and the revenue changes
as the level of output changes.

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of
activity shown on the same chart as the variation of income (or sales, revenue) with the same variation
in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is
represented on the chart below by the intersection of the two lines:

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In the diagram above, the line OA represents the variation of income at varying levels of production
activity ("output"). OB represents the total fixed costs in the business. As output increases, variable
costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output,
Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and
hence neither profit nor loss is made.

Example:
We can use the following data to calculate break-even point.
 Sales price per unit = $500
 variable cost per unit = $300
 Total fixed expenses = $70,000
Required: Calculate break-even point using equation method.
Solution:
BEP in units = fixed costs
Unit contribution
BEP = 70,000
500-300
BEP = 350 Units

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Graphical Representation (Break-even Chart )

The break even point in sales dollars can be computed by multiplying the break even level of unit sales
by the selling price per unit.
350 Units × $500 Per unit = $175,000

Example 2
ABC Limited produces and sells a single product and the unit variable production cost is 300/= and the
unit variable cost of selling is 100shs.
Fixed costs total is 600,000/= and the unit sales price is 600/=.
ABC limited budgets to make and sell 3600 units in the next year

Required;
Draw a BEP chart showing the expected output and sales volume required to break-even
Breakeven point in sales revenue/amount
¿ cost
BES =
p /v ratio

BEP in units or Quantity

FC
BEQ =
SP−VC
Where
FC is fixed costs, SP is the selling price and VC is the variable cost per unit

Assumptions Underlying Break-Even Analysis:

The break-even analysis is based on certain assumptions and these are presented below;
(i) All costs can be separated into fixed and variable components,
(ii) Fixed costs will remain constant at all volumes of output,

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(iii) Variable costs will fluctuate in direct proportion to volume of output,

(iv) Selling price will remain constant,
(v) Product-mix will remain unchanged,
(vi) The number of units of sales will coincide with the units produced so that there is no opening or
closing stock,
(vii) Productivity per worker will remain unchanged,
(viii) There will be no change in the general price level.

Uses / importance of Break-Even Analysis:

(i) It helps in the determination of selling price which will give the desired profits.
(ii) It helps in the fixation of sales volume to cover a given return on capital employed.
(iii) It helps in forecasting costs and profit as a result of change in volume.
(iv) It gives suggestions for shift in sales mix.
(v) It helps in making inter-firm comparison of profitability.
(vi) It helps in determination of costs and revenue at various levels of output.
(vii) It is an aid in management decision-making (e.g., make or buy, introducing a product etc.),
forecasting, long-term planning and maintaining profitability.
(viii) It reveals business strength and profit earning capacity of a concern without much difficulty and
effort.

Limitations of Break-Even Analysis / CVP Analysis:

a. Break-even analysis is based on the assumption that all costs and expenses can be clearly separated
into fixed and variable components. In practice, however, it may not be possible to achieve a clear-
cut division of costs into fixed and variable types.
b. It assumes that fixed costs remain constant at all levels of activity. It should be noted that fixed
costs tend to vary beyond a certain level of activity.
c. It assumes that variable costs vary proportionately with the volume of output. In practice, they
move, no doubt, in sympathy with volume of output, but not necessarily in direct proportions..
d. The assumption that selling price remains unchanged gives a straight revenue line which may not
be true. Selling price of a product depends upon certain factors like market demand and supply,
competition etc., so it, too, hardly remains constant.
e. The assumption that only one product is produced or that product mix will remain unchanged is
difficult to find in practice.
f. Apportionment of fixed cost over a variety of products poses a problem.
g. It assumes that the business conditions may not change which is not true.
h. It assumes that production and sales quantities are equal and there will be no change in opening
and closing stock of finished product, these do not hold good in practice.
i. The break-even analysis does not take into consideration the amount of capital employed in the
business. In fact, capital employed is an important determinant of the profitability of a concern.
j. Because of so many restrictive assumptions underlying the technique, computation of a breakeven
point is considered an approximation rather than a reality.

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d) MARGIN OF SAFETY
It is the difference between budgeted sales volume and the break-even level of sales.
It is simply a measurement of how far sales can fall short of budget before the business makes a loss.
It is usually expressed in terms of percentages of budgeted sales.
MOS = Budgeted or actual sales –Break even sales.
e) Operating leverage
It is a measure of the extent to which fixed costs is being used in an organization
Contribution
O.L =
Net income

Exercise
A company makes a single produce with a selling price of 40,000/= and unit variable cost of 24,000/=.
Fixed costs incurred include production costs of 80.000.000shs and administration costs of 40.000.000

Required
a) Calculate Break-even quantity
b) Contribution sales ratio or PV ratio
c) Break-even sales

TARGET PROFIT
To earn any amount of profit, the firm has to operate beyond BEP the units to be produced and sold in
order to get profits or desired profits are obtained as below.

Profit +¿ costs
Q=
selling price−variable cost (unit contribution)

FC + Profit
Q=
SP−VC

Example
Ken 2000 Ltd produces and sells a single product to its customers. The following data, relates to their
books as at 31.12.09

Annual fixed costs 10.000.000/=

Selling price per unit 20,000/=
Variable cost per unit
Production costs 9,000/=
Selling and distribution 7,000/=

A profit of 2,000,000/= is being planned

Required
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a) How many units should be produced and sold in order to get the desired profits
b) Determine the amount of sales that can be made to get the planned profit
To find sales that can be made to achieve a given level of profits, the following formula is applied.

FC + PROFIT
Sales =
C/ S ratio / pvratio
Where
C/S = contribution to sales ratio or profit volume ratio

TARGET PROFIT AFTER TAXATION

The desired goal of profits may be stated in terms of profit after taxes. In such cases, the following
formular is applied.

Desired profit
Amount of units to be produced = FC + 1−tax rate
SP−VC
Illustration
The company plans to earn an after tax profit of 1200, 000/= and that the income tax rate is 30%. The
unit selling price is 10,000/= and variable cost per unit is 6,000/= fixed costs of 20,000,000/= will be
incurred
Calculate
a) Units to be produced achieve the desired profit
b) Sales revenue to be obtained in order to get the desired profit.

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UNIT NINE
COSTING TECHINIQUES

The nature of costing can be looked at or analyzed by considering the two major techniques
which try to explain what constitutes the unit cost of the product or service. These include
Absorption costing and Marginal Costing technique.
The two techniques try to analyze how costs can be classified or related to the product
produced by the firm. But the most important matter here is whether or not to incorporate
fixed manufacturing overheads in the cost of the product. It is important to note that one
technique is used by management during product costing and stock valuation but not both.
Marginal /variable /direct costing /Contribution Approach
This is technique in which production units are valued at marginal cost of production i.e. only
those costs of production that varies with output are considered as product costs.
• This technique assigns only variable manufacturing costs to products and includes them
in the inventory valuation.
• This technique classifies costs according to their behavior, i.e. divides them into variable.
and fixed costs
• In this case, fixed costs are written off as period costs since they relate to accounting
periods but not units of output.
• Therefore they are charged against the profit in the period in which goods are
sold.
• Direct material, direct labour and variable manufacturing overhead costs are the product
costs and the fixed production and non production costs are taken as period costs.

Basic Terms Used

Gross contribution: Is the difference between sales and variable costs of sales.
Net contribution: Is the difference between gross contribution and non - production variable
costs. E.g. Variable selling and distribution costs
Decisions are made on the basis of net contribution not net profit. It is from this contribution
that fixed costs are met. Any surplus arising after fixed costs are met becomes the net profit.
Features of Marginal Costing:
i. This technique is used to ascertain the marginal cost and to know the impact of variable costs on
the volume of output.
ii. All costs are classified on the basis of variability into fixed cost and variable cost. Semi-variable
costs are segregated into fixed and variable costs.
iii. Marginal (i.e., variable) costs are treated as the cost of the product or service. Fixed costs are
charged to Costing Profit and Loss Account of the period in which they are incurred.
iv. Stock of finished goods and work-in-progress are valued on the basis of marginal costs.
v. Selling price is based on marginal cost plus contribution.
vi. Profit is calculated in the usual manner. When marginal cost is deducted from sales it gives rise to
contribution. When fixed cost is deducted from contribution it results in profit.
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vii. Break-even analysis and cost-volume profit analysis are integral parts of this technique.
viii. The relative profitability of products or departments is based on the contribution made available by
each department or product.

Advantages of Marginal Costing:

(i) The technique is simple to understand and easy to operate because it avoids the complexities
of apportionment of fixed costs which, is really, arbitrary.
(ii) It also avoids the carry forward of a portion of the current period’s fixed overhead to the
subsequent period. As such cost and profit are not vitiated. Cost comparisons become more
meaningful.
(iii) The technique provides useful data for managerial decision-making.
(iv) There is no problem of over or under-absorption of overheads.
(v) The impact of profit on sales fluctuations are clearly shown under marginal costing.
(vi) The technique can be used along with other techniques such as budgetary control and standard
costing.
(vii) It establishes a clear relationship between cost, sales and volume of output and breakeven
analysis.
(viii) It shows the relative contributions to profit which are made by each of a number of products,
and shows where the sales effort should be concentrated.
(ix) Stock of finished goods and work-in-progress are valued at marginal cost, which is uniform.
Limitations of Marginal Costing:
(i) Segregation of costs into fixed and variable elements involves considerable technical difficulty.
(ii) The linear relationship between output and variable costs may not be true at different levels of
activity. In reality, neither the fixed costs remain constant nor do the variable costs vary in proportion
to the level of activity.
(iii) The value of stock cannot be accepted by taxation authorities since it deflates profit.
(iv) This technique cannot be applied in the case of contract costing where the value of work-in-
progress will always be high.
(v) This technique also cannot be used in the case of cost plus contracts unless fixed costs and profits
are considered.
(vi) Pricing decisions cannot be based on contribution alone.
(vii) The elimination of fixed costs renders cost comparison of jobs difficult.
(viii) The distinction between fixed and variable costs holds good only in the short run. In the long run,
however, all costs are variable.
(ix) With the increased use of automatic machinery, the proportion of fixed costs increases. A system
which ignores fixed costs is, therefore, less effective.
(x) The technique need not be considered to be unique from the point of cost control.

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Application of Marginal Costing–

1) Profit Planning
Profit planning involves forecasting activity level in order to gain or maintain specified amount of
profit. Under profit planning start is made from the end result. Profit figure is planned and activity
level necessary for yielding that profit is attempted. It should be noted that the activity level will
involve working out how that level will yield specified profit. In this exercise sale, cost and
production activities are all reviewed in harmony with each other to determine how they will yield
the desired profit figure.

2) Presentation of cost data for control purpose

Under marginal costing cost data is presented in such a way that it confirms to all the requirements
of management to effect control. Data presentation is based on the behavioural study of cost. This
leads the management to exercise better control over the cost. Under absorption costing cost data
may be misleading for the purpose of decision making.

3) Make or Buy decision

Decision to make or buy should involve comparison of seller’s price with marginal cost of that
component. But this approach will lead to wrong conclusion. When a component is produced, a art
of plant capacity is utilized, i.e. some contribution is earned. If a company is running at its full
capacity the contribution thus earned will be lost by not manufacturing the component. But this
approach will lead to wrong conclusion. When a component is produced a part of plant capacity is
utilized,i.e. some contribution is earned. If a company is running at full capacity the contribution
thus earned will be lost by not manufacturing the component. Of course, if company is not working
at its full capacity the question of lost contribution will become another factor of consideration

4) Optimizing the product mix

When a concern manufactures a number of products, a problem arises as to which product or sale
mix will yield maximum profit. Such a problem can be solved by marginal contribution analysis.
Product mix, which gives the maximum contribution, will be the optimum mix.

5) Alternative use of production facilities

When an alternative method of manufacturing a product or alternative is available, marginal
contribution analysis should be made to arrive at the decision. The alternative yielding the highest
contribution will be selected.
6) Evaluation of performance
A company may have different departments or product lines. All these departments and product
lines may have different revenue earning potential. A company always concentrates on the
departments or the product lines which yield more contribution than others. The relative
performance of each department or product is studied by marginal contribution analysis. This
analysis will help the company to take decision that will maximize the profits.

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ABSORPTION COSTING
It is a costing technique where all normal costs whether it is variable or fixed costs are charged to cost
units produced.
 It is a costing technique in which production units are valued at full costs of production i.e.
variable production costs plus fixed production costs.
 Thus all costs are absorbed into production. The operating statements do not distinguish
between fixed and variable costs.
 Consequently the valuation of stocks and work - in - progress contains both fixed and variable
elements.
 Fixed manufacturing costs are allocated or absorbed in the process using either activity based or
traditional absorption methods.
 In this case they lead to over or under absorption. Over - absorbed overheads are usually added
to the profit while under absorbed overheads are deducted from the profit in order to arrive at
the adjusted profit.
 Non production costs (variable and fixed) are written off in total during the period.
Note:
 When actual production is greater than budgeted production, then over- absorption occurs.
 When actual production is less than budgeted production, then under - absorption occurs.
The amount of the over or under absorption is the difference between actual and budgeted output with
the fixed overhead absorption rate i.e. (Budgeted production - Actual production) x F.O. A.R =
Amount of under /over absorption overheads.

Advantages of Absorption Costing:

1. Absorption costing recognizes the importance of including fixed production costs in product cost
determination and in determining a suitable pricing policy. The pricing based on absorption costing
similarly ensures that all costs are covered.
2. Absorption costing conforms to accrual and matching accounting concepts which requires matching
costs with revenue for a particular accounting period.
3. Absorption costing avoids the separation of costs into fixed and variable elements which cannot be
easily and accurately done.
4. The presentation of under- absorption and over-absorption of factory overheads in absorption costing
discloses inefficient or efficient utilisation of production resources which is not possible in variable
costing.
5. The allocation and apportionment of fixed factory overheads to cost centres or departments makes
managers more aware and responsible for the costs and services provided to their centres/departments.
Limitations of Absorption costing
1. Many accountants argue that fixed costs, whether related to manufacturing or to selling and
administration, are period costs which produce no future benefits and therefore, should not be included
in the cost of the product and inventory.
2. The validity of product costs determined under absorption costing depends upon the appropriateness
of apportionment of overhead costs in a reasonably correct manner. But in practice, many overhead
costs are apportioned by using arbitrary methods. The resulting costs figures, therefore, are doubtful
and if included in the costs of products can make the product costs inaccurate and unreliable.

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3. Absorption costing is not helpful to management in decision making. Various types of managerial
problems, such as selection of production volume and optimum capacity utilization, selection of
product-mix, whether to buy or manufacture, evaluation of performance, choice of alternatives can be
solved only with the help of variable costing analysis.
4. Absorption costing is not helpful in control of costs and planning and control function. It is not
useful in fixing the responsibility for incurrence of costs. It is not practical to hold a manager
accountable for costs over which he has no control. Once he learns that he cannot control part of the
costs with which he is charged, his sense of responsibility for controlling his direct cost somehow
seems to weaken. Allocating indirect costs also distorts results of operations besides complicating
control and decision-making. Distortion occurs because different bases of apportionment produce
different allocation to products and affect different results.

Example

Kayemba ltd is a splash manufacturing company located in Mbuya has provided you with the following
data that related to its undertaking for the two years of 2014 and 2015
Year 1, 2014 Ugx
Selling price per carton 30,000
Cartons sold during the year 800
Cartons sold during the year 1,000
Total direct labor and direct materials costs per carton 7,000
Variable overheads per carton amounted to 5,000
Total fixed factory overheads during the years amounted to 5,000,000
Selling and distribution costs per carton 5,000
Fixed administrative overheads 2,500,000
Opening stock units were 200 valued on the above cost structure
Year 2, 2015 Ugx
Selling price per carton 31,000
Cartons sold during the year 1,000
Cartons produced during the year 1,300
Total direct labor and direct material costs per carton 7,000
Variable overheads per carton amounted to 5,000
Total fixed factory overheads during the year amounted to 5,000,000
Selling and distribution cost per carton 5,500
Fixed administrative overheads 2,500,000

Required:
Prepare kasumbaLtd’s profit statement using
(i) Marginal costing technical for the year 2014 and 2015
(ii) Absorption costing technique for the year 2014 and 2015
(iii) Reconcile the profits

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