MERU UNIVERSITY OF SCENCE AND TECHNOLOGY

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

BFC 3227: COST ACCOUNTING

COURSE OUTLINE
Credit Hours: 3 Credits
Contact Hours: 45 HOURS
Prerequisite: Financial Accounting II

Course Purpose
This course is designed to help the students develop knowledge and understanding of how to prepare and process basic cost
and quantitative information to support management in planning and decision-making in a variety of business contexts.
Technical aspects of cost accounting will be taught in the course. Emphasis will be placed on the students’ ability to apply
the technical aspects of cost accounting to business decisions and problem solving.

Course Objectives
On successful completion of this paper, candidates should be able to:
i. Explain the nature and purpose of cost accounting
ii. Describe costs classification on different basis
iii. Explain and apply cost accounting techniques
iv. Prepare and coordinate budgets and budgetary control for planning, feedback and control
v. Use management accounting techniques to make and support decision-making.

Course Content

Week Topics Content Time

(Hours)
1-2 The nature and purpose of cost  The nature and scope of cost accounting 6
accounting  The purpose of cost accounting
information
 Relationship between cost accounting
and financial accounting
 Cost terms and concepts
3-5 Cost accumulation  Elements of cost: materials, Labour and 9
Overheads
 Ascertainment of material cost
 Labour costing
 Overheads
 Service department cost allocation and
apportionment
 Overhead analysis
 Overhead absorption rates
 Over and under absorption
6 CAT 1 3

7-10 Costing Methods  Job costing 9

 Contract costing
 Batch costing

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 Week Topics Content Time
(Hours)
 Operation costing
 Process costing
 Service costing
11 CAT 2 3

12 Budgeting  Nature and purpose of budgeting 6

 Types of budgets
 Functional budgets
 Cash Budgeting
 Flexible budgets
 Zero based Budgeting
13-14 FINAL EXAMINATION 2

Delivery Methods and Learning Evaluation

Case analysis will form a key component of quizzes, assignments, and exams. Classes will include both lectures, and,
discussion on material that students will have prepared for ahead of time, or material that will be presented in the class.
Grades will be based on class participation, case assignments, and a final exam as follows:
 Class participation 10%
 Case assignments 20%
 Final examination 70%
 Total 100%

Recommended Course Materials

Charles Horngren, Srikant Datar and George Foster, “Cost Accounting: A Managerial Emphasis,” 12th edition
(Prentice-Hall, 2005).

Drury C: Management and Cost Accounting, Book power Publishing, current Edition

Horngren C.T and Foster, C; Cost Accounting – A Managerial Emphasis, 8th Edition

Horngren, C.T and Sunder G. L: Introduction to Management Accounting, Prentice- Hall, 7th Edition

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1.0 NATURE AND SIGNIFICANCE OF COST ACCOUNTING

Objectives:
At the end of this topic, students should be able to:
o Describe the nature of cost and various ways in which cost may be classified
o Explain various users of accounting information and their respective information needs
o Prepare a manufacturing cost statement and a profit statement.

1.1 Definition of Cost Accounting

Cost accounting has been defined by many accounting scholars in various forums.

Cost accounting is a branch of accounting that is involved in the classification, recording and ascertainment of
costs of producing a given product or the cost of providing the service. Cost accounting is a quantitative
method that accumulates, classifies, summarizes and interprets information for the following three major
purpose
 Operational planning and control
 Special decisions
 Product decisions

“That part of management accounting which establishes budgets and standard costs and actual costs of
operations, processes, departments or products and the analysis of variances, profitability or social use of
funds” (Chartered Institute of Management Accountants - CIMA)

“That which identities, defines, measures, reports and analyses the various elements of direct and indirect
costs associated with producing and marketing goods and services. Cost accounting also measures
performance, product quality and productivity” (Letricia Gayle Rayburn)

“A systematic process of collecting, summarizing and recording data regarding the various resources and
activities in a firm so as to calculate the basis of production costs used in financial accounting or making other
relevant decisions in a firm (Horngren C.T)
Cost accounting is broad and extends beyond calculating production costs for inventory valuation, which
government-reporting requirements largely dictate. However accountants do not allow external reporting
requirements to determine how they measure and control internal organizations activities. In fact, cost accounting
focus is shifting from inventory valuation for financial reporting to costing for decision making.
The main objective of cost accounting is communicating financial information to management for planning,
evaluating and controlling performance, and also to assist management to make more informed decisions. Its
data is used by managers to guide their decisions.

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1.2 The Users of Accounting Information
These include but not limited to the following:

The various users and their respective need for information can be described as below:
 The management:-they need to compare their performance with the previous years and with other
similar businesses so as to identify areas where urgent action nee to be taken to safeguard the interest
of the business. They require information for decision making and control activities e.g. information is
needed on the estimated selling price, costs, demand profitability of various products that are made by
the organization.
 Shareholders:- they need to know whether their funds are invested wisely.
 Government:- the revenue authority will need information on the amount of profit that is subject to
taxation. In addition, the central statistical office will collect accounting information and require such
information such as sales activity, profits, investments, stock, dividends paid etc for determining
policies to manage the economy.
 Potential investors: -they need to make decisions such as which shares to buy.
 Financiers:- To know whether the business is in a position to meet their claims.
 Employees:- require information on the ability of the firm to meet wage demands and avoid
redundancies.

An examination of the various users of accounting information indicates that they can be divided into two
categories:
 Internal parties within the organization
 External parties such as shareholders, creditors and regulatory agencies, outside the business.

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Consequently, there are two branches of Accounting that reflect the internal and the external users of accounting
information: These are Management and Financial Accounting.

Management Accounting is concerned with the provision of information to people within the organization to help
them make better decisions and improve the efficiency and effectiveness of existing operations. Management
accounting is an integral part of management concerned with identifying, presenting and interpreting information
used for formulating strategy , planning and controlling activities, decision making, optimism, use of resources,
disclosure to intended parties and safeguarding assets.

On the other side, Financial Accounting information is concerned with the provision of information to the
external parties outside the organization. In other words, Financial accounting is a branch of accounting that
organizes accounting information for presentation to interested parties outside the business through financial
statements (profit & Loss account, Cash flow statement) discussing financial position and operating results of a
business.

Management accounting is defined as an integral part of management concerned with identifying, presenting and
interpreting information used for:
 Formulating strategy
 Planning and controlling activities
 Decision taking
 Optimizing the use of resources
 Disclosure to shareholders and others external to the entity
 Disclosure to employees
 Safeguarding assets.

There are similarities between the objectives of both management and cost accounting and indeed in practice
there is no true dividing line. In general, Management accounting is wider in scope and uses more advanced
techniques. However, it requires a sound costing system to provide basic data. Both management accounting and
cost accounting are in the main concerned with the provision of information (often in great detail) for internal
planning, control and decision making purposes with considerable emphasis on the costs of functions, activities,
processes and products.

Cost accounting has been defined as that part of management accounting which establishes budgets and standards
costs and actual costs of operation, processes, departments or products and analysis of the variances, profitability
or social use of funds.

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 1.2 Differences between Financial and Cost Accounting
Point of Financial Accounting Cost Accounting
Distinction
1 Origin Since 1494, double entry and From 19th Century
bookkeeping has been practiced
2 Purpose To prepare financial statements To provide details of cost
i.e. P&L, B/Sheet, Cash flow information
statement etc.
3 Target Group Owners, Government, Investors, Management cost accounting
Lenders, Management etc. information i.e private and
confidential
4 Statutory Preparation of financial Maintenance of cost information
requirement statements ie. A legal is voluntary
requirement of the company’s
Act of Cap 486
5 Analysis of cost Financial statements show profit Shows detailed cost data of each
and profits and loss for a period of activity product or department
6 Periodicity of Financial statements are usually Preparation of cost statements is
reporting prepared periodically eg. a continuous process eg. Daily,
Annually, semi annually or weekly, monthly or as required
quarterly by the management.
7 Nature of records Concerned with historical Concerned with historical costs,
records present costs as well as pre
determined costs (future costs)
8 Auditing It a requirement for public No such requirement
requirements limited companies to have their
books audited

1.4 Overlap of Financial Accounting and Cost Accounting (Similarities)

i. In both branches of accounting, accounting is developed within the same accounting information system
that accumulates and classifies raw data and generates statements for the management.
ii. The manner in which the accountants measure the components of cost, assign cost periods and allocate
costs to segments or departments is similar I both branches of accounting.
iii. The two accounting systems are applicable to all forms of businesses i.e. Product and service business
iv. In both branches of accounting, financial reports about the firm’s activities are produced.
v. An accountant ca n serve as a financial accountant or a cost accountant or both at the same time

1.5 Objectives of Cost Accounting

i. Ascertainment of cost:
The cost of production is relevant when determining the selling price of a product or a service.
Selling price = cost + profit
ii. Determining profitability of the products
In cost accounting, revenue and costs will be presented for each product and it will be possible to find out
the profitable product and the ones which are not profitable to be discontinued.

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 iii. Cost control
Reports for each department on product are prepared and the actual cost is compared with the expected
cost. Any variances are identified and analyzed.
iv. Detection of wastage
Using the cost data, there will be figures showing the expected quantity of output. The actual quantity
will be compared with the expected quantity of output and the difference will help in identifying
wastages.
v. Evaluation of the efficiency of the firm
When cost are computed for each product and section it will be possible to make a comparison from one
month to the other to determine efficiency and improve on any poor performance.
vi. Making special decision and investigations
The cost accountant will be required to select information which will be required in making special
decisions e.g. whether to replace the old machine with a new one, whether to make a product or buy it,
whether to change the selling price e.t.c.
vii. Facilitating preparation of financial statements
The financial statements e.g. the profit and loss account will be prepared using some of the cost
accounting information e.g. the expenses in the profit and loss account are the costs in cost accounting.

1.6 Definition of Common Cost Accounting Terms

Cost
This is the total expenditure incurred on a specific item or activity. It is the value of economic resources
used in production of a product or provision of a certain service. It is the amount of resources given up to
obtain a good or a service.

Cost unit
This is a quantitative unit of a product, time or service in relation to which cost may be ascertained eg. A
kilogram of sugar, a litre of milk, a tone of sand etc. It can be a unit of service like a passenger seat, a
patient bed, etc

Cost object
To guide their decisions, managers want to know how much a particular thing such as a product, a service a
process etc costs thus a cost object is anything for which a separate measurement of cost is designed.
Examples of cost object
- Product - Department
- Customer - Project

Cost center:
It’s a location, person or an equipment for which cost may be ascertained and used for purposes of cost
control and accountability by those responsible for them.
A cost center is a business segment whose manager has control over costs but not over revenue or
investment funds. Service departments such as accounting, finance, general administration, legal,
personnel and so on, are usually considered to be cost centers. In addition, manufacturing facilities are
often considered to be cost centers. The managers of cost centers are usually expected to minimize the
costs while providing the level of services or the amount of products demanded by the other parts of the
organization. For example, the manager of a production facility would be evaluated at least in part by
comparing actual costs to how much costs should have been for the actual number of good units produced
during the period. Standard costing and variance analysis page deals this evaluation of the performance of
cost centers in detail.

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Profit center:
A profit center is any business segment whose manager has control over both cost and revenue. Like a
cost center, a profit center generally does not have control over investment funds. Profit center managers
are often evaluated by comparing actual profit to targeted or budgeted profit. Segmented income
statements should be used to evaluate the performance of profit center managers.

Investment center:
An investment center is any segment of an organization whose manager has control over cost, revenue
and investments in operating assets. Investment centers are usually evaluated using return on investment
or residual income measures.

Responsibility Center:
Responsibility center is broadly defined as any part of an organization whose manager has control over
cost, revenue, or investment funds. Cost centers, profit centers and investment centers are all known as
responsibility centers.

Cost Driver
← Its an activity that makes an organization incur cost. An activity can have more than one cost driver
attached to it. For example, a production activity may have the following associated cost-drivers: a
machine, machine operator(s), floor space occupied, power consumed, and the quantity of waste and/or
rejected output

Costing
Costing is ascertainment of costs. The value of resources required to produce any commodity / provide
any service is called cost. The costs should be recorded, charged to the relevant jobs and presented to
management for decision making. This helps evaluate the performance of the organization. The costing
deals with all aspects of cash ascertainment.

Cost accounting
Cost accounting has a wider scope than costing. The main objective of cost accounting are to establish
budgeted and standards cost and to analyze the variances between actual and budgeted results. Thus
costing is part of cost accounting which covers costing techniques in addition to cost ascertainment.

1.7 Costing Systems

This is a combination of procedures, records, rules etc designed to provide various types of information
required by the management in conducting operations of an organization

1.7.1 Factors to Consider Before Installing a Cost Accounting System

i. Preliminary investigations should be made before installing cost system e.g. Type of business, the nature
of the products, method of production etc. in order to determine the type of costing system to be applied.
ii. The organization structure of a business should be studied to ascertain the scope of authority with
minimum change in the existing structure.
iii. The method of purchases, storage and issue of materials should be examined and improved where
necessary.

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 iv. Design forms and accounting records which involve minimal clerical work and expenditure.
v. The existing records of remuneration labor, recruitment and the keeping of employees records should be
analyzed and imposed where necessary.
vi. The system installed should be simple and easy to operate
vii. The system should be introduced gradually.

1.7.2 Advantages of Cost Accounting Systems

i. Helps in cost control
ii. It helps in decision making
iii. It guides in fixing of selling prices
iv. It reveals idle capacity either machines or staff who receive payment yet they don’t exist
v. It checks the accuracy of financial account especially in issues of cost
vi. Benefits the employees in terms of motivation, remuneration and improved working conditions
vii. It reveals profitable and non profitable activities / products

1.7.3 Difficulties in Installation of Cost Accounting System

i. Resistance from accounting staff due to increased work.
ii. Lack of support from top management
iii. Non Co-operation from working and supervisory staff

1.8 Classification of Costs

This involves the grouping of related costs under different basis

1.8.1 Purpose of Cost Classification

i. To facilitate cost predictions
There is need to forecast the cost expected to be incurred in a business organization prediction facilities
budgeting and hence cost control

ii. Managerial Efficiency

Cost classification enables the grouping of costs that a manager can control, managers are said to be
efficient if they can control costs which fall within their discretion.

iii. To facilitate cost allocation

Cost allocation is the charging of costs to a specific department which incurred the cost. Allocation is
only possible if costs are properly classified and summarized in their rightful categories.

iv. Ascertainment of profits

The concept of profit is judged as gross, net or retained. Costs must be appropriately classified to
facilitate the computation of the above profit concept

v. To facilitate cost control

By understanding what causes cost and the behavior of cost, managers are able to control the cost that
fall within their discretion.

1.8.2 Bases of Cost Classification

i. Classification based on the nature of cost
Manufacturing based on the nature of costs
These are costs incurred in production of goods and services e.g. Cost of raw materials, factory labor
and manufacturing overheads (OH)

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 Non manufacturing costs
These are costs which are not incurred in the production of goods and services but are incurred in
activities other than production e.g. Selling and distribution costs, administration cost etc.
ii. Classification based on traceability to the cost units.
Direct costs
These are costs that are directly associated with the cost units e.g. Direct materials, direct labor and
other direct expenses – prime cost
Indirect cost
These cannot be identified with the products. They are also called overheads e.g. Manufacturing
overheads, selling and distribution overheads as well as administrative overheads.
iii. Classification based on controllability
Controllable costs
These are costs which fall within managers discretion and therefore the costs can be influenced by
the manager
Semi controllable costs
These are costs that the management have partial control e.g. Salaries of unionizable workers which
are determined by the management in agreement with the trade unions
Uncontrollable costs
These are costs that managers cannot influence at their own discretion eg. Taxes, licenses, pension
contribution etc.

iv. Classification based on the behavior with output

Variable Cost Behaviour

There are two main divisions of variable cost patterns ie. Linear and non linear (curvilinear)

a) Linear Variable Cost

Is where the relationship between variable cost and output can be shown as a straight line on a graph

C
O
S
T

OUTPUT OUTPUT OUTPUT

For calculations and analysis, its usually more convenient to express the linear relationship algebraically this:

Cost = bx where x=volume of output in units

b=a constant representing variable cost per unit e.g. Linear variable cost
The materials contained in each assembly C530 are
3 Brackets @ sh 125 each
30 Screws @ sh 2 each
6 pulleys @ sh 67 each

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 What is the expected variable cost of materials for producing 40 assemblies?

Solution
Material Cost/ Assembly
3 X 125 375
30 X 2 60
6 X 67 402
Variable cost/assembly 837

Cost = bx
= sh 837 X 40
= sh 3348

b) Non linear/ Curvilinear Variable Costs

In general where the relationship between variable cost and output can be shown as a curved line on a graph, it
would be said to be curvilinear. Two typical curvilinear variable costs or convex and concave
Convex Concave
C C
O O
S S
T T

OUTPUT OUTPUT

Convex Where each extra unit of output causes a less than proportionate increase in cost
Concave Where each extra unit of output causes a more the proportionate increase in cost eg. Where a
piecework scheme for individual workers with differential rates. If rates increased by small
amount at progressively higher output levels the graphing of wages for a number of workers
would result in a concave cost function
Other statistical function which may represent such a cost function is compound interest curve.

Illustration
Analysis of cost and activity records for a project show that the variable cost can be accurately represented by
the function

Cost = (bx + cx2 + dx3)

Where b = 8, c = 0.5 and d = 0.03
Calculate
(i) Variable cost when production is 10 units
(ii) Variable cost when production is 15 units
Is the function convex or concave?

(i) Cost = 8 x 10 + 0.5 x 102 + 0.03 x 103

= 160
(ii) Cost = 8 x 15 + 0.5 x 152 + 0.03 x 153
= 333.75

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 It will be seen that the increase from 10 to 15 units results in more that a doubling of variable cost. This shows
there’s a more than appropriate increase in the unit cost of extra production so that the function is concave.

1.9.2 Fixed cost

It’s a cost which is incurred for a period which within certain output and turnover limits, tends to be unaffected
by fluctuations I the levels of activity (output or turnover)e.g., rent rates, insurance, salaries of executives.

An alternative term for fixed cost is period cost

C
O Costs assumed to be constant
S at all level of activity
T

OUTPUT

Fixed cost can be expressed algebraically: Cost = a where a is a constant

1.9.3 Semi variable costs ( also semi fixed or mixed costs)

- It’s a cost containing both fixed and variable components and which is thus partly affected by fluctuation
in the level of activity.
- Rarely is a cost purely fixed or purely variable, frequently there are elements of both classifications in a
cost e.g. Electricity changes contain a fixed element, the standing charge and a variable element , the cost
per unit consumed.
- They can be shown graphically as follows:

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 Linear Convex Concave

a a a

a = Fixed cost

- It can expressed algebraically as:

(1)Linear semi variable : Cost = a + bx
(2)Curvilinear semi variable: Cost = a + bx + cx2 + dx3 …….+ function

Illustration
Analysis of maintenance department cost shows that there is a fixed element of 500 per month and a variable
element related to machine hours amounting to 2.25 per machine hour.
What is the expected cost for a month when the planned activity level is
(i) 1500 machine hour
(ii) 1800 machine hours

Solution
(i) Total cost = a + bx
= 500 + 2.25 (1500)
= 3875
(ii) Total cost = 500 + 2.25 (1800)
= 4550

v. Classification based on function

Production costs
These are costs incurred in the factory whether direct or indirect eg prime cost, depreciation of the
factory, power and electricity used in the factory, factory insurance et c.
Selling and distribution costs
These are costs incurred in transferring finished goods to the customers eg. Sales men commission,
salaries of marketing staff, advertising, discounts, depreciation of delivery vans, warehousing costs,
carriage outwards etc.
Administration cost
These are costs incurred in the management and running of the business eg salaries of general
managers, accountants, secretaries, finance costs such as interest charged and bank charges etc.

vi. Classification based on avoidability of costs

Avoidable costs
These are specific costs of an activity or segment which will not be incurred if the segment was
discontinued e.g. Cost of raw materials use to produce a product where production has been
discontinued.q2
Unavoidable costs
These are costs that must be incurred e.g. Payment required in a valid contractual commitment.

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 vii. Classification based on the relevance of the decision making
Relevant costs
These are costs that ca n be changed by the decision of the management. When management makes
financial decisions regarding future opportunities, such as cost are relevant because they ca n be
altered by the management.
Irrelevant costs
These are costs not affected by the decision of the management e.g. Current fixed costs such costs
should be ignored when making a decision.
viii. Classification based on the time period the cost is incurred
Product costs
These are costs incurred in purchasing or manufacturing inventory, they can be identified with the
goods purchased or produced.
Period costs
These are costs not assigned to productive activity expressed in the time period to which they are
charged to the profit and loss as expenses.

ix. Classification based on the managerial discretion

Discretionary cost
These are fixed costs that are reversible after a short period of time eg. Rent on the factory building,
advertising costs etc.
Committed costs
These are fixed costs that continue for a long period of time they are also called non discretionary
costs eg. Cost of constructing a factory plant, a long-term lease for a machine etc.
Prime costs
This is equal to direct materials + Direct labor + Direct expenses

1.8.3 OTHER CONCEPTS OF COST

i. Conversion Costs
These is the total direct labor and manufacturing overheads
ii. Opportunity costs
This is the value of any opportunity a person foregoes to engage in an alternative activity
iii. Shut down/ Sunk costs
Shut down costs are costs incurred when production is not going on eg. Due to lack of raw
material, examples of shutdown costs include rent and insurance of buildings, depreciation
etc. sunk costs are historic or post costs which have already been incurred.
iv. Out of pocket costs
These are costs which that will vary with the decision made.

v. Joint costs
This is a common cost . when two or more products are produced out of one material or
process, the cost of the raw material will be a joint stock
vi. Research and development costs
This is a cost of searching for new improved products, new application of materials or new
improved methods of processing

1.90 Elements of Costs

Cost elements are categorized into three ie.
i. Direct material
ii. Direct Labor
iii. Direct expenses

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Direct materials
These are the costs of raw materials that can be economically identified with each unit of the finished
product eg. Paper used to make a book. The cost of raw materials that cannot be directly identified with a
product is the indirect material eg. Glue used in making a book, paint used on a stool. Indirect materials
are treated as manufacturing overheads

Direct Labor
This represents the payroll costs of production workers who are directly employed and work in the finished
product. Direct labour cost include wages to the factory workers NSSF , NHIF borne by the company.
Indirect labour cost include foreman salaries, supervisors wages, factory cleaning staff, production &
administration wages and salaries etc. indirect labour is considered as a manufacturing overhead.

Direct expenses
These are other costs apart from direct materials and direct labour which are capable of being identified
economically with the finished product eg. Royalties paid per product, the cost of hiring specialized
equipment and tools, cost of purchasing specialized equipment tools cost of hiring specialized labour

Manufacturing overheads/ factory costs

All other costs which cannot be identified economically with the finished products although they are
incurred the manufacturing process are called manufacturing overhead. In other words, the sum of all
indirect cost is referred to as manufacturing overhead.

1.11 Preparation of a Manufacturing Cost Statement

This is a statement that shows the total cost incurred by a business within a specified period of time
Format
shs shs
Cost of raw materials
Opening stock raw material XXX
Add purchases raw material XXX
Carriage inwards raw material XXX
XXX
Less Return outwards raw material (XXX) XXX
Total cost of raw material XXX
Less closing stock of raw material (XXX)
Cost of raw material in production XXX
Add direct labor XXX
Add direct expenses XXX
Prime cost XXX
Opening work in progress XXX
Less closing work in progress (XXX) XXX
XXX
Factory/Manufacturing/Production Overheads
Factory rent XXX
Depreciation of plant XXX
Depreciation of factory building XXX
Factory cleaning XXX
Factory electricity XXX XXX
Total cost of production XXX
Selling and distribution cost XXX
Administration cost XXX

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Total cost incurred XXX

NB: When a profit and loss account has to be prepared, the selling and distribution costs as well as the
administration cost must be expensed in the profit and loss therefore, the manufacturing cost statement will end at
the point where the total cost of production is obtained.

Illustration
The following information is obtained from the books of Juhudi ltd for the year ended 31st December, 2006
Stocks 1st January 2016 “000”
Raw materials 48
Work in progress 9.8
Finished goods 120
Wages paid to factory workers 148
Factory insurance 52
Plant balance1st Jan 2016 400
Factory rent 180
Cleaning costs 200
Purchases of raw materials 350
Stocks as at 31st December 2016
Raw materials 21
Work in progress 8
Carriage on raw materials 42
Returns of raw materials to suppliers 6.2
Salary of marketing manager 200
Fixed administration expenses 140
Salesmen commission 60

Additional information
i. Out of the wages paid to the workers, 90% is considered direct
ii. Cleaning costs should be apportioned as follows; 70% factory
20% warehouse
10% office
iii. Depreciation n on plant should be provided at the rate of 20% of the plant balance on 1st January 2016
iv. Factory rent accrued on 31st December 2016 was shs 120,000/=
Required
Prepare a manufacturing cost statement for the year ended 31st December 2016

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 Juhudi Limited
Manufacturing Cost Statement
for the year ended 31ST December 2016

Sh 000 Sh 000
Cost of raw materials
Opening stock of raw materials 48
Add purchases of raw material 350
Carriage inwards of raw material 42
392
less return inwards of raw materials (6.2) 385.8
Total cost of raw materials 433.8
Less closing stock raw materials (21)
Cost of raw materials used in production 412.8
Add direct labour 133.2 133.2
Prime cost 546
Opening work in progress 9.8
Less closing work in progress (8) 1.8
547.8
Production/factory overhead cost
factory rent (18,000+120,000) 300
Depreciation on plant 80
Indirect labour(10%X148) 14.8
Factory Insurance 52
Cleaning cost (70%X200) 140 586.8
Total cost of production 1134.6
Selling& distribution cost
Cleaning cost warehouse (20% X 200) 40
Salary of marketing manager 200
Sales men commission 60 300
Administration cost: 000 000
Cleaning cost of office (10%X200) 20
Fixed administration cost 140 160
Total costs incurred 1594.6

Illustration 2
Given the information in illustration 1, determine the total cost per unit and the selling price per unit assuming
(a) The firm produced 1000 units
(b) The business needs to make a profit of 20% on cost

Solution:
(a) Cost per unit = total cost incurred
Units produced
Cost /unit = 1,594,600
1000 = 1,594.6shs

(b) Selling price per unit= total sales/Unit sold

Total sales = 1,594,600 + (20% X 1,594,600) = 1,913,520

 selling price per unit = 1,913,520/1,000 = 1,913.52 shs

Wachira A.K. 17 M.U.S.T. - BFC 3227

Illustration
The following balances remained in the books of Ujuzi Ltd and manufacturing co for the year ended 30 th
November 2015
Stocks 1st December 2014 000
Raw materials 500
Working in progress 200
Finished goods 1,500
Purchase of raw materials 4,000
Return outwards raw materials 50
Repairs to factory building 250
Salaries & wages
Factory workers 900
Sales men 180
Administration staff 420
Insurance 500
Royalties paid 200
Depreciation on plant 120
Depreciation on buildings 400
Advertising expenses 40
Discount allowed 5
Cleaning expenses of the building 15
Bank charges 14
Depreciation delivery van 26
Stocks on 30th November 2015
Raw materials 480
Work in progress 300
Finished goods 1,200
Rent 2,000
Direct expenses 230
Sales 12,000
Sales returns 500

Additional information
(i) The factory building has been damaged as result of faulty electricity wiring. A provision of shs 100,000
is required for the repairs.
(ii) The company building occupies an area of 10,000m 2 of this area the factory occupies 5,000 m 2,
warehouse occupies 2,000 m2 and the rest is occupied by administration office
(iii) Prepaid insurance amounted to shs 50,000 at the end of the year. Insurance is apportioned in the ration
2:2:1 to the factory, warehouse and offices respectively.
(iv) A provision of shs 50,000 needs to be made for a bonus payable to the factory supervisors
Required
(a) Manufacturing cost statement
(b) Trading profit and loss account for the year ended 30th November 2015

Wachira A.K. 18 M.U.S.T. - BFC 3227

 Ujuzi ltd
Manufacturing Cost Statement
for the year ended 30th November 2005

sh 000 Sh 000
Cost of raw material
Opening stock raw materials 500
Add purchases of raw materials 4000
Less return outward raw material (50) 3950
To tal cost of raw materials 4450
Less closing stock raw material (480)
Cost of raw materials used in production 3970
Add direct labour 900
Direct expenses 230
Royalties paid 200 1330
Prime cost 5300
Opening work in progress 200
Less closing work in progress (300) (100)
5200
Production/factory overhead
Repairs to factory building ( 250+100) 350
Insurance(500-50=450) (2/3 X 450) 180
Depreciation on plant 120
Depreciatin on building (5000/10000X400) 200
Cleaning expenses of building(5000/1000x15) 7.5
Rent (5000/1000x2000) 1000
Bonus factory supervisors 50 1907.5
Total cost of production 7107.5

Ujuzi ltd
Trading profit & loss account
For the year ended 30th November 2005
Sh Sh
Sales of finished goods 12000
Less sales returns (500) 11500

Cost of sales
Opening stock of finished goods 1500
Add cost of production 1707.5
8607.5
Less closing stock of finished goods (1200) (7407.5)
Gross profit 4092.5

Wachira A.K. 19 M.U.S.T. - BFC 3227

Selling and Distribution Expenses
Rent (2000/1000x2000) 400
Sales men commission 180
Insurance (2/5x450) 180
Dep. Building (2000/10000x400) 80
Advertising expenses 40
Discount allowed 5
Cleaning expenses (2000/1000 x 15) 3
Dep. Delivery vans 26 914
Administration expenses
Salaries Adm. staff 420
Insurance (1/5x450) 90
Cleaning expenses (3000/10000 x 15) 4.5
Depreciation building (3000/1000 x 400) 120
Bank charges 14
Rent (3000/1000 x 2000) 600 (1248.5)
1930

Summary
Cost accounting is concerned with ascertainment and control of costs. Its purpose is to provide detailed
information for control, planning and decision making. Costs can be broadly classified as either direct or indirect.
Direct costs are those that are readily identifiable to a cost unit. Direct material, direct labour and direct expenses
form prime cost. All those costs not identifiable with as direct are termed as indirect costs. Indirect materials,
indirect labour, and indirect expenses are collectively known as overheads.

Review Questions
Question One
Explain the advantages of centralized system of maintaining stores (5mks)
Question Two
Distinguish between the following accounting terminologies
a) Direct and indirect cost (4 marks)
b) Cost center and cost unit (4 marks)
c) Joint product and by product (4 marks)
d) Period cost and product costs (4 marks)
(Total 16 marks)
Question Three
a) Describe the duties of an accountant in an organization (4 marks)
b) Differentiate the following terminologies
(i) Relevant costs and irrelevant costs (4 marks)
(ii) Cost center and cost unit (4 marks)
(iii) Semi-fixed and semi variable costs (4 marks)
(iv) Sunk costs and product costs (4 marks)
(Total 20 marks)
Question Four
State and describe five factor which must be considered before installing a cost accounting system in a
manufacturing organization. (20 marks)

Wachira A.K. 20 M.U.S.T. - BFC 3227

2.0 MATERIALS COTROL

Chapter Objectives:
At the end of this topic, students should be able to:
o Explain the need for material control
o Describe the material control processes
o Value materials issued using different methods
o Compute an estimate of various stock levels in a given situation

2.1 Introduction
Materials or inventory comprise of raw materials, semi finished goods (work in progress) and finished inventory.
Inventory control is the systematic control over procurement, storage and usage of materials so as to maintain an
even flow of materials and avoiding at the same time excessive investment in inventories.

Inventory Comprise of raw materials, semi finished goods (WIP) and finished inventory. Inventory control is the
systematic control over procurement, storage and usage of materials and avoids at the same time exercise
investment in inventories.

2.2 Essentials of Material Control

- Materials of the appropriate quality and specification should be purchased only when required and
appropriately authorized.
- The suppliers chosen should represent an appropriate balance between quality, service and delivery
- Materials should be properly received and inspected.
- Appropriate storage facilities should be provide and stock levels physically checked on regular basis.
- Direct materials used in production should be charged to production on an appropriate and consistent
pricing basis
- Indirect materials used in production and non production departments should be appropriately charged
to the correct cost center and included in the appropriate cost center.
- The documentation, accounting systems and controls at each stage should be well designed and
effective
- Stock taking must be well organized to ensure that stock quantities on hand are available when required.

2.3 The Inventory Control Process

Material/inventory control involves the following:
- Purchasing of materials
- Receiving of materials
- Inspection of materials
- Issuing of materials
- Maintenance of stores records
- Stores audit

The above control operations are described below:

Wachira A.K. 21 M.U.S.T. - BFC 3227

2.3.1 Purchasing of inventory
A large proportion of firm’s cost is represented by bought in materials. The crucial factors in purchasing
function are price, quality and delivery.

Although the exact system varies from firm to firm, the following procedure is typical:

Production Inventory Store Keepers Departmental

Records Managers

Purchase requisition specifying:

Quantity, quality, specification, delivery requirements, compatibility requirements e.t.c.

Suppliers Search for possible suppliers using own records,

Search directories, Trade Associations etc.

Request for Enquiries/Requests for tenders sent to possible

tender suppliers fully specifying requirements

Receipt of Receipt and vetting of quotations, tenders

Quotation frequently involving liaison with origination
source.

Supplier Selection Supplier Selection

Purchase Order Dispatch of purchase order and distribution of Copies to

copies - Supplier
- Accounts costing
- Originating
Progress chasing, monitoring of deliveries department
- Goods reception
- Inspection
- Progress chasers

Receipt of Goods

Fig: Outline of purchase procedures

Wachira A.K. 22 M.U.S.T. - BFC 3227

The procedure shown in the above figure is described below:

a. Material requisition will be placed by the user departments using material requisition forms and the
stores department is expected to fulfill the orders.
b. The stores department also has to monitor stock levels to ensure materials are available when required
c. When any materials reach reorder level, the stores department complete a purchase requisition from
the user dpt. instructing the purchasing department to obtain the required quantity of material
d. The purchasing department will then complete the purchase order form specifying the material
required and send it to the supplier.
e. If the supplier is not yet identified the purchasing department will obtain quotations from prospective
suppliers e.g. through tender system
f. A schedule of quotation is then completed and then the document is used to evaluate and identify the
most suitable supplier.
g. The supplier will then send the goods normally with the suppliers invoice and delivery note.
h. The goods received will be assessed for quality and quantity by the receiving department and a Goods
Received Note (GRN) will be issued which will be used to transfer goods to the store.
i. Any discrepancies are recorded in a purchasing discrepancy note which will give raise to credit note
when payment is being made.

2.3.2 Reception and Inspection Procedures

Receipt of goods in material reception

Quantities received checked and goods received note GRN Copies

raised. Details of goods received checked with purchased - Accounts payable
order - Purchase office
- Production control
- Inspection
- Stores
Inspection of goods for quality, specification etc. - File
inspection note raised
Inspection copies to:
- Accounts payable
- Purchase office
- Production control
Goods taken into store and GRN and / or inspection note - Stores
signed - File

2.3.3 Inventory Issues

Inventory must be appropriately authorized and amount issued recorded so that the appropriate charge can be
made to production. The usual way this is done is by a material requisition (MR). A Materials Requisition Form
contains: Quantity, Part Number, Description, Job to be done, Authorization
On presenting an MR to the store man, it would be checked for correction and authorization before an issue is
made. The MR is forwarded to stores records for updating the stock records and also the cost department.
2.3.4 Storage of Inventory
It involves following
- Checking the of materials
- Observance of stock levels

Wachira A.K. 23 M.U.S.T. - BFC 3227

 - Putting materials into bins and racks
2.3.5 Stock Audit
Its physical verification of stock with inventory records. It can be Periodic stock verification
or Continuous stock verification

2.4 Objectives of Materials Control

(i) No stock outs
Under stocking leads to running out of stock leading to stoppage in productions, idle time, loss of order,
customer and goodwill.
(ii) No stock excess
Investment in materials must be kept as low as possible considering production customary requirements
and financial resources, overstocking leads to high storage cost, tied up capital observation low profit
etc.
(iii) Proper quality
A company should purchased inferior quality or sometimes very superior quality rather purchases of
specified quality
(iv) Minimize wastages
Proper storage conditions should be provided to avoid deterioration, theft, evaporation etc.
(v) Information about materials an up to date acing information materials is required.
(vi) Economy in purchasing
Purchasing at the most favorable prices is product thus reduction in purchasing cost.

2.5 Requirements of Good Material Control System

(i) Proper coordination and cooperation between various departments such as purchasing stores,
receiving, inspection, accounting etc.
(ii) If there is central purchasing it should be under control of competent purchasing management.
(iii) There should be proper classification and codification of materials
(iv) Materials requirements should be properly planned
(v) An up to date information on quality of materials in stores should be maintained.
(vi) Adequate records should be introduced to control materials during product and for finished goods
qualities.
(vii) Storage of motels should be well planned subject to adequate safeguard and supervision.
(viii) Stock levels should be fixed for each items of materials.
(ix) Purchases of materials should be controlled through budgeting.
(x) There should be regular reporting to the management regarding purchases issue s, stores materials and
special records should be prepared on obsolete item spoilage and returns to supplies.
Stores
The term stores means raw materials, work in progress, finished goods, tools , components, maintenance
materials, consumable stores etc. Stores are usually headed by a storekeeper or a store manager i.e. a man or a
woman of un-devoted integrity suitable trained, experienced and well versed in the principle of good store
keeping.

2.6 Duties and Responsibilities of a Storekeeper

(i) Maintenance of materials in a tidy manner
(ii) Proper maintenance of records of material received, issued and in stores
(iii) Accepting materials into the stores having ascertain that the delivery complies with the specific details
on the goods received note
(iv) Issuing materials against duly authorized requisition forms
(v) Requisition further supply from the purchasing department when the recorder level is attained

Wachira A.K. 24 M.U.S.T. - BFC 3227

 (vi) Preventing the entry of any unauthorized persons in the stores rooms
(vii) Periodic comparison of bin card balances with physical qualities
(viii) Advising the management on obsolete and slow mining stock.

2.7 Recording Documents Involved

(i) Bin card
It is kept at physical actual location of the item. It is updated with physical stock movement. It contains
details on the type of stock quantities received and issued with dates but would not necessarily show
the value of such stock
(ii) Store control card
It is kept in the storekeeper office or some other premises away from the actual stock. It is updated
using documents such as materials requisition forms and goods received note. It shows quantities and
not necessarily values. It checks on the quantities reflected on the bin card and physical stock item.
(iii) Store ledger account
It is kept in the accounts office. The update of stock must use various forms and supportive
documents such as requisition forms and goods received note. The note will be shown in terms of
quantity and value pricing method such as FIFO, LIFO, and WEIGHTED AVERAGE etc. it is an
independent check on the stored items.

2.8 Procurement of Materials

This can be done in two ways
(i) Centralized purchasing
This is where there is a separate purchasing department with the task of making or purchasing all types
of materials. The head of the department is the purchasing manager or the chief buyer.

Advantages
a) It is possible to have specialized purchasing staff in one department
b) Leads to foundation terms of purchasing e.g. better terms of payment higher discounts etc,.
c) Leads to standardization of quality of materials.
d) Better control of purchasing is possible, reckless buying by unauthorised individual is avoided
e) All purchases are record in one place

Disadvantages
a) Creation and maintenance of centralized purchasing department leads to higher administration
cost which organization may not afford
b) It may not be suitable for branches which are far apart e.g. transport requisition and delays in
receiving materials

(ii) Decentralized purchasing

It is where each department/branch makes its own purchases. Its common where branches are located
in different geographical location. The branch manager purchases in local market.
Advantages
a) Leads to reduction of administration cost because there is no creation and maintenance of
purchasing department
b) its suitable for branches which are far apart
Disadvantages
a) its not possible to have specialized purchasing staff.
b) Standardizing of quality of material is not possible,.
c) The purchasing records are maintained in different places.

Wachira A.K. 25 M.U.S.T. - BFC 3227

 d) It is not possible to bargain at favorable terms of purchasing e.g. better terms of payment
and higher discounts

2.10 Pricing Materials Issues

2.10.1 Objectives of inventory valuation

1. To change to production of a consistent and basis the cost of materials used.
2. To provide a satisfactory basis of valuation for inventory on hand.

2.10.2 Problems of inventory pricing / valuation

1. Rapidly changing prices for bought in materials and components
2. The stock of any given material is usually made up of several deliveries which may have been made at
different prices.
3. The frequent impossibility of identifying items with their delivery consignment.
4. The sensitivity of profit calculations to the pricing method adopted particularly where materials form a large
part of total cost.

2.10.3 Methods of Valuing Inventory Issues

When materials are issued by storekeeper, they are valued in order to determine the material cost of different jobs
or products. The following methods are used:-

i. First In First Out (FIFO)

- The goods issued are those which have been longest on hand and that those remaining in stock represent
the latest purchases
- The stocks whose cost is to be carried forward were acquired most recently.
- Under this method, the materials are issued at the cost price of that consignment which was received first.
- When this consignment is finished, then cost price of next consignment is charged to value material
issues.

Advantages
(i) Based on realistic assumptions i.e. materials are issued in order of receipts
(ii) Materials are issued at actual cost thus no unrealized profits of loses which arises
(iii) Valuation of closing stock is at cost as well as the latest price
(iv) The method is easy to understand and operated provided the purchases are few and prices do not
fluctuate frequently.
Disadvantages
(i) Materials are charged to production and oldest prices thus cost of production may lag behind the
current economic conditions
(ii) Similar jobs/cost units worked on simultaneously may be charged differently from materials
(iii) Frequently changes in material prices or frequent purchases bring in cumbersome calculations.

ii. LAST IN FIRST OUT (LIFO)

- Under this method, goods issued on any particular date are those which were most recently acquired and
therefore stocks whose cost is to be carried forward are those which were acquired earliest
- The materials are issued at the cost price that consignment which was received most recently.

Advantages
(i) Materials are changes to produce products at the latest prices and therefore in time of raising prices
quotations will be safe and profitable

Wachira A.K. 26 M.U.S.T. - BFC 3227

 (ii) Like FIFO materials are issued at actual cost hence no unrealized profit or loses
(iii) The method is easy to operate especially when prices are fairy constant and purchases are few.

Disadvantages
(i) The method is not realistic as it does not confirm to physical flow of materials
(ii) Closing stock is valued at oldest prices which may not represent the current economic value
(iii) Like FIFO similar jobs done simultaneously may have different prices
(iv) The method is cumbersome if prices fluctuate frequently and there on numerous purchases

iii. Simple Average

- This method uses a simple average of prices of all consignment in stock is calculated and this average
price is used to value material issues.
- When the first consignment is exhausted, then the price of that consignment is eliminated and simple
average of remaining prices is calculated and so on.
NB quantities are not taken into consideration.

iv. Weighted Average (W.A.)

Under this method, the total value of goods in stock is divided by the number of units of stock to give
Weighted Average price.

Advantages
(i) It smoothens out fluctuation in purchases price thus advents where prices variation are wide.
(ii) A new issue price is calculated at the time of each purchase and not at every issue hence if receipt are
few, calculation are reduced.
(iii) There are no unrealized profits since item cost are averaged.
Disadvantages
(i) Issues may not be at the current market price
(ii) If purchases are frequent then will be numerous calculations of issue price
(iii) To attain accuracy, sufficient number of places have to be made which is tedious
(iv) Excessively high or low prices paid in the past are reflected in the issue price for a consideration time
even after the materials is considered.

Other Methods
v. Base Stock method
- Under this method, a fixed quantity is carried as base stock. It’s assumed that a fixed minimum stock base
of stock of the material is always carried at original cost. It’s kept for emergencies and stock level is not
allowed to fall below this level.
- Its similar to FIFO method coz after deducting the base stock figure, the remaining issues are valued at
FIFO basis

vi. Replacement Cost (Next In First Out)

- Under this method, materials are valued at replacement cost or market value. Thus materials issued are
valued at replacement cost/ market price i.e. material issued are valued according to cost of replacing such
materials.
- This method is logical but difficult to ascertain the price of the next purchase.

vii. Standard Price

Wachira A.K. 27 M.U.S.T. - BFC 3227

 - This is a pre determined price that is arrived after considering factors like consumption of materials
expected changes in price of materials etc.
- All material issues are priced at a standard price. This method is simple, stable and provided a check on
efficiency of the enterprise.

Illustration
The following details were extracted from the stores ledger card of a small manufacturing company during
the month of November 2007
November 2 Received 500 units @ shs 20 each
8 Received 300 units @ shs 22 each
10 Issued 400 units
15 Issued 200 units
20 Received 600 units @ shs 25 each
25 Issued 300 units
27 Received 200 units @ shs 26 each
30 Issued 100 units
Standard price for each unit after the month of may id shs 25/. Market price of this material on December is
shs 27/ unit and 400 units were purchased on that day
Required: Prepare a stores ledger card using the above methods.

2.11 Stock Controls

This is a function of ensuring that the stocks are available to meet production requirements
The main objective of stock control is to minimize costs associated with stocks which include;
a. Purchase cost: This can be minimized by bulk buying to enjoy quantity discounts
b. Stock holding cost: e.g. rent, security, pilferage, theft etc.
c. Stock ordering cost: e.g. telephone, postage, inspection etc.
d. Stock out cost: These are costs associated with running out of stock e.g. loss of goodwill.

2.11.1 Setting stock levels / limits

This is done to avoid stock out and stock excesses. A scientific approach is adopted in fixing the stock levels
which should be reviewed periodically. There are various levels to be computed for each stock item this
include:

1. Minimum stock level

Refers to the point below which the level of stock should not fall. It is really a buffer stock which will guard
against the possibility of the stocks being depleted to zero before arrival of the next order.
Some factors which may contribute to low stock levels are;
i) The time taken in evaluating and updating of materials technically.
ii) Scarcity of supplies resulting in delays in placing orders for replacement of stock.
iii) High scrap levels in production process requiring issues from stores.
iv) Change in production pattern leading to increased usage.

The minimum stock level may be calculated as; reorder level- (normal usage x normal reorder period).
In fixing the maximum stock level the following factors are to be considered
a. Ratio of consumption
b. Delivery time

Wachira A.K. 28 M.U.S.T. - BFC 3227

 c. The risk of obsolescence and deterioration
d. Storage space available
e. Cost of storage
f. Availability of funds to purchase the stocks
g. Seasonal considerations e.g. bulk purchasing during low price season
h. Restrictions imposed by the government e.g. quotas.

2. Maximum stock level

Refers to the highest quantity of stock which is expected to be in store at any time. In setting the maximum stock
level it will be necessary to consider;
i) The availability of storage space and facilities
ii) Cost of financing stock.
iii) Perishability and seasonal nature of the material or stock.

Maximum stock level may be calculated as; reorder level +reorder quantity - (minimum usage x minimum
reorder level)

3. Reorder level.

This is the level at which an order will be placed for additional supplies of materials so that delivery will be made
when the minimum stock level is reached. In calculating the reorder level, it is worthwhile to find the anticipated
u7sage rate and the expected delivery period (lead time).
Reorder level = maximum usage x maximum reorder period
In this way the reorder level allows for normal usage and reorder period plus minimum stock which was set to
allow for unforeseen additional usage or delivery delays.

4. Reorder Quantity

This is the quantity which should be purchased when the reorder level reached.
Reorder quantity = maximum stock level – reorder level + (maximum usage x minimum reorder period)
In this way the reorder quantity will avoid the possibility of stock being in excess of the maximum stock
level, should the most advantageous usage and delivery conditions occur. This could be important where the
maximum stock level is constrained by the amount of storage space available.

5. Average stock level

The average stock level = Minimum stock level + Maximum stock level
2
6. Stock turnover
This shows the average number of times the stock item is replaced in a given period.
Stock turnover = Annual Demand
Average Stock

Illustration i
The following information relates to BB Ltd for a stock item X with an annual demand of 50,000 units. Reorder
period is 3-5 months. Consumption rate is 2500-4500 units per month and reorder quantity has been calculated as
20000 units. Required
i) Reorder level

Wachira A.K. 29 M.U.S.T. - BFC 3227

 ii) Minimum stock level
iii) Maximum stock level
iv) Average stock level
v) Stock turnover

Solution
i) Reorder level = maximum consumption x maximum reorder period
= 4500 x 5
= 22,500 units

ii) Minimum stock level= reorder level – ( average stock x Average reorder period)
= 22500-(3500 x 4)
= 8500 units
iii) Maximum stock level= Reorder level + reorder quantity – (Minimum stock x minimum
reorder period)
= 22500 + 20000- (8,500x3)
=35000 units
iv) Average stock level = minimum stock level + maximum stock level
2
= 5800+35000
2

= 21750 units

v) Stock turn over = annual demand

Average stock
= 50000
21750
= 2.30
= 2 times

Illustration ii
The following information has been extracted from the books of ABC ltd which uses component Y which has
minimum usage of 400kg per day and maximum usage of 800 kg per day. Lead time is 10-14 working days and
annual demand of 69600 kgs. Reorder quantity is 12000 kgs
Required
Calculate the relevant stock levels.
i) Reorder level = maximum consumption x minimum reorder period
= 800 x 14
= 11200kgs

ii) Minimum stock level = reorder level – (average stock x average reorder period)
= 11200-(600x12)
= 4000 kgs
iii) Maximum stock level = reorder level + reorder quantity – (minimum stock x minimum
reorder period)
= 11200+1200-(400x10)
= 19200 kgs

Wachira A.K. 30 M.U.S.T. - BFC 3227

iv) Average stock level = Minimum stock level + maximum stock level
2
= 4000+19200
2
=11600kgs

v) Stock turnover = annual demand

Average stock
= 69600
11600
=6 times
Illustration iii
The following is provided for material PQ 251
Max usage = 6000 units/wk
Min usage = 4000 units/wk
Reorder period/lead time = 4-6 wks
Reorder quantity = 30,000 units
Required
(a) Reorder level
(b) Min SL
(c) Max SL
(d) Ave Sl
Solution
(a) Reorder l = Max usage x Max reorder period
6000X6=36000 units

(b) Min SL = Reorder level – (normal usage X Normal reorder period)

36000 - (5000 X 5wks) = 11000 units

(c) Max SL = Min SL + RQ + Min C X Min RP

11000 + 30000 + (4000X4) = 57000 units

(d) Av SL = Max SL + Min SL = 57000 +11000 = 34000

2 2

Recall: Formulation of various Stock Levels is as follows:

i. Re-order level = Max usage X Max lead time (reorder period)
ii. Min Stock level = RL – (Normal Consumption X Normal reorder period )
iii. Max S. L. = Min SL + Reorder Quantity + (Min Cons x Min Reorder period)
iv. Reorder Quantity = Max Stock Level – Min Stock Level – (Min C X Min reorder period)

2.11.3 Economic Order Quantity (EOQ)

This is a special order quantity at which the cost of having stocks is minimum. The cost of having stock can
be broken down into 2 parts
a. Holding cost
 Cost of capital tied up

Wachira A.K. 31 M.U.S.T. - BFC 3227

  Warehousing cost
 Cost associated with deterioration
 Obsolescence cost
 Insurance cost
b. Ordering cost
 Clerical cost
 Telephone charges
 Stationery
 Postage
 Inspection costs
 Salaries to receiving employees.

EOQ = 2cd
ip

Where c = delivery cost per batch i = stock holding cost per annum
d = annual demand of product p = cost price per item

Assumptions of EOQ
1. There is only one type of product
2. The price per unit of material is fixed and no quantity discount even with bulk buying
3. Annual demand is known
4. There is instantaneous replenishment i.e. lead time is zero
5. There is no stock out
6. Annual stock holding cost per unit is known and is constant
7. Cost per order is known and is constant
8. The rate of consumption is uniform

Illustration
A company has an annual demand for material P of 25000 tonnes per annum. The cost per ton is shs 2000 and the
stock holding cost is 25% per annum of the stock value. Delivery cost per batch is shs 400.
Required calculate EOQ and number of orders per year.

EOQ = 2cd = 2 x x400 x x25000 = 2 x 400 x 25000

ip 25% x 2000 500

= 200 units

Number of order per year = annual demand = 25000

EOQ 200

= 125 orders
Illustration
Bidii ltd uses a component whose demand is fairly constant at 100 units per day for 200 days year. The cost of
ordering is shs 400 and the cost per unit is shs 5. The holding cost is 25% of the purchase price
Required
a. Calculate EOQ
b. The number of orders per day
c. Operating cycle

Wachira A.K. 32 M.U.S.T. - BFC 3227

 d. Holding costs
e. Ordering cost at EOQ
f. Total costs
a. EOQ = 2cd = 2 x 400 x 20000 = 16000000
ip 25% x 5 1.25

EOQ = 3578 units

b. No. of orders per year = annual demand = 20000

EOQ 3578

= 6 orders

c. Operating cycle = No. of days during the period = 200 = 33 times

No. of orders during the year 6

d. Holding cost at EOQ = EOQ x holding cost

2

= 3578 x 1.25
2

=shs 2236.25

e. Ordering cost at EOQ = demand x ordering cost

EOQ

= 100 x 200 x 400

3578

=2235.89

f. Total cost = holding costs + ordering costs

= 2236.25 + 2235.89
= shs 4472.14
Practice Question
Material BZ has an annuals demand of 4500 units. Ordering cost is shs 20 per order, carrying cost is 20% of the
basic item price which is shs 10
Required
a. EOQ
b. Holding cost at EOQ
c. Ordering cost at EOQ
d. Total cost at EOQ
e. No. of orders during the period
f. Operating cycle

Limitations of EOQ model

1. The material price may not always be fixed especially where there is bulk buying
2. The firm will always experience stock out
3. In most cases, the rate of consumption is not uniform

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 4. The cost per order is not always known and is constant as it may change due to inflation political instability
etc.

Summary
There should be a consistent, reasonably simple method of pricing issues so that the production is charged
a realistic figure for materials consumed. The problems involved in pricing issues arise form changing
purchase price, frequent impossibility of identifying materials with particular purchases. The major
pricing methods are First in first Out (FIFO), Last In First Out (LIFO), Simple Average method and
Weighted Average method. Others include replacement method, standard price method and base stock
method.

Concept check
Question one
a) State and briefly the essential requirements of an effective stock control system( 12 marks)
b) State and explain the possible causes of discrepancies revealed by physical stock counts and
explain how they can be addressed. ( 8 marks)
( 20 Marks)
Question Two
Distinguish between continuous stocktaking and annual stocktaking and explain the advantages and
disadvantages of each of them. (Total 20 marks)
Question Three
A business firm which is engaged in manufacturing should adequately control materials used in the production
process from the point of procurement up to the point the materials are issued to production
Required
Clearly explain how a business firm would reasonably achieve this objective.(10 marks)

Question Four
The following information relates to item P003 stocked by 2000 products Ltd. For the month of April 2018
Date Receipts (units) Issues (units) Unit cost (sh)
April 3 4400 18
4 3200
6 2600 20
12 2700
14 3000 22
18 2800 21
20 2200
22 2600 23
25 3800
26 3100 24
27 2500 25
28 3200 25
29 6900

The closing balance for March 2018 was a batch of 3000 units received at a unit price ksh 19
Required
a) Stores perpetual inventory record for item P003 for April 2018 under LIFO system of stores issues
(14mks)
b) Closing stock valuation (6mks)

Question five

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 a) Explain the advantages of centralized system of maintaining stores (5mks)
b) Explain the assumptions behind the Economic Order Quantity (EOQ) (5mks)
c) The following information is given for material Y-20

Consumption
Annual 360,000 units
Maximum 1,200 units/day
Minimum 800 units /day
Normal 900 units/day
Re-order period 12-24 days
Re-oder quantity 32,000 units

Required
a) Reorder level (3mks)
b) Minimum stock level (3mks)
c) Maximum stock level (3mks

Question six
Nyali mbali ltd are retailers who sell ceramic tiles. During the month of July to September 2000 there were price
fluctuations. Due to the above problem the company had to adjust its selling prices.
The following transactions took place during the period.
3 July Opening stock was 5000 tiles value d at Sh 825,000
10 July Orders placed with the company increased, so, extra tiles had to be obtained from Mombassa.
Therefore, 22,000 tiles were purchased at a cost of Sh 140 each but in addition; there was a freight
and insurance charge of Sh 5 per tile
31 July During the month 20000 tiles were sold at a price of Sh 220 each
4 August A new batch of 14000 tiles were purchased at a cost of Sh 175 per tile
30 August The sales for the month of August were 14000 tiles at a selling price of Sh 230 each
1 September A further 24000 tiles were purchased at a cost of Sh 195 each
30 September 270,000 tiles were sold during September at a price of Sh 240 each
The cost accountant of Nyali Mbali Ltd decided he would apply first in first out basis and weighted average
methods of material pricing for the purpose of comparison.
Required
(i) A stores ledger account using Simple average and weighted average cost methods and showing stock
values at 30 September 2000
(14 marks)
(ii) The trading accounts using each of the above methods (6 marks)

Question seven
Samba Ltd produces three joint products in two processes. All the units pass through process I to process II. At
the end of process II, the joint product emerge. The data below relates to the operations for the first quarter of
2001

Process I Process II
Sh Sh
Direct materials (40,000 kg @ sh 2.50) 100,000
Direct labour 60,000 92,000
Overheads 40,000 118,000
Normal loss as a percentage of input 10%
Scrap values per unit Sh 2

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Output in units 35,000
No loss is expected in process II
There was no opening or closing work in progress. The output and the selling prices were as follows:

Joint product Output (Kg) Selling price (Sh)

X 10,000 20
Y 16,000 15
Z 9,000 16
Required
a) Process I account (6 marks)
b) Abnormal loss/ gain account (4 marks)
c) Determine the profits or losses from each joint product if costs are apportioned using sales value method
(6 marks)
d) Briefly explain how the physical limits is different from sales value method in (c ) above(4 marks)
(Total 20 marks)
Question eight
Tindo Ltd buys and sells product Q-3. It values stock on the basis of Last in first out (LIFO). At 1 June 2001,
stock in hand consisted of 4,500 units which were acquired at sh 50 per unit. The operations for the month were
as follows:
Date purchases Sales
4 5,000 @ sh 48
5 6,000 @ sh 60
7 5,500 @ sh 49
11 4,000 @ sh 50
12 7,000 @ sh 61
13 5,000 @ sh 50
18 6,000 @ sh 47
19 8,000 @ sh 64
20 6,000 @ sh 49.50
21 5,000 @ sh 65
22 7,000 @ sh 50
25 6,000 @ sh 49
26 2,000 @ sh 47
28 500 @ sh 60
29 14,000 @ sh 64

The company incurred operating costs of sh 450,000 during the month

Required
a) Stores ledger cards (14 marks)
b) Closing stock valuation (2 marks)
c) Trading account for the month (4 marks)
(Total 20 marks)

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 3.0 LABOUR COSTING

Objectives:
At the end of this topic, students should be able to:
o Describe different methods of labour costing
o Compute labour cost using those methods

3.1 1ntroducion
In chapter one, we mentioned direct and indirect labour. Direct labour is labour directly engaged in production
work and can be conveniently identified wholly to a particular job, product, process, etc. It involves the cost
incurred in the construction, composition and conditioning of the product. On the other hand, indirect labour cost
includes salaries paid to those workers who are not directly engaged in converting raw materials to finished
goods, e.g. supervisors, inspectors, watchman, cleaners, e.t.c.

There is need for adequate system of recruitment, selection and placement of workers to jobs. The company
should ensure that employees are well remunerated. it should also provide healthy working conditions consistent
with legal requirement and competitive undertaking. e.g physical conditions.

Personnel Department is concerned with recruitment, discharge and transfer of labour. Requisition for new
personnel is made to other departments. On receipt of such requisition, the personnel manager proceeds to recruit
persons from various sources such as technical institutes, employment agencies, internal transfers, advertisement
in newspapers, poaching from other company’s e.t.c.
On recruitment of new employees, the following departments are notified:
a) Department where the employee has to report to his duties.
b) The payroll department
c) Time office for recording attendance.

3.2 Labour Remuneration

The term remuneration or emolument is used to cover gross earnings of the employee. It includes wages and
salaries according to time or piece rate or other financial benefits as well as fringe benefits. The efficiency can be
increased by using improved equipment more effective utilization of plant and by adoption of better methods of
production.

However, the most important contribution must come from the labour. The methods of remuneration which
allows high wages to be paid have the effect of increasing labour cost but may also result in increased production
and productivity thereby reducing labour cost per unit. On the other hard low wages generally results in high
labour cost per unit due to low productivity and high rate of labour turnover.

3.3 Labour Turnover

It is the rate of change in composition of the labour force in an organization. a controlled labour turnover is good
for a healthy employer-employee relationship as it creates

vacancies for internal promotion and maintains a high morale for young and ambitious workers who may bring in
new ideas and methods of performing work from other employers. Labour turnover may be expressed in a rate as
follows:

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Labour turnover = Number of workers that left during a period x 100
Average number of workers during a period.

Average number of workers = workers at the beginning + workers at the end

2

Labour turnover reports should be prepared regularly giving a breakdown of the cost.

Causes of Labour Turnover

There are 2 major causes of labour turnover:

(i.) Avoidable Causes

This includes:-
 Low wages and allowances
 Unhappy relations with supervisors and co-workers.
 Unsatisfactory working conditions.
 Lack of medical facilities, housing, transport. e.t.c.
 Inadequate job security and recruitment benefit.

(ii.) Unavoidable Causes

This includes:-
 Death
 Retirement
 Accident or illnesses.
 Discharge on disciplinary grounds.
 Domestic disputes like marriages
 Transfer of spouses to other towns.
 Personal dislikes for jobs or environment
 Incapacitation such as insanity.

Labour turnover is expensive and generally may be minimized because it results in increased cost of production,
classified under 2 categories.

Preventive Cost
It is cost incurred to keep the labour force satisfied so as to prevent/discourage the employee from leaving the
firm through:-
a) Adequate salaries and wages
b) Cost of personal management, i.e. efforts by the personnel management in maintaining good relations
between management and workers.
c) Cost of welfare activities and services such as canteen, co-operative societies education, transport facilities
and housing schemes.
d) Cost of medical services and medical schemes.
e) Pension schemes to provide security and retirement benefit.
f) Extra bonus and other prerequisites in excess of those given by other similar firms to discourage employees
from the job.

Replacement Cost
It is cost for replacing an employee who has left. This cost may include:-
a) Cost of recruitment and selection of new workers.
b) Cost of training new workers

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 c) Loss of output due to some damages time-gap in obtaining new workers.
d) Cost of accidents due to lack of experience of new workers.
e) Loss due to inefficiency of new workers
f) Cost of defective work by new
g) Cost of tools and main breakdown due to faulty handling by the new workers, e.t.c

Reduction and Control of Labour Turnover

a) Devising a suitable and satisfactory wage policy
b) Providing working conditions conducive to health and efficiency.
c) Impartial and sympathetic attitude of personal management
d) Introducing financial and non-financial incentive plans.
e) Providing promotional opportunities
f) Introducing labour participation in management
g) Introducing affective grievances/complains procedures
h) Strengthening the welfare measures.

Features/Characteristics of a Satisfactory Labour Remuneration System

1) The system should produce the best quality and quantity of work
2) It should be satisfactory from the point of view of both the employer and employee and should be related to
effort.
3) The scheme should be clearly defined and understandable to workers
4) The system should guarantee a minimum living wage to each worker irrespective of his efficiency.
5) No maximum limit should be placed on the amount of individual earnings.
6) The earning of the workers should not be affected by matters beyond their control.
7) It should reduce labour turnover and labour absenteeism
8) The system should be flexible so as to allow room for changes.
9) Should be capable of operation without excessive clerical work
10) Methods demanding detailed recording of time, quality work and quantity of output should be avoided.
11) Should be one which is in use in that particular industry or in the locality if possible.

3.4 Methods of Labour Remuneration

1. Time-based method.
a) Basic system.
This is based on the number of hours worked times basic rate per hour, e.g, 40 hours per week is expected
for each employee. additional hours worked is classified as overtime and paid at a higher rate, e.g, a time
and quarter or a time and half, e.t.c. However, the performance also has to be monitored, i.e, there is need
for close supervision such that worker are not paid for attendance but are paid for working.

Illustration I
Mr. George has worked for 53 hours. The normal working hours are 40 hours per week. The wage rate is 25 per
hour and overtime is paid at a rate and a third. Calculate the gross earnings.

Solution
Normal pay 40 hours x ksh 25 = ksh1, 000
Overtime pay 13 hours x (ksh 25 + 1/3 x 25) ksh 433
Ksh1,433

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 Advantages
i) Simple to understand and operate as calculation of wages is based on the number of hours
worked.
ii) Workers concentrate on quality and hence avoid over-speeding which compromises quality.
iii) The system is certain as the workers are assured of the basic rate.
Disadvantages
(i.) Constant supervision may be necessary which increases cost of production.
(ii.) May lead to decrease in production hence cost per unit
(iii.) Employees of the same grade are paid the same irrespective of experience.
(iv.) No real incentive to increase output

b) High Pay Rate System

It is a fixed rate rather than the usual rate. It provides a strong incentive by paying rates well above
average performance. With higher rates the managers demand higher levels of performance and
efficiency.

Merits
i) Simple to operate and understand as calculation of wages is based on the number of hours worked.
ii) Provides a direct incentive without complication of work done.
iii) Requires less supervision.
iv) Reduce labour turnover
v) Attracts high grade of workers
vi) Leads to increased production
vii) Workers concentrate on quality.
viii) The system is certain as the workers are sure of basic rate.

Demerits
i) Causes other employers to raise their rates to attract better workers
ii) It defeats the purposes if the original target is not met
iii) Close supervision is required hence it increases cost of production.

c) Graduated Time Rate System

Wages are paid at time which varies with changes of living index hence the rates are adjusted periodically
according to the index. The method takes into account the changing economic conditions hence the living
conditions.

Common Bonuses Found in Time Rate System

i) Shift bonus-an extra amount is paid to working in shifts
ii) Time keeping bonus-if one has kept a good time over the week he is remunerated on time keeping.
iii) Continuous working bonus-it is where the factory has achieved continuous production without go
slows, machines breakdowns, power failure, e.t.c. hence workers receive weekly bonuses..

2. Piece Rate Plan/Output Or Performance based System

Each employee is paid for the quantity of work done at a specified rate per piece which is fixed in advance,e.g.if
the rate per piece is shs 200, the worker who completes 40 pieces is paid Shs 8,000. The method should specify
causes where a worker completes a number of pieces and some are found defective.

Wachira A.K. 40 M.U.S.T. - BFC 3227

Areas where the method is recommended
a) Where the nature of work done is such that it is repetitive,e.g. putting of price tags, packaging, loading,etc
b) Where the work done is closely related to the employee’s skills and efforts e.g., painting a house, ploughing a
land,etc.
c) Where the business has maintains other records to ensure workers report to work punctually.
d) Where it is easy to compute labour cost per unit in advance
e) Where it is easy to compute labour cost per unit in advance
f) Where the business has sufficient production to guarantee employees adequate quantity of work.

Merits
 There is direct connection between wages, production and efforts of individuals, i.e the more the units
produced, the units produced, the higher the wages earned.
 Direct incentives to make workers produce more units and earn higher wages.
 Due to the increased number of units, the total cost per unit is reduced.
 The labour cost is fixed in advance and hence it is possible to compute total cost in advance before the item is
produced.
 Every employee is interested in maximizing the output and hence no need for strict supervision. The only
supervision required is inspection of finished products and to ensure materials and machines are not damaged.
 Since workers are interested in maximizing the output, there will be few cases of absenteeism and idle time.

Demerits
 It difficult to set a piece rate which is far and acceptable to the employees.
 Workers aim at maximizing the quantity but not the quality.
 Increased damages of machines due to workers rushing in their jobs.
 Poor health and fatigue on the part of the workers as they strive to produce as many units as possible.
 The normal flow of work may be affected due to absenteeism, where the workers feel they have earned
enough.
 The system fixes uniform rate per piece therefore compromising good workmanship/quality job in the
product.
 There is no minimum wages to be paid and hence no security on the product.

Types of Piece Rate

a) Straight/flat piece rate
A rate per piece is fixed and used to compute wages for all employees without taking into account the levels
of output and efforts of individual’s employees.

Illustration ii
AB Ltd produces and sells table covers. Employees are paid Shs 30 per table cover. Compute wages of john who
completes 100 table covers in a week and peter who completes 150 table covers in the same week

Solution
John pay = 100 Tables × Ksh 30 per table = Ksh 3000
Peter pay = 150 Tables × Ksh 30 per table = Ksh 4500

b) Differential piece rate

Different rates per piece are fixed for different levels of production, e.g .from:
1-50 units pay at shs.10 per unit.
51-100 units pay at shs 15 per unit

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 101-200 units pay at shs 20 per unit

Illustration iii
XY Ltd makes pegs and uses differential piece rate as follows;
Quantity Rates per peg (Shs)
1-100 20
101-200 30
201-300 40
301-400 50
Above 400 60
Find wages for each of the following:
A-150 pegs
B-250 pegs
C-200 pegs
D-450 pegs

Solution
A (100×Ksh 20) + (50× Ksh 30) = Ksh 3500
B (100×Ksh 20) + (50× Ksh 30) + (50×Ksh 40) = Ksh 7,000
C (100×Ksh 20) + (50× Ksh 30) = Ksh 5,000
D (100×Ksh 20) + (50× Ksh 30) + (100×Ksh 40) + (100×Ksh 50) + (50×Ksh 60) = Ksh 17,000

3.5 Premium Bonuses Plan

These are computed on either time rate or piece rate. An extra reward above the ordinary rate per hour or per
piece is paid to an employee where performance is superior to the required standard / above standards. for
example if an employee is expected to complete 20 packing bags in a day and the employee completes 35 bags in
the same day, an extra wage is paid for 15 bags.

Features of a Good Premium Bonus Plan/Scheme

 The standards set for an employee to achieve should be determined, accurate and within the limits, i.e.,
achievable.
 The system should be acceptable by the workers.
 Wages paid should be having a connection with the worker’s efforts.
 Wages paid should be sufficiently high to attract greater efforts in the job.
 The system should be easy and simple to understand.
 The system should be economical and aims increasing the firm’s production.
 It should put a maximum limit on the amount earned by the worker.
 It should have a laid down procedure on how wages are to be settled.

Types of Premium Bonus Plan/System

i. Individual premium plan
The worker or labourer is recognized and remunerated / rewarded individually. Under this plan bonus are
determined as follows:

a). Halsey scheme

Each individual is allowed a given time for a specific task. The time taken to complete the task is recorded. If
time taken is less than time allowed, the difference is called time saved.

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NB: there is no time saved if time taken is more than time allowed.

Bonus = 50% (time saved × wages rate)

Where; time saved = time allowed – time taken
Wage rate is basic rate per hour or per specific time.

Defective Units
These are units completed but found defective, i.e damaged and are acceptable. If defective units are to be paid
for, they are excluded in computing the time allowed.

Illustration iv
The wage rate per hour is shs.10 and time allowed to complete a unit is one hour.
Peter completed 100 units within a time of 45 minutes per unit.

Required
Calculate the bonus paid under Hasley scheme.
Solution
Time allowed for 100 units 100 × 60 minutes = 6,000 minutes
Time taken 100 × 45minutes = 4,500 minutes
Time 1,500 minutes

Bonus 50% × 1,500/60 × ksh 10 = Ksh 125

b) Hasley Weir Scheme

It is similar to Hasley Scheme but bonus is paid at the rate of 30% of time saved

Formula
Bonus = 30% (Time saved × Wage rate)
Using above illustration – the answer is Shs. 83

c) Rowan Scheme
Under this scheme any other fraction is used other than 50%x or 30%
Formula
Bonus = Time taken (Time save × wage rate)
Time allowed

Illustration iv
The standard time to complete a job is 40 hours. An employee takes 30 hours to complete the same job. The rate
per hour is Shs. 25.
Required:
Calculate an employee’s earning under
1. Hasley Scheme (30 Hrs × Ksh 25) + (10 × .5 × Ksh 25) = Ksh 875
2. Hasley Weir scheme (30 Hrs × Ksh 25) + (10 × 3 × Ksh 25) = Ksh 825
3. Rowan Scheme (30 Hrs × Ksh 25) + (30/40 × 10 × 25) = Ksh 937.5

Wachira A.K. 43 M.U.S.T. - BFC 3227

Class work
Under a premium bonus scheme, workers received a guaranteed basic hourly minimum rate of pay plus a bonus
of 50% of the time saved. No payment is paid beyond the time allowed but the bonus which is paid at the basic
hourly rate is applicable to the accepted output only. No penalty is imposed on rejected output. The following
details are available for the month of January 2021.

Worker A B C
Time allowed per unit (hrs) ¼ 1/6 ½
Units produced 474 684 175
Units rejected 54 84 25
Time taken (hrs) 78 72 80
Basic Pay per hour (Kshs) 6 6 3
Required
From the above information calculate for each employee
a) Bonus hours and amount of bonus paid
b) Gross wages earned
c) Labour cost for each good unit sold

e) Group Incentive Scheme/ Group Bonus Plan

I f the nature of production such that the labour is used as group and not as individual employees then the
bonuses and premiums can only be computed for the whole group.
In most manufacturing industries, the total output comes from the effort of the group and the production of each
individual cannot be determined.

CONDITIONS REQUIRED FOR APPLICATION OF GROUP OWNERS

(i.) The group must have workers of relatively similar skills.
(ii.) The group should not be too large.
(iii.) The output should be under the control of the group, i.e., the group effort should influence the output.

SHARING OF THE GROUP BONUSES

The amount of group bonus once computed can be distributed as follows:
(i.) EQUALITY
Bonus = Total group
Number of employees

ii RATE PER HOUR

Bonus = Total group bonus

Total hours for all workers

i. PERECENTAGE OF WAGES EARNED

Bonus = Total group bonus

Total wages of employees

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ii. ANY OTHER BASIS AS DETERMINED BY THE MANAGEMENT

f) Profit Sharing Co. ownership

It is a type of a group incentive scheme where employees can participate in sharing of bonus under two
methods:-

i. PROFIT-SHARING
The management declares a certain percentage and offers this percentage to the labourers/workers in form
of a bonus. It is distributed among them using equal basis, percentage of the wages or rate per hour.

ii. CO.OWNERSHIP/PARTNERSHIP
It is a non-cash type of bonus where the employees are allowed to acquire shares of the organization or
company and become shareholder. This method has the weakness in that if an organization incurs a loss,
nothing is distributed to the shareholders, i.e no dividends.

Wachira A.K. 45 M.U.S.T. - BFC 3227

 Labour Costing Assignment
Question One
Based on the data below you are required to calculate the remuneration of each employee as determined by each
of the following methods
i. Hourly rate
ii. Basic piece rate
iii. Individual bonus scheme where the employee receives the bonus in proportion of the time saved to
time allowed
Name of employee Salmon Roala Pike
Units produced 270 200 220
Time allowed in minutes per unit 10 15 12
Time taken (hours) 40 38 36
Rate per hour (Kshs) 125 105 120
Rater per unit (Kshs) 20 25 24

QUESTION TWO
A Factory issues a job to employee A to produce 35 articles; it takes two standard hours to produce each article.
Another job is given to employee B to produce 60 articles; it takes one and half standard hours to produce each
article. For every hour saved, a bonus is paid at 50% of the base, which is Sh.200 per hour. The factory works a
40-hour week and overtime is paid at a rate of one and a third. At the end of the week, A’s articles and B’s clock
cards show 49 and 46 hours respectively and the work is complete. However, three of A’s articles and three B’s
articles failed to pass inspection. This was due to defective material and in view of this all the articles produced
were paid for, although as scrap they have no seleable value.
Required : For both A and B:
a) Bonus due (8 marks)
b) Total gross wages due (8 marks)
c) Wages cost per unit of articles passing inspection (4 marks)

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 OVERHEAD ALLOCATION/ APPORTIONMENT

Objectives:
At the end of this topic, students should be able to:
o Compute cost allocation using various methods
o Compute Overhead absorption rates using different bases

Overhead costs may be defined as the total cost of indirect materials, indirect labour and indirect expenses.
They may occur or be charged to:
a) Production cost centers i.e. making, finishing and packing departments.
b) Service costs centers for example maintenance and power generation
c) Other non production cost centers for example administration, selling and distribution
In this section, we will look at how these overhead costs are charged to production and non-production
departments so as to determine the total cost incurred by every department in the organization. Examples of
overheads include. E.g. factory rent, repair of plant, depreciation of plant and factory etc

Overhead cost classification and analysis

Overhead costs may be analyzed into
a) That which may be directly identifiable with a single cost center, for example, wages paid to indirect
workers who work solely in one cost center such as production department.
b) That which is incurred as a single figure and is then shared amongst cost centers which make use of it,
for example, the rates payable to the local authority
c) The total cost of a service department, for example, maintenance department will have various costs
charged to it for material, labor and other expenses.

Allocation and Apportionment of Overhead Costs

Allocation of overheads is the term used where the overhead cost item can be charged to a specific cost
center without the need for any estimation procedure. For example,
a) The salary of the sales manager will be allocated to the selling cost center,
b) The salary of the engineer in charge of power generation will be charged to power generating cost
center.

Apportionment of overheads occurs where the total value of an overhead item is shared between two or
more cost centers that use the overheads. It is important that an apportionment basis which reflects the benefit
extracted by a cost center is used. For example, the rates payable to the local authority may be apportioned
on the basis of area of occupancy of each cost center. The following points should be kept in mind for
apportionment of overheads:
i. Basis adopted should be equitable and practicable
ii. Charges should be made to different departments in relation to benefits received.

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 The following basis are most commonly used for apportioning items of overhead among production departments
Bases Items of overhead
Floor area Rent, rates, taxes, depreciation of building
Weight of materials Store Keeping materials
Killowatt Hours Power consumption
Number of employees Group insurance, canteen expenses, NHIF contributions
Capital (Book) values Depreciation of plant and machinery
Delivery expenses Weight, volume, tone-miles

Apportionment of overheads is done using overhead analysis sheet otherwise called departmental distribution
summary.

Illustration
ABC Company ltd is divided into four departments, A, B, C, D. The actual costs for the period are as follows:
Rent Sh6,000
Repair Sh 3,600
Depreciation Sh 2,700
Light Sh 600
Supervision Sh 9,000
Stock insurance Sh 3,000
Employees contributions to group insurance Sh 900
Power Sh 5,400

The following data is available in respect of the four departments

A B C D
Area sq. ft. 450 330 270 150
Number of workers 72 48 36 24
Total wages Sh 24,000 18,000 12,000 6,000
Horse power of machines 800 600 400 200
Value of plant Sh 72,000 54,000 36,000 18,000
Value of stock Sh 45,000 27,000 18,000

Required: Apportion the costs to the various departments on most equitable basis.

Solution
Items Apportionment Total Dpt. A B C D

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 basis
Rent Area Sq. ft. Sh 6,000 2250 1650 1350 750
Repair to plant Value of plant 3,600 1440 1080 720 360
Depreciation Value of plant 2,700 1080 810 540 270
Light Area sq.ft. 600 225 165 135 75
Supervision No of workers 9,000 3600 2400 1800 1200
Stock insurance Value of stock 3,000 1500 900 600 -
Group insurance No. of employees 900 360 240 180 120
Power Horse power of 5,400 2160 1620 1080 540
machines
Total 31,200 12,615 8,865 6,405 3,315

Absorption of production overhead costs

What is overhead absorption?
Absorption of overheads refers to the sharing out of overhead costs to the various cost centers that used the
overheads. It is used when the overheads cannot be allocated or attributed to a specified cost centre.
The aim is to establish the overhead cost per unit of output having allocated and or apportioned overhead
costs. The next stage should be to absorb them into the cost of production.

What are the bases of overhead absorption and what factors are considered in their selection?
The first stage in absorption is to establish the absorption rate
What is an overhead absorption rate and what types are there?
NB: Overheads incurred are normally absorbed on the basis of estimated or budgeted figures. The following
basis may be applied leading to the following types of rates.

i. Percentage of direct material cost = overhead cost x 100

Direct material cost
ii. Percentage of direct labour cost = overhead cost x 100
Direct labour cost
iii. Direct prime cost = overhead cost x 100
Prime cost
iv. Labour hours = overhead cost
Labour hours
v. Units of output = overhead cost
Units of output
vi. Machine hours = overhead cost
machine hours

Illustration 2

Wachira A.K. 49 M.U.S.T. - BFC 3227

The budgeted production overheads and other budgeted data of calculata Ltd are as follows:

Budget
Overhead for the period = Kshs 36,000 Production department
Direct material cost Kshs 32,000
Direct labour cost Kshs 40,000
Machine hours 10,000
Direct hours of labour 18,000
Units of output 10000
Required
Determine the absorption rate of the overheads
Solution
Total overhead costs to be absorbed = Kshs 36000

Absorption rate Calculation

a) Direct material cost shs 36000 x 100 = 112.50%
32000
b) Direct labour 36000 x 100 = 90%
40000
c) Machine hours shs 36000 = Shs 3.6/machine hour
10000 hrs
d) Labour direct hours shs 36000 = Shs 2/direct hour
18000 hrs

e) Units of output shs 36000 = Shs 3.6/unit

10000 units
f) Prime cost = Direct labour + direct material cost
= 32000 + 40000
= Shs 72000
∴ Overhead absorption rate based on prime cost = 36000 x 100 = 50%
72000
The overhead cost will vary according to the absorption base. Assume that in the company an individual
production has a material cost of Shs 80, labour cost of shs 85, requires 36 labour hours and 23 machine hours to
complete. Determine
i. Overhead per individual production on the above different bases
ii. Individual production cost

Solution

Wachira A.K. 50 M.U.S.T. - BFC 3227

a) Production overhead per each absorption rate
Direct Material cost 112.5 x 80 = Shs 90
100
Direct labour cost 90 x 80 = Shs 72
100

Prime cost 50 x (80+ 85) = Shs 82.50

100
Machine hours 23 x 36 = Shs 82.80

Labour hours 36 x 2 = Shs 72

b) Production cost per each absorption base = Prime cost + Overhead cost
Prime cost + Overhead cost = Product cost
Direct material cost 165 + 90.00 = 225.00
Direct labour cost 165 + 72.00 = 237.00
Prime cost 165 + 82.50 = 247.50
Machine hours 165 + 82.80 = 247.80
Labour hours 165 + 72.00 = 237.00

Example 3
Two products x and y are made using similar equipment and methods. The data for the last period are.
X y
Units produced 6,000 8,000
Labour hours per unit 1 2
Machine hours per unit 4 2
Set – ups in period 15 45
Orders handled in the period 12 60

Overheads for period Sh

Relating to production setups 179,000
Relating to order handling 30,000
Relating to machine activity 55,000
264,000

Calculate the overheads to be absorbed per unit of each product based on conventional absorption costing using
labour hour absorption rate.

Solution
Labour hours
Product x = 6,000 x 1 = 6,000
Product y = 8,000 x 2 = 16,000

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Labour hour OAR = 246,000 = Sh 12 per hour
22,000
Overheads absorbed on labour hours
Product x Product y
Overheads absorbed 1 x Sh x 12 = 12 2 x Sh12 = 24
Total overheads 12 x 6,000 = Sh 72,000 8,000 x Sh24 = 192,000

Example 4
i) Name five different rates used for absorption of overheads
ii) The following information is available from a manufacturing company.

Sh
Total overheads 600,000
Total direct wages 480,000
Total indirect wages 16,000
Total direct material 300,000
Total indirect materials 15,000

Wage rate per hour 4

Direct material cost per Kg 5
Direct labour hours 120,000
Indirect labour hours 4,000
Machine hours 15,000
Indirect material usage 60,000
Direct material usage 3,000
Units of output 750,000

Calculate any three of the rates named in (a) above.

Solution

Direct labour hours.

O.H Absorption rate = Total overheads
Direct Labour Hours.

= 600,000 = Sh 5 per hour

120,000

Machine Hours rate = Total Overheads = 600,000 = Sh 40 per machine hour

Machine hours 15,000

Direct wages percentages

OH Absorption rate = Total overheads x 100 = 600,000 = 125%
Direct wages 15,000

Wachira A.K. 52 M.U.S.T. - BFC 3227

Illustration 3m
The following is the budget of Superb Engineering Works for the year 2002
Factory overheads Kshs 62,000
Direct labour cost Kshs 98,000
Direct labour hours 155,000
Machine hours 50,000
Actual labour hours were 40,000
Actual machine hours were 30,000
Actual direct labour costs were Kshs 50,000
Actual direct material costs were Kshs 45,000

Required
a) Determine the overhead application rate on the basis of
i. Direct labour hours
ii. Direct labour cost
iii. Machine hours, and
iv. Overhead costs
v. Production cost
Solution
i. Direct labour hours method

Overhead application rate (OAR) =

ii. Direct labour cost method

OAR =

iii. Machine hour method

OAR =

b) Overhead costs using

i. Direct labour hours = 0.4 x 40000 = Shs 16000
ii. Direct labour cost = 63.27% x 50000 = Shs 31630
iii. Machine hours = 30,000 x 1.24 = Shs 37200

Wachira A.K. 53 M.U.S.T. - BFC 3227

c) Production cost using each of the methods
Prime cost Overheads Total cost ∴Cost/unit
i. Direct labour hours 95,000 16,000 111,000 111.00
ii. Direct labour cost 95,000 31,630 126,630 126.63
iii. Machine hours 95,000 37,200 132,200 132.20

Wachira A.K. 54 M.U.S.T. - BFC 3227

 COSTING METHODS

Objectives:
At the end of this topic, students should be able to:
- Explain various methods of product costing
- Cost a product or a service using appropriate costing method

Costing methods are designed to suit the way goods are processed or manufactured or the way that services are
provided. Thus each from will use a costing method with unique features.

There are two broad categories of product costing methods, namely specific order costing and continuous/
process costing.

a). Specific order costing

Apply where work consists of separate contracts or jobs and frequently and not always the jobs or contracts are
different from each other.
The main subdivision of specific order costing is
(a) Job costing
(b) Batch costing
(c) Contract costing

b). Continuous operation / Process costing (unit costing)

It’s a costing method applicable where goods or services result from a sequence of conditions or repetitive
operations or processes to which cost are charged before being averaged over the units produced during the
period

The divisions are shown in the figures below:

Specific Order Costing Continuous Operation Costing

Job Batch Contract Process Service /

Costing Costing Costing Costing Function
Costing

Product costing service costing

Fig: Costing methods

NB: Dotted line shows there’s an overlap

Wachira A.K. 55 M.U.S.T. - BFC 3227

Job costing
When a customer with specific product or service requirements places an order, we call the order a job. For
example, suppose a famous diva orders a custom sofa-set, the carpenter would consider this order a job. Orders
are also placed for batches of product, such as a batch of a particular style and size of men’s running shoes sold
under the brand name of a retail shoe store. The shoe manufacturer would consider this order a job. Orders are
also placed for services, such as the preparation of a tax return. When a client brings his tax records to an
accountant, the accounting firm considers this order a job.

Manufacturers that use job costing include aircraft builders, carpenters, tailors, masons and auto- mobile
manufacturers, and custom designed jewelers, among others. Job costing is also frequently used in service
industry organizations such as hospitals, accounting firms, and re-pair shops. Job costing is an accounting
method used to assign product costs to custom-made products or services which are produced singly or in small
batches. It is the process of determining the labor and materials cost for each job in a systematic way, and then
using this information to create a quote for the customer. The main objective is to charge all costs incurred to the
particular job and establish the profit or loss on each job and to provide valuation of work in progress. Its
appropriate for special projects i.e. jobs that meet customers specifications / requirements. Job costing can be
used in virtually any industry to ensure that the product pricing covers actual costs, overhead and provides a
profit. The most important item in this process is accurate tracking of time and costs associated with any job.
There are a several accounting software packages available to help business owners accurately track all business
expenses. In order to provide an accurate quotation, it is very important to specify the exact requirements in
writing and to obtain agreement from the client. Once the details have been finalized, you can then begin to
determine the actual costs of the materials.

Assigning Direct Costs

Accounting records are used to trace the costs of direct materials and direct labor to each job. For example,
suppose that Aluminum Benders, Inc., produces aluminum vents for heating and cooling systems. The company
works with contractors on large commercial buildings. Each job requires different styles and lengths of vents
and joints. Therefore, the company uses job costing. Work is performed in two different departments: machining
and assembly.

Source documents are manual or electronic records created to capture and provide information about
transactions or events. For example, the direct labor employees at Aluminum Benders create daily time reports
that show the time they spend on individual jobs. The accounting department uses the time reports to calculate
employee pay and to trace direct labor hours to individual jobs. Each time report may include several different
jobs. Similarly, when materials such as wood or ply wood are requisitioned for each job, they are tracked in the
accounting system using the materials requisition form.

The cost and activity information gathered from source documents is used to record costs in a subsidiary ledger
for each new job. This record is called a job cost record and contains all of the costs traced and assigned to a
specific job.

Allocating overheads
Allocating overhead to individual products is a two-stage process. In the first stage, a variety of over- head
costs are collected in an overhead cost pool. A cost pool is a group of individual costs that are accumulated for
a particular purpose. In the second stage, costs are allocated from the cost pool to individual jobs. Successful
completion of the two stages requires four steps as follows.

Wachira A.K. 56 M.U.S.T. - BFC 3227

 1. Identify the relevant cost object.
2. Identify one or more overhead cost pools and allocation bases.
3. For each overhead cost pool, calculate an overhead allocation rate.
4. For each overhead cost pool, allocate costs to the cost object.

Features of job costing

- Each job is comparatively short duration
- Work is undertaken to customers specific requirements
- Direct costs are charged/allocated to the job
- Overheads are applied on a predetermined rate.

To cost a job, the following factors are necessary

- Comprehensive works documentation. Typically this includes works orders and bill of material
(material requisition)
- An appropriate time booking system using either time sheets or piece work tickets
- A well organized basis to the costing system with clearly defined cost centers, good labour analysis,
appropriate overhead absorption rates and a relevant materials issuing pricing system.

BATCH COSTING

It’s a type of job costing where a cost unit consists of a group of identical items e.g. batch of 500 shoes, a
batch of 5000 trousers etc.

Illustration
A company manufacturers assemblies to order and has the following budgeted overheads for the year, based
on normal activity levels.
Department Budgeted over heads Overhead absorption base
Blanking 18,000 1,500 labour hours
Machining 43,000 2,500 machine hours
Welding 20,000 1,800 labour hours
Assembly 15,000 1,000 labour hours

Assembling and administrative overheads are 20% of factory cost. An order for 250 assemblies type x128,
made as batch 5931, incurred the following costs:
Materials £3107
Labour 128 hours blanking shop at £5.25/hour
452 hours machining shop at £5.50/hour
90 hours welding shop at £5.25/hour
175 hours assembly shop at £4.80/hour
£525 was paid for the hire of special x- ray equipment for testing the welds. The time booking in the machine
shop was 643 machine hours.
Calculate the total cost of the batch, the unit cost and the profit per assembly if the selling price was £150 per
assembly.

Solution
The first step is to calculate the overhead absorption rates for the production deposits.

Blanking = = £12 OAR/labour hour

Wachira A.K. 57 M.U.S.T. - BFC 3227

 Machining = = £17.2 OAR/machine hour

Welding = = £11.1 OAR/labour hour

Assembling = = £15 OAR/labour hour

Total cost – Batch number 5931

Direct Material 3107
Direct Expenses 525
Direct labour 128 x 5.25
452 x 5.50
90 x 5.25
175 x 4.80
Prime cost
Production overhead absorption
Blanking 128 x 12
Machining 643 x 17.2
Welding 90 x 11.1
Assembly 175 x 15 16219.6
Factory cost 24322.1
Selling and administrative overhead (20% of factory cost) 4864.42
Total cost 29186.52

Total cost per unit = = £116.75

Profit per unit = £33.25

Class work Question 1

The budgeted variable overheads of kiwanda Ltd for the year 2001 are given as below:

Department Overhead(shs) Absorption base

A 150,000 15,000 direct labour hours
B 200,000 25,000 direct labour hours
C 120,000 20,000 direct labour hours
D 300,000 30,000 machine labour hours

Additional Information
 Selling and administering overheads are changed at 10% of total production costs while the profit mark
up is 25% of total costs:

Wachira A.K. 58 M.U.S.T. - BFC 3227

  An order for 2,000 units was received from a customer. The batch number of this order is 510. The
following additional information in respect of this batch is provided below:
 Direct materials – 87,000/=
 Direct Labor – Dept A (150 direct labor hrs) – 12shs. Direct labor hour.

o Dept B (40 direct labor hrs) @ 15shs. Per hr

o Dept C (60 direct labor hrs) @20shs. Per hr
o Dept D (100 direct labor hrs) @10shs. Per hr
A total of 50 machine hours were used in this job

Required
a) Calculated the total cost of the batch
b) Cost/Unit
c) Selling Price of the batch
d) Selling Price unit

Practice Question 1
Zed Y ltd manufacture office furniture to customers specifications. There are two stage in the manufacture of
each item namely, assembly and finishing. In the assembly department, overheads are absorbed on the basis of
prime cost incurred in that department. In the finishing department, overheads are applied on the basis of total
accumulated cost on the job in both stages inclusive of overheads absorbed in assembly.

The selling price of the item is then determined by applying the usual 40% margin. The following information is
provided about budgeted data for the next financial period.

Item Assembly Finishing

Materials Sh 480,000 Sh 300,000
Overheads Sh 594,000 Sh 428,500
Labour cost Sh 180,000 Sh 120000
Labour hours 3,000 1,500

Required:
a) Calculate the overhead absorption rates for each production process
b) Job No 148 shows the following data concerning its production.

Item Assembly Finishing

Materials Sh 5,000 Sh 3,500
Labour cost Sh 2,700 Sh 1,600
Labour hours 12 4
Prepare the cost statement for this job and indicate the proposed final selling price

Practice Question 2
Mambo printers have been asked to quote for the printing of 4,000 and 6,000 copies of a newsletter. They
have given you the following as their estimates:

Sh

Wachira A.K. 59 M.U.S.T. - BFC 3227

 Fixed Costs
Plate making 3,000
Layout and design 1,000
Artwork 800
Variable costs:
Paper (per 200 copies) 400
Binding (per 200 copies) 100
Covers (per 1,000 copies) 800
Printing labour (per 200 copies) 250

The printers practice is to add 25% on cost to cater for administration cost and profit.

Required:
Prepare quotations for
i. 4,000 copies
ii. 6,000 copies

Practice Question 3

Jobbers Ltd receive a request from A in December for a small machine to be manufactured as per the customer’s
specifications. Jobbers Ltd prepare an estimate and quote a price of $600 which is accepted by A.
The work on A’s order was put in hand in January on the basis of Production order No. 1001.
Abstract of stores requisition issued in January.
D57 $48
D61 $24
D70 $26
Two operatives (cost centres), each paid at $2.20 per hour, had been employed and their timesheets showed that
each had worked for 30 hours on that order. Production Overhead rate in cost centre 1 is $2 per direct labour hour
and in the cost centre 2, 100% on direct wages. Administration and other overhead is recovered at 30% on
production cost.
Required:
Prepare a statement showing cost and profitability of the order from A

CONTRACT COSTING
A contract is an agreement between two or more persons (contractor and contractee) which is legally binding and
enforceable by the law. The contract may involve construction of a building, roads, dams, bridges etc.

Features of Contract Costing

i) The contract is long term
ii) The contract is constructional in nature
iii) The contracts are site based
iv) The contract involve significant uncertainty (risk) due to their long term nature
v) Usually, the contracts are large in size
vi) Separate account is prepared for each account
vii) Payments by the contractee are made in various stages (progress payment)

Objectives of Contract Costing

i) To ascertain the total cost incurred in construction

Wachira A.K. 60 M.U.S.T. - BFC 3227

 ii) To ascertain the amount to charge on completion of the contract
iii) To ascertain the profit or loss from each contract.

Types of contracts
1. Fixed price contract
This is a contract where the contract price is fixed as agreed between the contractor and contractee. Some of
the contracts may contain a cost escalation clause which is meant to provide for any future changes in the
contract price due to increase in price of materials, labour and overheads.
2. Cost plus contracts
These are contracts that involve reimbursement of cost of construction to the contractor by the contractee plus
a percentage of the cost which acts a the profit of the contractor.
3. Cost contracts
This is a contract where the contractor is refunded the cost incurred. Such contracts are common amongst
government ministries

Contract costs
1. Direct materials
Dr: -Material from the store to the site
-Material bought for the contract, &,
Cr: -Material returned to the store
-Material transferred to other sites
2. Direct labour- wages and salaries paid (& any dues) to workers at the site.
3. Direct expenses e.g. cost of hiring machinery, Cost of specialized labour among others
4. Contract overheads – Expenses incurred at the site e.g. depreciation of machinery at site, rent at site,
subcontractors fees etc.
5. Institutional expenses (head office charges) these are costs incurred as a result of the existence of a
contractor and are incurred even when there is no control. Such costs are not charged to the contract eg
head office rent and rates.
6. Sub contracting fee-e. g. welding, carpentry, plumbing etc.

Terms
i) Work certified
This is the amount of work that according to the architect hired by the contractor is complete. Based on the
work certified the contractor will ask for progress payment
ii) Retention money
This is the percentage of the value of the work certified retained by the contractee and will only be paid to the
contractor upon full completion of the contract as per the specifications give y the contractee.
iii) Value of work not certified
This is the cost of work that has been completed by the contractor but has not been inspected by the architects
. the contractor shall estimate the value of the work not certified.
iv) Notional profit
This is the total estimated profit of the contract
Notional profit = value of work + value of work – cost incurred to date
Certified not certified

According to the prudence concept, the total profit should not be recognized in the profit and loss because the
concept requires that only revenues received and be recognized in the accounts.

v) Attributable Profit (AP)

This is the portion of the notional profit that is included I the profit and loss account in any year of income.

Wachira A.K. 61 M.U.S.T. - BFC 3227

Rules applied in estimated AP
a) If the contract is in its early stages (less than i/3 complete) no profits should be recognized
b) If the contract is 1/3 complete: AP = 1/3 x notional profit x cash received
Work certified
c) If the contact is 2/3 complete: AP = 2/3 x Notional Profit x Cash received
Work certified
d) If the contract is nearing completion: AP = Notional profit x value of work certified
Contract Price
e) Profit provision. This is the difference between notional profits and attributable profit
Profit provision = notional profit – attributable profit

FORMAT OF CONTRACT ACCOUNT

CONTRACT A/C
FOR THE YEAR ENDED……
Opening balance Materials xxx Materials returned to the store xxx
Plant xxx Materials at site xxx
Loose Tools xxx Plant balance c/d xxx
Purchases materials xxx Materials returned to supplier xxx
Plant xxx Materials sold (cost) xxx
Labour cost(paid + accrued) xxx
Site expenses xxx
Materials delivered from other sites xxx
Overheads charged against other contracts xxx
Any other contract expenses xxx Cost incurred to date c/d xxx
xxx (balance figure) xxx
Cost incurred to date c/d xxx Cost of work certified xxx
Notional profit c/d xxx Cost of work not certified xxx
(balance figure) xxx xxx
Attribute profits xxx Notional profit b/d xxx
Profit provision xxx
xxx xxx
Opening balances Materials xxx
Plant xxx
Loose tools xxx

Valuation of work in progress (W.I.P)

Cost incurred to date xxx
Add attributable profit xxx
Less cash received (xxx)
W.I.P. xxx

Contractee account / clients account

Work certified xxx Cash received xxx

Bal c/d (retention money) xxx
xxx xxx

Wachira A.K. 62 M.U.S.T. - BFC 3227

 Architecht’s Certificate Account
Attributable Profit xxx Work certified xxx
Profit provision xxx
Balance c/d xxx
xxx xxx

Illustration
Kirinyaga construction ltd is currently engaged in construction of a bridge at a price of shs 900,000,000. it has
been agreed that the retention money is 10% of the work certified. It is the company’s policy to transfer 2/3 of
notional profit to the profit & loss account. The contract commenced on 1 st November 2005. The following
information relates to the contract 1st year of operation to 31st October 2016.

Details shs ‘000’

Plant (1st Nov. 2015) 90,000
Direct materials received at site 115,200
Direct wages paid 59,400
Direct expenses paid 10,800
Site expenses 16,650
Plant (31st Oct 2016) 67,500
Direct materials returned from site 1,125
Direct wages accrued 1,350
Direct expenses accrued 450
Allocated overheads 8,100
Direct material cost from site to other projects 1,350
Direct materials on site 15,975
Cash received in respect of work certified 202,500
Cost of work completed but not certified 31,500
Required
a) Contract account for the year ended 31/10/2016
b) Valuation of work in progress
c) Contractee account
d) Architect’s certificate account

Wachira A.K. 63 M.U.S.T. - BFC 3227

 KIRINYAGA CONSTRUCTION LTD
CONTRACT ACCOUNT
FOR THE YEAR ENDED 31ST OCTOBER, 2016

‘000’ ‘000’
Plant balance c/d 90,000 Plant balance c/d 67,500
Materials required 115,200 Direct materials returned 1,125
Direct wages: paid 59,400 Direct materials from site
Accrued 1,350 60,750 to other projects 1,350
Direct exp.: paid 10,800 Direct materials on site (c/d) 15,975
Accrued 450 11,250
Site expenses 16,650
Allocated overheads 8,100 Cost incurred to date c/d 216,000
301,950 301,950
Cost incurred to date b/d 216,000 Cost of work certified 225,000
Notional profit c/d 40,500 Cost of work not certified 31,500
256,500 256,500
Attributable profit 24,300 Notional profit c/d 40,500
Profit provision 16,200
40,500 40,500

Plant balance b/d 67,500

Materials balance b/d 15,975
W.I.P. 37,800

Workings

Valuation of w.i.p
Cost incurred to date 216,000
Add attributable profits 24,300
Less cash received (202,500)
W.I.P. 37,800

Work certified 202,500x100 = 225,000

90

CONTRACTEE A/C
Work certified 225,000 Cash received 202,500
Bal. c/d (retention money) 22,500
225,000 225,000

ARCHITECTS CERTIFICATE A/C

Sh sh
Attributable profits 24,300 Work certified 225,000
Profit provision 16,200
Balance c/d 184,500
225,000 225,000

Wachira A.K. 64 M.U.S.T. - BFC 3227

Class Work

XYZ limited has been awarded a contract to build a house. This is a contract No 45 for the company and the
contract price is shs.2.65 million. At the end of the company’s financial year, the contract was 85% complete and
hence regarded as being near completion. You are also provided with the following information about the
contract:

Particulars Shs.
Materials purchased and delivered 580,000
Materials issued from store 60,000
Materials returned to stores 7,000
Site expenses 300,000
Site wages 200,000
Plant sent to site 100,000
Architect’s fees 30,000
Plant returned from site 10,000
Subcontractor’s fees 105,000
Head Office overheads absorbed 60,000

Valuation at the year ending disclosed the following:

Shs
Materials: 19,500
Plant on site 50,000
Work done but not yet certified 60,000

Additional Information
1. The portion of the work which was completed during the year and certified by the architect was assessed
as representing 75% of the whole contract price. The contractee made payments to this extent less 10%
retention money.
2. The management of the company decided for the purpose of preparing the company’s annual accounts to
make a provision of a third of the national profit against the possibility of defects and other contingencies
arising later in respect of the work already certified for payment.

Required
a) The contract account
b) Amount of profit or loss to be taken to the main profit and loss account of the company.
c) Value of work in progress.

Wachira A.K. 65 M.U.S.T. - BFC 3227

Practice Question One
Explain the reason(s) why construction companies find it prudent to declare profits on uncompleted contracts.
(2 marks)
On 4 May 1999, Pendo Construction Company was contracted by Mara Paradise Ltd. to construct a leisure park
in Nairobi at a contract price of Sh. 950,000,000. Work commenced on the contract on 28 July 1999. Retention
money was agreed at 10% of work certified. At the end of the first year, no profits were declared as the contract
was considered to be in its infancy
The following details relate to the contract for the year ended 31 December 2000:
Sh’000
Balances brought forward 1.1.2000

Materials on site 4,500

Accrued wages 1,250
Plant (cost) 150,000
Cost of work done 158,000
Work certified to 31 December 1999 160,000

Transactions during the year.

Materials delivered to site:
Ex-stores 14,600
By suppliers 128,400
Additional plant (cost) 120,000
Subcontractors fees 18,450
Consultancy fee 28,000
Inspection fee 500
Salaries and wages 160,000
Head office expenses 1,200
Material transfers out 15,000
Materials sales (cost Sh 19,800) 22
Plant hire 250
Direct expenses 2,600
Total cash received from contractee 580,000
Work certified during the year 660,000
Cost of work uncertified 42,000
Balances carried forward:
Materials on site 51,000
Wages accrued 2,800

Plants have been purchased for use on this contract. Pendo Construction Company provides for depreciation on
plant at 12 1/2% per annum on cost.

Wachira A.K. 66 M.U.S.T. - BFC 3227

Required:
(i) Contract account for the year to 31 December 2000, clearly showing the profits/ (losses) on contract for
the year. (10 marks)
(ii) Valuation of work-in-progress. (4 marks)
(iii) Account of Mara Paradise Ltd. (4 marks)

Practice Question Two

On 1 November 2001, Jiwe Construction Company Ltd was awarded a contract to construct an office block for
the Association of Women Accountants of Kenya (AWAK). The office block is scheduled for completion by 31
March 2003.

The following information extracted from the books of Jiwe Construction Company Ltd relates to the contract for
the year ended 31 October 2002:

Shs.
Material issues – From central stores 5,500,000
- By suppliers, direct to site 14,200,000
Labour charges 10,100,000
Amounts paid to subcontractors 4,501,000
Plant and machinery bought on 1 6,000,000
November 2001
Loose tools and consumables 126,000
Head office expenses – apportioned 1,184,000

On 31October 2002, the stock of materials at site amounted to Sh 2,100,300. On the same date thee were
amounts outstanding with respect to wages, Sh 350,000 and for subcontract work, Sh 25,000.

Jiwe construction Company Ltd received Sh 36 million from AWAK which represents the amount of certificate
issued by their architect s in respect of work completed to 31 October 2002 after deducting 15% retention money.
It is estimated that work costing Sh 360,000 is not covered by this certificate.

You are also informed that:

1. The plant and machinery specifically purchased for the project is to be depreciated at 20% straight-line with
no residual value.
2. That Jiwe Construction Company Ltd only takes 2/3 of the profit on work certified to its revenue account.

Required:
a) Contract account for the period ended 31 March 2002. (8 marks)
b) Profit to be taken to the credit of the company’s revenue account. (4 marks)
c) Calculate the work-in-progress. (4 marks)
d) Illustrate how the balances on the contract account would appear in the balance sheet of the company.
(4 marks)

Wachira A.K. 67 M.U.S.T. - BFC 3227

PROCESS COSTING

Objectives:
At the end of this topic, students should be able to:
o Describe the nature of cost and various ways in which cost may be classified
o Explain various users of accounting information and their respective information needs
o Prepare a manufacturing cost statement and a profit statement.

It is a costing method that is applicable where products resulting from a sequence of continuous repetitive
operations or processes are produced. Cost of different material, labour and overheads are recorded in each
process account. Costs are averaged over the products produced during a period. Usually, the basic input material
enters the production line at the end and after a number of processes and conversions emerges at the other end of
the finalized products. Therefore, the finished product of one stage becomes input of the next stage of production

Thus, cost per unit = Total process cost for the period
The number of expected productions

Input material and materials introduced.

The raw materials introduced in the first process are transferred to the second process after processing. The
output of process 1 becomes the input of process 2 and so on. The full cost of the completed unit transferred from
the previous process forms the input material is 100% complete. Materials introduced in the current process is
extra material needed in the process and should always be shown separately from input material. Sometimes
input material is referred as material 1 and material introduced as material 2.

Process losses
They are losses that are experienced during the production process caused by a certain amount of material being
lost or deteriorated due to ash, evaporation, leakage, off cuts, trimming or spoilage.

Types of process losses

(i) Normal loss

Certain losses are inherent in production and can not be eliminated e.g. liquid may evaporate, part of
the cloth required to make suit maybe lost, losses occur in cutting wood to make furniture. Normal loss
is the loss of the output experienced during the normal production condition. These loses occur under
efficient operating conditions and are unavoidable. Through experience based on repetitive production
the firm will determine the level of normal loss.

(ii) Abnormal losses

They are the losses that are experienced during the production process and they result when actual loss
is greater than normal loss.

(iii) Waste
These are losses that have no value

(iv) Scrap
These are losses that can be sold at some throw away price to produce some supplementary revenue

(v) Abnormal gain

Is experienced when actual losses are less than normal losses. It represents savings on cost.

Wachira A.K. 68 M.U.S.T. - BFC 3227

Book keeping for process losses
 Abnormal loss
Dr: Abnormal loss account
Cr: Process account with the cost of the losses
 Scrap abnormal loss
Dr: cash/ scrap debtor (sales) account
Cr: Abnormal loss account with the scrap value of the losses
 Abnormal gain (represent a saving on cost)
Dr: Process account
Cr: Abnormal gain account
 Scrap abnormal gain
Dr: Abnormal gain etc with scrap value of losses
Cr: Scrap debtors account with scrap value of losses
NB: Scraping the losses, reduces the process costs
Thus when losses are scrapped, the cost per unit can be computed using the formula shown below:

Cost/unit of good production = Total process cost – Scrap value of Normal loss
The expected production

Illustration
Production of product x passes through three processes A, B and C. During January, 3000 units of material were
issued to process A at shs 25/=/ unit in the three processes were respectively. Other costs were:
A B C
Direct materials cost 15000/= 36000/= 54000/=
Direct labour 90000/= 60000/= 30000/=
Direct expenses 8400/= 15600/= 6000/=

Total overheads amounted to shs 270000/= for the period. The firm uses direct labour cost to apply overheads at
a rate of 150% in each department

Required
Show process account and finished goods inventory account

COMPANY
Process A
Units @ Ksh Units @ Ksh
Input material 3000 25/= 75000 Transfer to department B 3000 107.8 323400
Introduced material 15000
Direct labour 90000
Direct expenses 8400
Manufacturing overheads 135000
3000 323400 3000 323400

Wachira A.K. 69 M.U.S.T. - BFC 3227

 Process B account
Units @ Ksh Units @ Ksh
Transfers from Process A 3000 107.8 323400 Transfer to process C 3000 175 525000
Direct material 36000
Direct labour 60000
Direct expenses 15600
Manufacturing overheads 90000
3000 525000 3000 525000

Process C account
Units @ Amt Unit @ Amt
Transfers from Process B 3000 175 525000 Transfer to finished 3000 220 660000
Direct material 54000 goods inventory
Direct labour 30000
Direct expenses 6000
Manufacturing overheads 45000
3000 660000 3000 660000

Process A
Cost/ unit = 323400 = 107.8
3000
Finished goods inventory account
Units @ Amt Unit @ Amt
Transfer from process 3 3000 220 660000 balance c/d 3000 220 660000

Illustration
In manufacturing of product A. 6000kg of material at a cost of 5/= per kg were issued to process 1. Direct
material were Ksh 9000/= , overhead in the department 6900/= . 5250kg of the output were produced. Normal
loss 10% of good production
Required
Show process 1 account
Abnormal loss account

Process 1 account

Unit @ Amt Unit @ Amt

Input material 6000 5 30000 Normal loss 600 - --
Direct labour 9000 Abnormal loss 150 8.50 1275
Overheads 6900 Transfer to finished 5250 8.50 44625
To finished goods
6000 45900 6000 45900

Cost/ unit of good production = 45900 = 8.50 shs

5400
Normal loss = 10% of 6000 = 600kgs
Therefore expected production = 6000 – 600kgs = 5400
Actual production = 5250
Abnormal loss is therefore 150
NB: Abnormal losses and abnormal gains are costed same as good production

Wachira A.K. 70 M.U.S.T. - BFC 3227

Illustration 3
Assuming that the losses in example 2 above will be scrapped at sh 2.10 per kg. Show the process account and
abnormal loss account
Solution
Scrap value of net loss = 600kg x 2.10 = sh 1260
Expected production = 5400kg

Process Account

Units @ Amt Unit @ Amt

Direct Material 6000 5 30000 Normal Loss 600 2.10 1260
Direct Labour 9000 Actual Loss 150 8.2667 1240
Direct overheads 6900 Transfer Finished goods 5250 43400
6000 45900 6000 45900
Cost/ unit of good production = 8.2667
th
NB Estimate at least to the 4 decimal point

Abnormal Loss Account

Units @ Amt Unit @ Amt
Process I 150 8.2667 1240 Scrap debtors A/c 150 2.10 315
P & L Account 925
150 1240 150 1240

Scrap Debtor
Units @ Amt Unit @ Amt
Normal Loss 600 2.10 1260 Balance C/d 1575
Allowed Loss 150 2.10 315
750 1575 1575

This is a supplementary revenue to be credited = P& L Account (miscellaneous revenue)

Illustration 4
Suppose the actual production in example 2 was 5490kgs and losses will be scrapped at shs 2.10
Required
Show the necessary accounts

Workings
Normal loss = 10% of input (6000) = 600kg
Expected production = 5400
Actual production = 5490
Abnormal gain 90

Wachira A.K. 71 M.U.S.T. - BFC 3227

 Progress 1 account
Kg @ Amt Kg @ Amt
Input material 6000 5 30000 Normal Loss 600 2.10 1260
Direct Labour 9000 Transfer to finished 5490 45384
Abnormal gain 90 8.2667 744 goods inventory
6090 46644 6090 46644

Cost/ unit of goods production = Total cost of production – Scrap value

Expected production

= 45900 – 1260 = sh 8.26667

5400

Abnormal Gain Account

Kg @ Ksh Kg @ Ksh

Scrap debtor 90 2.10 189 Process 1 Account 90 8.2667 744

Profit & Loss Account 555
90 744 90 744

Scrap Debtors
Kg @ Amt Kg @ Amt
Normal Loss 510 2.10 1071 Abnormal gain 90 2.10 189
Balance c/d 420 2.10 882
510 1071 510 1071

Balance C/d 420 2.10 882

This credit to scrap Abnormal Gain is necessary so that the scrap debtor account shows a balance of sh 882 as the
units we’ve owned i.e. (510-90)

Illustration 5
Orion Ltd produces a single product which undergoes three processes. The following details relate to one period.

Process
1£ 2£ 3£
Raw material (60,000 units) 80,000
Material introduced 23,500 18,750 22,100
Direct wages 15,600 12,000 13,400
Overheads allotted to processes 3,800 4,600 3,200
Other overheads to the £27,000
Units Units Units
Output in units 55,200 53,800 49,600
Normal loss of 5% of the input to each process is anticipated.

Units lost have the following scrap values

Wachira A.K. 72 M.U.S.T. - BFC 3227

 After process 1 Nil
After process 2 £1
After process 3 £1.80

There was no opening or closing or closing W-I-P

Prepare ledger accounts for the period.

Process 1 Account
DR CR
Units CPU Amt. Units CPU Amt
Raw materials 60,000 80,000 Normal loss 3,000 - -
Material introduced 23,500 Abnormal loss 1,800 2.336 4,205
Direct wages 15,600 Process 2 a/c 55,200 2.336 128,968
Overheads allocated
to process 3,800
Other overheads
applied on wages 10,273
6,000 133,173 6,000 133,173

Process 2 Account
DR CR
Units CPU Amount Units CPU Amounts
Process 1 A/C 55,200 2.336 128,968
Material introduced 18,750 Process 3 a/c 53,800 3.22151 173,855
Direct wages 12,000
Overheads allocated 4,600 Normal loss 2,760 2,760
Other overheads 7,902
Abnormal gain 1,360 3.2319 4,395
56,560 176,615 56,560 176,615

Process (R) = 169,460 = 3.2319

52,440

Process 3
DR CR
Units CPU Amount Units CPU Amounts
Process 3 a/ c 55,800 3.2315 173,855
Allocated costs 3,200 Finished good a/c 49,600 4.2367 210,141
Direct wages 13,400
Other overheads 8,824 Normal loss 2,690 1.8 4,842
Introduced 22,100
material Abnormal loss
a/c 1,510 4.2367 6,397
58,800 221,379 53,800 221,380

216,537 = 4.2367
51,110

DR Abnormal gain/loss CR

Wachira A.K. 73 M.U.S.T. - BFC 3227

Process 1 A/C 4,205 Process 2 A/C 4,395
Process 2 A/C 6,397 Scrap sale (III) (1.8 x 1,510) 2,718
Scrap Sales (II) (1.0 x 1,360) 1,360

DR Scrap Sales A/C CR

Abnormal losses a/c 2,718 Abnormal gains a/c 1,360

Normal loss a/c Process (II) 2,760
Normal loss Process (III) 4,842

Process i
Input 60,000 units
Normal loss (5% x 60,000) (3,000) 133,173 = 2.336
Notional output 57,000 57,000
Actual output 55,200
Abnormal loss 1,800

Process ii
Input 55,200
Normal loss (5% x 55,000) (2,760)
Expected output 52,440
Actual output (53,800)
Abnormal gain 1,360

Process iii
Input 53,800
Normal loss (5% x 53,800) 2,690
Expected output 51,110
Actual output (49,600
Abnormal loss 1,510

Wachira A.K. 74 M.U.S.T. - BFC 3227

 BUDGETS

Objectives:
At the end of this topic, students should be able to:
o Explain the meaning and need for budgets
o Prepare different kinds of budgets for an organization

- A budget is a quantitative expression of a plan of action in advance of the period to which it relates.
- Budgets may be prepared for the business as a whole for departments, for functions such as sales and
production, or for financial and resource item such as cash, capital exp, man power, purchases etc.

Benefits of Budgeting

Planning and Coordination

Budgeting forces planning to take place. The budgeting process provides for the coordination of activities
and departments of the organization so that each facet of the operation contributes towards the overall
plan.

Clarification of authority and responsibility

A budget provides clear guidelines for managers and supervisors and is the major way in which
organizational objectives are translated into specific tasks and objectives related to individual managers.
The budgeting process makes it necessary to classify the responsibilities of each manager who has a
budget.

Communication
A budget communicates the agreed plans to all the staff involved - both vertically and horizontally to
ensure that coordination is achieved e.g. there must be full liaison between the sales and production
functions to ensure that coordinated budgets are developed.

Control
Deviations of actual results from planned result are noted so that corrective action may be taken. Because
of ‘exceptional principle’ which is at the least of budgetary control management time can be saved and
attention directed to areas of most concern.

Motivation
The involvement of lower and middle management in budget preparation and establishment of clear targets
one motivating factors. Provided there is proper participation, goal congruence is encouraged &
motivation increased.

Better Liquidity
The integration of budgets makes possible better cash and working capital management

Principal Budget Factor/Limiting/Key Factor

This is a factor which at any given time effectively limits the activities of an organization. It may be customers
demand, production capacity, labor shortage, materials, space or finance.
Since such a constraint will have a persuasive effect on all plans and budgets. The limiting factor must be
identified and its effect on each of the budgets carefully considered during the budget preparation process.

Wachira A.K. 75 M.U.S.T. - BFC 3227

Fixed and Flexible Budgets
- A fixed budget is a budget which is designed to remain unchanged irrespective of the volume of output or
turnover attained.
- A flexible budget is a budget which is designed to adjust the budgeted cost levels to suit the level of
activity actually attained. This is done by analyzing cost into fixed and variable elements so that the
budgets may be ‘flexed’ according to the actual activity.
- For control purpose its vital that flexible budgeting is used. Only by comparing what the costs should
have been with the expenditure incurred at the actual activity level can any control be exercised.
- The major purpose of a fixed budget is at planning stage when it serves to define the broad objective of
the organization. It’s unlikely to be of any real value for control purposes except if the level of activity
turned out to be exactly as planned.
- A formal definition of flexible budget is:
‘A budget which, by recognizing different cost behavior patterns is designed to change as the volume of
output changes.’
- The results obtained from flexing a budget are only accurate if the costs behave in the ways predicted.

Illustration i
After study of planned activities, forecast cost levels and the pattern of cost behavior the following budget has
been prepared based on anticipated activity level of 8,000 labour hours.
Nature of expense Budgeted cost Cost Cost
For 8000 labour hrs Classifications (x=activity level)
Direct wages 55,500 Linear Semi-Var 3,500+6.5x
Direct materials 84,000 Linear Variables 10.5x
Salaries 22,000 Fixed 22,000+0x
Depreciation 9,500 Fixed 9,500+0x
Other overheads 19,200 Curvi-linear variable 0.0003x2
Based on the above data it is required to prepare budgets for activity levels of 7,800 and 8,400 labour hours

Solution
Expenses Cost Budgets for Budgets for
Activity of 7,800hrs activity of 8,400hrs
Direct wages 3,500+0.3x 54,200 58,100
Direct materials 10.5x 81,900 88,200
Salaries 22,000+0x 22,000 22,000
Depreciation 9,500 9,500
Other overheads 18,252 21,168

NB:
(a) Using a flexible budget the planned expenses level for the actual activity ac n be compared with the
actual expense so highlighting discrepancies.
(b) A budget analyzed to fixed and variable elements can be flexed to provide realistic budgeted expense for
any given activity level, eve n where the activity change month by month.

Illustration ii
AB Company makes a single product and has an average production of 5,000 units a month although this varies
widely. The following extract from the overhead statement for the extrusion department shows the make-up of
the budget and a month’s actual results.

Wachira A.K. 76 M.U.S.T. - BFC 3227

Budget for Actual Results for
Average production of January Production of
5,000 units 4,650 units

Shs. Shs. Shs.

Indirect Labour Fixed 300,000
Variable Shs. 100/unit 500,000 800,000 790,000
Consumables (all variable) 1,500,000 1,425,000
Variable Overheads 2,000,000 1,820,000
Fixed Overheads 1,250,000 1,250,000
Shs. 5,550,000 Shs. 5,285,000

Show two budgetary control statements for January, one based on the fixed budget for 5,000 units and one based
on flexible budget for the actual level of production.

Fixed Budget (Actual Results)

Expense type Fixed Budget Actual Results Budget Variance

Favourable (Adv.)
Shs. Shs. Shs.
Indirect Labor 100,000 790,000 10,000
Consumables 1,500,000 1,425,000 75,000
Variable Overheads 2,000,000 1,820,000 180,000
Fixed Overheads 1,250,000 1,250,000 -
Shs 5,550,000 Shs. 5,285,000 Shs. 265,000

NOTE: The variances are the differences between budget and actual. They are favorable when actual costs are
BELOW budget and adverse when above.

FLEXIBLE BUDGET (Actual Results)

Expense type Flexible Budget Actual Budgeted

For 4.650 units results variance
Indirect labor
Fixed 300,000
Variable 465,000 765,000 790,000 (250,000)
Consumables
1,500,000 = Sh. 300/unit 1,395,000 1,425,000 (300,000)
5,000
Variable
Overheads Sh. 400/unit 1,860,000 1,820,000 40,000
Fixed Overheads 1,250,000 1,250,000 -
5,270,000 5,285,000 (15,000)

Wachira A.K. 77 M.U.S.T. - BFC 3227

MASTER BUDGET
It contains various subsidiary or functional budgets. It’s a summary of all other budgets and includes also a
budgeted profit and loss account and a balance sheet. It shows the overall picture of the budgeted targets for the
next period. It helps to coordinate the activities of a big enterprise. A functional budget is one which relates to
any of the functions of an enterprise. The various functional budgets or parts of the master budget are:
i. Sales budget: shows the number of units of different products which a firm wants to sell i.e. Next one
period
ii. Production budget: gives details of goods to be produced in a specific period.
iii. Purchases budget: shows the various raw materials and other items to be purchased in order to meet
production demand.
iv. Production cost budget: Gives information on various elements of production cost e.g. Direct material,
Direct labour, production overheads
v. Cash budget: Comprises the details of expected cash receipts and payments in the next few months or one
year period.
vi. Budgeted profit and loss account: is prepared to find out budgeted profit
vii. Budgeted Balance Sheet: gives details of assets and liabilities at the end of the budgeted period.

Illustration 1
A manufacturing company produces two products namely Q and P. Two types of material X and Y are used in
manufacture of these products. The following information is provided by the company for the year 2016.
(a) Budgeted Sales
Product Qty Price
Q 18,000 65
P 20,000 80
(b) Material used
Material X Y
Unit cost Shs. 6 Shs. 3
Qty used
Q 3 6
P 5 4
There were the following stocks: -
Product Opening Closing
Q 3,000 1,500
P 2,000 2,500
Material
X 5,000 6,000
Y 2,000 3,000

Required
Prepare the following budgets: -
(i) Sales budget
(ii) Production budget
(iii) Material usage in quantities budget
(iv) Material purchases in quantity and value

Wachira A.K. 78 M.U.S.T. - BFC 3227

Sales Budget
Product Quantity Selling price Sales volume
Q 18,000 65 1,170,000
P 20,000 80 1,600,000
2,770,000

Production Budget
Q P
Production for the year Closing 1,500 2,500
Sales for the year 18,000 20,000
Less Opening stock (3,000) (2,000)
Production 16,500 20,500

Material usage in quantities budget

Qty per product Q P Total
X (3 x 16,500) (5 x 20,500)
Y
X Y
Q (3 x 16,500) = 49,500 16,500 x 6 = 990,000
P 5 x 20,500 = 102,500 20,500 x 4 = 82,000
152,000 units 181,000 units
Material Purchases
X Y
Closing stock 6,000 3,000
Opening stock (5,000) (4,000)
Quantity 152,000 181,000
153,000 units 180,000 units
Cost per unit Shs. 6 Shs. 3
Shs. 918,000 Shs. 540,000

Illustration II
Ideal products limited manufactures two products A and B. for the financial year ended 30 June 2004, the
following information was assembled for preparation of the budget.
Standard data per unit
Direct materials Standard price per Kg Product A Product B
Sh Sh Sh
M1 10 10 4
M2 20 4 6
Direct Standard rate Product A Product B
Labour Per hour Hours Hours
L1 30 8 10
L2 20 12 5
The following additional information was available
a) Fixed production overhead costs were recovered on a direct labour basis
b) Administration, selling and distribution costs were absorbed at the rate of 20% of production cost
c) Profit was estimated at the rate of 25% of cost of making and selling the products
d) Expected sales Product A Product B
Sh ‘000’ Sh ‘000’
13,494 18,816

Wachira A.K. 79 M.U.S.T. - BFC 3227

 e) Finished goods stock valued at standard production cost was as follows:
Product A Product B
Sh ‘000’ Sh ‘000’
1 July 2003 1,730 1,176
30 June 2004 1,038 1,568
f) Direct materials stock valued at standard prices was as follows:
Material M1 Sh ‘000’ Material M2 Sh ‘000”
1 July 2003 640 600
30 June 2004 360 800

g) For the year ended 30 June 2004, ‘fixed overheads had been budgeted at Sh 5,760,000 and direct
labour hours budgeted at 3,600,000 110hours
h) It is management’s expectations that there will be no opening and closing work in progress
Required
a) Production budget in units (8 marks)
b) Direct material cost budget (3 marks)
c) Purchases budget (6 marks)
d) Direct labour cost budget (3 marks)
Solution
(a) Products
A B
Sh Sh
Material 1 100.0 40.0
Material 2 80.0 120.0
180.0 160.0
Direct labour L1 240.0 300.0
L2 240.0 100.0
660.0 560.0
Production overheads @ 1.60 32.0 24.0
692.0 584.0
Selling & distribution 20% 138.4 116.8
830.4 700.8
Profit margin 25% 207.6 175.2
Selling price per unit 1038.0 876.0

Units to be sold
A B
13,494,000 18,816,000
1038 876
13,000 21,479
Opening stock finished goods in units
A B
1,730,000 1,176,000
692 584
2,500 2,014

Wachira A.K. 80 M.U.S.T. - BFC 3227

Closing stock finished goods in units
A B
1,038,000 1,568,000
692 584
1,500 2,685

Ideal products Ltd

Production budget in units
A B Total
Sales in units 13,000 21,479 34,479
Closing Stock 1,500 2,685 4,185
14,500 24,164 38,664
Less: Opening stock (2,500) (2,014) (4,514)
Production in units 12,000 22,150 34,150
(8 marks)
(b) Direct materials cost budget
M1 M2 Totals
Sh Sh Sh
Product A 1,200,000 960,000 2,160,000
Product B 886,000 2,658,000 3,544,000
2,086,000 3,618,000 5,704,000
( 3 marks)
(c) Purchases budget
M1 M2 Totals
Sh Sh Sh
Material Cost 2,086,000 3,618,000 5,704,000
Closing stock 360,000 800,000 1,160,000
2,446,000 4,418,000 6,864,000
Opening stock (640,000) (600,000) (1,240,000)
Material purchases in Sh 1,806,000 3,818,000 5,624,000
Material purchases in kg 180,600 190,900 381,800
( 6 marks)

(d) Direct labour cost budget

L1 L2 Totals
Sh Sh Sh
Product A 2,880,000 2,880,000 5,760,000
Product B 6,645,000 2,215,000 8,860,000
9,525,000 5,095,000 8,860,000
(3 marks)

Wachira A.K. 81 M.U.S.T. - BFC 3227

 (e) Material usage budget
M1 M2
Production A: 12000 units X10kg = 120,000kg X4kg = 48,000kg
B: 22151 units Xkg = 88604kg X6kg = 132,906kg
208,604kg 180,906kg
Cost per unit X sh. 10 X sh. 20

Sh 2,086,040 Sh 3,618,120
(Total 20 marks)

CASH BUDGET
- It shows the expected cash receipts and expected cash payments during the budgeted period. Liquidity
and cash flow management are key factors in successful operations and of any organizations. Its with
good reason that the cash budget should receive close attention from accountants and managers
- It shows the effects of budgeted activities – selling, buying, paying wages, investing in capital equipments
etc the cash flow of the organization.
- It’s prepared to ensure that there will be just sufficient cash in hand to cope adequately with budgeted
activities. the cash budget may show that there’s likely to be a deficiency of each in some future period in
which case overdrafts or loans have to be arranged or activities curtailed – or alternatively the budget may
show that there is likely to be a cash surplus in which case appropriate investment or use for the surplus
can be planned rather than merely leaving the cash idle in a current account.
- The main functions of a cash account
i. To ensure that the cash is available for revenue expenditure
ii. To indicate when, where and how much cash will be needed and whether this is permanent or
temporary.
iii. Preserve liquidity throughout the year
iv. Reveal surplus cash for investment or expansion of facilities
v. Guide management on financing capital expenses internally or externally.

Illustration
On 1 January the summary Balance Sheet of CH Ltd was as follows:
Shs. Shs.
Share capital 40,000 Machinery at cost 80,000
Reserves 20,000 less Accum. Dep. (19,200)
Loan 15% 40,000 Stocks 24,200
Proposed dividends 1,000 Debtors 25,000
Overdraft 9,000 _______
110,000 110, 000

The following are expected during the next three months:

Sales Purchases Expenses
January 150,000 100,000 20,000
February 200,000 150,000 25,000
March 300,000 280,000 30,000
All sales are on credit and the collection has the following pattern: During the month of sale 80% (a 4% discount
is given for payment in this period). In the subsequent month 20%. Payment for purchase is made in the month of
purchase in order to take advantage of a 10% prompt settlement discount calculated on the gross purchase figures
shown above. Stock levels are expected to remain constant throughout the period. Depreciation of machinery is
calculated at the rate of 12% p.a. on cost. The appropriate portion for each month January – March is included in

Wachira A.K. 82 M.U.S.T. - BFC 3227

the expenses figures above. Expenses are paid for in the month in which they are incurred. The proposed
dividend will be paid in January. Loan interest for the three months will be paid in March.

Required:
i) Prepare a cash budget for each of the three months January to March.
ii) Prepare a forecast Trading, Profit and Loss Account for the period.
iii) Prepare forecast Balance Sheet as at 31st March.
iv) Briefly explain why the change in Cash Balance between 1 January and 31 March is not the same as the profit
or loss figure for the period.

Cash Budget
Jan Feb March
Opening Balance (9,000) 21,000 45,400
+ Receipts 140,200 183,600 270,400
Cash available 131,200 204,600 315,800
Payments
Creditors 90,000 135,000 152,000
Expenses 19,200 24,200 29,200
Interest 1,500
Dividends 1,000 ______ ______
110,200 159,200 282,700

Balance c/f 21,000 45,400 33,100

Workings: Sales cash inflows January February March

December 29,000 - -
Jan Sales (80% x 150,000) 96% 115,200 30,000 -
Feb 96% (80% x 200,000) - 153,600 40,000
March 96% (80% x 300,000) ___-___ ___-___ 230,400
140,200 183,600 270,400

Payments to creditors
Purchases 100,000 150,000 280,000
Discount 10,000 15,000 28,000
90,000 135,000 152,000

Expenses 20,000 25,000 30,000

Less Deposit (non-cash item) 800 800 800
19,200 24,200 29,200

Loan interest = 18% x 40,000 = 6,000 x 3 = 1,500

12

Discounts Jan 150,000 x 0.8 x 0.04 = 4,800

Feb 200,000 x 0.8 x 0.04 = 6,400
March 300,000 x 0.8 x 0.04 = 9,600
20,500

Budgeted Profit & Loss Account

Wachira A.K. 83 M.U.S.T. - BFC 3227

 Shs.
Sales 650,000
Less Cost of sales 530,000
Gross Profit 120,000
Discount received (530,000 x 10%) 53,000
Less expenses
General expenses 72,600
Depreciation 2,400
Discount allowed 20,800
Loan interest 1,500 97,300
75,700

Balance Sheet
Fixed Assets
Share capital 40,000 Machinery 80,000
P & L a/c 75,700 Acc. Dep. (2,400 + 19,200) 21,600
Reserves 20,000 58,400
135,700
Current Assets
Loan 40,000 Stocks 24,200
Debtors 60,000
_______ Cash 33,100 117,300
175,700 175,700

NB: Debtor = 20% x 300,000 = 60,000

Wachira A.K. 84 M.U.S.T. - BFC 3227

REVIEW QUESTIONS

Question One
a) In the context of budgetary control explain the main functions and importance of a cash budget ( 5
marks)
b) You are in charge of making forecast and preparing budgets. You have been supplied with cost and
revenue forecasts and details of payments as follows:
Forecast of revenue and cost for the quarter ending 31 March 2001
January February March
Direct Shs Shs Shs
Materials (purchase) 112,000 100,000 135,000
Wages 90,000 80,000 100,000
Over head
Production 34,000 32,000 40,000
Administration 22,000 20,000 27,000
Selling & distribution 13,000 11,000 18,000

Sales 360,000 350,000 440,000

Forecast of revenue and costs for the quarter ending 30 June 2001
April May June
Direct Shs Shs Shs
Materials (purchase) 90,000 67,000 79,000
Wages 72,000 54,000 63,000
Overhead:
Production 45,000 36,000 40,000
Administration 22,000 25,000 27,000
Selling & distribution 13,000 11,000 16,000

Sales 350,000 360,000 360,000

Cash balance on 1 April 2001Sh. 90,000
Other details
 Period of credit allowed by suppliers averages two months
 Debenture to the value of shs. 125,000 are being issued in May 2001 and the amount is expected
to be received during the month.
 A new machine is being installed at the end of March 2001 at a cost of shs 150,000 and payment is
promised in early May 2001
 Sales commission of 3% is payable within one month sales.
 A dividend of sh. 100,000 is to be paid in June 2001
 There is a delay of one month in the payment of the overheads. There is also a delay in payment
of wages averaging a quarter of a month.
 Twenty per cent of the debtors pay cash, receiving a cash discount of 4% and 70% of debtors pay
within one month and receive a cash discount of 21/2%. The other debtors pay within two months
Required
A cash budget on a monthly basis from the second quarter of the years 2001 (15 marks)
(Total 20 marks)

Wachira A.K. 85 M.U.S.T. - BFC 3227

 Question Two
A company prepares the following main budgets:
Sales budget
Manufacturing budget
Purchasing budget
Selling and administration overheads budget
Budgeted balance sheet
Required
Describe the purpose and content of each of the above budgets

Wachira A.K. 86 M.U.S.T. - BFC 3227