Level 3

Management Accounting
Techniques

Study Buddy
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Introduction to your Study Buddy
The aim of the study buddy is to teach you Management Accounting Techniques in an
order that makes sense and an order that we would deliver it in the classroom. We pride
ourselves on this as we’ve always obtained excellent exam results!
Please use the study buddy as your first learning resource as it aims to:
 Help you learn what’s relevant, quickly, as we know your time is precious
 Structure learning in a logical way
 Teach key subjects in a clear and concise way
 Help you apply knowledge to what happens in the real world
 Improve your study and exam technique
 Keep you interested and motivated.
The Study Planner which is also located in your study buddy acts as a checklist as it
indicates the order of the sections and also when you need to access your online content
which is available on Moodle.
Your online content consists of the following:
 Knowledge Checks – This is just a quick test to help you decide whether you’re
ready to move, of if you need to work through the topic again and/or read more in
the Osborne tutorial.
 Study Modules – These award winning Study Modules cover the trickier parts of
the syllabus, so we advise that you work through them to ensure that you are 100%
confident.
 DL Workbooks – These workbooks go alongside your study modules, so we advise
you to have them at hand when you start to study the relevant study module.
Please note you are able to print off these workbooks.
 Consolidation Test – This test will check you’re up to speed with everything that
you have covered so far in the sections.
 Progress Test – This progress test has been designed to test your knowledge on
all the sections covered within your Tutorial part of the course. So if you do not do
so well you will need to go back and recap on the topic areas you have struggled
with. Otherwise, if you have performed really well, you are now ready to move onto
the Workbook Activities.
 Mock Exam – Now it's time to put all your hard work into action.
We can’t over-emphasise how important it is for you to complete your mock exam to
check your understanding and prepare you for your real exam.
1. Attempt the mock exam under timed conditions, without reference to your
study materials, so that you get a realistic gauge of how prepared you are.
2. After you've completed the mock, review the correct answers.
3. Identify any weaker areas that you might need to revisit as a part of your
revision and before you attempt the AAT practice assessments on MyAAT.
Tip: our research shows that those students who complete this mock under exam
conditions will perform better in their final exam.
The Osborne Books Tutorial is an excellent resource that will aid your learning. It contains
activities for you to practise to ensure that you fully understand those topic areas you have
just learnt.
Your Osborne Books Workbook acts as a revision resource. The questions are similar to
those you could expect to see in your actual exam. Therefore it is fundamental that you
complete all the questions in your Workbook.
Please remember that despite this being a Distance Learning course, you are never
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please do not hesitate to contact your mentor or academic support team in the first instant.
We hope that you have a fabulous learning experience with us, and we wish you every
success in studying your course with us.

Spreadsheet skills for Management Accounting

The Management Accounting Techniques unit expects students to be able to use
spreadsheet skills to complete management accounting tasks.
The Osborne Books Management Accounting Techniques Tutorial and Workbook contain
case studies and questions that apply spreadsheets skills to management accounting.
Students using this study buddy should ensure that they use the Osborne Books
Spreadsheets for Management Accounting Tutorial text to learn how to use the
spreadsheet skills that they need to complete these activities.
All of the spreadsheets files required to complete the case studies and activities in the
Osborne Books Tutorial and Workbook, and the Spreadsheets for Management
Accounting Tutorial are available on the product pages on the Osborne Books website,
and are clearly signposted in the Osborne Books texts.
Study Planner

Management Accounting Techniques

Study
Target
Buddy Content Completed
Date
Section
TUTORIAL
1 An introduction to management accounting
Knowledge Check: Management accounting
Study Module: Types of costing system
Knowledge Check: Cost classification
Knowledge Check: Types of costing system
2 Material costs
Knowledge Check: Materials
3 Labour costs
Knowledge Check: Labour
4 Overheads and expenses
Study Module: Overheads
Knowledge Check: Overheads
5 Methods of costing
6 Marginal, absorption and activity based costing
Consolidation Test
7 Aspects of budgeting
Knowledge Check: budgets and variance
analysis
8 Short-term decisions
Knowledge Check: Short term decision
making
9 Cash budgeting and resources ratios
Study Module: Principles of cash budgeting
Knowledge Check: Principles of cash
budgeting
Study Module: Spreadsheets for
management information
Knowledge Check: Spreadsheets for
management information
Progress Test
 WORKBOOK
Osborne Management Accounting
Techniques - Workbook:
Complete all the workbook activities
Mock Exam A
MyAAT - AAT Practice Assessment 1
MyAAT - AAT Practice Assessment 2

Please note that your Study Planner is a checklist which indicates the order of the
materials you need to access when studying for this unit.
You will find your Knowledge Checks, Study Modules, Consolidation Test, Progress
Test and Mock Exam A in Moodle, and we advise you access these when you are
indicated to do so via your study planner.
The award winning Study Modules are additional on-line resources which are designed
to help you understand the trickier topic areas of the syllabus which Kaplan Financial has
kindly allowed us to use in your course.
You must log into your MyAAT account to access the AAT Practice Assessments.
Finally, please note that to access your Online Osborne Tutorial and Workbook you
must visit: [email protected].
Good luck and we hope you enjoy your Management Accounting
Techniques course.
Glossary
Throughout your course we will use International terminology, as this is what you
will use in the assessment. However, you may also need an awareness of UK
Standard Terms.

It’s worth revising these just before an exam just in case!

UK Standards International Accounting Standards

Profit and loss account Statement of profit or loss

Sales/turnover Revenue/turnover

Operating profit Profit from operations

Balance sheet Statement of financial position

Fixed assets Non-current assets

Long term liabilities Non-current liabilities

Financed by (capital) Equity

Stock Inventories

Debtors Trade and other receivables

Creditors Trade and other payables

 Section 1
An introduction to management
accounting

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover the purpose of management accounting (which is also called
cost accounting) and revise the basic costing principles which you learnt in an earlier
Level 2 unit.

When you have finished studying this section you will be able to:

– Explain the purpose of management accounting

– Distinguish between management accounting and financial accounting

– Describe a cost unit

– Describe the different types of responsibility centres

– Explain how costs can be classified by element, by nature, by function and by

behaviour

– Split costs into fixed and variable elements

– Calculate the cost of a good or service

– Produce a total cost statement

 S ec t io n 1 Page | 2

PURPOSE OF MANAGEMENT ACCOUNTING

Most companies formulate long-term plans for the future. These plans are known as
strategic plans and typically cover periods of three to five years. They set out the
objectives of the company and then describe how these objectives will be met. The
plan will cover financial strategy of course, but also other areas such as marketing
and technological advances.

These strategic plans must then be put into action by managers, and this is where
management accounting comes in. Also known as cost accounting, it involves
analysing a company’s financial data in order to assist in:

 Short-term decision-making

 Planning and monitoring expenditure

 Controlling costs and maximising profits

Techniques such as forecasting, budgeting and costing are used to provide

management with information about the financial consequences (good or bad) of
the decisions they are considering. Such decisions could include whether to
purchase new production machinery, whether to introduce or close product lines, or
perhaps whether to make changes in staffing levels, all decisions which will
ultimately affect the profitability of the business.

Management accountants use forecasting to predict future inflows of revenue,

costing methods to price products and services, budgeting to calculate the financial
resources required in order to meet the plan and variance analysis tools to make
comparisons between actual results and expected (budgeted) results.

All of this information will be used by the managers to control costs and monitor
performance in their specific areas of responsibility. It is therefore vital that internal
management reports contain information that is both accurate and reliable and
provides the level of detail needed to ensure the future security and profitability of
the company.

MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING

Unlike financial accounting, management accounting does not concern itself with
the reporting of past financial transactions. Instead, it looks towards the future.

Activity 1
You have already come across the differences between management and financial
accounting in your previous studies. Use the table below to list typical activities
carried out by management and financial accountants. Once you’ve completed the
activity, take a look at our suggestions at the back.
 S ec t io n 1 Page | 3

Financial accounting Management accounting

Activity 2
Now see if you can summarise the key differences between the two approaches to
financial transactions taken by management and financial accounting by completing
the following table:

Feature Select from Management Financial

accounting accounting
Focus on Future / Past
Types of Primarily financial /
information Wide range of data
Level of detail Summaries / Daily
details
Format Any format / Fixed
format
Users External / Internal
Purpose Reporting profits /
Assisting in planning,
decision making and
control
Key Management reports /
documents Statements of profit
and loss and financial
position
Confidentiality Can be made public /
highly confidential
 S ec t io n 1 Page | 4

COST UNITS AND COMPOSITE COST UNITS

Cost units are units of output (whether they are products such as cars or services
such as a bus journey) to which costs can be attributed. When all the costs
associated with producing the unit are combined, they form the total cost value of a
unit. This can then be used for decision making purposes – for example establishing
the selling price per unit.

Sometimes cost units are composite cost units which means that they are made
up of more than one variable, and these are commonly found in service industries.
Examples of this would be the cost of a bus passenger per kilometre travelled, or
the cost of a hotel bed per day.

RESPONSIBILITY CENTRES
Responsibility centres describe a segment of the business for which a manager has
responsibility – the four main types are cost centres, revenue centres, profit centres
and investment centres.

COST CENTRE
The manager has responsibility for controlling costs only.

Examples include a production department in a factory, or a support function such

as the administration department in a college.

PROFIT CENTRES
The manager has responsibility for costs and revenues – that is, for earning a profit.
An example would be the branch of a retail outlet where managers can make pricing
and layout decisions to influence sales as well as control costs.

REVENUE CENTRES
The manager has responsibility for earning a particular level of sales revenue, for
example running a sales team or running a branch of a coffee shop where all the
costs are incurred by head office.

INVESTMENT CENTRES
The manager has responsibility for earning a return on the assets invested in the
segment. This means that they control not just revenue and cost-based decisions
but also decisions about purchasing non-current assets. Returns calculations can
be as simple as Profit earned / Investment x 100.
 S ec t io n 1 Page | 5

Activity 3
We are now going to use the information given in the case study: Providing
Information for Management in Chapter 1 of your Osborne Tutorial, to help ensure
you understand the differences between the different types of responsibility centres.

First read the situation described in the case study and then use the information
provided, which we have replicated below, to complete the tables and decide which
of the two centres is performing best if they are treated as

(i) Cost centres

(ii) Revenue centres

(iii) Profit centres or

(iv) Investment centres

Once you have checked your answers at the back of this section, then turn to the
conclusion in your Osborne Tutorial to see how the information may be used in a
management report.
Conservatory Plants Shrubs
£(000) £(000)
Costs: Materials 137 151
Labour 93 134
Expenses 45 70
Revenue 425 555
Money invested 450 400
(i) Cost centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)
 S ec t io n 1 Page | 6

(ii) Revenue centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)

(iii) Profit centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)

(iv) Investment centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)

CLASSIFICATION OF COSTS
A business incurs costs in making products or producing services, in delivering its
products or services to its customers and in providing the support functions needed
to run the business.

Take a look now at the diagram showing the relationship between these different
costs in Chapter 1 of your Osborne Tutorial.

Management needs to organise these costs in a way that is useful for decision
making. Let’s have a look now at some of the ways in which costs can be classified:
 S ec t io n 1 Page | 7

Classification of costs by element and by nature

Costs can be classified by element (materials, labour and expenses) and by nature
(direct or indirect).
Direct costs Any costs that can be directly attributed to the manufacture of a
product are known as direct costs. In manufacturing the total of
all direct costs is called the prime cost.
Materials Direct materials are the raw materials that become part of the
product.
Labour Direct labour costs come from the production operatives (those
that are directly involved in manufacturing the product).
Expenses Direct expenses are other direct costs such as the hire of
specialist equipment.
Indirect costs These are costs that cannot be directly attributed to the end
product but are still costs involved in the production process.
They are also known as overheads.
Materials Indirect materials are those that don’t form part of the end product.
An example might be lubricants and oils for the machinery.
Labour Are other factory workers that are not production operatives, for
example, a factory supervisor or production manager.
Expenses Any other overhead (running costs such as insurance, rent, heat
and light) which is not directly linked to a specific product.

Classification of costs by function

Another way of classifying costs is according to the type of work being done.

Typical headings include:

 Production costs

 Non-production costs

– Administration

– Selling and distribution

– Finance
 S ec t io n 1 Page | 8

Classification of costs by behaviour

The final way of classifying costs is classification by behaviour. This looks at how
costs behave as we change the level of output.

Fixed costs
These costs remain constant regardless of output as illustrated in the graph below.

Fixed costs normally relate to factory costs such as factory rent and insurance. If
you study the graph above, you can see that:

 If we produce no units of output, we still will incur fixed costs of £50,000

 If we produce 20,000 units of output, fixed costs will still be £50,000

A fixed cost is usually only fixed within a certain capacity range.

For example, a factory may only be able to produce 100,000 units. To enable it to
produce more, it may need to rent additional space, which would incur an additional
fixed cost. This would then be referred to as a stepped fixed cost, which we will look
at next.

Fixed costs are also considered to be time related, as the cost normally rises on an
annual basis, as may well be the case with factory rent.
 S ec t io n 1 Page | 9

Activity 4
Use the information below to calculate the fixed cost per unit at the following levels
of production. What do you notice about the cost per unit as output increases?
25,000 units 50,000 units 75,000 units
Fixed costs £100,000

Stepped fixed costs

We’ve already mentioned that fixed costs only ever fixed over a limited range of
output. Take a look at the graph below:

In this example, a machine costs £500 and can produce 10,000 units of output.
However, once we exceed 10,000 units of output, we need to hire an additional
machine costing a further £500. Both machines can then produce a maximum output
of 20,000 units before a third additional machine needs to be hired, and so on.
 S ec t io n 1 Page | 10

Activity 5
Calculate the cost per step based on the following information:

 Machine costs for a factory are stepped, increasing with every 12,000 units
produced

 Factory records show the cost of machines for the period were £36,000

 The number of units produced in the period were 64,000

Round to the nearest whole number.

(i) Number of steps =

(ii) Cost per step =

Variable costs
These costs move in line with production output. For example, if the material cost of
1 unit was £5 then the cost of 2 units would be £10.

Total variable costs can be calculated as the cost per unit × the number of units
 S ec t io n 1 Page | 11

Now consider this…

We saw in Activity 4 that the fixed cost per unit falls as output increases, because
the same figure is being divided by a larger and larger number.

This can be illustrated on a graph

However that is not true for variable costs. Here the cost per unit remains the same
no matter how many units are produced. (For the moment we are ignoring the impact
of any purchase discounts that may be offered if we buy large quantities of
materials.)

This is shown in the graph below:

 S ec t io n 1 Page | 12

Activity 6
The variable cost per unit of a product is £2.50

Fixed costs for the factory are £50,000

(1) Calculate total costs for the following levels of output

(2) Calculate the total cost per unit

10,000 units 20,000 units 30,000 units
Variable costs (£)
Fixed costs (£)
Total cost (£)
Cost per unit (£)
(3) Explain why the total cost per unit changes at different levels of output

Semi variable costs

These costs contain both fixed and variable elements. Consider your utility bills (for
example gas and electricity): they often include a fixed charge (the standing charge)
and a variable charge which increases as you use more of the supply.

How can you tell if costs are semi-variable?

Activity 7
Calculate the cost per unit at the following levels of output:
10,000 units 20,000 units
Total costs £25,000 £50,000
Cost per unit £
You can compare your answer to the answer at the back if you need to. You should
be able to see that at both levels of output the cost per unit is the same, so this is
clearly a variable cost.
Now try it again…
10,000 units 20,000 units
Total costs £ 35,000 60,000
Cost per unit £
You can see here that the cost per unit changes at different levels of output. By
process of elimination we can see that it’s not a variable cost and it’s not a fixed
cost, as the total cost does not remain constant. So, it must be a semi-variable cost.
 S ec t io n 1 Page | 13

The graph below illustrates how the total cost is found. At both levels of output there
is a fixed cost of £10,000, plus a variable cost of £2.50 per unit. So at an output of
20,000 units the total cost is £2.50 × 20,000 = £50,000 plus £10,000 = £60,000.

In some instances, the assessment may give you the fixed cost which of course
helps but in other assessments you may be asked to find the fixed and variable
costs yourself.

Activity 8
You are given the following information:

The electricity cost for the factory totals £130,000

The fixed cost is £40,000

The number of units produced were 45,000

What is the variable cost per unit?

 S ec t io n 1 Page | 14

What happens if you’re not provided with the fixed and variable cost?

If you are not given any information, you need to calculate the fixed and variable
costs.

We use what is known as the High Low Method so let’s take a look at this:
Total costs £ Output (Units)
Highest 186,700 25,600
Lowest 174,800 20,000
Difference (Step 1) 11,900 5,600
To find the variable cost:

(Step 1) Calculate the difference in total costs and the difference in total output
(we have already done that in the table)

(Step 2) Divide the difference of £11,900 by 5,600 units = £2.125 per unit variable
cost

To find the fixed cost:

(Step 3) Find the total variable cost for the highest number of units = 25,600 ×
£2.125 = £54,400

(Step 4) Find the fixed cost for the highest number of units = Total cost £186,700
less £54,400 variable cost = £132,300

Activity 9
Check that the figures in the previous activity are correct by applying the answers
from steps one and two to the lowest level of output. Follow the steps from the
previous page.

Step one Has been done for you

Step two Has been done for you

Step three

Step four
 S ec t io n 1 Page | 15

Activity 10
Now have another go at calculating the fixed and variable costs using the following
information:
Total costs £ Output (Units)
Lowest 21,750 5,000
Highest 31,500 10,000
Step one: Difference

Step two Find the variable cost per unit

Step three Find the total variable cost
using the highest output
Step four Find the fixed cost
Check
Step three Find the total variable cost
using the lowest output
Step four Find the fixed cost

CALCULATING THE COST OF GOODS AND SERVICES

We have now revised enough management accounting to calculate a product cost.
You may first wish to read the section titled ‘Calculating the cost of goods and
services’ in Chapter 1 of your Osborne Tutorial which summarises the stages
involved in gathering all of the costs together. Alternatively you can dive straight in…

Activity 11
For the purpose of this example we are going to apportion the variable and fixed
overheads on the number of units produced. The information will relate to the
production of one unit.

Data:

 The number of units produced = 10,000

 Direct materials per unit = £1.50

 Direct labour per unit = £3.50

 Direct expenses per unit = £0.75

 Total variable overheads = £9,000

 Total fixed overheads = £25,000

 S ec t io n 1 Page | 16

Using the knowledge you have gained, and problem-solving techniques, complete
the following table:
Prime cost £ Per Unit
Direct material
Direct labour
Direct expenses
Prime cost per unit
Marginal cost
Prime cost
Variable overhead (hint, calculate the variable cost per unit)
Marginal cost per unit
Full Cost (Absorption)
Marginal cost
Fixed overheads (hint, calculate the overhead cost per unit)
Full Cost (Absorption) per unit
So, there we have it!

Now let’s pause for thought:

We calculated that the full absorption cost of one unit is £9.15.

Do you recall we said the fixed cost per unit changes with output?

This means that if only 5,000 units had been produced the fixed cost per unit would
have been £5 making the full absorption cost £11.65 per unit.

Can you see the difference this would make if we decided to set prices based on
the full cost of producing a unit? Just remember this for now and we will come back
to it in later sections.

In practice, this type of costing information is used for making multiple different
decisions, for example:

 What sales price should we set?

 How many units should we produce?

 Is there enough demand for the product?

 Do we base the selling price on the marginal cost, or do we use the full
absorption cost?

This is what management accounting is all about – making decisions!

 S ec t io n 1 Page | 17

TOTAL COST STATEMENT

A total cost statement also brings together all the costs in producing the output of a
business during a period and may be produced as part of the organisation’s periodic
reviews. It groups the costs as follows:
TOTAL COST STATEMENT £
Direct Materials x
Direct Labour x
Direct Expenses x
PRIME COST X
Production overheads Factory costs associated with x
manufacturing the products
PRODUCTION COSTS This is the total product cost X
Selling and distribution costs x
Non-production overheads
Administration costs (these are also known as x
period costs)
Finance costs x
TOTAL COST X
We can then use this to produce a statement of profit or loss:
STATEMENT OF PROFIT OR LOSS
£
Revenue x
Less:
Total cost (x)
Profit X
 S ec t io n 1 Page | 18

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

We said at the start of this section that management accounting information could
be presented in any format which suits management’s needs. A key tool used by
management accountants to produce this information is spreadsheets, and so we
will complete this section (and all those that follow) by considering the application of
spreadsheets to management accounting.

You may have already learned some spreadsheet skills at Level 2, and you may
well also have spreadsheet skills that you have picked up at school, or college or at
work. This will stand you in good stead. However, everything that you will need for
this assessment is covered in your Spreadsheet Skills for Management Accounting
tutorial, and you should use it to support you as you attempt the spreadsheet
activities that we direct you to in your Introduction to Management Accounting
Osborne Tutorial. You will also need to access the Management Accounting
Techniques Tutorial Book product page on the Osborne Books website
www.osbornebooks.co.uk, which contains practice spreadsheets for you to
download.

You should now attempt the Case Study at the end of Chapter 1 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It uses
the information we have just revised and shows you how to produce a basic
statement of profit or loss.
 S ec t io n 1 Page | 19

Osborne Books Activities

You should now practice what you have learnt in this section using the activities at
the end of Chapter 1. You can also complete the chapter activities for Chapter 1 of
the Osborne Books Workbook.
 S ec t io n 1 Page | 20

What you have learnt in this section

 Management accounting is also known as cost accounting

 It is used to provide information to those running a business to assist with

decision making, planning and control.

 Responsibility centres classify segments of the business depending on the

extent to which the manager is responsible for costs, revenues, profits or return
on investments

 Costs are classified depending on the needs of management – they can be

classified by:

– Nature – whether they are direct or indirect

– Element – what they are made up of E.g. materials, labour or expenses

– Function – the section of the business that incurs them E.g.

administration or production

– Behaviour – how they change depending on output levels E.g. fixed or

variable

 The total of the direct costs of manufacturing is known as the prime cost

 Indirect costs are also known as overheads

 The total cost of a unit of output can be calculated as:

[Direct costs + Indirect costs (production overheads)] / Number of units of

output

 A total cost statement is produced periodically and lists all the direct costs and
the overheads (both production and non-production) incurred by the business
during the period

 A statement of profit or loss shows the net result when total costs for a period
are deducted from revenue during that period
 S ec t io n 1 Page | 21

Answers to home study activities

Activity 1
Financial accounting Management accounting
 Record all types of transactions  Research to plan for future
 Bank reconciliation  Forecast future sales and
expenditure
 Complete VAT returns  Cost new products and services
 Inventory control  Make investment decisions
 Preparation of the statement of  Prepare income and expenditure
profit or loss and statement of budgets
financial position
 Credit control/debt collection  Cash flow forecast
 Payroll calculations  Compare expected performance
to actual performance

Activity 2
Feature Management accounting Financial accounting
Focus on Future Past
Types of information Wide range of data Primarily financial
Level of detail Daily details Summaries
Format Any format Fixed format
Users Internal External
Purpose Assisting in planning, Reporting profits
decision making and
control
Key documents Management reports Statements of profit and
loss and financial position
Confidentiality Highly confidential Can be made public
 S ec t io n 1 Page | 22

Activity 3
(i) Cost centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)
Conservatory plants
Costs Costs

Materials 137 Materials 151

Labour 93 Labour 134

Expenses 45 Expenses 70

Total 275 Total 355

(ii) Revenue centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)
Shrubs
Revenue 425 Revenue 555

(iii) Profit centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)
Shrubs
Revenue 425 Revenue 555

Less (275) Less (355)

costs costs

Profit 150 Profit 200

 S ec t io n 1 Page | 23

(iv) Investment centre

Working for: Working for: Best performing centre

is:
Conservatory Plants Shrubs

£(000) £(000)
Shrubs
Profit / 150 / 450 Profit / 200 / 400
Investment × 100 = Investment × 100 =
× 100 33% x 100 50%

Activity 4
25,000 units 50,000 units 75,000 units
Fixed costs £100,000/25,000 = £100,000/50,000 = £100,000/75,000 =
£100,000 £4.00 £2.00 £1.33
You should have noticed that the fixed cost per unit falls as output increases. This
is important when we are considering price setting and want to set a price that
covers the cost of the unit.

Activity 5
First calculate the number of steps:

64,000 units divided by 12,000 units = 5.33

This can be rounded this up to 6 steps

Now calculate the cost per step:

Cost of machines = £36,000 so, if we divide this by 6, the cost per step becomes
£6,000

Activity 6
10,000 units 20,000 units 30,000 units
Variable costs £ 25,000 50,000 75,000
Fixed costs £ 50,000 50,000 50,000
Total cost £ 75,000 100,000 125,000
Cost per unit £ 7.50 5.00 4.17
As the fixed costs are spread across more units, so the fixed cost per unit decreases.
This means that although the variable cost per unit stays the same across the whole
range of production output, overall the cost per unit decreases,
 S ec t io n 1 Page | 24

Activity 7
10,000 units 20,000 units
Total costs £25,000 £50,000
Cost per unit £ 2.50 2.50

10,000 units 20,000 units

Total costs £35,000 £60,000
Cost per unit £ 3.50 3.00

Activity 8
Variable cost is calculated as

Total cost £130,000 – Fixed cost £40,000 = £90,000

£90,000/45,000 units = £2.00 per unit

Activity 9
Step one Has been done for you
Step two Has been done for you
Step three 20,000 × £2.125 = £42,500 total variable cost
Step four £174,800 – £42,500 = £132,300 fixed costs

Activity 10
Total costs £ Output (Units)
Lowest 21,750 5,000
Highest 31,500 10,000
Step one: Difference 9,750 5,000

Step two Find the variable cost per unit £9,750/5,000 = £1.95
Step three Find the total variable cost 10,000 × £1.95 = £19,500
using the highest output
Step four Find the fixed cost £31,500 – £19,500 = £12,000
Check
Step three Find the total variable cost 5,000 × £1.95 = £9,750
using the lowest output
Step four Find the fixed cost £21,750 – £9,750 = £12,000
 S ec t io n 1 Page | 25

Activity 11
Prime cost £
Direct material 1.50
Direct labour 3.50
Direct expenses 0.75
Prime cost per unit 5.75
Marginal cost
Prime cost 5.75
Variable cost £9,000/10,000 0.90
Marginal cost per unit 6.65
Full Cost (Absorption)
Marginal cost 6.65
Fixed overheads £25,000/10,000 2.50
Full Cost (Absorption) per unit 9.15
 Section 2
Material costs

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover material or inventory and consider how it is acquired and how
the associated costs are recorded.

When you have finished studying this section you will be able to:

– Describe the different types of inventories held by business

– Calculate the amount of inventory to be ordered using the fixed order method

– Use the economic order quantity formula to calculate the size of an order

– Value inventory using first in first out (FIFO) and weighted average (AVCO)
valuation methods

– Describe the differences between FIFO and AVCO

– Complete the basic bookkeeping entries for inventory

 S ec t io n 2 Page | 2

TYPES OF MATERIALS INVENTORY

In this section we are going to look at how we manage inventory in a costing system.
There are three main types of inventory that we need to concern ourselves with,
they are:

 Raw Materials

 Work in Progress (WIP)

 Finished Goods

You should remember from the last section that we also distinguish between direct
materials (those which are incorporated into the products) and indirect materials
(such as cleaning materials or industrial lubricants) that are used when making the
products and form part of production overheads.

Material purchases are usually the responsibility of a separate purchases or

procurement department charged with ensuring that good quality materials are
bought at competitive prices and delivered to the business as needed.

Take a look now at the diagram ‘Materials held by Business’ in Chapter 2 of your
Osborne Tutorial which shows the different types of materials held by different types
of organisations.

PLANNING OF PURCHASES AND CONTROL OF MATERIALS

Most businesses order raw materials in batches which are delivered to the
warehouse and then transferred to production when they are needed.

However, raw materials cost money and if you buy too much at any given time, you
are effectively using resources that could have been spent elsewhere in the
company. What’s more, once you have bought the materials, they may need to be
stored and this costs yet more money in rent, security, insurance and so on.

But if you don’t buy enough for your needs, production may be slowed down, or
could even stop whilst you wait for more to be delivered. This lag – the time taken
between the placing of an order and the delivery of the materials – is known as the
lead time. And when the materials are received, they may not pass the quality
inspection, and need to be sent back. So many businesses choose to carry buffer
stocks – additional inventory to protect against unplanned stockouts.

Some businesses take a different approach. Some, such as supermarkets operate

perpetual inventory systems, which track every item in and out of inventory and
automatically place orders to maintain pre-set inventory levels. Others, such as
some manufacturing companies, operate just-in-time (JIT) systems in which
carefully chosen suppliers work to deliver supplies directly to the point in the
production line where they are needed at the exact time when they are required.
This allows the business to keep inventory levels extremely low.
 S ec t io n 2 Page | 3

However, for the majority of businesses, which order regularly, and carry some
buffer stocks, it is important to balance the need for inventory with the costs of
storage, and make decisions about when and how much to buy.

MATERIAL PURCHASES: FIXED QUANTITY METHOD

This method involves ordering a set quantity each time an order is placed.

To use this method, a business needs to know:

 The lead time – how long it will take a supplier to deliver the goods once they
are ordered

 The maximum inventory level – this is often directly linked to how much
storage space the business has available

 The buffer inventory – the amount of extra stock the business wants to keep
‘just in case’

 The re-order level – the amount of inventory which has to be left to trigger a
new order (this needs to be carefully determined)

 The re-order quantity – the size of the order to be placed (this may also be
determined using formulae). You may also be asked for:

– The maximum reorder quantity – the most you can order before you
run out of storage for example. You may need to know this when
considering an offer of a bulk purchase discount

– The minimum reorder quantity – this is the amount that you absolutely
must order if you are to ensure that you hold at least the re-order level.
This may be needed if stocks fall unexpectedly low and need to be
urgently replenished. However you will still only hold the re-order level
and will then need to place another order.

You should make sure that you learn all these terms and can distinguish between
them.

Take a look now at the diagram in your Osborne Tutorial which illustrates the
fluctuating levels of inventory in a fixed quantity method of re-ordering.
 S ec t io n 2 Page | 4

Activity 1
A company manufactures leather jackets.

Each jacket requires 2 square metres of material. The average daily output is 25
jackets.

The company policy regarding inventory levels and other relevant information is as
follows:

 Minimum inventory levels (buffer) = 250 square metres

 Maximum inventory levels = 1,500 square metres

 Average daily usage = 50 square metres

 Lead time (supplier to factory) = 10 days

Calculate the re-order level

Hint: Think about how long it will take the inventory to arrive and what we will use
whilst we are waiting.

Exam Tip

We have not given you a formula for this, instead we are asking you to work out
the answer for yourself.

In management accounting textbooks, you’re often presented with lots of

formulae, and encouraged to “memorise” them. In the real world you wouldn’t
memorise most formulae, but instead you would understand what you’re
calculating and use problem solving techniques to work out the answer. Problem
solving is a big part of management accounting (especially at Professional
Diploma level) so you do need to work on these skills from the outset.

The re-order levels must be monitored on a regular basis to ensure that any changes
in demand for the jackets, sometimes referred to as seasonal variations can be met.
It would be unacceptable if a large order was secured over a short time span and
then had to be turned away due to lack of raw materials.

In setting the above re-order levels, the company would have taken into
consideration warehouse capacity, the accuracy of their forecast demand figures,
and the expected lifespan of the material itself. A warehouse with space occupied
by unusable obsolete materials is something to be avoided.
 S ec t io n 2 Page | 5

Activity 2
We will now look at the worked example in Chapter 2 of your Osborne Tutorial. The
information is repeated again here for you:

A4 white copy paper:

Average daily usage: 30 reams (each ream holds 500 sheets)

Average lead time: 5 days

Buffer inventory: 100 reams

Maximum inventory level based on available storage: 900 reams.

Calculate:
The re-order level

The maximum re-order quantity

The minimum re-order quantity

MATERIALS PURCHASES: ECONOMIC ORDER QUANTITY (EOQ)

We mentioned earlier that holding too much inventory is an inefficient use of
resources. But it’s also true that every time another order has to be placed the
business will incur further ordering costs. The trick is to find a balance between:

 Holding costs: The cost of holding the inventory, for example the rent or rates
on the warehouse, plus costs like insurance premiums and security protection.
This cost will go up the more inventory you hold at one time.

 Order costs: The cost of placing orders for the materials, for example the
wages of the people doing the ordering (the staff working in procurement). This
cost will go up the more times you place an order in the period.

To do this, we use a formula known as the Economic Order Quantity (EOQ).

This is the order quantity that minimises the total of holding costs plus ordering costs
as shown on the graph below:
 S ec t io n 2 Page | 6

The EOQ takes account of:

 Holding costs

 Order costs

 Annual usage (consumption) of the materials

and is calculated as:

2 ×annual usage ×ordering cost

ඨ
inventory holding cost

Exam Tip
You will need to learn this formula and you will need a calculator with a square
root function to use it!
 S ec t io n 2 Page | 7

Activity 3
Have a go at calculating the EOQ using the following data:

 The cost of placing an order = £20

 The cost of holding the inventory = £1.25 per unit per year

 The annual usage of the material = 5,000 kg

INVENTORY RECORDS
Most businesses record their inventory either on computer software or manually.

You should now read this section in Chapter 2 of your Osborne Tutorial and take a
look at a typical inventory recording system.

VALUATION OF INVENTORY
At the end of each year, a business will need to value the inventory it carries for the
calculation of profits in its financial statements.

You learnt about accounting rules in the financial accounting topics you have
studied. IAS 2 – tells us how to value inventory. If you recall it applies the prudence
concept and states that inventory should be valued at the lower of cost or net
realisable value.

You should also remember than this rule is applied to each separate item of
inventory, or, where this is impractical, for each separate group of similar items. You
cannot just compare the total inventory cost with its total net realisable value.

The basic technique is straightforward:

Number of items held × (cost or NRV per item) = inventory value.

However in a manufacturing company some items may still be only part made when
we come to valuing them – that is they are work in progress (WIP). How do we
decide what they cost?

The answer is that we use the concept of equivalent units. We will cover this later
in the course, but for now here is a simple summary of the principle:

We estimate how complete the items are (25%? 60%?) and work out how many
whole units they are equivalent to.
 S ec t io n 2 Page | 8

For example:

In a factory 20,000 units will be completed in the period.

Additionally the expected closing WIP will be 6,000 units which will be 70% complete

How many equivalent completed units will have been produced?

Answer

6,000 units will be 70% complete (6,000 × 70%) so they are equivalent to 4,200
completed units.

20,000 plus 4,200 = 24,200 completed units.

You should now read through the case study ABC manufacturing: Inventories
Valuation. It is a bit further through Chapter 2 but it is helpful to take a look at it now.
You don’t need to attempt it, but read through the solution carefully to make sure
you follow the principles being applied.

METHODS OF INVENTORY VALUATION

There are two methods of inventory valuation which are accepted by IAS 2 for use
in the financial statements:

 FIFO = First In First Out

 AVCO = Weighted Average Cost

FIFO
This assumes that the first items received into inventory will be the first to be sold or
used – that is, we use the oldest goods first. This is a logical approach if materials
may deteriorate over time.

The inventory remaining at the end of any given period will therefore consist of the
latest items placed into inventory (and be valued at the price we paid for them).

AVCO
This is used where it is not really possible to identify which units have been used –
for example where a quantity of liquid is added to a tank, or a heap of components
is added to a bin. The weighted average cost is recalculated each time an item is
purchased and receipted into inventory and each time an item is issued from
inventory.

The inventory at the end of any given period is therefore valued at the weighted
average cost of all purchases.

So, let’s take a look at how the two methods of valuation work.
 S ec t io n 2 Page | 9

What follows is a simple example which is designed to help you understand the
principle behind these methods and understand the effects each of the methods
have on the Cost of Goods Sold. Follow the examples through and check the
numbers on your calculator to make sure that you understand what is happening at
each stage

Note: your assessment might ask you to fill in the gaps of an incomplete inventory
record card. It may also ask you to identify which method of valuation is being used
so look to see how the value of issues is calculated.

FIFO method of valuation

A business has 10,000 units of material in inventory at the start of the period and
has received two more deliveries since.

When they are ready to issue 12,000 units to production:

 10,000 units are taken from the opening balance

 2,000 units are taken from inventory receipts 1

Inventory Record Details Quantity Value £

Opening balance 10,000 units at £2.50 10,000 25,000
Inventory receipt 1 5,000 units at £3.00 5,000 15,000
Inventory receipt 2 4,000 units at £3.10 4,000 12,400
Issues to 12,000 units (12,000) (31,000)
production
 10,000 units at £2.50 =
£25,000
 2,000 units at £3.00 = £6,000
= £31,000 in total
Closing valuation 7,000 21,400
 S ec t io n 2 Page | 10

AVCO method of valuation

With this technique we recalculate the average every time a transaction takes place.
Take your time to follow through the workings below.
Inventory Record Details Quantity Value £
Opening balance 10,000 units at £2.50 10,000 25,000
Inventory receipts 1 5,000 units at £3.00 5,000 15,000
Totals 15,000 40,000
Average Cost £40,000 / 15,000 = £2.67*
Inventory receipts 2 4,000 units at £3.10 4,000 12,400
Totals 19,000 52,400
Average Cost £52,400/19,000 = £2.76
Issues to production 12,000 units at £2.76 (12,000) (33,120)
Closing valuation 7,000 19,280
* Since we did not issue any units at this stage, we never use the £2.67 valuation.
By the time we came to issue the 12,000 units we had taken delivery of another
4,000 units so the average had changed to £2.76.

The effect on the Cost of Goods Sold

The figure used for Cost of Goods Sold forms part of the Gross Profit calculation
and ultimately therefore affects the Net Profit of the company.

If you look at the calculations below you can see the difference the valuation method
makes:
Method FIFO AVCO
Opening inventory 10,000 units at £2.50 25,000 25,000
Purchases 5,000 units at £3.00
plus 4,000 units at £3.10 27,400 27,400
Closing inventory valuation (21,400) (19,280)
Cost of Goods Sold 31,000 33,120
This different effect means that care must be taken to select the most appropriate
method.
 S ec t io n 2 Page | 11

Activity 4
You should now take a look at the case study: H Rashid Computer Supplies:
Inventory Records in Chapter 2 of your Osborne Tutorial. We have provided you
with the tables you will need to complete your workings below and added in some
of the numbers to get you started.

Exam Tip

In the tables below we have left enough space for your workings. However in your
assessment you may only be given enough space to record the final total for each
cell.

FIFO
Date Receipts Issues Balance
Quantity Cost Total Quantity Cost Total Quantity Cost Total
(units) per unit cost (units) per unit cost (units) per unit cost
£ £ £ £ £ £
Jan 40 3.00 120
Feb 20 3.60 40 3.00 120
20 3.60* 72
60 192
March 36

April

May

* We do not calculate an average cost per unit here because we are using FIFO
 S ec t io n 2 Page | 12

AVCO
Date Receipts Issues Balance
Quantity Cost Total Quantity Cost Total Quantity Cost Total
(units) per unit cost (units) per unit cost (units) per unit cost
£ £ £ £ £ £
Jan 40 3.00
Feb 20 3.60 40 3.00 120
20 3.60 72
60 3.20* 192
March 36

April

May

* Note that you will need to calculate the average cost per unit at the end of every
transaction as we are using an AVCO approach.

Effect on profit
FIFO AVCO
£ £
Revenue

Cost of Sales
Opening inventory units @
Purchases units @ plus
units @
Less:
Closing inventory units
Total

Gross profit
(Revenue less Cost of sales)
 S ec t io n 2 Page | 13

COMPARISON OF FIFO AND AVCO

You should now turn to this section in Chapter 2 of your Osborne Tutorial and make
notes on the key differences between the two techniques. We have provided you
with space for your notes below:
Notes on comparison of FIFO and AVCO methods of inventory valuation
FIFO AVCO
Method

Calculation

Inventory valuation

Profits and taxation

Administration

Cost of sales

BOOKKEEPING FOR MATERIALS COSTS

Once raw materials have arrived at the factory gate they need to be booked into
their designated inventory locations, sometimes referred to as Bins although they
may equally well be shelves or boxes.

The inventory records then need to be updated so that they always reflect current
inventory holdings (levels) – that is the amount of inventory held.

(The final recorded valuation of the inventory is a matter for the accounting function
and we will deal with that later on in this learning material).

Let’s take a look at how raw materials pass through the manufacturing process to
give you an idea of the bookkeeping entries involved. Remember, we are not dealing
with the payment of suppliers here (that is dealt with separately by the accounting
department). This example is deliberately over-simplified as you only need to have
a basic understanding of the process.
 S ec t io n 2 Page | 14

For the purposes of this exercise let’s assume a delivery of 400 units where each
unit has a value of £15 so the total value of the delivery is 400 units × £15 = £6,000

1 Accounting for raw materials upon arrival

The first stage is to record the arrival of the asset we have just taken into stores:

 We record the liability to the supplier (credit)

 And the receipt of inventory which is a current asset (debit)

DR PLCA (liability) CR
Raw materials £6,000

DR Raw Material Inventory (current asset) CR

PLCA £6,000

2 Moving raw materials to production

When the raw materials are required for the production process, they are then
moved from the raw material store into production, where it is known as Work in
Progress (WIP)

 The raw materials now leave the store (credit)

 And enter the manufacturing process as Work in Progress (debit)

DR Raw Material Inventory (current asset) CR
PLCA £6,000 Production £6,000

DR Direct Production CR
(WIP – current asset)
Raw materials £6,000
For simplicity we have assumed all materials are used in production,

Note: At this point the materials are used by production and the WIP accumulates
elements of labour and overhead costs. For the purposes of our example let’s
assume we spend another £2,000 converting the materials into finished goods.
 S ec t io n 2 Page | 15

3 Moving into finished goods

When the manufacturing process is complete the finished product will be inspected
by the Quality Control Department for any defects and then transferred to the
finished goods warehouse to await dispatch to a customer.
DR Direct Production (WIP – current asset) CR
Raw materials £6,000 Finished goods £8,000
Labour and overhead £2,000

DR Finished Goods CR
(current asset)
Production £8,000

Keep in mind WIP is a continuous process and we will be adding elements of labour
and overhead over time. WIP is a semi-made product so it will have more value than
the raw materials but less value than the final finished goods. We will look at more
complex examples later.

Activity 5
In an assessment you’re often required to provide journal entries for movements of
inventory. We have provided descriptions of activity in the journal, see if you can
complete the following journals (Note that we have ignored any increase in value
arising as a result of labour or overheads).

Account code Account name

1000 Raw materials – leather

1100 Direct production – leather jackets
1200 Finished goods
2000 PLCA
Journal
Account code Account name DR £ CR £
£25,000 of leather is purchased to make leather jackets

£25,000 of leather is moved from stores to production

£25,000 leather jackets are finished and moved to finished goods stores
 S ec t io n 2 Page | 16

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

Spreadsheets are an ideal tool for tracking inventory movements, and may be used
by businesses without purpose-built inventory management systems.

Where they are used, they must be carefully protected, as if a thief can amend the
inventory records at the same time as stealing the stock, they will effectively cover
up their crime and it may be very difficult to spot.

Typically they may be used to:

 Track inventory levels

 Analyse how long inventory has been held (especially important if quality
deteriorates over time)

 Compare cost and net realisable value of stock lines

 Produce year-end inventory values

You should now attempt the Case Study at the end of Chapter 2 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
help you to practice gathering items into categories, comparing cost and net
realisable values, producing a final inventory valuation and creating a pie chart to
illustrate the information.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 2 Page | 17

Osborne Books Activities

You should practice what you have learnt in this section using the case studies:

 Using economic order quantity and inventory records

 Blue Jeans Ltd: Bookkeeping for material costs

in Chapter 2 of your Osborne Tutorial

You should then attempt the activities at the end of the Chapter.

You can also complete the chapter activities for Chapter 2 of the Osborne Books
Workbook.
 S ec t io n 2 Page | 18

What you have learnt in this section

 Businesses have three main types of inventory: Raw Materials, Work in
Progress (WIP) and Finished Goods

 Lead time is how long it will take a supplier to deliver the goods once they are
ordered

 Maximum inventory level is the most that can be held and is often directly
linked to how much storage space the business has available

 Buffer inventory is the amount of extra stock the business wants to keep ‘just
in case’

 Re-order level is the amount of inventory which has to be left to trigger a new
order (this needs to be carefully determined)

 Re-order quantity is the size of the order to be placed

 Two key costs that need to be balanced when considering the re-order quantity
are the costs of holding inventory and the costs of ordering. These can be
taken into account by calculating the economic order quantity (EOQ)

 Inventory is valued at the lower of cost and net realisable value (IAS 2)

 When recording costs, a business may use the FIFO or the AVCO methods.
Both give different cost of goods sold figures which must be considered when
a method is selected

 When inventories are recorded, the records must detail receipts, issues to
production and the final balance held
 S ec t io n 2 Page | 19

Answers to home study activities

Activity 1
We have to maintain a minimum inventory level of 250 square metres

It takes 10 days to deliver inventory and we use 50 square metres a day, so in the
time we are waiting for an order we will use 500 square metres of inventory.

So we need to order more when we have got 250 + 500 = 750 metres left in inventory

Re-order level = (50 × 10) + 250 = 750 square metres

If you want a formula for this it is:

ROL = (average usage × average lead time) + buffer inventory

But hopefully you can see that it is actually easier just to work it out based on what
you know about the business rather than learn a formula.

Activity 2
The re-order level

We want to have 100 reams at all times.

After we order we will use 5 × 30 = 150 reams whilst we wait for the next delivery.

The re-order level is 100 + 150 = 250 reams

The maximum re-order quantity

The maximum inventory we can store is 900 reams and we plan to always keep
100 reams in stock.

So the most we can order at one time is 900 – 100 – 800 reams.

As a formula this would be:

Maximum re-order quantity = maximum inventory level – buffer inventory

 S ec t io n 2 Page | 20

The minimum re-order quantity

Given it takes 5 days to deliver and we use 30 reams a day whilst we wait, we
need to order a very minimum of 150 reams just to stand still.

However if we did this when we only had 250 reams left (the re-order level we
have calculated) we will be down to 100 reams by the time they arrive and will
immediately have to re-order.

As a formula this would be:

Minimum re-order quantity = average usage x average lead time

Activity 3
Answer = √[(2 × 5,000 kg × £20)/£1.25] = √160,000

The square root of 160,000 = 400 units

So if we order batches of 400 units it will keep the total cost of ordering and storage
at its lowest – in other words it’s efficient.

Activity 4
The answers are directly below the case study in your Osborne Tutorial

Activity 5
Journal
Account code Account name DR £ CR £
£25,000 of leather is purchased to make leather jackets
1000 Raw materials 25,000
2000 PLCA 25,000
£25,000 of leather is moved from stores to production
1100 Direct Production 25,000
1000 Raw materials 25,000
£25,000 leather jackets are finished and moved to finished goods stores
1200 Finished goods 25,000
1100 Direct Production 25,000
 Section 3
Labour costs

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover the factors which affect labour costs and how they are
recorded.

When you have finished studying this section you will be able to:

– Explain the factors affecting the rate at which wages are paid

– Describe the different types of labour payments made to production staff

– Distinguish between direct and indirect labour costs

– Calculate the wages costs for a business

– Perform basic accounting journals to record wages costs

 S ec t io n 3 Page | 2

ACCOUNTING FOR LABOUR COSTS

Activity 1
We have already looked at different types of costs and cost behaviour. So, let’s
review the concepts here. In your own words can you explain the following?

Direct cost

Indirect cost

Fixed cost

Variable cost

Semi-variable cost

Stepped fixed cost

The inclusion of labour costs when valuing inventory

The accounting rule IAS 2 Inventories requires us to value inventory at the lower
of cost or net realisable value.

Cost includes:

 costs of making the product (including fixed and variable manufacturing

overheads) and

 other costs incurred in bringing the inventories to their present location and
condition

We discussed in the last section how raw materials are issued to production at cost
price (using FIFO or AVCO methods of valuation). Once the materials start to be
made into products, other costs will be incurred. These costs will include elements
of labour and production overhead, as the product moves through the production
process, until it’s considered complete. So, it’s essential that we accurately account
for these costs.
 S ec t io n 3 Page | 3

In this section we are looking specifically at labour costs, and will need to distinguish
between:

Direct labour costs Those costs that can be attached directly to the
production of a unit (cost unit). They would consist of
the direct hourly wages (time rate) of production
operatives

Indirect labour costs Those costs that are part of the production process but
cannot be directly attached to a unit of production, such
as the wages of the raw material stores personnel, the
production planning department and factory
administration

Factors that affect labour costs

Activity 2
List the factors that a business may need to take into account when deciding how
much to pay their staff:

Check your answers against our suggestions at the back of this section.

LABOUR PAYMENT METHODS

Labour payments can be based on one of three main methods:
 Time rate – basic pay for hours worked. This may include overtime payments
which are additional amounts paid for working outside of contracted hours
 Piecework payments – a sum paid
– per unit completed or
– based on an agreed output per hour. The pre-determined level of output
which management expect an employee to achieve in one working hour
is known as a standard hour – a term you will come across many times
in your studies.
Sometimes the employee may also be guaranteed a minimum wage.
 Bonus payments – a time rate plus a bonus for exceeding targets
 S ec t io n 3 Page | 4

Activity 3
A company produces handmade clothing and must select a payment system for its
staff. It is choosing between

(i) time rate

(ii) piecework – payment per item made with no minimum wage

(ii) a bonus scheme which pays time rate plus a bonus for each item made over
a target number

Think about each of the three payment methods listed and put a cross against the
methods which would be likely to achieve the goals listed

Goals Time rate Piecework Bonus

Motivate staff to produce more

Ensure quality products

Provide staff with regular income

You should now read this section in Chapter 3 of your Osborne Tutorial and make
notes on any aspects of the three methods that you were unaware of. You need not
attempt the case study that follows as we will come back to it later in this section.

Time rate

Piecework

Bonus
 S ec t io n 3 Page | 5

OVERTIME, IDLE TIME AND EQUIVALENT UNITS

Overtime payments and overtime premium

If an employee’s normal contracted working day is 8 hours plus overtime and they
work 10 hours, the final 2 hours would be paid overtime. The rate paid will depend
on company policy but might be, for example, time and a half or double time.

Direct v indirect labour

Remember that we can split labour costs into direct and indirect costs? Well the
usual approach taken to overtime is to treat the amount paid over the time rate as
indirect – that is, we split it over all of the units made rather than attributing it to
specific units. We call this additional amount the overtime premium.

This has implications for the way we calculate overtime payments:

If an employee is paid £12 per hour, with overtime paid at time and a half, we can
calculate their payment as:

10 hours at the basic rate of pay of £12 per hour = £120 – treated as a direct cost

2 hours at the overtime premium rate of £6 (£12 × 0.50) = £12 – treated as an

indirect cost

Total pay = £120 plus £12 = £132

(So just to be clear – don’t be tempted to calculate the normal hours at the time rate
and then the overtime hours separately at time and a half – as you won’t have split
out the overtime premium properly. Calculate all the worked hours at the time rate,
then find the overtime premium paid on the overtime hours.)

Idle time
There may be times when machine breakdowns, or materials shortages mean that
workers have nothing to do for a while, but still need to be paid – that is any
employees who are normally paid under the piecework or bonus systems will still
receive their basic rate of pay for the period of stoppage. Alternatively they may be
on holiday, or sick, or sent on training courses which mean they cannot carry out
their usual production tasks.

In all these cases, the pay for the non-productive period would be treated as an
indirect overhead cost.
 S ec t io n 3 Page | 6

Activity 4
Now have a go at the case study Westmid Manufacturing: Labour Payment in
Chapter 3 of your Osborne Tutorial. We have left some space below for your
workings:

Employee Workings Payment

Jayne Brown

Stefan Wozniak

Tracey Johnson

Pete Bronyah

Martin Lee

Sara King
 S ec t io n 3 Page | 7

USING A TIME SHEET

In order to calculate gross wages, a business must keep a record of the hours
worked, or the amounts produced. You may well have to complete a time sheet in
your own workplace.

You should now read through this section in Chapter 3 of your Osborne Tutorial
including following the entries made in the case study Calculating the Pay to make
sure you understand the logic.

You could be asked in your assessment to complete labour timesheets for

processing by the payroll department. These are relatively straightforward but you
must ensure you pay attention to how overtime should be dealt with. Overtime
premium is entered in the overtime premium column and basic pay for all the
hours worked at basic rate is recorded in the basic pay column. If you make
mistakes you will lose marks.

Activity 5
Complete the time sheet based on the following information:

 Basic pay is £10 per hour

 8 workers work their standard 12-hour shift Monday to Thursday

 On Friday, Saturday and Sunday 4 workers worked a 15-hour shift

 Overtime is paid at time and a half

Basic £ Premium £ Total £
Monday
Tuesday
Wednesday
Thursday
Friday
Saturday
Sunday
Totals
 S ec t io n 3 Page | 8

BOOKKEEPING FOR LABOUR COSTS

Bookkeeping entries for payroll were covered at Foundation Certificate level. Let’s
review the topic here so you can see the differences between how you accounted
for basic payroll and how you will account for payroll in a manufacturing
environment.

How is your pay calculated?

£ £
GROSS WAGES The amount you are paid before X
deductions
Less compulsory
deductions:
 Tax (Pay As You The amount deducted from your X
Earn/PAYE) National wages by your employer,
Insurance (NI) collected on behalf of HMRC.
 Pension contributions If you contribute to a pension X
scheme this will also be deducted
from your gross wage. (X)
NET PAY The amount you receive after X
deductions.

What is the cost to the employer of employing you?

£ £
GROSS WAGES The amount your employer has X
agreed to pay you.
Plus
 Employer’s NI Your employer also has to X
contribute to your national
insurance contributions at a
certain percentage.
 Pension contributions
Your employer will have agreed X
to pay a percentage to your
pension scheme (under the new
government auto- enrolment X
pension scheme).
WAGES COST Amount employer has to pay X
We use a wages control account to record the totals of all the individual employee
wage calculations for the period.

The account’s purpose is to reconcile the total wage cost with how the money is
distributed. So, it should always balance to zero.
 S ec t io n 3 Page | 9

DR Wages control account CR

Distributed to: Total cost to the employer:

 The employees (net wages)  Gross wages

 HM Revenue (all NI and tax)  Employers NI
 Pension company  Employers pension contributions

Debit entry records how the Credit entry records total cost to
money is distributed the employer

Activity 6
(a) Enter the following data into the control account provided and balance it to
zero.

Gross wages for the month £7,000

Employer’s NI £1,500

Employer’s Pension contributions £1,000

Net pay paid to employees £5,500

Employee’s NI £1,000

Employee’s pension contribution £500

DR WAGES CONTROL CR

We’ve used the control account to calculate the total wage cost and to show how it
is to be distributed. Now we need to complete the double-entry into the ledger
accounts.
 S ec t io n 3 Page | 10

(b) Record the total expense

DR Wages expense account CR

(c) Record the amounts owed (liabilities)

DR HM Revenue liability CR

DR Pension fund liability CR

(d) Record the net amount paid to employees

DR Cashbook CR

Accounting differences in a costing system

In the previous example we recorded the total cost in one expense account. Now
we are going to look at the differences in accounting for labour costs when there are
different types of labour.

Where there is one type of labour, such as in a service industry, labour costs are
not always analysed, so the bookkeeping entry to record the expense was:

DR Wages control account CR

α Total cost to employer

DR Wages expense account CR

α Total cost to employer

 S ec t io n 3 Page | 11

In a manufacturing business, different types of labour costs will be analysed as

follows:
DR Wages control account CR
α Direct labour (production)
β Indirect labour (production)
γ Other labour costs (non-production)

DR Direct production costs CR

α Direct labour

DR Production overheads CR

β Indirect labour for production

DR Non-production overheads CR

γ Other labour costs (e.g. admin)

Activity 7
So, let’s revisit the example of overtime payments and see if you can complete the
accounting entries using a journal.

Exam Tip

Remember that overtime premium is usually recorded as indirect labour.

However, an organisation could have a different policy, so it’s essential you read
the question carefully.

Production staff’s total pay at basic rate was £120

Overtime premium was £12

Total pay was £132

 S ec t io n 3 Page | 12

Complete the journal entries below

Journal Account where it is recorded DR £ CR £
Total pay

Basic rate pay

Overtime premium

Does your journal

balance?
Now let’s look at some more examples of accounting entries for labour:

Activity 8
(a) An employee is contracted to work 8 hours a day and is paid £12 per standard
hour to produce 24 units per day (that is 3 units per hour or 20 minutes per
unit)

The total pay will be:

(b) However the employee only produces 18 units.

How many standard hours has the employee worked?

(c) How much will the employee be paid?

(d) What will the bookkeeping entries be for the piecework production worker if
they’re paid £96?
Journal DR £ CR £

Does your journal balance?

 S ec t io n 3 Page | 13

(e) Had the employee exceeded the basic pay of £96 the difference would be
considered an indirect production line labour cost. Let’s say pay was £106.
What would the journal entry be now?
Journal DR £ CR £

Does your journal balance?

Activity 9
See if you can calculate the bonus payment given the following information:

An employee is paid a basic rate of £9.00 per hour based on an 8-hour day

A bonus of 15% is paid on any time saved

Expected output is 12 units per hour. The employee actually produces 18 units per
hour
 S ec t io n 3 Page | 14

Now complete the journal:

Journal DR £ CR £

Does your journal balance?

Activity 10
Let’s now look at group bonus payments

 The basic rate of pay = £12 per unit

 The team bonus = 20% of the basic rate

 Company sets a target production of 18,000 units

 The team actually produce 19,500 units

 The bonus is paid for each unit produced which exceeds the target.

(a) Can you use problem solving skills to calculate the group bonus payment?

(b) Can you prepare the journal for the bonus cost?
Journal DR £ CR £

Does your journal balance?

 S ec t io n 3 Page | 15

Activity 11
You should now have a go at the case study Blue Jeans Ltd: Bookkeeping for
Labour Costs in Chapter 3 of your Osborne Tutorial. We have left some space below
for your workings:
DR Wages control account CR

20-4 Code number Debit £ Credit £

21 May 2200
21 May 4200
21 May 2400
21 May 4200
21 May 2600
21 May 4200

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

Spreadsheets are often used to:

 Check the arithmetical accuracy of payroll calculations

 Collect payroll data for comparison with the automated payroll software figures

 Analysing labour costs for use by management

You should now attempt the Case Study at the end of Chapter 3 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
help you to practice collecting hours worked by staff, calculating labour costs and
illustrating the breakdown of labour costs in a pie chart.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 3 Page | 16

Osborne Books Activities

You should now practice what you have learnt in this section using the activities at
the end of Chapter 3. You can also complete the chapter activities for Chapter 3 of
the Osborne Books Workbook.
 S ec t io n 3 Page | 17

What you have learnt in this section

 A wide range of factors can affect the labour rates paid by businesses

 Labour may be paid at a time rate, for piecework or using a bonus system

 Some labour costs such as overtime premiums, or idle time are treated as
indirect costs

 Labour costs must be recorded in the books of the business according to the
types of cost they represent
 S ec t io n 3 Page | 18

Answers to home study activities

Activity 1
Direct cost Cost that can be traced to an individual product or service

Indirect cost Cost that cannot be traced to an individual product or

service

Fixed cost Cost that remains fixed no matter what output is achieved

Variable cost Cost that is driven by output. Cost will increase in

proportion to output

Semi variable cost Has a fixed proportion and variable proportion

Stepped fixed cost Cost that is fixed, but will change by a fixed amount,
normally if output exceeds a threshold

Activity 2
Factors which may affect wage rates include:

 Costs in the area (such as housing and transport costs)

 Competitor’s pay rates

 Regulations set by government about minimum wages

 Interest rates and inflation rates

 Local levels of unemployment

 Government incentives such as apprenticeship schemes

 S ec t io n 3 Page | 19

Activity 3
Goals Time rate Piecework* Bonus*

Motivate staff to produce more x x

Ensure quality products x

Provide staff with regular income x x

*These methods of payment tends to put the emphasis on output. This may well
have an adverse effect on the quality of the end product and could also cause an
increase in rejected units as staff rush to meet productivity targets.

Even this simple exercise illustrates that no one method will achieve all a business’s
goals!

Activity 4
The answer is directly below the case study in your Osborne Tutorial

Activity 5
Basic £ Premium £ Total £
Monday 8 × 12 hours × £10 = £960 £960
Tuesday £960 £960
Wednesday £960 £960
Thursday £960 £960
Friday 4 × 15 hours × £10 = £600 4 × 3 hours × £5 = £60 £660
Saturday £600 £60 £660
Sunday £600 £60 £660
Totals £5,640 £180 £5,820

Activity 6
(a)
DR WAGES CONTROL CR
Cashbook (net pay) £5,500 Gross wages £7,000
HM Revenue and Customs £2,500 Employers NI £1,500
Pension contributions £1,500 Employers Pension £1,000

£9,500 £9,500
 S ec t io n 3 Page | 20

(b)
DR Wages expense account CR

Wages control £9,500

(c)
DR HM Revenue and Customs liability CR

Wages control £2,500

DR Pension fund liability CR

Wages control £1,500

(d)
DR Cashbook CR

Wages control 5,500

Activity 7
Journal Account where it is recorded DR £ CR £
Total pay Wages control account 132

Basic rate pay Direct production costs account 120

Overtime premium: Production overheads account 12

Does your journal 132 132

balance?
 S ec t io n 3 Page | 21

Activity 8
(a) Total pay is 8 hours × £12 = £96

(b) 6 standard hours (18 units × 20/60 minutes)

(c) The pay will be reduced, even though they worked the 8 hours. The total pay
will be = 6 standard hours × £12 = £72

(d)
Journal DR £ CR £
Direct production costs 96
Wages control 96
Does your journal balance? 96 96
(e)
Journal DR £ CR £
Direct production costs 96
Production overheads 10
Wages control 106
Does your journal balance? 106 106

Activity 9
Basic pay = 8 hours × £9.00 = £72.00 plus bonus pay £5.40* = £77.40

* Bonus pay calculation:

The employee produced 6 units more than standard (18 – 12)

6/12 × 100 = 50% more

So that should have taken 50% more time

8 hours × 50% = 4 hours saved

£9.00 × 15% × 4 hours = £5.40

Note: As the worker is more productive, the employer saves 4 hours × £9.00 =
£36.00 less the bonus paid of £5.40 = £30.60
 S ec t io n 3 Page | 22

Journal
Journal DR £ CR £
Direct production costs 72.00
Production overheads variable 5.40
Wages control account 77.40
Does your journal balance? 77.40 77.40

Activity 10
(a) 19,500 units less 18,000 units target × £12 × 20% = £3,600 (Group bonus
payment)

(b)
Journal DR £ CR £
Production overheads 3,600
Wages control account 3,600
Does your journal balance? 3,600 3,600

Activity 11
The answer is directly below the case study in your Osborne Tutorial
 Section 4
Overheads and expenses

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover how overhead costs and expenses are incorporated into the
cost of each unit of output.

When you have finished studying this section you will be able to:

– Explain why overheads need to be absorbed into units of production

– Allocate overheads to cost centres

– Apportion overheads to cost centres using a fair basis

– Calculate an overhead recovery rate to absorb overheads into units of

production

– Calculate the period end over or under recovery of overheads

– Perform the adjustments needed to the statement of profit or loss to reflect the
impact of over or under recovery of overheads
 S ec t io n 4 Page | 2

OVERHEADS
We need to work out the expected cost of making products in order to:

 Compare actual spending with the budgeted costs and so control any
overspending

 Set product prices that will ensure the business covers its costs and earns a
profit

 Value inventory so that we can calculate the cost of goods sold and so produce
a statement of profit or loss (whether for use by management or as part of the
financial statements).

Note

This process is carried out at the beginning of the period – so everything we are
going to look at will be based on budgeted figures.

It’s obvious that all the prime costs (direct material, direct labour and direct
expenses) should be included in the unit cost of a product but what about other costs
that cannot be directly traced to an individual unit but still play a part in the
manufacturing process?

Manufacturing overheads are all the costs associated with the manufacturing
process other than raw materials, direct labour and direct expenses. They may be:

1 Variable manufacturing overheads

These costs fluctuate in proportion to the level of activity (output) of the company
and so directly relate to the cost associated with producing each unit. They include
indirect materials, indirect labour and indirect expenses.

These overheads along with direct materials, direct labour and direct expenses are
always included in product costs and together they form the basis of marginal
costing.

2 Fixed manufacturing overheads

These are costs that remain constant within a range of output and cannot be traced
directly to the cost of a unit. They include costs such as factory rent, factory
insurance and typically factory supervisor’s/managers’ salaries (although this
depends on company policy). Other examples would be services such as the
maintenance department that maintains the production machinery and raw material
stores that issues materials. All of these costs and more need to be taken into
account if the full cost per unit is to be calculated.

When fixed costs are added to the marginal cost of a unit, the end result is known
as the full or total absorption cost. As we discussed in the last section, IAS2
requires inventory to be valued at full absorption cost when it is included in the
financial statements.
 S ec t io n 4 Page | 3

You should remember from Section 1 however, that whilst total cost of fixed
overheads does not fluctuate with output, the fixed cost per unit does and this will
have implications for the overall product cost if full absorption costing is used.

We covered cost units, cost classification and cost behaviour in Section 1. You can
refer back to that section if you need to refresh your memory.

Other overheads

Businesses also incur non-production overheads such as administration (for

example running the office functions), selling and distribution (for example sales
staff salaries, delivery vehicle running costs Etc.) and finance (E.g. bank interest).
These are never included when we are working out product costs for valuation
purposes.

Activity 1
A business has budgeted the following costs:

 Materials £7 per unit

 Labour 2 hours per unit at £8 per hour

 Variable overhead £3 per unit

 Fixed costs: Production £100,000 Administration £20,000

 Budgeted output 50,000 units

Calculate the marginal cost, and full absorption cost of a unit of output.
Costs Cost per unit £



Marginal cost

Full absorption cost
 S ec t io n 4 Page | 4

COLLECTING OVERHEADS IN RESPONSIBILITY CENTRES

The factory management team need to ensure products are charged with a fair and
appropriate amount of overhead. In the activity above we simply took the total
production overhead and divided it by the output. However in practice it is a more
complex process and careful consideration is needed ensure that these costs are
spread over the units of production in the most efficient way possible.

The first step in this process is to gather together all the production related overhead
costs and then

1 Where possible allocate overheads to the cost centre that generated the cost.
So the salaries of managers working in the production department can be
immediately allocated to production for example.

2 Apportion (share out) the remaining overheads between the cost centres on
a fair basis

For example:

 Factory rent and rates, buildings insurance, light and heat could be
apportioned based on floor space

 Factory plant depreciation could be based on the carrying value of the assets

 The wages of production supervisors could be based on the estimated amount

of time spent in each area of the factory (e.g. processing, assembly line,
packing line)

 Maintenance department and raw materials stores could be based on usage

or directly allocated if appropriate

Of course, this method of allocating and apportioning costs can only be based on
best estimates made by the factory management – it is not perfect, but is a fair
apportionment.
 S ec t io n 4 Page | 5

Activity 2
Let’s take a look and see how this all comes together.

A business has three separate production departments: Processing, Assembly and

Packing.

The following costs have been incurred:

£
Factory Rent 180,000
Factory Rates 48,000
Factory Insurance 12,000
Light and Heating 30,000
Depreciation charge 5,250
Production supervisor salary 28,800
Departmental overheads
 Processing overheads 300,000
 Assembly overheads 200,000
 Packing overheads 100,000
600,000
Total 904,050
Additional information includes:
Factory Layout Floor area m2
Processing 3,000
Assembly 2,000
Packing 1,000
Total square metres 6,000

Carrying value of plant & machinery £

Processing area 12,000
Assembly line 6,000
Packing line 3,000
Total carrying value £ 21,000
 S ec t io n 4 Page | 6

Production supervisor’s time Time spent hrs

Processing area 4,000
Assembly line 3,000
Packing line 2,600
Total hours 9,600

(a) Allocation

The first step is to identify costs incurred by specific cost centres and allocate them.
We recommend you do this first, so that you don’t accidently apportion them to cost
centres that are not expected to incur the cost. We have allocated the first, so you
know what is required.

Identify the costs for assembly line and packing line and add them to the table.
Total Cost Processing Assembly Packing
£ £ £ £
Departmental overheads 600,000 300,000

Get into good habits – always check that the

allocated or apportioned figures add back to the
original total.

Check your answers against our version at the back before continuing.

(b) Apportionment

Now it’s time to apportion the costs that are shared by the production departments.
We will illustrate how to apportion factory rent.
Workings
Principle The total cost is £180,000. We need to divide this cost by the
total square footage of the factory which is 6,000 sq. metres
to give a cost per square metre.
Process area We can then multiply by the square metres that the process
area accommodates*:
£180,000/6,000 sq. metres × 3,000 sq. metres = £90,000
Assembly line £180,000/6,000 × 2,000 = £60,000
Packing line £180,000/6,000 × 1,000 = £30,000
 S ec t io n 4 Page | 7

* Exam Tip

For the purpose of your qualification we do not recommend converting square

footage to percentages, or rounding the cost per square metre otherwise your
answer may include rounding differences which the computerised assessment
does not recognise.

Total Cost Processing Assembly Packing

£ £ £ £
Departmental overheads 600,000 300,000 200,000 100,000
Factory rent 180,000 90,000 60,000 30,000
(bi) Rates, insurance and lighting and heating are all apportioned on the same
basis (by floor area occupied). Can you now apportion those costs?

Total Cost Processing Assembly Packing

£ £ £ £
Departmental overheads 600,000 300,000 200,000 100,000
Factory rent 180,000 90,000 60,000 30,000
Factory rates
Factory insurance
Factory light and heat
(bii) Depreciation will be apportioned on the basis of the value of plant and
machinery. We have done the first calculation for you, to show you what is
required. Can you do the rest?

Depreciation apportionment:
£5,250/£21,000 × £12,000 = £3,000

Total Cost Processing Assembly Packing

£ £ £ £
Departmental overheads 600,000 300,000 200,000 100,000
Factory rent 180,000 90,000 60,000 30,000
Factory rates 48,000 24,000 16,000 8,000
Factory insurance 12,000 6,000 4,000 2,000
Factory light and heat 30,000 15,000 10,000 5,000
Depreciation 5,250 3,000
 S ec t io n 4 Page | 8

(c) Finally, we can apportion the supervisor’s salary, based on the time spent in
each department. Again, we’ve done the first calculation for you to show you
what’s required.

Supervisor’s salary apportionment

£28,800/9,600 hours × 4,000 hours = £12,000

Total Cost Processing Assembly Packing

£ £ £ £
Departmental overheads 600,000 300,000 200,000 100,000
Factory rent 180,000 90,000 60,000 30,000
Factory rates 48,000 24,000 16,000 8,000
Factory insurance 12,000 6,000 4,000 2,000
Factory light and heat 30,000 15,000 10,000 5,000
Depreciation 5,250 3,000 1,500 750
Supervisors salary 28,800 12,000
Well done, you’ve done your first overhead allocation and apportionment activity!

Activity 3
You should now attempt the case study Pilot Engineering Ltd: Overhead allocation
and apportionment in Chapter 4 of your Osborne Tutorial. We have provided you
with space for your answer and workings below:
Budgeted overheads Basis of Total Dept X Dept Y
apportionment £ £
Factory rates
Wages of supervisor
Heating and lighting
Depreciation of machinery
Buildings insurance
Machinery insurance
Specialist materials
Total overheads
 S ec t io n 4 Page | 9

Workings

SERVICE DEPARTMENTS
Some departments (costs centres) within a company will provide services to other
departments. If we think of the maintenance department for instance: although its
costs cannot be directly linked to the manufacturing process, it will be required to
carry out repairs and machine setups on the production machinery – so some of its
costs do relate to production.

For us to be able to charge all overheads to cost units, all overheads eventually
need to be charged to production cost centres, so service departments and the costs
associated with them do need to be taken into account when allocating and
apportioning overheads.

Reapportionment of service department overheads

To help you understand the process, let’s look at an example:

In this example, for simplicity overheads have already been allocated and
apportioned to the relevant costs centres.
Total Factory 1 Factory 2 Stores Maintenance
overheads £ £ £ £
£
Service Centres
Total budgeted
overheads 100,000 40,000 20,000 30,000 10,000
The costs that have been charged to stores and maintenance now need to be
charged to the production departments on a fair basis. Typically they are charged
to the production departments on a basis of their usage of the service which may
well fluctuate over time.

There are two methods which we can use:

Direct apportionment This method is used when service centres provide
method services to production cost centres only
Step-down method This method is used when some of the service
centres not only work for production departments but
also provide services to other service centres.
 S ec t io n 4 Page | 10

Direct apportionment
In this example, both stores and maintenance provide services to both production
departments, but they do not provide services to each other.

You are told that overheads are to be apportioned to each production department
as follows:
Factory 1 Factory 2
Stores 60% 40%
Maintenance 70% 30%

Total Factory 1 Factory 2 Stores Maintenance

overheads £ £ £ £
£
Service Centres
Total
budgeted 100,000 40,000 20,000 30,000 10,000
overheads
Reapportion 18,000 12,000 (30,000)
to stores (60%) (40%)

Apportion to Remove the costs

production depts from stores

Activity 4
Now you can reapportion the costs for maintenance to each production department
using the same method.
Total Factory 1 Factory 2 Stores Maintenance
overheads £ £ £ £
£
Service Centres
Total
budgeted 100,000 40,000 20,000 30,000 10,000
overheads
Reapportion to 18,000 12,000 (30,000)
stores (60%) (40%)
Reapportion to
maintenance
Totals 0
 S ec t io n 4 Page | 11

Step-down method
Let’s now look at the step-down method. The technique is to

First: Reapportion the service centre that does work for the other centres

Second: Reapportion the other service centres.

Activity 5
For this activity we have assumed that allocated overheads are the same as in the
previous one, but this time the maintenance department provides services worth
£2,000 to the stores department. However the stores department does nothing in
return (the formal way of saying this is ‘does not provide reciprocal services’).

(1) Apportion £2,000 of maintenance’s costs to stores, before sharing out what’s
left using the same basis as before (70:30).

(2) Stores does not provide services to maintenance, so recalculate stores total
costs and apportion directly to each production department using the same
basis as before (60:40).
Total Factory 1 Factory 2 Stores Maintenance
overheads £ £ £ £
£
Service Centres
Total budgeted
overheads 100,000 40,000 20,000 30,000 10,000
Reapportion to
stores
Totals
Reapportion to
maintenance
TOTALS
Note: You may be wondering how we deal with the situation where both service
centres provide services to the other. In fact there is a technique to manage this –
but since you do not need to know it for your assessment we will not be covering it
here.

As we’ve seen, traditional methods of allocating overheads may include the floor
space occupied by the manufacturing plant, the number of machine hours or direct
labour hours used in the production cycle, or the number of units produced. Although
these methods of overhead allocation/reallocation adhere to accounting rules in that
a proportion of manufacturing overhead is assigned to each unit produced, they can
never be fully accurate, as they assign overhead costs to a product based on
average rates. Some companies are now adopting an alternative more far-reaching
approach to sharing out overhead costs. This is known as the Activity Based Costing
method (ABC) and we will look at this in Section 6.
 S ec t io n 4 Page | 12

Activity 6
You should now practice your technique by attempting the case study: Korecki Ltd:
Allocation and apportionment of overheads in Chapter 4 of your Osborne Tutorial.
We have provided you with space for your answer below:
Budgeted Basis of Cutting Assembly Maintenance Stores Admin Total
overheads apportionment £ £ £ £ £ £
Depreciation
- machinery
Power -
machinery
Rent and
rates
Light and
heat
Indirect
labour
Totals
Reapportion
maintenance
Reapportion
stores
Reapportion
admin
Total
overheads

OVERHEAD ABSORPTION (RECOVERY)

We’ve taken a look at how overheads are allocated from the main budget to cost
centres, and how from there they are reapportioned from service centres to the main
production centres. We now need to look at how these overheads are absorbed into
cost units.

To absorb overheads we need to calculate an overhead absorption rate (OAR).

This is the rate at which indirect costs are assigned to a cost unit.

Let’s look at the types of overhead absorption/recovery rates that can be calculated.

Direct labour hour method

Overheads are absorbed based on the direct labour hours worked

Total Budgeted Overheads of the Cost Centre

Total Budgeted Direct Labour Hours
 S ec t io n 4 Page | 13

Example:

 Total Overheads of £292,500

 Total Direct Labour Hours of 45,000

OAR = £6.50 per hour

So if a unit requires 2.50 hours direct labour to manufacture, the amount of overhead
assigned to (otherwise known as recovered by or absorbed by) each unit would
be £6.50 × 2.50 hours = £16.25

Activity 7

Machine hour method

Total Budgeted Overheads of the Cost Centre
Total Budgeted Machine Hours

Total Overheads = £292,500

Total Machine Hours = 22,500

(a) Using the same principle as above, calculate the overhead absorption rate
based on machine hours

(b) If a unit requires 0.75 of an hour of machine time to manufacture, what amount
would be recovered or absorbed per unit?

(c) If overhead was absorbed on a units basis, and the budgeted units were
50,000, what would the overhead recovery/absorption rate be?
 S ec t io n 4 Page | 14

Service sector – hourly rate (or sales price / unit method)

Remember that not all companies manufacture. Some will supply a service of some
sort. For example, accountants and solicitors absorb overheads on the basis of the
hours of chargeable time worked

OAR = cost per hour of chargeable time:

Total Budgeted Cost Centre Cost

Total chargeable hours in cost centre

Activity 8
A firm of architects has budgeted overhead costs for the Drawings department of
£200,000. It expects to work 5,000 chargeable hours in the year.

In April 400 hours are charged

How much overhead will be absorbed in April?

This same technique can be applied for any basis set by the company. You should
be prepared to use your problem-solving skills to any basis described in your
assessment questions.

As we have seen, the way the OAR is calculated will normally be based around the
activity of the business. So in a manufacturing environment, if the factory floor is
labour intensive then the direct labour method will be most suited, if the factory floor
is more geared to machinery, then the machine hour method would be more useful.
You may also come across the units method in your studies but this can only be
used where each unit of production is identical and therefore fairly carrying the same
proportion of overhead cost.

Whichever method is adopted the aim is to recover/absorb as much overhead as

possible, so the method should be chosen wisely reviewed on a regular basis to
ensure that it’s still valid and applicable to the business. Come the end of the
financial year, the actual overhead spend will be compared to the budgeted
overhead spend and any variances (differences) will be considered. This is
particularly relevant to companies who run a standard costing system which we will
talk about later in the study material.
 S ec t io n 4 Page | 15

OVER AND UNDER ABSORPTION OF OVERHEAD

What do we mean when we talk about absorbing overhead into units of production?

Remember we said at the beginning of this section that one of the reasons we need
to include the overheads in the value of the units we produce is because it is required
by IAS 2 when producing the financial statements. Absorbing the overhead
effectively means that we have ensured the overheads are taken into account when
calculating the profit or loss earned by the business.

However, the OAR we calculate is based on our budgets at the beginning of the
period. So in practice it is unlikely that when we compare the amount of overhead
absorbed/recovered by actual production with the actual overhead spend, the two
figures will match each other. There will be cases where overheads have been
under absorbed and cases where overheads have been over absorbed. So, what
does this mean?

Activity 9
Budgeted units = 24,000
Budgeted overhead cost = £150,000
Actual units produced = 25,000
Actual cost of overheads = £154,000

(a) Calculate the overhead absorption/recovery (OAR) rate per unit

(b) How much overhead has been recovered/absorbed by the production of

25,000 units? Hint, multiply the OAR by actual units produced

(c) Compare the total overhead recovered to actual overhead cost, is it more or
less?

So overabsorption occurs where the overheads absorbed into product units are
greater than the actual overheads incurred.
 S ec t io n 4 Page | 16

Let’s pause for thought: In a cost accounting system, overhead is charged to the
profit or loss on an absorption basis. So in this case £156,250 was charged to the
profit or loss. To reflect the correct cost we will now need to reduce the cost by
£2,250 – that is we will need to credit the profit or loss, so that the true cost of
£154,000 is accurately recorded.
DR Production Overhead Control Account CR
£ £
Actual overhead cost (bank) 154,000 Overhead absorbed 156,250
*Over absorbed overhead 2,250 *Under absorbed overhead
* We will only have an entry on one side or the other – depending on whether we
have over or under absorbed
DR Production (Cost of Sales) CR
£ £
Overhead absorbed 156,250

DR Profit or loss (variances) CR

£ £
Production overhead 2,250

Activity 10
Let’s say we absorb £140,000 and this is the amount recorded in the statement of
profit or loss (P/L) but the actual overheads are £150,000

Complete the entries in the two accounts to identify the entry we would we need to
make in the P/L to adjust it appropriately.
DR Production Overhead Control Account CR
£ £
Actual costs (Bank) Overhead absorbed

Under absorbed overhead

Over absorbed overhead

DR Profit/Loss (variances) CR
£ £

Well done! You can now account for over or under absorption of fixed production
overheads.
 S ec t io n 4 Page | 17

Activity 11
You should now have a go at the case study Boxit Ltd: Bookkeeping for Overheads
in Chapter 4 of your Osborne Tutorial. We have left some space below for your
workings:
DR Production Overhead Control Account: CR
Cutting department (2500)
£ £

DR Production Overhead Control Account: CR

Assembly department (2600)
£ £

20-8 Code number Debit £ Credit £

24 March 2200
24 March 2500
24 March 2200
24 March 2600
24 March 5500
24 March 2500
24 March 2600
24 March 5500

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

Spreadsheets are a perfect tool for carrying out the repetitive and time-consuming
calculations involved in allocating and apportioning overheads.

You should now attempt the Case Study at the end of Chapter 4 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
help you to practice allocating and apportioning overheads and shows you how to
produce the OARs needed to absorb the overhead costs.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 4 Page | 18

Osborne Books Activities

You should now practice what you have learnt in this section using the activities at
the end of Chapter 4. You can also complete the chapter activities for Chapter 4 of
the Osborne Books Workbook.
 S ec t io n 4 Page | 19

What you have learnt in this section

 Production overheads are indirect production costs

 Budgeted production overheads need to be absorbed into units of production

 They are allocated to specific cost centres where they are incurred by that cost
centre alone

 Shared costs are shared (apportioned) between cost centres on a fair basis

 The overheads allocated and apportioned to service cost centres must then be
reapportioned to production centres using either a direct method, or the step-
down method if one of the service centres provides services to the other.

 Once costs have been allocated and apportioned, they are absorbed into
product units by calculating an overhead recovery rate (OAR)

 An OAR is calculated as:

Total budgeted cost centre overhead / planned activity level in the cost centre

Where the planned activity level may be direct labour hours, direct machine
hours or chargeable hours worked in a professional services company

 Since OARs are based on budgeted figures the actual amount absorbed may
not match the amount spent. The difference may be an over-absorption (when
more is absorbed than is spent) or an under-absorption (when less is absorbed
than is spent).

 Bookkeeping entries must be made to debit overheads to production and

adjust for over or under absorption by crediting or debiting the statement of
profit and loss
 S ec t io n 4 Page | 20

Answers to home study activities

Activity 1
Costs Cost per unit £
 Materials 7
 Labour 16
 Variable overhead 3
Marginal cost 26
 Fixed costs (£100,000* / 50,000 units) 2
Full absorption cost 28
* Note that the £20,000 of administration costs is not included. Non-production
overheads are never included in product costs.

Activity 2
Total Cost Processing Assembly Packing
£ £ £ £
Departmental overheads 600,000 300,000 200,000 100,000
Factory rent 180,000 90,000 60,000 30,000
Factory rates 48,000 24,000 16,000 8,000
Factory insurance 12,000 6,000 4,000 2,000
Factory light and heat 30,000 15,000 10,000 5,000
Depreciation 5,250 3,000 1,500 750
Supervisors salary 28,800 12,000 9,000 7,800
Totals 904,050 450,000 300,500 153,550

Do you remember the tip we gave? Always check

that the total figures add back to the original total.
 S ec t io n 4 Page | 21

Activity 3
The answer is directly below the case study in your Osborne Tutorial

Activity 4
Total Factory 1 Factory 2 Stores Maintenance
overheads £ £ £ £
£
Service Centres
Total budgeted
overheads 100,000 40,000 20,000 30,000 10,000
Reapportion to 18,000 12,000 (30,000)
stores (60%) (40%)
Reapportion to 7,000 3,000 (30,000) (10,000)
maintenance (70%) (30%)
Totals 100,000 65,000 35,000 0 0
Don’t forget to check your totals!

Activity 5
Total Factory 1 Factory 2 Stores Maintenance
overheads £ £ £ £
£
Service Centres
Total
budgeted 100,000 40,000 20,000 30,000 10,000
overheads
Reapportion 5,600 2,400 2,000 (10,000)
to stores (10,000 – (10,000 – (as given
2,000) × 2,000) × in the Q)
70% 30%
Totals 32,000 0
Reapportion 19,200 12,800 (32,000)
to (32,000 × (32,000 ×
maintenance 60%) 40%)
TOTALS 100,000 64,800 35,200 0

Activity 6
The answer is directly below the case study in your Osborne Tutorial
 S ec t io n 4 Page | 22

Activity 7
(a) £292,500/22,500 hours = £13

(b) £13 × 0.75 hours = £9.75

(c) £292,500/50,000 = £5.85 per unit

Activity 8
OAR = £200,000 / 5,000 = £40

400 hours × £40 = £16,000 of overhead absorbed in April

Activity 9
(a) OAR £500,000 / 24,000 = £6.25

(b) Amount recovered/absorbed £6.25 × 25,000 units = £156,250

(c) Amount absorbed £156,250 less amount spent £154,000 = £2,250 over
absorbed

Activity 10
Not enough overhead has been charged to the P/L so we would need to debit it with
a further £10,000. This will reduce profit.
DR Production Overhead Control Account CR
£ £
Actual costs 150,000 Overhead absorbed 140,000

Under absorbed overhead 10,000

Over absorbed overhead

DR Profit/Loss (variances) CR
£ £
Production overhead 10,000

Activity 6
The answer is directly below the case study in your Osborne Tutorial
 Section 5
Methods of costing

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

Cost accounting is the gathering together of the costs associated with a particular
product or service. This information can then be used to help the business manage
and control its overall expenditure. This section will cover the methods of costing
which can be used by different types of businesses.

When you have finished studying this section you will be able to:

– Calculate the cost and selling price of a one-off order

– Calculate the cost and selling price for a batch of items

– Calculate the cost and amount to charge for a service

– Calculate the cost per unit for items passing through a continuous production
process including in the case of:

 Work in progress at period end

 Expected (normal) waste

 Unexpected (abnormal) waste

 Scrap revenues earned from sale of the waste

 S ec t io n 5 Page | 2

UNIT COSTING
In the previous sections we discussed how the costs of materials, labour and
overheads are accounted for and how they are incorporated into product costs. We
use the term cost object to refer to the unit of product, or service, or activity we are
costing. This could be:

 A manufactured item – a car for example, or a calculator

 A fixed quantity – for example a kilo of firewood, or a litre of fertiliser

 A composite unit – for example a bed day in a hospital or a passenger mile for
a transport company

 A service – for example an audit or a legal consultation

We have established that there are four elements to the cost:

Activity 1
Can you identify the costs which make up the four different elements?
Element Made up of
Prime cost

Marginal cost

Full absorption cost – suitable for

inventory valuation under IAS 2
Total cost – never used for inventory
valuation purposes
You should now take a look at a worked example of a simple unit costing exercise
for a toy manufacturer in Chapter 5 of your Osborne Tutorial.

COSTING METHODS FOR SPECIFIC ORDERS

So far, we have been assuming that units are produced, stored and then advertised
and sold to customers. But sometimes customers ask for specific goods or services
to be made or delivered to order. In this case there is not a standard unit cost and
instead the costs for the specific order need to be gathered together so that they
can be charged to the customer.

There are two costing methods that can be used to gather the specific costs:

 Job costing

 Batch costing
 S ec t io n 5 Page | 3

Note: Both these techniques will calculate the cost before absorption of overheads.
However this final absorption stage will still be needed to ensure that overheads are
recovered when pricing the product or service so that the business can still earn a
profit.

SPECIFIC ORDERS: JOB COSTING

This is used where each job is a one-off, performed separately from other work, and
the costs associated with the job can be specifically identified.

Examples could include a construction project, a car service, a wedding party or

preparation of the business’s accounts.

Take a look at the diagram in Chapter 5 of your Osborne Tutorial: the main steps in
job costing, to see the stages in the job costing process, and then read the case
study: Fashionaid: Job Costing for an illustration of how a job cost is prepared.

Activity 2
An order has been received for a bespoke hospitality tent.

The tent requires 1,875 square metres of material and will pass through 3
manufacturing processes before it is complete.

You are provided with the following information:

 The cost of the material = £30.00 per square metre

 The required machine setup time (expense) = 6.00 hours at £15.00 per hour

 Processing stages direct labour (hours and rates):

– Machining 30.00 hours at £15.00 per hour

– Stitching 40.00 hours at £14.00 per hour

– Finishing 20.00 hours at £12.00 per hour

Overheads are recovered on a direct labour hourly basis. The budget files indicate
that total budgeted overheads = £240,750 and total budgeted labour hours = 26,750

Profit required = 25% on cost

You are required to calculate the total cost of the job and to quote a total price to
the customer using the template provided
 S ec t io n 5 Page | 4

Job Sheet for bespoke hospitality tent

Cost £
2
Direct Materials Metre Rate £

Machine setup Hours Rate £

Direct Labour Hours Rate £

 Machining
 Stitching
 Finishing
Total direct labour hours

Overheads Recovered on a direct labour hour basis

Hours Rate £

Total cost of job

Profit 25% on cost
Selling price total job

SPECIFIC ORDERS: BATCH COSTING

This is used where a business makes a number of identical items in a single batch
– for example paint mixes or medical drug production.

Before the manufacturing process begins, each batch will be issued with its own
unique identification code, and all the costs consumed in the production process will
be given that code – for example the code will be specifically recorded on all related
raw materials requisition slips. As each batch may be slightly different even though
the manufacturing process is the same, the batch number can be used to identify
the specific batch a single item is from.

In practice, the accounting technique used is the same as for job costing but unlike
a specific one-off order, each batch made will consist of the same number of units
and the units in all the batches will be made in exactly the same way. The final stage
will therefore be to calculate a

 Cost per unit: Total batch cost / number of units in the batch

 Price per unit: Total batch cost plus profit required / number of units in the
batch
 S ec t io n 5 Page | 5

Activity 3
You should now attempt the case study: Amber Ltd: Batch costing for children’s
clothes in Chapter 5 of your Osborne Tutorial. We have left space below for your
answer.
Batch cost: 1,000 sequin dresses
Cost £
2
Direct Materials Metre Rate £

Direct Labour Hours Rate £

 Cutting
 Sewing
 Finishing
Total direct labour hours

Variable overheads Recovered on a direct labour hour basis

Hours Rate £

Total cost
Profit
Selling price

Total cost per unit

Selling price per unit

COSTING METHODS FOR CONTINUOUS WORK

Some businesses do not move from one job to another, but instead produce
continuously throughout the period.

For example a train operator may run trains throughout the day and night, and will
charge each customer for the journey they take – this requires them to use service
costing.

And many manufacturing plants run constantly making cars, cakes or computers.
They use a unit costing method.

Let’s take a closer look at them both.

 S ec t io n 5 Page | 6

CONTINUOUS WORK: SERVICE COSTING

Service costing aims to establish the cost of providing a service to others. The
technique is adopted by companies in fields such as utilities (suppliers of gas,
electricity and water), transport, cleaning and professional services (such as
accountants). It is not commonly found in the manufacturing sector where batch
costing or process costing (which we will cover next) are used.

Pricing a service can be more difficult than pricing a product as the allocation of
costs can be more subjective. A business will want to make sure that the price it
quotes is competitive but if the customer accepts the quoted price, it forms the basis
of the contract, so they need to beware of under-pricing.

Bear in mind too that if a service contract is for a one-off job, then a job costing
approach would be taken in order to quote a price – we are assuming here that the
business provides the same service to multiple customers.

Features of service costing include:

 The output is intangible – it is performance of an act rather than the production

of a finished good

 Composite units are commonly the items being costed. For a cleaning
company it may be the cost per square metre cleaned, for a transport company
it may be the running costs of a vehicle per mile.

 Labour costs are viewed as direct costs and are usually the bulk of the cost of
sales figure in the financial statements of a service provider

 All other costs are usually deemed indirect since there is no physical end
product and the materials costs will be very low relative to the total cost

 Overheads are often referred to as support costs and will include costs such
as the payroll costs of administration staff and the rental of office space. They
are usually treated as period costs which means they are charged to the
statement of profit or loss in the time period in which they occur.

It can be more difficult to recover overheads within the selling price when charging
for services, and many smaller companies simply add a percentage to the cost of
materials and labour. However, it is important to ensure that all support costs are
covered over the period so that the firm can remain profitably in business.

One solution is to produce a detailed analysis of traceable costs (materials and

labour) and un-traceable costs (overheads) before a price for the service is quoted
to the customer. This is done by producing a cost sheet for review by management.
 S ec t io n 5 Page | 7

Activity 4
You run a small cleaning company and you’ve noticed an advert in the local paper
indicating a service contract is up for tender at the local council offices. The advert
states that the total cleaning area amounts to 62,500 square metres, and tenders
are required in the region of £2.00 to £3.00 per square metre.

Labour costs are expected to be £60,000 for the job.

You investigate costings for the cleaning materials required and which will come to
£10,000 over the contract. Other direct costs will total around £2,000 and overheads
will be £28,000.

You decide to take the cost plus 25% approach when calculating your profit

Prepare a tender for submission to the local Council.

Calculations in preparation for the tender
£
Direct materials (Detergents/Cleaning Fluids)
Direct Labour (Cleaners)
Other Direct Costs (Mops, Buckets, Gloves)
Overheads (Admin Staff, Rent, Rates, Light/Heating)

Total costs

Profit: cost plus 25%

Total cost including profit

Cleaning Area Square Metres

Cost per unit

Activity 5
A plumber’s overheads include costs such as vehicle running costs, insurance, use
of home as office, stationery and so on. The total comes to £7,200 per year.

The plumber works 25 chargeable hours per week (other hours are spent travelling
between jobs, doing free quotes, and completing paperwork).

The plumber works 45 weeks of the year and wants to earn a wage of £15 per hour.
What is the minimum price which a customer should be charged per hour, in order
to ensure all costs are covered?
 S ec t io n 5 Page | 8

CONTINUOUS WORK: UNIT COSTING

This technique is used by manufacturing firms that have a continuous flow of
production, where it would not be possible to identify the costs of an individual unit.
Typically the units will pass through more than one process, before the product is
complete. The units are measured by output for example:

 Cost per litre (fertilizer, beer, lubricants)

 Cost per square metre (fabric, flooring)

 Cost per kilogram (firewood, ground coffee)

Inputs are added at each stage of the process. These are costs such as raw
materials, labour and production overheads. Labour and production overheads are
sometimes referred to as conversion costs as they are incurred converting the
materials into finished goods. At each stage of production all the costs are pooled
and carried forward to the next part of the production process (if there is one), until,
after the final process, they are charged to finished goods.

The final cost of production is divided by the number of output units to arrive at an
average cost per unit.

The advantage of this technique is that the cost of the process can be calculated at
each stage which makes it easier to control costs. However, there are two issues
that need to be considered when costing the units:

1 What do we do about work-in-progress? – products that are only partially

complete at a period end

2 How do we record wastage (this could be expected waste such as sawdust

generated as timber is cut, or unplanned waste – such as number of products
that are defective and have to be disposed of.

WORK-IN-PROGRESS – EQUIVALENT UNITS

We first mentioned equivalent units in Section 2 when we talked about valuing
inventory. The concept is used to help us value partially completed products at
period end.

It’s normal procedure for companies to prepare management accounts for internal
use on a monthly or quarterly basis so that they can review performance. For those
companies in the manufacturing sector, the need to calculate cost of goods sold
requires that they can decide on a value for inventory and this may include work in
progress (WIP).
 S ec t io n 5 Page | 9

What is WIP?

At the end of any given period it is normal for a manufacturing firm to have a quantity
of semi-manufactured goods on hand. These are goods that have entered the
production process, incurring costs as they move through, but are not yet
completed.

Obviously, goods nearing completion have incurred more costs (and are therefore
more valuable) in terms of raw material, labour and overheads than goods that have
just entered the process. However, since we don’t know exactly how complete each
unit is at any one time, we have to make a best estimate based on what the company
would expect to make during the period and the costs associated with that level of
production.

Calculating equivalent units

The principle is simple:

If there are 1,000 units which are exactly 40% complete, then this is equivalent to
400 completed units (1,000 × 40%).

But what if the process has already had all the materials added but we have not yet
completed the work necessary to turn the materials into finished goods? Then the
units would be 100% complete with regard to materials but only partially complete
with regard to labour and overhead:

Let’s look at an example:

At the end of a period a company has the following items:

 Units Completed = 1,000

 Units in Progress = 400

The items of WIP are 100% complete with regard to materials but have only had
50% of the labour and overheads needed to finish them (labour and overhead costs
are both time related).

The costs incurred in the period are:

 Materials = £11,200

 Labour = £6,000

 Variable production overheads = £3,600

 S ec t io n 5 Page | 10

Let’s look at how this would be calculated and recorded. Since the table can be a
little confusing to follow, we have provided you with a step-by-step explanation of
the table that follows:
WIP Units
Cost Cost of Completed Units % EUs Total Cost WIP
element inputs units Complete EUs per unit

1 2 3 4 5 6 7 8 9
Materials 11,200 1,000 400 100 400 1,400 8.00 3,200

1 The total cost of materials input to the process is

2 £11,200

3 1,000 units are completed

4 but 400 still being worked on

5 However all the materials have already been put into the process so the 400
units of WIP are 100% complete with regard to materials?

6 So 400 × 100% comes to 400 equivalent units (EUs)

7 Since completed units are clearly 100% complete, the total number of EUs is
1,400

8 The cost of materials per EU is therefore £11,200/1,400 = £8

9 So with respect to materials, the 400 units of WIP can be valued as 400 units
× £8 = £3,200

Now let’s take a look at how the cost per unit is calculated for labour when not all of
the resource has been used.
WIP Units
Cost Cost of Completed Units % EUs Total Cost WIP
element inputs units Complete EUs per unit

Materials 11,200 1,000 400 100 400 1,400 8.00 3,200

1 2 3 4 5 6 7 8 9
Labour 6,000 1,000 400 50 200 1,200 5.00 1,000
 S ec t io n 5 Page | 11

1 The total cost of labour input to the process is

2 £6,000

3 1,000 units are completed

4 but 400 still being worked on

5 Only 50% of the labour has been done so far so the 400 units of WIP are 50%
complete with regard to labour

6 So 400 × 50% comes to 200 equivalent units (EUs)

7 Since completed units are 100% complete, the total number of EUs is 1,200

8 The cost of materials per EU is therefore £6,000/1,200 = £5

9 So with respect to labour, the 400 units of WIP can be valued as 200 units ×
£5 = £1,000

Activity 6
Can you now record the variable overhead and total up the table?
WIP Units
Cost Cost of Completed Units % EUs Total Cost WIP
element inputs units Complete EUs per unit

Materials 11,200 1,000 400 100 400 1,400 8.00 3,200

Labour 6,000 1,000 400 50 200 1,200 5.00 1,000

Variable
overhead

Total

This process assumes that all 400 of the EUs of WIP were the same degree of
complete – that is – we averaged the costs across them all equally. In some
manufacturing processes, such as a car plant where cars go steadily along a
production line, being worked on as they go, we would know that the cars that have
only just entered the production line are far less complete than those that are almost
at the end. So, unlike the AVCO method we have used, the business may use a
FIFO approach. However you will not need to use a FIFO method in your
assessment.
 S ec t io n 5 Page | 12

ACCOUNTING FOR WASTAGE

As we explained earlier, we need to be able to account for two different types of
waste:

 Normal or expected waste: This is the result of every day anticipated events
such evaporation, offcuts, breakage, test units and so on

 Abnormal waste: This is waste that we were not expecting – perhaps a

production process was faulty, or the materials were a poorer quality than we
intended.

Remember that we cost our units at the beginning of the period and our calculations
will be based on budgeted costs. So, normal or expected waste is simply part of
production, and the costs will be included in our overall production costs and spread
over units of production.

But we can’t anticipate abnormal waste (that’s the whole point – it is unanticipated)
– so instead we must value it separately.

Before we show you how to account for wastage, we first need to introduce you to
the process account:
Dr Production Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Materials All the inputs are recorded Normal waste All the outputs are
Conversion costs: on this side – you may be Completed recorded on this side.
given the conversion cost units There may only be normal
as one figure or it may be waste or there may also
 Labour split between labour and Abnormal be abnormal waste as
overhead. waste well
 Overhead

Now let’s have a look at how to account for the waste, using an example:

A business buys 10,000 kgs of materials for use in a production process for £0.80
per kg. £4,000 of labour and overhead will be incurred converting the materials into
finished goods.

The business knows that the production process will generate about 400kg of waste.
So expected output is 10,000kg – 400kg = 9,600kg.

The expected cost per unit = £12,000 / 9,600 = £1.25

 S ec t io n 5 Page | 13

Dr Production Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Materials 10,000 0.8 8,000 Normal 400
waste
Conversion 4,000 Finished 9,600 1.25 12,000
costs goods
10,000 12,000 10,000 12,000

Dr Finished goods Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Production 9,600 1.25 12,000

Notice that:

 The total quantity must balance –the normal waste plus the quantity of finished
good is equal to the total input

 The normal waste is not valued at the cost per unit – it is expected and so
the cost is considered to be part of the cost of good production

 The value of finished goods can then be entered in the finished goods account

Abnormal wastage
Abnormal waste is where the final output is lower than we would have expected. So
if, in the last example, we had actually ended up with only 9,400 kg of finished
product, then our overall figures would be:
kg
Input 10,000
Less normal waste (400)
Expected output 9,600
Less actual output (9,400)
Abnormal waste 200
The cost of abnormal waste needs to be separately accounted for. We did not expect
it and management should be alerted to what has happened.
 S ec t io n 5 Page | 14

Our accounts would then look like this:

Dr Production Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Materials 10,000 0.8 8,000 Normal 400
waste
Conversion 4,000 Finished 9,400 1.25 11,750
costs goods
Abnormal 200 1.25 250
wastage
10,000 12,000 10,000 12,000

Dr Finished goods Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Production 9,400 1.25 11,750

Dr Abnormal wastage Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Production 200 1.25 250 To P/L 250

Note that:

 The abnormal waste is valued at the expected cost per unit

 The figure in the abnormal waste account would be debited to the statement
of profit or loss at the end of the period to reflect the cost of incurring the
unexpected waste. In this way it is treated as a period cost rather than being
carried forward in the value of inventory.

Scrap sales
One final point to think about:

Wastage may be saleable – sawdust can be sold for hamster cages, material off-
cuts can be sold to quilters, and scrap metal can be melted down and sold for use
in new production processes.

So we need to have a way to account for the revenue.

You won’t be surprised to learn that the way we account for it depends on whether
the waste is normal or abnormal.
 S ec t io n 5 Page | 15

Activity 7
Can you suggest

(i) why we have to account for the revenue differently depending on whether it
was earned selling normal or abnormal waste and

(ii) how we might account for it?

Let’s take a look:

Let’s assume that in our example above all of the waste could be sold for 24p per
kg.

At the start of the period we would expect 400kg × 24p = £96 of income from selling
our waste product.

So our cost per unit calculation would be:

Unit cost = Total costs less the scrap value of normal waste

Expected output

= (£12,000 – 96)/9,600 = £1.24

And that is the figure that will be used to value finished goods and abnormal
wastage:
Dr Production Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Materials 10,000 0.8 8,000 Normal 400 0.24 96
waste
Conversion 4,000 Finished 9,400 1.24 11,656
costs goods
Abnormal 200 1.24 248
wastage
10,000 12,000 10,000 12,000
 S ec t io n 5 Page | 16

The scrap value earned on the abnormal wastage will then be debited to that
account and the net figure is then used to debit the statement of profit or loss – in
other words the income has been set off against the cost of the abnormal wastage.
Dr Abnormal wastage Cr
Quantity Unit Total Quantity Unit Total
Kg cost cost Kg cost cost
£ £ £ £
Production 200 1.24 248 Bank 200 0.24 48

To P/L 200

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

The costing examples we have used in this section have been quite simple. In
practice they can be complex – with many different direct and indirect costs to be
dealt with. Spreadsheets are a great tool for gathering costs and finding the
appropriate cost per unit. When properly formatted they can be regularly updated
and the changes can even feed through into the charts and graphs used to illustrate
the information.

You should now attempt the Case Study at the end of Chapter 5 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
help you to practice working out the cost and selling price for goods produced in
batches.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 5 Page | 17

Osborne Books Activities

You should now read practice what you have learnt in this section using the activities
at the end of Chapter 5. You can also complete the chapter activities for Chapter 5
of the Osborne Books Workbook.
 S ec t io n 5 Page | 18

What you have learnt in this section

 Firms must select the costing method which is appropriate for the type of
business they are in

 Some firms produce discrete items, some produce multiple batches, and
others run production lines continuously

 Where customers request a specific order, the business may use:

– Job costing – for a single one-off order

– Batch costing – for a batch of identical units

 Where production is continuous, the method used may be:

– Service costing – for service providers such as accountants

– Unit costing – for manufacturers running production lines

 The basic principle is simple – gather all the costs and divide by the number of
units produced to get a cost per unit.

 If there is work in progress (WIP) we first need to work out how many units of
completed production it is equivalent to. 1,000 units of WIP that are 60%
complete equal 1,000 × 60% = 600 equivalent units

 Where there is wastage, this needs to be recorded in the process cost

accounts.

 Normal waste is expected at the outset so it is treated as part of the cost of

good production. Abnormal waste is not expected so it must be valued and
recorded separately for review by management and is debited to the statement
of profit or loss.

 Any scrap proceeds on the sale of waste must also be taken into account.
Scrap proceeds on normal waste will have been anticipated and are deducted
from the input cost in the calculation of the cost per unit. Scrap proceeds on
abnormal losses by definition cannot be anticipated. Instead they are deducted
from the cost of the abnormal loss in the abnormal loss account and only the
net amount is taken to the statement of profit or loss.
 S ec t io n 5 Page | 19

Answers to home study activities

Activity 1
Element Made up of
Prime cost Direct materials plus direct labour
Marginal cost All direct costs:
Prime costs plus direct variable
production overheads
Full absorption cost – suitable for All production costs:
inventory valuation under IAS 2 Marginal cost plus indirect costs (fixed
production overheads)
Total cost – never used for inventory All costs:
valuation purposes Full absorption cost plus fixed non-
production overheads such as selling
and administration costs

Activity 2
Job Sheet for bespoke dresses order
Cost £
2
Direct Materials Metre Rate £
1,875 30 56,250

Machine setup Hours Rate £

6 15 90

Direct Labour Hours Rate £

 Machining 30 15 450
 Stitching 40 14 560
 Finishing 20 12 240
Total direct labour hours 90

Overheads Recovered on a Direct Labour Basis

Hours Rate £
*£240,750 / 26,750 90 *9 810

Total cost of job 58,400

Profit 25% on cost 14,600
Selling price total job 73,000
 S ec t io n 5 Page | 20

Activity 3
The answer is directly below the case study in your Osborne Tutorial.

Activity 4
£
Direct materials (Detergents/Cleaning Fluids) 10,000
Direct Labour (Cleaners) 60,000
Other Direct Costs (Mops, Buckets, Gloves) 2,000
Overheads(Admin Staff, Rent, Rates, Light/Heating) 28,000

Total costs 100,000

Profit: cost plus 25% 25,000

Total cost including profit 125,000

Cleaning area square metres 62,500

Cost per unit = 125,000/62,500 = £2.00 2.00

Activity 5
25 hours × 45 weeks = 1,125 chargeable hours

£7,200/1,125 chargeable hours = £6.40 per hour to recoup overheads

Plus £15 for the wage required = £21.40 per hour minimum
 S ec t io n 5 Page | 21

Activity 6
WIP Units
Cost Cost of Completed Units % EUs Total Cost WIP
element inputs units Complete EUs per unit

Materials 11,200 1,000 400 100 400 1,400 8.00 3,200

Labour 6,000 1,000 400 50 200 1,200 5.00 1,000

Variable 3,600 1,000 400 50 200 1,200 3.00 600

overhead

Total 20,800 16.00 4,800

Activity 7
The sale of expected waste is anticipated – and it is set off against the cost of good
production to reduce the cost per unit

The sale of abnormal waste is not anticipated – so it is separated out and set against
the cost of the abnormal waste in the abnormal waste account.
 Section 6
Marginal, absorption and activity
based costing

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover the use of marginal and absorption costing and the impact it
has on the calculation of profits.

When you have finished studying this section you will be able to:

– Explain the difference between marginal and full absorption costing

– Calculate the marginal cost of a unit

– Calculate the full absorption cost of a unit

– Produce a marginal costing statement of profit or loss

– Produce a full absorption costing statement of profit or loss

– Explain any difference in profit between a marginal costing and a full

absorption costing statement of profit or loss

– Explain the purpose of activity based costing (ABC)

– Calculate the fixed overhead per unit using ABC

 S ec t io n 6 Page | 2

MARGINAL AND ABSORPTION COSTING SYSTEMS

In this section we are going to look at the differences between marginal and
absorption costing systems, but before we do, we just need to recap on some of the
main concepts we have already covered when talking about costs.

Product Costs

Product costs are associated with a manufacturing process.

Variable costs are made up of direct materials, direct labour, direct expenses and
variable manufacturing overheads. When added together these costs form the
basis of marginal costing in which all costs are charged to the profit and loss
account in the period. Marginal costing is a technique used by management to help
make decisions internally but is not suitable for use in the financial statements.

For financial reporting purposes, remember that accounting rules require us to

prepare accounts on an accruals basis and inventory valuation should include all
costs that are incurred in making the product – that is they should include all fixed
production overheads. This is the basis of full absorption costing. This means
that if there are some products that have not yet been sold, the related production
costs will be carried forward into the next accounting period via the inventory
valuation.

Non-production overheads

These are costs that are not incurred in the production process so they cannot be
attached to the cost of goods sold. Such costs are usually time related rather than
production volume related and are typically associated with selling, distribution and
administration. They are period costs – always charged to the profit or loss account
in the period in which they occur and unlike product costs, they cannot be carried
forward into the next accounting period by way of inventory.

Let’s now take a closer look at the two methods:

MARGINAL COSTING
Marginal costing is concerned with the cost of producing and selling one more unit.

One of the costing concepts associated with marginal costing is contribution.

The contribution of one unit is calculated as:

Selling price – variable cost

So if a unit which costs the business £5 per unit in variable costs is sold for £8, then
it contributes £8 – £5 = £3 towards paying for fixed overheads and earning a profit.
 S ec t io n 6 Page | 3

If we sell 10,000 units, we would say that our contribution is 10,000 × £3 = £30,000
– that is our output contributes a total of £30,000 towards the overall fixed overhead
bill, and, if fixed overheads are less than £30,000, then we will also make a profit.

Marginal costing is used in short-term decision making, as only the direct costs
relevant to the manufacture of the product are considered. It does not take account
of fixed overheads, as these costs are incurred regardless of output.

All fixed overheads are treated as period costs charged to the profit and loss
account during the production period and the calculation of profit is not affected by
changes in inventory levels.

Absorption Costing
Under this method of costing the full cost of manufacturing a unit is used to value
inventory.

The full cost of a unit equals the marginal cost per unit plus the cost of the fixed
production overheads which have been absorbed into the product. We looked at
how to carry out this absorption process in Section 4.

By calculating a full absorption cost, the business can work out an appropriate
selling price to ensure all of its overheads are covered. If this price would be
uncompetitive, it is an indication to management that they need to improve cost
control.

Absorption costing smooths out the profits of a company by carrying an element of

fixed costs into the following period by including them in the closing inventory
valuation.

Let’s look at a comparison of the two methods:

Activity 1
The budgeted revenue and costs for a unit of production are as follows:
Selling price per unit £20.00
Direct materials per unit £1.50
Direct labour per unit £3.50
Variable overhead per unit £0.90
Budgeted monthly fixed overhead £25,000
Budgeted monthly production 10,000 units
Budgeted monthly sales 8,000 units
Opening inventory 2,000 units
 S ec t io n 6 Page | 4

(a) Calculate the contribution per unit based on the marginal costing method.

Remember in a marginal costing system:

 Marginal cost is the total of all the variable costs, it does not take fixed
overheads into account

 The marginal cost can be used to value inventory for use in management
accounts only
Marginal cost Per unit £ Per unit £
Selling price
Less total variable cost:
 Direct materials
 Direct labour
 Variable overhead

Contribution per unit

(b) Can you now calculate the profit per unit using a total absorption costing
method?

Remember in a full absorption costing system:

 Fixed costs are charged to the units produced, which enables us to calculate
profit per unit.

 The full absorption cost is used to value inventory and so this method can be
used for valuing inventory in the financial statements under IAS 2
Full absorption cost Per unit £ Per unit £
Selling price
Less total absorption cost:
 Direct materials
 Direct labour
 Variable overhead
 Fixed cost per unit*

Profit per unit

 S ec t io n 6 Page | 5

Working for fixed cost per unit:

Hint: On the absence of any other information, fixed costs are absorbed based on
budgeted production levels

(c) Can you use the information you have calculated so far to find the production
profit or loss for the period applying marginal costing principles?

Remember:

 All the fixed costs are written off during the period.
Marginal cost production profit and loss £ £
Sales
Less cost of sales:
 Opening inventory
 Variable cost of production
 Less closing inventory
Cost of sales
Total contribution
Fixed costs
Profit

Working for closing inventory:

Hint: Closing inventory can be worked out: You know how many items you had in
opening inventory, and how many you produced and sold in the period. What will
you be left with at the end of the period?
 S ec t io n 6 Page | 6

(d) Now calculate the production profit using full absorption costing.
Absorption profit and loss £ £
Sales
Less cost of sales:
 Opening inventory
 Variable cost of production
 Fixed costs of production
 Less closing inventory

Profit
(e) What do you notice about the marginal and full absorption costing profits?

The reason that the profit under full absorption costing is £5,000 more than under
marginal costing is as follows:

 Under marginal costing the full fixed production costs of £25,000 were treated
as a period cost and deducted from revenue.

 Under full absorption costing the fixed overhead was absorbed into the units
of production. And in our calculation of cost of sales, we:

– added in 2,000 units of opening inventory – each of which had absorbed

£2.50 of fixed overheads – so compared to the marginal cost calculation
we increased costs by 2,000 × £2.50 = £5,000

– deducted the cost of the 4,000 units of closing stock each of which had
also absorbed £2.50 of fixed overheads – so compared to the marginal
cost calculation we decreased costs by 4,000 × £2.50 = £10,000

The net impact was to reduce the cost of sales figure by £5,000. And since the
cost went down by £5,000, the profit went up by £5,000.

So in conclusion, there will be a difference between marginal and absorption

costing profits wherever there is a change in the level of inventory over the
period. The difference will be:
 S ec t io n 6 Page | 7

The change in inventory over the period in units x the fixed cost per unit.
Opening inventory 2,000 units
Closing inventory 4,000 units
Difference 2,000 units
Fixed cost per unit £2.50
Difference in profit (£2.50 × 2,000) £5,000
However remember that:

 The higher profit recorded under absorption costing does not mean the
company has done any better! It is simply that some of the fixed production
overheads were deducted from this period’s cost of sales. They will feature in
next period’s opening inventory so the cost has simply been deferred to next
year.

 If the level of inventory had fallen over the period, more fixed overheads would
have been added to cost of sales in opening inventory than were deducted in
closing inventory and so the absorption profit would have been lower than the
marginal cost profit.

 For the purposes of the financial statements under IAS 2, absorption costing
must be used.

Activity 2
You should now turn to Chapter 6 of your Osborne Tutorial and complete the case
studies Wyvern Bike Company: Marginal Costing and Wyvern Bike Company:
Absorption Costing. When you have completed them both, compare their profits.
What do you notice? Why do you think that has happened?

We have left space for your workings below. However it is important that you get
used to the different ways of calculating the figures so we have left you to lay out
your own workings.
Marginal costing
 S ec t io n 6 Page | 8

Absorption costing

Comment on the two profit figures

 S ec t io n 6 Page | 9

Activity 3
Now complete the case study Chairs Ltd: Marginal and absorption costing in
Chapter 6 of your Osborne Tutorial. Look at the two profit figures and comment on
what you find.
 S ec t io n 6 Page | 10

Activity 4
You overhear a conversation between the Management Accountant and the
Finance Director discussing the production of the year-end financial statements. The
Management Accountant says, ‘let’s just use the marginal costing system that we
use for the monthly management accounts. That way we can cut our tax bill’.

(a) Why might using marginal costing have this effect?

(b) What does the Finance Director need to consider before he gives his
response?

(c) Which fundamental ethical principles could be compromised and why?

ACTIVITY BASED COSTING

We mentioned in Section 4 that the way in which overheads are absorbed into
product units by many businesses is based on average usage and therefore the
technique provides only an approximate overhead cost per unit.

Activity based costing (ABC) was developed in the 1970s and requires a more
detailed analysis of overheads to provide a more accurate estimate of the overhead
cost per unit.

Let’s look at a simple example:

A company makes two products.

Each year it makes:

 4 batches of Product X. Each batch weighs 100kg and contains 500 units

 10 batches of Product Y. Each batch weighs 200kg and contains 200 units
 S ec t io n 6 Page | 11

The company has fixed production overheads of £12,080.

The simplest method of absorbing overheads would be on a per unit basis so:

£12,080 / (4 batches × 500 units + 10 batches × 200 units) = £3.02 per unit

But this is just an average and takes no account of what actually happens during
production. So let’s take a closer look:

Although the production overheads of £12,080 are fixed and don’t change according
to production volume, we can still ask ourselves ‘what activities are driving these
costs?’ – that is – why do we need to incur them in the first place?

Further investigation shows that they are made up as follows:

Cost £ Incurred:
Setting up machinery £4,200 Every time a batch of products is made
Materials handling £2,880 As a result of the kgs of material handled
Quality inspections £5,000 Carried out for every 10 units produced
Let’s look at how we can use this information:

Set up costs

We are told that each year the company makes 4 batches of product X and 10
batches of product Y.

So it incurs £4,200 setting up 14 batches

£4,200 / 14 = £300 per set up

Materials handling costs

We are told that a batch of X weighs 100kg whilst a batch of Y weighs 200kg.

So we handle:

(100kg × 4 batches) + (200kg × 10 batches) = 2,400kg

which equates to £2,880 / 2,400kg = £1.20 per kg handled

 S ec t io n 6 Page | 12

Quality inspections

We are told that a batch of X has 500 units and a batch of Y has 200 units.

So overall we make:

(500 × 4 batches) + (200 × 10 batches) = 4,000 units.

Since we inspect every 100 units that equates to 4,000 /100 = 40 inspections

Which is £5,000 / 40 = £125 per inspection

Now let’s think about how this might be reflected in the costs of the two products:
Product X Product Y
£ £
Set up costs @ £300 per batch set up
 4 batches × £300 1,200
 10 batches × £300 3,000
Materials handling @ £1.20 per kg handled
 4 × 100kg × £1.20 480
 10 × 200kg × £1.20 2,400
Quality inspections @ £125 per inspection
 (500 × 4)/100 = 20 inspections @ £125 2,500
 (200 × 10)/100 = 20 inspections @ £125 2,500
Total 4,180 7,900
Cost per batch:
 £4,180 / 4 1,045
 £7,900 / 10 790
Cost per unit
 £1,045 / 500 2.09
 £790 / 200 3.95
Look at the difference!

Our original cost per unit calculation was £3.02 per unit, but by using activity based
costing we have got two very different figures – £2.09 per unit of X and £3.95

This is because, although we make the same number of each product, the real cost
drivers are set up costs (we make more batches of Y) and the cost of materials
handling (product Y is heavier).

ABC has given us a more realistic overhead cost per unit which better reflects what
it actually costs us to produce the two products.
 S ec t io n 6 Page | 13

You may have already noticed the main disadvantage though – ABC requires a
business to collect far more information and requires far more calculations (that
takes time and expense) to produce the cost per unit.

Remember that in the end ABC is simply a form of absorption costing. A business
must first decide whether to choose a marginal or absorption costing approach. If it
chooses absorption costing it must then select the form of absorption costing that is
most suitable for its business – the more traditional approach or ABC.

Activity 5
You should now attempt the case study: AyeBee: Activity based costing in Chapter
6 of your Osborne Tutorial. We have left space for your workings below.

Other cost drivers

In practice there are a whole host of potential cost drivers which can be related to
the level of activity carried out by a business. You should turn to this section of your
Osborne Tutorial now to read a list of examples.
 S ec t io n 6 Page | 14

THE USE OF COST POOLS

Turn now to the diagram below the heading ‘using activity based costing’ in Chapter
6 of your Osborne Tutorial. Read the description of how the process is carried out,
the advantages it offers and the comparison provided on the three different costing
methods we have looked at in this section. Make notes in the space provided below.

Steps in ABC

Advantages of ABC
 S ec t io n 6 Page | 15

Comparison of costing methods

Marginal costing Absorption costing Activity based costing

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

Spreadsheets can be used to great effect to produce product costings which can
then be used to calculate marginal and absorption costing statements of profit or
loss. They also take a lot of the effort out of calculating the detailed absorption rates
used in activity based costing.

You should now attempt the Case Study at the end of Chapter 6 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
help you to practice producing a marginal costing statement of profit or loss.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 6 Page | 16

Osborne Books Activities

You should now read practice what you have learnt in this section using the activities
at the end of Chapter 6. You can also complete the chapter activities for Chapter 6
of the Osborne Books Workbook.
 S ec t io n 6 Page | 17

What you have learnt in this section

 Marginal costing and full absorption costing are two different ways of managing
fixed production overheads

 Marginal costing values inventory by adding up all of the variable costs of

production. It is associated with the calculation of contribution which is
calculated as selling price less variable costs. Fixed production overheads are
treated as a period cost and deducted in the statement of profit or loss.

 Marginal costing is used to help management make short-term decisions

 Full absorption costing spreads the fixed production overhead costs over the
units of production. They are valued at variable cost plus an element of fixed
cost per unit. This method is required for use in inventory valuations in the
financial statements under IAS 2.

 Marginal costing and full absorption costing can give different profit figures if
inventory levels change over the period. The difference is the change in
inventory level × fixed overhead cost per unit.

 Activity based costing (ABC) is a more sophisticated form of absorption costing

which uses cost drivers to spread the fixed costs of production over units based
on the activities which drive the business to incur the costs.
 S ec t io n 6 Page | 18

Answers to home study activities

Activity 1
(a)

Marginal cost Per unit £ Per unit £

Selling price 20.00
Less total variable cost:
 Direct materials (1.50)
 Direct labour (3.50)
 Variable overhead (0.90)
(5.90)
Contribution per unit 14.10
(b)
Full absorption cost Per unit £ Per unit £
Selling price 20.00
Less total absorption cost:
 Direct materials (1.50)
 Direct labour (3.50)
 Variable overhead (0.90)
 Fixed cost per unit* (2.50)
(8.40)
Profit per unit 11.60

*Budgeted overheads = £25,000

Budgeted production = 10,000 units

OAR = £25,000 / 10,000 units = £2.5 per unit

 S ec t io n 6 Page | 19

(c)
Marginal cost production profit and loss £ £
Sales (8,000 units × £20.00) 160,000
Less cost of sales:
 Opening inventory (2,000 units × £5.90) 11,800
 Variable cost of production 59,000
(10,000 units × £5.90)
 Less closing inventory (4,000* units × £5.90) 23,600
Cost of sales (47,200)
Total contribution 112,800
Fixed costs (25,000)
Profit 87,800
* Opening inventory is 2,000 units. We plan to make another 10,000 units
which will mean we have 2,000 + 10,000 = 12,000 units available to sell but
only plan to sell 8,000 units. That will leave 12,000 – 8,000 = 4,000 units of
closing inventory.

Opening inventory + Production – Sales = Closing inventory

(d)
Absorption profit and loss £ £
Sales (8,000 units × £20.00) 160,000
Less cost of sales:
 Opening inventory (2,000 units × £8.40) 16,800
 Variable cost of production (10,000 units × £5.90) 59,000
 Fixed costs of production 25,000
 Less closing inventory (4,000 × £8.40) 33,600
(67,200)
Profit 92,800
(e) In the full absorption costing system, profit is £5,000 more. This is the result of
absorbing fixed production overheads into inventory.

Activity 2
The answers are directly below the case studies in your Osborne Tutorial.

Activity 3
The answer is directly below the case studies in your Osborne Tutorial.
 S ec t io n 6 Page | 20

Activity 4
(a) Using a marginal costing system may give rise to a lower reported profit figure
if there are closing inventories at the end of a period. This is due to the different
treatment of fixed costs. Marginal costing values inventories on marginal or
variable costs alone, i.e. direct materials, direct labour and direct expenses.
Absorption costing values inventories by taking into account the marginal cost
plus a share of the fixed overheads. Therefore, if inventory levels are rising a
proportion of the fixed overhead is carried to the following reporting period.

Closing inventory will have a lower value using marginal costing, resulting in
higher cost of sales and lower profits. Reporting a lower profit figure in this way
could therefore result in less tax on profits being calculated.

(b) The Finance Director should consider what the accounting standards say. It is
a requirement of IAS 2 Inventories that closing inventories are valued using
the absorption costing system for financial statements. Using the marginal
costing system for financial reporting would therefore be breaching this
standard.

(c) The fundamental ethical principles that could be compromised include

integrity. This is because manipulating the profit figure in this way is being
dishonest about the true performance of the business.

Another ethical principle that could be compromised is objectivity. This is

because by manipulating the profit figure the business may gain financially
from the reduced tax bill which could provide greater job and financial stability
for the Director and the Accountant - there may even be undue influence on
them to make this decision.

Professional behaviour may also be compromised as if their actions were to

be discovered, it would reflect badly on the accountancy profession as a whole,
bringing it into disrepute.

Activity 5
The answers are directly below the case studies in your Osborne Tutorial.
 Section 7
Aspects of budgeting

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover the use and production of budgets to help with financial
planning.

When you have finished studying this section you will be able to:

– Describe how budgets are used

– Explain how the costs and revenues used in the budget are generated

– Distinguish between fixed and flexible budgets

– Flex a budget for a change in activity level

– Calculate the variances for a production department

– Identify the possible causes of variances

– Explain the meaning of a rolling budget

 S ec t io n 7 Page | 2

WHAT IS A BUDGET?
A budget is simply a financial plan that is prepared in advance. A budget can be
used for:

 Decision making – such as setting prices, or selecting appropriate materials

or labour for production

 Planning – such as working out what resources we will need for example, how
much material to buy, how many workers to employ, whether we will need to
borrow more money from the bank

 Control – by comparing what actually happens with our original budget we can
spot problems as soon as they arise

In this section we are focused on the budgets that are produced for production, but
in practice a business will produce multiple budgets – one for each area of the
business.

We looked at how we put together budgeted costs per unit in the previous sections.
But where do the costs we use come from?

In practice, senior management will work out what costs it expects the business to
incur and what prices it can charge – based on the business’s normal behaviour and
activities – that is, what it would usually achieve if it was reasonably efficient. These
are known as attainable standards and we therefore describe the budgeted figures
created using them as standard costs and standard selling prices.

When setting the standard costs and revenues it is important to consult with the
managers who actually know what can reasonably be achieved – after all it is these
managers who will be held responsible if they don’t achieve the budget – and we
want them to believe it is realistic and so be motivated to achieve it. The process
of including managers in the budget setting process is known as participatory
budget setting and the process of holding them accountable if the budget is not
achieved is known as responsibility accounting.

These types of standards are used for raw material costs, material usage per unit,
labour rates, output per hour, and overhead absorption rates per hour, and together
they provide management with a powerful tool for monitoring performance. By
comparing the amounts that were actually spent with these standards management
can identify and investigate any problems. The process of comparing standard and
actual results is known as variance analysis and we return to this technique shortly.

First let’s look at the different types of budgets management may draw up:
 S ec t io n 7 Page | 3

Fixed Budgets
Once these budgets are set, they remain unchanged regardless of actual activity
(actual sales volumes or actual production levels). This type of budget setting is
normal in situations where business activity is expected to remain relatively
unchanged throughout the year.

For example, a college administration department might use fixed budgets basing
them on last year’s performance plus a little extra to build in target growth and
adjusting for any other planned activities which may differ from the previous year.

Flexed Budgets
A flexible budget is one that can be adjusted to reflect changes in levels of activity
or output.

This is really important when management comes to compare the budget with the
actual results. Imagine your boss asked you organise an event for 20 people and
gave you a budget of £100 (£5 per head) for food. However, due to a late change
suggested by your boss, the final event ends up being for 40 people. You manage
to negotiate a discount with the caterer and spend £160 on food. How would you
feel if your boss then complained that you’d gone £60 over budget? You would
probably immediately point out that for 40 people you’d expect to spend £200 and
in fact you’d done really well! What you have done instinctively here is flexed the
budget to reflect the number of people you actually had to feed.

Flexed budgets work on the same principle as marginal costing:

Variable costs and revenues (which move in relation to output) are separated out
from the fixed costs which do not vary.

Then when the actual activity level is known the variable costs and revenues can be
‘flexed’ to show the budgeted costs and revenues that would be expected at that
activity level.

Exam tip
In Section 1 we discussed the concept of stepped fixed costs – costs which are
fixed over a certain range of output but increase if output exceeds that amount. If
a business does have some stepped fixed costs, then these will need to be
separated out too so that we can put the right level of fixed cost in once we know
the activity level.
Please read the questions in an assessment carefully to make sure you spot any
stepped fixed costs!
 S ec t io n 7 Page | 4

Activity 1
A company had put together its budget for the period based on an output of 20,000
units. However at the end of the period it had actually produced 22,500.

Use the information provided to produce a flexed budget for the period. We have
done the first line for you.
Flexed Budget
Budget Flexed Actual
Number of units 20,000 22,500 22,500

Manufacturing £ Workings £ £
requirements
Direct Raw Material A1 30,000 £30,000/ 34,250
20,000 × 22,500
Direct Raw Material B2 35,000 33,380
Direct Raw Material C3 40,000 39,260
Direct Labour 180,000 205,000
Direct Expenses 15,000 16,110
Prime Cost 328,000

Variable Overheads 45,000 51,350

Marginal Cost 379,350

Fixed Overheads 60,000 63,750

Full Absorption Cost 443,100

IDENTIFYING THE AMOUNT OF FIXED AND VARIABLE COSTS

In Section 1 we introduced the High Low method which can be used to separate
out fixed costs if they are not given to you separately in a question. The method
was:

To find the variable cost:

(Step 1) Calculate the difference in total costs and the difference in total output

(Step 2) Divide the difference in cost by the difference in output to find the variable
cost per unit
 S ec t io n 7 Page | 5

To find the fixed cost:

(Step 3) Find the total variable cost for the highest number of units

(Step 4) Find the fixed costs by deducting total variable cost from the total costs
for the highest number of units

Let’s practice using the High Low method now:

Activity 2
A business has collected the following cost information from its production
processes over the past few months:
Total costs £ Output (Units)
Highest cost 382,000 29,000
Lowest cost 278,000 16,000
What are the variable cost per unit and the fixed cost of production?

Step 1

Total costs £ Output (Units)

Highest cost 382,000 29,000
Lowest 278,000 16,000
Difference

Step 2

Step 3

Step 4
 S ec t io n 7 Page | 6

Activity 3
You should now attempt the case study: Flexible budget for revenue and costs,
including semi-variable costs in Chapter 7 of your Osborne Tutorial now. We have
provided you with space for your workings and a table for you to complete the
budget.

Tip: to answer this question, you will need to use the budget information provided
for 800 units in the table below, as well as reading the information given in the
situation at the beginning of the case.
Batches produced and sold 800 1,000 1,500
£ £ £
Sales revenue 24,000

Variable costs
 Direct materials 4,400
 Direct labour 6,800
 Overheads 4,800

Semi-variable costs 4,100

 Variable element
 Fixed element

Total cost 20,100

Total profit 3,900

Profit per batch (to 2 decimal places) 4.88

 S ec t io n 7 Page | 7

Workings
Sales revenue per batch

Direct material per batch

Direct labour per batch

Variable overheads per batch

Semi-variable costs

Total costs £ Output (Units)

Highest cost
Lowest cost
Difference

BUDGETED CONTRIBUTION
If a business is using a marginal costing approach, then it will calculate a budgeted
contribution as well as a budgeted profit. You should remember from the last section
that contribution is sales less variable costs.
 S ec t io n 7 Page | 8

Activity 4
Have a go now at the case study: Murray Manufacturing: Budgeted Contribution in
Chapter 7 of your Osborne Tutorial which requires you to produce a budgeted
contribution. We have provided you with a table for your answer.
Workings MM6
Selling price per unit
Less: variable costs per unit:
 Direct materials
 Direct labour
Contribution per unit

Sales volume in units

Total contribution
Less: fixed overheads
Budgeted profit

BUDGETS AND VARIANCES

A variance is the difference between the budgeted / standard amount in the budget
and the actual cost or revenue recorded for the period.

Variances may be adverse (A) or favourable (F)

Adverse If a variance is adverse, it’s not good!
It means that either:
 the cost is more than expected, or
 the income is less than expected
Favourable If a variance is favourable it is good. It means that either:
 the cost is less than expected, or
 the income is greater than expected
At the end of each period, management should calculate, report and analyse
variances. Take a look now at the diagram under the heading Monitoring of Budget
Reports in Chapter 7 of your Osborne Tutorial. It is slightly further through the
chapter but it is helpful to understand the overall process before we look at it in more
detail.
 S ec t io n 7 Page | 9

Activity 5
In Activity 1 you flexed the budget for a company based on its actual activity level.
Can you now work out the variances that management will need to review?
Flexed Budget
Flexed Actual Variance A/F

Number of units 22,500 22,500

Manufacturing requirements £ £ £

Direct Raw Material A1 33,750 34,250

Direct Raw Material B2 39,375 33,380
Direct Raw Material C3 45,000 39,260
Direct Labour 202,500 205,000
Direct Expenses 16,875 16,110

Prime Cost 337,500 328,000

Variable Overheads 50,625 51,350

Marginal Cost 388,125 379,350

Fixed Overheads 60,000 63,750

Full Absorption Cost 448,125 443,100

Companies who operate under a standard costing system will generate their internal
Trading Profit or Loss Accounts using budgeted figures. They will then use journal
entries to convert the budgeted figures to actual figures for use in their final
statements.

Adverse variances will be debited to the profit and loss resulting in a reduction of
profit.

Favourable variances will be credited to the profit and loss resulting in an increase
in profit.
 S ec t io n 7 Page | 10

Management by exception
Not all variances need to be investigated. The benefits of the investigation must be
worth the time and costs involved.

Management will want to investigate those variances that are significant – that is big
enough to warrant their attention. A business may therefore set a limit on the size
of the variance or the percentage change on budget and only investigate those that
exceed this limit. This is known as setting the limit for materiality. For example a
company may decide that an adverse/favourable variance of up to 5% is acceptable
given the inherent problems involved in forecasting volumes and costs accurately
but that anything above 5% should be investigated.

Here’s a simple example:

 The standard cost (expected cost) of material per kg is £5.00

 During the budget period the company purchases 5,000 kg

 The actual cost of the material was £26,500

 Management investigate all variances over £2,000 or where they are 5% over
budget.

What’s the variance?

The expected cost was 5,000 × £5.00 = £25,000

The actual cost was £26,500

So the variance is £1,500 adverse

The reason the variance is adverse is because the material actually cost £1,500
more than expected (budgeted).

Management must now decide whether to investigate the reasons why it occurred
as part of their process of cost control. The increase was under £2,000, but £1,500
/ £25,000 = 6% over budget so they will investigate.

Note that it is worth investigating both adverse and favourable variances. Adverse
variances may identify problems, but favourable variances can indicate where we
are doing things well and we can learn how to replicate the behaviour elsewhere.
 S ec t io n 7 Page | 11

Reporting cycle
To be of use budget reports must be

 Accurate – so that management can trust the figures

 In a useful format – so that management can quickly and easily find the
relevant information

 Timely – they must be sent soon after the period being reviewed so that there
is time to take action as needed. This will vary from business to business but
may be weekly, fortnightly or monthly.

 Relevant – the variance report must be sent to those managers who can
influence the outcome. For example purchasing managers need to know when
we have spent more than planned, sales managers need to know if we have
not managed to sell our goods for the budgeted price.

Revision of budgets
The standard costs and revenues used to create the budgets will need to be
regularly reviewed. A report comparing standards with actual performance is of little
use if the standards are out of date. Changes may be needed as a result of:

 Inflation

 Alterations to the product specification – such as different materials being used

 Changes in the way the product is made – such as replacing direct labour with
automated machinery

 Competitor actions affecting potential selling prices

Controllable and non-controllable costs and revenues

When reporting on variances it is important to ask whether the manager or
supervisor was able to control the cost or revenue in the first place. For example,
you should remember from Section 4 that we allocated factory rent costs to
production departments. But if the factory owner increases the rent in negotiation
with senior management, the production manager can’t then be held responsible for
the resulting adverse fixed production overhead variance. On the other hand if the
production manager improves the productivity of the workforce by improving working
methods which result in a positive labour cost variance, then clearly they are
responsible for that.
 S ec t io n 7 Page | 12

So when we are considering variances we distinguish between:

 Controllable costs – which can be influenced by the manager or supervisor

in the short term

 Non-controllable or Uncontrollable costs – which cannot be influenced by

the manager or supervisor in the short term

CAUSES OF VARIANCES
Variances may be the result of changes in day-to-day operational matters, or arise
because of one-off events such as fire in the factory.

Activity 6
In activity 5 the Raw Material B2 recorded a favourable variance of £5,995. Can you
suggest reasons why this might have happened?

Activity 7
Can you now suggest reasons why the direct labour cost might have been £2,500
more than expected?

A long list of potential causes of variances can be found under the heading Causes
of Variances in Chapter 7 of your Osborne Tutorial book. Take a look at the list now.
Note in particular the inter-relationship between variances – how buying cheaper
materials may cause more wastage, or how using more skilled staff may mean fewer
production hours are needed.
 S ec t io n 7 Page | 13

Note that if the comparison between budgeted costs and actual costs is to be
meaningful, it is necessary to ensure that the recording of actual expenditure mirrors
the way the budget was originally setup i.e. revenues and costs are coded to the
appropriate revenue and cost accounts, and cost centres. If it does not, then you
may spend time chasing and trying to explain a variance that doesn’t actually exist
(these are known as pseudo-variances).

Once variances have been investigated and the reasons for them identified, the
information should be presented to management so that action can be taken to
prevent a re-occurrence (provided of course that the variances are controllable).
The type of action taken will depend upon whether the variance is short-term or a
long-term variance.

An example of a short-term variance is a normal fluctuation in the materials price

which will tend to even out over time. Typically for every adverse variance there is
a favourable one to off-set it.

However long-term variances may require action to be taken, for example:

 investing in new production equipment to prevent material wastage or to

improve output

 sourcing alternative materials suppliers to secure better prices

 redesigning products to reduce the number of expensive components used

The investigation could even prompt a complete review of how the budget was
originally constructed and on what basis.

Activity 8
You should now attempt the case study Exbury Ltd: Variances in flexible budgets in
Chapter 7 of your Osborne Tutorial. We have provided a pro forma answer table for
you to complete below.
Original Flexed Actual Variance
budget budget
Units sold 10,000 12,000 12,000
£000 £000 £000 £000
Sales revenue 250 290
Less costs:
Direct materials 80 90
Direct labour 110 140
Fixed overheads 30 35
Operating profit 30 25
 S ec t io n 7 Page | 14

ROLLING BUDGETS
A rolling budget (also known as a continuous budget or a moving average total
budget) is extended one period at a time so that it always covers the same time
frame.
For example, a budget covering the next 12 months, has been drawn up from
January to December. At the end of January, this month will ‘drop off’ and the budget
for the following January will be added to the end of budget instead. So the whole
budget now covers the period February to January.
The advantage of this approach is that:

 The budget for the latest period can be adjusted to take account of recent
developments

 Seasonal variations will be reflected in the appropriate budget period so that

managers can see trends as they emerge

 Management are always looking ahead over the same time frame

 Management can focus on the short-term as well as the long-term results

However rolling budgets do require additional time and effort to constantly update
them and managers may end up more focused on the next period’s budget than
they are on this period’s performance.

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

Spreadsheets are an essential budgeting tool. A well-constructed spreadsheet will
allow management to flex budgets with minimal effort – variable and semi-variable
costs will be recalculated to match whatever activity level is assumed. And different
assumptions about costs or resource requirements can be simply revised.
This also offers management an additional benefit – they can quickly create multiple
budgets based on differing assumptions so they can better understand the
implications of their decisions. This is known as sensitivity analysis – comparing
a budget with one set of assumptions (‘if we sell 10,000 units’ for example) with
another with different assumptions (‘what if we sell 12,000 units?’).
A spreadsheet also makes quick work of calculating variances for a budget report
and using conditional formatting (for example, highlighting significant variances) can
make it clearer for management to read.
You should now attempt the Case Study at the end of Chapter 7 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
take you through the process of developing budgets and performing sensitivity
analysis on the results.
Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 7 Page | 15

Osborne Books Activities

You should now practice what you have learnt in this section using the activities at
the end of Chapter 7. You can also complete the chapter activities for Chapter 7 of
the Osborne Books Workbook.
 S ec t io n 7 Page | 16

What you have learnt in this section

 Budgets are based on standard costs and revenues – that is, what can
reasonably be expected if the business is normally efficient

 Budgets are used to plan, make decisions, and control the business

 Fixed budgets are drawn up for a set period of time and then not altered

 Flexible budgets are restated based on the actual activity level of the business

 Variances are the differences between the budgeted amount and the actual
amount recorded. They may be favourable (F) or adverse (A)

 Significant variances should be investigated and action should be taken where

they can be controlled

 Variances can arise for a variety of different reasons. Sometimes there may
be a relationship between two variances – such as where poor quality
materials lead to cheaper prices but more material waste during production

 Rolling budgets are kept up to date by adding in an additional period to the end
once the most recent period has ended
 S ec t io n 7 Page | 17

Answers to home study activities

Activity 1
Flexed Budget
Budget Flexed Actual
Number of units 20,000 22,500 22,500

Manufacturing £ Workings £ £
requirements
Direct Raw Material A1 30,000 £30,000/20,000 × 22,500 33,750 34,250
Direct Raw Material B2 35,000 £35,000/20,000 × 22,500 39,375 33,380
Direct Raw Material C3 40,000 £40,000/20,000 × 22,500 45,000 39,260
Direct Labour 180,000 £180,000/20,000 × 22,500 202,500 205,000
Direct Expenses 15,000 £15,000/20,000 × 22,500 16,875 16,110
Prime Cost 337,500 328,000

Variable Overheads 45,000 £45,000/20,000 × 22,500 50,625 51,350

Marginal Cost 388,125 379,350

Fixed Overheads 60,000 DO NOT CHANGE 60,000 63,750

Full Absorption Cost 448,125 443,100

Activity 2
Step 1
Total costs £ Output (Units)
Highest cost 382,000 29,000
Lowest 278,000 16,000
Difference 104,000 13,000
Step 2

£104,000 / 13,000 = £8 per unit

Step 3

Total variable cost for 29,000 units = 29,000 × £8 = £232,000

Step 4

Total fixed cost = total cost less total variable cost = £382,000 – £232,000 =
£150,000
 S ec t io n 7 Page | 18

Activity 3
The answer is directly below the case study in your Osborne Tutorial.

Activity 4
The answer is directly below the case study in your Osborne Tutorial.

Activity 5
Flexed Budget
Flexed Actual Variance A/F

Number of units 22,500 22,500

Manufacturing requirements £ £ £

Direct Raw Material A1 33,750 34,250 –500 A

Direct Raw Material B2 39,375 33,380 5,995 F
Direct Raw Material C3 45,000 39,260 5,740 F
Direct Labour 202,500 205,000 –2,500 A
Direct Expenses 16,875 16,110 765 F

Prime Cost 337,500 328,000 9,500 F

Variable Overheads 50,625 51,350 –725 A

Marginal Cost 388,125 379,350 8,775 F

Fixed Overheads 60,000 63,750 –3,750 A

Full Absorption Cost 448,125 443,100 5,025 F

 S ec t io n 7 Page | 19

Activity 6
Possible reasons include:

 The budgeted (standard) cost per unit of £1.75 (£35,000/20,000 units) had
been set incorrectly in the first place

 The standard cost was set some time ago and hasn’t been reviewed or
updated

 The business has changed to a different material supplier

 The existing supplier may now be offering bulk discounts on larger orders

 The business may have decided to use a cheaper grade of material

 The materials may be purchased from another country and there has been a
fluctuation in the exchange rate

Activity 7
Possible reasons include:

 Additional overtime was required to achieve the increase in output

 Agency staff were used to cover sickness and cost more than the regular
workers

 A higher skilled workforce was used to reduce the number of rejected items

 There has been a change in the minimum wage imposed by Government

Activity 8
The answer is directly below the case study in your Osborne Tutorial.
 Section 8
Short-term decisions

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover the use of cost accounting information to make short-term
decisions.

When you have finished studying this section you will be able to:

– Explain what is meant by a short-term decision

– Calculate the break-even point for a business in units and revenue

– Calculate the margin of safety for a product and explain its meaning

– Calculate the profit volume ratio for a product and explain its meaning

– Prepare schedules to compare the impact on profit of different short-term

decisions

– Calculate the price to charge for a special ‘one-off’ order when a business has
spare capacity
 S ec t io n 8 Page | 2

SHORT-TERM DECISIONS
Short-term decisions are those which will affect the business over the coming weeks
and months – usually we say that the furthest ahead we are looking when making a
short-term decision is one year.

In this section, we will be using the principles of marginal costing that we have
covered in previous sections and will be distinguishing between:

Relevant costs or revenues: those costs or revenues that will change as a result
of a decision

Non-relevant / Irrelevant costs or revenues: those costs or revenues that won’t

change regardless of what decision we make

Let’s look at a simple example:

We are trying to decide whether to increase our output by 1,000 units. This will
impact our direct labour and materials costs and our variable production overheads,
but will not have any impact on the rent of the factory (unless of course it means we
need to rent a second factory to do so). As there will be potential increases in
materials, labour and variable costs they will be relevant to our decision. But the
factory rental cost is not relevant unless it is a stepped fixed cost and would actually
increase as a result of the decision.

Reporting decisions
When the information gathered about potential decisions is reported to management
it is vital that it is clear, concise and accurate. You should now read the sections on
reporting decisions, written reports and verbal presentations in Chapter 8 of your
Osborne Tutorial now. They will remind you of the importance of producing useful
reports for management.

BREAK-EVEN
Break-even analysis is used to determine the activity level at which revenues (or
savings) equal costs. That is, the point at which neither a profit nor a loss is made.

You may well use the term break-even when making your own short-term decisions,
for example – if I buy a car to save the bus fare to work, how many journeys would
I need to make before I break-even? – that is, before the cost of the car equals the
savings in bus fares.

Break-even analysis is also referred to as Cost Volume Profit (CVP) analysis as it

looks at the relationship between costs, volume and profit. It is an important area of
management accounting and decision making and is centred around the calculation
of contribution which we introduced in Section 6 when we were talking about
marginal costing.
 S ec t io n 8 Page | 3

Exam Tip

We are about to introduce a lot of formulae. However to be a proficient accountant,

it’s essential you understand what you are calculating, rather than simply
memorising lists of formulae. It will help you to develop strong problem-solving
skills and will stand you in excellent stead if the question is not worded exactly the
way you expected.

Contribution is the revenue that’s left after deducting variable costs. It contributes
to paying fixed costs and any further contribution left after fixed costs have been
covered will be profit. It is calculated as:

Contribution per unit = Selling price per unit – variable costs per unit

Break-even point is the number of units that must be sold to cover all costs:

Break-even point = Fixed costs / Contribution per unit

Activity 1
So, to illustrate how simple the calculation is let’s look at an example using small
numbers.

You should be able to work this out without using the formula, using basic problem-
solving skills.

 The selling price of your new product is £5.10

 The variable costs of each product are £2.60

Once you have paid the variable costs, you will have £2.50 left per product to
contribute towards other costs, that is, the contribution is £2.50 per unit.

(a) Your overheads are £10. How many products do you need to sell to cover your
overheads before you start making a profit?

(b) Let’s now use larger figures. How many units need to be sold to cover fixed
costs in the following example?

 Selling price per unit = £12.00

 Variable costs per unit = £7.00

 Fixed overheads = £120,000

 S ec t io n 8 Page | 4

This formula is not the only way in which break-even can be worked out. Another
way of finding the break-even point is to plot the information on a graph.

The lines for fixed costs, total costs and sales revenue are plotted on the chart. The
break-even point can be read off the graph at the point where the sales revenue is
equal to the total costs:

Activity 2
Turn now to the case study: Fluffy Toys Ltd: Break-even and read through the
solution, which shows you a graph constructed for a specific set of figures. For now
just focus on following the explanation. You will have the chance to practice
constructing these graphs in your spreadsheet case study at the end of the section.

BREAK-EVEN: MARGIN OF SAFETY

Margin of safety is the amount by which actual sales exceeds the break-even point.
It can be expressed as:

 A number of units

 A sales revenue amount

 A percentage using the formula

(Actual sales units – breakeven sales units) / Actual sales units × 100

This is a reasonably straight forward percentage calculation. We are comparing the

proportion of sales above the break-even point to actual sales.
 S ec t io n 8 Page | 5

Activity 3
Let’s calculate the margin of safety for the data in Activity 1b:

 Selling price per unit = £12.00

 Variable costs per unit = £7.00

 Fixed overheads = £120,000

 Breakeven point = 24,000

And assuming actual sales were 35,000 units.

What does the answer mean?

It means that sales can fall by 31% (rounded) before reaching the break-even point.
This is relatively high. It would be a higher risk if the margin of safety was 10% for
example.

Margin of safety is an important measure when trading conditions are poor as it tells
management how much they need to worry about falling sales figures.

BREAK-EVEN: TARGET PROFIT

You can also use the break-even calculation to work out how many units you would
need to sell to not just cover costs but also achieve a target profit.

Units to earn a target profit = Fixed costs plus target profit / contribution per unit
 S ec t io n 8 Page | 6

Activity 4
Continuing with the data in Activity 1b)

 Selling price per unit = £12.00

 Variable costs per unit = £7.00

 Fixed overheads = £120,000

Calculate the break-even point in units to cover costs and a target profit of £50,000.

A break-even point can also be expressed in terms of revenue.

Activity 5
What is the break- even point for the previous example expressed in terms of
revenue?

However the break-even point in revenue can also be calculated another way and
for that we need to learn another ratio – the profit-volume (PV) ratio also known
as the contribution-sales (CS) ratio.

BREAK-EVEN: PROFIT-VOLUME RATIO

The PV or CS ratio expresses the amount of contribution earned from a unit relative
to its sales price. For example if a product has a CS ratio of 30% this means that
30% of the product’s sales price is contribution. To put it another way, the first 70%
of the selling price is used to pay back the variable costs, and the 30% that is left
will contribute towards covering fixed costs and earning a profit.

CS ratio = Contribution per unit / Sales price per unit

Using the CS ratio gives us another way to calculate the break-even point in
revenue:

Break-even point in revenue = Fixed costs / CS ratio

 S ec t io n 8 Page | 7

Activity 6
(a) Enter the figures for the contribution to sales (CS) ratio using the data from
earlier in the task

(b) Calculate the break-even point in revenue for this example using the CS ratio.

WHEN TO USE BREAK-EVEN ANALYSIS

Break-even analysis can be useful in a number of ways:

 when starting a new business or introducing new product lines – to work out
how many units we need to sell to cover our costs

 when making changes – for example to the cost structure of new products, to
see how it would affect our profitability

 to answer what-if questions (e.g. what if sales revenues fall by 10%)

‘SPECIAL ORDER’ PRICING

If a business has spare capacity, it might be willing to take on additional work at a

lower than usual price. However, management is unlikely to be willing to make a
loss on the work, so it will need to know what price will guarantee that it at least
breaks even. Then it can set any price above that amount and know that its costs
will be covered.

Let’s consider a really simple example:

 S ec t io n 8 Page | 8

A business, which uses a full absorption costing system has the capacity to produce
1,000 units per month. It has worked out the standard cost for the product as:
£
Direct materials 7
Direct labour 4
Variable overhead 3
Total direct costs 14
Fixed overhead 6
Total cost 20
Profit = cost x 50% 10
Selling price 30
However it is currently only selling 700 units per month. A new customer asks if they
can order 200 units next month.

How much should the company charge to make sure it at least breaks even on the
order?

Hint: It’s not simply 200 × £30!

This is because although the company is using full absorption costing, for decision
making we need to use marginal costing. If it makes another 200 units, the relevant
costs (those that will change) are the variable costs – the fixed costs will remain the
same.

The increase in costs from the order will be 200 × £14 = £2,800

So provided the company charges at least £2,800 for the order it will break even on
it. If it can charge anything more then it will make a profit.

This gives management some really useful information. Its usual price for 200 units
would be £6,000 but it only needs £2,800 to break-even. So it can now start
negotiating with the new customer – offering them a good deal to encourage them
to start trading with the company, but ensuring that they don’t lose money at the
same time.
 S ec t io n 8 Page | 9

Activity 7
You should now attempt the case study Wyvern Bike Company: Special Orders in
Chapter 8 of your Osborne Tutorial. Use the table provided below to work out the
impact of each of the two offers they are considering and how each compares to
their current situation:
Weekly statement of profit or loss
Existing Existing Existing
production of production plus production plus
100 units 50 units @ 100 units @ £80
£ £120 £
£
Sales revenue per week
 Bikes @ £200
 Bikes @ £120
 Bikes @ £80

Less production costs:

 Direct materials
 Direct labour
 Production
overheads
Profit

COST AND REVENUE PLANNING

The same principles can be used to assess the potential impact of different business
decisions on the overall profitability of the business, decisions such as:

 What would happen if we increased selling prices to increase profits, given that
it might mean we sold fewer units?

 What if we instead reduced selling prices to increase profits by selling more

units and earning more revenue?

Where we are testing out proposed changes it is important to take a methodical

approach, and it is also important that management can quickly understand what
we have done. The columnar approach we used in the last activity is therefore really
helpful here too.
 S ec t io n 8 Page | 10

Activity 8
You should now attempt the case study: Brookes and Company: Cost and Revenue
Planning in Chapter 8 of your Osborne Tutorial. You will notice that the actual
requirement is to prepare a report for management stating your advice on whether
to undertake either of two proposals, with reasons and workings. This means you
will need to use your judgement about what information would be useful to
management.

You can use the skills you have learnt in this section by calculating the break-even
point and margin of safety for each of the options being considered and comparing
them with the current position, and we have added space into the table below for
you to add in your answers. We have provided additional boxes for your workings
and your report to management.
Brookes and Company
Cost and revenue planning
Existing Proposal 1 Proposal
output 120,000 280,000
100,000 units units units
£ £ £
Sales revenue per week
 100,000 units
 120,000 units
 80,000 units
Total revenue
Less all costs:
 Direct materials
 Direct labour
 Variable production overheads
 Fixed production overhead
 Fixed non-production
overhead
Total costs
Profit

Other information
Break-even in units
Margin of safety
 S ec t io n 8 Page | 11

Workings
Budgeted fixed overheads:
 Fixed production overheads =
 Fixed non-production overheads =
Break-even (fixed costs / contribution per unit)
 Now =
 Proposal 1 =
 Proposal 2 =
Margin of safety (current output – break even output) / current output × 100
 Now =
 Proposal 1 =
 Proposal 2 =

Report on pricing proposals

To: Managing Director
From: Accounts assistant
Date: Today
Introduction

Report

Conclusion
 S ec t io n 8 Page | 12

MARGINAL COSTING IN DECISION MAKING

Some final thoughts to bear in mind about marginal costing:

 In the long run all the fixed costs must be covered. Marginal costing is great
for making short-term decisions but management must also ensure that over
the longer-term prices do cover all costs.

 Marginal costing is often used to price one-off contracts to attract new

business. But care should be taken that other customers don’t find out and try
to negotiate their own prices down to the same level.

 If we quote a low starting price based on marginal costing principles to attract

a customer, we need to bear in mind that we will need to put the price up over
the longer term to remain profitable and we need to be sure they will accept
the price rise.

 If new products are sold at just enough to cover marginal cost it may help to
build brand awareness and increase sales. But if the impact is that customers
stop buying the older goods which have been priced to cover the fixed costs
then the business will end up losing money.

 The ‘just above marginal cost’ approach is also often used to clear stocks of
older products, or to sell unused hotel rooms or flights at the last minute.

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

As we have seen in this section, examining the impact of different potential decisions
using marginal costing principles has involved creating several columns of different
information – one for each decision. You undoubtedly wished you had a
spreadsheet to speed up your workings as you were completing the examples – and
they are excellent tools for this job. Not only do they allow managers to see the
different impact of each proposal, but they also allow for the construction of break-
even graphs to provide a visual illustration of the outcomes.

You should now attempt the Case Study at the end of Chapter 8 of your Osborne
Tutorial: Spreadsheet skills to provide management accounting information. It will
take you through the process of analysing a series of proposals using the skills you
have learnt in this section and show you how to construct a break-even chart.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 8 Page | 13

Osborne Books Activities

You should now practice what you have learnt in this section using the activities at
the end of Chapter 8. You can also complete the chapter activities for Chapter 8 of
the Osborne Books Workbook.
 S ec t io n 8 Page | 14

What you have learnt in this section

 Short term decisions are those that will impact costs and revenues over the
coming weeks or months – up to a period of one year.

 Break even analysis considers the point at which total costs = total revenue. It
is calculated as fixed cost / contribution per unit. This can be adapted to find
the number of units to sell to make a target profit:

Units to earn a target profit = Fixed costs plus target profit / contribution per
unit

 The relationship between sales revenues, fixed costs and variable costs can
be found using break-even analysis, tabular comparisons or a graph.

 The margin of safety is the amount by which actual sales exceeds the break-
even point. It is calculated as (Actual sales units – breakeven sales units) /
Actual sales units × 100.

 The profit volume (PV) or contribution sales (CS) ratio tells us what percentage
of the sales price contributes to fixed costs and profits. It is calculated as
contribution per unit / sales price per unit.

 This ratio can be used to find the break-even point in revenue:

Fixed costs / CS ratio

 Special order pricing is used where a business has spare capacity. You need
to find the increase in marginal costs related to the one-off order. Any price
above that amount will increase profits.

 In the long run all costs must be covered if the business is to remain profitable.
Marginal costing is a useful decision making tool but fixed overheads cannot
be ignored in the long-term.
 S ec t io n 8 Page | 15

Answers to home study activities

Activity 1
(a) Since you will need £10 to cover overheads and each item contributes £2.50
towards them, you will need to sell £10 / £2.50 = 4 units to break-even.

(b) The logic is exactly the same:

Contribution is £12 – £7 = £5 per unit

Fixed overheads are £120,000

So we will cover our fixed overheads (break-even) at £120,000 / £5 = 24,000

units

You can double-check your calculations: 24,000 × £5 = £120,000

Activity 2
There is no solution to this activity. You are simply required to read through the case
study and its solution.

Activity 3
(35,000 – 24,000) / 35,000 × 100 = 31% (rounded)

Activity 4
Target profit in units = Fixed costs plus target profit / contribution per unit =

(£120,000 + £50,000) / £5 = 34,000 units

Activity 5
If we break-even when we have sold 24,000 units, this is equivalent to revenue of
24,000 × £12 = £288,000.
 S ec t io n 8 Page | 16

Activity 6
(a) Contribution / Sales = £5 / £12 = 0.42 (rounded)

The answer is telling us that 42% of the sales price of the product is
contribution (that is the first 58% of the selling price is used to pay back the
variable costs, what’s left (42%) will contribute towards covering fixed costs
and earning a profit.

(b) Break-even point in revenue using the CS ratio is

Fixed costs / CS ratio

£120,000 / 0.42 = £285,714

You may now be concerned that this is a different answer from the one we
calculated in Activity 5 – however the difference is due to the fact that we
rounded up the answer we calculated in part a) before we used it here.

If you want to check this to reassure yourself and you have a mathematical
calculator, do all of the calculation in one go:

£120,000 ÷ (£5 / £12) = £288,000

Activity 7
The answer is directly below the case study in your Osborne Tutorial

Activity 8
The answer is directly below the case study in your Osborne Tutorial
 Section 9
Cash budgeting and resources
ratios

What you are going to cover in this section:

This section of your Study Buddy covers the same topics as the chapter in the
Osborne Books Tutorial, so make sure that you have your book to hand when you
are studying.

This section will cover the purpose and production of cash budgets, the funding of
non-current assets and the management of current assets.

When you have finished studying this section you will be able to:

– Explain the purpose of a cash budget

– Complete a cash budget taking account of the timings of receipts and

payments

– Describe some of the options available for funding the acquisition of non-
current assets

– Explain the use and meaning of resource ratios

– Calculate key resource ratios

– Explain the meaning of the working capital cycle

– Calculate the working capital cycle

– Explain how a business can improve its liquidity position

 S ec t io n 9 Page | 2

PURPOSE OF A CASH BUDGET

Without cash available a business will not survive long enough to make profits. Many
companies fail because they run out of cash rather than because they did not have
a profitable business model. A business must be able to pay suppliers and
employees and pay its bills as they fall due – that is – it must be liquid. We use the
term liquidity when describing how much readily available cash a business has.

A cash budget is a vital tool as it focuses on liquidity. It is a forecast of future receipts

and payments broken down by week or month and may cover the next quarter, the
next six months or even the next year.

By producing a cash budget, the business can ensure it has enough funds available
to meet its obligations and make decisions about how to use any surplus cash (so
that it is put to good use rather than just sitting in a current account).

DIFFERENCES BETWEEN CASH AND PROFIT

‘Cash’ is the amount of money a business has available that it can use immediately
to enable it to continue trading on a daily basis. However this is not the same thing
as profit.

When we prepare financial statements to calculate profit, we record transactions in

the period in which they have happened (applying the accruals concept) rather than
the period in which the money was transferred, and we use the terms income and
expenditure to describe the revenue and costs for the period. So, although profitable
businesses do generate cash, profits do not reflect the change in cash balance of a
business. Profit figures are affected by accounting adjustments such as:

 Accruals and prepayments

 Irrecoverable/doubtful debts and provisions

 Depreciation

 Gains and losses on the sale of assets

All of which increase or decrease profit, but do not result in a cash inflow or outflow
for the business.
 S ec t io n 9 Page | 3

We are interested instead in the actual cash flows and their timings, for example:

 Receipts from receivables

 Payments to payables

 Payments to suppliers of non-current assets

 Payments to employees, and to settle other operating expenses such as

utilities, or rent

 Interest charges on loans or overdrafts

 Payments of dividends or drawings made by the owners

LAYOUT OF A CASH BUDGET

Below is a proforma for a typical cash budget – let’s take a look.

You should notice that:

 It is in three sections:

1 Receipts

2 Payments

3 Summary of the bank account.

Obviously you can put in as many lines into the first two sections as you have
different types of receipts and payments.

 The third section works out how much money will be left in the bank account
at the end of each period. It is this closing balance figure that management
must monitor closely, to ensure that they do not run out of funds or have large
cash surpluses sitting there unused.

 The net cash flow for the period is added to the opening bank balance to
calculate the closing balance for the period. The closing balance at the end of
one period then becomes the opening balance in the next.
 S ec t io n 9 Page | 4

Cash budget for the quarter

Month 1 Month 2 Month 3
£ £ £
Receipts
Capital received x
Sale of non-current assets
Trade receivables income x x
Total receipts X X X

Payments
Purchase of non-current assets x
Payments to trade payables x x x
Operating expenses x x
Drawings x
Total payments X X X

Net cash flow X X X

(Total receipts – total payments)
Opening bank balance x x x
Closing bank balance X X X
(Opening bank balance + Net cash flow)

Benefits of a cash budget

A cash budget helps a business to:

 Plan for future spending

 Reschedule payments to smooth cash flows and ensure funds are available

 Arrange additional funds as needed (for example a bank overdraft or short-

term loan)

 Identify potential cash surpluses and make arrangements to invest them short-
term to earn interest
 S ec t io n 9 Page | 5

FORECASTING CASH RECEIPTS AND PAYMENTS

Activity 1
Let’s have a go a creating a cash budget for a period.

The budgeted Statement of Profit or Loss account for the first four months trading
of a new business is as follows:
£ £
Sales 22,000
Less cost of sales:
Opening inventory 0
Purchases 21,000
Less closing inventory (7,000)
(14,000)
Gross profit 8,000
Less:
Cash expenses 4,000
Depreciation 1,000
(5,000)
Budgeted profit 3,000
The following additional information is also available:

 Sales are to be made on 2 months’ credit terms. All customers are expected
to take full advantage of the credit terms.

 Purchases made in the first month must be paid for immediately. After that,
purchases will be on one month’s credit.

 The budgeted sales and purchases figures are based on the following monthly
figures:
Sales Purchases
£ £
Month 1 4,000 6,000
Month 2 6,000 6,000
Month 3 5,000 4,000
Month 4 7,000 5,000
Total 22,000 21,000
 S ec t io n 9 Page | 6

 Cash expenses are based on paying out £1,000 in each of the first four months
of trading

 Equipment is to be purchased costing £15,000 which will be paid for in the first
month of the business. The depreciation shown in the budgeted Statement of
Profit or Loss account is based on depreciating this equipment at 20% per year
on a straight – line basis.

 £25,000 will be invested in the business in month 1.

 The business has no opening bank balance.

 £2,000 is to be taken out of the business in month 4 as drawings.

Using the template on the next page prepare a cash flow budget for the first four
months of trading. Use the following steps to help you:

Step 1: Enter the capital invested as a receipt in month 1.

Step 2: Enter the receipts from sales – remember that sales are made on 2
months’ credit.

Step 3: Enter the payments for purchases – remember that the first month’s
purchases are paid for in month 1 and from then on purchases are
given one months’ credit.

Step 4: Enter the payment for expenses.

Step 5: Enter the payments for non-current assets and drawings into the
appropriate month.

Step 6: Total the receipts and payments and then calculate each month’s net
cash flow which will be the difference between the receipts in and the
payments out.

Step 7: Enter the opening bank balance in month 1.

Step 8: Using the net cash flow for each month and the opening bank balance
bought forward, calculate the bank balance carried forward for each
month. The closing bank balance (bank balance carried forward) for
one month is then entered as the opening bank balance for the
following month (bank balance bought forward).
 S ec t io n 9 Page | 7

Cash Budget for Months 1 to 4

Month 1 Month 2 Month 3 Month 4
£ £ £ £
Receipts
Investment
Sales
Total receipts

Payments
Purchases
Expenses
Non-current assets
Drawings
Total payments

Cash flow
(Total receipts – total
payments)

Opening balance b/f

Closing balance c/f
Now compare your cash budget to the model answer at the end of the section. Note
that depreciation does not appear in the cash flow – depreciation is an accounting
adjustment and not a cash payment.

Sometimes the timing of cash flows can be a little more complex and we need a
methodical technique to help us work them out.
 S ec t io n 9 Page | 8

Activity 2
A colleague is preparing the cash budget for the first quarter of the year. You work
in credit control and have been asked to provide the information regarding expected
cash receipts.

 Opening trade receivables are expected to settle in the first month £56,000

 50% of sales are cash sales

 Of the remaining sales 60% of customers are expected to pay within the one-
month credit terms and 40% will pay in month two

Use the table to help you structure your answer:

Month 1 Month 2 Month 3
£ £ £
Sales 80,000 85,000 90,000

Cash inflows
Cash sales (50%)
Credit sales
 Payment from opening receivable
 Sales from month 1
(£80,000 × 50% = £40,000)

One month credit (60% × £40,000)

Nil 24,000
Two month’s credit

 Sales from month 2

One month credit
Two-month credit (falls in month 4)
Total cash received

Prompt payment discounts

Sometimes you may be told that customers are offered a prompt payment discount.
This means that your receipts will be lower but the money will be received earlier.
For example:

A company makes sales of £100,000 in January on two month’s credit. Customers

are offered a 2% discount if they pay after just one month. The company expects
50% of the customers to take up the offer. What are the receipts from January’s
sales?
 S ec t io n 9 Page | 9

In February 50% of the customers will pay, taking advantage of the discount:

£100,000 × 50% × 98% = £49,000

The remaining customers will pay in March and will pay the full amount:

£100,000 × 50% = £50,000

You should now read the full worked example ‘payments to trade payables’ in
Chapter 9 of your Osborne Tutorial. Make sure that you follow all the figures.

Activity 3
Now attempt the case study: Cash budget for a new business in Chapter 9 of your
Osborne Tutorial. We have provided you with a pro-forma for your answer below.
Evie Myles
Cash budget for the six months ending 30 June 20-4
Jan Feb Mar Apr May June
£ £ £ £ £ £
Receipts
Capital introduced
Trade receivables
Total receipts for
month

Payments
Non-current assets
Trade payables
Expenses
Drawings
Total payments for
month

Net cash flow

Opening bank
balance (overdraft)
Closing bank balance
(overdraft)
 S ec t io n 9 Page | 10

FUNDING NON-CURRENT ASSETS

We are now going to look at how a business might raise the funds needed to acquire
non-current assets such as vehicles, plant and equipment or computer systems. It
is important that you understand the features of each choice as you could be asked
to recommend the most suitable option for a specific business in your assessment.
Method Features
Cash purchase  Suitable where the business already has the cash
available.
 May pay on delivery or take advantage of seller’s
credit terms
 Legal title (ownership) normally passes on the date of
purchase (even if the purchase is on credit)
Part exchange  An old asset is traded in and used as part payment for
the new one
 The balance is then paid using available cash or by
borrowing the funds
 Common when purchasing vehicles (some vehicle
sellers also act as finance companies and provide the
loan needed to pay the balance but they are typically
more expensive than a traditional bank loan would
have been)
Borrowing (loans)  The business borrows money from a bank or other
finance provider to purchase a non-current asset
 Loans can be for periods of five to ten years – the
business will usually try to match the length of the
borrowing to the life of the asset
 Legal title (ownership) usually passes to the business
on the date of purchase.
 The business will be charged interest on the amount
outstanding on the loan
 The business will need to make regular repayments to
cover the loan and the interest charged
 Loans for the purchase of land and buildings are
typically more complex and are not covered here.
Note: Bank loans are not the same as bank overdrafts which
are temporary rights to overdraw on a current account and
are not suitable for the purchase of non-current assets.
Borrowing (hire  Under hire purchase (HP) a finance company owns
purchase) the asset and allows the business to use it in return for
an upfront deposit and regular instalment payments.
 At the end of the period of the HP agreement,
ownership of the asset passes to the business.
 HP agreements may be used where a business cannot
(or does not wish to) take out any further long-term
borrowing
 S ec t io n 9 Page | 11

USE OF RESOURCE RATIOS

Cash may be the most liquid resource that a business has, but other current assets
such as receivables and inventory can also be turned into cash relatively quickly
(inventory can be sold turning into a receivable, and all being well, receivables will
pay when their credit period is up).

It is therefore useful to assess how well a business is managing all its current assets
by calculating its resource ratios. The figures for the period must then be compared
with:

 Figures from the previous period

 Industry average figures

 Specific competitors whose performance we wish to match

Ratio What it measures Formula Suitable or good
figure
Inventory The number of days Inventory / Cost This depends on the
holding on average that of sales × 365 industry but should be
period (days) inventory is held for. consistent over time. A
Used by businesses jeweller will have a
that buy and sell longer inventory
goods. holding period than a
food retailer.
Trade The number of days Trade Depends on the
receivables on average it takes receivables / business
collection a credit customer to Credit sales × 30 to 60 days is
period (days) pay. 365 common
Key is that it matches
credit terms offered
Trade The number of days Trade payables Depends on the
payables on average it takes / Cost of sales × business
period (days) to pay a supplier for 365 30 to 60 days is
purchases made on common
credit.
Key is that it matches
credit terms offered
Ideally it will be longer
than the receivables
period so cash is
received from sales
before we need to pay
our bills
 S ec t io n 9 Page | 12

Working capital cycle

In practice the individual ratios listed above are linked and we can use them together
to calculate the working capital cycle. This is a measure of the time it takes for a
business to convert its spending on raw materials into cash received from sales. It
is also known as the cash operating cycle, and can be illustrated using the following
diagram:

It is calculated as the period between when cash leaves the business as payments
to suppliers and when cash payments are received from customers. It’s in a
business’s interest to convert inventory to a receivable, then the receivable into
cash, as quickly as possible. It should also hold onto cash by paying payables, or
debts, only when they become due.

The shorter the working capital cycle, the shorter the period of time between paying
for goods received into inventory and receiving the cash for their ultimate sale, and
therefore the business can survive with lower levels of liquid resources.

The formula for the working capital cycle in days is:

Inventory holding period plus Receivables credit period less Payables credit period

Example

A business buys inventory on two months credit. It holds inventory for a period of
four months during which time it is prepared for sale. Inventory is then sold to
customers on one month’s credit.

The working capital cycle for the company is:

Inventory days + Receivable days – Payable days

4 + 1 – 2 = 3 months

We can test this out by trying out some actual dates.

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The company buys the inventory at the end of May. Since it has two months credit
it will pay at the end of July. Meanwhile it holds the inventory for four months to the
end of September, at which point it is sold. The customer has one month’s credit
and pays at the end of October. So the cash cycle is from the end of July (when the
supplier was paid) to the end of October (when the customer paid) – a period of 3
months!

Activity 4
Can you calculate the average cash cycle using the information that follows?

 Inventory is held for an average of 90 days.

 Payables are paid in an average of 30 days.

 Receivables take an average of 45 days to pay

IMPROVING CASH FLOW

The impact of the working capital cycle will vary from business to business – some
small traders may operate largely on a cash basis, buying one day and selling the
next. But larger firms will often buy and sell on extended credit and hold inventory
for several months. They will therefore need to exercise strong management
controls over their current assets.

In the same way as we compared the individual resource ratios with prior periods or
other companies, we need to do the same for the working capital cycle. If it is getting
shorter – the business is showing good resource management – if it is getting longer
– that is not good news and action may need to be taken.

There are two ways to manage problems with liquidity.

1 Improving the individual elements of the working capital cycle:

 Improve debt collection procedures to decrease receivables days.

 Incentivise customers to pay earlier by offering prompt payment

discounts to decrease receivables days. However if this is suggested,
remember that it will also result in less money being received overall.

 Delay payments to suppliers (increase payable days). The risk here is

that if payments are delayed too long, suppliers may worry and stop
supplying more goods. The business may also get a reputation for being
in financial difficulties which can discourage customers from purchasing
from the firm, and even encourage employees to leave.
 S ec t io n 9 Page | 14

 Reduce inventory levels through better stock management or by working

harder to increase sales (reducing the inventory holding period). There is
a risk though in reducing inventory levels too low as it might mean that
customer orders cannot be met.

2 Raise more funds:

 Sell non-current assets – assuming they are not needed by the business

 Raise debt finance via loans or overdrafts

 Ask owners to inject more finance

Activity 5
You should now attempt the case study: Managing Working Capital in Chapter 9 of
your Osborne Tutorial. Notice that you are not just required to do the calculations
but are also asked to make brief notes on your findings for the accountant.

We have provided you with a table for your workings and space for your notes.
Last year (days) This year (days)
Resource ratio
Workings Answer Workings Answer
Inventory holding
period

Trade receivables
collection period

Trade payables
payment period

Working capital
cycle
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Notes

SPREADSHEET SKILLS FOR MANAGEMENT ACCOUNTING

The creation of cash flow forecasts is ideally suited to the use of a spreadsheet. By
carefully linking the assumptions being made to the calculation of the figures, the
business can quickly identify the impact of changing policies such as credit terms,
or offering a prompt payment discount.

Spreadsheets can also be used to calculate the resource ratios needed to monitor
performance and highlight areas for management attention.

You should now attempt the Case Study at the end of Chapter 9 of your Osborne
Tutorial: Spreadsheet skills to produce a cash flow. It will work through a cash flow
forecast for a small business.

Don’t forget to consult the Spreadsheet Skills for Management Accounting tutorial if
you get stuck along the way.
 S ec t io n 9 Page | 16

Osborne Books Activities

You should now practice what you have learnt in this section using the activities at
the end of Chapter 9. You can also complete the chapter activities for Chapter 9 of
the Osborne Books Workbook.
 S ec t io n 9 Page | 17

What you have learnt in this section

 A cash budget forecasts cash flows for the forthcoming period

 It focuses on the business’s liquidity and helps management to plan spending

and cash management

 It is important to take account of the actual timing of payments to payables and

receipts from receivables

 Non-current assets can be acquired using a range of options including cash

purchase, part exchange, loans and hire purchase

 Resource ratios can be used to measure how well management is controlling

current assets. There are three main ratios:

– Inventory holding period (days)

– Trade receivables collection period (days)

– Trade payables period (days)

 The working capital cycle is a measure of the time it takes for a business to
convert its spending on raw materials into cash received from sales. It is
calculated as:

Inventory holding period plus Receivables credit period less Payables credit
period

 A business can improve liquidity by improving the individual ratios or by raising

additional finance
 S ec t io n 9 Page | 18

Answers to home study activities

Activity 1
Cash Budget for Months 1 to 4
Month 1 Month 2 Month 3 Month 4
£ £ £ £
Receipts
Investment 25,000
Sales – – 4,000 6,000
Total receipts 25,000 – 4,000 6,000

Payments
Purchases 6,000 – 6,000 4,000
Expenses 1,000 1,000 1,000 1,000
Non-current assets 15,000 – – –
Drawings – – – 2,000
Total payments 22,000 1,000 7,000 7,000

Cash flow 3,000 (1,000) (3,000) (1,000)

(Total receipts – total
payments)

Opening balance b/f 0 3,000 2,000 (1,000)

Closing balance c/f 3,000 2,000 (1,000) (2,000)
 S ec t io n 9 Page | 19

Activity 2
Month 1 Month 2 Month 3
£ £ £
Sales 80,000 85,000 90,000

Cash inflows
Cash sales (50%) 40,000 42,500 45,000
Credit sales
 Payment from opening receivable 56,000
 Sales from month 1
(£80,000 × 50% = £40,000)

One month credit (60% × £40,000)

Nil 24,000
Two month’s credit (40% × £40,000)
16,000
 Sales from month 2
(£85,000 × 50% = £42,500)

One month credit (60% × £42,500)

25,500
Two-month credit (falls in month 4)
Total cash received 96,000 66,500 86,500

Activity 3
The answer is directly below the case study in your Osborne Tutorial.

Activity 4
90 + 45 – 30 = 105 days

Activity 5
The answer is directly below the case study in your Osborne Tutorial.