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BASIC ACCOUNTING
FOR NON-ACCOUNTANTS

Melanie Cloete • Ferina Marimuthu

Fourth edition

Van Schaik
PUBLISHERS

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 Published by Van Schaik Publishers
A division of Media24 Books
1059 Francis Baard Street, Hatfield, Pretoria
All rights reserved
Copyright © 2022 Van Schaik Publishers

No part of this publication may be reproduced, stored in a retrieval system, or transmitted

in any form or by any means – electronic, mechanical, photocopying, recording or
otherwise – without the written permission from the publisher, except in accordance with
the provisions of the Copyright Act 98 of 1978.

Please contact DALRO for information regarding copyright clearance for this publication. Any unauthorised copying
could lead to civil liability and/or criminal sanctions.

Tel: 086 12 DALRO (from within South Africa) or +27 (0)11 712 8000
Fax: +27 (0)11 403 9094
Postal address: PO Box 31627, Braamfontein, 2017, South Africa
http://www.dalro.co.za

First edition 2008

Second edition 2015
Third edition 2018
Third revised edition 2019
Fourth edition 2022

ISBN: 978 0 627 03890 7

eISBN: 978 0 627 03891 4

Commissioning editor Claire Thornton

Production manager Shelley Swanepoel
Editorial coordinator Nangamso Phakathi
Copy editor Deidre du Preez
Proofreaders Erika Janse van Rensburg and Alexa Barnby
Cover design by Gisela van Garderen
Cover image iStock Images
Typeset in 9.5 on 13 pt Caecilia by Pace-Setting & Graphics, Pretoria
Printed and bound by Creda Communications

Every effort has been made to obtain copyright permission for material used in this book.
Please contact the publisher with any queries in this regard.

Please note that reference to one gender includes reference to the other.

Website addresses and links were correct at time of publication.

This book has been reviewed by independent peer reviewers.

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 About the authors

Melanie Cloete is a lecturer in the Management Accounting Department at the Durban

University of Technology whose experience in academia spans almost three decades. Her
qualifications include a Higher Diploma in Education (Economic Science), Bachelor’s Degree
in Technology: Cost and Management Accounting, and a Master of Accounting degree. She is
currently a PhD candidate at the University of KwaZulu-Natal. Her lecturing experience
includes Financial Accounting, Cost Accounting and Management Accounting at undergraduate
and postgraduate levels. She is driven by her passion for teaching and uses innovative teaching
methods to empower students with the critical thinking skills required by the fourth industrial
revolution. Her publications include articles on critical thinking and assessments in DHET
accredited journals and the co-authorship of a book titled Cost and Management Accounting:
Operations and Management- A Southern African approach (Juta).

Ferina Marimuthu is a senior lecturer and the head of department in Financial Accounting at
the Durban University of Technology. Ferina is an accomplished and seasoned professional with
over two decades of extensive experience in higher education at both undergraduate and
postgraduate levels. She holds a PhD in Finance, obtained from the University of KwaZulu-
Natal. Ferina is a distinguished scholar who has received merit awards in both her undergraduate
and postgraduate qualifications. She is the general editor and author of several accounting
textbooks and has also reviewed for both local and international publishing houses. In addition,
Ferina has to her credit several publications comprising of DHET accredited journal articles,
conference proceedings and book chapters. This has been the impetus for her active involvement
in research in the fields of accounting and finance. Ferina’s esteemed authoring expertise in the
accounting discipline combined with her academic experience blends theory and practice in her
writing. She is progressive-minded and always keeps abreast of new developments in higher
education and the accounting field. Identifying innovative approaches and improved solutions to
challenges both motivates and drives her. Similarly, her goal is to remain on the cutting edge of
advancements in the higher education landscape by introducing fresh perspectives and new
techniques.

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 Preface

This book is a result of the combined efforts of the authors, who have consolidated several
modules in accounting. It began to take shape during the merger of the ML Sultan and the Natal
technikons in 2003.

The book sought to close a gap identified in the market: a lack of texts that dealt with the basics
of financial accounting, management accounting and financial management. As a result,
numerous changes distinguish this edition from the earlier editions. The chapter contents have
been updated in accordance with the relevant accounting standards and accounting environment,
and additional end-of-chapter exercises have been provided to ensure that students have
sufficient practice to reinforce accounting concepts. The contents of the fourth edition have been
updated to include the latest developments in accounting and comply with International
Financial Reporting Standards (IFRS). This book is intended primarily for non-accounting
specialists and is ideal for

students doing introductory accounting courses at tertiary institutions

short courses, including company in-house training programmes
practitioners/professionals
individuals who wish to teach themselves.

The chapters include comprehensive, illustrative examples that are easy to understand, with test-
yourself questions and solutions. Each chapter concludes with a variety of tutorial exercises,
including multiple-choice and discussion questions, to test the student’s knowledge and
comprehension. A solutions manual and a test bank are available from the publisher for
instructors who prescribe the text.

The accounting discipline is constantly changing and is both stimulating and far-reaching. We
hope that this fourth edition with its comprehensive and up-to-date coverage will contribute to a
better understanding of the discipline. We look forward to the same overwhelming response to
this edition from our readers as to the previous editions.

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 Acknowledgements

We wish to thank Claire Thornton and the entire Van Schaik team who have worked tirelessly to
ensure the success of this edition. We would also like to thank all the academics and
practitioners at the various institutions who have prescribed the book. Their valuable feedback
on the third edition is appreciated. We dedicate this book to our loving husbands and children
for their unwavering support and patience over the years.

We trust that this book will be enjoyed and used by various academics and practitioners alike.
We welcome constructive advice and criticism. Please feel free to send us useful suggestions on
how we can improve the book.

With best wishes for a stimulating and positive learning experience.

Melanie Cloete and

Ferina Marimuthu
June 2021

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 Table of contents

CHAPTER 1 Introduction to accounting

1.1 What is accounting?
1.1.1 Definition of accounting
1.1.2 Nature of accounting
1.2 Users of accounting information
1.3 How useful is accounting information?
1.4 The basic business forms found in South Africa
1.4.1 Sole trader
1.4.2 Partnership
1.4.3 Close corporation (CC)
1.4.4 Company
1.5 Types of business activity
1.5.1 Service businesses
1.5.2 Manufacturers
1.5.3 Wholesalers
1.5.4 Retailers
1.6 Considerations before commencing a business
1.7 The accounting field

CHAPTER 2 Financial accounting concepts and terminology

2.1 How wealthy are you?
2.2 Accounting classifications
2.2.1 Assets
2.2.2 Liabilities
2.2.3 Equity

CHAPTER 3 The accounting equation

3.1 The basic accounting equation (BAE)
3.2 The effect of transactions on the basic accounting equation (BAE)
3.2.1 Transactions that affect assets and equities only
3.2.2 Transactions that give rise to income and expenditure
3.2.3 Transactions involving payments by debtors

CHAPTER 4 Accounting cycle: journals, ledgers and trial balance

4.1 Conceptual framework

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 4.2 The accounting cycle
4.2.1 Transactions
4.2.2 Source documents
4.2.3 Journals
4.2.4 Ledger accounts
4.2.5 Pre-adjustment trial balance
4.2.6 Adjustments
4.2.7 Post-adjustment trial balance
4.2.8 Closing entries
4.2.9 Final trial balance
4.2.10 Financial statements
4.2.11 Analysis and interpretation
4.3 Retailers
4.3.1 Perpetual method of accounting for stock
4.3.2 Periodic method of accounting for stock

CHAPTER 5 Basic financial statements with year-end adjustments

5.1 Year-end adjustments
5.1.1 Depreciation
5.1.2 Allowance for credit losses
5.1.3 Prepaid expenses
5.1.4 Accrued expenses
5.1.5 Accrued income
5.1.6 Income received in advance
5.2 Closing process

CHAPTER 6 Company financial statements and their analysis and interpretation

6.1 Introduction
6.2 Company terminology
6.2.1 Share capital
6.2.2 Share premium
6.2.3 Types of shares
6.2.4 Reserves
6.2.5 Profits, taxation, reserves and dividends
6.3 Company financial statements (statement of comprehensive income and statement of
financial position)
6.4 Introduction to analysis and interpretation
6.4.1 The need for comparison
6.4.2 Methods for analysing financial statements
6.5 Calculation of ratios
6.5.1 Liquidity ratios
6.5.2 Efficiency ratios

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 6.5.3 Profitability ratios
6.5.4 Solvency ratios

CHAPTER 7 Bank reconciliation

7.1 Control over cash
7.1.1 The business’s records
7.1.2 The bank’s records
7.2 Reconciliation process
7.2.1 Steps for bank reconciliation

CHAPTER 8 Value-added tax (VAT)

8.1 Introduction
8.2 Who should be registered as a vendor?
8.3 Rates and exemptions
8.4 The VAT system
8.4.1 Input tax
8.4.2 Output tax
8.4.3 VAT payable/refundable
8.4.4 Calculating VAT
8.5 Mark-ups on cost price and selling price
8.5.1 Percentage mark-up on cost price
8.5.2 Percentage mark-up on selling price

CHAPTER 9 Cost classification and terminology

9.1 The cost concept
9.2 Cost classification in relation to the product or period
9.2.1 Manufacturing costs (product costs)
9.2.2 Non-manufacturing costs (period costs)
9.3 Cost classification in relation to volume of production (cost behaviour)
9.3.1 Fixed costs
9.3.2 Variable costs
9.3.3 Semivariable, semifixed or mixed costs
9.4 Separating a mixed cost
9.5 Cost classification for control or evaluation
9.5.1 Controllable and non-controllable costs
9.6 Cost classification for decision making
9.6.1 Relevant costs
9.6.2 Irrelevant costs

CHAPTER 10 Materials
10.1 Classification of materials
10.1.1 Direct material

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 10.1.2 Indirect material
10.1.3 Work in progress
10.1.4 Finished goods
10.1.5 Inventory
10.2 Accounting entries
10.3 Stock control
10.3.1 Carrying costs (holding costs)
10.3.2 Ordering costs
10.3.3 Stock-out costs
10.3.4 Lead time
10.3.5 Economic order quantity (EOQ)
10.3.6 Reorder level (ROL)
10.3.7 Minimum stock level (MinSL)
10.3.8 Maximum stock level (MaxSL)
10.3.9 Average stock level (AveSL)
10.4 Stock valuation methods
10.4.1 The perpetual and periodic inventory control systems
10.4.2 First-in-first-out (FIFO) method
10.4.3 Weighted average method

CHAPTER 11 Labour
11.1 Classification of labour
11.1.1 Direct labour
11.1.2 Indirect labour
11.2 Remuneration methods
11.2.1 Salaries
11.2.2 Hourly wages
11.2.3 Piecework pay
11.3 Calculating the remuneration
11.3.1 Basic wage
11.3.2 Gross wage
11.3.3 Net wage
11.3.4 Normal deductions
11.4 Accounting entries
11.5 Incentive schemes
11.6 Labour recovery rate
11.6.1 Productive hours
11.6.2 Annual labour cost
11.7 Payroll accounting
11.7.1 Salaries journal
11.7.2 Wages journal

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 CHAPTER 12 Overheads and job costing
12.1 What are overheads?
12.2 Job costing (absorption costing)
12.2.1 Why do we need to know about overheads?
12.2.2 Steps involved in job costing and accounting entries

CHAPTER 13 Cost-volume-profit (CVP) analysis

13.1 Introduction
13.1.1 Fixed costs
13.1.2 Variable costs
13.1.3 Marginal costing layout
13.2 Assumptions of CVP analysis
13.3 CVP according to the contribution margin approach
13.3.1 Calculation of breakeven point
13.3.2 Calculation of margin of safety
13.3.3 Sales required to achieve expected (target) profit or return
13.4 Using CVP analysis in decision making
13.4.1 Change in the selling price
13.4.2 Change in the variable cost
13.4.3 Change in the fixed cost
13.5 Summary of formulae needed for CVP analysis
13.5.1 Breakeven point in units
13.5.2 Breakeven point in rands
13.5.3 Sales necessary to make a desired profit
13.5.4 Margin of safety

CHAPTER 14 Short-term decision making

14.1 Introduction
14.1.1 Manufacturing cost per unit according to marginal and absorption costing
14.1.2 Income statements according to marginal and absorption costing
14.2 Decisions using marginal costing
14.2.1 Special order decisions
14.2.2 Dropping a product or department
14.2.3 Choice of products where a limiting factor exists
14.2.4 Make versus buy

CHAPTER 15 Budgetary control

15.1 Introduction
15.2 Operational budgets
15.2.1 Sales budget
15.2.2 Production budget
15.2.3 Direct materials usage budget

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 15.2.4 Direct materials purchases budget
15.2.5 Direct labour budget
15.2.6 Manufacturing overheads budget
15.2.7 Sales and administration expenditure budget
15.2.8 Inventory budget
15.3 Flexible budgets
15.4 Cash budgets

CHAPTER 16 Standard costing and variance analysis

16.1 Introduction
16.2 A standard costing system
16.2.1 Standard cost card
16.2.2 Advantages of standard costing
16.2.3 Disadvantages of standard costing
16.3 Variance analysis
16.4 Sales variances
16.4.1 Sales price variance
16.4.2 Sales quantity variance
16.5 Production cost variances
16.5.1 Direct materials variances
16.5.2 Direct labour variances
16.5.3 Variable manufacturing overheads variances
16.5.4 Fixed manufacturing overheads variances

CHAPTER 17 Time value of money

17.1 Introduction
17.2 Cash flow and other time value of money concepts
17.3 Interest
17.3.1 Simple interest
17.3.2 Compound interest
17.3.3 Nominal rate
17.3.4 Effective rate
17.4 Formulae used in calculating the time value of money
17.4.1 Present value of a single cash flow
17.4.2 Present value of an ordinary annuity
17.4.3 Present value of an annuity due
17.4.4 Present value of a perpetuity
17.4.5 Future value of a single cash flow
17.4.6 Future value of an ordinary annuity
17.4.7 Future value of an annuity due
17.4.8 Repayment of loan/annual instalment
17.4.9 Loan amortisation

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 CHAPTER 18 Capital budgeting
18.1 Introduction
18.2 Capital budgeting process
18.3 Categories of capital budgeting projects
18.4 Why do organisations use investment appraisal?
18.5 Relevant and irrelevant cash flows in investment appraisal
18.6 Capital budgeting techniques
18.6.1 Payback method
18.6.2 Accounting rate of return
18.6.3 Net present value
18.6.4 Profitability index
18.6.5 Internal rate of return

Index

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 1 Introduction to accounting

Outcomes

At the end of this chapter students should be able to

define the purpose of accounting

identify the main users of accounting information
explain the difference between financial accounting and cost and management accounting.

Chapter outline

1.1 What is accounting?

1.1.1 Definition of accounting
1.1.2 Nature of accounting
1.2 Users of accounting information
1.3 How useful is accounting information?
1.4 The basic business forms found in South Africa
1.4.1 Sole trader
1.4.2 Partnership
1.4.3 Close corporation (CC)
1.4.4 Company
1.5 Types of business activity
1.5.1 Service businesses
1.5.2 Manufacturers
1.5.3 Wholesalers
1.5.4 Retailers
1.6 Considerations before commencing a business
1.7 The accounting field

1.1 What is accounting?

1.1.1 Definition of accounting

Accounting is a system of

gathering – the bringing together of all financial information that has an effect on a specific
business

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 analysing – determining how the financial information will affect the business
recording – inputting the financial information through proper accounting processes
reporting – summarising all financial information for a given period of time so that it can be
read and understood in a more condensed format
interpreting – preparing an analysis of the summarised reports to allow users to make
informed decisions about the business.

1.1.2 Nature of accounting

Accounting is a rapidly changing field, reacting in response to the changes that occur in the
external environment. Accounting is a means of communication used to convey a message about
the finances of a business. The main purpose of accounting is to provide its users with both
financial and non-financial information that will assist them in making informed decisions. It is
essential that the users of this information should understand it, otherwise it is of no value.

1.2 Users of accounting information

The users of accounting information can be divided into two groups, namely internal users
(users within the organisation) and external users (users outside the organisation). The users
listed below use accounting information for different reasons.

Internal users:

Owners – use accounting information to determine whether their business is profitable and
financially viable over a long period of time.
Managers – use accounting information to ensure that the business operates efficiently and to
solve problem areas highlighted in the accounting information.
Employees and their representatives – use accounting information to determine whether their
employer is able to provide stable employment and remuneration.

External users:

Customers – use accounting information to determine whether the business can provide them
with the products that they require for a long period of time.
Competitors – use accounting information to maintain a competitive edge.
Lenders – use accounting information to determine whether the business would be able to
repay a loan and the interest on it.
Government – uses accounting information to determine whether the business should be
registered and, if so, how much tax should be paid.
Suppliers – use accounting information to determine whether the business is able to make
payments for goods purchased on credit.
Investment analysts – use accounting information to determine whether the business would be
a good investment, and to assess the risk and return on an investment in the business.

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 This list of potential users is not exhaustive, but these are the most important.

1.3 How useful is accounting information?

Financial information should be useful to its users. The qualitative characteristics that influence
the usefulness of accounting information can be grouped into fundamental and enhancing
qualitative characteristics. The fundamental characteristics include:

Relevance – the information reported must be relevant to the needs of the users. This may
involve reporting information that could influence the economic decisions of the users.
Faithful representation – the information reported must represent what actually happened. The
characteristics of faithful representation include: neutrality (be free from error), free from bias
and completeness (full disclosure of all necessary information). Hence, the information
should be a faithful representation of the reality of the transaction.

The qualitative characteristics that enhance the usefulness of financial information include

Comparability – the information must be comparable to the financial information presented

by other organisations and also various accounting periods within the organisation, so that
users can identify trends in the performance and financial position of the organisation.
Understandability – the information must be readily understandable by all users of financial
statements.
Timeliness – the information must be published within a reasonable time after the financial
year has ended. The more time that has lapsed, the less relevant the information to the users.
Verifiability – the extent to which information is reproducible given the same data and
assumptions. In other words, it assures users that the information presented represents
faithfully what it purports to represent. Information is verifiable if it can be audited.

It is important to bear in mind that the benefit derived from providing accounting information
should outweigh the costs.

1.4 The basic business forms found in South Africa

The basic business forms in South Africa are the sole trader, partnership, close corporation and
company.

1.4.1 Sole trader

The business comprises one owner.

The owner will supply the capital for starting the business.
There are no legal formalities other than a licence to trade.

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 The owner is taxed on business profits in his own hands.
The business is not a distinct legal person, that is, it has no legal personality.

Advantages:

The owner is independent.

The owner is directly involved with customers / clients and can supervise staff closely.
Decisions can be taken quickly and the business can be adapted to take advantage of business
opportunities.

Limitations:

Expansion prospects are hampered by the limited access to capital.

The owner is personally liable or has unlimited liability for the debts of the business, should
the business fail to pay its own debts. Due to the unlimited nature of the liability, creditors can
have access to the owner’s personal assets for the payment of the debts of the organisation.
The owner may not be versatile or skilled enough to do everything for the entity.
There is no continuity of operations, should the owner die or retire.

1.4.2 Partnership

This is a legal relationship that exists between two to 20 people carrying on a business for the
purpose of making a profit.
Each partner’s profits are taxed in his own hands, similar to a sole trader.

Advantages:

New partners bring in additional capital and introduce new ideas.

Partners can specialise in different areas.
Increased capital and division of labour between partners facilitate expansion of the business.

Limitations:

Partners are jointly and severally liable, meaning that if the partnership is unable to pay a
debt, then the partners will have to contribute from their personal assets. In the event that a
partner is unable to contribute his portion, the remaining partners will have to make up the
shortfall.
Ownership by a partner is not easily transferable because a new partnership must be formed
when a partner wants to exit the partnership.
The continued existence of a partnership is limited as a partnership ceases to exist when a
partner wishes to sell or dies.
The funds available for the activities of the business are limited to the combined funding of
the partners. This can limit expansion or growth.

1.4.3 Close corporation (CC)

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 This is a legal entity unique to South Africa and was established in terms of the Close
Corporations Act 69 of 1984.
When the Companies Act 71 of 2008 came into effect in May 2011, the registration of new
CCs was no longer possible.
CCs that were registered prior to the Companies Act of 2008 coming into effect are still
allowed to operate.
A close corporation is formed when the members lodge a founding statement (similar to a
constitution) with the Registrar of Close Corporations.
A CC can have between one and 10 members, who are natural persons.
It is a separate legal entity or juristic person. It can sue or be sued in its own right.
It is taxed in its own hands (figuratively) at the same rates as companies, that is, income is not
taxed in the hands of members.

Advantages:

Members enjoy limited liability. The liability of the members is limited to the amount they
have contributed to the close corporation.
A CC enjoys perpetual succession, i.e. it may continue to operate under its registered name,
even if there are changes in its membership.
Members only become liable when certain rules are breached.
An audit of the books is not required by law. Banks, creditors and the South African Revenue
Service (SARS) may, however, request audited financial statements.
A CC may acquire shares in a company. Note that a company cannot acquire membership in a
CC, as only natural persons can be members.

Limitations:

Restriction of the number of members to 10 limits the capital and possible growth of the
business.
A CC is taxed at the same rate as a company, which is a higher rate than a sole trader or
partnership.
In order for a member to leave the CC or be paid out, all members have to agree to dispose of
a member’s interest.

1.4.4 Company

A company is a legal organisation distinct from its “owners”, who are referred to as
shareholders and can be one or more individuals or organisations.
According to the Companies Act of 2008 that came into operation on 1 May 2011, all
companies fall into one of two broad categories:

1. Profit companies – companies incorporated for the purpose of financial gain for their
shareholders. These include:

– private companies: to be reflected as “Proprietary Limited” or “(Pty) Ltd”

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 – public companies: to be reflected as “Limited” or “Ltd”
– personal liability companies: to be reflected as “Incorporated” or “Inc”.
– state-owned companies: to be reflected as “SOC Ltd”

2. Non-profit companies to be reflected as NPC must be incorporated by three or more

persons and have an objective of furthering some public benefit or relating to cultural or
social activities. Generally, the purpose of these organisations is to help society, and any
income derived is used to fund programmes and cover operational expenses. Considering
these organisations are established to benefit society, they are generally not taxed by the
government. Many of these organisations rely on donations and grants for funding.

For the purpose of this book, we shall focus on profit companies, in particular private and
public.

A private company is an organisation comprising one or more persons. Its name ends with
the words “Proprietary Limited (Pty Ltd)”. It is governed by the Companies Act of 2008 and
is incorporated in terms of the MOI. It is prohibited from offering its shares to the public. This
means that the transferability of its shares is restricted.
A public company is an organisation comprising one or more persons. Its name ends with the
word “Limited (Ltd)”. It is governed by the Companies Act 71 of 2008 and is incorporated in
terms of the Memorandum of Incorporation (MOI). Securities are issued through an initial
public offering (IPO) and are traded on an open market such as the Johannesburg Stock
Exchange (JSE).
The formation and activities of a company are regulated by the Companies Act of 2008,
making a company much more complicated and expensive to form than any other form of
business. The registration of a company must be made at the Companies and Intellectual
Property Commission (CIPC).
A company is a distinct and separate legal entity apart from its shareholders.
Shareholders enjoy limited liability. Unlike a sole trader and a partnership, the shareholders
do not have to pay the company’s debt if it cannot do so itself.
A company is managed by the board of directors, which is headed by the chief executive
officer.

Advantages:

The limited liability of the shareholders ensures that shareholders are not responsible for the
debts of the company (in the case of public companies).
There is improved access to capital which in turn can stimulate growth.
A company enjoys perpetual succession. The unlimited life of the company ensures that
investors can keep their shares as a long-term investment.

Table 1.1 The difference between public and private companies

Private company Public company

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 Private company Public company
Transferability A private company is prohibited A public company is allowed to transfer
of securities from offering its shares to the its securities and offer its securities to
public and the transferability of its the public.
shares is restricted.
Name The name of a private company The name of a public company must end
must end with the expression with the word “Limited” or its
“Proprietary Limited” or its abbreviation “Ltd”.
abbreviation “(Pty) Ltd”.
Directors The board of a private company A public company requires a minimum of
must comprise at least one three directors.
director.
Annual A private company is not A public company is required to hold an
general compelled to hold an annual annual general meeting.
meeting general meeting.
Notice period A private company is required to A public company is required to give 15
for give 10 business days’ notice for business days’ notice for shareholder
shareholder shareholder meetings. meetings.
meetings
Disclosure A private company is now subject A public company is obliged to comply
to fewer disclosure and with the additional transparency and
transparency requirements than accountability requirements of Chapter 3
before (old Companies Act of of the Companies Act of 2008.
1973).
Lodging of A private company is not required A public company is required to lodge its
financial to lodge its annual financial annual financial statements with the
statements statements with the CIPC. CIPC.

Table 1.2 Comparison of the characteristics of each business form

Sole trader Partnership Close corporation Company

What are Owners Partners Members Shareholders
owners
called?
How many 1 owner 2–20 1–10 members 1 or more persons
owners? partners
Legal None Voluntary Founding statement lays MOI represents the
requirements agreement down the legal founding document
between requirements in terms of in terms of the
partners. the CCs Act. Companies Act of
2008.
Type of Unlimited Unlimited Limited liability. A CC is a Limited liability.
liability: if the liability. The liability. separate legal person. Shareholders are
business owner is Partners are not liable for the
goes liable for all jointly and debts unless the
bankrupt, debts in his severally MOI or Companies
who is held personal liable for the Act of 2008 states
responsible? capacity. debts. otherwise.

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 Sole trader Partnership Close corporation Company
Is the Does not Does not According to the “Notice of
business have to be have to be Companies Act of 2008, Incorporation and
required to registered registered no further registration of signed MOI should
register with with an with an CCs. be filed with the
an external external external Notice of
body? body. body. Incorporation at
CPIC.”
Continuity: Entity Partnership Unlimited. The CC Unlimited. The
what ceases to terminated operates separately from duration of a
happens if exist. on death or members, therefore enjoys company is
an owner withdrawal perpetual continuation. perpetual, except if
dies / of one of the limited in terms of its
retires? partners. founding statement.
Transfer of The owner Transfer is Can be transferred to an Private: the Act
ownership can transfer, complicated individual if all members restricts the
sell or close unless agree. transferability of
down at any stipulated in shares. Public:
time. the unlimited and free
partnership transfer of shares.
agreement.
How are Profits are Profits are Taxed as company tax. Subject to double
business taxed in the taxed in the Subject to double taxation taxation on the
profits hands of the hands of the on the taxable income and taxable income and
taxed? owner. partners. Secondary Tax on STC payable on
Companies (STC) payable declared dividends.
on declared dividends.

1.5 Types of business activity

The various types of business activity include service businesses, manufacturers, wholesalers
and retailers.

1.5.1 Service businesses

This business provides a service for which it charges a fee. The fees received for the services
rendered are called fee income. Examples include plumbers, attorneys, accountants, architects,
electricians and computer repair persons.

1.5.2 Manufacturers
These businesses buy raw materials that they then transform into a finished product. The raw
materials are not always raw material in their true sense and may be items that have already
undergone some manufacturing. For example, a furniture manufacturer would use wood, while a
car manufacturer would use car seats, tyres and so on manufactured by someone else. The
manufacturer physically makes or produces the goods and sells them to wholesalers and
retailers.

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 1.5.3 Wholesalers
Wholesalers are often termed the middlemen, because they buy in bulk from the manufacturer
and then supply the goods in a slightly smaller quantity to the retailer. In a few instances,
wholesalers may sell to the public.

1.5.4 Retailers
Retailers buy goods from the wholesalers or manufacturers and then sell these goods at a mark-
up to the general public (consumer). The cost price of the product plus the mark-up gives the
selling price. In a broader context retailers can also be viewed as organisations that provide
services. This is because they

bring goods within reach of the consumer

allow the consumer to buy on credit
pay attention to the needs of their consumers
sell goods in small quantities
make consumers aware of new products on the market
offer convenience shopping.

1.6 Considerations before commencing a business

The following are considered to be some significant issues which must be addressed before a
business enterprise can be launched with any hope of success:

The type of business activity – where the market does not offer a particular product or service,
an individual may identify an opportunity to provide that product or service in such a way that
the potential consumer will benefit and a profitable business with growth potential can be
maintained. Some experience or specialised knowledge is usually required, but a goal-
directed entrepreneur could arrange that this be provided by employees. At this stage the
entrepreneur usually engages in a strategy known as a SWOT analysis in which careful
consideration is given to the strengths and weaknesses of the business as well as to the
opportunities for and threats to the business. This analysis provides information with which
the probable success of the business can be assessed. There is virtually no business
opportunity which does not have a risk of failure. It is this risk which must be assessed and
weighed up against the potential for providing a return on the capital which will be invested.
The entity form – the different entity forms have been discussed in an earlier section. This is a
significant decision because of the impact on continuity and control of the business, as well as
factors such as taxation and regulatory responsibilities.
The location of the business – it is sometimes difficult to choose the geographical location of
a business, particularly in the case of a manufacturing business. Relative transport costs must
be considered when deciding either to locate close to the source of raw materials or close to
the market which will purchase the goods. The availability of suitable premises and the
proximity of appropriate employees for the business will all contribute towards the probable
success.

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 Capital requirements – virtually all types of business require capital in order to purchase the
assets that are required for the business to function. These assets include furniture, equipment,
vehicles and inventory of goods. In addition, the credit facilities customers will be allowed
will determine the amount of capital required to commence business. Furthermore, funds for
daily expenses and the payment of wages and salaries are needed. Once the amount of capital
required has been determined, a plan or budget of future revenue and expenses is drafted.

1.7 The accounting field

Accounting must accumulate financial data for two widely different objectives:

1. External reporting to meet the needs of those who have an interest in the business but who do
not participate in the running of the business.

2. Internal reporting to meet the needs of those who are actively engaged in the management of
the business.

Accounting covers a broad range of activities, but can be aggregated into a data collection
system, the ongoing collection of data into that system, and the reporting of information from
that system. There are several types of accounting which range from financial accounting to the
preparation of tax returns.

The accounting fields include::

Financial accounting is the process of recording financial information and reporting that
information to external users. Financial accounting is governed by accounting standards
issued by the Financial Accounting Standards Board (FASB) and the International
Accounting Standards Board (IASB). The rules for communicating in accounting language
are set out in detail in the International Financial Reporting Standards (IFRS). There are
several career tracks involved in financial accounting. There is a specialty in external
reporting, which usually involves a detailed knowledge of accounting standards. There is also
the controller track, which requires a combined knowledge of financial and management
accounting.
The management accounting field covers the reporting of financial information to internal
users such as the managers of the business. Financial information is provided for specific
purposes, which managers can use in their decision making, and which leads to the attainment
of the objectives of the organisation. One field within management accounting is cost
accounting. A career track in this area can eventually lead to a controller position, or can
diverge into a number of specialty positions, such as a cost accountant, billing clerk, payables
clerk and payroll clerk.
The tax field is concerned with the proper compliance with tax regulations, tax filings and tax
planning to reduce a company’s tax burden in the future. There are multiple tax specialties,
tracking toward the tax manager position.
The auditing field includes internal and external auditing. Internal auditing involves the
examination of systems and transactions to see if they operate as intended (free from
weaknesses, fraud, waste and mismanagement) and the reporting of these findings to

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 management. External auditing involves the examination of accounting records to see if the
auditor can attest to the fairness of the information presented in the financial statements. The
career track progresses from various auditor positions, with specialties available including the
information systems auditor and the environmental auditor.

Table 1.3 The major differences between financial accounting and management
accounting

Basis of Financial accounting Management accounting

comparison
1. Who is External users, i.e. people outside Internal users, i.e. people within the
information the organisation. organisation.
prepared for?

2. What type of General purpose reports, Specific purpose reports, concerning

reports are concerning the company as a a specific department / unit or
prepared? whole. branch.

3. How much Reports provide users with a broad Reports provide managers with
detail is overview of the performance of the considerable detail to assist them in
provided in business for a specific period. making operational decisions.
the reports?

4. Are there Financial reports must be produced Reports are tailored to meet the
specific according to a specified format, as needs of specific managers, i.e. the
formats that laid down by various accounting format of financial reports is not
must be standards. governed by law.
complied
with?
5. How often Reports must be produced at least Reports are produced as the need
must reports once a year. arises, i.e. when required by
be prepared? management.

6. Is the Provides information concerning the Provides information concerning the

information past performance of the business. future performance of the business.
past or future
orientated?

7. What type of Reports contain only information Reports contain financial and non-
information is that can be quantified in monetary financial information, e.g. the
contained in terms. measures of physical quantities of
the reports? stock.

TUTORIAL EXERCISES

Exercise 1
Match the items that appear to be most appropriate:

1.1 Sole trader a. jointly and severally liable

1.2 Partnership b. membership limited to shares
1.3 Private company c. enjoys entire profit of the business
1.4 Public company d. income is not taxable in the hands of members
1.5 Close corporation e. maximum of 50 shareholders

Exercise 2

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 Multiple-choice questions

1. Internal users of accounting information are …

a. owners, customers and competitors.
b. owners, managers and employees.
c. customers, competitors and lenders.
d. owners, competitors and employees.

2. The qualitative characteristics are …

a. comparability, understandability, readiness and relevance.
b. comparability, readiness, relevance, reliability and faithful representation.
c. relevance, faithful representation, understandability, comparability, verifiability and
timeliness.
d. faithful representation, reliability, readiness, relevance and comparability.

3. A person who opens a business alone and who is the sole owner falls under which
business form:
a. Company
b. Close corporation (or CC)
c. Sole trader
d. Partnership

4. A limitation of a close corporation (or CC) is …

a. members are jointly and severally liable.
b. expansion prospects are hampered by the limited access to capital.
c. financial statement must be prepared in terms of the General Accepted Accounting
Practices.
d. the owner cannot transfer, sell or close down at any time.

5. Wholesalers are often termed …

a. the middleman.
b. retailers.
c. manufactures.
d. sole trader.

6. An example of a service business is a …

a. shop that sells clothes.
b. hairdresser who does hair.
c. wholesaler that buys in bulk.
d. labourer.

Exercise 3
Read through the following statements. Answer true or false. If false, give a reason.
3.1 A sole trader has limited liabilities.
3.2 A partnership has a minimum of one partner and a maximum of 50 partners.
3.3 A public company has to have a minimum of seven directors to run the company.
3.4 A private company lacks continuity.

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 3.5 A partnership has unlimited liabilities.

Exercise 4
4.1 Give five examples of service businesses and state how they derive their income.
4.2 Explain the major cost items that a service business will incur.

Exercise 5
Jack and Jill are partners in a partnership. They are considering whether they should continue
with their partnership or rather trade as a company. Name the advantages that should be
taken into account when evaluating the option to change the form of the organisation to a
company.

Exercise 6
The objective of financial statements is to provide information about the financial position and
financial performance of an enterprise that is useful to users in making economic decisions. It
is important for financial information to be comparable, understandable, relevant and reliable.
Describe what each of these characteristics means in the context of financial information.
Give examples of problems which may prevent financial information from fulfilling all of these
characteristics.

Exercise 7
Two sisters are operating similar businesses in neighbouring towns near Mpumalanga.
Senayshia has been operating a hardware business as a sole trader for the past five years
with no prior tertiary qualification. Camishka, who recently completed her MBA in
Stellenbosch, has been running a similar store for the past two years. Camishka has
contacted Senayshia to see if she would be interested in going into a partnership with her.
She believes that there could be several advantages to running the two stores in partnership,
such as trade discounts for a larger business.
The sisters meet over coffee to discuss the business proposal. Camishka suggests that, as
the stores are of similar size and have the same profit level, the profits of the partnership
should be split evenly. Camishka assures Senayshia that there is very little of the
administrative form-filling you get with starting up a company, so start-up will be a breeze.
Senayshia approaches her uncle, a small business adviser, for some advice on the proposal.
She is not quite clear on the legal status of a partnership, and wonders what formalities would
be involved in setting up the partnership.
Advise Senayshia on the pros and cons of setting up a partnership with Camishka.

Exercise 8
Listed below are businesses in Durban, a city in KwaZulu-Natal. You are required to classify
them into the different types of business.

Name of business What it does

Beauty and Balance Provides beauty therapy to clients
Shoprite Sells groceries
Precision Tec CC Manufactures typewriter ribbon
Prime Property Estate agency offering residential and commercial
sales and rental properties
African Caskets Makes caskets and coffins
The Window Boutique Makes a variety of blinds
eThekwini Plumbers Provides a plumbing service
OK Furniture Sells furniture

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 Name of business What it does
Leap Pest Control Provides a pest control service
Cellucity Sells cellphones
Old Town Italy Italian restaurant
PEP Sells clothing, footwear & homeware
Earth Landscapes Landscaping and irrigation

Exercise 9
Lulu is starting her own business, “Jali’s Tyre House”, and she must decide which form of
ownership to choose. She has asked you to assist her with this decision. Lulu has
approached two of her relatives, Phumzile and Thabisile, to join her in the venture so that she
can increase the capital that is available. Lulu is not required to register this business with any
external bodies.

1. Which form of ownership should she choose?

a. Sole trader
b. Partnership
c. Public company
d. Close corporation

2. If they decide to establish a partnership, it means that Lulu will be liable for which of the
following:
a. Her capital contribution
b. The debts incurred by herself
c. The debts incurred by her two relatives with her consent
d. The debts incurred by her two relatives without her consent
e. All of the above

3. If Lulu decides on a particular form of ownership, the name of her business will read
“Jali’s Tyre House (Pty) Ltd”. The form of ownership will therefore be a:
a. Partnership
b. Close corporation
c. Public company
d. Private company

4. When discussing the venture with Phumzile and Thabisile, Lulu changes her mind and
decides she would rather have full control of her business.

Which form of ownership would she then prefer?

a. Sole trader
b. Partnership
c. Company
d. Close corporation

5. If Lulu decides to include Phumzile and Thabisile in her venture, by choosing this
business form they will be referred to as shareholders and will receive a dividend as a
return on their investment. Which business form did they choose?
a. Sole trader

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 b. Partnership
c. Company
d. Close corporation

6. Lulu would like to know that the business could continue to operate even if she dies. In
the event of her death, her ownership would be transferred to her daughter. The other
two members have agreed. Which business form should they choose?
a. Sole trader
b. Partnership
c. Company
d. Close corporation

Exercise 10
Listed below are statements relating to management accounting and financial accounting.
Identify whether the statement relates more closely to the characteristics of financial
accounting or management accounting.
a) Useful for making investment decisions
b) Focuses on the future
c) Internally focused
d) Reports to shareholders and other interested parties
e) Used for planning, control and decision-making purposes
f) Summarises transactions into a set of financial statements
g) Focused on external user groups
h) Prepare reports for managers
i) Used in making costing and pricing decisions
j) Historical perspective, reporting on the past rather than planning for the future

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 2 Financial accounting concepts and
terminology

Outcomes

At the end of this chapter students should be able to classify items as assets, liabilities or
owner’s equity.

Chapter outline
2.1 How wealthy are you?
2.2 Accounting classifications
2.2.1 Assets
2.2.2 Liabilities
2.2.3 Equity

2.1 How wealthy are you?

Some people are considered wealthier than others. Your wealth is determined by what you have,
that is, your possessions less what you owe (your debts). In essence, wealth is what you are
worth, that is, your net worth. It is your financial position at a particular point in time.

Possessions – Debts = Wealth (net worth)

ILLUSTRATIVE EXAMPLE

Draft a statement of financial position for Bheki Zwane, a student at the Durban University of
Technology, who wants to know how much he is worth as at 31 December 20x1.
Bheki had the following possessions and debts as at 31 December 20x1

Cellphone R 2 500
Clothing R 3 000
Apple iPad R 12 000
University fees R 3 700
Loan from his father R 1 500

Solution
Statement of financial position of Bheki Zwane as at 31 December 20x1

Possessions Debts
Cellphone R2 500 University fees R3 700
Clothing R3 000 Loan from father R1 500
Apple iPad R12 000

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 Net worth R12 300
R17 500 R17 500

Bheki Zwane’s net worth as at 31 December 20x1 is R 12 300.

From a personal perspective it is acceptable to use terms such as wealth, possessions and
debts. However, from a business perspective the following terms are used:

Possessions = Assets
Debts = Liabilities
Net worth = Equity

In the business world, the concepts of assets, liabilities and equity are used in order to ensure
that irrespective of the business form, the users are able to understand the financial
statements of the entity. Each of these concepts are further explained under the accounting
classifications below.

2.2 Accounting classifications

The accounting classifications covered in this chapter relate to sole traders. It is important to be
familiar with the following definitions as you will be using them continuously throughout
financial accounting.

2.2.1 Assets
Assets are the resources controlled by an entity resulting from past events, out of which future
economic benefits will flow. There are two categories of assets:

2.2.1.1 Non-current assets

A non-current asset is an item of value with a lifespan of more than one year, for example
buildings and vehicles. This includes property, plant and equipment, intangible assets and
financial assets.

2.2.1.2 Current assets

A current asset is an item of value with a lifespan of less than one year, which is easily
converted to cash, for example cash in the bank and debtors.

2.2.2 Liabilities
Liabilities are present obligations resulting from past events, the settlement of which leads to
decreases in economic benefits. There are two categories of liabilities:

2.2.2.1 Non-current liabilities

These are obligations of the business which are payable over a period of more than one year, for
example a bond from the bank on a property.

2.2.2.2 Current liabilities

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 These are obligations of the business which are payable within one year, for example bank
overdraft and creditors.

Net asset value = Total assets – Total liabilities

2.2.3 Equity
Equity is the remaining interest in a business entity’s assets after deducting all liabilities. The
financial performance of a business entity is measured in terms of profit or loss. The profit for
the period is when the income exceeds expenses and the loss for the period arises when
expenses exceed income. Hence, the financial performance of a business entity indicates the
changes in equity for the period which results from the profit generated or the loss incurred.

Owners’ equity is the interest of the owner in the business, and includes the owner’s capital
contribution, drawings and profit/loss.

Profit/Loss = Income – Expenses

2.2.3.1 Income
Income consists of receipts by a business for its normal operations, for example sales, fees
earned, rent received and interest received. These increase economic benefit within a current
period.

2.2.3.2 Expenses
Expenses are amounts spent by a business during its normal operations (but excluding capital
expenses), for example rent paid, advertising, salaries and insurance. These decrease economic
benefit within a current period. How the aforementioned terms fit together in the accounting
equation will be explored in the next chapter.

TEST YOURSELF 2.1

Classify each of the following items as either a non-current asset (NCA); current asset (CA);
non-current liability (NCL); current liability (CL); owner’s equity (OE); income (I) or expense
(E):

NCA CA NCL CL OE I E
a) Capital
b) Delivery vehicle
c) Weekly wages
d) Sales
e) Trading stock
f) Mortgage loan
g) Telephone account
h) Debtors (trade receivables)
i) Computer
j) Interest received
k) Creditors (trade payables)

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 NCA CA NCL CL OE I E
l) Interest paid
m) Property
n) Discount allowed
o) Discount received
p) Depreciation
q) Stationery used
r) Stationery unused (stationery on
hand)
s) Bank overdraft
t) Drawings
u) Photocopy machine
v) Shop fittings

TUTORIAL EXERCISES Accounting classification

Exercise 1
Yatish Naidoo is a final year university student who has a passion for cycling. He has started
competing in cycling tournaments and has spent a substantial amount of money on entrance
fees and cycling gear. He has requested that his statement of financial position to be drawn
up in order to determine his net worth.
The list below indicates all his belonging and debts as at 31 March 20x2

Racing bicycle R2 800

Cycling kit R 600
Clothing R2 520
Fitbit watch R3 000
Bank R 550
Cellphone R2 000
Loan from father R2 500
Loan from mother R1 850

Exercise 2
Nerisha Moodley loves modern dance. She has asked you to determine her financial position
in order to decide if she can afford modern dance classes.
Information for the month of December 20x1

1st She owned a cellphone worth R2 800, jewellery R1 860, clothing R4 000, sports equipment R840 and R250 in a
bank account, she owed her father R100 and her older sister R70.
2nd Nerisha received her allowance of R200.
3rd Nerisha went to the mall and spent R20 on taxi fare. At the mall she bought a peanut and chia smoothie for R35.
Her mother gave her spending money which she used to buy a dress for R250 and a pair of shoes for R300.
10th She paid her sister R70 she had borrowed the previous month.
12th It was a friend’s birthday so Nerisha bought her make up costing R50.
15th Her brother borrowed R40 from her.
20th The family had a burglary and Nerisha’s cellphone was stolen. The phone was not insured.
22nd Nerisha paid her father half the amount owed to him.

Required

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 2.1 Record Nerisha’s financial position for the month of December 20x1 using the following
columns.

Date Cellphone Jewellery Clothes Sports Bank Loan to Net Loan from Loan from
equipment brother worth father sister

2.2 Draw up the statement of financial position for Nerisha as at the 31 December 20x1.

Exercise 3
Match the term in column one with the most appropriate explanation in column 2.

Term Explanation
3.1 Debtors Costs of depreciation on assets
control
3.2 Equipment Costs incurred for insurance
3.3 Depreciation Discount given to debtors
3.4 Accumulated Costs incurred from water and electricity
depreciation
3.5 Bank Costs incurred from advertising
3.6 Capital Discount received from creditors
3.7 Drawings Amount owed to the bank (this happens if there is a negative bank
balance)
3.8 Loan Amount owed to creditors
3.9 Creditors Balance of a loan owed
control
3.10 Bank Total amount of assets (taken out of the business) by the owner
overdraft
3.11 Discount Total amount owned/contributed by the owner(s)
received
3.12 Advertising Balance of the cash available in the bank account
3.13 Insurance Amount owed to the business by debtors\customers
3.14 Water and Total depreciation recorded for each different type of noncurrent asset
electricity – there is a separate accumulated depreciation account for each non-
current asset
3.15 Discount Cost price of the equipment owned
allowed

Exercise 4
Below are lists of statements. Indicate whether each of these statements is true or false. If the
statement is false, then rephrase the statement in order to make it true.
4.1 Financial position and net worth are one and the same thing.
4.2 The main purpose of accounting is to provide information on the business entity’s
financial position and financial results.
4.3 A business is regarded as a separate entity from its owners.
4.4 A business will make a profit when its income is less than its expenditure.
4.5 The net profit is the owner’s return for the capital that he or she has invested in the
business.
4.6 Expenses are incurred in order to generate income.

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 4.7 Net asset value represents the portion by which the total liabilities exceed the total
assets.
4.8 Assets and liabilities are the elements that are used to measure the financial position of
an entity.
4.9 Income and expenditure are the elements that are used to measure the financial results
of an entity, i.e. profitability.

Exercise 5
5.1 Discuss the concept of financial position.
5.2 Discuss the concept of net profit.
5.3 Describe the characteristic of assets, equity and liabilities.
5.4 When applying for a loan to start your own business, what accounting information will the
bank require?
5.5 What are the two main sources of financing?

Exercise 6
Gail is a qualified hairdresser who has set up a hairdressing salon at her home. She is not
certain about the accounting classifications. You are required to assist her in correctly
classifying the following items. You must view all transactions from the salon’s point of view.
Classify each of the following items as either an asset (A); liability (L); income (I) or expense
(E).
6.1 Money borrowed from her husband to set up the salon
6.2 Receipts from customers
6.3 Stock of shampoo, conditioners, colour rinses and treatments
6.4 Water and electricity used in the salon
6.5 Wages of her assistant
6.6 Amounts owed to the suppliers of stock
6.7 Hairdryers, flat irons and other equipment bought for the salon
6.8 Amount owed to Gail by customers
6.9 Call charges for the telephone used in the salon
6.10 Amount paid for tea, coffee, sugar and milk for the clients

Exercise 7
The following balances were extracted from the records of CJ Traders on 31 July 20x2:

Vehicles 402 000

Accounts receivable 90 000
Accounts payable 66 000
Petty cash 5 000
Bank overdraft 35 000
Investment in shares 80 000
Loan 160 000
Shop fittings 190 000
Cash float 12 000
Mortgage bond 360 000

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 Required
Determine the totals for:
7.1 Current assets
7.2 Non-current assets
7.3 Current liabilities
7.4 Non-current liabilities
Calculate the equity of CJ Traders as at 31 July 20x2

Exercise 8
For each of the independent scenarios determine the correct value for A, B and C.

Scenario 1 Scenario 2 Scenario 3

R R R
Building 480 000 Bank overdraft 30 000 Equity C?
Loan 60 000 Cash float B? Equipment 120 000
Vehicle 220 000 Saving account 16 000 Mortgage bond 26 000
Equipment 100 000 Equipment 64 000 Bank overdraft 14 000
Mortgage bond A? Short-term loan 20 000 Petty cash 2 000
Petty cash 6 000 Equity 34 000 Cash Float 24 000
Bank account 84 000 Savings account 68 000
Equity 620 000 Property & plant 240 000

TEST YOURSELF SOLUTION

TEST YOURSELF 2.1 SOLUTION

NCA CA NCL CL OE I E
a) Capital
b) Delivery vehicle
c) Weekly wages
d) Sales
e) Trading stock
f) Mortgage loan
g) Telephone account
h) Debtors (trade receivables)
i) Computer
j) Interest received
k) Creditors (trade payables)
l) Interest paid
m) Property
n) Discount allowed

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 NCA CA NCL CL OE I E
o) Discount received
p) Depreciation
q) Stationery used
r) Stationery unused (stationery on hand)
s) Bank overdraft
t) Drawings
u) Photocopy machine
v) Shop fittings

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 3 The accounting equation

Outcomes

At the end of this chapter students should be able to show the effect of various transactions on
the basic accounting equation (BAE) of both a service organisation and a retail
organisation.

Chapter outline

3.1 The basic accounting equation (BAE)

3.2 The effect of transactions on the basic accounting equation (BAE)
3.2.1 Transactions that affect assets and equities only
3.2.2 Transactions that give rise to income and expenditure
3.2.3 Transactions involving payments by debtors

3.1 The basic accounting equation (BAE)

From a large corporation to the local hairdresser, every business transaction will have an effect
on an organisation’s financial position. The financial position is measured by the following
items:

1. Assets (what it owns)

2. Liabilities (what it owes)
3. Owner’s equity (the difference between assets and liabilities)

The accounting equation offers us a simple way to understand how these three items relate to
each other.

The three main elements of accounting fit together in the following way:

Assets (A) = Owner’s equity (OE) + Liabilities (L)

The right-hand side of the equation is owner’s equity + liabilities. This represents all the money
that is available to the business in the long term from the owner and from outsiders. What
happens to this money? It is used to purchase assets.

In other words, the money raised from the owner and from outsiders (loans) is converted into
assets. Therefore, the left-hand side of the equation equals the right-hand side of the equation.

ILLUSTRATIVE EXAMPLES

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 Example 1
Mr Hayne, the owner of Prima Innovations, invests R140 000 in order to start his business.
Owner’s equity is therefore R140 000. He also approaches a bank which lends him R100
000. Liabilities are therefore R100 000.
Owner’s equity (R140 000) + Liabilities (R100 000) = R240 000
What happens to this R240 000?
It will be used to purchase assets:

i.e. Building R120 000

Vehicle R50 000
Machinery R30 000
R200 000
Bank (cash) R40 000
R240 000

Therefore, Assets (R240 000) = OE (R140 000) + Liabilities (R100 000)

The basic accounting equation (BAE) and its components are summarised as follows:

Assets = Owner’s equity + Liabilities

Owner’s Income Expenses Non-current
Non-current assets
funds liabilities
Land and buildings Capital Sales Purchases Long-term loans
Add: Net Fees earned Rent paid Mortgage bond
Furniture
profit
Less: Rental income Salaries and Current liabilities
Equipment
Drawings wages
Interest income Interest paid Creditors (accounts
Motor vehicles
payable)
Commission Stationery used VAT
Fixed deposit
received
Discount Telephone Bank overdraft
Current assets
received
Debtors (accounts Water and
receivable) electricity
Trading stock Bank charges
(inventory)
Bank Repairs
Petty cash Advertising
Petrol and oil
Discount
allowed

Example 2
The assets of Beauty Salon amount to R50 000 and its liabilities (creditors) to R10 000.

Required
Calculate the owner’s equity.

Solution
A = OE + L

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 OE =A–L
OE = R50 000 – R10 000
= R40 000

Example 3
K. Masondo is the owner of Mars Services, which offers a carpet cleaning service. As at 31
March 20x1, Mars Services owns equipment amounting to R120 000, clients owe R50 000 for
services rendered and Mars Services owes R25 000 to a supplier for parts purchased. Mars
also has R8 000 cash in the bank.

Required
Complete the BAE for Mars and determine the owner’s equity.

Solution

Step 1 Identify the assets:

Equipment R120 000
Debtors R 50 000
Cash at bank R 8 000
Step 2 Identify the liabilities:
Creditors R 25 000
Step 3 Substitute these values in the BAE and solve:
A = OE + L
OE = A – L
OE = (R120 000 + R50 000 + R8 000) – R25 000
= R178 000 – R25 000
= R153 000

TEST YOURSELF 3.1

Balance the accounting equation by calculating the missing figure.

1. Bank R15 000

Accounts payable R50 000
Accounts receivable R15 000
Capital R10 000
Equipment ?
2. Loan ?
Capital R80 000
Inventory R12 000
Vehicles R60 000
Bank R18 000

TUTORIAL EXERCISES

Exercise 1
An undertaking called Quick Enterprises was formed on 3 January 20x1, on which date the
owner invested R50 000 in the business and borrowed R80 000 from Strand Bank. During the
month of January 20x1 the enterprise acquired the following assets:
Cash at bank R40 000 and a motor vehicle that cost R90 000.
1.1 What was the total value of the assets on 31 January 20x1?
1.2 What was the total value of the liabilities on 3 January 20x1?

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 1.3 What was the owners’ capital on 3 January 20x1?
1.4 Compile an accounting equation to reflect Quick Enterprises’ financial position on 31
January 20x1.

Exercise 2
BB Ltd commenced operations in 2004. The owner, Bee-Bee, invested her vehicle worth R20
000, she then invested a further R40 000 in cash. The company bought a new motor vehicle
at the cost of R100 000, this was paid by the balance of the bank account and a loan:
2.1 What is the value of the total assets?
2.2 What is the total value of liabilities?
2.3 How much is the owner’s capital?
2.4 Compile an accounting equation to reflect the above company.

Exercise 3
In each of the following independent situations determine the following:
3.1 The assets of a business which has owner’s equity of R20 000 and liabilities of R10 000.
3.2 The owner’s equity of a business which has assets of R50 000 and liabilities of R32 000.
3.3 The liabilities of a business which has assets of R120 000 and owner’s equity of R90
000.
3.4 The owner’s contribution during the year, if a business has assets of R60 000, liabilities
of R15 000 and owner’s equity (excluding capital contributed by the owner during the
year) of R25 000.

Exercise 4
Calculate the missing figures using the BAE.

R
4.1 Bank = 20 000
Vehicles = 25 000
Equipment = 35 000
Capital = ?
4.2 Capital = 750 000
Mortgage loan = 250 000
Bank = ?
Machinery = 900 000
Debtors = 50 000
4.3 Bank overdraft = 25 000
Debtors = 75 000
Buildings = 500 000
Furniture = 200 000
Creditors = 250 000
Capital = ?

3.2 The effect of transactions on the basic accounting equation

(BAE)

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 Every financial transaction, however simple or complex, affects the BAE.

3.2.1 Transactions that affect assets and equities only

3.2.1.1 Capital contributions
T. Zondo has decided to open a mobile motor vehicle repair and service unit called Prima
Innovations. He has withdrawn R50 000 from his personal savings account and deposited it in
the Prima Innovations bank account.

Let us examine the effect of this transaction:

A separate entity, Prima Innovations, has been established.

The business, Prima Innovations, now has an asset: cash in the bank of R50 000.
The owner, T. Zondo, has provided Prima Innovations with funds and increased his interest in
that business. The owner’s equity (capital) is now R50 000.

Assets = Owner’s equity +

Liabilities
Bank Capital
R R R
Previous balances 0 0 0
This transaction +50 000 +50 000 0
New balances 50 000 = 50 000 + 0

Remarks:

In an enterprise that has not yet entered into any transaction, the elements of the BAE will
always be 0.
The terms “bank” and “capital” in the analysis are actually the names of accounts.
Capital may be contributed in the form of cash or any other asset (i.e. equipment). Equipment
instead of bank will then increase.

3.2.1.2 Loans
Prima Innovations has borrowed R30 000 with a payback period of three years. The R30 000
was paid into the business’s bank account.

Let us examine the effect of this transaction:

The asset, bank, increases by R30 000.

A liability, namely loan, has now been created.

Assets = Owner’s equity + Liabilities

Bank Capital Loan
R R R
Previous balances 50 000 50 000 0
This transaction + 30 000 + 30 000

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 New balances 80 000 = 50 000 + 30 000

Remarks:

The result of the previous transactions forms the previous balance and is carried forward in
this transaction.
Liabilities arise when another party or institution supplies funds (makes a loan to the
business).
The borrowed amount of R30 000 is added to both sides of the BAE, since the money
received will increase the bank account and a liability (loan) has also been created.

3.2.1.3 Purchase of assets for cash

Prima Innovations has purchased tools for R40 000 and issued a cheque for this amount.

Let us examine the effect of this transaction:

The asset, bank, decreases by R40 000.

The asset, equipment, increases by the same amount of R40 000.

Assets = Owner’s equity + Liabilities

Equipment Bank Capital Loan
R R R R
Previous balances 0 80 000 50 000 30 000
This transaction + 40 000 – 40 000 0 0
New balances 40 000 40 000 = 50 000 + 30 000

Remarks:

There are two assets now, namely equipment and bank.

The effect is on one side of the equation, that is, the asset side. One asset is replaced by
another asset.

3.2.1.4 Buying assets on credit (creating a debt)

Prima Innovations has bought a vehicle for R100 000 on credit (account) from GM Motors. An
amount of R20 000 was paid as deposit. The balance is to be paid in equal instalments within
one year.

Let us examine the effect of this transaction:

The asset, vehicle, increases by R100 000.

A liability, creditor, comes into being.
The amount owing to GM Motors, the creditor, stands at R80 000 (R100 000 – R20 000).
The asset, bank, decreases by R20 000 because of the deposit paid.
The bank balance now stands at R20 000.
There are now three assets – equipment, bank and vehicles.

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 Assets = Owner’s equity + Liabilities
Vehicles Equipment Bank Capital Loan Creditors
R R R R R R
Previous balances 0 40 000 40 000 50 000 30 000
This transaction + 100 000 – 20 000 +80 000
New balances 100 000 40 000 20 000 = 50 000 + 30 000 80 000

Remarks:

The transaction is recorded when it is entered into and not when the payment is made.
Both sides of the BAE increase.

3.2.1.5 Payments to creditors

Prima Innovations has issued a cheque of R8 000 to GM Motors for the first instalment.

Let us examine the effect of this transaction:

The asset, bank, decreases by R8 000.

The liability (the amount owing to the creditor) also decreases by R8 000.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Bank Capital Loan Creditors
R R R R R R
Previous balances 100 000 40 000 20 000 50 000 30 000 80 000
This transaction – 8 000 – 8 000
New balances 100 000 40 000 12 000 = 50 000 + 30 000 72 000

Remarks:

Both sides of the BAE decrease.

3.2.1.6 Withdrawals by owner

T. Zondo has withdrawn R1 000 from the business to pay part of a private loan.

Let us examine the effect of this transaction:

The asset, bank, decreases by R1 000.

T. Zondo’s capital (equity) in Prima Innovations decreases by R1 000.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Bank Loan Creditors
R R R R R R
Previous balances 100 000 40 000 12 000 50 000 30 000 72 000
This transaction – 1 000 – 1 000
New balances 100 000 40 000 11 000 = 49 000 + 30 000 72 000

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 Remarks:

Withdrawals (referred to as drawings) are the opposite of capital contributions and these
reduce capital. NB: withdrawals are not expenditure.
Both sides of the BAE are reduced.

3.2.2 Transactions that give rise to income and expenditure

3.2.2.1 Income (cash)
Prima Innovations has provided services for a client and has received a cheque of R2 500.

Let us examine the effect of this transaction:

The asset, bank, increases by R2 500.

The fee that Prima Innovations earned is regarded as income.
This income belongs to the owner.
Owner’s equity therefore increases by R2 500.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Bank Loan Creditors
R R R R R R
Previous balances 100 000 40 000 11 000 49 000 30 000 72 000
This transaction + 2 500 +2 500
New balances 100 000 40 000 13 500 = 51 500 + 30 000 72 000

Remarks:

The objective of the enterprise is to earn income.

Income increases owner’s equity.
Both sides of the BAE increase.

3.2.2.2 Income (credit)

Prima Innovations has supplied repair services for S. Cele’s taxis and bills him for R4 500.

Let us examine the effect of this transaction:

The asset, debtor, comes into being and increases by R4 500.

Fees earned is an income item.
Owner’s equity increases by R4 500.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Debtors Bank Loan Creditors
R R R R R R R
Previous balances 100 000 40 000 0 13 500 51 500 30 000 72 000
This transaction +4 500 0 +4 500 0 0

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 New balances 100 000 40 000 4 500 13 500 = 56 500 + 30 000 72 000

Remarks:

Prima Innovations has rendered services to S. Cele, who does not pay immediately.
S. Cele is therefore a debtor.
A debtor arose from a credit transaction.
The income is earned when the service is rendered and not when the cash is received.
Both sides of the BAE increase.

3.2.2.3 Expenditure (cash)

Prima Innovations issues a cheque of R1 800 for wages.

Let us examine the effect of this transaction:

The asset, bank, decreases by R1 800.

Wages are an expenditure item.
An expenditure item has a negative effect on owner’s equity.
Owner’s equity decreases by R1 800.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Debtors Bank Loan Creditors
R R R R R R R
Previous balances 100 000 40 000 4 500 13 500 56 000 30 000 72 000
This transaction –1 800 –1 800 0 0
New balances 100 000 40 000 4 500 11 700 = 54 200 + 30 000 72 000

Remarks:

An expenditure is incurred and decreases income.

The negative effect is transferred to owner’s equity.
Therefore we say that an expenditure item decreases owner’s equity.
Both sides of the BAE decrease.

3.2.2.4 Expenditure (credit)

Prima Innovations has received a billing from Ethekwini Municipality for water and electricity
amounting to R700. This amount has not yet been paid.

Let us examine the effect of this transaction:

A credit expenditure gives rise to creditors. Ethekwini Municipality is therefore a creditor.

The liability, creditors, increases by R700.
Electricity and water is an expenditure.
Owner’s equity decreases by R700.

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 Assets = Owner’s equity + Liabilities
Vehicles Equipment Debtors Bank Loan Creditors
R R R R R R R
Previous balances 100 000 40 000 4 500 11 700 54 200 30 000 72 000
This transaction – 700 0 + 700
New balances 100 000 40 000 4 500 11 700 = 53 700 + 30 000 72 700

Remarks:

Expenditure may also be incurred on credit.

An expenditure is incurred when it takes place and not when it is paid.
The right-hand side of the BAE increases and decreases.
No effect is experienced on the left-hand side of the BAE.

3.2.3 Transactions involving payments by debtors

Prima Innovations has received a cheque of R3 000 from S. Cele as part payment of his account.

Let us examine the effect of this transaction:

The asset, bank, increases by R3 000.

The asset, debtors, decreases by R3 000.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Debtors Bank Loan Creditors
R R R R R R R
Previous balances 100 000 40 000 4 500 11 700 53 500 30 000 72 700
This transaction –3 000 +3000 0 0 0
New balances 100 000 40 000 1 500 14 700 = 53 500 + 30 000 72 700

Remarks:

This transaction affects the assets only.

The left-hand side of the BAE increases and decreases.
Payment by a debtor indicates a settlement/part settlement of his financial obligation and not
the creation of income.

Assets = Owner’s equity + Liabilities

Vehicles Equipment Debtors Bank Capital Income/Expense Loan Creditors
R R R R R R R R
+ 50 000 + 50 000
+ 30 000 + 30 000
+ 40 000 – 40 000
+ 100 000 – 20 000 + 80 000
– 8 000 –8 000
– 1 000 – 1 000
+ 2 500 + 2 500
+ 4 500 + 4 500

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 – 1 800 – 1 800
– 700 + 700
– 3 000 + 3 000
100 000 40 000 1 500 14 700 = 49 000 4 500 + 30 000 72 700

Assets = R156 200

Owner’s equity + Liabilities = (R53 500 + R102 700) = R156 200

How much profit has the business generated and what is the financial position of the business?

The accounting equation does not answer these questions, and therefore has to be adapted into a
statement of comprehensive income (which indicates the profit) and a statement of financial
position (which indicates the financial position).

Here are the basic formats of these financial statements. This will be covered in more depth in
Chapter 4.

Statement of comprehensive income of Prima Innovations

Income R R
Fee income (R2 500 + R4 500) 7 000
Less: Expenses 2 500
Wages 1 800
Water and electricity 700
Net income 4 500

Statement of financial position of Prima Innovations

Assets R R
Non-current assets 140 000
Vehicles 100 000
Equipment 40 000
Current assets 16 200
Debtors 1 500
Bank 14 700
156 200
Equity and liabilities
Owner’s equity 53 500
Capital 50 000
Less: Drawings 1 000
Add: Net income 4 500

Liabilities 102 700

Non-current liabilities 30 000

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 Loan 30 000
Current liabilities 72 700
Creditors 72 700
156 200

TEST YOURSELF 3.2

Sipho’s Car Wash opened in October 20x1. Sipho offers various car-wash services to his
customers. The following transactions took place during the month.
1 The owner contributed R50 000 cash and an old computer worth R2 500.
2 Purchased car-wash soap on credit for R800.
3 Received R1 500 for washing customers’ cars.
4 Paid Telkom R250 for telephone calls.
5 Bank charges for the month, R90.
Record transactions in the accounting equation.

TUTORIAL EXERCISES

Exercise 5 (excluding debits and credits)

T. Gordon starts a new business known as Super Deliveries on 1 January 20x1.
On 1 January 20x1 he deposits R15 000 in the bank to commence business and the following
transactions take place during January 20x1:
2 Purchases a delivery van on credit for R60 000 from X Ltd and pays a deposit of R6 000
by cheque, the balance to be paid by the end of March.
3 Pays rental for premises for January R2 000.
10 Receives R15 000 cash for delivery services rendered.
12 Buys stationery costing R500 by cheque.
14 Borrows R20 000 cash from Strand Bank at 15% per annum, interest is payable with
effect from 1 January 20x1 (refer to 28 January).
15 Invoices Brown Ltd for delivery of services rendered R10 000.
17 Withdraws R3 000 from the business for his own use.
20 Receives an account from Z Motors for petrol bought, R800.
24 Pays salaries and wages of R1 500 by cheque.
26 Receives a cheque from Brown Ltd for R8 000.
28 Issues a cheque in favour of Strand Bank for the interest payable for January 20x1.
31 Issues a personal cheque for R75 000 to purchase another delivery vehicle.

Required
Enter the above transactions in the accounting equation.

Exercise 6 (excluding debits and credits)

The following transactions appeared in the books of Sencam Traders for the month of June
20x1:
1 Bought a sanding machine for R2 800 on credit.

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 2 Bought stationery from CNA and paid R110 by cheque.
3 Bought varnishes and paintbrushes on credit, R1 100.
5 Rendered services on credit, R6 000.
6 Paid R200 to have motor vehicle serviced.
7 Received R8 400 cash from debtors.
8 Drew a cheque for R1 200 to pay creditors.
9 Owner invested a further R4 000 into his business.
11 Cash received for services rendered, R2 600.
12 Returned furniture costing R1 200 to the supplier, as it was defective. The supplier
granted full credit for the return.
13 Owner took a cheque for his personal use, R300.

Required
Enter the transactions in the accounting equation.
DOUBLE ENTRIES (DEBITS/CREDITS)
As we have discovered, each transaction has a dual effect on the accounting equation. This
is known as the double-entry system. The dual effect is also reflected by using debit and
credit entries. The debit and credit entries take place in the general ledger, which follows a T-
account system. The left-hand side is the debit side and the right-hand side is the credit side.
You must learn the following rules for debit and credit, as shown below. Remember, every
debit entry must have an equal and corresponding credit entry.

Assets Owner’s equity Liabilities

+ – – + – +
debit credit debit credit debit credit

The three main groups of accounts may be illustrated as follows:

Assets Liabilities Owner’s equity accounts:

Capital and drawings
Income accounts
Expense accounts

Assets = Owner’s equity + Liabilities

Dr Liabilities
Dr Asset accounts Cr Dr Capital Cr
accounts Cr
+ – – + – +
Increases on the Decreases Decreases on Increases on Decreases Increases
debit side on the the debit side the credit side on the on the
Normal balance credit side Normal balance debit side credit side
= debit balance = credit balance Normal
balance =
credit
balance
Dr Drawings Cr
+ –
Increases on Decreases on
the debit side the credit side

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 Normal
balance = debit
balance
Dr Income accounts Cr
– +
Decreases on Increases on
the debit side the credit side
Normal balance
= credit balance
Dr Expense accounts Cr
+ –
Increases on Decreases on
the debit side the credit side
Normal
balance = debit
balance

ILLUSTRATIVE EXAMPLE: Debits and credits

1. T. Zondo decided to open a mobile motor vehicle repair and service unit called Prima
Innovations. He withdrew R50 000 from his personal savings account and deposited it in
Prima Innovations’ bank account.
2. Prima Innovations borrowed R30 000 with a payback period of three years. The R30 000
was paid into the business’s bank account.
3. Prima Innovations purchased tools for R40 000 and issued a cheque for this amount.
4. Prima Innovations bought a vehicle for R100 000 on credit (account) from GM Motors. An
amount of R20 000 was paid as deposit. The balance is to be paid in equal instalments
within one year.
5. Prima Innovations issued a cheque of R8 000 to GM Motors, being the first instalment.
6. T. Zondo withdrew R1 000 from the business to pay towards a private loan.
7. Prima Innovations provided services for a client and received a cheque of R2 500.
8. Prima Innovations provided repair services to S. Cele’s taxis and billed him for R4 500.
9. Prima Innovations issued a cheque of R1 800 for wages.
10. Prima Innovations received a billing from Ethekwini Municipality for water and electricity
amounting to R700. This amount has not yet been paid.
11. Prima Innovations received a cheque for R3 000 from S. Cele as part payment on his
account.
12. The business wants to establish a petty cash float of R500 using money withdrawn from
its bank account.

Date Assets = R OE + R Liabilities R Account debit Account credit

1 + 50 000 + 50 000 0 Bank Capital
2 + 30 000 0 + 30 000 Bank Loan
3 + 40 000 0 0 Equipment
– 40 000 0 0 Bank
4 + 100 000 0 + 80 000 Vehicle Creditors

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 – 20 000 0 0 Bank
5 – 8 000 0 – 8 000 Creditors Bank
6 – 1 000 – 1 000 0 Drawings Bank
7 + 2 500 + 2 500 0 Bank Fee income
8 + 4 500 + 4 500 0 Debtors Fee income
9 – 1 800 – 1 800 0 Wages Bank
10 0 – 700 + 700 Water and electricity Creditors
11 + 3 000 0 0 Bank
– 3 000 0 0 Debtors
12 + 500 0 0 Petty cash
– 500 0 0 Bank

TEST YOURSELF 3.3

You have been employed as a bookkeeper for Sonali Singh Consulting (Pty) Ltd.
The following are the transactions that took place during November 20x1, being the first
month of business:

1. Ms Sonali Singh, the owner, introduced her contribution of R100 000 cash, and furniture and equipment of R30 000
into the business.
2. Paid R12 000 by cheque for rent.
5. Bought a vehicle costing R90 000 from BMW. Paid a deposit of R30 000 and the balance is payable over four
months in equal instalments.
7. The owner drew cash of R1 600 for personal use.
10. Paid first instalment on the vehicle, R1 250.
12. Bought stationery on credit from CNA stationers, invoice issued: R2 800.
15. Rendered a service and charged Ms Bridget Mudalo R2 500; she will pay in the following month.
26. Received cash of R5 200 for services rendered.
29. Paid salaries and wages of R4 000.

Required
Record the transactions in the accounting equation for November 20x1.

TUTORIAL EXERCISES

Exercise 7
Cami opened a training centre in January 20x1 under the name Shay — Active. Choose the
correct accounting entry for each of the statements listed below.
7.1 Cami transferred R10 500 from her personal bank account to the bank account of Shay
— Active training.

Account Account A= OE + L
debit credit
A Bank Capital + R10 500 + R10 500 0
B Capital Bank + R10 500 + R10 500 0
C Bank Capital – R10 500 – R10 500 0

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 Account Account A= OE + L
debit credit
D Bank Capital + R10 500 0 + R10 500

7.2 The owner took R1 000 from the business for her personal use.

Account Account A= OE + L
debit credit
A Bank Drawings – R1 000 – R1 000 0
B Drawings Bank – R1 000 – R1 000 0
C Drawings Creditors – R1 000 0 – R1 000
D Creditors Drawings – R1 000 0 – R1 000

7.3 Received R5 000 from the customers who were trained during the month.

Account Account A= OE + L
debit credit
A Sales Bank + R5 000 + R5 000 0
B Creditors Sales + R5 000 + R5 000 0
C Bank Service fees + R5 000 + R5 000 0
D Bank Sales + R5 000 + R5 000 0

7.4 Computers were purchased from Icona Ltd for R10 000 on credit.

Account Account A= OE + L
debit credit
A Loan Equipment + R10 000 0 + R10 000
B Equipment Loan + R10 000 0 + R10 000
C Equipment Creditors + R10 000 0 + R10 000
D Creditor Equipment + R10 000 0 + R10 000

7.5 Paid R2 750 to Icona Ltd to settle the account.

Account Account A= OE + L
debit credit
A Creditors Bank – R2 750 + R2 750 0
B Bank Debtors – R2 750 0 – R2 750
C Bank Creditors – R2 750 0 – R2 750
D Creditors Bank – R2 750 0 – R2 750

7.6 The secretary’s monthly salary was paid in cash, R500.

Account Account A= OE + L
debit credit
A Bank Salary + R500 + R500 0
B Salary Bank + R500 – R500 0
C Salary Creditors 0 – R500 – R500

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 Account Account A= OE + L
debit credit
D Debtors Salary 0 + R500 + R500

7.7 Bought stationery on credit for R800 from Regent Stationers.

Account Account A= OE + L
debit credit
A Bank Stationery – R800 – R800 0
B Stationery Creditors 0 – R800 + R800
C Creditors Stationery 0 + R800 + R800
D Stationery Bank – R800 + R800 0

Required
Record the above transactions in the accounting equation, clearly stating which accounts are
debited and credited.

Exercise 8
Dr Dan has decided to open up his own dental practice, operating under the name of Fluoride
Dental Practice. The following transactions took place during October 20x6, his first month of
business.
2 Dr Dan invested R40 000 into a bank account, which he opened up in the name of the
business.
4 He bought R75 400 worth of dental equipment from dental suppliers. An amount of R22
000 was paid immediately and the balance will be paid off over the next few months.
7 R30 000 was acquired as a loan from DTU Bank.
10 Dr Dan contributed a vehicle valued at R60 000 to the business.
14 Cash fees of R3 670 were collected from clients.
16 R120 was paid to hire a computer.
18 Provided services for clients amounting to R4 580 on credit.
20 Dr Dan took R250 out of the business bank account to buy his wife a birthday present.
25 Rent of R1 200 was paid.
27 Telkom was paid R180 for telephone use.
29 Dr Dan paid R3 200 to dental suppliers (see 4 October above) and R1 000 to DTU Bank
to reduce the loan.
30 Paid R260 interest on the loan.
31 Received payments from debtors amounting to R580.

Required
Record the above transactions in the accounting equation.

Exercise 9
You have been employed as a bookkeeper for Nyathi Marketing Consultants. The following
are the transactions that took place during February 20x6, being the first month of business.
1 Mr Zama, the owner, introduced his contribution of R50 000 cash and furniture and
equipment costing R29 000 into the business. Cash was then deposited into the
business bank account.

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 5 Paid R1 000 by cheque for rent.
7 Bought stationery on credit from AB Stationers; invoice issued, R2 500.
10 Rendered a service and charged Miss Shozi R3 500. She will pay in the following month.
12 Bought a vehicle costing R90 000; Mr Zama paid R30 000 deposit and the balance was
payable over four years in equal monthly instalments.
15 Received cash of R5 200 for services rendered.
25 The physical stock count revealed that unused stationery amounted to R500.
28 Paid the first instalment on the vehicle, R1 250. Mr Zama withdrew cash of R1 600 for
personal use.

Required
Record the transactions in the accounting equation for the month of February 20x6.

Exercise 10
Shavik Singh decided to open up his own taxi repair and service unit called Scoundrel
Enterprises. The following transactions took place during August 20x1, his first month of
business.
1. Mr Singh invested R150 000 of his own cash into the business banking account.
3. Acquired a loan of R50 000 from White Diamond Bank.
4. Mr Singh purchased equipment and tools for R38 000 cash.
8. Provided services for his first client and received a cheque of R8 400.
10. Bought a motor vehicle on credit for R100 000. He paid R50 000 deposit from the bank
account and the balance is payable over two years in equal monthly instalments.
12. Mr Singh withdrew R1 800 to buy an expensive gift for his wife.
15. Provided services for SK’s taxis and billed it R3 800.
19. Issued a cheque for wages, R2 900.
22. Paid R550 interest on the loan from White Diamond Bank.
27. Received a cheque for R2 800 from SK’s taxis.

Required
Record the above transactions in the accounting equation, clearly stating which accounts are
debited and credited.

Exercise 11
Mahi Ltd commenced business in October 20x1. The following information represents the
transactions for the first month of business:
DATE
1 The owner, Mahi Singh, deposited an amount of R200 000 in ABSA Bank as her capital
contribution.
2 Purchased inventory from Lumber Ware Ltd for R50 000 on credit.
4 Paid electricity deposit of R8 000 by cheque.
6 Sold inventory to Kay Kay (Pty) Ltd for R1 500 on credit.
12 Paid Lumber Ware Ltd R25 000 by cheque.
14 Kay Kay (Pty) Ltd returned inventory to the value of R300; was not according to order.
25 Paid wages of R80 000 to office personnel by cheque transfer into their bank accounts.
26 Kay Kay (Pty) Ltd paid R1150 in full settlement of amount owing.

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 29 Paid telephone account of R800 by cheque to Telkom.

Example: Paid for electricity by means of an electronic funds transfer, R900.

No. Assets = Equity + Liabilities
i.e. −R900 −R900 0

30 Paid Lumber Ltd a further R10 000 on account; the balance to be paid in November.
Required
Record the above transactions in the ledger journal of Mahi Ltd and present your answer in
the following format:

Account debited Account credited Amount

Exercise 12
Show the effect of the following transactions of Roman Stores in the accounting equation.
Use “+” to denote an increase, “−” to denote a decrease and “0” to denote no change to the
elements of the equation. Follow the example given.
Assume that the bank balance is favourable at all times.

Transactions
1 Purchased a vehicle for cash, R300 000.
2 Bought stationery on credit from JH Stationers, R700.
3 Received R800 cash from a debtor in settlement of her debt.
4 Purchased an air conditioner on credit, R12 000.
5 The proprietor increased her capital contribution from R100 000 to R150 000 by
means of a cash deposit.
6 Received R18 000 cash from customers for services rendered.
7 The telephone account was paid by means of a debit order, R1 600.
8 The proprietor transferred R1 000 cash from the current account of the business for
her personal use.
9 Paid the account of a creditor, R6 000.
10 Services rendered to customers on credit amounted to R7 000.

Exercise 13
The following transactions were extracted from the books of Nzuza Traders during February
20x1.

Day Transaction Amount

1 Capital contribution R50 000
4 Bought merchandise for cash R15 000
9 Paid the monthly rent R1 500
15 Purchased stock on credit R18 000
16 Donated merchandise R400
19 Stock withdrawals by the owner R1 300
24 Credit sales R15 000
26 Cash sales R9 000
27 Returns of stock by debtors R600
28 Paid carriage on purchases R1 200
Paid sundry expenses R4 000

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 Required
Record the transactions in the accounting equation, clearly indicating the account to be
debited and credited.

TEST YOURSELF SOLUTIONS

TEST YOURSELF SOLUTION 3.1

1. Assets = OE + Liabilities
R30 000 = R10 000 + R50 000
Equipment = R60 000 – R30 000
= R30 000
2. Assets = OE + Liabilities
R90 000 = R80 000 + R0
Loan = R90 000 – R80 000
= R10 000

TEST YOURSELF SOLUTION 3.2

No ASSETS = OWNERS EQUITY + LIABILITIES

Bank Equipment Capital Income/Expenses Creditors
1 +50 000 +2 500 +52 500
2 –800 +800
3 +1 500 +1 500
4 –250 –250
5 –90 –90

TEST YOURSELF SOLUTION 3.3

Date Asset Owner’s equity Liabilities

01 + R100 000 Bank + R130 000 Capital 0
+ R30 000 Furniture and 0 0
equipment
02 R12 000 Bank R12 000 Rent expense 0
05 + R90 000 Motor vehicle R30 0 + R60 000 Creditors
000 Bank control
07 R1 600 Bank R1 600 Drawings 0
10 R1 250 Bank 0 R1 250 Creditors
control
12 0 R2 800 Stationery + R2 800 Creditors
control
15 + R2 500 Debtors control + R2 500 Services 0
rendered

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 Date Asset Owner’s equity Liabilities
26 + R5 200 Bank + R5 200 Services 0
rendered
29 + R4 000 Bank R4 000 Salaries and 0
wages
Total

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 4 Accounting cycle: journals, ledgers and trial
balance

Outcomes

At the end of this chapter students should have an understanding of the accounting cycle and
be able to

calculate cost of sales

prepare selected journals and ledgers
prepare, basic financial statements of a sole trader using both the periodic and the perpetual
methods of stock valuation.

Chapter outline

4.1 Conceptual framework

4.2 The accounting cycle
4.2.1 Transactions
4.2.2 Source documents
4.2.3 Journals
4.2.4 Ledger accounts
4.2.5 Pre-adjustment trial balance
4.2.6 Adjustments
4.2.7 Post-adjustment trial balance
4.2.8 Closing entries
4.2.9 Final trial balance
4.2.10 Financial statements
4.2.11 Analysis and interpretation
4.3 Retailers
4.3.1 Perpetual method of accounting for stock
4.3.2 Periodic method of accounting for stock

4.1 Conceptual framework

This is a brief introduction to a conceptual framework of basic accounting because at this stage
of your studies an in-depth discussion is not necessary. The conceptual framework identifies
four principal qualitative characteristics of accounting, namely comparability, understandability,
timeliness and verifiability. These concepts have been discussed in Chapter 1.

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 Fundamental accounting concepts include the concepts of going concern, matching, consistency
and prudence.

Going concern concept. This concept implies that the business will continue to operate for a
long time (in the foreseeable future), and there is no intention to cease operations.
Matching concept. Revenue and costs are recognised as they are earned or incurred
irrespective of the timing of the receipt of cash or its payment, and matched with one another,
that is, all revenue earned is matched with all expenses incurred in earning that revenue
during the relevant accounting period.
Consistency concept. Items can be recorded in a number of different ways. Therefore, each
business should try to choose the method that gives the most reliable picture of the business.
This cannot be done if one method is used in one year and another method is used in the next
year and so on. Constantly changing the method would lead to misleading profits being
calculated from the accounting records. Therefore, the convention of consistency is used,
which states that once a firm has fixed a method for the accounting treatment of an item, it
will enter all similar items that follow in exactly the same way.
Prudence concept. If an item can be dealt with in more than one way, the most conservative
option should be followed, meaning that if there were a choice of accounting methods, it
would be prudent to select the one which has the least favourable effect on net income and
financial position. Where there is doubt or uncertainty, the prudence concept requires that
estimates be conservative. This is also known as the doctrine of conservatism.

4.2 The accounting cycle

There are 11 basic stages in the accounting cycle (see Figure 4.1). Some of these stages are
performed on a daily basis, some on a monthly basis, while others are only performed at the end
of the accounting period. The full accounting cycle has more steps than the basic accounting
cycle. Owing to the length of the accounting cycle, this chapter divides the cycle into two
distinct parts. The first part of this chapter deals with the preparation of journals, ledgers and a
trial balance, while the latter part of the chapter covers the preparation of the basic financial
statements of a sole trader. Chapters 5 and 6 deal with year-end adjustments and analysis and the
interpretation of financial statements, respectively. The objective of this chapter is to provide a
basic overview of the cycle, culminating in the preparation of basic financial statements, hence
the implication of value added tax is not covered.

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 Figure 4.1 The accounting cycle

4.2.1 Transactions
Transactions occur daily in any business concern. A transaction is an agreement between two
parties to make something happen. Cash is not necessarily involved in this occurrence. It could
be that we

buy (credit or cash)

sell (credit or cash)
pay

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 receive money
return goods
receive goods back, etc.

We will always be one of the two parties involved, for example

we and the owner

we and the bank
we and the debtor
we and the creditor
we and any other party.

4.2.2 Source documents

Under no circumstances may any entry be made in the records without a source document to
substantiate the entry. A specific source document is used for every type of transaction. It is also
important to distinguish between an original and a duplicate source document.

Examples of source documents used:

Receipt – for cash received

Cash slip or cash register slip – for cash sales of goods
Cheque – for cash payment
Credit purchase invoice – for credit purchases
Credit sales invoice – for credit sales
Credit note – for returns by debtors
Debit note – for returns to creditors

Note: Digital payment methods replaced cheque payments in South Africa effective from 31
December 2020. However, cheque payment will still be referred to in subsequent chapters as
cheques have not been discontinued worldwide.

4.2.3 Journals
The purpose of a journal is to summarise transactions of the same type. A distinction is made,
for example, between a cash transaction and a credit transaction. A further distinction is made
with regard to cash transactions, namely cash payments and cash receipts.

The following journals are applicable:

General journal (GJ)

Cash receipts journal (CRJ)
Cash payments journal (CPJ)
Debtors’ journal (DJ) or sales journal (SJ)
Creditors’ journal (CJ) or purchases journal (PJ)

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 Debtors’ allowances journal (DAJ) or sales returns journal (SRJ)
Creditors’ allowances journal (CAJ) or purchase returns journal (PRJ)
Petty cash journal (book) (PCJ)

This chapter will only cover the cash journals and credit journals.

4.2.4 Ledger accounts

GENERAL LEDGER
When information is transferred from the journals to the general ledger, we use the term post.
The purpose of a general ledger account is to determine a balance for each account in the
records. An account is opened for every item, whether it is an asset, liability, income or expense,
and the balance or total is determined for every account. A balance is determined by calculating
the difference between the debit and the credit side of each account. The left-hand side of an
account represents the debit side, and the right-hand side the credit side.

EXAMPLE OF A GENERAL LEDGER ACCOUNT

A general ledger account is in the shape of a “T”, with the name of the account at the top:
“Vehicles” in this instance. All transactions relating to vehicles (buying, selling, etc.) will be
accounted for in this account to enable us to determine the balance at the end of a specific
period.

DEBTORS AND CREDITORS LEDGERS

These are subsidiary ledgers, since they provide more details about specific accounts in the
general ledger. The debtors ledger provides more details about the debtors control account in the
general ledger, i.e. it contains all the details of the individual debtors. The creditors ledger
provides more details of the creditors control account in the general ledger, i.e. it contains all the
details of the individual creditors.

4.2.5 Pre-adjustment trial balance

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 This represents a summary of the debit and credit balances in the general ledger before any
adjustments are made to these balances. The main purpose for drafting the trial balance at this
point in the accounting cycle is to ensure that the transactions have been captured correctly. The
debit side of the trial balance must equal the credit side.

4.2.6 Adjustments
An adjustment is not a transaction; in other words, it does not involve two parties. Adjustments
are changes that are made at the end of the financial period. Examples of adjustments:

Depreciation
Expenses prepaid
Accrued expenses
Accrued income
Income received in advance
Allowance for credit losses

Adjustments are made in the general journal and the journal description acts as the source
document. The entries in the general journal are posted to the general ledger accounts.
Adjustments will be covered in more detail in Chapter 5.

4.2.7 Post-adjustment trial balance

A post-adjustment trial balance is prepared after making all the necessary adjustments. It
represents the final balances of all general ledger accounts and includes income, expense, asset,
owner’s equity and liability accounts.

4.2.8 Closing entries

Closing entries are made using the general journal. All income and expense accounts are closed
so that no balances remain on these accounts and a clean start can be made during the next
financial year. Income and expense accounts that influence gross profit are closed off against the
trading account; all other income and expense accounts are closed off against the profit and loss
account. Closing entries will be covered in more detail in Chapter 5.

4.2.9 Final trial balance

After all the closing entries have been made, the only balances that remain in the general ledger
are assets, liabilities and profit or loss as calculated in the profit and loss account. The final trial
balance therefore consists of a summary of those closing balances that remain in the general
ledger after all the closing entries have been made.

4.2.10 Financial statements

The financial statements of a business entity comprise five sections. These are as follows:

Statement of profit or loss and other comprehensive income

Statement of financial position
Statement of changes in equity

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 Statement of cash flow
Notes
The headings of the statements must contain the name of the business, the name of the
statement as well as the reporting period

Note: The statement of cash flow is beyond the scope of this book and will not be covered.

4.2.10.1 Statement of profit or loss and other comprehensive income

The purpose of the statement of profit or loss and other comprehensive income is to determine
the gross and net profit of the business concern for a relevant period. Only income and expenses
appear in the statement of profit or loss and other comprehensive income. This statement shows
the performance of the business for the whole financial period under review.

The heading of the statement of profit or loss and other comprehensive income reads as follows:

Business name

Statement of profit or loss and other comprehensive income for the year ended
__________ 20xx.

4.2.10.2 Statement of financial position

The statement of financial position shows the financial position of the business at that particular
point in time.

The heading of the statement of financial position reads as follows:

Business name

Statement of financial position as at __________ 20xx.

4.2.10.3 Statement of changes in equity

The purpose of the statement of changes in equity is to show the value of the owners’
investment in the business.

The heading of the statement of changes in equity reads as follows:

Business name

Statement of changes in equity for the year ended __________ 20xx.

4.2.10.4 Statement of cash flow

The purpose of the cash flow statement is to show the movement of cash within a specific
financial period.

The heading of the statement of cash flow always reads as follows:

Business name

Statement of cash flow of __________ for the year ended __________ 20xx.

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 4.2.10.5 Notes to the financial statements
The main purpose of the notes is to provide additional information regarding certain items in the
statement of profit or loss and other comprehensive income, as well as the statement of financial
position. The main notes drafted include accounting policies, non-current assets, inventories
(stock), investments, etc. For the purpose of this book, we will only focus on the notes for
accounting policy and non-current assets.

The notes are always numbered, so that they can be cross-referenced, that is, found easily on the
face of the financial statements.

4.2.11 Analysis and interpretation

The final step in the accounting cycle is the analysis and interpretation of the information
contained in the financial statements. This is done by calculating ratios and comparing the
figures in the financial statements with those of other concerns or with budgets that have been
drawn up previously.

4.3 Retailers

Up to this point, we have dealt with the financial statements (i.e. the statement of profit or loss
and other comprehensive income, as well as the statement of financial position) of a service
business, that is, a business that provides a service for which it charges a fee. The fee received
for services rendered is called fee income. Rather than offering a service (hairdressing,
plumbing, etc.), for which the customer is charged a fee, many businesses (supermarket, shoe
store, etc.) choose to sell a physical, tangible product in order to make a profit. These businesses
are known as retailers.

The retailer buys products from a wholesaler and sells them to consumers. The retailer makes a
profit by adding a mark-up to the cost of the product. The selling price includes this mark-up.

In other words: Cost price R1 000

+ Mark-up R250
= Selling price R1 250

The selling price must be high enough to

cover the amount paid for the product

pay the business operating expenses
make a profit.

The products bought for the purpose of resale are called trading stock. Trading stock is also
called “purchases”, “goods” or “merchandise”. These descriptions imply that the items are
bought for resale and they should not be confused with products the business buys for its own
use. Trading stock is usually a retailer’s largest asset and the way this stock is controlled and
accounted for is very important to the profitability of the business.

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 Retailing businesses may account for their stock using one of two methods:

The perpetual method or

The periodic method

4.3.1 Perpetual method of accounting for stock

Perpetual means continuous. According to this method the selling price and the cost price are
known for each item sold. It is therefore very easy to work out how profitable an item is by
simply matching the selling price of the goods sold to the cost price of those same goods.

The amount by which the selling price exceeds the cost price is known as the gross profit.

Gross profit = Selling price – Cost price

Establishing the gross profit on each item sold is very useful. However, the implementation of
this method in an organisation with a large turnover of items, like a supermarket, can be difficult
and expensive. A sophisticated, computerised system would be required to keep track of the cost
price and selling price of each item sold.

The recording of transactions under the perpetual system requires two important accounts,
namely trading stock and cost of sales. The trading stock account is continuously updated to
reflect the cost of the stock available for sale, while the cost of sales account is continuously
updated to reflect the cost of the stock sold.

Stocktaking occurs at the end of the accounting period to verify that the balance of stock
available for sale and the balance of the trading stock account agree.

4.3.2 Periodic method of accounting for stock

Organisations that trade in a large volume of goods and for which the perpetual method is not
practical still have the same basic information needs. At some point, they must be able to
determine the gross profit of the organisation. In order to do this, they will use the periodic
method of accounting for stock whereby the cost of stock available for sale and the cost of
goods sold is only updated periodically.

THE RECORDING OF TRANSACTIONS UNDER THE PERIODIC METHOD

When a retailer using the periodic method buys items for resale at a profit, the cost price of the
item affects the purchases account.

STOCK ON HAND
As long as the retailer sells all his stock, then the calculation of the gross profit is the same as in
the perpetual method because cost of sales = purchases. This situation seldom arises and is not
desirable, since a retailer always needs stock on the shelves to sell.

The retailer can still work out the cost price of the goods sold by using the following formula:

Cost of sales = Opening stock + Purchases – Closing stock

In order to determine the amount of closing stock, the retailer will have to do a physical stock
count of the stock that he has not sold. In other words, he will periodically (from time to time)
have to do stocktaking in order to calculate the cost of sales so that he can then work out the

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 gross profit. The stocktaking is usually done on the last day of the financial period. It is
important to remember that the closing stock, at the end of one financial period, becomes the
opening stock at the beginning of the following period.

ILLUSTRATIVE EXAMPLE: Journals, general ledger and trial balance

Example 1 Cash journals (perpetual method)

Roshan Nunden has just opened his own business called Rosh Traders. The cash
transactions for the first month of trading were as follow:
August 20x6

1 Roshan deposited R70 000 into the business bank account as his capital contribution.
2 Roshan obtained a loan of R30 000 from Gold Bank at 15% interest per annum.
5 Purchased equipment and tools for R35 000 cash from Equip Ltd.
7 Purchased stock for resale from Nadesan Suppliers, R25 000.
10 Issued a cheque to pay weekly wages, R1 500.
12 Sold goods to customers for cash R20 000, cost price R16 000.
15 Purchased goods for resale from Naidoo Suppliers, R30 000.
17 Issued a cheque to pay weekly wages, R1 500.
18 Sold goods for cash, R15 000; cost price R12 000.
20 Roshan withdrew cash to buy a birthday gift for his wife, R1 500.
24 Issued a cheque to pay weekly wages, R1 500.
25 Paid interest on loan for the month. Paid monthly rental of R2 000 to Properties Ltd.
31 Issued a cheque to pay weekly wages, R1 500. Paid the municipality R1 000 for water
and electricity.

Required
Assume that the business uses the perpetual method of stock valuation. Prepare the
following for the month of August 20x6:
Cash receipts and cash payments journals; general ledger and trial balance

Note: Under the perpetual method both the sales and cost of sales are recorded in the CRJ,
while all goods bought are recorded under trading stock in the CPJ.

Solution

Cash receipts journal of Rosh Traders for August 20x6 FOL. CRJ1
Doc Day Details Fol Analysis of Bank Sales Cost of Sundry
no. receipts sales accounts
Amount Fol Details
rec 1 1 Roshan 70 000 70 70 000 B1 Capital
Nunden 000
rec 2 2 Gold Bank 30 000 30 30 000 B2 Loan: Gold
000 Bank
CRR1 12 Sales 20 000 20 20 16 000
000 000
CRR2 18 Sales 15 000 15 15 12 000
000 000
135 35 28 000 100 000
000 000
B3 N1 N2

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 Cash payments journal of Rosh Traders for August 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Trading Wages Sundry Details
number stock accounts
Amount Fol
01 5 Equip Ltd 35 000 35 000 B4 Equipment and
tools
02 7 Nadesan 25 000 25 000
Suppliers
03 10 Cash 1 500 1 500
04 15 Naidoo Suppliers 30 000 30 000
05 17 Cash 1 500 1 500
06 20 Cash 1 500 1 500 B5 Drawings
07 24 Cash 1 500 1 500
08 25 Gold Bank 375 375 N3 Interest on loan
09 25 Properties Ltd 2 000 2 000 N4 Rent
10 31 Cash 1 500 1 500
Municipality 1 000 1 000 N5 Water and
electricity
100 55 000 6 000 39 875
875
B3 B6 N6

* R30 000 × 15% ÷ 12 = R375

Notes: Cash receipts journal and cash payments journal:

The headings and columns used in the journals depend on how often the transactions
occur. This will vary from business to business.
Transactions that occur regularly are recorded in a separate column, while transactions that
occur infrequently are recorded in the sundries column.
Cash receipts and payments for the month are recorded in date order.
Cash received is not banked after each transaction, but rather at the end of the day.
Consequently, the CRJ has an analysis of receipts column and a bank column. All
transactions are entered into both the analysis of receipts column and the bank column.
The analysis of receipts column is particularly useful when more than one receipt has
occured on the same day. The bank column reflects the total receipts that are banked for
the day.
Transactions recorded in the sundry accounts are posted to the individual accounts in the
general ledger. The folio column indicates the folio reference of the affected accounts in the
general ledger.
The totals of the other columns also have folio references and are posted to the general
ledger as well.
Folio references are important, as they assist with the cross-checking of transactions.

General ledger of Rosh Traders for the month of August 20x6

Capital B1

Date Details Fol Amount Date Details Fol Amount

1 Aug Bank CRJ1 70
20x6 000,00
Loan: Gold Bank B2
Date Details Fol Amount Date Details Fol Amount
2 Aug Bank CRJ1 30
20x6 000,00

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 Bank B3
Date Details Fol Amount Date Details Fol Amount
31 Aug Total CRJ1 135 31 Aug Total CPJ1 100
20x6 receipts 000,00 20x6 payments 875,00
Balance c/d 34
125,00
135 135
000,00 000,00
1 Sept Balance b/d 34
20x6 125,00
Tools and equipment B4
Date Details Fol Amount Date Details Fol Amount
5 Aug Bank CPJ1 35
20x6 000,00
Drawings B5
Date Details Fol Amount Date Details Fol Amount
20 Aug Bank CPJ1 1 500,00
20x6
Trading stock B6
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CPJ1 55 31 Aug Cost of CRJ1 28
20x6 000,00 20x6 sales 000,00
Balance c/d 27
000,00
55 55
000,00 000,00
1 Sept Balance b/d 27
20x6 000,00
Sales N1
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CRJ1 35
20x6 000,00
Cost of sales N2
Date Details Fol Amount Date Details Fol Amount
31 Aug Trading CRJ1 28
20x6 stock 000,00
Interest on loan N3
Date Details Fol Amount Date Details Fol Amount
25 Aug Bank CRJ1 375,00
20x6
Rent N4
Date Details Fol Amount Date Details Fol Amount
25 Aug Bank CPJ1 2 000,00
20x6

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 Water and electricity N5
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CPJ1 1 000,00
20x6
Wages N6
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CPJ1 6 000,00
20x6

Notes: General ledger

The general ledger is divided into two sections, i.e. the balance sheet section and the
nominal accounts section.
The balance sheet section comprises all the assets, liabilities and equity accounts. The
folio reference for the balance sheet section accounts starts with a “B”.
The nominal accounts section comprises all income and expense accounts. The folio
reference for the nominal accounts section starts with an “N”.
In the general ledger the balance sheet accounts are balanced off, while the nominal
accounts are totalled.

Trial balance of Rosh Traders on 31 August 20x6

Folio Debit Credit

Balance sheet section R R
Capital B1 70 000,00
Loan: Gold Bank B2 30 000,00
Bank B3 34 125,00
Tools and equipment B4 35 000,00
Drawings B5 27 000,00
Trading stock B6 1 500,00
Nominal accounts section
Sales N1 35 000,00
Cost of sales N2 28 000,00
Interest on loan N3 375,00
Rent N4 2 000,00
Water and electricity N5 6 000,00
Wages N6 1 000,00
135 000,00 135 000,00

Notes: Trial balance

The trial balance is a summary of all the accounts in the general ledger and their respective
balances or totals.
It is used to check the accuracy of the general ledger, as the total debits must equal the
total credits.

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 Example 2 Cash journals (periodic method)
Assuming that Rosh Traders uses the periodic method of stock valuation, prepare the
following for the month of August 20x6:
Cash receipts and cash payments journals; general ledger and trial balance
Note: Under the periodic method, only sales are recorded in the CRJ, while all goods bought
are recorded under purchases in the CPJ.
Solution

Cash receipts journal of Rosh Traders for August 20x6 FOL. CRJ1
Doc Day Details Fol Analysis of Bank Sales Sundry
no. receipts accounts
Amount Fol Details
rec 1 1 Roshan 70 000,00 70 000,00 70 000,00 B1 Capital
Nunden
rec 2 2 Gold Bank 30 000,00 30 000,00 30 000,00 B2 Loan: Gold
Bank
CRR1 12 Sales 20 000,00 20 000,00 20
000,00
CRR2 18 Sales 15 000,00 15 000,00 15
000,00
135 35 100
000,00 000,00 000,00
B3 N1

Cash payments journal of Rosh Traders for August 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Purchases Wages Sundry
number account
Amount Fol Details
01 5 Equip Ltd 35 000,00 35 B4 Equipment and
000,00 tools
02 7 Nadesan 25 000,00 25 000,00
Suppliers
03 10 Cash 1 500,00 1
500,00
04 15 Naidoo Suppliers 30 000,00 30 000,00
05 17 Cash 1 500,00 1
500,00
06 20 Cash 1 500,00 1 500,00 B5 Drawings
07 24 Cash 1 500,00 1
500,00
08 25 Gold Bank 375,00 375,00 N3 Interest on loan
09 25 Properties Ltd 2 000,00 2 000,00 N4 Rent
10 31 Cash 1 500,00 1
500,00
Municipality 1 000,00 1 000,00 N5 Water and
electricity
100 55 000,00 6 39
875,00 000,00 875,00
B3 N2 N6

General ledger of Rosh Traders for the month of August 20x6

Capital B1

Date Details Fol Amount Date Details Fol Amount

1 Aug Bank CRJ1 70
20x6 000,00
Loan: Gold Bank B2

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 Date Details Fol Amount Date Details Fol Amount
2 Aug Bank CRJ1 30
20x6 000,00
Bank B3
Date Details Fol Amount Date Details Fol Amount
31 Aug Total CRJ1 135 31 Aug Total CPJ1 100
20x6 receipts 000,00 20x6 payments 875,00
Balance c/d 34
125,00
135 135
000,00 000,00
1 Sept Balance b/d 34
20x6 125,00
Tools and equipment B4
Date Details Fol Amount Date Details Fol Amount
5 Aug Bank CPJ1 35
20x6 000,00
Drawings B5
Date Details Fol Amount Date Details Fol Amount
20 Aug Bank CPJ1 1 500,00
20x6
Sales N1
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CRJ1 35
20x6 000,00
Purchases N2
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CPJ1 55
20x6 000,00
Interest on loan N3
Date Details Fol Amount Date Details Fol Amount
25 Aug Bank CRJ1 375
20x6
Rent N4
Date Details Fol Amount Date Details Fol Amount
25 Aug Bank CPJ1 2 000,00
20x6
Water and electricity N5
Date Details Fol Amount Date Details Fol Amount
31 Aug Bank CPJ1 1 000,00
20x6
Wages N6
Date Details Fol Amount Date Details Fol Amount

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 31 Aug Bank CPJ1 6 000,00
20x6

Trial balance of Rosh Traders on 31 August 20x6

Folio Debit Credit

Balance sheet section R R
Capital B1 70 000,00
Loan: Gold Bank B2 30 000,00
Bank B3 34 125,00
Tools and equipment B4 35 000,00
Drawings B5 1 500,00
Nominal accounts section
Sales N1 35 000,00
Purchases N2 55 000,00
Interest on loan N3 375,00
Rent N4 2 000,00
Water and electricity N5 1 000,00
Wages N6 6 000,00
135 000,00 135 000,00

Example 3 Cash and credit journals (perpetual method)

Mr Entrepreneur recently retired from his job. He lives in an area where there are only
informal traders and spaza shops, which sell a limited range of goods. The residents have to
travel at least 20 kilometres to the nearest supermarket. He therefore decides to use his
retirement savings to start a local supermarket, which he names the Convenient Store. He
has found an ideal building suitable for his requirements, i.e. a medium-sized supermarket,
and has entered into a lease agreement with Properties Ltd.
Initially, he decides on operating his business from Monday through to Saturday. However,
should the demand increase, he might consider extending his operating hours to a Sunday.
He has appointed a manager to oversee the business operations, as well as three other
workers. He has also decided to offer certain customers the opportunity to buy on credit but
he will first do a thorough background check on each applicant. To ensure sufficient cash flow
he has opted to buy goods for cash as well as on credit. He will also negotiate with his
prospective creditors for credit terms that are longer than the terms of his debtors.
The following transactions took place during April 20x6, his first month of trading:

1 Mr Entrepreneur deposited R65 000 into a bank account in the name of the business, as
his capital contribution. Paid the rental of R3 000 to Properties Ltd. Paid the water and
electricity of R3 000 to the municipality. Purchased shop fittings on credit from City
Equipment totalling R15 000 and paid a 10% deposit. Purchased stock from XYZ
Traders for R90 000 cash.
2 Purchased stock for resale on credit from Stock Suppliers, R35 311,50. Returned stock
to the value of R311,50 to Stock Suppliers which had been damaged in transit. Bought
packing material to the value of R702 from HS Packaging and paid by cheque. Drew a
cheque for the cash float to the value of R500.
3 Cash sales from the opening day R28 011; cost of sales R22 408,80.
5 Sublet part of the building to Mr P. Gordon and received rental of R750. Cash sales for
the day totalled R18 682,50; cost of sales R14 946.

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 6 Drew cash to pay weekly wages of R2 250.
8 Bought stock to the value of R8 067 from A.Z. Mthembu and paid by cheque.
9 Sold goods on credit to B. Ross R1 039,50; cost of sales R831,60.
12 Purchased computer equipment and office supplies from Bee Wholesalers. The
computer equipment totalled R7 890 and was purchased on credit, while the office
supplies, which totalled R717, were cash a purchase.
13 Sold goods on credit to V. Persad totalling R448,50; cost of sales R358,80. Drew cash to
pay weekly wages of R2 250.
18 Sold goods for cash, R13 185; cost of sales R10 548.
20 Drew a cheque to pay for the following:
Wages R2 250
For the owner’s personal use R1 500
21 Bought stock from B.T. Zenda and paid by cheque, R4 012,50. Sold stock for cash R18
855; cost of sales R15 084. Sold goods on credit to V. Persad R267; cost of sales
R213,60. On the same day, V. Persad returned goods to the value of R100, which were
damaged. Cost price of these goods was R80.
22 B. Ross paid R142,50 on her account and was allowed a discount of R7,50. Sold goods
for cash R15 357; cost of sales R12 285,60.
23 Paid R825 to the local newspaper for advertising.
26 Drew a cheque to pay weekly wages R2 250. Purchased office supplies for R500 on
credit from Bee Wholesalers. Received R448,50 from V. Persad in part payment of her
account.
28 Issued cheques to the following creditors:
Stock Suppliers R30 000
Bee Wholesalers R1 500
City Equipment R1 500
and received a discount of R600, R30 and R30 respectively.
Also issued a cheque to Properties Ltd for the monthly rental of R3 000.
29 Sold goods for cash R25 113; cost of sales R20 090,40. Sold goods on credit to B. Ross
R393; cost of sales R314,40. Mrs Ross paid R300 on her account.
30 Paid the telephone account of R892,50 to Moklet and R3 750 to Mr I.N. Charge, the
manager, for his salary.
31 Sold goods for cash R22 926; cost of sales R18 340,80.

Required
Assuming that the Convenient Store uses the perpetual method to account for its stock,
prepare the following for the month of April 20x6:
a) All the relevant subsidiary journals.
b) Debtors ledger; creditors ledger and general ledger, and extract a trial balance.
Solution
a)

Cash receipts journal of the Convenient Store for April 20x6 FOL. CRJ1
Doc Day Details Fol Analysis Bank Sales Cost Debtors Discount Sundry
no. of of control allowed accounts
receipts sales Amount Fol Details
rec 1 1 Mr 65 65 65 B1 Capital
Entrepreneur 000,00 000,00 000,00
CRR1 3 Sales 28 28 28 22
011,00 011,00 011,00 408,80
rec 2 5 P. Gordon 750,00 750,00 750,00 N4 Rent

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 received
CRR2 Sales 18 18 18 14
682,50 682,50 682,50 946,00
CRR3 18 Sales 13 13 13 10
185,00 185,00 185,00 548,00
CRR4 21 Sales 18 18 18 15
855,00 855,00 855,00 084,00
rec3 22 B. Ross DL1 142,50 142,50 150,00 –7,50
CRR5 Sales 15 15 15 12
357,00 357,00 357,00 285,60
rec4 26 V. Persad DL2 448,50 448,50 448,50
CRR6 29 Sales 25 25 25 20
113,00 113,00 113,00 090,40
rec5 B. Ross DL1 300,00 300,00 300,00
CRR7 31 Sales 22 22 22 18
926,00 926,00 926,00 340,80
208 142 113 898,50 –7,50 65
770,50 129,50 703,60 750,00
B6 N9 N11 B7 N10

Cash payments journal of the Convenient Store for April 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Trading Creditors Discount Wages Sundry
number stock control received account
Amount Fol Details
01 1 Properties 3 3 N1 Rent
Ltd 000,00 000,00
02 Municipality 3 3 N2 Water and
000,00 000,00 electricity
03 City CL1 1 1 500,00
Equipment 500,00
04 XYZ 90 90
Traders 000,00 000,00
05 2 HS 702,00 702,00 N3 Packing
Packaging material
06 Cash 500,00 500,00 B3 Cash float
07 6 Cash 2 2
250,00 250,00
08 8 A.Z. 8 8
Mthembu 067,00 067,00
09 12 Bee 717,00 717,00 N5 Office
Wholesalers supplies
10 13 Cash 2 2
250,00 250,00
11 20 Cash 3 2 1 B5 Drawings
750,00 250,00 500,00
12 21 B.T. Zenda 4 4
012,50 012,50
13 23 Local 825,00 825,00 N6 Advertising
newspaper
14 26 Cash 2 2
250,00 250,00
15 28 Stock CL2 29 30 000,00 –600,00
Suppliers 400,00
16 Bee CL3 1 1 500,00 –30,00
Wholesalers 470,00
17 City CL1 1 1 500,00 –30,00
Equipment 470,00
18 Properties 3 3 N1 Rent
Ltd 000,00 000,00
19 30 Moklet 892,50 892,50 N7 Telephone
20 Manager: 3 3 N8 Salaries
I.N. Charge 750,00 750,00
162 102 34 500,00 –660,00 9 17

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 806,00 079,50 000,00 886,50
B6 B9 B8 N12 N13

Notes: Cash receipts journal and cash payments journal:

When goods are bought or sold on credit an additional folio column is used in the cash
journal.
The additional folio references in the cash journal are for the individual debtor and creditor
accounts in the debtors ledger and creditors ledger.
The individual debtor accounts in the debtors ledger are credited when cash is received
from the debtors.
The individual creditor accounts in the creditors ledger are debited when cash is paid to the
creditors.

Debtors journal of the Convenient Store for April 20x6 FOL. DJ1
Doc Day Details Fol Debtors control Sales Cost of sales
Inv002 9 B. Ross DL1 1 039,50 1 039,50 831,60
Inv003 13 V. Persad DL2 448,50 448,50 358,80
Inv004 21 V. Persad DL2 267,00 267,00 213,60
Inv005 29 B. Ross DL1 393,00 393,00 314,40
2 148,00 2 148,00 1 718,40
B7 N9 N11

Debtors allowances journal of the Convenient Store for April 20x6 FOL. DAJ1
Doc Day Details Fol Debtors allowances Cost of sales
Credit note 1 21 V. Persad DL2 100,00 80,00
100,00 80,00
N14 N11

Notes: Debtors journal and debtors allowances journal:

Credit sales and returns for the month are recorded in date order.
Only the totals of the columns are posted to the general ledger.
The folio references in the debtors journal and debtors allowances journal are for the
individual debtor accounts in the debtors ledger.
The individual debtor accounts in the debtors ledger are debited with the credit sales and
are credited with the returns.
The total of all the debtor balances in the debtors ledger (debtors schedule) must equal the
balance reflected in the general ledger debtors control account.

Creditors journal of the Convenient Store for April 20x6 FOL. CJ1
Doc Day Details Fol Creditors control Trading stock Sundry account
Amount Fol Details
InvF01 1 City Equipment CL1 15 000,00 15 000,00 B2 Shop fittings
InvF02 2 Stock Suppliers CL2 35 311,50 35 311,50
InvF03 12 Bee Wholesalers CL3 7 890,00 7 890,00 B4 Computer equipment
InvF04 26 Bee Wholesalers CL3 500,00 500,00 N5 Office supplies
58 701,50 35 311,50 23 390,00

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 B8 B9

Creditors allowances journal of the Convenient Store for April 20x6 FOL. CAJ1
Doc Day Details Fol Creditors control Trading stock
Debit note 1 2 Stock Suppliers CL2 311,50 311,50
311,50 311,50
B8 B9

Notes: Creditors journal and creditors allowances journal:

Credit purchases and returns for the month are recorded in date order.
Only the totals of the columns are posted to the general ledger.
The folio references in the creditors journal and creditors allowances journal are for the
individual creditor accounts in the creditors ledger.
The individual creditor accounts in the creditors ledger are credited with the credit
purchases and are debited with the returns.
The total of all the creditor balances in the creditors ledger (creditors schedule) must equal
the balance reflected in the general ledger creditors control account.

b)
General ledger of the Convenient Store for the month of April 20x6
Capital B1

Date Details Fol Amount Date Details Fol Amount

1 Bank CRJ1 65
April 000,00
20x6
Shop fittings B2
Date Details Fol Amount Date Details Fol Amount
1 Creditors control CJ1 15
April 000,00
20x6
Cash float B3
Date Details Fol Amount Date Details Fol Amount
2 Bank CPJ1 500,00
April
20x6
Computer equipment B4
Date Details Fol Amount Date Details Fol Amount
12 Creditors control CJ1 7
April 890,00
20x6
Drawings B5
Date Details Fol Amount Date Details Fol Amount
20 Bank CPJ1 1
April 500,00
20x6

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 Bank B6
Date Details Fol Amount Date Details Fol Amount
30 Total receipts CRJ1 208 30 Total payments CPJ1 162
April 770,50 April 806,00
20x6 20x6
Balance c/d 45
964,50
208 208
770,50 770,50
1 Balance b/d 45
May 964,50
20x6
Debtors control B7
Date Details Fol Amount Date Details Fol Amount
30 Sales DJ1 2 21 Debtors DAJ1 100,00
April 148,00 April allowances
20x6 20x6
30 Bank and CRJ1 898,50
April discount
20x6
Balance (must c/d 1
equal the 149,50
balance in the
debtors
schedule)
2 2
148,00 148,00
1 Balance b/d 1
May 149,50
20x6
Creditors control B8
Date Details Fol Amount Date Details Fol Amount
2 Trading stock CAJ1 311,50 30 Total purchases CJ1 58
April April 701,50
20x6 20x6
30 Bank and discount CPJ1 34
April 500,00
20x6
Balance (must c/d 23
equal the balance 890,00
in the creditors
schedule)
58 58
701,50 701,50
1 Balance b/d 23
May 890,00
20x6
Trading stock B9

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 Date Details Fol Amount Date Details Fol Amount
21 Cost of sales DAJ1 80,00 2 Creditors CAJ1 311,50
April April control
20x6 20x6
30 Bank CPJ1 102 30 Cost of sales CRJ1 113
April 079,50 April 703,60
20x6 20x6
Creditors control CJ1 35 Cost of sales DJ1 1
311,50 718,40
Balance c/d 21
737,50
137 137
471,00 471,00
1 Balance b/d 21
May 737,50
20x6
Rent N1
Date Details Fol Amount Date Details Fol Amount
1 Bank CPJ1 3
April 000,00
20x6
28 Bank CPJ1 3
April 000,00
20x6
6
000,00
Water and electricity N2
Date Details Fol Amount Date Details Fol Amount
1 Bank CPJ1 3
April 000,00
20x6
Packing material N3
Date Details Fol Amount Date Details Fol Amount
2 Bank CPJ1 702,00
April
20x6
Rent received N4
Date Details Fol Amount Date Details Fol Amount
5 Bank CRJ1 750,00
April
20x6
Office supplies N5
Date Details Fol Amount Date Details Fol Amount
12 Bank CPJ1 717,00
April
20x6
26 Creditors control CJ1 500,00

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 April
20x6
1
217,00
Advertising N6
Date Details Fol Amount Date Details Fol Amount
23 Bank CPJ1 825,00
April
20x6
Telephone N7
Date Details Fol Amount Date Details Fol Amount
30 Bank CPJ1 892,50
April
20x6
Salaries N8
Date Details Fol Amount Date Details Fol Amount
30 Bank CPJ1 3
April 750,00
20x6
Sales N9
Date Details Fol Amount Date Details Fol Amount
30 Bank CRJ1 142
April 129,50
20x6
30 Debtors control DJ1 2
148,00
144
277,50
Discount allowed N10
Date Details Fol Amount Date Details Fol Amount
30 Debtors control CRJ1 7,50
April
20x6
Cost of sales N11
Date Details Fol Amount Date Details Fol Amount
30 Trading stock CRJ1 113 21 Trading stock DAJ1 80,00
April 703,60 April
20x6 20x6
Trading stock DJ1 1 Total 115
718,40 342,00
115 115
422,00 422,00
Discount received N12
Date Details Fol Amount Date Details Fol Amount
30 Creditors CPJ1 660,00
April control

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 20x6
Wages N13
Date Details Fol Amount Date Details Fol Amount
30 Bank CPJ1 9
April 000,00
20x6
Debtors allowances (sales returns) N14
Date Details Fol Amount Date Details Fol Amount
21 Debtors control DAJ1 100,00
April
20x6

Debtors ledger of the Convenient Store

B. Ross DL1
Date Details Fol Debit Credit Balance
9 April 20x6 Invoice 002 DJ1 1 039,50 1 039,50
22 April 20x6 Receipt 4 CRJ1 142,50 897,00
Discount allowed CRJ1 7,50 889,50
29 April 20x6 Invoice 005 DJ1 393,00 1 282,50
Receipt 5 CRJ1 300,00 982,50

V. Persad DL2
Date Details Fol Debit Credit Balance
13 April 20x6 Invoice 003 DJ1 448,50 448,50
21 April 20x6 Invoice 004 DJ1 267,00 715,50
21 April 20x6 Credit note 1 DAJ1 100,00 615,50
26 April 20x6 Receipt 4 CRJ1 448,50 167,00

Debtors schedule

B. Ross DL1 982,50

V. Persad DL2 167,00
1 149,50

Creditors ledger of the Convenient Store

City Equipment CL1

Date Details Fol Debit Credit Balance
1 April 20x6 Invoice F01 CJ1 1 5000,00 15 000,00
1 April 20x6 Cheque 03 CPJ1 1 500,00 13 500,00
28 April 20x6 Cheque 017 CPJ1 1 470,00 12 030,00
Discount received CPJ1 30,00 12 000,00

Stock Suppliers CL2

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 Date Details Fol Debit Credit Balance
2 April 20x6 Invoice F02 CJ1 35 311,50 35 311,50
2 April 20x6 Debit note 1 CAJ1 311,50 35 000,00
28 April 20x6 Cheque 015 CPJ1 29 400,00 5 600,00
Discount received CPJ1 600,00 5 000,00

Bee Wholesalers CL3

Date Details Fol Debit Credit Balance
12 April 20x6 Invoice F03 CJ1 7 890,00 7 890,00
26 April 20x6 Invoice F04 CJ1 500,00 8 390,00
28 April 20x6 Cheque 016 CPJ1 1 470,00 6 920,00
Discount received CPJ1 30,00 6 890,00

Creditors schedule

City Equipment CL1 12 000,00

Stock Supplies CL2 5 000,00
Bee Wholesalers CL3 6 890,00
23 890,00

Note: The debtors and creditors schedules are a summary of the individual accounts in the
debtors and creditors ledgers.
Trial balance of the Convenient Store on 30 April 20x6

Folio Debit Credit

Capital B1 65 000,00
Shop fittings B2 15 000,00
Cash float B3 500,00
Computer equipment B4 7 890,00
Drawings B5 1 500,00
Bank B6 45 964,50
Debtors control B7 1 149,50
Creditors control B8 23 890,00
Trading stock B9 21 737,50
Rent N1 6 000,00
Water and electricity N2 3 000,00
Packing material N3 702,00
Rent received N4 750,00
Office supplies N5 1 217,00
Advertising N6 825,00
Telephone N7 892,50
Salaries N8 3 750,00
Sales N9 144 277,50

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 Discount allowed N10 7,50
Cost of sales N11 11 5342,00
Discount received N12 660,00
Wages N13 9 000,00
Debtors allowances N14 100,00
234 577,50 234 577,50

Example 4 Cash and credit journals (periodic method)

Assuming that the Convenient Store uses the periodic method to account for its stock,
prepare the following for the month of April 20x6:
a) All the relevant subsidiary journals
b) Debtors ledger, creditors ledger and general ledger, and extract a trial balance
Solution
a)

Cash receipts journal of the Convenient Store for April 20x6 FOL. CRJ1
Doc Day Details Fol Analysis of Bank Sales Debtors Discount Sundry
no. receipts control allowed accounts
Amount Fol Details
rec1 1 Mr 65 000,00 65 65 B1 Capital
Entrepreneur 000,00 000,00
CRR1 3 Sales 28 011,00 28 28
011,00 011,00
rec 2 5 P. Gordon 750,00 750,00 750,00 N4 Rent
received
CRR2 Sales 18 682,50 18 18
682,50 682,50
CRR3 18 Sales 13 185,00 13 13
185,00 185,00
CRR4 21 Sales 18 855,00 18 18
855,00 855,00
rec3 22 B. Ross DL1 142,50 142,50 150,00 –7,50
CRR5 Sales 15 357,00 15 15
357,00 357,00
rec4 26 V. Persad DL2 448,50 448,50 448,50
CRR6 29 Sales 25 113,00 25 25
113,00 113,00
rec5 B. Ross DL1 300,00 300,00 300,00
CRR7 31 Sales 22 926,00 22 22
926,00 926,00
208 142 898,50 –7,50 65
770,50 129,50 750,00
B6 N9 B7 N10

Cash payments journal of the Convenient Store for April 20x6 FOL. CPJ1
Cheque Day Details Fol Bank Purchases Creditors Discount Wages Sundry
number control received account
Amount Fol Details
01 1 Properties 3 3 N1 Rent
Ltd 000,00 000,00
02 Municipality 3 3 N2 Water and
000,00 000,00 electricity
03 City CL1 1 1 500,00
Equipment 500,00
04 XYZ traders 90 90 000,00
000,00

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 05 2 HS 702,00 702,00 N3 Packing
Packaging material
06 Cash 500,00 500,00 B3 Cash float
07 6 Cash 2 2
250,00 250,00
08 8 A.Z. 8 8 067,00
Mthembu 067,00
09 12 Bee 717,00 717,00 N5 Office
Wholesalers supplies
10 13 Cash 2 2
250,00 250,00
11 20 Cash 3 2 1 B5 Drawings
750,00 250,00 500,00
12 21 B.T. Zenda 4 4 012,50
012,50
13 23 Local 825,00 825,00 N6 Advertising
newspaper
14 26 Cash 2 2
250,00 250,00
15 28 Stock CL2 29 30 000,00 –600,00
Suppliers 400,00
16 Bee CL3 1 1 500,00 –30,00
Wholesalers 470,00
17 City CL1 1 1 500,00 –30,00
Equipment 470,00
18 Properties 3 3 N1 Rent
Ltd 000,00 000,00
19 Moklet 892,50 892,50 N7 Telephone
20 Manager: 3 3 N8 Salaries
I.N. Charge 750,00 750,00
162 102 079,50 34 500,00 –660,00 9 17
806,00 000,00 886,50
B6 N11 B8 N12 N13

Debtors journal of the Convenient Store for April 20x6 FOL. DJ1
Doc Day Details Fol Debtors control Sales
Inv002 9 B. Ross DL1 1 039,50 1 039,50
Inv003 13 V. Persad DL2 448,50 448,50
Inv004 21 V. Persad DL2 267,00 267,00
Inv005 29 B. Ross DL1 393,00 393,00
2 148,00 2 148,00
B7 N9

Debtors allowances journal of the Convenient Store for April 20x6 FOL. DAJ1
Doc Day Details Fol Debtors control Sales returns
Credit note 1 21 V. Persad DL2 100,00 100,00
100,00 100,00
B7 N15

Creditors journal of the Convenient Store for April 20x6 FOL. CJ1
Doc Day Details Fol Creditors control Purchases Sundry account
Amount Fol Details
InvF01 1 City Equipment CL1 15 000,00 15 000,00 B2 Shop fittings
InvF02 2 Stock Suppliers CL2 35 311,50 35 311,50
InvF03 12 Bee Wholesalers CL3 7 890,00 7 890,00 B4 Computer equipment

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 InvF04 26 Bee Wholesalers CL3 500,00 500,00 N5 Office supplies
58 701,50 35 311,50 23 390,00
B8 N11

Creditors allowances journal of the Convenient Store for April 20x6 FOL. CAJ1
Doc Day Details Fol Creditors control Purchases returns
Debit note 1 2 Stock Suppliers CL2 311,50 311,50
311,50 311,50
B8 N14

b)
General Ledger of the Convenient Store for the month of April 20x6
Capital B1

Date Details Fol Amount Date Details Fol Amount

1 April Bank CRJ1 65
20x6 000,00
Shop fittings B2
Date Details Fol Amount Date Details Fol Amount
1 April Creditors CJ1 15
20x6 control 000,00
Cash float B3
Date Details Fol Amount Date Details Fol Amount
2 April Bank CPJ1 500,00
20x6
Computer equipment B4
Date Details Fol Amount Date Details Fol Amount
12 April Creditors CJ1 7
20x6 control 890,00
Drawings B5
Date Details Fol Amount Date Details Fol Amount
20 April Bank CPJ1 1
20x6 500,00
Bank B6
Date Details Fol Amount Date Details Fol Amount
30 April Total receipts CRJ1 208 30 April Total CPJ1 162
20x6 770,50 20x6 payments 806,00
Balance c/d 45
964,50
208 208
770,50 770,50
1 May Balance b/d 45
20x6 964,50
Debtors control B7
Date Details Fol Amount Date Details Fol Amount

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 30 April Sales DJ1 2 21 April Bank and CRJ1 898,50
20x6 148,00 20x6 discount
30 April Sales returns DAJ1 100,00
20x6
Balance c/d 1
149,50
2 2
148,00 148,00
1 May Balance b/d 1
20x6 149,50
Creditors control B8
Date Details Fol Amount Date Details Fol Amount
2 April Bank and CPJ1 34 30 April Total CJ1 58
20x6 discount 500,00 20x6 purchases 701,50
30 April Purchases CAJ1 311,50
20x6 returns
Balance c/d 23
890,00
58 58
701,50 701,50
1 May Balance b/d 23
20x6 890,00
Rent N1
Date Details Fol Amount Date Details Fol Amount
1 April Bank CPJ1 3
20x6 000,00
28 April Bank CPJ1 3
20x6 000,00
6
000,00
Water and electricity N2
Date Details Fol Amount Date Details Fol Amount
1 April Bank CPJ1 3
20x6 000,00
Packing material N3
Date Details Fol Amount Date Details Fol Amount
2 April Bank CPJ1 702,00
20x6
Rent received N4
Date Details Fol Amount Date Details Fol Amount
5 April Bank CRJ1 750,00
20x6
Office supplies N5
Date Details Fol Amount Date Details Fol Amount
12 April Bank CPJ1 717,00

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 20x6
26 April Creditors CJ1 500,00
20x6 control
1
217,00
Advertising N6
Date Details Fol Amount Date Details Fol Amount
23 April Bank CPJ1 825,00
20x6
Telephone N7
Date Details Fol Amount Date Details Fol Amount
30 April Bank CPJ1 892,50
20x6
Salaries N8
Date Details Fol Amount Date Details Fol Amount
30 April Bank CPJ1 3
20x6 750,00
Sales N9
Date Details Fol Amount Date Details Fol Amount
30 April Bank CRJ1 142
20x6 129,50
30 Debtors DJ1 2
control 148,00
144
277,50
Discount allowed N10
Date Details Fol Amount Date Details Fol Amount
30 April Debtors CRJ1 7,50
20x6 control
Purchases N11
Date Details Fol Amount Date Details Fol Amount
30 April Bank CPJ1 102
20x6 079,50
Creditors CJ1 35
control 311,50
137
391,00
Discount received N12
Date Details Fol Amount Date Details Fol Amount
30 April Creditors CPJ1 660,00
20x6 control
Wages N13
Date Details Fol Amount Date Details Fol Amount
30 April Bank CPJ1 9

******ebook converter DEMO Watermarks*******

 20x6 000,00
Purchases returns N14
Date Details Fol Amount Date Details Fol Amount
2 April Creditors CAJ1 311,50
20x6 control
Sales returns N15
Date Details Fol Amount Date Details Fol Amount
21 April Debtors DAJ1 100,00
20x6 control

Debtors ledger of the Convenient Store

B. Ross DL1
Date Details Fol Debit Credit Balance
9 April 20x6 Invoice 002 DJ1 1 039,50 1 039,5
22 April 20x6 Receipt 4 CRJ1 142,50 897,00
Discount allowed CRJ1 7,50 889,50
29 April 20x6 Invoice 005 DJ1 393,00 1 282,50
Receipt 5 CRJ1 300,00 982,50

V. Persad DL2
Date Details Fol Debit Credit Balance
13 April 20x6 Invoice 003 DJ1 448,50 448,50
21 April 20x6 Invoice 004 DJ1 267,00 715,50
21 April 20x6 Credit note 1 DAJ1 100,00 615,50
26 April 20x6 Receipt 4 CRJ1 448,50 167,00

Debtors schedule

B. Ross DL1 982,50

V. Persad DL2 167,00
1 149,50

Creditors ledger of the Convenient Store

City Equipment CL1

Date Details Fol Debit Credit Balance
1 April 20x6 Invoice F01 CJ1 15 000,00 15 000,00
1 April 20x6 Cheque 03 CPJ1 1 500,00 13 500,00
28 April 20x6 Cheque 017 CPJ1 1 470,00 12 030,00
Discount received CPJ1 30,00 12 000,00

Stock Suppliers CL2

Date Details Fol Debit Credit Balance
2 April 20x6 Invoice F02 CJ1 35 311,50 35 311,50

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 2 April 20x6 Debit note 1 CAJ1 311,50 35 000,00
28 April 20x6 Cheque 015 CPJ1 29 400,00 5 600,00
Discount received CPJ1 600,00 5 000,00

Bee Wholesalers CL3

Date Details Fol Debit Credit Balance
12 April 20x6 Invoice F03 CJ1 7 890,00 7 890,00
26 April 20x6 Invoice F04 CJ1 500 8 390,00
28 April 20x6 Cheque 016 CPJ1 1 470,00 6 920,00
Discount received CPJ1 30,00 6 890,00

Creditors Schedule

City Equipment CL1 12 000,00

Stock Suppliers CL2 5 000,00
Bee Wholesalers CL3 6 890,00

Trial balance of the Convenient Store on 30 April 20x6

Folio Debit Credit

Capital B1 65 000,00
Shop fittings B2 15 000,00
Cash float B3 500,00
Computer equipment B4 7 890,00
Drawings B5 1 500,00
Bank B6 45 964,50
Debtors control B7 1 149,50
Creditors control B8 23 890,00
Rent N1 6 000,00
Water and electricity N2 3 000,00
Packing material N3 702,00
Rent received N4 750,00
Office supplies N5 1 217,00
Advertising N6 825,00
Telephone N7 892,50
Salaries N8 3 750,00
Sales N9 144 277,50
Discount allowed N10 7,50
Purchases N11 137 391,00
Discount received N12 660,00
Wages N13 9 000,00
Purchases returns N14 311,50

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 Sales returns N15 100,00
234 889,00 234 889,00

TEST YOURSELF 4.1

The accountant of Balance It Ltd has drafted the journals for the month of April 20x5. Using
the information from the journals, draft the debtors control and creditors control accounts.
Balance these accounts on 30 April 20x5.
Column totals of the journals on 30 April 20x5:

Cash receipts journal CRJ4

Sundry Cost of sales Sales Debtors Discount Bank
accounts allowed
27 290 32 400 48 600 42 790 3 210 120
330

Cash payments journal CPJ4

Sundry Trading Wages Creditors Discount Bank
accounts stock received
8 440 16 800 4 000 76 590 4 040 104
490

Debtors journal DJ4

Sales Cost of sales
62 400 41 600

Creditors journal CJ4

Creditors Trading Equipment Stationery Packing Sundry
control stock material accounts
86 970 52 870 17 120 1 840 5 770 9 370

Creditors allowances journal CAJ4

Creditors Trading Equipment Stationery Packing Sundry
control stock material accounts
9 530 4 490 3 020 470 810 740

TUTORIAL EXERCISES: Journals, ledgers and trial balance

Exercise 1
1.1 List and explain the qualitative characteristics of accounting information.
1.2 Indicate whether the statements provided below are true or false:

1.2.1 A business event that has a monetary impact on the financial statements is called
an accounting transaction.
1.2.2 Cash is an important part of every transaction.

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 1.2.3 Credit notes are the source documents used when a creditor returns goods to the
business.
1.2.4 Receipts are used to record all cash payments.
1.2.5 Journals are known as the books of first entry and are used to record transactions
in a standardised format.
1.2.6 The debtors’ allowances journal is used to record all returns made by creditors.
1.2.7 The general ledger contains all the financial activities of the business pertaining to
assets, owner’s equity, liabilities, income and expenses.
1.2.8 The debtors and creditors ledgers are subsidiary ledgers which are used to record
additional details about the debtors control and creditors control accounts.
1.2.9 The purpose of a trial balance is to summarise the debit and credit balances in the
subsidiary ledgers.
1.2.1
0 Retailers can account for their stock using either the perpetual method or the
periodic method.

Exercise 2
Trade It Ltd has been in operation since 20x1. The business has been very profitable over the
last few years. It has retained a large portion of the market because of the high-quality
products that it sells. Its meticulous record-keeping has also assisted in timely decision
making.
The following transactions took place in the month of July 20x9:
1 The owner, Mr Retail, increased his capital contribution by R50 000.
2 The business premises required upgrades for which Mr Retail secured a loan from Lend
It Bank. The loan totalled R20 000 at an interest rate of 15% per annum.
4 Bought replenishment stock on credit from ABC Ltd totalling R11 748 and from XYZ
traders R10 447,50.
5 Sold goods for cash R1 340; cost of sales R1 072.
9 Sold goods on credit to C. James R717; cost of sales R573,60.
10 Paid weekly wages, R500.
13 Sold goods on credit to S. Blair totalling R486, cost of sales R388,80.
17 Paid weekly wages.
19 Bought stock for cash R2 000.
21 Received a cheque of R285 from C. James and allowed him a discount of R15. Sold
goods on credit to C. James R543; cost of sales R434,14.
24 Paid weekly wages.
28 Issued cheques to the following creditors:

ABC Ltd R8 820

XYZ Traders R7 350
and received a discount of R180 and R150 respectively.

29 Received payment from the following debtors:

S. Blair R462 discount allowed R24

C. James R608 discount allowed R32
Paid monthly interest on loan.

30 Paid the monthly rental of R2 000 to Maxre.

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 Paid the municipality R1 500 for water and electricity for the month.
Required
Assuming that Trade It Ltd uses the perpetual method to account for its stock, prepare the
following for the month of July 20x9:
a) All the relevant subsidiary journals
b) Debtors ledger, creditors ledger and general ledger, and extract a trial balance

Exercise 3
Using the same transactions provided in Exercise 2, prepare the following for the month of
July 20x9:
a) All the relevant subsidiary journals
b) Debtors ledger, creditors ledger and general ledger, and extract a trial balance
Assume that Trade It Ltd uses the periodic method to account for its stock.

TEST YOURSELF 4.1 SOLUTION

General Ledger of Balance It Ltd

Balance Sheet Section

Debtors control B7
Date Details Fol Amount Date Details Fol Amount
20.5 30 Sales DJ4 62 20.5 30 Bank and CRJ4 42
April 400,00 April discount 790,00
Balance c/d 19
610,00
62 62
400,00 400,00
20.5 1 Balance b/d 19
May 610,00

Creditors control B8
Date Details Fol Amount Date Details Fol Amount
20.5 30 Trading stock CAJ4 9 20.5 30 Total CJ4 86
April 530,00 April Purchases 970,00
Bank and CPJ4 76
discount 590,00
Balance c/d 850,00
86 86
970,00 970,00
20.5 1 Balance b/d 850,00
May

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 Accounting Cycle: Basic Financial Statements

Example 1 Perpetual method (basic financial statements)

Trial balance of Weesel Stores on 31 December 20x1

R
Capital 57 300
Drawings 7 500
Equipment 68 000
Accumulated depreciation on equipment 10 200
Loan (7,5% p.a.) 30 000
Trading stock 17 200
Fixed deposit (12% p.a.) 10 000
Debtors control (trade receivables) 15 400
Creditors control (trade payables) 16 300
Bank 6 200
Sales 135 000
Cost of sales 90 000
General expenses 8 000
Wages and salaries 24 500
Interest income 250
Interest on loan 2 250

Required
Prepare the financial statements of Weesel Stores; its financial year-end is 31 December
20x1.

Solution
Weesel Stores
Statement of profit or loss and other comprehensive income for the year ended 31
December 20x1

R R
Sales (revenue) 135 000
Less: Cost of sales 90 000
Gross profit for the year 45 000
Add: Other income 250
Interest income 250
Gross income for the year 45 250
Less: Operating expenses 34 750
General expenses 8 000
Wages and salaries 24 5004
Less: Interest on loan (finance cost) 2 250

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 Net profit for the period 10 500

The profit for the period belongs to the owner and is reflected in the statement of changes in
equity.
Notes:

The interest income and interest expense items are shown separately. The purpose is to
indicate the income generated and expenses incurred from normal operations.
Other comprehensive income includes revaluation surplus on land, which is beyond the
scope of this book.

Weesel Stores
Statement of financial position at 31 December 20x1

Assets Notes R R
Non-current assets 2 67 800
Equipment 57 800
Fixed deposit (12% p.a.) 10 000
Current assets 38 800
Stock 17 200
Debtors 15 400
Bank 6 200
Total assets 106 600
Equity
Owner’s equity 60 300
Non-current liabilities 30 000
Loan (7,5% p.a.) 30 000
Current liabilities 16 300
Creditors 16 300
Total equity and liabilities 106 600

Weesel Stores
Statement of changes in equity for the year ended 31 December 20x1

Capital R57 300

+ Net profit for the period R10 500
– Drawings (R7 500)
R60 300

The R60 300 is reflected on the face of the statement of financial position as owner’s equity.
Notes of Weesel Stores for the year ended 31 December 20x1

Note 1: Accounting policies

The financial statements have been prepared in accordance with generally accepted
guidelines laid down in the International Financial Reporting Standards (IFRS). The
financial statements have used accounting policies that are consistent with previous
financial periods.
Note 2: Non-current assets

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 Cost Accumulated depreciation Book value/carrying value
R R R

Equipment 68 000 10 200 57 800

Example 2 Periodic method (basic financial statements)

Trial balance of Hobbit Traders on 31 March 20x2

R
Capital 106 100
Drawings 12 500
Vehicles 55 000
Accumulated depreciation on vehicles 5 500
Equipment 30 000
Accumulated depreciation on equipment 3 000
Shares: JSE 8 500
Stock (1 April 20x1) 20 000
Debtors control 6 365
Creditors control 5 900
Bank 12 065
Cash float 380
Sales 126 766
Purchases 90 545
Consumable stores 725
Stationery expenses 1 934
Rent income 3 170
Wages 11 475
General expenses 947

Additional information
Stock on hand at 31 March 20x2 was R10 000.

Required
Prepare the financial statements for Hobbit Traders.

Solution
Hobbit Traders
Statement of profit or loss and other comprehensive income for the year ended 31
March 20x2

R R
Sales 126 766
Less: Cost of sales 100 545
Opening stock 20 000

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 Add: Purchases 90 545
Goods available for sale 110 545
Less: Closing stock 10 000
Gross profit for the year 26 221
Add: Other income 3 170
Rent income 3 170
Gross income for the year 29 391
Less: Operating expenses 15 081
Consumable stores 725
Stationery 1 934
Wages 11 475
General expenses 947
Net profit for the period 14 310

Note: Since the business has no external financing, finance costs were not included in the
statement of profit or loss and other comprehensive income.
Hobbit Traders
Statement of financial position as at 31 March 20x2

Assets Notes R R
Non-current assets 2 85 000
Vehicles 49 500
Equipment 27 000
Shares: JSE 8 500

Current assets 28 810

Stock 10 000
Debtors 6 365
Bank 12 065
Cash float 380
Total assets 113 810

Equity and liabilities 107 910

Owner’s equity 107 910
Non-current liabilities –
Current liabilities 5 900
Creditors 5 900
Total equity and liabilities 113 810

Hobbit Traders
Statement of changes in equity for the year ended 31 March 20x2

Capital R106 100

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 + Net profit for the period R 14 310
– Drawings (R12 500)
R107 910

Notes of Hobbit Traders for the year ended 31 March 20x2

Note 1: Accounting policies

The financial statements have been prepared in accordance with generally accepted
guidelines laid down in the International Financial Reporting Standards (IFRS). The
financial statements have used accounting policies that are consistent with previous
financial periods.
Note 2: Non-current assets
Cost Accumulated depreciation Book value/carrying value
R R R

Vehicles 55 000 5 500 49 500

Equipment 30 000 3 000 27 000
85 000 8 500 76 500

When the periodic method is used, there are various items that affect the purchases and
sales accounts.

Items affecting the purchases account are as follows:

Carriage on purchases
The cost of transporting goods purchased to the business premises is called “carriage on
purchases”, which increases the value of the purchases.
Alternative terms used for carriage on purchases are

railage on purchases
railage in
freight in.

Purchases returns
This item arises when a business returns goods previously purchased to the supplier.
Purchases returns decrease the value of the purchases.
The alternative term used for purchases returns is “returns outwards”.

Customs/import duties
This is the cost of bringing goods into the country.

Items affecting the sales account are as follows:

Sales returns
This item arises when clients return goods previously sold to them. Sales returns decrease
the value of the sales. The alternative term used for sales returns is “returns inwards”.

Carriage on sales
This is the cost incurred in transporting the goods sold to the client. Carriage on sales is
treated as a normal operating expense, that is, it is used in the calculation of the net profit
and not the gross profit. It does not increase the value of sales.

Note: Carriage on sales does not affect the sales account.

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 Alternative terms used for carriage on sales are

railage on sales
railage out
freight out.

Example 3 Periodic method items affecting purchases and sales

Below is an extract from the books of Black Traders as at 31 December 20x1, the end of their
financial period.

Sales R155 000

Purchases 82 000
Sales returns 5 000
Purchases returns 2 000
Carriage on purchases 3 000
Carriage on sales 1 500
Stock (1/1/20x1) 50 000

A physical stocktaking on 31 December 20x1 revealed that stock to the value of R45 000 was
on hand.

Required
Calculate the gross profit for the period. Indicate how carriage on sales will be disclosed.

Solution
Calculation of gross profit for the period

R R
Net sales (R155 000 – R5 000) 150 000
Less: Cost of sales 88 000
Opening stock 50 000
Add: Net purchases (R82 000 – R2 000) 80 000
Add: Carriage on purchases 3 000
Goods available for sale 133 000
Less: Closing stock 45 000
Gross profit for the period 62 000
Less: Operating expenses 1 500
Carriage on sales 1 500
Net profit for the period 60 500

Note: Carriage on sales was not added to the sales figure and therefore had no effect on the
calculation of gross profit.

TEST YOURSELF 4.2

Trial balance for Simba’s Hardware on 30 June 20x2 is given below.

Debit R Credit R

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 Capital 121 000
Drawings 34 000
Loan: Helpful Bank 30 000
Vehicles 72 000
Equipment 67 300
Stock (1/7/20x1) 17 500
Debtors 8 400
Creditors 10 900
Bank 1 780
Cash float 250
Sales 197 320
Purchases 111 000
Carriage in 2 700
Advertising 4 600
Consumable stores 7 300
Hire income 2 200
Interest on loan 5 400
Salaries and wages 26 790
Stationery 500
Sundry expenses 1 900
361 420 361 420

The stock at 30 June 20x2 was R21 000.

Required
Draft the following financial statements:
a) The statement of profit or loss and other comprehensive income for the year ended 30
June 20x2.
b) The statement of financial position at 30 June 20x2.

TUTORIAL EXERCISES

Exercise 4
Trial balance for Shiloh Clothing on 28 February 20x2

R
Capital 98 000
Drawings 14 500
Premises 70 000
Vehicles 12 500
Equipment 12 100
Loan PBS (17% p.a.) 8 000

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 Mortgage bond (15% p.a.) 10 000
Shares JSE 850
Accounts receivable 1 500
Accounts payable 14 500
Trading stock 13 250
Cash float 250
Bank 21 750
Sales 63 750
Cost of sales 42 500
Advertising 540
Bank charges 165
Dividends received 30
Interest paid 2 860
Electricity and water 160
Licence 225
Rent income 7 200
Wages 7 920
Stationery and postage 140
Telephone 270

Required
Prepare the annual financial statements for Shiloh Clothing.

Exercise 5
T. Green drew up the following trial balance as at 30 September 20x8. You have to draft a
statement of profit or loss and other comprehensive income for the year to 30 September
20x8 and a statement of financial position as at that date. Provide all relevant notes where
applicable.

Debit Credit
R R
Capital 61 910
Drawings 16 840
Cash at bank 6 820
Trading stock 54 950
Debtors 24 600
Creditors 18 740
Motor vehicle 8 200
Office equipment 12 500
Sales 261 800
Cost of sales 176 886
Return inwards (sales returns) 1 100
Carriage outwards (carriage on sales) 618

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 Debit Credit
R R
Motor expenses 3 260
Rent 5 940
Telephones charges 810
Wages and salaries 25 620
Insurance 984
Office expenses 2 754
Sundry expenses 568
342 450 342 450

Exercise 6
Trial balance for V. Yearwood on 30 September 20x6

Debit Credit
R R
Inventory 1 October 20X5 4 736
Carriage outwards (carriage on sales) 400
Carriage inwards (carriage on purchases) 620
Return inwards (sales returns) 410
Return outwards (purchases returns) 644
Purchases 23 748
Sales 37 200
Salaries and wages 7 724
Rent 608
insurance 156
Motor expenses 1 328
Office expenses 432
Lighting and heating expenses 332
General expenses 628
Premises 10 000
Motor vehicles 3 600
Fixtures and fittings 700
Debtors 7 792
Creditors 3 462
Cash at bank 964
Drawings 2 400
Capital 25 272
66 578 66 578

Inventory as at 30 September 20x6 was R5 892.

Required

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 From the trial balance provided above prepare the financial statements for V. Yearwood.

Exercise 7
The following trial balance was extracted from the books of A. Maharaj on 30 April 20x7.
From it, prepare the statement of profit and loss and other comprehensive income and a
statement of financial position with all the relevant notes.

Debit Credit
R R
Sales 37 200
Purchases 23 112
Inventory 1 May 20x6 7 552
Carriage outwards (carriage on sales) 652
Carriage inwards (carriage on purchases) 468
Return inwards (sales returns) 880
Return outwards (purchases returns) 710
Salaries and wages 4 894
Motor expenses 1 328
Rent 1 152
Sundry expenses 2 404
Motor vehicles 4 800
Fixtures and fittings 1 200
Debtors 9 154
Creditors 6 090
Cash at bank 7 992
Drawings 4 100
Capital 25 688
69 688 69 688

Inventory as at 30 April 20x7 was R9 996.

Exercise 8
You are required to prepare the financial statement for D. Small using the trial balance
provided below.
Trial balance for D. Small on 31 March 20x6

Debit Credit
R R
Inventory 1 April 20x5 36 320
Sales 184 680
Purchases 138 370
Carriage inwards (carriage on purchases) 840
Carriage outwards (carriage on sales) 3 140
Return outwards (purchases returns) 1 280

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 Debit Credit
R R
Wages and salaries 20 480
Rent and rates 6 030
Communication expenses 1 248
Commissions payable 432
Insurance 810
Sundry expenses 636
Building 40 000
Debtors 28 640
Creditors 16 320
Fixtures 5 700
Cash at bank 6 170
Drawings 15 240
Capital 101 776
304 056 304 056

Inventory as at 31 March 20x6 was R44 780.

TEST YOURSELF SOLUTIONS

TEST YOURSELF 4.2 SOLUTION

Simba’s Hardware
Statement of profit or loss and other comprehensive income for the year ended 30 June 20x2

R R
Sales 197 320
Less: Cost of sales 110 200
Opening stock 17 500
Add: Purchases 111 000
Add: Carriage in 2 700
Goods available for sale 131 200
Less: Closing stock 21 000
Gross profit for the year 87 120
Add: Other income 2 200
Hire income 2 200
Gross income for the year 89 320
Less: Operating expenses 41 090
Advertising 4 600
Consumable stores 7 300
Salaries and wages 26 790
Stationery 500
Sundry expenses 1 900
Less: Interest on loan 5 400
Net profit for the year 42 830

Simba’s Hardware

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 Statement of financial position as at 30 June 20x2

Notes R R
Non-current assets 2
Vehicles 72 000
Equipment 67 300
139 300
Current assets 31 430
Stock 21 000
Debtors 8 400
Bank 1 780
Cash float 250
TOTAL ASSETS 170 730
Equity and liabilities
Owner’s equity 129 830
Non-current liabilities 30 000
Loan: Helpful Bank 30 000
Current liabilities 10 900 10 900
Creditors
TOTAL EQUITY AND LIABILITIES 170 730

Simba’s Hardware
Statement of changes in equity for the year ended 30 June 20x2

Capital R 121 000

Add: Net profit for the year R 42 830
Less: Drawings R 34 000
R 129 830

Notes for Simba’s Hardware for the year ended 30 June 20x2:

Note 1: Accounting policies

The financial statements have been prepared in accordance with generally accepted guidelines laid down in the
International Financial Reporting Standards (IFRS). The financial statements have used accounting policies that are
consistent with previous financial periods.
Note 2: Non-current assets
Cost price Accumulated depreciation Book value
R R R
Vehicles 72 000 72 000
Equipment 67 300 67 300
139 300 139 300

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 5 Basic financial statements with year-end
adjustments

Outcomes

At the end of this chapter students should be able to

journalise the following adjustments:

– depreciation
– allowances for credit losses
– prepaid expenses
– accrued expenses
– accrued income
– income received in advance

draft the financial statements after the year-end adjustments have been taken
into account
make the closing transfers at the end of the accounting period.

Chapter outline

5.1 Year-end adjustments

5.1.1 Depreciation
5.1.2 Allowance for credit losses
5.1.3 Prepaid expenses
5.1.4 Accrued expenses
5.1.5 Accrued income
5.1.6 Income received in advance
5.2 Closing process

5.1 Year-end adjustments

Adjustments are made at the end of the accounting period in order to correct mistakes and to
update account balances. These changes arise due because the financial statements are prepared
on the accrual basis. The accrual basis states that all transactions must be recorded when they
occur and not only when cash is received or paid out. However, in order to calculate the net
profit for the period, all income and expenses for the accounting period must be taken into
account; this is in line with the matching concept. The matching concept requires that all income
generated and expenses incurred in a specific accounting period must be reflected in the same

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 period regardless of whether or not they have been received or paid. Year-end adjustments are
made at the end of the accounting period to ensure that the financial statements are a true
reflection of the business’s accounts.

The following adjustments are made at year-end:

Depreciation
Allowance for credit losses
Prepaid expenses
Accrued expenses
Accrued income
Income received in advance/prepaid income

5.1.1 Depreciation
When a business buys an item such as a vehicle or equipment, the cost is treated as an asset and
not as an expense, which decreases the owner’s equity.

These assets are acquired to be utilised over a period of years. With use, the asset is likely to
lose value through wear and tear. This loss should be allocated to the financial year in which the
asset was used to generate income. For fair presentation, this should be recorded as an expense
for that year and the value of the asset should be decreased accordingly. This is done to match
the income earned with the expense incurred in earning that income.

This allocated expense is called depreciation. The basics that underlie depreciation are the
following:

The asset should be used to generate income in the course of conducting business.
The expense should be fairly allocated over the lifetime of the asset.
The asset should be fairly presented in the statement of financial position, that is, at book
value/carrying value.

Depreciation is an expense which affects the statement of profit or loss and other comprehensive
income; it is a non-cash item, as no cheque is issued.

ILLUSTRATIVE EXAMPLES

Example 1 Depreciation
A business has equipment which costs R10 000. Provide for depreciation of R1 000 on
equipment.
Solution
Two accounts are affected (double-entry principle):

1. Depreciation (an expense which appears in the statement of profit or loss and other
comprehensive income)
2. Accumulated depreciation on equipment (a negative asset which appears in the
statement of financial position)

Debit Credit

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 Depreciation (+) R1 000
Accumulated depreciation on equipment (+) R1 000

Methods for calculating depreciation

There are many ways of calculating depreciation, but for the purpose of this book we will only
be covering two methods, namely the straight-line method and the reducing balance method.

The straight-line method. This method is also known as the cost method or fixed instalment
method. In terms of this method an equal or fixed amount of depreciation is written off each
year. The depreciation to be written off each year is calculated as a fixed percentage of the
cost of the asset.
The reducing balance method. This method is also known as the diminishing balance
method. This is an accelerated method because more depreciation is written off in the
earlier years. The reason for this is that the asset is likely to require more repair expenses
in later years. In this way the costs are smoothed out over the lifetime of the asset. The
depreciation to be written off each year is calculated as a fixed percentage of the book
value/carrying value (cost less accumulated depreciation) of the asset.

Example 2 Depreciation
The following balances were extracted from the books of SS Stores as at 28 February 20x2:

Vehicles at cost R120 000

Accumulated depreciation on vehicles R33 300
Equipment at cost R70 000
Accumulated depreciation on equipment R42 000

Adjustments

1. Depreciation on vehicles must be provided for at 15% per annum using the reducing
balance method.
2. Depreciation on equipment must be provided for at 10% per annum using the fixed
instalment method.

Required
Prepare the journal entry for depreciation and indicate how the following will be shown in the
statement of profit or loss and other comprehensive income, as well as the statement of
financial position:

Accumulated depreciation on vehicles

Accumulated depreciation on equipment
Depreciation

Solution
Workings:
Calculation of depreciation on vehicles

Book value = Cost – Accumulated depreciation on vehicles

= R120 000 – R33 300
= R86 700
Depreciation = Book value × 15%
= R86 700 × 15% = R13 005
Calculation of depreciation on equipment
Cost = R70 000
Depreciation = R70 000 × 10% = R7 000

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 Total depreciation for the period is therefore R13 005 + R7000 = R20 005

Debit Credit
Depreciation (+) (R13 005 + R7 000) R20 005
Accumulated depreciation on vehicles (+) R13 005
Accumulated depreciation on equipment (+) R 7 000

Statement of profit or loss and other comprehensive income

Less: Operating expenses

Depreciation (R13 005 + R7 000) R20 005

Statement of financial position

Non-current assets
Accumulated depreciation on vehicles (R33 300 + R13 005) = R46 305
Accumulated depreciation on equipment (R42 000 + R7 000) = R49 000

TUTORIAL EXERCISE Year-end adjustments: depreciation

Exercise 1
The following balances were extracted from the books of TKZ Stores as at 30 June 20x2.

Furniture and fittings at cost R42 000

Accumulated depreciation on furniture and fittings R6 300
Vehicles at cost R35 000
Accumulated depreciation on vehicles R18 000

Adjustments

1. Depreciation on vehicles must be provided for at 20% per annum using the straight-line
method.
2. Depreciation on furniture and fittings must be provided for at 15% per annum using the
reducing balance method.

Required
Prepare the journal entry for depreciation and indicate how the following will be shown in the
statement of profit or loss and other comprehensive income, as well as the statement of
financial position:

Accumulated depreciation on furniture and fittings

Accumulated depreciation on vehicles
Depreciation

5.1.2 Allowance for credit losses

When preparing financial statements, the accountant will be conscious of the fact that some of
the debtors included in the debtors control balance are unlikely to settle their accounts; they are
doubtful debts.

It would be prudent for the accountant to provide for this eventuality and reflect a reduced
amount for debtors in the statement of financial position. By providing for the anticipated credit

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 losses, the accountant will avoid giving the reader of the financial statements a misleading
impression of the value of the business assets. This is in line with the accounting concept called
prudence (the doctrine of conservatism).

In providing for these anticipated credit losses or doubtful debts, the accountant will also be
attempting to ensure the satisfactory matching of the year’s income from credit sales with the
expenses incurred in earning that income (debts not settled).

The accountant must anticipate the percentage of debtors who are in doubt. How much to
provide for doubtful debts is usually based on past experience and the economic climate.

The following are typical transactions encountered with regard to doubtful debts:

Writing off credit losses when an allowance for credit losses account does not exist
The creation of an allowance for credit losses
Increasing the allowance for credit losses
Decreasing the allowance for credit losses
Writing off credit losses when an allowance for credit losses account does exist

Note: Since the allowance for credit losses is merely an estimate, it is likely that this estimate
will not be 100% correct; consequently, from year to year this estimate will have to be adjusted;
that is, either increased or decreased.

5.1.2.1 Writing off credit losses when an allowance for credit losses account
does not exist
Debit: credit losses (expense item) will increase.

Credit: debtors control (current asset) will decrease.

5.1.2.2 The creation of an allowance for credit losses

Debit: credit losses (expense item) will increase.

Credit: allowance for credit losses (negative asset) will increase.

5.1.2.3 Increasing the allowance for credit losses

Debit: credit losses (expense item) will increase.

Credit: allowance for credit losses (negative asset) will increase.

5.1.2.4 Decreasing the allowance for credit losses

Debit: allowance for credit losses (negative asset) will decrease.

Credit: credit losses (expense item) will decrease.

5.1.2.5 Writing off credit losses when an allowance for credit losses account
does exist
Debit: allowance for credit losses (negative asset) will decrease.

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 Credit: debtors control (current asset) will decrease.

ILLUSTRATIVE EXAMPLE: Allowance for credit losses

The following balances appeared among others in the books of EE Traders as at 30 June
20x3, the last day of the financial year:

Debtors R50 700

Allowance for credit losses R2 500

Adjustments

1. J. James, who owes the business R700, has been declared insolvent and his debt must
be written off.
2. Adjust the allowance for credit losses to 8% of outstanding debtors.

Required
Prepare the journal entry and indicate how the following accounts will be shown in the
statement of profit or loss and other comprehensive income, as well as the statement of
financial position:

Debtors control
Allowance for credit losses
Credit losses

Solution
Step 1
Before the allowance for credit losses account can be adjusted, any outstanding credit losses
must be written off. Since the allowance for credit losses account exists, the journal entry is
as follows:

Debit Credit
Allowance for credit losses R700
Debtors control R700

Step 2
After writing off credit losses, adjust the allowance for credit losses to 8% of outstanding
debtors. The calculation is as follows:

Outstanding debtors are = R50 000 (R50 700 – R700)

Allowance for credit losses should be 8% of outstanding debtors = R4 000 (R50 000 × 8%)
Currently the allowance for credit losses is = R1 800 (R2 500 – 700)

Therefore, the allowance for credit losses must be increased by R2 200 in order to equal R4
000 (i.e. R4 000 – R1 800 = R2 200).
Increasing the allowance for credit losses
Journal entry

Debit Credit
Credit losses R2 200
Allowance for credit losses R2 200

Change (increase) in the allowance for credit losses of R2 200.

In conclusion, the balances/totals on the above accounts are as follows:

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 Debtors control R50 000 (current asset)
Allowance for credit losses R4 000 (negative asset)
Credit losses R2 200 (expense item)

Statement of profit or loss and other comprehensive income

Less: Operating expenses
Credit losses R2 200

Statement of financial positio

Current assets R46 000
Debtors R50 000
Less: Allowance for credit losses R4 000

TUTORIAL EXERCISE Year-end adjustment: allowance for credit losses

Exercise 2
The following balances appeared among others in the books of ZZ Traders at 28 February
20x1, the last day of the financial year:

Debtors control account R58 200

Allowance for credit losses R2 150
Credit losses R9 360

Adjustments

1. I. Isaac, who owes the business R640, has been declared insolvent and his debt must be
written off.
2. Adjust the allowance for credit losses to 5% of outstanding debtors.

Required
Prepare the journal entry and indicate how the following accounts will be shown in the
statement of profit or loss and other comprehensive income and the statement of financial
position:

1. Debtors control
2. Allowance for credit losses
3. Credit losses

5.1.3 Prepaid expenses

Prepaid expenses refer to payments that you have made in one accounting period even though
some of them are only due in the next accounting period. Even though the expense was made in
full, only the part due for payment in the current accounting period should be matched to the
income for the current accounting period.

ILLUSTRATIVE EXAMPLE

The following information was extracted from the records of ABC Traders for the financial
year ended 28 February 20x1:

Insurance R13 000

Additional information The insurance was paid until 31 March 20x1

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 Required
Prepare the journal entry and show the effect of the transaction on the statement of profit and
loss and other comprehensive income, as well as the statement of financial position.
Journal entry

Debit Credit
Prepaid expenses R1 000
Insurance R1 000

Notes: The insurance was paid from 1 March 20x0 to 31 March 20x1 (13 months). Therefore,
the insurance per month equals R1 000 (R13 000/13 months). The amount of R1 000 which
relates to the next accounting period, but has been paid in the current accounting period, is
the prepaid expense. The insurance is an expense account that is credited because it must
decrease, and the prepaid expense is debited because it is an asset account which
increased.

Statement of profit or loss and other comprehensive income

Less: Operating expenses
Insurance (R13 000 – R1 000) R12 000

Statement of financial position

Current assets
Prepaid expenses R1 000

5.1.4 Accrued expenses

These refer to expenses that have been incurred in the current accounting period, but have not
been paid for. These expenses have to be written off against the income of the current
accounting period, even though they have not yet been paid.

ILLUSTRATIVE EXAMPLE

The following information was extracted from the records of ABC Traders for the financial
year ended 28 February 20x1.

Water and electricity R5 500

Additional information The water and electricity for February 20x1 is still due

Required
Prepare the journal entry and show the effect of the transaction on the statement of profit and
loss and other comprehensive income, as well as the statement of financial position.
Journal entry

Debit Credit
Water and electricity R500
Accrued expenses R500

Notes: The water and electricity were paid from 1 March 20x0 to 31 January 20x1 (11
months). Therefore, the water and electricity per month equals R500 (R5 500/11 months).
The amount of R500 which relates to the current accounting period, but has not been paid, is
the accrued expense. Water and electricity is an expense account that is debited because it
must increase, and accrued expenses is credited because it is a liability account which
increased.

Statement of profit or loss and other comprehensive income

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 Less: Operating expenses
Water and electricity (R5 500 + 500) R6 000

Statement of financial position

Current liabilities
Accrued expenses R500

5.1.5 Accrued income

This refers to income that you have earned during the current accounting period, but have not
yet received. This income must be recorded in full in the current accounting period, even though
it has not yet been received.

ILLUSTRATIVE EXAMPLE

The following information was extracted from the records of ABC Traders for the financial
year ended 28 February 20x1.

Rent received R22 000

Additional information The rent has only been received for 11 months

Required
Prepare the journal entry and show the effect of the transaction on the statement of profit and
loss and other comprehensive income, as well as the statement of financial position.
Journal entry

Debit Credit
Accrued income R2 000
Rent R2 000

Notes: The rent was received from 1 March 20x0 to 31 January 20x1 (11 months). Therefore,
the rent per month equals R2 000 (R22 000 / 11 months). The amount of R2 000, which has
not been received, relates to the current accounting period, and is accrued income. Rent is an
income account that is credited because it must increase, and accrued income is debited
because it is an asset account which increased.

Statement of profit or loss and other comprehensive income

Add: Other income
Rent (R22 000 + R2 000) R24 000

Statement of financial position

Current assets
Accrued income R2 000

5.1.6 Income received in advance

This refers to income that you have received in advance (that is, before it is due). In terms of the
matching principle only the income generated for the current accounting period should be
recorded in the statement of profit or loss and other comprehensive income and the prepaid
amount should be deferred or transferred to the next accounting period as a current liability in
the statement of financial position.

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 ILLUSTRATIVE EXAMPLE

The following information was extracted from the records of ABC Traders for the financial
year ended 28 February 20x1.

Rent received R26 000

Additional information The rent received includes March 20x1

Required
Prepare the journal entry and show the effect of the transaction on the statement of profit and
loss and other comprehensive income, as well as the statement of financial position.
Journal entry

Debit Credit
Rent received R2 000
Income received in advance R2 000

Notes: The rent was received for 1 March 20x0 to 31 March 20x1 (13 months). Therefore, the
rent per month equals R2 000 (R26 000/13 months). The amount of R2 000 which has been
received in advance relates to the next accounting period and is income received in advance.
Rent is an income account that is debited because it must decrease, and income received in
advance is credited because it is a liability account which increased.

Statement of profit or loss and other comprehensive income

Add: Other income
Rent (R26 000 – R2 000) R24 000

Statement of financial position

Current liability
Income received in advance R2 000

5.2 Closing process

Once all the year-end adjustments have been dealt with, the closing-off process takes place. The
purpose of this process is to close off all the income and expense accounts for the period in
order to determine the profit or loss for the period. No totals remain in these accounts and a
clean start can be made in the next financial period. The main accounts involved in this process
are the trading account, and the profit and loss account. The closing-off process is summarised
in steps 1 to 4.

Step 1: Close off the sales and cost of sales accounts to the trading account, in order to
determine the gross profit for the period.

Trading account
Cost of sales xxx Sales xxx
Profit and loss account (gross xxx
profit)
xxx xxx

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 Step 2: Transfer the gross profit calculated in the trading account to the profit and loss account.

Step 3: Close off all the income and expense accounts to the profit and loss account, and
determine the net profit or loss for the period.

Step 4: The net profit is transferred to the capital account, since it belongs to the owner.

Profit and loss account

All expense accounts xxx Trading (gross profit) xxx
Capital (net profit) xxx All income accounts xxx

xxx xxx

TEST YOURSELF 5.1

The following balances were, inter alia, taken from the ledger of Hot Chicks on 28 February
20x3.

R
Purchases 364 965
Carriage on sales 5 642
Discount received 3 690
Rates and taxes 4 320
Salaries and wages 67 420
Rent received 13 200
Sales 564 369
Telephone 3 622
Stationery 2 913
Carriage on purchases 3 696
Returns inwards 5 729
Furniture at cost 24 364
Allowance for credit losses 3 600
Accumulated depreciation on furniture 1 464
Accumulated depreciation on plant 13 000
Repairs 995
Insurance 1 985
Credit losses 1 365
Debtors 74 965
Drawings 14 360
Plant at cost 73 000
Stock (1/3/02) 36 982

Additional information

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 1. Stock on 28 February 20x3 amounted to R42 029.
2. Provide depreciation as follows: Furniture – 10% per annum using reducing balance
method, Plant – 20% per annum using straight-line method.
3. Write off a debtor to the value of R965 as irrecoverable.
4. Adjust the allowance of credit losses to 5% of outstanding debtors.

Required
Prepare a statement of profit or loss and other comprehensive income for the year ended 28
February 20x3.

TUTORIAL EXERCISES

Exercise 1
Indicate in the spaces that follow whether the following accounts must appear in the
statement of profit or loss and other comprehensive income, or the statement of financial
position:

Purchases Loan: ABC Bank

Prepaid income Depreciation (year)
Debtors Refreshments
Wages Equipment
Rent paid Accumulated depreciation
Interest received Drawings
Unused stationery Prepaid expenses
Accrued income Accrued expenses

Exercise 2
The following balances were extracted from the books of TKZ Stores as at 30 June 20x2.

Furniture and fittings at cost R42 000

Accumulated depreciation on furniture and fittings R6 300
Vehicles at cost R35 000
Accumulated depreciation on vehicles R18 000

Adjustments

1. Depreciation on vehicles must be provided for at 20% per annum using the straight-line
method.
2. Depreciation on furniture and fittings must be provided for at 15% per annum using the
reducing balance method.

Required
Prepare the journal entry for depreciation and indicate how the following will be shown in the
statement of profit or loss and other comprehensive income, as well as the statement of
financial position:

Accumulated depreciation on furniture and fittings

Accumulated depreciation on vehicles
Depreciation

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 Exercise 3
The following balances appeared among others in the books of ZZ Traders as at 28 February
20x1, the last day of the financial year:

Debtors control account R58 200

Allowance for credit losses R2 150
Credit losses R9 360

Adjustments

1. I. Isaac, who owes the business R640, has been declared insolvent and his debt must be
written off.
2. Adjust the allowance for credit losses to 5% of outstanding debtors.

Required
Prepare the journal entry and indicate how the following accounts will be shown in the
statement of profit or loss and other comprehensive income and the statement of financial
position:

Debtors control
Allowance for credit losses
Credit losses

Exercise 4
The following trial balance was extracted from the books of A Shabalala at the close of
business on 28 February 20x7.

Debit Credit
R R
Sales 394 800
Purchases 225 600
Cash at bank 22 800
Cash in hand 4 200
Capital account 1 March 20X6 198 000
Drawings 57 000
Office furniture 32 400
Accumulated depreciation – office furniture 3 600
Rent 20 400
Wages and salaries 51 600
Discount allowed 13 800
Discount received 7 200
Debtors 98 400
Creditors 49 800
Inventory 1 March 20x6 59 400
Allowances for credit losses 1 March 20x6 5 400
Delivery van 57 600
Accumulated depreciation – delivery van 9 600

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 Van running costs 9 000
Bad debts written off 16 200
668 400 668 400

Additional information

1. Inventory as at 28 February 20x7, R70 200.

2. Wages and salaries accrued at 28 February 20x7, R1 800.
3. Rent prepaid at 28 February 20x7, R2 800.
4. Van running costs owing at 28 February 20x7, R1 200.
5. Increase the allowances for credit losses by R1 200.
6. Provide for depreciation as follows: office furniture R3 600; delivery van R9 600.

Required
Draw up the statement of profit and loss for the year ending 28 February 20X7 together with a
statement of financial position as at 28 February 20X7.

Exercise 5
T. Shezi, a sole trader, extracted the following trial balance from his books at the close of
business on 31 March 20x9.

Debit Credit
R R
Sales 839 400
Purchases 457 200
Inventory 1 April 20x8 103 200
Capital 1 April 20x8 144 000
Bank overdrafts 87 000
Cash 1 800
Discount allowed 28 800
Discount received 18 600
Return inwards 16 200
Return outwards 11 400
Carriage outwards 43 200
Rent and insurance 34 800
Allowances for credit losses 13 200
Fixtures and fittings 24 000
Delivery van 42 000
Debtors 238 200
Creditors 121 200
Drawings 57 600
Wages and salaries 178 800
General office expenses 9 000
1 234 800 1 234 800

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 Additional information

1. Inventory as at 31 March 20x9, R85 800.

2. Wages and salaries accrued as at 31 March 20x9, R4 200; office expense owing, R400.
3. Rent prepaid 31 March 20x9, R3 600.
4. Increase the allowances for credit losses by R3 000 to R16 200.
5. Provide for depreciation as follows: fixtures and fittings R2 400; delivery van R6 000.

Required
Prepare a statement of profit and loss for the year ended 31 March 20X9 together with a
statement of financial position as at that date, using vertical format.

Exercise 6
From the following trial balance of J. Sithole, store owner, prepare a statement of profit and
loss for the year ended 31 December 20x7, and a statement of financial position as at that
date, taking consideration of the adjustments shown below.

Debit Credit
R R
Sales 8 000 000
Purchases 7 000 000
Sales returns 100 000
Purchases returns 124 000
Opening stock at 1 January 20x7 2 000 000
Allowances for credit losses 16 000
Wages and salaries 600 000
Rates 120 000
Telephone 20 000
Shop fittings at cost 880 000
Accumulated depreciation – shop fittings 80 000
Van at cost 720 000
Accumulated depreciation – van 120 000
Debtors 196 000
Creditors 140 000
Bad debts 4 000
Capital 3 580 000
Bank balance 60 000
Drawings 360 000
12 060 000 12 060 000

Additional information

1. Closing inventory as at 31 December 20x7, R2 400 000.

2. Accrued wages, R100 000.

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 3. Rates prepaid, R10 000.
4. The allowances for credit losses is to be increased to 10% of debtors.
5. Telephone account outstanding, R4 400.
6. Depreciate shop fittings at 10% annum, and van at 20% per annum, on cost.

Exercise 7
The following trial balance has been extracted from the ledger of Mrs Joy, a sole trader. Trial
balance as at 31 May 20x6.

Debit Credit
R R
Sales 2 761 560
Purchases 1 647 000
Carriage 102 880
Drawings 156 000
Rent, rates and insurance 132 440
Postage and stationery 60 020
Advertising 26 600
Salaries and wages 528 400
Bad debts 17 540
Allowances for credit losses 2 600
Debtors 242 400
Creditors 129 420
Cash in hand 3 540
Cash at bank 20 040
Inventory as at 1 June 20x5 238 540
Equipment at cost 1 160 000
Accumulated depreciation 380 000
Capital 1 061 820
4 335 400 4 335 400

Additional information
The following additional information as at 31 May 20x6 is available:

1. Rent is accrued by R4 200.

2. Rates have been prepaid by R17 600.
3. R44 200 of carriage represents carriage inwards on purchases.
4. Equipment is to be depreciated at 15% per annum using the straight-line method.
5. The provision for bad debts to be increased by R800.
6. Inventory at the close of business has been valued at R271 020.

Required
Prepare the statement of profit or loss and other comprehensive income and the statement of
financial position for Mrs Joy.

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 Exercise 8
The following information was obtained from the accounting records of Nitro Traders on 28
February 20x6, the end of the accounting period for the entity.
Pre-adjustment trial balance of Nitro Traders on 28 February 20x6

Debit Credit
R R
Capital 66 100
Drawings 16 000
Vehicles (at cost price) 100 000
Equipment (at cost price) 40 000
Accumulated depreciation on vehicles 36 000
Accumulated depreciation on equipment 8 000
Loan: Zuza Bank 20 000
Bank 4 300
Fixed deposit: Zuza Bank 15 000
Debtors control 5 200
Trading inventory (1 March 20x5) 10 000
Creditors control 4 100
Sales 250 000
Purchases 153 600
Carriage on purchases 4 200
Carriage on sales 550
Rent expense 15 600
Stationery 3 800
Insurance 4 800
Rates and taxes 350
Credit losses 400
Telephone 1 980
Water and electricity 10 800
Commission received 180
Rental income 2 200

ADJUSTMENTS

1. A physical stocktake on 28 February 20x6 showed the following:

Stationery on hand R200

Inventory on hand R17 800

2. Depreciation must be provided for as follows:

Vehicles – 20% per annum on the cost price

Equipment – 10% per annum using the reducing balance method

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 3. The loan from Zuza Bank was obtained on 31 December 20x5. Interest was payable at
the end of every six months at 15% per annum. As yet, no interest has been paid.
4. A fixed deposit was made on 1 September 20x5. The interest rate amounted to 10% per
annum. As yet, no interest has been received.
5. An additional amount of R200 must be written off as irrecoverable.
6. Insurance included an amount of R1 800 in respect of additional insurance taken out and
paid for, for the period 1 January 20x6 to 31 December 20x6.
7. Rental income of R200 was received in advance.

Required
8.1 Prepare the statement of profit or loss and other comprehensive income for the year
ended 28 February 20x6.
8.2 Prepare the statement of financial position as at 28 February 20x6.

TEST YOURSELF SOLUTION

TEST YOURSELF SOLUTION 5.1

Statement of profit or loss and other comprehensive income of Hot Chicks for the year ended
28 February 20x3

R R
Sales 564 369
Less: Sales returns 5 729
Net sales 558 640
Less: Cost of sales 360 630
Opening stock 36 982
Add: Purchases 364 965
Less: Purchases returns –2 984
Add: Carriage on purchases 3 696
Goods available for sale 402 659
Less: Closing stock –42 029
Gross profit 198 010
Add: Other income 16 890
Rent received 13 200
Discount received 3 690
Gross income for the year 214 900
Less: Operating expenses 106 217
Carriage on sales 5 642
Rates and taxes 4 320
Salaries and wages 67 420
Telephone 3 622
Stationery 2 913
Repairs 995
Insurance 1 985
Credit losses (R1 365 + R1 065) 2 430
Depreciation (R2 290 + R14 600) 16 890
Net profit for the year 108 683

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 6 Company financial statements and their
analysis and interpretation

Outcomes

At the end of this chapter students should

have an understanding of company terminology

be able to draft a statement of comprehensive income and a statement of financial position
for a company
be able to calculate selected liquidity, efficiency and profitability ratios and interpret the results
of these ratios.

Chapter outline

6.1 Introduction
6.2 Company terminology
6.2.1 Share capital
6.2.2 Share premium
6.2.3 Types of shares
6.2.4 Reserves
6.2.5 Profits, taxation, reserves and dividends
6.3 Company financial statements (statement of comprehensive income and statement of
financial position)
6.4 Introduction to analysis and interpretation
6.4.1 The need for comparison
6.4.2 Methods for analysing financial statements
6.5 Calculation of ratios
6.5.1 Liquidity ratios
6.5.2 Efficiency ratios
6.5.3 Profitability ratios
6.5.4 Solvency ratios

6.1 Introduction

Companies were introduced in Chapter 1. In this chapter we will cover various company
terminology and financial statements. We will also cover the analysis and interpretation of
company financial statements using ratio analysis.

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 In 2011, the government adopted new Companies Act Regulations under the Companies Act of
2008 that prescribe the reporting frameworks based on each individual company’s public
interest score. Entities that are currently reporting under Statements of Generally Accepted
Accounting Practice (SA GAAP) are required to move to either IFRS (International Financial
Reporting Standards) or IFRS for SMEs, as SA GAAP is no longer available for use in respect
of financial years commencing on or after 1 December 2012. The International Accounting
Standards Board (IASB) has provided several exceptions to entities to ease the transition to
either IFRS or IFRS for SMEs.

6.2 Company terminology

The main difference that distinguishes a company from other forms of ownership is its limited
liability; that is, the owner’s personal assets are protected. This makes it possible to raise large
amounts of capital. Other benefits to shareholders include the transferability of shares and the
continued existence of the company, even with changes in ownership.

The Companies Act of 2008 specifies the rules and regulations for companies from registration
to deregistration and provides for the formation of two types of companies, namely a profit
company and a non-profit company.

PROFIT COMPANIES
These are companies that are incorporated for the purpose of financial gain for their
shareholders. Profit companies are further subdivided into five types:

State-owned company (SOC)

Private company (Pty) Ltd
Public company (Ltd)
Personal liability company (Inc.)
External company (foreign companies incorporated outside the Republic of South Africa)

We will focus only on public companies (Ltd) and private companies (Pty) Ltd. The main
difference is that only the public company may apply for a listing of its shares on the JSE and
can sell shares to the general public. In public companies, management does not rest with the
shareholders; instead, shareholders appoint directors to manage the company. In private
companies, the owners retain control of the management of the company and are also normally
the directors of the company. The Companies and Intellectual Properties Commission (CIPC) is
the place where company documents are available for public inspection.

A company is incorporated by lodging the Notice of Incorporation and Memorandum of

Incorporation (MOI). The MOI is a document that sets out the rights, duties and responsibilities
of the directors, shareholders and others that have a relationship with the company.

6.2.1 Share capital

Once a company has been formed, capital can be raised by issuing shares. This is known as
share capital. We have what is known as authorised share capital and issued share capital.

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 6.2.1.1 Authorised share capital
This is the amount of share capital that the company is authorised to issue according to the
CIPC. The authorised share capital must state specifically the types of share, for example
preference or ordinary, and the number of shares, as well as the par value / nominal value of the
shares. The company can issue all or only part of this capital as it wishes.

6.2.1.2 Issued share capital

This is the amount of the authorised share capital that the company has actually issued.

6.2.2 Share premium

If the company has been making good profits, it may choose to issue shares for more than the
nominal value (the original price of the shares). This extra money generated is known as the
share premium. For example, the nominal value of a share is R1,00 but the company issues the
shares for R1,50 each. The extra 50 cents generated per share is the share premium. This is seen
as a capital profit on the sale of the shares.

6.2.3 Types of shares

The shareholders of the company receive a share of the profits in the form of dividends. The
dividends they receive are dependent on the type of share they have purchased, as well as the
company’s dividend policy.

6.2.3.1 Preference shares

Holders of these shares receive a fixed rate dividend every year and have preferential rights over
and above those of ordinary shareholders, that is, they must be paid their dividends first. These
shareholders do not have voting rights. There are various types of preference share, which will
not be covered in this book.

6.2.3.2 Ordinary shares

Holders of these shares do not receive a fixed dividend each year. The dividend received
fluctuates according to the company’s prosperity and dividend policy. The owners of these
shares have voting rights and rank after preference shareholders for certain rights, for example a
payout on liquidation of the company.

6.2.4 Reserves
The equity of a company consists of share capital and reserves. Reserves are essential profits
that are retained within the business and can be used for expanding of the business, for example
to purchase new machinery, inventory, etc. There are two types of reserve, non-distributable and
distributable.

6.2.4.1 Non-distributable reserves

These reserves are non-trading profits which are not available for distribution to shareholders as
a dividend. They are recorded in the financial statements as share capital and share premium.

6.2.4.2 Distributable reserves

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 This refers predominantly to retained earnings. This figure is adjusted every year with that
amount in the statement of comprehensive income that is not spent on expenses and dividends.

6.2.5 Profits, taxation, reserves and dividends

Companies are treated as separate legal entities and are therefore liable for taxation (as opposed
to sole traders and partnerships, which are not separate from their owners).

Once the profits have been calculated, the first slice must go to the Receiver of Revenue in the
form of taxation.

Thereafter, profits are divided between reserves and dividends, with the remainder being
retained in the company (as retained earnings).

Ordinary shareholders have no rights to profits. They only receive a share of the profits if the
directors declare a dividend. In other words, the payment of a dividend is not automatic.
Proposed dividends mean that the company still has to pay out the amounts that it has estimated
for the financial year-end to the relevant parties.

6.3 Company financial statements (statement of comprehensive

income and statement of financial position)

ILLUSTRATIVE EXAMPLE

Example 1
Receiver of Revenue (income tax)
This is a current liability and will therefore appear in the statement of financial position.
Income tax
This is an expense and will therefore appear in the income statement.
Shareholders for dividends
This is a current liability and will therefore appear in the statement of financial position.
Dividend on ordinary shares
This is an expense and will therefore appear in the income statement.
Retained income/earnings
This is part of the shareholders’ equity and will therefore appear in the statement of financial
position.
Here is a list of transactions that must be analysed according to the accounting equation.
Note transactions 1–6 build upon each other:

Transaction 1: Made two provisional tax payments of R20 000 each, one in June and one in December. (Assume that
the balance in the bank account on 1 January was R50 000.)
Transaction 2: The total income tax for the year, in accordance with the tax assessment, was estimated to be R43 800.
Transaction 3: The company has 100 000 ordinary shares of R1 each in issue. An interim dividend of 5 cents per share
was declared and paid to shareholders.
Transaction 4: The directors recommended a final dividend of 7 cents per share.
Transaction 5: The balance on the retained income account from last year was R25 000.

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 Transaction 6: The net profit / income for the year amounted to R75 000.

Transaction 1: Made two provisional tax payments of R20 000 each for the year.
How to treat a provisional tax payment
Current government legislation requires companies to make provisional tax payments to the
Receiver of Revenue during the financial year. The first provisional tax payment is made six
months after the beginning of the accounting period.
The second provisional tax payment is made at the end of the accounting period and the
same accounting treatment will apply as for the first provisional payment.

June
Transaction Assets = Owner’s + Liabilities Account Account
equity debit credit
1 – 20 000 – 20 000 Receiver of Bank
Revenue

December

Transaction Assets = Owner’s + Liabilities Account Account

equity debit credit
1 – 20 000 – 20 000 Receiver of Bank
Revenue

Transaction 2: The total income tax for the year, in accordance with the tax
assessment, was estimated to be R43 800.
How to treat a tax assessment
The tax assessment for the year indicates the amount of tax the company must pay for the
year, that is, the tax expense for the year.

Transaction Assets = Owner’s + Liabilities Account Account

equity debit credit
Previous – 40 000 – 40 000 Receiver of Bank
transaction 1 Revenue
2 – 43 800 + 43 800 Income tax Receiver of
(expense) Revenue
Bal/totals – 40 000 – 43 800 + 3 800

Extract from the statement of comprehensive income

(inclusive of transactions 1–2 only)

Income tax R43 800

The income tax expense of R43 800 for the year is shown in the income statement.
Extract from the statement of financial position

Current assets
Bank R10 000 (R50 000 – R40 000)

Current liabilities
Receiver of Revenue R3 800

The balance of R10 000 represents what is left in the bank account after making the two
provisional tax payments.

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 The balance of R3 800 in the Receiver of Revenue (income tax) account reflects the amount
still owed to the Receiver.

Transaction 3: The company has 100 000 ordinary shares of R1 each in issue. An
interim dividend of 5 cents per share was declared and paid to shareholders.
How to treat an interim dividend
If the company is in a sound financial position, the directors have the right to declare and pay
interim dividends during the year. Interim dividends must be taken into account when the final
dividend for the year is determined.
When dividends are declared, it implies that the company has just created a liability. Once
these dividends have been paid out, they are converted into an expense. Dividends may only
be declared out of profits available for distribution after provision has been made for income
tax due.
Calculation: 100 000 shares × 0,05 = R5 000

Transaction Assets = Owner’s + Liabilities Account Account

equity debit credit
3 – 5 000 – 5 000 Dividends on Bank
ordinary
shares

Extract from the statement of comprehensive income

(inclusive of transactions 1–3 only)

Income tax R43 800
Dividends on ordinary shares R5 000

Extract from the statement of financial position

Current assets
Bank R5 000 (R10 000 – R5 000)

Current liabilities
Receiver of Revenue R3 800

Transaction 4: The directors recommended a final dividend of 7 cents per share.

How to treat a declaration of a final dividend
A final dividend is declared at the end of the accounting period, but has not yet been paid to
the shareholders.
Calculation: 100 000 shares × 0,07 = R7 000

Transaction Assets = Owner’s + Liabilities Account Account

equity debit credit
Previous – 5 000 – 5 000 Dividends on Bank
transaction 3 ordinary
shares
4 – 7 000 – 7 000 Dividends on Shareholders
ordinary for dividends
shares
Bal/totals – 5 000 – 13 000 + 7 000

Extract from the statement of comprehensive income

(inclusive of transactions 1–4 only)

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 Income tax R43 800
Dividends on ordinary shares R12 000 (R5 000 + R7 000)

Extract from the statement of financial position

Current assets
Bank (R10 000 – R5 000) R5 000

Current liabilities
Receiver of Revenue R3 800
Shareholders for dividends R7 000

The balance of R7 000 on the shareholders for dividends account reflects the amount still
owing to shareholders. The R5 000 interim dividend is not shown, since it has been declared
and paid.

Transaction 5: The balance on the retained income account from last year was R25
000.

Transaction 6: The net profit/income for the year amounted to R75 000.
How to appropriate/distribute the net profit earned and how to determine the amount of
net profit that is retained for the year
Once the profits have been calculated, the first slice must go to the Receiver of Revenue in
the form of taxation.
Thereafter, profits are divided between reserves, preference dividends and ordinary
dividends, and the remainder is retained in the company (as retained earnings).
Extract from the statement of comprehensive income
(calculation of net profit retained for the year)

Net profit before taxation 75 000

Less: Taxation 43 800
Net profit after taxation 31 200
Less: Dividends on ordinary shares 12 000
Net profit retained for the year 19 200
Add: Net profit retained at the beginning of the year 25 000
Net profit retained for the year 44 200

Extract from the statement of financial position

Current assets
Bank (R10 000 – R5 000) R5 000

Current liabilities
Receiver of Revenue R3 800
Shareholders for dividends R7 000

Example 2
The following trial balance has been extracted from the books of account of Ben Ltd as at 31
December 20x0:

Debit R Credit R
Administrative expenses 2 370 000
Bank overdraft 630 000

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 Authorised and issued shares
Ordinary shares of R1 each 800 000
10% preference shares of R1 each 200 000
Trade and other payables 1 580 000
Trade and other receivables 2 790 000
Selling and distribution expenses 900 000
Investment 700 000
Interest income 120 000
Furniture and fittings (carrying value) 60 000
Plant and equipment (carrying value) 3 000 000
Interim ordinary dividends paid 80 000
Preference dividends paid 10 000
Retained profit (1 January 20x0) 3 000 000
Purchases 8 000 000
Sales 13 200 000
Share premium 380 000
Inventory (1 January 20x0) 2 000 000
19 910 000 19 910 000

Additional information

1. Stock as at 31 December 20x0 is R2 400 000.

2. Taxation based on the profit for the year is estimated at R530 000.
3. The directors proposed a final ordinary dividend of R0,20 per ordinary share. (Remember
the preference dividend as well.)

Required
Prepare the financial statements of Ben Ltd.

Solution
Ben Ltd
Statement of comprehensive income for the year ended 31 December 20x0

Sales 13 200 000

Cost of sales (7 600 000)
Gross profit 5 600 000
Operating expenses (3 270 000)
Operating profit 2 330 000
Interest and other income 120 000
Earnings before interest and taxation (EBIT) 2 450 000
Taxation (530 000)
Net profit after taxation 1 920 000
Preference dividends (10 + 10) (20 000)

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 Earnings available to ordinary shareholders 1 900 000
Ordinary dividends (80 + 160) (240 000)
Retained profit for the year 1 660 000
Retained profit (1 January 20x0) 3 000 000
Retained profit (31 December 20x0) 4 660 000

Ben Ltd
Statement of financial position as at 31 December 20x0

Debit R Credit R
Assets
Non-current assets 3 760 000
Property, plant and equipment 3 060 000
Other investment 700 000

Current assets 5 190 000

Inventory 2 400 000
Trade and other receivables 2 790 000
Total assets 8 950 000
Equity and liabilities
Shareholders equity
Authorised and issued share capital 1 000 000
Ordinary shares 800 000
10% preference shares 200 000

Share premium 380 000

Retained profit 4 660 000

Current liabilities 2 910 000

Bank overdraft 630 000
Trade and other payables 1 580 000
Receiver of Revenue 530 000
Shareholders for dividends (160 + 10) 170 000
Total equity and liabilities 8 950 000

6.4 Introduction to analysis and interpretation

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 Analysis is the process of examining the information on the financial statements. Interpretation
is using the analysed information to make informed business decisions. This is considered the
last phase in the accounting cycle.

The aim of analysing the financial statements is to assess the financial health of the business and
to assist management in making informed decisions in areas such as profit planning, pricing,
working capital management, financial structure and so on. The historical data contained in the
financial statements is used as the basis for evaluating the future prospects of the company.

6.4.1 The need for comparison

The information obtained from analysing the financial statements must be compared with a
benchmark so that the information can be interpreted and evaluated. Possible benchmarks for
comparison are as follows: previous years, budgets, similar companies, industry results or other
accepted norms.

6.4.2 Methods for analysing financial statements

Financial statements may be analysed using the following methods:

Comparative financial statements compare the financial statements for a required period of
time, for example five or 10 years. The trend over the years can then be calculated and
analysed.
Indexed financial statements – the first year is shown as the base year (set as 100%) and the
subsequent years and figures are shown as percentages of that year. This gives the reader a
good overview of the growth or decline from the base year to a certain date.
Common size statements – each item on the statements is stated as a percentage of the total
of the specific section. For example, in the statement of financial position, current and non-
current assets will be stated as a percentage of the total assets; in the statement of profit or
loss and other comprehensive income, the figures will be stated as a percentage of revenue.
Ratio analysis compares items or examines the relationships between items on a financial
statement. Ratios illustrate relationships between different aspects of an organisation’s
operations and provide relative measures of the financial condition and performance of the
organisation. Ratio analysis can be performed using time-series or cross-sectional analysis, or
a combination of both:

– Cross-sectional analysis involves the comparison of different firms’ financial ratios at the
same point in time.
– Time-series analysis involves the comparison of a company’s current to its past
performance and the evaluation of developing trends.

ILLUSTRATIVE EXAMPLE

You are given the following comparative statement of comprehensive income of Cyril
Ramaphosa Ltd for five years:

20x5 20x4 20x3 20x2 20x1

R’000 R’000 R’000 R’000 R’000
Revenue 3 640 2 552 1 506 2 054 1 569
Cost of sales (1 503) (998) (525) (553) (402)
Gross profit 2 137 1 554 981 1 501 1 167

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 Operating costs (778) (650) (445) (506) (150)
Distribution costs (258) (203) (145) (123) (53)
Administrative expenses (15) (13) (11) (14) (9)
Other expenses (3) (36) (32) (22) (26)
Net operating profit /(loss) 1 083 652 348 836 929
Interest and other income 39 36 25 19 22
Earnings before interest and tax (EBIT) 1 122 688 373 855 951
Interest expense (106) (102) (54) (86) (93)
Profit before tax 1 016 586 319 769 858
Income tax expense (284) (164) (89) (215) (240)
Net profit 732 422 230 554 618

Required
Redraft the comparative statement of comprehensive income by using the following
techniques:
a. Indexed statements
b. Common size statements (use Revenue as the base section)
Solution
To prepare the indexed statements each item on the statements is stated as a percentage of
the base year 20x1.
a. Indexed statements

20x5 20x4 20x3 20x2 20x1

% % % % %
Revenue 232 163 96 131 100
Cost of sales 374 248 131 138 100
Gross profit 183 133 84 129 100
Operating costs 519 433 297 337 100
Distribution costs 487 383 274 232 100
Administrative expenses 167 144 122 156 100
Other expenses 12 138 123 85 100
Net operating profit/(loss) 117 70 37 90 100
Interest and other income 177 164 114 86 100
Earnings before interest and tax 118 72 39 90 100
Interest expense 114 110 58 92 100
Profit before tax 118 68 37 90 100
Income tax expense 118 68 37 90 100
Net profit 118 68 37 90 100

To prepare the common size statements each item on the statements is stated as a
percentage of the revenue.
b. Common size statements

20x5 20x4 20x3 20x2 20x1

% % % % %
Revenue 100,0 100,0 100,0 100,0 100,0
Cost of sales 41,3 39,1 34,9 26,9 25,6
Gross profit 58,7 60,9 65,1 73,1 74,4
Operating costs 21,4 25,5 29,5 24,6 9,6
Distribution costs 7,1 8,0 9,6 6,0 3,4
Administrative expenses 0,4 0,5 0,7 0,7 0,6
Other expenses 0,1 1,4 2,1 1,1 1,7
Net operating profit/(loss) 29,8 25,5 23,1 40,7 59,2
Interest and other income 1,1 1,4 1,7 0,9 1,4
Earnings before interest and tax 30,8 27,0 24,8 41,6 60,6

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 Interest expense 2,9 4,0 3,6 4,2 5,9
Profit before tax 27,9 23,0 21,2 37,4 54,7
Income tax expense 7,8 6,4 5,9 10,5 15,3
Net profit 20,1 16,5 15,3 27,0 39,4

TEST YOURSELF 6.1

The management of Black Panther Limited are in the process of restructuring their business.
They consider their comparative financial statements, but they need to see a good overview
of the growth and decline of items through the years. The following is an extract of the
statement of comprehensive income of Black Panther Limited for five years:

20x5 20x4 20x3 20x2 20x1

R’000 R’000 R’000 R’000 R’000
Revenue 15 223 12 225 13 556 9 986 7 056
Distribution costs (850) (989) (776) (678) (569)
Earnings before interest and tax (EBIT) 5 333 3 765 4 155 2 314 1 415

Required

a) Redraft the extract from the statement of comprehensive income for Black Panther Limited
by using the following techniques:

i) Indexed statements (round off your answer to the full percentage)

ii) Common size statements (round off your answer to one decimal place)

6.5 Calculation of ratios

Financial ratios are a quick and easy way of assessing a business’s financial state. A ratio
expresses the relationship between two figures on the financial statements. Only selected ratios
will be covered in more detail:

Liquidity ratios
Efficiency ratios
Profitability ratios
Solvency ratios

6.5.1 Liquidity ratios

An organisation’s liquidity is very important to its operations. Lenders and suppliers that
provide products and services on credit are concerned about these ratios. Liquidity ratios
indicate the ability of the organisation to generate and conserve cash from its working capital in
order to meet its short-term debts. Working capital refers to the current assets and current
liabilities, which are directly related to the operating activities of an organisation.

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 Ratio Formula What does the ratio measure?
1. Current Current assets

Current liabilities
It indicates the business’s ability to settle short-term
ratio obligations (current liabilities) using short-term assets
(current assets).
2. Quick Current assets – Inventory
The quick ratio is basically the current ratio excluding
Current liabilities
ratio/acid stock, as stock is the hardest to convert into cash in the
test ratio short term. It measures the immediate debt-paying
ability of the company.

6.5.2 Efficiency ratios

These ratios measure how efficiently assets and liabilities have been utilised within the business.
These ratios can calculate the turnover of receivables, the repayment of liabilities and the
general use of inventory and machinery.

Ratio Formula What does the ratio measure?

1. Debtors Credit sales
The debtors turnover ratio indicates the number of
Trade receivables
turnover times debtors are covered by credit sales.

2. Receivable Trade receivables

× 365 This ratio shows how long debtors take to pay in
Credit sales
days days.
(debtors’
collection
period)

3. Inventory Cost of sales

This ratio indicates how many times inventory on
Inventory
turnover hand has been sold during the year. This ratio may
indicate whether there is an over- or under-
investment in inventory.
4. Days’ Inventory
× 365 This ratio indicates how many days inventory
Cost of sales
inventory on spends on the shelf before it is sold. A long shelf
hand life is not good for liquidity because it ties up cash.

5. Creditors Credit purchases

The credit turnover ratio indicates how many times
Trade payables
turnover creditors are paid during the year.

6. Payable days Trade payables

× 365 This ratio indicates how long in days the business
Credit purchases
(creditors’ takes to repay the creditors. Dramatic increases in
payment this ratio may indicate liquidity problems.
period)

Note: Where the average value can be calculated if the opening and closing value is given, then
the average value must be used in the ratio.

6.5.3 Profitability ratios

Profit is an important measure of an organisation’s success. An organisation needs profit to
survive, as well as to ensure continued support and funding from equity and debt providers.
Profitability ratios deal with the return of profit on the capital invested in a company.

Ratio Formula What does the ratio measure?

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 Ratio Formula What does the ratio measure?
Gross Gross prof it
×
100 The gross profit margin ratio
Revenue 1
profit expresses the gross profit as a
margin percentage of revenue.
Operating Operating prof it
×
100 The operating profit is the net profit
Revenue 1
profit after accounting for operating
margin expenditure but before finance
costs, tax and investment income.
The operating profit margin is the
operating profit expressed as a
percentage of revenue.
Net profit Prof it af ter tax
×
100
The net profit margin expresses the
Revenue 1
margin net profit as a percentage of
revenue. It looks at the relationship
between profits earned and sales
generated.
Return on Net prof it bef ore interest and tax
×
100 This ratio indicates whether the
Total assets 1
assets assets of the business are being
used effectively to produce a
reasonable profit.
Return on Net prof it af ter tax and pref erence dividends
×
100 The return on equity ratio expresses
Ordinary shareholders’ equity 1
equity the relationship between the profit
attributable to ordinary shareholders
and the capital invested by ordinary
shareholders.
Return on Net prof it bef ore interest and tax
×
100 The return on capital employed ratio
Capital employed 1
capital expresses the relationship between
employed the profits earned and owner’s
capital invested plus long-term
financing. The net profit amount is
before interest paid if it is assumed
that the interest paid relates only to
long-term liabilities.

6.5.4 Solvency ratios

These ratios measure the organisation’s ability to repay its long-term debts, which include the
repayment of capital and the payment of interest.

Ratio Formula What does the ratio measure?

Interest Earnings bef ore interest and tax
times the operating profit will cover interest expense.
Interest expense
cover The more coverage, the safer it is to borrow funds.
ratio
Debt to Long-term debt
This ratio measures the level of financial risk. Debt
Equity
equity financing creates an obligation that has to be paid
ratio whether or not the organisation can afford it.

ILLUSTRATIVE EXAMPLE

Statement of comprehensive income of Sencam Ltd for the year ended 31 December
20x3

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 20x3 20x2
R R
Sales 3 782 000 3 355 000
Cost of sales (2 571 760) (2 382 050)
Opening inventory 1 525 000 1 403 000
Purchases 2 022 760 2 504 050
Goods available for sale 3 547 760 3 907 050
Closing inventory 976 000 1 525 000
Gross profit 1 210 240 972 950
Operating expenses (644 648) (822 280)
Operating profit 565 592 150 670
Interest and other income 92 720 45 750
Profit before interest expense and taxation (EBIT) 658 312 196 420
Interest expense (91 500) (73 200)
Profit before taxation 566 812 123 220
Taxation (150 792) (54 900)
Profit after taxation* 416 020 68 320

*Without minority interest, this is also equal to earnings attributable to shareholders in this
example.

Statement of financial position for Sencam Ltd at 31 December 20x3

20x3 20x2
Assets R R
Non-current assets 2 330 200 2 549 800
Property, plant and equipment 2 025 200 2 305 800
Other investments 305 000 244 000
Current assets 1 695 800 1 982 500
Inventory 976 000 1 525 000
Trade and other receivables 622 200 457 500
Cash and cash equivalents 97 600 nil
Total assets 4 026 000 4 532 300
Equity and liabilities
Equity and reserves 2 305 800 2 025 200
Share capital 1 220 000 1 220 000
Accumulated profit 1 085 800 805 200
Non-current liabilities
Interest-bearing borrowings 610 000 488 000
Current liabilities 1 110 200 2 019 100
Trade and other payables 1 061 400 1 311 500
Current tax payable 48 800 36 600

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 20x3 20x2
Bank overdraft nil 671 000
Total: equity and liabilities 4 026 000 4 532 300

Additional information

20x3 20x2
1. Sales consist of:
Credit sales 2 989 000 2 501 000
Cash sales 793 000 854 000
R3 782 000 R3 355 000
2. Purchases consist of:
Credit purchases 1 512 800 2 200 880
Cash purchases 509 960 303 170
R2 022 760 R2 504 050
3. The following balances are available for 31 December 20x1:
Trade and other receivables R384 300
Trade and other payables R1 342 000
Inventory R1 403 000
4. For 20x1 the following information is given:
Sales R2 501 000
Cost of sales R1 586 000

Required
Calculate all the liquidity, efficiency, profitability and solvency ratios for 20x3 and 20x2, and
indicate whether there is an improvement or a decline in each ratio.
Note: Round off calculations to two decimal places where necessary and assume 365 days in
the year.

Solution
Liquidity ratios

Current ratio

Current assets

Current liabilities

20x3 20x3

1 695 800 1 982 500

1 110 200 2 019 100

= R1,53 : R1 = R0,98 : R1

Improvement from 20x2 to 20x3

Quick ratio

Current assets – inventory

Current liabilities

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 20x3 20x2

1 695 800–976 000 1 982 500–1 525 000

1 110 200 2 019 100

719 800 475 500

= =
1 110 200 2 019 100

= R0,65 : R1 = R0,23 : R1

Improvement from 20x2 to 20x3

Efficiency ratios

Debtors’ turnover

Credit sales

Trade receivables

20x3 20x2

2 989 000 2 501 000

(622 200+457 500)/2 (457 500+384 300)/2

2 989 000 2 501 000

= =
539 850 420 900

= 5,53 times = 5,94 times

Decline from 20x2 to 20x3

Debtors’ collection period

Trade receivables
× 365
Credit sales

20x3 20x2

(622 200+457 500)/2 (457 500+384 300)/2

= × 365 = × 365
2 989 000 2 501 000

539 850 420 900

= × 365 = × 365
2 989 000 5 501 000

= 66 days = 61 days

Decline from 20x2 to 20x3

Inventory turnover

Cost of sales

Inventory

20x3 20x2

2 571 760 2 382 050

(976 000+1 525 000)/2 (1 525 000+1 403 000)/2

2 571 760 2 382 050

= =
1 250 500 1 464 000

= 2,06 times = 1,63 times

Improvement from 20x2 to 20x3

Inventory days

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 Inventory
× 365
Cost of sales

20x3 20x2

(976 000+1 525 000)/2 (1 525 000+1 403 000)/2

× 365 × 365
2 571 760 2 382 050

1 250 500 1 464 000

= × 365 = × 365
2 571 760 2 382 050

= 177 days = 224 days

Improvement from 20x2 to 20x3

Creditors’ turnover

Credit purchases

Trade payables

20x3 20x2

1 512 800 2 200 880

(1 061 400+1 311 500)/2 (1 311 500+1 342 000)/2

1 512 800 2 200 880

= =
1 186 450 1 326 750

= 1,28 times = 1,66 times

Decline from 20x2 to 20x3

Creditors’ payment period

Trade payables
× 365
Credit purchases

20x3 20x2

(1 061 400 +1 311 500)/2 365 (1 311 500 +1 342 000)/2 365
× ×
1 512 800 1 2 200 880 1

1 186 450 365 1 326 750 365

= × = ×
1 512 800 1 2 200 880 1

= 286 days = 220 days

Decline from 20x2 to 20x3

Profitability ratios

Gross margin

Gross prof it
× 100
Revenue

20x3 20x2

1 210 240 100 972 950 100

× ×
3 782 000 1 3 355 000 1

= 32% = 29%

Improvement from 20x2 to 20x3

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 Net margin

Prof it af ter tax

× 100
Revenue

20x3 20x2

416 020 100 63 320 100

× ×
3 782 000 1 3 355 000 1

= 11% = 2,04%

Improvement from 20x2 to 20x3

Operating profit margin

Operating prof it
× 100
Revenue

20x3 20x2

565 592 100 150 670 100

× ×
3 782 000 1 3 355 000 1

= 14,95% = 4,49%

Improvement from 20x2 to 20x3

Return on assets

Net prof it bef ore interest and tax

× 100
Total assets

20x3 20x2

658 312 100 1964 200 100

× ×
4 026 000 1 4 532 300 1

= 16,35% = 4,33%

Improvement from 20x2 to 20x3

Return on capital employed

Net prof it bef ore interest and tax

× 100
Capital employed

20x3 20x2

566 812 +91 500 100 123 220 +73 200 100
× ×
2 305 800 +610 000 1 2 025 200 +488 000 1

658 312 100 196 420 100

= × = ×
2 915 800 1 2 513 200 1

= 22,58% = 7,82%

Improvement from 20x2 to 20x3

Return on equity

Net prof it bef ore interest and tax

× 100
Capital employed

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 20x3 20x2

416 020 100 63 320 100

× ×
2 305 800 1 2 025 200 1

= 18,04% = 3,37%

Improvement from 20x2 to 20x3

Solvency ratios

Interest cover ratio

Earnings bef ore interest and tax

× 100
Interest expense

20x3 20x2

658 312 196 420

91 500 73 200

= 7,2 times = 2,7 times

Debt to equity ratio

Long-term debt: equity

20x3 20x2

610 000 : 2 305 800 488 000 : 2 025 200

= 0,26 : 1 = 0,24 : 1

TEST YOURSELF 6.2

The financial statements of Marimuthu Ltd contained, inter alia, the following information for
the years 20x3 and 20x2:
Statement of comprehensive income

20x2 20x3
R R
Credit sales 2 400 000 3 000 000
Cost of sales 1 200 000 1 680 000
Gross profit 1 200 000 1 320 000
Administrative expenses 440 000 480 000
Selling expenses 480 000 600 000
Net profit before tax 280 000 240 000
Tax 120 000 100 000
Net profit after tax 160 000 140 000
Dividends 80 000 140 000

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 Accumulated profit for year 80 000 –

Statement of financial position information

20x2 20x3
R R
Share capital (ordinary shares R2 par value) 400 000 400 000
Reserves 160 000 160 000
Long-term loans 280 000 280 000
840 000 1 000 000
Property, plant and equipment 600 000 844 000
Inventory 200 000 336 000
Trade and other receivables 400 000 600 000
Bank 40 000 –
Creditors (400 000) (780 000)
840 000 1 000 000

Required
Calculate the following ratios for 20x3 only; assume 365 days in a year:
6.1 Current ratio
6.2 Acid test ratio
6.3 Inventory turnover
6.4 Debtors’ collection period
6.5 Gross profit to turnover (gross margin)
6.6 Net profit to shareholders’ equity (return on equity)
6.7 Net profit to capital employed (return on capital employed)
6.8 Return on assets
Note: Where necessary round off to two decimal places.

TUTORIAL EXERCISES

Exercise 1
Read through the following statements and select the most appropriate option:

1.1 The two basic measures of liquidity are

a. inventory turnover and current ratio.
b. current ratio and quick ratio.
c. gross profit margin and ROE.
d. current ratio and total asset turnover.

1.2 The _________ ratio may indicate the firm is experiencing stockouts and lost sales.
a. creditors’ payment period
b. inventory turnover

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 c. debtors’ collection period
d. quick ratio

1.3 The _________ ratio may indicate poor collections procedures or a lax credit policy.
a. creditors’ payment period
b. inventory turnover
c. debtors’ collection period
d. quick ratio

1.4 The _________ ratios are primarily measures of return.

a. liquidity
b. activity
c. debt
d. profitability

1.5 Operating profits are defined as

a. gross profits minus operating expenses.
b. sales revenue minus cost of goods sold.
c. earnings before depreciation and taxes.
d. sales revenue minus depreciation expense.

1.6 _________ analysis involves the comparison of different firms’ financial ratios at the
same point in time.
a. Time-series
b. Cross-sectional
c. Marginal
d. Combined

1.7 _________ analysis involves the comparison of current to past performance and the
evaluation of developing trends.
a. Time-series
b. Cross-sectional
c. Combined
d. Quantitative

Exercise 2
The following information was taken from the books of ABC Ltd:

31/12/20x3 31/12/20x2
R R
Inventory 150 000 120 000
Purchases 765 000 680 000
Trade and other payables 200 160 114 224
Investments 60 000 60 000
Furniture 35 000 60 000
Vehicles 75 000 30 000

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 Sales 900 000 750 000
Customs and excise 30 000 25 000
Net income before interest and taxation 84 000 65 000
Bank overdraft 41 320 50 000
Trade and other receivables 121 110 100 810

ADDITIONAL INFORMATION

R6 000 interest was paid during the year, while no interest was received.
All purchases are on credit and 25% of the sales are for cash.
Assume 365 working days per annum.

Required
Calculate the following for the year ended 31 December 20x3:

2.1 Net margin (round off to two decimal places)

2.2 Debtors’ collection period (round off to the nearest whole number)
2.3 Acid test ratio (round off to two decimal places)
2.4 Gross margin (round off to two decimal places)
2.5 Creditors’ payment period (round off to the nearest whole number)
2.6 Days’ inventory on hand (round off to the nearest whole number)
2.7 Current ratio (round off to two decimal places)

Exercise 3
Part A
The following information has been extracted from the recently published account of Crown
Ltd:
Statement of financial position as at 28 February

20x2 20x1
R’000 R’000
Fixed assets 3 700 2 860
Current assets 3 900 3 380
Inventory 1 280 980
Trade and other receivables 2 460 2 160
Cash and cash equivalents 160 240
Total assets 7 600 6 240

Capital and reserves 4 090 3 350

Ordinary share capital 1 600 1 600
Reserves 2 490 1 750

Long-term liabilities 1 600 1 200

Debentures 1 600 1 200
Current liabilities 1 910 1 690
Bank overdraft 220 160

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 Trade and other payables 1 500 1 380
Taxation 60 40
Dividends 130 110
Total equity and liabilities 7 600 6 240

Extracts from profit and loss account

20x2 20x1
R’000 R’000
Sales (credit) 22 400 19 500
Cost of sales 16 920 13 650
Net profit before tax 930 640
This after charging:
Depreciation 720 560
Debenture interest 130 102
Interest on bank overdraft 30 18
Audit fees 40 20
Net profit after tax 466 320

Required
Calculate the following ratios for Crown Ltd for 20x1:
(Assume a 365-day year and round off calculations to two decimal places.)
3.1 Return on capital employed
3.2 Gross margin
3.3 Current ratio
3.4 Debtors’ collection period
3.5 Inventory turnover
Part B
The following ratios are those calculated for Sencam Ltd based on its published accounts for
20x2, and also the latest industry average ratios:

Sencam Ltd 28 February 20x2 Industry average

Return on capital employed 19,16% 18,50%
Net margin 4,87% 4,73%
Gross margin 24,46% 35,23%
Current ratio 2,04:1 1,90:1
Debtors’ collection period 40 days 52 days
Inventory turnover 13,22 times 18,30 times

Required
3.6 Explain what each ratio indicates (measures).
3.7 Identify whether there is an improvement or a decline in the ratio compared to the
industry average.

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 Exercise 4
Part A
TK Ltd has been in operation for three years and produces antique furniture for the export
market. The most recent set of accounts for the company is set out below:
Statement of comprehensive income for the year ended 30 November 20x3

R’000 R’000
Sales 2 600
Less: Cost of sales 1 620
Gross profit 980
Less: Operating expenses 660
Interest on loan 78
Selling and distribution expenses 408
Administration expenses 174
Net profit before taxation 320
Less: Taxation 95
Net profit after taxation 225
Less: Ordinary dividends 160
Retained profit for the current year 65
Add: Retained profit at the beginning of the year 300
Retained profit at the end of the year 365

Statement of financial position as at 30 November 20x3

R’000 R’000 R’000

Cost Accumulated Book value
depreciation
Non-current assets
Freehold land and buildings at 228 – 228
cost
Plant and machinery 942 180 762
1 170 180 990
Current assets 1 420
Inventory 600
Trade debtors 820
Total assets 2 410
Equity and liabilities
Capital and reserves 1 065
Ordinary shares of R1 each 700
Retained profits 365
Non-current liabilities 200
Loan SD Bank 12% p.a. 200

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 Current liabilities 1 145
Trade creditors 665
Taxation 48
Bank overdraft 432
Total equity and liabilities 2 410

Required
Calculate the following ratios:
4.1 Return on capital employed
4.2 Return on equity
4.3 Gross profit margin
4.4 Net profit margin
4.5 Return on assets
Round off to the nearest whole number.
Part B
The following ratios have been taken from the books of TK Ltd over the past years of trading,
together with the relevant industry averages:

Ratios 20x2 Industry

1. Current ratio 1,9 2
2. Acid test (quick ratio) 0,8 1
3. Inventory turnover 4 times 6 times
4. Debtors’ collection period (days) 51 days 40 days
5. Creditors’ payment period (days) 61 days 50 days

Required
4.6 For each of the above five ratios, answer the following:
a. What does the ratio measure?
b. State whether there is an improvement or decline in the ratio in comparison with the
industry average.
4.7 Comment on the company’s overall liquidity position in comparison with industry.

Exercise 5
Part A
Business A and Business B are both engaged in retailing, but seem to take different
approaches to this trade according to the information available. Based on the ratios given
below, determine which of the two businesses is performing better.

Ratio Business A Business B

Profitability
(a) Return on capital employed (ROCE) 20% 17%
(b) Return on ordinary shareholders’ funds (ROSF) 30% 18%
(c) Net margin 12% 10%
Liquidity
(d) Debtors’ collection period 63 days 21 days
(e) Creditors’ payment period 50 days 45 days
(f) Inventory turnover period 52 days 25 days

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 Required
5.1 Explain what each of the above ratios (a)–(f) measures.
5.2 In terms of profitability and liquidity for each of the ratios (a)–(f) given above, indicate
which business is performing better.

Example Business A Business B

Current ratio R2: R1 R1,50: R1

Answer
Business A

Part B
The financial statements for Harridges Ltd are given below for the two years ended 30 June
20x2 and 20x1. Harridges Ltd operates a department store in the centre of a small town.
Harridges Ltd
Profit and loss account for the years ended 30 June 20x2/20x1

20x2 20x1
R’000 R’000
Sales (all credit) 2 600 3 500
Cost of sales 1 560 2 350
Gross profit 1 040 1 150
Less: Expenses
Wages and salaries 320 350
Overheads 260 200
Depreciation 150 250
Operating profit 310 350
Less: Interest payable 50 50
Profit before taxation 260 300
Less: Taxation 105 125
Profit after taxation 155 175
Less: Dividends proposed 65 75
Profit retained for the year 90 100
Add: Retained income at the beginning of the year 260 350
Retained income at the end of the year 350 450

Statement of financial position as at 30 June

20x2 20x1
R’000 R’000 R’000 R’000
Assets
Non-current assets 1 265 1 525
Current assets 735 660
Inventory 250 400
Trade and other receivables 105 145

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 Cash at bank 380 115
Total assets 2 000 2 185
Equity and liabilities
Capital and reserves
Share capital at R1 per share 490 490
Share premium 260 260
Retained income 350 450
1 100 1 200
Non-current liabilities
Loan AB Bank 500 500
Current liabilities 400 485
Trade and other payables 235 300
Shareholders for dividends 65 75
Accrued expenses 100 110
Total equity and liabilities 2 000 2 185

Required
Calculate the following ratios for 20x2 only (assume a 365-day year):

5.3 Net margin (round off to the nearest whole number)

5.4 Acid test ratio (round off to two decimal places)
5.5 Debtors’ collection period (round off to the nearest whole number)
5.6 Days’ inventory on hand (round off to the nearest whole number)

Exercise 6
The following ratios have been taken from the books of Mkhize Ltd over the past three years
of trading, together with the relevant industry averages:

Ratio 20x0 20x1 20x2 Industry average

1. Days’ inventory on hand 30 days 40 days 65 days 35 days
2. Debtor collection period 60 days 90 days 120 days 60 days
3. Gross margin 33% 50% 66% 45%
4. Return on equity 15% 20% 24% 18%

Required
Part A
For each of the above ratios, answer the following:
6.1 What does the ratio measure?
6.2 State whether there is an improvement or a decline in the ratio in comparison with the
industry average.
Part B
6.3 If you were considering investing in Mkhize Ltd, which of the above ratios would you be
interested in and why?

Exercise 7

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 Calculate the following ratios for years 20x2 and 20x1 by using the selected information
below. Discuss your findings and offer detailed reasons for the change in the ratios from the
one year to the next.
7.1 Gross profit margin
7.2 Operating profit margin
7.3 Return on total assets
7.4 Current ratio
7.5 Debt to equity ratio

20x2 20x1
R R
Revenue 777 000 663 000
Net operating profit / (loss) 93 000 48 000
Gross profit 312 000 298 000
Operating costs (101 000) (150 000)
Total assets 969 000 879 000
Interest-bearing borrowings 572 000 555 000
Total current assets 94 000 89 000
Total equity 330 000 265 000
Total current liabilities 67 000 59 000

The current portion of interest-bearing borrowings included in current liabilities is R34 000.

Exercise 8
Xolani Gumede was recently appointed as an investment banker at Smiths Manufacturing
Ltd. The following financial information has been presented to him as a prospective
investment opportunity:
Extracts from the trial balance of Smiths Manufacturing Ltd at 31 December 20x1:

R’000
Revenue 50 000
Gross profit 10 000
Profit for the year 4 000
Credit purchases 20 000
Total assets 5 000
Total liabilities 5 500
Current assets 1 625
Inventories 500
Current liabilities 1 800
Average trade accounts payable 2 700

The bank uses the following basis to make investment decisions for the sector this company
operates in:

Net profit margin of at least 5%

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 Solvency ratio of at least 1: 1

Acid test ratio of at least 1: 1

Creditors’ payment period of less than 60 days

Required
Calculate the required ratios and comment on whether or Xolani should support an
investment in Smiths Manufacturing Ltd based on each of the ratios individually.

Exercise 9
Extracts from the latest financial statements of Tshabalala (Pty) Ltd are presented below
together with additional information:
Abbreviated statement of comprehensive income for the year ended 30 April 20x8

R’000
Sales 8 200
Cost of sales (6 230)
Gross profit 1 970
Operating costs (1 040)
Earnings before interest and tax 930
Interest expense (100)
Net profit before tax 830
Taxation (249)
Net profit after tax 581

Abbreviated statement of financial position as at 30 April 20x8

Assets R’000
Non-current assets
Property, plant and equipment 6 200

Current assets 2 920

Inventory 1 500
Accounts receivable 1 360
Cash 60

Total assets 9 120

Equity and liabilities

Shareholders’ equity 6 370
Share capital 3 850
Retained earnings 2 520

Non-current liabilities
Long-term debt 830

Current liabilities 1 920

Accounts payable 1 230
Other 690

Total equity and liabilities 9 120

Additional information

1. Tshabalala (Pty) Ltd is a small private company that manufactures and supplies motor
components to the major vehicle assembly plants in South Africa, including Toyota, VW
and BMW.

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 2. Ninety percent (90%) of its sales are on credit.
3. The following balances were extracted from Tshabalala’s statement of financial position at
30 April 20x7:

3.1 Inventory R1 420 000

3.2 Accounts receivable R1 280 000

4. As one of the manager owners of the company, you are wanting to assess the
comparative performance and financial position of the company with that of Smith’s (Pty)
Ltd, which also operates in the same industry.

You have managed to source the following financial ratios of Smith’s for its latest
reporting period:

Ratio Smith’s (Pty) Ltd.

Current ratio 1.35: 1
Quick ratio 0.90: 1
Inventory turnover – Note (a) 5.2 times
Receivable days – Note (b) 85 days
Gross profit margin 26%
Net profit margin 9.5%
Return on assets (ROA) – Note (c) 13.2%
Return on equity (ROE) 11.8%
Debt to equity 0.20: 1
Interest cover 10.5 times

Notes
Notes concerning Smith’s ratios:
a) Inventory turnover is based on average inventory and cost of sales.
b) Receivable days is based on average accounts receivable and credit sales.
c) ROA is based on earnings before interest and tax.
Required
9.1 Calculate the ratios of Tshabalala (Pty) Ltd for the year ended 30 April 20x8, as listed in
the table above (under additional information 4.), to enable a comparison to be made
with Smith’s (Pty) Ltd (assume 365 days in the year).
9.2 List Tshabalala’s ratios that are better than Smith’s in each of the following categories:
liquidity, efficiency, profitability and solvency.
9.3 Comment on the issues that Tshabalala’s management needs to address to improve its
financial performance and financial position.

Exercise 10
Extracts from the latest financial statements of Seacom Traders (Pty) Ltd are presented below
together with additional information:
Seacom Traders (Pty) Ltd
Abbreviated statement of comprehensive income for the year ended 28 February 20x8

Sales (Note 1) R335 000

Less: Cost of sales (Note 2) 187 900

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 Gross profit 147 100
Less: Operating expenses 21 600
Profit before interest and tax 125 500
Less: Interest paid 4 860
Net profit before tax 120 640
Less: Taxes 33 780
Net profit after tax 86 860

Abbreviated statement of financial position as at 28 February 20x8

20x8 20x7
ASSETS
Non-current assets 191 670 151 640
Net property, plant and equipment
Current assets 49 060 46 080
Inventory 25 100 24 050
Trade receivables 9 060 8 150
Cash and cash equivalent 83 220 78 280
274 890 229 920
Total assets
EQUITY AND LIABILITIES
Ordinary shareholders’ equity
Share capital 100 000 100 000
Retained earnings 102 090 63 670
Total equity 202 090 163 670
Non-current liabilities
Long-term debt 49 600 48 170
Current liabilities
Trade payables 21 320 17 030
Other 1 880 1 050
23 200 18 080
Total equity and liabilities 274 890 229 920

Notes

1. Sales comprise a range of merchandise sold mainly on credit with only 25% on average
being cash sales.
2. The company trades 365 days in a year.

Additional information
The following industry norms for the year ended 28 February 20x8 were established:

Ratio Industry norms

Current ratio 2.71
Quick ratio 1.23
Inventory turnover 3.0 times (note 1)
Days’ inventory on hand 95 days (note 1)
Receivable days 40 days (note 2)
Net profit margin 27%
Return on assets (ROA) 47% (note 3)
Return on equity (ROE) 45%
Debt to equity 0.30:1

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 Ratio Industry norms
Interest cover 20 times

Notes

1. The industry norm has been based on average inventory and cost of sales.
2. The industry norm has been based on average receivables and credit sales.
3. The industry norm has been based on net profit before interest and tax.

Required
10.1 Calculate the ratios of Seacom Traders (Pty) Ltd for the year ended 28 February 20x8,
as listed in the table above, to enable a comparison to be made with the industry
norms.
10.2 State for each ratio category separately, whether Seacom’s overall liquidity, efficiency,
profitability and solvency is better than the industry norm.
10.3 Draw conclusions concerning the financial performance and position of Seacom (Pty) Ltd
compared to the industry.

Exercise 11
The management of Sizwe Ltd is busy restructuring the business. The following is an extract
of the comparative statement of comprehensive income of Sizwe Ltd for five years:

20x5 20x4 20x3 20x2 20x1

R’000 R’000 R’000 R’000 R’000
Revenue 15 223 12 225 13 556 9 986 7 056
Distribution costs (850) (989) (776) (678) (569)
Earnings before interest and tax 5 333 3 765 4 155 2 314 1 415
(EBIT)

Additional information

1. Sizwe is a company that sells and distributes office furniture to office parks and has a few
large clients.
2. Sizwe purchased and sold furniture with defects in 20x1. These sales were lost because
the furniture was returned. After that, it had to convince its clients that it would do detailed
inspections before delivery.
3. ProCon Ltd, a client of Sizwe, was liquidated in July 20x4. This was due to poor market
conditions as well as fraudulent actions by its management.
4. Sizwe is currently under new management. They were appointed in 20x5.

Required

a) Redraft the extract of the comparative statement of profit or loss and other
comprehensive income of Sizwe Ltd by using the following techniques:

i) Indexed statements (round off your answer to no decimal place).

ii) Common size statements (round off your answer to one decimal place).

Given the strategic or non-financial information provided in the additional information, provide
context to the financial analysis.

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 TEST YOURSELF SOLUTIONS

TEST YOURSELF SOLUTION 6.1

i) Indexed statements:
(The first year is shown as the base year [in this case year 20x1] – set equal to 100 and
figures for subsequent years are shown as a percentage of that year, which gives a good
overview of the growth or decline from the base year to a certain date.)

20x5 20x4 20x3 20x2 20x1

% % % % %
Revenue 216* 173 192 142 100

Distribution costs 149 174 136 119 100

Earnings before interest and tax (EBIT) 377 266 294 164 100

*20x5: (15 223/7 056) × 100

20x4: (12 225/7 056) × 100
20x3: (13 556/7 056) × 100
20x2: (9 986/7 056) × 100
20x1: (7 056/7 056) × 100 (Base year = 100%)
ii) Common size statements:
(Each item on the statement is stated as a percentage of the total of the specific section.
In this case as a percentage (%) of revenue.)

20x5 20x4 20x3 20x2 20x1

% % % % %
Revenue 100,0 100,0 100,0 100,0 100,0

Distribution costs 5,6* 8,1 5,7 6,8 8,1

Earnings before interest and tax (EBIT) 35,0 30,8 30,7 23,2 20,1

(14)
*20x5: (850/15 232) x 100
20x4: (989/12 225) x 100
20x5: (5 333/15 223) x 100
20x4: (3 765/12 225) x 100

TEST YOURSELF SOLUTION 6.2

6.1 Current ratio = Current assets

Current liabilities

= (336 000+600 000)

780 000

= 936 000 ÷ 780 000

= 1,20: 1
6.2 Acid test ratio = Current assets−Stock

Current liabilities

= (336 000+336 000)

780 000

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 = 600 000 ÷ 780 000
= 0,77: 1
6.3 Inventory turnover rate = Cost of sales

Average stock

= 1680 000

(200 000+336 000)÷2

= 1 680 000 ÷ 268 000

= 6,27 times per year
6.4 Debtors’ collection period = Average debtors
× 365
Credit sales

= (400 000+600 000)÷2

× 365
3 000 000

= 500 000 ÷ 3 000 000

= 61 days
6.5 Gross profit to turnover = Gross prof it
× 100
Sales

= 1320 000
× 100
3 000 000

= 44%
6.6 Return on equity = Net prof it af ter tax andpref erence divided
× 100
Ordinary shareholders’ equity

= 140 000
× 100
(400 000+160 000)

= 140 000
× 100
560 000

= 25%
6.7 Return on capital employed = Net prof it bef ore interest and tax
× 100
Capital employed

= 240 000
× 100
(400 000+160 000+440 000)

= 240 000
× 100
1000 000

= 24%
6.8 Return on assets = Net prof it bef ore interest and tax
× 100
Total assets

= 240 000
× 100
(844 000+336 000+600 000)

= 240 000
× 100
1780 000

= 13,48%

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 7 Bank reconciliation

Outcomes

At the end of this chapter students should be able to

understand the general principles of control over cash

compare the cash journals with the bank statement
prepare an adjusted bank account in the general ledger and a bank reconciliation statement.

Chapter outline

7.1 Control over cash

7.1.1 The business’s records
7.1.2 The bank’s records
7.2 Reconciliation process
7.2.1 Steps for bank reconciliation

7.1 Control over cash

It is important to check accounting entries regularly to ensure accuracy and control. Cash is the
lifeblood of any organisation and poor cash management can ultimately lead to an enterprise’s
demise.

The checking of the cash journals and the bank statements on a monthly basis confirms the
balance of cash held at the bank.

7.1.1 The business’s records

All money received is recorded in the cash receipts journal and all money paid out is recorded in
the cash payments journal. At the end of the month the totals of these two journals are posted to
the bank account in the general ledger. The bank account is a current asset; therefore, all receipts
are debited; that is, they increase the bank balance. All payments are credited in the bank
account; that is, they decrease the bank balance.

7.1.2 The bank’s records

The bank also records all the transactions that affect our bank balance, and at the end of the
month it sends us a copy of these transactions in the form of a bank statement.

The main difference between the way we record transactions and the way the bank records
transactions is that the bank statement will be the mirror image of the cash journals. The bank
credits to increase and debits to decrease our bank balance. This is opposite to what we do in the

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 general ledger. The reason for this is that the bank views our account as a liability. From its
point of view, it owes us the money that is in our bank account. The bank follows the rule: to
increase a liability, credit, and to decrease a liability, debit.

Clearly, the cash journals and the bank statements reflect the same entries, and therefore in
essence should have the same closing balance. If the closing balance in our records does not
agree with the closing balance in the bank statement, a bank reconciliation must be conducted.

7.2 Reconciliation process

Many of the discrepancies are simply caused by time delays.

Items not appearing in the business cash Items not appearing on the bank statement
journals
1. Bank charges, including service fees, cash 1. Deposits made but not yet recorded by the
deposit fees, etc. bank because they were made close to the
statement date. They were not processed
by the bank in time and will therefore only
appear on the following month’s bank
statement.

2. Payments made by the bank for stop 2. Cheques issued but not recorded by the
orders or debit orders, i.e. insurance bank because they have not been
premiums. presented to the bank for payment.

3. Deposits made directly into our bank

account by a debtor, i.e. rental.

4. Dishonoured cheques (R/D cheques)

previously deposited in good faith by the
business.

5. Interest on overdraft

These items do not appear in the These items do not appear in the bank’s
business’s books and must therefore be books and must therefore be entered on
entered into the general ledger bank the bank reconciliation statement.
account.
Any errors that have been made in the Any errors made by the bank must be
cash journals must be corrected in our corrected on the bank reconciliation
books. statement.

7.2.1 Steps for bank reconciliation

1. Compare the closing balance in the general ledger bank account with the closing balance in
the bank statement. If they are not the same, then continue with step 2.
2. Compare the cash journals and the bank statement and circle any item that does not appear
in both sets of records.

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 3. Items that appear on the bank statement but not in the cash journals must be entered into the
cash journals. (Alternatively, these items can also be recorded directly in the general ledger
bank account.)
4. Items that appear in the cash journals but not on the bank statement must be entered on the
bank reconciliation statement.
5. Any errors that have been made in the cash journals must be corrected in the cash journals.
(Alternatively, these items can also be recorded directly in the general ledger bank account.)
6. Any errors made by the bank must be corrected on the bank reconciliation statement.

ILLUSTRATIVE EXAMPLE

The following information was extracted from the accounting records of XYZ Ltd:
Abridged cash receipts journal for December 20x1

Date Details Bank (R)

04 D. Duma 656,00
09 S. Sibiya 1 312,00
14 Rent received 984,00
21 P. Pillay 1 695,76
28 G. Govender 602,34
31 S. Brewer 602,08
5 852,18

Abridged cash payments journal for December 20x1

Date Details Cheque Bank (R)

no.
05 P. Paul P1260 796,84
06 Rent expense P1270 787,20
08 Stock P1280 3 204,56
10 Happy Traders P1290 877,40
11 Beach Motors P1300 626,16
12 Greenfingers Garden Services P1310 288,64
15 Rates and taxes – municipality P1320 116,12
21 Wages P1330 1 476,00
30 Telephone – post office P1340 1 233,28
9 406,20

The bank reconciliation statement as at 30 November 20x1 was as follows:

Bank reconciliation statement as at 30 November 20x1

R
Favourable balance as per bank statement 522,50
Less: Outstanding cheques

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 R
P1020 131,20
P1040 137,04
P1080 1 000,46
P1250 399,84
Add: Outstanding deposit 280,12
Balance as per bank account (865,92)

The bank statement from BNF Bank was received and read as follows:
Bank statement as at December 20x1

Date Details Cheques Deposits Balance

Debit Credit (R)
(R) (R)
01 Balance 522,50 Cr
02 Deposit 280,12 802,62 Cr
05 Deposit 656,00 1 458,62 Cr
06 P1260 796,84 661,78 Cr
07 P1270 787,20 125,42 Dr
09 P1280 3 204,56 3 329,98 Dr
11 Deposit 1 312,00 2 017,98 Dr
12 SF 20,00 2 037,98 Dr
CB 29,52 2 067,50 Dr
15 Deposit 984,00 1 083,50 Dr
16 P1320 116,12 1 199,62 Dr
22 Deposit 1 695,76 496,14 Cr
23 P1330 1 476,00 979,86 Dr
24 SO (SPCA) 164,00 1 143,86 Dr
26 CU (R. Rudolf) 492,00 1 635,86 Dr
27 OI 110,54 1 746,40 Dr
28 P1020 131,20 1 877,60 Dr
30 SO (B. Square) 65,60 1 943,20 Dr

Explanation of abbreviations
SF – service fees
SO – stop order
CU – cheque unpaid/RD
CB – cheque book printing
OI – overdraft interest
Required

1. Prepare the adjusted cash journals.

2. Post from the cash journals to the general ledger bank account.

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 3. Prepare the bank reconciliation statement as at 31 December 20x1.

ILLUSTRATIVE EXAMPLE: Solution

Abridged cash receipts journal for December 20x1

Day Details Bank (R)

30 Total receipts 5 852,18
5 852,18

Abridged cash payments journal for December 20x1

Date Details Cheque no. Bank (R)

30 Total payments 9 406,20
Bank charges (R20 + R29,52) 49,52
Interest on overdraft 110,54
Stop order (SPCA) 164,00
Stop order (B. Square) 65,60
Debtors (Dishonoured cheque) R. 492,00
Rudolf
10 287,86

General ledger
Bank
Dec 31 20x1 Receipts 5 852,18 Dec 01 20x1 Balance b/d R865,92
Balance c/d 5 301,60 31 Payments 10 287,86

11 153,78 11 153,78
Jan 01 20x2 Balance c/d 5 301,60

ABC Limited
Bank reconciliation statement as at 31 December 20x1

Debit R Credit R
Debit balance as per bank statement 1 943,20
Debit: Outstanding cheques
P1040 137,04
P1080 1 000,46
P1250 399,84
P1290 877,40
P1300 626,16
P1310 288,64
P1340 1 233,28
Credit: Outstanding deposits 602,34
602,08
Credit balance as per bank account 5 301,60

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 Debit R Credit R
6 506,02

OR
ABC Limited
Bank reconciliation statement as at 31 December 20x1

R R
Unfavourable balance as per bank statement (1 943,20)
Less: Outstanding cheques (4 562,82)
P1040
P1080 (137,04)
P1250 (1 000,46)
P1290 (399,84)
P1300 (877,40)
P1310 (626,16)
P1340 (288,64)
(1 233,28)
Add: Outstanding deposit 602,34
602,08
Credit balance as per bank account (5 301,60)

TEST YOURSELF 7.1

The following is the bank reconciliation for May 20x1, the bank statement for June 20x1 and a
summary of the cash records for June 20x1 for SDB Ltd:

General ledger
Bank
Date Detail Fol Amount
1 June 20x1 Balance b/d R2 353,50

Cash receipts journal for June 20x1 CRJ 6

04 Deposit 800
10 Deposit 1 700
15 Deposit 2 100
25 Deposit 1 500
30 Deposit 1 100
7 200

Cash payments journal for June 20x1 CPJ 6

01 Cheque 185 900
04 Cheque 186 510
10 Cheque 187 1 414
17 Cheque 188 440
25 Cheque 189 1 134
30 Cheque 200 516

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 4 914

Bank reconciliation statement as at 31 May 20x1

Balance as per bank statement 2 826,50

Add: Outstanding deposit 1 232,00
Less: Outstanding cheques
No. 180 (770,00)
No. 183 (935,00)
Balance as per general ledger bank account 2 353,50

SAVINGS BANK
Bank statement
Date Code Cheque Cheques and other debits Deposits Balance
no. R R R
May R2
31 826,50
Jun 01 1 232,00 4 058,50
185 900,00 3 158,50
SF 4,50 3 154,00
03 183 935,00 2219,00
SF 4,50 2 214,50
05 800,00 3 014,50
11 SF 7,00 1 700,00 4 707,50
12 187 1 414,00 3 293,50
SF 7,00 3 286,50
16 2 100,00 5 386,50
17 188 440,00 4 946,50
SF 4,00 4 942,50
Rent 500,00 5 442,50
26 1 500,00 6 942,50
27 RD 1 200,00 5 742,50
(James)
SF 6,00 5 736,50
28 189 1 134,00 4 602,50
SF 6,00 4 596,50

Explanation of abbreviations:
SF – service fees CB – chequebook printing
SO – stop order OI – overdraft interest
RD – cheque unpaid

Required

1. Prepare the adjusted cash journals.

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 2. Post from the cash journals to the general ledger bank account.
3. Prepare a bank reconciliation statement as at 30 June 20x1.

TUTORIAL EXERCISES: Bank reconciliation

Exercise 1
Below is a list of statements. Indicate whether the statements are true or false. If the
statement is false, then rephrase the statement in order to make it true.
1.1 Bank reconciliation is a verification process.
1.2 Bank reconciliation is important for control over costs.
1.3 Many of the discrepancies between the business’s records and the bank’s records are
caused by time delays.
1.4 The bank’s records and the business’ records are mirror images of each other.
1.5 Payments made by the bank on clients’ behalf include debit orders and stop orders.
1.6 Any errors made by the bank must be corrected in the cash journals.
1.7 Any errors made by the business must be corrected in the bank reconciliation statement.
1.8 A dishonoured cheque is a cheque that has been marked “refer to drawer” due to
insufficient funds in the debtors’ account.
1.9 A stale cheque is an old cheque that cannot be cashed due to its age.
1.10 A cheque is considered stale if it is more than six months old and it must be cancelled.

Exercise 2
Using the information provided below, draw up a bank reconciliation statement and determine
the balance of the bank account of Lukhozi Traders as at 31 December 20x6.

Cheques not presented for payment R1 700

Deposits reflected in the cash receipts journal but not on the bank statement R3 600
Credit balance as per the bank statement R34 145

Exercise 3
The following information was taken from the books of ABC Enterprises for October 20x0:
Bank reconciliation statement as at 30 September 20x0

R
Balance according to bank statement 261
Add: Outstanding deposits 140
Less: Outstanding cheques: No. 102 66
No. 104 68
No. 108 500
Unfavourable balance according to bank account –233

Cash receipts journal for October 20x0

Day Details Bank (R)

8 Deposit rent received 984
25 Deposit fees earned 1 339

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 31 Deposit fees earned 651
2 974

Cash payments journal for October 20x0:

Date Cheque no. Payee Details Amount (R)

5 126 W. Raymond Creditors 398
6 127 H. Kor Rent paid 394
8 128 Makro Stock 1 602
10 129 Makro Stock 438
11 130 SW Motors Repairs 313
12 131 A. James Legal services 144
15 132 Municipality Electricity 58
21 133 D. Dunn Salaries 738
25 134 Telkom SA Telephone 616
4 701

Bank statement as at October 20x0

Date Description Debit (R) Credit Balance (R)

9/30 Balance b/f 261 Cr
9/30 Deposit 140 401 Cr
10/8 Deposit 984 1 385 Cr
10/12 Cheque 126 398 987 Cr
10/14 Cheque 127 394 593 Cr
10/15 Cheque 128 1 602 1 009 Dr
10/15 Service fees 5 1 014 Dr
10/15 Service fees 40 1 054 Dr
10/15 Chequebook fees 4 58 Dr
10/16 Cheque 132 58 1 116 Dr
10/25 Deposit 1 339 223 Cr
10/26 Cheque 133 738 515 Dr
10/28 Stop order – Mutual 95 610 Dr
10/31 Cheque 102 66 676 Dr

ADDITIONAL INFORMATION
The stop order for R95 on 28 October 20x0 on the bank statement was debited in error by the
bank to the account of ABC Enterprises. The stop order was for ZA Traders.

Required
3.1 Prepare the adjusted cash journals.
3.2 Post from the cash journals to the general ledger bank account.
3.3 Prepare the bank reconciliation statement as at 31 October 20x0.

Exercise 4

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 The information given below was extracted from the accounting records of Tanya Thompson.
Required
4.1 Complete the cash receipt journals and cash payments journals of Tanya Thompson, a
sole trader, for the year ending 31st October 20x5 after taking the information provided
into account.
4.2 Post to the bank account in the general ledger. Balance the account.
4.3 Prepare the bank reconciliation statement as at 31st October 20x5.
ADDITIONAL INFORMATION

No
1. The bank column of each of the cash journals showed the following totals before the October 20x5 bank statement
was received:
Cash receipts journal R300 000
Cash payments journal R350 000

2. A comparison of the Cash Journal of Tanya Thompson for October 20x5 and the bank reconciliation for September
20x5 with the bank from October 20x5 received the following differences.
2.1 Entries that appeared on the bank statement but not in the cash journals:
2.1.1 A cheque for R6 800 previously received from the lessee for rent was dishonoured because of insufficient funds.
2.1.2 Debit order of R3 800 in favour of Telkom for the personal account of the proprietor.
2.1.3 The bank on 31st October reflected the following bank charges:
Service fee R1 500
Cash deposit fee R1 000
Interest on overdraft R100

2.1.4 A deposit by a debtor to settle his account of R6 000.

2.1.5 A deposit of R50 000 by Key Bank for a successful loan application.
2.2 Entries in the cash journals that did not appear in the bank statement:
2.2.1 A deposit of R102 400 made 31 October 20x5.
2.2.2 The following payment of R 8 700 must be made in October 20x5 in favour of C. Mkhize.
2.3 Additional information:
2.3.1 The payment in favour of C. Mkhize made on the (23rd September 20x5) which appeared in the bank reconciliation
statement for September 20x5 did not appear in the bank statement for October 20x5.
2.3.2 Payment of R4 800 made to Rix Club during January 2018 as a donation which must be cancelled as the club no
longer exists.
2.3.3 The bank account in the ledger of Tanya Thompson reflected a debit balance of R38 800 on the 1st October 20x5.
2.3.4 The bank statement showed an unfavourable balance of R57 300 on 31st October 20x5.

Exercise 5
The following information was obtained from the records of A. Avis for December 20x2
5.1 Complete the cash receipts journal and cash payments journal for December 20x2.
5.2 Post to the bank account in the general ledger. Balance the account.
5.3 Prepare the bank reconciliation statement as at 31 December 20x2.
ADDITIONAL INFORMATION

No
1. The bank column of each of the cash journals showed the following totals before the 31st December 2002 bank
statement was received:
Cash receipts journal R87 600
Cash payments journal R87 890

A comparison of the cash journals of A. Avis for December 20x2 and the bank reconciliation statement for
November 20x2 with the bank statement of ND bank for December 20x2 revealed the following differences.
2.1 Entries on the bank statement which did not appear in the cash journals:
2.1.1 A payment of R1 570 previously received from a debtor H. Harris, was dishonoured because of insufficient funds.

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 No
2.1.2 A debit order for R700 in favour of OM Insurers for the monthly insurance premium.
2.1.3 Charges levied by N D Bank:
Service fee R100
Cash deposit fee R40
Credit commission R370
Interest on overdraft R120

2.1.4 A deposit of R500 by ND Bank into the account of A. Avis for interest on fixed deposit.
2.1.5 A deposit of R900 by a tenant, H. Hadebe, into the account of A. Avis for rent.
2.2 Entries in the cash journals that do not appear on the bank statement:
2.2.1 A deposit of R25 600 made on the 31st December 20x2.
2.2.2 The following payment issued during December 20x2:
Payment Cheque No.1: R3 170
Payment Cheque No. 2: R1 040

2.3 Additional information

2.3.1 Payment Cheque 3 dated (15 November 20x2) which appeared in the bank reconciliation statement for November
20x2 did not appear in the bank statement for December 20x2, R3 000.
2.3.2 Payment of R1 200 made to KwaDukuza Sports on 25 December as a donation must be cancelled as the club no
longer exists.
2.3.3 The bank account in the ledger of A. Avis had a debit balance of R9 700 on 1 December 20x2.
2.3.4 The bank statement showed a debit balance of R9 290 on 31 December 20x2.

Exercise 6
The following information was obtained from the books of Gloss Distributors after comparing
the cash book with the bank statement on 30 April 20x4:

1. Balance on bank statement, R22 100 credit.

2. Balance in general ledger bank account on 1 April 20x4, R8 300 debit.
3. Pencil total of cash receipts journal, R26 456.
4. Pencil total of cash payments journal, R16 438.
5. A deposit of R4 000 does not appear in the cash receipts journal, but was made directly
into the bank account of Gloss Distributors by a client.
6. Bank charges on bank statement amount to R463.
7. Interest received on bank statement, R125.
8. The following cheques were written out on 30 April 20x4 but were not on the bank
statement: cheque no. 301 for R450 and cheque no. 302 for R1 570.
9. An amount of R550 was written in the cash receipts journal instead of the cash payments
journal.
10. Insurance policy premium R900 was paid by debit order.
11. No entry has been made in the company’s book in respect of a cheque returned by the
bank marked “refer to drawer”. The cheque was for R280 and was received from S. van
Wyk in settlement of his account.
12. The bank had erroneously credited Gloss Distributors’ account with an amount of R380.

Required
Do the following:
6.1 A general ledger bank account properly balanced off
6.2 A bank reconciliation statement as at 30 April 20x4

Exercise 7

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 Galvin Traders received their bank statement on 28 February 20x2 and compared it with its
cash receipts journal and cash payments journal. The following facts came to light:

1. The bank statement had a favourable balance of R362 on 28 February 20x2 and the bank
account in the general ledger had a credit balance of R1 240 on 28 February 20x2.
2. A cheque for R146 from B. Bankrupt, a debtor, was received from the bank marked “refer
to drawer”, and has not been redeposited.
3. A deposit of R400 for rent received was made directly into the bank account of the
enterprise by a tenant.
4. A deposit of R1 420 was recorded as R1 240 in the cash receipts journal. The deposit
was for cash sales.
5. A deposit of R400 made on 28 February 20x2 does not appear on the bank statement.
6. Insurance premiums to the value of R120 were paid by debit order. The amount appears
on the bank statement, but was not recorded in the cash payments journal.
7. The following cheques were not presented to the bank for payment by 28 February 20x2:

No. 208 R150 (drawn on 1 July 20x1 in favour of a creditor, N. Noop)

No. 421 R35
No. 425 R1 120

8. Cheque no. 418 for an amount of R10 appears on the bank statement as R1.
9. Cheque no. 101 for R220 drawn by Galvin Ltd was erroneously included in Galvin
Traders, bank statement.
10. A cash purchase for R1 180 made with cheque no. 412 drawn on 13 February 20x2 is
shown in the cash payments journal as R1 810.
11. Bank charges of R36 appear on the bank statement, but were not recorded in the cash
payments journal.

Required
7.1 Prepare the bank account of Galvin Traders in the general ledger.
7.2 Prepare a bank reconciliation statement as at 28 February 20x2.

Exercise 8
The following information was extracted from the accounting records of GB Traders for the
month of April 20x1:

1. On 1 April 20x1 the bank account showed a debit balance of R770,72.

2. On 30 April 20x1 the bank statement showed a credit balance of R119,11.
3. The column subtotals of the cash receipts journal on 30 April 20x1, before the cash
receipts journal was compared with the bank statement, were as follows:

Sundry Cost of Sales VAT Debtors Discount Bank

accounts sales allowed
R1 288,91 R2 216,75 R4 R44 R1 R5 750 R7
433,50 335 015,00 123,26

4. The column subtotals of the cash payments journal on 30 April 20x1, before the cash
payments journal was compared with the bank statement, were as follows:

Sundry Wages Trading Debtors Creditors Discount Bank

accounts stocks received
R3 151,30 R36 R3 074,81 – R1 R6 745 R7

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 000 258,40 777,06

5. The bank statement for April 20x1 was compared with the cash receipts journal and cash
payments journal for April 20x1. The following differences were found:

The following bank charges appeared on the bank statement only: service fees of
R12,40, levy on debit transactions of R4,00 and cash handling fees of R4,90.
The bank statement showed an unpaid cheque for R95,43 received from R. Wilson, a
debtor, in settlement of his account. The cheque was dishonoured due to insufficient
funds.
A stop order for R64,64, in favour of the Permanent Insurance Company for an
insurance premium, appeared in the bank statement only.
A deposit of R620,00 appeared in the bank statement only. This amount was rental
which was deposited into GB Traders’ current account by CP Chemist.
The bank debited GB Traders’ current account with cheque no. 917 for R231. This
cheque was drawn by GB Hotel.
A deposit of R744,83, dated 30 April 20x1, did not appear on the bank statement.

6. The following cheques had not been presented for payment by 30 April 20x1:
No. 184, issued on 16 February 20x1 for R85,40
No. 391, issued on 28 April 20x1 for R306,84
No. 393, issued on 30 April 20x1 for R147,15

Required
Draft the following for the month of April 20x1:
8.1 A bank account properly balanced off.
8.2 A bank reconciliation statement.

TEST YOURSELF SOLUTION

TEST YOURSELF SOLUTION 7.1

1. Abridged cash receipts journal for June 20x1

Day Details Bank (R)

30 Total receipts 7 200,00
Rental income (direct deposit) 500,00
7 700,00

Abridged cash payments journal for June 20x1

Date Details Cheque Bank (R)

no.
30 Total payments 4 914,00
Bank charges 39,00
Debtors (dishonoured cheque) 1 200,00
6 153,00

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 2.

General ledger Bank

June 01 20x1 Balance b/d 2 353,50 June 30 20x1 Payments 6 153,00
30 receipts 7 700,00
- Balance c/d 3 900,50
10 053,50 10 053,50
July 01 20x1 Balance b/d 3 900,50

Method 1: Double entry

1. Bank reconciliation statement as at 30 June 20x1

Debit R Credit R
Credit balance as per bank statement 4 596,50
Credit: Outstanding deposit 1 100,00
Debit: Outstanding cheques
No. 180 770,00
No. 186 510,00
No. 200 516,00
Debit balance as per bank account 3 900,50
5 696,50 5 696,50
totals are
equal

Method 2: Arithmetic
Bank reconciliation statement as at 30 June 20x1

Balance as per bank statement 4 596,50

Add: Outstanding deposit 1 100,00
Less: Outstanding cheques 1 796,00
No. 180 770,00
No. 186 510,00
No. 200 516,00 –
Balance as per bank account 3 900,50

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 8 Value-added tax (VAT)

Outcomes

At the end of this chapter students should be able to

convey basic background knowledge of VAT

calculate VAT
calculate mark-ups on cost price and on selling price
calculate selling prices (inclusive and exclusive of VAT).

Chapter outline

8.1 Introduction
8.2 Who should be registered as a vendor?
8.3 Rates and exemptions
8.4 The VAT system
8.4.1 Input tax
8.4.2 Output tax
8.4.3 VAT payable/refundable
8.4.4 Calculating VAT
8.5 Mark-ups on cost price and selling price
8.5.1 Percentage mark-up on cost price
8.5.2 Percentage mark-up on selling price

8.1 Introduction

Value-added tax (VAT) is a system of taxation that was implemented on 30 September 1991. It is
levied whenever a product is sold or a service is rendered, with a few exceptions (exempt
supplies). The government raises revenue by requiring that certain traders, known as vendors,
register for VAT in order to charge VAT on taxable supplies of goods or services. The South
African Revenue Services (SARS) is the government organisation which administers the VAT
Act and ensures that the tax is collected. No person is exempt from paying VAT, irrespective of
how much or how little they earn.

8.2 Who should be registered as a vendor?

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 It is compulsory for a person to register if he runs a business where his total value of taxable
supplies exceeds or is likely to exceed R1 million for a 12-month period. A person may apply
for voluntary registration, provided that the minimum threshold of R50 000 has been exceeded
in the past 12-month period. Persons who are liable to register, and those who have registered
voluntarily, are referred to as vendors. Vendors have to perform certain duties and take on
certain responsibilities, such as issuing tax invoices where required, including VAT in all prices
quoted, ensuring that VAT is collected on taxable transactions and that they submit returns, and
making payments on time.

8.3 Rates and exemptions

VAT is paid on the supply of goods or services in South Africa and also on goods imported into
South Africa. VAT is levied at the standard rate of 15% from 1 April 2018. Prior to this date,
VAT was levied at 14%. The VAT rate is controlled by the government and can be adjusted by
the Minister of Finance at any time. There are certain goods and services which are either
exempt or which are subject to tax at the zero rate.

A standard-rated supply is a supply of goods or services which is subject to VAT at the rate of
15%. As a general rule, the supply of all goods and services is taxable at the standard rate,
unless it is specifically zero rated or exempt:

Zero-rated supplies. There are some goods where VAT is levied at 0% as these are deemed
essential goods by the government. An input tax deduction can be claimed against zero-rated
supplies in the same manner as supplies at 15%. These include fuel levy goods, certain basic
foodstuffs, such as graded maize meal and brown bread, and certain exported goods or
services. Certain basic foodstuffs are zero rated, provided they are not supplied for immediate
consumption, such as a glass of milk served in a restaurant, or added to a standard-rated
supply.
Exempt supplies. No VAT is levied on these goods, that is, no output tax and no input tax
deductions are allowed against these supplies. They include medical and trade union
contributions, educational services, residential accommodation, etc.

(Note: Zero-rated and exempt supplies will not be dealt with any further.)

8.4 The VAT system

The mechanics of the VAT system are based on a subtractive or credit input method which
allows the vendor to deduct the tax incurred on the organisation’s inputs (input tax) from the tax
collected on the supplies made by the organisation (output tax).

The vendor submits a VAT 201 return to SARS every tax period, where the input tax incurred is
offset against the output tax collected and the balance is paid to SARS by the 25th day of the tax
period concerned. The VAT collected is paid over to SARS every two months, unless the value

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 of taxable supplies in a 12-month period exceeds R30 million. In such instances, the vendor
must submit returns electronically on a monthly basis. Certain farming enterprises are allowed
to pay VAT on a biannual basis and small businesses with taxable supplies of less than R1,5
million in a 12-month period may pay their VAT every four months.

8.4.1 Input tax

This is the tax that the vendor himself has borne in respect of goods or services supplied to him.
In other words, it is VAT paid by a business or consumer to other businesses on the supply of
goods or services it receives. There are some expenses on which input tax is not allowed, such
as the fees or subscriptions payable for membership of any sporting, social or recreational club,
association or society; the acquisition of motor cars and entertainment.

8.4.2 Output tax

This is the tax which the VAT registered vendor charges on the supply of goods or services in
the course of business both to other businesses and to ordinary consumers. A VAT registered
business will need to calculate VAT on each VAT-able item.

8.4.3 VAT payable/refundable

This is the difference between the output tax and the input tax. Where a vendor’s outputs exceed
his inputs, VAT will be payable on the difference, and where a vendor’s inputs exceed his
outputs, a refund will be paid.

VAT charged on supplies made (output tax) – VAT paid to your suppliers (input tax) =
the amount of VAT payable/refundable

ILLUSTRATIVE EXAMPLES

Example 1
The following example illustrates the VAT system.

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 Summary of transactions

Vendor Selling price Input tax Output tax Tax due to

(excluding SARS
VAT)
Farmer R100 0 R15 R15
Processor R400 R15 R60 R45
Manufacturer R600 R60 R90 R30
Retailer R700 R90 R105 R15
Customer – – – –
R165 R270 R105

TEST YOURSELF 8.1

Use the following table to explain how the VAT system would work if the farmer produced
maize, which he sold to the miller who produced flour. The miller sold the flour to the baker
who then used the flour to make cakes, which were then sold to the local supermarket.

Vendor Selling price Input tax Output tax Tax due to SARS
Farmer R10 0 R1,50 R1,50
Manufacturer R50 R1,50 R7,50 R6,00
Wholesaler R70 R7,50 R10,50 R3,00

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 Vendor Selling price Input tax Output tax Tax due to SARS
Retailer R100 R10,50 R15,00 R4,50
R19,50 R34,50 R15,00

8.4.4 Calculating VAT

VAT inclusive. When an amount is inclusive of VAT, it means that the VAT is included in the
amount. For example, an amount of R1 150 is VAT inclusive. To calculate the VAT amount, the
following formula can be used:
% VAT rate VAT inclusive amount
VAT = ×
100+%VAT rate 1

15 R1 150
= ×
100+15 1

= R150

VAT exclusive. When an amount is exclusive of VAT, then it means that the amount does not
include VAT. For example, an amount of R1 000 is excluding VAT. To calculate the VAT
amount, the following formula can be used:
% VAT rate amount excluding VAT
VAT = ×
100 1

15 R1 000
= ×
100 1

= R150

Example 2
Mr Hayne purchases computer hardware components for R1 000 (excluding VAT) from a
computer hardware manufacturer, and assembles a computer which he sells to Miss Cami for R1
710 (including VAT). Miss Cami then installs software programs and sells the computer to Miss
Senaysh (the end user) for R3 420 (including VAT).

In a VAT system, the tax is levied as follows:

Input tax Output tax VAT payable to

SARS/refundable to
vendor
Supplier of hardware 15/100 × R1 R150
components 000
= R150
Mr Hayne 15/100 × R1 15/115 × R1 R223 – R150 = R73
000 710
= R150 = R223
Miss Cami 15/115 × R1 15/115 × R3 R446 – R223 = R223
710 420
= R223 = R446
Miss Senaysh is the end user, therefore there is no further VAT.
Total amount of VAT collected by SARS is the amount of VAT R446
charged on the final sale to Miss Senaysh, the end user.

Note the formulae used, that is, if the amount is VAT inclusive or exclusive.

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 Once the input and output VAT amounts have been calculated, they can be recorded in the ledger
accounts as follows:

SARS: VAT payable

Input VAT R223 Output VAT R446
Balance c/d R223
R446 R446
Balance b/d R223

TEST YOURSELF 8.2

The following transactions occurred in Msomi Stores during January 20x1:

1. Purchased inventory from Mbali Suppliers for R2 806.

2. Sold inventory on a cash basis to Sharon Zunckel Traders and received R3 542.
3. Paid weekly wages of R5 000 to the supervisor, Stephanie Singh.
4. Purchased stationery for R575.

Calculate the amount of VAT in each transaction. Prices quoted are inclusive of VAT unless
otherwise stated.

8.5 Mark-ups on cost price and selling price

VAT can lead to overpricing of goods if it is not excluded from mark-up calculations. When
goods are purchased and the cost of goods purchased has been established, the merchandiser
must decide on a pricing policy, which requires a mark-up. A mark-up is the difference between
the selling price and the cost price of goods. It can be expressed as a percentage on either the
cost price or the selling price. Whatever the mark-up is calculated on is 100%.

The following formula can be used to calculate the marked price. Note that the term “marked
price” refers to the price including VAT and the term “selling price” refers to the amount which
is received excluding VAT.

Cost price + Mark-up (on cost / selling price) = Selling price + VAT = Marked price

Using the formula below, you can calculate any of the missing amounts, provided that you have
a known value and its rate (%) to use:
% of unknown (what you want to calculate) Rand value of known
×
% of known (what you are using to calculate unknown) 1

8.5.1 Percentage mark-up on cost price

When the mark-up is on cost price, then cost price becomes 100%. The selling price becomes
100% plus the percentage mark-up. To calculate VAT or the marked price, the selling price must
be designated as 100% (see Table 8.1).

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 Table 8.1

Cost price Mark-up (on Selling price VAT @ 15% Marked price
cost) 10% (VAT inclusive)
R100 R10 R110 R16,50 R126,50
100% 10% 110%
100% 15% 115%

The following can be calculated using Table 8.1:

Selling price using cost price

Rand value Rate (%)

Cost price R100 100%
Selling price ? 110% (100% + 10%)

% of unknown Rand value of known

Selling price = ×
% of known 1

% of selling price Rand value of cost price

= ×
% of cost price 1

110% R100
= ×
100% 1

= R110

Mark-up using selling price

Rand value Rate (%)

Selling price R110 110% (100% + 10%)
Mark-up ? 10%

% of unknown Rand value of known

Mark-up = ×
% of known 1

% of mark-up Rand value of selling price

= ×
% of selling price 1

10% R110
= ×
110% 1

= R10

VAT using marked price

Rand value Rate (%)

Marked price R126,50 115% (100% + 15%)
VAT ? 15%

% of unknown Rand value of known

VAT = ×
% of known 1

% of VAT Rand value of marked price

= ×
% of marked price 1

15% R126,50
= ×
115% 1

= R16,50

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 8.5.2 Percentage mark-up on selling price
If goods are marked up on selling price, then on a percentage basis the selling price equals
100%. Cost price equals 100% minus the percentage mark-up. For the purpose of VAT, the
selling price is always 100%.

Table 8.2

Cost price 30% mark-up Selling price VAT @ 15% Marked price
(on selling (VAT inclusive)
price)
R77 R33 R110 R16,50 R126,50
70% 30% 100%
100% 15% 115%

The following can be calculated using Table 8.2:

Cost price using selling price

Rand value Rate (%)

Cost price ? 70% (100% – 30%)
Selling price R110 100%

% of unknown rand value of known

Cost price = ×
% of known 1

% of cost price rand value of selling price

= ×
% of selling price 1

70% R110
= ×
100% 1

= R77

TEST YOURSELF 8.3

Complete the table:

Cost price % mark-up Selling price

R100 50% on selling price ?
? 40% on cost price R210
R280 ? (% on cost) R364

TUTORIAL EXERCISES

Exercise 1
Listed below are multiple-choice questions. Select the most appropriate answer.

1.1 Which of the following is not a rate of VAT?

a. Zero rate
b. Standard rate of 15%

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 c. Exempt goods
d. Standard rate of 16%

1.2 A vendor does not have to register for VAT if

a. his total value of taxable supplies exceeds or is likely to exceed R1 million for a 12-
month period.
b. his total value of taxable supplies exceeds or is likely to exceed R50 000 for a 12-
month period.
c. his total value of taxable supplies is less than R50 000 for a 12-month period.
d. his total value of taxable supplies exceeds or is likely to exceed R100 000 for a 12-
month period.

1.3 Which one of the following statements is incorrect?

a. Output tax is that which the vendor charges on the supply of goods or services in the
course of business.
b. Input tax is the tax which the vendor himself has borne in respect of goods or
services supplied to him.
c. Certain basic foodstuffs are zero rated, such as a glass of milk served in a
restaurant.
d. No output tax and no input tax deductions are allowed against exempt supplies.

1.4 Nitin and Riya buy goods to the value of R900, including VAT, from Builders House. How
much VAT have they paid?
a. R900,00
b. R110,53
c. R117,39
d. R774,00

1.5 Avesh and Su registered for VAT several years ago. Their business has expanded in the
past 12 months and has generated a turnover of R31 million. How frequently must they
submit a VAT return?
a. Every six months
b. Every month
c. Every two months
d. Biannually

Exercise 2
Identify the concepts in the table:

Item Statement Concept

1 Tax on the consumption of goods and services in the economy.
2 Goods or services which are taxed at a rate of 0%, i.e. milk,
brown bread, maize, fruit, etc.
3 These items involve services that are not subject to VAT at
either the standard rate or the zero rate, i.e. childcare services,
educational services, etc.
4 In South Africa items are taxed at the rate of 15%.
5 Goods or services that are subject to VAT.

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 Item Statement Concept
6 VAT which a registered vendor would charge on items which
it sells.
7 VAT that you pay on all your business expenses and for
which you have a tax invoice. It also relates to VAT paid on
other goods and services bought or rented for the business.

Exercise 3
Answer the following questions relating to cost, mark-up and selling prices (ignore VAT):
3.1 Levashnee sells her product for R1 260. If her mark-up percentage on cost is 40%, what
is her cost price?
3.2 Wesley bought a table for R640. If his gross margin is 40%, how much must he sell it
for?
3.3 Elaine buys a frame for R650 and sells it for R845 to Ashley. What is her mark-up
percentage on cost?

Exercise 4
Complete the following table

No. Cost price Mark-up Exclusive: VAT (15%) Inclusive:

Selling price Selling price
1 R25 (a) R45 R6.75 (b)
2 (c) R25 R135 (d) (e)
3 R280 10% (f) (g) (h)
4 R540 (i) R648 (j) (k)
5 R700 25% (l) (m) R1 006.25

Exercise 5
Complete the following table:

Goods/services Standard Zero-rated VAT

rated exempted
Rent paid on an outbuilding for domestic use
Hotel accommodation
White bread
Rice
Mealie rice
School fees
Water and electricity
Interest on loan
Baked beans
Fruit

Exercise 6
Complete the following table:

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 Cost price % mark-up Selling price VAT (15%) Marked price
R2 000 20% on cost A B C
R2 000 20% on selling price D E F
G 25% on cost R3 000 H I
J 40% on cost K L R9 591
R4 500 25% on selling price M R900 N

Exercise 7
The following transactions occurred between 1 February 2018 - 28 February 2018:
A VAT-registered farmer sells 10 Starking apples to a VAT-registered factory for R2 each. No
VAT is charged by the farmer to the factory, as the supply of fresh fruit is zero rated. Since all
the farming supplies purchased were subject to VAT at the zero rate, the farmer did not have
any input tax to deduct.
The factory also buys cans from another vendor for R29,90 (including 15% VAT). It
manufactures 20 cans of apple pieces and sells them to a hypermarket for R4,56 each
(including 15% VAT).
The hypermarket sells 15 of the cans to its customers for R6,84 each (inclusive of VAT).
Since the hypermarket’s customers are the final consumers and are not registered for VAT,
there is no input or output tax for these customers.

Required
7.1 Illustrate the above scenario of input and output tax.
7.2 Calculate the total amount paid to SARS.

Exercise 8
Camishka’s mum gives her R200 and a shopping list and sends her to the supermarket.
When she is done paying for her shopping, she checks her till slip and thinks that the VAT
shown on the till slip is incorrect. She calculates 14% of the balance due to be R26,12.
Shown here is the till slip.

Required
Help Camishka by answering the following questions:
8.1 Why are the tomatoes indicated with a *?
8.2 What is the total cost of the items that are VAT inclusive?
8.3 Is 14% of this total R22,05 or R26,12?
8.4 Show how the balance due was calculated.
8.5 Explain why Camishka is incorrect in believing the VAT is wrong.

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 Exercise 9
Complete the table below by calculating the missing amounts:

Amount (R) 100,00 10,00 4,50 354,39

VAT (R) 15,00 4,73 27,14
Total (R) 20,46 115,00 11,50 5,18

Exercise 10
Identify the mistakes on the following till slip:
19/03/2018

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 Tax invoice VAT No. 442333888109
Milk 2L R 17.99*
Apples 2,5kg R 20.99*
Carrier bag 24L R 0.40
Carrier bag 24L R 0.40
Sunflower oil 250ml R 14.99*
Salted chips R 7.99
Brown bread loaf R 6.99*
Brown bread loaf R 6.99*
Sauce Peri Peri R 13.99
Balance due R90.73
EFT Credit Card R 90.73
TAX-CODE TAXABLE TAX VALUE
Zero VAT R0 R0.00*
VAT R79.59 R11.14
Total tax R11.14
CHANGE R0.00

TEST YOURSELF SOLUTIONS

TEST YOURSELF SOLUTION 8.1

The farmer produced maize, which he sold for R10 plus VAT of R1,50 to the miller. The miller
produced flour which he then sold for R50 plus VAT of R7,50 to the baker. The baker used the
flour to make cakes which were then sold to the supermarket for R70 plus VAT of R10,50.
The supermarket thereafter sold the cakes for R100 plus VAT of R15 to the customer.

TEST YOURSELF SOLUTION 8.2

1. 2 806 × 115
15
= 366

2. 3 542 × 115
15
= 462

3. 3 VAT is not paid on wages.

4. 575 × 15

115
= 75

TEST YOURSELF SOLUTION 8.3

Cost price % mark-up Selling price

R100 50% on selling price R200
R150 40% on cost price R210
R280 30% (R84) R364

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 9 Cost classification and terminology

Outcomes

At the end of this chapter students should be able to classify costs into their various categories.

Chapter outline

9.1 The cost concept

9.2 Cost classification in relation to the product or period
9.2.1 Manufacturing costs (product costs)
9.2.2 Non-manufacturing costs (period costs)
9.3 Cost classification in relation to volume of production (cost behaviour)
9.3.1 Fixed costs
9.3.2 Variable costs
9.3.3 Semivariable, semifixed or mixed costs
9.4 Separating a mixed cost
9.5 Cost classification for control or evaluation
9.5.1 Controllable and non-controllable costs
9.6 Cost classification for decision making
9.6.1 Relevant costs
9.6.2 Irrelevant costs

9.1 The cost concept

Costs can be defined in a number of ways, depending on one’s point of view. For the purpose of cost
and management accounting, a cost is defined as follows:

A cost is a resource that is sacrificed or foregone in order to achieve a specific objective. In other
words, costs are incurred to ensure a future profit.

9.2 Cost classification in relation to the product or period

The process of classifying costs and expenses begins by relating them to the different phases in a
business’s operation. In a manufacturing organisation, the total operating costs consist of manufacturing
and non-manufacturing costs.

9.2.1 Manufacturing costs (product costs)

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 These are costs that are associated with the manufacturing of certain products, which include direct
materials, direct labour and manufacturing (factory) overheads. Direct material and direct labour may
be combined into a classification called prime cost. Direct labour and manufacturing overheads may be
combined into another classification called conversion cost, which represents the cost of converting
direct material into finished products.

Direct materials are all materials that form an integral part of the finished product and that can be
included directly in calculating the cost of the product, for example crude oil to make gasoline, wood
used to make furniture, and so on.
Direct labour is labour expended to convert direct materials into the finished product, for example
the wages of the carpenter in the furniture factory, the wages of assembly line workers in a car plant,
and so on.
Manufacturing overheads, also known as factory overheads, include all indirect costs, such as
indirect materials, indirect labour and all other manufacturing costs that cannot be allocated directly
to a product or job, for example factory rent, depreciation on plant and equipment, factory
maintenance and repairs, water and electricity for the factory, and so on.
Indirect materials are materials used in the production process but which are not linked to specific
products or jobs. They are used on a per-product basis in such insignificant amounts that monitoring
them as direct materials is not worthwhile, for example nails, screws, glue and factory supplies such
as lubricating oils, consumable materials, and so on.
Indirect labour is labour costs that are not linked to the production of specific products or jobs. It
refers to salaries paid to employees whose roles enable the direct workers to manufacture the
products, for example the wages of supervisors, maintenance workers, security guards and so on.

Direct material + Direct labour = Prime cost

Direct labour + Manufacturing overheads = Conversion cost

Direct material + Direct labour + Factory overheads = Total manufacturing cost

9.2.2 Non-manufacturing costs (period costs)

These are costs that are associated with a specific accounting period and not specific products. These
costs include marketing (selling and distribution) expenses and administrative expenses, since they are
incurred in generating sales in a given accounting period, but are not linked to specific units sold. These
costs are treated as expenses for the period in which they are incurred because they are presumed not to
benefit the future periods. They are simply all the operating costs in the income statement.

Marketing expenses begin at the point where manufacturing has been completed and the product is in
a saleable condition. They include selling and delivery expenses, such as sales salaries, commissions,
travel expenses, advertising, and so on.
Administrative expenses are incurred in directing and controlling the organisation. They include the
salary of the CEO, office expenses, depreciation on office equipment, legal expenses and so on.

9.3 Cost classification in relation to volume of production (cost

behaviour)

Because costs do not remain the same, it is vital to understand how they behave and what factors affect
their behaviour. Below are three behavioural patterns exhibited by costs. It is important to note that

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 these behavioural patterns are affected by the level of activity (volume) and time.

Behavioural patterns exhibited by costs are

fixed
variable
semivariable, semifixed or mixed.

9.3.1 Fixed costs

A fixed cost is a cost that remains constant in total, regardless of changes in the level of activity, but on
a per-unit basis it varies/changes with the level of activity.

ILLUSTRATIVE EXAMPLE

The monthly rental charge for a photocopy machine is R20 000.

Number of copies made during

Monthly rental cost Average cost per copy
the month
R20 000 200 R100
R20 000 625 R32
R20 000 2 000 R100

Note: This monthly rental cost of R20 000 will be incurred regardless of the number of copies made
during the month. Other examples of fixed costs include the salaries of production managers,
property tax, rent and insurance.
In this graph, the monthly rental is the same regardless of the production volume.

9.3.2 Variable costs

A variable cost is a cost that varies/changes in total in direct proportion to the variation in the level of
activity, but on a per-unit basis it remains constant.

ILLUSTRATIVE EXAMPLE

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 A company produces external hard drives and each hard drive requires a component that costs R80.

Number of hard drives Cost per component Total variable cost for the
hard drives
1 R80 R80
500 R80 R40 000
1000 R80 R80 000

Note: The total cost increases and decreases as the activity level increases and decreases, but the
variable cost expressed on a per-unit basis is constant, that is, R80 per component.
Examples of variable costs are raw materials, sales commission, production wages and packing
costs.

9.3.3 Semivariable, semifixed or mixed costs

A semivariable cost is also known as a semifixed or mixed cost. It is a cost that contains both a variable
portion and a fixed portion. The fixed portion of the mixed cost is the basic charge for having a service
ready and obtainable. The variable portion represents the charge made for the actual use of the service.

ILLUSTRATIVE EXAMPLE

A company leases equipment used in its manufacturing facility. The lease agreement requires a
monthly lease payment of R20 000, plus 90 cents for each hour that the equipment is operated
during the month. Examples of semivariable costs are repairs and maintenance.

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 9.4 Separating a mixed cost

Mixed costs must be separated into their fixed and variable portions for decision making. There are
three methods used to separate a mixed cost. These are the high-low method, scattergraph method and
least-squares method (regression analysis). The scattergraph and least-squares methods are beyond the
scope of this book. The high-low method uses the difference between the highest and lowest activity
and their corresponding costs, in order to determine the variable portion of the semivariable cost. The
formula used is:

Change in cost ÷ Change in activity

ILLUSTRATIVE EXAMPLE

A company has incurred the following maintenance costs over a 12-month period:

Months Maintenance hours Maintenance costs R

January 90 5 300
February 50 4 500
March 70 4 900
April 55 4 600
May 60 4 700
June 75 5 000
July 95 5 400
August 65 4 800
September 80 5 100
October 85 5 200
November 40 4 300
December 45 4 400

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 The maintenance cost is a semivariable cost and the production manager has asked you to separate
it into its fixed and variable portion using the high-low method.

Solution
Step 1
Find the highest activity level and the corresponding cost, then find the lowest activity level and the
corresponding cost. Use the formula to determine the variable portion. Because the formula is
measuring the change in the cost and the change in the activity, it represents the variable portion of
the semivariable cost. Only variable costs will change with the level of activity.
Change in cost ÷ Change in activity
= (R5 400 – R4 300) ÷ (95 – 40)
= R1 100 ÷ 55
= Variable rate is R20 per maintenance hour

Step 2
Determine the fixed portion of the semivariable cost, using the following formula:
Fixed cost = Total cost – Variable cost
= R4 300 – (R20 × 40 maintenance hours)
= R4 300 – R800
= R3 500

Note: You can apply the formula to determine the fixed cost using either the lowest or the highest
activity levels with their corresponding costs.

9.5 Cost classification for control or evaluation

9.5.1 Controllable and non-controllable costs

In evaluating the performance of a manager, an important step is to classify costs that are controllable
by that manager. Costs that are uncontrollable by that manager are generally irrelevant to evaluations of
the manager’s performance, and the manager should not be held responsible for them.

If a particular level of management has power to authorise/allow a cost, it is considered controllable,

and if a particular level of management does not have the power to authorise a cost, it is considered
non-controllable.

9.6 Cost classification for decision making

When deciding among a number of possible alternatives or actions, it is important to identify the costs
and revenues that are relevant to the choice. Consideration of irrelevant items can be a significant waste
of time and resources.

9.6.1 Relevant costs

A cost is relevant if it is going to affect a decision being taken. Opportunity, differential/incremental
and avoidable costs are all considered to be relevant costs.

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 9.6.1.1 Opportunity cost
An opportunity cost may be defined as the value of the potential benefit that is lost or sacrificed when
one course of action is chosen above the competing course of action.

ILLUSTRATIVE EXAMPLES

Example 1
Wesley is employed on a part-time basis at a chain store. His rate of pay is R500 per week. He would
like to spend a week with his grandparents on their farm but he has no leave available. If he takes a
week’s leave anyway, he would lose R500. This R500 in lost wages will be termed an opportunity
cost.

Example 2
Paul is an administrative officer for a company that pays him a salary of R150 000 per annum. He
would like to further his current qualification and is thinking about leaving the company and returning
to university to study full-time. If he returns to university, he would have to give up his R150 000
salary. The foregone salary would be an opportunity cost, that is, the cost of seeking higher
education.

Opportunity costs are not recorded in the books, but must be considered by managers when making
decisions.

9.6.1.2 Differential/incremental cost

A cost that is present under one option but is absent in total or in part under another option is known as
a differential cost, that is, the difference in total cost between alternatives.

Differential/incremental revenue is the difference in revenue between the two alternatives.

9.6.1.3 Avoidable cost

Any cost that can be avoided is relevant to the decision-making process. This is the cost of an activity
or business sector that can be avoided if that activity or business sector did not exist. All costs are
considered avoidable, except

sunk costs
future costs that do not differ between alternatives at hand.

Unavoidable costs must be eliminated from the decision at hand.

ILLUSTRATIVE EXAMPLE

A company produces two products, Trix and Trex. Product Trex is currently making a loss. Should
the company drop the product?

Option 1 keep Option 2 drop Difference

product Trex product Trex increase or
(R) (R) decrease (R)
Sales 80 000 0 (80 000)
Less: Variable cost 55 000 0 55 000
Marginal income 25 000 0 (25 000)
Less: Fixed costs 39 750 18 000 21 750
* Rental 6 000 6 000 0

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 Salaries and wages 12 000 0 12 000

Advertising 9 750 0 9 750

* Depreciation on factory equipment 3 000 3 000 0

* Administrative expenses 9 000 9 000 0

Net profit/loss (14 750) (18 000) (3 250)

* Irrelevant/unavoidable costs

Do not drop product Trex since the net loss will increase by R3 250.

9.6.2 Irrelevant costs

Irrelevant costs are costs that remain the same regardless of the decision taken.

9.6.2.1 Sunk costs

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made
now or in the future. Since sunk costs cannot be changed by any present or future decision, they should
not be used in analysing future courses of action. All fixed costs are sunk costs, for example
depreciation.

ILLUSTRATIVE EXAMPLE

A company has recently spent R100 000 on developing a new product. The money cannot be
recovered even if a decision is taken to abandon further development of the new product. The cost is
therefore irrelevant to future decisions concerning the product. It is a sunk cost.

TEST YOURSELF 9.1

Classify the items below as product or period costs. If you have classified an item as a product cost,
indicate whether it is direct materials, direct labour or manufacturing overheads. If you have classified
an item as a period cost, indicate whether it is a marketing/selling or an administrative cost.
a) Raw materials used to manufacture products.
b) Wages of workers who handle material during the production process.
c) Advertising costs.
d) Depreciation on a vehicle used by the managing director.
e) The production manager’s salary.
f) Lease payments on manufacturing equipment.
g) Lease payments on vehicles used by sales personnel.
h) Depreciation on manufacturing equipment.
i) Rent on factory building.
j) Cleaning material used by production workers.

TUTORIAL EXERCISES

Exercise 1
The following information relates to the transactions of XYZ Ltd.

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 Month of the year Units produced Costs incurred (R)
January 12 000 28 000
February 4 000 16 000
March 10 000 24 000
April 8 000 22 000
May 5 000 18 000

Based on the information provided above, you are required to calculate the following costs and then
select the correct corresponding alphabet letter:
1.1 The variable cost per unit.

a) R0,67
b) R2,33
c) R1,5
d) R1,43

1.2 The fixed overhead cost.

a) R10 000
b) R19 960
c) R40
d) R10 840

1.3 The total variable cost for April.

a) R5 360
b) R18 640
c) R11 440
d) R12 000

1.4 If XYZ Ltd decides to produce 7000 units in any given month, the variable cost for that month
would be:

a) R10 010
b) R10 500
c) R16 310
d) R4 690

1.5 Refer to 1.1.4 above, the total overhead cost for the month would amount to:

a) R24 650
b) R22 280
c) R18 680
d) R20 500

Exercise 2
Smile Ltd is a photoshop based in Cape Town. The business was founded in 2009 and operates from
the Gateway Mall in Umhlanga. The shop pays a monthly rental to the centre of R10 000. The cost of
printing photographs for customers amounts to R5 000 per month. The company has three general
workers, and these employees earn a basic wage of R400 per week. Smile Ltd also employs a
photographer who earns a salary of R4 500 per month. Smile Ltd has recently conducted market
research and has discovered a new method of operating its photoshop. This method is very different
from the traditional approach used for the past few years. This new method allows customers to take
their photographs using Professional Photographer Machine 1. Thereafter, customers can edit their

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 photos and either print or store their photos on a USB, and this would be done using the second
machine, the Photo Self Help Station 2. The cost of renting the Professional Photographer Machine 1
is R3 000 per month, and renting the Photo Self Help Station 2 is R300 each month. Smile Ltd
estimates that it would need one of the Professional Photographer Machine 1 and four of the Photo
Self Help Station 2.
If Smile Ltd decides to implement the new method of taking pictures at its store, it would only need to
have two general staff employees, and would not need a photographer.
The estimated costs of digital prints from the new machines would amount to R500 per month.
Saving the photos onto USBs for its customers would be at no cost to the business.
You are required to answer the following questions based on the information provided:
2.1 Which costs are relevant for the cost comparison?
2.2 Which costs are unavoidable with regard to the decision of traditional photographs vs digital
photographs?
2.3 Which method of taking and printing photographs should Smile Ltd use?

Present your answer in a tabular format, showing all workings.

Exercise 3
State whether the following statements are true or false.
3.1 Interest paid on loan from the bank is a period cost.
3.2 Conversion costs consist of material and labour.
3.3 An opportunity cost is the best alternative foregone or given up.
3.4 Advertising is a direct expense.
3.5 Rent is a semi-fixed cost.
3.6 Telephone is a semivariable cost.
3.7 Raw material is a fixed cost.
3.8 Wages of the factory production workers is an indirect cost.
3.9 Direct costs are costs that cannot be accurately traced to a particular cost objective.
3.10 Depreciation of a vehicle that is used by the managing director is a product cost.

Exercise 4
Kirsty Ltd is a company which manufactures a range of electrical appliances. The company has been
in existence since the early 1990s and follows a differentiation strategy. Up to now, this strategy has
been effective in maintaining its market share. Recently, however, its market share has declined
slightly with other competitors entering the market. It is now considering changing its long-term
strategy to a competitive price strategy. This strategy would require it to reduce costs in all areas of
the business. To assist it with this strategy, classify each of the following costs as either a product or
a period.

Cost items Product Period

cost cost
a) Depreciation on factory plant and machinery.
b) Cost of printer cartridges for the administrative offices.
c) Salary of the production supervisor.
d) Supplies and other indirect materials used in production.
e) Protective clothing that is worn by machine operatives.
f) Salary of the storeman in the finished goods warehouse.
g) Repairs and maintenance costs for machinery in the factory.
h) Sales commission paid to salespersons.
i) Salary of the forklift truck driver in the raw materials warehouse.

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 Cost items Product Period
cost cost
j) Stationery and other supplies used in the office.
k) Direct material used to manufacture the electric appliances.
l) Insurance for the plant and machinery.
m) Payments made to an advertising agency for television
advertisements.
n) Transportation cost of direct material used in the manufacturing
process.
o) Overtime paid to production workers.
p) Salary of the chief executive officer of the company.

Exercise 5
Match the statement in Column A with the most suitable cost concept in Column B. Each statement
belongs to only one cost concept. The cost concept can only be used once. Next to each number,
write down only the letter of the alphabet of the cost concept (Example 5.1. B)

COLUMN A COLUMN B
5.1 Manufacturing overheads and direct labour added together. A. Prime costs
5.2 A cost that remains constant in total but varies on a per-unit basis. B. Variable cost
5.3 A cost that varies in total but remains constant on a per-unit basis. C. Product cost
5.4 Direct materials and direct labour added together are known as … D. Total
manufacturing
cost
5.5 A cost that has already been incurred and cannot be changed by any E. Conversion
decision made now or in the future. costs
5.6 It is the potential benefit that is lost when choosing one option that F. Opportunity
makes it necessary to give up another option. costs
5.7 Costs that are associated with the manufacture of products. G. Fixed costs
5.8 Costs that are the direct responsibility of a particular manager. H. Period costs
5.9 Costs that are associated with specific accounting periods and not I. Controllable
products. costs
5.10 Direct materials, direct labour and manufacturing overheads added J. Sunk costs
together are known as …

Exercise 6
ABC Manufacturing Company had the following data for the month of May 20x1:

Direct materials R200 000

Direct labour R300 000
Manufacturing overheads R150 000
Selling and administrative expenses (70% variable, 30% fixed) R240 000

Manufacturing overheads is a mixed cost and is based on the number of units produced. The
manufacturing overhead costs for the last few months are given below:

Months Production in units Manufacturing overhead

costs
January 7 000 R160 000
February 5 000 R140 000
March 8 000 R170 000

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 Months Production in units Manufacturing overhead
costs
April 9 000 R180 000
May 6 000 R150 000

Required
Calculate the following costs:
6.1 Prime cost
6.2 Conversion cost
6.3 Product cost
6.4 Period cost
6.5 Total variable cost
6.6 Total fixed cost

Exercise 7
The cost accountant of XYZ Manufacturers identified the following expenses applicable to its
operations:
7.1 Cost of oils used to lubricate production machinery.
7.2 Motor vehicle licences for lorries.
7.3 Depreciation on factory plant and equipment.
7.4 Cost of chemicals used in the laboratory.
7.5 Commission paid to sales representatives.
7.6 Salary of the secretary to the managing director.
7.7 Trade discount given to customers.
7.8 Holiday pay for machine operators.
7.9 Salary of security guard in raw material warehouse.
7.10 Fees to advertising agency.
7.11 Rent of finished goods warehouse.
7.12 Salary of scientist in the laboratory.
7.13 Insurance on the company’s premises.
7.14 Salary of supervisor working in the factory.
7.15 Cost of printer cartridges in the general office.
7.16 Protective clothing for machine operators.
Required
Classify costs according to the following cost terms. Each expense can only be classified once:
production overheads, selling and distribution overheads, administrative overheads, research and
development overheads.

Exercise 8
Classify costs according to the following cost terms: product, period, fixed, variable, mixed, sunk and
opportunity.

Cost item Variable Fixed Mixed Period Direct Indirect Sunk Opportunity
cost cost cost cost product product cost cost
cost cost
Example: Salary of the X X X
company’s managing
director

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 Cost item Variable Fixed Mixed Period Direct Indirect Sunk Opportunity
cost cost cost cost product product cost cost
cost cost
8.1 Wood used in
the
manufacturing
of tables.
8.2 Wages of
assembly line
workers, who
are paid per
hour.
8.3 Rental on
manufacturing
facility.
8.4 Salary of
production
manager.
8.5 Overtime
premiums paid
to assembly
line workers.
8.6 Depreciation on
manufacturing
equipment,
using the
straightline
method of
depreciation.
8.7 Salary of the
distribution
clerk in finished
goods
warehouse.
8.8 Commissions
paid to sales
persons.
8.9 Cost of car
licences for
vehicles used
by
salespersonnel.
8.10 Trade
discounts
granted to
customers.
8.11 Rental income
foregone on
factory space.
8.12 Salary of
storeman in
raw materials
warehouse.

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 Cost item Variable Fixed Mixed Period Direct Indirect Sunk Opportunity
cost cost cost cost product product cost cost
cost cost
8.13 Electricity used
for operating
machinery.
8.14 Photocopier in
the general
office, leased at
basic monthly.
charge plus an
additional
amount for
each copy
made.
8.15 Advertising
costs budgeted
at R400 000
per annum.

Exercise 9
The detailed income statement of a South African manufacturer is presented below.

R’000
Revenue 500 000
Salaries
Factory (workers) 61 000
Factory (management) 55 000
Sales 42 000
Human resources and payroll 5 000
Accounting 10 000
Internal audit 8 000
Directors 40 000
Security 6 500
Engineers 2 500
Depreciation
Factory equipment 10 000
Warehouse fixtures 2 500
Office fixtures and fittings 2 200
Forklifts 1 500
Delivery vehicles 1 600
Buildings 3 500
Purchases from creditors
Raw material 95 000
Spare parts for factory equipment 7 000
Grease and lubricants for factory machinery 2 900
Stationery for administrative use 2 100
Water and electricity

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 R’000
Factory 22 000
Raw material warehouse 3 000
Office 4 000
Other
Royalty 10 000
Telephone (office) 3 500
Cleaning (office) (flat rate as per contract) 1 800
Entertainment (this amount is spent every period) 600
Speeding fines (delivery) 180
Repairs (delivery) 6 500
External audit fee (as agreed per contract) 32 000
Advertising and marketing (this amount is spent in every period) 32 000
55 720

You are required to assist the cost accountant to classify cost items listed 1–9 in the additional
information as listed in the income statement using the following categories:

Manufacturing (state whether it constitutes direct materials, direct labour or overheads) or non-
manufacturing.
Fixed or variable.

Example Factory workers are paid on the basis of hours worked in order to match labour
hours to production equipment.

Manufacturing costs/ Non-

product costs manufacturing/
period costs
Direct Direct Overheads
materials Labour
Example Factory 61 000 61 000
(workers)

Additional information

1. Factory management are permanent employees who are paid fixed salaries regardless of hours
worked.
2. Sales staff remunerations include a commission of 5% of revenue.
3. Security guards are on the premises 24 hours a day, 7 days a week. Part of their responsibilities
includes checking that all goods that leave the premises are accompanied by an authorised
dispatch note.
4. An engineering team is permanently employed to monitor the factory equipment and perform
routine maintenance on a regular basis.
5. All assets are depreciated on a straight-line basis. Three buildings exist on the premises, the
factory building, the warehouse in which raw materials are stored and the administrative building.
The depreciation on these buildings for the year amounts to R1 400, R1 050 and R1 050
respectively.
6. The amount of part replacements and lubrication that machines require is directly proportional to
the number of operating hours. Operating hours are dependent on production volumes.
7. Water and electricity costs for the raw material warehouse and office remain constant from month
to month, regardless of sales and production volume changes. R3 000 of the water and electricity

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 requirements of the factory are unaffected by production requirements. The remaining amount
and majority of the cost are directly affected by production volumes.
8. Telephone for the office includes a fixed charge of R600.
9. Repair cost varies directly with production quantities.

TEST YOURSELF SOLUTION

TEST YOURSELF SOLUTION 9.1

a) Raw materials used to manufacture products

Raw materials used to manufacture products (product/direct materials)
b) Wages of workers who handle material during the production process
Wages of workers who handle material during the production process (product/direct
labour)
c) Advertising costs
Advertising costs (period/marketing or selling)
d) Depreciation on a vehicle used by the managing director
Depreciation on a vehicle used by the managing director (period/administrative)
e) The production manager’s salary
The production manager’s salary (product/manufacturing overheads)
f) Lease payments on manufacturing equipment
Lease payments on manufacturing equipment (product/manufacturing overheads)
g) Lease payments on vehicles used by sales personnel
Lease payments on vehicles used by sales personnel (period/marketing or selling)
h) Depreciation on manufacturing equipment
Depreciation on manufacturing equipment (product/manufacturing overheads)
i) Rent on factory building
Rent on factory building (product/manufacturing overheads)
j) Cleaning material used by production workers
Cleaning material used by production workers (product/manufacturing overheads)

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 10 Materials

Outcomes

At the end of this chapter students should be able to

distinguish between direct and indirect materials

demonstrate knowledge of the various stock control levels
calculate the economic order quantity and value of stock on hand using FIFO (first-in-first-out
method) and the weighted average method of stock valuation.

Chapter outline

10.1 Classification of materials

10.1.1 Direct material
10.1.2 Indirect material
10.1.3 Work in progress
10.1.4 Finished goods
10.1.5 Inventory
10.2 Accounting entries
10.3 Stock control
10.3.1 Carrying costs (holding costs)
10.3.2 Ordering costs
10.3.3 Stock-out costs
10.3.4 Lead time
10.3.5 Economic order quantity (EOQ)
10.3.6 Reorder level (ROL)
10.3.7 Minimum stock level (MinSL)
10.3.8 Maximum stock level (MaxSL)
10.3.9 Average stock level (AveSL)
10.4 Stock valuation methods
10.4.1 The perpetual and periodic inventory control systems
10.4.2 First-in-first-out (FIFO) method
10.4.3 Weighted average method

10.1 Classification of materials

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 Material, labour and overheads are the three cost elements that make up the cost of any job or
product. In subsequent modules we will focus on a precise classification for each cost element.

Material can be classified as direct and indirect.

10.1.1 Direct material

Direct material is the raw material that is converted into a finished product by the manufacturing
process. This material is visible in the final product, that is, it can (easily) be physically traced to
the final product, for example steel in the manufacturing of a motor vehicle and wood in the
manufacturing of a table.

10.1.2 Indirect material

Indirect material is material used in the manufacturing process that contributes to the conversion
of the direct material. This material cannot be physically (easily) traced to the final product, for
example the chemicals in iron ore for the manufacturing of steel, and glue used in the
manufacturing of a table.

10.1.3 Work in progress

Work in progress is the raw material that has been partially converted in the production process.
This material therefore cannot be classified as raw material or as a finished product. Work in
progress consists of a portion of all three cost elements – material, labour and overheads.

10.1.4 Finished goods

Finished goods are products that have passed through the entire production process and have
been completed.

10.1.5 Inventory
This term includes all the material (direct and indirect), work in progress and finished goods that
the enterprise has at any given point in time.

10.2 Accounting entries

Accounting entries for recording the purchasing and issuing of materials are similar to those
used in financial accounting records for a perpetual inventory system. They are also based on
the double-entry principle, which requires that there should be a corresponding credit entry for
each debit entry. A control account for inventory is kept in the general ledger. A separate
computerised inventory system is usually kept that contains the details for each inventory type.
A physical inventory count is done and compared with the computerised inventory system on a
periodic basis. The total balance of all inventories in the inventory system is reconciled monthly
to the inventory control account in the general ledger. The material inventory control account is
debited as materials are received, and the accounts payable account or bank account (whichever
is applicable) is credited. Both direct and indirect materials may be recorded in the material
inventory control account.

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 When raw material is issued to production, direct material is recorded as work in progress (WIP)
and indirect material as manufacturing overheads. All consumables, like stationery issued to the
sales department, will be allocated to non-manufacturing overheads. Material and supplies
(indirect material) requisitions are recorded as follows:

Debit Credit
WIP [direct material] xxx
Manufacturing overheads [indirect material] xxx
Non-manufacturing overheads [other consumables] xxx
Material inventory control xxx

All returns from production or other departments to stores result in credits in the WIP account
and / or the manufacturing overheads account and in debits to the material inventory control
account. Material returns are recorded as follows:

Debit Credit
Material inventory control xxx
WIP [direct material] xxx
Manufacturing overheads [indirect material] xxx
Non-manufacturing overheads [other consumables] xxx

ILLUSTRATIVE EXAMPLE

The following balances were taken from the books of Caminaysh Ltd on 1 March 20x1:

Material inventory control (Dr) R12 500

WIP (Dr) R16 000
Accounts payable (Cr) R30 000

Transactions during March 20x1:

Material purchased on credit R30 000
Material issued:
Direct material R27 500
Indirect material R2 000

The company uses a perpetual inventory system to record its inventory.

Required
Prepare the journal entries and the ledger accounts for the month.

Solution
The journal entries for the above-mentioned transactions are:

Debit Credit
Material inventory control 30 000
Accounts payable 30 000
Recording of material purchased
WIP 27 500
Manufacturing overheads 2 000
Material inventory control 29 500

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 Recording of material issued

The ledger account for the above-mentioned transactions is:

Material inventory control

Balance b/d 12 500 WIP 27 500

Accounts payable 30 000 Manufacturing overheads 2 000
Balance c/d 13 000
42 500 42 500
Balance b/d 13 000

10.3 Stock control

Stock control is the system that a firm uses to control its investment in stock, which includes

recording and monitoring stock levels

forecasting future demand
deciding when to order and how much to order.

There are usually three reasons for holding inventory:

1. Transaction motive – this refers to holding inventory for daily usage in the production
process.
2. Precautionary motive – this refers to holding extra inventory when future demand is
uncertain and / or the supply is unreliable, for example a material used in production is
going to be discontinued by the supplier.
3. Speculative motive – this refers to holding more or less inventory than usual, because a
change in the supplier’s price is anticipated, for example a fuel price increase.

The main objective of stock control is to minimise in total the costs associated with stock. These
costs can be classified into three groups: carrying costs, ordering costs and stock-out costs.

10.3.1 Carrying costs (holding costs)

Carrying costs are those costs associated with the storage of the stock. These include

storage charges (rent, heating and lighting, air-conditioning and refrigeration)

stores staffing
stores equipment and maintenance
security and insurance
stocktaking, stock recording and audit costs
material handling costs

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 obsolescence and deterioration
theft, evaporation and vermin damage
interest on capital invested in the stock.

The carrying costs can be calculated as:

Average stock × Carrying cost per unit

10.3.2 Ordering costs

Ordering costs are those costs associated with obtaining the stock. These include

administrative costs of purchasing

transportation costs.

The ordering costs are calculated as:

Number of orders × Cost per order

The number of orders can be calculated as:

Annual demand ÷ Order size

10.3.3 Stock-out costs

Stock-out costs are those costs associated with not having sufficient stock to meet the
customers’ needs. These costs tend to be intangible and include

the loss of contribution and profit owing to being out of stock

loss of future sales
cost of stoppages in production caused by stock outs
extra costs of having to meet urgent small orders.

10.3.4 Lead time

Lead time is the time taken from when an order is placed with the supplier, to when it arrives on
the business’s premises.

10.3.5 Economic order quantity (EOQ)

EOQ is the optimum quantity that should be ordered that will minimise the total combined
ordering and carrying costs.

2×Annual requirement×Order cost

EOQ = √
Carrying or holding cost per unit

2DO
= √
(P×i)+H

Where:
D = Annual demand
O = Order cost

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 P = Purchase price
I = Interest rate
H = Holding cost per unit

*When there is interest applicable to the number of units, then there is an additional opportunity
cost that must be included in the calculation of the holding cost. The holding cost per unit can be
calculated as the purchase price multiplied by the interest rate (this is the opportunity cost of
interest forgone) plus the holding cost per unit. Note that this part of the question, i.e. (P x i), is
only necessary if the question provides information on the purchase price and the interest rate.

10.3.6 Reorder level (ROL)

ROL is the level of stock at which another order (replenishment order) should be placed. The
reorder level depends on the lead time and the usage during the lead time. It allows for the worst
situation to occur without the danger of running out of stock, that is, it provides for the situation
where the business is running at maximum production and the supplier takes the maximum
delivery time. It is calculated as follows:

Maximum usage × Maximum lead time

or

(Average usage × Average lead time) + Safety stock

10.3.7 Minimum stock level (MinSL)

MinSL is the amount of stock that is kept to cover the possibility that there may be an increase
in demand and problems with the ordering and the delivery of goods. It is a buffer to guard
against stock-outs. It is also referred to as safety stock. It is calculated as follows:

Max usage × Min lead time

10.3.8 Maximum stock level (MaxSL)

MaxSL is the amount of stock for which storage space would be required. It is used to indicate
to management when stocks have risen too high.

10.3.9 Average stock level (AveSL)

AveSL reflects the average stockholding for the year. It is calculated by taking the order size or
EOQ divided by 2.

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 Figure 10.1 Diagrammatic illustration of the various stock control levels

Demand is 200 units per week

Lead time = 5 weeks
EOQ = 1 200 units
ROL = 1 400 units
MinSL (safety stock) = 400 units
MaxSL = 1 600 units
AveSL = 1 000 units

ILLUSTRATIVE EXAMPLE: Calculation of EOQ

ABC Motor Corporation Ltd produces approximately 180 motor vehicles a day. In half of these
vehicles a specific type of air filter is used. The company works 360 days a year, on average.
The cost of carrying one air filter in stock for the year amounts to R10 and the cost of placing
an order is R50.

Required
a) Calculate the EOQ for the air filters. Round off to the nearest whole number.
b) Calculate the ordering and carrying costs.
Solution

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 2×Annual requirement Ordering cost
a) EOQ = √
Carrying or holding cost per unit

2×(90×360)×R50
= √
R10

2×32 400×R50
= √
R10

3 240 000
= √
R10

= 569.2 air f ilters

= 570 air f ilters (round of f to the next whole number)

b) Ordering costs = Number of orders × Cost per order

= 32 400/570 × R50

= 57 orders × R50

= R2 850

Carrying costs = Average stock × Carrying cost per unit

= 570/2 × R10

= R2 850

TEST YOURSELF 10.1

Sencam Ltd provides you with the following information regarding its inventory:

Annual usage 208 000 units

Interest rate 9,5%
Cost price per unit R22 per unit
Stock holding cost R7 per unit
Ordering cost R25 per order
Maximum weekly usage 4 000 units
Minimum weekly usage 3 000 units
Maximum lead time 6 weeks
Minimum lead time 2 weeks

Calculate the following:

a. EOQ
b. Number of orders
c. Safety stock
d. Average stock
e. Reorder point

10.4 Stock valuation methods

10.4.1 The perpetual and periodic inventory control systems

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 In Chapter 4 you were briefly introduced to the periodic and perpetual inventory methods in
calculating the cost of sales. In this chapter we will expand on these concepts. Most companies
use either a periodic or perpetual method of recording inventory and calculating cost of sales.

In a perpetual inventory system, inventory accounts are updated after each transaction, i.e.
inventory quantities are continuously updated. In a periodic inventory system, on the other hand,
the value of ending inventory is determined at the end of each accounting period by a physical
stock count.

The perpetual inventory system has a number of advantages over the periodic inventory system,
for example gross profit can be determined without an inventory count. Secondly, the physical
inventory on hand can be checked against the trading inventory account. The inventory account
reflects the inventory on hand at any moment in time. Thirdly, individual items of inventory can
be more easily monitored, especially if one has a computerised system that updates the
inventory records at the till.

A purchases account is used when the periodic method of recording inventory is in operation.
Whenever goods are bought, they are debited to the purchases account and when goods are sold,
they are credited to the revenue account. A separate inventory account is kept but is not used at
all during the year. Its sole function is to keep a record of the opening inventory at the beginning
of the year. It is only adjusted at the end of each financial year.

A cost of sales account is used when the perpetual method of recording inventory is in
operation. When goods are purchased, they are entered into the trading inventory account and
when goods are sold, they are entered into the sales account, debiting the bank or the debtor. In
addition, a credit entry is made to the trading inventory account, thus keeping a perpetual record
of the inventory on hand. An entry is also made in the cost of sales account, which therefore
keeps a permanent and up-to-date record of the cost price of the goods that have been sold.

Table 10.1 Differences between a perpetual and a periodic inventory system

Perpetual Periodic inventory system

inventory system
Inventory These accounts are The cost of sales account does not exist during the
account and continuously accounting period. It is shown as a closing entry at the
cost of sales updated during the end of the accounting period and determined as a
account accounting period. balancing figure or by using the following formula:
Opening inventory
+ Purchases
− Closing inventory
The value of ending inventory is determined at the end
of each accounting period by a physical stock count.

Purchases, There is no Purchases are recorded in the purchases account and

purchase purchases account. directly debited to the inventory account. Purchase
returns, and returns are directly credited to the inventory account.
purchase
allowances
accounts

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 Perpetual Periodic inventory system
inventory system
Sale of goods Recording is made Recorded via a single journal entry.
via two journal
entries:
(1) recording the
sales value of
inventory
(2) recording the
cost of goods
sold

Closing entry Closing entries only Closing entries not required for inventory account.
required to update
inventory and cost
of goods sold
account.

The following example will illustrate the typical journal entries under a periodic and perpetual
inventory system.

ILLUSTRATIVE EXAMPLE

The following transactions were extracted from the records of Zeus Enterprises:

Opening inventory, R5 000

Bought goods on credit for R1 000
Bought goods for cash R600
Sold goods on credit for R300 (cost R200)
Sold goods for cash, R400 (cost R267)
Closing inventory, R6 000

Record the transactions under both the periodic and perpetual methods by means of journal
entries and calculate the gross profit.
The terms “accounts receivable” and “accounts payable” are used for debtors and creditors
respectively.

Periodic inventory method Perpetual inventory method

Dr Cr Dr Cr
R R R R

Purchases 1 000 Trading inventory 1 000

Accounts payable 1 000 Accounts payable 1 000

Purchases 600 Trading inventory 600

Bank 600 Bank 600

Accounts receivable 300 Accounts receivable 300

Revenue 300 Revenue 300

Bank 400 Cost of sales 200

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 Revenue 400 Trading inventory 200

Bank 400
Revenue 400

Cost of sales 267

Trading inventory 267

Calculation of gross profit:

R R R
Revenue 700 Revenue 700
Less: Cost of sales 600 Less: Cost of sales 467
Opening inventory 5 000 Gross profit 233
Add: Purchases 1 600
Cost of goods available for sale 6 600
Less: Closing inventory 6 000
Gross profit 100

Note: Various accounts are affected under each method. Under the perpetual method, there
is an inventory loss of R133, which must be taken to the income statement as an expense,
i.e.:

Inventory
R R
Balance b/d 5 000 Cost of sales 200
Creditors 1 000 Cost of sales 267
Bank 600 Inventory loss 133*
Balance b/d 6 000
6 600 6 467

*This credit side would be R133 less than the debit side. The adjusting journal entry would be:

Dr Inventory loss R133

Cr Trading inventory R133

10.4.2 First-in-first-out (FIFO) method

PERIODIC INVENTORY
A physical stock count is done at the end of the accounting period to determine the inventory on
hand (closing balance). Using the FIFO method to compute the cost of ending inventory, the
cost of the most recent purchases is used, after which the cost of goods sold can be computed.

PERPETUAL INVENTORY
According to this method, the material that is purchased first is used (issued) first. That is, the
oldest stock is issued first at the price at which it was originally purchased. Consequently, the
stock on hand at the end of the financial period (closing stock) will be valued at the cost of the
more recently acquired material, which is in line with the current market values.

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 10.4.3 Weighted average method

PERIODIC INVENTORY
When using the weighted average method, the weighted average unit cost is used to calculate
the cost of goods sold and the cost of ending inventory. The weighted average unit cost is
computed using the following formula:
Total cost of units available f or sale
Number of units available f or sale

PERPETUAL INVENTORY
According to this method, the new material that is purchased is added to the material already in
stock. An average price must be determined after each purchase by dividing the total cost of
stock on hand by the total number of units on hand.

ILLUSTRATIVE EXAMPLE: Stock valuation

The following transactions have been concluded in respect of a particular stock item for the
month of February 20x1:
1 Stock on hand: 100 units at R10,00 per unit
3 Issued stock: 40 units
4 Received stock: 160 units at R12,00 per unit
5 Issued stock: 40 units
6 Issued stock: 60 units
7 Returned stock to the supplier: 20 units received on 4 February 20x1.

Required
Calculate the value of the closing stock for the month of February 20x1 using the following
methods of stock valuation:

FIFO
Weighted average

Where necessary, round off to two decimal places.

Solution
Periodic inventory
The solution to the example will depend on the basis that is used to value inventory, i.e. FIFO
or weighted average, and whether periodic or perpetual inventory is used. However, the
number of units on hand will remain the same irrespective of which method is used.
FIFO: Periodic inventory

February Units Cost per unit (R) Total (R)

01 Opening inventory 100 10,00 1 000
04 Purchases 160 12,00 1 920
07 Returns (20) 12,00 (240)
Goods available 240 1 680
Issues (140)

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 Closing inventory 100 1 200

Weighted average: Periodic inventory

February Units Cost per unit (R) Total cost (R)

01 100 10,00 1 000
04 160 12,00 1 920
07 (20) 12,00 (240)

240 2 680

Weighted average unit cost = R2 920/260 units

= R11,2308 per unit

Units available for sale 240

Less: Units sold (40 + 40 + 20 + 40) 140
Units in ending inventory 100

Cost of goods sold: 140 units × R11,23 = R1 572,20

Cost of ending inventory: 100 units × R11,23 = R1 123

Solution
Perpetual inventory
Stores ledger card (FIFO)

Date Received Issued Balance

Feb Units Price Amount Units Price Amount Units Price Amount
R R R R R R

01 100 10,00 1 000

03 40 10,00 400 60 10,00 600
04 160 12,00 1 920 60 10,00 600
160 12,00 1 920
05 40 10,00 400 20 10,00 200
160 12,00 1 920
06 20 10,00 200 Nil Nil Nil
40 12,00 480 120 12,00 1 440
07 (20) 12,00 (240) 100 12,00 1 200

Closing stock value = R1 200

Total cost of issues = R1 480 (R400 + R400 + R200 + R480)
Total cost of stock purchased = R1 680 (R1 920 – R240)

Stores ledger card (weighted average)

Date Received Issued Balance

Feb Units
Price Amount Units
Price Amount Units
Price Amount
R R R R R R

01 100 10,00 1 000

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 03 40 10,00 400 60 10,00 600
04 160 12,00 1 920 220 11,45 2 520
05 40 11,45 458 180 11,45 2 061
06 60 11,45 687 120 11,45 1 374
07 (20) 12,00 (240) 100 11,34 1 134

Calculations
4 February 20x1 total cost ÷ total number of units
= (R600 + R1 920) ÷ (60 + 160)
= R2 520 ÷ 220 units
= R11,45

7 February 20x1 total cost ÷ total number of units

= (R1 374 – R240) ÷ (120 – 20)
= R1 134 ÷ 100 units
= R11,34

Closing stock value = R1 134

Total cost of issues = R1 545 (R400 + R458 + R687)
Total cost of stock purchased = R1 680 (R1 920 – R240)

TEST YOURSELF 10.2

Baloo Enterprises has presented the following information regarding inventory for December
20x1:

Dec 01 Opening Inventory 200 units @ R18 per unit

Dec 11 Purchases 300 units @ R20 per unit
Dec 13 Issues 200 units
Dec 16 Purchases 400 units @ R22 per unit
Dec 21 Issues 500 units
Dec 27 Purchases 100 units @ R24 per unit

Required
a. Based on the periodic inventory system, compute the cost of closing inventory and the
cost of goods sold as at 31 December 20x1 using both the FIFO and weighted average
methods.
b. Based on the perpetual inventory system, compute the cost of closing inventory and the
cost of goods sold as at 31 December 20x1 using both the FIFO and weighted average
methods.

TUTORIAL EXERCISES

Exercise 1
1.1 Racquets Unlimited is planning to stock two new products next year. The following
information is made available:

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 The expected annual demand for Standard Racquets will be 100 000 racquets, and the
cost to place each order is R15. The total holding cost for one of these racquets is R5
per year (including interest). The expected demand for Deluxe Racquets will be 2 500
racquets a week, and the cost to place each order is R16. The handling costs for one of
these racquets is R9 per racquet. An additional R1 per racquet will be incurred for theft
and fire insurance for Deluxe Racquets. Assume that there are 52 weeks in a year and
that the expected warehouse rent is R450 000 a year.

The economic order quantity for Racquets Unlimited of the proposed new racquets is as
follows:

(1) Standard Racquets: 775 racquets; Deluxe Racquets: 645 racquets

(2) Standard Racquets: 258 racquets; Deluxe Racquets: 403 racquets

(3) Standard Racquets: 775 racquets; Deluxe Racquets: 680 racquets

(4) Standard Racquets: 258 racquets; Deluxe Racquets: 645 racquets

1.2 The warehouse presents you with the following information on a specific model of
cellular device for the month ended 31 July 20x1. The company uses the FIFO method
of inventory valuation.

Date Transaction details

July
1 Opening inventory 300 units at R40 each.
2 Bought 250 at 5% discount of the price per unit of opening inventory.
6 Issued 350 units to production.
10 Bought 50 units at R47 each, 10% of the purchase price per unit is freight charged, which was paid for this
order.
25 Returned to supplier 10 units bought on 2 July 20x1.
29 Bought 25 units at R49 each.

1.2.1 The value of the inventory on 2 July 20x1, assuming that there was a fire at the
warehouse and half of the inventory bought on 2 July 20x1 was destroyed, is
(1) R16 570
(2) R21 500
(3) R16 750
(4) R20 500

1.2.2 The value of the inventory issued to production on 6 July 20x1 is

(1) R14 000
(2) R13 900
(3) R31 900
(4) R21 900

1.2.3 The value of the inventory on 31 July 20x1 is

(1) R1 225
(2) R2 585
(3) R11 300
(4) R11 030

Exercise 2
A manufacturing company uses 3 500 units of raw material XT per week. The cost of ordering
one unit of XT amounts to R45 and the storage and holding costs associated with one unit

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 are as follows:

Cost per unit per annum R

Interest on funds invested 5,00
Insurance 7,60
Municipal charges 10,40
Miscellaneous 7,00
30,00

Assume that there are 52 weeks in the year.

Required
Calculate the EOQ for raw material XT. Round off to the nearest whole number.

Exercise 3
Totoso (Pty) Ltd buys gluten free flour in bulk and repackages it in different sizes for the retail
sector. The company uses 1 440 kg of flour per month. The cost of placing an order is R25
and the carrying cost is R15 per kg. The company reveals that the maximum weekly usage is
100 kg, while the minimum weekly usage is 80 kg. It has managed a consistent 90 kg
average usage over the last couple of years. Time taken from the date of order to the day of
receiving inventory from the supplier ranges from 2 to 3 weeks or an average of 2.5 weeks.
Required
Calculate
3.1 Economic order quantity
3.2 Determine the number of orders
3.3 Total annual costs of inventory
3.4 Reorder level
3.5 Minimum inventory level

Exercise 4
The following information is available for the month of January 20x1 concerning raw material
WG, which is used in the manufacturing of widgets.

Opening stock 1 160 units at R3,50 each

Received stock 2 500 units at R4,20 each
16 180 units at R2,25 each
Issued stock 6 300 units
20 370 units

Required
Calculate the value of the closing stock of raw material WG for the month of January 20x1,
using the following methods of stock valuation:
4.1 FIFO
4.2 Weighted average
Where necessary, round off to two decimal places.

Exercise 5
Tshabalala Traders records inventory using a periodic inventory system and valuates its stock
using the FIFO method. The following transactions took place during the month of March:

Purchases:
03 March 200 units at R350 per unit
20 March 100 units at R370 per unit

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 Material requisitions received from the manufacturing department:
10 March 260 units
25 March 30 units
The closing stock for February was 20 units at a value of R320 per unit.

Required
Calculate the value of the closing stock for March.

Exercise 6
The following transactions have been concluded in respect of a particular stock item for the
month of June 20x1:

1 Stock on hand: 100 units at R10,00 per unit

4 Issued stock: 40 units
6 Received stock: 100 units at R20,00 per unit
11 Issued stock: 50 units
19 Issued stock: 30 units
28 Returned stock to the supplier: 10 units received on 6 June 20x1

Note: The business uses a mark-up of 20% on cost.

Required
Determine the value of closing stock, cost of sales and gross profit, using FIFO.

Exercise 7
The following transactions took place in the books of XYZ Ltd with regard to stock item PTL
for the month of September 20x1:

1 Balance of 20 at R15,10 each

5 Purchased 20 at R17,00 each.
9 Sold 5 at R35,00 each.
15 Purchased 7 at R19,50.
25 Returned 3 to the supplier, which originally cost R15,10 each.
28 Purchased 10 at R19,50.

Required
For the month of September 20x1:
7.1 Calculate the value of closing inventories using the weighted average inventory method.
7.2 Calculate the gross profit generated on the stock item PTL.
Where necessary, round off to two decimal places.

Exercise 8
Manufacturers Ltd has provided you with the following information for the month of November
20x1 regarding a part that is used during the manufacturing process:

1 Stock on hand comprised the following purchases:

Purchases of 25 October 20x1
(80 units at R12 each, total cost of R960)
Purchases of 30 October 20x1
(800 units at R12,40 each, total cost of R9 920)
5 Issued to production, 640 units.

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 9 Purchased 800 units at R12,80 each, total cost of R10 240.
Freight charges on these purchases amounted to R80.
15 Issued 1000 units.
20 Purchased 1200 units at R12,60 each, total cost of R15 120.
25 Returned to the supplier 240 units purchased on 20 November 20x1.

Required
For the month of November 20x1:
8.1 Calculate the cost of issues to production and value of closing inventories using FIFO.
8.2 Calculate the value of closing inventories using the weighted average method of stock
valuation.
Where necessary, round off to two decimal places.

Exercise 9
Sica Ltd presented information about the material purchases and issues for the month of
June 20x1. It uses a perpetual inventory system.
Date

8 Direct materials issued R4 100

10 Issued from factory maintenance supplies R275
14 Returned direct materials to the warehouse R1 400
18 Purchased raw materials on credit R17 900
21 Returned raw materials bought on credit to supplier R5 200

Required
Record the above transactions using journal entries.

Exercise 10
Zuma Ltd manufactures a single product, The Gloc. The following information with regard to
the raw material needed in the production process are supplied to you:

Normal delivery time: 2,5 weeks

Maximum delivery time: 3,5 weeks
Normal usage: 52 000 units per year
Purchase price per unit: R8,50
Cost of placing an order: R18,00
Interest rate: 2% per year
Storing cost per unit: R2,50

Required
10.1 Calculate the EOQ.
10.2 Calculate the reorder point if the organisation does not keep safety stock.
10.3 Calculate the reorder point if the organisation has a policy to keep safety stock.
10.4 Calculate the safety stock that should be kept by the organisation.

Exercise 11
Zeus Enterprises uses a periodic inventory system and accounts for inventory at the end of
each accounting period by doing a physical stock count. The first-in-first-out (FIFO) method is
applied to compute the cost of ending inventory.
The following information regarding inventory is provided for the year 20x1:

Feb 01 Opening inventory 200 units @ R18 per unit

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 Feb 11 Purchases 300 units @ R20 per unit
Sept 16 Purchases 400 units @ R22 per unit
Nov 14 Purchases 100 units @ R24 per unit

On 31 December 20x1, after doing a physical stock count, there are 300 units on hand.

Required
Using the FIFO method, compute the following:
11.1 Cost of closing inventory at 31 December 20x1.
11.2 Cost of goods sold during the year 20x1.

Exercise 12
Bubbles Enterprises uses a periodic inventory system. Accounting for inventory at the end of
each accounting period is done by doing a physical stock count. The weighted average
method is applied to compute the cost of ending inventory. The following information is
available regarding one of its products for December 20x1:

Date Transaction details

December
01 Opening balance 100 units @ R10,20
06 Purchases: 400 units @ R10,45
07 Sales: 200 units
13 Purchases: 300 units @ R10,50
14 Sales: 250 units
19 Purchases: 200 units @ R10,55
24 Purchases: 400 units @ R10,80
27 Sales: 700 units
28 Sales: 100 units
31 Purchases: 300 units @ R10,90

Required
Compute inventory cost at 31 December 20x1 using the weighted average method.

TEST YOURSELF SOLUTIONS

TEST YOURSELF SOLUTION 10.1

a. EOQ = 2DO
√
(P×i)+H

= 2×208 000×R25
√
(22×0.095)+R7

= 1069.63 units
= 1070 units (roundup)
b. Number of orders per year
Annual usage ÷ EOQ
= 208 000 ÷ 1 070
= 194.39 orders
= 194 orders
c. Safety stock
= Max. usage × min. lead time
= 4 000 × 2
= 8 000
d. Average stock
= EOQ ÷ 2 + Safety stock
= 1 070 ÷ 2 + 8 000

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 = 8 535 units
e. Reorder point
= Max. usage × max. lead time
= 4 000 × 6
= 24 000

TEST YOURSELF SOLUTION 10.2

a. PERIODIC INVENTORY
Cost of ending inventory
If the FIFO method is used, the units remaining in the inventory represent the most recent
costs incurred to purchase the inventory. The cost of 300 units on 31 December 20x1 would,
therefore, be computed as follows:

1 Opening inventory 200 × R18 = R3 600

11 Cost of 300 units purchased on 11 December 300 × R20 = R6 000
16 Cost of 400 units purchased on 16 December 400 × R22 = R8 800
27 Cost of 100 units purchased on 27 December 100 × R24 = R2 400
Goods available for sale 1 000 R20 800
13 Issued 200 units on 13 December (200)
21 Issued 500 units on 21 December (500)
Closing inventory 300 R6 800*

*Value of closing inventory

Cost of 100 units purchased on 14 November 100 × R24 = R2 400

Cost of 200 units purchased on 16 September 200 × R22 = R4 400
Cost of 300 units on hand on 31 December R6 800

Cost of goods sold during the year 20x1

Beginning inventory (200 x R18) R3 600

Purchase during the year (R6 000 + R8 800 + R2 400) R17 200
Cost of goods available for sale R20 800
Less: Ending inventory R6 800
Cost of goods sold R14 000

Compute inventory cost at 31 December 20x1 using the weighted average method.

Units Cost per unit Total cost

December 01 200 R18 R3 600
December 11 300 R20 R6 000
December 16 400 R22 R8 800
December 27 100 R24 R2 400
Total 1 000 R20 800

Weighted average unit cost = R20 800/1 000 units = R20,80 per unit

Units available for sale 1 000

Less: Units issued (200 + 500) 700
Units in ending inventory 300

Cost of goods sold: 700 units × R20,80 = R14 560

Cost of ending inventory: 300 units × R20,80 = R6 240

b. PERPETUAL INVENTORY

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 Baloo Enterprises – FIFO stores ledger card for December 20x1

Date Received Issued Balance

Units Price Amount Units Price Amount Units Price Amount
R R R R R R
01 200 18 3 600 200 18 3 600
11 300 20 6 000 300 20 6 000
13 200 18 3 600 300 20 6 000
16 400 22 8 800 300 20 6 000
400 22 8 800
21 300 20 6 000
200 22 4 400 200 22 4 400
27 100 24 2 400 200 22 4 400
100 24 2 400

Cost of closing inventory = R4 400 + R2 400 = R6 800

Cost of goods sold = R3 600 + R6 000 + R4 400 = R14 000
Baloo Enterprises – Weighted average stores ledger card for December 20x1

Date Received Issued Balance

Units Price Amount Units Price Amount Units Price Amount
R R R R R R
01 200 18 3 600
11 300 20 6 000 500 19,20 9 600
13 200 19,20 3 840 300 19,20 5 760
16 400 22 8 800 700 20,80 14 560
21 500 20,80 10 400 200 20,80 4 160
27 100 24 2 400 300 21,87 6 560

Cost of closing inventory = 300 units @ R21.87 = R6 560

Cost of goods sold = R3 840 + R10 400 = R14 240

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 11 Labour

Outcomes

At the end of this chapter students should be able to

distinguish between direct and indirect labour

calculate an employee’s remuneration
ascertain the labour recovery rate for the business
prepare the wages and salaries journals.

Chapter outline

11.1 Classification of labour

11.1.1 Direct labour
11.1.2 Indirect labour
11.2 Remuneration methods
11.2.1 Salaries
11.2.2 Hourly wages
11.2.3 Piecework pay
11.3 Calculating the remuneration
11.3.1 Basic wage
11.3.2 Gross wages
11.3.3 Net wage
11.3.4 Normal deductions
11.4 Accounting entries
11.5 Incentive schemes
11.6 Labour recovery rate
11.6.1 Productive hours
11.6.2 Annual labour cost
11.7 Payroll accounting
11.7.1 Salaries journal
11.7.2 Wages journal

11.1 Classification of labour

Labour is the physical and / or mental effort used to manufacture a product or provide a service. It can
be classified as either direct or indirect.

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 11.1.1 Direct labour
Direct labour is the labour cost that can be physically traced to the creation of a specific product in a
“hands-on” sense (such as assembly line workers in a plant).

11.1.2 Indirect labour

Indirect labour is the labour cost that cannot be physically traced to the creation of a specific product,
for example factory supervision and maintenance wages.

11.2 Remuneration methods

There are three basic types of remuneration method. A business entity can choose to apply one of
these methods or they can use a combination.

11.2.1 Salaries
A salary is a fixed amount paid to an employee on a monthly basis. The employees that normally
receive salaries include managerial staff, supervisors and administrative workers.

11.2.2 Hourly wages

Workers are paid a specific rate based on the numbers of hours spent at work:

Hourly wages = Hours worked × Rate of pay per hour

Although workers are paid per hour, their output is also monitored by their immediate supervisor.
This is to ensure that they are not being paid merely for being present at work.

11.2.3 Piecework pay

Under the piecework system, employees are paid in accordance with the actual number of units that
they have produced:

Piecework pay = Number of units produced × Rate of pay per unit

This system can only be applied if the employee’s output can be determined with certainty.

11.3 Calculating the remuneration

There are three stages in the calculation of an employee’s remuneration, i.e. basic, gross and net
wages.

11.3.1 Basic wage

Basic remuneration is the normal wages that an employee earns.

11.3.2 Gross wages

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 The gross wage includes the basic wage, overtime, bonus and allowances. There are two types of
overtime that can be calculated for an employee: normal overtime and double overtime. Normal
overtime is the overtime worked after hours during the week and on a Saturday. It is remunerated at
one and a half times the normal rate. Double overtime is overtime that is worked on a Sunday or a
public holiday. It is remunerated at twice the normal rate.

An employee may be entitled to an annual bonus, as well as various other allowances, which can
include a cellphone allowance, car allowance, etc. These allowances would be dependent upon the
type of job that the employee is required to do.

11.3.3 Net wage

The net wage is an employee’s take-home pay after all the deductions have been considered.

There are numerous deductions that affect an employee’s wage, such as pension, pay as you earn
(PAYE), the Unemployment Insurance Fund (UIF), medical aid, etc.

11.3.4 Normal deductions

The employer makes certain deductions from the employees’ remunerations and pays them over to
various third parties on their behalf. These deductions include pension, PAYE, UIF, medical aid, trade
union fees and allowances. As part of the fringe benefits, employers may also contribute to various
funds on the employee’s behalf.

Note: The employer’s contributions are not considered when we calculate the employees’ net wage.
These contributions are paid directly to the relevant funds.

11.3.4.1 Pension fund

The purpose of a pension fund is to provide an investment for an employee’s retirement. Only
permanent employees contribute to a pension fund. According to the South African Income Tax Act,
an employer is allowed to deduct 7,5% from an employee’s basic wage and pay it over to a specified
pension fund. The employer also contributes to the pension fund on the employee’s behalf. Pension is
the first deduction that is made.

11.3.4.2 Pay as you earn (PAYE)

The government charges its citizens and business entities taxation. The purpose of this taxation
process is to cover government expenditure. Pay as you earn refers to the personal tax that individuals
pay over to the South African Revenue Services (SARS). The amount that is charged to individuals is
stipulated in the tax tables. These tables change from year to year. For the purpose of this book you
will always be given a percentage to work with. PAYE is calculated as a percentage of taxable
income.

Taxable income = Basic wage – Pension fund contributions

11.3.4.3 Unemployment Insurance Fund (UIF)

The Unemployment Insurance Act of 2001 protects workers who become unemployed. It covers
individuals who are out of work, as well as those who cannot work due to pregnancy and prolonged
illness. According to the Act, employers are entitled to deduct 1% of an employee’s basic wage and
pay it over to the fund. The contributions to the UIF are compulsory for the employer and the
employee. The government also contributes to this fund.

11.3.4.4 Medical aid fund

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 The purpose of a medical aid fund is to subsidise individuals who may encounter unexpected medical
expenses. This is made possible due to a large number of people contributing to the fund.

11.3.4.5 Trade unions

Trade unions are organised associations of workers formed to protect the rights and interests of
employees. The trade union fees are deducted by the employer and paid over to the employees,
chosen trade unions.

11.3.4.6 Allowances
There are various allowances that employers may give to employees depending upon the employees’
job specifications and type of organisation. These allowances include travel allowances, cellphone
allowances and housing subsidies.

Travel and cellphone allowances are used to remunerate employees who use their private vehicles
and/or cellphones for business use. Housing subsidies are allowances given to employees to assist
with their mortgage repayments.

Format for the net wage calculation

R R
Basic wages xxx
Add: Normal overtime xxx
Add: Double overtime xxx
Add: Bonus xxx
Add: Allowances xxx
Gross wage xxx
Less: Pension fund (xxx)
Taxable income xxx
Less: Other deductions (xxx)
Pay as you earn (PAYE) xxx
Unemployment Insurance Fund (UIF) xxx
Medical aid xxx
Net wage xxx

Note: The employees must complete their normal working hours before qualifying for overtime.

11.4 Accounting entries

There are three main journal entries involved in the recording of wages. These are as follows:

A journal entry to record the employee’s gross wage, net wage and deductions.
A journal entry to record the employer’s contributions.
A journal entry to record the total payments.

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 Recording the employee’s gross wage, net wage and deductions

Recording the employer’s contributions

Debit Credit
Wages account xxx
Pension fund xxx
UIF xxx
Medical aid fund xxx

Recording the total payments

Debit Credit
Wages payable xxx
Pension fund (employer and employee contributions) xxx
SARS (PAYE) xxx
UIF (employer and employee contributions) xxx
Medical aid fund (employer and employee contributions) xxx
Bank xxx

ILLUSTRATIVE EXAMPLE: Net wage and accounting entries

Miss Mungal is an employee of Manufacturing Ltd. She works in the assembly department and
receives an hourly pay rate of R80. The normal working week consists of 40 hours, from Monday to
Friday.

Monday 10 hours
Tuesday 10 hours
Wednesday 7 hours
Thursday 12 hours
Friday 8 hours
Saturday 5 hours
Sunday 5 hours

Normal overtime is calculated at time and a half, while overtime worked on Sundays and public
holidays is calculated at double the normal rate of pay. Contributions to the relevant funds are as
follows:

Pension fund at 7,5% of basic wage; the employer contributes to this fund on a rand-for-rand
basis.
Medical aid totals R150 per week, of which 40% is paid by the employer and the balance by the
employee.

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 Unemployment Insurance Fund (UIF) at 1% of basic wage; the employer contributes to the fund
on a rand-for-rand basis.
The PAYE rate is 18% of taxable income.

Required
Calculate the net wage of Miss Mungal for the week ended 28 February 20x1 and prepare all the
necessary journal entries. Where necessary, round off to two decimal places.

Solution
Net wage of Miss Mungal for the week ended 28 February 20x1

R R
Basic wage (40 hours × R80) 3 200,00
Normal overtime (13 hours × R80 × 1,5) 1 560,00
Double overtime (5 hours × R80 × 2) 800,00
Gross wage 5 560,00
Less pension (R3 200 × 7,5%) 240,00
Taxable income 5 320,00
Less other deductions 1 079,60
PAYE (R5 320 × 18%) 957,60
Medical aid (R150 × 60%) 90,00
UIF (R3 200 ×1%) 12,00
Net wage 4 240,40

Calculation of employer contributions

Pension fund contributions R240,00

UIF R32,00
Medical aid fund (R150 × 40%) R60,00
Total employer contributions R332,00

Accounting entries
Recording employee’s gross wage, net wage and deductions

Debit Credit
Wages account (gross wage amount) 5 560,00
Wages payable (net wage amount) 4 240,40
Pension fund 240,00
SARS (PAYE) 957,60
UIF 32,00
Medical aid fund 90,00

Recording employer contributions

Debit (R) Debit (R)

Wages account 332,00
Pension fund 240,00
UIF 3 200,00

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 Medical aid fund 60,00

Recording the total payment

Debit (R) Credit (R)

Wages payable 4 240,40
Pension fund (R90 + R90) 480,00
SARS (PAYE) 957,60
Medical aid (R90 + R60) 150,00
UIF (R32 + R32) 64,00
Bank 5 892,00

TEST YOURSELF 11.1: NET WAGE CALCULATION

The following information was taken from the time sheet of Mr Curtis for the week ended 23 May
20x2.

Day Hours worked

Monday 8
Tuesday 8
Wednesday 8
Thursday 8
Friday 7
Saturday 4
Sunday 4

A normal working week is 40 hours, from Monday to Friday. Normal overtime is remunerated at
one and a half times, while double overtime is remunerated at twice the normal rate. The hourly
rate of pay is R62,50.
Mr Curtis contributes to the following funds:

Pension at 7,5% of his basic wage; the employer also contributes to this fund on a rand-for-rand
basis.
UIF at 1% of his basic wage.
PAYE at 18% of taxable income.
Medical aid at 12% of basic wages split between the employer and employee on a 60: 40 basis
respectively.

Required
a) Calculate Mr Curtis’s net wage for the week ended 23 May 20x2.
b) Calculate the employer contributions.
Note: Where necessary, round off to two decimal places.

11.5 Incentive schemes

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 The main purpose of an incentive scheme is to increase productivity. Employees are rewarded for
time saved or additional units produced in the form of a bonus.

11.6 Labour recovery rate

The purpose of the labour recovery rate is to ascertain what the business entity is spending on each
employee. The formula used is as follows:

Total annual labour cost

Labour recovery rate =
Total annual productive hours

11.6.1 Productive hours

The productive hours relate to the actual working hours for all the employees for the year.

11.6.2 Annual labour cost

The annual labour cost includes all the items that the business entity pays for; that is, the basic wage,
bonus, allowances, as well as all the fringe benefits.

ILLUSTRATIVE EXAMPLE: Labour recovery rate

StitchIt Ltd is a company that operates in the clothing industry. It produces a wide range of clothes
for the whole family. The company is well known for its good quality clothing. It employs four
pattern designers, one for each range of clothing. These pattern designers work eight hours a day
for five days a week and are paid at a rate of R75 per hour. They also receive the following fringe
benefits:

A bonus equal to four weeks of normal earning

A housing allowance of R600 per employee per month
A clothing allowance of R500 per employee per quarter

The company also contributes to the following funds on the employees’ behalf: pension at 7,5%
and UIF at 1% of normal earnings.
The pattern designers are entitled to three weeks’ vacation leave for the year. The calendar for the
current year indicates that there are 13 public holidays. Idle time is anticipated to be 3% of
available time. Assume that there are 52 weeks in the year.

Required
Calculate the following:
a) Annual productive hours
b) Total annual labour cost
c) Hourly recovery rate

Solution
a) Annual productive time Hours

Number of hours in a year (52 w × 40 hours p / w × 4 employees) 8 320

Less: Vacation hours (3 w × 40 hours × 4 employees) (480)
Less: Public holidays (13 days × 8 hours p / day × 4 employees) (416)

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 Available productive hours 7 424
Less: Idle time (3% × 7 424) (222,72)
Annual productive hours 7 201,28

b) Annual labour cost R’s

Basic wage (40 hours × R75 × 4 employees × 52 weeks) 624 000
Add: Annual bonus (40 hours × R75 × 4 employees × 4 weeks) 48 000
Add: Housing allowance (600 × 12 months × 4 employees) 28 800
Add: Clothing allowance (500 × 4 quarters × 4 employees) 8 000
Add: Pension fund contributions (7,5% × 624 000) 46 800
Add: UIF contributions (1% × 624 000) 6 240
Annual labour cost 761 840

c) Hourly recovery rate

= Annual labour cost ÷ Annual productive hours

= R761 840 ÷ 7 201,28

= R105,79

TEST YOURSELF 11.2: LABOUR RECOVERY RATE

A marketing company has employed a graphic design specialist. Her basic annual salary is R360
000 and she is entitled to an annual bonus of R30 000. The company operates a 40-hour week and
employees are entitled to three weeks’ annual leave.
There are 13 public holidays annually. Idle time is equal to 3% of available productive time. The
company contributes 7,5% and 1% of the basic salary towards the pension fund and UIF,
respectively. Assume that there are 52 weeks in the year.
Required
Calculate the following:
a) Annual productive hours
b) Total annual labour cost
c) Hourly recovery rate

11.7 Payroll accounting

Payroll accounting is the system used by employers to keep track of their employees’ wages and
salaries, bonuses, fringe benefits, etc. Computerised payroll systems comprise software packages that
provide an efficient way of organising, storing and maintaining data on all employees.

The computerised payroll system performs the same function as the manual system, but there are
various advantages to using the computerised system as opposed to the manual system:

It saves time and resources.

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 It allows for the accessing of data and the updating of information electronically.
It decreases the rate of errors, since the processing is done by a computer.
Some payroll software packages can be integrated with other functions within the organisation,
such as the time clock system. The date and time are imported into the payroll system as the
employee swipes his electronic card.

There are various payroll accounting software packages on the market to suit the needs of the
business. Small and medium-sized businesses can purchase off-the-shelf software, while larger
businesses have the option of having the payroll accounting software package tailored to their needs.

In the manual system the salaries and wages journals are drafted and posted to the general ledger.
Each of these journals will be discussed in more detail.

11.7.1 Salaries journal

The salaries journal is drafted on a monthly basis and is used to record the gross salary, employee
deductions, net salary, as well as the employer contributions for each salaried employee. The cash
payments journal is then drafted to record the payments made to the employees, as well as the
payments to the relevant funds. The totals of the aforementioned journals are then posted to the
general ledger.

ILLUSTRATIVE EXAMPLE: Salaries journal and posting

Workers Ltd has three salaried employees. Mr Govender, the manager, Mrs Yearwood, the factory
supervisor, and Mr Nzuza, the administrative assistant. The monthly gross salary per employee is
R45 000, R33 000 and R30 000 respectively.
The following deductions are made from each employee’s gross salary: 7,5% to the Workers’
Pension Fund; 5% to the Feel Good Medical Aid Scheme, and 1% to the Unemployment Insurance
Fund. The employer also contributes to the Workers’ Pension Fund and the Unemployment
Insurance Fund on a rand-for-rand basis for each employee. The PAYE deduction is 18% of
taxable income.

Required
Based on the information provided, draft the salaries journal and cash payments journal of Workers
Ltd for the month of April 20x2 and post to the relevant general ledger accounts.

Solution

Salaries journal of Workers Ltd for April 20x2 SJ1

Employee Gross Deductions Net Employer contributions
salary Pension Medical UIF Receiver of Total salary Pension UIF Total
fund 7,5% aid 5% 1% revenue (PAYE) fund
18%
Govender 45 3 375,00 2 250,00 450,00 7 492,50 13 31 3 375,00 450,00 3
000,00 567,50 432,50 825,00
Yearwood 33 2 475,00 1 650,00 330,00 5 494,50 9 23 2 475,00 330,00 2
000,00 949,50 050,50 805,00
Nzuza 30 2 250,00 1 500,00 300,00 4 995,00 9 20 2 250,00 300,00 2
000,00 045,00 955,00 550,00
108 8 100,00 5 400,00 1 17 982,00 32 75 8 100,00 1 9
000,00 080,00 562,00 438,00 080,00 180,00

Workings
Employee contributions
Pension fund: 7,5% of gross salary

Govender R45 000 x 7,5% = R3 375

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 Yearwood R33 000 x 7,5% = R2 475
Nzuza R30 000 x 7,5% = R2 250

The employer will contribute the same amount as the employees to the pension fund.

Medical aid scheme: 5% of gross salary

Govender R45 000 x 5% = R2 250

Yearwood R33 000 x 5% = R1 650
Nzuza R30 000 x 5% = R1500

UIF: 1% of gross salary

Govender R45 000 x 1% = R450

Yearwood R33 000 x 1% = R330
Nzuza R30 000 x 1% = R300

The employer will contribute the same amount as the employees to the UIF.

PAYE: 18% of taxable income

Gross salary – Pension = Taxable income

Govender (R45 000 – R3 375) x 18% = R7 492,50

Yearwood (R33 000 – R2 475) x 18% = R5 494,50
Nzuza (R30 000 – R2 250) x 18% = R4 995,00

Cash payments journal of Workers Ltd for April 20x2 CPJ1

Day Details Sundry Bank
R R
30 Creditors for salaries 75 438,00 75 438,00
# Workers’ Pension Fund (8 100 + 8 100) 16 200,00 16 200,00
Feel Good Medical Aid Scheme 5 400,00 5 400,00
# UIF (1 080 + 1 080) 2 160,00 2 160,00
Receiver of Revenue (PAYE) 17 982,00 17 982,00

# Inclusive of employee and employer contributions

General ledger of Workers Ltd

Creditors for salaries
30 Bank CPJ1 75 30 Salaries (net salaries) 75
April 438 April SJ1 438
20x2 20x2
Pension fund
30 Bank CPJ1 16 30 Salaries SJ1 8
April 200 April 100
20x2 20x2
Pension fund 8
contribution SJ1 100
16 16
200 200
Medical aid scheme
30 Bank CPJ1 5 30 Salaries SJ1 5
April 400 April 400
20x2 20x2

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 Unemployment Insurance Fund
30 Bank CPJ1 2 30 Salaries SJ1 1
April 160 April 080
20x2 20x2
UIF contributions SJ1 1
080
2 2
160 160
Receiver of Revenue (PAYE)
30 Bank CPJ1 17 30 Salaries SJ1 17
April 982 April 982
20x2 20x2
Salaries
30 Sundry (gross salaries) SJ1 108
April 000
20x2
Pension fund contributions
30 Pension fund SJ1 8
April 100
20x2
UIF contributions
30 UIF SJ1 1
April 080
20x2
Bank
30 Creditors for salaries 75
April CPJ1 438
20x2
Pension fund CPJ1 16
200
Medical aid scheme 5
CPJ1 400
Unemployment 2
Insurance fund CPJ1 160
Receiver of revenue 17
(PAYE) CPJ1 982

11.7.2 Wages journal

The wages journal is similar to the salaries journal, except that it is drafted on a weekly basis, not a
monthly basis. It is used to record the basic wages, overtime, employee deductions, net wage as well
as the employer contributions for each employee. The cash payments journal is then drafted to record
the payments made to the employees as well as the payments made to the relevant funds. The totals of
the aforementioned journals are then posted to the general ledger.

ILLUSTRATIVE EXAMPLE: Wages journal and posting

Assemble It Ltd produces electrical components for use in the manufacturing industry. The workers
in the assembly department are Mr Moodley, Mrs Nyawo and Mr Naidoo. A normal working week
consists of eight hours a day from Monday through to Friday. Overtime on weekdays and on

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 Saturdays is considered normal overtime and is remunerated at time and a half. Overtime worked
on a Sunday or public holiday is considered double overtime and is remunerated at twice the
normal rate. The following information relates to the three employees for the week ended 31
October 20x6.

Employee Hours worked Hourly rat

Monday Tuesday Wednesday Thursday Friday Saturday Sunday
Mr Moodley 8 8 10 7 8 2 0 R50
Mrs Nyawo 8 12 8 8 8 0 3 R45
Mr Naidoo 8 8 8 6 8 4 2 R55

Deductions are as follows:

Medical aid contributions per week

– Mr Moodley R150
– Mrs Nyawo R120
– Mr Naidoo R145
Unemployment Insurance Fund Employees contribute 1% of their basic wage to the
Unemployment Insurance Fund. The employer contributes an equal amount to the fund on the
employees’ behalf.
Pension fund Employees contribute 7,5% of their basic wage to the pension fund, while the
employer contributes 10% to the fund on their behalf.
PAYE is 18% of taxable income.

Required
Based on the information provided, draft the wages journal and cash payments journal of
Assemble It Ltd for the week ended 31 October 20x6 and post to the relevant general ledger
accounts.

Solution

Wages Journal of Assemble It Ltd for the week ended 31 October 20x6 WJ1
Employee Normal time Overtime Gross Deductions Net Employer
wage wage contributions
Hours Total Hours Total Pension Medical UIF Receiver Total Pension UIF Total
fund aid 1% of fund
7,5% Revenue
(PAYE)
18%
Moodley 40 2 3 225 2 225 150 150 20 373,5 693,50 1 200 20 220
000 531,50
Nyawo 40 1 7 540 2 340 135 120 18 396,9 669,90 1 180 18 198
800 670,10
Naidoo 40 2 4 385 2 585 165 145 22 435,6 767,60 1 220 22 242
200 817,40
6 1 7 150 450 415 60 1 206 2 5 600 60 660
000 150 125,60 019,00

Workings
Overtime

Normal overtime Double overtime Total overtime

Moodley 225 (3 × 1,5 × 50) 0 225
Nyawo 270 (4 × 1,5 × 45) 270 (3 × 2 × 45) 540
Naidoo 165 (2 × 1,5 × 55) 220 (2 × 2 × 55) 385

Pension fund: 8% of basic wage (employee contributions)

Moodley R2 000 × 7,5% = R150

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 Nyawo R1 800 × 7,5% = R135
Naidoo R2 200 × 7,5% = R165

Pension fund: 10% of basic wage (employer’s contributions)

The employer would contribute 10% to the pension fund on the employees’ behalf.

Moodley R2 000 × 10% = R200

Nyawo R1 800 × 10% = R180
Naidoo R2 200 × 10% = R220

UIF: 1% of basic wage (employee contribution)

Moodley R2 000 × 1% = R20

Nyawo R1 800 × 1% = R18
Naidoo R2 200 × 1% = R22

The employer would contribute the same amount as the employees to the UIF.
PAYE 18% of taxable income
Gross wage – Pension = Taxable income

Moodley (R2 225 – R150) × 18% = R373,50

Nyawo (R2 340 – R135) × 18% = R396,50
Naidoo (R2 585 – R165) × 18% = R435,60

Cash payments journal of Assemble It Ltd for the week ended 31 October 20x6 CPJ1
Day Details Sundry Bank
31 Oct Creditors for wages R5 0109 R5 0109
# Pension fund (450 + 600) 1 050,00 1 050,00
Medical aid scheme 415,00 415,00
# UIF (60 + 60) 120,00 120,00
Receiver of Revenue (PAYE) 1 206 1 206

General ledger of Assemble It Ltd

Creditors for wages
31 Bank CPJ1 5 019 31 Wages (net wages) 5 019
Oct Oct WJ1
20x6 20x6
Pension fund
31 Bank CPJ1 1 31 Wages WJ1 450
Oct 050,00 Oct
20x6 20x6
31 Pension fund 600
Oct contributions WJ1
20x6
1 1
050,00 050,00
Medical aid scheme
31 Bank CPJ1 415 31 Wages WJ1 415
Oct Oct
20x6 20x6
Unemployment Insurance Fund
31 Bank CPJ1 120 31 Wages WJ1 60
Oct Oct

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 20x6 20x6
31 UIF contributions 60
Oct WJ1
20x6
120 120
Receiver of Revenue (PAYE)
31 Bank CPJ1 1 206 31 Wages WJ1 1 206
Oct Oct
20x6 20x6
Wages
31 Sundry (gross wages) WJ1 7 150
Oct
20x6
Pension fund contributions
31 Pension fund WJ1 1
Oct 050,00
20x6
UIF contributions
31 UIF WJ1 120
Oct
20x6
Bank
31 Creditors for wages R5
Oct CPJ1 019
20x6
31 Pension fund CPJ1 1
Oct 050,00
20x6
31 Medical aid scheme 415,00
Oct CPJ1
20x6
31 Unemployment 120,00
Oct Insurance Fund
20x6 CPJ1
31 Receiver of 1 206
Oct Revenue (PAYE)
20x6 CPJ1

TUTORIAL EXERCISES

Exercise 1
The wage clerk at Make It Manufacturers prepared the following wage analysis for Mr T. Zulu, for
the last week of September.

Hours worked
Monday 8
Tuesday 10
Wednesday 9
Thursday 8
Friday 8
Saturday 4

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 Sunday 2
49

Additional information

1. The normal working week extends from Monday to Friday, 8 hours per day. Any time worked in
addition to this on weekdays and on Saturdays is remunerated at time and a half. Sundays and
public holidays are remunerated at double time.
2. The guaranteed hourly rate of pay is R120.
3. The employee contributes 7,5% of basic wages to the pension fund while the employer
contributes on a rand-for-rand basis to the fund on the employees’ behalf.
4. According to the tax tables supplied by SARS, the PAYE deduction is 18% of taxable income.
5. The UIF deduction is equivalent to 1,5% of gross wages.
6. The employee contributes 4% of their basic wage to a medical aid scheme. This is matched
rand for rand by the employer.

Required
Calculate the net wage due to Mr T. Zulu for the last week of September. Round off to two
decimal places.

Exercise 2
An engineering company has employed a product design specialist. His basic annual salary is
R480 000, and he is entitled to an annual bonus of R40 000. The company operates a 40-hour
week and each employee is entitled to 3 weeks annual leave. There are 12 public holidays
annually. Idle time is equal to 5% of available productive time. The company contributes 7,5% and
1% of the basic salary towards the pension and UIF funds, respectively.

Required
Calculate the following:
2.1 Annual productive hours
2.2 Total annual labour cost
2.3 Hourly recovery rate
Where necessary round off to two decimal places.

Exercise 3
The following information relates to two employees of Labour Ltd, Mrs Yearwood and Mr Naidoo.
The normal working week is 40 hours, 5 days at 8 hours per day. The basic wage rate for both
employees is R170 per hour. Overtime pay is calculated at time and a half of basic pay for all
overtime worked. Mrs Yearwood has worked on Job 1, while Mr Naidoo was employed exclusively
to complete Job 2.
Both Job 1 and 2 were completed by the last week in October. Mrs Yearwood took 52 hours to
complete Job 1 and produced 117 units, while Mr Naidoo took 49 hours to complete Job 2 and
produced 126 units.
Both employees contribute to the following funds:

Pension fund, at 7,5% of basic wage

Unemployment insurance fund at 1% of basic wage
Medical fund at R50 per week, per employee
The standard employee taxation deductions is 18% of taxable income.

Required
Calculate the net wages payable to both employees for the last week of October.
Round off to two decimal places.

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 Exercise 4
Appliance Ltd manufactures electric appliances in various department. The following information
relates to Department A, which employs 5 workers.
The normal annual salary is R120 000 per employee. The company pays a holiday bonus of 10%
of normal salary to each employee and contributes to the following funds on the employees’ behalf.

7,5% of normal salary to the pension fund

5% of normal salary to the medical aid scheme, the employee and employer contribute on a
50:50 basis to the medical aid scheme

A normal working week is 5 days at 8 hours per day. Holiday leave per employee is 3 weeks in a
year. The calendar for the current year showed 11 public holidays. Idle time is 5% of actual working
hours. There are 52 weeks in the year.

Required
Calculate the following for Department A
4.1 The annual labour cost
4.2 Total productive hours for the year
4.3 The hourly recovery rate per employee

Exercise 5
Mr Avatar works for the repairs and maintenance department at the Durban International Airport.
His job description is to conduct repairs and routine checks on all the airplanes in the Fly SAA fleet.
The time sheet of Mr Avatar shows that he worked for 46 hours during a 40-hour working week. On
both a Monday and a Wednesday, he worked three hours’ overtime. Overtime is compensated at
time and a half. The normal wage is R300 per hour. Pension fund and medical aid contributions are
7,5% and 14% of normal wages respectively and are paid on a 50:50 basis by employer and
employee. PAYE of 18% on taxable income is deducted from the employee’s wages. Mr Avatar
also receives a travel allowance of R250 per week as well as a cellular phone allowance of R300
per week due to his work commitments. He has recently joined a trade union for which he pays a
membership fee of R25 per week.

Required
Calculate Mr Avatar’s net earnings for the week.

Exercise 6
A company’s labour contract requires an hourly wage rate of R100,00 per hour for its production
workers. The following data is available concerning the company’s operations:
1) Employees work 8 hours a day, 5 days a week and have 3 weeks of paid vacation per year
plus 8 paid holidays. Idle time constitutes 5% of the time available for production.
2) Fringe benefits based on normal earnings includes a 4,5% contribution towards medical aid
and 7,5% towards pension fund. Each employee is also paid a bonus equal to two weeks
normal earnings.
3) Deductions for each employee consists of:

a) PAYE 18% of taxable income

b) Pension 7,5% of normal earnings
c) Medical Aid 4,5% of normal earnings
d) UIF R19,20 per week

Required
6.1 Calculate the following:

6.1.1 The annual hours available for production

6.1.2 The total annual labour cost per employee

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 6.1.3 The labour recovery rate
6.1.4 The weekly net pay of an employee

6.2 Prepare the journal entry to record the labour cost for the week.
Where necessary round off to two decimal places.

Exercise 7
Be Beautiful is a beauty spa that has three employees: a specialist nail technician, a hairstylist and
a receptionist. The receptionist is a salaried employee, while the nail technician and hairstylist are
paid based on their client numbers. The basic rate of pay per client is R80 and R100 for the nail
technician and the hairstylist respectively. They receive 1,5 times the normal rate for a Saturday
and double the normal rate for a Sunday and public holiday.
For the week ended 12 August 20x5 the number of clients who visited the spa were as follows:

Monday Tuesday Wednesday (public holiday) Thursday Friday Saturday

Miss C. Cutex 6 8 5 8 10 3
(Nail technician)
Mrs B. Straight 8 12 10 12 12 6
(Hairstylist)

The following deductions are applicable to the employees:

Pension: 7,5% of basic wage

Medical aid: R200 per week
PAYE: 18% of taxable income
UIF: 1% of basic wage

The employer contributions are on a rand-for-rand basis to the pension fund, as well as the UIF on
the employees’ behalf.

Required
Based on the information provided, draft the wages journal and cash payments journal for Be
Beautiful for the week ended 12 August 20x5 and post them to the relevant general ledger
accounts.

Exercise 8
Starting Out is a printing business that was established about two years ago. It designs and prints
banners and invitations for parties and weddings, among other things. Mr Confused, a first-year
university student, has been assisting the business with its payroll accounting. Mr Confused was
not certain about how to correctly record the details of each salaried employee in the salaries
journal; consequently, he made numerous errors. The company has approached you – a recent
graduate – to assist it in correcting the errors reflected in its records.
The business has four salaried employees whose details are as follows:
The manager, Mr B. Busy: monthly salary of R50 000. The receptionist, Mrs R. Friendly: monthly
salary of R10 000. The designer, Mr D. Sign: monthly salary of R20 000. The worker in the print
room, Mr I. Copy: monthly salary of R15 000.
The employee and employer contributions are as follows:
Pension fund: 7,5% of basic salary on a 40:60 percentage basis between the employee and
employer UIF: 1% of basic salary by the employee and 1,5 % by the employer. Medical aid: 4% of
basic salary by the employee. PAYE: 18% of the employees’ taxable income.
Mr Confused recorded the aforementioned details incorrectly in the salaries journal for the month of
July 20x3.

Salaries journal of Starting Out for the month of July 20x3 SJ1
Employee Basic Deductions Net Employer contributions
salary Pension Medical UIF Receiver of Total salary Pension UIF Total
fund 7,5% aid 4% 1% Revenue (PAYE) fund 1,5%

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 B. Busy 50 000 2 250 2 000 750 8 595,00 13 36 1 500 500 2
595,00 405,00 000
R. 10 000 450 400 150 1 719,00 2 7 300 100 400
Friendly 719,00 281,00
D. Sign 20 000 900 800 300 3 438,00 5 14 600 200 800
438,00 562,00
I. Copy 15 000 675 600 225 2 578,50 4 10 450 150 600
078,50 921,50
95 000 4 275 3 800 1 16 330,50 25 69 2 850 950 3
425 830,50 169,50 800

Required
8.1 Correct the errors and redraft the salaries journal.
8.2 Record the payments made in the cash payments journal.
8.3 Post to the relevant general ledger accounts.

TEST YOURSELF SOLUTIONS

TEST YOURSELF SOLUTION 11.1: NET WAGE CALCULATION

a) Net wage of Mr Curtis for the week ended 23 May 20x2

Normal time (40 hrs × R62,50) R 2 500,00

Normal overtime (3 hrs × 1,5 × R62,50) 281,25
Double overtime (4 hrs x 2 x R62,50) 500,00
Total gross earnings 3 281,25
Less: Pension fund R2 500 × 7,5% 187,50
Taxable income 3 093,75
Deductions: 701,88
PAYE (18% of R3 093,75) 556,88
Medical aid (12% of R2 500 × 40%) 120,00
UIF (1% of R2 500) 25,00
Net wage for the week ended 23 May 20x2 2 391,87

b) Calculate the employer contributions.

Pension fund: R187,50

Medical aid fund: (12% × R2 500 × 60%) R180,00
Total employer contributions R 367,50

TEST YOURSELF SOLUTION 11.2: LABOUR RECOVERY RATE

a) Annual productive hours

Number of hours in a year (52 w × 40 hours p/w) 2 080
Less: Vacation hours (3 w × 40 hours) (120)
Less: Public holidays (13 days × 8 hours p/day) (104)
Available productive hours 1 856
Less: Idle time (3% × 1 856) (55,68)
Annual productive hours 1 800,32

b) Total annual labour cost

Basic salary R360 000
Add: Annual bonus 30 000
Add: Pension fund contributions (7,5% × R360 000) 27 000
Add: UIF contributions (1% × R360 000) 3 600
Annual labour cost 420 600

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 c) Hourly recovery rate
Hourly recovery rate
= Annual labour cost ÷ Annual productive hours
= R420 600 ÷ 1 800,32
= R233,63

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 12 Overheads and job costing

Outcomes

At the end of this chapter students should be able to

calculate the overhead absorption rates

use the calculated overhead absorption rate to calculate the total cost of a job
calculate the over- or under-applied overheads.

Chapter outline

12.1 What are overheads?

12.2 Job costing (absorption costing)
12.2.1 Why do we need to know about overheads?
12.2.2 Steps involved in job costing and accounting entries

12.1 What are overheads?

Overheads are all factory costs other than direct materials and direct labour. Manufacturing
overheads can be organised into three categories as follows:

1. Indirect materials:

Cleaning material
Factory supplies, dyes
Glue, screws
Lubricants and coolants
Scrap and waste materials

2. Indirect labour:

Employer contributions which increase the total labour cost (i.e. employer contributions
to pension funds, medical aid funds, the Unemployment Insurance Fund and workmen’s
compensation insurance)
Wages of factory cleaners
General and casual labour
Idle time costs of direct labour
Overtime premiums

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 Shift premiums
Holiday pay and service bonus pay
Salaries of raw material handlers
Salaries of storemen
Wages of security guards in the factory

3. Other manufacturing overheads:

Depreciation on factory building, plant and equipment

Lease for factory plant and equipment
Fire and liability insurance for the factory
Municipal rates and taxes for the factory
Rent of factory building, warehouse, etc.
Electricity or power for the factory
Water for the factory
Telephone charges for the factory

12.2 Job costing (absorption costing)

We have learnt about materials and labour, and now overheads. These three cost elements can
now be added together to calculate the cost of a product or job.

A job costing system is used by enterprises that produce different products, jobs or batches
using the same manufacturing facility. Each product is made according to the customer’s
specifications. Examples of the industries that use a job costing system are as follows: printing,
construction, shopfitting, furniture manufacturing, jewellery design, etc.

12.2.1 Why do we need to know about overheads?

Enterprises have to prepare quotations for jobs before the job is actually complete. In essence,
they are trying to determine what the price of the job should be on completion. The material and
labour costs for jobs can be determined with certainty, but the factory overhead costs cannot.

The enterprise has to estimate how much of the factory overhead costs should be charged to
specific jobs. This is done by means of overhead absorption rates.

12.2.2 Steps involved in job costing and accounting entries

STEP 1: CALCULATE THE OVERHEAD ABSORPTION RATE (OAR)

Overhead absorption rates must be calculated for each production department involved in the
production process. This allows the overheads to be absorbed into the cost of the goods

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 manufactured and sold; that is, the overhead cost is added to the cost of the job as the job passes
through each production department.

OARs are used to estimate how much of the factory overheads must be charged to specific
products. Choosing the best OAR will be dependent on whether the enterprise is capital
intensive or labour intensive. For example:

A suitable basis for capital-intensive enterprises would be machine hours.

A suitable basis for labour-intensive enterprises would be labour hours or labour cost.

Choosing the best OAR is not an easy task and therefore management decides on what
application rate to use after a thorough investigation of estimated and actual overheads from
previous years. Below are the six common OARs used to apply overheads when quoting for
jobs:
Budgeted overheads
Materials cost basis = × 100
Budgeted direct materials

= %of direct materials cost

Budgeted overheads
Units of production =
Budgeted units of production

= Rand rate per unit of production

Budgeted overheads
Machine hours basis =
Budgeted machine hours

= Rand rate per machine hour

Budgeted overheads
Direct labour hours =
Budgeted labour hours

= %per labour hour

Budgeted overheads
Direct labour cost = × 100
Budgeted labour cost

= %per labour cost

Budgeted overheads
Prime cost = × 100
Budgeted prime cost

= %of prime cost

STEP 2: CALCULATE THE COST PRICE OF THE JOB

To calculate the cost of the job, add up the following:

Direct materials + Direct labour + Overheads (applied to the job) = Total cost of the
job

Accounting entries

The three cost elements (Direct materials + Direct labour + Applied overheads) are accumulated
in the work in progress account in the general ledger as follows:

Work in progress account (production account)

Direct materials xxx Finished goods account xxx
Direct labour xxx
Overheads (applied) xxx
xxx xxx

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 This work in progress account represents the production process where all the costs to produce
the products, both direct and indirect, are accumulated. The end result of the production process
is completed products. Consequently, the output of the production process is transferred to the
finished goods account, where it will then be sold.

Finished goods account

Work in progress xxx Cost of sales xxx

STEP 3: CALCULATE THE SELLING PRICE OF THE JOB

Total cost of the job + Mark-up = Selling price

STEP 4: DETERMINE IF OVERHEADS HAVE BEEN OVER- OR UNDER-APPLIED

Budgeted An estimate or forecast of what overheads should be in a future period
overheads:
Applied The overheads that have been charged to various jobs/products using an
overheads: overhead absorption rate (OAR)
Actual The actual overheads incurred for the period
overheads:

At the end of the financial year, the applied overheads are totalled and the actual overheads are
totalled. If applied overheads are greater than actual overheads, then the overheads have been
over-applied; that is, you have charged customers too much for overheads. The over-applied
overheads will decrease cost of sales. If the applied is less than the actual, then the overheads
have been under-applied; that is, you have charged customers too little for overheads. The
under-applied overheads will increase cost of sales. Management strives to make applied
overheads and actual overheads equal; however, it is highly unusual for this to happen. A
marked difference between actual and applied overheads is a good indicator for management
that a more appropriate OAR should be used to charge overheads to jobs.

Accounting entries

The overheads account in the general ledger would appear as follows:

Under-applied overheads

Overheads account
Actual xxx Work in progress (applied) xxx
Under-applied (increases cost of xxx
sales)
xxx xxx

Over-applied overheads

Overheads account

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 Actual xxx Work in progress (applied) xxx
Over-applied (decreases cost of xxx
sales)
xxx xxx

ILLUSTRATIVE EXAMPLE: Job costing

The following information relates to a self-employed tiler for the month of February 20x1. Two
clients have requested that Mr Tiler provide them with quotations as soon as possible. Mr
Tiler has asked you to assist him with preparing these quotations. The mark-up that he
requires on all jobs is 10% on cost.
The details of the two jobs are as follows:

Bathroom 1 Bathroom 2
Size of the bathroom 10 m2 20 m2
Materials cost R30 per m2 R35 per m2
Labour cost R50 per hour R50 per hour
Labour hours 3 hours 6 hours

The budgeted overheads for February 20x1 total R900 and the budgeted labour hours for the
month are nine hours. (Mr Tiler is planning to go on holiday after he has completed these two
jobs, therefore the budgeted hours are only nine hours.) A suitable basis for the absorption of
overheads would be labour hours, since tiling is labour intensive.
Where necessary round off to two decimal places.
Solution
Follow the four steps:
Step 1: Calculate the overhead absorption rate

Budgeted overheads
OAR: Direct labour hours =
Budgeted labour hours

= R900/(3 hrs + 6 hrs)

= R100 per direct labour hour

Step 2: Calculate the cost price of the job

Bathroom 1 Bathroom 2
Material cost (10 m2 × R30) R300 (20 m2 × R35) R700
Add: Labour cost (3 hrs × R50) R150 (6 hrs × R50) R300
Add: Applied overheads (3 hrs × R100) R300 (6 hrs × R100) R600
Total cost R750 R1 600

Accounting entries
Work-in-progress account (Bathroom 1)

Direct materials 300 Finished goods account 750

Direct labour 150
Overheads (applied) 300

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 750 750

Work-in-progress account (Bathroom 2)

Direct materials R700 Finished goods account R1 600

Direct labour 300
Overheads (applied) 600
1 600 1 600

Step 3: Calculate the selling price of the job

Bathroom 1 Bathroom 2
Total cost R750 R1 600
Add: Mark-up of 10% 75 160
Selling price of the job 825 1 760

Step 4: Determine if overheads have been over- or under-applied

Using two scenarios, determine if the overheads have been over- or under-applied:

Scenario 1: If the actual overheads for the month of February 20x1 totalled R1 000
Scenario 2: If the actual overheads for the month of February 20x1 totalled R800

Scenario 1 Scenario 2
Applied overheads (R300 + R600) R900 (R300 + R600) R900
Less: Actual overheads R1 000 R800
Under-applied (R100)
Over-applied R100

Only do steps 3 and 4 if they are listed as part of the requirements for the question.
Accounting entries
Scenario 1: Under-applied overheads
Overheads account

Actual R1 000 Work in progress (applied) R900

Under-applied (increases cost R100
of sales)
R1 000 R1 000

Scenario 2: Over-applied overheads

Overheads account

Actual R800 Work in progress (applied) R900

Over-applied (decreases cost R100
of sales)
R900 R900

TEST YOURSELF 12.1

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 You are given the following information regarding the Bantex Manufacturing Company:

Budgeted information:
Labour hours 72 000
Production costs:
Direct materials R96 000
Direct labour R72 000
Overheads R144 000

Actual information for March 20x3:

Job no. Direct materials costs Direct labour costs Direct labour hours
5 R1 920 R1 760 1 600
6 R1 200 R1 440 1 520

Required

1. Calculate the predetermined overhead rates based on the

a) material cost basis.

b) labour hours basis.

2. Calculate the total costs of

a) job 5 if overheads are absorbed on the basis of material cost.

b) job 6 if overheads are absorbed on the basis of labour hours.

3. Calculate the selling price of the jobs if the mark-up is 20% on cost.

TUTORIAL EXERCISES

Exercise 1
For each of the multiple-choice questions that follow, select the most appropriate answer.

1.1 Which of the following is not a basis for absorbing manufacturing overheads?
a. Direct labour hours
b. Direct materials cost
c. Machine hours
d. Conversion cost

1.2 The process of allocating overheads to jobs or products produced is known as

a. overhead apportionment
b. overhead absorption
c. overhead allocation
d. none of the above

1.3 Over-applied overheads result when

a. budgeted overheads are more than actual overheads
b. actual overheads are less than applied overheads
c. budgeted overheads are less than actual overheads

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 d. actual overheads are more than applied overheads

1.4 Under-applied overheads result when

a. budgeted overheads are more than actual overheads
b. actual overheads are less than applied overheads
c. budgeted overheads are less than actual overheads
d. actual overheads are more than applied overheads

1.5 The following information relates to questions 1.5.1–1.5.3:

Budgeted manufacturing overheads R2 000 000

Budgeted material cost R1 250 000
Actual overheads R1 750 000
Actual material cost R1 050 000

1.5.1 The overhead absorption rate based on the direct material cost would be
a. 120% of direct materials cost
b. 150% of direct materials cost
c. 160% of direct materials cost
d. 140% of direct materials cost

1.5.2 The overheads applied for the period would be

a. R1 680 000
b. R1 860 000
c. R1 570 000
d. R1 608 000

1.5.3 The over- or under-applied overheads for the period would be

a. over-applied by R250 000
b. under-applied by R250 000
c over-applied by R70 000
d. under-applied by R70 000

Exercise 2
A summary of the budget data for the finishing department of a company for the 20x1 year is
given below:

Manufacturing overhead costs R5 714 724

Units of production 2 745 000 units
Direct material costs R4 505 094
Direct labour costs R5 160 112
Direct labour hours 1 342 000 hours
Machine hours 515 450 hours

Required
Determine the manufacturing overhead absorption rates under each of the following bases.
Round off to the nearest two decimal places:
2.1 Units of production
2.2 Direct materials cost
2.3 Machine hours

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 2.4 Direct labour hours
2.5 Direct labour cost
2.6 Prime cost

Exercise 3
A manufacturing company in the furniture industry uses a job costing system. The following
are the budgeted figures for all jobs processed during the current year:

Direct material costs R240 000

Direct labour costs R200 000
Manufacturing overhead costs R960 000
Direct labour hours 400 000 hours
Machine hours 600 000 hours

The actual information relating to job 6815 during the year was as follows:

Direct material cost R24 000

Direct labour cost R10 000
Machine hours 6 000 hours

The company applies manufacturing overheads to jobs performed on the basis of machine
hours.

Required
3.1 Calculate the total manufacturing cost of job 6815.
3.2 State two factors that the company should consider when deciding on the mark-up for its
jobs.

Exercise 4
The following data concerning a partly complete overhead analysis has been provided.

Departments Total budgeted overheads Direct labour hours

Production costs:
Machining R87 800 3 200
Assembly R133 400 7 000
Finishing R55 800 6 000

Required
Calculate overhead absorption rates for each production cost centre, based on direct labour
hours.
If job XYZ went through the factory as follows, complete the job cost statement below:

Machining Assembly Finishing Total

Direct labour at R20 per hr 4 hrs 3 hrs 2 hrs
Direct material R320 R410 R700
Overhead absorbed
Total factory cost
Mark-up (20% on SP)
Invoice price to customers

Round off calculations to two decimal places, where applicable.

Exercise 5

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 Peter Ltd uses direct machine hours as the basis for applying the overheads to units
produced. The budgeted overheads for the next year are R1 000 000 and budgeted machine
hours are 312 500 hours.
In May the company produced 10 000 units using machine hours. By the end of the year, total
machine hours utilised was 330 000 hours and the actual overhead cost incurred was R1 120
000.
Required
5.1 Calculate the overhead rate.
5.2 Determine the amount of applied overheads during the period.
5.3 Calculate the over-/under-applied overheads for the year.
5.4 Determine the actual overhead cost of each unit manufactured.

Exercise 6
A company uses a predetermined overhead rate based on machine hours. Budgeted factory
overhead for the year was estimated at R7 600 000, and actual factory overhead incurred
amounted to R7 380 000. Actual machine hours were 1 190 000. The applied overheads for
the year amounted to R7 140 000.
Required
6.1 Calculate the budgeted machine hours.
6.2 Calculate the over-/under-applied manufacturing overheads.
Round off to the nearest whole number where applicable.

Exercise 7
Mkhize Ltd uses a job costing system. The following information is available in respect of May
20x5, the first month of business:

1. Purchases of materials R42 600

2. Materials were requisitioned as follows:
Job No. 1 R16 950
Job No. 2 R17 360
Indirect materials R4 360
3. The payroll was summarised as follows:
Direct labour
Job No. 1 (249 hours) R12 450
Job No. 2 (273 hours) R13 650
Indirect labour R2 800
The following additional expenditure on overheads was incurred:
Electricity and water R3 130
Depreciation – Equipment R8 200
Rent of factory R8 000

4. Overheads are applied on a labour hour basis. The budgeted manufacturing overheads
are R27 000 per month and the budgeted normal capacity is 600 labour hours per month.
5. Job No. 1 (300 units) was completed during the month and 200 units were sold on 31 May
for R130 per unit.
6. Job No. 2 was still in progress by 31 May.

Required
7.1 Calculate the total cost of Job No.1 and the cost of the work in progress of Job no.2 at
31 May 20x5.
7.2 Calculate the profit or loss on the sale of the 200 units of Job No.1.

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 7.3 Calculate the total manufacturing overheads over- or under-applied.

Exercise 8
Wizard Car Services uses a job costing system. Work in process – 1 February 20x6, for Job
C was R35 010. Two new jobs were started in February 20x6, Job P and Job F.
Manufacturing overheads are applied to jobs on the basis of direct labour hours. The
budgeted manufacturing overheads for the year were R1 500 000 and budgeted labour cost
was R2 000 000. Direct labour workers are paid a rate of R50 per hour.
Transactions during February 20x6 were as follows:
Material was issued as follows:

Direct material:
C R24 600
P R13 840
F R16 200
Indirect material R 4 300

The time sheet reveals that wages were incurred as follows:

Direct labour:
C R8 600
P R17 000
F R27 000
Indirect labour R11 000

Factory overheads incurred were:

Insurance R8 500
Rates and taxes R6 400
Depreciation R16 000

Job C and P were completed and delivered to customers. The company charges cost plus
40% mark-up. The over or under applied manufacturing overheads must be closed off against
cost of goods sold.
Required
8.1 Calculate the predetermined overhead rate.
8.2 Calculate the total cost of each completed job.
8.3 Calculate the amount of work in process as at 28 February 20x6.
8.4 How much is under-/over-applied manufacturing overhead?
8.5 Calculate the gross profit/loss for a business.

TEST YOURSELF SOLUTION

TEST YOURSELF SOLUTION 12.1

You are given the following information regarding the Bantex Manufacturing Company:
Budgeted information:

Labour hours 72 000

Production costs:
Direct materials R96 000
Direct labour R72 000
Overheads R144 000

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 Actual information for March 20x3:

Job no. Direct materials cost Direct labour cost Direct labour hours
5 R1 920 R1 760 1 600
6 R1 200 R1 440 1 520

1. Calculate the predetermined overhead rates based on

Budgeted overheads
Overhead rate =
Budgeted base

a) Material cost basis

Material cost basis = R144 000
× 100
R96 000

= 150% of material cost

b) Labour hours basis
Labour hour basis = R144 000
72 000

= R2 per labour hour

2. Calculate the total costs of

a) Job 5 if overheads are absorbed on the basis of material cost.

b) Job 6 if overheads are absorbed on the basis of labour hours.

3. Calculate the selling price of the jobs if the mark-up is 20% on cost.

Calculation of total costs and selling price:

Job 5 Job 6
Direct materials cost R1 920 R1 200
Direct labour cost R1 760 R1 440
Prime cost R3 680 R2 640
Overheads allocated R2 880 R3 040
Job 5 – material costs R1 920 × 150%
Job 6 – labour hours 1 520 × R2
Total costs R6 560 R5 680
Add: Mark-up (20% on cost) R1 312 R1 136
Selling price R7 872 R6 816

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 13 Cost-volume-profit (CVP) analysis

Outcomes

At the end of this chapter students should be able to:

describe cost-volume-profit analysis

calculate the breakeven point
use cost-volume-profit analysis to estimate profits
calculate and evaluate the effect of changes in selling prices, volume and costs.

Chapter outline

13.1 Introduction
13.1.1 Fixed costs
13.1.2 Variable costs
13.1.3 Marginal costing layout
13.2 Assumptions of CVP analysis
13.3 CVP according to the contribution margin approach
13.3.1 Calculation of breakeven point
13.3.2 Calculation of margin of safety
13.3.3 Sales required to achieve expected (target) profit or return
13.4 Using CVP analysis in decision making
13.4.1 Change in the selling price
13.4.2 Change in the variable cost
13.4.3 Change in the fixed cost
13.5 Summary of formulae needed for CVP analysis
13.5.1 Breakeven point in units
13.5.2 Breakeven point in rands
13.5.3 Sales necessary to make a desired profit
13.5.4 Margin of safety

13.1 Introduction

Cost-volume-profit (CVP) analysis is a decision-making tool that helps management determine

the effects that changes in costs, price, quantity and mix will have on future profits. Managers
commonly use CVP analysis as a tool to answer questions such as the following:

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 How much can sales drop before the company will incur losses?
How will a change in costs, price or volume affect profits?
How many units must be sold to achieve a planned profit?
What profit will a certain sales volume yield?
At what volume of production are costs and income equal?

In Chapter 9 you were introduced to fixed costs and variable costs. Management requires cost
information in a format that promotes their planning, control and decision-making tasks. These
tasks can best be performed when information on the fixed and variable cost components are
available.

13.1.1 Fixed costs

Fixed costs are costs that do not change in total with different production levels, for example
rent on premises.

13.1.2 Variable costs

Variable costs are costs that change in total with different production levels, but remain constant
on a per-unit basis; that is, the variable cost per unit will remain constant irrespective of the
changes in the production levels, for example raw materials.

13.1.3 Marginal costing layout

Marginal costing layout of an income statement

R
Sales (10 000 units × R5) 50 000
Less: Variable costs (10 000 units × R2) 20 000
Contribution margin/marginal income 30 000
Less: Fixed costs 20 000
Net profit 10 000

Note 1: When using the marginal costing layout, total costs have been divided into fixed and
variable costs.

Note 2: Sales – Variable costs = Contribution

(This is the contribution towards paying fixed costs and making a profit.)

A business will only begin making a profit once all expenses have been covered. This means
that variable expenses (i.e. cost price of the goods) must be covered by the selling price of the
goods. Any profits on the sale of goods must then contribute towards the payment of the fixed
costs. Once these fixed costs have been covered, it can be said that the business has broken even
and so can start to make a profit.

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 13.2 Assumptions of CVP analysis

The following are a few basic assumptions that CVP analysis is based on:

The selling price will remain constant, irrespective of the level of activity.
All costs can be divided into fixed and variable components.
Fixed costs will remain constant, irrespective of the volume; variable costs will change in
direct proportion to the volume.

13.3 CVP according to the contribution margin approach

CVP analysis will be illustrated by means of the following example:

Budgeted income statement of Toys Ltd, a manufacturer of product Doll

Total Cost per unit %

Sales (10 000 units) R400 000 R40 100
Less: Variable costs (10 000 units) R300 000 R30 75
Contribution margin/marginal income R100 000 R10 25
Less: Fixed costs R40 000
Net profit R60 000

The contribution margin is the amount remaining after variable costs have been deducted from
sales revenue. It is first used to cover fixed costs and then contributes to the profit for the period.
If the contribution margin is not sufficient to cover fixed costs, then there will be a loss.

The contribution margin can also be shown on a per unit basis, which is calculated as follows:

Contribution margin per unit = Selling price – Variable cost per unit
= R40 – R30
= R10

The contribution margin expressed as a percentage is known as the contribution margin ratio,
which is the difference between the sales and the variable cost, expressed as a percentage of
sales. Unit amounts or total amounts can be used in the calculation of this ratio.

Contribution margin ratio = (Sales – Variable costs) ÷ Sales × 100

= (R400 000 – R300 000) ÷ R400 000 × 100
= 25%
or
= (SP per unit – VC per unit) ÷ SP per unit × 100

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 = (R40 – R30) ÷ R40 × 100
= 25%

A higher contribution margin ratio means that the contribution increases rapidly as the sales
levels increase. Once the breakeven point has been passed, profits will accumulate more rapidly
than a product with a lower contribution margin ratio.

13.3.1 Calculation of breakeven point

At the breakeven point, total revenue equals total costs and profit is equal to zero. At this point,
contribution is equal to fixed costs.

Figure 13.1 Illustration of breakeven point using a breakeven graph

BREAKEVEN QUANTITY
Breakeven quantity is the number of units that must be sold so as to recover all fixed costs;
that is, the point at which no profit or loss is incurred.

Breakeven quantity = Fixed costs ÷ Contribution margin per unit

= R40 000 ÷ R10

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 = 4 000 units

Breakeven value is the equivalent of breakeven quantity expressed in rands; that is, the sales
revenue necessary to recover all costs.

Breakeven value = Breakeven quantity × Selling price

= 4 000 units × R40
= R160 000
or
Breakeven value = Fixed costs ÷ Contribution margin ratio
= R40 000 ÷ 25%
= R160 000

The breakeven value can also be used to calculate the breakeven quantity:

Breakeven quantity = Breakeven value ÷ Selling price

= R160 000 ÷ R40
= 4 000 units

13.3.2 Calculation of margin of safety

The margin of safety represents the amount by which the sales exceed the breakeven sales. It is
an indication of the amount by which sales can drop before any losses are sustained. It can be
calculated and expressed in units, rand value or as a percentage.

MARGIN OF SAFETY EXPRESSED AS A VALUE

= Total sales – Breakeven sales

= R400 000 – R160 000

= R240 000

or

= Profit ÷ Contribution margin ratio

= R60 000 ÷ 25%

= R240 000

MARGIN OF SAFETY EXPRESSED IN UNITS

= Total sales (units) – Breakeven sales (units)

= 10 000 units – 4 000 units

= 6 000 units

MARGIN OF SAFETY RATIO (EXPRESSED AS A PERCENTAGE)

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 Total sales – Breakeven sales
= × 100
Total sales value

R240 000
= × 100
R400 000

= 60%

or

Total sales (units) – Breakeven sales (units)

= × 100
Total sales units

6 000
= × 100
10 000

= 60%

This indicates that sales can decrease by 60% before the company will incur a loss.

13.3.3 Sales required to achieve expected (target) profit or return

Using CVP techniques, the sales value or volume that will produce a certain net profit can also
be determined. Using the illustrative example, suppose that an expected profit of R30 000 is
anticipated from the sales of product Doll.

ILLUSTRATIVE EXAMPLE

The calculation will be as follows:

Fixed costs + Target prof it

Sales volume (units) =
Contribution margin per unit

R40 000+R30 000

=
R10

= 7 000 units

Sales value 1 = Sales volume × Selling price per unit

= 7 000 units × R40 per unit

= R280 000

or

Fixed costs + Target prof it

Sales value =
Contribution margin ratio

R40 000+R30 000

=
0,25

= R280 000

Proof

Total
Sales (7 000 units × R40) R280 000
Less: Variable costs (7 000 units × R30) R210 000
Contribution margin R70 000
Less: Fixed costs R40 000
Target profit R30 000

Note: The above two formulae used to calculate sales volume and value are adjustments to
the breakeven quantity and breakeven value formulae. That is, if sales volume is required,
then the breakeven quantity formula is adjusted by adding target profit to fixed costs and,

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 similarly, if the sales value is required, then the breakeven value formula is adjusted by
adding target profit to fixed costs.

13.4 Using CVP analysis in decision making

This technique reveals the effect management decisions are likely to have on the future profit
structure. It enables management to predict the results of decisions. An analysis of the
breakeven point enables management to take effective steps and to influence the variable factors
in a purposeful manner.

We will now examine the effect of changes in price, costs or volume on profits, contribution and
the breakeven point.

These figures will be used to discuss the different factors, which change in the following
illustrative examples:

Sales units 20 000

Sales price per unit R15
Variable costs per unit R9
Contribution margin per unit R6
Contribution margin ratio 40%
Total fixed costs for the period R60 000
Breakeven value (BEV) R150 000
Breakeven quantity (BEQ) 10 000 units

13.4.1 Change in the selling price

Changes in the selling price alter the contribution ratio, change the breakeven point and affect
profit.

ILLUSTRATIVE EXAMPLE

Assume an increase of 10% in the selling price to achieve a target profit of R30 000.

Required
Calculate the following:

1. Contribution margin ratio

2. Breakeven point in units and rand
3. Number of units that must be sold to achieve the target profit

Round off to the nearest whole number.

Solution

Current After price increase

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 Selling price per unit R15,00 R16,50
Variable costs R9,00 R9,00
Contribution margin R6,00 R7,50
Contribution ratio 40% 45%

BEQ = Fixed costs ÷ Contribution per unit = R60 000 ÷ R6 = R60 000 ÷ R7,50
= 10 000 units = 8 000 units
BEV = BEQ × SP = 10 000 × 15 = 8 000 × 16,50
= R150 000 = R132 000

Number of units to achieve the target profit

Fixed costs + Target prof it R60 000+R30 000 R60 000+R30 000
= = =
Contribution margin per unit R6 R7,50

= 15 000 units = 12 000 units

If the selling price is increased and other costs remain constant, the contribution margin is
higher and the fixed costs can be recovered faster, thus the breakeven point drops. Profits
beyond the breakeven point are higher and losses below the breakeven point are lower.
If the selling price is decreased and other costs remain constant, the contribution margin is
lower and the rate of fixed cost recovery is slower, thus the breakeven point climbs upwards.
Profits beyond the breakeven point are lower and losses below the breakeven point are
higher.

13.4.2 Change in the variable cost

Like changes in the selling price, increases and decreases in the variable cost alter the
contribution ratio, change the breakeven point and affect profits.

ILLUSTRATIVE EXAMPLE

Assume an increase of 20% in variable cost due to increases in the material prices. The
company needs to achieve a target profit of R30 000.

Required
Calculate the following:

1. Contribution margin ratio

2. Breakeven point in units and rand
3. Number of units that must be sold to achieve the target profit

Round off the nearest whole number.

Solution

Current After price increase

Selling price per unit R15,00 R15,00
Variable costs R9,00 R10,80
Contribution margin R6,00 R4,20
Contribution ratio 40% 28%

BEQ = Fixed costs ÷ Contribution per unit = R60 000 ÷ R6 = R60 000 ÷ R4,20
= 10 000 units = 14 286 units
BEV = Fixed costs ÷ Contribution ratio = 60 000 ÷ 0,40 = R60 000 ÷ 0,28
= R150 000 = R214 286

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 Number of units to achieve the target profit

Fixed costs + Target prof it R60 000+R30 000 R60 000+R30 000
= = =
Contribution margin per unit R6 R4,20

= 15 000 units = 21 429 units

An increase in variable costs has the same effect as a decrease in the selling price; the
contribution margin is lower and the rate of fixed cost recovery is slower, thus the breakeven
point climbs higher. Profits after the breakeven point are lower; losses before the breakeven
point are higher.
A decrease in variable costs has the same effect as an increase in the selling price; the
contribution margin is higher and the rate of fixed cost recovery is accelerated, thus the
breakeven point drops. Profits beyond the breakeven point are higher; losses below the
breakeven point are lower.

13.4.3 Change in the fixed cost

Increases and decreases in the fixed cost do not alter the contribution margin ratio, but they do
change the breakeven point.

ILLUSTRATIVE EXAMPLE

Assume an increase of R10 000 in fixed costs.

Required
Calculate the following:

1. Contribution margin ratio

2. Breakeven point in units and rand
3. Number of units that must be sold to achieve the target profit

Round off to the nearest whole number.

Solution

Current After price increase

Selling price per unit R15,00 R15,00
Variable costs R9,00 R9,00
Contribution margin R6,00 R6,00
Contribution ratio 40% 40%

BEQ = Fixed costs ÷ Contribution per unit = R60 000 ÷ R6 = R70 000 ÷ R6
= 10 000 units = 11 667 units
BEV = Fixed costs ÷ Contribution ratio = R60 000 ÷ 0,40 = R70 000 ÷ 0,40
= R150 000 = R175 000

Number of units to achieve the target profit

Fixed costs + Target prof it R60 000+R30 000 R70 000+R30 000
= = =
Contribution margin per unit R6 R6

= 15 000 units = 16 667 units

If fixed costs are increased, the breakeven point climbs higher. Profits after the breakeven
point are lower by the amount of the increase; losses before the breakeven point are greater
by the amount of the increase.

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 A decrease in fixed costs causes the breakeven point to drop. Profits beyond the breakeven
point are greater by the amount of the decrease; losses below the breakeven point are
smaller by the amount of the decrease.

13.5 Summary of formulae needed for CVP analysis

13.5.1 Breakeven point in units

Fixed costs
=
(Selling price p/u – Variable cost p/u)

or

Breakeven units = Breakeven rands ÷ Selling price

13.5.2 Breakeven point in rands

Firstly, you need to calculate the contribution margin ratio:

CONTRIBUTION MARGIN RATIO

Sales – Variable costs
= × 100
Sales

BREAKEVEN POINT IN RANDS

Fixed costs
=
Contribution margin ratio

or

Breakeven rands = Breakeven units × Selling price

13.5.3 Sales necessary to make a desired profit

Add the required/target profit to the fixed costs in either of the breakeven formulae:
Fixed costs + Required prof it
Sales in units tomake target prof it =
(Selling price p/u – Variable cost p/u)

Fixed costs + Required prof it

Sales in rands to make target prof it =
Contribution margin ratio

13.5.4 Margin of safety

MARGIN OF SAFETY AS A PERCENTAGE

Budgeted sales – Breakeven sales

= × 100
Budgeted sales

MARGIN OF SAFETY IN RANDS

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 = Budgeted sales – Breakeven sales

or

= Profit ÷ Contribution margin ratio

MARGIN OF SAFETY IN UNITS

= Budgeted sales in units – Breakeven sales in units

This shows how close the business is operating to its breakeven point. In other words, is the
business only just breaking even or does it have some breathing space?

TEST YOURSELF 13.1

A company sells 21 000 units of a particular product per annum. The unit selling price is R20.
Budgeted variable manufacturing costs are R11 per unit and budgeted fixed factory
overheads are R35 000 per annum.
Budgeted variable selling expenses are R3 per unit and budgeted fixed selling expenses are
R25 000 per annum.

Required
a) Calculate the net profit using the marginal costing format if the company sold 21 000
units.
b) Calculate the breakeven point in units and in rand.
c) Calculate how many units the company would have to sell in order to generate a target
profit of R120 000 and calculate the rand sales that the company would have to
generate to earn the same target profit.
d) Calculate the margin of safety as a percentage if 21 000 units were sold. (Round off to
the nearest whole number.)

TUTORIAL EXERCISES

Exercise 1
For each of the multiple-choice questions that follow, choose the most appropriate answer.
Questions 1.1–1.9 are based on the following information:
Campers Ltd sells sleeping bags. The selling price of each sleeping bag is R145. Variable
costs are R105 per sleeping bag, and the total fixed costs are R330 000 per month. At
present, the company sells 8 000 sleeping bags per month.
1.1 The contribution per sleeping bag is:

A R40
B R45
C R50
D R55

1.2 How many sleeping bags would have to be sold to break even?

A 8 500
B 8 250

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 C 8 520
D 8 502

1.3 The breakeven point in rands is:

A R1 960 250
B R1 169 250
C R1 196 250
D R1 691 250

1.4 How many sleeping bags would have to be sold to earn a minimum profit of R8 000 per
month?

A 8 500
B 8 540
C 8 405
D 8 450

1.5 The margin of safety ratio is:

A (3,13%)
B 3,13%
C 3,31%
D (3,31%)

1.6 The net profit or loss under the present operating conditions is:

A loss of R20 000

B loss of R10 000
C profit of R20 000
D profit of R10 000

In an attempt to improve profitability, the company has investigated the impact of three
independent proposals 1.7–1.9.
1.7 In an attempt to increase profits, the cost accountant has proposed the following.

Proposal 1: An increase of R6 000 in the monthly advertising cost increases the

number of sleeping bags sold to 10 000 units for the month. This proposal would result
in the following:

A loss of R64 000

B profit of R46 000
C profit of R64 000
D loss of R46 000

1.8 Proposal 2: Reduce the selling price by 10%, and the sales in units will increase by
20%. There will be no change in the total fixed costs and the variable cost per unit. This
proposal would result in the following:

A profit of R85 200

B loss of R82 500
C profit of R82 500

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 D loss of R85 200

1.9 Proposal 3: Improve the quality of the sleeping bags by increasing the variable
production costs per unit by 5%. This will result in an increase of 15% in the selling
price, and the number of sleeping bags sold would decrease to 6000 units. Fixed costs
remain unchanged. This proposal would result in the following:

A profit of R9 000
B loss of R9 000
C profit of R9009
D loss of R9009

Exercise 2
Sunshine Stores had sales of R4 500 000 for 20x1. Fixed expenses totalled R1 200 000 and
the net profit totalled R1 500 000.
Required
2.1 Present the above information in the marginal costing format.
2.2 Calculate the contribution margin ratio.
2.3 Calculate the breakeven point in rands.
2.4 Calculate the margin of safety ratio. (Round off to the nearest whole number.)

Exercise 3
Fast Ltd budgets March sales at R265 000. The variable expenses are expected to be 56% of
sales and profit is expected to be R31 768.
Required
3.1 Calculate the breakeven point for March in rands.
3.2 Calculate the March sales if the company makes a profit of R10 560 (all the cost
relationships were the same as budgeted).

Exercise 4
Stellenwood Wine was established by Mr KWV Martin in 1965, with its first vineyard in
Franschoek, Western Cape. The company manufactures wine to supply major retailers. The
management accountant is concerned with the June 20x2 results and provides you with the
following information for a product called Red Wine, which is a popular brand in stores.
The following budgeted income statement reflects the following:

Sales (43 000 units @ R75) R3 225 000

Less: Variable costs R2 150 000
Less: Fixed costs R 500 000
Net Profit R 575 000

Required
Calculate the following:
4.1 Contribution margin per unit
4.2 Contribution margin ratio
4.3 Variable cost ratio
4.4 Breakeven point in rands
4.5 Assuming the company has a sales level of R300 000, what is the margin of safety ratio?
4.6 The profit or loss, if the company sells 17 500 units of Red Wine using the original data.

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 Note: Where necessary, round off to two decimal places.

Exercise 5
Monex Ltd produces and sells Product A. The product is sold on the local market and is
extremely popular among customers. Production and sales for the product are as follows:

R/units
Direct materials 1,20
Wages 1,40
Variable production overheads 0,70
Fixed production overheads 1,10
Variable selling and administrative overhead 0,15
Fixed selling and administrative overheads 0,43

Production and sales for the period were as follows:

Units
Production 250 000
Sales 250 000

Production was at normal levels. Unit costs in opening stock were the same as those for the
period listed above. The selling price of product A was R5,70 per unit.

Required
From the above information, you are required to
5.1 calculate variable cost per unit and total fixed costs
5.2 calculate the breakeven quantity and revenue for product A
5.3 calculate the margin of safety quantity and revenue for product A
5.4 outline any three limitations of breakeven analysis.

Exercise 6
The current market for golf balls is estimated at 80 000 balls per month and market research
indicates that with a selling price of R3 per golf ball, a market penetration of one third to a half
can be achieved within 12 months. Your company has devised a process which will produce
golf balls with a fixed cost of R97 500 per month and a variable cost of R1,50 per ball.

Required
6.1 Calculate the contribution margin (CM) ratio.
6.2 Calculate the breakeven point in units and in rands.
6.3 Calculate the number of golf balls that must be sold in order to earn a target profit of R52
500.
6.4 Calculate the margin of safety as a percentage. (Round off to the nearest whole
number.)
6.5 Further market research reveals that at a selling price of R2,80 the company could reach
sales of 135 000 balls.
a. Calculate the profit to be made if the company sells 135 000 golf balls per month.
(Draft a marginal costing income statement.)
b. Calculate the new breakeven point in units.
c. Should the company reduce the selling price? Give a reason for your answer.

Exercise 7

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 Mbambo Limited has given you the following information about product MBS101, and you are
required to analyse the company using the cost volume profit technique. Any missing data is
presented in the additional information.

Sales R80
Less: Variable cost of sales ?
Direct material ?
Direct labour ?
Variable manufacturing overheads ?
Sales commission ?
= Marginal contribution ?
Less: Total fixed cost R60 000
Fixed manufacturing overheads R27 000
Fixed marketing R20 000
Fixed administration R13 000
Net profit ?

Additional information
Sales represent 100%, while the total variable cost represents 50%, leaving the company with
a contribution of 50%. The variable cost of sales is broken down into the proportion of 4:8:6:2,
direct material, direct labour, variable manufacturing overheads, and sales commission,
respectively. The company manufactured and sold 5 000 units for June.

Required
7.1 Compile a complete marginal costing income statement.
7.2 Calculate the contribution per unit.
7.3 Calculate breakeven in units and in rands.
7.4 By what percentage can the company sales drop before it starts making a loss?
7.5 If the company desires a net profit of R250 000, how many units must be sold to achieve
this? Comment on the net profit change by comparing the original net profit with the
desired net profit.

Exercise 8
A company that manufactures a single product incurred the following costs for the period.

Labour (25% variable) R8 000

Materials (100% variable) R12 000
Selling costs (10% variable) R2 000
Other costs (fixed) R7 000
Total costs R29 000

A normal period sales are 500 units at R70 each, but up to 650 units could be made in a
period. Various alternatives are being considered:

Option 1 Reduce the selling price to R63 each and sell all that could be made;
Option 2 Increase the selling price to R80 each at which price sales would be 400 units;
Option 3 Keep the current plan.

Required
8.1 From the options provided, choose the most profitable plan and give a reason for your
answer?
8.2 What would be the CM ratio under each plan? (Round off to the nearest whole number.)
8.3 What would be the break-even point in units under each plan? (Round off to the nearest
whole number.)

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 TEST YOURSELF SOLUTION

TEST YOURSELF SOLUTION 13.1

a) The net profit using the marginal costing format if the company sold 21 000 units.

Sales (21 000 × R20) R420 000

Less: Variable cost (21 000 × R14) R294 000
Contribution R126 000
Less: Fixed costs (R35 000 + R25 000) R 60 000
Net profit R 66 000

b) The breakeven point in units and in rand.

Breakevenpoint inrand = Fixed costs

Contribution margin ratio

= R60 000

30%

= R200 000
Breakevenpoint inunits = R200 000

R20

= 10 000 units

c) Calculate how many units the company would have to sell in order to generate a target
profit of R120 000 and calculate the rand sales that the company would have to generate to
earn the same target profit.

Sales units = Fixed costs+Target prof it

Contribution margin per unit

= R60 000+R120 000

R20−R14

= R180 000

R6

= 30 000 units
Sales value = Sales units × Selling price
= 30 000 units × R20
= R600 000

d) The margin of safety as a percentage if 21 000 units were sold. (Round off to the nearest
whole number.)

MOS as a percentage
= (Budgeted sales − Breakeven sales) ÷ Budgeted sales × 100
= (21 000 units − 10 000 units) ÷ 21 000 units × 100
= 52%
Or
= (Budgeted sales − Breakeven sales) ÷ Budgeted sales × 100
= (R420 000 − R200 000) ÷ R420 000 × 100
= 52%

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 14 Short-term decision making

Outcomes

At the end of this chapter students should be able to

distinguish between marginal and absorption costing

draft an income statement using the marginal costing format
apply marginal costing to short-term decisions.

Chapter outline

14.1 Introduction
14.1.1 Manufacturing cost per unit according to marginal and absorption costing
14.1.2 Income statements according to marginal and absorption costing
14.2 Decisions using marginal costing
14.2.1 Special order decisions
14.2.2 Dropping a product or department
14.2.3 Choice of products where a limiting factor exists
14.2.4 Make versus buy

14.1 Introduction

In Chapter 4 you were introduced to the traditional/absorption costing method for drawing up an
income statement. In this chapter we will focus on marginal costing and contrast the differences
between the two methods. Other terms used for marginal costing are variable costing and direct
costing.

14.1.1 Manufacturing cost per unit according to marginal and absorption costing
The objective of product costing is to determine the total manufacturing cost per unit. This can
be determined as follows: total manufacturing cost incurred for the period divided by the total
number of units produced for the period.

When the unit cost is known, calculating the cost of units that are still in stock and the cost of
units sold is straightforward. It is determining what should be included in the unit cost that
becomes difficult. According to the absorption costing method, both fixed and variable costs are
included in the unit cost. The marginal costing method, on the other hand, includes only the
variable cost in the unit cost of a product.

Marginal costing: Cost per unit Absorption costing: Cost per unit

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 Marginal costing: Cost per unit Absorption costing: Cost per unit
Direct materials Direct materials
Add: Direct labour Add: Direct labour
Add: Variable manufacturing overheads Add: Manufacturing overheads (fixed + variable)
= Cost per unit = Cost per unit

14.1.2 Income statements according to marginal and absorption costing

The following example will be used to illustrate the difference in the structure of the income
statement under the two costing methods.

ILLUSTRATIVE EXAMPLE

Starlite Ltd manufactures a product, Sparkles. The following information has been provided
for March 20x9:

Units manufactured and sold 10 000

Selling price per unit R50
Variable manufacturing cost R25 per unit
Fixed manufacturing cost R100 000
Variable selling and administrative cost R5 per unit sold
Fixed selling and administrative cost R35 000

Required
Draft an income statement for March 20x9 according to the

1. absorption costing method

2. marginal costing method.

Solution
1. Income statement: absorption costing

Note: Under absorption costing, costs are grouped according to whether they are product or
period.
2. Income statement: marginal costing

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 Note: Under marginal costing, costs are grouped according to whether they are fixed or
variable.

Both methods result in a net profit of R65 000. This is because the number of units
manufactured and sold is the same; there is no opening or closing stock on hand. In
this book, we will only look at questions where the units manufactured and sold
are the same.
The main feature of marginal costing is the separation of costs into fixed and variable costs
and the calculation of contribution.

Fixed costs
These are costs that remain constant in total, regardless of the change in the level of activity.

Variable/marginal costs
These are costs that vary in total, in direct proportion to the changes in the level of activity.

Marginal costing is important for short-term decision making

It is assumed that in the short term only variable costs alter or change, while fixed costs
remain the same. Therefore, it is only the variable costs that are relevant for short-term
decision making.

14.2 Decisions using marginal costing

Short-term decisions are decisions that seek to make the best use of existing facilities. These
decisions include

special order decisions

dropping a product or department
key factor/limiting factor decisions
make-versus-buy decisions.

Note: The most important thing to remember when making decisions using marginal costing is
that there must be a positive contribution for something to be acceptable. Both financial and
non-financial information must be considered before a final decision is taken.

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 14.2.1 Special order decisions
This kind of decision is required when a firm has spare capacity and is offered a special order,
below normal prices, which will take up the unused capacity. The decision is based on whether
or not the special order will make a contribution to the fixed costs.

ILLUSTRATIVE EXAMPLE

Sweets Ltd manufactures chocolates which it sells for R50 per box. Current output is 20 000
boxes per period, which represents 80% of capacity. It has the opportunity to use the surplus
capacity by selling its product at R30 per box to a supermarket chain who will sell it as an
“own label” product.
Total costs for the last period were R700 000, of which R200 000 were fixed. (Note that fixed
costs will remain unchanged.) This represents a total cost of R35 per box. Current profits are
R300 000.
Should the supermarket order be accepted even though the selling price is below the total
cost?

Steps for making special order decisions

Determine the following: Is production capacity available? Will fixed costs remain unchanged?
Will current selling prices not be affected by the acceptance of the special order? If your
answer is “yes” to all these questions, then proceed to the next step.

1. Calculate the surplus capacity.

2. Calculate the variable cost per unit.
3. Draft a marginal costing income statement for the special order only.

If the contribution is positive, accept the order.

If the contribution is negative, reject the order.

4. Calculate the profit after the special order has been accepted.

Note: Only calculate the profit if it is stipulated in the question.

Solution
The key point is that the price of R30 offered by the supermarket should be compared with
the marginal costs of production, not with the total costs.

Step 1: Calculate the surplus capacity

What quantity would the supermarket order amount to?
80% = 20 000 boxes
100% = 25 000 boxes (100 ÷ 80) × 20 000
20% = 5 000 boxes (20 ÷ 80) × 20 000
Therefor, the supermarket order would amount to 5 000 boxes, which is 20% of the total
capacity.

Step 2: Calculate the variable cost per unit

Total variable costs
*Variable cost per unit =
Total number of boxes produced

R500000
=
20000 boxes

= R25 per box

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 Step 3: Draft the marginal costing income statement for the special order
The supermarket order would produce the following extra contribution:

Sales (5 000 × R30) R150 000

Less: Marginal costs (5 000 × R25) R125 000
Contribution R25 000

If the contribution is positive, accept the order.

If the contribution is negative, reject the order.

The supermarket order generates a positive contribution, which means a further R25 000
towards payment of fixed costs. Therefore, the acceptance of the supermarket order should
increase the overall profits.

Step 4: Calculate the profit after the special order has been accepted
Note: Only calculate the profit if it is stipulated in the question.

Sales (5 000 × R30) + (20 000 × R50) R1 150 000

Less: Marginal costs (5 000 × R25) + 500 000 R625 000
Contribution R525 000
Less: Fixed costs R200 000
Net income R325 000

Before a final decision can be made, the following non-financial factors should be considered:

Will the acceptance of one order at a lower price lead other customers to demand lower
prices as well?
Is this particular order the most profitable way of using the spare capacity?
Will the supermarket order lock up capacity which could be used for future full-price
business?
Is it absolutely certain that fixed costs will not alter?
Will sales of the product in the supermarket’s “own label” form reduce the main branded
sales?

TEST YOURSELF 14.1: SPECIAL ORDER

Splashee Ltd manufactures and markets floaters which they sell for R20 per pack. Current
output is 40 000 packs per month, which represents 80% of capacity. They have the
opportunity to utilise their surplus capacity by selling their product at R13 per pack to a sports
chain store who will sell it as their brand product. Total costs for the last month were R560
000, of which R160 000 were fixed costs. This represented a total cost of R14 per pack.

Required
Should Splashee Ltd accept the sports store order? Provide detailed calculations in support
of your answer.

14.2.2 Dropping a product or department

If a business has a range of products or departments, one of which is thought to be unprofitable,
it may consider dropping the loss-making product or department.

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 ILLUSTRATIVE EXAMPLE

A pharmaceutical company is considering whether to drop product Bar from its line, because
accounting statements show that this product is being sold at a loss.
The question of profitability of product Bar was raised by the following operating statement:

Product Ace Product Bar Product Lase Total

R R R R
Sales 100 000 15 000 25 000 140 000
Total costs 85 000 17 000 18 500 120 500
Net profit (loss) 15 000 (2 000) 6 500 19 500

The total costs can be separated into fixed and variable costs after some examination of the
costs:

Product Ace Product Bar Product Lase Total

R R R R
Variable costs
Direct materials 15 000 2 000 3 000 20 000
Direct labour 30 000 4 000 5 000 39 000
Indirect manufacturing costs 15 000 3 000 4 000 22 000
Selling and administration 6 000 800 1 000 7 800
Fixed costs
Indirect manufacturing costs 20 000
Selling and administration 11 700

Required
Based on the above information, should product Bar be dropped? What other factors should
be considered?

Steps for dropping a product or department

1. Draft a marginal costing income statement if the information is not given in this format.
Show fixed costs in total and not per product.
2. Look at the contribution of each product.

If the contribution is positive, do not drop the department or product, as it contributes

towards the payment of fixed costs.
If the contribution is negative, drop the department or product.

3. Indicate your decision at this point, giving reasons.

4. To support your decision, draft a marginal costing income statement that excludes the
loss-making product or department.

Solution
Arrange the original statement in marginal costing format:

Product Ace Product Bar Product Lase Total

R R R R

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 Sales 100 000 15 000 25 000 140 000
– Variable costs 66 000 9 800 13 000 88 800
Direct materials 15 000 2 000 3 000 20 000
Direct labour 30 000 4 000 5 000 39 000
Indirect manufacturing costs 15 000 3 000 4 000 22 000
Selling and administration 6 000 800 1 000 7 800
Contribution margin 34 000 5 200 12 000 51 200
– Fixed costs 31 700
Indirect manufacturing costs 20 000
Selling and administration 11 700
Net income 19 500

This presentation does, of course, give the same overall profit but, in addition, the contribution
of each product is shown. It will be seen that product Bar makes a contribution of R5 200
towards the payment of fixed costs, which means that this product is worth keeping.

Marginal costing income statement excluding the loss-making product

Product Ace Product Lase Total

R R R
Sales 100 000 25 000 125 000
– Variable costs 66 000 13 000 79 000
Direct materials 15 000 3 000 18 000
Direct labour 30 000 5 000 35 000
Indirect manufacturing costs 15 000 4 000 19 000
Selling and administration 6 000 1 000 7 000
Contribution margin 34 000 12 000 46 000
– Fixed costs 31 700
Indirect manufacturing costs 20 000
Selling and administration 11 700
Net income 14 300

Or calculation can be shown as follows:

Profit without product Bar

Contribution: Product Ace R34 000
Contribution: Product Lase R12 000
R46 000
Less: Fixed costs R31 700
Profit R14 300

If product Bar is dropped, the profit will decrease by R5 200 (R19 500 – R14 300) as shown
above.
Before a final decision can be made, the following non-financial factors should be considered:

What impact will dropping the product have on the long-term profitability of the business?

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 What impact will dropping the product have on employee assurance regarding their
employment?
What impact will dropping the product have on customer opinions?

TEST YOURSELF 14.2: DROPPING A PRODUCT OR DEPARTMENT

A company is considering dropping products Lex and Trex from its line because accounting
statements show that these products are being sold at a loss. The sales of the remaining
products cannot be increased because the market is already saturated. The following
operating statement considered typical of a year’s operations raises the question of the
profitability:

ABC Ltd
Income statement for the year ended 30 June 20x1

Product Product Product Product

Nexis (R) Lex (R) Bantex (R) Trex (R)
Sales 100 000 115 000 25 000 30 000
Less: Variable costs 60 000 108 000 10 500 36 000
Marginal income/loss 40 000 7 000 14 500 (6 000)
Less: Fixed costs* 25 000 9 000 8 000 6 000
Net profit or loss 15 000 (2 000) 6 500 (12 000)

*Fixed costs are committed costs that will not decrease if production is reduced.

Required
Advise management whether the loss-making products should be dropped. Provide detailed
workings to support your decision.

14.2.3 Choice of products where a limiting factor exists

This decision looks at when a business has the option of producing various products and there is
a single binding constraint. Binding constraints include a restriction on the following: labour
hours, machine hours, raw material, etc. These binding constraints prevent the business from
achieving its sales demand and consequently the business must determine the optimal
production mix that will maximise profits.

ILLUSTRATIVE EXAMPLE

A company is able to produce four products and is planning its production mix for the next
period. Estimated cost, sales and production data are as follows:
Product A B C D
Selling price per unit R60 R90 R120 R108
Less: Marginal costs
Labour (at R6 per hour) R18 R12 R42 R30
Material (at R3 per litre) R18 R54 R30 R36
Contribution per unit R24 R24 R48 R42

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 Resources per unit
Labour (hours) 3 2 7 5
Material (litres) 6 18 10 12
Maximum demand (units) 5 000 5 000 5 000 5 000

Required
Based on the above information, what is the most profitable production mix under the two
following independent assumptions?

1. If labour hours are limited to 50 000 in a period.

2. If material is limited to 110 000 litres in a period.

Where necessary round off calculations to two decimal places.

Steps for a limiting factor decision

1. Calculate the contribution per product.

2. Calculate the contribution per limiting factor for each product.
3. Rank the products according to which product has the highest contribution per limiting
factor.
4. Determine the most profitable production mix, that is, which product will not be fully
supplied.
5. Calculate the profit generated from the products produced.

Note: Only calculate the profit if it is stipulated in the question.

Solution
It will be seen that all the products show a contribution so that there is a case for their
production. However, because constraints exist, the products must be ranked in order of
contribution per unit of the limiting factor so that overall contribution can be maximised.
1. If labour hours are limited to 50 000 in a period:

Product A B C D
Contribution per unit R24 R24 R48 R42
÷ Labour hours per unit 3 2 7 5
= Contribution per labour hour (per limiting factor) R8 R12 R6,86 R8,40
Ranking 3rd 1st 4th 2nd

To make all the products to the demand limits, we would need:

(5 000 × 3) + (5 000 × 2) + (5 000 × 7) + (5 000 × 5)
= 85 000 labour hours
As there is a limit of 50 000 labour hours in the period, the products should be ranked in
order of attractiveness judged by contribution per labour hour; that is, B, D, A and C.
Best production plan when labour hours are restricted:

Produce 5 000 units B using 10 000 labour hours

5 000 units D using 25 000 labour hours
5 000 units A using 15 000 labour hours
and no units of C
which uses a total of 50 000 labour hours available.

2. If material is limited to 110 000 litres in a period:

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 Product A B C D
Contribution per unit R24 R24 R48 R42
÷ Number of litres of material 6 18 10 12
Contribution per litres of material R4 R1,33 R4,80 R3,50
Ranking 2nd 4th 1st 3rd

To make all products to the demand limits, we would need:

(50 000×6) + (5 000×18) + (5 000×10) + (5 000×12)
= 30 000 + 90 000 + 50 000 + 60 000
= 230 000 litres
Ranking of products by contribution per litres of material is C, A, D and B.
Best production plan when material is restricted:

Produce 5 000 units of C using 50 000 litres of material

5 000 units of A using 30 000 litres of material
which equals 80 000 litres of material
2 500 units of D using 30 000 litres material (30 000 ÷ 12 = 2 500) and
no units of B which uses a total of 110 000 litres of material

Note: The optimum production mix is a short-term solution to maximising profits. The
company should consider the long-term solution to the binding constraint. The long-term
solution would include sourcing additional labour and raw material suppliers.

TEST YOURSELF 14.3: LIMITING FACTOR

ABC Ltd produces three products. Information relating to these products is provided below:

Product A Product B Product C

Selling price per product R140 R130 R150
Direct materials R65 R40 R60
Direct labour:
Production: R12 per hour R48 R36 R24
Assembly: R3 per hour R6 R18 R21
Resources per unit
Labour hours:
Production 4 hours 3 hours 2 hours
Assembly 2 hours 6 hours 7 hours
Maximum sales demand in units 20 000 26 000 18 000

The labour hours in the assembly department are not limited.

Required
a. Calculate the most profitable production mix if the labour hours in the production
department are limited to 180 000 in a period.
b. Which products will not be fully supplied?
c. Calculate the profit for the year assuming that fixed costs amount to R700 000.

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 14.2.4 Make versus buy
In this decision the business must choose either to produce a product or component in-house or
buy it from an external supplier. There are two alternatives available:

Alternative 1: Where the production of the product or component does not impact on existing
production

Alternative 2: Where the production of the product or component impacts on existing

production

ILLUSTRATIVE EXAMPLE

Alternative 1
Ethie Ltd currently produces 10 000 units of component PRC435 in-house. The cost per unit
of component PRC435 is:

Rand
Direct materials 5,00
Direct labour 2,50
Variable manufacturing overheads 3,50
Fixed manufacturing overheads 7,00
Total cost 18,00

This component can be purchased from an external supplier at a cost of R15,50 per unit. The
company has unused capacity and can produce the component in-house.

Alternative 2
Ethie Ltd does not have spare capacity and currently component PRC435 is not being
produced in-house. Production of this component would displace the existing production of
product WTY1 by 1 000 units. The variable cost to manufacture product WTY1 is R100 and
this product sells for R150 per unit.
Under each alternative, determine if the company should produce the component in-house or
purchase it from an external supplier.

Steps involved in the make-versus-buy decision

1. Compare the cost to buy the component with the variable cost to manufacture the
component.
2. If the production of the component displaces/replaces existing production, then add the
lost contribution to the variable cost of manufacturing the component in-house.
3. Choose the option that has the lowest costs.

Solution
Alternative 1

Buying-in price R 15,50

Less: Variable manufacturing cost R 11,00 (R5 + R2,50 + R3,50)
Savings per component R 4,50

The decision is to manufacture the components in-house rather than buying them from an
external supplier. This results in a saving of R4,50 per component and an increase in profits
of R45 000 (R4,50 × 10 000). The variable cost to manufacture is cheaper than the buying-in
price and the company has surplus production capacity. The fixed costs are irrelevant to this
decision, since they will be incurred whether or not the component is produced in-house.

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 Alternative 2

Buying-in price R 155 000 (R15,50 × 10 000)

Less: Variable manufacturing cost R 110 000 (R11,00 × 10 000)
Lost contribution R 50 000 (R150 – R100) × 1 000
Savings from buying in R 5 000

The decision is to purchase the component from an outside supplier instead of manufacturing
it in-house, as this will result in a saving of R5 000.
Before a final decision can be made, the following non-financial factors should be considered:

How reliable is the supplier?

Will the supplier maintain the quality of the components?
Will the supplier increase the price of the component in the near future?

TEST YOURSELF 14.4: MAKE VERSUS BUY

Superb Ltd currently produces three products as well as the two subcomponents that are
required to manufacture these products. Due to the increase in the demand for their products,
production capacity has become constrained. Superb Ltd is trying to source a supplier that
can produce the subcomponents. The cost per unit for subcomponent TRY1 and TRY2 is as
follows:

TRY1 R TRY2 R
Direct materials 5,00 3,50
Direct labour 10,00 8,00
Variable manufacturing overheads 7,50 7,75
Fixed manufacturing overheads 7,50 3,75
Total cost 30,00 22,00

The buying-in prices of subcomponents TRY1 and TRY2 are R25 and R18 respectively.
Which subcomponents, if any, should Superb Ltd purchase from the external supplier? What
other non-financial factors should be considered before a final decision is made?

TUTORIAL EXERCISES

Exercise 1
For each of the questions that follow, select the most appropriate answer.
1.1 Under absorption costing, the cost per unit includes
a. direct materials + direct labour + fixed manufacturing overheads
b. direct material + direct labour + fixed and variable manufacturing overheads
c. direct materials + direct labour + variable manufacturing overheads
d. none of the above

1.2 A constrained resource

a. prevents an organisation from meeting its sales demand or production level
b. is a limiting factor
c. includes items such as machine hours, labour hours, floor space, etc.

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 d. all of the above are applicable

1.3 Non-financial indicators

a. must be considered before any decision is taken
b. are qualitative factors which include issues such as employee morale, customer
satisfaction and long-term profitability
c. cannot be quantified in monetary terms
d. all of the above

1.4 A company produces special bath soaps for individuals who suffer from eczema. These
soaps retail at R8,50 per bar. Currently, the company is operating at 80% capacity,
which is equivalent to 25 000 bars of soap. The variable manufacturing cost per bar of
soap is R2,50. The company has an opportunity to utilise its surplus capacity in the
form of a special order, but this special order would be at a reduced selling price of
R5,50 per bar of soap.
This special order would result in
a. a positive contribution of R18 750
b. a positive contribution of R15 870
c. a negative contribution of R18 750
d. a negative contribution of R15 870

1.5 AB Ltd has two departments, Department A and Department B. The following
information pertains to the two departments:

Department A (R) Department B (R) Total (R)

Sales 200 000 250 000 450 000
Less: Variable costs 100 000 150 000 250 000
Contribution 100 000 100 000 200 000
Less: Fixed costs 60 000 150 000 210 000
Net profit or loss 40 000 (50 000) 10 000

If the company drops the loss-making product, the net profit will
a. decrease by R100 000
b. decrease by R50 000
c. decrease by R150 000
d. none of the above
Questions 1.6 and 1.7 are based on the following information:
The MDC Company produces three products with the following costs and selling prices:

Products
A B C
Selling price per unit R15 R20 R20
Variable cost per unit R8 R10 R12
Contribution margin per unit R7 R10 R8
Direct labour hours per unit 1 hr 1,5 hrs 2 hrs
Machine hours per unit 3,5 hrs 2 hrs 2,5 hrs

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 1.6 If MDC Company has a limit of 10 000 direct labour hours but no limit on units produced
or machine hours, then the three products should be produced in the order:
a. A, B and C
b. B, C and A
c. C, A and B
d. A, C and B

1.7 If MDC Company has a limit of 15 000 machine hours, but no limit on units produced or
direct labour hours, then the three products should be produced in the order:
a. A, B and C
b. B, C and A
c. A, C and B
d. C, A and B

1.8 A company produces three components: X1, X2 and X3. The cost per unit for each
component is as follows:

X1 (R) X2 (R) X3 (R)

Variable manufacturing costs 10,00 32,00 20,00

Fixed manufacturing costs 8,00 33,20 15,00

Total cost 18,00 65,20 35,00

An external supplier can supply these components at the following prices:

X1 R16,00
X2 R28,00
X3 R22,00

Which components should the company purchase from the external supplier?

a. X1 and X3
b. X2 and X3
c. Only X2
d. Only X1

Exercise 2
In a certain period 20 000 litres of Sparko were produced and sold. Costs, revenues and
sales were as follows:

Sales (20 000 litres) R900 000

Production costs
Variable R350 000
Fixed R220 000
General overheads
(selling and admin) fixed R180 000

Required
Produce separate income statements using, firstly, the format which we have been using in
the past (total costing approach), and secondly, the marginal costing format.

Exercise 3

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 Music Ltd manufactures a product that has the following unit costs: direct materials, R10;
direct labour, R14; variable overheads, R6; and fixed overheads, R10. Fixed selling costs are
R400 000 per year. Variable selling costs of R2 per unit cover the transportation costs.
Although production capacity is 160 000 units per year, the company expects to produce only
130 000 units next year. The product normally sells for R60 each. A customer has offered to
buy 20 000 units for R36 each. The customer will pay the transportation charge on the units
purchased.
Required
3.1 What is the incremental cost per unit to Music Ltd for the special order?
3.2 What is the effect on Music Ltd income if the special order is accepted?

Exercise 4
Ethan Ltd has an annual capacity of 36 000 units. Budgeted operating results for 20x7 are as
follows:

Revenues (32 000 units @ R120) R3 840 000

Variable costs:
Manufacturing R768 000
Selling R256 000 R1 024 000
Contribution margin R 2 816 000
Fixed costs:
Manufacturing R320 000
Selling and administrative R240 000 R560 000
Operating income R2 256 000

A foreign wholesaler wants to buy 2 000 units at a price of R80 per unit. All fixed costs would
remain unchanged as the company operates within the relevant range. Variable selling costs
on the special order would be the same as the variable selling costs for regular orders.
Required
4.1 Determine the effect on operating income if the company produces the special order.
4.2 Should the company produce the special order?
4.3 Discuss any non-quantitative factors the company might want to consider when making
the decision.

Exercise 5
A cinema chain, based in Durban, owns three cinemas in the suburbs of Pinetown, Ballito and
Amanzimtoti. It has prepared budgets for the next year based on a ticket price of R8,00:

Pinetown Ballito Amanzimtoti Total

R R R R
Budgeted ticket receipts 3 200 000 2 400 000 1 600 000 7 200 000
Costs 2 600 000 2 100 000 1 800 000 6 500 000
Film hire 1 000 000 800 000 780 000 2 580 000
Wages and salaries 600 000 500 000 320 000 1 420 000
Overheads 1 000 000 800 000 700 000 2 500 000
Net profit/loss 600 000 300 000 (200 000) 700 000

The overhead costs are 40% variable and 60% fixed. The management is concerned about
the Amanzimtoti cinema and the fact that it is showing a budgeted loss, and is considering
closing the cinema and selling the site to a property developer.

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 Required
5.1 Draft a marginal costing income statement, showing the contribution and the profit for
each cinema.
5.2 On the grounds of profitability, do you think that the Amanzimtoti cinema should be
closed? Give a reasoned explanation for your decision.

Exercise 6
The operations of ABC Ltd are divided into Division A and Division B. Projections for the next
year are as follows:

Division Division Division

A B
Sales R120 000 R 80 000 R 200 000
Less: Variable costs R40 000 R30 000 R70 000
Contribution margin R80 000 R50 000 R130 000
Less: Direct fixed costs R25 000 R60 000 R85 000
Segment margin R55 000 R (10 000) R 45 000
Less: Allocated common costs R20 000 R15 000 R35 000
Operating income (loss) R35 000 R(25 000) R10 000

Required
6.1 Determine operating income for ABC Ltd as a whole if Division B is dropped.
6.2 Discuss whether Division B should be eliminated.

Exercise 7
Nadburgh Ltd manufactures three products of which the average costs of production are as
follows:

X Y Z
Direct materials R57 R36 R54
Direct labour:
Production department at R6 per hour R24 R36 R12
Assembly department at R3 per hour R9 R12 R6

Maximum potential sales for next year are:

X 12 000 units at R134 each

Y 20 000 units at R120 each
Z 16 000 units at R104 each

Production hours are restricted to 164 000, so the sales demand cannot be met. Assembly
hours are not limited.

Required
7.1 Calculate and state the order in which product demand should be satisfied.
7.2 State which products would not be fully supplied.
7.3 Calculate the anticipated profit for next year, assuming fixed costs are R644 000.

Exercise 8
Harini Ltd manufactures two products: X and Y. Information about the products is as follows:

Product X Product Y
Revenue per unit R300 R250
Variable costs per unit R160 R140
Contribution margin per unit R140 R110

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 Total demand 30 000 units 24 000 units
Machine hours per unit 1 0,5

There are 10 000 machine hours available during the quarter.

Required
8.1 Which of the products should Harini Ltd produce if it can only produce one of the
products?
8.2 Assume that the company uses half of the hours available to produce Product X and half
of the hours available to produce Product Y. What is the company’s total contribution
margin?
8.3 Assume that Harini Ltd produces the product mix that will maximise profit. What is the
total contribution margin?

Exercise 9
Kirsty Ltd manufactures 40 000 components per year. The manufacturing cost of the
components was determined as follows:

Direct materials R300 000

Direct labour R480 000
Variable manufacturing overheads R180 000
Fixed manufacturing overheads R240 000
Total R1 200 000

The component can be purchased from an outside supplier at a cost of R26.

Required
Calculate the effect on income if Kirsty Ltd purchases the component from the outside
supplier.

Exercise 10
Star Ltd manufactures 100 000 components per year. The manufacturing cost per unit of the
components is as follows:

Direct materials R24

Direct labour R26
Variable overheads R10
Fixed overheads R20
Total unit cost R80

An outside supplier has offered to sell the component to Star Ltd for R70.
Required
10.1 What is the effect on income if Star Ltd purchases the component from the outside
supplier?
10.2 Assume that Star Ltd can avoid R1 400 000 of the total fixed overhead costs if it
purchases the components. Now what is the effect on income if Star Ltd purchases the
component from the outside supplier?

TEST YOURSELF SOLUTIONS

TEST YOURSELF 14.1 SOLUTION: SPECIAL ORDER

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 Calculation of surplus capacity
100 ÷ 80 × 40 000 = 50 000
Therefore, surplus capacity = 10 000
Calculation of variable cost per unit
R560 000 – R160 000 = R400 000
R400 000 ÷ 40 000 = R10 per pack
The special order will make the following contribution:

Sales (10 000 × R13) R130 000

Less: Marginal costs (10 000 × R10) R100 000
Contribution R30 000

Accept the order as it adds R30 000 towards the payment of fixed costs.
Profit once the order is accepted:

Sales (40 000 × R20) + R130 000 R930 000

Less: Marginal costs (50 000 × R10) R500 000
Contribution R430 000
Less: Fixed costs R160 000
Net profit R270 000

TEST YOURSELF 14.2 SOLUTION: DROPPING A PRODUCT OR

DEPARTMENT

Calculation of total profit should production of products Lex and Trex be discontinued:

Product Nexis Product Bantex Total

Sales R100 000 R25 000 R125 000
Variable costs R60 000 R10 500 R70 500
Marginal income/loss R40 000 R14 500 R54 500
Fixed costs* R48 000
Net income R6 500

Calculation of total net profit if the production of Trex only is discontinued:

Product Nexis Product Lex Product Bantex Total

Sales R100 000 R115 000 R25 000 R140 000
Variable costs R 60 000 R108 000 R10 500 R 78 500
Marginal income/loss R 40 000 R7 000 R14 500 R 61 500
Fixed costs* R 13 500 R 48 000
Net income

Recommendation: The greatest benefit is achieved when the production of product Trex only
is stopped. The marginal income of R7 000 that product Lex yields can be used to cover part
of the fixed cost.

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 TEST YOURSELF 14.3 SOLUTION: LIMITING FACTOR

a. The limiting factor is 180 000 production hours.

Product A Product B Product C

Sales R140 R130 R150
Less: Variable costs R119 R94 R105
(65 + 48 + 6) (40 + 36 + 18) (60 + 24 + 21)
Contribution R21 R36 R45
Production hours per unit 4 hours 3 hours 2 hours
Contribution per labour hour R5,25 R12,00 R22,50

Therefore, production will be as follows: Product C, Product B and then Product A.

Product mix Product C 18 000 × 2 hours = 36 000 hours

Product B 26 000 × 3 hours = 78 000 hours
Product A 16 500 × 4 hours = 66 000 hours
Limiting factor is 180 000 hours

b. Which products will not be fully supplied?

Product A will not be fully supplied.

c. Calculate the profit for the year assuming that fixed costs amount to R700 000.

Profit for the year

Contribution Product C 18 000 × R45 R810 000
Contribution Product B 26 000 × R36 R936 000
Contribution Product A 16 500 × R21 R346 500
Total contribution R2 092 500
Less: Fixed costs R700 000
Net profit R1 392 500

TEST YOURSELF 14.4 SOLUTION: MAKE VERSUS BUY

TRY1 TRY2
R R
Buying-in price 25,00 18,00
Less: Variable manufacturing cost 22,50 19,25
Savings per subcomponent 2,50
Additional cost per subcomponent (1,25)

Subcomponent TRY2 should be purchased from the external supplier, since it costs R1,25
more to manufacture it in-house. The non-financial factors that should be considered are:

How reliable is the supplier?

Will the supplier maintain the quality of the components?
Will the supplier increase the price of the component in the near future?

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 15 Budgetary control

Outcomes

At the end of this chapter students should be able to

demonstrate an understanding of the master budget

draft operational, flexible and cash budgets.

Chapter outline

15.1 Introduction
15.2 Operational budgets
15.2.1 Sales budget
15.2.2 Production budget
15.2.3 Direct materials usage budget
15.2.4 Direct materials purchases budget
15.2.5 Direct labour budget
15.2.6 Manufacturing overheads budget
15.2.7 Sales and administration expenditure budget
15.2.8 Inventory budget
15.3 Flexible budgets
15.4 Cash budgets

15.1 Introduction

Budgeting is planning one’s income and expenses for the future. It is a plan expressed in
monetary terms and is based on the past experience of the business and on estimations.

15.2 Operational budgets

An operational budget is a budget that is prepared for a specific department or cost centre. All
the operating budgets are then combined into the master budget, which includes a budgeted
statement of profit or loss and other comprehensive income and a budgeted statement of
financial position.

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 Operating budgets are all interdependent; that is, information concerning one is required for the
preparation of the other. Figure 15.1 illustrates the interrelationship between the different
budgets.

Figure 15.1 Diagram of the interrelationship of the major budgets for a typical
manufacturing concern

Operating budgets consist of the following smaller budgets:

15.2.1 Sales budget

The sales budget is the starting point for budgeting, because inventory levels, purchases and
operating expenses are geared to the rate of sales activities. The sales budget is an estimate of
future sales, often broken down into both the number of units to be sold and the expected sales
in rand for the budget period.

15.2.2 Production budget

The production budget looks at the number of completed products that must be produced within
the budget period. It is based on the estimated sales for the budget period and also takes into
account the requirement for opening stock and closing stock of finished goods.

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 The production budget looks only at the number of units to be produced and not the costs
associated with producing these units. The subsequent budgets will look at the material, labour
and overhead costs of producing the units.

15.2.3 Direct materials usage budget

This budget looks at the quantity of raw materials that will be used in producing the finished
goods.

15.2.4 Direct materials purchases budget

This budget looks at the quantity and the rand value of raw materials that must be purchased in
order to cope with the usage of raw materials and the requirements for opening and closing
stocks of raw materials.

15.2.5 Direct labour budget

This budget looks at the labour hours required to produce the finished products, as well as the
rand value of these labour hours.

15.2.6 Manufacturing overheads budget

This budget is a summary of all the indirect costs associated with producing the completed
products.

15.2.7 Sales and administration expenditure budget

The sales expenditure budget looks at the costs associated with the sales activities of the
business for the budget period, that is, the costs associated with obtaining the orders and the
costs associated with executing the orders.

The administrative budget looks only at expenditure relating to the business as a whole.

15.2.8 Inventory budget

Inventory budgets should not be prepared separately, since the figures are directly related to
other operational budgets.

Examples of inventory budgets include

direct materials/raw materials

work in process
finished products.

ILLUSTRATIVE EXAMPLE: Operational budgets

Wizz Ltd manufactures and sells two products, Wazz and Zazz. In July 20x1, the budget
department gathered the following data in order to project sales and budget requirements for
20x2:
20x2 Projected sales
The company is expected to sell the following:
83 000 units of Wazz at R250 each

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 22 000 units of Zazz at R450 each

20x2 Expected stocks in units

Product Expected 1 Jan 20x2 Desired 31 Dec 20x2
Wazz 16 000 25 000
Zazz 20 000 15 000

In order to produce one unit of Wazz and Zazz, the following raw materials are used:

Raw material Unit Amount used per unit

Wazz Zazz
R kg 2 4
F kg 3 6
C unit – 3

Projected data for 20x2 in respect of raw materials is as follows:

Raw material Anticipated purchase price Expected stock 1 Jan 20x2 Desired stock 31 Dec 20x2
R R25 24 000 kg 52 000 kg
F R15 35 000 kg 78 000 kg
C R10 3 000 units 1 000 units

Projected direct labour requirements for 20x2 and rates are as follows:

Product Hours per unit Rate per hour

Wazz 6 hrs R9,50
Zazz 9 hrs R12,50

Overheads are applied at the rate of R6,50 per direct labour hour.

Required
Based on the above projections and budget requirements for 20x2 for Wazz and Zazz,
prepare the following budgets for 20x2:

1. Sales budget (units and rands)

2. Production budget (units)
3. Raw materials usage budget (units)
4. Raw materials purchases budget (units and rands)
5. Direct labour budget (hours and rands)
6. Budgeted value of closing stock of finished goods at 31 December 20x2 (in rands)

Solution
1. Sales budget

Units Price Total

Wazz 83 000 R250 R20 750 000
Wazz 22 000 R450 R9 900 000
R30 650 000

2. Production budget

Wazz Zazz
Expected sales in units 83 000 22 000
Add: Closing stock 25 000 15 000

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 108 000 37 000
Less: Opening stock 16 000 20 000
Number of units to be produced 92 000 17 000

3. Raw materials usage budget

R F C
Wazz (92 000 × 2; 3; 0) 184 000 276 000 0
Zazz (17 000 × 4; 6; 3) 68 000 102 000 51 000
252 000 kg 378 000 kg 51 000 units

4. Raw materials purchases’ budget

R F C
Raw materials usage 252 000 378 000 51 000
Add: Closing stock 52 000 78 000 1 000
304 000 456 000 52 000
Less: Opening stock 24 000 35 000 3 000
280 000 421 000 49 000
× unit price R25 R15 R10
R7 000 000 R6 315 000 R490 000

5. Direct labour budget

Wazz Zazz
Production units 92 000 17 000
× Labour hours 6 hrs 9 hrs
552 000 hrs 153 000 hrs
× Wage rate R9,50 R12,50
R5 244 000 R1 912 500

6. Budgeted value of closing stock of finished goods

Wazz (R) Zazz (R)

Raw material R (R25 per kg × 2; 4) 50 100
Raw material F (R15 per kg × 3; 6) 45 90
Raw material C (R10 per unit hour × 0; 3) 0 30
Labour (Wazz R9,50 per hour × 6 hrs) 57 –
(Zazz R12,50 per hour × 9 hrs) – 112,50
Prime cost 152 332,50
Overheads (R6,50 per direct labour hour × 6; 9) 39 58,50
Cost per unit R191 R391
Closing stock of finished goods 25 000 15 000
Total cost R4 775 000 R5 865 000

TEST YOURSELF 15.1

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 The following information was obtained from the financial records of Action Ltd. Details of
manufacturing for 20x3 include the following:
(a) Two types of product, namely product Ace (selling price of R25 each) and product Base
(selling price of R35 each) are to be manufactured, the standard composition being as
follows:

Requirements per unit of finished product

Product Product
Ace Base
Material Tic (R1 per kg) 1,5 kg 3 kg
Material Tac (R1,80 per kg) 2 kg 1,5 kg
Direct labour (R3 per hour) 2 hours 3 hours

Note: Expected changes

The direct labour hours required per unit of finished product are expected to increase by
one hour for each product in the month of May, because of the hiring of new production
workers. This will result in the hourly rate decreasing by 10%.

There is also expected to be a 50% increase in the price of material Tic and a 20-cent
increase in the price of material Tac in the month of May.
(b) Expected sales

May
Product Ace 6 000 units
Product Base 12 000 units

(c) Stock on hand (in units)

1 May 20x3 31 May 20x3

Product Ace 2 000 8 000
Product Base 4 000 10 000
Material Tic 30 000 kg 20 000 kg
Material Tac 20 000 kg 10 000 kg

(d) The production overheads for the budget period are expected to amount to R216 000.
Overheads are absorbed into finished products on the basis of labour hours.
Required
Prepare the following functional budgets for May:
a. Sales budget (in units and rands)
b. Production budget (in units)
c. Raw materials purchases’ budget (in units and rands)
d. Direct labour budget (in hours and rands)
e. Budgeted value of closing stock of finished goods as at 31 December 20x4 (in rands)

TUTORIAL EXERCISES: Operational budgets

Exercise 1

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 Gadget Ltd manufactures one product known as Widget. The following information relates to
the preparation of the budget for the year ended 31 March 20x4:

Sales budget details for product Widget:

Expected selling price per unit R100
Expected sales in units 10 000

All sales are on credit terms.

Raw materials:

Widget requires five units of raw material S and 10 units of raw material O. Material S is
expected to cost R3 per unit and material O R4 per unit.
All goods are purchased on credit terms.
Departments involved:

Two departments are involved in producing Widget, namely the machinery and the
assembly departments. The following information is relevant:

Direct labour hours per unit of product Direct labour rate per hour
Machinery 1 R6,00
Assembly 0,5 R8,00

ADDITIONAL INFORMATION

1. The production overheads for the budget period are expected to amount to R50 000 in the
machinery department and R50 000 in the assembly department.
2. Overheads are absorbed into finished products on the basis of labour hours.
3. At 1 April 20x3 stocks were as follows:

Product Widget 800 units

Raw material S 4 500 units
Raw material O 12 000 units

All stocks at 31 March 20x4 are expected to increase by 10%.

Required
Prepare the following budgets for Gadget Ltd for the year to 31 March 20x4:
1.1 Sales budget (in units and rands)
1.2 Production budget (in units)
1.3 Raw materials usage budget (in units)
1.4 Raw materials purchases’ budget (in units and rands)
1.5 Direct labour budget (in hours and rands)
1.6 Budgeted value of closing stock of finished goods as at 31 December 20x4 (in rands)

Exercise 2
The senior manager of The Body Shop has requested the functional budgets for 20x9. The
following information has been provided:
Production department
The first step in the manufacturing of bar soaps is the selection of raw materials. Raw
materials are selected on the basis of several factors, which may include human and
environmental safety, cost, compatibility with other soap ingredients, and the appearance and
performance characteristics of the final product. While the actual production process may
vary, there are some steps that are common to all bar soaps. The traditional and luxurious bar

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 soaps are made from olive oil, coconut oil, soybean, lye beads and water. The breakdown of
the material for each bar is as follows:

Traditional Luxurious
Olive oil 3,10 ounces 4,75 ounces
Coconut oil 2,50 ounces 4,5 ounces
Soybean 115 ml 140 ml
Lye beads 90 ml 81 ml
Water 150 ml 170 ml

The production manager, Ms Phumzile Nxumalo, requested skilled and semi-skilled workers
from the Human Resource department. The soaps are manufactured in batches. Each batch
produces 20 bars of soaps. The breakdown of the labour requirement per batch is as follows:

Semi-skilled Skilled
Traditional 900 minutes 1 200 minutes
Luxurious 1 500 minutes 2 400 minutes

The inventory levels have been estimated for 20x9. The inventory held at the end of 20x8 for
traditional and luxurious soap was 50 000 and 20 000 bars respectively. The manager
expects the inventory levels to increase by 10% at the end of the 20x9.
Human Resource Department
Employees are separated into skilled and semi-skilled as requested by the production
manager. Ms Thabisile Malevu, the human resource administrator processed the employment
details of the staff.
The rate for the employees were as follows:

Semi-skilled Skilled
20x8 R50 per hour R150 per hour
20x9 R10 per hour 7,5%
Increase in rates expected

Marketing Department
Mr David Green, the sales manager, expects selling prices for traditional and luxurious soap
to be R7 and R15 per bar respectively in 20x9. He has provided the following information for
the sales demand per batch of 20 bars for traditional and luxurious soap in 20x9.

Traditional Luxurious
Within Durban 500 batches 250 batches
Outside Durban 1 000 batches 500 batches

Required
2.1 Sales budget (in soaps and rands)
2.2 Production budget (in soaps)
2.3 Labour budget for the skilled employees
2.4 Material usage budget for product luxurious

Exercise 3

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 Shiloh Lang operates a dairy manufacturing business called Sendairy. The company
produces organic milk, organic cheese, organic yoghurt and organic ice cream. The company
currently has 30 variants of organic ice cream. The best-selling organic ice cream is
Strawberry Glaze, of which the sales have more than tripled during the last six months. The
following information relates to the production of Strawberry Glaze for the month ended May
20x1:
The two main ingredients required for the production of Strawberry Glaze are organic milk
and organic mixed berries. The organic milk produced by Sendairy is used in the production
of Strawberry Glaze. The mixed berries are sourced from a local supplier that specialises in
growing organic berries.
The forecasted sales figure for Strawberry Glaze is 16 000 units at R40 each. Each unit of
Strawberry Glaze requires 5 litres of organic milk and 4 kg of organic mixed berries to
produce. The company accountant calculated the cost of organic milk to be R12 per litre. In
addition, the organic mixed berries are purchased at R11 per kg. The price of organic mixed
berries is expected to increase to R25 per kg in June 20x1.
The company’s manufacturing process is 90% machine intensive. Therefore, the company
employs workers only to package the final product. It takes 0,5 hours to package the final
product. These workers are remunerated at R45 per hour.
The inventory levels for the month of May 20x1 are:

01 May 20x1 30 May 20x1

Strawberry Glaze 4 000 units 7 000 units
Organic milk 56 000 litres 45 000 litres
Organic mixed berries 30 000 kg 36 000 kg

The budgeted manufacturing overheads are R20 000, while the budgeted machine cost is
R200 000. The variable manufacturing overheads are absorbed on a machine cost basis. The
actual machine cost for the month is R300 000. The fixed manufacturing overheads for the
month are R47 000.

Required
Draft the following budgets for the month of May 20x1:
3.1 Sales budget
3.2 Production budget
3.3 Direct materials usage budget
3.4 Direct materials purchases budget
3.5 Direct labour budget
3.6 Manufacturing overheads budget

15.3 Flexible budgets

A fixed budget is a budget that is prepared for one level of activity and does not change when
the level of activity changes – it is static. Because fixed budgets are rigid in nature, they cannot
be used for cost control purposes unless the activity achieved is exactly the same as planned.
Consequently, in practice most budgets are flexible.

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 A flexible budget is a budget that is designed to allow the cost levels to be changed to suit the
actual activity level. These budgets are “flexed” or adjusted, so to speak, to correspond with the
actual activity level. Flexible budgeting therefore requires a thorough understanding of cost
behaviour.

Flexible budgeting is therefore useful for planning and cost control. Actual costs for actual
activity should always be compared with budgeted costs for actual activity. For example, it is
meaningless to compare the actual costs associated with producing 10 000 units with the
budgeted costs of producing 8 000 units. Like must be compared with like.

Performance reports use the flexible budget approach to determine variances (differences) which
are used in cost control.

ILLUSTRATIVE EXAMPLE: Flexible budgets and performance reports

Manufacturers Ltd produces a single product called Gadget. Production varies widely, but the
normal monthly production level is 12 000 units. The following data is available for April 20x1:
Cost budget for production level of 12 000 units

Cost Cost behaviour Budget (R)

Direct labour Variable (R4 per unit) 48 000
Direct materials Variable (R7 per unit) 84 000
Production overheads Mixed (20 000 fixed + R4 per unit) 68 000
Administrative overheads Fixed 54 000
Total budgeted costs 254 000

The actual level of production for April 20x1 was 12 800 units and the actual costs were as
follows:

R
Direct labour 56 400
Direct materials 87 000
Production overheads 69 600
Administrative overheads 54 600

Required
Prepare the following:

1. Flexible budgets for 10 000 and 14 000 units

2. A performance report for the month of April 20x1 indicating clearly whether the variances
are favourable or unfavourable

Solution
1. Flexible budgets

Cost Flexed budget 10 Original budget 12 Flexed budget 14

000 units 000 units 000 units
Direct labour (R4 per unit) R40 000 R48 000 R56 000
Direct materials (R7 per unit) R70 000 R84 000 R98 000
Production overheads (20 000 R60 000 R68 000 R76 000
fixed + R4 p/u)

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 Administrative overheads R54 000 R54 000 R54 000
Total budgeted costs R224 000 R254 000 R284 000

2. Performance report for the month of April 20x1

Cost Flexed for 12 Actual costs 12 Variance

800 units 800 units (difference)
Direct labour (R4 per unit) R51 200 R56 400 R(5 200)
Direct materials (R7 per unit) R89 600 R87 000 R2 600
Production overheads (20 000 R71 200 R69 600 R1 600
fixed + R4 p/u)
Administrative overheads R54 000 R54 600 (R600)
Total costs R266 000 R267 600 R(1 600)

Analysis of results of performance report:

A negative variance indicates that the company has overspent, while a positive variance
indicates that it has underspent.
The difference between the budget and the actual totals is not significant, but a closer
investigation of the individual variances is necessary.
The labour and material variances are high in comparison with the other variances. The
company has overspent on direct labour by R5 200 for the month; possible reasons could
be overtime premiums, increase in wage rate, etc. The company has underspent on
material by R2 600; possible reasons could be quantity discount (purchasing department
negotiated skilfully with supplier and got a good price).
The accuracy of the flexible budget and performance report is dependent on the accuracy
of the original cost behaviour analysis.

Note: If the variable cost per unit is not provided, it must be calculated as follows:

Variable cost per unit = Total costs ÷ Total number of units

The cost per unit for all variable costs will be the same. By definition a variable cost is a cost
that varies in total, but on a per unit basis it remains the same.
If a cost is a mixed cost, then it must be separated into its fixed and variable portions as
follows:

Highest cost – Lowest cost

Variable cost per unit =
Highest volume – Lowest volume

Fixed cost = Total cost– Variable cost

TEST YOURSELF 15.2

UTY Ltd produces one uniform product. The company encounters wide fluctuations in activity
levels from month to month. The following departmental overheads budget for the assembly
department depicts expectations of currently attainable activity of 61 000 units per month.
Budgeted costs based on normal production levels (61 000 units)

R
Indirect labour – variable 122 000
Supplies – variable 6 100
Power – variable 12 200

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 Repairs – variable 3 050
Other variable overheads 9 150
Depreciation – fixed 61 000
Other fixed overheads 30 500
244 000

Actual information for June 20x1 (48 800-unit level of production)

R
Indirect labour – variable 120 475
Supplies – variable 6 100
Power – variable 11 956
Repairs – variable 2 379
Other variable overheads 6 100
Depreciation – fixed 61 000
Other fixed overheads 30 500

Required
a. Prepare flexible budgets for 48 800-, 61 000- and 73 200-unit levels of production. (Three
flexible budgets should be prepared.)
b. Prepare a performance report for June 20x1. (Compare actual figures to the 48 800 flexible
budget and show any variances.)

TUTORIAL EXERCISES: Flexible budgets and performance reports

Exercise 4
Top Dawg Kids Clothing is a South African national retailer and design house, offering natural
and organic cotton clothing of the finest quality and comfort. The company’s mission of
creating fashion inspired by nature was born in a student apartment in Cape Town back in
1990, and has evolved into a market-leading leisurewear brand for dogs, Top Dawg kids. Co-
founder and CEO, Lulu Jali, recognised the untapped demand for high quality leisurewear
produced from natural fibres for our canine family members. Top Dawg Kids stays true to that
original vision by designing classic, timeless garments that are modern, comfortable and
made from high quality natural fabrics.
The design and supply chain teams oversee the entire manufacturing process, from sourcing
the correct fabrics to designing and creating garments that the company’s furry customers
love to wear. By ensuring that it knows exactly where all fabric and each piece of clothing is
made, it creates and maintain an ethical and transparent supply chain managed from its
Support Centre in Durban.
Top Dawg Kids drew up an operating statement for 20x9.

Units 7 500u 10 000u

R R
Sales 675 000 900 000
Direct material 75 000 100 000
Direct labour 167 000 222 000
Manufacturing overheads:
Water & electricity 41 250 55 000
Telephone 27 000 36 000
Depreciation 5 000 5 000

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 Units 7 500u 10 000u
R R
Repairs & maintenance 90 650 120 650
Profit 269 100 361 350

The actual results for the production and sale of 8 000 units appear below:
The selling price per unit has increased by 10% from that which was budgeted. The company
changed suppliers and the direct material cost per unit has since decreased to R9, 80 per
unit.
Other actual costs are listed as follows:

Direct labour R202 000

Manufacturing overheads:
Water & electricity R39 200
Telephone R29 200
Depreciation R5 000
Repairs & maintenance R101 450

Required
Draw up a performance report for Top Dawg Kids Clothing.

Exercise 5
The cost department of CY Manufacturing Company prepared the following flexible budget for
department 2 for February 20x1:

Production quantity 4 800 5 400 6 000

Capacity utilisation 80% 90% 100%
Variable overheads: R R R
Indirect labour 1 600 1 800 2 000
Manufacturing supplies 1 920 2 160 2 400
Heat, power and light 240 270 300
Fixed overheads:
Maintenance 1 300 1 300 1 300
Total budgeted factory overheads 5 060 5 530 6 000

The actual production for the month of February 20x1 was 5 700 units and actual factory
overheads were as follows:

R
Indirect labour 1 880
Manufacturing supplies 2 325
Heat, power and lights 325
Maintenance 1 280
Total actual factory overheads 5 810

Required
Draft a performance report for the month of February 20x1 indicating clearly whether the
variances are favourable or unfavourable.
Note: Round off final answers to the nearest whole number.

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 Exercise 6
The managing director of HFSC Manufacturers is concerned with the operating results for
March 20x1. They are producers and sellers of a single product called Deluxe. You have
recently attended a course on budgeting and decide to use your experience by applying the
principles of flexible budgeting to the product currently made and sold by your company. The
following information is made available:
Statement of profit or loss and comprehensive income for the period March 20x1

Budget Actual
Units R45 000 R40 000
Sales R1 800 000 R1 600 000
Less: Variable expenses R810 000 R760 400
Direct materials R360 000 R357 000
Direct labour R270 000 R253 000
Variable overheads R135 000 R110 400
Selling and administrative R45 000 R40 000
Contribution R990 000 R839 600
Less: Fixed expenses R750 000 R753 200
Manufacturing overheads R405 000 R408 200
Selling and administrative R345 000 R345 000
Net profit R240 000 R86 400

Required
Compile a flexible budget at actual activity level.

15.4 Cash budgets

Cash budgets help the enterprise anticipate its future cash needs, which is of extreme importance
since poor cash management is a major reason for business failure. This budget translates all the
other budgets into cash terms and shows in detail the pattern of actual cash received (inflows)
and actual cash paid (outflows) for the budget period.

The cash budget helps to highlight potential future difficulties; that is, if cash is going to be
exceptionally tight in a given period, thereby giving management an opportunity to seek
alternative sources of finance.

The following are non-cash items (i.e. there is no movement in the cash balance) and should not
appear in the cash budget under any circumstances:

Depreciation
Provision for credit losses

Format of the cash budget

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 Opening cash balance for the period X
Add: Cash receipts for the period X
Total cash available X
Less: Cash payments for the period X
Closing cash balance for the period X

ILLUSTRATIVE EXAMPLE: Cash budget

The following information has been provided for ABC Ltd:

The opening cash balance on 1 January was expected to be R60 000. The budgeted sales
(all credit) were as follows:

R
November 160 000
December 180 000
January 150 000
February 150 000
March 160 000

An analysis of the records shows that debtors settle their accounts according to the following
pattern: 60% within the month of sale, 25% in the month following sale and 15% in the
second month following sale.
An extract from the purchases budget was as follows:

R
November 120 000
December 110 000
January 90 000
February 110 000
March 110 000

All purchases are on credit and are paid for as follows: 90% in the month of purchase and the
balance in the month after purchase.
Wages are R30 000 per month and overheads are R40 000 per month (including R10 000
depreciation); these are settled in cash every month.
Taxation of R16 000 has to be settled in February and the company will receive a settlement
of an insurance claim of R50 000 in March.

Required
Prepare a cash budget for January, February and March. Show all workings.

Solution
Workings
Receipts from sales

January cash (R)

Nov (15% × 160 000) 24 000
Dec (25% × 180 000) 45 000
Jan (60% × 150 000) 90 000
159 000

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 February cash (R)
Dec (15% × 180 000) 27 000
Jan (25% × 150 000) 37 500
Feb (60% × 150 000) 90 000
154 500
March cash (R)
Jan (15% × 150 000) 22 500
Feb (25% × 150 000) 37 500
Mar (60% × 160 000) 96 000
156 000

Payments for purchases

January cash (R)

Dec (10% × 110 000) 11 000
Jan (90% × 90 000) 81 000
92 000
February cash (R)
Jan (10% × 90 000) 9 000
Feb (90% × 110 000) 99 000
108 000
March cash (R)
Feb (10% × 110 000) 11 000
Mar (90% × 110 000) 99 000
110 000

Cash budgets of ABC Ltd

January (R) February (R) March (R)

Opening balance 60 000 67 000 37 500
Add: Cash receipts
Receipts from sales 159 000 154 500 156 000
Insurance claim 50 000
Total cash available 219 000 221 500 243 500
Less: Cash payments
Purchases 92 000 108 000 110 000
Wages 30 000 30 000 30 000
Overheads (less depreciation) 30 000 30 000 30 000
Taxation 16 000
Closing balance 67 000 37 500 73 500

TEST YOURSELF 15.3

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 The following information is available concerning the operations of Apec Ltd: the opening
cash balance on 1 December is R10 000. Actual and projected sales and purchases are as
follows:

Sales Purchases
October R180 000 R100 000
November R250 000 R184 000
December R300 000 R183 750
January R150 000 R99 750
February R120 000 R170 000

All sales are on credit. A discount of 2% is given on sales if payment is received within the
first 10 days of the month following sale. Cash is received from credit sales as follows:
70% within the discount period (at the beginning of the month following sale)
20% at the end of the month following sale
8% in the second month following sale
2% uncollectable
Purchases are paid for as follows:
50% in the month of purchase and the balance in the month following the month of purchase.
Total budgeted marketing, distribution and customer service costs for the year are R400 000.
This amount includes depreciation of R40 000. Marketing, distribution and customer service
costs are paid as incurred.
Required
Prepare cash budgets for December and January.

TUTORIAL EXERCISES: Cash budget

Exercise 7
EPC Company has the following information regarding its business operations:
1. Opening cash balance on 1 September 20x1 was R22 250.
2. Sales are as follows (all sales are on credit):

July R125 000

August R150 000
September R200 000
October R300 000
November R120 000

3. Debtors’ terms are as follows:

– 25% of sales are collected in the month of the sale

– 70% in the month following the sale
– 3% in the second month following the sale
– The remainder is uncollectable

4. Merchandise purchases and expenses are as follows:

September October November

Merchandise purchases R120 000 R175 000 R87 500
Salaries and wages R22 500 R25 000 R20 000

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 Advertising R65 000 R72 500 R40 000
Rent payments R4 500 R4 500 R4 500
Depreciation R5 000 R5 000 R5 000

Merchandise purchases are paid in full in the month following the month of purchase.
Accounts payable for merchandise purchases on 31 August that will be paid during
September total R90 000. All other expenses are paid in the month incurred.
5. Equipment costing R5 000 will be purchased for cash during September.
6. A loan of R20 000 will be made in September and repaid in November.
7. Interest on the loan is calculated at R600 per month.

Required
Prepare a cash budget for the months of September and October.

Exercise 8
The summary of EX Ltd’s transactions for June, July and August 20x1 and its expected
transactions for September 20x1 are as follows:

June July August September

Sales (20% cash; 80% credit) R110 000 R90 000 R75 000 R60 000
Purchases (30% cash; 70% credit) R27 000 R24 000 R18 000 R15 000
Salaries and wages R42 000 R33 000 R30 000 R12 000
Rental R600 R600 R650 R600
General expenses R9 000 R8 000 R9 000 R7 000
Payments made on loan R5 000

ADDITIONAL INFORMATION

1. The bank overdraft at 1 August 20x1 amounted to R9 600.

2. Interest on a R6 000 investment at 10% per annum is received every six months in March
and September.
3. Credit sales are collected as follows:
40% in the month of sale
30% in the first month after the sale
28% in the second month after the sale
2% irrecoverable
4. Credit purchases are paid for within the month of purchase in order to obtain a discount of
2%.
5. All other expenses are paid in cash.

Required
Prepare the cash budget for August and September 20x1.

Exercise 9
Vuwani Ltd is a privately owned manufacturer of gymnastic equipment in South Africa.
Information about the company is as follows. The business is growing modestly at present but
faster growth is planned. The business experiences seasonal sales. Vuwani Ltd is
anticipating a cash flow problem as a result of its planned growth of R450 000 in June. The
bank balance for April is R10 000. The directors of the company own 100% of the share

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 capital between them. None of the director-shareholders will be in a position to invest capital
in the business for the next 2 to 3 years.
The estimates for the forthcoming six-month period in 2020 are as follows:
Total sales are as follows: February = R500 000; March = R500 000;
April = R560 000; May = R610 000; June R650 000; July = R650 000.
Sales are 50% cash and the balance is on credit.
Credit collections are as follows: 50% collected one month after the sale and the balance in
the second month after the sale.
Purchases are calculated as 60% of the next month’s sales, 10% of purchases are made in
cash, 50% of total purchases are paid for one month after purchase, and the remaining 40%
of total purchases are paid for two months after purchase.
The firm pays rent of R8 000 per month. Basic salary and wage costs are fixed at R6 000 per
month plus a variable cost of 7% of the current month’s sales. A tax payment of R54 500 is
due in June.
New equipment costing R75 000 will be bought and paid for in April. An interest payment of
R30 000 is paid in June. Dividends of R12 500 will be paid in April.
No principal repayments or retirements are due during these months.
Required
Prepare a cash budget for April, May and June. Round off to the nearest whole number if
necessary.

Exercise 10
CTG Ltd made the following estimates for the three months ending 31 March 20x1:

January (R) February (R) March (R)

Cash sales 28 000 25 000 28 000
Credit sales 72 000 60 000 48 000
Purchases 30 000 25 000 12 000
Salaries and wages 16 000 16 000 16 000
Rental 2 000 2 000 2 000
General expenses 15 000 15 000 15 000
Advertising expenses 2 000 2 000 2 000

ADDITIONAL INFORMATION

1. Credit sales are collected as follows:

60% in the month of sale
20% in the month following the sale
15% in the second month following the sale
5% written off as bad debts
2. All purchases are paid for in cash.
3. Salaries and wages are paid in the month incurred, except for January, which are paid in
February.
4. Rental for the use of premises is paid on a monthly basis.
5. General expenses include an amount of R1 000 for depreciation and are paid in the
month incurred.
6. The favourable bank balance at 1 February 20x1 is R5 000.
7. A dividend of R15 000 will be paid in March.
8. Interest on a loan of R600 000 at 10% per annum is payable every month.
9. Advertising will be incurred on a monthly basis and be paid for in cash.

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 Required
Prepare the cash budget for CTG Ltd for February and March 20x1.

Exercise 11
A supermarket operates on a cash-sale basis. Management expects the next three months
from January to March 20x1 to demand some cash requirements beyond the normal
operational outflows. A monthly cash budget to identify possible cash needs up to the end of
March 20x1 must therefore be developed from the information and projections which have
been made available. A cash balance of R28 700 is currently on hand and a balance of at
least R20 000 must be available at the beginning of each month.
(a) Sales forecasts are:

January R180 000

February R240 000
March R210 000
April R240 000

The store has recently introduced a card system and 40% of cash from sales each month is
only received by the middle of the following month.
(b) Cost of goods sold averages 75% of sales. Inventory purchased during each month
averages the cost of sales for the following month. Inventory on hand on 1 December
20x0 amounted to R270 000. Inventory is paid for as follows:

50% in the month of purchase

50% in the month following the month of purchase

(c) Operating expenses are projected as follows:

(i) Salaries and wages at 12% of sales, paid in the month of sale.
(ii) Other expenses at an average 10% of sales, paid in the month of sale.
(iii) Cash receipts expected from repayment of a loan to an employee of R6 000 due
in March 20x1.
(iv) Repayment of short-term loan of R3 000 is due in February 20x1.
(v) Repayments of long-term loans of R4 000 each are due in January and March
20x1.
(vi) A new refrigerator was purchased for R48 000 and four payments of R12 000
each are due in February, March, April and May 20x1.
(vii) Depreciation on all equipment is written off at the rate of R5 000 per month.
(viii) Interest income from an investment of R4 900 per month is expected.
(ix) A bonus of R52 500 is due to staff in January 20x1.
(x) Company tax payment of R14 000 is due in March 20x1.

Required
Prepare the cash budget for the quarter ended 31 March 20x1.

TEST YOURSELF SOLUTIONS

TEST YOURSELF SOLUTION 15.1

a. Sales budget Units Unit price (R) Value

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 Ace 6 000 25 150 000
Base 12 000 35 420 000
570 000

b. Production budget Ace Base

Sales requirements 6 000 12 000
Add: Closing stock 8 000 10 000
Production requirements 14 000 22 000
Less: Opening stock 2 000 4 000
Units produced 12 000 18 000

c. Raw materials purchases’ budget Material Tic Material Tac

Material usage
Ace: 12 000 × 1,5 kg; 2 kg 18 000 24 000
Base: 18 000 × 3 kg; 1,5 kg 54 000 27 000
Total materials used 72 000 51 000
Add: Closing stock 20 000 10 000
Material required 92 000 61 000
Less: Opening stock 30 000 20 000
Materials purchased (kg) 62 000 41 000
Unit price (X) R1,50 R2,00
Materials purchased (rand) R93 000 R82 000

d. Direct labour budget Ace Base

Production units 12 000 18 000
Hours per unit (X) 3 4
Total hours required 36 000 72 000
Rate per hour (X) R2,70 R2,70
Direct labour cost R97 200 R194 400

e. Budgeted value of closing stock Ace (R) Base (R)

Raw material Tic (R1,50 per kg × 1,5; 3) 2,25 4,50
Raw material Tac (R2,00 per kg × 2; 1,5) 4,0 3,00
Labour (R2,70 per hour × 3 hrs; 4 hrs) 8,10 10,80
Prime cost 14,35 18,30
Overheads (R2 per direct labour hour × 3; 4) 6,00 8,00
Cost per unit 20,35 26,30
Closing stock of finished goods 8 000 10 000
Total cost 162 800 263 000

Overhead rate = R216 000 ÷ R108 000 hours = R2 per labour hour

TEST YOURSELF SOLUTION 15.2

a. Flexible budgets for 48 800-, 61 000- and 73 200-unit levels of production.

Units
Cost 48 800 61 000 73 200
per unit
(R)
Indirect labour 2 R97 600 R122 000 R146 400
Supplies 0,10 R4 880 R6 100 R7 320

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 Units
Cost 48 800 61 000 73 200
per unit
(R)
Power 0,20 R9 760 R12 200 R14 640
Repairs 0,05 R2 440 R3 050 R3 660
Variable overheads 0,15 R7 320 R9 150 R10 980
Depreciation R61 000 R61 000 R61 000
Fixed overheads R30 500 R30 500 R30 500
R213 500 R244 000 R274 500

b. Prepare a performance report for June 20x1.

Performance report based on 48 800 units

Actual Budgeted Variance
Indirect labour R120 475 R97 600 22 875 U
Supplies R6 100 R4 880 1 220 U
Power R11 956 R9 760 2 196 U
Repairs R 2 379 R2 440 61 F
Variable overheads R6 100 R7 320 1 220 F
Depreciation R61 000 R61 000
Fixed overheads R30 500 R30 500
R238 510 R213 500 25 010 U

TEST YOURSELF SOLUTION 15.3

Cash Budget of Apec Ltd

December January
R R
Opening balance 10 000 32 025
Add: Cash receipts
Cash received from credit sales 235 900 285 800
Less: Cash payments
Purchases (183 875) (141 750)
Marketing, distribution and customer service costs
(400 000 – 40 000 ÷ 12) (30 000) (30 000)
Closing balance 32 025 146 075
Workings
Cash receipts December January
R R
October R180 000
70% beginning of November – 2%
20% end of November
8% December 14 400
November R250 000
70% beginning of December – 2% 171 500
20% end of December 50 000

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 8% January 20 000
December R300 000
70% beginning of January – 2% 205 800
20% end of January 60 000
8% February
January R150 000
70% beginning of February – 2%
20% end of February
8% March
February R120 000
70% beginning of March – 2%
20% end of March
8% April
R235 900 R285 800
Cash payments
December January
R R
October R100 000
50% in October
50% in November
November R184 000
50% in November
50% in December 92 000
December R183 750
50% in December 91 875
50% in January 91 875
January R99 750
50% in January 49 875
50% in February
February R170 000
50% in February
50% in March
R183 875 R141 750

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 16 Standard costing and variance analysis

Outcomes

At the end of this chapter students should be able to

understand the use of a standard costing system

calculate material, labour and overheads variances
calculate sales variances
reconcile budgeted to actual profit.

Chapter outline

16.1 Introduction
16.2 A standard costing system
16.2.1 Standard cost card
16.2.2 Advantages of standard costing
16.2.3 Disadvantages of standard costing
16.3 Variance analysis
16.4 Sales variances
16.4.1 Sales price variance
16.4.2 Sales quantity variance
16.5 Production cost variances
16.5.1 Direct materials variances
16.5.2 Direct labour variances
16.5.3 Variable manufacturing overheads variances
16.5.4 Fixed manufacturing overheads variances

16.1 Introduction

In Chapter 15, you were introduced to budgeting as a means of planning, controlling and
monitoring business activities. This chapter continues the theme of control by the use of
standard costing and variance analysis.

In a manufacturing environment, it can be difficult to track down the causes of variances unless
a detailed analysis is carried out. These variances can be identified and quantified by using a
standard costing system.

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 16.2 A standard costing system

Used to improve planning and control, and to facilitate product costing.

Forces planning, resulting in a more efficient operation with less waste, eliminating
overspending, excessive inventory, wasted time, etc.
A standard is a benchmark or a norm for measuring performance.
Standards fall into two categories:

– Ideal standards, which allow for no breakdowns or other work interruptions.

– Practical or currently attainable standards, which can be reached under efficient operating
conditions without extraordinary effort by properly trained and experienced employees.

A standard cost prescribes performance and minimum allowable costs. Each element of cost
of production is broken down and costed. For each product a standard cost card is drawn up.
Setting standards. Historical data provides a good starting point for determining standards for
materials, labour and overheads. This data must be adapted for changes in technology,
production methods, etc. Effective standard setting requires a combined effort and the
experience of all concerned to predict future trends. These standards must be revised
regularly.

16.2.1 Standard cost card

A standard cost is a predetermined unit cost for any resource that an organisation uses to
manufacture a product. A standard cost card displays the standard or expected usage and cost for
one unit of a particular product. Detailed cost and usage information in the standard cost card
can assist in calculating a variety of variances to determine exactly where a problem occurred.
The following table illustrates a basic standard cost card.

Standard cost card: Product SeCa

Direct materials 4 metres R5,00 per metre R20
Direct labour 8 hours R10 per hour R80
Variable production overhead 8 hours R5 per hour R40
Production cost per unit R140

16.2.2 Advantages of standard costing

Provides a good basis for cost comparisons, in particular with the use of flexible budgets.
Enables managers to use management by exception whereby their attention is focused only on
those variances that are significant, thereby saving management time.
Provides a basis for managerial performance evaluation and determining bonuses.
Participation in setting standards and assigning responsibility can have motivational effects on
employees.

16.2.3 Disadvantages of standard costing

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 Standard costing systems tend to focus too heavily on cost minimisation.
May encourage cost reduction, which can adversely affect other areas of strategic importance.
Controlling one department’s costs may increase costs in other departments.
Too much emphasis is placed on the cost and efficiency of direct labour, which can be
insignificant in the face of increasing automation.
Variance analysis does not explicitly encourage continuous improvement due to 12-month
standards.
Standard costs become outdated quickly due to shorter product life cycles.

16.3 Variance analysis

The overall variance as learnt in flexible budgets can be broken down in order to identify the
effects on the volume and price of resource inputs.
Variances arise when the actual quantity or price of a production component differs from the
standard quantity or price.
Each production component can have a price (rate, budget or spending) variance, and a
quantity (efficiency or usage) variance.
Costs that should have been incurred at the actual level of activity according to the standard
are compared with actual costs incurred. The difference is the variance.
A favourable variance occurs when actual costs are less than the standard costs at actual
volume.
An unfavourable variance occurs when actual costs are more than the standard costs at actual
volume.

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 Figure 16.1 Diagrammatic illustration of variances

16.4 Sales variances

As mentioned previously, variance analysis is used by an enterprise to exercise control over its
costs. It is, however, just as important to control sales as it is to ensure that planned profits are
achieved.

Sales variances are the opposite of production variances, because they represent income and not
costs. Therefore, when the actual sales are greater than the budgeted sales, the variance is
favourable and vice versa. We will cover only two sales variances, namely sales price and sales
quantity.

16.4.1 Sales price variance

The sales price variance is the difference between the standard price per unit and the actual price
per unit for the number of units sold in the period:

(AP – SP) × AV

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 16.4.2 Sales quantity variance
The sales quantity variance is the difference between the budgeted number of units sold and the
actual number sold valued at the standard gross profit per unit.

(AV – BV) × Standard gross profit per unit

(Standard gross profit per unit = Standard selling price – Standard cost price)

Explanation of abbreviations

AP – actual price
SP – standard price
AV – actual sales volume
BV – budgeted sales volume

ILLUSTRATIVE EXAMPLE

WG Ltd manufactures products Widget and Gadget. The following information is relevant to
the two products:

Budgeted Budgeted Standard sales Actual Actual

sales production cost price per unit sales sales in
(units) per unit (R) (R) (units) rands
Widget 1 200 10 20 1 100 19 800
Gadget 800 5 10 720 7 920
Total 2 000 1 820 27 720

Required
Calculate the following variances for each product and in total:

1. Sales price variance.

2. Sales quantity variance.

Where necessary round off to two decimal places.

Solution
1. Sales price variance

(AP – SP) × AV
Widget = (R18* – R20) × 1 100 units = R2 200 U
Gadget = (R11* – R10) × 720 units = R720 F
Total sales price variance = R1 480 U
*R19 800 ÷ 1 100 U = R18
*R7 920 ÷ 720 U = R11

You sold each unit of Widget for R2 less than planned, therefore Widget has an unfavourable
sales price variance of R2 200. Each unit of Gadget was sold for R1 more than what
was planned, therefore the sales price variance for Gadget is R720 favourable. The
total sales price variance is calculated by adding the R2 200 u + R720 f.
2. Sales quantity variance

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 (AV – BV) × Standard gross profit per unit
Widget = (1 100 – 1 200) × (R20 – R10) = R1 000 U
Gadget = (720 – 800) × (R10 – R5) = R400 U
Total sales quantity variance = R1 400 U

You sold fewer units than expected of both Widget and Gadget, therefore both these products
have sales quantity variances that are unfavourable.

TEST YOURSELF 16.1

Tom Keen Ltd manufactures two products: M and N. The following is relevant to the two
products:

Product Product
M N
Budgeted sales units 1 200 800
Budgeted manufacturing cost per unit R20 R10
Standard sales price per unit R40 R20
Actual sales units 1 100 720
Sales value R39 600 R15 840

Required
Calculate the following for each variance and in total:
a. Sales price variance
b. Sales quantity variance

16.5 Production cost variances

16.5.1 Direct materials variances

Price variance measures the effect on the cost of purchasing at a price that is different from
standard. This variance can arise due to an unexpected price increase/decrease, inefficiency of
the purchasing department, quality of material purchased, quantity of material purchased, etc.

The materials price variance is the difference between the standard and the actual unit price of
raw material multiplied by the actual quantity of raw material:

(SP – AP) × AQ

Usage (quantity) variance measures the effect on the cost of using a different quantity of
material in production compared with the standard quantity that should have been used for the
actual production output. This variance can arise due to the efficiency (or lack thereof) of a
production department, quality of material, machine breakdowns, skill of workers, supervision,
etc.

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 The usage variance is calculated by determining the difference between the actual quantity of
material used and the quantity that should have been used for actual production, according to the
standard, multiplied by the standard price:

(SQ – AQ) × SP

Total direct materials variance is the difference between actual total materials cost and the
budgeted total materials cost, or the total variance is the sum of the price and usage variances:

(AP × AQ) – (SP × SQ)

or

Price variance + Usage variance

Explanation of abbreviations

AP – actual price (material)

SP – standard price (material)
AQ – actual quantity
SQ – standard quantity allowed

16.5.2 Direct labour variances

Rate variance measures the effect on cost of paying a different labour rate compared to the
standard. This variance is caused by an unexpected wage increase/decrease, incorrect standards
established, skill of workers employed, etc.

The direct labour rate variance is the difference between the standard hourly rate and the actual
hourly rate multiplied by the actual time used:

(SR – AR) × AH

Efficiency variance measures the effect on cost of using a different number of direct labour
hours, compared to the standard hours that should have been used for the actual production
output. This variance is caused by the skill of workers, quality of material, machine breakdowns,
supervision of workers, incorrect standards established, etc.

The direct labour efficiency variance is calculated by determining the difference between the
actual hours worked and the hours that should have been worked to produce the output,
according to the standard, multiplied by the standard rate.

(SH – AH) × SR

The total labour variance is the difference between actual total labour cost and the budgeted
total labour cost, or the total variance is the sum of the rate and efficiency variance:

(AR × AH) – (SR × SH)

or

Rate variance + Efficiency variance

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 Explanation of abbreviations

AR – actual rate (labour)

SR – standard rate (labour)
AH – actual hours
SH – standard hours allowed

16.5.3 Variable manufacturing overheads variances

Spending (rate) variance is a measure of the difference between the actual variable overheads
and the standard variable overheads rate multiplied by actual activity. This variance is caused by
incorrect standards established, an increase/decrease in the cost of variable overheads, efficient
(or inefficient) use of variable overheads items, etc.

The variable manufacturing overheads rate variance is the difference between the standard rate
and the actual rate multiplied by the quantity used of the allocation basis, which can be labour
hours, machine hours, etc. (if hours are used as basis):

(AR – SR) × AH

Efficiency variance measures the difference between the actual activity and the standard
activity allowed, given the actual output multiplied by the standard variable overheads rate. This
variance is caused by efficient (or inefficient) use of time, quality of material used, machine
breakdowns, supervision of workers, incorrect standards established, etc.

The variable manufacturing overhead efficiency variance is calculated by determining the

difference between the actual hours worked and the hours that should have been worked to
produce the output, according to the standard, multiplied by the standard rate (if the allocation
base is time):

(SH – AH) × SR

Total variable manufacturing overhead variance is the difference between actual total
manufacturing overheads and the budgeted total variable overheads, or the total variance is the
sum of the rate and efficiency variance:

(AR × AH) – (SR × SH)

or

Spending variance + Efficiency variance

Explanation of abbreviations

AR – actual rate (variable overheads rate)

SR – standard rate (variable overheads rate)
AH – actual hours
SH – standard hours allowed

16.5.4 Fixed manufacturing overheads variances

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 Marginal costing system: Fixed manufacturing overheads are not allocated to production, but
written off as a period cost. Only a fixed overhead expenditure variance is calculated. This
variance is caused by actual overhead costs being different from expected and can arise due to
an increase/decrease in salaries paid to supervisors or other fixed overheads, overbudgeting for
some fixed expenses, etc. It is calculated as the difference between actual fixed overheads and
budgeted fixed overheads:

AFO – BFO

Absorption costing system: Besides the expenditure variance, a volume variance which
measures the utilisation of available facilities is calculated. The volume variance occurs when
standard hours allowed for actual output are different from the budgeted (normal) activity level
planned for the period.

(BH – SH) × SR

or

(Actual units – Budgeted units) × SR

Explanation of abbreviations

AFO = Actual fixed overheads

BFO – Budgeted fixed overheads
BH – Budgeted hours
SH – Standard hours allowed
SR = Standard rate (fixed overhead rate)

ILLUSTRATIVE EXAMPLE

The following information has been extracted from the records of Senayshia’s Beautiful
Baskets for the month of March 20x1:
Standard cost card:

R
Materials 1,40 kg @ R4,10/kg 5,74
Direct labour 0,90 hours @ R4,50/hour 4,05
Variable overheads R2,20/hour @ 0,90 hours 1,98
Fixed overheads 6,34
18,11

Senayshia’s Beautiful Baskets

Performance report
Original budget Flexible budget Actual Variance
Volume 240 000 220 000 220 000
Sales R6 000 000 R5 500 000 R5 060 000 R440 000 U
Less: Cost of sales R4 346 400 R4 111 000 R4 049 698 R61 302 F
Direct materials R1 377 600 R1 262 800 R1 252 240 R10 560 F
Direct labour R972 000 R891 000 R857 648 R33 352 F

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 Variable overheads R475 200 R435 600 R438 570 R2 970 U
Fixed overheads R1 521 600 R1 521 600 R1 501 240 R20 360 F
Profit R1 653 600 R1 389 000 R1 010 302 R378 698 U

Variable overheads allocation is based on direct labour hours, while fixed manufacturing
overheads are allocated on the basis of units produced, all at predetermined rates based on
budgeted costs and volumes.
Actual production costs:

Material 313 060 kg at R4 per kg

Direct labour 194 920 hours at R4,40 per hour

Required
Prepare a complete variance analysis.

Solution

Materials price variance = (SP – AP) × AQ

= [R4,10 – R4,00] × 313 060
= R31 306 (F)
Materials usage variance = (SQ* – AQ) × SP
*standard quantity allowed is calculated using actual units produced multiplied = [(220 000 × 1,40) – 313 060] × R4,10
by the standard material requirement.
= (308 000 – 313 060) x R4,10
= R20 746 (U)
Total material variance = Material price + Material usage
= 31 306 (F) + 20 746 (U)
= R10 560 (F)
Direct labour rate variance = (SH* – AH) × SR
*standard hours allowed is calculated using actual units produced multiplied by = [220 000 × 0,90 – 194 920] × R4,50
the standard labour requirement.
= [198 000 – 194 920] × R4,50
= R13 860 (F)
Direct labour efficiency variance = (SH* – AH) × SR
= [220 000 × 0,90 – 194 920] × R4,50
= R13 860 (F)
Total labour variance = Labour rate + Labour efficiency
= 19 492 (F) + 13 860 (F)
= R33 352 (F)
Variable o/h expenditure variance = (SR – AR) × AH
= (R2,20 – R2,25) × 194 920
= R9 746 (U)
Variable o/h efficiency variance = (SH – AH) × SR
= [198 000 – 194 920] × R2,20
= R6 776 (F)
Total variable overheads variance = (AH × AR) – (SH × SR)
= (194 920 × R2,25) – (220 000 × 0,90 × R2,20)
= 438 570 – 435 600
= R2 970 (U)
Fixed overheads expenditure variance = Budgeted cost – Actual cost
= 1 521 600 – 1 501 240
= R20 360 (F)
Fixed overheads volume variance = (Actual units – Budget units) × Standard rate
= [220 000 – 240 000] × R6,34
= R126 800 (U)
Total fixed overheads variance = Actual cost – (Actual units × SR)
= 1 501 240 – (220 000 × R6,34)
= 1 501 240 – 1 394 800
= R106 440 (U)

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 Sales price variance = (AP – SP) × AQ
= (R23 – R25) × 220 000
= R440 000 U
Sales volume variance = (AV – BV) × Standard profit
= (220 000 – 240 000) × (R25 – R18,11)
= R137 800 (U)

Senayshia’s Beautiful Baskets

Standard cost operating statement
R R
Budgeted net profit 1 653 600
Add: Sales volume variances 137 800 U
Standard profit (flexed budget profit) 1 515 800
Add/(less): Favourable/adverse variance 505 498 U
Sales price variance 440 000 (U)
Material price 31 306 (F)
Material usage 20 746 (U)
Labour rate 19 492 (F)
Labour efficiency 13 860 (F)
Variable overheads rate 9 746 (U)
Variable overheads efficiency 6 776 (F)
Fixed overhead expenditure 20 360 (F)
Fixed overhead volume 126 800 (U)
Actual profit 1 010 302

TEST YOURSELF 16.2

The following standard costs were developed for one of the products of HFSC Manufacturers:
Standard cost card per unit

Direct materials 4 metres @ R14 per metre R56,00

Direct labour 8 hours @ R10 per hour R80,00
Variable overheads 8 hours @ R8 per hour R64,00
Fixed overheads 8 hours @ R12 per hour R96,00
Total standard cost per unit R296,00

The following information is available regarding the company’s operations for the period:

Units produced 11 000

Materials purchased 52 000 metres at R13,70 per metre
Materials used 40 000 metres
Direct labour 84 000 hours costing R840 000
Overheads incurred:
Variable R756 000
Fixed R1 000 000

Budgeted fixed overheads for the period is R960 000, and the standard fixed overhead rate is
based on an expected capacity of 80 000 direct labour hours.

Required
a. Calculate the materials price variance.
b. Calculate the materials usage variance.
c. Calculate the labour rate variance.

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 d. Calculate the labour efficiency variance.
e. Calculate the variable overheads spending variance.
f. Calculate the variable overheads efficiency variance.
g. Calculate the fixed overheads spending variance.
h. Calculate the fixed overheads volume variance.

TUTORIAL EXERCISES

Exercise 1
Multiple-choice questions

1.1 Standard costs include the quantity and price of inputs for each unit of product. These
inputs include
a. delivery costs
b. marketing costs
c. accounting costs
d. overhead costs

1.2 Variances indicate

a. the cause of the variance
b. who is responsible for the variance
c. that actual performance is not going according to plan
d. when the variance should be investigated

1.3 Price variances focus on the difference between

a. actual price and standard price for actual quantity allowed for units actually produced
b. actual price and standard price for standard quantity allowed for units actually
produced
c. actual price and standard price for actual quantity allowed for estimated activity
d. none of the above

1.4 The materials price variance is calculated as

a. (Actual price – Standard price) × Actual quantity
b. (Actual price – Standard price) × Standard quantity
c. (Actual quantity – Standard quantity) × Actual price
d. (Actual quantity – Standard quantity) × Standard price

1.5 Efficiency variances focus on the difference between

a. actual quantity used and standard quantity allowed for estimated activity
b. actual quantity used and standard quantity allowed for units actually produced
c. quantity allowed for estimated production and standard quantity allowed for units
actually produced
d. none of the above

1.6 The labour efficiency variance is calculated as

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 a. (Actual direct labour hours used – Standard direct labour hours that should have
been used) × Actual direct labour hours used
b. (Actual hourly wage rate – Standard hourly wage rate) × Standard direct labour
hours that should have been used
c. (Actual direct labour hours used – Standard direct labour hours that should have
been used) × Actual hourly wage rate
d. (Actual direct labour hours used – Standard direct labour hours that should have
been used) × Standard hourly wage rate

Exercise 2
Max Company has developed the following standards for one of its products:

Direct materials 15 kg @ R16 per pound

Direct labour 4 hours @ R24 per hour
Variable overheads 4 hours @ R14 per hour

The following activities occurred during the month of October 20x1:

Materials purchased 10 000 kg costing R170 000

Materials used 7 200 kg
Units produced 500 units
Direct labour 2 300 hours at R23,60 per hour
Actual variable overheads R30 000

The company records materials price variances at the time of purchase.

2.1 The variable standard cost per unit would be

a. R392
b. R336
c. R296
d. R152

2.2 The materials price variance would be

a. R50 000 favourable
b. R50 000 unfavourable
c. R10 000 unfavourable
d. R10 000 favourable

2.3 The materials usage variance would be

a. R40 000 unfavourable
b. R40 000 favourable
c. R4 800 unfavourable
d. R4 800 favourable

2.4 The labour rate variance would be

a. R920 unfavourable
b. R920 favourable
c. R800 unfavourable
d. R800 favourable

2.5 The labour efficiency variance would be

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 a. R7 200 unfavourable
b. R7 200 favourable
c. R6 280 unfavourable
d. R6 280 favourable

Exercise 3
Grunter Ltd sells two types of product: Ras and Som. The following information for April 20x1
is available:

Budgeted information
Product Unit sales Standard selling price per unit Standard cost price per unit
Ras 15 000 R4,80 R2,25
Som 75 000 R2,10 R1,11
Actual information
Product Unit sales Total sales Total cost
Ras 18 000 85 500 R40 680
Som 82 000 173 840 R94 300

Required
Calculate the following variances for each product and in total:
3.1 Sales price variance.
3.2 Sales quantity variance.

Exercise 4
Alpha Beta Ltd manufactures two types of product: A and B. The following actual and
budgeted information is available for December 20x1:

Product A Product B
Budgeted information
Standardised selling price R5,00 R8,00
Standardised cost price R3,35 R5,70
Sales 8 000 units 4 000 units
Actual information
Sales R39 000 (7 500 units) R27 750 (3 900 units)

Required
Calculate the following variances for each product and in total:
4.1 Sales price variance.
4.2 Sales quantity variance.
Where necessary round off final answer to two decimal places.

Exercise 5
A manufacturer of a single product line has provided you with the following actual and
standard information for April 20x7:

Product manufactured

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 Product manufactured
Budgeted information:
Standard selling price R15
Standard cost price R10
Sales 8 000 units
Actual information:
Sales 7 200 units
Sales value R117 000

Required
Calculate the sales price and sales quantity variance.

Exercise 6
The following question comprises three independent sections.
6.1 The following materials standards have been established for a particular product:

Standard quantity per unit of output is 3,6 metres @ R10,20 per metre

The following data pertain to operations concerning the product for the last month:

Actual materials purchased 7 100 metres

Actual cost of materials purchased R68 515
Actual materials used in production 6 600 metres
Actual output 1 780 units

Required

6.1.1 What is the materials price variance for the month?

6.1.2 What is the materials quantity variance for the month?

6.2 The following labour standards have been established for a particular product:

Standard labour hours per unit of output 2,8 hours

Standard labour rate R11,50 per hour
The following data pertain to operations concerning the product for the last month:
Actual hours worked 6 900 hours
Actual total labour cost R80 385
Actual output 2 300 units

Required

6.2.1 What is the labour rate variance for the month?

6.2.2 What is the labour efficiency variance for the month?

6.3 The following standards for variable manufacturing overheads have been established for
a company that makes only one product:

Standard hours per unit of output 6,9 hours

Standard variable overheads rate R15,80 per hour
The following data pertain to operations for the last month:
Actual hours 6 100 hours
Actual total variable overheads cost R97 600
Actual output 800 units

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 Required

6.3.1 What is the variable overheads spending variance for the month?
6.3.2 What is the variable overheads efficiency variance for the month?

Exercise 7
Bratz Ltd is a company specialising in custom-made evening dresses. It caters to each
individual customer’s needs by tailor-making a dress according to the specifications it
receives.
A standard cost card for one of its products, Kelso Nite Out, is given below:

R
Selling price 250,00
Production costs:
Direct materials: 12 metres per Kelso Nite Out 18,00
Direct labour: 4 hours per Kelso Nite Out 24,00
Overheads 100,00
Gross profit 108,00

The budgeted production for the month of June 20x1 is 1 000 units.
Actual results for the production and sale of the Kelso Nite Out were as follows:

Sales – 1 200 units at R240,00 each

Production was 1 300 units
Direct materials – 6 000 metres at a cost of R22 400
Direct labour – 5 000 hours at R6,00 per hour
Variable overheads – R75 500
Fixed overheads per unit are R85,00.
The actual profit for June 20x1 was R119 700

Required
Calculate the following variances:
7.1 Material price
7.2 Material usage
7.3 Total materials variance
7.4 Labour rate
7.5 Labour efficiency
7.6 Total labour variance
7.7 Variable overheads efficiency
7.8 Variable overheads spending

Exercise 8
Deshayne Ltd produces and sells high-quality rubber for vehicles. An extract from the
company’s most recent income statement is given below:

Sales R400 000

Less: Variable costs
Direct materials (R98 800)
Direct labour (R78 800)
Variable factory overheads (R14 400)

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 Contribution margin R208 000

The company uses a standard costing system for planning and control purposes. The
standard cost and usage per unit are:

Direct materials 6,4 metres R76,80

Direct labour 2,8 labour hours R56,80
Variable overheads 1,4 machine hours R11,20
R144,00

As indicated above, the variable overheads cost is applied to products on the basis of
machine hours. The company has produced and sold 5 000 units at R160,00 per unit.

Actual information
Direct materials of 15 200 metres at R197 600
Direct labour cost of R157 600 at R19,70 per hour
Variable overheads cost of R28 800 at R7,20 per hour

Required
Determine the following variances:
8.1 Direct materials price variance
8.2 Direct materials usage variance
8.3 Direct labour rate variance
8.4 Direct labour efficiency variance
8.5 Variable overheads spending variance
8.6 Variable overheads efficiency variance

Exercise 9
SC Ltd produces a single product of which the standard cost of one unit for June 20x1 was as
follows:

Direct material (4,8 kg @ R6 per kg) R28,80

Direct labour (6 hrs @ R9 per hour) R54,00
Overheads (R4 per labour hour) R24,00
R106,80

The standard selling price of one unit was R150 and budgeted sales were 1 800 units. All
overheads are fixed in nature.
The actual results were as follows:

1 950 units were made and sold for a total of R302 250.
Direct materials used were 10 000 kg at a total cost of R58 000.
Direct labour was 12 500 hours at a cost of R115 000.
Actual fixed overheads were R48 200.

Required
9.1 Calculate the following variances:
a. Materials price variance
b. Materials usage variance
c. Labour rate variance

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 d. Labour efficiency variance
e. Fixed overheads expenditure
f. Fixed overheads volume
9.2 Calculate the expected profit and prepare a variance report for management, reconciling
the standard profit expected with the actual profit.

Exercise 10
FISRICK Interiors had the following standard information available for the year 20x4.
Standard absorption product cost data is as follows:

Cost per unit

Direct material (8 kg) R80,00
Direct labour (R15 per hour) R30,00
Variable overheads R40,00
Fixed overheads R90,00
Total product cost R240,00
Selling price per unit R250,00

The following actual results in the form of an income statement for October 20x4 with actual
production and sales of 12 500 units.

R
Direct material (105 000 used) 1 025 000
Direct labour (27 000 hours) 360 000
Variable overheads (27 000 hours) 490 000
Fixed manufacturing overheads 1 060 000

Variable manufacturing overheads are based on direct labour hours, while fixed
manufacturing overheads are allocated based on units of production. Budgeted production
and sales were 12 000 units. The actual selling price was R300 per unit.

Required
10.1 Calculate the materials price variance.
10.2 Calculate the materials usage variance.
10.3 Calculate the labour rate variance.
10.4 Calculate the labour efficiency variance.
10.5 Calculate the variable overheads spending variance.
10.6 Calculate the variable overheads efficiency variance.
10.7 Calculate the fixed overheads spending variance.
10.8 Calculate the fixed overheads volume variance.

TEST YOURSELF SOLUTIONS

TEST YOURSELF 16.1 SOLUTION

1. Sales price variance

= Standard price − Actual sales
Product M
= (1 100 × R40) − 39 600
= 44 000 − 39 600
= 4 400 u

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 Product N
= (720 × R20) − 15 840
= 14 400 − 15 840
= 1 440 f
Total sales price variance
= 4 400 u + 1 440 f
= 2 960 u
2. Sales quantity variance
= (Actual sales volume – Budgeted sales volume) × Standard gross profit per unit
Product M
= (1 100 − 1 200) × (40 − 20)
= 100 × 20
= 2 000 u
Product N
= (720 − 800) × (20 − 10)
= 80 × 10
= 800 u
Total sales quantity variance
= 2 000 u + 800 u
= 2 800 u

TEST YOURSELF 16.2 SOLUTION

a. materials price variance

= 52 000 metres × (R13,70 − R14,00)
= R15 600 F
b. materials usage variance
= (40 000 metres × R14) − (11 000 units × 4 metres × R14)
R56 000 F
c. labour rate variance
= R840 000 − (84 000 hours × R10)
= R-0-
d. labour efficiency variance
= (84 000 hours × R10) − (11 000 units × 8 hours × R10)
= R40 000 F
e. variable overheads spending variance
= R756 000 − (84 000 hours × R8)
= R84 000 U
f. variable overheads efficiency variance
= (84 000 hours × R8) − (11 000 units × 8 hours × R8)
= R32 000 F
g. fixed overheads spending variance
= R1 000 000 − R960 000
= R40 000 U
h. fixed overheads volume variance
= R960 000 − (11 000 units × 8 hours × R12)
= R96 000 F

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 17 Time value of money

Outcomes

At the end of this chapter students should be able to

understand the concepts of cash flow and the time value of money
calculate interest
calculate the time value of money.

Chapter outline

17.1 Introduction
17.2 Cash flow and other time value of money concepts
17.3 Interest
17.3.1 Simple interest
17.3.2 Compound interest
17.3.3 Nominal rate
17.3.4 Effective rate
17.4 Formulae used in calculating the time value of money
17.4.1 Present value of a single cash flow
17.4.2 Present value of an ordinary annuity
17.4.3 Present value of an annuity due
17.4.4 Present value of a perpetuity
17.4.5 Future value of a single cash flow
17.4.6 Future value of an ordinary annuity
17.4.7 Future value of an annuity due
17.4.8 Repayment of loan/annual instalment
17.4.9 Loan amortisation

17.1 Introduction

The time value of money implies that a particular sum of money in your hand today is worth
more than the same sum at some future date. For example, given the choice between receiving
R1 000 today or R1 000 a year from now, you should take the money today. In this chapter, we
will explain the basic concepts related to the time value of money and illustrate selected
calculations using basic mathematical principles, expressed as formulae. The time value of
money is important, because the majority of business decisions boil down to a trade-off between

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 spending or borrowing money today and receiving or paying back money in the future. Financial
managers use the time value of money principle as a tool to determine how much money an
organisation must earn in the future to justify today’s expenditures on investments.

17.2 Cash flow and other time value of money concepts

Cash flow is any receipt (cash inflow) or payment (cash outflow) of money that occurs at a
specific point in time. Cash flows form the basis of time value of money calculations and are
either single cash flows, annuities or unequal cash flows.

Single cash flows This is a once-off cash inflow or outflow.

Annuity This is a stream of equal receipts or payments at equal intervals of
time.
Ordinary annuity This is an annuity where the payments take place at the end of each
period at the same time that interest is calculated.
Perpetuity This is an annuity where the payments continue forever.
Annuity due This is an annuity where the payments are due at the beginning of each
period.
Compounding This refers to the calculation of interest on a principal amount and then
adding that interest to the principal amount in the subsequent period.
The investment grows in each subsequent period by the amount of
interest it would earn over the period. Compounding calculates the
future value of a sum invested today for a number of years.
The cost of capital This is the rate of interest used by the organisation when determining
the time value of money. Alternative terms used are discount rate and
required rate of return.
Discounting This is the reverse of compounding. It considers the future value and
establishes its equivalent value today (present value). It involves
removing the interest that is embedded in the future value.
Future value (FV) The future value is the amount that an investment will be worth at a
future date if invested at a particular simple or compound interest rate.
Present value This is the value of the future value in today’s terms determined by the
(PV) application of the discount rate.

17.3 Interest

Interest is the price paid for money borrowed or received for money invested. If you borrowed a
sum of money from the bank for a certain period of time, you will have to pay the bank for the
use of the money. The percentage agreed on between the borrower and the lender is the interest

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 rate. In this section we will discuss the following two types of interest rates that apply in time
value of money calculations: simple interest and compound interest.

17.3.1 Simple interest

Simple interest is the interest calculated on the amount of money originally borrowed (or
invested), referred to as the principal (P). Simple interest means accruing the same amount of
interest each year based on the same principal amount. Interest is not earned on accrued interest.
The amount of interest can be calculated using the following formula:

I=P×i×n

The final amount (principal plus interest) can be calculated as:

A = P(1 + i × n)

Where:

I = interest
P = principal
i = interest rate
n = time
A = Final Amount

ILLUSTRATIVE EXAMPLE

Mr Sipho invests R6 000 at 10% simple interest for four years. How much interest will his
investment accrue and what amount will he receive at the end of the four years?
Solution
The interest accrued will be:

I = P×i×n
= R6 000 x 10% x 4
= R2 400

The value of the investment after four years will be:

A = P(1 + i × n)
= R6 000[1 + (10% x 4)]
= R8 400

Alternatively, the value of the investment after four years can be calculated as:

Principal amount R6 000

Add: The interest accrued for the three years (R6 000 × 10% × 4 years) R2 400
Future value R8 400

17.3.2 Compound interest

When we borrow or invest money at a compound interest rate, the interest due at the end of each
year is added to the amount of the original loan or investment. The following year’s interest is

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 then calculated on the new balance, consisting of the principal and the interest portion that was
added. It therefore refers to interest that is earned on interest.

Money invested at compound interest increases quicker in value, which is why compound
interest is preferred over simple interest. For example, repayments on loans from banks and
housing bonds are usually based on compound interest. The final amount, including the
investment plus any interest can be calculated as:

A = P(1 + i)n

When interest is compounded more frequently, that is more than once per annum, then the
formula can be adapted as:

Semi-annually: A = P(1 +
i
)
years×2

Quarterly A = P(1 +
i
)
years×4

Monthly: A = P(1 +
i
)
years×12

12

Weekly: A = P(1 +
i
)
years×52

52

ILLUSTRATIVE EXAMPLE

Mr Sanders invests R6 000. Interest is at 10% per year compounded annually. How much will
he receive at the end of four years?
Solution
The value of the investment after four years, including capital and interest, will be:

A = P(1 + i)n
= R6 000 (1 x 0.10)4
= R6 000 (1,4641)
= R8 784,60
= R8 785

Alternatively, the value of the investment after four years can be calculated as:

Year Interest calculation Interest Balance

1 R6 000 × 0,10 R600 R6 600
2 R6 600 × 0,10 R660 R7 260
3 R7 260 × 0,10 R726 R7 986
4 R7 986 × 0,10 R799 R8 785

The future value of the investment has grown to R8 785 using compound interest. You will
have noticed how the annual interest earned increases, therefore compound interest is when
interest is payable on both capital and accumulated interest. It assumes reinvestment of the
interest receivable at the end of the year, at the same interest rate.
Other interest rates that we apply in time value of money calculations are nominal and
effective interest rates, where the compounding takes place more than once per year.

TEST YOURSELF 17.1

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 Dr Haruna Maama invests R100 000 at 8% simple interest for three years. How much interest
will his investment accrue and what amount will he receive at the end of the three years?
Should he invest at 8% per annum compounded annually instead?

17.3.3 Nominal rate

This is known as the quoted rate in cases where interest is calculated more than once a year. The
adjustment of compounding is not taken into account. For example, if the bank quotes you a rate
of 10% compounded monthly, the nominal rate is 10% even though the true interest will be
much more, since there is compounding.

If the effective rate is known, then the nominal rate can be calculated as follows:
1

n
Nominal rate = n [(1 + i) − 1]

Where:

i = the effective interest rate

n = the number of compounding periods per annum

ILLUSTRATIVE EXAMPLE

The effective interest rate of a loan is 15% per annum. Interest is compounded every quarter.
Calculate the nominal rate.
Solution
1

Nominal rate = 4 [(1 + 0,15)

4
− 1]

0.25
= 4 [(1,15) − 1]

= 0,1422

= 14,22%

Therefore, the nominal rate (quoted rate) is 14,22%.

17.3.4 Effective rate

This is the rate of interest actually earned in one year after taking into account the adjustment of
compounding. For example, if the bank quotes you a rate of 10% compounded monthly, the
effective rate will be much more, since there is compounding. It can be calculated using the
following formula:
n
I
Ef f ective rate = (1 + ) − 1
n

Where:

I = the nominal interest rate (quoted rate)

n = the number of compounding periods per annum

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 I
= the periodic rate (rate per period)
n

ILLUSTRATIVE EXAMPLE

The nominal interest rate on a loan is 15% per annum compounded semi-annually. Calculate
the effective interest rate of the loan.
Solution
n
I
Ef f ective rate = (1 + ) − 1
n

2
0,15
= (1 + ) − 1
2

= 0,1556

= 15,56%

Therefore the actual interest paid on the loan is 15,56%.

TEST YOURSELF 17.2

You want to invest money in order to pay your university fees. Two options are available:
(a) Use a special savings account that pays 1% interest compounded monthly.
(b) Use a premium savings account with a 12% quoted nominal interest rate per annum,
compounded quarterly.
Which option will you choose?

17.4 Formulae used in calculating the time value of money

Financial managers use the time value of money principles to justify expenditures on new
investments. It is therefore important to have an understanding of the various ways that the
future and present values may be calculated, i.e. mathematical formulae, factor tables (at the end
of the chapter) and financial calculators. The latter method is beyond the scope of this textbook
and will not be discussed.

17.4.1 Present value of a single cash flow

The mathematical formula used for calculating the present value of a single cash flow is:

1
PV = FV [ ]
n
1 + i

Where:

PV = present value
FV = future value

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 i = interest rate
n = number of periods

Table A, at the end of the chapter, presents the present value factors of a single cash flow. The 1
÷ (1 + i)n in the mathematical formula can be replaced by the applicable factor from the table,
instead of calculating it mathematically.

ILLUSTRATIVE EXAMPLE

In three years from now, you want to buy a vehicle to the value of R150 000. What is the
amount that you must invest now at 10% compound interest per annum in order to reach your
goal of R150 000 at the end of the three-year period?
Solution
The present value of a single cash flow can be calculated using the mathematical approach
as follows:

1
PV = FV [ n ]
1+i

1
= 150 000 [ 3
]
1+0,10

= 150 000 × 0,751

= R112 650

Using the table approach, the factor can be found in Table A using a discount rate of 10% and
three years as the number of periods:

PV = FV × PVIF10%;3

= R150 000 × 0,751

= R112 650

17.4.2 Present value of an ordinary annuity

The mathematical formula used for calculating the present value of an ordinary annuity (annuity
received at the end of the period) is:

1
PV = PMT [1 − n
]
(1+i)

Where:

PMT = annuity amount (payment)

Table B, at the end of the chapter, presents the present value factors of cash flows invested at the
end of each period. The equation in the square brackets in the mathematical formula can be
replaced by the applicable factor from the table, instead of calculating it mathematically.

ILLUSTRATIVE EXAMPLE

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 An amount of R5 000 is to be invested annually at the end of each year for five years at 10%
compound interest per annum. Determine the present value of this annuity.
Solution
Using the mathematical approach, the present value can be calculated as follows:

1
PV = PMT [1 − n ]
(1+i)

1
= 5 000 [1 − 5
]
(1+0,10)

0,10

= R5 000 × 3,791

= R18 955

Using the table approach, the factor can be found in Table B using a discount rate of 10% and
five years as the number of periods:

PV = FV × PVIFA10%;5

= R5 000 × 3,791

= R18 955

17.4.3 Present value of an annuity due

ILLUSTRATIVE EXAMPLE

An amount of R6 000 is to be invested annually at the beginning of each year for three years
at 10% compound interest per annum. Determine what the present value of this annuity will
be at the beginning of the first year.
Solution
= R6 000 × [1,7355 + 1]
= R6 000 × 2,7355
= R16 413

Using the table approach:

This is an annuity due (received/paid at the beginning of the period): Table B shows the PV
factors of annuities received/paid at the end of the year for n years. The factor must be
adjusted from Table B. Use the Table B factor of the previous period (n – 1) and add 1
000.
PV = Annuity × Present value of R1 per period factor (Table B)
= R6 000 × 2,736*
= R16 416
*Table B at 10% for two years = 1,736 + 1,000 = 2,736
The present value of the annuity due is R16 413 (rounded off to the nearest rand). The slight
difference of R3 is because of the rounding off of the factors in Table B to three decimals.

17.4.4 Present value of a perpetuity

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 A perpetuity means that the cash flow will be received or paid periodically at certain time
intervals into infinity, since there is no termination date.

The formula used for calculating the present value of a perpetuity (PVP) is:

Annual return (received or paid)

PVp =
Interest rate or required return

ILLUSTRATIVE EXAMPLE: Present value of a perpetuity

Miss Cami sought advice from her financial advisor, as she wants to establish a trust fund by
investing an amount of money at 15% compounded annually. She wants to receive R30 000
per year indefinitely from the trust fund. What is the present value of the amount that she will
have to invest now?

Solution
Annual return (received or paid)
PVp =
Interest rate or required return

R30 000
=
0,15

= R200 000

17.4.5 Future value of a single cash flow

The mathematical formula used for calculating the future value of a single cash flow is:

FV = PV(1 + i)n

Table C, at the end of the chapter, presents the future value factors of a single cash flow. The (1
+ i)n in the mathematical formula can be replaced by the applicable factor from the table, instead
of calculating it mathematically.

ILLUSTRATIVE EXAMPLE

If you invest R10 000 now at 20% compound interest over a four-year period, what amount
will you receive at the end of the three years?

Solution
Using the mathematical approach, the future value of a single flow can be calculated as
follows:
n
FV = PV × (1 + i)

4
= R10 000 × (1 + 0,20)

= R10 000 × 2,074

= R20 740

We can replace (1 + i)n with the applicable FV factor from Table C, instead of calculating it
mathematically. Using the table approach, the factor can be found in Table C using a discount
rate of 20% and four years as the number of periods:

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 FV = PV × FVIF20%;4

= R10 000 × 2,074

= R20 740

17.4.6 Future value of an ordinary annuity

The mathematical formula used for calculating the future value of an ordinary annuity (annuity
received at the end of the period) is:
n
(1 + i) − 1
FV = PMT [ ]
i

Table D, at the end of the chapter, presents the future value factors of cash flows invested at the
end of each period. The equation in the square brackets in the mathematical formula can be
replaced by the applicable factor from the table, instead of calculating it mathematically.

ILLUSTRATIVE EXAMPLE

A person would like to invest R5 000 at the end of each year at an annual interest rate of
14%. What is the value of the investment after four years?

Solution
Using the mathematical approach, the future value can be calculated as follows:
n
(1+i) −1
FV = PMT [ ]
i

4
(1+0,14) −1
= R5 000 [ ]
0,14

= R5 000 × 4,921

= R24 605

We can replace [ (1+i) −1

i
] with the applicable FV factor from Table D, instead of calculating it
mathematically. Using the table approach, the factor can be found in Table D using a discount
rate of 14% and four years as the number of periods:
FV = PV × FVIFA14%;4

= R5 000 × 4,921

= R24 605

17.4.7 Future value of an annuity due

ILLUSTRATIVE EXAMPLE

Mr Hayne intends to establish a savings account for his daughters’ university education when
they enter high school. He will make payments of R5 000 each into this account at the
beginning of each year and will earn compound interest of 8% per annum on his investment.
You are required to calculate the future value of the annuity due after five years when his
daughters will have finished high school.

Solution
Using the mathematical approach, the future value can be calculated as follows:

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 n+1
(1+i) −1
FV = PMT [ − 1]
i

5+1
(1+0,08) −1
= R5 000 [ − 1]
0,08

= R5 000 × (7,3359– 1)

= R5 000 × 6,3359

= R31 680

This formula differs from the FV formula for an ordinary annuity only in that –1 is subtracted
(to recognise the first payment that is paid now) and 1 is added to the number of periods (n +
1), since the first payment was made at the beginning of the year and was already accounted
for when 1 was subtracted.
Using the table approach, the factor can be found in Table D using a discount rate of 8% and
five years as the number of periods. Thereafter the factor must be multiplied by (1 + i) to
arrive at the factor at the beginning of the period. Alternatively, using Table C, add the factors
for periods one to five at a discount rate of 8%.
FV = PMT × FVIFA8%;5 × 1,08

= R5 000 × (5,8666 × 1,08)

= R5 000 × 6,3359

= R31 680

TEST YOURSELF 17.3

Using the tables, determine the factors for the following:

(a) The future value of R1 after five periods at 16% per period.
(b) The present value of R1 after 10 periods at 14% per period.
(c) The future value of R1 per period after eight periods at 10% per period.
(d) The present value of R1 per period after 14 periods at 15% per period.

17.4.8 Repayment of loan/annual instalment

ILLUSTRATIVE EXAMPLE

Your client wants to obtain a loan to finance a new vehicle. His bank offers him a loan to the
value of R120 000 at 16% interest per annum, repayable in equal annual instalments over six
years, including capital and interest. Your client has asked you to calculate the amount of the
instalment that he will have to pay each year.

Solution
Present value
Annuity =
Present value of R1 per period f actor @ i; n

Present value
Annuity =
Present value of R1 per period f actor @16%; 6 years

R120 000

3,685

= R32 564

17.4.9 Loan amortisation

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 A loan amortisation schedule will show you how much your loan reduces by every period, over
the full period of the loan. You can determine how much of your instalment goes towards
interest and how much towards reducing the capital (actual loan amount).

ILLUSTRATIVE EXAMPLE

Using the previous example, where the instalment for a 16% loan of R120 000 for a period of
six years was calculated as R32 564, the amortisation schedule will be shown as follows:

Year Opening balance Interest Instalment Closing balance

R R R R
1 120 000 19 200 32 564 106 636
2 106 636 17 061,76 32 564 91 133,76
3 91 133,76 14 581,40 32 564 73 151,16
4 73 151,16 11 704,19 32 564 52 291,35
5 52 291,35 8 366,62 32 564 28 093,97
6 28 093,97 4 495,04 32 564 (25,01)*
Difference due to rounding.

TEST YOURSELF 17.4

To expand its operations, Sencam International has applied to Capitec Bank for a three-year
R3 500 000 loan.

Required
Calculate the instalment. Prepare a loan amortisation table assuming a 10% interest rate.

TUTORIAL EXERCISES

Exercise 1
Match the following concepts to the correct definitions:

1.1 the present A It is the amount that an investment will be worth at a future date
value if invested at a particular simple or compound interest rate.
concept
1.2 the future B It is the current value of future cash flows, determined by the
value application of a discount rate.
concept
1.3 compound C It is the process used to determine the present value of an
interest investment.
1.4 simple D It is the interest on the principal investment for the entire term.
interest
1.5 the concept E It is the calculation of interest and the addition of that interest to
of the principal for investment in the following period.
discounting
1.6 unequal F It is a non-repetitive cash inflow or outflow.

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 cash flows
1.7 a single cash G It is an annuity where the payments continue indefinitely.
flow
1.8 an ordinary H It is the unequal cash flows that occur repetitively at the end of
annuity each payment interval.
1.9 a perpetuity I It is an annuity where the payments fall due at the beginning of
each period.
1.10 an annuity J It is an annuity where the payments take place at the end of
due each payment interval.

Exercise 2
Identify whether the following statements are true or false:
2.1 An ordinary annuity is an annuity for which the cash flow occurs at the beginning of each
period.
2.2 Time value of money is based on the belief that a rand that will be received at some
future date is worth more than a rand today.
2.3 Annuity due is an amount that occurs at the beginning of each period.
2.4 Starting to invest early for retirement reduces the benefits of compound interest.
2.5 If a bank compounds savings accounts quarterly, the nominal rate will exceed the
effective annual rate.
2.6 The present value of a future sum decreases as either the discount rate or the number of
periods per year increases; other factors remain constant.
2.7 As a result of compounding, the effective annual rate on a bank deposit (or a loan) is
always equal to or greater than the nominal rate on the deposit (or loan).
2.8 When a loan is amortised, a relatively high percentage of the payment goes to reducing
the outstanding principal in the early years, and the percentage of the principal
repayment declines in the later years of the loan.
2.9 Interest earned on a given deposit that has become part of the principal at the end of a
specified period is called compound interest.
2.10 The nominal and effective rates are equivalent for annual compounding.

Exercise 3
Elda du Toit borrows R100 000 to start a business. She will repay the capital plus interest
after five years. The bank quotes as follows:

a) 12% p.a. simple interest, or

b) 11% p.a. compound interest, compounded annually, or
c) 10,25% p.a. compound interest, compounded monthly.

3.1. Calculate the amount payable in each case (a) to (c).

3.2. Calculate the interest in each case (a) to (c).
3.3. Which is the cheapest option?

Exercise 4
This question consists of six independent sub questions. Answers must be calculated
correctly to four decimals and one-tenth of a percent. Show all your workings.
4.1 Determine the present value of an annuity of R40 000 received at the end of each period
for 10 periods, at a discount rate of 8% per period.

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 4.2 Determine the present value of an annuity of R40 000, received at the beginning of each
period for 10 periods, at a discount rate of 8% per period.
4.3 Determine the future value of an amount of R30 000, invested at the end of each period
for 10 periods, at an interest rate of 8% per period.
4.4 Determine the future value of an amount of R30 000, invested at the beginning of each
period for 10 periods, at an interest rate of 8% per period.
4.5 Determine the effective interest rate for a savings account which bears interest at a
nominal rate of 6% per annum, compounded monthly.
4.6 Determine the nominal interest rate for a loan which bears interest at an effective rate of
6% per annum, if interest is compounded half-yearly.

Exercise 5
Calculate the final amount in each case
5.1 Joe Biden invested R5 000 for five years at 9% p.a. simple interest.
5.2 Sipho Dlomo invested R8 000 for three years at 8,8% p.a. simple interest.
5.3 Kamala Harris invested R11 000 for 10 years at 7,45% p.a. simple interest.
5.4 Jiya Maharaj invested R5 000 for five years at 9% p.a. compound interest, compounded
annually.
5.5 Bongekile Nyawo invested R8 000 for three years at 8,8% p.a. compound interest,
compounded annually.
5.6 Sasha Pillay invested R11 000 for 10 years at 7,45% p.a. compound interest,
compounded annually.

Exercise 6
Zwelihle Nzuza inherited R12 500 from his grandmother which he invested at a nominal
interest rate of 8,5% p.a. compounded monthly.
Required
a. Calculate the effective interest rate.
b. Calculate the value of the investment after five years by using the effective investment
rate.
c. Check your answer in (b) by using the nominal interest rate.

Exercise 7
Listed below are multiple-choice questions. Choose the most appropriate option for each
statement.

7.1 An amount of R5 000 is invested now at a rate of 8% per annum. What will be the value
of the investment after five years, if simple interest is added once at the end of the
period?
a. R5 400
b. R7 000
c. R6 600
d. R4 600

7.2 If a single amount of R12 000 is invested at 8% per annum with interest compounded
quarterly, the amount to which the principal will have grown by the end of year three is
approximately
a. R15 117
b. R14 880

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 c. R15 218
d. R15 880

7.3 What is the present value of R2 000 payable in two years’ time, if the interest rate is 8%
per annum, compounded annually?
a. R1 747
b. R1 714
c. R2 280
d. R2 140

7.4 The future value of an ordinary annuity of R1 000 each year for 10 years, deposited at
3%, is
a. R11 800
b. R1 344
c. R10 000
d. R11 464

7.5 The future value of a R2 000 annuity due deposited at 8%, compounded annually for
each of the next 10 years, is
a. R28 974
b. R31 292
c. R14 494
d. R13 420

7.6 The present value of an ordinary annuity of R3 500 each year for five years at a discount
rate of 12% is
a. R1 985
b. R12 618
c. R6 168
d. R3 920

Exercise 8
Calculate the following time value of money problems and show all workings, including
formulae used:
8.1 The present value of R100 received at the end of year one, R200 received at the end of
year two, and R300 received at the end of year three, assuming an opportunity cost of
13%.
8.2 The future value of R200 received today and deposited at 8% for three years.
8.3 The present value of R200 to be received 10 years from today, assuming an opportunity
cost of 10%.
8.4 If the present value interest factor for i percent and n periods is 0,270, the future value
interest factor for the same i and n is …?
8.5 A generous benefactor to the local ballet plans to make a once-off endowment which
would provide the ballet with R150 000 per year into perpetuity. The rate of interest is
expected to be 5% for all future time periods. How large must the endowment be?
8.6 What is the future value of a R10 000 annuity due deposited at 12% compounded
annually for each of the next five years?

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 8.7 Calculate the future value of an ordinary annuity of R2 000 each year for 10 years,
deposited at 12%.
8.8 Calculate the future value of R10 000 received today and deposited for six years in an
account that pays interest of 12%, compounded quarterly.

Exercise 9
Kim Misra buys a lounge suite with a value of R6 500. She pays a deposit of 10%. Simple
interest is paid on the balance at 14% p.a. for three years.

Required
9.1. Calculate the total amount she has to repay after three years.
9.2. Calculate how much money she has to pay monthly if she wants to repay the amount in
9.1. in 36 equal monthly instalments.

Exercise 10
10.1 Your dad has borrowed R12 000 at a rate of 10% from a finance company and must
repay it in four equal instalments at the end of each of the next four years. How large would
his payments be?
10.2 You have borrowed R14 000 from the bank at a rate of 10% and must repay it in five
equal instalments at the end of each of the next five years. How much interest would
you have to pay in the first year?
10.3 You plan to borrow R35 000 at a 7,5% annual interest rate. The terms require you to
amortise the loan with seven equal end-of-year payments. How much interest would
you be paying in year two?
10.4 Tiago borrows R15 000 from Capital Bank at 10% annually compounded interest to be
repaid in six equal installments. Calculate the interest paid in the second year using an
amortisation table.

The four basic factor tables included at the end of this chapter are as follows:

Table A: Present value of R1 AFTER n years (cash flow occurs at END of period)
Table B: Present value of R1 per annum received FOR n years (cash flow occurs at
END of period)
Table C: Future value of R1 AFTER n years (cash flow occurs at BEGINNING of
period)
Table D: Future value of R1 per annum received FOR n years (cash flow occurs at
END of period)

TEST YOURSELF SOLUTIONS

TEST YOURSELF 17.1 SOLUTION

The interest accrued will be:

I = P×i×n
= R100 000 × 8% × 3
= R24 000

The value of the investment after three years will be:

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 A = P(1 + i × n)
= R100 000 [1 + (8% × 3)]
= R124 000

Should he invest at 8% per annum, compounded annually, the value of the investment after
three years, including capital and interest, will be:

A = P(1 + i)n
= R100 000(1 × 0,08)3
= R100 000(1,259712)
= R125 971,20
= R125 971

Therefore, Dr Maama should choose to invest at the compound interest rate.

TEST YOURSELF 17.2 SOLUTION

Firstly, you need to express the cost (interest) of each option as an EAR (effective
annual rate) as follows:

(a) Special savings account:

EAR = (1 + 0,01)12 − 1,0
= (1,01)12 – 1,0
= 1,1268 – 1,0
= 0,1268
= 12,68%
(b) Premium savings account:
EAR = (1 + 0,03)4 – 1,0
= (1,03)4 – 1,0
= 1,1255 – 1,0
= 0,1255
= 12,55%

TEST YOURSELF 17.3 SOLUTION

Using the tables, the factors will be as follows:

(a) The future value of R1 after five periods @ 16% per period
FVIF of R1 = 2,1003
(b) The present value of R1 after ten periods @ 14% per period
PVIF of R1 = 0,270
(c) The future value of R1 per period after eight periods @ 10% per period
FVIF of R1 per period =11,436
(d) The present value of R1 per period after 14 periods @ 15% per period
PVIF of R1 per period = 5,724

TEST YOURSELF 17.4 SOLUTION

Instalment = PMT ÷ PVIFA10%;3
= 3 500 000 ÷ 2,487
= R1 407 318,05

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 Year Opening Interest Instalment Closing balance
balance R R R
R
0 3 500 000,00 0
1 1 057 318,05 350 000,00 1 407 318,05 2 442 681,95
2 1 163 049,85 244 268,20 1 407 318,05 1 279 632,10
3 1 279 354,84 127 963,21 1 407 318,05

Table A Present value of R1 received/paid after n years

Formula: 1

(1+i)
n

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 Table B Present value of R1 per annum received/paid at the end of the year for n
years

Formula: [1 − 1
(1+i)
n ]
i

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 Table C Future value of R1 received now, after n years

Formula: (1 + 1)n

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 Table D Future value of R1 per annum received for n years at the end of each
year
n

Formula:
(1+i) −1

Click here to download PDF versions of Tables A, B, C and D

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 18 Capital budgeting

Outcomes

At the end of this chapter, students should be able to

describe the capital budgeting process

explain the purpose of investment appraisal
identify athe relevant cash flows of a project
analyse the costs, benefits and risks of an investment project
calculate the payback period, net present value and internal rate of return of a project
evaluate investment projects.

Chapter outline

18.1 Introduction
18.2 Capital budgeting process
18.3 Categories of capital budgeting projects
18.4 Why do organisations use investment appraisal?
18.5 Relevant and irrelevant cash flows in investment appraisal
18.6 Capital budgeting techniques
18.6.1 Payback method
18.6.2 Accounting rate of return
18.6.3 Net present value
18.6.4 Profitability index
18.6.5 Internal rate of return

18.1 Introduction

Organisations need to make important decisions regarding which long-term projects (fixed
assets such as property, plant and equipment) they should undertake that will generate returns,
and which they should reject. To arrive at such decisions, organisations use the capital budgeting
process.

A profit-making organisation will have to provide appropriate returns to those who have
invested their money in it. To achieve that, the organisation will have to identify projects that are
suitable and that can provide the organisation itself with such appropriate returns.

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 The capital budgeting process involves the maximisation of shareholder wealth. Therefore, in
striving to maximise the wealth of shareholders, an organisation must bear in mind the needs of
stakeholders other than shareholders, such as suppliers, employees and the general public.

18.2 Capital budgeting process

Capital decisions are very costly, and therefore mistakes will involve very high costs if they are
to be reversed. It is very important to plan well for capital investments. This will involve a lot of
people both inside and outside the organisation, and hence this contributes to the complexity of
the process.

The capital investment process has six stages, including the following:

STAGE 1: SCREENING STAGE

Organisations must screen the various types of capital investment project that are necessary in
order to achieve its objectives. It is the responsibility of management to identify various capital
investment projects available to invest in, based on the organisation’s strategies.

STAGE 2: SEARCH STAGE

At this stage, organisations need to obtain more information regarding the alternative investment
projects that are available. This will enable them to make more informed decisions when
investing in specific projects. Some of the alternatives that were identified at the screening stage
will be rejected early on at the search stage, once additional information has been received.
Other alternatives will be evaluated more thoroughly at stage 3, the information acquisition
stage.

STAGE 3: INFORMATION ACQUISITION STAGE

When deciding on alternatives, an organisation needs to consider the predicted revenues
and costs, and the impact of investing in each of these alternatives. Both the qualitative financial
factors and the quantitative factors are very important. The responsibility for identifying these
factors lies with the management accountant.

STAGE 4: AUTHORISATION STAGE

The most suitable projects that meet the organisation’s objectives and the benefits of which
exceed the costs will be selected for investment. The cost-benefit analysis is usually the
responsibility of the management accountant who prepares a formal analysis of all projects,
including their financial outcomes. This is then used by managers to determine the best
project(s).

STAGE 5: FINANCING STAGE

The organisation now needs to obtain funds for the project(s) that it has chosen to invest in.
There are different sources of funds that could be used, namely retained earnings (these are
internal sources of funds that the organisation has built up through the years when profits were
made) and funds from the capital markets (equity and debt). It is the responsibility of the
Finance Department to arrange funding for the organisation.

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 STAGE 6: IMPLEMENTATION STAGE
The chosen project(s) will be implemented. Constant monitoring of how the performance of the
project(s) is progressing is vital at this stage. The information generated during the monitoring
exercise is fed into the post-completion audit, which will be dealt with later in this chapter.

18.3 Categories of capital budgeting projects

Capital projects are for the long term – usually with a life of at least one year. Organisations
normally classify capital budgeting projects into the following categories:

1. Expansion projects. Organisations engage in projects in order to increase the size of their
businesses, for example when acquiring other businesses to enter new markets, or even to
increase their market share in existing business operations.
2. Replacement projects. When fixed assets are used on a frequent basis, they age as a result
of wear and tear, resulting in the asset breaking down increasingly and consequently
affecting the general productivity of the organisation. The organisation is then forced to
replace the asset with a new, more efficient asset.
3. Regulatory projects. In some instances, certain projects have to be undertaken by
organisations because they are required by law to do so. This may be necessary to improve
safety at work or to preserve the environment. In such cases, the organisation is obliged to
execute the project, even though it will not generate much (or any) revenue.
4. New projects. These are projects that the organisation has never undertaken before. They
expose the organisation to even greater uncertainties compared to other categories of
projects. Decisions relating to new projects also involve more time and human resources.

The projects can be classified as independent projects that have unrelated cash flows or
mutually exclusive projects that compete against one other. If projects are independent, they
can all be selected, provided they meet the organisation’s expectations. However, when projects
are mutually exclusive, then acceptance of one project implies rejection of the other.

18.4 Why do organisations use investment appraisal?

Organisations use assets to convert inputs into outputs that they provide to customers. Since
resources are generally not limitless; the organisation needs to maximise the benefit it gets from
the resources it uses. An organisation has to deal with two decisions in order to address its
capital budgeting alternatives:

1. It has to make a decision regarding the assets to be acquired.

2. It must decide how much the organisation is willing to spend to acquire those assets.

The acquisition decision will come as a result of weighing the benefits to be gained against the
costs that will be incurred. The management of an organisation must conduct an investment

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 appraisal in order to make sure that whatever decisions are taken are consistent with the overall
objectives of the organisation. Generally, it will be important to look at all the available
alternatives so as to compare and choose the one from which the organisation will derive the
most benefit. Hence, the primary purpose of investment appraisal is concerned with maximising
the wealth of shareholders.

A simple real-world assumption is that if an organisation maximises the benefits it generates by

using resources, it will translate into the maximisation of the benefits that investors would get.
This is a simplification of the real world, since more factors that will impact on the capital
budgeting process will need to be considered.

18.5 Relevant and irrelevant cash flows in investment appraisal

The relevant financial inputs for decision making are future cash flows that will differ between
the various alternatives being considered. Therefore, only relevant cash flows should be
considered, that is, incremental or differential cash flows. The following cash flows are
discussed in terms of their relevance or irrelevance:

Additional costs of fixed assets. The total cost of fixed assets includes any transportation and
installation costs, as these are substantial costs incurred by organisations when fixed assets
are acquired. These charges are therefore added to the price of the assets when the cost of the
project is being determined.
Depreciation. This is a non-cash charge even though depreciation shelters income from
taxation. This has an impact on cash flow, although depreciation itself is not a cash flow.
Depreciation is added to net operating profit after tax (NOPAT) when estimating the cash flow
of a project or the wear-and-tear allowance stipulated by the tax authorities must be part of
the tax calculation in order to arrive at the operating cash flow. The only investment appraisal
method to include depreciation is the accounting rate of return.
Incremental cash flows. These are additional cash flows that represent the change in the
organisation’s total cash flows that occurs as a direct result of accepting the project.
Interest expenses. These are expenses that are not included in the cash flow of a project since
the cost of debt is already embedded in the cost of capital (minimum required rate of return),
which is the rate used to discount the project cash flows. Subtracting interest from the cash
flows will amount to double counting interest costs.
Opportunity cost. This is the value the organisation will lose as a result of taking the next
best alternative. This includes, for example, the cash flow forfeited when an asset is retained.
These costs are relevant and should be included in investment decisions.
Sunk cost. This is a cost that has already been incurred, or an organisation has signed a
contract (committed itself) regarding the cost. It is a past cost that cannot be reversed. Such
costs are irrelevant when it comes to investment appraisal and have to be excluded from such
an exercise.
Working capital. This type of capital is used to finance the additional inventories that are
required to support a new operation. Towards the end of a project’s life, inventories will be
used, but not replaced, and receivables will be collected and not replaced. As these changes

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 occur, the organisation will receive cash inflows, which will allow the investment in working
capital to be returned at the end of the project’s life. Working capital is an amount invested at
the beginning of the investment period, where it is reflected as an outflow, and released at the
end of the investment period, where it is reflected as an outflow. This is as a result of the
working capital being no longer required, and the cash that was tied up in it is made available.
It is not an annual cash flow. In some cases, however, additional investment in working
capital is needed on an annual basis. This additional investment in working capital will also
be included as a cash flow, and be recouped at the end of the project. Working capital does not
qualify for tax relief and is excluded from capital allowance calculations.

18.6 Capital budgeting techniques

The following appraisal methods are used to decide whether or not capital projects should be
accepted for inclusion in the capital budget and also for ranking the projects:

Payback
Accounting rate of return
Net present value (NPV)
Profitability index (PI)
Internal rate of return (IRR)

The payback and the accounting rate of return methods do not take into account the time value
of money, whereas the net present value, profitability index and internal rate of return methods
are referred to as discounted cash flow methods, because they also consider the time value of
money.

18.6.1 Payback method

The payback period is the length of time that it takes for an investment project to recoup the
funds invested in the project. This method is based on cash flows. It provides a measure of
liquidity and risk, that is, the sooner the investor can recover the initial investment, the sooner he
can invest it elsewhere and lower the risk of this particular investment.

Organisations normally set the required payback period as a standard that has to be adhered to,
and if the payback period of an investment project is shorter than this standard period, the
project will be accepted. When faced with mutually exclusive projects (projects that compete
with each other), the project with the shortest payback period would be selected.

It is advisable not to use the payback method on its own to evaluate capital projects, as it is only
a measure of payback and not of profitability.

Where the cash flows are constant, the payback can be calculated as follows:
Initial investment
Payback =
Annual net cash inf low

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 A payback period may not always be exactly in a full year. To calculate the payback in years and
months, multiply the decimal fraction of a year by 12 to convert the decimal to months.

ILLUSTRATIVE EXAMPLE 18.1

Zeus Ltd invested R2 million in a project that is expected to generate net cash inflows of
R500 000 for the next five years.
Calculate the payback period for the project.

Solution
R2 000 000
Payback =
R500 000

= 4 years

Where cash flows are uneven, the payback is calculated by working out the cumulative cash
flow over the life of a project.

ILLUSTRATIVE EXAMPLE 18.2

Bubbles Ltd wants to acquire a machine that will be used for printing books to be published.
The machine will be used for five years and will cost R250 000. The expected cash inflows
from this project are given as follows:

Year Cash flows

R
1 100 000
2 75 000
3 65 000
4 40 000
5 30 000

The organisation has a standard payback period of three years.

Required
Determine whether this project will be accepted or rejected by using the payback method.

Solution

Year Cash flows Cumulative cash flows

R R
0 –250 000 –250 000
1 100 000 –150 000
2 75 000 –75 000
3 65 000 –10 000
4 40 000 10 000/40 000 = 0.25
5 30 000

In the first year, the organisation recovers R100 000 of the amount invested, and the
remaining balance that still needs to be recouped is R150 000. The original investment is
recovered between years 3 and 4. Only R10 000 needs to be recovered from the R40 000-
year 4 cash flow, hence 0,25 of a year is needed to recover that. The payback period is 3,25
years (3 + 0,25) or 3 years and 3 months (0,25 × 12 months = 3 months). This is slightly
higher than the standard payback period set by the organisation. Therefore, the project will be
rejected.

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 Advantages of the payback period

It is simple to calculate and easy to understand.

More emphasis is placed on earlier cash flows, as they are likely to be more accurate than
cash flows that come in later years.

Disadvantages of the payback period

The time value of money is ignored.

The cash flows that come after the payback period has been met are ignored.

18.6.2 Accounting rate of return

The accounting rate of return (ARR) is the only appraisal method that uses accounting profits as
opposed to cash flows. This method estimates the rate of return from an investment project
without the use of either discounting or compounding. It is also known as return on investment
(ROI) or return on capital employed (ROCE) and has variations in its formulae. The most
common formula is:

Average annual prof it 100

ARR = =
Average value of investment 1

If the ARR is greater than the organisation’s target return, then the project should be accepted.
When comparing mutually exclusive projects, the project with the highest ARR should be
chosen.

ILLUSTRATIVE EXAMPLE 18.3

Sencam Ltd is considering an investment in a capital project that requires R150 000, where
the required rate of return is 12%. Straight-line depreciation will be charged on the capital
expenditure over the five-year life of this project. The equipment will not have any residual
value at the end of its useful life. The cash flows expected over the life span of the project
are:

Year Cash flows

R
1 80 000
2 80 000
3 65 000
4 40 000
5 20 000

Required
Determine whether this project will be accepted or rejected by using the accounting rate of
return.

Solution
The total cash inflows for the five years are:
R80 000 + R80 000 + R65 000 + R40 000 + R20 000 = R285 000

Total profit = Total cash inflows – Depreciation

= R285 000 – R150 000

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 = R135 000
Average profit = R135 000/5 years = R27 000

Initial investment + Residual value

Average investment =
2

R150 000 + R0
=
2

= R75 000

R27 000 100

Hence ARR = ×
R75 000 1

= 36%

Since this method is based on profits rather than cash flows, it is affected by accounting
policies. These policies can be different for each organisation, and as such it makes this
measure of accounting rate of return less useful than methods that are based on cash flows.
Advantages of the accounting rate of return

It is simple to calculate and easy to understand.

The total useful life of the project is considered.
It is expressed in terms that managers of organisations can relate to; that is, profit and
capital.

Disadvantages of the accounting rate of return

The time value of money is ignored.

Profits rather than cash flows are used in the calculation.

18.6.3 Net present value

The net present value (NPV) represents the net benefit or net loss in present value terms earned
on the project. It is calculated by discounting the future after tax cash flows, and then
subtracting the initial investment.

This is theoretically the best method of investment appraisal, as it calculates the gain/loss due to
the shareholders. An NPV of zero implies that the cash flows of the project exactly cover the
capital invested and provides the required return on the capital. If the NPV is positive, then the
project is generating more cash flows than required to service the debt and to provide the
required return to shareholders. It should therefore be accepted. A negative NPV signifies that
the project is not generating sufficient cash flows to service the debt and to provide the required
return for shareholders, and should thus be rejected. When faced with mutually exclusive
projects, the project with the highest NPV should be selected.

ILLUSTRATIVE EXAMPLE 18.4

Caminaysh College is a private college that needs to install a new electronic student
registration system. It is considering two mutually exclusive projects with equally useful lives.
System ITSS will meet all the college’s requirements, and system COIL, which costs more to
implement, will have greater earnings potential because of its features. The financial figures
for each investment project are set out in the following table:

System ITSS System COIL

Initial investment R 60 000 R 75 000
Project useful life 5 years 5 years

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 Project cash inflows

Year R R
1 11 000 17 000
2 20 000 22 500
3 22 000 25 000
4 21 000 24 500
5 20 000 25 000

The cost of capital is 15%.

Required
Calculate the net present value of these two projects and recommend which project has to be
undertaken based only on financial figures.
Solution
System ITSS

Cash flows Discount factor @ 15% Present value

R R
–60 000 1,000 –60 000
11 000 0,870 9 570
20 000 0,756 15 120
22 000 0,658 14 476
21 000 0,572 12 012
20 000 0,497 9 940
NPV 1 118

System COIL

Cash flows Discount factor @ 15% Present value

R R
–75 000 1,000 –75 000
17 000 0,870 14 790
22 500 0,756 17 010
25 000 0,658 16 450
24 500 0,572 14 014
25 000 0,497 12 425
NPV –311

(Discount factors at 15% from present value table A)

The decision rule is that any project that generates a higher positive net present value is
acceptable. In this situation, System ITSS is only acceptable since it has a higher positive
NPV. But System COIL has a negative NPV. Therefore, based on financial factors only,
System ITSS will be preferable.
Advantages of a net present value method

The time value of money is taken into consideration.

All the cash flows for the project are used.
The absolute gain or loss due to the shareholders is calculated.
The discount rate used for appraising the project can be adjusted to reflect the level of
inherent risk in different projects.
It is based on cash flows and not profits. Using cash flows is more appropriate for decision
making.

Disadvantages of the net present value method

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 It is not well understood by non-financial managers.
The project that has a higher NPV does not always represent the best investment project
for the organisation.
It is difficult to determine the cost of capital to be used for discounting the cash flows.
It is not easy to understand NPV analysis figures compared to the percentage figures given
by the accounting rate of return and the internal rate of return.

18.6.4 Profitability index

The profitability index of a project is calculated by dividing the present value of the cash flows
of the project by its initial investment. Use of the NPV rule becomes problematic if the
organisation does not have enough funds to invest in all the projects with positive NPVs when
capital is rationed. In such cases, it becomes very important to rank projects according to their
profitability index, that is, according to their earning power. The profitability index of a project
is calculated as follows:

PV of cash f lows of the project

Prof itability index (PI) =
Initial investment

The profitability index is related to the NPV approach. Every time the NPV is positive, the PI is
more than 1, and if the NPV is negative, the PI will be less than 1. The decision criterion is to
invest in the project if the profitability index (PI) is greater than 1.

ILLUSTRATIVE EXAMPLE 18.5

Using the information from Illustrative example 18.4, calculate the profitability index for both
projects.

Solution
Sum of the present value of the cash flows as per the previous example:

System ITSS System COIL

R R
9 570 14 790
15 120 17 010
14 476 16 450
12 012 14 014
9 940 12 425
61 118 74 689

PI for System ITSS = R61 118

R60 000
= 1,019

PI for System COIL = R74 689

R75 000
= 0,996

In this case, System ITSS will be ranked first because of its higher PI and also because it is >
1. The profitability index is an indication of the value that the organisation will receive in
exchange for every rand invested in a capital investment project.

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 18.6.5 Internal rate of return
The internal rate of return (IRR) requires that the actual rate of return of the project be
calculated. It is the discount rate at which the NPV of a project will be zero, that is, it is the rate
at which the project breaks even. This means that at the IRR, the total present value of the
discounted cash inflows is equal to the total present value of the cash outflows of the project.
The IRR is the exact rate of return that the project is expected to achieve. If the IRR exceeds the
cost of capital used to finance the project, a surplus will remain after paying for the capital, and
this will be due to the shareholders, which increases shareholder wealth.

Using linear interpolation, we can determine the IRR. Use one low rate to achieve a positive
NPV and one high rate to achieve a negative NPV. Then use interpolation to calculate the IRR
that results in a nil NPV. Calculate the NPV at two different rates, and then use the following
formula to derive the IRR:

c
IRR = a + [ × (b − a)]
c − d

Where

a = Lower discount rate

b = Higher discount rate

c = NPV at lower discount rate

d = NPV at higher discount rate

When inputting figures into formulae, do not convert percentage to decimals; instead use whole
numbers and add in a percentage sign at the end.

ILLUSTRATIVE EXAMPLE 18.6

Using information from Illustrative example 18.4, calculate the IRR.

Solution
Firstly, we need to calculate two NPVs: one NPV must be positive and the other must be
negative. For illustrative purposes, the two discount rates are given. These rates are usually
determined through trial and error.
SYSTEM ITSS

Cash flows Discount factor @ 15% Present value Discount factor @ 16% Present value
R R R
–60 000 1,000 0.497 1,000 –60 000
11 000 0,870 9 570 0,862 9 482
20 000 0,756 15 120 0,743 14 860
22 000 0,658 14 476 0,641 14 102
21 000 0,572 12 012 0,552 11 592
20 000 0,497 9 940 0,476 9 520
NPV 1 118 NPV –444

SYSTEM COIL

Cash flows Discount factor @ 15% Present value Discount factor @ 14% Present value
R R R

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 –75 000 1,000 –75 000 1,000 –75 000
17 000 0,870 14 790 0,877 14 909
22 500 0,756 17 010 0,769 17 303
25 000 0,658 16 450 0,675 16 875
24 500 0,572 14 014 0,592 14 504
25 000 0,497 12 425 0,519 12 975
NPV –311 NPV 1 566

SYSTEM ITSS

c
IRR = a + [ × (b − a)]
c − d

Where

a = 15%

b = 16%

c = R1 118

d = (R444)

1118
IRR = 15 + [ × (16 − 15)]
1118−(444)

= 15 + [0,72 × 1]

= 15,72%

SYSTEM COIL

c
IRR = a + [ × (b − a)]
c − d

Where

a = 14%

b = 15%

c = R1 566

d = (R311)

1566
IRR = 14 + [ × (15 − 14)]
1566−(311)

= 14 + [0,83 × 1]

= 14,83%

Normally, the organisation’s discount rate will be given in most questions. Using this discount
rate to calculate the NPV, will give us a guide as to whether the NPV is positive or negative. If
the NPV at this rate is positive, the next NPV to be calculated has to be negative, and we will
have to choose a much higher discount rate than the one we have just used.
In contrast, if the initial NPV turns out to be negative at the organisation’s discount rate, then
the next NPV to be calculated has to be positive. We will need to use a discount rate that is
much lower than the one used initially.
The IRR for System ITSS (15,72%) is above the cost of capital of 15% (as per Illustrative
example 18.4); therefore it should be accepted, whereas the IRR for System COIL (14,83%)

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 is below the cost of capital of 15%, and should therefore be rejected.
Advantages of internal rate of return

It considers the time value of money.

Its simplicity makes the concept easy to understand.
All cash flows are taken into consideration.

Disadvantages of internal rate of return

IRR cannot accommodate changing interest rates.

IRR is a relative figure, whereas NPV is an absolute figure. Therefore, IRR can give a
different ranking from the ranking proposed by NPV.
The IRR method assumes that project earnings for the period of the investment will be
reinvested at the IRR, and this usually overestimates the returns from the project.
If a project has irregular cash flows, that is, the project generates negative cash flows in
between positive cash inflows, the project can have more than one IRR.

TEST YOURSELF 18.1

Veeara (Pty) Ltd is considering an investment of R50 000. The corporation expects to get
after-tax cash inflows of R16 000 per year for the first five years, and R7 500 for the last three
years of the project. Straight-line depreciation is charged for the entire useful life of the
project. The required rate of return is 8% for this project.

Required
a. Payback period
b. Net present value
c. Internal rate of return
d. Accounting rate of return

ILLUSTRATIVE EXAMPLE 18.7

Roshan Ltd is considering investing R400 000 in a new plant that will increase sales by 10
000 units per annum. Units sell for R30,00 each and have a variable cost of R12,00 each.
Cash fixed costs are expected to increase by R60 000 as a direct result of the investment.
The plant will be depreciated to zero over its five-year useful life. It is anticipated that Roshan
Ltd will receive R20 000 on scrapping the plant at the end of its useful life. This investment is
expected to require R50 000 in working capital. The company tax rate is 30% and the
required return is 10%.

Required

1. Calculate the operating and total cash flows over the life of the investment.
2. Calculate the NPV for the project.

Solution

Operating cash flow: R

Sales (10 000 × R30) 300 000

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 Variable costs (10 000 × R12) (120 000)
Contribution 180 000
Fixed costs (60 000)
Depreciation (R400 000 ÷ 5 yrs) (80 000)
Profit before interest and tax 40 000
Tax (30%) (12 000)
Net profit after tax 28 000
Add: Depreciation 80 000
Operating cash flow 108 000

Net present value:

Year 0 Year 1–4 Year 5

R R R
Investment (400 000)
Working capital (50 000) 50 000
Operating cash flow 108 000 108 000
After tax salvage value 14 000
Total cash flow (450 000) 108 000 172 000
PV factor at 10% 1,000 3,170* 0,621*
Present value (450 000) 342 360 106 812
Net present value (R828)

*Table B: 4 years and 10%; Table A: 5 years and 10%

The project has resulted in a negative net present value, which signifies that the project is not
generating sufficient cash flows to service the debt and to provide the required return to
shareholders, and should therefore be rejected.

TUTORIAL EXERCISES

Exercise 1
Mahi, Sonali and Shakti started their own business producing toys for toddlers. Their
business had grown since its inception in 2015. They have recently expanded their business
to include toys for older kids. This expansion requires an initial outlay of R320 000 and
working capital of R50 000. They are expecting to receive cash inflows for years 1 to 3 of R70
000, R135 000 and R240 000, respectively. Using a discount rate of 10%, determine the NPV
and the IRR of the project.

Required

a. Payback period
b. Net present value
c. Internal rate of return
d. Accounting rate of return

Exercise 2
Riya Corp is reviewing an investment proposal. The initial cost of the investment is R52 500.
The estimated cash flows and net profit for each year are presented in the schedule below. All
cash flows are assumed to take place at the end of the year.

Year Net cash flows Net profit

1 R20 000 R2 500
2 R17 500 R3 500
3 R15 000 R4 500

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 4 R12 500 R5 500
5 R10 000 R6 500

The cost of capital is 12%.

Required

a. Payback period
b. Accounting rate of return (base your calculation on the initial cost of the investment)
c. Net present value

Exercise 3
North Coast Boards requires an investment of R1 000 000 in new machinery that has an
expected life of five years with annual cash flows of R240 000 received at the end of each
year.

Required

a. Compute the payback period.

b. Compute the net present value using a 12% discount rate.
c. Compute the internal rate of return.
d. Would you recommend that this project be accepted? Give reasons.

Exercise 4
Su (Pty) Ltd is considering a capital investment project that requires an initial investment of
R145 000 and has an expected life of four years. Annual cash flows at the end of each year
are expected to be as follows:

Year Amount
1 R35 000
2 R45 000
3 R55 000
4 R50 000

Required

a. Compute payback assuming that the cash flows occur evenly throughout the year.
b. Compute the net present value of the project using an 8% discount rate.

Exercise 5
Hayne Ltd has invested R10 000 in new machinery. This machine is expected to generate a
net cash flow saving in operating cost after tax of R2 500 per annum for five years.
Depreciation has been calculated at R2 000 per annum, but it has not been included in
determining the cost saving, as it does not constitute cash flow.

Required

a. Calculate the payback period for the project.

b. Calculate the ARR for the project.

Exercise 6
Marion Avenue Traders is considering the purchase of a new machine that will cost R15
million and have a productive life of five years. It is expected that at the end of five years the
machine could be sold for R1 million. The company’s policy is to depreciate equipment
straight line to zero over its useful life, which is also acceptable for tax purposes. The

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 machine is expected to generate annual profits before interest and taxes of R3 million. The
tax rate is 30%. Additional working capital of R2 million will be required when the machine is
first purchased and will remain constant until the end of its life, when working capital will be
reduced to zero.
Marion Avenue Trader’s weighted average cost of capital is 15% and it requires projects to
generate an internal rate of return at least equal to cost of capital. If this requirement is met, it
also requires that projects must pay back their total investment within three years.

Required
a. Calculate the net present value of the project.
b. Calculate the internal rate of return of the project; interpolated between 15% and 20%.
c. Calculate the payback period of the project.
d. Make recommendations on whether the project should be accepted or not.

Exercise 7
Shakti Mothilal (Pty) Ltd is currently evaluating two investment projects involving the purchase
of machinery. The following relative cash flow data is used:

Machine A Machine B
R R
Initial investment 160 000 160 000
Income
1 30 000 30 000
2 40 000 30 000
3 50 000 30 000
4 60 000 30 000
5 70 000 30 000
250 000 150 000
Scrap value at end of economic life R5 000 Nil

The firm’s cost of capital is 12%.

Ignore tax and work to the nearest rand.

Required
a. Calculate the payback period of each project for machines A and B.
b. Calculate the rate of return on average investment for machine B.
c. Calculate the net present value (NPV) for each project.
d. Summarise the preferences dictated by NPV measures and indicate, giving reasons, which
project you would recommend.

Exercise 8
SeCa Com has been offered a seven-year contract to supply a part for the military. After
careful study, the company has developed the following estimated data relating to the
contract:

Cost of equipment required R300 000

Working capital required R50 000
Annual cash flows R70 000
Salvage value of equipment on termination of the contract R5 000

It is not expected that the contract would be extended beyond the initial contract period. The
company’s cost of capital is 10%.

Required

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 Use the net present value method to determine whether the contract should be accepted.
Round all computations off to the nearest rand.

TEST YOURSELF SOLUTIONS

TEST YOURSELF 18.1 SOLUTION

Year Cash flows Cumulative cash flows

R R
0 –50 000 –50 000
1 16 000 –34 000
2 16 000 –18 000
3 16 000 –2 000
4 16 000 14 000
5 16 000 30 000
6 7 500 37 500
7 7 500 45 000
8 7 500 52 500

The payback period is between years 7 and 8. More precisely, it is

R50 000
R16 000
= 3,125 years
Therefore, the payback period is 3,125 years or 3 years 1,5 months.
a. Net present value

Year DCF @ 8% Present value

R R
0 –50 000 1 –50 000
1 16 000 0,926 14 816
2 16 000 0,857 13 712
3 16 000 0,794 12 704
4 16 000 0,735 11 760
5 16 000 0,681 10 896
6 7 500 0,63 4 725
7 7 500 0,583 4 373
8 7 500 0,54 4 050
27 036

b. Internal rate of return

Year Cash flows DCF @ 8% Present value DCF @ 25% Present value
R R R
0 –50 000 1 –50 000 1 –50 000
1 16 000 0,926 14 816 0,8 12 800
2 16 000 0,857 13 712 0,64 10 240
3 16 000 0,794 12 704 0,512 8 192
4 16 000 0,735 11 760 0,41 6 560
5 16 000 0,681 10 896 0,328 5 248
6 7 500 0,63 4 725 0,262 1 965
7 7 500 0,583 4 373 0,21 1 575
8 7 500 0,54 4 050 0,168 1 260
27 036 –2 160

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 At a discount rate of 8%, the NPV is R27 036. We need to calculate another NPV at a
higher rate to get a negative NPV, since the one at 8% is positive. Let us use 25%:

27 036
IRR = 8 + [
27 036−(2160)
× (25 − 8)]

= 8 +[0,926 ×17]
= 8 +15,7
= 23,7% or 24%

c. Accounting rate of return

The total cash inflows for the five years are:

R16 000 + R16 000 + R16 000 + R16 000 + R16 000 + R7 500 + R7 500 + R7 500 =
R102 500

Total profit = Total cash flows –Depreciation

= R102 500 –R6 250
= R96 250
Average profit = R96 250
8 years
= R12 031,25

Average investment = Initial investment+Residual value

= R50 000+R0
2

= R25 000
ARR = R12 031,25

R25 000

= 48,13%

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 Index

A
accounting 1
nature of accounting 2
accounting classifications 20
assets 20
current assets 20
non-current assests 20
accounting concepts 53
consistency concept 54
going concern concept 53
matching concept 53
prudence concept 54
accounting cycle 54
adjustments 58
analysis and interpretation 60
closing entries 58
final trial balance 58
financial statements 58
journals 56
ledger accounts 57
post-adjustment trial balance 58
pre-adjustment trial balance 57
source documents 56
transactions 55
accounting field 10
auditing field 11
financial accounting 11
management accounting 11
tax field 11
analysing financial statements 139
common size statements 139
comparative financial statements 139
indexed financial statements 139
ratio analysis 139
assumptions of CVP analysis 282
breakeven point 284
expected (target) profit or return 286
margin of safety 285

B
bank reconciliation 170

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 basic accounting equation (BAE) 29
business forms 3
close corporation (CC) 5
company 5
partnership 4
sole trader 3

C
capital budgeting process 400
authorisation stage 400
financing stage 400
implementation stage 401
information acquisition stage 400
screening stage 400
search stage 400
capital budgeting projects 401
exclusive projects 401
expansion projects 401
independent projects 401
new projects 401
regulatory projects 401
replacement projects 401
capital budgeting techniques 403
accounting rate of return 405
internal rate of return 409
net present value 407
payback method 404
profitability index 408
cash budgets 338
classification of labour 243
direct labour 243
indirect labour 243
closing process 118
company 5
non-profit companies 6
private company 6
profit companies 6
public company 6
cost 201
cost behaviour 203
fixed costs 203
semivariable, semifixed or mixed costs 204
variable costs 204
cost classification 201
manufacturing costs (product costs) 201
non-manufacturing costs (period costs) 202
cost classification for control 206
controllable and non-controllable costs 206
cost classification for decision making 207

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 avoidable cost 208
differential/incremental cost 207
irrelevant costs 208
opportunity costs 207
relevant costs 207
sunk costs 208
cost-volume-profit (CVP) 281

D
decisions using marginal costing 301
dropping a product or department 304
limiting factors 307
make versus buy 310
special order decisions 302
direct labour variances 354
efficiency variance 355
rate variance 354
total labour variance 355
direct materials variances 354
price variance 354
total direct materials variance 354
usage (quantity) variance 354

E
economic order quantity (EOQ) 223
employee’s remuneration 244
basic wage 244
gross wage 244
net wages 245
normal deductions 245
equity 21
expenses 21
income 21

F
fixed manufacturing overheads variances 356
expenditure variance 356
volume variance 356
flexible budgets 333

I
incentive schemes 250
interest 372
compound interest 373
effective rate 375
nominal rate 375
simple interest 373

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 J
job costing (absorption costing) 268
actual overheads 270
applied overheads 270
budgeted overheads 270
overhead absorption rates 268

L
labour recovery rate 250
annual labour costs 251
productive hours 251
liabilities 21
current liabilities 21
non-current liabilities 21

M
mark-ups 192
percentage mark-up on cost price 192
percentage mark-up on selling price 194
materials 219
direct material 219
finished goods 220
indirect material 220
inventory 220
work in progress 220

O
operational budgets 323
direct materials purchases budget 325
direct materials usage budget 325
inventory budget 325
manufacturing overheads budget 325
production budget 324
sales and administration expenditure budget 325
sales budget 324
overheads 267
indirect labour 267
indirect materials 267
other manufacturing overheads 268

P
payroll accounting 252
salaries journal 253
wages journal 256
production cost variances 354

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 ratio analysis 139
efficiency ratios 143
liquidity ratios 142
profitability ratios 143
solvency ratios 144
remuneration methods 244
hourly wages 244
piecework pay 244
salaries 244
reserves 131
distributable reserves 132
non-distributable reserves 132
retailers 60
periodic method of accounting for stock 61
perpetual method of accounting for stock 61

S
sales variances 352
sales price variance 352
sales quantity variance 352
share capital 130
authorised share capital 130
issued share capital 131
standard costing system 349
standards 349
ideal standards 349
practical or currently attainable standards 350
setting standards 350
standard cost 350
stock control 222
average stock level (AveSL) 224
carrying costs 222
economic order quantity (EOQ) 223
lead time 223
maximum stock level (MaxSL) 224
minimum stock level (MinSL) 224
ordering costs 223
reorder level (ROL) 224
stock-out costs 223
stock valuation methods 226
first-in-first-out method (FIFO) 229
perpetual and periodic inventory control systems 226
weighted average method 229

T
time value of money 376
future value of a single cash flow 379
future value of an annuity due 381

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 future value of an ordinary annuity 380
loan amortisation 382
present value of a perpetuity 379
present value of a single cash flow 377
present value of an annuity due 378
present value of an ordinary annuity 377
repayment of loan/annual instalment 382
time value of money concepts 372
annuity 372
annuity due 372
compounding 372
cost of capital 372
discounting 372
future value (FV) 372
ordinary annuity 372
perpetuity 372
present value (PV) 372
single cash flows 372
types of business activity 9
manufacturers 9
service businesses 9
wholesalers 9
types of shares 131
ordinary shares 131
preference shares 131

U
usefulness of accounting information 3
comparability 3
faithful representation 3
relevance 3
timeless 3
understandability 3
verifiability 3
users of accounting information 2
external users 2
internal users 2

V
value added tax (VAT) 187
exempt supplies 188
input tax 188
output tax 189
standard-rated supply 188
VAT payable/refundable 189
zero-rated supplies 188
variable manufacturing overheads variances 355
efficiency variance 355
spending (rate) variance 355

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 total variable manufacturing overhead variance 356
variance analysis 351

Y
year-end adjustments 109
accrued expenses 115
accrued income 116
allowance for credit losses 112
depreciation 110
income received in advance 117
prepaid expenses 114

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