Management Accounting 2024

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A PRACTICAL APPROACH TO MANAGEMENT ACCOUNTING

GARIBA O. A. ANINANYA
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MANAGEMENT ACCOUNTING

Introduction
The scope of Management Accounting is broader than the scope of cost accounting. In Cost
Accounting, the primary emphasis is on cost and it involves identification, collection, analysis,
accumulation, interpretation and presentation of the costs of business operations for the
determination of the costs and profitability of products and services.

Management Accounting on the other hand is an accounting system that helps management to
improve its efficiency. The main thrust of Management Accounting is towards determining
policy and formulating plans to achieve desired objectives of management. It helps management
in planning, controlling and analyzing the performance of the organization in order to follow the
path of continuous improvement.

Management Accounting is therefore, the process of collecting, collating and reporting


information that is of use to the management of an organization for making decisions,
monitoring past performance and for making the most efficient use of available resources.

Objective of Management Accounting


The fundamental objective of management accounting is to assist management to carry out its
duties efficiently and maximize profits or minimize losses. It includes computation of plans and
budgets covering all aspects of the business. Example: production, selling, distribution, research
and finance. Management accounting systematic allocate responsibilities for implementation of
plans and budgets. It analysis of all transactions, financial and physical, to enable effective
comparison to be made between the forecasts and actual performance.

The main objectives of management accounting are as follows:


1. To formulate Planning and policy
Planning involves forecasting on the basis of available information, setting goals; framing
polices determining the alternative courses of action and deciding on the program of activities. It
facilitate the preparation of statements in the light of past results and gives estimation for the
future.

2. To interpretation of financial documents


Management accounting is to present financial information to the management. Financial
information must be presented in such away that it is easily understood. It presents accounting
information with the help of statistical devices like charts, diagrams, graphs, etc.

3. To assist in Decision-making process


Management accounting makes decision-making process more scientific with the help of various
modern techniques. Information/figure relating to cost, price, profit and savings for each of the
available alternatives are collected and analyzed accordingly which will provide a base for taking
sound decisions.
4. To help in control
Management accounting is a helpful for managerial control. Management accounting tools e.g.
standard costing and budgetary control are helpful in controlling performance. Cost control is
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affected through the use of standard costing and departmental control is made possible through
the use of budgets. Performance of each and every individual is controlled with the help of
management accounting.

5. To provide report
Management accounting keeps the management fully informed about the latest position of the
concern through reporting. It helps management to take proper and quick decisions. It informs
the performance of various departments regularly to the top management.

6. To Facilitate Coordination of Operations


Management accounting provides tools for overall control and coordination of business
operations. Budgets are important means of coordination.

Role of the Management Accountant in Decision Making

He provides relevant information to managers to assist them to make good decisions. To play
this role effectively, it is important for him to have a good understanding of the decisions faced
by the various mangers.

Depending upon the company situation - size, nature and organisational set up and his own
capabilities and position in the company, the management accountant may be required to
perform various and varied functions. The importance and effectiveness of his function would
also depend upon the confidence reposed in him by the top management and the functional
managers. His functions generally embrace each and every activity of the management which
can be summarized as follows:

1. Management Accountant establishes, coordinates and administers plans to facilitate the


forecasting of sales, expense budgets and cost standards that will permit profit planning,
capital budgeting and financing.

2. He will formulate accounting policy and procedures. Operating data and special reports must
be prepared so that the performance can be compared with plans and standards, and any variance
between actual operations and pre-determined standards can be analysed for corrective actions
by management. Such comparisons between actual and expected activities should help the
management in proper fixation of responsibility and also in the evaluation of the various
functional and divisional heads.

3. Management Accountant is responsible for the protection of the business assets to the extent
possible by external controls, internal auditing and insurance coverage.

4. He will be responsible for tax policies and procedures and will supervise and coordinate the
reports required by various authorities.

5. Management Accountant must continually be aware of economic and social forces as well as
the effect of governmental policies and actions on business activities.
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An analysis of the above list (obviously not exhaustive) of functions, reflects the status of a
management accountant. He is the principal officer incharge of the accounts of the company. He
shall be responsible to the Board of directors for the maintenance of adequate accounting
procedures and records on the operation of the business. He shall be responsible to the president
or the chairman of the board with respect to the administration of his office. He shall perform
such other duties and functions as may from time to time be assigned to him by the president or
chairman of the board or the Board of directors. Thus, in his broad functional activities, the
management accountant is responsible to the policy making group of top management, whereas,
in his administrative activities he is responsible to the top executive officer.

Tools and Techniques of Management Accounting

A number of tool and techniques have been used under management accounting to help
management in achieving the desired goals. For this the management accountant normally uses
the following tool and techniques:

(i) Financial Planning: Financial planning is the process of deciding in advance about the
financial activities necessary for the organisation to achieve the desired objectives. It includes
determining both long term and short term financial objectives, formulating financial policies
and developing the financial procedures etc. Financial policies may relate to the determination of
the capital requirement, sources of funds, determination and distribution of income, use of debt
and equity capital and the determination of the optimum level of investment in various areas.

(ii) Financial Statement Analysis: Financial statements are analysed to make data more
meaningful. Comparative statement analysis, common size statement analysis, trend analysis,
ratio analysis, cash flow analysis etc. are the major techniques of financial statement analysis
used in management accounting.

(iii) Decision Making: Management accounting helps the management through the techniques of
marginal costing, differential costing, capital budgeting, cash flow analysis, discounted cash flow
etc. to select the best alternative which will maximise the profits of the business.

(iv) Control Techniques: Management should ensure that the plan formulated by it has been
translated into action. Standard costing and budgetary control techniques are useful control
techniques used by management.

(v) Statistical and Graphical Techniques: Management accountant uses various statistical and
graphical techniques in order to make the information more meaningful and presentation of the
same in such a form so that it may help the management in decision making. The techniques of
linear programming, statistical quality control, investment chart, sales and earning chart etc. are
of vital use.

(vi) Reporting: Management accountant prepares the necessary reports for providing information
to the different levels of management by proper selection of data to be presented, organisation of
data or selecting the appropriate method of reporting.
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The Importance of Management Accounting Information

Some of the major decisions are;

1. Make or buy 5. Capital expenditure decisions

2. Accepting or rejecting an order 6. Increasing production capacity

3. To further process or not 7. Optimizing product mix

4. Fixation of selling price 8. Maintaining a desired Level of profit

9. Alternative use of production facilities

For all these decisions, providing the relevant information is necessary and management
accounting generates this information, which enables the management to take such decisions.

RELEVANT COSTS
Relationship between relevant, irrelevant, opportunity and past costs

Relevant costs Irrelevant costs


Future costs which vary with the decision Costs which are the same irrespective of which
under consideration decisions is made
Opportunity costs Outlay costs Past coasts

The cost of being Future cash Future cash outflows Coasts which were
deprived of the next outflows which which do not vary with incurred as a result of a
best option vary with the the decision past decision
decision
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RELEVANT COSTS AND REVENUES


Relevant costs and revenues (also called incremental costs and revenues) arise as a direct result
of a project going ahead. If a cost happens whether or not a project goes ahead it is irrelevant.
For instance, a sunk cost such as rent of factory paid whether or not the project goes ahead is
irrelevant. Other examples are:
• Fixed costs already paid out are sunk costs, i.e. paid out and gone forever are irrelevant.
• Wages or salaries of new employees who will be taken on if the project goes ahead are
relevant.
• The wages paid to existing employees who are unaffected by whether or not the project
goes ahead are irrelevant.
• Expenses incurred either to the project or other projects if the project goes ahead are
relevant.

Example 1.1
INDURANCE LTD has an old car standing around which it bought several months ago for
GHC3,000. The car needs a replacement engine before it can be sold. It is possible to buy a
reconditioned engine for GHC300. This would take seven hours to fit by a mechanic who is paid
GHC4 an hour. At present the company is short of work, but the owners are reluctant to lay off
any mechanics or even to cut down their basic working week because skilled labour is difficult to
find and an upturn in repair work is expected soon. Without the engine the car could be sold for
an estimated GHC3,500.

What is the minimum price at which the company would have to sell the car, with a
reconditioned engine fitted to justify doing the work?

Solution:
The minimum price
GHC
Opportunity cost of the car 3,500
Cost of the reconditioned engine 300
Total 3,800

The original cost of the car is irrelevant, it is the opportunity cost which concerns us. The cost of
the new engine is relevant because if the work is done the company will have to pay out the
GHC300; if the job is not done nothing will have to be paid. This is known as an outlay cost.

The labour cost is irrelevant because the same cost will be incurred whether the mechanic under
takes the work or not. This is because the mechanic is being paid to do nothing if this job is not
undertaken, and thus the additional cost arising from job is zero.
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It should be emphasized that the company will not seek to sell the car with its recondition engine
for GHC3,800. It will seek to charge as much as possible for the car. On the other hand, any
price above the £3,800, will make the company better off financially than not undertaking the
job.

Example 1.2

Assume exactly the same circumstances as in example1.1, except that the company is quite busy
at the moment. If a mechanic is to be put on the engine replacement job it will mean that other
work which the mechanic could have done during the seven hours, all of which could be charged
to a customer, will not be undertaken. The company’s labour charge is GHC12 per hour.

What is the minimum price at which the company would have to sell the car, with a
reconditioned engine fitted, to justify doing the work under these altered circumstances?

Solution:
The minimum price
GHC
Opportunity cost of the car 3,500
Cost of the reconditioned engine 300
Labour cost (7 × GHC12) 84
Total 3,884

The relevant labour cost here is that which the company will have to sacrifice in making the time
available to undertake the engine replacement job. While the mechanic is working on this job, the
company is losing the opportunity to do work for which a customer would pay GHC84. Note that the
GHC4/hour mechanic’s wage is still not relevant. This is because the mechanic will be paid the GHC4
irrespective of whether it is the engine replacement work or some other job which is undertaken.

Example 1.3

An organization is contemplating the purchase of a new machine and has provided you with the following
information.
An old machine which cost ₵144,000 some years ago and has a book value of ₵36,000 can be traded in
now for ₵25,000. At the end of year 5 it could be sold for ₵8,000.
The new machine would cost ₵465,000 now, and at the end of year 5 could be sold for ₵70,000.
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Maintenance / running costs have been estimated as follows:

Year Old machine New machine


₵ ₵
1 24,000 18,000
2 16,000 18,000
3 16,000 18,000
4 18,000 20,000
5 17,000 20,000

Sales would increase by ₵120,000 per year.


Costs would increase by ₵45,000 per year.
Two employees earning ₵19,000 per year each would be made redundant, each receiving ₵24,000
redundancy pay.
Materials already in stock which originally cost ₵14,000 can be used on the project. They have no other
use and no disposal value.
New packaging materials will have to be bought at a cost of ₵7,000 per year.

Required:
Compute the net cash flows for the project and advise management
Solution
The relevant cash flows are:

Year(s) 0 1 2 3 4 5 Total
₵000 ₵000 ₵000 ₵000 ₵000 ₵000 ₵000
Inflows:
Additional sales - 120 120 120 120 120
Residual value
(new machine ) - - - - - 70
Maintenance savings
(old 24 –new 18) - 6 - - - -
Labour savings - 38 38 38 38 38

Nil 164 158 158 158 228 866


Outflows:

New machine (465 – trade in £25) 440 - - - - -


Old machine lost
-residual value - - - - - 8
Additional maintenance - - 2 2 2 3
9

Additional costs - 45 45 45 45 45
Redundancy pay (assumed paid now) 48 - - - - -
Packing materials - 7 7 7 7 7
488 52 54 54 54 63 765

Net cash flows (488) 112 104 104 104 165 101
Advise to Management

The project is profitable since it has a Net Cash Inflow of ₵101,000. Management should
therefore undertake the project.

Please note the following points.

• The cost and book value of the old machine are irrelevant, past expenditures and
incomes of whatever category cannot be charged, whether or not a new project goes
ahead.
• If the project goes ahead, a trade-in of ₵25,000 will be received now but the residual
value of ₵8,000 in year 5 will be cost.
• Making the two employees redundant results in a saving each year of ₵38,000 and a
one-off payment immediately of ₵48,000. The expense of the material costing
₵14,000 which is already in stock is irrelevant because it has no other use or disposal
value. If it had a disposal value, this would appear as a loss of revenue.

One of the most important key words in this area is additional. The item in question is relevant
if, as a result of the project going ahead, it generates additional income or gives rise to additional
costs.

1.4 ZURIGALUU LAMKANBEY LTD has been offered a one-year contract. The company will
utilize an existing machine that is only suitable for such contract work. The machine cost 300
million cedis five years ago and has depreciated 48 million cedis a year on a straight-line basis,
thus has a book value of ¢60 million. The machine can be sold now for 96 million cedis or in a
year’s time for ¢12m. Four types of material would be needed for the needed for the contract as
follows:

Material In Stock Required for Purchase Current Buying Current Resale

Contract Price Price price

Qty Qty ₵ ₵ ₵

W 1200 300 21,600 18,000 1400


10

X 200 1,100 9,000 33,600 25,200

Y 3000 600 6,000 9,600 7,200

Z 1800 1,200 21,600 2,400 22,800

W and Z are in regular use in the company. X could be sold if not used for the contract and ther'
are no other uses for Y, which is deemed to be obsolete.

Required:

What are the relevant costs in connection with the contract (ignore the time value of money).

SOLUTION:

1. The revenue lost for not selling the machine now, (₵92m-₵12m = ₵84m). The historical
cost is irrelevant. It is a Sunk cost. The depreciation details are also irrelevant. They
relate to accounting conventions. The relevant cost is the opportunity cost caused by the
reduction in resale value over the duration of the contract.

2. Material costs.

W 300 x ¢18,000 = ¢5.4m. Replenishment will be made at current Price (current market

price).

X 200 X ¢25,200 = ¢5.04m

If contract is not accepted it could be sold.

900 x ¢33,600 = 30.24m


If accepted, the remaining 900 will he bought at current market price, ¢35.28m
Y 600 x ¢7 200= ¢4.32m
The opportunity cost is current resale price.

Z 1,200 x ¢24,000=¢1288m

The same reason as for W. Replenishment will be made at current Price (current

market price).
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1.5

(a) Tech Indo Company Limited produces an industrial detergent with the following unit cost card
¢
Direct Materials 2,000
Direct Labour 1,000
Variable Overhead 3,000
Fixed Overhead 8,000

The production capacity is 300,000 units per year. Due to the recent economic crisis, the
company expects to produce only 180,000 units for the coming year. The company also has
fixed selling cost totaling ¢500 million per year and variable selling costs of ¢1,000 per unit.
The product normally sells for ¢12,000 each.
At the beginning of the year, a customer from the Volta Region which is outside the area
normally served by the company, offered to buy 100,000 units for ¢7,000 each. The
customer also offered to pay all transportation expenses of ¢20 per unit and selling expenses.
Required
(i) Using quantitative justification, should the company accept the order?
(ii) Provide four (4) qualitative factors normally considered in such tactical decisions
(iii) What are relevant costs? State the characteristics of relevant costs.
(b) Would your decision in (i) above have been different if the customer had offered ¢6,000

Solution:

(a) Relevant Cost and Benefits ¢’000 ¢’000


Sales Revenue (100,000 x 7000) 700,000
Direct Materials (100,000 x 2000) 200,000
Direct Labour (100,000 x ¢1000) 100,000
Variable Overhead (100,000 x 3000) 300,000 600,000
Contribution 100,000
Decision: Accept the order since it would increase profit by ¢100 million..
(b) Qualitative Factors
- Idle capacity - Plant efficiency
- Employee layoffs - Market share
- Community Image - Employee attitudes
- Competitors action - Discovery of new products
- Quality of substitutes
- Reliability of supply sources
- Labour relations
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(c) Relevant costs are future costs that differ under various alternatives
Characteristics:
- Future costs that relate to the objective of the institution
- Differ from one alternative to another
(d) Yes, because the Company will be able recover its total variable cost.

Self - assessment

1. A company has been invited to supply a large batch of electrical components over a period of
six months at a contract price of ₵300,000.
The costs of the batch are made up as follows:
Materials: XZXL 90 and TZX 131 will have to be ordered specially and will cost ₵180,000.
YYY 631 cost ₵43,000 and is already in stock; it has no other use, but could be resold for
₵18,000.
A further supply of YYY 631 will have to be acquired at a cost of ₵11,000.
Labour: Existing employees currently paid £68,000 in total will be used to produce the
components. They will have to work some overtime, which should work out at ₵16,000 in total.
A number of new employees will have to be taken on and paid a total of ₵45,000. The
additional work will be handled by existing supervisory staff who are currently paid ₵40,000 for
all of the work they supervise.
Another department will have to subcontract some of their production to another company, at a
cost of ₵34,000.
Overheads: Fixed production overheads for the period are ₵29,000. Variable production
overheads for the period applicable to the contract would be ₵18,000. Other fixed overheads for
the period amount to ₵36,000.
You are required to compare the relevant cost with the contract price and advise management.

2. JB Limited is a small specialist manufacturer of electronic components and much of its output
is used by makers of aircraft, for both civil and military purposes. One of the aircraft
manufacturers has offered a contract to JB Limited for the supply, over the next twelve months,
of 400 identical components. The data relating to the production of each component are as
follows:

(a) Material requirements


3 kg of material M1 (see note 1 below)
2kg of material P2 (see note 2 below)
1 part no.678 (see note 3 below)
Note 1: Material M1 is in continuous use by the company; 1000 kg are currently held in
stock at their original cost of GHC4.70/kg, but is known that future purchases will cost
GHC5.50/kg.
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Note 2:1200kg of material P2 are held in stock. The original cost of this material was
GHC4.30/kg. The material has not been required for the last two years. Its scrap value is
GHC1.50 per kg. The only foreseeable alternative use is as a substitute for material P4 (in
current use) but this would involve further processing costs of GHC1.60/kg. The current
cost of material P4 is GHC3.60/kg.
Note 3: it is estimated that part no. 678 could be bought foe GHC50 each.
(b) Labour requirements: Each component would require five hours of skilled labour and five
hours of semi-skilled. An employee possessing the necessary skills is available and is
currently paid GHC5/hour. A replacement would, however, have to be obtained at a rate
of GHC4/hour for the work which would otherwise be done by the skilled employee. The
current rate for semi-skilled work is GHC3/hour and an additional employee could be
appointed for this work.
(c) General manufacturing costs: it is JB Limited’s policy to charge a share of the general
costs (rent, heating and so on) to each contract undertaken at the rate of GHC20 for each
machine hour used. If the contract is undertaken, the general costs are expected to
increase over the duration of the contract by GHC3,200.
Spare machine capacity is available and each component would require 4 machine hours.
A price of GHC120 per component has been offered by the potential customer.

Required:
Should the contract be accepted? Support your conclusion with appropriate figures to
present to management.

3. Asitiwaan Ltd, a small business which specializes in building electronic control equipment, has just
received an order from a customer for eight identical robotic units. These will be completed using the
company’s own labour force and factory capacity. The product specification prepared by the estimating
department shows the following:

▪ Materials and labour requirements per robotic unit:


Component X 2 per unit
Component Y 1 per unit
Component Z 4 per unit
▪ Other miscellaneous items:
Assembly labour 25 hours per unit (but see below)
Inspection labour 6 hours per unit

As part of the costing exercise the business has collected the following information:

▪ Component X: This is an item normally held by the business as it is in constant demand. The 10
units currently in stock were invoiced to the company at GHC1.50 per unit but the sole supplier
has announced a price rise of 20 per cent effective immediately. The company has not yet paid
for the items in stock.
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▪ Component Y: 25 units are in stock. This component is not normally used by the company but is
in stock due to a cancelled order following the bankruptcy of a customer. The stock originally
cost the company GHC4,000 in total, although the company has recouped GHC1,500 from the
liquidator. As the company can see no use for it, the finance director proposes to scrap the 25
units.
▪ Component Z: This is in regular use by the company. There is none in stock but an order is about
to be sent to a supplier for 75 units, irrespective of this new proposal. The supplier charges
GHC20 per unit for all units on any order over 100 units.

Other miscellaneous items are expected to cost GHC2.50 in total.

Assembly labour is currently in short supply in the area and is paid GHC3 per hour. If the order is
accepted, all necessary labour will have to be transferred from existing work and other orders will
be lost. It is estimated that for each hour transferred to this contract GHC45 will be lost (calculated
as lost sales revenue GHC60, less materials GHC12 and labour GHC3). The production director
suggests that, owing to a learning process, the time taken to make each unit will reduce, from 25
hours to make the first one, by 1 hour per unit made.

Inspection labour can be provided by paying existing personnel overtime which is at a premium of
50 per cent over the standard rate of GHC5 per hour.

When the company is working out its contract prices, it normally adds an amount equal to GHC20
per assembly hour to cover overheads. To the resulting total, 40 per cent is normally added as a
profit markup.

Required: Prepared an estimate of the minimum price that you would recommend the
company to charge for the proposed contract, explanations for any items included.

APPLICATIONS [MERITS] OF MARGINAL COSTING

Marginal costing is a very useful technique of costing and has great potential for management in
various managerial tasks and decision- making process. The applications of marginal costing are
discussed in the following paragraphs:

1. Key Factor Analysis


The management has to prepare a plan after taking into consideration the
constraints, if any, on the various resources. These constraints are also known as limiting factors
or principal budget factors as discussed in the topic of ‘Budgets and Budgetary Control’. These
key factors may be availability of raw material, availability of skilled labour, machine hours
availability, or the market demand of the product. Marginal costing helps the management to
decide the best production plan by using the scarce resources in the most beneficial manner and
thus optimize the profits.

1. Profit Planning
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Another important application of marginal costing is the area of profit planning. Profit planning,
generally known as budget or plan of operation may be defined as the planning of future
operations to attain a defined profit goal. The marginal costing technique helps to generate data
required for profit planning and decision-making. For example, computation of profit if there is a
change in the product mix, impact on profit if there is a change in the selling of the areas of
profit planning in which necessary information can be generated by marginal costing for decision
making. The segregation of costs between fixed and variable is thus extremely useful in profit
planning

Decision Making:
Managerial decision-making is a very crucial function in any organization.
Decision – making should be on the basis of the relevant information. Through the marginal
costing technique, information about the cost behaviour is made available in the form of fixed
and variable costs. The segregation of costs between fixed and variable helps the management in
predicting the cost behaviour in various alternatives. Thus it becomes easy to take decisions.
Some of the decisions are to be taken on the basis of comparative cost analysis while in some
decisions the resulting income is the deciding factor. Marginal costing helps in generating both
the types of information and thus the decision making becomes rational and based on facts rather
than based on intuition. Some of the crucial areas of decision-making are mentioned below.
• Make or buy decisions
• Accepting or rejecting an offer
• Variation in selling price
• Variation in product mix
• Variation in sales mix
• Key factor analysis
• Evaluation of different alternatives regarding profit improvement
• Closing down/continuation of a division
• Capital expenditure decisions.

2. Cost Control
One of the important challenges in front of the management is the control of cost. In the modern
competitive environment, increase in the selling price for improving the profit margin can be
dangerous as it may lead to loss of market share. The other way to improve the profit is cost
reduction and cost control. Cost control aims at not allowing the cost to rise beyond the present
level

Illustrations

2.1. XYZ Ltd. is manufacturing three products, A, B and C. All the products use the same raw
material which is available to the extent of 61 000 kg only. The following information is
available from the books and records of the company.

Particulars Product A Product B Product C


Selling price per unit GH₵ 100 140 90
Variable cost per unit GH₵ 75 110 65
Raw material requirement per unit [kg] 5 8 6
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Market demand - units 5000 3000 4000

Advise the company about the most profitable product mix and also compute the amount of
profit resulting from such product mix if the fixed costs are GH₵150,000

Solution
It is given in the example that the raw material is available to the extent of 61 000 kg only. It can
be understood easily that if all the products are produced to the maximum possible extent
according to the market demand, the resultant profit will be highest. However it is not possible as
the raw material is not available to that extent. Therefore there is a need to work out the priority
of the products on the basis of contribution per kg of raw material [as it is a key factor] and then
produce the products in the order of priority. The following statement is prepared to show the
priority of the products on this basis.

Contribution per Unit and per Kg of Raw Material

Particulars Product A Product B Product C


Selling price per unit GH₵ 100 140 90
Less: Variable cost per unit GH₵ 75 110 65
Contribution per unit GH₵ 25 30 25
Contribution per kg of raw material * 25/5 =5 30/8 = 3.75 25/6 = 4.16
Priority I III II
* Contribution per kg of raw material is computed by dividing the contribution per unit by the
raw material requirement per unit.

The next step in the example will be to prepare a statement of best production plan based on the
priorities worked out in the above statement and compute the amount of profit resulting from the
same. This is shown in the following statement.

Optimum Product Mix and the Resulting Profit

Product Number of units Raw material Total raw Cont. Total


[In order of to be produced requirement material per unit Contribution
priority] per unit consumption GH₵ GH₵

A 5000 5kg 25, 000 25 125,000


C 4000 6kg 24, 000 25 100,000
B 1500 8 kg 12, 000 30 45,000
Total 61, 000 270,000
Less fixed costs 150,000
Profit 120,000

After producing products A and C to the maximum possible extent, i.e. as per the market
demand, the balance quantity of material available is 12000 kg and in this quantity 1500 units of
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B can be produced as the requirement for B is 8 kg per unit. The amount of profit computed
above will be the highest in the given situation.

2.2 You have been given the information below by GARBLUPEE COMPANY LTD.
Manufactures of high quality computer components.
Components A B C D
¢m ¢m ¢m ¢m
Selling price per unit 20 30 40 36
Variable costs per unit:
Direct labour GH₵2/hrs 6 4 14 10
Direct materials GH₵1/kg 6 18 10 12
Maximum demand (units) 5,000 5,000 5,000 5,000
Limits: 50,000 labour hours
110,000 kgs.
Required:
Determine which components the company should produce to maximize profit.

Solution

Components A B C D
Direct lab hrs required
(Cost per unit / Rate per Hour ) 3 2 7 5

Direct materials required per unit 6 18 10 12


(Cost per unit / rate per unit)
Selling price / u (GH₵m) 20 30 40 36
Variable costs:
DLC / U GH₵m (6) (4) (14) (10)
DMC / U GH₵m (6) (18) (10) (12)
Contribution per Unit 8 8 16 14

Contribution per DLH (¢m) 2.667 4 2.286 2.8


Ranking 3rd 1st 4th 2nd
Contribution / DMs per unit) 1.333 0.444 1.6 1.167
Ranking 2nd 4th 1st 3rd

PRODUCTION
DLHs as limiting factor
Component Rank Units DLHs Required Cumulative Hrs.
18

B 1 5,000 10,000 10,000


D 2 5,000 25,000 35,000
A 3 5,000 15,000 50,000
C 4 - - -

DMs as limiting factor


Component Rank Units Kgs of DMs required Cumulative kgs of Ms
C 1 5,000 50,000 50,000
A 2 5,000 30,000 80,000
D 3 2,000 30,000 110,000
B 4 - - -
Maximum contribution
Total contribution when B, D and A are produced
Components A B D Total
¢m ¢m ¢m ¢m
Contribution (c/u x Units 40,000 40,000 70,000 150,000

Total contribution when C, A and D are produced


Components A C D Total
GH₵m GH₵m GH₵m GH₵m
Contribution (c / u x units) 40,000 80,000 35,000 155,000

From the analysis above, the company will maximize profit when it produces 5,000 units of A,
5,000 units of C and 2,500 units of D since this option gives the company the highest
contribution of GH₵155billion as against GH₵150 billion under the other option.

Self - assessment

DFL produces three brands of soap A, B and C of which unit costs are as follows:

A B C

Machine hours 10 12 14

Direct Materials@50/kg 700(14kg) 600(12kg) 500(10kg)

Direct Wages@75/hr 900(12hrs) 600(12kg) 300(4hrs)

Variable Overheads 200 400 300

Marginal Cost 1,800 1,600 1,100

Selling price 2,400 2,100 1,500


19

Sales demand for the year is fixed as follows:

A Maximum of 4,000

B Maximum of 6,000

C Maximum of 6,000

In order to maintain its presence in the market, DFL must produce a minimum of 1,000 units of product A.

The supply of raw materials is unlimited, but available machine hours are limited to 200,000and direct
labour hours to 50,000

Requirement:

Determine the production strategy for the three products to maximize profitability of the
company.

DECISION TO CLOSE OR CONTINUE


2.3 The annual flexible budget of SUMBRU Ltd is as follows:

Production capacity 40% 60% 80% 100%


GH₵ GH₵ GH₵ GH₵
Costs:
Direct labour 16,000 24,000 32,000 40,000
Direct material 12,000 18,000 24,000 30,000
Production overhead 11,400 12,600 13,800 15,000
Administration overhead 5,800 6,200 6,600 7,000
Selling and dist. overhead 6,200 6,800 7,400 8,000
51,400 67,600 83,800 100,000
Because of trading difficulties the company is operating at 50 percent capacity. Selling price
have had to be lowered to what the directors maintain is an uneconomic level, and they are
considering whether or not the factory should be closed down until trading conditions improve.

A market research consultant has advised that in about twelve moths’ time there is every
indication that sales will increase to about 75 percent of normal capacity, and that the revenue to
be produced in the second year will amount to GH₵90,000. The present revenue from sales at 50
percent capacity would amount to only GH₵49,500 for a complete year.

If the directors decide to close down the factory for a year it is estimated that the following costs
would be incurred:
20

GH₵
Fixed costs 11,000
Closing down costs 7,500
Maintenance 1,000

And it would also cost GH₵4,000 to re-open the factory.


Required: Advise the directors as to whether or not they should close down the firm.
Solution

Profit or loss

*At1%

VC FC at 50% activity at 75% activity

GH₵ GH₵ GH₵ GH₵ GH₵ GH₵

Sales 49,500 90,000

400 Direct labour 20,000 30,000

300 Direct material 15,000 22,500

60 9000 Prod. Overhead 12,000 13,500

20 5000 Admin. overhead 6,000 6,500

30 5000 Selling and dist. 6,500 59,500 7,250 79,750

Profit/ (Loss) (10,000) 10,250

* The variable cost at the 1% for production overhead;

= (GH₵12,600- GH₵11,400)/20%

= GH₵1200/20%

= GH₵60 at 1% level of activity

. ̇ . , the Fixed Cost = GH₵11400- (GH₵60x40) = GH₵9000


21

Costs if factory closes down

GH₵

Fixed costs 11,000

Closing down costs 7,500

Maintenance 1,000

Reopening costs 4,000

23,500

It is more expensive to close the factory - GH₵23,500 loss compared with the GH₵10,000 loss.
At the 75 per cent level of activity a profit of GH₵10,250 would be made. The net effect if the
factory is closed is down and reopened next year is a loss of GH₵13,250. However, if it
continues the net effect will be a profit of GH₵250. It is therefore prudent to continue or stay in
business.

2.4 The information below has been presented to you by GARBS CONSULTANTS, a firm that
provides accounting and legal services in Longsaland.
Departments (segments )
A B C TOTAL

¢000 ¢000 ¢000 ¢000


Fees 70 150 20 240
Variable expenses 14 60 4 78
Fixed (segmental) 22 40 6 68
Rent 14 30 4 48
Partners salaries 14 30 4 48

Currently the firm is encountering a rising financial problems and has decided to drop
department B to ensure profitability.

a. Should the department be dropped?


b. A marketing consultant has advised that B’s revenue or fees can be increased by
GH¢120,000 if an Art Campaign is mounted. The cost of this campaign will be ¢60,000.
22

What effect will this campaign have on segment B and the firm as a whole?

Solution

a) Maintaining B
Contribution Approach A B C Total
GH₵000 GH₵000 GH₵000 GH₵000
Fees 70 150 20 240
Variable expenses 14 60 4 78
contribution 56 90 16 1 68
Segmental fixed cost (22) (40) (6) ( 68)
34 50 10 94
Rent ( 48)
Partners salaries ( 48)
Loss ( 2)

Without B
A C Total
GH₵000 GH₵000 GH₵000
Contribution 56 16 72
Segmental costs (22) (6) (28)
34 10 44
Rent (48)
Partners salaries (48)
Loss (52)

Increase in loss = GH₵52,000 - GH₵2,000


= GH₵ 50,000
The increase in loss of GH₵50,000 represents the excess of the contribution over the segmental
fixed costs in department B (that is GH₵90,000 - GH₵ 40,000 = GH₵50,000).
Decision rule:
Department B should be maintained since doing so will minimize the firm’s loss (ie. reduce the
firm’s loss by GH₵50,000)
‘b’ GH₵000
23

Fees 120
Variable cost (*0.4 x GH₵120,000) (48)
72
Fixed cost 60
12
*B’s Variable cost as a percentage of fees = (60000/150000)100
= 40% or 0.4

The effect(s):
1. Department B’s excess contribution over it segmental cost will increase by GH₵12,000.
2. The firm as a whole will make profit of GH₵10,000 instead of the loss of GH₵ 2,000.

MAKE OR BUY DECISION

2.5 WERIKZEEM INDUSTRIES has the follow cost data regarding the manufacture of Part
ACT 313. Production level is 20 000 units.

TOTAL COST COST/UNIT

¢’ 000 ¢’ 000

Direct materials 20 000 1.00

Direct labour 80 000 4.00

Variable factory overhead 40 000 2.00

Fixed factory overhead 80 000 4.00

220000 11.00

ABORO Ltd, another company, offered to sell to the company the same part for ¢10.00. The
manufacturing facilities can be used to produce a different product (X) with a contribution to
profit of ₵65,000,000 or rented out for 35,000,000.

Should the company make or buy the part?

Solution

Total Variable Costs

MAKE BUY

₵ ₵
24

Direct materials 1000

Direct labour 4000

Variable overhead 2000

7000 10,000

MAKE BUY: IDLE BUY: RENT BUY: MANUF X

¢’000 ¢’000 ¢’000 ¢’000

RENT REVERNUE - - 35 000 -

CONTRIBUTION - - - 65 000

OBTAINING PARTS (140 000) (200 000) (200 000) (200 000)

NET REVENUE (COST) (140 000) (200 000) (165 000) (135 000)

The above analysis indicates that the best option is to buy the parts and use the manufacturing
facilities for another product, which will produce a contribution greater than all the options.

ADD OR DROP

2.6 SUMBUKER STORES LTD has three departments: Groceries, General Merchandise and
Books/Stationery. The management is considering dropping the Groceries department because it
is making consistent losses. Below is a composite income statement for the stores as a whole and
the constituent departments.

TOTAL GROCERIES GM B/S


¢M ¢M ¢M ¢M
Sales 1900 1 000 800 100
Variable expenses (1420) (800) (560) ( 60)
Contribution 480 200 240 40
Fixed expenses:

Avoidable (265) (150) (100) (15)


Unavoidable (180) (60) (100) (20)
Net Income/ (Profit) 35 (10) 40 5
25

Solution Analysis
Keep Drop
¢m ¢m
Sales 1 900 900
Variable expenses 1 420 620

Contribution 480 280


Fixed expenses:
Avoidable (265) *(115)
Unavoidable (180) (180)
Net Income (Loss) 35 (15)
*¢265m - ¢150m(avoidable cost) = ¢115m

From the analysis, it is advisable to keep the groceries department because the company will be
worse off if it decides to drop.

Note that the 2 will share the unavoidable costs shared by the 3 if groceries dept. is dropped.

What is the exact amount the company will lose if groceries are dropped? The loss will be
50million cadis: The contribution of ¢200m less the avoidable fixed cost of C150m or the net
income of ₵35m that would be made when the apartment is kept plus the ₵15m loss when it is
dropped: (i.e. ¢35m + ¢15m = ₵50m).

SELL OR PROCESS FURTHER [1st ASSIGNMENT]

2.7 A firm processes input Ai into products X and Y. The processing cost consists of fixed
overhead of ₵C50 000, direct labour of ₵800 per unit and variable overhead of ₵1200 per unit of
Ai processed. Each unit of Ai processed results in two units of X and one unit of Y. Current
capacity is 100 units of Ai. Each unit of X is sold for ₵4000 and Y for ₵1500.
26

Management is considering installation of a new department that will process units of Y into an
equal number of units of Z. Each unit of Z will sell for ₵5000.

The new department's incremental cost structure will consist of fixed overhead to ₵50000, direct
labour of ₵900 per unit, variable overhead of ₵1350 per unit and direct materials of ₵850 per
unit.

Should the Y units be further processed?

Suggested solution:

Alternative A
Be4 FP Process further Difference

Revenue (X & Y) ¢ 950 000 (X & Z) ¢1300 000 ¢ 350 000


Incremental costs - *(360 000) (360 000)
Income / (Loss) 950 000 940 000 (10 000)
*¢900x100+¢1350x100+¢850x100+¢50000 = ¢360000
Alternative B ¢
Revenue for Z 500 000

Processing costs (360 000)


140 000
Less Opportunity cost 150 000
Net Income/(Loss) (10 000)
From the analysis under any of the alternative treatments, the company will be worse processing
further joint product Y into Z.

KEEP OR REPLACE
2.7 Consider the data below which relate to an old machine being used in the company and a
new one management intends buying to replace the old one:
Old Machine New machine
¢’000 ¢’000
Original cost 10 000 8 000
27

Useful life (years) 10 4


Age (years) 6 0
Accumulated Depreciation 6 000 0
Book value 4 000 N/A

Disposal value (now) 2500 N/A


Disposal value in 4 years 0 0
Annual cash operation cost 5000 3000
Decision:
Should the old equipment be replaced with the new one?
Suggested Analysis and Decision

KEEP REPLACE DIFFERENCE


¢’000 ¢’000 ¢’000
Cost of operation (4 years) 20000 12000 8000
Disposal value ( income) - (2500) 2500
New machine (cost) - 8000 (8000)
Total costs 20000 17500 (2500)
The total cost for the four years will be less when the old machine is replaced. The difference in
the cost under the two alternatives is ₵2.5 million in favour of replacement.

BENCHMARKING FOR SETTING OF STANDARDS

Benchmarking is the process of identifying "best practice" in relation to a product/service and the
processes by which those products/services are created and delivered. The objective of benchmarking is
to understand and evaluate the current position of a business or organisation in relation to "best
practice" and to identify areas and means of performance improvement.

The Benchmarking Process

Benchmarking involves looking outward (outside a particular business, organisation, industry, region or
country) to examine how others achieve their performance levels and to understand the processes they
use. Benchmarking therefore helps to understand the processes behind excellent performance.

Application of benchmarking involves four key steps:


28

(1) Understand in detail existing business processes

(2) Analyse the business processes of others

(3) Compare own business performance with that of others analysed

(4) Implement the steps necessary to close the performance gap

Benchmarking should not be considered a one-off exercise. To be effective, it must become an ongoing,
integral part of an ongoing improvement process with the goal of keeping abreast of ever-improving
best practice.

In the same way benchmarking should be followed while determining the standard for costs. Production
manager and cost accountant must work together in setting the standards. Production manager should
determine the quantity standards and cost accountant should work out for price standards.

Reporting of Variances to Management

The primary purpose of reporting to management is to enable them to take corrective action and arrest
unfavourable variances to the extent possible. Therefore, timely and prompt reporting of the variance is
of utmost importance. The individual or department responsible for adverse controllable variance
should be located. For instance, a variation in the price paid for raw materials would be the
responsibility of the purchase manager and a variation in production efficiency is the responsibility of
the production manager. The board and the managing director would be concerned with the overall
efficiency, with which their plans have been operated by the lower levels of management. The profit
and loss account should be prepared in a special manner - staring with the standard or budgeted profit,
the various variances would be put in two columns, favourable and unfavorable, and the net results
added to or deducted from the standard profit, thus arriving at the actual profit. Management can easily
see the factors that have contributed to the change in the profit picture. While reporting the analysis of
variances to management, graphs and charts might be used or analysis may be reported in the form of
statement and reports giving main details.

In order that variance reporting should be effective, it is essential that the following conditions are
fulfilled:

(i) The variances arising out of each factor should be correctly segregated. If part of a variance due to
one factor is wrongly attributed to or merged with that of another, the analysis report submitted to the
management would be misleading and wrong inferences may be drawn from it;

(ii) Variances, particularly the controllable variances should be reported with promptness as soon as
they occur. This would enable corrective action being taken in time;

(iii) Analysis of uncontrollable variances should be made with the same care as for controllable
variances since the analysis of the off standard situation may reveal far reaching effects on the economy
of the concern; and
29

(iv) The forms of reports for the different types of variances should be designed keeping in view the
needs of the management and the size of the concern, and no standard forms can, therefore, be
suggested.

It is better to present the profit figures by way of reconciliation of budgeted (or standard) and actual
profits on the basis of variances.

STANDARD COSTING

Standard Costing is an important tool in the hands of management for improving the
management control by providing parameters for comparison of actual with these
parameters.

Definitions
Standard Cost is defined as, ‘a pre-determined cost which is calculated from management’s
standard of efficient operation and the relevant necessary expenditure. It may be used as a basis
for price fixation and for cost control through variance analysis.’ [CIMA – UK]
Standard Costing on the other hand is defined as, ‘preparation and use of standard costs, their
comparison with actual costs and analysis of variances into their causes and points of
incidences.’ [CIMA – UK]

Setting of Standards
The heart of the standard costing is setting of standards. Standard setting should be done
extremely carefully to ensure that the standards are realistic and neither too high nor too low. If
very high standards are set, it will be impossible to attain the same and there will be always an
adverse variance. This will result in lowering the morale of the employees. On the other hand, if
standards are set too low, they will be attained very easily and the favourable variances will
create complacency amongst the employees. In view of this, the standards should be set very
carefully.

Reasons for using Standards

Standard costing system:

➢ Provides management with frequent variance reports which highlight when costs and/or
revenues are not going according to expectations. Thus, Management can take
appropriate corrective action as early as possible;
➢ Provides management with an early warning about possible losses and inefficiencies;
➢ Helps to ensure the control of all the elements of cost and revenue in terms of price and
volume;
➢ Works well in small, medium and large-scale businesses;
30

➢ Helps to achieve uniformity in the costing of jobs and/or products.

Standard to be used

To be of any real use to management, a standard has to be realistic. Thus, the current standard
and the normal standard are recommended. However, both should be flexible enough to be
revised and amended to reflect environmental changes which take place from time to time, even
in the short term. Thus, if current conditions change significantly, then the standard should also
be changed.

There are a number of standards which could be adopted, some of which are;
Basic standard
A standard which is established for use unaltered over a long period of time.
Current standard
A standard related to current conditions, and which is established for use over a short period of
time.
Expected standard
The standard which it is anticipated can be attained during a future specified budget period.

Normal standard
The average standard which it is anticipated can be attained over a future period of time.
Ideal standard
The standard which can be attained under the most favourable conditions possible.
Historical standard
The average standard which has been achieved in the past. It is a loose standard because there is
a possibility that the average past performance may include inefficiencies.
VARIANCE ANALYSIS
A variance is the difference between a standard cost/revenue and the actual cost/revenue. It could
be favourable or Adverse
An adverse (or negative) variance arises where the actual expenditure exceeds the planned (i.e.
standard) expenditure or where standard revenue exceeds actual revenue.
A favourable (or positive) variance arises where the actual expenditure is less than the planned
expenditure or where actual revenue exceeds standard revenue.
Variance reports
31

Comparative reports or statements should be presented to management at regular intervals. They


should highlight significant adverse variances, and provide explanations of why they have
occurred. This should help management to decide upon the appropriate action needed to put right
anything which has gone wrong.
32

The diagram below lists a number of variances which, in aggregate, affect the profit variance.

Profit variance

Total cost variance Total sales margin variance

Direct labour Direct materials Overhead Selling and sales sales


variance cost variance variance distribution margin margin
Variance price quantity/volume
Variance variance

Efficiency Rate Usage Price


Variance variance variance variance

Mix Yield
33

INVESTIGATING THE REASONS FOR VARIANCES

Implementing a standard costing system represents a major investment of time and other
resources for most businesses. The benefits of this investment will outweigh the costs only if
full use is made by management of the information conveyed by variances. It is important, too,
that the investigation of variances is carried out promptly. The standard costs should be
compared with actual on a monthly basis; this is realistic and it reflects actual practice in
industry. If the comparison are to be made annually or even quarterly, any underlying problems
would persist for far too long. In order for management to be able to exert full control frequent
and timely action is required.

Deciding Which Variances Merit Investigation

It is a matter of management policy to decide the level at which a variance becomes significant
and worthy of further investigation. The following criteria will probably be important in
deciding which variances merit investigation:

• Significance in percentage or monetary terms. For example, management may


decide to investigate any variance, favorable or unfavorable, which is greater than
5%. Or they may use a monetary criterion, such as investigate any variance
greater than ₵5000.
• Frequency of occurrence. Variances may be individually minor, but cumulatively
significant. For example, if there is a persistent adverse materials price variance
across a range of different materials items, this may point to lax purchasing
management.

Principal reasons for the occurrence of variances

Sales variances

• Actual sales volume may differ from budget volume because of such factors as:
• greater than expected success of an advertising campaign
• improved efficiency and effectiveness of sales staff
• failure of a competitor
• entry of a new competitor into the market
• loss of sales staff, or loss of morale and motivation through poor management.

Sales prices may differ because of such factors as:

• lowering of prices to increase volume


• lowering of prices to respond to new competition
• •increasing prices to take advantage of exit of competitor from the market
• •fashion trends (it may be possible to charge higher prices for fashionable items).

33
34

Direct materials variances

Price variances may arise because of any, or a combination, of the following factors:

• successful negotiation for lower prices


• obtaining quantity discounts for large orders
• variation in material quality
• volatile market for material, leading to unexpected increases or decrease in price

Quantity variances may arise as follows:

• better or worse quality of material than expected


• employment of higher or lower skilled workers than anticipated
• level of supervision/number of quality checks
• poor functioning of machinery.

Direct labour variances

Rate variances may arise in the following circumstances


• The mix of labour differs from plan; for example, using more higher paid staff in
production because of under-employment elsewhere in the factory
• Unexpected increase in rate arising from the conclusion of negotiations over wage
levels.

Efficiency variances may arise as follows:

• better or worse quality of material than expected


• employment of higher or lower skilled workers than anticipated
• level of supervision/ number of quality checks
• poor functioning of machinery.

Overhead variances
Overhead variances may arise because of any of the following:

• non-controllable price changes because of events in the wider economy • poor


management control over costs
• Improved management control over costs.
Last, but not least, variances may occur simply because the standard cost was
incorrectly set. For example, if the standard cost for a particular item reflects the
best possible cost achievable only in ideal circumstances, then it is unlikely to be
met. The existence of variances may signal no more than the need to alter the

34
35

standard cost. However, before this step is taken the variance should be
thoroughly investigated to ensure that there is no other cause.

Materials and Labour Variances


In their simplest from, materials and labour variances can be computed as follows:
The total variance
This is the overall variance and results from a comparison of the actual quantity in terms of
materials or labour hours with the standard set for the actual level of activity attained:
Standard quantity (SQ) at standard price (SP) Materials Labour
(for actual level of activity) SQ x SP SH x SP
Less Actual quantity (AQ) at actual price (AP) AQ x AP AH x AP
= materials Labour
Cost (wages) cost
(total) variance (total) variance

Example - Labour Variances


Using the following information, calculate the labour variances:

Standard labour rate ₵8 per component


Hours 2 per component

Actual production data was:


1,000 components produced
Labour rate paid ₵8.40 per hour
Hours worked 1,950 hours

Solution
The labour cost variance (i.e. the total variance);
= SC - AC
= (Standard hours x Standard rate
for actual production) less (Actual hours x Actual rate)
= (2,000 x ₵8) - (1,950 x ₵8.40)
= ₵16,000 - ₵16,380
= ₵380 Adverse

Labour rate variance


= ( SR - AR)AHs
= (standard rate- Actual rate) x actual hours
= ( ₵8 - ₵8.40) x 1950
= ₵780 Adverse

35
36

Labour efficiency variance;


= ( standard hours– Actual hours) x standard rate per hour of actual input
= (2,000-1,950) hours x ₵8
= ₵400 Favourable

Summary ₵
Labour rate variance (780) (A)
Labour efficiency variance 400 (F)

Labour cost variance (380) (A)


Layout of the above may be improved by setting out calculation as follows:

Standard labour cost ( 2,000 x ₵8) 16,000
Less Actual labour cost (1,950 x ₵8.40) 16,380

Labour Cost Variance ₵380 adverse

Another approach for calculating the same variances is shown below:


Labour cost labour rate
or or labour
Wages wages rate efficiency
Variance variance variance

₵ ₵ ₵

Standard hours at standard rate


(2,000 at ₵8) for the actual
Level of activity 16,000 16,000

Actual hours at standard rate


(1,950 at ₵8) 15,600 15,600

Actual hours at actual rate


(1,950 at ₵8.40) 16,380 16,380
₵380A ₵780A ₵400F

Summary (proof) ₵
Labour rate variance (780) A
Labour efficiency variance 400 F

Labour cost variance (380) A

36
37

Labour cost variance This is the total variance which arises from comparing the actual labour
cost with the standard labour cost, for the actual level of activity achieved. In the example, the
actual was greater by ₵380 than standard cost, which means the variance is adverse, representing
an overspend.

Labour rate variance This is calculated by multiplying the actual hours, 1,950 by the difference
in the wage rate paid:

(SR – AR) AHs


Hours rate
Actual 1,950 x £8.00 Standard ₵15,600

Less Actual 1,950 x ₵8.40 Actual ₵16,380

Actual 1,950 x -40p (difference) variance ₵780 (adverse)

The variance is adverse because it cost the company 40p per hour more than had planned. Thus,
every actual hour worked costs the company 40p more than planned.

Labour efficiency variance This is an evaluation of the time lost or saved at the standard rate.
It is calculated as follows; (SHs - AHs)SR.

Standard
Hours rate ₵
Time allowed - Standard 2,000 x ₵8 = 16,000
Time taken - Actual 1,950 x ₵8 = 15, 600
Hours saved 50 x ₵8 variance ₵ 400 F

This variance was fabourable, because the work performed was done in 50 hours less than the
standard time allowed.

Materials Mix And Yield Variances

Mix Variance
The mix we are talking about is the mix of materials (rather like a cookery recipe) which has to
be combined to produce a product. The mix variance is due to the actual mix of materials used
being different from the standard mix. It can be computed by subtracting the standard cost of the
standard yield from the actual quantity at standard price.

Yield variance
A yield in manufacturing terms is the expected output from a given input of materials. The
yield variance is attributable to producing an actual yield which is lesser or greater than the
standard yield. It is calculated as follows;

37
38

(Actual Yield –Standard Yield)SC per unit

Actual yield 475 kilos


Standard yield (485 kilos)

Less than the standard -10 kilos

Multiply this by the standard cost per kilo and you have the yield variance.
However, note that there are several different ways and formats in use for the computation of
variances.
The following example should help you to better understand mix and yield variances.

Example 1:
IWC Ltd manufactures a product containing materials in the following proportions and at the
standard cost shown:

30% material X at ₵50 per kilo


70% material Y at ₵60 per kilo

A standard loss of 5% is expected in production.


During a period when 96 kilos of the product were produced, 32 kilos of material X at an actual
cost of ₵49 per kilo, and 68 kilos of material Y at an actual cost of ₵63 per kilo, were used.
Calculate the material cost variance using the tabular method.

Solution

Given that;
AQ = Actual quantity ; X= 32, Y= 68
AP = Actual price ; X= ₵49, Y= ₵63
SP = Standard price; X= ₵50, Y= ₵60
SC = Standard cost = ₵60*
SY = Standard yield = 95 kilos
AY = Actual yield = 96 kilos

IWC PLC

*Materials X 30 kilos at ₵50 per kilo 1,500
Materials Y 70 kilos at ₵60 per kilo 4,200
100
Less loss 5
Standard 95 kilos at *₵60 per kilos standard cost ₵5,700
*SC/u =₵5,700/95= ₵60
(AQ x AP) ₵ ₵
(a) Actual cost of X (32 x ₵49) 1,568
Kilos produce Y (68 x ₵63) 4,284 5,852

38
39

(AQ x SP)
(b)Actual quantity X (32 x ₵50) 1,600
At standard price Y (68 x ₵60) 4,080 5,680

(c)Standard cost of standard


Yield
(SY x SC)
(95 x ₵60) 5,700

(d)Standard cost of
Actual Yield in kilos
(AY x SC)
(96 x ₵60) 5,760
Summary:

Price variance ( b – a) , (SP-AP)AQ 172 A
Mix variance ( c – b) , (SY x SC)- (AQ x SP) 20 F
Yield variance ( d – c) , (AY - SY) SC 60 F
Total Materials Cost Variance (d – a ) [(SC of AY) - AC)] 92 A

Material Usage Variance ₵

Mix variance 20 F
Yield variance 60 F
₵80 F

Proof
(d – b) ₵
(SC x AQ) (d) 5,760
Less (AQ x SP) (b) 5,680
₵80 F

The Reconciliation of Standard And Actual Profits

Variances can be used to explain the difference between the standard profit and the actual profit.
The example that follows illustrates this.

Example:
Galamsay Politico-Economic Ltd makes a single product, which requires 3 kilos of materials
normally costing ₵5 per kilo, and takes one standard hour’s labour to produce. Labour employed
on this process is expected to be paid ₵8 per hour.
During the month, it is estimated that 1,000 units will be sold at ₵56 each. Overheads (all fixed
in relation to output) are budgeted to be ₵1,800 per month.

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It can be assumed that no stocks of raw material or finished product are carried.
The actual wages paid for the period were ₵9,180, representing 1,080 at ₵8.50 per hour.

Materials purchased during the month were as follows:


Kilos ₵
2,500 at ₵5.50 per kilo 13,750
700 at ₵5per kilo 3,500
17,250

A total of 1,080 hours were taken on the process to produce 1,100 units, all of which were sold.
Units were sold at ₵52 each.
Overheads incurred were ₵2,100.
Required
Prepare the standard cost and operating statements, showing clearly any variances and reconcile
the two.

Solution

Galamsay Ltd
Actual profit and loss account for 1100 units

Actual sales ₵ ₵
1,100 at ₵52 57,200
Less actual costs:
Materials 2,500 at ₵5.50 13,750

700 at ₵5 3,500
17,250
Labour
1,080 hours at ₵ 8.50 9,180
Overheads 2,100 28,530
Net profit 28,670

Standard cost statement



Budgeted sales 1,000 at ₵56 56,000
Sales volume variances 100 at ₵56 5,600
1,100 at ₵56 61,600

Standard costs for 1,100 units



Materials 1,100 x 3 kilos x £5 16, 500
Labour 1,100 at ₵8 8, 800
Overheads 1,800 27,100
Standard profit for 1,100 units ₵34,500

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Reconciliation Statement

Standard profit ( as calculated) 34,500

Variance Profit Loss


(Favourable) (Adverse)
Sales price variance:
(₵52 - ₵56 )1,100 4,400
Material price variance:
[₵17,250 – (3,200 kilos) ₵5] 1,250
Materials usage variance:
(3,300 – 3,200) ₵5 500
Labour rate variance:
(1,080 hours) ₵8 - (₵9,180) 540
Labour efficiency variance:
(1,080 – 1,100 hours) ₵8 160
Overheads variance:
₵1,800 - ₵2,100 300

660 6,490 5,830 A


Actual Profit ₵28,670

Self-assessment
1. Ganinanya Ltd makes a single product. The product requires 2 litres of material normally
costing ₵6 per litres, and takes two standard hours of labour to produce. Labour employed on
this process should earn ₵9.00 per hour.
During the month, it is estimated that 1,000 units will be sold at ₵40 each. Overheads (all fixed
in relation to output) are budgeted to be ₵1,000 per month.
It can be assumed that no stocks of raw materials or finished products are carried.
The actual wage rate paid was ₵9.25 per hour. Other 'actual' data for the period are:

• Materials purchased and used during the month were 2,300 litres at ₵5.75,
• 2,200 hours were taken to produce 1,200 units, all of which were sold. Units were sold at
₵42 each.
• Overheads incurred were ₵1, 150.
Required: Prepare a product standard cost statement, monthly operating statement and a
reconciliation statement showing clearly any variances.
2. ARMAGGEDDON & Co. Ltd manufactures a product containing materials in the following
proportions and at the standard cost shown for 100 kilos input:
40 per cent material XL90 at ₵53 per kilo

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60 per cent material Z007 at ₵33 per kilo


A standard loss of 18 per cent is expected in production.
During the period under review, 80 kilos of the product were produced, using 42 kilos of
material XL90 at an actual cost of ₵50 per kilo, and 58 kilos of material Z007 at an actual cost of
₵35 per kilo
Calculate the material variances, i.e.:
1. price;
2. usage;
3. mix;
4. yield;
5. total (cost)
3. As management accountant of the Northern Share Nut Co. Ltd, you are responsible for
collecting the following data for December 20XN
Prepare a statement for your board of directors reconciling the budget (target) operating profit
with the actual operating profit.
Target (Standard) Actual
Sales (units) 10,000 8,000
Sales ₵120,000 ₵99,516

₵ ₵
Cost of sales:
Materials
(60,000 kilos at 50p) 30,000 (52,000 kilos) 24,118
Labour
(20,000 hours at ₵2.50) 50,000 (18,000 hours) 47,560

Operating Costs 80,000 71,678


Operating Profit 40,000 27,838
4. GBELSE Ltd makes a single product. This product requires 2 kilos of material normally
costing ₵6 per kilo, and takes two standard hours of labour to produce. Labour employed on this
process is expected to earn the standard rate of ₵7.50 per hour.
During the month, it is estimated that 1,000 units will be sold at ₵32 each. Overheads (all fixed
in relation to output) are budgeted to be ₵1,200 per moth
It can be assumed that no stocks of raw materials or finished products are carried.

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Shortly after the period commences, operators receive a 50p per hour increase in their hourly rate
of pay. Other 'actual' data for the period are:

• Materials purchased and used during the month 2,100 kilos at ₵5.60 per kilo.
• 2,000 hours were taken on the process to produce 1,100 units, all of which were sold.
Units were sold at ₵30 each.
• Overheads incurred were ₵1,700.
Prepare a product standard cost statement and monthly operating statement, and a reconciliation
statement, showing clearly any variances.

BUDGETS AND BUDGETARY CONTROL

Definition:
Budget and Budgetary Control.

Budget has been defined by CIMA U.K. as, ‘A financial and/or quantitative statement prepared
prior to a defined period of time, of the policy to be pursued during that period for the purpose of
achieving a given objective.’
If we analyze the definition, the following features of budget emerge.

I. A budget is a statement that is always prepared prior to a defined period of time. This means
that budget is always prepared for future period and not for the past.
II. Budget is prepared either in quantitative details or monetary details or both. This means that
budget will show the planning in terms of money or in quantity or both.

III. Every organization has well defined objectives, which are to be achieved in a particular span
of time.
It is of paramount importance that there should be systematic efforts to bring them into reality.
As a part of these efforts, it is necessary to formulate a policy and it is reflected in the budget.

Budgetary Control is actually a means of control in which the actual results are compared with
the budgeted results so that appropriate action may be taken with regard to any deviations
between the two. Budgetary control has the following stages.

_ Developing Budgets: The first stage in budgetary control is developing various budgets. It will
be necessary to identify the budget centers in the organization and budgets will have to develop
for each one of them.
_ Recording Actual Performance: There should be a proper system of recording the actual
performance achieved. This will facilitate the comparison between the budget and the actual.
_ Comparison of Budgeted and Actual Performance: One of the most important aspects of
budgetary control is the comparison between the budgeted and the actual performance. The
objective of such comparison is to find out the deviation between the two and provide the base
for taking corrective action.
_ Corrective Action: Taking appropriate corrective action on the basis of the comparison
between the budgeted and actual results is the essence of budgeting. A budget is always prepared

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for future and hence there may be a variation between the budgeted results and actual results.
There is a need for investigation and taking appropriate action so that the deviations will not
repeat in the future.

Objectives of Budgeting
An effective budgeting system plays a crucial role in the success of a business organization. The
budgeting system has the following objectives, which are of paramount importance in the overall
efficiency and effectiveness of the business organization.
_ Planning: Planning is necessary for doing any work in a systematic manner. A well- prepared
plan helps the organization to use the scarce resources in an efficient manner and thus achieving
the predetermined targets becomes easy. A budget is always prepared for future period and it
lays down targets regarding various aspects like purchase, production, sales, manpower planning
etc. This automatically facilitates planning.
_ Co-ordination: For achieving the predetermined objectives, apart from planning, coordinated
efforts are required. Budgeting facilitates coordination in the sense that budgets cannot be
developed in isolation. For example, while developing the production budget, the production
manager will have to consult the sales manager for sales forecast and purchase manager for the
availability of the raw material. Production budget cannot be developed in isolation. Similarly
the purchase and sales budget as well as other functional budgets like cash, capital expenditure,
manpower planning etc cannot be developed without considering other functions. Hence the
coordination is automatically facilitated.
_ Control: Planning is looking ahead while controlling is looking back. Preparation of budgets
involves detailed planning about various activities like purchase, sales, production, and other
functions like marketing, sales promotion, manpower planning. But planning alone is not
sufficient. There should be a proper system of controlling which will ensure that the work is
progressing as per the plan. Budgets provide the basis for such controlling in the sense that the
actual performance can be compared with the budgeted performance. Any deviation between the
two can be found out and analyzed to ascertain the reasons behind the deviation so that necessary
corrective action can be taken to rectify them.Thus budgeting helps immensely in controlling
function.

Benefits of Budgeting/Budgets

Budgeting plays an important role in planning and controlling. It helps in directing the scarce
resources to the most productive use and thus ensures overall efficiency in the organization.

Budgeting/Budgets are generally regarded as having five areas of usefulness, described below.
1. Promote forward-thinking and the possible identification of short term problems.
2. Help to co-ordinate the various sections of the business.
3. Motivate managers to better performance.
4. Provide a basis for a system of control.
5. Provide a system of authorisation for managers to spend up to a particular limit.

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FORECAST AND BUDGET

A forecast is an assessment of probable future events. Budget is an operating and financial plan of a
business enterprise. At planning stage it is necessary to prepare forecasts of probable course of action
for the business in future. Budget is a sort of commitment or a target which the management seek to
attain on the basis of the forecasts made. Forecasts are made regarding sales, production cost and
financial requirements of the business. A forecast denotes some degree of flexibility while a budget
denotes a definite target.

The following points of distinction can be noted between forecast and budget:

(i) Forecast is a mere estimate of what is likely to happen. It is a statement of probable events which are
likely to happen under anticipated conditions during a specified period of time.

Budget shows that policy and programme to be followed in a future period under planned conditions.

(ii) Forecasts, being statements of future events, do not connote any sense of control.

A budget is a tool of control since it represents actions which can be shaped according to will so that it
can be suited to the conditions which may or may not happen.

(iii) Forecasting is a preliminary step for budgeting. It ends with the forecast of likely events.

It begins when forecasting ends. Forecasts are converted into budgets.

(iv) Forecasts have wider scope, since it can be made in those spheres also where budgets can not
interfere.

Budgets have limited scope. It can be made of phenomenon non capable of being expressed
quantitatively.

OBJECTIVES OF BUDGETARY CONTROL

The objectives of budgetary control are the following :

(1) To use different levels of management in a co-operative endeavour for achievement of the
objectives of the firm.

(2) To facilitate centralised control with delegated authority and responsibility.

(3) To achieve maximum profitability by planning income and expenditure through optimum use of the
available resources.

(4) To ensure adequate working capital in other resources for efficient operation of business.

(5) To reduce losses and wastes to the minimum.

(6) To bring out clearly where effort is needed to remedy the situation.

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(7) To see that the firm is not deflected from marching towards its long-term objectives without being
overwhelmed by emergencies.

(8) Various activities like production, sales, purchase of materials etc. are co-ordinated with the help of
budgetary control.

ADVANTAGES OF BUDGETARY CONTROL

Budgetary control makes all the differences between drifting in an unchartered sea and following a well
plotted course towards a predetermined distinction. It serves as a valuable aid to management through
planning, co-ordination and control.

The principal advantages of a budgetary control system are enumerated below:

(1) Budgetary control aims at maximisation of profits through effective planning and control of income
and expenditure - directing capital and resources to the best and most profitable channel.

(2) There is a planned approach to expenditure and financing of the business so that economy is
affected in the utilisation of funds to the optimum benefit of the concern.

(3) It provides a clear definition of the objective and policies of the concern and a tool for objecting
these policies to periodic examination.

(4) The task of managerial co-ordination is facilitated through budgetary control.

(5) Since each level of management is aware of the task and is fully conscious as to the best way by
which it is to be performed, maximum effective utilisation of men, materials and resources can be
attained.

(6) Reports are furnished under the principles of management or control by exception. Only deviations
from budgets which point out the weak spots and inefficiencies are properly looked into.

(7) It cultivates in the management the habit of thinking ahead - making careful study of the problems
in advance before taking decisions.

(8) A budgetary control system assists delegation of authority and is a powerful tool of responsibility
accounting.

(9) Budgets are the fore-runners of standard costs in the sense that they create necessary conditions to
suit setting up of standard costs.

(10) The method of evaluating performance against budgets provides a suitable basis for establishing
incentive system of remuneration by results as also spotting people with exceptional qualities of
leadership and management.

(11) Since it involves foreseeing difficulties of various types, it will lead to their removal in time.

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LIMITATIONS OF BUDGETARY CONTROL

(1) Budgetary control starts with the formulation of budgets which are mere estimates. Therefore, the
adequacy or otherwise of budgetary control system, to a very large extent, depends upon the adequacy
or accuracy with which estimates are made.

(2) Budgets are meant to deal with business conditions which are constantly changing. Therefore,
budgets estimates lose much of their usefulness under changing conditions because of their rigidity. It is
necessary that budgetary control system should be kept adequately flexible.

(3) The system of budgetary control is based on quantitative data and represent only an impersonal
appraisal to the conduct of business activity unless it is supported by proper management of personal
administration.

(4) It has often been found that in practice the organisation of budgetary control system become top
heavy and, therefore, costly specially from the point of view of small concern.

(5) Budgets and budgetary control have given rise to a very unhealthy tendency to be regarded as the
solvent of all business problems. This has resulted in a very luke-warm human effort to deal with such
problems and ultimately results in failure of budgetary control system.

(6) It is a part of human nature that all controls are resented to. Budgetary control which places
restrictions on the authority of executive is also resented by the employees.

The limitations stated above merely point to the need of maintaining the budgetary control system on a
realistic and dynamic basis rather than as a routine.

PRELIMINARIES FOR THE ADOPTION OF A SYSTEM OF BUDGETARY CONTROL

For the successful implementation of a system of budgetary control certain pre-requisites are to be
fulfilled. They are summarised below:

(1) There should be an organisation chart laying out in clear terms the responsibilities and duties of
each level of executives and the delegation of authority to the various levels.

(2) The objectives, plans, and policies of the business should be defined in clear cut and unambiguous
terms.

(3) The budget factor or the key factor(s) which will be the starting point of the preparation of the
various budgets should be indicated.

(4) For formulation and efficient execution of the plan, a Budget Committee should be set up.

(5) There should be an efficient system of accounting to record and provide data in line with the
budgetary control system.

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(6) There should be a proper system of communication and reporting between the various levels of
management.

(7) There should be a Budget Manual wherein all details regarding the plan and its procedure of
operation are given as also the length of the budget period.

(8) The budgets should primarily be prepared by those who are responsible for performance.

(9) The budgets should be comprehensive, complete, continuous and realistic to attain.

(10) There should be an assurance from the top management executives for co-operation and
acceptance of the budgetary control system.

(11) For the success of a budgetary control system, it is essential that there should be a sound
organisation for budget preparation, budget maintenance, and budget administration. The budgetary
control organisation is usually headed by a top executive who is known variously as the Budget
Controller, Budget Director, or Budget Officer, who may have under him a Budget Committee
constituted with the representatives of various departments like purchases, sales, production,
development, administration and accounts.

Unless the philosophy of budgeting and budgetary control is accepted by everyone in authority, the
system may work only haphazardly. The full and frank and active cooperation of all is required while
framing budgets. Then only they will feel committed to the achievements of targets set for them.

The Budget-Setting Process

Budgeting is such an important area for businesses and other organizations that it tends to be
approached in a fairly methodical and formal way. This usually involves a number of steps,
described below.

The 9 Steps in the budget-setting process

Estqablish who will take responsibility for the


budget setting process

Communicate budget guidelines to relevant


manager

Identify the key or limiting factor

Prepare the budget for the area of the limiting


factor
Review and co-ordinate budgets

Prepare draft budgets for the other areas

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Prepare the master budgets to all interested


parties

Communicate the budgets to all interested


parties

Monitor actual performance relative to the


budget

Preparation for Budgetary Control


A budgetary control is extremely useful for planning and controlling as described earlier.
However, to get the benefits, sufficient preparation should be made. For complete success, a
solid foundation should be laid down.

Master Budget: Functional Budgets’ are prepared for planning of the individual function of the
organization. For example, budgets are prepared for Purchases, Sales, Production, Human
Resource Planning, and so on. A Master Budget is a consolidation of all the functional budgets.
It shows the projected Profit and Loss Account and Balance Sheet of the business organization.
For preparation of this budget, all functional budgets are combined together and the relevant
figures are incorporated in preparation of the projected Profit and Loss Account and Balance
Sheet. Thus Master Budget is prepared for the entire organization and not for individual
functions.

_ Fixed and Flexible Budgets:


Fixed Budgets: When a budget is prepared by assuming a fixed percentage of capacity
utilization, it is called as a fixed budget. A fixed budget may be prepared when the budgeted
output and actual output are quite close and not much deviation exists between the two. In such
cases, maximum control can be exercised between the budgeted performance and actual
performance.
Flexible Budgets: A flexible budget is a budget that is prepared for different levels of
capacity utilization. It can be called as a series of fixed budgets prepared for different levels of
activity. For example, a budget can be prepared for capacity utilization levels of 50%, 60%, 70%,
80%, 90% and 100%. The basic principle of flexible budget is that if a budget is prepared for
showing the results at say, 15, 000 units and the actual production is only 12,000 units, the
comparison between the expenditures, budgeted and actual will not be fair as the budget was
prepared for 15,000 units.
Therefore a flexible budget is developed for a relevant range of production from 12,000 units to
15,000 units. Thus even if the actual production is 12,000 units, the results will be comparable
with the budgeted performance of 12,000 units. Even if the production slips to 8,000 units, the
manager has a tool that can be used to determine budgeted cost at 9, 000 units of output. The
flexible budget thus, provides a reliable basis for comparisons because it is automatically geared
to changes in production activity. Thus a flexible budget covers a range of activity, it is flexible
i.e. easy to change with variation in production levels and it facilitates performance measurement
and evaluation.

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While preparing flexible budget, it is necessary to study the behavior of costs and divide them
into fixed, variable and semi variable. After doing this, the costs can be estimated for a given
level of activity.
It is also necessary to plan the range of activity. A firm may decide to develop flexible budget for
activity level starting from 50% to 100% with an interval of 10% in between. It is necessary to
estimate the costs and associate them with the chosen level of activity.
Finally the profit or loss at different levels of activity will be computed by comparing the costs
with the revenues.

Classifi cation of Budgets According to Time: According to this classifi cation, budgets are
divided in the following categories.
Short Term Budget: Any budget that is prepared for a period up to one year is known as
Short Term Budget. Functional budgets are normally prepared for a period of one year and then
it is broken down month wise.
Medium Term Budget: Budget prepared for a period 1-3 years is Medium Term Budget.
Budgets like Capital Expenditure, Manpower Planning are prepared for medium term.
Long Term Budgets: Any budget exceeding 3 years is known as Long Term Budgets.
Master Budget is normally prepared for long term. In the modern days due to uncertainty, very
few budgets are prepared for long term.

Techniques of Budgeting
Zero Base Budgeting: Zero Base Budgeting is a method of budgeting whereby all
activities are revaluated each time the budget is to be formulated and every item of expenditure
in the budget is fully justified. Thus Zero Base Budgeting involves starting from scratch or zero.
Zero based budgeting [also known as priority based budgeting] actually emerged in the late
1960s as an attempt to overcome the limitations of incremental budgeting. This approach
requires that all activities are justified and prioritized before decisions are taken relating to the
amount of resources allocated to each activity. Hence in Zero Based Budgeting, the beginning is
made from scratch and each activity and function is reviewed thoroughly before sanctioning the
same and all expenditures are analyzed and sanctioned only if they are justified.
Besides adopting a ‘Zero Based’ approach, the Zero Based Budgeting also focuses on programs
or activities instead of functional departments based on line items, which is a feature of
traditional budgeting. It is an extension of program budgeting. In program budgeting, programs
are identified and goals are developed for the organization for the particular program. By
inserting decision packages in the system and ranking the packages, the analysis is strengthened
and priorities are determined.

Applications of Zero Based Budgeting:


The following stages/steps are involved in the application of Zero Based Budgeting.
_ Each separate activity of the organization is identified and is called as a decision package.
Decision package is actually nothing but a document that identifies and describes an activity in
such a manner that it can be evaluated by the management and rank against other activities
competing for limited resources and decide whether to sanction the same or not.
_ It should be ensured that each decision package is justified in the sense it should be ascertained
whether the package is consistent with the goal of the organization or not.

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_ If the package is consistent with the overall objectives of the organization, the cost of
minimum efforts required to sustain the decision should be determined.
_ Alternatives for each decision package are considered in order to select better and cheaper
options.
_ Based on the cost and benefit analysis a particular decision package/s should be selected and
resources are allocated to the selected package.

Benefits from Zero Based Budgeting


ZBB has a wide application not only in the Government Departments but also in the private
sector in a variety of business.
The benefits from ZBB can be summarized in the following manner.
_ ZBB facilitates review of various activities right from the scratch and a detailed cost benefit
study is conducted for each activity. Thus an activity is continued only if the cost benefit study is
favorable. This ensures that an activity will not be continued merely because it was conducted in
the previous year.
_ A detailed cost benefit analysis results in efficient allocation of resources and consequently
wastages and obsolescence is eliminated.
_ A lot of brainstorming is required for evaluating cost and benefits arising from an activity and
this results into generation of new ideas and also a sense of involvement of the staff.
_ ZBB facilitates improvement in communication and co-ordination amongst the staff.
_ Awareness amongst the managers about the input costs is created which helps the organization
to become cost conscious.
_ An exhaustive documentation is necessary for the implementation of this system and it
automatically leads to record building.

Limitations of Zero Based Budgeting:


The following are the limitations of Zero Based Budgeting.
_ It is a very detailed procedure and naturally is time consuming and lot of paper work is
involved.
_ Cost involved in preparation and implementation of this system is very high.
_ Morale of staff may be very low as they might feel threatened if a particular activity is
discontinued.
_ Ranking of activities and decision-making may become subjective at times.
_ It may not be advisable to apply this method when there are no financial considerations, such
as ethical and social responsibility because this will dictate rejecting a budget claim on low
ranking projects.

Performance Budgeting
It is budgetary system where the input costs are related to the performance i.e. the end results.
This budgeting is used extensively in the Government and Public Sector undertakings. It is
essentially a projection of the Government activities and expenditure thereon for the budget
period. This budgeting starts with the broad classification of expenditure according to functions
such as education, health, irrigation, social welfare etc. Each of the functions is then classified
into programs sub classified into activities or projects. The main features of performance
budgeting are as follows.
_ Classification into functions, programs or activities

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_ Specification of objectives for each program


_ Establishing suitable methods for measurement of work as far as possible.
_ Fixation of work targets for each program.
Objectives of each program are ascertained clearly and then the resources are applied after
specifying them clearly. The results expected from such activities are also laid down. Annual,
quarterly and monthly targets are determined for the entire organization. These targets are broken
down for each activity center. The next step is to set up various productivity or performance
ratios and finally target for each program activity is fixed. The targets are compared with the
actual results achieved. Thus the procedure for the performance budgets includes allocation of
resources, execution of the budget and periodic reporting at regular intervals.
The budgets are initially compiled by the various agencies such as Government Department,
public undertakings etc. Thereafter these budgets move on to the authorities responsible for
reviewing the performance budgets. Once the higher authorities decide about the funds, the
amount sanctioned is communicated and the work is started. It is the duty of these agencies to
start the work in time, to ensure the regular flow of expenditure, against the physical targets,
prevent over runs under spending and furnish report to the higher authorities regarding the
physical progress achieved.
In the final phase of performance budgetary process, progress reports are to be submitted
periodically to higher authorities to indicate broadly, the physical performance to be achieved,
the expenditure incurred and the variances together with explanations for the variances.

Incremental budgeting
As explained earlier, this is a budgeting technique in which the previous year budget is used as
the baseline for the current year’s budget by adding or subtracting amounts from the previous
year’s budget.
Advantages

a) It is easy to develop
b) In terms of resources , it is cheap to develop
c) It is a quick way of developing budgets for what may be many cost centers in a large
organization.

Disadvantages

a) There will be a failure to carefully justify each item of expenditure in each budget.
Activities which are redundant, less in demand, or could be done in a more effective and
efficient manner, will not be changed or eliminated and so significant amounts of
resources could be used.
b) Managers know that if they fail to spend their budget, it is likely to be reduced, they
therefore spend the whole budget, whether such expenditure is necessary or not in the
account year.
c) No priories are established to guide management decision making if more or less
resource become available after the budget has been established, e.g. cash flow may have
been over – or under – estimated.

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d) It makes expenditure more dependent on the political and persuasive process of


individual mangers than on the real needs of the organization. Thus leading to waste and
lower profitability due to the misallocation of resources.

Participatory Budget
Is a budget that has been developed through joint decision making by management and
operational staff.

Advantages
1. Inputs – From staff who are familiar with the needs of the organization.
2. Knowledge – Makes use of all staff which improves the quality of forecast.
3. Improves staff morale and motivation.
4. Training ground – For junior officers especially to acquire the needed skills for budget
preparation
5. High degree of acceptance and commitment
6. Produces a more realistic budget
7. Encourages co-ordination among departments
8. Ensures that operational plans are in line with organizational objectives.

Disadvantages
1. Time counseling
2. Inferiority complex – Operational staff who do not have the required skills may not
contribute during the budget preparation.
3. Cost – Is more expensive. More people will be paid additionally in cash or in kind.
4. Encourages “empire building” or formation of cliques.
5. Some managers may introduce slack into the budget.

Behavioural Aspect of Budgeting

Human beings are involved in the budgeting process, and they will not act in the same way to
similar situations.

The following are areas which should be of particular concern to management because of their
behavioural implications:

1. The setting of targets and standards. This involves the setting of goals which are fair and
attainable. Unattainable goals will only promote conflict and because frustration.
2. The budget as a ‘whipping post’, i.e. organization problems or variances resulting from
comparisons being blamed on ‘the budget’. It is important that the cause of such
problems and variances should be identified and communicated clearly to management.
3. Budgets put people under pressure, as in the case of ‘control by responsibility’ (see P. 97)
re production targets, sales targets and budgeted overhead expenditure.

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4. Some personnel may not be aware of what the budget is, or what it is trying to do. This is
why staff education is necessary on a continuing basis.
5. Budgets can lead to a ‘blinkered’ approach. This may be the case where a particular
function or department achieves its budget targets, but at the expenses of all other
functions.
6. Participation. This principle of good budgeting should be introduced and used with care.
Problems can arise by the involvement of some employees and not others in the budget
preparation process and the setting of targets, etc.

It is accepted that budgets are intended to affect human behavior and that human behavior cannot
always be predicted. The human element must always be taken into account and carefully
evaluated and monitored at frequent intervals.

Thus steps will need to be taken to eliminate personal bias and avoid false perceptions. Hence
the need for clear communications of objectives, policies, reports, information and proper control
as shown in figure 2, to achieve the desired performance.

Responsibility Authority

Exception Comparative
Reporting Control
statements showing
Variances

Monitoring Feedback

Flexible budgets Matching /uniformity


of calculations
ACTION

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Figure 2. Control in budgeting


QUETIION

You are the management accountant of ASALPUNG LTD. Your Managing Director has asked
for your advice on budgeting. The MD believes that managers who implement a budget should
be involved in setting the budget.

a. Discuss with reference to behavioural arguments, reasons for and against this view
b. Explain how behavioural factors that constrain the efficiency and effectiveness of
budgets may be overcome by the ways in which the budgets are formulated.

SUGESTED ANSWER

(a) Behavioral arguments for involving managers in budget preparation.


i. Managers will be more likely to adopt budget targets as realistic goals if they have
been involved in setting them.
ii. Motivation may improve as the result of a team spirit' developing through the
involvement of more managers.
iii. managers are encouraged to think more innovatively and use their own Initiative
if they are involved in the planning process, as opposed to having but imposed on
them,
iv. Managers who feel aggrieved by imposed budgets may under-perform intentional
in order to discredit the budget
v. Goal congruence - where an individual’s personal goals are congruent with those
of the organization - is more likely to exist in a participatory system involving
managers in setting their budgets enables individual aspiration levels to be taken
into account.

Behavioral Arguments against involving Managers in Budget Preparation.

(i) Managers may try to build unnecessary expenditure budgetary slack - into their
budgets in order to reduce the risk of overspending
(ii) Communication problems can arises if too many managers are involved in the
process, each having a different personal perspective of the business and its
environment
(iii) It is difficult to develop co-ordination if several managers are involved in the process,
each having a different personal perspective of the business and its environment
(iv) There is a danger that participation will be cosmetic only, because managers are
'consulted' about something that in reality has already been decided. Such pseudo-
participation can only generate cynicism.
(v) Individual managers may not be able to take the wider view of the whole business
which is required in the budget setting process. There is a danger that 'empire

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building' will develop, with each manager attempting to secure resources for his own
budget without considering the effects on other parts of the business.

(b) Many of the behavioral factors which limit the effectiveness and Efficiency of budgets
can be overcome with the use of zero base budgeting. Traditional budgetary planning
processes often use the current year's budget as a starting point for the budget for the
following year. This leads to many problems including:
(i) Overspending to prevent subsequent year's budgets from being reduced;
(ii) The inclusion of unnecessary expenditure in the budget as a cushion against
overspending;
(iii) Continuation of expenditures and practices from one year to another, without
questioning their validity;
(iv) Lack of incentive for managers to be forward thinking and innovative.

Zero base budgeting practices can overcome these problems because each budget is started from
scratch without being based on the previous year. Managers are required to quantify the benefits
to be received from expenditure in their budgets, and resources are allocated according to a cost-
benefit ranking.

EXAMPLES

1. The following information relates to the Mind Your Business Manufacturing Company

Average sales price ₵56. Sales in units: January 375000 February 379500 March 408500.
Desired finished goods inventories (units) January 1st 204650 (cost ₵9618550). January 31st
201500 February 28th 195900 March 31st 206100.

One unit of direct materials is required to produce one finished unit. Direct materials cost per
unit: ₵44. Desired ending direct material inventory; 55% of next month's production. April
production: 216710 units.

The estimated direct labour hours and direct labour costs per hour to complete one unit are as
follows:

Hours/Unit Cost/Hour

January 0.834409 ₵3,595,359

February 0.830115 ₵3,613,957

March 0.856078 ₵3,504,352

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Variable factory overhead application rates per direct labour hour;


Indirect labour 0.50

Payroll taxes 0.20

Maintenance 0.25

Heat and light 0.05

Power 0.10

Miscellaneous 0.02

Variable selling expenses as a percentage of total cedi sales

Commissions 0.04%

Travel 0.02%

Advertising 0.03%

Bad debts 0.01%

Fixed expenses per month:

Salaries: Sales 3400 Taxes: Administrative ¢250

Office 650 Insurance: administrative 500

Executive 2800 Insurance: factory 1500

Depreciation: factory 2500 Insurance: factory 700

Taxes: factory 1000 Insurance: factory 950

Insurance: factory 700 Insurance: factory 600

Power: factory 350 Insurance: factory 400

Assume

All fixed expenses are paid when incurred

Direct materials are paid when received

All sales are for cash

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Cash balance on January 1st is ₵1500000

Required: Given the information above, prepare the following budgets for the first quarter;

(a) Sales in units and cedis


(b) Production
(c) Direct materials purchase
(d) Direct materials usage
(e) Direct labour

Solution Mind Your Business Manufacturing Company

a) Sales Budget
January ¢ 375000 ¢56 ¢2,1000,000
February 379500 56 2,152,000
March 408500 56 22,876,000
65,128,000
b) PRODUCTION DUDGET (UNITS)
JANUARY FEBRUARY MARCH
Sales Budget 375000 379500 408500
Desired ending stock 201500 195900 206100
576500 575400 614600

opening stock 204650 201500 195900


Production required 371650 373900 418700
c) DIRECT MATERIALS PURCHASE BUDGET

JANUARY FEBRUARY MARCH

Units 371,850 373,900 418,700


Desired ending stock 205,645 230,285 119,191
577,495 604,185 537,891
Beginning stock 204,518 205,645 230,285
Purchase required 372,977 398,540 307,606
X Price per unit ¢44 ¢44 ¢44

Purchase cost ¢16,410,988 ¢17,535,760 ¢13,534,664

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d) DIRECT MATERIALS USAGE


JANUARY FEBRUARY MARCH
Production 371850 373900 418700
X Price per unit ¢44 ¢44 ¢44
Usage cost ¢16,361,400 ¢l6,451,600 ¢l8,422,800

e) DIRECT LABOUR BUDGET


JANUARY FEBRUARY MARCH
Units 371850 373900 418700
X Hrs/U 0.834409 0.830115 0.856078
Hours required 310275 310380 358440
X Wage Rate ¢3.59359 ¢3.613957 ¢3.504352

Direct Labour cost ¢115,550 ¢1,121,700 ¢1,256,100

2. As the accountant of MY QUEEN you are to prepare the company's cash forecast for the next three
months, JUNE - AUGUST based on the following forecasts and estimates. All figures are in ¢’000.

1. Credit Sales in April and May were ¢260000 and ¢290000 respectively
2. It is estimated that sales, all on credit, for June will be C300000 and will rise by ¢50000
and ¢70000 in the second and third months respectively.
3. Cash sales in the three months will be ¢75000, ¢87500 and ¢92000 respectively.
4. Collections from trade debtors conform to the following pattern.
i.80% in the month of sales; 2% discount allowed
ii.10% in the month following sales
iii.8% in the second month following sales
iv.2% generally proved to be bad debt.
5. Material purchased on credit for May was ¢50000. Credit purchases for June July and
August is estimated to be ¢220000, ¢200000 and ¢300000. All payments for credit
purchases are made as follows:
i.60% in the month of purchase
ii.40% in the month following purchase
6. General and administrative expenses for June will he ¢60000. These are expected to rise
by ¢5000 per month.
7. Interest earned or Investments are estimated at ¢3000 per month.
8. Plant and machinery.' will be acquired at ¢180000 in July. Depreciation, which is charged
monthly, is calculated at 20% per annum, no scrap value.
9. Estimated cash balance at June 1, is ¢125000.
10. Additional information
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(a) Expense item June July August

Taxes 350 400 420

Miscellaneous 1000 1100 1300

Selling 50000 70000 75000

(i) Operating expenses will be ¢60000 per month and paid as an when incurred
(ii) The company receives ¢15000 monthly from rentals
(iii) ¢25000 will be realized in July from the sale of obsolete machinery
(iv) A minimum end month cash balance of ¢10000 is to be maintained
(v) Money can be borrowed or repaid in multiples of ¢10000

11. Assume that management does not want to borrow more cash than necessary and want to
repay as promptly as possible. Ignore interest on any borrowing.

SOLUTION

MY COMPANY LTD

CASH BUDGET: JULY - AUGUST 2000

JUNE JULY AUGUST

RECEIPTS: ¢000 ¢000 ¢000

Cash sales (3) 75000 87500 2000

Collection from Debtors (284) 285000 327600 349080

Interest on investment (7) 3000 3000 3000

Rentals (lOc) 15000 15000 15000

Sale of machinery (lOd) …….. 25000 ……..

TOTAL 378000 458100 459080

PAYMENTS:

Materials Purchases (5) 232000 208000 260000

General & Administrative Exp. (6) 60000 65000 70000

P&M(8) 180000

Taxes (lOa) 350 400 425

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Miscellaneous 1000 1100 1300

Selling (10a) 50000 70000 75000

Operating Expenses (lOb) 60000 60000 60000

TOTAL 403350 584500 466725

Cash balance b/d (9) 125000 99650 10000

Total Receipts 378,000 458100 459080

Total cash available 503000 557750 469080

Total payment 403350 584500 466725

Balance before / financing 99650 (26750) 2355

Financing need/Repayment - 36750 7645

Balance c/d 99650 10000 10000

Flexible Budget
3. Blameless, a company in BUKEKE provided you with the following information for period 3.
Budget actual
Output / sales (units) 500,000 460,000
¢’000 ¢’000
Sales 60,000 57.500
Cost of sales:
Materials 12,500 10,120
Labour 10,000 9,660
Manufacturing overheads 5,000 3,450
27,500 23,230

Other expenses:
Selling expenses 8,000 7,220
Distribution expenses 9,000 8,232
Administration expenses 4,000 4,000
21,000 19,452
Net profit 11,500 14,818

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Note that the budget was based on:


• Selling expenses being 50 per cent fixed and 50 per cent variable;
• Distribution expenses being 33 1/3 per cent fixed and 66 2/3 per cent variable;
• Administration expenses being all fixed
Required: Compare the actual figures with a budget based upon an output/sales
level of 460,000 units.

Solution
BLAMELESS FLEXIBLE BUDGET
Budget Actual Comments
Output/sales units 460,000 460,000

¢'000 ¢'000
Sales at ¢120 55,200 57,500 ¢5 per unit more
revenue
Cost of sales (aft variable):

Materials at ¢25 11,500 10,120 gone down

Labour at ¢20 9,200 9,660 gone up

Manufacturing overheads at 10 4,600 3,450 gone down

¢25,300 ¢23,230
Gross Profit ¢29,900 ¢34,270

Less Other expenses:


Selling expenses Fixed 4,000 4,000

Variable at ¢8 3,680 3,220 gone down

Distribution expenses Fixed 3,000 3,000

Variable at ¢12 5,520 5,232 gone up

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Administration expenses Fixed 4,000 4,000


20,200 19,452
Net profit ¢9,700 ¢14,818
The actual profit is greater because the selling price was greater than that which was budgeted,
and material costs, manufacturing overheads, and variable selling and distribution expenses were
less than planned. However, labour costs were greater than budgeted.

It was assumed that the actual fixed selling expenses and fixed distribution expenses were the
same as the budget.

CASH BUDGET

Cash forecast precedes a cash budget. A cash forecast is an estimate showing the amount of cash
which would be available in a future period.

Cash budget shows future cash inflows and outflows for a specific period. It has two main parts
showing detailed estimates of (i) cash receipts and (ii) cash disbursements.

Estimates of cash-receipts are prepared on a monthly basis and depend upon estimated cash-
sales, collections from debtors and anticipated receipts from other sources such as sale of assets,
borrowings etc.

Estimates of cash disbursements are based on estimated cash purchases, payment to creditors,
employees remuneration, bonus, advances to suppliers, budgeted capital expenditure for
expansion etc.

Objectives

The main objectives of preparing cash budget are as follows:

(i) The probable cash position as a result of planned operation is indicated and thus
the excess or shortage of cash is known. This helps in arranging short term
borrowings in advance to meet the situations of shortage of cash or making
investments in times of cash in excess.
(ii) Cash can be co-ordinated in relation to total working capital, sales investment and
debt.
(iii) A sound basis for credit for current control of cash position is established. (iv)
The effect of sudden and seasonal requirements, large stocks, delay in collection
of receipts etc. on the cash position of the organisation is revealed.

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Preparation

A cash budget can be prepared by any of the following methods:

(i) Receipts and payments method


(ii) Adjusted profit and loss account method
(iii) Balance sheet method.

Receipts and Payments Method

In this method the cash receipts from various sources and cash payments to various agencies are
estimated. Delay in cash receipts and lag in payments are taken into account for making
estimates. Since this method is based on the concept of cash accounting, accruals and
adjustments obviously cannot find place in the preparation of cash budgets.

The opening balance of cash of a period and the estimated cash receipts are added and from this,
the total of estimated cash payments are deducted to find out the closing balance.

Adjusted Profit and Loss Account Method

In this method the opening balance is adjusted with the anticipated increases or decreases in current
assets and liabilities, provision for depreciation, special receipts and the net profit for the year before
taxation and appropriations. From the aggregate amount of these, the estimated taxation and dividends
payable, expenditure on fixed assets and special payments if any are deducted . The resulting balance is
the estimated cash in hand at the end of the budget period.

The vital point of difference between receipts and payments method and adjusted profit and loss
method is that the former takes into account only cash transactions while the latter considers non cash
items as it reverses all accruals.

Further, adjusted profit and loss method gives only a broad idea of the cash position but receipts and
payments method furnishes the maximum possible details.

Balance Sheet Method

Under this method of preparing cash budget a forecast balance sheet is prepared as at the end of the
budget period with all items of assets and liabilities except cash balance which is arrived at as a
balancing figure.

The magnitude of the two sides of the balance sheet excluding cash balance would determine whether
the bank account would show a debit or credit balance i.e. cash balance at bank or bank overdraft.

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Illustration

Akanbonglie has just won an award of ₵10,000 as the best student in Walden University for
2013. As she had always wanted to set up her own business, she intends to use her award for this
purpose. Akanbonglie plans to commence trading on 1 October, 2013 and she anticipates that her
sales and purchases for the first six months will be as follows:

Sales Purchases

₵ ₵

October 5,000 6,000

November 7,000 7,000

December 9,000 8,000

January 10,000 9,000

February 11,000 10,000

March 12,000 11,000

Due to the highly competitive nature of market forces, planned gross profit will only be about 10
per cent of sales. Management also feels that it will be necessary to offer generous sales credit
terms of three months. So, cash from October's sales will be received in January. Suppliers of
goods for resale will have to be paid in the month following that of purchase. It has been agreed
that the bank manager will authorize an overdraft when the need arise.

Akanbonglie will work from home and she expects that her business electricity consumption will
be ₵350 per quarter, payable December and March. General expenses will be approximately ₵50
a month, payable in the month they are incurred.

The budgeted closing stock at 31 March 2014 is ₵2,400.

Required:

i A cash budget for the six months to 31 March 2014.

ii A budgeted trading, profit and loss account for the six months to 31 March 2014.

iii A budgeted balance as at 31 March 2014.

iv A cash budgeting system may force management into action. Discuss briefly.

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SOLUTION

Cash Budget for Oct. 2013-Mar. 2014

Oct. Nov. Dec. Jan. Feb. Mar.


₵ ₵ ₵ ₵ ₵ ₵
Balance b/d 10,000 9,950 3,900 (3,500) (6,550) (8,600)

Inflows- Sales - - - 5,000 7,000 9,000

Total 10,000 9,950 3,900 1,500 450 400


Outflows:
Purchases - 6,000 7,000 8,000 9,000 10,000
Light and heat - - 350 - - 350

General expenses 50 50 50 50 50 50

Total 50 6,050 7,400 8,050 9,050 10,400

Balance c/d – Cash/(Overdraft) 9,950 3,900 (3,500) (6,550) (8,600) (10,000)

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ii
Budgeted trading and profit and loss account for the period 1 October 19X3 31 March 19X4
₵ ₵
Sales 54,000

Less Cost of sales


Purchases 51,000
Less Closing stock 2,400 48,600
Gross profit (Proof - 10% X sales) 5,400
Less Expenses
Light and heat 700

General expenses 300 1,000


Net profit 4,400
iii
Akanbonglie Budgeted balance sheet as at 31 March 2014

Capital employed: ₵ ₵

Capital 10,000
Add Net profit 4,400 14,400
Current assets:
Stock 2,400
Debtors (10,000+11,000+12,000) 33,000
35,400

Less Current liabilities:


Creditors 11,000
Bank overdraft 10,000 21,000 14,400
14,400

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Management will be forced into action if there is frequent comparison of budget with actual
results under a regime of management by exception, i.e. action is taken if there are significant
adverse variances, forcing management to secure co-ordination, co-operation and the
participation of subordinates with target-setting, etc.

Self-Assessment

1. Draw up a cash budget for VBK & Co from the following information for the six months
ended 30 June 2014:Opening cash (including bank) balance ₵78,600

Production in Units:

2013 2014

Nov. Dec. Jan. Feb. Mar. Apr. May Jun.

5000 6000 5000 8000 6000 5000 5000 6000

Raw materials used in production cost ₵10 per unit. Of this 25 per cent is paid in the same month
as production and 75 per cent in the month following production.

Direct labour costs of ₵1 per unit are payable in the same month as production.

Variable expenses are ₵6 per unit, payable 50 per cent in the same month as production and 50
per cent in the month following production.

Sales at ₵50 per unit:

2013 2014

Oct. Nov. Dec. Jan. Feb. Mar. Apr. May Jun.

200 600 600 768 720 640 500 500 560

Debtors take an average credit period of two months.


• Fixed overheads are ₵18,000 per month, payable each month.
• New equipment costing ₵84,000 is to be paid for in February 2013
• Rent of ₵6,000 per quarter is due to be received in March and June.

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Solution
Production raw materials:
2013 2014
Nov Dec. Jan. Feb. Mar. Apr. May June

₵ ₵ ₵ ₵ ₵ ₵ ₵ ₵
(i) Actual: 5,000 6,000 5,000 8,000 6,000 5,000 5,000 6,000

Paid: 25% of CM* 1,250 2,000 1,500 1,250 1,250 1,500

75% of PM+ 4,500 3,750 6,000 4,500 3,750 3,750


Total 5,750 5,750 7,500 5,750 5,000 5,250
(ii) Variable expenses:
50% of current month* 1,500 2,400 1,800 1,500 1,500 1,800
50% of previous month+ 1,800 1,500 2,400 1,800 1,500 1,500

3,300 3,900 4,200 3,300 3,000 3,300

Cash budget for the Six months ending 30th June,2014


Balance Receipts Payments Balance
b/f c/f

19X6 ₵ Sales Rent Raw Labour Variable Fixed Fixed ₵


Received materials expenses
o’heads Assets
₵ ₵ ₵ ₵ ₵
₵ ₵

Jan. 78,600 30,000 - 5,750 5,000 3,300 18,000 - 76,500


Feb. 76,550 30,000 - 5,750 8,000 3,900 18,000 84,000 (13,100)
Mar. (13,100) 38,400 6,000 7,500 6,000 4,200 18,000 - (4,400)
Apr. (4,400) 36,000 - 5,570 5,000 3,300 18,000 - (270)
May (270) 32,000 - 5,000 5,000 3,300 18,000 - 730
Jun 730 25,000 6,000 5,250 6,000 3,300 18,000 - (820)

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2. The following data has been supplied to you for Mukilakila’s year ended 31 December 2013:

Budget Actual

Level of activity 75% 60%/


₵'000 ₵'000
Direct costs:
Materials 120 91
Labour 150 132
Variable overheads 60 51
330 274
Fixed overheads 50 56

380 330

Required: Prepare a flexible budget for the actual level of activity, and compute the variances.

Solution

Mukilakila

Budget Actual

Level of activity 60% 60% Variance

₵000 ₵000 ₵000

Direct costs:

Materials 96 91 5

Labour 120 132 (12)

Variable overheads 48 51 (3)

264 274 (10)

Fixed overheads 50 56 (6)

314 330 (16)

3. KPINGSA is starting up a new business on 1 January 2014. They provide the following
information:

Quarterly rent of premises, payment due on 25 March and 25 June 300
Cash outlay on equipment – payable 25 January 60,000

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Monthly planned purchases of stock for resale:


January 30,000
February 20,000
March to June ( per month) 16,000
All stock is bought on two months; credit

Monthly planned sales are:


January 10,000
February 16,000
March to June ( per month) 26,000
• Planned gross profit each month is one average 25 per cent of sales.
• All sales are on one month’s credit. No bad debts or arrears of payment are expected.
• Monthly cash outlay on general expenses is expected to be ₵500.
• Salaries are expected to be ₵1.400 per month.
• Depreciation of equipment on the first half-year is estimated at ₵3,000.
• KPINGSA will pay ₵65,000 cash into the business. They do not plan to withdraw any
money from the business during the year.
Required:
Prepare a monthly cash budget for the half-year, and closing balance sheet as at 30 June 2014.

4. ACHOIAK MANUFACTURING LTD manufactures and sells two products, A and B. In July
2013 the budget section gathered the following data in order to project sales and budget
requirement for 2014.

1. Projected Sales for 2003: Product Units Price/ Unit


¢’000

A 60000 560

B 40 000 800

Expected stock at January 1, 2014: A 20000 B: 8000 units

Desired ending stock Dec 31, 2014 A 25000 B 9000 units

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2. In order to produce one unit of A and B, the following raw materials are used.

Raw materials Amount used per unit

A B

X(kg) 4 5

Y(kg) 2 3

Z (each) - 1

3. Project data for 2013 with respect to raw materials are as follows:

Raw Materials Price Expected (1/1/14) Desired (31/12/03)

X ¢8 000 32 000 kg 36 000 kg

Y ¢5000 29000kg 32000kg

Z ¢3000 6000each 7000 each

4. Projected Direct labour equipments for 2003 and wage rates are:

Product Hours/Unit Rate/Hour

A 2 C48 000

B 3 ₵64000

5. Factory overhead is ¢16000per direct labour hour:

Required: Based on the above projections and budget requirement for 2014 for A and B, prepare
the following budgets; a) Sales

b) Production (in units)

c) Raw Material purchases in quantities and in cedis and

d) direct labour.

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DIVISIONAL PERFORMANCE MEASUREMENT AND TRANSFER PRICING


Responsibility Accounting
Is a setting or system in which decision making is vested in a central management while their
efficient implementation is vested in the managers to be evaluated. Costs are traced to either the
individual who has the best knowledge about why the costs arose or the activity that caused the
costs. It measures the plans and action of each responsibility centre.
Responsibility centers;
❖ Cost centers
Management is accountable for costs (expenses) only.
❖ Revenue centers
Management is accountable for revenues (sales) only
❖ Profit centers
Management is accountable for both revenues and costs
❖ Investment centers
Management is accountable for costs, revenues, profit and capital invested to
generate profit.
Procedure for Responsibility Accounting (R A)

• Identification of decision points (cost centre) within the organization.


• Matching of decision and individual so that decision authority and decision responsibility
are aligned.
• Allocation of resources for performance of the tasks at the various decision points.
• Selection of measures of performance (performance stands)
• Observation of the decision makers actual performance and comparison with the
performance standards.
Objectives of Responsibility Accounting

• To control cost
• To assess profitability
• To determine the return on investment
• To render quality services.

R A system vary

• No two organizations are alike.


• A firm would not try to identify all decision points.
• The cost of system decision planning and control would tend to exceed the benefits for
many decision points (cost benefit analysis).
• The emphasis would therefore be on those decision points that are critical to the
operations of the organization.
How to Evaluate Cost Centers

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• Unit costs of products and services are compared to a budget or standard figure.
• Variances are calculated and investigated if necessary.

How to Evaluate Efficiency

• Consider alternative sources of input from both within and outside the firm.
Standards should be continually updated to ensure that they are realistic and useful as
basis for appraisal.

• Costs should also be traceable

Reasons for Divisionalisation:


Modern businesses are often extremely complex organization.

• Many large business supply a wide range of products and services


• Have operating units located throughout the world.
• Have an extended management hierarchy
• Inability of top management to know everything that is going on in various operating units
• Inability of top management to make all the decision necessary for running the various units.
• There is therefore the need for top management to devolve some decisions to the various
divisional heads.
Bases of Divisionalisation

• Products
• Geographical Location.

Merits of Dividionalisation
1. Better quality decision making
2. Motivational tool
3. Minimizes head office burearacy
4. Awareness of market conditions and prices.
Demerits of Dividionalisation
1. Dysfunctional decision making
2. Goal congruence may suffer (cost conflict)

Reasons for Running a Business on Divisional Basis


-Market information -Timely decision
-Management motivation -Strategic role of control management
-Management development -Specialist knowledge

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Problems of Organising a Business into Divisions

• Goal conflict
• Risk avoidance
• Management pecks
• Increasing cost
• Unhealthy competition

Reducing the Effects on Divisionalising on a Business

• Goal conflict and competition


• Regulate the behavious of divisional managers
• Risk avoidance by management
• Encourage divisional management to take on more risk if the returns are high
Management ‘Perks’

• Observe the behavourr and actions of divisional managers


• Duplication of effort – increasing cost
• Centralize the following functions;
1. Administration
2. Accounting
3. R and D
4. Marketing
Measures Of Divisional Performance
1. Divisional (Absolute) profit
2. Divisional ROCE or ROL
3. Divisional Residual Income (RT)
Decentralization
Is the delegation of decision making authority throughout an organization by allowing managers
at various levels of authority to make key decisions relating to their areas of responsibility.

Merits:
1. It spreads the burden of decision making among the levels of management in the entire
organization.
2. It allows mangers greater decision – making control over their segments thereby
providing excellent opportunity for lower managers to rise in the organization.
3. It increases jobs satisfaction and providers greater incentive for segmental mangers to put
forth their best efforts.
4. Decisions are best made at the level in an organization where problems and opportunities
arise.
5. It provides a more effective basis for measuring a manager’s performance.
6. It minimizes the burden of information overload on top management.

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Measures of Divisional PerformancE


1. ROI or ROCE
This is calculated by expressing Net income as a percentage of invested capital
ROI = (Divisional Profit/ Divisional Investment) x 100%
Strengths:
1. It can act as a comprehensive measure of divisional performance
2. It direct and simplify the efforts of investment centre managers in maximizing
controllable income.
3. It can serve as a basis for measuring investment centre mangers performance in utilizing
resources within their control.
4. It can serve as a basis for measuring investment centre managers performance in
controlling costs.
5. It provides an objective measure of investment centre performance
6. It can help investment centre managers explore alternative courses of action that might
lead to the maximum possible improvement in their performance
7. It can provide an incentive to use existing controllable ones to their fullest and to acquire
only those additional resources that will increase ROL.
Principal Weakness
1. It does not seek to maximize absolute income
2. It may be unrealistically high and unachievable
3. It may serve as a disincentive to investment centre managers to maximize investment
income
4. It can easily create goal conflict.
5. It may oversimplify a highly complex process of investment centre performance
evaluation and decision making.
6. It can make the allocation resources very difficult.
Residual Income (RI);
This is net income less inputed interest charge or investment capital.
RI = Net Y – Int. charge
Strength:

• It combines the qualities of both the absolute and relative measure.


• It is an alternative to ROI.

Divisional Absolute Profit;


This measures the absolute profit of each division.

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Transfer Pricing
Is the process of determining the price at which goods should be transferred from one profit
centre to another profit centre within the same company.

• It becomes necessary when there are interval transfers of goods and services and it is
required to appraise the separate performances of the division or departments involved.
Objective of Transfer Pricing – ( G R A P T )

1. Goal congruence: - The decisions of all managers of profit centres are consistent with the
objectives of the organization as a whole.
2. Performance measurement: - Divisional performance can be measured on the basis of
profit.
3. Autonomy: - To maintain the autonomy of profit centre managers. This will motivate
them to work harder.
4. Minimize global tax liability for example through income splitting.
5. Accurate seconding of movement of goods and services.
6. Fair profit allocation between divisions.

Methods of setting transfer prices:


1. Market based prices
2. Cost – based
• Full cost
• Variable cost
3. Negotiated transfer prices
There are therefore four main approaches to transfer pricing in practice namely; market price,
variable cost, full cost and negotiation price.
Market prices
The prices that exist in the external market – outside the organization.
Merits
1. The price is objective
2. It can be verified
3. It has real economic credibility
4. It represents the opportunity cost of the goods and services.
Problems:
1. Non – existence of an external market
2. Non – existence of potential external customers

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Variable cost
Goods and services are transferred at the variable cost of production. Hence, fixed costs
are excluded from the cost of the goods.
No profit margin is also included.
Merits
1. The problem of dealing with unrealized profits by the head office in avoided.
2. It is in line with the realization concept.
Application
1. When external market does not exist.
2. When the division is operating under capacity
3. Where saving and made by the selling division – selling distribution.
Full cost
Goods and services are transferred at the full cost of production without adding any profit
margin.
Problems;
1. Transfer of inefficiencies from the selling division to the buying division.
2. It is not linked to the opportunity cost approach.
3. The buying division may buy from outside.
4. It does not provide any real incentive for divisional managers to keep costs down.
Negotiated Prices
Goods and services are transferred at prices agreed upon by the selling and buying divisions after
negotiation between them.

Problem:
1. It can lead to several disputes
2. It is time consuming
3. May consume top management time
4. Central management may act in a way to undermine the autonomy of the divisions.
5. The prices are artificial and misleading.
Application:
1. Where there is an external market for the goods supplied.
2. Where the divisional managers have the option to accept or reject.
3. Where the prices will be a valid measure of divisional performance.

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Illustration 1 - Divisional performance measurement


An investment centre has reported a profit of 28,000. It has the following assets and liabilities:
₵ ₵
Non-current assets (at NBV) 100,000

Inventory 20,000
Trade receivables 30,000
50,000
Trade payables 8,000 42,000
142,000

Determine the ROI

ROI might be measured as: Profit/Capital Emploed = (₵28,000/₵142,000)100 = 19.7%.

However, suppose that the centre manager has no responsibility for debt collection. In this
situation, it could be argued that the centre manager is not responsible for trade receivables, and
the centre's capital employed should be ₵112,000. If this assumption is used, ROI would be
(₵28,000/₵112,000)100 = 25.0%.

Illustration 2

For the past few years, an investment centre has been making annual profits of GHS60,000 on
average capital employed of GHS400,000 (NBV as at the end of each year). This performance is
expected to continue unless a decision is taken to invest in Project X. Project X would cost
GHS100,000 and have a life of four years. It would make the following additions to the annual
cash profits of the division:

Year GHS

1 10,000

2 30,000

3 60,000

4 60,000

The firm's current hurdle rate is 12%.

Will the investment centre manager accept the project?

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Solution

Year Profit/loss Year-end Divisional Divisional ROCE

from CE CE profit CE

Project X Project X

GHS GHS GHS GHS

Current - - 60,000 400,000 15.0%

1 (15,000) 75,000 45,000 475,000 9.5%

2 5,000 50,000 65,000 450,000 14.4%

3 35,000 25,000 95,000 425,000 22.4%

4 35,000 0 95,000 400,000 23.8%

The investment centre manager is unlikely to undertake Project X because ROI over the next two
years would be reduced. The project would make a loss in Year 1 (negative ROI) and in Year 2
the project's ROI is only 10% i.e. (5,000/50,000)100, which is lower than 12% and the ROI for
the rest of the investment centre.

Illustration 3
An investment centre has net assets of GHS800,000, and made profits before interest of
GHS160,000. The notional cost of capital is 12%.
Given that performance is measured by RI, on what basis will a project be accepted or
undertaken?

GHS
Profit before interest 160,000
Less Notional interest (12% × GHS800,000) 96,000
RI 64,000
Investment centre managers who make investment decisions on the basis of short-term
performance will want to undertake any investments that are ≥ GHS64,000.

Illustration 4

An investment centre has net assets of ₵800,000, and made profits before interest of ₵160,000.
The notional cost of capital is 12%.
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An opportunity has arisen to invest in a new project costing ₵100,000. The project would have a
four-year life, and would make cash profits of ₵40,000 each year.

Required:

(a) What would be the average ROI with and without the investment?
Would the investment centre manager wish to undertake the investment if performance is
judged on ROI in Year1?
(b) What would be the average annual RI with and without the investment?
Would the investment centre manager wish to undertake the investment if performance is
judged on RI in Year 1?

Solution

To calculate ROI and RI, use the value for CE as at the start of Year 1.

(a) ROI

It is assumed that depreciation is charged on a straight-line basis at ₵25,000 each year, so that
the increase in annual profit with the investment will be ₵15,000 i.e. (₵40,000 - ₵25,000).

Without the investment With the investment

Profit ₵160,000 ₵175,000

Capital employed ₵800,000 ₵900,000

ROI 20.0% 19.4%

ROI would be lower; therefore the centre manager will not want to make the investment.

(b) RI

Without the investment With the investment

₵ ₵

Profit 160,000 175,000

Notional interest

(₵800,000 x 12%) 96,000 (₵900,000 x 12%) 108,000

RI 64,000 67,000

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The investment centre manager will want to undertake the investment because it will
increase RI. (This is because the accounting return on the new investment is 15% in Year 1
i.e. (*₵15,000/₵100,000)100 which is higher than the notional cost of interest.)

*₵40,000(annual inflow) - ₵25,000(annual depreciation)=₵15,000

Illustration 5

GARB Ltd has two divisions with the following information:

Division A Division B

₵ ₵

Current Profit 90,000 10,000

Current CE 300,000 100,000

Division A has been offered a project costing ₵100,000 and giving returns of ₵20,000. Division
B has also been offered a project costing ₵100,000 and giving returns of ₵12,000. The company's
cost of capital is 15%. Divisional performance is judged on ROCE and the ROCE-related bonus
is sufficiently high to influence the managers' behaviour.

(a) What decisions will be made by management if they act in the best interests of their
division (and in the best interests of their bonus)?

(b) What should the managers do if they act in the best interests of the company as a
whole?

Solution

Division A Division B

Old ROCE (90/300)100% 30% (10/100)100% 10%


New ROCE ((90+20|)/(300+100))100% 27.5% ((10+12)/ (100+110))100% 11%

Will manager want to accept project? No Yes

(a) The manager of Division A will not want to accept the project as it lowers his ROCE from
30% to 27.5%. The manager of Division B will like the new project as it will increase his ROCE
from 10% to 11 %. Although the 11 % is bad, it is better than before.

(b) Looking at the whole situation from the group point of view, management will be in a
ridiculous position in that, the group has been offered two projects, both costing ₵100,000. One
project gives a profit of ₵20,000 and the other ₵12,000. Left to them, they would end up

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accepting the project giving only ₵12,000. This is because ROCE is a defective decision making
method and does not guarantee that the correct decision will be made.

TRANSFER PRICING

Illustration 1

Division A makes components, all of which are transferred to division B for use in making the
firm’s major product. At present there is no system of transfer pricing.

DIV A Components DIV B Finished goods External market

Comment on the current system with respect to the following areas:

(a) Division A's performance appraisal.

(b) Division B's performance appraisal.

(c) Division B's decision making.

Solution

(a) Division A has no external revenue so there is no problem treating it as a cost centre and
assessing performance accordingly

The lack of a transfer price does not cause issues for A.

(b) Division B has revenue and costs so; it should be treated as either a profit centre or an
investment centre. Either way, profit will be a key measure of performance.

Under the current system division B effectively receives the components for free, thus making it
appear to be more profitable than it deserves.

Also division B is not being held responsible for all factors under its control. For example,
suppose employees in B wasted some components due to carelessness – this will result in more
costs for A to make additional components but there is no adverse impact on B’s profit.

A transfer price should make B’s profit more realistic and ensure better cost control.

Note: If, however, division A were to acquire external revenue streams

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(e.g. selling components to other firms), then it would also have to be treated as a profit centre.
To determine a fair profit for division A, the firm would have to introduce a transfer price so that
A has the cost of components made for B and some corresponding revenue.

(c) The lack of transfer price means that B is not taking into account all of the company's costs
when making decisions. For example:

• the price of the final product may be set too low


• new products may be developed that are not commercially viable.

Illustrating 2

Division A of Robi Ltd. makes a product A22, which it sells externally and to another division
in the Robi Ltd, Division B. Division B uses product A22 as a component in product B46, which
it sells externally. There is a perfect external market for both A22 and B46.

Costs and sales prices are as follows:


Division A DivisionB
ProductA22 Product B46
Variable production cost ₵12 per unit
Further variable costs ₵15 per unit
Fixed costs ₵200,000 ₵300,000
Sales price ₵20 per unit ₵45 per unit
Division A can either sell product A22 externally for ₵20 or transfer the product internally to
Division B. Unless the transfer price is ₵20 or more, Division A will prefer to sell externally, in
order to maximise its profit.

Division B can either buy product A22 from external suppliers at $20, or buy internally from
Division A. If the transfer price exceeds ₵20, Division B will prefer to buy externally, in order to
minimise its costs and so maximise its profit.

i.What is the ideal market price?


ii. What advice will you give to management?

Solution

The ideal transfer price:


Marginal cost in Division A 12
Opportunity cost: contribution foregone from external sale by
transferring a unit to Division B: (₵20 - ₵12) 8
Ideal transfer price (market price) 20

It can be seen that, in these circumstances, setting the transfer price as the market price satisfies
all of the objectives of a transfer pricing system outlined above.

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Advice to Management:
• The only transfer price at which Division A and Division B will be willing to trade with
each other is ₵20, the external market price.
• At a transfer price of ₵20, each division would produce and sell up to its capacity. Each
division would maximize its profit
by making and selling as much as possible, and the total company profit would be
maximized. Goal congruence would be achieved.
• In both Divisions A and B, the manager should be motivated to make and sell as much
as possible, and to keep costs under control, in order to maximize profit.
• This price would probably be negotiated freely between the managers of Divisions A and
B, without head office interference.
• The performance of each profit centre would be measured on a fair basis.
• If company policy is to encourage inter-divisional sales unless there is a good
commercial reason for selling or buying externally, the two divisions should trade
internally up to the output capacity of the lower-capacity division.

Illustration 3
Archer Group has two divisions, Division X and Division Y. Division X manufactures a
component X8 which is transferred to Division
Y. Division Y uses component X8 to make a finished product Y14, which it sells for ₵20. There
is no external market for component X8. Costs are as follows:

Division X Division Y
Component X8 ProductY14
₵ per unit ₵ per unit
Variable production cost 5 3
Annual fixed costs ₵40,000 ₵80,000
*Excluds the cost of transferred units of X8
The budgeted output and sales for Product Y14 is 20,000 units. One unit of component X8 goes
into the manufacture of one unit of Y14.
Required:
i. Determine the maximum and minimum transfer prices that the buying division should pay.

ii. What will be the situation if Division X transfers it product to Y at marginal cost or marginal
cost plus mark-up?
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Solution
Contribution accruing to the Company as a whole from the extra units

Selling price 20
Variable costs (₵5+₵3) 8
12
The additional contribution is ₵12 for each extra unit of Y14 made and sold.
Since there is no external market for component X8, the transfer price will be cost-based. 'Cost'
might be marginal cost or full cost. The transfer price might also include a mark-up on cost to
allow a profit to Division X.
The maximum transfer price that division Y will pay Division X


Marginal revenue 20
Marginal cost 3
17
Minimum transfer price that Division Y should be willing to pay X
₵ ₵

Marginal revenue 20
Marginal cost 3
Fixed cost/ unit (₵80,000/20,000 units) 4 7
13
In theory, division Y should therefore be prepared to pay up to ₵17 (₵20 - ₵3) for each unit of X8.

It could be argued, however, that Division Y would not want to sell Product Y14 at all if it made
a loss. Division Y might therefore want to cover its fixed costs as well as its variable costs. Fixed
costs in Division Y, given a budget of 20,000 units, are ₵4 per unit.
The total cost in Division Y is ₵7 (₵3 + ₵4). On this basis, the minimum transfer price that
Division Y should be willing to pay is $13 (₵20 - ₵7).

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Transfer at Marginal Cost to Y

The short-term opportunity cost to Division X of transferring units of X8 to Division Y is the


marginal cost of production, ₵5.

At a transfer price of ₵5, Division X would be expected to sell as many units of X8 to Division
Y as Division Y would like to buy.

However, although marginal cost represents the opportunity cost to Division X of transferring
units of X8, it is not an ideal transfer price.

• At a transfer price of ₵5, Division X would not make contribution from each unit
transferred. The Division would therefore make a loss of ₵40,000 (its fixed costs).
• This transfer price would not motivate the manager of Division X to maximise output.
• It is unlikely that the manager of Division X would be prepared to negotiate this price
with Division Y, and a decision to set the transfer price at ₵5 would probably have to be
made by head office.
• If Division X is set up as a profit centre, a transfer price at marginal cost would not
provide a fair way of measuring and assessing the division's performance.

Transfer price = marginal cost plus mark-up

If the transfer price is set at marginal cost plus a mark-up for contribution, the manager of
Division X would be motivated to maximise output, because this would maximise contribution and profit
(or minimise the loss).

As indicated earlier, Division Y would want to buy as much as possible from Division
X provided that the transfer price is not higher than ₵17, or possibly ₵13.

If a transfer price is set at marginal cost plus a mark-up for contribution, the ‘ideal’
range of prices lies anywhere between ₵5 and ₵17. The size of the mark-up would be
a matter for negotiation. Presumably, the transfer price that is eventually agreed would
be either:

Imposed by head office, or

Agreed by negotiation between the divisional managers, with the more powerful or
skillful negotiator getting the better deal on the price.

Self Assessment

ZAANZEM company has two profit centres, centre A and centre B. centre A supplies centre
B with a part-finished product. Centre B completes the production and sells the finished units
in the market at GH₵35 per unit.

Budgeted data for the year:

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Division A Division B
Number of units transferred/sold 10,000 10,000
GH₵ per unit GH₵ per unit
Materials costs 8 2
Other variable costs 2 3
Annual fixed costs GH₵60,000 GH₵30,000

Calculate the budgeted annual profit of each profit centre and the organisation as a
whole if the transfer price for components supplied by Division A to Division B is:
(a) GH₵20.
(b) GH₵25.
(c) Explain why it is necessary to set a transfer price.
(d) If Division A can sell the part-finished components to external customers at
GH₵23 per unit, explain why this is the optimum transfer price.

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