CAF - 8

COST & MANAGEMENT

ACCOUNTING

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN i

Fourth edition published by
The Institute of Chartered Accountants of Pakistan
Chartered Accountants Avenue
Clifton
Karachi – 75600 Pakistan
Email: [email protected]
www.icap.org.pk

© The Institute of Chartered Accountants of Pakistan, October 2019

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ii THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 TABLE OF CONTENTS

CHAPTER PAGE

Chapter 1 Inventory valuation 1

Chapter 2 Inventory management 17

Chapter 3 Overheads 39

Chapter 4 Labor costing 69

Chapter 5 Marginal costing and absorption costing 85

Chapter 6 Cost flow in production 109

Chapter 7 Job and service costing 153

Chapter 8 Process costing 175

Chapter 9 Budgeting 253

Chapter 10 Standard costing 313

Chapter 11 Variance analysis 325

Chapter 12 Target costing 411

Chapter 13 Relevant costs 427

Chapter 14 Cost-volume-profit (CVP) analysis 449

Chapter 15 Decision making techniques 485

Chapter 16 Introduction to financial instruments 537

Chapter 17 Time value of money 563

Chapter 18 Sustainability reporting 627

Appendix 641

Index 645

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iv THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN
 CHAPTER 1

INVENTORY VALUATION

AT A GLANCE
IN THIS CHAPTER
Inventory is one of the major components of manufacturing and
AT A GLANCE trading organizations and, in most cases, the biggest cost of any
product. Therefore, proper procedures should be in place to put

AT A GLANCE
SPOTLIGHT controls over inventory’s cost and its usage cycle.
Inventory which is consumed during the production is treated
1. Material: Procedures & as expense whereas the unused inventory at the end of
Documentation reporting period is treated as an asset in the financial
statements.
2. Inventories and their Valuation
Net realizable value(NRV) is the estimated selling price in the
ordinary course of business less the estimated cost of
3. Comprehensive Examples
completion and estimated cost necessary to make the sale.
STICKY NOTES Inventory should be valued at lower of cost or NRV in the
financial statements.

SPOTLIGHT
The inventories that are purchased in bulk quantities with
different prices during a period are allocated cost on the basis
of First In First Out (FIFO) or Weighted Average Cost (AVCO).

STIKCY NOTES

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 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

1. MATERIALS: PROCEDURES AND DOCUMENTATIONS

Materials are the basic components of manufacturing and production process in a goods manufacturing entity.
Materials are also called raw materials which are used in the production of a finished products (such as Crude
Oil is a raw material for Petrol, Milk is a raw material for Yogurt, Yarn is a raw material for Garment whereas
Petrol, Yogurt and Garment are the finished products).
An entity that purchases materials to be used in its production or further sale, must ensure that proper
procedures are in place to enable the controls over their costs, purchase quantity, quality as well as usage
quantity.
In order to make the controls effective, their documentation is necessary so that verifiable records can be
maintained.
AT A GLANCE

The following example shall illustrate the procedure of purchasing, storing and issuing the raw materials to the
production department.
 Example 01:
A Limited is engaged in the manufacturing of Cotton Garment. It uses yarn as its raw material. It
requires 10 tons of yarn for the next production.
The Production Department raises the Material Requisition (M.R) to the Store / Warehouse of
the company depicting the quantity and time at which the stock is needed. The Store / Warehouse
of the company raises a Purchase Requisition (P.R) to the Purchase / Procurement Department.
The Purchase / Procurement Department raises a request for quotation to the yarn suppliers and
on the basis of accepted quotation, raises a Purchase Order (P.O) which is delivered to the
supplier. The supplier on the basis of P.O (which includes quantity, rate and time of delivery)
delivers the yarn at the store / warehouse of A Limited and issues a Goods Dispatch / Delivery
SPOTLIGHT

Note (GDN) to the Store and Purchase/ Procurement Departments of A Limited. The storekeeper
/ warehouse in-charge of A Limited issues a Goods Received Note (GRN) the copy of which is
given to the supplier and Purchase / Procurement Department after inspecting the goods along
with the invoice.
The Storekeeper / Warehouse in-charge arranges the goods on the First in First Out (FIFO) basis
or Weighted Average (AVCO) basis depending upon the company’s policy (usually perishable
products are carried at FIFO basis).
The Store then issues the raw materials to the Production Department and prepares a Goods
Issue Note (GIN).
The following table summarizes the above procedures and documents.
STIKCY NOTES

Process Documents
Production Department raise material requisition to Store / Material Requisition
Warehouse
Store / Warehouse issues purchase requisition to Purchase Requisition
Procurement / Purchase Department
Procurement Department raises Purchase Order to the Purchase Order
approved supplier
Supplier delivers goods at company’s warehouse Goods Dispatch / Delivery
Note and Invoice / Bill
The warehouse in-charge receives the goods and inspect Goods Received Note
The warehouse issues raw materials to the production Goods Issue Note
department

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CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

Documentation of purchase process is therefore needed:

 to ensure that the procedures for ordering, receiving and paying for materials has been
conducted properly, and there is no error or fraud
 to provide a record of materials purchases for the financial accounts
 to provide a record of materials costs for the cost and management accounts.
 to ensure physical controls over the materials and to ensure they are used not used
improperly
The detailed procedures for purchasing materials and the documents used might differ according
to the size, complexity and nature of the business. However, the basic requirements are same for
all types of business where material purchases are made.

AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

2. INVENTORIES AND THEIR VALUATION

2.1. Types of Inventories:
Inventory comprises raw materials, work-in-process, stores, spares and tools and finished goods.
Raw materials are consumed in the production during a period. They are treated as expense whereas those raw
materials that are remaining at the end of the reporting period are treated as current assets and are termed as
inventories.
Work-in-process is the inventory on which partial costs have been incurred. For instance, for manufacturing a
liter of mango juice, 100% of mango pulp (raw material) has been put into process whereas the labor has worked
only 50% up to the end of the reporting period. Due to this, the product is not considered completed nor it is a
raw material any more. This kind of inventory is called work-in-process and is treated as current asset.
AT A GLANCE

Finished goods are the final products that are sold to the consumers / customers. The goods that have been sold
to the customers are treated as expense in the financial statements whereas, the goods that have not been sold
till the end of the reporting period are considered as inventories.
Stores, spares and loose tools are used in the equipment and machinery and are kept in inventory so that in
case of any damage to the machinery or equipment, the production should not stop and necessary tools are
available in stock to resume the production at earliest.
The companies usually maintain the stock of such tools and spare parts for all the machinery and equipment,
whether or not such machinery or equipment are used in production. However, the cost of production shall only
include the cost of those stores, spares and tools that are used in the production machinery and equipment.
Accordingly, the units so used in the machineries or equipment are treated as expense and the ones which are
unused are classified as current assets.
SPOTLIGHT

2.2. Cost of Inventory:

The following table explains the cost of each type of inventory:
Inventory Cost
Raw Material Purchase price including import duties & taxes (other than those subsequently
recoverable by the entity), transport, handling and other cost directly attributable
to the purchase of goods. Trade discounts, rebates and other similar items are
deducted in determining the cost. (IAS 2)
Work-in-process Cost of raw material as determined above, plus direct labor cost and production
overhead costs to the extent of work done.
STIKCY NOTES

Stores, spares and tools Same as Raw Material

Finished Goods Cost of raw material as determined above, plus direct labor cost and production
overheads.
Sometimes, the inventories are damaged or become wholly or partly obsolete. In such a case, the company
 Either have to incur more cost to bring them into saleable condition due to which the cost may exceed
the selling price
 Or sell them in the damaged / obsoleted form for which the selling price would probably be lower than
actual cost as demand of such obsoleted product may have come down
In such cases, the company needs to bring the inventories at their net realizable value.

2.3. Net Realizable Value:

Net realizable value is the estimated selling price in the ordinary course of business less the estimated cost of
completion and estimated cost necessary to make the sale (IAS 2).
It refers to the net amount that an entity expects to realize from the sale of the inventory in the ordinary course
of business (IAS 2).

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CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

2.4. Valuation of Inventory:

An entity is required to evaluate, at the end of each reporting period, the net realizable value of its inventories
and value the inventories at lower of:
 Cost or
 Net realizable value
The cost of the inventories are ordinarily lower than the net realizable value. Therefore, the inventories are
carried at their costs. However, the cost may exceed the net realizable value in the following cases:
 The inventories are damaged,
 The inventories have become wholly or partially obsolete,
 The selling price of the inventories have declined, or

AT A GLANCE
 The estimated cost of completion or estimated cost to be incurred to make the sale have increased (IAS
2).
 Example 02:
A business has three items of inventory currently carried at their cost. The market prices of the
inventories have fallen down due to sudden decrease in demand. Their estimated selling prices,
cost of completion and selling costs are as under:

Cost Sales price Cost of completion Selling costs

Rs. Rs. Rs. Rs.
Finished Product A1 8,000 7,800 - 500
Finished Product A2 14,000 12,000 - 200

SPOTLIGHT
Work-in-process B1 16,000 14,000 1,500 200

Calculate the NRV of the inventories.

Est. Selling price – Est. Cost of completion - Est. Selling Cost: Rs.
Finished Product A1 7,800 – 500 7,300
Finished Product A2 12,000 – 200 11,800
Work-in-process B1 14,000 – 1,500-200 12,300

It is to be noted that for finished goods no further processing cost is needed and therefore, the

STIKCY NOTES
formula for NRV does not include cost to complete.
 Example 03:
A business has following items of inventories with their costs and NRV. You are required to
calculate the value at which the inventories should be carried.

Cost of Cost to Selling

Inventories Cost
Completion Sell Price
---------------Rs.----------------
Raw Materials 150,000 500,000 50,000 850,000
Work-in-process 450,000 250,000 50,000 850,000
Finished Goods – in good condition 700,000 - 50,000 850,000
Finished Goods – damaged during 700,000 300,000 50,000 850,000
transport

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 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

Calculating the value of inventories:

NRV (Est. Selling Value at

Price-Est. Cost to lower of
Inventories Cost
complete-Est. Cost cost or
to Sell) NRV
---------------Rs.----------------
Raw Materials 150,000 300,000 150,000
Work-in-process 450,000 500,000 450,000
Finished Goods – in good condition 700,000 800,000 700,000
Finished Goods – damaged during transport 700,000 500,000 500,000
AT A GLANCE

It is to be noted here that the finished goods that were damaged during transport need to be
worked on further before sale, therefore, the formula of NRV shall now include cost to complete
the goods.

2.5. Cost Formula

With some inventory items, particularly large and expensive items, it might be possible to recognize the actual
cost of each item.
In practice, however, this is unusual because the task of identifying the actual cost for all inventory items is
impossible because of the large numbers of such items and when the prices of those items differ in different
periods. The following example explains the situation well.
 Example 04:
SPOTLIGHT

On 1 January a company had an opening inventory of 100 units which cost Rs.50 each.
During the year it made the following purchases:
 5 April: 300 units at Rs. 60 each
 14 July: 500 units at Rs. 70 each
 22 October: 200 units at Rs. 80 each.
During the period it sold 800 units as follows:
 9 May: 200 units
 25 July: 200 units
STIKCY NOTES

 23 November: 200 units

 12 December: 200 units
This means that it has 300 units left at the end of the year (100 + 300 + 500 + 200 – (200 + 200
+ 200 + 200 + 200))
But since the units were purchased at different prices so what price should the remaining units
be allocated?
Should the units be allocated cost of units that were purchased last (that is Rs. 80)? But in that
case the inventory shall be overstated as only 200 out of 300 units were purchased at Rs. 80.
Should the cost of oldest purchased units be used? But in this case inventory will be understated.
Should the units be given the weighted average cost?
A system is therefore needed for measuring the cost of inventory.

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CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

The historical cost of inventory is usually measured by one of the following methods:
 First in, first out (FIFO)
 Weighted average cost (AVCO)
The FIFO and weighted average cost (AVCO) methods of inventory valuation are used within perpetual inventory
systems. They can also be used to establish a cost for closing inventory with the period-end inventory system.

First-in, first-out method of valuation (FIFO)

With the first-in, first-out method of inventory valuation, it is assumed that inventory is consumed in the strict
order in which it was purchased or manufactured. The first items that are received into inventory are the first
items that go out.
To establish the cost of inventory using FIFO, it is necessary to keep a record of:

AT A GLANCE
 the date that units of inventory are received into inventory, the number of units received and their
purchase price (or manufacturing cost)
 the date that units are issued from inventory and the number of units issued.
With this information, it is possible to put a cost to the inventory that is issued (sold or used) and to identify the
cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units that are used, it follows that the
value of inventory at any time should be the cost of the most recently-acquired units of inventory.
 Example 05:
Taking the data from example 04 above, we are preparing the cost ledger as per FIFO method:

SPOTLIGHT
Receipts Issues Balance
Date Qty @ Rs. Qty @ Rs. Qty @ Rs.
1 Jan b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 50/60 23,000
9 May 100 50 5,000 100 50 5,000
100 60 6,000 100 60 6,000
200 50/60 11,000 (200) 50/60 (11,000)
200 60 12,000

STIKCY NOTES
14 Jul 500 70 35,000 500 70 35,000
700 60/70 47,000
25 Jul 200 60 12,000 (200) 60 12,000
500 70 35,000
22 Oct 200 80 16,000 200 80 16,000
700 70/80 51,000
23 Nov 200 70 14,000 (200) 70 (14,000)
500 70/80 37,000
12 Dec 200 70 14,000 (200) 70 (14,000)
1,100 74,000 800 51,000 300 70/80 23,000
Note: 1,100 minus 800 equals 300
74,000 minus 51,000 equals 23,000

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Weighted average cost (AVCO) method

With the weighted average cost (AVCO) method of inventory valuation it is assumed that all units are issued at
the current weighted average cost per unit.
The normal method of measuring average cost is the perpetual basis method. With the perpetual basis AVCO
method, a new average cost is calculated whenever more items are purchased and received into store. The
weighted average cost is calculated as follows:
 Formula:

Cost of inventory currently in store + Cost of new items received

Average cost:
Number of units currently in store + Number of new units received
AT A GLANCE

 Example 06:
Taking the data from example 04 above, we are preparing the cost ledger as per AVCO method:

Receipts Issues Balance

Date Qty. @ Rs. Qty. @ Rs. Qty. @ Rs.
1 Jan b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 57.5000 23,000
9 May 200 57.5000 11,500 (200) 57.5000 (11,500)
200 57.5000 11,500
SPOTLIGHT

14 Jul 500 70 35,000 500 70 35,000

700 66.4286 46,500
25 Jul 200 66.4286 13,286 (200) 66.4286 (13,286)
500 66.4286 33,21
22 Oct 200 80 16,000 200 80 16,000
700 70.3057 49,21

23 Nov 200 70.3057 14,061 (200) 70.3057 (14,061)

500 70.3057 35,153
12 Dec 200 70.3057 14,061 (200) 70.3057 (14,061)
STIKCY NOTES

1,100 74,000 800 52,912 300 70.3057 21,092

Note: 1,100 minus 800 equals 300
74,000 Minus 52,912 equals 21,092
 Example 07:
XYZ Limited manufactures four products. The related data for the year ended December 31,
20X3 is given below:

A B C D
Opening inventory
- Units 10,000 15,000 20,000 25,000
- Cost (Rs.) 70,000 120,000 180,000 310,000
- NRV (Rs.) 75,000 110,000 180,000 300,000
- Production in units 50,000 60,000 75,000 100,000

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A B C D
Costs of goods produced (Rs.) 400,000 600,000 825,000 1,200,000
Variable selling costs (Rs.) 60,000 80,000 90,000 100,000
Closing inventory (units) 5,000 10,000 15,000 24,000
Damaged units included in
closing inventory 300 600 800 1,500

Weighted Weighted
Inventory valuation method in use FIFO FIFO
Average Average
Unit cost of purchase from market (Rs.) 10.50 11.00 11.50 13.00

AT A GLANCE
Selling price per unit (Rs.) 10.00 12.00 12.00 12.50
Unit cost to repair damaged units (Rs.) 3.00 2.00 2.50 3.50

The company estimates that selling expenses will increase by 10% in January 20X4.
In computing the amount of closing inventory that should be reported in the statement of
financial position as on December 31, 20X3, following are the considerations.
To calculate the cost of closing stock, we have to first calculate the cost of goods available for sale
to determine the weighted average cost per unit for the purpose of AVCO method.

Formula A B C D
Step 1: Calculating Units Sold during the

SPOTLIGHT
Units
period
Opening stock Given 10,000 15,000 20,000 25,000
Production during Given 50,000 60,000 75,000 100,000
the period
Goods available Op. stock + production 60,000 75,000 95,000 125,000
for sale during the period
Closing Stock Given (5,000) (10,000) (15,000) (24,000)
Units Sold Goods available for 55,000 65,000 80,000 101,000
sale – Closing Stock

STIKCY NOTES
*Units sold are calculated only to determine the mix of units for the purpose of costing of
closing stock as per FIFO.
Step 2: Calculating Cost of goods available for sale
-----------------Rs.--------------
Opening stock From the given data 70,000 110,000 180,000 300,000
valuation (at
lower of cost and
NRV)
Cost of Given 400,000 600,000 825,000 1,200,000
production for the
period
Cost of goods Op. stock + production 470,000 710,000 1,005,000 1,500,000
available for sale during the period

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 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

Formula A B C D
Step 3: Calculating cost of closing stock
A & B (W/Avg.): (Cost of goods available 39,167 94,667
for sale /Goods
available for sale) x
Closing Stock
C & D (FIFO): (Cost of goods 165,000 288,000
produced during the
period/Goods
produced during the
period) x Closing
AT A GLANCE

Stock
Step 4: Calculating NRV
Sales price - per Given 10.0 12.0 12.0 12.5
unit
Total sales price (Closing Stock x Sales 50,000 120,000 180,000 300,000
of closing stock Price per unit)
Selling costs (Selling (6,000) (13,538) (18,563) (26,139)
Cost/Production
Units) x Closing Stock
SPOTLIGHT

Repair cost of Damaged units x (900) (1,200) (2,000) (5,250)

damaged units repair cost per unit
NRV of Closing Selling price – cost to 43,100 105,262 159,438 268,611
stock sell – cost to complete
Value of closing Lower of cost and NRV 39,167 94,667 159,438 268,611
stock to be
reported in the
SFP
STIKCY NOTES

2.6. Comparison of Methods

The different methods of inventory valuation will give significantly different valuations for the cost of sales and
the value of closing inventory during a period of high inflation (when prices are increasing)
 With FIFO during a period of high inflation, the cost of sales will be lower than the current replacement
cost of materials used. The closing inventory value should be close to current value since they will be the
units bought most recently.
 With AVCO during a period of high inflation, the cost of sales will be higher and the value of closing
inventory lower than with FIFO valuation.
In the example used above to illustrate FIFO and AVCO, prices were rising and the valuations of the cost of goods
issued and closing inventory were as follows
Valuation method Cost of goods issued Closing inventory
Rs. Rs.
FIFO 5,100 2,300
AVCO 5,290 2,110

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The valuation of closing inventory is higher and the cost of goods issued is lower using FIFO. This is typical during
a period when prices are rising steadily.
The opposite is true when prices are falling. The valuation of closing inventory is lower and the cost of goods
issued is higher using FIFO.

Advantages & Disadvantages of FIFO

Advantages
 Logical (probably represents physical reality)
 Easy to understand and explain to managers
 Gives a value near to replacement cost
Disadvantages

AT A GLANCE
 Can be cumbersome to operate
 Managers may find it difficult to compare costs and make decisions when they are charged with varying
prices for the same materials
In a period of high inflation, inventory issue prices will lag behind current market value

Advantages & Disadvantages of AVCO

Advantages
 Smoothens out price fluctuations
 Easier to administer than FIFO and LIFO (Last in First Out)

SPOTLIGHT
Disadvantages
 Issue price is rarely what has been paid
 Prices tend to lag a little behind current market values when there is gradual inflation

STIKCY NOTES

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3. COMPREHENSIVE EXAMPLES
 Example 01:
Mehanti Limited(ML) produces and markets a single product Wee. Two chemicals Bee and Gee
are used in the ratio of 60:40 for producing 1 liter of Wee. ML follows perpetual inventory system
and uses weighted average method for inventory valuation. The purchase and issue of Bee and
Gee for May 20X3, are as follows:
Bee Gee
Date Receipt Issue Receipt Issue
Liter Rate Liter Liter Rate Liter
02-05-20X3 - - 450 110 -
AT A GLANCE

05-05-20X3 - - 560 - - 650

09-05-20X3 - - 300 - - 300
12-05-20X3 420 52 - 700 115 -
18-05-20X3 - - 250 - - 150
24-05-20X3 500 55 - 250 124 -
31-05-20X3 - - 500 - - 450
Following further information is also available:
i. Opening inventory of Bee and Gee was 1,000 liters at the rate of Rs.50 per liter and 500
liters at the rate of Rs. 115 per liter respectively.
ii. The physical inventories of Bee and Gee were 535 liters and 140 liters respectively. The
stock check was conducted on 01 June and 31 May 20X3 for Bee and Gee respectively.
SPOTLIGHT

iii. Due to contamination, 95 liters of Bee and 105 liters of Gee were excluded from the stock
check. Their net realizable values were Rs20 and Rs.50 per liter respectively.
iv. 250 liters of Bee which was received on 01 June 20X3 and 95 liters of Gee which was
issued on 31 May 20X3 after the physical count were included in the physical inventory.
v. 150 liters of chemical Bee was held by ML on behalf of a customer, whereas 100 liters of
chemical Gee was held by one of the suppliers on ML’s behalf.
vi. 100 liters of Bee and 200 liters of Gee were returned from the production process on
31May and 01 June 20X3 respectively.
vii. 240 liters of chemical Bee purchased on 12th May and 150 liters of chemical Gee
purchased on 24th May 20X3 were in advertently recorded as 420 liters and 250 liters
STIKCY NOTES

respectively.
a) Reconcile the physical inventory balances with the balances as per book.
Reconciliation (Bee) Liters
Bal. as per physical count (1st June) 535
Add: Contaminated Stock 95
Less: Receipt of June, 1 (250)
Third party stock (150)
Balance as per books (W-1) 230
Reconciliation (Gee) Liters
Balance as per physical count (31st May) 140
Less: Issued after Count (95)
Actual Physical as on 31.5.20X3 45
Add: Contaminated stock 105
Stock with 3rd party 100
Stock as per books (W-2) 250

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(W-1) (Bee)
Receipts Issues Balance
Date
Units PUC TC Units PUC TC Units PUC TC
1-5-X3 1,000 50 50,000
5-5- X3 560 50 28,000 440 50 22,000
9-5- X3 300 50 15,000 140 50 7,000
12-5- X3 420 52 21,840 560 51.5 28,840
18-5- X3 250 51.5 12,875 310 51.5 15,965
24-5- X3 500 55 27,500 810 53.66 43,465
31-5- X3 500 53.66 26,830 310 53.66 16,635
31-5- X3 (100) (53.66) 5366 410 53.66 22,001
31-5- X3 (180)* (52) (9,360) 230 54.96 12,641
(Adj)

AT A GLANCE
*Purchases of 240 litters erroneously recorded as 420 litters now corrected. It is assumed
that the error was highlighted on 31st May or later.
(W-2) (Gee)
Receipts Issues Balance
Date
Units PUC TC Units PUC TC Units PUC TC
1-5- X3 500 115 57,500
2-5- X3 450 110 49,500 950 112.63 107,000
5-5- X3 650 112.63 73,210 300 112.63 33,790
9-5- X3 300 112.63 33,789 - - -
12-5-X3 700 115 80,500 700 115 80,500
18-5- X3 150 115 17,250 550 115 63,250

SPOTLIGHT
24-5- X3 250 124 31,000 800 117.81 94,250
31-5- X3 450 117.81 53,015 350 117.81 41,235
31-5- X3 *(100) 124 12,400 250 115.34 28,835
*Purchases of 150 litters were erroneously recorded as 250 litters. It is assumed that
error is highlighted on 31st May 20X3.
b) Determine the cost of closing inventory of chemical Bee and Gee. Also compute the cost
of contaminated materials as on 31 May 20X3.
Valuation of Bee
As on 31 May 20X3
Units PUC TC

STIKCY NOTES
Balance as per books 230 54.96 12,641
Less: contaminated stock (BV) (95) (54.96) (5,221)
Add: contaminated stock (NRV) 95 20 1,900
Balance as per books as on 31 May 20X3 230 40.52 9,320
Above calculated stock include 95 liters of contaminated stock @ 20/ liter i.e. its NRV
Thus the cost of closing inventory of Bee is Rs. 9,320 and cost of contaminated material
would be Rs. 1,900 included above.
Valuation of Gee
As on 31 May 20X3
Units PUC TC
Stock as per books 250 115.34 28,835
Less: Contaminated stock (BV) (105) (115.34) (12,110.70)
Add: Contaminated stock (NRV) 105 50 5,250
Value of stock as on 31 May 20X3 250 87.90 21,974.30

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 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

Thus the cost of closing inventory of Gee is Rs. 21,974.30 including the cost of contaminated
material Rs. 5,250.
Above calculated stock include 105 liters of contaminated material at its NRV i.e. Rs. 50/ liter.
 Example 02:
Quality Limited (QL) is a manufacturer of washing machines. The company uses perpetual
method for recording and weighted average method for valuation of inventory.
The following information pertains to a raw material (SRM), for the month of June 20X3.
i. Opening inventory of SRM was 100,000 units having a value of Rs. 80 per unit.
ii. 150,000 units were purchased on June 5, at Rs. 85 per unit
iii. 150,000 units were issued from stores on June 6.
iv. 5,000 defective units were returned from the production to the store on June 12.
AT A GLANCE

v. 150,000 units were purchased on June 15 at Rs. 88.10 per unit.

vi. On June 17, 50% of the defective units were disposed of as scrap, for Rs. 20 per unit,
because these had been damaged on account of improper handling at QL.
vii. On June 18, the remaining defective units were returned to the supplier for replacement
under warranty.
viii. On June 19, 5,000 units were issued to production in replacement of the defective
units which were returned to store.
ix. On June 20, the supplier delivered 2,500 units in replacement of the defective units
which had been returned by QL.
x. 150,000 units were issued from stores on June 21.
xi. During physical stock count carried out on June 30, 2010 it was noted that closing
SPOTLIGHT

inventory of SRM included 500 obsolete units having net realizable value of Rs. 30 per
unit. 4,000 units were found short.
Necessary journal entries to record the above transactions would be prepared as follows
Debit Credit
Journal entries:
Rupees
5-Jun-20X3 Raw material 12,750,000
Account payable (150,000 x 85) 12,750,000
(Cost of material purchased)
6-Jun-20X3 Work in process 12,450,000
Raw material 12,450,000
STIKCY NOTES

(Issue of raw material to production)

12-Jun-20X3 Raw material 415,000
Work in process 415,000
(Defective material returned from the
production)
15-Jun-20X3 Raw material 13,215,000
Account payable (150,000 x 88.1) 13,215,000
(Cost of material purchased)
17-Jun-20X3 Cash (2,500 x 20) 50,000
Factory overheads 165,000
Raw material 215,000
(Defective units sold as scrapped)
18-Jun-20X3 Account payable 212,500
Raw material 212,500
(Defective material returned to the
supplier)

14 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

Debit Credit
Rupees
19-Jun-20X3 Work in process 430,050
Raw material 430,050
(Replacement of defective material to
production by the store)
20-Jun-20X3 Raw material 212,500
Account payable (2,500 x 85) 212,500
(Goods returned were replaced by the
supplier)
21-Jun-20X3 Work in process 12,900,000
Raw material 12,900,000

AT A GLANCE
(Issue of raw material to production)
Factory overheads -
30-Jun-20X3 {500 x (86-30)} (obsolete items) 28,000
Factory overheads -
(4,000 x 86) (shortages) 344,000
Raw material 372,000
(Cost of obsolete and shortages charged to
factory overheads)

Receipts /(Issues)
Date Particulars
Quantity Rate Rupees

SPOTLIGHT
01-Jun-20X3 Balance 100,000 80.00 8,000,000
05-Jun-20X3 Purchases 150,000 85.00 12,750,000
Balance 250,000 83.00 20,750,000
06-Jun-20X3 Issues (150,000) 83.00 (12,450,000)
12-Jun-20X3 Returned from production 5,000 83.00 415,000
15-Jun-20X3 Purchases 150,000 88.10 13,215,000
Balance 255,000 86.00 21,930,000
17-Jun-20X3 Defective goods sold (2,500) 86.00 (215,000)
18-Jun-20X3 Returned to supplier (2,500) 85.00 (212,500)

STIKCY NOTES
Balance 250,000 86.01 21,502,500
19-Jun-20X3 Replacement to production (5,000) 86.01 (430,050)
20-Jun-20X3 Replacement by supplier 2,500 85.00 212,500
Balance 247,500 86.00 21,284,950

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 15

 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

STICKY NOTES

Inventory is valued at lower of cost or NRV

Net Realizable value is the estimated selling price in the ordinary course of
business
AT A GLANCE

The costs of large volume inventories are calculated using FIFO or AVCO
method

FIFO & AVCO methods provide different results of cost of sales and closing
value of inventories if the prices are moving frequently
SPOTLIGHT
STIKCY NOTES

16 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 2

INVENTORY MANAGEMENT

AT A GLANCE
IN THIS CHAPTER
Inventory management refers to the process of ordering,
storing and using a company’s inventories. Managers of
AT A GLANCE
inventory-intensive industries have to be very vigilant to

AT A GLANCE
manage the inventories in such a way so as to make adequate
SPOTLIGHT
stock available to meet expected demands at minimum costs,
while keeping it safe from obsolescence and damage.
1. What is Inventory Management?
They have to determine:
2. Inventory Levels and Buffer
 order quantity at which the relevant cost is lowest and
Stock
level of stock at which the order must be placed.
3. Comprehensive Examples  quantity in addition to the normal usage to meet
unexpected demand in order to avoid loss of profit whereas
STICKY NOTES keeping the holding cost lowest.
Costs associated with inventories include: cost of purchasing,

SPOTLIGHT
ordering and holding the inventory. Relevant costs are the costs
that occur on the occurrence of an activity.
EOQ model is used to determine the order quantity at which the
cost is minimum. EOQ can be determined using: Tabular
Method, Graphical Method and EOQ Formula.
A business entity shall always maintain certain levels of
inventories. These levels are: Re-order Level, Safety Stock /
Buffer Stock, Maximum and Minimum Inventory Levels.
Probabilities are used to make the comparison of holding cost
with stock-out cost to achieve cost efficiencies.

STIKCY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 17

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

1. WHAT IS INVENTORY MANAGEMENT?

Inventory management refers to the process of ordering, storing and using a company’s inventories. This
includes management of raw materials, components and finished products as well as warehousing and
processing such items.
Since the inventory is the most important component of any inventory-intensive sectors, special efforts are put
to ensure that:
 There is sufficient inventory of raw materials available to produce the quantity of finished goods to meet the
sale forecast,
 There is sufficient inventory of finished goods available to meet the immediate sales requirement (both
expected and unexpected) to avoid stock out situations,
AT A GLANCE

 The quantity so available is not in excess of the market needs to avoid any obsolescence, damage or blockage
of finance and
 The costs associated with inventory are minimized.

1.1. Why do companies hold stocks?

There are three general reasons:
1. Transactions motive
2. Precautionary motive and
3. Speculative motive.
The transactions motive occurs when there is a need to hold stocks to meet production and sales requirements
SPOTLIGHT

instantaneously.
The firm might also decide to hold additional amounts of stocks to cover the possibility that it may have
underestimated its future production and sales requirements or the supply of raw materials may be unreliable
because of uncertain events affecting the supply of materials. This represents precautionary motive which
applies only when future demand is uncertain.
When it is expected that future input prices may change, a firm might maintain higher or lower stock levels to
speculate on the expected increase or decrease in future prices. This is called speculative motive.

1.2. Costs Associated with Inventories:

Inventory management is quite critical for the companies as it includes substantial costs. Following are the costs
that are associated with inventories:
STIKCY NOTES

1. Cost of purchasing the inventory – the price that is quoted by supplier

2. Cost of ordering the inventory – such as clerical costs of preparing the material requisition, purchase
order, receiving deliveries and paying invoices, labor cost for the inspection of goods and placing the
goods in warehouse and cost incurred in making payments.
3. Cost of holding the inventory – such as interest cost on borrowings for purchase of inventory,
insurance cost, warehouse and storage cost, handling cost and cost of obsolescence, deterioration of
inventory and opportunity cost of holding the stocks.
All these costs are financed either through company’s own funding or borrowings from banks.
a) If inventories are financed using company’s own funds, the company would have to bear the opportunity
cost in a way had these funds were not invested in the inventories could be used in investing in any other
avenues to earn a fixed return. The gain so forgone shall be treated as the opportunity cost.
b) Similarly, if the inventories are funded by obtaining bank loan, the interest on such loan shall make the
part of cost of inventories.

18 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

Now if the investment on which a fixed return could be attained or the loan was obtained, for three months, the
company would have to complete its cycle of purchasing, manufacturing, selling and realizing cash in three
months to:
 adjust the opportunity cost with gain from sale of inventories or
 pay off the borrowings and interest
which if not materialize in the given time would make the company to bear more cost (more interest, more
storage and insurance costs etc.). Therefore, to avoid such a situation the companies put substantial efforts to
determine the expected market demand on the basis of which purchasing and manufacturing plans are made in
order to achieve a point of inventory at which the cost is minimized.
The mathematicians have therefore derived quantitative models to determine the level of stock to be maintained
at which the price is minimal (known as optimum stock level).

AT A GLANCE
Such quantitative models undertake only relevant costs in calculation.

1.3. Relevant and Irrelevant Cost:

Relevant costs are the costs that occur on the occurrence of an activity.
Irrelevant costs are those that occur whether or not any activity is carried.
 Example 01:
A company is planning to shut down its operations for two months. The operations run on a
factory for which company pay rent of Rs. 50,000 per month. The company uses raw material of
Rs. 75,000 for monthly production and incurs Rs. 60,000 towards labor cost. Due to it shut down,
the company would not purchase raw material for the two months and pay half to the labors as

SPOTLIGHT
per labor unions agreement. However, it would be required to pay full amount of rent for the
factory.
In this case the cost of raw materials and half cost of labor is relevant as the same occur when the
factory runs. Whereas, the rent of the factory and half cost of labors shall occur irrespective the
operations run or not and is irrelevant.
This concept shall be discussed in detail in chapter ‘Budget, Budgetary Controls and Decision Making’ and here
we will look at areas that are relevant for decisions relating to inventories.
The relevant cost that should be considered when determining optimum stock levels are holding cost and
ordering cost.
Relevant Holding Cost to be used in quantitative models should include only those items that will vary with the

STIKCY NOTES
levels of stock. For example, in the case of storage and warehouse only those costs should be included that will
vary with changes in number of units ordered. Such costs are called variable costs.
 Example 02:
Fixed and variable holding costs
Salaries of storekeepers, depreciation of equipment and fixed rental of equipment and buildings
are often irrelevant because they are unaffected by changes in stock levels.
On the other hand, if storage space is owned and can be used for other productive purposes, such
as to obtain rental income, then the opportunity cost must be included in the analysis.
Similarly, the insurance cost of stock must be undertaken when the premium are paid at the
fluctuating value of stocks and not the fixed insurance cost per annum.
To the extent that funds are invested in stocks, the analysis must include opportunity cost (as
explain in cost associated with inventories). The opportunity cost is reflected by the required
return that is lost from investing in stocks.

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 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

The relevant holding costs for other items such as material handling, obsolescence and
deterioration are difficult to estimate and these costs are not very critical to the investment
decision.
Normally, the holding costs are expressed as a percentage rate per rupee of average investment.
Same as holding costs, the ordering costs that are common to all inventory decisions are
irrelevant and only the incremental costs of placing an order are useful for this purpose.
Note: the cost of purchasing or manufacturing the inventories are irrelevant for the purpose
of determining optimum stock level since it remains unchanged irrespective of the order size
or stock levels unless quantity discounts are available.
 Example 03:
Ore Limited (OL) is a manufacturer of sports bicycles. The company buys tyres from a local
AT A GLANCE

vendor.
Following data, relating to a pair of tyres, has been extracted from OL’s records:
Cost (per unit) Rs.
Storage cost based on average inventory 80
Insurance cost based on average inventory 60
Store keeper’s salary (included in absorbed overheads) 8
Cost incurred on final quality check at the time of delivery 10
Other relevant details are as follows:
i. The purchase price is Rs. 900 per pair.
ii. The annual demand for tyres is 200,000 pairs.
SPOTLIGHT

iii. The ordering cost per order is Rs. 8,000.

iv. The delivery cost per order is Rs. 3,000.
v. OL’s rate of return on investment in inventory is 15%.
vi. Recently the vendor has offered a quantity discount of 3% on orders of a minimum of
5,000 pairs.
a) Annual Ordering Cost, can be calculated as follows:
Annual Ordering Cost = Number of orders per annum x cost per order
Number of orders = Annual demand / order size = 200,000/5000 = 40 orders per annum
Cost per Order = Ordering Cost + Delivery Cost = Rs. 8,000 + Rs. 3,000 = 11,000
STIKCY NOTES

Therefore, the annual ordering cost = 40 x 11,000 = Rs. 440,000

b) To calculate Average inventory, following calculations would be required:
Average Inventory = (Opening quantity of stock + Closing quantity of stock) / 2
(0+5000)/2 = 2,500 pairs
c) Annual Holding cost, to be calculated as follows:
Annual Holding Cost = Holding Cost per unit x Average Inventory
Holding cost per unit:
Storage cost based on average inventory = 80
Insurance cost based on average inventory = 60
Opportunity Cost = Rs. 900 x 97% x 15% = 130.95
Total (relevant) holding cost per unit = 270.95
Annual Holding Cost = 270.95 x 2,500 = 677,375

20 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

d) Lastly, Total Cost of Inventory would be

Total Cost of Inventory:
Purchase cost (net of discount) = 900 x 200,000 x 97% = 174,600,000
Annual Ordering Cost = (a) = 440,000
Annual Holding Cost = (c) = 677,375
Total Cost of Inventory per annum = 175,717,375
Note: for the purpose of average stock it is assumed that there is no inventory available when the
order is received and the inventory is consumed at a constant rate throughout the period,
therefore, opening stock is zero and closing stock is the order size.
Alternatively, it can be assumed that the stock level is at the quantity of order received (5,000 in

AT A GLANCE
this case) which is consumed at a constant rate and becomes zero before the new order is
received. This way opening shall become 5,000 and closing will be zero. However, in both cases
the answer will be same.
Therefore, the average inventory is quantity reordered divided by 2.

1.4. Quantitative Models for determining Optimum Stock Levels:

There are models which incorporate transactions motive for holding optimum level of stocks. This is possible
where a company is able to predict the demand for its inputs and outputs with perfect certainty and where it
knows with certainty that prices of inputs, will remain constant for some reasonable length of time.
In such a situation, the optimum order will be determined by those costs that are affected by either:

SPOTLIGHT
 the quantity of stocks held or
 the number of orders placed.
If more units are ordered at one time, fewer orders will be required per year. This will result in reduction in
ordering costs.
As seen in above example, if order size is 10,000 units, the number of orders will be 200,000 / 10,000 = 20 orders
which will reduce the ordering cost to Rs. 220,000
However, when fewer orders are placed, larger average stocks must be maintained which leads to increase in
holding costs that is (10,000 / 2) x 270.95 = 1,354,750. Hence the total relevant cost (ordering cost + holding
cost) shall become Rs. 1,574,750 that is Rs. 457,375 higher than the one calculated at 5,000 units (i.e.
440,000+677,375=1,117,375).

STIKCY NOTES
Therefore, an optimum level must be determined at which the total relevant cost is minimized. This optimum
level is called Economic Order Quantity (EOQ).
The EOQ can be determined using the following methods:
1. Tabular Method
2. Graphical Method
3. EOQ Formula
We shall look into these methods using the following example.
 Example 04:
Stock items 6786:
A company uses 40,000 units of stock item 6786 each year. The item has a purchase cost of Rs.10
per unit. The cost of placing an order for re-supply is Rs.2. The annual holding cost of one unit of
the item is 10% of its purchase cost.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 21

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

if it would be required to calculate the economic order quantity for item 6786, to the nearest unit
using:
a) Tabular method
b) Graphical method
a) Tabular Method:

Order Quantity (Q) 100 200 300 400 500 600 800 10,000
Average Inventory (Q/2) 50 100 150 200 250 300 400 5000
Number of Purchase 400 200 133 100 80 67 50 4
Orders (Annual Demand
(A) / Q)
AT A GLANCE

Annual Holding Cost 50 100 150 200 250 300 400 5000
(10% x 10 x Average
Inventory)
Annual Ordering Cost (2 800 400 266 200 160 134 100 8
x No. of Orders)
Total Relevant Cost 850 500 416 400 410 434 500 5,008
So the relevant cost is minimum at 400 units per order where OC and HC are equal. This is
the optimum point or EOQ

b) Graphical Presentation Method:

We have taken total relevant cost (ordering cost + holding cost) on the vertical axis and order
SPOTLIGHT

quantity and average inventory on the horizontal axis.

We can see that as the average inventory and order size increases, the holding cost also increases
whereas the order cost decreases.
It also to be noted here that the total relevant cost line is lowest at a point where ordering cost
line and holding cost line are intersecting. This intersecting point determines our EOQ.

EOQ
900
800
STIKCY NOTES

700
Total Relevant Cost

600
500
400
300
200
100
0
50 100 150 200 250 300 400
100 200 300 400 500 600 800

Order Quantity

Relevant Annual Cost Holding Cost Ordering Cost

22 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

c) EOQ Formula:
EOQ can be identified using a formula. As of now we have understood the relationship of holding
cost, ordering cost and order quantities. We have also understood that total relevant cost is the
sum of holding cost and ordering cost:
Total Relevant Cost (TRC) = Annual Holding Cost (AHc) + Annual Ordering Cost (AOc)
We are now denoting the variables as:
Annual Demand = A
Quantity per Order / Order size = Q
Cost per Order = Oc
Holding cost per unit = Hc

AT A GLANCE
Average Inventory = Q / 2
Annual Ordering Cost (AOc) shall be calculated as (A / Q) x Oc
Annual Holding (AHc) shall be calculated as (Q / 2) x Hc
𝐴 𝑄
TRC = × 𝑂𝑐 + 2 × 𝐻𝑐
𝑄

When differentiating the above equation with respect to Q and setting the derivative equal to
zero, we get the economic order quantity ‘Q’:

2𝐴𝑂𝑐
𝑄=√
𝐻𝑐

SPOTLIGHT
Applying this formula to the example 2 above:

(2 ∗ 40,000 ∗ 2)
𝑄=√
1

= 400 𝑢𝑛𝑖𝑡𝑠

Assumptions of EOQ:
EOQ model is valid only as per the following assumptions:

STIKCY NOTES
1. The holding cost per unit will be constant
2. The average inventory is equal to one half of the order quantity as the stock is consumed at a constant
rate throughout the period.
3. The cost per order is constant
4. There are no quantity discounts available.
5. The demand for its inputs and outputs can be predicted with perfect certainty
 Example 05:
Taking the data from example 04, determine the effect of an increase in annual holding cost per
unit on:
a) EOQ
b) Total annual ordering cost
In order to fulfil the requirement, assume that HC has increased to 15%, the revised HC will be
= 15% x 10 = 1.5

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 23

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

(2×40,000×2)
The revised EOQ would be √ = 326.6 ≈ 327
1.5

Effect: the order size shall decrease due to increase in holding cost.
The Annual Ordering Cost shall increase due to reduction in order size.
40,000
𝐴𝑂𝑐 = × 2 = 𝑅𝑠. 244.6
326.6
The AOC has increased by Rs. 44.6

1.5. Quantity Discounts affecting the decision of order size:

Sometimes, the suppliers offer discounts on bulk purchases. In such a case, the EOQ model can only be used when
AT A GLANCE

the total costs including purchase price after taking into account the discounts is more than the cost at EOQ. This
means, the entity shall evaluate both the options and determine which option gives the lesser cost.
 Example 06:
Entity G uses 105 units of an item of inventory every week. These cost Rs.150 per unit. They are
stored in special storage units and the variable costs of holding the item is Rs.4 per unit each year
plus 2% of the inventory’s cost.
a) If placing an order for this item of material costs Rs.390 for each order, the optimum order
quantity to minimize annual costs would be calculated as follows. It is assumed that there
are 52 weeks in each year.
The annual holding cost per unit of inventory = Rs.4 + (2% × Rs.150) = Rs.7.
SPOTLIGHT

Annual demand = 52 weeks × 105 units = 5,460 units.

2  390  5,460 = 780 Units

EOQ 
7
b) Now suppose that the supplier offers a discount of 1% on the purchase price for order sizes
of 2,000 units or more. The order size to minimize total annual costs would require following
calculations
A discount on the price is available for order sizes of 2,000 units or more, which is above the EOQ.
The order size that minimizes cost is therefore either the EOQ or the minimum order size to
obtain the discount, which is 2,000 units.
STIKCY NOTES

Order size Order size

Annual costs
780 units 2,000 units
Rs. Rs.
Purchases
(5,460 × Rs.150): ((5,460 × Rs.150 × 99%) 819,000 810,810
Holding costs 2,730 6,970
(Rs.7 × 780/2): (Rs.6.97 × 2,000/2)
Ordering costs 2,730 1,065
(Rs.390 × 5,460/780): (Rs.390 × 5,460/2,000)
Total costs 824,460 818,875

Conclusion: The order size that will minimize total annual costs is 2,000 units

24 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

2. INVENTORY LEVELS AND BUFFER STOCK

A business entity shall always maintain certain levels of inventories. These levels are:
a) Re-order Level
b) Safety Stock / Buffer Stock
c) Maximum Inventory Level
d) Minimum Inventory Level
So far, it has been assumed that when an item of materials is purchased from a supplier, the delivery from the
supplier will happen immediately. In practice, however, there is likely to be some uncertainty about when to
make a new order for inventory in order to avoid the risk of running out of inventory before the new order arrives
from the supplier. The period of time between placing a new order with a supplier and receiving the delivery of
the same is called “Lead Time”. This lead time could be in days, weeks or months.

AT A GLANCE
On the basis of this lead time, the companies determine the level of stock at which the order should be placed to
avoid stock-out situation. The level at which a new order is placed is called “Re-order Level”.
Such re-order level is determined using the average consumption during lead time. However, sometimes the
demand during lead time exceeds the expectations, in such case, if the demand is not fulfilled, the customers may
move to competitors and result in loss of profit and good will. Also, the delivery may delay the expected time due
to which the company may fail to produce the expected demand which again result in loss of profits. To avoid
such risk, the company also maintains a level of stock which is called “Safety Stock or Buffer Stock”

The re-order level is determined by two ways:

- Under certain circumstances = Average consumption during lead time =Average Lead Time (days /
week / month) x Average Consumption per day / week / month. This is also called Minimum

SPOTLIGHT
Inventory Level
- Under uncertain circumstances = maximum lead time (days / weeks / month) x maximum demand
per day / week / month

The Safety Stock is determined as:

Re-order level at uncertain circumstances – Re-order level at certain circumstances
(Maximum Demand x Maximum Lead Time) – (Average consumption x Average Lead Time)

STIKCY NOTES
Due to safety stock, the average inventory shall become:
𝑄
+ 𝑆𝑎𝑓𝑒𝑡𝑦 𝑆𝑡𝑜𝑐𝑘
2

This way, the entity carries safety stock on the basis of maximum demand as well as maximum delivery time.
However, the probability of both the events occurring at the same time is very low. Thereby, the management is
incurring excessive holding cost on safety stocks.
If the cost of holding safety stocks is greater than the cost of stock-out, the business would be incurring more
loss. Therefore, a level should be set where the cost of stock-out plus the cost of holding the safety stock is
minimized.

Stock-out Cost are the opportunity cost of running out of stock. As the stock-out occurs when there is demand
but no stock available, therefore, the loss of profit, which could be earned had the stock available. It also leads
to loss of customers’ goodwill as the customers may move to the products of competitors. If the customer is
permanently lost, the stock-out cost is determined using the loss of future profits as well.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 25

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

Once the stock-out cost has been estimated, the cost of holding safety stocks should be compared for various
demand levels. This can be done using probability theory by attaching probabilities to different potential demand
levels.

2.1. Probability Theory to determine the Safety Stocks:

A probability table can be prepared. For each possible reorder level under consideration, we can calculate:
 the probable demand in the lead time between order and delivery;
 the risk of having excess inventory (buffer stock) and its cost;
 the risk of stock-outs, and their cost.
The reorder level selected might be the reorder level at which the expected value (EV) of cost is minimized
 Example 07:
AT A GLANCE

Entity X uses item Z in its production process. It purchases item Z from an external supplier, in
batches.
For item Z, the following information is relevant:

Holding cost Rs.15 per unit per year

Stock out cost Rs.5 for each stock-out
Lead-time 1 week
EOQ 270 units

Entity X operates for 48 weeks each year. Weekly demand for unit Z for production is variable,
SPOTLIGHT

as follows:

Units demanded during the lead time Probability

70 10%
80 20%
90 30%
100 40%

in suggesting, whether a reorder level of 90 units or 100 units would be more appropriate. The
probabilities in the above example allow us to identify the possible stock-outs associated with
different reorder levels.
STIKCY NOTES

Demand is always greater than 60 units in the lead time. Therefore, if the company allowed
inventory to fall to 60 units before placing an order, it would face a stock shortage in every lead
time. There is a 10% chance that demand would be 70 leading to a shortage of 10 units, a 20%
chance that demand would be 80 leading to a shortage of 20 units, a 30% chance that demand
would be 90 leading to a shortage of 30 units and a 10% chance that demand would be 100
leading to a shortage of 40 units. This can be used to work out the expected value of the stock out
and its associated cost.
Setting a higher reorder level reduces the chance of a stock out but the company would then have
more inventory on hand on average and this would increase holding cost. For example, if the
company set the reorder level to 80 units it would only face stock-out if demand were greater
than 80 in the lead time. The above information shows that there is a 30% chance that demand
would be 90 leading to a shortage of 10 units and a 10% chance that demand would be 100
leading to a shortage of 20 units. Thus, the stock-out cost would be reduced. However, the
company would hold an extra 20 units on average compared to a reorder level of 60 units.

26 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

In doing so, following steps are suggested:

Step 1: Calculate the average demand in the lead time
The average demand in the lead-time is:
(70 × 10%) + (80 × 20%) + (90 × 30%) + (100 × 40%) = 90 units
Average annual demand is 48 weeks × 90 units = 4,320 units.
4,320
Since the EOQ is 270 units, entity X will expect to place orders = 16 orders each year.
270
Therefore, there will be 16 lead times each year.
Step 2: Set up a probability table
(Starting with a reorder level set to the average demand in the lead time and then looking at higher

AT A GLANCE
reorder levels).

Reorder level of 90 (the company will be out of stock if demand is greater than 90)
Demand = 100
Stock outs if demand is 100 10 units
Probability of demand of 100  0.4
Cost per stock out  Rs. 5
Number of orders per year  16
Annual stock out cost 320
Buffer stock (reorder level  average demand in lead time) nil
320

SPOTLIGHT
Reorder level of 100 (the company will never be out of stock)
Stock out cost nil
Buffer stock (reorder level  average demand in lead time) 10 units
Holding cost per unit per annum  Rs. 15
Rs. 150
The reorder level should be set at 100 units. The extra cost of the buffer stock (Rs. 150) achieves
savings by reducing the stock out cost (Rs. 320).

2.2. Maximum inventory level:

STIKCY NOTES
A company will set a maximum level for inventory. Inventory held above this would incur extra holding cost
without adding any benefit to the company.
The inventory level should never exceed a maximum level. If it does, something unusual has happened to either
the supply lead time or demand during the supply lead time. The company would investigate this and take action
perhaps adjusting purchasing behavior.
When demand during the supply lead time is uncertain and the supply lead time is also uncertain, the maximum
inventory level is found as follows.

Maximum inventory level:

Re-order level X
Add: Re-order quantity / EOQ X
XX
Less: Minimum Demand x Minimum Lead Time (X)
X

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 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

2.3. Minimum inventory level:

The inventory level could be dangerously low if it falls below a minimum warning level. When inventory falls
below this amount, management should check that a new supply will be delivered before all the inventory is used
up, so that there will be no stock-out.
When demand during the supply lead time is uncertain and the supply lead time is also uncertain, the minimum
(warning) level for inventory is set as follows.

Minimum inventory level:

Re-order level X
Less: Average Demand x Average Lead Time (X)
X
AT A GLANCE

 Example 08:
Stock Item 6787:
Data relating to stores item 6787 are as follows.
Daily use: 300 units
Lead time for re-supply: 5 – 20 days
Reorder quantity: 10,000 units
in order to identify the reorder level for this stock item, to avoid the possibility of inventory-
outs, following calculations would be required:
Reorder level to avoid inventory-outs
= Daily demand × Maximum lead time
SPOTLIGHT

= 300 units × 20 days

= 6,000 units.
 Example 09:
Robin Limited (RL) imports a high value component for its manufacturing process. Following
data, relating to the component, has been extracted from RL’s records for the last twelve months:

Maximum usage in a month 300 units

Minimum usage in a month 200 units
Average usage in a month 225 units
STIKCY NOTES

Maximum lead time 6 months

Minimum lead time 2 months
Re-order quantity 750 units

The average stock level for the component would be calculated as follows:
Average stock level:
Average stock level = minimum level + ½ (reorder quantity)
As minimum level is not given it will be computed as follows:
Re-order level = maximum usage × maximum lead time
Re-order level = 300 × 6 = 1,800 units.
Minimum level = Re-order level – (average usage × average lead time)
Minimum level = 1,800 – (225 × (6+2/2) = 900 units.
Therefore, Average stock level = 900 + (½ 750) = 1,275 units.

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3. COMPREHENSIVE EXAMPLES
 Example 01:
Orchid Limited (OL) is a trading concern. It is planning to implement Economic Order Quantity
model (EOQ) from 1 April 2019. OL deals in four products each of which is purchased from a
different supplier. To compute EOQ for one of its products Beta, the following data has been
gathered:
i. Actual data for the last year relating to Beta:
Annual Sales Units 72,000
Safety Stocks Units 2,000
Transit Losses as % of purchases 10%
Average Holding Cost per Month Rs. 500,000

AT A GLANCE
Average Holding Cost per Month per Unit Rs. 80
Number of Purchase Order issued for Beta 40
ii. Total cost of purchase department for the last year amounted to Rs. 4,500,000 which
included fixed cost of Rs. 1,350,000. A total of 100 purchase orders were issued during
the last year.
iii. Projections for the next year:
Increase in Sales Volume 25%
Safety Stock Units 2,500
Transit Losses as % of Purchase 6%
Impact of inflation on all costs 10%

SPOTLIGHT
iv. Closing inventory (excluding safety stock) varies in line with the sale volume.
EOQ for Beta can be calculated as follows:
Annual demand (Purchases): Units
Projected sales 72,000×1.25 90,000
Opening stock - including safety stock (500,000÷80) (6,250)
Closing stock - including safety stock [(6,250–2,000)×1.25]+2,500 7,813
Purchases - net of transit losses 91,563
Purchases including transit losses of 6% 91,563÷0.94 97,407

Ordering cost per order: Rupees

STIKCY NOTES
Variable cost (4,500,000–1,350,000)×(1.1÷100) 34,650
Holding cost per unit per annum 80×1.1×12 1,056

Economic Order Quantity (EOQ): Units

SQRT[(2×Annual demand × Ordering cost per order)÷Carrying cost per unit]
SQRT[(2×97,407×34,650)÷1,056] 2,528
 Example 02:
ABC has recently established a new unit in Multan. Its planning for the first year of operation
depicts the following:
i. Cash sales 600,000 units
ii. Credit sales 1,200,000 units
iii. Ending inventory Equivalent to 15 days sales
iv. Number of working days in the year 300
v. Expected purchase price Rs. 450 per unit

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 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

Manufacturer offers 2% discount on purchase of 500 units or more as bulk quantity discount.
The company intends to avail this discount.
vi. Carrying costs include:
- Financial cost of investment in inventory @ 16% per annum.
- Godown rent of Rs. 10,000 per month.
vii. Ordering costs are Rs. 300 per order.
Computation of the Economic Order Quantity (EOQ) and the estimated carrying costs and
ordering costs for the first year of operation would be as follows.
Computation of annual requirement
Units sold on cash basis 600,000
Units sold on credit basis 1,200,000
AT A GLANCE

Ending Inventory (1.8 million x 15/300) 90,000

Annual purchases 1,890,000
Computation of Carrying Cost per unit
Carrying cost per unit (Rs. 450 × 98% × 16%) (Bulk quantity discount availed) Rs. 70.56
Computation of EOQ
EOQ = 2  1,890,000  300
70.56
= 4,009 units
Estimated carrying cost = (EOQ/2) × carrying cost per unit
= 4,009/2 × 70.56
= Rs. 141,438
SPOTLIGHT

Add: Godown rent p.a. = Rs. 120,000

Total carrying cost = Rs. 261,438
Estimated ordering cost = (annual requirement / EOQ) × cost per order
= (1,890,000 / 4,009) × 300
= Rs.141,432
 Example 03:
Karachi Limited is a large retailer of sports goods. The company buys footballs from a supplier in
Sialkot. Karachi Limited uses its own truck to pick the footballs from Sialkot. The truck
capacity is 2,000 footballs per trip and the company has been getting a full load of footballs
STIKCY NOTES

at each trip, making 12 trips each year.

Recently the supplier revised its prices and offered quantity discount as under:
Quantity Unit price (Rs.)
2,000 400
3,000 390
4,000 380
6,000 370
8,000 360
Other related data is given below:
 All the purchases are required to be made in lots of 1,000 footballs.
 The cost of making one trip is Rs. 15,000.
 The company has the option to hire a third party for transportation which would
charge Rs. 9 per football. The cost of placing an order is Rs. 2,000.
 The carrying cost of one football for one year is Rs. 80.

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i. When required to work out the most economical option, below are the computations
involved
Karachi Limited
Price per football A 400 390 380 370 360
Annual purchases B 24,000 24,000 24,000 24,000 24,000
(nos.)
Purchase cost A×B 9,600,000 9,360,000 9,120,000 8,880,000 8,640,000
Minimum order C 2,000 3,000 4,000 6,000 8,000
size
No. of orders (B÷C) D 12.00 8.00 6.00 4.00 3.00
Ordering cost D × 2,000 24,000 16,000 12,000 8,000 6,000

AT A GLANCE
Trips per order E 1.00 1.00 + 2.00 3.00 4.00
(C÷2,000) (hired
transport)
Total no. of trips F 12.00 8.00 12.00 12.00 12.00
(D×E)
Transportation cost F×15,000 180,000 120,000 180,000 180,000 180,000
Hired transport 8,000 72,000
cost units×9
Average inventory G 1,000 1,500 2,000 3,000 4,000
(C÷2)
Inventory carrying G × 80 80,000 120,000 160,000 240,000 320,000

SPOTLIGHT
cost
Total cost (Rs.) 9,884,000 9,688,000 9,472,000 9,308,000 9,146,000
ii. Also computation of the annual savings in case the company revises its policy in accordance
with the computation in (i) above, will be as follows.
The most economical option is to purchase 3 lots of 8,000 footballs each against the existing
purchases of 12 lots of 2,000 footballs. The saving will be as under:
Cost for 12 lots of 2,000 footballs each. 9,884,000
Cost for 03 lots of 8,000 footballs each. 9,146,000
Cost saving Rs. 738,000

STIKCY NOTES
 Example 04:
Modern Distributors Limited (MDL) is a distributor of CALTIN which is used in various
industries and its demand is evenly distributed throughout the year.
The related information is as follows:
 Annual demand in the country is 240,000 tons whereas MDL’s share is 32.5% thereof.
 The average sale price is Rs. 22,125 per ton whereas the profit margin is 25% of cost.
 The annual variable costs associated with purchasing department are expected to
be Rs. 4,224,000 during the current year. It has been estimated that 10% of the
variable costs relate to purchasing of CALTIN.
 Presently, MDL follows the policy of purchasing 6,500 tons at a time.
 Carrying cost is estimated at 1% of cost of material.
 MDL maintains a buffer stock of 2,000 tons.

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 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

Computation of the amount of savings that can be achieved if MDL adopts the policy of placing
orders based on Economic Order Quantity would be as follows:
Purchase department’s variable cost: Rs. 4,224,000
Costs applicable to product CALTIN - 10% of above Rs. 422,400
Ordering costs per purchase order
Annual purchases of CALTIN (tons) [240,000 x 32.5%) Tons 78,000
Existing size of purchase order (tons) Tons 6,500
No. of orders (78,000 / 6,500) Orders 12
Ordering cost per order (422,400/12) Rs. 35,200
Carrying costs per ton (22,125 / 1.25 x 1%) Rs. Per Ton 177
AT A GLANCE

Computation of EOQ 2  78,000 tons x 35,200  5,570 tons

177
EOQ Existing
Demand of CALTIN Tons 78,000 78,000
Order quantity Tons 5,570 6,500
No. of orders 14 12
Average inventory excluding buffer stock (Q / 2) Tons 2,785 3,250
Cost of placing orders (Rs 35,200 per order) Rupees 492,800 422,400
Carrying cost ([Avg. Inventory x Rs. 177) Rupees 492,945 575,250
Total costs Rupees 985,745 997,650
SPOTLIGHT

Savings on adoption of EOQ Rupees 11,905

 Example 05:
Aroma Herbs (AH) deals in a herbal tea. The tea is imported on a six monthly basis. The
management is considering to adopt a stock management system based on Economic Order
Quantity (EOQ) model. In this respect, the following information has been gathered:
i. Annual sale of the tea is estimated at 60,000 kg at Rs. 1,260 per kg. Sales are evenly
distributed throughout the year.
ii. C&F value of the tea after 10% discount is Rs. 900 per kg. Custom duty and sales tax are
paid at the rates of 20% and 15% respectively. Sales tax paid at import stage is
refundable in the same month.
STIKCY NOTES

iii. Use of EOQ model would reduce the quantity per order. As a result, bulk purchase
discount would be reduced from 10% to 8%.
iv. Cost of financing the stock is 1% per month.
v. Annual storage cost is estimated at Rs. 320 per kg.
vi. Administrative cost of processing an order is Rs. 90,000. Increase in number of purchase
orders would reduce this cost by 10%.
vii. AH maintains a buffer stock equal to fifteen days' sales.
a) Economic order quantity can be computed as follows (EOQ):
Annual demand of herbal tea (A) kg 60,000.00

Rupees
Purchase cost per kg (C&F + Import duty) [(900÷0.9)*0.92 ×1.2] B 1,104.00
Ordering cost per purchase order 90,000×90% C 81,000.00
Annual holding cost per kg

32 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Rupees
- Finance cost B×1%×12 132.48
- Storage cost 320.00
(D) 452.48
EOQ =
SQRT [(2×annual demand × ordering cost) ÷ Holding cost per kg)]
SQRT [(2×60,000×81,000)÷452.48)] (E) kg 4,635.00
b) Determination of the amount of savings (if any) which can be achieved by AH by
adopting the stock management system based on EOQ model would be as follows
Savings on adopting EOQ:

AT A GLANCE
No. of purchase orders (A÷E) (F) 13 2
Holding of inventory:
- Average inventory (E÷2); (A÷F ÷2) 2,318 15,000
- Buffer stock 2,500 2,500
(G) 4,818 17,500

-------- Rupees --------

Ordering costs (C×F); (90,000×F) 1,053,000 180,000
Holding costs of inventory (G×D); (G×*449.6) 2,180,049 7,868,000
Purchasing cost of tea (A×B); (60,000×900×1.2) 66,240,00 0 64,800,000
Cost of 60,000 kg of tea 69,473,04 9 72,848,000

SPOTLIGHT
Savings on using EOQ model (72,848,000 – 69,473,049) 3,374,951
*Existing holding cost per unit (900×1.2×0.12)+320=449.6
 Example 06:
Chocó-king Limited (CL) produces and markets various brands of chocolates having annual
demand of 80,000 kg. The following information is available in respect of coco powder which is
the main component of the chocolate and represents 90% of the total ingredients.
i. Cost per kg is Rs. 600.
ii. Process losses are 4% of the input.
iii. Purchase and storage costs are as follows:

STIKCY NOTES
 Annual variable cost of the procurement office is Rs. 6 million. The total number of
orders (of all products) is estimated at 120.
 Storage and handling cost is Rs. 20 per kg per month.
 Other carrying cost is estimated at Rs. 5 per kg per month.
iv. CL maintains a buffer stock of 2,000 kg.
a) Economic order quantity (EOQ) can be calculated as follows:
Annual requirement of the coco powder 80,000÷0.9690% kg 75,000
Ordering cost per order (6,000,000÷120) Rs. 50,000
Storage and handling 2012 240
Other carrying cost 512 60
Carrying cost per kg Rs. 300
Economic order quantity (EOQ)
SQRT[(2 × Annual demand × Ordering cost per order) ÷ Carrying cost per kg]
SQRT[(275,00050,000)÷300] = √25,000,000 = 5,000

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 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

A vendor has offered to CL a quantity discount of 2% on all orders of minimum of 7,500 kg.
Advise CL, whether the offer of the vendor may be accepted. This would require computation
as below:
b) Analysis of purchases using EOQ / minimum quantity as offered by the vendor:
EOQ Vendor's offer
No. of orders (75,000÷5,000), (75,000÷7,500) A 15.00 10.00
Average inventory including buffer stock
(Order quantity÷2)+2,000 B 4,500 5,750

Rs. Rs.
Annual cost of placing orders (A×50,000) 750,000 500,000
AT A GLANCE

Carrying cost (B×300) 1,350,000 1,725,000

Discount on placing order of 7,500 kg each
(75,0006002%) - (900,000)
Net cost 2,100,000 1,325,000
Annual saving on acceptance of vendor's offer 775,000

 Example 07:
Hockey Pakistan Limited (HPL) is engaged in the manufacturing of a single product ‘H-2’ which
requires a chemical ‘AT’. Presently, HPL follows a policy of placing bulk order of 60,000 kg of AT.
However, HPL’s management is presently considering to adopt economic order quantity model
SPOTLIGHT

(EOQ) for determining the size of purchase order of AT.

Following information is available in this regard:
i. Average annual production of H-2 is 45,600 units. Production is evenly distributed
throughout the year.
ii. Each unit of H-2 requires 10 kg of AT. Cost of AT is Rs. 200 per kg. 5% of the quantity
purchased is lost during storage.
iii. Annual cost of procurement department is Rs. 2,688,000. 65% of the cost is variable.
iv. AT is stored in a third party warehouse at a cost of Rs. 6.25 per kg per month.
v. HPL’s cost of financing is 8% per annum.
a) Computation of Economic Order Quantity (Units to order) would be as follows
STIKCY NOTES

SQRT [(2×annual demand × ordering cost) ÷ Holding cost per kg)]

SQRT [(2×480,000 (W-4) × 218,400 (W-1) ÷ 91(W.5)] 48,000
W-1: Ordering cost per order (Rs.) (1,747,200( W-2)÷8 (W-3) 218,400
W-2: Purchase department cost -Variable cost (Rs.) 2,688,000×65% 1,747,200
W-3: Number of orders 480,000 (W-4)÷60,000 8
W-4: Annual Requirement of AT (kg) 45,600×10/95% 480,000
W-5: Holding cost (Rs. per unit) Rs. per unit
Storage cost (6.25 per kg per month×12) 75
Finance cost 200×8% 16
Total holding cost (Rs. per unit) 91

b) Supplier of AT has offered a discount of 5% quantity per order is increased to 120,000

kg. Whether HPL should accept the offer or not, the evaluation would involve following:
Evaluation of discount offer from supplier of AT

34 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Comparison of cost EOQ As per offer

Annual Requirement of AT (kg) A (W-4) 480,000 480,000
Order quantity (kg) B (EOQ, Given) 48,000 120,000
Number of orders C=A/B 10 4
Average inventory (kg) D=B/2 24,000 60,000
--------- Rupees ---------
Ordering cost C×218,400 (W-1) 2,184,000 873,600
Holding cost
D×91(W-5);[D×{75(W-5)+(16(W-5)×95%)}] 2,184,000 5,412,000
Purchase cost
(200×480,000); (200×480,000×95%) 96,000,000 91,200,000

AT A GLANCE
Total cost 100,368,000 97,485,600
Opinion: Offer from AT's supplier should be accepted as it would reduce the purchase
cost.
c) The practical limitations/assumptions of EOQ are as follows
i. The formula assumes that demand/usage is constant throughout the period. In
practice, actual demand/usage may be uncertain and subject to seasonal
variations.
ii. Holding cost per unit are assumed to be constant. Further, many holding costs are
fixed throughout the period and not relevant to the model whereas some costs (e.g.
store keepers' salaries) are fixed but change in steps.
iii. Purchasing cost per unit is assumed to be constant for all purchase quantities and

SPOTLIGHT
is ignored while calculating order size in EOQ. In practice, quantity discounts can
be available in case of bulk purchasing.
iv. The ordering costs are assumed to be constant per order placed. In practice, most
of the ordering costs are fixed or subject to stepwise variation. It is therefore,
difficult to estimate the incremental cost per order.
 Example 08:
Alpha Motors (Pvt.) Ltd. uses a special gasket for its automobiles which is purchased from a local
manufacturer. The following information has been made available by the procurement
department:
Annual requirement (no. of gaskets) 162,000

STIKCY NOTES
Cost per gasket (Rs.) 1,000
Ordering cost per order (Rs.) 27,000
Carrying cost per gasket (Rs.) 300
The gaskets are used evenly throughout the year. The lead time for an order is normally 11 days
but it can take as much as 15 days. The delivery time and the probability of their occurrence are
given below:
Delivery time (in days) Probability of occurrence
11 68%
12 12%
13 10%
14 6%
15 4%

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 35

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

a) Computation of EOQ and Ordering Costs, Assuming a 360 day year.

2 x 162,000 x 27,000
EOQ = 300
EOQ = 5,400 gaskets
Number of orders = 162,000 / 5,400 = 30 Orders
Ordering costs = 30 x Rs. 27,000 = Rs. 810,000
b) Computation of the safety stock and re-order level if the company is willing to take
(Assuming a 360 day year):
 20% risk of being out of stock?
 10% risk of being out of stock?
AT A GLANCE

Safety stock required to be maintained at 20% and 10% risk level

Risk level
20% 10%
Number of days required to be maintained 1 2
Safety Stock
1 x 450 (W-1) 450
2 x 450 (W-2) 900
W-1
Average Stock requirements per day = Annual Demand ÷ 360 days
= 162,000 ÷ 360 = 450
Re-Order Level at 20% and 10% risk level
SPOTLIGHT

Re-order level = (Average Consumption x Average Lead Time) + Safety Stock

Re-order level at 20% = (450 x 11) + 450 = 5,400 gaskets
Re-order level at 10% = (450 x 11) + 900 = 5,850 gaskets
Notice the trade off, in the above example, between the cost of stock out and the holding costs at
different reorder levels. A higher reorder level reduces the chance of a stock out but incurs higher
holding costs.
Practically the risks associated with a stock out are so great that the company always tries to
avoid it even if it leads to extra holding cost.
 Example 09:
Hi-way Engineering Limited uses budgeted overhead rate for applying overhead to production
STIKCY NOTES

orders on a direct labor cost basis for department A and on a machine hour basis in department
B.
The company made the following forecasts for August 2006:
Dept A Dept B
Budgeted factory overhead (Rs.) 216,000 225,000
Budgeted direct labor cost (Rs.) 192,000 52,500
Budgeted machine hours 500 10,000
During the month, 50 units were produced in Job no. CNG-011. The job cost sheet for the month
depicts the following information:
Dept A Dept B
Material issued (Rs.) 1,500 2,250
Direct labor cost (Rs.) 1,800 1,250
Machine hours 60 150

36 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Actual data for the month were as follows:

Dept A Dept B
Factory overhead (Rs.) 240,000 207,000
Direct labor cost (Rs.) 222,000 50,000
Machine hours 400 9,000
a) Predetermined overhead rates for each department would be computed as follows:
Dep A Dep B
Budgeted factory overhead (Rs.) 216,000 225,000
Pre determined Overhead rate 216,000/192,000*100= 225,000/10,000=
125% of labor cost 22.5 per machine hours

AT A GLANCE
(activity= labor cost) (activity=machine hour)
b) The total costs and unit cost of Job no. CNG-011, would be as follows
Dep A Dep B Total
cost
Material issued (Rs.) 1500 2250 3750
Direct labor cost (Rs.) 1800 1250 3050
Factory overheads (actual activity*predetermined 2250 3375 5625
overhead rate)
Total cost 5550 6875 12425
Number of units 50 50 50

SPOTLIGHT
Per unit cost (total cost/number of units) 111 137.5 248.5
c) The over / under applied overhead for each department would be as follows:
Dep A Dep B
Actual factory overheads 240,000 207,000
Applied factory overheads (actual activity*predetermined 277,500 202,500
overhead rate)
(over) under applied factory overheads (37,500) 4500

STIKCY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 37

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

STICKY NOTES

Inventory management refers to the process of ordering, storing and using a

company’s inventories

Relevant costs are the cost that occur on the occurrence of an activity.
AT A GLANCE

Economic order quantity is used to determine the order quantity at which

cost is minimum.

The EOQ can be determined using tabular method, graphical method and EOQ
formula

Inventory management includes determining re-order level, safety stock,

SPOTLIGHT

minimum and maximum inventory levels.

STIKCY NOTES

38 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 3

OVERHEADS

AT A GLANCE
IN THIS CHAPTER
Overheads are the costs those that incur in the course of making
a product, providing of service or running department but
AT A GLANCE
which cannot be traced directly and fully to the product, service

AT A GLANCE
or department.
SPOTLIGHT
Overheads are charged to departments, cost center, cost pools
1. Manufacturing Expenses and products using a predetermined rate.
Predetermined rate is determined using estimated figures of
2. Costing of Production Overheads
the overhead cost and the activity level.
3. Basis of apportionment of Shared costs of service departments are distributed among
Service Centre Costs to departments first and then total overheads are calculated for
Production Departments the production departments to be further allocated to products.
At the end of the period, the applied overhead is compared with
4. Over or Under Applied /
actual overhead to determine over or under absorption of
Absorbed Overhead

SPOTLIGHT
overheads.
5. Comprehensive Examples

SITCKY NOTES

STIKCY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 39

 CHAPTER 3: OVERHEADS CAF 8: CMA

1. MANUFACTURING EXPENSES
Manufacturing expenses are of two types:
1. Direct expenses – expenses that are fully traceable to the product, service or department that is being
costed.
 Examples:
 Raw Materials that are specifically used for the product in consideration,
 Labor which is directly involved in converting the raw material
 Other expenses that are specifically incurred for the product.
2. Indirect expenses (Production overheads) –are those expenses that incur in the course of making a
product, providing of service or running department but which cannot be traced directly and fully to the
AT A GLANCE

product, service or department.

 Examples:
 Labor which is not directly involved in the conversion of raw material but indirectly involved in
making of the product. Such as supervisor who is responsible to supervise the production
process is not directly involved and therefore treated as indirect cost,
 Tools, spares and materials that are used in the machinery or equipment used in the
production,
 Factory rent if the factory premises are hired,
 Depreciation of machinery and equipment.
 Electricity and other utility expenses incurred for the production facilities
SPOTLIGHT

The manufacturing expenses generally comprise:

a) Direct materials,
b) Direct labors and
c) Production / manufacturing / factory overheads.

Note:
Material cost + Labor cost are called ‘Prime Costs’
Labor cost + Overhead cost are called ‘Conversion Costs’
STIKCY NOTES

1.1 Cost Behaviors:

Cost behaviors refer to how a cost reacts to changes in the level of activity. As the activity level rises or falls,
a particular cost may rise or fall as well or it may remain constant. To help make such distinctions, the costs
are often categorized as ‘variable cost’ or ‘fixed cost’
Variable costs are those that vary with the level of output. For example, 100 units of raw materials are used
to produce 100 units of the final product. It means for one unit of final product one unit of raw material will
be required. Where the cost of one unit of material is Rs.10, the cost of 100 units will be (10x100) Rs. 1,000.
Similarly, labors take two hours to produce 1 unit of final product and so 400 hours will be used to produce
200 units. The labors charge Rs. 5 per hour and so there cost at 200 units using 400 hours will be Rs. 2,000.
Since these costs vary with the variations in the output therefore, these are called variable costs.
The variable expenses are fixed per unit of output while they vary in total.

Note: there are few expenses that are called ‘Semi-variable’ because they carry some fixed part of cost
and some variable. For example, electricity bill comprises of fixed charges as line rent / fixed connection
charges as well as variable charges based on units of power consumed.

40 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Fixed costs are those that occur irrespective of the level of output. For example, the rent of the factory shall
be charged on monthly basis whether or not the production is carried. The rent is charged for the occupation
of the premises and therefore, do not vary with the production.
Fixed expenses vary per unit of output while they are fixed in total.
For example, factory rent is Rs. 10,000 per month. During month 1, the company produced 100 units and
during month 2 it produced 150 units. The rent per unit for month 1 and 2 would be Rs. 100 (10,000/100)
and Rs. 66.67 (10,000/150) however, the actual cost paid is Rs. 10,000 each month.

Note: Few fixed costs are called ‘Step fixed costs’ which remains same at certain activity level and
changes when the activity level changes. For example, a company uses one supervisor to supervise up to
25 labors who produce 100,000 units a month. The cost of supervisor is Rs. 15,000. Next month, the
company intends to produce 125,000 units using 6 more labors. Now a new supervisor would be required

AT A GLANCE
to supervise additional 6 labors and 25,000 units. The cost is now increased to 30,000 when the activity
level increased.

1.2 Production overheads and non-production overheads:

Production Overheads:
Overheads that incur in relation to the production processes are called production overheads (also called
manufacturing overheads / factory overheads). For example, salary of factory supervisor, depreciation of
production machine, electricity cost of factory, rent of factory premises etc.
Non-Production Overheads:
Overheads that incur to support the overall objectives of the business are called non-production overheads.

SPOTLIGHT
For example, salaries of sales team, salaries of finance, HR and IT teams, rent of the building occupied by
finance, IT, sales and HR departments (other than production department), Depreciation of computers being
used in these departments etc. These are classified as ‘Administrative Expenses, Marketing, Selling and
Distribution Expenses’ in the Statement of Comprehensive Income.
Administrative Expenses:
The term administration generally relates to the functions necessary for the overall running of the business.
Administrative costs include all costs associated with the general management of the organization rather
than with manufacturing or selling. Examples of administrative activities include implementing and ensuring
the effectiveness of fire extinguishing system for the safety of employees and overall business, ensuring the
overall security of the business premises, the accounting and finance, human resource and information
technology functions of the business are classified under administration and the cost incurred to run these

STIKCY NOTES
functions are called administrative expenses.
These are mostly fixed expenses and charged to profit and loss account in the period in which they occur.
Marketing, Selling and Distribution Expenses:
These expenses are related to the process of selling inventory to customers. These costs include all costs that
are incurred to secure customer orders and get the finished product to the customer. Examples of marketing,
selling and distribution activities are advertising the company’s products / services on electronic and print
media, devising and implementing marketing strategies to enter new markets, obtaining information about
customers and competitors, distributing products to the markets for the customers, obtaining feedbacks
from customers after sales and providing after sales services. The costs so incurred in performing such
activities are classified as marketing, selling and distribution expenses.
These are both fixed and variable. Salaries of marketing staff, cost of advertisement, depreciation of
equipment used in the marketing and distribution department etc. are fixed expenses. Commission of sales
staff which depends on the number of units sold, delivery charges per weight of the unit or area of the carrier
occupied by the unit are considered as variable expenses.

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The administrative and marketing, selling and distribution expenses are never made part of the cost of the
product. However, for internal reporting purposes (marginal costing) the variable marketing and selling
costs are charged to cost of goods sold in determining the contribution margin. (This concept is discussed in
Chapter 5)
These multiple bifurcations of expenses are elaborated as under:

Manufacturing
Expenses

Indirect Expenses
AT A GLANCE

Direct Expenses
(Production Overeads)

Variable Expenses Fixed Expenses Variable Expenses Fixed Expenses

Overheads
SPOTLIGHT

Production Overheads Non-Production Overheads

Fixed admin and Variable marketing

Fixed Overheads Variable Overheads overheads
marketing overheads

In addition to classifying costs as manufacturing and non-manufacturing, they can also be classified as period
cost and product cost. To understand the difference between product costs and period costs, we must first recall
the matching principle from financial accounting.
The matching principle is based on the accrual concept that costs incurred to generate a particular revenue
STIKCY NOTES

should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is
incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an
expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.
Period costs are all costs that are not product costs. Period costs are not included as part of the cost of either
purchased or manufactured goods instead, period costs are expensed in the period in which they are incurred.
Identifying manufacturing overheads:

Overhead Classification
Depreciation of factory machinery Manufacturing overhead
Factory insurance Manufacturing overhead
Salary of the Finance Director Administration overhead
Depreciation of the accounts clerk’s computer Administration overhead
Petrol used in delivery vehicles Selling overhead
Cost of an advertising campaign Selling overhead

42 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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2. COSTING OF PRODUCTION OVERHEADS

When more than one products are being produced using the same facilities, then they are allocated cost on
individual basis. The costs that are directly attributable to the product can be easily allocated to that product.
However, costs that are incurred in accumulation for all the products, need to be allocated on systematic basis.
The simplest way to allocate such cost is to divide the total cost on total units produce. If all the products utilize
same amount of the resources, then such a method is acceptable. However, practically, the products use the
resources in different proportion.
Also, businesses tend to keep their costs at predetermined / estimated rates (standard rates) so that planning
and budgeting can be made with some certainty.
Furthermore, as the fixed cost per unit change when the volume changes, it will not be good to charge the cost of
inefficiency (that is low production volumes) to the customers as the cost per unit will increase if volume

AT A GLANCE
decreases. Similarly, the savings on high volume production is also not offered to the customers.
Another reason is that sales price is kept constant during a certain period (say for one year) because if on the
basis of fixed costs, the cost per unit changes every month and the company changes the sale price accordingly,
the customers would have to compare the prices with competitors each time the price changes, which may result
in loss of customers as well as fluctuating results every month. Therefore, the sales price is kept constant. When
the sale price is constant, the management should want the cost per unit be constant so as to identify
inefficiencies and to avoid month to month fluctuations.
Therefore, an overhead rate is determined using estimates of cost and activity level rather than actual results.

2.1 Predetermined Factory Overhead Rate:

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑

SPOTLIGHT
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐵𝑎𝑠𝑒 𝑡𝑜 𝑏𝑒 𝑈𝑠𝑒𝑑
Estimated factory overhead:
The estimated factory overhead is the amount of overheads that management expects to incur in the coming
periods. This shows that factory overhead rate is calculated in advance and for certain length of period (say for
one year).
Base to be used:
The following bases can be used for this purpose:
1. Physical output
2. Direct material cost

STIKCY NOTES
3. Direct labor cost
4. Direct labor hours
5. Machine hours
The selection of the base depends upon the nature or the function of the factory overhead. For example, if the
factory overhead cost comprises indirect labor predominantly, the direct labor cost or hour can be used as base.
If it relates to machine expenditures such as maintenance, depreciation and normal wear tear, then the base
could be machine hours.
The base selection also depends on the nature of business and it may vary from company to company,
department to department and one cost center to the other.
 Example 01:
Ahsan Enterprises (AE) produces three products Alpha, Beta and Gamma. The management has
some reservations on the method of costing. Consequently, the cost accountant has reviewed the
records and gathered the following information:

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 43

 CHAPTER 3: OVERHEADS CAF 8: CMA

i. The costs incurred during the latest quarter were as follows:

Rupees
Direct material 240,000
Direct labor 1,680,000
Indirect wages – machine maintenance 600,000
– stores 360,000
– quality control 468,000
– cleaning and related services 400,000
Fuel and power 2,800,000
AT A GLANCE

Depreciation on plant, machinery and building 1,560,000

Insurance on plant and machinery 240,000
Insurance on building 60,000
Stores, spares and supplies consumed 1,800,000
Rent, rates and taxes 1,200,000

ii. The production report for the previous quarter depicted the following information:

Production Direct labor Machine hours Inspection hours

(units) hours per unit per unit per unit
SPOTLIGHT

Alpha 12,000 20.00 6.00 2.00

Beta 20,000 5.00 8.00 3.00

Gamma 45,000 4.00 10.00 4.00

The rate of depreciation for plant and machinery is 10% per annum.

a) Calculations that would be required to determine the factory overhead rate on various
basis are as follows:
STIKCY NOTES

a) Physical Output Bases:

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑
9,488,000
77,000 (𝑤 − 1)
Factory Overhead Rate = Rs. 123.221 per unit

b) Direct Labor Cost Bases:

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡
× 100
𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐶𝑜𝑠𝑡
9,488,000
= × 100
1,680,000 (𝑔𝑖𝑣𝑒𝑛)
Factory Overhead Rate = 564.76%

44 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

c) Direct Labor Hour Bases:

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠
9,488,000
520,000 (𝑤 − 1)
Factory Overhead Rate = Rs. 18.246 per direct labor hour

d) Machine Hour Bases:

𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐶𝑜𝑠𝑡
𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐻𝑜𝑢𝑟𝑠
9,488,000

AT A GLANCE
682,000 (𝑤 − 1)
Factory Overhead Rate = Rs. 13.912 per machine hour
W-1 Alpha Beta Gamma Total
Physical Output 12,000 20,000 45,000 77,000
Direct Labor Hours per unit 20.00 5.00 4.00
Total Hours (12,000 x 20) (20,000 x 5) (45,000 x 4) 520,000
= 240,000 = 100,000 =180,000
Machine Hours per unit 6.00 8.00 10.00
Total Hours (12,000 x 6) (20,000 x 8) (45,000 x 10) 682,000

SPOTLIGHT
72,000 160,000 450,000

b) Factory overhead cost allocable to each product can be determined as follows:

Alpha Beta Gamma Total

Allocation based on physical units:
Physical Units 12,000 20,000 45,000 77,000
Factory Overhead 123.221 123.221 123.221
Rate based on
physical output
Cost allocated to the (12,000* (20,000* (45,000* 9,488,000

STIKCY NOTES
products 123.221) 123.221) 123.221)
= 1,478,652 = 2,464,420 = 5,544,945
Allocation based on direct labor cost:
Direct Labor cost (1,680,000 (1,680,000 (1,680,000
per unit /77,000) /77,000) /77,000)
= 21.818 = 21.818 = 21.818
Labor Cost for total (12,000* (20,000* (45,000* 1,680,000
units 21.818) 21.818) 21.818)
= 261,818.182 = 436,363.636 = 981,818.182
Factory Overhead 564.76% 564.76% 564.76%
rate
Cost allocated to the (564.76%* (564.76% * (564.76% * 9,488,000
products 261,818.182) 436,363.636) 981,818.182)
= 1,478,649.340 = 2,464,415.605 = 5,544,935.168

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 45

 CHAPTER 3: OVERHEADS CAF 8: CMA

Alpha Beta Gamma Total

Allocation based on direct labor hours:
Direct Labor Hours 240,000 100,000 180,000 520,000
(w-1)
Factory overhead 18.246 18.246 18.246
rate
Cost allocated to the (240,000x (100,000x (180,000x 9,488,000
products 18.246) = 18.246) = 18.246) =
4,379,076.923 1,824,615.385 3,284,307.692
Allocation based on machine hours:
AT A GLANCE

Machine Hours 72,000 160,000 450,000 682,000

(w-1)
Factory overhead 13.912 13.912 13.912
rate
Cost allocated to the (72,000x (160,000x (450,000* 9,488,000
products 13.912) = 13.912) = 13.912) =
1,001,665.689 2,225,923.754 6,260,410.557

Here, we can see that once the predetermined rate is calculated using all the bases, the factory overhead cost is
then allocated to the products in the proportion of the utilization of such bases on which the rate was calculated.
Once the amount is distributed to the products, factory overhead cost per unit can be calculated.
SPOTLIGHT

We must also note that factory overhead cost allocated to products in each case is different. This is why selection
of base is very crucial and management must determine with vigilance the appropriate base to be used.

2.2 Factors affecting the predetermined overhead rate:

In addition to the selection of bases, the following more factors are also considered:
1. Activity level selection
2. Inclusion or exclusion of fixed overheads
3. Single rate or several rates

2.2.1. Activity Level Selection:

STIKCY NOTES

Activity level can be described as the level at which the business performs its production activities. For example,
a company has the capacity to produce 100,000 units every month using 7,000 labor hours and 5,000 machine
hours. However, in past months the company has only produced 80,000 units due to the market demand. This
shows that company’s activity level is 80% (80,000/100,000) of its maximum capacity.
The company expects that there is no change in the demand and therefore, the same number of units shall be
produced. This is called Normal Capacity.
If the company expects that the demand will increase or decrease and estimates a level at 90% or 70%, this is
called Expected Actual Capacity.
In normal capacity, the overhead rate is calculated using average utilization of plant and expenditures over a
period long enough to level out the highs and lows that occur in every business venture. A rate based on normal
capacity should not change periodically because of change in actual production. The rate will be changed when
the prices of certain expense items change or when fixed costs increase or decrease.
In expected actual capacity, the overhead rate is determined using the expected cost and production at expected
actual output for the next production period. This method usually results in different predetermined rates for
each period. When the company is unable to judge its current performance on a long range (normal capacity)
then this activity level is used.

46 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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2.2.2. Inclusion and Exclusion of Fixed Overheads:

In cost accounting there are two methods of assigning costs to the product:
a) Absorption costing / conventional costing or full costing
b) Marginal Costing or Direct Costing
In Absorption costing, both fixed and variable manufacturing expenses are included in product cost. However,
in Marginal costing, fixed expenses are considered as period cost and not the product cost and therefore, are not
included in the cost of the product.
Similarly, when predetermined overhead rate is determined, both fixed and variable overhead expenses are taken
into account when using absorption costing, whereas, only variable overhead costs are taken into account in
marginal cost system. This way, the fixed expenses shall be charged off in the profit and loss account in full unlike
absorption where the portion of fixed cost is absorbed in the actual production.

AT A GLANCE
2.2.3. Single Overhead Rate or Several Rates:
Overhead rates can be classified as:
a) Blanket rate or Plant-wide rate,
b) Departmental rates or Cost centers or cost pool rates.
A plant-wide or blanket overhead rate is used to describe a single overhead rate that is established for the
organization as a whole.
If a business produces single product using one or more producing departments, a single overhead rate can be
used. However, if more than one products are produced using more than one departments, and each of them
consuming different amount of overheads in each department, then using a blanket rate would not allocate the

SPOTLIGHT
justified cost to products. Therefore, a separate rate is determined for each independent department and are
called departmental rates. Departments are also called cost centers. However, cost centers may be a small
segment within a department.
 Example 02:
A company makes two products, Product X and Product Y. Each product is processed through
two cost centers, CC1 and CC2. The following budgeted data is available.

CC1 CC2
Allocated and apportioned overheads Rs. 126,000 Rs. 180,000
(All overheads are fixed costs.)

STIKCY NOTES
Direct labor hours per unit
Product X 1.5 2.0
Product Y 1.2 2.6

The budgeted production is 12,000 units of Product X and 10,000 units of Product Y. Fixed
overheads are absorbed into costs on a direct labor hour basis.
The budgeted total fixed overhead cost per unit for Product X and for Product Y can be calculated
using:
a) Blanket rate
In blanket rate, the overhead costs and labor hours of both departments / cost centers
shall be summed and evenly distributed between both the products irrespective of their
usage of the labor hours. Thereafter, using the blanket overhead rate, the overhead cost
shall be allocated to each product using number of hours used by each product. Then the
total allocated cost is divided by total units to arrive at the cost per unit.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 47

 CHAPTER 3: OVERHEADS CAF 8: CMA

Factory Overhead rate = (𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑)/(𝐷𝑖𝑟𝑒𝑐𝑡 𝐿𝑎𝑏𝑜𝑢𝑟 𝐻𝑜𝑢𝑟𝑠)

FOH rate = 144,000/((1.5 + 2.0) × 12,000 + (1.2 + 2.6) × 10,000)
FOH rate = 144,000 / 80,000
Blanket rate of overhead = Rs. 1.8 per direct labor hour
b) Cost center rates:
In cost center rates, the total hours of each center shall be calculated first. The overhead
cost of each department shall be divided by the total hours of that department to arrive
at the absorption rate for each department / cost center. Thereafter, the overhead cost
shall be charged to products on the basis of hours used by each unit of products.

CC1 CC2
AT A GLANCE

Total hours Total hours

Product X 12,000 × 1.5 18,000 12,000 × 2.0 24,000

Product Y 10,000 × 1.2 12,000 10,000 × 2.6 26,000

30,000 50,000

Total overheads Rs.126,000 Rs.180,000

Absorption rate per hour Rs.4.20 Rs.3.60

SPOTLIGHT

Product X Product Y
Fixed overhead cost/unit
Rs. Rs.

CC1 1.5 × Rs.4.20 6.30 1.2 × Rs.4.20 5.04

CC2 2.0 × Rs.3.60 7.20 2.6 × Rs.3.60 9.36

Total 13.50 14.40

We can see that in blanket rate, the overhead cost per unit is almost equal for both the
products irrespective of the hours used by them. Therefore, departmental rates system
STIKCY NOTES

provides more accurate allocation of overheads.

In some situations, it is possible to go a stage further and establish separate overhead
rates for small segments within a department (such as group of similar machines in a
department). These small segments are called cost centers. A department can be
reciprocated as cost center. However, a cost center or cost pool describes a location to
which overhead costs are initially assigned. The total cost accumulated in each cost
center are then assigned to cost objects using a separate allocation base for each cost
center. Therefore, it can be a department but it can also be a smaller segment.
When a departmental overhead rate is determined for the entire department, it may
result in inaccurate allocation of overheads when a department consists of a number of
different production centers with products passing through the departments consume
overheads of each production center in different proportions. Therefore, determining
overhead rates for each production centers / cost pools would help achieving the more
accurate results.

48 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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 Example 03:
Using the data in Example 01, when required to calculate the factory overhead cost per unit, for
each product, by allocating individual expenses on the basis of specific utilization of related
facilities, please see below

Allocation
Alpha Beta Gamma Total
basis
Production (no. of units) A 12,000 20,000 45,000 77,000
Machine hours per unit 6 8 10
Total machine hours Units x Machine 72,000 160,000 450,000 682,000
hours per unit

AT A GLANCE
Units inspected 600 400 1,350 2,350
Per unit inspection hours 2 3 4
Total no. of hrs for units Units inspected x 1,200 1,200 5,400 7,800
inspected hours per unit
Overhead allocation:
Indirect wages:
Machine maintenance Machine hours 63,343 140,763 395,894 600,000
Stores Store 144,000 54,000 162,000 360,000
consumption

SPOTLIGHT
Quality control Inspected hours 72,000 72,000 324,000 468,000
Cleaning and related services Factory space 160,000 140,000 100,000 400,000
utilization
Fuel and power Machine hours 295,601 656,892 1,847,507 2,800,000
Depreciation on plant and 600,000 400,000 300,000 1,300,000
machinery Machinery cost
Depreciation on building Factory space 104,000 91,000 65,000 260,000
(1,560,000-1,300,000) utilization
Insurance on plant and Cost of 110,769 73,846 55,385 240,000

STIKCY NOTES
machinery Machinery
Insurance on building Factory space 24,000 21,000 15,000 60,000
utilization
Stores, spares and supplies 720,000 270,000 810,000 1,800,000
consumed Actual
Rent, rates and taxes Factory space 480,000 420,000 300,000 1,200,000
utilization
Total overheads B Rs. 2,773,714 2,339,500 4,374,786 9,488,000
Cost per unit (B/A) Rs. 231.14 116.98 97.22

In this example we could see that rate is calculated for each expense using its related activity and
then allocation is based on the proportion utilized by the products of such activities.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 49

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 Example 04:
A production center has three production departments, A, B and C.
Budgeted production overhead costs for the next period are as follows:

Rs.
Factory rent 60,000
Equipment depreciation 80,000
Insurance 20,000
Heating and lighting 18,000
Indirect materials:
AT A GLANCE

Department A 7,000
Department B 6,600
Department C 9,400
Indirect labor:
Department A 40,000
Department B 27,000
Department C 20,000

Insurance costs relate mainly to health and safety insurance, and will be apportioned on the basis
SPOTLIGHT

of the number of employees in each department. Heating and lighting costs will be apportioned
on the basis of volume.
Other relevant information is as follows:

Total Department A Department B Department C

Direct labor hours 18,000 8,000 6,000 4,000
Number of employees 50 20 16 14
Floor area (square 1,200 300 400 500
metres)
STIKCY NOTES

Cost of equipment 1,000 200 600 200

(Rs.000s)
Volume (cubic metres) 18,000 8,000 6,000 4,000

a) Calculation for the overhead costs and overhead absorption rate for the period for each
production department, assuming that a separate direct labor hour absorption rate is
used for each department, would be as follows.

Basis of Total A B C
apportionment
--------------------Rs.-----------------
Indirect Given 23,000 7,000 6,600 9,400
materials
Indirect labor Given 87,000 40,000 27,000 20,000
Rent Floor area 60,000 15,000 20,000 25,000

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Basis of Total A B C
apportionment
--------------------Rs.-----------------
Depreciation Equipment cost 80,000 16,000 48,000 16,000
Insurance Employee 20,000 8,000 6,400 5,600
numbers
Heating, lighting Volume 18,000 8,000 6,000 4,000
Total 288,000 94,000 114,000 80,000
Direct labor hours 8,000 6,000 4,000

AT A GLANCE
Absorption rate (per direct labor hour) Rs. 11.75 Rs.19.00 Rs.20.00

b) Then, overhead absorption rate for the period, assuming that a single factory-wide direct
labor hour absorption rate is use, would be calculated as below:
If a single factory-wide absorption rate is used instead of separate absorption rates for
each department, the absorption rate would be Rs.16 per direct labor hour
(=Rs.288,000/18,000 hours).

2.3 Apportionment of Shared Overhead Costs of departments and cost centers:

Some costs cannot be allocated in full to a cost center, because they are shared by two or more cost centers. These
are divided between the cost centers on a reasonable basis.
Before going further in this concept, we must know the types of departments within an organization.

SPOTLIGHT
With respect to the production process of an organization, there are two types of departments involved
1. Production / Manufacturing Department(s) – that are directly involved in the manufacturing such as
cutting, assembling, finishing, machining and so on.
2. Service / Support Department(s) – that provide support to the manufacturing department(s) such as
packaging department, materials procurement department, shipping, storage, inspection and so on.
Now, as the service centers provide support to all the production centers, their costs should be divided among
those production centers in a systematic basis. Thereby, the process of cost accumulation to apportionment /
allocation to absorption can be understood as:
1. Costs of all departments and cost pools are accumulated in those departments and cost pools.

STIKCY NOTES
2. The accumulated costs of service departments is then apportioned / allocated to the production
departments.
3. The total accumulated costs (own plus allocated costs) of production departments are allocated to cost
pools within those departments.
4. Cost accumulated at cost pools is then used to calculate the absorption rate.
 Example 05:
On December 1, 20X3 Zia Textile Mills Limited purchased a new cutting machine for Rs.
1,300,000 to augment the capacity of five existing machines in the Cutting Department. The new
machine has an estimated life of 10 years after which its scrap value is estimated at Rs. 100,000.
It is the policy of the company to charge depreciation on straight line basis.
The new machine will be available to Cutting Department with effect from February 1, 20X4. It is
budgeted that the machine will work for 2,600 hours in 20X4. The budgeted hours include:
- 80 hours for setting up the machine; and
- 120 hours for maintenance.

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The related expenses, for the year 20X4 have been estimated as under:
i. Electricity used by the machine during the production will be 10 units per hour @ Rs.
8.50 per unit.
ii. Cost of maintenance will be Rs. 25,000 per month.
iii. The machine requires replacement of a part at the end of every month which will cost
Rs. 10,000 on each replacement.
iv. A machine operator will be employed at Rs. 9,000 per month.
v. It is estimated that on installation of the machine, other departmental overheads will
increase by Rs. 5,000 per month.
Cutting Department uses a single rate for the recovery of running costs of the machines. It has
been budgeted that other five machines will work for 12,500 hours during the year 20X4,
AT A GLANCE

including 900 hours for maintenance. Presently, the Cutting Department is charging Rs. 390 per
productive hour for recovery of running cost of the existing machines.
In Computing the revised machine hour rate which the Cutting Department should use during
the year 20X4, following working would be required.
Calculation of Annual Charges of New Machine

Rupees
Total budgeted costs of existing five machines (Rs. 390 x (12,500 - 900)) 4,524,000
Add: Costs of new machines
i. Depreciation (1,300,000 – 100,000)/10 x 11/12 110,000
SPOTLIGHT

ii. Electricity (2,400 x 10 x Rs. 8.5) 204,000

iii. Cost of maintenance (Rs. 25,000 x 11) 275,000
iv. Part replacement (Rs. 10,000 x 11) 110,000
v. Operator Wages (Rs. 9,000 x 11) 99,000
vi. Departmental expenses (Rs. 5,000 x 11) 55,000
Total Cost 5,377,000
STIKCY NOTES

Productive Budgeted hours (12,500 + 2,600 - 900 - 120 - 80) 14,000

Adjusted machine hours rate 384.07

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3. BASIS OF APPORTIONMENT OF SERVICE CENTRE COSTS TO PRODUCTION

DEPARTMENTS
Case 1
The costs of service centers usually is apportioned among the production departments on the basis of their usage
of services. For example, Service department X provides electricity to three production departments A, B and C
in the ratio of 3:2:1 therefore, the cost of department X must be allocated to production departments in the same
ratio.
 Example 06:
Ternary Engineering Limited produces front and rear fenders for a motorcycle manufacturer.
It has three production departments and two service departments. Overheads are allocated on

AT A GLANCE
the basis of direct labor hours. The management is considering changing the basis of overhead
allocation from a single overhead absorption rate to departmental overhead rate. The estimated
annual overheads for the five departments are as under:

Production Departments Service

Fabrication Phosphate Painting Inspection Maintenance
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Direct materials 6,750 300 750
Direct labor 1,200 385 480
Indirect material 30 75

SPOTLIGHT
Other variable overheads 200 70 100 30 15
Fixed overheads 480 65 115 150 210
Total departmental expenses 8,630 820 1,445 210 300
Maximum production
capacity 20,000 25,000 30,000
Direct labor hours 24,000 9,600 12,000
Machine hours 9,000 1,000 1,200

STIKCY NOTES
Use of service departments:
Maintenance - Labor hours 630 273 147
Inspection - Inspection hours 1,000 500 1,500

a) Computation of the single overhead absorption rate for the next year, would be as follows

Production departments Rs. (000)

Variable overhead 370
Fixed overhead 660
Service department
Inspection 210
Maintenance 300
1,540

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Production departments Rs. (000)

Estimated direct labor hours (DLH)
Fabrication 24,000
Phosphate 9,600
Painting 12,000
Total estimated direct labor hours 45,600
Estimated Total Overheads
Single overhead absorption rate =
Estimated Direct Labor Hours
AT A GLANCE

Rs. 1,540,000 = Rs. 33.77 per

=
45,600 hours direct labor hour

b) Computation of the departmental overhead absorption rates in accordance with the below
circumstances would be as follows:
 The Maintenance Department costs are allocated to the production department
on the basis of labor hours.
 The Inspection Department costs are allocated on the basis of inspection hours.
 The Fabrication Department overhead absorption rate is based on machine hours
whereas the overhead rates for Phosphate and Painting Departments is based on
direct labor hours.
SPOTLIGHT

Production Service
Fabrication Phosphate Painting Inspection Maintenance
Rupees in thousand
Variable Overhead 200 70 100 60 90
Fixed Overhead 480 65 115 150 210
Allocation of Maintenance Department Costs on the basis of labor hours
630 ÷ 1,050 x 300 180 (180)
STIKCY NOTES

273 ÷ 1,050 x 300 78 (78)

147 ÷ 1,050 x 300 42 (42)
Allocation of Inspection Department Costs on the basis of Inspection hours
1,000 ÷ 3,000 x 210 70 (70)
500 ÷ 3,000 x 210 35 (35)
1,500 ÷ 3,000 x 210 105 (105)
930 248 362 - -

Base Machine hours Direct labor hours

number of hours 9,000 9,600 12,000
Departmental Overhead Rate (Rs.) 103.33 25.83 30.17

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 Example 07:
Sparrow (Pvt) Limited (SPL) is engaged in the manufacture of two products A and B. These
products are manufactured on two machines M1 and M2 and are passed through two service
departments, Inspection and Packing, before being delivered to the warehouse for final
distribution. SPL’s overhead expenses for the month of August 2011 were as follows:

Rupees
Electricity 2,238,000
Rent 1,492,000
Operational expenses of machine M1 5,500,000

AT A GLANCE
Operational expenses of machine M2 3,200,000

Following information relates to production of the two products during the month:

A B
Units produced 5,600 7,500
Labor time per unit – Inspection department 15 minutes 12 minutes
Labor time per unit – Packing department 12 minutes 10 minutes

The area occupied by the two machines M1 and M2 and the two service departments is as follows:

SPOTLIGHT
Square feet
Machine M1 5,500
Machine M2 4,800
Inspection department 12,000
Packing department 15,000

Machine M1 has produced 50% units of product A and 65% units of product B whereas machine
M2 has produced 50% units of product A and 35% units of product B.
For Allocating overhead expenses to both the products A and B., the following calculation shall

STIKCY NOTES
be made

Allocation of costs
Basis Machine M1 Machine M2 Inspection Packing Total
to cost centers
Area Occupied 5,500 4,800 12,000 15,000 37,300
Allocation of Area 330,000 288,000 720,000 900,000 2,238,000
Electricity
Allocation of rent Area 220,000 192,000 480,000 600,000 1,492,000
Operational cost 5,500,000 3,200,000 - - 8,700,000
6,050,000 3,680,000 1,200,000 1,500,000 12,430,000

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ALLOCATION OF COST TO PRODUCTS

Basis of Cost Allocation A B TOTAL
Units produced 5,600 7,500
Inspection time (hrs.) 1,400 1,500 2,900
(5,600 x 15 min /60) & (7,500 x 12 min /60)
Packing time (hrs.) 1,120 1,250 2,370
(5,600 x 12 min /60) & (7,500 x 10 min /60)
Units produced on Machine M1 2,800 4,875 7,675
(50% A and 65% B)
AT A GLANCE

Units produced on Machine M2 2,800 2,625 5,425

(50% A and 35% B)
Cost Allocated
Machine M1 cost 2,207,166 3,842,834 6,050,000
Machine M2 cost 1,899,355 1,780,645 3,680,000
Inspection department cost 579,310 620,690 1,200,000
Packing department cost 708,861 791,139 1,500,000
5,394,692 7,035,308 12,430,000
SPOTLIGHT

Case 2
However, in some cases, one or more service departments use other service department. In such a case, the cost
of that service department shall be distributed first which provides services to other service departments too
and the cost shall be distributed to all the departments (that is production and service departments which receive
its services). Thereafter, the cost of remaining service departments are distributed to production departments.
Case 3
In some cases, the structure becomes complex when service departments share services with each other. For
example, Department X and Y provides services to each other as well as to production departments. In such a
case, reciprocal apportionment of cost is carried. The following methods are used for such apportionment:
STIKCY NOTES

a) Repeated distribution method

b) Simultaneous equation method

Repeated Distribution Method:

In this method, cost of one service department is apportioned to all the departments according to the determined
proportion. This way, the cost of that department becomes zero. Thereafter, the cost of other service department
is distributed to all the departments in the given proportion. Now since the departments share services, the
department whose cost is distributed first has receive the portion of cost from the departments whose costs are
subsequently apportioned. This will happen with all the service departments. Therefore, the process of
distribution should be repeated till all the costs including the ones after repeated distribution have become zero.

Simultaneous Equation Method:

In this method, simultaneous equations are made to solve the problem in shortest way.
These methods can be best understood through examples.

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 Example 08:
In a factory with four production departments and two service departments, the operating costs
for the month of October were as shown below.
Rs.
Production Department 1 700,000
Production Department 2 300,000
Production Department 3 400,000
Service departments
Canteen 78,000
Boiler house 100,000
1,578,000

AT A GLANCE
The costs of running the canteen are apportioned to each department on the basis of the
estimated use of the canteen by employees in each department.
The costs of the boiler house are apportioned on the basis of the estimated consumption of power
by each department.
The service departments’ costs are therefore apportioned as follows:
Canteen Boiler house
% %
Production Department 1 40 30
Production Department 2 20 30
Production Department 3 30 20

SPOTLIGHT
Service departments
Canteen - 20
Boiler house 10 -
Preparation of a statement showing the allocation of costs to the production departments using
the repeated distribution method would be as follows:
C = Canteen
BH = Boiler house
Dept 1 Dept 2 Dept 3 C BH
Rs. Rs. Rs. Rs. Rs.

STIKCY NOTES
Initial overheads 700,000 300,000 400,000 78,000 100,000
Apportion:
BH (30:30:20:20) 30,000 30,000 20,000 20,000 (100,000)
98,000
C (40:20:30:10) 39,200 19,600 29,400 (98,000) 9,800
BH (30:30:20:20) 2,940 2,940 1,960 1,960 (9,800)
C (40:20:30:10) 784 392 588 (1,960) 196
BH (30:30:20:20) 59 59 39 39 (196)
C (40:20:30:10) 15 8 12 (39) 4
BH (30:30:20:20) 1 1 1 1 (4)
C (40:20:30:10) 1 0 0 (1) 0
Total overhead 773,000 353,000 452,000

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a) the simultaneous equations method.

Let Y = the total overheads apportioned from the Boiler House
This gives us the simultaneous equations:
X = 78,000 + 0.2 Y … (1)
Y = 100,000 + 0.1 X … (2)
Re-arrange:
78,000 = X – 0.2 Y … (1)
100,000 = – 0.1 X + Y … (2)
Multiply (2) by 10
1,000,000 = – X + 10Y … (3)
AT A GLANCE

Add (1) and (3)

1,078,000 = 9.8Y
Y = 110,000
Therefore, from (1) and substituting Y = 110,000:
X = 78,000 + 0.2 (110,000) = 100,000.
Dept 1 Dept 2 Dept 3
Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000
Apportion:
BH (30%, 30% and 20% of 110,000) 33,000 33,000 22,000
SPOTLIGHT

C (40%, 20% and 30% of 100,000) 40,000 20,000 30,000

Total overhead apportionment 773,000 353,000 452,000

 Example 09:
The expenses of the production and service departments of a company for a year are as follows:
Expenses before distribution Service provided (%age)
Department of service department cost Dept. X Dept. Y
Rs. ‘000
Production department - A 500 50 40
-B 400 30 50
STIKCY NOTES

Service department – X 100 - 10

-Y 60 20 -
For allocating the service departments expenses to production departments by:
a) Repeated distribution method
Production Service
Department Department
A B X Y
Total expenses as given 500 400 100 60
Allocation of X department cost 50 30 (100) 20
Allocation of Y department cost 32 40 8 (80)
Allocation of X department cost 4 2 (8) 2
Allocation of Y department cost 1 1 - (2)
587 473 - -

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b) Simultaneous equation method

Let total expenses of department X inclusive of expenses allocated from department
Y=x
Let total expenses of department Y inclusive of expenses allocated from department
X=y
Then according to question
x = 100 + 0.1 y ------------ eq. (1)
y = 60 + 0.2 x -------------- eq. (2)
Putting the value of y from eq.(1) in eq.(2)
x = 100 + 0.1 (60 + 0.2x)
= 100 + 6 + 0.02 x

AT A GLANCE
x – 0.02 x = 106
x = 108
y = 60 + 0.2x
= 60 + 22 = 82
ALLOCATIONS
Production
Description Department
A B
Product department costs 500 400

SPOTLIGHT
Distribution of X department cost
(108  50%) & (108  30% ) 54 32
Distribution of Y department cost
(82  40%) & (82  50% ) 33 41
587 473

STIKCY NOTES

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4. OVER OR UNDER APPLIED / ABSORBED OVERHEAD

Once the factory overhead rate is determined using the estimated amount of factory overhead and estimated
base, it is used to charge overhead cost to the jobs, products or work performed.
Since, not all overhead costs are known at the time of making the product, (such as electricity bill is received after
the month end) therefore, the estimated rate is used to apply the overhead cost to the job or product using actual
activity level. This is called absorption or application of overheads to the products / jobs.
Due to this, at each period end, the management calculates and compares the actual overhead cost with the
applied overhead cost and determine the over or under applied overheads.
The over or under absorbed overhead is calculated as follows:

Actual Factory Overhead xxx

AT A GLANCE

Applied / Absorbed Factory Overhead

(Budgeted overhead rate x actual activity level of the selected base) (xxx)
Over or Under Applied / Absorbed Overhead xxx

 Over applied / absorbed means the actual overhead cost is lesser than the cost applied to the production
 Under applied / absorbed means the actual overhead cost is greater than the cost applied to the production

Treatment of Over or Under Applied / Absorbed Overhead:

The over or under applied overhead so calculated is treated either as:
a) Period cost – charged to cost of goods sold, or
SPOTLIGHT

b) Product cost – charged to production (including closing inventory)

For financial reporting purposes, it is often closed to cost of goods sold as period cost.
 Example 10:
Amber Limited (AL) manufactures a single product. Following information pertaining to the year
20X4 has been extracted from the records of the company’s three production departments.

Material Labor Machine

Department
Rs. in million Hours
A 80 200,000 400,000
STIKCY NOTES

Budgeted B 150 500,000 125,000

C 120 250,000 350,000
A 80 220,000 340,000
Actual B 150 530,000 120,000
C 120 240,000 320,000

AL produced 3.57 million units during the period. The budgeted labor rate per hour is Rs. 120.
The overheads for Department-A is budgeted at Rs. 5.0 million, for Department-B at 15% of labor
cost and for department-C at 5% of prime cost of the respective departments. Actual overheads
for department A, B and C are Rs. 5.35 million, Rs. 8.90 million and Rs. 7.45 million respectively.
Overheads are allocated on the following basis:
Department-A Machine hours
Department-B Labor hours
Department-C Percentage of Prime cost

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There was no beginning or ending inventory in any of the production departments.

a) For calculating budgeted overhead application rate for each department, the following
working shall be made

Budgeted overhead rate for department-A Rs. in million

Budgeted Overhead rate per machine hour (OHD/MH Rs.5m/400,000) Rs. 12.5
Budgeted overhead rate for department-B
Budgeted labor cost (Rs. 120 × 500,000) 60
Budgeted overhead (Rs. 60 m × 15%) 9
Budgeted overhead rate per labor hour (Rs. 9 m/0.5 m) 18

AT A GLANCE
Budgeted overhead rate for department-C
Budgeted overhead as a % of Prime Cost (Rs.7.5 m /150 m) 5%

b) For calculation of the total and departmental actual cost for each unit of product, the
following working shall be made

Departments
Rupees in million
A B C

SPOTLIGHT
Material cost 80.00 150.00 120.00
Labor cost
(0.22 m × Rs. 120) 26.40
(0.53 m × Rs. 120) 63.60
(0.24 m × Rs. 120) 28.80
Actual overhead cost 5.35 8.90 7.45
Total Cost 111.75 222.50 156.25

STIKCY NOTES
Unit cost (Cost/3.57 m. units) (Rs.) 31.30 62.32 43.77
Total Actual Cost per unit (Rs.) 137.39

c) For calculation of over or under applied overhead for each department, the following
working shall be made.

(0.34 m × 12.5) 4.25

(0.53 m × Rs. 18) 9.54
(Rs. 148.8 m × 5%) 7.44
Actual Overhead Cost 5.35 8.90 7.45
Under applied / (over applied) 1.10 (0.64) 0.01

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5. COMPREHENSIVE EXAMPLES
 Example 01:
Salman Limited (SL) has two production departments, PD-A and PD-B, and two service
departments, SD-1 and SD-2. A summary of budgeted costs for the year ending June 2015 is as
follows:

PD-A PD-B SD-1 SD-2 Total

----------------------- Rs. in ‘000 -----------------------
Direct labor 5,400 3,648 - - 9,048
Direct material 13,500 9,120 - - 22,620
AT A GLANCE

Indirect labor 1,900 600 50 20 2,570

Indirect materials 900 1,100 150 55 2,205
Factory rent - - - - 1,340
Power cost - - - - 1,515
Depreciation - - - - 3,500

Other related data is as follows:

PD-A PD-B SD-1 SD-2

SPOTLIGHT

Production (units) 2,250 800 - -

Direct labor hours (per unit) 20 38 - -
Machine hours 19,250 12,250 2,800 700
Kilowatt hours (000) 800 600 50 150
Floor area (square feet) 5,000 4,000 500 500
Basis of overhead application Machine hours Direct labor hours - -

SL allocates the costs of service departments applying repeated distribution method. Details of
services provided by SD-1 and SD-2 to the other departments are as follows:
STIKCY NOTES

Service Departments PD-A PD-B SD-1 SD-2

SD-1 30% 65% - 5%
SD-2 55% 35% 10% -

The departmental overhead absorption rate can be calculated as follows:

Allocation of overheads and overheads absorption rate

Allocation Total PD-A PD-B SD-1 SD-2

basis Rs. in 000
Direct labor - - - - -
Direct material - - - - -
Indirect labor - 1,900 600 50 20
Indirect materials - 900 1,100 150 55

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Allocation Total PD-A PD-B SD-1 SD-2

basis Rs. in 000
Factory rent Floor area 1,340 670 536 67 67
Kilowatt
Power hrs. 1,515 758 568 47 142
Machine
Depreciation hrs. 3,500 1,925 1,225 280 70
6,153 4,029 594 354
Allocation of service departments cost:

AT A GLANCE
SD-1 30:65:5 178 386 (594) 30
SD-2 55:35:10 211 134 39 (384)
SD-1 30:65:5 12 25 (39) 2
SD-2 55:35:10 1 1 0 (2)
6,555 4,576 - -

Machine D. labor
Allocation basis
hrs. hrs.

SPOTLIGHT
Machine/D. labor hours 19,250 30,400 800×38
Overhead absorption rate per hour Rs. 340.52 150.53

 Example 02:
Opal Industries Limited (OIL) produces various products which pass through Processing and
Finishing departments. Logistics and Maintenance departments provide necessary support for
the production. Following information is available from OIL’s records for the month of June 2017:

(i) Overhead costs Direct labor hours

*Budgeted Actual Budgeted Actual

STIKCY NOTES
Departments
-------- Rupees -------- -------- Rupees --------
Processing 560,000 536,000 14,000 14,350
Finishing 320,000 258,000 10,000 9,800
Logistics - 56,700 - -
Maintenance - 45,000 - -

*including apportionment of overhead costs of support departments

(ii) Costs of support departments are apportioned as under:

Processing Finishing Logistics Maintenance

Logistics 50% 40% - 10%
Maintenance 35% 45% 20% -

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a) Allocate actual overhead costs of support departments to production departments

using repeated distribution method.

Allocation of support departments' actual overheads:

Production Support
departments departments

Processing Finishing Logistics Maintenance

Rupees

Cost incurred 536,000 258,000 56,700 45,000

AT A GLANCE

Allocation of support departments' costs:

Logistics
50%:40%:0%:10% 28,350 22,680 (56,700) 5,670

Maintenance
35%:45%:20%:0% 17,734 22,802 10,134 (50,670)

Logistics 5,067 4,054 (10,134) 1,013

Maintenance 354 456 203 (1,013)

SPOTLIGHT

Logistics (Being immaterial

amount, allocated to production
dept. only) 50:40 113 90 (203) -

Total - Actual overhead costs A 587,618 308,082 - -

b) Compute under/over applied overheads for the month of June 2017.

Under/over applied overheads:

Predetermined overhead rate:

STIKCY NOTES

Budgeted direct labor hours B 14,000 10,000

Budgeted overhead costs C 560,000 320,000

Budgeted overhead rate (C÷B) D 40.00 32.00

Overheads applied:

Actual direct labor hours E 14,350 9,800

Overheads applied (D×E) F 574,000 313,600

Overheads under/(over) applied

(A-F) 13,618 (5,518)

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 Example 03:
Following information has been extracted from the records of RT Limited for August 20X3:

Departments
Production Service
P-1 P-2 P-3 S-1 S-2
Budgeted machine hours 60,000 100,000 120,000

Actual machine hours 60,500 110,000 100,000

Budgeted labor hours 50,000 200,000 75,000

AT A GLANCE
Actual labor hours 55,000 190,000 75,000

Budgeted material cost (Rs. ‘000) 50,000 40,000 3,000

Actual material cost (Rs. ‘000) 50,000 42,000 3,200

Budgeted overheads (Rs. ‘000) 1,200 2,000 2,250 600 700

Actual overheads (Rs. ‘000) 1,250 2,000 1,800 500 750
Services provided by S-1 20% 30% 40% - 10%
Services provided by S-2 30% 40% 20% 10% -

SPOTLIGHT
Basis of overhead application Machine Labor 75% of
hours hours Material cost

a) Allocation of Service dept. cost to production dept. - Repeated distribution method:

Production Dept. Service Dept.

P1 P2 P3 S1 S2
Rupees in thousand
S1 overheads allocation % 20% 30% 40% 10%
S2 overheads allocation % 30% 40% 20% 10%

STIKCY NOTES
Actual overheads as given 1,250 2,000 1,800 500 750
Allocation of S2 cost
30:40:20:10 225 300 150 75 (750)
Allocation of S1 cost
20:30:40:10 115 172 230 (575) 58
Allocation of S2 cost
30:40:20:10 17 23 11 6 (58)
Allocation of S1 cost
20:30:40:10 1 2 3 (6)
Allocation from service dept. 358 497 394
Total 1,608 2,497 2,194  

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b) Compute department wise over / under applied overheads.

Department wise over / under applied overheads:

P1 P2 P3
Budgeted OH’s 1,200,000 2,000,000 2,250,000
Re-distributed OH’s of service 365,657 510,101 424,242
departments (W-2)
Total budgeted OH’s (I) 1,565,657 2,510,101 2,674,242

Budgeted Base Machine Hours Labor Hours Material Cost

AT A GLANCE

60,000 200,000 -
Budget OAR (II) Rs. 26.0943 Rs. 12.5505 75% of DMC
Per M.H Per L.H Given
Actual data of Base (III) 60,500 190,000 Rs. 3,200,000
Applied FOH (III x II) Rs. 1,578,705 2,384,595 2,400,000
Actual FOH (W-1) 1,608,586 2,497,475 2,193,939
(Under)/Over FOH Applied (29,881) (112,880) 206,061

(W-1)
SPOTLIGHT

P-1 P-2 P-3

Actual FOH
Direct Incurred 1,250,000 2,000,000 1,800,000
Share of service dept’s (part a) 358,586 497,475 393,939
1,608,586 2,497,475 2,193,939

(W-2) Allocation of Service departments using Repeated Distribution Method.

R.T Limited FOH Distribution Sheet
For the month of August, 2009 (Based on Budgeted Cost for Computation of Budgeted OAR)
STIKCY NOTES

Date Particulars Head Amount Basis Production Department Service Department

of P1 P2 P3 S1 S2
A/c
Budgeted 1,300,000 600,000 700,000
Overheads
Redistribution
S–1 20:30:40:10 120,000 180,000 240,000 (600,000) 60,000
760,000
S–2 30:40:20:10 228,000 304,000 152,000 76,000 (760,000)
S–1 20:30:40:10 15,200 22,800 30,400 (76,000) 7,600
S–2 30:40:20:10 2,280 3,040 1,520 760 (7,600)
S–1 20:30:40:10 152 228 304 (760) 76
S–2 30:40:20:10 23 30 15 8 (76)
S–1 20:30:40:10 2 3 3 (8) -
1,300,000 365,657 510,101 424,242 0 0

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CAF 8: CMA CHAPTER 3: OVERHEADS

STICKY NOTES

Manufacturing expenses are of two types: Direct expenses and Indirect

Expenses.
Direct expenses are fully traceable to the product/service/department being
costed. E.g. Raw material and Labor. Indirect expenses (Production
overheads) –incur in the course of making a product/providing service/
running department but cannot be traced directly and fully to the product,
service or department

AT A GLANCE
Costs are often categorized as variable cost that vary with the level of output
and fixed cost that occur irrespective of the level of output.

Production Overheads incur in relation to the production processes (also

called manufacturing overheads / factory overheads). Non-Production
Overheads incur to support the overall objectives of the business. (classified
as ‘Administrative Expenses, Marketing, Selling and Distribution Expenses’ in
the Statement of Comprehensive Income.)

SPOTLIGHT
Estimated factory overheads can be calculated using physical output, direct
material cost, direct labor cost, direct labor hours, machine hours.

In addition to the selection of bases, the following factors are also considered
to estimate factory overheads:
1. Activity level: at which the business performs its production activities

STIKCY NOTES
2. Inclusion or exclusion of fixed overheads: Absorption costing /
conventional costing/full costing or Marginal Costing/Direct Costing
3. Single rate or several rates Blanket rate/Plant-wide rate, Departmental
rates or Cost centers/cost pool rates.

The overhead costs of servicing departments are transferred to production

departments and service departments in the proportion of the facilities used

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 CHAPTER 3: OVERHEADS CAF 8: CMA

When service departments share services with each other, reciprocal

apportionment of cost is carried with one of the following methods:
a) Repeated distribution method
b) Simultaneous equation method

All the production related overhead costs are to be accumulated at the

smallest segment of the production process
AT A GLANCE

Budgeted overhead rate is calculated to allocate cost to the products

At the period end, actual overhead is compared with applied
Overhead rate to calculate the over or under absorption
SPOTLIGHT
STIKCY NOTES

68 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 4

LABOR COSTING

AT A GLANCE
IN THIS CHAPTER
Labor is an important element in a production cost.
AT A GLANCE Industries that are dependent on human workforce have to

AT A GLANCE
adopt strategies that benefit them in terms of human resource
SPOTLIGHT retention as well as keeping their labor cost low.
Various wage systems are designed to achieve these objectives.
1. Introduction to Labor costing
and Cost Control Management must have to monitor labor performance in terms
of productivity (efficiency) and effectiveness (cost).
2. Management of Productivity and
A quantitative method called ‘Learning Curve’ is used to
Efficiency
calculate in advance the expected time to be taken by the labors
when they become fully conversant with the work.
3. Wage Incentive Plans

4. Learning Curve Theory

SPOTLIGHT
5. Recording and Accounting for
Labor Cost

6. Comprehensive Examples

STICKY NOTES

STIKCY NOTES

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 CHAPTER 4: LABOR COSTING CAF 8: CMA

1. INTRODUCTION TO LABOR COSTING AND LABOR COST CONTROL

Labor cost is the second important element of the cost of production after material cost. Labor costs constitute a
major portion of the total cost of a product or service that may take the form of wages, salaries and/or other
incentives of employee remunerations. The profitability and growth of the entity depends greatly upon the
proper utilization of the human resources that in turn needs to be properly recoded and controlled.

1.1. Types of labor cost:

The labor cost has two types:
a) Direct Labor Cost: Direct labor cost is any cost that is specifically incurred for or can be readily charged to
or recognized with any specific contract, job or work order. In cost accounting it is classified as direct labor
cost which becomes part of prime cost. For example: In a watch manufacturing factory, a worker operating
AT A GLANCE

a molding machine to produce a part of wrist watch.

b) Indirect Labor Cost: Where the direct labor can be recognized with and charged to the job, the indirect
labor cannot be so charged and hence is treated as part of the factory overheads. For example: Wages paid
to supervisor of a factory or salary paid to driver of delivery van used for distribution of the product.
Wage payments are generally based on the productivity, time and skill or their combination. Proper control and
accounting for this cost factor and motivation of worker is important in bringing efficiency to an enterprise.
 For example:
Wage payment based on productivity: Wages paid on the basis of number of units produced,
like stitching 2000 pieces of shirts at Rs. 75 per piece.
Wage payment based on time: Wages paid on the basis of number of hours a worker
SPOTLIGHT

performed his in a production line, like 160 hours paid at Rs. 175 per hour.
Wage payment based on skill: A wage differentiation due to varied skills, like skilled workers
are paid higher than apprentice for the same job.

1.2. Measuring labor activity:

It is important to differentiate between “production” and “productivity” while measuring labor activity.
 Production: Production refers to the quantity or volume of the output produced i.e. the total number of
units produced. Production therefore is a measure of quantity of work.
 Productivity: Productivity unlike production is a measure of efficiency with which the units have been
produced.
STIKCY NOTES

 Example 01:
Mr. X is supposed to produce six units in every hour at work. The standard productivity rate is
six units per hour for every employee. During the week he made 252 units in 38 hours of work.
The productivity ratio is worked out as:
The total production in the week is 252 units.
Productivity is a relative measure of the hours actually taken and the hours that should have been
taken to make the output. It might be determined in either of the following two methods
Method 1:
252 units should take 42 hours
But took 38 hours
Productivity ratio = 42/38 x 100 110.5%

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Method 2:
In 38 hours Mr.X should make 228 units
But made 252 units
Productivity ratio = 252/228 x 100 110.5%
Comment: A productivity ratio greater than 100% indicates that the actual efficiency is better
than the standard or expected level of efficiency.

1.3. Labor payment methods:

The choice of appropriate labor payment method is very important for any organization as it:
 may affect the cost of the finished products specially when it is a labor intensive organization,
 casts a major impact on the morale and efficiency of the employees and serious consideration should

AT A GLANCE
therefore be given to the possible motivational impact of the remuneration method being adopted.
The two widely known basic labor payment methods are time rate and piece work. These are discussed in detail
below:

Time rate
Time rate/ time work or basic pay is where the employee gets paid on the basis of his time spent at work. The
most common form of this type is a day-rate system.

The formula used for calculating wages under this method is:
Wages = Hours worked x Per hour pay rate

SPOTLIGHT
 If an employee works for more hours than the basic daily requirement or on days which do not constitute a
part of the working week (e.g. Saturdays and Sundays), then he may be entitled to an overtime payment.
The overtime hours are usually paid at a premium rate such as “time and a quarter”, “time and a half” or
“double-time”.
Time and a quarter for example, means that 1.25 times the basic hourly rate is paid for hours worked in
excess of the basic requirement. The overtime premium is the extra rate paid over and above the basic rate.
If employees work unsocial hours, e.g. overnight, then they are entitled to a shift premium which is quite
similar to an overtime premium and means that the employees are paid at an increased hourly rate.
 Example 02:
If the basic rate of pay per hour is Rs. 6 and overtime rate is time and a half, then calculating the

STIKCY NOTES
overtime premium for 8 hours worked in excess of the basic requirement would involve below
working

Rs.
Basic Pay (8 x Rs. 6) 48
Overtime premium (8 x Rs. 3) 24
Total (8 x Rs. 9) 72

Piecework:
Under this method the employee is paid an agreed amount for each unit of output completed or for each task
carried out. Output units per hour may also be an agreed upon number that is referred to as “standard hour
produced”. It is also normal under piecework scheme that the employees get a guaranteed minimum wage
regardless of the number of units produced. This safeguards them from loss of earnings when the production is
low and is not on account of their own fault.

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The wages under the piecework system can be calculated as:

Wages = Units produced x Per unit pay rate

 Example 03:
Straight piecework with guaranteed minimum wage
Sara is paid Rs. 20 for each unit produced with a guaranteed wage of Rs. 2000 for a 40-hour week.
For a series of 4 weeks of the month she produced 140, 160, 180 and 200 units. In order to
calculate total amount for the month, please see below:

Rs.
Week 1 [(140 units x Rs. 20) + Rs. 2000] 4,800
AT A GLANCE

Week 2 [(160 units x Rs. 20) + Rs. 2000] 5,200

Week 3 [(180 units x Rs. 20) + Rs. 2000] 5,600
Week 4 [(200 units x Rs. 20) + Rs. 2000] 6,000
Total for the month 21,600

1.4. Basis of labor cost control:

Labor cost control requires analysis of labor cost with different angles and perspectives, such as, cost per hour,
cost by departments, by product lines, by direct and indirect angle, by rates, by jobs or processes.
Labor cost controls aim to achieve maximum efficiency without compromising the quality and effectiveness of
the operations. Cost analysis and wage system help in achieving this objective.
SPOTLIGHT

 Example 04:
ABC Publishers Limited pays wages to workers working on book binding machine at the rate of
Rs. 17 per book. Workers are not paid for the misaligned binding and such book is scraped for
Rs. 15 per kg. The policy motivates the workers to work hard and maximize productivity.
However, the rate of wastage in ABC is 3% as against industry average of 1%.
ABC re-visited the wage policy and felt that it is likely that workers tend to compromise the
quality because of insignificant loss they suffer due to bad quality. It intends to bring a policy
whereby a deduction of Rs. 70 will be made from the wages for each misaligned binding beyond
1% industry average. However, it is estimated that such policy will reduce the efficiency of
workers because they would reduce the speed to achieve desired quality benchmark and avoid
STIKCY NOTES

deduction.
The cost controller of ABC is supposed to work out the differential cost and revenue to evaluate
the policy before implementation. For this purpose, cost controller needs precise data with
reasonable accuracy about the machine capacity, labor related wastage, impact of slow speed and
contribution margin per unit.
Effective labor cost control is achieved through different tools including;
 analyzing the targeted production,
 preparing labor budget and standardizing labor cost per unit,
 monitoring output, quality, wastage ratios, rework cost due to bad workmanship
 wage incentive systems.

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2. MANAGEMENT OF PRODUCTIVITY AND EFFICIENCY

2.1. Labor Productivity:
Labor productivity can be described as a ratio between labor hours and units produced.

2.2. Labor Efficiency:

Labor efficiency measures how efficiently workers produce a given quantity of units.
Productivity can be stated in one figure, such as; in Engine Installation Department of Motor company, 3 units
per 8 labor hours is the productivity of the department. In assessing efficiency, a single figure would not suffice.
There should be any comparable figure, like own historical data, industry average or budgeted productivity.
If Motors company achieved 3 units per 8 labor hours’ productivity in 2018 in Engine Installation Department as

AT A GLANCE
against 2.8 units per 8 labor hours in 2017. The department efficiently utilized its human resources in the year
2018 as compared to 2017
Efficiency is achieved through high motivation and skills of workers and by better processes and quality of
machines and tools. Improved productivity positively impacts the business profits and the earnings of workers.
It may be noted that productivity and efficiency measures generally indicate number of output as against the
labor input and do not usually refer to the quality and level of bad workmanship. The quality aspect is also
important to achieve the objectives of cost controls.

2.3. The importance of measuring productivity and efficiency:

In a competitive business environment where the price of a product is difficult to be controlled by the producers,
the efficient utilization of resources is the key. Labor cost in many industries is so significant that its efficiency

SPOTLIGHT
can make the difference. A producer should be able to set standards of performance in terms of hours and cost
per hour or cost per unit of production.
The performance standards measure the performance in unit and rupee term and variances help the managers
to focus around the problem areas.
► Example 05:
In a production department the performance standards for a production of 3,000 units are set as
2,000 hours at Rs. 90 per hour. If 2,200 hours are used at standard rate of Rs. 90 per hour to
produce 3,000 units then there is an unfavorable labor efficiency ratio of 90.91% (2,000 /2,200).
In rupee term the unfavorable variance is Rs. 18,000 computed as (100%-90.91%) * 2,200*90

STIKCY NOTES
There can be a variance as against the performance standards, which arises due to difference in wage rates.
Therefore, a total variance between the performance standards and actual results is analyzed in a way that we
arrive at the break up of both variances, namely, labor efficiency variance and labor rate variance.

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3. WAGE INCENTIVE PLANS

Initially, bonus/incentive schemes had been introduced for workers who had been working under a time-based
system, in order to compensate them for their inability to increase their earnings. Wage incentive plans refer to
performance linked compensation paid to improve motivation and productivity. Incentive schemes may either
be short-term or long-term schemes.

3.1. Bonus Systems:

Bonus systems base workers’ earnings on a combination of extra time served and work done. The indirect labor
is usually paid on a weekly or monthly basis, such wages and salaries may also be increased by bonus payments.
AT A GLANCE
SPOTLIGHT

Characteristics of bonus systems:

 A target is set and the performance is matched against that target.
 Employees feel trusted and motivated, the productivity increase and they are paid more for their increased
efficiency.
 Despite of the organization’s labor cost being increased in terms of bonus payments, the total unit cost of
the output stands reduced and the profit per unit of sale is increased.
The widely known bonus/ incentive schemes are discussed in the following paragraphs.
STIKCY NOTES

3.2. High day-rate system:

Under a high day-rate system employees get paid at a higher than average hourly rate provided they agree to
produce a given amount of product at a given quality.
 Example 06:
Shahid makes 200 units in a 40-hour week if he were to be paid Rs. 4 per hour, but 240 units if
he were paid Rs. 5 per hour.
a) The amount to be paid to Shahid in both the cases, would be calculated as

Rs.
i. Amount to be paid to Shahid
a. Under low day-rate scheme 40 hours x Rs. 4 160
b. Under high day-rate scheme 40 hours x Rs. 5 200

74 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 4: LABOR COSTING

b) In order to calculate labor cost per unit, amount paid would be

ii. Labor cost per unit

a. Under low day-rate scheme (40 x 4) 0.8/unit
200
b. Under high day-rate scheme (40 x 5) 0.833/unit
240

c) cost per unit of output if the production overhead is recorded at the rate of Rs. 4 per direct
labor hour, would be as follows

Cost per unit

a. Under low day-rate scheme (40 x 8) 1.60/unit

AT A GLANCE
200
b. Under high day-rate scheme (40 x 9) 1.5/unit
240

Comment:
Though in the given example the labor cost per unit is lower under the low day-rate scheme but
the total unit cost is lower under the high day-rate scheme. Therefore, we see that the high day-
rate scheme in the given scenario would reward both i.e. the employer (a lower unit cost by 10p)
and employee (an extra Rs.1 earned per hour).

Advantages

SPOTLIGHT
 It is easier to calculate and understand.
 It assures the employee a consistently high wage.

Disadvantages
 Employees cannot go beyond the fixed hourly rate for the extra effort they put in. In the example given above
if the employee makes 280 units instead of 240 units in a 40 hours week, the cost per unit would decrease
even further but all the savings would go to the benefit of the employer and none would go to the employee.
 The high wages might become the accepted wage level for normal working. Management might need to keep
checks on the productivity and efficiency levels of the employees.

3.3. Individual bonus schemes:

STIKCY NOTES
An individual bonus scheme sets out performance objectives/targets and usually forms part of the performance
appraisal systems of organizations. Every individual’s bonus is calculated separately and is unique to every
employee. So basically it is an incentive whereby an employee has to qualify to be entitled for a bonus on top of
his/ her basic wage.
 Example 07:
Rs.100 per unit bonus is paid to an employee if he produced at least 500 units per month. If an
employee achieves that performance standard, then he will be entitled to get a bonus on all units
produced.

3.4. Group bonus schemes:

In cases where individual efforts cannot be exactly measured and employees work as a team, individual incentive
schemes become impracticable. In such scenarios, group incentive schemes are found to be more relevant and
feasible. Even in cases where an individual alone cannot complete his job without the cooperation of his fellow
workers, there too, group incentive schemes are given preference over the individual bonus schemes.

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Group bonus plans reward all team members equally based on overall performance of the team members. It
usually comes into play when individual output cannot be measured with accuracy. Therefore, team performance
is evaluated on the basis of time taken to complete the job rather than output produced. Usually, the bonus earned
by the group is divided among the group members in accordance with their respective base rates.
For Example, a bonus may be paid to department which has a reject rate in unit of output below a specified ratio
in proportion to their respective basic wages.

Advantages
 Group schemes reduce the clerical efforts to be put in for the calculations of individual incentive schemes.
 They are easy to be administered.
 Group schemes improve the team cohesion.
AT A GLANCE

Disadvantages
 Employees might demand for minimum targets for accepting the scheme.
 Employees doing the best and the worst might fall victim to team’s politics.

3.5. Profit sharing schemes:

A profit sharing scheme offers the employees a certain proportion of the organization’s profits. The size of this
offer is related to the designation of the employee and also the length of the employment period to date.

Advantages
 The biggest advantage is that the organization will pay only what it can afford to pay out of the actual
SPOTLIGHT

profits earned.
 Such schemes can be offered to indirect labor as well.

Disadvantages
 Employees may be putting in best of their efforts yet the organization might still incur losses on account of
issues beyond the control of the employees.
 It is a long term commitment that the organization is asking for. The employees have to wait for the bonus
until the year ends. The reward is not an immediate one.

3.6. Share incentive schemes:

STIKCY NOTES

A share incentive scheme is where the employees of the company are given an option to acquire the shares as an
incentive. In this way the employees’ morale rises so does their loyalty due to the feeling that they now have a
stake in the company they work for.

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4. LEARNING CURVE THEORY

4.1. Learning Effect:
Learning is the process by which an individual acquires skill, knowledge and ability. When a new product or
process is started, the performance of the worker is relatively low since the job has just recently started but if it
is fairly repetitive in nature then the learning phenomenon takes place. When the experience is gained, the
worker is likely to become more confident and knowledgeable about the task thus the performance improves,
which in turn reduces the time taken per unit and increases the productivity.
The effect that learning casts on employees, can be represented by a line called a learning curve. It displays the
relationship between the production time per unit and the cumulative number of units produced. Learning curve
has a direct impact on direct labor wages.

AT A GLANCE
Eventually when the worker has had enough experience and nothing more is left for him to learn, then the
learning process stops i.e. the learning would stop after a certain time limit and beyond specific number of units
produced.
Assumptions
 The amount of time required to complete a unit of a product or a given task will decrease every time the
task is undertaken.
 The unit time will decrease at a decreasing rate, and
 The time reductions will have a predictable pattern.

4.2. Learning curve theory:

The learning curve theory refers to the phenomenon that the cumulative average time required per unit will

SPOTLIGHT
decrease by a constant percentage every time total output of the product doubles. Doubling of output is an
important part of the measurements determining the learning effect.
For example, if we take 80% learning effect, the cumulative average time required per unit is reduced to 80% of
the previous cumulative average time when the output is doubled. Note that the cumulative average time is the
average time per unit for all units produced till now, inclusive of the first unit made.
 Example 08:
If the first unit of output requires 100 hours and a 70% learning effect occurs, then determine
the production times for:
 Total production

STIKCY NOTES
 Incremental total hours
 Incremental hours per unit
Cumulative Cumulative
Total
no. of units avg. Incremental time
Time
produced time/unit
Total Time per
time unit
Hours Hours Hours Hours
1 100.0 (x1) 100
2 (70%) 70.0 (x2) 140 40 ÷1 40
4 (70%) 49.0 (x4) 196 56 ÷2 28
8 (70%) 34.3 (x8) 274.4 78.4 ÷4 19.6

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 Formula:

Y = axb
Where
Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units produced (output)
b = the learning curve factor (i-e. log LR/log2)
LR = the learning rate as a decimal

 Example 09:
AT A GLANCE

Find the value of b when a 90% learning curve effect takes place.
b = log 0.9/log 2
= -0.0458/0.3010
= -0.152
SPOTLIGHT
STIKCY NOTES

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5. RECORDING AND ACCOUNTING FOR LABOR COST

5.1 Recording labor costs
There are various departments within an organization that are involved in collecting, recording and costing of
labor. The procedures involve production planning, time and motion study, timekeeping, labor budgeting, etc. A
brief detail of the departments involved and procedures performed by them in the due process is discussed
below.

Human Resource department

The HR department is primarily responsible for the hiring of employees, engaging them, their transfer, departure
and termination etc. This department maintains employees’ records and issues the reports for the management
to facilitate the decision making process of HR related issues.

AT A GLANCE
Production Planning department
The Production Planning department schedules work, issues the job orders to production departments and
chases up jobs in the factory when they run late.

Time keeping department

The timekeeping department keeps track of the time spent in the factory by each worker and the time spent by
each worker on each job. The time keeping activity might be carried out using any of the following tools with
reference to the relevance and importance to the nature of activity.

 Daily time sheets: The daily time sheet is filled in by the employee on everyday basis. It will record how

SPOTLIGHT
his/ her time in the factory has been spent. The total time on the sheet should however correspond to the
record on the attendance form.

 Weekly time sheets: They are similar to the daily time sheets but are sent to the cost office towards the end
of every week.

 Job cards: Job cards are job specific and are prepared for every job or batch separately. In a time sheet the
worker if engaged with many jobs will have several entries related to the respective jobs wherein in case of
job cards, each job card will contain the detail of activities carried out by the employee in respect to that
specific job only.

 Piecework or operation card: A Piecework ticket contains the record of total number of items produces by
the employee and the total number of the units rejected. Payment would be made for only the items that are

STIKCY NOTES
as per the required standards.

Cost accounting department

The cost accounting department accumulates and classifies all the data related to the labor costs. The information
is then shared with the management to help determine the control measures if required.

5.2 Journal entries for recording labor costs

The primary journal entry for payroll is the summary-level entry that is compiled from the payroll register and
which is recorded in either the payroll journal or the general ledger. This entry usually includes debits for the
direct labor expense, salaries and the company's portion of payroll taxes. There will also be credits to the liability
for payroll taxes that have not been paid, as well as for the amount of cash already paid to employees for their
net pay. The basic entry (assuming no further breakdown of debits by individual department) is:

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 CHAPTER 4: LABOR COSTING CAF 8: CMA

(i) to record the total wages earned

Debit Credit
Payroll xxx
Accrued Payroll tax xxx
Payroll advances xxx
Payroll deductions xxx
Accrued Payroll xxx
(ii) to record payment of the payroll
Debit Credit
AT A GLANCE

Accrued Payroll xxx

Cash/Bank xxx
(iii) To record the closure of the Payroll account
Debit Credit
W-I-P – Direct Labor xxx
FOH – Indirect Labor xxx
Selling Expenses Control a/c – Sales Salaries xxx
Administrative Exp – Office Salaries xxx
SPOTLIGHT

Payroll xxx
STIKCY NOTES

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6. COMPREHENSIVE EXAMPLES
 Example 01:
Quality Plastics Limited (QPL) produces plastic bodies of various appliances according to the
customers’ specifications. It has received an order for supply of 10,000 plastic bodies of a
washing machine. The supply is to be made within 30 days.
The following information is available:
i. QPL carries out production process in batches of 100 units each. Cost of the first batch
is estimated as under:

Rupees
Direct material (inclusive of 10% input losses) - 1,100 kg 66,000

AT A GLANCE
Direct labor cost at normal rate - 200 hours 44,000
Overheads at normal rate 200 hours 30,000

ii. It is estimated that due to learning curve effect, completion of the first, second, third
and fourth batch would require 200, 160, 148 and 140 hours respectively.
This learning effect would continue till completion of 64 batches only.
Learning effect at various learning levels is as under:

80% 85% 90%

–0.322 –0.235 –0.152

SPOTLIGHT
iii. It is estimated that after completion of the first 16 batches, material input losses would
be reduced from 10% to 6%.
iv. QPL works a single shift of 8 hours per day. For the above order, QPL can spare 8,000
direct labor hours. Overtime hours can be worked at 1.5 times the normal rate. During
the overtime hours, overheads would be 1.25 times the normal rate.
The price that QPL should quote in order to earn a margin of 25% of the selling price would be
computed as follows

Material Rs.
First 16 batches (16*66,000) 1,056,000

STIKCY NOTES
Next 84 batches 84*(66,000*.9/.94) 5,308,085
Direct labor cost
Normal hours at Rs. 220 1,760,000
Overtime hours at Rs. 330 686,070
Overheads
Normal hours at Rs. 150 1,200,000
Overtime hours at Rs. 187.5 389,813
Total costs 10,399,968
Order price at a margin of 25% of the selling price 13,866,624

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W.1: Learning curve %:

Average hours per Learning

Batch No. Cumulative hours
batch curve %
1 200.00 200.00
2 (200+160) 360.00 180.00 (180/200) 90%
4 (360+148+140) 648.00 162.00 (162/180) 90%
Hours for first 64 batches 64*200*(64)-0.152 6,803
Hours for first 63 batches 63*200*(63) -0.152 ( 6,712)
AT A GLANCE

Hours per batch after 63rd batch 91

Hours required:
First 64 batches 6,803
Last 36 batches (91×36) 3,276
Total hours 10,079
Overtime hours (10,079 – 8,000) 2,079

 Example 02:
Smart Processing Limited (SPL) is considering to sign a contract for manufacturing 10,000 auto
SPOTLIGHT

parts for a large automobile assembler. The parts would be produced in batches of 500 units
each. The estimated cost of the first batch is as under:

Rupees

Direct material ( kg) 135,000

Direct labor (1,500 hours) 225,000

Variable overheads (Rs. 120 per direct labor hour) 180,000

Set-up cost per batch 40,000

STIKCY NOTES

Fixed costs:

- Depreciation of equipment purchased for the project 45,000

- Allocation of existing overheads @ Rs. 16 per hour 24,000

Cost of first batch 649,000

Additional information:
i. The set-up cost per batch would be reduced by 5% for each subsequent batch.
However, there would be no further reduction in the set-up cost from the 5th batch
onward.
ii. Learning curve effect is estimated at 90% but would remain effective for the first eight
batches only.
iii. The index of 90% learning curve is -0.152.

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The contract price that would enable SPL to earn an incremental profit of 30% of the contract
price would be computed as follows

Computation of contract price Rupees

Cost of material 135,000×20 2,700,000

Direct labor cost:

- For the first 8 batches (W-1) 8,748

- For the last 12 batches (W-1) 937×12 11,244

19,992 ×150 2,998,800

AT A GLANCE
Variable overheads 19,992 ×120 2,399,040

Batch set-up cost:

- For the first 4 batches 40,000+[40,000×(0.95)1]+[40,000×(0.95)2]+[40, 148,395

000×(0.95)3]

- For the last 16 batches [(40,000×(0.95)3)]×16 548,720

Fixed costs:

- Depreciation on equipment purchased 45,000×20 900,000

for the project

SPOTLIGHT
- Allocation of existing fixed overheads Irrelevant cost -

Total incremental cost of the contract A 9,694,955

Contract price (A÷70%) 13,849,936

W-1: Direct labor hrs. per batch for batch 9 onward: Hours

Direct labor hours for the first 8 batches 8×1,500×(8)–0.152 8,748

Direct labor hours for the first 7 batches 7×1,500×(7)–0.152 (7,811)

STIKCY NOTES
Hours per batch for 8th and onward batches 937

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STICKY NOTES

Labor cost is measured with respect to ‘Production’ and ‘Productivity’

Labor intensive industries tend to develop labor and production designated

wage policies
AT A GLANCE

Labor performances are worked out at each period end to analyze the cost
and productivity outcome

Learning curve is used to quantify the expected output in the expected time

Payroll account generally includes debit for direct labor expense, salaries and
SPOTLIGHT

the company’s portion of payroll taxes. Credit would be liability or amount of

cash paid to the employees.
STIKCY NOTES

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 CHAPTER 5

MARGINAL COSTING AND

ABSORPTION COSTING

AT A GLANCE
IN THIS CHAPTER

AT A GLANCE
In marginal costing only variable costs (marginal costs) are
AT A GLANCE charged to the cost of making and selling a product or service.
Fixed costs are treated as period costs and are deducted from
SPOTLIGHT profit. They are charged in full against the profit of the period in
which they are incurred.
1. Marginal Cost and Marginal In absorption costing variable costs as well as fixed production
Costing costs are charged to the cost of making the product or service.
Fixed production cost are absorbed using a predetermined
2. Reporting Profit with Marginal absorption rate.
Costing
In marginal costing the closing stocks are valued at marginal
3. Reporting Profit with (variable) production cost where as in absorption costing stocks
Absorption Costing are valued at their full production cost which includes absorbed

SPOTLIGHT
fixed production overhead.
4. Marginal and Absorption If the opening and closing stock levels differ the profit for the
Costing Compared accounting period under the two methods of cost accumulation
will be different because the two systems value stock differently.
5. Advantages and Disadvantages
of Absorption and Marginal
Costing

6. Comprehensive Examples

STICKY NOTES

STIKCY NOTES

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1. MARGINAL COST AND MARGINAL COSTING

1.1 Marginal cost
The marginal cost of an item is its variable cost.
 Marginal production cost = Direct materials + Direct labor + Direct expenses + Variable production
overhead.
 Marginal cost of sale for a product = Direct materials + Direct labor + Direct expenses + Variable production
overhead + Other variable overhead (for example, variable selling and distribution overhead).
 Marginal cost of sale for a service = Direct materials + Direct labor + Direct expenses + Variable overhead.
It is usually assumed that direct labor costs are variable (marginal) costs, but often direct labor costs might be
AT A GLANCE

fixed costs, and so would not be included in marginal cost. E.g. If the workers are not being paid on piece rate
basis but rather on fixed salary.
Variable overhead costs might be difficult to identify. In practice, variable overheads might be measured using
a technique such as high/low analysis or linear regression analysis, to separate total overhead costs into fixed
costs and a variable cost per unit of activity.
 For variable production overheads, the unit of activity is often either direct labor hours or machine hours,
although other suitable measures of activity might be used.
 For variable selling and distribution costs, the unit of activity might be sales volume or sales revenue.
 Administration overheads are usually considered to be fixed costs, and it is very unusual to come across
variable administration overheads.
In simple words…
SPOTLIGHT

In marginal costing the cost of the product is variable Production Cost only.

1.2 Marginal costing and its uses

Marginal costing is a method of costing with marginal costs. It is an alternative to absorption costing as a method
of costing. In marginal costing, fixed production overheads are not absorbed into product costs.
There are several reasons for using marginal costing:
 To measure profit (or loss), as an alternative to absorption costing
 To forecast what future profits will be
 To calculate what the minimum sales volume must be in order to make a profit
STIKCY NOTES

It can also be used to provide management with information for decision making.
Its main uses, however, are for planning (for example, budgeting), forecasting and decision making as it deals
with costs that can be directly changed in the short term.

1.3 Assumptions in marginal costing

For the purpose of marginal costing, the following assumptions are normally made:
 Every additional unit of output or sale, or every additional unit of activity, has the same variable cost as every
other unit. In other words, the variable cost per unit is a constant value.
 Fixed costs are costs that remain the same in total in each period, regardless of how many units are produced
and sold.
 Costs are either fixed or variable, or a mixture of fixed and variable costs. Mixed costs can be separated into
a variable cost per unit and a fixed cost per period.

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 The marginal cost of an item is therefore the extra cost that would be incurred by making and selling one
extra unit of the item. Therefore, marginal costing is particularly important for decision making as it focuses
on what changes as a result of a decision.

1.4 Contribution margin

Contribution is a key concept in marginal costing.
Contribution margin = Sales – Variable costs
Fixed costs are a constant total amount in each period. To make a profit, an entity must first make enough
contribution to cover its fixed costs. Contribution therefore means: ‘contribution towards covering fixed costs
and making a profit’.
Total contribution margin – Fixed costs = Profit

AT A GLANCE
In simple words…
Contribution margin is sales minus all Variable costs

SPOTLIGHT
STIKCY NOTES

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2. REPORTING PROFIT WITH MARGINAL COSTING

2.1 Total contribution minus fixed costs
Profit is measured by comparing revenue to the cost of goods sold in the period and then deducting other
expenses.
The cost of goods sold is the total cost of all production costs in the period adjusted for the inventory movement.
In a marginal cost system, the opening and closing inventory is measured at its marginal cost. The cost per unit
only includes the variable costs of production (direct materials + direct labor + direct expenses + variable
production overhead).
When measuring profits using marginal costing, it is usual to identify contribution, and then to subtract fixed
costs from the total contribution, in order to get to the profit figure.
AT A GLANCE

Illustration: Rs. Rs.

Sales 360,000
Direct costs 105,000
Variable production costs 15,000
Variable sales and distribution costs 10,000
Total marginal costs (130,000)
Total contribution 230,000
Total fixed costs (150,000)
Profit 80,000
SPOTLIGHT

Total contribution and contribution per unit

In marginal costing, it is assumed that the variable cost per unit of product (or per unit of service) is constant. If
the selling price per unit is also constant, this means that the contribution earned from selling each unit of
product is the same.
Total contribution can therefore be calculated as: Units of sale  Contribution per unit.
 Example 01:
A company manufactures and sells two products, A and B.
Product A has a variable cost of Rs.6 and sells for Rs.10, and product B has a variable cost of Rs.8
and sells for Rs.15.
STIKCY NOTES

During the period, 20,000 units of Product A and 30,000 units of Product B were sold.
Fixed costs were Rs.260,000. What was the profit or loss for the period?
Contribution per unit:
Product A: Rs.10 – Rs.6 = Rs.4
Product B: Rs.15 – Rs.8 = Rs.7
Rs.
Contribution from Product A: (20,000  Rs.4) 80,000
Contribution from Product B: (30,000  Rs.7) 210,000
Total contribution for the period 290,000
Fixed costs for the period (260,000)
Profit for the period 30,000

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2.2 A marginal costing income statement with opening and closing inventory
The explanation of marginal costing has so far ignored opening and closing inventory.
In absorption costing, the production cost of sales is calculated as ‘opening inventory value + production costs
incurred in the period – closing inventory value’.
The same principle applies in marginal costing. The variable production cost of sales is calculated as ‘opening
inventory value + variable production costs incurred in the period – closing inventory value’.
When marginal costing is used, inventory is valued at its marginal cost of production (variable production
cost), without any absorbed fixed production overheads.
If an income statement is prepared using marginal costing, the opening and closing inventory might be shown,
as follows:

AT A GLANCE
Illustration: Marginal costing income statement for the period Rs. Rs.
Sales 440,000
Opening inventory at variable production cost 5,000
Variable production costs
Direct materials 60,000
Direct labor 30,000
Variable production overheads 15,000
110,000
Less: Closing inventory at variable production cost (8,000)

SPOTLIGHT
Variable production cost of sales 102,000
Variable selling and distribution costs 18,000
Variable cost of sales 120,000
Contribution 320,000
Fixed costs:
Production fixed costs 120,000
Administration costs (usually 100% fixed costs) 70,000
Selling and distribution fixed costs 90,000

STIKCY NOTES
Total fixed costs 280,000
Profit 40,000

If the variable production cost per unit is constant (i.e. it was the same last year and this year), there is no need
to show the opening and closing inventory valuations separately, and the income statement could be presented
more simply as follows:

Illustration: Marginal costing income statement for the period Rs. Rs.
Sales 440,000
Variable production cost of sales 102,000
Variable selling and distribution costs 18,000
Variable cost of sales 120,000
Contribution 320,000

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Rs. Rs.
Fixed costs:
Production fixed costs 120,000
Administration costs (usually 100% fixed costs) 70,000
Selling and distribution fixed costs 90,000
Total fixed costs 280,000
Profit 40,000

2.3 Calculation of marginal cost profit

AT A GLANCE

The following example illustrates the calculation of marginal cost profit.

In the next section the same scenario will be used to show the difference between marginal cost profit and total
absorption profit.
 Example 02:
Mingora Manufacturing makes and sells a single product:

Rs.

Selling price per unit 150

Variable costs:
SPOTLIGHT

Direct material per unit 35

Direct labor per unit 25

Variable production overhead per unit 10

Marginal cost per unit 70

STIKCY NOTES

Budgeted fixed production overhead Rs. 110,000 per month

The following actual data relates to July and August:

July August

Fixed production costs Rs. 110,000 Rs. 110,000

Production 2,000 units 2,500 units

Sales 1,500 units 3,000 units

There was no opening inventory in July.

This means that there is no closing inventory at the end of August as production in the two
months (2,000 + 2,500 units = 4,500 units) is the same as the sales (1,500 + 3,000 units = 4,500
units)

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The profit statements for each month are shown below. Work through these carefully one month
at a time.

July August
Sales:
1,500 units  Rs. 150 225,000
3,000 units  Rs. 150 450,000

Opening inventory nil 35,000

Variable production costs

AT A GLANCE
Direct material: 2,000 units  Rs. 35 70,000
Direct labor: 2,000 units  Rs. 25 50,000
Variable overhead 2,000 units  Rs. 10 20,000

Direct material: 2,500 units  Rs. 35 87,500

Direct labor: 2,500 units  Rs. 25 62,500
Variable overhead 2,500 units  Rs. 10 25,000
Closing inventory

SPOTLIGHT
500 units @ (70) (35,000)
Zero closing inventory nil
Cost of sale (105,000) (210,000)
Contribution 120,000 240,000
Fixed production costs (expensed) (110,000) (110,000)
Profit for the period 10,000 130,000

In simple words…
To calculate profit, we have to deduct all Fixed Cost from Contribution Margin.

STIKCY NOTES

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3. REPORTING PROFIT WITH ABSORPTION COSTING

3.1 Reporting profit with absorption costing
Absorption costing is the ‘traditional’ way of measuring profit in a manufacturing company. Inventory is valued
at the full cost of production, which consists of direct materials and direct labor cost plus absorbed production
overheads (fixed and variable production overheads).
Fixed production overhead may be under- or over- absorbed because the absorption rate is a predetermined
rate. This was covered in chapter 3.
Over and under absorption is the difference between absorbed and actual overheads. If absorbed are greater
than actual overheads, it is over absorption and vice versa.
The full presentation of an absorption costing income statement might therefore be as follows (illustrative
AT A GLANCE

figures included):

Illustration: Total absorption costing income statement for the period Rs. Rs.

Sales 430,000

Opening inventory at full production cost 8,000

Production costs

Direct materials 60,000

Direct labor 30,000

SPOTLIGHT

Production overheads absorbed 100,000

198,000

Less: Closing inventory at full production cost (14,000)

Full production cost of sales (184,000)

246,000

(Under)/over absorption
STIKCY NOTES

Production overheads absorbed 100,000

Production overheads incurred (95,000)

Over-absorbed overheads 5,000

251,000

Administration, selling and distribution costs (178,000)

Profit 73,000

3.2 Calculation of total absorption costing profit

The following example uses the same base scenario as that used to illustrate marginal costing. This means you
can compare the difference between absorption and marginal costing profits.

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 Example 03:
Mingora Manufacturing makes and sells a single product

Rs.

Selling price per unit 150

Variable costs:

Direct material per unit 35

Direct labor per unit 25

AT A GLANCE
Variable production overhead per unit 10

70

Fixed overhead per unit (see below) 50

Total absorption cost per unit 120

Normal production 2,200 units per month

Budgeted fixed production overhead Rs. 110,000 per month

SPOTLIGHT
Fixed overhead absorption rate Rs. 110,000/2,200 units= Rs. 50 per unit

The following data relates to July and August:

July August

Fixed production costs Rs. 110,000 Rs. 110,000

Production 2,000 units 2,500 units

STIKCY NOTES
Sales 1,500 units 3,000 units

There was no opening inventory in July.

This means that there is no closing inventory at the end of August as production in the two
months (2,000 + 2,500 units = 4,500 units) is the same as the sales (1,500 + 3,000 units =
4,500 units)

Total absorption cost profit statement

July August
Sales:
1,500 units  Rs. 150 225,000
3,000 units  Rs. 150 450,000

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July August

Opening inventory nil 60,000

Variable production costs
Direct material: 2,000 units  Rs. 35 70,000
Direct labor: 2,000 units  Rs. 25 50,000
Variable overhead 2,000 units  Rs. 10 20,000

Direct material: 2,500 units  Rs. 35 87,500

Direct labor: 2,500 units  Rs. 25 62,500
AT A GLANCE

Variable overhead 2,500 units  Rs. 10 25,000

Fixed production costs (absorbed)

2,000 units  Rs. 50 100,000
2,500 units  Rs. 50 125,000
Closing inventory
500 units @ (70 + 50) (60,000)
Zero closing inventory nil
Cost of sale (180,000) (360,000)
SPOTLIGHT

Profit for the period before adjustment for over and under
absorption
(Under)/over absorption 45,000 90,000
Production overheads absorbed 100,000 125,000
Production overheads incurred 110,000 110,000
Over- (under)absorbed overheads (10,000) 15,000
Profit for the period after adjustment for over and under
absorption 35,000 105,000

 Example 04:
STIKCY NOTES

Silver Limited (SL) produces and markets a single product. Following budgeted information is
available from SL’s records for the month of March 20X4:

Volumes
Sales 100,000 units
Production 120,000 units
Standard costs:
Direct materials per unit 0.8 kg at Rs. 60 per kg
Labor per unit 27 minutes at Rs. 80 per hour
Variable production overheads Rs. 40 per labor hour
Variable selling expenses Rs. 15 per unit
Fixed selling expenses Rs. 800,000

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Fixed production overheads, at a normal output level of 105,000 units per month, are estimated
at Rs. 2,100,000. The estimated selling price is Rs. 180 per unit.
Assuming there are no opening stocks, preparation SL’s budgeted profit and loss statement for
the month of March 20X4 using absorption costing would be as follows:

Absorption costing: Rupees

Sales [100,000 x Rs. 180 ] 18,000,000
Less: Cost of sales:
Opening stock -
Add: Direct materials [ 0.8 x 120,000 x 60] 5,760,000

AT A GLANCE
Direct labor [27/60 x 120,000 x 80] 4,320,000
Variable overheads [ 27/60 x 120,000 x 40] 2,160,000
Fixed overheads
[ 2,100,000 / 105,000 x 120,000] 2,400,000
14,640,000
Less: Closing stock
[14,640,000 / 120,000 x 20,000] (2,440,000)
Cost of sales (12,200,000)

SPOTLIGHT
Less: Over-absorbed overheads
[ 2,100,000 / 105,000 x 15,000] (300,000)
Gross profit 6,100,000
Less: Selling expenses:
Variable [ 100,000 x 15] (1,500,000)
Fixed (800,000)
(2,300,000)
Net profit 3,800,000

STIKCY NOTES

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4. MARGINAL COSTING AND ABSORPTION COSTING COMPARED

4.1 The difference in profit between marginal costing and absorption costing
The profit for an accounting period calculated with marginal costing is different from the profit calculated with
absorption costing.
The difference in profit is entirely due to the differences in inventory valuation as fixed overheads are treated as
period cost in marginal costing and as product cost in absorption costing.
The main difference between absorption costing and marginal costing is that in absorption costing, inventory
cost includes a share of fixed production overhead costs.
 The opening inventory contains fixed production overhead that was incurred last period. Opening inventory
is written off against profit in the current period. Therefore, part of the previous period’s costs is written off
AT A GLANCE

in the current period income statement provided that the opening inventory is sold during the current year.
 The closing inventory contains fixed production overhead that was incurred in this period. Therefore, this
amount is not written off in the current period income statement but carried forward to be written off in the
next period income statement.
The implication of this is as follows (assume costs per unit remain constant):
 When there is no change in the opening or closing inventory, exactly the same profit will be reported using
marginal costing and absorption costing.
 If inventory increases in the period (closing inventory is greater than opening inventory), the fixed
production overhead brought forward from last period will be less than share of production overhead
carried forward to next period, thus the absorption costing profit would be higher than marginal costing
profit.
SPOTLIGHT

 Similarly, if inventory decreases in the period (closing inventory is less than opening inventory), marginal
costing profit would be higher than absorption costing.
The difference in the two profit figures is calculated as follows:
 Formula:
Profit difference under absorption costing (TAC = total absorption costing) and marginal
costing (MC)
Assuming cost per unit is constant across all periods under consideration.
Number of units increase or decrease  Fixed production overhead per unit
 Example 04 (Contd):
STIKCY NOTES

Profit difference July August Over the two months

Absorption costing profit 35,000 105,000 140,000
Marginal costing profit 10,000 130,000 140,000
Profit difference 25,000 (25,000) nil
This profit can be explained the different way the inventory movement is cost under each
system:
Units Units Units
Closing inventory nil nil
2,000 units made less 1,500 sold 500
Opening inventory nil 500 nil
500 (500) nil
Absorbed fixed production overhead per unit Rs. 50 Rs. 50 Rs. 50
Profit difference 25,000 (25,000) nil

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Note that the difference is entirely due to the movement in inventory value:
Profit difference – due to inventory movement

TAC inventory movement: July August Over the two months

Closing inventory 60,000 nil nil
Opening inventory nil (60,000) nil
60,000 (60,000) nil
MC inventory movement
Closing inventory 35,000 nil nil
Opening inventory nil (35,000) nil

AT A GLANCE
35,000 (35,000) nil
Profit difference 25,000 (25,000) nil

Reconciliation between absorption costing profit and marginal costing profit

July August
Marginal costing profit 10,000 130,000
July-adjust for FOH in inventory (500 units x Rs. 50) 25,000
August-adjust for FOH in inventory (500 units x Rs. 50) (25,000)
Absorption costing profit 35,000 105,000

SPOTLIGHT
4.2 Summary: comparing marginal and absorption costing profit
To calculate the difference between the reported profit using marginal costing and the reported profit using
absorption costing, you might need to make the following simple calculations.
 the increase or decrease in inventory during the period, in units.
 the fixed production overhead cost per unit.
The important points to remember are:
 The difference in profit is the increase or decrease in inventory quantity multiplied by the fixed production
overhead cost per unit.
 If there has been an increase in inventory, the absorption costing profit is higher. If there has been a

STIKCY NOTES
reduction in inventory, the absorption costing profit is lower.
 Ignore fixed selling overhead or fixed administration overhead. These are written off in full as a period cost
in both absorption costing and marginal costing, and only fixed production overheads are included in
inventory values.
 Example 05:
A company uses marginal costing. In the financial period that has just ended, opening inventory
was Rs.8,000 and closing inventory was Rs.15,000. The reported profit for the year was
Rs.96,000.
If the company had used absorption costing, opening inventory would have been Rs.15,000 and
closing inventory would have been Rs.34,000.
What would have been the profit for the year if absorption costing had been used?
In doing so, please see the following:
There was an increase in inventory. It was Rs.7,000 using marginal costing (= Rs.15,000 –
Rs.8,000). It would have been Rs.19,000 using absorption costing.

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Rs.
Increase in inventory, marginal costing 7,000
Increase in inventory, absorption costing 19,000
Difference (profit higher with absorption costing) 12,000
Profit with marginal costing 96,000
Profit with absorption costing 108,000

The profit is higher with absorption costing because there has been an increase in inventory
(production volume has been more than sales volume.)
 Example 06:
AT A GLANCE

A company uses absorption costing. In the financial period that has just ended, opening inventory
was Rs.76,000 and closing inventory was Rs.49,000. The reported profit for the year was
Rs.183,000.
If the company had used marginal costing, opening inventory would have been Rs.40,000 and
closing inventory would have been Rs.28,000.
What would have been the profit for the year if marginal costing had been used?
There was a reduction in inventory. It was Rs.27,000 using absorption costing
(= Rs.76,000 – Rs.49,000). It would have been Rs.12,000 using marginal costing.

Rs.
SPOTLIGHT

Reduction in inventory, absorption costing 27,000

Reduction in inventory, marginal costing 12,000
Difference (profit higher with marginal costing) 15,000
Profit with absorption costing 183,000
Profit with marginal costing 198,000

Profit is higher with marginal costing because there has been a reduction in inventory during
the period.
STIKCY NOTES

 Example 07:
The following information relates to a manufacturing company for a period.

Production 16,000 units Fixed production costs Rs.80,000

Sales 14,000 units Fixed selling costs Rs.28,000

Using absorption costing, the profit for this period would be Rs.60,000. Assuming there is no
opening inventory
What would have been the profit for the year if marginal costing had been used?
Ignore the fixed selling overheads. These are irrelevant since they do not affect the difference in
profit between marginal and absorption costing.
There is an increase in inventory by 2,000 units, since production volume (16,000 units) is higher
than sales volume (14,000 units).
If absorption costing is used, the fixed production overhead cost per unit is Rs.5
(=Rs.80,000/16,000 units).

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The difference between the absorption costing profit and marginal costing profit is therefore
Rs.10,000 (= 2,000 units  Rs.5).
Absorption costing profit is higher, because there has been an increase in inventory.
Marginal costing profit would therefore be Rs.60,000 – Rs.10,000 = Rs.50,000.
 Example 08:
Red Company is a manufacturing company that makes and sells a single product. The following
information relates to the company’s manufacturing operations in the next financial year.

Opening stock: Nil

Production: 18,000 units

AT A GLANCE
Sales: 15,000 units
Fixed production overheads: Rs.117,000
Fixed sales overheads: Rs.72,000

Using absorption costing, the company has calculated that the budgeted profit for the year will
be Rs.43,000.
What would be the budgeted profit if marginal costing is used, instead of absorption costing?
In completing the requirement, Production overhead per unit, with absorption costing, please
see below:
= Rs.117,000/18,000 units

SPOTLIGHT
= Rs.6.50 per unit.
The budgeted increase in inventory = 3,000 units (18,000 – 15,000).
Production overheads in the increase in inventory = 3,000 × Rs.6.50 = Rs.19,500.
With marginal costing, profit will be lower than with absorption costing, because there is an
increase in inventory levels.
Marginal costing profit = Rs.43,000 - Rs.19,500 = Rs.23,500.
 Example 09
Entity T manufactures a single product, and uses absorption costing. The following data relates
to the performance of the entity during October.

STIKCY NOTES
Profit Rs.37,000
Over-absorbed overhead Rs.24,000
Sales (48,000 units) Rs.720,000
Non-production overheads (all fixed costs) Rs.275,000
Opening inventory Rs.144,000
Closing inventory Rs.162,000

Units of inventory are valued at Rs.9 each, consisting of a variable cost (all direct costs) of Rs.3
and a fixed overhead cost of Rs.6. All overhead costs are fixed costs.
a) When required to calculate the actual production overhead cost for October and the
profit that would have been reported in October if Entity T had used marginal costing,
see below working.

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units
Opening inventory (Rs.144,000/Rs.9) 16,000
Closing inventory (Rs.162,000/Rs.9) 18,000
Increase in inventory in October 2,000
Sales 48,000
Production in October 50,000

Rs.
AT A GLANCE

Absorbed production overhead (50,000 × Rs.6) 300,000

Over-absorbed overheads 24,000
Actual production overhead expenditure 276,000

a) Since, inventory increased during October; therefore, the reported profit will be higher
with absorption costing than with marginal costing, as below

Rs.
Absorption cost profit 37,000
Increase inventory × fixed production overhead per unit
SPOTLIGHT

(2,000 × Rs.6) 12,000

Marginal costing profit 25,000

Proof:

Rs. Rs.
Sales 720,000
Variable cost of sales (48,000 × Rs.3) 144,000
Contribution 576,000
STIKCY NOTES

Fixed production overheads (see above) 276,000

Other fixed overheads 275,000

Total fixed overheads 551,000
Marginal costing profit 25,000

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5. ADVANTAGES AND DISADVANTAGES OF ABSORPTION AND MARGINAL

COSTING
The previous sections of this chapter have explained the differences between marginal costing and absorption
costing as methods of measuring profit in a period. Some conclusions can be made from these differences.
 The amount of profit reported in the cost accounts for a financial period will depend on the method of costing
used.
 Since the reported profit differs according to the method of costing used, there are presumably reasons why
one method of costing might be used in preference to the other. In other words, there must be some
advantages (and disadvantages) of using either method.

5.1 Advantages and disadvantages of absorption costing

AT A GLANCE
Absorption costing has a number of advantages and disadvantages.
Advantages of absorption costing
 Inventory values include an element of fixed production overheads. This is consistent with the requirement
in financial accounting that (for the purpose of financial reporting) inventory should include production
overhead costs.
 Calculating under/over absorption of overheads may be useful in controlling fixed overhead expenditure.
 By calculating the full cost of sale for a product and comparing it will the selling price, it should be possible
to identify which products are profitable and which are being sold at a loss.
Disadvantages of absorption costing


SPOTLIGHT
Absorption costing is a more complex costing system than marginal costing.
 Absorption costing does not provide information that is useful for decision making (like marginal costing
does).
 Assigning of Production overheads always include an element of discretion; and
 It might led to sub-optimal decision-making as a product might be discontinued due to loss which might be
caused by fixed production over head.

5.2 Advantages and disadvantages of marginal costing

Marginal costing has a number of advantages and disadvantages.
Advantages of marginal costing

STIKCY NOTES
 It is easy to account for fixed overheads using marginal costing. Instead of being apportioned they are treated
as period costs and written off in full as an expense the income statement for the period when they occur.
 There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment
necessary in the income statement at the end of an accounting period.
 Marginal costing provides useful information for decision making.
Disadvantages of marginal costing
 Marginal costing does not value inventory in accordance with the requirements of financial reporting.
(However, for the purpose of cost accounting and providing management information, there is no reason
why inventory values should include fixed production overhead, other than consistency with the financial
accounts.)
 Marginal costing can be used to measure the contribution per unit of product, or the total contribution
earned by a product, but this is not sufficient to decide whether the product is profitable enough. Total
contribution has to be big enough to cover fixed costs and make a profit.

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6. COMPREHENSIVE EXAMPLES
 Example 01:
Entity RH makes and sells one product. Currently, it uses absorption costing to measure profits
and inventory values. The budgeted production cost per unit is as follows:

Rs.
Direct labor 3 hours at Rs.6 per hour 18
Direct materials 4 kilograms at Rs.7 per kilo 28
Production overhead (Fixed cost) 20
66
AT A GLANCE

Normal output volume is 16,000 units per year and this volume is used to establish the fixed
overhead absorption rate for each year.
Costs relating to sales, distribution and administration are:
Variable 20% of sales value
Fixed Rs.180,000 per year.
There were no units of finished goods inventory at 1 October Year 5.
The fixed overhead expenditure is spread evenly throughout the year.
The selling price per unit is Rs.140.
SPOTLIGHT

For the two six-monthly periods detailed below, the number of units to be produced and sold
are budgeted as follows:

Six months ending Six months ending

31 March Year 6 30 September Year 6
Production 8,500 units 7,000 units
Sales 7,000 units 8,000 units

The entity is considering whether to abandon absorption costing and use marginal costing
instead for profit reporting and inventory valuation.
STIKCY NOTES

a) Calculation of the budgeted fixed production overhead costs each year, is as follows.
Budgeted production overhead expenditure =
Normal production volume × Absorption rate per unit
= 16,000 units × Rs.20 = Rs.320,000.
Since expenditure occurs evenly throughout the year, the budgeted production overhead
expenditure is Rs.160,000 in each six-month period.
b) Statements for management showing sales, costs and profits for each of the six-monthly
periods using marginal and absorption costing would be prepared as follows
i. marginal costing
ii. absorption costing

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Workings Rs. per unit

Direct material 18
Direct labor 28
Marginal cost of sale 46

i. Marginal costing

Six months to Six months to 30

31 March September
Units sold 7,000 8,000

AT A GLANCE
Rs. Rs. Rs. Rs.
Sales at Rs.140 980,000 1,120,000
Marginal cost of sales (at Rs.46) 322,000 368,000
658,000 752,000
Variable admin & distribution
(20% of sales value) 196,000 224,000
Contribution 462,000 528,000
Fixed costs
Production (Rs.320,000/2) 160,000 160,000

SPOTLIGHT
Other (Rs.180,000/2) 90,000 250,000 90,000 250,000
Profit 212,000 278,000

ii. Absorption costing

The fixed overhead absorption rate is based on the normal volume of production. Since
budgeted output in each six-month period is different from the normal volume, there
will be some under- or over-absorption of production overhead in each six-month
period.

Six months to Six months to 30

STIKCY NOTES
31 March September
Units sold 7,000 8,000
Rs. Rs. Rs. Rs.
Sales at Rs.140 980,000
Production cost of sales (at Rs.66) 462,000 528,000
518,000 592,000
Production overhead absorbed 170,000 140,000
(8,500 × Rs.20: 7,000 × Rs.20)
Actual production overhead 160,000 160,000
Over-/(under-) absorbed
10,000 (20,000)
overheads
528,000 572,000

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Six months to Six months to 30

31 March September
Sales, distribution, admin costs
Variable 196,000 224,000
(7,000 × Rs.28: 8,000 × Rs.28)
Other 90,000 90,000
286,000 314,000
Profit 242,000 258,000

c) An explanatory statement reconciling for each six-monthly period the profit using
marginal costing with the profit using absorption costing, is prepared below.
AT A GLANCE

Reconciliation of profit figures

Six months to 31 March Year 6
Increase in inventory (8,500 – 7,000 units) 1,500 units
Production overhead absorbed in these
Rs.20 per unit
units (absorption costing)
Therefore absorption costing profit
Rs.30,000
higher by
Six months to 30 SeptemberYear 6
Reduction in inventory (7,000 – 8,000 units) 1,000 units
SPOTLIGHT

Production overhead absorbed in these

Rs.20 per unit
units (absorption costing)
Therefore absorption costing profit
Rs.20,000
lower by
The difference in reported profits is due entirely to differences in the valuation of
inventory (and so differences in the increase or reduction in inventory during each
period).
 Example 02:
Zulfiqar Limited makes and sells a single product and has the total production capacity of 30,000
units per month. The company budgeted the following information for the month of January
STIKCY NOTES

20X4:
Normal capacity (units) 27,000
Variable costs per unit:
Production (Rs.) 110
Selling and administration (Rs.) 25
Fixed overheads:
Production (Rs.) 756,000
Selling and administration (Rs.) 504,000

The actual operating data for January 20X4 is as follows:

Production 24,000 units

Sales @ Rs. 250 per unit 22,000 units
Opening stock of finished goods 2,000 units

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During the month of January 20X4, the variable factory overheads exceeded the budget by Rs.
120,000.
a) Preparation of profit statement for the month of January using marginal and
absorption costing would be as follows

Profitability Statement under Marginal Costing Rupees

Sales (22,000 units @ Rs. 250) 5,500,000
Variable Costs:
Production Costs:
Cost of productions (24,000 x Rs.110) 2,640,000
Additional Variable Costs. 120,000

AT A GLANCE
2,760,000
Less: Closing stocks (2,760,000 / 24,000 x 4,000) (460,000)
Add: Opening stocks (2,000 x Rs. 110) 220,000
2,520,000
Selling and administrative expenses (22,000 x 25) 550,000
3,070,000
Contribution Margin 2,430,000
Less: Fixed costs
Production 756,000

SPOTLIGHT
Selling and administrative expense 504,000
1,260,000
Net Profit 1,170,000

Profitability Statement under Absorption Costing Rupees

Sales (22,000 units @ Rs. 250) 5,500,000
Cost of Goods Sold
Cost of production (24,000 x Rs. 138 (W-1) 3,312,000
Additional variable costs. 120,000

STIKCY NOTES
3,432,000
Less: Closing stocks (3,432,000 / 24,000 x 4,000) (572,000)
Add: Opening stocks (2,000 x Rs. 138) 276,000
3,136,000
Under applied factory overhead
84,000
(3,000 (W-2) x Rs.28 (W-1))
3,220,000
Gross Profit 2,280,000
Selling expenses
(Rs. 504,000 + 22,000 x Rs.25) 1,054,000
1,226,000

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W-1: Rupees
Variable overhead per unit 110
Fixed overhead per unit (Rs. 756,000 / 27,000) 28
138

W-2: Units
Budgeted production - Normal capacity 27,000
Actual production 24,000
Under-utilized capacity 3,000
AT A GLANCE

b) Then, if required to reconcile the difference in profits under the two methods, please
see below

Rupees
Profit under absorption costing 1,226,000
Less: Closing stock (under-valued in marginal costing)
(Rs. 572,000 - Rs. 460,000) (112,000)
Add: Opening stock (under-valued in marginal costing)
(Rs. 276,000 - Rs. 220,000) 56,000
SPOTLIGHT

Profit under marginal costing 1,170,000

 Example 03:
Following information has been extracted from the financial records of ATF Limited: Production
during the year units 35,000

Finished goods at the beginning of the year units 3,000

Finished goods at the end of the year units 1,500
Sale price per unit Rs. 200
STIKCY NOTES

Fixed overhead cost for the year Rs. 1,000,000

Administration and selling expenses Rs. 200,000
Annual budgeted capacity of the plant units 40,000

The actual cost per unit, incurred during the year, was as follows:

Rupees
Material 70
Labor 40
Variable overheads 30

Company uses FIFO method for valuation of inventory. The cost of opening finished goods
inventory determined under the absorption costing method system was Rs. 450,000. Fixed
overhead constituted 16% of the total cost last year.

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a) Preparation of profit statements for the year, under absorption and marginal costing
systems, would be as follows

Absorption Marginal
Costing Costing
(Rs.) (Rs.)
Sales (3,000 + 35,000-1,500) × Rs. 200 7,300,000 7,300,000
Cost of goods manufactured
Opening Inventory 450,000 378,000*
Add: Cost of goods manufactured
5,775,000 4,900,000
(35,000 × 165) & (35,000 / 140)

AT A GLANCE
6,225,000 5,278,000
Less: Ending inventory
(247,500) (210,000)
(1,500 x 165) & (1,500 × 140)
(5,997,500) 5,068,000
Gross profit / contribution margin 1,322,500 2,232,000
Less: unabsorbed overheads
(125,000) -
[1,000,000 – (Rs. 25 × 35,000)]
Less: Administration and selling expenses (200,000) (200,000)
Fixed overheads - (1,000,000)

SPOTLIGHT
Net Profit 997,500 1,032,000

*Cost of opening finished goods under marginal costing Rs. 450,000 × (100%-16%) = Rs.
378,000
Computation of Cost of goods manufactured (COGM) & Ending Inventory:

Rupees
Material Cost 70
Labor Cost 40

STIKCY NOTES
Variable overhead 30
Cost per unit under marginal costing system 140
Fixed overhead (Rs. 1,000,000/40,000) 25
Cost per unit under absorption costing system 165

b) Then, if required to reconcile net profits determined under each system, following
computations would be required.

Rupees
Net Profit under Absorption Costing 997,500
Add: Difference in opening finished goods (Rs. 450,000 – 378,000) 72,000
Less: Difference in ending finished goods (Rs. 247,500 – 210,000) (37,500)
Net Profit under Marginal Costing 1,032,000

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STICKY NOTES

In marginal costing, cost of product is variable production cost only but in

absorption costing the cost of the product is variable plus fixed production cost

In marginal costing there is a concept of contribution margin i.e.

Contribution Margin = Sales – all variable cost (both production and non-
production)
AT A GLANCE

To arrive at profit all Fixed cost (both production and non-production) should
be deduced from contribution margin.

In Absorption costing the cost of the product includes variable production cost
plus fixed production overheads estimated by using predetermined absorption
rate

In absorption costing over / under absorbed overheads are calculated by

SPOTLIGHT

comparing absorbed overheads with actual overheads.

In marginal costing the stock is valued at variable production cost only but in
absorption costing it is valued at variable plus fixed production cost. This is the
reason that the profit figure is different in marginal and absorption costing.
STIKCY NOTES

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 CHAPTER 6

COST FLOW IN PRODUCTION

AT A GLANCE
IN THIS CHAPTER
Accounting is a systematic process of identifying, recording,
AT A GLANCE measuring, classifying, verifying, summarizing, interpreting
and communicating financial information

AT A GLANCE
SPOTLIGHT Cost accounting is primarily about costing of the product and
Management accounting is all about Planning, Control and
1. Accounting for Inventory Decision Making.

2. Cost bookkeeping Systems Accounting for the production of inventory mirrors the cost
flow from Raw Material accounts, wages control account,
3. Comprehensive Examples Production overhead control account to WIP account and then
to finished goods and P&L account.
STICKY NOTES Integrated accounts combine both financial and cost accounts
in one system of ledger accounts. Interlocking systems contain
separate cost accounting and financial accounting ledgers.

SPOTLIGHT
STIKCY NOTES

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1. ACCOUNTING FOR INVENTORY

There are two main methods of recording inventory.
 Periodic inventory method (period end system)
 Perpetual inventory system
Each method uses a ledger account for inventory but these have different roles.

Periodic inventory method

Opening inventory in the trial balance (a debit balance) and purchases (a debit balance) are both transferred to
cost of sales thus clearing both accounts.
Closing inventory is recognized in the inventory account as an asset (a debit balance) and the other side of the
AT A GLANCE

entry is a credit to cost of sales. Cost of sales comprises purchase in the period adjusted for movements in
inventory level from the start to the end of the period.

Perpetual inventory method

A single account is used to record all inventory movements. The inventory account is used to show the current
cost of inventory in hand. In this type of accounting, a separate account for purchases is not maintained as part
of double entry records. The account is also used to record all issues out of inventory. These issues constitute the
cost of sales.
When the perpetual inventory method is used, a record is kept of all receipts of items into inventory (at cost) and
all issues of inventory to cost of sales.
Each issue of inventory is assigned a cost, and the cost of the items issued is either the actual cost of the inventory
SPOTLIGHT

(if it is practicable to establish the actual cost i.e. the inventory is individually identifiable) or a cost obtained
using a valuation method.
Each receipt and issue of inventory is recorded in the inventory account. This means that a purchases account
becomes unnecessary, because all purchases are recorded in the inventory account. Though a separate detail of
purchases may be maintained for vendor documentation purposes.
All transactions involving the receipt or issue of inventory must be recorded, and at any time, the balance on the
inventory account should be the value of inventory currently held. Though there is no need for inventory count
but one at the end of each period is conducted to maintain control over the integrity of records.

1.1 Accounting for the production of inventory

STIKCY NOTES

Costing systems
The above methods of accounting for inventory were previously explained for a company that buys and sells
goods. This chapter explains how to account for goods that are manufactured instead of purchased.
As a simple starting point:
 For a retail company, the cost of goods sold is simply the purchase price of the goods.
 For a manufacturing company, the cost of goods sold is the total production cost including direct materials,
direct labor and production overheads. The accounting systems must identify these costs and then transfer
them into finished goods (usually via work-in-progress) and thus into cost of sales.

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 Illustration: Cost flow

AT A GLANCE
This diagram implies that cost accounting can be studied as a series of steps:
Step No. Stage of inventory Accounting treatment
1. The inventory is purchased Recognize costs in appropriate cost accounts
2. The inventory is issued to the Transfer costs from the cost accounts into
production process work-in- progress
3. Finished products are Transfer costs from work-in-progress into
obtained at the end of finished goods

SPOTLIGHT
manufacturing process
4. Finished goods are sold Transfer costs from the finished goods account
into the statement of profit or loss (income
statement) to become part of cost of sales

1.2 Possible complications

Complex production processes

The above steps provide an overview to help you understand the accounting process. There might be variations
from this in practice. For example, a complex production process might involve several different processes and
this might be reflected in the transfer of costs along a chain of WIP accounts before a final transfer into finished

STIKCY NOTES
goods.

Outsource Production:
Most industries rely on outsourcing all or part of their production process. In many industries certain processes
are outsourced e.g. in textile companies, the process of spinning may be done in-house then the thread be given
to an outsourced vendor for knitting and then the knitted cloth be brought back after paying manufacturing
charges to the outsourced party to make finished products.

Wages control account

A system will probably contain a wages control account. This will be used to recognize the total wages cost. Some
of these might relate to indirect labor or non-production activities.
 Any amounts relating to indirect labor must be transferred to a production overhead account.
 Any amounts relating to non-production labor (e.g. sales or administration) should be transferred into one
or more non-production overhead accounts
 The direct labor related to production is transferred to WIP

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 Illustration: Cost flows showing reclassification of non-production wages

AT A GLANCE

Over (under) absorption of fixed production overhead

The fixed production overheads account is debited with the actual fixed production overhead incurred in the
period. Fixed production overheads are transferred into WIP using a pre-determined absorption rate. The
difference between the absorbed overhead and the actual overhead is over (under) absorption. This must be
SPOTLIGHT

adjusted in the statement of profit or loss.

 Illustration:
STIKCY NOTES

 Example 01
A company manufactures and sells a range of products in a single factory. Its budgeted
production overheads for Year 6 were Rs.150,000, and budgeted direct labor hours were 50,000
hours.
Actual results in Year 6 were as follows:

Rs.
Direct materials costs 130,000
Direct labor costs 160,000
Fixed production overhead 140,000 (40,000 hours)

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There was no opening or closing inventory at the beginning or end of Year 6.

The company uses an absorption costing system, and production overhead is absorbed using a
direct labor hour rate.
The information would be accounted for as follows.

Recognition of costs
Debit Credit
Direct materials 130,000
Direct labor 160,000
Fixed production overhead 140,000

AT A GLANCE
Cash/payables 430,000

Transfer of costs into work-in-progress

Debit Credit
WIP 130,000
Direct materials 130,000
WIP 160,000
Direct labor 160,000
WIP (see working below) 120,000

SPOTLIGHT
Fixed production overhead 120,000

Working
The predetermined absorption rate is Rs.150,000/50,000 hours = Rs.3 per direct labor hour.
Therefore, the amount transferred = Rs. 120,000 (40,000 hrs  Rs. 3)
Transfer of costs from work-in-progress into finished goods

Debit Credit
Finished goods 410,000
WIP 410,000

STIKCY NOTES
Accounting for under-absorption of fixed production overhead

Debit Credit
Statement of profit or loss (see working below) 20,000
Fixed production overhead 20,000

Working: Under absorption

Rs.

Overhead absorbed (40,000 hours @ RS. 3 per hour) 120,000

Overhead incurred (actual cost) (140,000)

Under absorption (20,000)

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This can be represented (in part) by the following diagram (figures in Rs. 000)
AT A GLANCE

1.3 Accounting entries in the cost accounting system

The following suite of journals describes the typical accounting entries that might be posted within a cost
accounting system that uses perpetual inventory system.
SPOTLIGHT

Journals to recognize expenses as incurred

Illustration: Costing journals – recognition of expenses as incurred

Debit Credit
Purchase of raw materials
Inventory (raw materials) X
Payables (or cash) X
Payment of wages
Wages control a/c X
STIKCY NOTES

Cash X
Recognition of production overhead
Overhead control a/c X
Cash X
Record production depreciation within overheads
Overhead control a/c X
Accumulated depreciation (assets used in production) X
Record non-production overheads
Non-production overhead control a/c X
Payables (or cash) X

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Journals to adjust for possible complications

Illustration: Costing journals – Reclassifying production expense into overheads

Debit Credit

Reclassification of indirect labor into overheads

Overhead control a/c X

Wages control a/c X

Issue of indirect materials

Overhead control a/c X

AT A GLANCE
Inventory (raw materials) X

Journals to recognize use of resources in production

Illustration: Costing journals – Transfer of costs into WIP as production proceeds

Debit Credit
Issue of direct materials to WIP
Inventory (WIP) X
Inventory (raw materials) X

SPOTLIGHT
Use of direct labor in production
Inventory (WIP) X
Wages control account X
Absorption of overheads into production
Inventory (WIP) X
Overhead control a/c X

Journal to recognize completion of production

Illustration: Costing journals – Transfer of costs from WIP into finished goods

STIKCY NOTES
Debit Credit
Transfer of costs on completion of production
Inventory (finished goods) X
Inventory (WIP) X

Journal to recognize transfer of costs to statement of profit or loss when the goods are sold

Illustration: Costing journals – Transfer of costs into statement of profit or loss

Debit Credit
Recognition of cost of sales in P&L control account
P&L control a/c X
Inventory (finished goods) X

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Recognition of under-absorption of fixed production overhead

P&L control a/c X
Overhead control a/c X
Recognition of over-absorption of fixed production overhead
Overhead control a/c X
P&L control a/c X
Recognition of overheads in P&L control account
P&L control a/c X
Overhead control a/c X
AT A GLANCE

1.4 Recognizing sales and the calculation of profit

So far this chapter has explained the flow of cost information. Goods are made to be sold. Any accounting system
must be able to record sales and allow for the calculation of profit (or loss).
The accounting system would allow for the following journals.

Illustration: Journals to recognized revenue and allow the calculation of profit (or loss)
Debit Credit
Recognition of sales
SPOTLIGHT

Receivables (or cash) X

Sales X
Recognition of sales in P&L control account
Sales X
P&L control a/c X
Transfer from P&L control account to reserves
Profit:
P&L control a/c X
STIKCY NOTES

Retained earnings X
or loss:
Retained earnings X
P&L control a/c X

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2. COST BOOKKEEPING SYSTEMS

Cost book-keeping systems can be categorized into two types in terms of how the cost accounts relate to other
ledger accounts. These two systems are called:

 integrated accounts;

 interlocking accounts.

Interlocking accounts involve using separate ledgers for costing and for financial reporting purposes. Each of
these ledgers includes an account (or accounts) to reflect the relationship with the other ledger (thus they are
said to interlock). Interlocking systems can vary in the range of transactions reflected in the cost ledger.

 In some systems the cost ledger includes only costing information.

AT A GLANCE
 In other systems the cost ledger recognizes sales and the subsequent calculation of profit. For ease of
description we will describe this system as being fully interlocking.

Each of these systems will be explained and illustrated with an example.

2.1 Integrated accounts

Integrated accounts can be defined as

 A single set of accounting records that provide financial and cost accounts using a common input of data.

 A system where all information (both financial and costing) is kept in a single set of books.

SPOTLIGHT
As the name suggests, the cost accounts are integrated into the entity’s bookkeeping system. There is a single
general ledger which includes the cost accounts.

Double entry is simply the normal double entry associated with maintaining a set of accounts including the
entries described above.

In practice most companies and ERP solutions available in the market use integrated accounting system.

Advantages of integrated accounts

 Avoids duplication of effort between cost and financial accounting systems.

 Removes the need to reconcile two different systems.

STIKCY NOTES
 A single consistent profit figure is available.

Disadvantages of integrated accounts

 Using a single system for external reporting and the provision of management information reduces
flexibility. For example, inventory must be valued at full absorption cost for external reporting purposes (in
accordance with IAS 2: Inventories) but management might require marginal cost information for decision
making.

 Illustration:

This diagram shows the various ledger accounts and accounting entries used within integrated
accounts.

Chart of accounting flow in an integrated accounts system

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AT A GLANCE

The direct materials account above might be named differently, for example, raw materials a/c,
inventory (raw materials) a/c, stores etc. Similarly, the WIP account might be described as
inventory (WIP) a/c and the finished goods account as inventory (finished goods) a/c.
The above diagram does not show it but there may well be a need for an entry to account for Over
(under) absorption of fixed production overhead as explained earlier in this chapter (section
1.5).
Profit or loss is calculated in the usual way as the balance on the P&L account. The balance would be transferred
SPOTLIGHT

to the accumulated profit account (retained earnings account).

2.2 Integrated accounts: Comprehensive illustration

The following illustration applies the accounting entries to ledger accounts for a comprehensive example.
The following balances and transactions relate to a manufacturing company.

Opening inventories raw materials 10,000kg Rs.25,000

work in progress nil
finished goods 1,000 units Rs.100,000
STIKCY NOTES

Materials purchases 28,000 kg Rs.77,000

issues to production 30,000kg FIFO
Labor paid 16,000 hours Rs.96,000
production 15,000 hours
Production overhead Rs.250,000
Standard overhead rate per hour Rs.20
Completed production 4,000 units
Closing inventories raw materials see above
work in progress nil
finished goods 500 units FIFO
Sales revenue see above Rs. 540,000

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The balances and transactions would be recorded in the general ledger, as below.
Recognition of expenses as incurred

Purchase of raw materials Debit Credit

Inventory (raw materials) 77,000
Payables 77,000
Payment of wages
Wages control a/c 96,000
Cash 96,000
Overhead incurred

AT A GLANCE
Overhead control a/c 250,000
Cash 250,000

Reclassification of wages expense into overhead

Debit Credit
Overhead control a/c 6,000
Wages control a/c 6,000

Working

SPOTLIGHT
Number of hours: 16,000  15,000 1,000
Hourly rate: Rs. 96,000/16,000 hours Rs.6
Transfer (Rs.) 6,000

Transfer of expenses into WIP as production proceeds

Raw materials used Debit Credit

Inventory (WIP) 80,000
Inventory (raw materials) 80,000

STIKCY NOTES
Working: FIFO Rs.
First 10,000 kgs (opening inventory) 25,000
Next 20,000 kgs (from purchases 55,000
(20,000 kgs/28,000 kgs)  Rs.77,000
Transfer (Rs.) 80,000

Use of direct labor Debit Credit

Inventory (WIP) 90,000
Wages control a/c (96,000  6,000) 90,000

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Overhead absorbed
Inventory (WIP) 300,000
Overhead control a/c 300,000

Working Rs.
15,000 hours @ Rs. 20 per hour (given) Rs. 300,000

Transfer of costs from WIP into finished goods Debit Credit

Inventory (finished goods) 470,000
AT A GLANCE

Inventory (WIP) 470,000

Working: Balance in WIP before transfer Rs.

Opening WIP 
Raw materials 80,000
Direct labor 90,000
Overhead absorbed 300,000
470,000
Less: Closing WIP 
SPOTLIGHT

470,000

Note:

Cost per unit = Rs. 470,000 /4,000 units Rs. 117.5

Transfer of costs to costing P&L a/c

Transfer of finished goods to cost of sales Debit Credit

STIKCY NOTES

P&L control account 511,250

Inventory (finished goods) 511,250

Working Units Rs.

Opening inventory of finished goods 1,000 100,000
Production 4,000 470,000
5,000 570,000
Closing inventory of finished goods (@ Rs. 117.5) (500) (58,750)
4,500 511,250
Over-absorption of overhead
Overhead control a/c 44,000
P&L control a/c 44,000

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Working: Rs.
Overhead incurred 250,000
Transfer from wages control a/c 6,000
256,000
Overhead absorbed 300,000
Over absorption 44,000

Recognition of sales and calculation of profit

Recognition of sales Debit Credit

Receivables 540,000

AT A GLANCE
Sales 540,000
Sales 540,000
P&L control a/c 540,000

Recognition of sales Debit Credit

Transfer of profit to accumulated profit
P&L control a/c 72,750
Accumulated profit 72,750

SPOTLIGHT
Working: Profit for the period Rs.
Sales 540,000
Cost of sales
Opening inventory
Raw materials 25,000
Finished goods 100,000
125,000

STIKCY NOTES
Production costs
Raw materials 77,000
Wages 96,000
Overheads 250,000
423,000
Closing inventory
Raw materials 22,000
Finished goods 58,750
(80,750)
(467,250)
Profit 72,750

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The general ledger T accounts after the double entries are as follows:
Raw materials
Rs. ‘000 Rs. ‘000
B/f 25,000
Payables (not shown) 77,000 To WIP 80,000
C/f 22,000
102,000 102,000

Wages control
AT A GLANCE

Rs. ‘000 Rs. ‘000

Cash (not shown) 96,000 Overhead control 6,000
To WIP 90,000
96,000 96,000

Overhead control
Rs. ‘000 Rs. ‘000
Cash (not shown) 250,000 To WIP 300,000
Wages control 6,000
SPOTLIGHT

P&L control a/c (over abs.) 44,000

300,000 300,000

Work in progress (WIP)

Rs. ‘000 Rs. ‘000
Raw materials 80,000 Finished goods 470,000
Wages control 90,000
Overhead control 300,000
470,000 470,000
STIKCY NOTES

Finished goods
Rs. ‘000 Rs. ‘000
B/f 100,000 P&L control a/c 511,250
WIP 470,000 C/f 58,750
570,000 570,000

Sales
Rs. ‘000 Rs. ‘000
P&L control a/c 540,000
Receivables (not shown) 540,000
540,000 540,000

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P&L control a/c

Rs. ‘000 Rs. ‘000
Sales 540,000
Finished goods 511,250 Over absorption 44,000
Profit for the period 72,750
588,000 588,000

2.3 Interlocking accounts

Interlocking accounts can be defined as
 A system in which the books are divided into two ledgers.

AT A GLANCE
 Cost accounts are maintained in a cost ledger (also known as the factory ledger) and the other accounts are
maintained in the general ledger.
There are separate records but these are kept in agreement or are readily reconcilable.
It is convenient to think of a business split into two entities (but remember that this is not necessarily the case):
 The head office maintains the general ledger which is used to generate external reports; and
 A factory maintains the cost ledger (or factory ledger) which is used to record manufacturing.
Each ledger contains an account which reflects each entity’s relationship with the other entity. Thus:
 The general ledger contains a Factory Ledger Control Account (FLC a/c). This is a receivable and shows
the assets that the head office owns that are held by the factory.

SPOTLIGHT
 The factory ledger contains a General Ledger Control Account (GLC a/c). This is a payable that shows the
assets that the factory is holding on behalf of the head office. At each period end this would be the sum of
raw materials, WIP and finished goods not yet sold.
The balances on these accounts are a mirror image of each other and should agree.
Raw materials are purchased by the head office for the factory. Similarly, the head office pays wages for the
production staff and pays the factory overheads. The general ledger reflects this with the following double
entries.

Illustration: Expenses incurred by the head office for the factory

General ledger Debit Credit

STIKCY NOTES
Purchase of direct materials
Factory ledger control a/c X
Payables X
Payment for direct labor
Factory ledger control a/c X
Cash X
Production overhead incurred
Factory ledger control a/c X
Cash/payables X

The result of the above is that the factory ledger control account in the general ledger shows that the factory
“owes” these amounts to the head office. They are amounts the head office has invested in the factory.

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The amounts are entered in the factory ledger as follows.

Illustration: Expenses incurred by the head office for the factory

Factory ledger Debit Credit
Purchase of direct materials
Inventory (raw materials) X
General ledger control a/c X
Payment for direct labor
Direct labor X
General ledger control a/c X
AT A GLANCE

Production overhead incurred

Production overheads X
General ledger control a/c X

In the factory ledger, costs are transferred from the cost accounts into WIP and hence on to finished goods as
previously described. The finished goods are the output the head office receives from the factory for onwards
sale. The following entries are then made to reflect the completion and transfer of production. The goods may
not be physically moved from factory to head office but become available for sale.

Illustration: Completion of production Debit Credit

SPOTLIGHT

Completion of production: Factory ledger

General ledger control a/c X
Inventory (finished goods) X
Completion of production: Financial ledger
Inventory (finished goods) X
Factory ledger control a/c X

 Illustration:
The following diagram provides an overview of the various ledger accounts and the flow of
STIKCY NOTES

information represented by the accounting entries used within interlocking accounts.

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General ledger control account

AT A GLANCE
FLC a/c = Factory ledger control account

2.4 Interlocking accounts: Comprehensive illustration

The following illustration applies the accounting entries to ledger accounts for a comprehensive example.
The following balances and transactions relate to a manufacturing company.

Opening inventories raw materials 10,000kg Rs.25,000

(held by factory) work in progress nil
finished goods 1,000 units Rs.100,000

SPOTLIGHT
Rs.125,000
Materials purchases 28,000 kg Rs.77,000
issues to production 30,000kg FIFO

Labor paid 16,000 hours Rs.96,000

production 15,000 hours

Production overhead Rs.250,000

Standard overhead rate per hour Rs.20

STIKCY NOTES
Completed production 4,000 units

Closing inventories raw materials see above

work in progress nil
finished goods 500 units FIFO

Opening balance on general ledger control account in factory ledger (and factory ledger
control account in general ledger). Rs. 125,000
(Note that this represents the inventory held by the factory)
Sales revenue see above Rs.540,000

The following pages will show how the balances and transactions would be recorded in the cost ledger and the
financial ledger.

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Factory ledger
Recognition of expenses as incurred

Purchase of raw materials Debit Credit

Inventory (raw materials) 77,000
General ledger control a/c 77,000
Payment of wages
Wages control a/c 90,000
General ledger control a/c 90,000
Overhead incurred
AT A GLANCE

Overhead control a/c 250,000

General ledger control a/c 250,000

Transfer of expenses into WIP as production proceeds

Raw materials used Debit Credit

Inventory (WIP) 80,000
Inventory (raw materials) 80,000

Working: FIFO Rs.

SPOTLIGHT

First 10,000 kgs (opening inventory) 25,000

Next 20,000 kgs (from purchases 55,000
(20,000 kgs/28,000 kgs)  Rs.77,000
Transfer (Rs.) 80,000

Use of direct labor Debit Credit

Inventory (WIP) 90,000
Wages control a/c 90,000
STIKCY NOTES

Overhead absorbed
Inventory (WIP) 300,000
Overhead control a/c 300,000

Working
15,000 hours @ Rs. 20 per hour (given) Rs. 300,000

Transfer of costs from WIP into finished goods

Debit Credit
Inventory (finished goods) 470,000
Inventory (WIP) 470,000

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Working: Balance in WIP before transfer Rs.

Opening WIP 
Raw materials 80,000
Direct labor 90,000
Overhead absorbed 300,000
470,000
Less: Closing WIP 
470,000

AT A GLANCE
Note:

Cost per unit = Rs. 470,000 /4,000 units Rs. 117.5

Transfer of costs in respect of finished goods

Over-absorption of overhead Debit Credit

Overhead control a/c 50,000

Inventory (finished goods) 50,000

SPOTLIGHT
Working: Rs.

Overhead incurred 250,000

Overhead absorbed 300,000

Over absorption 50,000

Transfer of finished goods to cost of sales Debit Credit

General ledger control a/c 461,250

STIKCY NOTES
Inventory (finished goods) 461,250

Working Units Rs.

Opening inventory of finished goods 1,000 100,000

Production 4,000 470,000

5,000 570,000

Closing inventory of finished goods (@ Rs. 117.5) (500) (58,750)

4,500 511,250

(50,000)

461,250

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The Factory Ledger T accounts after the double entries are as follows:

Raw materials

Rs. ‘000 Rs. ‘000

B/f 25,000
GLC a/c 77,000 To WIP 80,000
C/f 22,000

102,000 102,000
AT A GLANCE

Wages control

Rs. ‘000 Rs. ‘000

GLC a/c 90,000 To WIP 90,000

96,000 96,000

Overhead control

Rs. ‘000 Rs. ‘000

SPOTLIGHT

GLC a/c 250,000 To WIP 300,000

Finished goods 50,000

300,000 300,000

Work in progress (WIP)

Rs. ‘000 Rs. ‘000

Raw materials 80,000 Finished goods 470,000
STIKCY NOTES

Wages control 90,000

Overhead control 300,000

470,000 470,000

Finished goods

Rs. ‘000 Rs. ‘000

B/f 100,000 GLC a/c 461,250
Over absorption 50,000
WIP 470,000 C/f 58,750

570,000 570,000

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General Ledger Control Account (GLC a/c)

Rs. ‘000 Rs. ‘000
B/f 125,000
Raw materials 77,000
Finished goods 461,250 Direct labor 90,000
C/f 80,750 Overheads 250,000
542,000 542,000

General ledger

Recognition of expenses as incurred Debit Credit

AT A GLANCE
Purchase of raw materials
Factory ledger control a/c 77,000
Payables 77,000
Payment of wages
Factory ledger control a/c 90,000
Non-production wages 6,000
Cash 96,000
Overhead incurred
Factory ledger control a/c 250,000

SPOTLIGHT
Cash 250,000
Inventory (finished goods) 461,250
Factory ledger control a/c 461,250

Recognition of sales Debit Credit

Receivables 540,000
Sales 540,000
Sales 540,000
P&L control a/c 540,000

STIKCY NOTES
P&L control a/c (cost of sales) 461,250
Inventory (finished goods) 461,250
P&L control a/c (cost of sales) 6,000
Non-production wages 6,000
Transfer of profit to accumulated profit
P&L control a/c 72,750
Accumulated profit 72,750
Working: Profit for the period Rs.
Sales 540,000
Cost of sales (461,250)
Non-production wages (6,000)
Profit 72,750

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The general ledger T accounts after the double entries are as follows:

Payables
Rs. ‘000 Rs. ‘000
C/f 77,000 FLC a/c 77,000
77,000 77,000

Cash
Rs. ‘000 Rs. ‘000
b/f X FLC a/c 90,000
AT A GLANCE

Non-production wages (not shown) 6,000

FLC a/c 250,000
c/f X
X X

Inventory (finished goods)

Rs. ‘000 Rs. ‘000
FLC a/c 461,250 P&L control a/c 461,250
461,250 461,250
SPOTLIGHT

Sales
Rs. ‘000 Rs. ‘000
P&L control a/c 540,000 Receivables (not shown) 540,000
540,000 540,000

Profit & Loss Control Account

Rs. ‘000 Rs. ‘000
Finished goods 461,250 Sales 540,000
STIKCY NOTES

Non-production wages 6,000

Profit for the year 72,750
540,000 540,000

Factory Ledger Control Account (FLC a/c)

Rs. ‘000 Rs. ‘000
B/f 125,000
Raw materials 77,000
Direct labor 90,000 Finished goods 461,250
Overheads 250,000 C/f 80,750
542,000 542,000

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Points to note
The opening balance in the General Ledger Control Account in the factory ledger is a payable of Rs. 125,000.
This is balanced by the sum of the inventory of raw materials (Rs. 25,000) and finished goods (Rs. 100,000)
brought forward at the start of the period.
The opening balance in the Factory Ledger Control Account in the general ledger is a receivable of Rs. 125,000.
The closing balance in the General Ledger Control Account in the factory ledger is a payable of Rs. 80,750. This
is balanced by the sum of the inventory of raw materials (Rs. 22,000) and finished goods (Rs. 58,750) carried
forward at the end of the period.
The opening balance in the Factory Ledger Control Account in the general ledger is a receivable of Rs. 80,750.
The profit for the year (Rs. 72,750) is not affected by the costing system. This figure is the same as that in the
earlier example on integrated accounts.

AT A GLANCE
2.5 Fully interlocking accounts
This version of interlocking accounts involves the recognition of sales and the calculation of profit in the cost
ledger as well as in the general ledger.
Many double entries need to be made in both records though some transactions do not affect the cost ledger. For
example:
 receipts from customers,
 payments to suppliers;
 interest received and paid;
 dividend payments;

SPOTLIGHT
 share issues.

Cost ledger
Double entry in the cost system is maintained through a “Cost ledger control account (CLCA)”. The balance on
this account is akin to the capital account in the general ledger. Typically, at a period end it balances out to the
sum of the cost account inventories (raw materials + WIP + finished goods). These figures should agree with
those found in the general ledger but profit and inventory figures in cost and financial accounts might need to be
reconciled due to timing differences.
The CLCA is close to be being a mirror image of the P&L control account in the main ledger with the vast majority
of entries being the same but on the different side to each other.

STIKCY NOTES
Advantages of interlocking accounts
 Allows greater flexibility

Disadvantages of interlocking accounts

 Duplication of effort as entries need processing in both sets of ledgers
 Different profit figures may emerge
 Inventory valuations will be different between the two systems
 Reconciliation may be necessary (which takes time and effort)

Cost ledger control account (CLC)

This account is used for ‘the other side’ of cost accounting double entries within interlocking accounts to replace
accounts that are not included (as being of no interest for costing purposes). This account is sometimes called
‘the dustbin account’.

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Examples of such accounts include:

 Cash
 Bank
 Trade receivables
 Trade payables
 Illustration:
The following diagram provides an overview of the various ledger accounts and the flow of
information represented by the accounting entries used within fully interlocking accounts.
AT A GLANCE
SPOTLIGHT
STIKCY NOTES

2.6 Fully interlocking accounts: Comprehensive illustration

The following illustration applies the accounting entries to ledger accounts for a comprehensive example.
The following balances and transactions relate to a manufacturing company.

Opening inventories raw materials 10,000kg Rs.25,000

work in progress nil

finished goods 1,000 units Rs.100,000

132 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Materials purchases 28,000 kg Rs.77,000

issues to 30,000kg FIFO

production

Labor paid 16,000 hours Rs.96,000

production 15,000 hours

Production overhead Rs.250,000

Standard overhead rate per hour Rs.20

Completed production 4,000 units

AT A GLANCE
Closing inventories raw materials see above

work in progress nil

finished goods 500 units FIFO

Sales revenue see above Rs.540,000

Note that the opening cost ledger trial balance is as follows:

Debit Credit
Raw materials 25,000

SPOTLIGHT
Finished goods 100,000
Cost ledger control a/c 125,000

The following pages will show how the balances and transactions would be recorded in the cost ledger and the
financial ledger.
Cost ledger
Recognition of expenses as incurred

Purchase of raw materials Debit Credit

Inventory (raw materials) 77,000

STIKCY NOTES
Cost ledger control a/c 77,000
Payment of wages
Wages control a/c 96,000
Cost ledger control a/c 96,000
Overhead incurred
Overhead control a/c 250,000
Cost ledger control a/c 250,000

Reclassification of wages expense into overhead

Debit Credit
Overhead control a/c 6,000
Wages control a/c 6,000

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Working
Number of hours: 16,000  15,000 1,000
Hourly rate: Rs. 96,000/16,000 hours Rs.6
Transfer (Rs.) 6,000

Transfer of expenses into WIP as production proceeds

Raw materials used Debit Credit

Inventory (WIP) 80,000
Inventory (raw materials) 80,000
AT A GLANCE

Working: FIFO Rs.

First 10,000 kgs (opening inventory) 25,000
Next 20,000 kgs (from purchases 55,000
(20,000 kgs/28,000 kgs)  Rs.77,000
Transfer (Rs.) 80,000

Use of direct labor Debit Credit

Inventory (WIP) 90,000
Wages control a/c (96,000  6,000) 90,000
SPOTLIGHT

Overhead absorbed
Inventory (WIP) 300,000
Overhead control a/c 300,000

Working
15,000 hours @ Rs. 20 per hour (given) Rs. 300,000

Transfer of costs from WIP into finished goods Debit Credit

STIKCY NOTES

Inventory (finished goods) 470,000

Inventory (WIP) 470,000

Working: Balance in WIP before transfer Rs.

Opening WIP 
Raw materials 80,000
Direct labor 90,000
Overhead absorbed 300,000
470,000
Less: Closing WIP 
470,000

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Note:
Cost per unit = Rs. 470,000 /4,000 units Rs. 117.5

Transfer of costs to costing P&L a/c

Transfer of finished goods to cost of sales Debit Credit

P&L control account 511,250
Inventory (finished goods) 511,250

Working Units Rs.

Opening inventory of finished goods 1,000 100,000

AT A GLANCE
Production 4,000 470,000
5,000 570,000
Closing inventory of finished goods (@ Rs. 117.5) (500) (58,750)
4,500 511,250

Over-absorption of overhead Debit Credit

Overhead control a/c 44,000
P&L control a/c 44,000

SPOTLIGHT
Working: Rs.
Overhead incurred 250,000
Transfer from wages control a/c 6,000
256,000
Overhead absorbed 300,000
Over absorption 44,000

STIKCY NOTES
Recognition of sales and calculation of profit
Recognition of sales Debit Credit
Cost ledger control a/c 540,000
Sales 540,000
Transfer of sales to P&L control a/c
Sales 540,000
P&L control a/c 540,000
Transfer of profit to cost ledger control a/c
P&L control a/c 72,750
Cost ledger control a/c 72,750

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Working: Proof of profit Rs.

Sales 540,000
Cost of sales
Finished goods 511,250
Over-absorption of overhead (44,000)
(467,250)
Profit 72,750

The cost ledger T accounts after the double entries are as follows:
AT A GLANCE

Raw materials
Rs. ‘000 Rs. ‘000
B/f 25,000
CLC a/c 77,000 To WIP 80,000
C/f 22,000
102,000 102,000

Wages control
SPOTLIGHT

Rs. ‘000 Rs. ‘000

CLC a/c 96,000 Overhead control 6,000
To WIP 90,000
96,000 96,000

Overhead control
Rs. ‘000 Rs. ‘000
CLC a/c 250,000 To WIP 300,000
STIKCY NOTES

Wages control 6,000

P&L control a/c (over abs.) 44,000
300,000 300,000

Work in progress (WIP)

Rs. ‘000 Rs. ‘000
Raw materials 80,000 Finished goods 470,000
Wages control 90,000
Overhead control 300,000
470,000 470,000

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Finished goods
Rs. ‘000 Rs. ‘000
B/f P&L control a/c 511,250
100,000

WIP 470,000 C/f 58,750

570,000 570,000

Sales
Rs. ‘000 Rs. ‘000

AT A GLANCE
P&L control a/c 540,000 CLC a/c 540,000
540,000 540,000

Costing Profit & Loss Account (CPL)

Rs. ‘000 Rs. ‘000
Finished goods 511,250 Sales 540,000
CLC a/c (profit) 72,750 Overhead control 44,000
584,000 584,000

SPOTLIGHT
Cost Ledger Control Account (CLC a/c)

Rs. ‘000 Rs. ‘000

B/f 125,000
Raw materials 77,000
Direct labor 96,000
Overheads 300,000

STIKCY NOTES
Sales 540,000
P&L control a/c 72,750
C/f 80,750
620,750 620,750

Note that the closing cost ledger trial balance is as follows:

Debit Credit
Raw materials 22,000
Finished goods 58,750
Cost ledger control a/c 80,750

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 CHAPTER 6: COST FLOW IN PRODUCTION CAF 8: CMA

General ledger

Recognition of expenses as incurred Debit Credit

Purchase of raw materials
Inventory (raw materials) 77,000
Payables 77,000
Payment of wages
Wages control a/c 96,000
Cash 96,000
AT A GLANCE

Overhead incurred
Overhead control a/c 250,000
Cash 250,000
Transfer of expenses to P&L control a/c
P&L control a/c 77,000
Purchases 77,000
P&L control a/c 96,000
SPOTLIGHT

Wages control a/c 96,000

P&L control a/c 250,000
Overhead control a/c 250,000
Transfer of opening inventory to P&L control a/c
Raw materials
P&L control a/c 25,000
Inventory (raw materials) 25,000
STIKCY NOTES

Finished goods
P&L control a/c 100,000
Inventory (finished goods) 100,000
Recognition of closing inventory
Raw materials
Inventory (raw materials) 22,000
P&L control a/c 22,000
Finished goods
Inventory (finished goods) 58,750
P&L control a/c 58,750

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Recognition of sales and calculation of profit

Recognition of sales Debit Credit
Receivables 540,000
Sales 540,000
Sales 540,000
P&L control a/c 540,000
Transfer of profit to accumulated profit
P&L control a/c 72,750
Accumulated profit 72,750

AT A GLANCE
Working: Profit for the period Rs.
Sales 540,000
Cost of sales
Opening inventory
Raw materials 25,000
Finished goods 100,000
125,000

SPOTLIGHT
Production costs
Raw materials 77,000
Wages 96,000
Overheads 250,000
423,000
Closing inventory
Raw materials 22,000

STIKCY NOTES
Finished goods 58,750
(80,750)
(467,250)
Profit 72,750

The general ledger T accounts after the double entries are as follows:

Purchases

Rs. ‘000 Rs. ‘000

Payables (not shown) 77,000 P&L control a/c 77,000

77,000 77,000

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 CHAPTER 6: COST FLOW IN PRODUCTION CAF 8: CMA

Wages control

Rs. ‘000 Rs. ‘000

Cash (not shown) 96,000 P&L control a/c 96,000

96,000 96,000

Overhead control
AT A GLANCE

Rs. ‘000 Rs. ‘000

Cash (not shown) 250,000 P&L control a/c 250,000

250,000 250,000

Inventory (raw materials)

Rs. ‘000 Rs. ‘000

SPOTLIGHT

B/f 25,000 P&L control a/c 25,000

P&L control a/c 22,000 C/f 22,000

47,000 47,000

Inventory (finished goods)

Rs. ‘000 Rs. ‘000

STIKCY NOTES

B/f 100,000 P&L control a/c 100,000

P&L control a/c 58,750 C/f 58,750

158,750 158,750

Sales

Rs. ‘000 Rs. ‘000

P&L control a/c 540,000 Receivables (not shown) 540,000

540,000 540,000

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Profit & Loss Control Account

Rs. ‘000 Rs. ‘000

Purchases 77,000 Sales 540,000

Wages control a/c 96,000

Overhead control a/c 250,000

Opening inventory Closing inventory

Raw materials 25,000 Raw materials 22,000

AT A GLANCE
Finished goods 100,000 Finished goods 58,750

Profit for the year 72,750

620,750 620,750

SPOTLIGHT
STIKCY NOTES

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3. COMPREHENSIVE EXAMPLES
 Example 01:
At 1 July a manufacturing company had the following balances in the general ledger adjustment
account in its cost ledger:

Rs.
Balance brought forward (credit) 5,625
Stores ledger control account 2,125
Finished goods stock control account 1,500
Work in progress control account 2,000
AT A GLANCE

Open ledger accounts for the above items in the cost ledger, post the following items which
occurred in the four-month period up to 31 October and open up other accounts as considered
necessary, including a costing profit and loss account.

Stock material purchased 12,000

Stock materials issued to production 12,500
Stock materials issued to maintenance department 1,000
Wages – direct 10,830
Included in direct wages is indirect work 600
Factory overheads incurred 4,200
Factory overheads absorbed into production 5,800
SPOTLIGHT

Work transferred to finished stock, at cost 24,000

Factory cost of sales 22,500
Sales at selling price 28,750
Administrative and selling costs (to be written off against profits) 4,250

General ledger control a/c

Rs. Rs.
Balance b/d 5,625
Sales account 28,750 Stores 12,000
STIKCY NOTES

Wages 10,830
Production overhead 4,200
Administration and selling expenses 4,250
Balance c/d 10,155 Profit and loss a/c 2,000
38,905 38,905
Balance b/d 10,155

Stores ledger control a/c

Rs. Rs.
Balance b/d 2,125 Work in progress 12,500
General ledger control 12,000 Production overhead 1,000
Balance c/d 625
14,125 14,125
Balance b/d 625

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Wages control a/c

Rs. Rs.
General ledger control 10,830 Production overhead 600
Work in progress 10,230
10,830 10,830

Production overhead control a/c

Rs. Rs.
Stores ledger control 1,000 Work in progress 5,800
Wages control 600
General ledger control 4,200

AT A GLANCE
5,800 5,800

Administration and selling expenses control a/c

Rs. Rs.
General ledger control 4,250 Profit and loss a/c 4,250
4,250 4,250

Sales a/c
Rs. Rs.
Profit and loss a/c 28,750 General ledger control 28,750

SPOTLIGHT
28,750 28,750

Work in progress control a/c

Rs. Rs.
Balance b/d 2,000 Finished goods control 24,000
Stores 12,500
Wages 10,230
Production overhead 5,800 Balance c/d 6,530
30,530 30,530

STIKCY NOTES
Balance b/d 6,530

Finished goods control a/c

Rs. Rs.
Balance b/d 1,500 Cost of sales 22,500
Work in progress 24,000
Balance c/d 3,000
25,500 25,500
Balance b/d 3,000

Cost of goods sold

Rs. Rs.
Finished goods stock 22,500 Profit and loss a/c 22,500
22,500 22,500

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Profit and loss a/c

Rs. Rs.
Cost of goods sold 22,500 Sales 28,750
Administration and selling 4,250
expenses
Profit (to general ledger 2,000
control)

28,750 28,750
 Example 02:
AT A GLANCE

Kaat Ltd operates separate cost accounting and financial accounting systems. The following
manufacturing and trading statement has been prepared from the financial accounts for the
quarter ended 31 March.

Rs. Rs.
Raw materials
Opening stock 48,000
Purchases 108,800
156,800
Closing stock (52,000)
Raw materials consumed 104,800
SPOTLIGHT

Direct wages 40,200

Production overhead 60,900
Production cost incurred 205,900
Work in progress
Opening stock 64,000
Closing stock (58,000) 6,000
Cost of goods produced carried down 211,900
Sales 440,000
STIKCY NOTES

Cost of goods sold

Finished goods opening stock 120,000
Cost of goods produced brought down 211,900
331,900
Finished goods closing stock (121,900) (210,000)
Gross profit 230,000

The following information has been extracted from the cost accounts:
Control account balances at 1 January

Rs.
Raw material stores 49,500
Work in progress 60,100
Finished goods 115,400

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Transactions for the quarter

Rs.
Raw materials issued 104,800
Cost of goods produced 222,500
Cost of goods sold 212,100
Loss of materials damaged by flood (insurance claim pending) 2,400

A notional rent of Rs.4,000 per month has been charged in the cost accounts. Production
overhead was absorbed at the rate of 185% of direct wages. Profit at the end of the period is
shown as Rs.238,970.
a) Preparation of the relevant control accounts in the cost ledger, would be as follows

AT A GLANCE
Raw materials stores a/c
Rs. Rs.
Balance b/f 49,500 Work in progress 104,800
Purchases 108,800 Loss due to flood 2,400
Balance c/f 51,100
158,300 158,300
Balance b/f 51,100

Work in progress control a/c

SPOTLIGHT
Rs. Rs.
Balance b/f 60,100 Finished goods 222,500
Raw materials 104,800 Balance c/f 56,970
Direct wages 40,200
Production overhead 74,370
279,470 279,470
Balance b/f 56,970

Finished goods control a/c

STIKCY NOTES
Rs. Rs.
Balance b/f 115,400 Cost of sales 212,100
Work in progress 222,500 Balance c/f 125,800
337,900 337,900
Balance b/f 125,800

Production overhead
Rs. Rs.
General ledger control 60,900 Work in progress 74,370
Notional rent 12,000
Overhead overabsorbed 1,470
74,370 74,370

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 CHAPTER 6: COST FLOW IN PRODUCTION CAF 8: CMA

b) Prepare a statement reconciling the gross profit as per the cost accounts and the
financial accounts.
Reconciliation statement
Rs. Rs. Rs.

Profit as per financial accounts 230,000

Difference in stock values

Work in progress opening stock 3,900

Finished goods opening stock 4,600

AT A GLANCE

Finished goods closing stock 3,900

-------------- 12,400

Raw materials opening stock 1,500

Raw materials closing stock 900

Work in progress closing stock 1,030

(3,430)

8,970
SPOTLIGHT

Profit as per cost accounts 238,970

Cost accounting profit and loss Rs. Rs. Rs.

Sales 440,000

Cost of sales 212,100

Loss of stores 2,400

214,500
STIKCY NOTES

Overhead over-absorbed 1,470

Notional rent 12,000

(13,470)

(201,030)

238,970

 Example 03:
Mirza Limited is engaged in the manufacturing of spare parts for automobile industry. The
company records the purchase and issue of materials in a store ledger which is not integrated
with the financial ledger. It is the policy of the company to value inventories on weighted average
basis. The valuation is carried out by the Finance Department using stores memorandum record.
A physical stock count is carried out after every six months. Any shortage/excess is then adjusted
in the financial as well as stores ledger.

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On December 31, 20X3, physical stock count was conducted by the Internal Auditor of the
company. He submitted the following statement to the Finance Department:

Balance (in units) Cost per unit (Rs.)

Item Code Store Financial
Physical Average Current
Ledger Records
010-09 20,500 20,500 20,000 2.00 2.25
013-25 10,000 10,000 10,000 4.00 1.50
017-10 5,500 5,500 5,000 1.00 1.10
022-05 4,000 4,500 5,500 2.00 2.00

AT A GLANCE
028-35 1,200 1,200 1,000 2.75 2.50
035-15 640 600 600 3.00 3.50

On scrutinizing the details, Finance Department was able to ascertain the following reasons:

Item Code Reasons

010-09 500 units were defective and therefore the Internal Auditor
excluded them while taking the physical count.
013-25 This item is not in use and is considered obsolete. The net realizable value is
Rs. 0.60 per unit.
017-10 Shortage is due to theft.

SPOTLIGHT
022-05 A receipt of 1,000 units was not recorded. The remaining difference is
due to errors in recording the quantity issued.
028-35 200 units returned to a supplier were not recorded. The invoiced cost was
Rs. 3 per unit.
035-15 Discrepancy is due to incorrect recording of a Goods Receipt Note.

a) Necessary Journal entries to record the adjustments in the financial ledger would be
prepared as follows
Journal Entries in Financial Ledger

STIKCY NOTES
Dr. Cr.
Rupees Rupees
(i) Cost of sales/ FOH/ Abnormal loss 1,000
Stores Ledger A/c 1,000
(Record the normal loss of item # 010-09
(ii) Cost of sales/ FOH 34,000
Provision for obsolescence 34,000
(Record the provision for obsolescence against item # 013-25)
(iii) Cost of sales/ FOH/ Abnormal loss 500
Stores Ledger A/c 500
(Record the theft of item # 017-10)

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Dr. Cr.
Rupees Rupees
(iv) (a) Stores Ledger A/c 2,000
Creditors / Cash 2,000
(Record the purchase of items # 022-05 )
(b) No adjustment
(v) Creditors/ Cash 600
Stores Ledger A/c 600
(Record the return of item # 028-35)
AT A GLANCE

(vi) No adjustment

b) In order to make necessary adjustments in the stores, following need to be noted

i. The quantity should be shown as issued in the stores ledger.
ii. No adjustment.
iii. 500 units should be shown in the issue column and adjust the balance accordingly.
iv. a) 1,000 units should be recorded on the receipt side of individual stores ledger
account.
b) The issue column of the individual stores ledger account should be reduced by
SPOTLIGHT

500 units.
v. 200 units should be reduced from the receipt and accordingly adjust the balance
columns of the individual stores ledger account.
vi. The postings of incorrectly recorded Goods Receipt Note should be corrected.
 Example 04
Sapphire limited (SL) fabricates parts for auto manufacturers and follows job order costing. The
company’s head office is situated in Lahore but the factory is in Karachi. A separate set of
records is kept at the head office and at the factory. Following details were extracted from SL’s
records for the month of February 20X4.
STIKCY NOTES

Jobs
A B C
Materials issued to production (units)
 Material X 40,000 - 10,000
 Material Y - 75,000 25,000
Direct labor hours worked (hours) 6,000 9,000 15,000
Labor rate per hour (Rs.) 75 60 65

The other related information is as follows:

i. Materials purchased on account:
 100,000 units of material X at Rs. 25 per unit
 150,000 units of material Y at Rs. 35 per unit

148 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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ii. The head office prepared the payroll and deducted 8% for payroll taxes. The payroll
amounted to Rs. 3.0 million out of which Rs. 1.0 million pertained to selling and
administrative staff salaries. After charging direct labor cost to each job the balance
amount of payroll cost was attributed to general factory overhead.
iii. Factory overhead was applied to the jobs at Rs. 25 per direct labor hour.
iv. Actual factory overheads amounted to Rs. 700,000 including depreciation on machinery
amounting to Rs. 400,000. All payments were made by head office.
v. Over or under-applied factory overheads are closed to cost of goods sold account.
vi. Jobs A and B were completed during the month. Job A was sold for Rs. 2.0 million to one
of the auto manufacturer on credit. The customer however, agreed to settle the
transaction at 2% cash discount.

AT A GLANCE
vii. Selling and administrative expenses, other than salaries paid during the month were Rs.
500,000.
Journal entries to record all the above transactions in SL’s factory ledger and general ledger for
the month of February 20X4, would be prepared as follows.

General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
Material X 2,500,000 Factory Ledger 7,750,000
Material Y 5,250,000 Trade Creditors 7,750,000

SPOTLIGHT
General Ledger 7,750,000
(Purchase of material)
Payroll 2,000,000 Factory Ledger 2,000,000
General Ledger 2,000,000 Selling and 1,000,000
administrative
expenses
Accrued Payroll 2,760,000
(Payroll accrual) Payroll taxes 240,000

STIKCY NOTES
No Entry Accrued payroll 2,760,000
Payroll Taxes 240,000
Bank 3,000,000
(Payment of
payroll & taxes)
Work in process A 1,000,000
Work in process B 2,625,000
Work in process C 1,125,000 No Entry
Material X 1,250,000
Material Y 3,500,000

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General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
(Issuance of raw material to WIP)
Work in process A 450,000
Work in process B 540,000
Work in process C 975,000 No Entry
Factory overheads 35,000
Payroll 2,000,000
AT A GLANCE

(Direct labor cost allocated to WIP)

Work in process A 150,000
Work in process B 225,000
Work in process C 375,000 No Entry
Factory overheads - applied 750,000
(Factory overheads applied to WIP)
Factory overheads 700,000 Factory Ledger 700,000
General Ledger 700,000 Bank 300,000
SPOTLIGHT

Accumulated 400,000
Depreciation
(Actual factory
overheads transferred)
Factory overheads - 15,000 Factory Ledger 15,000
applied
General Ledger 15,000 Cost of goods sold 15,000
(Over applied overheads transferred to cost of goods sold)
STIKCY NOTES

Finished goods A 1,600,000

Finished goods B 3,390,000 No Entry
Work in process A 1,600,000
Work in process B 3,390,000
(Jobs A and B completed and transferred to finished goods)
General Ledger 1,600,000 Cost of goods sold 1,600,000
Finished goods A 1,600,000 Factory Ledger 1,600,000
(Job A delivered and transferred to cost of goods sold)
No Entry Trade Debtors 2,000,000
Sales 2,000,000

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General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
(Job A sold to
customer)
No Entry Bank 1,960,000
Cash discount 40,000
Trade debtors 2,000,000
(Amount realized

AT A GLANCE
from customer)
No Entry Selling and 500,000
administrative
expenses
Bank 500,000
(Payment of
Selling and admin.
Expenses)

SPOTLIGHT
STIKCY NOTES

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 CHAPTER 5: COST FLOW IN PRODUCTION CAF 8: CMA

STICKY NOTES

The objective of accounting for production of inventory is to record and mirror

the cost throughout the production process.

The cost flows from:

 material account, wages control account,
AT A GLANCE

production overhead account to WIP account;

 then to finished goods accounts; and
 ultimately to Profit and loss account.

Cost book-keeping systems can be categorized into two types in terms of how
the cost accounts relate to other ledger accounts:
 integrated accounts;
 interlocking accounts.
SPOTLIGHT

Integrated accounts combine both financial and cost accounts in one system of
ledger accounts. A reconciliation between cost and financial profits is not
necessary with an integrated system.

Interlocking accounts are recorded in factory ledger for cost accounts and
general ledger for other accounts, which are readily reconcilable.
STIKCY NOTES

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 CHAPTER 7

JOB AND SERVICE COSTING

AT A GLANCE

IN THIS CHAPTER A costing method is one which is designed to suit the way goods
are processed or manufactured or the way that services are
provided.

AT A GLANCE
AT A GLANCE
A job is a cost unit which consists of a single order or contract.
SPOTLIGHT Job costing is a basic cost accounting method applicable where
work consists of separate contracts, jobs or batches.
1. Job costing
The cost of a job consists of direct material cost, direct labor
2. Service costing cost, direct expenses, production overheads and administrative,
selling and distribution overheads.
3. Comprehensive examples Service organizations do not make or sell tangible goods. Service
costing differs from other costing methods. With many services
STICKY NOTES the cost of direct materials consumed will be relatively small
compared to labor, direct expenses and overheads cost.

SPOTLIGHT
The output of most service organizations is often intangible and
difficult to define. A unit cost is therefore difficult to calculate.
Specific characteristics of services are intangibility,
simultaneity, perishability and heterogeneity.

STIKCY NOTES

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1. JOB COSTING
1.1 The nature of job costing
Job costing is used when a business entity carries out tasks or jobs to meet specific customer orders. Although
each job might involve similar work, they are all different and are carried out to the customer’s specific
instructions or requirements.
Examples of ‘jobs’ include work done for customers by builders or electricians, audit work done for clients by a
firm of auditors, and repair work on motor vehicles by a repair firm.
Job costing is similar to contract costing, in the sense that each job is usually different and carried out to the
customer’s specification or particular requirements. However, jobs are short-term and the work is usually
carried out in a fairly short period of time. Contracts are usually long-term and might take several months or
even years to complete.
AT A GLANCE

1.2 The cost of a job

A cost is calculated for each individual job, and this cost can be used to establish the profit or loss from doing the
job.
Job costing differs from most other types of costing system because every job is a cost unit which consists of a
single order or contract and the costing is being done for every job separately. The expected cost of a job has to
be estimated so that a price for the job can be quoted to a customer.
The features of Job costing are as follows:
 Work is undertaken to customer’s special attention
 Each order is of short duration
SPOTLIGHT

 Jobs move through processes and operations as a continuously identifiable unit.

 Each job usually differs in one or more respects from every other job and therefore a separate record must
be maintained to show the details of a particular job.
 Job costs are allocated on a job cost sheet or job cost card.
 Rectification work is the cost of rectifying substandard work. it is to be charged as direct cost of the job
concerned if not a frequent occurrence and can be directly attributable to a job. It is to be treated as
production overhead if regarded as normal part of the work and it is of recurring nature.
A job costing system is usually based on absorption costing principles, and in addition a cost is included for non-
production overheads, as follows.

Illustration: Job cost Rs.

STIKCY NOTES

Direct materials 500

Direct labor 300
Direct expenses 200
Prime cost 1,000
Production overhead absorbed 750
Production cost of the job 1,750
Non-production overheads 400
Total job cost 2,150
In many cases, job costs include not just direct materials costs and direct labor costs, but also direct expenses,
such as:
 the rental cost of equipment hired for the job
 the cost of work done for the job by sub-contractors
 the depreciation cost of equipment used exclusively on the job.

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Production overheads might be absorbed on a direct labor hour basis, or on any other suitable basis.
Non-production overheads might be added to the cost of the job:
 as a percentage of the prime cost of the job, or
 as a percentage of the production cost of the job.
 Example 01:
The following cost information has been gathered about Job number 453.
The direct materials cost is Rs.100, the direct labor cost is Rs.60 and direct expenses are Rs.40.
Direct labor costs Rs.20 per hour. Production overheads are charged at the rate of Rs.30 per
direct labor hour and non-production overheads are charged at the rate of 40% of prime cost.
The job cost for Job 453 is calculated as follows:

AT A GLANCE
Job cost: Job 453 Rs.
Direct materials 100
Direct labor (3 hours at Rs.20) 60
Direct expenses 40
Prime cost 200
Production overhead (3 hours at Rs.30) 90
Production cost of the job 290
Non-production overheads (40% of prime cost) 80

SPOTLIGHT
Total job cost 270

 Example 02:
A company operates a job costing system. Job number 6789 will require Rs.345 of direct
materials and Rs.210 of direct labor, which is paid Rs.14 per hour. Production overheads are
absorbed at the rate of Rs.30 per direct labor hour and non-production overheads are absorbed
at the rate of 40% of prime cost.
The total expected cost of the job would require following calculations

Rs.

STIKCY NOTES
Direct materials 345
Direct labor (15 hours) 210
Prime cost 555
Production overheads (15 hours × Rs.30) 450
Full production cost 1,005
Non-production overheads (40% × Rs.555) 222
Full cost of sale for the job 1,227

1.3 Cost records and accounts for job costing

In order to establish the cost of each individual job in a costing system, it is necessary to have procedures for
recording direct costs in such a way that they can be allocated to specific jobs. Production overheads and non-
production overheads can be charged using overhead absorption rates within a system of absorption costing.

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Each job is given a unique identity number, or job number. The costs for individual jobs are recorded as follows.
 The direct materials for a job are issued directly from stores to the job. The materials requisition note should
specify the job number and the costs of the materials are charged to the job.
 The labor time spent on a job is recorded on time sheets or job sheets. The time sheets for each individual
employee identify the jobs he has worked on and the time that he spent on each job. These can be converted
into a cost for the job at the employee’s hourly rate.
 A system is needed for recording direct expenses to specific jobs. Costs might be obtained from purchase
invoices from suppliers, and recorded in the job cost record (the ‘job sheet’) for the job.
 Production overheads are charged to the job (absorbed, in an absorption costing system) at the appropriate
absorption rate, when the job has been completed.
 Similarly, non-production overheads can be charged when the job has been finished by charging them at the
AT A GLANCE

appropriate absorption rate.

Direct costs and overheads are recorded on a job sheet or job card for the job. At one time, a job card used to be
an actual card or sheet of paper, although job costing systems are now likely to be computerized.
In a costing system, a job account is similar to a work in progress account, except that it is for one job only. In a
company that specializes in jobs, the work in progress account is the total of all the individual job accounts.

Illustration: Job cost account

Job account: Job 12345
Rs. Rs.
Direct materials 1,800 Cost of sales 7,800
Direct wages 2,500
SPOTLIGHT

Direct expenses 500

Production overhead 3,000
7,800 7,800
When the job is finished, the total cost of the job is transferred to the cost of sales.
 Example 03:
The following information relates to job activity in the month of June.
Job 0503 Job 0402 Job 0607
Contract price Rs. 500,000 Rs. 980,000 Rs. 600,000
STIKCY NOTES

Commenced 3 May 2 April 7 June

Completed 25 June Not completed 19 June
Opening WIP comprised: na
Direct materials (all material X) Rs. 5,000 Rs. 10,000
Direct labor (all grade A) Rs. 10,000 Rs. 18,000
Variable production o’head Rs. 12,000 Rs. 21,600
Fixed production overhead Rs. 12,800 Rs. 23,040
Rs. 39,800 Rs. 72,640
Material issues from stores:
Material X 200 kgs 800 kgs 900 kgs
Material Y 400 kgs 600 kgs
Labor
Grade A 60 hours 120 hours 150 hours
Grade B 25 hours 100 hours 20 hours

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Costs:
Material X Rs. 220 per kg
Material Y Rs. 500 per kg
Grade A Rs. 250 per hour
Grade B Rs. 400 per hour
Variable overhead recovery rate Rs. 300 per hour
Fixed production overhead is absorbed using direct labor hours
Budgeted fixed production overhead Rs. 160,000
Budgeted labor hours 500 hours
Actual fixed production overhead expenditure in the Rs. 161,000
period

AT A GLANCE
The company needed to hire a special machine for job 0402 at a cost of Rs. 5,000 in the current
month.
20 kgs of raw material were returned to stores on completion of job 0607.
For internal profit reporting purposes administration and marketing expenses are added to cost
of sales at 20% at the time of completion of the job. Actual administration and marketing expense
in the period was Rs. 130,000.
(Note: The system suggested is the similar to that for the receivables control account backed up
by the receivables ledger. In this case there is a WIP control account backed up by the job costing
ledger).
Task 1 – Schedule of resources used in month

SPOTLIGHT
Material X Kgs Cost per kg Rs.
Job 0503: 200 220 44,000
Job 0402 800 220 176,000
Job 0607 900 220 198,000
Less returns (20) 220 (4,400)
880 220 193,600
1,880 220 413,600

Material Y Kgs Cost per kg Rs.

Job 0503: 400 500 200,000

STIKCY NOTES
Job 0402 600 500 300,000
1,000 500 500,000

Labor grade A Hours Cost per hour Rs.

Job 0503: 60 250 15,000
Job 0402: 120 250 30,000
Job 0607: 150 250 37,500
330 250 82,500

Labor grade B Hours Cost per hour Rs.

Job 0503: 25 400 10,000
Job 0402: 100 400 40,000
Job 0607: 20 400 8,000
145 400 58,000

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Variable overhead Hours Cost per hour Rs.

Job 0503: 60 + 25 = 85 300 25,500
Job 0402: 120 + 100 = 220 300 66,000
Job 0607: 150 + 20 = 170 300 51,000
475 300 142,500

Fixed overhead Hours Cost per hour Rs.

Job 0503: 85 320 27,200
Job 0402: 220 320 70,400
Job 0607 170 320 54,400
475 320 152,000
AT A GLANCE

Task 2 – Journal entries to record costs in the job accounts

Debit Credit
Issues of Material X
Job 0503 account 44,000
Job 0402 account 176,000
Job 0607 account 198,000
Material X inventory account 418,000
Returns of Material X
Material X inventory account 4,400
SPOTLIGHT

Job 0607 account 4,400

Issues of Material Y
Job 0503 account 200,000
Job 0402 account 300,000
Material Y inventory account 500,000
Grade A labor
Job 0503 account 15,000
Job 0402 account 30,000
STIKCY NOTES

Job 0607 account 37,500

Grade A labor account 82,500
Grade B labor
Job 0503 account 10,000
Job 0402 account 40,000
Job 0607 account 8,000
Grade B labor account 58,000
Variable overhead
Job 0503 account 25,500
Job 0402 account 66,000
Job 0607 account 51,000
Variable overhead account 142,500

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Debit Credit
Fixed overhead
Job 0503 account 27,200
Job 0402 account 70,400
Job 0607 account 54,400
Fixed production overhead account 152,000
Hire cost
Job 0402 account 5,000
Cash 5,000

AT A GLANCE
Task 3 – Job cost accounts

Job 0503
Rs. Rs.
Balance b/d 39,800
Issues from stores:
Material X 44,000
Material Y 200,000
Labor:
Grade A 15,000

SPOTLIGHT
Grade B 10,000
Variable overhead 25,500
Fixed overhead 27,200 Cost of sales 361,500
361,500 361,500

Job 0402
Rs. Rs.
Balance b/d 72,640

STIKCY NOTES
Issues from stores:
Material X 176,000
Material Y 300,000
Labor:
Grade A 30,000
Grade B 40,000
Variable overhead 66,000
Fixed overhead 70,400

Machine hire 5,000 Balance c/d 760,040

760,040 760,040

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Job 0607
Rs. Rs.
Issues from stores: Returns to stores
Material X 198,000 Material X 4,400
Labor:
Grade A 37,500
Grade B 8,000
Variable overhead 51,000
Fixed overhead 54,400 Cost of sales 344,500
AT A GLANCE

348,900 348,900

Task 4–Job cost cards (showing the resources allocated to the jobs and the allocation of
administration and marketing expenses for the jobs completed in the period. Also
incorporate the revenue for the period and show the profit or loss on those jobs
completed)

Job 0503 Job 0402 Job 0607

Material X
In opening WIP 5,000 10,000 na
In period 44,000 176,000 193,600
49,000 186,000 193,600
SPOTLIGHT

Material Y (in period) 200,000 300,000

Grade A labor
In opening WIP 10,000 18,000 na
In period 15,000 30,000 37,500
25,000 48,000 37,500
Grade B labor 10,000 40,000 8,000
Variable overhead
In opening WIP 12,000 21,600
STIKCY NOTES

In period 25,500 66,000 51,000

37,500 87,600 51,000
Fixed overhead
In opening WIP 12,800 23,040
In period 27,200 70,400 54,400
40,000 93,440 54,400
Machine hire 5,000
Factory cost 361,500 760,040 344,500
Administration and 72,300 68,900
marketing @ 20%
Cost of sale 433,800 413,400
Contract price 500,000 600,000
Profit 66,200 186,600

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Task 5– Journal entries to record costs in the general ledger (Assuming that the company
operates a system using a control account in its general ledger for jobs show the double
entry (as T-accounts) to account for job activity in the period)
The following journals were not asked for but they are included to help you to understand the
double entry in the general ledger.

Debit Credit
a Issues of Material X
WIP control account 418,000
Inventory control account 418,000
b Returns of Material X

AT A GLANCE
Inventory control account 4,400
WIP control account 4,400
c Issues of Material Y
WIP control account 500,000
Inventory control account 500,000
d Grade A labor
WIP control account 82,500
Payroll control account 82,500

SPOTLIGHT
e Grade B labor
WIP control account 58,000
Payroll control account 58,000
f Variable overhead
WIP control account 142,500
Variable overhead account 142,500
g Fixed overhead

STIKCY NOTES
WIP control account 152,000
Fixed production overhead account 152,000
h Hire cost
WIP control account 5,000
Cash 5,000
i Transfer of costs on completed sales
Cost of sales account
Job 0503 361,500
Job 0607 344,500
706,000
WIP control account 706,000

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WIP control
Rs. Rs.
Balance b/d
Job 0503 39,800
Job 0402 72,640
112,440
a) Inventory control 418,000 b) Inventory control 4,400
c) Inventory control 500,000
d) Payroll control 82,500
e) Payroll control 58,000
AT A GLANCE

f) Var. overhead 142,500

g) Fixed overhead 152,000
h) Hire cost 5,000 i) Cost of sales 706,000
Balance c/d 760,040
1,470,440 1,470,440
Balance b/d 760,040

Cost of sales
Rs. Rs.
SPOTLIGHT

i) WIP control a/c 706,000

Fixed production overhead

Rs. Rs.
Balance b/d 161,000 g) WIP control a/c 152,000
(Actual spend)

We now need to recognize the following entries. Once again journals are provided for your
convenience.

Debit Credit
STIKCY NOTES

j Administration and marketing mark-up (20% of

cost of sales figure)
Cost of sales account (20% of 706,000) 141,200
Administration and marketing control a/c 141,200
Note that this is the same sum of the two figures shown
on the job cost card in task 4 (72,300 + 68,900)
k Transfer of balance on cost of sales to the income
statement
Income statement 847,200
Cost of sales account 847,200
l Under recovery of fixed production overhead
Income statement (161,000 – 152,000) 9,000
Fixed production overhead account 9,000

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Debit Credit
m Over recovery of administration and marketing
overhead
Administration and marketing control a/c 11,200
Income statement (141,200 – 130,000) 11,200
n Recognition of revenue on finished jobs
Receivables (500,000 + 600,000) 1,100,000
Income statement 1,100,000

WIP control

AT A GLANCE
Rs. Rs.
Balance b/d 760,040

Cost of sales
Rs. Rs.
i) WIP control a/c 706,000
j) Admin and marketing 141,200 k) Income statement 847,200
847,200 847,200

SPOTLIGHT
Fixed production overhead
Rs. Rs.
Balance b/d (actual) 161,000 g) WIP control a/c 152,000
i) Income statement 9,000
161,000 161,000

Administration and marketing

Rs. Rs.
Balance b/d (actual) 130,000 j) Cost of sales 141,200

STIKCY NOTES
m) Income statement 11,200
141,200 141,200
Balance b/d

Income statement
Rs. Rs.
k) Cost of sales 847,200 j) Cost of sales
i) Fixed production OH 9,000 m) Admin and mkt. 11,200
n) Receivables 1,100,000
Profit (Balancing figure) 255,000
1,111,200 1,111,200

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 Example-04:
Ahmer and Company is engaged in production of engineering parts. It receives bulk orders from
bicycle manufacturers and follows job order costing. On July 1, 20X3 two jobs were in progress
whereas two jobs were opened during the year. The details are as follows:

JOBS
A B C D
Work in process – opening (Rs.) 1,400,000 2,500,000 - -
Raw material issued from stores (Rs.) 800,000 1,200,000 1,500,000 600,000
Direct labor hours worked (Hours) 20,000 30,000 15,000 18,000
Rate of direct labor per hour (Rs.) 20 18 16 15
AT A GLANCE

Other related information is as follows:

i. Factory overhead is applied to the jobs at Rs. 10 per labor hour.
ii. Actual factory overheads for the year amounted to Rs. 900,000.
iii. Under/over applied factory overheads are charged to profit and loss account.
iv. Job A was completed during the year. All the goods were shipped to the customers.
v. Job B was also completed during the year. However, about 10% of the goods were
rejected during inspection. These were transferred to Job C where they will be used
after necessary adjustments.
Journal entries to record all the above transactions can be prepared as follows:
SPOTLIGHT

General Journal entries

Date Particulars Ledger Debit Credit
folio
1 Work in process A 800,000
Work in process B 1,200,000
Work in process C 1,500,000
Work in process D 600,000
Raw material 4,100,000
STIKCY NOTES

(Issuance of raw material to WIP)

2 Work in process A (20,000*20) 400,000
Work in process B (30,000*18) 540,000
Work in process C (15,000*16) 240,000
Work in process D (18,000*15) 270,000
Payroll 1,450,000
(Direct labor cost allocated to WIP)
3 Work in process A (20,000*10) 200,000
Work in process B (30,000*10) 300,000
Work in process C (15,000*10) 150,000
Work in process D (18,000*10) 180,000

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General Journal entries

Date Particulars Ledger Debit Credit
folio
Factory overheads applied 830,000
(Factory overheads applied to WIP @ Rs. 10
per direct labor hours)
4 Factory overheads applied 830,000
Profit and loss account (900,000-830,000) 70,000
Factory overheads Control 900,000

AT A GLANCE
(Factory overheads applied transferred to
overheads control a/c and under applied
overheads charged to P&L account)
5 Finished goods A 2,800,000
(1,400,000+800,000+400,000+200,000)
Work in process A 2,800,000
(Job A completed and transferred to finished
goods)
6 Finished goods – B 4,086,000

SPOTLIGHT
90% of
(2,500,000+1,200,000+540,000+300,000)
Work in process C 454,000
10% of
(2,500,000+1,200,000+540,000+300,000)
Work in process B 4,540,000
(Job B completed and transferred to finished
goods, 10% rejected items transferred to Job C)
7 Cost of goods sold 6,886,000

STIKCY NOTES
Finished goods A 2,800,000
Finished goods B 4,086,000
(Jobs A and B delivered and transferred to cost
of goods sold.)
Rs. 21,506,000 21,506,000

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2. SERVICE COSTING
2.1 The nature of services and operations
It is usual to explain costing in terms of how to calculate and record the costs of manufactured products. However,
many business entities do not make and sell products; they provide services.
Service organization do not make or sell tangible goods. Services are any activity carried out by a party to the
benefit of another that is essentially intangible and does not result in the ownership of anything.
Examples include hotel services, consultancy services, legal and accounting services, providers of telephone
services (telecommunications companies), providers of television and radio channels, entertainment services,
postal services, medical services, and so on.
AT A GLANCE

Characteristics of services
These are major characteristics of services:
 Intangibility: They do not have a physical substance unlike goods. They cannot be held or seen.
 Inseparability: Consumption and creation of a service cannot be separated. Services are consumed as they
are created. A service does not exist until it is consumed by the person being served.
 Variability: Services face the problem of maintaining consistency in the standard of output. Goods can
usually be supplied to a standard specification. This is more difficult to achieve for services.
 Perishability: Services cannot be stored. They do not have a shelf life.
 Lack of ownership: Services do not result in the transfer of property in anything. The purchase of a service
only confers on the customer a temporary benefit.
SPOTLIGHT

 Heterogeneous: a haircut is heterogeneous and so the exact service received will vary each time, not only
will two hairdressers cut hair differently, but a hairdresser will not consistently deliver the same standard
of haircut.

Operations
Operations are activities. Like services, they do not result in a finished product to sell to customers. Examples of
operations include a customer service center taking telephone calls and e-mails from customers, and the staff
canteen providing meals to employees.

2.2 Service costing, product costing and job costing compared

STIKCY NOTES

Costs can be established for services, such as hotel accommodation, telephone calls, auditing work, holidays and
travel, and so on. The costs of a service are the sum of direct materials, direct labor, direct expenses (if any) and
a share of operational overheads.
Costs can also be established for operations, in a similar way.
Service costing differs from costing in manufacturing industries in several ways.
 There is no production system; therefore, there are no production overheads.
 Direct materials costs are often a fairly small proportion of total costs (for example, the direct materials costs
to a telecommunications company of providing telephone services are very small).
 In some service industries, direct labor costs are high (for example, in the film-making industry, accountancy
and investment banking).
 General overhead costs can be a very high proportion of total costs.
 Inventory is usually very small; therefore, absorption costing is usually of little or no value for management
information purposes.

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Not all entities that provide services will use service costing. The purpose of service costing is to provide
information to management about the costs of different services that the entity provides, and the profitability of
each of the different services. Each service should be fairly standard. If they are not standard services, it is more
sensible to use job costing to calculate the cost of each ‘job’ of service. For example:
 Service costing might be used by a hospital to record or calculate the cost of each of the different services
provided by the hospital, such as the cost of treating a patient for a particular condition such as cardiac
arrests etc.
 Job costing might be used by a professional firm such as a firm of accountants or solicitors, where the cost of
each job depends largely on the amount of time spent on each job by the professional staff.

2.3 Cost units in service costing: composite cost units

One of the main problems with service costing is that it can be difficult to identify a suitable cost unit for the

AT A GLANCE
service. It is often appropriate to use a composite cost unit in service costing. This is a cost that is made up from
two variables, such as a cost per man per day (a cost per ‘man/day’). Here, the two variables are ‘men’ (the
number of employees) and ‘days’.
Examples of composite cost units used in service costing are as follows:
 The cost per room per day. This is a useful unit cost in the hotel services industry.
 The cost per passenger mile or the cost per passenger kilometer (= the average cost of transporting a
passenger for one mile or one kilometer). This unit measure of cost is used by transport companies that
provide bus or train services.
 The cost per ton mile delivered (= the average cost of transporting one ton of goods for one mile). This unit
cost is commonly used for costing freight services and delivery operations.
 The cost per patient/day (= the average cost of treating one patient for one day) or the cost per hospital

SPOTLIGHT
bed/day (= the cost of maintaining one hospital bed in a hospital for one day). These costs are used by health
service providers.
 The cost per man day. This unit cost is widely used in professional services, such as auditing, legal services
and consultancy services.
Composite cost units can be used in addition to a ‘job costing’ type of service costing system. For example, a firm
of accountants might calculate the cost of each job performed for a client. In addition, it might calculate the
average cost per man day for the professional services such as taxation, auditing, consultancy etc. that it provides.
 The cost of each service ‘job’ enables management to monitor costs and profits on individual jobs for a
customer.
 The composite cost, which is an average cost for all ‘jobs’ allows management to monitor the general level

STIKCY NOTES
of costs.

2.4 Calculating the cost per unit of service (or operation)

The cost of a service unit (or composite cost unit) is calculated as follows.
 Formula

Total costs of the service

Cost per unit of service
Number of units of service

Total costs are the costs of direct materials, direct labor, direct expenses and variable overheads plus a charge
for fixed overheads (unless marginal costing is used to cost the services).

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The total number of service units might be a bit more difficult to calculate. Here are a few examples.
 Example 05:
A hotel has 80 standard twin-bedded rooms. The hotel is fully-occupied for each of the 350 days
in each year that it is open. The total costs of running the hotel each year are Rs. 3,360,000.
What would be a useful measure of the cost of providing the hotel services?
A useful unit cost is the cost per room/day. This is the average cost of maintaining one room in
the hotel for one day.
Room available in a year = 80 rooms × 350 days = 28,000
Cost per room/day = Rs. 3,360,000/28,000 = Rs 120.
 Example 06:
AT A GLANCE

A train company operates a service between two cities, Southtown and Northtown. The distance
between the cities is 400 miles. During the previous year, the company transported 200,000
passengers from Southtown to Northtown and 175,000 passengers from Northtown to
Southtown. The total costs of operating the service were Rs.60 million.
What would be a useful measure of the cost of providing the train service between the two cities?
A useful unit cost is the cost per passenger/mile. This is the average cost of transporting one
passenger for one mile.
Passenger/miles per year = (200,000 × 400) + (175,000 × 400) = 150 million.
Mile = Rs. 60,000,000/150,000,000 = Rs.0.40.
SPOTLIGHT
STIKCY NOTES

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3. COMPREHENSIVE EXAMPLES
 Example 01:
RI Limited (RIL) is engaged in the manufacturing of spare parts for industrial machines. RIL
receives bulk orders from its customers and follows job order costing. Following data pertains to
two of the jobs which were started in the month of February 2018:

Job F01 Job F02

Size of job order (Units) 5,400 3,600
Labor hours used 27,500 21,600
Labor rate per hour Rs. 360 Rs. 400

AT A GLANCE
i. Each unit of both jobs require 24 kg of raw material S40. Purchase price of S40 was Rs.
30 per kg.
ii. The inventory of S40 at beginning and end of the month was Rs. 2,940,000 and Rs.
1,740,000 respectively.
iii. Wages were paid on 28 February 2018. Income tax withheld from the wages amounted
to Rs. 500,000 which would be deposited in government treasury in the following
month.
iv. Job F01 was in process at month-end. However, Job F02 was completed during the
month of February and finished goods were sent to warehouse. During the delivery to
the customer, 500 units were damaged badly and their realizable value is 50% of the
cost.

SPOTLIGHT
Total labor hours utilized during the month were 100,000. Factory overheads are applied at Rs.
120 per direct labor hour. Under/over applied factory overheads are charged to cost of sales at
month-end. Total actual factory overheads amounted to Rs. 11,000,000, out of which 40% were
fixed.
Journal entries to record the transactions for the month of February 2018 can be prepared as
follows:
Journal entries

Debit Credit
Date Particulars
----- Rs. in '000 -----

STIKCY NOTES
1 Purchases - Raw material (W-1) 5,280
Supplier/cash 5,280
(Purchased raw material)
2 Work in process (F01) (W-1) 3,888
Work in process (F02) (W-1) 2,592
Raw material 6,480
(Allocated raw material consumed to the jobs)
3 Work in process (F01) (27,500×360) 9,900
Work in process (F02) (21,600×400) 8,640
Payroll 18,540
(Allocated direct labor to the jobs)

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Debit Credit
Date Particulars
----- Rs. in '000 -----
4 Payroll 18,540
Accrued payroll tax 500
Bank/Cash 18,040
(Paid of payroll)
5 Work in process (F01) (27,500×120) 3,300
Work in process (F02) (21,600×120) 2,592
Factory overheads applied 5,892
AT A GLANCE

(Applied factory overheads to the jobs @ Rs. 120 per

direct labor hour)
6 Finished goods (2,592+8,640+2,592) 13,824
Work in process (F02) 13,824
(Transferred WIP of job F02 to finished goods)
7 Damaged goods (at NRV) 960
(13,824/3,600×500×50%) Abnormal loss - P&L 960
(13,824/3,600×500×50%)
Finished goods 1,920
(Recorded 500 damaged units)
SPOTLIGHT

8 Cost of sales (13,824–1,920) 11,904

Finished goods 11,904
(Transferred total finished goods to cost of sales)
9 Factory overheads applied (100,000×120) 12,000
Cost of sales (overhead over applied) 1,000
Factory overheads control 11,000
(Transferred applied factory overheads to control
a/c and charged under applied overheads to cost of
STIKCY NOTES

sales)
10 Factory overheads control 11,000
Cash/suppliers 11,000
(Recorded actual factory overheads incurred)

W-1: Rs. In 000

Material consumption - F01 (5,400×24×30) 3.888.00
Material consumption - F02 (3,600×24×30) 2,592.00
Add: Closing stock of raw material Given 1,740.00
Less: Opening stock of raw material Given (2,940.00)
Purchases - Raw material 5,280.00

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 Example 02:
Modern Engineering Workshop (MEW) is engaged in production of customized spare parts of
textile machinery. The following information pertains to the jobs worked by MEW during the
month of June 2014:

Job 101 Job 202

Size of job order 4,000 units 5,000 units
------------ Rs. in ‘000 ------------
Opening work in process 15,000 -
Raw material consumed 10,000 31,000

AT A GLANCE
Direct labor used (Rs. 100 per hour) 5,000 8,000

i. Overheads are applied to jobs at Rs. 25 per direct labor hour. Under/over applied
overheads are transferred to cost of sales.
ii. Job 101 was completed during the month and the goods were sent to the warehouse for
delivery to the customer. During the transfer to the warehouse, 160 units were damaged.
Net realizable value of the damaged units was Rs. 500,000. Remaining units were
transferred to the customer.
iii. Job 202 is in process; however, 2,000 units are fully complete and were transferred to
the warehouse during the month while 3,000 units are 70% complete as at 30 June 2014.
iv. Actual overheads for the month of June 2014 amounted to Rs. 4,000,000.

SPOTLIGHT
In order to prepare journal entries to record the above transactions, please see below:

Journal entries
Debit Credit
Date Particulars
Rs. in '000
1 Work in process Job # 101 10,000
Work in process Job # 202 31,000
Raw material 41,000

STIKCY NOTES
(Raw material consumed for jobs)
2 Work in process Job # 101 5,000
Work in process Job # 202 8,000
Payroll 13,000
(Direct labor cost allocated to jobs)
3 Work in process Job # 101 1,250
5,000/100*25
Work in process Job # 202 2,000
8,000/100*25
Factory overheads applied 3,250
(Overheads applied to the jobs @ Rs. 25 per direct
labor hour)

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Journal entries
Debit Credit
Date Particulars
Rs. in '000
4 Factory overheads applied 3,250
Cost of sales – overhead under applied 750
(4,000–3,250)
Factory overheads control 4,000
(Transfer of applied factory overheads to control
a/c and under applied overheads charged to cost
of sales)
AT A GLANCE

5 Finished goods (Job # 101) 30,000

(15,000+10,000+5,000+1,250)*3,840/4,000
Damaged goods (at NRV) 500
Profit and loss account (damaged goods cost 750
exceeding NRV) (31,250×160/4,000)-500
Work in process Job # 101 31,250
(WIP of Job order # 101 transferred to finished
goods)
6 Cost of sales 30,000
SPOTLIGHT

Finished goods 30,000

(Finished goods of Jobs # 101 transferred to cost
of sales)
7 Finished goods 20,000
(31,000+8,000+2,000)/(2,000+3,000*0.7)*2,000
Work in process Job # 202 20,000
(Units fully completed for Job # 202 transferred
to finished goods)
STIKCY NOTES

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STICKY NOTES

Job costing is a costing method used where each cost unit is separately
identifiable. The work is undertaken to customer’s specific requirements and
the job is of short duration. The main focus of Job costing is to calculate cost of
a specific job or batch.

Costs for each job are collected on a job cost card. Costs includes Material,
labor and overheads. Overheads are absorbed in to the cost of jobs using pre-

AT A GLANCE
determined overhead absorption rates.

Service costing can be used by companies operating in a service industry

often by companies wishing to establish the cost of services carried out by
some of their departments

Service costing differs from the other costing methods. With many services
the cost of direct materials consumed will be relatively small compared to the

SPOTLIGHT
labor, direct expenses and overheads cost.

STIKCY NOTES

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

174 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 8

PROCESS COSTING

AT A GLANCE
IN THIS CHAPTER Process Costing is used where production is a continuous
process and it is not possible to identify separate units of
AT A GLANCE Production.

AT A GLANCE
SPOTLIGHT The output of one process is the input to a subsequent
process until a completed product is produced.
1. Introduction to Process costing, There is often a loss in process which is called normal loss
2. Losses due to spoilage, wastage, evaporation etc.
3. Abnormal Gain If actual loss is greater than normal loss the difference is
called abnormal loss and if actual loss is less than normal
4. Process Costing With Closing Work In loss, we treat the difference as abnormal gain.
Progress
Losses and Gain can occur at different stages in the
5. Opening Work In Progress process
6. Work in Progress and losses Loss or spoilage may have a scrap value; the scrap value

SPOTLIGHT
7. Losses and Gain at differenet stages of normal loss will probably be deducted from the cost of
in the process material in the process.
8. Joint and By Products The scrap value of abnormal loss (or abnormal Gain) will
probably be set off against its cost, in an abnormal loss and
9. Cost of Rework abnormal gain account, and only the balance on the
10. Comprehensive Examples account will be written to the P & L account at the end of
the period.
STICKY NOTES Process account may have closing and opening WIP, there
are two methods to deal with opening WIP – FIFO and
Weighted Average.

STIKCY NOTES
Output from production may be a single product but there
may be joint products or by Products

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1. INTRODUCTION TO PROCESS COSTING

1.1 Process costing
Process costing is used when output is produced in a continuous process system, and it is difficult to separate
individual units of output. The output of one process is the input to a subsequent process until a completed
product is produced. There is often a loss in the process which is called expected or normal loss.
Examples of manufacturing where process costing is used are:
 chemicals manufacturing;
 petroleum refining
 the manufacture of liquids; and
AT A GLANCE

 the continuous processing of high volumes of low-cost food items such as tins of peas or beans, or bottles of
tomato ketchup.
In these types of production process, losses in process might occur and there are often problems in measuring
exactly the amount of unfinished work-in-process at the end of a period.
The basic principle of costing is the same as for other types of costing. The cost of a unit of output from a process
is measured as the total cost of resources consumed by the process divided by the total units produced.

1.2 Features of Process Costing

Process costing provides a system of costing where any or all of these characteristics occur.
 The output of one process is the input to a subsequent process until a completed product is produced.
 Output is normally measured in total quantities, such as tones or liters produced, or in very large quantities
SPOTLIGHT

of small units (such as the number of cans or tins).

 Materials might be added in full at the start of a process or might be added gradually throughout the process.
The materials are processed to produce the final output. In a process costing system, it is usual to distinguish
between:
o direct materials; and
o conversion costs, which are direct labor costs and production overheads.
 There might be losses in the process (due to evaporation, spoilage, wastage or chemical reaction) so the
quantity of output might therefore be less than the quantity of materials input. Process costing provides a
system of costing that allows for expected losses in the manufacturing process.
 When there is a continuous production process there will usually be closing work in process and it is difficult
STIKCY NOTES

to measure the quantity of work-in-process (incomplete production) at the end of a financial period. Process
costing provides a method of measuring and costing incomplete WIP.
 Output from production might be a single product, but there may be joint products and by products.
 Depending on the relative value of product, process costing offers methods of costing for each of the different
products.
 In some process manufacturing systems, there is a series of sequential processes. For example, a
manufacturing system might consist of three consecutive processes: raw materials are input to Process 1,
then the output from Process 1 goes onto the next process (Process 2) and the output from Process 2 then
goes into a final process, Process 3. The output from Process 3 is the final product. Each process is different
and all these characteristics do not occur in all processes.

1.3 The basics of Process Costing

Where a series of separate processes is required to manufacture the finished product the output of one process
becomes the input to the next until the final output is made in the final process. For example, if two processes
are required the accounts would be like this.

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 Illustration:
Simple process account

Process 1 Account
Units Rs. Units Rs.
Materials 100 1,000
Output to
Conversion cost 500 Process 2 100 1,500
100 1,500 100 1,500

AT A GLANCE
Process 2 Account
Units Rs. Units Rs.
Material from process 1 100 1,500

Added materials 50 500

Direct labor 700
Output to
Production overhead 400 Finished Goods 150 3,100
150 3,100 150 3,100

Note that direct labor and production overhead may be treated together as conversion cost

SPOTLIGHT
Added material, labor and production overheads in process 2 are added gradually throughout
the process. Materials from process 1 is introduced in full at the start of Process 2.

1.4 Addition of Materials in Subsequent Process

Many industries that utilize process costing have more than one processes through which the units pass through
before being turned into finished goods e.g. In oil refining the crude oil passes through distillation, reforming,
isomerization etc. before turning into a final finished product.
As the production passes through different products, the finished goods output of one process becomes the raw
materials input of the next process, in addition to the units from the previous process, new materials may also
be added in the next process. In order to separately distinguish the costs incurred in different processes or

STIKCY NOTES
department the cost from the previous process are labelled as “Direct Materials – Process 1”.
 Illustration

Descriptions Process X Process Y

Materials Added (KGs) 10,000 2,000
Materials (Rs.) 30,000 3,000
Direct Wages (Rs.) 16,000 40,000
Production OH as % of Direct Wages 25% 30%
Normal Loss% 5% 5%
Materials Output (KGs) 9,500 10,925

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Process 1 A/c
KGs Rs. KGs Rs.

Direct Materials 10,000 30,000 Normal Loss 500

Output to
Direct Wages 16,000 Process 2 9,500 50,000
Production OH 4,000
10,000 50,000 10,000 50,000

Process 2 A/c
AT A GLANCE

KGs Rs. KGs Rs.

Direct Materials
- process 1 9,500 50,000 Normal Loss 575
Direct Materials 2,000 3,000 Output 10,925 105,000
Direct Wages 140,000
Production OH 12,000
11,500 105,000 11,500 105,000
SPOTLIGHT
STIKCY NOTES

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2. LOSSES
2.1. Normal loss
A feature of process manufacturing is that there is often some loss or wastage in production and output quantities
are less than input quantities of materials.
Normal loss is the expected loss in the process due to evaporation of liquids, wastage or rejected units.
 Formula: Normal loss

Normal loss = Quantity of material input  Expected output OR

Quantity of material input = Normal loss + Expected output OR
Expected output = Quantity of material input  Normal loss

AT A GLANCE
Normal loss is usually expressed as a percentage of the input units of materials.
 Example 01:
Normal loss of a process is 10%.
A company puts 5,000 liters into the process.
Normal loss is 10% of 5,000 = 500.
Expected output from the process would be 90% of 5,000 liters = 4,500 liters
Normal loss is unavoidable in the normal course of events. It is inherent in the physical and chemical reactions
that take place in a process.

SPOTLIGHT
 Example 02:
A person buys a one liter tin of soup.
The soup must be heated but heating will cause evaporation.
When the soup is ready to eat there will be less than a liter left.
Normal loss is how much evaporation would normally be expected.

2.1.1. Normal loss with no recovery value

 Example 03:
A person buys a one liter tin of soup for Rs. 500.

STIKCY NOTES
Normal evaporation during cooking is 10%.
When the soup is ready to eat there is 0.9 liters left.
The person has paid Rs. 500 for 0.9 liters and this is unavoidable.
The implication of this simple example is as follows. The normal loss is something that is unavoidable in order to
get the good output. The cost of the lost units is part of the cost of obtaining the good output.
All of the cost should be assigned to the good output and none to the normal loss.
If the normal loss has no scrap value it is given a nil value. This means that all of the costs of input must be
recognized as part of good output.
 Formula: Cost of good output

Total process costs

Per unit Cost of good output =
Expected units of output

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 Example 04:
The following information relates to a production process:

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,800 liters
Direct materials cost Rs. 3,600
Direct labor cost Rs. 300
Production overhead absorbed Rs. 600
AT A GLANCE

Solution

The cost per unit produced can be calculated as follows:

Rs.
Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs.2.50
SPOTLIGHT

Process account in the cost ledger

The process cost account (shown below) is a work-in-progress account for the process. The debit side of the
account records direct materials, direct labor costs and production overheads absorbed. The credit side of the
WIP account records the cost of the finished output.
The account also includes memorandum columns for the quantities of direct materials input and the quantities
of output and loss. Normal loss is shown so that the quantities columns add up to the same amount on the debit
or credit sides, but the normal loss has no cost (as it’s cost is built into the cost of output).

Process account with normal loss (no scrap recovery)

STIKCY NOTES

The following information relates to a production process X.

The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Output (actual) at Rs. 2.5
Materials 2,000 3,600 each 1,800 4,500
Direct labor 300
Prod. overhead 600 Normal loss 200 
2,000 4,500 2,000 4,500

Note that it is always useful to draft a process account at the start of an answer as it focuses the mind on what
needs to be done.

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2.1.2. Normal loss with recovery value

In some cases, losses in a process have a scrap value. The normal loss quantity might not be physically lost but is
changed in some way, so that it is not the same as good output. For example, there might be some kind of chemical
separation with a substance scraped off the top of the liquid in the process and whatever is scraped off might
have a scrap value.
If normal loss has a scrap value, the company is able to recover some of the input costs to the process. The scrap
value reduces the cost of the process.
To reflect this in the process account the normal loss is measured at its scrap value and the calculation of the cost
of good output becomes:
 Formula:

Total process costs  Scrap value of the normal loss

AT A GLANCE
Per unit Cost of good output =
Expected units of output

 Example 05:
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,800 liters
Scrap value of normal loss Rs. 0.9 per liter

SPOTLIGHT
Direct materials cost Rs. 3,600
Direct labor cost Rs. 300
Production overhead absorbed Rs. 600

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500

STIKCY NOTES
Less scrap value of normal loss (200 litres  0,9) (180)
4,320
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs.2.40

The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Output (actual)
Materials 2,000 3,600 at Rs. 2.4 each 1,800 4,320
Direct labor 300
Prod. O’hd 600 Normal loss 200 180
2,000 4,500 2,000 4,500

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2.1.3. Normal loss with cost of disposal

In other cases, a company might have to pay to dispose of losses in a process. The substance scraped off the top
of the liquid in the process might be toxic and has to be disposed of safely.
The cost of disposal represents an additional cost to the process.
To reflect this in the process account the normal loss is measured at zero but the expected costs of disposal are
debited to the process account.
 Formula:

Total process costs + Disposal costs of the normal loss

Per unit Cost of good output =
Expected units of output
AT A GLANCE

 Example 06:
The following information relates to a production process X

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,800 liters
Disposal cost of normal loss Rs. 1 per liter

The cost per unit produced can be calculated as follows: Rs.

SPOTLIGHT

Direct materials 3,600

Direct labour 300
Production overheads 600
Total production cost 4,500
Disposal costs of normal loss (200 litres  1) 200
4,700
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.6111
STIKCY NOTES

The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Output (actual) at
Materials 2,000 3,600 Rs. 2.6111 each 1,800 4,700
Direct labor 300
Prod. overhead 600
Disposal cost of
normal loss 200 Normal loss 200 
2,000 4,700 2,000 4,700

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2.2. Abnormal Loss

Normal loss is the expected amount of loss in a process. Actual loss might be more than the expected or normal
loss. When actual loss exceeds normal loss, there is abnormal loss. The difference between total actual loss and
normal loss is abnormal loss.
 Formula:
Abnormal loss = Actual loss – Expected (normal) loss
From earlier:
Quantity of material input = Normal loss + Expected output
But:
Expected output = Actual output + Abnormal loss
Therefore:

AT A GLANCE
Quantity of material input = Normal loss + Actual output + Abnormal loss
Total loss = Normal loss + Abnormal loss.
Abnormal loss is not expected and should not happen. It therefore makes sense to give it a cost. By giving a cost
to abnormal loss, management information about the loss can be provided, and management can be made aware
of the extent of any problem that might exist with excessive losses in process.

2.2.1. Accounting for abnormal loss

If it is assumed that all losses in process occur at the end of the process, units of abnormal loss are cost in exactly
the same way in the as units of finished output. This might seem a little strange but the idea is to highlight the
impact of the loss.

SPOTLIGHT
The cost per unit of abnormal loss is therefore the same as the cost of units of good output. This is exactly the
same as before.
 Formula:

Total process costs  Scrap value of the normal loss

Per unit Cost of good output =
Expected units of output
The cost of units of abnormal loss is treated as an expense for the period, and charged as an expense in the
income statement for the period.
 Example 07:
The following information relates to a production process X.

STIKCY NOTES
Input quantities 2,000 liters
Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,700 liters
Therefore abnormal loss 100 liters

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.5

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Costing:
Cost of finished output = 1,700 units  Rs.2.50 = Rs.4,250.
Cost of abnormal loss = 100 units  Rs.2.50 = Rs.250.
The process account can be completed as follows
Process X
Liters Rs. Liters Rs.
Output (actual) at
Materials 2,000 3,600 Rs. 2.5 each 1,700 4,250
Direct labor 300 Abnormal loss 100 250
AT A GLANCE

Production overheads 600

Normal loss 200 
2,000 4,500 2,000 4,500

Note that the abnormal loss is included in the credit side of the account, in the same way that
normal loss is shown on the credit side. However, whereas normal loss has no value/cost,
abnormal loss has a cost.
The appropriate abnormal loss double entry in the cost ledger is:

Debit Credit
Abnormal loss account X
SPOTLIGHT

Process accounts X

hence,

Abnormal loss account

Liters Rs. Liters Rs.
Process X account 100 250

At the end of the financial period, the balance on the abnormal loss account is written off as a cost in the costing
income statement. Unlike normal loss the cost of abnormal loss is not built into inventory, however, the cost of
abnormal loss is treated as a period cost rather than a product cost.
STIKCY NOTES

2.2.2. Abnormal loss with recovery value

When loss has a scrap value, the scrap value of normal loss is deducted from the process cost, as explained
earlier.
Abnormal loss will also have a scrap value but this is treated differently to the scrap value of normal loss.
 The cost of expected units of output is calculated in the usual way.
 The scrap value of normal loss is normal loss units  scrap value per unit (as usual).
 In the process account the cost of abnormal loss is measured at the cost of expected units (just as before).
 Periodically the units in the normal loss account are transferred to a scrap account at scrap value.
 The balance on the abnormal loss account is an expense for the period (measured at the cost of the units
less the scrap value of abnormal loss).
 This means that scrap value of abnormal loss is set off against the cost of abnormal loss in the abnormal
loss account, not the process account.

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 Illustration:

Debit Credit

Cash (money from the sale of scrapped units) X

Abnormal loss account X

The net cost of abnormal loss (cost of abnormal loss minus its scrap value) is then transferred
as a expense to the cost accounting income statement at the end of the accounting period.
 Example: 08:
The following information relates to a production process X.

AT A GLANCE
Input quantities 2,000 liters
Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,700 liters
Therefore abnormal loss 100 liters
Scrap value of normal loss Rs. 0.9 per liter

The cost per unit produced can be calculated as follows: Rs.

SPOTLIGHT
Direct materials 3,600
Direct labour 300
Production overheads 600
Scrap value of normal loss (200  Rs.0.90) (180)
Total production cost 4,320
Expected output (90% of 2,000) ÷1,800 liters
Cost per litre Rs. 2.4

STIKCY NOTES
Costing:
Cost of finished output = 1,700 units  Rs. 2.40 = Rs. 4,080.
Cost of abnormal loss = 100 units  Rs. 2.40 = Rs. 240.
Normal loss = 200 units  Rs. 0.9 = Rs. 180
The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Materials 2,000 3,600 Output 1,700 4,080
Direct labor 300 Abnormal loss 100 240
Prod. overhead 600 Normal loss 200 180
2,000 4,500 2,000 4,500

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Accounting for the losses

The double entry to account for the losses can be completed as follows

Abnormal loss account

Liters Rs. Liters Rs.
Process X account 100 240 Scrap account 100 90
Income statement 150
100 240 100 240

Normal Loss /Scrap account

AT A GLANCE

Liters Rs. Liters Rs.

Proces1s X account
(normal loss) 200 180 Cash 300 270
Abnormal loss
account 100 90
300 270 300 270
SPOTLIGHT
STIKCY NOTES

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3. ABNORMAL GAIN
Abnormal loss occurs when actual loss is more than the expected (normal) loss. Abnormal gain occurs when the
actual loss is less than normal loss. Abnormal gain is the difference between the expected normal loss and the
actual loss. It might be due to enhanced efficiency of the manufacturing process, if the gain is expected to be
permanent then the expected loss ratio should be revised.
 Formula: Abnormal gain

Abnormal gain = Expected (normal) loss – Actual loss

From earlier:
Expected output = Actual output + Abnormal loss

AT A GLANCE
Gain is opposite in sign so goes to the other side of the expression:
Expected output + Abnormal gain = Actual output

Actual loss = Normal loss – Abnormal gain

3.1. Accounting for abnormal gain: no scrap value for loss

The method of costing for abnormal gain is the same in principle as for abnormal loss. If it is assumed that all
losses occur at the end of the process, the cost per unit of finished output and the value/cost of abnormal gain
are calculated as the cost per expected unit of output. (i.e. the cost of good output)
The cost per unit of abnormal loss is therefore the same as the cost of units of good output. This is exactly the
same as before.

SPOTLIGHT
 Formula: Cost of good output

Total process costs  Scrap value of the normal loss

Per unit Cost of good output =
Expected units of output

The differences between costing for abnormal loss and costing for abnormal gain are that:
 Abnormal gain is a benefit rather than an expense. Whereas abnormal loss is written off as a cost at the end
of the financial period, abnormal gain is an adjustment that increases the profit for the period.
 Abnormal gain is recorded as a debit entry in the process account, because it is a benefit.

STIKCY NOTES
 The other side of the double entry is recorded in an abnormal gain account. At the end of the period, the
balance on the abnormal gain account is then transferred to the income statement as a benefit for the
period, adding to profit.
 Example 09:
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,850 liters
Therefore abnormal gain 50 liters

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The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Conversion costs (direct labour + production overheads) 900
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.5

Costing:
Cost of finished output = 1,850 units  Rs. 2.50 = Rs. 4,625.
AT A GLANCE

Cost of abnormal gain = 50 units  Rs. 2.50 = Rs. 125.

Normal loss = zero (as there is no scrap value).
The process account can be completed as follows
Process X
Liters Rs. Liters Rs.
Materials 2,000 3,600 Output 1,850 4,625
Conversion cost 900
Abnormal gain 50 125 Normal loss 200 nil
2,050 4,625 2,050 4,625
SPOTLIGHT

Accounting for abnormal gain: ledger entries

The abnormal gain is shown on the debit side of the process account, and the total number of units in the
memorandum column for quantities (2,050) is larger than the actual quantity of units input to the process
(2,000).
The appropriate double entry in the cost ledger is:
 Illustration:

Debit Credit
STIKCY NOTES

Process account X
Abnormal gain account X

Continuing from the previous example:

Abnormal gain account

Liters Rs. Liters Rs.

Income Process X
Statement 125 account 50 125

The balance on this account is taken to the costing income statement at the end of the period,
and added to the reported profit.

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3.2. Abnormal gain where loss has a scrap value

When loss has a scrap value, the value of abnormal gain is actually less than the amount shown in the process
account. The process has been more efficient and produced more good output than expected but there are less
normal loss units so the revenue from scrap is less than expected.
Accounting for the scrap value of abnormal gain is similar to accounting for the scrap value of abnormal loss.
 In the process account (WIP), abnormal gain is valued at the cost per expected unit of output.
 The scrap value of normal loss is normal loss units  scrap value per unit (as usual).
 The scrap value of abnormal gain is recorded as a debit entry in the abnormal gain account (in a similar way
to recoding the scrap value of abnormal loss as a credit entry in the abnormal loss account).
 The scrap value of the abnormal gain is set off against the value of the abnormal gain in the abnormal gain
account, not the process account.

AT A GLANCE
 The balance on the abnormal gain account is the net value of abnormal gain (value of abnormal gain minus
the scrap value not earned from the normal loss). This balance is transferred as a net benefit to the cost
accounting income statement at the end of the accounting period.
 Example 10:
Abnormal gain where loss has recovery value
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters

SPOTLIGHT
Actual output 1,850 liters
Therefore abnormal gain 50 liters

Scrap value of normal loss Rs. 0.9 per liter

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600

STIKCY NOTES
Direct labour 300
Production overheads 600
Scrap value of normal loss (200  Rs.0.90) (180)
Total production cost 4,320
Expected output (90% of 2,000) ÷1,800 liters
Cost per litre Rs. 2.4

Costing:
Cost of finished output = 1,850 units  Rs. 2.40 = Rs. 4,440.
Cost of abnormal gain = 50 units  Rs. 2.40 = Rs. 120.
Normal loss = 200 units  Rs. 0.90 = Rs. 180.

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The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Materials 2,000 3,600 Output 1,850 4,440
Conversion cost 900
Abnormal gain 50 120 Normal loss 200 180
2,050 4,620 2,050 4,620

Accounting for the abnormal gain and the normal loss

The double entry to account for the losses can be completed as follows
AT A GLANCE

Abnormal gain account

Liters Rs. Liters Rs.
Process X
Scrap account 50 45 account 50 120
Income statement 75
50 120 50 120

The balance on this account is Rs.75. This is treated as an addition to profit in the cost
accounting income statement for the period.
SPOTLIGHT

Normal Loss /Scrap account

Liters Rs. Liters Rs.
Process X a/c (normal 200 180 Abnormal gain 50 45
loss) account
Cash 150 135
200 270 200 180

The company expected to be able to sell 200 liters of scrap product. The abnormal gain means
that they only have 150 liters to sell.
 Example 11:
STIKCY NOTES

500 liters of a liquid were input to a process at a cost of Rs. 7,200. Normal loss is 20% of the input
quantity. Actual loss was equal to the normal loss.
In order to calculate (a) the cost of completed output from the process, and (b)if there is any, the
cost of any abnormal loss or the value of any abnormal gain; please see below:

litres
Input 1,500
Normal loss (20%) 300
Expected output 1,200

Cost per unit of expected output = Rs. 7,200/1,200 liters = Rs.6 per liter.
Actual output = 1,200 liters.
Cost of actual output = 1,200 liters × Rs.6 = Rs. 7,200.
There is no abnormal loss or abnormal gain.

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 Example 12:
1,500 liters of liquid were input to a process at a cost of Rs. 7,200. A normal loss of 20% of the
input is expected. The actual output for the period was only 1,100 liters.
For the above example, calculate
a) the cost of completed output from the process, and
b) if there is any, the cost of any abnormal loss or the value of any abnormal gain

litres
Input 1,500
Normal loss (20%) 300

AT A GLANCE
Expected output 1,200
Actual output 1,100
Abnormal loss 100

Cost per unit = same as in Example 1, Rs.6 per liter.

Cost of actual output = 1,100 liters × Rs.6 = Rs. 6,600.
Cost of abnormal loss = 100 liters × Rs.6 = Rs.600.
 Example 13:
1,500 liters of liquid were input to a process at a cost of Rs. 7,200. A normal loss of 20% of the

SPOTLIGHT
input is expected. Loss is sold as scrap, for a net sales price of Rs.0.40 per liter. The actual output
from the process was 1,200 liters.
For the above example, calculate:
a) the cost of completed output from the process, and
b) if there is any, the cost of any abnormal loss or the value of any abnormal gain

Rs.
Input cost 7,200
Scrap value of normal loss (300 × Rs.0.40) 120

STIKCY NOTES
Net cost of the process 7,080

Cost per unit of expected output = Rs. 7,080/1,200 liters = Rs.5.90 per liter.
Actual output = 1,200 liters.
Cost of actual output= 1,200 liters × Rs.5.90 = Rs. 7,080.
There is no abnormal loss or abnormal gain.
 Example 14:
1,500 liters of liquid were input to a process at a cost of Rs. 7,200. The output from the process
was 1,100 liters. Normal loss is 20% of the input quantity. Any lost units have a scrap value of
Rs.0.40 per liter.
For each of this example, calculate:
a) the cost of completed output from the process, and
b) if there is any, the cost of any abnormal loss or the value of any abnormal gain

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Cost per unit = same as in Exercise 3, Rs.5.90 per liter.

Cost of actual output = 1,100 liters × Rs.5.90 = Rs. 6,490.
Cost of abnormal loss = 100 liters × Rs.5.90 = Rs.590.
This cost of abnormal loss is the amount recorded in the process account.
The net cost of abnormal loss is reduced (in the abnormal loss account) by the scrap value of the
lost units.

Rs.
Cost of abnormal loss in the process account 590
Scrap value of abnormal loss (100 × Rs.0.40) (40)
AT A GLANCE

Net cost of abnormal loss (= expense in the income statement) 550

 Example 15:
1,500 liters of liquid were input to a process at a cost of Rs. 7,200. Normal loss is 20% of the input
quantity but the actual output for the period was 1,250 liters. Loss has no scrap value.
Calculate:
a) the cost of completed output from the process, and
b) if there is any, the cost of any abnormal loss or the value of any abnormal gain

litres
Input 1,500
SPOTLIGHT

Normal loss (20%) 300

Expected output 1,200
Actual output 1,250
Abnormal gain 50

Cost per unit = same as in Example 1, Rs.6 per liter.

Cost of actual output = 1,250 liters × Rs.6 = Rs. 7,500.
Value of abnormal gain = 50 liters × Rs.6 = Rs.300 (= debit entry in the process account)
 Example 16:
STIKCY NOTES

1,500 liters of liquid were input to a process at a cost of Rs. 7,200. The output from the process
was 1,250 units. Normal loss is 20% of the input quantity. Any lost units have a scrap value of
Rs.0.40 per liter. Calculation of the following is given in this example:
a) the cost of completed output from the process, and
b) if there is any, the cost of any abnormal loss or the value of any abnormal gain

litres
Input 1,500
Normal loss (20%) 300
Expected output 1,200
Actual output 1,250
Abnormal gain 50

Cost per unit = same as in Exercise 3, Rs.5.90 per liter.

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Cost of actual output = 1,250 liters × Rs. 5.90 = Rs. 7,375.

Value of abnormal gain = 50 liters × Rs.5.90 = Rs.295.
This value of abnormal gain is the amount recorded in the process account (as a debit entry).
The value cost of abnormal gain is reduced (in the abnormal gain account) by the scrap value of
the units that have not been lost.

Rs.
Value of abnormal gain in the process account 295
Scrap value forgone: (50 × Rs.0.40) (20)
Net value of abnormal gain (= income in the income statement) 275

AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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4. PROCESS COSTING WITH CLOSING WORK IN PROGRESS

4.1. Sharing out process costs between finished units and unfinished inventory
When manufacturing is a continuous process, there may be unfinished work-in-progress (WIP) at the start and
end of a period. This section looks at closing WIP. In all the examples in this section it is assumed that there is no
opening WIP. Also note that the examples in this section assume that there are no losses.
This means that some units have been started and finished in the year and others have been started but not
finished.
It stands to reason that the cost or value of an unfinished unit is less than the cost of a completed unit. The costs
of the process must be shared between finished output and unfinished work-in-process on a fair basis.
Previous sections have explained that costs are allocated to output by calculating a cost per unit. This involves
AT A GLANCE

dividing a cost figure by the number of units of expected output.

In order to do this when there is closing work in progress, we use the concept of equivalent units.

4.2. Equivalent units

An equivalent unit means ‘equal to one finished unit of output’. This is quite a simple idea. A number of partially
complete units is the equivalent of a number of complete units depending on their degree of completion. It is
assumed that the costs are added uniformly throughout the process, unless otherwise mentioned.
 Illustration:
200 units that are 50% complete are equivalent to 100 (50%  200) complete units
400 units that are 20% complete are equivalent to 80 (20%  400) complete units
SPOTLIGHT

Costs are shared between finished units and inventory by calculating a cost per equivalent unit.

Complication
In all of the previous examples a cost per unit was calculated by dividing the total process costs (perhaps
adjusting for expected normal loss or cost of disposal) by the expected number of units.
The existence of work in progress complicates this because the work in progress might be complete to different
degrees in respect of different cost inputs. For example, a unit in the closing work in progress might be 80%
complete with respect to material but only 50% complete with respect to labor.
In this case, the number of equivalent units of direct materials cost in a period will therefore differ from the
STIKCY NOTES

number of equivalent units of labor.

A cost per unit is calculated for each type of cost using the equivalent units for that cost. The cost of output is
then based on these individual costs.
Costs for finished output and closing inventory can be calculated from the number of equivalent units and the
cost per equivalent unit.

4.3. A three-stage calculation

We recommend a three-stage calculation:
 Prepare a statement of equivalent units to calculate the equivalent units for each type of cost in the output
from the process and for closing WIP
 Next, prepare a statement of cost per equivalent unit for each type of cost.
 Third, prepare a statement to calculate the cost of finished output and closing WIP from the statement of
equivalent units and statement of cost per equivalent unit.

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 Example 17:
The following information relates to a production process X.

Input quantities 4,000 units

Completed output 3,500 units
Closing WIP 500 units

All the direct materials are added to production at the beginning of the process.
Closing inventory of 500 units is therefore 100% complete for materials but is only 40%
complete for conversion

The costs incurred in the period were: Rs.

AT A GLANCE
Direct materials 24,000
Converison costs: 7,400

Statement of equivalent units would require be as follows:

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 3,500 100% 3,500 3,500
Closing WIP:
Materials 500 100% 500

SPOTLIGHT
Conversion 40% 200
4,000 4,000 3,700
Statement of cost per equivalent unit
Direct materials Conversion costs
Total costs Rs.24,000 Rs.7,400
Equivalent units ÷ 4,000 ÷ 3,700
Cost per equivalent unit Rs.6 Rs.2
Statement of evaluation

STIKCY NOTES
Rs.
Cost of finished goods (3,500  (Rs. 6 + Rs. 2)) 28,000
Cost of closing WIP
Materials (500 units  Rs. 6) 3,000
Conversion (200 units  Rs. 2) 400
3,400
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Direct materials 4,000 24,000 Finished goods 3,500 28,000
Conversion costs - 7,400 Closing WIP 500 3,400
4,000 31,400 4,000 31,400

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 Example 18:
A manufacturing company operates two processes. Output from Process 1 is transferred as input
to Process 2. Output from Process 2 is the finished product.
Data for the two processes in January are as follows:

Process 1
Opening work in process Nil
Units introduced into the process 14,000
Units completed and transferred to the next process (Process 2) 10,000
Closing work-in-progress 4,000
Material cost added during the period Rs.70,000
AT A GLANCE

Conversion cost added during the period Rs.48,000

Materials are input into Process 1 at the start of the process and conversion costs are incurred at
a constant rate throughout processing. The closing work-in-progress in Process 1 at the end of
January is estimated to be 50% complete for the conversion work.

Process 2
Opening work-in-process Nil
Units transferred into the process from Process 1 10,000
Closing work-in-progress 1,000
Units completed and transferred to finished goods inventory 9,000
SPOTLIGHT

Costs for the period:

Cost of production transferred from Process 1 Rs.90,000
Conversion cost added during the period Rs.57,000
Added materials during Process 2 Rs.36,000
The materials from Process 1 are introduced at the start of processing in Process 2, but the added
materials are introduced at the end of the process. Conversion costs are incurred at a constant
rate throughout processing. The closing work-in-progress in Process 2 at the end of January is
estimated to be 50% complete.
It is required to
STIKCY NOTES

a) Calculate the cost of completed output from Process 1 and Process 2

b) Calculate the cost of the closing work-in-process in each process at the end of January.
c) Prepare the Process 1 account and the Process 2 account for January.
There is no opening inventory in either process; therefore, there is no difference between the
weighted average cost and FIFO valuation methods.
Process 1
Equivalent units Total Direct materials Conversion costs
Total units Equivalent units Equivalent units
Completed units 10,000 10,000 10,000
Closing inventory 4,000 4,000 (4,000 × 50%) 2,000
Total equivalent units 14,000 14,000 12,000
Cost Rs.70,000 Rs.48,000
Cost per equivalent unit Rs.5 Rs.4

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Direct
Statement of evaluation Conversion costs Total cost
materials
Rs. Rs. Rs.
Completed (10,000 × Rs.5) 50,000 (10,000 × Rs.4) 40,000 90,000
units
Closing (4,000 × Rs.5) 20,000 (2,000 × Rs.4) 8,000 28,000
inventory
70,000 48,000 118,000

The process account is prepared as follows:

Process 1 account

AT A GLANCE
units Rs. units Rs.
Direct 14,000 70,000 Process 2 10,000 90,000
materials account
Conversion 48,000 Closing 4,000 28,000
costs inventory c/f
14,000 118,000 14,000 118,000

Process 2
Materials from Conversion Added
Equivalent units Total
Process 1 costs materials
Equivalent Equivalent Equivalent
Total units

SPOTLIGHT
units units units
Completed units 9,000 9,000 9,000 9,000
Closing inventory 1,000 1,000 500 0
Total equivalent units 10,000 10,000 9,500 9,000
Cost Rs.90,000 Rs.57,000 Rs.36,000
Rs.9 Rs.6 Rs.4
Note: The added materials are added at the end of the process, which means that there are no
added materials in the (unfinished) closing inventory.
Statement of Materials from Conversion Added Total

STIKCY NOTES
evaluation Process 1 costs materials cost
Rs. Rs. Rs. Rs.
Completed units 81,000 54,000 36,000 171,000
Closing inventory 9,000 3,000 0 12,000
90,000 57,000 36,000 183,000

The process account is prepared as follows:

Process 2 account
units Rs. units Rs.
Materials from 10,000 90,000 Finished goods 9,000 171,000
Process 1
Conversion costs 57,000
Added materials 36,000 Closing inventory c/f 1,000 12,000
10,000 183,000 10,000 183,000

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5. OPENING WORK IN PROGRESS

5.1. Introduction to opening work in progress
Opening work in progress adds another level of complexity.
When there is opening work in progress there are two types of cost on the debit side of the account. These are
the costs that were incurred last period and brought forward as work in progress and the costs that were
incurred in the current period. The issue is whether they should be treated together or separately. This question
is addressed in the accounting policy adopted for opening work in progress.
 weighted average cost method treats all costs on the debit side of the account in the same way.
 first-in, first-out (FIFO) method allocates the costs in opening WIP to the finished goods and then spreads
the remaining costs elsewhere.
AT A GLANCE

5.2. Opening Work In Progress: Weighted Average Cost Method

5.2.1. The underlying principle

When the weighted average cost method is used, the assumption is that all units produced during the period and
all units of closing inventory should be valued at the same cost per equivalent unit for materials and the same
cost per equivalent unit for conversion costs.
An average cost per equivalent unit is calculated for all units of output and closing inventory. This includes the
units that were partly-completed at the beginning of the period (and which were therefore valued as closing WIP
at the end of the previous period).
The calculation of equivalent units is based on the number of units finished in the period (it does not matter
when they were started) and the number of units in closing WIP.
SPOTLIGHT

5.2.2. The three-stage calculation

The costs are worked out in a similar way to the previous example (where there was no opening WIP).
 Statement of equivalent units. Prepare a statement of equivalent units for finished output and for closing
WIP.
 Statement of cost per equivalent unit. Calculate the cost per equivalent unit for direct materials and the
cost per equivalent unit for conversion costs. However, remember to include the cost of the opening WIP.
The materials cost of the opening WIP should be included in the total direct materials cost, and the
conversion costs in the opening WIP should be added to the conversion costs for the current period.
You will normally have to calculate a separate cost per equivalent units for materials and for conversion
STIKCY NOTES

costs. This is because the equivalent units of closing inventory will be different for materials and
conversion costs.
 Statement of evaluation. Having calculated the equivalent units and a cost per equivalent unit, prepare a
statement of evaluation.
 Example 19:
The following information relates to a production process X.
Opening inventory 3,000 units
Material cost in opening WIP (100% complete) Rs. 12,600
Conversion costs in opening WIP (30% complete) Rs. 970
During the month
Input quantities 7,000 units
Completed output 8,000 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

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All the direct materials are added to production at the beginning of the process.
Closing inventory of 2,000 units is therefore 100% complete for materials but is only 60%
complete for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000
Converison costs: 17,430

Statement of equivalent units

Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs

AT A GLANCE
Finished output 8,000 100% 8,000 8,000
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 10,000 9,200
And the Statement of cost per equivalent unit, would be as follows

Direct materials Conversion costs

Total costs
Costs in opening WIP Rs. 12,600 Rs. 970

SPOTLIGHT
Costs in the period Rs. 28,000 Rs.17,430
Rs. 40,600 Rs.18,400
Equivalent units ÷ 10,000 ÷ 9,200
Cost per equivalent unit Rs. 4.06 Rs. 2
Statement of evaluation

Rs.
Cost of finished goods (8,000  (Rs. 4.06 + Rs. 2)) 48,480
Cost of closing WIP

STIKCY NOTES
Materials (2,000 units  Rs. 4.06) 8,120
Conversion (1,200 units  Rs. 2) 2,400
10,520

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 8,000 48,480
Conversion costs - 17,430 Closing WIP 2,000 10,520
10,000 59,000 10,000 59,000

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5.2.3. Weighted average cost method: summary

The weighted average cost method for process costing with opening WIP can be summarized as follows.
 All output and closing inventory is valued at the same cost per equivalent unit
 Cost of opening inventory + Costs in the period = Total costs
 Units of closing inventory + Units of output in the period = Total equivalent units
 Cost per equivalent unit = Total costs/Total equivalent units
Illustration for the summary of weighted average calculation of cost per unit, is below
Direct Conversion
materials costs
Cost of opening inventory X X
AT A GLANCE

Costs incurred in the period X X

Total costs Xm Xcc

Number of units output Y Y

Equivalent units of closing inventory Y Y
Total equivalent units Ym Ycc
Cost per equivalent unit (Xm/Ym) (Xcc/Ycc)

5.3. Opening Work In Progress: FIFO Method

SPOTLIGHT

5.3.1. FIFO method in process costing

The first-in, first-out (FIFO) method of process costing is based on the assumption that the opening units of work-
in-process at the beginning of the month will be the first units completed. The cost of these units is their value at
the beginning of the period plus the cost to complete them in the current period.
It is necessary to calculate the number of equivalent units of work done in the period. This consists of:
 The equivalent units of direct materials and conversion costs required to complete the opening WIP. These
are the first units completed in the period.
 The equivalent units of finished output in the period that was started as well as finished in the period. These
have one equivalent unit of direct materials and one equivalent unit of conversion costs. The total number
STIKCY NOTES

of these units is:

o the total finished output in the period
o minus the quantity of opening WIP (which are completed first)
 The equivalent units of closing WIP (calculated in the normal way).

5.3.2. The three-stage calculation

The three-stage calculation with the FIFO method is similar to the calculation method previously described, with
the exception that in the statement of evaluation, the cost of finished output consists of:
 The finished cost of opening WIP which is the sum of:
o the costs in the opening WIP value at the start of the period; plus
o the costs in the current period to complete these units; plus
 the cost of finished output started as well as finished in the period.
Study the following example carefully.

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 Example 20:
The following information relates to a production process X.
Opening inventory 3,000 units
Material cost in opening WIP (100% complete – therefore 0% is needed in
this period) Rs. 12,600
Conversion costs in opening WIP (30% complete – therefore 70% is
needed in this period) Rs. 970
Rs. 13,570

During the month

AT A GLANCE
Input quantities 7,000 units
Completed output 8,000 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

All the direct materials are added to production at the beginning of the process.
Closing inventory of 2,000 units is therefore 100% complete for materials but is only 60%
complete for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000

SPOTLIGHT
Converison costs: 17,430

In solving for Statement of equivalent units, please see below:

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Started last period
Opening WIP 3,000
Materials 0% nil

STIKCY NOTES
Conversion 70% 2,100
Started and finished in the period 5,000 100% 5,000 5,000
Finished in period 8,000 5,000 7,100
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 7,000 8,300

Statement of cost per equivalent unit

Total costs in current period Rs. 28,000 Rs.17,430

Equivalent units ÷ 7,000 ÷ 8,300
Cost per equivalent unit Rs. 4 Rs. 2.1

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Statement of evaluation

Rs.
Cost of goods finished in the period (8,000 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100  Rs. 2.1) 4,410
17,980
Started and finished in this period (5,000  Rs. 4 + Rs. 2.1) 30,500
48,480
AT A GLANCE

Cost of closing WIP

Materials (2,000 units  Rs. 4) 8,000
Conversion (1,200 units  Rs. 2.1) 2,520
10,520

These costs would be recorded in the process account as follows

Process (WIP) account
units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 8,000 48,480
SPOTLIGHT

Conversion costs - 17,430 Closing WIP 2,000 10,520

10,000 59,000 10,000 59,000

(Tutorial note: If you compare this example using FIFO with the previous example using the
weighted average cost method, you will see that the cost of finished output and value of closing
WIP is the same in each case. This is a coincidence. Normally, the two methods provide different
costs for finished output and different closing WIP valuations.)

5.3.3. FIFO method: summary

The first-in, first-out method for process costing with opening WIP can be summarized as follows.
STIKCY NOTES

 The cost of the opening units completed in the current period is calculated separately from the cost of the
units that are started and finished in the current period.
 A cost per equivalent unit is calculated for the current period, as follows:
 Illustration for the summary of weighted average calculation of cost per unit, is given below
Direct Conversion
materials costs
Costs incurred in the current period TCm TCc
Equivalent units of work in the current period:
to complete opening WIP X Y
to start and finish units X Y
to make closing WIP X Y
Total equivalent units of work in this period Xm Ycc
Cost per equivalent unit in the current period TCm / Xm TCc / Ycc

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 These costs are used to apportion the process costs in the current period between:
o the cost of completing the opening WIP
o the cost of units started and finished in the current period
o the value of closing inventory.
 Having calculated costs for the current period, the valuation of output from the process
is calculated as follows:
and illustration for the summary of evaluation of outputs under the FIFO method, is given
below:

Rs.

AT A GLANCE
Cost of Items started in the previous period and finished in this period
Opening WIP X
Cost of finishing the opening WIP
To complete material X
To complete other costs X
X
Cost of items started and finished in this period X
Cost of items finished in the period X

SPOTLIGHT
Cost of items started in this period
Material X
Other costs X
X
Total process costs X

STIKCY NOTES

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6. WORK IN PROGRESS AND LOSSES

6.1. Introduction
Earlier in the chapter, we explained that normal loss is measured at zero or its scrap value if it has one. This
recognized that the scrap recovery reduces the overall cost of the process.
When a question requires the calculation of cost per unit by components of cost, the question arises as to at what
cost the expected scrap recovery should be set off against. After all, the value of the scrapped unit would lay
partly in its material cost but also partly in its conversion costs. The usual approach is to employ a convention
that ignores the complication, and offset the expected scrap recovery against the material cost only.
We saw that abnormal loss is measured in the same way as good production. The number of abnormal loss units
are included in the expected good output used in the cost per unit calculation.
AT A GLANCE

The same principles are followed when a question requires the calculation of cost per unit by component through
the calculation of equivalent units. The number of equivalent units taken to build the abnormal loss must be
included in the total number of equivalent units.
 Example 21:
The following information relates to a production process X

Input quantities 4,000 units

Normal loss (all units having a scrap recovery of Rs. 1) 10% of input
Completed output 3,000 units
Closing WIP 500 units
SPOTLIGHT

All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to
conversion as they are 100% complete for material).
Closing inventory of 500 units is therefore 100% complete for materials but is 60% complete
for conversion.
The costs incurred in the period were: Rs.
Direct materials 24,000
Converison costs: 7,400
It is useful to construct an extra working with these questions to show the physical number of
STIKCY NOTES

units.
Closing work in progress and losses – (Preliminary working)
Units
Opening WIP 0
Input 4,000
Total possible units 4,000
Normal loss (10% of input) (400)
Expected good output 3,600
Actual good output (3,000)
Closing WIP (500)
Abnormal loss 100

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Closing work in progress and losses

Statement of equivalent units

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 3,000 100% 3,000 3,000
Closing WIP:
Materials 500 100% 500
Conversion 60% 300
Abnormal loss

AT A GLANCE
Materials 100 100% 100
Conversion 50% 50
3,600 3,600 3,350
Statement of cost per equivalent unit

Total costs Rs.24,000 Rs.7,400

Expected scrap recovery of normal loss (10%  4,000 units  Rs. 1) Rs. (400)
Rs.23,600 Rs.7,400
Equivalent units ÷ 3,600 ÷ 3,350
Cost per equivalent unit Rs.6.56 Rs.2.21

SPOTLIGHT
Statement of evaluation
Note that the costs per unit above have been rounded to two decimal places. However, the
calculations below are based on unrounded figures (23,600/3,600 and 7,400/3,350)

Rs.
Cost of finished goods (3,000  (Rs. 6.56 + Rs. 2.21)) 26,294
Cost of closing WIP
Materials (500 units  Rs. 6.56) 3,278
Conversion (300 units  Rs. 2.21) 662
3,940

STIKCY NOTES
Cost of closing abnormal loss
Materials (100 units  Rs. 6.56) 656
Conversion (50 units  Rs. 2.21) 110
766
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Direct materials 4,000 24,000 Finished goods 3,000 26,294
Normal loss 400 400
Conversion costs - 7,400 Abnormal loss 100 766
Closing WIP 500 3,940
4,000 31,400 4,000 31,400

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6.2. Opening WIP and losses (Weighted average)

 Example 22:
The following information relates to a production process X
Opening inventory 3,000 units
Material cost in opening WIP (100% complete) Rs. 12,600
Conversion costs in opening WIP (30% complete) Rs. 970
During the month
Input quantities 7,000 units
Normal loss (all units having a scrap recovery of Rs. 1) 5% of Current input
Completed output 7,500 units
AT A GLANCE

Closing WIP (100% complete for direct materials and 60% 2,000 units
complete for conversion costs).
All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to
conversion as they are 100% complete for material).
Closing inventory of 2,000 units is therefore 100% complete for materials but is 60% complete
for conversion.
The costs incurred in the period were: Rs.
Direct materials 28,000
Converison costs: 17,430
SPOTLIGHT

Opening work in progress and losses – Weighted average method – Preliminary working)
Units
Opening WIP 3,000
Input 7,000
Total possible units 10,000
Normal loss (5% of input) (350)
Expected good output 9,650
Actual good output (7,500)
Closing WIP (2,000)
STIKCY NOTES

Abnormal loss 150

Opening work in progress and losses – Weighted average method
Statement of equivalent units
Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
Finished output 7,500 100% 7,500 7,500
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
Abnormal loss
Materials 150 100% 150
Conversion 50% 75
9,650 9,650 8,775

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Statement of cost per equivalent unit

Direct materials Conversion costs

Total costs Rs. Rs.
Costs in opening WIP 12,600 970
Costs in the period 28,000 17,430
Expected scrap recovery of normal loss (350)
(5%  7,000 units  Rs. 1)
40,250 18,400
Equivalent units ÷ 9,650 ÷ 8,775
Cost per equivalent unit 4.17 2.10

AT A GLANCE
Statement of evaluation
Note that in costs per unit above have been rounded to two decimal places. However, the
calculations below are based on unrounded figures (40,250/9,650 and 18,400/8,775)

Rs.
Cost of finished goods (7,500  (Rs. 4.17 + Rs. 2.1)) 47,009
Cost of closing WIP
Materials (2,000 units  Rs. 4.17) 8,342
Conversion (1,200 units  Rs. 2.1 2,516

SPOTLIGHT
10,858
Abnormal loss
Materials (150 units  Rs. 4.17) 626
Conversion (75 units  Rs. 2.1 157
783

These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.

STIKCY NOTES
Opening WIP 3,000 13,570 Finished goods 7,500 47,009
Direct materials 7,000 28,000 Normal loss 350 350
Conversion costs - 17,430 Abnormal loss 150 783
Closing WIP 2,000 10,858
10,000 59,000 10,000 59,000

8.3 Opening WIP and losses (FIFO)

 Example 23:
The following information relates to a production process X.

Opening inventory 3,000 units

Material cost in opening WIP (100% complete Rs. 12,600
Conversion costs in opening WIP (30% complete – Rs. 970
Rs. 13,570

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During the month

Input quantities 7,000 units
Normal loss (all units having a scrap recovery of Rs. 1) 5% of current
input
Completed output 7,500 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to
conversion as they are 100% complete for material).
AT A GLANCE

Closing inventory of 2,000 units is therefore 100% complete for materials but is 60% complete
for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000
Converison costs: 17,430

Opening work in progress and losses – FIFO method – Preliminary working

Units
Opening WIP 3,000
Input 7,000
SPOTLIGHT

Total possible units 10,000

Normal loss (5% of input) (350)
Expected good output 9,650
Actual good output:
Started in the previous period but finished in this period (3,000)
Started and finished in this period (4,500)
Output in this period (7,500)
Closing WIP (2,000)
STIKCY NOTES

Abnormal loss 150

Opening work in progress and losses – FIFO method

Statement of equivalent units

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Started last period
Opening WIP 3,000
Materials 0% nil
Conversion 70% 2,100
Started and finished in the period 4,500 100% 4,500 4,500
Finished in period 7,500 4,500 6,600

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Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
Abnormal loss
Materials 150 100% 150
Conversion 50% 75
9,650 6,650 7,875

Statement of cost per equivalent unit

Direct Conversion

AT A GLANCE
materials costs
Total costs in current period 28,000 17,430
Expected scrap recovery of normal loss (350)
(5%  3,500 units  Rs. 1)
27,650 17,430
Equivalent units ÷ 6,650 ÷ 7,875
Cost per equivalent unit Rs. 4.16 Rs. 2.21

Opening work in progress and losses – FIFO method

Statement of evaluation

SPOTLIGHT
Note that the costs per unit above have been rounded to two decimal places. However, the
calculations below are based on unrounded figures (27,650/6,650 and 17,430/7,875)

Rs.
Cost of goods finished in the period (7,500 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100  Rs. 2.21) 4,648
18,218
Started and finished in this period (4,500  (Rs. 4.16 + Rs. 2.21)) 28,671

STIKCY NOTES
46,889

Cost of closing WIP Rs.

Materials (2,000 units  Rs. 4.16) 8,316
Conversion (1,200 units  Rs. 2.21) 2,655
10,971
Cost of abnormal loss
Materials (150 units  Rs. 4.16) 624
Conversion (75 units  Rs. 2.21) 166
790

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These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 7,500 46,889
Conversion costs - 17,430 Normal loss 350 350
Abnormal loss 150 790
Closing WIP 2,000 10,971
10,000 59,000 10,000 59,000
AT A GLANCE

Tutorial note: FIFO stock valuation is more common than the weighted average method, and
should be used unless an indication in given to the contrary. You may be presented with limited
information about the opening stock which forces you to use either the FIFO or the weighted
average method. The rules are as follows:
1. If you are given with degree of completion of each element of opening stock but not the
value of each element, then you must use FIFO method.
2. If you are not given the degree of completion of each element in opening stock but you
are given with value, then you must use weighted average method.
SPOTLIGHT
STIKCY NOTES

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7. LOSSES AND GAINS AT DIFFERENT STAGES IN THE PROCESS

7.1. Assumptions about when loss occurs
In the earlier explanation of accounting for abnormal loss and abnormal gain, it was assumed that losses occur
at the end of the production process. This assumption is not relevant for normal loss, but it is relevant for
abnormal loss and abnormal gain, because these are given a value.
If it is assumed that losses occur at the end of a process, units of abnormal loss or gain are given a cost or value
as if they are fully completed units – and so one equivalent unit each.
If losses occur at a different stage in the process, this assumption should not be applied. Instead, the concept of
equivalent units should be used to decide the cost of the abnormal loss or the value of the abnormal gain.
Equivalent units can be used provided that an estimate is made of the degree of completion of units at the time

AT A GLANCE
that loss occurs in the process. Differing degrees of completion might be used for direct materials and conversion
costs.

7.2. Equivalent units and abnormal loss part-way through the process
When loss occurs part-way through a process, the cost of any abnormal loss should be calculated by:
 establishing the equivalent units of direct materials and conversion costs for the loss
 calculating a cost per equivalent units
 using the calculations of equivalent units and cost per equivalent unit to obtain a cost for finished output and
abnormal loss in the period.
 Example 24:

SPOTLIGHT
Abnormal loss and loss part-way through a process
The following information relates to a production process X.

Input quantities 10,000 units

Normal loss 10%
Therefore expected output 9,000 units
Actual output 8,500 units
Therefore abnormal loss 500 units
Direct materials are added in full at the beginning of the process, and loss occurs 60% of the way
through the process.

STIKCY NOTES
The costs incurred in the period were: Rs.
Direct materials 27,000
Converison costs: 13,200
Statement of equivalent units
Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
Finished output 8,500 100% 8,500 8,500
Abnormal loss
Materials 500 100% 500
Conversion 60% 300
Expected output 9,000 9,000 8,800

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Statement of cost per equivalent unit

Direct materials Conversion costs

Rs. 27,000 Rs.13,200
Equivalent units ÷ 9,000 ÷ 8,800
Cost per equivalent unit Rs. 3 Rs. 1.5

Statement of evaluation

Rs.
Cost of finished goods (8,500  (Rs. 3 + Rs. 1.5)) 38,250
AT A GLANCE

Abnormal loss
Materials (500 units  Rs. 3) 1,500
Conversion (300 units  Rs. 1.5) 450
1,950

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Direct materials 10,000 27,000 Finished goods 8,500 38,250
SPOTLIGHT

Abnormal loss 500 1,950

Conversion costs - 13,200 Normal loss 1,000 nil
10,000 40,200 10,000 40,200

7.3. Equivalent units and abnormal gain part-way through the process
The same principles apply to the valuation of abnormal gain where the loss/gain occurs part-way through the
process. However, there is one important difference. Equivalent units of abnormal gain are given a negative value
and are subtracted from the total equivalent units of output in the period.
Perhaps the easiest way to think of the reason for this is that abnormal gain is on the opposite side of the process
STIKCY NOTES

account (the debit side) from actual finished output (credit side) and abnormal gain equivalent units are
subtracted because they offset the cost of the finished output.
 Example 25:
Abnormal gain part-way through a process
The following information relates to a production process X.

Input quantities 6,000 units

Normal loss 10%
Therefore expected output 5,400 units
Actual output 5,600 units
Therefore abnormal gain 200 units

Direct materials are added in full at the beginning of the process, and loss occurs 40% of the
way through the process.

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The costs incurred in the period were: Rs.

Direct materials 27,000
Converison costs: 11,040

Statement of equivalent units

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 5,600 100% 5,600 5,600
Abnormal gain (200)

AT A GLANCE
Materials 100% (200)
Conversion 40% (80)
Expected output 5,400 5,400 5,520

Statement of cost per equivalent unit

Direct materials Conversion costs

Rs. 27,000 Rs.11,040
Equivalent units ÷ 5,400 ÷ 5,520
Cost per equivalent unit Rs. 5 Rs. 2

SPOTLIGHT
Statement of evaluation

Cost of finished goods (5,600  (Rs. 5 + Rs. 2)) 39,200

Cost of abnormal gain
Materials (200 units  Rs. 5) 1,000
Conversion (80 units  Rs. 2) 160
1,160

These costs would be recorded in the process account as follows.

STIKCY NOTES
Process (WIP) account
units Rs. units Rs.
Direct materials 6,000 27,000 Finished goods 5,600 39,200
Conversion costs - 11,040
Abnormal gain 200 1,160 Normal loss 600 nil
6,200 39,200 6,200 39,200

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8. JOINT PRODUCTS AND BY-PRODUCTS

8.1. Definition of joint products
In some process manufacturing systems, two or more different products are produced. Joint product costs can
be defined as:
 Joint products are two or more products generated simultaneously, by a single manufacturing process
using common input, and being substantially equal in value
Until the joint products are produced in the manufacturing process, they cannot be distinguished from each
other. The same input materials and processing operation produces all the joint products together.
Each joint product has a substantial sale value relative to each other joint product.
AT A GLANCE

 For example:
The refining of crude oil produces a series of products fuel oil, gasoline, and kerosene. Domestic
animals are grown for food and their hides are turned into leather.

8.2. Apportioning common processing costs between joint products

The costs of the common process that produces the joint products are common costs. In order to calculate a cost
for each joint product, these common costs must be shared (apportioned) between the joint products. The
common costs of the process must be apportioned between the joint products on a fair basis, in much the same
way that overhead costs are apportioned between cost centers.
One of the following three methods of apportionment is normally used:
 Units basis: Common costs are apportioned on the basis of the total number of units produced. The cost per
SPOTLIGHT

unit is the same for all the joint products. (This is also described as the physical quantities basis).
 Sales value at the split-off point basis: Common costs are apportioned on the basis of the sales value of the
joint products produced, at the point where they are separated in the process (the ‘split off point’).
 Net realizable value (sales value less further processing costs basis: Common costs are apportioned on
the basis of their eventual sales value after they have gone through further processing to get them ready for
sale.

 Example 26:
Two joint products JP1 and JP2, are produced from a common process.
During March, 8,000 units of materials were input to the process. Total costs of processing (direct
STIKCY NOTES

materials and conversion costs) were Rs. 135,880.

Output was 5,000 units of JP1 and 3,000 units of JP2.
JP1 has a sales value of Rs. 40 per unit when it is output from the process and can be sold for
Rs.120 per unit after further processing costs of Rs.25 per unit.
JP2 has a sales value of Rs. 55 per unit when it is output from the process and can be sold for
Rs.80 per unit after further processing costs of Rs.15 per unit.
Joint costs can be apportioned in one of the following ways.

Output Units
JP1 5,000
JP2 3,000
8,000

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Costs: Rs.
JP1: 5,000 units/8,000 units  Rs.135,880. 84,925
JP2: 3,000 units/8,000 units  Rs.135,880. 50,955
135,880
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 84,925
JP2 3,000 50,955
8,000 135,880 8,000 135,880

AT A GLANCE
Sales value at point of split off
Sales value Rs.
JP1 (5,000 units  Rs. 40) 200,000
JP2 (3,000 units  Rs. 55) 165,000
365,000
Costs: Rs.
JP1: Rs. 200,000/ Rs. 365,000  Rs.135,880. 74,455
JP2: Rs. 165,000/ Rs. 365,000  Rs.135,880. 61,425
135,880

SPOTLIGHT
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 74,455
JP2 3,000 61,425
8,000 135,880 8,000 135,880
Net realizable value at the point of split off

NRV value Rs.

STIKCY NOTES
JP1 (5,000 units  Rs. 120  Rs. 25) 475,000
JP2 (3,000 units  Rs. 80  Rs. 15) 195,000
670,000
Costs: Rs.
JP1: Rs. 475,000/Rs. 670,000  Rs.135,880. 96,333
JP2: Rs. 195,000/Rs. 670,000  Rs.135,880. 39,547
135,880
These costs would be recorded in the process account as follows.
Process account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 96,333
JP2 3,000 39,547
8,000 135,880 8,000 135,880

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 Example 27:
Physical unit basis
In a joint process, two joint products are made, Product A and Product B. There is no inventory
of work-in-process. Information relating to last month’s production is set out in the table below.

Joint product Opening inventory Closing inventory Sales

units units units
A 800 1,200 8,000
B 700 300 10,000

The costs of the joint process in the month were Rs. 144,000. These are apportioned between
the joint products on the basis of units produced.
AT A GLANCE

The joint processing costs for the month that are charged to each product can be calculated as
follows

Production
units
Joint product A: (1,200 + 8,000 – 800) 8,400
Joint product B: (300 + 10,000 – 700) 9,600
Total production 18,000

Joint processing costs Rs.144,000

SPOTLIGHT

Joint processing costs per unit Rs.8

Apportionment of joint costs Rs.

To Joint product A: (8,400 × Rs.8) 67,200
To Joint product B: (9,600 × Rs.8) 76,800
144,000

8.3. By-products
When two or more different products are produced, any product that does not have a substantial sales value is
STIKCY NOTES

called a by-product.
By products are outputs from a joint process that are relatively minor in quantity and/or value.
A by-product has a small value relative to the joint products but it may have some value.
The proceeds of sale of the by-product can be treated in a number of ways and the method chosen has an
implication for how the by-product is measured in the joint process account.
Possible methods include:

Treatment of proceeds of sale Measurement of by-product in joint process

account
As revenue (adding it to the revenue from sales of No cost is allocated to the by product.
other products).
As other income No cost is allocated to the by product.
As a deduction from joint process costs (this is the By-product is measured at scrap value (the accounting
most commonly used method). treatment is very similar to that used for normal loss).

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Since a by-product does not have any substantial value, there is no sense in charging it with a share of the
common processing costs.
Instead, the sales value of the by-product is usually deducted from the common processing costs (just as for
normal loss). If there are joint products, the common processing costs are apportioned after deducting the sales
value of the by-product from the total costs of the process.
 Example 28:
Two joint products JP1 and JP2, are produced from a common process.
During March, 9,000 units of materials were input to the process. Total costs of processing (direct
materials and conversion costs) were Rs. 135,880.
Output was 5,000 units of JP1 and 3,000 units of JP2 and 1,000 units of by-product BP3.
JP1 has a sales value of Rs. 40 per unit when it is output from the process and can be sold for

AT A GLANCE
Rs.120 per unit after further processing costs of Rs.25 per unit.
JP2 has a sales value of Rs. 55 per unit when it is output from the process and can be sold for
Rs.80 per unit after further processing costs of Rs.15 per unit.
BP3 has a sales value of Rs.1.58 per unit.
The company’s policy is to treat the proceeds of sale of a by-product as a reduction of joint
process costs
Apportionment of the process costs between the joint products on the basis of net realizable sales
value at the split off point, would be as follows.
Net realizable value at the point of split off
Common process costs Rs.

SPOTLIGHT
Total process costs 135,880
Deduct: Sales value of by-product (1,000  Rs.1.58) (1,580)
134,300

NRV value Rs.

JP1 (5,000 units  Rs. 120  Rs. 25) 475,000
JP2 (3,000 units  Rs. 80  Rs. 15) 195,000
670,000

STIKCY NOTES
Costs: Rs.
JP1: Rs. 475,000/Rs. 670,000  Rs. 134,300. 95,213
JP2: Rs. 195,000/Rs. 670,000  Rs. 134,300. 39,087
134,300

These costs would be recorded in the process account as follows.

Process account
units Rs. units Rs.
Processing cost 9,000 135,880 JP1 5,000 95,213
JP2 3,000 39,087
By product 1,000 1,580
9,000 135,880 9,000 135,880

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 Example 29:
Two joint products XX and YY, are produced from a common process.
During July, 11,000 units of materials were input to the process. Total costs of processing (direct
materials and conversion costs) were Rs. 100,000.
Output was 6,000 units of XX and 4,000 units of YY and 1,000 units of by-product Q.
XX has a sales value of Rs. 24 per unit when it is output from the process.
YY has a sales value of Rs. 12 per unit when it is output from the process.
Q has a sales value of Rs.1 per unit
The company’s policy is to apportion joint costs based on sales value at the point of split off.
80% of the output of both XX and YY was sold by the month end.
AT A GLANCE

The proceeds of sale of the by-product could be treated in one of the following ways.
Sales value at point of split off deducting proceeds of sale of the by-product from the joint process
cost (as before)
Sales value Rs.
XX (6,000 units  Rs. 24) 144,000
YY (4,000 units  Rs. 12) 48,000
192,000

By-product deducted from cossts Rs.

XX: Rs. 144,000/ Rs. 192,000  (Rs.100,000  Rs. 1,000) 74,250
SPOTLIGHT

YY: Rs. 48,000/ Rs. 192,000  (Rs.100,000  Rs. 1,000). 24,750

99,000
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Processing cost 11,000 100,000 XX 6,000 74,250
YY 4,000 24,750
Q 1,000 1,000
STIKCY NOTES

11,000 100,000 11,000 100,000

The income statement would show the following:

Rs.
Revenue:
Sales of XX (80%  6,000 units  Rs. 24) 115,200
Sales of YY (80%  4,000 units  Rs. 12) 38,400
153,600
Cost of sales:
Production costs 99,000
Less: Closing inventory (20%  99,000) (19,800)
(79,200)
Profit 74,400

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Sales value at point of split off treating proceeds of sale of the by-product as other income

Sales value Rs.

XX (6,000 units  Rs. 24) 144,000
YY (4,000 units  Rs. 12) 48,000
192,000

By-product deducted from costs Rs.

XX: Rs. 144,000/ Rs. 192,000  Rs.100,000 75,000
YY: Rs. 48,000/ Rs. 192,000  Rs.100,000 25,000
100,000

AT A GLANCE
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Processing cost 11,000 100,000 XX 6,000 75,000
YY 4,000 25,000
Q 1,000 nil
11,000 100,000 11,000 100,000

The income statement would show the following:

SPOTLIGHT
Revenue:
Sales of XX (80%  6,000 units  Rs. 24) 115,200
Sales of YY (80%  4,000 units  Rs. 12) 38,400
153,600

Cost of sales:
Production costs 100,000
Less: Closing inventory (20%  100,000) (20,000)

STIKCY NOTES
(80,000)
Gross profit 73,600
Other income 1,000
Profit 74,600

The profit in the above example is higher than the profit in the previous example by Rs. 200.
This is because the whole sales proceeds from the sale of the by-product has been recognized as
other income.
When the sales proceeds from the sale of the by-product are deducted from the joint process cost
part of that deduction is carried forward to the next period in the valuation of closing inventory.
The deduction in joint process costs was Rs. 1,000 and 80% of the inventory to which it relates
has been sold leaving 20% (Rs. 200) to be carried forward to the next period.

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9. COST OF REWORK
Sometimes the loss incurred in processing is not scrapped but is subject to a further rectification process, this
extra processing cost is referred to as rework.
Rework might be performed on units that are either classified as normal or abnormal loss:

9.1. Normal Rework

The rework cost is charged to the normal processing cost. Rework may involve some material use, labor use
etc. Hence the entry is:

Debit Credit
Process account X
AT A GLANCE

Materials Account X
Direct Labor Account X

9.2. Abnormal Rework

Abnormal rework is not charged to process account so that that it will not appear in future estimates for
similar jobs. It is recorded in a separate loss account:

Debit Credit
Loss from Abnormal Rework account X
Materials account X
SPOTLIGHT

Direct Labor account X

STIKCY NOTES

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10. COMPREHENSIVE EXAMPLES

 Example 01:
XYZ operates several process production systems.
a) For Process 5, the FIFO method of valuing opening work-in-progress is used, and the
following details relate to September Year 5.
Opening work-in-process was 600 units, each 80% processed as to materials and 60%
processed as to conversion costs.
Finished output was 14,500 units. There were no abnormal losses or gains.
Closing work-in-process was 800 units, each 70% processed as to materials and 40%
processed as to conversion costs.

AT A GLANCE
Costs of processing during the current period were:
Materials: Rs. 36,450
Conversion costs: Rs. 17,352.
Calculation for the cost per equivalent unit of output produced during September (=
one unit started and completed during the month), would be as follows
FIFO method

Equivalent units Total Direct materials Conversion costs

Units Equivalent units Equivalent units
Completion of opening WIP 600 (20%) 120 (40%) 240

SPOTLIGHT
Other completed units 13,900 13,900 13,900
14,500 14,020 14,140
Closing inventory 800 (70%) 560 (40%) 320
Total equivalent units 15,300 14,580 14,460
Costs in the current period Rs.36,450 Rs.17,352
Cost per equivalent unit Rs.2.5 Rs.1.2

Cost per equivalent unit of fully completed units in the current period = Rs.2.50 + Rs.1.20 =
Rs.3.70.

STIKCY NOTES
b) The following details relate to Process 16 in September Year 5:

Opening work-in-progress 2,000 litres, fully complete as to materials and 40%

complete as to conversion. The cost of materials in the
opening WIP was Rs.9,860 and conversion costs in the
opening WIP were Rs.4,700.
Material input 24,000 litres, cost Rs.130,540
Conversion costs in the month Rs.82,960
Output to process 2 23,000 litres
Closing work-in-progress 3,000 litres, fully complete as to materials and 45%
complete as to conversion.

The weighted average cost system is used for inventory valuation in Process 16.

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Calculation of the cost per unit of output from this process during September, would be as
follows:
Weighted average cost

Equivalent units Total Direct materials Conversion costs

Total units Equivalent units Equivalent units
Completed units 23,000 23,000 23,000
Closing inventory 3,000 (100%) 3,000 (45%) 1,350
Total equivalent units 26,000 26,000 24,350
Costs: Rs. Rs.
AT A GLANCE

Opening WIP 9,860 4,700

Current period costs 130,540 82,960
Total costs 140,400 87,660
Cost per equivalent unit Rs.5.40 Rs.3.60

Cost per equivalent unit of fully completed units in the current period = Rs.5.40 + Rs.3.60 =
Rs.9.00.
 Example 02:
Yahya Limited produces a single product that passes through three departments, A, B and C.
SPOTLIGHT

The company uses FIFO method for process costing. A review of department A’s cost records
for the month of January 20X4 shows the following details:

Units Material Labor

Rs. Rs.
Work in process inventory as at January 1, 20X4 16,000 64,000 28,000
(75% complete as to conversion costs)
Additional units started in January 20X4 110,000 - -
Material costs incurred - 430,500 -
Labor costs incurred - - 230,000
STIKCY NOTES

Work in process inventory as at January 31, 20X4 18,000 - -

(50% complete as to conversion costs)
Units completed and transferred in January 20X4 100,000 - -

Overhead is applied at the rate of 120% of direct labor. Normal spoilage is 5% of output. The
spoiled units are sold in the market at Rs. 6 per unit.
The required computations for the month of January, are as follows:
a) Equivalent production units.

Material FOH/ Labor

Units Units
Units completed and transferred out 100,000 100,000
Less: Beginning inventory (all units) 16,000 16,000
Started and completed in January 84,000 84,000

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Material FOH/ Labor

Units Units
Beginning inventory (completed in January)
Labor and FOH (25%) 4,000
Closing inventory (completed in January)
Material (100%) 18,000
Labor and FOH (50%) - 9,000
Normal loss (5% of output) 5,000 5,000
Abnormal loss 3,000 3,000
110,000 105,000

AT A GLANCE
b) Costs per unit for material, labor and factory overhead.

Material 430,500-(6*5000) = Rs 3.81

110,000 – 5,000
Labor 230,000 = Rs 2.30
105,000 - 5,000
Factory Overhead Rs. 2.30 x 120% = Rs 2.76
= Rs 8.87

c) Cost of abnormal loss (or gain), closing work in process and the units transferred

SPOTLIGHT
to the next process.

Rupees
Cost of abnormal loss
3,000 units @ Rs.8.87 26,610
Closing work in process
Material (18,000 x Rs. 3.81) 68,580
Labor (18,000 x Rs. 2.30 x 50%) 20,700
FOH (18,000 x Rs. 2.76 x 50%) 24,840

STIKCY NOTES
114,120
Cost of units transferred to next process
From beginning inventory
Beginning Inventory-Already incurred costs
Materials 64,000
Labor 28,000
Factory Overhead (Rs. 28,000 x 120%) 33,600
Beginning Inventory-Costs incurred in January
Labor (16,000 x Rs. 2.30 x 25%) 9,200
FOH (16,000 x Rs. 2.76 x 25% 11,040
units fully produced during the current month (84,000 x Rs. 8.87) 745,080
890,920

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 Example 03:
A chemical is manufactured by passing through two processes X and Y using two types of direct
material, A and B. In process Y, a by-product is also produced which is then transferred to process
Z where it is completed. For the first week of a month, the actual data has been as follows:

Process
X Y Z
Output of main product (kgs) 9,400 8,000
Output of by-product (kgs) 1,400 1,250
Direct material (Rs.) 123,500
- A (9,500 units)
AT A GLANCE

Direct material (kgs) 500 300 20

- B added in process
Direct material (Rs.) 19,500 48,100 1,651
- B added in process
Direct wages (Rs.) 15,000 10,000 500
Scrap value (Rs. per unit) 5 10 6
Normal loss of units in process (%) 4 5 5
The factory overheads are budgeted @ 240% of direct wages and are absorbed on the basis of
direct wages. Actual factory overheads for the week amounted to Rs. 65,000. Estimated sales
value of the by-product at the time of transfer to process Z was Rs. 22 per unit.
SPOTLIGHT

Preparation the required accounts for the given example are as follows
a) Process accounts for X, Y and Z.
Process X A/c
kgs Rs. kgs Rs.
Direct materials – A 9,500 123,500 Normal loss 400 2,000
A/c
Direct material – B 500 19,500 Abnormal loss 200 4,000
A/c
Transfer to
STIKCY NOTES

Direct wages 15,000 process Y 9,400 188,000

Production overheads @ 240%
of direct wages 36,000
10,000 194,000 10,000 194,000

Working:
Cost per unit of good units and abnormal loss units Rupees
Total cost less scrap
(194,000 – 2,000) 192,000
No. of units including abnormal losses
(9,400 + 200) 9,600
Cost per unit (Rs.) 20

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Process Y A/c
kgs Rs. kgs Rs.
Transfer from process X 9,400 188,000 Normal loss A/c 485 4,850
Direct materials – B 300 48,100 Finished goods 8,000 240,000
Direct wages 10,000 Byproduct 1,400 30,800
Production overheads @
240% of direct wages 24,000
9,700 270,100
Abnormal gain A/c 185 5,550

AT A GLANCE
9,885 275,650 9,885 275,650

Working:
Cost per unit of good units and abnormal loss units Rupees
Total cost less scrap and by-product cost (270,100 – 4,850 – 30,800) 234,450
Less: Total No. of units less normal losses and by-product
(9700-485-1400) 7,815
Cost per unit (Rs.) 30

Process Z A/c

SPOTLIGHT
Units Rs. Units Rs.
Input 1,400 30,800 Normal loss A/c 71 426
Abnormal loss
Direct materials – B 20 1,651 A/c 99 2,475
Direct wages 500 Finished goods 1,250 31,250
Production overheads
@ 240% of direct
wages 1,200
1,420 34,151 1,420 34,151

STIKCY NOTES
Working: Cost per unit of good and abnormal loss units Rupees
Total cost less scrap (34,151 – 426) 33,725
No. of units including abnormal losses (1,420 – 71) 1,349
Cost per unit (Rs.) 25

b) Abnormal loss and abnormal gain accounts.

Abnormal Loss A/c
Units Rs. Units Rs.
Process X 200 4,000 Bank Account 200 1,000
Process Z 99 2,475 Bank account 99 594
Costing P & L A/c 4,881
299 6,475 299 6,475

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Abnormal Gain A/c

Units Rs. Units Rs.
Bank A/c / normal loss A/c 185 1,850 Process Y 185 5,550
Costing P & L A/c 3,700
185 5,550 185 5,550

c) Factory overhead account.

Factory overheads A/c
Rs. Rs.
Cash/bank/payables (actual
AT A GLANCE

overheads) 65,000 Charged to process accounts:

Process X 36,000
Process Y 24,000
Process Z 1,200
Cost of goods sold accounts:
Overheads under absorbed 3,800
65,000 65,000

 Example 04:
Smart Processing Limited produces lubricants for industrial machines. Material COX is
introduced at the start of the process in department A and subsequently transferred to
SPOTLIGHT

department B. Normal loss in department A is 5% of the units transferred.

In department B, material COY is added just after inspection which takes place when the
production is 60% complete. 10% of the units processed are evaporated before the inspection
stage. However, no evaporation takes place after adding material COY. During the year, actual
evaporation in department B was 10% higher than the estimated normal losses because of high
level of sulphur contents in natural gas used for processing.
Other details for the year ended December 31, 20X3 are as under:
Department A Department B
Rupees
STIKCY NOTES

Opening work in process 2,184,000 2,080,000

Material input - 600,000 Liters 17,085,000
- 500,000 Liters 9,693,000
Labor 8,821,000 6,389,000
Overheads 2,940,000 3,727,000

Department A Department B
Completion % Completion %
Liters Conversion Liters Conversion
Material Material
costs costs
Opening WIP 64,500 100 60 40,000 100 60
Closing WIP 24,000 100 70 50,000 100 80
Conversion costs are incurred evenly throughout the process in both departments. The
company uses FIFO method for inventory valuation.

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a) Calculations for the equivalent production units, would be

Quantity Schedule (in liters) Dept. A Dept. B

WIP opening 64,500 40,000
Started in process / material added 600,000 500,000
Received from preceding department - 610,000
664,500 1,150,000
Transferred out to B (664,500-24,000)x100/105 610,000 -
Transferred to finished goods (1,150,000-50,000-61,000-6,100) - 1,032,900
WIP closing 24,000 50,000

AT A GLANCE
Normal loss – A (664,500-24,000)x5/105) 30,500 -
Normal loss – B (10% x 610,000) - 61,000
Abnormal loss – B (10% x 61,000) - 6,100
664,500 1,150,000

Equivalent production unit (in liters)

Department A Department B
Material Conversion Material Conversion
Units completed and transferred out 610,000 610,000 1,032,900 1,032,900
Opening Inventory (60% completed) (64,500) (38,700) (40,000) (24,000)

SPOTLIGHT
Abnormal loss (B: 6,100 x 60%) - - - 3,660
Closing inventory (A: 70%, B: 80%) 24,000 16,800 50,000 40,000
569,500 588,100 1,042,900 1,052,560

b) The cost of abnormal loss and closing WIP, would be calculated as:

Department A Department B
Cost of abnormal loss
Quantity Rate Amount Quantity Rate Amount
(Department B)
Units Rs. Rs. Units Rs. Rs.
From department A 6,100 (W-2) 333,044

STIKCY NOTES
(610,000 x 10% x 10%) 54.60
Labor (60%) 3,660 6.07 22,216
Overheads (60%) 3,660 3.54 12,956
- 368,216
WIP-closing costs
From department A - - - 50,000 (W-2) 1,421,000
28.42
Material 24,000 30.00 720,000 50,000 9.29 464,500
Labor (70%, 80%) 16,800 15.00 252,000 40,000 6.07 242,800
Overheads (70%, 80%) 16,800 5.00 84,000 40,000 3.54 141,600
1,056,000 2,269,900

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c) For the cost of finished goods produced, calculations would be as follows

Rupees
Total costs charged to department (W-1) 51,863,000
Less: WIP closing costs (Computed above) (2,269,900)
Less: Cost of abnormal loss (Computed above) (368,216)
Costs transferred to finished goods 49,224,884

W-1: Cost charged to department:

Department A Department B
AT A GLANCE

Equivalent Cost Unit cost Equivalent Cost Unit cost

Units (Rs.) (Rs.) Units (Rs.) (Rs.)
WIP - opening 2,184,000 2,080,000
inventory
Cost from 29,974,000
department A
Material 569,500 17,085,000 30.00 1,042,900 9,693,000 9.29
Labor 588,100 8,821,000 15.00 1,052,560 6,389,000 6.07
Overheads 588,100 2,940,000 5.00 1,052,560 3,727,000 3.54
SPOTLIGHT

Total cost to 31,030,000 50.00 51,863,000 18.90

be accounted
for

W-2: Allocation of cost received from department A:

Quantity Amount (Rs.) Unit cost (Rs.)
Units received from A 610,000
Normal loss at 10% (61,000)
STIKCY NOTES

549,000 *29,974,000 54.60

Abnormal loss at 1% (6,100) (333,044) 54.60
Units after inspection 542,900 29,640,956 54.60
Addition of material COY 500,000
1,042,900 29,640,956 28.42
*Rs. 31,030,000 (Total cost) – Rs. 1,056,000 (Closing WIP) = Rs. 29,974,000

 Example 05:
Hornbill Limited (HL) produces certain chemicals for textile industry. The company has three
production departments. All materials are introduced at the beginning of the process in
Department-A and subsequently transferred to Department-B. Any loss in Department-B is
considered as a normal loss.
The following information has been extracted from the records of HL for Department-B for the
month of August 20X3:

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Department B
Opening work in process (Liters) Nil
Closing work in process (Liters) 10,500
Units transferred from Department-A (Liters) 55,000
Units transferred to Department-C (Liters) 39,500
Labor (Rupees) 27,520
Factory overhead (Rupees) 15,480
Materials from Department-A were transferred at the cost of Rs. 1.80 per liter.
The degree of completion of work in process in terms of costs originating in Department-B was
as follows:

AT A GLANCE
WIP Completion %
50% units 40%
20% units 30%
30% units 24.5%

(Tip: Treat the costs transferred from department A in the same way as material costs
introduced at the start of the department B process and treat department B costs in the same
way as conversion costs).

Preliminary working: Units

Opening WIP 0

SPOTLIGHT
Input (previous process) 55,000
Total possible units 55,000
Actual good output (39,500)
Closing WIP (10,500)
Normal loss (as specified in the question) 5,000

a) For the given examples, Statement of equivalent units would be:

Statement of equivalent units

Equivalent units

STIKCY NOTES
Output Total Percentage Materials Department
units complete (input from B costs
Dept. A)
Finished output 39,500 100% 39,500 39,500
Closing WIP:
Materials 10,500 100% 10,500
Dept. B costs 50%  40% 2,100
Dept. B costs 20%  30% 630
Dept. B costs 30%  24.5% 770
3,500
55,000 50,000 43,000

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b) Statement of Statement of cost per equivalent unit

Materials
Department
(input from
B costs
Dept. A)
Total costs:
Input from department A (55,000 units  Rs. 1.8) Rs.99,000
Department B costs (27,520 + 15,480) Rs. 43,000
Equivalent units (÷) 50,000 4,300
Cost per equivalent unit Rs.1.98 Rs.1.00

c) Statement of evaluation of units would be

AT A GLANCE

Rs.
Cost of finished goods (39,500  (Rs. 1.98 + Rs. 1.00)) 117,710
Cost of closing WIP
Materials (10,500 units  Rs. 1.98) 20,790
Conversion (3,500 units  Rs. 1.00) 3,500
24,290

d) Process WIP would be accounted for as follows:

Process (WIP) account
SPOTLIGHT

units Rs. units Rs.

Transfers 55,000 99,000 Finished goods 39,500 117,710
from A (transfer to C)
Labour 27,520 Normal loss 5,000 
Overhead 15,480 Closing WIP 10,500 24,290
55,000 142,000 55,000 142,000

 Example 06:
Fowl Limited (FL) manufactures two joint products X and Y from a single production process.
STIKCY NOTES

Raw material Benz is added at the beginning of the process. Inspection is performed when the
units are 50% complete. Expected loss from rejection is estimated at 10% of the tested units.
Following details are available for the month of May 20X3:

Units Material Conversion cost

(Rs.) (Rs.)
Opening work in process 15,000 90,000 25,000
Transferred to finished goods:
− Product- X 50,000 547,125 228,875
− Product- Y 25,000
Loss due to rejection 12,500 - -
Closing work in process 10,000 - -

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Additional information:
i. Opening and closing work in process are 75% complete.
ii. The normal loss is sold as scrap at the rate of Rs. 1.50 per unit.
iii. Production costs are allocated to joint products on the basis of weight of output.
iv. The company uses weighted average method for inventory valuation.
When required to prepare departmental statements for equivalent units and its cost, preliminary
working for the month would be as follows:

Preliminary working) Units

Opening WIP 15,000

AT A GLANCE
Input 82,500
Expected good output 97,500
Actual good output
Product X (50,000)
Product Y (25,000)
Closing WIP (10,000)
Loss 12,500

Normal loss: Opening WIP is 75% complete and must have been tested in the previous period.

SPOTLIGHT
Therefore, normal loss is on input units only (82,500 × 10%) = 8,250 units
Abnormal loss units (12,500  8,250) = 4,250 units

Statement of equivalent units

Equivalent units
Total Percentage
Output Direct Conversion
units complete
materials costs
Finished output
Product X 50,000 100% 50,000 50,000

STIKCY NOTES
Product Y 25,000 100% 25,000 25,000
100%
Closing WIP: 10,000
Materials 100% 10,000
Conversion 75% 7,500
Abnormal loss 4,250
Materials 100% 4,250
Conversion 50% 2,125
89,250 89,250 84,625

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Statement of cost per equivalent unit Direct Conversion

materials costs
Total costs Rs. Rs.
Costs in opening WIP 90,000 25,000
Costs in the period 547,125 228,875
Expected scrap recovery of normal loss (8,250 units  Rs. 1.5) (12,375)
624,750 253,875
Equivalent units ÷ 89,250 ÷ 84,625
Cost per equivalent unit 7 3
AT A GLANCE

Statement of evaluation Rs.

Cost of finished goods
Product X (50,000  (Rs. 7 + Rs. 3)) 500,000
Product Y (25,000  (Rs. 7 + Rs. 3)) 250,000
Cost of closing WIP
Materials (10,000 units  Rs. 7) 70,000
Conversion (7,500 units  Rs. 3) 22,500
SPOTLIGHT

92,500
Abnormal loss
Materials (4,250 units  Rs. 7) 29,750
Conversion (2,125 units  Rs. 3) 6,375
36,125

Process (WIP) account

STIKCY NOTES

units Rs. units Rs.

Opening WIP 15,000 115,000 Finished goods
Direct materials 82,500 547,125 Product X 50,000 500,000
Conversion costs - 228,875 Product Y 25,000 250,000
Normal loss 8,250 12,375
Abnormal loss 4,250 36,125
Closing WIP 10,000 92,500
97,500 891,000 97,500 891,000

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 Example 07:
Platinum Limited (PL) manufactures two joint products Alpha and Beta and a by-product Zeta
from a single production process. Following information is available from PL’s records for the
month of February 20X4:

Direct material 25,000 kg. @ Rs. 25 per kg.

Direct labor @ Rs. 15 per hour Rs. 432,000
Normal process loss 20% of the material consumed
Overheads are allocated to the products at the rate of Rs. 10 per direct labor hour. The normal
loss is sold as scrap at the rate of Rs. 8 per kg.
Following data relates to the output from the process:

AT A GLANCE
Product Output ratio Selling price per kg. (Rs.)
Alpha 75% 95.0
Beta 15% 175.0
Zeta 10% 52.5

Alpha is further processed at a cost of Rs. 30 per unit, before being sold in the market. Joint
costs are allocated on the basis of net realizable value.
a) Computation of the total manufacturing costs for February 20X4 would be as follows.

Total cost of output: Kg. Rupees

SPOTLIGHT
Direct material [25,000 x Rs. 25] 25,000 625,000
Direct Labor 432,000
Overheads [ 432,000 / Rs. 15 x Rs. 10] 288,000
1,345,000
Less: Sale of scrap [ 25,000 x 20% x Rs. 8] (5,000) (40,000)
Total cost of products 20,000 1,305,000

b) And the calculation for the profit per kg for Alpha, Beta would be as follows:

STIKCY NOTES
Profit per kg of Alpha and Beta: Rupees
Joint costs of products 1,305,000
Less: Sale of Zeta [20,000 x 10% x Rs. 52.5] (105,000)
1,200,000

Output NRV at Joint cost Total Profit

Product Kg. Total NRV
% split-off allocation profit per Kg.
Alpha 15,000 75% 95-30=65 975,000 780,000 195,000 13
Beta 3,000 15% 175 525,000 420,000 105,000 35
18,000 1,500,000 1,200,000

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 Example 08:
Oceanic Chemicals manufactures two joint products Sigma and Beta in a single process at its
production department. Incidental to the production of these products, it produces a by-product
known as ZEE. Sigma and ZEE are sold upon completion of processing in production department
whereas Beta goes to refining department where it is converted into Theta.
Joint costs are allocated to Sigma and Beta on the basis of their net realizable values. Proceeds
from sale of by-product are treated as reduction in joint costs. In both the departments, losses up
to 5% of the input are considered as a normal loss.
Actual data for the month of June 2015:

Department
Production Refining
AT A GLANCE

Cost ------ Rs. in '000 ------

Material input at Rs. 50 per kg 3,000 -
Direct labor at Rs. 100 per hour 2,500 350
Production overheads 1,850 890

Output ---------- Liters----------

Sigma 34,800 -
Beta 16,055 -
ZEE (by-product) 5,845 -
SPOTLIGHT

Theta - 15,200

Sigma, Theta and by-product ZEE were sold at Rs. 300, Rs. 500 and Rs. 40 per liter respectively.
There was no work in process at the beginning and the end of the month.
The cost per liter of Sigma and Theta, for the month of June 2015 would require following
calculations:

Oceanic Chemicals Sigma Theta

Product-wise cost of Sigma and Theta ----------- Rs. in '000’ -----------
Joint costs of production W.2 4,303.49 2770.98
STIKCY NOTES

Cost of refining (350+890) - 1,240.00

(A) 4,303.49 4,010.98
No. of units produced Liter. (B) 34,800 15,252
Cost per Liter Rs. (A÷B) 123.66 262.98

W.1: Joint cost of production Rs. in '000’

Joint cost of production (3,000+2,500+1,850) 7,350.00
Sale proceeds from by-product ZEE (5,84540) (233.80)
7116.20
Cost of abnormal loss of production [7,116.20÷(34,800+16,055+300)300] (41.73)
7,074.47

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NRV at Units Total Joint cost

W.2: Allocation of joint costs split-off produced NRV allocation
Rs. Liters -------- Rs. in '000 --------
Sigma 300.00 34,800 10,440.00 4,303.49
Beta 500-[(350+890)÷15,252)] 418.70 16,055 6,722.23 2,770.98
17,162.23 7,074.47

Production Refining
W.3: Abnormal loss quantity
---------- Liters ----------

AT A GLANCE
Input quantity 3,000,000÷50 60,000 16,055
Output quantity (34,800+16,055+5,845) (56,700) (15,200)
Production losses 3,300 855
Normal losses up to 5% of input (60,000×5%), (16,055×5%) 3,000 803
Abnormal loss 300 52

 Example 09:
Ababeel Foods produces and sells chicken nuggets. Boneless chicken is minced, spiced up, cut to
standard size and semi-cooked in the cooking department. Semi-cooked pieces are then frozen

SPOTLIGHT
and packed for shipping in the finishing department.
Inspection is carried out when the process in the cooking department is 80% complete. Normal
loss is 5% of input and comprises of:
2% weight loss due to cooking; and
3% rejection of nuggets. The rejected nuggets are sold at Rs. 60 per kg.
Overheads are applied at the rate of 120% of direct labor cost. Inventory is valued using weighted
average cost. Following information pertains to cooking department for the month of June 2014:

Kg. Material Labor

STIKCY NOTES
----- Rs. in ‘000 -----
Opening work in progress (100% complete to 30,000 6,260 1,288
material and 50% complete to conversion)
Costs for the month 420,000 50,000 20,000
Weight after cooking 440,000 - -
Transferred to finishing department 362,000 - -
Closing work in progress (100% complete to material 65,000 - -
and 65% complete to conversion)

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 CHAPTER 8: PROCESS COSTING CAF 8: CMA

Preparation of the process account for cooking department for the month of June 2014 would
be as follows.

Ababeel Foods
Cooking department production and cost for June 2014
Process account - Cooking department
Kg. Rs. in '000' Kg. Rs. in '000'
Opening WIP 30,000 (W-2)9,094 Normal loss:
Material 420,000 50,000  weight loss (W.1) 7,700 -
Labor 20,000  rejection (W.1) 11,550 693
AT A GLANCE

Overheads 24,000 Abnormal loss:

(20,000*1.2)
 weight loss (W.1) 2,300
 rejection (W.1) 1,450
(W.2) 3,750 829
Transferred out (W.2) 362,000 88,328
Closing WIP (W.2) 65,000 13,244
450,000 103,094 450,000 103,094
SPOTLIGHT

W-1: Normal and abnormal Total loss Normal loss (Cooking Abnormal
losses: loss at 2% & rejection loss
loss at 3% of input) (Balancing)
Kg.
Weight loss:
Opening WIP 30,000
Input for the month 420,000
450,000
STIKCY NOTES

Transferred to finishing
department (362,000)
Closing WIP
(65,000)
Total loss 23,000
Weight loss (450,000-440,000) 10,000 (450,000- 7,700 2,300
65,000)×2%
Rejection loss (balancing) 13,000 (450,000- 1,550 1,450
65,000)×3%
23,000 19,250 3,750

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W-2: Cost and equivalent Material Conv. Total cost

quantity: cost cost
Rs. in '000'
Opening WIP 1,288*2.2 6,260 2,834 9,094
Cost added 20,000*2.2 50,000 44,000 94,000
Normal rejection valued @ Rs. 60 11,550*60 (693) - (693)
per kg
Total cost (A) 55,567 46,834 102,401
Rupees
Cost per kg. (A×1,000)÷(B) 129.0 115.0 244.0

AT A GLANCE
Equivalent kg. Total cost
Material Conv. (Rs. in ‘000)
Finished goods 362,000 362,000 88,328
Closing WIP (100% to material and 65% to conv.) 65,000 42,250 13,244
Total abnormal loss 3,750 3,000 829
(100% to material and 80% to conv.)
Total equivalent quantity and cost (B) 430,750 407,250 102,401

 Example 10:

SPOTLIGHT
Cricket Chemicals Limited (CCL) is a manufacturing concern and has two production processes.
Process I produces two joint products i.e. X-1 and X-2. Incidental to the production of joint
products, it produces a by-product known as Zee. X-1 is further processed in process II and
converted into ‘X1-Plus’.
Following information has been extracted from the budget for the year ending 31 August 2019:
i. Process wise budgeted cost:
Process I Process II
-------------- Rupees ------------
Direct material (500,000 liters) 98,750,000 -

STIKCY NOTES
Conversion cost 72,610,000 19,100,000
ii. Expected output ratio from process I and budgeted selling prices:
Products Output ratio in process I Selling price (Rs. per liter)
Joint product – X-1 55% -
Joint product – X-2 40% 532
By-product – Zee 5% 120
X1-Plus - 768

Additional information:
i. Material is added at the beginning of the process and CCL uses 'weighted average
method' for inventory valuation.
ii. Joint costs are allocated on the basis of net realizable value of the joint products at the
split-off point. Proceeds from the sale of by-product are treated as reduction in joint
costs.

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iii. Joint product X-2 is sold after incurring packing cost of Rs. 75 per liter.
iv. Normal production loss in process I is estimated at 5% of the input which occurs at
beginning of the process. Loss of each liter results in a solid waste of 0.7 kg which is sold
for Rs. 10 per kg. No loss occurs during process II.
v. Budgeted conversion cost of process I and process II include fixed factory overheads
amounting to Rs. 7,261,000 and Rs. 3,820,000 respectively.
a) Preparation of product wise budgeted income statement for the year ending 31 August 2019,
under marginal costing is given below

Cricket Chemicals Limited

Product wise budgeted income statement X1 - Plus X2
- (Marginal costing) ---- Rs. in million ----
AT A GLANCE

Sales [768×261,250 (W-4)], [532×190,000(W-4)] 200.64 101.08

Variable production cost:
Joint cost (W-1) (108.96) (52.11)
Process II Conversion cost (19.10m–3.82m) (15.28) -
Packing cost (75×190,000) - (14.25)
Budgeted contribution margin 76.40 34.72
Fixed cost:
Joint cost (W-1) (4.91) (2.35)
Process II conversion cost (3.82) -
SPOTLIGHT

Budgeted profit 67.67 32.37

Total budgeted profit 100.04

W-1: Allocation of joint cost on the basis of NRV

Joint NRV at Production Total NRV Joint cost Fixed Variable
products split-off point (Units) (A×B) allocation on NRV cost (D) joint cost
(Rs. per unit) (B) basis (C) (C–D)
(A) ---------------------- Rs. in million ----------------------
X1 694.89 261,250 181.54 113.87 4.91 108.96
STIKCY NOTES

768–73.11 (W-4) (168.33×181.5/ (7.26×181.54/

(W-3) 268.37) 268.37)
X2 457.00 190,000 86.83 54.46 2.35 52.11
(532–75) (W-4) (168.3×86.83/ (7.26×86.83/
268.37) 268.37) (W-1)
268.37 (W-2)168.33 7.26 161.07

W-2: Joint cost - Process I Rs. in million

Direct material 98.75
Conversion cost 72.61
Proceeds from By product - Zee (23,750 (W-4)×120) (2.85)
Proceeds from sale of normal loss (25,000(W-4)×0.7kg×10) (0.18)
Total joint cost 168.33

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W-3: Conversion cost -

Process II (Rs. per unit) [19,100,000 / 261,250 (W-4)] 73.11

Process I
W-4: Quantity schedule
--- Liters ---
Input quantity 500,000
Joint product - X-1 (500,000–25,000)×55% (261,250)
Joint product - X-2 (500,000–25,000)×40% (190,000)
By product – Zee (500,000–25,000)×5% (23,750)
Normal loss (500,000×5%) (25,000)

AT A GLANCE
b) CCL has recently received an offer from Football Industries Limited (FIL) to purchase the
entire expected output of X-1 during the year ending 31 August 2019 at Rs. 670 per litter. It
is estimated that if process II is not carried out, fixed costs associated with it would reduce
by Rs. 2,500,000. Advise whether FIL’s offer may be accepted.
Evaluation of offer from FIL Rs. in million
Loss of revenue if offer is accepted {261,250 (W-4) ×(768–670)} (25.60)
Variable cost saved in process-II (19.10m – 3.82m) 15.28
Fixed cost saved 2.50
(Decrease)/Increase in budgeted profits (7.82)
Conclusion: Offer should not be accepted

SPOTLIGHT
 Example 11:
Production at Platinum Chemicals (PC) involves two processes I and II. Following information
pertains to the month of August 2017:
i. Actual cost:
Process I Process II
--------- Rupees ---------
Direct material (12,000 liters) 5,748,000 -
Conversion 2,610,000 1,542,000
ii. Production and sales

STIKCY NOTES
Process I Process II
Description Remarks
------ Liters ------
Products:
Joint product – J101 5,000 - Sold for Rs. 1,200 per liter after
incurring packing cost of Rs. 120 per
liter
Joint product – J202 4,500 - Transferred to process II for
conversion into a new product J-plus
By-product – BP01 1,000 - Sold at the split-off point for Rs. 500
per liter
J-plus - 3,400 Sold for Rs. 1,400 per liter
Work-in-process:
Opening - -
Closing - 650 70% complete as to conversion

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iii. Materials are introduced at the beginning of process I and PC uses 'weighted average
method' for inventory valuation.
iv. Proceeds from sale of by-product are treated as reduction in joint costs. Joint costs are
allocated on the basis of net realizable values of the joint products at split-off point.
v. Normal production losses in both processes are estimated at 10% of the input and are
incurred at beginning of the process. Loss of each liter in process I results in a solid waste
of 0.8 kg which is sold for Rs. 100 per kg. Loss of process II has no sale value.
a) The cost of sales of J101 and J-plus for the month of August 2017, would be
calculated as follow:

Platinum Chemicals
Cost of sales for the month of August 2017 - J101 J-plus
AT A GLANCE

Product J101 and J-plus

Quantity sold Liters. 5,000 3,400
-------------- Rupees --------------
Allocated joint costs from process I (W-1) 4,147,792 -
3,456,494(W-1)÷(3,400+650)×3,400 - 2,901,748
Process II – Conversion cost (3,400×400) - 1,360,000
Packing cost (5,000×120) 600,000 -
4,747,792 4,261,748

W-1: Allocation of joint cost - Process I (on the basis of NRV)

SPOTLIGHT

Joint product NRV per unit at Units Total NRV Joint cost
split-off produced allocation
------- Rs. ------- Liters ------- Rupees -------
J101 (1,200-120) 1,080 5,000 4,147,792
5,400,000
J202 [1,400- 1,000 4,500 4,500,000 3,456,494
400(W-3)]
(W-2)
9,900,000 7,604,286
STIKCY NOTES

W-2: Joint costs - Process I Rupees

Direct material 5,748,000
Proceeds from sale of solid waste - normal loss 1,200 (W-4)×80%×100 (96,000)
Proceeds from sale of by-product BP01 1,000(W-4)×500 (500,000)
5,152,000
Cost of abnormal loss 5,152,000×300÷9,800 (157,714)
Conversion cost 2,610,000
Cost allocation between joint products J101 and J202 7,604,286
W-3: Conversion cost per unit - Process II Rupees
Conversion cost of process II A 1,542,000
Equivalent units 3,400(W-4)+(650×0.7) B 3,855
Cost per unit (A÷B) C 400

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Process I Process II
W-4: Normal and abnormal losses quantity
--------- Liters ---------
Input quantity 12,000 4,500
Less: J101 (5,000) -
J202 – Transfer to process II (4,500)
By-product BP01 (1,000) -
J-plus - (3,400)
Closing work in process (70% conversion) - (650)
Normal loss - 10% of input (12,000×10%); (1,200) (450)
(4,500×10%)

AT A GLANCE
Abnormal loss 300 -

b) For the given example, accounting entries to record production gains/losses and
their ultimate disposal, are as follows.

Journal entries to record production and disposal of solid waste

Debit Credit
Date Description
-------- Rupees --------
30-Aug-2017 Solid waste inventory (normal loss at sale 96,000
price) (W-2)
Solid waste inventory (abnormal loss at cost) 157,714

SPOTLIGHT
(W-2)
WIP - Process I 253,714
(Normal losses at sale price and abnormal
losses at cost credited to WIP)
30-Aug-2017 Bank (1,200+300)×0.8×100 120,000
Profit and loss account Balancing 133,714
Solid waste inventory 253,714
(Sale of normal and abnormal solid waste)

 Example 12:

STIKCY NOTES
Bela Enterprises (BE) produces a chemical that requires two separate processes for its
completion. Following information pertains to process II for the month of August 2016:
kg Rs. in '000
Opening work in process (85% to conversion) 5,000 2,000
Costs for the month:
Received from process I 30,000 18,000
Material added in process II 15,000 10,000
Conversion cost incurred in process II - 11,000
Finished goods transferred to warehouse 40,000 -
Closing work in process (60% to conversion) 4,000 -
In process II, material is added at start of the process and conversion costs are incurred evenly
throughout the process. Process losses are determined on inspection which is carried out on 80%
completion of the process. Process loss is estimated at 10% of the inspected quantity and is sold
for Rs. 100 per kg.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 241

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BE uses FIFO method for inventory valuation.

a) A statement of equivalent production units, would be prepared as follows:

Equivalent units Quantity

schedule
Statement of equivalent units: Material Conversion
------------------- kg -------------------
Opening WIP (85% to conversion) (5,000) (4,250) 5,000
Received from process I 30,000
Material added in process II 15,000
50,000
AT A GLANCE

Transferred to finished goods 40,000 40,000 40,000

Goods started and completed during the A 35,000 35,750
month
Closing WIP (60% to conversion) B 4,000 2,400 4,000
Normal loss at 10% 4,100
(50,0005,0004,000)×10%
Abnormal loss (80% conversion) C 1,900 1,520 1,900
(Balancing)
D 40,900 39,670 50,000
SPOTLIGHT

b) Computation of costs would be as follows

Material Conversion Total

Cost per unit ---------- Rs. in ‘000 ----------
Opening WIP - - 2,000
Cost for the month: Process I 18,000 - 18,000
Process II 10,000 11,000 21,000
Normal loss quantity at sale price (4,100×100) (410) - (410)
STIKCY NOTES

Total cost E 27,590 11,000 40,590

----------------- Rupees -----------------
Cost per unit F=(E÷D) 674.57 277.29

(i) Cost of finished goods: --------------- Rs. in ‘000 -------------

Opening WIP 2,000
Cost for the month A×F 23,610 9,913 33,523
35,523
(ii) Cost of closing WIP B×F 2,698 666 3,364
(iii) Cost of abnormal loss C×F 1,282 x421 1,703

242 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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c) Accounting entries to account for production losses for the month would be as follows

Accounting entries to account for production losses:

Debit Credit
Date Description
--- Rs. in '000 ---
1 Scrap inventory (normal loss quantity) 4,100×100 410
WIP – II 410
(Normal loss quantity credited to WIP at sales value)
2 Scrap inventory (abnormal loss quantity) 1,900×100 190
Profit and loss account (Balancing) 1,513

AT A GLANCE
WIP – II As (iii) above 1,703
(Loss on abnormal loss quantity debited to profit and
loss account)

 Example 13:
KS Limited operates two production departments A and B to produce a product XP-29.
Following information pertains to Department A for the month of December 2014.
Liters Rs. in '000
Opening work in process (Material 100%, conversion 80%) 15,000
 Material 5,000

SPOTLIGHT
 Direct labor and overheads 2,125
Actual cost for the month:
 Material 120,000 36,240
 Overheads 14,224
 Direct labor 11,500
Expected losses 5%
Closing work in process (Material 100%, conversion 80%) 17,000
Units transferred to Department B 110,000

KS uses FIFO method for inventory valuation. Direct materials are added at the beginning of the

STIKCY NOTES
process. Expected losses are identified at the time of inspection which takes place at the end of
the process. Overheads are applied at the rate of 80% of direct labor cost.
a) Equivalent production units

KS Limited
Equivalent production: Material Conversion
------------ Liters ------------
Units completed and transferred out 110,000 110,000
Closing WIP (100% material and 80% 17,000 13,600
conversion)
Opening WIP (100% material and 80% (15,000) (12,000)
conversion)
Abnormal loss W.1 2,100 2,100
Equivalent production (A) 114,100 113,700

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 243

 CHAPTER 8: PROCESS COSTING CAF 8: CMA

Cost per liter: ---------- Rupees ----------

Cost incurred in December 2014 (B) 36,240,000 25,603,200
(14,224,000×1.8)
Cost per liter (B÷A) 317.62 225.18
b) Cost of goods transferred to Department B

Rs. in '000
From opening WIP:
- Cost incurred prior to 1 Dec. 2014 5,000+2,125 7,125
- Conversion cost incurred in Dec. 2014 15,000×20%×225.18 676
7,801
AT A GLANCE

From units started and completed in Dec. 2014 51,566

[(110,000-15,000)×(317.62+225.18)]
59,367

W.1: Abnormal loss Liters

Opening WIP 15,000
Units started in December 2014 120,000
Closing WIP (17,000)
Units completed in December 2014 118,000
Transferred to department B (110,000)
SPOTLIGHT

Normal loss 118,000 × 5% (5,900)

Abnormal loss 2,100
c) Accounting entries for the month of December 2014 are as follows

Date Description Debit Credit

Rs. in '000
31-Dec-14 WIP - Department A 61,843
Raw material 36,240
Payroll 14,224
STIKCY NOTES

Applied overheads 14,224×80% 11,379

(Cost charged / overheads applied to department
A)
31-Dec-14 Applied overheads 11,379
Cost of sale (under applied overheads) 121
Overhead control account 11,500
(Under-absorbed overheads charged to P&L
account)
31-Dec-14 WIP - Department B 59,367
P&L account (abnormal loss) 1,140
[2,100×(317.62+225.18)]
WIP - Department A 60,507
(Units transferred to B and abnormal loss charged
to department B and P&L account respectively)

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 Example 14:
Quality Chemicals (QC) produces one of its products through two processes A and B. Following
information has been extracted from the records of process A for the month of January 2016.

Quantity Material Conversion

Units --------Rs. In ‘000’-------
Opening work in process 5,000 2,713 1,499
Input during the month 20,000 10,000 5,760
Transferred to process B 18,000 - -
Closing work in process 6,000 - -

AT A GLANCE
Additional information:
i. Materials are introduced at the beginning of the process. In respect of conversion,
opening and closing work in process inventories were 40% and 60% complete,
respectively.
ii. Inspection is performed when the units are 50% complete. Expected rejection is
estimated at 5% of the inspected units. The rejected units are not processed further and
sold at Rs. 100 per unit.
iii. QC uses 'weighted average method' for inventory valuation.
a) Computation of equivalent production units and cost per unit, would require

Process A - production and cost for the Quantity Equivalent

SPOTLIGHT
month of January 2016 units
Equivalent units under weighted average schedule Material Conv.
method:
-------------- No. of units --------------
Opening WIP (40% to conversion) 5,000
Input for the month 20,000
A 25,000
Transferred to process B 18,000 18,000 18,000
Closing WIP (60% to conversion) 6,000 6,000 3,600

STIKCY NOTES
Normal loss-5% of the inspected units 1,250 - -
(A5%)
Abnormal gain (50% to conv.) (Bal.) (250) (250) (125)
Normal equivalent units B 25,000 23,750 21,475
Cost per unit: ------ Rs. in '000 ------
Opening WIP 2,713 1,499
Cost for the month 10,000 5,760
Scrapped units at sale price 1,250100 (125) -
C 12,588 7,259
Cost per unit C÷B 530 338

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b) Journal entries to record the above transactions would be as follows

Accounting entries
Date Description Debit Credit
--- Rs. in '000 ---
1 WIP - Process A 15,760
Raw material 10,000
Labor and overheads 5,760
(Material, labor and overheads charged to Process
A)
2 WIP - Process A (250530)+(125338) 175
AT A GLANCE

OR (250530)+(250169)
Abnormal gain 175
(To record abnormal gain)
3 Scrapped units 1,250100 125
WIP - Process A 125
(Sales value of rejected units credited to WIP)
4 WIP - Process B 15,624
18,000×(530+338)
WIP - Process A 15,624
(Goods completed transferred to Process B)
SPOTLIGHT

5 Abnormal gain 175

(250×530)+(125×338)
Scrapped units 250100 25
Profit or loss account 150
(Abnormal gain adjusted to profit or loss account)
 Example 15:
Ravi Limited (RL) is engaged in production of industrial goods. It receives orders from steel
manufactures and follows job order costing. The following information pertains to an order
received on 1 December 2016 for 6,000 units of a product:
STIKCY NOTES

Production details for the month of December 2016:

Units
Produced and transferred to finished goods 3,200
Delivered to the buyer from the finished goods 3,000
Units rejected during inspection 120
Closing work in process (100% material and 80% conversion) 680

Actual expenses for the month of December 2016:

Rupees
Direct material 1,140,000
Direct labor (6,320 hours) 948,000
Factory overheads 800,000

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Additional information:
 Factory overheads are applied at Rs. 120 per hour. Under/over applied factory
overheads are charged to profit and loss account.
 Units completed are inspected and transferred to finished goods. Normal rejection is
estimated at 10% of the units transferred to finished goods. The rejected units are sold
as scrap at Rs. 150 per unit.
 RL uses weighted average method for inventory valuation.
a) Work in process for the month of December 2016 would be

WIP
Description Units Rupees Description Units Rupees

AT A GLANCE
Raw material W.1 4,000 1,140,000 Finished goods 3,200 2,490,336
(A) [3,200×778.23 (W-2)]
Direct labor 948,000 Norm al loss 320 48,000
(320×150)
Applied overheads 758,400 Closing WIP *(Bal.) 680 463,710
(6,320×120)
Abnormal gain 200 155,646
[200×(778.23)]
4,200 3,002,046 4,200 3,002,046
*(680×296.74)+(544×481.49)

SPOTLIGHT
Equivalent units
W-1: Equivalent units and costs applied to Quantity Material Conversion
the job schedule
Transferred to finished goods 3,200 3,200 3,200
Closing WIP 680×80% 680 680 544
Normal loss at 10% of the units completed 320
3,200×10%
4,200

STIKCY NOTES
Abnormal gain 120–320 (200) (200) (200)
Normal production A 4,000 3,680 3,544

W-2: Cost per unit ----------- Rupees -----------

Raw material 1,140,000
Direct labor - 948,000
Applied overheads 6,320×120 - 758,400
Normal loss - sales price 320×150 (48,000)
B 1,092,000 1,706,400
(B÷A) 296.74 481.49
778.23

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b) Accounting entries to record over/under applied overheads and production loss/gains

Date Description Debit Credit -

--------- Rupee ---------
31-Dec 2016 Factory overhead applied (6,320×120) 758,400
P& L account–overheads under applied 41,600
Factory overheads control 800,000
(Transfer of applied factory overheads to
control a/c and under applied overheads
charged to P&L account)
31-Dec 2016 WIP (200×778.23) 155,64 6
AT A GLANCE

Abnormal gain 155,646

(To record abnormal gain)
31-Dec2016 Scrap inventory (320×150) 48,000
WIP 48,000
(Sales value of rejected units credited to
WIP)
31-Dec2016 Abnormal gain (200×778.23) 155,646
Scrap inventory (320- 120)×150 30,000
P&L account 125,646
SPOTLIGHT

(Abnormal gain adjusted to P&L account)

 Example 16:
Tulip Enterprises (TE) manufactures a product Alpha that requires two separate processes, A
and B. Following information has been extracted from the cost records of Process B for the month
of February 2019:
Quantity Process A Process B cost
cost
Material Conversion
Liters ------------------Rs. In ‘000’----------------
Opening work-in-process – Process B 10,000 1,500 600 400
STIKCY NOTES

(80% complete as to conversion)

Cost for the month:
- Received from process A 90,000 14,000 - -
- Added during process B 12,000 - 7,000 5,600
Closing work-in-process – Process B 9,500 - - -
(70% complete as to conversion)

Additional information:
i. Materials are added at start of the process.
ii. Normal loss is estimated at 5% of the input. Loss is determined at completion of the
process. Loss of each liter results in a solid waste of 0.75 kg. During the month of
February 2019, solid waste produced was 6,000 kg.
iii. Solid waste is sold for Rs. 170 per kg after incurring further cost of Rs. 20 per kg.
iv. TE uses weighted average method for valuation of inventory.

248 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Accounting entries to record the transactions of process B are as follows (Narrations to

accounting entries are not required)
Accounting entries for Process B
Date Description Debit Credit
------ Rs. in '000 ------
1 WIP - Process B 26,600
WIP - Process A 14,000
Raw material 7,000
Labor and overheads 5,600

AT A GLANCE
2 Scrapped inventory (Normal loss) [C×0.75×170] 653
Bank [C×0.75×20] 77
WIP - Process B (Normal loss) (W-1) 576
3 Scrapped inventory (Abnormal loss) 367
[D×0.75×170]
Profit or loss account 448
Balancing
Bank [D×0.75×20] 43
WIP - Process B (Abnormal loss) (D×H) 772

SPOTLIGHT
4 Finished goods (E×H) 25,366
WIP - Process B 25,366

W-1: Equivalent production and cost per liter - Weighted average method
Quantity Equivalent units
Schedule
Material Conversion
------------------ Liters ------------------
Opening WIP (80% complete as to 10,000

STIKCY NOTES
conversion)
Input for the Process A 90,000
month -
Process B 12,000
Total input A 112,000
Closing WIP (70% complete B 9,500 9,500 6,650
as to conversion)
Normal loss (A–B)×5% C 5,125 - -
Abnormal loss D 2,875 2,875 2,875
[(6,000÷0.75)–C]
Transferred to finished E 94,500 94,500 94,500
goods Balancing
F 112,000 106,875 104,025

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Process A & Process B

material conversion
costs costs
------ Rs. in '000 ------
Opening WIP Process A 1,500
Process B 600 400
Cost for the Process A 14,000
month
Process B 7,000 5,600
Scrapped inventory (Recovery from normal scrapped (576)
units) (C×0.75)×(170–20)
AT A GLANCE

Total cost G 22,524 6,000

Rupees
G÷F×1,000 210.74 57.68
Total - Cost per liter H
268.42
SPOTLIGHT
STIKCY NOTES

250 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 8: PROCESS COSTING

STICKY NOTES

Process costing is used where production is a continuous process, the output

of one process will be input to the next until a finished product is being
produced

Losses may occur in process. If a certain level of loss is expected this is called
normal loss. If losses are greater than expected the difference is abnormal
loss and if losses are less than normal the difference is known as abnormal
gain

AT A GLANCE
Scrap value of normal loss to be deducted from the cost of materials before
cost per equivalent unit is calculated. Units of normal loss are valued at their
scrap vale in the process account

Abnormal loss and gains have no concern with the cost of goods units of
production. The scrap value of the abnormal losses is not credited to the
process account, and abnormal loss and gain units carry the same full cost as
a good unit of production

SPOTLIGHT
When units are partly completed at the end of a period (closing WIP) it is
necessary to calculate the equivalent units of production in order to
determine the cost of a completed unit

There are two methods to deal with opening work in progress i.e. FIFO and
weighted average cost method.

STIKCY NOTES
In the weighted average method, no distinction is made between units of
opening stock and new units introduced to the process during the period. The
cost of opening stock is added to costs incurred during the period and units of
opening stock are each given a value of one full equivalent unit off production

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 CHAPTER 8: PROCESS COSTING CAF 8: CMA

If there is opening and closing WIP, losses during the process and the loss has
no scrap value the following rules should be followed.
 Costs should be divided between finished output, closing stock and
abnormal loss/gain using equivalent units as a basis of apportionment
 Units of abnormal loss / gain are often taken to be one full equivalent unit
each, and are valued on this basis
 Abnormal loss units are an addition to the total equivalent units produced
but abnormal gain units are subtracted in arriving at the total number of
equivalent units produced
AT A GLANCE

When loss has a scrap value and the equivalent units are a different
percentage of the total units for materials, labor and overheads, it is
conventional that the scrap value of normal loss is deducted from the cost of
materials before a cost per equivalent unit is calculated

If units are rejected as scrap or loss at an inspection stage before the

completion of processing, units of abnormal loss should count as a proportion
of an equivalent unit, according to the volume of work done and materials
added up to the point of inspection
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 9

BUDGETING

AT A GLANCE
IN THIS CHAPTER
Forecasting refers to the use of historic data to determine
AT A GLANCE
the direction of future trends for which various qualitative

AT A GLANCE
SPOTLIGHT
and quantitative methods are used.

1. Introduction to forecasting A Budget is a quantitative estimation of costs, revenues

and resources of an entity for a defined period of time.
2. Basics of budgeting
Companies use budgeting and forecasting as tools to
3. Types of budgets determine allocation of resources for an upcoming period
of time.
4. Approaches to budgeting
Both forecasting and budgeting, although distinct, but
5. Budgeting in Non-Profit their use and their dependency on each other make them
organisations inseparable. Tus the has implications for business

SPOTLIGHT
decisions.
6. Human and motivational aspects
of budgeting

7. Comprehensive Examples

STICKY NOTES

STIKCY NOTES

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 CHAPTER 9: budgeting CAF 8: CMA

1. INTRODUCTION TO FORECASTING
1.1 Forecasting
Forecasting refers to the use of historic data to determine the direction of future trends. Companies use
forecasting as a tool to determine how to allocate their budgets for an upcoming period of time. Investors utilize
forecasting as a measure to determine if events affecting a company (e.g. sales expectations) will increase or
decrease the price of shares in that company. Forecasting also provides an important benchmark for firms which
have a long-term perspective of operations. All financial forecasts, whether about the specifics of a business, like
sales growth, or predictions about the economy as a whole, are informed guesses.

1.2 Types of forecasts

There are three major types of forecasts, which many businesses rely on:
AT A GLANCE

 Demand (Sales) forecast: Demand or sales forecasts are fundamental to a company’s planning and control
decisions. They give the expected level of demand for the company’s products or services through some
future periods. In the case of manufacturing companies demand forecasts form the basis of the production
levels.
 Economic forecast: Economic forecasts involve such matters as future state of the economy; inflation
rates etc. and have a profound influence on the success of future business activities.
 Technological forecast: Technological forecasts usually focus on the rate of technological progress or the
nature of technological developments in areas related to the business and technology.

1.3 Forecasting methods: Qualitative methods

There are a number of different methods by which a business forecast can be made. All the methods fall into one
SPOTLIGHT

of two primary approaches: qualitative and quantitative.

Qualitative methods
The qualitative method is based on human judgement and opinions. It is a subjective and non-mathematical
approach. It can incorporate well the latest changes in the environment but its being subjective can bias the
forecast and reduce the forecast accuracy. Qualitative models have mostly been successful with short-term
predictions, but this approach faces limitations due to its reliance on opinion over measurable data.

Qualitative models include:

 Market Research: uses surveys & interviews to identify customer preferences. This method is especially
STIKCY NOTES

useful where the industry serves a limited market. Based on the future needs of the customers a general
overall forecast for the demand can be made. For example, a market survey would be like

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 Jury of Executive opinion: It involves small group of high-level managers. The group participates in
generating new ideas by working together wherein the managerial experience is combined with statistical
models.
 Delphi Method: It is basically a more formal version of the jury of opinion method. A panel of experts is
given a situation and asked to make initial predictions, on the basis of a prescribed questionnaire, these
experts develop written opinions. These responses are analyzed and summarized and submitted back to
the panel for further considerations. All these responses are anonymous so that no member is influenced
by others’ opinions. This process is repeated until a consensus is obtained.
 Estimates of the sales force: The sales people being closer to consumers can estimate future sales in their
own territories more accurately. Based on these and the opinions of sales managers, reasonable trends of
the future sales can be calculated. These forecasts are good for short range planning since sales people are
not sufficiently sophisticated to predict long-term trends.

AT A GLANCE
1.4 Forecasting methods: Quantitative methods
Quantitative model is based on mathematical modelling and attempts at trying to take the human element out of
the analysis. These models are concerned merely with the data and avoid the uncertainty of subjectivity. The
consistency and objectivity enable this approach to consider much information and data at one time.
Quantitative models include time series models and causal models.

1.4.1. Time Series Models:

These models are based on the assumption that all information needed is contained in the time series of data.
Further it assumes that the future will follow the same pattern as the past. Time-series methods use time as
independent variable to produce demand. In a time, series, measurements are taken at successive point in time
or over successive periods. Some forecast models used to forecast the level of a time series are as follows:

SPOTLIGHT
Trend Projections:
Trend: is an important characteristic of time series models. Trends show gradual upward and downward
movement of data over time. Although time series may display trend, there might be data points lying above or
below trend line.
Cyclic Component: Any recurring sequence of points above and below the trend line that lasts for more than a
year is considered to constitute the cyclical component of the time series—that is, these observations in the time
series deviate from the trend due to fluctuations.
Seasonal Component: The component of the time series that captures the variability in the data due to seasonal
fluctuations is called the seasonal component. The seasonal component is similar to the cyclical component in

STIKCY NOTES
that they both refer to some regular fluctuations in a time series. Seasonal components capture the regular
pattern of variability in the time series within one-year periods. Seasonal commodities are best examples for
seasonal components.
Irregular Component: Random variations in times series is represented by the irregular component. The
irregular component of the time series cannot be predicted in advance. The random variations in the time series
are caused by short-term, unanticipated and nonrecurring factors that affect the time series.
Moving Averages
Averaging methods are appropriate when a time series displays no significant effects of trend, cyclical, or
seasonal components. In such a case, the goal is to smooth out the irregular component of the time series by using
an averaging process. The moving averages method is the most widely used smoothing technique. In this method,
the forecast is the average of the last “x” number of observations, where “x” is some suitable number. Eg. The
average of last three months of sales.

∑ 𝐃𝐞𝐦𝐚𝐧𝐝 𝐢𝐧 𝐏𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐧 𝐩𝐞𝐫𝐢𝐨𝐝𝐬

Equation: Moving Average = 𝐧

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 Example 01:
You are a manager of a museum store that sells historical replicas. You are required to forecast
sales (’000) for 20X5 using a 3 period moving average.

Year Output (’000 of units) Moving Total Moving Average

20X0 4 --- ---
20X1 6 --- ---
20X2 5 --- ---
20X3 3 4+6+5 = 15 15/3 = 5.0
20X4 7 6+5+3 = 14 14/3 = 4.7
AT A GLANCE

20X5 NA 5+3+7 = 15 15/3 = 5.0

Averaging methods further include weighted averages and weighted moving averages method.
Naïve approach:
Naïve approach assumes demand in next period is the same as demand in the most recent period, e.g. if June sales
were Rs. 48,000, then July sales would also be Rs. 48,000.
 Example 02:

Period Actual Demand Rs. (000’s) Forecast Rs. (000’s)

January 46
SPOTLIGHT

February 60 46
March 72 60
April 58 72
May 40 58
June 40

1.4.2. Causal Models:

Causal methods use the cause-and-effect relationship between the variable whose future value is being
STIKCY NOTES

forecasted and other related variables or factors. A simple causal model is linear regression in which a straight-
line relationship is modelled between the variable we are forecasting and another variable in the environment.
The correlation is used to measure the strength of the linear relationship between these two variables.
Linear regression method:
Regression analysis is a statistical technique used to develop a mathematical model that shows how a set of
variables are related. This mathematical relationship can be used to generate forecasts. The variable that is being
forecasted is called the dependent variable and the variable or variables that help in forecasting the values of the
dependent variable are called the independent variables. Regression analysis that uses one dependent variable
and one independent variable and estimates the relationship between these two variables by a straight line is
called a simple linear regression.
Scatter Plots: The first step in regression is to plot your data on a scatter plot. The following table lists the monthly
sales and advertising expenditures for all the months of the last year by a digital electronics company.

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Month Sales Advertising

Rs. ‘000 Rs. ‘000
January 100 5.5
February 110 5.8
March 112 6
April 115 5.9
May 117 6.2
June 116 6.3

AT A GLANCE
July 118 6.5
August 120 6.6
September 121 6.4
October 120 6.5
November 117 6.7
December 123 6.8

In this case, you would plot last year's data for monthly sales and advertising expenditures as shown on the
scatter plot below. (Data for independent and dependent variables must be from the same period of time.)

SPOTLIGHT
Sales Rs. '000

130

125

120

115

110

STIKCY NOTES
105

100
5 5.5 6 6.5 7 7.5 8
Advertising Rs. '000

This scatter plot represents the historical relationship between an independent variable, shown on the x-axis,
and a dependent variable, shown on the y-axis.
Regression Line: The figure below is the same as the scatter plot above, with the addition of a regression line
fitted to the historical data.

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 CHAPTER 9: budgeting CAF 8: CMA

Sales Rs. '000

130

125

120

115

110

105
AT A GLANCE

100
5 5.5 6 6.5 7 7.5 8
Advertising Rs. '000

The regression line is the line with the smallest possible set of distances between itself and each data point. As
you can see, the regression line touches some data points, but not others. The distances of the data points from
the regression line are called error terms.
The extension of the line of regression requires the assumption that the underlying process causing the
relationship between the two variables is valid beyond the range of the sample data. Regression is a powerful
business tool due to its ability to predict future relationships between variables such as these.
Equation of a Regression Line: You may recall the equation of a straight line from your review of the Linear
Functions topic in the Algebra section of the course on Quantitative methods.
SPOTLIGHT

y = a + bx
Variables, constants, and coefficients are represented in the equation of a line as
 x represents the independent variable
 y represents the dependent variable
 the constant a denotes the y-intercept—this will be the value of the dependent variable if the independent
variable is equal to zero, this represent the component value of y that is independent of x.
 the coefficient b describes the movement in the dependent variable as a result of a given movement in the
independent variable
STIKCY NOTES

 Formula:

Given a number of pairs of data, a line of best fit (y = a + bx) can be constructed by calculating values for a and
b using the following formulae:
∑y b∑x
a= −
n n
𝑛 𝑥𝑦 − 𝑥 ∑ 𝑦
∑ ∑
𝑏=
𝑛 ∑ 𝑥 2 − (∑ 𝑥)2
Where:
x, y = values of pairs of data.
n= the number of pairs of values for x and y.
= A sign meaning the sum of. (The capital of the Greek letter sigma).
Note: the term b must be calculated first as it is used in calculating a.

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Method
 Set out the pairs of data in two columns, with one column for the values of x and the second column for the
associated values of y. (For example, x for output and y for total cost.
 Set up a column for x², calculate the square of each value of x and enter the value in the x² column.
 Set up a column for xy and for each pair of data, multiply x by y and enter the value in the xy column.
 Sum each column.
 Enter the values into the formulae and solve for b and then a. (It must be in this order as you need b to find
a).
The concept of predictability is an important one in business. Common business uses for linear regression
include forecasting sales and estimating future investment returns.
Forecasting

AT A GLANCE
Once the equation of the line of best fit is derived, it can be used to make forecasts of impact of changes in x on
the value of y.
 Example 03:
A company has recorded the following output levels and associated costs in the past six
months:

Month Output (000 of units) Total cost (Rs m)

January 6.8 42.3
February 8.7 48.1
March 9.2 50.7

SPOTLIGHT
April 7.1 42.6
May 7.5 46.5
June 8.5 48.2

In order to construct the equation of a line that is of best fit for this data, please see below

Working: x Y x2 xy
January 6.8 42.3 46.24 287.64
February 8.7 48.1 75.69 418.47

STIKCY NOTES
March 9.2 50.7 84.64 466.44
April 7.1 42.6 50.41 302.46
May 7.5 46.5 56.25 348.75
June 8.5 48.2 72.25 409.7
47.8 278.4 385.48 2233.46
= x = y = x2 = xy

n ∑ xy − ∑ x ∑ y 6(2233.46) − (47.8)(278.4)
b= =
n ∑ x 2 − (∑ x)2 6(385.48) − (47.8)2
13400.76 − 13307.52 93.24
= = = 3.325
2312.88 − 2284.84 28.04

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This is the cost in millions of rupees of making 1,000 units)

∑y b∑x 278.4 3.325(47.8)
a= − a= −
n n 6 6
a = 46.4 − 26.49 = 19.91
Line of best fit: 𝑦 = 𝑎 + 𝑏𝑥
𝑦 = 19.91 + 3.325𝑥

 Example 04:
The records of direct labor hours and total factory overheads of IMI Limited over first six months
of its operations are given below:
AT A GLANCE

Direct labor Hours in 000 Total factory Overheads Rs. in 000

September 20X9 50 14,800
October 20X9 80 17,000
November 20X9 120 23,800
December 20X9 40 11,900
January 20X0 100 22,100
February 20X0 60 16,150

The management is interested in distinguishing between the fixed and variable portion of the
SPOTLIGHT

overhead and using the least square regression method, it is required to estimate the variable
cost per direct labor hour and the total fixed cost per month.
Both variable and fixed costs are calculated using regression analysis as follows:

Direct labor Overheads

(xy) (x2)
Hours (x) (y)

September 20X9 50 14,800 740,000 2,500

October 20X9 80 17,000 1,360,000 6,400
STIKCY NOTES

November 20X9 120 23,800 2,856,000 14,400

December 20X9 40 11,900 476,000 1,600
January 20X0 100 22,100 2,210,000 10,000
February 20X0 60 16,150 969,000 3,600
450 105,750 8,611,000 38,500

n( xy) - ( x)( y) 6 x 8,611,000- 450x 105,750

b (Variable cost per unit)    143.1053
n( x 2 )  (  x )2 6 (38,500)- (450)2

( y)  b(  x) (105,750- 143.11(450))
a (Fixed costs per month)    6,892
n 6

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 Example 05:
Linear regression analysis
A company has estimated the following linear regression line to describe the relationship
between its output and costs:
𝒚 = 𝟏𝟗. 𝟗𝟏 + 𝟑. 𝟑𝟐𝟓𝒙
(Where x is in thousands and y is millions of rupees).
What costs would be expected for output of 3,000 units and 10,000 units? Using the equation,
as follows the predicted costs would be $29.885 and $ 53.16
𝑦 = 19.91 + 3.325𝑥
3,000 units 𝑦 = 19.91 + 3.325(3) = 29.885

AT A GLANCE
10,000 units 𝑦 = 19.91 + 3.325(10) = 53.16

SPOTLIGHT
STIKCY NOTES

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2. BASICS OF BUDGETING
2.1 Introduction to budgets
A budget is a quantitative estimation of costs, revenues and resources of an entity for a defined period of time.
Budgeting has always been part of the activities of any business organization as it helps the business in better
understanding of its business environment to navigate its position and direction.
Budgets help organizations to plan in advance about what resources they shall need and the time when such
resources will be required. This helps the management to have a better understanding of resources to be
arranged and managed, resulting in a smooth flow of operations and avoiding unfavorable surprises.

2.2 Forecasting vs. budgeting

AT A GLANCE

Budgeting and Forecasting are two important constituents of managerial decision making process. To avoid
crises in the business, managers and owners make use of two essential tools – forecasting and budgeting.
Budgeting refers to preparing a list of guidelines for expenditures for future and it is usually done a year in
advance. It is used as a benchmark in analyzing the financial health of a business, whereas forecasting uses
accumulated historical data to predict financial outcomes for future months or years.
Even though both of these functions are distinct and are not same but their use and their dependency on each
other make them inseparable and thus many confuse the two as same and use them interchangeably. Let’s
understand the technical difference between these two.

Forecasting Budgeting
Forecasts are statements of probable events. Budgets relate to planned events.
SPOTLIGHT

Forecast is only a tentative estimate. Budget is a target fixed for a period.

Forecasting results in planning. Planning results in budgeting.
Forecasting does not act as a tool to control. Budgets serves as controlling tools.

Let’s understand the difference between a forecast and a budget with the help of an example.
At the start of a financial period, a company expected to produce 200,000 units at the end of first quarter.
Information gathered at the end of the first month in the quarter revealed that labor’s learning rate was faster
than expected and thus they have become more efficient and effective. If the process keeps its current pace as
experienced in the first month then it is expected that at the end of the quarter the output would be 230,000.
In this example, 200,000 is the budgeted figure. This is the amount which the management established before
STIKCY NOTES

starting production. During the production process however based on month end information it is predicted that
output will be 230,000. This is the forecast amount which has been forecasted based on the latest information.
And now this forecast will be used to prepare a revised budget to see its effect on different aspects.

2.3 Purposes of budgeting

Budgeting serves various purposes in an organization. Few purposes of budgets are as follows:
 Planning: is an important and integral part of any organization. Planning helps organizations set targets
for the upcoming period so that everyone across the organization can work towards the achievement of
such targets. An organization without a plan is just like a football team in the ground without a goal post.
Budgets assist an organization in the planning process as through the formulation of budget an
organization has a plan in hand about quantity of goods that they shall be producing and the number of
units that will be sold etc. A properly structured planning process provides a suitable opportunity for the
company to analyze its environment and how its business strategy fits with the same.

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 Control: Performance cannot be measured and reviewed without giving targets at first place. Budgets
when compared to actual results help in controlling the performance so that factors which might hinder
the attainment of objectives can be identified. Managers are held accountable for controlling costs and
revenues of their departments and they are asked to take remedial actions in case of discrepancies. There
is no point in setting targets if actual performance is not compared with them. Likewise, there is no point
in controlling actual performance if targets are not set before hand to compare.
 Decision making: One of the key purposes of management accounting is to provide information useful for
decision making. Budgeting is important for decision making as it gives business a sense of direction, an
estimation of revenues, cost and resources. From where these resources will be arranged and where they
are consumed.
For instance, a company sets an objective to increase profits by 10% over five years’ term. Sales, production
and purchases budgets are set up and cash requirements are also stated accordingly. Cash budget shows
negative balance over next four months. Now here decision has to be made on how to make up for this

AT A GLANCE
deficiency. Either money has to be borrowed or asset has to be sold. A decision is required here so overall
objectives are not affected. Thus, budgeting serves as a guiding post illuminating the pitfalls that the
company might encounter in trying to achieve its objectives.
 Resource allocation: is an area of conflict amongst departmental managers. They often complain that
resources assigned to them are not enough for the requirements. While preparing budgets, needs of each
department are evaluated and resources are assigned to them accordingly. This process is usually
performed with the participation of managers, however, in case of disagreements the decision is imposed.
Organizations want to ensure that resources have been utilized to the maximum and reduce wastage of
resources to the minimum. Because strategic level has got better understanding on the availability of
resources and needs of each department, and it is the responsibility of the strategic management to make
fair allocation of the available resources. There is a strong possibility that manager may not be satisfied
with what they get but their grievances can be reduced by negotiations and counselling.

SPOTLIGHT
 Coordination and communication: Each employee in the organization wants to know what he or she is
supposed to do. Budgets form a key to communicate organization’s goals to its employees in monetary
form. If an employee has been told that organization wants to increase shareholders’ wealth, then he must
ask what he has to do in order to increase it. Then budgets translate it and define them their task.
An organization is often divided into many departments and divisions but the activities of these
departments are somehow dependent on each other. The system cannot work properly without proper
coordination and communication amongst these departments. If sales department doesn’t coordinate with
production department then customers’ orders might not be met. The situation gets even worse when
production department is out of stock because purchasing department did not know the quantity of
material that has to be purchased. So while preparing budgets all department managers are required to
coordinate and are assigned their responsibilities. The budgeting exercise serves as the occasion when the

STIKCY NOTES
roles and responsibilities of each department are defined and communicated.

2.4 Stages in the budgeting process

Important terminologies that may need to be understood for the budgeting process are as follows:
Budget committee is a team comprising of senior level management and heads of departments that approves
budgets and reviews the performance on periodic basis. It is not necessary that they are the ones who prepare
budget. They have the responsibility to ensure that the objectives have been embedded into the budgets.
Budget manual is a document to provide useful information on how budgets will be prepared, how they are
presented, to whom they are presented and when. It sets out the responsibilities of person connected with the
budgets.
Budget period is time frame for which budget is prepared and used.
Planning Department is responsible for developing the budget after consulting with other departments and
functions and the approval of the budget committee. In larger organizations, there might be a separate planning
department, however, in smaller organizations the process may be delegated to the finance department in
addition to their day-to-day activities.

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Stages
 Communicating details of budget policy: First step is to communicate policies and manual to those
responsible for preparation of budgets. Objectives and long term goals must be communicated to them.
They must know the basis on which goals have been set.
 Identify principal budget factor: Principal budget factor refers to the resource that is restricted in supply,
therefore before planning for the entire organization, budgeting is required for the Principal Budget Factor.
For instance, if material is limited in supply so it has to identify how many kilograms of material can be
available. On the basis of its availability production quantity will be determined and sales will then be
calculated.
 Preparation of budgets: If all resources are in full supply, sales budget will be prepared first and the on
basis of sales remaining budgets will be prepared including production, labor, and overheads budgets.
 Final acceptance: After all negotiation and documentation, budgets will be presented in front of budget
AT A GLANCE

committee for final approval. If there are any objections raised, necessary amendments will be made
accordingly. Once budget has been improved, responsibilities are assigned to departmental managers to
achieve targets mentioned in budgets.
 Ongoing review of budgets: The process is not ended up here. Periodic review is necessary so that
managers must be focused and do not take budgets for granted. Performance should be compared with
actual results on periodic basis and deviations from the budgets both negative and positive are investigated

2.5 Budgeting for profitability

Planning and budgeting process for profit aids companies to forecast profit and loss from the expected expenses
and revenues. Targeted sales and estimated costs are matched with the desired profit in order to analyze
financial implications. This means that companies would benefit from setting profit objectives or forecast profits
based on expected operations. Usually, profit objectives are set and then sales and operational planning is done
SPOTLIGHT

while at other times planning phase leads to projected profits decisions.

STIKCY NOTES

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3. TYPES OF BUDGETS
3.1 Sales budget
Sales budget is the first and basic component of master budget and it shows the expected number of sales units
of a period and the expected price per unit. If there is no restriction of resources, sales budget is the foundation
of all other budgets, since all expenditure is ultimately dependent upon volume of sales.
 Illustration:
An extract from a sample sales budget is as under:
Product A B C D
No. of units 45,000 54,000 20,000 60,000
Selling price per unit (Rs.) 45 40 65 80

AT A GLANCE
Total Sales (Rs.) 2,025,000 2,160,000 1,300,000 4,800,000

3.2 Production budget

Production budget is a schedule showing planned production in units which must be made by a manufacturer
during a specific period to meet the expected demand for sales and the planned finished goods inventory.
Normally the production budget lags the sales budget by one month. Eg. Stocks to be sold in May will be produced
in April, however, this is dependent on production scheduling and storage needs.
 Illustration:
A sample of production budget is as under:
Product A B C D

SPOTLIGHT
Budgeted Sales (Qty) 45,000 54,000 20,000 60,000
Budgeted Closing inventory (Qty) 5,000 10,000 2,500 8,000
Total Production Required 50,000 64,000 22,500 68,000
Less: Opening Inventory (3,000) (5,000) - (2,500)
Products to be Manufactured 47,000 59,000 22,500 65,500

3.3 Direct materials budget

Direct material purchases budget shows budgeted beginning and ending direct material inventory, the quantity
of direct material that will be used in production, the amount of direct material that must be purchased and its

STIKCY NOTES
cost during a specific period. This forms the basis of the procurement plan.
 Illustration:
Direct materials budget
A sample of direct Material Purchases Budget is mentioned as under:
Product A B C D
Budgeted Production Units 47,000 59,000 22,500 65,500
Material Required / Unit (Kg) 3.00 4.50 8.00 4.00
Material Required for Production (Kg) 141,000 265,500 180,000 262,000
Budgeted Closing Material (Kg) 12,000 15,000 20,000 40,000
Budgeting Opening Material (Kg) (4,500) (6,000) (12,000) (22,000)
Budgeted Material Purchases (kg) 148,500 274,500 188,000 280,000
Cost / Kg 2.5 3.5 2.1 4
Budgeted Purchases (Rs.) 371,250 960,750 394,800 1,120,000

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3.4 Direct labor budget

Direct labor budget shows the total direct labor cost and number of direct labor hours needed for production. It
helps the management to plan its labor force requirements. This serves as the basis of recruitment plan.
 Illustration:
A sample Direct Labor Budget is as follows:

Product A B C D
Budgeted Production Units 47,000 59,000 22,500 65,500
Budgeted Labor / Unit (Hrs.) 1.50 2.50 3.00 1.00
Budgeted Labor Hours 70,500 147,500 67,500 65,500
AT A GLANCE

Cost / Labor Hour (Rs.) 8 8 8 8

Budgeted Direct Labor Cost (Rs.) 564,000 1,180,000 540,000 524,000

3.5 Manufacturing overhead budget

The factory overhead budget shows all the planned manufacturing costs which are needed to produce the
budgeted production level of a period, other than direct costs which are already covered under direct material
budget and direct labor budget.
 Illustration:
A sample of the overhead budgets is as under:

Product A B C D
SPOTLIGHT

Budgeted Production Units 47,000 59,000 22,500 65,500

Variable OH / Unit (Rs.) 2.00 1.80 2.40 0.56
Total Variable OH (Rs.) 94,000 106,200 54,000 36,680
Allocated Fixed OH (Rs.) 65,000 25,000 35,000 84,500
Budgeted Direct Labor Cost (Rs.) 159,000 131,200 89,000 121,180

 Example 06:
Following data is available from the production records of Flamingo Limited (FL) for the
quarter ended 30 June 20X1.
STIKCY NOTES

Rupees
Direct material 120,000
Direct labor @ Rs. 4 per hour 75,000
Variable overhead 70,000
Fixed overhead 45,000
The management’s projection for the quarter ended 30 September 20X1 is as follows:
i. Increase in production by 10%.
ii. Reduction in labor hour rate by 25%.
iii. Decrease in production efficiency by 4%.
iv. No change in the purchase price and consumption per unit of direct material.
Variable overheads are allocated to production on the basis of direct labor hours.

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Preparation of a production cost budget for the quarter ended 30 September 20X1, would be as
follows
Actual (30-06-20X1) Budget (30-09-20X1)
Production Cost Budget
Rupees
Direct material cost 120,000 132,000
Direct labor cost (W-1) 75,000 64,350
Prime Cost 195,000 196,350
Production Overhead:
Variable 70,000 80,080
Fixed 45,000 45,000
Total cost 310,000 321,430

AT A GLANCE
W-1:
The labor hours will increase by 10%. Also there will be increase in labor hours as production
efficiency has decreased by 4%. Therefore, increased total labor hours will be:
110 104
(75,000  4)  18,750    21,450
100 100
Rate is decreased to Rs. 3. Therefore, direct labor cost will be 21,450 x 3 = Rs. 64,350.

3.6 Ending finished goods inventory budget

The ending finished goods inventory budget calculates the cost of the finished goods inventory at the end of every
budget period. It also includes the unit quantity of finished goods at the end of every budget period; the real basis
of this information is the production budget. The principal aim of inventory budget is to provide for the amount

SPOTLIGHT
of the inventory asset that appears in the budgeted balance sheet. When a company needs to closely monitor its
fund balances on an ongoing basis, the ending finished goods inventory budget should be reviewed on a regular
basis.
The ending finished goods inventory budget contains an itemization of three major costs that are required to be
included in the inventory asset in the balance sheet. These costs are:
 Direct materials: The cost of materials per unit (as listed in the direct materials budget), multiplied by the
number of ending units in inventory (as listed in the production budget).
 Direct labor: The direct labor cost per unit (as listed in the direct labor budget), multiplied by the number
of ending units in inventory (as listed in the production budget).
 Overheads: The amount of overhead cost per unit (as listed in the manufacturing overhead budget),

STIKCY NOTES
multiplied by the number of ending units in inventory (as listed in the production budget).
 Illustration
XYZ Corporation sells a product “S” and has derived its main cost components. Its ending
finished goods inventory budget would be as follows:
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Cost per unit:
Direct materials cost Rs.12.50 Rs.12.50 Rs.12.75 Rs.12.75
Direct labor cost 4.00 4.50 4.50 4.50
Manufacturing Overhead cost 6.50 6.50 6.50 6.75
Total cost per unit Rs.23.00 Rs.23.50 Rs.23.75 Rs.24.00
Ending finished goods units 8,000 12,000 10,000 9,000
x Total cost per unit Rs.23.00 Rs.23.50 Rs.23.75 Rs.24.00
= Ending finished goods inventory Rs.184,000 Rs.282,000 Rs.237,500 Rs.216,000

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3.7 Cost of goods manufactured budget

Cost of goods manufactured is the cost incurred to manufacture the finished goods and includes elements of all
the costs including material, purchases and manufacturing overheads.
The cost of goods manufactured budget outlines the total budgeted cost of units manufactured for a period.
 Illustration:

Product A B C D
Direct Material Purchases 371,250 960,750 394,800 1,120,000
Opening Direct Material 11,250 21,000 25,200 88,000
Closing Direct Material (30,000) (52,500) (42,000) (160,000)
AT A GLANCE

Direct Material Cost 352,500 929,250 378,000 1,048,000

Direct Labor Cost 564,000 1,180,000 540,000 524,000
Manufacturing Overhead 159,000 131,200 89,000 121,180
Budgeted Cost of Goods manufactured 1,075,500 2,240,450 1,007,000 1,693,180

3.8 Cost of goods sold budget

Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold.
The cost of goods sold budget outlines the total budgeted cost of units sold for a period. Once the cost of goods
manufactured budget and cost of goods sold budget are drawn up, information from these budgets appear in
SPOTLIGHT

other budgets for the same period as well. For example, the budgeted income statement uses the value of cost of
goods sold to determine the gross profit for the period and the balance sheet includes the finished goods ending
inventory in total assets.
 Illustration:

Product A B C D
Budgeted Cost of Goods manufactured 1,075,500 2,240,450 1,007,000 1,693,180
Finished goods beginning inventory 90,000 140,000 190,000 90,000
Total cost of goods available for sale 1,165,500 2,380,450 1,197,000 1,783,180
STIKCY NOTES

Finished goods ending inventory (130,000) (120,000) (260,000) (290,000)

Cost of goods sold 1,035,500 2,260,450 937,000 1,493,180

3.9 Selling and administrative expenses budget

Selling and administrative expense budget provides details of budgeted costs for the sales of the products and
for managing affairs of the business.
Selling and administrative expenses can be both either fixed or variable. For example, sales staff may be paid
commission on every unit sold by them or they can get a fixed salary, furthermore administrative expenses could
be fixed like rent, depreciation or it could vary depending upon entertainment expense incurred etc.
The selling and administrative budget is dependent upon the sales and production budget, the number of sales
staff is directly correlated with the sales figure and the space rentals are determined on the basis of production
requirements.

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 Illustration:
Sample Selling and Administrative budget is as under:

Product A B C D
Budgeted Selling Expenses
Sales Commission (Rs.) 26,200 43,550 2,410 3,590
Budgeted Admin. Expenses:
Office Rent 76,000 25,400 8,000 8,000
Office Salaries 45,000 45,000 10,000 10,000
Total Selling & Admin. Expense 147,200 113,950 20,410 21,590

AT A GLANCE
3.10 Capital expenditure budget
This is the budget that provides for the acquisition of assets necessitated by the following factors:
 Replacement of existing assets
 Purchase of additional assets to meet increased production
 Installation of improved type of machinery to reduce costs
Capital expenditure budgeting is the process of establishing a financial plan for purchases of long-term business
assets.
The capital expenditure budget should take account of the principal budget factor. If available funds are limiting
the organization’s activities, then they will more than likely limit capital expenditure. As part of the overall

SPOTLIGHT
budget coordination process, the capital expenditure budget must also be reviewed in relation to the other
budgets.
This is in some respect the riskiest element of any budget, as its long term impact would be greater than the other
budget types eg. Investing in a technology that subsequently becomes obsolete might imperil the very survival
of the company.
 Illustration

Project Description/detail of capital investment items Month Rs. ‘000

Installation of new personal computers and flat screen
LV 45 April 10,000
monitors throughout office and factory

STIKCY NOTES
Plant replacement of obsolete packing equipment by
LV46 October 50,000
new automated and electronic machinery
Budgeted capital expenditure 60,000

3.11 Cash budget

Cash budget is a summary statement of the firm’s expected cash inflows and outflows over a projected time
period. It helps in determining the future cash needs of the firm and also assists in planning for financing of those
needs. It acts as a tool to exercise control over cash and liquidity of the firm. The overall objective is to enable the
firm to meet all its commitments in time and preventing accumulation of unnecessary large balances with it as
well.
Functions of cash budget
 Assists with the identification of required cash when commitments are due: If debts are not paid in
time, poor reputation will affect the credit rating of the business. Cash budgets ensure that cash is available
when commitments fall due.

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 Reveals periods of excess funds: Businesses avoid keeping idle funds in bank accounts as these amounts
earn them lower interest returns. Cash budgets help businesses identify idle funds and the opportunities
where they could invest these amounts to earn higher returns.
 Reveals weaknesses in business’s debt collection policy: Cash budgets can locate the weaknesses in
business’s credit collection policy by comparing the trends that the debtors follow in making payments
with the credit period allowed.
 Adjustments for seasonal fluctuations: Some businesses experience high/low sales during different
seasons of the year, e.g. Tourism, farming etc. Cash budgets can help in making adjustments for such
seasonal fluctuations.
 Reveals periods when shortages of funds may occur: The periods where shortages of funds may occur
can be identified ahead of time. This can help businesses make arrangements with banks to meet shortfalls.
Cash budgets are often demanded by banks as well when businesses seek loans, to find if the business is
capable of meeting repayments.
AT A GLANCE

 Illustration:
A cash budget for January, February and March 20X6 is to be prepared from the following
information.

January February March

Rs. Rs. Rs.
Cash Sales 100,000 200,000 150,000
Cash Purchases 60,000 80,000 100,000
Expenses 10,000 15,000 20,000
SPOTLIGHT

Collection from debtors 30,000 50,000 20,000

Payment to creditors 20,000 10,000 70,000
*Opening balance for 1st January is Rs. 15,000.
Opening Balance 15,000 55,000 200,000
Add: Receipts
Cash sales 100,000 200,000 150,000
Collection from debtors 30,000 50,000 20,000
145,000 305,000 370,000
Less: Payments
STIKCY NOTES

Cash Purchases 60,000 80,000 100,000

Expenses 10,000 `15,000 20,000
Payment to creditors 20,000 10,000 70,000
Closing balance 55,000 200,000 180,000
 Example 07:
During the year ending June 30, 20X1 Abdul Habib Company Limited has planned to launch a
new product which is expected to generate a profit of Rs. 9.3 million as shown below:

Rs. in ‘000’
Sales revenue (24,000 units) 51,600
Less: cost of goods sold 37,500
Gross profit 14,100
Less: operating expenses 4,800
Net profit before tax 9,300

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The following additional information is available:

i. 75% of the units would be sold on 30 days credit. Credit prices would be 10% higher
than the cash price. It is estimated that 70% of the customers will settle their account
within the credit term while rest of the customers would pay within 60 days. Bad debts
have been estimated @ 2% of credit sales. All cash and credit receipts are subject to
withholding tax @ 6%.
ii. 80% of the expenses forming part of cost of goods sold are variable. These are to be paid
one month in arrears.
iii. The production will require additional machinery which will be purchased on July 1,
20X0 at a cost of Rs. 60 million. The machine is expected to have a useful life of 15 years
and salvage value of Rs. 7.5 million. The company has a policy to charge depreciation on
straight line basis. The depreciation on the machinery is included in the cost of goods

AT A GLANCE
sold as shown above.
iv. Variable operating expenses excluding bad debts are Rs. 105 per unit. These are to be
paid in the same month in which the sale is made.
v. 50% of the fixed costs would be paid immediately when incurred while the remaining
50% would be paid 15 days in arrears.
vi. The management has decided to maintain finished goods stock of 1,000 units.
If it is required to calculate the cash requirements for the first two quarters, following solution
may be considered
Cash Management

SPOTLIGHT
Total sales Units Weight Sales Ratio
Cash sales – 25% 6,000 1.0 6,000
Credit sales – 75% 18,000 1.1 19,800
24,000 25,800
Sales Revenue (Rs. in ‘000) 51,600
Cash Selling price per unit 2,000
Credit selling price per unit 2,200

Cash Requirement 20X1

STIKCY NOTES
Qtr. 1 Qtr. 2
Particulars
--- Rs. in ‘000 ---
Purchase of machinery (60,000) -
Sale receipts
Cash sales (2,000  6,000 / 4  94%) 2,820 2,820
Receipts from credit sales – as per working below 5,211 9,120
Cost of goods sold – variable (37,500 x 80%) /122 and 3 (5,000) (7,500)
Variable cost of finished stock 30,000 / 24,000  1,000 (1,250) -
Variable operating expenses (105  3  2,000) (630) (630)
Payment of fixed costs (457  2.5) / (457  3.0) (1,143) (1 ,372)
(59,992) 2,438

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Month 1st Month 2nd

1 2 3 Qtr. 4 5 6 Qtr.
---------- Rs. in ‘000 ----------
Working for credit sales
Credit sales
3,30 3,300 3,300 3,300 3,300 3,300
(18,000÷122,200)
Settlement – 70% 2,310 2,310 2,310 2,310 2,310
28% 924 924 924 924
Gross receipts 2,310 3,234 5,544 3,234 3,234 3,234 9,702
AT A GLANCE

Tax @ 6% (333) (582)

Receipts net of tax 5,211 9,120

Operating expenses
Total operating expenses – given 4,800
Less: Variable cost per unit (105  24,000) (2,520)
Bad debt expense (2,200  18,000  2%) (792)
Fixed operating expenses 1,488
Fixed cost
SPOTLIGHT

Fixed factory overheads 7,500

Less: Depreciation (60m – 7.5m) / 15 (3,500)
Fixed operating overheads 1,488
5,488
Fixed cost per month 457

3.12 Master budget

As demonstrated above, budgeting is a collective process in which various departments / divisions of the
organization prepare their plans for the upcoming periods, which in turn are aggregated into a corporate budget.
STIKCY NOTES

Corporate Budget is also termed as Master Budget.

Master Budgets are in the form of Projected Financial Statements and they help an organization plan in advance
about its targets for the upcoming periods.
Preparation of Master Budget in any organization would require company to prepare various components of
operational budgets which could then be aggregated into the master budget. It can be referred to as the end
product of the budgeting process. It takes the macro view of the business and coordinates with production, raw
materials, manpower and other resources with production targets. It cuts across divisional boundaries to
coordinate firms’ diverse activities. The operating budgets are the building blocks that complete the master
budget.
Elements of master budget with their brief explanation have already been mentioned earlier in this chapter.
Following example explains the overall process of preparing a master budget.
 Example 08:
XYZ Company manufactures two products STAR and BRIGHT. There are two manufacturing
departments in a company Dept 1 and Dept 2. All material has been added in dept 1
The standard material and labor usage for each product is as follows:

272 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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STAR BRIGHT
Details of Dept 1
Material X (Rs. 20/kg) 3 kgs 5 kgs
Material Y (Rs. 15/kg) 5 kgs 4 kgs
Direct Labor (Rs. 10/hr) 5 hrs 2.5 hrs
Details of Dept 2
Material Nil Nil
Direct Labor (Rs. 12/hr) 4 hrs 6 hrs
Inventory details

Finished Product STAR BRIGHT

AT A GLANCE
Forecast Sales (Units) 8000 2000
Selling Price / Unit (Rs.) 500/- 450/-
Ending Inventory 1800 200
Beginning Inventory 2000 500
RAW MATERIAL MATERIAL X MATERIAL Y
Beginning Inventory 5000 Kgs 6000 Kgs
Ending Inventory 4000 Kgs 7000 Kgs

Details of overheads
Budgeted variable overhead rates per labor hour DEPT 1 DEPT 2

SPOTLIGHT
Indirect labor Rs. 4 Rs. 3
Electricity (variable) Rs. 3 Rs. 5
Maintenance ( variable) Rs. 2 Rs. 4
Budgeted fixed overheads
Rent Rs.50,000 Rs.45,000
Supervision Rs. 20,000 Rs. 10,000
Electricity (fixed) Rs. 6,500 Rs. 5,000
Maintenance (fixed) Rs. 10,000 Rs. 2,100

STIKCY NOTES
Non-manufacturing overheads
 Salaries Rs. 30,000
 Depreciation Rs. 20,000
 Advertising Rs. 25,000
 Miscellaneous Rs. 10,000
Budgeted cash flows are as follows:
Q1 Q2 Q3 Q4
Rs. Rs. Rs. Rs.
Receipts 800,000 1,000,000 800,000 900,000
Payments:
Material 400,000 200,000 300,000 100,000
Wages 200,000 500,000 100,000 129,300
Other 300,000 200,000 400,000 100,000

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Balance Sheet as on 200X

Rs. 000 Rs. 000 Rs. 000
Land 2,000
Building and equipment 3,000
Acc. Depreciation: (480) 2,520 4,520
Current Assets
Inventory – Finished goods 1,300
– Raw materials 800
Debtors 800
Cash 1,000 3,900
Total Assets 8,420
AT A GLANCE

Equity and Liabilities

Ordinary share capital 3,000
Reserves 2,000 5,000
Non-current liabilities 2,000
Current liabilities 1,420 3,420
Total Equity And Liabilities 8,420
A Master budget for 200Y and the relevant budgets are as follows:
a) Sales Budget

Product Units Sold Selling Price /Unit (Rs.) Total Revenue (Rs.)
SPOTLIGHT

Star 8,000 500 4,000,000

Bright 2,000 450 900,000
4,900,000
b) Production Budget and Stock Level
Once the sales budget has been completed next step is to find out how many units need to be
produced. Because ultimately resources have been consumed on units produced rather than
units sold.

STAR BRIGHT
Sales 8000 2000
STIKCY NOTES

Closing stock 1800 200

Units Required 9800 2200
Already held in stock (2000) (500)
Production 7800 1700
c) Direct Material Usage Budget

Star Bright Total

Total Total Total
Material Kgs Price Rs. Kgs Price Rs. Kgs Price Rs.
‘000 ‘000 ‘000
X *23,400 20 468 ***8,500 20 170 319,00 20 638
Y **39,000 15 585 ****6,800 15 102 45,800 15 687
1,053 272 1,325

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* 7800 units x 3 kgs/unit = 23,400

** 7800 units x 5 kgs/unit = 39,000
*** 1700 units x 5 kgs/unit = 8,500
**** 1700 units x 4 kgs/unit = 6,800
d) Material Purchase Budget
The objective of material purchase budget is to purchase right quantity of material at right time
and at right price. It is purchasing manager’s responsibility to do so. He or she on the basis of
material usage budget and stock determines the estimated quantity to be purchased to meet up
the requirement of next year.

Material X (kgs) Material Y (kgs)

AT A GLANCE
Material usage 31900 (Schedule #3) 45,800 (Schedule #3)
Ending stock 4,000 7,000
Material required 35,900 52,800
Already in stock (Opening) (5,000) (6,000)
Total purchases 30,900 46,800
Unit Price Rs. 20/kg Rs. 15/kg
Purchases (In Rs.) 618,000 702,000
e) Direct Labor Budget
On the basis of units produced it has to be determined that how many labor hours are required

SPOTLIGHT
during next year, where different grades of labor exists. These should be specified separately in
the budget

Star Bright Total

Total Total Total
Dept Hrs Rate Hrs Rate Hrs Rate
Rs. ‘000 Rs. ‘000 Rs. ‘000
1 *39,000 10 390 ***4,250 10 42.5 43,250 10 432.5
2 **31,200 12 374.4 ****10,200 12 122.4 41,400 12 496.8
764.4 164.9 929.3
* 7800 units x 5 hrs/unit = 39,000

STIKCY NOTES
** 7800 units x 4 hrs/unit = 31,200
*** 1700 units x 2.5 hrs/unit = 4250
**** 1700 units x 6 hrs/unit = 10,200
f) Manufacturing Overheads
Departmental activity on which overheads have to be absorbed must be decided first before
overheads have been absorbed into products.
Dept 1: Factory Overhead Budget

Anticipated activity Star 39,000

Bright 4,250
43,250 hrs

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STAR BRIGHT TOTAL

Variable overheads
Indirect labor (Rs. 4/hr) Rs. 156000 Rs. 17,000 Rs. 173,000
Electricity – variable (Rs. 3/hr) 117,000 12,750 129,750
Maintenance – variable (Rs. 2/hr) 78,000 8,500 86,500
351,000 38,250 389,250

Fixed overheads
Rent 50,000
Supervision 20,000
AT A GLANCE

Electricity-fixed 6,500
Maintenance-fixed 10,000
Rs. 86,500
Total labor hours 43,250
Fixed overhead rate Rs. 2/hr
Fixed overhead charged to *78,000 *8,500
products
Total overheads 429,000 46,750 475,750
* Rs. 2/hr x 39,000 hrs = 78,000
** Rs. 2/hr x 4,250 hrs = 8,500
SPOTLIGHT

Dept. 2 Factory Overhead Budget:

Anticipated activity Star 31,200

Bright 10,200
41,400 hrs
STAR BRIGHT TOTAL
Variable overheads
Indirect labor (Rs. 3/hr) Rs. 93,600 Rs. 30,600 Rs. 124,200
Electricity – variable (Rs. 5/hr) 156,000 51,000 207,000
STIKCY NOTES

Maintenance – variable (Rs. 4/hr) 124,800 40,800 165,600

374,400 122,400 496,800
Fixed overheads
Rent 45,000
Supervision 10,000
Electricity-fixed 5,000
Maintenance-fixed 2,100
Rs. 62,100
Total labor hours 41,400
Fixed overhead rate Rs. 1.5/hr
Fixed overhead charged to products *46,800 **15,300
Total overheads 421,200 137,700 558,900
* Rs. 1.5/hr x 31,200 hrs = 46,800
** Rs. 1.5/hr x 10,200 hrs = 15,300

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g) Cash Budget
For Six Month Period Ending June, 200y
All values are in Rs. 000
Q1 Q2 Q3 Q4 TOTAL
Opening Balance 1,000 900 1,000 1,000 1,000
Receipts 800 1,000 800 900 3,500
1,800 1,900 1,800 1,900 4,500
Payments
Purchase of material 400 200 300 100 1000
Payment of wages 200 500 100 129.3 929.3

AT A GLANCE
Other expenses 300 200 400 100 1000
900 900 800 329.3 2929.3
Closing balance 900 1000 1000 1570.7 1570.7
Balance Sheet as On 200Y
Rs. 000 Rs. 000 Rs. 000
Land 2,000
Building and equipment 3,000 4,500
Acc. Depreciation *(500) 2,500
Current assets
Inventory – Finished goods **1570.7
– Raw material 185

SPOTLIGHT
Debtors 688.7
Cash ***2,200 4,644.4
Total Assets 9,144.4
Equity and liabilities
Ordinary share capital 3,000
Reserves 2,000
Profit and loss account 299.75 2,299.75
Con-current liabilities 2,000
Current liabilities ****1,844.65 3,844.65
Total Equity And Liabilities 9,144.4

STIKCY NOTES
* accumulated depreciation at start of the year Rs. 480,000
Depreciation expense of the year 20,000
Accumulated depreciation at end of the year 500,000
** from cash budget
*** opening debtors + sales - receipts
800 + 4900 - 3500 = 2200
**** opening creditors 1420
Purchase of material 1320
Less: payment of material (1000) 320
Labor expense 929.3
Payment 929.3 --
VOH 886.05
FOH 148.6
Selling and admin (90 – 20) 70
Payment for other expense (1000) 104.65
Closing creditors 1844.65

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h) Selling and Administration Budget

Salaries Rs. 30,000
Depreciation 20,000
Advertising 25,000
Miscellaneous 10,000
Total 85,000
Cost per unit
STAR BRIGHT
Units Rs. Units Rs.
Direct material
AT A GLANCE

X (Rs. 20/kg) 3kgs 60 5kgs 100

Y (Rs. 15/kg) 5kgs 75 4kgs 60
Direct labor
Dept 1 (Rs. 10/hr) 5 hrs 50 2.5 hrs 25
Dept 2 (Rs. 12/hr) 4hrs 48 6hrs 72
Variable overheads
Dept 1 (Rs. 9/hr) 5 hrs 45 2.5 hrs 22.5
Dept 2 (Rs. 12/hr) 4hrs 48 6hrs 72
Fixed overheads
Dept 1 (Rs. 2/hr) 5 hrs 10 2.5 hrs 5
Dept 2 (Rs. 1.5/hr) 4hrs 6 6 hrs 9
SPOTLIGHT

342/unit 365.5/unit
i) Master Budget
Budgeted Income Statement
For The Year Ending Dec 200y
Rs. 000 Rs. 000 Rs. 000
Sales (a) 4,900
Opening stock of raw material (balance sheet) 800
Purchases (d) 1,320
Less: Closing stock of raw material *(185)
STIKCY NOTES

Cost of raw material consumed 1,935

Direct labor (e) 929.3
Variable overhead (f) 886.05
Fixed overhead (f) 148.6
Total manufacturing cost 3,898.5
Opening stock of finished goods (balance sheet) 1,300
Less: Closing stock of finished goods **(688.7)
Cost of goods sold (4,510.25)
Gross Profit 389.75
Selling and administration cost (85)
Net Profit 304.75
* From schedule # 4 4000 kgs x Rs. 20/kg + 7000 x Rs.15/kg
** From schedule # 2 1800 units x Rs.342/unit + 200 units x Rs.365.5/unit

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4. APPROACHES TO BUDGETING
4.1 Flexible and fixed budgets

Flexible budgets
Flexible budgets are, as their names suggest variable and flexible depending on the variability in the results
expected in the future. Such budgets are most useful for businesses that operate in an ever changing business
environment, and have the need to prepare budgets that are able to reflect the many outcomes that are possible.
The use of a flexible budget ensures that a firm is prepared to some extent to deal with the unexpected turn
around in events, and able to better guard itself against losses arising from such scenarios. A possible
disadvantage of this form of budgeting is known to be the fact that they may be complicated to prepare, especially
when the scenarios being considered are numerous in number, and complex in nature. Another issue is that they

AT A GLANCE
may confuse the employees as to their ultimate targets and goals.
 Illustration

Activity Level: 8000 9000 10,000 11,000 12,000

Direct Labor hours
Variable Costs
Indirect materials (Rs. 1.50) Rs. 12,000 Rs. 13,500 Rs. 15,000 Rs. 16,500 Rs. 18,000
Indirect labor 16,000 18,000 20,000 22,000 24,000
(Rs. 2.00)
Utilities (Rs. 0.50) 4,000 4,500 5,000 5,500 6,000
Total Variable Costs 32,000 36,000 40,000 44,000 48,000

SPOTLIGHT
Fixed Costs
Depreciation 15,000 15,000 15,000 15,000 15,000
Supervision 10,000 10,000 10,000 10,000 10,000
Property taxes 5,000 5,000 5,000 5,000 5,000
Total Fixed costs 30,000 30,000 30,000 30,000 30,000
Total Costs Rs. 62,000 Rs. 66,000 Rs. 70,000 Rs. 74,000 Rs. 78,000
Fixed budgets
Fixed budgets are used in situations where the future income and expenditure can be known, with a higher
degree of certainty, and have been quite predictable over time. These types of budgets are commonly used by

STIKCY NOTES
organizations that do not expect much variability in the business or economic environment. Fixed budgets are
simpler to prepare and less complicated. In addition, keeping track is easier with fixed budgets, since the budget
will not vary from time to time. One significant disadvantage of using a fixed budget is that it does not account
for changes in expenditure and income over time. Thus, during times of unexpected economic changes the actual
scenario may turn out to be different from what is laid out in a fixed budget.

4.2 Incremental budgeting

It is a simple approach towards budgeting which starts by taking the budgets from previous budget period and
then adds (or subtracts) any incremental amount for the next budget period. Incremental amounts will be added
for:
 Inflation in costs next year
 Any other changes like tax rates
 Possibly, the cost of additional activities that will be carried out next year
Incremental budgeting may be appropriate for certain costs. For example, in a stable environment it may be
sufficient to budget salary costs by taking current year plus wage inflation.

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Traditionally this type of budgeting would have been very evident in the public sector. This would often result in
departments becoming locked in to public expenditure.
Advantages of incremental budgeting
 It is a simple, quick and easy approach towards budgeting.
 Suitable in a stable environment where historic figures are reliable and are
 not expected to change.
 Information does not need to be searched, it is readily available.
Disadvantages of incremental budgeting
 The deficiencies or say ‘budgetary slack’ which were incorporated in previous period is likely to be carried
forward for the next budget period.
AT A GLANCE

 Uneconomic economic activities may continue for the next period, for example a company may continue to
make parts in-house when it might be cheaper to outsource.
 Amount of increment (inflation or growth) may be difficult to estimate.
 Example 09:
Falcon (Private) Limited (FPL) is in the process of preparing its annual budget for the next year.
The available information is as follows:
i. Budgeted and actual production and sales for the current year:
Budgeted Actual
--------- Units ---------
SPOTLIGHT

Production 25,000 23,760

Sales 24,000 22,800
ii. Current year’s actual production cost per unit:
Rupees
Raw material input (49 kg) 980
Direct labor 800
Variable production overheads 500
Fixed production overheads 400
2,680
STIKCY NOTES

iii. Inventory balances:

FPL maintains the following inventory levels:
Raw material Average two months’ consumption based on budgeted
production
Finished goods Average one month’s budgeted sales
Work in process (opening 1,500 units (100% complete as to material and 60% as to
as well as closing) conversion cost)
FPL follows absorption costing and uses FIFO method for valuation of inventory.
iv. Impact of inflation:

Inflation %
Raw material and variable overheads 8
Direct labor 10
Fixed overheads (excluding depreciation) 5

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v. Sales volume would increase by 10%.

vi. Balancing and modernization of plant would be carried out at a cost of Rs. 20 million
which would:
 increase depreciation from Rs. 5,800,000 to Rs. 7,016,800;
 reduce raw material wastages from 5% to 2% of input; and
 increase labor efficiency by 7%.
For the above example, budgeted statement of cost of sales for the next year may be as
follows:

Falcon (Private) Limited Rupees

Opening work in process:

AT A GLANCE
Raw material cost 1,500×980 1,470,000
Conversion cost 1,500×60%×(800+500+400) 1,530,000
A 3,000,000
Manufacturing expenses:
Raw material cost (W-4) 25,497,753
Conversion cost 25,170(W-1)×1,791(W-2) 45,079,470
B 70,577,223
Closing work in process:
Raw material cost 1,500×1,026(W-2) (1,539,000)

SPOTLIGHT
Conversion cost 1,500×60%×1,791(W-2) (1,611,900)
C (3,150,900)
Finished goods:
Opening stock 2,000(W-1)×2,680 D 5,360,000
Closing stock 2,090(W-1) ×2,817(W-2) E (5,887,530)
Cost of sales (A+B+C+D+E) 69,898,793

W-1: Budgeted production for the next year Units

Sales for the next year 22,800×1.1 25,080

STIKCY NOTES
Finished goods inventory: Closing 25,080÷12 2,090
Opening 24,000÷12 (2,000)
Work in progress: Closing (100% to material and 60% to 1,500
conversion)
Opening (100% to material and 60% (1,500)
to conversion)
25,170
W-2: Budgeted cost per unit for the next year Rupees
Raw material 980×0.95÷0.98×1.08 1,026
Direct labor 800×93%×1.1 818
Variable overheads 500×1.08 540
Fixed overheads 10,906,000(W-3)÷25,170(W-1) 433
1,791
2,817

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W-3: Budgeted fixed overheads for the next year Rupees

Current year's fixed overheads (400×23,760)-5,800,000 3,704,000
(excluding depreciation)
5% increase for next year's fixed 3,704,000×1.05 3,889,200
overheads (excluding depreciation)
Depreciation for the next year 7,016,800
10,906,000
W-4: Budgeted raw material consumption for the next year Kg
Required raw material 25,170 (W-1) × (49×0.95÷0.98) 1,195,575
including 2% wastage
Opening raw material inventory (25,000×49×2÷12) 204,167
AT A GLANCE

Raw material issues on FIFO basis from: Rupees

- Opening raw material inventory 204,167×(980÷49) 4,083,340
- Current purchases at revised price (1,195,575- 21,414,413
204,167)×(980÷49)×1.08
25,497,753

4.3 Zero based budgeting

A simple idea of preparing a budget from a zero base each time i.e. as though there is no expectation of current
activities to continue from one period to the next. ZBB is normally found in service industries where costs are
more likely to be discretionary. A form of ZBB is used in local government. There are four basic steps to follow:
SPOTLIGHT

 Prepare decision packages: Identify all possible services (and levels of service) that may be provided and
then cost each service or level of service, these are known individually as decision packages.
 Rank: Rank the decision packages in order of importance, starting with the mandatory requirements of a
department. This forces the management to consider carefully what their aims are for the coming year.
 Funding: Identify the level of funding that will be allocated to the department.
 Utilize: Use up the funds in order of the ranking until exhausted.
Advantages (as opposed to incremental budgeting)
 Emphasis on future need not past actions.
 Eliminates past errors that may be perpetuated in an incremental analysis.
STIKCY NOTES

 A positive disincentive for management to introduce slack into their budget.

 A considered allocation of resources.
 Encourages cost reduction.
Disadvantages
 Can be costly and time consuming.
 May lead to increased stress for management.
 Only really applicable to a service environment.
 May “re-invent” the wheel each year.
 May lead to loss continuity of action and short term planning.

4.4 Continuous budgeting (Rolling budgets)

In a periodic budgeting system, the budget is normally prepared for one year, a totally separate budget will then
be prepared for the following year. In continuous budgeting the budget from one period is “rolled on‟ from one
year to the next.

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Typically, the budget is prepared for one year, only the first quarter in detail, the remainder in outline. After the
first quarter is revised for the following three quarters based on the actual results and a further quarter is
budgeted for.
This means that the budget will again be prepared for 12 months in advance. This process is repeated each
quarter (or month or half year).

Advantages (as opposed to periodic budgeting)

 The budgeting process should be more accurate.
 Much better information upon which to appraise the performance of management.
 The budget will be much more relevant by the end of the traditional budgeting period.
 It forces management to take the budgeting process more seriously.

AT A GLANCE
Disadvantages
 More costly and time consuming.
 An increase in budgeting work may lead to less control of the actual
 results.

4.5 Performance budgeting

Performance budgeting is a system of planning, budgeting and evaluation that emphasizes the relationship
between money budgeted and results expected. Performance budgeting focuses on results as departments are
held accountable to certain performance standards. By focusing the relationship between strategic planning and
resource allocation, performance budgeting focuses more attention on longer time horizons. These budgets are

SPOTLIGHT
established in such a way that each item of expenditure is related to specific responsibility center and is closely
linked with the performance of that standard. This type of budget is commonly used by the government to show
the link between the funds provided to the public and the outcome of these services. Decisions made on these
types of budgets focus more on outputs or outcomes of services than on decisions made based on inputs. In other
words, allocation of funds and resources are based on their potential results.

STIKCY NOTES

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5. BUDGETING IN NON-PROFIT ORGANISATIONS

5.1 Budgeting needs of Non – profit organizations
As we know that the objectives of an organization form the basis of its budgets. Budgets in profit oriented and
non-profit organizations have same characteristics, except for the fact that the budgets for non-profit
organizations are not designed with a focus on profitability.
Non-profit organizations normally face difficulty in arranging finances because they don’t have access to several
sources of finances like profit oriented businesses. They are more dependent on charities, donations, ministry
funds which cannot be predicted with reasonable accuracy. Moreover, performance of non-profit organizations
relies heavily on external stakeholders, so under such circumstances forecasting future results becomes a
challenge.
AT A GLANCE

In a non-profit organization the budgeting process is initiated with an exercise by the managers where they
calculate the expected costs of the activities being supervised by them. Any desirable changes are also
accommodated if needed. The available resources to fund the budgeted level of public services should be enough
to cover the overall costs of such services.
The difficulty central to the budgeting process of non-profit organizations is the issue of defining “specific
quantifiable objectives”, besides, the actual accomplishments are even more difficult to be measured. This is
because at many occasions the outputs cannot be measured in monetary terms. In organizations driven by profit
motive sales revenues reflect the outputs. This explains well the concept that budgets in non-profit organizations
tend to be mainly concerned with the input resources (i.e. expenditure) whereas in profit oriented organizations
the budgets focus on the relationship between inputs and outputs. However, in recent years’ efforts have been
put in to overcome the deficiencies and attempts are being made to develop measures to be used for the
comparison of budgeted and actual accomplishments.
SPOTLIGHT

5.2 Traditional format: Line item budgets

A line item budget is considered as the traditional format of budgeting in non-profit organizations. In such
budgets the expenditures are presented in detail, but the activities undertaken are given less attention. It shows
the nature of the expenses but not the purpose. Any anticipated or expected changes in costs and activity levels
are reflected in the budget. These budgeted figures when compared with the actual expenditure show if the
authorized budgeted expenditure has been exceeded or under-spending was witnessed. Moreover, the spending
pattern too can be analyzed by comparing the data of the current year and for the previous year.
Line item budgets though fail to recognize the cost of activities and the programs to be executed. Moreover, line
item budgets do not guarantee the efficient and effective use of the resources.
 Illustration
STIKCY NOTES

Actual Original Revised Proposed

20X4 budget budget budget
20X5 20X5 20X6
Rs. Rs. Rs. Rs.
Employees 1,200,000 1,350,000 1,360,000 1,630,000
Maintenance expenses 6,000 10,000 8,000 12,000
Office supplies 30,000 40,000 44,000 143,000
Freight 24,000 28,600 28,900 30,200
Establishment expenses 223,000 220,000 216,000 200,000
Agency charges 8,000 7,000 6,800 9,600
Financing charges 3,500 3,900 4,000 114,000
Other expenses 2,200 3,000 3,300 3,700
1,496,700 1,662,500 1,671,000 2,142,500

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6. HUMAN AND MOTIVATIONAL ASPECTS OF BUDGETING

6.1 Budgetary slack
Success of budgets depend upon how motivated employees are to meet budget targets. Two employees might
have different perception about a single budget. It is very difficult to involve each of them. If a very large number
of employees have been involved in budget making process, there is a likelihood of budgetary slack to result as
a consequence. Budgetary slack (or bias) is a deliberate overestimation of expenditure and/or underestimation
of revenues in the budgeting process. This can happen because managers want easy targets (e.g. for an “easy life”
or to ensure targets are exceeded and bonuses won) or simply to “play the system”. Either way, this results in a
budget that is poor for control purposes and gives rise to meaningless variances.

6.2 Dysfunctional behavior

AT A GLANCE
Budgets may also lead to dysfunctional behavior. Dysfunctional behavior is when individual managers seek to
achieve their own objectives at the expense of the objectives of the organization i.e. Abetting a “silo culture” in
the organization whereby departmental goals and objectives are prioritized over those of the organization. A key
performance management issue is to ensure that the system of targets and measures used do not encourage such
behavior but rather encourages goal congruence.

6.3 Budgetary styles

In order to motivate employees to take targets seriously, commitment from senior level management to
implement budgetary control and system must be shown. In many organizations, targets are duly set but these
are not used to compare the actual performance. As a result, in such cases, employees after getting targets show
relax attitude as they know they would not be held accountable against the targets.

SPOTLIGHT
Many managers seek budgets as a punitive device, which basically aims at punishing them on their poor
performance rather than to reward them. It happens when employees have lower confidence on senior level
management and they think that budgets are set up in such a way that makes it impossible to achieve those set
targets, such a scenario would result in a severe dysfunctional organization.
Level of participation and budgetary style also affects human behavior. Two common budgetary styles are:
 Imposed style of budgeting: A budget that is set without allowing the ultimate budget holder to have the
opportunity to participate in the budgeting process. Also called “top-down” budgeting.
 Participative style of budgeting: A system in which budget holders have the opportunity to participate
in setting their own targets. Also called “bottom up” budgeting.

Advantages of participation Disadvantages of participation

STIKCY NOTES
Increased motivation to the budget holders. Senior managers may not be able to give up control.
Should contain better information due to Poor decision making due to inexperienced staff.
participation by those who are closer to the action.
Increases managers’ understanding. Lack of goal congruence and wastage of resources.

6.4 Motivation
Budgets represent a target and aiming for target is itself a strong motivator. Managers and employees know in
advance what level of performance is expected from them. What if mangers have been told that ‘good’
performance is expected from you. Next question they ask is ‘define good’? They want targets in quantified terms
and time frame in which these targets are to be attained. Level of motivation depends upon how easy or difficult
they perceive that target. If target becomes too easy, there is no motivation to perform well or task is no more
challenging. If it’s too difficult, motivation still goes down because they might take targets to be un-attainable. So,
the aim is to set budgets which are perceived as being possible, but which motivate employees to try harder than
they otherwise might have done.

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7. COMPREHENSIVE EXAMPLES
 Example 01:
Double Crown Limited (DCL) is engaged in manufacturing of a product Zee. Sales projections
according to DCL's business plan for the year ending 31 December 2017, are as follows:

May June July August

------------------------ Rs. in million ------------------------
Sales 60 55 70 68

Additional information includes:

AT A GLANCE

i. Goods are sold at a gross margin of 40% on sales.

ii. Ratio of direct material, direct wages and overheads is 6:3:1 respectively.
iii. Normal loss is 5% of the units completed.
iv. Inventory levels maintained by DCL are as under:

Direct materials Next month’s budgeted consumption

Finished goods 50% of next month’s budgeted sales

v. 10% of all purchases are in cash. Remaining purchases are paid in the following month.
vi. Direct wages include DCL's contribution at 5% of the direct wages, towards canteen
expenses. An equal amount is deducted from the employees’ wages. Direct wages are
SPOTLIGHT

paid on the last day of each month. Both contributions are paid to the canteen contractor
in the following month.
vii. Overheads for each month include depreciation on plant and machinery and factory
building rent, amounting to Rs. 0.2 million and Rs. 0.1 million respectively. The rent is
paid on half yearly basis in advance on 30 June and 31 December each year.
If required to prepare budget for material purchases, direct wages and overheads, for the
month of June 2017, working would involve:

Budget for material purchases, direct wages May Jun Jul Aug
and overheads for the month June 2017
----------- Rs. in million -----------
STIKCY NOTES

Sales (A) 60.00 55.00 70.00 68.00

Cost of sales A×60% (B) 36.00 33.00 42.00 40.80

Finished goods: Opening stock B÷2 (18.00) (16.50) (21.00)

Closing stock 16.50 21.00 20.40

Cost of goods manufactured 34.50 37.50 41.40

5% Normal loss - no effect, as being normal loss - - -

it is already included in cost of goods produced

Cost of goods produced (C) 34.50 37.50 41.40

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May Jun Jul Aug

----------- Rs. in million -----------
Budgeted direct material purchases - (as opening 22.50 24.84
inventory is equal to current month consumption,
purchases would be equal to the next month
consumption)
(37.5×60%),(41.4×60%) (D)
Budgeted direct wages C×3÷10 (E) 11.25
Budgeted overheads C×1÷10 (F) *3.75
* (Including fixed overheads – Depreciation and Rent amounted to Rs. 0.2 million and Rs. 0.1
million respectively)

AT A GLANCE
 Example 02:
Tennis Trading Limited (TTL) was incorporated on 1 September 2018 and would start trading
from the month of October 2018. As part of planning and budgeting process, the management
has developed the following estimates:
i. During the month of September 2018, TTL would pay Rs. 5 million, Rs. 2 million and Rs.
1.2 million for purchase of a property, equipment and a motor vehicle respectively.
ii. Projected sales for October is Rs. 12 million. The sales would increase by Rs. 2.5 million
per month till January 2019. From February 2019 and onwards, sales would be Rs. 25
million per month.
iii. Cash sales is estimated at 30% of the total sales.

SPOTLIGHT
iv. Credit customers are expected to pay within one month of the sales.
v. 80% of the credit sales would be generated by salesmen who would receive 5%
commission on sales. The commission is payable in the following month after sales.
vi. Gross profit margin would be 30%.
vii. TTL would maintain inventory at 80% of the projected sale of the following month, up
to December 2018 and thereafter, 85% of the projected sale of the following month.
All purchases of inventories would be on two months’ credit.
i. Salaries would be Rs. 1.5 million in September and Rs. 2 million per month, thereafter.

STIKCY NOTES
Other administrative expenses would be Rs. 1 million per month from September till
January 2019 and Rs. 1.3 million per month thereafter. Both types of expenses
would be paid in the same month in which they are incurred.
ii. An aggressive marketing scheme would be launched in September 2018. The related
expenses are estimated at Rs. 7 million. 50% of the amount would be payable in
September and 50% in October 2018.
iii. Marketing expenses from October 2018 would consist of 65% variable and 35% fixed
expenses. Total expenses in October 2018 would be Rs. 2 million. All expenses would be
paid in the month in which they occur.
iv. Bank balance as of 1 September 2018 is Rs. 12 million. TTL has arranged a running
finance facility from a local bank at a mark-up of 10% per annum. The mark-up is
payable at the end of each month on the closing balance.
The TTL wants now a cash forecast (month-wise) from September 2018 to February 2019 to
analyze sustainability over the period.

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In order to forecast cash inflows and outflows first of all working for sales (W-1) and purchases
(W-2) is done as follows:

W-1: Monthly sales Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19

------------------------ Rs. in million --------------------
Sales 12.00 14.50 17.00 19.50 25.00
(12+2.5) (14.50+2.5) (17+2.5)

W-2: Purchases Sep-18 Oct - 18 Nov-18 Dec-18

------------------------ Rs. in million --------------------
Cost of sale (70% of sales) - 8.40 10.15 11.90 13.65
AT A GLANCE

Less: Opening stock - (6.72) (8.12) (9.52)

Add: Closing stock
(80% of cost of sales of next month
till Dec.) 6.72 8.12 9.52 10.92
Total purchases 6.72 9.80 11.55 13.30

Cash budget for the period from September 2018 to February, 2019

Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19

------------------------ Rs. in million --------------------
Collections
SPOTLIGHT

- From cash sales

(Sales of current month(W-1)×30%) - 3.60 4.35 5.10 5.85 7.50
- From credit customers
(Sales of previous month (W-1)×70%) - - 8.40 10.15 11.90 13.65
Total cash inflows A - 3.60 12.75 15.25 17.75 21.15
Payments
Cash paid to suppliers W-2 - - 6.72 9.80 11.55 13.30
Wages and salaries 1.50 2.00 2.00 2.00 2.00 2.00
STIKCY NOTES

Other administrative expenses 1.00 1.00 1.00 1.00 1.00 1.30

Commission
(Last month sale × 70% ×80%×5%) - - 0.34 0.41 0.48 0.55
Marketing expenses – Fixed - 0.70 0.70 0.70 0.70 0.70
Marketing expenses - Variable
{(2×65%/12(W-1))×Sales} - 1.30 1.57 1.84 2.11 2.71
Initial promotion and advertisement
expenses (7×50%) 3.50 3.50 - - - -
Property 5.00 - - - - -
Equipment 2.00 - - - - -
Motor vehicle 1.20 - - - - -
Total cash outflows B 14.20 8.5 12.33 15.75 17.84 20.56

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Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19

------------------------ Rs. in million --------------------
Net cash inflows / (outflows) (A-B) (14.20) (4.90) 0.42 (0.50) (0.09) 0.59
Opening balance 12.00 (2.22) (7.18) (6.82) (7.38) (7.53)
Closing balance for mark-up
calculation (2.20) (7.12) (6.76) (7.32) (7.47) (6.94)
Mark-up @ 10% (Closing balance ×
p.a 10%/12) (0.02) (0.06) (0.06) (0.06) (0.06) (0.06)
Closing balance (2.22) (7.18) (6.82) (7.38) (7.53) (7.00)

AT A GLANCE
 Example 03:
Smart Limited has prepared a forecast for the quarter ending December 31, 20X9, which is based
on the following projections:
i. Sales for the period October 20X9 to January 20X0 has been projected as under:
Rupees
October 20X9 7,500,000
November 20X9 9,900,000
December 20X9 10,890,000
January 20X0 10,000,000
Cash sale is 20% of the total sales. The company earns a gross profit at 20% of sales. It intends to

SPOTLIGHT
increase sales prices by 10% from November 1, 20X9. Effect of increase in sales price has been
incorporated in the above figures.
ii. All debtors are allowed 45 days credit and are expected to settle promptly.
iii. Smart Limited follows a policy of maintaining stocks equal to projected sale of the next
month.
iv. All creditors are paid in the month following delivery. 10% of all purchases are cash
purchases.
v. Marketing expenses for October are estimated at Rs. 300,000. 50% of these expenses are
fixed whereas remaining amount varies in line with the value of sales. All expenses are
paid in the month in which they are incurred.

STIKCY NOTES
vi. Administration expenses paid for September were Rs. 200,000. Due to inflation, these
are expected to increase by 2% each month.
vii. Depreciation is provided @ 15% per annum on straight line basis. Depreciation is
charged from date of purchase to the date of disposal.
viii. On October 31, 20X9 office equipment having book value of Rs. 500,000 (40% of the
cost) on October 1, 20X9 would be replaced at a cost of Rs. 2,000,000. After adjustment
of trade-in allowance of Rs. 300,000 the balance would have to be paid in cash.
ix. The opening balances on October 1, 20X9 are projected as under:
Rupees
Cash and bank 2,500,000
Trade debts – related to September 5,600,000
Trade debts – related to August 3,000,000
Fixed assets at cost (20% are fully depreciated) 8,000,000

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Based on the given information, preparation a month-wise cash budget for the quarter ending
December 31, 20X9, would be as follows

Cash budget for the quarter October October November December

- December 20X9 Rupees in '000'
Opening cash and bank balances 2,500 1,476 1,428
Cash receipts:
Cash sales 1,500 1,980 2,178
Collection from debtors Note 1 5,800 5,800 6,960
Total receipts 7,300 7,780 9,138
9,800 9,256 10,566
AT A GLANCE

Cash payments:
Cash purchases Note 2 720 792 727
Creditors Note 2 5,400 6,480 7,128
Marketing expenses – Fixed (300/2) 150 150 150
Marketing expenses - Variable Note 3 150 198 218
Admin. Expenses (2% increase per month) 204 208 212
Purchase of equipment (2,000-300) 1,700
Total payments 8,324 7,828 8,435
Closing cash and bank balances 1,476 1,428 2,131
SPOTLIGHT

Profit & Loss Account for the quarter ending December 31, 20X9
Rupees in '000'
Sales (7,500+9,900+10,890) 28,290
Cost of goods sold:
Opening stock (80% of October sale of Rs. 7,500) 6,000
Purchases (7,200+7,920+7,273) 22,393
Goods available for sale 28,393
STIKCY NOTES

Closing stock (Purchases of Dec. 20X9) (7,273)

21,120
Gross profit 7,170
Admin. & Marketing expenses:
Marketing expenses - Fixed 450
Marketing expenses – variable Note 3 566
Admin. Expenses 624
Depreciation Note 4 258
Loss on replacement of machinery {500-(1,250*15%/12=16)-300} 184
2,082
NET PROFIT 5,088

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Oct.X9 Nov.X9 Dec.X9 Jan.X0

Note 1 - Cash collection from sales:
Rs.’000 Rs.’000 Rs.’000 Rs.’000
Total sales 7,500 9,900 10,890 10,000
Cash sales (20% of total) 1,500 1,980 2,178
Credit sales (80% of total) 6,000 7,920 8,712
Cash from debtors:
2nd. fortnight of August 3,000
1st. fortnight of September (5,600/2) 2,800
2nd. fortnight of September (5,600/2) 2,800
1st. fortnight of October (6,000/2) 3,000

AT A GLANCE
2nd. fortnight of October (6,000/2) 3,000
1st. fortnight of November (7,920/2) 3,960
5,800 5,800 6,960

Oct.X9 Nov.X9 Dec.X9 Jan.X0

Note 2 - Purchases:
Rs.’000 Rs.’000 Rs.’000 Rs.’000
Sales 7,500 9,900 10,890 10,000
Sale price increase 0% 10% 10% 10%
Sales excluding price 7,500 9,900/ 10,890/ 10,000/
increase effect 1.10 1.10 1.10

SPOTLIGHT
7,500 9,000 9,900 9,091
Projected purchases 9,000*0.80 9,900*0.80 9,091*0.80
based on next month sales 7,200 7,920 7,273
Cash purchases 10% 720 792 727
Credit purchases 90% 6,480 7,128 6,545
Payment to creditors (7,500*0.8*0.9) 6,480 7,128
(Last month’s balance of creditors) 5,400

Note 3 - Variable marketing expenses:

STIKCY NOTES
Sales 7,500 9,900 10,890 -
Variable marketing expenses 300 / 2 150/7,500* 150/7,500* -
9,900 10,890
150 198 218 -

Note 4 – Depreciation Oct.X9 Nov.X9 Dec.X9 Jan.X0

Fixed assets at cost 8,000 - - -
Less: Fully depreciated assets 20% (1,600) - - - -
6,400 80 - - -
Disposals on Oct. 31 at cost (1,250) - - - -
(500,000/40%)
5,150 - - - -
Additions on October 31 at cost 2,000 - - - -
7,150 - 89 89 -

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 Example 04:
Shahid Limited is engaged in manufacturing and sale of footwear. The company sells its products
through company operated retail outlets as well as through distributors. The management is in
the process of preparing the budget for the year 20X0-X1 on the basis of following information:
i. The marketing director has provided the following annual sales projections:
No. of units Retail price range
Men 1,200,000 Rs. 1,000 – 4,000
Women 500,000 Rs. 800 – 2,500
The previous pattern of sales indicates that 60% of units are sold at the minimum price;
10% units are sold at the maximum price and remaining 30% at a price of Rs. 2,000 and
Rs. 1,200 per footwear for men and women respectively.
AT A GLANCE

ii. It has been estimated that 30% of the units would be sold through distributors who are
offered 20% commission on retail price. The remaining 70% will be sold through
company operated retail outlets.
iii. The company operates 22 outlets all over the country. The fixed costs per outlet are Rs.
1.2 million per month and include rent, electricity, maintenance, salaries etc.
iv. Sales through company outlets include sales of cut size footwears which are sold at 40%
below the normal retail price and represent 5% of the total sales of the retail outlets.
v. The company keeps a profit margin of 120% on variable cost (excluding distributors’
commission) while calculating the retail price.
vi. Fixed costs of the factory and head office are Rs. 45 million and Rs. 15 million per month
respectively.
SPOTLIGHT

In preparing budgeted profit and loss account for the year 20X0 – 20X1, considering above
conditions, working may be done as follows:
Price Units Amount (Rs. ‘000s)
Men Women Men Women Men Women
Minimum 1,000 800 720,000 300,000 720,000 240,000
Maximum 4,000 2,500 120,000 50,000 480,000 125,000
Average 2,000 1,200 360,000 150,000 720,000 180,000
Total 1,200,000 500,000 1,920,000 545,000
STIKCY NOTES

Rs. 000s
Sales revenue – gross (1,920,0000 + 545,000) 2,465,000
Less : Commission to distributors 20% ×30% of above 147,900
Cut size discount 40% × (5% of 70%) 34,510
182,410
Sales – net 2,282,590
Variable cost 100/220 of gross revenue 1,120,455
1,162,135
Less : Factory overheads 12 × 45m 540,000
Gross profit 622,135
Less : Admin overheads 12 ×15m 180,000
Cost of retail outlets 12 × 22 × 1.2m 316,800
496,800
Net profit 125,335

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 Example 05:
Beta (Private) Limited (BPL) deals in manufacturing and marketing of bed sheets. The
management of the company is in the phase of preparation of budget for the year 20X3-X4. BPL
has production capacity of 4 million bed sheets per annum. Currently the factory is operating at
68% of the capacity. The results for the recently concluded year are as follows:

Rs. in million
Sales 3,400
Cost of goods sold
Material (1,493)
Labor (367)

AT A GLANCE
Manufacturing overheads (635)
Gross profit 905
Selling expenses (60% variable) (287)
Administration expenses (100% fixed) (105)
Net profit before tax 513

Other relevant information is as under:

i. The raw material and labor costs are expected to increase by 5%, while selling and
distribution costs will increase by 4% and 8% respectively. All overheads and fixed
expenses except depreciation will increase by 5%.
ii. Manufacturing overheads include depreciation of Rs. 285 million and other fixed

SPOTLIGHT
overheads of Rs. 165 million. During the year 20X3–X4 major overhaul of a machine is
planned at a cost of Rs. 35 million which will increase the remaining life from 5 to 12
years. The current book value of the machine is Rs. 40 million and it has a salvage value
of Rs. 5 million. At the end of 12 years, salvage value will increase on account of general
inflation to Rs. 9 million. The company uses straight line method for depreciating the
assets.
iii. Variable manufacturing overheads are directly proportional to the production volume
of production.
iv. Selling expenses include distribution expenses of Rs. 85 million, which are all variable
v. Administration expenses include depreciation of Rs. 18 million. During 20X3–X4, an
asset having book value of Rs. 1.5 million will be sold at Rs. 1.8 million. No replacement

STIKCY NOTES
will be made during the year. Depreciation for the year 20X3-X4 would reduce to Rs. 17
million.
The management has planned to take following steps to increase the sale and improve
cost efficiency:
 Increase selling price by Rs. 150 per unit.
 The sales are to be increased by 25%. To achieve this, commission on sales will be
introduced besides fixed salaries. The commission will be paid on the entire sale
and the rate of commission will be as follows:
No. of units Commission % on total sales
Less than 35,000 1.00%
35,000 – 40,000 1.25%
40,000 – 50,000 1.50%
Above 50,000 1.75%

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 Currently the sales force is categorized into categories A, B and C. Number of

persons in each category is 20, 30 and 40 respectively. Previous data shows that
total sales generated by each category is same. Moreover, sales generated by each
person in a particular category is also the same. The trend is expected to continue
in future.
 The overall efficiency of the workforce can be increased by 15% if management
allows a bonus of 20%. Further increase in production can be achieved by hiring
additional labor at Rs. 180 per unit.
In order to prepare profit and loss budget for the year 20X3–X4 step by step
calculations are as follows:
Production capacity 4,000,000
Actual production (4,000,000 × 68% = 2,720,000 × 1.25) 3,400,000
AT A GLANCE

Selling price / unit [(3,400 ÷ 2.72) + 150] Rs. 1,400

Rs.in million
Sales (1,400 × 3,400,000) 4,760.00
Less: sales commission (W-1) (63.50)
4,696.50
Cost of goods sold (W–2) (3,170.70)
Gross profit 1,525.80
Selling expenses
SPOTLIGHT

Distribution expenses (1.08 × 1.25 × 85m) (114.75)

Selling expenses -Variable [(287 × 60% – 85m) × 1.04 × 1.25] (113.36)
Selling expenses - Fixed [(287 × 40%) × 1.05] (120.50)
(348.61)
Administration expenses
Admin expenses - other than depreciation [(105 – 18)m × (91.40)
1.05]
Admin expenses - depreciation (18 – 1)m (17.00)
(108.40)
STIKCY NOTES

Other income (Gain on sale of asset) (1.8 – 1.5)m 0.30

Net profit / (loss) 1,068.49

W-1: Sales commission

Avg. Commission
Units to (Rs.’000)
No. of unit Commission
Categories Ratio be sold
persons sale/ % (B) A×B×Rs.
(A)
person 1,400
A 33.33% 1,133,333 20 56,667 1.75% 27,767
B 33.33% 1,133,333 30 37,778 1.25% 19,833
C 33.33% 1,133,334 40 28,333 1.00% 15,867
100% 3,400,000 90 63,467

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W-2: Cost of goods sold Rs. in million

Material (1,493 × 1.05 × 1.25) 1,959.6
Labor (W-2.2) 511.5
Variable overheads [(635-285-165)×1.05×3,400÷2,720] 242.8
Overheads fixed - other than depreciation(165 × 1.05) 173.3
Overheads fixed - depreciation (W-2.1) 283.5
3,170.7
W-2.1: Depreciation
Existing depreciation 285.0

AT A GLANCE
Less: depreciation on machine to be overhauled [(40 – 5)m ÷ 5] 7.0
278.0
Add: Depreciation on machine after overhauling [(40+35–9)m ÷12] 5.5
283.5
W-2.2: Labor Cost Units Total cost
Cost of existing units (367 × 1.05) 2,720,000 385.4
15% increase in production by paying bonus @ 20%
408,000 77.1
(2,720,000 × 15%) (385.4 × 20%)
Existing labor cost with increased efficiency 3,128,000 462.5

SPOTLIGHT
Cost of remaining units by hiring additional labor
272,000 49.0
@ Rs. 180 (3,400,000 – 2,720,000 – 408,000)
3,400,000 511.5

 Example 06:
Cinemax Limited has recently constructed a fully equipped theatre and 3 cinema houses at a cost
of Rs. 30 million. The theatre has a capacity of 800 seats and each cinema has a capacity of 600
seats. Information and projections for the first year of operations are as follows:
i. Fixed administration and maintenance cost of the entire facility is Rs. 4.5 million per
year.

STIKCY NOTES
ii. The average cost of master print of a Hollywood film is Rs. 4 million while the cost of
master print of a Bollywood film is Rs. 6.5 million.
iii. Two cinema houses are dedicated for Hollywood films which show the same film at the
same time while one cinema house will show Bollywood films.
iv. Each Bollywood film is displayed for 6 weeks and the average occupancy level is 70%.
Each Hollywood film is displayed for 4 weeks and the average occupancy level is 65%.
On weekdays, there are 2 shows while on weekends (Sat and Sun), 3 shows are
displayed. Ticket price has been fixed at Rs. 350.
v. Variable cost per show is Rs. 35,000 and setup cost of each film is Rs. 500,000.
vi. No films would be shown during 8 weeks of the year.
vii. Theatre is rented to production houses at Rs. 60,000 per day. Each play requires setup
time of 2 days while rehearsal time needs 1 day. Each play is staged 45 times. One show
is staged on weekdays whereas two shows are staged on weekends.

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 CHAPTER 9: budgeting CAF 8: CMA

viii. There is an interval of 2 days whenever a new play is to be staged. No plays are staged
during the month of Ramadan and first 10 days of Muharram.
ix. The construction costs of theatre and cinema houses are to be depreciated over a period
of 15 years.
Assume 52 weeks in a year and 30 days in a month.
In order to calculate budgeted profit, estimated revenue and expenses can be calculated as
follows:

Hollywood Bollywood
W-1: Revenue from Cinemas
film film
No. of weeks 52 52
AT A GLANCE

No shows (8) (8)

No. of weeks during which show to be displayed A 44 44
No. of weeks each film is displayed B 4 6
No. of cinemas C 2 1
Total no. of films D= A/B 11 7.33
No. of shows per week (2×5+3×2) F 16 16
Total shows per film G=B×C×F 128 96
Average occupancy per show (600×65%,70%) H 390 420
Ticket price I 350 350
Revenue from Cinemas G×H×I×D 192,192,000 103,488,000
SPOTLIGHT

Hollywood Bollywood
W-2: Variable costs
film film
Cost per film Rs. 4,000,000 6,500,000
Setup cost Rs. 500,000 500,000
Show cost [35,000×128/96(G from W-1)] Rs. 4,480,000 3,360,000
Variable cost per film Rs. 8,980,000 10,360,000
Total number of films in a year (E from W-1) 11 7.33
STIKCY NOTES

Total variable costs Rs. 98,780,000 75,938,800

W-3: No. of days theatre rented out.

No. of available days (360─30─10) A 320
No. of days one play will be staged (45/9×7) C 35
Gap between two plays D 2
Setup and rehearsal time E 3
F 40
Total no. of plays G=B÷F 8
Per day rental Rs. 60,000
Rental income from theatre [320─(2×8) × 60,000] Rs. 18,240,000

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Budgeted Profit And Loss Statement

Revenues Rupees
Revenue from Cinemas [192,192,000(W-1)+103,488,000(W-1)] 295,680,000
Rental income from theatre 18,240,000
313,920,000
Expenses
Variable costs of films [98,780,000(W-2)+75,938,800(W-2)] 174,718,800
Depreciation on Cinema and Theatre houses (30m÷15) 2,000,000
Fixed administration and maintenance cost 4,500,000
181,218,800
Budgeted profit 132,701,200

AT A GLANCE
 Example 08:
Rose Industries Limited (RIL) is in process of preparation of its budget for the year ending 31
March 2020. In this respect, following information has been extracted from RIL's projected
financial statements for the year ending 31 March 2019:
Information and projections for the budget year ending 31 March 2020:
i. The management estimates that profitability can be increased by employing the
following measures:
 Introduction of cash sales at 5% less than the credit sales price. This would increase
the total sales volume by 30% whereas credit sales volume would reduce by 20%
as some of the existing customers would shift to cash sales.

SPOTLIGHT
 Installation of a software that would automatically generate follow-up emails to
the customers and relevant reports for the management. The software having
useful life of 10 years would be operational from 1 April 2019. The software would
cost Rs. 2.5 million and its maintenance cost is estimated at Rs. 0.15 million per
quarter. It is expected that as a result of the use of this software, RIL would be able
to reduce its fixed operating costs by 15%.
 As the purchases increase, RIL would negotiate with the suppliers and receive 2%
trade discount.
 Cost reduction measures would be taken which would save 5% of the variable
conversion and variable operating costs.

STIKCY NOTES
ii. The increase in working capital requirements would be met by arranging a running
finance facility of Rs. 100 million at a mark-up of 10% per annum. It is estimated that on
an average, 90% of the facility would remain utilized during the budget year.
iii. Effect of inflation on price of raw material and all other costs (excluding depreciation)
would be 10%.
iv. Closing raw material and finished goods inventories would increase by 8%.
RIL uses marginal costing and follows FIFO method for valuation of inventory.
Budgeted profit or loss statement for the year ending 31 March 2020, assuming that except stated
otherwise, all transactions are evenly distributed over the year (360 days), would be prepared
as follows
Budgeted profit or loss statement for the year ending 31 March 2020 Rs. in million
Sales - credit 2,800×0.8 2,240.00
Sales - cash [(2,800×1.3)–2,240]×0.95 1,330.00
3,570.00

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Variable cost of goods sold: Rs. in million

Raw material consumption (W-1) (1,574.84)
Variable conversion cost [280÷360,000×471,200(W-2)]×0.95×1.1 (382.98)
Manufacturing cost (1,957.82)
Opening finished goods (110.00)
Closing finished goods (W-3) 179.99
Variable cost of goods sold (1,887.83)
Gross contribution margin 1,682.17
Variable operating cost (190×1.30)×0.95×1.1 (258.12)
Net contribution margin 1,424.05
AT A GLANCE

Fixed conversion cost (160–24)×1.1+24 (173.60)

Fixed operating cost [(45–16)×0.85×1.1+16] +(2.5×10%)+(0.15×4) (43.97)
10% mark-up on running finance facility 100×90%×10% (9.00)
Net profit 1,197.48
W-1: Budgeted raw material consumption Rs. in million
Consumption at last year's price 1,120÷360,000×471,200(W-2) 1,465.96
Use of opening raw material 70.00
Use of current purchases [(1,465.96–70)×1.10]×0.98 1,504.84
1,574.84
SPOTLIGHT

W-2: Budgeted production quantity Units

Sales 360,000×1.3 468,000
Finished goods inventory - closing 40,000×1.08 43,200
- opening (40,000)
471,200
W-3: Finished goods inventory valuation using marginal costing and FIFO Rs. in million
Raw material cost 43,200×(1,120÷360,000)×1.1×0.98 144.88
Variable conversion cost 43,200×(280÷360,000)×1.1×0.95 35.11
STIKCY NOTES

179.99
 Example 08:
Mazahir (Pakistan) Limited manufactures and sells a consumer product Zee. Relevant
information relating to the year ended June 30, 20X3 is as under:
Raw material per unit 5 kg at Rs. 60 per kg
Actual labor time per unit (same as budgeted) 4 hours at Rs. 75 per hour
Actual machine hours per unit (same as budgeted) 3 hours
Variable production overheads Rs. 15 per machine hour
Fixed production overheads Rs. 6 million
Annual sales 19,000 units
Annual production 18,000 units
Selling and administration overheads (70% fixed) Rs. 10 million

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Salient features of the business plan for the year ending June 30, 20X4 are as under:
i. Sale is budgeted at 21,000 units at the rate of Rs. 1,100 per unit.
ii. Cost of raw material is budgeted to increase by 4%.
iii. A quality control consultant will be hired to check the quality of raw material. It will
help improve the quality of material procured and reduce raw material usage by 5%.
Payment will be made to the consultant at Rs. 2 per kg.
iv. The management has negotiated a new agreement with labor union whereby wages
would be increased by 10%. The following measures have been planned to improve the
efficiency:
 30% of the savings in labor cost would be paid as bonus.
 A training consultant will be hired at a cost of Rs. 300,000 per annum to improve

AT A GLANCE
the working capabilities of the workers.
On account of the above measures, it is estimated that labor time will be reduced by 15%.
v. Variable production overheads will increase by 5%.
vi. Fixed production overheads are expected to increase at the rate of 8% on account of
inflation. Fixed overheads are allocated on the basis of machine hours.
vii. The company has a policy of maintaining closing stock at 5% of sales. In order to avoid
stock-outs, closing stock would now be maintained at 10% of sales. The closing stocks
are valued on FIFO basis.
A budgeted profit and loss statement for the year ending June 30, 20X4 under marginal and
absorption costing would be as follows:

SPOTLIGHT
Marginal Absorption Marginal Absorption
Costing Costing Costing Costing
Units
Cost per Cost per
Rupees
unit unit
Sales 21,000 1,100 23,100,000 23,100,000
Cost of goods sold
300+300
Opening stock 950 300+300+45 612,750 929,414
+45+333.33

STIKCY NOTES
Production for the year 22,150 648.5 648.5+306.09 14,364,275 21,144,169
Closing inventory 2,100 648.5 648.5+306.09 (1,361,850) (2,004,639)
13,615,175 20,068,944
Variable selling and
21,000 157.89 3,315,690
administration cost
Contribution margin / Gross profit 6,169,135 3,031,056
Selling and administration costs {(21,000x157.89} + 7,000,000 10,315,690
Fixed cost - production W -2 6,780,000
Fixed cost - Selling & administration (70%  10,000,000) 7,000,000
Net loss (7,610,865) (7,284,634)

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Profit reconciliation:
In absorption costing fixed costs:
- Brought forward from the last year
950  333.33 (316,664)
through opening inventory
- Carried forward to the next year through
2,100  306.09 642,789
closing inventory
- Rounding of difference 106
(7,284,634) (7,284,634)

W-1: Variable cost per unit for 20X3-X4

AT A GLANCE

Raw material (5*0.95*60*1.04) 296.40

Raw material inspection (5*0.95*2) 9.50
Labor (4*0.85*75*1.1) 280.50
Labor incentive cost 30%*(4*0.15*75*1.1) 14.85
Variable production overheads 15*1.05*3 47.25
Variable production costs 648.50
Variable selling and admin. costs (30%*10,000,000)/19,000 157.89
806.39

W-2: Fixed production cost for 20X3-X4

SPOTLIGHT

Annual fixed production overheads (6,000,000*1.08) 6,480,000

Training consultant cost 300,000
6,780,000

W-3: Fixed production cost per unit

Year ended June 30, 20X3 6,000,000/18,000 333.33
Year ended June 30, 20X4 6,780,000/22,150 306.09

W-4: Production for the year Units

STIKCY NOTES

Sales 21,000
Opening inventory 19,000* 5% (950)
Closing inventory 21,000*10% 2,100
Production for the year 22,150

 Example 09:
Zinc Limited (ZL) is engaged in trading business. Following data has been extracted from ZL’s
business plan for the year ended 30 September 20X2:

Sales Rs. ‘000

Actual:
January 20X2 85,000
February 20X2 95,000

300 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 9: budgeting

Sales Rs. ‘000

Forecast:
March 20X2 55,000
April 20X2 60,000
May 20X2 65,000
June 20X2 75,000

Following information is also available:

i. Cash sale is 20% of the total sales. ZL earns a gross profit of 25% of sales and uniformly
maintains stocks at 80% of the projected sale of the following month.

AT A GLANCE
ii. 60% of the debtors are collected in the first month subsequent to sale whereas the
remaining debtors are collected in the second month following sales.
iii. 80% of the customers deduct income tax @ 3.5% at the time of payment.
iv. In January 20X2, ZL paid Rs. 2 million as 25% advance against purchase of packing
machinery.
The machinery was delivered and installed in February 20X2 and was to be operated on
test run for two months. 50% of the purchase price was agreed to be paid in the month
following installation and the remaining amount at the end of test run.
v. Creditors are paid one month after purchases.
vi. Administrative and selling expenses are estimated at 16% and 24% of the sales

SPOTLIGHT
respectively and are paid in the month in which they are incurred. ZL had cash and bank
balances of Rs. 100 million as at 29 February 20X2.
A month-wise cash budget for the quarter ending 31 May 20X2, would be as follows.

Month-wise Cash Budget Rs. in ‘000

Mar Apr May
Opening balance 100,000 109,204 104,828
Collections 83,800 68,800 59,400
Payments:
Purchases (47,250) (44,250) (48,000)

STIKCY NOTES
Selling expenses (13,200 ) (14,400) (15,600)
Administrative expenses (8,800) (9,600 ) (10,400 )
Packing machinery (3,000 ) (3,000) -
Tax withheld by 80% of customers @ 3.5% (2,346) (1,926 ) (1,663 )
(74,596 ) (73,176) (75,663)
Closing balance 109,204 104,828 88,565

Working notes:
W-1: Collections - Jan Sales 85,000
Feb Sales 95,000

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 CHAPTER 9: budgeting CAF 8: CMA

Mar Apr May

Sales Gross 55,000 60,000 65,000
Collections:
Cash sales 11,000 12,000 13,000
1st month after sale 45,600 26,400 28,800
2nd month after sale 27,200 30,400 17,600
83,800 68,800 59,400

W-2 Purchases:
Sales Gross (June) 75,000
AT A GLANCE

Feb Mar Apr May

Sales Gross 95,000 55,000 60,000 65,000
Cost of sales [75% of sales] A 71,250 41,250 45,000 48,750
Less: Opening stock [80% of cost of sale] B (57,000) (33,000) (36,000) (39,000)
Add: Closing stock C 33,000 36,000 39,000 45,000
[80% of next month’s cost of sales]
Purchases (A+C–B) 47,250 44,250 48,000 54,750
Payment to creditors 47,250 44,250 48,000

 Example 10:
SPOTLIGHT

Sadiq Limited (SL) is in the process of preparation of budget for the year ending 31 December
2018. Following are the extracts from the statement of profit or loss for the year ended 31
December 2017:

Rs. in million
Sales (30% cash sales) 7,500
Cost of goods sold (4,000)
Gross profit 3,500
Operating expenses (1,250)
STIKCY NOTES

Net profit before tax 2,250

Raw material inventory as on 1 January 2017 amounted to Rs. 152 million. There were no
opening and closing inventories of work in process and finished goods. SL follows FIFO method
for valuation of inventories.
Following are the projections to be used in the preparation of the budget:
i. Selling price would be reduced by 5%. Further, credit period offered to customers would
be reduced from 45 days to 30 days. As a result, volumes of cash and credit sales are
expected to increase by 10% and 5% respectively.
ii. Ratio of manufacturing cost was 5:3:2 for raw material, direct labor and factory
overheads respectively.
iii. All operating expenses and 20% of factory overheads are fixed. Total depreciation for
the year 2017 amounted to Rs. 100 million and was apportioned between manufacturing
cost and operating expenses in the ratio of 7:3. Depreciation for the next year would
remain the same.

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iv. Raw material inventory would be maintained at 30 days of consumption. Up to 31

December 2017, it was maintained at 45 days of consumption.
v. Raw material prices and direct labor rate would increase by 10% and 6% respectively.
vi. Impact of inflation on all other costs would be 5%.
vii. The existing policy of payment to raw material suppliers in 30 days is to be changed to
15 days. Other costs are to be paid in the month of incurrence.
The budgeted net cash inflows/(outflows) for the year ending 31 December 2018 (Assuming
there are 360 days in a year), would be as follows

Inflows Rs. in million

Cash sales (7,500×30%)×1.1×95% – A 2,351.25

AT A GLANCE
Budgeted credit sales 2018 (7,500×70%)×95%×1.05 5,236.88
Trade debtor (Opening) (7,500×70%)×(45/360) 656.25
Trade debtor (Closing) 5,236.88×30/360 (436.41)
Collections from debtors B 5,456.72
Total inflows A+B 7,807.97

Outflows
Payment to suppliers (W-1) 2,343.78
Direct labor 4,000×{(70%×1.05)+(30%×1.1)} ×30%×1.06 1,354.68

SPOTLIGHT
Variable factory overheads 4,000×{(70%×1.05)+(30%×1.1)}× 715.68
{(20%–(20%×20%)}×1.05
Fixed factory overheads [{4,000×(20%×20%)}–{(100×70%)}]×1.05 94.50
Operating expenses {1,250–(100×30%)}×1.05 1,281.00
Total outflows 5,789.64
Net cash inflows 2,018.33

W-1: Payments to material suppliers

STIKCY NOTES
Consumption of raw material 2018 (4,000×50%)×{(70%×1.05)+(30%×1.1)} 2,130.00
at 2017 price
Opening raw material at 2017 (4,000×50%)×(45/360)
price (250.00)
Closing raw material at 2017 price 2,130×30/360 177.50
Purchases of 2018 at 2017 price 2,057.50

Purchases of 2018 – at increased price 2,057.50×1.1 2,263.25

Trade creditor (Opening) 2,098(W-2)×30/360 174.83
Trade creditor (Closing) 2,263.25×15/360 (94.30)
Payment to suppliers 2,343.78

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W-2: Purchases 2017

Consumption of raw material 2017 4,000×50% 2,000.00
Opening raw material Given (152.00)
Closing raw material (W-1) 250.00
Purchases 2017 2,098.00
 Example 11:
Queen Jewels (QJ) deals in imitated ornaments and operates its business on-line through a web-
portal. Orders are received through the website and dispatched through a courier.
The mode of payments available to customers are as follows:

Mode of payments % of sales

AT A GLANCE

Cash on delivery which is collected by the courier 60%

Advance payments through credit cards 40%

Cash collected by the courier is settled after every 7 days. The courier company’s charges are Rs.
300 per order which are deducted on a monthly basis from the first payment due in the
subsequent month. Payments through credit cards are credited by the bank in 7 days.
High value items which represent 25% of the sales through credit cards are dispatched after 15
days of receipt of payment. All other dispatches are made immediately and delivered on the same
day.
Following further information is available:
i. Sales are made at cost plus 30%.
SPOTLIGHT

ii. Sales and sales orders are projected as under:

Sep. 2015 Oct. 2015 Nov. 2015 Dec. 2015 Jan. 2016
Sales (Rs.) 4,600,000 5,000,000 4,200,000 5,800,000 6,000,000
Sales orders (Nos.) 400 450 470 490 520
iii. High value items are purchased on receipt of the order. Stock level of other goods is
maintained at 25% of projected sales of the next month. 40% of all purchases are paid
in the same month whereas balance is paid in the next month.
iv. Purchases during the month of September 2015 amounted to Rs. 3.2 million.
STIKCY NOTES

v. Selling and administrative expenses are estimated at Rs. 50 million per annum and
include depreciation of tangible and amortization of intangible assets amounting to Rs.
8 million and Rs. 2 million respectively.
vi. Cash and bank balances as at 30 September 2015 amounted to Rs. 5.5 million.
vii. Purchases/sales occur evenly throughout the quarter.
A cash budget of QJ for the quarter ending 31 December 2015 is as follows (Month-wise cash
budget is not required)

Receipts: Rs. in '000’

Collection from sales excluding 10% sales of high valued items:
- 7 days sale in September received in October (4,600÷30790%) 966
- Sales for the quarter ending 31 December 2015 (5,000+4,200+5,800)90% 13,500
- 7 days sale in December collected in January 2015 (5,800/30790%) (1,218)
13,248

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Receipts: Rs. in '000’

Collection in advance from 10% sales of high valued items:
- 8 days(15-7) sales in October received in September (5,000/30810%) (133)
- Sales for the quarter ending 31 December 2015 (5,000+4,200+5,800)10% 1,500
- 8 days sale of Jan. 2016 collected in Dec. 2015 (6,000÷30810%) 160
1,527
Deduction of courier charges from collection
- No. of orders recorded in the previous month (400+450+470) 1,320

AT A GLANCE
- No. of high value orders of Aug. delivered in Sep. 2015 -
- No. of high value orders of Nov. delivered in Dec. 2015 (47010%÷2) (24)
No. of orders delivered previous month 1,296
Courier charges at Rs. 300 per order 1,296300 (389)
Total collection for the quarter 14,386

Payments:
Cost of sales for the quarter (cost plus 30%) (5,000+4,200+5,800)÷1.3 11,538
Opening stock 1 October 2015 (865)

SPOTLIGHT
5,00090%25%÷1.3
Closing stock 31 December 2015 6,00090%25%÷1.3 1,038
Purchases 11,712
60% of Sept. purchases paid in Oct. (3,20060%) 1,920
60% of Dec. purchases to be paid in Jan. 2016 (W.1) 4,49660% (2,698)
Payments for purchases 10,934

Expenses paid excluding depreciation and amortization 10,000

STIKCY NOTES
(50,000-8,000-2,000)÷4
Net outflow for the quarter ended 31 December (6,548)
2015

Cash and bank balances as at 1 October 2015 5,500

Cash and bank balances as at 31 December 2015 - Overdraft (1,048)
W.1: Purchases for December 2015
Cost of sales for Dec. 2015 (cost plus 30%) 5,800÷1.3 4,462
Opening stock 1 December 2015 4,46290%25% (1,004)
Closing stock 31 December 2015 6,00090%25%÷1.3 1,038
Purchases 4,496

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 Example 12:
The home appliances division of Umair Enterprises assembles and markets television sets. The
company has a long term agreement with a foreign supplier for the supply of electronic kits for
its television sets.
Relevant details extracted from the budget for the next financial year are as follows:

Rupees
C&F value of each electronic kit 9,500
Estimated cost of import related expenses, duties etc. 900
Variable cost of local value addition for each set 3,500
AT A GLANCE

Variable selling and admin expenses per set 900

Annual fixed production expenses 12,000,000
Annual fixed selling and admin expenses 9,000,000

Fixed production overheads are allocated on the basis of budgeted production which is 5,000
units.
The present supply chain is as follows:
i. The company sells to distributors at cost of production plus 25% mark-up.
ii. Distributors sell to wholesalers at 10% margin.
iii. Wholesalers sell to retailers at 4% margin.
SPOTLIGHT

iv. Retailers sell to consumers at retail price i.e. at 10% mark-up on their cost.
Performance of the division had not been satisfactory for the last few years. A business consulting
firm was hired to assess the situation and it has recommended the following steps:
a) Reduce the existing supply chain by eliminating the distributors and wholesalers.
b) Reduce the retail price by 5%.
c) Offer sales commission to retailers at 15% of retail price.
d) Provide after sales services.
e) Launch advertisement campaign; expected cost of campaign would be around Rs. 5
million.
STIKCY NOTES

It is expected that the above steps will increase the demand by 1,500 sets. The average cost of
providing after sales service is estimated at Rs. 450 per set.
a) The total budgeted profit under the present situation; and if the recommendations of the
consultants are accepted and implemented are as follows:

Budgeted cost and sales price per set Rupees

C & F value 9,500
Import related costs and duties 900
Variable cost of local value addition 3,500
Variable cost per set 13,900
Fixed production overheads (Rs. 12,000,000/5,000 sets) 2,400
Budgeted cost of production per set 16,300
Add: Gross profit (Rs. 16,300 × 25%) 4,075
Budgeted sales price per set to distributor 20,375

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Rupees
Budgeted gross profit (Rs 4,075 × 5,000 sets) 20,375,000
Less: Admin & selling expenses
Variable (Rs. 900 × 5,000 sets) (4,500,000)
Fixed (9,000,000)
Budgeted annual profit 6,875,000

Computation of budgeted consumer price of each set

Budgeted sales price of the company 20,375.00
Add: distributor margin (Rs. 20,375 × 10/90) 2,263.88

AT A GLANCE
Budgeted sales price of the distributor 22,638.88
Add: wholesaler margin (Rs. 22,638.88 × 4/96) 943.29
Budgeted sales price of wholesaler 23,582.17
Add: retailer’s markup (Rs. 23,582.17 × 10%) 2,358.21
Budgeted retail price 25,940.39
Revised retail price (Rs. 25,940.39 × 95%) 24,643.37

Revised profit forecast after considering consultants’ recommendation:

Rupees

SPOTLIGHT
Sales (6,500 sets × Rs. 24,643.37) 160,181,905
Less: Cost of goods sold for 6,500 units
Electronic Kits @ Rs 9,500 61,750,000
Cost of import and duty @ Rs 900 5,850,000
Local value addition @ Rs 3,500 22,750,000
Fixed overhead cost 12,000,000
(102,350,000)
Gross Profit 57,831,905

STIKCY NOTES
Less: Selling & Admin expenses
Variable (6,500 sets × Rs 900) 5,850,000
Fixed 9,000,000
Cost of advertisement campaign 5,000,000
Cost of after-sale service (6,500 × Rs. 450) 2,925,000
Retailers commission (Rs. 160,181,905 × 15%) 24,027,285
(46,802,285)
Profit by implementing the proposal of consultant 11,029,620
Based on above results, management should accept the recommendation of the
consultant.

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b) Description of what other factors would you consider while implementing the
consultants’ recommendations are as follows.
In the light of the changes recommended by the consultant, the company will have to
consider whether it has the necessary infrastructure to:
i. deal with a far larger number of retailers as against the present few distributors.
ii. produce and sell extra 30% t.v. sets.
iii. attend to after sale activities on its own. The question is silent as to who
presently attends to this activity.
iv. conduct effective advertisement campaign.
Fixed expenses related to manufacturing as well as selling and admin are likely to
AT A GLANCE

increase but no such increase has been anticipated.

 Example 13:
RS Enterprises is a family concern headed by Mr. Rameez. It is engaged in manufacturing of a
single product but under two brand names i.e. A and B. Brand B is of high quality and over the
past many years, the company has been charging a 60% higher price as compared to brand A. As
the company has progressed, Mr. Rameez has felt the need for better planning and control. He
has compiled the following data pertaining to the year ended November 30,20X8:

Rupees Rupees
Sales 5,522,400
Production costs:
SPOTLIGHT

Raw materials 2,310,000

Direct labor 777,600
Overheads 630,000 3,717,600
Gross profit 1,804,800
Selling and administration expenses 800,000
1,004,800

A B
No. of units sold 5400 3600
STIKCY NOTES

Labor hours required per unit 5 6

Other information is as follows:

i. 20% of B was sold to a corporate buyer who was given a discount of 10%. The buyer has
agreed to double the purchases in 20X9 and Mr. Rameez has agreed to increase the
discount to 15%.
ii. In view of better margins in B, Mr. Rameez has decided to promote its sale at a cost of
Rs. 250,000. As a result, its sales to customers other than the corporate customer, are
expected to increase by 30%. However, the production capacity is limited. He intends to
reduce the production/sale of A if necessary. Mr. Rameez has ascertained that 90%
capacity was utilized during the year ended November 30, 20X8 whereas the time
required to produce one unit of B is 20% more than the time required to produce a unit
of A.
iii. 2.4 kgs of the same raw material is used for both brands but the process of
manufacturing B is slightly complex and 10% of all raw material is wasted in the process.
Wastage in processing A is 4%.

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iv. The price of raw material has remained the same for the past many years. However, the
supplier has indicated that the price will be increased by 10% with effect from March 1,
20X9.
v. Direct labor per hour is expected to increase by 15%.
vi. 40% of production overheads are fixed. These are expected to increase by 5%. Variable
overheads per unit of B are twice the variable overheads per unit of A. For 20X9, the
effect of inflation on variable overheads is estimated at 10%.
vii. Selling and administration expenses (excluding the cost of promotional campaign on B)
are expected to increase by 10%.
A profit forecast statement for the year ending November 30, 20X9 would be prepared as follows.

AT A GLANCE
Computation of Sales for 20X8
A B Normal B Corporate Total
Ratio of sale price 1.00 1.60 1.44
Actual sale Qty 5,400.00 2,880.00 720.00
Ratio of sale value 5,400.00 4,608.00 1,036.80 11,044.80
Sales value 2,700,000.00 2,304,000.00 518,400.00 5,522,400.00

A B
Current year’s production (at 90% capacity) 5,400.00 3,600.00
Production at full capacity 6,000.00 4,000.00

SPOTLIGHT
If only B is produced the company can produce 9,000 units (4,000 + 6,000 / 1.2).
Required production of B in the next year = (2,880 x 1.3) + (2 x 720) = 3744 + 1440 = 5,184 units
Remaining capacity can be utilized to produce 4,579 units of A [(9,000 - 5,184) x 1.2].
Computation of Sales for 20X9 Rupees
Sales of A (4,579 x 500) 2,289,500
Sales of B (5,184 x 800) 4,147,200
6,436,700
Discount to Corporate customer (1,440 × 800 × 15%) 172,800

STIKCY NOTES
6,263,900

Consumption of Raw Material Kgs

Consumption of raw material in 20X8 (A: 5,400 x 2.4 / 0.96) 13,500.00
Consumption of raw material in 20X8 (B: 3,600 x 2.4 / 0.90) 9,600.00
Total 23,100.00
Rupees
Price per kg of raw material ( 2,310,000 / 23,100) 100.00
Total expected consumption in 20X9 (A: 4,579 x 2.4 / 0.96) 11,447.50
Total expected consumption in 20X9 (B: 5,184 x 2.4 / 0.90) 13,824.00
Total consumption for 20X9 25,271.50
Average price for 20X9 ((100 x 3) + (110 x 9)) / 12 107.50

Total cost of raw material for 20X9 2,716,686.25

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Computation of Direct Labor Hours

Labor hours used in 20X8 (A: 5,400 × 5) 27,000
Labor hours used in 20X8 (B: 3,600 × 6) 21,600
48,600

Labor hours forecast for 20X9 (A: 4,579 × 5) 22,895

Labor hours forecast for 20X9 (B: 5,184 × 6) 31,104
53,999

Increase in labor hours 5,399

AT A GLANCE

Labor cost for 20X9 (1.15 x (777,600 x 53,999 / 48,600)) Rs. 993,582

Production overheads for 20X8 : Rupees

Fixed overheads (40% x 630,000) 252,000.00

Variable overheads (630,000-252,000) 378,000.00

A B Total
Ratio of variable overheads 1.00 2.00
Total units produced 5,400.00 3,600.00
SPOTLIGHT

Product (units) (K) 5,400.00 7,200.00 12,600.00

Total variable overheads (Rs.) (L) 162,000.00 216,000.00 378,000.00

Per unit variable overheads (Rs.) (L /K) 30.00 60.00

Production overheads for 20X9: A B Total

Fixed overheads (1.05 x 252,000) (Rs.) 264,600.00
Per unit variable overheads (Rs.) 33.00 66.00
STIKCY NOTES

Total units 4,579 5,184

Total variable overheads (Rs.) 151,107.00 342,144.00 493,251.00
Total overheads (Rs.) 757,851.00

PROFIT FORECAST STATEMENT FOR 20X9 Rupees

Sales 6,263,900.00
Material 2,716,686.25
Labor 993,582.00
Overheads 757,851.00 4,468,119.25
Gross margin 1,795,780.75

Selling and administration expenses (800,000 x 1.1) + 250,000 1,130,000.00

665,780.75

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STICKY NOTES

Forecasting uses historical data to make informed decisions about the

businesses’ future. Types of forecast involve Demand (sales) forecast,
Economic forecast, Technological forecast

Qualitative methods of forecasting include market research, jury of executive

opinion, Delphi method & Estimates of the sales force.

AT A GLANCE
Quantitative methods of forecasting include time series models (trend
projections, moving averages & Naïve approaches) and causal models (linear
Regression method)

Budgeting refers to preparing a list of guidelines for expenditures for future

and it is usually done a year in advance. Purposes of budget include planning,
control, decision making, resource allocation as well as coordination and
communication.

There are also fixed or flexible budgets where contextual situations and

SPOTLIGHT
business environments are known or varied respectively.

Types of budget include from sales and production budget, direct material &
labor budget, manufacturing overhead to cash and capital expenditure
budget. A master budget entails all the segments of the budget into one
collective process; also called corporate budget.

Zero based budgeting means preparing budget from a zero base each time.
Past actions or impact are less likely to impact future decisions.

STIKCY NOTES
Budgeting in Non-Profit organizations are similar to corporate budgeting
process, except for the fact that the budget for non-profit organizations are
not designed with a focus on profitability.

There are some human and motivational aspects in budgeting process too.
These include budgetary slack, dysfunctional behavior, budgetary styles as
well as motivation to complete the process.

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 10

STANDARD COSTING

AT A GLANCE
IN THIS CHAPTER
Standard costing is the preparation of standard costs to assist
AT A GLANCE setting budgets and evaluating managerial performance.

AT A GLANCE
A standard cost is carefully predetermined estimated unit cost.
SPOTLIGHT It is usually a standard cost per unit of production or per unit of
service rendered.
1. Using And Deriving Standard
Costs A standard cost when established is an average expected unit
cost because it is only an average actual results will vary to some
2. Allowing For Waste And Idle extent above and below the average.
Time The difference between standard and actual is known as
variance. The process by which the total difference between
3. Comprehensive Examples standard and actual results is analyzed in known as variance
analysis.
STICKY NOTES

SPOTLIGHT
STIKCY NOTES

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1. USING AND DERIVING STANDARD COSTS

1.1 Standard costing
Standard costing involves the establishment of predetermined estimates of the costs of products or services, the
collection of actual costs and the comparison of the actual results with the predetermined estimates. The
predetermined costs are known as standard costs and the difference between standard and actual is known as
variance.
 Standard cost is an estimated or predetermined cost of performing an operation or producing a good or
service, under normal conditions.
 Standard costing is a control technique that reports variances by comparing actual costs to pre-set standards
so facilitating action through management by exception.
AT A GLANCE

Standard costing may be used with either a system of absorption costing or a system of marginal costing.
In simple words…
Standard costing involves using an expected cost (standard cost) as a substitute for actual cost in the accounting
system. Periodically the standard costs are compared to the actual costs. Differences between the standard and
actual are recorded as variances in the costing system.

When is standard costing appropriate?

Standard costing can be used in a variety of situations.
 It is most useful when accounting for homogenous goods produced in large numbers, when there is a degree
of repetition in the production process.
SPOTLIGHT

 A standard costing system may be used when an entity produces standard units of product or service that
are identical to all other similar units produced.
 Standard costing is usually associated with standard products, but can be applied to standard services too.
A standard unit should have exactly the same input resources (direct materials, direct labor time) as all other
similar units, and these resources should cost exactly the same. Standard units should therefore have the same
cost.

1.2 Standard cost

A standard cost is a predetermined unit cost based on expected direct materials quantities and expected
direct labor time, and priced at a predetermined rate per unit of direct materials and rate per direct labor hour
and rate per hour of overhead.
STIKCY NOTES

Standard costs of products are usually restricted to production costs only, not administration and selling and
distribution overheads.
Overheads are normally absorbed into standard production cost at an absorption rate per direct labor hour.
 Example 01:
The standard cost of a Product XYZ might be:
Rs. Rs.
Direct materials:
Material A: 2 litres at Rs.4.50 per litre 9.00
Material B: 3 kilos at Rs.4 per kilo 12.00
21.00

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Rs. Rs.
Direct labor
Grade 1 labor: 0.5 hours at Rs.20 per hour 10.00
Grade 2 labor: 0.75 hours at Rs.16 per hour 12.00
22.00
Variable production overheads: 1.25 hours at Rs.4 per hour 5.00
Fixed production overheads: 1.25 hours at Rs.40 per hour 50.00
Standard (production) cost per unit 98.00

Who sets standard costs?

AT A GLANCE
Standard costs are set by managers with the expertise to assess what the standard prices and rates should be.
Standard costs are normally reviewed regularly, typically once a year as part of the annual budgeting process.
 Standard prices for direct materials should be set by managers with expertise in the purchase costs of
materials. This is likely to be a senior manager in the purchasing department (buying department).
 Standard rates for direct labor should be set by managers with expertise in labor rates. This is likely to be a
senior manager in the human resources department (personnel department).
 Standard usage rates for direct materials and standard efficiency rates for direct labor should be set by
managers with expertise in operational activities. This may be a senior manager in the production or
operations department, or a manager in the technical department.
 Standard overhead rates should be identified by a senior management accountant, from budgeted overhead
costs and budgeted activity levels that have been agreed in the annual budgeting process.

SPOTLIGHT
1.3 The uses of standard costing
Standard costing has four main uses.
 It is an alternative system of cost accounting. In a standard costing system, all units produced are recorded
at their standard cost of production.
 When standard costs are established for products, they can be used to prepare the budget.
 It is a system of performance measurement. The differences between standard costs (expected costs) and
actual costs can be measured as variances. Variances can be reported regularly to management, in order to
identify areas of good performance or poor performance.
 It is also a system of control reporting. When differences between actual results and expected results (the
budget and standard costs) are large, this could indicate that operational performance is not as it should be,

STIKCY NOTES
and that the causes of the variance should be investigated. Management can therefore use variance reports
to identify whether control measures might be needed, to improve poor performance or continue with good
performances.
When there are large adverse variances, this might indicate that actual performance is poor, and control action
is needed to deal with the weaknesses.
When there are large favorable variances, and actual results are much better than expected, management should
investigate to find out why this has happened, and whether any action is needed to ensure that the favorable
results continue in the future.
Variances and controllability
The principle of controllability should be applied in any performance management system
When variances are used to measure the performance of an aspect of operations, or the performance of a
manager, they should be reported to the manager who is:
 responsible for the area of operations to which the variances relate, and
 able to do something to control them.

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There is no value or practical purpose in reporting variances to a manager who is unable to do anything to control
performance by sorting out problems that the variances reveal and preventing the variances from happening
again.
It is also unreasonable to make a manager accountable for performance that is outside his control, and for
variances that he can do nothing about.
1.4 Deriving a standard cost
A standard variable cost of a product is established by building up the standard materials, labor and production
overhead costs for each standard unit. This will be the standard cost in marginal costing system.
In a standard absorption costing system, the standard fixed overhead cost is a standard cost per unit, based on
budgeted data about fixed costs and the budgeted production volume.
Deriving the standard usage for materials
AT A GLANCE

The standard usage for direct materials can be obtained by using:

 historical records for material usage in the past, or
 the design specification for the product
Deriving the standard efficiency rate for labor
The standard efficiency rate for direct labor can be obtained by using:
 historical records for labor time spent on the product in the past, or
 making comparisons with similar work and the time required to do this work, or
 ‘time and motion study’ to estimate how long the work ought to take
SPOTLIGHT

Deriving the standard price for materials

The standard price for direct materials can be estimated by using:
 historical records for material purchases in the past, and
 allowing for estimated changes in the future, such as price inflation and any expected change in the trade
discounts available
Deriving the standard rate of pay for labor
Not all employees are paid the same rate of pay, and there may be differences to allow for the experience of the
employee and the number of years in the job. There is also the problem that employees may receive an annual
increase in pay each year to allow for inflation, and the pay increase may occur during the middle of the financial
STIKCY NOTES

year.
 The standard rate of pay per direct labor hour will be an average rate of pay for each category or grade of
employees.
 The rate of pay may be based on current pay levels or on an expected average pay level for the year, allowing
for the expected inflationary pay rise during the year.
 Example 02:
A company produces bookshelves. Each bookshelf requires three planks of wood. A box of wood
contains 15 planks and costs Rs.45.
Currently 20% of wood is wasted during production. Management would like to reduce this
wastage to 10%.
Calculate a standard material cost for a bookshelf based on
a) Ideal conditions
Standard cost per plank = Rs.45/15 planks = Rs.3 per plank
Ideal standard: 3 planks  Rs.3 = Rs.9 per bookshelf

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b) Current conditions
Current standard: 3/0.80 planks = 3.75 planks at Rs.3 = Rs.11.25 per bookshelf
c) Attainable conditions
Attainable or target standard: 3/0.9 = 3.33 planks at Rs.3 = Rs.10 per bookshelf
1.5 Types of standard & their behavioral aspects
Standards are predetermined estimates of unit costs but how is the level of efficiency inherent in the estimate
determined? Should it assume perfect operating conditions or should it incorporate an allowance for waste and
idle time? The standard set will be a performance target and if it seen as unattainable this may have a detrimental
impact on staff motivation. If the standard set is too easy to attain there may be no incentive to find
improvements.
There are four types of standard, and any of these may be used in a standard costing system. One of the purposes

AT A GLANCE
of standard costing is to set performance standards that motivate employees to improve performance. The type
of standard used can have an effect on motivation and incentives. The types of standards and their behavioral
aspects are given below:
Ideal standards.
These assume perfect operating conditions. No allowance is made for wastage, labor inefficiency or machine
breakdowns. The ideal standard cost is the cost that would be achievable if operating conditions and operating
performance were perfect. In practice, the ideal standard is not achieved.
Ideal standards are unlikely to be achieved. They may be very useful as long term targets and may provide senior
managers with an indication of the potential for savings in a process but generally the ideal standard will not be
achieved. Consequently, the reported variances will always be adverse. Employees may be becoming de-
motivated when their performance level is always worse than standard and they know that the standard is

SPOTLIGHT
unachievable.
Attainable standards.
These assume efficient but not perfect operating conditions. An allowance is made for waste and inefficiency.
However, the attainable standard is set at a higher level of efficiency than the current performance standard, and
some improvements will therefore be necessary in order to achieve the standard level of performance.
Attainable standards are the most likely to motivate employees to improve performance as they are based on
challenging but attainable targets. It is for this reason that standards are often based on attainable conditions.
However, a problem with attainable standards is deciding on the level of performance that should be the target
for achievement. For example, if an attainable standard provides for some improvement in labor efficiency,
should the standard provide for a 1% improvement in efficiency, or a 5% improvement, or a 10% improvement?

STIKCY NOTES
Current standards.
These are based on current working conditions and what the entity is capable of achieving at the moment.
Current standards do not provide any incentive to make significant improvements in performance, and might be
considered unsatisfactory when current operating performance is considered inefficient.
Current standards may be useful for producing budgets as they are based on current levels of efficiency and may
therefore give a realistic guide to resources required in the production process. However current standards are
unlikely to motivate employees to improve their performance, unless there are incentives for achieving favorable
variances (for achieving results that are better than the standard), such as annual cash bonuses.
Basic standards.
These are standards which remain unchanged over a long period of time. Variances are calculated by comparing
actual results with the basic standard, and if there is a gradual improvement in performance over time, this will
be apparent in an improving trend in reported variances.

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Basic standards will not motivate employees to improve their performance as they are based on achievable
conditions at some time in the past. They are also not useful for budgeting because they will often be out of date.
In practice, they are the least common type of standard.
When there is waste in production, or when idle time occurs regularly, current standard costs may include an
allowance for the expected wastage or expected idle time. This is considered in more detail later.

1.6 Reviewing standards

How often should standards be revised? There are several reasons why standards should be revised regularly.
Regular revision leads to standards which are meaningful targets that employees may be motivated to achieve
(for example, through incentive schemes).
Variance analysis is more meaningful because reported variances should be realistic.
AT A GLANCE

In practice, standards are normally reviewed annually. Standards by their nature are long-term averages and
therefore some variation is expected over time. The budgeting process can therefore be used to review the
standard costs in use.
SPOTLIGHT
STIKCY NOTES

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2. ALLOWING FOR WASTE AND IDLE TIME

2.1 Materials wastage in standard costing
Waste is an unavoidable feature of some production processes. The actual amount of materials wasted may vary
from one period to another, but there may be a standard rate of wastage or a ‘normal’ rate of loss which is a
measure of the average rate of wastage or loss.
An allowance for expected loss can be included in a standard cost. The standard cost can be based on the expected
quantity of input materials required to produce one unit of output (which is the same principle as that used for
normal loss in process costing).
 Example 03:
A company manufactures a product in a process production system. There is some wastage in

AT A GLANCE
production, and normal loss is 10% of the number of units input to the process. One unit of raw
material is required to produce one unit of finished goods.
The standard price per unit of direct material is Rs.4.50 per unit.
a) If an ideal standard is used, and the standard does not provide for any loss in process,
standard direct material cost per unit of output would be as follows
Ideal standard
No loss; therefore, standard cost =
1 unit of direct materials at Rs.4.50 per unit of material = Rs.4.50 per unit of output.
b) If the standard cost allows for a loss of 10% of input materials in producing each unit of

SPOTLIGHT
output, then Standard Direct material cost per unit of output would be:
Attainable or current standard: allow for 10% loss
Standard input to produce one unit of = 1/0.9 units = 1.111 units.
Therefore, standard cost =
1.111 units of materials at Rs.4.50 per unit = Rs.5 per unit of output.
 Example 04:
A company produces sandwiches. Each sandwich requires two slices of bread and a loaf of bread
contains 24 slices. Each loaf of bread costs Rs.6. It is estimated that currently 20% of bread is
wasted. Management would like to reduce this wastage to 10%.

STIKCY NOTES
Calculation of a standard material cost for a sandwich based on various conditions are given
below
a) Ideal conditions
Standard cost per slice of bread = Rs.6/24 slices = Rs.0.25
Ideal standard: 2 slices  Rs.0.25 = Rs.0.50
b) Current conditions
Current standard: 2/0.80 slices = 2.5 slices at Rs.0.25 = Rs.0.625
c) Attainable conditions
Attainable or target standard: 2/0.9 = 2.22 slices at Rs.0.25 = Rs.0.555.
Note that the current and attainable standard costs include an allowance for wastage, and a
materials usage variance will occur only if the actual wastage rate differs from the standard
wastage rate.

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2.2 Idle time and standard costing

Idle time occur when the direct labor employees are being paid but have no work to do. The causes of idle time
may be:
 A breakdown in production, for example a machine breakdown that halts the production process
 Time spent waiting for work due to a bottleneck or hold-up at an earlier stage in the production process
 Running out of a vital direct material, and having to wait for a new delivery of the materials from a supplier.
 A lack of work to do due to a lack of customer orders.
A feature of idle time is that it is recorded, and the hours ‘lost’ due to idle time are measured.
Sometimes idle time may be an unavoidable feature of the production process, so that an allowance for idle time
is included in the standard cost.
AT A GLANCE

Methods of including idle time in standard costs

There are different ways of allowing for idle time in a standard cost.
 Method 1. Include idle time as a separate element of the standard cost, so that the standard cost of idle time
is a part of the total standard cost per unit.
 Method 2. Allow for a standard amount of idle time in the standard hours per unit for each product. This is
the same approach described above for materials wastage and standard costing. The standard hours per unit
therefore include an allowance for expected idle time.
 Example 05:
A company manufactures Product X. Due to the nature of the production process, there is some
SPOTLIGHT

idle time and it has been estimated that the ‘normal’ amount of idle time is 10% of hours worked.
Ignoring idle time, the standard time to make 1 unit of Product X is 0.36 hours. Labor is paid
Rs.18 per hour.
This means that the labor time to make 1 unit of product X is 0.36/0.90 = 0.40 hours, of which
0.04 hours are idle time.
There are two ways of making an allowance for in the standard cost the expected idle time.
Method 1: Include idle time as a separate element of the standard cost. The standard cost per
unit will include the following items:

Rs.
STIKCY NOTES

Active hours worked: 0.36 hours  Rs.18 per hour 6.48

Idle time: 0.04 hours  Rs.18 per hour 0.72
7.20

Method 2: Include an allowance for expected idle time in the standard hours per unit for each
product.
Standard cost = 0.40 hours  Rs.18 per hour = Rs.7.20

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3. COMPREHENSIVE EXAMPLES
 Example 01:
A company manufactures two products, X and Y. In Year 1 it budgets to make 2,000 units of
Product X and 1,000 units of Product Y. Budgeted resources per unit and costs are as follows:

Product X Product Y
Direct materials per unit:
Material A 2 units of material 1.5 units of material
Material B 1 unit of material 3 units of material
Direct labor hours per unit 0.75 hours 1 hour

AT A GLANCE
Costs
Direct material A Rs.4 per unit
Direct material B Rs.3 per unit
Direct labor Rs.20 per hour
Variable production overhead Rs.4 per direct labor hour

Fixed production overheads per unit are calculated by applying a direct labor hour absorption
rate to the standard labor hours per unit, using the budgeted fixed production overhead costs of
Rs.120,000 for the year.
The standard full production cost per unit of product X and Y are as follows
First calculate the budgeted overhead absorption rate.

SPOTLIGHT
Budgeted direct labor hours hours
Product X: (2,000 units  0.75 hours) 1,500
Product Y (1,000 units  1 hour) 1,000
2,500
Budgeted fixed production overheads Rs.120,000
Fixed overhead absorption rate/hour Rs.48

STIKCY NOTES
Product X Product Y
Rs. Rs.
Direct materials
Material A (2 units  Rs.4) 8 (1.5 units  Rs.4) 6
Material B (1 unit  Rs.3) 3 (3 units  Rs.3) 9
Direct labor (0.75 hours  Rs.20) 15 (1 hour  Rs.20) 20
Variable production overhead (0.75 hours  Rs.4) 3 (1 hour  Rs.4) 4
Standard variable prod’n cost 29 39
Fixed production overhead (0.75 hours  Rs.48) 36 (1 hour  Rs.48) 48
Standard full production cost 65 87

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 Example 02:
A company manufactures two products, Laurel and Hardy. In Year 1 it budgets to make 6,000
units of Product Laurel and 2,000 units of Product Hardy. Budgeted resources per unit and costs
are as follows:

Laurel Hardy
Direct materials per unit:
Material X 3 kg 1kg
Material Y 2 kg 6 kg
Direct labor hours per unit 1.6 hours 3 hours
AT A GLANCE

Budgeted Costs
Direct material X Rs. 3 per unit
Direct material Y Rs. 4 per unit
Direct labor Rs. 25 per hour
Variable production overhead Rs. 5 per direct labor hour

Fixed production overheads per unit are calculated by applying a direct labor hour absorption
rate to the standard labor hours per unit, using the budgeted fixed production overhead costs of
Rs.187,200 for the year.
The standard full production cost per unit of product Laurel and Hardy are as follows
SPOTLIGHT

First calculate the budgeted overhead absorption rate.

Budgeted direct labor hours hours

Laurel: (6,000 units  1.6 hours) 9,600
Hardy (2,000 units  3 hours) 6,000
15,600
Budgeted fixed production overheads Rs. 187,200
Fixed overhead absorption rate/hour Rs. 12 / hour
STIKCY NOTES

Laurel Hardy
Rs. Rs.
Direct materials
Material X (3 kg  Rs. 3) 9 (1 kg  Rs. 3) 3
Material Y (2 kg  Rs.4) 8 (6 kg  Rs. 4) 24
Direct labor (1.6 hrs  Rs.25) 40 (3 hrs  Rs.25) 75
Variable production overhead (1.6 hrs  Rs.5) 8 (3 hrs  Rs.5) 15
Standard variable prod’n cost 65 117
Fixed production overhead (1.6 hrs  Rs.12) 19.2 (3 hrs  Rs.12) 36
Standard full production cost 84.2 153

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 Example 03:
A company manufactures Product Y. Due to the nature of the production process, there is some
idle time and it has been estimated that the ‘normal’ amount of idle time is 20% of hours worked.
Ignoring idle time, the standard time to make 1 unit of Product Y is 0.56 hours. Labor is paid
Rs.30 per hour.
Calculate the standard cost of the expected idle time using each of the following three methods:
i. Include idle time as a separate element of the standard cost
ii. Include an allowance for expected idle time in the standard hours and standard
cost
The labor time to make 1 unit of product X is 0.56/0.80 = 0.70 hours, of which 0.14 hours are idle

AT A GLANCE
time.
i. Include idle time as a separate element of the standard cost.
The standard cost per unit will include the following items:

Rs.
Active hours worked: 0.56 hours  Rs.30 per hour 16.80
Idle time: 0.14 hours  Rs.30 per hour 4.20
21.00

ii. Include an allowance for expected idle time in the standard hours and in standard
cost.

SPOTLIGHT
Standard cost = 0.70 hours  Rs.30 per hour = Rs.21.00

STIKCY NOTES

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STICKY NOTES

A standard is a pre-determined unit of cost for stock valuation, budgeting and

control

A standard cost card shows full details of the standard cost of each product
AT A GLANCE

The standard for each type of cost (material, labor and Overhead) is made up
of a standard resource price and a standard resource usage

The difference between standard and actual is known as a variance. The

process by which the total difference between standard and actual results is
analyzed in known as variance analysis.

Performance standards are used to set efficiency targets. There are four
types: Ideal, Current, Basic and Attainable
SPOTLIGHT

There may be a standard rate of wastage or a ‘normal’ rate of loss which is a

measure of the average rate of wastage or loss. An allowance for expected
loss can be included in a standard cost.
STIKCY NOTES

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VARIANCE ANALYSIS

AT A GLANCE
IN THIS CHAPTER
A budget is a standard, set to coordinate between different
AT A GLANCE departments and managers.

AT A GLANCE
We prepare budgets to motivate managers and to evaluate their
SPOTLIGHT performance.

1. Standard cost and budgets The original budget prepared at the beginning of a budget
period is known as the fixed budget. When we shift our standard
2. Direct Material Variances for actual activity it is called flexed budget.
Variances are calculated for control purposes.
3. Direct labor Variances
Total Cost variances are to be calculated by comparing total
standard cost with total actual cost.
4. Variable production overhead
variances Total material, labor and overhead variances can be calculated
by comparing total standard cost with total Actual cost
5. Fixed production overhead cost respectively.

SPOTLIGHT
variances: absorption costing
Material variance can be divided into material Price and usage
variance.
6. Interelationship of Variances
Labor variance can be divided into labor rate and efficiency
7. Standard marginal costing variance.
Variable overhead can vary with number of units or with
8. Materials mix and yield
number of hours.
variances
Fixed overhead variances are Expenditure and volume
9. Calculating actual cost and variances.
standard cost from variances
For all cost variances if actual cost is greater than standard it is

STIKCY NOTES
an adverse variance.
10. Comprehensive Examples
Variances can be interrelated for example an adverse material
STICKY NOTES usage variance may be due to favorable material price variance.
Mix variances are to be calculated where there is more than one
type of material or labor involved.
Work back of variance is where we have to calculate actual and
standard cost from variances given.

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1. STANDARD COST AND BUDGETS

Business entities plan their future activities. This is often done through the drafting of budgets. A budget is a
formal plan (for a specified time period), expressed mainly in financial terms and covering all the activities of the
entity.
Standard costing is a component of budgeting in some companies. It is appropriate for companies engaged in
mass production of large numbers of homogenous (identical) items where there is a great deal of repetition in
the production process. In such cases it is relatively straightforward to identify a standard unit of output (cost
unit) and to establish how much making a single unit should cost.
Standard costs are constructed by estimating the quantities of standard amounts of input (for example materials
and labor) and estimating the cost of buying these over the future period covered by the standard.
AT A GLANCE

Companies can often measure the standard quantities with a high degree of confidence. Remember that standard
costing is appropriate in conditions of high production numbers and a lot of repetition. In an environment in
which the future could be predicted with a reasonable degree of certainty. Companies might make thousands of
items and this experience leads to knowledge of the process and a better idea of cost structure and flow of costs
through the process.
Standard costs for a unit are often set out in a record called a standard cost card. A typical standard cost card is
as follows.
 Example 01:
Standard cost card (Marden Manufacturing Limited)
Rs.
Direct materials 5 kg @ Rs.1,000 per kg 5,000
SPOTLIGHT

Direct labor 4 hours @ Rs. 500 per hour 2,000

Variable overhead 4 hours @ Rs. 200 per hour 800
Marginal production cost 7,800
Fixed production overhead 4 hours @ Rs. 600 per hour 2,400
Total absorption cost 10,200
The above standard costs will be used in examples throughout this chapter to illustrate variance
analysis.
Standard costs link to the budget through activity levels. For example, if a company wanted to
make 1,200 of the above units the budget would show a material cost of Rs. 6,000,000 (1,200
Rs. 5,000)
STIKCY NOTES

1.1. Budgets and actual results for a period:

1.1.1. Fixed budget

The original budget prepared at the beginning of a budget period is known as the fixed budget. A fixed budget is
a budget for a specific volume of output and sales activity, and it is the ‘master plan’ for the financial year that
the company tries to achieve.
 Example 02:
Marden Manufacturing Limited has budgeted to make 1,200 units and sell 1,000 units in January.
The selling price per unit is budgeted at Rs. 15,000.
The standard costs of production are as given in the previous example.
The budget prepared for January is as follows:
Unit sales 1,000
Unit production 1,200

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Budget Rs. ‘000

Sales (1,000 units 15,000) 15,000
Cost of sales:
Materials (1,200 units Rs. 5,000 per unit) 6,000
Labor (1,200 units Rs. 2,000 per unit) 2,400
Variable overhead (1,200 units Rs. 800 per unit) 960
Fixed overhead (1,200 units Rs. 2,400 per unit) 2,880
12,240
Closing inventory (200 units Rs. 10,200 per unit) (2,040)

AT A GLANCE
Cost of sales (1,000 units Rs. 10,200 per unit) (10,200)
Profit 4,800

Note: Budgeted profit = 1,000 units  (Rs. 15,000 Rs. 10,200 per unit) = Rs. 4,800,000
One of the main purposes of budgeting is budgetary control and the control of costs. Costs can be
controlled by comparing budgets with the results actually achieved.
Differences between expected results and actual results are known as variances. Variances can be either
favorable (F) or adverse (A) depending on whether the results achieved are better or worse than expected.
Consider the following:
 Example 03:

SPOTLIGHT
At the end of January Marden Manufacturing Limited recorded its actual results as follows.
Budget Actual
Unit sales 1,000 900
Unit production 1,200 1,000
Budget Rs. ‘000 Rs. ‘000
Sales 15,000 12,600

Cost of sales: Budget Actual

Materials 6,000 4,608

STIKCY NOTES
Labor 2,400 2,121
Variable overhead 960 945
Fixed overhead 2,880 2,500
12,240 10,174
Closing inventory (2,040) (1,020)
Cost of sales (10,200) (9,154)
Profit 4,800 3,446

Note: The actual closing inventory of 100 units is measured at the standard cost of Rs. 10,200
per unit. This is what happens in standard costing systems. (in exam if question is silent about
inventory measurement then actual closing inventory shall be measured at actual absorption
cost.

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What does this tell us?

The actual results differ from the budget. The company has not achieved its plan in January. Profit is less than
budgeted. The company would like to understand the reason for this in as much detail as possible.
The technique that explains the difference between actual results and the budget is called variance analysis. This
technique identifies the components of the difference between the budgeted profit and the actual profit in detail
so that they can be investigated and understood by the company.
The sales figure is less than budgeted but why? The sales figure is a function of the quantity sold and the selling
price per unit. The quantity sold is 100 units less than budgeted but what about the impact of any difference in
the sales price?
At first sight it looks as if the company has made savings on every cost line. For example budgeted material cost
was Rs. 6,000,000 but actual spend was only Rs. 4,608,000. However, this is not a fair comparison because the
AT A GLANCE

budgeted cost was to make 1200 units whereas the company only made 1,000 units.

1.1.2. Flexed budget

Variances are not calculated by comparing actual results to the fixed budget directly because the figures relate
to different levels of activity and the comparison would not be like to like. A second budget is drawn up at the
end of the period. This budget is based on the actual levels of activity and the standard revenue and standard
costs. This budget is called a flexed budget.
 Example 04:
The flexed budget prepared by Marden Manufacturing Limited at the end of January (based on
actual levels of activity and standard revenue per unit and standard cost per unit) is as follows:
SPOTLIGHT

Unit sales 900

Unit production 1,000
Budget Rs. ‘000
Sales (900 units 15,000) 13,500

Cost of sales: Rs. ‘000

Materials (1,000 units Rs. 5,000 per unit) 5,000
Labor (1,000 units Rs. 2,000 per unit) 2,000
STIKCY NOTES

Variable overhead (1,000 units Rs. 800 per unit) 800

Fixed overhead (1,000 units Rs. 2,400 per unit) 2,400
10,200
Closing inventory (100 units Rs. 10,200 per unit) (1,020)
Cost of sales (900 units Rs. 10,200 per unit) (9,180)
Profit 4,320

This shows the amount that the company would have received for the actual number of units
sold if they had been sold at the budgeted revenue per item.
It shows what the actual number of units produced (1,000 units) would have cost if they had
been made at the standard cost.
The flexed budget is a vital concept. It sits at the heart of variance analysis.

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1.1.3. Comparison of actual results to the flexed budget.

All three statements can be combined as follows:
 Example 05:
Fixed budget, flexed budget and actual results for a period.
At the end of January, Marden Manufacturing Limited has recorded its actual results as follows
(together with the original fixed budget and the flexed budget for the month).
Fixed budget Flexed budget Actual
Unit sales 1,000 900 900
Unit production 1,200 1,000 1,000

AT A GLANCE
Budget Actual Actual
Budget Rs. ‘000 Rs. ‘000 Rs. ‘000
Sales 15,000 13,500 12,600
Cost of sales:
Materials 6,000 5,000 4,608
Labor 2,400 2,000 2,121
Variable overhead 960 800 945
Fixed overhead 2,880 2,400 2,500
12,240 10,200 10,174

SPOTLIGHT
Closing inventory (2,040) (1,020) (1,020)
Cost of sales (10,200) (9,180) (9,154)
Profit 4,800 4,320 3,446

Note: The actual closing inventory of 100 units is measured at the standard total absorption cost
of Rs. 10,200 per unit. This is what happens in standard costing systems. (in exam if question is
silent about inventory measurement then actual closing inventory shall be measured at actual
absorption cost
The information for Marden Manufacturing Limited’s performance in January will be used throughout this
chapter to illustrate variance analysis.

STIKCY NOTES
Note that the above example is unlikely to be something that you would have to produce in the exam. It is
provided to help you to understand what variance analysis is about.

1.2. Variance Analysis

Variance analysis explains the difference between the fixed budget profit and the actual profit in detail. This
paragraph provides an initial commentary for variances which will be explained in detail later.
Both the fixed budget and the flexed budget are based on the standard revenue per unit and the standard costs
per unit. Therefore, the difference between the fixed budget profit and the flexed budget profit is caused only by
difference in volume. This figure of Rs. 480,000 (Rs. 4,800,000 Rs. 4,320,000) is called the sales volume
variance.
Revenue is sales quantity  sales price per unit. The revenue in the flexed budget and the actual revenue are both
based on the actual quantity sold. Therefore, the difference between the two figures of Rs. 900,000 (Rs.
13,500,000 Rs. 12,600,000) is due to a difference in the selling price per unit. This difference is called the sales
price variance.

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The difference between each variable cost line in the flexed budget and the equivalent actual figure is a total cost
variance for that item. For example, the actual results show that 1,000 units use material which cost Rs.
4,608,000. The flexed budget shows that these units should have used material which cost Rs. 5,000,000. The
difference of Rs. 392,000 is due to a combination of the actual material used being different to the budgeted usage
of 5kgs per unit and the actual price per kg being different to the budgeted price per kg. In other words, the total
variance can be explained in terms of usage and price.
Variable cost variances can be calculated for all items of variable cost (direct materials, direct labor and
variable production overhead). The method of calculating the variances is similar for each variable cost item.
The total cost variance for the variable cost item is the difference between the actual variable cost of production
and the standard variable cost of producing the items.
However, the total cost variance is not usually calculated. Instead, the total variance is calculated in two parts,
that add up to the total cost variance:
AT A GLANCE

 a price variance or rate variance or expenditure per hour/per kg variance.

 a usage or efficiency variance.
The difference between the fixed overhead in the flexed budget and the actual fixed overhead is over absorption.

1.3. Cost variances

Adverse and favorable cost variances

In a standard costing system, all units of output are valued at their standard cost. Cost of production and cost of
sales are therefore valued at standard cost.
Actual costs will differ from standard costs. A cost variance is the difference between an actual cost and a
SPOTLIGHT

standard cost.
 When actual cost is higher than standard cost, the cost variance is adverse (A) or unfavorable (U).
 When actual cost is less than standard cost, the cost variance is favorable (F).
Different variances are calculated, relating to direct materials, direct labor, variable production overhead and
fixed production overhead.
In a cost accounting system, cost variances are adjustments to the profit in an accounting period.
 Favorable variances increase the reported profit.
 Adverse variances reduce the reported profit.
STIKCY NOTES

The method of calculating cost variances is similar for all variable production cost items (direct materials, direct
labor and variable production overhead).
A different method of calculating cost variances is required for fixed production overhead.

1.4. Variances and performance reporting

Variance reports are produced at the end of each control period (say, at the end of each month).
 Large adverse variances indicate poor performance, provided they are due to factors controllable by
management, and the need for control action by management.
 Large favorable variances indicate unexpected good performance. Management might wish to consider how
this good performance can be maintained in the future.
Variances might be reported in a statement for the accounting period that reconciles the budgeted profit with
the actual profit for the period. This statement is known as an operating statement.

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2. DIRECT MATERIALS VARIANCES

2.1 Direct materials: total cost variance
The total direct material cost variance is the difference between the actual material cost in producing units in the
period and the standard material cost of producing those units.
 Illustration:

Rs.
Standard material cost of actual production:
Actual units produced  Standard kgs per unit  Standard price per kg X
Actual material cost of actual production:

AT A GLANCE
Actual units produced  Actual kgs per unit  Actual price per kg (X)
X

The variance is adverse (A) if actual cost is higher than the standard cost, and favorable (F) if
actual cost is less than the standard cost.
 Example 06:
For Marden Manufacturing Limited, following information is given.
Standard material cost per unit: (5kgs @Rs. 1,000 per kg) = Rs. 5,000 per unit
Actual production in period = 1,000 units.
Materials purchased and used: 4,850 kgs at a cost of Rs. 4,608,000

SPOTLIGHT
Direct materials total cost variance is calculated as follows:
Rs. ‘000
Standard: 1,000 units should cost (@ Rs. 5,000 per unit) 5,000
Actual: 1,000 units did cost (4,608)
Total cost variance (F) 392

The direct materials total cost variance can be analyzed into a price variance and a usage variance.
 A price variance measures the difference between the actual price paid for materials and the price that
should have been paid (the standard price).

STIKCY NOTES
 A usage variance measures the difference between the materials that were used in production and the
materials that should have been used (the standard usage).
 Example 07:
A unit of Product P123 has a standard cost of 5 liters of Material A at Rs.3 per liter. The standard
direct material cost per unit of Product 123 is therefore Rs.15.
In a particular month, 2,000 units of Product 123 were manufactured. These used 10,400 liters
of Material A, which cost Rs.33,600.
The total direct material cost variance is calculated as follows:
Rs.
2,000 units of output should cost ( Rs.15) 30,000
They did cost 33,600
Total direct materials cost variance 3,600 (A)

The variance is adverse, because actual costs were higher than the standard cost.

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2.2 Direct materials price variance

The price variance may be calculated for the materials purchased or materials used. Usually it is calculated at the
point of purchase as this allows the material inventory to be carried at standard cost.
 Illustration:

Rs.
Standard material cost of actual production:
Actual kgs purchased  Standard price per kg X
Actual material cost of actual purchases
Actual kgs purchased  Actual price per kg (X)
X
AT A GLANCE

 Example 08:
For Marden Manufacturing Limited, standard material cost per unit is (5kgs @Rs. 1,000 per kg)
= Rs. 5,000 per unit
Actual production in period = 1,000 units.
Materials purchased and used: 4,850 kgs at a cost of Rs. 4,608,000
Direct materials price variance is calculated as follows:

Rs. ‘000
Standard: 4,850 kgs should cost (@ Rs. 1,000 per kg) 4,850
SPOTLIGHT

Actual: 4,850 kgs did cost (4,608)

Materials price variance (F) 242

If there are two or more direct materials, a price variance is calculated separately for each
material.
 Example 09:
A unit of Product P123 has a standard cost of 5 liters of Material A at Rs.3 per liter. The standard
direct material cost per unit of Product 123 is therefore Rs.15. In a particular month, 2,000 units
of Product 123 were manufactured. These used 10,400 liters of Material A, which cost Rs.33,600.
The price variance is calculated on the quantity of materials purchased/used.
STIKCY NOTES

Materials price variance:

Rs.
10,400 litres of materials should cost ( Rs.3) 31,200
They did cost 33,600
Material price variance 2,400 (A)

The price variance is adverse because the materials cost more to purchase than they should have
done (i.e. actual cost was higher than the standard or expected cost).

2.3 Direct materials usage variance

The usage variance is calculated by comparing the actual quantity of material used to make the actual production
to the standard quantity that should have been used to produce those units. In other words, the actual usage of
materials is compared with the standard usage for the actual number of units produced,

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The difference is the usage variance, measured as a quantity of materials. This is converted into a money value
at the standard price for the material.
 Illustration:

kgs
Standard quantity of material used to make the actual production X
Actual quantity of material used to make the actual production (X)
Usage variance (kgs) X
Standard cost per kg (multiply by) X
Usage variance (Rs.) X

AT A GLANCE
 Example 10:
For Marden Manufacturing Limited, standard material cost per unit: (5kgs @Rs. 1,000 per kg) =
Rs. 5,000 per unit
Actual production in period = 1,000 units.
Materials purchased and used: 4,850 kgs at a cost of Rs. 4,608,000
Direct materials usage variance is calculated as follows:

kgs
Standard: 5,000
Making 1,000 units should have used (@ 5 kgs per unit)

SPOTLIGHT
Actual: Making 1,000 units did use (4,850)
Usage variance (kgs) (F) 150
Standard cost per kg Rs. 1,000
Usage variance (Rs.) (F) Rs. 150,000

2.4 Alternative calculations

Variances can be calculated in a number of ways. A useful approach is the following line by line approach.
 Formula:

STIKCY NOTES
AQ purchased AC X
X Price variance
AQ purchased SC X
X Inventory movement
AQ used SC X
X usage variance
SQ used SC X
Where:
AQ = Actual quantity
AC = Actual cost per kg
SC = Standard cost per kg
SQ = Standard quantity needed to make actual production

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 Example 11:
Alternative method for calculating material variances (Marden Manufacturing Limited)
Standard material cost per unit: (5kgs Rs. 1,000 per kg) = Rs. 5,000 per unit
Actual production in period = 1,000 units.
Materials purchased and used: 4,850 kgs at a cost of Rs. 4,608,000

Rs. ‘000 Rs. ‘000

AQ purchased AC
4,850 kgsRs. X per kg 4,608
AQ purchased SC 242 (F) Price variance
AT A GLANCE

4,850 kgsRs. 1,000 per kg 4,850

AQ used SC nil inventory movement
4,850 kgsRs. 1,000 per kg 4,850
SQ used SC 150 (F) Usage variance
5,000 kgsRs. 1,000 per kg 5,000
SQ = 1,000 units  5 kgs per unit = 5,000 kgs

 Example 12:
A unit of Product P123 has a standard cost of 5 liters of Material A at Rs.3 per liter.
SPOTLIGHT

The standard direct material cost per unit of Product 123 is therefore Rs.15. In a particular
month, 2,000 units of Product 123 were manufactured.
These used 10,400 liters of Material A, which cost Rs. 33,600.
The direct material usage variance is calculated as follows
Materials usage variance

litres
2,000 units of Product P123 should use ( 5 litres) 10,000
They did use 10,400
Material usage variance in litres 400 (A)
STIKCY NOTES

Standard price per litre of Material A Rs.3

Material usage variance in Rs. Rs.1,200 (A)

The usage variance is adverse because more materials were used than expected, which has added
to costs.

2.5 Direct materials: possible causes of variances

When variances occur and they appear to be significant, management should investigate the reason for the
variance. If the cause of the variance is something within the control of management, control action should be
taken. Some of the possible causes of materials variances are listed below.

Materials price variance: causes

Possible causes of favorable materials price variances include:
 Different suppliers were used and these charged a lower price (favorable price variance) than the usual
supplier.

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 Materials were purchased in sufficient quantities to obtain a bulk purchase discount (a quantity discount),
resulting in a favorable price variance.
 Materials were bought that were of lower quality than standard and so cheaper than expected.
Possible causes of adverse materials price variances include:
 Different suppliers were used and these charged a higher price (adverse price variance) than the usual
supplier.
 Suppliers increased their prices by more than expected. (Higher prices might be caused by an unexpected
increase in the rate of inflation.)
 There was a severe shortage of the materials, so that prices in the market were much higher than expected.
 Materials were bought that were better quality than standard and more expensive than expected.

AT A GLANCE
Materials usage variance: causes
Possible causes of favorable materials usage variances include:
 Wastage rates were lower than expected.
 Improvements in production methods resulted in more efficient usage of materials (favorable usage
variance).
Possible causes of adverse materials usage variances include:
 Wastage rates were higher than expected.
 Poor materials handling resulted in a large amount of breakages (adverse usage variance). Breakages mean
that a quantity of materials input to the production process are wasted.
 Materials used were of cheaper quality than standard, with the result that more materials had to be thrown

SPOTLIGHT
away as waste.

STIKCY NOTES

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3. DIRECT LABOR VARIANCES

3.1 Direct labor: total cost variance
The total direct labor cost variance is the difference between the actual labor cost in producing units in the period
and the standard labor cost of producing those units.
 Illustration:

Rs.
Standard labor cost of actual production:
Actual units produced  Standard hrs per unit  Standard rate per hr X
Actual labor cost of actual production:
AT A GLANCE

Actual units produced  Actual hours per unit  Actual rate per hour (X)
X
The variance is adverse (A) if actual cost is higher than the standard cost, and favorable (F) if actual cost is less
than the standard cost.
 Example 13:
Direct labor – Total cost variance (Marden Manufacturing Limited)
Standard labor cost per unit: (4 hrs@Rs. 500 per hr) = Rs. 2,000 per unit
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Direct labor total cost variance is calculated as follows:
SPOTLIGHT

Rs. ‘000
Standard: 1,000 units should cost (@ Rs.2,000 per unit) 2,000
Actual: 1,000 units did cost (2,121)
Total cost variance (A) 121
The direct labor total cost variance can be analyzed into a rate variance and an efficiency variance. These are
calculated in a similar way to the direct materials price and usage variances.
 A rate variance measures the difference between the actual wage rate paid to per labor hour and the rate
that should have been paid (the standard rate of pay).
 An efficiency variance (or productivity variance) measures the difference between the time taken to make
STIKCY NOTES

the production output and the time that should have been taken (the standard time).
3.2 Direct labor rate variance
The direct labor rate variance is calculated for the actual number of hours paid for.
The actual labor cost of the actual hours paid for is compared with the standard cost for those hours. The
difference is the labor rate variance.
 Illustration:
Rs.
Standard labor cost of actual production:
Actual hours paid for  Standard rate per hour X
Actual labor cost of actual purchases
Actual hours paid for  Actual rate per hour (X)
X

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 Example 14:
For Marden Manufacturing Limited), standard labor cost per unit: (4 hrs@Rs. 500 per hour) =
Rs. 2,000 per unit
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Direct labor rate variance is calculated as follows:

Rs. ‘000
Standard: 4,200 hours should cost (@ Rs. 500 per hour) 2,100
Actual: 4,200 hours did cost (2,121)

AT A GLANCE
Labor rate variance (A) 21

If there are two or more different types or grades of labor, each paid a different standard rate per
hour, a rate variance is calculated separately for each labor grade.

3.3 Direct labor efficiency variance

The direct labor efficiency variance is calculated for the hours used on the units produced.
For the actual number of standard units produced, the actual hours worked is compared with the standard
number of hours that should have been worked to produce the actual output. The difference is the efficiency
variance, measured in hours. This is converted into a money value at the standard direct labor rate per hour.
 Illustration:

SPOTLIGHT
Hours
Standard labor hours used to make the actual production X
Actual labor hours used to make the actual production (X)
Efficiency variance (hours) X
Standard cost per hour (multiply by) X
Efficiency variance (Rs.) X

 Example 15:
For Marden Manufacturing Limited, standard labor cost per unit: (4 hrs@Rs. 500 per hour) = Rs.

STIKCY NOTES
2,000 per unit
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Direct labor efficiency variance is calculated as follows:

Hours
Standard: 4,000
Making 1,000 units should have used (@ 4 hours per unit)
Actual: Making 1,000 units did use (4,200)
Efficiency variance (hours) (A) 200
Standard cost per hour Rs. 500
Efficiency variance (Rs.) (A) Rs. 100,000

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 Example 16:
Product P234 has a standard direct labor cost per unit of:
0.5 hours × Rs.12 per direct labor hour = Rs.6 per unit.
During a particular month, 3,000 units of Product 234 were manufactured. These took 1,400
hours to make and the direct labor cost was Rs. 16,200.
The total direct labor cost variance, the direct labor rate variance and the direct labor efficiency
variance for the month, would be calculated as follows

Total direct labor cost variance Rs.

3,000 units of output should cost (Rs.6) 18,000
They did cost 16,200
AT A GLANCE

Direct labor total cost variance 1,800 (F)

The variance is favorable, because actual costs were less than the standard cost.
The direct labor rate variance is calculated by taking the actual number of hours worked (and
paid for).

Direct labor rate variance Rs.

1,400 hours should cost (Rs.12) 16,800
They did cost 16,200
Direct labor rate variance 600 (F)
SPOTLIGHT

The rate variance is favorable because the labor hours worked cost less than they should have
done.
The labor efficiency variance, like a materials usage variance, is calculated for the actual number
of units produced. The variance in hours is converted into a money value at the standard rate of
pay per hour.

Direct labor efficiency variance hours

3,000 units of Product P234 should take ( 0.5 hours) 1,500
They did take 1,400
Efficiency variance in hours 100 (F)
STIKCY NOTES

Standard direct labor rate per hour Rs.12

Direct labor efficiency variance in Rs. Rs.1,200 (F)

The efficiency variance is favorable because production took less time than expected, which has
reduced costs.

Labor cost variances: summary Rs.

Labor rate variance 600 (F)
Labor efficiency variance 1,200 (F)
Total direct labor cost variance 1,800 (F)

3.4 Idle time variance

Idle time occurs when the direct labor employees are being paid but have no work to do. The causes of idle time
may be:
 A breakdown in production, for example a machine breakdown that halts the production process

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 Time spent waiting for work due to a bottleneck or hold-up at an earlier stage in the production process
 Time spent rearranging the production line for a new batch
 Running out of a vital direct material, and having to wait for a new delivery of the materials from a supplier.
 A lack of work to do due to a lack of customer orders.
A feature of idle time is that it is recorded, and the hours ‘lost’ due to idle time are measured. Idle time variance
is part of the efficiency variance.
Sometimes idle time might be a feature of a production process for example where there may be bottlenecks in
a process that might lead to idle time on a regular basis. In this case the expected idle time might be built into the
standard cost.
 If idle time is not built into the standard cost the idle time variance is always adverse.

AT A GLANCE
 If it is built into the standard cost the idle time variance might be favorable or adverse depending on whether
the actual idle time is more or less than the standard idle time for that level of production.

Idle time not part of standard cost

As stated above if the idle time is not included in the standard cost, any idle time is unexpected and leads to an
adverse variance.
 Illustration:

Hours
Actual hours paid for X
Actual hours worked (X)

SPOTLIGHT
Idle time (hours) X
Standard cost per hour (multiply by) X
Idle time (Rs.) X

Calculating the idle time variance will affect the calculation of the direct labor efficiency variance.
If idle time occurs but is not recorded the idle time variance is part of the direct labor efficiency
variance. (if record is maintained then idle time is separately recorded)
 Example 17:
For Marden Manufacturing Limited, standard labor cost per unit: (4 hours Rs. 500 per kg) = Rs.
2,000 per unit

STIKCY NOTES
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Labor hours worked: 4,100 hours
Direct labor idle time variance is calculated as follows:

Hours
Actual hours paid for 4,200
Actual hours worked (4,100)
Idle time (hours) (A) 100
Standard cost per hour (multiply by) Rs. 500
Idle time (Rs.) (A) Rs. 50,000

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Direct labor efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 4 hours per unit) 4,000
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (A) 100
Standard cost per hour Rs. 500
Efficiency variance (Rs.) (A) Rs. 50,000

3.5 Alternative calculations

AT A GLANCE

The following shows the line by line approach for labor varices.
 Formula:

AHpaid for AR X
X Rate variance
AHpaid for SR X
X Idle time variance
AHworked SR X
X Efficiency variance
SHworked SR X
SPOTLIGHT

Where:
AH = Actual hours
AR = Actual rate per hour
SR = Standard rate per hour
SH = Standard hours needed to make actual production

 Example 18:
For Marden Manufacturing Limited, standard labor cost per unit: (4 hours @Rs. 500 per kg) = Rs.
2,000 per unit
STIKCY NOTES

Actual production in period = 1,000 units.

Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Labor hours worked: 4,100 hours
Alternate method for calculating labor variances would be
Rs. ‘000 Rs. ‘000
AH paid for AR
4,200 hours Rs. X per hour 2,121
AH paid for SR 21 (A) Price variance
4,200 hours Rs. 500 per hour 2,100
AH worked SR 50 (A) Idle time
4,100 hours Rs. 500 per hour 2,050
SH worked SR 50 (A) Efficiency
4,000 hours Rs. 500 per hour 2,000
SQ = 1,000 units  4 hours per unit = 4,000 hours

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3.6 Idle time variance where idle time is included in standard cost

Methods of including idle time in standard costs

There are different ways of allowing for idle time in a standard cost.
 Method 1. Include idle time as a separate element of the standard cost, so that the standard cost of idle time
is a part of the total standard cost per unit.
 Method 2. Allow for a standard amount of idle time in the standard hours per unit for each product. The
standard hours per unit therefore include an allowance for expected idle time. This is feasible when the idle
time is a necessary feature of the production process such as in batch processing.
 Example 19:
For Marden Manufacturing Limited, standard labor rate = Rs. 500 per hour

AT A GLANCE
A unit of production should take 3.6 hours to produce.
Expected idle time is 10% of total time paid for.
Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).
Idle time can be built into the standard as follows:

Method 1 Rs.
Labor 3.6 hours Rs. 500 per hour 1,800

SPOTLIGHT
Idle time 0.4 hours Rs. 500 per hour 200
2,000
Method 2
Labor 4 hours Rs. 500 per hour 2,000

The two methods will result in the identification of the same overall variance for idle time plus
labor efficiency but the split of the number may differ.
For Marden Manufacturing, standard labor rate = Rs. 500 per hour
A unit of production should take 3.6 hours to produce.

STIKCY NOTES
Expected idle time is 10% of total time paid for.

Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).

Method 1
Idle time can be built into the standard as follows:

Rs.
Labor 3.6 hours Rs. 500 per hour 1,800
Idle time 0.4 hours Rs. 500 per hour 200
2,000

Actual production in period = 1,000 units.

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Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000

Labor hours worked: 4,100 hours
Direct labor idle time variance is calculated as follows:
Hours
Expected idle time (1,000 units  0.4 hours per unit) 400
Actual idle time (4,200 hours  4,100 hours) (100)
Idle time (hours) 300 F
Standard cost per hour (multiply by) Rs. 500
Idle time (Rs.) Rs. 150,000 F

Direct labor efficiency variance is calculated as follows:

AT A GLANCE

Hours
Standard:
Making 1,000 units should have used (@ 3.6 hours per unit) 3,600
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (500) A
Standard cost per hour Rs. 500
Efficiency variance (Rs.) Rs. 250,000 A

Method 2
SPOTLIGHT

Idle time can be built into the standard as follows:

Rs.
Labor 4 hours Rs. 500 per hour 2,000

Actual production in period = 1,000 units.

Labor hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Labor hours worked: 4,100 hours

Direct labor idle time variance is calculated as follows: Hours

STIKCY NOTES

Expected idle time (10% of 4,200 hours paid for) 420

Actual idle time (4,200 hours  4,100 hours) (100)
Idle time (hours) 320 F
Standard cost per hour (multiply by) Rs. 500
Idle time (Rs.) Rs. 160,000 F

Direct labor efficiency variance is calculated as follows: Hours

Standard: 3,580
Making 1,000 units should have used (4 hours per unit less 10% of
the hours paid for = 4,000 – (10% of 4,200))
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (520) A
Standard cost per hour Rs. 500
Efficiency variance (Rs.) Rs. 260,000 A

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In summary the idle time variance is part of the efficiency variance. Different methods result in a
different split of the idle time variance and efficiency variance but the figures always sum to the
same total.
Revisiting the previous examples:
Sum of idle time and efficiency variances (Marden Manufacturing Limited)

Idle time Efficiency Total

variance variance
Idle time not recorded  100 (A) 100 (A)
Idle time recorded:
not part of standard cost 50 (A) 50 (A) 100 (A)

AT A GLANCE
part of standard cost (method 1) 150 (F) 250 (A) 100 (A)
part of standard cost (method 2) 160 (F) 260 (A) 100 (A)

3.7 Direct labor: possible causes of variances

When labor variances appear significant, management should investigate the reason why they occurred, and take
control measures where appropriate to improve the situation in the future. Possible causes of labor variances
include the following.
Possible causes of favorable labor rate variances include:
 Using direct labor employees who were relatively inexperienced and new to the job (favorable rate variance,
because these employees would be paid less than ‘normal’).

SPOTLIGHT
 Actual pay increase turning out to be less than expected.
Possible causes of adverse labor rate variances include:
 An increase in pay for employees.
 Working overtime hours paid at a premium above the basic rate.
 Using direct labor employees who were more skilled and experienced than the ‘normal’ and who are paid
more than the standard rate per hour (adverse rate variance).
Possible causes of favorable labor efficiency variances include:
 More efficient methods of working.

STIKCY NOTES
 Good morale amongst the workforce and good management with the result that the work force is more
productive.
 If incentive schemes are introduced to the workforce, this may encourage employees to work more quickly
and therefore give rise to a favorable efficiency variance.
 Previously unaccounted for learning and experience curves
 Using employees who are more experienced than ‘standard’, resulting in favorable efficiency variances as
they are able to complete their work more quickly than less-experienced colleagues.
Possible causes of adverse labor efficiency variances include:
 Using employees who are less experienced than ‘standard’, resulting in adverse efficiency variances.
 An event causing poor morale.

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4. VARIABLE PRODUCTION OVERHEAD VARIANCES

4.1 Variable production overhead: total cost variance
The total variable production overhead cost variance is the difference between the actual variable production
overhead cost in producing units in the period and the standard variable production overhead cost of producing
those units.
 Illustration:

Rs.
Standard variable production overhead cost of actual production:
Actual units produced  Standard hrs per unit  Standard rate per hr X
AT A GLANCE

Actual variable production overhead cost of actual production:

Actual units produced  Actual hours per unit  Actual rate per hour (X)
X

The variance is adverse (A) if actual cost is higher than the standard cost, and favorable (F) if
actual cost is less than the standard cost.
 Example 20:
Variable production overhead – Total cost variance (Marden Manufacturing Limited)
Standard variable production overhead cost per unit: (4 hrs@Rs. 200 per hr) = Rs. 800 per unit
Actual production in period = 1,000 units.
SPOTLIGHT

Variable production overhead = Rs. 945,000.

Labor hours paid for: 4,200 hours
Direct variable production overhead total cost variance is calculated as follows:
Rs. ‘000
Standard: 1,000 units should cost (@ Rs. 800 per unit) 800
Actual: 1,000 units did cost (945)
Total cost variance (A) 145

The variable production overhead total cost variance can be analyzed into an expenditure variance (spending
rate per hour variance) and an efficiency variance.
STIKCY NOTES

 The expenditure variance is similar to a materials price variance or a labor rate variance. It is the difference
between actual variable overhead spending in the hours worked and what the spending should have been
(the standard rate).
 The variable overhead efficiency variance in hours is the same as the labor efficiency variance in hours
(excluding any idle time variance), and is calculated in a very similar way. It is the variable overhead cost or
benefit from adverse or favorable direct labor efficiency variances.

4.2 Variable production overhead expenditure variance

It is normally assumed that variable production overheads are incurred during hours actively worked, but not
during any hours of idle time.
 The variable production overhead expenditure variance is calculated by taking the actual number of hours
worked.
 The actual variable production overhead cost of the actual hours worked is compared with the standard cost
for those hours. The difference is the variable production overhead expenditure variance.

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A variable production overhead expenditure variance is calculated as follows. Like the direct labor rate variance,
it is calculated by taking the actual number of labor hours worked, since it is assumed that variable overhead
expenditure varies with hours worked.
 Illustration:

Rs.
Standard variable production overhead cost of actual production:
Actual hours worked  Standard rate per hour X
Actual variable production overhead cost of actual purchases
Actual hours worked  Actual rate per hour (X)
X

AT A GLANCE
 Example 21:
Variable production overhead expenditure variance (Marden Manufacturing Limited)
Standard variable production overhead cost per unit: (4 hrsRs. 200 per hr) = Rs. 800 per unit
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours
Labor hours worked: 4,100 hours at a variable overhead cost of Rs. 945,000.
Variable production overhead rate variance is calculated as follows:

Rs. ‘000

SPOTLIGHT
Standard: 4,100 hours should cost (@ Rs. 200 per hour) 820
Actual: 4,100 hours did cost (945)
Labor rate variance (A) (125)

4.3 Variable production overhead efficiency variance

The variable production overhead efficiency variance in hours is exactly the same as the direct labor efficiency
variance in hours.
It is converted into a money value at the standard variable production overhead rate per hour.
 Illustration:

STIKCY NOTES
Hours
Standard hours used to make the actual production X
Actual hours used to make the actual production (X)
Efficiency variance (hours) X
Standard cost per hour (multiply by) X
Efficiency variance (Rs.) X

 Example 22:
Variable production overhead efficiency variance (Marden Manufacturing Limited)
Standard variable production overhead cost per unit: (4 hrs@Rs. 200 per kg) = Rs. 800 per unit
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours

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Labor hours worked: 4,100 hours at a variable overhead cost of Rs. 945,000.
Variable production overhead efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 4 hours per unit) 4,000
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (A) 100
Standard cost per hour Rs. 200
Efficiency variance (Rs.) (A) Rs. 20,000
AT A GLANCE

 Example 23:
Product P123 has a standard variable production overhead cost per unit of: 1.5 hours × Rs.2 per
direct labor hour = Rs.3 per unit.
During a particular month, 2,000 units of Product 123 were manufactured. These took 2,780
hours to make and the variable production overhead cost was Rs.6,550.
The total variable production overhead cost variance, the variable production overhead
expenditure variance and the variable production overhead efficiency variance for the month
would be calculated as follows.

Total variable production overhead cost variance Rs.

2,000 units of output should cost (Rs.3) 6,000
SPOTLIGHT

They did cost 6,550

Total variable production overhead cost variance 550 (A)
Variable production overhead expenditure variance Rs.
2,780 hours should cost (Rs.2) 5,560
They did cost 6,550
Variable production overhead expenditure variance 990 (A)
The expenditure variance is adverse because the expenditure on variable overhead in the hours
worked was more than it should have been.

Variable production overhead efficiency variance hours

STIKCY NOTES

2,000 units of Product P123 should take ( 1.5 hours) 3,000

They did take 2,780
Efficiency variance in hours 220 (F)
Standard variable production overhead rate per hour Rs.2
Variable production overhead efficiency variance in Rs.440 (F)

The efficiency variance is favorable because production took less time than expected, which has
reduced costs.

Variable production overhead cost variances: summary Rs.

Variable production overhead expenditure variance 990 (A)
Variable production overhead efficiency variance 440 (F)
Total variable production overhead cost variance 550 (A)

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4.4 Alternative calculations

The following shows the line by line approach for variable production overhead variances.
 Formula:

AH worked AR X
X Rate variance
AH worked SR X
X Efficiency variance
SH worked SR X

AT A GLANCE
Where:
AH = Actual hours
AR = Actual rate per hour
SR = Standard rate per hour
SH = Standard hours needed to make actual production

 Example 24:
Alternative method for calculating variable production overhead variances (Marden
Manufacturing Limited) would involve:
Standard variable production overhead cost per unit: (4 hrs@Rs. 200 per kg) = Rs. 800 per unit

SPOTLIGHT
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours
Labor hours worked: 4,100 hours at a variable overhead cost of Rs. 945,000.

Rs. ‘000 Rs. ‘000

AH worked AR
4,100 hours Rs. X per hour 945
AH worked SR 125 (A) Expenditure

STIKCY NOTES
4,100 hours Rs. 200 per hour 820
SH worked SR 20 (A) Efficiency
4,000 hours Rs. 200 per hour 800
SH = 1,000 units  4 hours per unit = 4,000 hours

4.5 Variable production overhead: possible causes of variances

Possible causes of favorable variable production overhead expenditure variances include:
 Forecast increase in costs not materializing
Possible causes of adverse variable production overhead variances include:
 Unexpected increases in energy prices
Anything that causes labor efficiency variance will have an impact on variable production overhead efficiency
variances as variable production overhead is incurred as the labor force carries out production.

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Possible causes of favorable variable production overhead efficiency variances include:

 More efficient methods of working.
 Good morale amongst the workforce and good management with the result that the work force is more
productive.
 If incentive schemes are introduced to the workforce, this may encourage employees to work more quickly
and therefore give rise to a favorable efficiency variance.
 Using employees who are more experienced than ‘standard’, resulting in favorable efficiency variances as
they are able to complete their work more quickly than less-experienced colleagues.
Possible causes of adverse variable production overhead efficiency variances include:
 Using employees who are less experienced than ‘standard’, resulting in adverse efficiency variances.
AT A GLANCE

 An event causing poor morale.

SPOTLIGHT
STIKCY NOTES

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5. FIXED PRODUCTION OVERHEAD COST VARIANCES: ABSORPTION COSTING

5.1 Over/under absorption
Variances for fixed production overheads are different from variances for variable costs.
With standard absorption costing, the standard cost per unit is a full production cost, including an amount for
absorbed fixed production overhead. Every unit produced is valued at standard cost.
This means that production overheads are absorbed into production costs at a standard cost per unit produced.
This standard fixed cost per unit is derived from a standard number of direct labor hours per unit and a fixed
overhead rate per hour.
The total fixed overhead cost variance is the total amount of under-absorbed or over-absorbed overheads, where
overheads are absorbed at the standard fixed overhead cost per unit.

AT A GLANCE
As mentioned in an earlier chapter, the total under- or over-absorption of fixed overheads can be analyzed into
an expenditure variance and a volume variance.
The total volume variance can be further analyzed in standard absorption costing, into a fixed overhead capacity
variance and a fixed overhead efficiency variance.
 Illustration:

SPOTLIGHT
STIKCY NOTES
5.2 Total fixed production overhead cost variance
The total fixed overhead cost variance is the amount of:
 under-absorbed fixed production overhead (= adverse variance) or
 over-absorbed fixed production overhead (= favorable variance).
 Illustration:

Fixed production overhead absorbed in the period: Rs.

Actual units produced  Fixed production overhead per unit X
Actual fixed production overhead incurred in the period (X)
Total fixed production overhead variance (Over/(under) absorption) X/(x)

The total fixed production overhead cost variance can be analyzed into an expenditure variance and a volume
variance. Together, these variances explain the reasons for the under- or over-absorption.

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 Example 25:
For Marden Manufacturing Limited, over/under absorption is required based on the following
information

Budgeted fixed production overhead Rs.2,880,000

Budgeted production hours: 4,800 hours

= Budgeted production volume  Standard hours per unit
= 1,200 units  4 hours per unit

Overhead absorption rate Rs. 2,880,000/4,800 hours Rs. 600 per hour

Standard fixed production overhead per unit Rs. 2,400 per unit
= 4 hours Rs. 600 per hour
AT A GLANCE

Actual fixed production overhead Rs. 2,500,000

Actual production 1,000 units

The total cost variance for fixed production overhead (over/under absorption) is calculated as
follows:

Rs. ‘000

Fixed production overhead absorbed in the period: 2,400

= Actual units produced  Fixed production overhead per unit
= 1,000 units Rs. 2,400 per unit
SPOTLIGHT

Actual fixed production overhead incurred in the period (2,500)

Under absorption (adverse cost variance) 100

The amount of fixed production overhead absorption rate is a function of the budgeted fixed production
overhead expenditure and the budgeted production volume.
The total variance can be explained in these terms.

5.3 Fixed production overhead expenditure variance

STIKCY NOTES

A fixed production overhead expenditure variance is very easy to calculate. It is simply the difference between
the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure.
 Illustration:

Rs.

Budgeted fixed production overhead X

Actual fixed production overhead incurred (X)

Fixed production overhead expenditure variance X

An adverse expenditure variance occurs when actual fixed overhead expenditure exceeds the budgeted fixed
overhead expenditure.
A favorable expenditure variance occurs when actual fixed overhead expenditure is less than budget.

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 Example 26:
For Marden Manufacturing Limited, fixed production overhead – expenditure variance would be
as follows:

Rs. ‘000

Budgeted fixed production overhead 2,880

Actual fixed production overhead (2,500)

Fixed production overhead expenditure variance (F) 380

Fixed overhead expenditure variances can be calculated, for control reporting, for other overheads as well as
production overheads. For example:

AT A GLANCE
 an administration fixed overheads expenditure variance is the difference between budgeted and actual fixed
administration overhead costs
 a sales and distribution fixed overhead expenditure variance is the difference between budgeted and actual
fixed sales and distribution overhead costs

5.4 Fixed production overhead volume variance

The fixed production overhead volume variance measures the amount of fixed overheads under- or over-
absorbed because of the fact that actual production volume differs from the budgeted production volume.
The volume variance is measured first of all in either units of output or standard hours of the output units.
The volume variance in units (or standard hours of those units) is converted into a money value, as appropriate,

SPOTLIGHT
at the standard fixed overhead cost per unit (or the standard fixed overhead rate
 Illustration:

Units

Actual production volume (the number of units produced) X

Budgeted production volume (X)

Fixed production overhead volume variance (units) X

Standard absorption rate per unit X

STIKCY NOTES
Fixed production overhead volume variance(Rs.) X

When actual activity volume exceeds the budget, there will be over-absorption of fixed overheads, which is a
‘favorable’ variance. When actual activity volume is less than budget, there will be under-absorption of fixed
overhead, which is an ‘adverse’ variance.
When overheads are absorbed on the basis of direct labor hours or machine hours, the actual hours worked
might be higher or lower than budgeted. The reasons for a favorable or an adverse volume variance might
therefore be any of the following.
 Working more hours than budgeted might be caused by working overtime, or taking on additional direct
labor employees.
 Working fewer hours than budgeted might be caused by staff shortages (due to employees leaving or absence
from work), hold-ups in production or lack of customer orders.

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 Example 27:
For Marden Manufacturing Limited, fixed production overhead – volume variance would be as
follows:

Budgeted fixed production overhead Rs.2,880,000

Budgeted production hours: 4,800 hours
= Budgeted production volume  Standard hours per unit
= 1,200 units  4 hours per unit
Overhead absorption rate Rs. 2,880,000/4,800 hours Rs. 600 per hour
Standard fixed production overhead per unit Rs. 2,400 per unit
= 4 hours Rs. 600 per hour
AT A GLANCE

Actual fixed production overhead Rs. 2,500,000

Actual production 1,000 units
The volume variance is calculated as follows:
Units
Actual number of units produced 1,000
Budgeted production (1,200)
Fixed production overhead volume variance(units) (A) (200)
Fixed production overhead per unit Rs. 2,400
Fixed production overhead volume variance(Rs.) (A) Rs. 480,000
SPOTLIGHT

The under-absorption has been analyzed into an expenditure and a volume variance.
Analysis of under absorption
Summary Rs.
Expenditure variance 380,000 Favourable
Volume variance (480,000) Adverse
Total under -absorbed overhead 100,000 Adverse

 Example 28:
STIKCY NOTES

A company budgeted to make 5,000 units of a single standard product in Year 1.

Budgeted direct labor hours are 10,000 hours.
Budgeted fixed production overhead is Rs.40,000.
Actual production in Year 1 was 5,200 units, and fixed production overhead was Rs.40,500.
The total fixed production overhead cost variance, the fixed overhead expenditure variance and
the fixed overhead volume variance for the year, would be as follows
Standard fixed overhead cost per unit = Rs.8 (Rs.40,000/Rs.5,000 units)
Fixed production overhead total cost variance Rs.
5,200 units: standard fixed cost (Rs.8) = fixed overhead absorbed 41,600
Actual fixed overhead cost expenditure 40,500
Fixed production overhead total cost variance 1,100 (F)

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The variance is favorable, because fixed overhead costs have been over absorbed.

Fixed overhead expenditure variance Rs.

Budgeted fixed production overhead expenditure 40,000
Actual fixed production overhead expenditure 40,500
Fixed overhead expenditure variance 500 (A)
This variance is adverse because actual expenditure exceeds the budgeted expenditure.

Fixed overhead volume variance units of

production
Budgeted production volume in units 5,000
Actual production volume in units 5,200

AT A GLANCE
Fixed overhead volume variance in units 200 (F)
Standard fixed production overhead cost per unit Rs.8
Fixed overhead volume variance in Rs. Rs.1,600 (F)
This variance is favorable because actual production volume exceeded the budgeted volume

Summary Rs.
Fixed overhead expenditure variance 500 (A)
Fixed overhead volume variance 1,600 (F)
Fixed overhead total cost variance 1,100 (F)
 Example 29:

SPOTLIGHT
In its annual financial plan for Year 1, a manufacturing company budgets that production
overhead expenditure will be Rs.800,000 and that there will be 100,000 direct labor hours of
work. It uses a single absorption rate, which is a rate per direct labor hour.
Actual production overhead during Year 1 was Rs.805,000 and 105,000 direct labor hours were
worked.
The production overhead absorption rate for the year is Rs.800,000/100,000 = Rs.8 per direct
labor hour. All cost units produced during the year are charged with production overheads at the
rate of Rs.8 for each direct labor hour.

Rs.

STIKCY NOTES
Overheads absorbed (105,000 hours × Rs.8)
(Overheads included in product costs) 840,000
Actual overhead expenditure 805,000
Over-absorbed overheads 35,000

This is added to profit when calculating the actual profit for Year 1.
Explaining the over-absorbed overhead
The over-absorbed overhead of Rs.35,000 can be explained by a combination of an expenditure
variance and a volume variance.

Rs.
Budgeted overhead expenditure 800,000
Actual overhead expenditure 805,000
Expenditure variance 5,000 Adverse

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The expenditure variance is adverse because actual expenditure was more than planned
expenditure, and this has resulted in some under-absorption of overhead.

Hours
Budgeted volume (direct labor hours) 100,000
Actual volume (direct labor hours) 105,000
Volume variance (direct labor hours) 5,000 Favourable
Absorption rate/direct labor hour Rs.8
Volume variance in Rs. Rs.40,000 Favourable

The volume variance is favorable because actual hours worked exceeded the planned hours,
AT A GLANCE

and this has resulted in some over-absorption of overhead.

Summary Rs.
Expenditure variance 5,000 Adverse
Volume variance 40,000 Favourable
Total over-absorbed overhead 35,000 Favourable

5.5 Fixed production overhead efficiency and capacity variances

Any volume variance might be due to two reasons:
 The company has worked a different number of hours than budgeted for a variety of reasons. They have
operated at a different capacity.
SPOTLIGHT

 During the hours worked the company has operated at a different level of efficiency to that budgeted.
The fixed production overhead volume variance can be analyzed into a fixed overhead efficiency variance and a
fixed overhead capacity variance.

Fixed production overhead efficiency variance

This is exactly the same, in hours, as the direct labor efficiency variance and the variable production overhead
efficiency variance.
It is converted into a money value at the standard fixed overhead rate per hour.
 Illustration:
STIKCY NOTES

Hours
Standard hours used to make the actual production X
Actual hours used to make the actual production (X)
Efficiency variance (hours) X
Standard cost per hour (multiply by) X
Efficiency variance (Rs.) X

 Example 30:
For Marden Manufacturing Limited, standard fixed production overhead cost per unit: (4 hrsRs.
600 per hr) = Rs. 2,400 per unit
Actual production in period = 1,000 units.
Labor hours paid for: 4,200 hours

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Labor hours worked: 4,100

Fixed production overhead efficiency variance is calculated as follows:

Hours
Standard: 4,000
Making 1,000 units should have used (@ 4 hours per unit)
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (A) 100
Standard cost per hour Rs. 600
Efficiency variance (Rs.) (A) Rs. 60,000

AT A GLANCE
Fixed production overhead capacity variance
This is the difference between the budgeted and actual hours worked (excluding any idle time hours). It is
converted into a money value at the standard fixed overhead rate per hour.
 Illustration:

Hours
Actual number of hours worked X
Budgeted hours to be worked (X)
Capacity variance (hours) X

SPOTLIGHT
Standard cost per hour (multiply by) X
Capacity variance (Rs.) X

 Example 31:
Fixed production overhead capacity variance (Marden Manufacturing Limited)

Budgeted fixed production overhead Rs.2,880,000

Budgeted production hours: 4,800 hours
= Budgeted production volume  Standard hours per unit
= 1,200 units  4 hours per unit

STIKCY NOTES
Overhead absorption rate Rs. 2,880,000/4,800 hours Rs. 600 per hour
Standard fixed production overhead per unit Rs. 2,400 per
= 4 hours Rs. 600 per hour unit
Actual fixed production overhead Rs. 2,500,000
Actual production 1,000 units

The fixed production overhead capacity variance is calculated as follows:

Hours
Actual number of hours worked 4,100
Budgeted hours to be worked (4,800)
Capacity variance (hours) (A) 700
Standard cost per hour (multiply by) Rs. 600
Capacity variance y variance (Rs.) (A) Rs. 420,000

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 Example 32:
A company budgeted to make 5,000 units of a single standard product in Year 1.
Budgeted direct labor hours are 10,000 hours.
Budgeted fixed production overhead is Rs.40,000.
Actual production in Year 1 was 5,200 units in 10,250 hours of work, and fixed production
overhead was Rs.40,500.
Calculate the fixed overhead efficiency variance and the fixed overhead capacity variance for the
year.
The standard direct labor hours per unit = 10,000 hours/5,000 units = 2 hours per unit.
The standard fixed overhead rate per hour = Rs.40,000/10,000 hours = Rs.4 per hour.
AT A GLANCE

The standard fixed overhead cost per unit is 2 hours  Rs.4 per hour = Rs.8 (or Rs.40,000/5,000
units).

Fixed overhead efficiency variance hours

5,200 units should take (× 2 hours) 10,400
They did take 10,250
Efficiency variance in hours 150 (F)
Standard fixed overhead rate per hour Rs.4
Fixed overhead efficiency variance in Rs. Rs.600 (F)
SPOTLIGHT

Fixed overhead capacity variance hours

Budgeted hours of work 10,000
Actual hours of work 10,250
Capacity variance in hours 250 (F)
Standard fixed overhead rate per hour Rs.4
Fixed overhead capacity variance in Rs. Rs.1,000 (F)

The capacity variance is favorable because actual hours worked exceeded the budgeted hours
(therefore more units should have been produced).

Summary Rs.
STIKCY NOTES

Fixed overhead efficiency variance 600 (F)

Fixed overhead capacity variance 1,000 (F)
Fixed overhead volume variance 1,600 (F)

5.6 Fixed production overheads: possible causes of variances

Some of the possible causes of fixed production overhead variances include the following.

Fixed overhead expenditure variance

 Poor control over overhead spending (adverse variance) or good control over spending (favorable variance).
 Poor budgeting for overhead spending. If the budget for overhead expenditure is unrealistic, there will be an
expenditure variance due to poor planning rather than poor expenditure control.
 Unplanned increases or decreases in items of expenditure for fixed production overheads, for example, an
unexpected increase in factory rent.

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Fixed overhead volume variance

A fixed overhead volume variance can be explained by anything that made actual output volume different from
the budgeted volume. The reasons could be:
 Efficient working by direct labor: a favorable labor efficiency variance results in a favorable fixed overhead
efficiency variance.
 Working more hours or less hours than budgeted (capacity variance).
 An unexpected increase or decrease in demand for a product, with the result that shorter/longer hours were
worked (adverse/favorable capacity variance)
 Strike action by the workforce, resulting in a fall in output below (adverse capacity variance).
 Extensive breakdowns in machinery, resulting in lost production (adverse capacity variance).

AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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6. INTERRELATIONSHIPS BETWEEN VARIANCES

6.1 The nature of interrelationships between variances
Some causes of individual variances have already been listed.
The reasons for variances might also be connected, and two or more variances might arise from the same cause.
This is known as an interrelationship between two variances.
For example, one variance might be favorable and another variance might be adverse. Taking each variance
separately, the favorable variance might suggest good performance and the adverse variance might suggest bad
performance. However, the two variances might be inter-related, and the favorable variance and the adverse
variance might have the same cause. When this happens, management should look at the two variances together,
in order to assess their significance and decide whether control action is needed.
Interrelationships between variances are given below.
AT A GLANCE

6.2 Materials price and usage

A materials price variance and usage variance might be inter-related. For example, if a company decides to use a
material for production that is more expensive than the normal or standard material, but easier to use and better
in quality, there will be an adverse price variance. However, a consequence of using better materials might be
lower wastage. If there is less wastage, there will be a favorable material usage variance. Therefore, using a
different quality of material can result in an adverse price variance and a favorable usage variance.
6.3 Labor rate and efficiency
If there is a change in the grade of workers used to do some work, both the rate and efficiency variances may be
affected.
For example, if a lower grade of labor is used instead of the normal higher grade:
SPOTLIGHT

 there should be a favorable rate variance because the workers will be paid less than the standard rate
 however, the lower grade of labor may work less efficiently and take longer to produce goods than the
normal higher grade of labor would usually take. If the lower grade of labor takes longer, then this will give
rise to an adverse efficiency variance.
Therefore, the change in the grade of labor used results in two ‘opposite’ variances, an adverse efficiency variance
and a favorable rate variance.
When inexperienced employees are used, they might also waste more materials than more experienced
employees would, due to mistakes that they make in their work. The result might be not only adverse labor
efficiency, but also adverse materials usage.
6.4 Labor rate and variable overhead efficiency
STIKCY NOTES

When a production process operates at a different level of efficiency the true cost of that difference is the sum of
any costs associated with labor hours. Therefore, the issues described above also affect the variable overhead
efficiency variance.
6.5 Capacity and efficiency
If a production process operates at a higher level of efficiency that might mean that it does not have to operate
for as long to produce the budgeted production volume. The favorable fixed production overhead efficiency
variance would cause an adverse fixed production overhead capacity variance.
The reverse is also true. If a production process operates at a lower level of efficiency that might mean that it has
to operate for longer than was budgeted. The adverse efficiency fixed production overhead variance would cause
a favorable fixed production overhead capacity variance.
6.6 Footnote: the importance of reliable standard costs
It is important to remember that the value of variances as control information for management depends on the
reliability and accuracy of the standard costs. If the standard costs are inaccurate, comparisons between actual
cost and standard cost will have no meaning. Adverse or favorable variances might be caused by inaccurate
standard costs rather than by inefficient or efficient working.

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7. STANDARD MARGINAL COSTING

7.1 Standard marginal costing
The Marden Manufacturing Limited example used in the earlier sections was based on the company using
standard total absorption costing.
This sections looks at what happens when a company uses standard marginal costing instead.
Under marginal costing units produced and finished goods inventory are valued at standard variable production
cost, not standard full production cost. This means that the budgeted profit will differ from that found for the
same scenario under total absorption costing.
Marginal costing variances are calculated exactly as before with two important differences:
 the sales volume variance is expressed as a monetary amount by multiplying the volume variance expressed

AT A GLANCE
in units by the standard contribution per unit rather than the standard profit per unit; and
 there is no fixed overhead volume variance.
The Marden Manufacturing Limited example will be used to illustrate the approach.
 Example 33:
Rs.
Direct materials 5 kg @ Rs.1,000 per kg 5,000
Direct labor 4 hours @ Rs. 500 per hour 2,000
Variable overhead 4 hours @ Rs. 200 per hour 800
Marginal production cost 7,800

SPOTLIGHT
Fixed budget
Here is the fixed budget to show the detailed calculation of the budgeted profit.
Marden Manufacturing Limited has budgeted to make 1,200 units and sell 1,000 units in January.
The selling price per unit is budgeted at Rs. 15,000.
The standard costs of production are as given in the previous example.
The budget prepared for January is as follows:
Unit sales 1,000
Unit production 1,200
Budget Rs. ‘000

STIKCY NOTES
Sales (1,000 units 15,000) 15,000

Cost of sales: Rs. ‘000

Materials (1,200 units Rs. 5,000 per unit) 6,000
Labor (1,200 units Rs. 2,000 per unit) 2,400
Variable overhead (1,200 units Rs. 800 per unit) 960
9,360
Closing inventory (200 units Rs. 7,800 per unit) (1,560)
Cost of sales (1,000 units Rs. 7,800 per unit) (7,800)
7,200
Fixed overhead (2,880)
Profit 4,320

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This figure could have been calculated more easily as follows:

Rs. ‘000
Budgeted contribution (1,000 units  (Rs. 15,000Rs. 7,800) 7,200
Less: Budgeted fixed production overhead (2,880)
Profit 4,320

Flexed budget
Here are profit statements redrafted to marginal cost basis.
For Marden Manufacturing Limited, fixed budget, flexed budget and actual results for a period,
would require following calculations
AT A GLANCE

Fixed budget Flexed budget Actual

Unit sales 1,000 900 900
Unit production 1,200 1,000 1,000

Budget Actual Actual

Budget Rs. ‘000 Rs. ‘000 Rs. ‘000
Sales 15,000 13,500 12,600
Cost of sales:
Materials 6,000 5,000 4,608
SPOTLIGHT

Labor 2,400 2,000 2,121

Variable overhead 960 800 945
9,360 7,800 7,674
Closing inventory (1,560) (780) (780)
Cost of sales (7,800) (7,020) (6,894)
7,200 6,480 5,706
Fixed overhead (2,880) (2,400) (2,500)
Profit 4,320 4,080 3,206
STIKCY NOTES

Note: The actual closing inventory of 100 units is measured at the standard marginal production
cost of Rs. 7,800 per unit. This is what happens in standard costing systems. (in exam if question
is silent about inventory measurement then actual closing inventory shall be measured at actual
marginal cost)

7.2 Standard marginal costing variances

Identical variances
All variable cost variances are the same under standard total absorption costing and standard marginal costing.
Sales price variance is the same under standard total absorption costing and standard marginal costing.
Fixed overhead variances
Only the fixed production overhead expenditure variance is relevant and this is calculated in the same way as
seen previously.
There is no fixed production overhead volume variance

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Sales volume variance

The sales volume variance shows the effect on contribution of the difference between the actual sales volume
and the budgeted sales volume.
The variance is calculated by comparing the actual number of units sold (actual sales volume) to the number of
units expected to be sold when the original budget was drafted (budgeted sales volume).
This is then expressed as a money value by multiplying it by the standard contribution per unit.
 Illustration:

Units
Budgeted sales volume X
Actual sales volume (X)

AT A GLANCE
Sales volume variance (units) X
Standard contribution per unit (multiply by) Rs. X
Sales volume variance (Rs.) X

 Example 34:
Sales volume variance (Marden Manufacturing Limited)
Budgeted sales volume 1,000 units
Budgeted selling price per unit Rs. 15,000
Standard cost per unit (from the standard cost card) Rs. 7,800
Therefore, standard contribution per unit Rs. 7,200

SPOTLIGHT
Sales volume variance is calculated as follows: Units
Budgeted sales volume 1,000
Actual sales volume 900
Sales volume variance (units) (A) 100
Standard contribution per unit (multiply by) Rs. 7,200
Sales volume variance (A) Rs. 720,000

7.3 Standard marginal costing operating statement

STIKCY NOTES
With standard marginal costing, an operating statement is presented in a different way from an operating
statement with standard absorption costing.
Budgeted contribution is reconciled with actual contribution, by means of the sales price variance, sales volume
variance and variable cost variances.
Fixed cost expenditure variances are presented in a separate part of the operating statement.
 Example 35:
Operating statement for Marden Manufacturing Limited (standard marginal costing)

Rs. ‘000 Rs. ‘000 Rs. ‘000

Budgeted contribution 7,200
Sales price variance (900) (A)
Sales volume variance (720) (A)
5,580

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Rs. ‘000 Rs. ‘000 Rs. ‘000

Cost variances (F) (A)
Direct materials price 242
Direct materials usage 150
Direct labor rate 21
Direct labor efficiency 50
Direct labor idle time 50
Variable production o’head expenditure 125
Variable production o’head efficiency 20
Total cost variances 392 266 126 F
AT A GLANCE

5,706
Budgeted fixed production overhead 2,880
Fixed production overhead expenditure (380)
variance (F)
Less: Actual fixed production overheads (2,500)
Actual Profit 3,206

Now let’s look at the absorption costing pro forma operating statement.
The format of the operating statement for a firm using absorption costing will have budgeted
profit at the top, then sales variances then cost variances and finally actual profit.
SPOTLIGHT

Rs. ‘000 Rs. ‘000 Rs. ‘000

Budgeted Profit (1) 4,800
Sales volume variance (2) (480) (A)
Standard Profit on actual sales
Sales Price variance (900) (A)
Profit before cost variances 3,420
Cost variances (F) (A)
Direct materials price 242
Direct materials usage 150
STIKCY NOTES

Direct labor rate 21

Direct labor efficiency 50
Direct labor idle time 50
Variable production o’head expenditure 125
Variable production o’head efficiency 20
Fixed production overhead expenditure variance (F) 380
Fixed Production overhead volume variance 480
772 746 26 F
Actual Profit 3,446

Tutorial Notes.
1. Budgeted Profit = Budgeted sales * Standard Profit
2. Sales volume variance = (Actual Sales – Budgeted sales) * Standard Profit

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8. MATERIALS MIX AND YIELD VARIANCES

8.1 Total material Usage Variance
When standard costing is used for products which contain two or more items of direct material, the total
materials usage variance can be calculated by calculating the individual usage variances in the usual way and
adding them up (netting them off).
 Example 36:
Product X is produced from three direct materials, A, B and C, that are mixed together in a
process. The following information relates to the budget and output for the month of January

Standard cost: Actual:

AT A GLANCE
Standard price Standard Quantity
Material Quantity
per kilo cost used
kg Rs. Rs. kg
A 1 20 20 160
B 1 22 22 180
C 8 6 48 1,760
10 90 2,100
Output 1 unit 200 units
Usage variances can be calculated in the usual way:

Making 200 units should have used: A (kgs) B (kgs) C (kgs)

SPOTLIGHT
200  1 kg of A 200
200  1 kg of B 200
200  8 kgs of C 1,600
Making 200 units did use: (160) (180) (1,760)
Usage variance in kgs 40 (F) 20 (F) (160) (A)
Standard cost per kg 20 22 6
Usage variance in Rs. 800 (F) 440 (F) (960) (A)
Total usage variance = Rs. 280 (F) (800 + 440 -960)

STIKCY NOTES
Substitutable materials
If the materials are substitutable (i.e. less of one type of material can be compensated for by more of another)
the direct materials usage variance can be analyzed into:
 a materials mix variance; and
 a materials yield variance
The total of these two variances is the total material usage variance.
It is vital to understand that this further analysis should only be performed if the materials can be substituted
for each other. Mix and yield variances have a useful meaning only when the proportions (or ‘mix’) of the different
raw materials in the final product can be varied and so are subject to management control.
 In the above example fewer kilograms of A but more kilograms of B and C than expected were used to make
200 units. The mix changed and this had an effect on the yield.
 In contrast, if a company manufactured a car, no number of extra tyres could compensate for one less engine!
Mix and yield variances are irrelevant in this case.

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8.2 Direct materials mix variance

The materials mix variance measures how much of the total usage variance is attributable to the fact that the
actual combination or mixture of materials that was used was more expensive or less expensive than the
standard mixture for the materials.
The mix component of the usage variance therefore indicates the effect on costs of changing the combination (or
mix or proportions) of material inputs in the production process.
The material mix variance indicates the effect on profits of having an actual materials mix that is different from
the standard material mix.
The materials mix variance is calculated as follows (making reference to the example above):
i. Take the total quantity of all the materials used (2,100 kg in the example) and calculate what the
quantities of each material in the mix should be if the total usage had been in the standard proportions
AT A GLANCE

or standard mix (1:1:8 in the above example).

ii. Compare the actual quantities of each individual material that were used, and the standard quantities
that would have been used (the standard mix) if the total usage had been in the standard proportions or
standard mix.
iii. The mix variance for each material (expressed in kgs) is the difference between the quantity of each
material actually used and the quantity of that material that should have been used in the standard mix.
The total mix variance in material quantities is always zero.
iv. Convert the mix variance for each individual material into a money value by multiplying by the standard
price per unit of the material.
v. These figures are summed to give the total mix variance
SPOTLIGHT

 Example 37:

Mix Mix
Std. cost
Material Actual mix (kgs) Standard mix variance variance
per kg
(kgs) (Rs.)
A 160 (10%  2,100) 50 (F) 20 1,000 (F)
210
B 180 (10%  2,100) 30 (F) 22 660 (F)
210
C 1,760 (80%  2,100) (80) (A) 6 (480) (A)
STIKCY NOTES

1,680
2,100 2,100 0 1,180 (F)

For each individual item of material, the mix variance is favorable when the actual mix is less
than the standard mix, and the mix variance is adverse when actual usage exceeds the standard
mix.
The total mix variance is favorable in this example because the actual mix of materials used is
cheaper than the standard mix.

8.3 Direct materials yield variance

The materials yield variance is the difference between the actual yield from a given input and the yield that the
actual input should have given in standard terms. It indicates the effect on costs of the total materials inputs
yielding more or less output than expected.
The yield variance can be calculated in several ways. No one method is better than any other (use the one that
makes most sense to you).

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Working
Based on the above example note that:
 The standard cost of each unit (kg) of input = Rs. 90/10kg = Rs. 9 per kg
 The standard cost of each unit of output = Rs. 90 per unit

Method 1: Based on output

This compares the actual yield to the expected yield from the material used. The difference is then valued at the
standard cost of output.
In the above example 10 kg of material in should result in 1 unit of output.
Therefore, 2,100 kg of material in should result in 210 units of output.

AT A GLANCE
The difference between this figure and the actual output is the yield variance as a number of units. This is then
multiplied by the expected cost of a unit of output.
 Example 38:

Units
2,100 kgs of input should yield (@10 kg per unit) 210
2,100 kgs of input did yield 200
Yield variance (units) 10 (A)
Standard cost of output Rs. 90
Materials yield variance (Rs.) Rs. 900 (A)

SPOTLIGHT
Method 2: Based on inputs
This compares the actual usage to achieve the yield to the expected usage to achieve the actual yield. The
difference is then valued at the standard cost of input.
In the above example 1 unit should use 10 kg of input.
Therefore, 200 units should use 2,000 kg of input.
The difference between this figure and the actual input is the yield variance as a number of units. This is then
multiplied by the expected cost of a unit of output.
 Example 38 (Contd.):

STIKCY NOTES
Units
200 units of product X should use ( 10 kgs) 2,000
did use 2,100
Yield variance in quantities 100 (A)
Standard cost of input Rs. 9/kg
Yield variance in money value Rs. 900 (A)
Summary
Mix variance + yield variance = usage variance

Rs.
Mix variance 1,180 (F)
Yield variance (900) (A)
Usage variance (= mix + yield variances) 280 (F)

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8.4 Alternative method

An alternative approach is to use a line by line method.
This starts with the standard cost of the actual quantity used in the actual mix.
This figure is made up as:
 Actual Quantity (AQ) in the Actual Mix (AM) at the Standard Cost per unit (SC)
 Elements of this are then changed in sequence to identify the variances. In the table below the element that
changes have been written in bold.
 Example 39:

AQ in AM @ SC
AT A GLANCE

kgs Rs. Rs.

A 160 × 20 3,200
B 180 × 22 3,960
C 1,760 × 6 10,560
2,100 17,720

AQ in SM @ SC
A (0.1) 210 × 20 4,200 1,180 F MIX
B (0.1) 210 × 22 4,620
C (0.8) 1,680 × 6 10,080
SPOTLIGHT

2,100 18,900

SQ in SM @ SC
A (0.1) 200 × 20 4,000 900 A YIELD
B (0.1) 200 × 22 4,400
C (0.8) 1,600 × 6 9,600
2,0001 18,000
1 This figure is the number of kgs that making 200 units should have used.
STIKCY NOTES

8.5 Factors to consider when changing the mix

Analysis of the material usage variance into the mix and yield components is worthwhile if management have
control of the proportion of each material used. Management will seek to find the optimum mix for the product
and ensure that the process operates as near to this optimum as possible.
Identification of the optimum mix involves consideration of several factors:
 Cost. The cheapest mix may not be the most cost effective. Often a favorable mix variance is offset by an
adverse yield variance and the total cost per unit may increase.
 Quality. Using a cheaper mix may result in a lower quality product and the customer may not be prepared to
pay the same price. A cheaper product may also result in higher sales returns and loss of repeat business.
 The fall in quality would make the company vulnerable to reputational risk.

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9. CALCULATING ACTUAL COSTS OR STANDARD COSTS FROM VARIANCES

9.1 Calculating actual cost from variances and standard cost
In your examination, you might be given a question where you are required to:
 calculate actual costs, given information about variances and standard costs, or
 calculate standard cost, given information about variances and actual costs.
This type of problem does not occur in practice, but it is a useful way of testing knowledge of variances.
This type of problem can be solved by using the tables to calculate variances, described in this chapter. You can
enter into a table all the data given by the question. The ‘missing figure’ for actual cost or standard cost can then
be calculated.

AT A GLANCE
Some examples will be used to illustrate the technique.
 Example 40:
The standard direct materials cost of making Product B is Rs.20, consisting of 4 kilos of material
at Rs.5 per kilo.
During one period, 1,250 kilos of the material were purchased and the direct materials price
variance was Rs.250 (A).
The actual costs of direct materials purchased and used in the period, would be calculated as
follows
A table should be prepared showing how the total materials cost variance is calculated, and the
figures that are available should be entered in the table.

SPOTLIGHT
Rs.
1,250 kilos of material should cost (× Rs.5) 6,250
The materials did cost ?
Total materials cost variance 250 (A)
Actual purchase costs were higher than standard cost because the price variance is adverse.
Actual purchase costs were therefore Rs.6,250 + Rs.250 = Rs.6,500.
 Example 41:
The standard direct material cost of Product C is Rs.21 (6 kilos of material at Rs.3.50 per kilo).
During a period when 400 units of Product C were made, the direct material usage variance was

STIKCY NOTES
Rs.630 (F).
The actual quantity of direct materials used in the period, would be calculated as follows:
A table should be prepared showing how the materials usage variance is calculated, and the
figures that are available should be entered in the table.
Materials usage variance kilos
400 units of Product C should use ( 6 kilos) 2,400
They did use ?
Material usage variance in kilos ?
Standard price per kilo Rs.3.50
Material usage variance in Rs. Rs.630 (F)
From this information we can calculate the material usage variance in kilos. A usage variance is
valued at the standard cost per unit of material; therefore, the usage variance in Rs. can be
converted into a usage variance in kilos:

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Usage variance = Rs.630(F)/Rs.3.50 per kilo = 180 kilos (F).

The variance is favorable, which means that actual usage was less than the standard (expected)
usage. We know that the standard usage is 2,400 kilos.
Actual material usage was therefore:
2,400 kilos – 180 kilos = 2,220 kilos.
 Example 42:
In the standard cost of Product D, the cost of Grade A labor is Rs.24 per unit (= 1.5 hours per unit
at Rs.16 per hour). During a month when 500 units of Product D were made and 780 hours were
worked, the labor rate variance for Grade A labor was Rs.1,500 (F).
The actual cost of Grade A labor in the month, would be calculated as follows
A table should be prepared showing how the labor rate variance is calculated, and the figures
AT A GLANCE

that are available should be entered in the table.

Direct labor rate variance Rs.
780 hours should cost (Rs.16) 12,480
They did cost ?
Direct labor rate variance 1,500 (F)
The rate variance was favorable, which means that actual costs were less than standard.
Actual cost of Grade A labor = Rs.12,480 – Rs.1,500 = Rs.10,980.
 Example 43:
SPOTLIGHT

In a standard absorption costing system, the standard fixed production overhead cost per unit of
Product E is Rs.36. This represents 3 direct hours at Rs.12 per hour.
The budgeted production volume in the period was 6,000 units of Product E. The fixed
production overhead volume variance was Rs.12,600 (F).
The actual quantity of Product E that was produced, would be calculated as follows
A table should be prepared showing how the production overhead volume variance is calculated,
and the figures that are available should be entered in the table.
Fixed overhead volume variance units of production
Budgeted production volume in units 6,000
Actual production volume in units ?
STIKCY NOTES

Fixed overhead volume variance in units ? (F)

Standard fixed production overhead cost per unit Rs.36
Fixed overhead volume variance in Rs. Rs.12,600 (F)
We know the volume variance in Rs. The volume variance is valued at the standard fixed
overhead cost per unit. The volume variance in Rs. can therefore be converted into a volume
variance in units as follows:
Rs. 12,600(F)/Rs.36 per unit = 350 units (F).
Actual production volume is higher than the budgeted volume, because the volume variance is
favorable. The budgeted production volume was 6,000 units.
Actual production volume = 6,000 units + 350 units = 6,350 units.

9.2 Calculating standard cost from variances and actual cost

The same approach can be used to calculate a standard cost or budget amount if you are given a variance and
data about actual costs (or sales revenues). Some further examples will illustrate the technique.

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 Example 44:
Product F uses a direct material, material M. The standard price of material M is Rs.4 per kilo.
During one month, 2,500 units of Product F were manufactured. These required 12,000 kilos of
material M and the material usage variance was Rs.2,000 (A).
We know the standard price of material M, but we need to calculate the standard material usage.
This can be obtained from the data provided. A table should be prepared showing how the
material usage variance is calculated, and the figures that are available should be entered in the
table.
Materials usage variance kilos
2,500 units of Product F should use ?
They did use 12,000

AT A GLANCE
Material usage variance in kilos ?
Standard price per kilo Rs.4
Material usage variance in Rs. 2,000 (A)
We know the material usage variance in Rs.. The variance is valued at the standard price per unit
of material. From the information provided we can therefore calculate the material usage
variance in kilos:
Usage variance = Rs.2,000(A)/Rs.4 per kilo = 500 kilos (A).
The variance is adverse, which means that actual usage was more than the standard (expected)
usage. The standard material usage is therefore:
12,000 kilos – 500 kilos = 11,500 kilos.
This is the standard usage for 2,500 units of Product F, so the standard usage per unit is

SPOTLIGHT
11,500/2,500 = 4.60 kilos per unit.
The standard material cost for Product F is therefore:
4.6 kilos of material M at Rs.4 per kilo = Rs.18.40.
 Example 45:
The standard time required to make one unit of Product G is 1.25 hours of direct labor. During
one month, total direct labor costs were Rs.119,000. The company made 6,800 units of Product
G. These took 9,100 direct labor hours and the direct labor rate variance was Rs.8,400 (F).
The standard direct labor cost per unit of Product G, would be calculated as follows
We know the standard direct labor time, which is 1.25 hours per unit, but we need to calculate
the standard direct labor rate per hour. This can be obtained from the data provided. A table

STIKCY NOTES
should be prepared showing how the labor rate variance is calculated, and the figures that are
available should be entered in the table.
Direct labor rate variance Rs.
9,100 hours should cost ?
They did cost 119,000
Direct labor rate variance 8,400 (F)
The rate variance is favorable, which means that actual costs were lower than standard costs.
The actual labor cost for the 9,100 hours was Rs.119,000. Expected costs are higher.
The 9,100 hours should therefore cost Rs.119,000 + Rs.8,400 = Rs.127,400.
The standard rate per hour is Rs.127,400/9,100 hours = Rs.14 per hour.
The standard direct labor cost of Product G is:
1.25 hours at Rs.14 per hour = Rs.17.50
Tutorial note: It is easy to get confused about whether variances should be added or subtracted
in this type of calculation. You need to think carefully and logically, to avoid making a mistake.

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10. COMPREHENSIVE EXAMPLES

 Example 01:
A company makes a single product and uses standard absorption costing. The standard cost per
unit is as follows:

Rs. per unit

Direct materials 8
Direct labor 6
Fixed production overheads 12
26
AT A GLANCE

Budgeted production is 14,000 units per month. Last month, actual production was 14,800 units,
and actual costs were as follows:

Total costs Rs.

Direct materials 125,000
Direct labor 92,000
Fixed production overheads 170,000
387,000

A statement for the month that reconciles budgeted costs, standard costs and actual costs would
be prepared as follows
SPOTLIGHT

Reconciliation statement Rs.

Budgeted costs for the month (14,000 units  Rs.26) 364,000
Extra standard costs of additional production (800 units  Rs.26) 20,800
Standard costs of actual production (14,800 units  Rs.26) 384,800
Cost variances
Direct materials total cost variance 6,600 (A)
Direct labor total cost variance 3,200 (A)
STIKCY NOTES

Fixed overheads expenditure variance 2,000 (A)

Fixed overheads volume variance 9,600 (F)
Actual total costs in the month 387,000

Workings: Direct materials total cost variance Rs.

14,800 units should cost ( Rs.8) 118,400
They did cost 125,000
Direct materials total cost variance 6,600 (A)

Direct labor total cost variance Rs.

14,800 units should cost ( Rs.6) 88,800
They did cost 92,000
Direct labor total cost variance 3,200 (A)

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Fixed production overheads total cost variance Rs.

14,800 units: standard fixed overhead cost ( Rs.12) 177,600

Actual fixed overhead cost 170,000

Fixed production overheads total cost variance 7,600 (F)

Note: The fixed overhead total cost variance can be divided into:
a) an expenditure variance
b) a volume variance

Fixed production overheads expenditure variance Rs.

AT A GLANCE
Budgeted fixed overhead expenditure (14,000  Rs.12) 168,000
Actual fixed overhead expenditure 170,000
Fixed production overheads expenditure variance 2,000 (A)

Fixed production overheads volume variance units

Budgeted units of production 14,000
Actual units produced 14,800
Fixed production overheads volume variance in units 800 (F)
Standard fixed overheads per unit Rs.12

SPOTLIGHT
Fixed production overheads volume variance in Rs. Rs.9,600 (F)

 Example 02:
a) Z Company uses a standard costing system and has the following labor cost standard in relation
to one of its products:
4 hours of skilled labor at Rs.6.00 per hour: Rs.24.00
During October, 3,350 units of this products were made, which was 150 units less than budgeted.
The labor cost incurred was Rs.79,893 and the number of direct labor hours worked was 13,450.
The direct labor rate and efficiency variances for the month, would be as follows:

STIKCY NOTES
Direct labor rate variance Rs.
13,450 hours should cost ( Rs.6) 80,700
They did cost 79,893
Labor rate variance 807 (F)

Direct labor efficiency variance hours

3,350 units should take ( 4 hours) 13,400
They did take 13,450
Efficiency variance in hours 50 (A)
Standard rate per hour Rs.6
Direct labor efficiency variance in Rs. Rs.300 (A)

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b) Company J uses a standard costing system and has the following data relating to one of its
products:

Rs. per unit Rs. per unit

Selling price 9.00
Variable cost 4.00
Fixed cost 3.00
7.00
Profit 2.00

The budgeted sales for October Year 5 were 800 units, but the actual sales were 850 units. The
AT A GLANCE

revenue earned from these sales was Rs.7,480.

The sales price and sales volume variances for October using standard absorption costing and
standard marginal costing, would be as follows:

Sales price variance Rs.

850 units should sell for (× Rs.9) 7,650
They did sell for 7,480
Sales price variance 170 (A)

Sales volume variance, absorption costing units

SPOTLIGHT

Actual sales volume (units) 850

Budgeted sales volume (units) 800
Sales volume variance in units 50(F)

Standard profit per unit Rs.2

Sales volume variance (profit variance) in Rs. Rs.100 (F)

Sales volume contribution variance, marginal costing

STIKCY NOTES

Sales volume variance in units 50 (F)

Standard contribution per unit (Rs.9 - Rs.4) Rs.5

Sales volume variance (contribution variance) Rs.250 (F)

c) The budget was to produce 15,000 units. The standard fixed production cost of a product is Rs.20,
which is 4 hours at a rate of Rs.5 per direct labor hour. Actual production was 14,600 units and
actual fixed production overhead expenditure was Rs.325,000. The production output was
manufactured in 58,000 hours of work.
Calculations for the following variances are given below:
i. the fixed production overhead total cost variance
ii. the fixed production overhead expenditure variance and volume variance
iii. the fixed production overhead efficiency variance and capacity variance

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(i) Fixed production overhead total cost variance Rs.

Standard fixed overhead cost of 14,600 units ( Rs.20) 292,000
Actual fixed overhead expenditure 325,000
Fixed overhead total cost variance (under-absorption) 33,000 (A)

(ii) Fixed production overhead expenditure variance Rs.

Budgeted fixed overhead expenditure (15,000  Rs.20) 300,000
Actual fixed overhead expenditure 325,000
Fixed overhead expenditure variance 25,000 (A)

AT A GLANCE
Fixed production overhead volume variance units
Budgeted production volume 15,000
Actual production volume 14,600
Volume variance in units 400 (A)
Standard fixed overhead rate per unit Rs.20
Fixed production overhead volume variance in Rs. Rs.8,000 (A)

(iii) Fixed production overhead efficiency variance hours

14,600 units should take  4 hours) 58,400

SPOTLIGHT
They did take 58,000
Efficiency variance in hours 400 (F)

Standard fixed overhead rate per hour Rs.5

Fixed production overhead efficiency variance in Rs. Rs.2,000 (F)

Fixed production overhead capacity variance hours

Budgeted hours of work (15,000  4 hours) 60,000

STIKCY NOTES
Actual hours of work 58,000
Capacity variance in hours 2,000 (A)

Standard fixed overhead rate per hour Rs.5

Fixed production overhead capacity variance in Rs. 10,000 (A)

 Example 03:
A company operates a standard overhead absorption costing system. The standard fixed
overhead rate per hour is Rs.25. The following data relate to last month:
Actual hours worked 8,250
Budgeted hours 9,000
Standard hours of actual production 7,800
Actual fixed overhead expenditure Rs.211,000

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For the month, calculations of the following variances are given below
o the fixed overhead capacity variance
o the fixed overhead efficiency variance
o the fixed overhead expenditure variance.

Fixed production overhead capacity variance hours

Budgeted production hours of work 9,000
Actual production hours of work 8,250
Capacity variance inhours 750 (A)
Standard fixed overhead rate per hour Rs.25
AT A GLANCE

Fixed production overhead capacity variance in Rs. Rs.18,750 (A)

Fixed production overhead efficiency variance hours
Standard hours produced 7,800
Actual hours worked 8,250
Efficiency variance in hours 450 (A)
Standard fixed overhead rate per hour Rs.25
Fixed production overhead efficiency variance in Rs. Rs.11,250 (A)
Fixed production overhead expenditure variance Rs.
Budgeted fixed overhead expenditure (9,000 hours × Rs.25) 225,000
SPOTLIGHT

Actual fixed overhead expenditure 211,000

Fixed overhead expenditure variance 14,000 (F)

 Example 04:
A manufacturing company uses a standard absorption costing system in accounting for its
production costs.
The standard cost of a unit of product is as follows:

Standard Standard Standard

quantity price/rate cost
Rs. Rs.
STIKCY NOTES

Direct materials 5 kilos 6.00 30.00

Direct labor 20 hours 4.00 80.00
Variable production overhead 20 hours 0.20 4.00
Fixed production overhead 20 hours 5.00 100.00

The following data relates to Period 1:

Budgeted output 25,000 units

Actual output - produced 20,000 units
Units sold 15,000 units
Materials put into production 120,000 kilos
Materials purchased 200,000 kilos
Direct labor hours paid 500,000 hrs

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Due to a power failure 10,000 hours were lost.

Cost of materials used Rs.825,000

Rate per direct labor hour Rs.5
Variable production overhead Rs.70,000
Fixed production overhead Rs.2,100,000

For Period 1, calculations for the following variances are given below:
o the material price variance
o the material usage variance
o the direct labor rate variance

AT A GLANCE
o the direct labor idle time variance
o the direct labor efficiency variance
o the variable overhead total cost variance
o the fixed overhead expenditure variance
o the fixed overhead volume variance
o the total manufacturing cost variance.

Material price variance Rs.

120,000 kilos of materials should cost ( Rs.6) 720,000

SPOTLIGHT
They did cost 825,000
Material price variance 105,000 (A)
Material usage variance kilos
20,000 units should use ( 5 kilos) 100,000
They did use 120,000
Material usage variance in kilos 20,000 (A)
Standard price per kilo of material Rs.6
Material usage variance in Rs. Rs.120,000 (A)

STIKCY NOTES
Direct labor rate variance Rs.
500,000 hours should cost ( Rs.4) 2,000,000
They did cost ( Rs.5) 2,500,000
Labor rate variance 500,000 (A)
Direct labor idle time variance =
10,000 hours (A)  Rs.4 per hour = Rs.40,000 (A)
Direct labor efficiency variance hours
20,000 units should take ( 20 hours) 400,000
They did take (500,000 – 10,000) 490,000
Efficiency variance in hours 90,000 (A)
Standard rate per hour Rs.4
Direct labor efficiency variance in Rs. Rs.360,000 (A)

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Variable overhead total cost variance Rs.

20,000 units should cost ( Rs.4) 80,000
They did cost 70,000
Variable overhead total cost variance 10,000 (F)
Fixed production overhead expenditure variance Rs.
Budgeted fixed overhead expenditure (25,000 units  Rs.100) 2,500,000
Actual fixed overhead expenditure 2,100,000
Fixed overhead expenditure variance 400,000 (F)
Fixed production overhead volume variance units
AT A GLANCE

Budgeted production volume 25,000

Actual production volume 20,000
Volume variance in units 5,000 (A)
Standard fixed overhead rate per unit Rs.100
Fixed production overhead volume variance in Rs. Rs.500,000 (A)

Summary Favourable Adverse

Variance Rs. Rs.
Material price 105,000
Material usage 120,000
SPOTLIGHT

Direct labor rate 500,000

Direct labor idle time 40,000
Direct labor efficiency 360,000
Variable overhead cost 10,000
Fixed overhead expenditure 400,000
Fixed overhead volume 500,000
410,000 1,625,000
Manufacturing cost total variance Rs.1,215,000 (A)
STIKCY NOTES

 Example 05:
A production manager is studying the cost report for the six-month period that has just ended.
The production department incurred overhead costs of Rs.680,000 and had under-absorbed
overheads of Rs.46,400. The actual direct labor hours worked in the department were 48,000
hours, which was 2,000 hours less than budgeted. Actual hours and standard hours are same,
For the given example, the budgeted absorption rate per direct labor hour, would be:

Rs.
Actual overhead expenditure 680,000
Under-absorbed overhead (46,400)
Absorbed overhead 633,600
Hours worked 48,000
Therefore budgeted absorption rate per hour (Rs.633,600/48,000) Rs.13.20

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The budgeted overhead expenditure, would be calculated as follows:

hours
Actual hours worked 48,000
This was less than budget by 2,000
Budgeted hours 50,000
Absorption rate per hour Rs.13.20
Budgeted overhead expenditure
(50,000 hours × Rs.13.20) Rs.660,000

The overhead expenditure and overhead volume variances in the period, would be,

AT A GLANCE
Volume variance in hours 2,000 hours Adverse
Absorption rate per hour Rs.13.20
Volume variance in Rs. Rs.26,400 Adverse

Rs.
Actual overhead expenditure 680,000
Budgeted overhead expenditure 660,000
Expenditure variance 20,000 Adverse

 Example 06:

SPOTLIGHT
Lettuce makes a product – the vegetable guard. It is the organic alternative to slug pellets and
chemical sprays.
For the forthcoming period budgeted fixed costs were Rs.6,000 and budgeted production and
sales were 1,300 units.
The vegetable guard has the following standard cost:

Rs.
Selling price 50
Materials 5kg  Rs.4/kg 20
Labor 3hrs  Rs.4/hr 12

STIKCY NOTES
Variable overheads 3hrs  Rs.3/hr 9
Actual results for the period were as follows:
1,100 units were made and sold, earning revenue of Rs.57,200.
6,600kg of materials were bought at a cost of Rs.29,700 but only 6,300 kg were used
3,600 hours of labor were paid for at a cost of Rs.14,220. The total cost for variable overheads
was Rs.11,700 and fixed costs were Rs.4,000.
The company uses marginal costing and values all inventory at standard cost.
a) Assuming now that the company uses absorption costing, recalculating the fixed production
overhead variances, would be as follows:
Tutorial note: If the company uses absorption costing with a direct labor hour absorption rate,
we can calculate an expenditure, capacity and efficiency variance for fixed production overheads.
The first step is to calculate a budgeted absorption rate per hour
Budgeted labor hours: 1,300  3 = 3,900 hrs

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Budgeted fixed cost Rs.6,000

Budgeted absorption rate: Rs.6,000 /3,900 = Rs.1.54
Fixed overhead expenditure variance
Same as in (a): Rs.2,000 (F).
Fixed overhead capacity variance
hours
Budgeted hours of work 3,900
Actual hours worked 3,600
Capacity variance in hours 300 (A)
Standard fixed overhead rate per hour Rs.1.54
AT A GLANCE

Fixed overhead capacity variance in Rs. Rs.462 (A)

Fixed overhead efficiency variance
Efficiency variance in hours = 300 hours (A) – see answer to (a).
Fixed overhead efficiency variance = 300 hours (A)  Rs.1.54 = Rs.462 (A).
b) Possible causes for the labor variances that have been calculated are discussed below:
Labor rate
The labor rate variance is favorable indicating a lower rate per hour was paid than expected. This
is perhaps because more junior or less experienced staff were used during production. Though
less likely, it is possible that staff had a pay cut imposed upon them. Finally, an incorrect or
outdated standard could have been used.
SPOTLIGHT

Labor efficiency
This is significantly adverse, indicating staff took much longer than expected to complete the
output. This may relate to the favorable labor rate variance, reflecting employment of less skilled
or experienced staff. Staff demotivated by a pay cut are also less likely to work efficiently.
It may also relate to the reliability of machinery as staff may have been prevented from reaching
full efficiency by unreliable equipment
 Example 07:
Carat plc, a premium food manufacturer, is reviewing operations for a three-month period. The
company operates a standard marginal costing system and manufactures one product, ZP, for
STIKCY NOTES

which the following standard revenue and cost data per unit of product is available:
Selling price Rs. 12.00
Direct material A 2.5 kg at Rs. 1.70 per kg
Direct material B 1.5 kg at Rs. 1.20 per kg
Direct labor 0.45 hrs at Rs. 6.00 per hour
Fixed production overheads for the three-month period were expected to be Rs. 62,500.
Actual data for the three-month period was as follows:
Sales and production 48,000 units of ZP were produced and sold for Rs. 580,800
Direct material A 121,951 kg were used at a cost of Rs. 200,000
Direct material B 67,200 kg were used at a cost of Rs. 84,000
Direct labor Employees worked for 18,900 hours, but 19,200 hours were
paid at a cost of Rs. 117,120
Fixed production overheads Rs. 64,000

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Budgeted sales for the three-month period were 50,000 units of Product ZP.
a) The following variances are required to be calculated for the given example:
i. price, mix and yield variances for each material;
ii. labor rate, labor efficiency and idle time variances.
Sales volume contribution per unit

Rs. /unit Rs. /unit

Standard sales price 12·00
Material A (Rs. 1·70 × 2·5) 4·25
Material B (Rs. 1·20 × 1·5) 1·80

AT A GLANCE
Labor (Rs. 6·00 × 0·45) 2·70
8·75
Standard contribution 3·25

Direct material price variances

Material A price variance Rs.

Actual quantity × actual price 200,000
Actual quantity × standard price (Rs. 1·70 × 121,951) 207,317
Price variance 7,317 (F)

SPOTLIGHT
Material B price variance Rs.
Actual quantity × actual price 84,000
Actual quantity × standard price (Rs. 1·20 × 67,200) 80,640
Price variance 3,360 (A)

Materials mix and yield variances

Standard cost of input and output
kg Rs. /kg Standard cost
Material A = Rs. 1·70 × 2·5 = 2.5 Rs. 1.7 4·25

STIKCY NOTES
Material B = Rs. 1·20 × 1·5 = 1.5 Rs. 1.2 1·80
4.0 6·05
Standard cost of input = Rs. 6.05/4kg
Standard cost of output = Rs. 6.05/unit
Material mix
Actual Standard Standard Mix Standard Mix
mix ratio mix variance cost per variance
(kg) kg (Rs.)
A 121,951 2.5 118,220 3,731 1.7 6,343 (A)
B 67,200 1.5 70,931 (3,731) 1.2 (4,477) (F)
189,151 189,151 1,866 (A)

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Material yield variance

Units
189,151 did yield 48,000
189,151 should have yielded (÷ 4kg) 47,288
Extra yield 712
Standard cost of a unit Rs. 6.05
Yield variance Rs. 4,309 (F)
Alternative calculation
AQ AM SC
A 121,951 × Rs. 1.7/kg 207,317
AT A GLANCE

B 67,200 × Rs. 1.2/kg 80,640

189,151 287,957
MIX
(1,866) (A)
AQ SM SC
189,151 × Rs. 6.05/4kg 286,091
YIELD
4,309 (F)
SQ SM SC
SPOTLIGHT

192,000 × Rs. 6.05/4kg 290,400

48,000 × 4kg

or 48,000 units × 6.05

Labor variances
Labor rate Rs.
Actual hrs × actual rate 117,120
Actual hrs × standard rate (19,200 × Rs. 6) 115,200
Rate: 1,920 (A)
STIKCY NOTES

Labor efficiency Rs.

Actual hrs worked × standard rate
18,900 hours × Rs. 6 113,400
Standard hrs × standard rate
48,000 units × .45 hrs × Rs. 6 129,600
Efficiency: 16,200 (F)
Labor idle time Hours
Actual hrs paid for 19,200
Actual hrs worked 18,900
Idle time (hours) 300
Standard rate Rs. 6
Idle time (Rs. ) 1,800 (A)

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b) Possible explanations for the following variances are also discussed below:
i. material price, mix and yield variances for material A;
ii. labor rate, labor efficiency and idle time variances.
The favorable material A price variance indicates that the actual price per kilogram was less than
standard. Possible explanations include buying lower quality material, buying larger quantities
of material A and thereby gaining bulk purchase discounts, a change of supplier, and using an
out-of-date standard.
The adverse material A mix variance indicates that more of this material was used in the actual
input than indicated by the standard mix. The favorable material price variance suggests this may
be due to the use of poorer quality material (hence more was needed than in the standard mix),
or it might be that more material A was used because it was cheaper than expected.

AT A GLANCE
The favorable material A yield variance indicates that more output was produced from the
quantity of material used than expected by the standard. This increase in yield is unlikely to be
due to the use of poorer quality material: it is more likely to be the result of employing more
skilled labor, or introducing more efficient working practices.
It is only appropriate to calculate and interpret material mix and yield variances if quantities in
the standard mix can be varied. It has also been argued that calculating yield variances for each
material is not useful, as yield is related to output overall rather than to particular materials in
the input mix. A further complication is that mix variances for individual materials are inter-
related and so an explanation of the increased use of one material cannot be separated from an
explanation of the decreased use of another.
The unfavorable labor rate variance indicates that the actual hourly rate paid was higher than

SPOTLIGHT
standard. Possible explanations for this include hiring staff with more experience and paying
them more (this is consistent with the favorable overall direct material variance), or
implementing an unexpected pay increase. The favorable labor efficiency variance shows that
fewer hours were worked than standard. Possible explanations include the effect of staff training,
the use of better quality material (possibly on Material B rather than on Material A), employees
gaining experience of the production process, and introducing more efficient production
methods. The adverse idle time variance may be due to machine breakdowns; or a higher rate of
production arising from more efficient working (assuming employees are paid a fixed number of
hours per week).
 Example 08:
Hexa Limited uses a standard costing system. The following profit statement summarizes the

STIKCY NOTES
performance of the company for August 20X3:

Rupees
Budgeted profit 3,500
Favorable variance:
Material price 16,000
Labor efficiency 11,040 27,040
Adverse variance:
Fixed overheads expenditure (16,000)
Material usage ((6,000)
Labor rate (7,520) (29,520)
Actual profit 1,020

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The following information is also available:

Standard material price per unit (Rs.) 4.0

Actual material price per unit (Rs.) 3.9
Standard wage rate per hour (Rs.) 6.0
Standard wage hours per unit 10
Actual wages (Rs.) 308,480
Actual fixed overheads (Rs.) 316,000
Fixed overheads absorption rate 100% of direct wages

a) Budgeted output in units, actual number of units purchased, actual units produced,
AT A GLANCE

actual hours worked and actual wage rate per hour would be calculated as follows:

(i) Budgeted output in units

Actual Fixed Overhead Rs. 316,000
Less: Adverse Fixed Overhead Variance Rs. 16,000
Budgeted Fixed Overhead Rs. 300,000
Direct wages per unit (Rs. 6 x 10 hours) Rs. 60
Budgeted output in units (Rs. 300,000/60) 5,000 units
(ii) Actual number of units purchased
Material Price Variance – Total Rs. 16,000
SPOTLIGHT

Price Variance per unit (Rs. 4.0 – Rs. 3.9) Re. 0.1
Units purchased (Rs. 16,000 / 0.1) 160,000
(iii) Actual units produced
Standard Wages (308,480 – 7,520 + 11,040) Rs. 312,000
Standard Labor Cost (Rs. 6 x 10 hours) Rs. 60
Units produced (Rs. 312,000 / Rs. 60) 5,200
(iv) Actual hours worked
Actual Labor Costs Rs. 308,480
Less: Labor Rate Variance 7,520
STIKCY NOTES

Actual Labor Costs at Standard Rate 300,960

Standard Rate per hour Rs. 6.00
Actual hours worked (300,960 / 6) 50,160
(v) Actual Wages / Actual Hours = Rs. 308,480 / 50,160 = Rs. 6.15

b)

Possible causes of favorable material price variance

Fortunate buy
Inferior quality materials
Unusual discount due to bulk quantity purchase
Drop in market price
Less costly method of transportation

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Possible causes of unfavorable material quantity variance

Carelessness
Poorly adjusted machines
Unskilled workers
New equipment
Inferior quality materials
Possible causes of favorable labor efficiency variance
Use of better skilled workers
High quality material
New equipment

AT A GLANCE
Possible causes of unfavorable labor rate variance
Use of workers with better skills
Change in pay scales
Overtime

 Example 09:
Excellent Limited makes and sells a single product. The standard cost card for the product, based
on normal capacity of 45,000 units per month is as under:
Rupees

SPOTLIGHT
Material 60 kgs at Rs. 0.60 per kg 36.00
Labor ½ hour at Rs. 50.00 per hour 25.00
Variable factory overheads, 30% of direct labor cost 7.50
Fixed factory overheads 6.50
Total 75.00
Actual data for the month of August 20X3 is as under:
Work in process on August 1, 20X3 (60% converted) Units 10,000
Started during the month Units 50,000

STIKCY NOTES
Transferred to finished goods Units 48,000
Work in process on August 31, 20X3 (50% converted) Units 10,000
Material purchased at Rs. 0.50 per kg Rs. 1,750,000
Material issued to production Kgs 3,100,000
Direct labor at Rs. 52 per hour Rs. 1,300,000
Factory overheads (including fixed costs of Rs. 290,000) Rs. 600,000

The company uses FIFO method for inventory valuation.

All materials are added at the beginning of the process. Conversion costs are incurred
evenly throughout the process. Inspection takes place when the units are 80% complete.
Under normal conditions, no spoilage should occur.

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a) A quantity and equivalent production schedules for material and conversion costs would
be prepared as follows:
Preliminary working Rs.
Units in process at beginning 10,000
Units started during the month 50,000
Total possible units 60,000
Normal loss 
Expected good output: 60,000
Actual good output:
Started in the previous period but finished in this period 10,000
AT A GLANCE

Started and finished in this period (balance) 38,000

Finished in this period (given) (48,000)
Closing WIP (10,000)
Loss of units (Balance quantity) 2,000

Total Percentage Conversion

Units made in period Materials
units complete cost
Started last period
Opening WIP 10,000
Materials 0%
SPOTLIGHT

Conversion 40% 4,000

Started and finished in period 38,000 100% 38,000 38,000
Good output 48,000
Started but not finished
Closing WIP 10,000
Materials 100% 10,000
Conversion 50% 5,000
Abnormal loss 2,000
STIKCY NOTES

Materials 100% 2,000

Conversion 80% 1,600
Units made in period 50,000 48,600
b) Material, labor and variable overhead variances are calculated below. (Assuming that
the material price variance is calculated as materials are used rather than as they are
purchased).
Material, labor and variable overhead variances
1) Material price variance Rs.
3,100,000 kgs should cost (@ 0.6 per kg) 1,860,000
3,100,000 kgs did cost (@ 0.5 per kg) 1,550,000
Material price variance (F) 310,000

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2) Material quantity variance Kgs.

Making 50,000 units should use (@60 kg per unit) 3,000,000
Making 50,000 units did use 3,100,000
Material quantity variance in kgs (A) (100,000)
Standard cost per kg (Rs.) 0.6
Material quantity variance in Rs. (A) (60,000)
3) Labor rate variance Rs.
25,000 hrs should cost (@ 50 per hr) 1,250,000
25,000 hrs did cost (@ 52 per hr) 1,300,000
Labor rate variance (A) (50,000)

AT A GLANCE
W: Labor hours worked = Rs.1,300,000 ÷ Rs. 52 = 25,000 hrs
4) Labor efficiency variance hrs.
Making 48,600 units should use (@ 0.5 hrs per unit) 24,300
Making 48,600 units did use 25,000
Labor efficiency variance in hrs (A) (700)
Standard rate per hr (Rs.) 50
Labor efficiency variance in Rs. (A) (35,000)
5) Variable overhead rate variance Rs.
25,000 hrs should cost (@ 15 per hr) 375,000

SPOTLIGHT
25,000 hrs did cost (Rs.600,000 less Rs.290,000) 310,000
Variable overhead rate variance (F) 65,000
6) Variable overhead efficiency variance hrs.
Making 48,600 units should use (@ 0.5 hrs per unit) 24,300
Making 48,600 units did use 25,000
Variable overhead efficiency variance in hrs (A) (as above) (700)
Standard rate per hr (Rs.) 15
Variable overhead efficiency variance in Rs. (A) (10,500)

STIKCY NOTES
c) The over (under) absorption of fixed production overhead and analyze it into
expenditure variance and volume variance would be calculated below:

Over(under) absorption of fixed production overhead

Note: Fixed overhead absorption rate is Rs.6.5 per unit. Each unit takes 0.5 hrs.
Therefore, the fixed overhead absorption rate is Rs. 13 per hour.
1) Over(under) absorption Rs.
Amount absorbed (48,600 units at Rs. 6.5 per unit) 315,900
Actual expenditure 290,000
Over absorption (F) 25,900
2) Fixed production overhead expenditure variance Kgs.
Budgeted expenditure (45,000 units @ Rs. 6.5 per unit) 292,500
Actual expenditure 290,000
Expenditure variance in Rs. (F) 2,500

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3) Fixed production overhead volume variance Rs.

Budgeted volume 45,000
Actual volume 48,600
Volume variance in units (F) 3,600
Standard rate per unit (Rs.) 6.5
Labor efficiency variance in Rs. (F) 23,400
d) Analyze the fixed production overhead volume variance into efficiency and capacity
variances.

1) Fixed overhead efficiency variance hrs.

AT A GLANCE

Making 48,600 units should use (@ 0.5 hrs per unit) 24,300
Making 48,600 units did use 25,000
Fixed overhead efficiency variance in hrs (A) (as above) (700)
Standard rate per hr (Rs.) 13
Fixed overhead efficiency variance in Rs. (A) (9,100)
2) Fixed overhead capacity variance Rs.
Budgeted hours (45,000 hours at 0.5 hr per unit) 22,500
Actual hours worked 25,000
Capacity variance in hrs (F) 2,500
SPOTLIGHT

Standard rate per hr (Rs.) 13

Capacity variance in Rs. (F) 32,500

 Example 10:
You have recently been appointed as the Financial Controller of Watool Limited. Your
immediate task is to prepare a presentation on the company’s performance for the recently
concluded year. You have noticed that the records related to cost of production have not been
maintained properly. However, while scrutinizing the files you have come across certain details
prepared by your predecessor which are as follows:
i. Annual production was 50,000 units which is equal to the designed capacity of the plant.
STIKCY NOTES

ii. The standard cost per unit of finished product is as follows:

Raw material X 6 kg at Rs. 50 per kg
Raw material Y 3 kg at Rs. 30 per kg
Labor- skilled 1.5 hours at Rs. 150 per hour
Labor- unskilled 2 hours at Rs. 100 per hour
Factory overheads Variable overheads per hour are Rs. 100 for skilled labor and
Rs. 80 for unskilled labor. Fixed overheads are Rs. 4,000,000.
iii. Data related to variation in cost of materials is as under:
Material X price variance Rs. 95,000 (Adverse)
Material Y actual price 6% below the standard price
Material X quantity variance Nil
Material Y quantity variance Rs. 150,000 (Adverse)

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iv. Opening raw material inventories comprised of 25 days of standard consumption

whereas closing inventories comprised of 20 days of standard consumption.
v. Actual labor rate for skilled and unskilled workers was 10% and 5% higher respectively.
vi. Actual hours worked by the workers were 168,000 and the ratio of skilled and unskilled
labor hours was 3:4 respectively.
vii. Actual variable overheads during the year amounted to Rs. 16,680,000. Fixed overheads
were 6% more than the budgeted amount.
a) Actual purchases of each type of raw materials is calculated as follows:

Actual quantity purchased: Material X

Standard consumption quantities (50,000 units  6kg per unit) 300,000

AT A GLANCE
Usage variance 0
Actual usage 300,000
Opening inventory (300,000 kgs  25/365) (20,548)
Closing inventory (300,000 kgs  20/365) 16,438
Inventory movement (4,110)
Actual purchase quantity (kgs) 295,890

Actual cost of purchase:

Standard rate (Rs. per kg) 50

SPOTLIGHT
Actual quantity purchased at standard rate (Rs.) 14,794,500
Price paid above / (below) the standard rate
{adverse / (favorable) price variance} 95,000
Actual cost of purchase 14,889,500

Actual quantity purchased: Material Y

Standard consumption quantities (50,000 units  3kg per unit) 150,000
Usage variance (Rs.150,000 @Rs.30 per kg) 5,000

STIKCY NOTES
Actual usage 155,000
Opening inventory (150,000 kgs  25/365) (10,274)
Closing inventory (150,000 kgs  20/365) 8,219
Inventory movement (2,055)
Actual purchase quantity (kgs) 152,945

Actual cost of purchase:

Standard rate (Rs. per kg) 30
Actual quantity purchased at standard rate (Rs.) 4,588,350
Price paid above / (below) the standard rate (6%) (275,301)
Actual cost of purchase 4,313,049

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b) Labor rate and efficiency variances, variable overhead rate and efficiency variances and
fixed overhead expenditure variance, would be calculated as follows:

Labor and overhead variances:

Labor rate variances: Skilled Unskilled
labor labor
Actual hours at standard rate
168,000×3/7 72,000
168,000×4/7 96,000
Standard rates per hour 150 100
Actual hours at standard rate 10,800,000 9,600,000
AT A GLANCE

Price variances
10% (A) (1,080,000)
5% (A) (480,000)
Labor efficiency variance:
50,000 units should use
@1.5 hours 75,000
@2 hours 100,000
50,000 units did use 72,000 96,000
Labor efficiency variance (hours) (F) 3,000 4,000
Standard rate per hour (Rs.) 150 100
SPOTLIGHT

Labor efficiency variance (Rs.) (F) 450,000 400,000

Variable overhead rate variances:

168,000 hours should cost Rs.
168,000  3/7  Rs.100 7,200,000
168,000  4/7  Rs.80 7,680,000
14,880,000
168,000 hours did cost 16,680,000
Variable overhead rate variance (A) 1,800,000
STIKCY NOTES

Variable overhead efficiency variance: Skilled Unskilled

50,000 units should use Hrs Hrs
@1.5 hours 75,000
@2 hours 100,000
50,000 units did use 72,000 96,000
Labor efficiency variance (hours) (as before) 3,000 4,000
Standard rate per hour (Rs.) 100 80
Variable overhead efficiency variance (Rs.) (F) 300,000 320,000
Total (Rs.) (F) 620,000
Fixed overhead expenditure variance Rs.
Budgeted fixed overhead 4,000,000
Variance (6%) 240,000

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 Example 11:
The following data relates to actual output, actual costs and variances for the four-weekly
accounting period number 4 of a company which makes only one product.
The value of work-in-progress at the end of period 4 was the same as the value of work-in-
progress at the beginning of the month.

Actual production of Product XY 18,000 units

Actual costs incurred: Rs.000
Direct materials purchased and used (150,000 kg) 210
Direct labor costs (32,000 hours) 136

AT A GLANCE
Variable production overhead 38

Variances: Rs.000
Direct materials price 15 Favourable
Direct materials usage 9 Adverse
Direct labor rate 8 Adverse
Direct labor efficiency 16 Favourable
Variable production overhead expenditure 6 Adverse
Variable production overhead efficiency 4 Favourable

SPOTLIGHT
Variable production overhead varies with labor hours worked.
A standard marginal costing system is operated.
A standard product cost sheet for one unit of Product XY, showing how the standard marginal
production cost of the product is made up is presented below:

Standard marginal production cost – Product XY Rs.

Direct materials (8 kilos at Rs.1.50 per kilo) 12.0
Direct labor (2 hours at Rs.4 per hour) 8.0

STIKCY NOTES
Variable production overhead (2 hours at Rs.1 per hour) 2.0
Standard marginal production cost 22.0

Tutorial note: This problem tests your understanding of the formulae for calculating variances.
Here, you are given the actual costs and the variances, and have to work back to calculate the
standard cost. The answer can be found by filling in the balancing figures for each variance
calculation.
Workings

Materials price variance Rs.

150,000 kilos of materials did cost 210,000
Material price variance 15,000 (F)
150,000 kilos of materials should cost 225,000

(The variance is favorable, so the materials did cost less to buy than they should have cost.)

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Therefore, the standard price for materials is Rs. 225,000/150,000 kilograms = Rs.1.50 per kilo.

Materials usage variance

Materials usage variance in Rs. = Rs.9,000 (A)
Standard price for materials = Rs.1.50
Materials usage variance in kilograms = 9,000/1.50 = 6,000 kilos (A)
kilos
18,000 units of the product did use 150,000
Material usage variance in kilos 6,000 (A)
18,000 units of the product should use 144,000
AT A GLANCE

Therefore, the standard material usage per unit of product = 144,000 kilos/18,000 units = 8 kilos
per unit.

Direct labor rate variance Rs.

32,000 hours of labor did cost 136,000
Direct labor rate variance 8,000 (A)
32,000 hours of labor should cost 128,000

Therefore, the standard direct labor rate per hour = Rs. 128,000/32,000 hours = Rs.4 per hour.
Direct labor efficiency variance
SPOTLIGHT

Labor efficiency variance in Rs. = Rs.16,000 (F)

Standard rate per hour = Rs.4
Labor efficiency variance in hours = 16,000/4 = 4,000 hours (F)

hours

18,000 units of the product did take 32,000

Labor efficiency variance in hours 4,000 (F)

18,000 units of the product should take 36,000

STIKCY NOTES

Therefore, the standard time per unit of product = 36,000 hours/18,000 units = 2 hours per unit.
This number of hours per unit also applies to variable production overheads.

Variable overhead expenditure variance Rs.

32,000 hours did cost 38,000

Variable overhead expenditure variance 6,000 (A)

32,000 hours should cost 32,000

Therefore, the variable production overhead rate per hour = Rs. 32,000/32,000 hours = Rs.1 per
hour.

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 Example 12:
MZ Limited (MZL) manufactures a single product X and uses standard marginal costing system.
The standard cost card of product X is as follows:

Rupees
Raw material (13 kg @ Rs. 135 per kg) 1,755
Labor (14 hours @ Rs. 100 per hour) 1,400
Variable production overheads (Rs. 75 per labor hour) 1,050

Following data is available in respect of operations for the month of February 2018:
i. 55,000 units were put into process. 1,500 units were lost in process which were
considered to be normal loss. Process losses occur at the end of the process.

AT A GLANCE
ii. 698,000 kg of material was purchased at Rs. 145 per kg. Material is added at the start of
the process and conversion costs are incurred evenly throughout the process.
iii. 755,000 labor hours were worked during the month. However, due to certain labor
related issues, wages were paid at Rs. 115 per hour.
iv. Fixed production overheads are budgeted at Rs. 40 million for the month of February
2018. Total actual production overheads amounted to Rs. 95 million.
v. Actual fixed production overheads exceeded budgeted fixed overheads by Rs. 1.1
million.
vi. Inventory balances were as under:

SPOTLIGHT
01 February 2018 28 February 2018
Raw material (kg) 15,000 17,000
Work in process (units) 5,000 (60% converted) 6,000 (80% converted)
Finished goods (units) 10,000 12,000

vii. MZL uses FIFO method for valuing the inventories.

Material, labor and overhead variances are computed as follows

Material, labor, overhead variances Rs. in '000

Cost variances under marginal costing

STIKCY NOTES
Material price variance Adv. (6,960.00)
[(135–145)×696,000]
Material usage variance Adv. (67.50)
{(53,500(W.3)×13)– 696,000(W.1)}×135
Labor rate variance Adv. (11,325.00)
(100–115)×755,000
Labor efficiency variance Fav. 520.00
{(14×54,300)(W.3)–755,000}×100
Variable overheads expenditure variance Fav. 2,725.00
(755,000×75)–Rs. 53,900,000(W.4)
Variable overheads efficiency variance Fav. 390.00
{(54,300(W.3)×14)–755,000}×75
Fixed overhead expenditure variance Adv. (1,100.00)
(40,000–41,100) (W.4))

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W-1:
Actual material usage (kg) (698,000+15,000–17,000) 696,000.00

W-2: Quantity schedule Units

WIP (opening) 5,000.00
Units started 55,000.00
Total units in production 60,000.00
Normal loss (1,500.00)
AT A GLANCE

WIP (End) (6,000.00)

Finished goods/Transferred out 52,500.00

Conversion
W-2: Quantity schedule Material
cost
---------- Units ----------
Finished goods/Transferred out (W-2) 52,500.00 52,500.00
Less: WIP (Opening) (5,000.00) (5,000.00)
Started and finished in this period 47,500.00 47,500.00
SPOTLIGHT

Add: WIP (Opening) (5,000×40%) 2,000.00

Add: WIP (Closing) (6,000×80%) 6,000.00 4,800.00
Equivalent production units 53,500.00 54,300.00
W-4: Actual variable and fixed overheads Rs. in '000
Budgeted fixed overheads Given 40,000.00
Actual fixed overheads exceeded applied overheads Given 1,100.00
Actual fixed overheads 41,100.00
Less: Total actual variable and fixed overheads Given 95,000.00
STIKCY NOTES

Actual variable overheads 53,900.00

 Example 13:
Jack and Jill (JJ) manufactures various products. The following information pertains to one of its
main products:
i. Standard cost card per unit

Rupees
Direct material (5 kg at Rs. 40 per kg) 200
Direct labor (1.5 hours at Rs. 80 per hour) 120
Factory overheads 130% of direct labor

ii. Fixed overheads are budgeted at Rs. 3 million based on normal capacity of 75,000 direct
labor hours per month.

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iii. Actual data for the month of June 2015

Units
Opening work in process (80% converted) 8,000
Started during the month 50,000
Transferred to finished goods 48,000
Closing work in process (60% converted) 7,000
Rupees
Material issued to production at: Rs. 38 per kg 1,900,000
Rs. 42 per kg 8,400,000

AT A GLANCE
Direct labor at Rs. 84 per hour 6,048,000
Variable factory overheads 6,350,000
Fixed factory overheads 2,850,000

iv. Materials are added at the beginning of the process. Conversion costs are incurred
evenly throughout the process. Losses up to 3% of the input are considered as normal.
However, losses are determined at the time of inspection which takes place when units
are 90% complete.
v. JJ uses FIFO method for inventory valuation.
a) Equivalent production units is calculated as follows

SPOTLIGHT
Equivalent production
Quantity units
Equivalent units using FIFO: schedule
(Units) Material Conversion
(Units) (Units)
Opening WIP (80% conversion) 8,000 (8,000) (6,400)
Units started during the month 50,000
58,000
Units transferred to finished goods 48,000 48,000 48,000

STIKCY NOTES
Closing WIP (60% conversion) 7,000 7,000 4,200
Normal loss 3% of input - -
(58,000-7,000)  3% 1,530

Abnormal loss (90% conversion) Bal. 1,470 1,470 1,323

58,000 48,470 47,123
A B (A×B)

b) Computation for the following variances for the month of June 2015 are given below
 Material rate and usage
 Labor rate and efficiency
 Variable factory overhead expenditure and efficiency
 Fixed factory overhead expenditure and volume

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Variances: kg/Hrs. (Standard- Fav./

/Rs. Actual) (adv.)
Rupees
Material price variance:
Actual material usage W.2 50,000 40 - 38 = Rs. 2.00 100,000
Actual material usage W.2 200,000 40 - 42 = (Rs. 2.00) (400,000)
(300,000)
Material usage variance:
Standard material rate per kg 40.00 242,350 - 250,000 (306,000)
= (7,650 kgs)
Labor rate variance:
AT A GLANCE

Actual labor hours W.2 72,000 80 - 84 = (Rs. 4.00) (288,000)

Labor efficiency variance:
Standard labor rate per hour 80.00 70,685 - 72,000 = (105,200)
(1,315 Hrs.)
Variable overhead expenditure variance:
Actual labor hours at standard rate 72,000 (W.1) 64.00 4,608,000
Actual variable overheads (6,350,000)
(1,742,000)
Variable overhead efficiency variance:
Standard variable overhead rate per W.1 64.00 70,685 - 72,000 = (84,160)
SPOTLIGHT

hour (1,315 Hrs.)

Fixed overhead expenditure variance:
Budgeted fixed production overhead 3,000,000
Actual fixed production overhead (2,850,000)
150,000
Fixed overhead volume variance:
Standard fixed overhead rate per W.1 40.00 70,685 - 75,000 = (172,600)
hour (4,315 Hrs.)
STIKCY NOTES

W.1: Statement of standard factory overhead rate per hour: Rs.

Standard factory overhead rate per hour (120130%)÷1.5 104.00
Standard fixed factory overhead rate per hour 3,000,000÷75,000 40.00
Standard variable factory overhead rate per hour 104-40 64.00

Standard usage of Actual usage of material

W.2:
material/labor /labor/overheads
Eq. Per Kg/ Amount Per kg/ Kg
units unit hrs. hrs. (Rs.) /hrs.
Material 48,470 5.0 kg 242,350 1,900,000 38.00 50,000
8,400,000 42.00 200,000
10,300,00 250,00
0 0
D. labor 47,123 1.5 hrs. 70,685 6,048,000 84.00 72,000
V. overheads 6,350,000 88.1944 72,000

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 Example 14:
Hexal Limited is a manufacturer of various machine parts. Following information has been
extracted from the cost records of one of its products AXE for the month of June 2014:
i. Standard cost per unit:

Rupees
Raw material 170.00
Direct labor (1.25 hours) 150.00
Overheads 137.50
ii. Based on normal capacity of 128,000 direct labor hours, fixed overheads are estimated
at Rs. 2,560,000.

AT A GLANCE
iii. Following information pertains to production of 100,000 units of product AXE:

Actual direct labor hours worked 130,000

Unfavorable material usage variance Rs. 820,000
Unfavorable material price variance Rs. 600,000
Actual direct labor cost Rs. 16,250,000
Actual fixed and variable overheads Rs. 15,500,000

For the month of June 2014, actual material cost and labor variances are computed as follows

Actual direct material cost Rupees

SPOTLIGHT
Standard material cost 100,000*170 17,000,000

Un-favorable material usage variance 820,000

Un-favorable material price variance 600,000

18,420,000

Favorable/
Direct labor variances
(Adverse)

1 Direct labor rate variance

STIKCY NOTES
(Standard rate per hour-Actual rate per hour)*Actual hours

[(150/1.25)-(16,250,000/130,000)]*130,000 (650,000)

2 Direct labor efficiency variance

(Standard hours-Actual hours)*Standard rate per hour

(100,000*1.25)-130,000)*120 (600,000)

W-1
Standard total overheads rate per labor hour 137.5/1.25 110.00
Standard fixed overhead rate per labor hour 2,560,000/128,000 20.00
Standard variable overhead rate per labor hour Rs. 90.00

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 Example 15:
Zamil Industries (ZI) produces and markets an industrial product Zeta. ZI uses standard
absorption costing system. The break-up of Zeta’s standard cost per unit is as under:

Rupees
Materials: Axe – 1 kg 160
Zee – 2 kg 210
Direct labor – 0.8 hours 200
Overheads – 0.8 hours 180

Production of Zeta for the month of August 2016 was budgeted at 15,000 units. Information
AT A GLANCE

pertaining to production of Zeta for August 2016 is as under:

i. Raw material inventory is valued at lower of cost and net realizable value. Cost is
determined under FIFO method. Stock cards of materials Axe and Zee are reproduced
below:

Axe Zee
Date Description Cost per Cost per
kg kg
kg (Rs.) kg (Rs.)
1-Aug Opening balance 9,000 150 4,000 120
8,000 122
3-Aug Purchase returns - - (2,000) 122
SPOTLIGHT

4-Aug Purchases 17,000 148 35,000 125

6-Aug Issues to production (16,000) - (29,000) -

ii. Actual direct wages for the month were Rs. 3,298,400 consisting of 11,780 direct labor
hours.
iii. Fixed overheads were estimated at Rs. 540,000 based on budgeted direct labor hours.
iv. The actual fixed overheads for the month were 583,000.
Actual sales of Zeta for the month of August 2016 was 12,000 units. Opening and closing finished
goods inventory of Zeta was 5,000 and 8,500 units respectively.
STIKCY NOTES

a) Following variances are calculated as follows:

i. Material price, mix and yield variances
ii. Labor rate and efficiency variances

Material price variance:

Actual material usage at actual price using FIFO
Axe Zee Net
adverse
Issues Actual Issues Actual variance
Rs. Rs.
(kg) rate (kg) rate Rs.
9,000 150 1,350,000 4,000 120 480,000
7,000 148 1,036,000 6,000 122 732,000
- - - 19,000 125 2,375,000
16,000 2,386,000 29,000 3,587,000

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Actual material usage at standard price:

16,000 160 2,560,000 29,000 (210÷2) 3,045,000
105
Fav./(Adverse) variance 174,000 (542,000) (368,000)
Material mix variance
Actual usage at Mix quantity
Actual mix Std. cost
std. variance Rs.
(kg) per (kg)
mix ratio (kg) (Adv.)/Fav.
Axe 16,000 15,000 (1,000) 160 (160,000)
Zee 29,000 30,000 1,000 105 105,000

AT A GLANCE
45,000 45,000
Material mix variance – adverse (55,000)
Material yield variance
Per unit Std. raw
Yield
material usage at Rs.
(no. of units)
Std. price
Standard yield (45,000÷3) 15,000 (160+210) 370 5,550,000
Actual yield (12,000+8,5005,000) 15,500 370 5,735,000
Yield variance – favorable 185,000
Labor variance Rs.

SPOTLIGHT
Labor rate variance
Actual hours at standard rate 11,780×(200÷0.8) 2,945,000
Actual hours at actual (3,298,400)
Labor rate variance – adverse (353,400)
Labor efficiency variance
Allowable hours at standard rate (15,500×0.8)×(200÷0.8) 3,100,000
Actual hours at standard rate 11,780×(200÷0.8) (2,945,000)
Labor efficiency variance – favorable 155,000

STIKCY NOTES
a) Computation of applied fixed overheads and analysis ‘under/over applied fixed factory
overheads’ into expenditure, efficiency and capacity variances are as follows:

Analyses of under/over applied fixed overheads Rs.

Standard fixed overhead rate per hour (540,000÷15,000×0.8) 45

Applied fixed overheads (15,500×0.8×45) 558,000

Actual fixed overheads (583,000)
Under applied overheads
(25,000)
Fixed overhead expenditure variance
Budgeted fixed overheads 540,000
Actual fixed overheads (583,000)
Fixed overhead expenditure variance – adverse (A) (43,000)

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Fixed overhead efficiency variance Rs.

Allowable hrs. for actual production at standard cost 15,500×0.8×45 558,000
Actual hours worked at standard rate 11,780×45 (530,100)
Fixed overhead efficiency variance – favorable (B) 27,900
Fixed overhead capacity variance
Actual hours worked at standard rate 11,780×45 530,100
BU hours at standard rate 12,000×45 (540,000)
Fixed overhead capacity variance – adverse (C) (9,900)
Under applied fixed overheads (A)+(B)+(C) (25,000)
AT A GLANCE

 Example 16:
Hexo Limited is using a standard absorption costing system to monitor its costs. The
management is considering to adopt a marginal costing system. In this respect, following
information has been extracted from the records for the month of December 2016:
i. Actual as well as budgeted sale was 10,500 units at Rs. 2,000 per unit.
ii. Standard cost per unit is as follows:

Rupees
Direct material 5 kg @ Rs. 158 790
SPOTLIGHT

Direct labor 3 hours @ Rs. 150 450

Production overheads (fixed & variable) Rs. 120 per labor hour 360
1,600

iii. Budgeted fixed overheads were Rs. 1,650,000.

iv. Production and actual costs were as under:

Units
Production: Budgeted 11,000
STIKCY NOTES

Actual 12,000

Actual variable costs: Rupees

Direct material (58,000 kg @ Rs. 160) 9,280,000
Direct labor (35,000 hours @ Rs. 155) 5,425,000
Variable overheads 2,975,000

v. Applied fixed overheads exceeded actual overheads by Rs. 200,000.

vi. There was no opening finished goods inventory. Closing finished goods inventory was
1,500 units.

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a) The profit for the month of December 2016, using standard marginal costing, would be
computed as follows:

Profit for the month of December 2016 - Standard marginal costing

Rupees
Sales 10,500×2,000 21,000,000
Production cost 12,000×(790+450+(W.1) 210) (17,400,000)
Closing stock 1,500×(790+450+(W.1) 210) 2,175,000
Variable cost of sales at standard rate (15,225,000)
Contribution margin 5,775,000
Budgeted fixed overheads (1,650,000)

AT A GLANCE
Profit at standard rate 4,125,000
W-1: Production overhead rate: Per unit Per hour
------------ Rupees ------------
Standard overhead rate (fixed & variable) 360 (360÷3) 120
Less: Standard fixed overhead rate (1,650,000÷11,000) 150 (150÷3) 50
Standard variable overhead rate per hour 210 70

b) Reconciliation for the profit computed above with actual profit under marginal costing,
by incorporating the related variances is given below:

Reconciliation of standard and actual profit under marginal costing: Rupees

SPOTLIGHT
Standard profit as above (A) 4,125,000
(Adverse)/favorable cost variances:
Direct material price (116,000)
(SR–AR)×AQ=(158–160)×58,000
Direct material usage 316,000
(Allowable Qty.–AQ)×SR=[(5×12,000)–58,000]×158
Direct labor rate (175,000)
(SR–AR)×AH= (150–155)×35,000

STIKCY NOTES
Direct labor efficiency 150,000
(Allowable Hrs. –AH)×SR= [(3×12,000)–35,000]×150
Variable overheads expenditure (525,000)
Actual cost – (SR×AH)=2,975,000-(70×35,000)
Variable overheads efficiency 70,000
(Allowable Hrs.–AH)×SR=(36,000–35,000)×70
Fixed overheads expenditure variance (BU overheads – Actual 50,000
overheads) [1,650,000–(12,000 ×150–200,000)]
Net adverse variance (B) (230,000)
Closing stock (Difference of standard and actual variable costs)
[(9,280,000+5,425,000+2,975,000)÷12,000×1,500]-[(1,600- 35,000
150)×1,500](C)
Actual profit under marginal costing A+B+C 3,930,000

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c) Reconciliation for the actual profit under marginal and absorption costing, is given
below:

Actual profit under absorption costing: Rupees

Actual profit under marginal costing – as above 3,930,000
Fixed cost carried forward to the next year with closing inventory 200,000
under absorption costing whereas under marginal costing fixed costs
are charged in the year of incurrence
(1,800,000-200,000)÷12,000)×1,500
Actual profit under absorption costing 4,130,000

 Example 17:
AT A GLANCE

Sigma Limited (SL) is a manufacturer of Product A. SL operates at a normal capacity of 90%

against its available annual capacity of 50,000 machine hours and uses absorption costing. The
following summarized profit statements were extracted from SL's budget for the year ending 31
December 2015.

Actual - 2014 Budget - 2015

Units Rs. In ‘000 Units Rs. In ‘000
Sales 4,125 49,500 4,600 56,580
Opening inventory 400 (3,400) 600 (5,400)
Cost of production 4,325 (38,925) 4,500 (44,325)
Closing inventory 600 5,400 500 4,925
SPOTLIGHT

Under absorbed production (100) -

overheads
Selling and administration cost (3,000) (5,250)
(30% fixed)
Net profit 9,475 6,530

Other relevant information is as under:

2014 Budget - 2015

Standard machine hours per unit 10 hours 10 hours
STIKCY NOTES

Standard production overhead rate per unit Rs. 2,000 Rs. 2,250
Estimated fixed production overheads at normal capacity Rs. 3,600,000 Rs. 4,050,000
Actual production overheads Rs. 8,750,000 -
(Actual machine hours 44,000)

a) Under/over absorbed production overheads can be understood as:

Production overhead rate is predetermined at beginning of the year based on budgeted
annual overheads and budgeted annual production. Overhead are applied to actual
hours/units using predetermined overhead rate. However, actual overheads and actual
production may differ from the budgeted overheads and production, therefore, it would
result in under/over absorption of production overheads.
b) Analysis for the under absorbed production overheads of SL for the year ended 31
December 2014, into spending and volume variances. Give two probable reasons for
each variance, would be as follows

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(i) Spending variance

Hours allowed for actual production of 4,325 units 4,325×10 43,250
Rs. in ‘000
Budgeted variable overheads for hours allowed 43,250×0.12*1 5,190
Standard fixed overheads 3,600
8,790
Actual overheads 8,750
Favorable spending variance A 40
(ii) Volume variance
Estimated fixed overheads at normal capacity 45,000×0.08*2 3,600

AT A GLANCE
Fixed overheads for hours allowed for actual 43,250×0.08*2 3,460
production
Adverse volume variance B (140)
Under absorbed production overheads (A+B) (100)
*1Variable cost per hour [(2,000÷10)–(3,600,000÷(50,000×90%)]=120
*2Fixed cost per hour [(2,000÷10) –120]=80
Reasons for favorable spending variance:
(i) Lesser spending/decrease in price of overhead items as compared to budget.
(ii) Over-estimating overhead expenditure while preparing the budget.

SPOTLIGHT
Reasons for adverse volume variance:
(i) Under-utilization of available capacity
(ii) In-efficient use of machine hours

c) A budgeted Profit and Loss Statement for the year ending 31 December 2015, using
marginal costing would be prepared as follows:

For the year ending 31 December 2015 Rs. in '000

Sales 56,580
Variable cost of sales:

STIKCY NOTES
Opening inventory 5,400-(600×0.8*3) (4,920)
Cost of production (44,325–4,050) (40,275)
Closing inventory 4,925-(500×0.9*4) 4,475
(40,720)
Gross contribution margin 15,860
Variable selling and administration cost 5,250×70% (3,675)
Net contribution margin 12,185
Fixed production overheads (4,050)
Fixed selling and distribution overheads 5,250×30% (1,575)
Net profit 6,560
*3 Fixed cost per unit – 2014 [3,600,000÷(50,000×90%÷10)=800
*4 Fixed cost per unit – 2015 [4,050,000÷(50,000×90%÷10)=900

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d) Analysis of the difference between budgeted profit determined under absorption and
marginal costing, for the year ending 31 December 2015, is given below.

Rs. in '000
Net profit under marginal costing 6,560
Under absorption costing:
 fixed overheads brought from the last year as (600×0.8) *3
included in the opening inventory (480)
 fixed overheads carried forward to the next year as (500×0.9) *4 450
included in the closing inventory
Net profit under absorption costing 6,530
AT A GLANCE

 Example 18:
Daisy Limited (DL) manufactures and markets product Zee. DL uses standard absorption costing.
Following information pertains to product Zee for the month of February 2019.
i. Data extracted from the budget for the month of February 2019:

Production Units 27,000

Cost of production: Rs. In ‘000
Direct material X:16,000 kg @ Rs. 400 per kg 6,400
SPOTLIGHT

Y:14,000 kg @ Rs. 300 per kg 4,200

Direct Labor 10,000 hours @ Rs. 220 per hour 2,200
Factory overheads (including fixed overheads of Rs. 900,000) 2,500
Rs. 250 per labor hour

ii. Actual input ratio of X and Y was 55:45 respectively.

iii. Direct materials are added at the beginning of the process. Actual process losses were
6% of the output. There is no change in the direct material prices during the month.
iv. DL increased wages by 12% as against the budgeted increase of 8% which improved
labor efficiency by 5%.
STIKCY NOTES

v. Due to higher than expected inflation, actual factory overhead rate was 6% higher than
the budgeted rate.
vi. Conversion costs were incurred evenly throughout the process.
vii. 27,400 units of Zee were transferred to finished goods. There was no opening or closing
work in process. Finished goods inventory at the beginning and closing of the month was
1,000 units and 1,500 units respectively.
Computation for the following variances is given below
 Material price, mix and yield variances
 Labor rate and efficiency variances
 Over/under applied overheads and analyze it into:
o variable overhead expenditure and efficiency variances
o fixed overhead expenditure and volume variances

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Variances for the month of February 2019 Units

Budgeted production A 27,000
Actual production B 27,400
Allowable production from actual input A÷D×E C 26,140
kg
Total budget input quantity X 16,000+Y 14,000 D 30,000
Total actual input quantity B×1.06 E 29,044
Rs.
Standard material cost per finished unit (6,400,000+4,200,000)÷A F 392.59
Hours

AT A GLANCE
Allowable hours for actual production 10,000÷A×B G 10,148
Actual hours G×0.95 H 9,641
Rs.
Standard Fixed overhead rate per hour 900,000÷10,000 J 90
Standard variable overhead rate per hour 250–90 K 160

Material mix variance

Description Actual input Actual input in Rate Fav/
in standard 55:45 ratio (kg) per kg (Adverse)
mix ratio (kg) (Rs.) variance
(Rs. in '000)

SPOTLIGHT
X 16,000÷D×E 15,490.13 E×0.55 15,974.20 400.00 (193.63)
Y 14,000÷D×E 13,553.87 E×0.45 13,069.80 300.00 145.22
Total E 29,044.00 E 29,044.00 (A) (48.41)
Material yield variance:
(Actual yield - Allowable yield from actual input)×Standard material cost per unit
[(B–C)×F] (F) 494.66
Material price variance:
No variance as there is no change in prices of material. -

STIKCY NOTES
Labor rate variance:
(Standard rate - Actual rate) × Actual hours (A) (78.56)
[220–(220÷1.08×1.12)]×H
Labor efficiency variance:
(Allowable hours - Actual hours) × Standard rate [G–H×220] (F) 111.54
Overheads over/(under) applied
Applied overheads G×250 2,537.00
Actual overheads:
- Variable overheads H×K×1.06 1,635.11
- Fixed overheads 900×1.06 954.00
2,589.11
Overheads under applied (A) (52.11)

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Analysis of under applied overheads:

(i) Variable overhead expenditure variance:
(Standard variable overheads rate – Actual variable overhead rate) × Actual hours
[K–(K×1.06)×H] (A) (92.55)
Variable overhead efficiency variance
(Allowable hours – Actual hours) × Standard variable overhead rate per hour
(G–H)×K (F) 81.12
(ii) Fixed overhead expenditure variance 900,000×6% (A) (54.00)
Fixed overhead volume variance:
(Allowable hours – Budgeted hours)×Standard fixed overhead rate
AT A GLANCE

per hour
(G–10,000)×J (F) 13.32

 Example 19:
Seema Enterprises (SE) produces various leather goods. It operates a standard marginal costing
system. For one of its products Bela, following information was extracted for the month of
December 2015 from SE's budget document for the year 2015.

Rs. In million
Sales 9,800 units 25.00
Cost of production of 10,000 units
SPOTLIGHT

Direct material 5,000 kg. 9.00

Direct Labor 24,000 hrs 3.60
Variable overheads 2,000 machine hrs 4.40
Fixed overheads 3.80
Actual production for the month of December 2015 was 12,000 units whereas SE earned revenue
of Rs. 30 million by selling 11,000 units of Bela. Following information pertains to actual cost of
production for the month:
i. 5,700 kg material was issued to production. Raw materials are valued using FIFO
method. Other details relating to the raw material used for Bela are as follows:
STIKCY NOTES

Kg Rs. In million
1-Dec-2015 Opening balance 3,000 5.70
10-Dec-2015 Purchases 15,000 26.25
ii. To minimize labor turnover, SE increased production wages by 10% above the standard
rate, effective 1 December 2015. This improved labor efficiency by 5% as compared to
budget.
iii. 2,100 machine hours were worked. Details of overheads are as under:
 Depreciation amounted to Rs. 1.6 million (same as budgeted)
 Factory building rent amounted to Rs. 1.20 million (same as budgeted)
 All other overheads were 4% in excess of the budget
iv. Variances are treated as period cost and charged to cost of sales.
v. There was no opening finished goods inventory of Bela. Actual closing inventory may be
valued at standard marginal production costs.

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a) Budgeted and actual profits of Bela for the month of December 2015 using marginal
costing is computed below:

Rs. in
million
Budgeted profit:
Sales (9,800 units) 25.00
Variable costs (9+3.6+4.4) (17.00)
Closing finished goods inventory at standard cost 0.34
17÷10,000×200
Contribution margin 8.34

AT A GLANCE
Fixed cost (3.80)
4.54

Actual profit:
Sales (11,000 units) 30.00
Variable costs (W-1) (19.74)
Closing finished goods inventory at standard cost 1.70
17×1,000÷10,000
Contribution margin 11.96
Fixed cost 1.6+1.2+(3.8-1.6-1.2)1.04 (3.84)

SPOTLIGHT
8.12
W-1: Actual variable cost
Material cost using FIFO 3,000 5.70
2,700 (2,70026.25÷15,000) 4.73
Kg 5,700 10.43
Labor cost; Actual labor hours (24,000÷10,00012,0000.95) 27,360
Actual hrs. at actual rate 27,360(3.6÷24,0001.1) 4.51
Variable overheads:
Actual machine hrs. at actual rate 2,100(4.4÷2,0001.04) 4.80

STIKCY NOTES
19.74

b) The budgeted profit with actual profit using relevant variances under marginal costing
would be reconciled as follows

Reconciliation of budgeted profit with actual profit Rs. in million

Budgeted profit (As computed in (a) above) 4.54
Favorable/(adverse) variances:
Sales volume (contribution margin) variance:
Actual sale quantity at standard contribution margin 9.36
8.34÷9,80011,000
BU sale quantity at standard contribution margin 8.34
1.02

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Sales price variance Rs. in million

Actual sale quantity at actual price 30.00
Actual sale quantity at standard price 25÷9,80011,000 28.06
1.94
Material price variance:
Actual usage at actual price (W-1) 10.43
Actual usage at standard price 5,700(9÷5,000) 10.26
(0.17)
Material usage variance
Actual usage at standard rate 10.26
AT A GLANCE

Allowable usage at standard rate 10.80

(5,000÷10,00012,000)(9÷5,000)
0.54
Labor rate variance
Actual hours at actual rate (W-1) 4.51
Actual hours at standard rate 27,360(W-1)(3.6÷24,000) 4.10
(0.41)
Labor efficiency variance
Actual hours at standard rate 4.10
SPOTLIGHT

Allowable hours at standard rate 4.32

24,000÷10,00012,000(3.6÷24,000)
0.22
Variable overhead expenditure variance
Actual machine hours at actual rate (W-1) 4.80
Actual machine hours at standard rate 4.62
2,100(W-1)(4.4÷2,000)
(0.18)
STIKCY NOTES

Variable overhead efficiency variance

Actual machine hours at standard rate 4.62
Allowable machine hours at standard rate 5.28
2,000÷10,00012,000(4.4÷2,000)
0.66
Fixed overhead expenditure variance
Actual fixed overheads (As computed in (a) above) 3.84
Standard fixed overheads 3.80
(0.04)
Fixed overhead volume variance
Under marginal costing, there is no fixed overhead volume variance -
as fixed costs are treated as period cost and not allocated to products.
Actual profit 8.12

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 Example 20:
Following information has been extracted from the records of Silver Industries Limited (SIL) for
the month of June 2017:

Production Direct labor Variable & fixed

units hours overheads (Rs.)
Available capacity 10,000 30,000 -
Budget 8,000 24,000 3,600,000
Actual 8,600 25,000 3,900,000

Fixed overheads were budgeted at Rs. 1,200,000. Applied fixed overheads exceeded actual fixed
overheads by Rs. 20,000.

AT A GLANCE
SIL uses standard absorption costing. Over/under applied factory overheads are charged to
profit and loss account.
i. Accounting entries to record the factory overheads would be prepared as follow:

Date Description Debit Credit

-------- Rupees --------
30-Jun- Work in process/Finished goods 3,870,000
17 [8,600×(24,000÷8,000)×150(W-1)
PL account (Under absorbed overheads) (Bal.) 30,000
Overhead control account 3,900,000

SPOTLIGHT
(Under-absorbed overheads charged to profit &
loss account)

ii. Analysis for under/over applied overheads into expenditure, efficiency and capacity
variances, would be as follows.

Rupees
Variable overhead expenditure variance
Actual hours at standard variable rate 25,000×100 2,500,000
Actual variable overheads (W-2) 2,630,000

STIKCY NOTES
Adverse variance A (130,000)
Variable overhead efficiency variance
Allowable hours at standard rate 8,600×3×100 2,580,000
Actual hours at standard variable rate 25,000×100 2,500,000
Favorable variance B 80,000
Fixed overhead expenditure variance
Budgeted fixed overheads 1,200,000
Actual fixed overheads (W.2) 1,270,000
Adverse variance C (70,000)
Fixed overhead efficiency variance
Allowable hours at standard rate 8,600×3×50 1,290,000
Actual hours at standard rate 25,000×50 1,250,000
Favorable variance D 40,000

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Fixed overhead capacity variance

Budgeted hours at standard rate 24,000×50 1,200,000
Actual hours at standard rate 25,000×50 1,250,000
Favorable variance E 50,000
(A+B+C+D+E) (30,000)
W-1: Standard fixed and variable overhead rate per hour Rupees
Standard fixed and variable overhead rate per hour 3,600,000÷24,000 150
Less: Standard fixed overhead rate per hour 1,200,000÷24,000 50
Standard variable overhead rate per hour 100
W-2: Actual fixed overheads
AT A GLANCE

Applied fixed overheads 8,600×(24,000÷8,000)×50 1,290,000

Applied overheads exceeded actual overheads (20,000)
Actual fixed overheads 1,270,000
Actual variable overheads (Balancing) 2,630,000
Total variable overheads 3,900,000

iii. Comments on the difference between overhead variances under marginal and
absorption costing are given below:

All variable and fixed overhead variances under marginal and absorption costing are
same, except for the fixed overhead volume (efficiency and capacity) variances which
SPOTLIGHT

can be calculated only under absorption costing.

In absorption costing, fixed overheads are allocated to the products and these are
included in the inventory valuations. Therefore, fixed overhead volume variances can be
computed under absorption costing only.
In marginal costing, only variable overheads are assigned to the product; fixed
overheads are regarded as period costs and written off as a lump sum to the profit and
loss account. Therefore, fixed overhead volume variances cannot be computed under
marginal costing.
STIKCY NOTES

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STICKY NOTES

A budget is a plan expressed in money. It is prepared and approved prior to

the budget period.

In a flexible budget the aim is to decide what total cost should be at different
levels of output and sales. Fixed cost normally remain fixed, only variable
costs and revenues vary with increase or decrease in the level of activity.

AT A GLANCE
A Variance is the difference between planned or standard cost and actual cost.
The process by which the total difference between standard and actual results
is analyzed is known as variance analysis.

The direct material total cost variance is the difference between what the
output actually cost and what it should have cost in terms of materials. It can
be further divided in to material Price and Usage Variance.

SPOTLIGHT
The direct labor total cost variance is the difference between what the output
actually cost and what it should have cost in terms of labor. It can be further
divided in to labor rate and efficiency Variance.

The variable production overhead total variance can be subdivided in to the

variable production overhead expenditure variance and the variable
production overhead efficiency variance.

STIKCY NOTES
The fixed production overhead total variance can be subdivided in to an
expenditure variance and a volume variance.

Mix variance can be divided in to price, mix and yield variances.

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 12

TARGET COSTING

AT A GLANCE
IN THIS CHAPTER
Target costing involves setting a target cost by subtracting a
desired profit margin from a Competitive Selling / market
AT A GLANCE
Price.

AT A GLANCE
SPOTLIGHT The target cost may be less than the planned initial product cost
but it is a target to be achieved by the time the product reaches
1. Target Costing the maturity stage of the product life cycle.
A cost gap is to be calculated by comparing current cost and the
2. Implementing & Determining
target cost. This cost gap is to be reduced over time by applying
Target Costing
effective cost reduction techniques, improving technologies
and processes.
3. Target costing and cost gap

4. Implications And Advantages

5. Comprehensive Examples

SPOTLIGHT
STICKY NOTES

STIKCY NOTES

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 CHAPTER 12: TARGET COSTING CAF 8: CMA

1. TARGET COSTING
1.1 Target Costing – Defined
Target costing involves setting a target cost by subtracting a desired profit margin from a competitive Selling/
market Price.

1.2 Target Costing – Explained

Target costing is used mainly for new product development. This is because whenever a new product is designed
and developed for a competitive market, a company needs to know what the maximum cost of the new product
must be so that it will sell at a profit.
A company might decide the price that it would like to charge for a new product under development, in order to
AT A GLANCE

win a target share of the market. The company then decides on the level of profitability that it wants to achieve
for the product, in order to make the required return on investment. Having identified a target price and a target
profit, the company then establishes a target cost for the product. This is the cost at which the product must be
manufactured and sold in order to achieve the target profits and return at the strategic market price.

1.3 Target cost - Defined

Target cost is an estimate of a product cost which is determined by subtracting a desired profit margin from a
competitive selling / market price. This target cost may be less than the planned initial product cost but it is
expected to be achieved by the time the product reaches the maturity stage of the product life cycle.

1.4 Cost gap - Defined

Cost gap is the difference between the expected cost and the target cost. it can be calculated as:
SPOTLIGHT

Cost gap = Expected cost – Target cost

1.5 Origins of target costing

Target costing originated in Japan in the 1970s. It began with the recognition that customers were demanding
more diversity in products that they bought, and the life cycles of products were getting shorter. This meant that
new products had to be designed more frequently to meet customer demands.
Companies then became aware that a large proportion of the costs of making a product are committed at the
design stage, before the product goes into manufacture. The design stage was therefore critical for ensuring that
new products could be manufactured at a cost that would enable the product to make a profit for the company.
STIKCY NOTES

It is not just a cost cutting exercise but rather holistically redesigning the entire production process to eliminate
unnecessary costs, without reducing the value created by the product.

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2. IMPLEMENTING & DETERMINING TARGET COSTING

2.1 Implementing target costing
Steps involved in the implementation of target costing process are as follows:
Step 1 Determine a product specification of which an adequate sales volume is estimated.
Step 2 Determine a selling price at which the organization will be able to achieve a desired market share.
Step 3 Estimate the required profit based on return on sales or return on investment.
Step 4 Calculate Target cost = Estimated selling price – target price
Step 5 Compile an estimated cost for the product on the anticipated design specification and current cost
levels.

AT A GLANCE
Step 6 Calculate target cost gap = estimated cost – target cost
Step 7 Make efforts to close the gap by applying effective cost reduction techniques, improving
technologies and processes.

2.2 Determining a Target cost

 Illustration:

New product design and development Rs.

Decide: The target sales price X
Deduct: The target profit margin (X)

SPOTLIGHT
Equals: The target cost (maximum cost in order to meet or exceed the X
target profit)

 Example 01:
A construction company wants to calculate a target cost for a new flat, the expected market
price is Rs. 5,000,000.
The company require a desired Profit Margin of 14%.
calculation of the target cost to achieve the desired Profit would be as follows:
Profit Required = Rs. 5,000,000 * 14% = 700,000/-

STIKCY NOTES
Target Cost = Rs. (5,000,000 – 700,000) = Rs. 4,300,000/-

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3. TARGET COSTING AND COST GAP

3.1 Target costing and the target cost gap
 Example 02:
A company has designed a new product. NP8. It currently estimates that in the current market,
the product could be sold for Rs.70 per unit. A gross profit margin of at least 30% on the selling
price would be required, to cover administration and marketing overheads and to make an
acceptable level of profit.
A cost estimation study has produced the following estimate of production cost for NP8.

Cost item
AT A GLANCE

Direct material M1 Rs.9 per unit

Direct material M2 Each unit of product NP8 will require three metres of material M2,
but there will be loss in production of 10% of the material used.
Material M2 costs Rs.1.80 per metre.

Direct labor Each unit of product NP8 will require 0.50 hours of direct labor time.
However it is expected that there will be unavoidable idle time equal
to 5% of the total labor time paid for. Labor is paid Rs.19 per hour.

Production It is expected that production overheads will be absorbed into product

overheads costs at the rate of Rs. 60 per direct labor hour, for each active hour
worked. (Overheads are not absorbed into the cost of idle time.)
SPOTLIGHT

a) The expected cost of Product NP8

Rs.
Direct material M1 9.0
Direct material M2: 3 meters  100/90  Rs.1.80 6.0
Direct labor: 0.5 hours  100/95  Rs.19 10.0
Production overheads: 0.5 hours  Rs.60 30.0
Expected full cost per unit 55.0
STIKCY NOTES

b) Target cost for NP8

Rs.
Sales price 70.0
Minimum gross profit margin (30%) 21.0
Target cost 49.0

c) The size of the cost gap

Rs.
Expected cost per unit (a above) 55.0
Target cost per unit (b above) (49.0)
6.0

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The company needs to identify ways of closing this cost gap.

3.2 Closing the target cost gap

Target costs are rarely achievable when the product is first manufactured, target cost may be much lower than
the current cost determined by current technology and processes.
Target costing should involve a multi-disciplinary approach to close the cost gap. The management accountant
should be involved in measuring estimated costs. Ways of reducing costs might be in product design and
engineering, manufacturing processes used, selling methods and raw materials purchasing. Ideas for reducing
costs can therefore come from the sales, manufacturing, engineering or purchasing departments.
Common methods of closing the target cost gap are:
 To re-design products to make use of common processes and components that are already used in the

AT A GLANCE
manufacture of other products by the company.
 To discuss with key supplier’s methods of reducing materials costs. Target costing involves the entire ‘value
chain’ from original suppliers of raw materials to the customer for the end-product, and negotiations and
collaborations with suppliers might be an appropriate method of finding important reductions in cost.
 To eliminate non-value added activities or non-value added features of the product design. Something is
‘non-value added’ if it fails to add anything of value for the customer. The cost of non-value added product
features or activities can therefore be saved without any loss of value for the customer. Value analysis may
be used to systematically examine all aspects of a product cost to provide the product at the required quality
at the lowest possible cost. This is the crux of target costing.
 Using standardized components will reduce the cost but it might impact the innovation element for the
product
 To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce

SPOTLIGHT
costs.
 To achieve economies of scale. Producing in larger quantities will reduce unit costs because fixed overhead
costs will be spread over a larger quantity of products. However, production in larger quantities is of no
benefit unless sales demand can be increased by the same amount.
 To achieve cost reductions as a result of the learning curve or the experience curve effect. The learning curve
effect is often observed in labor tasks of a complex nature. It results in cost savings as workers become more
familiar with performing a new and complex task and this can be modelled mathematically. The experience
curve effect relates to cost savings made in costs other than labor costs as the company becomes more
familiar with production of a new product. For example, management of the process and marketing may
become more efficient as the company gains experience of making and selling the product.

STIKCY NOTES
 Example 03:
Scriba Company (SC) is trying to launch a new product into a competitive market in North
America. Test marketing has revealed the following demand curve for the product:
P = 600 – 0.005Q
The estimated market for the product is 500,000 units per year. The company would like to
capture 10% of this market.
The company has established a cost card based on 50,000 units of sales each year:

Rs.
Direct materials 100
Direct labor 30
Fixed overhead 70
Total cost 200

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The company wishes to achieve a target profit of Rs. 10,000,000 for sales of this product per year.
a) What price will the company have to charge to capture its required market share and
what is the target unit cost to achieve its target profit?
Tutorial note: The company will need to sell 50,000 units to gain 10% of the market.
The first step is to calculate the price that the item has to be sold at to achieve this market
share. This can be calculated by using the demand curve:
P = 600 – 0.005Q
P = 600 – (0.005  50,000)
P = 600 – 250
P = Rs.350
AT A GLANCE

Since the company wishes to generate Rs.10,000,000 profit in total, this equates to a unit
profit of:
Rs.10,000,000 / 50,000 = Rs.200 per unit.
Once target price and target profit are available it is possible to calculate target cost:
Target price – target profit = target cost
Rs.350 – Rs.200 = Rs.150 per unit
b) What is the size of the target cost gap and how might Scriba Company seek to close this
gap?
The target cost gap is calculated as:
SPOTLIGHT

Rs.
Target unit cost 150
Current unit cost 200
Target cost gap 50

Currently actual cost is one third higher than it should be to reach the target profit.
The company can undertake various strategies to bring costs down to target:
Product redesign
This is the most effective way of reducing costs. Once the design of a product has been
finalized it is difficult to reduce significantly the majority of a product's cost. If PC has
STIKCY NOTES

not yet finalized the design and production of the product, it would be very worthwhile
them revisiting the design and production planning stages of the product lifecycle.
Outsourcing
PC could seek a deal with a third party manufacturer to make the product. Complete
outsourcing would not only remove the variable cost element of production but could
also lead to huge fixed cost savings. This is a course of action worth exploring by the
company. Suitable controls over any patents and quality would need to be in place,
together with guarantees of delivery times and the ability to be flexible with production
volumes.
Cost reduction
PC has to be careful with cost cutting. If applied badly the company could damage the
value of the product, leading to a fall in market price. Cost reduction, however, seeks
ways of lowering cost without reducing the value of the product. PC would seek to
preserve those features of the product key to its customer value whilst seeking to reduce
the cost of other areas. This, for instance, could involve cutting down on the quality of
packaging.

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4. IMPLICATIONS AND ADVANTAGES

4.1 Advantages of target costing
There are several possible advantages from the use of target costing.
 It helps to improve the understanding within a company of product costs.
 It recognizes that the most effective way of reducing costs is to plan and control costs from the product
design stage onwards.
 It helps to create a focus on the final customer for the product or service, because the concept of ‘value’ is
important: target costs should be achieved without loss of value for the customer.
 It is a multi-disciplinary approach, and considers the entire supply chain. It could therefore help to promote
co-operation, both between departments within a company and also between a company and its suppliers

AT A GLANCE
and customers.
 Target costing can be used together with recognized methods for reducing costs, such as value analysis, value
engineering, just in time purchasing and production, Total Quality Management and continuous
improvement i.e. Kaizen costing.
 Target costing recognizes that process improvement and cost cutting is not a top down process but rather
one where workers who actually work on the product could come up with valuable suggestions

4.2 The implications of using target costing

The use of a target costing system has implications for pricing, cost control and performance measurement.
Target costing can be used with pricing policy for a company’s products or services. A company might decide on
a target selling price for either a new or an existing product, which it considers necessary in order to win market

SPOTLIGHT
share or achieve a target volume of sales. Having identified the selling price that it wants for the product, the
company can then work out a target cost.
Cost control and performance measurement has a different emphasis when target costing is used.
 Cost savings are actively sought and made continuously over the life of the product
 There is joint responsibility for achieving benchmark savings. If one department fails to deliver the cost
savings expected, other departments may find ways to achieve the savings
 Staff are trained and empowered to find new ways to reduce costs while maintaining the required quality.
Target costing is more likely to succeed in a company where a culture of ‘continuous improvement’ exists.

STIKCY NOTES
4.3 Target costing and services
Target costing can be used for services as well as products. Services vary widely in nature, and it is impossible
to make general statements that apply to all types of services. However, features of some service industries that
make them different from manufacturing are as follows.
 Some service industries are labor-intensive, and direct materials costs are only a small part of total cost.
Opportunities for achieving reductions in materials costs may therefore be small.
 Overhead costs in many services are very high. Effective target costing will therefore require a focus on how
to reduce overhead costs.
A service company might deliver a number of different services through the same delivery system, using the
same employees and the same assets. Introducing new services or amendments to existing services therefore
means adding to the work burden of employees and the diversity or complexity of the work they do.
 A system of target costing therefore needs to focus on quality of service and value for the customer.
Introducing a new service might involve a loss of value in the delivery of existing services to customers. For
example, adding a new service to a telephone call center could result in longer waiting times for callers.

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 New services might be introduced without proper consideration being given to whether the service is
actually profitable. For example, a restaurant might add additional items to its menu, in the belief that the
only additional cost is the cost of the food. In practice there would be implications for the purchasing and
preparation of the food and possibly also for the delivery of food from the kitchen to the restaurant dining
area. New items added to the menu might therefore make losses unless all aspects of cost are properly
considered.
 When a single delivery system is used for services, the cost of services will consist largely of allocated and
apportioned overheads. For target costing to be successful, there must be a consistent and ‘fair’ method of
attributing overhead costs to services (both existing services and new services).
 Services might be provided by not-for-profit entities. For example, health services might be provided free of
charge by the government. When services are provided free of charge, target costing can be used for new
services. However, it is doubtful whether concepts of ‘target price’ and ‘target profit’ can be used by a not-
for-profit entity. This raises questions about how to decide what the target cost should be and will probably
AT A GLANCE

be some arbitrary figure.

 Example 04:
A company wishes to introduce a new product to the market.
The company estimates the market for the product to be 50,000 units.
The company uses target costing.
Current projected costs are as follows:

Rs. ‘000
Manufacturing cost
SPOTLIGHT

Bought in parts (100 components) 50,000

Direct labor (assembly of components) 5,000
10 hours  Rs. 500 per hour
Machine costs (750,000,000 ÷ 50,000) 15,000
Ordering and receiving 500
(500 orders  100 components Rs. 500 per order) ÷ 50,000 units
Quality assurance (10 hours  Rs. 800 per hour) 8,000
Rework costs 1,000
10% (probability of failure)  Rs. 10,000 (cost of rework)
STIKCY NOTES

Non-manufacturing costs
Distribution 10,000
Warranty costs 1,500
10% (probability of recall)  Rs. 15,000 (cost to correct)
91,000
Target selling price (Rs.) 100,000
Target margin 20%
Target profit (Rs.) 20,000
Target cost (Rs.) 80,000

The company has undertaken market research which found that several proposed features of the
new product were not valued by customers. Redesign to remove the features leads to a reduction
in the number of components down to 80 components and a direct material cost reduction of
12%.

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The reduction in complexity has other impacts:

Assembly time will be reduced by 20%.
Quality assurance will only require 6 hours.
The probability of a failure at the inspection stage will fall to 5%.
The probability of an after-sales failure will also fall to 5%.
Cost of warranty corrections will fall by Rs. 2,000.
Reduced weight of the product will reduce shipping costs by Rs. 1,000 per unit.
The revised projected costs are as follows:

Before After

AT A GLANCE
Rs. ‘000 Rs. ‘000
Manufacturing cost
Bought in parts (100 components) 50,000
Bought in parts (80 components with 12% reduction) 44,000
Direct labor (assembly of components)
10 hours  Rs. 500 per hour 5,000
8 hours (20% reduction)  Rs. 500 per hour 4,000
Machine costs (750,000,000 ÷ 50,000) 15,000 15,000
Ordering and receiving

SPOTLIGHT
500 orders  100 components  Rs. 500 per order/50,000 units 500
500 orders  80 components  Rs. 500 per order/50,000 units 400
Quality assurance
10 hours  Rs. 800 per hour 8,000
6 hours  Rs. 800 per hour 4,800
Rework costs
10%  Rs. 10,000 1,000
5%  Rs. 10,000 500

STIKCY NOTES
Non-manufacturing costs
Distribution 10,000 9,000
Warranty costs
10%  Rs. 15,000 1,500
5%  Rs. 13,000 650
91,000 78,350
The target cost is achieved.

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5. COMPREHENSIVE EXAMPLES
 Example 01
Pollar Co assembles and sells a range of components for motor vehicles and it is considering a
proposal to add a new component to its product range. This is a component for electric motor
cars, which has been given the code number NP19. The company sees an opportunity to gain
market share in a market that is expected to grow considerably over time, but already
competition from rival producers is strong.
Component NP19 would be produced by assembling a number of parts bought in from external
suppliers, and would then be sold on to manufacturers of electric cars. Pollar Co would use its
current work force of assembly workers to make the component. Production overheads are
currently absorbed into production costs on an assembly hour basis.
AT A GLANCE

Pollar Co is considering the use of target costing for the new component.
a) Brief description for how target costing might be used in the development and
production of a new product, is as follows
When a company identifies a product that it wishes to make and sell, it must design the
product in a way that will appeal to customers. A product design and specification must
be prepared, based on a combination of technical considerations and market research.
The component will also consider the price at which the product will be sold. The price
that can be obtained will often depend on the price of similar rival products in the
market, or on market research into customer attitudes to price. This may be called the
target price.
SPOTLIGHT

The company should decide on the profit margin it would like to make from the product.
The desired margin is subtracted from the target price to obtain a target cost.
A cost estimate is then produced for the product if it is made to the planned design and
specification and this cost estimate is compared with the target cost. If the cost estimate
is higher than the target cost, the difference is called a cost gap.
When a cost gap exists, the company should re-consider the planned product design and
look for ways of reducing the estimated cost to the level of the target cost – in other
words, the aim should be to eliminate the cost gap before actual production of the new
product item begins.
b) The benefits of adopting a target costing approach at an early stage in the development
of a new product would be
STIKCY NOTES

Target costing should begin at an early stage in the product design and development
process because the opportunity for reducing production costs is greatest at the design
stage. If there is a cost gap, the product design can be amended. Because the measures
to reduce costs are made at an early stage, it is easier to find ways of reducing costs that
do not take away significant value for the customer. (If costs are reduced in a way that
reduces value for the customer, the target sales price will probably not be achievable.)
If target costing is introduced at a later stage in the product development, for example
after the material components, product design features and production methods have
been finally agreed, there are fewer opportunities for cost reduction.
Early adoption of target costing also helps to create a general awareness of the need for
cost control, and it increases the probability that new products will be developed at a
cost that allows the company to sell them at a competitive price whilst making an
acceptable level of profit. It can therefore be argued that target costing improves the
probability of commercial success (profitability) for new products.

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c) If a target costing approach is used and a cost gap is identified for component NP19,
possible measures that Pollar Co might take to reduce the gap are suggested below
If a cost gap is identified early in the product design process, the team responsible for
the product development (which should include marketing staff as well as production
and R&D staff) should consider every aspect of the product design and planned
production method to consider ways of reducing the costs.
The aim should be to make changes in a way that does not remove significant value for
the customer. For example some aspects of the product, such as the materials or parts
used, could be changed and parts that are less expensive used instead. Some features of
the product design might be removed without loss of significant value.
As an alternative (or in addition to) looking for cheaper or fewer parts to the product,
cost savings might be achieved by identifying suppliers who are willing to provide parts

AT A GLANCE
at a lower cost. Prices from suppliers might be re-negotiated, such as the fixed costs of
buying part 1922 in batches.
It might be possible to change the production process in some ways to reduce the
assembly time required per unit, or different assembly workers might be hired at a lower
rate of pay per hour.
Finding ways of reducing overhead costs can be difficult because indirect costs cannot
be identified directly with specific products. However, if Pollar Co uses target costing for
new products, it would be surprising if it did not also employ methods of looking for
savings in overhead costs (such as total quality management and continuous
improvement).
Now if Cost information for the new component NP19 is as follows:

SPOTLIGHT
1. Part 1922: Each unit of component NP19 requires one unit of part 1922. These bought-
in parts are purchased in batches of 5,000 units, and the purchase cost is Rs.5.30 each
plus delivery costs of Rs.2,750 per batch.
2. Part 1940: Each unit of component NP19 requires 20 cm of part 1940, which costs
Rs.2.40 per meter to purchase. However, it is expected that there will be some waste due
to cutting and that 5% of the purchased part will be lost in the assembly process.
3. Other parts for component NP19 will also be bought in and will cost Rs.7.20 per unit of
the component.
4. Assembly labor. It is estimated that each unit of component NP19 will take 25 minutes

STIKCY NOTES
to assemble. Assembly labor, which is not in short supply, is paid Rs.24 per hour. It is
also estimated that 10% of paid labor time will be idle time.
5. Production overheads. Analysis of recent historical costs for production overheads
shows the following costs:
Total production Total assembly labor hours
overhead worked
Rs.
Month 1 912,000 18,000
Month 2 948,000 22,000
Fixed production overheads are absorbed at a rate per assembly hour based on normal
activity levels. In a normal year, Pollar Co works 250,000 assembly hours.
Pollar Co estimates that it needs to sell component NP19 at a price of no more than Rs.56
per unit to be competitive, and it is considered that an acceptable gross profit margin on
components sold by the company is 25%. Gross margin is defined as the sales price
minus the full production cost of sales.

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d) The expected cost per unit of component NP19 and any cost gap that exists, would be
calculated as follows.
Workings: production overhead costs
Production overhead costs can be estimated using the high-low method.

Production overheads hours Rs.

Month 1: Total cost 18,000 912,000
Month 2: Total cost 22,000 948,000
Therefore variable cost 4,000 36,000
Variable production overhead cost per hour = Rs. 36,000/4,000 = Rs.9
AT A GLANCE

Production overheads Rs.

Month 1: Total cost of 18,000 hours 912,000
Variable cost (18,000  Rs.9) 162,000
Therefore fixed costs per month 750,000
Annual fixed production overhead costs = Rs.750,000  12 = Rs.9,000,000.
Fixed production overhead absorption rate = Rs. 9,000,000 / 250,000 = Rs.36

Cost estimate and cost gap estimate

Cost per unit of NP19 Rs.
Part 1922: Rs.5.30 + (Rs.2,750/5,000) 5.850
SPOTLIGHT

Part 1940: 0.20  Rs.2.40  100/95 0.505

Other parts 7.200
Assembly labor cost: 25/60  Rs.24  100/90 11.111
Variable overheads: 25/60  Rs.9 3.750
Fixed overheads: 25/60  Rs.36 15.000
Total estimated production cost 43.416
Target cost (75% of Rs.56) 42.000
Cost gap (1.416)
STIKCY NOTES

 Example 02:
Hi-tech Limited (HL) assembles and sells various components of heavy construction equipment.
HL is working on a proposal of assembling a new component EXV-99. Based on study of the
product and market survey, the following information has been worked out:
Projected lifetime sale of the component EXV-99 Units 500,000
Selling price per unit Rs. 11,000
Target gross profit percentage 40%
Information about cost of production of the new component is as follows:
i. One unit of EXV-99 would require:
Parts no. Net quantity Cost per unit/kg (Rs.)
XX 1 unit 2,350
YY 1.5 kg 1,400
ZZ 1 unit 1,200

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The above parts would be imported in a lot, for production of 1,000 units of EXV-99.
Custom duty and other import charges would be 15% of cost price. HL is negotiating
with the vendor who has agreed to offer further discount.
ii. On average, assembling of one unit of EXV-99 would require 1.8 skilled labor hours at
Rs. 200 per hour. The production would be carried out in a single shift of 8 hours. At the
start of each shift, set-up of machines would require 30 minutes. 6% of the input quantity
of YY and ZZ would be lost during assembly process.
iii. HL works at a normal annual capacity of 4,000,000 skilled hours. Actual production
overheads and skilled labor hours for the last two quarters are as under:

Quarter ended Total assembly hours Production overheads (Rs)

30-Sep-2014 950,000 65,600,000

AT A GLANCE
31-Dec-2014 1,050,000 68,000,000

iv. A special machine that would be used exclusively for the production of EXV-99 would
be purchased at a cost of Rs. 1,500,000.
From the above information, determination of the discount that HL should obtain in order to
achieve the target gross profit, would involve following:

Discount required from vendors to achieve target gross profit from Rs. in million
sale of EXV-99
Total cost estimated W.1 3,624.27
Target cost [11,000×60%×500,000] 3,300.00

SPOTLIGHT
Cost gap 324.27
Discount amount to be obtained from the vendor [324.27÷1.15] 281.97
Required discount % [(281.97÷2,931(W.1)×100 9.62%

W.1: Cost estimate for 500,000 units of EXV-99:

Material XX (2,350×500,000) 1,175.00
Material YY (incl. process loss at 6%)(1.5÷0.94×1,400×500,000) 1,120.00
Material ZZ (incl. process loss at 6%)(1.0÷0.94×1,200×500,000) 636.00

STIKCY NOTES
2,931.00
Custom duty and other import charges [2,931×15%] 439.65

Direct labor:
Labor cost (1.8×200×500,000) 180.00
Labor set up cost (1.8÷7.5×0.5×200×500,000) 12.00
Production overheads:
Variable [1.80×24.00(W.2)×500,000] 21.60
Fixed [1.80×42.80(W.3)×500,000] 38.52
Fixed – cost of machine 1.50
Total cost 3,624.27

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W.2: Variable overhead rate per hour: Hours Rupees

Quarter ended 31 December 2014 1,050,000 68,000,000
Quarter ended 30 September 2014 (950,000) (65,600,000)
100,000 2,400,000
Variable overhead rate per hour (using high-low method)
(2,400,000÷100,000 24.00

W.3: Fixed overhead rate per hour:

Cost for the quarter ended 30 September 2014 65,600,000
Less: Variable cost [950,000×24(W.3)] (22,800,000)
AT A GLANCE

Fixed overheads per quarter 42,800,000

Fixed overheads per annum [42,800,000×4] 171,200,000
Fixed overhead rate per hour at normal capacity of 4,000,000 hrs.
[171,200,000÷4,000,000] 42.80
SPOTLIGHT
STIKCY NOTES

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STICKY NOTES

Target costing involves setting a target cost by subtracting a desired profit

margin from a Competitive Selling / market Price.

Target cost = Market Price – Desired Profit Margin

Cost gap = Expected Cost – Target cost

AT A GLANCE
Cost gap can be bridged by effective cost reduction techniques, better
technology and Improved Processes

Advantages of target costing are proactive approach towards cost reduction,

achievement of desired profit and Quality product in accordance with
customer requirements

SPOTLIGHT
STIKCY NOTES

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 13

RELEVANT COSTS

AT A GLANCE
IN THIS CHAPTER Relevant costs are costs that will occur in the future. They
include costs that have not been already occurred in the past.
AT A GLANCE For decision making purposes only, relevant costs matters.

AT A GLANCE
SPOTLIGHT Identifying relevant costs would involve cost of materials, labor
and overheads. In this respect, Relevant costs of materials are
the additional cash flows that will be incurred (or benefits that
1. The Concept of Relevant Costing
will be lost) by using the materials for the purpose that is under
consideration.
2. Identifying Relevant Costs
Relevant cost of labor would involve some considerations. If
3. Comprehensive Examples labor is not in restricted supply, the relevant cost of the labor is
its variable cost. However, if labor is a fixed cost and there is
STICKY NOTES spare labor time available.
Only variable overhead costs are considered relevant for
decision making. This is because it is an estimate of cash

SPOTLIGHT
spending per hour for each additional hour. Although, fixed
overhead absorption rates are irrelevant, the only overhead
fixed costs that are relevant costs for a decision are extra cash
spending that will be incurred, or cash spending that will be
saved, as a direct consequence of making the decision.

STIKCY NOTES

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1. THE CONCEPT OF RELEVANT COSTING

1.1 Information for decision-making
Management make decisions about the future. When they make decisions for economic or financial reasons, the
objective is usually to increase profitability or the value of the business, or to reduce costs and improve
productivity.
When managers make a decision, they make a choice between different possible courses of action (options), and
they need relevant and reliable information about the probable financial consequences of the different options
available. A function of management accounting is to provide information to help managers to make decisions,
by providing estimates of the consequences of selecting any option.
AT A GLANCE

Traditionally, cost and management accounting information was derived from historical costs (a measurement
of actual costs). For example, historical costs are used to assess the profitability of products, and control
reporting typically involves a comparison of actual historical costs with a budget or standard costs.
Accounting information for decision-making is different, because decisions affect the future, not what has already
happened in the past. Accounting information for decision-making should therefore be based on estimates of
future costs and revenues.

 Decisions affect the future, but cannot change what has already happened. Decision-making should therefore
look at the future consequences of a decision, and should not be influenced by historical events and historical
costs.
 Decisions should consider what can be changed in the future. They should not be influenced by what will
SPOTLIGHT

happen in the future that is unavoidable, possibly due to commitments that have been made in the past.
 Economic or financial decisions should be based on future cash flows, not future accounting measurements
of costs or profits. Accounting conventions, such as the accruals concept of accounting and the depreciation
of non-current assets, do not reflect economic reality while the cash flows, on the other hand, do reflect the
economic reality of decisions. Managers should therefore consider the effect that their decisions will have
on future cash flows, not reported accounting profits.
Relevant costs should be used for assessing the economic or financial consequences of any decision by
management. Only relevant costs and benefits should be taken into consideration when evaluating the financial
consequences of a decision.
STIKCY NOTES

As a relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision, it
is used for target profit analysis as well.

1.2 Concepts and terms used in relevant costing

The key concepts in this definition of relevant costs are as follows:

 Relevant costs are costs that will occur in the future. They cannot include any costs that have already
occurred in the past.
 Relevant costs of a decision are costs that will occur as a direct consequence of making the decision. Costs
that will occur anyway, no matter what decision is taken, cannot be relevant to the decision.
 Relevant costs are cash flows. Notional costs, such as depreciation charges, notional interest costs and
absorbed fixed costs, cannot be relevant to a decision.
Several terms are used in relevant costing, to indicate how certain costs might be relevant or not relevant to a
decision.

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Incremental cost
An incremental cost is an additional cost that will occur if a particular decision is taken. Provided that this
additional cost is a cash flow, an incremental cost is a relevant cost.
 Example 01:
A company has identified that each cost unit it produces has the following costs:
Rs. in ‘000
Direct materials 50
Direct labor 20
70

AT A GLANCE
Fixed production overhead 30
Total absorption cost 100

The incremental cost of making one extra unit is Rs. 70,000. Making one extra unit would not affect the fixed cost
base.

Differential cost
A differential cost is the amount by which future costs will be different, depending on which course of action is
taken. A differential cost is therefore an amount by which future costs will be higher or lower, if a particular
course of action is chosen. Provided that this additional cost is a cash flow, a differential cost is a relevant cost.
 Example 02:
A company needs to hire a photocopier for the next six months. It has to decide whether to

SPOTLIGHT
continue using a particular type of photocopier, which it currently rents for Rs.2,000 each month,
or whether to switch to using a larger photocopier that will cost Rs.3,600 each month. If it hires
the larger photocopier, it will be able to terminate the rental agreement for the current copier
immediately.
The decision is whether to continue with using the current photocopier, or to switch to the larger
copier. One way of analyzing the comparative costs is to say that the larger copier will be more
expensive to rent, by Rs.1,600 each month for six months. The differential cost of hiring the larger
copier for six months would therefore be Rs.9,600.

Avoidable and unavoidable costs

STIKCY NOTES
An avoidable cost is a cost that could be saved (avoided), depending whether or not a particular decision is taken.
An unavoidable cost is a cost that will be incurred anyway.
Avoidable costs are relevant costs.
Unavoidable costs are not relevant to a decision.
 Example 03:
A company has one year remaining on a short-term lease agreement on a warehouse. The rental
cost is Rs.100,000 per year. The warehouse facilities are no longer required, because operations
have been moved to another warehouse that has spare capacity.
If a decision is taken to close down the warehouse, the company would be committed to paying
the rental cost up to the end of the term of the lease. However, it would save local taxes of
Rs.16,000 for the year, and it would no longer need to hire the services of a security company to
look after the empty building, which currently costs Rs.40,000 each year.
The decision about whether to close down the unwanted warehouse should be based on relevant
costs only.

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Local taxes and the costs of the security services (Rs.56,000 in total for the next year) could be
avoided and so these are relevant costs.
The rental cost of the warehouse cannot be avoided, and so should be ignored in the economic
assessment of the decision whether to close the warehouse or keep it open for another year.

Committed cost
Committed costs are a category of unavoidable costs. A committed cost is a cost that a company has already
committed to or an obligation already made, that it cannot avoid by any means.
Committed costs are not relevant costs for decision making.
 Example 04:
A company bought a machine one year ago and entered into a maintenance contract for Rs.
AT A GLANCE

20,000 for three years.

The machine is being used to make an item for sale. Sales of this item are disappointing and are
only generating Rs, 15,000 per annum and will remain at this level for two years.
The company believes that it could sell the machine for Rs. 25,000.
The relevant costs in this decision are the selling price of the machine and the revenue from sales
of the item.
If the company sold the machine it would receive Rs. 25,000 but lose Rs. 30,000 revenue over the
next two years – an overall loss of Rs. 5,000
The maintenance contract is irrelevant as the company has to pay Rs. 20,000 per annum whether
it keeps the machine or sells it.
SPOTLIGHT

Leases normally represent a committed cost for the full term of the lease, since it is extremely
difficult to terminate a lease agreement.

Sunk costs
Sunk costs are costs that have already been incurred (historical costs) or costs that have already been committed
by an earlier decision. Sunk costs must be ignored for the purpose of evaluating a decision, and cannot be relevant
costs.
 Example 05:
A company must decide whether to launch a new product on to the market.
It has spent Rs.900,000 on developing the new product, and a further Rs.80,000 on market
STIKCY NOTES

research.
A financial evaluation for a decision whether or not to launch the new product should ignore the
development costs and the market research costs, because the Rs.980,000 has already been spent
and would not be recovered regardless to go ahead with the launch or not. The costs are sunk
costs.

1.3 Opportunity costs

Relevant costs can also be measured as an opportunity cost. An opportunity cost is a benefit that will be lost by
taking one course of action instead of the next-most profitable course of action.
 Example 06:
A company has been asked by a customer to carry out a special job. The work would require 20
hours of skilled labor time. There is a limited availability of skilled labor, and if the special job is
carried out for the customer, skilled employees would have to be moved from doing other work
that earns a contribution of Rs.60 per labor hour.

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A relevant cost of doing the job for the customer is the contribution that would be lost by
switching employees from other work. This contribution forgone (20 hours × Rs.60 = Rs.1,200)
would be an opportunity cost. This cost should be taken into consideration as a cost that would
be incurred as a direct consequence of a decision to do the special job for the customer. In other
words, the opportunity cost is a relevant cost in deciding how to respond to the customer’s
request.
 Example 07:
Fazal Industries Limited is currently negotiating a contract to supply its products to K-Mart, a
large chain of departmental stores. K-Mart finally offered to sign a one year contract at a lump
sum price of Rs. 19,000,000.
The Cost Accountant of Fazal Industries Limited believes that the offered price is too low.
However, the management has asked you to re-assess the situation. The cost accountant has

AT A GLANCE
provided you the following information:
Statement of Estimated Costs (Project: K-Mart)

Notes Rupees

Material:

X (at historical cost) (i) 1,500,000

Y (at historical cost) (ii) 1,350,000

Z (iii) 2,250,000

SPOTLIGHT
Labor:

Skilled (iv) 4,050,000

Supervisory (v) 2,250,000

Overheads (vii) 8,500,000

Total cost 20,710,000

You have analyzed the situation and gathered the following information:

STIKCY NOTES
i. Material X is available in stock. It has not been used for a long time because a substitute
is currently available at 20% less than the cost of X.
ii. Material Y was ordered for another contract but is no longer required. Its net realizable
value is Rs. 1,470,000.
iii. Material Z is not in stock.
iv. Skilled labor can work on other contracts which are presently operated by semi- skilled
labor who have been hired on temporary basis at a cost of Rs. 325,000 per month. The
company will need to give them a notice of 30 days before terminating their services.
v. Unskilled labor will have to be hired for this contract.
vi. Two new supervisors will be hired for this contract at Rs. 15,000 per month. The present
supervisors will remain employed whether the contract is accepted or not.
vii. These include fixed overheads absorbed at the rate of 100% of skilled labor. Fixed
production overheads of Rs. 875,000 which would only be incurred if the contract is
accepted, have been included for determining the above fixed overhead absorption rate.

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Preparation of a revised statement of estimated costs using the opportunity cost approach, for
the management of Fazal Industries to state whether the contract should be accepted or not
would involve following analysis
Revised Statement of Estimated Costs
Under the Opportunity Cost Approach

Rupees
Materials
X (1,500,000 x 80%) 1,200,000
Y (NRV) 1,470,000
AT A GLANCE

Z (Purchase price) 2,250,000

Labor
Skilled 4,050,000
Unskilled 2,250,000
Supervisory (Rs. 15,000 x 2 x 12) 360,000*

Overheads
SPOTLIGHT

Avoidable fixed overhead 875,000

Variable overheads (Rs. 8,500,000 – Rs. 4,050,000) 4,450,000

16,905,000

Conclusion:
The company should accept the order as it will give them incremental cash flows of Rs. 2,095,000
(Rs.19,000,000-Rs.16,905,000).
STIKCY NOTES

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2. IDENTIFYING RELEVANT COSTS

There are certain rules or guidelines that might help you to identify the relevant costs for evaluating any
management decision.

2.1 Relevant cost of materials

The relevant costs of a decision to do some work or make a product will usually include costs of materials.
Relevant costs of materials are the additional cash flows that will be incurred (or benefits that will be lost) by
using the materials for the purpose that is under consideration.
If none of the required materials are currently held as inventory, the relevant cost of the materials is simply
their purchase cost. In other words, the relevant cost is the cash that will have to be paid to acquire and use the
materials.

AT A GLANCE
If the required materials are currently held as inventory, the relevant costs are identified by applying the
following rules:

SPOTLIGHT
Note that the historical cost of materials held in inventory cannot be the relevant cost of the materials, because
their historical cost is a sunk cost.
The relevant costs of materials can be described as their ‘deprival value’. The deprival value of materials is the

STIKCY NOTES
benefit or value that would be lost if the company were deprived of the materials currently held in inventory.
 If the materials are regularly used, their deprival value is the cost of having to buy more units of the materials
to replace them (their replacement cost).
 If the materials are not in regular use, their deprival value is either the net benefit that would be lost because
they cannot be disposed of (their net disposal or scrap value) or the benefits obtainable from any alternative
use. In an examination question, materials in inventory might not be in regular use, but could be used as a
substitute material in some other work. Their deprival value might therefore be the purchase cost of another
material that could be avoided by using the materials held in inventory as a substitute.
 Example 08:
A company has been asked to quote a price for a one-off contract.
The contract would require 5,000 kilograms of material X. Material X is used regularly by the
company. The company has 4,000 kilograms of material X currently in inventory, which cost Rs.4
per kilogram. The price for material X has since risen to Rs.4.20 per kilogram.

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The contract would also require 2,000 kilograms of material Y. There are 1,500 kilograms of
material Y in inventory, but because of a decision taken several weeks ago, material Y is no longer
in regular use by the company. The 1,500 kilograms originally cost Rs.14,400, and have a scrap
value of Rs.3,600. New purchases of material Y would cost Rs.10 per kilogram.
For the relevant costs of the materials to assist management in identifying the minimum price to
charge for the contract, please see below:
Material X
This is in regular use. Any units of the material that are held in inventory will have to be replaced
for other work if they are used for the contract. The relevant cost is their replacement cost.
Relevant cost = replacement cost = 5,000 kilograms × Rs.4.20 = Rs.21,000.
Material Y
AT A GLANCE

This is not in regular use. There are 1,500 kilograms in inventory, and an additional 500
kilograms would have to be purchased. The relevant cost of material Y for the contract would be:

Rs.
Material held in inventory (scrap value) 3,600
New purchases (500  Rs.10) 5,000
Total relevant cost of Material Y 8,600

 Example 09:
A company is considering whether to agree to do a job for a customer. It has sufficient spare
capacity to take on this job.
SPOTLIGHT

To do the job, three different direct materials will be required, Material X, Material Y and Material
Z. Data relating to these materials is as follows:

Quantity Original cost of

Quantity Current
currently units currently Current
needed disposal
Material held as held as purchase price
for the job value
inventory inventory
units units Rs. per unit Rs. per unit Rs. per unit
X 800 200 20 23 22
STIKCY NOTES

Y 600 400 15 19 12
Z 500 300 30 40 20

Material X is regularly used by the company for other work. Material Y is no longer in regular use,
and the units currently held as inventory have no alternative use. Material Z is also no longer in
regular use, but if the existing inventory of the material is not used for this job, they can be used
as a substitute material on a different job, where the contribution would be Rs.25 per unit of
Material Z used.
For calculation of the total relevant costs of the materials for this job for the customer, please see
below:
Material X: This material is in regular use. Its relevant cost is therefore its current replacement
cost, because any existing inventory will be replaced if it is used on the job.
Materials Y and Z: The relevant cost of the additional quantities that will have to be purchased
is their current replacement cost.

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Material Y: units already held in inventory. The relevant cost of these units is their
opportunity cost, which is the cash that could be obtained by disposing of them.
Material Z: units already held in inventory. The relevant cost of these units is the higher value
of their disposal value (Rs.20 per unit) and the contribution that they would earn if they are used
as a substitute material on a different job (Rs.25 per unit)
Relevant costs Rs. Rs.
Material X: 800 units  Rs.23 18,400
Material Y:
Opportunity cost of units in inventory = disposal value
(400 units  Rs.12) 4,800

AT A GLANCE
Purchase cost of additional units (200 units  Rs.19) 3,800
8,600
Material Z:
Opportunity cost of units in inventory = (300 units  Rs.25) 7,500
Purchase cost of additional units (200 units  Rs.40) 8,000
15,500
Total relevant cost of materials 42,500

2.2 Relevant cost of labor

The relevant costs of a decision to do some work or make a product will usually include costs of labor.

SPOTLIGHT
The relevant cost of labor for any decision is the additional cash expenditure (or saving) that will arise as a direct
consequence of the decision.
 If the cost of labor is a variable cost, and labor is not in restricted supply, the relevant cost of the labor is
its variable cost. For example, suppose that part-time employees are paid Rs.18 per hour, they are paid only
for the hours that they work and part-time labor is not in short supply. If management is considering a
decision that would require an additional 100 hours of part-time labor, the relevant cost of the labor would
be Rs.18 per hour or Rs.1,800 in total.
 If labor is a fixed cost and there is spare labor time available, the relevant cost of using labor is 0. The
spare time would otherwise be paid for idle time, and there is no additional cash cost of using the labor to
do extra work. For example, suppose that a new contract would require 30 direct labor hours, direct labor is

STIKCY NOTES
paid Rs.20 per hour, and the direct workforce is paid a fixed weekly wage for a 40-hour week. If there is
currently spare capacity, so that the labor cost would be idle time if it is not used for the new contract, the
relevant cost of using 30 hours on the new contract would be Rs.0. The 30 labor hours must be paid for
whether or not the contract work is undertaken.
 If labor is in limited supply, the relevant cost of labor should include the opportunity cost of using the labor
time for the purpose under consideration instead of using it in its next-most profitable way.
 Example 10:
Department 1. The contract would require 200 hours of work in department 1, where the
workforce is paid Rs.16 per hour for a fixed 40-hour week. There is currently spare labor capacity
in department 1 and there are no plans to reduce the size of the workforce in this department.
Department 2. The contract would require 100 hours of work in department 2 where the
workforce is paid Rs.24 per hour. This department is currently working at full capacity. The
company could ask the workforce to do overtime work, paid for at the normal rate per hour plus
50% overtime premium. Alternatively, the workforce could be diverted from other work that
earns a contribution of Rs.8 per hour.

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Department 3. The contract would require 300 hours of work in department 3 where the
workforce is paid Rs.24 per hour. Labor in this department is in short supply and all the available
time is currently spent making product Z, which earns the following contribution:
Rs. Rs.
Sales price 98
Labor (2 hours per unit) 48
Other variable costs 30
78
Contribution per unit of product Z 20

In evaluating the relevant cost for the contract of labor in the three departments, following
AT A GLANCE

working may be helpful

Department 1. There is spare capacity in department 1 and no additional cash expenditure
would be incurred on labor if the contract is undertaken.
Relevant cost = Rs.0.
Department 2. There is restricted labor capacity. If the contract is undertaken, there would be a
choice between:
 overtime work at a cost of Rs.36 per hour (Rs.24 plus overtime premium of 50%) – this
would be an additional cash expense, or
 diverting the labor from other work, and losing contribution of Rs.8 per hour – cost per
hour = Rs.24 basic pay + contribution forgone Rs.8 = Rs.32 per hour.
SPOTLIGHT

It would be better to divert the workforce from other work, and the relevant cost of labor is
therefore 100 hours × Rs.32 per hour = Rs.3,200.
Department 3. There is restricted labor capacity. If the contract is undertaken, labor would have
to be diverted from making product Z which earns a contribution of Rs.20 per unit or Rs.10 per
labor hour (Rs.20/2 hours). The relevant cost of the labor in department 3 is:

Rs.
Labor cost per hour 24
Contribution forgone per hour 10
Relevant cost per hour 34
STIKCY NOTES

Relevant cost of 300 hours = 300 × Rs.34 = Rs.10,200.

Summary of relevant costs of labor:

Rs.
Department 1 0
Department 2 3,200
Department 3 10,200
13,400

 Example 11:
The manager of a small printing business has received enquires about printing three different
types of advertising leaflet, type A, type B and type C. Selling price and cost information for these
leaflets is shown below:

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Leaflet type: Type A Type B Type C

Rs. Rs. Rs.
Selling price, per 1,000 leaflets 300 660 1,350
Estimate printing costs:
Variable costs, per 1,000 leaflets 120 210 390
Specific fixed costs per month 7,200 12,000 28,500

In addition to the specific fixed costs, Rs.12,000 per month will be incurred in general fixed costs.
The printing business receives an enquiry from a customer about printing 30,000 of a different

AT A GLANCE
type of leaflet. The customer is willing to pay Rs.25,000. The variable labor and overhead costs
of producing these leaflets would be Rs.80 per 1,000 leaflets.
The leaflets would be printed on a special type of paper. This costs Rs.500 per 1,000 leaflets.
However, there are already sufficient quantities of the paper in inventory for 20,000 of the
leaflets. This special paper was purchased three months ago for a customer who then cancelled
his order. The material has a disposal value of Rs.1,500, but it could also be used to produce
20,000 units of leaflet C. The cost of normal paper for leaflet C is Rs.300 per 1,000 leaflets.
For calculation of the relevant costs of making the leaflets for this special order and profit
increase as a result of undertaking the order would require following workings
Relevant costs Rs.
Materials

SPOTLIGHT
To be purchased: 10,000  Rs.500/1,000 5,000
Currently held in inventory 6,000
(Relevant cost = higher of [Rs.1,500 and (20,000  Rs.300/1,000)]
Variable costs of labor/overheads 2,400
(30,000  Rs.80/1,000)
Total relevant costs (13,400)
Contract price 25,000

STIKCY NOTES
Incremental profit 11,600

2.3 Relevant cost of overheads

Relevant costs of expenditures that might be classed as overhead costs should be identified by applying the
normal rules of relevant costing. Relevant costs are future cash flows that will arise as a direct consequence of
making a particular decision.
Fixed overhead absorption rates are therefore irrelevant, because fixed overhead absorption is not
overhead expenditure and does not represent cash spending
However, it might be assumed that the overhead absorption rate for variable overheads is a measure of actual
cash spending on variable overheads. It is therefore often appropriate to treat a variable overhead hourly rate as
a relevant cost, because it is an estimate of cash spending per hour for each additional hour worked.
The only overhead fixed costs that are relevant costs for a decision are extra cash spending that will be incurred,
or cash spending that will be saved, as a direct consequence of making the decision.

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 Example 12:
A company bought a machine six years ago for Rs.125,000. Its written down value is now
Rs.25,000. The machine is no longer used for normal production work, and it could be sold now
for Rs.17,500. A project is being considered that would make use of this machine for six months.
After this time the machine would be sold for Rs.10,000.
Calculating the relevant cost of the machine to the project would involve:
Relevant cost = Difference between sale value now and sale value if it is used. This is the relevant
cost of using the machine for the project.
Relevant cost = Rs.17,500 - Rs.10,000 = Rs.7,500.
 Example 13:
AT A GLANCE

A contract is under consideration which would require 1,400 hours of direct labor. There is spare
capacity of 500 hours of direct labor, due to the cancellation of another order by a customer. The
other time would have to be found by asking employees to work in the evenings and at weekends,
which would be paid at 50% above the normal hourly rate of Rs.15.
Alternatively, the additional hours could be found by switching labor from other work which
earns a contribution of Rs.5 per hour.
Relevant cost of direct labor if the contract is accepted and undertaken would require:
A total of 900 hours would have to be found by either working overtime at a cost of Rs.15 × 150%
= Rs.22.50 per hour, or diverting labor from other work that earns a contribution of Rs.5 per hour
after labor costs of Rs.15 per hour. The opportunity cost of diverting labor from other work is
therefore Rs.20 per hour. This is less than the cost of working overtime. If the contract is
SPOTLIGHT

undertaken, labor will therefore be diverted from the other work.

It is assumed that the 500 hours of free labor time (idle time) available would be paid for anyway,
even if the contract is not undertaken. The relevant cost of these hours is therefore Rs.0

Relevant cost of labor Rs.

500 hours 0
900 hours (× Rs.20) 18,000
Total relevant cost of labor 18,000

 Example 14:
STIKCY NOTES

Tychy Limited (TL) is engaged in the manufacture of Specialized motors. The company has been
asked to provide a quotation for building a motor for a large textile industrial unit in Punjab.
Following information has been obtained by TL’s technical manager in a one-hour meeting
with the potential customer. The manager is paid an annual salary equivalent to Rs. 2,500 per
eight-hour day.
i. The motor would require 120 ft. of wire-C which is regularly used by TL in production.
TL has 300 ft. of wire-C in inventory at the cost of Rs. 65 per ft. The resale value of wire-
C is Rs. 63 and its current replacement cost is Rs. 68 per ft.
ii. 50 kg of another material viz. Wire-D and 30 other small components would also be
required by TL for the motor. Wire-D would be purchased from a supplier at Rs. 10 per
kg. The supplier sells a minimum quantity of 60 kg per order. However, the remaining
quantity of wire-D will be of no use to TL after the completion of the contract. The other
small components will be purchased from the market at Rs. 80 per component.
iii. The manufacturing process would require 250 hours of skilled labor and 30 machine
hours.

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The skilled workers are paid a guaranteed wage of Rs. 20 per hour and the current spare
capacity available with TL for such class of workers is 100 direct labor hours. However,
additional labor hours may be obtained by either:
 Paying overtime at Rs. 23 per hour; or
 Hiring temporary workers at Rs. 21 per hour. These workers would require 5 hours
of supervision by AL’s existing supervisor who would be paid overtime of Rs. 20
per hour.
The machine on which the motor would be manufactured was leased by TL last year at
a monthly rent of Rs. 5,000 and it has a spare capacity of 110 hours per month. The
variable running cost of the machine is Rs. 15 per hour.
iv. Fixed overheads are absorbed at the rate of Rs. 25 per direct labor hour.

AT A GLANCE
The relevant cost of producing textile motor, together with reasons for the inclusion or
exclusion of any cost from your computation would be as follows

Tychy Limited (TL) Note Rs.

Technical manager – meeting 1 NIL
Wire – C 2 8,160
Wire – D 3 600
Components 4 2,400
Direct labor 5 3,250
Machine running cost 6 450

SPOTLIGHT
Fixed overhead 7 NIL
Total relevant cost 14,860
Notes:
1. In case of technical manager’s meeting with the potential client, the relevant cost is NIL
because it is not only a past cost but also the manager is paid an annual salary and
therefore TL has incurred no incremental cost on it.
2. Since wire-C is regularly used by TL, its relevant value is its replacement cost. The
historical cost is not relevant because it is a past cost and the resale value is not relevant
since TL is not going to sell it.
3. Since wire-D is to be purchased for the contract therefore its purchase cost is relevant.

STIKCY NOTES
TL only requires 50 kg of wire-D but due to the requirement of minimum order quantity
TL will be purchasing 60 kg of the material and since TL has no other use for this
material, the full cost of purchasing the 60 kg is the relevant cost.
4. Since the components are to be purchased from the market at a cost of Rs. 80 each.
Therefore, the entire purchase price is a relevant cost.
5. The 100 hours of direct labor are presently idle and hence have zero relevant cost. The
remaining 150 hours are relevant. TL has two choices: either use its existing employees
and pay them overtime at Rs. 23 per hour which is a total cost of Rs. 3,450: or engage the
temporary workers which would cost TL Rs. 3,250 including supervision cost of Rs. 100.
The relevant cost is the cheaper of the two alternatives i.e. Rs. 3250.
6. The lease cost of machine will be incurred regardless of whether it is used for the
manufacture of motors or remains idle. Hence, only the incremental running cost of Rs.
15 per hour is relevant.
7. Fixed overhead costs are incurred whether the work goes ahead or not so it is not a
relevant cost.

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3. COMPREHENSIVE EXAMPLES
 Example 01:
BB Company has received an enquiry from a customer for the supply of 500 units of a new
product, product B22. Negotiations on the final price to charge the customer are in progress and
the sales manager has asked you to supply relevant cost information.
The following information is available:
1) Each unit of product B22 requires the following raw materials:
Raw material type
X 4 kg
AT A GLANCE

Y 6 kg
2) The company has 5,000 kg of material X currently in stock. This was purchased last year
at a cost of Rs.7 per kg. If not used to make product B22, this stock of X could either be
sold for Rs.7.50 per kg or converted at a cost of Rs.1.50 per kg, so that it could be used
as a substitute for another raw material, material Z, which the company requires for
other production. The current purchase price per kilogram for materials is Rs.9.50 for
material Z and Rs.8.25 per kg for material X.
3) There are 10,000 kilograms of raw material Y in inventory, valued on a FIFO basis at a
total cost of Rs.142,750. Of this current inventory, 3,000 kilograms were purchased six
months ago at a cost of Rs.13.75 per kg. The rest of the inventory was purchased last
month. Material Y is used regularly in normal production work. Since the last purchase
of material Y a month ago, the company has been advised by the supplier that the price
SPOTLIGHT

per kilogram has been increased by 4%.

4) Each unit of product B22 requires the following number of labor hours in its
manufacture:
Type of labor:
Skilled: 5 hours
Unskilled: 3 hours
Skilled labor is paid Rs.8 per hour and unskilled labor Rs.6 per hour.
5) There is a shortage of skilled labor, so that if production of B22 goes ahead it will be
necessary to transfer skilled workers from other work to undertake it. The other work
STIKCY NOTES

on which skilled workers are engaged at present is the manufacture of product B16. The
selling price and variable cost information for B16 are as follows:

Rs./unit Rs./unit
Selling price 100
Less: variable costs of production
Skilled labor (3 hours) 24
Other variable costs 31
55
45

6) The company has a surplus of unskilled workers who are paid a fixed wage for a 37-hour
week. It is estimated that there are 900 hours of unused unskilled labor time available
during the period of the contract. The balance of the unskilled labor requirements could
be met by working overtime, which is paid at time and a half.

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7) The company absorbs production overheads by a machine hour rate. This absorption
rate is Rs.22.50 per hour, of which Rs.8.75 is for variable overheads and the balance is
for fixed overheads. If production of product B22 is undertaken, it is estimated that an
extra Rs.4,000 will be spent on fixed costs. Spare machining capacity is available and
each unit of B22 will require two hours of machining time in its manufacture using the
existing equipment. In addition, special finishing machines will be required for two
weeks to complete the B22. These machines will be hired at a cost of Rs.2,650 per week,
and there will be no overhead costs associated with their use.
8) Cash spending of Rs.3,250 has been incurred already on development work for the
production of B22. It is estimated that before production of the B22 begins, another
Rs.1,750 will have to be spent on development, making a total development cost of
Rs.5,000.

AT A GLANCE
The minimum price that the company should be prepared to accept for the 500 units of
product B22 would be calculated as follows together with brief explanation:
(Note: The minimum price is the price that equals the total relevant costs of producing
the items. Any price in excess of the minimum price will add to total profit).
Workings for relevant costs
Material X
The company has enough kilograms of material X in inventory for the contract. When it is used,
the inventory of material X will not be replaced. The relevant cost of the material is therefore its
opportunity cost, not its replacement cost. The opportunity cost is the higher of its current sale
value (Rs.7.50 per kg) or the net saving obtained if it is used as a substitute for material Z (Rs.9.50
– Rs.1.50 = Rs.8 per kg). The relevant cost of material X is therefore Rs.8 per kg.

SPOTLIGHT
Material Y
Material Y is in regular use, so its relevant cost is its current replacement cost.

kg Rs.
Total inventory 10,000 142,750
Purchased six months ago 3,000 ( Rs.13.75) 41,250
Purchased last month 7,000 101,500

Purchase price last month = Rs.101,500/7,000 kg = Rs.14.50 per kg.

STIKCY NOTES
Current purchase price = 4% higher = Rs.14.50 × 1.04 = Rs.15.08.
Skilled labor
Skilled labor is in short supply. If it is used to make product B22, workers will have to be taken
off other work. The relevant cost of skilled labor is the wages for the skilled workers for the time
spent on B22, plus the lost contribution (net of skilled labor cost) from not being able to make
units of product B16.
Opportunity cost of skilled labor
Skilled labor cost per unit of Product B16 = Rs.24
Number of hours per unit = 3 hours
Contribution per unit of B16 = Rs.45
Contribution per skilled labor hour from B16 = Rs.15
Opportunity cost of skilled labor if it is used to make B22 = (500 × 5) × Rs.15 = Rs.37,500

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Unskilled labor
900 unskilled labor will be available at no incremental cost to the company (as it is already being
paid and is not fully employed). There is no relevant cost for these hours. The additional 600
hours required will involve extra wage payments, including overtime payments. The relevant
cost of these 600 hours is Rs.6 per hour × 150% = Rs.9 per hour, including the overtime premium.
Overheads
Variable overheads are included as relevant costs because they will be additional costs if the units
of B22 are made. The only incremental fixed costs, however, are the extra cash costs of Rs.4,000.
The fixed overhead absorption rate is ignored. The additional costs of hiring special finishing
machinery are also included as a relevant cost.
Development costs
AT A GLANCE

Those costs already incurred are past costs (sunk costs) and are not relevant. The future
development costs involve additional expenditure and are included as relevant costs.
Minimum price for making 500 units of B22

Materials: Rs.
X (500 units  4kg)  Rs.8 16,000
Y (500 units  6kg)  Rs.15.08 45,240
Labor:
Skilled wages (500 units  5 hours)  Rs.8 20,000
SPOTLIGHT

Opportunity cost (500 units  5 hours)  Rs.15 37,500

Unskilled [(500  3) – 900] x 6  1.5 5,400
Overheads: Rs.
Variable (500 units  2 hours)  Rs.8.75 8,750
Fixed Incremental spending 4,000
Machine hire (2 weeks  Rs.2,650) 5,300
Development costs 1,750
STIKCY NOTES

Minimum price 143,940

 Example 02:
Topaz Limited (TL) is the manufacturer of consumer durables. Pearl Limited, one of the major
customers, has invited TL to bid for a special order of 150,000 units of product Beta.
Following information is available for the preparation of the bid.
i. Each unit of Beta requires 0.5 kilograms (kg) of material “C”. This material is produced
internally in batches of 25,000 kg each, at a variable cost of Rs. 200 per kg. The setup
cost per batch is Rs. 80,000. Material “C” could be sold in the market at a price of Rs. 225
per kg. TL has the capacity to produce 100,000 kg of material “C”; however, the current
demand for material “C” in the market is 75,000 kg.
ii. Every 100 units of product Beta requires 150 labor hours. Workers are paid at the rate
of Rs. 9,000 per month. Idle labor hours are paid at 60% of normal rate and TL currently
has 20,000 idle labor hours. The standard working hours per month are fixed at 200
hours.

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iii. The variable overhead application rate is Rs. 25 per labor hour. Fixed overheads are
estimated at Rs. 22 million. It is estimated that the special order would occupy 30% of
the total capacity. The production capacity of Beta can be increased up to 50% by
incurring additional fixed overheads. The fixed overhead rate applicable to enhanced
capacity would be 1.5 times the current rate. The utilized capacity at current level of
production is 80%.
iv. The normal loss is estimated to be 4% of the input quantity and is determined at the time
of inspection which is carried out when the unit is 60% complete. Material is added to
the process at the beginning while labor and overheads are evenly distributed over the
process.
v. TL has the policy to earn profit at the rate of 20% of the selling price.
In calculating the unit price that TL could bid for the special order to Pearl Limited would require

AT A GLANCE
following working:

Calculation of unit price to be quoted to Pearl Limited:

Material (25,000 × 200)+(53,125 × 225) + 80,000 W-1 17,033,125
Labor (20,000 ×45 × 40%) + (210,625 × 45) W-2 9,838,125
Variable overhead (230,625 × Rs. 25) 5,765,625
Incremental fixed cost (22m / 10 ×1.5) 3,300,000
35,936,875
Profit margin (25% of cost) 8,984,219

SPOTLIGHT
Sale price 44,921,094
Sale price per unit ( Rs. 44,921,094 / 150,000) 299
W-1: Material
Input units of material C (150,000 / 96%) × 0.5 78,125
W-2: Labor
Labor hours – completed units 150,000 x 1.50 225,000
– lost units {[(150,000 / 0.96) – 150,000] × 1.5 × 60%} 5,625
230,625

STIKCY NOTES
 Example 03:
JD is a small specialist manufacturer of electronic components and much of its output is used by
the makers of aircraft. One of the small number of aircraft manufacturers has offered a contract
to Company JD for the supply of 400 identical components over the next twelve months.
The data relating to the production of each component is as follows:
a) Material requirements:
3 kilograms material M1: see note 1 below
2 kilograms 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. 1,000 kilograms are currently
held in stock at a carrying amount of Rs.4.70 per kilogram but it is known that future
purchases will cost Rs.5.50 per kilogram.

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Note 2: 1,200 kilograms of material P2 are held in inventory. The original cost of the
material was Rs.4.30 per kilogram but as the material has not been required for the last
two years it has been written down to Rs.1.50 per kilogram (scrap value). The only
foreseeable alternative use is as a substitute for material P4 (in current use) but this
would involve further processing costs of Rs.1.60 per kilogram. The current cost of
material P4 is Rs.3.60 per kilogram.
Note 3: It is estimated that the Part No. 678 could be bought for Rs.50 each.
b) Labor requirements
Each component would require five hours of skilled labor and five hours of semi-skilled.
An employee possessing the necessary skills is available and is currently paid Rs.5 per
hour. A replacement would, however, have to be obtained at a rate of Rs.4 per hour for
the work that would otherwise be done by the skilled employee. The current rate for
AT A GLANCE

semi-skilled work is Rs.3 per hour and an additional employee could be appointed for
this work.
c) Overhead
JD absorbs overhead by a machine hour rate, currently Rs.20 per hour of which Rs.7 is
for variable overhead and Rs.13 for fixed overhead. If this contract is undertaken it is
estimated that fixed costs will increase for the duration of the contract by Rs. 3,200.
Spare machine capacity is available and each component would require four machine
hours.
A price of Rs.145 per component has been suggested by the large aircraft manufacturer.
In stating whether or not the contract should be accepted, please see below calculations
SPOTLIGHT

with that supports conclusion with appropriate figures for presentation to management.
The contract should be accepted if the revenue from the contract will exceed the relevant
costs of the contract.
Workings
Material M1. This material is in continuous/regular use. The relevant cost of the 1,000
kilograms is their replacement cost.
Relevant cost = 400 components × 3 kilos × Rs.5.50 per kilo = Rs.6,600.
Material P2. The material held in inventory has a relevant cost that is the higher of its
scrap value (Rs.1.50) and the costs saved by putting it to an alternative use, which is Rs.2
STIKCY NOTES

(Rs.3.60 – Rs.1.60).
There are more units held in stock than are needed for the contract. The excess quantity
should be ignored.
Relevant cost of material in stock = 400 components × 2 kilos × Rs.2 per kilo = Rs.1,600.
Part 678. Relevant cost = 400 components × Rs.50 = Rs.20,000.
Skilled labor. The relevant cost of skilled labor is the extra cash that would have to be
spent to hire additional labor.
Relevant cost = 400 components × 5 hours per component × Rs.4 per hour = Rs.8,000.
Semi-skilled labor. Relevant cost = 400 components × 5 hours per component × Rs.3 per
hour = Rs.6,000.
Variable overheads. It is assumed that the overhead absorption rate for variable
overheads is the rate at which cash expenditure is incurred on variable overheads.
Relevant cost = 400 components × 4 machine hours per component × Rs.7 per machine
hour = Rs.11,200.

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Relevant cost statement Rs.

Material M1 6,600
Material P2 1,600
Part 678 20,000
Skilled labor 8,000
Semi-skilled labor 6,000
Variable overheads 11,200
Incremental fixed costs 3,200
Total relevant costs 56,600

AT A GLANCE
Contract sales value (400  Rs.145) 58,000
Incremental profit 1,400

Undertaking the contract will add Rs.1,400 to total profit. On a purely financial basis, this
means that the contract is worth undertaking. However, management might take the
view that a higher profit margin is desirable, and the suggested price of Rs.145 per
component might be negotiable.
 Example 04:
Rugby Limited (RL) is engaged in manufacturing of a product ‘B1’. Presently, RL is considering
to launch a new product B1–Extra which has a demand of 10,000 units per month. The estimated

SPOTLIGHT
selling price of B1–Extra is Rs. 2,000 per unit. Other relevant information is as follows:
i. Each unit of B1-Extra would require 2 kg of material X and 1.5 labor hours. Material X is
available in the market at Rs. 520 per kg. Alternatively, instead of material X, RL can use
2.5 kg of a substitute material Y which can be produced internally. Production of each kg
of Y would require raw material costing Rs. 300 and 0.5 labor hour.
ii. Presently, about 14,000 labor hours remain idle each month and are paid at the rate of
50% of the normal wage rate of Rs. 250 per hour and such payments are charged to
administration expenses.
iii. Any shortfall in required labor hours can be met through overtime at the rate of 40%
above the normal wage rate.

STIKCY NOTES
iv. Records of last 4 months show the following factory overheads (variable and fixed) at
different levels of direct labor hours:

Month 1 Month 2 Month 3 Month 4

Direct labor (Hours) 174,000 172,000 170,000 168,000
Factory overheads (Rs. in ‘000) 58,280 57,840 57,400 56,960

The expected relevant cost per unit of B1-Extra and determine the cost gap (if any) if RL requires
a margin of 30%, would be as follows:

Rugby Limited
Cost gap per unit Rs. per unit
Expected relevant cost per unit (15,800,000/10,000) 1,580.00
Less: Target cost per unit (2,000×70%) 1,400.00
Cost gap (1,580–1,400) 180.00

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Relevant costs of producing B1-Extra

Material cost 10,000×1,040 (W-1) 10,400,000
Direct labor cost (W-2) 2,100,000
Variable overheads 10,000×1.5×220 (W-4) 3,300,000
Total relevant cost 15,800,000

Rs. per unit of

W-1: Decision to use X or Y
B1-Extra
Cost of Y for each unit of B1-Extra
Material cost (300×2.5) 750.00
AT A GLANCE

Labor cost (Without overtime) (250×50%)×(0.5×2.5) 156.25

Variable factory overheads [(220(W-4)×0.5)×2.5] 275.00
Fixed (existing) (Not relevant) -
Cost of Y for each unit of B1-Extra 1,181.25
Cost of material X for each unit of B1-Extra (520×2.0)(Given) 1,040.00
Extra cost on producing Y internally (Not feasible) 141.25
W-2: Direct labor cost for B1-Extra Rupees
Labor cost – hours (14,000×250×50%) 1,750,000
Labor cost – overtime (1,000(W-3)×1.4×250) 350,000
SPOTLIGHT

Total direct labor cost 2,100,000

W-3: Overtime hours required Labor hours
Available labor hours 14,000
Labor hours required (10,000×1.5) 15,000
Excess hours required - Overtime hours (1,000)
W-4: Variable factory overhead rate by
High Low Variable
high-low method
(a) (b) (a–b)
STIKCY NOTES

Factory overheads (Rs.) A 58,280,000 56,960,000 1,320,000

Labor hours B 174,000 168,000 6,000
Variable factory overheads rate per hour
(Rs.) (A÷B) 220

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STICKY NOTES

Relevant costs are cash flows that will occur in the future as a direct
consequence of making the decision

Relevant costs include incremental costs (additional cost that will occur if a
particular decision is taken), differential costs (amount by which future costs
will be different), avoidable costs (cost that can be saved) and opportunity
costs (a benefit that will be lost by taking a course of action).

AT A GLANCE
Relevant costs of materials, labor or overheads are the additional cash flows
that will be incurred (or benefits that will be lost) by using the materials for
the purpose that is under consideration or arise as a direct consequence of
the decision.

SPOTLIGHT
STIKCY NOTES

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 CHAPTER 13: RELEVANT COSTS CAF 8: CMA
AT A GLANCE
SPOTLIGHT
STIKCY NOTES

448 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 14

COST-VOLUME-PROFIT (CVP) ANALYSIS

AT A GLANCE
IN THIS CHAPTER Cost-volume-profit analysis is used to show how costs and
profits change with changes in the volume of activity.
AT A GLANCE

AT A GLANCE
Contribution margin facilitates analysis of cost-volume-profit. It
SPOTLIGHT is equal to sales minus variable expenses. It also allows
approximation of profit for decision making. The same can also
1. The nature of CVP analysis be used in planning and evaluating profit resulting from change
in volume or cost. Hence aids in selection of optimize product
2. Break-even analysis mix and sales target.
Break-even point is often required to calculate the volume of
3. Break-even charts and profit- sales required in a period (such as the financial year) to ‘break
volume charts even’ and make neither a profit nor a loss. The break-even point
can therefore be calculated by dividing the total contribution
4. Multi-product CVP analysis required (total fixed costs) by the contribution per unit.
5. Comprehensive Examples

SPOTLIGHT
STICKY NOTES

STIKCY NOTES

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 CHAPTER 14: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

1. THE NATURE OF CVP ANALYSIS

1.1 Introduction to CVP analysis
CVP analysis stands for cost-volume-profit analysis’. It is used to show how costs and profits change with
changes in the volume of activity. CVP analysis is an application of marginal costing concepts.

1.2 Assumptions in CVP analysis

Costs are either fixed or variable. The variable cost per unit is the same at all levels of activity (output and sales).
Whereas total fixed costs are a constant amount in each period.
Fixed costs are normally assumed to remain unchanged at all levels of output at least in the short term.
The contribution per unit is constant for each unit sold (of the same product).
AT A GLANCE

The sales price per unit is constant for every unit of product sold; therefore, the contribution to sales ratio is also
a constant value at all levels of sales.
If sales price per unit, variable cost per unit and fixed costs are not affected by volume of activity sales and profits
are maximized by maximizing total contribution.

1.3 Contribution
Contribution is a key concept. Contribution is measured as sales revenue less variable costs.
Profit is measured as contribution minus fixed costs.
 Illustration:
SPOTLIGHT

Rs.

Sales (Units sold × sales price per unit) X

Variable costs (Units sold × variable cost price per unit) (X)

Contribution X

Fixed costs (X)

Profit X

Total contribution = Contribution per unit  Number of units sold.

STIKCY NOTES

Many problems solved using CVP analysis use either contribution per unit (CPU) or the CS (Contribution/Sales)
ratio.
Contribution per unit
It is assumed that contribution per unit (sales price minus variable cost) is a constant amount over all sales
volumes.
 Example 01:
A company makes and sells a single product. The product has a variable production cost of Rs.8
per unit and a variable selling cost of Rs.1 per unit.
Total fixed costs (production, administration and sales and distribution fixed costs) are expected
to be Rs. 500,000.
The selling price of the product is Rs.16.

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The profit at sales volumes of 70,000, 80,000 and 90,000 units can be calculated as follows.

70,000 units 80,000 units 90,000 units

Rs. Rs. Rs.
Sales revenue (Rs.16/unit) 1,120,000 1,280,000 1,440,000
Variable cost (Rs.9/unit) (630,000) (720,000) (810,000)
Contribution (Rs.7/unit) 490,000 560,000 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000

AT A GLANCE
Notes
A loss is incurred at 70,000 units of sales because total contribution is not large enough to cover
fixed costs. Profit increases as sales volume increases, and the increase in profit is due to the
increase in total contribution as sales volume increases.
Somewhere between 70,000 and 80,000 there is a number of units which if sold would result in
neither a profit nor a loss. This is known as the breakeven position.
The contribution line could have been completed without calculating the sales and variable costs
by simply multiplying the quantity sold by the CPU.
Considering facts as before, calculating total contribution as the number of units  contribution

SPOTLIGHT
per unit, would be as follows:

Contribution per unit Rs.

Sales price per unit 16
Variable production cost per unit (8)
Variable selling cost per unit (1)
Contribution per unit 7

70,000 units 80,000 units 90,000 units

STIKCY NOTES
Rs. Rs. Rs.
70,000  Rs. 7 per unit 490,000
80,000  Rs. 7 per unit 560,000
90,000  Rs. 7 per unit 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000

 Example 02:
Jimco makes and sells a single product, Product P. It is currently producing 112,000 units per
month, and is operating at 80% of full capacity. Total monthly costs at the current level of
capacity are Rs. 611,000. At 100% capacity, total monthly costs would be Rs. 695,000. Fixed costs
would be the same per month at all levels of capacity between 80% and 100%.
At the normal selling price for Product P, the contribution/sales ratio is 60%.

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The variable cost per unit of Product P and total fixed costs per month would be calculated as:
100% capacity each month = 112,000 units/0.80 = 140,000 units.
Using high/low analysis:

units Rs.
High: Total cost of 140,000 695,000
Low: Total cost of 112,000 611,000
Difference: Variable cost of 28,000 84,000
AT A GLANCE

Therefore, variable cost per unit = Rs. 84,000/28,000 units = Rs.3.

Substitute in high equation Cost (Rs)

Total cost of 140,000 units 695,000
Variable cost of 140,000 units (× Rs.3) 420,000
Therefore fixed costs per month 275,000
In addition, if it is required to calculate the current normal sales price per unit, and the
contribution per unit at the price, the same would require following calculations:
Contribution/sales ratio = 60%
Therefore, variable cost/sales ratio = 40%
SPOTLIGHT

The normal sales price per unit = Rs.3/0.40 = Rs.7.50

The contribution per unit at the normal selling price is Rs.7.50 – Rs.3 = Rs.4.50 per unit.
CS (Contribution/Sales) ratio
The sales revenue in each case could be calculated by dividing the total contribution for a given
level of activity by the CS ratio.
Formula:

CS ratio (contribution to Contribution per unit

sales ratio) Selling price per unit
STIKCY NOTES

Using data of Example 01:

Contribution to sales ratio:

Contribution per unit/Selling price per unit = 7/16 = 0.4375

70,000 units 80,000 units 90,000 units

Rs. Rs. Rs.
Contribution (Rs.7/unit) 490,000 560,000 630,000
CS ratio ÷0.4375 ÷0.4375 ÷0.4375
Sales revenue 1,120,000 1,280,000 1,440,000

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2. BREAK-EVEN ANALYSIS
2.1 Break-even analysis
CVP analysis can be used to calculate a break-even point for sales.
Break-even point is the volume of sales required in a period (such as the financial year) to ‘break even’ and make
neither a profit nor a loss. At the break-even point, profit is 0.
Management might want to know what the break-even point is in order to:
 identify the minimum volume of sales that must be achieved in order to avoid a loss, or
 assess the amount of risk in the budget, by comparing the budgeted volume of sales with the break-even
volume.

AT A GLANCE
 estimate the inflow of cash required by the business before it starts generating its own funds.

2.2 Calculating the break-even point

The break-even point can be calculated using simple CVP analysis.
At the break-even point, the profit is Rs.0. If the profit is Rs.0, total contribution is exactly equal to total fixed
costs.
We therefore need to establish the volume of sales at which fixed costs and total contribution are the same
amount.
There are a number of methods of calculating the break-even point when the total fixed costs for the period are
known:

SPOTLIGHT
Method 1: Breakeven point expressed as a number of units.
The first method is to calculate the break-even point using the contribution per unit. This method can be used
where a company makes and sells just one product.
 Formula:

Breakeven point expressed as a number of units

Total fixed costs
Break-even point in sales units =
Contribution per unit

Total fixed costs are the same as the total contribution required to break even, and the break-even point can
therefore be calculated by dividing the total contribution required (total fixed costs) by the contribution per unit.

STIKCY NOTES
Remember to include any variable selling and distribution costs in the calculation of the variable cost per unit
and contribution per unit.
Once the breakeven point is calculated as a number of units it is easy to express it in terms of revenue by
multiplying the number of units by the selling price per item.
 Example 03:
A company makes a single product that has a variable cost of sales of Rs.12 and a selling price of
Rs.20 per unit. Budgeted fixed costs are Rs.600,000.
What volume of sales is required to break even?
Method 1

Total fixed costs

Break-even point in sales units
Contribution per unit

Contribution per unit = Rs.20 – Rs.12 = Rs.8.

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Therefore, break-even point:

/
In units: Rs.600,000 Rs.8 per unit = 75,000 units of sales.
In sales revenue: 75,000 units × Rs.20 per unit = Rs.1,500,000 of sales.
Method 2: Breakeven point expressed in sales revenue
The second method calculates the break-even point in sales revenue.
 Formula:

Breakeven point expressed in sales revenue

Fixed costs
Break-even point in revenue =
AT A GLANCE

Contribution to sales ratio

Once the breakeven point is calculated as an amount of revenue it is easy to express it as a number of units by
dividing the revenue by the selling price per item.
 Example 04:
A company makes a single product that has a variable cost of sales of Rs.12 and a selling price of
Rs.20 per unit. Budgeted fixed costs are Rs.600,000.
What volume of sales is required to break even?
Method 2

Total fixed costs

SPOTLIGHT

Break-even point in revenue =

C/S ratio

C/S ratio = Rs.8/Rs.20 = 40%

Therefore, break-even point:
In sales revenue = Rs.600,000/0.40 = Rs.1,500,000 in sales revenue.
In units = Rs.1,500,000 ÷ Rs.20 (sales price per unit) = 75,000 units.
 Example 05:
A soft drink company is planning to produce mineral water. It is contemplating the purchase of
plant with a capacity of 100,000 bottles a month. For the first year of operation the company
STIKCY NOTES

expects to sell between 60,000 to 80,000 bottles. The budgeted costs at each of the two levels are
as follows:

Rupees
Particulars 60,000 bottles 80,000 bottles
Material 360,000 480,000
Labor 200,000 260,000
Factory overheads 120,000 150,000
Administration expenses 100,000 110,000
The production would be sold through retailers who will receive a commission of 8% of sale price.
In order to calculate, the break-even point in rupees and units, if the company decides to fix
the sale price at Rs. 16 per bottle, please see below working

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Calculation of variable and fixed cost

Total costs Variable cost
Fixed
Per 60,000 cost
60,000 80,000 20,000
bottle bottles
bottles bottles bottles (A – E)
C/20,000 D×60,000
A B C D E F
Material 360,000 480,000 120,000 6.00 360,000 -
Labor 200,000 260,000 60,000 3.00 180,000 20,000
Factory overheads 120,000 150,000 30,000 1.50 90,000 30,000

AT A GLANCE
Administration
expenses 100,000 110,000 10,000 0.50 660,000 70,000
780,000 1,000,000 220,000 11.00 660,000 120,000

Calculation of variable and fixed cost

Rupees
Variable cost per bottle as above 11.00
Commission to retailers (8% of Rs. 16.00) 1.28
Variable cost per bottle 12.28

SPOTLIGHT
Contribution per bottle (16.00 – 12.28) Rs. 3.72
PV ratio (contribution to sales ratio 3.72/16.00) 23.25%

Fixed cost 120,000

Break-even point (bottles) = = = 32,258 bottles
Contribution per bottle 3.72
Break-even point in Rupees = 32,258 × 16.00 = Rs. 516,128

STIKCY NOTES
In addition, computation of the break-even point in units if the company offers a discount of
10% on purchase of 20 bottles or more, assuming that 20% of the sales will be to buyers who
will avail the discount, would be as follows:

Average sales price (before discount) Rs.16.00

Average discount per unit @ 10% on 20% of sales = 0.02 of Rs. 16.00 (0.32)
New average sales price 15.68
Variable cost per bottle as above 11.00
Commission to retailers (8% of Rs. 15.68) 1.25
Variable cost per bottle 12.25

Contribution per bottle (15.68 – 12.25) Rs. 3.43

Fixed cost 120,000
Break-even point (bottles) = = = 34,985 bottles
Contribution per bottle 3.43

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 CHAPTER 14: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

2.3 Margin of safety

The margin of safety is the difference between:
 the budgeted sales (in units or Rs.) and
 the break-even amount of sales (in units or Rs.).
It is usually expressed as a percentage of the budgeted sales. However, it may also be measured as:
 a quantity of units (= the difference between the budgeted sales volume in units and the breakeven sales
volume), or
 an amount of sales revenue (= the difference between the budgeted sales revenue and the total sales revenue
required to break even).
It is called the margin of safety because it is the maximum amount by which actual sales can be lower than
budgeted sales without incurring a loss for the period. A high margin of safety therefore indicates a low risk of
AT A GLANCE

making a loss.
The margin of safety is often expressed as a percentage of budgeted sales.
 Formula:

Margin of safety (units)

Margin of safety =  100
Budgeted sales (units)

Margin of safety (revenue)

Margin of safety =  100
Budgeted revenue

 Example 06:
SPOTLIGHT

A company budgets to sell 25,000 units of its product. This has a selling price of Rs.16 and a
variable cost of Rs.4. Fixed costs for the period are expected to be Rs.240,000.
The break-even point = Rs.240,000/(Rs.16 – 4) = 20,000 units.
The budgeted sales are 25,000 units.
Margin of safety = Budgeted sales – break-even sales
= 25,000 – 20,000 = 5,000 units
Margin of safety ratio 5,000 units/25,000 units =20% of budgeted sales
This means that sales volume could be up to 20% below budget, and the company should still
STIKCY NOTES

expect to make a profit.

 Example 07:
Auto Industries Limited (AIL) manufactures auto spare parts. Currently, it is operating at 70%
capacity. At this level, the following information is available:

Break-even sales Rs. 125 million

Margin of safety Rs. 25 million
Contribution margin to sales 20%
AIL is planning to increase capacity utilization through the following measures:
Selling price would be reduced by 5% which is expected to increase sales volume by 30%.
Increase in sales would require additional investment of Rs. 40 million in distribution vehicles
and working capital. The additional funds would be arranged through a long-term loan at a cost
of 15% per annum. Depreciation on distribution vehicles would be Rs. 5 million.

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As a result of increased production, economies of scale would reduce variable cost per unit by
10%.
a) Preparing for profit statements under current and proposed scenarios would involve
following calculations:
Auto Industries Limited Current Proposed
Profit statement Rs. in million
Sales (125+25), 150*1.3*0.95 150.00 185.25
Variable cost of sales
(150*80%), 120*90%*1.3) (120.00) (140.40)
Contribution margin 30.00 44.85

AT A GLANCE
Fixed cost (125×20%), 25+5+
(40*15%) (25.00) (36.00)
Net profit 5.00 8.85

b) In addition, computing break-even sales and margin of safety after taking the above
measures would have following results.

Break-even sales (185.25÷44.85)×36 148.70

Margin of safety (185.25-148.70) 36.55

2.4 Target profit

SPOTLIGHT
Management might want to know what the volume of sales must be in order to achieve a target profit. CVP
analysis can be used to calculate the volume of sales required.
The volume of sales required must be sufficient to earn a total contribution that covers the fixed costs and makes
the target amount of profit. In other words, the contribution needed to earn the target profit is the target profit
plus the fixed costs.
The sales volume that is necessary to achieve this, is calculated by dividing the target profit plus fixed costs by
the contribution per unit in the usual way.
 Formula:

Volume target expressed in units

STIKCY NOTES
Total fixed costs + target profit
Volume target (units) =
Contribution per unit

Once the volume target is calculated as a number of units it is easy to express it in terms of revenue by multiplying
the number of units by the selling price per item.
Similarly, the sales revenue that would achieve the target profit is calculated by dividing the target profit plus
fixed costs by the C/S ratio.
 Formula:

target expressed in sales revenue

Total fixed costs + target profit
target in revenue(Rs.) =
Contribution to sales ratio
Once the volume target is calculated as an amount of revenue it is easy to express it as a number of units by
dividing the revenue by the selling price per item.

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 Example 08:
A company makes and sells a product that has a variable cost of Rs.5 per unit and sells for Rs.9
per unit.
Budgeted fixed costs are Rs.600,000 for the year, and the company wishes to make a profit of at
least Rs.100,000.
The sales volume required to achieve the target profit can be found as follows:
The total contribution must cover fixed costs and make the target profit.
Rs.
Fixed costs 600,000
Target profit 100,000
AT A GLANCE

Total contribution required 700,000

Contribution per unit = Rs.9 – Rs.5 = Rs.4.
Sales volume required to make a profit of Rs.100,000:
Rs.700,000/Rs.4 per unit = 175,000 units.
Therefore, the sales revenue required to achieve target profit
175,000 units × Rs.9 = Rs.1,575,000
Alternatively:
C/S ratio = 4/9
Sales revenue required to make a profit of Rs.100,000
SPOTLIGHT

= Rs.700,000  (4/9) = Rs.1,575,000.

Therefore, the number of units required to achieve target profit
Rs.1,575,000 ÷ Rs. 9 = 175,000 units

 Example 09:
A company makes a single product that it sells at Rs.80 per unit. The total fixed costs are
Rs.360,000 for the period and the contribution/sales ratio is 60%. Budgeted production and sales
for the period is 8,000 units.
The margin of safety for the period, as a percentage of the budgeted sales would be calculated as
follows
STIKCY NOTES

Contribution per unit = 60% × Rs.80 = Rs.48

Fixed costs = Rs.360,000
Break-even point = Rs.360,000/Rs.48 per unit = 7,500 units
Budgeted sales = 8,000 units
Margin of safety = (8,000 – 7,500) units = 500 units
As a percentage of budgeted sales, the margin of safety is (500/8,000) × 100% = 6.25%.
 Example 10:
A company makes and sells a single product. The following data relates to the current year’s
budget.

Sales and production (units): 8,000

Variable cost per unit: Rs.20
Fixed cost per unit: Rs.25
Contribution/sales ratio: 60%

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The selling price next year will be 6% higher than the price in the current year budget and the
variable cost per unit will be 5% higher than in the current year budget. Budgeted fixed costs
next year will be 10% higher than budgeted fixed costs in the current year.
If required to calculate (i) the budgeted contribution per unit and (ii) the budgeted total profit
for the current year following working is required
i. Contribution/sales ratio = 60%
Therefore, variable costs/sales ratio = 40%.
Variable cost per unit = Rs.20
Therefore, sales price per unit = Rs.20/0.40 = Rs.50.
Contribution per unit = Rs.50 – Rs.20 = Rs.30.
Rs.

AT A GLANCE
Budgeted contribution (8,000 × Rs.30) 240,000
Budgeted fixed costs (8,000 × Rs.25) 200,000
Budgeted profit, current year 40,000
However, for the next year, in order to calculate the number of units that will have to be sold in
order to achieve a total profit that is equal to the budgeted profit in the current year please see
below.
ii. Sales price next year = Rs.50 × 1.06 = Rs.53 per unit
Variable cost per unit next year = Rs.20 × 1.05 = Rs.21
Therefore, contribution per unit next year = Rs.53 – Rs.21 = Rs.32
Rs.
Target profit next year 40,000

SPOTLIGHT
Fixed costs next year (200,000 × 1.10) 220,000
Target contribution for same profit as in the current year 260,000
Therefore target sales next year = Rs.260,000/Rs.32 per unit = 8,125 units.
 Example 11:
Entity D makes a single product which it sells for Rs.10 per unit. Fixed costs are Rs.48,000 each
month and the product has a contribution/sales ratio of 40%.
If budgeted sales for the month are Rs.140,000, the margin of safety in units would be
Break-even point = Rs.48,000/0.40 = Rs.120,000 (sales revenue).
Margin of safety (in sales revenue) = Rs.140,000 – Rs.120,000 = Rs.20,000.

STIKCY NOTES
Selling price per unit = Rs.10.
Margin of safety (in units) = Rs.20,000/Rs.10 = 2,000 units.
 Example 12:
Entity E has monthly sales of Rs.128,000, but at this level of sales, its monthly profit is only
Rs.2,000 and its margin of safety is 6.25%.
From the above information we can calculate (i) fixed costs as well as (ii) the level of monthly
sales needed to increase the monthly profit to Rs.5000 as follows:
i. The margin of safety is 6.25%. Therefore the break-even volume of sales = 93.75% of
budgeted sales = 0.9375 × Rs.128,000 = Rs.120,000
Budget (Rs.) Break-even (Rs.)
Sales 128,000 120,000
Profit 2,000 0
Total costs 126,000 120,000

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This gives us the information to calculate fixed and variable costs, using high/low
analysis.

Rs. Revenue Rs. Cost

High: Total cost at 128,000 126,000
Low: Total cost at 120,000 120,000
Difference: Variable cost of 8,000 6,000
Therefore variable costs = Rs.6,000/Rs.8,000 = 0.75 or 75% of sales revenue.

Substitute in high or low equation Cost (Rs.)

Total cost at Rs.128,000 revenue 126,000
AT A GLANCE

Variable cost at Rs.128,000 revenue (× 0.75) 96,000

Therefore fixed costs 30,000
Alternate approach
i. At sales of Rs.128,000, profit is Rs.2,000.
The contribution/sales ratio = 100% – 75% = 25% or 0.25.
To increase profit by Rs.3,000 to Rs.5,000 each month, the increase in sales must
be:
(Increase in profit and contribution) ÷ C/S ratio
= Rs.3,000/0.25 = Rs.12,000.
Sales must increase from Rs.128,000 (by Rs.12,000) to Rs.140,000 each month.
SPOTLIGHT

Alternative approach to the answer

Rs.
Target profit 5,000
Fixed costs 30,000
Target contribution 35,000
C/S ratio 0.25
Therefore sales required (Rs.35,000/0.25) Rs.140,000
 Example 13:
Octa Electronics produces and markets a single product. Presently, the product is manufactured
STIKCY NOTES

in a plant that relies heavily on direct labor force. Last year, the company sold 5,000 units with
the following results:
Rupees
Sales 22,500,000
Less: Variable expenses 13,500,000
Contribution margin 9,000,000
Less: Fixed expenses 6,300,000
Net income 2,700,000
a) Break-even point in rupees and the margin of safety would be
Break even point in Rupees
Fixed Expense
Break even point in Rupees 
Contribution margin%
6,300,000
= = Rs. 15,750,000
40% (W-1)

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W-1: Rupees
Selling price 22,500,000
Less: variable expense 13,500,000
Contribution margin 9,000,000
Contribution margin % 40% (9,000,000 / 22,500,000)

Margin of safety = Current sales - Break even sales

Current sales
= 22,500,000 - 15,750,000 = 30%

AT A GLANCE
22,500,000
b) For the contribution margin ratio and the break-even point in number of units if variable
cost increases by Rs. 600 per unit can be calculated. The selling price per unit if the
company wishes to maintain the contribution margin ratio achieved during the previous
year involves following working.

New CM Ratio Rupees

Selling price 22,500,000
Less: variable expense 16,500,000 (Rs.13,500,000 + 5,000 x Rs. 600)
Contribution margin 6,000,000
Contribution margin % 26.67% (Rs. 6,000,000 / Rs. 22,500,000)

SPOTLIGHT
Break-even point in units
Fixed Expense
Break-even point in units =
Contribution margin per unit
6,300,000
= = 5,250 units
Rs. 6,000,000 ÷ 5,000
New Selling Price
Let S = new selling price per unit
S= Variable Costs per unit + S x 0.4

STIKCY NOTES
S= (Rs. 16,500,000 ÷ 5,000) + 0.4S
0.6 S = Rs. 3,300
S= Rs. 5,500

c) The company is also considering the acquisition of a new automated plant. This would
result in the reduction of variable costs by 50% of the amount computed in (b) above
whereas the fixed expenses will increase by 100%. If the new plant is acquired, units
that will have to be sold next year to earn net income of Rs. 3,150,000 would be
No. of units to be sold next year to earn a profit of Rs. 3,150,000
New contribution per unit
Selling price Rs. 4,500
Less: variable expenses Rs. 1,650 (Rs. 16,500,000 / 5,000 x 50%)
Contribution margin Rs. 2,850

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New breakeven point in units to achieve net income of Rs. 3,150,000t

Fixed Expense  Target Profit
Break even point in units 
Contribution margin per unit
(Rs. 6,300,000 x 2) + Rs. 3,150,000
= = 5,526 units
Rs. 2,850

 Example 14:
The following information pertains to Hope Limited for the latest financial year:

Rupees
Sales price per unit 1,600
AT A GLANCE

Direct labor per unit 240

Variable cost (other than direct labor) per unit 960
Fixed cost (no labor cost included) 850,000

Volume of sales and production was 6,000 units which represent 80% of normal capacity. The
management of the company is planning to increase wages of direct labor by 15% with effect
from next financial year.
i. In order to calculate the number of units to be sold to maintain the current profit if the sales
price remains at Rs. 1,600 and the 15% wage increase goes into effect, please see below:

Units to be sold to maintain the current profit: Rs.

SPOTLIGHT

Sales (6,000 units × 1,600) 9,600,000

Variable cost [6,000 × (960+240)] (7,200,000)
Contribution margin A 2,400,000
Revised contribution margin per unit [1,600–960–(240×1.15)] B 364
Units to be sold A÷B 6,593 Units

ii. The management believes that an additional investment of Rs. 760,000 in machinery (to be
depreciated at 10% annually) will increase normal capacity by 25%. Determine the selling
price in order to earn a profit of Rs. 2 million assuming that all units produced at increased
STIKCY NOTES

capacity can be sold and that the wage increase goes into effect.

Selling price per unit to earn a profit of Rs. 2 million:

Revised capacity (6,000 ÷ 0.8 × 1.25) Units 9,375
Revised fixed cost 850,000 + (760,000 × 10%) Rs. 926,000
926,000+2,000,000
New selling price = + (2401.15) + 960 Rs. 1,548
9,375

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3. BREAK-EVEN CHARTS AND PROFIT-VOLUME CHARTS

3.1 Break-even chart
A break-even chart is a chart or graph showing, for all volumes of output and sales:
 total costs, analyzed between variable costs and fixed costs
 sales
 profit (= the difference between total sales and total costs)
 the break-even point (where total costs = total sales revenue, and profit = 0).
The concept of a break-even chart is similar to a cost behavior chart, but with sales revenue shown as well.
If the chart also indicates the budgeted volume of sales, the margin of safety can be shown as the difference

AT A GLANCE
between the budgeted volume and the break-even volume of sales.
Two illustrations for of break-even are shown below. The only difference between them is the way in which
variable costs and fixed costs are shown.
 In the first illustration, variable costs are shown on top of fixed costs. Fixed costs are represented by the
horizontal line of dashes. Fixed costs are the same amount at all volumes of sales. Variable costs are shown
on top of fixed costs, rising in a straight line from sales of Rs.0. Total costs are shown as the sum of fixed costs
and variable costs.
 In the second (a more unusual presentation), fixed costs are shown on top of variable costs. An advantage of
this method of presentation is that total contribution is shown. This is the difference between the total sales
line and the total variable costs line.
 Total costs are exactly the same in both diagrams.

SPOTLIGHT
Because the sales price per unit is constant, the total sales revenue line rises in a straight line from the origin of
the graph (i.e. from x = 0, y = 0).
First break-even chart: variable costs on top of fixed costs
 Illustration 01:

Rs.
Sales

Break-even PROFIT

STIKCY NOTES
point Total costs

Variable
costs

Fixed LOSS Margin of

costs safety

Break-even Budgeted Sales volume

point sales

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 Illustration 02:

Rs.
Sales

Break-even PROFIT
point Total costs

Contribution
Fixed LOSS
AT A GLANCE

costs Margin of
Variable safety
costs
Break-even Budgeted Sales volume
point sales

Points to note
You should be able to identify the following points on these charts.
 The break-even point is shown on both charts as the volume of sales at which total revenue equals total costs.
 In the second chart, total contribution at the break-even point is shown as exactly equal to fixed costs.
 If budgeted sales are shown on the chart, the margin of safety can also be show, as the difference between
SPOTLIGHT

budgeted sales and the break-even point.

3.2 Profit/volume chart (P/V chart)

A profit volume chart (or P/V chart) is an alternative to a break-even chart for presenting CVP information. It is
a chart that shows the profit or loss at all levels of output and sales.
 Illustration:

Rs.
profit
Margin of
Profit
STIKCY NOTES

safety

Budgeted Sales
sales
Fixed
costs Break-even
point

Rs.
loss

At Rs.0 sales, there is a loss equal to the total amount of fixed costs. The loss becomes smaller as sales volume
increases, due to the higher contribution as sales volume increases. Break-even point is then reached and profits
are made at sales volumes above the break-even point.

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We could draw a line on the graph to show fixed costs. This line should be drawn parallel to the x axis, starting
at the loss (= total fixed costs) at Rs.0 sales. By drawing this line for fixed costs, total contribution would be shown
as the difference between the line showing the profit (or loss) and the line for the fixed costs.
 Example 15:
You are a management accountant for a business that develops specialist computers. You are
consulted to investigate the viability of marketing a new type of hand-held computer.
With the help of the manager of research and development, the production manager, the buyer
and the sales manager, you have made the following estimates of annual sales and profitability:

Sa1les Profit/(loss)
units Rs.

AT A GLANCE
12,000 (30,000)
15,000 150,000
18,000 330,000

The selling price will be Rs.150.

A traditional break-even chart using the information given above will be prepared as follows:

SPOTLIGHT
Workings

STIKCY NOTES
Sales
Sales Profit
(at Rs.150)
units Rs. Rs.
18,000 2,700,000 330,000
12,000 1,800,000 (30,000)
Difference 6,000 900,000 360,000

An increase in sales from 12,000 units to 18,000 units results in an increase of Rs.900,000 in
revenue and Rs.360,000 in contribution and profit.
From this, we can calculate that the contribution is Rs.60 per unit (Rs.360,000/6,000) and the
C/S ratio is 0.40 (Rs.360,000/Rs.900,000). Variable costs are therefore 0.6 or 60% of sales.
To draw a break-even chart, we need to know the fixed costs.

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Substitute in high or low equation

When sales are 18,000 units: Rs.
Sales (at Rs.150 each) 2,700,000
Variable cost (sales  60%) 1,620,000

Contribution (sales  40%) 1,080,000

Profit 330,000
Therefore fixed costs 750,000
When sales are 18,000 units: Rs.
AT A GLANCE

Fixed costs 750,000

Variable cost (see above) 1,620,000
Total costs 2,370,000

In addition, the margin of safety if annual sales are expected to be 15,000 units can be calculated
as
Break-even point = Fixed costs ÷ C/S ratio
= Rs.750,000/0.40 = Rs.1,875,000
Break-even point in units = Rs.1,875,000/Rs.150 per unit = 12,500 units.
SPOTLIGHT

If budgeted sales are 15,000 units, the margin of safety is 2,500 units (15,000 – 12,500).
This is 1/6 or 16.7% of the budgeted sales volume.
STIKCY NOTES

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4. MULTI PRODUCT CVP ANALYSIS

4.1 Breakeven analysis – Contribution per batch or per unit
The techniques for contribution margin can be extended to multi-product analysis. However, in order to do this
we need to make a further assumption (which might seem very unrealistic).
This assumption is that products are sold in a set ratio which does not change with volume. This assumption
allows us to calculate a weighted average contribution per unit or batch and/or CS ratio which can be used to
solve breakeven, margin of safety and target profit problems.

Formula: Breakeven point for batches

Total fixed costs
Break-even point in batches =

AT A GLANCE
Contribution per batch

Total fixed costs

Break-even point in revenue =
CS ratio for the batch

 Example 16:
The following budget information refers to the two products of a company.

X Y
Sales price per unit 100 120

SPOTLIGHT
Variable cost per unit (75) (111)
Contribution per unit 25 9
Sales volume 15,000 5,000
Sales mix 3 1
CS ratio 0.25 0.075
Fixed costs 315,000

In calculating the number of units at which the company will breakeven using the average
contribution per batch and the average contribution per unit and the revenue, please see below

STIKCY NOTES
Average contribution per batch
X and Y are sold in the ratio of 3:1 (15,000:5,000) therefore the average contribution per batch
is: (3× 25) + (1×9) = Rs.84
Breakeven as a number of batches is given by:
Fixed costs/Contribution per batch = Rs.315,000/Rs.84 = 3,750 batches

Units
Batches X Y
(3 per batch) (1 per batch)
Breakeven 3,750 11,250 3,750
Revenue per unit Rs.100 Rs.120
Revenue 1,125,000 450,000 = 1,575,000

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4.2 Breakeven analysis – C/S ratio

 Example 16 (Contd):
The following budget information refers to the two products of a company.

X Y
Sales price per unit 100 120
Variable cost per unit (75) (111)
Contribution per unit 25 9
Sales volume 15,000 5,000
Sales mix 3 1
AT A GLANCE

CS ratio 0.25 0.075

Fixed costs 315,000

For breakeven revenue using the average C/S ratio and the unit sales first average Average
contribution and revenue per batch (as before) would be calculated that is
Average contribution per batch (as before): (3× 25) + (1×9) = Rs.84
Average revenue per batch: (3× 100) + (1×120) = 300 + 120 = Rs.420
Note that 300 out of every 420 will be revenue from selling X and 120 from selling Y.
Weighted average CS ratio: Rs.84/Rs.420 = 0.20
Breakeven in revenue is given by
SPOTLIGHT

Fixed costs/CS ratio = Rs.315,000/0.20 = Rs.1,575,000

Units
Revenue X (300/420) Y (120/420)
Breakeven 1,575,000 Rs.1,125,000 Rs.450,000
Revenue per unit ÷ Rs.100 ÷ Rs.120
Units 11,250 3,750 = 15,000 units

4.3 Margin of safety – Multi product

STIKCY NOTES

The margin of safety is calculated in the same way as for single products by comparing the budgeted activity level
to the breakeven. The breakeven point can be compared to the budgeted activity level using batches, units or
revenue.
This will be illustrated using the previous example.
 Example 16 (Contd):
Margin of safety
Batches Units Revenue
Budgeted activity 5,000 20,000 2,100,0001
Breakeven point 3,750 15,000 3,750
Margin of safety 1,250 5,000 450,000
Margin of safety as percentage of sales 25% 25% 25%
1 Budgeted revenue = (Rs.100 × 15,000) + (Rs.120 × 5,000) = Rs.2,100,000

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4.4 Target profit

The target profit is calculated in the same way as for single products. The necessary contribution to earn the
target profit is the target profit plus the fixed costs. The activity level required to achieve the necessary
contribution may be found using contribution per unit, contribution per batch or the CS ratio.
 Example 16 (Contd):
The company wishes to make a profit of Rs.189,000 on a fixed cost base of Rs.315,000
Average contribution per batch = Rs.84
Average contribution per unit = Rs.21
Weighted average CS ratio = 0.20
Target profit

AT A GLANCE
Batches Units Revenue
Target profit (Rs.189,000 + Rs.315,000) Rs.504,000 Rs.504,000 Rs.504,000
Contribution per batch Rs.84
Contribution per unit Rs.21
C/S ratio 0.20
6,000 24,000 Rs.2,520,000
Sales of X (×3 and × ¾) 18,000 18,000
Sales of Y (×1 and × ¼) 1,000 6,000

SPOTLIGHT
Proof of revenue

X Y
Units to be sold 18,000 6,000
Selling price per unit 100 120
Revenue 1,800,000 720,000 Rs.2,520,000

STIKCY NOTES

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5. COMPREHENSIVE EXAMPLES
 Example 01:
Sword Leather Limited (SLL) produces and sells shoes. The following information pertains to its
latest financial year:

Rs. in million
Sales (62,500 pairs) 187.5
Fixed production overheads 35.0
Fixed selling and distribution overheads 10.0
AT A GLANCE

Variable production cost (in proportion of 40:35:25 for material, labor

60% of sale
and overheads respectively)
Variable selling and distribution cost 15% of sale

To increase profitability, SLL has decided to introduce new design shoes and discontinue the
existing deigns. In this regard it has carried out a study whose recommendations are as follows:
i. Replace the existing fully depreciated plant with a new plant at an estimated cost of Rs.
50 million. The new plant would:
 reduce material wastage from 10% to 5%;
 decrease direct wages by 5%; and
 increase variable overheads by 6% and fixed overheads by Rs. 15 million
SPOTLIGHT

 (including depreciation on the new plant).

ii. Improve efficiency of the staff by paying 1% commission to marketing staff and annual
bonus amounting to Rs. 1.5 million to other staff.
iii. Introduction of new designs would require an increase in variable selling and
distribution cost by 2%.
iv. Sell the newly designed shoes at 10% higher price.
v. Maintain finished goods inventory equal to one month’s sale.
if the budgeted sale has been determined with the objective of maintaining 25% margin
of safety on sale, computation of budgeted production for the first year would be as
follow:
STIKCY NOTES

Budgeted production of the new design shoes for the first year Rs. per unit
Sales 187,500,000÷62,500×1.1 (A) 3,300.00
Variable costs:
Direct material (3,000×0.6×0.4)÷1.1×1.05 (687.27)
Direct wages 3,000×0.6×0.35×0.95 (598.50)
Production overheads 3,000×0.6×0.25×1.06 (477.00)
Selling and distribution 3,000×0.15×1.02 (459.00)
Sales commission to marketing staff 3,300×1% (33.00)
(B) (2,254.77)
Contribution margin (C) 1,045.23
Total fixed cost (Rs.) (35+10+15+1.5) (D) 61,500,000

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Budgeted production: No. of pairs

Break-even sales D÷C (E) 58,839
Margin of safety on sales at 25% E÷0.75×0.25 19,613
Budgeted sales (F) 78,452
Inventory - average one month's sales F ÷12 6,538
Budgeted production 84,990

 Example 02:
The manager of a small printing business has received enquires about printing three different
types of advertising leaflet, type A, type B and type C. Selling price and cost information for these

AT A GLANCE
leaflets is shown below:

Leaflet type: Type A Type B Type C

Rs. Rs. Rs.
Selling price, per 1,000 leaflets 300 660 1,350
Estimate printing costs:
Variable costs, per 1,000 leaflets 120 210 390
Specific fixed costs per month 7,200 12,000 28,500

In addition to the specific fixed costs, Rs.12,000 per month will be incurred in general fixed costs.

SPOTLIGHT
Assuming that fixed orders have been received to print 50,000 of Leaflet A and 50,000 of Leaflet
B each month, the quantity of Leaflet C that must be sold to produce an overall profit, for all three
leaflets combined, of Rs.5,400 per month would be calculated as follows:
Tutorial note: The volume of sales required to achieve a target profit is an application of CVP
analysis.

Rs. Rs.
Target profit 5,400
General fixed costs 12,000
Specific fixed costs:

STIKCY NOTES
Leaflet Type A 7,200
Leaflet Type B 12,000
Leaflet Type C 28,500
Total contribution required 65,100
Contribution from:
50,000 Leaflets Type A: (50  (300 – 120)) 9,000
50,000 Leaflets Type B: (50  (660 – 210)) 22,500
31,500
Contribution required from Leaflets Type C 33,600

The contribution from Leaflets Type C is Rs.(1,350 – 390) = Rs.960 per 1,000 leaflets.
The sales quantity of Leaflets Type C required to achieve a target profit of Rs.5,400 each month
is therefore Rs.33,600/Rs.960 per 1,000 = 35,000 leaflets.

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In addition, the printing business now receives an enquiry from a customer about printing
30,000 of a different type of leaflet. The customer is willing to pay Rs.25,000. The variable labor
and overhead costs of producing these leaflets would be Rs.80 per 1,000 leaflets.
The leaflets would be printed on a special type of paper. This costs Rs.500 per 1,000 leaflets.
However, there are already sufficient quantities of the paper in inventory for 20,000 of the
leaflets. This special paper was purchased three months ago for a customer who then cancelled
his order. The material has a disposal value of Rs.1,500, but it could also be used to produce
20,000 units of leaflet C. The cost of normal paper for leaflet C is Rs.300 per 1,000 leaflets.
In calculating the relevant costs of making the leaflets for this special order, when it is required
to indicate by how much profit would increase as a result of undertaking the order, please see
below:

Relevant costs Rs.

AT A GLANCE

Materials
To be purchased: 10,000  Rs.500/1,000 5,000
Currently held in inventory 6,000
(Relevant cost = higher of [Rs.1,500 and (20,000  Rs.300/1,000)]
Variable costs of labor/overheads 2,400
(30,000  Rs.80/1,000)
Total relevant costs (13,400)
Contract price 25,000
SPOTLIGHT

Incremental profit 11,600

 Example 03:
Himalayan Rivers (HR) is planning to install a new plant. Planned production from the plant for
the next year is 150,000 units. Cost of production is estimated as under:

Rs. In million
Direct material 6.00
Direct Labor 5.00
Production overheads 10.29
STIKCY NOTES

Production overheads include the following:

i. Factory premises would be acquired on rent at a cost of Rs. 1.8 million per annum.
ii. Indirect labor has been budgeted at 30% of direct labor cost, 50% of which would be
fixed.
iii. Depreciation of the plant would be Rs. 0.5 million.
iv. Total power and fuel cost has been budgeted at Rs. 3 million. 80% of power and fuel cost
would vary in accordance with the production.
v. All remaining production overheads are variable.
The sales and marketing budget includes the following:
i. Employment of two sales representatives at a monthly salary of Rs. 25,000 each and a
sales commission of 2% on sales achieved.

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ii. Hiring of a delivery van at Rs. 70,000 per month. (iii) Launching an advertisement
campaign at a cost of Rs. 1.5 million
The breakeven sales revenue and quantity for the next year if HR expects to earn a contribution
margin of 40% on sales, net of 2% sales commission, would be calculated as follows.

Break-even sales revenue and quantity Rs. in million

Break even sales revenue 6.59(W-2)÷[(100–2)×40%] 16.81
Break even sales quantity [16,810,000÷200(W.1)] Units 84,050

W-1: Sales price per unit Rs. in million

AT A GLANCE
Variable overheads (excluding 2% sales commission):
Direct material 6.00
Direct labor 5.00
Variable overheads 10.29-3.65 (W-2) 6.64
17.64
Variable overheads % to sales [100-(100-2)40%]–2% 58.80%

Sales price per unit (17.64÷58.8%)÷150,000 Rs. 200.00

SPOTLIGHT
W-2: Fixed cost Rs. in million
Production overheads:
Rent - factory premises 1.80
Indirect labor 530%50% 0.75
Depreciation of plant 0.50
Power and fuel 320% 0.60
3.65
Sales and marketing expenses:

STIKCY NOTES
Employees’ salaries 25,000212 0.60
Delivery van 70,00012 0.84
Advertisement campaign 1.50
Total fixed overheads 6.59

 Example 04:
Following information has been extracted from the projected results of Saffron Limited (SL) for
the year ending 31 March 2019:

Sales Rs. 160 million

Contribution margin 30%
Margin of safety 25%

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Information for the next year ending 31 March 2020:

i. SL is planning to increase its sales by reducing sales prices by 5% and launching a sales
campaign at a cost of Rs. 5 million.
ii. Cost efficiency measures planned for the next year are expected to reduce variable cost
per unit by 10%.
iii. Inflation impact on all costs would be 8%, except depreciation. At present, depreciation
is 40% of the total fixed cost.
iv. Margin of safety would be maintained at 25%.
a) A budgeted statement of profit or loss for the year ending 31 March 2020 based on the
above projections, would be as follows:
AT A GLANCE

Budgeted statement of profit or loss for the year ending 31 March 2020
Rs. in million
Sales 152(W-2)÷43.14×56.97 200.73
Variable cost Balancing (143.76)
Contribution margin (CM) (at a safety margin of 25% and fixed cost of 56.97
Rs. 42.73 million) [42.73(W-1)÷0.75]
Fixed cost (W-1) (42.73)
Net profit 14.24
W-1: Fixed Cost
SPOTLIGHT

- For 2019 (160×0.3×0.75) 36.00

- For 2020:
Depreciation (36×0.4) 14.40
Other fixed cost (36-14.40)×1.08+5 28.33
42.73
W-2: CM on revision of sales price and variable cost Rs. in million
Sales (160×0.95) 152.00
Variable cost (160×0.7)×1.08×0.9 (108.86)
Contribution margin 43.14
STIKCY NOTES

b) The percentage increase in sales volume would be

Increase in sales volume %:
Budgeted sales of 2019-20 at 2018-19 prices (200.73÷0.95) 211.29
Increase in sales volume (%) (211.29–160)÷160 32.06%

 Example 05:
Digital Industries Limited (DIL) incurred a loss for the year ended 30 June 2017 as it could
achieve sales amounting to Rs. 89.6 million which was 80% of the break-even sales. Contribution
margin on the sales was 25%. Variable costs comprised of 45% direct material, 35% direct labor
and 20% overheads.
During a discussion on the situation, the Marketing Director was of the view that no increase in
sales price was possible due to severe competition. However, sales volume can be increased by
reducing prices. The Production Director was of the view that since the plant is quiet old, the
production capacity cannot be increased beyond the current level of 70%.

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Accordingly, the management has developed the following plan:

A new plant would be installed whose capacity would be 20% more than installed capacity of the
existing plant. The cost and useful life of the plant is estimated at Rs. 30 million and 10 years
respectively. The funds for the new plant would be arranged through a long-term bank loan at a
cost of 10% per annum. Capacity utilization of 85% is planned for the first year of the operation.
The new plant would eliminate existing material wastage which is 5% of the input and reduce
direct labor hours by 8%.
The existing plant was installed fifteen years ago at a cost of Rs. 27 million. It has a remaining
useful life of three years and would be traded in for Rs. 2 million.
DIL depreciates its fixed assets on straight line basis over their estimated useful lives.
To sell the entire production, selling price would be reduced by 2%.

AT A GLANCE
Material would be purchased in bulk quantity which would reduce direct material cost by 10%.
Direct wages would be increased by 8% which would increase production efficiency by 10%.
Impact of inflation on overheads would be 4%.
In order to calculate the projected sales for the next year and the margin of safety percentage
after incorporating the effect of the above measures, please see below:
Digital Industries Limited
Projected sales and margin of safety % for the next year

Rs. in million

SPOTLIGHT
Projected sales for the next year (89.6÷0.7)×1.2×0.85×0.98 (A) 127.95
Margin of safety % to projected sales (A-B)÷A×100 8.66%
Break-even sales [A÷ (A-C) × D] (B) 116.87
Variable cost:
Variable cost – 2017 level of 75% [127.95(A)÷0.98]×0.75 97.92

Variable cost on incorporating impact of changes:

Direct material (97.92×0.45)×0.95×0.9 37.67
Direct labor (97.92×0.35)×0.92×0.9×1.08 30.65

STIKCY NOTES
Overheads (97.92×0.20)×1.04 20.37
Variable cost – projected (C) 88.69

Fixed cost - projected:

Fixed cost – 2017 (equal to CM for break-even sales) (89.6÷0.8) ×0.25 28.00
Depreciation - old plant 27÷(15+3) (1.50)
26.50
Impact of 4% inflation 26.5×4% 1.06
Depreciation - new plant 30÷10 3.00
Long-term loan interest at 10% (30-2) ×10% 2.80
Loss on Disposal (4.5-2) 2.50
(D) 35.86

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 Example 06:
Washington Limited (WL) is a listed company having paid-up capital of Rs. 140 million. WL deals
in the manufacturing of washing machines. Following are the extracts from the budgeted
statement of profit or loss for the year ending 31 December 2018:

Rs. in ‘000
Sales revenue (Rs. 10,000 per unit) 168,000
Cost of goods sold (including fixed cost of Rs. 21.2 million) (127,000)
Gross profit 41,000
Operating expenses (including fixed cost of Rs. 4.5 million) (16,000)
AT A GLANCE

Profit before taxation 25,000

Taxation @ 30% (7,500)
Profit after taxation 17,500

Additional information:
i. An analysis of actual results for the first two months of the year 2018 shows that:
 Due to change in import duty structure, imported products have become available
in the market at much cheaper prices. Consequently, it was decided to reduce the
selling price to Rs. 9,500 per unit with effect from 1 January 2018.
 1,500 washing machines were sold during the period.
SPOTLIGHT

 Due to increase in raw material prices with effect from 1 January 2018, variable
cost of sales has increased by 5%.
ii. To boost the sales, WL has decided to launch a promotion campaign at an estimated cost
of Rs. 5 million.
iii. The directors of WL wish to pay 5% dividend to its ordinary shareholders. However,
according to the agreement with the bank, WL cannot pay dividend exceeding 80% of its
profit after taxation.
The minimum number of units to be sold in remaining 10 months to enable WL to pay the desired
dividend can be calculated as follows:
STIKCY NOTES

Washington Limited Rupees

Dividend needs to pay 140,000,000×5% 7,000,000
Profit after tax (required) (7,000,000÷0.8) 8,750,000

Required contribution margin in remaining 10 months

Profit before tax (required) 8,750,000 /70% 12,500,000
Add: Fixed cost (Jan - Dec) (21,200,000+4,500,000) 25,700,000
Add: Promotion campaign Given 5,000,000
Contribution margin required 43,200,000
Contribution margin recovered in 1st two months (W-1) (3,304,464)
Required contribution in remaining 10 months 39,895,536

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Rupees
Forecasted sales revenue to earn in next 10 months 172,037,670
39,895,536/23.19%(W-1)
Number of units to be sold 172,037,670/9,500 18,109
W-1: Actual results of first two months of 2018
Sales 1,500×9,500 14,250,000.00
Variable manufacturing cost 9,918,750.00
(127,000,000–21,200,000)/ *16,800×1.05×1,500
Variable operating cost (16,000,000–4,500,000)/16,800×1,500 1,026,785.71

AT A GLANCE
Contribution margin 3,304,464.29
Contribution margin % 23.19%
*Budgeted number of units to be sold 168,000,000/10,000 16,800

 Example 07:
Basketball (Private) Limited (BPL) is in the process of planning for the next year. BPL is currently
operating at 70% of the production capacity. The management wants to achieve an increase of
Rs. 36 million in profit after tax of the latest year.
The summarized statement of profit or loss for the latest year is as follows:

Rs. in million

SPOTLIGHT
Sales 567
Cost of sales (60% variable) (400)
Gross profit 167
Operating expenses (40% variable) (47)
Profit before tax 120
Tax (25%) (30)
Profit after tax 90

Following are the major assumptions/projections for the next year’s budget:

STIKCY NOTES
i. Selling price of all products would be increased by 8%. However, to avoid any adverse
impact of price increase, 10% discount would be offered to the large customers who
purchase about 30% of the total sales. Additionally, distributor commission would be
increased from 2% to 3% of net selling price.
ii. Average variable costs other than distributor commission are projected to increase by
4% while fixed costs other than depreciation are projected to increase by 5%.
iii. Depreciation for the latest year was Rs. 90 million and would remain constant.
The amount of sales required to achieve the target profit and well as the production capacity that
would be utilized to achieve the calculated amount of sales would require following working:

Basketball Private Limited Rs. in million

Budgeted sales to achieve target profit

[361.11m (W-1)/53.7%(W-2)] 672.46

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W-1: Contribution margin required in next year

Total existing fixed cost including depreciation
(400m×40%)+(47m×60%) 188.20
Add: Increase in fixed costs in next year (188.2m–90m)×5% 4.91
Add: Target profit for the next year (90m+36m)÷75% 168.00
Total contribution margin required in next year 361.11
W-2: Budgeted Contribution margin (next year)
Budgeted sales [567m×1.08] 612.36
Less: Discount @ 10% on 30% of sales [612.36m×10%×30%] (18.37)
AT A GLANCE

Net average sales 593.99

Less: Distributor commission on net average sales [593.99m×3%] (17.82)
Less: Variable cost [247.46m (W-3)×1.04] (257.36)
Budgeted contribution margin 318.81
Budgeted contribution margin ratio (318.81m/593.99m) 53.7%
W-3: Variable cost (existing)
Distributor commission (567m×2%) 11.34
Variable cost [{(400m×60%)+(47m×40%)} –11.34m] 247.46
Average increase in selling price
SPOTLIGHT

(1.08×30%×90%)+(1.08×70%) OR [1.08–(1.08×10%×30%)] A 1.0476

Capacity to be utilized during next year
[(672.46m (part a)÷A) ÷ (567m÷70%)] 79.25%

 Example 08:
Solvent Limited has two divisions each of which makes a different product. The budgeted data
for the next year is as under:

Product A Product B
Rupees
Sales 200,000,000 150,000,000
STIKCY NOTES

Direct material 45,000,000 30,000,000

Direct labor 60,000,000 45,000,000
Factory overheads 35,000,000 15,000,000
Price per unit 20 25

Details of factory overheads are as follows:

i. Product A is stored in a rented warehouse whose rent is Rs. 0.25 million per month.
Product B is required to be stored under special conditions. It is stored in a third party
warehouse and the company has to pay rent on the basis of space utilized (varies in
accordance with the production in units). The rent has been budgeted at Rs. 0.12 million
per month.
ii. Indirect labor has been budgeted at 20% of direct labor. 70% of the indirect labor is
fixed.

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iii. Depreciation for assets pertaining to product A and B is Rs. 6.0 million and Rs. 2.0 million
respectively.
iv. 80% of the cost of electricity and fuel varies in accordance with the production in units
and the total cost has been budgeted at Rs. 4.0 million.
v. All other overheads are fixed.
The break-even sales assuming that the ratio of quantities sold would remain the same, as has
been budgeted above would be calculated as follows:

Solvent Limited Product A Product B Total

Sale – units 10,000,000 6,000,000 16,000,000
Sales price per unit 20 25

AT A GLANCE
Sales in Rupees 200,000,000 150,000,000 350,000,000

Less: Variable costs Product A Product B Total

Direct material 45,000,000 30,000,000 -
Direct labor 60,000,000 45,000,000 -
Variable overheads (Note 1) 5,600,000 5,340,000 -
110,600,000 80,340,000 190,940,000
Contribution margin Rs. 89,400,000 69,660,000 159,060,000
Contribution margin % to sales 45.446%

SPOTLIGHT
Break even sales revenue:
Total 39,060,000/0.45446 85,948,699

Budgeted sales ratio Revenue (Rs.) Ratio

Product A revenue 200,000,000 4
Product B revenue 150,000,000 3
Total revenue 350,000,000 7
Revenue from A at breakeven 49,113,542
85,948,699  4/7

STIKCY NOTES
Revenue from B at breakeven 36,835,157
85,948,699  3/7
Sales price per unit ÷20 ÷25
Quantity of A: 49,113,542/20 2,455,677
Quantity of A: 36,835,157/25 1,473,406
Note 1: Variable & fixed overheads:
Total overheads as given 35,000,000 15,000,000 50,000,000
Variable overheads:
- Rent based on space utilized
120,000 * 12 - 1,440,000 -
- Indirect labor
60,000,000*20%*30% 3,600,000

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Budgeted sales ratio Revenue (Rs.) Ratio

45,000,000*20%*30% 2,700,000 -
- Electricity & fuel
(4,000,000*80%)/16,000,000*10,000,000 2,000,000 - -
(4,000,000*80%)/16,000,000*6,000,000 - 1,200,000 -
Variable overheads (5,600,000) (5,340,000) (10,940,000)
Fixed costs (Total overheads-Variable 29,400,000 9,660,000 39,060,000
overheads)

 Example 09:
KPK Dairies Limited (KDL) is planning to introduce three energy flavored milk from 1 July 2015.
AT A GLANCE

In this respect, following projections have been made:

C-Plus I-Plus V-Plus

Planned production (No. of packets) 540,000 275,000 185,000
Sales (No. of packets) 425,000 255,000 170,000
Production cost per packet: ----------- Rupees -----------
Direct material 100 98 97
Direct labor 15 13 12
Variable overheads 23 19 16
SPOTLIGHT

Fixed overheads 25 22 20
Selling and distribution cost per packet:
Variable overheads 12 8 10
Fixed overheads 5 5 5
Total cost per packet 180 165 160

KDL will sell its products through a distributor at a commission of 5% of sale price and expects
to earn a contribution margin of 40% of net sales i.e. sales minus distributor's commission.
Computation for breakeven sales in packets and rupees, assuming that ratio of quantities sold
STIKCY NOTES

would be as per projections would require:

KPK Dairies Limited
Break-even sales: C-Plus I-Plus V-Plus Total
- In total – No. of packets(H÷G) A 287,660
- Product wise – No. of packets (A×C) B 143,830 86,298 57,532 287,660
- Product wise – Rupees (B×D) 37,850,303 20,893,609 13,625,879 72,369,791

W.1: Sales quantity ratio ----------------------------Liters----------------------------

Projected sales 425,000 255,000 170,000 850,000
Sales quantity ratio C 0.5 0.3 0.2 1.0

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W.2: Contribution margin per combination: -------------------------- Rupees --------------------------

Gross sales price per unit (E÷0.57*) D 263.16 242.11 236.84
Commission at 5% of sales (13.16) (12.11) (11.84)
Variable cost per unit E (150.00) (138.00) (135.00)
(100+15 (98+13+ (97+12+
+23+12) 19+8) 16+10)
Contribution margin (CM) per unit F 100.00 92.00 90.00
CM in sales quantity ratio(C×F) G 50.00 27.60 18.00 95.60
VC% to sales: (100-5%) × 60% = 57%*

AT A GLANCE
W-3: Fixed overheads
Production fixed 13,500,000 6,050,000 3,700,000
overheads (540,000×25) (275,000×22) (185,000×20) 23,250,000
Selling and distribution 2,125,000 1,275,000 850,000
fixed overheads (425,000×5) (255,000×5) (170,000×5) 4,250,000
H 27,500,000

 Example 10:
Khan Limited (KL) imports and sells a product ‘AA’. KL is faced with a situation where lead time
is mostly predictable i.e. 1 month but lead time usage varies quite significantly. Data collected for

SPOTLIGHT
past three years shows that probability for lead time usage is as follows:

No. of units demanded during lead time Probability of demand during lead time (%)
1,000 30
660 50
450 20

Other relevant information is as follows:

i. Annual demand is 8,640 units.
ii. Contribution margin is Rs. 40 per unit.

STIKCY NOTES
iii. Purchase orders are raised on the basis of economic order quantity model. Annual
iv. holding cost is Rs. 100 per unit whereas average cost of placing an order is Rs. 6,750.
Following re-order levels are to be evaluated where KL’s profit would be maximized:
 1,000 units
 450 units

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Also expected demand during lead time can be determined as follows

Reorder Demand Stock out Stock out Stock Average Holding Expected
level level per order per year out cost inventory cost Probability total cost
(Units) (Units) (Units) (Units) (Rs.) (Units) (Rs.) (Rs.)
d= c× g=[a–b+
a b c 8(W-2) e=d×40 EOQ h=g×100 i j=(h+e)×i
(W-1)]/2
1,000 - - - 540 54,000 30% 16,200
1,000 660 - - - 880 88,000 50% 44,000
AT A GLANCE

450 - - - 1,090 109,000 20% 21,800

82,000
1,000 550 4,400 176,000 540 54,000 30% 69,000
450 660 210 1,680 67,200 540 54,000 50% 60,600
450 - - - 540 54,000 20% 10,800
140,400
1,000 280 2,240 89,600 540 54,000 30% 43,080
720 660 - - - 600 60,000 50% 30,000
(W-3)
450 - - - 810 81,000 20% 16,200
SPOTLIGHT

89,280

Conclusion: Profit would be maximized at re-order level of 1,000 units.

Rupees
W-1: EOQ (Units) = SQRT[ 2×8,640×6,750)/100] 1,080.00
W-2: No. of orders (8,640/1,080) 8.00
W-3: Expected value (1,000×30%)+(660×50%)+(450×20%) 720.00
STIKCY NOTES

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STICKY NOTES

Cost-volume-profit analysis is used to how changes in costs and profits with

the change in volume activity.

Contribution is measured as sales revenue less variable costs. And profit is

measured as contribution minus fixed costs.

AT A GLANCE
Breakeven point is the point where total contribution is exactly equal to total
fixed cost. It is calculated by dividing total fixed costs with contribution per
unit.

Margin of safety is the difference between budgeted sales and the break-even
amount of sales. It is usually expressed as a percentage of the budgeted sales.

SPOTLIGHT
If the target profit is known, then the volume of sales desired to achieve the
target profit can be calculated using the formula as below:
Volume target (units) = (Total fixed costs + target profit)/contribution per
unit

Breakeven chart is a visual representation showing all volumes of output and

sales with their total costs, sales, profits and break-even points.

STIKCY NOTES

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

484 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 15

DECISION MAKING TECHNIQUES

AT A GLANCE
IN THIS CHAPTER Management are often required to make decisions where
company is at stake. These decisions are required to make
AT A GLANCE where factors or sources are limited, Concepts of relevant

AT A GLANCE
costing and cost-volume-profit analysis are used for such
SPOTLIGHT decisions.
One-off contract decisions, special pricing decisions, make or
1. Introduction To Decision
buy decisions and many other short term decisions including
Making
join product, discontinuation of operations, replacement of
equipment or plant and further processing decisions, are some
2. Limiting Factor Decisions
of the decision making areas that may need management’s
attention.
3. Make Or Buy Decisions:

4. Other Short Term Decisions

5. Comprehensive Examples

SPOTLIGHT
STICKY NOTES

STIKCY NOTES

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1. INTRODUCTION TO DECISION MAKING

1.1 Types of decision
Relevant costs can be applied to both short-term and long-term decisions.
 Short-term decisions are decisions where the financial consequences occur soon after the decision is taken.
For example, a short-term decision may result in an immediate increase in profit (additional net cash
inflows), or an increase in annual profits and cash flows.
 A long-term decision is one where a capital investment may be required and the benefits of the investment
will be obtained over a period of several years.
The concept of relevant costs is the same for both short-term and long-term decisions, except that for long-term
AT A GLANCE

decisions the time value of money should also be taken into consideration.
Examples of management decisions where relevant costing is used are:
 Limiting factor decisions
 One-off contract decisions: management might want to decide whether or not to undertake a contract for a
specified fixed price. If it is a one-off contract, rather than regular production work, it would be worthwhile
undertaking the contract if the extra revenue from the contract is higher than the relevant costs of doing the
work (including any opportunity costs).
 Make-or-buy decisions
 Shutdown decisions
 Joint product further processing decisions.
SPOTLIGHT

1.2 Marginal costing and decision-making

It is often assumed that marginal costs are relevant costs for the purpose of decision-making.
 The marginal cost of a product is the extra cost that would be incurred by making and selling one extra unit
of the product.
 Similarly, the marginal cost of an extra hour of direct labor work is the additional cost that would be incurred
if a direct labor employee worked one extra hour. When direct labor is a variable cost, paid by the hour, the
marginal cost is the variable cost of the direct labor wages plus any variable overhead cost related to direct
labor hours.
This chapter focuses on decision-making when there are limiting factors that restrict operational capabilities.
STIKCY NOTES

Decision-making techniques for limiting factor situations are based on the following assumptions:
 The objective is to maximize profit and this is achieved by maximizing contribution;
 Marginal costs (variable costs) are the only relevant costs to consider in the model: and
Fixed costs will be the same whatever decision is taken; therefore, fixed costs are not relevant to the decision.

1.3 Incremental cost analysis

Incremental analysis helps companies decide whether or not to accept a special order. This special order is
typically lower than its normal selling price. Incremental analysis also assists with allocating limited resources
to several product lines to ensure a scarce asset is used to maximum benefit.
 Example 01:
A company sells an item for Rs. 500,000. The company pays Rs. 200,000 for labor, Rs. 100,000
for materials and Rs. 50,000 for variable overhead selling expenses. The company allocates Rs.
50,000 per item for fixed overhead costs.

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The company is not operating at capacity and will not be required to invest in equipment or
overtime to accept a special order it receives. Then, a special order requests the purchase of 20
items for Rs. 400,000 each.
The sum of all variable costs and fixed costs per item is Rs. 400,000. However, the Rs. 50,000 of
allocated fixed overhead costs are a sunk cost as already spent. The company has excess capacity
and should only consider the relevant costs. Therefore, the cost to produce the special order is
Rs. 350,000 per item (Rs. 200,000 + Rs. 100,000 + Rs. 50,000) and the profit per item is Rs. 50,000
(Rs. 400,000 – Rs. 350,000).
While the company is still able to make a profit on this special order, the company must consider
the consequences of operating at full capacity. If no excess capacity is present, additional
expenses to consider include investment in new fixed assets, overtime labor costs, and the
opportunity cost of lost sales.

AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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2. LIMITING FACTOR DECISIONS

2.1 Limiting factor: the issue
It is often assumed in budgeting that a company can produce as many units of its products (or services) as is
necessary to meet the available sales demand. Sales demand is therefore normally the factor that sets a limit on
the volume of production and sales in each period.
Sometimes, however, there could be a shortage of a key production resource, such as an item of direct materials,
or skilled labor, or machine capacity. In these circumstances, the factor setting a limit to the volume of sales and
profit in a particular period is the availability of the scarce resource, because sales are restricted by the amount
that the company can produce.
If the company makes just one product and a production resource is in limited supply, profit is maximized by
AT A GLANCE

making as many units of the product as possible with the limited resources available.
However, when a company makes and sells more than one products with the same scarce resource, a budgeting
problem is to decide how many of each different product to make and sell in order to maximize profits.

2.2 Identifying limiting factors

A question might tell you that there is a restricted supply of a resource without telling you which one it is.
In this case you must identify the limiting factor by calculating the budgeted availability of each resource and the
amount of the resource that is needed to meet the available sales demand.
 Example 02:
A company manufactures and sells two products, Product X and Product Y which are both
manufactured using two different machines.
SPOTLIGHT

The time taken to make each product together with the maximum machine time availability and
contribution per unit and demands are as follows:
Product X Y Hours available
Machine type 1 10 minutes per unit 6 minutes per unit 3,000 hours
(6 per hour) (10 per hour)
Machine type 2 5 minutes per unit 12 minutes per unit 4,200 hours
(12 per hour) (5 per hour)
Sales demand in units 12,000 15,000
Which machine is the limiting factor is identified by calculating the time needed to meet the total
STIKCY NOTES

demands for both goods and comparing that to the machine time available:
Machine type 1 Machine type 2
(hours) (hours)
12,000 ÷ 6 per hour 2,000
12,000 ÷ 12 per hour 1,000
Making 15,000 units of Y would use:
15,000 ÷ 10 per hour 1,500
15,000 ÷ 5 per hour 3,000
Total hours needed to meet maximum demand 3,500 4,000
Total hours available 3,000 4,200
Therefore, machine 1 time is the limiting factor

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2.3 Maximizing profit when there is a single limiting factor

When there is just one limiting factor (other than sales demand), total profit will be maximized in a period by
maximizing the total contribution earned with the available scarce resources.
The approach is to select products for manufacture and sale according to the contribution per unit of scarce
resource in that product.
Step 1: Calculate the contribution per unit of each type of good produced.
Step 2: Identify the scarce resource.
Step 3: Calculate the amount of scarce resource used by each type of good produced.
Step 4: Divide the contribution earned by each good by the scarce resource used by that good to give the
contribution per unit of scarce resource for that good.

AT A GLANCE
Step 5: Rank the goods in order of the contribution per unit of scarce resource.
Step 6: Construct a production plan based on this ranking. The planned output and sales are decided by working
down through the priority list until all the units of the limiting factor (scarce resource) have been used.
 Example 03:
A company manufactures and sells two products, Product X and Product Y which are both
manufactured using two different machines.
The time taken to make each product together with the maximum machine time availability and
contribution per unit and demands are as follows:

Product X Y Hours available

SPOTLIGHT
Machine type 1 10 minutes per unit 6 minutes per unit 3,000 hours
(6 per hour) (10 per hour)
Machine type 2 5 minutes per unit 12 minutes per unit 4,200 hours
(12 per hour) (5 per hour)
Contribution per unit Rs. 7 Rs. 5
Sales demand in units 12,000 15,000

Given that machine 1 is a limiting factor the optimal production plan (that which maximizes
annual contribution and hence profit) can be found as follows:
Step 1: Calculate the contribution per unit of goods produced (given)

STIKCY NOTES
Step 2: Identify scarce resource (given as machine 1 in this case)
Step 3: Calculate the amount of scarce resource used to make each type of product (given in this
case)
Step 4: Contribution per unit of scarce resource (machine time)

Product X Y
Contribution per unit Rs. 7 Rs. 5
Machine type 1 time per unit 10 minutes 6 minutes
Contribution per hour (Machine type 1) Rs. 42 Rs. 50
Step 5: Ranking 2nd 1st

The products should be made and sold in the order Y and then X, up to the total sales demand for
each product and until the available machine 1 time is used completely.

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Step 6: Construct a production plan to maximize contribution

Machine 1 hours Contribution Total
Product Sales units
used per unit (Rs.) contribution (Rs.)
Y (1st) 15,000 1,500 5 75,000
(maximum)
X (2nd ) 9,000 1,500 7 63,000
(balance)
3,000 138,000
Note: The plan is constructed as follows:
Y is ranked first so the company needs to make as many of these as possible. The most it can sell
AT A GLANCE

is 15,000 units which would take 1,500 hours (10 per hour) to make. The company has 3,000
hours available so all of these can be made.
The company now has 1,500 hours left. X is ranked second and the most of X that can be sold is
12,000 units. This would use 2,000 hours (6 per hour). This means that only 9,000 units of X can
be made (found as 1,500 units at 6 per hour or 12,000 units  1,500 hours/2,000 hours).
 Example 04:
A company makes four products, A, B, C and D, using the same direct labor work force on all the
products.
The company has no inventory of finished goods.
Direct labor is paid Rs. 12 per hour.
To meet the sales demand in full would require 12,000 hours of direct labor time.
SPOTLIGHT

Only 6,000 direct labor hours are available during the year.
Budgeted data for the company is as follows:
Product A B C D
Annual sales demand (units) 4,000 5,000 8,000 4,000
Rs. Rs. Rs. Rs.
Direct materials cost 3.0 6.0 5.0 6.0
Direct labor cost 6.0 12.0 3.0 9.0
Variable overhead 2.0 4.0 1.0 3.0
Fixed overhead 3.0 6.0 2.0 4.0
STIKCY NOTES

Full cost 14.0 28.0 11.0 22.0

Sales price 15.5 29.0 11.5 27.0
Profit per unit 1.5 1.0 0.5 5.0
The optimal production plan would be calculated as follows:
Step 1: Calculate the contribution per unit of goods produced
Product A B C D
Sales price 15.5 29.0 11.5 27.0
Direct materials cost 3.0 6.0 5.0 6.0
Direct labor cost 6.0 12.0 3.0 9.0
Variable overhead 2.0 4.0 1.0 3.0
Variable cost per unit (11.0) (22.0) (9.0) (18.0)
Contribution per unit 4.5 7.0 2.5 9.0

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Product A B C D
Step 2: Identify scarce resource (given as labor in this case)
Step 3: Labor hours per unit
(total labor cost/labor cost per hour) 6/12 12/12 3/12 9/12

0.5 1 0.25 0.75

Step 4: Contribution per hour
(contribution per unit/ labor hours per unit 4.5/0.5 7/ 1 2.5/0.25 9/0.75

Contribution per hour (Rs. ) 9 7 10 12

Step 5: Ranking 3rd 4th 2nd 1st
The products should be made and sold in the order D, C, A and then B, up to the total sales

AT A GLANCE
demand for each product and until all the available direct labor hours (limiting factor
resources) are used up
Step 6: Construct a production plan to maximize contribution
Direct labor Contribution Total
Product Sales units
hours used per unit contribution
Rs. Rs.
D (1st) 4,000 (maximum) 3,000 9.0 36,000
C (2nd) 8,000 (maximum) 2,000 2.5 20,000
A (3rd) 2,000 (balance) 1,000 4.5 9,000
6,000 65,000

SPOTLIGHT
Note: The plan is constructed as follows:
D is ranked first so the company needs to make as many of these as possible. The most it can sell
is 4,000 units which would take 3,000 hours (0.75 hours per unit) to make. The company has
6,000 hours available so all of these can be made.
The company now has 3,000 hours left. C is ranked second and the most of C that can be sold is
8,000 units. This would use 2,000 hours (0.25 hours per unit).
The company now has 1,000 hours left. A is ranked third and the most of these that can be sold
is 4,000 units. However, this would use 2,000 hours (0.5 hours per unit) so only half of these can
be made.

STIKCY NOTES
 Example 05:
A company makes four products, W, X, Y and Z, using the same single item of direct material in
the manufacture of all the products. Budgeted data for the company is as follows:
Product W X Y Z
Annual sales demand (units) 4,000 4,000 6,000 3,000
Rs. Rs. Rs. Rs.
Direct materials cost 5.0 4.0 8.00 6.00
Direct labor cost 4.0 6.0 3.00 5.00
Variable overhead 1.0 1.5 0.75 1.25
Fixed overhead 8.0 12.0 6.00 10.00
Full cost 18.0 23.5 17.75 22.25
Sales price 50.0 31.5 59.75 54.25
Profit per unit 32.0 8.0 42.00 32.00

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Due to restricted supply, only Rs. 78,000 of direct materials will be available during the year. And
it required to identify the quantities of production and sales of each product that would maximize
annual profit, please see below
This question does not tell you the amount of material but it does give you its value. The analysis
can proceed in the usual way using contribution per value of material rather than contribution
per amount of material.
W X Y Z
Rs. Rs. Rs. Rs.
Sales price/unit 50.0 31.5 59.75 54.25
Variable cost/unit 10.0 11.5 11.75 12.25
Contribution per unit 40.0 20.0 48.00 42.00
AT A GLANCE

Direct materials per unit (Rs.) 5 4 8 6

Rs. contribution per Rs.1 direct 8.0 5.0 6.0 7.0
material
Priority for making and selling 1st 4th 3rd 2nd

Profit-maximising budget
Direct Contribution Total contribution
Product Sales units
materials (Rs.) per unit (Rs.) (Rs.)
W (1st) 4,000 20,000 40 160,000
Z (2nd) 3,000 18,000 42 126,000
SPOTLIGHT

Y (3rd) - balance 5,000 40,000 48 240,000

78,000 526,000

 Example 06:
a) Company X manufactures four liquids: A, B, C and D. The selling price and unit cost details
for these products are as follows:

Liquid A Liquid B Liquid C Liquid D

Rs. per litre Rs. per litre Rs. per litre Rs. per litre
Selling price 100 110 120 120
STIKCY NOTES

Costs:
Direct materials 24 30 16 21
Direct labor (Rs.6/hour) 18 15 24 27
Direct expenses 0 0 3 0
Variable overhead 12 10 16 18
Fixed overhead (note 1) 24 20 32 36
Total cost per litre 78 75 91 102
Profit per litre 22 35 29 18

Note 1
Fixed overhead is absorbed on the basis of labor hours, based on a budget of 1,600 hours per
quarter (three months).

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During the next three months the number of direct labor hours is expected to be limited to
1,345 hours. The same labor is used for all products.
The marketing director has identified the maximum demand for each of the four products
during the next three months as follows:
Liquid A 200 liters
Liquid B 150 liters
Liquid C 100 liters
Liquid D 120 liters
No inventories are held at the beginning of the period that could be used to satisfy demand
in the period.

AT A GLANCE
If the company requires to determine the number of liters of liquids A, B, C and D to be
produced and sold in the next three months in order to maximize profits and calculate the
profit that this would yield; working is given below:

A B C D
Rs. Rs. Rs. Rs.
Sales price 100 110 120 120
Variable cost per litre 54 55 59 66
Contribution per litre 46 55 61 54
Direct labor hours/unit 3 2.5 4 4.5
Contribution /direct labor hour (Rs.) 15.33 22.00 15.25 12.00

SPOTLIGHT
Priority for manufacture/sale 2nd 1st 3rd 4th

The fixed overhead absorption rate is Rs.8 per hour. This can be calculated from the
overhead cost and direct labor hours for any of the four products.
The budgeted labor hours for calculating this absorption rate was 1,600 hours, therefore
budgeted fixed costs are 1,600 hours × Rs.8 = Rs.12,800.
The output and sales that will maximize contribution and profit is as follows:

Contribution Contribution
Product Litres Hours
/litre (Rs.) /profit (Rs.)
B1 150.0 375 55 8,250.0

STIKCY NOTES
A 200.0 600 46 9,200.0
C (balance) 92.5 370 61 5,642.5
1,345 23,092.5
Fixed costs (see above) 12,800.0
Profit 10,292.5

b) Suppose that a contract has been made before the beginning of the period by Company
X and one of its customers, Company Y. Company X has agreed to supply Company Y
with supply of 20 liters of each A, B, C and D during the three-month period.
This sales demand from Company Y is included in the demand levels shown above in
part (a) of the question.
For the above scenario please see below working for following requirements

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Given the contract with Company Y, determine the number of liters of liquids A, B, C and
D to be produced and sold in the next three months in order to maximize profits, if the
maximum number of labor hours remain 1,345 hours for the period.
The profit that this would yield, would be calculated as follows:
In this situation, there is a minimum sales demand from Company Y that must be met:

Contribution Contribution
Product Litres Hours
/litre (Rs.) (Rs.)
A: (3 hours/litre) 20 60 46 920
B: (2.5 hours/litre) 20 50 55 1,100
C: (4 hours/litre) 20 80 61 1,220
AT A GLANCE

D: (4.5 hours/litre) 20 90 54 1,080

280 4,320
Total hours available 1,345
Hours remaining 1,065

The remaining 1,065 hours should be used to maximize contribution, using the same
priorities as before. However, maximum sales demand should be reduced by 20 liters for
each product, to allow for the sales to Company Y.
The output and sales that will maximize contribution and profit, allowing for the sales to
Company Y, are as follows:

Contribution/ Contribution/
SPOTLIGHT

Product Litres Hours

litre profit
Rs. Rs.
B 130 325 55 7,150
A 180 540 46 8,280
C (balance) 50 200 61 3,050
1,065 18,480
Contribution from sales to Y 4,320
Total contribution 22,800
STIKCY NOTES

Fixed costs 12,800

Profit 10,000

 Example 07:
A company produces three products using the same raw material. The raw material is in short
supply and only 3,000 kilograms shall be available in April 2009, at a cost of Rs. 1,500 per
kilogram.
The budgeted costs and other data related to April 2009 are as follows:

X Y Z
Maximum demand (units) 1,000 800 1,200
Selling price per unit (Rs.) 3,750 3,500 4,500
Material used per unit (kg) 1.6 1.2 1.8
Labor hours per unit (Rs. 75 per hour) 12 16 15

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The number of units that should be produced by the company to earn maximum profit would be
determined as follows:
X Y Z
Selling price A 3,750 3,500 4,500
Material cost per unit at Rs. 1,500 per kilogram B 2,400 1,800 2,700
Labor cost per unit at Rs. 75 per hour C 900 1,200 1,125
Profit per unit (A – B – C) D 450 500 675
Material usage in kilograms per unit E 1.6 1.2 1.8
Profit per kg of material used (D ÷ E) F 281.25 416.67 375.00
Preferred order of manufacture 3 1 2
Maximum demand in units 1,000 800 1,200

AT A GLANCE
Total raw material available – kgs 3,000
Less: consumption for 800 units of Y (800 x 1.2 kgs) 960
Balance available 2,040
Consumption for 1,200 units of Z = (1,200 x 1.8 kgs) 2,160
Limited to 1,133 units @ 1.8 kg per unit 2,040
Balance -
Therefore, the production should be as follows:
Y = 800 units
Z = 1,133 units
In addition, the number of units to be produced if finished products are also available from an

SPOTLIGHT
external supplier at the following prices per unit:
Rupees
X 3,450
Y 3,100
Z 3,985
It would require following calculations
Product X Y Z
Selling price A 3,750 3,500 4,500
Cost of purchase B 3,450 3,100 3,985
Profit per unit from outside purchase (A – B) C 300 400 515

STIKCY NOTES
Profit from own manufacture
(as calculated in (a) above) D 450 500 675
Loss in profit on purchase as compared to own
manufacture (D – C) E 150 100 160
Material usage in kilograms per unit F 1.6 1.2 1.8
Loss in profit per kg as compared to own
manufacture (E ÷ F) G 93.8 83.3 88.9
Preferred order of manufacture 1 3 2
Total raw material available - kgs 3,000
Less: consumption for 1,000 units of X 1,600
Balance available 1,400
Consumption for 1,200 units of Z = 2,160
Limited to 778 units @ 1.8 kg per unit 1,400
Balance -

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3. MAKE OR BUY DECISIONS

3.1 Make-or-buy decisions: outsourcing
A make-or-buy decision is a decision about:
 whether to make an item internally or to buy it from an external supplier, or
 whether to do some work with internal resources, or to contract it out to another organization such as a sub-
contractor or an outsourcing organization.
The economic basis for the decision whether to make internally or whether to buy externally (outsource
production) should be based on relevant costs. The preferred option from a financial viewpoint should be the
one that has the lower relevant costs.
AT A GLANCE

A financial assessment of a make-or-buy decision typically involves a comparison of:

 the costs that would be saved if the work is outsourced or sub-contracted, and
 the incremental costs that would be incurred by outsourcing the work.
 Example 08:
A company manufactures a component that is included in a final product that it also
manufactures. Management have identified an external supplier who would be willing to supply
the component.
The variable cost of manufacturing the component internally is Rs.10 and the external supplier
would be prepared to supply the components for Rs.13 each. It has been estimated that cash
savings on general overhead expenditure will be Rs.48,000 each year if internal production is
ended. The company needs 10,000 units of the component each year.
SPOTLIGHT

The decision regarding whether the company make or buy the component would require
following evaluations
The annual relevant costs and benefits of a decision to buy the components externally can be
presented as follows:

Rs.
Extra costs of purchasing externally (10,000 units  (Rs.13 - Rs.10)) (30,000)
Cash savings in overhead expenditures 48,000
Net benefit from external purchasing (outsourcing) per year 18,000
STIKCY NOTES

Conclusion: The company would increase its profit by purchasing externally instead of making
the items in-house. The recommendation on financial considerations is therefore to buy
(outsource production), not make internally.
 Example 09:
Galaxy Engineers (GE) manufactures and sells a wide range of products. One of the raw materials
XPI is in short supply and only 80,000 kg are available in GE's stores. Following information
pertains to the products in which XPI is used:

Product A Product B Product C

Budgeted local sales/requirement Units 4,500 1,000 2,500
Committed export sales as per Units - 800 -
agreement

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----------------- Per unit------------------

Sales price Rs. 20,000 14,100 For internal use
Material XPI (Rs. 500 per kg) kg 14 12 2
Other material (Rs. 300 per kg) kg 5 3 1
Direct labor hours (Rs. 100 per hours 20 15 5
hour)
Variable overheads based on labor % 80% 80% 80%
cost
Fixed overheads per direct labor Rs. 95 75 60
hour

AT A GLANCE
Product C is used in other products made by GE. If it could not be produced internally, it has to
be purchased from market at Rs. 3,000 per unit.
When required to determine the number of units of each product that should be manufactured,
to earn maximum profit, following analysis may be of some assistance.

Product Product Product Material

A B C XPI
---------- Units---------- kg
Budgeted sales/requirements 4,500 1,800 3,000
---------- Rupees ----------

SPOTLIGHT
For
internal
Sales price per unit 20,000 14,100 use only
Opportunity cost per unit (Purchase price) - - 3,000
Cost of production per unit:
Material XPI usage at Rs. 500 per kg (7,000) (6,000) (1,000)
Other material usage at Rs. 300 per kg (1,500) (900) (300)
Direct labor at Rs. 100 per hour (2,000) (1,500) (500)

STIKCY NOTES
Variable overheads at 80% of labor cost (1,600) (1,200) (400)
(12,100) (9,600) (2,200)
CM/savings from own manufacturing (A) 7,900 4,500 800
Per unit usage of material XPI (B) kg 14 12 2
CM per one kg of material XPI (A)÷(B) Rs. 564 375 400
Ranking based on CM per XPI kg 1st 3rd 2nd
Production from available material XPI:
Production of committed export sales - 800 - 9,600
Production in ranking order 4,500 200 2,500 70,400
Optimal production Units 4,500 1,000 2,500 80,000

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 Example 10:
Condaco produces two products with the following costs and revenue per unit:
Product A Product B
Rs. Rs.
Sales price 20 10
Variable cost 8 6
Fixed cost 4 3
units units
Sales demand 2,000 3,000
There are only 7,000 machine hours available, and Product A requires 4 machine hours per unit
AT A GLANCE

and Product B requires 1 machine hour per unit

Following calculations to be used when required calculate the profit-maximizing production and
sales mix.
Total machine hours required to meet sales demand = (2,000 × 4) + (3,000 × 1) = 11,000. Since
only 7,000 hours are available, machine hours are a limiting factor.
Product A Product B
Rs. Rs.
Sales price 20 10
Variable cost 8 6
Contribution 12 4
SPOTLIGHT

Machine hours per unit 4 1

Contribution per hour Rs.3 Rs.4
Priority for manufacture 2nd 1st
Decision: produce and sell the following products:

Product Units Machine hours Contribution per unit Total contribution

Rs. Rs.
B 3,000 3,000 4 12,000
A (balance) 1,000 4,000 12 12,000
STIKCY NOTES

7,000 24,000

Now assume that all the data is the same, except that we are able to sub-contract the products
for an additional variable cost of Rs.1 per unit for A and Rs.0.50 per unit for B. The profit-
maximizing decision would be evaluated as follows:

Product A Product B
Rs. Rs.
Extra cost of external purchase 1 0.50
Machine hours saved by external purchase 4 1
Extra cost per machine hour saved Rs.0.25 Rs.0.50
Priority for manufacture 1st 2nd

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Number of Machine Contribution

Item Contribution
units hours per unit
Make Rs. Rs.
A 1,750 7,000 12 21,000
Buy
A (balance) 250 (12 – 1) 11 2,750
B 3,000 (4 – 0.5) 3.5 10,500
Total contribution 34,250

 Example 11:
NK Enterprises produces various components for telecom companies. The demand of these

AT A GLANCE
components is increasing. However, NK’s production facility is restricted to 50,000 machine
hours only. Therefore, NK is considering to buy certain components externally. In this respect,
the following information has been gathered:

Components
Description
X-1 X-2 X-3 X-4
Estimated demand in units 6,500 2,000 7,100 4,500
Machine hours required per unit 8 4 5 2
In-house cost per unit: ------------ Rupees ------------
Direct material 20.0 28.0 23.0 22.0
Direct labor 9.0 5.0 9.0 8.0

SPOTLIGHT
Factory overheads 16.0 8.0 8.5 5.0
Allocated administrative overheads 5.0 4.0 3.0 2.0
50.0 45.0 43.5 37.0
External price of the component per unit 35.0 40 34.0 33.0
Factory overheads include fixed overheads estimated at Rs. 1.50 per machine hour.
The number of units to be produced in-house and bought externally, would be determined as
follows:

X-1 X-2 X-3 X-4

STIKCY NOTES
Demand in units (A) 6,500 2,000 7,100 4,500
Machine hours per unit (B) 8 4 5 2
------------------ Rupees ------------------
In-house cost 50.00 45.00 43.50 37.00

X-1 X-2 X-3 X-4

Irrelevant cost for decision making
- Fixed overheads 1.5×B (12.00) (6.00) (7.50) (3.00)
- Allocated administrative overheads (5.00) (4.00) (3.00) (2.00)
Relevant production cost (C) 33.00 35.00 33.00 32.00
Per unit cost of buying externally (D) 35.00 40.00 34.00 33.00

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X-1 X-2 X-3 X-4

Incremental cost in case of external buying:
- Per unit (C-D) (E) 2.00 5.00 1.00 1.00
- Per machine hour (E÷B) 0.25 1.25 0.20 0.50
Ranking for in-house production 3rd. 1st. 4th. 2nd.
No. of units for in-house production:
*[50,000–(2,000×4) – (4,500×2)]/8 (F) *4,125 2,000 - 4,500
No. of units to be bought externally A-F 2,375 - 7,100 -

3.2 Make-or-buy decisions: non-financial considerations

When relevant costs are used to make a decision, it is assumed that the decision should be based on financial
AT A GLANCE

considerations and whether the decision will add to profit (cash flows).
In reality, however, managers are likely to think about non-financial issues as well as financial issues when
making their decisions. The non-financial considerations in any decision will depend on the circumstances, and
will vary from one decision to another. Non-financial considerations can influence a decision. In your
examination, be prepared to identify relevant non-financial issues in a particular situation, and discuss their
potential implications.
Non-financial considerations that will often be relevant to a make-or-buy decision include the following.
 When work is outsourced, the entity loses some control over the work. It will rely on the external supplier
to produce and supply the outsourced items. There may be some risk that the external supplier will:
- produce the outsourced items to a lower standard of quality, or
fail to meet delivery dates on schedule, so that production of the end-product may be held up by a lack
SPOTLIGHT

-
of components.
 The entity will also lose some flexibility. If it needs to increase or reduce supply of the outsourced item at
short notice, it may be unable to do so because of the terms of the agreement with the external supplier. For
example, the terms of the agreement may provide for the supply of a fixed quantity of the outsourced item
each month.
 A decision to outsource work may have implications for employment within the entity, and it may be
necessary to make some employees redundant. This will have cost implications, and could also adversely
affect relations between management and other employees.
 It might be appropriate to think about the longer-term consequences of a decision to outsource work. What
might happen if the entity changes its mind at some time in the future and decides either (a) to bring the
STIKCY NOTES

work back in-house or (b) to give the work to a different external supplier? The problem might be that taking
the work from the initial external provider and placing it somewhere else might not be easy in practice, since
the external supplier might not be co-operative in helping with the removal of its work.
 The company cannot hope to maintain any competitive advantage from the work of the external supplier,
since the competitors can hire the same supplier.
The non-financial factors listed above are all reasons against outsourcing work. There might also be non-financial
benefits from outsourcing work to an external supplier.
 If the work that is outsourced is not specialized, or is outside the entity’s main area of expertise, outsourcing
work will enable management to focus their efforts on those aspects of operations that the entity does best.
For example, it could be argued that activities such as the management of an entity’s fleet of delivery vehicles,
or the monthly payroll work, should be outsourced because the entity itself has no special expertise on these
areas.
 The external supplier, on the other hand, may have specialist expertise which enables it to provide the
outsourced products or services more efficiently and effectively. For example a company might outsource
all its IT support operations, because it cannot recruit and retain IT specialists. An external service provider,
on the other hand, will employ IT specialists.

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3.3 Make-or-buy decisions with scarce resources

A different situation arises when an entity is operating at full capacity, and has the opportunity to outsource
some production in order to overcome the restrictions on its output and sales. For example, a company might
have a restriction, at least in the short-term, on machine capacity or on the availability of skilled labor. It can seek
to overcome this problem by outsourcing some work to an external supplier who makes similar products and
which has some spare machine time or labor capacity.
In this type of situation, a relevant costing approach is to assume that the entity will:
 seek to maximize its profits, and therefore
 outsource some of the work, provided that profits will be increased as a consequence.
The decision is about which items to outsource, and which to retain in-house. The profit-maximizing decision is
to outsource those items where the costs of outsourcing will be the least.

AT A GLANCE
To identify the least-cost outsourcing arrangement, it is necessary to compare:
 the additional costs of outsourcing production of an item with
 the amount of the scarce resource that would be needed to make the item in-house.
Costs are minimized (and so profits are maximized) by outsourcing those items where the extra cost of
outsourcing is the lowest per unit of scarce resource ‘saved’.
The examples below illustrate the relevant costing technique required.
 Example 12:
Super clean Company is a contract cleaning company. It provides three services; daily office
cleaning, intensive cleaning of office space and minor repairs. However it has insufficient

SPOTLIGHT
resources to do all the work available, and wishes to use a sub-contractor to take on some of the
work.
Information relating to the different type of work is as follows:
Average labor Variable Budgeted Sub-contractor
hours per cost per number of quote per job
job job(Rs.) jobs (Rs.)
Daily office cleaning 4 60 1,500 80
Intensive cleaning 6 108 400 150
Minor repairs 3 56 640 100

STIKCY NOTES
There are 8,000 labor hours available. The serviced that should be sub-contracted would be
analyzed using following workings
The company can do all three types of job more cheaply with its own staff than by hiring the sub-
contractor. However, provided that it earns more than Rs.80 for a daily office cleaning job, Rs.150
for an intensive cleaning job and Rs.100 for a minor repairs job, it is profitable to use the sub-
contractor to make up the shortfall in in-house resources.
The problem is to decide which work to outsource/sub-contract. The ranking should be
established as follows:
Daily office Intensive Minor
cleaning cleaning repairs
Rs. Rs. Rs.
Cost of doing the work in-house 60 108 56
Cost of sub-contractor 80 150 100
Extra cost of outsourcing, per job 20 42 44

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Daily office Intensive Minor

cleaning cleaning repairs
Hours saved by sub-contracting 4 6 3
Extra cost per hour saved Rs.5 Rs.7 Rs.14.
Priority for outsourcing 1st 2nd 3rd
Priority for doing work with own resources 3rd 2nd 1st
It is cheaper to sub-contract office cleaning than intensive cleaning. It is most expensive to sub-
contract minor repairs and this is the first choice of job to be carried out in-house. The cost-
minimizing plan should be to carry out the following work:

Budgeted Total labor Total

jobs hours variable cost
AT A GLANCE

Rs.
Minor repairs 640 1,920 35,840
Intensive cleaning 400 2,400 43,200
Office cleaning (balance) 920 3,680 55,200
Maximum labor hours available 8,000
Sub-contract: Office cleaning 580 46,400
180,640

 Example 13:
SPOTLIGHT

Wombat Company makes four products, W, X, Y and Z. All four products are made on the same
machines, and the machine capacity for the year at Wombat’s factory is 3,500 hours. However, it
is able to obtain any of these products in unlimited quantities from a sub-contractor.
Budgeted data is as follows.

Product W X Y Z
Annual sales demand (units) 4,000 6,000 3,000 5,000
Rs. Rs. Rs. Rs.
Sales price per unit 15 20 18 17
Variable cost per unit, in-house manufacture 5 7 6 7
STIKCY NOTES

Cost of external purchase (outsourcing) 8.0 11.8 10.5 11.0

Machine hours per unit, in-house production 0.25 0.50 0.30 0.40

Which items should be produced in-house and which should be outsourced? The question would
require following calculations to reach the conclusion
The selling price for each product is higher than the variable cost of purchasing each product
externally; therefore, profit will be maximized by making the products in-house or purchasing
them externally, up to the full amount of the annual sales demand.

Product W X Y Z
Rs. Rs. Rs. Rs.
Variable cost per unit, in-house manufacture 5.00 7.00 6.00 7.00
Cost of external purchase (outsourcing) 8.00 11.8 10.50 11.00
Extra cost of outsourcing, per unit 3.00 4.80 4.50 4.00

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Product W X Y Z
Rs. Rs. Rs. Rs.
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40
Extra cost of outsourcing, per machine hour saved Rs.12 Rs.9.6 Rs.15 Rs.10
Priority for outsourcing 3rd 1st 4th 2nd
Priority for in-house production 2nd 4th 1st 3rd

The cost-minimizing and profit-maximizing budget is as follows.

Product Total variable cost

Units Machine hours
In-house production: Rs.

AT A GLANCE
Y 3,000 900 18,000
W 4,000 1,000 20,000
Z (balance) 4,000 1,600 28,000
3,500
Z 1,000 11,000
X 6,000 70,800
Total variable cost 147,800

 Example 14:

SPOTLIGHT
An engineering company has been experiencing problems with restricted availability of
resources. The company manufactures a variety of casings. It makes four types of casing. Each
casing requires the same bought-in component and some high-grade steel. The standard costs
for the four types of casing are as follows:

Casing A B C D
Rs. Rs. Rs. Rs.
Steel 250 500 190 390
Bought-in component 50 50 50 50
Direct labor 60 60 50 100

STIKCY NOTES
Variable production costs 40 50 40 50
Fixed production costs 180 240 150 270
Selling and administration costs 145 225 120 215
Profit 35 55 30 55
Selling price 760 1,180 630 1,130

All the selling and administration costs are fixed and the same single component is used for each
of the four products. Direct labor is paid Rs.8 per standard hour and each member of the
workforce is capable of producing any of the casings.
The company’s main customer has ordered 30 units of Casing A, 20 units of B, 30 units of C and
20 units of D for production and delivery in the next month. Senior management have agreed that
this order should be treated as a priority order and that these casings must be manufactured and
delivered to the customer next month. This is necessary to maintain the goodwill of the customer.
It is estimated that this order represents 10% of the total demand next month for each type of
casing.

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The company operates a just in time system, and has no inventories of steel, components or
finished goods.
If the aim is to maximize profit for the month, establish the production and selling plan for the
company next month in each of the following situations:
a) Situation 1. Supplies of steel are limited to Rs.250,000.
b) Situation 2. Only 400 bought-in components are available from suppliers.
c) Situation 3. A labor dispute restricts available productive labor hours in the month to 2,125.
d) Situation 4. A labor dispute restricts available productive labor hours in the month to 2,125;
but the manufacture of any quantities of the four casings could be sub-contracted to an
outside supplier. The cost of buying the casings externally would Rs.475, Rs.705, Rs.380 and
Rs.640 for Casing A, Casing B, Casing C and Casing D respectively. In addition, it should be
AT A GLANCE

assumed that the major customer insists that its order is completed by the company itself
and the manufacture should not be sub-contracted.
Each of the restrictions on production should be treated independently, as four different
situations.

Working: contribution per A B C D

unit Rs./unit Rs./unit Rs./unit Rs./unit
Profit 35 55 30 55
Fixed costs:
Production 180 240 150 270
Selling 145 225 120 215
SPOTLIGHT

Contribution 360 520 300 540

Resources required for the priority order for the major customer
Units
Casing Steel Direct labor
required
per unit Total per unit Total
Rs. Rs. hours hours
A 30 250 7,500 7.5 225.0
B 20 500 10,000 7.5 150.0
STIKCY NOTES

C 30 190 5,700 6.25 187.5

D 20 390 7,800 12.5 250.0
Total 31,000 812.5
a) Steel in short supply and restricted to Rs. 250,000
Casing A B C D
Rs. Rs. Rs. Rs.
Contribution/unit 360 520 300 540
Steel costs/unit 250 500 190 390
Contribution/Rs.1 steel cost 1.44 1.04 1.58 1.38
Ranking for manufacture 2nd 4th 1st 3rd

It is assumed that the sales forecasts for the month are correct.

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Profit-maximizing production schedule

Steel used A B C D
Rs. units units units units
Priority order 31,000 30 20 30 20
Sales of C 51,300 270
Sales of A 67,500 270
Sales of D 70,200 180
220,000
Balance: Sales of B 30,000 60
Total steel available 250,000

AT A GLANCE
Total production/sales 300 80 300 200

b) Components are in short supply and restricted to 400 units

A B C D
Contribution/unit Rs.360 Rs.520 Rs.300 Rs.540
Components/unit 1 1 1 1
Contribution/component Rs.360 Rs.520 Rs.300 Rs.540
Ranking for manufacture 3rd 2nd 4th 1st

Profit-maximizing production schedule

Components used A B C D

SPOTLIGHT
units units units units units
Priority order 100 30 20 30 20
Sales of D 180 180
280
Balance: Sales of B 120 120
Total available 400
Total production/sales 30 140 30 200

c) Labor is in short supply and restricted to 2,125 hours

STIKCY NOTES
Casing A B C D
Contribution/unit Rs.360 Rs.520 Rs.300 Rs.540
Labor hours/unit 7.50 7.50 6.25 12.5
Contribution per hour Rs.48.00 Rs.69.33 Rs.48.00 Rs.43.20
Ranking for manufacture 2nd 1st 2nd 4th

Profit-maximizing production schedule

Labor hours A B C D
units units units units
Special order 812.5 30 20 30 20
Remaining hours 1,312.5 175
Total hours 2,125.0
Total production/sales 30 195 30 20

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d) Make or buy decision

A B C D
Rs. Rs. Rs. Rs.
Contribution if made 360 520 300 540
Contribution if bought in 285 475 250 490
Extra contribution if made 75 45 50 50
Labor hours 7.5 7.5 6.25 12.5
Extra contribution per hour Rs.10 Rs.6 Rs.8 Rs.4
Ranking/priority for making 1st 3rd 2nd 4th
AT A GLANCE

Profit-maximizing production schedule

Casing Hours A B C D
Special order 812.5 30 20 30 20
Remaining hours 1,312.5 175
Total hours 2,125.0
Made internally 205 20 30 20
Purchased externally 95 180 270 180
Total sales 300 200 300 200
SPOTLIGHT
STIKCY NOTES

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4. OTHER SHORT TERM DECISIONS

The principles of relevant costing can be applied to any type of management decision, not just make-or-buy
decisions. Examples of other types of management decision where relevant costing may be used are:
 One-off contract decisions
 Shutdown decisions
 Joint product further processing decisions.

4.1 One-off contract decisions

Management might have an opportunity to carry out a contract or job for a customer, where the job is ‘once only’
and will not be repeated in the future. The decision is therefore to decide whether to agree to do the job at the
price offered by the customer, or to decide a selling price at which an incremental profit would be made.

AT A GLANCE
If it is a one-off contract, rather than regular production work, it would be worthwhile undertaking the contract
if the extra revenue from the contract is higher than the relevant costs of doing the work (including any
opportunity costs).
The incremental profit from the one-off contract is the revenue that would be obtained minus the relevant costs.
One-off contract decisions might occur when a company has spare capacity, and an opportunity arises to earn
some extra profit. This type of analysis should not be applied to most contract decisions, however, because a
company must earn sufficient profits in total to cover its fixed costs and make a profit. Relevant costs do not help
management to decide what the size of the profit margin should be, in order to ensure that the company makes
an overall profit from all its activities.
 Example 15:

SPOTLIGHT
Faisal Ltd. is deciding whether or not to proceed with a one-off special contract for which it would
receive a once-off payment of Rs. 200,000
Details of relevant costs are:
a) The special contract requires 200 hours of labor at Rs.600 per hour. Employees
possessing the necessary skills are already employed by Faisal Ltd. but are currently idle
due to a recent downturn in business.
b) Materials X and Y will be used. 100 tonnes of material X will be needed and sufficient
material is in inventory as the material is in common use by the company. Original cost
of material in inventory was Rs.150 per tonne but it would cost Rs.180 per tonne to
replace if used in this contract. Material Y is in inventory as a result of previous over-

STIKCY NOTES
purchasing. The original cost of material Y was Rs.50,000 but it has no other use.
Unfortunately material Y is toxic and if not used in this contract Faisal Ltd. must pay
Rs.24,000 to have it disposed.
c) The contract will require the use of a storage unit for three months. Faisal is committed
to rent the unit for one year at a rental of Rs.8,000 per month. The unit is not in use at
present. However, a neighboring business has recently approached Faisal Ltd. offering
to rent the unit from them for Rs.11,000 per month.
d) Overheads are absorbed at Rs.750 per labor hour which consists of Rs.500 for fixed
overhead and Rs.250 for variable overhead. Total fixed overheads are not expected to
increase as a result of the contract.
A trainee accountant has calculated that it will cost Rs. 359,000 to deliver the contract
(calculation below) and concluded that the contract should therefore not be accepted for
Rs.200,000.

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Description Relevant cost Rs.

Labor: 200 hours x Rs. 600 120,000

Material X: 100 tonnes x Rs. 150 15,000
Material Y: Original cost 50,000
Storage: 3 months x Rs. 8,000 24,000
Overheads: Rs. 750 x 200 150,000
Total 359,000

Advise whether the contract should be accepted or not on financial grounds would include:
AT A GLANCE

a) The relevant cost of labor is zero as no extra cost will be incurred as a result of this
contract.
b) The relevant cost of a material that is used regularly is its replacement cost. Additional
inventory of the material must be purchased for use in this contract. The relevant cost
of material X is therefore Rs.180 per tonne i.e. Rs.180 x 100 = Rs.18,000
c) There is a relevant saving from using material Y from not having to pay the disposal cost
of Rs.24,000.
d) As Faisal is already committed to rent the storage unit for one year the monthly rental
cost is not relevant to the contract. However, the opportunity cost is the foregone rental
income that Faisal would have made from the neighboring business for the three months
needed for this contract. i.e. 3 x Rs.11,000 = Rs.33,000
SPOTLIGHT

e) The fixed overhead is not relevant because there is no increment to fixed overheads
expected as a result of this contract. Therefore the relevant overhead cost is just the
variable part of Rs.250 per hour x 200 hours = Rs.50,000
So in total the relevant cost is Rs. 77,000 as follows:

Description Relevant cost Rs.

Labor 0
Material X 18,000
Material Y (24,000)
Storage 33,000
STIKCY NOTES

Overheads 50,000
Total 77,000

Conclusion: The contract should be accepted as it would make an incremental profit to Faisal of
Rs. 123,000 (revenue of Rs. 200,000 less relevant costs of Rs. 77,000).

4.2 Shutdown decisions

A shutdown decision is a decision about whether or not to shut down a part of the operations of a company. From
a financial viewpoint, an operation should be shut down if the benefits of shutdown exceed the relevant costs.
A shutdown decision may be a long-term decision when there are large initial expenditures involved (for
example, costs of making the work force redundant). For the purpose of the examination, however, any shutdown
decision will be a short-term decision.

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 Example 16:
Company V makes four products, P, Q, R and S. The budget for next year is as follows:

P Q R S Total
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Direct materials 300 500 400 700 1,900
Direct labor 400 800 600 400 2,200
Variable overheads 100 200 100 100 500
800 1,500 1,100 1,200 4,600

AT A GLANCE
Sales 1,800 1,650 2,200 1,550 7,200
Contribution 1,000 150 1,100 350 2,600
Directly attributable fixed costs (400) (250) (300) (300) (1,250)
Share of general fixed costs (200) (200) (300) (400) (1,100)
Profit/(loss) 400 (300) 500 (350) 250

‘Directly attributable fixed costs’ are cash expenditures that are directly attributable to each
individual product. These costs would be saved if operations to make and sell the product were
shut down.
Decision would be required regarding whether any of the products should be withdrawn from

SPOTLIGHT
the market. Following reasons and calculations may be observed:
From a financial viewpoint, a product should be withdrawn from the market if the savings from
closure exceed the benefits of continuing to make and sell the product. If a product is withdrawn
from the market, the company will lose the contribution, but will save the directly attributable
fixed costs.
Product P and product R both make a profit even after charging a share of general fixed costs. On
the other hand, product Q and product S both show a loss after charging general fixed costs, and
we should therefore consider whether it might be appropriate to stop making and selling either
or both of these products, in order to eliminate the losses.

STIKCY NOTES
Effect of shutdown P Q R S
Rs.‘000 Rs.‘000 Rs.‘000 Rs.‘000
Contribution forgone (1,000) (150) (1,100) (350)
Directly attributable fixed costs saved 400 250 300 300
Increase/(reduction) in annual cash flows (600) 100 (800) (50)

Although product S makes a loss, shutdown would reduce annual cash flows because the
contribution lost would be greater than the savings in directly attributable fixed costs.
However, withdrawal of product Q from the market would improve annual cash flows by
Rs.100,000, and withdrawal is therefore recommended on the basis of this financial analysis.
Decision recommended: Stop making and selling product Q but carry on making and selling
product S.

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4.3 Joint product further processing decisions

Joint products are products manufactured from a common process. In some instances, a company might have a
choice between:
 selling the joint product as soon as it is output from the common process, or
 processing the joint product further before selling it (at a higher price).
This is a short-term decision, and the financial assessment should be made using relevant costs and revenues.
The financial assessment should compare:
 the revenue that will be obtained (less any selling costs) from selling the joint product as soon as it is output
from the common process, and
 the revenue that will be obtained if the joint product is processed further, less the incremental costs of
further processing and then selling the product.
AT A GLANCE

Applying relevant costing, the costs of the common process are irrelevant to the decision, because these costs
will be incurred anyway, whatever the decision. The decision should be to further process the joint product if the
extra revenue from further processing exceeds the extra (relevant) costs of the further processing.
 Example 17:
A company produces two joint products from a common process. For every 100 kilograms of
input to the common process, output consists of 40 kilograms of joint product 1 (JP1) and 60
kilograms of joint product 2 (JP2). The costs of the common process are Rs.400 per 100 kilograms
of input.
JP1 can be sold for Rs.10 per kilogram and JP2 can be sold for Rs.16 per kilogram.
Alternatively, JP1 can be processed to make a finished product, FP1. Costs of further processing
SPOTLIGHT

consist of variable costs of Rs.6 per kilogram and fixed costs of Rs.120,000 per year. Of these fixed
costs, Rs.96,000 would be directly attributable to the further processing operations, and the
remaining Rs.24,000 would be an apportionment of general fixed overhead costs. The further
processed product (FP1) would have a selling price of Rs.28 per kilogram.
It is estimated that 15,000 kilograms of JP1 will be produced each year. There are no losses in
any process.
Should JP1 be sold as soon as it is produced from the common process, or should it be further
processed into Product FP1? Following may be the solution
The common processing costs are irrelevant to the further processing decision. The annual
relevant costs and benefits of further processing JP1 are as follows:
STIKCY NOTES

Rs.
Revenue from selling FP1 (per kilogram) 28
Variable further processing cost (6)
Additional variable revenue from further processing 22
Opportunity cost: sales of JP1 forgone (10)
Benefit per kilogram from further processing 12
Number of kilograms produced each year 15,000
Total annual benefits before directly attributable fixed costs 180,000
Directly attributable fixed costs of further processing (96,000)
Net annual benefits of further processing 84,000
Recommendation: The joint product should be processed to make FP1, because this will
increase annual profit by Rs. 84,000.

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4.4 Equipment/Plant Replacement and investment decisions

Equipment buying or replacement decisions are capital investment decisions which require discounted cash flow
analysis. Moreover, book value of the replaced asset is irrelevant of sunk cost in this situation.
 Example 18:
Decimal World Limited manufactures and sells modems. It manufactures its own circuit boards
(CB), an important part of the modem.
The present cost to manufacture a CB is as follows:

Rupees
Direct material 440
Direct labor 210

AT A GLANCE
Variable overheads 55
Fixed overheads
Depreciation 60
General overheads 30
Total cost per unit 795

The company manufactures 400,000 units annually. The equipment being used for
manufacturing CB has worn out completely and requires replacement. The company is presently
considering the following options:
a) Purchase new equipment which would cost Rs. 240 million and have a useful life of six

SPOTLIGHT
years with no salvage value. The company uses straight-line method of depreciation. The
new equipment has the capacity to produce 600,000 units per year. It is expected that
the use of new equipment would reduce the direct labor and variable overhead cost by
20%.
b) Purchase from an external supplier at Rs.730 per unit under a two year contract.
The total general overheads would remain the same in either case. The company has no other
use for the space being used to manufacture the CBs.
In analyzing company’s situation which course of action would you recommend to the company
assuming that 400,000 units are needed each year?

STIKCY NOTES
Differential Cost per Modem
Make Buy
Rs. Rs.
Outside supplier's costs 730
Direct materials 440
Direct labor (Rs. 210 x 80%) 168
Variable overheads (Rs. 55x80%) 44
Depreciation (Rs. 240,000,000 ÷ 6 years ÷ 400,000) 100
752 730
The company should accept the offer of external supplier because the price offered is lower than
the variable costs of product.
Recommendation for the company when its annual requirements were 600,000 units would
require following analysis

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Differential Cost per Modem

Make Buy
Rs. Rs.
Outside supplier's costs 730
Direct materials 440.00
Direct labor (Rs. 210 x 80%) 168.00
Variable overheads (Rs. 55 x 80%) 44.00
Depreciation (Rs. 240,000,000 ÷ 6 years ÷ 600,000) 66.67
718.67 730
AT A GLANCE

The company should purchase the new equipment and make the modems if 600,000 modems
per year are needed.
However, there may be other factors that the company should consider, before making a decision.
These are
i. Will volume in future years be increasing? If yes then buying the new equipment
becomes more desirable.
ii. Will quality control be maintained if the CB purchased from external suppliers?
iii. Will the external supplier be dependable in making delivery schedules?
iv. Can the company begin making the CB again if the supplier proves to be unacceptable?
v. If the external supplier’s offer is accepted and the needs for CB increases in future years,
SPOTLIGHT

will the supplier have the added capacity to provide more than 400,000 CB per year?
vi. If the order size increases, will the supplier given any additional bulk quality discount.
vii. Will the external supplies be able to supply the CB after 2 years?

4.5 Decisions for Discontinuing operations

Some operations are more profitable than the others. In this respect, organizations may often consider less
profitable ventures to be discontinued for allocation of resources to those making more profits.
 Example 19:
Stamba makes two components, A and B, for which costs in the next year are expected to be as
STIKCY NOTES

follows:

A B
Production (units) 30,000 20,000
Variable costs per unit: Rs. Rs.
Direct materials 6 5
Direct labor 3 9
Variable production overheads 1 3
Variable production cost 10 17

Direct labor is paid Rs.12 per hour. There will be only 19,500 hours of direct labor time available
next year, and any additional components must be purchased from an external supplier.

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Total fixed costs per annum are expected to be as follows:

Rs.
Incurred as a direct consequence of making A 40,000
Incurred as a direct consequence of making B 50,000
Other fixed costs 30,000
120,000
An external supplier has offered to supply units of A for Rs.12.50 and units of B for Rs.23.
a) Recommendation regarding whether Stamba should shut down internal production of
Component A or Component B and switch to external purchasing is given below.
Component A Component B
Rs. Rs.

AT A GLANCE
Cost of making internally 10.0 17.0
Cost of buying 12.5 23.0
Extra variable cost of buying 2.5 6.0
Quantities required next year 30,000 20,000
Total extra variable cost of buying 75,000 120,000
Fixed costs saved by closure 40,000 50,000
Net extra costs of buying 35,000 70,000

It appears that it would cost the company more each year to shut down internal
production of either component and switch to external purchasing.

SPOTLIGHT
b) Recommendation regarding the quantities that Stamba should make of the components,
and the quantities that it should buy externally, in order to obtain the required quantities
of both components at the minimum cost would be as follows.
In addition, the total annual cost will be calculated below
Tutorial note. To answer part (b), you will need to consider that labor is a limiting
factor.
Production hours required hours
Component A (30,000  0.25 hours) 7,500
Component B (20,000  0.75 hours) 15,000
Total hours required 22,500

STIKCY NOTES
Total hours available 19,500
Shortfall 3,000
There are insufficient hours available to manufacture everything internally. Some
components must be purchased externally.

Component A Component B
Rs. per unit Rs. per unit
Cost of making internally 10.0 17.0
Cost of buying 12.5 23.0
Cost saved by making 2.5 6.0
Hours required to make internally 0.25 hours 0.75 hours
(Rs.3/Rs.12 per hour: Rs.9/Rs.12 per hour)
Costs saved per hour by making Rs.10 Rs.8
(Rs.2.50/0.25 hours: Rs.6/0.75 hours)

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It is better to make Component A internally than Component B.

Component Units Hours Cost/unit Cost

Rs. Rs.
A 30,000 7,500 10 300,000
B (balance) 16,000 12,000 17 272,000
Variable cost of internal manufacture 19,500 572,000
Cost of external purchase – balance of units
required 4,000 23 92,000
Fixed costs 120,000
AT A GLANCE

Total costs 784,000

c) Non-financial considerations relevant to make-or-buy decision are discussed below:

Risks of outsourcing work:
i. Supplier may produce items to a lower standard of quality.
ii. The supplier may fail to meet delivery dates and the buyer may dependent on the
supplier to commit onward delivery to its buyer. In case of buying of a component,
production process of the end-product may be held up by a lack of component.
Benefits of outsourcing work:
i. Outsourcing work will enable the management to focus all of its efforts on those
SPOTLIGHT

aspects of operation the entity does best.

ii. The external supplier may have specialist expertise which enables it to provide
outsourced products more efficiently and at a cheaper price.

4.6 Pricing decisions for special orders

Sometimes decisions include one-time order related prizing decisions or prices related to deals and offers
outside market. Such decisions although seems to be rejected as prices are lower than the actual costs incurred.
However, in such cases relevant costs are much lowered and hence may seem profitable for the company.
STIKCY NOTES

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5. COMPREHENSIVE EXAMPLES
 Example 01:
Areesh Limited deals in various products. Relevant details of the products are as under:

AW AX AY AZ
Estimated annual demand (units) 5,000 10,000 7,000 8,000
Sales price per unit (Rs.) 150 180 140 175
Material consumption:
Q (kg) 2 2.5 1.5 1.75
S (kg) 0.5 0.6 0.4 0.65

AT A GLANCE
Labor hours 2 2.25 1.75 2.5
Variable overheads (based on labor cost) 75% 80% 100% 90%
Fixed overheads per unit (Rs.)
10 20 14 16
(based on 80% capacity utilization)
Machine hours required:
Processing machine hours 5 6 8 10
Packing machine hours 2 3 2 4

Company has a long term contract for purchase of material Q and S at a price of Rs. 15 and Rs. 20
per kg respectively. Wage rate for 8 hours shift is Rs. 200.

SPOTLIGHT
The estimated overheads given in the above table are exclusive of depreciation expenses. The
company provides depreciation on number of hours used basis. The depreciation on each
machine based on full capacity utilization is as follows:
Hours Rs.
Processing machine 150,000 150,000
Packing machine 100,000 50,000
The company has launched an advertising campaign to promote the sale of its products. Rs. 2
million have been spent on such campaign. This cost is allocated to the products on the basis of
sale.

STIKCY NOTES
The number of units of each product that the company should produce in order to maximize the
profit and the product wise and total contribution at optimal product mix can be calculated as
follows:

AW AX AY AZ Total
Sale price 150.00 180.00 140.00 175.00
Less: Variable cost
Material Q at Rs 15 30.00 37.50 22.50 26.25
Material S at Rs 20 10.00 12.00 8.00 13.00
Labor cost at Rs. 25 per hour 50.00 56.25 43.75 62.50
Overheads 37.50 45.00 43.75 56.25
127.50 150.75 118.00 158.00
Contribution margin per unit 22.50 29.25 22.00 17.00
Annual demand (Units) 5,000 10,000 7,000 8,000

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AW AX AY AZ Total
Possible production under each machine:
Processing machine:
Machine hours required per unit 5.00 6.00 8.00 10.00
Average CM per hour 4.50 4.88 2.75 1.70
Production priority 2 1 3 4
No. of units that can be produced
in available hours in order of CM
priority (Restricted to annual
demand) 5,000 10,000 7,000 900
AT A GLANCE

Hours required 25,000 60,000 56,000 9,000 150,000

Contribution margin (Rs.) 112,500 292,500 154,000 15,300 574,300

Production for product ‘Z’ has to be restricted to 900 units due to limited number of machine
hours.

AW AX AY AZ Total
Packing machine:
Machine hours required per unit 2.00 3.00 2.00 4.00
Average CM per hour 11.25 9.75 11.00 4.25
Production priority 1 3 2 4
SPOTLIGHT

No. of units that can be produced

in available hours in order of CM
priority (Restricted to annual
demand) 5,000 10,000 7,000 8,000
Hours required 10,000 30,000 14,000 32,000 86,000
Conclusion:
The packing machine can meet the full demand but capacity of processing machine is limited.
Therefore, product mix of processing machine will be manufactured.
Assumption:
It has been assumed that the wage rate per eight hours is divisible.
STIKCY NOTES

 Example 02:
Jaseem Limited manufactures a stationery item in three different sizes. All the sizes are
manufactured at a plant having annual capacity of 1,800,000 machine hours.
Relevant data for each product is given below:
Small Medium Large
Size Size Size
Sales price per unit (Rs.) 75 90 130
Direct material cost per unit (Rs.) 25 32 35
Labor hours per unit 3 4 5
Variable overheads per unit (Rs.) 5 7 8
Machine hours per unit 2 4 5
Demand (Units) 210,000 150,000 180,000
Minimum production required (Units) 100,000 100,000 100,000

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Other relevant information is as under:

i. Cost of the monthly payroll is Rs. 1,500,000.
ii. Fixed overheads are Rs. 110,000 per month and are allocated on the basis of machine
hours.
The number of units to be produced for each size may involve following calculations
Small size Medium size Large size
Sales price 75.00 90.00 130.00
Direct material cost (25.00) (32.00) (35.00)
Variable overheads (5.00) (7.00) (8.00)
Contribution margin 45.00 51.00 87.00

AT A GLANCE
Machine hours 2.00 4.00 5.00
Contribution margin per hour 22.50 12.75 17.40
Priority based on contribution per
machine hour 1 3 2

Small Medium Large Machine

Units to be produced:
size size size hours
Minimum production - Units 100,000 100,000 100,000
Hours consumed for minimum
production 200,000 400,000 500,000 1,100,000

SPOTLIGHT
Units in excess of minimum
production in CM priority:
Small size - Units 110,000 220,000
Large size - Units 80,000 400,000
Medium size – Units 20,000 80,000
Total 210,000 120,000 180,000 1,800,000

 Example 03:
Bauxite Limited (BL) is engaged in the manufacture and sale of three products viz. Pentagon,
Hexagon and Octagon. Following information is available from BL’s records for the month of

STIKCY NOTES
February 2012:
Pentagon Hexagon Octagon
Sales price per unit (Rs.) 2,300 1,550 2,000
Material cost per Kg. (Rs.) 250 250 250
Labor time per unit (Minutes) 20 30 45
Machine time per unit (Hours) 4 2.5 3
Net weight per unit of finished product (Kg.) 6 4 5
Yield (%) 90 95 92
Estimated demand (Units) 10,000 20,000 9,000

Each worker is paid monthly wages of Rs. 15,000 and works a total of 200 hours per month. BL’s
total overheads are estimated at 20% of the material cost.

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Fixed overheads are estimated at Rs. 5 million per month and are allocated to each product on
the basis of machine hours. 100,000 machine hours are estimated to be available in February
2012.
Based on optimum product mix, computation of BL’s net profit for the month of February 2012
would be as follows:
Computation of net profit on the basis of optimum product mix:

Pentagon Hexagon Octagon

Selling price 2,300 1,550 2,000
Less: Variable Costs
Direct Material
AT A GLANCE

(250 × 6 /0.9) 1,666.67

(250 × 4 /0.95) 1,052.63
(250 × 5 /0.92) 1,358.70
Direct Labor
[15,000 /200 × (20/60)] 25.00
[15,000 /200 × (30/60)] 37.50
[15,000 /200 × (45/60)] 56.25
Variable Overheads
[1666.66 × 20% - (Rs. 50 × 4 hrs)] 133.33
SPOTLIGHT

[1052.63 × 20% - (Rs. 50 × 2.5 hrs)] 85.53

[1358.70 × 20% - (Rs. 50 × 3 hrs)] 121.74
Total Variable Cost 1,825.00 1,175.66 1,536.69
Contribution per unit 475.00 374.34 463.31
Machine Hours required per unit 4.0 2.5 3.0
Contribution per Machine Hour 118.75 149.74 154.44
Ranking 3 2 1

Now, the scarce Hours will be allocated as per ranking.

STIKCY NOTES

Product Volume Hours required Hours used Balance unused

100,000
Octagon 9,000 3.0 27,000 73,000
Hexagon 20,000 2.5 50,000 23,000
Pentagon (Bal.) 5,750 4.0 23,000 -
Profit arising from above production plan
Contribution Contribution
Product Units
per unit margin
Octagon 9,000 463.31 4,169,790
Hexagon 20,000 374.34 7,486,800
Pentagon 5,750 475.00 2,731,250
Total Contribution 14,387,840
Less: Fixed costs (5,000,000)
Net Profit 9,387,840

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 Example 04:
Alpha Limited (AL) manufactures and sells products A, B and C. In view of limited production
capacity, AL is meeting the demand for its products partly through imports.
The following information has been extracted from the budget for the next year:

A B C
Machine hours used in production 240,000 225,000 270,000
--------------- No. of units ---------------
Sale 42,000 35,000 26,500
Production 30,000 25,000 22,500
Imports 12,000 10,000 4,000

AT A GLANCE
-------------- Rs. in million --------------
Sales 252.00 175.00 185.50
Cost of production:
- Direct material 48.00 31.25 40.50
- Direct labor 45.00 40.00 56.25
- Variable overheads 33.00 25.00 29.25
- Fixed overheads 28.80 27.00 32.40
Cost of import of finished products 68.40 47.00 26.88

SPOTLIGHT
Additional information:
a) AL is working at 100% capacity.
b) AL believes that it can obtain substantial quantity discounts from foreign suppliers if it
increases the import volumes. Each product is supplied by a different supplier. After
intense negotiations, the suppliers have offered discounts of 15%, 10% and 12% for
products A, B and C respectively.
In preparing a product-wise plan of production/imports to maximize the company’s profitability,
please see below analysis

Product-A Product-B Product-C

STIKCY NOTES
Capacity utilization Machine hours (A) 240,000 225,000 270,000
Sales of units to be produced (B) 30,000 25,000 22,500
Sales of units to be imported (C) 12,000 10,000 4,000
Total sale units 42,000 35,000 26,500

Rupees in million
Variable Cost of production:
Direct material 48.00 31.25 40.50
Direct labor 45.00 40.00 56.25
Overheads 33.00 25.00 29.25
Total cost (D) 126.00 96.25 126.00
Cost per produced unit E (D÷B) 4,200.00 3,850.00 5,600.00

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Rupees in million
Cost of imports:
Existing cost of imported finished goods: 68.40 47.00 26.88
Bulk discount offered 15% 10% 12%
Discounted price of imported goods (F) 58.14 42.30 23.65

Rupees
Cost per imported unit G (F÷C) Rs. 4,845.00 4,230.00 5,912.00
Loss per unit on imports (G-F) (645.00) (380.00) (312.50)
Production Plan:
AT A GLANCE

Machine hours per unit H (A÷B) 8.00 9.00 12.00

Loss per machine hour on imports Rs. (80.63) (42.22) (26.04)
Production priority to save loss on imports 1st. 2nd. 3rd.
Production from available hours of 735,000 in
sequence of the above priority:
Product-A Units demand 42,000
Hrs. utilized (42,000×8) 336,000
Product-B Units demand 35,000
Hrs. utilized (35,000×9) 315,000
Product-C Units from remaining hrs. 7,000
SPOTLIGHT

Remaining hrs, [735-336-315] 84,000

Import plan:
Product-C:
Demand exceeding production (26,500-7,000) - - 19,500
Total units 42,000 35,000 26,500

 Example 05:
Artery Limited (AL) produces and markets three products viz. Alpha, Beta and Gamma. Following
information is available from AL’s records for the manufacture of each unit of these products:
STIKCY NOTES

Alpha Beta Gamma

Selling price (Rs.) 66 88 106
Material-A (Rs.4 per kg) (Rs.) 8 0 12
Material-B (Rs.6 per kg) (Rs.) 12 18 24
Direct labor (Rs. 10 per hour) (Rs.) 25 30 25

Alpha Beta Gamma

Variable overhead based on:
− Labor hours (Rs.) 1.5 1.8 1.5
− Machine hours (Rs.) 1.6 1.4 1.2
Total (Rs.) 3.1 3.2 2.7
Other data:
Machine hours 8 7 6
Maximum demand per month (units) 900 3,000 5,000

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Additional information:
i. AL is also engaged in the trading of a fourth product Zeta, which is very popular in the
market and generates a positive contribution. AL currently purchases 600 units per
month of Zeta from a supplier at a cost of Rs. 40 per unit. In-house manufacture of Zeta
would require: 2.5 kg of material-B, 1 hour of direct labor and 2 machine hours.
ii. Materials A and B are purchased from a single supplier who has restricted the supply of
these materials to 22,000 kg and 34,000 kg per month respectively. This restriction is
likely to continue for the next 8 months.
iii. AL has recently accepted a Government order for the supply of 200 units of Alpha, 300
units of Beta and 400 units of Gamma each month for the next 8 months. These quantities
are in addition to the maximum demand stated above.
iv. There is no beginning or ending inventory.

AT A GLANCE
In determining whether AL should manufacture Zeta internally or continue to buy it from the
supplier during the next 8 months, following are the required calculations
The internal manufacturing cost of Zeta would be as follows:
Rs. per unit
Direct material-B (2.5 kg @ Rs. 6/kg) 15.0
Direct labor (1 hours @ Rs. 10/hour) 10.0
Variable overhead W-1
Direct labor (1 hour @ Rs. 0.60/hour) 0.6
Machine hours (2 hours @ Rs. 0.20/hour) 0.4

SPOTLIGHT
Total 26.0

The buying price of the component is Rs. 40 per unit so if resources are readily available the
company should manufacture the component. However, due to the scarcity of resources during
the next 8 months the contribution earned from the component needs to be compared with the
contribution that can be earned from the other products.
W-1:
Using Alpha (though any product could be used) the variable overhead rate per hour can be
calculated:
Labor related variable overheads per unit = Rs 1.5
Direct labor hours per unit = Rs 25 / Rs 10 = 2.5 hours

STIKCY NOTES
Labor related variable overhead per hours = Rs. 1.5 / 2.5 hour = Rs 0.60 per hour
Machine related variable overhead per hour = Rs. 1.6 / 8 hour = Rs 0.2 per hour
Both material-A and material-B are limited in supply during the next 8 months, but calculations
are required to determine whether this scarcity affects the production plans of AL. The resources
required for the maximum demand must be compared with the resources available to determine
whether either of the materials is a binding constraint.
Total quantity of each product to be manufactured:
Government order Market demand Total
Units
Alpha 200 900 1,100
Beta 300 3,000 3,300
Gamma 400 5,000 5,400
Zeta 0 600 600

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All figures in kg:

Resource Available Requirement Alpha Beta Gamma Zeta

Direct material-A 22,000 18,400 2,200 0 16,200 0
Direct material-B 34,000 35,200 2,200 9,900 21,600 1,500

It can be seen from the above that the scarcity of material-B is a binding constraint and therefore
the contributions of each product and the component per kg of material-B must be compared.

Alpha Beta Gamma Zeta

Rupees
Contribution 17.9 36.8 42.3 14.0
AT A GLANCE

Contribution /kg of material-B 8.95 12.27 10.58 5.60

Rank 3 1 2 4

AL should manufacture 120 units of Zeta and continue to purchase 480 units from the market.
 Example 06:
Snooker (Private) Limited (SNPL) manufactures a component ‘Beta’ which is used as input for
many products. The current requirement of Beta is 18,000 units per annum. Current production
cost of Beta is as follows:

Rs. per unit

Direct material 3,670
SPOTLIGHT

Direct labor 1,040

Variable manufacturing overheads 770
Fixed manufacturing overheads 870
Total cost 6,350
A supplier has recently offered SNPL to supply Beta at Rs. 7,000 per unit. The management has
nominated a team to evaluate the offer which has gathered the following information:
1. There is a shortage of labor. However, some of the labor would become available due to
outsourcing of Beta, which would be utilized for production of a product ‘Zee’. The
estimated selling price of Zee is Rs. 5,800 per unit whereas production cost would be as
follows:
STIKCY NOTES

a. Direct material would cost Rs. 2,600 per unit.

b. Each unit of Zee would require 20% more labor as compared to each unit of
Beta.
c. Estimated variable manufacturing overheads would be Rs. 480 per unit.
2. Outsourcing of Beta and production of Zee would result in net reduction in fixed
manufacturing overheads by Rs. 1,900,000 per annum.
The decision regarding outsourcing by SNPL would require following evaluation:

Snooker Private Limited Rupees

Additional cost of outsourcing of component Beta W-1 (27,360,000)
Additional contribution from utilizing spare capacity by producing
Zee W-2 22,080,000
Net savings of fixed factory overheads 1,900,000
Loss due to outsourcing (3,380,000)

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Opinion: SNPL should not outsource the production of component X.

W-1: Difference between cost of production and cost of outsourcing
Rupees
of component Beta
Purchase cost (18,000×7,000) 126,000,000
Variable production costs saved [18,000×(3,670+1,040+770)] 98,640,000
Allocation of shared cost (irrelevant) Ignore -
Additional cost of outsourcing component Beta 27,360,000

W-2: Profit from spare capacity - Production of Zee Rupees

Sales revenue of Zee [5,800×15,000 (W-3)] 87,000,000

AT A GLANCE
Material [(2,600×15,000 (W-3)] (39,000,000)
Labor (1,040×15,000 (W-3)×1.2) (18,720,000)
Variable manufacturing overheads (480×15,000) (7,200,000)
Profit from Zee 22,080,000
W-3: Production of Zee (18,000÷1.2) 15,000
 Example 07:
DEL Limited manufactures radiators for car manufacturers. In normal operations, about 200,000
units are sold per annum at an average selling price of Rs. 15,000 per unit. Manufacturing process
is carried out by 500 highly skilled labors who work an average of 180 hours per month at Rs.

SPOTLIGHT
250 per hour. Raw material cost is Rs. 3,000 per unit. Annual factory overheads are estimated at
Rs. 540 million. Variable overheads are 150% of labor cost.
DEL had received an offer from TRU Limited to manufacture 4,000 units of radiators of trucks, at
Rs. 50,000 per unit. DEL had expected to earn significantly high margin on this order and had
planned to stop normal production for this purpose. It had already procured the raw material for
Rs. 60 million but before the start of manufacturing it came to know that TRU has gone into
liquidation.
To deal with the situation, DEL’s marketing department has negotiated with another truck
manufacturer, NTR Limited. NTR’s specifications are slightly different and the price offered by
NTR is Rs. 40,000 per unit.

STIKCY NOTES
The costs to be incurred on the new order and other relevant details are as follows:
1. Additional raw material of Rs. 12 million would have to be purchased for NTR’s order.
2. DEL expects that first unit would take 10 hours. The labor time would be subject to a
95% learning rate upto 1,000 units. Thereafter, the learning rate would stop. The index
of 95% learning curve is -0.074.
3. Variable overheads would be 240% of the cost of labor.
4. Fixed overheads are to be applied at Rs. 400 per labor hour.
5. Total cost of preparing the plant for NTR’s order and resetting it to the normal
production would be Rs. 4 million.
If the order from NTR is not accepted, raw materials of Rs. 60 million already procured would
have to be sold at 70% of their cost. However, raw material worth Rs. 10 million can be utilized
in the car’s radiators after slight alteration at a cost of Rs. 1 million. The altered raw material can
produce 30% components of 10,000 car radiators.

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Whether DEL may accept the order from NTR would require following calculations:

DEL Limited
Acceptance of order from NTR Limited for truck radiators Rs. in million
Revenue from NTR Limited 40,000×4,000 160.00
Additional raw material (12.00)
Raw material already procured – sales value (60-10)×70% (35.00)
– use value for truck radiators (10,000×3,000×30%)-1 (8.00)
Labor cost [22,647.91 (W-1)×250] (5.66)
AT A GLANCE

Variable overheads (5.66×240%) (13.58)

Preparation and resetting cost of the plant (4.00)
Fixed overheads applied To be ignored -

81.76
Loss of CM for not producing car radiators 4,194 (W-2) ×8,625 (W-3) (36.17)
Profit on acceptance of the order from NTR 45.59

Conclusion: DEL should accept the order from NTR Limited

W-1: Direct labor hours for production of truck radiators Hours
SPOTLIGHT

Direct labor hours for 1,000 units [1,000×10×(1,000)-0.074] 5,997.91

Direct labor hours for 999 units [999×10×(999)-0.074] (5,992.36)
Hours per unit for 1,001 and onward 5.55
Direct labor hours for first 1,000 units 5,997.91
Direct labor hours for next 3,000 units (5.55×3,000) 16,650.00
22,647.91

W-2: No. of Car radiators to be produced if NTR's order is not

STIKCY NOTES

accepted
Labor hours per unit of car radiator (500×180×12)÷200,000 Hrs. 5.40
No. of car radiators to be produced 22,647.91 (W-1) ÷ 5.40 Nos. 4,194
W-3: Contribution margin per unit/hour for car radiators Rupees
Selling price 15,000
Raw material cost (3,000)
Labor cost (500×180×250×12)÷200,000 (1,350)
Variable overheads 150%×1,350 (2,025)
Contribution margin per unit 8,625

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 Example 08:
In May 2015, the board of directors of Sahil Limited (SL) had decided to close one of SL’s
operating segments at the end of the next year. The sales and production for the next year were
budgeted at 50,000 units and on the basis thereof, the budget of the segment for the next year
was approved as follows:

Rs. in ‘000
Sales 5,000
Direct material (50,000 kg) (950)
Direct labor (1,000)
Variable production overheads (500)

AT A GLANCE
Fixed production overheads (1,750)
Administrative and selling overheads (500)
Budgeted net profit 300

However, rumors of the closure prompted majority of the segment’s skilled labor to leave the
company. Consequently, the management is considering the following alternatives to cope with
the issue:
 Close the segment immediately and rent the factory space for one year at a rent of Rs.
40,000 per month; or
 Employ contract labor which would be able to produce a maximum of 40,000 units in
the year. The quality of the product is however expected to suffer due to this change.

SPOTLIGHT
The following further information is available:
1. The sales manager estimates that a sales volume of 30,000 units could be achieved at the
current selling price whereas sales volume of 40,000 units would only be achieved if the
price was reduced to Rs. 90 per unit.
2. 25,000 kg of raw material is in stock. Any quantity of the material may be sold in the
market at a price of Rs. 19 per kg after incurring a cost of Rs. 2 per kg. Up to 15,000 kg
can be used in another segment of the company in place of a material which currently
costs Rs. 18 per kg.
3. Wages of contract labor would be Rs. 24 per unit. SL would also be required to spend Rs.

STIKCY NOTES
40,000 on the training of the contract labor.
4. Due to utilization of contract labor, variable production overheads per unit are expected
to increase by 20%.
5. Fixed production overheads include:
 Depreciation of three machines used in the segment amounting to Rs. 170,000.
These machines originally costed Rs. 1.7 million and could currently be sold for Rs.
830,000. If the machines are used for production in the next year, their sales value
would reduce by Rs. 5 per unit of production.
 All other costs included in ‘fixed production overheads’ represent apportionments
of general overheads.
6. 40% of administrative and selling overheads are variable whereas the remaining
amounts represent apportionment of general overheads.

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In advising the best course of action for Sahil Limited, please see below:

Available options
Immediate Operation using contract
closure and labor
renting of
To produce To produce
factory bldg.
30,000 units 40,000 units
-------------- Rupees --------------
Incremental savings
Sales (30,000100), 40,00090) 3,000,000 3,600,000
Rental income (40,00012) 480,000
AT A GLANCE

Proceeds from sale of machine

(830,000-30,0005), (830,000-40,0005) 830,000 680,000 630,000
Direct material - Use for other segment
(15,00018) 270,000 - -
Direct material - sale externally
[10,000(19-2)] 170,000 - -
Fixed production overheads; apportionment of
general overheads (1,750-170= 1580) - - -
Fixed admin and selling overheads;
apportionment of general overheads
SPOTLIGHT

(50060%=300) - - -
Incremental costs
Purchase of direct material
(5,00019), (15,00019) - (95,000) (285,000)
Training of contract labor - (40,000) (40,000)
Contract labor cost
(30,00024), (40,00024) - (720,000) (960,000)
Variable production overhead
(500÷501.230,000),(500÷501.240,000) - (360,000) (480,000)
STIKCY NOTES

Variable admin. & selling overheads:

[(50040%)÷5030], [(50040%)÷5040] - (120,000) (160,000)
Net savings 1,750,000 2,345,000 2,305,000

Conclusion: Since the highest savings occur with a production level of 30,000 units, SL should
operate the segment at this level of activity.
 Example 09:
Zee Chemicals Limited (ZCL) produces two joint products, Alpha and Beta from a single
production process. Both products are processed upto split-off point and sold without any
further processing.
Presently, ZCL is considering the following proposals:
 Expansion of the existing facility by installing a new plant
 Installation of a refining plant to sell either Alpha or Beta after refining

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To assess the above proposals, following data has been gathered:

i. Actual cost incurred in the month of December 2014:
Rs. in '000
Direct material 15,000
Variable conversion costs (Rs. 230 per hour) 4,890
Fixed overheads 2,600
ii. Actual production and selling price for the month of December 2014:
Liters Selling price per liter (Rs.)
Alpha 11,300 1,000
Beta 14,700 1,125

AT A GLANCE
iii. There is no process loss and joint costs are apportioned between Alpha and Beta
according to the weight of their output.
iv. Details of the proposed plans are as follows:
Expansion of Installation
existing of refining
facility plant
Capacity in machine hours per month 5,000 5,000
------------ Rs. in '000 ------------
Cost of plant and its installation 20,000 25,000
Estimated residual value at the end of life 1,400 2,800

SPOTLIGHT
Estimated additional fixed overheads per month 250 500
Estimated useful life of the plant 20 Years 20 Years

v. Estimated variable cost of refining and sales price of refined products:

Alpha Beta
Rupees per liter
Direct material 90 125
Conversion cost (Rs. 150 per hour) 68 80
Selling price 1,380 1,525
vi. There would be no loss during the refining process. There is adequate demand for Alpha

STIKCY NOTES
and Beta at split-off point and after refining.
It is important to evaluate each of the above proposals and give recommendations. Following
calculations may be of some help:
Expansion Refining plant
(Sale at split-off point) (Sale after refining)
Alpha Beta Alpha Beta
Sales/incremental sales
1,000 1,125 380 400
value per liter
(1,380–1,000) (1,525 – 1,125)
Variable cost at split-off (765) (765) (158) (205)
point/cost of refining per (15,000+4,890) ÷
liter (90+68) (125+80)
(11,300+14,700)
Contribution margin per
liter A 235 360 222 195

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Expansion Refining plant

(Sale at split-off point) (Sale after refining)
Alpha Beta Alpha Beta
CM from 5,000 hours:
Total hours worked in 21,261 Hrs.
December 2014 (4,890,000÷230)
Hours per liter for refining 0.453 Hrs. 0.533 Hrs.
(68÷150) (80÷150)
Production from 5,000 2,657 Ltrs. 3,457 Ltrs. 11,038 Ltrs. 9,381 Ltrs.
hours B (5,000/21,26 (5,000/21,26 (5,000÷0.453) (5,000÷0.533)
1×11,300) 1×14,700)
AT A GLANCE

Contribution margin 1,868,915 2,450,436 1,829,295

(A×B) (2,657×235)+(3,457×360) (11,038×222) (9,381×195)
Fixed overheads:
Depreciation per month
(20,000-1,400)÷20÷12 (77,500)
(25,000-2,800)÷20÷12 (92,500) (92,500)
Additional fixed overheads
per month (250,000) (500,000) (500,000)
Net profit per month 1,541,415 1,857,936 1,236,795

Recommendations: As refining of Alpha produces the highest profit, ZCL should install refining
plant to refine and sell 11,038 liters of Alpha.
SPOTLIGHT

 Example 10:
Sarwar Limited (SL) manufactures two industrial products i.e. K2 and K9. It also manufactures
other products in accordance with the specification of customers. SL’s products require
specialized skilled labor. Maximum labor hours available with the company are 300,000 per
month.
Following information has been extracted from SL’s budget:
K2 K9
---- Rs. per unit ----
Selling price 16,500 26,000
STIKCY NOTES

Direct material 6,000 8,000

Direct labor (Rs. 300 per hour) 4,500 7,500
Variable production overheads (based on labor hours) 1,875 3,125
Applied fixed production overheads (based on labor hours) 1,500 2,500
Monthly demand (Units) 5,000 8,000
An overseas customer has offered to purchase 3,000 units of a customized industrial product ‘A-
1’ at a price of Rs. 35,000 each. The duration of contract would be one month.
The cost department has ascertained the following facts in respect of the contract:
i. Each unit of A-1 would require 3 units of raw material B-1 and 2 units of raw material C-3.
B-1 is available in the local market at Rs. 2,500 per unit. However, the required quantity of
C-3 is not available in the local market and would be imported from Srilanka at a landed cost
of Rs. 2.4 million.
ii. Each unit of A-1 would require 35 labor hours.

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iii. A specialized machinery would be hired for five days. However, due to certain production
scheduling issues, it is difficult for SL to exactly predict when the machine would be required.
As a result of negotiations, SL has received the following offers:
Falah Modarba has quoted a rent of Rs. 0.9 million for the entire month. If accepted, SL would be
able to sublet the machine at Rs. 20,000 per day.
Tech Rentals has quoted a rent of Rs. 57,000 per day and guaranteed availability of machinery
when required.
The management believes that it can increase/decrease the production of K2 and K9, if required.
The maximum profit that can be earned by SL, in the above situation can be determined as below:
K2 K9 A-1
-------------------- Rs. per unit --------------------

AT A GLANCE
Selling price Given 16,500.00 26,000.00 35,000.00
Variable cost 12,375.00 18,625.00 23,270.00
(6,000+4,500+1,875) (8,000+7,500+3,125) (W-1)
Contribution per unit A 4,125.00 7,375.00 11,730.00
Labor hours required per unit B 15 25 35
(4,500/300) (7,500/300) Given
CM per labor hour (Rs.) A/B 275.00 295.00 335.14
Ranking 3 2 1
Allocation of 300,000 hours C 195,000 105,000
(300,000–105,000) (35×3,000)
Units to be produced C/B 7,800.00 3,000.00

SPOTLIGHT
Contribution margin for the month after accepting special contract Rs. in million
A-1 (3,000×11,730) 35.19 K-9 (7,800×7,375) 57.53
Contribution margin 92.72
Fixed cost (1,500/15)×300,000 30.00
Maximum profit 62.72
W-1: Relevant cost for A-1 Rs. per unit
Material cost - B1 (3×2,500) 7,500.00

STIKCY NOTES
Material cost - C3 (2,400,000/3,000) 800.00
Labor cost (35×300) 10,500.00
Variable overheads [{1875÷(4,500÷300)}×35] 4,375.00
Machine hire cost [Lower of (57,000×5) and {900,000– 95.00
(20,000×25)}]/3,000
Variable cost per unit of A-1 23,270.00

 Example 11:
Ideal Chemicals (IC) blends and markets various cleaning chemicals. Presently, IC’s plant is
working at 70% capacity. To utilize its idle capacity, IC is planning to acquire rights to produce
and market a new brand of chemical namely Z-13 on payment of fee of Rs. 160,000 per month.
In this respect, the relevant information is summarized as under:
i. Z-13 would be produced using the existing plant whose cost is Rs. 81 million. Processing
would be carried out in batches of 2,000 liters of raw-materials.

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Production costs per batch are estimated as under:

Raw material: Imported 1,200 liters @ Rs. 1,500 per liter

Local 800 liters @ Rs. 900 per liter
Direct labor 4,000 hours @ Rs. 165 per hour
Variable production overheads @ Rs. 120 per direct labor hour

1,700 liters of Z-13 is produced from each batch. 100 liters are lost by way of evaporation
whereas 200 liters of input is converted into solid waste. The approximate weight of the solid
waste is 225 kg per batch.
ii. Net volume of each bottle of Z-13 would be 1.25 liters.
AT A GLANCE

iii. The solid waste would be refined to produce a by-product, polishing wax. Refining would
cause an estimated loss of 2% of by-product output.
iv. Cost of refining and sales price of wax would be Rs. 250 and Rs. 400 per kg respectively.
Net sales revenue (sales less refining cost) from sale of wax is to be deducted from the
cost of the main product.
v. Variable selling overheads are estimated at Rs. 175 per unit.
vi. The plant is depreciated at 10% per annum. It is estimated that production of Z-13 would
utilize 20% capacity of the plant.
vii. To introduce Z-13, IC plans to launch a sales campaign at an estimated cost of Rs. 3.5
million.
SPOTLIGHT

viii. IC wishes to sell Z-13 at a contribution margin of 40% on sales.

In determining Z-13’s sale price per unit and annual units to be sold, if IC intends to earn an
incremental profit before tax of Rs. 10 million from its sale; please see below:

Ideal Chemicals Units

Finished units per batch 1,700÷1.25 (A) 1,360
By-product units per batch 225÷1.02 221

Variable production cost per unit: Rupees

STIKCY NOTES

Material: Imports 1,200×1,500 1,800,000

Local 800×900 720,000
Direct labor 4,000×165 660,000
Variable production overheads 4,000×120 480,000
Net sales revenue from sale of by-product 221×(400–250) (33,150)
(B) 3,626,850
Variable production cost per unit (B÷A) 2,666.80
Variable selling overheads per unit 175.00
Variable cost per unit (C) 2,841.80
Sales price per unit to earn 40% contribution on sale D=(C÷0.6) 4,736.33

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No. of sale units to earn annual profit before tax of Rs. 10,000,000
Incremental fixed overheads and profit:
- Fee for blending and marketing of Z-13 160,000×12 1,920,000
- Sales promotion expenses 3,500,000
- Required incremental profit before tax 10,000,000
(E) 15,420,000
Required annual sales units No. of units E÷ (D-C) 8,139

 Example 12:
Lily (Private) Limited (LPL) has two factories. LPL manufactures a product Delta in its Quetta

AT A GLANCE
factory. One unit of Delta is assembled from three components P, Q and R which are produced in
the Hub factory. Monthly demand of Delta is estimated at 5,000 units.
Following information is available in respect of each component:

P Q R
Quantity required for one unit of Delta 2 2 3
Machine hours required for producing each component 4 3 5

Cost of production: ----------Rupees---------

Direct material 900 800 300
Direct Labor 270 250 240

SPOTLIGHT
Factory overheads 500 700 280
Allocated administrative overheads 40 30 50

Fixed factory overheads are charged at Rs. 20 per machine hour.

Production capacity at Hub factory is restricted to 100,000 machine hours per month. In order
to meet the demand, LPL is considering to purchase P, Q and R from a vendor at Rs. 1,700, Rs.
1,800 and Rs. 870 per unit respectively.
In determining how LPL can optimize its profit in the above situation, please see below working

P Q R

STIKCY NOTES
Quantity required to produce one unit of Delta A 2 2 3
Machine hours to produce the components B 4 3 5
Components required to produce 5,000 units of
C
Delta (5,000×A) 10,000 10,000 15,000

Relevant production cost per component: ----------- Rupees ---------

Direct material 900 800 300
Direct labor 270 250 240
Variable overheads
500–(B×20); 700–(B×20); 280–(B×20) 420 640 180
Fixed overheads (Not relevant) - - -
Allocated administrative overheads (Not relevant) - - -
Total relevant cost D 1,590 1,690 720

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----------- Rupees ---------

External purchase price per component E 1,700 1,800 870
Savings per component in case of in-house
production E–D = F 110 110 150
Savings per machine hour for in-house
production F÷B 27.50 36.67 30.00
Priority for in-house production 3rd. 1st. 2nd.
In-house production in sequence of
priority Units G - 10,000 14,000
Use of available hours G×B - 30,000 70,000
AT A GLANCE

External purchase Units C–G 10,000 - 1,000

 Example 13:
Jasmine Limited (JL) manufactures various products according to customers' specifications. In
March 2019, JL is required to submit a tender for supply of 5,000 plastic bodies of a washing
machine. In this respect, following information has been gathered:
i. The production would be carried out on JL’s plant at its Sialkot factory. Cost of the plant
is Rs. 3,600,000. Its estimated useful life is 96,000 hours. Each plastic body (unit) would
require 2 machine hours.
ii. Production would be carried out in ten batches of 500 units each. Cost per unit for the
first batch has been estimated as under:
SPOTLIGHT

Rupees
Direct material 2 kg 150
Direct Labor 3 labor hours 300
*Overheads (based on direct labor hours):
Variable overheads 240
Fixed overheads 360
*Overheads do not include depreciation of the plant

iii. Direct material consumption would reduce by 5% in each subsequent batch up to the
STIKCY NOTES

third batch and would become constant thereafter.

iv. Applicable learning curve effect is 95% but it will remain effective for the first six batches
only. The index of 95% learning curve is –0.074.
The bid amount that JL should quote to earn 30% contribution margin, would be calculated as
follows:
Rs. in '000
Direct material cost:
For first 3 batches 75,000+ (75,000×0.95) +[75,000×(0.95)2] 214
For last 7 batches 75,000×(0.95)2×7 474
A 688
Direct labor cost:
For first 6 batches (W-1) 7,882×100 788
For last 4 batches (W-1) 1,224×4×100 490
B 1,278

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Rs. in '000
Overheads
Variable overheads based on direct labor hours 240÷3×1278 1,022
Variable overheads based on machine hours
(molding plant depreciation) 3,600÷96,000×(5,000×2) 375
1,397
Fixed overheads -
C 1,397
Bid amount to earn 30% contribution margin (A+B+C)÷0.7 4,804

AT A GLANCE
W-1: Direct labor hours at 95% learning curve Hours
For the first 6 batches 6×(500 units × 3 hours)×(6)–0.074 7,882
For the first 5 batches 5×(500 units × 3 hours)×(5)–0.074 (6,658)
For the 7th. batch and onwards 1,224

 Example 14:
Binary Ltd. (BL) manufactures three products, A, B and C. It is the policy of the company to
apportion the joint costs on the basis of estimated sales value at split off point. BL incurred the
following joint costs during the month of August 20X3:

SPOTLIGHT
Rs. in ‘000
Direct material 16,000
Direct labor 3,200
Overheads (including depreciation) 2,200
Total joint costs 21,400
During the month of August 20X3 the production and sales of Product A, B and C were 12,000,
16,000 and 20,000 units respectively. Their average selling prices were Rs. 1,200, Rs. 1,400 and
Rs.1,850 per unit respectively.
In August 20X3, processing costs incurred on Product A after the split off point amounted to Rs.

STIKCY NOTES
1,900,000.
Product B and C are sold after being packed on a specialized machine. The packing material costs
Rs. 40 per square foot and each unit requires the following:
Product Square feet
B 4.00
C 7.50
The monthly operating costs associated with the packing machine are as follows:
Rupees
Depreciation 480,000
Labor 720,000
Other costs 660,000
All the above costs are fixed and are apportioned on the basis of packing material consumption
in square feet.

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a) The joint costs to be apportioned to each product, would be calculated as follows:

Total joints costs as given in the question Rs. 21,400,000

Joint Costs (Rs.)

Product A:
Rs.12,500,000 (W-1) / Rs. 61,480,000 (W-1) x Rs. 21,400,000 4,351,008
Product B:
Rs.19,283,738 (W-1) / Rs. 61,480,000 (W-1) x Rs. 21,400,000 6,712,297
Product C:
Rs.29,696,262 (W-1) / Rs. 61,480,000 (W-1) x Rs. 21,400,000 10,336,695
AT A GLANCE

21,400,000

W-1 : Computation of sales Product A Product B Product C Total

value at split off point Rs. Rs. Rs.
Sales value
Rs. 1,200 x 12,000 14,400,000
Rs. 1,400 x 16,000 22,400,000
Rs. 1,850 x 20,000 37,000,000
SPOTLIGHT

Less:
Further processing costs – A (1,900,000)
Packing costs - Fixed (556,262)
B: Rs. 1,860,000 (W2)×64,000 ÷
214,000 (W3)
C: Rs. 1,860,000 (W2)×150,000
÷ 214,000 (W3) (1,303,738)
Packing costs – Variable
B: 64,000 x Rs. 40 (2,560,000)
STIKCY NOTES

C: 150,000 x Rs. 40 (6,000,000)

Estimated sales value at split
off point 12,500,000 19,283,738 29,696,262 61,480,000
W-2: Fixed costs relating to packing machine = 480,000 + 720,000 + 660,000 = Rs.
1,860,000
W-3: Total Volume in Square Feet

Product Square Feet per Unit Units produced Total Volume

B 4.00 16,000 64,000
C 7.50 20,000 150,000
214,000

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a) BL has received an offer from another company to purchase the total output of Product
B without packaging, at Rs. 1,200 per unit. Determine the viability of this offer.
To sell Product B without packaging for Rs. 1,200 per unit, following calculations would
be required:

Packaged (Rs.) Unpackaged (Rs.)

Selling price per unit 1400 1,200
Less: Variable cost of packing (Rs.40 x 4) 160 -
Contribution margin 1,240 1,200

Conclusion: Since the alternative option has a lower contribution margin, the decision
should be to continue to sell Product B with packaging at Rs. 1,400 per unit

AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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STICKY NOTES

In profitability decisions, limiting factors refer to the circumstances in which

in availability of production resources are scarce. Identifying the limiting
factor will help meet the sale or profit demand with the available resources.

Often companies have to go through make or buy decisions that is decisions

whether to make internally or to buy externally. These decisions involve
relevant costs that is lower from a financial point of view.
AT A GLANCE

Various non-financial considerations are involved in make or buy decisions

which may involve control, employee redundancy as well as maintaining a
competitive advantage of the company.
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 16

INTRODUCTION TO FINANCIAL
INSTRUMENTS

AT A GLANCE
IN THIS CHAPTER The objective of understanding the concepts of financial

AT A GLANCE
instruments is to understand the different aspects of financial
AT A GLANCE management. An important aspect of financial management is
the choice of among different options of financing for company’s
SPOTLIGHT assets. The aim is to achieve an efficient capital structure by
maintaining an adequate working capital maintaining balance
1. Core Sources Of Finance between equity and debt capital in the long term capital
structure and creating a suitable balance between short –term
2. Equity and long term funding.

3. Debt The two main sources of finance used in long term capital
structure of company is are equity and dept. the choice between
4. Other Common Sources Of these sources are affected by various factors. For eg. Costs,

SPOTLIGHT
Finance flexibility, repayments and so on.

5. Direct And Indirect Divisibility, liquidity and holding period are amongst the basis
Investment which are used to differentiate between indirect and indirect
investment decisions
6. Other Financial Instruments
Other options available to investors before invest is the buying
STICKY NOTES and selling of different financial instruments to hedge them
against future expected losses.

STIKCY NOTES

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1. CORE SOURCES OF FINANCE

A suitable balance between short-term and long-term funding
Adequate working capital
A suitable balance between equity and debt capital in the long-term capital structure
1.1 Factors considered before selecting source of finance
Before selecting the source of finance the company should consider different factors that are:
 Amount required – for example access to long-term bank lending may be restricted due to the amount of
risk that banks are willing to take. The company may be required to raise new long-term capital through the
sale of equity shares (see below).
AT A GLANCE

 Cost – the company should consider both the on-going servicing cost and the initial arrangement cost for its
financing. For example, the cost of both raising and servicing equity may be high as shareholders accept high
risk in return for the promise of higher rewards (dividends).
 Duration – broadly speaking short-term financing is used to fund short-term assets and long-term financing
used to fund long-term assets.
 Flexibility – the Directors should consider balancing risk, cost and flexibility. For example in a year with low
profits (or even a loss) the company could decide not to pay a dividend to the shareholders. However, most
debt financing requires the payment of interest irrespective of company performance.
 Repayment – the company needs to carefully forecast future cash flows in order to ensure it is able to repay
debt as it falls due. For example, a company should ensure it generates enough cash to repay a 10-year bank-
loan in 10-years’ time on the due date.
 Impact on financial statements – stakeholders such as equity investors and the providers of debt finance
SPOTLIGHT

will often analyses a company’s financial statements to help them assess the risk involved in financing the
company. Therefore, the company should consider the impact that its financial management decisions might
have on its financial statements and the message that sends to providers of finance. The details of sources of
finance are explained in next section.
There are two main sources of finance:
a) Equity
b) Debt
STIKCY NOTES

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2. EQUITY
Providers of equity are the ultimate owners of the company and exercise control through the voting rights
attached to shares.
Equity shareholders gain a return on their investment in two ways:
 Capital gains – the value of their share in the company increases as the value of the company increases
 Dividends – companies return cash to shareholders through the payment of dividends. Dividends are
typically paid once or twice per year.
The cost of equity is higher than other forms of finance as the equity holders carry a high level of risk, and
therefore command the highest of returns as compensation.
New issues to new investors will dilute control of existing owners. Finance is raised through the sale of shares to

AT A GLANCE
existing or new investors (existing investors often have a right to invest first which is called pre-emption rights).
Issue costs can be high.
The company issues two types of shares to raise equity finance:
 The ordinary shares holders are the real owners of the company and are entitled for residual profit of the
company. Their investments are not normally redeemable.
 The Preference share holders are entitled normally for fix dividend before distribution of profit to ordinary
shareholders. Their investments are normally redeemable.
Comparison of Ordinary shares and preference shares
The company can issue ordinary shares as well as preference shares to raise equity finance but the characteristics
of both types of shares are different as:

SPOTLIGHT
Feature Ordinary shares Preference shares

Dividend rate Variable – higher in a good year, lower in Fixed e.g. 4% per annum
a bad year

Dividend Paid only if there are spare funds after Receives the dividend before ordinary
distribution the payment of a preference dividend shareholders (therefore lower risk)

Liquidation The last to be repaid in a liquidation Repaid before (in preference to) the ordinary
shareholders

Voting rights Normally receive the right to vote on Typically receive no right to vote on company

STIKCY NOTES
major decisions. Each ordinary share decisions.
would attract one vote.

2.1. Methods of Floatation

There are five principal methods for a company to raise equity finance:
 Initial public offer
 Private placing
 Introduction
 Right Issue
 Bonus Issue
2.1.1. Initial public offer (IPO)
A public offer refers to the process in which a company offers its shares for sale to private and/or institutional
investors. The first time the company offers its shares for sale is called an initial public offer.

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Shares are normally offered at a fixed price which is decided by the company and its broker. The issue price
needs to be attractive to prospective shareholders in order to incentivize them to invest.
An initial public offer normally involves the acquisition (or underwriting) by an issuing house of a large block of
shares of a company. They will then offer them for sale to the general public and/or other investors. The issuing
house is normally a merchant bank or a syndicate of banks.
IPOs are normally the most expensive route to market and are therefore commonly seen with larger companies
looking to raise substantial amounts of capital.
2.1.2. Private placing
With a private placing an issue of equity shares is ‘placed’ by the company with one or more institutional
investors through a broker. Unlike with an IPO it is not open to the general public.
Placing is a lower risk and lower cost method of issuing shares. Placing is suitable when issuing a lower volume
AT A GLANCE

of shares than in an IPO. For such issues the costs of an IPO such as advertisement, marketing and underwriting
costs are unjustified by the size of issue.
A private placing normally results in a narrower shareholder base and potentially lower liquidity in the shares
once the company has been admitted to a market.
There may be some limits on the maximum amount of an issue that can be placed. This will depend on local law.
Placing is popular with listing on the AIM (Alternative Investment Market). AIM is an alternative to the main
stock exchange and is more suited to companies with lower capitalization levels than the very largest of
companies.
2.1.3. Introduction
Under a stock exchange introduction, no new shares are made available to the market. An ‘introduction’ describes
SPOTLIGHT

when shares in a large company are already widely held by the public (typically at least 25% of a company’s
ordinary share capital - so that a market for the shares already exists) and the company wants its shares to be
publicly tradable on a recognized stock market.
A company might execute an ‘introduction’ in order to enhance the marketability of its shares and gain better
access to capital in the future through increased exposure to a wider investor base.
Comparison of Introduction with other methods of raising equity
If the company uses placing a method of raising equity finance as compare to introduction, then it can avail
different benefits that are:
 Placings are cheaper and therefore well suited to smaller issues.
STIKCY NOTES

 Placings are quicker to perform.

 Placings are likely to involve less disclosure of information.
At the same time if the company uses placing a method of raising equity finance as compare to introduction then
it faces different drawbacks that are:
Most of the shares are usually placed with a small number of institutional investors. This means that most of the
shares are unlikely to be available for public trading and therefore institutional investors will have control of the
company.
2.1.4. Other methods
Right Issue
This is when a company issues new shares to its existing ordinary shareholders. Each shareholder has the right
to buy new shares in proportion to their existing shareholding – e.g. “1 for 1” which means a shareholder can buy
one new share for each one they already own.

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Bonus Issue
With a bonus issue no new capital is raised. The company capitalizes part of its reserves by making a bonus issue
to the existing shareholders. This has the effect of increasing the number of shares in circulation (and thus
increase liquidity) although as no new capital was raised the average value of the greater number of shares will
fall proportionally. This is normally done when company does not want to pay cash dividends.
Difference between Right issue and bonus issue
In case of right issue the company issues shares to its existing shares holders in exchange of consideration that
increases the assets of company normally in cash.
In case of bonus issue the company issue shares by capitalizing its existing reserves that increase the shares of
company without increasing the assets of company.
For example, if company ‘A’ limited issued 5,000 right shares to existing shares holders of Rs. 100 per share then

AT A GLANCE
at the same time it increases the share capital as well as cash of the company by Rs. 5,000,00.
On the other hand, if company ‘A’ issues 5,000 bonus shares to its existing shares holders then it only increasing
its share capital by Rs. 500,000.

SPOTLIGHT
STIKCY NOTES

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3. DEBT
Debt finance describes finance obtained when a company borrows money in exchange for the payment of
interest.
Debt can be categorized between short-term and long-term depending on the length of time between issuance
and maturity. However, this classification is not a perfect science.
Generally speaking, short term finance is used to fund short-term working capital requirements. Long term
finance is used for major long-term investments and is usually more expensive and less flexible than short term
finance (because the lender is risking their money for longer).
Types of long and short-term debt finance include:

Short-term Long-term
AT A GLANCE

Overdraft Bonds, loan stock, debentures, loan notes, commercial paper

Short-term bank loan Euro bonds
Certificate of deposit Convertible bonds and warrants
Treasury-bill Long-term bank loan
Trade credit

Debt is also classified between redeemable and irredeemable:

 Redeemable debt will be repaid and cancelled.
SPOTLIGHT

 Irredeemable debt is (in theory) never repaid. The debt buyer benefits solely from the interest payments
they receive.
Irredeemable debt is less common compared to redeemable debt although some national, state and local
governments and some companies do issue irredeemable debt, typically as bonds or debentures. The other
common type of irredeemable debt is when companies issue irredeemable preference shares. These are similar
to normal preference shares except that the capital is not repaid.
3.1. Factors influencing the choice of debt finance
Availability
For example, only listed companies will be able to make a public issue of loan notes on a stock exchange. Smaller
companies may only be able to obtain significant amount of debt finance from the banks or other financial
STIKCY NOTES

institutions.
Duration
If finance is sought to buy a particular asset to generate revenue for the business, the period of repayment of the
finance should match the length of time that the asset will be generating revenues.
Fixed or floating rates
Expectations of interest rate movements will determine whether a company chooses to borrow at a fixed or
floating rate. Fixed rate finance may be more expensive, but the business runs the risk of adverse upward rate
movements if it chooses floating rate finance on the other hand it will have to forego the upside potential of rate
reduction.
Security and covenants
The choice of finance may be determined by the assets that the business is willing or able to offer as security,
also on the restrictions in the covenants that the lenders wish to impose and the business is able to bear.

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3.2. Advantages and disadvantages of debt finance

Advantages of debt finance to investors
 Investors are entitled to a fixed return each year thus reducing the risk of variable income (e.g. dividends).
 In the case of non-payment of interest, debt holders can appoint a liquidator.
 Debt is attractive to investors because it will be secured against the assets of the company.
 In the case of liquidation debt holders rank higher than other payables for recovery of dues.
Advantages of debt finance to the company
 Debt is a cheaper form of finance than equity because, unlike dividends, debt interest is tax deductible in
most tax regimes.
 Debt holders do not have any voting rights and therefore will not participate in the decision making process

AT A GLANCE
therefore the current owners do not have to yield decision making powers.
 In the case of high profits companies only have to pay a fixed interest.
 There is no immediate dilution in earnings and dividends per share.
 Low issuance cost as compared to equity.
 Provides the company with a facility to raise cash.
Disadvantages of debt finance to investors
 Debt holders do not have any voting rights.
 In case of high profit, their interest will be limited (fixed interest).
 If the bonds or debentures are unsecured, the investment will be high risk compared to secure loans.

SPOTLIGHT
Disadvantages of debt finance to the company
 Companies have to provide security against the debt provided which may limit their use of the mortgaged
asset.
 In the case of very low profits or losses fixed interest still has to be paid.
 In the case of non-payment of interest debt holders can appoint liquidators which will affect the reputation
of the company.
 In the case of company liquidation, the company must repay the debt holders first.
 The future borrowing capacity of the firm will be reduced as there will be fewer assets to provide security
for future loans.
 The real cost is likely to be high as compared with other sources of finance.

STIKCY NOTES
 The more highly geared the company, the higher will be its risk profile.
3.3. Selection of Source of finance
Decision of selecting the source of finance by the company is very critical for its long term survival.
For evaluating the source of finance the company should consider its gearing level as:
Equity is used to provide long-term finance. ‘Gearing’ describes the balance of long-term financing between non-
interest-bearing Equity and interest-bearing Debt – the higher the proportion of interest-bearing debt the higher
the gearing. Equity finance may be used in preference to debt finance if the company is already highly geared.
Note that per company law private companies are typically not allowed to offer shares for sale to the public at
large. In such cases the private limited company would need to convert to a public limited company to enable it
to offer shares for sale to the public.
3.4. Bonds, loan notes, debentures, commercial paper and loan stock
The basic principle of bonds, loan notes, debentures, commercial paper and loan stock is the same. An investor
loans money to a company in exchange for receiving interest and the subsequent repayment of the loan.

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All these instruments have a ‘par value’ that signifies the debt owed by a company to the instrument holder.
These instruments can be bought and sold on the capital markets. These markets are known as secondary
markets, since they trade debt that has already been issued. The market value may be different from the par
value. This is because the market value depends upon market forces and interest rate expectations.
Interest is usually paid every year or every six months and is calculated on the par value. Usually the interest rate
is fixed: however, it may also be floating (variable) related to the current market interest rate.
In today’s markets the terms bonds, loan note, debentures and commercial paper are often used interchangeably
although the legal definition can vary between jurisdictions.
The most commonly accepted differences between the instruments are:
 Commercial paper – very short term with a maturity of less than 9 months
AT A GLANCE

 Loan note – short term with maturity of less than 12 months in the case of government notes, or less than 5
years for corporate loan notes
 Debenture – unsecured long-term loan
 Bond – secured long-term loan (typically between 5 and 20 years)
For the rest of this section we will use the generic term ‘loan stock’ to include bonds, loan notes, debentures and
commercial paper.
Market value of loan stock
Unlike shares, debt is often issued at par which is Rs100 (also called nominal value). Where the coupon
(interest) rate is fixed at the time of issue, it will be set according to prevailing issuing debt.
Subsequent changes in market and company conditions will cause the market value of the bond to fluctuate,
although the coupon will stay at the fixed percentage of nominal value.
SPOTLIGHT

The basic principle for valuing loan stock based on future expected returns is:

(Interest earnings x annuity (Redemption value x

Value of debt = +
factor) Discounted cash flow factor)

OR

M.V. of debt= P.V of interest payments+ P.V of redemption value

The market will also take account of other market factors such as reputation, interest rate expectations and risk
when valuing debt. Detailed valuation is outside the scope of this paper.
STIKCY NOTES

 Example 01:
If ‘A’ limited has the following data
Interest per annum Rs. 490
Required rate of return 10%
Loan agreement 5 years
Interest rate 7% p.a
Redemption value 7% premium
Loan amount 7000
In the above context the market value of debt is =(490 x 3.79) + (7490 x .621)
= 1857 + 4651
= Rs. 6508

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Charge (mortgage) on loan stock

Loan stock may be secured through a fixed or floating charge on assets. A fixed charge may be on specific assets
such as land and buildings. The specified assets cannot be sold while the loan is outstanding. A floating charge is
a charge on a class of assets, such as inventory, receivables or machinery. Sale of some assets of the class is
permitted. When a fault arises, such as a default in payment of interest, a floating charge converts into a fixed
charge on the specific class of assets.
Interest rate on loan stock
Interest rate can be fixed (agreed at the outset) or floating (vary over the life depending on prevailing market
interest rates).
3.4.1. Deep discounted bonds
A deep discount bond is a bond offered at a large discount on the par value of the debt so that a significant

AT A GLANCE
proportion of the return to the investor comes by way of a capital gain on redemption rather than through
interest payment.
3.4.2. Zero coupon bonds
A zero coupon bond is the extreme case of a deeply discounted bond with an interest rate of zero. All investor
returns are gained through capital appreciation.
Advantages of zero coupon bonds to borrowers
 Zero coupon bonds can be used to raise cash immediately without the need to repay cash until redemption.
 The cost of redemption is known at the time of issue and so the borrower can plan to have funds available to
redeem the bonds at maturity.

SPOTLIGHT
Advantages of zero coupon bonds to lenders
 The advantage for lenders is restricted, unless the rate of discount on the bonds offers a high yield.
 They are ideal for investors who are willing to sacrifice periodic return for a higher return at maturity.
 The only way of obtaining cash from the bonds before maturity is to sell them, and their market value will
depend on the remaining term to maturity and current market interest rates.
3.4.3. Euro bonds
A Eurobond is a bond denominated in a currency that is not native to the country where it is issued.
Eurobonds are named after the currency they are denominated in. For example:
 A Eurodollar bond could be issued anywhere outside the USA

STIKCY NOTES
 A European bond could be issued anywhere outside Japan
 A Euro sterling bond could be issued anywhere outside the UK
Eurobonds are normally issued by an international syndicate and are an attractive financing tool as they
normally have small par values and high liquidity. Eurobonds give the issuer flexibility to choose the country in
which to offer their bond according to the country’s regulatory constraints.
3.4.4. Convertible bonds and warrants (hybrids)
A hybrid is a financial instrument that combines features of equity and debt. Convertible bonds and warrants
are examples of hybrids.
Convertible bonds are fixed interest debt securities which give the holder the right to convert the bond into
ordinary shares of the company. The conversion takes place at a pre-determined rate and on a pre-determined
date. If the conversion does not take place the bond will run its full life and be redeemed on maturity. Conversion
rates often vary overtime.
Once converted, convertible securities cannot be converted back into original fixed return security.

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A warrant is similar to a convertible bond in that the warrant allows the holder to buy stock at a set price (rather
than convert the underlying bond into stock). As such the ‘stock’ part of a warrant can be separated from the
bond and traded on its own whereas a convertible bond cannot be separated.
3.4.5. Features of convertible securities
How they work
Interest is paid at an agreed rate for a specified period. At the end of the period the holder can choose to be repaid
in cash or to change the debt into equity shares. Whether or not conversion occurs depends on the share price at
the conversion date.
The issuing company will need to raise cash in order to pay back the amount if conversion is not chosen.
Conversion rate
AT A GLANCE

The conversion rate is expressed as a conversion price. i.e. the price of one ordinary share that will be
appropriated from the nominal value of the convertible bond. Conversion terms may vary over time.
Conversion value
The current market value of ordinary shares into which a loan note may be converted is known as the conversion
value. The conversion value will be below the value of the note at the date of issue, but will be expected to increase
as the date for the conversion approaches on the assumption that a company’s shares ought to increase in market
value over time.
Conversion premium
A conversion premium is the difference between the market price of the convertible bond and its conversion
value. In other words, it is the difference between the market price of the convertible bond and the market price
of shares into which the bond is expected to be converted.
SPOTLIGHT

Conversion value = Conversion ratio x Market price/share (Ordinary shares)

Conversion premium = Current market Price/Value - Conversion value

As the conversion date approaches the market price of a convertible bond and its conversion value tend to be
equal. In other words, the conversion premium will be negligible. Initially the conversion value is lower than the
market value of the bond. The conversion premium is proportional to the time remaining before conversion. It
is highest in the beginning and decreases so that, just before conversion, it is negligible.
 Interest rate on convertible debt
Convertible securities attract lower interest rates than straightforward debt due to the presence of a
STIKCY NOTES

conversion right. The lender is, in effect, lending money and buying a call option on the company’s shares.
 Market price of convertibles
The actual market price of convertible notes depends upon:
- The price of straight debt.
- The current conversion value.
- The length of time before conversion may take place.
- The markets expectation as to future equity returns and the risks associated with these returns.
Advantages of convertible bonds to a company
 Convertible bonds serve a company as delayed equity. Thus a company can delay the issue of ordinary shares
(equity) and the resultant reduction in earnings per share (EPS).
 Similarly, if the directors feel that the prices of shares of the company are depressed at present and therefore
do not represent a favorable time to issue new ordinary shares immediately it may issue convertible bonds.
 The interest payable on the bond is tax deductible.

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 Since interest payments are fixed financial planning becomes easier.

 The convertible bonds are expected to be self-liquidating in the sense that cash is not needed to redeem
them.
Advantages of convertible bonds to investors
 A convertible bond offers the unique combination of fixed interest plus lower risk in the beginning and the
possibility of higher gains in the long run.
 Investors get an opportunity to participate in the growth of the company.
 It is possible for investors to evaluate the performance of a company and then decide whether to opt for
conversion.
Disadvantages of convertible bonds to the company

AT A GLANCE
 On conversion there will be a reduction in EPS.
 On conversion there may be a reduction in the control of existing shareholders.
 Before conversion gearing will be higher, thereby affecting the risk profile of the company.
Disadvantages of convertible bonds to investors
 Future dividend payments are not taken into account in the calculations. Therefore, after conversion there
may be less profit available for distribution as dividends. In this case investors will incur an opportunity cost
related to their investment.
 Example 02:
Aamir Foods Limited (AFL) has issued 8,000 convertible bonds of Rs. 100 each at par value. The
bonds carry mark-up at the rate of 8% which is payable annually. Each bond may be converted

SPOTLIGHT
into 10 ordinary shares of AFL in three years. Any bonds not converted will be redeemed at Rs.
115 per bond.
In the above contexts if the bondholders require a return of 10% and the expected value of AFL’s
ordinary shares on the conversion day is:
a) Rs. 12 per share
b) Rs. 10 per share
Then the current market price of the bonds is:
Current market value for 8,000 convertible bonds

STIKCY NOTES
Current market value
Cash for 8,000 bonds, when
Discount
flows/value price per share is
Year Description factor at
for 8,000
10% (a) (b)
bonds
Rs. 12 Rs. 10

Rupees --------- Rupees -------

1 Annual interest (8,000×100×8%) 64,000 0.909 58,176 58,176

2S Annual interest (8,000×100×8%) 64,000 0.826 52,864 52,864

3 Annual interest (8,000×100×8%) 64,000 0.751 48,064 48,064

159,104 159,104

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Current market value

Cash
Discount for 8,000 bonds, when
flows/value price per share is
Year Description factor at
for 8,000
10% (a) (b)
bonds
Rs. 12 Rs. 10
Bonds’ value at higher of shares' expected value and bonds' redemption value:
Expected value of 10 Redemption
shares value of one
bond
3 (a) 120.00 115.00 960,000*1 0.751 720,960
3 (b) 100.00 115.00 920,000*2 0.751 690,920
AT A GLANCE

Current market value for 8,000 convertible bonds 880,064 850,024

*1 (8,000 × 120)
*2 (8,000 × 115)

3.5. Bank loans and overdrafts

3.5.1. Bank loans
Banks provide term loans as medium or long-term financing for customers. The customer borrows a fixed
amount and pays it back with interest. The capital is typically repaid at the end of the term although it may be
repayable in tranches.
With a loan both the customer and the bank know exactly what the repayment of the loan will be and how much
SPOTLIGHT

interest is payable and when. This makes planning (budgeting) simpler compared with the uncertainty of the
overdraft (see below).
Other features of bank loans include:
 Interest and fees are tax deductible.
 Once the loan is taken interest is paid for the duration of the loan.
 A loan might become immediately repayable if loan covenants are breached but failing that the cash is
available for the term of the loan.
 Can be taken out in a foreign currency as a hedge of a foreign investment.
 A company can offer security in order to secure a loan.
STIKCY NOTES

Short-term loans are suitable for funding smaller investments and long-term loans are suitable for funding major
long-term investments.
Difference between Bank Loan and Loan Stock:
if company wants to know which type of loan is beneficial for it either bank loan or loan stock then it considers
the following points:

Feature Bank loans Loan stock

Flexibility It may be possible to alter the terms of the Terms are fixed
bank loan as the finance requirements of the
company changes
Confidentiality Only the bank will require limited Customer will have to fulfil the publicity
information as part of the loan application requirements that an issue of loan stock
on the financial markets would need
Speed Quick to arrange Slower to arrange due to the need to fulfil
the requirements of a public issue

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Feature Bank loans Loan stock

Costs Low cost High issuance costs
Restrictions Restrictions such as collateral and possible Much less restrictive
restrictive covenants are normally required
Financial Detailed financial information such as No such submissions required
information budgets and management accounts may
have to be submitted periodically to the
bank

3.5.2. Overdrafts
With an overdraft facility the borrower can borrow through their current account on a short-term basis up to an

AT A GLANCE
agreed overdraft limit. However, overdrafts are repayable on demand whereas term loans are repayable only on
the date(s) agreed when the loan was arranged.
Other features include:
 Interest and fees are tax deductible.
 Interest is only paid when the account is overdrawn.
 Penalties for breaching overdraft limits can be severe.
Overdrafts are normally used to finance day-to-day operations and as such form an important component of
working capital management policies.
3.6. Leases
An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right

SPOTLIGHT
to use an asset for an agreed period of time (IFRS 16).
As per IFRS 16 lessee shall capitalize all leases except short term and low value lease and IFRS 16 identifies two
types of lease for Lessor one is finance lease and other is operating lease:
3.6.1. Finance lease
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset.
Title may or may not eventually be transferred.
3.6.2. Operating Lease
An operating lease is a lease other than a finance lease.
The tax deductibility of rental payments depends on the tax regime but typically they are tax deductible in one

STIKCY NOTES
way or another.
Finance leases are capitalized and affect key ratios (ROCE, gearing)
In both cases:
 legal ownership of the asset remains with the lessor; but
 the lessee has the right of use of the asset in return for a series of rental payments
The leases differ in the following respects for lessor:

Finance lease Operating lease

Lease term Long (compared to the life of the asset). Short (compared to the life of the
Usually for major part of the asset’s life. asset)
Risks and rewards of Pass to the lessee Remain with the lessor
ownership
Insurance of the asset Lessee’s responsibility Lessor’s responsibility

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Finance lease Operating lease

Maintenance of the asset Lessee’s responsibility Lessor’s responsibility
Ownership The contract may allow the lessee to buy The contract never allows the
the asset at the end of the lease (often at a lessee to buy the asset at the end
low price – giving the lessee a bargain of the lease
purchase option)

3.7. Other short-term debt instruments

Other short-term debt instruments which an investor can trade before the debt matures include:
 Certificates of deposit (CDs)
 Treasury bills (T-bills)
AT A GLANCE

Trade credit is a further mechanism for funding short-term financing requirements.

3.7.1. Certificates of deposit (CDs)
A CD is a security that is issued by a bank, acknowledging that a certain amount of money has been deposited
with it for a certain period of time (usually, a short term). The CD is issued to the depositor, and attracts a stated
amount of interest. The depositor will be another bank or a large commercial organization.
CDs are negotiable and traded on the CD market (a money market), so if a CD holder wishes to obtain immediate
cash, he can sell the CD on the market at any time. This secondary market in CDs makes them attractive, flexible
investments for organizations with excess cash.
3.7.2. Treasury bills (T-bills)
Treasury bills are issued by a government to finance short-term cash deficiencies in the government's
SPOTLIGHT

expenditure program. They are essentially bonds issued by the government, giving a promise to pay a certain
amount to their holder on maturity.
Treasury bills typically have a term of less than a year to maturity after which the holder is paid the full value of
the bill.
3.7.3. Trade Credit
Credit available from supplies is one of the easiest and cheapest sources of short term finance. If credit is
obtained, it reduces the need for finance from other sources e.g. banks.
Advantages of trade credit:
 The advantage of trade credit is that no interest is usually charged unless the firm defaults on payment.
STIKCY NOTES

 Current assets such as raw materials can be purchased on credit with payment terms normally varying
between 30 to 90 days.
 In a period of high inflation, purchasing through trade credit will be very helpful in keeping costs down.
Disadvantages of trade credit:
 Delays in payment will worsen a company’s credit rating.
 Additional credit is difficult to obtain if you are currently delaying the payments.
 Cost of trade credit beyond the agreed terms is very high in terms of the penalty interest charged as well as
in terms of retaining relations with suppliers.

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4. OTHER COMMON SOURCES OF FINANCE

4.1. Venture capital (VC)
The term ‘venture capital’ is normally used for capital provided to a private company by specialist investment
institutions, sometimes with support from banks in the form of loans.
The company must demonstrate to the venture capitalist organization that it has a clear strategy and a convincing
business plan.
A venture capital organization will only invest if there is a clear ‘exit route’ (e.g. a listing on an exchange).
Investment is typically for 3-7 years after which the VC will realize their profits and exit the investment.
Factors to consider the appropriateness of Venture Capital:

AT A GLANCE
 VC is an important source of finance for management buy-outs.
 VC can provide finance to take young private companies to the next level.
 VC may provide cash for start-ups but this is less likely.
4.2 Business angels
Business angels are wealthy individuals who invest directly in small businesses, usually by purchasing new
equity shares. Angels do not get involved in the management of the company.
Business angels are not that common. There is too little business angel finance available to meet the potential
demand for equity capital from small companies. Business angels are a way for small companies to raise equity
finance, normally at the very start of their life.
4.3 Private equity funds

SPOTLIGHT
Private equity describes equity in operating companies that are not publicly traded on a stock exchange.
Private equity as a source of finance includes venture capital and private equity funds.
A private equity fund looks to take a reasonably large stake in mature businesses.
In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature
company and tries to enhance value by eliminating inefficiencies or driving growth.
Their view is to realize the investment, possibly by breaking the business into smaller parts.
Private equity’s approaches to eliminate inefficiencies usually by downsizing have attracted criticism.
Factors to consider the appropriateness of private equity fund. For example, if the company wants to judge when

STIKCY NOTES
private equity fund is appropriate it should consider the following points:
 If used as a source of funding a private equity fund will take a large stake (30% is typical) and appoint
directors.
 Private equity is a method for a private company to raise equity finance where it is not allowed to do so from
the market.
4.4 Asset securitization and sale
Securitization is the process of converting existing assets or future cash flows into marketable securities.
Typically, the following occur simultaneously:
 Company A sets up Company B (described as a special purpose vehicle or SPV) and transfers an asset to it
(or rights to future cash flows).
 Company B issues securities to investors for cash. These investors are then entitled to the benefits that will
accrue from the asset.
 The cash raised by Company B is then paid to Company A.

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In substance this is like Company A raising cash and using the asset as security. Accounting rules might require
Company A to consolidate Company B even though it might have no ownership interest in it.
Conversion of existing assets into marketable securities is known as asset-backed securitization and the
conversion of future cash flows into marketable securities is known as future-flows securitization.
Factors to consider the appropriateness of asset securitization and sale
 Asset securitization is used extensively in the financial services industry.
 Securitization allows the conversion of assets which are not marketable into marketable ones.
 Securitization allows the company to borrow at rates that are commensurate with the rating of the asset. A
company with a credit rating of BB might hold an asset rated at AA. If it securitizes the asset it gains access
to AA borrowing rates.
AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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5. DIRECT AND INDIRECT INVESTMENT

Direct investment describes when an investor owns all or part of an asset. With indirect investment, the investor
gains exposure to the risks and rewards of an underlying asset without actually owning it through vehicles such
as securities, funds, derivatives and private equity. For instance, A direct investor might own a building then
make a profit from the capital appreciation when they sell the building. Whereas, an indirect investor might
invest in an investment fund whose return is then based on the average movement in property values. They will
therefore make a profit as property values grow without actually owning the building.
Similarly, a direct investor would buy shares in a company and an, an indirect investor might invest in a pension
fund that speculates on the movement in market price of shares through buying futures.
Foreign Direct Investment (FDI)
FDI describes when a company invests in overseas operations either by buying (and directly owning) a foreign

AT A GLANCE
company, or by expanding existing operations overseas.
Difference between Direct & Indirect investment
Direct and indirect investment can normally be differentiated by levels of divisibility, liquidity and holding
period.
Note though that these are general observations rather than specific rules. The main differences are:

Direct investment Indirect investment

Divisibility Often required to fund the whole More opportunity to spread the risk and share the
project – e.g. building and owning an indirect investment with other investors. This
overseas distribution network. Thus enables the investor to invest in more opportunities
greater levels of capital are required. each one with a more modest amount.

SPOTLIGHT
For example being part of a syndicate of 20 investors
who invest in 20 different start-up opportunities
through an overseas holding company exposes the
investor to 20 opportunities rather than just one.
Liquidity Normally illiquid due to the size More liquid than direct investments as investment
(larger) and uniqueness of the funds are often open-ended with investors entering
investment. and leaving the investment vehicle frequently in an
open market.
Holding Potentially longer-term, may be Medium term. For example investing in a real estate
period permanent. For example owning a investment fund until a price target has been met.

STIKCY NOTES
factory in a foreign territory.

Investment vs. speculation

Investment and speculation are similar in that they both involve an investor risking capital in the expectation of
making a profit. However, a number of differences exist as detailed in the table below.

Feature Investment Speculation

Timeframe Normally long-term Often short to medium- term
Attitude to risk Risk neutral Risk seeker
Liquidity Investment usually involves putting money into an Speculators often invest in more
asset that isn’t typically marketable in the short term. marketable assets as they do not
The objective is to yield a series of returns over the plan to own them for too long.
life of the investment.
Volatility Investors build their strategy based on the Speculators will normally expect
expectation that a certain price movement or income some kind of change without
stream will occur. necessarily knowing what.

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Feature Investment Speculation

Investment risk Low-moderate risk Moderate-high risk
Expected Moderate returns for taking moderate risk High returns in exchange for high
returns risks.
Where do Yield (interest, dividends, coupons) and capital Capital (price) appreciation
returns come (price) appreciation
from?
Basis for Careful research Intuition, rumor, charts, some
investment research
choice

 Example 03:
AT A GLANCE

An investor might opt to buy shares in large established companies with a strong record of paying
a steady (modest) dividend and increasing the share price steadily yet consistently over a long
period.
The speculator on the other hand might look to buy shares in a company they think is about to
be taken over. They hope that the take-over will occur soon which would attract a sharp increase
in share price in the short-term after which the speculator would immediately sell their shares.
Similarly, with property, an investor may buy a rental property in an area where rentals are
consistently strong with the intention of owning the property for say 20 years. The speculator
might buy a property in the hope that the site will be bought at a significant premium in the short
term say for retail or social development.
SPOTLIGHT
STIKCY NOTES

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6. OTHER FINANCIAL INSTRUMENTS

6.1. Options
An option gives the holder the right, but not the obligation to trade ‘something’. The ‘something’ might be shares,
a foreign currency or a commodity.
The holder of an option pays a premium in exchange for the option. This is similar to paying a car insurance
premium i.e. the fee paid in advance to cover a subsequent event that may or may not occur.
If the holder of the option takes up the option, this is called ‘exercising’ the option.
Let’s say an investor pays a premium of Rs. 300 for the option to buy a share in Company A for Rs. 20,000 in 3
months’ time. Rs. 20,000 is called the ‘strike price’.
If the price of shares in Company A is Rs. 25,000 in 3 months’ time then the holder of the option will exercise

AT A GLANCE
their right to buy a share at Rs. 20,000. They could immediately see that share for Rs. 25,000 in the open market
making a profit of Rs. 5,000 (less the original option premium of Rs. 300).
However, if in 3 months’ time the market price of shares in company A is only Rs. 18,000. In this case the holder
of the option will not exercise their option to buy for Rs. 20,000 as they can buy shares in Company A at that time
in the open market for Rs. 18,000. In this case the option ‘lapses’ (i.e. is not exercised).
The option to buy something in the future is called a CALL option. The option to sell something in the future is
called a PUT option.
When the market price of the underlying product (e.g. a share) is such that to exercise the option would enable
the option holder to make a profit this is called ‘in the money’. If the underlying price is such that to exercise the
option would lose money, the option is said to be ‘out of the money’.

SPOTLIGHT
So in the previous example the call option with a strike of Rs. 20,000 is ‘in the money’ when the market price of
the shares is above Rs. 20,000, but ‘out the money’ when the market price of the shares is trading below Rs.
20,000.
Options have both an intrinsic value and a time value.
6.1.1 Intrinsic value
Intrinsic value is the difference of an ‘in-the-money’ option between the underlying’s price and the strike price.
An ‘out-the-money’ option has no intrinsic value.
 Intrinsic value (call option) = underlying price – strike price
 Intrinsic value (put option) = strike price – underlying price

STIKCY NOTES
6.1.2 Time value
Time value describes the excess premium paid above the intrinsic value for the ‘potential’ that the underlying
price will move sufficiently before exercise date in order to secure an overall profit. It follows then that time
value decreases over time and decays to zero at expiration. This is called ‘time decay’.

Time value = premium – intrinsic value

6.1.3 Options can be further classified as follows:

 Exchange traded options – these are standardized products traded in an open market.
 Over the counter (OTC) options – these are bespoke products where terms are agreed specifically between
the two counterparties.
 Example 04:
Company A purchases a call option giving it the right to buy shares in Company B in 6 months’
time for Rs. 500. The current share price of Company B is Rs. 450.

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In 6 months’ time, if the market price of shares in Company B is above Rs. 500 then Company A
will exercise its right to buy shares at the pre-determined price of Rs. 500.
However, if the market price of Company B shares is below Rs. 500 in 6 months’ time then
Company A would let the option lapse (i.e. why would it buy shares at Rs. 500 when it could just
go to the open market and buy them for a lower market price).
 Example 05:
If an investor paid a premium of Rs. 300 for the option to buy 500 shares in ABC limited for Rs.
20,000 at any time the next three months. The investor exercised his right to buy the shares when
the price in the market was Rs. 50 per share.
In the context of the above example strike price is 40 per share. Because in the example the
investor has an option to buy shares so it is a call option. There would be a loss of Rs. 5940-35)
AT A GLANCE

per share, if the investor exercises the option to buy shares at a strike price of Rs. 40 per share
as against the prevailing market price of Rs. 35 per share. Therefore, the option was termed as
out the money.
 Example 06:
If an investor paid a premium of Rs. 60 to buy a put option at a strike price of Rs. 300. The current
market price of the share is Rs. 260.
In the above context if the investor wants to know the profit/loss if the market price of the share
on the expiry date of the option i.e. 30 days from now is:
1) Rs. 180 : Strike price-underlying price
=300 – 180 -60
SPOTLIGHT

= 60 (profit)
2) Rs. 260 : Strike price – underlying price
=300 – 260
=Rs. 20 Loss
3) Rs. 380 : Strike price – underlying price
= (Rs.60) (loss)
(option should not be exercised and should be allowed to lapse.)
 Example 07:
STIKCY NOTES

On 1 January 2019, Marigold Enterprises (ME) purchased an option for Rs. 10,000 allowing ME
to buy 5,000 shares of Aroma Limited (AL) at a price of Rs. 140 per share, during the next two
months. On 12 February 2019, ME purchased the shares at the agreed price when the market
value of AL's shares was Rs. 180 per share.
Briefly explain each of the following terms and relate each term to the above scenario, wherever
possible:
(i) ‘Call option’ and ‘Put option’
(ii) ‘In the money' and 'Out the money'
i. ‘Call option’ and ‘Put option’
An option to buy something in the future is called a ‘call option’.
An option to sell something in the future is called a ‘put option’.
In the given situation, option is for purchase of shares, therefore, it is a ‘call option’.

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ii. ‘In the money' and 'Out the money'

When the market price of the share is such that by exercising the option, the option
holder makes a profit, the option is said to be ‘in the money’.
When the market price of the share is such that by exercising the option, the option
holder suffers a loss, the option is said to be ‘out the money’.
By exercising the option, ME made a profit of Rs. 38 (180–140–2) per share, therefore,
the option is said to be ‘in the money’.
6.1.4 Currency options
Currency options offer an advantage over both currency forwards and futures (see below) since they not only
protect against downside risk but also allow the buyer of the option to take advantage of favorable currency
movements. This is possible by allowing the option to lapse by paying-off the option premium.

AT A GLANCE
When is a currency option used?
 Where there is uncertainty about foreign currency receipt and payments
 To support an overseas contract priced in a foreign currency
 To allow the publication of price list for its goods in a foreign currency
 To protect the import or export of price sensitive goods. If there is a favorable movement in exchange rates,
options allow the importers or exporters to profit from the favorable change but in case of unfavorable
movements the strike price would set the floor or the ceiling for the exchange rate.
6.2. Caps, collars and floors
A cap is a ceiling agreed to an interest rate

SPOTLIGHT
A floor is a lower limit set for an interest rate
A collar combines both caps and floors thus maintaining the interest rate within a particular range.
 Example 08:
A company’s current prevailing variable borrowing rate is 8%.
The company treasurer has identified that a rise in interest rates above 10% could cause serious
financial difficulties for the company.
The company could buy an interest rate cap at 10% from the bank. As part of the deal the
company agrees to a floor of 7%.

STIKCY NOTES
Thus:
If interest rates rise above 10%, the bank will reimburse the company for the excess in interest
payments
If interest rates fall below 7% the company will reimburse the bank the difference.
Note that the company would suffer a fee (premium) levied by the bank for entering into such
an arrangement.
6.3. Interest rate swaps
An interest rate swap is an agreement between two parties to exchange interest rate payments. The objective
might be to:
 switch from paying one type of interest to another
 Raise less expensive loans
 Securing better deposit rates

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In essence, party A agrees to pay the interest on party B’s loan, whilst party B agrees to pay the interest on party
A’s loan.
The counterparties to interest rate swaps are typically the large financial institutions, national and local
governments and other international institutions.
The most common motivation for entering a swap agreement is to switch from paying floating (variable) rate
interest to fixed rate, and vice versa. This will typically be for either speculative reasons or used for hedging.
 Example 09:
Company A currently pays interest on a Rs. 10m loan at a fixed rate of 10%.
Company B currently pays floating rate interest on a Rs. 10m loan at LIBOR + 1% (assume LIBOR
is currently 9%).
AT A GLANCE

Company A and Company B enter into an interest rate swap agreement whereby:
- Company A agrees to pay Company B a floating rate of LIBOR + 1% on a notional loan of
Rs.10m
- Company B agrees to pay Company A a fixed rate of 10% on a notional loan of Rs. 10m
Note that Company A and Company B retain their original loan obligation. However, when
combined with the effect of the interest rate swap, the effect is that Company A ends up paying
LIBOR + 1% and Company B pays a fixed 10%.
 Example 10:
Unity Limited (UL) has obtained a loan of Rs. 250 million from Eastern Investment Limited (EIL)
for 5 years. The loan carries a floating (variable) rate of interest which is paid annually. The
existing rate is 10%.
SPOTLIGHT

To avoid losses on account of any extra-ordinary increase in interest rate, UL bought an interest
rate cap at 12% from Sawera Bank Limited (SBL). In addition, they also agreed to a floor at 8%.
The interest which UL would pay to EIL and the amounts which UL and SBL would pay to settle
their obligations towards each other, if the interest rate on the due date is:
a) 13% per annum
b) 6% per annum

Unity Limited
Amounts payable by UL to EIL: Rs. in million
STIKCY NOTES

Interest rate is 13% 250×13% 32.50

Interest rate is 6% 250×6% 15.00
Settlement between UL and SBL:
Interest rate is 13% Payable by SBL to UL (13%-12%)×250 2.50
Interest rate is 6% Payable by UL to SBL (8%-6%)×250 5.00

6.4. Currency swaps

A currency swap is an agreement to make a loan in one currency and to receive a loan in another currency.
With currency swaps 3 sets of cash flows are involved:
 Principals are exchanged when the swap starts.
 Interest payments are made over the life of the swaps.
 The underlying principal amounts are re-exchanged.
Banks are involved in swap arrangements as swap dealers.

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Advantages of currency swaps

 They enable a company to obtain funds at a cheaper rate than borrowing in domestic markets, thereby
resulting in cost reduction.
 They enable a company to restructure its debt profile without physical redemption or issuance of new debt.
 They facilitate access to the international capital markets by avoiding exchange control restrictions.
 They enable a company to hedge its currency exposure for longer time periods than is possible with forwards
contracts.
Disadvantages of currency swaps
 If the government imposes exchange control restrictions the swaps may turn out to be risky.
 In the case of adverse movements in exchange rates the swaps may not achieve its purpose of cost reduction.

AT A GLANCE
 There is the possibility that the counterparty may default giving rise to a credit risk. Swaps arranged with a
bank as the counterparty tend to be less risky.
 Finding companies whose needs mutually offset one another is difficult and only partially reduces currency
exposure risk.
 If a company cannot find a match a credit swap may be used. Credit swaps involve a deposit in one currency
and a loan in another. The deposit is returned after the loan is repaid.
6.5. Forwards
A forward contract is a binding agreement to exchange a set amount of goods at a set future date at a price agreed
today.
Forward contracts are used by business to set the price of a commodity well in advance of the payment being
made. This brings stability to the company who can budget with certainty the payment they will need to raise or

SPOTLIGHT
the revenue that a given set of output would bring.
Forwards are particularly suitable in commodity markets such as gold, agriculture and oil where prices can be
highly volatile.
 Example 11:
A coffee wholesaler needs to purchase coffee beans for future production and wants to acquire
them for a fixed price. This can be achieved by agreeing with the producer to purchase a quantity
of coffee beans for delivery at a specific date in the future at a price agreed now.
In June when the price of a consignment is Rs. 1m the wholesaler might agree a price with the
supplier of Rs. 1.1m for delivery at the end of September which remains set through to delivery.

STIKCY NOTES
Forward contracts are tailor-made between the two parties and therefore difficult to cancel (as
both sides need to agree). A slightly more flexible approach would be to use futures (see below).
6.6 Futures
Futures share similar characteristics to Forward contracts i.e.:
 Prices are set in advance.
 Futures hedges provide a fixed price.
 Futures are available on commodities, shares, currencies and interest rates.
However, futures are standardized contracts that are traded on an open futures market (unlike forward contracts
which are unique to the two counterparties).
Advantages of futures
 Futures are standardized in terms of currencies, the amount and maturity dates.
 Futures are “marked to market” – this means that companies can reflect current market prices at year-end
even though the future is yet to mature.

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 In futures hedging, there is flexibility of closing a position at any time before the delivery date.
 Futures contracts can be cancelled (or hedged) by an opposite transaction.
 Futures can be arranged quickly and effectively.
 Multiple contracts can be bought or sold.
Disadvantages of futures
 Margins (i.e. a deposit e.g. 6% of the underlying transaction value) are tied up in making the contracts until
position is reversed.
 Considerable administration costs are involved in managing them.
 Continuous monitoring and decision making is required to ensure that intended rates work effectively.
 Example 12:
AT A GLANCE

A coffee wholesaler needs to purchase coffee beans for future production in September but wants
certainty over the price.
In June when the price of a consignment is Rs. 1m the wholesaler might buy a coffee futures
contract at Rs. 1.1m that expires 30 September. This means the coffee wholesaler is committing
to buying a consignment at Rs. 1.1m in September.
6.6.1 Currency futures
A foreign exchange futures contract is an agreement between two parties to buy or sell a particular currency at
a particular rate on a particular future date.
When entering into a currency futures contract no one is actually buying or selling anything. The participants are
agreeing to buy or sell currencies on pre-agreed terms at a specified future date if the contract is allowed to reach
SPOTLIGHT

maturity which it rarely does.

The range of available rates contracts is however limited and usually only cover major currencies.
STIKCY NOTES

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STICKY NOTES

Sources of Finance may include Equity and Debt. There are certain factors
which may be considered before selecting sources of finance

Equity financing may include ordinary as well preference shares as well

as in addition, methods of flotation include Initial public offer, private
placing, right or bonus issues

AT A GLANCE
Debt Financing would include bonds, loan notes, debentures, commercial
paper and loan stock. Lease is another form of debt financing. Each of the
source has its own advantage and disadvantage.

Other Common Sources Of Finance may include Venture Capital, Business

Angles, Private equity funds and asset securitisation and sale

SPOTLIGHT
Direct and Indirect Investment & Speculation would be required to note
for Divisibility, Liquidity and Holding period.

Other Financial Instruments may include options, Caps, Collars and Floors
Interest rate swaps, Currency swaps, Forwards and forwards

STIKCY NOTES

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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 CHAPTER 17

TIME VALUE OF MONEY

AT A GLANCE
IN THIS CHAPTER
The objective of learning time value of money concept involves
the evaluation and appraisal of investment projects involving
AT A GLANCE
capital expenditures. Capital expenditure refers the spending on

AT A GLANCE
non-current assets such as building, machinery, equipment or
SPOTLIGHT
investing in new business.
1. Core principle & four steps The purpose of investment appraisal is to make decision about
model whether the capital expenditures project is worthwhile and
whether investment project should be undertaken.
2. Net present value(NPV) method
The core principles and techniques for evaluating capital
expenditure project are predicted in four following steps
3. Internal rate of return(IRR)
1. The estimation of expected future cash flows from projects
4. DCF & Inflation (cash receipt & cash payments) using relevant costing
principles.
5. DCF & Taxation

SPOTLIGHT
2. The determination of expected future period where
estimated expected future cash flows (cash inflows & cash
6. Comprehesive Examples outflows) will be occurred.
STICKY NOTES 3. Apply the time value of money concept and discount future
cash flows to present values using discount factor or cost of
capital.
4. To make decision for acceptance or rejection of proposed
investment project using discounted cash flows
techniques(DCF). There are two techniques involving DCF
concepts for evaluation of investment projects that are Net
Present Value Method(NPV) and Internal rate of

STIKCY NOTES
return(IRR)

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1. CORE PRINCIPLE & FOUR STEPS MODEL

The core principles of evaluating investment projects involving capital expenditures using time value of money
concept is based on discounted cash flows methods (DCF). Using DCF techniques like Net present value method
(NPV) and internal rate of return, an entity can decide whether investment project should be undertaken or not.
The core principle is defined in following four steps model framework:
Step 1: The estimation of expected future cash flows from projects (cash receipt & cash payments) using relevant
costing principles.
Step 2: The determination of expected future period where estimated expected future cash flows (cash inflows
& cash outflows) will be occurred.
Step 3: Apply the time value of money concept and discount future cash flows to present values using discount
AT A GLANCE

factor or cost of capital.

Step 4: To make decision for acceptance or rejection of proposed investment project using discount cash flows
techniques(DCF). There are two techniques involving DCF concepts for evaluation of investment projects that
are:
a) Net Present Value Method(NPV)
b) Internal rate of return(IRR)

1.1 Step 1: Estimation of expected future cash flows

The expected future cash flows related to investment project are measured using relevant costing principles.
Expected cash flows are:
SPOTLIGHT

a) The amount that will be spent for purchase of non-current asset. It involves large sum of money normally
occurred at the start of project.
b) Future cost and revenues (cash inflows and cash outflows) arise from the use of non-current assets.
c) Disposal value of asset at the end of its useful life.
d) The investment in working capital related to investment projects.

1.1.1 Relevant costing principles:

As investment appraisal of capital expenditures based on decision making techniques so relevant costs and
revenues should be used in decision of acceptance or rejection of investment projects.
STIKCY NOTES

1.1.2 Definition of relevant cost and benefits

Relevant costs are cash flows. Any items of cost that are not cash flows must be ignored for the purpose of
decision. For example, depreciation expenses are not cash flows and must always be ignored.
Relevant costs are future cash flows. Costs that have already been incurred are not relevant to a decision that is
being made now. The cost has already been incurred, whatever decision is made, and it should therefore not
influence the decision. For example, a company might incur initial investigation costs of Rs. 20,000 when looking
into the possibility of making a capital investment. When deciding later whether to undertake the project, the
investigation costs are irrelevant, because they have already been spent and are not recoverable if the investment
is not undertaken.
Relevant costs are also costs that will arise as a direct consequence of the decision, even if they are future cash
flows. If the costs will be incurred whatever decision is taken, they are not relevant to the decision.
Relevant costs can also be measured as an opportunity cost. An opportunity cost is a benefit that will be lost by
taking one course of action instead of the next-most profitable course of action.

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 Example 01:
A company is considering an investment in a major new information system. The investment will
require the use of six of the company’s IT specialists for the first one year of the project.
These IT specialists are each paid Rs. 100,000 each per year. IT specialists are difficult to recruit.
If the six specialists are not used on this project, they will be employed on other projects that
would earn a total contribution of Rs. 500,000. The relevant cost of the IT specialist in Year 1 of
the project would be:

Rs.
Basic salaries 600,000
Contribution forgone 500,000

AT A GLANCE
Total relevant cost 1,100,000

 Example 02:
A company has been asked by a customer to carry out a special job. The work would require 20
hours of skilled labor time. There is a limited availability of skilled labor, and if the special job is
carried out for the customer, skilled employees would have to be moved from doing other work
that earns a contribution of Rs.60 per labor hour.
A relevant cost of doing the job for the customer is the contribution that would be lost by
switching employees from other work. This contribution forgone (20 hours × Rs.60 = Rs.1,200)
would be an opportunity cost. This cost should be taken into consideration as a cost that would
be incurred as a direct consequence of a decision to do the special job for the customer. In other
words, the opportunity cost is a relevant cost in deciding how to respond to the customer’s

SPOTLIGHT
request.
Conclusion:
a) Variable cost is normally relevant for decision making like incremental, differential,
avoidable, opportunity, cost are example of relevant cost.
b) Fixed cost are normally irrelevant (other than incremental fixed cost) like Sunk or past
cost, unavoidable, committed cost are examples of irrelevant cost.

1.1.3 Relevant cost of materials

As explained earlier in the text, relevant costs of materials are the additional cash flows that will be incurred (or
benefits that will be lost) by using the materials for the purpose that is under consideration.

STIKCY NOTES
If none of the required materials are currently held as inventory, the relevant cost of the materials is simply
their purchase cost and if the required materials are currently held as inventory, the relevant costs are identified
by applying the certain rules.
Note that the historical cost of materials held in inventory cannot be the relevant cost of the materials, because
their historical cost is a sunk cost.
The relevant costs of materials can be described as their ‘deprival value’. The deprival value of materials is the
benefit or value that would be lost if the company were deprived of the materials currently held in inventory.

1.1.4 Relevant cost of labor

The relevant cost of labor for any decision is the additional cash expenditure (or saving) that will arise as a direct
consequence of the decision. If the cost of labor is a variable cost, and labor is not in restricted supply, the
relevant cost of the labor is its variable cost. If labor is a fixed cost and there is spare labor time available, the
relevant cost of using labor is 0. The spare time would otherwise be paid for idle time, and there is no additional
cash cost of using the labor to do extra work. If labor is in limited supply, the relevant cost of labor should include
the opportunity cost of using the labor time for the purpose under consideration instead of using it in its next-
most profitable way.

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1.1.5 Relevant cost of overheads

Relevant costs of expenditures that might be classed as overhead costs should be identified by applying the
normal rules of relevant costing. Relevant costs are future cash flows that will arise as a direct consequence of
making a particular decision.

1.1.6 Relevant cost of existing equipment

When new capital equipment will have to be purchased for a project, the purchase cost of the equipment will be
a part of the initial capital expenditure, and so a relevant cost.
However, if an investment project will also make use of equipment that the business already owns, the relevant
cost of the equipment will be the higher of:
 The current disposal value of the equipment, and
AT A GLANCE

 The present value of the cash flows that could be earned by having an alternative use for the equipment.
 Example 03:
A company bought a machine six years ago for Rs. 125,000. Its written down value is now Rs.
25,000. The machine is no longer used for normal production work, and it could be sold now for
Rs. 17,500. A project is being considered that would make use of this machine for six months.
After this time the machine would be sold for Rs. 10,000.
Relevant cost = Difference between sale value now and sale value if it is used. This is the relevant
cost of using the machine for the project.
Relevant cost = Rs. 17,500 - Rs. 10,000 = Rs. 7,500.
SPOTLIGHT

1.1.7 Relevant cost of investment in working capital

It is important that you should understand the relevance of investment in working capital for cash flows. This
point has been explained previously.
Strictly speaking, an investment in working capital is not a cash flow. However, it should be treated as a cash
flow, because:
 When capital investment projects are evaluated, it is usual to estimate the cash profits for each year of the
project.
 However, actual cash flows will differ from cash profits by the amount of the increase or decrease in working
capital.
 You should be familiar with this concept from cash flow statements.
STIKCY NOTES

 If there is an increase in working capital, cash flows from operations will be lower than the amount of cash
profits. The increase in working capital can therefore be treated as a cash outflow, to adjust the cash profits
to the expected cash flow for the year.
 If there is a reduction in working capital, cash flows from operations will be higher than the amount of cash
profits. The reduction in working capital can therefore be treated as a cash inflow, to adjust the cash profits
to the expected cash flow for the year.
 The investment in working capital is assumed to be recovered at the end of project. Unless it is stated that it
may be recovered straight line basis.
 Example 04:
A company is considering whether to invest in the production of a new product. The project
would have a six-year life. Investment in working capital would be Rs. 30,000 at the beginning of
Year 1 and a further Rs. 20,000 at the beginning of Year 2.
It is usually assumed that a cash flow, early during a year, should be treated as a cash flow as at
the end of the previous year.

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The relevant cash flows for the working capital investment would therefore be as follows:

Year Rs.
1 (cash outflow) (30,000)
2 (cash outflow) (20,000)
6 (cash inflow) 50,000

1.2 Step 2: Timing of Cash flows

The identification of timing of future estimated cash flows is very important. It must be clear at what time the
cash flows whether cash outflows or cash inflows related to project will be occurred.
As the investment decision is based on discounting future cash flows to their present values using the time value

AT A GLANCE
of money concept, for discounting future cash flows discount factor will be used so determination of exact timing
of future cash flows is very critical for choosing and applying exact discount factors.
The following assumptions are made about the timing of cash flows during each year:
 All cash flows for the investment are assumed to occur at a discrete point in time (usually the end of the
year).
 If a cash flow will occur early during a particular year, it is assumed for the sake of simplicity that it will occur
at the end of the previous year. Therefore, cash expenditure early in Year 1, for example, is assumed to occur
at time 0.

Time 0 cash flows

Often cash flows are described as occurring in a particular year (e.g. year 1, year 2 etc.). The project commences

SPOTLIGHT
at time 0. Sometimes time 0 is described as year 0 but this is misleading. There is no year 0, it can be assumed to
be the present time. The first year (year 1) starts at time 0 and ends one year after this.
Cash flows at the beginning of the investment (at time 0) are already stated at their present value.
 Example 05:
A company is considering a new large project. It owns a piece of land that it bought for Rs. 6,000
over forty years ago. This land is currently not being used but could be sold now for Rs. 1.2
million. If it is used it could be sold in three years’ time for Rs. 1.3 million.
The company will spend Rs. 500,000 building a work processing plant for the project. The
company finances the plant with a three-year bank loan at 5%. The resale value of the plant is Rs.
50,000 at the end of year 3.

STIKCY NOTES
The raw material requirements for the project output of 100 tons of Product X together with
information about amounts already held are as follows:

Raw material A B
Current amounts in inventory (tons) 100 100
Cost (per ton) Rs.95 Rs.80
Scrap value (per ton) Rs.30 Toxic
Replacement cost (per ton) Rs.100 Rs.90
Used elsewhere? Yes No
Contribution per ton used on other products**
(**contribution = after deduction of current replacement cost) Rs.40 Rs.400
Annual requirement (tons) 200 100

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Notes
Raw material B is toxic. No further supplies are available until the end of the first year. Material
B is also being used in another product, for which 50 tons are required annually. This other
product is being discontinued from the end of year 1.
There are no other uses for Material B. To dispose of material B would cost the company Rs.125
per ton.
The standard cost card prepared by the management accountant shows a cost for Product X of
Rs.450 per ton produced. This includes a direct labor cost of Rs.100 per unit of Product X.
There is spare capacity in the labor force – no extra personnel or overtime will be needed to
produce the new product.
Receipts from sales will be:
AT A GLANCE

Year 1 Rs.500,000
Year 2 Rs.500,000
Year 3 Rs.300,000
The project will last three years. Assume that all cash flows occur at the end of the relevant year.
The expected future cash outflows and inflows for calculation of Net Cash Flows are:
1. Land
By undertaking the project, the company will forgo the immediate sale of the land, for
which it could obtain Rs.1,200,000. This revenue forgone is an opportunity cost.
However, if the project is undertaken, the land can be sold at the end of Year 3 for
SPOTLIGHT

Rs.1,300,000
2. Plant
The relevant cash flows are its current cost (the Rs.500,000 is assumed to be a cash cost)
and its eventual disposal value. The 5% financing of the plant is irrelevant and must be
ignored: interest costs are implied in the cost of capital, which is 10%, not 5%.
3. Labor costs
Labor costs are irrelevant because they are not incremental cash flows. The wages or
salaries will be paid whether or not the project goes ahead.
4. Material A costs
Material A is in regular use; therefore, its relevant cost is its replacement cost. Annual
STIKCY NOTES

cost = 200 tons × Rs.100 = Rs.20,000.

5. Material B costs
100 tons are currently in inventory and no additional units can be obtained until Year 2.
The choices are to use all 100 tons to make Product X, or to use 50 tons to make the other
product and dispose of the remaining 50 tons.
The other product earns a contribution of Rs.400 per ton of Material B used, and the contribution
is after deducting the replacement cost of the material. The opportunity cost of using the 50 tons
to make Product X instead of this other product in Year 1 is therefore Rs.490 per ton. The total
opportunity cost of lost cash flow is therefore 50 tons at Rs.490 each = Rs.24,500, but in Year 1
only.
However, by making Product X, the company will also avoid the need to dispose of 50 tons of
Material B at a cost of Rs.25 per ton. It is assumed that these costs would be incurred early in
Year 1 (T0). Making and selling Product X will therefore save the company disposal costs of 50
tons × Rs.25 = Rs.6,250 at t0.

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Based on above analysis the calculation of Net cash flow is as under:

Year 0 1 2 3
Rs. Rs. Rs. Rs.
Land (1,200,000) 1,300,000
Plant (500,000) 50,000
Sales 500,000 500,000 300000
Material A (20,000) (20,000) (20,000)
Material B: disposal costs saved 6,250
Material B: cash profits forgone (24,500)

AT A GLANCE
Material B: purchase costs (9,000) (9,000)
Net cash flow (1,693,750) 455,500 471,000 1,621,000

1.3 Step 3: Discounting Cash flows using time value of money concept
One of the basic principles of finance is that a sum of money today is worth more than the same sum in the future.
If offered a choice between receiving Rs 10,000 today or in 1 years’ time a person would choose today.
A sum today can be invested to earn a return. This alone makes it worth more than the same sum in the future.
This is referred to as the time value of money.
The impact of time value can be estimated using one of two methods:
Compounding which estimates future cash flows that will arise as a result of investing an amount today at a given

SPOTLIGHT
rate of interest for a given period. An amount invested today is multiplied by a compound factor to give the
amount of cash expected at a specified time in the future assuming a given interest rate.
Discounting which estimates the present day equivalent (present value which is usually abbreviated to PV) of a
future cash flow at a specified time in the future at a given rate of interest. An amount expected at a specified
time in the future is multiplied by a discount factor to give the present value of that amount at a given rate of
interest. The discount factor is the inverse of a compound factor for the same period and interest rate. Therefore,
multiplying by a discount factor is the same as dividing by a compounding factor. Discounting is the reverse of
compounding.
Money has a time value, because an investor expects a return that allows for the length of time that the money is
invested. Larger cash returns should be required for investing for a longer term.
These methods are further explained as under:

STIKCY NOTES
1.3.1. The time value of money compounding & Annuities

Compound interest
Compound interest is where the annual interest is based on the amount borrowed plus interest accrued to date.
The interest accrued to date increases the amount in the account and interest is then charged on that new
amount.
Compounding is used to calculate the future value of an investment, where the investment earns a compound
rate of interest. If an investment is made ‘now’ and is expected to earn interest at r% in each time period, for
example each year, the future value of the investment can be calculated as follows.
 Formula:

Sn = So × (1 + r)n

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Where:
Sn = final cash flow at the end of the loan (the amount paid by a borrower or received by
an investor or lender).
So = initial investment
r = period interest rate
n = number of periods
Note that the (1 +r)n term is known as a compounding factor

 Example 06:
A person borrows Rs 10,000 at 10% to be repaid after 3 years.
The calculation for final cash flow would require
AT A GLANCE

Sn = So × (1 + r)n
Sn = 10,000 × (1.1)3 = 13,310
 Example 07:
A company is investing Rs.200,000 to earn an annual return of 6% over three years. If there are
no cash returns before the end of Year 3, the return from the investment after three years is:
Future value=Amount today×(1+r)n
Future value=200,000×(1.06)3 =238,203

Annuities
SPOTLIGHT

An annuity is a series of regular periodic payments of equal amount.

Examples of annuities are:
 Rs.30,000 each year for years 1 – 5
 Rs.500 each month for months 1 – 24.

There are two types of annuity:

 Ordinary annuity – payments (receipts) are in arrears i.e. at the end of each payment period
 Annuity due – payments (receipts) are in advance i.e. at the beginning of each payment period.
STIKCY NOTES

 Illustration:
Assume that it is now 1 January 2013
A loan is serviced with 5 equal annual payments.
Ordinary annuity The payments to service the loan would start on 31 December 2013 with
the last payment on 31 December 2017.
Annuity due The payments to service the loan would start on 1 January 2013 with the
last payment on January 2017.
All payments (receipts) under the annuity due are one year earlier than under the ordinary
annuity.

Calculating the final value of an annuity

The following formula can be used to calculate the future value of an annuity.

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 Formula:

Future value of an annuity

X(1+r)n −1
Ordinary annuity Sn =
r
X(1+r)n −1
Annuity due Sn = × (1 + r)
r
Where:
Sn = final cash flow at the end of the loan (the amount paid by a borrower or received by
an investor or lender).
X = Annual investment
r = period interest rate
n = number of periods

AT A GLANCE
 Example 08:
A savings scheme involves investing Rs.100,000 per annum for 4 years (on the last day of the
year).
If the interest rate is 10% the sum to be received at the end of the 4 years is:
X(1+i)n −1 100,000(1.1)4 −1
Sn = Sn =
i 0.1
100,000(1.4641−1)
Sn =
0.1
46,410
Sn = = Rs. 464,100
0.1

SPOTLIGHT
 Example 09:
A savings scheme involves investing Rs.100,000 per annum for 4 years (on the first day of the
year).
If the interest rate is 10% the sum to be received at the end of the 4 years is:
X(1+r)n −1 100,000(1.1)4 −1
Sn = × (1 + r) Sn = × 1.1
r 0.1
100,000(1.4641−1)
Sn = × 1.1
0.1
46,410
Sn = × 1.1 = Rs. 510,510
0.1

STIKCY NOTES
Sinking funds
A business may wish to set aside a fixed sum of money at regular intervals to achieve a specific sum at some
future point in time. This is known as a sinking fund.
The question will ask you to calculate the fixed annual amount necessary to build to a required amount at a given
interest rate and over a given period of years.
The calculations use the same approach as above but this time solving for X as Sn is known.
 Example 10:
A company will have to pay Rs.5,000,000 to replace a machine in 5 years.
The company wishes to save up to fund the new machine by making a series of equal payments
into an account which pays interest of 8%.
The payments are to be made at the end of the year and then at each year end thereafter.
What fixed annual amount must be set aside so that the company saves Rs.5,000,000?

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X(1+i)n −1 X(1.08)5 −1
Sn = 5,000,000 =
i 0.08
X(1.469−1)
5,000,000 =
0.08
X(0.469)
5,000,000 =
0.08
5,000,000×0.08
𝑋= = Rs. 852,878
0.469

1.3.2 The time value of Money-Discounting & Annuities

Discounting
Discounting is the reverse of compounding. Future cash flows from an investment can be converted to an
AT A GLANCE

equivalent present value amount.

Present value of future return is the future cash flow multiplied by the discount factor.
 Formula:

𝟏
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐟𝐚𝐜𝐭𝐨𝐫 =
(𝟏+𝐫)𝐧

Where:
r = the period interest rate (cost of capital)
n = number of periods

 Example 11:
SPOTLIGHT

A person expects to receive Rs 13,310 in 3 years.

If the person faces an interest rate of 10% what is the present value of this amount?
1
Present value = Future cash flow ×
(1+r)n
1
Present value = 13,310 ×
(1.1)3

Present value = 10,000

Discount tables
STIKCY NOTES

Discount factors can be calculated as shown earlier but can also be obtained from discount tables. These are
tables of discount rates which list discount factors by interest rates and duration.
 Illustration:

Discount rates (r)

(n) 5% 6% 7% 8% 9% 10%
1 0.952 0.943 0.935 0.926 0.917 0.909
2 0.907 0.890 0.873 0.857 0.842 0.826
3 0.864 0.840 0.816 0.794 0.772 0.751
4 0.823 0.792 0.763 0.735 0.708 0.683

(Full tables are given as an appendix to this text).

Where:
n = number of periods

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 Example 12:
The present value of Rs 60,000 received in 4 years assuming a cost of capital of 7%.
1
From formula PV = 60,000 × = 45,773
(1.07)4

From table (above) PV = 60,000 × 0.763 = 45,780

The difference is due to rounding. The discount factor in the above table has been rounded to 3 decimal places
whereas the discount factor from the formula has not been rounded.

Interpreting present value

It is important to realize that the present value of a cash flow is the equivalent of its future value after taking time
value into account. Using the above example to illustrate this, Rs 10,000 today is exactly the same as Rs 13,310
in 3 years at an interest rate of 10%. The person in the example would be indifferent between the two amounts.

AT A GLANCE
He would look on them as being identical.
Also the present value of a future cash flow is a present day cash equivalent. The person in the example would
be indifferent between an offer of Rs 10,000 cash today and Rs 13,310 in 3 years.
The present value of a future cash flow is the amount that an investor would need to invest today to receive that
amount in the future. This is simply another way of saying that discounting is the reverse of compounding.
 Example 13:
If an investor need to invest now in order to have Rs.1,000 after 12 months, and the compound
interest on the investment is 0.5% each month then present value is:
Present value = Rs.1,000  [1/(1.005)12 ]= Rs.1,000 × 0.942 = Rs.942.

SPOTLIGHT
Using present values
Discounting cash flows to their present value is a very important technique. It can be used to compare future
cash flows expected at different points in time by discounting them back to their present values thereby aiding
in their comparison.
 Example 14:
A borrower is due to repay a loan of Rs 120,000 in 3 years.
He has offered to pay an extra Rs 20,000 as long as he can repay after 5 years.
The lender faces interest rates of 7%. Is the offer acceptable?
1
Existing contract PV = 120,000 × = Rs 97,955
(1.07)3

STIKCY NOTES
1
Client’s offer Present value = 140,000 × = Rs 99,818
(1.07)5

The client’s offer is acceptable as the present value of the new amount is greater than the present
value of the receipt under the existing contract.
 Example 15:
An investor wants to make a return on his investments of at least 7% per year.
He has been offered the chance to invest in a bond that will cost Rs 200,000 and will pay Rs
270,000 at the end of four years.
In order to earn Rs 270,000 after four years at an interest rate of 7% the amount of his investment
now would need to be:
1
PV = 270,000 × = Rs 206,010
(1.07)4
The investor would be willing to invest Rs 206,010 to earn Rs 270,000 after 4 years.

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However, he only needs to invest Rs 200,000.

This indicates that the bond provides a return in excess of 7% per year.
 Example 16:
How much would an investor need to invest now in order to have Rs 100,000 after 12 months, if
the compound interest on the investment is 0.5% each month?
The investment ‘now’ must be the present value of Rs 100,000 in 12 months, discounted at 0.5%
per month.
1
PV = 100,000 × = Rs 94,190
(1.005)12
Present values can be used to appraise large projects with multiple cash flows. This is covered
AT A GLANCE

later in this chapter.

Annuities
An annuity is a constant cash flow for a given number of time periods. A capital project might include estimated
annual cash flows that are an annuity.
Examples of annuities are:
 Rs.30,000 each year for years 1 – 5
 Rs.20,000 each year for years 3 – 10
 Rs.500 each month for months 1 – 24.
The present value of an annuity can be computed by multiplying each individual amount by the individual
SPOTLIGHT

discount factor and then adding each product. This is fine for annuities of just a few periods but would be too
time consuming for long periods. An alternative approach is to use the annuity factor.
An annuity factor for a number of periods is the sum of the individual discount factors for those periods.
 Example 17:
The present value of Rs.50,000 per year for years 1 – 3 at a discount rate of 9%.

Year Cash flow Discount factor at 9% Present value

1 50,000 1 = 0.917 45,850
(1.09)
STIKCY NOTES

2 50,000 1 = 0 842 42,100

(1.09)2
3 50,000 1 = 0.772 38,600
(1.09)3
NPV 126,550
or:
1 to 3 50,000 2.531 126,550

Annuity discount factors can be used in DCF investment analysis, mainly to make the calculations
easier and quicker.
An annuity factor can be constructed by calculating the individual period factors and adding them
up but this would not save any time.
In practice a formula or annuity factor tables are used.

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 Formula:

Annuity factor (discount factor of an annuity)

There are two version of the annuity factor formula:
Method 1 Method 2
𝟏 𝟏 𝟏−(𝟏+𝐫)−𝐧
Annuity factor = (𝟏 − (𝟏+𝐫)𝐧) = ( )
𝐫 𝐫
Where:
r = discount rate, as a proportion
n = number of time periods

 Example 18:

AT A GLANCE
Year Cash flow Discount factor Present value
1 to 3 50,000 2.531 (W) 126,550

Working: Calculation of annuity factor

Method 1: Method 2:
1 1 1 − (1 + 𝑟)−𝑛
= (1 − ) =( )
𝑟 (1 + 𝑟)𝑛 𝑟
1 1 1 − (1.09)−3
= (1 − ) =( )
0.09 (1.09)3 0.09
1 1
= (1 − ) 1 − 0.7722
0.09 1.295 =( )

SPOTLIGHT
0.09
1
= (1 − 0.7722) 0.2278
0.09 =
0.09
1
= (0.2278) = 2.531 = 2.531
0.09

 Illustration:

Discount rates (r)

(n) 5% 6% 7% 8% 9% 10%
1 0.952 0.943 0.935 0.926 0.917 0.909
2 1.859 1.833 1.808 1.783 1.759 1.736

STIKCY NOTES
3 2.723 2.673 2.624 2.577 2.531 2.487
4 3.546 3.465 3.387 3.312 3.240 3.170
5 4.329 4.212 4.100 3.993 3.890 3.791

(Full tables are given as an appendix to this text).

Where:
n = number of periods
 Example 19:
The present value of the cash flows for a project, if the cash flows are Rs.60,000 each year for
years 1 – 5, and the cost of capital is 9%.
Rs.60,000 × 3.890 (annuity factor at 9%, n = 5) = Rs.233,400.
Note that if an annuity starts at time zero (rather than t1) the annuity factor is adjusted by adding
1 to it.

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 Example 20:

Year Cash flow Annuity factor (9%) Present value

1 to 3 50,000 2.531 (as before) 126,550
0 to 3 50,000 3.531 176,550

Gap annuities and annuities that start after t1

There may be a gap in the pattern of annuities. The approach in this case is to construct an annuity factor by
removing the discount factors that relate to the gap (remembering that the objective is to arrive at a sum of the
discount factors that relate to each period in which there is a cash flow).
 Example 21:
AT A GLANCE

The present value of a cash flow of Rs 60,000 each year for years 1 – 3 and 5 – 7, if the cost of
capital is 10%.

Discount factor
(10%)
Annuity factor for t17
1 1 4.868
Annuity factor = (1 − )
0.1 (1.1)7
Less: discount factor that relates to the gap (t4)
1 0.683
Discount factor =
(1.1)4
SPOTLIGHT

Discount factor for 13 and 57 4.185

Therefore, the PV of 60,000 per annum every year from t1 to t7 except t4:
PV = 60,000 × 4.185 = 251,100
An annuity might be expected to start at some point in the future other than at t1.
There are two approaches to dealing with this.
Method 1: Remove the discount factors that relate to the gap (as above).
Method 2: Apply the annuity factor for the actual number of payments. This will produce a cash
equivalent value at a point in time one period before the first cash flow. This is then discounted
STIKCY NOTES

back to the present value.

 Example 22:
The annuity factor for a series of cash flows from t4 to t15 at a cost of capital of 12%

Method 1 Discount factor

(12%)
Annuity factor for t115
1 1 6.811
Annuity factor = (1 − )
0.12 (1.12)15
Less: discount factor that relates to the gap (t1 to 3)
1 1 2.402
Annuity factor = (1 − )
0.12 (1.12)3
Discount factor for t4 to t15. 4.409

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Method 2 Discount factor

(12%)
Annuity factor for t112 (as there are 12 cash flows)
1 1 6.194
Annuity factor = (1 − )
0.12 (1.12)12

When this is applied to an annuity which starts at t4 it produces a cash

equivalent at t3.
Therefore it must be discounted back to t0
1 0.712
Discount factor =
(1.12)3

AT A GLANCE
Discount factor for t4 to t15 4.410

The small difference is due to rounding

Present value of a perpetuity

Perpetuity is a constant annual cash flow ‘forever’, or into the long-term future. Some countries notably United
Kingdom in the times of war have issued bonds without a maturity date.
In investment appraisal, an annuity might be assumed when a constant annual cash flow is expected for a long
time into the future.
 Formula:

SPOTLIGHT
1
Perpetuity factor =
r

Where:
r = the cost of capital

 Example 23:

Cash flow Present value

2,000 in perpetuity, starting in Year 1

STIKCY NOTES
1
Cost of capital = 8% = × Annual cash flow
r

1
= × 2,000 = 25,000
0.08

Perpetuity factors that start after t1 or have a gap in the sequence of cash flows are constructed
in the same way as those for annuities.

Method 1
Remove the discount factors that relate to the gap.

Method 2
Apply the perpetuity factor to the actual number of payments. This will produce a cash equivalent
value at a point in time one period before the first cash flow. This is then discounted back to the
present value by using the individual period discount factor.

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 Example 24:
The present value of Rs. 5,500 in perpetuity, starting in Year 4 at a cost of capital of 11% is:

Method 1 Discount factor (12%)

Annuity factor for t1  ∞
1 9.091
Perpetuity factor =
0.11
Less: discount factor that relates to the gap (t1 to 3)
1 1 2.444
Annuity factor = (1 − )
0.11 (1.11)3
AT A GLANCE

Discount factor for t4 to ∞. 6.647

Method 2 Discount factor (10%)
Annuity factor for t1  ∞
1 9.091
Perpetuity factor =
0.11
When this is applied to an annuity which starts at t4 it
produces a cash equivalent at t3.
Therefore it must be discounted back to t0
1 0.731
Discount factor =
(1.11)3
SPOTLIGHT

Discount factor for t4 to t15 6.646

The small difference is due to rounding
Present value = 6.646 × 5,500 = 36,553

Application of annuity arithmetic

Equivalent annual costs
An annuity is multiplied by an annuity factor to give the present value of the annuity.
This can work in reverse. If the present value is known, it can be divided by the annuity factor to give the annual
STIKCY NOTES

cash flow for a given period that would give rise to it.
 Example 25:
For example, the present value of 10,000 per annum from t1 to t5 at 10% is:

Time Cash flow Discount factor Present value

1 to 5 10,000 3.791 37,910

The annual cash flow from t1 to t5 at 10% would give a present value of 37,910 is:
37,910
Divide by the 5 year, 10% annuity factor 3.791
10,000
This can be used to address the following problem.

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 Example 26:
A company is considering an investment of Rs.70,000 in a project. The project life would be five
years.
What must be the minimum annual cash returns from the project to earn a return of at least 9%
per annum?
Investment = Rs.70,000
Annuity factor at 9%, years 1 – 5 = 3.890
Minimum annuity required = Rs.17,995 (= Rs.70,000/3.890)
Loan repayments
 Example 27:

AT A GLANCE
A company borrows Rs 10,000,000.
This to be repaid by 5 equal annual payments at an interest rate of 8%.
The calculation of the payments is as under:
The approach is to simply divide the amount borrowed by the annuity factor that relates to the
payment term and interest rate
Rs
Amount borrowed 10,000,000
Divide by the 5 year, 8% annuity factor 3.993
Annual repayment 2,504,383

SPOTLIGHT
Sinking funds (alternative approach to that seen earlier)
A person may save a constant annual amount to produce a required amount at a specific point in time in the
future. This is known as a sinking fund.
 Example 28:
A man wishes to invest equal annual amounts so that he accumulates 5,000,000 by the end of 10
years.
The annual interest rate available for investment is 6%.
The equal annual amounts that should he set aside are
Step 1: Calculate the present value of the amount required in 10 years.

STIKCY NOTES
𝟏
𝐏𝐕 = 𝟓, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × = 𝟐, 𝟕𝟗𝟏, 𝟗𝟕𝟒
(𝟏.𝟎𝟔)𝟏𝟎

Step 2: Calculate the equivalent annual cash flows that result in this present value
Rs
Present value 2,791,974
Divide by the 10 year, 6% annuity factor 7.36
Annual repayment 379,344

If the man invests 379,344 for 10 years at 6% it will accumulate to 5,000,000.

Amount invested to earn a return
Annuity factors express the value of a stream of future cash into a present value. The approach can be used in
reverse to show what stream of future cash flows would provide a given return (the discount rate) if an amount
was invested today.

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 Example 29:
A company is considering an investment of Rs.70,000 in a project. The project life would be five
years.
So the minimum cash returns from the project to earn a return of at least 9% per annum is:

Rs
Present value (Investment) 70,000
Divide by the 5 year, 9% annuity factor 3.89
Minimum annuity required 17,995
1.4 Step 4: Investment decision based on discounting cash flows methods
AT A GLANCE

For making decision for acceptance or rejection of investment is based on involving capital expenditures is based
on discounted cash flows techniques that are:
a) Net present value(NPV) method
b) Internal rate of return (IRR) method
These techniques are explained in detail in next section as under:
SPOTLIGHT
STIKCY NOTES

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2. NET PRESENT VALUE(NPV) METHOD

2.1 Calculating the NPV of an investment project
In NPV analysis, all future cash flows from a project are converted into a present value, so that the value of all the
annual cash outflows and cash inflows can be expressed in terms of ‘today’s value’.
The net present value (NPV) of a project is the net difference between the present value of all the costs incurred
and the present value of all the cash flow benefits (savings or revenues).

Approach
Step 1: List all cash flows expected to arise from the project. This will include the initial investment, future cash
inflows and future cash outflows.

AT A GLANCE
Step 2: Discount these cash flows to their present values using the cost that the company has to pay for its capital
(cost of capital) as a discount rate. All cash flows are now converted and expressed in terms of ‘today’s value’.
Step 3: The net present value (NPV) of a project is difference between the present value of all the costs incurred
and the present value of all the cash flow benefits (savings or revenues).
 If the present value of benefits exceeds the present value of costs, the NPV is positive.
 If the present value of benefits is less than the present value of costs, the NPV is negative.
The decision rule is that, ignoring other factors such as risk and uncertainty, and non-financial considerations, a
project is worthwhile financially if the NPV is positive. It is not worthwhile if the NPV is negative.
The net present value of an investment project is a measure of the value of the investment. For example, if a
company invests in a project that has a NPV of Rs.2 million, the value of the company should increase by Rs.2

SPOTLIGHT
million.

2.2 Assumptions about the timing of cash flows

In DCF analysis, the following assumptions are made about the timing of cash flows during each year:
 All cash flows for the investment are assumed to occur at a discrete point in time (usually the end of the
year).
 If a cash flow will occur early during a particular year, it is assumed for the sake of simplicity that it will occur
at the end of the previous year. Therefore, cash expenditure early in Year 1, for example, is assumed to occur
at time 0.

STIKCY NOTES
Time 0 cash flows
Often cash flows are described as occurring in a particular year (e.g. year 1, year 2 etc.). The project commences
at time 0. Sometimes time 0 (t0) is described as year 0 but this is misleading. There is no year 0, it can be assumed
to be the present time. The first year (year 1) starts at time 0 and ends one year after this.
Cash flows at the beginning of the investment (at time 0) are already stated at their present value.
The discount factor for a cash flow in time 0 is 1/(1 + r)0.
Any value to the power of 0 is always = 1. Therefore, the discount factor for time 0 is always = 1.000, for any cost
of capital.
This means that the present value of Rs.1 in time 0 is always Rs.1, for any cost of capital.

2.3 Advantages and Disadvantages of the NPV method

The advantages of the NPV method of investment appraisal are that:
 NPV takes account of the timing of the cash flows by calculating the present value for each cash flow at the
investor’s cost of capital.

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 DCF is based on cash flows.

 It evaluates all cash flows from the project.
 It gives a single figure, the NPV, which can be used to assess the value of the investment project. The NPV of
a project is the amount by which the project should add to the value of the company, in terms of ‘today’s
value’.
 The NPV method provides a decision rule which is consistent with the objective of maximization of
shareholders’ wealth. In theory, a company ought to increase in value by the NPV of an investment project
(assuming that the NPV is positive).
The main disadvantages of the NPV method are:
 The time value of money and present value are concepts that are not easily understood
 There might be some uncertainty about what the appropriate cost of capital or discount rate should be for
AT A GLANCE

applying to any project.

 It does not take into account the risk and uncertainty of estimates and scarcity of resources.
 It fails to relate the return of the project to the size of the cash outlay.

2.4 Two methods of presentation

If you are required to present NPV calculations in the answer to an examination question, it is important that you
should be able to present your calculations and workings clearly. There are two normal methods of presenting
calculations, and you should try to use one of them.
The two methods of presentation are shown below, with illustrative figures.
 Illustration Format 1:
SPOTLIGHT

Year Description of item Cash flow Discount factor Present

at 10% Value
Rs. Rs.
0 Machine (40,000) 1.000 (40,000)
0 Working capital (5,000) 1.000 (5,000)
1-3 Cash profits 20,000 2.487 49,740
3 Sale of machine 6,000 0.751 4,506
3 Recovery of working capital 5,000 0.751 3,755
STIKCY NOTES

NPV 13,001

 Illustration Format 2:

Year 0 1 2 3
Description of item Rs. Rs. Rs. Rs.
Machine/sale of machine (40,000) 6,000
Working capital (5,000) 5,000
Cash receipts 50,000 50,000 50,000
Cash expenditures (30,000) (30,000) (30,000)
Net cash flow (45,000) 20,000 20,000 31,000
Discount factor at 10% 1.000 0.909 0.826 0.751
Present value (45,000) 18,180 16,520 23,281
NPV 12,981

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For computations with a large number of cash flow items, the second format is probably easier.
This is because the discounting for each year will only need to be done once.
Note that changes in working capital are included as cash flows. An increase in working capital,
usually at the beginning of the project in Time 0, is a cash outflow and a reduction in working
capital is a cash inflow. Any working capital investment becomes Rs.0 at the end of the project.
Investment decision is not a financing decision so financing cost like financial charges or interest
cost are not include while calculating NPV
 Example 30:
A company with a cost of capital of 10% is considering investing in a project with the following
cash flows.

AT A GLANCE
Year Rs (m)
0 (10,000)
1 6,000
2 8,000

The NPV calculation is:

Year Cash flow Discount factor (10%) Present value

0 (10,000) 1 (10,000)
1 6,000 1 5,456
(1.1)

SPOTLIGHT
2 8,000 1 6,612
(1.1)2
NPV 2,068

The NPV is positive so the project should be accepted.

 Example 31:
A company is considering whether to invest in a new item of equipment costing Rs.53,000 to
make a new product.
The product would have a four-year life, and the estimated cash profits over the four-year period
are as follows:

STIKCY NOTES
Year Rs.
1 17,000
2 25,000
3 16,000
4 12,000

The NPV of the project using a discount rate of 11%

NPV calculation would be as follows:

Year Cash flow Discount factor (11%) Present value

0 (53,000) 1 (53,000)
1 17,000 1 15,315
(1.11)

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Year Cash flow Discount factor (11%) Present value

2 25,000 1 20,291
(1.11)2
3 16,000 1 11,699
(1.11)3
4 12,000 1 7,905
(1.11)4
NPV 2,210

The NPV is positive so the project should be accepted.

 Example 32:
AT A GLANCE

A company is considering whether to invest in a new item of equipment costing Rs.65,000 to

make a new product.
The product would have a three-year life, and the estimated cash profits over this period are as
follows.

Year Rs.
1 27,000
2 31,000
3 15,000

The NPV of the project using a discount rate of 8%

SPOTLIGHT

NPV calculation:

Year Cash flow Discount factor (8%) Present value

0 (65,000) 1 (65,000)
1 27,000 1 25,000
(1.08)
2 31,000 1 26,578
(1.08)2
3 15,000 1 11,907
(1.08)3
STIKCY NOTES

NPV (1,515)

The NPV is negative so the project should be rejected.

 Example 33:
A company is considering whether to undertake an investment. The cost of capital is 10%. The
initial cost of the investment would be Rs.50,000 and the expected annual cash flows from the
project would be:

Year Revenue Costs Net cash flow

Rs. Rs. Rs.
1 40,000 30,000 10,000
2 55,000 35,000 20,000
3 82,000 40,000 42,000

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a) The calculation of compounding arithmetic for calculation of investment at the end of year 3
is:

a. Compounding Rs.
Investment in Time 0 (50,000)
Interest required (10%), Year 1 (5,000)
Return required, end of Year 1 (55,000)
Net cash flow, Year 1 10,000
(45,000)
Interest required (10%), Year 2 (4,500)
Return required, end of Year 2 (49,500)

AT A GLANCE
Net cash flow, Year 2 20,000
(29,500)
Interest required (10%), Year 3 (2,950)
Return required, end of Year 3 (32,450)
Net cash flow, Year 3 42,000
Future value, end of Year 3 9,550

b) Using discounting the calculation of NPV of the project is:

Year Cash flow Discount factor at 10% Present value

SPOTLIGHT
Rs. Rs.
0 (50,000) 1.0 (50,000)
1 10,000 1/(1.10)1 9,091
2 20,000 1/(1.10)2 16,529
3 42,000 1/(1.10)3 31,555
Net present value +7,175

c) The reconciliation of present value and future value based on above calculations is:
NPV × (1 + r)n = Future value: Rs.7,175 × (1.10)3 = Rs.9,550

STIKCY NOTES
This example shows a simple capital project with an initial capital outlay in Time 0 and cash
inflows for three years. The same technique can be applied to much bigger and longer capital
projects, and projects with negative cash flows in years other than Time 0.
 Example 34:
A company has estimated that its cost of capital is 8.8%. It is deciding whether to invest in a
project that would cost Rs.325,000.
The NPV if the net cash flows of the project after Year 0 are:
if cash flows form years 1 – 6: Rs.75,000 per year is:
Present value of net cash flows of Rs.75,000 in Years 1 – 6 =

$75,000  1 
1  
0.088  1.088  
6

=Rs.852,273 (1 – 0.603)
=Rs.338,352

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Then the NPV is:

Year Cash flow Discount factor (8.8%) PV
Rs. Rs.
0 (325,000) 1.000 (325,000)
1–6 75,000 per year 338,352
NPV 13,352
The project has a positive NPV and should be undertaken.
For example, if the company has following cash flows pattern
Year Rs.
AT A GLANCE

1 50,000
2–6 75,000
Then the calculation of NPV is:
The annuity PV formula can be used to calculate the ‘present value’ as at the end of Year 1 for
annual cash flows from Year 2 onwards.
End-of-Year 1 ‘present value’ of net cash flows of Rs.75,000 in Years 2 – 6 =

$75,000  1 
1  
0.088  1.088 5 

=Rs.852,273 (1 – 0.656)
SPOTLIGHT

=Rs.293,182
Year Cash flow Discount factor (8.8%) PV
Rs. Rs.
0 (325,000) 1.000 (325,000)
1 50,000 1/1.088 45,956
2–6 293,182 1/1.088 269,469
NPV (9,575)

The project has a negative NPV and should not be undertaken.

STIKCY NOTES

For example, if the cash flow of the project after year 0 are Rs. 50,000 every year in perpetuity
then calculation of NPV is:
Year Cash flow Discount factor (8.8%) PV
Rs. Rs.
0 (325,000) 1.000 (325,000)
1 onwards in perpetuity 50,000 1/0.088 568,182
NPV 243,182
The project has a positive NPV and should be undertaken.
 Example 35:
Ali & Co. is a medium sized medical research company, engaged in the development of new
medical treatments. To date company has invested Rs. 250,000 in the development of a new
product called ‘Gravia’ which can be recovered by selling the formula to an outsider. It is
estimated that it will take further two years of development and testing before ‘Gravia’ is
approved by medical industry regulators.

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The company believes that it can sell the patent for Gravia to a multinational pharmaceutical
company for Rs.1,000,000 when it has been fully developed. The directors of the Ali & co. are
currently reviewing the Gravia projects as there is some concern about the size of the required
finance to complete the development work.
Following information is relevant to the projects:
 To complete the development Ali & Co. will need to acquire additional type A material
expected cost Rs.150,000 per annum over the next two years.
 Type B material will also be required. Currently there is sufficient stock of type B
material to last for the two years of the project. The material originally cost Rs. 50,000.
Its replacement cost is Rs.75,000. Instead of using it on this project, it could immediately
be sold as scrap for Rs. 20,000 It has no further alternative use.
 If it is decided to continue with Gravia project, specialist equipment will need to be

AT A GLANCE
purchase immediately for Rs. 100,000. This equipment could eventually be sold at the
end of the project for Rs.25,000.
 Two chemists currently employed for an annual salary of Rs.20,000 each will be made
redundant whenever Gravia project ends. Redundancy payments are expected to be one
full year’s salary each.
 Laboratory technicians currently employed by Ali & Co. are working on Gravia project
at a total annual cost of Rs. 85,000. The company has a variety of other projects to which
the technicians could be transferred whenever the Gravia projects ends.
 Annual fixed overheads are 100,000 of which Rs.60,000 are general overheads, and
remaining Rs.40,000 are directly associated with the project.
 Interest cost on borrowed finance is Rs.20,000 per annum.

SPOTLIGHT
 All cash flows occur at the end of the year unless otherwise stated.
 The discount rate used by Ali & Co. to appraise its projects is 10%.
The example relates to Ali Co., a medium sized medical research company. That is going to
consider a project relating to complete development of product called Gravia that xis partly
completed to date.
 Firstly, the future expected cash flows (cash inflows and outflows) will be identified
based on relevant costing principles excluding irrelevant cost.
 Following are irrelevant cost for projects.
a) Original cost and replacement of material B as it is not in regular use.

STIKCY NOTES
b) Current annual salary of two employees who have already employed being a past
cost.
c) Annual fixed overheads other than directly attributable fixed cost.
d) Interest cost as its affect is automatically considered through discounting.
 Based on above analysis the calculation of net and discounted cash flows is as under:
Year 0 Year 1 Year 2
Value of Gravia (250,000) 1000,000
Material A (150,000) (150,000)
Material B (20,000)
Special list Equipment (100,000) 25,000
Redundancy Payment (40,000)
Investment Fixed cost (40,000) (40,000)
Net Cash flows (370,000) (190,000) 795,000

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Year 0 Year 1 Year 2

Discount factor 1.000 0.909 0.826
Discount factor (370,000) (172,710) 656,670
NPV: 113,960
Decision:
The project has a positive NPV. The project should be undertaken because it will increase the
value of the company and the wealth of its shareholders.
 Example 36:
Consolidated Oil wants to explore for oil near the coast of Ruritania. The Ruritanian government
is prepared to grant an exploration license for a five-year period for a fee of Rs.300,000 per
AT A GLANCE

annum. The license fee is payable at the start of each year. The option to buy the license must be
taken immediately or another oil company will be granted the license.
However, if it does take the license now, Consolidated Oil will not start its explorations until the
beginning of the second year.
To carry out the exploration work, the company will have to buy equipment now. This would cost
Rs.10,400,000, with 50% payable immediately and the other 50% payable one year later. The
company hired a specialist firm to carry out a geological survey of the area. The survey cost
Rs.250,000 and is now due for payment.
The company’s financial accountant has prepared the following projected income statements.
The forecast covers years 2-5 when the oilfield would be operational.
SPOTLIGHT

Projected income statements

Year
2 3 4 5
Rs.‘000 Rs.‘000 Rs.‘000 Rs.‘000
Sales 7,400 8,300 9,800 5,800
Minus expenses:
Wages and salaries 550 580 620 520
Materials and consumables 340 360 410 370
License fee 600 300 300 300
STIKCY NOTES

Overheads 220 220 220 220

Depreciation 2,100 2,100 2,100 2,100
Survey cost written off 250 - - -
Interest charges 650 650 650 650
4,710 4,210 4,300 4,160
Profit 2,690 4,090 5,500 1,640

Notes
The license fee charge in Year 2 includes the payment that would be made at the beginning of
year 1 as well as the payment at the beginning of Year 2. The license fee is paid to the Ruritanian
government at the beginning of each year.
The overheads include an annual charge of Rs.120,000 which represents an apportionment of
head office costs. The remainder of the overheads are directly attributable to the project.
The survey cost is for the survey that has been carried out by the firm of specialists.
The new equipment costing Rs.10,400,000 will be sold at the end of Year 5 for Rs.2,000,000.

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A specialized item of equipment will be needed for the project for a brief period at the end of year
2. This equipment is currently used by the company in another long-term project. The manager
of the other project has estimated that he will have to hire machinery at a cost of Rs.150,000 for
the period the cutting tool is on loan.
The project will require an investment of Rs.650,000 working capital from the end of the first
year to the end of the license period.
The company has a cost of capital of 10%. Ignore taxation.
The example relates to a consolidated oil company that is going to consider a project regarding
the exploration of oil near the coast of Ruritania.
The project will be evaluated on Net Present Value (NPV) method.
Firstly, the future expected cash flows (cash inflows and out flows) will be identified using

AT A GLANCE
relevant costing principles.
Following cost will be irrelevant in the example and should be excluded while considering
expected future cash flows.
 Survey cost that is past cost
 Depreciation that is non-cash flows cost
 Apportioned overheads that are not real cash flows
 Interest charges because its affect is automatically considered through discounting of
cash flows
 The working capital incurred at start of project assumed to recovered at end of project
Based on above analysis the calculation of discounted cash flows and NPV is as under

SPOTLIGHT
Year 0 1 2 3 4 5
Rs.000 Rs.000 Rs.000 Rs.00 Rs.000 Rs.000
Sales 7,400 8,300 9,800 5,800
Wages (550) (580) (620) (520)
Materials (340) (360) (410) (370)
Licence fee (300) (300) (300) (300) (300)
Overheads (100) (100) (100) (100)
Equipment (5,200) (5,200) 2,000

STIKCY NOTES
Specialised equipment (150)
Working capital (650) 650
(5,500) (6,150) 5,960 6,960 8,370 7,460

Discount factor at 10% 1.000 0.909 0.826 0.751 0.683 0.621

Present value (5,500) (5,590) 4,923 5,227 5,717 4,633

NPV = + Rs.9,409,000
Decision:
The project has a positive NPV. The project should be undertaken because it will increase the
value of the company and the wealth of its shareholders.

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3. INTERNAL RATE OF RETURN (IRR)

The internal rate of return method (IRR method) is another method of investment appraisal using DCF.
The internal rate of return of a project is the discounted rate of return on the investment.
 It is the average annual investment return from the project
 The NPV of the project cash flows is zero when those cash flows are discounted at the IRR.
 The internal rate of return is therefore the discount rate that will give a net present value = Rs.0.

3.1 The investment decision rule with IRR

A company might establish the minimum rate of return that it wants to earn on an investment. If other factors
such as non-financial considerations and risk and uncertainty are ignored:
AT A GLANCE

 If a project IRR is equal to or higher than the minimum acceptable rate of return, it should be undertaken
 If the IRR is lower than the minimum required return, it should be rejected.
Since NPV and IRR are both methods of DCF analysis, the same investment decision should normally be reached
using either method.
The internal rate of return is illustrated in the diagram below:
 Illustration:
SPOTLIGHT

3.2 Calculating the IRR of an investment project

STIKCY NOTES

The IRR of a project can be calculated by inputting the project cash flows into a financial calculator. In your
examination, you might be required to calculate an IRR without a financial calculator. An approximate IRR can
be calculated using interpolation.
To calculate the IRR, you should begin by calculating the NPV of the project at two different discount rates.
 One discount rate should yield a positive NPV, and the other should give negative NPV. (This is not essential.
Both NPVs might be positive or both might be negative, but the estimate of the IRR will then be less reliable.)
 Ideally, the NPVs should both be close to zero, for better accuracy in the estimate of the IRR.
When the NPV for one discount rate is positive and the NPV for another discount rate is negative, the IRR must
be somewhere between these two discount rates.
Although in reality the graph of NPVs at various discount rates is a curved line, as shown in the diagram above,
using the interpolation method we assume that the graph is a straight line between the two NPVs that we have
calculated. We can then use linear interpolation to estimate the IRR, to a reasonable level of accuracy.

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 Formula:

IRR interpolation formula

NPVA
IRR = A% + ( ) × (B − A)%
NPVA −NPVB

Ideally, the NPV at A% should be positive and the NPV at B% should be negative.
Where:
NPVA = NPV at A%
NPVB = NPV at B%

AT A GLANCE
3.3 Advantages and Disadvantages of the IRR method
The main advantages of the IRR method of investment appraisal are:
 As a DCF appraisal method, it is based on cash flows, not accounting profits.
 Like the NPV method, it recognizes the time value of money.
 It is easier to understand an investment return as a percentage return on investment than as a money value
NPV in Rs.
 For accept/reject decisions on individual projects, the IRR method will reach the same decision as the NPV
method.
The disadvantages of the IRR method are:
 It is a relative measure (% on investment) not absolute measure in Rs.. Because it is a relative measure, it

SPOTLIGHT
ignores the absolute size of the investment. For example, which is the better investment if the cost of capital
is 10%:
o an investment with an IRR of 15% or
o an investment with an IRR of 20%?
 If the investments are mutually exclusive, and only one of them can be undertaken the correct answer is that
it depends on the size of each of the investments. This means that the IRR method of appraisal can give an
incorrect decision if it is used to make a choice between mutually exclusive projects.
 Unlike the NPV method, the IRR method does not indicate by how much an investment project should add to
the value of the company.
 Example 37:

STIKCY NOTES
A business requires a minimum expected rate of return of 12% on its investments.
A proposed capital investment has the following expected cash flows.

Year Cash flow Discount Present Discount Present

factor at value at factor at value at
10% 10% 15% 15%
0 (80,000) 1.000 (80,000) 1,000 (80,000)
1 20,000 0.909 18,180 0.870 17,400
2 36,000 0.826 29,736 0.756 27,216
3 30,000 0.751 22,530 0.658 19,740
4 17,000 0.683 11,611 0.572 9,724
NPV + 2,057 (5,920)

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𝐍𝐏𝐕𝐀
Using 𝐈𝐑𝐑 = 𝐀% + ( ) × (𝐁 − 𝐀)%
𝐍𝐏𝐕𝐀 −𝐍𝐏𝐕𝐁
𝟐,𝟎𝟓𝟕
𝐈𝐑𝐑 = 𝟏𝟎% + ( ) × (𝟏𝟓 − 𝟏𝟎)%
𝟐,𝟎𝟓𝟕−−𝟓,𝟗𝟐𝟎
𝟐,𝟎𝟓𝟕
𝐈𝐑𝐑 = 𝟏𝟎% + ( ) × 𝟓%
𝟐,𝟎𝟓𝟕+𝟓,𝟗𝟐𝟎
𝟐,𝟎𝟓𝟕
𝐈𝐑𝐑 = 𝟏𝟎% + ( ) × 𝟓%
𝟕,𝟗𝟕𝟕
𝐈𝐑𝐑 = 𝟏𝟎% + 𝟎. 𝟐𝟓𝟖 × 𝟓% = 𝟏𝟎% + 𝟏. 𝟑%
𝐈𝐑𝐑 = 𝟏𝟏. 𝟑%
Conclusion The IRR of the project (11.3%) is less than the target return (12%).
The project should be rejected.
 Example 38:
AT A GLANCE

The following information is about a project.

Year Rs.
0 (53,000)
1 17,000
2 25,000
3 16,000
4 12,000

This project has an NPV of Rs.2,210 at a discount rate of 11%

The calculation of expected IRR is:
SPOTLIGHT

NPV at 11% is Rs.2,210. A higher rate is needed to produce a negative NPV. (say 15%)

Year Cash flow Discount factor at 15% Present value at 15%

0 (53,000) 1.000 (53,000)
1 17,000 0.870 14,790
2 25,000 0.756 18,900
3 16,000 0.658 10,528
4 12,000 0.572 6,864
STIKCY NOTES

NPV (1,918)
Using
NPVA
IRR = A% + ( ) × (B − A)%
NPVA − NPVB
2,210
IRR = 10% + ( ) × (15 − 10)%
2,210 − −1,918
2,210
IRR = 10% + ( ) × 5%
2,210 + 1,918
2,210
IRR = 10% + ( ) × 5%
4,128
IRR = 10% + 0.535 × 5% = 10% + 2.7%
IRR = 12.7%

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 Example 39:
The following information is about a project.

Year Rs.
0 (65,000)
1 27,000
2 31,000
3 15,000

This project has an NPV of Rs. (1,515) at a discount rate of 8%

AT A GLANCE
The calculation of estimated IRR is:
NPV at 8% is Rs.(1,515). A lower rate is needed to produce a positive NPV. (say 5%)

Year Cash flow Discount factor at 5% Present value at 5%

0 (65,000) 1.000 (65,000)
1 27,000 0.952 25,704
2 31,000 0.907 28,117
3 15,000 0.864 12,960
NPV 1,781
NPVA

SPOTLIGHT
Using IRR = A% + ( ) × (B − A)%
NPVA −NPVB
1,781
IRR = 5% + ( ) × (8 − 5)%
1,781−−1,515
1,781
IRR = 5% + ( ) × 3%
1,781+1,515
1,781
IRR = 5% + ( ) × 3%
3,296
IRR = 5% + 0.540 × 3% = 5% + 1.6%
IRR = 6.6%
 Example 40:
A company is considering whether to invest in a new item of equipment costing Rs.45,000 to
make a new product. The product would have a four-year life, and the estimated cash profits over

STIKCY NOTES
the four-year period are as follows.
Year Rs.
1 17,000
2 25,000
3 16,000
4 04,000

The project would also need an investment in working capital of Rs.8,000, from the beginning of
Year 1.
The company uses a discount rate of 11% to evaluate its investments.
The expected calculation of IRR is:
The cash outflow in Year 0 = cost of equipment + working capital investment = Rs.45,000 +
Rs.8,000 = Rs.53,000.

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The cash inflow for year 4 = project’s net cash profits + working capital recovered = Rs.4,000 +
Rs.8,000 = Rs.12,000.

Cost of capital 11% Cost of capital 15%

Year Cash flow Discount factor PV Discount factor PV
Rs. Rs. Rs.
0 (53,000) 1.000 (53,000) 1.000 (53,000)
1 17,000 0.901 15,317 0.870 14,790
2 25,000 0.812 20,300 0.756 18,900
3 16,000 0.731 11,696 0.658 10,528
AT A GLANCE

4 12,000 0.659 7,908 0.572 6,864

NPV + 2,221 (1,918)

NPV at 11% cost of capital = + Rs.2,221

 2,221 
IRR  11%   15 11%
 2,221 1,918 
= 11% + 2.1% = 13.1%
 Example 41:
There are two mutually exclusive projects.
SPOTLIGHT

Year Project 1 Project 2

Rs. Rs.
0 (1,000) (10,000)
1 1,200 4,600
2 - 4,600
3 - 4,600
IRR 20% 18%
STIKCY NOTES

NPV at 15% + Rs.43 + Rs.503

In the above example project 2 is better, because it has the higher NPV. Project 2 will add to value
by Rs.503 but Project 1 will add value of just Rs.43.
 Example 42:
Sona Limited (SL) is considering investment in a joint venture. The entire cash outlay of the
project is Rs. 175 million which would require to be invested by SL immediately. The joint
venture partner, Chandi Limited (CL) would provide all the necessary technical support.
The other details of the project are estimated as follows:
The project would extend over a period of four years.
Sales are estimated at Rs. 155 million per annum for the first two years and Rs. 65 million per
annum during the last two years.
Cost of sales and operating expenses excluding depreciation would be 50% and 10% of sales
respectively.

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CL would be entitled to share equal to 5% of sales and the remaining profit would belong to SL.
At the end of the project, SL would be able to recover Rs. 100 million of the invested amount.
Assume that all cash flows other than the initial cash outlay arise annually in arrears.
The example relates to Sona Limited(SL) that is considering investment in Joint venture. The joint
venture partner is Chandi Limited(CL). The company that will provide all necessary technical
details in return of 5% share in sales.
 The duration of project is 4 years and all future expected cash flows with timing
occurrence are given.
 Based on above the calculation of Net cash flows and discounted cash flows on two
discount rate 12% and 15% are given as under:

AT A GLANCE
Project’s Internal rate of Year 0 1 2 3 4
return
---------------------- Rs. in million ----------------------
Sales - 155.00 155.00 65.00 65.00
Cost of sales (50%) - (77.50) (77.50) (32.50) (32.50)
Operating expense (10%) - (15.50) (15.50) (6.50) (6.50)
5% of sales for technical - (7.75) (7.75) (3.25) (3.25)
support by CL
Investment (175.00) - - - 100.00

SPOTLIGHT
Net cash flows (175.00) 54.25 54.25 22.75 122.75

Discount factor (15%) 1.00 0.87 0.76 0.66 0.57

Present value (175.00) 47.20 41.23 15.02 69.97
Net present value NPVA (1.58)
at 15%

Discount factor (12%) 1.00 0.89 0.79 0.71 0.63

STIKCY NOTES
Present value (175.00) 48.28 42.86 16.15 77.33
Net present value NPVB 9.62
at 12%
After calculation of NPV values at two discount rates that are 12% and 15%, the expected
calculation of IRR using interpolation formula is:
A%+ [NPVA÷ (NPVA-NPVB)] × (B%-A %)
Internal rate of return (IRR) 15%+ [-1.58 ÷ (-1.58-9.62)] ×
(12%-15%)
14.58%

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3.4 Summary: comparison of the two investment appraisal methods

The key points to note are that:
 It is often equally as good to use NPV or IRR
 However, NPV has two advantages over IRR
 The NPV method indicates the value that the investment should add (if the NPV is positive) or the value that
it will destroy (if the NPV is negative).
 When there are two or more mutually exclusive projects, the NPV will always identify the project that should
be selected. This is the project that will provide the highest value (NPV).
 The IRR method has the advantage of being more easily understood by non-accountants
 Another disadvantage of the IRR method is that a project might have two or more different IRRs, when some
annual cash flows during the life of the project are negative. (The mathematics that demonstrate this point
AT A GLANCE

are not shown here.)

SPOTLIGHT
STIKCY NOTES

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4. DCF AND INFLATION

4.1 Inflation and long-term projects
When a company makes a long-term investment, there will be costs and benefits for a number of years. In all
probability, the future cash flows will be affected by inflation in sales prices and inflation in costs.
Inflation increases the return on investments required by investors. In a world without inflation an investor
might be content with a 10% return on an investment. With inflation the investor knows that the purchasing
power of future cash flows received will be less due to inflation and so wants a higher return to compensate for
that.
Inflation should be incorporated in financial planning and decision making.

4.2 General and specific rates of inflation

AT A GLANCE
Inflation is measured by measuring the prices of a set of goods and services (often described as a basket of goods
and services having different weightings) at various points in time, and then seeing by how much they have
increased or decreased. Some may rise, and some may fall, but the overall change in the price level is an indication
of the inflation level.
Within that basket each good and service will inflate at its own specific rate. For example, the rate of inflation
specific to fuel oil might be 10% whereas the rate specific to rice might be 1%.
General inflation is the overall change in the price of a basket of goods and services calculated as an average of
the specific rates weighted in some way to reflect the relative importance of the good or service in the economy.

4.2.1 Inflation rates for different cash flows

SPOTLIGHT
The inflation can be:
 Specific: Different for each cash flow item (e.g sales price may be increasing by 5% whereas variable costs
are subject to an inflation rate of 4%.
 General: a single inflation rate for all cash flows
Inflation rates might be:
 Specific for each coming year (e.g 5% for year 1, 8% for year 2, 10% for year 3 and so on.
 General: A single rate for all coming years (e.g Materiel cost is expected to increase by 6% per annum over
the life of project

4.3 Definitions: Real cash flows and money (nominal) cash flows

STIKCY NOTES
Real cash flows are cash flows expressed in today’s price terms. (They ignore the expectation of inflation).
Money (nominal) cash flows are cash flows that include expected inflation. They are the actual amount of cash
received at a point in time.
Money cash flows can be derived from real cash flows by inflating the real cash flow by the rate of inflation
specific to that cash flow and vice versa.
 Example 43:
A vendor sells ice creams. He knows that a bowl of ice cream sells for Rs. 50 today. He is planning
future sales and expects to sell 1,000 bowls next year and the year after.
He expects inflation to be 10%.
These future sales can be expressed in real terms or in money terms.
Real cash flows
Year 1 cash sales (1,000 bowls  Rs. 50) 50,000
Year 2 cash sales (1,000 bowls  Rs. 50) 50,000

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Money cash flows

Year 1 cash sales (1,000 bowls  Rs. 50  1.1) 55,000
Year 2 cash sales (1,000 bowls  Rs. 50  1.12) 60,500

5.4 Definitions: Real cost of capital and money (nominal) cost of capital
Real cost of capital is the return required by investors measured in terms of a constant price level. It excludes the
expectation of inflation.
Money (nominal) cost of capital the return required by investors measured in terms of a changing price level. It
includes the expectation of inflation
The real cost of capital and the money cost of capital are linked together by the following equation.
AT A GLANCE

 Formula:

The Fisher equation

1 + m = (1 + r) × (1 + i)
Where:
m = money rate
r = real rate
i= rate of inflation

The rate of inflation used above is the general rate of inflation.

SPOTLIGHT

 Example 44:
A company has a money cost of capital of 12% and inflation is 5%.
The real rate can be found as follows:
1 + m = (1 + r) × (1 + i) 1.12 = (1 + r) (1.05)
Therefore, r = (1.12/1.05) – 1 = 0.0666 or 6.67%
Available information
There are models that can be used to estimate cost of capital in practice. These models provide a
money cost of capital.
STIKCY NOTES

When performing DCF analysis a company will know current prices. Cash flow information is
available in real terms.
Possible methods
There are two possible approaches to incorporating the expectation of inflation into NPV
calculations. Either:
 real cash flows should be discounted at the real cost of capital; or
 money cash flows should be discounted at the money cost of capital.
In order to use one of these approaches and given the information that is likely to be available
(real cash flows and money cost of capital) either the real cost of capital has to be derived from
the money cost using the Fisher equation or the future cash flows have to be inflated to give the
money flows.
The most common approach is to adjust the real cash flows to the money cash flows and discount
these by the money cost of capital.

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4.5 Discounting money cash flows at the money cost of capital

The cost of capital used in DCF analysis is normally a ‘money’ cost of capital. This is a cost of capital calculated
from current market returns and yields.
When estimates are made for inflation in future cash flows, the rules are as follows:
 Estimate all cash flows at their inflated amount. Since cash flows are assumed to occur at the year-end, they
should be increased by the rate of inflation for the full year.
 To estimate a future cash flow at its inflated amount, you can apply a formula.
 Formula:

CF at time n at inflated amount = CF at current price level × (1 + i) n

Where:

AT A GLANCE
CF = cash flow
i = the annual rate of inflation

All the cash flows must be re-stated at their inflated amounts. The inflated cash flows are then discounted at the
money cost of capital, to obtain present values for cash flows in each year of the project.
These are netted to find the NPV of the project.
 Example 45:
A company is considering an investment in an item of equipment costing Rs. 150,000. The
equipment would be used to make a product. The selling price of the product at today’s prices
would be Rs. 10 per unit, and the variable cost per unit (all cash costs) would be Rs. 6.

SPOTLIGHT
The project would have a four-year life, and sales are expected to be:

Year Units of sale

1 20,000
2 40,000
3 60,000
4 20,000

At today’s prices, it is expected that the equipment will be sold at the end of Year 4 for Rs. 10,000.
There will be additional fixed cash overheads of Rs. 50,000 each year as a result of the project, at
today’s price levels.

STIKCY NOTES
The company expects prices and costs to increase due to inflation at the following annual rates:
Item Annual inflation rate
Sales 5%
Variable costs 8%
Fixed costs 8%
Equipment disposal value 6%
The company’s money cost of capital is 12%.
The NPV of the project is calculated as follows:
 The example involves real cash flows that needs to be inflated at given rates so that they
become money cash flows.
 The cost to capital given in the question is 12% that is money cost of capital.
 The NPV of the project by discounting money cash flows with money cost of capital is

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Item Time 0 Year 1 Year 2 Year 3 Year 4

Rs. Rs. Rs. Rs. Rs.
Equipment purchase (150,000)
Equipment disposal
(Rs. 10,000 × (1.06)4) 12,625
Revenue
At today’s prices 200,000 400,000 600,000 200,000
At inflated prices (5% per 210,000 441,000 694,575 243,101
year)
Costs
AT A GLANCE

Variable, today’s prices 120,000 240,000 360,000 120,000

Fixed, today’s prices 50,000 50,000 50,000 50,000
Total, today’s prices 170,000 290,000 410,000 170,000
At inflated prices (8% per 183,600 338,256 516,482 231,283
year)
Net cash profit 26,400 102,744 178,093 11,818
Net cash flows (150,000) 26,400 102,744 178,093 24,443
Discount factor (12%) 1 0.893 0.797 0.712 0.636
(150,000) 23,575 81,887 126,802 15,546
SPOTLIGHT

Net present value + 97,810

Discounting real cash flows at the real cost of capital

Instead of calculating the NPV of a project by discounting ‘money’ cash flows at the money cost of capital, NPV
can be calculated using a real cost of capital applied to cash flows at today’s prices.
Discounting real cash flows using a real cost of capital will give the same NPV as discounting money cash flows
using the money cost of capital, where the same rate of inflation applies to all items of cash flow.
 Example 46:
A company is considering an investment in an item of equipment costing Rs.150,000.
STIKCY NOTES

Contribution per unit is expected to be Rs.4 and sales are expected to be:

Year Units of sale

1 20,000
2 40,000
3 60,000
4 20,000

Fixed costs are expected to be Rs.50,000 at today’s price levels and the equipment can be
disposed of in year 4 for Rs.10,000 at today’s price levels. The inflation rate is expected to be 6%
and the money cost of capital is 15%.
 The example involves real cash flows that need to be discounted using real cost of capital
 The cost to capital given in the question is 15% that is money cost of capital and inflation
rate is 6%. This needs to be converted in real cost of capital as:
 The real discount rate = 1.15/1.06 – 1 = 0.085 = 8.5%

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The NPV of the project by discounting real cash flows with real cost of capital is:

Item Time 0 Year 1 Year 2 Year 3 Year 4

Rs. Rs. Rs. Rs. Rs.
Equipment purchase (150,000)
Equipment disposal 10,000
Contribution 80,000 160,000 240,000 80,000
Fixed costs (50,000) (50,000) (50,000) (50,000)
Net cash flow at today’s prices (150,000) 30,000 110,000 190,000 40,000
Discount factor (8.5%) 1 1/1.085 1/1.0852 1/1.0853 1/1.0854

AT A GLANCE
Present values (150,000) 27,650 93,440 148,753 28,863

Net present value 148,706

 The example involves real cash flows that need to be converted into money cash flows
using inflation rate.
 The cost to capital given in the question is 15% that is money cost of capital.
 This needs to be converted in real cost of capital as:
The NPV of the project by discounting money cash flows with money cost of capital is

Item Time 0 Year 1 Year 2 Year 3 Year 4

SPOTLIGHT
Rs. Rs. Rs. Rs. Rs.
Equipment purchase (150,000)
Equipment disposal 10,000
Contribution 80,000 160,000 240,000 80,000
Fixed, today’s prices (50,000) (50,000) (50,000) (50,000)
Net cash flow at today’s prices (150,000) 30,000 110,000 190,000 40,000
Inflation adjustment ×1 ×1.06 ×1.062 ×1.063 ×1.064
Money cash flows (150,000) 31,800 123,596 226,293 50,499

STIKCY NOTES
Discount factor (15%) 1 0.870 0.756 0.658 0.572
Present values (150,000) 27,666 93,439 148,901 28,885
Net present value 148,891

 Example 47:
Badger plc., a manufacturer of car accessories is considering a new product line. This project
would commence at the start of Badger plc.’s next financial year and run for four years. Badger
plc.’s next year end is 31st December 2012.
The following information relates to the project:
A feasibility study costing Rs.8 million was completed earlier this year but will not be paid for
until March 2013. The study indicated that the project was technically viable.
Capital expenditure
If Badger plc. proceeds with the project it would need to buy new plant and machinery costing
Rs.180 million to be paid for at the start of the project. It is estimated that the new plant and
machinery would be sold for Rs.25 million at the end of the project.

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If Badger plc. undertakes the project it will sell an existing machine for cash at the start of the
project for Rs.2 million. This machine had been scheduled for disposal at the end of 2016 for Rs.1
million.
Market research
Industry consultants have supplied the following information:
Market size for the product is Rs.1,100 million in 2012. The market is expected to grow by 2%
per annum.
Market share projections should Badger plc. proceed with the project are as follows:

2013 2014 2015 2016

Market share 7% 9% 15% 15%
AT A GLANCE

Cost data: 2013 2014 2015 2016

Rs.m Rs.m Rs.m Rs.m
Purchases 40 50 58 62
Payables (at the year-end) 8 10 11 12
Payments to sub-contractors, 6 9 8 8
Fixed overheads (total for Badger plc)
With new line 133 110 99 90
Without new line 120 100 90 80

Labor costs
SPOTLIGHT

At the start of the project, employees currently working in another department would be
transferred to work on the new product line. These employees currently earn Rs.3.6 million. An
employee currently earning Rs.2 million would be promoted to work on the new line at a salary
of Rs.3 million per annum. A new employee would be recruited to fill the vacated position.
As a direct result of introducing the new product line, employees in another department
currently earning Rs.4 million would have to be made redundant at the end of 2013 resulting in
a redundancy payment of Rs.6 million at the end of 2014.
Material costs
The company holds a stock of Material X which cost Rs.6.4 million last year. There is no other use
for this material. If it is not used the company would have to dispose of it at a cost to the company
STIKCY NOTES

of Rs.2 million in 2013. This would occur early in 2013.

Material Z is also in stock and will be used on the new line. It cost the company Rs.3.5 million
some years ago. The company has no other use for it, but could sell it on the open market for Rs.3
million early in 2013.
Further information
The year-end payables are paid in the following year.
The company’s cost of capital is a constant 10% per annum.
It can be assumed that operating cash flows occur at the year end.
Time 0 is 1st January 2013 (t1 is 31st December 2013 etc.)
The example relates to Badger Plc. A company that is considering investment in new product line.
The project life is 4 years and it will be evaluated on NPV model incorporating inflation:
 Firstly, the future expected cash flows (cash inflows and out flows) are identified based
on relevant costing principles excluding irrelevant cost.

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Following costs are irrelevant:

a) Current earning of employees working in another department being past cost.
b) The original cost of material X being past cost.
c) The original cost of material Z being past cost.
Based on above analysis the calculation of Net, discounted cash flows and NPV (work to the
nearest millions) is as under:
01/01/13 31/12/13 31/12/14 31/12/15 31/12/16
Rs. m Rs. m Rs. m Rs. m Rs. m
0 1 2 3 4
Machine (180) 25

AT A GLANCE
Existing machine 2 (1)
Operating flows
Sales W1 79 103 175 179
Purchases W2 (32) (48) (57) (73)
Payments to
subcontractors (6) (9) (8) (8)
Fixed overhead (13) (10) (9) (10)
Labor costs:
Promotion (3) (3) (3) (3)
Redundancy (6)

SPOTLIGHT
Material
X 2
Y (3)
Net operating flows (1) 25 27 98 109
(179) 25 27 98 109
Discount factor (10% 1.000 0.909 0.826 0.751 0.683
(179) 23 22 74 74
NPV 14
Working:

STIKCY NOTES
1. Sales
2012 2013 2014 2015 2016
Rs. m Rs. m Rs. m Rs. m Rs. m
Market size 1,100 1,122 1,144 1,167 1,191
Market share 0.07 0.09 0.15 0.15
Sales 79 103 175 179
2. Purchases
2013 2014 2015 2016
Opening payables - 8 10 11
Add purchases 40 50 58 62
Less closing payables (8) (10) (11) -
Cash for purchases 32 48 57 73
Decision: The project has a positive NPV. The project should be undertaken because it will
increase the value of the company and the wealth of its shareholders.

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 Example 48:
Clear Co. specializes in the production of UPVC windows and doors. It is considering whether to
invest in a new machine with a capital cost of Rs. 4 million. The machine would have an expected
life of five years at the end of which it would be sold for Rs, 450,000.
If the new machine would be purchased the existing machine could either be sold immediately
for Rs.250,000 or hired out to another company at a rental amount of Rs,100,000 per annum,
payable in advance for three years, If the machine is hired out rather than sold it will have no
residual value at the end of three years period. The existing machine generates annual revenues
of Rs.8 million and its running costs are Rs,840,000 per annum.
If the new machine is purchased revenues are expected to increase by 20 %. In Addition to this,
however machine running costs are also expected to increase. Estimate have shown that, in the
first year with the new machine, running costs will increase by 18%. In every subsequent year
AT A GLANCE

thereafter, running costs will continue to 18% higher than each previous years costs.
The company’s cost of capital is 10%. All workings should be in Rs.’000’.
The example relates to Clear & Co. with two options:
a) Selling of existing machinery immediately
b) Hiring of existing machinery for three years receiving rent in advance.
The project will be evaluated on NPV and IRR model after allowing for inflation.
 All future cash flows (cash inflows & cash out flows) are given based on relevant costing
principles with their timing of occurrence.
 Based on above analysis the calculation on Net cash flows, discounted cash flows and
SPOTLIGHT

NPV under both option are given as under:

Option (a) Selling of existing machinery

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
New machinery cost (4000) 450
Selling price of 250
existing machinery
Revenues (20% 9600 9600 9600 9600 9600
STIKCY NOTES

income)
Running cost (18% in (991) (1170) (1380) (1629) (1,922)
cash subsequent
year)
Net cash flows (3,750) 8609 8430 8220 7971 8,128
Discount factor 1.000 0.909 0.826 0.751 0.683 0.621
(10%)
Discounted cash (3,750) 7826 6963 6173 5444 5,047
flows
NPV 27,703

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Option (b) Hiring of existing machinery

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000) Rs.(000)
New machinery cost (4000) 450
Rentals of existing 100 100 100
machine
Revenues (20% 9600 9600 9600 9600 9600
income)
Running cost (18% in (991) (1170) (1380) (1629) (1,922)
cash subsequent

AT A GLANCE
year)
Net cash flows (3900) 8709 8530 8220 7971 8,128
Discount factor 1.000 0.909 0.826 0.751 0.683 0.621
(10%)
Discounted cash (3900) 7916 7046 6173 5444 5,047
flows 4936
NPV 27,727

Decision: The company should invest in new machinery and should rent out the existing
machinery because with this option NPV is 27,727(000) that is higher than the NPV of option 1

SPOTLIGHT
relates to selling of existing machinery
 Example 49:
Tropical Juices (TJ) is planning to expand its production capacity by installing a plant in a building
which is owned by TJ but has been rented out at Rs. 6 million per annum. The relevant details are
as under:
i. The cost of the building is Rs. 40 million and it is depreciated at 5% per annum.
ii. The rent is expected to increase by 5% per annum.
iii. Cost of the plant and its installation is estimated at Rs. 60 million. TJ depreciates plant
and machinery at 25% per annum on a straight line basis. Residual value of the plant

STIKCY NOTES
after four years is estimated at 10% of cost.
iv. Additional working capital of Rs. 25 million would be required on commencement of
production.
v. defined. Selling price of the juices would be Rs. 350 per liter. Sales quantity is projected
as under:

Year 1 Year 2 Year 3 Year 4

Liters 250,000 300,000 320,000 290,000

vi. Variable cost would be Rs. 180 per liter. Fixed cost is estimated at Rs. 100 per liter based
on normal capacity of 280,000 liters. Fixed cost includes yearly depreciation amounting
to Rs. 16 million.
vii. Rate of inflation is estimated at 5% per annum and would affect the revenues as well as
expenses.
viii. TJ's cost of capital is 15%.

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The example to Tropical Juices (TJ) that is considering to expand its production capacity by
installing a plant which has been currently rented out. The decision will be evaluated on NPV
model incorporating inflation.
 The relevant cash inflows and out flows with their timing of occurrence are given in
question except deprecation of machinery being non cash flows cost.
 Based on above analysis the calculation of net cash flows, discounted cash flows and NPV
is as under:

Year 0 Year 1 Year 2 Year 3 Year 4

Cash inflows/(outflows)
------------------------ Rs. in million ------------------------
AT A GLANCE

Loss of opportunity - (6.30) (6.62) (6.95) (7.29)

(Bldg. rent)
Cost of plant and its (60.00) 6.00
Installation
Working capital (25.00) - - - 25.00
Sales 87.50 110.25 123.48 117.50
(0.25×350) (0.3×350 (0.32×350 (0.29×350
×1.05) ×1.052) ×1.053)
Variable cost (45.00) (56.70) (63.50) (60.43)
SPOTLIGHT

(0.25×180) (0.3×180 (0.32×180 (0.29×180

×1.05) ×1.052) ×1.053)
Fixed cost (12.00) (12.60) (13.23) (13.89)
(0.28×100)-16 (12×1.05) (12×1.052) (12×1.053)
Net cash flows (85.00) 24.20 34.33 39.80 66.89
Present value factor at 1.000 0.870 0.756 0.658 0.572
15%
Present value at 15% (85.00) 21.05 25.95 26.19 38.26
STIKCY NOTES

Net present value 26.45

(NPV) at 15%

Decision: The project has a positive NPV. The project should be undertaken because it will
increase the value of the company and the wealth of its shareholders.

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5. DCF & TAXATION

5.1 Taxation cash flows in investment appraisal
In project appraisal, cash flows arise due to the effects of taxation. When an investment results in higher profits,
there will be higher taxation. Tax cash flows should be included in DCF analysis. In DCF analysis it is normally
assumed that tax is payable on the amount of cash profits in any year.
For example, if taxation on profits is 32% and a company earns Rs.10,000 cash profit each year from an
investment, the pre-tax cash inflow is Rs.10,000, but there is a tax payment of Rs.3,200.
Similarly, if an investment results in lower profits, tax is reduced. For example, if an investment causes higher
spending of Rs.5,000 each year and the tax on profits is 32%, there will be a cash outflow of Rs.5,000 but a cash
benefit from a reduction in tax payments of Rs.1,600.

AT A GLANCE
Working capital flows are not subject to tax.
Where accounting measures are given remember that depreciation is not a tax allowable expense and does not
represent cash flows. It should be ignored in drafting cash flows (or perhaps added back if already deducted).

5.2 Interest costs and taxation

Interest cash flows are not included in DCF analysis. This is because the interest cost is in the cost of capital
(discount rate).
Interest costs are also allowable expenses for tax purposes, therefore, present values are estimated using the
post-tax cost of capital. The post-tax cost of capital is a discount rate that allows for the tax relief on interest
payments. This means that because interest costs are allowable for tax purposes, the cost of capital is adjusted
to allow for this and is reduced accordingly.

SPOTLIGHT
The cost of capital is explained in more detail in a later chapter. Briefly however, the following formula holds in
cases where debt is irredeemable.
 Formula:

Post-tax interest cost

Post tax-cost of debt = Pre-tax interest cost (1 – tax rate)

 Example 50:
Post-tax interest cost Interest on debt capital is 10% and the rate of tax on company profits is
32%.

STIKCY NOTES
Post tax-cost of debt = Pre-tax interest cost (1 – tax rate)
= 10% (1 - 0.32) = 6.8%

5.3 Timing of cash flows for taxation

 When cash flows for taxation are included in investment appraisal, an assumption must be made about when
the tax payments are made. The actual timing of tax payments depends on the tax rules that apply in the
relevant jurisdiction. Usually, one or other of the following assumptions is used. Tax is payable in the same
year as the profits to which the tax relates; or
 tax is payable one year later (‘one year in arrears’). (For example, tax on the cash profits in Year 1 is payable
in Year 2).
Either of these two assumptions could be correct.
 Example 51:
A project costing Rs.60,000 is expected to result in net cash inflows of Rs.40,000 in year 1 and
Rs.50,000 in year 2.

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Taxation at 32% occurs one year in arrears of the profits or losses to which they relate.
The post-tax cost of capital is 8%.
Assume that the cost of the project is not an allowable cost for tax purposes (i.e. capital
allowances should be ignored).

Year 0 1 2 3
Initial outlay (60,000)
Cash inflows 40,000 50,000
Tax on inflows (12,800) (16,000)
Annual cash flows (60,000) 40,000 37,200 (16,000)
AT A GLANCE

Discount factors 1 0.926 0.857 0.794

Present values (60,000) 37,040 31,880 (12,704)
NPV (3,784)

The NPV of the project is negative so it should be rejected.

5.4 Tax-allowable depreciation (capital allowances)

 The nature of tax allowable depreciation
 Tax allowable depreciation in Pakistan
 Balancing charge or balancing allowance on disposal
SPOTLIGHT

5.5 The nature of tax allowable depreciation

Non-current assets are depreciated in the financial statements. However, depreciation in the financial statements
is not an allowable expense for tax purposes.
Instead, the tax rules provide for ‘tax-allowable depreciation’ according to rules determined by the government.
Tax-allowable depreciation affects the cash flows from an investment by altering the tax payment and the tax
effects must be included in the project cash flows.

5.6 Tax allowable depreciation in Pakistan

Tax rules in Pakistan are set out in the Income Tax Ordinance, 2001 (as amended). Exam questions tend to specify
STIKCY NOTES

the tax rates and allowance percentages to be used.

5.7 Initial allowance

Section 23 of the ordinance allows a deduction of an initial allowance in the year in which an asset used for
business purposes is brought into use. This initial allowance is currently set at 25% of the cost of the asset.

5.8 Normal depreciation (written down allowance)

A further deduction of a percentage of the tax written down value on a reducing balance basis is also allowed in
each period. The percentage depends on the type of asset as specified in the third schedule to the ordinance. The
deduction that relates to machinery and plant is usually 10%. This written down allowance is claimed in addition
to the initial allowance in the year in which an asset is purchased.
 Example 52:
An asset costs Rs.80,000.
Allowable initial allowance is 25% and normal depreciation is 10% under the reducing balance
method.

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Tax on profits is payable at the rate of 29%.

The cash flow benefits from the tax depreciation are calculated as follows:

Year TWDV Tax allowable Tax saved

depreciation (29%)
Rs. Rs. Rs.
0 Cost 80,000
1 Initial allowance (20,000) 20,000 5,800
60,000
2 Normal depreciation (6,000) 6,000 1,740

AT A GLANCE
54,000
3 Normal depreciation (5,400) 5,400 1,566
48,600
4 Normal depreciation (4,860) 4,860 1,409
43,740
5 Normal depreciation (4,374) 4,374 1,268
39,366
Normal depreciation (3,937) 3,937 1,142
TWDV, end of Year 5 35,429

SPOTLIGHT
 The tax cash flows (tax savings) should be treated as cash inflows in the appropriate year
in the DCF analysis.
 Note that the relevant cash flow to be included in DCF analyses are the tax effects of the
tax allowable depreciation not the tax allowable depreciation itself.
 The tax saved in the first year Rs. 7,540. This is the sum of the savings on the initial
allowance (Rs.5,800) and the normal depreciation in the first year (Rs. 1,740).

5.9 Balancing charge or balancing allowance on disposal

When an asset is scrapped or sold there might be a balancing charge or a balancing allowance. This is the

STIKCY NOTES
difference between:
 the written-down value of the asset for tax purposes (TWDV); and
 Its disposal value (if any).
The effect of a balancing allowance or balancing charge is to ensure that over the life of the asset the total amount
of tax allowable depreciation equals the cost of the asset less its residual value.

5.10 Balancing allowance

This occurs when the written-down value of the asset for tax purposes is higher than its disposal value.
The balancing allowance is an additional claim against taxable profits.

5.11 Balancing charge

This occurs when the written-down value of the asset for tax purposes is lower than the disposal value.
The balancing charge is a taxable amount, and will result in an increase in tax payments.

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5.12 Impact on DCF analysis

The cash saving or cash payment is included in the cash flows for DCF analysis.
Note: An annual capital allowance is not claimed in the year of disposal of an asset. Instead, there is simply a
balancing allowance (or a balancing charge).
 Example 53:
A company is considering an investment in a non-current asset costing Rs.80,000. The project
would generate the following cash inflows:

Year Rs.

1 50,000
AT A GLANCE

2 40,000

3 20,000

4 10,000

Allowable initial allowance is 25% and normal depreciation is 10% under the reducing balance
method.
Tax on profits is payable at the rate of 32%.
It is expected to have a scrap value of Rs.20,000 at the end of year 4. The post-tax cost of capital
SPOTLIGHT

is 9%.
The calculation of NPV is as:

0 1 2 3 4

Rs.000 Rs.000 Rs.000 Rs.000 Rs.000

Capital flows (80.0) 20.0

Tax saving on tax

STIKCY NOTES

allowable depreciation (W2) 8.3 1.7 1.6 7.6

Cash inflows 50.0 40.0 20 10.0

Tax on cash inflows (16.0) (12.8) (6.4) (3.2)

Net cash flows (80.0) 42.3 28.9 15.2 34.4

Discount factor 1.000 0.917 0.842 0.772 0.708

Present values (80.0) 38.8 24.3 11.7 24.4

NPV 19.2

Note that the tax saving on tax allowable depreciation in year 1 of Rs. 8,320 is made up of is 6,400
+ 1,920.

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Working
Year TWDV Tax allowable Tax saved
Depreciation (32%)

Rs. Rs. Rs.

0 Cost 80,000
1 Initial allowance (20,000) 20,000 6,400
60,000
Normal depreciation (6,000) 6,000 1,920
54,000

AT A GLANCE
2 Normal depreciation (5,400) 5,400 1,728
48,600
3 Normal depreciation (4,860) 4,860 1,555
43,740
4 Cash proceeds (20,000)
Balancing allowance 23,740 23,740 7,597

The impact of the balancing allowance (charge) is that the amount claimed in allowances is
always equal to the cost of the asset less its disposal proceeds.

SPOTLIGHT
This means that the amount of tax saved is always the tax rate applied to this difference.
Therefore, in the above example:
 Total tax allowable depreciation = 80,000 – 20,000 = 60,000 (20,000 + 6,000 + 5,400 +
4,860 + 23,740).
 Total tax saved = 32% * 60,000 = 19,200 (6,400 + 1,920 + 1,728 + 1,555 + 7,597).
 Example 54:
Baypack Company is considering whether to invest in a project whose details are as follows.
The project will involve the purchase of equipment costing Rs. 2,000,000. The equipment will be
used to produce a range of products for which the following estimates have been made.

STIKCY NOTES
Year 1 2 3 4
Rs. Rs. Rs. Rs.
Average sales price 73.55 76.03 76.68 81.86
Average variable cost 51.50 53.05 49.17 50.65
Incremental annual fixed costs Rs.1,200,000 Rs.1,200,000 Rs.1,200,000 Rs.1,200,000
Sales units 65,000 100,000 125,000 80,000

The sales prices allow for expected price increases over the period. However, cost estimates are
based on current costs, and do not allow for expected inflation in costs. Inflation is expected to
be 3% per year for variable costs and 4% per year for fixed costs. The incremental fixed costs are
all cash expenditure items. Tax on profits is at the rate of 30%, and tax is payable in the same
year in which the liability arises.

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Baypack Company uses a four-year project appraisal period, but it is expected that the equipment
will continue to be operational and in use for several years after the end of the first four-year
period.
The company’s cost of capital for investment appraisal purposes is 10%.
The example relates to Baypack a company that is considering an investment for purchase of
equipment. The life of project is 4 years. The project will be evaluated on NPV model
incorporating inflation and taxation.
 All future cash flows are given on relevant costing principles.
 The only variable cost and fixed cost are required to be inflated at 3% and 4%
respectively.
 Based on above analysis the net cash flows, discounted cash flows and NPV are as under.
AT A GLANCE

Year 0 1 2 3 4
Rs. 000 Rs. 000 Rs. 000 Rs. 000
Initial investment (2,000)
Total contribution (W) 1,433 2,298 3,439 2,497
Fixed costs (1,248) (1,298) (1,350) (1,404)
Taxable cash flow 185 1,117 2,089 1,093
Tax (30%) (56) (335) (627) (328)
129 782 1,462 765
SPOTLIGHT

Discount factor, 10% 1 0.909 0.826 0.751 0.683

Present values (2,000) 117 646 1,098 522
NPV = Rs. 383,000

Workings: Contribution
Year 0 1 2 3 4
Rs. Rs. Rs. Rs.
STIKCY NOTES

Average sales price 73.55 76.03 76.68 81.86

Average variable cost 51.50 53.05 49.17 50.65
22.05 22.98 27.51 31.21
Sales units 65,000 100,000 125,000 80,000
Total contribution 1,433 2,298 3,439 2,497

Decision: The project has a positive NPV. The project should be undertaken because it will
increase the value of the company and the wealth of its shareholders.

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6. COMPREHENSIVE EXAMPLES
 Example 01:
Valika Limited (VL) plans to introduce a new product AX which would be used in hybrid cars.
Following information is available in this regard:
Initial investment in the new plant including installation and commissioning is estimated at Rs.
50 million. The plant is expected to have a useful life of four years and would have annual capacity
of 200,000 units.
The demand of AX for the first year is expected to be 180,000 units which would increase by 10%
per annum in year 2 and 3. However, in year 4 the demand is expected to decline by 10%.
The contribution margin for the first year is estimated at Rs. 100 per unit which is expected to

AT A GLANCE
increase by 5% each year. The new plant would be installed at VL’s premises which are presently
rented out at Rs. 1.8 million per annum. As per the terms of rent agreement, the rent is received
in advance and is subject to 7% increase per annum.
Working capital of Rs. 10 million would be required at the commencement of the project.
Working capital is expected to increase by 10% each year.
The new plant would be depreciated at the rate of 25% under the reducing balance method. Tax
depreciation is to be calculated on the same basis. The residual value of the plant at the end of
useful life is expected to be equal to its carrying value.
VL’s cost of capital is 10%.
Tax rate is 30% and is paid in the year in which the tax liability arises.

SPOTLIGHT
The example relates to VL limited. That is considering introducing a new product for which
investment would be required in new plant. The life of project is 4 years. The project will be
evaluated on NPV model incorporating inflation and taxation.
The plant will be installed in premises which are currently rented out. So sacrifice of rental
income become opportunity cost for this decision net of tax.
 Tax deprecation and tax payments would be considered in relevant cash flows of project.
 The working capital of state of project is expected to increase 10% in subsequent year
and full amount is assumed to record at end of project.
 All other cash flows are straight forward according to their timing.

STIKCY NOTES
 Based on above analysis calculation of net and discounted cash flows are as under:

Year 0 Year 1 Year 2 Year 3 Year 4

------------------- Rs. in million -------------------
Contribution margin (W-1) - 18.00 20.79 22.05 22.69
Tax/Accounting depreciation - (12.50) (9.38) (7.04) (5.28)
(50×0.25, 0.75)
Net profit before tax - 5.50 11.41 15.01 17.41
Tax liability @ 30%. - (1.65) (3.42) (4.50) (5.22)
Net profit after tax - 3.85 7.99 10.51 12.19
Add back depreciation 12.50 9.38 7.04 5.2 8
Rent income lost 1.8×1.07 (1.93) (2.07) (2.21) (2.36)

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Year 0 Year 1 Year 2 Year 3 Year 4

------------------- Rs. in million -------------------
Tax saved on rent income 1.93×30% 0.58 0.62 0.66 0.71
Residual value receipts 15.80
(50–34.2 Total dep.)
Initial investment (50.00)
Working capital (W-2) (10.00) (1.00) (1.10) (1.21) 13.31
Net cash (outflows)/inflows (61.93) 13.86 14.68 14.64 47.29
Discount rate @ 10% 1.0000 0.9091 0.8264 0.7513 0.6830
AT A GLANCE

Present value (61.93) 12.60 12.13 10.99 32.29

Net present value 6.08

W-1: Annual contribution margin Year 1 Year 2 Year 3 Year 4

Contribution margin per unit (Rs.) A 100.00 105.00 110.25 115.76
100 100×1.05 105×1.05 110.25×1.05
Annual demand (Units) 180,000 198,000 217,800 196,020
180,000 198,000 217,800
×1.10 ×1.10 ×90%
Production - Restricted to capacity 180,000 198,000 200,000 196,020
SPOTLIGHT

(Units) (Up to 200,000 units p.a) B

Annual CM (Rs. in million) (A×B) 18.00 20.79 22.05 22.69

W-2: Working capital requirement Year 1 Year 2 Year 3

Working capital current year 11.00 12.10 13.31
10×1.1 11×1.1 12.10×1.1
Working capital last year 10.00 11.00 12.10
(Increase)/Decrease (1.00) (1.10) (1.21) 13.31
Decision:
STIKCY NOTES

The project has a positive NPV. The project should be undertaken because it will increase the
value of the company and the wealth of its shareholders.
 Example 02:
Diamond Investment Limited (DIL) is considering to set-up a plant for the production of a single
product X-49. The details relating to the investment are as under:
The cost of plant amounting to Rs. 160 million would be payable in advance. It includes
installation and commissioning of the plant.
Working capital of Rs. 20 million would be required at the commencement of the commercial
operations.
DIL intends to sell X-49 at cost plus 25% (cost does not include depreciation on plant). Sales for
the first year are estimated at Rs. 300 million. The sales quantity would increase at 6% per
annum.
The plant would be depreciated at the rate of 20% under the reducing balance method. Tax
depreciation is to be calculated on the same basis. Estimated residual value of the plant at the
end of its useful life of four years would be equal to its carrying value.

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Tax rate is 34% and tax is payable in the year the liability arises.
DIL’s cost of capital is 18%. All costs and prices are expected to increase at the rate of 5% per
annum.
The example relates to DIL a company, which is considering investment in a plant for production
of new product.
The project will be evaluated on NPV and IRR model after incorporating inflation and taxation.
 The sale revenue will be increased yearly (volume 6% and price 5%)
 The cost of sales is calculated at cost plus 25% (sales 1.25)
 All other cash flows are straight forward according to their timings on assumption that
all cash flows would arise at the end of the year unless otherwise specified.
 Based on above analysis calculation of net and discounted cash flows arrears under.

AT A GLANCE
Net Present Value (NPV) of the project

Year 0 Year 1 Year 2 Year 3 Year 4

Cash inflows/(outflows) - Rupees in million
Sales (yearly increase: volume 6% - 300.00 333.90 371.63 413.62
& price 5%)
Cost (Sales ÷ 1.25) - (240.00) (267.12) (297.30) (330.90)
Plant depreciation at 25% of WDV - (32.00) (25.60) (20.48) (16.38)
Net profit - 28.00 41.18 53.85 66.34
Tax @ 34% - (9.52) (14.00) (18.31) (22.56)

SPOTLIGHT
Add back depreciation - 32.00 25.60 20.48 16.38
Cost of plant and its installation (160.00) - - - 65.54
Working capital (20.00) - - - 20.00
Projected cash flows (180.00) 50.48 52.78 56.02 145.70
PV factor at 18% 1.00 0.85 0.72 0.61 0.52
Present value (180.00) 42.91 38.00 34.17 75.76
NPV at 18% ( 𝑁𝑃𝑉𝐴 ) 10.84
Internal Rate of Return (IRR) of the project:

STIKCY NOTES
PV factor at 22% 1.00 0.82 0.67 0.55 0.45
PV at 22%
(Projected cash flow × PV factor) (180.00) 41.39 35.36 30.81 65.57
NPV at 22% (𝑁𝑃𝑉𝐵 ) (6.87)

Based on above calculations the expected IRR using interpolation formula is:
𝑁𝑃𝑉𝐴 10.84
𝐼𝑅𝑅 = 𝐴% + ( ) = 18% + ( )
𝑁𝑃𝑉𝐴 − 𝑁𝑃𝑉𝐵 10.84 − (−6.87) 20.45%
× (𝐵% − 𝐴%) × (22% − 18%)

Decision: The project has a positive NPV. The project should be undertaken because it will
increase the value of the company and the wealth of its shareholders.
The IRR is 20.45% the project should be accepted if the project IRR is more than expected IRR.

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 Example 03:
Cloudy Company Limited (CCL) manufactures and sells specialized machine X85. A newer
version of the machine is gaining popularity in the market and CCL is therefore considering to
introduce a similar version i.e. D44. Detailed research in this respect has been carried out during
the last six months at a cost of Rs. 3.25 million.
The related information is as under:
i. Initial investment in the new plant for manufacturing D44 would be Rs. 450 million
including installation and commissioning of the plant. (ii) Projected production and
sales of D44 are as follows:

Year 1 Year 2 Year 3 Year 4

AT A GLANCE

------------------ No. of units ------------------

20,000 25,000 27,000 29,000

Sales volume of X85 in the latest year was 30,000 units. It is estimated that introduction of D44
would reduce the sale of X85 by 2,000 units every year.
ii. Estimated selling price and variable cost per unit of D44 in year 1 is estimated at Rs.
40,000 and Rs. 32,000 respectively. The contribution margin on X85 in year 1 is
estimated at Rs. 5,500 per unit.
iii. Fixed costs in year 1 are estimated at Rs. 45 million. However, if the new plant is installed
these costs would increase to Rs. 75 million.
iv. Impact of inflation on selling price, variable cost and fixed cost would be 10% for both
SPOTLIGHT

the machines/plants.
v. The new plant would be depreciated at the rate of 25% under the reducing balance
method. Tax depreciation is to be calculated on the same basis. The residual value of the
plant at the end of its useful life of four years is expected to be equal to its carrying value.
vi. Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
vii. CCL’s cost of capital is 12%.
By computing Internal rate of return (IRR) of the new plant CCL may decide whether it should
introduce D44. (Assume that all cash flows would arise at the end of the year unless stated
otherwise) as follows:
STIKCY NOTES

Year 0 Year 1 Year 2 Year 3 Year 4

Projected production and sales of
D44 Units (A) - 20,000 25,000 27,000 29,000
------------------- Rs. in million -------------------
Contribution margin of D44
(40,000-32,000)×1.1×A - 160.00 220.00 261.36 308.79
Research cost To be ignored - - - - -
Loss of CM of X85 (5,500×2,000×1.1) - (11.00) (24.20) (39.93) (58.56)
Existing fixed cost To be ignored - - - - -
Incremental fixed cost (75-45)×1.1 - (30.00) (33.00) (36.30) (39.93)
Tax/Accounting depreciation
450×0.25 - (112.50) (84.38) (63.29) (47.47)
Net profit before tax - 6.50 78.42 121.84 162.83

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Year 0 Year 1 Year 2 Year 3 Year 4

Tax liability @ 30% - (1.95) (23.53) (36.55) (48.85)
Net (loss)/profit after tax - 4.55 54.89 85.29 113.98
Add back non-cash item of
depreciation - 112.50 84.38 63.29 47.47
Plant cost/residual value at the end
of useful life (450.00) - - - 142.36
Total cash (outflows) / inflows (450.00) 117.05 139.27 148.58 303.81
Net cash inflows 258.71
Discount factor at 15% 1.0000 0.8696 0.7561 0.6575 0.5718

AT A GLANCE
Present value (450.00) 101.79 105.30 97.69 173.72
Net present value at 15% NPVa 28.50
Discount factor at 20% 1.0000 0.8333 0.6944 0.5787 0.4823
Present value (450.00) 97.54 96.71 85.98 146.53
Net present value at 20% NPVb (23.24)
IRR = A% + [NPVa ÷ ( NPVa - NPVb) × 15%+[28.50÷{28.50-(-23.24)} × (20%-
(B% - A%)] 15%)] 17.7 %

Conclusion:
IRR 17.75% is higher than CCL's cost of capital (12%), therefore, CCL should introduce D44.

SPOTLIGHT
 Example 04:
Modern Transport Limited (MTL) is considering an investment proposal from Burraq Cab
Services (BCS). As per the proposal, MTL would provide branded cars to BCS under the following
terms and conditions:
i. BCS would pay rent of Rs. 1.8 million per annum per car to MTL. The cars would operate
on a 24-hour basis. The payment would be made at the end of year.
ii. Cost of the drivers and maintenance cost of the car would initially be paid by BCS but
would be adjusted against car rentals payable to MTL at the end of each year.
iii. MTL would provide a smart mobile to each driver.
MTL has estimated the following costs for deployment of a car with BCS:

STIKCY NOTES
Description Rupees Remarks
Car purchase price 2,000,000 Estimated useful life and residual value of the car
is 4 years and Rs. 0.75 million respectively.
Car registration fee 35,000 One-time payment on registration of the car.
Mobile phone price per set 15,000 To be charged-off in the year of purchase.
Insurance premium 50,000 To be paid at the beginning of each year. It would
reduce by Rs. 5,000 each year due to decrease in
WDV of the car.
Annual salaries per driver 300,000 Would work in 8-hour shifts.
Annual maintenance cost 60,000 Due to ageing of cars, cost would increase by 10%
each year.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 617

 CHAPTER 17: TIME VALUE OF MONEY CAF 8: CMA

Additional information:
 The car would be depreciated at the rate of 25% under the reducing balance method.
 Tax depreciation is to be calculated on the same basis.
 Applicable tax rate is 30% and tax is payable in the year in which the liability arises.
 Inflation is estimated at 5% per annum.
 MTL's cost of capital is 12% per annum.
MTL’s decision to accept or reject the proposal would require following analysis:
Evaluation of BRC’s proposal
Year 0 Year 1 Year 2 Year 3 Year 4
----------------------- [Cash inflows/(outflows)] ----------------------
AT A GLANCE

-------------------------------- Rupees --------------------------------

Car's (cost) / residual
value (2,000,000) - - - -
Registration charges (35,000) - - - -
Initial investment (A) (2,035,000) - - - -
Cost of three mobile
phones (15,000×3) (45,000) - - - -
Revenue
(1,800,000×1.05) - 1,800,000 1,890,000 1,984,500 2,083,725
Salaries/meals of drivers
(3×300,000×1.05) - (900,000) (945,000) (992,250) (1,041,863)
SPOTLIGHT

Maintenance cost
(60,000×1.05×1.10) - (60,000) (69,300) (80,042) (92,448)
Insurance premium
(50,000-5,000) (50,000) (45,000) (40,000) (35,000) -
(B) 795,000 835,700 877,208 949,414
Taxation 30%
(B-W.1)× 30% - (70,875) (134,741) (175,811) (241,769)
Residual value of car 750,000
Net cash flows (2,130,000) 724,125 700,959 701,397 1,457,644
Discount factor @ 12% 1.0000 0.8929 0.7972 0.7118 0.6355
STIKCY NOTES

Present value (2,130,000) 646,571 558,805 499,254 926,333

Net present value 500,963

Conclusion: The net present value is positive; therefore, the proposal should be accepted.
W.1: Adjustment for tax liability
Accounting/tax depreciation
(A×25%) (C) - (508,750) (381,563) (286,172) (214,629)*
Profit on disposal of car
750 – (A–C) - - - - 106,114*
Mobiles' cost charged off - (45,000) - - -
Insurance premium allowable
for tax-next year - 45,000 40,000 35,000 -
Insurance premium allowable
for tax this year - (50,000) (45,000) (40,000) (35,000)
- (558,750) (386,563) (291,172) (143,515)

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 Example 05:
Golf Limited (GL) is engaged in the manufacturing and sale of a single product ‘Smart-X’. The
existing manufacturing plant is being operated at full capacity but the production is not sufficient
to meet the growing demand of Smart-X. GL is considering to replace it with a new Japanese plant.
The production capacity of new plant would be 50% more than the existing capacity.
To assess the viability of this decision, the following information has been gathered:
i. The purchase and installation cost of new plant would be Rs. 500 million and Rs. 25
million respectively. The supplier would send a team of engineers to Pakistan for final
inspection of the plant before it is commissioned. 50% of the total cost of Rs. 12 million
to be incurred on the visit, would be borne by GL.
ii. As a result of installation of the new plant, fixed costs other than depreciation would

AT A GLANCE
increase by Rs. 30 million.
iii. The existing plant has an estimated life of 10 years and is in use for the last 6 years.
Plant’s tax carrying value is Rs. 50 million. A machine supplier has offered to purchase
the existing plant immediately at Rs. 45 million.
iv. During the latest year, 6 million units were sold at an average selling price of Rs. 550 per
unit. Variable manufacturing cost was Rs. 450 per unit. GL expects that it can increase
the sales volume by 25% in the first year after the plant’s installation. Thereafter, the
sales volume would increase by 4% per annum.
v. The new plant would be depreciated under the straight line method. Tax depreciation is
calculated on the same basis. The residual value of the plant at the end of its useful life
of 4 years is estimated at Rs. 60 million.

SPOTLIGHT
vi. Applicable tax rate is 30% and tax is paid in the year in which the liability arises.
vii. Rate of inflation is estimated at 5% per annum and would affect the revenues as well as
expenses.
viii. GL’s cost of capital is 12%.
ix. All receipts and payments would arise at the end of the year except cost of setting up the
plant which would arise at the beginning of the year. It may be assumed that the new
plant would commence operations at the start of year 1.
On the basis of internal rate of return (IRR), advise whether GL should acquire the new plant.
Please see below evaluation of IRR for the said requirement
Year 0 Year 1 Year 2 Year 3 Year 4
Descriptions

STIKCY NOTES
--------------------- Rs. in million ------------------------
Incremental contribution margin
(W-1) - 157.50 198.45 244.25 295.37
Incremental fixed cost
(30×1.05) - (30.00) (31.50) (33.08) (34.73)
Tax depreciation
[{500+25+(12×50%)-60)×25%}] - (117.75) (117.75) (117.75) (117.75)
Net profit / (loss) before tax - 9.75 49.20 93.42 142.89
Tax @ 30% - (2.93) (14.76) (28.03) (42.87)
Tax savings on loss of disposal of
old plant (50m–45m)×30% - 1.50 - - -
Net profit / (loss) after tax - 8.32 34.44 65.39 100.02
Adding back depreciation (Non-
cash item) - 117.75 117.75 117.75 117.75

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 619

 CHAPTER 17: TIME VALUE OF MONEY CAF 8: CMA

Year 0 Year 1 Year 2 Year 3 Year 4

Descriptions
--------------------- Rs. in million ------------------------
Initial investment
[500m+25m+(12m×50%)–45m] (486.00) - - - -
Receipts from residual value - - - - 60.00
Total cash (outflows) / inflows
(A) (486.00) 126.07 152.19 183.14 277.77

Discount factor at 12% (B) 1.0000 0.8929 0.7972 0.7118 0.6355

Present value (A×B) (486.00) 112.57 121.33 130.36 176.52
AT A GLANCE

Net present value at 12% NPVb 54.78

Discount factor @ 18% (C) 1.0000 0.8475 0.7182 0.6086 0.5158

Present value (A×C) (486.00) 106.84 109.30 111.46 143.27
Net present value at 18% NPVc (15.13)
IRR = B%+[NPVb/(NPVb–NPVc)×C%–B%)] =
17%
12%+[54.78/(54.78+15.13)×{18%–12%}]

Conclusion: Since IRR is higher than the GL's cost of capital existing plant should be replaced.

Year 1 Year 2 Year 3 Year 4

SPOTLIGHT

W-1: --------- Units in million -------------

Production with new plant (6×1.25), (LY×1.04) 7.50 7.80 8.11 8.43
Production with old plant 6.00 6.00 6.00 6.00

Incremental production (A) 1.50 1.80 2.11 2.43

Contribution margin per unit(550–450)×1.05(B) 105.00 110.25 115.76 121.55

Incremental contribution margin (A×B) 157.50 198.45 244.25 295.37

 Example 06:
STIKCY NOTES

The following information has been extracted from the projected financial statements of
Lotus Enterprises (LE) for the year ending 30 September 2016:

Rs. in million
Sales (100% credit sales) 3,000
Raw material consumption 900
Raw material inventory (including imports of Rs. 98 million) 158
Conversion cost: Variable 570
Fixed (including depreciation of Rs. 16 million) 40
Operating cost: Variable 730
Fixed (including depreciation of Rs. 27 million) 120
Trade creditors (local purchases) 95
Advance to suppliers for import of raw material 30

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LE is in the process of preparing its budget for the next year. The relevant information is as under:
i. Sale volume is projected to increase by 30%. In order to finance the additional working
capital, the management has decided to adopt the following measures:
 Introduce cash sales at a discount of 2%. It is estimated that 20% of the customers would
avail the discount.
 The present average collection period is 45 days. LE has decided to improve follow-ups
which would ensure collection within 40 days.
 40% of the raw material consumed is imported which is paid in advance on placement
of purchase order. The delivery is made within 30 days after the placement of order. LE
has negotiated with the foreign suppliers and agreed that from the next year, payments
would be made on receipt of the goods.
 Local purchases would be paid in 50 days.

AT A GLANCE
ii. As a result of increased production, economies of scale would reduce variable
conversion cost per unit by 5%.
iii. Due to price increases, cost of raw material and all other costs (excluding depreciation)
would increase by 10% and 8% respectively.
iv. Average days for payment of other costs would remain the same i.e. 25 days.
v. There is no opening and closing finished goods inventory.
vi. Quantity of closing local and imported raw material as a percentage of raw material
consumption would remain the same.
vii. LE uses FIFO method of valuation of inventory.
Cash budget for the next year would be prepared as follows. (Assuming that all transactions occur

SPOTLIGHT
evenly throughout the year (360 days) unless otherwise specified)
Inflows: Rs. in million
Sale proceeds from:
– Cash sales (net of cash discount) (3,000×1.3)×20%×98% 764.40
– Credit sales:
Credit sales for the year (3,000×1.3)×80% 3,120.00
Trade debtors – closing balance 3,120×40÷360 (346.67)
2,773.33
Trade debtors – opening balance 3,000×45÷360 375.00

STIKCY NOTES
Collection from credit sales 3,148.33
(A) 3,912.73

Outflows:
Payments for raw material imports and local Local
Imports
purchases: purchases
Imports and local purchases for the year W.1 544.14 792.00 1,336.14
Trade creditors - closing balance 792×50÷360 - (110.00) (110.00)
544.14 682.00 1,226.14
Adjustment of advance for imports (30.00) - (30.00)
Trade creditors - opening balance - 95.00 95.00
514.14 777.00
(B) 1,291.14

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 621

 CHAPTER 17: TIME VALUE OF MONEY CAF 8: CMA

Payments for expenses:

Conversion cost Operating cost
Variable Fixed Variable Fixed
Cost for the year 760.27 25.92 1,024.92 100.44 1,911.55
570×1.3× (4016)× 730× (12027)
95%×1.08 1.08 1.3×1.08 ×1.08
Closing–payables (52.80) (1.80) (71.18) (6.97) (132.75)
(760.27÷ (25.92÷ (1,024.92 (100.44)
360×25) 360×25) ÷360×25) ÷360×25
AT A GLANCE

707.47 24.12 953.74 93.47 1,778.80

Opening–payables 39.58 1.67 50.69 6.46 98.40
570÷ (40-16)÷ 730÷ (120-27)
360×25 360×25 360×25 ÷360×25
Payments 747.05 25.79 1,004.43 99.93
(C) 1,877.20
Net cash inflows (A-B-C) 744.39

W-1: Imports/purchases for the next year: Imports Local purchases

SPOTLIGHT

--------- Rs. in million ---------

Raw material consumption using FIFO:
- From current year’s import : at old price 30.00 -
at revised price [(900×1.3×40%)(98+30)]×1.1 374.00 -
- Current year’s purchases: at
revised price [(900×1.3×60%)60]×1.1 - 706.20
404.00 706.20
Closing raw
STIKCY NOTES

material inventory (98×1.3×1.1), (60×1.3×1.1) 140.14 85.80

Total imports/local purchases for the next year 544.14 792.00

 Example 07:
Omega Limited (OL) is the sole distributor of goods produced by ABC Limited which is a leading
brand in the international market. OL is now planning to establish a factory in collaboration with
ABC Limited. The factory would be established on a land which was purchased at a cost of Rs. 20
million in 2005. The existing market value of the land is Rs. 40 million. The cost of factory building
and plant is estimated at Rs. 30 million and Rs. 100 million respectively.
The factory will produce goods which are presently supplied by ABC Limited. The sale for the
first year of production is estimated at Rs. 300 million. The existing profit margin is 20% on sales.
As a result of own production, cost per unit would decrease by 10%. The sale price and cost of
production per unit (excluding depreciation) are expected to increase by 10% and 8%
respectively, each year.

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Following further information is available:

 ABC Limited would assist in setting up of the factory for which it would be paid an
amount of Rs. 10 million at the time of signing the agreement. In addition, ABC Limited
would be paid a royalty equal to 3% of sales.
 The factory building and installation of plant would be completed and commercial
production would start one year after signing the agreement.
 50% of the cost of plant would be financed through a five year loan with interest payable
annually at 10% per annum. Principal would be repaid at the end of 5th year.
 A working capital injection of Rs. 15 million would be required at the commencement of
commercial production.
 OL charges depreciation on factory building and plant under the straight line method.

AT A GLANCE
 OL uses a five year project appraisal period. The residual value of the factory building
 and plant after five years is estimated at 50% and 10% of cost respectively.
 The market value of the land after five years is estimated at Rs. 70 million.
 OL’s cost of capital is 12%.
The net present value of the project assuming that unless otherwise specified, all cash
inflows/outflows would arise at the end of year, would be calculated as follows. (taxation is
ignored)

Year 0 1 2 3 4 5 6
Cash inflows/(outflows) – Rs. in million
Land (40.00) - - - - - 70.00

SPOTLIGHT
Factory building 2 (10.00) 1 (20.00) 1 15.00
Plant installation (100.00) 10.00
Loan 50.00 - - - - (50.00)
Working capital (15.00) - - - - 15.00
Sales (10% - - 300.00 330.00 363.00 399.30 439.23
growth)
Cost of goods sold W.1 (210.60) (227.45) (245.64)
(8% growth) (195.00) (265.30)
Royalty (3% of (9.00) (9.90) (10.89) (11.98) (13.18)

STIKCY NOTES
sales)
Interest on loan - - - - -
Net cash flows (50.00) (85.00) 96.00 109.50 124.66 141.68 220.75
PV factor at 12% 1.00 0.89 0.80 0.71 0.64 0.57 0.51
Present value (50.00) (75.65) 76.80 77.75 79.78 80.76 112.58
Net present value of the project 302.02

W.1 - Cost of goods sold: Rs. in million

Cost of own production (Including depreciation) (300×80%×90%) 216.00
Depreciation – factory building (30×50%)÷5 (3.00)
Depreciation – Plant (100×90%)÷5 (18.00)
195.00

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 623

 CHAPTER 17: TIME VALUE OF MONEY CAF 8: CMA

 Example 08:
Larkana Fabrication Limited is considering an investment in a new machine, with a maximum
output of 200,000 units per annum, in order to manufacture a new toy. Market research
undertaken for the company indicated a link between selling price and demand, and the research
agency involved has suggested two sales strategies that could be implemented, as follows:

Strategy 1 Strategy 2
Selling price (in current price terms) Rs.8.00 per unit Rs.7.00 per unit
Sales volume in first year 100,000 units 110,000 units
Annual increase in sales volume after first year 5% 15%

The services of the market research agency have cost Rs.75,000 and this amount has yet to be
AT A GLANCE

paid.
Larkana Fabrication Limited expects economies of scale to reduce the variable cost per unit as
the level of production increases. When 100,000 units are produced in a year, the variable cost
per unit is expected to be Rs.3.00 (in current price terms). For each additional 10,000 units
produced in excess of 100,000 units, a reduction in average variable cost per unit of Rs.0.05 is
expected to occur. The average variable cost per unit when production is between 110,000 units
and 119,999 units, for example, is expected to be Rs.2.95 (in current price terms); and the
average variable cost per unit when production is between 120,000 units and 129,999 units is
expected to be Rs.2.90 (in current price terms), and so on.
The new machine would cost Rs.1,600,000 and would not be expected to have any resale value
at the end of its life.
SPOTLIGHT

Operation of the new machine will cause fixed costs to increase by Rs.110,000 (in current price
terms). Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling
price and unit variable costs is expected to be 3% per year.
The company has an average cost of capital of 10% in money (nominal) terms
a) the sales strategy which maximizes the present value of total contribution. Ignore
taxation in this part of the question is determined as follows:
Contribution

Strategy 1
Year 1 2 3 4 5
STIKCY NOTES

Demand (units) 100,000 105,000 110,250 115,762 121,551

Selling price (unit) 8.00 8.00 8.00 8.00 8.00
Variable cost (unit) 3·00 3.00 2.95 2.95 2.90
Contribution (unit) 5.00 5.00 5.05 5.05 5.10
Inflated contribution 5.15 5.30 5.52 5.68 5.91
Total contribution (Rs.) 515,000 556,500 608,580 657,528 718,366
10% discount factors 0.909 0.826 0.751 0.683 0.621
PV of contribution (Rs.) 468,135 459,669 457,044 449,092 446,105

Total PV of Strategy 1 contributions = Rs.2,280,045.

624 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Strategy 2
Year 1 2 3 4 5
Demand (units) 110,000 126,500 145,475 167,296 192,391
Selling price (unit) 7.00 7.00 7.00 7.00 7.00
Variable cost (unit) 2.95 2.90 2.80 2.70 2.55
Contribution (unit) 4.05 4.10 4.20 4.30 4.45
Inflated contribution 4.17 4.35 4.59 4.84 5.16
Total contribution (Rs.) 458,700 550,275 667,730 809,713 992,738
10% discount factors 0.909 0.826 0.751 0.683 0.621

AT A GLANCE
PV of contribution (Rs.) 416,958 454,527 501,465 553,034 616,490

Total PV of strategy 2 contributions = Rs.2,542,474.

Strategy 2 is preferred as it has the higher present value of contributions.
b) Evaluating the investment in the new machine using internal rate of return:

Year 1 2 3 4 5
Rs. Rs. Rs. Rs. Rs.
Total contribution 458,700 550,275 667,730 809,713 992,738
Fixed costs (114,400) (118,976) (123,735) (128,684) (133,832)

SPOTLIGHT
Profit 344,300 431,299 543,995 681,029 858,906
10% discount factors 0.909 0.826 0.751 0.683 0.621
Present value 312,969 356,253 408,540 465,143 533,381
20% discount factors 0.833 0.694 0.579 0.482 0.402
Present value of profits 286,802 299,322 314,973 328,256 345,280

Including the cost of the initial investment to give the present values at two discount rates:

10% discount rate 20% discount rate

STIKCY NOTES
Rs. Rs.
Sum of present values of profits 2,076,285 1,574,633
Initial investment (1,600,000) (1,600,000)
Net present value 476,285 (25,367)

IRR = 10% + [476,285/(476,285+ 25,367)] × (20 – 10)% = 19.5%

Since the internal rate of return is greater than the company’s cost of capital of 10%, the
investment is financially acceptable.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 625

 CHAPTER 17: TIME VALUE OF MONEY CAF 8: CMA

STICKY NOTES

Time value of money can be used for evaluation of investment projects using
NPV or IRR methods.

Core principles and 4 steps model

1. The estimation of expected future cash flows from projects (cash
receipt & cash payments) using relevant costing principles.
AT A GLANCE

2. The determination of expected future period where estimated

expected future cash flows (cash inflows & cash outflows) will be
occurred.
3. Apply the time value of money concept and discount future cash
flows to present values using discount factor or cost of capital.
4. To make decision for acceptance or rejection of proposed
investment project using discounted cash flows techniques(DCF).

Net present value method (NPV)

SPOTLIGHT

Step 1: List all cash flows expected to arise from the project.
Step 2: Discount these cash flows to their present values using the cost that
the company has to pay for its capital (cost of capital) as a discount rate.
Step 3: Identify the net present value (NPV) of a project is difference
between the present value of all the costs incurred and the present value
of all the cash flow benefits (savings or revenues).

When discounted are IRR rate, NPV of project is zero.

𝑵𝑷𝑽𝑨
STIKCY NOTES

𝑰𝑹𝑹 = 𝑨% + ( ) × (𝑩% − 𝑨%)

𝑵𝑷𝑽𝑨 − 𝑵𝑷𝑽𝑩

Inflation and taxation impacts DCF. Inflation applies when in long run projects
are affected by inflation in sales prices or costs. Also tax saving on tax
allowable depreciation/allowances can impact decision making.

626 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 18

SUSTAINABILITY REPORTING

AT A GLANCE
IN THIS CHAPTER
The term “business” used to be defined as an economic system
AT A GLANCE where goods and services are exchanged for one another or for
money. Accordingly, the annual reports of organizations used to

AT A GLANCE
disclose and communicate the performance in terms of financial
SPOTLIGHT
profit attributable to shareholders for the period.
1. Sustainability & Integrated The objective of understanding the concept of Sustainability
reporting report is to recognize the corporate social responsibility (CSR)
of corporate entities in a structured way. Sustainability report
2. International Federation of is a report published by a company or organization about the
Accountants (IFAC) economics, environmental and social impacts caused by its
Sustainability Framework 2.0 everyday activities.
Sustainability reporting introduces the concept of integrated
3. Key Themes & key consideration
reporting. An integrated report is a concise communication
of IFAC Framework on
about how an organization strategy, governess, performance
Sustainability

SPOTLIGHT
and prospects in the context of its external environment lead to
criteria of financial as well as non-financial value over short,
STICKY NOTES
medium and long term.
Sustainability report combines the analysis of financial and non-
financial performance which is and intense of integrated
reporting.
Reporting on sustainability is considered by International
Federation of Accountants (IFAC) but it is still a voluntary
requirement in most of justification.

STIKCY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 627

 CHAPTER 18: SUSTAINABILITY REPORTING CAF 8: CMA

1. SUSTAINABILITY & INTEGRATED REPORTING

1.1 Integrated Reporting
An integrated report is a concise communication about how an organization’s strategy, governance, performance
and prospects, in the context of its external environment, lead to the creation of value over the short, medium
and long term.
It provides an insight about the external environment that affects an organization, the capital used and affected
by the organization and how the organization interacts with the external environment and the capitals to create
value over the short, medium and long term.
The capitals are stocks of value that are increased, decreased or transformed through the activities and outputs
of the organization. They are categorized as financial, manufactured, intellectual, human, social and relationship,
AT A GLANCE

and natural capital. Existing practices of measuring capital other than financial are in evolution stage and have
yet to attain the level of generally accepted standards.
Integrated reporting requires the process of integrated thinking, and the application of principles such as
connectivity of information. The process takes into consideration the relationships between its various operating
and functional units and the capitals that the organization uses or affects.
The idea of sustainability reporting is evolved from the concept of integrating reporting.
 Example 01:
In the context of integrated reporting, the term ‘capitals’ refers to the stocks of value that are
increased, decreased or transformed through the activities of an organization. There are different
categories of capitals, in the context of integrated reporting. These may be listed below:
SPOTLIGHT

(i) Financial (ii) Human

(iii) Manufactured (iv) Social and relationship
(v) Intellectual (vi) Natural

1.2 Sustainability Reporting

The concept of Corporate Citizenship evolved further and took shape of a structured initiative in the corporate
world and was termed ‘sustainability’. The term smartly communicates the concept behind the process covering
most important essence of organization’s ability to (a) last and (b) contribute to the society for a long time or
indefinitely. Accordingly, it requires performance in four key areas, namely:
STIKCY NOTES

 Economic
 Environmental
 Social
 Governance performance
Reporting on sustainability - sometimes referred to as environmental, social, and governance reporting is still a
standalone and voluntary requirement in most of the jurisdiction.
Global Reporting Initiative (GRI) explained the sustainability report is a report published by a company or
organization about the economic, environmental and social impacts caused by its everyday activities. The report
also presents the organization's values and governance model, and demonstrates the link between its strategy
and its commitment to a sustainable global economy.
A program of data collection, communication, and responses is necessary to produce a regular sustainability
report. Moreover, the sustainability performance is monitored on an on-going basis. To shape the organization's
strategy and policies, and improve performance the data can be provided regularly to decision makers.

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Sustainability reporting has emerged as a vital resource for managing change towards a sustainable global
economy that combines long term profitability with ethical behavior, social justice and environmental care.
Sustainability reporting can be considered as synonymous with other terms for non-financial reporting; triple
bottom line reporting, corporate social responsibility (CSR) reporting, and more.
A more recent development in sustainability reporting is that it combines the analysis of financial and non-
financial performance which is an intrinsic element of integrated reporting. The recent trend shows that the
uptake of sustainability reporting is increasing among organizations of all types and sizes.
A focus on sustainability helps organizations manage their social and environmental impacts and improve
operating efficiency and natural resource stewardship, and it remains a vital component of shareholder,
employee, and stakeholder relations. Firms continuously seek new ways to improve performance, protect
reputational assets, and win shareholder and stakeholder trust.
Sustainability disclosure can serve as a differentiator in competitive industries and foster investor confidence,

AT A GLANCE
trust and employee loyalty. Analysts often consider a company’s sustainability disclosures in their assessment of
management quality and efficiency, and reporting may provide firms better access to capital.
Sustainability reporting requires companies to gather information about processes and impacts that they may
not have measured before. This new data, in addition to creating greater transparency about firm performance,
can provide firms with knowledge necessary to reduce their use of natural resources, increase efficiency and
improve their operational performance.
Besides, sustainability reporting can prepare organizations to avoid or mitigate environmental and social risks
that might have material financial impacts on their business while delivering better business, social,
environmental and financial value.
For reporting to be as useful as possible for managers, executives, analysts, shareholders and stakeholders, a
unified standard that allows reports to be quickly assessed, fairly judged and simply compared is a critical asset

SPOTLIGHT
Difference between financial performance based reporting & Sustainability Reporting
There is a difference between financial performance based reporting & Sustainability Reporting.
Financial performance based reporting is based on the concept of explaining final performance of business for
the period. The final report objective is to explain the impact of financial performance in creating shareholders’
wealth assuming that management is only responsible for maximizing the wealth of shareholders.
The term sustainability communicates the concept behind the covering most important essence of organization
ability to last and contribute to the society for a long time or indefinitely. Sustainability reporting is based on the
concept of corporate citizenship and explaining it in structural way.. Accordingly, it requires performance in four
key areas namely:

STIKCY NOTES
a) Economic
b) Environmental
c) Social
d) Governance performance

Relationship between integrated reporting and sustainability reporting

The relationship between integrated reporting and sustainability reporting is vital. The sustainability report uses
the concepts of different capitals used by an organization for its long term survival as:
Integrated reporting is a method of presentation about how the organization interacts with the external
environment and how an organization’s strategy, governance, performance and prospects, in the context of its
external environment, lead to the creation of value over the short, medium and long term.

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The integrated report uses different categories of ‘capitals’ that are:

i. Financial
ii. Human
iii. Manufactured
iv. Social and relationship
v. Intellectual
vi. Natural
As the idea of sustainability report is emerged from integrating reporting so the Global Reporting Initiative (GRI),
sustainability report is published by a company or organization about the economic, environmental and social
impacts caused by its everyday activities. The report also presents the organization’s values and governance
AT A GLANCE

model. It demonstrates the link between its strategy and its commitment to a sustainable global economy.

1.3 Benefits of sustainability reporting

According to GRI an effective sustainability reporting cycle should benefit all reporting organizations.

Internal benefits for companies and organizations can include:

 Increased understanding of risks and opportunities
 Emphasizing the link between financial and non-financial performance
 It provides supports in the development of long term management strategy and policy, and business plans
 It helps in streamlining processes, reducing costs and improving efficiency
SPOTLIGHT

 It helps benchmarking and assessing sustainability of performance with respect to laws, norms, codes,
performance standards, and voluntary initiatives
 It helps avoiding being implicated in publicized environmental, social and governance failures
 It helps in comparing performance internally, and between organizations and sectors

External benefits of sustainability reporting can include:

 Mitigating – or reversing – negative environmental, social and governance impacts
 Improving reputation and brand loyalty
 Enabling external stakeholders to understand the organization’s true value, and tangible and intangible
assets
STIKCY NOTES

 Demonstrating how the organization influences, and is influenced by, expectations about sustainable
development

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2. INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)

SUSTAINABILITY FRAMEWORK 2.0
The IFAC Sustainability Framework (the Framework) primarily targets professional accountants working in
commerce, industry, financial services, education, and the public and not-for-profit sectors. IFAC strongly
believes that these professional accountants can influence the way organizations integrate sustainability into:
 Mission,
 Goals and objectives
 Strategies
 Management and operations

AT A GLANCE
 Definitions of success
 Stakeholder communications

2.1 The role of professional accountants

a) Sustainable Organizational Success

Professional accountants can broadly be categorized as creators, enablers, preservers, and reporters of
sustainable value for their organizations. The principal expectations of professional accountants in business as
derived from the activities they will need to perform to support the development of sustainable organizational
success. How an accountant’s professional background and orientation equip them with the necessary qualities
to support their contribution, and particularly to act as integrators by incorporating sustainability factors into
their organizational strategy, operations, and reporting. This will allow organizations to simultaneously deliver

SPOTLIGHT
improved business performance and to contribute to a better world.
The role of professional accountants is more than simply that of preparers or assurers of financial and
sustainability reports. More than one-half of all professional accountants globally work in organizations and are
adapting to a world in which sustainability is the key to long-term organizational performance.
The Framework helps professional accountants to understand how, in their diverse roles, they can influence
change. In clearly defining the different facets of sustainability and corporate responsibility, the Framework can
help professional accountants grasp all the important aspects of sustainability that they may encounter, directly
or indirectly, and that will be important to their organizations.

b) Finance Function

STIKCY NOTES
The Framework will provide professional accountants with an opportunity to consider themselves as
knowledgeable change agents. Professional accountants are well positioned to help organizations interpret
sustainability issues in a relevant way for their organizations, and to integrate those issues into the way they do
business.
Although developing a sustainable organization is a multi-disciplinary responsibility, the finance function needs
to be clear on its role in providing and supporting sustainability leadership for several reasons:
 The finance function is well placed to influence behavior and outcomes through incorporating sustainability
considerations into strategies and plans, business cases, capital expenditure decisions, and into performance
management and costing systems.
 Integrated sustainability management involves managing opportunity and risk, measuring and managing
performance, and providing insight and analysis to support decision making. This plays to the strengths of
professional accountants working in finance functions and offers opportunities to provide higher value
business partnering.

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 Improving the quality of stakeholder communications and the reporting of sustainability information and
how it connects to an organization’s strategy and operations requires the same rigor as the process of
financial reporting. Materiality, relevance, comparability, accuracy, and completeness continue to be
essential qualitative characteristics of information. Professional accountants understand the need for, and
how to implement quality data and robust systems to capture, maintain, and report performance. They also
have the project management skills needed to put such systems in place, applying appropriate processes and
controls.
 To rise to the challenge, professional accountants, on an individual level, will need to understand how
sustainability does or might affect their role, and to identify and utilize the continuing professional
development resources available from their own professional body, IFAC, and other sources. Continuing
education will help accountants learn more about the applied aspects of sustainability and determine
approaches to organizational improvement and transformation. Accountants working in audit and advisory
roles, particularly in SMEs, can consider how they could embrace sustainability issues (using the Framework
AT A GLANCE

as a starting point) to add value to their client service/advisory role. Importantly, when acting in a public
interest-related reporting or advisory capacity, it might be necessary to consider whether sustainability
issues have been properly addressed and disclosed.
These Key Perspectives on Key Themes on Key consideration are explained in detail as under in the next section
SPOTLIGHT
STIKCY NOTES

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3. KEY THEMES & KEY CONSIDERATION OF IFAC FRAMEWORK ON

SUSTAINABILITY
The details of Key themes and Key consideration is as under:

3.1 Business strategy perspective

The role of leadership and business strategy is to promote the integration of sustainability issues at a strategic
level, so that they are embedded in organizational development covering strategy, planning, enterprise risk
management, and operations. The importance of tone at the top encourages the integration of governance and
sustainability into strategy, operations, and reporting of an organization. This philosophy revolves around
leadership, sustainability and corporate citizenship. Responsible leaders direct company strategies and
operations with a view to achieve sustainable economic, social and environmental performance.

AT A GLANCE
3.1.1 Defining sustainability and the business case
Key Theme: Establishing an understanding and definition of sustainability that helps to ensure that an
organization is both socially and environmentally responsible at the same time as being economically viable.
Developing a strong business case to highlight what sustainable development means for an organization, and
how improved social and environmental performance can translate into enhanced business performance, will
contribute to a better understanding of the benefits that might be achieved with a more holistic business
approach.
Key considerations for professional accountants
 Create awareness of how the finance function can get involved in establishing a business case
 Ensure clarity on uses of the business case

SPOTLIGHT
 Focus the business case on linking sustainability to strategy and the impacts of organizational activity on
society and the environment
 A business case evolves as the business environment changes
 Identifying significant, material, and relevant environmental and social issues

3.1.2 Vision and leadership

Key theme: Integrating a more sustainable approach into the way an organization does business requires change
and leadership from senior management.
Key considerations for professional accountants

STIKCY NOTES
 A strategic approach to sustainability helps to identify a range of competitive strategies
 Values guide behaviors and decisions
 Integration of sustainability into the key business drivers requires leadership and ownership within the
governing body and at all management levels
 Managerial and operational structures deliver the vision and strategy and ensure accountability and
ownership

3.1.3 Stakeholder engagement

Key theme: Stakeholder engagement has emerged as a vital tool to develop an understanding of what
sustainability means for organizations, and how it can contribute to value creation and the viability of their
operations. Failure to identify and engage with stakeholders is likely to lead to poor performance by:
 Hurting customer satisfaction and perceptions
 Adversely affecting employee motivation and morale
 Damaging relationships in the supply chain

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 Possibly compromising an organization’s reputation with the wider community

 The quality of sustainability reporting also depends on constructive stakeholder engagement.
Key considerations for professional accountants
 Reinforce the importance of stakeholder engagement
 Establish a systematic and carefully planned approach to entering a dialogue with stakeholders
 Stakeholder dialogue can help managers consider how best to deal with the trade-offs between economic,
social, and environmental performance
 Ensure that ongoing stakeholder engagement initiatives are continuous, dynamic, and periodically reviewed
 Build the knowledge and professional skills needed to deal with the challenges of understanding and
balancing stakeholder expectations
AT A GLANCE

3.1.4 Goals and target setting

Key theme: To develop qualitative and quantitative goals and targets to facilitate the delivery of high-level vision
and strategy.
Key considerations for professional accountants
 Establish goals, targets, and performance measures
 Identify outcomes where possible
 Engage employees involved in executing strategy
 Link to rewards
 Establish a baseline against which progress can be monitored
SPOTLIGHT

3.1.5 Integration with risk management

Key theme: Integrating sustainability issues into a rigorous and adaptive risk management approach that allows
for the interpretation of opportunities, risk factors, and causation.
Key considerations for professional accountants
 Integrate sustainability issues into risk management and other management systems
 Gather information and assess cost benefit
 Assess potential impact
 Interpreting risk and causation
STIKCY NOTES

 Dealing with opportunity and risk

3.1.6 Engagement of suppliers

Key theme: Working closely with suppliers to improve sustainability performance and procurement.
Key considerations for professional accountants
 The overriding importance of values and a risk-based perspective to guide decisions
 Identify the opportunities associated with sustainable procurement
 Supplier monitoring and support is ongoing via periodic meetings and training, and with the consideration
of collaborative opportunities
 Consider a systematic process for supplier selection that is clear to all potential and current suppliers
 Communicate how an organization builds relationships and does business with business partners and
suppliers

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Professional competence and the due care for Professional Accountants. The role of financial accountants in
defining sustainability and business case is very important. The professional accountants should use the
professional competence and the due care in performing his duty as it:
 Create awareness of how the finance function can get involved in establishing a business case
 Ensure clarity on uses of the business case
 Focus the business case on linking sustainability to strategy and the impacts of organizational activity on
society and the environment
 A business case evolves as the business environment changes
 Identifying significant, material, and financial value for reporting to be as useful as possible for managers,
executives, analyst, shareholders and stakeholders, a unified standard that allows reports to be quickly
assessed, fairly judge and simple compared is critical asset.

AT A GLANCE
3.2 Operational perspectives

3.2.1 Management and accounting activities to improve sustainability performance

The operational perspective covers a range of management and management accounting activities to support
and improve (a) an organization’s sustainability performance, and (b) its integration into management and
operational activities. Traditional management practices tend to focus solely on the financial or economic
outcome of operational activities. Integration or embedding sustainability considerations into business practice
involves considering the social and environmental outcomes of activities in addition to their economic impacts.
Leading organizations are bringing these factors into their decision-making processes with support from
professional accountants.

3.2.2 Cutting costs by minimizing waste

SPOTLIGHT
Key theme: Clearly understanding the possibilities for quickly improving environmental performance.
Improving environmental performance need not just involve complex plans and activities requiring significant
investment.
Organizations have many opportunities for quick wins through energy efficiency and waste minimization, to
make an immediate positive impact on the environment, and to achieve efficiencies and cost savings.
Key considerations for professional accountants
Energy efficiency
 Identifying large environmental costs that could be reduced

STIKCY NOTES
 Monetizing procedures for costs, savings, and revenues related to any business activities with a potential
environmental impact
 Using measurement and targets and ensuring accountability
 Small (and no cost) changes can lower energy costs and reduce carbon emissions
 Spreading awareness
Waste and water minimization
 Minimizing materials waste
 Tracking physical accounting information
 Reviewing and understanding the impact of legislation regarding waste
 Changing processes

3.2.3 Carbon foot printing

Key theme: Using carbon accounting to calculate organizational carbon footprint in order to (a) manage GHG
emissions and make reductions over time, (b) report the footprint accurately to external stakeholders, and (c)
invest in lower energy technologies and more efficient methods of operating.

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Key considerations for professional accountants

 Moving beyond a GHG inventory
 Determine how to manage carbon emissions data
 Distinguish between boundaries, in terms of organizational and product footprints, and between entities in
the supply chain
 Establish principles of a carbon audit report and the key issues to be disclosed in external reports for
stakeholders
 Greenhouse gas inventory audit

3.2.4 Improving information to support decisions and reporting

Key theme: Improved social and environmental performance and transparency requires information flows to
AT A GLANCE

support the strategic and operational management of sustainability issues. The required environmental and
social information to support management and operational decisions is not, however, often readily available,
either being non-existent or limited to measuring liabilities for compliance purposes.
Key considerations for professional accountants
 Moving from a conformance- to an integrated performance-based view of accounting for sustainability
impacts
 Identifying, defining, and classifying costs to motivate desired activities and behaviors
 Working across organizational functions, particularly integrating accounting, procurement and operations
 Accounting for social costs and valuing social impacts
 Using environmental and social cost and other non-financial information for project appraisal and capital
SPOTLIGHT

budgeting

3.2.5 Integrated management control systems

Key theme: Developing integrated management and (internal) control systems to ensure alignment of
sustainability performance to organizational objectives.
Key considerations for professional accountants
 MCSs should incorporate specific activities that support sustainability goals and objectives into the
organization’s overall management and control cycle
 MCSs should ideally help to integrate social and environmental factors alongside financial and quality factors
 (Internal) control effectiveness depends on effective governance and risk management
STIKCY NOTES

 Setting out the role of internal auditing

 Integrating sustainability (and particularly environmental) factors into financial processes, such as
budgeting and forecasting

3.2.6 Performance measurement and KPIs

Key theme: Using strategic performance measurement systems, performance measures, and KPIs to ensure the
delivery of strategic and sustainability-related objectives.
Key considerations for professional accountants
 Integrate sustainability measures where they have been identified as an important driver of strategy
 Judge how scientific cause-and-effect relationships between measures need to be to inform decisions
 Consider how sector or industry norms can influence KPI selection
 Develop and use eco-efficiency indicators to link monetary and physical information for decision making
 Develop and use socio-efficiency indicators to better understand social impacts
 Consider how to usefully present metrics and KPIs in internal and external reporting

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3.2.7 Integrating performance and Professional accountants

Sustainability reporting introduces the concept of Integrating performance that is not only based on financial
performance so the role of professional accountant is very critical for improving information to support decision
and reporting.
In the above context the key considerations for professional accountants are:
 Moving from a conformance- to an integrated performance-based view of accounting for sustainability
impacts
 Identifying, defining, and classifying costs to motivate desired activities and behaviors
 Working across organizational functions, particularly integrating accounting, procurement and operations
 Accounting for social costs and valuing social impacts
 Using environmental and social cost and other non-financial information for project appraisal and capital

AT A GLANCE
budgeting

3.3 Reporting perspective

External reporting by organizations has evolved over the years from providing financial statements and
accompanying notes to the present day, where the trend is to provide an annual report, consisting of financial
statements, some form of management commentary, some form of environment, social, and governance
performance data, and, particularly from many larger organizations, a separate report covering nonfinancial
sustainability and corporate social responsibility disclosures. In addition, many jurisdictions, either by way of
statute or listing rules, impose rules relating to continuous disclosure of information about specified events or
matters that would be of concern to participants in the securities market. Jurisdictions likewise adopt different
approaches to annual, half-year, and quarterly cycles of reporting.

SPOTLIGHT
3.3.1 Developing an organizational reporting strategy
Key theme: A reporting strategy that will yield a complete picture of an organization’s performance for a range
of stakeholders is needed. This will involve using sustainability reporting frameworks and principles, such as
GRI’s Reporting Framework, and ensuring that their use contributes to meaningful sustainability and integrated
reporting. Integrated reporting is a new paradigm in reporting that requires connecting an organization’s
strategy, its financial performance, and its performance on environmental, social, and governance issues.
Key considerations for professional accountants
 Determine the range of users and their needs for various types of reports and disclosures
 Project planning and management, and structured processes, will underpin a successful reporting regime

STIKCY NOTES
 Break down functional silos to facilitate effective integrated reporting
 Use reporting frameworks and guidelines to help develop reporting processes and to ensure that all relevant
sustainability information is disclosed
 Disclosing performance across the value supply chain
 Meeting stakeholder needs in local markets

3.3.2 Reflecting sustainability impacts in financial statements

Key theme: Incorporating environmental and social issues into financial statements to support an organization’s
stewardship role and to enable users to make more well-informed decisions regarding environmental and social
impacts on assets, liabilities, income, and expenditures.
Key considerations for professional accountants
 Establishing how to reflect environmental (and, where applicable, other sustainability-related) liabilities
and costs in financial statements prepared under IFRSs
 Determining specific sustainability disclosure requirements under national securities regulations and
Generally Accepted Accounting Principles (GAAP)

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 Considering additional information and disclosure to improve transparency on environmental performance

 Determining materiality in the context of what information management believes is important for investors
to make informed financial decisions about an organization

3.3.3 Narrative reporting for enhanced transparency to investors

Key theme: Using narrative reporting to provide greater transparency on business performance and to ensure
that sustainability-related disclosures are useful to investors.
Key considerations for professional accountants
 Avoiding over-disclosure and clutter
 Ensuring a forward-looking orientation
 Viewing narrative reporting as a fair reflection of the management information used internally
AT A GLANCE

3.3.4 Determining materiality

Key theme: Understanding and reconciling approaches to applying materiality to sustainability and integrated
reporting.
Key considerations for professional accountants
 In defining report content, materiality should be considered along with the need for other important
information characteristics
 Accountability for materiality thresholds and judgments
 Linking the determination of materiality to strategy, risk management, and sector benchmarks
 Determining a process for resolving different expectations regarding materiality
SPOTLIGHT

 Where information is reported can help (a) to reinforce materiality criteria, and (b) to keep the length of
disclosures manageable (particularly where the application of materiality might vary between reporting for
wider stakeholders from investors)

3.3.5 External review and assurance of sustainability disclosures

Key theme: Establishing an approach to external assurance that adds credibility to an organization’s reporting
and provides internal benefits, such as helping to improve underlying reporting processes.
Key considerations for professional accountants
 The quality of external assurance is directly linked to stakeholder inclusiveness
STIKCY NOTES

 Clarifying the purpose and scope of the assurance

 The choice of service provider
 Establishing the type of engagement
 Enhancing the assurance statement

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STICKY NOTES

Integrating Reporting is a process of integrating thinking and connectivity of

information. It describe the relationship between operating and functional
using with capital that organization uses

Sustainability Reporting explains economic, environmental and social

impacts caused by its everyday activities. It requires performance in four
areas namely, economic, environmental, social and governance performance

AT A GLANCE
International Federation of Accountants (IFAC) Sustainability Framework
describes role of professional accountants in driving sustainability
organizational success as well as financial accountants and finance functions

Key themes and considerations are provided with respect to three areas
namely Business Strategy perspectives, operational perspectives and
reporting perspective

SPOTLIGHT
STIKCY NOTES

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AT A GLANCE
SPOTLIGHT
STIKCY NOTES

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 APPENDIX

Present value table

This table shows the discount factor for an amount at the end of n periods at r%.

Interest rates (r)

AT A GLANCE
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 .990 .980 .971 .962 .962 .943 .935 .926 .917 .909
2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .826
3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .751
4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .683
5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .621

SPOTLIGHT
6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .564
7 .933 .871 .813 .760 .711 .665 .623 .583 .547 .513
8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .467
9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .424
10 .905 .820 .744 .676 .614 .558 .508 .463 .422 .386

11 .896 .804 .722 .650 .585 .527 .475 .429 .388 .350

STIKCY NOTES
12 .887 .788 .701 .625 .557 .497 .444 .397 .356 .319
13 .879 .773 .681 .601 .530 .469 .415 .368 .326 .290
14 .870 .758 .661 .577 .505 .442 .388 .340 .299 .263
15 .861 .743 .642 .555 .481 .417 .362 .315 .275 .239

16 .853 .728 .623 .534 .458 .394 .339 .292 .252 .218
17 .844 .714 .605 .513 .436 .371 .317 .270 .231 .198
18 .836 .700 .587 .494 .416 .350 .296 .250 .212 .180
19 .828 .686 .570 .475 .396 .331 .277 .232 .194 .164
20 .820 .673 .554 .456 .377 .312 .258 .215 .178 .149

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 APPENDIX CAF 8: CMA

Interest rates (r)

Periods
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 .901 .893 .885 .877 .870 .862 .855 .847 .840 .833
2 .812 .797 .783 .769 .756 .743 .731 .718 .706 .694
3 .731 .712 .693 .675 .658 .641 .624 .609 .593 .579
4 .659 .636 .613 .592 .572 .552 .534 .516 .499 .482
5 .593 .567 .543 .519 .497 .476 .456 .437 .419 .402
AT A GLANCE

6 .535 .507 .480 .456 .432 .410 .390 .370 .352 .335
7 .482 .452 .425 .400 .376 .354 .333 .314 .296 .279
8 .434 .404 .376 .351 .327 .305 .285 .266 .249 .233
9 .391 .361 .333 .308 .284 .263 .243 .225 .209 .194
10 .352 .322 .295 .270 .247 .227 .208 .191 .176 .162

11 .317 .287 .261 .237 .215 .195 .178 .162 .148 .135
SPOTLIGHT

12 .286 .257 .231 .208 .187 .168 .152 .137 .124 .112
13 .258 .229 .204 .182 .163 .145 .130 .116 .104 .093
14 .232 .205 .181 .160 .141 .125 .111 .099 .088 .078
15 .209 .183 .160 .140 .123 .108 .095 .084 .074 .065

16 .188 .163 .141 .123 .107 .093 .081 .071 .062 .054
17 .170 .146 .125 .108 .093 .080 .069 .060 .052 .045
STIKCY NOTES

18 .153 .130 .111 .095 .081 .069 .059 .051 .044 .038
19 .138 .116 .098 .083 .070 .060 .051 .043 .037 .031
20 .124 .104 .087 .073 .061 .051 .043 .037 .031 .026

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CAF 8: CMA APPENDIX

Cumulative present value

This table shows the annuity factor for an amount at the end of each year for n years at r%.

Interest rates (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487

AT A GLANCE
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

SPOTLIGHT
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 8.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

STIKCY NOTES
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 643

 APPENDIX CAF 8: CMA

Interest rates (r)

Periods
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0685 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
AT A GLANCE

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
SPOTLIGHT

12 6.492 6.194 5.918 5.660 5.421 5.197 4.968 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675

16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
STIKCY NOTES

18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

644 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 INDEX

Attainable standards 317

a Avoidable costs 429

AT A GLANCE
Abnormal
gain
rework
187
220
b
Abnormal loss 183 Bank loans 548
with recovering value 184 Basic standards 317
Absorbed overhead 60 Basics of budgeting 262
Absorption costing 92 Bonds 544
advantages & disadvantages 101 Bonus issue 541
profit 92 Bonus systems 74

SPOTLIGHT
Accounting information 428 Break-even
Accounting for analysis 453
abnormal gain 187 contribution per unit 467
abnormal loss 183 c/s ratio 468
inventory 110 chart 463
job costing 155 point 453
production of inventory 110 Budgeting
Accounting entries in cost accounting systems 114 approaches 379

STIKCY NOTES
Activity level selection 46 continuous (rolling) 282
Actual cost from variances and standard costs 367 incremental 279
Administrative expenses 41 non-profit organizations 284
Adverse variances 349 purposes 262
Annuities 570,574 performance 283
arithmetic 578 stages 263
gap 576 zero-based 282
Apportioning common processing costs Budget 262
between joint products 214 capital expenditure 269
Apportionment 51,53 cash 269
of service department cost to production 53 cost of goods manufactured 268
of shared overhead costs 51 cost of goods sold 268
Asset securitization & Sales 551 direct materials 265

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 645

 INDEX CAF 8: CMA

Budget Cost
direct labor 266 behavior 40
ending finished goods inventory 267 bookkeeping systems 117
flexible & fixed 279,326 center rate 44
line item 284 formulas for inventory 6
manufacturing overhead 266 gap 412
master 272 ledger 131
production 265 ledger control account 131
sales 265 of inventory 13
selling and administrative expenses 268 of a job 154
Budgetary of a rework 220
AT A GLANCE

slack 285 of production overhead 43

styles 285 per unit of service 167
Buffer stock 25 records 155
Business angels 551 units in service costing 167
By-products 216 variances 330
Costing systems 110

c
Cost accounting department 79
Complex production process 111
Cost book keeping systems 117
SPOTLIGHT

Capital gains 539

Cost ledger control accounts (CLC) 131
Capital expenditures 269
Cost-volume-profit (CVP) analysis 450
Caps, collars and floors 557
assumptions 450
Capacity & efficiency 358
contributions 450
Causal models 256
Currency
Certificates of deposit (CDs) 550
futures 560
Charge (or mortgage) on loan stock 545
options 557
Commercial paper 544
swap 558
Committed costs 430
STIKCY NOTES

Current standards 317

Composite cost units 167
Compound interest 569
Comparison of methods
Contribution per unit
10
450
d
Contribution margin 87 DCF and taxation 607
Contribution/Sales ratio 452 Debentures 544
Contribution per batch 467 Debt 542
Control reporting 315 Debt finances 543
Convertible bonds 545 Choices 542
Cost Decision for discounting operations 512
associated with inventory 18 Decision for pricing 514

646 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA INDEX

Decision-making 486 Expenditure variance 344,350

marginal costing 486 Equivalent annual costs 578
Deep discount bond 545

f
Delphi method 255
Deprival value 433
Differential cost 429
Factors influencing the choice of debt finance 542
Direct and indirect investment 553
Factors to consider when changing mix 366
Direct investment 553
Favorable variances 315,330

AT A GLANCE
Direct labor
FIFO method in process costing 200
Costs 70
Finance Function 631
efficiency variance 337
Finance lease 549
idle time 338
First-in, first-out method (FIFO) 7,200
possible causes of variance 343
Fixed overhead 47
rate variance 336
Variances 361
total cost variance 336
Fixed costs 41
variances 336
Fixed production overhead
Direct materials
capacity variance 355

SPOTLIGHT
total cost variance 331
cost variances 349
possible causes of variance 334
efficiency & capacity variance 354
mix variance 364
expenditure variance 350
price variance 332
volume variance 351
usage variance 332
possible causes of variance 356
yield variance 364
Flexed budget 328
Discount tables 572
Flotation 539
Discounting 572
Forecasting 254
Cash flows 569

STIKCY NOTES
types 254
Money cash flows 599
methods 254
Real cash flows 600
Foreign Direct Investment 553
Dividends 539
Forwards 559
Divisibility 553
Futures 559
Future Cash flows 564

e Fully interlocking accounts

comprehensive illustration
131
132
Economic order quantity (EOQ) 21

g
formula 23
Equity 539
Equivalent units 194,211
Gap annuities 576
and abnormal loss/gain 211
Group Bonus Scheme 75
Euro bonds 545

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 647

 INDEX CAF 8: CMA

h
Intrinsic value 555
Introduction 540
Inventory level & Buffer Stock 25
High-day rate system 74
Inventory management 18
Holding period 553
Inventories and their valuation 4
Human & motivational aspects of budgets 285
Investment
Hybrids 545
appraisal 564
Investment vs. speculation 553

i IRR method
Irrelevant cost
590
19
Ideal standards 317
AT A GLANCE

Identifying limiting factors 488

Identifying relevant costs 433 j
Identical variances 360
Job
Idle time and standard costs 320
costing 154
Idle time variance 338
nature 154
IFAC Sustainability framework 2.0 631
sheet 156
Inclusion & Exclusion of fixed overheads 47
Joint products 214
Incremental cost 51,429
further processing decisions 510
analysis 486
SPOTLIGHT

Journal entries for labor cost 79

Incremental budgeting 279
Jury of executive opinion 255
Indirect labor cost 70
Indirect investment 553
Individual bonus schemes
Inflation and long-term projects
75
597
l
Information for decision making 428 labor
Initial public offer 539 activity 70
Interest rate swaps 557 costing 70
STIKCY NOTES

Internal rate of return (IRR) method 590 cost control 70,72

Integrated accounts 117 curve theory 77
comprehensive illustration 118 efficiency 73
Integrated reporting 628 payment methods 71
Interlocking accounts 123 productivity 73
comprehensive illustration 125 rate & efficiency 358
Interpolation formula 591 Leases 549
Interrelationships between variances 358 Learning Curve theory 77
Interest rate Learning effect 77
on loan stock 545 Limiting factor decisions 488
swaps 557 Line item budgets 284

648 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA INDEX

Linear regression method 256 Methods of flotation 539

Liquidity 553 Minimum inventory level 28
Loan note 544 Moving average 255
Loan stock 545,548 Multi product CVP analysis 467
Loan repayments 579

n
Losses and gains at different
stages of the process 211

Naive approach 266

AT A GLANCE
m Net present value (NPV) method
Net realizable value (NRV)
581
4,214
Make-or-buy decisions 496 Nominal value 544
non-financial consideration 500 Non-production overheads 41
scarce resources 501 Normal depreciation 608
Marketing, selling & distribution expenses 41 Normal loss 179
Manufacturing expenses 40 with cost of disposal 182
Manufacturing overheads 41 with no recovery value 179
budget 266 with recovery value 181

SPOTLIGHT
Margin of safety 456 Normal rework 220
multiproduct 468 NPV
Marginal cost 86 calculations 598
Marginal costing

o
advantages and disadvantages 101
and absorption costing 96
assumptions 86
One-off contract decisions 507
and decision-making 486
Opening

STIKCY NOTES
contribution 87
Work in progress 198
income statement 89
Work in progress & losses 206
uses 86
Operating lease 549
Marginal production costs 86
Operating statement 330,361
Marginal costs & sales 86
Opportunity costs 430
Marginal cost profit 90
Options 555
Market research 254
Over the counter 555
Materials
Optimum stock level 21
mix and yield variances 363
Ordinary shares 539
procedures and documentation 2
Outsourcing 496
wastage in standard costing 319
Over-absorption 349
Maximum inventory level 27
Over/under
Maximizing profit with single limiting factor 489
applied Overheads 60
Measuring productivity & Efficiency 73

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 649

 INDEX CAF 8: CMA

r
over/under absorption 349
of fixed production overhead 112
Overdrafts 549
Real cash flows 597
Real cost of capital 598

p Recognizing sales
Recording labor cost
116
79
Par value 544 Recording sales & Calculating profit 116
Performance budgeting 383 Recovery value 179,181
Performance reporting 330 Relevant cash flows 566
Periodic inventory method 110 Relevant costing 428
AT A GLANCE

Perpetual inventory method 110 principles 564

Perpetuity 577 Relevant cost of
Piece work 71 and benefits 564
Predetermined overhead rate 43,46 existing equipment 566
Preference shares 539 investment in working capital 566
Present values 573 labor 435,565
Private materials 433,565
equity funds 551 overheads 437,566
placing 540 Relevant holding cost 19
SPOTLIGHT

Probability theory – safety stock 26 Reorder level 25

Process costing 176 Replacement & investment decisions 511
basics 176 Reporting profit
features 176 with absorption costing 92
with closing work in process 194 with marginal costing 88
Production overhead 41 Repeated distribution method 56
Profit/volume chart (P/V chart) 464 Reviewing standards 318
Profit sharing scheme 76 Rights issue 540
Purchase process 3 Role of professional accountants 631
STIKCY NOTES

Rolling budgets 282

q
Qualitative methods - forecasting 254
s
Quantitative methods - forecasting 255 Safety inventory 25
Quantitative models – optimum stock level 21 Sales
Quantity discounts – order size decisions 24 value at the split-off point basis 214
volume variance 361
Service
characteristics 166

650 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA INDEX

costing 166 Target cost gaps

operations 166 Target profit 457,567
Share incentive scheme 76 Taxable cash flows 607
Short term decisions 507 Time rate 71
Short term debt instruments 550 Time value of money 564
Shutdown decisions 508 Time series models 255
Simultaneous equation method 56 Timing of cash flows 567
Single limiting factor 489 Total contribution 88,450

AT A GLANCE
Single overhead rate 47 Total fixed
Sinking funds 571 production overhead cost variance 349
Sources of finance 538 Trade Credit 550
Standard costing 314 Treasury bills (T-bills) 550
idle time 320 Trend projections 255
material wastage 319 Types
uses 315 of standards 317
Standard marginal costing 359 of decisions 486
operating statement 361 of inventories 4

SPOTLIGHT
variances 360

u
Standard costs 314
budget 326
from variance and actual cost 368
Unavoidable cost 429
Statement of cost per equivalent unit 198
Under-absorption 92,349
Statement of equivalent units 198
Usage variance 332,363
Stock-out costs 25
Using present value 573
Sunk costs 430
Sustainability reporting 628

STIKCY NOTES
benefits
frameworks 2.0
630
631
v
Valuation of inventory 5
Variable overhead 86
t Variable production overhead variances 343
total cost variance 343
Target costing 412
efficiency variance 345
and services 417
expenditure variance 344
advantages 417
possible causes 347
determination 413
Variance analysis 329
implications 417
Variances and controllability 315
implementation 413
Variances and performance reporting 330
origins 412
Venture capital 551

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 651

 INDEX CAF 8: CMA

w
Warrants 545
Waste 319,635
Weighted average cost (AVCO) method 8,198
Wages control account 111
Wage incentive plans 74
Work in progress & losses 204

y
AT A GLANCE

Yield variance 364

z
Zero based budgeting 282
Zero coupon bond 545
SPOTLIGHT
STIKCY NOTES

652 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN