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ACCA Paper F2

Management Accounting Class Notes June 2009

 London School of Business and Finance 2009

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 London School of Business and Finance 2009

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Contents

Syllabus Aim

5

Main Capabilities

5

Examiner

6

Format of Paper

6

Articles on ACCA website

6

Unit 1:

Introduction to Cost Accounting

7

Unit 2:

Material, Labour & Stock Control

25

Unit 3:

Overheads and Absorption Costing

39

Unit 4:

Marginal Costing & Contribution Theory

51

Unit 5:

Costing for Jobs, Batches and Services

59

Unit 6:

Process costing; Joint and By-products

71

Unit 7:

Budgets

91

Unit 8: Unit 9:

CVP Analysis Limiting Factors; Linear Programming; Relevant Costs.

115

Unit 10:

Standard Costing and Variance Analysis

131

105

Solutions to exercises

Section B

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Syllabus Aim To develop knowledge and understanding of how to prepare and process basic cost and quantitative information to support management in planning and decision-making in a variety of business contexts.

Main Capabilities On successful completion of this paper candidates should be able to: A

Explain the nature and purpose of cost and management accounting

B

Describe costs by classification, behavior and purpose

C

Apply essential business mathematics and use computer spreadsheets

D

Explain and apply cost accounting techniques

E

Prepare and coordinate budgets and standard costing for planning, feedback and control

F

Use management accounting techniques to make and support decision-making.

Within these main capabilities, ACCA provides a more detailed guidance on the syllabus. This can be found on pages 3 – 8 of your textbook.

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Examiner The paper F2 examiner is David Forster, who previously examined paper 1.2. David also wrote the F2 pilot paper, which gives us a good indication of how syllabus areas will be examined under F2. David has made notable changes to the paper, both in format and syllabus content.

Format Paper F2 can be sat as a written or a computer based paper. 2 hour paper Both computational and non-computational questions 90 marks in total 40 two mark questions and 10 one mark questions Mix of MCQ and true or false. In the CBE equivalent, other question forms may be used, such as multiple response, multiple-response matching, or number entry.

ALL QUESTIONS ARE COMPULSORY

Articles Five steps to multiple-choice success 17 May 2007 Steve Widberg describes a five-step approach to answering multiple-choice questions Building knowledge 03 Nov 2006 Bob Souster, David Forster and Nicola Ventress guide students through the new ACCA Qualification Knowledge Module papers / RELEVANT TO NEW ACCA QUALIFICATION PAPERS F1, F2, AND F3

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Unit 1: Introduction to Cost Accounting 1. The difference between financial accounting and management accounting. 2. The different classifications of costs within an organisation. 3. How to separate fixed and variable costs and use this information for forecasting. 4. Which costs are involved directly in the production of goods and services. 5. How to draw a scatter-graph and use regression analysis for forecasting. 6. The definition and reasoning behind the use of expected values. 7. Use of expected values for forecasting.

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INTRODUCTION Accounting is divided into two main areas – financial accounting and management accounting. Whereas financial accounting looks at the performance of the organisation (in the past), management accounting looks at providing the information which is used for decision making within the organisation (for the future). Decision making may be on either an operational, tactical or strategic level within the organisation. How can we differentiate between these? Strategic

Tactical

Long term

Medium term

Operational

Short term

DATA AND INFORMATION Many people assume that data and information are the same. They are not. Data is raw, unprocessed information. Examples:

Information is processed information. It must be processed in a way that makes it meaningful to the user. Examples:

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For data to be meaningful it must have certain characteristics or attributes. These are many but can be summarised by the acronym – ACCURATE. Can you identify what you think would be an attribute for each of the letters of accurate? A C C U R A T E What do we use information for? In organisations it is used for planning, decision making and control. Each of these three uses will be highlighted throughout this subject. Before that, how would you describe each of these techniques? Planning:

Decision making:

Control:

ORGANISATIONS No organisation will operate as a single entity. Each organisation would be divided up into various departments. Some of these departments would be dealing with producing our products while others would be providing a service, both to our customers and to our production departments. These will be highlighted later in the course. All departments need to be responsible for their costs.

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Cost centre – is defined as a production or service location, a function, an activity or an item of equipment for which costs can be ascertained. Revenue centre – a centre devoted to raising revenue only. Profit centre – a centre accountable for costs and revenues. Investment centre – a centre which has its performance evaluated by its return on capital employed. Cost unit – a unit of product or services for which costs can be ascertained. These are usually classed in relation to the unit the product is sold in. Examples: Petrol Paint Bread

- per litre - per tin - per loaf

Using these cost units assist us being able to cost the products made. We also need to identify service units. These will be discussed in the session on service costing. COST CLASSIFICATIONS / BEHAVIOUR Costs in any organisation come in many forms and relate to many different things. We can divide or classify these costs into 3 main areas: • Materials • Labour • Overheads Materials and labour costs speak for themselves, however overheads cover many different expenses within the business – rent, administration, heating and lighting, motoring – the list is endless. As well as dividing the costs into these 3 classifications each cost can be further classified into fixed, variable, stepped and semi-variable. This classification depends upon the behaviour of the cost. A fixed cost is just that – fixed. We pay the same amount of money per period regardless of whether we produce 0 units, 500 units or 500,000 units. An example of a fixed cost would be the rent of a building. A fixed sum we pay each period.

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A fixed cost can be represented in a graph as:

Variable costs vary with the number of units of production. For example if it costs £5 to make 1 unit we assume that it costs £10 to make 2, £50 to make 10 and so on. A variable cost can be represented in a graph as:

Stepped costs are fixed costs which are only fixed for a certain level of production. An example of this might be a supervisor in a factory on a salary. Each supervisor is in charge of 20 workers. As soon as we employ more than 20 workers we need to employ another supervisor. A stepped cost may be represented in a graph as:

In addition to splitting our costs in this manner, they can also be spilt into direct and indirect categories. • Direct costs are those which are directly involved with the making of a product or service. • Indirect costs are those which are incurred for other reasons. For instance, the wages of a production worker is said to be a direct cost whilst the wages (salary) of a supervisor would be considered as an indirect cost. We will deal with these classifications in more detail in future sessions.

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A semi-variable cost contains a fixed and a variable element. An example of this would be an electricity bill where we pay a fixed charge per period plus a variable charge for each unit of electricity consumed. A semi-variable cost can be represented in a graph as:

We assume that all these relationships are linear, i.e. the act is a straight line. Unfortunately in practice this does not happen due to economies of scale (discounts for quantity purchases or sales). For the purposes of our studies we will assume that costs react to each other in a linear (straight line) relationship. Costs that are entirely fixed or variable are easy to allocate to products. A semi-variable cost is more difficult. Unless we have accurate data we have to calculate each element so that we can use the information for forecasting. The method we use is called the HIGH-LOW method. It is based upon the equation of a straight line: y = a + bx This can also be represented as: Total cost = fixed cost + (variable cost x no of units)

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FORECASTING An important part of cost accounting is forecasting for the future. In order to be able to forecast we need to use historic data. We can use one of three methods: 1. High-low method 2. Scatter graphs 3. Regression analysis HIGH-LOW METHOD The idea behind this technique is that if you purchase two types of item, you can deduce the price of one of them if you know the price of the other. EXAMPLE 1: 3 kgs of potatoes and a cabbage cost £1.85 5 kgs of potatoes and a cabbage cost £2.55 How much does 1 kg of potatoes cost? How much does the cabbage cost? Solution: What we can do here is take the lowest from the highest to find the cost of 2 kgs of potatoes. This then enables us to find the price of the cabbage. 5 – 3 = 2 kgs potatoes

£2.55 - £1.85 = £0.70

1 kg potatoes = £0.70/2 = £0.35 Cabbage must equal £2.55 – (5 x £0.35) = £0.80 In this instance the potatoes are the variable cost and the cabbage is the fixed cost, as it does not change. Exercise 1: The following cost information is available. Output Cost

65,000 units £133,000

105,000 units £210,000

Using the above data, calculate the fixed and variable costs for the business and the total cost for 165,000 units.

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Solution: Variable cost per unit Total fixed cost Total cost for 165.000 units

=£ =£ =£

+ (£

x 165,000 units) = £

It is essential to master this technique as it is a common examination question and you will be required to use this technique many times during your management accounting studies. When there are more than two pairs of data given we will almost always use the highest and lowest for this technique. CLASS EXERCISES: 1.

A manufacturing company has four types of cost (identified as T1, T2 , T3 and T4). The total cost for each type at two different production levels is: Cost type T1 T2 T3 T4

Total cost for 125 units £ 1,000 1,750 2,475 3,225

Total cost for 180 units £ 1,260 2,520 2,826 4,644

Which two cost types would be classified as being semi-variable? A B 2.

T1 and T3 T1 and T4

C D

T2 and T3 T2 and T4

The following diagram represents the behaviour of one element of cost: Total cost

Volume of activity

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Which of the following descriptions is consistent with the above diagram? A. Annual total cost of factory power where the supplier sets a tariff based on a fixed charge plus a constant unit cost for consumption which is subject to a maximum annual charge. B. Total annual direct material cost where the supplier charges a constant amount per unit which then reduces to a lower amount per unit after a certain level of purchases. C. Total annual direct material cost where the supplier charges a constant amount per unit nut when purchases exceed a certain level a lower amount per unit applies to all purchases in the year. D. Annual total cost of telephone services where the supplier makes a fixed charge and then a constant unit rate for calls up to a certain level. This rate then reduces for all calls above this level. 3.

An organisation has the following total costs at two activity levels: Activity level (units) 17,000 Total costs (£) 140,000

22,000 170,000

Variable cost per unit is constant in this range of activity and there is a step up of £5,000 in the total fixed costs when activity exceeds 18,000 units. What is the total cost at an activity level of 20,000 units? A £155,000 B £158,000

C £160,000 D £163,000

Before answering this question, think carefully about the information given relating to the step cost. How should we use it? SCATTER-GRAPHS A scatter-graph is a graph on which pairs of data, which have no direct relationship, are plotted. Graphs have two axes. In order for this information to be plotted in a meaningful manner they would require three – impossible! In order to estimate future costs for a given activity level, we must draw a line through these points. It is impossible to draw a straight line which will connect all points and so we draw what is known as a LINE OF BEST FIT. From this line we can estimate future costs. www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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This line is very subjective. Everyone will draw it in a slightly different place and so our forecasts will also differ. To make a more accurate prediction of future costs we will use regression analysis. REGRESSION ANALYSIS This is also known as the least squares method. In this method we are required to calculate totals of columns of figures. A total is represented by the sign Σ. This is pronounced sigma. The first column of figures x represents the units. The second column y represents the costs. Σx is the total of the column of x. We also need to calculate Σxy, Σx2. The formulae we will use is: y = a + bx

b=

n∑ xy − ∑ x∑ y n∑ x 2 − (∑ x )

2

We will also need to calculate the average of x and y. This is done by diving the total of x (and y) by n as in the second equation.

a = y − bx

or

a=

y x −b n n

where n = number of items. EXAMPLE 2: Month January February March April May June

Units 400 600 550 800 750 900

Cost (£) 1,050 1,700 1,600 2,100 2,000 2,300

Using the following methods, calculate the fixed and variable cost elements and forecast the cost for an output of 850 units. 1. High-low method 2. Regression analysis

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Solution: 1. High-low method

2. Regression Month

Units (x)

Costs (y)

January February March April May June

400 600 550 800 750 900

1050 1700 1600 2100 2000 2300

Xy

X2

Y2

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CORRELATION: Regression analysis assumes a linear relationship. However, this does not measure the degree of correlation between the variables as it is unlikely that the true relationship is a straight line. To do this we need to calculate the correlation co-efficient, r. (This is known as Pearson’s correlation coefficient.)

r=

n∑ xy − ∑ x ∑ y

[(n∑ x

2

)(

− (∑ x ) n∑ y 2 − (∑ y ) 2

2

)]

r varies between +1 and –1. +1 means perfect linear correlation 0 means no correlation -1 means perfect negative linear correlation Using the information above in exercise 2, calculate the correlation coefficient. What does this answer signify?

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INTERPOLATION AND EXTRAPOLATION: This is simply identifying values of x and y from the regression line plotted. Interpolation is where we interrogate the line within the known range. Extrapolation is where we interrogate the line outside of the known range where the accuracy/relationship is assumed to be still valid. In reality this is not always so. THE COEFFICIENT OF DETERMINATION: The coefficient of determination is represented by r2 – the square of r. This signifies how much of the variation in the dependent variable is because of the variation in the independent variable. The remaining variation is then assumed to be because of random fluctuations. To explain this in simple terms, it means that if r = 1 then r2 would also = 1 or 100%. This would assume that units and costs would be in perfect proportion i.e. if units were doubled then costs would also double. If r2 is below 100%, part of the increase in costs would be for other reasons. It may be that a discount was obtained in the cost of material or that the labour cost was lower/higher because of different productivity/efficiency. What is the coefficient of determination from exercise 2?

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EXPECTED VALUES: Expected values are based on weighted averages. What is a weighted average as opposed to a simple average? In order to calculate an expected value we multiply the probability of something happening (p) by the expected number of times that this will occur (n). The expected value is therefore n x p To calculate the expected value of a series of things happening we simply add up the total of all the expected values. Expected values are also used in decision making situations. A series of expected value calculations can be made and the one with the best overall expected value would be chosen. EXAMPLE 3: A company has a choice of three alternative investments. If successful investment A gives a NPV of £100,000, of which there is a 40%, however if not it will yield NPV (£40,000). Investment B, if successful (60%) will yield NPV £50,000 but if not NPV (£20,000). Investment C if it is successful (80% chance) will yield NPV £40,000, however if not it will deliver NPV (£10,000). Which investment should be considered? PRACTICE EXERCISES: Read Chapters 1 – 4 of your study text. Attempt the questions in sections 1 – 4 of your practice kit (pages 3 – 12)

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HOMEWORK QUESTIONS: 1.

Month 1 2 3 4 5 6

Units 340 300 380 420 400 360

Cost (£) 2,260 2,160 2,320 2,400 2,300 2,320

Using the following two methods, calculate the fixed and variable cost elements and forecast the cost for an output of 350 units. a. High-low method b. Regression analysis

2. An organisation is using linear regression analysis to establish an equation that shows a relationship between advertising expenditure and sales. It will then use the equation to predict sales for given levels of advertising expenditure. Data for the last five periods are as follows: Period number 1 2 3 4 5

Advertising expenditure £000 17 19 24 22 18

Sales £000 108 116 141 123 112

What are the values of ‘Σx’, ‘Σy’ and ‘n’ that need to be inserted into the appropriate formula? Σx Σy n A £600,000 £100,000 5 B £100,000 £600,000 5 C £600,000 £100,000 10 D £100,000 £600,000 10

3. Which of the following correlation coefficients indicates the weakest relationship between two variables? A + 1·0 B + 0·4 C – 0·6 D – 1·0

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4. An organisation has the following total costs at three activity levels: Activity level (units) 8,000 12,000 15,000 Total cost £204,000 £250,000 £274,000 Variable cost per unit is constant within this activity range and there is a step-up of 10% in the total fixed costs when the activity level exceeds 11,000 units. What is the total cost at an activity level of 10,000 units? A. B. C. D.

£220,000 £224,000 £227,000 £234,000

5. Regression analysis is being used to find the line of best fit (y = a + bx) from five pairs of data. The calculations have produced the following information: ∑x = 129 ∑y = 890

∑x2 = 3,433 ∑y2 = 29,929

∑xy = 23,091

What is the value of ‘a’ in the equation for the line of best fit (to the nearest whole number)? A. 146 B. 152 C. 210 D. 245

6. A company needs to decide between two projects – Project X and Project Y. The profits that may be generated from each project are as follows: Project X Probability Profit 0.4 £3,000 0.6 £1,500

Project Y Probability Profit 0.35 £10,000 0.65 £0

Which project should be chosen? What is the expected value of the profit?

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7. Three independent experts have estimated the probability of a company’s future annual sales: Sales Expert W Expert X Expert Y

High (£1m) 0.2 0.1 0.1

Medium (£0.5m) 0.3 0.4 0.6

Low (£0.25m) 0.5 0.5 0.3

The highest expected value for the company’s annual sales is given by: A. B. C. D.

W only X only Y only Both W and Y

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Unit 2: Materials, Labour, Stock Control

At the end of this lecture you will have learned how to do the following: 1. Describe the procedures and documents required for ordering, receiving and issuing stocks of materials. 2. Explain the reasons for holding stock 3. Calculate and interpret optimal re-order levels, re-order quantities and minimum and maximum levels of stock to be held. 4. How to minimise the total cost of holding and ordering stocks. 5. Describe and illustrate different methods of remuneration for work done. 6. Calculate direct and indirect labour costs. 7. Account for overtime payments. 8. Illustrate measures of identifying labour turnover, efficiency and productivity.

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MATERIALS Materials required for stock and later issue to production are subject to a set procedure: a. A purchase requisition is raised and sent to the purchasing dept. b. A purchase order is sent to the supplier. c. A delivery note is received together with the goods (advice note). This is checked to the purchase order to ensure it is the same. d. A GRN (goods received note) records the details for entering into stock. e. A purchase invoice is sent to the company from the supplier to request payment. We are mainly concerned with the receipt of goods into stock and the issue of goods from stock to production. There are five main methods of doing this: 1. LIFO 2. FIFO 3. Weighted average 4. Periodic weighted average 5. Standard cost LIFO Each issue is charged at the latest price of the stock being held from which the issue could have been made. FIFO Each issue is charged at the earliest price of the stock being held from which the issue could have been made. Weighted average Each issue is charged at a weighted average price of the stock being held at that time. Value of total stock Units of stock Periodic weighted average A weighted average price of the total receipts in a period is calculated. This is then used as the rate for charging for issues in the following period. Standard cost Each issue is charged at a standard cost, which has been agreed beforehand. Differences between the standard price and the actual price are charged to the P&L account and treated as a periodic adjustment. Calculation of these is no longer part of the F2 syllabus.

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STOCK HOLDING COSTS The company needs to hold a certain amount of stock to ensure it can meet customer demand. This has a charge to it: • Warehouse space • Operatives • Insurance • Capital costs • Deterioration costs These costs vary according to the amount of stock held at any one time. The company must try to minimise these costs by holding as little stock as is possible. It costs money to order stock. This may be in the form of: • Administrative costs • Delivery charges The greater the number of orders, the greater the charge incurred. This means that we need to have as few orders as possible to minimise the ordering costs. By looking at these two costs we can see that larger orders cost more to hold and less to order. Smaller orders cost less to hold and more to order. What we need to do is find a point where we are able to minimise the total cost of ordering and holding stock. There are two ways of calculating this point. The first is by means of a tabular format whereby we calculate the cost of orders using various order quantities and the cost of holding those quantities to find the total cost. Ordering costs are Stock holding costs are

D x Co Q Q x Ch 2

The second method (and most usual) is done by means of what is known as EOQ (economic order quantity).

EOQ = Where

2CoD Ch Co = cost of placing each order D = annual demand Ch = cost of holding one item for a year.

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EXERCISE 1: Calculate the economic order quantity (EOQ) for the following item of inventory: • Quantity required per year 32,000 items; • Order costs are $15 per order; • Inventory holding costs are estimated at 3% of inventory value per year; • Each unit currently costs $40.

Bulk Discounts Sometimes suppliers will give a discount for orders of large quantities This quantity may not be the EOQ, but the discount given may make the higher order quantity worthwhile So far we have ignored the purchase costs of the materials, because they were common to all order quantities. When bulk discounts are present we must calculate the total cost including the purchase price. EXERCISE 2: BF manufactures a range of domestic appliances. Due to past delays in suppliers providing goods, BF has had to hold an inventory of raw materials, in order that the production could continue to operate smoothly. Due to recent improvements in supplier reliability, BF is re-examining its inventory holding policies and recalculating economic order quantities (EOQ). • Item “Z” costs BF £1000 per unit • Expected annual production usage is 65,000 units • Procurement costs (cost of placing and processing one order) are £2500 • The cost of holding one unit for one year has been calculated as £300 The supplier of item “Z” has informed BF that if the order was 2,000 units or more at one time, a 2% discount would be given on the price of the goods.

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Required: Calculate the EOQ for item “Z” before the quantity discount. Advise BF if it should increase the order size of item “Z” so as to qualify for the 2% discount.

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RE-ORDER LEVELS It is essential we know when to re-order goods so that we do not run out of stock. This must take account of LEAD times – the time between placing the order and the goods arriving in the warehouse for use. Re-order level = maximum demand x maximum lead time Minimum stock level = re-order level – (average demand x average lead time) Maximum stock level = re-order level + re-order quantity – (minimum demand x minimum lead time) EXERCISE 3: Calculate the re-order level, minimum stock level and maximum stock level from the following data: Minimum lead time Average lead time Maximum lead time Maximum usage Minimum usage Re-order quantity

4 days 5 days 7 days 500 per day 300 per day 5,400

FREE STOCK Free stock is that amount of stock which is left over after all commitments have been met. It can be calculated as: Physical stock + Stock on order – Stock for customers’ orders already committed. PRACTICE QUESTIONS: Attempt the questions in section 6 (pages 14 – 16) of revision kit.

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LABOUR COSTS Employees may be paid a fixed salary per week/month or a wage based on the amount of hours worked or work done in a period. Basic rate is usually paid for each hour worked. Overtime premium is paid on top of basic rate for each hour worked over and above the normal working hours. E.g. An employee is paid £10 per hour for a 38 hour week and an overtime premium of 25% (time and a quarter). In a week in which he works 42 hours he is paid – 42 hours x £10 4 hours x £2.50 Total wage

= = =

£420 £ 10 £430

His normal wage would be £380 PLEASE NOTE –` for the purposes of accounting we show the TOTAL hours worked x basic rate and the OVERTIME hours worked x premium only. This is because the premium part is treated differently in the accounts. The overtime premium is charged as: 1. general indirect overhead if it is a normal occurrence 2. to the job if it is requested that the job be done quickly in overtime 3. to another job if that job is requested to be done quickly and it means that the employees have to work later. We must also measure and monitor IDLE TIME. This is time spent doing nothing. It may be breaks, machine breakdowns, lack of orders etc. This time cannot be charged directly to jobs but must be costed and incorporated into indirect overheads. Accounting for labour costs in the accounts is done through a labour control account. The total cost of labour is shown as a debit entry. Direct labour is shown as a credit entry to work-in-progress. Indirect labour is shown as a credit entry to production overheads. Idle time is shown as a credit entry to production overheads. Labour control account (Wages) £ Total wages paid 25,000 WIP (direct labour) P. Ohds (indirect labour) P. Ohds (idle time etc)

£ 15,000 9,000 1,000

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In addition to being paid a regular salary, labour can be paid in a variety of ways. These include being paid bonuses for working/producing more than is expected or being paid individually for each item they produce. Method

Description

Graph

Hourly paid

Workers are paid for time spent at work and not output, possibly receiving an enhanced rate as the result of overtime

ÂŁ wages

hrs

Piecework

In this case workers are paid by output rather than time spent. A rate per unit is used to calculate wages Alternatively, output can be converted into standard time and workers paid on standard hours.

ÂŁ wages

units

In addition to being paid a single piecework rate they may be paid on a differential piecework scheme. This will mean that they are paid a lower rate for the first number of units produced and this will increase for further units.

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Guaranteed minimum wage

In order to give wage stability, many workers will be guaranteed a minimum wage. Once output or attendance time reaches a threshold level, workers will revert to a variable rate of pay.

£ wages

units

BONUS SCHEMES In addition, both individuals and groups may be awarded bonus payments based upon their efficiency in getting the work done. Bonuses are usually calculated by estimating how long the work should take and comparing it to how long it did take. This then gives us the amount of time saved. The time saved is multiplied by the given percentage and the rate to find the amount of bonus awarded. If you are required to calculate a bonus, information will be given on how to do it. EXERCISE 4: A company employs 3 workers who are paid on a piece-work basis. The rate of pay is £2.25 for each unit produced in a week, up to 100 units, and a rate of £3 for each unit in excess of 100 units. There is a guaranteed minimum weekly wage of £180 for each employee. During one week, the output produced by each employee was: Employee A B C

Units produced 96 122 76

What was their total pay for the week? EXERCISE 5: Johnson is paid by the hour. She gets paid £7.50 an hour basic plus an overtime premium of £2.50 for any hours over 40 in a week. Johnson assembles seed propagators. Each propagator should take 30 minutes to complete. Johnson is paid a bonus of 50% of time saved based on www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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her standard hourly rate. Idle time is not included in the calculation of actual time taken. Last week Johnson was at work for 54 hours, though 4 of these were lost due to a machine breakdown. She assembled 124 propagators that week. Johnson's total wages are:

£

How much of Johnson’s wages should be treated as a direct cost and how much as an indirect cost? LABOUR RATIOS Labour ratios are used to: • Measure efficiency • Measure turnover • Measure capacity LABOUR TURNOVER – Number of staff leaving and needing replacement Average number of employees LABOUR EFFICIENCY – Actual output in standard hours Actual hours LABOUR CAPACITY – Actual hours worked Budgeted hours

X 100%

x 100%

x 100%

The CAPACITY ratio x the EFFICIENCY ratio = PRODUCTION VOLUME ratio A standard hour is the number of units which should be achieved in a period of one hour. To calculate the actual output in standard hours we take the number of units completed (actual output) x the time each unit should take. This tells up how efficient our workforce is. 100% is average. Above that is good. Below 100% and our workforce is not working up to the required standard. PRACTICE QUESTIONS Attempt the questions in sections 6 and 7 (pages 14 – 19) of your revision kit.

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HOMEWORK QUESTIONS1. Jane plc purchases its requirements for component RB at a price of £80 per unit. Its annual usage of component RB is 8,760 units. The annual holding cost of one unit of component RB is 5% of its purchase price and the cost of placing an order is £12·50. Required: (a) Calculate the economic order quantity (to the nearest unit) for component RB. (b) Assuming that usage of component RB is constant throughout the year (365 days) and that the lead time from placing an order to its receipt is 21 days, calculate the stock level (in units) at which an order should be placed. (c) (i) Explain the terms ‘stockout’ and ‘buffer stock’. (ii) Briefly describe the circumstances in which Jane plc should consider having a buffer stock of component RB.

2. A company uses 9,000 units of a component per annum. The component has a purchase price of £40 per unit and the cost of placing an order is £160. The annual holding cost of one component is equal to 8% of its purchase price. What is the Economic Order Quantity (to the nearest unit) of the component? A 530 B 671

C D

949 1,342

3. A company determines its order quantity for a component using the Economic Order Quantity (EOQ) model. What would be the effects on the EOQ and the total annual ordering cost of an increase in the annual cost of holding one unit of the component in stock? A B C D

EOQ Lower Higher Lower Higher

Total annual ordering cost Higher Lower No effect No effect

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4. Which one of the following would be classified as indirect labour? A B C D

Assembly workers on a car production line Bricklayers in a house building company Machinists in a factory producing clothes Forklift truck drivers in the stores of an engineering company

5. A jobbing company operates a premium bonus scheme for its employees of 75% of the time saved compared with the standard time allowed for a job, at the normal hourly rate. The data relating to job 1206 completed by an employee is as follows: Allowed time for job 1206 Time taken to complete Job 1206 Normal hourly rate of pay

4 hours 3 hours £8

What is the total pay of the employee for Job 1206? A. £24 B. £30

C. D.

£32 £38

6. Point Ltd uses the economic order quality (EOQ) model to establish the reorder quantity for raw material Y. The company holds no buffer stock. Information relating to raw material Y is as follows: Annual usage Purchase price Ordering costs Annual holding costs

48,000 units £80 per unit £120 per order 10% of the purchase price

Required: a. Calculate i. The EOQ for raw material Y ii. The total annual cost of purchasing, ordering and holding stocks of material Y. The supplier has offered Point Ltd a discount of 1% on the purchase price if each order placed is for 2,000 units b. Calculate the total annual saving to Point Ltd of accepting this offer. c. List FOUR examples of holding costs.

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7. Point Ltd uses the economic order quality (EOQ) model to establish the reorder quantity for raw material Y. The company holds no buffer stock. Information relating to raw material Y is as follows: Annual usage Purchase price Ordering costs Annual holding costs

48,000 units £80 per unit £120 per order 10% of the purchase price

Required: b. Calculate iii. The EOQ for raw material Y iv. The total annual cost of purchasing, ordering and holding stocks of material Y. The supplier has offered Point Ltd a discount of 1% on the purchase price if each order placed is for 2,000 units d. Calculate the total annual saving to Point Ltd of accepting this offer. e. List FOUR examples of holding costs.

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Unit 3: Overheads and Introduction to Absorption Costing

At the end of this session you will have learned how to do the following: 1. Explain the difference between the treatment of direct and indirect overheads. 2. Allocate and apportion overheads to production and service cost centres using an appropriate basis. 3. Re-apportion service centre costs to production cost centres using: • Elimination method • Repeated distribution • Algebraic method (simultaneous equations) 4. Identify and calculate the appropriate overhead absorption rates for each cost centre. 5. Calculate, explain and account for over or under absorbed overheads.

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OVERHEADS Overheads are defined as expenditure on labour, materials or services that cannot be directly identified with a saleable cost unit. Overheads are divided into two main areas: ♦ Production and ♦ Non-production Production overheads are indirect costs that are directly related to the production. These include items such as: ♦ Power ♦ Maintenance of machinery Non-production overheads are necessary expenses of the business, which are not directly related to production. These can be classified into: ♦ Administration overheads ♦ Selling and distribution overheads ♦ Finance overheads COST ALLOCATION Some costs can be easily identified with a unit or units of production such as labour and material costs. These are said to be ‘allocated to the product’. Often they are allocated to the cost centre or department before being shared among the units of production. COST APPORTIONMENT Some costs relate the business as a whole. These costs then have to be shared between the various departments or cost centres. This is done by ‘apportioning the costs’. “The division of costs amongst two or more cost centres in proportion to the estimated benefit received, by using a proxy. E.g. Area, headcount, capital value etc. These overheads then have to be included into the cost of the products which are produced in that department. It would be easy to just divide the cost by the number of units made. This would be fine if only one product was made or if all products took exactly the same time to be made. As this is not the case we have to find a way of sharing the overhead costs between the products.

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EXERCISE 1: ABC is preparing its departmental budgets and product cost estimates for the year ended 31 December 19X5. The company has three manufacturing departments – Machining, Assembly and Finishing – together with a production maintenance department. The following costs and related data have been estimated for the year to 31 December 19X5: Costs: Indirect wages Indirect materials Power Light and heat Depreciation Rent and rates Personnel

Other data: Direct labour hours Machine hours Employees Floor area (m2) Net book value of fixed assets

Machining

Assembly

Finishing

Maint

Total

£’000 10 15

£’000 6 4

£’000 8 8

£’000 30 20

£’000 54 47 102 10 7 25 63

12,000 40,000 6 1,000 20,000

8,000 5,000 4 400 8,000

16,000 6,000 8 300 3,000

6,000 3 300 4,000

42,000 51,000 21 2,000 35,000

The maintenance department is expected to spend 60% of its time working for the machining department with the remainder of its time being shared equally between assembly and finishing. a.

Prepare an overhead analysis sheet for ABC Ltd for its year ended 31 December 19X5;

b.

Calculate appropriate overhead absorption rates for the machining, assembly and finishing departments; www.ebooks2000.blogspot.com

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Solution – method of working (a): From the question we can see that the costs for indirect wages and materials have been allocated directly to the cost centres. This is because we can identify these costs directly to the cost centres concerned. The remainder of the costs must be shared over the cost centres in relation to the amount of usage of the cost. This can be established by looking at the additional information and deciding which piece of information relates to which cost. For example the power costs would be determined by the number of hours the machines had been working and the light and heat by the overall area of the building. To apportion costs we need to take the total of the overhead cost and divide it by the total of the basis used. The resulting figure can then be multiplied by the individual usage of the cost. Power (for machining dept)

£102,000 51,000 m/c hours

x 40,000

This process can then be repeated for each cost and cost centre. The figures can then be inserted into the table above and the columns totalled. SECONDARY APPORTIONMENT Not all departments are production based. Some act as a service to the production departments. E.g. Canteen, stores, maintenance. The costs of these have to be included into the total overheads of the production departments. This is done by means of secondary apportionment. A means of apportioning overheads from service cost centres to production cost centres by means of relevant usage factors. ♦ A canteen – on basis of number of employees ♦ A stores – on the number of stores issues. Sometimes one service cost centre gives a service to another (reciprocal servicing). This has to be taken into account before the final apportionments are made. There are three ways of secondary apportionment: a. Continuous allotment (repeated distribution) b. Algebraic c. Elimination a. Continuous allotment – the costs are repeatedly shared on an equitable basis until they are all accounted for. b. Algebraic – by means of using simultaneous equations to arrive at the notional total used in the continuous allotment method.

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c. Elimination – this method is used where one service centre does not use the services of another. For instance it is unlikely that the stores would provide a service to the canteen while the canteen would provide a service to the stores. In this case the canteen costs would be apportioned first followed by the stores. In the exercise above there is only one service centre. This can be shared out over the three production centres in relation to the information given in the question. EXERCISE 2 (repeated distribution and algebraic methods): Production B

departments C

Service P

Dept:

A

Costs

£3,000

£4,000

£2,000

% of P used 20%

30%

25%

-

25%

% of Q used 25%

25%

30%

20%

-

£2,500

Q £2,700

Reapportion the service centre costs to the production centres using: a. b.

Repeated distribution method Algebraic method

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EXERCISE 3 (elimination method): The ABC washing machine Co. produces a standard washing machine in three production departments (Machining, Assembly, and Finishing) and two service departments (Materials handling and Production control). Costs for last year, when 2,000 machines were produced were as follows: Indirect materials;

ÂŁ

Materials handling

4,000

Indirect wages; 8,000 11,200

Materials handling Production control Other indirect expenses;

41,920 12,960 7,920 8,000 2,400

Machine shop Assembly Finishing Materials handling Production control

It is estimated that the benefit derived from the service departments is as follows: Materials handling; Machine shop Assembly Finishing

60% 30% 10%

Production control; Machine shop Assembly Finishing Materials handling

40% 30% 20% 10%

Prepare a statement showing the overhead allocated and apportioned to each of the production departments.

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OVERHEAD ABSORPTION This is a means of attributing overheads to a product or service based on the amount of time the product spends in that department. An absorption rate can be thought of as a charge out rate for overheads. Absorption rates can be calculated in a number of ways but the most common ways for exam questions are: ♦ A rate per unit ♦ A rate per labour hour ♦ A rate per machine hour.

It is worth remembering that absorption rates are always calculated using BUDGETED figures. Rates have to be available at the start of a period so it is possible to cost output as the period progresses. Actual figures are only available at the end of a period. Absorption rates are calculated as: Budgeted overheads / budgeted activity = OAR A single absorption rate can be calculated for a company as a whole, known as a blanket rate. Equally, separate absorption rates can be calculated for individual departments, know as departmental rates. Exercise 4: Blanket Rates Tulip Ltd makes a single product, the Bulb. Each Bulb has a prime cost of £20.00, takes 2 labour hours and 5 machine hours. The following budgeted information is available for the factory. Budgeted Overhead Budgeted Output Budgeted Labour Hours Budgeted Machine Hours

£100,000 20,000 units 50,000 hours 25,000 hours £

What is the absorption rate per unit? What is the absorption rate per labour hour? What is the absorption rate per machine hour? What is the total production cost using the unit based absorption rate? What is the total production cost using the labour hour absorption rate? What is the total production cost using the machine hour absorption rate? www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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Exercise 5: Departmental Rates It may be more accurate to calculate separate absorption rates for different departments. Would it be fair or meaningful to use labour hours, for instance, to charge out overheads in a machine intensive department? A company has the following information available: Cutting

Finishing

Budgeted Overhead Machine Hours Labour Hours

£100,000 50,000 20,000

£50,000 3,000 12,500

Actual Overheads Machine Hours Labour Hours

£132,000 40,000 28,000

£38,000 4,200 12,000

The following information is also available about one of the company's products:

Machine Hours Labour Hours

Cutting hrs 6 2

Finishing hrs 1 4 £

What is an appropriate absorption rate for the Cutting Department? What is an appropriate absorption rate for the Finishing Department? What is the total overhead cost per unit of product? Exercise 6: Calculate the overhead absorption rates for the three production departments in exercise 1.

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OVER/UNDER ABSORPTION OF OVERHEADS Calculation of the overhead absorption rate (OAR) is done by using budgeted figures. We cannot use actual figures because we do not know these until after the event. This means that for every item we make we absorb a certain amount of overheads into the unit. The total amount absorbed will depend upon the number of units made. It is highly unlikely that the budgeted production will agree exactly with the actual or that the budgeted overhead will agree with the actual spend. Because of this we need to calculate how much overhead has been absorbed into our production, compare this with the actual amount and make an adjustment to our P&L account. If we have absorbed too much (over absorption) we will have to add back the difference into our P&L. This will increase the reported profit. If we have not absorbed enough (under absorption) we will have to take more out of our P&L. This will decrease the reported profit. Under or over absorbed overhead is calculated using:

£ Absorbed overhead (actual activity x OAR) Actual Overhead Under/over absorption: Exercise 7: Under/Over Absorption Aurricula Ltd use absorption costing. The following information for its one production department is as follows: Shredding Budgeted Overhead Machine Hours Labour Hours

£200,000 100,000 30,000

Actual Overheads Machine Hours Labour Hours

£208,000 80,000 41,000

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Complete the following statement. Overheads were

ÂŁ by

Double Entries for Absorption If a company uses absorption costing, absorbed overheads will have to be recorded as will any under or over absorbed overheads. Ultimately, profits will have to be adjusted for over or under absorption of overheads. Exercise 8: Accounting for Overheads Write up the T- accounts below for Aurricula Ltd as far as possible using information contained in Exercise 7, including your answer to the question.

Overhead Control

WIP

P and L

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Practice questions: Attempt questions in section 8 (pages 19 – 23) of revision kit. HOMEWORK QUESTIONS 1. An organisation absorbs overheads on a machine hour basis. The planned level of activity for last month was 30,000 machine hours with a total overhead cost of £247,500. Actual results showed that 28,000 machine hours were recorded with a total overhead cost of £238,000. What was the total under absorption of overheads last month? A £7,000 B £7,500

C £9,500 D £16,500

2. A company manufactures two products P1 and P2 in a factory divided into two cost centres, X and Y. The following budgeted data are available: Cost centre X Allocated and apportioned fixed overhead costs £88,000 Direct labour hours per unit: Product P1 3·0 Product P2 2·5

Y £96,000 1·0 2·0

Budgeted output is 8,000 units of each product. Fixed overhead costs are absorbed on a direct labour hour basis. What is the budgeted fixed overhead cost per unit for Product P2? A £10 B £11

C £12 D £13

3. A manufacturing company uses a machine hour rate to absorb production overheads, which were budgeted to be £130,500 for 9,000 machine hours. Actual overheads incurred were £128,480 and 8,800 machine hours were recorded. What was the total under absorption of production overheads? A £880 B £900

C £2,020 D £2,900

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4. Which of the following would NOT be classified as a service cost centre in a manufacturing company? A B C D

Product inspection department Materials handling department Maintenance department Stores

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Unit 4: ABSORPTION AND MARGINAL COSTING; CONTRIBUTION THEORY;

At the end of this session you will have learned how to do the following: 1. Explain the concept and calculation of contribution. 2. Show the impact of the difference on stock valuations of absorption and marginal costing. 3. Produce profit and loss accounts using absorption and marginal costing. 4. Reconcile the profits achieved under each method.

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MARGINAL versus ABSORPTION COSTING There are two main methods of costing: ♦ Absorption costing – where the overhead costs are absorbed into the product cost by means of an overhead absorption rate (OAR) and ♦ Marginal costing – where the overhead costs are written off in full in the period in which they occur. In order to correctly assess the full cost of production we need to have a portion of these overheads included in the cost of the item. Absorption costing: Sales – production costs = gross profit Gross profit – expenses = Net profit Marginal costing: Sales – variable costs = contribution Contribution – fixed overheads = profit As can be seen from the above calculations, the difference is in the treatment of the fixed overheads. ♦ If the production equals the sales there will be no difference in the profits reported under each basis. ♦ If production is greater than sales or if sales are greater than production, there will be a difference as some of the fixed overheads will be included in the stock valuations. Exercise 1: A company makes and sells a single product. Details of this product are as follows: Per unit Selling price £20 Direct materials £6 Direct labour £3 Variable overheads £4 Fixed overheads £20,000 per month The fixed overhead is absorbed on the basis of expected production of 20,000 units per month. If actual production and sales are 20,000 units in a month, calculate www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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a. b.

The contribution per unit, the total contribution for the month and the total profit for the month, using marginal costing The profit for the month using absorption costing.

Solution: The contribution per unit = Selling price – variable cost. 20 – (6 + 3 + 4) = 7 Total contribution = 7 x 20,000 units = £140,000 Total profit = total contribution – total fixed costs £140,000 - £20,000 = £120,000 To calculate the profit using absorption costing we first need to calculate the OAR. This is equal to £20,000 / 20,000 units = £1 per unit This means that the full production cost per unit is variable cost + fixed cost = 13 + 1 = 14 Total sales = Total production cost = Total profit =

20,000 x £20 = 20,000 x £14 =

£400,000 £280,000 £120,000

Exercise 2: A company produces a single product with the following budget: Selling price £10 Direct materials £3 per unit Direct wages £2 per unit Variable overheads £1 per unit Fixed overheads £10,000 per month Budgeted production 5,000 units per month Show the operating statement for the month when 4,800 units were produced and sold using: a. Absorption costing b. Marginal costing Assume that all costs were as budget. You will notice that in this question you will need to account for over or under absorption. In the two exercises just done the profits achieved under both methods are exactly the same. This is because sales = production. If there is a difference in the sales and production, the profits will differ. We need to be able to reconcile these profits. This is a simple matter and very easy to do. It is also a common exam question.

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Exercise 3: Using the above budget in exercise 2, recalculate the operating statements assuming that production had been 6,000 units and sales 4,800 units.

Reconcile the profits. From the figures you have calculated you will see that there is a closing stock balance of 1,200 units. The value of these balances differ because of the amount of fixed overhead contained within the absorption costing stock. From this we can deduce that the difference in the profit figures is because of the change in the number of units of stock x OAR. Try it:

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IMPORTANT EXAM POINT: Please remember: ♦ If sales and production are equal, both profits will be the same. ♦ If sales are less than production, then absorption costing will give a higher profit. This is because some of the fixed overhead for the period is contained in the closing stock. ♦ If sales are greater than production, then absorption costing will give a lower profit. This is because some of the overhead from a period has been written off in the current period from the stock taken from the opening stock.

Exercise 4: A company uses an absorption costing system. The standard cost and profit for its product is as follows: £ Sales price 25 Variable costs (15) Contribution 10 Fixed cost apportionment (4) Profit 6 This is based on a production and sales level of 50,000 units per annum. The company is considering revising the budget as the demand would increase by 100% if the sales price per unit were reduced to £20 per unit. There would be no change in unit variable costs and fixed costs would only increase by 50%. What would be the new/revised standard profit per unit? Exercise 5: Z Ltd produces a single product. The management currently uses marginal costing, but is considering using absorption costing in the future. The budgeted fixed production overheads for the period are £250,000. the budgeted output for the period is 1,000 units. There were 400 units of opening stock for the period and 250 units of closing stock. If absorption costing principles were applied, by how much would the profit for the period compared to marginal costing differ? PRACTICE QUESTIONS: Attempt questions in section 9 (pages 23 – 26) of revision kit. www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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HOMEWORK QUESTION 1: Last year, Garns Ltd, started to make a single product with a unit selling price of £14. in the first year of operation, standard capacity was 50,000 units, production was 50,000 units and sales were 45,000 units. The actual costs incurred were: Fixed Raw materials Direct labour Factory overhead S & D expenses

£200,000 £80,000

Variable £3.00 per unit produced £2.00 per unit produced £1.00 per unit produced £1.00 per unit sold

Actual variable costs did not diverge from standard. Any under or overabsorbed overhead was written off directly at year end as an adjustment to the cost of goods sold. What would be the net profit achieved using: a. Marginal costing b. Absorption costing

QUESTION 2: Archibald Ltd manufactures and sells one product. Its budgeted profit statement for the first month of trading is as follows: £ £ Sales (1,200 units at £180 per unit) Less: Cost of sales: ess: Production (1,800 units at £100 per unit) Less: Less Closing stock (600 units at £100 per unit)

Gross profit Less Fixed selling and distribution costs Net profit

216,000 180,000 (60,000) ———— (120,000) ———— 96,000 (41,000) ——— 55,000 ———

The budget was prepared using absorption costing principles. If budgeted production in the first month had been 2,000 units then the total production cost would have been £188,000. (a) Using the high-low method, calculate: (i) the variable production cost per unit; and (ii) the total monthly fixed production cost. (b) If the budget for the first month of trading had been prepared using marginal costing principles, calculate: (i) the total contribution; and www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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(ii) the net profit. (c) Explain clearly the circumstances in which the monthly profit or loss would be the same using absorption or marginal costing principles.

QUESTION 3: The following information relates to a manufacturing company for next period: Units £ Production 14,000 Fixed production costs 63,000 Sales 12,000 Fixed selling costs 12,000 Using absorption costing the profit for next period has been calculated as £36,000. What would the profit for next period be using marginal costing? A B

£25,000 £27,000

C D

£45,000 £47,000

QUESTION 4: Pointdextre Ltd, which manufactures and sells a single product, is currently producing and selling 102,000 units per month, which represents 85% of its full capacity. Total monthly costs are £619,000 but at full capacity these would be £700,000. Total fixed costs would remain unchanged at all activity levels up to full capacity. The normal selling price of the product results in a contribution to sales ratio of 40%. A new customer has offered to take a monthly delivery of 15,000 units at a price per unit 20% below the normal selling price. If this new business is accepted, existing sales are expected to fall by one unit for every six units sold to this new customer. (a) For the current production and sales level, calculate: (i) the variable cost per unit; (ii) the total monthly fixed costs; (iii) the selling price per unit; (iv) the contribution per unit. (b) Calculate the net increase or decrease in monthly profit which would result from acceptance of the new business.

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Unit 5: COSTING FOR JOBS, BATCHES AND SERVICES.

At the end of this lecture you will have learned how to do the following: 1. Describe the characteristics of specific order costing 2. Describe situations where job, batch or service costing may be appropriate. 3. Illustrate the treatment of direct and indirect costs. 4. Complete cost records and accounts. 5. Estimate job costs from given information. 6. Recognise the difference between profit mark-up and profit margin. 7. Calculate profit mark-up and margin to establish selling prices. 8. Analyse service costs 9. Identify suitable cost unit measures that may be used in a variety of different operations and services.

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Introduction to Job Costing Jobbing production involves producing items to the specific order of a customer. As such, mass production of items does not occur and each job will have its own characteristics and hence costs. It is important, therefore, that costs due to an individual job are collected separately, and remain identifiable within the accounts. Job costs are normally collected on a job card that records specific costs incurred as part of the job. Once a job is completed overheads are added to work out the total cost of the job. In cost bookkeeping, a separate job account is maintained for each job. These are then consolidated into single work in progress account. Exercise 1: A company makes three products, details of which are given below: A local jobbing company has just completed a one-off job which involved making a specialist iron frame. The item was given the job number 666. Materials issued were as follows: Steel grade A: Steel grade B:

400 metres at a cost of £5.00 per metre 800 metres at £6.00 per metre

Note 60 metres of grade B steel were unused and were returned to store. The iron frame involved two production departments: Welding: Finishing:

220 normal hours, 100 overtime hours 100 normal hours, 100 overtime hours

Hourly rate Welding: Finishing:

£4.00 per normal hour, £1.00 overtime premium £5.00 per normal hour, £1.50 overtime premium

Production overheads are absorbed at the rate of £3.00 per direct labour hour in each department. Note the company uses cost plus pricing of work and adds 40% to the cost of a job to determine price. The company is very busy and would not normally work overtime on a job of this nature You have been asked to complete the cost summary below:

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Job 666 £

£

Materials Grade A Steel Grade B Steel Wages Wages Welding Wages Finishing Total Direct Cost Overheads Total Cost Profit Selling Price Exercise 2: A company operates a job costing system to enable them to identify the costs incurred in carrying out works to customer specifications. Wherever possible, this system allocates costs directly to a job. Production overhead costs are absorbed into the cost of a job at the end of each month at an actual rate per direct labour hour for each of the two production departments. The following information has been collected relating specifically to one job which was carried out in the month just ended: ♦

400 kgs of Material Y were issued from stores to Department A. Material Y is currently valued at £0.51 per kg.

76 direct labour hours were worked in Department A at a basic wage of £4.50 per hour. 6 of these hours were classed as overtime at a premium of 50%.

300 kgs of Material Z were issued from stores to Department B. department B returned 35 kgs of Material Z to the storeroom as it was excess to requirements for the job. Material Z is currently valued at £1.45 per kg.

110 direct labour hours were worked in Department B at a basic wage of £4.00 per hour. 30 of these hours were classified as overtime at a premium of 50%. All overtime worked in Department B in the month is as a result of the request of a customer for early completion of another job that had originally been scheduled for completion in the month following.

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Overhead costs incurred during the month on all jobs in the two production departments were as follows: Dept A Dept B £ £ Indirect labour, at basic wage rate 2,510 2,960 Overtime premium 450 60 Lubricants and cleaning compounds 520 680 Maintenance 720 510 Other costs 1,200 2,150 Total labour hours worked during the month 2,000 2,800 Prepare a list of the costs that should be assigned to the job. Exercise 3: The following information concerns Sunflower Ltd. At the end of last month, one job was uncompleted, and the costs to date were: JOB 6832

£

Direct Materials Direct Labour (120 hrs) Factory Overhead (£2 per hr) Factory cost to date

630 960 240 1,830

At the start of the month two new jobs were started: JOB 6833, JOB 6834. By the end of the month jobs 6832, 6833 were competed. The following cost information is available: Direct Materials Issued to: Job 6832 Job 6833 Job 6834 Materials Transfers: Job 6834 to Job 6833 Job 6832 to Job 6833

£ 2,390 1,680 3,950 £ 250 620

Materials Returned to Store From Job 6832

£ 870

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Direct Labour Hours Recorded Job 6832 Job 6833 Job 6834

430 hrs 650 hrs 280 hrs

Labour is charged at £8.00 per hour Production overheads are absorbed at the rate of £2.00 per labour hour. The actual overheads incurred during the month were £3,800. Complete the following job accounts: Job 6832

Job 6833

Job 6834

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Pricing When determining a price, a company may use mark up or margin. Mark up Margin

- profit expressed as a percentage of cost - profit expressed as percentage of price

Equally, a company may decide to use variable (marginal) cost of a unit or full cost when calculating a price. It is important to check questions that ask for prices carefully. Which cost is being used and is the question using mark up or margin? Exercise 4: A company has the following cost card:

Direct Labour Direct Materials Prime cost Variable Production Overhead Fixed Production overhead Production cost Variable non-production cost Fixed production cost Total

£ 10 12 22 5 4 31 6 3 40

£ Using a mark up on marginal cost of sales of 80%, what is the price? What is the resulting profit? Using a margin of 80% on total production cost what is the price? What is the resulting profit?

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SERVICE COSTING Definition: “Cost accounting for services or functions, e.g. canteens, maintenance, personnel. These may be referred to as service centres, departments or functions. Service costing is also known as Operations Costing.” Service organisations do not make or sell tangible goods. Most, however, still seek to make a profit and in doing so are required to build up costs of their services for charging out. Examples: Transport Accountants Hotels Hospitals Schools/colleges Banks etc. Recording costs for the organisations is very similar to other methods of costing i.e. direct and indirect costs. - they tend to have a very low level of direct material costs - it is difficult to cost one unit of output as it is often intangible - as no two service industries are similar, costing methods will differ considerably. Services have certain specific characteristics which have to be taken into account: Intangibility – - the performance of the service depends upon other factors rather than just the service. A bus service depends upon timing, reliability, comfort, cleanliness etc. Simultaneity – - the production and consumption of the service are done at the same time. The product cannot be inspected beforehand. The bus journey is provided and taken at the same time. It cannot be assessed before the journey takes place but comments can be made afterwards. Perishability – - the service is perishable. It cannot be provided in advance and stored. Heterogeneity – - the exact service provided will vary each time. The bus journey will vary as to the exact time it takes, the comfort of the passengers depends upon the number and type of people travelling at that particular time. www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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Identification of Cost Units Some service units can be easily costed using an apt basis. For others there may be a choice of bases to be used. E.g.

Canteen – cost per meal served Hotel can use several: Services cost per guest day Restaurant - cost per meal Conference facilities cost per hour

Each service organisation will therefore have to decide upon a basis to be used that is relevant to them. Exercise 5: The following information is provided for a 30 day period for the Rooms department of a hotel: Number of rooms in hotel Number of rooms available to let Average number of rooms occupied daily

Twin 260 240 200

Number of guests in period Average length of stay Total revenue in period Number of employees Payroll costs for period Items laundered in period Cost of cleaning supplies in period Total cost of laundering Listed daily rate for twin-bedded room Listed daily rate for single room

6,450 2 days £774,000 200 £100,000 15,000 £5,000 £22,500 £110 £70

Single 70 40 30

The hotel calculates a number of statistics including the following: Room occupancy

Total number of rooms occupied as a percentage of rooms available to let

Bed occupancy

Total number of beds occupied as a percentage of beds available

Average guest rate Total revenue divided by number of guests Revenue utilisation Actual revenue as a percentage of maximum revenue from available rooms Average cost per bed occupied

Total cost divided by number of beds occupied

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Calculate relevant statistics and ratios for the Hotel using the above information. All figures should be calculated to one decimal place: Exercise 6: Little Larson Ltd operates a small fleet of delivery vehicles. Standard costs have been established as follows: Loading Loading costs: Labour (casual) Equipment depreciation Supervision Drivers’ wages (fixed) Petrol Repairs Depreciation Supervision Other general expenses (fixed)

1 hour per tonne loaded £2 per hour £80 per week £80 per week £100 per man per week 10p per kilometre 5p per kilometre £80 per week per vehicle £120 per week £200 per week

There are two drivers and two vehicles in the fleet. During a quiet week, only six journeys were made. Journey 1 2 3 4 5 6

Tonnes carried (one way) 5 8 2 4 6 5

One-way distance of journey (km) 100 20 60 50 200 300

Calculate (a) The total variable cost for the week. (b) The total fixed cost for the week. (c) The expected average full cost per tonne/kilometre for the week. PRACTICE EXERCISES: Attempt the questions in section 12 (pages 32 – 35) of your practice kit.

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HOMEWORK QUESTIONS: QUESTION 1: Consider the following statements: (i) Job costing is only applicable to service organisations. (ii) Batch costing can be used when a number of identical products are manufactured together to go into finished stock. Is each statement TRUE or FALSE? Statement (i) A False B False C True D True

Statement (ii) False True True False

QUESTION 2: Sangazure Ltd manufactures many different products in a factory that has two production cost centres (T and W) and several service cost centres. The total budgeted overhead costs (after the allocation, apportionment and reapportionment of service cost centre costs), and other information for production cost centres T and W are as follows: Cost centre Budgeted overheads T W

£780,000 £173,400

Basis of overhead Budgeted activity absorption Machine hours 16,250 machine hours Direct labour hours 14,450 direct labour hours

(a) Calculate the overhead absorption rates for cost centres T and W. The prime cost of product PP, one of the products made by Sangazure Ltd, is as follows: £ per unit Direct material 10 Direct labour: Cost centre T 14 Cost centre W 21 One unit of product PP takes 35 minutes of machine time in cost centre T. The direct labour in cost centre T is paid £7 per hour and £6 per hour in cost centre W. (b) Calculate the total production cost for one unit of PP.

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QUESTION 3: A company operates a job costing system. Job number 812 requires £60 of direct materials, £40 of direct labour and £20 of direct expenses. Direct labour is paid at the rate of £8 per hour. Production overheads are absorbed at a rate of £16 per direct labour hour and non-production overheads are absorbed at a rate of 60% of prime cost. What is the total cost of job number 812? A B

£240 £260

C D

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£272 £320

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Unit 6: PROCESS COSTING; JOINT AND BY-PRODUCTS At the end of this lecture you will have learned how to do the following: 1. Define and account for normal and abnormal losses and abnormal gains. 2. Account for scrap (sales and disposal). 3. Calculate the cost per unit of output. 4. Define and calculate equivalent units. 5. Account for opening and closing work-in-progress using FIFO and weighted average methods. 6. Distinguish between joint and by-products. 7. Value joint and by-products at the point of separation using physical units and sales value methods.

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Introduction In a significant number of manufacturing processes it is not possible to identify individual cost units because of the continuous nature of production e.g. oil refining, paint production, chemical manufacture. Using process costing it becomes possible to derive a cost for both output and closing stocks. Process costing has a number of features that distinguish it from job, batch and service costing: a) Under continuous production there is almost always work in progress to be valued. b) Wastage during a continuous production process is common and has to be taken into account (see later). Students often find process costing a difficult topic to understand. However, it is straightforward if the following points are kept in mind: 1) Process accounts are simple control accounts that have debit and credit entries and are nothing more than work in progress accounts. 2) Ledger accounts contain quantity columns that should be balanced off. 3) A set of rules applies to each procedure - once learnt they always apply.

Example of Process Costing Manufacturing a product involves two processes, cutting and forming. Units of material input Cutting Forming

Cutting Forming

Value

1,000,000 500,000

£ 500,000 300,000

Direct Labour Costs £

Production Overhead £

200,000 150,000

200,000 150,000

Given that output from Cutting is fed into Forming, write up the process accounts. www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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PROCESS ACCOUNTS PROCESS 1 (CUTTING) Units Direct Materials 1,000,000 Direct Labour Production overheads 1,000,000

£ 500,000 200,000 200,000 900,000

Units Output to P2: 1,000,000

£ 900,000

1,000,000

900,000

PROCESS 2 (FORMING) Units 1,000,000 500,000

£ Materials from P1 900,000 Added materials 300,000 Direct Labour 150,000 Production overheads 150,000 1,500,000 1,500,000

Output to Finished Goods

Units £ 1,500,000 1,500,000

1,500,000 1,500,000

Calculating the unit cost of output is very straightforward: £1,500,000/1,500,000 = £1.00 Note that direct labour and production overheads are sometimes lumped together and termed conversion cost.

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Losses and Gains Most processes are not 100% efficient and involve some form of loss in weight or volume. This has to be accounted for. In process costing, an important division is made between NORMAL LOSS and ABNORMAL LOSS. NORMAL LOSS These are losses that are expected as part of the production process. The cost of a normal loss is spread across the remaining good units. Any scrap revenue from a normal loss is used to reduce the cost of the main process. ABNORMAL LOSS Abnormal losses are unexpected losses. Unless told otherwise it is assumed that losses occur at the end of the process and are costed at the same rate as good units. Any scrap revenue from an abnormal loss is offset against the cost of the abnormal loss in an abnormal loss/gain account. ABNORMAL GAIN Abnormal gains occur when losses are lower than expected. Abnormal gains represent extra good units so are costed at the same rate as other, expected, good units. By making more good units than expected a company will have lost out on scrap revenue. This is accounted for in abnormal loss/gain account. The heart of getting the correct answer in questions involving abnormal losses and gains is to calculate the unit cost of output correctly. This is calculated using: Total costs – value of normal loss Units of input – normal loss (expected output) Exercise 1: A process has a normal loss of 5%, which can be sold for £5 per tonne. In a period, materials used were 160 tonnes at £23 per tonne and labour and overheads amounted to £3,200. All losses were normal. What were the costs per tonne of good output?

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Process a/c

Normal loss a/c (Scrap sales)

Accounting for abnormal gains and losses. 1. Credit the account with the normal loss. 2. Calculate the difference between the actual good output and the expected good output and record these units as abnormal gain or loss. 3. Calculate the cost per unit based on expected good output divided into total costs minus any scrap value paid for normal loss. 4. Transfer the amounts for normal loss into a Normal Loss/Scrap Sales a/c. 5. Transfer the amounts for any abnormal loss or gain into an Abnormal Loss/Gain a/c. 6. Transfer the sales values from the Abnormal Loss/Gain account into the Normal Loss/Scrap Sales a/c. This will increase (or decrease) our sales revenue from sales of the wastage. 7. Balance the accounts by transferring the difference from the Abnormal Loss/Gain a/c to the Income Statement as a loss or gain on production. 8. The balance on the Normal Loss/Scrap Sales a/c will be debited to the Bank or Cash Book.

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Exercise 2: Using the above information (exercise 1), prepare the process accounts assuming that output was 150 tonnes. Process a/c

Normal loss a/c (scrap sales)

Abnormal loss/gain a/c

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Exercise 3: Using the above information (exercise 1), prepare the process accounts assuming that output was 156 tonnes. Process a/c

Normal loss a/c (scrap sales)

Abnormal loss/gain a/c

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Exercise 4: In a local factory normal loss is 10% and each scrapped unit makes £0.50 from process 1 and £3.00 from process 2. Using the following information, prepare: a) Process 1 Account b) Process 2 Account c) Abnormal Loss/Gain Account d) Scrap Account Direct materials added Direct materials cost Direct labour Production oh Output to process 2 Output to finished goods Actual production overhead

Process 1 2,000 units £8,100 £4,000 150% direct labour 1,750

Process 2 1,250 units £1,900 £10,000 120% direct labour 2,800 £17,800

Process 1 a/c

Process 2 a/c

Normal loss a/c (scrap sales)

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Abnormal loss/gain a/c

Work-in-progress and equivalent units At the end of the period there is likely to be some partly completed work (work-in-progress) and some of the costs of the period have to be attributed to it. The number of EQUIVALENT UNITS is calculated in order to spread the costs incurred over fully and partly completed units. If 2,000 units had been introduced into a process and only 1,500 had been completed it would be unfair to apportion costs in the ratio 3:1 between finished output and closing stock as the part-finished goods would not have 'received' their complete amount of labour and materials. This problem is overcome by converting part completed work into EQUIVALENT UNITS of finished output. For example, if 200 units were 70% completed, they would be charged with the cost of 140 completed units. Getting the right answer to a question involving closing work in progress is a three-stage process. Convert physical outputs to equivalent units by constructing a statement of equivalent units. Calculate the cost of equivalent units by constructing a statement of unit cost. Calculate the value of each output by multiplying the number of equivalent units by unit cost in a statement of valuation. Total equivalent units = complete units + equivalent units in WIP. Exercise 5: In a period 1,000 fully completed and 200 partly completed units were produced. The partly completed units were 50% complete. Total costs for the period were ÂŁ5,500. Calculate the cost per equivalent unit.

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Exercise 6: The following information is available for Stinkwort Ltd. Direct materials Direct Labour Production overhead

Units 5,000

£ 16,560 7,360 5,520 29,440

Of the 5,000 units, 4,000 were completed and 1,000 were 60% complete. £ The value of finished units is The value of closing WIP is Complete the process account below for Stinkwort Ltd. Process Account

In this example it was assumed that unfinished work was completed to the same extent for labour and materials. In reality, however, it may be the case that all materials have been added but only a portion of the labour (or any variation on this theme). The next exercise illustrates how this might be accounted for.

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Exercise 7: In a given period the production data and costs for a process were: Production

2100 fully complete 700 partly complete

Degree of completion of the partly complete units was: Materials 80% Labour 60% Overheads 50% The costs for the period were: Materials £24,800 Labour £16,750 Overheads £36,200 Calculate the total equivalent production, the cost per complete unit and the value of the WIP.

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Exercise 8: A chemical compound is manufactured as a result of two processes. Details for the second process – Process B – for the month of July are as follows: Opening WIP Materials transferred from Process A Labour cost Overheads Output transferred to finished goods Closing WIP

Nil 10,000 kg valued at £40,500 1,000 hrs paid at £5.616 per hour 50% of labour cost 8,000 kg 900 kg

Quality control checks at the end of the process normally lead to a rejection of 10%. Closing WIP is 100% complete for material content and 75% complete for both labour and overheads. Prepare the Process B account for July showing your workings.

In this question you have had to deal with losses and WIP. You will NOT have both in the same question in the examination at this level. You will at paper F5. www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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Opening work in progress We have been able to calculate the value of the closing work-in-progress using the degree of completion. As this is at the end of the period, we can assume that it is therefore the opening work-in-progress at the beginning of the next period. There are two methods for doing this – weighted average and FIFO. Weighted average method takes the total for each element of cost and this is divided by the equivalent units to find the cost per equivalent unit as previously calculated. FIFO method assumes that we complete the opening work-in-progress prior to starting on any new production. This method is preferred by the examiner. If not stated, we must look at the information given in the question to decide which method to use For weighted average method we require that the value of the opening workin-progress be broken down into each element of cost i.e. materials, labour, conversion etc. Statement of equivalent units Units of output x 100% + closing work-in-progress x % + abnormal loss x % if given (usually treated as 100%) abnormal gain x % if given (usually treated as 100%) = total equivalent units Valuation: Take each cost + share of work-in-progress and divide by total equivalent units. This gives cost per equivalent unit. Multiply cost per equivalent unit by units from statement of equivalent units to find valuation for process account. For FIFO method we require that the degree of completion (%) for each element of cost in opening work-in-progress is given. Statement of equivalent units Units of output x 100% opening work-in-progress x % of completion = equivalent units completed in period + closing work-in-progress x % + abnormal loss x % if given (usually treated as 100%) abnormal gain x % if given (usually treated as 100%) = total equivalent units  London School of Business and Finance 2009

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Valuation: Divide the cost for each expense by the total number of equivalent units to find cost per equivalent unit. To value output – multiply equivalent units completed in period by cost per equivalent unit. Then add the total value of opening work-in-progress brought forward. Valuation of abnormal loss or gain is as for weighted average method. PLEASE NOTE – I have included abnormal losses and gains in these calculations. At this level you will NOT be examined on losses/gains and WIP in the same question. You will however, be examined on them at F5 and so I have included them here to get you used to where they appear. Exercise 9: Imagine the following information is available Opening WIP Added units Closing WIP Finished units

500 units (60% complete) 1,000 units 300 units (50% complete) 1,200 units

£ 3,000 £10,500

Using the information above, write up the process account for the period using: AVCO FIFO

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Exercise 10: A company manufactures a product that requires two separate processes for its completion. Output from Process 1 is immediately input into Process 2. The following information is available for Process 2 for a period: (i)

Opening work-in-progress units: 12,000 units: 90% complete as to materials, 50% complete as to conversion costs.

(ii)

Opening work-in-progress value: Process 1 output £13,440 Process 2 materials added £4,970 Conversion costs £3,120

(iii)

Costs incurred during the period Process 1 output £107,950 (95,000 units) Process 2 materials added £44,000 Conversion costs £51,480

(iv)

Closing work-in-progress units: 10,000 units: 90% complete as to materials, 70% complete as to conversion costs.

(v)

The product is inspected when it is complete. 200 units of finished products were rejected during the period, in line with the normal allowance. Units rejected have no disposal value.

a. Prepare the Process 2 account using weighted average method. b. Prepare the Process 2 account using FIFO method.

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Joint and by-products Quite often when materials are input into a process, more than one product emerges. These are then known as ‘joint products’. “Two or more products separated in processing, each having a sufficiently high saleable value to merit recognition as a main product.” Joint costs

Product A

Process 1 Process 1

Product B Sometimes a product is made by accident or we discover we sell the wastage as a product. This is then known as a ’by-product’. “A product that is produced from a process, together with other products, that is either of insignificant quantity or insignificant sales value.” To distinguish between joint products and by-products: •

A joint product is an important saleable item. Production is geared to producing it.

A by-product is something produced which is a bonus to the company. It would not be produced as a main product.

Sometimes we are in a situation where we can sell our output from a process or we can process it further and sell other products a later stage. B Joint costs Process 1

Process 2

C D

A sold after process 1 Treatment of by-products and joint costs Up to the ‘split-off’ point all costs are classed as common or joint. They have to be shared between all joint products. After this point the additional costs have to be allocated to the various products.

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The main problem is of the need to split the joint or common costs between the joint products to enable us to cost them efficiently. There are two main methods used to spit these costs: 1. Physical quantities - The costs are apportioned in proportion to their physical weight or volume of production. 2. Sales value - The costs are apportioned in proportion to the sales value of production or the final sales value after further processing costs have been removed. Accounting for by-products is similar to accounting for normal losses; credit any income received to the process account and deduct this value form the total cost before apportioning the costs over the good production. Exercise 11: A process produces the following products: Product Quantity (Kg) Selling price / kg X 100,000 £1 Y 20,000 £10 Z 80,000 £2.25 The costs incurred in the process prior to the separation point were £240,000. Apportion the joint costs to each product using: a) Physical units basis b) Sales value basis. Exercise 12: Four joint products arise from a process. Total joint costs are £16,500 and outputs and selling prices are as follows: A B C D

200 kgs @ £20 300 kgs @ £14 500 kgs @ £18 100 kgs @ £30

Apportion the joint costs using: a) The physical units basis b) The sales value basis. When further processing has to be taken into account it is sometimes helpful to draw a small diagram and annotate the costs on to it.

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Exercise 13: PCC Ltd produces two joint products from a single process. Joint processing costs of £150,000 are incurred up to the split-off point, when 100,000 units of Pee and 50,000 units of Cee are produced. The selling prices at spilt-off point are £1.25 per unit for Pee and £2 per unit for Cee. The units of Pee could be processed further to produce 60,000 units of a new chemical Peeplus, but at an extra fixed cost of £20,000 and variable cost of 30p per unit of input. The selling price of Peeplus would be £3.25 per unit. Ascertain whether the company should sell Pee or Peeplus. Exercise 14: At the end of manufacturing in Process 1, Product K can be sold for £10 per litre. Alternatively product K could be further processed into product KK in Process 2 at an additional cost of £1 per litre input into this process. Process 2 is an existing process with spare capacity in which a loss of 10% of the input volume occurs. At the end of the further processing, product KK could be sold for £12 per litre. Which of the following statements is correct in respect of 9,000 litres of product K? A. B. C. D.

Further processing into product KK would increase profits by £9,000. Further processing into product KK would increase profits by £8,100. Further processing into product KK would decrease profits by £900. Further processing into product KK would decrease profits by £1,800.

Read the relevant chapter in your text book. Attempt the questions in sections 10 and 11 (pages 27 – 32) in your practice kit.

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HOMEWORK QUESTIONS QUESTION 1: A company operates a process costing system using the first in first out (FIFO) method of valuation. No losses occur in the process. The following data relate to last month: Opening work in progress Completed during the month Closing work in progress

Units Degree of completion 100 60% 900 150 48%

Value £680

The cost per equivalent unit of production for last month was £12. What was the value of the closing work in progress? A £816 C £936 B £864 D £1,800 What was the total value of the units completed last month? A B

£10,080 £10,320

C D

£10,760 £11,000

QUESTION 2: Saphir Ltd operates a process which creates two joint products, X and Y, in the ratio of 7 : 5 by weight. No stocks of work in progress are held in the process and there is a normal process loss equal to 5% of input. Losses have a realisable value of £2 per kg. The following information relates to the process for last month: 10,000 kg of raw materials with a total cost of £18,750 were input into the process and the direct labour costs were £50,000. Overheads were absorbed at a rate of 140% of direct labour. The actual loss was 400 kg. Joint production costs are apportioned to products using the sales value method. Selling prices of the joint products are: Product X Y

Selling price per unit £25·00 £37·50

(a) Prepare the process account for last month in which both the output weight and value for each of the joint products are shown. (b) Explain briefly the characteristics of a by-product.

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QUESTION 3: Information relating to two processes (F and G) was as follows: Process Normal loss as Input Output % of input litres litres F 8 65,000 58,900 G 5 37,500 35,700 For each process, was there an abnormal loss or an abnormal gain? A B C D

Process F Abnormal gain Abnormal gain Abnormal loss Abnormal loss

Process G Abnormal gain Abnormal loss Abnormal gain Abnormal loss

QUESTION 4: In a process where there are no work-in-progress stocks, two joint products (J and K) are created. Information (in units) relating to last month is as follows: Product Sales Opening stock of Closing stock of finished goods finished goods J 6,000 100 300 K 4,000 400 200 Joint production costs last month were £110,000 and these were apportioned to joint products based on the number of units produced. What were the joint production costs apportioned to product J for last month? A B

£63,800 £64,000

C D

£66,000 £68,200

QUESTION 5: If the losses in a process account were toxic and the company incurred costs in safely disposing of them, state how the disposal costs associated with the normal loss would have been recorded in the process account. No calculations are required.

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Unit 7: BUDGETING At the end of this session you will have learned how to do the following: 1. Identify the key or limiting factor for budgets. 2. Prepare functional budgets for sales, production, materials (usage and purchases), labour (hours and cost). 3. Utilise planning techniques by production of cash budgets. 4. Differentiate between fixed and flexible budgets. 5. Prepare flexible budgets and identify variances between budget and actual costs and revenues.

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Introduction A budget is defined as 'a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities and cash flows for a forthcoming accounting period’. Budgets are prepared for a number of reasons: 1) To set and communicate targets. 2) To establish a standard against which actual performance can be compared. 3) To co-ordinate inter and intra functional activities. Both functional budgets and a master budget can be prepared. Typical functional budgets include: ♦ ♦ ♦ ♦ ♦ ♦

Sales Budget Sales Overhead Budget Production Budget Materials Usage Budget Materials Purchase Budget Labour Budget

The master budget has three elements: Budgeted income statement Cash budget Budgeted balance sheet Budget construction is commonly overseen by a BUDGET COMMITTEE who often produce a BUDGET MANUAL. This commonly contains information on the following: 1) The objectives behind the budgeting process. 2) A list of organisational structures, including the major budgets (and their interrelationships), together with those responsible for controlling them. 3) Procedural and administrative information on budget preparation.

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Budget Preparation Before the Master Budget can be prepared functional budgets have to be completed. Given that functional budgets are inter-related, changes in one budget can engender changes in several others. The process is iterative and can be very time consuming. The budgeting process begins with identifying the PRINCIPAL BUDGET factor i.e. the factor limiting the activities of a company. The budget containing this limiting factor is the one to be constructed first as it controls all others. In most cases the principal budget factor is sales demand i.e. levels of production /service provision are controlled by levels of demand. Equally, however, availability of cash, labour, machine time and raw materials can all become the principal budget factor Sales Budgets Sales budgets are relatively straightforward to construct. Exercise 1: Creating a sales budget Dahlia Limited makes three products Collerette, Pompom and Cacti Budgeted Sales Collerette Pompom Cacti

2,000 @ £100 4,000 @ £130 3,000 @ £150

Using the information above complete the sales budget template:

Collerette

Pompom

Cacti

Total

Sales Volume Unit price Total Value

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Production Budgets Production Budgets can only be constructed once sales budgets have been completed and decisions made over planned stocks of finished goods. Exercise 2: Planning Production In addition to the sales figures given in Exercise 1, Dahlia Ltd intend to have the following stocks of finished goods. Finished Stock Budget

Opening Stock Units Closing Stock Units

Collerette

Pompom

Cacti

500 600

800 1,000

700 800

Using this information, complete the production budget for Dahlia Ltd. Collerette

Pompom

Cacti

Sales Units Closing stock Less Opening Stock Production Units

Material Usage and Purchase Budgets As this series of exercises based on Dahlia Ltd illustrates, functional budgets are interrelated to each other, and materials usage and purchase budgets are no different. A materials purchase budget can only be completed once a usage budget has been finalised, together with decisions regarding stocks of raw materials. In turn raw material usage cannot be completed until production figures are known.

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Exercise 3: How much material do we need? In exercise 2 you should have found that the company intends to manufacture the following number of each product. Production Units

Collerette 2,100

Pompom 4,200

Cacti 3,100

The following information on materials is available: Raw Material Usage M1 Collerette Pompom Cacti

5 3 2

M2 kg/unit 2 2 1

M3

Cost per kg

£5

£3

£4

M1 kg

M2 kg

M3 kg

21,000 18,000

10,000 9,000

16,000 12,000

2 3

Raw Materials Stock

Opening stock Closing

kgs Usage of M1 Usage of M2 Usage of M3 kgs

Value (£)

Purchases of M1 Purchases of M2 Purchases of M3

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Other Functional Budgets In addition to the functional budgets produced here it is possible to produce other functional budgets, including those for labour and overheads. As with other functional budgets there is a strong degree of inter-linkage. Exercise 4: Labour Budget Production figures for Dahlia Ltd's three products were as follows: Production Units

Collerette 2,100

Pompom 4,200

Cacti 3,100

The following information on labour usage is also available Hours per unit Hourly rate

Collerette 4 £8.50

Pompom 6 £8.50

hrs

Cacti 8 £8.50

Value (£)

Labour usage for the Collerette Labour usage for the Pompom Labour usage for the Cacti

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Exercise 5: Johnson Ltd manufactures two products, A and B, and is preparing its budget for 200X. Both products are made by the same grade of labour, grade Q. The company currently holds 800 units of A and 1,200 units of B in stock, but 250 of these units of B have just been discovered to have deteriorated in quality and must therefore be scrapped. Budgeted sales of A are 3,000 units and of B 4,000 units provided that the company maintains finished goods stocks at a level equal to 3 months’ sales. Grade Q labour was originally expected to produce one unit of A in two hours and one unit of B in three hours, at an hourly rate of £7.50 per hour. In discussions with trade union negotiators, however, it has been agreed that the hourly wage rate should be raised by 50p per hour provided that the times to produce A and B are reduced by 20%. Produce the production budget and direct labour budget for 19X9.

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Sometimes we have to take account of inefficiencies in production. We may lose some material or have a workforce which does not work at the required rate. Exercise 6: Truro Ltd manufactures a single product Q, with a single grade of labour. Its sales budget and finished goods stock budget for period 3 of 19X8 are as follows: Sales Opening stocks, finished goods Closing stocks, finished goods

700 units 50 units 70 units

The goods are inspected only when production work is completed and it is budgeted that 10% of finished work will be scrapped. The standard direct labour hour content of product Q is 3 hours. The budgeted productivity ratio for direct labour is only 80% (which means that labour is only working at 80% efficiency). The company employs 18 direct operatives who are expected to average 144 working hours each in period 3. Required: a) Prepare a production budget. b) Prepare a direct labour budget. c) Comment on the problem that your direct labour budget reveals, and suggest how this problem may be overcome.

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Flexible Budgets To this point the notes have examined the production of fixed budgets i.e. no account is taken of possible variation in budgeted levels of activity. Flexible budgets take into account possible variation in levels of activity and costs. They are defined as ‘a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes’. Flexible budgets are relatively straightforward to produce as they use the principles of marginal costing. Calculating fixed costs and fully variable costs is straightforward. However, care must be taken when dealing with semivariable costs i.e. costs that have a fixed and a variable element. Remember that semi-variable costs can be broken down into their fixed and variable elements by using the High-Low method. Exercise 7: Flexing a budget The following information for Artichoke Ltd is available. The company's directors are concerned by the large difference between budgeted and actual activity. They have asked you to produce a flexible budget and to present meaningful variances.

Sales Less Direct Materials Direct Labour Fixed Production overheads Gross Profit Less Variable Selling cost Fixed selling cost Profit

Budget 3,000 units £ 90,000

Flexed 4,000 units

30,000 15,000 2,500

Actual 4,000 units £ 110,000 45,000 20,000 2,300

42,500

42,700

3,000 1,500 38,000

4,000 2,000 36,700

Read the relevant chapter in your text book. Attempt the questions in section 13 (pages 36 – 38) of your practice kit.

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HOMEWORK QUESTIONS Question 1: Jane Ltd sells office equipment and is preparing its budget for October 2007.

BAX DAX FAX

Opening stock

Budgeted sales

63 36 90

290 120 230

Selling price (£) 120 208 51

Closing stock is 30% of sales. All 3 products are made using Materials A and B and Labour Grade C and D. The quantities are as follows:

BAX DAX FAX Cost

Material A 4 5 2 £12/mtr

Material B 2 3 1 £7/litre

Labour C (hrs) 3 5 2 £4 per hr

Labour D (hrs) 2 8 £6 per hr

Jane’s opening stock of Material A is 142 metres and 81 litres of Material B. They intend to increase this during October, so that there are sufficient raw materials to produce 50 units of each item of equipment. a. What are the budgeted sales for the period? b. How many FAX’s were to be produced during the month of October? c. How much of material A was used during the month? d. What was the cost of labour for the month? e. What quantity of Material A was purchased during October? f. What was the gross profit for the period?

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Unit 8 - CVP ANALYSIS

At the end of this session you will be able to: •

Calculate the contribution per unit of a good or service

Calculate the contribution to sales ratio (C/S)

Be able to draw a break-even chart and profit/volume chart.

Identify the break-even point by using: o Break-even chart o Profit/volume chart o Mathematical technique

Forecast sales required to be able to earn a required profit

Identify and calculate the margin of safety

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BREAK-EVEN ANALYSIS (CVP ANALYSIS) CVP analysis is a technique which uses cost behaviour to identify the level of activity at which we have no profit or loss (break-even point). It can also be used to predict the profits or losses to be earned at varying activity levels (using the assumed linearity of costs and revenues). CVP analysis assumes that selling prices and variable costs are constant per unit regardless of the level of activity and that fixed costs are just that – fixed. In order to calculate these levels we need to consider the contribution provided by each unit of production. Contribution is the term given to the difference between the selling price and the variable costs which contributes first towards paying the fixed costs and then towards providing profit. The price of each unit we sell consists of three (3) parts. a. the variable element which is incurred for each unit of production. b. the fixed element which varies according to the number of units made. If the units increase, the amount of fixed costs per unit required will decrease. c. the profit element. If we are to calculate the break-even point let us first imagine that the fixed costs are a large hole in the ground. What we need to find out is how many contributions it takes to fill that hole. Similarly the profit we require is the pile on top of the hole. How many contributions does it take to reach the required height? Formulae required (not given in exam): Unit contribution = Selling price per unit – Variable cost per unit Total contribution = Unit contribution x volume Break-even point (units) =

Fixed costs Unit contribution

Contribution target = Fixed costs + Target profit Volume target =

Contribution target Unit contribution

We can use these formulae to calculate our break-even point. Alternatively we can use either a traditional break-even chart or a profit/volume chart.

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BREAK-EVEN CHART: Costs and revenues

Sales revenue

Total costs Profit

Fixed costs Margin of safety Sales activity Break-even point PROFIT/VOLUME CHART: A break-even chart shows the costs and revenues at a number of activity levels. It does not however, show the amount of profit or loss at these levels. This is shown on the profit/volume chart.

Profit

Total profit

Break-even point

Loss Fixed costs (total loss)

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From this chart we can read off the amount of profit or loss for any level of activity. 1. The x axis represents sales (units or values) 2. The y axis shows profits above the x axis and losses below. 3. When sales = zero, the net loss is equal to the fixed costs. 4. If variable cost per unit and total fixed costs are constant throughout the relevant range, the profit/volume chart is shown as a straight line. 5. If there are\changes in either of these costs at various levels of activity, it will be necessary to calculate the profit or loss at each point where the cost structure alters before plotting the points onto the chart. Limitations of break-even analysis: Once costs and revenues have been determined, it is usually assumed that they will have a linear relationship. I.e. o Fixed costs will be constant over the relevant range o Variable costs will vary in direct proportion to volume o Selling price will remain unchanged o The efficiency and productivity of the workforce remain constant. The analysis covers either a single product or a mix of products at which it is assumed that the proportion of each product will remain the same as volume increases or decreases. In constructing a break-even chart, the sales and costs are likely to be valid only in a particular range of activity. This is referred to as THE RELEVANT RANGE. Outside this range the same cost and revenue relationships are unlikely to exist. E.g. An alteration in volume could affect the level of fixed costs (stepped) or the rate of variable costs or selling prices (economies of scale). Exercise 1 Breaking Even and Reaching a Target Profit. A company makes the Daisy. Each Daisy has a variable cost of £4 and a selling price of £9. Fixed costs for the company are £35,000. Given that company wishes to make a profit of £15,000, how many units does it have to: Units Sell to breakeven? Sell to reach its target profit?

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Margin of safety: The margin of safety is the area between the break-even point and the maximum sales. This is the area that the company can operate in and be certain of making a profit. It is usually classed as the amount of sales that a company can afford to lose before it gets into a loss making situation. Knowing that a product breaks even at a certain sales volume is helpful but it can be misleading in certain circumstances. A company makes two products, the breakeven volumes for which are shown below: Product A Product B

500 units 200 units

All other things being equal, which product is most likely to make a profit? It is tempting to state B as it has the lower breakeven point. You should reconsider this in the light of the budgeted sales figures below: Product A Product B

2,000 units 300 units

Breakeven sales are a smaller percentage of budgeted sales for Product A than they are for Product B and as such Product A is much more likely to make a profit. Margin of safety measures the difference between budgeted and breakeven sales and expresses it as a percentage of budgeted sales. It represents how far below budgeted sales actual sales can fall before a loss will be made. Margin of safety = (budgeted sales – breakeven sales / budgeted sales) x 100 Product A (2,000 – 500 / 2,000 x 100 = 75% Product B (300 – 200) / 300 x 100% = 33% Exercise 2 Margin of Safety A company is budgeting to sell 150,000 units at £7,00. Each unit has a variable cost of £4 and the company’s fixed costs are £342,000. What is the margin of safety?

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Quick exercises: 1.

Selling price Variable costs Fixed costs

£3 per unit £1 per unit £500

Calculate the break-even point 2.

If the fixed costs increase by 10% and the company aims to make £200 profit, what output is required?

3.

Assuming the maximum output is 250 units, what selling price would achieve the required profit target of £200 assuming the increased fixed costs?

4.

Budgeted sales Selling price Variable costs Fixed costs

80,000 units £8 £4 per unit £200,000

What would be the break-even point and the margin of safety? Contribution / sales ratio The above calculations are useful in calculating the break-even point of one unit of production. If a company makes more than one product it may be better to calculate the C/S ratio. C/S ratio =

Unit contribution Unit sales

or

Total contribution Total sales

A product having a sales price of £10 and unit contribution of £4 would have a C/S ratio of: £4 / £10 = 0.4 This means that forty pence of every pound of sales revenue is contribution. Breakeven sales revenue can then be calculated as: Fixed Costs / C/S Ratio

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Exercise 3 C/S Ratio Penstemon Ltd make a product, the Sepal Each Sepal sells for £15 and has a variable cost of £6. Total fixed costs are £198,000. The company is budgeting to sell 66,000 units. Unit contribution is:

£

C/S Ratio is: Breakeven revenue is

£

Margin of safety is:

£

Exercise 4: The following details relate to a shop which currently sells 25,000 pairs of shoes annually. Selling price per pair Purchase cost per pair Total annual fixed costs: Salaries Advertising Other fixed expenses

£40 £25 £100,000 £40,000 £100,000

Answer each part independently of data contained in other parts of the requirement. a) Calculate the break-even point and margin of safety in number of pairs of shoes sold. b) Assuming that 20,000 pairs of shoes were sold in a year, estimate the shop’s net income or loss. c) If a selling commission of £2 per pair of shoes sold was introduced, how many pairs of shoes would need to be sold in a year in order to earn a net income of £10,000? d) Assume that for next year an additional advertising campaign costing £20,000 is proposed, whilst at the same time selling prices are to be increased by 12%, what would be the break-even point in number of pairs of shoes?

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Read the relevant chapter in your study text. Attempt the questions in section 17 (pages 47 – 52) in your practice kit. HOMEWORK QUESTIONS QUESTION 1: A company manufactures a single product with a variable cost per unit of £22. The contribution to sales ratio is 45%. Monthly fixed costs are £198,000. What is the breakeven point (in units)? A B

4,950 9,000

C D

11,000 20,000

QUESTION 3: A company manufactures and sells a single product. The following data relate to a weekly output of 2,880 units: £ per unit Selling price Less costs: Variable production Other variable Fixed

£ per unit 80

30 10 25 —– (65) —– 15 —–

Profit What is the weekly break-even point (in units)? A B

1,900 1,440

C D

1,800 4,800

QUESTION 4: An organisation manufactures a single product which is sold for £60 per unit. The organisation’s total monthly fixed costs are £54,000 and it has a contribution to sales ratio of 40%. This month it plans to manufacture and sell 4,000 units. What is the organisation’s margin of safety this month (in units)? A B

1,500 1,750

C D

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2,250 2,500

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QUESTION 5: The following diagram represents a profit/volume chart for an organisation: Total cost

H 0

Output G

At the specific levels indicated, what do the lines ‘G’ and ‘H’ represent? A. B. C. D.

Line G Loss Loss Contribution Contribution

Line H Profit Contribution Profit Contribution

QUESTION 6: A company has three shops (R, S and T) to which the following budgeted information relates:

Sales Contribution Less Fixed costs Profit/(loss)

Shop R Total £000 400 100 (60) 40

Shop S £000 500 60 (70) (10)

£000 600 120 (70) 50

Shop T £000 1,500 280 (200) 80

60% of the total fixed costs are general company overheads. These are apportioned to the shops on the basis of sales value. The other fixed costs are specific to each shop and are avoidable if the shop closes down. If shop S is closed down and the sales of the two other shops remain unchanged, what would be the revised budgeted profit for the company? A. £50,000 B. £60,000

C. £70,000 D. £90,000

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Unit 9: LIMITING FACTORS; SCARCE RESOURCES; LINEAR PROGRAMMING; RELEVANT COSTS

At the end of this session you will have learned how to do the following: 1. Calculate the limiting factor of the organisation. 2. Assess the most profitable use of the limiting factor 3. Prioritise production, utilising the prioritisation rankings and any other known constraints. 4. Calculate the contribution (and profit) earned by this production mix. 5. Use linear programming to identify the most profitable use of resources when we have more than one limiting factor/constraint. 6. Draw a linear programming graph and identify the optimum production point by manipulating the objective function. 7. Identify relevant costs to be charged to a contract.

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LIMITING FACTORS (SCARCE RESOURCES) Within most business organisations there are not enough resources available to fulfil all the plans of the organisation. The factor which is in short supply is known as the ‘limiting factor’. When an organisation is short of a resource it has to make decisions regarding its production scheduling so as to make the best use of that resource. Typically the limiting factor is the forecast level of sales. In some circumstances, limited supply of labour or machine time could govern the level of output. Questions at this level, assume that a company wishes to maximise its return on the resources it has available. Limiting factor analysis is the technique used to calculate the mix of products that should be made to maximise return on a single limiting factor. Take the two products below. Which one should the company make to maximise its return on scarce machine hours? Red £ Unit Sales Price 40 Unit Variable Cost 10 Contribution 30 Unit Fixed cost 20 Unit Profit 10

Herring £ 80 20 60 20 40

It is tempting to state the Herring due to its higher unit profit. However, this could be the wrong suggestion for two reasons: Profit should not be used as its calculation includes fixed costs that do not change as the result of the decision. Furthermore, the apportioning of fixed cost between products could be quite arbitrary. Contribution should be used. Even if contribution is used the wrong decision can still be made. Contribution per unit of product does not take into account the amount of scarce resource used to generate that contribution. Decisions on production priorities should be made using the contribution generated per unit of scarce resource used – in this case contribution per machine hour.

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Imagine if 1,000 machine hours are available and each Red takes 1 hour and each Herring 3 hours.

Unit Sales Price Unit Variable Cost Contribution Machine hrs Contribution per hour Total hours available Total contribution

Red £ 40 10 30 1 30 1,000 £30,000

Herring £ 80 20 60 3 20 1,000 £20,000

METHOD OF WORKING a. If not stated, calculate the limiting factor b. Find the contribution per unit of each product by deducting variable cost from selling price. c. Calculate the contribution per unit of limiting factor by dividing the contribution per unit by the units of limiting factor required to make each product. d. Rank these in order of priority. e. Prepare a production schedule showing how many units of each product you are going to make taking account of priorities and prior contracts etc. f. Calculate the total contribution earned by this production. g. If required, deduct fixed costs to find the profit achieved in the period.

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Exercise 1: A company makes three products, details of which are given below: Demand Unit price Variable cost Labour hours

Speedwell 1,000 units £ 50 10 4

Nettle 1,000 units £ 70 50 1

Liatris 1,000 units £ 50 25 2

Total fixed costs for the company are £7,500. There are 1,800 hours available How much of each product should be made to maximise profit for the company? Units of Speedwell Units of Nettle Units of Liatris

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Exercise 2: X Ltd makes three products, A, B and C, of which unit costs, machine hours and selling prices are as follows:

Machine hours

A 10

B 12

C 14

Direct materials @ 50p/kg Direct wages @ 75p/hr Variable overheads Marginal cost Selling price Contribution per unit

£ 7 9 3 19 25 6

£ 6 6 3 15 20 5

£ 5 3 3 11 15 4

Sales demand for the period is:

4,000 6,000 6,000

As a matter of company policy it is decided to produce a minimum of 1,000 units of Product A. The supply of materials in the period is unlimited but machine hours are limited to 200,000 and direct labour hours to 50,000. Indicate the production levels that should be adopted for the three products in order to maximise profitability, and state the maximum contribution that would be achieved. Note: In this question we have a prior commitment that has to be honoured before we can proceed with our production scheduling.

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Exercise 3: X Ltd manufactures 4 liquids – A, B, C and D. The selling price and unit cost details for these products are as follows: A £/litre 100

B £/litre 110

C £/litre 120

D £/litre 120

Direct materials Direct labour (£6/hr) Direct expenses Variable overhead Fixed overhead

24 18 12 24

30 15 10 20

16 24 3 16 32

21 27 18 36

Profit

22

35

29

18

Selling price

Fixed overhead is absorbed on the basis of labour hours, based on a budget of 1,600 hours per quarter. During the next 3 months the number of direct labour hours is expected to be limited to 1,345. The same labour is used for all products. The marketing director has identified the maximum demand for each of the 4 products during the next 3 months as follows: A 200 litres B 150 litres C 100 litres D 120 litres These maximum demand levels include the effects of a contract already made between X Ltd and one of its customers, Y Ltd, to supply 20 litres each of A, B, C and D during the next 3 months. You are required to: a. Determine the number of litres of products A, B, C and D to be produced/sold in the next 3 months in order to maximise profits? b. Calculate the profit that this would yield.

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LINEAR PROGRAMMING Linear programming is a graphical technique used to identify the profit maximising production levels when there is more than one limiting factor (constraint). In order to be able to use this technique there must be a linear relationship between the variables. The best way of describing this technique is by means of an example. Exercise 4: A company makes and sells two products X and Y. It has a shortage of labour which is limited to 20,000 hours per annum. This is insufficient to satisfy the full demand for both products. The unit costs, contributions and labour hours are as follows: Product X

Selling price Variable cost

5 £ 80 50

Product Y 10 £ 100 50

Contribution

30

50

Labour hours per unit of output

The company can sell any number of product Y but expects the maximum annual demand of X to be 3,000 units Method: 1. Define the unknowns – the variables which must be considered. Let x = number of units of X produced and sold Let y = number of units of Y produced and sold 2. Formulate the constraints – the limitations to be placed on the variables. This means expressing them as a mathematical equation. Labour hours 5x + 10y ≤ 20,000 Maximum sales x ≤ 3,000 Non-negativity x, y ≥ 0 3. Formulate the objective function (what we want to maximise). This is usually to maximise contribution. Maximise

30x + 50y

4. Graph the constraints and objective function.

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We need to transfer these figures onto the graph by means of drawing straight lines which relate to the constraints already determined. 5. Identify the “feasible region”. This is the area where production is a feasible option. 6. Establish the optimum point using the graph or simultaneous equations. To find the optimum point, place a clear ruler along the objective function. Slide the ruler outwards from the origin, staying parallel to the objective function. The last point in the feasible region to cross the leading edge of the ruler is the optimum point. Exercise 5: A builder has purchased 21,000 square metres of land on which he plans to build two types of houses, detached and town-houses, within an overall budget of £2.1 million. A detached costs £35,000 to build and requires 600 square metres of land. A town house costs £60,000 to build and requires 300 square metres of land. To comply with local planning regulations, not more than 40 buildings may be constructed on this land, but there must be at least 5 of each type. From past experience the builder estimates the contribution on the detached to be about £10,000 and on the town house to be about £6,000. Contribution is to be maximised. Required: Write down the objective function. Write down the constraints of the problem. Graph these constraints and shade the feasible region. Determine the numbers of each type of house to be built to achieve the objective of maximising contribution.

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Relevant Costs and Revenues Relevant costing decisions are based on an analysis of what changes as the result of a decision – not total cost or total revenue but change in total cost and revenue. Exercise 6: A company makes moulds and estimates that it standard product costs £1,500 to make. At present there is spare capacity in the factory and the owners are searching for additional business. A small local company has offered to buy 10 moulds for £900 each. Should the company accept the offer? On the face of it the answer is clear. If each pump costs £1,500 and they can only sell them for £900, there is little point in their manufacture. However, using relevant costing the problem would be approached from a different angle. How does total cost change if one more pump is built? How does total revenue change if one more pump is sold? Imagine the following breakdown of mould cost is available. Materials Labour Fixed Production Overheads Total

£ 500 300 700 1,500

Making one more mould will incur an additional £500 of materials and £300 of labour. However, factory overheads will not change, as they are all fixed costs. The relevant (extra) cost of making one more mould is therefore £800. If the mould is sold, the company will receive £900. Relevant revenue Less Materials Labour Contribution

£ 900 (500) (300) 100

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Since sale of the mould makes a positive contribution the company should go ahead with the contract. This £100, although not profit, will contribute towards paying the company’s fixed costs. So what are relevant costs/revenues? Relevant costs and revenues are simply cash flows that arise as the result of a decision. If a cash flow if unaffected by a decision then it is not relevant. Relevant cash flows are future cash flows. In the example of the mould development costs for the product are not taken into account. They are sunk (historical costs) that will not be changed as a result of a decision. Relevant cash flows are incremental cash flows The quarterly bill for materials used to make moulds could be £50,000. Increasing the number of moulds produced by one unit increases the bill to £50,500. The relevant cost of the extra mould is neither £50,000 nor £50,500. It is the change in total material costs triggered by the decision to make one more mould - £500. Committed costs are not relevant Before the new contract for additional moulds arose the company was due to pay a labour bill of £7,000 at the end of the month. This is not a relevant cost as it will have to be paid regardless of the company’s decision regarding the extra moulds i.e. the company is committed to paying the wages irrespective of the decision being made. Relevant costs can be opportunity costs A company has a limited supply of materials. If it uses them to make moulds it cannot also make plastics. For every mould made the company loses contribution on plastics worth £200. This is a relevant cost i.e. it is a cash inflow that does not arise as the result of a decision to manufacture moulds.

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Exercise 7: A company has 600kgs of material in stock that cost £50/kg three years ago. To replace the material would cost the company £60/kg. Relevant Cost £ At present the company does not have a use for the materials. If it receives a one-off order that can use the material, what is the relevant cost per kg? At present the company does not have a use for the materials. However, it can sell the materials at £5/kg to a local scrap merchant. If it receives a one-off order that can use the material what is the relevant cost per kg? The company currently uses the materials in all of its products. It can sell the materials for £5 per kg to a local scrap merchant. If the company uses a kg of the materials in a product what is the relevant cost?

Read the relevant chapters in your study text. Attempt questions in sections 18 and 19 (pages 52 – 57) of your practice kit.

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HOMEWORK QUESTIONS QUESTION 1: A company, which manufactures four components (A, B, C and D) using the same machinery, aims to maximise profit. The following information is available: Component A

B

Variable production cost per unit (£) 60 Purchase cost per unit from an outside supplier (£) 100 Machine hours per unit to manufacture 4

C

D

64

70

68

120

130

110

7

5

6

As it has insufficient machine hours available to manufacture all the components required, the company will need to buy some units of one component from the outside supplier. Which component should be purchased from the outside supplier? A Component A B Component B

C Component C D Component D

QUESTION 2: A company manufactures two products (L and M) using the same material and labour. It holds no stocks. Information about the variable costs and maximum demands are as follows:

Material (£4 per litre) Labour (£7 per hour) Maximum monthly demand

Product L £/unit 13 35

Product M £/unit 19 28

Units 6,000

Units 8,000

Each month 50,000 litres of material and 60,000 labour hours are available. Which one of the following statements is correct? A B C D

Material is a limiting factor but labour is not a limiting factor. Material is not a limiting factor but labour is a limiting factor. Neither material nor labour is a limiting factor. Both material and labour are limiting factors.

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QUESTION 3: A company manufactures and sells two products (X and Y) which have contributions per unit of £8 and £20 respectively. The company aims to maximise profit. Two materials (G and H) are used in the manufacture of each product. Each material is in short supply – 1,000 kg of G and 1,800 kg of H are available next period. The company holds no stocks and it can sell all the units produced. The management accountant has drawn the following graph accurately showing the constraints for materials G and H.

Product Y (units)

100 Material G 90

Material H

0

125

150 Product X (units)

What is the amount (in kg) of material G and material H used in each unit of product Y? Material G Material H A 10 20 B 10 10 C 20 20 D 20 10 What is the optimal mix of production (in units) for the next period? A B

Product X 0 50

Product Y 90 60

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C D

60 125

50 0

QUESTION 4: JWW Ltd manufactures two products, X and Y, and any quantities produced can be sold for £60 per unit and £25 per unit respectively. Variable costs of the two products are:

Materials (at £5 per kg) Labour (at £6 per hour) Other variable costs Total

X £ per unit 15 24 6 ––– 45 –––

Y £ per unit 5 3 5 ––– 13 –––

Next month only 4,200 kg of material and 3,000 labour hours will be available. The company holds no stocks and aims to maximise its profits each month. (a) State the objective function and constraints in a form suitable for solving by linear programming. (b) Determine the optimal production plan for next month (in units).

QUESTION 5: The following graph relates to a linear programming problem: y (3) (2)

(1)

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x Page 125


The objective is to maximise total contribution and the dotted line on the graph depicts this function. There are three constraints, which are all of the ‘less than or equal to’ type which are depicted on the graph as the three solid lines labelled (1), (2) and (3). At which of the following intersections is total contribution maximised? A. Constraint (3) and the x axis B. Constraint (2) and constraint (3) C. Constraint (1) and constraint (2) D. Constraint (1) and constraint (3)

QUESTION 6: Which of the following statements correctly describes the shadow price of a resource in linear programming? A. The minimum sum payable for one more unit of the scarce resource B. The maximum sum payable for one more unit of the scarce resource C. The increase in total contribution if one more unit of a non-binding constraint is made available D. The increase in total contribution if one more unit of a binding constraint is made available

QUESTION 7: Merryl Ltd manufactures four components (E, F, G and H) which are incorporated into different products made by the company. All the components are manufactured using the same general purpose machinery. The following production cost and machine hour data are available: Variable production cost (£/unit) Fixed production cost (£/unit) General purpose machine hours per unit

E 32 6 5

F 27 14 6

G 34 8 7

H 35 16 8

The fixed production costs represent a share of factory-wide costs that have been related to the individual components by using a direct labour hour rate. There are no fixed costs which can be specifically related to individual components. From next month the company’s monthly manufacturing requirements are for 2,000 units of each component. The maximum number of machine hours available for component manufacture is 35,000 per month. The company can purchase any quantity of each component from Sergeant Ltd at the following unit prices next month: E - £48

F - £51

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G - £55

H - £63 Page 126


Merryl aims to minimise its monthly costs. a. Calculate the shortfall in general purpose machine hours next month. b. Determine how many units of which components should be purchased from Sergeant Ltd next month c. Identify 3 other factors that the management should consider before making a final decision to buy in components from Sergeant Ltd.

QUESTION 8: Jack Frost Ltd wishes to use a machine for one month on a new contract. The machine cost £100,000 five years ago. When purchased it had an estimated life of ten years and it is being fully depreciated using the straight line method. It is currently valued at £40,000. If we use the machine on this contract its value will have dropped to £15,000 by the end of the year otherwise it will be valued at £25,000. The machine is under-used but must be retained for use on similar contracts. The relevant cost of using this machine on the new contract is?

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Unit 10: STANDARD COSTING AND VARIANCES

At the end of thise session you will have learned how to do the following: 1. Calculate the standard cost per unit of a product. 2. Compare the standard cost with the actual to define the difference (variance). 3. Split the variances into their constituent parts. 4. Reconcile the standard profits with the actual profits through the variances. 5. Identify reasons for variances occurring.

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Introduction A standard cost is a carefully predetermined unit cost that is calculated in advance of production taking place. As such it includes standard amounts of labour at standard cost, standard amounts of materials at standard cost, together with budgeted overheads absorbed at pre-determined rates using budgeted levels of activity. Standard costing is often used to establish expected costs against which actual costs can be compared i.e. a standard cost can be used to establish control over costs. Differences between standard and actual costs are known as variances and the process of analysing differences between actual and standard costs is known as variance analysis.

A typical standard cost card might be as follows: £

£

Direct Material X (2 units) Y (3 units) Z (2 units)

7 8 9 24

Direct Labour Grade 1 (6 hrs) Grade 2 (5 hrs)

80 20

Standard Direct Cost Standard Variable Cost of Production Standard Fixed Cost Standard Factory Cost

100 124 100 50 274

Standard Administration and Selling Overhead Standard Cost of Sale Standard Profit (50%) Standard Sales Price

120 394 197 591

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Types of Standard Standard can be set on a number of bases. Ideal Standard This is the 'perfect' standard i.e. what should be achieved if there is no wastage or loss and the whole production process functions perfectly. This type of standard can act as long-term aspirational target. Attainable Standard These are standards in advance of what is currently being achieved. However, the degree of improvement required to attain the standard is a practical proposition. This form of standard can be very motivational for staff. Current Standard This is the standard an organisation is currently achieving. It does not provide inspiration for improvement but it does provide a benchmark against which to measure day-to-day activity. Basic or Historic Standard This is a standard that was set sometime ago and has not been updated. It allows a company to measure its progress over time.

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Exercise 1: Standard Cost Card Using information in the paragraph below produce a standard cost card for product Callestemon. Each Callestemon uses 2kg of material Q at a standard cost of £30 per kg, 6 hours of labour at £10 per hour. Variable overheads have a standard cost of £15 per hour. The company has fixed production overheads of £20,000 and is budgeting to produce 500 units. A standard profit of £100 is added to cost to determine standard price. £ Materials Labour Overheads Fixed Overheads Standard Cost Standard Profit Standard Price Variance and Variance Analysis Variances can be defined as the 'Difference between a planned, budgeted or standard cost and the actual cost incurred. The same comparisons can be made for revenues’. Analysis of the difference between standard and actual costs is known as VARIANCE ANALYSIS. FAVOURABLE VARIANCES occur when actual results are better than expected, producing higher than expected profits. ADVERSE VARIANCES occur when actual results are worse than expected, producing lower than expected profits.

Actual Results for the Callestemon

Units made and sold Sales revenue Materials 1,144kg bought and used 2,860 hours paid for Variable overheads Fixed overheads

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520 £169,000 £30,880 £30,745 £41,470 £22,000

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Variances are calculated in total (as the variance in flexible budgets). They are then broken down into their constituent parts as per the diagram below. Price Material Usage Rate Labour Efficiency Expenditure Variable overheads Efficiency Expenditure Fixed overheads Capacity Volume Efficiency Price Sales Volume profit

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Direct Materials Cost Variances The difference between expected and actual total costs of direct materials is known as the direct materials variance.

x

Actual quantity purchased

Standard price

x

Actual quantity purchased

Standard price

x

Actual quantity used

Actual price

Price variance

Usage variance Standard price

x

Standard quantity x actual production

You will notice that in many cases the quantity purchased is the same as the quantity used. PLEASE NOTE that if the actual quantity purchased x the actual price is given as a total figure in the question, there is NO need to divide it up. Often this produces figures with decimal places which will be rounded. Multiplying them again will produce an incorrect figure. Exercise 2: Materials Cost Variances Calculate the material cost variances for Callestemon.

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Direct Labour Cost Variances The direct labour cost variance is the difference between what a given level of output cost, in terms of direct labour, and what it was expected to cost, calculated using standard costing. Actual rate

x

Actual hours paid Rate variance

Standard rate

x

Actual hours paid Idle time variance

Standard rate

x

Actual hours worked Efficiency variance

Standard rate

x

Standard hours x actual production

Exercise 3: Labour Cost Variances Calculate the labour cost variances for Callestemon.

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Variable Overhead Variances The total variable overhead variance is the difference between the variable overhead actually incurred and the variable overhead that was expected using standard costing. Actual rate

x

Actual hours worked Expenditure variance

Standard rate

x

Actual hours worked Efficiency variance

Standard rate

x

Standard hours x actual production

Exercise 4: Variable Overhead Variances Calculate the variable overhead cost variances for Callestemon.

You will notice that the three sets of variances we have just calculated all use exactly the same equations. It is only the words that are different.

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Fixed Production Overhead Variances The total fixed production overhead variance can be broken down into expenditure, capacity and efficiency. Actual fixed overheads Expenditure Variance Budgeted fixed overheads Capacity Variance Actual hours at Std Fixed Cost per hour Efficiency Variance Flexed hours at Std Fixed Cost per hour

Exercise 5: Fixed Production Overhead Variances Calculate the fixed production overhead cost variances for Callestemon.

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Sales Variances Differences between standard and actual price, together with differences in sales volume, can give rise to a total sales variance. Actual sales

X Actual price Price Variance

Actual sales

X Standard price

Actual sales

X Standard profit margin Volume Variance

Budgeted sales

X Standard profit margin

The calculation of the volume variance here is often called ‘volume profit’ variance. This is because it is done using an absorption costing system. If we are using a marginal costing system, the variance is known as ‘volume contribution’ variance and we use the standard contribution instead of the standard profit. Exercise 6: Sales Variances Calculate the sales variances for Callestemon.

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Operating Statements Though individual variances provide useful information for management, they can be combined to produce an operating statement that can be used to reconcile budgeted and actual profit. Since an adverse variance brings down profit it is subtracted from budgeted profit in an operating statement. Conversely, each favourable variance puts up profit and should be added to budgeted profit. In the example of Callestemon, budgeted profit was: £100 x 500 = £50,000 Actual profit was: Sales revenue Materials Labour Variable overheads Fixed overheads Actual Profit

£ 169,000 (30,880) (30,745) (41,470) (22,000) 43,905

Exercise 7: Operating Statements Using information on variances, calculated in exercises 1-6, complete the operating statement for Callestemon Ltd. £ Budgeted Profit Sales Volume Variance Standard profit for actual sales volume Sales Price Variance Cost Variances F

A

Materials Price Materials Usage Labour Rate Labour Efficiency Variable Overhead Expenditure Variable Overhead Efficiency Fixed Overhead Expenditure Fixed Overhead Capacity Fixed Overhead Volume Total Actual profit www.ebooks2000.blogspot.com  London School of Business and Finance 2009

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Causes of Variances Variances can arise for a number of reasons. Example reasons are given in the table below. Fill in the grey boxes with further reasons.

Variance Materials Price

Purchase of better quality materials

Material Usage

Use of different quality materials

Labour Rate

Workers claiming overtime

Labour Efficiency

Inexperienced workers used to complete work

Variable Overhead Expenditure Variable Overhead Efficiency Fixed Overhead Sales Price

Sales Promotion

Sales Volume

Competition

Variances can be inter-related. Buying high quality materials will lead to an adverse materials price variance. However, better quality material will improve labour efficiency, leading to a favourable labour efficiency variance. Exam questions might require students to combine their knowledge of cost book keeping and standard costing. The rules are very simple. Resources and finished goods are transferred between T-accounts at standard. Further, variances are recorded in the account in which they first appear. Materials Price Variance Labour Rate Variance Materials Usage Variance Idle Time Variance Labour Efficiency Variance Total Overhead Variances

Stores (materials) Control Account Wages Control Account Work in Progress Account Work in Progress Account Work in Progress Account Overhead Control Account

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Read the relevant chapters in your study text. Attempt questions in sections 14 – 16 (pages 38 – 47) of your practice kit. HOMEWORK QUESTIONS QUESTION 1: A company’s budgeted sales for last month were 10,000 units with a standard selling price of £20 per unit and a contribution to sales ratio of 40%. Last month actual sales of 10,500 units with total revenue of £204,750 were achieved. What were the sales price and sales volume contribution variances? A B C D

Sales price variance (£) 5,250 adverse 5,250 adverse 5,000 adverse 5,000 adverse

Sales volume contribution variance (£) 4,000 favourable 4,000 adverse 4,000 favourable 4,000 adverse

QUESTION 2: A company operates a standard absorption costing system. The standard fixed production overhead rate is £15 per hour. The following data relate to last month: Actual hours worked 5,500 Budgeted hours 5,000 Standard hours for actual production 4,800 What was the fixed production overhead capacity variance? A B

£7,500 adverse £7,500 favourable

C D

£10,500 adverse £10,500 favourable

QUESTION 3: Last month 27,000 direct labour hours were worked at an actual cost of £236,385 and the standard direct labour hours of production were 29,880. The standard direct labour cost per hour was £8·50. What was the labour efficiency variance? A B

£17,595 Adverse £17,595 Favourable

C D

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£24,480 Adverse £24,480 Favourable

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QUESTION 4: Last month a company’s budgeted sales were 5,000 units. The standard selling price was £6 per unit with a standard contribution to sales ratio of 60%. Actual sales were 4,650 units with a total revenue of £30,225 What were the favourable sales price and adverse sales volume contribution variances?

A B C D

Sales price £ 2,325 2,500 2,325 2,500

Sales volume contribution £ 1,260 1,260 2,100 2,100

QUESTION 5: Ploverleigh Ltd, which manufactures a single product, uses standard absorption costing. The standard product cost per unit is as follows: £ Direct materials 11 Direct labour 24 Fixed production overhead 18 Budgeted and actual production for last month were 12,000 units and 12,500 units respectively. The actual costs incurred last month were: Direct materials Direct labour Fixed production overhead

£ 142,700 291,300 230,800

(a)

Prepare a statement that reconciles the standard cost of actual production with its actual cost for last month and highlights the total variance for each of the three cost elements.

(b)

Provide a breakdown of the total fixed production overhead variance in your statement in (a) by calculating two sub variances.

(c)

If Ploverleigh Ltd uses standard marginal costing instead of standard absorption costing, explain how AND why any of the three total variances calculated in (a) would be different and state clearly which, if any, of the variances would remain unchanged. No calculations are required.

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QUESTION 6: The standard direct material cost for a product is £50 per unit (12.5 kg at £4/kg). Last month the actual amount paid for 45,600 kg of material purchased and used was £173,280 and the direct material usage variance was £15,200 adverse. a. Calculate the direct material price variance b. What was the actual production last month?

QUESTION 7: Fairfax Ltd manufactures a single product which has a standard selling price of £22 per unit. It operates a standard marginal costing system. The standard variable production cost is £9 per unit. Budgeted annual production is 360,000 units and budgeted non-production costs of £1,152,000 per annum are all fixed. The following data relates to last month:

Production Sales

Budget units 30,000 32,000

Actual units 33,000 34,000

Last month the budgeted profit was £200,000 and the actual total sales revenue was £731,000. a. Calculate the sales price and sales volume contribution variances for last month showing clearly whether each variance is adverse or favourable. b. Explain how the two variances calculated above could be interrelated. c. Calculate the budgeted profit for last month assuming that the company was using absorption costing.

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Supplement

Solution to exercises

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Unit 1 Exercise 1: High Low

Units 105,000 65,000 40,000

Cost £210,000 £133,000 £ 77,000

Variable cost = £77,000/40,000 = £1.925 per unit Fixed cost = £210,000 – (105,000 x £1.925) = £7,875 Forecast for 165,000 units = £7,7875 + (165,000 x £1.925) = £325,500 CLASS EXERCISES 1. A simple way to identify these would be to assess which are totally variable. T1 = 1,000/125 x 180 = 1,440 T2 = 1,750/125 x 180 = 2,520 T3 = 2,475/125 x 180 = 3,564 T4 = 3,225/125 x 180 = 4,644

Ans = Semi variable Ans = Variable Ans = Semi variable Ans = Variable

Answer = A 2. This diagram shows a variable above a fixed cost. The variable cost decreases after a certain level of activity (slope is less steep). Answer = D 3. From the information give we cannot use the high-low method in its normal form as the fixed cost increases by £5,000. We need to remove this stepped increase first and add it back in any forecasts we make above the limit of 18,000 units. High Low

Units 22,000 17,000 5,000

Cost £165,000 £140,000 £ 25,000

Variable cost = £25,000/5,000 = £5 per unit Fixed cost = £140,000 – (17,000 x £5) = £55,000 Forecast for 20,000 units = £55,000 + (20,000 x £5) + 5,000 = £160,000 Answer = C

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Example 2: 2. High-low method 2,300 – 1,050 900 – 400

=

1,250 500

Variable cost = £2.50 Fixed cost = 2300 – (900 x £2.50) = £50 Forecast for 850 units = 50 + (850 x £2.50) = £2175 3. Regression Month January February March April May June

x

y 1,050 1,700 1,600 2,100 2,000 2,300 10,750

400 600 550 800 750 900 4,000

x2 y2 160,000 1,102,500 360,000 2,890,000 302,500 2,560,000 640,000 4,410,000 562,500 4,000,000 810,000 5,290,000 2,835,000 20,252,500

xy 420,000 1,020,000 880,000 1,680,000 1,500,000 2,070,000 7,570,000

b=

(6 * 77,570,000) − (4,000 *10,750) (6 * 2,835,000) − 4,000 2

b=

45,420,000 − 43,000,000 17,010,000 − 16,000,000

a=

10,750  4,000  − * 2.396  = 194.33 6  6 

b = £2.396

For forecasting, our equation is y = 194.33 + 2.396x 850 units = 194.33 + (2.396 x 850) = £2,230.93 4. Correlation: r=

r=

(6 * 77,570,000) − (4,000 *10,750)

[(6 * 2,835,000 − 4,000 )(6 * 20,252,500 − 10,750 )] 2

2,420,000

2

= 0.98697

1,010,000 * 5,952,500

5. Coefficient of determination = r2 = 0.974 = 97%

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Example 3: A = (100,000 * 40%) + ( (40,000) * 60%) = £16,000 B = (50,000 * 60%) + ( (20,000) * 40%) = £22,000 C = (40,000 * 80%) + ( (10,000) * 20%) = £28,000 C is the best option.

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Unit 2: Exercise 1. EOQ =

2 * 15 * 32,000 = 894 (to nearest whole number) 40 * 3%

Exercise 2. EOQ =

2 * 2500 * 65,000 = 1,041 = 1,000 (nearest whole number) 300

Number of orders per year = 65,000/1,000 = 65 * £2,500 = £162,500 Cost of holding = 1,000/2 * £300 = £150,000 Total cost = £312,500 If we purchase 2,000 units per order Ordering cost = 32.5 * £2,500 = £81,250 Holding cost = 2,000/2 * £300 = £300,000 Total cost = £381,250 BUT we save 65,000 * £1,000 * 2% = £1.3 m Answer = Yes Exercise 3. ROL = 500 * 7 = 3,500 Minimum level = 3,500 – (5 * 400) = 1,500 Maximum level = 3,500 + 5,400 – (4 * 300) = 7,700 Exercise 4: Employee Produced A 96 B

C Total

Rate 2.25

Earned Received 216.00 216.00

100 22 122

2.25 3.00

225.00 66.00 291.00

291.00

76

2.25

171.00

180.00 687.00

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Exercise 5:

Basic rate Overtime premium Bonus

Hours 54

Rate 7.50

Total 405.00

14

2.50

35.00 45.00

Total pay Bonus calculation: Should take Did take Time saved

485.00

124 units * 0.5 hrs

Bonus = 12 hrs * 50% * £7.50

62.00 50.00 12.00

= £45.00

Direct cost Worked hours @ basic rate Idle time Overtime premium Bonus

50 4

7.50 7.50

14

2.50

375.00 30.00

375.00

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Indirect cost

35.00 45.00 110.00

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Unit 3: Exercise 1: Costs

Basis

Machining

Assembly

Finishing

Maint

Total

Indirect wages Indirect materials

10.000 15.000

6.000 4.000

8.000 8.000

30.000 20.000

54.000 47.000

Power Light & Heat

allocated allocated machine hours floor area

80.000 5.000

10.000 2.000

12.000 1.500

1.500

102.000 10.000

Depreciation Rent & Rates

NBV floor area

4.000 12.500

1.600 5.000

0.600 3.750

0.800 3.750

7.000 25.000

Personnel

employees

18.000

12.000

24.000

9.000

63.000

144.500

40.600

57.850

65.050

308.000

39.030

13.010

13.010

-65.050

183.530

53.610

70.860

0.000

Secondary apportionment

Exercise 2: (repeated distribution method) A

B

C

P

Q

Total costs

3000.00

4000.00

2000.00

2700.00

P costs * %

500.00

750.00

625.00

2500.00 2500.00 0.00

3325.00

625.00

Q costs * % P costs * %

831.25 133.00

831.25 199.50

997.50 166.25

665.00 -665.00

-3325.00 166.25

Q costs * % P costs * %

41.56 6.65

41.56 9.98

49.88 8.31

33.25 -33.25

-166.25 8.31

Q costs * % P costs * %

2.08 0.5

2.08 0.66

2.49 0.5

1.66 -1.66

-8.31

4515.04

5835.03

3849.93

0.00

0.00

(algebraic method) P = 2500 + 20%Q Q = 2700 + 25%P Substituting Q into the first equation: P = 2500 + 20%(2700 + 25%P) P = 2500 + 540 + 5%P 0.95P = 3040 P = 3200 Q = 2700 + 25%(3200) Q = 3500

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Total costs

A 3000.00

B 4000.00

C 2000.00

P 2500.00

Q 2700.00

P costs * % Q costs * %

640.00 875.00

960.00 875.00

800.00 1050.00

-3200.00 700.00

800.00 -3500.00

4515.00

5835.00

3850.00

0.00

0.00

Exercise 3: Machine Indirect materials Indirect wages Indirect expenses Prod cont Handling

Assembly

Finishing

Handling

Prod control

Total

4000.00 8000.00

11200.00 2400.00

41920.00

12960.00

7920.00

8000.00

41920.00

12960.00

7920.00

20000.00

13600.00

96400.00

5440.00 12816.00

4080.00 6408.00

2720.00 2136.00

1360.00 -21360.00

-13600.00

0.00 0.00

60176.00

23448.00

12776.00

0.00

0.00

96400.00

Exercise 4: Absorption rate per unit = £100,000/20,000 = £5 per unit Production cost = £20 + £5 = £25 Absorption rate per labour hour = £100,000/50,000 hours = £2 per lab hr Production cost = £20 + (2 x £2) = £24 Absorption rate per machine hour = £100,000/25,000 hours = £4 per mc hr Production cost = £20 + (5 x £4) = £40 Exercise 5: This question has two pitfalls. Firstly, the actual data for the cost centres are irrelevant as absorption rates are always calculated using budgeted data. Secondly, the question does not give guidance over whether labour or machine hours should be used to calculate rates. This is straightforward to solve. For each department use the higher of labour or machine hours. Cutting: Use machine hours as budgeted machine hours higher than budgeted labour hours Finishing: Use labour hours as budgeted labour hours higher than budgeted machine hours.

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Absorption rates are calculated as: Budgeted Overhead / Budgeted Activity Cutting: £100,000 / 50,000 = £2 per machine hour Finishing: £50,000 / 12,500 = £4 per labour hour

Product Costing

Cutting 6 x £2 = £12

Finishing 4 x £4 = £16

Total £28

Exercise 6:

Total costs Machine hours Labour hours

Machining Assembly Finishing Maint 183,530 53,610 70,860 40,000 8,000 16,000 £4.59 £6.70 £4.43

0

Exercise 7: Overhead absorption rates are calculated using budgeted figures. Further, machine hours should be used as this is the higher of the two measures of activity. Absorption rates are calculated as: Budgeted Overhead / Budgeted Activity £200,000 / 100,000 = £2 per unit

Absorbed overhead (actual activity x OAR) (80,000 x £2)

£ 160,000

Actual Overhead

208,000

Under absorption:

48,000

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Exercise 8: Overhead Control Overhead Incurred

£ 208,000

Absorbed Oh (WIP) Under absorbed (P+L)

208,000

£ 160,000 48,000 208,000

WIP £ Absorbed overheads 160,000

£

P+L Under-absorbed overheads

£ 48,000

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£

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Unit 4: Exercise 2: Absorption costing: £

£ 48,000 38,400 9,600 400 9,200

Sales (4,800 x £10) Production cost (4,800 x £8) Under absorption

OAR = £10,000/5,000 = £2 per unit Total production cost = 3 + 2 + 1+ 2 = £8 Absorbed = 4,800 x £2 Actual overhead cost Under absorption

9,600 10,000 400

Marginal costing: £

£ 48,000 28,800 19,200 10,000 9,200

Sales (4,800 x £10) Production cost (4,800 x £6) Less fixed costs

Exercise 3: Absorption costing: £ Sales (4,800 x £10) Production cost (6,000 x £8) Closing stock (1,200 x £8)

48,000 9,600 38,400 9,600 2,000 11,600

Over absorption

Absorbed = 6,000 x £2 Actual overhead cost Over absorption

£ 48,000

12,000 10,000 2,000

Marginal costing: £ Sales (4,800 x £10) www.ebooks2000.blogspot.com  London School of Business and Finance 2009

£ 48,000 Page 154


Production cost (6,000 x £6) Closing stock (1,200 x £6)

36,000 7,200 28,800 19,200 10,000 9,200

Fixed costs

Reconciliation: Difference in profits = £2,400 Change in stocks x OAR = 1,200 x £2 = £2,400 Exercise 4:

Selling price Variable cost Contribution Fixed cost Profit per unit

Existing £ 25 15 10 4 6

Present fixed cost = £4 x 50,000 Fixed cost increased by 50% Sales units increased by 100% New OAR Exercise 5:

Proposed £ 20 15 5 3 2 = £200,000 = £300,000 = 100,000 = £3 per unit

OAR = £250,000/1,000 = £250 per unit Stock decreased by 150 units Profit for absorption costing will be lower by 150 x £250 = £37,500

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Unit 5: Exercise 1: Job 666 Materials* 1 Grade A Steel Grade B Steel Wages*2 Wages Welding Wages Finishing Total Direct Cost Overheads*3 Total Cost Profit Selling Price *1

£

£

2,000 4,440 1,280 1,000 8,720 1,560 10,280 4,112 14,392

Direct Material Costs £

Steel Grade A (400m x £5.00) Steel Grade B (740m x £6.00)

2,000 4,440

Note materials returned to store are not included in the cost of the job. *2

Direct Labour Cost £ 1,280 1,000 2,280

Welding Department (320hrs x £4.00) Finishing Department (200hrs x £5.00)

The question implies overtime is worked because the factory is generally busy. The overtime premium should not be charged to the customer and should, therefore, be charged to production overheads. Absorbed overheads Absorbed overhead (520 x £3.00)

£ 1,560

Price £10,280 x 1.40 = £14,392

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Exercise 2: Job 123 Materials* 1 Material Y Material Z Wages*2 Dept A Dept B Total Direct Cost Overheads*3 Total Cost *1

£

£

204 384.25 342 440 1,368.25 452.70 1820.95

Direct Material Costs £ 204 384.25

Material Y (400kg x £0.51) Material Z (265kg x £1.45)

Note materials returned to store are not included in the cost of the job. *2

Direct Labour Cost £ 342 440

Dept A (76hrs x £4.50) Dept B (110hrs x £4.00)

The question implies overtime in Dept A is worked because the factory is generally busy. The overtime premium should not be charged to the customer and should, therefore, be charged to production overheads. In Dept B the overtime is worked at the request of a customer but not this one, so it will be charged to the other job. This overtime premium is not a production overhead. Absorbed overheads Total overheads for the period Total hours OAR

Dept A £ 5,400 2,000 £2.70 /hr

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Dept B £ 6,300 (ex premium) 2,800 £2.25 /hr

Page 157


Exercise 3: Job 6832 Opening Balance Materials Control Labour (£8 x 430)

£ 1,830 2,390 3,440

Overhead (£2 x 430)

Material returns Job 6833 Finished Goods (bal)

£ 870 620 7,030

860 8,520

8,520

Job 6833 Materials Control Labour (£8 x 650) Overhead (£2 x 650) Job 6834 Job 6832

£ 1,680 5,200 1,300

Finished Goods

250 620 9,050

£ 9,050

9,050

Job 6834 Materials control Labour (£8 x 280) Overheads (£2 X 280)

£ 3,950 2,240 560

Job 6833 Closing WIP

6,750

£ 250 6,500 6,750

Exercise 4: Using a mark up on marginal cost of sales of 80%, what is the price? Marginal cost = £22 +£5 + £6 = £33 Mark up £33 x 1.8 = £59.40 What is the resulting profit? (£59.40 - £40 = £19.40) Using a margin of 80% on total production cost what is the price? Total production cost = £31 Price: £31 / 20 x 100 What is the resulting profit? (£155 - £40)

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£ 59.40

19.40 155 115

Page 158


Exercise 5: Room occupancy = 230/280 = 82.1% Bed occupancy = 430/520 = 82.7% Average guest rate = £774,000 / 6,450 = £120/guest Revenue utilisation = £774,000 / £876,000 = 88.4% [(240 x £110) + (40 x £70)] x 30 days Average cost per bed occupied = £127,500 / (6450 x 2) = £9.88 /bed Exercise 6: Variable £ Loading costs Labour (30 x 1 x 2)1 Depreciation Supervision Other costs Wages (£100 x 2) Petrol (10p x 730 x 2)2 Repairs (5p x 730 x 2) Depreciation (£80 x 2) Supervision General expenses

Fixed £

60 80 80 200 146 73 160 120 200 840

279 1 2

Total number of tonnes loaded = 30 Please note we have to make a trip back as well Tonnes 5 8 2 4 6 5

Cost per tonne km =

Kms Total 100 500 20 160 60 120 50 200 200 1200 300 1500 3680

1119 3680 =

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£ 0.30

Page 159


Unit 6: Exercise 1:

Materials Lab & ohds

Process a/c Units £ 160 3,680 N. loss 3,200 Output 160 6,880

Cost per tonne of good output =

Units 8 152 160

£ 40 6,840 6,880

6,880 – 40 160 – 8 = £45

Value of output = 152 x £45 = £6,840

Process a/c

Normal loss a/c (scrap sales) Units £ 8 40 Bank/cash

Units £ 8 40

40

40

Exercise 2:

Materials Lab & ohds

Process a/c Ab loss a/c

Process a/c

Process a/c Units £ 160 3,680 N. loss 3,200 Output Ab loss 160 6,880

Units £ 8 40 150 6,750 2 90 160 6,880

Normal loss a/c (scrap sales) Units £ Units 8 40 Bank/cash 10 2 10 50

Abnormal loss/gain a/c Units £ 2 90 Scrap sales P&L a/c 90

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Units 2

£ 50 50

£ 10 80 90

Page 160


Exercise 3:

Materials Lab & ohds Ab gain

Process a/c

Scrap sales P&L a/c

Units 160 4 164

Process a/c £ 3,680 N. loss 3,200 Output 180 7,060

Units £ 8 40 156 7,020 164 7,060

Normal loss a/c (scrap sales) Units £ Units 8 40 Bank/cash 4 Ab gain 4 40

Abnormal loss/gain a/c Units £ 4 20 Process a/c 160 180

£ 20 20 40

Units 4

£ 180 180

Exercise 4:

Materials Labour P Ohds

Units 2,000

2,000

Process 1 a/c £ 8,100 N. loss 4,000 Process 2 6,000 Ab loss 18,100

Units 200 1,750 50

£ 100 17,500 500

2,000

18,100

Cost of good output = (8,100 – 100) / (,000 – 200) = £10

Process 1 Materials Labour P Ohds Ab gain

Units 1,750 1,250

100 3,100

Process 2 a/c £ 17,500 N. loss 1,900 Output 10,000 12,000 1,500 42,900

Units 300 2,800

£ 900 42,000

3,100

42,900

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Page 161


Cost of good output = (41,400 – 900) / (3,000 – 300) = £15

Process 1 Process 2 Ab loss

Normal loss a/c (scrap sales) Units £ Units 200 100 Bank/cash 4 300 900 Ab gain 100 50 25 550 1,025

Process 1 Scrap sales P&L a/c

£ 725 300

104 1,025

Abnormal loss/gain a/c Units £ 50 500 Scrap sales 100 300 Process 2 725 150 1,525

Units £ 50 25 100 1,500 150 1,525

Exercise 5: % Units completion 100% 1,000 200 50%

Equivalent units 1,000 100 1,100

Cost per equivalent unit = £5,500 / 1,100 = £5 Exercise 6: Getting the right answer here is a three-stage process: 1. Calculating the number of equivalent units 2. Calculating the cost the cost per equivalent unit 3. Combining the above to value each output from the process Statement of Equivalent units Output Finished goods Closing WIP

Physical Units 4,000 1,000

Statement of Unit Cost

Equivalent units 4,000 (100% complete) 600 (60% complete)

9,440/4,600 = £6.40

Statement of Evaluation: Finished goods: 4,000 equivalent units x £6.40 =£25,600 Closing WIP: 600 equivalent units x £6.40 = £3,840 www.ebooks2000.blogspot.com  London School of Business and Finance 2009

Page 162


Materials Labour P Ohds

Units 5,000

5,000

Process a/c £ 16,560 Output 7,360 Closing WIP 5,520

Units 4,000 1,000

£ 25,600 3,840

29,440

5,000

29,440

Exercise 7: Process a/c Units £ Materials 2,800 24,800 Output (1) Labour 16,750 Closing WIP (2) P Ohds 36,200 (rounding error) 2,800 77,750

Output WIP

Cost Cost/Eq unit

Units £ 2,100 64,575 700 13,185 -10 2,800 77,750

Statement of Equivalent units Units % Materials Labour Overheads 2100 2100 2100 2100 100% 700 80% 560 60% 420 700 700 50% 350 2660 2520 2450 £24,800 £16,750 £36,200 £9.32 £6.65 £14.78

Statement of Valuation (1) Output = 2100 x (9.32 + 6.65 + 14.78) = £64,575 (2) WIP = (560 x 9.32) + (420 x 6.65) + (350 x 14.78) = £13,185 Exercise 8:

Process A Labour P Ohds

Process a/c Units £ 10,000 40,500 Output (1) 5,616 Closing WIP (2) 2,808 N Loss (3) Ab Loss (4) 10,000 48,924

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Units £ 8,000 43,680 900 4,698 1,000 0 100 546 10,000 48,924

Page 163


Output WIP Ab Loss Cost Cost/Eq unit

Statement of Equivalent units Units % Process A Labour Overheads 8000 100% 8000 8000 8000 900 100% 900 900 75% 675 675 100 100% 100 100 100 9000 8775 8775 £40,500 £5,616 £2,808 £4.50 £0.64 £0.32

Statement of Valuation (1) Output = 8,000 x (4.50 + 0.64 + 0.32) = £43,680 (2) WIP = (900 x 4.50) + 675 x (0.64 + 0.32) = £4,698 (3) N Loss = 0 as no sales value given therefore assumed no scrap value (4) Ab Loss = 100 x (4.50 + 0.64 + 0.32) = £546 (valued as good production). Exercise 9:

Op WIP Added units

Process a/c Units £ 500 3,000 Closing WIP 1,000 10,500 Finished units

W Ave FIFO Units £ £ 300 1,500 1,500 1,200 12,000 12,000

1,500 13,500

1,500 13,500 13,500

Statement of Equivalent units (W Average) Units % Costs 1200 Output 1200 100% WIP 300 50% 150 1350 Cost

10,500 3,000

Cost/Eq unit

£13,500 £10.00

Valuation: WIP = 150 x £10 = £1,500 Finished units = 1,200 x £10 = £12,000

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Page 164


Statement of Equivalent units (FIFO) Units % 100% Output 1200 - Op WIP 500 60% + WIP

300

50%

Cost Cost/Eq unit

Costs 1200 300 900 150 1050 £10,500 £10.00

Valuation: WIP = 150 x £10 = £1,500 Finished units = 900 x £10 = £9,000 + Op WIP b/f £3,000 Total £12,000 Exercise 10: Process 2 a/c Units £ Op WIP (1) 12,000 21,530 Closing WIP (2) Process 1 95,000 107,950 N Loss Materials 44,000 Output (3) Conversion 51,480 107,000 224,960

Units 10,000 200 96,800 107,000

W Ave FIFO £ £ 19,250 19,250 0 0 206,184 205,886 ** ** 225,434 225,136

(1) Value of opening WIP = £13,440 + £4,970 + £3,120 = £21,530 ** Please note the accounts do not balance because of roundings

Output Closing WIP

Cost (4) Cost/Eq unit

Statement of Equivalent units (W Average) Units % Process 1 Materials 96,800 100% 96,800 96,800 10,000 100% 10,000 90% 9,000 70% 106,800 105,800 121,390 48,970 1.14 0.46

Conversion 96,800

7,000 103,800 54,600 0.53

Valuation: (2) Closing WIP = (10,000 x 1.14) + (9,000 x 0.46) + (7,000 x 0.53) = £19,250 (3) Output = 96,800 x (1.14 + 0.46 + 0.53) = £206,184 (4) Cost is the total of period cost + share of opening WIP e.g. Process 1 = £13,440 + £107,950 = £121,390

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Page 165


Output - Op WIP

In period Closing WIP

Cost Cost/Eq unit

Statement of Equivalent units (FIFO) Units % Process 1 Materials 96,800 100% 96,800 96,800 12,000 100% 12,000 10,800 90% 50% 84,800 86,000 10,000 100% 10,000 90% 9,000 70% 94,800 95,000 107,950 44,000 1.14 0.46

Conversion 96,800

6,000 90,800

7,000 97,800 51,480 0.53

Valuation: (2) Closing WIP = (10,000 x 1.14) + (9,000 x 0.46) + (7,000 x 0.53) = £19,250 (3) Output = (84,800 x 1.14) + (86,000 x 0.46) + (90,800 x 0.53) = £184,356 Plus Opening WIP b/f £ 21,530 £205,886 Exercise 11: Product X Y Z

Quantity 100,000 20,000 80,000 200,000

S Price £1 £10 £2

Sales Value £100,000 £200,000 £180,000 £480,000

Physical units method –

£240,000 200,000

x 100,000 = £120,000 20,000 = £ 24,000 80,000 = £ 96,000

Sales value method -

£240,000 £480,000

x £100,000 = £ 50,000 £200,000 = £100,000 £180,000 = £ 90,000

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Page 166


Exercise 12: Product A B C D

Quantity 200 300 500 100 1,100

S Price £20 £14 £18 £30

Sales Value £4,000 £4,200 £9,000 £3,000 £20,200

Physical units method –

£16,500 1,100

x 200 = £3,000 300 = £4,500 500 = £7,500 100 = £1,500

Sales value method -

£16,500 £20,200

x 4,000 = £3,267 4,200 = £3,431 9,000 = £7,351 3,000 = £2,451

Exercise 13: Option 1 – sell 100,000 units of P @ £1.25 = £125,000 Option 2 – sell 60,000 units of P+ @ £3.25 = £195,000 Increase in revenue of £70,000 Extra costs are (100,000 x £0.30) + £20,000 = £50,000 Therefore net gain of £70,000 - £50,000 = £20,000 Exercise 14: Option 1 – sell 9,000 litres of K @ £10 = £90,000 Option 2 – sell (9,000 x 90%) litres of KK @ £12 = £97,200 Increase of £7,200 Extra costs are 9,000 x £1 = £9,000 Therefore loss of revenue (and therefore profits) of £1,800

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Page 167


Unit 7: Exercise 1: Collerette Sales Volume 2,000 Unit price £100 Total Value £200,000

Pompom 4,000 £130 £520,000

Cacti 3,000 £150 £450,000

Total £1,170,000

Exercise 2: Production budgets can only be completed once sales budgets are known. Note too, how opening and closing stocks of finished goods have to be taken into account. Opening stocks are a subtraction from the production total and closing stocks an addition. Sales Units Closing stock

Collerette 2,000 600

Pompom 4,000 1,000

Cacti 3,000 800

Less Opening Stock Production Units

2,600 (500) 2,100

5,000 (800) 4,200

3,800 (700) 3,100

Exercise 3:

Collerette Pompom Cacti Usage (kgs)

Production Units 2,100 4,200 3,100

M1 (kg)

M2 (kg)

M3 (kg)

10,500 12,600 6,200 29,300

4,200 8,400 3,100 15,700

8,400 9,300 17,700

When constructing the materials purchase budget, opening and closing stocks of material should be taken into account. Materials Purchase Budget

Budgeted usage Closing stocks Opening stocks Budgeted purchases Unit cost Total

M1 kg

M2 kg

M3 kg

29,300 18,000 47,300 21,000 26,300 £5 £131,500

15,700 9,000 24,700 10,000 14,700 £3 £44,100

17,700 12,000 29,700 16,000 13,700 £4 £54,800

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Page 168


Exercise 4: Labour budgets are relatively straightforward to construct. Multiply production figures by unit hours to get total hours consumed for each product. This can then be multiplied by hourly rates to get cost. Production Units Hours per unit Total hours Hourly rate Cost

Collerette 2,100 4 8,400 hrs £8.50 £71,400

Pompom 4,200 6 25,200 £8.50 £214,200

Cacti 3,100 8 24,800 £8.50 £210,800

Exercise 5:

- Opening stock Production units

A 3,000 750 3,750 800 2,950

B 4,000 1,000 5,000 950 4,050

Labour hours (2) Total hours Rate per hour

1.6 4,720 £8

2.4 9,720 £8

£37,760

£77,760

Budgeted sales Closing stock (1)

Labour cost

(1) – closing stock = (sales / 12) x 3 (2) – Labour hours = original time x 80% Exercise 6: Q Budgeted sales Closing stock - Opening stock Required units Scrap Production units

700 70 770 50 720 80 800

= 90% = 10% = 100%

Labour hours Total hours

3.0 2,400

= 80%

Paid hours

3,000

= 100%

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Page 169


Exercise 7: Sales and variable costs are scaled up according to the difference in activity level. Examples: Sales: 4,000 / 3,000 x £90,000 = £120,000 Direct materials: 4,000 / 3,000 x £30,000 = £40,000 Fixed costs are simply copied across the budget as these items are not related to activity.

Sales Less Direct Materials Direct Labour Fixed Production overheads Gross Profit Less Variable Selling cost Fixed selling cost Profit

Original Budget 3,000 units £ 90,000

Flexed Budget 4,000 units £ 120,000

Actual

Variances

4,000 units £ 110,000

£ 10,000 (A)

30,000 15,000 2,500

40,000 20,000 2,500

45,000 20,000 2,300

42,500

57,500

42,700

3,000

4,000

4,000

1,500 38,000

1,500 52,000

2,000 36,700

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5,000 (A) 0 200 (F)

0 500 (A) 15,300 (A)

Page 170


Unit 8: Exercise 1: The first step is to calculate unit contribution: £9 - £4 = £5 Breakeven sales volume can be calculated as: Fixed Costs/ Unit Contribution £35,000 / £5 = 7,000 units Target sales volume can be calculated as: Fixed costs + target profit / unit contribution £35,000 + £15,000 / £9 - £4 = 10,000 units

Sell to breakeven?

Units 7,000

Sell to reach its target profit?

10,000

Exercise 2: Step 1: Calculate unit contribution: Unit sales price – unit variable cost: £7 - £4 = £3 Step 2: Calculate breakeven sales: Fixed cost / unit contribution = breakeven sales volume £342,000 / £3.00 = 114,000 units Step 3: Calculate margin of safety: (Budgeted sales – breakeven sales / budgeted sales) x 100) 133,000 – (114,000 / 133,000) x 100 = 14.3%. The margin of safety is 14.3%. This means that sales can fall 14.3% below budget before a loss is made. Quick exercises: 1.

500 / (3 – 1) = 250

2.

(550 + 200) / 2 = 375

3.

250 = 750 / cont/unit cont/unit = 3 therefore s. price = 3 + 1 = 4

4.

BEP = 200,000 / (8 – 4) = 50,000 Margin of safety = (80,000 – 50,000) / 80,000 = 37.5%

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Page 171


Exercise 3: Unit contribution is (unit sales price – unit variable cost): £15 - £6 = £9 C/S Ratio (unit contribution / unit sales): £9 / £15 = 0.6 or 60% Breakeven revenue: Fixed costs / C/S Ratio = £192,000 / 0.6 = £320,000 Margin of safety: (Budgeted sales – breakeven sales / budgeted sales) x 100) Budgeted sales: 62,000 x £15 = £930,000 (£930,000 - £320,000 / £930,000) x 100 = 65.6% Exercise 4: a).

Unit contribution = £40 - £25 = £15 Breakeven point: Fixed costs / Contribution = £240,000 / 15 = 16,000 Margin of safety = Budgeted sales – breakeven sales = 25,000 – 16,000 = 9,000 pairs

b)

20,000 x £15 = £300,000 - £240,000 = £60,000

c)

Unit contribution = £40 – (£25 + 2) = £13 Required = (£240,000 + £10,000) / 13 = 19,231

d)

Unit contribution = (£40 + £4.80) – £25 = £19.8 Breakeven point: = (£240,000 + £20,000)/ 19.8 = 13,132

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Page 172


Unit 9: Exercise 1: Demand Unit price Variable cost Unit contribution Labour hours Contribution per hr Priority Number of products made Hours used

Speedwell 1,000 units £ 50 10 40 4 £10 3rd 0

Nettle 1,000 units £ 70 50 20 1 £20 1st 1,000

Liatris 1,000 units £ 50 25 25 2 £12.50 2nd 400

0

(1,000 x 1hr ) 1,000 hours

(400 x 2) 800 hours

Total hrs

Balance 1,800 800 -

Production Schedule Product Units Nettle Liatris

*

Hrs/unit 1,000 400

1 2

1,000 800

* Balancing figure

Exercise 2: Machine hours required: Demand Product A 4,000 B 6,000 C 6,000

Hrs/unit 10 12 14

Total hours 40,000 72,000 84,000 196,000

Labour hours required: Demand Product A 4,000 B 6,000 C 6,000

Hrs/unit (1) 12 8 4

Total hours 48,000 48,000 24,000 120,000

As we have 200,000 machine hours available we have spare capacity. Labour hours are limited to 50,000 which means we are short by 70,000 hours. Labour hours is our limiting factor. (1) Product A = £9 paid at £0.75 / hr = 12 hours

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Page 173


S Price Variable cost Cont / unit Labour hours Cont / lab hr Ranking

(1)

A £ 25 19 6

B £ 20 15 5

C £ 15 11 4

12 £0.50 3

8 0.625 2

4 £1 1

Production Schedule: Product Units A C B

Hrs/unit 1,000 6,000 1,750

*

Total hrs 12 4 8

12,000 24,000 14,000

Balance 50,000 38,000 14,000 -

* Balancing figure

Contribution Schedule: Product Units A C B

Cont / unit

Total cont

1,000 6,000 1,750

6 4 5

6,000 24,000 8,750 38,750

A £ 100 54 46 3 £15.33 2

B £ 110 55 55 2.5 £22.00 1

C £ 120 59 61 4 £15.25 3

Exercise 3:

S Price Variable cost Cont / unit Labour hours Cont / lab hr Ranking

(1)

D £ 120 66 54 4.5 £12.00 4

(1) Product A = £18 paid at £6 / hr = 3 hours Product A, B, C, D B A C

Units

*

Hrs/unit 20 130 180 50

Total hrs 14 2.5 3 4

280 325 540 200

Balance 1,345 1,065 740 200 -

* Balancing figure

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Page 174


Profit statement: Product A B C D

Units

Cont / unit 200 150 70 20

46 55 61 54

Less Fixed cost (2) Profit (2)

Total cont 9,200 8,250 4,270 1,080 22,800 12,800 10,000

Fixed overhead absorbed on basis of labour hours. Product A fixed overhead = £24, labour hours = 3, OAR = £8/lab hr Budgeted fixed overheads = 1,600 hours x £8 = £12,800

Exercise 5: Let the number of detached houses = x , and let the number of town houses = y Maximum contribution = 10x + 6y Constraints: Area 600x + 300y ≤ 21,000 Cost 35,000x + 60,000y ≤ 2.1 million Number x + y ≤ 40 Minimum x≥5 y≥5 From the graph.... Point x y A 5 32 B 12 28 C 30 10 D 32 5

Contribution(£000) 242 (1) 288 360 350

The optimum solution is point C. (1)

Contribution = (5x @ £10) + (32y @ £6) = £242,000

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Page 175


Exercise 7: A company has 600kgs of material in stock that cost £50/kg three years ago. To replace the material would cost the company £60/kg. Relevant Cost £ At present the company does not have a use for the materials. If it receives a one-off order that can use the material, what is the relevant cost per kg?

Nil

The company has no use for the material and the price paid for the material in stock is a sunk cost. At present the company does not have a use for the materials. However, it can sell the materials at £5/kg to a local scrap merchant. If it receives a one-off order that can use the material what is the relevant cost per kg?

£5

The company has no use for the material however it could sell the material for scrap. This is the opportunity cost of accepting the one-off order. The company currently uses the materials in all of its products. It can sell the materials for £5 per kg to a local scrap merchant. If the company uses a kg of the materials in a product what is the relevant cost?

£60

The company uses the materials in all products. Any materials used would have to be replaced so replacement cost is the relevant cost.

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Page 176


Unit 10: Exercise 1: Standard Cost Card £ Materials Labour Overheads Fixed Overheads Standard Cost Standard Profit Standard Price

2kg x £30/kg 6hrs x £10/hr 6hrs x £15/hr £20,000/500

60 60 90 40 250 100 350

Exercise 2: Materials Cost Variance: £ 30,880

Actual quantity of materials x actual cost Price Variance Actual quantity of materials x standard cost 1,144kg x £30/kg Usage Variance Standard quantity of materials for actual output at standard cost 520 units x 2kg x £30 Total materials cost variance is:

3,440 (F) 34,320 3,120 (A) 31,200

£320 (F)

Exercise 3: Labour Cost Variances

Actual hrs paid for x actual rate Rate Variance Actual hours x standard rate 2,860 x £10 Efficiency Variance Standard hours for actual output at standard rate 520 x 6hrs x £10/hr Total labour cost variance is:

£ 30,745 2,145 (A) 28,600 2,600 (F) 31,200

£455 (F)

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Page 177


Exercise 4: Variable Overhead Variances £ 41,470

Actual hrs paid for x actual rate Expenditure Variance Actual hours x standard rate 2,860 x £15 Efficiency Variance Standard hours for actual output at standard rate 520 units x 6hrs x £15 hr

1,430 (F) 42,900 3,900 (F) 46,800 £5,330 (F)

Total variable overhead cost variance is: Exercise 5: Fixed Overhead Variances Budgeted fixed overhead Actual fixed overhead Fixed overhead expenditure variance Budgeted units Actual units OAR / unit = £40 Fixed overhead volume variance = 20 units x £40 Budgeted hours

500 x 6 =

£ 20,000 22,000 2,000 (A) 500 520 800 (F)

3,000

Capacity variance

Actual Hours 520 x 6 =

OAR/hr = £40/6 hrs

1,733

(F)

800

(F)

3,120

Volume variance

Budgeted hours

(A)

2,860

Efficiency variance

Standard hours

933

(as above)

3,000

6.6667

Capacity variance is adverse because we did not work as many hours as we planned (we absorbed less overhead) Efficiency variance is favourable because we produced our output in less time than we should have. Volume variance is favourable because we made more units than we planned.

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Page 178


These variances can also be depicted in a triangular format: Actual hours Capacity variance

Efficiency variance OAR/hr

Budgeted hours

Standard hours Volume variance

Exercise 6: Sales Variances £ 169,000 13,000 (A) 182,000

Sales Price Actual sales volume x actual price Sales Price Variance Actual sales volume x standard price (520 x £350) Sales Volume Budgeted volume Actual volume Variance (units) Standard unit profit

500 520 20 (F) £100

Sales volume variance (£)

£2,000 (F)

Exercise 7: Operating Statements Completed operating statement for Callestemon Ltd £ 50,000 2,000 (F) 52,000 13,000 (A) 39,000

Budgeted Profit Sales Volume Variance Standard Profit for Actual Sales Sales Price Variance Cost Variances Materials Price Materials Usage Labour Rate Labour Efficiency Variable Overhead Expenditure Variable Overhead Efficiency Fixed Overhead Expenditure Fixed Overhead Volume Total Actual Profit

F

A 3,440 3,120 2,145 2,600 1,430 3,900 2,000 800 12,170

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7,265

4,905 (F) 43,905

Page 179

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