ACCA – MA/FMA
MANAGEMENT ACCOUNTING
STUDY NOTES
Contents
Sr. #
TOPICS
Page #
1.
COST CLASSIFICATION
01
2.
MATERIALS
16
3.
LABOUR
33
4.
OVERHEADS
48
5.
ABSORPTION AND MARGINAL COSTING
58
6.
OTHER COSTING TECHNIQUES
65
7.
JOB AND BATCH COSTING
75
8.
SERVICE COSTING
80
9.
PROCESS COSTING
83
10.
BUDGETING
90
11.
INVESTMENT APPRAISAL
109
12.
STANDARD COSTING
122
13.
STATISTICAL TECHNIQUES
138
14.
COST REDUCTION
162
15.
PERFORMANCE MEASUREMENT
167
16.
MANAGEMENT INFORMATION
192
17.
SPREADSHEET
217
18.
SUMMAZISING AND ANALYZING DATA
227
Cost Classification
MA/FMA Study Notes
COST CLASSIFICATION
❖ This Chapter Covers:
✓ COST
✓ COST UNIT
✓ COST CENTRE
✓ COST OBJECT
✓ DIRECT AND INDIRECT COST
✓ PRIME COST, PRODUCTION COST AND TOTAL COST
✓ FUNCTIONAL CLASSIFICATION
✓ PRODUCT AND PERIOD COST
✓ CONTROLLABLE AND UNCONTROLLABLE COST
✓ COST CLASSIFICATION BY BEHAVIOUR
✓ ANALYSING COST INTO FIXED AND VARIABLE ELEMENT
✓ APPLYING HIGH LOW METHOD
✓ OTHER COST CLASSIFICATIONS
Page 1
Cost Classification
MA/FMA Study Notes
Cost Accounting: “Cost accounting involves applying a set of principles, method and techniques to determine and
analyse costs within the separate units of a business”.
This involves: The establishment of budgets, standards costs and actual costs of operations, processes, activities or
products and the analysis of variances, profitability or the social use of funds.
Cost: “Any outflow of an item of value against which some benefit is received is called cost”.
Examples of cost can be:
1. Staff salaries e.g. baker’s salary, sales person salary etc.
2. Cost of all baking material like flour, sugar, chocolate etc.
3. Fuel cost
4. Transportation cost
5. Advertisement cost, etc.
Cost types differ from business to business. The larger the business, the more cost types that business might have.
Why organisations need costing systems?
An organisation’s costing system is the foundation of the internal financial information system for managers. It
provides the information that management needs to plan and control the organisation’s activities, and to make
decisions about the future. Examples of the type of information provided by a costing system are:
▪ Actual cost of unit for the latest period.
▪ Actual costs of operating a department for the latest period.
▪ The forecast costs to be incurred at different levels of activity.
Cost unit: “A unit of product or service with which cost is attached”.
For example;
▪ A table or a chair for furniture manufacturer,
▪ Room in a hotel,
▪ Batch of 1,000 sheets,
▪ Patient per night, etc.
Unit Cost: “All expenses carried out to make one unit of a product is called a cost of that unit or unit cost or cost per
unit”.
Cost Center: “A cost center is a production or service location, function, activity or item of equipment for which costs
are accumulated and analysed”. A cost centre is used as a ‘collecting place’ for costs. The cost of
operating the cost centre is determined for the period, and then this total cost is related to the cost
units which have passed through the cost centre.
For example,
Type of cost centre
Examples
Service location
Stores, canteen
Function
Sales, Production
Activity
Quality control
Item of equipment
Packing machine
Page 2
Cost Classification
MA/FMA Study Notes
Cost Object: “A cost object is any activity or item for which a separate measurement of cost is desired”. It can be a
cost unit or cost center. For example the cost of a product, the cost of rendering a service to a bank
customer or hospital patient, the cost of operating a particular department or sales territory, or
indeed anything for which one wants to measure the cost of resources used.
Need to classify cost: Complete set of information of cost to make one unit of product is relevant for management
use but the individual manager will not need complete set of information. For example,
▪ Production manager will need information which relates to make the unit of product.
▪ Stores manager will need information about the cost of raw material and the quantity of products.
That is why we classify cost in different logical groups (more meaningful form) for management use. Sometimes
management has to report internal and sometimes to external bodies.
The aim of a cost classification is to find the costs incurred in the production of a cost unit. This is important for a
number of reasons:
1.
2.
3.
4.
5.
6.
Setting the selling price (so that costs can be covered and a profit can be made)
Decision making (for example if a company is selling two products and has to make a decision to stop selling
one of them, it will decide by determining which of the product is making less profit and profit of course is
determined after finding the cost).
Planning future activities (as a company has limited resources, the planning is done after determining costs)
Control of resources and cost of production (by comparing actual costs with planned costs, we can investigate
the reasons for variances)
Reporting the results of the business (it depends on knowing the costs incurred e.g. the value of stocks etc.)
Budgeting (for the upcoming period)
Cost Classification.
By Nature
By Function
Product & period
cost
Controllable &
uncontrollable cost
By Behaviour
✓ By Nature: By nature cost has three elements: material, labour and expense. It is further divided into direct and
indirect cost.
Direct costs: “A cost that can be directly identifiable with a specific cost unit or cost center is called direct costs”.
For example, Material used in production, Worker paid for making a product, etc.
Indirect costs: “A cost that cannot be directly identifiable with a specific cost unit or cost center is called indirect
cost”. It is jointly incurred and must be shared out on an equitable basis. For example, Salaries,
Rent of the building, etc.
Page 3
Cost Classification
MA/FMA Study Notes
Now we look at each element in detail:

Materials: One with which the product is manufactured, like wood used in chair. It can be direct and
indirect.

Direct Material: The material, which can be directly and easily associated / related with a particular unit of
product / service and it is economically feasible to trace it in the product. It becomes a major part of finished
good. Examples include cloth for a shirt, Paper for a book, etc.
Indirect Material: Materials that cannot be directly traceable or identifiable. It will not become a major part
of product. Also the other materials used in factory which do not become the part of product at all.
Examples are, cleaning materials, lubricants, nails, glue, buttons, etc.
▪
Labour: The payment made to workers for the work they have done is called labour cost. It can be direct
and indirect.
▪
Direct Labour: The Labour/Labour wages which is directly involved in making the product. Examples are,
labour for assembling of chair, wage of carpenter, etc.
Indirect Labour: The wages or salaries paid to the workers which are not directly involved in production,
not making the product. Examples are, maintenance worker wage, raw material storekeeper salary, factory
manager's salary, factory supervisor's salary, etc.
▪
▪
Expense: Cost incurred other than materials and labour is called expenses. These can be direct and indirect.
Direct Expenses: Expenses which are specifically incurred for the job. Examples are special tools for a job,
hire of machinery for production, cost of special designs, etc.
Indirect Expenses: The expenses which are not specific to the production but without those, production
cannot be possible. These are intangible expenses. Examples are, factory rent and rates, factory electricity
bills, machine depreciation, factory repairs and maintenances, etc.
Sum of all direct costs is
called Prime cost
Accumulated under
single head called
‘Overheads’
Cost
Direct costs
Indirect costs
Direct Material
Direct Labour
Direct Expense
Indirect Material
Indirect Labour
Indirect Expense
Prime costs = Direct Materials + Direct Labour + Direct Expense
Production overheads = Indirect Material Cost + Indirect Labour Cost + Indirect Expenses
Page 4
Cost Classification
MA/FMA Study Notes
Production cost = Prime Cost + Production Overheads
Non‐manufacturing overheads = Selling cost + distribution cost + Administration cost + Finance cost + Research cost
Total cost = Production cost + Non‐manufacturing overheads
CONVERSION COST: These are the costs of converting purchased raw materials into finished or semi‐finished
products, i.e. production cost excluding direct material cost.
Conversion cost = Direct Labour + Direct Expenses + Production Overheads
Conversion cost = Total Production Cost – Direct Material Cost
Calculating the cost of a product:
Production cost
Direct material
Direct labour
Direct expense
Indirect material
Indirect labour
Indirect expense
Selling cost
Distribution cost
Administration cost
Finance cost
Research cost
Prime cost
Total manufacturing/
production/factory cost
Manufacturing/
production/factory
overheads
Total cost
of
the
company
Non‐manufacturing/ non‐
production/
non‐factory overheads
✓ By Function: “All activities and operations of the company are called functions”.
Different functions of an organisation: Consider the example of a furniture manufacturing company.
▪ They would have a factory department which is also called as production or manufacturing department.
▪ Also there might be a department helping with all sales (sales and distribution department).
▪ Than businesses also need advertisement and marketing (marketing department).
▪ This business might need a separate function to hire and train employees (Human resource department).
▪ Also to arrange money there might be a separate department (accounts and finance department).
▪ Most businesses also have an administration department to do all the administrative work.
When we classify cost according to the above mentioned functions, this is called as functional classification.
Following is the detail:
1. Production / Manufacturing Costs: Cost incurred in making the goods. There are three main elements of
production costs
● Cost of material: Material costs include the cost of obtaining the materials and receiving them within
the organisation. The cost of having the materials brought to the organisation is known as carriage
inwards.
● Cost of labour: Labour costs are those costs incurred in the form of wages and salaries, together with
related employment costs.
Page 5
Cost Classification
●
MA/FMA Study Notes
Cost of expenses: Expense costs are external costs such as rent, business rates, electricity, gas and
similar items which will be documented by invoices from suppliers.
2.
Selling cost: It is an indirect cost incurred in promoting sales and retaining customers.
● Advertising cost
● Sales promotion
● Printing of catalogues and price list
● Salaries and commissions of salesmen
● Sales department includes costs like staff, rent & rates and insurance of showroom
● Bad debts
● Cost of free samples to customers
3.
Distribution cost: It is an indirect cost incurred in making the packed product ready for dispatch and
delivering it to customers.
● Packing cost
● Wages of packers, drivers, dispatch clerks
● Rent and rates, insurance and depreciation of finished goods warehouse
● Cost of delivery of finished goods
4.
Administration Costs. Normally it includes office related expenses.
● Office Cost
● General manager’s salary
● Accountant’s salary
● Auditor’s fee
● Telephone and Postage costs
● Depreciation of Office Building and Equipment
5.
Financial Costs: Cost incurred when a business has to borrow.
● Interest paid on loans
● Cost for any legal documentation required to acquire loan
6.
Research Costs: Cost incurred before making a product like research work.
● Testing cost in the laboratory in making of medicine.
Important: Functional classification may have more heads, depending on the size and number of activities of an
organisation.
This classification helps in controlling cost, stock valuation and in the preparation of financial statements, etc.
❖ Question‐1: A company manufactures and retails clothing. You are required to group the costs, which are
listed below and numbered 1‐20, into the following classifications (each cost is intended to belong to only
one classification):
a) Direct material
b) Direct labour
c) Direct expenses
d) Production overheads
Page 6
Cost Classification
MA/FMA Study Notes
e)
f)
g)
h)
i)
Research cost
Selling cost
Distribution costs
Administration costs
Finance costs
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
Lubricant for sewing machines
Floppy disks for general office computer
Maintenance contract for general office photocopying machine
Telephone rental plus metered calls
Interest on bank overdraft
Performing rights society charge for music broadcast throughout the factory
Market research undertaken prior to a new product launch
Wages of security guards for factory
Carriage on purchases of basic raw materials
Royalty payable on number of units of product XY produced
Road fund licenses for delivery vehicles
Parcels sent to customers
Cost of advertising products on television
Audit fees
Chief accountant’s salary
Wages of operators in the cutting department
Cost of painting slogans on delivery vans
Wages of storekeepers in raw materials store
Wages of fork lift truck drivers who handle raw materials
Developing a new product in the laboratory
❖ Question‐2: The following data is given of a wooden furniture manufacturer:
$
Wood
5,000
Glue used in manufacturing
250
Leather skin for chairs
6,000
Designing costs of a skin (specific Request of the customer)
350
Machine hire charges
25,000
Other factory overheads
2,200
Selling overheads
1,400
Admin overheads
1,200
Find the prime cost, the production cost and the total cost.
✓ Product & Period Costs:
Product Costs: “Cost incurred on making product is called product cost”. Examples are, Materials, Labour and
expenses for production.
Page 7
Cost Classification
MA/FMA Study Notes
Period Costs: “A cost that does not change, which remains fixed. It relates with the passage of time rather than
the output of individual product or service is called period cost”. Examples are Salaries, Insurance, Rent of
building, etc.
This classification helps in controlling cost, inventory valuation and Absorption and Marginal costing, etc.
✓ Controllable & Uncontrollable Costs: Normally all the cost incurred by an organisation is controllable for
management. But some costs are uncontrollable for a particular manager.
▪
Controllable: A cost which can be influenced by management decisions and actions. Controllable costs can
be controlled by departmental managers for example material costs. Examples are Material used for
production, Labour paid to production workers, etc.
▪
Uncontrollable: A cost which is not influenced by management decisions and actions. These costs are not
under the control of departmental managers like general manager's salary. Examples are, Share of
electricity bills and rent expense of the building between the departments, etc.
✓ By Behaviour: “Cost behaviour is the way the costs change as the level of activity changes.”
The level of activity is the amount of work done or the volume of production (i.e. number of units produced).
Many factors may influence cost. Major influences include volume of output or level of activity. Level of activity
can be referred to in one of the following ways:
 Number of shirts produced.
 Number of labour hours worked.
 Number of machine hours worked, etc.
The common cost behaviour is that level as level of activity rises, cost will usually rise for example it will cost
more to produce 200 units than it will to produce 100 units. However; the problem is to determine which cost
will rise and by how much. Cost behaviour is usually measured according to the number of units produced.
Classification by Behaviour
Variable Costs
Fixed Costs
Stepped Fixed Cost
Semi‐Variable Cost.
➢ Variable Cost: “A cost that varies in total with the change in activity level but remains constant in per unit
is called variable costs”. Examples are;
● Direct costs are mostly variable costs.
● Sales commission is also variable in relation to volume of sales.
● If cost per labour hour worked is constant labour productivity is also constant. This means that
efficiency levels can be determined by analysing variable costs per unit.
Page 8
Cost Classification
MA/FMA Study Notes
Charts:
$ Total cost
$ per unit
0
Activity Level.
0
Activity Level.
Another example for Variable Cost is bonus payment for example when the activity reaches a certain level,
labour might get a bonus. Graph of this is shown below
Cost
$
Bonus
A
Up to Output A, No Bonus Is Awarded
In case of bulk purchase discount the purchase price/unit of raw material is constant and after achieving a
certain level of quantity a bulk purchase discount is given. After this point the price/unit will fall and will be
charged to further purchases and will also be applied retrospectively to all units already purchased. Graph
illustrating bulk purchase is shown below:
Cost
$
Level of activity
Page 9
Cost Classification
MA/FMA Study Notes
If bulk purchase discount is only available on additional units then the graph will change as follows:
Cost
$
Level of activity
If the relationship between total variable cost and volume of output can be shown as a curved line on graph,
the relationship is said to be Curvilinear.
➢ Fixed Costs: “A cost that remains fixed in total with the change in activity level (with a specific range) but
changes in per unit is called fixed cost”. Fixed cost does not depend on the activity level, it relates with the
passage of time. This means that fixed cost per unit decreases with an increase in the level of production.
Examples include the salary of the managing director, the rent of the factory building, straight‐line
depreciation etc.
Charts:
$ Total
costs
$ Per unit
0
Activity Level.
0
Activity Level.
➢ Stepped Fixed Cost: “The cost which remains fixed for a certain level of production, then increases by a
constant amount , and will then remain fixed again until another level of production has been achieved is
called stepped fixed cost.” Examples are,
1. A factory supervisor’s bonus could depend on output. At between 0 and 100 units of production, he
would be paid $200, for 101‐200 units he would be paid $300 and so on.
2. Rent of one factory building would be fixed but if more space needed due to higher output levels,
another building would have to be rented so total rent expense will increase.
3. Basic wages or minimum wage of employees may be fixed (by law) but as output rises more employees
are required.
Page 10
Cost Classification
MA/FMA Study Notes
Charts:
$ Total:
$ In per unit:
1
Activity level
0
Activity level
➢ MIXED COST (SEMI VARIABLE AND SEMI FIXED): “A cost which has both elements fixed and variable is
called semi‐variable cost”. These are costs, which are partly variable and partly fixed. Examples include the
phone bill. It has a fixed element, which is the line rent, and a variable element, which is the cost of a call.
Other examples include:
● Salesman's salary and commission
● Cost of running a car
GRAPH FOR TOTAL MIXED COST
Total Cost
Cost $
Variable cost portion (call charges)
10,000
Fixed Cost (line rent)
Fixed cost portion (line rent)
0
10
100
Activity Level (Units of output)
Here the slope of the line represents variable part of the cost.
Page 11
Cost Classification
MA/FMA Study Notes
GRAPH FOR MIXED COST PER UNIT
$ Cost/unit
1,000
100
0
10
100
Activity Level (Units of output)
❖ Question‐3: Identify the cost behaviour of the costs shown above in the table.
Cost item
X‐ray film used in radiology lab of a hospital
The costs of advertising a music concert
Rental cost of the space occupied by a McDonald restaurant
Property insurance on a coca cola bottling plant
The cost of synthetic material used to make Nike running shoes
Cost behaviour
Variable
Fixed
❖ Question‐4: A company has established the following information for the costs and revenues at an activity
level of 500 units:
Sales revenue
Direct materials
Direct labour costs
Production overheads
Selling costs
Profit
$
40,000
(15,250)
(10,000)
(6,000)
(5,000)
3,750
40% of the selling costs and 60% of the production overheads are fixed over all levels of activity.
What will be the total profit at an activity level of 700 units?
ANALYSING COST INTO FIXED AND VARIABLE ELEMENT
HIGH‐LOW METHOD: This a method used to determine fixed and variable elements of mixed cost. It relies on the
assumption that mixed costs are linear.
APPLYING HIGH‐LOW METHOD: This method consists of selecting the periods of highest and lowest activity levels
and comparing the changes in costs that result from two levels. Application of the method requires the following
steps:
Page 12
Cost Classification
MA/FMA Study Notes
1.
Identify two different levels of activities: the highest and the lowest level of activities and the corresponding
costs.
2.
Find the variable cost per unit by
Total costs at highest activity level – Total costs at lowest activity level
Total units at highest activity level – Total units at lowest activity level
3.
Compare the variable cost with the total costs at either the lowest activity level or highest activity level to
compute the total fixed cost.
Total costs at highest activity level – (Total units at highest level x Variable cost per unit)
OR
Total costs at lowest activity level – (Total units at lowest level x Variable cost per unit)
4.
Form the equation
Total Cost = Total Fixed Cost + Total Variable cost
Total Cost = Total Fixed Cost + (Variable cost per unit x Number of Units)
Y = a + bx
Where,
Y is the dependent variable i.e. the total cost for the period at activity level of X
x is the independent variable, i.e. the activity level
a is the constant, i.e. the total fixed cost for the period
b is also a constant, i.e. the variable cost per unit of activity
ADVANTAGES AND DISADVANTAGES OF HIGH LOW METHOD
Advantages:
● It is easy to use
● Easy to understand
Disadvantages:
● It relies on historical data assuming that level of activity is the only factor affecting cost and historical cost
can reliably predict future cost.
● It uses only two level of activity highest and lowest, which means that the result may be distorted because
of random variation of these values.
❖ Question‐5: The following data was collected for the period of January to March last year:
Months
January
February
March
Sales Units
8,500
9,100
10,200
Total Cost($)
46,000
50,000
54,925
Estimate the total costs when output is 9,500 units using high – low method.
Page 13
Cost Classification
❖ Question‐6: The
total costs
measured as follows:
Output Units
10,000
13,000
11,000
11,500
14,000
12,500
MA/FMA Study Notes
incurred at various output levels for a process operation in a factory were
Total Costs ($)
154,000
190,200
165,325
169,566
181,600
170,000
Using high‐low method, divide the costs of the process operation into fixed and variable cost. Then form the
equation and determine total cost at 16,000 units.
HIGH‐LOW METHOD WITH STEPPED FIXED COST
Sometimes fixed costs are only fixed within certain level of activity and increase in steps as activity increases.
The High‐Low method can still be used to estimate fixed and variable costs.
❖ Question‐7: A company incurs the following costs at various activity levels:
Activity level (units) Total Cost ($)
10,000
$180,000
20,000
$ 310,000
Variable cost is constant within this range but there is a step‐up of $35,000 in total fixed cost for output over
15,000 units. What is total cost for an activity level of 18,000 units?
Months
1
2
3
4
5
Units
1,000
2,000
900
1,200
2,200
Total cost ($)
4,400
7,200
3,000
5,900
7,100
❖ Question‐8: Information;
Fixed cost will increase by $200 when activity level is more than 1,000 units. Variable cost per units will remain
constant. Calculate total cost at 800 units and 1,500 units
HIGH‐LOW METHOD WITH CHANGES IN THE VARIABLE COST PER UNIT
Sometimes there may be changes in the variable cost per unit, and the High‐Low method can still be used to
determine the fixed and variable elements of semi‐variable cost. The variable cost per unit may change because:
● Availability of discounts
● Inflation
Page 14
Cost Classification
MA/FMA Study Notes
❖ Question‐9: The following information relates to the manufacture of Product JK in 20X8:
Output (Units)
200
300
400
Total Cost ($)
7,000
8,000
8,600
For output volumes above 350 units the variable cost per unit falls by 10%. (This applies to all units). Estimate
the cost of producing 450 units of Product JK in 20X9.
OTHER COST CLASSIFICATIONS
Avoidable Costs: Costs which would not be incurred if the activity to which they relate did not exist. For example
variable costs and specifically incurred fixed cost.
Unavoidable Costs: Costs which would incurred whether or not the product is discontinued for example factory rent.
Discretionary Costs: Costs which are incurred as a result of top management decision but cannot be raised or lowered
at fairly short notice like advertisement costs, sales promotion, research cost and training costs.
Page 15
Materials
MA/FMA Study Notes
MATERIALS
❖ This Chapter covers:
✓ MATERIALS
✓ STOCK CONTROL SYSTEM
✓ DOCUMENTS FOR BUYING MATERIAL
✓ STOCKTAKING
✓ STOCK VALUATION METHODS
✓ FREE STOCK
✓ ORDERING STOCK
✓ STOCK CONTROL LEVELS
✓ ECONOMIC ORDER QUANTITY
✓ BULK PURCHASE/ LARGE ORDER DISCOUNTS
✓ ECONOMIC BATCH QUANTITY
✓ ACCOUNTING FOR MATERIAL COSTS
Page 16
Materials
MA/FMA Study Notes
MATERIALS
Material is something with which product is manufactured. For example, wood is to manufacture chair so wood is
material, fabric used in making of shirt so fabric is material, etc. Material can be divided into the following categories:
Direct Material: The material, which can be directly or easily associated / related with a particular unit of product /
service. It becomes a major part of finished good. Examples: wood for a table, papers for a book, etc.
Indirect Material: Materials that are cannot be directly traceable or identifiable. It will not become a major part of
product. Examples: cleaning materials, lubricants, nails, glue, buttons, etc.
Inventory has three types:
Raw material: The goods purchased, which are to be used in the manufacturing of products. For example, plastic is
used for the manufacturing of toys.
Work in progress: When the product is in manufacturing phase that is known as work in progress. It represents the
intermediate stage of converting the raw material to finished goods.
Finished goods: When the manufacturing phase has ended, than we have products which are ready for dispatch are
called finished goods. For example, bike, marker, robot etc.
STOCK CONTROL SYSTEM
Stock control is the regulation of stock levels, which includes putting a value to the amounts of stock issued and
remaining. A business may wish to control stock because:
● Holding cost of stock may be expensive
● Production will be disrupted if there is stock‐out
● Unused stock with short shelf life may incur unnecessary expenses.
A stock control system for materials consist of
● Ordering of stock
● Purchase of stock
● Receipt of stock
● Storage
● Issue of stock
The Storage of Raw Materials: The objective of storekeeping:
● Speedy issue and receipt of materials
● Full identification of all materials at all times
● Correct location of all materials at all times
● Protection of materials from damage and deterioration
● Provision of secure stores to avoid pilferage, theft and fire
● Efficient use of storage space
● Maintenance of correct stock levels
● Keeping correct and up to date records of receipts, issues and stock levels
Page 17
Materials
MA/FMA Study Notes
The store department is responsible for:
● Receipt of goods;
● Storage of materials;
● Issue of materials;
● Recording receipts and issues.
The Purchase of Raw Materials: The purchase of material may be controlled by
● Purchasing only necessary items
● Orders to supplier after considering price & delivery issues;
● Goods received agreed with goods ordered in quantity and quality;
● Price paid is the price agreed when order was placed.
DOCUMENTS FOR BUYING MATERIALS
The company buys materials from the market for making products. The procedures and documents involved in
buying and selling are prime source of cost and revenue information. Their complexity will depend on the type and
size of both the organisation and the purchase. There are some descriptions of these documents:
Purchase requisition: It is a written request sent by the storekeeper to purchase department for buying the goods
when inventory level falls down to the Re‐order level. It is authorised by the supervisor of the stores or the
departmental head who is responsible for department’s budget.
Letter of Enquiry: It is used to determine an appropriate supplier. The purchase department sends out a letter of
enquiry (in case of new supplier) to various suppliers to find out about the price, delivery time, delivery charges,
discounts, terms of payment etc. The suppliers will respond to the letter of enquiry with:
● A catalogue and price list (for standard goods)
● A quotation (for non‐standard goods)
● An Estimate of cost (for services such as building work and repair)
Purchase Order: A purchase order is prepared by purchase department and sends to the selected or existing
supplier. It specifies the quantity, quality and the price of the goods that are to be bought. It is authorised by head
of purchase department. The original purchase order is sent to the supplier. Four copies of the purchase order are
sent to the following:
1. The Purchase department (To keep records)
2. The accounts department (so that when the goods are arrived and invoice is received, the invoice can be matched
with the purchase order for price confirmation)
3. The stores section (for updating the stock records and making arrangements for new stock)
4. The goods received section (so that they can expect to get the goods by the date mentioned on the purchase
order)
Advice Note: Advice note is an agreement which takes place as a result of trade with new supplier or change in terms
and conditions of the trade with the supplier to avoid future disruptions. Confirmation of purchase order is also done
with the sign of this agreement for the supplier.
Delivery Note: Supplier sends delivery note to the customer with the goods. It contains the details of the quantity
of goods send by the supplier. The delivery note has two copies, both are signed by buyer.
1. One copy is retained by buyer for documentation
Page 18
Materials
2.
MA/FMA Study Notes
Other copy is taken back to the supplier by the driver to confirm the supplier that the goods have been delivered
to the right buyer.
Important: If the supplier does not use his own transport, the consignment note will provide the same evidence as
the delivery note.
Goods Received Note (GRN) (internal document): When the goods have been received at the goods received
section, a goods received note is prepared and sent to the other departments so that they know that the goods have
arrived. It is also used to update stock records. Four copies of the goods received note are sent to the following
departments:
1. The accounts department (to check against the invoice and purchase order for quantity confirmation)
2. The stores section (for updating stock records)
3. The purchase department (to confirm that the goods have arrived)
4. The goods received section (will keep a copy in its records)
Invoice: The supplier’s sales department will send the invoice to the buyer’s accounts department detailing the
amount that the company has to pay to the supplier. The buying company should check the invoice carefully to check
the following:
● That the supplier has only charged for the goods which have been received (check Good received note for
quantity).
● That the price and terms are as agreed (look at the purchase order to check price).
● That the calculations on the invoice are correct (including VAT)
If the invoice is correct, an entry is passed in the purchase ledger. The purchase is then recorded in the accounts and
the invoice is paid.
Credit Note: If the invoice sent by the supplier has any error, a Debit Note is send to supplier by the accounts
department and then the supplier will send a credit note (which in effect reverses the invoice).
A credit note may be issued for the whole of the invoice instead of for the incorrect amount only so this way both
the supplier and the company can remove the incorrect invoice from their books and replace it with the correct
invoice. Accounts department of buyer authorises it to make payment against it.
Important: Two types of discounts may be offered by the suppliers:
Trade discount: usually given for larger orders. It is shown as a deduction in the invoice.
Cash discount/Settlement discount: usually given for prompt/immediate payment within a specified period of time.
It is NOT shown as a deduction on the invoice.
If VAT is payable, discounts are deducted from the cost of the goods and THEN VAT is calculated and added to the
invoice. (I.e. the amount net of VAT is coded)
OTHER DOCUMENTS USED IN AN ORGANISATION
There are more documents which are used in the organisation:
Store or material requisition: A material requisition will be completed when materials are needed from stores by
the production department. An officer from production will sign to authorise it, and stores will issue the materials
when the requisition is given to them. It is then used as a source document for:
Page 19
Materials
●
●
●
MA/FMA Study Notes
Updating the bin card in stores;
Updating the stores ledger account in the costing department; and
Charging the job, overhead or department that is using the materials.
Goods or material return note: A materials return note will accompany any unused material back to stores. In effect
this document is reverse of a material requisition and therefore it must contain all the information that is present
on material requisition and will be used as the source document to update the same records. This time, though, the
material will be a receipt into stock and a deduction from the job originally charged with the material issued.
Materials transfers and returns: A material transfer note is usually raised when material issued to one department
is transferred to another department directly. This note shows the name of both, transferor and transferee
departments. This process enables stock ledger accountant to appropriately allocate the cost between two
departments.
Page 20
Materials
MA/FMA Study Notes
Purchase Cycle:
PProduction
Department
Issue Material
Order to regular supplier
Available
(Material Requisition)
Stores
Department
If routine purchase
(Purchase order)
Not Available (Purchase Requisition)
Purchase
Departme
(Quotations)
If first purchase
(Letter of enquiry)
Multiple
suppliers in the
(Advice Note)
Copies:
1 Purchase Dept
1 Stores Dept
1 Goods Receipt
Dept. 1 Accounts
Sending goods
to stores
(Purchase Order)
Selected
Supplier
Goods Received Department
(Delivery Note)
Two copies:
(Goods Received Note)
1 for supplier
1 for goods receipts Dept
(Invoice)
(Credit note)
(Debit note)
Copies:
1 for Goods Receipt Dept
1 for Purchase Dept
1 for Accounts Dept
1 for Stores Dept. (with goods)
Invoice inaccurate
Invoice accurate
Pay the supplier
Accounts Department
DOCUMENTS FOR RECORDING MATERIAL
Purchased inventory is usually kept in warehouses or in stores. There are two types of stock records that are
maintained in the stores; Bin cards and Stock ledger accounts.
Bin Card: It contains the description of material held in stock. It is maintained and kept by the storekeeper for every
material in the stores. It can be manual or computerised inventory records. The information on the bin card would
be as follows:
● Description of the material (type of material)
● Stock code
Page 21
Materials
●
●
●
●
●
MA/FMA Study Notes
Stock unit (meters, kgs, boxes etc.)
Bin number (the location of the items in the store)
Issues to production records: date, quantity, material requisition number against which the material was issued
as a reference number.
Receipts records: date, quantity, good received note, Materials Returned Note (MRN) for goods that were
returned from the production department because they were not used in production (obviously the material will
also be sent back to the store with the materials returned note.)
Balance of the quantity of stock on hand after each stock movement (after each time stock is received or issued)
Note: Bin cards do not have the amounts or cost of stock.
Stock Ledger Account: It is maintained by the accounts department. It records quantities and values (amounts) of
all stock movements made from store department. It can be manual or computerised and this would enable the
amount of free stock to be monitored.
● Stock ledger accounts carry all the information that is in bin cards such as goods received note, material
requisition, material return note details etc, but they also have the value/cost of stock units.
● This means that total cost of each issue, receipt and that of the balance amount is shown in the store ledger
accounts.
Bin cards are kept in the store but the store ledger accounts are kept in the costing department or a separate stores
office where a cost bookkeeping clerk maintains them.
Important: Bin cards and store ledger accounts are kept by separate departments so comparing them to check if the
quantity of stock shown by each match can be a good control to ensure that the records are correct.
Computerised inventory control system: Now‐a‐days many inventory control systems are computerised. Features
of computerised inventory control systems:
a. Data must be inputted into the system: For example details relating to receiving goods may be entered directly
to the computer and after that goods received note will be printed & signed as evidence of the transaction.
Some systems may be devices such as bar code reader.
b. Inventory master file is maintained: This file contains details of every type of inventory and frequently updated
as defined by the company. It also contains details of inventory movement (receipt, issue or return) over a
period but this will depend on the type of system used.
c.
Two types of systems are generally used for recording inventory movement:
● Batch systems: Transactions relating to a certain defined period are grouped separately and then it is
updated to master file only.
● On line systems: Each transaction may be input to the master file directly. In this system, inventory records
are continuously updated that will help in monitoring & controlling inventory.
(The system may generate purchase orders automatically once the quantity in stock has fallen to reorder
level)
System will generate outputs: Outputs can be generated in any form depending upon users.
● Hard copy: Sometimes output may be required in form of paper for evidence purpose like goods received
note.
● Visual display unit (VDU screen): In response to an enquiry like current inventory level or details about a
particular transaction can be just viewed on screens.
Page 22
Materials
●
MA/FMA Study Notes
Printed reports: These reports are devised to fit in with the need of the organisation like inventory
movement reports, GRNs, different notes etc. Computerised inventory control systems are more up to date
and flexible in reporting as compared to manual systems but both systems require same type of data to
function properly.
Other systems of store control & recording:
1. Order cycling method: Under this method, stocks in hand of each material are reviewed periodically (every 1, 2
or 3 months). For low cost materials, a technique called the 90‐60‐30 days technique can be used, so that when
stock falls to 60 days’ supply, a fresh order is placed for 30 days’ supply so as to boost stocks to 90 days’ supply.
For high cost materials a more stringent stores control procedure is advised so as to keep down the holding cost
of stock.
2. Two bin system: In this method, each item of stock stores in two storage bins. When the first bin is empty, an
order must be placed for new suppliers, the second bin will contain enough quantity to be used until the first
order is received. It is a simple method not based on any formal analysis of usage so it may result in holding too
much quantity or too little.
3. Classification of material methods: In this method materials are classified in three categories:
● Expensive material
● Middle cost range material
● Inexpensive material
Expensive and medium cost materials require careful store control procedures to minimize cost.
On the other hand inexpensive material can be stored in large quantities because fewer controls are required.
This method is also called ABC method under which materials are classified in A, B or C groups (A is more
expensive material, B is medium cost material & C is inexpensive materials)
STOCKTAKING
A stock taking is the counting and recording of the physical quantities of each item of stock at regular interval
(monthly or annually) and the checking the balance against the stock record. If all receipts and issues of stocks are
correctly recorded, then total quantity counted should agree with the balance in the bin card and stock ledger
account. There are two methods of stocktaking:
● Periodic Stocktaking: All stocks are counted and updated on specific date periodically, usually at the end of the
accounting period.
● Perpetual and Continuous Stocktaking: All stocks are counted and updated after each transaction. Valuable
items are checked more frequently.
Advantages of continuous stocktaking compared to periodic stocktaking: Though the greatest disadvantage is
the time and manpower factor as it involves more frequent stocktaking, there are many advantages of
continuous over periodic stocktaking:
▪ It improves the quality of the physical stocktaking as there are more frequent physical counting;
▪ It allows stock discrepancies to be more fully investigated as more time is available;
▪ Maintain a higher working standards as the warehouse personnel know that they need to count the stock
more frequently;
▪ Production hold‐ups, a common issue in periodic stocktaking are eliminated.
▪ Deficiencies and discrepancies are detected sooner than they would be if there was an annual stocktaking
system in place.
▪ Control over inventory levels are improved as there is less likelihood of overstocking or running out of stock.
Page 23
Materials
MA/FMA Study Notes
STOCK DISCREPANCY
It is the difference between the physical and reorder quantity of inventory. The reasons for stock discrepancy
should be investigated and adjustments should be made accordingly if needed. There are some possible
adjustments:
Reasons for differences
Action taken
1. error in recording or calculating
correct the bin card
2. omission of goods received or issues
correct the bin card
3. stock store in wrong position
move back to correct place
4. goods may be stolen
review security system and goods written off as an
expense
STOCK VALUATION METHODS
Pricing of Materials Issued: Materials are purchased in large quantities at different prices and issued to production
in smaller lots. It is necessary to price the material requisitions so that the cost centres (and cost units) can be
charged in a fair and consistent manner.
Methods of pricing of raw materials:
1. FIFO (First in first out)
2. LIFO (Last in first out)
3. Weighted average (AVCO)
4. Periodic weighted average pricing method
1.
2.
First in First out (FIFO) Method: In this method, the inventory is used from the earliest purchases.
● The earliest price of materials is used for each issue.
● If prices are rising, issued price will be lower, vice versa.
● Closing stock is valued at most recent prices.
Advantages
● This method is adopted by most of the organisations as this method assumes the oldest receipts are issued
first.
● Issued prices are based on the prices actually paid for the stock.
● Closing stock values are based on the latest prices.
● It is an acceptable method for company act 1985, IAS 2, and for taxation purposes.
Disadvantages
● It uses the older prices and this can affect the costing of worked done.
● In time of rising prices FIFO value stock at out of date prices which lower the cost of sales figure thus
increases the profit figure which is not prudent.
Last in First out (LIFO) Method: In this method, the inventory is used from the latest purchases.
● The most recent price of materials is used for each issue.
● If prices are rising, issued price will be higher, vice versa.
● Closing stock is valued at the earliest prices.
Page 24
Materials
MA/FMA Study Notes
Advantages
● The value of closing stock is based on prices actually paid for the stock.
● Issues are valued at the most recent prices so it incorporates the prudence concept.
Disadvantages
● It is less realistic than FIFO since it assumes that the most recent purchases will be issued before the older
stock.
● LIFO is unacceptable for the purpose of taxation and IAS 2.
3.
Weighted Average Price Method: In this method, a weighted average rate is calculated before each stock issue,
whenever, two or more quantities at different rates is found in the balance. All issues are made at the weighted
average rate.
● Weighted average rate is calculated by dividing total cost of different quantities with the quantities sum.
● Weighted average rate is calculated before every issue.
● Issue price will be between FIFO & LIFO methods for example average price.
● Closing stock valued at weighted average rate.
Advantages
● Since prices are averages, it recognises that issues from stock have equal value to the business and variation
in these values is minimized.
● The value of closing stock will be fairly close to latest price paid for purchases.
● AVCO is an acceptable method for purpose IAS 2 and company act 1985.
Disadvantages
● Time consuming.
● It involves complex calculations
● The prices charged to the issues of stock will not agree to the price paid to purchase the stock
4.
Periodic Weighted Average Pricing Method: In this method, a weighted average rate is calculated for the whole
period on the basis of the period receipts. It is calculated at the end of the period, as it has to incorporate all
receipts (and their values) of the period. All issues are made in the period but are valued at the end of the period
at the periodic weighted average rate. Periodic weighted average rate is calculated as:
Periodic Average price per unit =
Cost of opening stock + Cost of all receipts in the period
Opening stock units + no of units received in the period
❖ Question 1: Receipts during the month are given below
January 8
800 tonnes @ $50 per tonne
January 16
500 tonnes @ $60 per tonne
January 26
700 tonnes @ $70 per tonne
During the same period four materials requisition were completed for 300 tonnes each on January 10,
19, 25 and 29.
Page 25
Materials
MA/FMA Study Notes
Required: Calculate the cost of issues and value of closing stock using each of the following valuation methods:
a. FIFO
b. LIFO
c. Weighted average
d. Periodic average
Comparison of FIFO, LIFO and AVCO
● The values for AVCO lie between those for LIFO and FIFO. This should always occur because AVCO is an averaging
method.
● Both LIFO and FIFO require records to be kept of each batch of purchases so that the appropriate price may be
attached to each issue.
● Price fluctuations are smoothed out with the AVCO method which makes the data easier to use for decision‐
making, although the rounding of the unit value might cause some difficulties.
● Many management accountants would argue that LIFO provides more relevant information for decision‐making
because it uses the most up‐to‐date price.
● However LIFO may sometimes confuse managers, since the pricing method represents the opposite to what is
happening in reality, that is, the items in store will probably be physically issued on a FIFO basis.
● The prices of receipts are rising during the month. Therefore the FIFO method, which prices issues at the older,
lower prices, results in the highest value of closing inventory and the highest profit figure. The AVCO method
produces results that lie between those for FIFO and LIFO.
FREE STOCK
Free stock means the stock available for use without any restrictions. When a material requisition from the
production department is received at the store, it is important to ensure that only that stock is issued which is ‘free’
(that has not been already scheduled to be used in production or allocated to a job). When an order is received from
a customer, the required quantity of material is reserved, to ensure the order is complete in the given deadline. Free
stock is calculated as:
Free stock = Stock in hand + Stock on order (with supplier) – Reserved/scheduled stock.
❖ Question 2: A business has 8,400 units outstanding for Material X on existing customer's orders. There are 4,000
units in stock and calculated free stock is 5,650 units. How many units does the wholesaler have on order with
his supplier?
ORDERING STOCKS
Some organisations place orders according to their plans of future production or sales. They planned on the basis of
the purchase and sales requirements for the upcoming period.
For Retail Business: One which purchases and sales goods. It considers sales demand, because purchases are made
in accordance with sales requirements. Order quantity is calculated as;
Order quantity = Sales requirements + Closing stock– Opening stock
For Manufacturing Business: One which buys raw materials from the market, convert it to products and sells them.
It buys raw materials as per the production requirements. Order quantity is calculated as;
Order quantity = Production requirements + Closing stock– Opening stock
Page 26
Materials
MA/FMA Study Notes
Production units can be calculated using the following equation.
Production units = Sales units + Closing stock – Opening stock
❖ Question 3: A company buys and sells Deltas. At the beginning of June the store’s manager realizes that there
are only 35 Deltas in stock and decides to order more. He determines from the sales department that the
planned sales for the next 3 months are as follows;
June
July
August
Planned sales
120
150
130
The store’s manager feels that there will be 50 Deltas in stock at the end of August. How many Deltas must be
ordered?
❖ Question 4: A business makes a product, the Eel, each unit of which requires 4kgs of material X. At the end of
July, the store’s manager decides to place more order for material X as there are only 220 kgs in stock at that
date. The production plans for the next 2 months are 400 Eels in August and 500 Eels in September. At the end
of September it is planned to have 300 kgs of material X in stock. How much of material X should be ordered?
STOCK CONTROL LEVELS
Stock control levels are maintained to avoid stock out situation. Stock out situation is when too little stock is left that
regular orders cannot be made. All expenses and losses suffered by the business as a result of stock out situation
are called stock out cost. There are three stock control levels maintained to minimise the chances of stock out. The
purpose is to ensure only the right quantity of stock is held, not over or under stocking.
Reorder Level: It is also called replenishment order level. When stock reaches this level, it indicates that ordering of
stock is necessary. At this level, even if usage is at maximum level and the lead‐time is the longest, there will still be
no stock‐out situation. It can be calculated as;
Reorder level = Maximum Usage x Maximum lead time
Lead time: Lead time is the time between placing the order and receiving the goods.
Maximum Level: This identifies the maximum quantity of stock to keep. It avoids cost of over‐stocking. The stock
level should not exceed from this level. It can be calculated as;
Maximum level = Reorder level + Reorder quantity – (Minimum usage x Minimum lead time)
Reorder quantity: Reorder quantity is the number of units of stock ordered each time when re‐order level is reached.
If it is set so as to minimise the total costs associated with holding and ordering stock, then it is known as EOQ.
Minimum Level: This is the lowest quantity of stock that should be kept. This level warns the danger of stock‐out.
When stock reaches this level, emergency action will have to be taken to avoid stock‐out.
Minimum level = Reorder level – (Average usage x Average lead time)
Note: Safety stocks (or buffer stocks) are level of units maintained in case there is unexpected demand. Buffer
Stock/Safety Stock can also be calculated using Minimum Level formula.
Page 27
Materials
MA/FMA Study Notes
❖ Question 5: Mike Ltd has the following information:
Reorder quantity
2,500
units
Usage per month:
Estimated delivery period:
Max
Min
Max
Min
1,000 units
700 units
8 weeks
4 weeks
Required: Calculate
● The reorder level
● The maximum level
● The minimum level
It is also important to understand the concept of average stock for stock control purpose:
Average Stock: Average stock is the average between the minimum stock level and the highest possible stock level.
It is calculated as;
Average stock = Safety stock + ½ reorder quantity
❖ Question 6: A component has a safety stock of 600 units and the reorder quantity is 4,000 units and at a rate of
demand which varies between 200 and 650 units per week. What is the average stock?
STOCK COSTS
Stock costs include purchase costs, holding costs, ordering costs and stock out costs.
Stock‐out cost: If stock is kept too low, there is a risk of stock‐out, for example production stoppage, loss of customer
goodwill, loss of sales, labour idle time and extra cost for urgent re‐orders.
Purchase cost: The cost of buying the material. This is the largest cost faced by an organisation and once purchased,
stock has to be carefully controlled and checked. It can be reduced through availability of bulk purchase discounts.
Page 28
Materials
MA/FMA Study Notes
Holding cost: The costs incurred in keeping and storing stock, for example interest charges, insurances, electricity
and water, storekeeper's wages and risk of obsolescence, pilferage and deterioration. A company has to make a
balance between keeping the stock for production and having an amount of working capital tied up in stock. It can
be reduced through ordering less quantity in an order. Reasons of holding stock are:
● To ensure sufficient quantity is available to meet future demand.
● To meet future shortage of required material.
● To avail bulk purchase discounts.
● To avoid blockage in production process.
● To avoid stock‐out costs.
Ordering cost: The costs involved in ordering, receiving and paying for stock for example administrative costs for
contacting supplier to place an order, transport costs, filing paper works, receiving goods, checking quantities and
paying invoices. It can be reduced through ordering more quantity per order.
The cost should be considered when determining optimum stock level consists of holding costs and ordering costs.
To maintain stock at optimum level and to minimise cost, the total costs of holding and ordering stock a company
can
● Order in large quantity by placing a few orders
● Order in small quantity and placing many orders
● The aim of stock control is to minimize stock costs.
ECONOMIC ORDER QUANTITY (EOQ)
The Economic Order Quantity (EOQ) is the optimized order size/ quantity that will result in minimum total annual
cost. In other words, it is the economic stock replenishment order size which minimizes stock costs. At EOQ, ‘Total
annual holding cost’ is equal to the ‘Total annual ordering cost’.
Assumptions / Limitations of EOQ model
● Demand is constant throughout the year.
● Lead time is constant or zero (for example suppliers are reliable)
● Purchase price per unit is constant (for example no bulk discounts)
● Holding cost per unit will be constant per annum.
● Ordering cost per order will be constant
● No safety stock
● Average stock concept
● Ignore any uncertainty.
EOQ formula is
Where, D: expected annual sale (demand)
Ch: cost of holding one item of stock for one year
Co: cost of placing one order
Page 29
Materials
MA/FMA Study Notes
Total annual costs = Total annual purchase cost + Total annual ordering cost +Total annual holding cost
No. of orders
= D/EOQ
Frequency of orders
= EOQ/D x 365 (if required in days)
Annual ordering cost
= No. of orders x Co
Annual holding cost
= (EOQ/2 + Safety stock) x Ch
Annual Purchase cost
= D x Purchase Price
EOQ GRAPH
The total costs are at a minimum for an order quantity at point Q, which is EOQ. It is also a point where the holding
cost curve intersects with the ordering cost curve. Which means annual ordering costs and annual holding costs are
equal at the point of intersection.
❖ Question 7: The demand of a company’s particular stock item is 25,000 units per year. The cost of ordering that
stock item is $32 per order and it costs $6.40 per item to store for a year. The purchase price is $16 per stock
item.
Required:
a. What is EOQ?
b. Calculate the number of orders will be placed?
c. What is frequency of orders?
d. What is the annual ordering cost?
e. What is the annual holding cost?
f. What are the total costs?
BULK PURCHASE / LARGE ORDER DISCOUNTS
Frequently, discount will be offered for ordering in large quantities. When bulk discounts are available we have two
options; take advantage of discount by ordering a larger quantity or ignore the discount offer and go for economic
order quantity. We take the decision based on mathematical calculation.
We choose the option under which the sum of three costs; total purchase cost, total inventory holding cost and total
inventory ordering cost, is minimised. The total cost under two options is compared at following level:
● Pre‐discount EOQ level.
● Minimum order size to earn discount.
If total cost is minimised at pre‐EOQ level then discount offer should be ignored outright and vice versa.
Page 30
Materials
MA/FMA Study Notes
It may be solved by the following procedures:
● Calculate EOQ as usual, ignoring discounts.
● If this is below the quantity which must be ordered to obtain discounts, calculate total annual stock costs at EOQ.
● Recalculate the total annual stock costs using the order size required to just obtain the discount.
● Compare the cost of steps 2 and 3 with the saving from the discount and select the minimum cost alternative.
● Repeat for all discount levels to determine the best ordering quantity.
The ways in which discounts might affect the order size and the total costs:
● Discounts are likely to lower the total purchase cost and it will likely to increase order size in order to obtain
discount in bulk purchases
● The total ordering cost will be reduced as the increase in order size will lower the number of orders.
● The total holding cost will be increased or decreased. The increase is due to the increase of the number of average
stocks held annually but if the holding cost is a percentage of purchase price, then the holding cost will per unit
per annum decrease when the purchase price decreases.
❖ Question 8: Ralph purchases raw material at a cost of $96 per unit. The annual demand for the raw material is
4,000 units. The holding cost per unit is 10% and the cost of placing an order is $300.
Required:
a. Calculate EOQ?
b. How many orders will be placed?
c. What will be the frequency of order?
d. Calculate the annual ordering cost?
e. Calculate the annual holding/stock holding cost?
f. Calculate total annual inventory cost at EOQ?
The supplier offers an 8% discount for orders of 1,000 units or more at a time.
g. Ascertain whether the company should secure the discount?
ECONOMIC BATCH QUANTITY (EBQ)
Economic Batch Quantity (EBQ), also called Optimal Batch Quantity or Economic Production Quantity, is a measure
used to determine the quantity of units that can be produced at minimum average costs in a given batch or
production run.
Where: Co = cost of setting up a batch
D = Demand per period
Ch= holding cost per unit per period
R = production replacement rate/production rate per period.
❖ Question 9: Which of the following statement is true about economic batch quantity (EBQ)?
a. EBQ gives even better result for reorder quantity compared to EOQ
b. EBQ means ordering quantities in large batches for each inventory component
c. EBQ means that once our stock level reaches to half of optimal level, new order should be placed
d. EBQ concept is used to determine optimal quantity that should be produced
Page 31
Materials
MA/FMA Study Notes
❖ Question 10: Gera is a manufacturing company. It produces goods and sent them to stores. Demand is met
throughout the year from this finished goods stock. The company can manufacture 40,000 units a month.
Machine set up costs are $2,500 per machine set up. Holding cost is $12 per month. Monthly demand for the
product is 30,000 units. What is economic batch quantity (EBQ)?
a. 7,071 units
b. 3,535 units
c. 6,124 units
d. 1,2640 units
ACCOUNTING FOR MATERIAL COSTS
The opening balance of materials is a debit balance because it is a current asset (i.e. it will come on the debit side of
the materials control account.)
Entries
1. Purchase of material (in an integrated system of accounts)
Debit Material control account
Credit Creditors account
Purchase of materials (in an interlocking system of accounts)
Debit Material control account
Credit Cost ledger control account
2. Direct material issued to production
Debit Work in progress control account
Credit Material control account
3. Indirect material issued to production
Debit Production overhead control account
Credit Material control account
4. Direct material returned to stores.
Debit Material control account
Credit Work in progress control account
5. Indirect material returned to stores.
Debit Material Control account
Credit Production overhead control account
Material account and its contents are given below:
Materials Control Account
Opening balance
Purchases
$
X
X
Returned to stores:
Direct Material (WIP)
Indirect Material (Production OHs)
X
X
$
Issued to production
Direct materials (WIP)
Indirect materials (Production OHs)
Written off
Return to supplier
Theft / Loss
Closing Balance
Page 32
X
X
X
X
X
X
Labour
MA/FMA Study Notes
LABOUR
❖ This Chapter Covers:
✓
LABOUR
✓
RECORDING OF LABOUR COST
✓
LABOUR REMUNERATION METHODS
✓
OVERTIME AND OVERTIME PREMIUM
✓
RECORDING OF LABOUR COST (DOCUMENTATION AND PROCEDURE)
✓
PERFORMANCE MEASUREMENT OF USING STANDARD HOURS
✓
BONUS SCHEME
✓
LABOUR TURNOVER
✓
ACCOUNTING FOR LABOUR COST
Page 33
Labour
MA/FMA Study Notes
LABOUR
Labour cost represents the human contribution to production. It is the cost paid to workers in exchange of the work
they have performed. It is an important cost factor requiring constant measurement, control and analysis. It is
classified as;
Direct Labour Cost: It can be specifically traced to or identified with a particular product/service. They are directly
involved in making a product. For example, wages of stitching worker in a garments company, doctor in a hospital,
accountant in a firm, etc.
Indirect Labour Cost: It cannot be specifically traced to or identified with a particular product/service. They are not
directly involved in making a product. For example, Admin manager’s salary and supervisor’s salary, maintenance
worker’s salary, etc.
Measuring Labour Activity: Production and productivity are common methods of measuring labour activity.
 Production: It is the quantity or volume of output produced by worker.
 Productivity: It is the measure of the efficiency with which output has been produced. It is the comparison of
input with the output.
PLANNING AND CONTROLLING PRODUCTIVITY
Production levels can be raised by
● Working overtime
● Hiring extra staff
● Subcontracting some work to an outside firm
● Managing the work force so as to achieve more output
Productivity if improved, the company will enable to produce its products in fewer hours therefore it will reduce
labour cost per unit.
Automation: When the automation (machinery) is introduced, it often increases productivity but then the
productivity will be correctly measured as output per machine hour, instead of per man hour.
Production levels can be reduced by
● Cancelling overtime
● Laying off staff
RECORDING LABOUR COST
Several departments are involved in the collection, recording and costing of labour. These include:
● Personnel;
● Production planning;
● Timekeeping: responsible for recording the attendance time and the time spent in the factory and spent on
particular job by each employee;
● Payroll: Labour costs paid to employees according to records;
● Cost accounting.
Page 34
Labour
MA/FMA Study Notes
Pay‐slips: Records showing how each employee's pay has been calculated are known pay‐slips. These are produced
payroll section in calculation of wages and salaries. It contains the details of hours (basic and overtime) worked,
incentives paid and the deductions made from salaries and wages.
Personnel Department: The personnel department is headed by a professional personnel officer trained in managing
people, labour laws, company personnel policy and industry conditions. The professional personnel should have an
understanding of the needs and problems of employees. He/she is responsible for:
● Engagement, transfer and discharge of employees
● Classification and method of remuneration
Production Planning Department: The production planning department is headed by a professional person, who
has good understanding of production techniques, product quality standards and industry conditions regarding
machinery and workers skills and expertise. The production planning department is responsible for:
● Scheduling work
● Issuing job orders to production department
● Chasing up jobs when they run late
Remuneration Payment Methods
Time related
Fixed Salary
Hourly Base
Rate payment
Output related
Straight Piece
rate payment
Differential Piece
rate payment
Guaranteed Piece
rate system
✓ Time Related
This is the most commonly used remuneration method. Under this system, employees are paid on the basis of
hours, days, week or month they work. It contains two systems, fixed salaries hourly base rate payments.
1. Fixed Salary: A fixed salary, which employee receives after particular time intervals (usually weekly,
monthly). It does not depend on output produced. Employees paid on fixed salary basis are required to work
specific hours. Either the employees would be paid extra or not when they work more than the required hours
depends on the business’s policy.
2. Hourly Based Rate Payments / Day Rate System: In this system, employees are paid on hourly basis of
number of hours worked they have worked. The company has decided a rate per hour with the worker, which
is fixed for each hour worked. It can be calculated as:
Hourly pay = Number of actual hours worked x standard rate per hour
Advantages and Disadvantages of time related pay:
Advantages: This system has some advantages including
● Simple pay system, both for employee and employer.
● Employees are only paid for the time they work.
● It focuses on quality of product rather than quantity.
Page 35
Labour
MA/FMA Study Notes
Disadvantages: This system has some serious drawbacks including
● Pay system is time based rather than output or performance based.
● There is no motivational impact on this pay system
● Employees may try to remain present in order to become entitled to the wages rather than focusing on
performance/output
In order to improve performance, employees need to be kept motivated. A time based system is not so
designed.
✓ Output Related (Piecework)
Under this system employees are paid based on output they have produced. Employees are paid for the good
units produced. This system is normally used for the production workers. It is further split into straight piece
rate system, differential piece rate system and guaranteed piece rate system.
1. Straight Piecework: Employees are paid according to the number of units that they produce in a period
at a flat rate per unit. Employees earn more as they produce more. There is no motivation for the employees
in this system as the rate remain unchanged.
Basic pay=Number of good units produced x standard rate per unit
2. Differential Piecework: Differential piecework system is where a higher amount per unit is paid the more
the employee produces. In this system, different band rates are offered which are applied on different range of
outputs. Only the additional units qualify for the higher rate. Such a differential system is too common
nowadays. This system is designed to improve productivity and employee morale but may have adverse effects
on employee health and social life.
❖ Example 1:Payments by differential piece rates for an organisation are as follows:
Up to 99 units per week
$1.75 per unit
100 to 119 units per week
$2.00 per unit
120 or more units per week $2.25 per unit
If an employee produces 103 units in a week how much will he be paid?
3. Guaranteed Piecework: Guaranteed piecework system is where the employee is paid a guaranteed amount
of minimum pay in case there is not enough work available for each employee.
❖ Example 2:A piecework system works as follows:
$3.2 per unit for up to
40 units per week
$3.5 per unit for 41 units to
50 units per week
$3.8 per unit for each unit over
50 units per week
There is a guaranteed weekly wage of $120 per week. One employee has produced the following
amounts for the last 2 weeks
Week 1 35 units
Week 2 44 units
Required: What is the employee’s gross wage for week 1 and 2?
Page 36
Labour
MA/FMA Study Notes
IDLE TIME / DOWN TIME
It is the time which is paid for at normal basic rate but in which no work is done. It is also known as non‐productive
time. It is always treated as an indirect labour cost for both direct and indirect workers. It cannot be in overtime but
overtime may arise due to idle time. Idle time hours are deducted from the normal basic hours.
Reasons for idle time: There are some possible reasons for idle time.
● Production disruption
● Machine breakdown
● Shortage of material
● Inefficient scheduling
● Poor labour supervision
● Payments for tea break
● Payments for rest periods
● Sudden fall in demand of a product
● Strike at supplier’s business
An idle time ratio is a useful ratio for the control of idle time:
Idle time ratio = Idle hours
x 100
Total hours paid
Total hours paid =Productive hours + Non‐productive hours
Total hours worked=only Productive hours
❖ Example 3: The active hours achieved (hours worked) by the workforce amounted to 4,500 hours, and the idle
times were 500.
Required: What is the idle time ratio?
OVERTIME
The hours worked above than the normal working hours are called overtime hours, it also includes weekends and
national holidays. Worker is paid at a higher rate than the basic rate for overtime hours. This increased portion in
the rate is called overtime premium rate.
Overtime premium: The additional /extra amount paid to the employee over the basic rate in overtime hours is
called overtime premium rate. Overtime rate is always higher than normal basic hourly rate. Overtime rate is the
sum of basic rate and the overtime premium rate.
Types of Overtime
1. General Overtime: It is done due to the general reasons like machine breakdown, production disruptions, etc.
Normally it is done to cover the production backlog.
2. Specific Overtime: It is done due to customer’s special request to complete his job earlier. Remember this order
is separate from the normal production schedule.
Page 37
Labour
MA/FMA Study Notes
Overtime
Specific Overtime
Direct workers
At basic rate and at
overtime premium rate
both are treated as
direct labour costs.
General Overtime
Indirect workers
Direct workers
At basic rate and at
overtime premium rate
both are treated as
Indirect labour costs.
At basic rate is treated as
direct and at overtime
premium rate is treated
as indirect labour costs.
Pattern to solve the question:
D.Lab
Costs $
Direct Workers:
Basic wage [(basic hours – idle time hour) x Basic rate]
Idle time (idle time hours x basic rate)
Overtime:
Specific:
At basic rate (specific overtime hours x basic rate)
At overtime premium rate (Specific overtime hours x overtime premium rate)
General:
At basic rate (general overtime hours x basic rate)
At overtime premium rate (general overtime hours x overtime premium rate)
Indirect Workers:
Basic wage [(basic hours – idle time hour) x Basic rate]
Idle time (idle time hours x basic rate)
Overtime:
Specific:
At basic rate (specific overtime hours x basic rate)
At overtime premium rate (Specific overtime hours x overtime premium rate)
General:
At basic rate (general overtime hours x basic rate)
At overtime premium rate (general overtime hours x overtime premium rate)
Ind.Lab
Costs $
X
X
X
X
X
X
X
X
X
X
X
X
XX
XX
Example 4: During the month of March, the following hours were worked
Direct production workers
2,300 hours plus 55 hours of overtime
Indirect workers
640 hours including 120 hours of overtime
Direct workers are paid @ $7.2 per hour and the indirect workers @ $6.2 per hour. Overtime hours
are paid at time and a half. Of the hours paid to the direct workers, 11 were idle time hours.
Required: What is the direct labour cost and indirect labour cost for the month?
Page 38
Labour
MA/FMA Study Notes
❖ Example 5: The labour costs of a manufacturing business for a week are given below:
Direct production workers
1,500 hours at $6.4 per hour
Direct production workers overtime hours
500 hours at $9.4 per hour
Indirect workers
700 hours at $5.2 per hour
Indirect workers overtime hours
80 hours at $8 per hour
Of the total overtime hours of 500, 150 hours of overtime were spend on making a product earlier
on specific request of the customer.
Required: Find the total direct and indirect cost for the week?
RECORDING OF LABOUR COST (DOCUMENTATION AND PROCEDURE)
There are some documents used to record the labour cost.
1. Employee record card
2. Clock card
3. Job card
4. Time card
1.
Employee Record Card: It contains the basic information concerning an employee. It is raised when an employee
is hired and it shows a history of progress if his/her work till leaving the firm. For example, date of joining the
firm, rate of pay, promotion, training, and departments in which experience has been gained, records of
sickness, absenteeism, etc.
When employee leaves the company, the card is completed with the closing date and if possible, the reason for
leaving. It is a source document for the rate of pay which is used in the compilation of other labour records.
Recording
Employee work time
●
●
Employee engaged on specific
jobs/assignments.
● Job sheet or Card
Clock Card
Time sheet
Clock Cards: It is used to record the time at which the workers arrive and the time at which they left the organisation.
It shows the time the worker has spent in the organisation. Workers who are paid on an hourly basis record the time
for which they have worked, on a clock card.
Modern time recording systems may not use physical cards they have computerised system.
Time Sheets: Time sheet is filled by the production employee as a record of where he has spent his time. The total
time on the timesheet should correspond with time shown on the attendance record. It can be filled daily or weekly.
Page 39
Labour
MA/FMA Study Notes
TIME SHEET
NAME:
DEPARTMENT:
CLOCK NO:
WEEK COMMENCING
Date
Job
Start
Finish
TOTAL
Total overtime payment:
Hours
Overtime Hrs
Foreman’s Signature:
$
.
Job Sheets: An employee records the time spent on the job on the job card. If an employee is working on different
jobs relating to different departments, he/she will need to keep a record of the time he/she has spent on each job.
A job card is prepared for each job or batch.
JOB SHEET
NAME:
DEPARTMENT:
WEEK COMMENCING
Product
CLOCK NO:
Units
Code
Price
Bonus
Total
GROSS WAGES:
TOTAL HOURS:
Foreman’s Signature: _____________
Date: ______________
Piecework ticket / operation card: The wages of piece workers and the labour cost of work done by them are
determined from piecework ticket. It records:
▪ Total quantity produced
▪ Rejected units
▪ Good units
Payments are made only for good units
Page 40
Labour
MA/FMA Study Notes
PERFORMANCE MEASUREMENT OF LABOUR USING STANDARD HOUR
It is not possible to measure output in terms of units produced for a department making several different products.
This problem can be overcome by ascertaining the standard hours produced, for example the amount of time,
working under efficient conditions, it should take to make each product. For example, the time allowed for producing
a product X is 5 hours. There are three labour performance ratios, are:
1.
Activity ratio / production volume ratio: This ratio measures how the overall production compares to planned
levels. It compares the number of standard hours equivalent to the actual work produced and budgeted hours.
It can be calculated as,
Standard hours for actual output x 100
Budgeted hours
2.
Capacity ratio: This ratio measures the extent of worker's capacity by their working hour has been achieved in
a period with the planned labour hours utilization. It can be calculated as,
Actual hours worked
x 100
Budgeted hours
3.
Efficiency ratio: This ratio measures the efficiency of the labour force by comparing equivalent standard hours
for product produced and actual hours worked. It is also known as productivity ratio. The benchmark of
efficiency is 100%. It can be calculated as,
Standard hours for actual output x 100
Actual hours worked
Relationship between the three ratios:
Activity ratio = Efficiency ratio x capacity ratio
Standard hours for actual output = Standard hours per unit x Actual output.
Standards hours per unit = Budgeted hours ÷ Budgeted units produced
❖ Example 6: Budgeted output for a month is 3,000 units. Budgeted time for the production is 300 hours. The
actual output in January is 3,300 units and actual time work by labour force is 320 hours.
Required: To calculate:
a) Activity ratio
b) Capacity ratio
c) Efficiency ratio
BONUS SCHEME
The basic principle of a bonus payment is that the employee is rewarded for any additional income. It may be due
to the employee's efficiency on production which helps savings in the cost of production for the organisation. The
bonus payable will depend on the method of payment of the employee and the policy of the organisation.
A standard is set for individual or group. If an employee or a group exceeds this standard, then the employee or the
group benefits from the bonus according to some formula based on the value of the time.
Page 41
Labour
MA/FMA Study Notes
Characteristics of bonus schemes are as follows:
● Employees are paid more for their additional effort.
● Bonus level is set at a productivity level that is achievable but above normal effort level. The purpose being to
attract all employees rather than limiting it to a few numbers of employees.
● Increase morale of employees.
● The objective of such scheme is to persuade employees to go for an extra effort to earn a satisfactory return.
At the same time it should be ensured that employees are working in the right direction, i.e. no substandard
production to achieve a bonus.
The successful implementation of a bonus/incentive scheme depends on a number of factors:
● Rewards offered should be closely linked to the effort expected by employees
● Bonus scheme details should be agreed with all employees
● Terms and conditions of bonus scheme should be easy to understand by employees
● The bonus should be paid to employees as soon as they deserve it
● All the employees concerned should be made aware of the bonus scheme implementation
● There must be some allowance for conditions outside the control of employees which affect their effort like
material shortage, substandard material, poor working environment, machine breakdowns and so on.
● Its objectives should be clearly defined.
● It should be attainable by employees.
● Bonus conditions are easy to understand.
● It should be fair for both employees and employer.
● Only those employees who make extra efforts should be rewarded.
There are some incentive schemes:
1. High‐day rate system
2. Individual bonus scheme
3. Group bonus scheme
4. Flat rate bonus (fixed amount bonus)
5. Percentage of salary paid as bonus
6. Profit sharing scheme
7. Incentive schemes involving shares;
8. Productivity related bonus (time saving bonus)
1.
High‐day Rate System: It is a system under which employees are paid a high hourly wage rate in expectation
that they will work more efficiently than similar employees on lower rate in other companies.
Advantages of high‐day rate scheme:
● Calculation is simple
● Easy to understand
● Guarantee to employees for increased rate of wage.
Disadvantages of high‐day rate scheme:
● Employees cannot earn more than fixed rate per hour for their extra efforts.
● More supervision is required.
● More efforts are required by employees as a result employees may prefer to work at lower day rate.
Page 42
Labour
2.
MA/FMA Study Notes
Individual bonus: Such schemes are designed to suit individual employee. Each individual employee can qualify
for a bonus over and above his basic pay by achieving a standard set for him. Standard level is set for each
employee separately according to his job nature and position in the hierarchy of the organisation. It means
amount of bonus can vary for each employee. The main features of an individual bonus scheme are:
● Employee can earn bonus by showing efficiency above given targets.
● The bonus is awarded for a unique performance standard for each employee
● Each individual employee is provided with the resources to use his potential to achieve that performance
level to become entitled to bonus
● Employee concerned gets involved in such a scheme to make implementation productive.
Following factors ensure success of such a bonus scheme:
● Performance levels set for bonus should be realistic otherwise employees would get frustrated very soon
resulting in failure of scheme
● Standard set for work should be capable of being measured in time so that standard time can be set for the
tasks
● Working conditions should be appropriate
Bonuses should be reviewed periodically so as to keep the scheme attractive for employees otherwise once the
employee has achieved that standard of performance employees would start perceiving bonuses as part of their
basic pay.
3.
Group bonus: It is more suitable for the organisation where work is largely team oriented. In such an
environment group bonus schemes are more appropriate. A group bonus scheme is a reward plan that rewards
the whole team if desired performance level is achieved. Effort of each and every member is an essential feature
of such a bonus scheme.
The main features of group bonus scheme include:
● One of the main objectives is to create a team work environment in the organisation. Result of the combined
effort of team members is greater than the sum of individual team members called synergy effect.
● In designing the bonus scheme it is always considered that extra effort from each team member is required to
achieve the desired performance level.
● To make the bonus scheme work, the performance standards are set in consultation with team members.
Advantages of group bonus schemes:
● Such a scheme is much easier to administer as compare to individual bonus schemes as no separate record of
individual employees performance and reward is maintained.
● A common goal increases the team work culture in an organisation.
● Efficiency level is found to be increased for such a scheme.
● By working in a team, members get to share skills of each other.
Disadvantages of group bonus scheme:
● When performance standard is set for a whole group, the group members try to set desired performance level
at a lower level than an optimum level. It is natural that employees have reservations about their team fellow
member’s performance.
● In case of failure to achieve the desired performance level, team members blame each other. Such an event is
disastrous for team work culture in the organisation.
Page 43
Labour
MA/FMA Study Notes
●
Once failed to achieve the desired performance level at group level, the group or team members prefer individual
bonus scheme over group bonus scheme.
4.
Flat rate bonus (fixed amount bonus): A fixed amount of money is paid as a bonus to employee who achieve
the given task in the given criteria. This is based on performance. For example $200 pays as a bonus to each
employee.
5.
Percentage of salary paid as bonus: In this scheme, a fixed percentage is applied on basic employee’s salary and
paid as bonus. Obviously it is paid to one who achieves the standard set for the bonus. For example 10% of
salaries paid as bonus.
6.
Profit sharing scheme: A profit sharing scheme is a scheme where the part of a company’s profit is paid to
employees as a reward for loyalty and contribution to the company's success. The size of the bonus depends on
their position and length of employment in the company. The reward may be in any form, i.e. cash, shares or a
combination of both.
The advantages of profit‐sharing schemes:
● Profit maximization of the company becomes the objective of all employees.
● As the workers are directly linked with the share of profit and then their morale is kept high. They do not
need strict supervision. Disciplined workers only can keep the standard of administration high.
● The workers, who leave the organisation during the course of year, lose their share of profit hence the
scheme is a positive incentive to the workers to stick to their jobs. Thus, it ensures low labour turnover.
● The company only pays when profits are available and company can afford it.
Disadvantages of profit sharing scheme:
● The profit results are not merely from the availability of capital or efforts of employees. It depends on several
other factors such as efficiency of management, market conditions, on several other factors beyond the
control of the employees.
● A share of profit is paid to the employees only at the end of a specified period. In other words, reward comes
long after the effort has been made. This time lag reduces the eagerness of employees to get something for
their efforts.
● At the time of profit distribution, employers may object to the profit sharing scheme. They argue that profit
is the reward of the risk which the employer runs. Further if there is a loss why should the employees not
bear the share of it?
● In years of recession employees would lose their interest in such a scheme at all.
● Labour turnover might be high just after the profit sharing.
7.
Incentive schemes involving shares: Now days this bonus scheme is very common. In this scheme companies
use their shares or right to acquires them as a form of incentive. A share option scheme is a scheme which gives
its members the right to buy their company’s shares in future at a defined price. An employee share ownership
plan is a scheme which acquires shares on behalf of a number of employees and it must distribute these shares
within a certain number of years of acquisition.
Page 44
Labour
MA/FMA Study Notes
The advantage of share schemes:
● Employee will feel interest in company as a stakeholder
Disadvantage of share schemes:
● Benefits are not certain because market price cannot be determined realistically in advance.
● Benefits are not immediate.
8.
Productivity related bonus (time saving bonus): This bonus is based on the efficient working of employee. The
employees are eligible for this if they achieve the given task in less than the allowed time or made more products
in basic allowed hours then the bonus is paid for hours saved. This scheme is mostly tested in exams.
Saved hours = Time allowed – Time taken
Bonus is calculated according to formulas in given question.
❖ Example 7: The following data relate to work at factory A.
Normal working day (basic hours)
Basic rate of pay per hour:
Standard time allowed to produce 1 unit
Bonus scheme
8 hours
$7
2 minutes
90% of time saved at basic rate.
Required: What will be the labour cost in a day when 360 units are made?
LABOUR TURNOVER
Labour turnover is a measure of the proportion of number of leavers who require replacements relate to the average
number of people employed. One of the main objectives of a personnel department is to minimize labour turnover.
This can be calculated as,
Number of leavers who require replacements x 100
Average number of employees in a period
The reasons of labour turnover
Some reasons of employee turnover are controllable but others are not. The controllable reasons of labour turnover
are as follows:
● Inadequate wage levels causing employees to switch.
● Poor morale and low motivation within the workforce.
● Making employees to work under uncomfortable environment.
● Too much workload on an employee.
● Recruiting employees which are not suitable for particular job.
● Lack of career progression opportunities in the organisation.
● Poor working relationships between employees and manager.
● Unrealistic expectations from employee.
Unavoidable reasons of labour turnover:
● Illness
● Accident
● Family problems
● Social issues
Page 45
Labour
●
●
MA/FMA Study Notes
Retirement
Death
Cost of labour turnover: Labour turnover costs are very large and management should try to keep labour turnover
as low as possible to minimize these costs. Labour turnover costs are divided into two replacement costs and the
prevention costs.
1.
Replacement costs: Recruitment and replacement of staff will involve advertising, interviewing and selection
which can be time consuming. There are some other replacement costs:
● Additional cost of training of new employees.
● Loss of efficiency due to new recruits learning the job.
● Adverse effect on morale of existing work force which can be lead to demotivated employees.
● Loss of profit due to delay in new labour becoming available.
● Increased wastage among new staff due to lack of expertise.
● Lower productivity level as new staff need time to get pace.
Therefore, labour turnover should be closely monitored and reduced if possible.
2.
Preventive costs: These costs are incurred to retain employees or in other word to avoid labour turnover. There
are some prevention cost:
● Improving working condition
● Keeping wages of labour up with market rate
● Provision of a pension
● Provision of welfare services
● Cost of medical facilities offered to employee and his family
● Cost of other benefits offered like interest free or low interest loans, training programs, sports facilities and
vacations etc.
● Bonuses or profit sharing schemes
❖ Example 8: Alpha co. employed 1400 employees at 01 July 2008 and 1250 at 01 January 2009. Number of leavers
during the period was 350. What is the labour turnover ratio?
❖ Example 9: Bravo co. employed 1030 persons at the start of the year and 1140 at the end of the year. 160
employees left the organisation during the year. What is labour turnover for Bravo co.?
ACCOUNTING FOR LABOUR COST:
1. Integrated system
Debit Wages control account
Credit Cash/ bank/ payables
2. Interlocking system
Debit Wages control account
Credit cost ledger control account
3. Charging Direct Wages to production department
Debit Work in progress account
Credit Wages control account
Page 46
Labour
4.
5.
MA/FMA Study Notes
Charging Indirect Wages to production department
Debit Production overhead account
Credit Wages control account
Charging Indirect Wages to non‐production department
Debit Non‐production overhead control account
Credit Wages control account
Wages control account
$
$
Bank
X
WIP (direct labour)
Production overhead (Indirect labour)
Overtime premium
Idle time
Shift allowance
Sick pay
XX
Page 47
X
X
X
X
X
X
XX
Overheads
MA/FMA Study Notes
OVERHEADS
❖ This Chapter Covers:
✓ REVENUE EXPENDITURE AND CAPITAL EXPENDITURE
✓ PRODUCTION AND NON –PRODUCTION OVERHEADS
✓ TREATMENT OF OVERHEADS
✓ APPROACHES TO RECORD THE COST
✓ ABSORPTION COSTING
✓ ALLOCATION AND APPORTIONMENT
✓ REAPPORTIONMENT METHODS
✓ BLANKET RATE AND DEPARTMENTAL RATE
✓ UNDER OR OVER ABSORPTION OF OVERHEADS
✓ THE REASONS FOR USING ABSORPTION COSTING
✓ NON‐MANUFACTURING OVERHEADS
Page 48
Overheads
MA/FMA Study Notes
REVENUE EXPENDITURE AND CAPITAL EXPENDITURE
Revenue expenditure: The expenses incurred during the course of business or incurred to maintain existing fixed
assets are called revenue expenditures. For example, repairing and service of assets. These are charged to the profit
and loss account as an expense.
Capital expenditure: The expenses incurred in the acquisition of fixed assets or incurred to enhance the life of fixed
asset are called capital expenses. For example, purchase of machinery, changing the engine of a car, etc. They are
not charged to the profit and loss account as an expense, they are capitalised in the fixed asset cost. Fixed assets
depreciate with usage and the depreciation amount is charged to the profit and loss account to write off the capital
expenditure over a period of time.
INDIRECT EXPENSES: The expenses which cannot be traced directly to a product, service or department. For example
rent, rates, insurance, depreciation, electricity, water, maintenance of plant and machinery. They are also classified
as overheads which consist of the total of all indirect cost (indirect material, indirect labour and indirect expenses).
PRODUCTION AND NON PRODUCTION OVERHEADS
Production / Manufacturing overheads: The indirect costs that are incurred or related to the production are called
production overheads. They make up part of the production cost. For example, glue used in furniture, supervisor’s
salary, electricity used in production, etc.
Non‐production / Non‐manufacturing overheads: The expenses that are not directly or indirectly incurred or related
to the production are called non‐production overheads. For example, selling overheads, distribution overheads,
administration overheads, and finance overheads, etc.
TREATMENT OF OVERHEADS
Overhead costs are cost incurred that cannot be charged directly into cost units. These costs must, however, be
charged into the cost units to avoid under‐estimation of product costs which may end up with under‐setting the
product selling price. Overheads are treated as product cost or period cost.
Product Cost: The cost of making a product is known as product cost. It includes direct material, direct labour, direct
expenses and production overheads.
Period Cost: The cost which is related to a period not to production is known as period cost. It includes selling and
distribution, research, finance, administration, etc.
Accounting Treatment of Product and Period Cost
Product cost is taken into profit and loss account only to the extent of number of units sold and cost of unsold units
is taken into to the balance sheet as a closing stock. Whereas period cost in total is charged to profit and loss account.
Product cost is used for stock valuation purpose but period cost is least concern with stock valuation.
APPROACHES TO RECORD THE COST
Costs are recorded and accumulated in cost accounting systems using one of two main approaches:
1. Marginal costing (will discuss in the next chapter)
2. Absorption costing
Page 49
Overheads
MA/FMA Study Notes
ABSORPTION COSTING: The objective of absorption costing is to include an appropriate share of the organisation’s
total production overhead in the total cost of a product. Absorption costing is a method of sharing overheads
between a numbers of different products units. Factory overhead cost will be added to each unit of product
manufactured and sold.
Overhead costs such as administrative staff’s salary, advertising cost, etc cannot be charged directly into cost units.
These costs must be charged as period cost.
The process is to share out all overheads amongst the cost centres and then to share their overheads amongst the
products made in the cost centre. Some cost centres provide necessary services to the production cost centres.
These cost centres are known as service cost centres, which includes stores, maintenance, canteen, etc. The
overheads incurred by the service cost centres must then be shared amongst the production cost centres until all
the overheads are within the production cost centre. Then finally the total overhead can be shared amongst the
units which are made in each of the production cost centres.
Cost Centre: A department or sub‐part of a division, to which costs can be identified. Cost centre can further be
divided into two major categories.
TYPES OF COST CENTRE
Production cost centre
Centres thot actually produce goods, directly involved in
production like assembly department, finishing
deportment etc.
Service cost centre
Centres that provide necessary services to the production
cost centres. Indirectly involved in production like stores,
maintenance and canteen, etc.
Under absorption costing system there are four steps of charging overhead costs to cost centres and cost units.
1. Allocation.
2. Apportionment.
3. Re‐apportionment.
4. Absorption
1.
Allocation: Costs that relate to a single cost centre are allocated to that cost centre. Mostly indirect materials
and indirect labour costs are allocated. Allocation is the charging or distributing of cost directly to the cost
centres or cost units. Allocation (distributing) relates to costs that can be identified with a specific cost centre.
2.
Apportionment: Apportionment where an overhead cost is common, combined or joint to more than one cost
centres and therefore needs to be shared out amongst the relevant cost centres based on benefit received by
each cost centre. Formula of overheads apportionment:
Overhead apportionment = Department’s base x Total production overheads
Total basis
Page 50
Overheads
For example
Cost
Rent and rates
Light and heat
Power
Employee related costs
Depreciation of plant & machinery
Insurance of plant & machinery
Canteen cost
MA/FMA Study Notes
Basis of apportionment
Floor area / space occupied
Floor area / space occupied
Kilowatt hour / capacity of machines
Number of employees / wages cost
Value of machinery
Value of machinery
Number of employees
❖ Example 1: The total rental cost of an organisation is $20,000. The total floor area of the building is 100,000
square feet. The assembly department takes up 6,000 square feet and the stores department 10,000 square
feet. How much of the total rent should be apportioned to the assembly department and the stores
department?
❖ Example 2: Caps Ltd has three production departments, Machining, Assembly and Finishing and two service
departments, Stores and Maintenance. The budgeted annual overhead costs are as follows:
$
Indirect material:
Machining
Assembly
Finishing
Stores
Maintenance
Indirect salaries and wages:
Machining
Assembly
Finishing
Stores
Maintenance
Other indirect expenses:
Lighting and heating
Rent
Insurance of machinery
Depreciation of machinery
Insurance of building
Management salaries
100,000
80,000
60,000
40,000
20,000
300,000
50,000
40,000
30,000
20,000
10,000
150,000
15,000
20,000
6,000
12,000
7,000
10,000
Page 51
Overheads
MA/FMA Study Notes
Other information:
Machining
Assembly
Finishing
Stores
Maintenance
Book value of machinery
100
80
60
40
20
300
Area Occupied m2
900
750
600
450
300
3,000
No of Employees
3
2
3
1
1
10
Prepare: Allocate and apportion overhead cost to cost centres using overheads analysis sheet.
3.
Reapportionment: The process in which service cost centres totals apportioned to productions cost centres, to
nil service cost centre balances is called re‐apportionment. Service departments are cost centres, which exist to
provide services to other departments. Having allocated and apportioned the costs to the production and
service departments, the totals of service cost centres, then latter need to be reapportioned to the production
cost centres.
Basis of Reapportionment:
Service cost centres
Bases of reapportionment
Stores
Number of material requisitions
Maintenance
Number of maintenance hours or number of maintenance calls
Canteen
Number of employees
Formula:
Overhead reapportionment = Department’s base x Service center cost
Total base
Two methods are available for reapportionment:
✓ Direct method (used when service centres only give services to production cost centers)
✓ Indirect method
Indirect method further subdivided into 2 methods:
● Step Down method (one way method): One service department provides services to other service
departments but others do not. Service department which does most work for other departments is
reapportioned first. Other reciprocal services are ignored.
● Reciprocal method (two‐way method): Service departments provide services to each other. Full
recognition is given for all work done by service departments for each other. It may be solved algebraically
by simultaneous equation or through repeated distribution.
Page 52
Overheads
MA/FMA Study Notes
❖ Example 3: Following information is given:
Production
Pressing
Assembly
$
$
Allocated cost
10,000
20,000
Apportioned costs
5,000
6,000
15,000
26,000
Re‐apportioned bases:
Use of canteen
50%
30%
Use of maintenance
55%
40%
Canteen
$
5,000
3,000
8,000
‐
5%
Service
Maintenance
$
6,000
3,000
9,000
20%
‐
Required: Reapportion the service department costs using:
a. Direct method;
b. Step‐down method; (if canteen provides services to maintenance but maintenance does not provide to
canteen)
c. Reciprocal methods/ repeated distribution method.
4.
Absorption rate: It is a method of converting total overheads to overheads absorption rate which ultimately
become part of cost per unit of the product. Overheads absorption rate is calculated as;
Overhead Absorption Rate = Budgeted Production Overhead
Budgeted Activity Level
Overheads absorption rate can be calculated by using seven different activity levels. The total of the overheads
in each production department must now be absorbed into the units of production on the following basis:
Absorption rate
Activity level
Direct labour hours
$ x per direct labour hour
Machine hours
$ y per machine hour
Units of production
$ z per unit (for standard units only)
Direct wages cost
% of direct wages cost
Direct materials cost
% of direct materials cost
Prime cost
% of prime cost
% of full production cost
Full production cost
❖ Example 4: The following data was collected for a water supply factory:
Production overheads
$20,000
Direct labour hours
2,000 hours
Machine hours
4,000 hours
Direct labour costs
$16,000
Direct material costs
$10,000
Production
2,500 units
Required: Calculate the OAR using each of the below bases.
a. Direct labour hour
b. Machine hour
c. Direct labour cost
d. Direct material cost
Page 53
Overheads
e.
f.
g.
MA/FMA Study Notes
Prime cost
Production cost
Unit production basis
❖ Example 5: Budgeted Overheads
= $85,000
Budgeted Machine Hours
= 15,000 hours
Required:
a. Calculate Absorption rate base on machine hours?
b. Calculate FOH charge per unit if one unit of product requires 5‐machine hours.
❖ Example 6: The following details are given about 2 production cost centres of a business
Manufacturing
Finishing
Budgeted overheads
$245,600
$185,400
Labour hours
38,000
88,000
Machine hours
80,000
20,000
The manufacturing cost centre is a largely machine based dept and the finishing is very much
labour based.
Required:
a. What is the overhead absorption rate in the manufacturing cost centre?
b. What is the overhead absorption rate in the finishing cost centre?
BLANKET RATE AND DEPARTMENTAL RATE
Blanket rate refers to a situation where single rate is used for the whole factory or organisation. It is appropriate if
the company has few departments and the departments are similar in their activities and they consume more or less
the same amount of overheads.
Departmental rate is also known as separate absorption rate. It uses a separate rate for each department or cost
centre. If the company has many departments and they differ significantly, departmental rates should be used. If
blanket overhead absorption rate is used for the whole factory then some products will receive a higher overheads
proportion and some will be under charged. Using a separate absorption rate is more appropriate where product
spent different amount of time in each department.
Comparison between blanket rate and departmental rate:
The use of blanket rate saves time and thus cost, but less accurate then departmental rates. Therefore a careful
selection of which type of rate to use is essential, taking into account the cost‐benefit analysis.
Page 54
Overheads
MA/FMA Study Notes
❖ Example 7: Peter plc has two production departments and manufactures 2 products, C & D.
Dept 1
Dept 2
Total
Budgeted Overheads
$16,000 $10,000 $26,000
Budgeted direct labour hours
4,000
1,000
5,000
Prime costs
Department 1
Department 2
Product
C
$70
‐
10 hours
Product
D
$80
20 hours
2 hours
Required: Calculate the factory cost of each product using the following overheads absorption rate:
a. A single factory rate of overhead (blanket rate)
b. Separate departmental rate of overhead (departmental rate)
OVER/ UNDER ABSORPTION OF OVERHEADS
Predetermined overhead absorption rate (OAR) is based on budgeted overheads and budgeted activity levels. The
absorbed overheads will differ from actual overheads incurred.
Absorbed overheads: The overheads charged on the actual production units at predetermined overheads absorption
rate to determine production cost are called absorbed overheads. They can be calculated as;
Absorbed overheads = Absorption rate x actual activity level
Absorbed overheads are compared with actual overheads incurred in a period; the difference is either under
absorption or over absorption.
Over Absorption: It is when extra overheads charged in the production cost than actual overheads incurred in the
period.
Under Absorption: It is when less overhead charged in the production cost than actual overheads incurred in the
period.
As a result, the following adjustments are required to be made to balance out the effect of this under/over
absorption.
● Absorbed OH > Actual OH = OVER absorption (add in profit or deduct from Cost of goods sold).
● Absorbed OH < Actual OH = UNDER absorption (deduct from profit or add to Cost of goods sold).
Note: If actual overheads incurred are not given then an assumption can be taken that
Budgeted overheads = Actual overheads
Under or over absorption of overheads will occur if:
● Actual overheads are different from the budgeted overheads.
● Actual activity level different from the budgeted activity level.
● Or both situations arise.
Page 55
Overheads
❖ Example 8:
MA/FMA Study Notes
Budgeted units
Budgeted production overheads
Actual units’
Actual production overheads
100 units
$200
120 units
$230
Required: Calculate the under or over absorption of overheads.
❖ Example 9:
Budgeted activity:
Budgeted production overheads:
25,000 labour hours
$50,000
Required: Calculate under or over absorption of overheads when Actual overheads and Actual labour hours
are:
Overhead Cost
Level of Activity
a. $48,000
26,000 hrs
b. $49,000
22,500 hrs
c. $47,000
23,500 hrs
THE REASONS FOR USING ABSORPTION COSTING
● Stock valuation: Stocks in hand are valued for the closing stock figure in the balance sheet and the cost of sales
figure in the profit and loss account. Absorption costing is recommended in financial accounting by the
statement of standard accounting practice on stocks and long term contracts.
●
Pricing decision: Many companies fix the selling price of a product by calculating the full cost of production and
then add a margin for profit. This is known as “full cost plus pricing”.
●
Profitability: When a company sells more than one product, overhead costs must be shared on a fair basis to
each product to judge the profitability of each product.
NON‐MANUFACTURING OVERHEADS
Non‐manufacturing overheads may be allocated by choosing a basis for overhead absorption rate which fairly
reflects the non‐production overheads. For external reporting purposes non‐manufacturing costs are required to be
treated as period cost but for internal reporting purposes it may be included into product cost.
Based on the nature of some businesses it is necessary to determine the total cost of the product in order to add a
profit margin the total cost figure and set the price. Examples of such businesses include construction contractors,
accounting and law firms. For such businesses it is quite appropriate to add non‐manufacturing expenses in the
product unit cost.
Basis for apportionment of non‐manufacturing overheads
There are two options available for apportioning non‐manufacturing costs to cost units:
Method 1: Choose a basis for apportioning non‐manufacturing overheads which fairly reflects non‐manufacturing
overhead such as direct labour hour, machine hour etc.
Page 56
Overheads
MA/FMA Study Notes
Method 2: Allocate non‐manufacturing overheads to product on the basis of products ability to bear such cost. For
example manufacturing cost may be used to apportion non‐manufacturing cost to product.
Overhead absorption rate =
Estimated non‐manufacturing cost
Estimated manufacturing cost
Other possible bases for allocating overhead costs are as follows:
Overhead
Possible absorption bases
Administration
Production cost
Selling overhead
Sales value
Distribution overhead
Sales value
Page 57
Absorption & Marginal Costing
MA/FMA Study Notes
ABSORPTION AND MARGINAL COSTING
❖ This Chapter Covers:
✓ INTRODUCTION
✓ PROFIT REPORTING
✓ PRODUCT AND PERIOD COST
✓ MARGINAL COSTING
✓ ABSORPTION COSTING
✓ MARGINAL COSTING AND ABSORPTION COSTING – A COMPARISON
✓ RECONCILIATION OF PROFIT BETWEEN MARGINAL COSTING AND ABSORPTION COSTING
✓ ACCOUNTING ENTRIES OF OVERHEADS
Page 58
Absorption & Marginal Costing
MA/FMA Study Notes
PROFIT REPORTING AND STOCK VALUATION
There are two cost accounting approaches used for profit reporting techniques
● Marginal costing
● Absorption costing
Overview
PROFIT
REPORTING
MARGINAL
COSTING
+ Fixed Overheads =
ABSORPTION
COSTING
COMPARISON
IMPACT ON
STOCK & PROFIT
RECONCILIATION
These two profit reporting techniques are based on concept of product and period cost.
PRODUCT AND PERIOD COST
Product Cost: The cost of making a product is known as product cost. It includes direct material, direct labour, direct
expenses and production overheads.
Page 59
Absorption & Marginal Costing
MA/FMA Study Notes
Period Cost: The cost which is fixed in total and related to a period and not to production is known as period cost. It
includes selling and distribution, research, finance, administration, etc.
Accounting Treatment of Product and Period Cost
Product cost is taken into profit and loss account only to the extent of number of units sold and cost of unsold units
is taken to the balance sheet as a closing stock. Whereas period cost in total is charged to profit and loss account.
Product cost is used for stock valuation purpose but period cost is least concerned with stock valuation.
MARGINAL COSTING
It is the accounting system in which variable production costs are charged to cost units and fixed costs of the period
are written off in full against the aggregate contribution. Under this, cost of one unit of product or service can be
avoided if that unit is not produced or provided. It is used for decision making and profit reporting.
Contribution: Contribution is the difference between sales and variable cost. It has fundamental importance in
marginal costing contribution towards covering of fixed overheads and making a profit. Contribution is more useful
for decision making. It can be calculated as,
● Contribution
= Total Sales Revenue – Total Variable Cost
● Contribution
= Total Fixed Cost + Total Profit
ABSORPTION COSTING
The accounting system in which variable and fixed production cost are charged to cost units and fixed non production
costs and variable non production cost of the period are written off in full against the aggregate gross profit. In
absorption costing fixed manufacturing overheads are absorbed into cost units. It is preferred over marginal costing
in reconciliation of financial accounts and management accounts because it has by default application of IAS 2 in
stock valuation.
Product cost under Absorption and Marginal costing:
Production cost per unit of an item usually consists of the following:
Absorption costing
$ cost per unit
Direct Material
X
Direct Labour
X
Direct Expense
X
Variable (Production) overheads
X
Fixed (Production) overheads /OAR
X
XX
Production cost per unit
●
Marginal costing
$ cost per unit
X
X
X
X
‐
XX
Cost per unit of marginal costing is also known as variable production cost per unit and of absorption costing is
also known as full production cost per unit.
Page 60
Absorption & Marginal Costing
MA/FMA Study Notes
FORMAT‐PROFIT USING MARGINAL COSTING:
$
Sales (sales units x selling price)
Variable Cost of Sales:
Opening Stock (opening stock units x variable cost per unit)
Production (production units x variable cost per unit)
Closing Stock (closing stock x variable cost per unit)
$
XX
X
XX
(X)
(X)
XX
Gross Contribution
Variable non‐manufacturing OH:
Variable selling overheads
Variable distribution overheads
Contribution
Fixed production overheads (Actual)
Fixed non‐manufacturing overheads:
Fixed selling overheads
Fixed distribution overheads
Fixed administration overheads
(X)
(X)
(X)
XX
(X)
(X)
(X)
(X)
(X)
XX
Net Profit
FORMAT‐ PROFIT USING ABSORPTION COSTING:
$
Sales (sales units x selling price)
Cost of Sales:
Opening Stock (opening stock units x full cost per unit)
Production (production units x full cost per unit)
Closing Stock (closing stock x full cost per unit)
Cost of sales
Unadjusted gross profit
(Under) / Over Absorbed
Adjusted gross profit
Variable non‐manufacturing overheads:
Variable selling overheads
Variable distribution overheads
Fixed non‐manufacturing overheads:
Fixed selling overheads
Fixed distribution overheads
Fixed administration overheads
$
XX
X
XX
(X)
(XX)
XX
(X)/ X
X
(X)
(X)
(X)
(X)
(X)
(X)
XX
Net Profit
Note: If closing stock is not given in the question, it can be calculated as;
Closing Stock units = Opening stock units + Production units – Sales Units
Remember closing of one period is opening for the next period.
Page 61
Absorption & Marginal Costing
MA/FMA Study Notes
Explanation of the Difference in Profit: Profit under both can be different and can be equal. The difference in profit
between the two costing methods is due to:
● The difference in stock levels between the beginning and the end of the year
● The difference in stock valuation under both methods (calculation of production cost per unit)
Profit situations could be:
Case A: When production exceeds sales (closing stock higher than opening stock) the profit under absorption costing
will be higher than that reported under marginal costing.
Case B: If sales exceed production (opening stock higher than closing stock) profit under marginal costing will be
higher than absorption costing.
Case C: If production and sales are equal (opening stock=closing stock) profit under absorption costing will be equal
to marginal costing
❖ Example 1: Alpha Ltd makes a product, the Mick. Information relating to the product is given as follows:
Normal production
30,000 units
Sales price
$40
Unit cost:
Direct material
$10
Direct labour
$8
$4
Variable production overhead
Variable sales overhead
$3
Fixed costs for the month:
Production Overheads
$60,000
Selling cost
$25,000
Administration cost
$20,000
There is no opening stock of finished goods. Assume budgeted total fixed costs equals to actual total
fixed cost at all activity levels. Actual sales and production for the three years are:
Years
1
2
3
Sales (units)
25,000
29,000
27,000
Production (units)
31,000
28,000
27,000
Required: Calculate profit under Absorption costing and Marginal costing for each of the three years?
ABSORPTION COSTING VS MARGINAL COSTING:
Cost per unit
Stock
Profit: If stock level change, the 2
methods
produce
different
operating profits.
Absorption costing
Includes fixed and variable
production cost; So it may arise
under/over
absorption
of
production overhead.
Valued at full production cost
Profit is higher if the stock levels
are rising
Page 62
Marginal costing
Includes only variable production
cost; fixed cost is not absorbed
but written off to P&L, so there is
no under/over absorption.
Valued at variable production
cost
Profit is higher If the stock levels
are falling
Absorption & Marginal Costing
MA/FMA Study Notes
RECONCILIATION OF PROFIT BETWEEN ABSORPTION AND MARGINAL COSTING
The difference in profits reported under the two systems is due to the different stock valuation methods used.
Summary:
If stock level increases, absorption costing profit is higher than marginal costing profit.
If stock level decreases, absorption costing profit is lower than marginal costing profit.
If stock level remains the same, absorption costing profit is equal to marginal costing profit
If one of the marginal costing’s or absorption costing’s profit is given, we can find the other one by using the following
format.
Profit under marginal costing
Increase / (decrease) in stock x Fixed production OH per unit
Profit under absorption costing
=
=
=
X
X / (X)
X
❖ Example 2: Robot plc manufactures and sells helicopters. The selling price is $12. Each blanket has the
following unit cost:
$
2
Direct material
Direct labour
1
Variable production overhead
2
3
Fixed production overhead
8
Administration costs are incurred at the rate of $20,000 per annum. The company achieved the following
production and sales of blankets:
Year
1
2
3
110
90
Production (000)
100
Sales (000)
90
110
95
The following information is also relevant:
1. The overhead costs of $2 and $3 per unit have calculated on the basis of a budgeted production volume of
90,000 units.
2. There was no inflation.
3. There was no opening stock.
4. There were no differences between actual and standard costs or selling prices.
Required: Prepare profit statement for each year using both methods and reconcile the profit figures reported
under the two techniques
ARGUMENTS IN FAVOUR OF ABSORPTION COSTING
● Fixed production costs are incurred in order to make output, it is therefore fair to charge all outputs with a share
of these costs.
● Closing stock values, by including a share of fixed production overhead, will be valued on the principle of IAS 2,
as required by financial accounting purpose.
● Including fixed cost in the value of closing stock allows the fixed cost to be charged only in the period of which
revenue is earned, thus following the cost ‐ revenue matching concept.
Page 63
Absorption & Marginal Costing
MA/FMA Study Notes
ARGUMENTS IN FAVOUR OF MARGINAL COSTING
● It is simple to operate as we do not have to determine fixed overhead absorption rate.
● Writing off fixed cost immediately in the period it is incurred follows the prudence concept of accounting.
● Fixed costs are irrelevant cost for decision making, thus highlighting contribution in profit statement provides
better information for decision making purposes.
● Profit will not be distorted through fluctuation in stock level and production level as the contribution calculated
is based on sales volume.
ACCOUNTING ENTRIES OF OVERHEADS
Debit Work in progress account
Credit Production overheads account (with the amount of overheads absorbed)
Over absorption of overheads
Debit Production overheads account
Credit Over absorbed account (with the balancing figure of production overheads account)
Under absorption of overheads
Debit Under absorbed account
Credit Production overheads account (with the balancing figure of production overheads account)
Closing entry of work in progress account
Debit Finished goods account
Credit Work in progress account (with the balancing figure of work in progress account)
Closing entry of under absorbed account
Debit Profit and loss account
Credit Under absorbed account (with the balancing figure of under absorbed account)
Closing entry of over absorbed account
Debit Over absorbed account
Credit Profit and loss account (with the balancing figure of over absorbed account)
Page 64
Other Costing Techniques
MA/FMA Study Notes
OTHER COSTING TECHNIQUES
❖ This Chapter Covers:
✓ INTRODUCTION
✓ ACTIVITY BASED COSTING
✓ ADVANTAGES AND DISADVANTAGES OF ABC
✓ TOTAL QUALITY MANAGEMENT
✓ LIFE CYCLE COSTING
✓ LIFE CYCLE COSTS
✓ TARGET COSTING
Page 65
Other Costing Techniques
MA/FMA Study Notes
INTRODUCTION
This chapter covers four major costing techniques are:
1. Activity based costing (ABC)
2. Total quality management (TQM)
3. Life cycle costing
4. Target costing
1.
ACTIVITY BASED COSTING
Activity‐based costing (ABC) is an alternative approach to the traditional method of absorption costing. The
traditional method of overheads absorption effectively absorbs on a production volume basis and may be
misleading for costs where the behaviour is not directly related to production volume.
The treatment of overheads proposed by Cooper and Kaplan questioned the wisdom of traditional approaches
based on allocation, apportionment and absorption. A rational assessment of the problem would suggest that
the methods of splitting overheads between activities is perfectly fair, whereas the absorption of overheads on
the basis of labour hours is not appropriate for those costs that are not related to time or to labour. For example,
the cost of quality control may be driven more by the number of inspections made rather than the overall
volume of units manufactured.
Definition: The ABC approach is to link overhead costs to the products or services that cause them by absorbing
overhead costs on the basis of activities that ‘drive’ costs (cost drivers) rather than on the basis of production
volume. ABC involves the identification of the factors (cost drivers) which cause the costs of the organisation’s
major activities. Support overheads are charged to products on the basis of their usage of an activity.
Cost drivers ‐ Any factor which causes a change in the cost of an activity. A cost driver is a unit of activity that
consumes resources. An alternative definition of a cost driver is a factor influencing the level of cost.
Cost pool ‐ A cost pool is group of costs having the same cost driver. It consumes resources and for which
overhead costs are identified and allocated. For each cost pool, there should be a cost driver.
Examples of cost driver and cost pool
Cost pool
Purchasing department costs
Maintenance costs
Production control costs
Quality control costs
Ordering costs
Dispatch costs
Material handling cost
Cost driver
number of purchase orders made
number of machine breakdowns
number of production runs
number of inspections carried out
number of purchase orders
number of customer orders
number of production runs
Reasons behind the development of ABC
● Traditional method of absorption costing was developed in a time when most organisations produced only
a limited range of products (which were produced through similar operations and consumed similar
proportions of overheads) and overheads costs were only a small part of total cost.
Page 66
Other Costing Techniques
●
●
●
●
●
MA/FMA Study Notes
ABC was first developed in the US where, in the 1950’s – 60’s, attempts were made to establish more
accurate allocation and absorption of selling and distribution overheads, based on value adding activities
which consume resources and the cost drivers which generate cost.
There had been a general agreement that traditional method of dealing with overheads had weaknesses,
particularly in business where there was a significant shift and change in the environment where firms
operate.
Business processes are now more complicated and automated which includes a more diverse product range
requiring wide support functions. Service providers have become a more significant feature in many
economies. With this shift, overheads have become an increasingly larger proportion of total cost, with
wide ranging activities and drivers generating such costs. With this change competition has increased and
the need to develop models which enable management to determine more accurate product cost has also
arisen.
Activity based costing could provide much more meaningful information about product costs and profits
when:
▪ Indirect costs are high relative to direct costs
▪ Products or services are complex
▪ Products or services are tailored to customer specifications
▪ Some products are sold in large numbers and others in small numbers.
Different products result in different levels of activities and resource consumption.
In terms of information resulting from an activity‐based system, the outcomes may be therefore:
● Improved control over overhead expenditure: The identification of costs by activity, and the linking of the
costs of each activity directly with products via cost drivers, provides more and better information
(compared with traditional methods) on the causes of cost occurrence. As a consequence control of
overhead expenditure should be enhanced.
● Increased accuracy and improved insight into the make‐up, of product costs: This should lead to more
informed product decisions. Many overheads may be viewed as long‐run variable costs, rather than as fixed
costs, influenced by a number of factors at different levels of business activity.
● Pricing can be based on more realistic cost data: The traditional method of absorption of overheads into
unit costs on a volume basis may be misleading, with the result that product costs can, potentially, be
materially under/overstated.
Thus, where cost plus pricing is in use, products that have been materially undercasted may be priced at
levels that generate a loss whilst products that have been materially overcasted may be priced at levels that
are uncompetitive.
● Sales strategy can be more soundly based:
More realistic product costs as a result of the use of ABC may enable sales staff to:
▪ Target customers selling to whom might appear unprofitable using absorption costing but may be
profitable under ABC.
▪ Stop targeting customers or market segments that are now shown to offer low or negative sales
margins.
▪ Front line sales staff will be able to negotiate prices with greater confidence.
▪ ABC can be used to review the profitability of products and services with a view to focusing the efforts
of sales staff upon those products and services which offer the highest sales margins.
● Performance management and decision making can be improved:
Research, production and sales effort can be directed towards those products and services which ABC has
identified as offering the highest sales margins.
Page 67
Other Costing Techniques
MA/FMA Study Notes
ABC can influence decisions as to which:
▪ New products/services to develop.
▪ Existing products/services to curtail or drop.
▪ Products/services should be promoted.
▪ Overhead costs to target.
ABC vs. Traditional Absorption Costing:
● Allocation of overheads: Absorption costing allocates overheads to production departments where ABC
assigns overheads to each major activity (cost pool). Under ABC reapportionment of service department
costs is avoided.
● Absorption of overheads: The major difference between the two methods is the way in which overheads
are absorbed into products. Traditional method usually use two absorption bases (labour hours or machine
hours) whereas ABC uses many cost drivers as absorption bases (number of orders, number of dispatches)
● Cost drivers and absorption rates: ABC focus attention on what causes cost to increase, the cost drivers,
whereas in traditional system, no rule is available for selecting a base.
Page 68
Other Costing Techniques
MA/FMA Study Notes
Steps involved in ABC:
Having discovered the cost drivers within the business, it may well decide to reorganize the original production
departments.
Page 69
Other Costing Techniques
MA/FMA Study Notes
ADVANTAGES AND DISADVANTAGES OF ABC
There are some plus and negative points of ABC:
Advantages:
● Allotment of overhead is fairer and therefore product costs are more accurate.
● There is a better understanding of what causes cost.
● The company can concentrate on producing the most profitable items.
● Control of overheads is easier, as responsibility for incoming costs must be given.
● Performance appraisal is more meaningful.
● Cost driver rates can be monitored and used to identify areas of weakness or inefficiency.
● Budget setting and sensitivity analysis are more accurate.
● Activity based budgeting (ABB) can be used.
● More accurate use of resources in making a product.
● By focusing attention on cost drivers it will help managers understand and manage overhead cost.
● An understanding of cost driver rates can help in budgeting overhead expenditure.
● ABC concerns itself with all overhead costs, and as a consequence it has proved very useful in service
industries.
● ABC is concerned with all overhead costs(production related and non‐production)
Disadvantages:
● ABC may be based on historic information but could be used for future strategic decisions.
● Selection of cost drivers may not be easy.
● Additional time and cost of setting up and administering the system.
● Cost measurement may not be easy.
● Assessing the degree of completion of work in progress with respect to each cost driver is difficult.
● Variance analysis is complicated.
● Implementation of ABC is often problematic.
● Many judgmental decisions still required in the construction of an ABC system.
2.
TOTAL QUALITY MANAGEMENT
Total Quality Management (TQM) is the process of applying a zero defect philosophy to the management of all
resources and relationships within an organisation as a means of developing and sustaining a culture of
continuous improvement which focuses on meeting customer expectations.
Quality means:
● How well a product is made or service is performed
● How well it fulfills its purpose
● How it measures up against its rivals
Importance of quality:
In modern business environment, there are some changes in customers’ behaviour
● Now customer emphasis on quality rather than quantity.
● Customer prefers timely deliveries
● It prefers reliable product with best quality
Page 70
Other Costing Techniques
MA/FMA Study Notes
Quality management becomes total when it applies on process of TQM:
Step 1:
Establish standards of quality for a product or service.
Step 2:
Determine procedures or methods through which required standards of quality can meet.
Step 3:
Monitor actual quality achieved and compare it with required standards.
Step 4:
Take control actions if the required standards are not met.
Principles of TQM:
a. Get it right, first time: Cost of preventing mistake is always less than cost of correcting. So the basic aim is
to get things right first time. Cost of mistakes/ delay/ misunderstanding:
▪ Waste of time
▪ Waste of efforts
▪ Loss of goodwill
▪ Loss of future sales
▪ Loss of money
▪ Material wastage
b. Continuous improvements: Second principle of TQM is continuous improvement in quality. It means get it
more right next time.
QUALITY CONFORMANCE COST
Internal failure costs: These costs arise from inadequate quality where the problem is discovered before the
transfer of ownership from supplier to buyers.
● Rework costs
● Down time or idle time due to quality problem
● Disposal of defective products
● Re‐inspection cost
● Cost of reviewing product after failure
External failure costs: The cost arising from poor quality discovered after the transfer of ownership from
suppliers to buyers.
● Warranty claims
● Cost of lost sales
● Cost of customer service section
● Complaint, investigation and processing costs
Appraisal costs: It is a cost incurred in initial ascertaining the product to quality requirement
● Inspection and tests
● Product quality audits
● Process control monitoring
● Test equipment expense
Prevention costs: Cost of any action taken to prevent or reduce defects of failures
● Customer surveys
● Research of customer needs
● Quality education and training programs
● Supplier reviews
● Investment in improved production equipment
Page 71
Other Costing Techniques
3.
MA/FMA Study Notes
LIFE CYCLE COSTING
It tracks and accumulates costs attributable to each product over the entire product life cycle. A product life
cycle can be divided into four phases:
a. Introduction
b. Growth
c. Maturity
d. Decline
a.
Introduction: It is the initial stage of the product. Major focus is to give awareness to people about the
product and its features. At this stage;
● Product introduce in market
● Heavy capital expenses on product development
● Potential customers will be unaware
● Very low demand
● Start earning some revenue
● More spending on advertisement
● Try to gain market share
b.
Growth: At this point the sales have started but still need for marketing because market needs to grow. At
this stage barriers need to be set for the new entrants to save profit margins. It includes;
● Gaining market
● Create demand
● Increase in sales revenue
● Start gaining profit
● Initial costs of investment are gradually recovered
Page 72
Other Costing Techniques
MA/FMA Study Notes
c.
Maturity: This is the boom period of the product. At this stage, sales are at the highest level. Efforts are
made to extend the maturity period, either by improving the quality, design, reducing price, promotions,
etc.
● Stable demand
● Continue to be profitable
● To sustain demand modification or improvement is required
d.
Decline: This is the last stage of the product. At this point the sales are at minimum level either the product
has been outdated or the customer has got some better alternate.
● Saturation point
● Fall in demand
● May be become loss maker
● At this time organisation stop selling the product
Note: Not all products follow this cycle, but it remains useful tool when considering decisions such as pricing.
LIFE CYCLE COSTS
This approach tracks and accumulates a product’s life cycle, including the pre‐production stage (when a large
proportion of costs are committed), which means that a product’s total profitability can be determined. It traces
non‐production costs to individual products over complete life cycle.
Costs are incurred from product’s design stage through development to market launch, production, sales and
finally withdrawal from the market. Costs like:
● Research and development costs
● Purchasing costs
● Retirement and disposal cots
● Training costs
● Production cost
● Distribution costs
● Marketing costs
Life cycle cost can apply to services, customers and projects as well as to physical products.
Advantages of Life Cycle Costing
● Full understanding of individual product profitability
● More accurate feedback information
● Cost reduction and revenue expansion opportunities more apparent
● Increased visibility of non‐production costs
Life cycle costing versus traditional absorption costing:
● Traditional costing system is based on financial accounting year and it divides product lifecycle into a series
of 12 month period. It assess profitability of a product on a periodic basis whereas life cycle costing tracks
and accumulates actual costs and revenue to each product over the entire product life.
Page 73
Other Costing Techniques
●
●
4.
MA/FMA Study Notes
Traditional costing system does not relate research costs to the products that caused them. Instead they
write off these costs on annual basis against the revenue generated by existing products. Through which the
existing products seems to be less profitable than they actually are. Whereas in life cycle costing research
cost is charged to the product which actually causes it.
Traditional costing system charge non‐production cost as period cost but life cycle costing charge non‐
production to which it relates.
TARGET COSTING
Target costing involves setting a cost by subtracting a desired profit margin from a competitive market price. To
compete in current competitive market, organisation must continually redesign the process so profit life cycles
have become much shorter. Now days many costs are committed at planning and designing stage of a product.
Target costing have great impact on design stage to reduce cost.
Steps involved in implementing target costing system:
1. Determine a product specification for which sales volume is estimated.
2. Set a selling price at which market share can b achieved
3. Estimate the organisation’s required profit
4. Calculate target cost = target selling price – target profit
5. Determine estimated cost of that product based on defined specifications
6. Calculate cost gap = estimated cost – target cost
7. Make efforts to close the gap. Try to close the gap at planning stage rather than controlling cost after arising
gap.
When a product is manufactured, its target cost may be very low as compared to currently attainable cost.
Management has to reduce costs through:
● Reducing number of components
● Proper training
● Use new technology
● Remove any non‐value adding activity
● Using different materials
● Use low paid staff
These techniques are known as value engineering.
Even if the product can be produced within target cost, target costing can be applied to throughout the entire
life cycle. Once target cost is achieved, it gradually be reduced and reduction is incorporated into budget process
(continuous cost saving).
Target costing versus traditional absorption costing
Traditional method develop a product , determine production cost, set a selling price with a resulting profit or
loss whereas target cost determines the selling price from the market , deduct the desired profit margin and
resulting in a target cost which must be achieved.
Page 74
Job & Batch Costing
MA/FMA Study Notes
JOB AND BATCH COSTING
❖ This Chapter Covers:
✓ INTRODUCTION
✓ JOB COSTING
✓ JOB COSTING PROCEDURES
✓ COLLECTION OF JOB COST
✓ TREATMENT OF RECTIFICATION WORK
✓ USE OF JOB COSTING INFORMATION
✓ PRICING THE JOB WITH COST PLUS PRICING
✓ BATCH COSTING
✓ USE OF BATCH COSTING
Page 75
Job & Batch Costing
MA/FMA Study Notes
Introduction
A costing system is a system of collecting costs which is designed to suit the way that goods are processed or
manufactured or the way that services are provided.
Costing method is a costing system used to accumulate costs together for the purposes of stock valuation and
valuation of issues.
Specific order costing: method is used when the work consists of separately identifiable jobs, batches or contracts.
Work only commences after an order is received.
Continuous operation costing: method is used when there is a continuous flow of identical units. Process costing is
a typical form of continuous production process.
JOB COSTING
Job: A job is a cost unit which consists of a single order or contract.
Job costing: It consists of a single order undertaken to customers’ special requirements and is usually for a short
duration. It relates to a costing system where each unit of batch of output is unique. This creates the need for the
cost of each unit to be calculated separately.
Job costing procedures:
The normal procedure in jobbing organisations involves:
● An initial enquiry is received from a customer.
● Details are confirmed and agreed with the customer as to the precise dimensions, quality of materials, quality
of finished goods, required delivery date, etc.
● A cost estimate is prepared based on the requirement of the customer.
● A profit markup or margin will be added to the total estimated cost in order to calculate a quotation (selling
price) for the job.
● If the estimate is accepted the job can be scheduled. All the material, labour or equipment required will be
arranged and normally reserved so that job is complete in the given deadline.
● After the completion of the job, actual cost of the job will compare with the estimated selling price for the
calculation of actual profit.
Job Sheet/Job Card
Cost of each job is recorded on a job sheet or job card. It is separately prepared for each job because each job is
different from another job.
COLLECTION OF JOB COST INFORMATION
Direct material Cost: Estimated material cost will be calculated by valuing the material included in the quotation
and cost of material purchased specifically for the job shall also be estimated. Actual material cost is taken from the
material requisitions and by applying values to issues or from the invoices of material specifically purchased.
Direct Labour Cost: Estimated labour time requirement will be determined from similar jobs from the past. Labour
rate will need to be considered for any increase or overtime. Actual labour hours are recorded over time sheets or
on job cards. Actual labour cost is calculated using information about the hours (from the job card) and labour rate
(predefined rate)
Page 76
Job & Batch Costing
MA/FMA Study Notes
Direct Expenses: Estimated expenses shall be determined from the suppliers. Details of actual expenses will be
determined from the invoices.
Production Overheads: Estimated production overheads will be calculated from overhead absorption rate is
operation based on an estimated activity level (like budgeted labour hours). Actual production overheads are
charged to the job using absorption rate and actual results (like actual labour hours). This means absorbed overheads
are charged to jobs.
Non‐Manufacturing Overheads: Non‐Manufacturing overheads are charged to a job as a percentage of some cost
such as Prime Cost, Production Cost etc.
Profit: Usual method of setting a selling price is cost plus pricing method. This method adds a profit to total cost to
arrive at a selling price. The final price to be charged will be affected by what competitors charge and by what a
customer is willing to pay.
TREATMENT OF RECTIFICATION WORK
Rectification cost: is the cost incurred in rectifying sub‐standard outputs. Rectification is necessary where defects
are discovered during the job or after completion of the job which requires additional work to be done. Sub‐standard
output returned to that department where the fault arises.
Rectification cost can be treated in two ways:
● If rectification work is not a frequent occurrence and can be identified with a specific job, then rectification costs
should be charged as a direct cost to the job concerned.
● If rectification work is regarded as a normal part of the work, then rectification cost should be treated as
production overheads and absorbed into the cost of all jobs for the period using overhead absorption rate.
USES OF JOB COSTING INFORMATION
● In making a decision as to the lowest price at which a job should be undertaken.
● In the estimation of a price for quotation to the customer.
● In the valuation of the partly completed job for balance sheet purpose.
● In the comparison of actual with budgeted data to facilitate operational control and for future cost or price
estimation.
PRICING THE JOB WITH COST PLUS PRICING
Many organisations base the price of a product or service on simple cost plus rule which involves estimating cost
and then adding a profit margin or markup in order to set the price. Cost plus pricing is a method of determining the
sales price by calculating the full cost of a product and adding a percentage mark‐up or margin of profit. The aim of
job costing is to collect all the cost information related to the job.
Job cost card: A typical job cost is calculated with the cost card is as follows:
$
X
Direct material
Direct labour
X
Direct expense
X
Prime cost
X
X
Production overheads (absorbed)
Page 77
Job & Batch Costing
Production cost
Non‐ manufacturing overheads
Total cost
mark up/margin
Selling price
MA/FMA Study Notes
X
X
X
X
X
❖ Example 1: Hope Ltd carried out Job Z in June which has the following information:
Material T:
700kgs were issued at a cost of $15 per kg.
Material U:
900kgs were issued at a cost of $12 per kg.
Department V:
170 labour hours were worked, of which 50 were overtime.
Department W:
160 labour hours were worked, of which 30 were overtime.
Overtime work was done in January because of a request by the customer to complete his job quickly. The basic
pay in Department V is $9 per hour. Overtime premium is $2 per hour. Basic pay in Department W is $10 per hour
and overtime premium is $2.5 per hour. Overhead absorption rate is $4.5 per direct labour hour in both
departments.
Required: Calculate the full production cost of Job Z?
❖ Example 2: Ropy Ltd budgets to make 40,000 units which have a variable cost of production of $8 per unit. Fixed
production costs are $90,000. The selling price is to be 25% higher than the full cost.
Required: Calculate the selling price of one product using the cost plus pricing method?
BATCH COSTING
It consists of a separate, readily identifiable group of product units which maintains their separate identity
throughout the production process. Batch costing is very much similar to that of job costing. A batch of identical
products is treated as an individual job. A batch is a cost unit where a quantity of identical items is manufactured.
Batch costing is essentially a variation of job costing. Instead of a single job, a number of product units are
manufactured as a batch. Batches may be made specifically to customer requirements or produced for holding in
stock prior to sale.
The procedures for costing batches are very similar to job costing. The batch is treated as a job during production
and all the cost are collected related to the job. Once the batch is completed, the cost per unit can be calculated.
Cost per unit = Total batch cost
In a batch
Number of units
Uses of batch costing
● Batch costing is appropriate in following circumstances:
● Where similar number of items are made for each order.
● Where a business produces a single item to meet customer’s specifications but where the product being made
contains components that are also used in other products. Such components will be made in batches.
Page 78
Job & Batch Costing
MA/FMA Study Notes
❖ Example 3: Ingrid Ltd manufactures model ships to order and has the following budgeted overheads for the
year, based on normal activity level.
Department
Budgeted overheads ($)
Budgeted activity
1,500 labour hours
Welding
$4,500
Assembly
$6,500
1,000 labour hours
Selling and administrative overheads are 15% of production cost. An order for 120 model ships, made as
Batch A, incurred the following costs.
Materials
$8,500
Labour
140 hours welding shop
$8/hour
200 hours assembly shop
$12/hour
$3,000 was paid for the hire of special X‐ray equipment for testing the welds.
Required: Calculate the cost per unit for Batch A?
WORK IN PROGRESS
At the period end, some jobs have been completed and some left incomplete (in process). The value of work in
progress is simply the sum of cost incurred on incomplete jobs (and charged as closing work in progress).
❖ Example 4: Autumn Ltd, worked on four Jobs during a period.
$ Job 1
$ Job 2
Opening work in progress
5,260
3,170
Material in period
1,120
4,650
Labour for period
580
3,970
$ Job 3
6,940
6,010
5,170
$ Job 4
‐
3,360
2,980
The production overheads for the period were exactly as budgeted, $11,430 is absorbed into the cost of Job
as a percentage of direct labour cost. Job 1, 3 and 4 were all completed in the period.
Required: What was the value of closing work in progress?
Page 79
Service Costing
MA/FMA Study Notes
SERVICE COSTING
❖ This Chapter Cover:
✓ INTRODUCTION
✓ THE USE OF SERVICE COSTING
✓ FEATURES OF SERVICE COSTING
✓ SERVICE COSTING COMPARED WITH PRODUCT COSTING
✓ THE UNIT COST MEASUREMENT
✓ OCCUPANCY MEASUREMENT
Page 80
Service Costing
MA/FMA Study Notes
INTRODUCTION
Service costing is a method of accounting for services or functions. It is also known as operation costing or function
costing. The service centres or service functions include maintenance, personnel, canteen or stores.
Service organisations do not make or sell tangible goods. Profit seeking service organisations include accountancy
firms, law firms, transport companies, hair salons, banks and hotels. Non‐profit organisations include hospitals,
schools and libraries, etc.
THE USE OF SERVICE COSTING
Service costing is used in:
● External Services: provided by a company in a service industry, for example car hiring services, transport
services, courier services, etc.
● Internal Services: carried out by internal departments of a company, for example the costs of the vans or Lorries
used in distribution departments, the costs in computer departments or costs for staff canteens.
FEATURES OF SERVICE COSTING
Intangibility: Output is ‘intangible’ rather than a tangible product.
Perishability: Services are not ‘storable’ and cannot be bought in bulk.
Simultaneity: Service is performed and consumed simultaneously.
Heterogeneity: Nature and output is never standardised as human input is major element of a service.
Cost nature: In a service industry sector a higher proportion of costs incurred are indirect as compared to direct
Composite cost units: More than one cost units like cost per patient/night, cost per passenger/mile.
SERVICE COSTING COMPARED WITH PRODUCT COSTING
● Labour element in service costing is more prominent than material used.
● There is no standardised process for recording of material, labour and other expenses. These all vary subject to
nature of service.
● Not all services are revenue generating; customer service centres, distribution facility, libraries etc are main
examples. So purpose of service costing may not, necessarily, be establishing a profit or loss attributable to that
service but rather to provide the management with costs associated and efficiency and effectiveness of service
being provided.
THE UNIT COST MEASUREMENT
One particular problem with service costing is the difficulty in defining a realistic cost unit that represents a suitable
measure of the service provided. Frequently, a composite cost unit may be deemed more appropriate. Hotels, for
example, may use the 'occupied bed‐night' as an appropriate unit for cost ascertainment and control. Other typical
cost units that can be used include:
Services
Transport company
Education
Hospital
Canteen
Cost unit
Passenger/kilometer tonne/mile or kilometer
Student/subject
Patient/night
Meals served
Page 81
Service Costing
MA/FMA Study Notes
Measure the Service cost per unit
Service cost can be measured with the following formula:
Service cost per service unit =
Service cost for the period
Number services occupied in the period
❖ Example 1: The following information is available for Rose Motel for the last 20 day period.
Number of rooms available per night
45
Percentage occupancy achieved
90%
Room servicing cost incurred
$30,000
Required: What is the room servicing cost per occupied room‐night last period?
Occupancy of services achieved: This is used to measure the occupancy of services against the total availability of
service. It is measured in percentage, which is used to calculate the service cost unit. It is calculated as
Occupancy of service (%) =
Number of services occupied in the period x 100
Number of services available in the period
❖ Example 2: A hotel calculates a number of statistics including average room occupancy. Average room
occupancy is calculated as the total number of rooms occupied as a percentage of rooms available to let. The
following information is provided for a 30‐day period.
Rooms with
Single
twin beds
rooms
Number of rooms in hotel
260
70
Number of rooms available to let
240
40
Average number of rooms occupied daily
200
30
Required: The average room occupancy is?
Page 82
Process Costing
MA/FMA Study Notes
PROCESS COSTING
❖ This Chapter Covers:
✓ PROCESS COSTING
✓ FEATURES OF PROCESS COSTING
✓ SOME IMPORTANT CONCEPTS
✓ STEPS TO SOLVE QUESTION
✓ CONCEPT OF EQUIVALENT UNITS
✓ LOSSES DURING THE PROCESS
✓ VALUING WORK IN PROGRESS
✓ JOINT AND BY PRODUCTS
✓ APPORTIONMENT OF JOINT COST INTO JOINT PRODUCTS
✓ ACCOUNTING TREATMENT FOR BY PRODUCTS
Page 83
Process Costing
MA/FMA Study Notes
PROCESS COSTING
Process costing is a costing method which is applicable in industries producing homogenous products in large
quantities. The purpose of process costing is a typical one for example stock valuation.
FEATURES OF PROCESS COSTING
Products are homogeneous that’s why production takes place in large quantities. Production is continuous (2 or
more processes are involved in product manufacturing. For example, oil refining, paper making and chemical
manufacturing, etc.
Some important terms and concepts related to process costing are as follows:
Finished Goods: These are the units that have been completed in the period. If finished products are produced by
more than one process then output of first process becomes the input of the next process. It means next process
depends on the output of the previous process.
Work‐In‐Progress: There might be some incomplete products at the end of the period, they are called work in
progress units. Work in progress might not be complete with respect to all the cost so equivalent units should be
calculated.
Normal Loss: During production process, some units might get lost, and if the loss is not more than the expected loss
then it is called as Normal Loss.
Abnormal Loss: If the actual loss is more than the expected loss then the excess loss is called as Abnormal Loss of the
process. It arises when actual output from a process is less than the expected output.
Abnormal Gain: If the actual output greater than the expected output, then the extra units produced are called as
Abnormal Gain. It is the amount by which actual loss is less than the expected loss.
By‐Product: In some industries, there might be a chance of joint and By‐products. By‐products should be treated at
scrap value.
Note:
▪ Loses might have a certain resale value, that value is called the “Scrap value”.
▪ Losses might have to dispose of at some cost to company, that cost is called “Disposal cost”.
▪ Conversion cost = Direct labour cost + Direct expenses + Production overheads.
Each process cost is measure through a process account
A process account may have the following contents.
Process Account
Units
$
Opening W‐I‐P
X
XX
Finished goods
X
XX
Closing W‐I‐P
Direct Material
XX
Normal Loss
Direct Labour
XX
By‐product
Factory Overheads
Abnormal Gain
X
XX
Abnormal Loss
Total
XX
XX
Total
Page 84
Units
X
X
X
X
X
XX
$
XX
XX
XX
XX
XX
XXX
Process Costing
MA/FMA Study Notes
Important points to remember:
● We will discuss the treatment of opening WIP later in this chapter.
● Normal loss and by‐product are valued at scrap value in the process account. Their scrap values are set off
against the cost of production usually material.
● Finished goods and closing WIP are valued at cost per unit in the process account.
● Abnormal loss and abnormal gain units are valued at the cost per unit same as of finished goods units. The net
loss or gain (after deducting scrap value from the cost) of abnormal loss and abnormal gain is charged to profit
and loss account in the period in which it occurs.
● In a process account only either abnormal loss or abnormal gain can arise at a time.
● Calculation details are given below:
STEPS TO SOLVE QUESTION:
Equivalent Units: Output units + (Closing WIP x % of completion) + / (‐) Abnormal Loss / (gain)
Cost per unit: ($Total input cost – $ Normal loss Value ‐ $ By‐product Value)/Equivalent units
Cost of Output: Output units x cost per unit
Cost of Abnormal loss/Gain: Abnormal loss/gain units x cost per unit
Cost of closing WIP: (Closing WIP x % of completion) x cost per unit
But if work‐in‐progress have different degrees of completion:
For example, closing WIP is 100% compete for material, 80% for Labour & 60% for FOH, than the calculation will be
performed as:
Equivalent Units:
Mat: Output units + (Closing WIP x 100%) + / (‐) Abnormal Loss / (gain)
Lab: Output units + (Closing WIP x 80%) + / (‐) Abnormal Loss / (gain)
FOH: Output units + (Closing WIP x 60%) + / (‐) Abnormal Loss / (gain)
Cost per unit:
Mat: [Total cost of material – Normal loss ($) ‐ By‐product ($)]/Equivalent units of material
Lab: Total cost of labour / Equivalent units of labour
FOH: Total cost of FOH / Equivalent units of FOH
Cost of Output:
Output units x Total cost per unit
Cost of Abnormal loss/Gain:
Abnormal loss/gain units x Total cost per unit
Page 85
Process Costing
MA/FMA Study Notes
Cost of Closing WIP:
Mat: (Closing WIP x 100%) x Cost per unit of material
Lab: (Closing WIP x 80%) x Cost per unit of labour
FOH: (Closing WIP x 60%) x cost per unit of FOH
Total
=X
=Y
=Z
XYZ
Note: If WIP’s degree of completion is same for direct labour and Factory overheads (FOHs) than we can use the term
conversion cost in the process cost by adding direct labour cost and the factory overheads, this will reduce the
calculation.
CONCEPT OF EQUIVALENT UNITS
A process is continuous in nature and at the end of a period there may be some units, which have been started but
have not been completed (are known as work in progress). The existence of work‐in‐progress gives a problem in
computing the average cost per unit as production units will be at different degree of completions, therefore we
cannot simply take total cost divided by total output.
It becomes more complicated if the degree of completions varies for various cost elements. For example, materials
may be added at the start of the process, and are thus fully complete, whereas labour and manufacturing overheads
(conversion cost) may be added uniformly throughout the process. Hence, the ending work in progress may consist
of materials that are 100% complete and conversion cost that is only partially complete. To solve this problem,
Equivalent units need to be used.
Equivalent unit: It refers to a notional quantity of completed units substituted for an actual quantity of incomplete
physical units in progress.
This means that 100 units 70% complete is equivalent to 70 units 100% complete (70 equivalent units). Thus, the
resources required in these 100 incomplete units is the same as the resources required in the 70 equivalent units.
Note:
● Normal Loss is an expected loss of the process and its units are ignored while calculating equivalent units. As the
company can predict for the normal loss when determining the cost per normal output unit.
● The equivalent unit for one abnormal gain or loss output is 1 since the company cannot predict it when
calculating the cost per normal output unit.
❖ Example 1: Alpha Ltd is a manufacturer of processed goods. In one process 5,000 units were input. There was
no opening or closing work‐in‐progress (W‐I‐P). The following costs were incurred:
Direct Material
$16,100
Direct Labour
$7,500
Factory Overheads
$5,500
Of the 5,000 introduced, 4,500 were completed during the month and transferred to the next process. There
is an expected wastage of 10% of input.
Required: Calculate the cost per equivalent units and prepare the process account for Alpha Ltd.
Page 86
Process Costing
MA/FMA Study Notes
❖ Example 2: The process details are given below:
Input Units
= 2,800 units
Finished output
= 2,620 units
Normal Loss
= 10% of Input
Material Cost = $26,005 + $16,800
Labour Cost
= $4,200
Overheads
= $8,320
Scrap value of loss
= $1 / unit
Required: Prepare a process account and calculate the value of abnormal gain and finished goods?
❖ Example 3: Bravo Ltd a liquid chemical compound is manufactured as result of two processes. Details of Process
2 for November are as follows:
Opening W‐I‐P
Nil
Material transferred from Process 1
$49,875 (50,000 liters)
Labour cost
500 hours @ $5/‐hour
Overheads
44% of labour cost
41,000 liters
Output transferred to finished goods
Closing W‐I‐P
5,000 liters
Quality control checks at the end of the process of manufacture and normally leads to a rejection rate of 5% of
input materials. Closing W‐I‐P is 100% completed for materials and 50% for conversion costs.
Required: Prepare the Process 2 account for Bravo Ltd?
LOSSES WITH DISPOSAL COST
Sometimes loss units have a disposal cost rather than some scrap value; for example additional cost is incurred in
disposing them off.
To deal with such a situation remember the following points (opposite to scrap value):
● Debit the disposal cost of normal loss units to process costs. The resulting amount would be used to value good
output and abnormal loss/gain
● Normal loss appears in process cost with nil value
● Disposal cost of abnormal loss units is included in abnormal loss account and therefore is transferred to income
statement
❖ Example 4: Input to a certain process is 500 units at a total cost of $5,750. Normal loss in the process is 10%.
Prepare a process account if output of the process is 430 units. Loss units are disposed off at a cost of $2 each.
VALUING OPENING WORK IN PROGRESS
The closing work in progress which is partially completed units at the end of the period becomes the opening work
in progress for next period of the same process. International Accounting Standard (IAS) 2 Inventories allows two
methods for inventory valuation;
● First in first out (FIFO)
● Weighted average method
Page 87
Process Costing
MA/FMA Study Notes
Remember the following rule:
● FIFO inventory valuation technique is normally used and should be used in examination unless specifically stated
otherwise.
● If degree of completion of each cost element is not provided in the question but just the value of each cost
element, use weighted average method.
● If, on the other hand, degree of completion is provided for each cost element but not the value of each cost
element, use FIFO method.
Note: Opening WIP with losses is not in the syllabus.
❖ Example 5: Charlie Ltd makes a product requiring several successive processes. Details of the first process are
as follows:
Opening work‐in‐progress
500 units
Degree of completion:
Material (valued @ $22,000) 80%
Conversion (valued @ 8,000) 40%
Units transferred to process 2
2,400 units
Closing work‐in‐progress
600 units
Degree of completion:
Materials
100%
Conversion
70%
Cost incurred in the period:
Material
$175,000
Conversion
$125,000
There were no process losses.
Required: Prepare the process account using:
a. Weighted average method.
b. FIFO method.
JOINT AND BY PRODUCTS
Joint Products: Joint Products are produced from the same process but which have significant sales value at point of
separation.
By Products: By Products on the other hand are the output of the same process but they have a very small sales value
as compared with the value of main products.
Page 88
Process Costing
MA/FMA Study Notes
Point of Separation/Split Point
£20
A
Process
B
C
£22
Purchase
Department.
£0.5
By Product
APPORTIONMENT OF JOINT COST INTO JOINT PRODUCTS
Process account will be as normal. The joint cost of the joint products is apportioned according to these methods:
● Physical Measurement Method (output units are used as base for apportionment)
● Sales Revenue Method (Sales revenue calculated on output units is used as base for apportionment)
● Net Realisable Value Method (NRV is used as base for apportionment)
❖ Example 6: Company operates a continuous process producing two joint products and a by‐product. Output
from the processes for a month was as follows:
Product
Selling Price
Units of output
$ Per Unit
from process
A
15
15,000
B
20
20,000
C
2
2,000
Total Joint Cost = $200,000
Required: What is the unit valuation of each product A and B using?
● Sales revenue basis
● Physical measurement basis
ACCOUNTING TREATMENT FOR BY‐PRODUCTS
In process costing, By‐Products are treated as normal losses and the sales value of By Product is treated as scrap
value of normal loss.
● Income from by product added to sales of main product
● Income from by product treated as a separate source of income
● Sales income of by product deducted from the cost of production
● Net realisable value of by product deducted from the cost of production
Nature
Realizable value
Accounting
Joint product
It’s the main product
High sales value
All the joint products are separately
accounted for
Page 89
By product
Supplementary product
Low sales value
A by‐product’s cost is not separately
accounted for.
Budgeting
MA/FMA Study Notes
BUDGETING
❖ This Chapter Covers:
✓ PLANNING & CONTROL CYCLE
✓ THE MAIN PURPOSE OF BUDGETING
✓ THE BUDGET SETTING PROCESS
✓ FUNCTIONAL BUDGETS
✓ FIXED, FLEXIBLE AND FLEXED BUDGETS
✓ BEHAVIOURAL IMPLICATIONS OF BUDGETING
✓ PARTICIPATION AND PERFORMANCE EVALUATION
Page 90
Budgeting
MA/FMA Study Notes
PLANING & CONTROL CYCLE
Decide Goals and Objectives
Step 1
Develop Plan
Step 2
Planning
process
Decide Resources needed and
Performance Standards
Start Operations
Step 3
Control
process
Measure actual results and
compare with the plan
Variance Analysis
Most organisations have long term goals which can be divided into objectives and action plan.
Objective: Measurable steps towards achieving the goals.
Action plan: Detailed steps for achieving the objectives. Action plans are often expressed in money terms and usually
called budget.
Budget: An organisation’s plan for a forthcoming period, expressed in monetary terms.
Forecasts and budgets are not the same thing. Forecast is a prediction of what is likely to happen. A budget is a
target, not a prediction, which has to be achieved. Any difference between the planned results and the actual results
are called variances.
Page 91
Budgeting
MA/FMA Study Notes
THE MAIN PURPOSE OF BUDGETING
Budget generally refers to a list of all planned expenses and revenues. The purpose of budgeting is to:
● Provide a forecast of revenues and expenditures i.e. construct a model of how our business might perform
financially speaking if certain strategies, events and plans are carried out.
● Enable the actual financial operation of the business to be measured against the forecast.
Department managers in a business are responsible for making decisions on a daily basis that affect the profitability
of the business. In order to make effective decisions and coordinate the decisions and actions of the various
departments, a business needs to have a plan for its operations. Planning the financial operations of a business is
called budgeting. A budget is a written financial plan of a business for a specific period of time, expressed in currency
and units. Each area of a business’s operations typically has a separate budget. For example, a business might have
a marketing budget, a production budget, a sales budget, a purchase budget, a research and development budget,
and a cash budget etc.
AIMS OF PREPARING BUDGETS
● To ensure the fulfillment of organisation’s objectives; budgets are set to make progress towards the
achievement of long term goals of the organisation.
● A framework for responsibility accounting; budgets are used to make departmental managers responsible for
their area.
● Planning for the future; budgets incorporate future developments.
● Best utilization of resources; budgeting process allocates resources to their best possible use.
● Cost controlling; budgets in advance set costs that should be matched with the activity. Budgeted cost defines
the limit of expenditure.
● To ensure proper coordination; interdependence of departments is taken into account while setting budgets.
● To motivate employees; budget targets motivate employees to improve their performance.
● Performance appraisals; results achieved on the basis of budget acts as base for employee performance
appraisal.
● Defining authority; budget acts as an authorisation for expenditure.
Budgets are therefore set in consultation with all the stakeholders in order to ensure that budget setting objectives
are achieved.
THE BUDGET SETTING PROCESS
Before budget setting process is commenced, long‐term goals of the organisation must be considered. Budget is
always set taking account of organisational goals. Budgets are steps towards the achievement of long term goals of
the organisation and hence budgets ensure the progress towards the ultimate goal of the organisation.
Administration of budget
Budget manual: It is a collection of instructions governing the responsibilities of persons. It defines the procedures,
forms, formats relating to budgets. It does not contain actual budget. It is usually prepared by management
accountant. It includes:
● Objective of budgets
● Organisation structure
● Guideline regarding making budgets
● Formats and layouts of budgets
Page 92
Budgeting
●
●
MA/FMA Study Notes
Interdependence of budgets
Budget Deadlines
Budget period: Budget period is a time period to which budget relates. Maximum it can be of one year.
Responsibilities of preparing budgets: Managers responsible for preparing budgets ideally be the managers who
are responsible for carrying out the budget.
Budget committee: Budget committee is usually responsible for coordination and administration of budgets.
Members of budget committee are:
● Managing directors as chairman
● Accountant as budget officer ( for assistance)
● Representatives from each department (sales, production, marketing).
Functions of budget committee:
● Coordination for budget preparation
● Issue timetables for functional budgets
● Assign responsibilities of budget preparation
● Provide information which is required for budget
● Communicate final budget to appropriate managers
● Variance calculation and investigation
● Continuous assessment of budgetary process.
BUDGET MAKING PROCESS
Communicate budget details and guidelines to responsible person.
● Set organisation’s goals and objectives
● Determine Principal Budget Factor. (Principal budget factor is the factor that limits an organisation’s activity for
a given period). It is also known as key budget factor or limiting budget factor. Usually it is Sales demand but it
can be any other Limiting Factor too. All the other budgets are dependent upon it.
● Prepare budget of principal budget factor.
● Prepare functional budgets dependent upon Principal budget. For example,
▪ Production cost budget
▪ Resources budget
▪ Machine utilization
▪ Material usage budget
▪ Purchasing budget
▪ Labour budget
▪ Overhead budget
▪ Marketing cost budget
▪ Personnel budget
▪ Research and development budget
● Prepare Master Budget. It includes:
▪ Cash budget (This shows anticipated sources and uses of cash for the forthcoming budget period. Short run
deficits and surpluses are identified to enable the appropriate action to be taken).
▪ Budgeted income statement
Page 93
Budgeting
MA/FMA Study Notes
▪
●
●
●
●
Budgeted balance sheet
Negotiate budgets with seniors for approval.
Coordination of budgets because some budgets are out of balances with others and need modifications.
Final acceptance of budgets.
Budget reviews.
FUNCTIONAL BUDGETS
✓ Sales Budget: It has already been established that budget preparation process begins from the principal budget
factor. Sales figure is subject to market demand so it is mostly principal budget factor and hence sales budget is
prepared before any other budget. Sales budget is quite straightforward.
Sales budget = expected sales demand (units) x selling price per unit
❖ Example 1: Walked Ltd. sells three produces; A, B and C. Demand and selling price for the next quarter are
estimated to be:
Demand
Selling price
A
10,000 units
$15
B
8,000 units
$18
$25
C
6,500 units
Required: Prepare sales budget for next quarter?
✓ Production Budget: Production budget is prepared based on sales budget. But if production capacity is principal
budgeting factor then production budget factor is prepared first. To find out whether production is principal
budget factor consider the following:
▪ Availability of materials
▪ Availability of labour
▪ Machine capacity
If any of above factors is limiting factor then production will be principal budgeting factor and will be prepared
before any other budget. But usually it is the sales figure that is principal budget factor and therefore sales
budget is prepared before any other budget. It can be prepared as;
Production budget in units = budgeted sales units + closing stock –opening stock
❖ Example 2: Wallace Ltd. sells three produces; Yellow and Green and Black. Forecast sales for the next quarter
are estimated to be:
Demand
10,000 units
8,000 units
6,500 units
Opening inventory of finished goods
1,150
850
1,200
Closing inventory required
1,500
1,000
600
Required: Prepare production budget for next quarter?
Material Budget: Material budget are of two types:
✓ Material usage budget: This budget is prepared to measure the expected usage of material based on budgeted
production quantity. It is calculated as,
Budgeted number of units for production x material quantity required per unit
Page 94
Budgeting
MA/FMA Study Notes
✓ Material purchase budget: This budget is prepared to estimate the purchases of materials to be made based on
expected usage. It can be measured as,
Material usage budget + closing inventory of material – opening inventory of material
❖ Example 3: Walker Ltd. sells three products. It plans to produce these products as follows:
A
10,350 units
B
8,180 units
C
5,900 units
The data about the materials required (in kg) to produce three products is as follows:
A
B
C
Material Y
2
3
1.5
Material Z
5
2.5
6
Material Y
Material Z
25,000
Opening stock (kg)
10,000
Closing inventory required (kg)
15,000
20,000
Cost per kg
$2
$3.50
Required: Prepare both material usage and material purchase budget in units and value?
✓ Labour budget: It is used to estimate the labour hours and labour cost incurred on production. Labour budget
is calculated simply by multiplying number of hours required for production to labour rate per hour. Labour
budget can be measured as;
Budgeted labour hours = Budgeted production units x Standard hours per unit
Budgeted labour cost = Budgeted labour hours x standard hourly rate
❖ Example 4: Wilkes Ltd. sells three products. It plans to produce these products as follows:
A
10,350 units
B
8,180 units
C
5,900 units
The data about the labour hours required to produce three products is as follows:
A
B
C
Labour hour per unit
5
3
2
Labour rate per hour is $6.
Required: Prepare labour hours budget and labour cost budget?
Labour budget based on standard hour
Productivity is often described in terms of standard hour. A standard hour describes the amount of work that is
achievable at standard efficiency level. This concept is particularly useful when dissimilar units are being
produced in a factory and management is interested to determine the production level of each product. If there
is a shortfall of labour hours, management can take a number of steps to address the problem:
● Recruit more workers
● Offer better overtime rates
● Offer incentives for labour force for achieving production targets
● Address the causes of scrap output
● Reduce closing inventory requirement
Page 95
Budgeting
MA/FMA Study Notes
❖ Example 5: Wicker’s Co, manufactures and sells a single product, Sigma. Budget for next period is being set
now. Details are as follows:
Expected sales
10,000 units
Opening stock of finished goods
2,500 units
Closing stock required
1,000 units
5% of production output is expected to be scrap. Each unit of Sigma takes 5 standard hours of labour.
Labour is currently working at 90% efficiency level. Labour is paid at a basic rate of $8 per hour.
Required: You are required to prepare labour hours and cost budget?
✓ Production overheads budget: Unlike non‐production overheads budget for production overheads can be set
quite comfortably as production overheads are directly related to production.
❖ Example 6: Details for Woken Ltd, are as follows:
A
B
C
Production (units)
10,350
8,180
5,900
Labour hour required
5
3
2
Variable productions overhead are absorbed at the rate of $1.50 per labour hour. Fixed overheads are
absorbed at the rate of $0.50 per labour hour.
Required: You are required to prepare overheads budget?
✓ Non‐production overheads: As non‐production overheads are not related to production but rather fixed in
nature like administration overheads and research overheads. Fixed costs can be predicted in advance but the
costs that incur subject to management decisions are harder to predict at the start of the period.
✓ Master budget: The master budget is the budget into which all subsidiary budgets are consolidated. The master
budget normally comprises:
● Budgeted income statement
● Budgeted balance sheet
● Budgeted cash flow statement (cash budget).
The master budgets will be drawn up after all the functional budgets have been approved.
✓ Budgeted income statement: The budgeted income statement is prepared by summarising the functional
budgets.
✓ Budgeted balance sheet: The budgeted balance sheet will show the likely financial position at the end of the
budget period.
✓ Cash budget: ‘A cash budget is a detailed budget of cash inflows and outflows incorporating both revenue and
capital items.’
● Consider only cash items.
● Ignore non‐cash items like depreciation, provisions etc.
● Take cash flows at the time of receipt and payment not at transaction time.
The cash budget shows the cash position as a result of all plans made during the budgetary process and gives
management the opportunity to take appropriate control action. An important part of the budgeting process,
and an important working capital management tool, is the production of cash budgets. These, produced on a
Page 96
Budgeting
MA/FMA Study Notes
monthly basis, will allow a firm to identify when cash surpluses or deficits are likely to arise so that suitable steps
(investing or borrowing) can be planned.
Appropriate control actions for cash:
Short term surplus:
Pay payables early to obtain discount or make short term investments.
Short term deficit:
Increase payables, reduce receivables, and arrange an overdraft.
Long term surplus:
Expand, diversify, replace /update fix assets.
Long term deficit:
Issue share capital, consider shutdown /divestment opportunities.
The production of this budget in practices and in exam questions will follow a similar pattern:
● Forecast sales
● Identify debtor payment patterns
● Calculate cash receipts
● Produce functional budgets to determine production, materials usage, materials purchases, labor
requirements, and other costs.
● Calculate cash payments
● Find net cash flow
● Calculate surplus /deficit and closing cash balances
❖ Example 7: WEB Co produces two products, Orb and Sac. The budget for the forthcoming year to 31 May 2018
is to be prepared expectations for the forthcoming year includes the following.
WEB Co,
STATEMENT OF FINANCIAL POSITION AS AT 1 June 2017
$
$
ASSETS
Non‐current assets
Land and building
45,000
Plant and equipment at cost
187,000
Less accumulated depreciation
75,000
112,000
Current assets
Raw materials
7,650
Finished goods
23,600
Receivables
19,500
Cash
4,300
55,050
212,050
EQUITY AND LIABILITIES
Capital assets
150,000
Share capital
Accumulated profits
55,250
205,250
Current liabilities
Payables
6,800
212,050
Page 97
Budgeting
MA/FMA Study Notes
The sales director has estimated the following:
Finished products
Demand for the company’s product
Selling price per unit
Closing inventory of finished products at 31 May 2018
Opening inventory of finished products at 1 June 2017
Unit cost of opening inventory
Amount of plant capacity required each unit of product
Machining
Assembling
Raw material content per unit of each product
Material Y
Material Z
Direct labour hours required per unit of product
➢ Finished goods are valued on FIFO basis at full production costs.
Orb
4,500 units
$32
400 units
900 units
$20
Sac
4,000 units
$44
1,200 units
200 units
$28
15 min
12 min
24min
18min
1.5kilos
2.0kilos
0.5kilos
4.0kilos
6 hours
9 hours
Raw materials
Closing inventory requirement in kilos at 31 May 2018
Opening inventory at 1 June 2017 in kilos
Budgeted cost of raw materials per kilo
Material Y
600
1,100
$1.50
Material Z
1,000
6,000
$1.00
Actual costs per kilo of opening inventories are as budgeted cost for the coming year.
Direct labour
The standard wage rate of direct labour is $1.60 per hour.
Production overhead
Production overhead is absorbed on the basis of machine hours, with separate absorption rates for each
department. The following overheads are anticipated in the production cost centre budgets.
Machining
Assembling
department
department
$
$
9,150
Supervisors’ salaries
10,000
2,000
Power
4,400
Maintenance and running costs
2,100
2,000
500
Consumables
3,400
General expenses
19,600
5,000
39,500
18,650
Depreciation is taken at 5% straight line on plant and equipment. A machine costing the company $20,000
is due to be installed on 1 November 2017 in the machining department, which already has machine
installed to the value of $100,000 (at cost). Land worth $180,000 is to be acquired in February 2018.
Page 98
Budgeting
MA/FMA Study Notes
Selling and administration expenses
$
14,300
3,500
10,100
2,500
30,400
Sales commissions and salaries
Travelling and distribution
Office salaries
General administration expenses
There is no opening or closing work in progress and inflation should be ignored.
Budgeted cash flows are as follows.
Quarters
Receipts from customers
Payments:
Materials
Wages
Other costs and expenses
1
70,000
2
100,000
3
100,000
4
40,000
7,000
33,000
10,000
9,000
20,000
100,000
10,000
11,000
205,000
5,000
15,000
5,000
Required: Prepare the following for the year ended 31 May 2018 for WEB Co?
a. Sales budget
b. Production budget (In quantities)
c. Direct material usage budget
d. Direct materials purchases budget
e. Direct labour budget
f. Plant utilisation budget
g. Factory overhead budget
h. Computation of factory cost per unit for each product
i. Cost of goods sold budget
j. Cash budget
k. A budgeted income statement account and statement of financial position
FIXED, FLEXIBLE AND FLEXED BUDGETS
✓ Fixed budget: A budget which remains unchanged regardless of activity level is called fixed budget.
It is also known as original budget. A fixed budget is prepared based on an estimated production plan at the
start of a period. Regardless of the fact that actual activity level during the period might be quite different fixed
budget is not adjusted. It does not give like with like comparison. Commonly used in service industries where
most costs is fixed (rather than manufacturing industries where many costs are variable). It does not give fair
performance evaluation if variable costs are significant. It can be said, therefore, that fixed budget is only
prepared for planning purpose. It is very useful for service organisations.
✓ Flexible Budgets: Multiple budgets are prepared at the start of the period at different capacity levels are called
flexible budgets. At the end of the period, the budget which is same or close to the actual activity level is used
for comparison. They provide better performance measurement as compared to fixed budgets. It determines
the cost behaviour patterns.
Page 99
Budgeting
MA/FMA Study Notes
✓ Flexed Budgets: A budget that flexes the budgeted level of costs and revenues according to the level of activity
actually achieved is called flexed budget. It is prepared at the end of the period at actual activity level, if
budgeted and actual activity is not same. It provides like with like comparison. It provides realistic performance
measurement. It determines cost behaviour patterns. For variance reporting, actual costs are compared with
the flexed budget for the same volume of production and sales. Variance can be either favourable or adverse.
Appropriate control action is then taken to control variances. Remember only sales and variable costs are flexed,
fixed costs are taken as it is from the original budget.
Variance Reporting
It is the reporting of differences between budgeted and actual performance
Variance = Actual – Budget (flex budget)
Variances are:
Favourable if the business has more money as a result
Unfavourable if the business has less money as a result
Favourable variances are NOT always good for the organisation. For example if the essential staff is not hired
the labour variance will be favourable but this may also mean that the production targets will not be met.
❖ Example 8: The following data is given:
Direct materials
Direct labour cost
Fixed Production overheads
Master budget
10,000 units
$
50,000
40,000
70,000
Actual
9,000 units
$
46,000
39,000
69,000
Required: What is the variable cost variance?
❖ Example 9: Width Ltd. manufactures and sells a single product; Omega. Operational capacity of plant is 100,000
units for a year but due to plant deterioration it is now expected that it can only produce 80,000 units of a year.
A budget is prepared at 80% and 90% plant capacity.
80%
90%
$
$
Sales
640,000
720,000
Costs:
Direct material
96,000
108,000
144,000
Direct labour
128,000
Production overheads
210,000
230,000
Selling & distribution overheads
50,000
50,000
484,000
532,000
Net income
156,000
188,000
Page 100
Budgeting
MA/FMA Study Notes
Actual production for the period was 68,000 units of Alpha. Actual costs and revenue for the period were
as follows:
$
Sales
680,000
Costs:
Direct material
105,400
Direct labour
132,600
Production overheads
213,200
Selling & distribution overheads
60,000
511,200
Net income
168,800
There was no opening and closing stock. Sales price is fixed.
Required: You are required to prepare a flexed budget and compare the actual results with the flexed budget.
Behavioural aspects of budgeting: It is very easy for the budgetary process to cause dysfunctional activity. For
example, if junior management believe that a budget imposed upon them is not attainable, their aim may well be to
ensure that the budget is not achieved, thereby proving themselves to be correct. This needs to be avoided, and
therefore an understanding of the behavioural aspects is necessary.
Participation: Managers may be involved in setting budget targets or these may be imposed by senior management
without consultation. There are basically two ways in which a budget can be set: from the top down (imposed
budget) or from the bottom up (participatory budget). Many writers refer to a third style (negotiated). There are
three ways of using budgetary information to evaluate managerial performance (budget constrained style, profit
conscious style, non‐accounting style).
TOP DOWN APPROACH/ IMPOSED STYLE OF BUDGETING
It is a budget, which is set without allowing the ultimate budget holders to have the opportunity to participate in the
budgeting process. It is also called ‘imposed’ budget, or non‐participative. In this approach to budgeting, top
management prepare a budget with little or no input from operating personnel which is then imposed upon the
employees who have to work to the budgeted figures.
Features
● Senior management prepare budgets
● Imposed on junior management
● Quicker than bottom up approach
● Time saving
The time when imposed budgets are effective:
● In newly‐formed organisations
● In very small businesses
● During periods of economic hardship
● When operational personnels lack budgeting skills
● When the organisation's different units require precise coordination
Page 101
Budgeting
MA/FMA Study Notes
Advantages and disadvantages
There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
● Strategic plans are likely to be incorporated into planned activities.
● It enhances the coordination between the plans and objectives of divisions.
● Involvement of senior management in operational decisions
● It decreases the input from inexperienced or uninformed lower‐level employees.
● It decreases the period of time taken to draw up the budgets.
Disadvantages
● Low employees morale and defensiveness (hard for people to be motivated to achieve targets set by someone
else)
● The feeling of team spirit may disappear.
● Acceptance of organisational goals & objectives could be limited
● The feeling of the budget as a punitive device could arise.
● Managers who are performing operations on a day to day basis are likely to have a better understanding of what
is achievable.
● Unachievable budgets could result if consideration is not given to local operating and political environments.
This applies particularly to overseas divisions.
● Lower‐level management initiative may be stifled.
BOTTOM‐UP APPROACH/PARTICIPATION STYLE OF BUDGETING
Bottom‐up budgeting system of budgeting in which budget holders have the opportunity to participate in setting
their own budgets. It has been argued that participation in the budgeting process will improve motivation and so
will improve the quality of budget decisions and the efforts of individuals to achieve their budget targets (although
obviously this will depend on the personality of the individual, the nature of the task (narrowly defined or flexible)
and the organisational culture). In this approach to budgeting, budgets are developed by lower‐level managers who
then submit the budgets to their superiors. The budgets are based on the lower‐level managers' perceptions of what
is achievable and the associated necessary resources.
Features
● Junior management prepare budgets
● Senior management review to ensure consistent with organisation objectives
● Risk of budget bias/slacks
Advantages and disadvantages
There are, of course, advantages and disadvantages to this style of setting budgets.
Advantages
● Morale and motivation is improved.
● Better communication
● Should contain better information, especially in a fast‐moving or diverse business
● Senior managers can concentrate on strategy.
● They are based on information from employees most familiar with the department.
● Knowledge spread among several levels of management is pulled together.
Page 102
Budgeting
●
●
●
●
●
●
MA/FMA Study Notes
They increase operational managers’ understanding and commitment to organisational objectives.
In general they are more realistic.
Coordination between units is improved.
Specific resource requirements are included.
Senior managers' overview is mixed with operational level details.
Individual manager’s aspiration levels are more likely to be taken into account.
Disadvantages
● They consume more time.
● Senior managers may resent loss of control.
● Bad decisions from inexperienced managers.
● Budgets may not be in line with corporate objectives.
● Budget preparation is slower and disputes can arise.
● An earlier start to the budgeting process could be required.
● Figures may be subject to bias if junior managers either try to impress or set easily achievable targets.
● Certain environments may preclude participation, e.g. sales manager may be faced with long‐term contracts
already agreed.
● They may cause managers to introduce budgetary slack and budget bias.
Whilst bottom‐up is generally seen as preferable, there are situations where top‐down is applicable.
Budget Slacks (Budget Padding): Budgetary slack is the difference between the minimum necessary costs and the
costs built into the budget or actually incurred. In the process of budgeting, managers might deliberately
overestimate cost and understate sales, so that they will not be blamed in the future for overspending and poor
results. Manager of profit centre might understate budgeted sales and/or overstate budgeted expenditure
(budgetary slack).
Reasons
● Reward systems may be linked to performance compared with budget. This encourages the manager to build
slack into the budget to maximize personal gain.
● To reduce work related stress by having easier targets.
● “Gaming” – some individuals enjoy trying to beat the system.
NEGOTIATED STYLE OF BUDGETING: A budget in which budget allowances are set largely on the basis of negotiations
between budget holders and those to whom they report. At the two extremes, budgets can be dictated from above
or simply emerge from below but, in practice, different levels of management often agree budgets by a process of
negotiation. In the imposed budget approach, operational managers will try to negotiate with senior managers the
budget targets which they consider to be unreasonable or unrealistic. Likewise senior management usually reviews
and revises budgets presented to them under a participative approach through a process of negotiation with lower
level managers.
Final budgets are therefore most likely to lie between what top management would really like and what junior
managers believe is feasible. The budgeting process is hence a bargaining process and it is this bargaining which is
of vital importance, determining whether the budget is an effective management tool or simply a clerical device.
Page 103
Budgeting
MA/FMA Study Notes
BEHAVIOURAL IMPLICATIONS OF BUDGETING
‘’Used correctly a budgetary control system can motivate but it can also produce undesirable negative reactions.’’
The purpose of a budgetary control system is to assist management in planning and controlling the resources of their
organisation by providing appropriate control information. The information will only be valuable, however, if it is
interpreted correctly and used purposefully by managers and employees. The correct use of control information
therefore depends not only on the content of the information itself, but also on the behavior of its recipients. This
is because control in business is exercised by people. Their attitude to control information will color their views on
what they should do with it and a number of behavioral problems can arise.
●
●
●
The managers who set the budget or standards are often not the managers who are then made responsible for
achieving budget targets.
The goals of the organisation as a whole, as expressed in a budget, may not coincide with the personal
aspirations of individual managers.
Control is applied at different stages by different people. A supervisor might get weekly control reports, and act
on them; his superior might get monthly control reports, and decide to take different control action. Different
managers can get in each others' way, and resent the interference from others.
Motivation: Motivation is what makes people behave in the way that they do. It comes from individual attitudes, or
group attitudes. Individuals will be motivated by personal desires and interests. These may be in line with the
objectives of the organisation, and some people 'live for their jobs'. Other individuals see their job as a chore, and
their motivations will be unrelated to the objectives of the organisation they work for.
It is therefore vital that the goals of management and the employees harmonise with the goals of the organisation
as a whole. This is known as goal congruence. Although obtaining goal congruence is essentially a behavioural
problem, it is possible to design and run a budgetary control system which will go some way towards ensuring that
goal congruence is achieved. Managers and employees must therefore be favourably disposed towards the
budgetary control system so that it can operate efficiently.
The management accountant should therefore try to ensure that employees have positive attitudes towards setting
budgets, implementing budgets (that is, putting the organisation's plans into practice) and feedback of results
(control information). If this desirable state of affairs does not exist the organisation is at risk of under‐performing
as a result of dysfunctional decision‐making.
Goal congruence is the state which leads individuals or groups to take actions that are in their self interest and also
in the best interest of the organisation.
Dysfunctional decision making occurs when goal congruence does not exist or is impaired. Managers and others
take decisions that promote their self‐interest at the expense of the interest of the organisation.
Poor attitudes when setting budgets:
If managers are involved in preparing a budget, poor attitudes or hostile behaviour towards the budgetary control
system can begin at the planning stage.
● Managers may complain that they are too busy to spend much time on budgeting.
● They may build 'slack' into their expenditure estimates.
● They may argue that formalizing a budget plan on paper is too restricting and that managers should be allowed
flexibility in the decisions they take.
Page 104
Budgeting
●
●
MA/FMA Study Notes
They may set budgets for their budget centre and not coordinate their own plans with those of other budget
centres.
They may base future plans on past results, instead of using the opportunity for formalized planning to look at
alternative options and new ideas.
On the other hand, managers may not be involved in the budgeting process. Organisational goals may not be
communicated to them and they might have their budget decided for them by senior management or administrative
decision. It is hard for people to be motivated to achieve targets set by someone else.
Poor attitudes when putting plans into action:
Poor attitudes also arise when a budget is implemented.
● Managers might put in only just enough effort to achieve budget targets, without trying to beat targets.
● A formal budget might encourage rigidity and discourage flexibility.
● Short‐term planning in a budget can draw attention away from the longer‐term consequences of decisions.
● There might be minimal cooperation and communication between managers.
● Managers will often try to make sure that they spend up to their full budget allowance, and do not overspend,
so that they will not be accused of having asked for too much spending allowance in the first place.
Poor attitudes and the use of control information:
The attitude of managers towards the accounting control information they receive might reduce the information's
effectiveness.
● Management accounting control reports could well be seen as having a relatively low priority in the list of
management tasks. Managers might take the view that they have more pressing jobs on hand than looking at
routine control reports.
● Managers might resent control information; they may see it as part of a system of trying to find faults with their
work. This resentment is likely to be particularly strong when budgets or standards are imposed on managers
without allowing them to participate in the budget‐setting process.
● If budgets are seen as pressure devices to push managers into doing better, control reports will be resented.
● Managers may not understand the information in the control reports, because they are unfamiliar with
accounting terminology or principles.
● Managers might have a false sense of what their objectives should be. A production manager might consider it
more important to maintain quality standards regardless of cost. He would then dismiss adverse expenditure
variances as inevitable and unavoidable.
● If there are flaws in the system of recording actual costs, managers will dismiss control information as unreliable.
● Control information might be received weeks after the end of the period to which it relates, in which case
managers might regard it as out‐of‐date and no longer useful.
● Managers might be held responsible for variances outside their control.
It is therefore obvious that accountants and senior management should try to implement systems that are
acceptable to budget holders and which produce positive effects.
Pay as a motivator
Many researchers agree that pay can be an important motivator, when there is a formal link between higher pay
(and other rewards, such as promotion) and achieving budget targets. Individuals are likely to work harder to achieve
budget if they know that they will be rewarded for their successful efforts. There are, however, problems with using
pay as an incentive.
Page 105
Budgeting
●
●
MA/FMA Study Notes
A serious problem that can arise is that formal reward and performance evaluation systems can encourage
dysfunctional behaviour. Many investigations have noted the tendency of managers to pad their budgets either
in anticipation of cuts by superiors or to make the subsequent variances more favourable. And there are
numerous examples of managers making decisions in response to performance indices, even though the
decisions are contrary to the wider purposes of the organisation.
The targets must be challenging, but fair, otherwise individuals will become dissatisfied. Pay can be a
demotivator as well as a motivator!
Performance evaluation
A very important source of motivation to perform well (to achieve budget targets, perhaps or to eliminate variances)
is, not surprisingly, being kept informed about how actual results are progressing, and how actual results compare
with target. Individuals should not be kept in the dark about their performance. The information feedback about
actual results should have the qualities of good information.
Features of feedback
● Reports should be clear and comprehensive.
● The 'exception principle' should be applied so that significant variances are highlighted for investigation.
● Reports should identify the controllable costs and revenues, which are the items that can be directly influenced
by the manager who receives the report. It can be demotivating if managers feel that they are being held
responsible for items which are outside their control and which they are unable to influence.
● Reports should be timely, which means they must be produced in good time to allow the individual to take control
action before any adverse results get much worse.
● Information should be accurate (although only accurate enough for its purpose as there is no need to go into
unnecessary detail for pointless accuracy).
● Reports should be communicated to the manager who has responsibility and authority to act on the matter.
Surprisingly research evidence suggests that all too often accounting performance measures lead to a lack of
goal congruence.
Managers seek to improve their performance on the basis of the indicator used, even if this is not in the best interests
of the organisation as a whole. For example, a production manager may be encouraged to achieve and maintain high
production levels and to reduce costs, particularly if his or her bonus is linked to these factors. Such a manager is
likely to be highly motivated. But the need to maintain high production levels could lead to high levels of slow‐
moving inventory, resulting in an adverse effect on the company's cash flow.
The impact of an accounting system on managerial performance depends ultimately on how the information is
used.
The use of budgets as targets:
In certain situations it is useful to prepare an expectations budget and an aspirations budget. Management and the
management accountant require strategies and methods for dealing with the tensions and conflict resulting from
the conflicting purposes of a budget.
Once decided, budgets become targets. As targets, they can motivate managers to achieve a high level of
performance. But how difficult should targets be? And how might people react to targets of differing degrees of
difficulty in achievement?
Page 106
Budgeting
●
●
●
MA/FMA Study Notes
There is likely to be a demotivating effect where an ideal standard of performance is set, because adverse
efficiency variances will always be reported.
A low standard of efficiency is also demotivating, because there is no sense of achievement in attaining the
required standards, and there will be no impetus for employees to try harder to do better than this.
A budgeted level of attainment could be 'normal': that is, the same as the level that has been achieved in the
past. Arguably, this level will be too low. It might encourage budgetary slack.
It has been argued that each individual has a personal 'aspiration level'. This is a level of performance in a task with
which the individual is familiar, which the individual undertakes for him to reach. This aspiration level might be quite
challenging and if individuals in a work group all have similar aspiration levels it should be possible to incorporate
these levels within the official operating standards.
Some care should be taken, however, in applying this.
● If a manager's tendency to achieve success is stronger than the tendency to avoid failure, budgets with targets
of intermediate levels of difficulty are the most motivating, and stimulate a manager to better performance
levels. Budgets which are either too easy to achieve or too difficult are de‐motivating, and managers given such
targets achieve relatively low levels of performance.
● A manager's tendency to avoid failure might be stronger than the tendency to achieve success.
(This is likely in an organisation in which the budget is used as a pressure device on subordinates by senior managers).
Managers might then be discouraged from trying to achieve budgets of intermediate difficulty and tend to avoid
taking on such tasks, resulting in poor levels of performance, worse than if budget targets were either easy or very
difficult to achieve.
It has therefore been suggested that in a situation where budget targets of an intermediate difficulty are motivating,
such targets ought to be set if the purpose of budgets is to motivate; however, although budgets which are set for
motivational purposes need to be stated in terms of aspirations rather than expectations, budgets for planning and
decision purposes need to be stated in terms of the best available estimate of expected actual performance. The
solution might therefore be to have two budgets.
● A budget for planning and decision making based on reasonable expectations.
● A second budget for motivational purposes, with more difficult targets of performance (that is, targets of an
intermediate level of difficulty).
These two budgets might be called an 'expectations budget' and an 'aspirations budget' respectively.
The management accountant and motivation
We have seen that budgets serve many purposes, but in some instances their purposes can conflict and have an
effect on management behaviour. Management and the management accountant therefore require strategies and
methods for dealing with the resulting tensions and conflict. For example, should targets be adjusted for
uncontrollable and unforeseeable environmental influence? But what is then the effect on motivation if employees
view performance standards as changeable?
Can performance measures and the related budgetary control system ever motivate managers towards achieving
the organisation's goals?
● Accounting measures of performance can't provide a comprehensive assessment of what a person has achieved
for the organisation.
Page 107
Budgeting
●
●
●
MA/FMA Study Notes
It is unfair as it is usually impossible to segregate controllable and uncontrollable components of performance.
Accounting reports tend to concentrate on short‐term achievements, to the exclusion of the long‐term effects.
Many accounting reports try to serve several different purposes, and in trying to satisfy several needs actually
satisfy none properly.
The management accountant does not have the authority to do much on his or her own to improve hostile or
apathetic attitudes to control information. There has to be support, either from senior management or from budget
centre managers. However, the management accountant can do quite a lot to improve and then maintain the
standard of a budgetary control reporting system.
➢ How senior management can offer support
▪ Making sure that a system of responsibility accounting is adopted.
▪ Allowing managers to have a say in formulating their budgets.
▪ Offering incentives to managers who meet budget targets.
▪ Not regarding budgetary control information as a way of apportioning blame.
➢ Budget centre managers should accept their responsibilities. In‐house training courses could be held to
encourage a collective, cooperative and positive attitude amongst managers.
➢ How the management accountant can improve (or maintain) the quality of the budgetary control system
▪ Develop a working relationship with operational managers, going out to meet them and discussing the
control reports.
▪ Explain the meaning of budgets and control reports.
▪ Keep accounting jargon in these reports to a minimum.
▪ Make reports clear and to the point, for example using the principle of reporting by exception.
▪ Provide control information with a minimum of delay.
▪ Make control information as useful as possible, by distinguishing between directly attributable and
controllable costs over which a manager should have influence and apportioned or fixed costs which are
unavoidable or uncontrollable.
▪ Make sure that actual costs are recorded accurately.
▪ Ensure that budgets are up‐to‐date, either by having a system of rolling budgets, or else by updating
budgets or standards as necessary, and ensuring that standards are 'fair' so that control information is
realistic.
Page 108
Investment Appraisal
MA/FMA Study Notes
INVESTMENT APPRAISAL
❖ This Chapter Covers:
✓ INTRODUCTION
✓ INVESTMENT APPRAISAL METHODS
✓ NON‐DISCOUNTED CASH FLOW METHODS
✓ INTEREST
✓ FUTURE VALUE
✓ PRESENT VALUE
✓ TIME VALUE OF MONEY CONCEPT
✓ DISCOUNTED CASH FLOW METHODS
✓ ANNUITY
✓ PERPETUITIES
✓ NOMINAL RATE AND EFFECTIVE RATE
✓ TABLES
Page 109
Investment Appraisal
MA/FMA Study Notes
INTRODUCTION
Capital expenditure often represents a significant investment by a company so it needs to be assessed very carefully.
A long term view of costs and benefits must be taken when reviewing a capital expenditure project.
Capital expenditure: Expenditure incurred in acquisition of non‐current assets. It is not charged to income statement
although a depreciation charge will usually be made to write off the capital expenditure gradually over time. Capital
expenditure appears in statement of financial position.
Revenue expenditure: Expenditure incurred for the purpose of trade off the business or to maintain the existing
earning capacity of non‐current assets. It is charged to income statement.
Capital income: Income from the sale of non‐current assets.
Revenue income: Income from the sale of trading assets. It also includes interest and dividend received from
investment held by the business.
Capital expenditure budget: Capital expenditure budget is a long term plan and is considered very important for the
business. Major expenses are required for it so most projects are considered individually and are fully appraised.
Suitable finance must be arranged for capital expenditure. Capital expenditure should have a positive value for the
business.
Investment appraisal
Investment appraisal techniques are required to determine:
● Whether a new project should be accepted
● Which of two (or more) projects to accept
● Whether to lease or buy a new asset
● How to raise finance for the purchase of an asset
Relevant and irrelevant costs
The cost which affects or be affected with decision is called as relevant cost. Relevant costing is used in long term
decision making and investment decisions. The relevant costs are:
● Only cash items
● Future cash flows
● Incremental cash flows
Following are the examples of some important relevant and irrelevant costs
Past or Sunk Cost or Historical cost: Costs that have been incurred in the past but they have no impact on today’s
decision are called Past Costs or Sunk Costs. They are irrecoverable costs. These are irrelevant for decision making
because we cannot change the past.
Committed cost: Cost that has to be incurred regardless of output of the decision is called committed cost. Committed
Costs are irrelevant to decision. Mostly fixed costs are committed cost.
Apportioned cost: All costs or charges are being allocated but without the responsible manager’s control or not
actual cost are irrelevant for decision making. For example absorbed overheads, fixed overheads.
Page 110
Investment Appraisal
MA/FMA Study Notes
Notional cost: A notional cost or imputed cost is a hypothetical accounting cost to reflect the use of a benefit for
which no actual cash expense is incurred. For example Notional rent, notional interest, depreciation, provisions.
These are non‐cash items and irrelevant for decision making.
Incremental Cost: Costs which are additional due to only one specific decision are incremental cost and they are
relevant.
Controllable Cost: Costs that can be controlled because of one particular decision are controllable costs and they are
relevant for decision making.
Uncontrollable Cost: Costs which cannot be controlled because of a specific decision are uncontrollable cost and they
are irrelevant for decision making.
Avoidable Cost: Costs that can be avoided because of one specific decision are avoidable costs and they are relevant.
Avoidable cost is cost which would not be incurred if the activity to which they related did not exist. Any direct cost
which can be saved from ceasing to sell a product or a closure of an outlet is an avoidable cost.
Unavoidable Cost: Costs that cannot be avoided because of one specific decision are unavoidable costs and they are
irrelevant for decision making.
Fixed cost: Fixed costs are generally irrelevant to decision making because they do not change but the incremental
fixed costs are always relevant.
Variable cost: Variable costs are normally relevant for decision making.
Opportunity Cost: Opportunity cost is the cost of second best alternative which we lose because of one particular
decision. Opportunity cost is the benefit which has been given up, by choosing one option instead of another.
Opportunity costs only apply to the use of scarce resources. Where resources are not scarce, no sacrifice exists from
using these resources. If no alternative use of resources exists then the opportunity cost is zero. But if resources
have an alternative use, and are scarce, then opportunity cost does exist.
INVESTMENT APPRAISAL METHODS
There are mainly two methods to appraise any prospective investment.
Non‐discounted cash flow methods (traditional methods)
● Accounting rate of return
● Simple payback period
Discounted cash flow methods (DCF methods)
● Discounted payback period
● Net present value
● Internal rate of return
(Various surveys have shown that the traditional methods are still more common than the discounted cash flow
methods, the theoretically inferior internal rate of return is more commonly used.)
Page 111
Investment Appraisal
MA/FMA Study Notes
NON‐DISCOUNTED CASH FLOW METHODS (TRADITIONAL METHODS)
✓ Accounting rate of return or Return on capital employed (ARR or ROCE)
This method of appraising the viability of a project over its several years’ life is similar to the method of assessing
the financial performance of a business over a single year.
It is sometimes called an accounting rate of return.’
Return on capital employed =
Average accounting profit per annum
x 100
Initial investment
The profit used is usually after depreciation but before interest and tax
Average accounting profit =
Average investment =
Total profit of all years
Number of years
Initial investment + scrap value
2
Decision rules
If accounting rate of return > Target
If accounting rate of return < Target
Accept the project
Reject the project
❖ Example 1: Woods Ltd plans to invest $400,000 in machinery that will save $170,000 in labour costs each year
for 5 years. What is this project’s return on capital employed?
❖ Example 2: A company is considering a project requiring outlay on fixed assets $320,000, with life of 3 years and
scrap value of $40,000. Net operating inflows each year are estimated as $176,000, followed by $120,000 and
finally $140,000. Calculate the project’s return on capital employed?
Advantages of Accounting rate of return
● Quick to calculate
● Simple to use and understand
● Familiar concept for managers
● Commonly used by external analysts
Disadvantages of Accounting rate of return
● Accounting profits might not be objectives of the organisation
● Different methods of calculation are possible
● It ignores the time value of money
● It considers accounting profits rather than cash flows
✓ Simple payback period
This is the time taken to recover the initial cash flows from the cash inflows of the project. Payback period is the
amount of time that is expected to take for the cash inflows from a capital investment project to equal the cash
outflows. It is particularly useful if there are liquidity problems or if distant forecasts are very uncertain.
Simple payback period
= Initial investment ÷ annual cash inflows (in case of annuity)
Page 112
Investment Appraisal
MA/FMA Study Notes
Decision rules
If Simple payback period < Target
If Simple payback period > Target
Accept the project
Reject the project
❖ Example 3: The project information is given below:
Cash Flows ($)
(50,000)
Year 0
Year 1
75,000
Year 2
75,000
Year 3
75,000
Year 4
75,000
Required: Calculate simple payback period
❖ Example 4: A project is expected to have cash flows.
Cash Flows ($)
Year 0
(2,000,000)
Year 1
500,000
Year 2
500,000
Year 3
400,000
Year 4
600,000
Year 5
300,000
Year 6
200,000
Required: Calculate payback period
Advantages of simple payback period
● It is easy to calculate and understand.
● It is widely used in practice as a first screening method.
● Its use will tend to minimize the effects of risk and help liquidity, because greater weight is given to earlier
cash flows which can probably be predicted more accurately than distant cash flows.
● It is based on cash flows rather than profits.
Disadvantages of simple payback period
● Total profitability is ignored.
● The time value of money is ignored.
● It ignores any cash flows that occur after the project has paid for itself. A project that takes time to get off
the ground but earns substantial profits once established might be rejected if the payback method is used,
whereas a smaller project, paying back more quickly, may be accepted.
Before we start discounted methods of investment appraisal we must understand some important terms
Page 113
Investment Appraisal
MA/FMA Study Notes
INTEREST: Money earned or paid for the use of money is called interest. Interest cost is always on outstanding
balance. The two types of interest are.
● Simple interest: Interest calculated on principal amount is Simple interest
Simple Interest = Principal amount x r x n
● Compound interest: Compound interest is calculated on principal amount as well as any previous outstanding
interest.
Compound Interest =
Principal amount (I + r)n
Where,
r = Interest rate
n = Number of years
TIME VALUE OF MONEY CONCEPT: There is a time preference for receiving the same sum of money sooner rather
than later. Conversely, there is a time preference for paying the same sum of money later rather than sooner.
Reasons for Time Preference for Money
There are three very important reasons why money has a time preference.
● Consumption Preference – money received now can be spent on consumption
● Risk preference – risk disappears once money is received.
● Investment preference – money received can be invested in the business, or invested externally.
FUTURE VALUE: Future value is defined as the value or sum of money at a future date at a particular interest rate.
Future value is calculated by multiplying present value with a compound factor:
F.V = P.V (1 + r)n
Where,
PV = Present value
FV = Future value
r = Interest rate / discount rate
n = Number of time periods
The method of converting present value into future value is called as compounding.
❖ Example 5: Present value is $15,000. What will be the future value at the end of 8th year if amount invested at
the interest rate of 8%?
❖ Example 6: If sum of money $10,000 is invested now at 5% interest rate. What will be the future value of this
amount at the end of year 1, 3, 7 & 10?
PRESENT VALUE: Present value is the value which refers to the value of money at today which is to be received in
future. The present value of a future sum tells us what a future sum is worth today. Present value is calculated by
multiplying future value with a discount factor
PV = FV (1 + r)‐n
Where,
PV = Present value
FV = Future value
r = interest rate / discount rate
n = number of time periods
Page 114
Investment Appraisal
MA/FMA Study Notes
The method of converting future value into present value is called as discounting.
❖ Example 7: If sum of money $16,000 is the future value at the end of 7th year of a rate of 5% interest. What will
be the value of this money in the end of year 6?
❖ Example 8: A sum of amount had been invested 5 years ago at 8%, which now has a value of $3,380. Calculate
the sum invested?
DISCOUNTED CASH FLOW METHODS (DCF METHODS)
Principles behind DCF methods
● It recognizes the “time value of money” (having the use of money has a cost for example interest).
● People would prefer to receive money sooner rather than later.
● Investors don’t attach equal values to equal sums of money receivable at different times.
● In investment appraisal calculations, reduce (discount) later cash flows.
● The discounting process is sometimes thought of as compound interest in reverse.
✓ Discounted payback period
Discounted payback period is same as simple payback period with the difference that cash flows are discounted
cash flows.
❖ Example 9: An investment information is given below:
Cash Flows ($)
(75,000)
Year 0
Year 1
25,000
Year 2
35,000
Year 3
20,000
Year 4
10,000
Interest rate is 5% per annum
Required: Calculate discounted payback period
Note: Simple payback period is always shorter than discounted payback period.
Example 10: An investment opportunity is as follows:
Cash Flows ($)
Year 0 (80,000)
Year 1 18,500
Year 2 38,500
Year 3 3,500
Year 4 11,900
Year 5 15,500
Year 6 39,000
Cost of capital = 7%
Required:
● Simple payback period
● Discounted payback period
Page 115
Investment Appraisal
MA/FMA Study Notes
✓ Net present value (NPV)
Net present value is the net of present values of cash flows.
Net present value = Present value of cash inflows – Present value of cash outflows.
Decision rules
If Net present value
= Positive
Accept the project
If Net present value
= Negative
Reject the project
❖ Example 11: A project information is given below:
Cash Flows ($)
(135,000)
Year 0
Year 1
50,000
Year 2
50,000
Year 3
50,000
Year 4
50,000
Year 5
50,000
Required: Calculate the net present value, if the cost of capital is 13%?
❖ Example 12: The relevant cash flows are given below:
Cash Flows ($)
(5,000)
Year 0
Year 1
1,000
Year 2
1,000
Year 3
1,000
Year 4
1,000
Year 5
1,000
Required: Calculate net present value if interest rate is 10%?
Advantages of Net present value
● Shareholder wealth is maximized.
● It considers time value of money.
● It takes into account the time value of money.
● It is based on cash flows which are less subjective than profit.
● Shareholders will get benefits if a project with a positive net present value is accepted.
● It considers cash flows after payback period
Disadvantages of Net present value
● It can be difficult to identify an appropriate discount rate.
● For simplicity, cash flows are sometimes all assumed to occur at year ends: this assumption may be
unrealistic.
● Some managers are unfamiliar with the concept of net present value.
Page 116
Investment Appraisal
MA/FMA Study Notes
✓ Internal rate of return
Internal rate of return is the point where the present value of cash inflows is exactly equal to the present value
of cash outflows. It refers to the discount rate where net present value is zero. It is calculated as
x (B – A)
IRR = A +
NPVA
NPVA ‐ NPVB
Where:
A = Lower discount rate
B = Higher discount rate
NPVA = NPVA at A
NPVB = NPVB at B
IRR is more accurate if:
A = Lower discount rate at which NPV is positive &
B = Higher discount rate at which NPV is negative
But these two should be closest
Decision rules
If internal rate of return > cost of capital
If internal rate of return < cost of capital
If internal rate of return = cost of capital
Accept the project (in this NPV would be positive)
Reject the project (in this NPV would be negative)
Project is gearing no return
❖ Example 13: A project requiring an investment of $1,200 is expected to generate returns of $400 in years 1 and
2 and $350 in years 3 and 4. If the NPV = $22 at 9% and the NPV = ‐ $4 at 10%. What is the IRR for the project?
❖ Example 14: Following information is given:
Cash Flow($)
(142,700)
Year 0
Year 1
51,000
Year 2
62,000
Year 3
73,000
Required: Calculate internal rate of return with discount rates of 10% & 20%?
Advantages of Internal rate of return
● It takes into account the time value of money, unlike other approaches such as simple payback period.
● Results are expressed as a simple percentage, and are more easily understood than some other methods.
● It indicates how sensitive calculations are to changes in interest rates.
Disadvantages of Internal rate of return
● Projects with unconventional cash flows can produce negative or multiple internal rates of return.
● Internal rate of return may be confused with accounting rate of return or return on capital employed (ROCE),
since both give answers in percentage terms.
● It may give conflicting recommendations with mutually exclusive projects, because the result is given in the
relative terms (percentages), and not in absolute terms ($) as with net present value.
● Some managers are unfamiliar with the internal rate of return method.
Page 117
Investment Appraisal
●
●
MA/FMA Study Notes
It cannot accommodate the changing interest rates.
It assumes that funds can be re‐invested at a rate equivalent to the internal rate of return, which may be
too high.
ANNUITY: Whenever a project is expected to earn equal amount of cash flows in equal interval of time for a defined
time period, then the cash flows are said to be an Annuity. Constant cash inflows or outflows for a defined
time period is called annuity.
Present value of annuity = constant cash flows x annuity factor
Annuity Factor
= 1 ‐ (1 + r)‐n
r
❖ Example 15: Cash outflow in Year 0 is $15,000. Cash inflow in Year 1 to Year 10 is 1,200. What are the present
value of annuity & the net present value of the project? Cash flows are discounted at 10% & annuity factor at
10% for 10 years is 6.145.
❖ Example 16: Find the present value of ten annual payments of $700, the first paid immediately and discounted
at 8% pa, giving your answer to the nearest $.
PERPETUITIES: Perpetuity is, in which equal cash flows are generated for unlimited time period. When a project has
expected to earn equal amount of cash flows in equal interval of time but for unlimited time period
is called perpetuity. If the perpetuity situation arises, the present value of perpetuity will be
calculated as:
Present value of perpetuity = constant yearly cash flows
r
❖ Example 17: Cash inflows for unlimited time period are $5,000 per annum cost of capital is 8%. Calculate the
present value of perpetuity.
NOMINAL RATE AND EFFECTIVE RATE
Nominal rate is the interest rate which is quoted by the financial institutions and effective rate is the actual rate of
interest earned that a company charge.
Nominal rate is used when interest is compounded only once in a period.
Effective rate is use when interest is compounded more than once in a period. Interest may be compounded daily;
weekly, monthly or quarterly Effective rate is greater than nominal rate when compounding is done for less than
one year. Effective rate is equals to the nominal rate if compounding is done at the end of year. Effective rate is
calculated as:
Effective Rate = [(1 + r)n – 1] x 100
Where,
r = nominal rate of interest per compounding
n = number of times compounding is done in a period.
Effective rate is also called Annual Percentage Rate (APR) or compound annual rate (CAR).
Page 118
Investment Appraisal
MA/FMA Study Notes
❖ Example 18: Nominal rate of interest = 12% per annum. What will be the effective rate of interest if the
compounding is done after every 6 months?
❖ Example 19: Nominal rate of interest = 15% per annum. What is the annual effective rate of interest, if
compounding is done after every 1‐month?
❖ Example 20: A bank offers depositors a nominal 4% pa, with interest payable quarterly. What is the effective
annual rate of interest?
❖ Example 21: A bank adds interest monthly to investors account even though interest rates are expressed in
annual terms. The current rate of interest is 12%. MR A deposits $2,000 on 1 July. How much interest will have
been earned by 31 December (to nearest $)?
a. $123
b. $60
c. $240
d. $120
Page 119
Investment Appraisal
MA/FMA Study Notes
TABLES
Page 120
Investment Appraisal
MA/FMA Study Notes
Page 121
Standard Costing
MA/FMA Study Notes
STANDARD COSTING
❖
This Chapter Covers:
✓ STANDARD COST
✓ STANDARD COST CARD
✓ USES OF STANDARD COSTING
✓ STANDARD‐SETTING
✓ ADVANTAGES AND DISADVANTAGES OF STANDARDS
✓ BUDGET AND STANDARD COMPARISON
✓ VARIANCES
✓ VARIANCE ANALYSIS
✓ OPERATING STATEMENTS
✓ BACKWARD VARIANCES
✓ INTERRELATIONSHIP BETWEEN VARIANCES
✓ REASONS OF VARIANCES
✓ SIGNIFICANCE OF VARIANCES
Page 122
Standard Costing
MA/FMA Study Notes
STANDARD COST
It is the planned unit cost of a product, component or service. A predetermined measurable quantity set in defined
conditions and expressed in money.
Standard costing: A system of accounting based on predetermined costs and revenue per unit, which are compared
to actual performance to provide useful feedback information to management.
Standard costing is involved in the following:
● Establishment of predetermined estimates of the costs of product and services
● Collection of actual cost
● Comparison of actual cost with the predetermined estimates.
The predetermined cost is known as standard cost and the difference between standard and actual cost is called
variance. The process through which differences are analysed is known as variance analysis.Although standard
costing can be used in manufacturing as well as service industries, its greatest benefits are realized where mass
production and repetitive work is undertaken.
Performance Standards
Performance standards are used to set efficiency targets. There are four types of standards:
1. Ideal standards
2. Attainable standards
3. Current standards
4. Basic standards
1.
Ideal Standards
▪ These standards are based on perfect or ideal situations i.e. no wastage, no idle time, no efficiencies.
▪ These standards are likely to be de‐motivating because reported variance is always adverse.
▪ Employees will often feel that standards are unattainable so they will not feel the need to work hard.
2.
Attainable Standards
▪ These standards are based on efficient situations to make them attainable.
▪ Some allowances are made for wastage or inefficiencies.
▪ They are realistic however challenging targets for employees.
▪ These standards are motivating for employees.
3.
Current Standards
▪ These are based on the current situation.
▪ Prepared for short term (just for current situations)
▪ When the current situation ends, standards are restated.
▪ These standards do not attempt to improve current level of efficiency.
4.
Basic Standards
▪ These standards are kept unaltered over long periods of time.
▪ These standards are likely to be outdated.
▪ They are the least useful for variance analysis.
Page 123
Standard Costing
MA/FMA Study Notes
USES OF STANDARD COSTING
▪ Stock valuation. For internal or external use.
▪ As a basis for pricing decisions i.e. cost plus pricing.
▪ For budget preparation/business planning.
▪ For budgetary control, reporting deviations from plan (reporting by exception)
▪ Use in variance analysis
▪ For performance measurement.
▪ Motivating staff by using standards as targets.
STANDARD COST CARD
● Standard cost card under Absorption costing
Product XYZ
$ per unit
Selling price
Production cost
Material
Labour
Variable overheads
Fixed overheads
Standard cost
Standard profit per unit
●
(2 kgs @ $20/kg)
(1.5 hours @ $2/hour)
(1.5 hours @ $6/hour)
(1 .5hours @ $10/hour)
$ per unit
100
40
3
9
15
(67)
33
Standard cost card under Marginal costing
Product XYZ
$ per unit
Selling price
Production
Materials
Labour
Variable overheads
Standard variable cost
Standard contribution per unit
(2 kgs @ $20/kg)
(1.5 hours @ $2/hour)
(1.5 hours @ $6/hour)
$ per unit
100
40
3
9
(52)
48
STANDARD‐SETTING
Standards are set for each element of cost in the production of a unit of output. It involves estimating the quantity
of the resource used and its associated costs. In addition a standard selling price is set.
➢ Direct materials
Materials standard is like: 5 kgs/unit x $10/kg = $50/unit
▪ Quantity standards are recorded, for example, as a bill of materials.
▪ Standard prices are obtained from the purchasing department which researches alternative suppliers and
selects those which can provide:
▫ Required quantity
▫ Sound quality
▫ Most competitive price
Page 124
Standard Costing
MA/FMA Study Notes
➢ Direct labour
Labour standard is like: 3 hours/unit x $8/hour = $24/unit
▪ Time measurements determine standard hours for the average worker to complete a job.
▪ Wage rates are determined by company policy/negotiations between management and unions.
➢ Variable overheads
Variable overheads standard is like: 3 hours/unit x $5/hour = $15/unit
▪ Variable overheads rate is often based upon labour hours or machine hours.
▪ A standard variable overhead rate per unit of activity is calculated.
▪ If there is no observable direct relationship between resources and output, past data is used to predict.
▪ The activity measure that exerts the greatest influence on costs is investigated– usually direct labour hours.
➢ Fixed overheads
Fixed overheads standard is like: 3 hours/unit x $2/hour = $6/unit
▪ This standard is developing by using fixed overhead absorption rate.
▪ Because fixed costs are largely independent of changes in activity, they are constant over wide ranges in the
short term.
▪ Therefore, for control purposes, a fixed overhead rate per unit of activity is inappropriate.
▪ For inventory valuation purposes IAS 2 requires standard fixed overhead rates.
➢ Selling price and margin
Sales standard is like: $30/unit x 100 units sold
▪ Anticipated market demand
▪ Competitive production and competitor’s action
▪ Manufacturing costs
▪ Inflation estimates
ADVANTAGES & DISADVANTAGES OF STANDARDS
Advantages
▪ Annual examination of costs and revenues.
▪ Provides a yardstick to judge performance.
▪ Helps management by exception.
▪ Helps bookkeeping.
Disadvantages
▪ Waste important resources like time and costs.
▪ Standard developed may be outdated.
▪ De‐motivating effect if system is poor.
Page 125
Standard Costing
MA/FMA Study Notes
BUDGET AND STANDARD COMPARISON
Budgets and standard are very similar and interrelated, but there are important differences between them.
Standards
Budget
Gives planed and aggregate costs for a
Shows the planned unit resources usage for a single task, for
function of cost centre
example the standard labour hours for a single units of
production
Can be prepared for all functions, even when
output cannot be measured
Limited to situation where representative action are
performed and output can be measured
Mostly expressed in money terms
Need not be expressed in money terms. For example a
standard rate of output does not need a financial value put
on it
VARIANCES: A variance is ‘the difference between a planned, budgeted or standard cost and the actual cost incurred’.
The same comparisons may be made for revenues.
Variance Analysis: The process by which the total difference between standard and actual results is analysed is
known as variance analysis.
Finally three figures arise:
▪ Original budget (standard costs/revenues at expected activity level)
It is calculated as standard cost/revenue per unit x budgeted units.
▪ Flexed budget (standard costs/revenues at actual activity level)
It is calculated as standard cost/revenue per unit x actual units.
▪ Actual results
It is calculated as actual cost/revenue per unit x actual units.
VARIANCE ANALYSIS
✓ Direct Material Cost Variance:
Direct material total variance refers to the total difference between what the output quantity should have cost
and what it did cost.
Direct material total variance can be computed as:
Actual output x standard cost per unit
X
Actual output at actual cost
(X)
Direct material total variance
X
It is made up of material price and usage variance.
Direct material price variance represents the difference between the standard cost and actual cost for the
material purchased or used. It can be computed as:
= (Actual Unit Cost ‐ Standard Unit Cost) x Actual Quantity Purchased/used or
Actual quantities x Standard price per quantity X
Actual cost of actual quantity
(X)
Material price variance
X
Page 126
Standard Costing
MA/FMA Study Notes
Direct material usage variance is the difference between the standard quantity of materials that should have
been used for the number of units actually produced, and the actual quantity of materials used, valued at the
standard cost per unit of material.
= (actual quantity used – standard quantity that should have been used) x standard cost per unit
❖ Example 1: Product X has a standard direct material cost as follows:
10 kilograms of material Y at $10 per kilogram = $100 per unit of X. During period 4, 1,000 units of X were
manufactured, using 11,700 kilograms of material Y which cost $98,600.
Required: Calculate the material variances?
Solution:
Direct material total variance
Standard cost for actual output:($100/unit x 1,000 units)
$100,000
Actual material cost
$98,600
Variance
$1,400 F
Direct material price variance
Standard price for actual usage:($10/kg x 11,700 kgs)
Actual material cost
Variance
$117,000
$98,600
$18,400F
Direct material usage variance
Standard usage for actual output:(10 kgs/unit x 1,000 units)
Actual usage
Variance in quantity
Standard price per kg
Variance in amount
10,000 kgs
11,700 kgs
1,700 kgsA
$10/kg
$17,000 A
Cases of Material:
If material purchase quantity and used quantity is different than material price variance is
calculated by using
Purchase quantity
If closing stock valued at standard cost
Use quantity
If closing stock valued at actual cost like (FIFO,
LIFO, AVCO)
❖ Example 2: A company uses raw material P in production, this raw material has a standard price of $3 per metre.
During one month 6,000 metres are bought for $18,600 and 5,000 metres are used in production. At the end of
the month, inventory will have been increased by 1,000 metres.
Required: Calculate material price variance if:
a. Closing stock value at standard cost
b. Closing stock value at actual cost (FIFO)
Page 127
Standard Costing
MA/FMA Study Notes
Solution:
Material price variance
Standard price for actual quantity purchased:($3/m x 6,000 m)
Actual material cost
Variance
$18,000
$18,600
$600 A
(Difference is due to value of closing stock i.e. 1,000 metres x $3/metre = $3,000 A)
Material price variance
Standard price for actual quantity used:($3/m x 5,000 m)
Actual material cost
Variance
$15,000
$18,600
$3,600 A
Direct Labour Cost Variance: Direct labour cost variance is the difference between the standard cost for actual
production and the actual cost in production. Direct labour total variance can be subdivided into labour rate
variance and labour efficiency variance.
Direct labour total variance can be computed as:
Actual output x standard cost per unit
X
Actual output at actual cost
(X)
Direct labour total variance
X
Direct labour rate variance is the difference between the standard cost and the actual cost paid for the actual
number of hours worked.
Actual hours at standard rate
X
Actual hours at actual rate
(X)
Labour rate variance
X
Direct labour efficiency variance is the difference between the standard labour hour that should have been
worked for the actual number of units produced and the actual number of hours worked when the labour
hours are valued at the standard rate.
= (actual hours taken for job – standard hours for job) x standard rate per hour
Idle time is not considered in calculation of this variance.
Idle Time Variance: Company may operate a costing system in which any idle time is recorded. Idle time may be
caused by machine breakdowns or not having work to give to employees, perhaps because of limited resources or
a shortage of orders from customers. When idle time occurs, the labour force is still paid wages for time at work,
but no actual work is done. Time paid for without any work being done is non‐productive and therefore inefficient.
In variance analysis, idle time is an adverse efficiency variance.
In case of idle time:
Labour efficiency variance
Labour efficiency variance
Idle time variance
By using productive hours
By using non productive hours
Page 128
Standard Costing
MA/FMA Study Notes
❖ Example 3: The standard direct labour cost of product X is as follows:
2 hours of grade Z labour at $5 per hour = $10 per unit of product X. During period 5, 1,500 units of product X
were made and the cost of grade Z labour was $17,500 for 3,080 hours. During the period, there is a shortage
of customer orders and 100 hours were recorded as idle time.
Required: Calculate labour variances?
Solution:
Direct labour total variance:
Standard cost for actual output:($10/unit x 1,500 units)
Actual labour cost
Variance
$15,000
$17,500
$2,500A
Direct labour rate variance
Standard rate for actual hours paid:($5/hour x 3,080 hours)
Actual labour cost
Variance
$15,400
$17,500
$2,100A
Direct labour efficiency variance
Standard hours for actual output:(2hours/unit x 1,500 units)
Actual hours worked
Variance in hours
Standard rate / hour
Variance in value
3,000 hours
2,980 hours
20 hours F
$5/hour
$100 F
Direct labour idle time variance
100 hours x $/5hour:
$500 A
✓ Variable overheads variance is the difference of expenses incurred and the efficiency working of product.
Variable overheads total variance can be computed as:
Actual output x standard cost per unit
X
Actual output at actual cost
(X)
Variable overheads total variance
X
Variable overhead expenditure variance is the difference between amount of variable production overhead
that should have been incurred in actual hours worked and the amount of variable production overhead actually
incurred.
Actual hours at standard rate
X
Actual hours at actual rate
(X)
Variable overheads expenditure variance
X
Page 129
Standard Costing
MA/FMA Study Notes
Variable overhead efficiency variance is very much similar to labour efficiency variance. It is the difference
between the standard labour hour that should have been worked for the actual number of units produced and
the actual number of hours worked when the labour hours are valued at the standard variable production
overhead rate.
= (actual hours taken for job – standard hours for job) x standard variable OAR per hour
❖ Example 4: Standard: 2 hours at $1.50 per hour = $3 per unit. During period 6, 400 units of product X were
made. The labour force was paid for 820 hours, of which 60 hours were recorded as idle time. The variance
overhead cost was $1,230.
Required: Calculate the variable cost variance?
Solution:
Variable production overhead total variance:
Standard overhead cost for actual production:($3/unit x 400 units)
Actual variance production overhead cost
Variance
Variance production overhead expenditure variance
Standard rate for actual hours worked:($1.50/hour x760 hours)
Actual variance production cost
Variance
Variance production overhead efficiency variance
Standard hours for actual production: (2hrs/unit x400 units)
Actual hours worked
Variance
Standard rate / hour
Variance
$1,200
$1,230
$30A
$1,140
$1,230
$90A
800 hours
760 hours
40 hours F
$1.5/hour
$60 F
Note:In the calculation of variable selling overheads variance uses sales units instead of production units.
✓ Fixed Production Overhead Variances: Fixed production overhead variance is the difference between the
incurred cost of fixed production overhead and the amount of overhead actually absorbed.
The amount of overhead absorbed is calculated by using the overhead rate which, at the time of absorption, is
based on budgeted figures. In absorption costing system under or over absorption of overheads is almost
inevitable. Recall the overhead absorption rate:
Overhead absorption rate = Budgeted fixed overheads
Budgeted activity level
Page 130
Standard Costing
MA/FMA Study Notes
Both, numerator and denominator are budgeted or planned. If either of two changes, it will result in over or
under absorption of overheads. Fixed production overhead variance is divided and analysed into:
▪ Expenditure variance
▪ Volume variance
● Volume efficiency variance
● Volume capacity variance
▪ Fixed overheads total variance can be computed as: It is same as under/over absorption of overheads.
Actual output x standard cost per unit
X
Actual output at actual cost
(X)
Fixed overheads total variance
X
▪ Fixed overhead expenditure variance: Fixed production overhead expenditure variance is simply the
difference between the actual fixed production overhead expenditure and the budgeted fixed production
overhead expenditure.
▪ Fixed overhead volume variance: Fixed overhead volume variance arises due to difference between actual
and budgeted activity level. To compute the volume variance difference between actual and budgeted
activity level is multiplied by budgeted absorption rate per unit.
▪ Fixed overhead volume efficiency variance is the difference between the actual number of hours worked
to produce a set amount of units and the standard hours for actual units. This figure is then multiplied by
the overhead rate for an hour of labour.
▪ Fixed overhead volume capacity variance is the difference between the actual number of hours worked
and the budgeted number of hours. This figure is then multiplied by the overhead rate for an hour of
labour.
❖ Example 5: A company budgets to product 1,000 units of product E during August. The expected time to produce
a unit of E is five hours and the budgeted fixed production overhead is $20,000. The standard fixed production
overhead cost per unit of product E will therefore be 5 hours at $4 per hour (= $20 per unit). Actual fixed
production overhead expenditure in August turns out to be $20,450. The labour force manages to produce 1,100
units of product E in 5,400 hours of work.
Required: Calculate fixed overheads variances?
Solution:
Fixed production overhead total variance:
Standard fixed overheads for actual output:($20/unit x 1,100 units)
Actual fixed overheads incurred
Variance
Fixed production overhead expenditure variance:
Budgeted fixed production overhead
Actual fixed production overhead
Variance
$20,000
$20,450
$450A
Fixed production overhead volume variance:
Budgeted production
Actual production
1,000 units
1,100 units
Page 131
$22,000
$20,450
$1,550F
Standard Costing
MA/FMA Study Notes
Variance
Standard absorption rate / unit
Variance
100 units F
$20/unit
$2,000 F
Fixed production overhead volume efficiency variance:
Standard hours for actual production (5hours/unit x 1,100 units)
Actual hours worked
Standard absorption rate / unit
Variance
Fixed production overhead volume capacity variance:
Budgeted hours
Actual hours worked
Standard absorption rate / unit
Variance
5,500 hours
5,400 hours
100 hours F
$4/hour
$400 F
5,000 hours
5,400 hours
400 hours F
$4/hour
1600F
Fixed production overhead variance
Under absorption costing
Under marginal costing
Five variances if absorption rate is calculated based on
productive hrs.
● Fixed production overhead total variance.
● Fixed production overhead expenditure variance.
● Fixed production overhead volume variance.
● Fixed production overhead volume efficiency variance.
● Fixed production overhead volume capacity variance.
There is only one variance of fixed production
overhead which is:
● Fixed production overhead expenditure
variance.
However, if absorption rate is calculated on the basis of
production units. There are only three variance:
● Fixed production overhead total variance.
● Fixed production overhead expenditure variance.
● Fixed production overhead volume variance.
✓ Sales Variances: Sales variance is the difference between actual sales and budget sales. Sales variance arises
from two reasons; either the sale price varies from planned or the volume of sales vary from budgeted. Sales
variance can, therefore, be divided in following two main areas:
▪ Price variance
▪ Volume variance
Page 132
Standard Costing
▪
▪
MA/FMA Study Notes
Sales price variance: Sales price variance is a measure of effect on profit of a change in sales price. Sales
price variance is difference between what the revenue should have been from sale of actual quantity and
what the actual revenue was.
Sales volume variance: Sales volume variance measures the effect on profit of change in volume of sales.
Volume variance calculates the difference between budgeted quantity and actual quantity sold, valued at
standard profit per unit or standard contribution per unit.
o Standard profit / unit =Standard selling price/unit – standard all cost / unit
o Standard contribution/unit = standard selling price /unit – standard all variable cost / unit
❖ Example 6: A company budgets to sell 8,000 units of product J for$12 per unit. The standard full cost per unit is
$7, which includes unit variable cost of $3. Actual sales were 7,700 units, at $12.50.
Required: Calculate sales variances?
Solution:
Sales price variance:
Standard sales price for actual units sold: ($12/‐unit x 7,700 units)
Actual sales revenue ($12.50/‐unit x 7,700 units)
Variance
$92,400
$96,250
$3,850F
Sales volume variance:
i.
Under absorption costing
Sales volume profit variance.
Budgeted units sold
Actual units sold
8,000 units
7,700 units
300 units A
$5/unit
$1,500 A
Standard profit / unit ($12 – $7 = $5/unit)
i.
Under marginal costing
Sales volume cost variance.
Budgeted units sold
Actual units sold
Standard contribution/unit ($12–$3=$9/unit)
Variance
Page 133
8,000 units
7,700 units
300 units A
$9/unit
$2,700 A
Standard Costing
MA/FMA Study Notes
THE OPERATING STATEMENTS
This summarizes the earlier work and reconciles budgeted with actual profit or cost
Under absorption costing
Adv
Fav
$000
$000
Budgeted profit
Sales variances
Price
X
(X)
Volume
X
(X)
$000
X
X/(X)
X
Cost variances
Materials
Labour
Variable Overhead
Fixed Overhead
Price
Usage
Rate
Idle time
Efficiency
Expenditure
Efficiency
Expenditure
Capacity
Efficiency
X
X
X
‐
X
X
X
X
X
X
X
(X)
(X)
(X)
(X)
(X)
(X)
(X)
(X)
(X)
(X)
(X)
X/(X)
X
Actual profit
●
All stocks must be valued at standard costing determining actual profit.
Operating statement under marginal costing
There are three differences between this and the total absorption approach just seen:
▪ The fixed overheads variance will be only the expenditure variance. There can be no volume variances, as there
is no attempt to absorb fixed overheads into production.
▪ The sales volume variance needs to be recalculated in terms of standard contribution, rather than standard
profit.
▪ Stock should be valued at standard marginal cost, rather than standard total absorption cost.
Page 134
Standard Costing
MA/FMA Study Notes
Under marginal costing
Budgeted contribution
Sales variances
Price
Volume
Cost variances
Materials
Labour
Variable Overhead
Price
Usage
Rate
Idle time
Efficiency
Rate
Efficiency
Fav
$000
Adv
$000
X
X
X
(X)
(X)
(X)
X
X
X
‐
X
X
X
(X)
(X)
(X)
(X)
(X)
(X)
(X)
X
(X)
$000
X
X/(X)
X
X/(X)
X
Actual contribution
Fixed overheads
Budgeted overhead
Expenditure variance
(X)
X
(X)
X/(X)
X
Actual profit
BACKWARD VARIANCES (REVERSE VARIANCES): Examination questions can be set in which the variances are
already given and the requirements are to find actual, budget or other data. This implies that students need to have
thorough and detailed knowledge on how to calculate variances. Essentially the process involved is working
backwards with the formula or statement to find missing figures. There is no set approach since questions will not
be identical.
INTERRELATIONSHIPS BETWEEN VARIANCE: Individual variances should not be looked in isolation. One variance
might be interrelated with another and much of it might have occurred only because the other, interrelated, variance
occurred too. This needs to be taken into account when deciding whether to investigate a variance or not. Two
variance are interdependent one will usually be adverse and the other one favourable here are some examples.
Page 135
Standard Costing
MA/FMA Study Notes
Interrelated variance
Explanation
Material price and
material usage
If cheaper materials are purchased in order to obtain a favourable price variance,
materials wastage might be higher and an adverse usage variance may occur. If
cheaper material is more difficult to handle, there might be an adverse labour
efficiency variance too. If a decision is made to purchase more expensive material,
the price variance will be adverse but the usage variance might be favourable as the
material is easier to use or of a higher quality.
Labour rate and labour
efficiency / material usage
If employees are paid higher rates for experience and skills, (using a highly skilled
team to do some work) might lead to an adverse rate variance and a favourable
efficiency variance and possibly a favourable material usage variance (experienced
staff are less likely to waste material). In contrast , a favourable rate variance might
indicate a longer‐than‐expected proportion of inexperienced workers in the
workforce , which could result in an adverse labour efficiency variance , and perhaps
poor materials handling and high rates of rejects and hence an adverse materials
usage variance.
The connection between selling price and sales volume is perhaps an obvious one.
A reduction in the selling price might stimulate bigger sales demand, so that an
adverse selling price variance might be counterbalanced by a favourable sales
volume variance. Similarly, a price rise would give a favourable price variance, but
possibly at the cost of a fall in demand and an adverse sales volume variance.
Selling price and sales
volume
Variable and fixed
production overhead
efficiency variances and
other variances
Because the variable and fixed production overhead efficiency variances are the
same , in hours, as the labour efficiency variance, any interrelationship between
other variances and the labour efficiency variance apply equally to the variable and
fixed production overhead efficiency variances. So if there is an interrelationship
between a favourable labour rate variance and an adverse labour efficiency
variance, there will also be interrelationships between the favourable labour rate
variance and adverse variable and fixed production overhead efficiency variances.
REASONS OF VARIANCES
Variance
Favourable
Material Usage
▪
▪
▪
Labour rate
▪
Idle time
▪
Adverse
Material used of higher quality than
standard.
More efficient use of material.
Errors in allocating material to jobs.
▪
▪
▪
▪
Defective material.
Excessive waste or theft.
Stricter quality control.
Errors in allocating material to jobs.
Use of workers at a rate of pay lower
than standard.
The idle time variance is always adverse.
▪
▪
▪
▪
Wage rate increases.
Use of high grade labour.
Machine breakdown.
Illness or injury to worker.
Page 136
Standard Costing
Labour efficiency
MA/FMA Study Notes
▪
▪
Output produced more quickly than
expected because of worker motivation,
better quality materials etc.
Errors in allocating time to jobs.
▪
▪
▪
Lost time in excess of standard.
Output lower than standard set
because of lack of training,
substandard materials etc
Errors in allocating time to jobs.
Fixed overhead
expenditure
▪
▪
Savings in costs incurred.
More economical use of services.
▪
▪
▪
Increase in cost of services used
Excessive use of services.
Change in type of services used.
Fixed overhead
efficiency
▪
See labour efficiency.
▪
See labour efficiency.
Fixed overhead
capacity
▪
Actual time worked greater than budget
(e.g. overtime working).
▪
▪
Excessive idle time.
Shortage of plant capacity.
SIGNIFICANCE OF VARIANCE: A variance can be considered significant if it will influence management’s actions and
secedes. Significant variances usually need investigating. If actual results are different from planned and
consequently resulted in variances, management need to consider a number of factors in order to decide whether
to investigate it or not. Variances are inevitable in routine processes and therefore investigating each and every
variance would not be worthwhile. Factors that should be considered as to whether to investigate a variance or not
include:
▪ The size of variance: If variance is immaterial then it needs not to be investigated.
▪
Controllability: Some investigations are not controllable by nature. An increase in price of material or shortage
of material and skills are major examples as opposed to material usage variance which is controllable by
management. In case of uncontrollable variance, plan should be changed for the next period.
▪
Cost of investigation: Cost of investigating a variance must be weighed against the benefits of correcting the
cause of a variance.
▪
Interdependence of variances: Sometimes adverse variance in one area is linked with a favorable variance in
some other area. For example if sub‐standard material is purchased, it would result in favorable material price
variance but at the same time would result in adverse material usage variance and adverse labour efficiency
variance. So while investigating an adverse variance, all relevant factors should be taken into account.
▪
Standard type used; at the start of this chapter, you studied about different types of standards. If a standard
was set which was not suitable to working conditions, adverse variances are inevitable. Standards should be set
at ‘normal’ level and not at an ideal level.
Page 137
Statistical Techniques
MA/FMA Study Notes
STATISTICAL TECHNIQUES
❖ This Chapter Covers:
✓ FORECAST AND BUDGET
✓ FORECASTING METHODS
✓ SEASONAL VARIATIONS
✓ LINEAR REGRESSION
✓ INDEX NUMBER
Page 138
Statistical Techniques
MA/FMA Study Notes
FORECAST AND BUDGET
Forecast: A forecast is an estimate of what might happen in the future. Forecast is based on some assumptions about
the conditions that are expected to apply.
Budget: A budget is a plan of what the organisation is aiming to achieve and what it has set as a target. Budgets are
more realistic because management will try to establish some control over the conditions that will apply in the
future.
FORECASTING METHODS
Forecasting methods are:
1. Scatter graph method
2. High- low method
3. Time series analysis
4. Linear regression analysis
1. SCATTER GRAPH METHOD
One forecasting technique is the scatter graph method. This is graphical way of forecasting. Steps involve in
forecasting under scatter graph method are:
Step 1: Collect data of past volumes of output and the associated cost of producing that output
Step 2: Plot the data on the graph which has cost on vertical axis and volume of output on the horizontal axis.
Step 3: Draw the line of best fit through the middle of the plotted points so that the distance of points above the
line is the same as the distance of points below the line.
The intersection of the line of best fit on the vertical axis is the fixed cost and slope of the line represents variable
costs.
It is a method of visual judgments that is a disadvantage of this method
Example 1: Prepare a scatter graph of the following cost and volume data and determine the total budgeted cost at
the volume of production of 6,900 units in month 5.
Month
1
2
3
4
Production cost
£
110,000
115,000
111,000
97,000
Production volume
Units
7,000
8,000
7,700
6,000
2. HIGH LOW METHOD
It is simple forecasting technique based on historical data. High – low method is already discussed in chapter 1
Page 139
Statistical Techniques
MA/FMA Study Notes
Advantages of high – low method:
 It is easy to use and understand
 It needs just two activity levels (highest and lowest)
Disadvantages of high – low method:
 It considers two extreme points which may be representative of normal conditions
 Based on two points so formula is not very accurate.
 Based on historical data.
3. TIME SERIES ANALYSIS
A time series is a series of figures relating to the changing value of a variable over time. The data often conforms to
a certain pattern over time. It is use to forecast sales. Graph of time series called a HISTOGRAM.
This pattern can be extrapolated into the future and hence forecasts are possible. Time periods may be any measure
of time including days, weeks, months and quarters.
Example 2:
▪ Annual cost for last ten years.
▪ Number of people employed in each last 10 years.
▪ Output per day of last month.
▪ Sales per month of last 3 years.
year
1
2
3
4
5
6
7
Sales $000
20
21
24
23
27
30
28
Page 140
Statistical Techniques
MA/FMA Study Notes
The histogram is as follows.
Sales
$’000
30
20
10
1
2
3
4
5
6
7
Year
The horizontal axis is always chosen to represent time, and the vertical axis represents the values of the data
recorded.
The four components of a time series are:
▪ The trend this describes the long term general movement of the data recorded.
▪ Seasonal variations are short term fluctuations in recorded values, a regular variation around the trend over a
fixed time period, usually one year.
▪ Cyclical variations are long term fluctuations in recorded values, economic cycle of booms and slumps. It takes
several years to complete.
▪ Random variations irregular, random fluctuations in the data usually caused by factors specific to the time series.
They are unpredictable.
In examination problems there is generally insufficient data to evaluate the cyclical and random variations, hence,
they are ignored.
Example 3 a trend and seasonal variations
The number of customers served by a company of travel agents over the past four years is shown in the following
histogram.
Page 141
Statistical Techniques
MA/FMA Study Notes
Customers
(000s) 10
Trend
5
0
Quarters
1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
20x0
20x1
20x2
20x3
In this example, there would appear to be large seasonal fluctuations in demand, but there is also a basic upward
trend.
Trends
Long term movement over time in the value of data recorded
Trend
Downward trend
Upward trend
Years
Output/hour(units)
Cost/unit ($)
4
30
1
5
24
1.08
6
26
1.20
7
22
1.15
8
21
1.18
9
17
1.25
No clear movement/static
Number of employees
100
103
96
102
103
98
Finding a trend
One method of finding the trend is by the use of moving averages. (Take moving averages which covers a cycle)
Moving averages of
Time series of even numbers
Time series of odd numbers
Apply two times moving averages
(Because trend value should
relate to a specific period)
apply once moving averages
Page 142
Statistical Techniques
MA/FMA Study Notes
Remember that when finding the moving average of a result having an even number, a second moving average has
to be calculated so that values can relate to specific actual figures. This method attempts to remove seasonal (or
cyclical) variation from a time series by a process of averaging so as to leave a set of figures representing the trend.
Moving average figure relate to midpoint of overall period.
Value of increase / decrease in trend =
last moving average – first moving average
No of moving averages - 1
Example 4 (odd numbers)
Year
Sales units
2000
390
2001
380
2002
460
2003
450
2004
470
2005
440
2006
500
Required: Take a moving average of the annual sales over a period of three years.
In this example, moving averages were taken of the results in an odd number of time periods, and the average then
related to the midpoint of the overall period.
Moving average of an even number of results
If the moving average were taken of results in an even number of time periods, the basic technique would be the
same, but the midpoint of the overall period would not relate to single period. The trend line average figures need
to relate to a particular time period. To overcome this difficulty, take a moving average of the moving average.
Example 5 (even numbers)
Year
Quarter
Volume of sales
‘000 units
2005
1
600
2
840
3
420
4
720
2006
1
640
2
860
3
420
4
740
2007
1
670
2
900
3
430
4
760
Required: Calculate the trend using moving average.
Page 143
Statistical Techniques
MA/FMA Study Notes
Solution:
Year
2005
1
Actual
volume of
sales
‘000 units
(A)
600
2
840
Quarter
Moving average of 4
quarters’ sales
Midpoint of 2 moving
averages trend line
‘000 units
(B/A)
‘000 units
(C)
645
3
420
650
655
4
720
657.50
660
2006
1
640
660
660
2
860
662.50
665
3
420
668.75
672.50
4
740
1
670
677.50
682.50
2007
683.75
685
2
900
687.50
690
3
430
4
760
Value of increase in trend = 687.50 – 650 = 5 per quarter
8-1
SEASONAL VARIATIONS
Short term fluctuations due to change in season
Affect seasonal businesses like ice-cream manufacturing
Finding the seasonal variation
There are two models to find out seasonal variations
▪ Additive model
▪ Multiplicative model
➢ Additive model
Seasonal variations are the difference between actual and trend figures. An average of the seasonal variations for
each time period within the cycle must be determined and then adjusted so that the total of the seasonal variations
sums to zero.
Seasonal variation = actual sales – trend
Page 144
Statistical Techniques
MA/FMA Study Notes
So
Time series (actual sales) = trend + seasonal variation
Here Y = T + R + S
Continue example 5
Year
2005
2006
2007
Quarter
1
2
3
4
1
2
3
4
1
2
3
4
Actual volume of
sales
‘000 units
600
840
420
720
640
860
420
740
670
900
430
760
Trend
Seasonal
variation
‘000 units
‘000 units
650
657.50
660
662.50
668.75
677.50
683.75
687.50
-230
62.50
-20
197.50
-248.75
62.50
-13.75
212.75
The variation between the actual result for any particular quarter and the trend line average is not the same from
the year to year, but an average of these variations can be taken.
2005
2006
2007
Total
Average (divided by 2)
Q1
Q2
-20
-13.75
-33.75
-16.875
197.50
212.50
410
205
Q3
-230
-248.75
Q4
62.50
62.50
-478.75
-239.375
125
62.50
Estimate of the seasonal or quarterly variation is almost done, but there is one more important step to take.
Variations around the basic trend line should cancel each other out, and add to the ‘zero’. At the moment they do
not. Therefore spread the total of the variations (11.25) across the four quarters (11.25/4) so that the final total of
the variations sum to zero.
Estimated quarterly variations
Adjusted to reduce variations to 0
Final estimates of quarterly variations
These might be rounded as follows:
Q1
-16.875
-2.8125
-19.6875
Q1 = -20
Q2
205
-2.8125
202.1875
Q2 = 202
Examiner is unlikely to ask you to derive the seasonal variations
Page 145
Q3
-239.375
-2.8125
-242.1875
Q3 = -242
Q4
62.50
-2.8125
59.6875
Q4 = 60
Total
11.25
-11.25
0
Total = 0
Statistical Techniques
MA/FMA Study Notes
Forecasted sales for quarter 2 of 2008.
Last trend calculated from moving averages 2007 Q2
2007 Q3
2007 Q4
2008 Q1
2008 Q2
Trend for quarter 2 of 2008
Forecasted sales = trend + seasonal variation
687.50
+5
+5
+5
+5
707.5
= 707.50 + 202 = 909.50
Example 6: The result of an additive time series model analysing production are shown below.
Weekly production
‘000 units
Week 1
-4
Week 2
+5
Week 3
+9
Week 4
-6
Which of the following statements is / are true in relation to the data shown in the table above?
I.
Production is on average 9000 units above the trend in week 3
II.
Production is on average 4 below the trend in week 1
III.
Production is on average 5 above the trend in week 2
IV.
Production in week 4 is typically 6 below the trend.
a.
b.
c.
d.
I only
I and II only
I and III only
II and IV only
Drawbacks of additive model:
When there is a steeply arising or a steeply declining trend, the trend will either get ahead of a fall behind the real
trend. So;
▪ The trend is not a good representation of actual figures
▪ The trend is probably unsuitable for forecasting.
➢ Multiplicative model
This model assumes that the components of the series are independent of each other. In this model, each actual
figure is expressed as a proportion of the trend.
Seasonal variation = actual sales / trend
So
Time series Y = T x S x R
The trend component will be same in both models but the seasonal and random component will vary according to
the model. In our example, we assume that random component is small and so ignore it. So:
Page 146
Statistical Techniques
MA/FMA Study Notes
Y=TxS
Then: S = Y/T
Continue Example 5
Year
2005
2006
2007
Quarter
1
2
3
4
1
2
3
4
1
2
3
4
2005
2006
2007
Total
Average (divided by 2)
Seasonal variation
(Y/T)
Actual volume of sales
(Y)
Trend
(T)
‘000 units
600
840
420
720
640
860
420
740
670
900
430
760
‘000 units
‘000 units
650
657.50
660
662.50
668.75
677.50
683.75
687.50
0.646
1.095
0.970
1.298
0.628
1.092
0.980
1.309
Q3
%
0.646
0.628
Q4
%
1.095
1.092
1.274
0.637
2.187
1.0935
Q1
%
Q2
%
0.970
0.980
1.950
0.975
1.298
1.309
2.607
1.3035
Instead of summing to zero, average should sum to 4 or 1 for each of the four quarters
Q1
Q2
Q3
Estimated quarterly variations
0.975
1.3035
0.637
Adjusted to reduce variations to 4
-0.00225
-0.00225
-0.00225
Final estimates of quarterly variations
0.97275
1.30125
0.63475
These might be rounded as follows:
Q1 = 0.97
Q2 = 1.30
Q3 = 0.64
This model is better than additive model
Page 147
Q4
1.0935
-0.00225
1.09125
Q4 = 1.09
Total
4.009
-0.009
4
Total = 4
Statistical Techniques
MA/FMA Study Notes
Forecasted sales for quarter 2 of 2008.
Last trend calculated from moving averages 2007 Q2
2007 Q3
2007 Q4
2008 Q1
2008 Q2
Trend for quarter 2 of 2008
Forecasted sales = trend x seasonal variation
687.50
+5
+5
+5
+5
______
707.5
______
= 707.50 x 1.30 = 919.75
De-seasonalise
This means that seasonal variations have been taken out, to leave a figure which might be taken as indicating the
trend
Example 7
Quarter
1
2
3
4
Actual sales
£’000
150
160
164
170
Seasonal adjustments
£’000
+3
+4
-2
-5
Required:
De-seasonalise these data.
Solution
Quarter
1
2
3
4
Actual sales
£’000
150
160
164
170
De-seasonalise sales
£’000
147
156
166
175
Page 148
Statistical Techniques
MA/FMA Study Notes
INDEX NUMBER / INDICES
Index is a measure of change over time by making some base. It provides standard way of comparing the values.
Index
Price index
Measure of change in the money
value of a group of items over time
Quantity index
Measure of change in the non-monetary
value of a group of items over time
Index = Pn x 100
Po
Quantity index = Qn x 100
Qo
Index number is calculated
by taking base
fixed base
one base is selected and all subsequent
are measured against that fixed
base before.
(use where basic nature of commodity is changed overtime)
chain base
take the base value of the changes
period immediate.
Example 8: Great Ltd sold leather jackets in 20X5 for $20,, in 20X6 they were $25, in 20X7 $30 and in 20X8 $35.
Assuming the base year to be 20X5, the price index numbers for the years 20X6 to 20X8 can be calculated as follows:
Solution:
20x6 index number = 25/20 x 100 = 125
20x7 index number = 30/20 x 100 = 150
20x8 index number = 35/20x 100 = 175
Example 9: Teakwood Ltd produces and sells high quality furniture in the UK. The total number of cupboards sold
by Teakwood Ltd was 4,000 in 20X5, 6,000 in 20X6, 9,000 in 20X7 and 10,000 in 20X8. Assuming the base year to be
20X5, the quantity index numbers for the years 20X6 to 20X8 can be calculated as follows:
20x6 index number = 6000/4000 x 100 = 150
20x7 index number = 9000/4000 x 100 = 225
20x8 index number = 10,000/4,000 x 100 = 250
Example 10: The price of one sandwich was $4 in 20X6, $5 in 20X7, $6 in 20X8 and $7 in 20X9. Assuming the base
year to be 20X6 the fixed base index number for 20X7 to 20X9 can be calculated as follows:
20x7 index number = 5/4 x 100 = 125
20x8 index number = 6/4 x 100 = 150
20x9 index number = 7/4 x 100 = 175
Page 149
Statistical Techniques
MA/FMA Study Notes
Example 11: Continued with the previous example, assuming the base year to be 20X6, the chain base indices for
the years 20X7 to 20X9 can be calculated as follows:
20x7 index number = 5/4 x 100 = 125
20x8 index number = 6/5 x 100 = 120
20x9 index number = 7/6 x 100 = 116.67
Composite index number
Composite index numbers are calculated for commodities which are different in nature. They cover more than one
item. But the items have some similarity.
An index number of housing costs may consider components such as rent, rates, maintenance charges, repairs,
insurance etc.
A simple composite index is calculated by adding the values of all the commodities of the year for which we are
calculating the index. The index number is found by dividing the same with the total value of all the commodities
during the base year.
Example 12: The following information is provided to calculate a simple aggregate composite index:
Item
Price in 20X7
Price in 20X8
Price in 20X9
Base year Cents
Cents
Cents
Milk (per litre)
50
70
80
Sugar (per kg)
25
30
20
Tea powder (per kg)
85
100
80
Calculate composite index number
Solution
Item
Milk (per litre)
Sugar (per kg)
Tea powder (per kg)
Total
Price in 20X7
Base year Cents
50
25
85
160
Price in 20X8
Cents
70
30
100
200
Price in 20X9
Cents
80
20
80
180
20x8 composite index number = ∑Pn x 100
∑Po
20x8 composite index number = 200/160 x 100 = 125
20x9 composite index number = 180/160 x 100 = 112.50
WEIGHTED AGGREGATE INDEX NUMBER
The weighted aggregate index number is a more accurate index number than a simple aggregate index number.
Weights are assigned to different components, and then the index number is calculated.
For example, for a price index, the quantity of the components can be considered as the weight, whereas for a
quantity index, the price of the component can be considered as the weight.
Page 150
Statistical Techniques
MA/FMA Study Notes
Steps to calculate weighted aggregated index number
▪ Calculate products of weight and base values
▪ Sum up the products of weight and base values
▪ Calculate products of weight and the current values
▪ Sum up the products of weight and the current values
▪ Calculate the index for the current aggregate, compared with the base aggregate
Page 151
Statistical Techniques
MA/FMA Study Notes
Example 13:
Laspeyre index number
A Laspeyre index is a special type of weighted average index. It always uses weights from the base time period.
Page 152
Statistical Techniques
MA/FMA Study Notes
Example 14:
Page 153
Statistical Techniques
MA/FMA Study Notes
Advantages of index number
▪ Index numbers help management to understand information
Page 154
Statistical Techniques
▪
▪
▪
MA/FMA Study Notes
The information or data is presented in percentage terms. For e.g. an increase of 5% in sales is more meaningful
than sales has increased from $4,567,990 to $4,796,390.
Comparing data and drawing conclusions is much easier with the help of indices.
Calculating the quantity and price index separately helps the management to know both the variables
independently.
Disadvantages of index number
▪ A base period has to be selected.
▪ The index can be calculated by different methods, therefore, there is no single correct method to calculate an
index.
▪ The results are on an approximation basis, and not exact.
▪ The figures obtained are averages. Significant changes in variables cannot be seen with the final results.
▪ They could be misleading as certain things can be changed over time.
▪ Indices consider new products that may appear; the old ones may be ignored.
CORRELATION
Two variables are said to be correlated if a change in the value of one variable is accompanied by a change in the
value of another variable.
For example:
▪ Total variable cost and production units
▪ Selling price of a product and its demand.
The purpose of correlation analysis is to measure and interpret the strength of linear relationship between two
variables.
Degrees of correlation:
Two variables might be perfectly correlated, partly correlated or uncorrelated. Correlation can be positive or
negative. The differing degrees of correlation can be illustrated bt scatter diagrams.
Perfect correlation
(a)
Y
(b)
Y
X
X
All the pairs of values lie on a straight line. An exact linear relationship exists between the two variables
Page 155
Statistical Techniques
MA/FMA Study Notes
Partial correlation
(a)
Y
(b)
Y
X
▪
▪
X
In (a), although there is no exact relationship, low values of X tend to be associated with low values of Y, and
high values of X with high values of Y.
In (b) again, there is no exact relationship, but low values of X tend to b associated with high values of Y and vice
versa.
No correlation
(c)
Y
X
The values of these two variables are not correlated to each other.
Positive and negative correlation
Correlation, whether perfect or partial, can be positive or negative.
Positive correlation means that the low values of one variable are associated with low values of other,
And high values of one variable are associated with high values of other.
Negative correlation means that the low values of one variable are associated with high values of other,
And high values of one variable are associated with low values of other.
Correlation coefficient (r):
Page 156
Statistical Techniques
MA/FMA Study Notes
it express degree of linear correlation between two variables.
It is from +1 to -1. Two variables are perfectly or partially correlated and if they are partially correlated ,they there
may be high or low degree of correlation.
FORMULA
The degree of correlation between two variables is measured by correlation coefficient.
Where X and Y represents pairs of data for two variables X and Y.
And ‘n’ stands for number of pairs of data used in calculation.
One must remember that correlation coefficient (r) always lie between -1 and +1. If your calculation results in
anything outside this range you must revise your calculations.
Example 15: Statistical department of a provincial government is currently developing a database to find out
whether there is any relationship between an individual’s annual income and his level of education. Following
information has been so far collected:
Individual
Income
Education
$’000
Years
X
Y
1
45
20
2
63
19
3
36
16
4
52
20
5
29
12
6
48
16
7
55
18
8
72
20
9
66
22
You are required to calculate correlation coefficient using above data.
Correlation in time series
A time series in a sequence of data points measured typically at successive times spaced at uniform intervals of time.
It is often the case that something is dependent on passage of time. A trend can be found when analysing a variable’s
movement with respect to time. For example the sale of beverages and ice-cream has strong relationship with time,
the sale of these products are at their peak during summer time and vice versa.
The correlation coefficient is calculated with time as X variable, the independent variable and other variable as Y,
the dependent variable. It is recommended that when analysing correlation in a time series it is more convenient to
replace years (time) with digits, i.e. X variable having time values of year 2001,2002,2003,2004 and so on should be
replaced with 0, 1, 2, 3 and so on. Note that first year is replaced with 0 not 1. You can use whatever figure for years
but using 0, 1, 2, 3… is most simplified.
Page 157
Statistical Techniques
MA/FMA Study Notes
Example 16: Demand of a particular product between 1999 and 2004 was as follows:
Year
1999
2000
2001
2002
2003
2004
Demand (units ‘000)
22
19
18
16
15
12
Determine whether there is any relationship between time and demand?
The coefficient of determination (r2)
The coefficient of determination, r2, is simply the square of correlation coefficient, r. it is useful because it gives the
proportion of variance (fluctuation) of one variable that is predictable from the other variable. In other words r 2
expresses the proportion of total variance in the value of one variable that can be fully explained by the other
variable.
The coefficient of determination is such that 0 ≤ r2 ≤ +1, i.e. it cannot be a negative value. The coefficient of
determination denotes the strength of linear association between X and y.
If r= -0.99 so coefficient of determination is +0.98, which means that 98% of variation in a variable is explained by
other variable.
Example 17: Which one of following is the correct definition of Correlation?
a. Departure of two random variable from independence
b. Departure of two random variables from dependence
c. Tendency of a variable towards other variable
d. The force by which two variables moves away from each other
Example 18: Correlation coefficient, r, indicates both the magnitude and direction of relationship between two
variables.
a. True
b. False
Example 19: Which one of following correctly defines ‘coefficient of determination’ r 2?
a. A measure used to calculate the variation not explained by independent variable
b. It is square of correlation coefficient, r, which is relationship between two variables
c. A measure used to calculate line of best fit
d. A static which indicates strength between two variables implied by a value of correlation
Example 20: A correlation coefficient of 0.8 means:
a. 80% of variation in dependent variable is explained by independent variable
b. 64% of variation in dependent variable is explained by independent variable
c. 20% variation in independent variable is explained by dependent variable
d. 64% of variation in independent variable is explained by dependent variable
Example 21: Correlation coefficient between sales of ice-cream and sale of sunglasses is found to be +0.90. What
does that mean?
a. Both variables have highly positive relationship
b. An increase in sale of sunglasses will also cause an increase in sale of ice-cream as ice-cream is independent
variable
c. There is no direct correlation between two variables. Both variables are commonly correlated with third
variable, weather.
d. A decrease in sale of ice-cream will also decrease sale of sunglasses, as ice-cream is independent variable
Page 158
Statistical Techniques
MA/FMA Study Notes
4. LINEAR REGRESSION
Regression analysis is the study of the relationship between variables. It is one of the most commonly used business
analysis tool and easy to use.
Line of best fit
Although correlation coefficient is used to trace out that whether there is any linear relationship between any two
variables but correlation coefficient solely cannot be used to predict the value of dependent variable, Y, based on
independent variable, X. Once it is found that two variables are correlated we can use the line of best fit. We can
use this equation for forecasting; putting a value for variable X and deriving a forecast value for dependent variable
Y.
Where,
Dependent variable is the single variable being explained/predicted by regression model.
Independent variable is the explanatory variable used to predict dependent variable.
Estimating line of best fit
The line of best fit is a cost equation and is of the form:
Y = a + bx
Where
a = total fixed cost,
b = gradient/slope of line or variable cost per unit
Regression analysis is used to establish the line of the best fit. Once the equation of line of best fit is
determined, it can be used for casting.
Regression analysis uses following formulas for estimating line of best fit:
Where n is the number of data pairs used in analysis.
Example 22: Following data is available for level of output and costs incurred at relevant output level:
Output (‘000 units)
10
15
13
18
19
20
Cost ($’000)
40
55
48
65
69
81
Calculate total cost at an activity level of 22500 units using regression analysis.
Regression line and time series analysis
Regression line can also be used in time series analysis. Time to be taken as independent variable and years to be
replaced with 0,1,2,3 and so on correlation coefficient is calculated.
The reliability of regression model in forecasting
As is the case with any other model, results from regression analysis will not be accurate or reliable. There are a
number of limitations of this model which cast doubt on its results:
Page 159
Statistical Techniques
▪
▪
▪
▪
▪
▪
▪
MA/FMA Study Notes
This model assumes that there exists a linear relationship but this is not always true, there might be a non-linear
relationship. The model is only appropriate if there is a linear relationship between two variables.
The model assumes that that there are only two variables. Value of one variable, the dependent variable Y, is
predicted from value of one other variable, the independent variable X. This is quite unrealistic as the value of
Y might be affected by many other factors not considered at all.
Past behavior is used to forecast future. The model assumes that past movement pattern of two variables will
continue in the future. Again, this is an unrealistic assumption.
Linear regression model is limited to predicting numeric output only. It cannot be used to predict any other sort
of information.
A lack of explanation about what has been learned can be a problem. Prediction of a figure not that is all desired.
The model is only appropriate if used to predict value of dependent variable within relevant range. Predicted
results are not reliable if model is used for extrapolation.
▫ Interpolation means using a line of best fit to predict a value within the two extreme points of the observed
range.
▫ Extrapolation means using a line of best fit to predict a value outside the two extreme points.
There must be sufficient number of data pairs. Even if correlation is high between two variables and have less
than ten pairs of data any forecast value should be regarded as somewhat unreliable.
We can still use the forecast produced by the model with high confidence if correlation coefficient between two
variables is high. Coefficient of determination tells us that how much of the variation in cost can be explained by
volume level. Higher the coefficient of determination the higher the reliance that could be placed on predicted result.
As a general rule if correlation is high (say positive or negative 0.9) the actual values will all lie close to regression
line. And if correlation is below 0.7 (-0.7 ≤ r ≤ +0.7), predicted value will only be a rough estimate of what the value
of Y is likely to be.
Example 23: There is no difference between two formulas:
a.
b.
True
False
Example 24: Following data is available relevant to linear regression model:
∑X2 = 55 ∑XY = 107
∑X = 15
n = 5 and
b= 1.7
What is the value of ‘a’?
a. 0.7
b. 0.8
c. 0.9
d. It is impossible to calculate from above data.
Example 25: In regression equation Y = a + bx, x is dependent variable
a. True
b. False
Page 160
Statistical Techniques
MA/FMA Study Notes
Example 26: Cost equation is of the form C = a + bx. For an activity level of 1000 units the gradient of the line is
$5.6 per unit and fixed cost is $100. What is the cost equation?
a. C = $ 100 + 5.6 (1000)
b. C = $ 5,600 + 100(1000)
c. C = $ 5,600 + 5.6 (1000)
d. C = $ 100,000 + 5.6 (1000)
Advantages of regression analysis:
It gives definitive line of best fit after taking account of all the given data.
It produces good forecasting results.
Many processes are linear so they are well defined by regression analysis.
Forecasting problems:
All forecasting methods are subject to have errors but it vary from case to case. Some main problems are:
▪ Future is always unpredictable or uncertain.
▪ Less data is available so less reliable forecasts.
▪ Pattern of forecasts and seasonal variations cannot be guaranteed to be continued in future.
▪ There is always a danger of random variations.
▪ Other changes which affects future forecasts:
▪ Political and economic changes:
It creates uncertainty for example change in interest rates, exchange rates or inflation.
▪ Environmental changes:
Changes in market will render the forecast made of less use.
▪ Technological changes
▪ Technological advances
▪ Social changes
Page 161
Cost Reduction & Value Enhancement
MA/FMA Study Notes
COST REDUCTION AND VALUE ENHANCEMENT
❖ This Chapter Covers:
✓ COST MANAGEMENT
✓ APPROACHES OF COST REDUCTION
✓ METHODS OF COST REDUCTION
✓ ANOTHER APPROACHES OF COST REDUCTION
✓ VALUE
✓ STEPS OF VALUE ANALYSIS
✓ ROLE OF SENIOR MANAGEMENT IN VALUE ANALYSIS
Page 162
Cost Reduction & Value Enhancement
MA/FMA Study Notes
COST MANAGEMENT
Cost can be managed by:
● Reducing cost
● Controlling cost
Cost reduction: Cost reduction is a planned and positive approach to reduce expenditure. Its aim is to reduce cost
to below budget. By changing working method, cost can be reduced to below current budget or standards.
Cost control: Cost control is concerned with regulating the costs of operating a business and keeping costs within
acceptable limits. Acceptable limits mean standards or budgets. If actual cost varies from budgeted cost then cost
action will be required. It means actual cost should be below the budget. Cost control actions lead to reduction in
excessive spending.
APPROACHES OF COST REDUCTION
There are two approaches used to reduce cost.
● Crash Program to cut spending levels
● Planned Program to reduce cost
Crash Program to cut spending levels
▪ Immediate plan to reduce spending without any proper planning like:
o Some projects might be abandoned
o Deferred some expenses
o Stop new recruitments
o Redundant unnecessary employees.
▪ It might create a panic situation
▪ Poor planning may lead to poor efficiency
▪ May be cost reduced in short term but increase in long term.
▪ May be useful in time of crisis.
Planned Program to reduce cost
▪ It involves continual assessments of organisation products, methods, services and so on
▪ It is a planned approach
▪ It reduces the cost for long term
Problems in introducing cost reduction programmes
▪ Resistance from employees
▪ To overcome this problem, proper communicate the program through some campaign.
▪ If the program introduce in one area may lead extra cost in other area.
▪ Not properly planned program create panic situation.
Managers’ responsibilities in reducing cost
▪ They should have a positive approach.
▪ They should do cost benefit analysis.
▪ Investigate area of potential cost reduction and identify unnecessary costs.
▪ Cost reduction should be planned, agreed, implemented and monitored by managers.
Page 163
Cost Reduction & Value Enhancement
MA/FMA Study Notes
Scope of cost reduction
▪ Cost reduction should be applied to whole organisation through campaigns
▪ Cost reduction campaigns should have a long term aim as well as short term objectives
▪ In short term only variable cost can reduce easily. Fixed cost remains unchanged like rent
▪ Some fixed costs can be avoided in short term like advertising or sales promotions. These are called discretionary
fixed costs
▪ In long term variable and fixed costs both can be either avoided or reduced
METHODS OF COST REDUCTION
✓ Improving efficiency includes:
▪ Improving efficiency of material usage
▪ Low level of wastage
▪ Better quality checks
✓ Improving labour productivity
▪ Pay incentives
▪ Change working methods
▪ Improving coordination between departments
▪ Give challenging standards
▪ Improving efficiency of equipment usage
▪ Better use of equipment resources
▪ Provide proper maintenance to avoid down time
✓ Material costs
▪ Avail bulk purchase discounts
▪ Introduce EOQ
▪ Use Cheap substitute material
▪ Improve store controls
✓ Labour cost
Work study is a mean of raising the productivity of an operating unit by reorganisation of work. There are two
parts of work study:
▪ Method study: It is the systematic recording and critical examination of existing and proposed ways of doing
work in order to develop and apply easier and more effective methods and reduce costs.
▪ Work measurement: It involves establishing the time for qualified workers to carry out a specified job at a
specified level of performance.
Methods of work study:
▪ Direct observation methods: It involves observing jobs in practice
▪ Synthetic methods: These are used to estimate work content of jobs without having to observe them.
Organisation and methods (O&M)
It is a term for techniques, including method study and work measurement that are used to examine
clerical, administrative and management procedures for improvements.
Page 164
Cost Reduction & Value Enhancement
MA/FMA Study Notes
Critical examination of existing and proposed ways of doing work in order to improve it through alternative
cost reduction methods and establishing the time for a skilled worker to carry out a specified job at specified
level of performance
✓ Finance Cost
▪ Avail cash discounts from suppliers
▪ Reassessed cash discounts offered to credit customers
▪ Borrow at low interest rates
▪ Improve foreign exchange dealings
✓ Rationalization
When organisations grow, especially through mergers and takeovers, there is a tendency for work to be
duplicated in different parts of the organisation. The elimination of unnecessary duplication and concentration
of resources is a form of rationalization.
✓ Expenses
▪ authorised expenses
▪ Evaluate capital expenditure
▪ Continually questions about expense items
ANOTHER APPROACH TO COST REDUCTION
Value analysis: It is a planned, scientific approach to cost reduction, which reviews the material composition of a
product and product’s design so that modifications and improvements can be made which do not reduce the value
of the product to the customer or user. This means the value of the product remains same with reduced cost.
Value engineering: It is the application of similar technique on new products so that new products are designed
and developed to a given value at minimum cost.
VALUES
There are four types of values:
Cost value: It is a cost of producing and selling an item
Exchange value: It is the market value of the product or service
Use value: It is what the item does, what the purpose it fulfils
Esteem value: It is the prestige the customer attaches to the product. It is the value which is given by customer
STEPS OF VALUE ANALYSIS
▪ Reduce unit cost so cost value is the only value which we try to reduce
▪ Value analysis try to provide same or improved use value in a low cost
▪ Value analysis try to maintain or enhance the esteem value at low cost
Page 165
Cost Reduction & Value Enhancement
MA/FMA Study Notes
ROLE OF SENIOR MANAGEMENT IN VALUE ANALYSIS
Value analysis programs must have the full backing of senior management. Management must therefore do the
following:
▪ Provide support like acting as a member of Value analysis programs, attend training sessions
▪ Establish goals for Value analysis programs to be achieved
▪ Select the personnel for value analysis
▪ Provide sufficient budget
▪ Insist on continual audit
▪ Give rewards
Page 166
Performance Measurement
MA/FMA Study Notes
PERFORMANCE MEASUREMENT
❖ This Chapter Covers:
✓
PERFORMANCE MEASUREMENT
✓
MISSION
✓
GOALS AND OBJECTIVE
✓
FINANCIAL PERFORMANCE MEASURES
✓
FURTHER ANALYSIS OF OPERATING PROFIT MARGINS
✓
RESIDUAL INCOME (RI)
✓
POSSIBLE LIMITATION OF FINANCIAL RATIO ANALYSIS
✓
INFORMATION REQUIRED FOR MEANINGFUL RATIO ANALYSIS
✓
NON FINANCIAL PERFORMANCE MEASURES
✓
BALANCED SCORECARD
✓
MONITORING PERFORMANCE MEASUREMENT
✓
BENCHMARKING
✓
PERFORMANCE MEASUREMENT IN NON‐PROFIT ORGANISATIONS (NPOs) AND PUBLIC
SECTOR ORGANISATIONS
Page 167
Performance Measurement
MA/FMA Study Notes
PERFORMANCE MEASUREMENT
Performance measurement is a vital part of control and aims to establish how well something or somebody is doing
in relation to a planned activity. Control is to compare actual results with the plan. Strategic management must
decide what they want the business to be and how to get there.
MISSION
Mission should identify the purpose of the business and what is it trying to achieve and just as importantly what the
business does not do. The managers of the business will contribute their views of the desired position of the business
in the future.
For this reason, the mission has also become known as the vision due to the requirement of being able to look into
the future.
This mission will be formally recorded within published documents and will become the benchmarks against which
the success of the business will be evaluated; any choice can be tested against the statement that defines the
aspirations, values, roles and goals of the business.
Purpose of mission
It shows why the company exists
● To create wealth for shareholders
● To satisfy all stakeholders
Mission provides the commercial logic for the organisation like products or services it offers & its competitive
position. It also defines its competence by which it hopes to prosper.
Mission statement
A mission statement is a formal, short, written statement of the purpose of a company or organisation. The mission
statement should guide the actions of the organisation, spell out its overall goal, provide a sense of direction, and
guide decision‐making. It provides "the framework or context within which the company's strategies are formulated.
The vision and the mission statements are often confused with one another and some organisations even use them
interchangeably. In simplest terms, the mission is the organisation's reason for existence, and vision is what it wants
to be
There is no standard format, but they should possess certain characteristics:
● Brevity
Easy to understand and remember
● Flexibility
To accommodate change
● Distinctiveness
To make the firm stand out
Mission statement can play an important role in the planning process.
a) Plans should outline the fulfilment of the organisation’s mission.
b) Evaluate and screening (mission helps to ensure consistency in decisions)
c) Implementation (mission also affects the implementations of a planned strategy, in the culture and business
practice of the firm)
Page 168
Performance Measurement
MA/FMA Study Notes
Goals
There are two types of goals:
Operational goals can be expressed as objectives. It can be measurable
For example cut cost, objective reduce budget by 10%
Non‐operational goals not all the goals can be measured
A university goal is might be to seek truth; this goal cannot be measured
Distinguish between goals and objectives
Goals
● Goals will support the mission.
● This is primary long term objective of the organisation
● Goals are the main purpose of the organisation.
● This is at overall organisational level.
● Goals are decided at corporate planning stage by strategic management.
Objectives
● Objectives are sub‐division of goals.
● Objectives are at departmental level.
● If the departments achieve their objectives, the organisation will achieve its goal.
Objectives usually are smart
● Specific
● Measurable
● Attainable
● Result orientated
● Time bounded
The goals set for different parts of the organisation should be consistent with each other (goal congruence) Some
objectives are primary corporate objectives (goals) and some are secondary objectives. Both should combine to
ensure the achievement of the overall corporate objective. For example a company sets its Primary objective as to
maximize profit, for this it has Secondary objectives like cost reduction, sales growth, customer satisfaction etc.
Objectives may be long term and short term. A company that suffering from losses in short term might continue to
have a long term primary objective of achieving a growth in profits, but in short term its primary objective might be
survival.
Strategic, tactical and operational objectives:
Objectives can also be classified as strategic, tactical or operational.
● Strategic objectives would include matters such as required level of company profitability
● Tactical objectives would concern with efficient and effective use of organisational resources
● Operation objectives would include guidelines for ensuring that specific tasks are carried out
Page 169
Performance Measurement
MA/FMA Study Notes
Trade‐off between the objectives:
When there is number of objective, some might be achieved on the expense of others. For example, a company’s
objective of achieving good profits and profit growth might have adverse consequences for the cash flows of the
business, of the quality of the firm’s products.
The problem of short‐termism
Short‐termism is when there is a bias towards short‐term rather than long‐term performance. It is often due to the
fact that managers' performance is measured on short‐term results.
Short‐termism is when there is a bias towards short‐term rather than long‐term performance.
Organisations often have to make a trade‐off between short‐term and long‐term objectives. Decisions which involve
the sacrifice of longer‐term objectives include the following.
(a) Postponing or abandoning capital expenditure projects, this would eventually contribute to growth and profits,
in order to protect short term cash flow and profits.
(b) Cutting R&D expenditure to save operating costs, and so reducing the prospects for future product
development.
(c) Reducing quality control, to save operating costs (but also adversely affecting reputation and goodwill).
(d) Reducing the level of customer service, to save operating costs (but sacrificing goodwill).
(e) Cutting training costs or recruitment (so the company might be faced with skills shortages).
Managers may also manipulate results, especially if rewards are linked to performance. This can be achieved by
changing the timing of capital purchases, building up inventories and speeding up or delaying payments and receipts.
Methods to encourage a long‐term view
Steps that could be taken to encourage managers to take a long‐term view, so that the 'ideal' decisions are taken,
include the following.
(a) Making short‐term targets realistic. If budget targets are unrealistically tough, a manager will be forced to make
trade‐offs between the short and long term.
(b) Providing sufficient management information to allow managers to see what trade‐offs they are making.
Managers must be kept aware of long‐term aims as well as shorter‐term (budget) targets.
(c) Evaluating managers' performance in terms of contribution to long‐term as well as short‐term objectives.
(d) Link managers' rewards to share price. This may encourage goal congruence.
(e) Set quality based targets as well as financial targets. Multiple targets can be used.
Page 170
Performance Measurement
MA/FMA Study Notes
The link between mission statements and key performance indicators
Performance measure can be divided in two groups
1. Financial performance measures (used to measure the performance of Profit Seeking Organisations)
It includes:
● Ratio analysis‐ Several profitability and liquidity measures can be applied to divisional performance reports.
● Variance analysis‐ is a standard means of monitoring and controlling performance; care must be taken in
identifying the controllability of and responsibility for each variance. (already studied in standard costing)
● Benchmarking (financial + non‐financial)
● Balanced scorecard (financial + non‐financial)
2.
Non‐financial performance measure (used to measure the performance of Profit Seeking Organisations and
Not For Profit Organisations)
● Benchmarking (financial + non‐financial)
● Balanced scorecard (financial + non‐financial)
FINANCIAL PERFORMANCE MEASURES
Ratio Analysis
Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis.
Financial ratios are categorized according to the financial aspect of the business which the ratio measures.
Financial ratios allow for comparisons
▪ Between companies
▪ Between industries
▪ Between different time periods for one company
▪ Between a single company and its industry average
Ratios generally hold no meaning unless they are benchmarked against something else, like past performance or
another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements,
and competition, are usually hard to compare.
Profitability Ratios
Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of
return. Management is always keen to measure its operating efficiency. Owners / shareholders invest their funds in
Page 171
Performance Measurement
MA/FMA Study Notes
the expectation of reasonable returns. The operating efficiency of a firm and its ability to ensure ample returns to
its owners / shareholders depends basically on the profits earned by it.
Operating profit margin
Operating profit is an income of the company that is generated from its own operations. It excludes income from
investment in other businesses. The ratio illustrates what proportion of sales revenue was retained in the form of
profit before the deduction of interest and tax. The operating profit ratio measures the operating efficiency and
pricing efficiency through cost control. If profit margin unsatisfactory means excessive cost or low selling price.
A company with a high operating profit margin ratio has high gross profit and low fixed costs. This provides
management with more flexibility while determining prices. Investors can measure the quality of the company’s
operations looking at the operating profit margin ratio over the period of time and comparing it with other
competitors in the industry.
The Operating Profit Margin Ratio is calculated as follows:
Profit before interest and tax = Total Sales ‐ Cost of Goods Sold – Non manufacturing overheads (except tax and
interest)
Total sales = Cash Sales + Credit Sales
Note: if no information about interest and tax is given then take NET PROFIT instead of Profit before interest and tax
Typical implication/observation
● It indicate the profit per $1 of sales (but not the volume of sales)
● If it increases during the period it is satisfactory
● Might be useful to compare the budget to assess expectations
● The possible causes of low or reducing profit margin are :
➢ Costs are high /increasing
➢ Sale price are low/reducing (but the result may be that turnover is increasing)
➢ A worse of the sale mix (by selling low margin product in the place of high margin product)
FURTHER ANALYSIS OF OPERATING PROFIT MARGINS
Gross profit margin
Gross profit margin ratio indicates how efficiently the material, labour and expenses related to production are used
by an organisation in order to produce a product at a lower cost. Higher percentage shows better control over the
costs and reasonable profit on sales. Comparison of the business ratios to those of similar businesses will reveal the
relative strengths or weaknesses in the business. The Gross Margin Ratio is calculated as follows:
Gross Profit = Total Sales ‐ Cost of Goods Sold
Total sales = Cash Sales + Credit Sales
Cost of goods sold to sales ratio
Page 172
Performance Measurement
MA/FMA Study Notes
When profit targets are not meet, cost to sales ratios are calculated to determine in which area of cost does the
problem lies
The ratio has measured the efficiency with which the company has acquired and used resources to generate sales.
Generally the lower the ratio, the better the cost efficiency is. The ratio does however need to be considered in
context with quality, which influences the volume of sales revenue. The ratio can be sub analysed by different costs:
material, labour and expenses
Non‐ manufacturing overheads to sales ratio
Earnings per share (EPS)
The earnings per share ratio is widely used to measure the profitability of the shareholders’ investment. EPS
represents the amount of profits attributable to each ordinary share or, what each share has generated in terms of
profits. In other words, EPS are the portion of a company of a company’s profit allocated to each outstanding share
of common stock. Often, investors compare the EPS of the company with the industry average and with the EPS of
other companies before taking investment decisions.
Price earnings ratio (P/E ratio)
Price earnings ratio compares current market price of each share with the per share earnings in order to assess the
company’s performance. It reflects investors’ expectations about the increase in the firm’s earnings. A high P/E ratio
indicates that investors are expecting higher growth in future compared to companies with low P/E ratio. It is more
useful to compare one company’s P/E ratio with that of the other companies in the same industry or the market in
general and with the company’s own P/E ratio of preceding years.
Return on capital employed (ROCE)
Return on investment (ROI) also called return on capital employed (ROCE)
ROCE is probably the most popular ratio for measuring general management performance in relation to the capital
invested in the business. ROI is normally used for divisional or investment centre performance appraisal. This ratio
expresses profits earned as a proportion of capital employed. It illustrates how efficiently the company is using its
capital to generate profits.
It is calculated as follows:
Page 173
Performance Measurement
ROCE
MA/FMA Study Notes
= Profit before interest and tax OR Net Profit x 100
Capital employed
Where
Capital employed = Net Assets = Fixed Assets + Current Assets – Current liabilities
Average Capital employed should be used. This is because if the company has purchased assets near the year end,
they will be included in the capital employed figure increasing the value of the capital employed figure BUT the
profits will only show one or two months of the assets contribution in generating profits.
Example:
Company A
Profit $5,000
Sales $100,000
Capital Employed
ROI will be
Company B
$5,000
$100,000
$50,000
10%
$25,000
20%
The profit of each company is the same but company B only invested $25,000 in assets to achieve that profit whereas
company A invested $50,000
Comparisons of ROCE can be made between different years or different companies.
QUESTION 1
1. The following data is given
$
180,000
100,000
50,000
34,500
Fixed Assets
Current Assets
Current Liabilities
Net Profit
Find the ROCE/ROI.
2.
The following data is given
$
46,600
12,000
24,000
1,000
7,500
250,000
75,000
Gross profit
Selling expenses
Admin Expenses
Tax
Interest on loans
Fixed Assets
Current Liabilities
Find ROI/ROCE.
RESIDUAL INCOME (RI)
In contrast to ROI, which is expressed as a percentage, residual income is expressed in absolute terms (i.e. as a dollar
amount). It is the measure of the centre’s profits after deducting a notional interest cost
Page 174
Performance Measurement
MA/FMA Study Notes
The formula is as follows:
Residual income = (profit before interest and tax + profit from any other investments) – notional interest charge
on capital employed
Notional interest charge = rate of notional interest x total capital employed
Important: the amount of total capital employed is calculated by including the non‐operational investments as well.
Advantages and disadvantages of residual income
Advantages
● It makes divisional managers aware of the cost of financing their divisions.
● It is an absolute measure of performance and not subject to the problems of relative measures such as return
on investment.
● In the long run it supports the net present value approach to investment appraisal (the present value of a
project’s residual income equals net present value of that project).
Disadvantages
● Residual income gives the symptoms not the causes of problems. If residual income falls the figures give little
clue as to why.
● Problems exist in comparing the performance of different sized divisions (large divisions will earn larger residual
incomes simply due to their size).
● Residual income when applied on a short term basis is a short term measure of performance and may lead
managers to overlook projects whose payoffs are long term. This could well be the case for the hotel chain.
QUESTION 1
A division with capital employed of $400,000 currently earns a ROI of 22%. It can make an additional investment of
$50,000 for a 5 year life with nil residual value. The average net profit from this investment would be $12,000 after
depreciation of $2,000. A notional interest charge amounting to 14% of the amount invested is to be charged to the
division each year. The residual income of the division after the investment will be:
(a) $5,000
(b) $32,000
(c) $37,000
(d) $39,000
Asset turnover
It is calculated as follows:
Asset turnover
=
total sales _
Capital employed
This ratio indicates the efficiency with which company is able to use all its (net) assets to gearing $1 sales. Generally,
the higher a company’s total net asset turnover, the more efficiently its assets have been used. The total net asset
turnover is probably of greatest interest to management, however, other parties, such as creditors and prospective
and present shareholder, will also be interested in the measure.
The return on investment is widely used by external analysts of company performance when the primary ratio is
broken down into its two secondary ratios:
ROI = Asset Turnover X Profit Margin
Page 175
Performance Measurement
ROI
=
total sales _
Capital employed
MA/FMA Study Notes
x profit before interest and tax
total sales
ROCE
= Profit before interest and tax OR Net Profit x 100
Capital employed
Fixed asset turnover
The ratio is used to measure the efficiency with which a company has used its fixed assets to generate sales.
Generally higher fixed asset turnover are preferred, although the value is meaningful only when compared inter‐
period or against the industry. This ratio can be sub‐analysed by land, building machinery fixtures and fittings
turnover etc.
Current asset turnover
The ratio is used to measure the efficiency with which a company has used its current assets to generate sales. It
helps to measure the effectiveness of working capital management. Generally higher current asset turnover are
preferred, although the value is meaningful only when compared inter‐period or against the industry. This ratio can
be sub‐analysed by debtor, stock (shown next), cash turnover etc
Stock turnover times
The time which stock turnover measure is the efficiency with which a company has used is stock (or inventory).
Liquidity Ratios
Liquidity
Liquidity refers the state of an asset’s nearness to cash. Nearness to cash has been defined in terms of the time and
effort needed to sell an asset. Liquidity is vital to the financial health of any company too much liquidity is a misuse
of money, and too little leads to severe cash problems. It is shown through these ratios:
Current ratio
Current ratio measures the short‐term solvency of a firm. It shows the availability of current assets for every one
dollar of current liability. The higher the current ratio, the larger is the amount of current assets in relation to current
liabilities and the company’s ability to meet its current obligations is greater too. If the current ratio is 2:1 or more,
the company is generally considered to have good short‐term financial strength. If the current ratio is less than 1
(liabilities exceed current assets), the company may face difficulties in meeting its short term obligations.
Page 176
Performance Measurement
MA/FMA Study Notes
Quick ratio or acid test ratio
Quick ratio determines the relationship between liquid assets and current liabilities. Liquid assets are the assets that
can be easily and immediately converted into cash without loss of value. A quick ratio of 1 to 1 or more represents
a satisfactory current financial position of a firm.
Activity ratios
Activity ratios measure the effectiveness of the firm’s use of resources.
Inventory turnover ratio
Inventory turnover
=
costs of goods sold
Average inventory
Here
Average inventory
beginning inventory + ending inventory
2
Inventory turnover ratio identifies the efficiency of an organisation in producing and selling its product. It shows the
number of times the inventory is sold or replaced during the given period. A high ratio indicates strong sales or
ineffective buying and a low ratio indicates poor sales and excess inventory.
Receivable turnover ratio
Receivable turnover
=
=
credit sales
Average receivables
The ratio shows how long an organisation takes to collect payments from its customers. It indicates the number of
times the receivables turnover each year. The higher the ratio, the better is the efficiency of the credit management
in the organisation.
Payables turnover ratio
Payables turnover
=
credit purchases
Average payables
This ratio shows how long an organisation takes to pay its suppliers.
Receivables collection period:
Receivables collection period = average debtors × 365
Sales
Inventory turnover period:
Inventory turnover period = average inventory × 365
Cost of goods sold
Payables payment period;
Payables payment period =average payables × 365
purchases
Page 177
Performance Measurement
MA/FMA Study Notes
Gearing ratios
The debt position of a company indicates the amount of other people money (other than the owner’s money) that
is being used by it in generating its profit. Typically, attention is placed on long‐term debts, since these commit the
company to pay interest over the longest run and eventually repay the sum borrowed. Since long term, debt has
prior claims, present and prospective shareholders pay close attention to the degree of indebtedness and ability to
repay debts.
In general, the more debt (or financial leverage) a company uses the greater will be its risk and return.
Gearing ratio (debt to equity ratio)
Prior charge capital (long term debt)
Prior charge capital + shareholders equity
The ratio is sometimes referred to as the debt –equity ratio indicates the relationship between the long‐term funds
provided by the loan group and those provided by the company’s owner. The figure is only meaningful in light of the
company’s business and comparison with other organisations within the industry is useful. The ratio can also be
measured as the relationship between prior‐ charge debt and the company’s assets. If this ratio is too high, lender
will view the business as high risk and owners may have trouble obtaining new finance and if this ratio is too low
usually indicates that the business is not using its cash and profits effectively to obtain business assets. This may
discourage investors because it mean that less profits are distributed to them.
Interest cover ratio
The interest cover ratio shows whether company is earning enough profit before interest to pay its interest costs
comfortable, or whether its interest costs are high in relation to the size of its profit, so that a fall in profit before
interest and tax would then have a significant effect on profits available for ordinary shareholders. An interest cover
of 2 times or less would be low, although benchmarks are different industry by industry.
Dividend cover
The dividend cover indicates:
● The proportion of distributable profit for the year that is being retained by the company.
● The level of risk that the company will not be able to maintain the same dividend payments in future years,
should earning fall.
● A high dividend covers means that a high proportion of profit is being returned, which might indicates that the
company is investing to achieve earning growth in the future.
POSSIBLE LIMITATION OF FINANCIAL RATIO ANALYSIS
However, this analysis approach must be used with circumspection and in circumspection with other analytical tools
and techniques as it have a number of limitations. These include:
Page 178
Performance Measurement
1.
2.
3.
4.
5.
6.
7.
MA/FMA Study Notes
That the approach is based on historical data and thus the ratio may not be a good guide to the future
The quality of the analysis is determined by the quality of the accounting information upon which it is based
considering here the distortion that can result from creative accounting such as window dressing of financial
statement to hide short term fluctuation.
Difference in accounting practices adopt by company over the treatment of fixed asset depreciation and
revaluation, stock valuation, research and development expenditure, goodwill write off and profit recognition.
The change value of money and differences in trading enjoinments over time.
A difficulty in deciding on a suitable yardstick and the interpretation of change e.g. is a higher return on net
asset (RONA) good or bad.
The use of ratios to measure performance may encourage sub‐optimal behaviours by managers e.g. short term
manipulation of results.
Ratios are normally based exclusively on finance, and reflect only financial indicators of performance. There are
of coursed non‐financial implications associated with performance.
INFORMATION REQUIRED FOR MEANINGFUL RATIO ANALYSIS
In addition to a company’s financial statement (balance sheet, profit and loss account and cash flow statement) the
following information would be useful:
1. Statistics of the industry as a whole and in particular financial and other ratios showing best industry average
and worst results
2. Detail of the company’s budget plans with a schedule of variances
3. Cash flow forecasts
4. Details of the company accounting policies and changes to any basis of accounting
5. Detail of future plans
6. Details of any post balance sheet event and of any contingencies
7. Detail of fixed assets with project remaining lives and likely replacement costs
8. Accounting adjustment to take account of inflation during the period under review
9. Government statistics concerning interest levels and other economic indicators
Example
You are given summarized results of an electrical engineering business as follows:
PROFIT AND LOSS ACCOUNT
£000
Turnover
60,000
Cost of sales
(42,000)
Gross profit
18,000
Operating expenses
(15,500)
Profit
2,500
Page 179
Performance Measurement
MA/FMA Study Notes
BALANCE SHEET
£000
Fixed assets
Current assets
Stock
Debtors
Cash
Creditor due within one year
Net current assets
Total asset less current liabilities
Capital and reserves
14,000
16,000
500
£000
12,500
30,500
(24,000)
6,500
19,000
19,000
Required
Calculate the following ratio, clearly showing the figures used in the calculations:
1. Current ratio
2. Quick/acid test ratio
3. Stock turnover period
4. Debtor turnover period
5. Creditor turnover in days
6. Gross profit percentage
7. Net profit percentage
8. ROCE
9. Asset turnover
Traceable and controllable costs
The main problem with measuring controllable performance is in deciding which costs are controllable and which
costs are traceable. The performance of the manager of the division is indicated by the controllable profit (and it is
on this that he is judged) and the success of the division as a whole is judged on the traceable profit.
Consider, for example, depreciation on divisional machinery. Would this be included as a controllable fixed cost or a
traceable fixed cost? Because profit centre managers are only responsible for the costs and revenues under their
control, this means that they do not have control over the investment in noncurrent assets. The depreciation on
divisional machinery would therefore be a traceable fixed cost judging the performance of the division, and not of
the individual manager.
NON FINANCIAL PERFORMANCE MEASURES
These are the qualitative measures which are not expressed in numeric. Due to Changes in cost structure, more
competitive environment and competitive manufacturing environment have led to an increased use of non‐financial
indicators.
● In modern businesses, a major investment is required for new technology and product life cycle have got
shorten. Mostly costs are committed at planning stage so it is too late to control cost in further stages.
● Financial measures do not convey full picture of the company’s performance. In competitive environment
companies are competing in terms of customer satisfaction, quality, product features, quality deliveries, after
sales services etc.
● New competitive process of making a product focuses on reducing time of production, less machine setups,
more efficient labour and machine, increase in productivity etc.
Page 180
Performance Measurement
MA/FMA Study Notes
Non‐financial measures
Key performance indicators
Competitiveness
●
●
●
sales growth by product or service
measures of customer base
relative market share and position
Quality of service
●
●
●
●
●
●
●
●
●
●
●
●
●
quality measures in every unit
evaluate suppliers on the basis of quality
number of customer complaints received
number of new accounts lost or gained
rejections as a percentage of production or sales
speed of response to customer needs
informal listening by calling a certain number of customers each week
number of customer visits to the factory or
workplace
number of factory and non‐factory manager visits
to customers
days absence
labour turnover
overtime
measures of job satisfaction
Customer satisfaction
Quality of working life
BALANCED SCORECARD
The balanced scorecard measures performance in four different perspectives. It employs a variety of financial and
non‐financial indicators.
● Financial perspective (financial success) – “how do we create value for our shareholders?
● Customer perspective (customer satisfaction) – “how do existing and new customers value from us?”
● Internal business perspective (process efficiency) – “what must process we excel at?”
● Innovation and learning perspective (growth) – “can we continue to improve and create future value?”
In balanced scorecard these four perspectives are act as Critical Success Factors (CSF).
A critical success factor is a performance requirement that is fundamental (critical) to competitive success.
These critical success factors have number of Key Performance Indicators (KPI)
These are the indicators used to measure performance. There are two types of key performance indicators.
● Financial key performance indicators (in monetary terms)
● Non‐Financial key performance indicators (in non‐monetary terms)
Financial perspective
This considers how the organisation can create value for its stakeholders. Performance measures are likely to include
traditional financial measures of profitability, cash flow and sales growth. This focuses on satisfying shareholder
value.
Appropriate performance measures are:
● Return on capital employed
● Profit margins
Page 181
Performance Measurement
MA/FMA Study Notes
Customer perspective
This looks at how existing and potential customers see the organisation. Performance measures could include
number of customer complaints, new customers acquired, on‐time deliveries etc. This is an attempt to measure
customers’ view of the organisation by measuring customer satisfaction.
Appropriate performance measures are:
● Customer satisfaction with timeliness
● Customer loyalty.
Internal business perspective
This considers the processes at which an organisation must excel if it is to achieve customer satisfaction and financial
success. Measures might include the speed of innovation, the quality of after sales service or manufacturing time.
This aims to measure the organisation’s output in terms of technical excellence and consumer needs.
Appropriate performance measures are
● Unit cost
● Quality measurement
Innovation and learning perspective
This looks at the organisation’s capacity to maintain its competitive position through the acquisition of new skills
and the development of new products and services. This focus on the need for continual improvement of existing
products and techniques and developing new ones to meet customers’ changing needs.
Appropriate performance measures are:
● A measure would include % of turnover attributable to new products.
The following important features of this approach have been identified.
(a) It looks at both internal and external matters concerning the organisation.
(b) It is related to the key elements of a company's strategy.
(c) Financial and non‐financial measures are linked together.
The balanced scorecard approach may be particularly useful for performance measurement in organisations which
are unable to use simple profit as a performance measure. For example the public sector has long been forced to
use a wide range of performance indicators, which can be formalized with a balanced scorecard approach.
Page 182
Performance Measurement
MA/FMA Study Notes
Advantages and disadvantages
As with all techniques, problems can arise when it is applied.
Advantages
All four perspectives
considered by managers
Consistency between
objectives,
control
systems and staff
Disadvantages
Conflicting measures
Selecting measures
Expertise
Interpretation
Explanation
Managers need to look at both internal and external matters affecting the organisation.
They also need to link together financial and non‐financial measures. Therefore they can
see how factors in one area affect all other areas.
It can be difficult to incorporate objectives into control systems such as budgets. So
targets set by a budget, say, may conflict with objectives. Moreover, staff may put their
own interpretation on objectives against the actual intention of the original objective.
The balanced scorecard should improve communication between different levels of the
organisation. The balanced scorecard strives to keep all these factors in balance.
Explanation
Some measures in the scorecard, such as research funding and cost reduction, may
naturally conflict. It is often difficult to determine the balance that will achieve the best
results.
Not only do appropriate measures have to be devised but the number of measures used
must also be agreed. Care must be taken that the impact of the results is not lost in a sea
of information.
Measurement is only useful if it initiates appropriate action. Non‐financial managers may
have difficulty with the usual profit measures. With more measures to consider this
problem will be compounded.
Even a financially trained manager may have difficulty in putting the figures into an
overall perspective.
Application of balanced scorecard
Two examples of in which a balanced scorecard might appear are given below:
Balanced Scorecard for a Restaurant
Financial success
Goals
To grow and open new restaurants
Profitable
Customer satisfaction
Goals
Great services
Repeat business
Innovative food
Process efficiency
Goals
Timely food delivery
Efficient staff
Low food wastage
Growth
Goals
Measures (KPI)
New restaurants opened
Net profit margins
Measures (KPI)
Excellent results on customer survey
Customers booking to come again
New menus on a regular basis
Measures (KPI)
Time from order to delivery
Processing of food order, few mistakes
Amount of food discarded
Measures (KPI)
Page 183
Performance Measurement
Trained staff
New menu choices
MA/FMA Study Notes
Employees with relevant training
Number of new dishes introduced
Balanced Scorecard for a Charity
Financial success
Goals
Income from charitable donations
Improved margins
Customer satisfaction
Goals
Continued donor support
Donor involvement in initiatives
Process efficiency
Goals
Reduce overheads
Claim back tax on gift aid
Growth
Goals
More project supported
More fundraising
More money pledged
Measures (KPI)
Donations received
Lower costs or increased income from all sources
Measures (KPI)
Direct debit setups
Fundraising and charity dinners
Measures (KPI)
Lower overheads measured by monitoring and accounts
Improved reclaim times for gift aided donation
Measures (KPI)
Number of projects given support
Number of fundraisers recruited
Amount of donations promised
Economy, Efficiency and Effectiveness
Value for money means providing a service in a way which is economical, efficient and effective.
Value for Money (VFM) is often referred to as the 3 E's ‐ Economy, Efficiency and Effectiveness.
●
Economy
It implies that the least possible cost should be incurred for acquiring and using resources, while maintaining
the appropriate quality ('doing things at a low price') like more clean plates per pound
●
Effectiveness
It focuses on the achievement of the desired objectives through the spending of available funds. It is concerned
with the relationship between the planned results and the actual results of projects, programs and other
activities ('doing the right things'). Like plates as clean as they should be
●
Efficiency
It is attaining desired results at minimum cost.
It implies the maximizing of output input ratio i.e. per unit of input the output should be the most. It is concerned
with the relationship the resources (input) and the output of goods, services and other results. Ideally, minimum
input should be used for a given output and maximum output should be achieved for a given input ('doing things the
right way') like more clean plates per squirt [ it combines effectiveness and efficiency ]
Page 184
Performance Measurement
MA/FMA Study Notes
University
●
●
Area
Economy
efficiency
Effectiveness
Possible
measure
Minimizing
cost
per
student
Maximizing
student/staff
ratio
Quality of degrees
awarded
It is clear that high effectiveness may conflict with economy and efficiency.
Multiple and conflicting objectives may exist due to the multiple stakeholders involved
Performance Measurement of Labour Using Standard Hour
It is not possible to measure output in terms of units produced for a department making several different products.
This problem can be overcome by ascertaining the standard hours produced, for example the amount of time,
working under efficient conditions, it should take to make each product.
For example the allowed time for producing a product X is 5 hours.
Activity ratio / production volume ratio
This ratio measures how the overall production compares to planned levels. It compares the number of standard
hours equivalent to the actual work produced and budgeted hours.
Standard hours for actual output x 100
Budgeted hours
Capacity ratio
This ratio measures the extent of worker's capacity by their working hour has been achieved in a period with the
planned labour hours utilization.
Actual hours worked
x 100
Budgeted hours
Efficiency ratio
This ratio measures the efficiency of the labour force by comparing equivalent standard hours for product produced
and actual hours worked. The benchmark of efficiency is 100%.
Standard hours for actual output x 100
Actual hours worked
Relationship between the three ratios
Activity ratio = Efficiency ratio x capacity ratio
Standard hours for actual output = Standard hours per unit X Actual output.
Standards hours per unit = Budgeted hours ÷ Budgeted units produced
Page 185
Performance Measurement
MA/FMA Study Notes
QUESTION 2
Budgeted output for a month is 3,000 units. Budgeted time for the production is 300 hours. The actual output in
January is 3,300 units and actual time work by labour force is 320 hours.
Required To calculate:
(a) Activity ratio’
(b) Capacity ratio
(c) Efficiency ratio
Performances measurement through cost per unit
In contract and process costing environment cost per unit is a useful performance measure.
Total cost
Number of units produced in the period
Cost per unit
=
Performance measure for Services
Characteristics of services
There are four particular characteristics of services, which affect both performance and its measurement:
Simultaneity – production and consumption of the service at the same time
Perishability – the inability to store the service
Heterogeneity also called variability – provision of a non‐standardized service
Intangibility– there is no physical product.
Performance measurement in service sectors
There are 6 key dimensions to performance in the service sector
● Competitive Performance
● Financial Performance
● Quality
● Resource utilization
● Flexibility
● Innovation
Together these areas influence the competitiveness of the business and ultimately its profitability. Therefore, these
four areas should form the ‘building blocks’ of performance evaluation systems in the service sector.
Competitive performance
● Sales Growth
● Market Share
● Obtain New Business
Financial performance
● Budgeted Expenditure Limit
● Standard Performance Measurement (Standard cost per unit; Productivity etc)
Page 186
Performance Measurement
MA/FMA Study Notes
Quality
Quality cannot be measured physically so it is assessed by different means, this will be more understandable by
following table
Service quality
factor
● Assess
● Cleanness
● Comfort
● Friendliness
Measure
Mechanism
Walking distance
Cleanness of environment and equipment
Crowdedness of airport
Staff attitude and helpfulness
Customer survey and internal operational data
Customer survey and management inspection
Customer survey and management inspection
Customer survey and management inspection
Resource utilisation
Resource utilization is measured in terms of productivity. The main output of accountancy firm is chargeable hours.
Productivity will therefore be measured as ratio some of the ratios are given below:
Business
Accountancy firms
Commonwealth hotels
Input
Man hours available
Rooms available
Flexibility
Flexibility has three aspects:
Speed of delivery
Output
Chargeable hours
Rooms occupied
This is vital in some services industries. measure included factors such as
waiting time in queries
Ability to respond in customer’s
specification
This will depend on type of services professional service such as legal advice
must tailored exactly the customer’s needs
Coping with demand
This is measurable in quantity terms. E.g. train company can measure exact
overcrowding
Innovation
How much cost it will take to develop new service and how effective this process is
In can be summarized as follows:
● Amount of spending on research and development
● Proportion of new service to total service provided
● Time between the identification of customer need and for a new service and making it available
MONITORING PERFORMANCE MEASUREMENT
Non‐financial performance measure (used to measure the performance of Profit Seeking Organisations and Not For
Profit Organisations)
● Benchmarking (financial + non‐financial)
● Balanced scorecard (financial + non‐financial)
Page 187
Performance Measurement
MA/FMA Study Notes
BENCHMARKING
Benchmarking involves the establishment, through data gathering, of targets and comparators, through whose use
relative levels of performance (and particularly areas of underperformance) can be identified. By the adoption of
identified best practices the performance of the organisation should be improved.
Types of benchmarking
Four types of benchmarking are commonly recognised.
Internal benchmarking
This involves the comparison of different departments or divisions within an organisation. Data for this is easy to
obtain and conditions are often comparable. Learning may be limited as comparisons are only being made within
the same company.
Competitive benchmarking
This involves comparing performance with that of direct competitors. The potential for learning is improved but data
may be difficult to obtain. For commercial reasons firms are often unwilling to divulge information to direct
competitors. The growth of benchmarking clubs and trade associations has reduced the problems of competitive
benchmarking
Functional benchmarking
Various functions in the business are compared with those recognised as the best external practitioners of the
function. A manufacturing company could compare its invoice preparation time with that of a credit card company,
its delivery time with a firm of couriers etc.
The potential for learning how to improve performance is very high, but comparability problems sometimes exist.
(This is sometimes referred to as operational or generic benchmarking)
Strategic benchmarking
This involves comparison of performance with competitors at the strategic level. Areas such as market share and
return on capital employed could be considered. Such comparisons are important in designing competitive strategy.
Reverse engineering
Buying a competitor’s product and dismantling it, in order to understand its content and configuration.
Why use benchmarking?
For setting standards
Benchmarking allows attainable standards to be established following the examination of both external and
internal information. If these standards are regularly reviewed in the light of information gained through
benchmarking exercises, they can become part of a program of continuous improvement by becoming increasingly
demanding.
Other reasons
Anna Green, in her article The Borrowers in the October 1996 edition of Pass magazine, explains the benefits of
benchmarking.
(a) Its flexibility means that it can be used in both the public and private sector and by people at different levels of
responsibility.
Page 188
Performance Measurement
MA/FMA Study Notes
(b) Cross comparisons (as opposed to comparisons with similar organisations) are more likely to expose radically
different ways of doing things.
(c) It is an effective method of implementing change, people being involved in identifying and seeking out different
ways of doing things in their own areas.
(d) It identifies the processes to improve.
(e) It helps with cost reduction.
(f) It improves the effectiveness of operations.
(g) It delivers services to a defined standard.
(h) It provides a focus on planning.
'Most importantly benchmarking establishes a desire to achieve continuous improvement and helps develop a
culture in which it is easier to admit mistakes and make changes.'
Stages
1. Planning and organisation e.g. setting up a steering group and setting out aims and objectives
2. Identification of key internal processes for analysis.
a. Practices. steps in a process
b. Metrics. measures of times and outcomes e.g. cost, quality
3. Researching potential partners. Collecting information and investigating metrics for comparison.
4. Making agreements and developing plans for exchange visits. Formulating a common program for internal data
collection
5. Partner site visits by benchmarking teams collect data
6. Analysing data and developing plans for improvements
7. Implementation and monitoring
Benefits of performance measurement systems
● Clarification and communication of organisational objectives e.g. profitability.
● Developing agreed measures of performance within the organisation e.g.ROCE.
● Allowing comparison of different organisations e.g. ratio analysis.
● Promoting accountability of the organisation to its stakeholders.
Problems
● Tunnel vision – an obsession with maximizing measured performance at the expense of non‐measured
performance e.g. staff welfare.
● Myopia (short sightedness) – maximizing short run performance at the expense of long run success.
● Manipulation of data – “creative” reporting e.g. trying to classify all adverse variances as planning variances.
● Gaming – e.g. building slack into budgets.
Solutions
● Participation – involve staff at all levels in the design and implementation of the system.
● Encourage a long‐term view among staff e.g. through company share option scheme.
● Ensure the system of performance evaluation is “audited” by experts to identify problems.
● Review the system regularly.
● Audit data used in performance measurement to prevent/detect manipulation.
Page 189
Performance Measurement
MA/FMA Study Notes
PERFORMANCE MEASUREMENT IN NON‐PROFIT MAKING ORGANISATIONS (NPMOs) AND PUBLIC SECTOR
ORGANISATIONS
Performance measurement in Non‐profit Making Organisations:
Performance cannot be judged by Profitability rather than it is judged in terms of inputs and outputs which ties in
with the Value for Money criteria.
Economy
Efficiency
Effectiveness
Problems with Non‐profit Organisations (NPOs):
● NPOs tend to have multiple objectives
● Outputs can seldom be measured
Performance can be measured by
● Input – Output Relation
● Judgments
● Comparisons
● Unit cost Measurement
Performance measurement in Public Sector Organisations:
Large volume of information on performance and value for money is produced
This information is for internal and external use
Performance can be measured against;
● Financial Performance Targets
● Volume of Output Targets
● Quality of Service Targets
● Efficiency Targets
Management Performance Measures
It is necessary to consider a manager and measure performance in relation to his or her area of responsibility. It is
unreasonable to assess managers’ performance in relation to matters that are beyond their control. Management
performance measures should therefore only include those items that are directly controllable by the manager. The
way to control their performance is to establish in advance a set of measures that will be used to evaluate their
performance at the end of the period. It is of critical importance that the performance measures are designed well.
Below are the possible performance measures of the management
Measures
Subjective Measures
Judgement of Outsiders
Upward Appraisal
Detail
An example is performance on a scale of 1 to 5. This will measure managerial
performance rather than divisional performance. The judgement should be
made by somebody impartial.
Bonus attached with the share price for example manager will receive bonus if
share price outperforms for three years. Increase in share price may reflect the
performance aspect.
This involves staff giving their opinions on the performance of their managers.
To be effective this requires health working relationships.
Page 190
Performance Measurement
Accounting Measures
MA/FMA Study Notes
These can be used, but must be tailored according to what or whom is being
judged.
Practical problems involved in measuring the performance of manager:
Distinguishing between the performance measures of managers and business
Difficult to devise performance measures that relate specifically to a manager to judge his or her performance as a
manager
Statistics such as days absent, professional qualification, personality etc, can assess the manager as an employee but
cannot assess its managerial performance
Impact of External Considerations:
The organisation is not sealed off from its environment, it is subject to the conditions present in that environment
and its performance is influenced by them. We must always be aware when measuring performance of the influence
of external conditions and changes in them.
For a commercial business, success is subject to general economic and market conditions.
Market Conditions:
A business operates in a competitive environment and suppliers, customers and competitors all influence one
another’s operations. The entry of a new and dynamic competitor, for example is certain to have an effect on
budgeted sales.
General Economic Conditions:
These influence businesses most obviously by increase and decrease in Demand and Supply. The role of government
is very important as government economic policy affects the demand.
For non‐profit making organisations, economic conditions and government policy are still important e.g. charity
organisations depending on donations will be subject to general feelings of prosperity.
The general conclusion from these and similar conditions is that appropriate attention should be paid to general and
specific external conditions when measuring performance.
Page 191
Management Information
MA/FMA Study Notes
MANAGEMENT INFORMATION
❖ This Chapter Covers:
✓
DATA AND INFORMATION
✓
TYPES OF DATA
✓
BIG DATA
✓
MANAGEMENT
✓
PURPOSE OF MANAGEMENT INFORMATION
✓
LEVELS OF MANAGEMENT AND INFORMATION REQUIREMENTS AT EACH LEVEL
✓
FEATURES OF MANAGEMENT INFORMATION
✓
SOURCES OF DATA AND INFORMATION
✓
TYPES OF SOURCE OF INFORMATION
✓
MANAGEMENT ACCOUNTING VERSUS FINANCIAL ACCOUNTING
✓
ROLE OF MANAGEMENT ACCOUNTANT
✓
RESPONSIBILITY ACCOUNTING
✓
TYPES OF CODES
Page 192
Management Information
MA/FMA Study Notes
DATA AND INFORMATION
The difference between data and information should be understood as these words are often used interchangeably.
Data is raw facts, figures, numbers and words relating to matters of an organisation.
Information is data processed to be meaningful and useful to an organisation.
TYPES OF DATA
The data can be further classified as
● Primary and secondary data
● Quantitative and qualitative data
● Sample and population data
Primary and secondary data
Primary data is data collected for specific purpose; raw data is basically primary data. Example: list of numbers.
Secondary data is data which have already been collected elsewhere for some other purpose, but which can be used
or adapted for the survey being conducted.
Quantitative data and Qualitative data
Qualitative data is data that cannot be measured and expressed in numbers but may reflect distinguishing
characteristics.
Example: the quality of labour used to produce the unit of output like skilled or semi‐skilled workers.
Quantitative data is data that can be measured and expressed in numbers. Example: the standard labour hours
required to produce one unit of output.
Quantitative data can be further classified into discrete and continuous data
Discrete and continuous data
Discrete data is data which only takes finite or countable number of values within given range.
Example: number of goals scored by a football player in last world cup, shoe size, no of students etc.
Continuous data is data, which can take on any value they are measured rather than counted.
Example: height of all members of your family.
Sample and population data
Sample data are the data arising because of investigating a sample. A sample is a selection from the population
Population data are data arising because of investigating the population. A population is the group of people or
objects of interest to the data collector
Page 193
Management Information
MA/FMA Study Notes
Big Data
Big Data can be defined as the data sets with such huge volume, high velocity of updating and a great variety, which
require specific technology to make use of it.
Simply Big Data is the amount of data that is being amassed on technology, which we know as Internet and because
the amount of information that is being uploaded every single passing second with such an increasing rate, it has
become incumbent upon enterprises to use this huge pile of ever rising data volumes for their benefit.
Even though this concept has been there since 1990, in the previous years it has come under the spotlight. Corporate
analysts have made special emphasis for companies to use this data and those who are not capable enough will lose
in the long run.
Uses of Big Data & Analytics for Organisations
Closely Knit Marketing
Customer Based Statistics and Analytics is one of the most crucial parts of the big data which can come quite useful
for any business. The ability to know customer preferences, interests and information about how the modern
consumer is making the purchase decisions can change how marketing works.
Product Development
Analytics can also provide data on how the products can be re‐engineered to perform better against competitors
and the response of this development can be studied in a fairly small amount of time in comparison to how much it
took some years back. Businesses can also analyze how particular trends fluctuate because of small changes in
products design and the branding aspect.
Risk Management
Such a vast variety of data collected over the past can also lead to better forecasts considering the maximum possible
variables that exist and can potentially affect the simulations. All businesses which face some risk can study the
patterns well and big data can help take effective decisions in advance to mitigate the risks involved.
Page 194
Management Information
MA/FMA Study Notes
New Revenue Streams
Businesses which hold large volumes of data can use this data to develop trends and use these to develop revenue
streams by providing these non‐personalized trends to businesses which might need this information to grow.
Related services can greatly benefit from having this knowledge on consumer statistics from large data holding
companies.
Proactive Approach
Big data would allow businesses to look for rising trends and customer’s preferences, which are shared through
EWOM (Electronic Word of Mouth) over the internet. These demands can be fulfilled by taking a proactive approach
and knowing what the customers want in advance. This was previously done by the research team by doing market
surveys and questionnaires to make analytics. With big data this would be a whole lot simplified and businesses will
be able to cost effectively gain a much better analysis of market demands.
MANAGEMENT
● People in charge of running the business
● For example Managers or Other Organisations who control the business
Management Information (MI)
● Information required by the managers for the purpose of planning, control and decision making
● Information given to people who run the business
● Information required varies according to responsibilities. For example a supervisor at a factory would require a
daily output report. A sales manager would require a weekly sales report etc.
● Information may be used for pricing, valuation of stock, determining profitability, deciding on purchase of capital
assets (fixed assets) etc.
● Examples of information the management
o cost to make a product
o number of products sold every month
o type of machinery required for production
Types of Management Information
Most organisations require the following types of Management information
a) Financial information
● Measured in terms of money
● For example sales of $10,000 in May
b) Non‐financial information
● Not measured in terms of money.
● For example customer satisfaction, trends, quality
c) Combination of financial and non‐financial information
● Increase sales by $2,000 due to good quality of product
PURPOSE OF MANAGEMENT INFORMATION
Major purpose of management information is
● Planning
● Control
● Decision‐making
Page 195
Management Information
MA/FMA Study Notes
Decision making in a broader concept and the planning stage and control stage also includes decision making in it
a) Planning
Planning involves the establishment of goals and objectives. It also involves selecting appropriate strategies to
achieve that objective.
● The management has to plan and manage resources that will be required to achieve the objectives. Plan
what resources are required and how they will be used.
● Resources can be monetary (like cash required for business) or human resources (like employees)
● Managing resources means how much would be spending on which project, how many people will be
working on that project etc.
Planning involves long term planning & short‐term planning.
Long term planning
It is also known as Corporate Planning involves selecting appropriate strategies for preparing long‐term plans
to achieve objectives.
● Time span depend on organisation’s industry and its environment usually for 3, 5,7,10 years.
● Detailed planning.
● Lengthy process.
● Decisions are taken by senior management or top‐level management and approved by Board of Directors.
Short term or tactical planning
Long term plans should be subdivided into short‐term plans for operational purposes usually converted it into
one year’s planning.
● Time span is shorter usually one year like budgets.
● Planning at departmental or functional level.
● By achieving short‐term plans, organisation can achieve its long‐term plans.
Page 196
Management Information
MA/FMA Study Notes
b) Control
When the plan is implemented, it should be evaluated by comparing actual results with plan so that to identify
derivation if any and investigate it.
Controls are at two stages:
1. Detailed operational plans compared with actual results of organisation regularly, report any variance, and
take corrective actions. Management control is the process by which managers ensure that resources are
obtained and used effectively and efficiently in the accomplishment of the organisation’s objectives.
● Effectively means that resources are used to achieve the organisation’s objectives.
● Efficiently means that the optimum (best possible) output is produced from the resources used.
2. Review long‐term plan to assess whether the objective plan is modified if required to avoid serious damage
in future.
Note: Planning is required for good control and without control, planning is useless.
Page 197
Management Information
c)
MA/FMA Study Notes
Decision Making
Decision‐making involves a choice between different alternatives. Management accountant provide good
information for each alternative so that managers take an informed decision. Decisions are taken at planning &
control stages.
Generally planning and control cycle has following steps
Identify goals and objectives
Identify alternative
solutions/opportunities which might
contribute towards achieving the
objective
Collect and analyze data relevant to
each opportunity and choose the best
option
Plan and Implement the decision and
monitor the performance
Obtain data about actual results
Compare actual results with plan and
control action should be taken if there
are any variances
LEVELS OF MANAGEMENT AND INFORMATION REQUIREMENTS AT EACH LEVEL
There are three levels of management
Strategic level
Strategic or high level management is involved in strategic planning, control and decision making. At this level of
management, senior managers decide or change the goals & objectives of the organisation. Senior managers take
decisions about profitability of different segments of business, future market changes, capital requirements, and
fixed assets requirement. Chief executive officers and board of directors are example of this level.
Strategic information has the following features:
(i)
It deals with the whole organisation.
(ii)
It is derived from both internal & external source.
Page 198
Management Information
(iii)
(iv)
(v)
(vi)
(vii)
MA/FMA Study Notes
It is relevant to long term.
It is summarized at a high level.
It is both quantitative & qualitative.
It is often prepared on an ‘ad hoc’ basis
It is not completely certain because future is unpredictable.
Tactical level
This is the middle level management. This level of management is involved in making departmental decisions
including decision making, planning and control about resources. Departmental managers are best example of this
level of management. They have to decide how much resources should be required and how efficiently they are
being employed. Decisions like productivity measures, Efficient & Effective use of organisation’s resources,
variance report, department’s profit, raw material purchase, labour scheduling.
Tactical information has the following features:
(i)
It deals with a function or department.
(ii)
It is mostly derived primarily from internal sources.
(iii)
It is prepared regularly and routinely.
(iv)
It is relevant to short and medium term.
(v)
It is summarized at a lower level as compare to strategic information.
(vi)
It is based on quantitative measures.
Operational level
They are the front line managers such as foreman or head clerks. They ensure that specific tasks are carried out
effectively & efficiently as planned. Operational management is involved in day to day decision making, planning
and control for example can be supervisor’s decision etc. Direct labor is usually the operational level management.
Operational information has the following features:
(i)
It is task specific.
(ii)
It is derived almost entirely from internal sources.
(iii)
It relates to the immediate terms (current).
(iv)
It is highly detailed about operations.
(v)
It is prepared very frequently like weekly or daily.
(vi)
It is largely quantitative.
FEATURES OF MANAGEMENT INFORMATION
Reliable:
It should present a correct picture of what is happening. The source of the information should be reliable. For
example if questionnaires in a survey filled out by same persons, it will not present the correct picture of the market
demand
Timely:
It should be in time for the decisions to be made. Information should be provided when required.
Relevant:
It should be relevant according to the needs of the management. Mostly senior managers may require summaries.
Unnecessary information should not be provided to the relevant person.
Page 199
Management Information
MA/FMA Study Notes
Complete:
It should have all required information for the job. Information that is correct but excludes something important is
likely to be of little value.
Accurate:
No unnecessary detail but should be accurate. In certain cases, figures may be rounded off to make reports easier.
There should be no mistake. Management information is not absolutely accurate
Clear:
Information should be in understandable form, communicated properly, clearly presented and use right
communication channel. Avoid accounting jargons.
Timeliness:
Time period covered by reports may vary for example monthly, weekly or daily
Cost effectiveness
The costs of providing the information must not outweigh the 'value added' benefits derived from its use.
Costs of information
● Cost of collecting data
● Cost of processing data
● Cost of storing data
● Opportunity cost of management time
Benefits of information
● Helps in decision making
● Values arising from good decision
● Reduces unnecessary cost
● Adoption of better marketing strategies
SOURCES OF DATA AND INFORMATION
Data and information come from many sources ‐ both internal (inside the business) and external.
Business data and information comes from multiple sources. The challenge for a business is to capture and use
information that is relevant and reliable.
The main sources are:
Internal Information
Accounting records are a prime source of internal information. They detail the transactions of the business in the
past ‐ which may be used as the basis for planning for the future (e.g. preparing a financial budget or forecast).
The accounting records are primarily used to record what happens to the financial resources of a business. For
example, how cash is obtained and spent; what assets are acquired; what profits or losses are made on the activities
of the business.
Page 200
Management Information
MA/FMA Study Notes
However, accounting records can provide much more than financial information. For example, details of the
products manufactured and delivered from a factory can provide useful information about whether quality
standards are being met. Data analysed from customer sales invoices provides a profile of what and to whom
products are being sold.
A lot of internal information is connected to accounting systems ‐ but is not directly part of them. For example:
‐
Records of the people employed by the business (personal details; what they get paid; skills and experience;
training records)
‐
Data on the costs associated with business processes (e.g. costing for contracts entered into by the business)
‐
Data from the production department (e.g. number of machines; capacity; repair record)
‐
Data from activities in direct contact with the customer (e.g. analysis of calls received and missed in a call
centre)
A lot of internal information is also provided informally. For example, regular meetings of staff and management will
result in the communication of relevant information.
External Information
As the term implies, this is information that is obtained from outside the business.
There are several categories of external information:
Information relating to way a business should undertake its activities
E.g. businesses need to keep records so that they can collect taxes on behalf of the government. So a business needs
to obtain regular information about the taxation system (e.g. PAYE, VAT, and Corporation Tax) and what actions it
needs to take. Increasingly this kind of information (and the return forms a business needs to send) is provided in
digital format.
Similarly, a business needs to be aware of key legal areas (e.g. environmental legislation; health & safety regulation;
employment law). There is a whole publishing industry devoted to selling this kind of information to businesses.
Information about the markets in which a business operates
This kind of external information is critically important to a business. It is often referred to as "market" or
"competitive intelligence".
Most of the external information that a business needs can be obtained from marketing research.
Marketing research can help a business do one or more of the following:
1. Gain a more detailed understanding of consumers’ needs – marketing research can help firms to discover
consumers’ opinions on a huge range of issues, e.g., views on products’ prices, packaging, recent advertising
campaigns
2. Reduce the risk of product/business failure – there is no guarantee that any new idea will be a commercial
success, but accurate and up‐to‐date information on the market can help a business make informed decisions,
hopefully leading to products that consumers want in sufficient numbers to achieve commercial success.
3. Forecast future trends – marketing research can not only provide information regarding the current state of the
market but it can also be used to anticipate customer needs future customer needs. Firms can then make the
necessary adjustments to their product portfolios and levels of output in order to remain successful.
Page 201
Management Information
MA/FMA Study Notes
TYPES OF SOURCE OF INFORMATION
1. Journal
Journal articles are primary information resources. Journals are published on a regular basis. Each journal title
focuses on a specific area or discipline. They describe research ‐ the generation of new knowledge ‐ and focus
on very specific topics.
2. Newspapers
Newspapers are primary sources of information. They are an excellent source when looking for current and up‐
to‐date information.
3. Websites
Websites are useful sources of current information and for an overview on a topic. Check our evaluating
websites page to ensure the information you find is reliable.
4. Statistics
Statistics are primary information. They can be very useful for looking at patterns and trends.
5. Trade association
A trade association, also known as an industry trade group, business association or sector association, is an
organisation founded and funded by businesses that operate in a specific industry. An industry trade association
participates in public relations activities such as advertising, education, political donations, lobbying and publishing,
but its main focus is collaboration between companies, or standardisation.
Government Authorities:
● HMRC
● Parliament
MANAGEMENT ACCOUNTING VERSUS FINANCIAL ACCOUNTING
Management Accounting
Purpose: to provide management with information to help them manage resources efficiently and make sensible
decisions.
There are no specific rules for management accounting. Depends on needs of organisations
Financial Accounting
Purpose: to provide accurate financial information for the company accounts which will be used by the senior
management (Balance Sheet and Profit and Loss) and external parties (e.g. investors)
Data used to prepare management accounts & financial accounts are same but analysed differently.
Financial accounts
● External user
● Prepare after a defined period mostly yearly
●
●
●
●
Companies have legal requirement to prepare it.
Have pre‐determined formats. Format is defined by
IAS, IFRS, and Law.
It is about whole organisation
It is mostly financial information
Page 202
Management accounts
● Internal user
● It can be prepared daily, weekly, monthly or
periodically.
● No legal requirement to prepare it.
● No specific format. Format is decided by
management.
● It is about activities of organisation
● It includes financial & non‐financial information
Management Information
●
MA/FMA Study Notes
●
Historical and current picture of business
Historical, current & future planning of
business.
Help in planning, control & decision making
●
ROLE OF MANAGEMENT ACCOUNTANT
The role of a management accountant assists the managers to manage by
 Provide information for planning;
 Supplying performance reports for controlling;
 Tailoring the accounting system to the organisational structure and thus reinforcing the objectives of the
organisational framework;
 Preparing the budgets that assist in providing the motivation to employees.
Limitations of Management Accounting Information
1. If any feature of management information is not present then this will be limit the usefulness of information.
2. It does not need to be accurate down to every penny/paisa. Management accounting information is not
absolutely accurate it is just accurate.
3. Decisions taken will depend on how frequently the reports are produced. For example of a report comparing
actual with budgeted is produced every month, information regarding any problems that are found will be useful
in the next month not in the current month.
4. If managers do not communicate with the cost and management accountant, the information provided by the
accountant might not be the type or of the format that the manager requires.
5. When comparisons are being made between different time periods, care has to be taken that price changes are
taken into consideration.
6. Even if the information provided by the cost and management accountant is timely and reliable, if it is
incomplete, it will not be of any use.
7. Most managers are not accountants so the cost accountant should ensure that the information that he/she is
giving to the manager doesn’t contain any accountancy jargon and explains matters in non‐accountancy terms
wherever possible so that it is understood by the manager
8. If the non‐financial factors are not considered, a correct picture might not be obtained.
Sampling
Purpose
To gain as much information as possible about the population by observing only a small proportion of the population
such as observing a sample.
Population
The term population is used to mean all the items under consideration in a particular enquiry.
Sample
Groups of items are drawn from the population.
Census
In situation where whole population is examined is called census. This situation is rare.
Page 203
Management Information
MA/FMA Study Notes
Advantages of sample
● Time saving
● More questions can be asked to a sample.
Disadvantages of census
● More cost than benefits.
● Out of date when observation complete.
● May be population destroyed in the process like in testing (in order to check the lifetime of an electric light bulb
it is necessary to leave bulb burning until it breaks)
Sample frame
● A sampling frame is a numbered list of all items in a population.
● Once a list of population is prepared, it is easier to choose a sample from it.
● Sometimes it is not possible to draw a sampling frame because population size is very large like a list of all
persons in a country.
Characteristics of sample frame:
Complete
All the members of a population should be included in it.
Accuracy
Information about population should be correct.
Adequacy
It should cover entire population.
Up to date
It should always be up‐to‐dated
Convenience
It is easily available for use.
No duplication
Each item in population should include once.
Choice of sample
One of the most important requirements of sample data is that they should be complete and represent all the
population in other words covers all the information.
Types of sampling
There are two methods of sampling
● Probability sampling
● Non‐ probability sampling
Page 204
Management Information
MA/FMA Study Notes
Probability Sampling
Probability sampling is a method in which there is a known chance of each member of the population appearing in
the sample.
It includes:
● Random sampling
● Stratified random sampling
● Systematic sampling
● Multistage sampling
● Cluster sampling
Random Sampling
Random sampling is a sample selected in such a way that every item in the population has an equal chance of being
included in a sample. Randomly choose sample. If random sampling is used, a sampling frame has to be constructed.
Advantages
● It is free from bias (equal choice of being selected)
Disadvantages
● Might be expensive
● An adequate sampling frame might not exist.
● Can produce an unrepresentative sample
● It might be difficult to obtain the data if the selected item covers a wide area
● It might be costly to obtain the data if the selected item covers a wide area
Stratified random sampling
Stratified random sampling is a method of sampling which involves dividing the population into groups (strata) like
males and females. Random sampling is then taken from each group.
Example 1
The number of cost and management accountant in each type of work in a particular country is as follows:
Partnerships
500
Public companies
500
Private companies
700
Public practices
800
2,500
If a sample of 20 were required, the sample would be made up as follows.
Sample
Partnerships
500 x 20 =
4
2,500
Public companies
500 x 20 =
4
2,500
Private companies
700 x 20 =
6
2,500
Public practices
800 x 20 =
6
2,500
20
Page 205
Management Information
MA/FMA Study Notes
Advantages
● Representative sample selected (every important category will have an elements in the final sample)
● The structure of the sample will reflect that of the population
● Influence can be made about each group
Disadvantages
● Requires prior knowledge of each item in the population
Systematic sampling
Systematic sampling is a sampling method, which works by selecting every nth item after random start like 23rd, 26th.
It is also called “Quasi Random” because it is not truly random.
Advantages
● It is easy to use
● It is cheap
Disadvantages
● It is possible that a biased sample might be chosen if there is a regular pattern to the population which coincides
with the sampling method like population arrange in this pattern A B C D E A B C D E A B C D …If every fifth item
is selected in a sample then there is a sample of Es only.
● It is not completely random since some samples have a zero chance of being selected
Multistage Sampling
Multistage sampling is a probability sampling method, which involves dividing the population into a number of
subpopulations and then selecting a small sample of this sub‐population at random.
Each subpopulation is then divided further, and then a small sample is again selected at random. This process is
repeated as many times as it is necessary.
Used where an entire country is a population. In this kind of sampling country divided into number of areas, areas
sub‐divided into small units and then choose a random sample.
Advantages
● Fewer investigators are needed
● It is not costly to obtain a sample
● Does not require a sample frame of the entire population
Disadvantages
● There is possibility of bias if only small number of region selected
● The methods not currently random once the final sampling areas have been selected the rest of the population
cannot be in the sample.
● If the population is heterogeneous, the area chosen should reflect the full range of the diversity
Page 206
Management Information
MA/FMA Study Notes
Cluster sampling
Cluster sampling is a non‐random sampling method that involves selecting one definable subsection of the
population as the sample, that subsection take to be representative of the population in question. For example
Cluster sample of all children at school in one country
Advantages
● It is good alternative to multistage sampling if a satisfactory sampling frame does not exist.
● It is inexpensive to operate
Disadvantages
● The potential for considerable bias
Non‐probability sampling
Non‐probability sampling is a method in which the chance of each member of the population appearing in the
sample is not known. There is only one method of such type of sampling.
Quota sampling
Quota sampling is commonly used by market researchers and involves stratifying the population and restricting the
sample to a fixed number in each stratum
Advantages
● It is cheap and administratively easy
● A much larger sample can be studied
● No sampling frame is necessary
● Only possible approach in certain situation such as television audience research
● Quota sampling yields enough accurate information for many forms of commercial market research
Disadvantages
● The method can result certain biases
Presentation of information
1) Presentation of information in Report writing
● The most formal way of communication.
● A formal report needed where a comprehensive/detailed investigation has taken place
● Many organisations have standard set of regular reports in prescribed formats which make it easier for
employees to read and locate information.
● Use charts, tables and good report layouts to increase understanding.
Four stages approach to report writing
● Prepare
● Plan
● Write
● Review
Page 207
Management Information
MA/FMA Study Notes
Prepare
Identify whether it is a detailed usual report, Ad Hoc report (unusual), short memo, discussion notes. Identify
the language.
Brief explanations
Main relevant key terms should be given.
Plan
Plan the structure of the report how to present the answer. The format of report is determined.
Write
The language used in a report should be clear and spelling should be correct. Use clear wordings and language.
Review
Read again to ensure report is clear and complete.
Structure of a report
The elements of a formal report are as follows:
● Title (subject of the report)
● Terms of reference ( clarify what has been requested)
● Introduction (who the report is from and to how the information was obtained)
● Main body (details about the issue discussed)
● Conclusions (summaries or findings)
● Recommendations (writer’s suggestions)
● Signature (of writer)
● Executive summary (summary of a detailed report to save manager’s time, it is not more than
1‐page)
Some tips
● avoid excessive long sentences
● avoid difficult words
● follow the professional manner
● if abbreviations are used explain them when they are first used in the report
● write correct English
2) Presentation of information in Tables
Tabulation is a process of presenting numerical data or information in the form of table. Tables consist of Rows
and Columns. Table is capable of showing only two variables, one shown in the columns and one in the rows.
Each column should have proper headings. It is two‐dimensional
Page 208
Management Information
MA/FMA Study Notes
Table requirements
The following points should be considered while presenting information in tables.
● Tables have proper title.
● All columns have clearly labeled.
● Make clear subtotals.
● Information presented can easy to read.
Example 1
Jordon Products plc has two departments, X and Y. The total wage bill in 20X0 was $513,000, of which $218,000 was
for department X and the rest for department Y.
The corresponding figures for 20X1 were $537,000 and $224,000. The number employed in department X was 30 in
20X0 and decreased by 5 for the next year. The number employed in department B was 42 in 20X0 and increased by
1 for the year 20X1.
Required
Tabulate this data to bring out the changes over the two‐year period for each department and the company as a
whole.
Solution
YEAR
20X0
20X1
Wages bill
Number employed
Wages bill
Number employed
DEPARTMENT X
$218,000
30
$224,000
25
DEPARTMENT Y
$295,000
42
$313,000
43
TOTAL
$513,000
72
$537,000
68
3) Presentation of information in Bar charts
A bar chart is a method of presenting information in which quantities are shown in the form of bars on the chart,
length of the bars being proportional to the quantities.
It is a most commonly used method of presenting information in a visual form. There are three main types of
bar charts.
a) Simple bar charts
A simple bar chart is a chart consisting of one or more bars, in which the length of each bar indicates the
magnitude of the corresponding information
Example 2
Year
1
2
3
4
5
6
Sales units
8,000
12,000
11,000
14,000
16,000
17,000
Page 209
Management Information
MA/FMA Study Notes
b) Component or percentage component bar charts
A component bar chart is a bar chart that gives a breakdown of each total into its component
Example 3
Year 7
Year 8
Year 9
units
units
Units
Region 1
10,000
12,000
17,000
Region 2
9,000
10,000
10,000
Region 3
5,000
6,000
7,000
Total
24,000
28,000
34,000
Page 210
Management Information
c)
MA/FMA Study Notes
Multiple bar charts
A multiple bar chart is a bar chart in which two or more separate bars are used to present sub‐divisions of
information.
Presentation of information in Line Graphs:
➢ Used to display a wide variety of information
➢ Used in commercial context
➢ Used for demonstrating trends
➢ Trends are the progress of events or fluctuations over time of variables such as profit, prices, sales, customer
complaints
➢ May also be used to compare the performance of various products, which are competing with each other
➢ May also be used for changes in share prices over time
Pie Charts
A pie chart is a circular chart in which the circle is divided into sectors. Each sector visually represents an item in a
data set to match the amount of the item as a percentage or fraction of the total data set.
Pie charts are useful to compare different parts of a whole amount. They are often used to present financial
information. E.g. A Company’s expenditure can be shown to be the sum of its parts including different expense
categories such as salaries, borrowing interest, taxation and general running costs (i.e. rent, electricity, heating etc).
Page 211
Management Information
MA/FMA Study Notes
RESPONSIBILITY ACCOUNTING
An accounting system under which responsibilities; like revenue and cost, are assigned to managers (responsible
persons);
Responsibility Centre
● A function or department of an organisation that is headed by a manager and the manager has direct
responsibility for its performance is known as a responsibility centre.
● Responsibility centres are usually divided into different categories. Here describes cost centre, revenue centre,
profit centre and investment centre.
1. Cost Centre
A cost centre is a production or service location, function, activity or item of equipment for which costs are
accumulated.
●
A unit of an organisation to which costs can be separately attributed
●
If a manager is responsible for costs attributable to his area of business, it means that the manager is
responsible for a cost centre.
●
Each cost centre will have a cost code and so all items of expenditure will be recorded according to
the correct cost code.
Costs in a Cost Centre
 Costs of one cost centre might be apportioned to other cost centres.
 The department, which received an apportionment of the shared costs, will have two kinds of costs.
1.
Directly attributable (i.e. for which the cost manager is responsible)
Shared costs (i.e. for which another cost centre is directly accountable)
2.
 The control system should trace shared costs back to the cost centres from which costs have been
apportioned so that there managers can be made accountable for the cost incurred.
 Information about costs may be collected as total actual costs, total budgeted costs and total cost
variances
 Costs may also be analysed in terms of ratios such as
 Cost per unit produced (actual and budgeted)
 Hours per unit produced (actual and budgeted)
 Selling costs per $ of sales. (actual and budgeted)
Page 212
Management Information

2.
MA/FMA Study Notes
Transportation costs per tonne/kilometre (actual and budgeted)
Revenue Centre
● A centre, which raises revenue and has no responsibility for costs.
● Manager of revenue centre is accountable only for revenues.
● For example department which obtains grants and donations for a charity, sales department
3. Profit Centre
 A profit centre is a part of a business accountable for both cost and revenue.
 If a manager is responsible for costs as well as income attributable to his area of business, it means that the
manager is responsible for a profit centre
 A profit centre manager is likely to be a senior person in the organisation who influences over both revenue
and cost.
 A profit centre is likely to cover a large area of operations
 A profit centre might be an entire division within the organisation or there may be a separate profit centre
for each product, brand, service etc.
 There are likely to be several cost centres within a profit centre.
4.
Investment Centre
 It refers to a profit centre with an additional responsibility for capital investment.
 Manager of investment centre has the responsibility for profit in relation to capital invested in his area.
 Mostly used in public sector organisations where the organisation is required to make a particular level
of profit in relation to their fixed assets (return on capital employed)
 Several profit centres might share the same capital items e.g. same building, stores etc. so an
investment centre is likely to include several profit centres.
Cost Codes:
After classifying cost, a coding system can be applied to make it easier to manage the cost data. It can be manual or
computerised. Each cost is identified through its unique code.
Some possible characteristics on which costs are separated are:
● Nature of cost ( material , labour, overheads)
It is known as subjective classification.
● Type of cost (direct and indirect)
● Cost centre or cost units to which cost should be related (known as subjective classification)
Features of good coding system
An effective and efficient coding system should include the following features:
● Code must be easy to use and well communicated.
● Unique code
● Coding system must allow for expansion
● Codes should be flexible
● It should be a comprehensive system ( suitable code )
● Codes should be time‐saving
Page 213
Management Information
●
●
●
●
●
●
MA/FMA Study Notes
Codes should be error free
Regularly updated codes
Code numbers should be issued from a single central point ( standardisation)
Dots, dashes. Colon etc should be avoided in codes
They should be uniform ( length or structure)
Not confusing
TYPES OF CODES
Composite codes
In costing, the first three digits in the composite code 211392 might indicate the nature of the expenditure (
subjective classification ) and the last three might indicate the cost centre of cost unit to be charged ( objective
classification).
So the digit 211 might refer to
2 materials
1 raw material
1 timber
This would indicate to anyone familiar with the coding system that the expenditure was incurred on timber.
The digit 392 might refer to:
3 direct cost
9 factory alpha
2 assembly department
This would indicate the expenditure was to be charged as a direct material cost to the assembly in factory alpha.
Other types of code
Here are some examples of codes.
a) Sequence (or progressive) codes
Numbers are given to items in ordinary numerical sequence, so that there is no obvious connection between an
item and its code.
For example:
000042
000043
000044
4cm nails
Office staplers
Hand wrench
b) Group classification codes
These are an improvement on simple sequence codes, in that a digit (often the first one) indicates the
classification of an item. For example:
4NNNNN
Nails
5NNNNN
Screws
NOTE: ‘N’ stands for another digit; NNNNN indicates there are five further digits in the code.
Page 214
Management Information
c)
MA/FMA Study Notes
Faceted codes
These are refinement of group classification codes, in that each digit of the code gives information about an
item. For example:
(i)
The first digit
1
2
3
(ii)
The second digit
1
2
3
(iii)
The third digit
1
2
3
Nails
Screws
Bolts
Etc...
Steel
Brass
Copper
Etc...
50mm
60mm
75mm
Etc...
A 60mm steel screw would have a code of 212.
d) Significant digit codes
These incorporate some digit(s) which is (are) part of the description of the item being coded. For example:
Screws
5060
60mm screws
50mm screws
5070
75mm screws
e) Hierarchical codes
This is a type of faceted code where each digit represents a classification, and each digit further to the right
represents a smaller subset than those to the left. For example:
3 = screws
32 = round headed screws
31 = flat headed screws
322 = steel (round headed ) screws and so on
A coding system does not have to be structured entirely on any one of the above systems. It can mix the various
features according to the items which need to be coded.
Example:
Formulate a coding system suitable for computer application for the cost accounts of a small manufacturing
company.
Page 215
Management Information
MA/FMA Study Notes
Solution
A suggested computer based four‐digit numerical coding system is set our below.
Basic structure
Code number
Second division
3000‐3999
Third division
Fourth division
100‐999
01‐39
allocation
This range provides for cost accounts and is divided into
four main departmental sections with ten cost centre
subsection in each department, allowing for a maximum
of 99 accounts of each cost centre.
Department 1
Department 2
Department 3
Department 4
Facility for ten cost centres in each department
Breakdown of costs in each cost centre
Direct costs
Variable costs
Fixed costs
Spare capacity
Codes 5000‐9999 could be used for the organisation’s financial accounts.
An illustration of the coding of steel screws might be as follows.
Department 2
Cost centre
Consumable stores
1
2109
2
2209
3
2309
4
2409
The four‐digit codes above indicate the following.
● The first‐digit, 2, refers to the department
● The second digit, 1, 2, 3 or 4, refers to the cost centre which incurred the cost
● The last two digits, 09, refers to material costs, steel screws’
Advantages of coding system
a) A code is usually briefer than a description, thereby saving clerical time in a manual system and storage in a
computerised system
b) A code is more precise than a description and therefore reduces a ambiguity
c) Coding facilitates data processing
Page 216
Spreadsheet
MA/FMA Study Notes
SPREADSHEET
❖ This Chapter Covers:
✓
INTRODUCTION
✓
WHY USE SPREADSHEETS?
✓
CELL CONTENTS
✓
FORMULA BAR
✓
WORKING WITH SPREADSHEETS
✓
KEYBOARD SHORTCUTS AND TOOLBAR BUTTONS
✓
CHARTS AND GRAPHS
✓
SPREADSHEET FORMAT AND APPEARANCE
✓
BUDGETING
Page 217
Spreadsheet
MA/FMA Study Notes
INTRODUCTION
A spreadsheet is a computer application that simulates a paper worksheet.
A spreadsheet is divided into rows (horizontal) and columns (vertical). The rows are numbered 1, 2,3… etc. and the
columns lettered A, B, C… etc.. Each individual area representing the intersection of a row and a column is called a
‘cell’. A cell address consists of its row and column reference. For example, in the spreadsheet below the word
‘Packet 2’ is in cell C2. The cell that the cursor is currently in or over is known as the ‘active cell’.
The main examples of spreadsheet packages are Lotus 1 2 3 and Microsoft Excel. We will be referring to Microsoft
Excel, as this is the most widely‐used spreadsheet. A simple Microsoft Excel spreadsheet, containing budgeted
figures and average of all for different product brands for the year, is shown below.
WHY USE SPREADSHEETS?
Spreadsheets provide a tool for calculating, analysing and manipulating numerical data. Spreadsheets make the
calculation and processing of data easier and quicker. For example, the spreadsheet above has been setup to
calculate average automatically. If you changed your estimate of sales in the cell with heading ‘Packet 1’ for colour
‘green’ from 10 to 20, when you input this figure in cell B2 the average in F2 would change accordingly.
Spreadsheets can be used for a wide range of tasks. Some common applications of spreadsheet are:
● Management accounts
● Cash flow analysis and forecasting
● Reconciliation
● Revenue analysis & comparisons
● Cost analysis and comparisons
● Budgets and forecasts
Page 218
Spreadsheet
MA/FMA Study Notes
CELL CONTENTS
The contents of any cell can be one of the following:
a) Text: A text cell contains words. Numbers that do not represent numeric values for calculation purposes (e.g. a
Part Number) may be entered in a way that tells Excel to treat the cell contents as text. To do this, enter an
apostrophe before the number e.g. ‘99.
b) Values: A value is a digit that can be used in a calculation.
c) Formulae: A formula refers to other cells in the spreadsheet, and some sort of computation with them. For
example, if a cell, D10 contains the formula=A10 ‐ B10 + C10, cell D10 will display the result of the calculation
subtracting the contents of cell B10 from the contents of cell A10 and adding up contents of cell C10. In Excel, a
formula always begins with an equals sign; =
FORMULA BAR
The following illustration shows the formula bar. (If the formula bar is not visible, choose View, Formula bar from
Excel main menu.)
The formula bar allows you to see and edit the contents of the active cell. The bar also shows the cell address of the
active cell (A3 in the example above).
Examples of spreadsheet formulae
Formulas in Microsoft Excel follow a specific syntax.
All of Excel formulae start with the equals sign = followed by the desired function that need to be calculated and the
calculation operators; +,*,/ and‐. Formulae can be used to perform a variety of calculations. Here as some examples.
a) =D8*5. This formula multiples the value in D8 by 5. The result will appear in the cell holding the formula.
b) =D7*B25. This multiplies the value in D7 by the value in B125.
c) =B11/E8. This divides the value in B11 by the value in E8. (*means multiply and / means divide by.)
d) =C5*B11‐D1. This multiplies the value in C5 by that B11 and then subtracts the value in D1 from the result. Note
that generally Excel will perform multiplication and division before addition or subtraction. If in any doubt, use
brackets (parentheses): = (C5*B11)‐D1.
e) =C7*117.5%. This adds 17.5% to the value in C7. It could be used to calculate a price including 17.5% sales tax.
f) = (C9+C10+C10)/3. Note that the brackets mean Excel perform the addition first. Without the brackets Excel
would first divide the value in C10 by 3 and then add the result to the total of the values in C9 and C10.
g) =5^2 gives you 2 to the power of 5, in other words 52. Likewise = 5^3 gives you 5 cubed and so on.
h) =9^(1/2) gives you the square root of 9. Likewise 81^(1/3) gives you the cube root of 81 and so on.
Page 219
Spreadsheet
MA/FMA Study Notes
WORKING WITH SPREADSHEETS
Essential basic skills include how to move around within a spreadsheet, how to enter and edit data, how to fill cells,
how to insert and delete columns and rows and how to improve the basic layout and appearance of a spreadsheet.
In this section we explain some basic spread sheeting skills. We give instructions for Microsoft Excel, the most widely
used package. Our examples should be valid with all versions of Excel released since 1997.
You should read this section while sitting at a computer and trying out the skills we describe ‘hands‐on’.
Moving about
The F5 key is useful for moving around within large spreadsheets. If you press the function key F5, a Go To dialogue
box will allow you to specify the cell address you would like to move to.
Also experiment by holding down Ctrl and pressing each of the direction arrow keys in turn to see where you end
up. Page up and page down keys are used to move up and down the sheet. Also try home and end and Ctrl + these
keys. Try Tab and Shift + Tab, too. These are all useful shortcuts for moving quickly from one place to another in a
large spreadsheet.
Editing cell content
Suppose in a spreadsheet cell E12 currently contains the value 333. If you wish to change the entry in cell E12 from
333 to 333456 there are four options‐as shown below.
(a)
Activate cell E12, type 333456 and press Enter.
To undo this and try the next option press Ctrl+Z: this will always undo what you have just done.
(b)
Double‐click in cell E12. The cell will keep its thick outline but you will now be able to see a vertical line
flashing in the cell. You can move this line by using the direction arrow keys or the Home and the End keys.
Move it to after 333 and then type 4556. Then press Enter. When you have tried this press Ctrl + Z to undo
it.
(c)
Click once before the number 333 in the formula bar. Again you will get the vertical line and you can type
in 456 after the 333. Then press Enter. Undo this before moving onto (d).
(d)
Press the function key F2. The vertical line cursor will be flashing in cell E12 at the end of the figures entered
there (after the 6). Press Home to get to a position after 333 and then type in 456 and press Enter, as before.
Deleting cell contents
You may delete the contents of a cell simply by making the cell the active cell and then pressing Delete. The contents
of the cell will disappear. You may also highlight a range of cells to delete and then delete the contents of all cells
within the range.
For example, enter any value in cell A1 and any value in cell A2. Move the cursor to cell A2. Now hold down the Shift
key (the one above the Ctrl key) and keeping it held down press the arrow. Cell A1 will stay white but cell A1 will go
black. What you have done here is selected the range A1 and A2. Now press the Delete key. The contents of cells A1
and A2 will be deleted.
Filling a range of cells
Start with a blank spreadsheet. Type the number 1 in cell A1 and the number 2 in cell A2. Now select cells A1 : A2,
this time by positioning the mouse pointer over cell A1, holding down the left mouse button and moving the pointer
down to cell A2. When cell A2 is highlighted release the mouse button.
Page 220
Spreadsheet
MA/FMA Study Notes
Now position the mouse pointer at the bottom right band corner of cell A2. When you have the mouse pointer in
the right place it will turn into a black cross.
Then, hold down the left mouse button again and move the pointer down to cell A10. You will see an outline
surrounding the cells you are trying to ‘fill’.
Release the mouse button when you have the pointer over cell A10. You will find that the software automatically
fills in the numbers 3 to 10 below 1 and 2.
Try the following variations of this technique.
a) Delete what you have just done and type in Jan in cell A1. See what happens if you select cell A1 and fill down
to cell A12: you get the months Feb, Mar, Apr and so on.
b) Type the number 5 in cell B1. Select B1 and fill down to cell B10. The cells should fill up with 5’s.
c) Type the number 2 in cell A1 and 4 in cell A2. Then select A1: A2 and fill down to cell A10. You get 2, 4, 6, 8, and
so on.
d) If you click on the bottom right hand corner of the cell using the right mouse button, drag down to a lower cell
and then release the button you should see a menu providing a variety of options for filling the cells.
Inserting columns and rows
Suppose we also want to add each row, for example cells A1 and B1. The logical place to do this would be cell C1,
but column C already contains data. We have three options that would enable us to place this total in column C.
a) Highlight cells C1 to C5 and position the mouse pointer on one of the edges. (It will change to an arrow shape).
Hold down the left mouse button and drag cells C1 to C5 into column D. There is now space in column C for our
next set of sums. Any formulae that need to be changed as a result of moving cells using this method should be
changed automatically‐but always check them.
b) The second option is to highlight cells C1 to C5 as before, position the mouse pointer anywhere within column
C and click on the right mouse button. A menu will appear offering you an option Insert… If you click on this you
will be asked where you want to shift the cells that are being moved. In this case you want to move them to the
right so choose this option and click on OK.
c) The third option is to insert a whole new column. You do this by clicking on the letter at the top of the column
(here C) to highlight the whole of it then proceeding as in (b). The new column will always be inserted to the left
of the one you highlight.
You can now display the sum of each of the rows in column C.
You can also insert a new row in similar way (or stretch rows).
(a) To insert one row, perhaps for headings, click on the row number to highlight it, click with the right mouse
button and choose insert. One row will be inserted above the one you highlighted. Try putting some headings
above the figures in columns A to C.
(b) To insert several rows click on the row number immediately below the point where you want the new rows to
appear and, holding down the left mouse button highlight the number of rows you wish to insert. Click on the
highlighted are with the right mouse button and choose Inset (or if you prefer, choose Insert, Rows from the
main menu).
Page 221
Spreadsheet
MA/FMA Study Notes
KEYBOARD SHORTCUTS AND TOOLBAR BUTTONS
Here are a few tips to improve the appearance of your spreadsheets and speed up your work. To do any of the
following to a cell or range of cells, first select the cell or cells and then:
a) Press Ctrl + B to make the cell contents bold.
b) Press Ctrl + I to make the cell contents Italic.
c) Press Ctrl + C to copy the contents of the cell.
d) Move the cursor and press Ctrl + V to paste the cell you just copied into the new active cell or cells.
There are also buttons in the Excel toolbar (shown below) that may be used to carry out these and other functions.
The best way to learn about these features is to use them‐enter some numbers and text into a spreadsheet and
experiment with keyboard and toolbar buttons.
CHARTS AND GRAPHS
Excel includes the facility to produce a range of charts and graphs. The chart wizard provides a tool to simplify the
process of chart construction.
Using Microsoft Excel, it is possible to display data held in a range of spreadsheet cells in a variety of charts or graphs.
The data in the spreadsheet could be used to generate a chart, such as those shown below.
Page 222
Spreadsheet
MA/FMA Study Notes
The Chart Wizard, which explains in moment, may also be used to generate a line graph. A line graph would normally
be used to track a trend over time. For example, the chart below graphs the Total Revenue would normally be used
to track a trend over time.
SPREADSHEET FORMAT AND APPEARANCE
Good presentation can help people understand the contents of a spreadsheet.
Titles and labels
A spreadsheet should be headed up with a title which clearly defines its purpose. Examples of titles are follows:
(a)
Income statement for the year ended 30 June 200X.
(b)
(i)
Area A: Sales forecast for the three months to 31 March 200X.
(ii)
Area B: Sales forecast for the three months to 31 March 200X.
(iii)
Combines sales forecast for the three months to 31 March 200X.
(c)
Salesman: Analysis of earnings and commission for the six months ended 30 June 200X.
Row and column headings (or labels) should clearly identify the contents of the row/column. Any assumptions made
that have influenced the spreadsheet contents should be clearly stated.
Formatting
There are wide ranges of options available under the Format menu. Some of these functions many also be accessed
through toolbar buttons. Formatting options include the ability to:
a) Add shading or borders to cells.
b) Use different sizes of text and different fonts.
Page 223
Spreadsheet
MA/FMA Study Notes
c)
Choose from a range of options for presenting values, for example to present a number as percentage (e.g. 0.08
as 8%), or with commas every third digit, or to a specified number of decimal places etc.
d) Invoices can be produced on a formatted spreadsheet.
Experiment with the various formatting options you.
Other issues: printing; controls; using spreadsheets with word processing software
Backing up is a key security measure. Cell protection and passwords can also be used to prevent unauthorised access.
Printing spreadsheets
The Print options for your spreadsheet may be accessed by selecting File and then Page Setup. The various Tabs
contain a range of options. You specify the area of the spreadsheet to be printed in the Print area box on the Sheet
tab. Other options include the ability to repeat headings on all pages and the option to print gridlines if required
(normally they wouldn’t be!)
Experiment with these options including the options available under Header/Footer.
Page 224
Spreadsheet
MA/FMA Study Notes
Controls
There are facilities available in spreadsheet packages which can be used as controls‐to prevent unauthorised or
accidental amendment or deletion of all or part of a spreadsheet.
a) Saving and back‐up. When working on a spreadsheet, save your file regularly, as often as every ten minutes.
This will prevent too much work being lost in the advent of a system crash. Spreadsheet files should be included
in standard backup procedures.
b) Cell protection. This prevents the user from inadvertently changing or erasing cells that should not be changed.
Look up how to protect cells using Excel’s Help facility. (Select Help from the main menu within Excel, then select
Contents and Index, click on the Find tab and enter the words ‘cell protection’.)
c) Passwords. You can set a password for any spreadsheet that you create. In Excel, simply click on Tools, then on
Protection, then on Protect Sheet or Protect Workbook, as appropriate.
Using spreadsheets with word processing software
There may be situation where you wish to incorporate the contents of all or part of a spreadsheet into a word
processed report. There are a number of options available to achieve this.
a) The simplest, but least professional option is to print out the spreadsheet and interleave the page or pages at
the appropriate point in your word processed document.
b) A neater option if you are just including a small table is to select and copy the relevant cells from the spreadsheet
to the computer’s clipboard by selecting the cells and choosing Edit, Copy. Then switch to the word processing
documents, and paste them in at the appropriate point.
c) Office packages, such as Microsoft Office allow you to easily use spreadsheets and word processing files
together.
For example, a new, blank spreadsheet can be ‘embedded’ in a document by selecting Insert, Object then, from
within the Create New tab, selecting Microsoft Excel worksheet. The spreadsheet is then available to be worked
upon, allowing the easy manipulation of numbers using all the facilities of the spreadsheet package. Clicking
outside the spreadsheet will result in the spreadsheet being inserted in the document. The contents of an
existing spreadsheet may be inserted into a Word documents by choosing Insert, Object and then activating the
Create from File tab. Then click the Browse button and locate the spreadsheet file. Highlight the file, then click
Page 225
Spreadsheet
MA/FMA Study Notes
Insert, and then OK. You may then need to move and resize the object, by dragging its borders, to fit your
document.
Advantages and disadvantages of spreadsheet software
Advantages of spreadsheets
● Excel is easy to learn and to use
● Spreadsheets make the calculation and manipulation of data easier and quicker
● They enable the analysis, reporting and sharing of financial information
● They enable ‘what‐if’ analysis to be performed very quickly
Disadvantages of spreadsheets
● A spreadsheet is only as good as its original design, garbage in = garbage out!
● Formulae are hidden from sight so the underlying logic of a set of calculations may not be obvious
● A spreadsheet presentation may make reports infallible
● Research shows that a high proportion of large models contain critical errors
● A database may be more suitable to use with large volumes of data
Uses of spreadsheet software
Spreadsheets can be used in a variety of accounting contexts. You should practice using spreadsheets; hands‐on
experience is the key to spreadsheet proficiency.
Management accountants will use spreadsheet software in activities such as budgeting, forecasting, reporting
performance and variance analysis.
BUDGETING
Spreadsheet packages for budgeting have a number of advantages.
(a)
Spreadsheet packages have a facility to perform ‘what if’ calculations at great speed. For example, the
consequences throughout the organisation of sales growth per year of nil, 5%, 8% and 10.50% and so on
can be calculated very quickly.
(b)
Preparing budgets may be needed to go through several drafts. If one or two figures are changed, the
computer will automatically make all the computational changes to the other figures.
(c)
A spreadsheet model will ensure that the preparation of the individual budgets is co‐ordinated. Data and
information from the production budget, for example, will be automatically fed through to the material
usage budget (as material usage will depend on production levels).
These advantages of spreadsheets make them ideal for taking over the manipulation of numbers, leaving staff to get
involved in the real planning process.
Page 226
Summarizing & Analyzing Data
MA/FMA Study Notes
SUMMARIZING AND ANALYZING DATA
❖ This Chapter Covers:
✓
INTRODUCTION
✓
UNGROUPED DATA – MEAN, MODE & MEDIAN
✓
GROUPED DATA – MEAN
✓
MEASURES OF DISPERSION – VARIATION & DEVIATION
✓
COEFFICIENT OF VARIATION
✓
EXPECTED VALUE & DECISION MAKING
✓
NORMAL DISTRIBUTION GRAPH & TABLE
✓
INTERPRETATION OF NORMAL DISTRIBUTION
Page 227
Summarizing & Analyzing Data
MA/FMA Study Notes
INTRODUCTION
Data has been and will be an important part for organisations to make their decisions. Since the customers are
getting more aware about their purchase decisions, it is extremely important for businesses to make use of data
available and operate accordingly to stay competitive in the current economic environment.
Statistics is the branch of Mathematics which deals with the calculation, organisation and interpreting of data, which
is numerical.
The Data that can be worked upon can be of two types essentially:
i. Ungrouped Data
ii. Grouped Data
UNGROUPED DATA
Ungrouped Data can be defined as data which is not in a certain sequence neither grouped nor classified into smaller
sub groups. Whereas Grouped Data can be seen as data which is not entirely pure rather some sort of classification
has been done with it. However either Grouped or Ungrouped data is still raw facts and figures, and if they are
converted into being useful for the user then it will no longer be data rather information.
Ungrouped Data can be converted into grouped data by classifying it and by analysing the frequencies within it so
that it can be rearranged accordingly. Following are some methods which are applied over ungrouped data:
Mean of Ungrouped Data
Mean simply is the arithmetic average of the whole population of data or average figure of the data sets which is
representative of the entire data.
The formula calculate mean = Sum of Observations / Total Number of Observations
If we suppose ‘n’ as the number of observations and 𝑥 1 ,𝑥 2 , 𝑥 3 … as the observations.
𝑥 1 + 𝑥 2 + 𝑥 3 ….+ 𝑥 𝑛
Then the formula would be =
Mean
(𝑥)=
(
𝛴𝑥
𝑛
)
𝑛
Example 1
Consider the following data:
22, 34, 56, 12, 18, 42, 50, 31
Sum of All observations (𝛴𝑥) = 22 + 34 + 56 + 12 + 18 + 42 + 50 + 31 = 265
Number of observations (n) = 8
Page 228
Summarizing & Analyzing Data
Mean
=
265
8
MA/FMA Study Notes
= 33.125
Median of Ungrouped Data
Median of any population of data / data set is the mid value. Simply it is the value which comes right in the middle
of the ungrouped data. It is found out by arranging the whole data set into ascending order first and then dividing it
into equal parts & selecting the one which comes in the middle.
Median = Sum of Observations / Total Number of Observations
n = Total number of Observations
This can be calculated as:
i) When n = odd
Median =
𝑛 + 1 𝑡ℎ
)
2
(
ii) When n = even
Median
=
𝑛
2
𝑛
2
( )𝑡ℎ 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛 + ( +1)𝑡ℎ 𝑜𝑏𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛
2
Example 2
Calculate Median of the two sets of Data
i)
N = odd
Data: 28, 22, 34, 56, 12, 18, 42, 50, 31
Arrange Data: 12, 18, 22, 28, 31, 34, 42, 50, 56
𝑛+1
9+1
2
2
Median
=(
ii)
N = even
)𝑡ℎ = (
) = 5𝑡ℎ = 31
Data: 22, 34, 56, 12, 18, 42, 50, 31
Page 229
Summarizing & Analyzing Data
Median =
MA/FMA Study Notes
𝑛
𝑛
8
8
12 + 18
2
2
2
2
2
( )𝑡ℎ + ( + 1)𝑡ℎ = ( )𝑡ℎ + ( + 1)𝑡ℎ =
= 15
Mode of Ungrouped Data
Mode can easily be defined as the value which occurs most frequently in the population of data / data set. Simply
put it is the most frequently occurring value in the entire data. It is denoted as Z.
Mode = Value with Highest Frequency
To find Mode in data set one has to give a count of frequency of every value and choose the one with the highest
count.
Example 3
Consider the following data:
22, 34, 56, 12, 12, 18, 42, 12, 50, 31, 42, 18
Observation (x)
18
22
12
31
34
42
50
56
Frequency (f)
2
1
3
1
1
2
1
1
Mode = 12 (since it has the highest frequency of 3)
Mode of Grouped Data
Grouped Data can be defined as data which can still be called raw but they have been classified in the form of
values and their frequencies are defined in the form of a table, which is also known as the frequency distribution
table.
Example 4
Score Frequency in an over for a 20 over match (120 balls) of Cricket
Score
Frequency
0
50
1
40
2
20
3
0
4
6
5
0
6
4
Page 230
Summarizing & Analyzing Data
MA/FMA Study Notes
Mode = 0 (since it has the highest frequency of 50)
Mean of Grouped Data
Mean is the average of the entire population / data set and in the case of grouped data it can be calculated in the
following way:
i) Direct method
x = observation
n = number of observations
f = frequency of value
Mean =
𝑥 1 𝑓1 + 𝑥 2 𝑓2 + 𝑥 3 𝑓3 ….+ 𝑥 𝑛 𝑓𝑛
(
(𝑓1 + 𝑓 2 + 𝑓3 ...+ 𝑓𝑛 )
)
OR
Mean
𝛴𝑓𝑥
=
𝛴𝑓
Mean = (Sum of the product of observations & frequencies) / (Sum of the frequencies)
Example 5
Consider the following grouped data:
Score (x)
Frequency (f)
Product of x and f
0
20
0 x 20 = 0
1
40
1 x 40 = 40
2
20
2 x 20 = 40
3
0
3x0=0
4
36
4 x 36 = 144
5
0
5x0=0
6
4
6 x 4 = 24
Total
120
248
Mean =
𝛴𝑓𝑥
𝛴𝑓
=
248
120
= 2.067
This means that the average score during the 20 overs match was approximately 2 runs per ball in a cricket match.
Page 231
Summarizing & Analyzing Data
MA/FMA Study Notes
Measures of Dispersion
In Statistics when analysing data sets it is important to understand more than just the values of central tendency.
Along with this it is equally important to see how well the data is spread and just looking at the mean of a dataset is
not sufficient for analysis purposes as it is possible that the mean of two datasets are equal but the data spread is
different.
Spread or Dispersion can be measured in a variety of ways as follows:
a. Range
b. Variance
c. Standard Deviation
Range
This is the simplest method to calculate the spread of any given data. It is the difference of the highest value with
the lowest value in the dataset.
Example 6
Ungrouped Data
Consider the data: 22, 45, 44, 25, 65, 80, 46, 59, 35, 29
Maximum Value = 80
Minimum Value = 22
Range
= 80 - 22
= 58
Grouped Data
Observation
28
35
66
68
80
45
Frequency
2
4
1
3
2
1
Maximum Value = 80
Minimum Value = 28
Range
= 80 - 28
= 52
Page 232
Summarizing & Analyzing Data
MA/FMA Study Notes
Variance
When any dataset is given it is essential before considering the data to understand the variability of the values. Since
mean is a single figure it must be understood how much difference in there in the mean and the other values existing
in the population data.
Ungrouped Data
This means that every value 𝑥 must be deducted from the mean denoted by 𝑥, which would tell us about the
difference in observations with the mean of the dataset.
Observation = 𝑥
Mean = 𝑥
n = Number of observations
This means that (𝑥1
− 𝑥 ), (𝑥2 − 𝑥 ), (𝑥3 − 𝑥 )… (𝑥𝑛 − 𝑥) will have to be calculated.
The problem with this however is that it would report positive and negative values, positive for values which were
below the mean in the population and vice versa hence if we were to take the average of these mean deviations we
will get zero as the answer.
The formula 𝛴(𝑥 − 𝑥)would result in zero which would be the sum of all the observations after deducting the mean
𝛴(𝑥 −𝑥)
(𝑥) from each of them. Even mean of this calculation
𝑛
will only give zero as the answer.
To resolve this problem square will be taken of the differences, this way the negative values will become positive
and the sum would not result in a zero. Since positive deviations cancel out negative deviations.
The average of the deviations when squared for a data set will result in a figure which in statistics is known as
population variance. It is denoted by 𝜎 2 and its formula is:
2
𝜎 =
2
∑𝑛
𝑖=1 (𝑥𝑖 − 𝑥 )
𝑛
2
2 𝛴(𝑥𝑖 − 𝑥)
𝜎 =
𝑛
OR
Statisticians have over the periods determined that this (population standard deviation) seems to underestimate the
population variance making it a biased estimate.
To resolve this it has been found that instead of dividing the sum by n, if (n - 1) is used it will provide a better estimate.
This is known as the Sample Standard Variance (𝑠 2 ) and is calculated using the formula:
2
𝑠 =
2
∑𝑛
𝑖 = 1 (𝑥𝑖 − 𝑥)
𝑛−1
OR
Page 233
2
𝑠 =
𝛴 (𝑥 − 𝑥 )2
𝑛−1
Summarizing & Analyzing Data
MA/FMA Study Notes
Grouped Data
To calculate the population variance of the ungrouped data the following formula will be used:
2
2 𝛴 𝑓(𝑥 − 𝑥 )
𝜎 =
𝛴𝑓
Sample standard variance would be:
2
2 𝛴 𝑓(𝑥 − 𝑥 )
𝑠 =
𝛴𝑓 − 1
Standard Deviation
Ungrouped Data
The value of dispersion however are best defined in the same terms as the observations which is why the square
root is taken of the 𝜎 2 and the resulting figure or 𝜎 is known as population standard deviation and is calculated using
the formula:
2
∑𝑛
𝑖 = 1 (𝑥𝑖 − 𝑥 )
𝜎 =√
𝑛
OR
𝛴 ( 𝑥 − 𝑥 )2
𝜎 =√
𝑛
This way Sample Standard Deviation(𝑠)is calculated as:
2
∑𝑛
𝑖 = 1 (𝑥𝑖 − 𝑥 )
𝑠 =√
𝑛−1
OR
Example 7
Calculate the variance and the standard deviation of the following data:
25, 18, 29, 34, 45, 40, 38
Page 234
𝛴 (𝑥 − 𝑥 )2
𝑠 =√
𝑛−1
Summarizing & Analyzing Data
Observations
MA/FMA Study Notes
Deviation of Observations
from mean
Squared Deviations
(𝑥𝑖 − 𝑥)
(𝑥𝑖 − 𝑥 )𝟐
25
25 - 33 = -8
64
18
18 - 33 = -15
225
29
29 - 33 = -4
16
34
34 - 33 = 1
1
45
45 - 33 = 12
144
40
40 - 33 = 7
49
38
38 - 33 = 5
25
𝑥
229
𝑠2 =
𝛴 (𝑥𝑖 − 𝑥 )2
𝑛−1
=
508
508
6
= 84.67
𝑠= √84.67 = 9.2
Grouped Data
2
∑𝑛
𝑖 = 1 𝑓(𝑥𝑖 − 𝑥 )
𝑠=√
𝛴𝑓 − 1
OR
𝛴 𝑓(𝑥 − 𝑥)2
𝑠=√
𝛴𝑓 − 1
Standard deviation indicates how much data is spread out from the mean. A lower value would mean that the
observations are very close to the mean whereas a higher value will indicate that the data is quite spread out from
the mean.
In a question for Grouped Data the frequency of the respective observations will be calculated and solved similarly
to how the variance was calculated.
Page 235
Summarizing & Analyzing Data
MA/FMA Study Notes
Example 8
Consider the following information:
Observation (x)
28
35
66
68
80
45
322
Frequency (𝑓)
2
4
1
3
2
1
13
𝛴𝑓𝑥
56
140
66
204
160
45
(𝑥 − 𝑥)
-23.62
-16.62
14.38
16.38
28.38
-6.62
𝑓(𝑥 − 𝑥 )
-47.24
-66.48
14.38
49.14
56.76
-6.62
𝑓(𝑥 − 𝑥 )2
2232
4420
207
2415
3222
44
𝑥=
𝛴𝑓𝑥 671
=
671
12540
= 51.62
𝛴𝑓 13
2
2 𝛴 𝑓(𝑥 − 𝑥 )
𝑠 =
𝛴𝑓 − 1
=
12540
13−1
=
12540
12
= 1045
𝑠 = √1045 = 32.33
Coefficient of Variation
Coefficient of variance is the extent of variation with respect to the mean of the population. It is usually written as
a percentage. It is calculated using the following formula:
𝐶𝑣 =
𝜎
𝑥
or
𝑠
𝑥
Coefficient of variation is calculated by dividing the standard deviation by the mean of the dataset. As it is usually
written as a percentage it is multiplied by 100%.
Example 9
A Dataset has a mean of 52 and the population standard deviation is calculated to be 8. What is the coefficient of
variation?
𝐶𝑣 =
𝜎
𝑥
Page 236
Summarizing & Analyzing Data
𝐶𝑣 =
MA/FMA Study Notes
8
= 0.1538 × 100% = 15.38%
52
EXPECTED VALUE
Expected Values can be simply understood to be long term average of a certain data population. This means that if
certain observations are done over a long period of time the following mean would be produced. These are then
used to make decisions according to the expected value. Even though the expected value might not actually be the
outcome but it gives a good idea about the value that can be expected nearest to it using the probabilities.
It is represented by
Expected Value =
E(X) or 𝜇
E(X) = 𝜇 = 𝛴𝑥𝑃(𝑥)
It can be calculated by taking the sum of the product of variable (x) and its probability of occurrence ( P(x) ).
Example 10
A Traffic police department of a city has determined the following statistics for road accidents on a certain road per
day and more than 3 accidents on this road were not reported in the data from which the observations were taken:
Number of Road Accidents (x)
Probability (P(x))
( xP(x) )
0
70% = 0.7
0 x 0.7 = 0
1
15% = 0.15
1 x 0.15 = 0.15
2
10% = 0.1
2 x 0.1 = 0.2
3
5% = 0.05
3 x 0.05 = 0.15
Total = 0.5
Expected Value = E(X) = 𝜇 = 𝛴𝑥𝑃(𝑥) = 0.5
This means that the expect value of road accidents on the said road is 0.5 accidents per day.
The traffic police can through this calculation determine whether this road would need surveillance by comparing
to some threshold which it might have in place e.g. if the expected value is above 0.8 accidents per day then a
surveillance car must be there to bring the number of accidents down.
Page 237
Summarizing & Analyzing Data
MA/FMA Study Notes
Properties of a Normal Distribution
A normal distribution is a continuous probability distribution for a random variable x. The graph of a normal
distribution is called the normal curve, which has all of the following properties:
1. The mean, median, and mode are equal.
2. The normal curve is bell-shaped and is symmetric about the mean.
3. The total area under the curve is equal to one.
4. The normal curve approaches, but never touches, the x-axis.
5. Between µ − σ and µ + σ the graph is concave down and elsewhere the graph is concave up. The points at which
the graph changes concavity are called inflection points.
Normal Distribution Graph
It is established by calculating the standard deviation that:
1. 68% of the values will fall within 1± standard deviation of the mean.
2. 95% of the values will fall within 2± standard deviation of the mean.
3. 97.7% of the values will fall within 3± standard deviation of the mean.
Page 238
Summarizing & Analyzing Data
MA/FMA Study Notes
If we look at the normal distribution graph:
99.7% of data
68% of data
95% of data
Interpreting Normal Distribution Graph
Normal Distribution graph represents the data in the form of a curve as shown above and the reflection points are
denoted by Z. The value of Z in the middle of the curve or at the mean is said to be 0 (Z = 0). The point to its left is
where Z = 1 and on left of mean is Z = -1 and so on.
These Z-scores are essential when understanding Normal Distribution Graphs.
Values of any normal distribution can be converted into Z-scores in the following way:
1. Deduct the Mean from the Value
2. Divide the Result with the standard deviation to get the z-score
This would also mean that if the z-score of a certain value is known then it can be calculated by going reverse in the
steps above.
Page 239
Summarizing & Analyzing Data
MA/FMA Study Notes
Normal Distribution Graph
Standard Normal Distribution Graph
Z = -3
Z = -2
Z = -1
Z=0
Page 240
Z=1
Z=2
Z=3
Summarizing & Analyzing Data
MA/FMA Study Notes
Normal Distribution Table
Normal Distribution table has percentages defined in accordance with the Z-scores of the values in the graph.
Example 11
Find the % of values which would fall from -1 z-score to +2.05 z-score.
To find out we would first have to see in the horizontal row for 1 and then then the column of 0.00 which would give
us the value of 0.8413 that is (84.13 - 50) 34.13% of values and the second one would be found out by looking at the
row 2 and in the column would have to be 0.05 giving a value of 0.9798 that is (97.98 - 50) 47.98%.
The total values from a -1 to +2.05 z-score would be 82.11%.
Page 241