COSTING

COST ING
An introduction
STUDENTS' MANUAL
THIRD EDITION

Colin Drury
Professor, Department of Accountancy and Finance,
University of Huddersfield

~~~][ SPR!NGER-SCIENCE+BUSINESS MEDIA, B.V.

First edition 1987
Second edition 1990
Reprinted 1993
Third edition 1994
© 1987, 1990, 1994 Col in Drury
Originally published by Chapman & Hali in 1994
Typeset in 10/12pt Times by EXPO Holdings, Malaysia
ISBN 978-0-412-58800-6 ISBN 978-1-4899-6878-4 (eBook)
DOI 10.1007/978-1-4899-6878-4
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 Contents

Preface vii

2 Cost and revenue classification

Answers to Chapter 2 1
3 Accounting for materials and labour
Answers to Chapter 3 7
4 Accounting for overhead expenditure
Answers to Chapter 4 19
5 Accounting entries for a job costing system
Answers to Chapter 5 35
6 Process costing
Answers to Chapter 6 51
7 Joint product and by-product costing
Answers to Chapter 7 65
8 Absorption costing and variable costing
Answers to Chapter 8 75
9 Cost-volume-profit analysis
Answers to Chapter 9 85
10 Measuring costs and benefits for decision-making
Answers to Chapter 10 101
11 Activity-based costing
Answers to Chapter 11 115
12 Capital investment decisions
Answers to Chapter 12 121
13 The budgeting process
Answers to Chapter 13 131
14 Control in the organization
Answers to Chapter 14 149
15 Standard costing and variance analysis
Answers to Chapter 15 157
16 Planning and control of stock levels
Answers to Chapter 16 177
 Preface

This manual is complementary to the main textbook, Costing: An introduc-

tion. Throughout the main book I have kept the illustrations simple to enable
the reader to understand the principles involved in designing and evaluating
management and cost accounting systems. More complex problems are pro-
vided at the end of each chapter so that the student can pursue certain topics
in more depth, and concentrate on the application of principles. The object-
ive of this manual is to provide solutions to the problems which have an
asterisk beside the question number and, where necessary, to supplement the
main text with a discussion of the additional issues raised by the questions.
The solutions given in this manual are my own and not the approved solu-
tion of the professional body setting the problem. Where an essay question is
asked and a full answer requires undue repetition of the book, either refer-
ences are made to the appropriate sections of the main book, or an answer
guide or outline is provided. You should note that there will be no 'ideal'
answer to problems which are not strictly numerical. Answers are provided
which, it is felt, would be generally acceptable in most contexts. Where possi-
ble the problems are arranged in ascending order of difficulty. A short
description of each problem is given at the beginning of each chapter of this
manual.
Finally I would like to thank, once again, the Institute of Chartered
Accountants in England and Wales, the Chartered Association of Certified
Accountants, the Chartered Institute of Cost and Management Accountants,
the Association of Accounting Technicians, the Joint Matriculation Board
and the Associated Examining Board for permission to reproduce problems
which have appeared in past examinations.
 Cost and revenue
classification
Answers to Chapter 2

Question summary

2.1 to 2.7
Essay questions on cost classification. Note that Question 2.4 also
includes a discussion of the role of the cost accountant. The answers to
some of these questions are contained within the chapter so the answers
listed here consist of a reference to the appropriate section in Chapter 2.
2.8
A multiple choice style question relating to cost behaviour.
2.9
A description of various cost terms - discretionary, variable, fixed,
notional and opportunity costs. The question also requires the student to
indicate whether a project should be continued or abandoned based on a
comparison of relevant revenues with relevant costs.
2.10to2.U
Short questions which can be used to test your understanding of cost
classification.
2.13
A more demanding and time-consuming Foundation/Stage 1 question
relating to cost behaviour.
2.14
Calculation of a product cost for cost-plus pricing.
2.15
Computation and discussion of relevant, sunk and opportunity costs for
decision-making.
2.16
Ascertaining the relevant cost of car journeys and the estimation of costs
at 80% of budgeted activity.

COST AND REVENUE CLASSIFICATION - - - - - - - - - - - - - - - - - - - - - - - -

 Answer to question 2.1
See the description of cost behaviour in the sections in Chapter 2 on
classification of costs for decision-making and classification of costs for control
for the answer to these questions. In particular the answer should provide
graphs for fixed costs, variable costs, semi-fixed costs and semi-variable costs.

Answer to question 2.2

You will find the answer to this question in Chapter 2. In particular the
answer should describe the classification of costs for stock valuation and
profit measurement; classification for decision-making and planning;
classification for control. In addition the answer should illustrate methods of
classification (see Chapter 2 for examples) within the above categories and
describe the benefits arising from classifying costs in the manner illustrated.

Answer to question 2.3

You will find the answer to this question in Chapter 2.

Answer to question 2.4

(a) See section on the role of the management accountant in the manage-
ment proct'ss in Chapter 1 for the answer to this question. In particular
your ans\\ .;r should stress that the cost accountant provides financial
information for stock valuation purposes and also presents relevant
information to management for decision-making and planning and cost
control purposes. For example, the cost accountant provides informa-
tion on the costs and revenues of alternative courses of action to assist
management in selecting the course of action which will maximize
future cash flows. By co-ordinating plans together in the form of budgets
and comparing actual performance with plans the accountant can pin-
point those activities which are not proceeding according to plan.
(b) (i) Direct costs are those costs which can be traced to a cost objective.
If the cost objective is a sales territory then fixed salaries of sales-
men will be a direct cost. Therefore the statement is incorrect.
(ii) Whether a cost is controllable depends on the level of authority
and time-span being considered. For example, a departmental
foreman may have no control over the number of supervisors
employed in his department but this decision may be made by his
superior. In the long term such costs are controllable.
(iii) This statement is correct. See section on sunk costs in Chapter 2
for an explanation.

2 COST AND REVENUE CLASSIFICATION

 Answer to question 2.5
See Chapter 2 for the answer to this question.

Answer to question 2.6

Cost information is required for the following purposes:
(a) costs for stock valuation and profit measurement;
(b) costs for decision-making;
(c) costs for planning and control.
For the alternative measures of cost which might be appropriate for each of
the above purposes see Chapter 2.

Answer to question 2. 7
(a) See Chapter 2 for a definition of opportunity cost and sunk cost.
(b) (i) Opportunity cost: If scarce resources such as machine hours are
required for a special contract then the cost of the contract should
include the lost profit that would have been earned on the next
best alternative. This should be recovered in the contract price.
(ii) Sunk cost: The original cost of equipment used for a contract is a
sunk cost and should be ignored. The change in the resale value
resulting from the use of the equipment represents the relevant
cost of using the equipment.
(c) The significance of opportunity cost is that relevant costs do not consist
only of future cash outflows associated directly with a particular course
of action. Imputed costs must also be included.
The significance of sunk costs is that past costs are not relevant for
decision-making.

Answer to question 2.8

Total fixed costs will remain unchanged in the short-term (within the relevant
range) and variable costs are constant per unit. If output declines fixed costs
per unit will increase. The correct answer is Option A since total variable
costs should decline if output is less than the original budget.

Answer to question 2.9

(a) A large proportion of non-manufacturing costs are of a discretionary
nature. In respect of such costs management has some significant range
of discretion as to the amount it will budget for the particular activity in

ANSWER TO QUESTION 2.9 3

 question. Examples of discretionary costs (sometimes called managed
or programmed costs) include advertising, research and development
and training costs. There is no optimum relationship between inputs (as
measured by the costs) and outputs (as measured by revenues or some
other objective function) for these costs. Furthermore, they are not pre-
determined by some previous commitment. In effect, management can
determine what quantity of service it wishes to purchase. For example, it
can choose to spend small or iarge amounts on research and develop-
ment or advertising. The great difficulty in controlling such costs is that
there is no established method for determining the appropriate amount
to be spent in particular periods.
For a description of fixed and variable costs see Chapter 2. Examples
of fixed costs include depreciation of the factory building, supervisors'
salaries and leasing charges. Examples of variable costs include direct
materials, power and sales commissions.
(b) The £500,000 is a sunk cost and cannot be avoided. It is therefore not a
relevant cost for decision-making purposes. The project should be con-
tinued because the incremental/relevant benefits exceed the incremen-
tal/relevant costs:

£000
Incremental benefits 350
Incremental costs 200
Net incremental benefits 150

(c) An opportunity cost is a cost which measures the opportunity which is

lost or sacrificed when the choice of one course of action requires that
an alternative course of action be given up. The following are examples
of opportunity costs:
(i) If scarce resources such as machine hours are required for a
special contract then the opportunity cost represents the lost
profit that would have been earned from the alternative use of
the machine hours.
(ii) If an employee is paid £5 per hour and is charged out at £11 per
hour for committed work then if that employee is redirected to
other work the lost contribution of £6 per hour represents the
opportunity cost of the employee's time.
The CIMA terminology defines a notional cost as: 'A hypothetical
cost taken into account in a particular situation to represent a benefit
enjoyed by an entity in respect of which no actual cost is incurred.' The
following are examples of notional cost:
(i) Interest on capital to represent the notional cost of using an asset
rather than investing the capital elsewhere.
(ii) Including rent as a cost for premises owned by the company so as
to represent the lost rent income resulting from using the
premises for business purposes.

4 COST AND REVENUE CLASSIFICATION

 Answer to question 2.10

(a) Production overhead: 1, 3, 8, 9, 14, 16.

Selling and distribution overhead: 2, 5, 7, 10, 11.
Administration overhead: 6, 13, 15.
Research and development overhead: 4, 12.
(b) Direct labour might be regarded as a fixed cost rather than a variable
cost for the following reasons:
(i) Legislation may prevent dismissal of employees or redundancy
costs may be too excessive to justify dismissal when a firm
encounters temporary slack periods.
(ii) Production workers tend to be paid fixed salaries irrespective of
the level of output.
(iii) Workers are no longer dismissed during slack periods.

Answer to question 2.15

(a) (i) For an explanation of sunk and opportunity costs see Chapter 2.
The down payment of £5,000 represents a sunk cost. The lost
profit from sub-letting the shop of £1,600 p.a. ( (£550 x 12)- £5,000)
is an example of an opportunity cost. Note that only the £5,000
additional rental is included in the opportunity cost calculation.
(The £5,000 sunk cost is excluded from the calculation.)
(ii) The relevant information for running the shop is:

£
Net sales 100,000
Costs (£87,000- £5,000 sunk cost) 82,000

18,000
Less opportunity cost from sub-letting 1,600

Profit 16,400

The above indicates that £16,400 additional profits will be

obtained from using the shop for the sale of clothing. It is
assumed that Mrs Johnson will not suffer any other loss of income
if she devotes half her time to running the shop.
(b) The CIMA terminology defines a notional cost as: 'A hypothetical cost
taken into account in a particular situation to represent a benefit
enjoyed by an entity in respect of which no actual expense is incurred.'
Examples of notional cost are:
(i) interest on capital to represent the notional cost of using an asset
rather than investing the capital elsewhere;
(ii) including rent as a cost for premises owned by the company so as
to represent the lost rent income resulting from using the
premises for business purposes.

ANSWERS TO QUESTION 2.15 5

IAnswer to question 2.16
(a) See Chapter 2 for a description of opportunity costs. Out of pocket cost
can be viewed as being equivalent to incremental or relevant costs as
described in Chapter 2.
(b) Depreciation is not a relevant cost since it will be the same for both
alternatives. It is assumed that tyres and miscellaneous represent the
additional costs incurred in travelling to work. The relevant costs are:

Using the car to travel to work:

£
Petrol 128
Tyres and miscellaneous 52
180
Contribution from passenger 120
Relevant cost 60

Using the train:

Relevant cost £188

(c) £000 £000 %

Sales 2,560.0 100
Direct materials 819.2 32
Direct wages 460.8 18
Variable production overhead 153.6 6
Variable administration/selling 76.8 3
Total variable cost 1,510.4 59
Contribution 1,049.6 41
Fixed production overhead (1) 768 30
Fixed administration/selling (2) 224 8.75
992
Profit 57.6 2.25

Notes:
(1) 100/80 X £2,560,000 X 0.24.
(2) 100/80 X £2,560,000 X 0.07.

6 COST AND REVENUE CLASSIFICATION

 Accounting for materials
and labour
Answers to Chapter 3

Question summary================
3.1 to 3.7
Various essay questions on topics related to Chapter 3.
3.8 to 3.11
Computations for various stores pricing methods. Question 3.10 and 3.11
also require the calculation of the economic order quantity (EOQ). In
addition, the final part of Question 3.11 requires the computation of
maximum and minimum stock levels and the reorder point.
3.12
This question consists of two parts: stores pricing and labour cost
accounting.
3.13
A simple question which is useful for illustrating some of the issues to be
considered when introducing an incentive scheme.
3.14 and 3.15
Calculation of earnings for piecework and premium bonus schemes.
3.16
Accounting treatment of holiday pay and overtime plus a computation
and evaluation of a time rate and incentive payment system.
3.17
Calculation of labour turnover percentage and efficiency ratio and a dis-
cussion of how labour turnover can be reduced.
3.18 to 3.20
These are more difficult problems which focus on the effects of introduc-
ing incentive schemes. Questions 3.18 and 3.19 are very similar.

ACCOUNTING FOR MATERIALS AND LABOUR - - - - - - - - - - - - - - - - - - - - - - 7

 Answer to question 3.2

Your reply should indicate that there is a need to verify that actual stocks
agree with the computerized records, which are likely to be more reliable
than a clerical recording system. Nevertheless, errors may still exist. In addition
there is the problem of theft and wastage. It is important therefore that phys-
ical stocks are checked periodically against the computerized records. Your
answer should stress that a continuous system of stocktaking is preferable to
the alternative of a complete periodic system of stocktaking.

Answer to question 3.4

(a) With a computer based system orders for receipts, issues and returns of
materials can be input usually with more speed and accuracy than a
manual system. Stock issue prices and balances will be automatically
determined by the computer program. For each item of stock, control
levels, such as minimum and maximum stock levels and the reorder
level, can be set-up. The computer based system will automatically high-
light those stock items which are outside the control levels and this will
minimize stockouts and overstocking. With a computerized system pur-
chase requisitions are automatically generated when stocks reach their
reorder point.
(b) The answer should describe goods received notes, stores requisitions
and purchase requisitions. See Chapter 3 for a description of these
items.

Answer to question 3.5

(a) The managing director's conclusions are incorrect because of the fol-
lowing:
(i) Purchases may be in excess of materials used to produce goods
for sale. In other words raw material stocks may have increased.
(ii) Material prices might have increased but the quantity of materials
purchased or used remains unchanged.
(iii) Stocks of work in progress (WIP) and finished goods may have
increased thus requiring more purchases.
(iv) The actual selling price may have been lower than expected.
(b) Material losses may have occurred because of the following:
(i) Purchase of inferior quality materials resulting in excessive
wastage. This might be overcome by setting standards indicating
the qualities required. If certain suppliers are known for the

8 ACCOUNTING FOR MATERIALS AND LABOUR

 higher quality materials a list of such suppliers should be kept.
Close co-operation is essential between the production depart-
ments and the purchasing department and the reporting system
should be designed so that the purchasing department is informed
immediately when inferior quality materials are purchased so that
steps can be taken to avoid a recurrence.
(ii) Use of inefficient and unskilled labour. This might be overcome by
improving training.
(iii) Obsolete stocks. This can be reduced by setting maximum,
minimum and reorder stock levels and regularly checking on the
frequency of issues. A report on obsolete stocks should be pre-
pared for management at frequent intervals indicating the
reasons for the obsolescence. All purchase requisitions should be
initiated only by the storekeeper who should check the stock
levels prior to completing the purchase requisition.

Answer to question 3.8

(a) (i) Stores ledger card - FIFO method

Date Receipts Issues Balance

Qty Price Value Qty Price Value Qty Value

£ £ £ £
April 1 40 400
4 140 11 1,540 180 1,940
10 40 10 400
50 11 550
- -
90 950 90 990
12 60 12 720 - - 150 1,710
13 90 11 990
10 12 120
- --
100 1,110 50 600
- --
16 200 10 2,000 250 2,600
21 50 12 600
20 10 200 180 1,800
- -
70 800
- -
23 80 10 800 100 1,000
26 50 12 600 150 1,600
29 60 10 600 90 1,000

ANSWER TO QUESTION 3.8 - - - - - - - - - - - - - - - - - - - - - - - - - - - 9

 (ii) Stores ledger card- LIFO method

Date Receipts Issues Balance

Qty Price Value Qty Price Value Qty Value

£ £ £ £
April 1 40 400
4 140 11 1,540 180 1,940
10 90 11 990 90 950
12 60 12 720 150 1,670
13 60 12 720
40 11 440
- --
100 1,160 50 510
- --
16 200 10 2,000 250 2,510
21 70 10 700 180 1,810
23 80 10 800 100 1,010
26 50 12 600 150 1,610
50 12 600
29 10 10 100
- -
60 700 90 910
- -

(b) Cost of material used in April: LIFO - £4,260; FIFO - £4,350

(c) See the Appendix to Chapter 3 for a description of the weighted
average method. With this method the issue price is determined by
dividing the total value by the number of units in stock. This will tend to
smooth out price fluctuations and the closing stock valuation will fall
between that resulting from the FIFO and LIFO methods. In times of
rising prices the cost of sales figure will be higher than FIFO but lower
than LIFO.

IAnswer to question 3.11

(a) (i) Two of the following methods of pricing should be selected:
FIFO
Date Receipts Issues Balance
Kg £ Kg £ Number £
1Nov. 20,000 60,000
3Nov. 5,000 20,000 25,000 80,000
10Nov. 12,000 60,000 37,000 140,000
17 Nov. 20,000 at £3 = £60,000
4,000 at £4 = £16,000 13,000 64,000
20Nov. 17,000 76,500 30,000 140,500
27 Nov. [ 1,000 at £4 =£4 ,000 ]
12,000 at £5 = £60,000
7,000 at £4.50 = £31,500 10,000 45,000

10 ACCOUNTING FOR MATERIALS ANO LABOUR

 LIFO
Date Receipts Issues Balance
Kg £ Kg £ Number £
1 Nov. 20,000 60,000
3Nov. 5,000 20,000 25,000 80,000
10 Nov. 12,000 60,000 37,000 140,000
17 Nov. [ 12,000 at £5 = £60,000]
5,000 at £4 = £20,000
7,000 at £3 = £21,000 13,000 39,000
20Nov. 17,000 76,500 30,000 115,500
27 Nov. [ 17,000 at £4.50 = £76,500 J
3,000 at £3 = £9,000 10,000 30,000

Averaged weighted cost

Date Receipts Issues Balance
Kg £ Kg £ Number £
1 Nov. 20,000 at £3 = 60,000
3Nov. 5,000 20,000 25,000 at £3.20 = 80,000
10Nov. 12,000 60,000 37,000 at £3.78 = 140,000
17 Nov. 24,000 at £3.78 = 90,720 13,000 at £3.78 = 49,280
20Nov. 17,000 76,500 30,000 at £4.19 = 125,780
27 Nov. 20,000 at £4.19 = 83,800 10,000 at £4.19 = 41,980

(ii) Job 124

FIFO LIFO WI Average
£ £ £
Direct material (Total issues) 171,500 186,500 174,520
Direct labour 50,000 50,000 50,000
Overhead 188,650 205,150 191,972
Total cost 410,150 441,650 416,492
Profit 45,572 49,072 46,400
Selling price 455,722 490,722 462,892

(iii) LIFO has produced a higher material cost and as a consequence a

higher selling price to reflect the upward trend in material costs
compared to FIFO. However the valuation of stock under LIFO
is a lot lower than FIFO as it is based upon older stock. Weighted
average arrives at figures between the extremities of FIFO and
LIFO but is not an actual cost. Note the effect on overhead of
using direct material as a basis of recovery.
(b) (i) See 'complete periodic stockcount' and 'continuous stocktaking'
in Chapter 3 for an evaluation of continuous stocktaking. The
advantages of continuous stocktaking are that:
(1) There is no need to stop production for stocktaking thus
saving production costs.
(2) Discrepancies are highlighted earlier than with periodic
stocktaking.

ANSWER TO QUESTION 3.11 11

 (b) (ii) The advantages of centralized stores are as follows:
(1) Economies of scale (e.g. fewer staff and lower stocks).
(2) Better control and security of stocks.
(3) Duplication of stocks can be avoided.
However, if production centres are located a long way from the
centralized stores there may be long delays in obtaining materials.
It may also be costly in terms of transportation costs.
(c) (i) Economic order quantity

=~2~0
D = Annual demand
0 = Cost of ordering/per order
H = Holding cost per item

2x 400x 50x150
2
1.732 kilos
(ii) Reorder level
= Maximum usage x maximum lead time
= 600 x 3 = 1,800 units
(iii) Minimum level of stock
= Reorder level - average usage in average lead time
= 1,800- (2 x 400) = 1,000 units
(iv) Maximum level of stock that should be held
Reorder level + EOQ - minimum usage in minimum lead
time
1,800 + 1,732- (4QQ X 1) = 3,132.

Answer to question 3.12

(a) FIFO: Because the units contained in the closing stock are less than the
most recent purchase quantity, the value of the closing stock will be based
on the price per unit of the most recent purchase. Therefore the value of
the closing stock is £123.20 consisting of 44 units at £2.80 per unit.
LIFO:

Receipts Issues
Opening stock 35 at £2.00
Nov. 2 25 at £2.00
Nov. 5 40 at £2.25
Nov.lO 38 at £2.25
Nov.13 30 at £2.50
Nov. 23 50 at £2.80
Nov. 24 48 at £2.80

From the above schedule we can see that the closing stock consists of
the following purchases:

12 - - - - - - - - - - - - - - - - - - - - - - ACCOUNTING FOR MATERIALS AND LABOUR

 £
Opening stock 10 at £2.00 = 20.00
November 5 purchase 2 at £2.25 = 4.50
November 13 purchase 30 at £2.50 = 75.00
November 23 purchase 2 at £2.80 = 5.60
Closing stock 105.10

(b) The value of material issued on November 24 is £125.76 and is calcu-

lated as follows:

Receipts Issues Closing balance

Quantity Price Value Quantity Price Value Quantity Price Value
£ £ £ £ £ £
1.11.81 35 2.00 70.00
2.11.81 25 2.00 50.00 10 2.00 20.00
5.11.81 40 2.25 90.00 50 2.20 110.00
10.11.81 38 2.20 83.60 12 2.20 26.40
13.11.81 30 2.50 75.00 42 2.41 101.40
23.11.81 50 2.80 140.00 92 2.62 241.40
24.11.81 48 2.62 125.76 44 2.62 115.64

The cost of the 10 units issued to replace those previously damaged

should be charged (debited) to a Scrap account and the Stores ledger
control account should be reduced (credited). The issue cost represents
abnormal scrap which should not be included in the stock valuation.
Therefore the cost of the scrap should be written off as a period cost. If
the scrap was considered to be a normal unavoidable cost inherent in
the production process then it would be reasonable to charge the cost
of the normal scrap to the job. For a discussion of the treatment of
normal and abnormal losses see Chapter 6.

(c) Calculation of total hours worked: Hours

Normal hours (£4,800 + £3 per hour) 1,600
Overtime hours (£1,440 + £4.50 per hour) 320
1,920

Allocation of wages cost: £

Capital expenditure: 60 hours at £3 180
Non-productive time: 280 hours at £3 840
Productive time: Balance of 1,580 hours (1,920- 340) at £3 4,740
Overtime premium: 320 hours at £1.50 480
Shift premium 360
6,600

ANSWER TO QUESTION 3.12 - - - - - - - - - - - - - - - - - - - - - - - - - 13

 The journal entries are as follows:

Dr Cr
Wages control account 6,600
Cost ledger control account (see Nate) 6,600
Work in progress account 4,740
Capital equipment account 180
Production overhead account (840 + 480 + 360) 1,680
Wages control account 6,600

Note:
For an explanation of this account see section on interlocking accounting,
Chapter 5.

IAnswer to question 3.15

(a) (i)
y z
£ £
Time-based earnings 154 (44 X £3.50) 180 (40 X £4.50)
Guaranteed minimum (80%) 123.20 144
Piecework earnings 168 (480 X £0.35) 136.50 (390 X £0.35)
Earnings £168 £144
(ii) Time taken 44 hrs 40 hrs
Time allowed 56 hrs (480 x 7/60) 45.5 hrs (390 x 7/60)
Time saved 12 hrs 5.5 hrs
Bonus hours 9 hrs 4.125 hrs
(75% of time saved)
Hours paid 53 hrs 44.125 hrs
Earnings £185.50 £198.56

(b) Time rate bases are preferable when:

(i) quality is more important than quantity;
(ii) employees have little control over their output.

IAnswer to question 3.16

(a) For the answer to this question you should refer to 'Elements of manu-
facturing cost' in Chapter 2 and 'Accounting treatment of various labour
cost items' in Chapter 3.

(b) Current system

Total weekly wages £960 (6 X £160)
Weekly wage per employee £160 (£960/6 employees)
Average output per employee 1,000 units (6,000 units/6)
Labour cost per unit of output 16p (£960/6,000 units)

14 - - - - - - - - - - - - - - - - - - - - - ACCOUNTING FOR MATERIALS AND LABOUR

 New system
Average output per employee 1,000 units (6,600 units/6)
Weekly wage per employee £180 (£800 X 16p) + (200 X 17p) +
(100 X 18p)
Total weekly wages £1,080 (£180 X 6)
Labour cost per unit of output 16.36p (£1,080/6,600 units)

Note that the above calculations are based on the assumption that each
individual produces the average output of 1,100 units per week. If this is
not the case then total wages will differ slightly from the above figure.
With time-based remuneration systems, workers are paid for the
number of hours attended at the basic wage rate. An additional
premium over the base rate is paid for overtime. The merits of time-
based systems are that they are simple to administer and easy to under-
stand. The weekly wage is known in advance and does not fluctuate with
changes in output. Time rate systems have a number of disadvantages.
In particular, there is no motivation to increase output, and this can
result in a greater need for supervision. Time-based systems are most
appropriate where the quality of the output is particularly important or
where the workers have little influence over the volume of production.
With individual performance-based remuneration systems, wages
paid are related to output. The merits of performance-based systems are
that effort and efficiency are rewarded, and this generally results in
higher wages, improved morale and the ability to attract efficient
workers. In the above illustration, on average, each employee's wage
increases by £20 per week (a 12.5% increase). The employer gains from
increased production, higher sales revenue and a decrease in unit fixed
costs. Labour cost per unit has increased in the above illustration, but it
is likely that this will be compensated for by a lower fixed overhead cost
per unit and additional sales revenue.
Individual performance-based remuneration systems suffer from the
following disadvantages:
(i) Some workers may suffer a decline in wages. For example, a
worker who produces 900 units per week would receive a weekly
wage of £145 (800 x 16p plus 100 x 17p ), a decline of £15 per
week.
(ii) Performance-based systems are more complex and expensive to
administer, and can result in complex negotiations and frequent
disputes.
(iii) Quality of output might suffer.

IAnswer to question 3.17

(a) Labour turnover percentage
Number of employees leaving during the period (7)
-------------------------------------x100
Average total number of employees for the period (42)
= 16.7%

15
ANSWERTOQUESTION 3.17 - - - - - - - - - - - - - - - - - - - - - - - - -
 (b) Possible reasons for the labour turnover include:
(i) Promotion either within or outside the firm.
(ii) Personal circumstances such as moving from the area, retirement,
pregnancy.
(iii) Dissatisfaction with pay or working conditions.
The costs of labour turnover include leaving, recruitment and training
costs. Leaving costs include the costs associated with completing the
appropriate documentation and lost production if the employees cannot
be immediately replaced. Recruitment costs result from the advertising,
selection and engagement of new staff. Training costs include costs asso-
ciated with lost production when training is being given, defective work
and low productivity during the training period.
Labour turnover and associated costs can be reduced by ensuring
that:
(i) pay and working conditions are satisfactory and comparable with
alternative employers;
(ii) adequate training is provided;
(iii) an appropriate career structure exists.
(c) The time allowed for 114,268 units is 5,194 hours (114,268/22)
Efficiency ratio= Time allowed (standard hours)/actual hours
= 5,194 hours/4,900 hours
= 106%
Therefore the labour rate is £4.738 per hour (£4.60 x 103/100)
Standard cost £23,892 (5,194 hours at £4.60)
Actual cost £23,216 (4,900 hours at £4.738)

Variance £676 Favourable

Answer to question 3.18

(a) Current average maximum production= 30 x 55 hours x 6 units= 9,900
units
Proposed maximum production= 30 x 55 hours x 8 units= 13,200 units

Existing payment system:

Output levels (units) 7,000 9,600 9,900
£ £ £
Sales value (£10 per unit) 70,000 96,000 99,000
Pre-finishing VC 56,000 76,800 79,200
Direct labour:
Guaranteed 3,600 3,600 3,600
Overtime (W1) 1,800 2,025
Variable overhead (W2) 560 768 792
Fixed overhead 9,000 9,000 9,000
Total cost 69,160 91,968 94,617
Profit 840 4,032 4,383

16 ACCOUNTING FOR MATERIALS AND LABOUR

 Proposed scheme:
Output levels (units) 7,000 9,600 9,900 12,000
£ £ £ £
Sales value 70,000 96,000 99,000 120,000
Pre-finishing VC 56,000 76,800 79,200 96,000
Direct labour at
£0.55 per unit 3,850 5,280 5,445 6,600
Variable overhead (W3) 420 576 594 720
Fixed overhead 9,000 9,000 9,000 9,000
Total cost 69,270 91,656 94,239 112,320
Profit 730 4,344 4,761 7,680

Workings:
W1 9,600 units require 1,600 hours (9,600/6)
:. Overtime = 400 hours x £4.50
9,900 units require 1,650 hours (9,900/6)
:. Overtime = 450 hours x £4.50
Basic hours= 1,200 hours
W2 7,000 units = (7,000/6) x £0.48
9,600 units = (9,600/6) x £0.48
9,900 units = (9,900/6) x £0.48
W3 7,000 units = (7,000/8) x £0.48
9,600 units = (9,600/8) x £0.48
9,900 units = (9,900/8) x £0.48
12,000 units = (12,000/8) x £0.48
(b) At low output levels the average wage rate per unit is £0.50 (£3 + 6
hours) compared with £0.55 with the incentive scheme. However, once
overtime is worked the wage rate per unit of output is £0.75 (£4.50/6)
compared with £0.55 per unit under the incentive scheme. Overtime
starts at 7,200 units (1,200 hours x 6 units). Hence savings will increase
with the incentive scheme beyond 7,200 units.
Variable overheads vary with productive hours. Therefore variable
overheads per unit will be £0.08 (£0.48/6) under the old scheme and
£0.06 per unit under the new scheme (£0.48/8).
The proposed incentive scheme will also enable the maximum output
level to be achieved thus enabling maximum sales demand to be achieved.

17
ANSWER TO QUESTION 3.18 - - - - - - - - - - - - - - - - - - - - - - - - -
 Accounting for overhead
expenditure
Answers to Chapter 4
Question summary

4.1 to 4.3
Discussion questions relating to Chapter 4.
4.4to 4.8
Questions which require the apportionment of overheads, the preparation of
overhead analysis statements and the calculation of departmental overhead
rates. Questions 4.5 and 4.8 also require the calculation of product costs. Part
(b) of Question 4.7 requires the preparation of an overhead control account.
This topic is dealt with in Chapter 5.
4.9
Multiple choice style question requiring the computation of the budgeted
annual level of machine hours.
4.10 to 4.17
Calculation and discussion of different overhead absorption rates. Questions
4.11 to 4.14 and 4.17 also require the calculation of the under/over recovery
of overheads. In addition, Question 4.13 requires an analysis of the
under/over recovery of overheads and a discussion of predetermined versus
actual overhead rates. Question 4.15 involves the reallocation of service
department overheads and 4.16 requires the separation of fixed and variable
overheads using the high-low method.
4.18
Calculation of overhead absorption rates and product costs.
4.19 to 4.22
Reapportionment of service department costs. Question 4.20 also requires a
product cost calculation.
4.23
Requires the calculation of overhead absorption rates and the extraction of vari-
able cost for a make-or-buy decision. This question is useful for emphasizing
the decision-making aspects at this stage. Alternatively, you may prefer to defer
this problem until make-or-buy decisions have been studied in Chapter 10.
4.24
An explanation of the calculation of a product cost using the principles
explained in Chapters 2 and 3. This is a difficult question but it is particularly
useful for reinforcing the cost accounting treatment of labour, materials and
overheads.

ACCOUNTING FOR OVERHEAD EXPENDITURE 19

IAnswer to question 4.5
(a) Departments
Total A B c X y
£ £ £ £ £ £
Rent and rates (1) 12,800 6,000 3,600 1,200 1,200 800
Machine insurance (2) 6,000 3,000 1,250 1,000 500 250
Telephone charges (3) 3,200 1,500 900 300 300 200
Depreciation (2) 18,000 9,000 3,750 3,000 1,500 750
Supervisors' salaries (4) 24,000 12,800 7,200 4,000
Heat and light (1) 6,400 3,000 1,800 600 600 400
Allocated 70,200 2,800 1,700 1,200 800 600
38,100 20,200 11,300 4,900 3,000
Reapportionment of X 2,450 (50%) 1,225 (25%) 1,225 (25%) (4,900)
Reapportionment of Y 600 (20%) 900 (30%) 1,500 (50%) (3,000)
£41,150 £22,325 £14,025
Budgeted D.L. hours (5) 3,200 1,800 1,000
Absorption rates £12.86 £12.40 £14.02

Notes:
(1) Apportioned on the basis of floor area.
(2) Apportioned on the basis of machine value.
(3) Should be apportioned on the basis of the number of telephone points or esti-
mated usage. This information is not given and an alternative arbitrary method of
apportionment should be chosen. In the above analysis telephone charges have
been apportioned on the basis of floor area.
(4) Apportioned on the basis of direct labour hours.
(5) Machine hours are not given but direct labour hours are. It is assumed that the
examiner requires absorption to be on the basis of direct labour hours.

(b) JOB 123 JOB 124

£ £
Direct material 154.00 108.00
Direct labour:
Department A 76.00 60.80
Department B 42.00 35.00
Department C 34.00 47.60
Total direct cost 306.00 251.40
Overhead:
Department A 257.20 205.76
Department B 148.80 124.00
Department C 140.20 196.28
Total cost 852.20 777.44
Profit 284.07 259.15

(c) Listed selling price 1,136.27 1,036.59

20 ACCOUNTING FOR OVERHEAD EXPENDITURE
 Note:
Let SP represent selling price.
Cost + 0.25SP = SP
Job 123: £852.20 + 0.25 SP = 1SP
0.75 SP = £852.20
Hence SP = £1,136.27
For Job 124: 0.75SP = £777.44
Hence SP = £1,036.59

(d) For the answer to this question see section on material control proce-
dure in Chapter 3.

IAnswer to question 4.7

(a) Overhead analysis:

Machine Machine
Basis of Total shop A shop B Assembly Canteen Maintenance
Overhead apportionment £ £ £ £ £ £

Indirect wages Actual 78,560 8,586 9,190 15,674 29,650 15,460

Consumable materials Actual 16,900 6,400 8,700 1,200 600
Rent and rates
Building insurance
Area
Area
16,700)
2,400 5,000 6,000 7,500 3,000 1,000
Heat and light Area 3,400
Power Technical 8,600 4,730 3,440 258 172
estimate
Depreciation Value of 40,200 20,100 17,900 2,200
machinery
166,760 44,816 45,230 26,832 33,250 16,632
Maintenance Machine 4,752 11,880 (16,632)
usage hours
Canteen DLHs 7,600 5,890 19,760 (33,250)

166,760 57,168 63,000 46,592

Machine usage hours 7,200 18,000

Direct labour hours 20,800
Machine hour rate £7.94 £3.50
Direct labour hour rate £2.24
(b) It will be necessary to read Chapter 5 before you can answer this question.
Production overhead control account
£ £
Cost ledger control account 176,533 WIP- overhead absorbed:
Machine shop A (7,300 x £7.94) 57,962
Machine shop B (18,700 x £3.50) 65,450
Assembly (21,900 x £2.24) 49,056
172,468
Under-absorbed overhead
transferred to P&L account 4,065
176,533 176,533

ANSWER TO QUESTION 4.7 - - - - - - - - - - - - - - - - - - - - - - - - - -

21
 (c) For the answer to this question see section on control accounts in
Chapter 5.

Answer to question 4.8

(a) (i) Overhead analysis sheet (£000s)

Cost Total Machine Direct Sales Adminis-

hours labour and tration
hours distribution
Energy and water 20 16 1.0 3.0
Electricity 14 14
Rent and rates 180 144 9.0 27.0
Repairs: machinery 25 25
buildings 10 8 0.5 1.5
Maintenance of patterns 45 45
Direct wage related costs 115 115
Indirect wages 83 83
Indirect wage related costs 10 10
Production management
salaries 133 133
Depreciation of machinery 150 150
Security 10 8 0.5 1.5
Inspection 60 60
Carriage out 88 88.0
Salesmen's salaries 100 100.0
Salesmen's expenses 50 50.0
Design and estimating 75 75.0
General management
and administration 232 232.0
Advertising 40 40.0
1,440 189 622 364.0 265.0

(ii) The production overhead relating to machinery should be ab-

sorbed on the basis of machine hours whereas the overhead
which is not related to machinery should be absorbed on the basis
of direct labour hours. There is no specific method which is
appropriate for absorbing non-manufacturing overheads. The aim
should be to select an input factor which corresponds most closely
with non-manufacturing overheads. Most examination questions
assume that administration overheads will be absorbed on the
basis of production cost, and selling overheads absorbed on the
basis of sales value. Appropriate overhead absorption rates are:
Machine hour rate= £1.05 (£189,000/180,000 machine hours).
Direct labour hour rate = £3.11 (£622,000/200,000 direct labour
hours).

22-----------------------------------
ACCOUNTING FOR OVERHEAD EXPENDITURE
 Selling overheads = 8% of sales value (£364,000/£4,500,000).
Administration overheads = 10% of production cost (£265,000/
£2,650,000).

The total production cost for the period is calculated as follows:

£000
Raw materials 750
Carriage on raw materials 49
Direct wages 1,040
Overhead: machinery 189
direct labour hours 622

2,650

(b) (i) Job 1019:

£
Raw materials 2,888
Direct wages 3,500
Production overhead:
300 machine hours x £1.05 = 315
700 direct labour hours x £3.11 = 2,177 2,492

Production cost 8,880

Selling and distribution 8% of £12,000 960
Administration 10% of £8,880 888

10,728

Quoted selling price 12,000

Expected profit 1,272
Expected profit, as percentage of selling price 10.60%

(ii) Expected profit for next year: £000

Sales 4,550
Production cost 2,650
Selling and distribution 364
Administration 265 3,279

Expected profit 1,271

Expected profit, as a percentage of sales 27.93%

The percentage profit on Job 1019 is 10.6% of selling price com-

pared with 27.93% expected for the forthcoming year. If the per-
centage profit on Job 1019 is typical of the profit also made on all
other jobs during the current year, then this would suggest that
the profit margins next year will be much higher than the current
year. However, it is inappropriate to make valid comparisons
based on such limited information.

ANSWER TO QUESTION 4.9 - - - - - - - - - - - - - - - - - - - - - - - - - -

23
IAnswer to question 4.9
Overhead recovery rate £714,000/119,000 machine hours
£6 per machine hour
Budgeted overhead (£720,000)
Budgeted machine hours =
Overhead recovery rate (£6)
120,000 machine hours
:. Answer= (c)

IAnswer to question 4.12

(a) Predetermined machine
Machine department overheads (£1,080,000)
hour rate =
Machine hours (80,000)
Machining department = £13.50 per machine hour
Hand finishing £760,000/120,000 labour hours
department
£6.33 per labour hour
(b) (i)
Machine department Hand finishing department
£ £
Overhead incurred 84,500 67,100
Overhead absorbed 81,000 (6,000 x £13.50) 60,800 (9,600 X £6.33)

Under recovery of 3,500 6,300

overheads
(ii) Overheads that are apportioned to cost centres tend to be on an
arbitrary basis and are unlikely to be controllable by the cost centre
manager. Managers should be held accountable for only those
overheads that they can control. See 'Responsibility accounting'
and 'Guidelines for reporting' in Chapter 14 for a more detailed
discussion of controllable and non-controllable costs.
(c) Absorption costing is used by companies to ensure that all products/
services bear an equitable share of company overheads. The Statement
of Standard Accounting Practice (SSAP 9) requires that stocks should
be valued at full production cost. Therefore absorption costing is
required to allocate overheads to products in order to meet financial
accounting requirements.

IAnswer to question 4.13

(a) Year 1
(1) Budgeted machine hours 132,500
(2) Budgeted fixed overheads £2,411,500 (132,500 X £18.20)

ACCOUNTING FOR OVERHEAD EXPENDITURE

24-----------------------------------
 (3) Actual machine hours 134,200 (£2,442,440/£18.20)
(4) Fixed overheads absorbed £2,442,440
(5) Actual fixed overheads incurred £2,317,461
Over-absorption of fixed overheads £124,979 (5-4)
The section on 'Under- and over-recovery of fixed overheads' in Chapter
4 indicates that an under or over-recovery will arise whenever actual
activity or expenditure differs from budgeted activity or expenditure.
Actual activity was 1,700 hours in excess of budget and this will result in
an over-recovery of fixed overheads of £30,940. Actual overheads
incurred was £94,039 (£2,317,461 - £2,411,500) less than budget and is
the second factor explaining the over-absorption of fixed overheads.

Summary £
Over-recovery due to actual expenditure
being less than budgeted expenditure 94,039
Over-recovery due to actual activity exceeding
budgeted activity 30,940
Total over-recovery of overhead for year 1 124,979

Year 2
(1) Budgeted machine hours (134,200 x 1.05) 140,910
(2) Budgeted fixed overheads £2,620,926
(3) Fixed overhead rate (£2,620,926/140,900 hours) £18.60
(4) Actual fixed overheads incurred £2,695,721
(5) Fixed overheads absorbed (139,260 x £18.60) £2,590,236
(6) Under-recovery of overhead for year 2 (4- 5) £105,485

Analysis of under-recovery of overhead £

Under-recovery due to actual activity
being less than budgeted activity (139,260- 140,910) x £18.60 30,690
Under-recovery due to actual expenditure being greater
than budgeted expenditure (£2,695,721 - £2,620,926) 74,795
Total under-recovery for the year 105,485

Change in the overhead rate

Change in the rate (£18.60- £18.20)/£18.20 + 2.198%
This can be analysed as follows:
Increase in budgeted
expenditure (£2,620,926- £2,411,500)/£2,411,500 + 8.684%
Increase in budgeted
activity (140,910 hours -132,500 hrs)/132,500 + 6.347%

The increase of 2.198% in the absorption rate is due to an expenditure

increase of 8.684% in budgeted expenditure partly offset by an increase
in budgeted activity of 6.347% over the 2 years.

Proof
(1.08684/1.06347)- 1 = 0.02198 (2.198%)

ANSWER TO QUESTION 4.13 - - - - - - - - - - - - - - - - - - - - - - - - -

25
 (b) See 'Blanket and departmental overhead rates' and 'Pre-determined
overhead rates' in Chapter 4 for the answers to these questions.

Answer to question 4.16

(a) (i) and (ii) An activity increase of 150 hours (1,650 -1,500) results in an
increase in total overheads of £675. It is assumed that the increase
in total overheads is due entirely to the increase in variable over-
heads arising from an increase in activity. Therefore the variable
overhead rate is £4.50 (£675/150 hours) per machine hour. The
cost structure is as follows:
(1) Activity level (hours) 1,500 1,650 2,000
(2) Variable overheads at
£4.50 per hour £6,750 £7,425 £9,000
(3) Total overheads £25,650 £26,325 £27,900
(4) Fixed overheads (3- 2) £18,900 £18,900 £18,900
(iii) The fixed overhead rate is £10.50 (£15 - £4.50 variable rate)
normal activity fixed overheads (£18,900)/fixed overhead
rate (£10.50)
1,800 machine hours
(iv) Under-absorption 100 machine hours (1,800- 1,700) at £10.50
£1,050
(b) (i) A machine hour rate is recommended for the machine department
because most of the overheads (e.g. depreciation and mainte-
nance) are likely to be related to machine hours. For non-machine
labour-intensive departments, such as the finishing department,
overheads are likely to be related to direct labour hours rather
than machine hours. Overheads are therefore charged to jobs per-
formed in the finishing department using the direct labour hour
method of recovery.

Calculation of overhead rates:

Machining Finishing
department department
Production overhead £35,280 £12,480
Machine hours 11,200
Direct labour hours 7,800
Machine hour overhead rate £3.15
Direct labour hour overhead rate £1.60

(ii) Machining Finishing

department department
Direct materials £ £
(189 X 1.1 X £2.35/0.9) 542.85
Direct labour (1)
25 hours x £4 100.00
28 hours x £4 112.00

26 ACCOUNTING FOR OVERHEAD EXPENDITURE

 Production overhead
46 machine hours at £3.15 144.90
28 direct labour hours at £1.60 44.80
787.75 156.80

Total cost of job= £944.55 (£787.75 + £156.80)

Note:
(1) Overtime premiums are charged to overheads, and are therefore not
included in the above job cost.

IAnswer to question 4.18

(a) (i) Calculation of budgeted overhead absorption rates:

Apportionment of overheads to production departments

Machine
Machine Fitting maintenance
shop section Canteen section Total
£ £ £ £ £
Allocated overheads 27,660 19,470 16,600 26,650 90,380
Rent, rates, heat and
light(1) 9,000 3,500 2,500 2,000 17,000
Depreciation & insurance
of equipment (1) 12,500 6,250 2,500 3,750 25,000
49,160 29,220 21,600 32,400 132,380
Service department
apportionment
Canteen (2) 10,800 8,400 (21,600) 2,400
Machine maintenance
section 24,360 10,440 (34,800)

84,320 48,060 132,380

Calculation of absorption bases:

Machine shop Fitting section
Direct
labour Total
Budgeted Machine hours Total cost per direct
Product production per product machine hours product wages
£ £
X 4,200 units 6 25,200 12 50,400
y 6,900 units 3 20,700 3 20,700
z 1,700 units 4 6,800 21 35,700
52,700 106,800

ANSWER TO QUESTION 4.18 27

 Budgeted overhead absorption rates:

Machine shop Fitting section

Budgeted overheads £84,320 Budgeted overheads £48,060

Budgeted machine hours 52,700 Budgeted direct wages £106,800

= £1.60 per machine hour = 45% of direct wages

Notes:
(1) Rent, rates, heat and light are apportioned on the basis of floor area. Depreciation
and insurance of equipment are apportioned on the basis of book value.
(2) Canteen costs are reapportioned according to the number of employees. Machine
maintenance section costs are reapportioned according to the percentages given
in the question.

(a) (ii) The budgeted manufacturing cost for producing one unit of
product X is as follows:
£
Machine shop: 6 hours at £1.60 per hour 9.60
Fittings section: 45% of £12 5.40
15.00

(b) The answer should discuss the limitations of blanket overhead rates and
actual overhead rates. See sections on blanket overhead rates and
departmental overhead rates and predetermined overhead rates in
Chapter 4 for the answer to this question.

Answer to question 4.19

(a) The service department cost should be reallocated using the following
bases:
Canteen: Number of employees
Engineering shop: Number of service hours
Stores: Number of stores orders
The canteen does not receive any services from the other service depart-
ments. Therefore the canteen should be reallocated first. The Engineer-
ing Shop receives services from the other two service departments and
should be reallocated last.

Overhead allocation
Dept. Basis Assemb Paint
M/C Eng Stores Canteen
shop shop
£ £ £ £ £ £
180,000 160,000 130,000 84,000 52,000 75,000
Canteen Employees 27,000 17,000 13,000 10,000 8,000 (75,000)
Stores Orders 24,000 18,000 12,000 6,000 (60,000)
Eng. shop Service hrs 45,000 30,000 25,000 (100,000)
Total overhead 276,000 225,000 180,000

28-----------------------------------
ACCOUNTING FOR OVERHEAD EXPENDITURE
 Machine hours 9,200
Direct labour hours 11,250
Labour cost £45,000
Machine hour rate £30
Direct labour hour rate £20
Direct labour cost rate 400% of direct labour cost

(b) Overhead absorption statement

M/C Assembly Paint shop
£ £ £
Overhead absorbed (1) 300,000 156,000 140,000
Actual overhead 290,000 167,000 155,000
(Under-) 11,000 15,000
Over-absorption 10,000

Note:
(1) 10,000 machine hours x £30 per hour
7,800 Direct labour hours at £20 per hour
400% of direct labour cost of £35,000

(c) See 'Predetermined overhead rates' in Chapter 4 for an explanation of

why overheads should be absorbed using predetermined bases. The
second part of the question relates to whether or not volume allocation
base (i.e. machine hours and direct labour hours or cost) are appropri-
ate, particularly when direct labour is a small proportion of total cost.
The answers should discuss the need for developing non-volume-based
cost driver rates using activity-based costing systems. Activity-based
costing is described in Chapter 11.

Answer to question 4.20

(a) To calculate product cost we must calculate overhead absorption rates

for the production departments. You can see from the question that the
service departments serve each other and it is therefore necessary to use
the repeated distribution method or the simultaneous equation method
to reallocate the service department costs. Both methods are illustrated
below.

Repeated distribution method:

Cutting Machining Pressing Engineering Personnel
£ £ £ £ £
Allocation per question 154,482 64,316 58,452 56,000 34,000
Engineering reallocation 11,200 (20%) 25,200 (45%) 14,000 (25%) (56,000) 5,600 (10%)
Personnel reallocation 21,780 (55%) 3,960 (10%) 7,920 (20%) 5,940 (15%) (39,600)
Engineering reallocation 1,188 (20%) 2,673 (45%) 1,485 (25%) (5,940) 594 (10%)
Personnel reallocation 327 (55%) 59 (10%) 119 (20%) 89 (15%) (594)
Engineering reallocation (1) 20 44 25 (89)
188,997 96,252 82,001

ANSWER TO QUESTION 4.20 - - - - - - - - - - - - - - - - - - - - - - - - - -

29
 Note:
(1) The costs are so small that any further apportionments are not justified.
Consequently a return charge of 15% is not made to the engineering
department and the costs are apportioned in the ratio 55:10:20.

Simultaneous equation method:

Let E =Total overhead allocated to engineering department.
Let P =Total overhead allocated to personnel department.
E = 56,000 + 0.15P
P = 34,000 + O.lOE
Rearranging the above equations:
E- 0.15P (1) = 56,000
-0.10E + P (2) = 34,000
Multiply equation (2) by 0.15 and equation (1) by 1:
E- 0.15P = 56,000
-0.015E + 0.15P = 5,100
Adding the above equations:
0.985E = 62,030
:. E = £51,030
Substituting forE in equation (1):
62,030- 0.15P = 56,000
6,030 = 0.15P
:. p = £40,200
We now apportion the values of E and P to the production departments
in the agreed percentages.

Cutting Machining Pressing

£ £ £
Allocation per question 154,482 64,316 58,452
Allocation of engineering 12,408 (20%) 27,914 (45%) 15,508 (25%)
Allocation of personnel 22,110 (55%) 4,020 (10%) 8,040 (20%)
189,000 96,250 82,000

Overhead absorption rates:

A comparison of the machine and direct labour hours in the machine
department indicates that machine hours are the dominant activity.
Therefore a machine hour rate should be used. A direct labour hour rate
is appropriate for the cutting and pressing departments. Note that
unequal wage rates apply in the cutting department but equal wage rates
apply in the pressing department. The direct wages percentage and the
direct labour hour methods will therefore result in identical overhead
charges to products passing through the pressing department and either
method can be used. Because of the unequal wage rates in the cutting
department the direct wages percentage method is inappropriate.

30-----------------------------------
ACCOUNTING FOR OVERHEAD EXPENDITURE
 The calculation of the overhead absorption rate is as follows:
Hours
Cutting: Product A (4,000 x 9 hours) 36,000
Product B (3,000 x 6 hours) 18,000
Product C (6,000 x 5 hours) 30,000
Total 84,000
£189,000
Absorption rate = = £2.25 per direct labour hour
84,000
Machining: Product A (4,000 x 2) 8,000
Product B (3,000 x 1112) 4,500
Product C (6,000 x 2 112) 15,000
Total 27,500
£96,250
Absorption rate = = £3.50 per machine hour
27,500
Pressing: Product A (4,000 x 2) 8,000
Product B (3,000 x 3) 9,000
Product C (6,000 x 4) 24,000
Total 41,000
£82,000
Absorption rate = = £2 per direct labour hour
41,000
Product cost calculations:
A (fully complete) B (partly complete)
£ £
Direct materials 7.00 4.00
Direct labour: Cutting (skilled) 12.00 (3 x £4) 20.00 (5 X £4)
(unskilled)15.00 (6 x £2.50) 2.50 (1 X £2.50)
Machining 1.50 C12 x £3) 0.75 (1 1/4 X £3)
Pressing 6.00 (2 x £3)
Prime cost 41.50 27.25
Overhead: Cutting 20.25 (9 X £2.25) 13.50 (6 X £2.25)
Machining 7.00 (2 X £3.50) 5.25 (1 112 X £3.50)
Pressing 4.00 (2 X £2)
72.75 46.00
(a) (i) (a) (ii)
(b) The accounting entries for overheads are presented in Chapter 5. You
will find when you read this chapter that a credit balance in the over-
head control account represents an over-recovery of overheads. Possible
reasons for this include:
(i) actual overhead expenditure was less than budgeted expenditure;
(ii) actual production activity was greater than budgeted production
activity.

ANSWER TO QUESTION 4.20 - - - - - - - - - - - - - - - - - - - - - - - - -

31
 Answer to question 4.24
Cost of Job 123
(a) Direct materials: £ £
Y (W1): 400 kg x £0.505 per kg 202.00
(W2): 265 kg x £1.45 per kg 384.25 586.25
Direct labour:
Dept A (W3): 76 hours x £4.50 per hour 342.00
Dept B (W4): 110 hours x £4.00 per hour 440.00 782.00

Overhead (W5)
Dept A: 76 hours x £2.70 per hour 205.20
Dept B: 110 hours x £2.25 per hour 247.50 452.70
1,820.95

Workings and comments:

£529.75 + (600 X £0.50) + (500 X £0.50) + ( 400 X £0.52)

W1
1,050 + 600 + 500 + 400
£0.505 weighted average price.
400 kg issued to Job 123 is a direct cost.
£9,946.50 + (16,000 X £1.46)
W2 x £1.45 weighted average price
6,970 + 16,000
Direct issues to the job are 270 kg (300 - 30) but 5 kg were
damaged and destroyed. It is unlikely that the damaged materials
are a direct consequence of the job and therefore it is incorrect to
regard the 5 kg as a direct cost to the job. If such losses are
expected to occur from time to time the cost of the lost materials
should be charged to departmental overheads and included in the
departmental overhead rate calculation. If such losses are abnor-
mal (as indicated in the question) they should not be charged as
product costs. Instead they should be charged to an abnormal
losses account (see Chapter 6) and written off to the Profit and
loss account as a period cost.
W3 Seventy-six hours have been directly identified to the job at the
hourly rate of £4.50. Six hours were overtime resulting in excess
payments. As these hours are likely to be due to the general high
level of production the overtime premium is included in the over-
head rate and shared out among all jobs. An additional three hours
rectification were spent on the job, but such a task is a normal part
of the work generally undertaken by the department. The cost of
rectification is therefore charged to overheads and included in the
overhead absorption rate. See section on defective units in Chapter
7 for the accounting treatment of the cost of rectification.

32 ACCOUNTING FOR OVERHEAD EXPENDITURE

 W4 110 hours are charged to the job. Of these, 30 hours were over-
time but this was a direct result of a customer's requirement on
another job. Therefore the overtime premium is not charged to
the job.
W5 All direct items can be ignored when calculating overhead rates
but direct materials include scrapped materials and direct labour
includes rectification work. However, scrapped materials are to be
regarded as abnormal costs but 20 hours rectification should be
charged to overheads. Department A overtime premium is part of
the overhead cost but the overtime premium for Department B is
charged directly to another customer.

Calculation of overhead rates:

Dept A DeptB
£ £
Rectification
(20 X £4.50) 90
Indirect labour 2,420 2,960
Overtime premium 450
Lubricants 520 680
Maintenance 720 510
Other 1,200 2,150
5,500 6,300

Direct labour hours 2,000 (£9,000 3 /£4.50) 2,800 (£11,200/£4)

Direct labour hour
overhead rate £2.70 £2.25

Note:
a£9,090 less £90 rectification cost.

(b) Information on the cost of individual jobs can be used as follows:

(i) for stock valuation of partly completed and completed jobs;
(ii) to determine the selling price of a product where no established
market price exists;
(iii) as an assessment of the profitability of a job when the selling price
is market determined.
Note that the job cost calculation may be inappropriate for decision-
making purposes. The major objective is to use the cost for stock valu-
ation purposes.

ANSWER TO QUESTION 4.24 - - - - - - - - - - - - - - - - - - - - - - - - - -

33
 Accounting entries for a
job costing system
Answers to Chapter 5

Question summary

5.1 to 5.3
Preparation of ledger accounts for an integrated accounting system.
5.4 to 5.6
Preparation of ledger accounts for an interlocking accounting system.
Question 5.5 also includes a reconciliation of the cost accounts with the
financial accounts.
5.7 and 5.8
Reconciliation of the cost and financial accounts.
5.9
Preparation of cost ledger accounts where extracts from the financial
accounts and the reconciliation of the costing and financial accounting
profit are given in the question.
5.10
Stores pricing on a weighted average basis and the preparation of the
raw materials and finished goods accounts.
5.11
Preparation of journal entries for payroll and labour cost accounting.
5.U
Preparation of the wages control accounts plus an evaluation of the
impact of a proposed piecework system.
5.13 to 5.17
Preparation of contract accounts.

-------------------------------35
ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM
IAnswer to question 5.1
(a) Stores ledger control account
£ £
Opening balance b/fwd 24,175 Materials issued:
Work in progress control 26,350
Creditors:
Materials purchased 76,150 Production overhead control 3,280
Closing stock c/fwd 70,695
---
£100,325 £100,325

Work in progress control account

£ £
Opening balance b/fwd 19,210 Finished goods control: 62,130
Stores ledger:
Materials issued 26,350
Wages control:
Direct wages 15,236
Production overhead control:
Overhead absorbed
(15,236 X 150%) 22,854
Profit and loss account:
Stock gain (see Note 1) 2,840 Closing stock c/fwd 24,360

£86,490 £86,490

Finished goods control account

£ £
Opening balance b/fwd 34,164 Profit and loss account:
Cost of sales 59,830
Work in progress:
Cost of goods sold 62,130 Closing stock c/fwd
(difference) 36,464
£96,294 £96,294

36------------------------------
ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM
 Production overhead control account
£ £
Prepayments b/fwd 2,100 W ark in progress:
Stores ledger: Overheads absorbed
Materials issued for repairs 3,280 (15,236 X 150%) 22,854
Wages control: Capital under construction
Idle time of direct workers 5,230 account:
Wages control: Overheads absorbed
Indirect workers' wages (2,670 X 150%) 4,005
(£3,342 + £890) 4,232 Profit and loss account
Cash/creditors: Under-absorbed overhead
Other overheads incurred 12,200 (balance) 183
£27,042 £27,042

Profit and loss account

£ £
Cost of goods sold 59,830 Sales 75,400
Gross profit c/fwd 15,570

£75,400 £75,400
Selling and distribution 5,240 Gross profit b/fwd 15,570
overheads Stock gain:
Production overhead control: W ark in progress 2,840
Under-absorbed overhead 183
Net profit c/fwd 12,987

£18,410 £18,410

Notes:
(1) The stock gain represents a balancing figure. It is assumed that the stock gain
arises from the physical count of closing stocks at the end of the period.
(2) The value of materials transferred between batches will be recorded in the sub-
sidiary records but will not affect the control (total) accounts.
(3) You may find it helpful if you prepare the Wages control account.

ANSWER TO QUESTION 5.1 37

 Wages control account
£ £
Direct wages: Work in progress 15,236
Wages accrued account 17,646 Capital equipment account 2,670
Employees' contributions Factory overhead:
account 4,364 Idle time 5,230
Indirect wages: Indirect wages 4,232
Wages accrued account 3,342
Employees' contributions
account 890
Balance (Wages accrued
account) 1,126
£27,368 £27,368

(b) (i) Large increase in raw material stocks. Is this due to maintaining
uneconomic stock levels or is it due to an anticipated increase in
production to meet future demand?
(ii) WIP stock gain.
(iii) Idle time which is nearly 25% of the total direct wages cost.
(iv) The gross direct wages are £22,010 (£17,646 + £4,364) but the allo-
cation amounts to £23,136 (£15,236 + £5,230 + £2,670).
(c) Stocks are valued at the end of the period because they represent unex-
pired costs which should not be matched against sales for the purpose of
calculating profits. Stocks represent unexpired costs which must be
valued for inclusion in the balance sheet. Manufacturing expense items
such as factory rent, etc. are included in the stock valuations because
they represent resources incurred in transforming the materials into a
more valuable finished product. SSAP 9 states: 'Costs of stock (and
WIP) should comprise those costs which have been incurred in bringing
the product to its present location and condition, including all related
production overheads.'

Answer to question 5.3

(a) Workings:
Fixed overhead absorption rate £301,352/27,100 machine hours
£11.12 per machine hour
Variable overhead absorption rate £96,021/£227,000
£0.423 per £ of direct labour
Fixed overheads absorbed 26,240 X £11.12 = £291,789
Variable overheads absorbed £212,630 X £0.423 = £89,942

38-------------------------------
ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM
 Direct materials stock
£ £
Opening balance 97,260 WIP: issues 417,264
WIP: returns 13,118 Materials suppliers: returns 8,263
Materials suppliers: Stock deficit (balance) 521
purchases 413,990 Closing balance 98,320

524,368 524,368

Manufacturing overheads
£ £
Suppliers: variable 90,672 WIP: variable overhead
Suppliers: fixed 300,876 absorbed 89,942
WIP: fixed overhead
absorbed 291,789
Variable overhead under-
absorbed; P&L Ale 730
Closing balance 9,087

391,548 391,548

Work in progress
£ £
Opening balance 15,668 Direct materials stock:
Direct materials stock: returns 13,118
issues 417,264 Completed production: to
Direct labour 212,630 P&L Ale (balance) 991,462
Variable overhead absorbed 89,942 Closing balance 22,713
Fixed overhead absorbed 291,789

1,027,293 1,027,293

Materials suppliers (creditors)

£ £
Bank: payments 389,761 Opening balance 56,473
Direct materials stock: Direct materials stock:
returns 8,263 purchases 413,990
Closing balance 72,439

470,463 470,463

ANSWER TO QUESTION 5.3 - - - - - - - - - - - - - - - - - - - - - - - - - - -

39
 (b) £
Sales 1,374,260
Less cost of sales:
Production costs 991,462
Direct materials stock deficit 521
Variable overhead under absorption 730
Selling and administration overheads 307,264

1,299,977

Net profit 74,283

IAnswer to question 5.5

(a) Raw materials stores account
£ £
Balance b/d 49,500 Work in progress 104,800
Purchases 108,800 Loss due to flood to
P&L account 2,400
Balance c/d 51,100

£158,300 £158,300

Balance b/d 51,100

Work in progress account

£ £
Balance b/d 60,100 Finished goods 222,500
Raw materials 104,800 Balance c/d 56,970
Direct wages 40,200
Production overhead 74,370

£279,470 £279,470

Balance b/d 56,970

Finished goods control account

£ £
Balance b/d 115,400 Cost of sales 212,100
Work in progress 222,500 Balance c/d 125,800

£337,900 £337,900

Balance b/d 125,800

Production overhead
£ £
General ledger control 60,900 Work in progress
(185% X £40,200) 74,370
Notional rent (3 x £4,000) 12,000
Overhead over-absorbed 1,470
£74,370 £74,370

40-------------------------------
ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM
 General ledger control account
£ £
Sales 440,000 Balance b/d ( 49,500 +
60,100 + 115,400) 225,000
Balance c/d 233,870 Purchases 108,800
Direct wages 40,200
Production overhead 60,900
Notional rent 12,000
P&L account
(profit for period, see (b)) 226,970

£673,870 £673,870
(b) Calculation of profit in cost accounts:
£
Sales: 440,000
Cost of sales 212,100
Loss of stores 2,400

214,500
Less overhead over-absorbed 1,470 213,030
Profit 226,970
Reconciliation statement (see Note):
£
Profit as per cost accounts 226,970
Differences in stock values:
Raw materials opening stock 1,500
Raw materials closing stock 900
WIP closing stock 1,030 3,430
WIP opening stock 3,900
Finished goods opening stock 4,600
Finished goods closing stock 3,900 (12,400) (8,970)
Add items not included in financial accounts:
Notional rent 12,000

Profit as per financial accounts £230,000

Note:
Stock valuations in the financial accounts may differ from the valuation in the cost
accounts. For example, raw materials may be valued on a LIFO basis in the cost
accounts whereas FIFO, or weighted average, may by use in the financial accounts.
WIP and finished stock may be valued on a marginal (variable costing) basis in the
cost accounts but the valuation may be based on an absorption costing basis in the
financial accounts. To reconcile the profits you should start with the profit from the
cost accounts and consider what the impact would be on the profit calculation if the
financial accounting stock valuations were used. If the opening stock valuation in the
financial accounts exceeds the valuation in the cost accounts then adopting the
financial accounting stock valuation will reduce the profits. If the closing stock valu-
ation in the financial accounts exceeds the valuation in the cost accounts then adopt-
ing the financial accounting stock valuation will increase profits. Note that the
notional rent is not included in the financial accounts and should therefore be added
to the costing profit in the reconciliation statement.

ANSWER TO QUESTION 5.5 - - - - - - - - - - - - - - - - - - - - - - - - - -

41
 (c) The over recovery of overhead could be apportioned between cost of
goods sold for the current period and closing stocks. The justification
for this is based on the assumption that the under/over recovery is due
to incorrect estimates of activity and overhead expenditure which leads
to incorrect allocations being made to the cost of sales and closing stock
accounts. The proposed adjustment is an attempt to rectify this incorrect
allocation.
The alternative treatment is for the full amount of the under/over
recovery to be written off to the cost accounting profit and loss account
in the current period as a period cost. This is the treatment recom-
mended by SSAP 9.

IAnswer to question 5.7

Interlocking accounts reconciliation
£ £
Profit per accounts 75,000
Add back Debenture interest 13,000
Write off of goodwill 20,000
Discounts allowed 7,000
Overheads 20,000
60,000
Less Rent received 25,000
Notional rent 14,000
Discounts received 5,000
Profit on machine 6,000
(50,000)
Stock adjustments Raw materials 2,000
Finished goods 6,000
8,000

Profit as per cost accounts 93,000

IAnswer to question 5.9

(a) Raw materials stock account
£ £
Opening stock (110 less 7) 103 Issues (difference) 578
Purchases 640 Returns (to supplier) 20
Closing stock (130 + 15) 145
£743 £743

ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM

42-------------------------------
 Work in progress account
£ £
Opening stock (25 + 3) 28 Finished goods account
Raw materials account 578 (difference) 984
Direct labour (220 + 20) 240 Closing stock (27 less 5) 22
Production overhead absorbed
(240 at 66213%) 160
£1,006 £1,006

Finished goods account

£ £
Opening stock (82less 9) 73 Cost of sales account
(difference) 989
Work in progress account 984 Closing stock (72 less 4) 68
£1,057 £1,057

Profit and loss account

£ £
Sales returns account 30 Sales account 1,530
Cost of sales account 989
Gross profit c/d 511
£1,530 £1,530

Production overheads Gross profit b/d 511

under-absorbed 2
Administration expenses 200
Net profit 309
£511 £511

The reconciliation statement indicates that discounts, selling expenses

and debenture interest are not included in the cost.accounts. Therefore
these items are not included in the costing profit and loss account.
(b) Interest on capital tied up in stocks should be taken into account for
decision-making and cost control purposes. This is because the interest
on capital tied up in stocks represents an opportunity cost (in terms of
the lost interest) which would have been earned if the money tied up in
stocks had been invested.
Interest on capital tied up in stocks should not be included in product
costs for stock valuation purposes as per SSAP 9. Therefore the cost
accumulation system will not include notional costs for stock valuation
purposes. Nevertheless, it is essential that all relevant costs (including
opportunity costs) are included in cost statements for the purposes of
decision-making and cost control.

43
ANSWER TO QUESTION 5.8 - - - - - - - - - - - - - - - - - - - - - - - - - -
j Answer to question 5.10
(a) Stores ledger card

Total Average price

Date Kilos value per kilo
(£) (£)
Opening balance 21,600 28,944 1.34
1 Issue (7,270) (9,742) 1.34
7 Purchase 17,400 23,490

31,730 42,692 1.3455 (£42,692/31,730)

8 Issue (8,120) (10,925) 1.3455
15 Issue (8,080) (10,872) 1.3455
20 Purchase 19,800 26,730

35,330 47,625 1.348 (£47,625/35,330)

22 Issue (9,115) (12,287) 1.348

Closing balance 26,215 35,338 1.348

Summary of transactions:
(£)
Opening balance 28,944
Purchases 50,220
Issues (43,826)

Closing balance 35,338

Raw material stock control account

(£) (£)
Opening balance 28,944 WIP 43,826
Purchases 50,220 Closing balance 35,338

79,164 79,164

Production costs for the period: (£)

Raw materials 43,826
Labour and overheads 35,407

79,233

Cost per unit (£79,233/17,150 units) £4.62

Units sold= opening stock (16,960) +production (17,150)

-closing stock (17,080) = 17,030 units

ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM

44---------------------------------
 Finished goods stock control account
(£) (£)
Opening balance 77,168 Cost of sales
Raw materials 43,826 (difference/
Labour and overhead 35,407 balancing figure) 77,491
Closing balance
(17,080 X £4.62) 78,910

156,401 156,4()1

(b) The financial ledger control account is sometimes described as a cost

control account or a general ledger adjustment account. For an explana-
tion of the purpose of this account see 'Interlocking accounting' in
Chapter 5.
(c) Budgeted production (units):
Sales 206,000
Add closing stock 18,128 (206,000 X 1.10 X 20/250)
Less opening stock (17,080)

207,048 units

For month 12 the raw material usage is 1.90 kilos per unit of output:
(7,270 + 8,120 + 8,080 + 9,115 = 32,585 kg used)/17,150 units produced
:. Budgeted material usage = 207,048 units x 1.9 kg per unit
= 393,391 kg
Budgeted material purchases
Budgeted usage 393,391 kg
Add closing stock 22,230 (11,700 x 1.9)
Less opening stock (26,215)
389,406 kg

IAnswer to question 5.13

(a) (i) Examples of long-term contract work include road building, civil
engineering, ship building and building of schools and hospitals.
(ii) Characteristics include:
(1) location of work may be remote from the contractor's main
office;
(2) high level of direct costs;
(3) the price of the contract may be fixed in advance.
(b) (i) For the answer to this question see the third paragraph of the
section headed 'Contract costing' in Chapter 5.
(ii) Attributable profit is that part of total profit which reflects the
profit attributable to that part of the work carried out at the
accounting date. Attributable profit should only be taken when the
outcome of the contract can be estimated with reasonable cer-
tainty. No profit should be taken in the early stage of the contract
because the outcome cannot be foreseen with reasonable certainty.

ANSWER TO QUESTION 5.13 45

 (iii) All of the anticipated loss should be recognized in accordance
with the prudence concept.

(c) Contract Account

£ £
Materials issued from Materials returned to
stores 600,000 stores 50,000
Wages paid 250,000 Materials on site c/fwd 20,000
Wages accrued 30,000 Value of plant c/fwd 60,000
Sub-contractors' charges 25,000 Cost of sales/work certified
Plant purchased at cost 100,000 (balance) c/fwd 900,000
Overheads 25,000
1,030,000 1,030,000

Cost of sales b/fwd 900,000 Attributable sales

Profit and loss a/c revenue 1,150,000
(profit taken) 250,000
1,150,000 1,150,000

Materials on site b/fwd 20,000 Wages accrued b/fwd 30,000

Value of plant b/fwd 60,000

Contractee's account
£ £
Value of work certified 1,200,000 Cash/Bank 1,000,000
Balance c/fwd 200,000

1,200,000 1,200,000

Note that the second section of the Contract account represents the con-
tract Profit and loss account. Attributable sales revenue is computed by
adding the profit taken to the cost of sales. The attributable profit taken
is calculated as follows:

Cash received to date (£1,000,000) x Estimated profit from

Contract price (£1,400,000) the contract (£350,000)
£250,000
Alternative more prudent approaches are possible for determining
attributable profit. The estimated profit from the contract is calculated
as follows:
£ £
Value of contract 1,400,000
Costs to date 900,000
Costs to completion 150,000 1,050,000

Anticipated profit £350,000

(d) (i) Under the old SSAP rules, Work in progress was valued as
follows: Costs to date, plus attributable profits, less progress pay-
ments received and receivable.

46 ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM

 (ii) Under the new rules, Work in progress is valued by deducting the
cost of work certified (cost of sales) from the cost to date.

IAnswer to question 5.15

a) Contract Accounts (for the previous year)
MNO PQR STU MNO PQR STU
£000 £000 £000 £000 £000 £000
Cost of contract to Wages accrued b/fwd 2
date b/fwd 190 370
Plant control account 8
Materials on site b/fwd 25 Materials on site c/fwd 8
Plant on site b/fwd 35 170 Plant on site c/fwd 70 110
Materials control Prepayments c/fwd 15
account 40 99 180
Wages control account 20 47 110 Cost of work not
certified c/fwd 26
Cost of work certified
cost of sales (balance) 82 411 786
Sub-contractors
account 35
Salaries 6 20 25
Plant control account 90 15
Wages accrued c/fwd 5
Apportionment of
construction services
(see Note 2) 4 10 22
160 421 937 160 421 937
Cost of sales b/fwd 82 411 786 Attributable sales revenue 82 390 915
Loss taken (1) 21
Profit taken this period (1) 114
Profit taken previous
periods (1) 15
82 411 915 82 411 915
Cost of work not certified b/f 26 Wages accrued b/fwd 5
Materials on site b/fwd 8
Plant on site b/fwd 70 110
Prepayment b/fwd 15

Notes:
(1) See (b)(i) for calculation.
(2) Costs incurred by construction services department
£000
Plant depreciation (12- 5) 7
Salaries 21
Wages paid 8
36

ANSWER TO QUESTION 5.15 47

 Wages incurred by each department are:
£000
MNO 20 (47 +5-2)
PQR 50
STU 110

180

The costs apportioned to each contract are:

£000
MNO 4 (20/180 X £36)
PQR 10 (50/180 X £36)
STU 22 (110/180 X £36)

36

(b) (i) Contract MNO: Nil

Contract PQR: £
Cost of contract to date (see part (a)) 411,000
Value of work certified 390,000

Recommended loss to be written off 21,000

Contract STU: £
Cost of work certified 786,000
Cost of work not yet certified 26,000
Estimated costs to complete 138,000

Estimated cost of contract 950,000

Contract price 1,100,000

Anticipated profit 150,000

The profit taken to date is calculated using the formula:

Cash received to date (£950,000) x Estimated profit from

Contract price (£1,100,000) the contract (£150,000)
= £129,545 (say £129,000)
The profit taken for the current period is £114,000 consisting of
the profit to date of £129,000 less the profit previously transferred
to the profit and loss account of £15,000.
(ii) Contract MNO: This contract is at a very early stage and it is
unlikely that the outcome can reasonably be foreseen. It is there-
fore prudent not to anticipate any profit at this stage.
Contract PQR: This contract has incurred a loss and applying the
prudence concept this loss should be written off as soon as it is
incurred.
Contract STU: Applying the prudence concept a proportion of the
profit, i.e. (Cash received to date)/( Contract price), is recognized
in this period. The proportion of profit that is recognized is arbi-
trary and very much a matter of opinion. Alternative apportion-
ments applying the concept of prudence could have been applied.

48 ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM

 Answer to question 5.17

(a) See section on contract costing in Chapter 5 for the answer to this
question.

(b) Contract Account

£000 £000
Cost of contract to date b/fwd 250 Materials on site c/fwd 18
Materials on site b/fwd 10 Stock discrepancy
Materials delivered to site 512 written off 4
Wages 487 Cost of work not certified
Hire of plant 96 c/fwd 35
Other expenses 74 Cost of work certified
Material discrepancies (1) 2 (cost of sales) c/fwd 1,453
General overhead
(£1,840 X 5% - 13) 79
£1,510 £1,510
Cost of sales b/fwd 1,453 Attributable sales revenue
Profit taken (2) 348 (£1,453 + £348) 1,801
£1,801 £1,801
Cost of work not certified b/fwd 35
Materials on site b/fwd 18

Notes:
(1) Opening stock (10) + Deliveries (512) - Closing stock (18) - Discrepancy
(4) = 500 materials booked. Discrepancy absorbed by contract is £2,000
(0.4% X £500,000).
(2) £
Cost of work certified 1,453
Cost of work not certified 35
Further costs to completion 215
Estimated cost of contract 1,703
Contract price 2,100
Anticipated profit 397

Profit taken= £397 x Value of work certified (£1,840) ~ £348

Contract price (2, 100)
It is assumed that no profit has been taken in previous periods. Note that
the contract is approximately 90% complete and the eventual profit can be
foreseen with reasonable certainty. Consequently it is inappropriate to be
excessively prudent in determining the amount of profit to be recorded in
the profit and loss account.

(c) The contract would be just over 50% complete but it is unlikely that the
eventual profit can be foreseen with reasonable certainty. It would be
reasonable to take some profit erring on the side of prudence. The profit
to date is £387,000 (Value of work certified (1,840) - Cost of work
certified (1,453)).

ANSWER TO QUESTION 5.17 - - - - - - - - - - - - - - - - - - - - - - - - -

49
 The following formula is one approach to applying the prudence
concept:
Cash received
Profit taken= 2/3 x Notional profit (387,000) x _ _ _ _ _ _ _ __
Value of work certified

ACCOUNTING ENTRIES FOR A JOB COSTING SYSTEM

50-------------------------------
 Process costing
Answers to Chapter 6

Question summary=================
6.1
An essay problem related to process costing.
6.2 to 6.4
Preparation of process accounts when there is no opening or closing work in
progress (WIP). Consequently, the problem of equivalent production does
not arise. These questions require the preparation of abnormal loss and gain
accounts.
6.5 and 6.6
Preparation of process accounts requiring the calculation of equivalent pro-
duction and cost per equivalent unit using the weighted average basis.
Neither problem includes any normal or abnormal losses.
6.7to 6.U
Calculation of equivalent production and cost per equivalent unit using the
weighted average basis. These questions include losses in process which are
charged only to completed production. Questions 6.8, 6.9, 6.11 and 6.12
involve losses in process which generate sales revenue. Questions 6.11 and
6.12 are the most difficult questions.
6.13 and 6.14
Questions similar to 6.7 to 6.12 with losses in process apportioned between
work in progress and completed production.
6.15
Preparation of process accounts with normal and abnormal losses not requir-
ing equivalent production calculations plus a description of weighted average
and FIFO methods of stock valuation.
6.16 to 6.19
Calculation of cost per equivalent unit using the FIFO basis. All of these
questions include losses in process. Question 6.19 is the most difficult ques-
tion requiring the calculation of unit costs for both the weighted average and
FIFO methods.
6.20
Cost control problem requiring the preparation of a performance report
using equivalent production calculations.

PROCESS COSTING - - - - - - - - - - - - - - - - - - - - - - - - - - - -
51
IAnswer to question 6.4
(a) (i) Process A account
Kg £ Kg £ £
Direct material 2,000 10,000 Normal loss 400 0.50 200
Direct labour 7,200 Process B 1,400 18.575 26,005
Process costs 8,400 Abnormal loss 200 18.575 3,715
Overhead 4,320

2,000 29,920 2,000 29,920

Unit cost= (£29,920- £200)/1,600 = £18.575

(ii) Process B account

Kg £ Kg £ £
Process A 1,400 26,005 Finished goods 2,620 21.75 56,989
Direct material 1,400 16,800 Normal loss 280 1.825 511
Direct labour 4,200 (10% X 2,800)
Overhead 2,520
Process costs 5,800

55,325
Abnormal gain 100 2,175

2,900 57,500 2,900 57,500

Unit cost= (£55,325- £511)/(2,800- 280) = £21.75

(iii) Normal loss/gain account

Kg £ Kg £
Process A 400 200 Bank (A) 400 200
Process B 280 511 Abnormal gain (B) 100 182.5
Bank (B) 180 328.5

680 711 680 711

(iv) Abnormal loss/gain

£ £
Process A 3,715 Process B 2,175
Normal loss/gain (B) 182.5 Bank 100
Profit & Loss 1,622.5
3,897.5 3,897.5

52---------------------------------------------
PROCESS COSTING
 (v) Finished goods
£ £
Process B 56,989

(vi) Profit and loss account (extract)

£ £
Abnormal loss/gain 1,622.5

IAnswer to question 6.5

(a) Cleansing agent process account
kg £ kg £
Ingredient A 2,000 1,600 Completed production 8,600 9,460
B 3,000 1,500 WIP c/fwd (1,170 + 516) 2,400 1,686
c 6,000 2,400
Wages 3,764
Overheads 1,882

11,000 £11,146 11,000 £11,146

Calculation of cost per unit:

Total Cost
Total Completed Equiv. Equiv. equiv. per
cost units WIP (1) WIP (2) units unit
£ £
Materials 5,500 8,600 600 1,800 11,000 0.50
Labour 3,764 8,600 360 450 9,410 0.40
Overheads 1,882 8,600 360 450 9,410 0.20
11,146 1.10

£
WIP (1): Materials 600 X £0.50 300
Labour 360 X £0.40 144
Overheads 360 x£0.20 72 516
WIP (2) Materials 1,800 X £0.50 900
Labour 450 X £0.40 180
Overheads 450 X £0.20 90 1,170
Completed units: 8,600 X £1.10 9,460

£11,146

Note that 11,000 kg were put into the process and 8,600 kg were com-
pleted. Therefore the WIP is 2,400 kg consisting of two batches - one
batch of 600 units 60% and the second batch of 1,800 units 25%
complete.

ANSWER TO QUESTION 6.5 - - - - - - - - - - - - - - - - - - - - - - - - - 53

 (b) See Chapter 6 for definitions and an explanation of the accounting treat-
ment of abnormal gains and equivalent units. See Chapter 7 for a
definition of by-products. Note that income from by-products should be
credited to the process account from which the by-product emerges.

IAnswer to question 6.8

(a) See the introduction to Chapter 6 for the answer to this question.

(b) The question does not specify at what point in the production process
the losses are detected. It is assumed that the losses are detected at the
end of the process when production is fully complete. Therefore normal
losses are not charged to WIP. The input to the process is 25,000 units
and the output consists of 15,000 completed units, 6,000 WIP and a
normal loss of 1,000 units (4% x 25,000). The balance of 3,000 units
represents the abnormal loss.

Statement of equivalent production and calculation of cost per unit

Total Cost
Comp. Abnormal Normal Closing equiv. per
Cost units loss loss WIP units unit WIP
£ £ £
Materials 62,000 15,000 3,000 1,000 6,000 25,000 2.48 14,880
Labour 44,000 15,000 3,000 1,000 4,000 23,000 1.913 7,652
Overhead 63,000 15,000 3,000 1,000 3,000 22,000 2.8636 8,592

169,000 7.2566 31,124

£
Cost of completed units (15,000 x £7.2566) 108,850
Add normal loss (1,000 x £7.2566-£2,000 scrap value) 5,256 114,106
Abnormal loss (3,000 x £7.2566) 21,770

167,000

Process Account
Units £ Units £
Materials 25,000 62,000 Finished goods stock 15,000 114,106
Labour 44,000 Normal loss 1,000 2,000
Overhead 63,000 Abnormal loss 3,000 21,770
WIP 6,000 31,124
25,000 169,000 25,000 169,000

Abnormal loss account

£ £
Process account 21,770 Profit and loss account 21,770

54 PROCESS COSTING
 The question implies that there is no scrap value in respect of abnormal
losses.
(c) See 'Normal and abnormal losses' Chapter 6 for the answer to this ques-
tion. Normal losses are assumed to be uncontrollable losses that are
inherent in the production process. Abnormal losses are avoidable and
controllable and the firm should investigate abnormal losses, ascertain
the reason for their ocurrence and take appropriate remedial action.

IAnswer to question 6.9

(a) The question does not indicate the stage in the production process when
the losses occur. It is assumed that losses are detected on completion.
Therefore the closing WIP is not charged with any of the loss and
normal and abnormal losses will be fully complete.

Abnormal loss= 10,000- (9,200 completed+ 200 WIP + 500 normal loss)
= 100 units

The calculation of the cost per unit and the value of WIP and completed
units is shown below:

WIP Total Cost

Completed Normal Abnormal equiv. equiv. per
units loss loss units units unit WIP
£ £ £
Materials (1) 2,350 9,200 500 100 200 10,000 0.235 47
Conversion
costs 8,000 9,200 500 100 120 9,920 0.806 97

10,350 1.041 144

£ £
Completed units (9,200 x £1.041) 9,581
Share of normal loss (500 x £1.041) 521
Less sale proceeds (500 x £0.10) 50 471
10,052
Abnormal loss (100 x £1.041) 104
WIP 144

10,300

Note that the cost of the input (£10,350) less sale proceeds of the normal
loss equals cost of output (£10,300).

Note:
(1) The cost of materials is the balancing figure in the Raw materials account.

55
ANSWER TO QUESTION 6.9 - - - - - - - - - - - - - - - - - - - - - - - - - -
 Raw materials account
£ £
Opening balance 600 Process account 2,350
Creditors 3,000 (difference)
Closing balance 1,250

3,600 3,600

Process account
Units £ Units £
Raw material 10,000 2,350 Normal loss 500 50
Conversion costs 8,000 Completed units 9,200 10,052
Abnormal loss 100 104
Closing WIP 200 144
----
10,000 10,350 10,000 10,350
----
Abnormal loss account
£ £
Process account 104 Scrap sales (100 x lOp) 10
P & L account 94

104 104

Normal loss (income due) account

£ £
Normal loss 50 Cash 50

(b) See section on contract costing in Chapter 5 and section on job and
process costing in Chapter 2 for the answer to this question.

IAnswer to question 6.10

(a) Production statement:
Input Output
Opening stock 3,400 Finished stock 36,000
Input 37,000 WIP 3,200
Normal loss 1,200

40,400 40,400

Cost statement:
WIP Total Cost
Opening Current Total Completed Normal equiv. equiv. per
stock cost cost units loss units units unit WIP
£ £ £ £ £ £ £ £
Materials 25,500 276,340 301,840 36,000 1,200 3,200 40,400 7.47 23,904
Conversion cost 30,600 336,000 366,600 36,000 1,200 1,600 38,800 9.45 15,120
668,440 16.92 39,024

55-----------------------------------------------
PROCESS COSTING
 Normal loss (1,200 x £16.92) 20,304
Completed units (36,000 x £16.92) 609,112 629,416
668,440

The question does not indicate at what stage in the production process
the normal loss is detected. It is assumed that the normal loss is detected
at the end of the production process, consequently it is not allocated to
WIP. Therefore, the total cost of production transferred to finished
stock is £629,416.
If the short-cut method described in Chapter 6 is adopted and the
normal loss equivalent units are excluded from the above unit cost cal-
culations the closing WIP valuation is £40,240 and the value of com-
pleted production is £628,200. This is equivalent to the following
calculation which apportions the normal loss between completed pro-
duction and WIP:

Completed
production WIP
£ £
Materials normal loss
(1,200 X £7.47 = £8,964) 8,232 (3,600/39,200) 732 (3,200/39,200)
Conversion cost normal loss
(1,200 X £9.45 = £11,340) 10,857 (36,000/37,600) 483
Normal loss allocation 19,089 1,215
WIP per cost statement 39,024
Completed production 609,112
628,201 40,239

(b) The following characteristics distinguish process costing from job

costing:
(i) The cost per unit of output with a process costing system is the
average cost per unit whereas job costing traces the actual cost to
each individual unit of output.
(ii) Job costing requires that a separate order and job number is used
to collect the cost of each individual job.
(iii) With a process costing system each unit of output is similar
whereas with a job costing system each unit of output is unique
and requires different amounts of labour, material and overheads.
(iv) With a job costing system costs are accumulated for each order
and WIP is calculated by ascertaining the costs which have been
accumulated within the accounting period. With a process costing
system costs are not accumulated for each order and it is neces-
sary to use the equivalent production concept to value WIP.
(v) With a process costing system the allocation of costs to cost of
goods sold and closing stocks is not as accurate because each cost
unit is not separately identifiable. Consequently, WIP is estimated
using the equivalent production concept.

ANSWER TO QUESTION 6.10 57

IAnswer to question 6.13
Statement of input and output (units):

Input Output
OpeningWIP 1,200 Completed and transferred to finished
stock 3,200
Transferred in 4,000 Normalloss 520
WIP (completed units) 500
Uncompleted WIP (balance) 980
5,200 5,200

It is not clear from the question at what point in the process the loss
occurs. It is assumed that the WIP has just passed the inspection point
and should be charged with a share of normal loss. By making no entry
for normal losses in the cost per unit calculation the normal loss is
apportioned automatically between completed units and WIP. You
could also have assumed that the loss was detected when the goods were
completed and charge all of the loss to completed production. If the
question does not specify when the loss occurs you should assume that it
occurs either at the end of the process or that the WIP has just passed
the inspection point. It is assumed that additional materials are added at
the start of the process.

Statement of cost per unit:

Opening Current Total Completed Equiv. Equiv. Cost
WIP cost cost units (WI) uncompleted total per
£ £ £ WIP units unit
Materials (W2) 10,800 34,830 45,630 3,700 980 4,680 9.75
Conversion cost 14,040 68,503 82,543 3,700 490 4,190 19.70
128,173 29.45

£
WIP: Completed units (500 x £29.45) 14,725
Uncompleted units: Materials (980 x £9.75) 9,555
Conversion cost (490 x £19.70) 9,653
33,933
Completed units transferred to finished stock
(3,200 X £29.45) 94,240
128,173

W1 Completed units = 3,200 + 500 (completed WIP).

W2 Materials include previous process cost (4,000 units at £7.50 each is
included in the current cost column).

56--------------------------------------------
PROCESS COSTING
 Process account
Units £ Units £
WIP b/fwd: 1,200 Normal loss 520
Materials 10,800 Transferred to finished
Conversion cost 14,040 stock 3,200 94,240
Transferred from Completed WIP c/fwd 500 14,725
previous process 4,000 30,000 Uncompleted WIP c/fwd 980 19,208
Materials 4,830
Direct wages 32,965
Overhead 35,538
5,200 128,173 5,200 128,173

IAnswer to question 6.15

(a) Expected output from an input of
39,300 sheets: 3,144,000 cans (39,300 x 80)
Less 1% rejects 31,440 cans
Expected output after rejects 3,112,560 cans

The normal loss arising from the rejects (31,440 cans) is sold at £0.26 per
kilo. It is therefore necessary to express the rejects in terms of kilos of
metal. Each sheet weighs 2 kilos but wastage in the form of offcuts is
2% of input. Therefore the total weight of 80 cans is 1.96 kilos (0.98 x 2
kilos) and the weight of each can is 0.0245 kilos (1.96 kilos/80 cans). The
weight of the normal loss arising from the rejects is 770.28 kilos (31,440
x 0.0245 kilos). The normal loss resulting from the offcuts is 1,572 kilos
(39,300 x 2 kilos x 0.02). Hence the total weight of the normal loss is
2,342.28 kilos (1,572 kilos + 770.28 kilos), with an expected sales value
of £609 (2,342.28 kilos x £0.26).

Process account
(£) (£)
Direct materials Finished goods
(39,300 X £2.50) 98,250 (3,100,760 cans x £0.042a) 130,232
Direct labour and Normal loss 609
overheads 33,087 Abnormal loss
(11,800 kilosb at £0.042a) 496
131,337 131,337

Abnormal loss account

(£) (£)
Process account 496 Sale proceedsc 75
Profit and loss account 421
496 496

ANSWER TO QUESTION 6.15 - - - - - - - - - - - - - - - - - - - - - - - - - 59

 Notes:
a Cost per unit = £98,250 + £33,087 - £609 = £0.042 per can
expected output (3,112,560 cans)
b Expected output (3,112,560 cans)- actual output (3,100,760 cans) =11,800 cans
c Abnormal loss =11,800 cans (3,112,560- 3,100,760)
This will yield 289.1 kilos (11,800 x 0.0245 kilos) of metal with a sales value of £75
(289.1 X £0.26).

(b) (i) See 'Opening and closing work in progress' in Chapter 6 for the
answer to this question.
(ii) See 'Weighted average method' and 'First in, first out method' in
Chapter 6 for the answer to this question.

IAnswer to question 6.16

(a) Production statement:
Input Blocks Output Blocks
OpeningWIP 400 Closing stock 500
Loss 300
Transfer from previous Completed units (balance) 4,100
process 4,500

4,900 4,900

Statement of equivalent production and calculation of cost and completed

production (FIFO) method):
Closing Current
Completed units WIP total Cost
Current less opening Abnormal equiv. equiv. per
costs WIP equiv. units loss units units unit
£ £
Previous process costs 9,000 3,700 (4,100- 400) 300 500 4,500 2.0
Materials 4,360 3,780 (4,100- 320) 180 (60%) 400 (80%) 4,360 1.0
Labour and overhead 2,125 3,860 (4,100- 240) 90 (30%) 300 (60%) 4,250 0.50

15,485 3.50

Cost of completed production: £ £

Opening WIP (given) 1,000
Previous process cost (3,700 x £2) 7,400
Materials (3,780 x £1) 3,780
Labour and overhead (3,860 x £0.50) 1,930 14,110
Cost of closing WIP:
Previous process cost (500 x £2) 1,000
Materials (400 x £1) 400
Labour and overhead (300 x £0.50) 150 1,550
Cost of abnormal loss:
Previous process cost (300 x £2) 600
Materials (180 x £1) 180
Labour and overhead (90 x £0.50) 45 825

60 PROCESS COSTING
 Process 3 account
Blocks £ Blocks £
OpeningWIP 400 1,000 Abnormal loss 300 825
Transfer from Process 2 4,500 9,000 Completed production
Current cost: transferred to
Materials 4,360 finished stock 4,100 14,110
Labour and overhead 2,125 Closing WIP 500 1,550
16,485 16,485

Abnormal loss account

Process 3 account 825 Cash/bank 300
Profit and loss account 525
825 825

(b) Closing stocks are valued in order that costs can be matched with
revenue for profit measurement purposes. The costs attached to the
closing WIP represent the unexpired costs of the process for the period.

IAnswer to question 6.17

(a)
Production statement
Input: Units
OpeningWIP 20,000
Transfer from previous process 180,000
200,000
Output:
Closing WIP 18,000
Abnormal loss 60
Completed units (balance) 181,940
200,000

Statement of equivalent production and calculation of cost of completed production and WIP
Completed units Closing Current Cost
Current less opening WIP total per
costs WIP equivalent Abnormal equivalent equivalent unit
(£) units loss units units (£)
Previous process
cost 394,200 161,940 60 18,000 180,000 2.19
Materials 110,520 167,940 60 16,200 184,200 0.60
Conversion cost 76,506 173,940 60 12,600 186,600 0.41
581,226 3.20

ANSWER TO QUESTION 6.17 61

 £ £
Cost of completed production:
Opening WIP (given) 55,160
Previous process cost (161,940 x £2.19) 354,649
Materials (167,940 x £0.60) 100,764
Conversion costs (173,940 x £0.41) 71,315 581,888

Cost of closing WIP:

Previous process cost (18,000 x £2.19) 39,420
Materials (16,200 x £0.60) 9,720
Conversion costs (12,600 x £0.41) 5,166 54,306
Value of abnormal loss (60 x £3.20) 192
636,386

Process 3 account
£ £
Opening WIP 55,160 Transfer to finished goods
Transfer from process 2 394,200 stock 581,888
Materials 110,520 Abnormalloss 192
Conversion costs 76,506 Closing WIP 54,306
636,386 636,386

(b) Normal losses are unavoidable losses that are expected to occur under
efficient operating conditions. They are an expected production cost and
should be absorbed by the completed production whereas abnormal
losses are not included in the process costs but are removed from the
appropriate process account and reported separately as an abnormal
loss. See 'Equivalent production and normal losses' in Chapter 6 for a
more detailed explanation of the treatment of normal losses.
(c) It' the weighted average method is used, both the units and value of WIP
are merged with current period costs and production to calculate the
average cost per unit. The weighted average cost per unit is then applied
to all completed units, any abnormal losses and closing WIP equivalent
units. In contrast, with the FIFO method the opening WIP is assumed to
be the first group of units completed during the current period. The
opening WIP is charged separately to completed production, and the
cost per unit is based only on current costs and production for the
period. The closing WIP is assumed to come from the new units that
have been started during the period.

62-----------------------------------------------
PROCESS COSTING
IAnswer to question 6.20
(a) Opening WIP Total Cost
Cost WIP Current Total Completed equivalent equivalent per WIP
element value cost cost units units units unit value
£ £ £ £ £
Direct materials 17,400 162,600 180,000 8,200 800 9,000 20 16,000
Conversion 10,000 173,920 183,920 8,200 160 8,360 22 3,520
363,920 42 19,520

Completed units 8,200 x £42 344,400

Total cost 363,920
Process account
Units £ Units £
OpeningWIP 1,000 27,400 Process B 8,200 344,400
Materials 8,000 162,600 Closing WIP c/d 800 19,520
Conversion cost 173,920

363,920 363,920

(b) Calculation of equivalent production produced during current period:

Equivalent units
Total equivalent Opening WIP produced during
units equivalent units period
Materials 9,000 1,000 8,000
Conversion cost 8,360 400 7,960

Performance report:
Standard cost Actual cost Difference
£ £ £
Materials 160,000 (8,000 X £20) 162,600 2,600A
Conversion cost 183,080 (7,960 X £23) 173,920 9,160F

6,560F

ANSWER TO QUESTION 6.20 - - - - - - - - - - - - - - - - - - - - - - - - - 63

 Joint product and
by-product costing
Answers to Chapter 7

Question summary================
7.1 to 7.3
Discussion problems on joint and by-products.
7.4to 7.6
Preparation of process accounts and the apportionment of joint costs to
products. Question 7.6 is also concerned with the accounting treatment of
by-products.
7.7
Preparation of a flow chart for joint and by-products and calculation of a
cost per unit.
7.8 to 7.15
Apportionment of joint costs and decisions on whether or not a product
should be further processed.

IAnswer to question 7.4

(a) Process 1
kg £ kg £
Materials 7,000 3,500 Normal loss (W2) 700 280
Labour and overhead 4,340 Transferred to
Abnormal gain (W3) 130 156 process 2 (W1) 6,430 7,716

7,130 7,996

Workings:
(1) Costperunit
Cost of production (£7,840) less Scrap value of normal loss (£280)
Expected output (6,300 kg)
= £1.20 per kg
(2) Normal loss is 10% of total output, which in this case is equivalent
to total input, i.e. Normal loss= 10% x (6,430 + 570)
(3) Abnormal gain= Actual output (6,430) less expected output (6,300).

JOINT PRODUCT AND BY-PRODUCT COSTING

--------------------------------------- 65
 Normal loss account Abnormal gain account
£ £ £ £
Process 1 (700 x 40p) 280 Abnormal gain Normal loss Process 1 156
a/c (130 x 40p) 52 (130 X 40p) 52
P & La/c 104
Cash (570 x 40p) 228

280 280 156 156

(b) Process 2
Kg £ Kg £
Previous process cost 6,430 7,716 By product net income 430 645
Labour and overhead 12,129 Output to be accounted for 19,200
E = 2,000, F = 4,000, total 6,000

6,430 19,845 6,430 19,845

The allocation of £19,200 toE and F depends on the apportionment method used.

(i) Physical output method:

E F
£ £

(1) Total output cost 6,400 [ 2 •000 X £19 200] 12,800 [ 4 ,000 X £19 200]
6,000 ' 6,000 '

(2) Closing stock 2,880 [ 2,000-1,100 X £6 400 ] 2,560 [ 4,ooo-3,200x£12 800]

2,000 ' 4,000 '

(3) Cost of sales 3,520 [ 1 •100 X £6 400] 10,240 [ 3•200 X £12 800]
2,000 ' 4,000 '

(4) Sales revenue 7,700 (1,100 X £7) 8,000 (3,200 X £2.50)

(5) Profit, (4)- (3) 4,180 (2,240)

(ii) Market value of output method:

E F
£ £
(1) Market value of output 14,000 (2,000 X £7) 10,000 (4,000 X £2.50)
(2) Cost of output 11,200 (£19,200 X 14/24) 8,000 (£19,200 X 10/24)
(3) Closing stock 5,040 (£11,200 X 900/2,000) 1,600 (£8,000 X 800/4,000)
(4) Cost of sales 6,160 (£11,200 X 1,100/2,000) 6,400 (£8,000 X 3,200/4,000)
(5) Sales revenue 7,700 8,000
(6) Profit (5) - (4) 1,540 1,600

JOINT PRODUCT AND BY-PRODUCT COSTING

66-----------------------------------
 (c) See Chapter 7 for the answer to this question. In particular the answer
should stress that joint cost apportionments are necessary for stock valu-
ation but such apportionments are inappropriate for decision-making.
For decision-making, relevant costs should be used. It can be seen from
the answer to part (b) that one method of apportionment implies that F
makes a loss whereas the other method indicates that F makes a profit.
Product F should only be deleted if the costs saved from deleting it
exceed the revenues lost.

Answer to question 7.7

(a) See Fig. 7.7 for the answer to this question.

Heat Second Product Blending

treatment distillation £1155
f------------~ X 1-------.,

225 tonnes
X £18 (W2)
=£4050
X1 f------+--IXXX
Input
1000 75 tonnes x £18 (W2) 555 tonnes
tonnes z =£1350 X £15 (W4)
£4000 = £8325

80 tonnes x £19 (W3) = £1520

100tonnes

Figure 7.7 Answer to Question 7.7(a)

Workings:
W1 ( 4,000 + 2,600- 300) + 900 = £7
W2 (2,100 + 3,300) + 300 = £18
W3 (1,400 + 2,400) + 200 = £19
W4 (2,800 + 1,500 + 1,155 + 1,350 + 1,520) + 555 = £15
(b) Product Output ( tonnes) Total cost Cost per tonne
£ £
XXX 555 8,325 15
y 225 4,050 18
z 120 2,280 19

(c) An alternative treatment is to credit the income direct to the Profit and
loss account rather than crediting the proceeds to the process from
which the by-product was derived.

67
ANSWER TO QUESTION 7.7 - - - - - - - - - - - - - - - - - - - - - - - - - - -
IAnswer to question 7.8
(i) B K c Total
£ £ £ £
Revenue 35,000 50,000 60,000
Pre-separation joint costs (1) 17,500 12,500 10,000
Post separation costs 20,000 10,000 22,500

Profit/ (loss) (2,500) 27,500 27,500 52,500

(ii) Incremental costs 20,000 10,000 22,500

Incremental revenue 14,000 30,000 42,000

Incremental benefit (6,000) 20,000 19,500

Therefore profit will increase by £6,000 if B is sold at split off

point and the revised product statements will be:

Revenue 21,000 50,000 60,000

Pre-separation costs (1) 17,500 12,500 10,000
Post separation costs 10,000 22,500

Profit 3,500 27,500 27,500 58,500

Note
(1) B = 3,500/8,000 x £40,000; K = 2,500/8,000 x £40,000; C= 2,000/8,000
X £40,000.

IAnswer to question 7.10

(a) (i)

(1) (2) (3) (4) (5)

Sales value Proportion Joint costs Cost per Stock
Product of production to total apportioned (1) kg (2) valuation (3)
£ £ £ £
A 700,000 7/30 420,000 30 60,000
B 1,200,000 4/10 720,000 36 108,000
c 1,000,000 113 600,000 24 96,000
D 100,000 1130 60,000 60 60,000

3,000,000 1,800,000 324,000

(1) Column 2 x £1,800,000.

(2) Joint cost apportioned+ kg produced.
(3) (Sales- production) x cost per kg.

68 - - - - - - - - - - - - - - - - - - - · JOINT PRODUCT AND BY-PRODUCT COSTING

 £ £
(ii) Sales: A (12,000 x £50)= 600,000
B (17,000 X £60) = 1,020,000
C (21,000 X £40) = 840,000 2,460,000
Joint cost of production 1,800,000
Less closing stock 324,000 1,476,000
Profit 984,000

(b) Cost information for decision-making should not be based on joint cost
allocations and yet the question is requiring candidates to use joint cost
allocations. The correct approach is to compare additional relevant
revenues with additional relevant costs:

A B c
£ £ £
Additional revenues 10 10 10
Additional variable cost 7 8 9
Contribution to fixed costs 3 2 1
Additional fixed costs per month 20,000 16,000 12,000
(Cost + 72 months)
Number of units sold to justify
further processing 6,667 8,000 12,000
(Fixed costs+ Unit contribution)

As long as the average monthly sales exceed the above output levels
further processing is justified.
An alternative approach would be:

A B c Total
£ £ £
Additional sales revenue per
month 120,000 170,000 210,000
Additional variable costs per
month (84,000) (136,000) (189,000)
Additional depreciation per
month (20,000) (16,000) (12,000)
Additional monthly profit 16,000 18,000 9,000 43,000

The above calculations are based on the sales volume given in part (a)
of the question.

ANSWER TO QUESTION 7.10 - - - - - - - - - - - - - - - - - - - - - - - - - -

69
IAnswer to question 7.11
(a) Operating statement for October 1979:
£ £
Sales: Product A (80,000 x £5) 400,000
Product B (65,000 x £4) 260,000
Product C (75,000 x £9) 675,000 1,335,000

Operating costs 1,300,000

Less closing stock ( 1) 200,000 1,100,000

Profit 235,000

Note:
Production for the period in kg:

A B c Total
Sales requirements 80,000 65,000 75,000
Closing stock 20,000 15,000 5,000

Production 100,000 80,000 80,000 260,000

£1,300,000
Cost per kg= = £5 per kg
260,000 kg

:. Closing stock = 40,000 kg at £5 per kg

(b) A B c Total
£
Incremental revenue per kg (£) 12 10 11.50
Variable cost per kg(£) 4 6 12.00

Contribution per kg (£) 8 4 (0.50)

Monthly production (kg) 100,000 80,000 80,000

Monthly contribution (£) 800,000 320,000 (40,000) 1,080,000

Monthly fixed overheads
(specific to B) 360,000 360,000

Contribution to refining general

fixed costs (£) 800,000 (40,000) (40,000) 720,000
Refining general fixed overheads 700,000

Monthly profit 20,000

Comments:
(1) It is more profitable to sell Product C in its unrefined state, and
Product B is profitable in its refined state only if monthly sales are
in excess of 90,000 kg (£360,000 fixed costs + £4 contribution per
unit).

70-----------------------------------
JOINT PRODUCT AND BY-PRODUCT COSTING
 (2) If both Products B and C are sold in their unrefined state then the
refining process will yield a profit of £100,000 per month (£800,000
Product A contribution less £700,000 fixed costs).
(3) The breakeven point for the refining process if only Product A
were produced is 87,500 kg (£700,000 fixed costs+ £8 contribution
per unit). Consequently, if sales of A decline by 121/z% the refining
process will yield a loss. Note that 80,000 kg of A were sold in
October.

Answer to question 7.14

(a) You can see from the question that the input is 240,000 kg and the
output is 190,000 kg. It is assumed that the difference of 50,000 kg is a
normal loss in output which occurs at the start of processing. Therefore
the loss should be charged to the completed production and WIP. By
making no entry for normal losses in the cost-per-unit calculation, the
normal loss is apportioned automatically between completed units and
WIP.
Total Cost
Opening Current Total Completed Closing equiv. per WIP
WIP cost cost units WIP units unit value
£ £ £ £ £
Materials 20,000 75,000 95,000 160,000 30,000 190,000 0.50 15,000
Processing cost 12,000 96,000 108,000 160,000 20,000 180,000 0.60 12,000
203,000 1.10 27,000
Completed units (160,000 units x £1.10) 176,000
203,000

(b) This question requires a comparison of incremental revenues and incre-

mental costs. Note that the costs of Process 1 are irrelevant to the deci-
sion since they will remain the same whichever of the two alternatives is
selected. You should also note that further processing 120,000 kg of the
compound results in 240,000 kg of Starcomp.

Incremental sales revenue: £ £

Starcomp (120,000 x 2 kg x £2) per kg 480,000
Compound (120,000 x £1.60) 192,000 288,000
Incremental costs: Materials 120,000
Processing cost 120,000 240,000
Incremental profits 48,000

It is therefore worthwhile further processing the compound.

(~) The sales revenue should cover the additional costs for further pro-
cessing the 40,000 kg compound and the lost sales revenue from the
40,000 kg compound if it is sold without further processing.

ANSWER TO QUESTION 7.14 - - - - - - - - - - - - - - - - - - - - - - - - - -

71
 Additional processing costs: £
Materials (£160,000- £120,000) 40,000
Processing costs (£140,000- £120,000) 20,000
Lost compound sales revenue (40,000 x £1.60) 64,000

124,000

£124,000
Minimum selling price per kg of Starcomp = £1.55
40,000 kg X 2

IAnswer to question 7.15

(a) Profit and loss account
w X z Total
(£) (£) (£) (£)
Opening stock 8,640 8,640
Production cost 189,060 228,790 108,750 526,600
Less closing stock (14,385) (15,070) (15,010) ( 44,465)

Cost of sales 174,675 213,720 102,380 490,775

Selling and administration costs 24,098 27,768 10,011 61,877

Total costs 198,773 241,488 112,391 552,652

Sales 240,975 277,680 100,110 618,765

Profit/ (loss) 42,202 36,192 (12,281) 66,113

Workings:
Joint process cost per kilo of output = £0.685 per kg (£509,640/
744,000 kg)
Production cost for products W, X andY:
Product W (276,000 kg x £0.685) £189,060
X (334,000 kg X £0.685) £228,790
Y (134,000 kg X £0.685) £91,790
Closing stocks for product W and X:
Product W (21,000 kg x £0.685) £14,385
X (22,000 kg X £0.685) £15,070
Cost per kilo of product Z:
(£)
Product Y (128,000 kg x £0.685) 87,680
Further processing costs 17,920
Less by-product sales (8,000 x £0.12) (960)

104,640

Cost per kilo (£104,640/96,000 kg) £1.09

72 - - - - - - - - - - - - - - - - - - - • JOINT PRODUCT AND BY-PRODUCT COSTING

 Closing stock of product Z (10,000 kg x £1.09) £10,900
Add closing stock of input Y (6,000 kg x £0.685) = £4,110
Closing stock relating to product Z £15,010

Production cost relating to final product Z:

£
Product Y (134,000 kg x £0.685) 91,790
Further processing costs 17,920
Less by-product costs (960)

108,750

(b) The joint costs are common and unavoidable to both alternatives, and
are therefore not relevant for the decision under consideration. Further
processing from an input of 128,000 kg of Y has resulted in an output of
96,000 kg of Z. Thus it requires 1.33 kg of Y to produce 1 kg of Z
(128/96).
(£)
Revenue per kilo for product Z 1.065 (£100,110/94,000 kg)
Sale proceeds at split-off point
(1.33 X £0.62) 0.823
Incremental revenue per kg from
further processing 0.242
Incremental costs of further processing 0.177 [(£17,920- £960)/96,000]
Incremental profit from further
processing
0.065

It is assumed that selling and administration costs are fixed and will be
unaffected by which alternative is selected. The company should there-
fore process Y further into product Z and not accept the offer from the
other company to purchase the entire output of product Y.
(c) See 'Methods of apportioning joint costs to joint products' in Chapter 6
for the answer to this question.

ANSWER TO QUESTION 7.15 - - - - - - - - - - - - - - - - - - - - - - - - - - 73

 Absorption costing and
variable costing
Answers to Chapter 8

Question summary

8.1and 8.2
Discussion questions relating to Chapter 8.
8.3 to 8.14
Preparation of variable costing and absorption costing profit statements and
computation of stock valuations. Questions 8.7, 8.8, 8.10 and 8.13 require the
reconciliation of absorption costing and variable costing profits. Question
8.11 also requires a statement of equivalent production in order to calculate
product costs. The most difficult questions are 8.12 to 8.14. Question 8.14
involves the re-apportionment of service department costs and the calcula-
tion of overhead rates prior to the preparation of profit statements.

Answer to question 8.5

(a)
Calculation of unit costs £
Direct material cost 10.00
Direct wages cost 4.00
Variable overhead cost 2.50
Variable manufacturing cost 16.50
Fixed manufacturing overhead (£400,000/320,000 units) 1.25
Total manufacturing cost 17.75

ABSORPTION COSTING AND VARIABLE COSTING - - - - - - - - - - - - - - - - - - - - - 75

 PROFIT STATEMENTS

(i) Marginal costing January-March April-June

£000 £000
Opening stock Nil 165
Production costs:
variable 1,155 (70,000 X £16.50) 1,650 (100,000 X £16.50)
Closing stock (165) (10,000 X £16.50) (330) (20,000 X £16.50)

990 1,485
Selling and distribution costs: variable 90 135
1,080 1,620
Revenue from sales 2,700 4,050

Contribution 1,620 2,430

Fixed production costs (100) (100)
Fixed selling and distribution costs (20) (20)
Fixed administration costs (30) (30)

Budgeted profit 1,470 2,280

(ii) Absorption costing £000 £000

Opening stock Nil 177.5

Total production costs 1,242.5 (70,000 X £17.75) 1,775.0 (100,000 X £17.75)

1,242.5 1,952.5
Closing stock (177.5) (10,000 X £17.75) (355.0) (20,000 X £17.75)
1,065.0 1,597.5
Add under absorption of production
overhead (10,000 x 1.25) 12.5
Less over absorption of production
overhead (20,000 x 1.25) (25.0)
Total selling and distribution costs 110.0 155.0
Administration costs 30.0 30.0
1,217.5 1,757.5
Revenue from sales 2,700.0 4,050.0
Budgeted profit 1,482.5 2,292.5

(b) The difference in profits of £12,500 is due to the fact that part of the
fixed production overheads (10,000 units at £1.25 per unit) are included
in the closing stock valuation and not recorded as an expense during the
current period. With the marginal costing system all of the fixed manu-
facturing costs incurred during a period are recorded as an expense of
the current period.
(c) It is assumed that the question requires the production overhead
account to be written up only in respect of fixed production overhead.

76----------------------------------
ABSORPTION COSTING AND VARIABLE COSTING
 Fixed Production Overhead Control Account
£ £
Actual expenditure 102,400 WIP Ale (74,000 x £1.25) 92,500
Under-absorption transferred
toP & L a/c 9,900

102,400 102,400

(d) See 'Some arguments in support of variable costing' for the answer to
this question.

IAnswer to question 8.6

(a) (i) % direct material cost:
Fixed production overhead (100,000)
- - - - - - - - - - - - - x 100 = 66.67% of direct material cost
Direct materials (150,000)

(ii) Machine hour rate:

Fixed production overhead (£100,000)/Machine hours (25,000) =
£4 per machine hour

(b) Charged to estimate No. 1234 using:

% direct material cost= £2,000 (66.67% x £3,000)
Machine hour rate= £3,200 (800 x £4)

(c)

Absorption Marginal
£ £
Materials 250,000 250,000
Labour 250,000 250,000
Fixed overhead (50,000 x £2.50) 125,000

Production cost 625,000 500,000

Closing stock:
Material 15,000 15,000
Labour 20,000 20,000
Overhead (4,000 x £2.50) 10,000 45,000 35,000

Cost of sales 580,000 465,000

Fixed costs 130,000
Under-absorbed overhead 5,000

585,000 595,000
Sales 600,000 600,000

Profit 15,000 5,000

77
ANSWER TO QUESTION 8.6 - - - - - - - - - - - - - - - - - - - - - - - - - -
I Answer to question 8.8
(a)
Variable cost per unit: £
Variable production cost 49
Variable non-manufacturing costs (20% off sales value) 28

77

Manufacturing absorption cost per unit 69

Fixed costs for the period (£20 x 16,000 units) £320,000 per annum
(£160,000 per six months)

(i) Marginal costing profit statements

March 1993 September 1993
£ £
Opening stock 73,500 (1,500 X £49)
Variable production costs 416,500 (8,500 X £49) 343,000 (7,000 X £49)
Less closing stock (73,500) (1,500 X £49) (24,500) (500 X £49)
343,000 392,000
Variable non-manufacturing costs 196,000 (7,000 X £28) 224,000 (8,000 X £28)
539,000 616,000
Sales 980,000 (7,000 X £140) 1,120,000 (8,000 X £140)

Contribution 441,000 504,000

Fixed costs
(£160,000 + £180,000/2) 250,000 250,000
Profit 191,000 254,000

(ii) Absorption costing profit statements

March 1993 September 1993
£ £
Opening stock 103,500 (1,500 X £69)
Production cost 586,500 (8,500 X £69) 483,000 (7,000 X £69)
Less closing stock (103,500) (1,500 X £69) (34,500) (500 X £69)
483,000 552,000
Under- (over-) recovery of
fixed overheads (10,000) (500 X £20) 20,000 (1,000 X £20)
473,000 572,000
Variable non-manufacturing costs 196,000 (7 ,000 X £28) 224,000 (8,000 X £28)
Fixed non-manufacturing costs 90,000 90,000
759,000 886,000
Sales 980,000 1,120,000
Profit 221,000 234,000

78---------------------------------
ABSORPTION COSTING AND VARIABLE COSTING
 (b) With a marginal costing system all of the fixed manufacturing overhead
incurred during a period is charged as an expense whereas fixed over-
heads are included in the stock valuations with the absorption costing
system. In the first period fixed overheads of £30,000 (1,500 x £20) are
included in the closing stock valuation and not charged as an expense of
the current period. Therefore the absorption costing profits exceed the
marginal costing profits by £30,000. In the second period stocks increase
by 1,000 units and the absorption costing statement includes £20,000
(1,000 x £20) in the stock movements. This results in absorption costing
profits being £20,000 less than the marginal costing profits. The follow-
ing is a reconciliation of the profit statements:

31st March 30th September

£ £
Marginal costing profits 191,000 254,000
Fixed production overheads included
in increases/ (decreases) in stock
movements 30,000 (20,000)
221,000 234,000

(c) For an explanation of those situations where marginal costing may be

beneficial in making decisions you should refer to Chapter 10 in respect
of the following situations:
(i) deleting a segment;
(ii) make or buy decisions;
(iii) pricing decisions;
(iv) product mix decisions where limiting factors exist;
(v) equipment replacement decisions.

Answer to question 8.12

(a) Absorption costing profit and loss account:
Period 2 Period 3
£ £ £ £
Sales 220,000 360,000
Cost of sales ( 1):
Opening stock 90,000 198,000
Cost of production 306,000 234,000
396,000 432,000
Less closing stock 198,000 108,000
Cost of sales 198,000 324,000
Under- (over-) absorbed fixed
overhead (2) (12,000) 186,000 12,000 336,000
Profit 34,000 24,000

ANSWER TO QUESTION 8.12 79

 Notes:
(1) Cost of sales calculated at £18 per unit (£12 variable cost+ £6 fixed cost).
(2) Period 1 Period 2
£ £
Fixed overhead incurred 90,000 90,000
Fixed overhead charged
to production 102,000 (17,000 X £6) 78,000 (13,000 X £6)

Under- (over-) recovery (12,000) 12,000

(b) (i) There are several approaches which can be used to reconcile the
profits between the two periods. The profits are reconciled on an
absorption costing basis because the profits are calculated on this
basis and this is also the system which is currently used by the
company.
Reconciliation of Period 2 and Period 3 profits £
Increase in sales 140,000
Less increase in cost of sales 126,000

14,000
Net change in under-/( over-) absorbed profits:
Period 2: Over-absorbed (12,000)
Period 3: Under-absorbed 12,000
Over-absorbed increases profits by £12,000
and under-absorbed decreases profits by
£12,000 therefore effect on difference on profits (24,000)

Decline in profits 10,000

(ii) The managing director has assumed that fixed costs are constant
per period at £90,000 and that the increase in sales of 7,000 units
will cause sales to increase by £140,000 (7,000 x £20) and variable
costs to increase by £84,000 (7,000 x £12). The difference repre-
sents an increase in profits of £56,000. In other words, the manag-
ing director has used a variable costing approach to calculate the
increase in profits.
(iii) With an absorption costing system the amount of fixed overhead
charged against profits for a period may be different from the
amount of fixed overheads incurred for that period. This is
because a proportion of the fixed overheads is included in the
stock valuation.
In Period 2 stocks have increased by 6,000 units whereas in
Period 3 stocks have declined by 5,000 units. The effect is as follows:

Period 1: £
Reduction in fixed overhead charge for the period
due to fixed overheads being included in the stock
increase (6,000 x £6) 36,000

80----------------------------------
ABSORPTION COSTING AND VARIABLE CD STING
 Period 2:
Increase in fixed overhead charge for period due to
decrease in stocks for period (5,000 x £6) 30,000

Therefore fixed overhead charged as an expense is as follows:

Absorption costing Variable costing

Period 2 £ 54,000 (£90,000- £36,000) £90,000
Period 3 £120,000 (£90,000 + £30,000) £90,000
Difference £ 66,000 Nil

With absorption costing extra fixed overhead charges due to stock

movements are £66,000 compared with zero for variable costing.
This accounts for the difference in profits between the two
systems:
£
Period 3: Variable costing profits increase 56,000
Period 3: Absorption costing profits decrease 10,000
Extra profits with variable costing 66,000

IAnswer to question 8.13

(a) Fixed costs (£180,000)
BE point = 45,000 units per period
Unit contribution (£10- £6)

(b) Period 1 Period 2 Period 3

£000 £000 £000
Opening stock 180
Production cost at £9 per
unit (W1) 630 (70 X £9) 360 (40 X £9) 540 (60 X £9)

630 540 540

Less closing stock 180 (20 X £9) 180 (20 X £9)
450 540 360
Under-/( over-) recovery of
fixed overheads (W2) (30) 60
Variable overhead expenditure
variance (W3) (2) 5

Total cost 418 605 360

Sales 500 600 400
Profit/ (loss) 82 (5) 40

ANSWER TO QUESTION 8.13 81

 Workings:
W1 Variable cost per unit = £6
Fixed cost per unit = £3 (180,000 + 60,000 units)

£9

W2 Period 110,000 units at £3

Period 2 20,000 units at £3
Period 3 actual production = normal activity
W3 Actual variable cost is compared with budgeted variable
costs for actual production and the difference represents
under/over spending:
Period 1 (70,000 x £1) - £68,000 £2,000 Favourable variance
Period 2 (40,000 x £1)- £45,000 £5,000 Adverse variance
Period 3 ( 60,000 x £1) - £60,000 0

(c) Period 1 Period 2 Period 3

£000 £000 £000
Contribution from output differing
from BE point (W1) + 20 + 60 -20
Fixed overhead included in stock
changes (W2) + 60 -60 + 60
Variable overhead expenditure
variance +2 -5 0
Profit for period + 82 -5 +40

Workings:
Period 1 Period 2 Period 3
W1 (50- 45) X £4 (60- 45) X £4 (40- 45) X £4
W2 (+20x£3) (-20 X £3) (+20x£3)

In Period 1, sales volume was 5,000 units in excess of the breakeven

sales volume and at a contribution of £5 per unit a profit of £20,000
would result if calculated on a marginal costing basis. However, actual
profit was £82,000. There are two reasons for this. First, absorption
costing has been used and £60,000 (20,000 units x £3) fixed overheads
has been carried forward in fixed overhead and thus deferred as an
expense. The breakeven point calculation assumes a marginal costing
system with fixed overheads of £180,000 per period being regarded as a
period cost. Second, the breakeven analysis and stock valuations assume
variable overheads will be £1 per unit of output. In Period 1 output was
70,000 units and expected variable overhead expenditure was £70,000.
Actual expenditure was £68,000 thus resulting in an increase in profits of
£2,000.
Similar comments apply to Periods 2 and 3 but note that the opening
stock exceeds closing stock by 20,000 units in Period 2. Consequently,
£60,000 fixed overheads (20,000 units x £3) are included as an expense in
the opening stock, but, since closing stock is zero, no fixed overheads
are deferred as an expense until Period 3. Therefore the total fixed over-
head charge for Period 2 is £240,000 (£180,000 + £60,000 included in the
opening stock).

82---------------------------------- ABSORPTION COSTING AND VARIABLE COSTING

J Answer to question 8.14

(a) Calculation of fixed manufacturing overhead rate (£000s)

Prodn. Prodn. Service General

Dept.l Dept.2 Dept. Factory Total
Allocated 380.0 465.0 265 230 1,340
Allocation of general factory 92.0 (40%) 115.0 (50%) 23 (10%) (230)
Share of service department: 288
Labour related costs (60%) 76.8 (8/18) 96.0 (10/18) (172.8)
Machine related costs (40%) 57.6 57.6 (115.2)
606.4 733.6 1,340
Units of output (OOOs) 120 120
Overhead rate per unit 5.0533 6.1133

Calculation of total manufacturing cost per unit

£
Direct materials 7.00
Direct labour 5.50
Variable overhead 2.00
Fixed overhead: Department 1 5.0533
Department 2 6.1133
Manufacturing cost 25.6666

Absorption costing profit statement

£000s
Production cost (116,000 x £25.666) 2,977.33
Less closing stocks (2,000 x £25.6666) 51.33
Cost of sales 2,926.00
Under-absorption of overhead:
Department 1 (£20,000 + (4,000 x £5.0533)) 40.21
Department 2 (4,000 units x £6.1133) 24.45
Non-manufacturing costs 875.00
Total cost 3,865.66
Sales (114,000 x £36) 4,104.00
Net profit 238.34

Note that the under-recovery of fixed overheads consists of £20,000

arising from actual overheads exceeding estimated overheads plus 4,000
times the fixed overhead rate because actual volume was 4,000 units less
than estimated volume.

ANSWERTOQUESTIDN8.14 - - - - - - - - - - - - - - - - - - - - - - - - - • 83
 (b)
Marginal costing profit statement
£000s
Variable production cost (116,000 x £14.50) 1,682
Less closing stocks (2,000 x £14.50) 29
1,653
Fixed manufacturing overhead (1,340 + 20) 1,360
Non-manufacturing overhead 875
3,888
Sales 4,104

Net profit 216

(c) See 'Variable costing and absorption costing: A comparison of their

impact on profit' in Chapter 8 for the answer to this question. The
answer should also explain why the profits calculated on an absorption
costing basis in (a) exceed the variable costing profit computation in (b)
by £22,340 (£238,340- £216,000). This is because stocks have increased
by 2,000 units and with the absorption costing profit computation fixed
manufacturing overheads of approximately £22,340 (2,000 units x
£11.1666 fixed overhead rate) are included in the closing stock valu-
ation. Therefore £22,340 of the fixed overheads is incurred as an
expense in the following period. The total fixed manufacturing overhead
charged as an expense against the current period is £1,337,660 ((116,000
x £11.166) - (2,000 x £11.166) + £64,660 under-absorption). With the
variable costing system all of the fixed overhead incurred during the
period of £1,360,000 is charged as an expense against the current
accounting period. The difference between the fixed overheads charged
as an expense (£1,337,660 - £1,360,000) accounts for the difference in
the profit computation.

84-----------------------------------
ABSORPTION COSTING AND VARIABLE COSTING
 Cost-volume-profit
analysis
Answers to Chapter 9

Question summary================

9.1 to 9.3
Discussion questions on cost-volume-profit CVP analysis.
9.4 to 9.10
Construction of breakeven or profit-volume graphs. Question 9.5 requires
the calculation of variable costs using the high-low method of analysing
fixed and variable costs. Question 9.8 includes a change in the sales mix
and 9.9 requires the preparation of a multi-product profit-volume graph.
Question 9.10 includes an increase in fixed costs.
9.11 to 9.18
These questions consist of a variety of CVP analysis problems using a non-
graphical approach. Question 9.17 also requires the preparation of a pro-
duction budget.
9.19
Multiple choice style question requiring the calculation of the breakeven
point based on a planned sales mix.
9.20
A simple problem which can be used to illustrate the product mix assump-
tions of CVP analysis.
9.21 and 9.22
More difficult questions requiring the calculation of breakeven points
based on different sales mix assumptions. Question 9.22 also involves a
product abandonment decision.
9.23 to 9.28
More demanding CVP analysis problems using a non-graphical approach.
These questions place a greater emphasis on decision-making aspects.

Answer to question 9.4

(a) (i) Breakeven chart: see Fig. 9.4(a).
(ii) Contribution graph: see Fig. 9.4(b).
(iii) Profit-volume graph: see Fig. 9.4(c).

COST-VOLUME-PROFIT ANALYSIS - - - - - - - - - - - - - - - - - - - - - - - - - 85
 (b) See Chapter 9 for the answer to this problem.
(c) The major limitations are:
(i) Costs and revenue may be linear only within a certain output
range.
(ii) In practice it is difficult to separate fixed and variable costs and
the calculations will represent an approximation.
(iii) It is assumed that profits are calculated on a variable costing
basis.
(iv) Analysis assumes a single product is sold or a constant sales mix is
maintained.
(d) The advantages are:
(i) The information can be absorbed at a glance without the need for
detailed figures.

80

70 Sales

8 60 Total costs
0
0
~
(/)
Q)
50
::J
c:
> 40
Q)

~
u
c: 30
til
(/)
(i5 20
t
0
u
10 Fixed costs

2 3 4 5 6
!
Units of production and sales (£000s)

Figure 9.4(a) Answer to question 9.4(a)(i): breakeven chart.

80

70 Sales

0 60 Total costs
0
0
~ t
50 Fixed costs
l
(/)
Q)
::J
c:
Q)
> 40
[]!
u 30

1
c:
til
(/)
(i5 20
0 Variable cost
u

~____i...____...------l...._________J j
10

2 3 4 5 6
Units of production and sales (£000s)

Figure 9.4(b) Answer to question 9.4(a)(ii): contribution graph.

86---------------------------------------
COST-VOLUME-PROFIT ANALYSIS
 30
0
0
0
~ 20
.~
e
a...
10 Units of
production
0
8
0
and sales

~ 10
"'
Q)
20
"'"'0
_J
30

Figure 9.4(c) Answer to question 9.4(a)(iii): profit-volume graph.

(ii) Essential features are emphasized.

(iii) The graphical presentation can be understood easily by non-
accountants.

Answer to question 9.5

(a) This question requires the separation of total cost into the fixed and
variable elements using the high-low method.

Low High
£ £
Sales at £30,000 per unit 480,000 (16 X £30,000) 900,000 (30 X £30,000)
Profit 40,000 250,000
Total costs (difference) 440,000 650,000

£000's
Breakeven chart
3,900 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -

Margin of
safety
costs

2.400
Revenue

Output 80 units 130 "units

Margin of safety

ANSWER TO QUESTION 9.5 - - - - - - - - - - - - - - - - - - - - - - - - - - - 87

 An increase in output of 14 units results in an increase in total costs of
£210,000. Assuming that fixed costs are constant for all activity levels
the variable costs per unit is £15,000 (£210,000/14 units). At 30 units
activity the variable costs will be £450,000 and monthly fixed costs are
£200,000 (£650,000- £450,000). Over a six-month period total fixed costs
are £1,200,000.
Breakeven point = Fixed costs (£1,200,000)/unit contribution (£15,000)
= 80 units.
(b) Revised unit
contribution £10,000
Revised total
contribution £143,000 (130 units x 1.1 x £10,000)
Revised profit £230,000 (£1,430,000- £1,200,000 fixed costs)
Current profit £750,000 (130 x £15,000-£1,200,000 fixed costs)
The selling price should not be reduced because profits will decline by
£520,000.
(c) Costs may not be variable and fixed throughout the entire production
range. For example, unit variable cost may not be constant because of
bulk discounts on purchases and increasing and decreasing returns (see
'Economists' model', Chapter 9). Costs may also be semi-fixed or semi-
variable (see Chapter 2 for an explanation of these terms).

Answer to question 9.9

(a)
Product Unit Sales volume Total Total sales
contribution (units) contribution revenue
(£000s) (£000s)
J 6 10,000 60 200
K 32 10,000 320 400
L (0.20) 50,000 (10) 200
M 3 20,000 60 200
90,000 430 1,000

Average contribution= 43% of sales revenue.

(b) and (c) The profit arising from the most profitable product (Product K) is drawn
first on the profit-volume graph (see Fig. 9.9). At £400,000 sales revenue
a profit of £80,000 (£320,000 contribution - £240,000 fixed costs) is
plotted on the graph. The profits arising from the remaining products
are then entered on the graph. Since fixed costs have already been
covered by Product K, the next product (Product J) will increase profits
by £60,000 (i.e. total contribution of £60,000). The second point to be
plotted is therefore cumulative sales of £600,000 and profits of £140,000.
The addition of Product M results in cumulative profits of £200,000
(£140,000 + £60,000) and cumulative sales revenue of £800,000. Finally,
the addition of Product L reduces total profits to £190,000.

88 COST-VOLUME-PROFIT ANALYSIS
 £000

Profit

200
190
M
I
I
140

J I
I
100
I
80 I
Breakeven point (£558 , 140)

Sales £000

Loss

100

200

240

Figure 9.9 Profit-volume graph for question 9.9.

The dashed line on the graph represents the average contribution per £1
of sales (43%) arising from the planned sales mix. The breakeven point
in sales value is £558,140 [Fixed costs (£240,000)/contribution ratio
(0.43)]. This is the point where the dashed line cuts the horizontal axis.
At zero sales level a loss equal to the fixed costs will be incurred and at
the maximum sales level profits will be £190,000 [(£1m x 0.43) -
£240,000].
Product K yields the largest contribution/sales ratio (80%) and
Products J and M yield identical ratios. Product L has a negative contri-
bution and discontinuation will result in profits increasing by £10,000.
(d) The contribution/sales ratio can be improved by:
1. increasing selling price;
2. reducing unit variable costs by improving labour efficiency or obtain-
ing cheaper materials from different suppliers;
3. automating production and substituting variable costs with fixed
costs.

ANSWER TO QUESTION 9.9 89

IAnswer to question 9.13
(a) BEP = Fixed cost (£210,000)/Contribution per unit (£17)
= 12,353 units
Margin of safety:
Budgeted contribution = £510,000 (£300,000 + £210,000)
Budgeted sales volume (units) = 30,000 (£510,000/£17)
Budgeted sales revenue = £750,000 (30,000 X £25)
BEP (£) = £308,825 (12,353 X £25)
Margin of safety = £441,175
(b) Required total contribution = £630,000 (£420,000 + £210,000)
Required unit contribution = £21 (£630,000/30,000 units)
Required selling price = £29 (£21 + £8 variable cost)
Present selling price =£25
Required percentage increase = 16%
(c) Proposal]: £
Total contribution 461,100 (31,800 X (£22.50- £8))
Fixed costs 210,000
Profit 251,100

Proposa/2 £
Total contribution 547,200 (28,800 X (£27 -£8))
Fixed cost 210,000
Profit 337,200

(d) For the answer to this question see section on the economists' model in
Chapter 9. In particular, the answer should stress that revenue and cost
functions may not be linear because:
(i) beyond a certain sales volume selling price may be reduced in
order to increase sales;
(ii) quantity discounts may result in the material cost per unit chang-
ing for different output levels;
(iii) at high output levels, bottlenecks may create inefficiencies and
cause increases in labour costs per unit of output;
(iv) fixed costs may increase in step functions as new equipment is
acquired to meet increased output.

IAnswer to question 9.16

(a) For a description of each of the items see:
(i) 'Normal and abnormal losses' in Chapter 6.
(ii) 'Performance reports' in Chapter 15.
(iii) 'Control accounts' and 'Recording the issue of materials' in
Chapter 5.
(iv) 'Under and over recovery of overheads' in Chapter 4.

90---------------------------------------- COST-VOLUME-PROFIT ANALYSIS

 (b) (i) and (ii)
£000s £000s £000s
Sales 600 700 800
Manufacturing costs 350 380 410
An increase in sales revenues of £100,000 results in an increase in total
costs of £30,000. Variable costs are therefore 30% of sales. The cost
structure is:
£000s £000s £000s
Sales 600 700 800
Variable costs 180 210 240
Fixed costs (balance) 170 170 170
Total manufacturing costs 350 380 410

The contribution/sales ratios and total fixed costs for each alternative
are:
Agents Sales force
Contribution/sales ratio 60% 70%
Fixed costs: Manufacturing (£000s) 170 170
Administration (£000s) 160 160
Selling (£000s) 60
Total 330 390

Note that the variable costs for the sales through agents alternative are
30% of sales (manufacturing) plus 10% of sales for commissions.
Therefore the contribution/sales ratio is 60%.
Breakeven point Fixed costs/Contribution ratio
Sales through agents £330,000/0.6 = £550,000
Own sales force £390,000/0.7 = £557,143

(b) (iii) Selling through own sales force has the higher breakeven point
because of the higher fixed costs. The statement shown below
indicates that profits are identical for both alternatives at the
lowest potential sales volume of £600,000. At higher levels of
sales it is more profitable to employ the company's own sales
force. This can be seen from the figures shown below. The
company should therefore employ its own sales force.

Estimated Profits for Potential Sales Volumes

(£000) Low Medium High
Sales Sales Sales
Agent force Agent force Agent force
Sales 600 600 700 700 800 800
Contribution 360 420 420 490 480 560
Fixed costs 330 390 330 390 330 390
Net profit 30 30 90 100 150 170

ANSWER TO QUESTION 9.16 91

j Answer to question 9.18
(a) Calculation of total contribution
£
Product A (460,000 x £1.80) 828,000
Product B (1,000,000 x £0.78) 780,000
Product C (380,000 x £1.40) 532,000

2,140,000

Calculation of total sales revenue

£
Product A (460,000 x £3) 1,380,000
Product B (1,000,000 x £2.45) 2,450,000
Product C (380,000 x £4) 1,520,000

5,350,000

fixed costs (£1,710,000) x total sales (£5,350,000)

Breakeven point
(sales revenue basis) total contribution (2,140,000)
£4,275,000

(b) £2.75 selling price

£
Total contribution 590,000 x (£2.75- £1.20) 914,500
Existi1_1g planned contribution 828,000

Extra contribution 86,500

Less additional fixed costs 60,000

Additional contribution to general fixed costs 26,500

£2.55 selling price

£
Total contribution 650,000 x (£2.55- £1.20) 877,500
Existing planned contribution 828,000

Extra contribution 49,500

Less additional fixed costs 60,000
Contribution to general fixed costs (10,500)

It is worthwhile incurring the expenditure on advertising and sales pro-

motion at a selling price of £2.75

(c) Required contribution existing contribution (£828,000)

+ additional fixed costs (£60,000)
£888,000

92---------------------------------------
COST-VOLUME-PROFIT ANALYSIS
 The required sales volume at a selling price of £2.75 that will generate a
total contribution of £888,000 in 572,903 units (£888,000/£1.55 unit con-
tribution).
(d) See 'Margin of safety' in Chapter 9 for the answer to this question. At
the existing selling price for product A, the margin of safety for Z Ltd is
£1,075,000 (£5,350,000 sales revenue - £4,275,000 breakeven point) of
sales revenue. This is 20.1% of the current level of sales. If Z Ltd incurs
the advertising and promotion expenditure and reduces the selling price
to £2.75 for product A, the breakeven point will increase to £4,446,000
and total sales revenue will increase to £5,593,000. This will result in a
margin of safety of £1,147,000 or 20.5% of sales.

Answer to question 9.19

Product X Product Y Total

Unit contribution £4 £5
Sales (units) 8,000 2,000
Total contribution £32,000 £10,000 £42,000
Total sales revenue £96,000 £16,000 £112,000

Average contribution per unit sold = £42,000/10,000 units= £4.20

Average selling price = £112,000/10,000 units= £11.20
Breakeven point (units) =Fixed costs/average contribution per unit
= £27,300/£4.20
= 6,500 units
Breakeven point (sales revenue) = 6,500 units x average selling price of
£11.20
= £72,800

Answer to question 9.20

Fixed cost~
Breakeven point
Contribution per unit
Product X 25,000 units (£100,000-+- £4)
Product Y 25,000 units (£200,000-+- £8)
Company as a whole= 57,692 units (£300,000-+- £5.20 3 )

Note:
(70,000 X £4) + (30,000 X £8)
a Average contribution per unit =
100,000 units
£5.20

The sum of the product breakeven points is less than the breakeven
point for the company as a whole. It is incorrect to add the product
breakeven points because the sales mix will be different from the

ANSWER TO QUESTION 9.20 - - - - - - - - - - - - - - - - - - - - - - - - -

93
 planned sales mix. The sum of the product breakeven points assumes a
sales mix of 50% to X and 50% to Y. The breakeven point for the
company as a whole assumes a planned sales mix of 70% to X and 30%
toY. CVP analysis will yield correct results only if the planned sales mix
is equal to the actual sales mix.

IAnswer to question 9.22

(a) (i)
Products 1 2 3 Total
(1) Unit contribution £1.31 £0.63 £1.87
(2) Specific fixed costs per unit £0.49 £0.35 £0.62
(3) General fixed costs per unit £0.46 £0.46 £0.46
(4) Sales volume (OOOs units) 98.2 42.1 111.8 252.1
(5) Total contribution (1 x 4) £128.642 £26.523 £209.066 £364.231
(6) Total specific fixed costs (2 x 4) £48.118 £14.735 £69.316 £132.169
(7) Total general fixed costs (3 x 4) £45.172 £19.366 £51.428 £115.966
(8) Unit selling price £2.92 £1.35 £2.83
(9) Total sales revenue (8 x 4) £286.744 £56.835 £316.394 £659.973

Average contribution per unit =Total contribution (£364.231)/sales volume

(252.1)
= £1.4448
Average selling price per unit =Total sales revenue (£659.973)/sales
volume (252.1)
= £2.6179
Total fixed costs
Breakeven point (units)
Average contribution per unit
= (£132.169 + £115.966)/£1.4448
= 171,743 units
Breakeven point (sales value) = 171,743 units x average selling price
(£2.6179)
= £449,606

Alternatively, the breakeven point (sales value) can be calculated using the
following formula:
Fixed costs (132.169 + £115.966)
Breakeven point= x Total sales (£659.973)
Total contribution (£364.231)
= £449,606

It is assumed that the question requires the calculation of the breakeven

point to cover both general and specific fixed costs. An alternative answer
would have been to present details of the breakeven point to cover only
specific fixed costs.

94---------------------------------------
COST-VOLUME-PROFIT ANALYSIS
 (a) (ii) The planned sales mix for Product 2 that was used to calculate the
breakeven point in (a) (i) is 42.11252.1. Therefore the number of units of
Product 2 at the breakeven point is:
42.11252.1 x 171,743 units= 28,681 units

(b) At the forecast sales volume the profit/contributions are as follows:

£000s
Contributions to all fixed costs 26.523
Less specific fixed costs 14.735

Contribution to general fixed costs 11.788

Less share of general fixed costs 19.366

Net Loss 7.578

Product 2 provides a contribution of £11,788 towards general fixed costs

and, unless savings in general fixed costs in excess of £11,788 can be
made if Product 2 is abandoned, it is still viable to produce Product 2. If
the company ceases production of Product 2 it will lose a contribution of
£11,788 and total profits will decline by £11,788. The company should
investigate whether a greater contribution than £11,788 can be gener-
ated from the resources. If this is not possible the company should con-
tinue production of Product 2.

Answer to question 9.24

(a) Powder Gas

Large Small Large Small Total
Contribution per unit (£) 3 3 6 2
Sales volume (1) 800 800 200 1,000
Total contribution (£) 2,400 2,400 1,200 2,000 8,000
Less fixed overheads (£) 3,100

Profit(£) 4,900

Note:
(1) Sales demand is restricted to maximum assembly capacity for small powder.

(b) Option 1 - increase in capacity for assembly of small powder units:

Units
Maximum sales demand 1,100
Maximum production capacity (800 + 500) 1,300
Additional sales volume (1,100- 800) 300

£
Additional contribution (300 x £3) 900
Additional fixed costs 1,200
Additional profit/ (loss) (300)

ANSWER TO QUESTION 9.24 - - - - - - - - - - - - - - - - - - - - - - - - - •

95
 Option 2 - increase in demand for large gas units:
Units
Maximum sales demand 500
Maximum production capacity 400
Additional sales volume (400- 200) 200
£
Additional contribution (1) 1,400
Additional fixed costs 1,200
Additional profit/ (loss) 200

Note: £
(1) Additional contribution: existing sales (200 units x £0.50p)
increase in contribution arising from a £0.50 increase in selling price 100
Additional contribution from extra sales (200 units x £6.50) 1,300
1,400

On the basis of the above information the company should select Option 2.

Answer to question 9.26

(a) Analysis of semi-variable costs (1):

Method A:
Increase in costs £10,000
Variable element £0.10 per copy
Increase in activity 100,000 copies
Fixed element =Total semi-variable cost (£55,000) less
variable costs (£35,000) at an activity
level of 350,000 copies.
:. Fixed element £20,000

Method B:
Increase in costs £5,000
Variable element £0.05 per copy
Increase in activity 100,000 copies
Fixed element =Total semi-variable cost (£47,500) less
variable costs (£17,500) at an activity
level of 350,000 copies.
:. Fixed element = £30,000

Note:
(1) The analysis is based on a comparison of total costs and activity levels at 350,000
and 450,000 copies per year.

96---------------------------------------- COST-VOLUME-PROFIT ANALYSIS

 Contribution per copy of new magazine:
Method A Method B
£ £
Selling price 1.00 1.00
Variable cost (given) (0.55) (0.50)
Variable element of semi-variable costs (0.10) (0.05)
Lost contribution from existing magazine (0.05) (0.05)

Contribution 0.30 0.40

Calculation of net increase in company profits:

Method A Method B
Copies sold 500,000 400,000 600,000 500,000 400,000 600,000
Contribution per copy 30p 30p 30p 40p 40p 40p
Total contribution £150,000 £120,000 £180,000 £200,000 £160,000 £240,000
Fixed costs (2) £100,000 £100,000 £100,000 £150,000 £150,000 £150,000

Net increase in profit £50,000 £20,000 £80,000 £50,000 £10,000 £90,000

Note:
(2) Method A= Specific fixed costs (£80,000) +Semi-variable element (£20,000) = £100,000
Method B =Specific fixed costs (£120,000) +Semi-variable element (£30,000) = £150,000

(b) Fixed costs

Breakeven point
Contribution per unit
Method A = £100,000 + 0.30 = 333,333 copies
Method B = £150,000 + 0.40 = 375,000 copies
The margin of safety is the difference between the anticipated sales and
the breakeven point sales:
Method A: 500,000-333,333 = 166,667 copies
Method B: 500,000- 375,000 = 125,000 copies
(c) Method B has a higher breakeven point and a higher contribution per
copy sold. This implies that profits from Method B are more vulnerable
to a decline in sales volume. However, higher profits are obtained with
Method B when sales are high (see 600,000 copies in (a)).
The breakeven point from the sale of the existing magazine is 160,000
copies (£80,000 + £0.50) and the current level of monthly sales is 220,000
copies. Therefore sales can drop by 60,000 copies before breakeven
point is reached. For every ten copies sold of the new publication, sales
of the existing publication will be reduced by one copy. Consequently, if
more than 600,000 copies of the new publication are sold the existing
magazine will make a loss. If sales of the new magazine are expected to
exceed 600,000 copies consistently then the viability of the existing
magazine must be questioned.

97
ANSWER TO QUESTION 9.26 - - - - - - - - - - - - - - - - - - - - - - - - -
 Answer to question 9.28
(a) Calculation of fixed and variable costs:
Fixed costs= Staff (£200) +Building occupancy cost (£460) = £660
Variable costs: Materials 1,540
Power 280
Staff (340- 200) 140

1,960

£1,960
Variable cost per unit= 700 . = £2.80
umts

£2 800
Average weekly sales= ' = 700 units
£4 I unit

Number of meals to earn profit of £300 per week

= Fixed costs + Required contribution = £660+ £330 = 800 units
Contribution per unit 1.20

(b) (i) Take-away High quality

foods foods
£ £
Contribution from new business (1) 540 268
Fixed costs from new business (610) (282)
-- --
Profit/ (loss) from new business (70) (14)
Impact on existing business:
Change in fixed costs (staff) (140)
Change in variable costs (2) 210 70
Additional sales (3) 108 52
Additional weekly profit 108 108

Notes:
(1) 720 meals at £0.75 for take-away foods
200 meals at £1.34 for high quality foods.
(2) Savings in material costs on existing business:
Take-away foods and high quality foods (700 x lOp) £70 each
Reduction in labour variable cost (now all fixed) £140
£210
(3) Revised contribution per unit:
Existing restaurant unit contribution £1.20
Add material variable cost saving 0.10

High quality foods 1.30

Add reduction in labour variable cost £140/700 0.20

Take-away foods £1.50

98------------------------------------- COST-VOLUME-PROFIT ANALYSIS

 Take-away foods results in an increase of 72 (720/10) meals at £1.50 contribu-
tion per meal.
High quality foods result in an increase of 40 meals (200/5) at £1.30 contri-
bution per meal.
(ii) The calculation of the sales volume at which the owners would earn no addi-
tional profits is as follows:
Take-away High quality
foods meals
Incremental fixed costs £610 £282
Less additional profit from existing
business due to a reduction in
material costs (700 x lOp) 70 70
£540 £212
Contribution per meal (1) £0.90 £1.60
:. Breakeven point 600 meals 133 meals

Note:
(1) Contribution per unit £0.75 £1.34
Extra contribution from increased
sales in restaurant arising from
diversification (see Note 3 in (b)(i) above)
*(£1.50/10) £0.15* £0.26**
**(£1.30/5) £0.90 £1.60

(c) The following conclusions should be drawn:

(1) Both proposals earn some profits.
(2) Take-away foods has a higher fixed cost and lower unit contribution than high
quality foods. Consequently, the breakeven point is higher for take-away
foods.
(3) If sales decline by 20% then take-away sales will be 576 meals compared with
160 meals for high quality sales. It can be seen from (b )(ii) that take-away
sales will be lower than the breakeven point whereas high quality sales will be
above the breakeven point.
(4) If sales are above the estimates given in the question then take-away foods
will produce the higher profits.
(5) Therefore the final decision depends on how confident the owners are that
sales will be above or below the estimated sales and their attitude towards
risk.

ANSWER TO QUESTION 9.28 - - - - - - - - - - - - - - - - - - - - - - - - - •

99
 Measuring costs and
benefits for decision-
making
Answers to Chapter 10

Question summary

10.1
Make-or-buy decisions.
10.2 to 10.4
Comparing relevant costs with a proposed pricing quotation.
10.5
Decision on which of two mutually exclusive contracts to accept.
10.6 and 10.7
Decision on whether projects involving sunk and opportunity costs should
be continued.
10.8 to 10.11
These questions involve deleting a segment or product abandonment de-
cisions. Question 10.10 also involves cost-volume-profit (CVP) analysis.
10.12
A recommendation as to whether to launch a new product.
10.13 to 10.15
Determining an optimal production schedule where a limiting factor applies.
10.16 and 10.17
Make-or-buy decisions and limiting factors.
10.18
Deleting a segment and determining an optimal production schedule
where a limiting factor applies.
10.19
Allocation of shop space based on limiting factors.
10.20
A decision on whether to undertake an advertising campaign and on
which product to buy in.
10.21
Limiting/key factors and a decision on whether it is profitable to expand
output by overtime. This is a difficult question for first-year students.

MEASURING COSTS AND BENEFITS FOR DECISION-MAKING 101

 Answer to question 10.4
(a) The relevant costs for the production of 400 components are as follows:

Materials £ £
M1 (1,200 kg at £5.50 replacement cost) 6,600
P2 (800 kg at £2 per kg) (1) 1,600
Part no. 678 (400 at £50 replacement cost) 20,000 28,200

Labour:
Skilled (2,000 hours at £4 per hour) 8,000
Semi-skilled (2,000 hours at £3 per hour) 6,000 14,000

Overheads:
Variable (1,600 machine hours at £7 per hour) 11,200
Fixed: Incremental fixed costs 3,200

Total relevant cost 56,600

Contract price (400 components at £145 per component) 58,000
Contribution to general fixed costs 1,400

The incremental revenues exceed the incremental costs. Therefore the

contract should be accepted subject to the comments in (b) below.

Note:
(1) If material P2 is not used on the contract it will be used as a substitute for
material P4. Using P2 as a substitute for P4 results in a saving of £2 (£3.60-
£1.60) per kg. Therefore the relevant cost of P2 consists of the opportunity
cost of £2 per kg.

(b) Three factors which should be considered are:

(i) Can a price higher than £145 per component be negotiated? The
contract only provides a contribution of £1,400 to general fixed
costs. If the company generates insufficient contribution from its
activities to cover general fixed costs then it will incur losses and
will not be able to survive in the long term. It is assumed that
acceptance of the contract will not lead to the rejection of other
profitable work.
(ii) Will acceptance of the contract lead to repeat orders which are
likely to provide a better contribution to general fixed costs?
(iii) Acceptance of the contract will provide additional employment
for 12 months and this might have a significant effect on the
morale of the workforce.

102 MEASURING COSTS AND BENEFITS FOR DECISION-MAKING

 Answer to question 10.5

(a) North East South coast

£ £
Material X from stock (1) 19,440
Material Y from stock (2) 49,600
Firm orders of material X (3) 27,360
Material X not yet ordered (4) 60,000
Material Z not yet ordered (5) 71,200
Labour (6) 86,000 110,000
Site management (7)
Staff accommodation and travel for
site management (8) 6,800 5,600
Plant rental received (9) (6,000)
Penalty clause (10) 28,000
193,600 264,400
Contract price 288,000 352,000
Net benefit 94,400 87,600

(b)
(1) If material X is not used on the North East contract the most
beneficial use is to use it as a substitute material thus avoiding
future purchases of £19,440 (0.9 x 21,600). Therefore by using the
stock quantity of material X the company will have to spend
£19,440 on the other materials.
(2) Material Y is in common use and the company should not dispose
of it. Using the materials on the South coast contract will mean
that they will have to be replaced at a cost of £49,600 (£24,800 x 2).
Therefore the future cash flow impact of taking on the contract is
£49,600.
(3) It is assumed that with firm orders for materials it is not possible to
cancel the purchase. Therefore the cost will occur whatever future
alternative is selected. The materials will be used as a substitute
material if they are not used on the contract and therefore, based
on the same reasoning as note 1 above, the relevant cost is the pur-
chase price of the substitute material (0.9 x £30,400).
(4) The material has not been ordered and the cost will only be
incurred if the contract is undertaken. Therefore additional cash
flows of £60,000 will be incurred if the company takes on the North
East contract.
(5) The same principles apply here as were explained in note (4) and
additional cash flows of £71,200 will be incurred only if the
company takes on the South coast contract.
(6) It is assumed that labour is an incremental cost and therefore
relevant.
(7) The site management function is performed by staff at central
headquarters. It is assumed that the total company costs in respect
of site management will remain unchanged in the short term

ANSWER TO QUESTION 10.5 - - - - - - - - - - - - - - - - - - - - - - - - - -

103
 whatever contracts are taken on. Site management costs are there-
fore irrelevant.
(8) The costs would be undertaken only if the contracts are under-
taken. Therefore they are relevant costs.
(9) If the North East contract is undertaken the company will be able
to hire out surplus plant and obtain a £6,000 cash inflow.
(10) If the South coast contract is undertaken the company will have to
withdraw from the North East contract and incur a penalty cost of
£28,000.
(11) The headquarter costs will continue whichever alternative is
selected and they are not relevant costs.
(12) It is assumed that there will be no differential cash flows relating to
notional interest. However, if the interest costs associated with the
contract differ then they would be relevant and should be included
in the analysis.
(13) Depreciation is a sunk cost and irrelevant for decision-making.

Answer to question 10.7

(a) A direct cost is physically traceable to some cost objective. The cost
objective is not necessarily a product; it may be, for example, a depart-
ment, a cost centre or a fleet of lorries. A cost may be direct to one cost
objective and indirect to another.

(b) Relevant
cost
£
(i) The costs incurred to date are sunk. Nil
(ii) The material cost of £60,000 is a sunk cost but if the
research project is undertaken there will be a saving
of disposal costs if the project continues. (5,000)
(iii) If the project is discontinued the labour which would
have been used on the project will earn a
contribution £50,000. The labour cost of £40,000 will
occur whatever alternative is selected. Therefore
the company will lose £90,000 (£50,000 + £40,000)
if the project continues. 90,000
(iv) It is assumed that research salaries of £60,000 could
be saved if the project is discontinued. Consequently,
it is a relevant cost of continuing with the project. The
redundancy payment will remain unchanged if the
project is discontinued, therefore it is not relevant. 60,000
However, the redundancy payment will be made
earlier if the project is discontinued. The lost interest
or interest cost on this earlier payment represents a
cost saving of continuing with the project. At an (2,500)
interest rate of 10% there will be a saving of £2,500.

104-------------- MEASURING COSTS AND BENEFITS FOR DECISION-MAKING

 (v) The general and building services is an apportioned cost
which will still continue if the project is discontinued.
Therefore the cost is not relevant to the decision.

Total relevant costs 142,500

Relevant revenues 300,000

Contribution to fixed costs and profits 157,500

The company should continue with the project.

IAnswer to question 10.8

(a) (i)
Product A B c
£ £ £
Selling price 15 12 11
Less variable costs:
Materials (5) (4) (3)
Labour (3) (2) (1.5)
Variable overhead (1) (3.50) (2) (1.5)

Contribution 3.50 4 5

Note:
(1) Fixed overheads are apportioned to products on the basis of sales volume
and the remaining overheads are variable with output.

(a) (ii)
Product B c
£ £
Selling price 12 9.50
Less variable costs:
Materials (4) (3)
Labour (2) (1.80)
Variable overhead (2) (1.50)

Contribution 4 3.20

(b) (i)
Product A B c Total
£ £ £ £
Total contribution 350,000 480,000 400,000 1,230,000
Less fixed costs:
Labour (220,000)
Fixed administration (900,000)

Profit 110,000

105
ANSWER TO QUESTION 10.8 - - - - - - - - - - - - - - - - - - - - - - - - -
 (b) (ii)
Product B c Total
£ £ £
Total contribution (1) 480,000 576,000 1,056,000
Less fixed costs:
Labour (2) (160,000)
Fixed administration (3) (850,000)

Profit 46,000

Notes:
(1) B =120,000 units x £4 contribution, C =180,000 units x £3.20 contribution.
(2) (25% x £320,000 for B) plus (25% x £160,000 x 2 for C).
(3) Fixed administration costs will decline by 1/6 of the amount apportioned to
Product A (100/300 x £900,000). Therefore fixed overheads will decline
from £900,000 to £850,000.

(c) Product A should not be eliminated even though a loss is reported for
this product. If Product A is eliminated the majority of fixed costs allo-
cated to it will still continue and will be borne by the remaining prod-
ucts. Product A generates a contribution of £350,000 towards fixed costs
but the capacity released can be used to obtain an additional contribu-
tion from Product C of £176,000 (£576,000- £400,000). This will result in
a net loss in contribution of £174,000. However, fixed cost savings of
£110,000 (£50,000 administration apportioned to Product A plus
£100,000 labour for A less an extra £40,000 labour for Product C) can be
obtained if Product A is abandoned. Therefore there will be a net loss in
contribution of £64,000 (£174,000 - £110,000) and profits will decline
from £110,000 to £64,000.

j Answer to question 10.10

(a) (i)
Product I Product II Product III Total
£000 £000 £000 £000
Sales 2,475 3,948 1,520 7,943
Contribution 1,170 1,692 532 3,394
Attributable fixed costs (275) (337) (296) (908)
General fixed costs (1) (520) (829) (319) (1,668)
(795) (1,166) (615) (2,576)
Profit 375 526 (83) 818
= £1.6/unit = £1.40/unit = (£0.04/unit)

Note:
(1) General fixed costs are allocated to products at 21% of total sales revenue
(£1,668/£7,943).

106---------------------------- MEASURING COSTS AND BENEFITS FOR DECISION-MAKING

 (a) (ii) If Product III is discontinued it is assumed that variable costs and
attributable (i.e. specific) fixed costs are avoidable. It is assumed
that general fixed costs are common and unavoidable to all prod-
ucts and will remain unchanged if Product III is discontinued.
However, it is possible that some general fixed costs may be
avoidable in the longer term. The revised profits if Product III is
discontinued will be:
£000s
Contribution of Products I and II (£1,170 + £1,692) 2,862
Attributable fixed costs (£275 + £337) (612)
General fixed costs (1,668)
Profit 582
Profits will decline by £236,000 (£818 - £582) if Product III is dis-
continued because A Ltd will no longer obtain a contribution of
£236,000 (£532- £296) towards general fixed costs.
(a) (iii) Extra sales of 15,385 units (£80,000 additional fixed costs/£5.20
unit contribution) will be required to cover the additional adver-
tising expenditure. It is assumed that existing fixed costs will
remain unchanged.
(a) (iv) The revised unit contribution will be £3.45 (£9.45- £6).
£1,692,000 (existing total contribution)
Required sales
£3.45 revised unit contribution

490,435 units (an increase of 30.4% over

the budgeted sales of 376,000 units)

(b) The following factors will influence cost behaviour in response to

changes in activity:
(1) The magnitude of the change in activity (more costs are likely to
be affected when there is a large change in activity).
(2) Type of expense (some expenses are directly variable with volume,
such as direct materials, whereas others are fixed or semi-fixed).
(3) Management policy (some expenses are varied at the discretion of
management, e.g. advertising).
(4) The time period (in the long term, all costs can be changed in
response to changes in activity whereas in the short term, some
costs, e.g. salaries of supervisors, will remain unchanged).

Answer to question 10.11

(a) Company gross profit% = 38% (£3,268/£8,600 x 100)

Therefore Division 5 gross profit % = 19%
Division 5 sales = £860,000 (10% x £8.6m)
Division 5 gross profit = £163,400 (19% X £860,000)
Division 5 contribution = £479,400 (£316,000 + £163,400)

ANSWER TO QUESTION 10.11 107

 The situation for the year ahead if the division were not sold would be
as follows:
Contribution = £527,340 (£479,400 X 1.1)
Less avoidable fixed costs = £455,700 [£316,000 + (£156,000-
£38,000)] X 1.05
Add contribution from other = £20,000
divisions

Expected profit = £91,640

If Division 5 were sold, the capital sum would yield a return of £75,400.
Therefore the decision on the basis of the above information should be
not to sell Division 5.
(b) Other factors that should influence the decision include:
(i) The need to focus on a longer-term horizon. A decision based
solely on the year ahead is too short and ignores the long-term
impact from selling Division 5.
(ii) The impact on the morale of the staff working in other divisions
arising from the contraction of activities and the potential threat
of redundancies.
(iii) Alternative use of the resources currently deployed in Division 5
instead of their current use.
(c) If Division 5 is sold, the capital sum would yield a return of £75,000, but
a contribution of £20,000 is lost. Consequently, a profit of £55,000 is
required. The required contribution is therefore £510,700 (£55,000 +
£455,700) and the percentage increase required is 6.5% (£510,700/
£479,400- 100% ).

IAnswer to question 10.14

(a) (i) Product X y z
£ £ £ £ £ £
Direct materials 50 120 90
Variable overhead 12 7 16
Direct labour:
Department A 70 40 75
Department B 24 18 30
Department C 32 126 16 74 60 165

Variable production cost 188 201 271

Sales price 210 220 300
Total
Unit contribution 22 19 29 £
Total contribution 165,000 114,000 174,000 453,000
Fixed costs 300,000

Profit 153,000

108-------------- MEASURING COSTS AND BENEFITS FOR DECISION·MAKING

 (a) (ii)
Department B labour hours limitation:
Product X 30,000 hours (7,500 x 4 hours)
Y 18,000 hours (6,000 x 3 hours)
Z 30,000 hours (6,000 x 5 hours)
78,000 hours

Products X y z
Unit contribution £22 £19 £29
Department B labour hours 4 3 5
Contribution per Department B hour £5.50 £6.33 £5.80
Ranking 3 1 2

Maximum sales are 9,000 units of X (7,500 x 1.20), 7,500 units of Y

(6,000 x 1.25) and 8,000 of Z (6,000 x 1.33). Using the above rankings
the optimal product mix is:

Product Units sold Department B Contribution

hours used £
y 7,500 22,500 142,500
z 8,000 40,000 232,000
X 3,875 (15,500/4) 15,500 85,250
78,000 459,750
Less fixed costs 300,000

Profit 159,750

(a) (iii) Factors to be considered which have not been taken into account
in the above analysis include:
(1) The impact on customer goodwill. Some customers may buy
all three products and they may choose to buy elsewhere if
their supply of Product X is restricted. Also the company
may permanently loose Product X customers if the supply is
restricted.
(2) Competitors' reactions. If supply of Product X is restricted,
competitors may exploit the situation by stressing that they
are able to meet demand for Product X and look after their
customers and provide a better service.
(3) Some of the fixed costs may be attributable to specific prod-
ucts and avoidable if output is reduced. When avoidable
fixed costs are taken into account the product mix specified
in (a) (ii) may not be the optimum mix.

(b) Linear programming should be used. This technique enables an object-

ive function to be maximized (e.g. contribution) subject to meeting the
requirements of more than one input constraint.

ANSWER TO QUESTION 10.14 109

 Answer to question 10.16

(a) Component Component Product Product

12 14 vw XY
£ £ £ £
Variable cost 42 32 30 64
Purchase price 60 30
Selling price 33 85
Decision Make Buy Sell Sell
The assumptions on which the above advice is based are:
(i) Variable costs will vary with units produced and are constant per
unit of output.
(ii) Direct labour is assumed to be a variable cost and not a fixed cost.
(iii) No limiting factors exist, and the company does not have any
capacity constraints which might result in the need to consider
opportunity costs.
(iv) Fixed costs are common and unavoidable to all alternatives, and
therefore will not change.
(v) No additional cost will be incurred if the component is purchased
- for example, additional inspection and ordering costs.
(vi) Quality and delivery will be satisfactory.
(vii) The facilities cannot be used for more profitable alternatives.

(b) Component Component Product Product Total

12 14 vw XY
Machine time per unit (hrs) 8 Buy 6 12
Production (units) 7,000 5,000 4,000
Machine hours required 56,000 30,000 48,000 134,000a
Contribution/cost saving (£) 18 (60- 42) 3 21
Contribution per machine hour (£) 2.25 0.50 1.75
Ranking 1 3 2

The company should produce 7,000 units of component 12. This requires 56,000 machine hours.
The remaining 24,000 machine hours should be used to produce 2,000 units of product XY.

Note:
•80,000 machine hours are available. Therefore machine hours are the limiting factor.

Answer to question 10.18

(a) (i) The forecasted results show that Product C makes a loss of £2,000.
However, if Product C is discontinued, sales will decline by
£32,000 and costs will decline by £24,000 (Prime cost + Variable
overhead). It is assumed that fixed overheads will still continue
and that the £10,000 will have to be borne by other products.
Therefore the company will lose a contribution of £8,000 towards

110 MEASURING COSTS AND BENEFITS FOR DECISION-MAKING

 fixed overheads and profit if Product C is discontinued and
company profits would be reduced by £13,000 as shown below:

£000
Sales (Products A and B) 196
Variable cost of sales:
Prime cost 78
Variable overhead 38 116
Total contribution 80
Less fixed overheads 67
Profit 13

(ii) The minimum extra sales of B to cover the £8,000 advertising is

calculated as follows:

Cost of advertising £8,000

= 1,600 units
Contribution per unit of product B (1) £5

Note:
(1) Total product contribution = £40,000
Units sold = 8,000 (96,000 sales+ £12, selling price
per unit)
Contribution per unit =£5

(iii) The existing contribution per unit for product A is calculated as

follows:

Total contribution = £40,000

Units sold = 10,000 (100,000 sales+ £10, selling price)
Contribution per unit = £4
Contribution per unit after a 10% reduction in selling price = £3.
Reduction in product contribution (10,000 units at £1) = £10,000.
Increased sales volume to obtain a £10,000 contribution:

Required contribution £10,000

= 3,333 units
Revised contribution per unit £3
% increase in sales volume

(b) A B c
Total contribution £40,000 £40,000 £8,000
Unit contribution (1) £4 £5 £2
Quantity of material used (kg) 8 4 1
Contribution per kg £0.50 £1.25 £2.00
Ranking (2) 3 2 1

ANSWER TO QUESTION 10.18 111

 Optimal production allocation:

Product Units Material used Unused material

(kg) (kg)
c 4,000 4,000 88,000
B 8,000 32,000 56,000
A 7,000 (3) 56,000

Notes:
(1) Total contribution+ units sold.
Units sold are calculated by dividing total revenue by the unit selling price.
(2) Ranking according to contribution per kg of materials used because mater-
ials are the scarce factor.
(3) 56,000 unused kg+ 8 kg per unit sold for Product A.

Answer to question 10.20

(a) Products A B c D Total
Selling price per unit (£) 9.95 11.95 22.95 19.95
Less variable costs (£) 6.50 7.80 16.50 13.95

Contribution per unit(£) 3.45 4.15 6.45 6.00

Machine hours per unit (1) 0.6 0.6 1.0 0.9

Machine hours required (000 hrs):
Budget 1 108 168 260 135 671
Budget 2 120 186 285 148.5 739.5
Additional buying in cost
per unit(£) 2.40 3.50
Additional buying in cost
per machine hour(£) 4.00 3.50

Note:
(1) Machine hours per unit= variable overheads per unit/variable overhead rate
per unit of £1. Existing production capacity is sufficient to meet the require-
ments of Budget 1, but there is a shortfall of 24,500 hours (739,500- 715,000)
for Budget 2. It is worthwhile buying in Product A and Product C, because
the selling price is in excess of the buying in price and the contribution from
the additional sales from Budget 2 is sufficient to cover the additional adver-
tising cost (see workings shown below). It is preferable to meet the shortfall
of 24,500 hours by purchasing Product C, because the extra cost per machine
hour is lower (£3.50 compared with £4 for product A). The extra cost of
buying in the 24,500 machine hours is £85,750 (24,500 x £3.50).
The following calculation indicates that it is worthwhile undertaking the
advertising campaign and selecting Budget 2:
Products A B c D Total
Additional sales volume (000 units) 20 30 25 15
Unit contribution (£) 3.45 4.15 6.45 6.00
Additional contribution (£000) 69 124.5 161.25 90 444.75
Less extra buying-in cost (£000) (85.75)
cost of advertising (290.00)

Additional profit 69.00

MEASURING COSTS AND BENEFITS FOR DECISION-MAKING

112 - - - - - - - - - - - - - - -
 (b) The figures in (a) are based on the following assumptions:
(i) Fixed costs (other than advertising) will remain unchanged.
(ii) Variable costs will increase directly in proportion to increases in
production.
(iii) Prices and efficiency will remain unchanged for all levels of output.
(iv) Production capacity will be restricted to 715,000 hours.
(v) The estimates of sales volume for each budget are sound estimates
and the risk of not achieving these estimates is justified.
The reasoning behind the advice given is based on the fact that the
additional relevant revenues exceed the additional relevant costs and
that costs are minimized by buying-in Product C.

ANSWER TO QUESTION 10.20 113

 Activity-based costing
Answers to Chapter 11

Question summary

ABC did not emerge until the late 1980s, and therefore very few examina-
tion questions have been set on this topic. This chapter contains five
questions.
Questions 11.1 and 11.2
Essay questions.
Questions 11.3 to 11.5
These questions require the computation of product costs adopting an
activity-based costing approach.
Questions 11.3 and 11.5
These questions require a comparison of product costs derived from tra-
ditional and activity-based costing systems.

Answer to question 11.2

The answer to the question should describe the two-stage overhead alloca-
tion process and indicate that most cost systems use direct labour hours in the
second stage. In today's production environment direct labour costs have
fallen to about 10% of total costs for many firms and it is argued that direct
labour is no longer a suitable base for assigning overheads to products. Using
direct labour encourages managers to focus on reducing direct labour costs
when they represent only a small percentage of total costs.
Approaches which are being adopted include:
(i) Changing from a direct labour overhead-recovery rate to recovery
methods based on machine time. The justification for this is that over-
heads are caused by machine time rather than direct labour hours and
cost.
(ii) Implementing activity-based costing systems that use many different
cost drivers in the second stage of the two-stage overhead allocation
procedure.

ACTIVITY-BASED COSTING 115

 The answer should then go on to describe the benefits of ABC outlined in
Chapter 11. Attention should also be drawn to the widespread use of direct
labour hours by Japanese companies. According to Hiromoto 1 Japanese
companies allocate overhead costs using the direct labour cost/hours to focus
design engineers' attention on identifying opportunities to reduce the prod-
ucts' labour content. They use direct labour to encourage designers to make
greater use of technology because this frequently improves long-term com-
petitiveness by increasing quality, speed and flexibility of manufacturing.

Answer to question 11.3

(a)
Total machine hours 120 x 4 hours)+ (100 x 3 hours)+ (80 x 2 hours)+
(120 x 3 hours)= 1,300 hours
£10,430 + £5,250 + £3,600 + £2,100 + £4,620
Machine hour overhead rate = - - - - - - - - - - - - - - - -
1,300 hours
= £20 per machine hour

Product A B c D
£ £ £ £
Direct material 40 50 30 60
Direct labour 28 21 14 21
Overheads at £20 per machine hour 80 60 40 60
148 131 84 141

Units of output 120 100 80 120

Total cost £17,760 £13,100 £6,720 £16,920

(b)
Costs Cost driver Cost driver Cost per
transactions unit
£ £
Machine department 10,430 Machine hours 1,300 hours 8.02
Set-up costs 5,250 Production runs 21 250
Stores receiving 3,600 Requisitions raised 80 (4 X 20) 45
Inspection/quality control 2,100 Production runs 21 100
Materials handing 4,620 Number of orders
executed 42 110

Note:
Number of production runs= Total output (420 units)/20 units per set-up.
Number of orders executed= Total output (420 units/10 units per order.
The total costs for each product are computed by multiplying the cost driver rate per
unit by the quantity of the cost driver consumed by each product.

1 Hiromoto, T. (1988) 'Another hidden edge -Japanese management accounting', Harvard

Business Review, July/August, pp. 22---D.

ACTIVITY-BASED COSTING
116 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
 A B c D
Prime costs 8,160 (£68 X 120) 7,100 3,520 9,720
Set ups 1,500 (£250 X 6) 1,250 (£250 X 5) 1,000 1,500
Stores/receiving 900 (£45 X 20) 900 900 900
Inspection/quality 600 (£100 X 6) 500 400 600
Handling despatch 1,320 (£110 X 12) 1,100 (£110 X 10) 880 1,320
Machine dept cost (1) 3,851 2,407 1,284 2,888
Total costs 16,331 13,257 7,984 16,928

Note:
(1) A= 120 units x 4 hours x £8.02; B = 100 units x 3 hours x £8.02

(c) Cost per unit

Costs from (a) 148.00 131.00 84.00 141.00

Costs from (b) 136.0 132.57 99.80 141.07
Difference (11.91) 1.57 15.80 0.07

Product A is over-casted with the traditional system, Products B and C

are under-casted and similar costs are reported with Product D. It is
claimed that ABC more accurately measures resources consumed by
products (see 'An illustration of ABC and traditional product costing
systems' in Chapter 11). Where cost-plus pricing is used, the transfer to
an ABC system will result in different product prices. If activity-based
costs are used for stock valuations then stock valuations and reported
profits will differ.

Answer to question 11.4

(a) For the answer to this question see Chapter 11.

(b) Machine-related costs

Machine hours for the period:

A= 500 x * 125
B = 5,000 X* 1,250
C=600x1 600
D = 7,000x 1~ 10,500
12,475

Machine hour rate= £3 per hour (£37,424/12,475 hours)

117
ANSWER TO QUESTION 11.4 - - - - - - - - - - - - - - - - - - - - - - - - -
 Set-up related costs
Cost per set-up = £256.18 (£4,355/17)
Set-up cost per unit of output:
Product A (1 x £256.18)/500 = £0.51
B (6 X £256.18)/5000 = £0.31
C (2 X £256.18)/600 = £0.85
D (8 X £256.18)/7,000 = £0.29

Material ordering related costs

Cost per order= £1,920/10 orders= £192 per order
Material ordering cost per unit of output:
Product A (1 x £192)/500 = £0.38
B (4 X £192)/5,000 = £0.15
C (1 X £192)/600 = £0.32
D (4 X £192)/7,000 = £0.11

Material handling related costs

Cost per material handing= £7,580/27 = £280.74
Material handling cost per unit of output:
Product A (2 x £280.74)/500 = £1.12
B (10 X £280.74)/5,000 = £0.56
C (3 X £280.74)/600 = £1.40
D (12 X £280.74)/7,000 = £0.48
Spare parts
Cost per part= £8,600/12 = £716.67
Adminstration of spare parts cost per unit of output:
Product A (2 x £716.67)/500 £2.87
B (5 X £716.67)/5,000 = £0.72
C (1 X £716.67)/600 £1.19
D (4 X £716.67)/7,000 = £0.41

Overhead cost per unit of output

Product A B c D
(£) (£) (£) (£)
ABC overhead cost:
Machine overheads 0.75 0.75 3.00 4.50
Set-ups 0.51 0.31 0.85 0.29
Material ordering 0.38 0.15 0.32 0.11
Material handling 1.12 0.56 1.40 0.48
Spare parts 2.87 0.72 1.19 0.41
5.63 2.49 6.76 5.79
Present system 1.20 1.20 4.80 7.20
Difference +4.43 +1.29 +1.96 -1.41

118------------------------ ACTIVITY-BASEDCOSTING
 The present system is based on the assumption that all overhead expen-
diture is volume-related, measured in terms of machine hours. However,
the overheads for the five support activities listed in the question are
unlikely to be related to machine hours. Instead, they are related to the
factors that influence the spending on support activities (i.e. the cost
drivers). The ABC system traces costs to products based on the quantity
(cost drivers) of activities consumed. Product D is the high volume
product, and thus the present volume-based system traces a large share
of overheads to this product. In contrast, the ABC system recognizes
that product D consumes overheads according to activity consumption
and traces a lower amount of overhead to this product. The overall
effect is that, with the present system, product D is overcosted and the
remaining products are undercosted. For a more detailed explanation
of the difference in resource consumption between products for an ABC
and traditional cost system see 'An illustration of ABC and traditional
product costing systems' in Chapter 11.

ANSWERTOQUESTION11.4 - - - - - - - - - - - - - - - - - - - - - - - - -
119
 Capital investment
decisions
Answers to Chapter 12

Question summary================
12.1
Payback and NPV calculations.
12.2
Calculation of internal rate of return (IRR) with equal annual cash flows.
12.3
A discussion of the authorization and control procedure for capital invest-
ment decisions plus payback and NPV calculations.
12.4
Calculation of accounting rate of return and NPV.
12.5
Part (a) requires the calculation of the NPV and the payback period. Part
(b) is concerned with a machine replacement decision. The cost savings of
replacing the machine are regarded as cash inflows and the revenues are
considered to be irrelevant since they are the same for the existing and the
replacement machine.
12.6
Calculation of NPV and payback.
12.7
Calculation of the payback period resulting from the introduction of a
new computerized accounting system. Cash inflows are represented by the
cost savings resulting from the introduction of the computer. Parts (b) and
(c) require a discussion of the effects of introducing a computerized
accounting system.
12.8 to 12.13
These questions require the calculation of payback, accounting rate of
return and net present value, and in most cases, require a recommenda-
tion as to which project should be accepted. Questions 12.8 and 12.11 also
require an explanation of the procedures for authorizing and controlling
capital investments.

CAPITAL INVESTMENT DECISIONS

----------------------------------------------121
IAnswer to question 12.1
(a) (i) Annual cash flow= Annual profit+ Annual depreciation (£15,000).
The annual cash flows for each project are as follows:
Year Project 1 Project 2
£ £
1 45,000 40,000
2 45,000 30,000
3 35,000 35,000
4 5,000 35,000
5 5,000 0

1 + 75-45 2+ 75-70
Payback period
45 35
1.7 years = 2.1 years

(ii) Discount Project 1 Project 2

Cash flow factor PV Cash flow PV
£ £ £ £
Outlay (75,000) 1 (75,000) (75,000) (75,000)
Year 1 45,000 0.869 39,105 40,000 34,760
2 45,000 0.756 34,020 30,000 22,680
3 35,000 0.657 22,995 35,000 22,995
4 5,000 0.571 2,855 35,000 19,985
5 5,000 0.497 2,485
PV Inflows £101,460 £100,420
NPV £26,460 £25,420

(b) See sections on the concept of NPV and payback methods in Chapter 12
for the answer to this question.
(c) Both the NPV and payback methods indicate that the firm should
choose Project 1.

IAnswer to question 12.2

(a) The IRR is where:
annual cash inflows x discount factor = investment cost
i.e. £4,000 x discount factor = £14,000
£14,000
Therefore discount factor = - - -
£4,000
= 3.5

122-------------------------------------- CAPITAL INVESTMENT DECISIONS

 We now work along the five-row table of the cumulative discount tables
to find the discount rate with a discount factor closest to 3.5. This is
13%. Therefore the IRR is 13%.

(b) The annual saving necessary to achieve a 12% internal rate of return is
where:
annual savings x 12% discount factor investment cost
i.e. annual savings x 3.605 = £14,000
£14,000
Therefore annual savings =---
3.605
= £3,883

(c) NPV is calculated as follows:

£4,000 received annually from years 1-5: (£)
£4,000 x 3.791 discount factor 15,164
Less investment cost 14,000

NPV 1,164

IAnswer to question 12.5

(a) This part of the question requires you to focus on the new machine only
and does not require a decision as to which machine should be pur-
chased. Depreciation should not be included in the analysis because it is
already included in the investment cost. Allocated costs are not relevant
costs. The net cash inflow per unit is £1.75 (£3- £1.25).

Net cash inflow Discount factor Present value

£ £
Year 1 70,000 (40,000 x £1.75) 0.833 58,310
2 70,000 0.694 48,580
3 52,500 0.579 30,398
4 35,000 0.482 16,870
5 35,000 0.402 14,070
168,228
Investment cost (150,000)
NPV 18,228

(i) Payback period: Cumulative cash inflows are £140,000 by the end
of year 2 and a further £10,000 is required to repay the initial cost.
Therefore the payback period is 2 years plus £10,000/£52,500 or
2.19 years.
(ii) NPV = £18,228.

(b) The cash inflows are represented by the savings in relevant operating
costs of £0.25 per unit (£1.50- £1.25) and the sale proceeds from the old
machine of £130,000.

ANSWER TO QUESTION 12.5 123

 Net cash inflow Discount factor Present value
£ £
Year 0 130,000 1.000 130,000
1 10,000 (40,000 X £0.25) 0.833 8,330
2 10,000 0.694 6,940
3 7,500 0.579 4,342
4 5,000 0.482 2,410
5 5,000 0.402 2,010

154,032
Investment cost (150,000)

NPV 4,032

(c) Factors to be considered:

(i) The quality of fruit pies.
(ii) The reliability and speed of delivery service.
(iii) The possibility of future price increases.
(iv) The number of suppliers. If there are few suppliers the group
might be entirely dependent on the supplier who may take advan-
tage of the situation.
(v) The impact on the work force. Will there be any redundancies? Is
there high unemployment in the area?

IAnswer to question 12.8

(a) Actual costs should be compared with estimated costs which were
included in the proposal. This process will provide an incentive for the
proposers of future projects to make careful estimates and also provide
an incentive to control costs and the date of completion.
Comparisons should take place at periodic intervals during the instal-
lation and construction stage of the project. Reports should be prepared
which give details of the percentage completion; over- or under-spend-
ing relative to the stage of completion; the estimated costs to complete
compared with the original estimate; the time taken compared to the
estimate for the current stage of completion; and also the estimated
completion date compared with the original estimate. This information
will enable management to take corrective cost-saving action such as
changing the construction schedule. Every effort should be made to
avoid a delay in completion because this can be expensive in terms of
additional costs.

(b) (i) Payback calculation:

Cash flows (1) Cumulative cash flows
£ £
Project A
Year 1 17,000 17,000
2 14,000 31,000
3 24,000 55,000
4 13,000 68,000

CAPITAL INVESTMENT DECISIONS

124 - - - - - - - - - - - - - - - - - - - -
 Project B
Year 1 15,000 15,000
2 13,000 28,000
3 15,000 43,000
4 29,000 72,000

Note:
(1) Cash flow= Annual profits+ Annual depreciation (£10,5000).

£46,000-£31,000
Payback period: A : 2 years + = 2.6 years
£24,000

£46,000 - £43,000
B: 3 years + 3.1 years
£29,000

Average rate of return calculation:

Average profit (£68,000- £46,000)/4 years

A: =22%
Average investment (£46,000/2) + (£4,000/2)

(£72,000- £46,000)/4 years

B: =26%
(£46,000/2) + (£4,000/2)

Net present value calculation:

Proposal A Proposal B
Year Factor Cash flow Present Cash flow Present
value value
£ £ £ £
1 0.833 17,000 14,161 15,000 12,495
2 0.694 14,000 9,716 13,000 9,022
3 0.579 24,000 13,896 15,000 8,685
4 0.482 9,000 4,338 25,000 12,050
4 0.482 4,000 1,928 4,000 1,928
44,039 44,180
Initial investment 46,000 46,000
Net present value (1,961) (1,820)

(ii) Advantages of each method:

Payback:
(1) Simple to calculate and easy to understand.
(2) Useful when liquidity is a problem.
(3) Early payback provides some protection against risk.

Accounting rate of return:

(1) Consistent with profit criteria used for external reporting.
(2) Concept of rate of return is widely understood by managers.

ANSWER TO QUEST! 0 N 12.8 125

 Net present value:
(1) Incorporates the time value of money.
(2) Takes into account the opportunity cost of investment.
The net present value method is recommended because it is the
theoretically correct method. It takes into account the time value
of money and the opportunity cost of an investment. For a more
detailed explanation you should read Chapter 12.

IAnswer to question 12.10

(a) The answer should stress that NPV is considered superior to the
payback method and the accounting rate of return because it takes
account of the time value of money. For a description of the time value
of money you should refer to 'Compounding and discounting' and 'The
concept of net present value' in Chapter 12. The answer should also
draw attention to the limitations of the payback method and accounting
rate of return described in Chapter 12.
(b) (i) To compute the NPV it is necessary to convert the profits into cash
flows by adding back depreciation of £25,000 per annum in respect
of the asset purchased at the end of year 3 for £75,000. The NPV
calculation is as follows:
Year Cash flow Discount factor NPV
£
3 (75,000) 0.675 (50,625)
4 35,000 0.592 20,720
5 28,000 0.519 14,532
6 27,000 0.465 12,555
(2,818)

(b) (ii) The cash flows are based on the assumption that the reinvestment
in R is not made at the end of year 3.
Discount Project T Project T Project R Project R
Year factor cash flows (1) NPV cash flows NPV
£ £ £ £
1 0.877 27,000 23,679 40,000 (3) 35,080
2 0.769 30,000 23,070 45,000 34,605
3 0.675 32,000 21,600 45,000 (4) 30,375
4 0.592 44,000 26,048
5 0.519 40,000 (2) 20,760
115,157 100,060
Investment outlay 70,000 60,000
NPV 45,157 40,060

Payback: T = 2 years+ (£70,000- £57,000)/£32,000 = 2.41 years

R = 1 year+ (£60,000- £40,000)/£45,000 = 1.44 years

126--------------------------------------- CAPITAL INVESTMENT DECISIONS

 The decision should be to invest in Project T because it has the higher
NPV.

Notes:
(1) Yearly profits plus (£70,000- £10,000)/5 years depreciation
(2) £18,000 profits + £12,000 depreciation + £10,000 sale proceeds
(3) Profits plus £60,000/3 years depreciation
(4) £75,000 investment outlay- £50,000 =Annual profit (£25,000). Cash flow=
£25,000 profit + £20,000 depreciation.

(c) For an explanation of the meaning of the term 'discount rate' see 'The
opportunity cost of an investment' in Chapter 12. The discount rate can
be derived from observations of the returns shareholders require in
financial markets. Where a project is to be financed fully by borrowing,
the cost of borrowing could be used as a basis for determining the
discount rate.

Answer to question 12.11

(a) The answer should describe the following stages:
(1) Initiation of proposals: The originator of a proposal should make a
request for a capital appropriation for those projects which would
seem to have merit. The request should include a description of the
proposal, the reasons for making it, and an estimate of the costs,
benefits and economic life.
(2) Approval of the proposal: A financial appraisal should be under-
taken by the accounting staff and a system of approval should be
established. A capital expenditure committee should be established
and the committee should then be responsible for approving all
major projects. Procedures should also be set for the approval at
lower management levels of the less important projects.
(3) Control: Actual costs should be compared with estimated costs
which were included in the project proposal. This process will
provide an incentive for the proposers of future projects to make
careful estimates and also provide an incentive to control costs and
the date of completion. Comparisons should take place at periodic
intervals during the installation and construction stage of the
project. Reports should be prepared which give details of the per-
centage completion; the estimated costs to complete compared with
the original estimate; the time taken compared to the estimate for
the current stage of completion; and also the estimated completion
date compared with the original estimate. This information will
enable management to take corrective cost-saving action, such as
changing the construction schedule. Every effort should be made to
avoid a delay in completion because this can be expensive in terms
of additional costs.
(4) Post-audit: A review of the project should be undertaken once it has
been completed to evaluate the capital expenditure decision. This
should involve a comparison of actual cash flows with budgeted cash
flows.

ANSWER TO QUESTION 12.11 127

 (b) (i) Annual depreciation for both projects is £40,000 per annum
(£200,000 - £40,000)/4 years. This is added back to profits to
compute cash flows.
Project X y
£ £
Year 1 Cash flows 120,000 70,000
2 120,000 90,000
3 80,000 130,000
4 100,000 200,000

Payback periods:
Project X = 1 year+ (£200,000- £120,000)/£120,000
= 1.67 years
Project Y = 2 years+ (£200,000- £160,000)/£130,000
= 2.3 years
(ii) Accounting rate of return
Project profits X y
£ £
Year 1 80,000 30,000
2 80,000 50,000
3 40,000 90,000
4 20,000 120,000
220,000 290,000
Number of years 4 4
Average profit 55,000 72,500
200,000 + 40,000 200,000 + 40,000
Average investment
2 2
= 120,000 = 120,000
55,000 72,500
Accounting rate of
return 120,000 120,000
=46% =60%

(iii) Discounted cash flow

Project X Project Y
Cash flow DCF Cash flow DCF
Factor £ £
0.862 Year 1 120,000 = 103,440 70,000 60,340
0.743 2 120,000 89,160 90,000 66,870
0.641 3 80,000 = 51,280 130,000 83,330
0.552 4 100,00 = 55,200 200,000 110,400
299,080 320,940
Less initial investment 200,000 200,000
Net present value 99,080 120,940

128---------------------------------------
CAPITAL INVESTMENT DECISIONS
 (c) The answer should explain that the decision should be based on the
NPV technique and justify the superiority of this method over the
payback and accounting rate of return methods. (See Chapter 12 for an
explanation.) Therefore Project Y should be selected.
(d) (i) See 'The opportunity cost of an investment' in Chapter 12 for an
explanation of the cost of capital. The cost of capital is important
because it represents the opportunity cost of shareholders' funds.
Only those projects which yield a return in excess of the opportun-
ity cost of capital should be accepted.
(ii) Risk can be taken into account by:
(1) increasing the discount rate for higher risk projects;
(2) using the payback method and, for high risk projects, accepting
only those projects with short payback periods.

129
ANSWER TO QUESTION 12.11 - - - - - - - - - - - - - - - - - - - - - - - - -
 The budgeting process
Answers to Chapter 13

Question summary================
13.1 and 13.2
Discussion questions relating to budgeting.
13.3 to 13.9
Preparation of cash budgets. Question 13.9 is the most difficult. Question
13.3 also requires the preparation of the budgeted Profit and loss account
and balance sheet and 13.6 involves the calculation of stock, debtor and
creditor balances.
13.10 to 13.16
Preparation of functional budgets. Question 13.14 also requires the calcu-
lation of sales to achieve a target profit and 13.16 involves the computa-
tion of a standard product cost.
13.17
Preparation of a budgeted Profit and loss account and Balance sheet plus
a description of how overheads are allocated to products.
13.18
Calculation of the number of budgeted direct labour employees required
to meet budgeted production plus the calculation of product direct labour
costs.
13.19
Calculation of direct labour hours to meet quarterly budgeted production
requirements and comparisons with budgeted available hours. Part (b)
requires a discussion of alternative courses of action to overcome a bud-
geted shortfall in labour hours.
13.20
Preparation of materials purchase and usage budget and journal entries
for a standard costing system.
13.21
Construction of a model in the form of equations for the preparation of a
cash budget.

THE BUDGETING PROCESS

------------------------------------------------131
IAnswer to question 13.3
(a) (i) Freewheel Ltd
Cash Budget July-December 1992
July Aug. Sep. Oct. Nov. Dec.
£ £ £ £ £ £
Opening balance 3,000 (1,500) (1,600) 15,300 14,100 8,200
Receipts
Sales
Cash 13,500 13,800 14,400 20,000 15,200 12,000
Credit 12,000 12,600 13,500 13,800 14,400 20,000
Share issue 20,000
--
25,500 26,400 47,900 33,800 29,600 32,000
Expenses
Purchases 12,000 13,000 14,000 18,000 16,000 14,000
Wages and
salaries ( 1) 6,000 7,500 7,500 7,500 9,000 9,000
(2) 2,000 2,000 2,500 2,500 2,500 3,000
Overheads 7,000 7,000 7,000 7,000 8,000 8,000
Fixed Asset
Purchase 10,000

27,000 29,500 31,000 35,000 35,500 44,000

Surplus/deficit (1,500) (3,100) 16,900 (1,200) (5,900) (12,000)
Closing balance 1,500 (1,600) 15,300 14,100 8,200 (3,800)

(ii)
Freewheel Ltd
Budgeted Profit and Loss Account
6 months July-December 1992
£ £
Sales 13,900 x £6 83,400
11,800 X £8 94,400
177,800
Less Cost of sales
Opening stock 25,000
Purchase 86,000
Closing stock (38,000)
73,000
Gross profit 104,800
Less expenses
Wages and salaries 62,000
Overheads 45,000
Depreciation (6 months) 8,500
(115,500)
Net loss (10,700)

132------------------------------------------- THE BUDGETING PROCESS

 (iii) Budgeted Balance Sheet
As at 31 December 1992
Cost Depree. Prov. NBV
£ £ £
Fixed assets 170,000 22,500 147,500
Current assets
Stock 38,000
Trade Debtors 27,200
Bank 65,200

Creditors: Amounts falling within one year

Trade creditors 24,000
Other creditors 41,000
Bank overdraft 3,800
(68,800)
Net current assets (3,600)
Total assets less current liabilities 143,900
Shares 120,000
Profit and loss account 23,900
143,900

(b) The answer should draw attention to:

(i) The net loss for the year.
(ii) The overdraft at the end of the period and the fact that dividends
and asset payments are due shortly means that there is an urgent
need to arrange overdraft cover.
(iii) Stocks have increased from two months to three months pur-
chases even though sales have declined. Why has this occurred?
(iv) Sales have declined in November and December. The reasons for
the decline should be investigated.

Answer to question 13.6

(a) Monthly cash budget:

Month 1 Month 2 Month 3 Month 4

£000 £000 £000 £000
Cash inflows:
Sales (W1) 24.0 93.6 92.6 90.7
Cash outflows:
Business purchase 315.0
Delivery van 15.0

ANSWER TO QUESTION 13.6 - - - - - - - - - - - - - - - - - - - - - - - - - 133

 Month 1 Month 2 Month 3 Month 4
£000 £000 £000 £000
Raw materials (W2) 44.375 29.375 30.625
Direct labour (W2) 27.0 17.25 18.0 18.75
Production overhead (W3) 10.5 10.5 10.5 10.5
Selling and administration 39.875 14.875 14.875 14.875
overhead (W4)
392.375 102.0 72.75 74.75
Surplus/( deficit) for month (368.375) (8.4) 19.85 15.95
Opening balance (368.375) (376.775) (356.925)
Closing balance (368.375) (376.775) (356.925) (340.975)

Workings:
Month 1 Month2 Month 3 Month 4
W1 Cash inflow from sales 24 24 23 24
Cash inflow from
credit sales 72 72 69
Less Discount (2.4) (2.4) (2.3)
69.6 69.6 66.7
Total cash inflow 24 93.6 92.6 90.7

W2 Selling price at a mark-up of 60% on production cost is £8 per unit

(£5.00 X 1.60).

Sales units = sales revenue+ 8.

(000 units) Month 1 Month2 Month 3 Month 4 Month 5 Month 6
Sales 12 12 11.5 12 12.5 13
+ Closing stock of
finished goods 12 11.5 12 12.5 13
Opening stock of
finished goods 6 12 11.5 12 12.5
Production 18 11.5 12 12.5 13
+ Closing stock of
raw materials 5.75 6 6.25 6.5
Opening stock of
raw materials 6 5.75 6 6.25
Purchase of raw
materials 17.75 11.75 12.25 12.75

Raw material cost (£000) Month 1 Month2 Month 3 Month4

Purchases at £2.50 44.375 29.375 30.265 31.875
Raw material payment (£000) 44.375 29.375 30.625
Direct labour cost and
payment (£000)
Production x £1.50 27 17.25 18 18.75

134 THE BUDGETING PROCESS

 W3 Production overhead = £1.00 x 150,000 units
:::£150,000
£24,000 (£120,000 + 5)
Less Depreciation
Annual payment £126,000
Monthly payment £10,500

W4 Selling and administration overhead = £208,000

Less depreciation (Year 1) 4,500 (£15,000 x 30%)

203,500
Less rent and rates 25,000

Year 1 payment 178,500 (excluding rent and

rates)
Monthly payment £14,875 (plus £25,000 in
Month 1)

£
(b) Finished goods stock (12,500 units x £5 per unit) 62,500
Raw materials stock (6,500 units x £2.50 per unit) 16,250
Debtors 69,600

148,350

Creditors 31,875

Apart from the purchase of the business the cash budget suggests that
there will be sufficient cash inflows to meet the cash outflows. The
current assets and debtors provide sufficient funds to cover the cred-
itors. However, this does not take into account possible funding by bank
overdraft to finance the business purchase.

IAnswer to question 13.8

(a) (i) Cash budget:
January February March April
£ £ £ £
Balance b/d 10,000 9,000 3,890 9,090
Sales (W1) 15,200 57,100 80,000
10,000 24,200 60,990 89,090
Purchases (W3) 11,550 24,500 26,950
Wages(W4) 4,800 19,800 22,200
Variable overhead (W5) 960 4,600 7,080
Fixed overhead (W6) 1,000 3,000 3,000 3,000
1,000 20,310 51,900 59,230
Balance c/d 9,000 3,890 9,090 29,860

ANSWER TO QUESTION 13.8 135

 Workings:
W1 Sales:
Amount 20% Discount Net 50% 20% 8% Total
5% cash
receipts
January
February 80,000 16,000 800 15,200 15,200
March 90,000 18,000 900 17,100 40,000 57,100
April 100,000 20,000 1,000 19,000 45,000 16,000 80,000
May 100,000 20,000 1,000 19,000 50,000 18,000 6,400 93,400

W2 Production:
Total
January 800 800
February 2,400 900 3,300
March 2,700 1,000 3,700
April 3,000 1,000 4,000
May 3,000
3,200 3,600 4,000 4,000

W3 Purchases at £7 per unit:

Current Following
Production month month Total Value(£)
January February (3,300) 1,650 1,650 11,550
February March (3,700) 1,650 1,850 3,500 24,500
March April (4,000) 1,850 2,000 3,850 26,950
W4 Direct wages:
February payment 800 X £6 £4,800
March payment 3,300 x£6 = £19,800
April payment 3,700 X £6 £22,200

W5 Variable overhead at £2 per unit:

Production February March April May
£ £ £ £
January (£1,600) 960 640
February (£6,600) 3,960 2,640
March (£7,400) 4,440 2,960
960 4,600 7,080 2,960

W6 Fixed overhead:
January February March April
£ £ £ £
January 1,000 2,000
February 1,000 2,000
March 1,000 2,000
April 1,000
1,000 3,000 3,000 3,000

136---------------------------------------- THE BUDGETING PROCESS

 (ii) It is assumed that the question relates to the amount received from
customers in May and not the amount due. The answer is £93,400
(see W1).
(b) A software package would eliminate the tedious arithmetical calcula-
tions which are necessary to produce cash budgets. Furthermore, it
would enable alternative scenarios to be considered such as what the
outcome would be if any of the parameters were changed.

Answer to question 13.12

The calculation of the standard cost and selling price for each product is as
follows:
Aye Bee
£ £
Direct material cost 128 160
Direct wages 60 40
Production overhead (see Note):
16 hours at £12 192
10 hours at £12 120
Production cost 380 320
Other overheads 76 64
Total cost 456 384
Profit margin 20/(100- 20) x Total cost 114 96
Selling price 570 480

Note:
£900,000
Production overhead absorption rate = = £12 per hour
75,000 hours

(a) Production budget (units):

Aye Bee
Sales 2,400 (£1,368,000 + £570) 3,200 (£1,536,000 + £480)
Add
Closing stock 500 (£190,000 + £380) 1,100 (£352,000 + £320)
2,900 4,300
Less
Opening
stocks (400) (£152,000 + £380) (800) (£256,000 + £320)
Production
required 2,500 3,500

ANSWER TO QUESTION 13.12 - - - - - - - - - - - - - - - - - - - - - - - - - 137

 (b) Purchase budget: X y z
Materials kg kg kg
Production: Aye 2,500 units 60,000 25,000 12,500
Bee 3,500 units 105,000 28,000 35,000

165,000 53,000 47,500

Plus closing stock 35,000 27,000 12,500

200,000 80,000 60,000

Less opening stock (30,000) (25,000) (12,000)

Purchases required (kg) 170,000 55,000 48,000

Cost per kg £2 £5 £6

Purchases cost £340,000 £275,000 £288,000

Total purchases £903,000

(c) Production cost budget: Aye Bee Total

Production (units) 2,500 3,500
£ £ £
Direct materials:
X at £2 per kg 120,000 210,000 330,000
Y at £5 per kg 125,000 140,000 265,000
Z at £6 per kg 75,000 210,000 285,000
320,000 560,000 880,000
Direct wages:
Unskilled at £3 per hour 75,000 52,500 127,500
Skilled at £5 per hour 75,000 87,500 162,500

150,000 140,000 290,000

Production overhead:
Direct labour hour rate
(£12 per hour) 480,000 420,000 900,000
Production cost 950,000 1,120,000 2,070,000

IAnswer to question 13.14

(a)
Product A B c Total
Sales mix weighting 1 2 4
(£) (£) (£) (£)
Unit selling price 215 250 300
Unit costs:
Frame 20 20 20
Component D (at £8 per unit) 40 8 24
E (at £5 per unit) 5 35 25
F (at £3 per unit) 12 15 3
57 58 52

138 THE BUDGETING PROCESS

 Labour:
Skilled (at £6 per hour) 12 9 9
Unskilled (at £4.50 per hour) 9 9 13.5
21 18 22.5
Variable production overhead 5 4 3.5
Contribution 112 150 202

Weighted by sales mix 112 300 808 1,220

Required period 1 contribution: (£m)

Profit 0.500 (£6.5 m/13)
Add fixed costs:
Production 0.056 (£0.728 m/13)
Selling and distribution 0.028 (£0.364 m/13)
Administration 0.026 (£0.388 m/13)
0.610
:. 500 (£610,000/£1220) 'mixes' must be sold each period.
(i) Sales budget
A B c
Sales quantities 500 1,000 2,000
Sales value (£) 107,500 250,000 600,000

(ii) Production budget

Sales quantities 500 1,000 2,000
Closing stock 270 630 1,440

770 1,630 3,440

Opening stock 300 700 1,600
Production 470 930 1,840

(iii) Material usage budget

Total
Usage: (units)
Frame 470 930 1,840 3,240
D 2,350 930 5,520 8,800
E 470 6,510 9,200 16,180
F 1,880 4,650 1,840 8,370

(iv) Purchases budget

Purchases (units): Frame D E F
Closing stock 900 3,600 9,000 3,600
Add used in production 3,240 8,800 16,180 8,370
4,140 12,400 25,180 11,970
Less opening stock 1,000 4,000 10,000 4,000
Purchases (unit) 3,140 8,400 15,180 7,970
Cost(£) 62,800 67,200 75,900 23,910

ANSWER TO QUESTION 13.14 139

 (v) Manpower budgets
Machining Assembly
(hours) (hours)
A (units produced x hours per unit) 940 940
B 1,395 1,860
c 2,760 5,520
5,095 8,320
Hours available per period (4 x 37.5) 150 150
Number of people required 34 56

(b) The following factors would need to be considered:

(i) The ability to be able to plan future production requirements,
since production might be halted if there was a sudden increase in
production. If production is volatile, there is a danger that stock-
outs might occur.
(ii) The speed and reliability of the delivery service. If suppliers can
deliver at short notice then stockouts are less likely to occur.
(iii) The extra costs involved arising from more frequent deliveries in
terms of ordering costs and quantity discounts.
(vi) Alternative use of storage space.
(v) The savings in holding costs arising from the reduction in stocks.
Stock reductions in units would be as follows:

Frames D E F
End of
period 1 900 3,600 9,000 3,600
Requirements
for 1 week 810 (3,240/4) 2,200 (8,800/4) 4,045 (16,180/4)2,092 (8,370/4)
Stock
reduction 90 1,400 4,955 1,508

Answer to question 13.15

(a) Production budget (units) and material purchases budget:
K B Total
Budgeted sales 3,000 4,500
Add closing stock (1) 750 1,500
3,750 6,000
Less anticipated opening stock 1,050 1,200
Production requirements 2,700 4,800

140------------------------------------------- THE BUDGETING PROCESS

 Material consumption 6 kg 2 kg
Material requirements (production budget) 16,200 kg 9,600 kg 25,800
Add closing stock (2) 4,300

30,100
Less opening stock 3,700
Total materials to be purchased (kg) 26,400
Budgeted material cost per kg £3
Total materials to be purchased (£) £79,200

Notes:
(1) There are 60 days in an accounting period. The budgeted sales quantities
per day are 50 units of K (3,000 + 60) and 75 ( 4,500 + 60) units for B.
Therefore the budgeted closing stocks are as follows:
K: 15 days at 50 units per day= 750 units
B : 20 days at 75 units per day= 1,500 units
(2) 10 days, consumption at 430 kg (25,800 + 60) per day.

Direct wages budget: K B Total

Budgeted production (see
production budget) 2,700 units 4,800 units
Standard hours per unit 5 3
Budgeted production in
standard hours 13,500 14,400 27,900
Budgeted production input
hours worked (27,900 x 100/90) 31,000
Add budgeted downtime
(20% X 31,000) 6,200
Total attendance hours required 37,200

Budgeted wages paid: £

Normal time (65 workers x 40 hours/week x 12 weeks 124,800
= 31,200 man hours) at £4
Overtime (37,200- 31,200 = 6,000 hours) at £6/hour 36,000
Total budgeted wages paid 160,800

(b) The following additional information is required:

(i) payment terms offered by each supplier;
(ii) intervals when wages are paid;
(iii) timing of payments deducted from employees to be paid to
relevant authorities;
(iv) analysis of wages paid each week during the period of production,
overtime, etc., are not constant week;
(v) analysis of total purchases on weekly basis.

ANSWER TO QUESTION 13.15 141

IAnswer to question 13.16
(a)
Product Y Product Z
£ £
Current Standards:
Direct materials:
A: 30 kg at £5.20 per kg 156.00
15 kg at £5.20 per kg 78.00
B: 30 kg at £1.80 per kg 54.00
40 kg at £1.80 per kg 72.00
Direct labour:
Mixing (2.5 hours at £4.50) 11.25 11.25
Packaging (5 hours at £4) 20.00 20.00

New Standards:
Direct materials:
A: 29.333 kg (1) at £5.46 per kg 160.16
14.667 kg (2) at £5.46 kg 80.08
B: 30 kg at £1.89 per kg 56.70
40 kg at £1.89 per kg 75.60
Direct labour:
Mixing (2.5 hours at £4.86) 12.15 12.15
Packaging (5 hours at £4.32) 21.60 21.60

Notes:
(1) Input for material A excluding loss= 26.667 kg (30/1.125)
Revised input for material A = 29.333 kg (26.667 x 1.10)
(2) Input excluding loss = 13.333 kg (15/1.125)
Revised input = 14.667 kg (13.333 kg x 1.10)

(b) (i) Production budget:

Product Y Product Z
(units) (units)
Sales 1,700,000 950,000
Add closing stock 200,000 125,000

1,900,000 1,075,000
Less opening stock 190,000 150,000

Production 1,710,000 925,000

(ii) Material B purchases budget:

Required for production: Kilos
Product Y:
1,710,000 units at 30 kg per hundred 513,000
Product Z:
925,000 units at 40 kg per hundred 370,000

883,000

142-------------------------------------------- THE BUDGETING PROCESS

 Add closing stock 90,000

973,000
Less opening stock 95,000
Purchases 878,000

(iii) Mixing labour budget:

Total production:
Product Y 1,710,000
Product Z 925,000
2,635,000 units
at 2.5 hours per hundred
= 65,875 hours

(c) For the answer to this question you should refer to 'Why do we produce
budgets' in Chapter 13. In particular, the answer should describe plan-
ning, co-ordinating, communicating, motivating, control and evaluation
roles of budgets.

IAnswer to question 13.17

Workings:
Average stock= (40,000 + 60,000)/2 = 50,000 units
Sales volume = 50,000 units x 6 = 300,000 units
Unit production cost= £0.54 (product costs are 60% of sales)
Selling price = £0.54/0.6 = £0.90
Total sales revenue = 300,000 x £0.90 = £270,000

(a) Budgeted profit and loss account:

£ £
Sales 270,000
Cost of sales (300,000 x £0.54) 162,000
Gross profit (40% x £270,000) 108,000
Selling and administration expenses:
Variable (4% x 270,000) 10,800
Fixed 81,000 91,800
Net profit 16,200

(b) Budgeted balance sheet:

£ £
Opening capital (1) 207,600
Net profit for year 16,200 223,800
Fixed assets 200,000
Less accumulated depreciation 40,000 160,000

ANSWER TO QUESTION 13.17 - - - - - - - - - - - - - - - - - - - - - - - - - 143

 Net current assets:
Stock (£20,000 raw material+ (60,000 x £0.54)) 52,400
Debtors (£270,000 sales/12) 22,500
Bank (2) 4,900

79,800
Less creditors 16,000 63,800

223,800

Notes:
(1) Opening capital: £
Fixed assets 180,000
Raw material stock 20,000
Finished goods stock (40,000 x £0.54) 21,600
Debtors 20,000
Creditors (16,000)
Bank overdraft (18,000)
207,600

(2) Opening balance (18,000)

Depreciation 20,000
Increase in debtors (2,500)
Increase in finished goods stock (10,800)
Profit 16,200
4,900

(c) For the answer to this question see section on procedure for calculating
departmental overhead rates in Chapter 4. In particular the answer
should contain a discussion of the following stages:
(i) Cost centres should be established for production and service
activities.
(ii) Estimate by type of expense those overheads which are direct
charges to cost centres.
(iii) Estimate by type of expense those overheads which benefit all
cost centres and apportion overheads to cost centres according to
relative benefits received.
(iv) Apportion service cost centre overheads to production cost
centres according to benefits received.
(v) Establish appropriate overhead absorption rates for each produc-
tion cost centre using direct labour hours or machine hours.
(vi) Charge overheads to jobs according to direct labour hours or
machine hours used.

Answer to question 13.19

(a) Product M:
Production budget Qtr 1 Qtr2 Qtr 3 Qtr4
Sales (units) 9,000 20,000 14,000 8,000
Closing stock 5,000 5,000 4,000 4,000
14,000 25,000 18,000 12,000

144------------------------------------------- THE BUDGETING PROCESS

 Less opening stock 3,000 5,000 5,000 4,000
Good production required 11,000 20,000 13,000 8,000
Budgeted rejects (20/80) 2,750 5,000 3,250 2,000
Production 13,750 25,000 16,250 10,000
Standard hours (5 hours per unit) 68,750 125,000 81,250 50,000
Product N:
Sales 10,000 16,500 11,000 7,000
Closing stock 4,000 4,000 2,000 2,000
14,000 20,500 13,000 9,000
Less opening stock 1,000 4,000 4,000 2,000
Production 13,000 16,500 9,000 7,000
Standard hours (3 hours) 39,000 49,500 27,000 21,000

Totals:
Total standard hours 107,750 174,500 108,250 71,000
Labour hours required (x 10/9) 119,722 193,889 120,278 78,889
Hours available - basic
(210 X 40 X 12) 100,800 100,800 100,800 100,800
Hours available - overtime
(210 X 12 X 12) 30,240 30,240 30,240 30,240
Total hours available 131,040 131,040 131,040 131,040
Shortfall 62,849
Surplus 11,318 10,762 52,151

(b) (i) There is a shortfall in the second quarter and a large surplus in the
other quarters, particularly in the fourth quarter. Possible courses
of action include:
(1) Increase production in the first quarter, but this will provide
only 11,318 hours to cover the shortfall of 62,849 hours.
(2) Carry zero stocks at the end of period 2. The hours which could
be saved are:

Hours
M (5,000 X 100/80 X 5 X 100/90) 34,722
N (4,000 X 3 X 100/90 13,333
48,055

This would cause problems in period 3 as there will be no

opening stocks and thus insufficient hours to meet sales
demand in this period.
(3) Improved labour efficiency (at present it is 90%) and reduce
the wastage rate of 20% for product M.
(4) There are surplus hours in quarter 4 and overtime is planned
for the third quarter. Overtime should be avoided by reducing

ANSWER TO QUESTION 13.19 - - - - - - - - - - - - - - - - - - - - - - - - - 145

 the planned closing stock for the third quarter and increasing
stocks in the fourth quarter.
(ii) If the labour hours are insufficient to meet budgeted sales volume
then, in the short term, profits can be maximized by concentrating
on the product which earns the largest contribution per labour
hour. The limitation of such an approach is that this may have a
harmful effect on customer goodwill if the company is not prepared
to meet the demand. This could reduce future sales.

IAnswer to question 13.21

(a) Lett= month for which forecast is required so that:
t0 = Current month
t 1 =Next month
L 1 = Previous month
Let S equal the sales for the current month.
The equations for use in the cash budgeting model are as follows:
Sales= S(1.01)t
Cost of sales= 0.75S (Gross profit margin is 33 113% on cost of sales.
Therefore cost of sales is 75% of sales)
Cash collections t months from now:
0.2S(1.01)t + 0.8(0.2S(l.01)t-t) + 0.8(0.6S(l.Ol)t-2) + 0.8(0.2S(l.01)t-3)
Purchases t months from now:
0.75S(1.01)t+2
Payments for purchases t months from now:
0.75S(l.01)t+ 1
Payment for expenses t months from now:
0.05S(1.01)t-t + 3,000 + 10,000
(b) S for June = £100,000
t = 3 (month of September is t + 3 months from June)
Collections during September:
0.2S(1.01)t + 0.8(0.2S(1.01)t-t) + 0.8(0.6S(1.01)t-2) + 0.8(0.2S(1.01)t-3)
= 0.2(100,000)(1.01) 3 + 0.8(0.2)(100,000)(1.01) 2
+ 0.8(0.6)(100,000)(1.01) + 0.8(0.2)(100,000)
= £20,606 + £16,322 + £48,480 + £16,000
= £101,408
Payments for purchases during September:
0.75S(l.01)t+t = 0.75(100,000)(1.01) 4 = £78,045

146------------------------------------------- THE BUDGETING PROCESS

 Payments for expenses during September:
=0.05S(1.01)2 + 3,000 + 10,000
= £5,100 + £3,000 + £10,000 = £18,100
The cash flow statement for September is as follows:
£ £
Receipts from sales 101,408
Payments: Purchases 78,045
Payroll 5,100
Utilities 3,000
Other costs 10,000 96,145

Increase in cash 5,263

(c) The following procedures can be applied to incorporate uncertainty:

(i) sensitivity analysis;
(ii) expected values;
(iii) simulation.
The most simple approach for cash budgeting is to apply sensitivity
analysis. By asking 'what if' questions, such as changes in percentages
for cash received each month from debtors, or changes in sales growth,
the variability of possible outcomes can be ascertained.

ANSWER TO QUESTION 13.21

-------------------------------------------147
 Control in the organization
Answers to Chapter 14

Question summary=================
14.1 to 14.3
Various discussion questions relevant to Chapter 14.
14.4 and 14.5
Preparation of cash and flexible budgets.
14.6
Preparation of flexible budget and a raw materials purchasing budget.
14.7
Preparation of functional and flexible budgets.
14.8 to 14.12
Questions relating to flexible budgeting. Question 14.8 requires calcula-
tions of variances from a flexible budget. Questions 14.9 and 14.10 require
the calculation of fixed and variable costs in order to prepare a flexible
budget and 14.11 involves the preparation of sales budgets based on limit-
ing factors. Question 14.12 requires the preparation of a flexible budget
and comments on the variances.
14.13
Comments on budget preparation and suggestions for improving the per-
formance reports.

IAnswer to question 14.5

(a)
Activity level(%) 90% 100% 110% 120%
Activity level
(direct labour hours- DLHs) 108,000 120,000 132,000 144,000
Fixed costs: £ £ £ £
Depreciation 22,000 22,000 22,000 22,000
Staff salaries 43,000 43,000 43,000 43,000
Insurances 9,000 9,000 9,000 9,000
Rent and rates 12,000 12,000 12,000 12,000

CONTROL IN THE ORGANIZATION - - - - - - - - - - - - - - - - - - - - - - - -

149
 Variable costs:
Power 32,400 36,000 39,600 43,200
Consumables 5,400 6,000 6,600 7,200
Direct labour 378,000 420,000 462,000 504,000
Semi-variable costs (1 ):
Fixed element 55,000 55,000 55,000 55,000
Variable element 270,000 300,000 330,000 360,000

Total 826,800 903,000 979,200 1,055,400

Note:
(1) The separation of costs into the fixed and variable elements is calculated
from past data using the high/low method:
DLHs Total cost
£
High (1988) 110,000 330,000
Low (1983) 80,000 255,000
Increase 30,000 75,000
Variable cost per DLH = £2.50 (£75,000/30,000 DLHs)
Fixed cost =£55,000 (£330,000- (110,000 X £2.50)]

(b) (i) Cash budget:

January February March April May June
Cash balance 2,000 (4,500) (3,200) (3,800) 2,300 9,800
+ Cash from sales 18,000 19,000 22,000 24,000 25,000 29,000
--------
20,000 14,500 18,800 20,200 27,300 38,800
--------
- Cash payments
Materials 9,000 10,000 7,000 9,000 11,000 4,000
Labour 3,900 4,000 4,200 4,700 3,700 4,100
Overhead 3,600 3,700 3,900 4,200 2,800 3,500
Capital 7,500 27,200
Tax 8,000
--------
24,500 17,700 22,600 17,900 17,500 38,800
--------

(ii) The firm should take the following action:

(1) It should arrange appropriate overdraft facilities from
February to April.
(2) The company pays suppliers one month after delivery but
allows customers two months' credit. The company should con-
sider delaying payment to suppliers by an extra month.
(3) There is a zero cash balance at the end of June and this sug-
gests the possibility of future liquidity problems.

CONTROL IN THE ORGANIZATION

150 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
IAnswer to question 14.8
(a)
£ £
Sales 235,000
Less variable costs:
Direct materials 77,000
Direct labour (£72,000 + £3,000) 75,000
Variable overheads 30,000 182,000

Contribution 53,000
Less fixed overheads (£41,000- £4,000) 37,000
Profit 16,000

(b) The variances will have been calculated by comparing actual expendi-
ture with the flexed budget. Actual sales are 90% of budgeted sales and
assuming stocks remain unchanged, actual production will be 90% of
budgeted production.

Flexed budget Actual Variance

£ £ £
Direct materials 72,000 (0.9 X £80,000) 77,000 5,000A
Direct labour 54,000 (0.9 X £60,000) 75,000 21,000A
Variable overheads 31,500 (0.9 X £35,000) 30,000 1,500F
Fixed overheads 35,000 37,000 2,000A

(c) For each variance, actual price paid per unit of the resources will be dif-
ferent from the budgeted price or the actual quantity will be different
from the budgeted quantity. Specific reasons include:
Direct materials: (i) purchase of uneconomic quantities at an excess-
ive price;
(ii) excessive wastage.
Direct labour: (i) increase in wage rates due to a national pay
award;
(ii) inefficient labour.
Sales: (i) actual selling price greater than budgeted
selling price (budgeted sales are 20,000 units at
£12.50 and actual sales are 18,000 units at
£13.05);
(ii) lower share of the market than expected (actual
sales volume was 2,000 units less than budgeted
volume).

(d) If the variance is due to a national pay award then the standards should
be adjusted. If the variance is due to inefficiency, the cause should be
ascertained and remedial action taken to eliminate the inefficiency. You
will find a full discussion of labour variances in Chapter 15.

ANSWER TO QUESTION 14.8 151

IAnswer to question 14.9
(a) Workings:
Units (see Note) 5,400 6,300 7,200
£ £ £
Direct materials 37,800 44,100 50,400
+ 6,300 + 6,300
Direct wages 16,200 18,900 21,600
+ 2,700 + 2,700
Production overhead 37,600 41,200 44,800
+ 3,600 + 3,600
Administration overhead 31,500 31,500 31,500
Selling and distribution 42,300 44,100 45,900
+1,800 +1,800

Note: 100% activity= 100/70 x 6,300 = 9,000 units.

Unit variable costs:

Direct materials = £7 per unit VC (£6,300 + 900 units)
Direct wages = £3 per unit VC (£2,700 + 900 units)
Production overhead = £4 per unit VC (£3,600 + 900 units)
Selling and distribution = £2 per unit VC (£1,800 + 900 units)

Fixed costs: Variable costs Total cost Fixed cost

at 5,400 units at 5,400 units (balance)
£ £ £
Direct materials 37,800 37,800
Direct labour 16,200 16,200
Production overhead 21,600 37,600 16,000
Administration overhead 31,500 31,500
Selling and distribution 10,800 42,300 31,500

Budget for 50% level of activity (4,500 units):

Variable costs: £
Direct materials (4,500 x £7) 31,500
Direct labour (4,500 x £3) 13,500
Variable production overhead (4,500 x £4) 18,000
Variable selling overhead (4,500 x £2) 9,000

72,000
Fixed cost: £
Production 16,000
Administration 31,500
Selling and distribution 31,500 79,000

151,000
Sales (100/80 x £151,000) 188,750
Profit 37,750

CONTROL IN THE ORGANIZATION

152 ----------------------------------------
 (b) (i) It may necessary to make labour redundant. This may result in
conflict with the unions, harm future employer-employee rela-
tions and lead to redundancy costs.
(ii) Cash flow problems may arise as it may take some time to reduce
fixed costs, and redundancy payments could seriously deplete a
firm's cash resources.
(iii) Long-run costs per unit will increase if fixed costs cannot be
decreased. The selling price may not cover long-run unit costs.

IAnswer to question 14.10

(a) Workings:
Volume of activity at 100% level= 50,000 units (£1.5m/£30)
The variable cost per unit is calculated from the following formula:
Change in costs
Change in activity
£
Material cost 7.50 (£37,000/5,000 units)
Labour costs 9.00 (£45,000/5,000 units)
Production overhead 3.50 (£17,500/5,000 units)
Administration 2.00 (£10,000/5,000 units)
Selling and distribution 1.00 (£5,000/5,000 units)

23.00

Fixed costs are calculated by deducting total variable costs from total
costs. The calculations (at 100% activity) are as follows:
£
Materials Nil
Labour 35,000 (£485,000- £450,000)
Production overhead 60,000 (£235,000- £175,00)
Administration 30,000 (£130,000- £100,000)
Selling and distribution 25,000 (£75,000- £50,000)

150,000
Variances

Flexed budget at 75% Favourable

activity (37 ,500 units) Actual (Adverse)
£ £ £ £
Revenue 1,125,000 1,075,000 (50,000)
Less costs
Material costs 281,250 311,750 (30,500)
Labour costs 372,500 351,500 21,000
Production costs 191,250 171,250 20,000
Administration costs 105,000 117,500 (12,500)
Selling and distribution 62,500 66,500 (4,000)

1,012,500 1,018,500 (6,000)

Profit 112,500 56,500 (56,000)

ANSWER TO QUESTION 14.10 - - - - - - - - - - - - - - - - - - - - - - - - -

153
 (b) The actual profit is £56,000 less than budgeted profit for the actual level
of activity. There is an adverse sales variance of £50,000 due to a reduc-
tion in the selling price. The sales variance accounts for most of the
profit variance. The reason for the selling price reduction should be
investigated. Was the reduction due to the depressed state of the market
or an attempt to generate increased sales revenue in order to increase
market share? The pricing policy should be investigated.
The labour cost and production variances are favourable possibly due
to an increase in efficiency, cost reduction and a reduction in overtime.
There was an adverse material variance of £30,500. This needs to be
investigated. Possible reasons for the variance include the purchase of
higher quality materials than planned, excessive wastage due to new pro-
duction methods or the use of new untrained or unskilled workers. The
latter may have resulted in the favourable labour wage rate variances.
All the variances should be investigated and appropriate remedial
action taken.

(c) It is assumed that the change in the cost structure refers only to the
order for 12,500 units (50,000 units - 37,500 units). The relevant
revenues and costs are as follows:
£
Selling price per unit 25.00
Materials (7.50)
Labour (£9 + £1) (10.00)
Production (£3.50 x 1.20) (4.20)
Administration (£2 x 1.25) (2.50)
Selling and distribution (1.00)

Contribution (0.20)

Contribution for 12,500 units (£2,500)

The order should be rejected because it provides a negative contribution
of £2,500.

Answer to question 14.11

(a) See section on determining the factor which restricts performance and
preparation of the sales budget for the answer to this question. In par-
ticular the answer should stress that the principal budget factor is the
factor which determines the level of activity. This will normally be the
level of sales but it could also be any resource in the business which
restricts the volume of sales (for example, machine capacity, labour or
shortage of materials). The principal budget factor is therefore impor-
tant because it determines the level of activity on which all budgets will
be based.
(b) A fixed budget is a budget which remains unchanged irrespective of the
volume of activity whereas a flexible budget is adjusted to the level of
activity which is actually attained. See section on flexible budgeting in
Chapter 14 for a description of flexible budgeting.

154 CONTROL IN THE ORGANIZATION

 Flexed budgets should be used for control purposes; costs should be
controlled by comparing actual costs with the actual level of activity and
not some level of activity which was assumed when the budget was pre-
pared. Fixed budgets are appropriate for planning purposes for deter-
mining the planned level of activity, but for control purposes actual
expenses should be compared with an adjusted budget based on the
actual level of activity.
(c) (i) The direct labour hours required for the first sales forecast are:
Product A Product B Product C Total
First sales forecast £44,000 £60,000 £6,000 £110,000
Second sales forecast £60,000 £75,000 £7,000 £142,000
The principal budget factors are:
First sales forecast = Sales
Second sales forecast = Direct labour

(ii) Sales limitation (first forecast):

A B C Total
Sales volume 22,000 40,000 6,000
Contribution per unit £4 £2 £2
Total contribution £88,000 £80,000 £12,000 £180,000
Less fixed costs £150,000
Profit £30,000

Direct labour limiting factor (second sales forecast)

A B c
(1) Contribution
per unit £3 £1.70 £1.60
(2) Contribution
per£1
of labour £1.50 (£3/2) £1.13 (£1.70/1.50) £1.60 (£1.60/1)
(3) Ranking 2 3 1
(4) Sales allo-
cation (Note) 30,000 45,333 7,000
(5) Contribution
(1) X (4) £90,000 £77,066 £11,200

£
Total contribution 178,266
Fixed costs 150,000
Profit 28,266

Note:
The sales allocation is calculated as follows:
Balance of
Direct labour direct labour
Sales volume cost cost available
Product C 7,000 £7,000 £128,000
Product A 30,000 £60,000 £68,000
Product B 45,333 (£68,000/£1.50) £68,000

155
ANSWER TO QUESTION 14.11 - - - - - - - - - - - - - - - - - - - - - - - - -
 Standard costing and
variance analysis
Answers to Chapter 15

Question summary ================

15.1 to 15.4
Calculation of material and labour variances. Question 15.4 requires the
calculation of variances and inputs and outputs from incomplete data.
15.5
Calculation of labour, material and sales variances plus a reconciliation of
actual and budgeted profit. Part (b) requires accounting entries for a
standard costing system for the purchase and issue of materials.
15.6
Calculation of labour variances and the preparation of a wages control
account.
15.7
Calculation of budgeted inputs and overhead variances.
15.8 to 15.11
Calculation of overhead variances.
15.12 to 15.14
Variance analysis and the reconciliation of standard and actual cost or
bugeted and actual profit.
15.15 to 15.19
Calculation of actual inputs working backwards from reported variances
given in the question and the calculation of variances from incomplete
information.
15.20
Calculation and explanation of sales margin variances.
15.21 to 15.24
Accounting entries for a standard costing system. Question 15.21 requires
the preparation of the stores ledger account when the price variance is
extracted at the time of issue and also at the time of purchase. Questions
15.22 to 15.24 require the calculation of labour, material and overhead vari-
ances. A full absorption costing system is operated with Questions 15.22 and
15.24 whereas 15.23 assumes that a variable costing system is in operation.

STANDARD COSTING AND VARIANCE A N A L Y S I S - - - - - - - - - - - - - - - - - - - - - - 157

 Question 15.23 also assumes that the company uses an interlocking
accounting system.
15.25 and 15.26
Calculation of productivity ratios. Question 15.25 also involves the calcula-
tion of labour and material variances.

IAnswer to question 15.2

(a) (i)
Flexed budget for month 6.
Original Flexed Actual Total
budget budget costs variances
Units of J 20,000 18,500 18,500
£ £ £ £
Direct materials 480,000 444,000 442,650 1,350F
Direct labour 140,000 129,500 129,940 440A
Variable overhead 60,000 55,500 58,800 3,300A
Fixed overhead 100,000 100,000 104,000 4,000A
780,000 729,000 735,390 6,390A

(ii)
Material price variance = (Standard price -Actual price) Actual quantity
= (AQxSP)-(AQxAP)
= (113,500 x £4)- £442,650 Actual cost)= £11,350F
Material usage variance = (Standard quantity- Actual quantity) x Standard
price
= (18,500 X 6 = 111,000- 113,500) X £4 = £10,000A
Wage rate variance =(Standard rate- Actual rate) x Actual hours
= (SRxAH)-(ARxAH)
= (£7 X 17,800)- £129,940 = £5,340A
Labour efficiency = (Standard hours- Actual hours) x Standard rate
variance = (18,500 x 1 hour= 18,500 hours -17,800) £7
= £4,900F

(b) See 'The budget period' in Chapter 13 for a description of rolling bud-
geting (i.e. rolling forecasts).

IAnswer to question 15.3

(a) The calculation of the standard purchase price for each item of mater-
ials is:
Powder: £1.50 per tube. Each tube requires 2 lb of powder
:. price per lb = £0.75

STANDARD COSTING AND VARIANCE ANALYSIS

158 - - - - - - - - - - - - - - - - -
 Chemicals: £0.60 per tube. Each tube requires 114 litre of
chemical
:. price per litre= £2.40
Tube: £0.30 per tube
The standard wage rate is £4.50 per hour and the standard cost of pro-
ducing one tube is £1.80. Therefore the standard time is 0.4 hours (£1.80
+ £4.50 per hour).

Material price variances = (Standard price less Actual price) x Actual

purchases:
£ £
Powder = (£0.75- £0.70) x 10,000 500F
Chemicals = (£2.40- £2.30) X 600 = £60F
(£2.40- £2.50) X 600 = £60A Nil
Tubes = (£0.30- £0.40) X 200 = £20A
(£0.30- £0.30) X 5,000 = Nil 20A 480F

Material usage variances= (Standard quantity less Actual issues) x

Standard price
Powder: ((4,500 x 2)- 9,800) x £0.75 = 600A
Chemicals: ((4,500 x D-1,050) x £2.40 = 180F
Tubes: ((4,500 x 1)- 4,520) x £0.30 = 6A 426A

Wage rate =(Standard rate less Actual rate) x Actual hours

= (£4.50- £8,910/2,050) X 2,050 = 315F
Labour efficiency = (Standard hours less Actual hours) x standard rate
(4,500 x 0.4 hours- 2,050) x £4.50 = 1,125A

(b) See Chapter 15 for a discussion of the possible causes of material and
labour variances. Causes which may be related specifically to this
problem include:
(i) Favourable price variances and adverse usage variance for powder.
This may be due to the purchase of inferior quality materials result-
ing in excessive usage and an adverse labour efficiency variance.
(ii) The adverse usage variance for powder may also be due to
inefficient handling or split bags.

IAnswer to question 15.6

(a)
X Y Total
Standard hours 3(£12/£4) 0.5 (£2/£4)
Output (units) 2,200 5,250
Standard hours produced 6,600 2,625 9,225

159
ANSWER TO QUESTION 15.6 - - - - - - - - - - - - - - - - - - - - - - - - -
 Standard hours 9,225
Efficiency ratio = ------ x 100% = - - x 100% = 85.4%
Actual hours 10,800

(b) Efficiency variance: (Standard hours -Actual hours) x Standard rate

Month 1 (9,225- 10,800) x £4 = £6,300A
Month 2 { 2,300 x 3 = 6,900 }
4,700 X 0.5 = 2,350 X £4 = £l,OOOF

9 250-9 000

Idle time month 2: 600 hours at £4 = £2,400A

Wage rate: (Standard rate - Actual rate) x Actual hours
Month 1 (£4- £44,800/10,800) X 10,800 = £1,600A
Month2 (£4- £39,600/9,600) X 9,600 = £1,200A

(c) Wages control account

£ £
Actual cost 44,800 WIP (standard cost): 9,225 x £4 36,900
Efficiency variance 6,300
Rate variance 1,600

£44,800 £44,800

WIP account
Wages control £36,900

(d) The efficiency variance may not result in a direct effect on the profit of a
company because:
(i) The guaranteed weekly wage results in part of the labour cost
being the equivalent of a fixed cost. Consequently, excess hours
or hours saved will not change the amount spent on labour.
(ii) Interdependencies, for example an adverse labour efficiency vari-
ance, may be due to the purchase of inferior quality materials.
Thus an adverse efficiency variance may be offset partly by a
favourable material price variance.
(iii) Efficiencies/inefficiencies will influence the amount of overtime
worked but labour efficiencies are calculated on standard wage
rates. Hence the impact of efficiency in terms of overtime pre-
miums would be reflected in the wage rate variance and not the
efficiency variance.

Answer to question 15.7

(a) (i) An increase in output of 4,000 tonnes results in total overhead
costs increasing by £36,000. It is assumed that fixed costs will
remain unchanged within this level of activity. Therefore the vari-
able overhead rate per unit of output will be £9 (£36,000/4,000
tonnes).

160 STANDARD COSTING AND VARIANCE ANALYSIS

 (ii) At 3,000 tonnes budgeted output the costs are as follows:
£
Total budgeted overhead 72,000
Variable element (3,000 x £9) 27,000

Fixed element (balance) 45,000

(iii) £45,000/(£18- £9) = 5,000 units

(iv) (5,500 tonnes x £9 for variable overheads) + £45,000 fixed over-
head= £94,500
(v) 5,500 units x £18 = £99,000
(vi) No information is given in the question about hours of input. It is
therefore assumed that variable overheads vary with output. Most
textbooks assume that variable overheads vary with direct labour
or machine hours of input.
Variable overhead expenditure variance: £
Budget flexed on output (5,500 units x £9) = 49,500
Actual variable overheads incurred 52,000

Variance 2,500A

(vii) Fixed overhead expenditure variance:

(Budgeted fixed overheads- Actual fixed overheads)
(£45,000- £53,750) = £8,750A
(viii) (Actual production- Budgeted production) x Fixed overhead rate
(5,500 tonnes- 5,000 tonnes) x £9 = £4,500F
(b) See 'Flexible budgeting' in Chapter 14 for an explanation of why it is
advantageous to use flexible budgets for the control of production over-
head expenses.
(c) (1) Power for the operation of machinery.
(2) Indirect materials.
(d) See 'Types of cost standards' in Chapter 15 for the answer to this
question.

IAnswer to question 15.8

(a)
Workings:
Budgeted output= 9,600 normal capacity/2 hours= 4,800 units
Budgeted fixed overhead rate per unit of output = £120,000/4,800 units =
£25
Budgeted fixed overhead rate per standard hour = £25/2 hours = £12.50
(i) Variable overhead expenditure variance
(Actual hours x variable overhead rate)- Actual cost
(9,300 X £3) = £27,900-£28,900 = £l,OOOA
(ii) Variable production overhead efficiency variance
(Standard hours- Actual hours) x Variable overhead rate
(5,000 x 2 hours = 10,000- 9,300) x £3 = £2,100F

161
ANSWER TO QUESTION 15.8 - - - - - - - - - - - - - - - - - - - - - - - - -
 (iii)Fixed production overhead expenditure variance
Budgeted cost -Actual cost
£120,000- £118,000 = £2,000F
(iv) Fixed production overhead volume variance
(Actual production- Budgeted production) x Standard rate
(5,000 units- 4,800 units) x £25 = £5,000F
Alternatively, output can be measured in standard hours:
(10,000 Standard hours - 9,600 Budgeted hours) x £12.50 =
£5,000F
(b) The volume variance can be subdivided into a volume efficiency vari-
ance and a volume capacity variance:
Volume efficiency variance
(Standard hours- Actual hours) x Fixed overhead rate
(10,000- 9,300) X £12.50 = £8,750F
Volume capacity variance
(Actual hours- Budgeted hours) x Fixed overhead rate
(9,300- 9,600) X £12.50 = £3,750A
For an explanation of the meaning of the above variances see 'Volume
efficiency and capacity variances' in Chapter 15.

IAnswer to question 15.10

(a) Labour efficiency variance:
[Standard hours (420,000 x 1/2 = 210,000)- Actual hours (202,000)]
x Standard rate (£3.90) = £31,200F
Overhead expenditure variance:
Fixed= Budgeted cost (£400,000)
Variable = Flexed budget (202,000 x £1)
Total = £602,000- Actual overheads (£620,000) = £18,000A
Fixed overhead volume:
[Actual output (420,000 units)- Budgeted output (400,000 units)]
x FOAR (£1 per unit) = £20,000F
or (210,000 Standard hours produced (SHP)- 200,000 Budgeted
SHP) x Fixed overhead absorption rate (FOAR) (£2 per hour)
= £20,000F
Variable overhead efficiency:
[Standard hours (210,000)- Actual hours (202,000)] x
Variable overhead absorption rate (VOAR) (£1) = £8,000F

Workings:
Standard hours per unit of output= 1/2 (200,000 hours/400,000 units)
Standard wage rate= Actual wage rate (Wage rate variance= Zero)
Standard wage rate= £3.90 per hour (£787,800/202,000 DLHs)
VOAR = £200,000 budgeted variable overheads/200,000 budgeted DLHs
FOAR (per unit) = £400,000/400,000 units
FOAR (per DLH) = £400,000/200,000 DLHs

162 STANDARD COSTING AND VARIANCE ANALYSIS

 (b) See sections on volume variance, volume efficiency variance and volume
capacity variance in Chapter 15 for the answer to this question.
(c) (i)
Standard hours for actual output (210,000)
Efficiency ratio = = 104%
Actual hours (202,000)
(ii) Because efficiency is better than standard, unit labour costs may be
expected to decline. However, because a bonus scheme is in oper-
ation, the wage payment will increase and this may cause unit
labour costs to increase. Total cost per unit may still decline since
fixed overhead costs will decrease as a result of fixed overheads
remaining unchanged but output increasing. If capacity is
restricted in the short term then the firm will be able to increase
sales volume and this ought to result in an increase in profit.

Answer to question 15.14

(a) Variance analysis can help management in the following ways:
(i) It pinpoints those areas where items are not proceeding according
to plan and where corrective action needs to be taken.
(ii) Variance analysis is based on the principle of management by
exception. Managers can devote their scarce time to focusing only
on those areas which are not proceeding according to plan.
(iii) Variances provide useful feedback information for future plan-
ning. If the variances are due to permanent changes arising from
changes in the environment the standards should be changed and
used as an input for the next period's budget preparation.
(iv) Variance analysis enhances responsibility accounting and pin-
points those managers responsible for taking remedial action to
eliminate inefficiencies.
(b) Standard product cost:
£
Direct materials (3 kg x £4.40 per kg) 13.20
Direct labour Ch hour x £5 per hour) 2.50
Variable overhead Ch hour x £12 per hour) 6.00 (Note 1)
Fixed overhead C/2 hour x £18 per hour) 9.00 (Note 2)
£30.70
Notes:
(1) Variable production overhead: (£150,000)/hours of operation (12,500) = £12
per hour.
(2) Fixed overhead (£270,00)/Normal operating capacity (15,000) = £18 per hour.
(i) Variance analysis:
Material price:
[Standard price (£4.40)- Actual price (£4.20)] x Actual purchases (80,000)
= £16,000F
Actual usage and purchases = £336,000/£4.20 per kg = 80,000 kg
Material usage:
[Standard usage (25,000 x 3 kg)- Actual usage (80,000 kg)] x
SP (£4.40 per kg) = £22,000A

163
ANSWER TO QUESTION 15.14 - - - - - - - - - - - - - - - - - - - - - - - - -
 Wage rate:
[Standard rate (£5 per hour)- Actual rate (£5.40 per hour)] x
Actual hours (14,000)
= £5,600A
Labour efficiency:
[Standard hours (25,000 x 'h hour)- Actual hours (14,000)]
x SR (£5 per hour)= £7,500A
Variable overhead efficiency:
[Standard hours (12,500)- Actual hours (14,000)]
x VOAR (£12 per hour) = £18,000A
Variable overhead expenditure:
Actual hours x VOAR (14,000 x £12)
-Actual variable overheads (£160,000) = £8,000F
Fixed overhead expenditure:
[Budgeted fixed overhead (£270,000)- Actual fixed overhead (£270,000)]
=0
Fixed overhead efficiency:
[Standard hours (12,500)- Actual hours (14,000)]
x FOAR (£18 per hour)= £27,000A
Fixed overhead capacity:
[Actual hours (14,000)- Budgeted hours (15,000)]
x FOAR (£18 per hour)= £18,000A

(ii) Variance statement for April:

Standard cost of actual production £
(25,000 X £30.70) 767,500
Favourable Adverse
Material: Price 16,000
Usage 22,000
Labour: Rate 5,600
Efficiency 7,500
Overhead: Variable efficiency 18,000
Variable expenditure 8,000
Volume efficiency 27,000
Volume capacity 18,000 74,100A
Actual cost 841,600

Answer to question 15.15

(a) (i) Material price variance = (SP- AP) AQ = (SP x AQ)- (AQ x
AP)
= (£1.20 X 142,000)- £171,820
= £1,420A
(ii) Material usage variance= (SO- AQ) SP
= (1,790 X 9 = 16,110 -16,270) X £1.20
=£192A
(iii) Actual price per kg in period 1 = £1.21 (£171,820/142,000 kg)
The actual price per kg for period 2 is not given and must be cal-
culated from the data given in the question.

164 STANDARD COSTING AND VARIANCE ANALYSIS

 Standard price= £1.20 x 1.06 = £1.272
(SP X AQ) = £1.272 X 147,400 (AQ) = £187,492.80
Price variance (£1,031.80F) = (SP x AQ)- (AQ x AP)
£1,031.30F = £187,492.80- (147,400 X AP)
£187,492.80-£1,031.80
AP
147,400
= £1.265 per kg
Cost inflation= (£1.265/£1.21-1) x 100% = 4.5%

(iv) Actual usage per unit in period 1 = 16,270 kg/1,790 units= 9.0894 kg
Actual usage in period 2 = 0.995 x 9 kg Standard usage = 8.995 kg
Change in usage (9.0894 - 8.995)/9.0894 x 100% = 1.5%
improvement
(b) See 'Types of cost standards' in Chapter 15 for the answer to this question.

IAnswer to question 15.17

(a)
Wage rate variance = (SP- AP) AH = (SP x AH)- (AP x AH)
= (£5 x 53 workers x 13 weeks x 40 hours)-
£138,500
= £700A
Labour efficiency = (SH - AH) SP
SH (Standard hours)= (35,000 x 0.4 hours)+ (25,000 x 0.56 hours)
= 28,000
AH (Actual hours) = 53 workers x 13 weeks x 40 hours= 27,560
Variance = (28,000- 27,560) x £5 = £2,200A
(b)
Material price variance (SP-AP) AQ
(AQ X SP)- (AQ X AP)
£430F (given) 47,000 SP- £85,110
£430 + 85,110
SP (Standard price)
47,000
= £1.82
Material usage variance = (SQ- AQ) SP
= (SQ X SP)- (AQ X SP)
£320.32A (given) = £1.82 SQ- (33,426 X £1.82)
-£320.32A = £1.82 SQ- £60,835.32
£1.82 SQ = £60,515
SQ = £60,515/£1.82 = 33,250
Note that SQ = Actual production (35,000 units) x Standard
usage
Therefore 35,000 x Standard usage = 33,250
Standard usage = 33,250/35,000
= 0.95 kg per unit of component X
(c) For the answer to this question you should refer to the detailed illustra-
tion of the budget process shown in Chapter 13. In particular, the

165
ANSWER TO QUESTION 15.17 - - - - - - - - - - - - - - - - - - - - - - -
 answer should indicate that if sales are the limiting factor the production
budget should be linked to the sales budget. Once the production
budget has been established for the two components, the production
quantity of each component multiplied by the standard usage of mater-
ial A per unit of component output determines the required quantity of
material to meet the production requirements. The budgeted purchase
quantity of material A consists of the quantity to meet the production
usage requirements plus or minus an adjustment to take account of any
planned change in the level of raw material stock.

Answer to question 15.18

(a) (i) Actualoutput:
Total standard direct wages cost (£8,300)
Actual output = = 415 units
Standard labour cost per unit (£20)
The total standard direct wages cost is:
Actual cost (£8,162) +net favourable wages variance (318- £180) =
£8,300
(ii) Actual profit:
£
Sales 29,880
Less: Direct materials 6,435
Direct wages 8,162
Fixed overheads 9,8ooa 24,397
Profit 5,483

Note:
•Assuming the production equals sales then budgeted output is £30,000
budgeted sales+ £75 budgeted selling price = 400 units
Budgeted fixed overheads= £10,000 (400 x £25)
Actual fixed overheads= £10,000-£200 favourable expenditure variance

(iii) Actual price per unit of materials:

Actual material cost (£6,435)

Actual price per unit = £1.65
Units of materials used (3,900)

Price variance: (AQ x SP)- (AQ x AP) 585A

(AQ X £1.50)- £6,435 -£585
:. £1.50AQ £5,850
:. AQ 3,900

(iv) Actual rate per direct labour hour:

Actual wages paid (£8,162)

Actual rate £3.85
Actual hours worked (2,120)

166 STANDARD COSTING AND VARIANCE ANALYSIS

 Rate variance: (AH x SR)- (AH x SR) £318F
(AH X £4)- £8,162 = £318F
:. £4AH = £8,480
:.AH = 2,120

(v) Amount of production overhead incurred:

£9,800 (see workings to (ii) above)
(vi) Amount of production overhead absorbed:
Units produced per (i) of 415 units x overhead rate per unit (£25)
= £10,375
(vii) Production overhead efficiency variance:
(Standard hours produced- Actual hours) x Standard overhead
rate per hour ((415 x 5)- 2,120) x £5 = £225A
(viii) Selling price variance:
(Actual selling price - Budgeted selling price) x Actual sales
volume (£72- £75) x 415 = £1,245A
Actual selling price = Actual sales (£29,880) + Actual sales
volume (415 units)
(ix) Sales volume profit variance:
(Actual sales volume - Budgeted sales volume) x Standard
margin (415- 400) x £15 = £225F
The standard margin is standard cost (£60) x (20/80) = £15

(b) An adverse variance may be offset by a favourable variance when:

(i) inferior cheap materials are purchased which results in inefficient
usage and an adverse usage variance;
(ii) employing a higher grade of labour than that specified in that
standard thus resulting in an adverse wage rate variance but
improved efficiency and a favourable efficiency variance.

IAnswer to question 15.20

(a) Profit statements
Budget North South Total
£ £ £
Budgeted sales 1,500,000 2,160,000 3,660,000
Budgeted costs 1,350,000 1,620,000 2,970,000
Budgeted profit 150,000 540,000 690,000
Actual
Actual sales 1,470,000 2,310,000 3,780,000
Actual costs 1,260,000 1,890,000 3,150,000
Actual profit 210,000 420,000 630,000
Sales variance 60,000F 120,000A 60,000A

(b) Sales margin quantity = (Actual sales - Budgeted sales) x Standard

margin
Northern = (40% X 350,000- 150,000) X £1 = £10,000A
Southern = (60% X 350,000 -180,000) X £3 = £90,000F

ANSWER TO QUESTION 15.20 - - - - - - - - - - - - - - - - - - - - - - - - - 167

 Sales margin price = (Actual selling price - Budgeted selling price)
x Actual quantity
Northern = (£1,470,000/140,000- £10) X 140,000 =
£70,000F
Southern = (£2,310,000/210,000- £12) X 210,000 =
£210,000A

Northern total sales margin variance = £10,000A + £70,000F = £60,000F

Southern total sales margin variance = £90,000F + £210,000A =
£120,000A
(c) In the Northern region there is an overall sales margin variance of
£60,000 which has resulted in actual profit exceeding budgeted profit by
this amount. Selling price has been increased from £10 to £10.50 and
this has resulted in the generation of additional profits of £70,000
(140,000 actual sales volume at £0.50 extra margin). However, the
favourable variance of £70,000 has ben offset by a loss in margin of
£10,000 arising from a decline in sales volume to 10,000 units. The
price/demand relationship should be investigated to ascertain whether a
further price rise can generate additional profits.
In the Southern region profits are £120,000 less than budget because
of an adverse sales margin variance. Actual selling price was £1 less than
budget, thus resulting in a reduction in the profit margin from £3 to £2
on a sales volume of 210,000 units. This price reduction accounted for a
£210,000 decline in profits. Unfortunately, the reduced selling price only
resulted in an increase in sales volume of 30,000 units which generated
an increase in profits of £90,000. These two factors account for the
overall decline in profits of £120,000. The reason for the price reduction
should be investigated to ascertain why there was such a dramatic
decline in sales volume. Consideration should be given to restoring the
price margin in order to generate additional profits.
(d) See 'Preparation of the sales budget' in Chapter 13 for the answer to
this question. In particular, the answer should indicate that budgets
should be based on sales persons' forecasts, trend in sales volume,
market research and competitors' prices.

Answer to question 15.21

(a) Workings:
(i) Material price variance identified on purchase of material
Variance= (SP- AP) x quantity purchased
4 November: (£1.04- £10,530/10,000) x 10,000 = £130A
23 November: (£1.04- £8,480/8,000) x 8,000 = £160A

STANDARD COSTING AND VARIANCE ANALYSIS

168 - - - - - - - - - - - - - - - - -
 Material Z stock account

£ £
Opening balance 2/11 WIP (2,000 x £1.04) 2,080
(9,000 kg at £1.04 9,360 7/11 WIP (4,500 x £1.04) 4,680
4/11 Purchases
(10,000 X £1.04) 10,400 20/11 WIP (4,000 x £1.04) 4,160
23/11 Purchases
(8,000 X £1.04) 8,320 27/11 WIP (6,000 x £1.04) 6,240
Closing balance
(10,500 X £1.04) 10,920
28,080 28,080

Creditors account

4/11 Material Z stock

account 10,400
4/11 Material price
variance account 130
23/11 Material Z stock
account 8,320
23/11 Material price
variance account 160

Material price variance account

4/11 Creditors account 130 30/11 Profit and loss

23/11 Creditors account 160 account 290

(ii) Material price variance identified at time of issue of material

Using the weighted average basis, the actual issue prices are calcu-
lated as follows:

£
Opening balance (9,000 x £1.07) 9,630
2 November issue (2,000 x £1.07) (2,140)
Balance 7,000 at £1.07 (£7,490/7,000) 7,490
4 November purchase (10,000 kg) 10,530
Balance (17,000 kg at £1.06) 18,020
7 November issue (4,500 x £1.06) (4,770)
20 November issue (4,000 x £1.06) (4,240)
Balance (8,500 x £1.06) 9,010
23 November purchase (8,000 kg) 8,480
Balance (16,500 kg at £1.06) 17,490
27 November issue (6,000 kg x £1.06) 6,360

ANSWER TO QUESTION 15.21 169

 Variance= (SP- AP) x actual issues
2 November: (£1.04- £1.07) x 2,000 = £60A
7 November: (£1.04- £1.06) x 4,500 = £90A
20 November: (£1.04- £1.06) x 4,000 = £80A
27 November: (£1.04- £1.06) x 6,000 = £120A
Note that the entries in the stock account in (a)(i) are based on the
approach described in Chapter 15 whereby the stock account is debited
at the standard cost and the variances are extracted at the time of pur-
chase. Where variances are extracted at the time of issue, it is preferable
to use an alternative approach when preparing the stock account. With
this approach, the stock account is debited at actual cost, and issues are
recorded at standard cost and price variances are recorded within the
stock account.

(iii) Material Z

kg £/unit £ kg £/unit £
1111 Opening balance 9,000 1.07 9,630 2/11 WIP 2,000 1.04 2,080
4/11 Purchases 10,000 1.053 10,530 2/11 Materials price
23/11 Purchases 8,000 1.06 8,480 variance 60
7/11 WIP 4,500 1.04 4,680
7/11 Materials price
variance 90
20/11 WIP 4,000 1.04 4,160
20111 Materials price
variance 80
27/11 WIP 6,000 1.04 6,240
27/11 Materials price
variance 120
30/11 Closing balance 10,500 1.06 11,130
27,000 28,640 27,000 28,640

Material price variance

£ £
2/11 Material Z 60 30/11 Profit and loss 350
7/11 Material Z 90
20/11 Material Z 80
27/11 Material Z 120
350 350

(b) The method by which variances are extracted at the time of purchase is
preferred because variances are reported at the earliest opportunity. In
addition, the stock recording system is simplified.

170 STANDARD COSTING AND VARIANCE ANALYSIS

 (c) Workings:
Equivalent units
Materials Labour and overhead
£ £
Completed production 9,970 9,970
Add closing WIP 8,000 6,000

17,970 15,970
Less opening WIP 6,000 3,000

Equivalent production 11,970 12,970

Material usage variance

(Actual usage- Standard usage) x Standard price
[6,000 kg- (11,970 units x 0.5)] x £1.04
£15.60A

Labour efficiency variance

(Actual hours- Standard hours) x Standard rate
[1,340 hours (12,970 units x 0.1)] x £4.80
£206.40A

Overhead variance
Actual cost - Standard cost
6,680- (12,970 units x 0.1 x £5.00)
£195A

Standard cost per unit: product X

Materials 0.5 kg x £1.04/kg £0.52
Direct labour 0.1 hours x £4.80/hour £0.48
Overhead 0.1 hours x £5.00/hour £0.50

£1.50

Process 1

£ £
Opening balance: Finished goods:
Materials: 9,970 units x £1.50 14,955
6,000 units x £0.52 Closing balance:
Direct labour and overhead: Materials:
3,000 units x £0.98 6,060 8,000 units x £0.52
Materials: Direct labour and overhead:
6,000 kilos x £1.04 6,240 6,000 units x £0.98 10,040
Direct labour: Material usage variance 15.6
1,340 hours x £4,80 6,432 Labour efficiency variance 206.4
Overheads 6,680 Overhead variance 195
25,412 25,412

ANSWER TO QUESTION 15.21 171

IAnswer to question 15.24
Workings:
Parts (a) and (b) require a detailed analysis of the variances. The variance
calculations are as follows:
Material price: (Standard price - Actual price) x Actual quantity purchased
Plaster of Paris (£8- £43,200/5,400) x 5,400 =£zero
Paint (£30- £5,800/173) x 173 = £610A

Material usage: (Standard quantity- Actual quantity (Note 1)) x Standard

price
Plaster of Paris (£286 (Note 2) x 20- 5,420) x £8 = £2,400F
Paint (286 x! -143) x £30 =£zero

Wage rate: (Standard rate- Actual rate) x Actual hours

(£10- £11) X 730 = £730A

Labour efficiency: (Standard hours -Actual hours) x Standard rate

(286 X 2.5- 730) X £10 = £150A

Fixed overhead expenditure: (Budgeted fixed overheads- Actual fixed

overheads)
(300 X £100- £34,120) = £4,120A

Volume efficiency: (Standard hours- Actual hours) x Fixed overhead rate

(Note 3)
(715 - 730) x £40 = £600A

Volume capacity: (Actual hours- Budgeted hours) x Fixed overhead rate

(Note 3)
(730- (300 X 2.5)) X £40 = £800A

Sales margin price: (Actual selling price- Budgeted selling price)

x Actual sales volume
(£380- £380) x 284 =Zero

Sales margin volume: (Actual sales quantity (Note 4)- Budgeted sales
quantity) x Standard margin
(284- 300) X £80 = £1,280A

(a) Stores ledger control account (plaster of paris)

kg £ kg £
Balance b/fwd 2,800 22,400 WIP (SQ x SP) 5,720 45,760
Creditors 5,400 43,200 Balance c/fwd
(Closing stock) 2,780 22,240
Material usage
variance 300 2,400
8,500 £68,000 8,500 £68,000

172 STANDARD COSTING AND VARIANCE ANALYSIS

 Stores ledger control account (paint)
litres £ litres £
Balance c/fwd 140 4,200 WIP ale (SQ x SP) 143 4,290
Creditors 173 5,190 Balance c/fwd
(Closing stock) 170 5,100
313 £9,390 313 £9,390

WIP account
£ £
Stores ledger control account: Finished goods stock a/c 85,800
Plaster 45,760
Paint 4,290
Wages control account
(SQ x SP) 7,150
Fixed overhead account 28,600

£85,800 £85,800

Finished goods stock account

£ £
Opening balance (9 x £300) 2,700 Cost of sales (284 x £300) 85,200
WIP account 85,800 Closing stock c/fwd 3,300

£88,500 £88,500

The entries in the creditors, wages and fixed overhead control accounts are
shown below:

Creditors
£
Stores ledger (plaster) 43,200
Stores ledger (paint) 5,190
Material price variance a/c 610

Wages control
£ £
Wages accrued a/c 8,030 WIP 7,150
Wage rate variance a/c 730
Labour efficiency variance a/c 150
£8,030 £8,030

173
ANSWER TO QUESTION 15.24 - - - - - - - - - - - - - - - - - - - - - - - - -
 Fixed overhead control
£ £
Expense creditors 34,120 Overhead expenditure
variance 4,120
Volume efficiency 600
Volume capacity 800
WIP a/c 28,600

£34,120 £34,120

(b) It is assumed that (ii) refers to a statement showing standard profit on

actual sales and (iii) refers to a statement showing actual profit.

(i) Budget trading statement: £

Sales revenue (300 x £380) (Note 4) 114,000
Cost of sales:
Materials: plaster (300 x £160) 48,000
paint (300 x £15) 4,500
Direct wages (300 x £25) 7,500
Fixed production overheads (300 x £100) 30,000 90,000
Budgeted profit £24,000

(ii) Standard cost trading statement: £

Actual sales (284 x £380) 107,920
Standard cost of sales (284 x £300) 85,200
Standard profit on actual sales £22,720

(iii) Financial trading statement: £

Actual sales 107,920
Opening stock (Note 5)
(£22,400 + £4,200 + £2,700) 29,300
Materials (£43,200 + £5,800) 49,000
Labour 8,030
Fixed overhead 34,120
120,450
Less closing stock (Note 5)
(£22,240 + £5,100 + £3,300) 30,640 89,810
Actual profit £18,110

(iv) Reconciliation:
£
Budgeted profit (i) 24,000
Less sales margin volume variance 1,280
Standard profit on actual sales (ii) 22,720

STANDARD COSTING AND VARIANCE ANALYSIS

174 - - - - - - - - - - - - - - - -
 Cost variances: Favourable Adverse
£ £
Paint price 610
Plaster usage 2,400
Wage rate 730
Labour efficiency 150
Fixed overhead expenditure 4,120
Volume efficiency 600
Volume capacity 800
2,400 7,010 4,610A
Actual profit (iii) £18,110

Notes:
(1) The actual material usage is calculated as:
Opening stock + Purchases - Closing stock
(2) Throughout the answer actual production and sales are expressed in
100 sets.
(3) The fixed overhead rate is expressed as a rate per standard hour
(that is 1 hour x £10 x 400% ).
(4) The budgeted production and sales are expressed in 100 sets.
(5) The opening and closing stocks are valued at standard cost. The
variances are written off as period costs.

Answer to question 15.25

(a) Material price variances:
(Standard price - Actual price) x Quantity purchased
A = (£3.25- £158,750/50,000) X 50,000 = £3,750F
B = (£4- £105,000/25,000) X 25,000 = £5,000A

Usage variances:
(Standard quantity- Actual quantity) x Standard price
A= (400 x 10 kg= 4,000 kg- 4,800 kg) X £3.25 = £2,600A
B = (400 X 5 kg= 2,000 kg -1,800 kg) X £4 = £800F

(b) Labour rate variances:

(Standard rate - Actual rate) x Actual hours
Department 1 = (£4 x £11,800/3,000) x 3,000 = £200F
Department 2 = (£5- £13,250/2,400) x 2,400 = £1,250A

Labour efficiency variances

(Standard hours - Actual hours) x Standard rate
Department 1 = (400 x 8 hours= 3,200- 3,000) x £4 = £800F
Department 2 = (400 x 5 hours= 2,000- 2,400) x £5 = £2,000A

(c) Material A price: purchase of inferior quality materials

Material B price: general increase in market prices
Material A usage: inefficient usage of materials
Material B usage: better training of workers, resulting in less wastage

ANSWER TO QUESTION 15.25 - - - - - - - - - - - - - - - - - - - - - - - - -

175
 Department 1 wage rate: use of a lower grade of labour
2 wage rate: general increase in wage rates
1 labour efficiency: introduction of more efficient working
practices, resulting a saving in labour
hours
2 labour efficiency: failure to maintain machinery in proper
condition, resulting in additional labour
hours to complete the operations

(d) (i) Production volume ratio:

Standard hours of actual output
X 100
Budgeted hours of output

400 x 8 hours
Department 1: X 100 = 94.12%
3,400 hours

400 x 5 hours
Department 1: X 100 = 76.92%
2,600 hours

(ii) Efficiency ratio:

Standard hours of actual output
X 100
Actual hours worked

400 x 8 hours
Department 1: X 100 = 106.67%
3,000 hours

400 x 5 hours
Department 2: X 100 = 83.33%
2,400 hours

(e) In Chapter 15 it was argued that the material price variance should be
extracted at the time of purchase. The only justification for extracting
the material price variance at the time of usage is for profit measure-
ment purposes. Where the material price variance is calculated on pur-
chases, the variance is charged as an expense to the periods in which the
materials are purchased. On the other hand, when the variance is calcu-
lated on issues, the variance is allocated to the periods when the mater-
ials are issued. For profit measurement purposes it could be argued that
material variances should be recognized as an expense in the period
when the materials are used and not in the period when the materials
are purchased.

176 STANDARD COSTING AND VARIANCE ANALYSIS

 Planning and control of
stock levels
Answers to Chapter 16

Question summary

For additional questions relating to the calculation of the EOQ and

maximum, minimum and reorder levels see Questions 3.10 and 3.11 in
Chapter 3.
16.1 and 16.2
Discussion questions relevant to Chapter 16.
16.3
Calculation of maximum, minimum and reorder stock levels.
16.4to 16.6
Calculation of EOQ when the purchase cost is constant per unit.
16.7 and 16.8
Calculation of EOQ when the purchase cost per unit varies with the
number of units purchased. Both questions require a schedule of costs for
different output levels.
16.9
Make-or-buy decision incorporating ordering and holding costs.

Answer to question 16.2

For a decision of the rationale behind EOQ models see Chapter 16. In par-
ticular the answer should stress that some costs will rise with an increase in
the order batch size (e.g. stockholding costs) while others will fall (ordering
and stockout costs). The objective is to determine the order level at which
total costs are minimized. The operation of the EOQ model depends upon
identifying the contributory variables and their relevant costs.
The principles of the EOQ model can be used to determine the delivery
service which the company will provide for its finished products. The EOQ
model might result in stockouts if the lost profits from the stockout are lower
than the costs of maintaining additional stocks. Therefore the model can be
used to set optimal stock levels and this has repercussions for the level of
delivery service offered to customers on finished goods. Similar principles can
be applied for determining the level of repair and follow-up service provided

PLANNING AND CONTROL OF STOCK LEVELS

--------------------------------------177
 to customers. The principles of the EOQ model can be combined with prob-
ability theory for determining the level of service offered to customers, either
in terms of delivering products or maintaining a repair service.

Answer to question 16.3

(a) (i) Continuous stocktaking refers to a situation where a sample of
stores items are counted regularly on, say, a daily basis. Sufficient
items should be checked each day so that during a year all items
are checked at least once. The alternative system of stocktaking is
a compete physical stockcount where all the stock items are
counted at one point in time. Continuous stocktaking is prefer-
able because production is not disrupted and any discrepancies
and losses are revealed earlier.
(ii) A perpetual inventory system is a stock recording system
whereby the balance is shown for a stock item after each receipt
or issue. In a non-computerized system the records are main-
tained on bin cards or stores ledger cards. A separate record is
maintained for each item of materials in stores. Therefore the
stock balance for each stores item is available at any point in
time.
(iii) For an explanation of ABC inventory analysis see 'Control of
stocks through classification' in Chapter 16.
(b) For the answer to this question you should refer to Chapter 16
('Relevant costs for quantitative models under conditions of certainty'
and 'Determining the economic order quantity').
(c) Normal control levels are the reorder level, minimum level, and
maximum level.
Reorder level = maximum usage x maximum lead time
= 800 kg x 14 days
= 11,200 kg
Minimum level = reorder level - average usage in average lead time
= 11,200 kg- (600 kg x 12 days)
= 4,000 kg
Maximum level = reorder level + EOQ -minimum usage in
minimum lead time
= 11,200 kg+ 12,000 kg- (400 kg x 10 days)
= 19,200 kg

Answer to question 16.5

(a) (i) EOQ =~ 2~0

where D = Annual demand
0 = Ordering cost per order
H = Holding cost per unit

178----------------------------------- PLANNING AND CONTROL OF STOCK LEVELS

 :. EOQ = 2x 48,000x £0.60
10% x£10
= 240
(ii) Number of orders required per year:

Annual requirements 48,000

- - = 200 order per year
EOQ 240

(iii) Total cost Holding cost + Ordering cost

240 (£1) + 48,000 (£0.60)
2 240
£240

(b) Usage per day= 133.33 (48,000 I 360 days)

Number of days usage in closing stock= 3 (400 + 133.33)
Lead time = 3 days
Therefore the next order should be placed immediately.
(c) Some of the problems which arise when attempting to apply the EOQ
formula include:
(i) Inventory is not always used at a constant rate, but the constant
usage assumption is implicit in the EOQ formula.
(ii) The EOQ formula requires estimates of (1) annual sales, (2) order-
ing costs, (3) purchase price per unit, and (4) cost of carrying
inventories. These items may be extremely difficult to estimate in
practice.

Answer to question 16.8

(a) For a definition of variable, semi-variable and fixed costs see Chapter 2.
Examples of each cost are:
Variable: Purchase price of raw materials
Variable cost of placing an order of £50 per order.
Variable cost of holding stocks at £0.40 per unit per
annum.
Semi-variable: Ordering costs and stockholding costs are both semi-
variable since they consist of a variable and fixed
portion.
Fixed: The £40 element of placing an order is a fixed cost.
These costs will consist of staff involved in placing and
handling orders, and their salaries will be unaffected by
the number of orders placed.

(b) Annual usage is 6,000 kg (12,000 x 0.4 x 10/8). It is assumed that the
apportioned order costs and the £0.50 long-term holding costs are not
relevant costs in the short term for establishing the economic order

ANSWER TO QUESTION 16.8 - - - - - - - - - - - - - - - - - - - - - - - - - -

179
 quantity. Because purchase costs are not constant per unit it is not poss-
ible to use the EOQ formula.

Annual costs
Purchase
cost of
Order 6,000 kg Order Holding costs Total
quantity per annum costs at £50 at £0.40 per unit (W1) costs
£ £ £ £ £
1,000 6,000 300 (6 X £50) 200 6,500
1,500 5,880 200 (4 X £50) 300 6,380
2,000 5,790 150 (3 X £50) 400 6,340
2,500 5,700 120 (2.4 X £50) 500 6,320
3,000 5,640 100 (2 X £50) 600 6,340
3,500 5,640 86 (1.71 X £50) 700 6,426

Working:
W1 Assuming constant usage, the relevant average stock is one half of
the order quantity. The safety stock of 250 units will be the same
for all order quantities and is not therefore included in the analysis.

The order quantity which minimizes the costs in the short term is 2,500 kg.

IAnswer to question 16.9

The cost of placing an order when the component is purchased is not given. It
can be obtained from the EOQ formula:

Q /200
~~ ,henceQ 2
2DO
H

HQ2
2DO, hence 0
2D

£0.25 (2,000)2
:. Cost of placing an order (0) £25
2(20,000)
Average stock level Minimum stock level + 1/z EOQ
400 + 1/z (2,000)
1,400 units

180----------------------------------- PLANNING AND CONTROL DF STOCK LEVELS

 Comparison of annual costs
Make Buy
£ £
Purchase cost 20,000 {£9) = 180,000
Storage 1,400 (£0.25) = 350
Ordering costs 10 (£25) = 250
Direct labour 20,000 (£6) = 120,000
Direct material 20,000 (£2) 40,000
Leasing 2,400

£163,000 £180,000

It is cheaper to make the component unless the released facilities have some
alternative use. If this opportunity cost is greater than £17,000 per annum
then it will be cheaper to buy the component. Note that the direct labour is
assumed to be a variable cost. The qualitative factors arising from the direct
labour force being made redundant should be considered if the component is
not made by the company.

181
ANSWER TO QUESTION 16.9 - - - - - - - - - - - - - - - - - - - - - - - - -