BAF2202: MANAGEMENT

ACCOUNTING I
George Gitari
 Course Content:
 Nature, Purpose and scope of Management Accounting;
 Decision Making environments and techniques;
 Cost Behavior; Cost Estimation;
 Variable and absorption costing
 Relevant costing;
 Cost-Volume- Profit Analysis;
 Master Budget and Responsibility Accounting
Expected Learning outcomes of the course
By the end of the course unit the learners should be
able to:-
i) Explain the importance of management accounting
in the management of organizations
ii) Apply management accounting techniques to solve
various management dilemmas
iii) Explain the importance of budgeting and
responsibility accounting in management of
organizations
Course Assessment
Continuous assessment tests and assignments (CAT)
20%
Assignments 10%
End of Semester Examination
70%
Total 100%
References
Core Text books:
i) Horngren C.T and Foster, G: (2009), Cost Accounting: A
Managerial Emphasis, (11th Edition)
ii) Hansen (2008); Management Accounting; Cengage Learning
( Thompson )

Recommended Text Books:
i) Horngren C.T Sundrem G L and Stratton W. O; (2007), An
introduction to Management Accounting, (10th International
Edition), Prentice Hall International Inc
NATURE AND PURPOSE OF
MANAGEMENT ACCOUNTING
 Accounting system provides accounting information to interested
users and since users have different types or forms of accounting.
 Accounting is the process of identifying, measuring and
communicating economic information to permit informed
judgments and decisions by the users of information.

 Costing or cost accounting is concerned with the

ascertainment of costs.
 The main objective of costing is to analyze the various costs
involved in the production of any commodity and to ensure that
these costs are controlled adequately. The difference between
selling price and cost of production is the profit of any business
enterprise. In order to increase the profit, cost must be reduced.
 Accounting is often referred to as the language of business. This
information system can be classified into:
 Financial Accounting
 Management Accounting
Definition
Financial accounting has been defined by
the Institute of Management Accountants
U.K. (C.I.M.A.) in the words “The analysis,
classification and recording of financial
transactions and the ascertainment of
how such transactions affect the
performance and financial position of a
business.
. It involves the development of general-
purpose financial statements largely for
external reporting. These statements are
developed in accordance with standards
Definition
Cost Accounting has been defined by C.I.M.A. in
the words “The application of accounting and
costing principles, methods and techniques in
the ascertainment of costs and the analysis of
savings and/or excess as compared with
previous experience or with standards”
 A systematic process of collecting, summarizing
and recording data regarding the various resources
and activities in a firm so as to calculate the basis
of production costs used in financial accounting or
making other relevant decisions in a firm
(Horngren C.T)
Definition
Management Accounting has been defined in the
words: “The provision of information required
by management for such purposes such as:
 Formulation of policies.
 Planning and controlling the activities of the
enterprise.
 Decision taking on alternative courses of action.
 Disclosure to those external to the entity
(shareholders and others)
 Disclosure to employees.
 Safeguarding assets.
Meaning

of Management Accounting
Management Accounting is the process of
identification, measurement accumulation, analysis,
preparation, interpretation and communication of
financial information used by management to plan,
evaluate and control within an organization and to ensure
appropriate use of and accountability for its resources.
Management accounting is concerned with
providing information to managers – that is, people
inside an organization who direct and control its
operations. In contrast, financial accounting is
concerned with providing information to
shareholders, creditors and others who are outside an
organization.
Management accounting focuses on both monetary and
non-monetary information (for example, cost drivers
such as labor hours and quantities of raw materials
purchased) that inform management decisions and
activities such as planning and budgeting, ensuring
Scope of management Accounting
 The scope of management accounting can be studied as follows:
 Financial accounting: Financial accounting forms the basis for analysis
and interpretation for furnishing meaningful data to the management.
The control aspect is based on financial data and performance evaluation,
on recorded facts and figures. So, management accounting is closely
related to financial accounting in many respects.
 Cost accounting: Cost accounting is the process and techniques of
ascertaining cost. Planning, decision making and control are the basic
managerial functions. The cost accounting system provides the necessary
tool for carrying out such functions efficiently. The tools includes
standard costing, inventory management, variable costing etc.
Budgeting and forecasting: Budgeting means expressing the plans,
policies and goals of the firm for a definite period in future. Forecasting
on the other hand, is a prediction of what will happen as a result of a
given set of circumstances. Forecasting is a judgment whereas the
budgeting is an organizational object. These are useful for management
accounting in planning.
 Inventory control: Inventory is necessary to control from the time it is
acquire till its final disposal as it involves large sum. For controlling
inventory, management should determine different level of stock. The
inventory control technique will be helpful for taking managerial
decisions.
Scope of Management Accounting
 Interpretation of data: Analysis and interpretation of financial
statements are important part of management accounting. After
analyzing the financial statements, the interpretation is made
and the reports drawn from this analysis are presented to the
management. Interpreting the accounting data to the authorities
in the management is the principal task of management
accounting.
 Reporting to management: The interpreted information must
be communicated to those who are interested in it. The report
may cover Profit and Loss Account, Cash Flow and Funds Flow
statements etc.
 Internal audit and tax accounting: Management accounting
studies all the tax matters to assist the management in
investment decisions vis-a-vis tax planning as a resource to enjoy
tax relief.
 Internal audit system is necessary to judge the performance of
every department. Management is able to know deviations in
performance through internal audit. It also helps management in
fixing responsibility of different individuals.
 Methods of procedures: This includes maintenance of proper
Objectives of Management Accounting
The following are the objectives of Management Accounting:
1) measuring performance:
Management accounting measures two types of performance.
First is employee performance and the second is efficiency
measurement. The actual performance is measured with the
standardized performance and a report of deviation from the
standard performance is reported to the management for the
effective decision making and also to indicate the effectiveness of
the methods in use. Both types of performance management are
used to make corrective actions in order to improve performance;
2) Assess Risk:
The aim of management accounting is to assess risk in order to
minimize risk;
3) Allocation of Resources:
is an important objective of Management Accounting
4) Presentation of various financial & Non-financial Reports to the
Management.
 Characteristics of Management Accounting:
1. Technique of Selective Nature:
 Management Accounting is a technique of selective nature. It takes into
consideration only that data from the income statement and position state merit
which is relevant and useful to the management. Only that information is
communicated to the management which is helpful for taking decisions on various
aspects of the business.
2. Provides Data and not the Decisions:
 The management accountant is not taking any decision but provides data which is
helpful to the management in decision-making. It can inform but cannot prescribe.
It is just like a map which guides the traveller where he will be if he travels in one
direction or another.
 Much depends on the efficiency and wisdom of the management for utilizing the
information provided by the management accountant.
3. Concerned with Future:
 Management accounting unlike the financial accounting deals with the forecast
with the future. It helps in planning the future because decisions are always taken
for the future course of action.
4. Analysis of Different Variables:
 Management accounting helps in analysing the reasons as to why the profit or loss
is more or less as compared to the past period. Moreover, it tries to analyse the
effect of different variables on the profits and profitability of the concern.
5. No Set Formats for Information:
 Management accounting will not provide information in a prescribed proforma like
 Roles of Management Accountants
The utility of management accounting
information includes: planning, organising,
directing and controlling
Helps in providing information in Managing
functions that are critical to business
performance
Supporting organizational management and
strategic development
Providing accurate and insightful information for
better decisions
Ensuring the organisation operate with integrity
 ETHICAL STANDARDS OF MANAGEMENT ACCOUNTANTS
Management accountants should behave ethically. They have an obligation
to follow the highest standards of ethical responsibility and maintain good
professional image. The Institute of Management Accountants (IMA) has
developed four standards of ethical conduct for management accountants
and financial managers.
1. Competence - Management accountants are to;-
 Maintain an appropriate level of professional competence by ongoing
development of their knowledge and skills.
 Perform their professional duties in accordance with relevant laws,
regulations, and technical standards.
 Prepare complete and clear reports and recommendations after
appropriate analyses of relevant and reliable information.
2. Confidentiality - Management accountants are to;-
 Refrain from disclosing confidential information acquired in the course of
their work except when authorized, unless legally obligated to do so.
 Inform subordinates as appropriate regarding the confidentiality of
information acquired in the course of their work and monitor their
activities to assure the maintenance of that confidentiality.
 Refrain from using or appearing to use confidential information acquired
in the course of their work for unethical or illegal advantage either
personally or through third parties.
 Cont……..
3. Integrity - Management accountants are to;-
 Avoid actual or apparent conflicts of interest and advise all appropriate
parties of any potential conflict.
 Refrain from engaging in any activity that would prejudice their ability to
carry out their duties ethically.
 Refuse any gift, favor, or hospitality that would influence or would appear
to influence their actions.
 Refrain from either actively or passively subverting the attainment of the
organization's legitimate and ethical objectives.
 Recognize and communicate professional limitations or other constraints
that would preclude responsible judgment or successful performance of
an activity.
 Communicate unfavorable as well as favorable information and
professional judgments or opinions.
 Refrain from engaging in or supporting any activity that would discredit
the profession.
4. Credibility - Management accountants are to;-
 Communicate information fairly and objectively.
 Disclose fully all relevant information that could reasonably be expected
Ethical Issues of Management
Accountant
Competence
• Maintain an appropriate level of professional
competence
• Prepare Clear and Complete report
Confidentiality
• Non disclose of Information unless requires by
the Law
Integrity
• Avoid conflict of information
• Refuse any gift, favour and be honest
Credibility
• Communicate information fairly and objectively
 Resolution of Ethical Conflict
 When faced with significant ethical issues, practitioners of management
accounting and financial management should follow the established
policies of the organization bearing on the resolution of such conflict. If
these policies do not resolve the ethical conflict, such practitioners should
consider the following courses of action;-
 Discuss such problems with the immediate superior except when it
appears that the superior is involved, in which case the problem
should be presented initially to the next higher managerial level.
 If a satisfactory resolution cannot be achieved when the problem
is initially presented, submit the issues to the next higher
managerial level. If the immediate superior is the chief executive officer,
or equivalent, the acceptable reviewing authority may be a group such as
the audit committee, executive committee, board of directors, board of
trustees, or owners. Except where legally prescribed, communication of
such problems to authorities or individuals not employed or engaged by
the organization is not considered appropriate.
 Clarify relevant ethical issues by confidential discussion with an
objective advisor to obtain a better understanding of possible
courses of action. Consult your own attorney as to legal obligations and
rights concerning the ethical conflict.
 If the ethical conflict still exits after exhausting all levels of internal
review, there may be no other recourse on significant matters than to
Benefits of Ethical behavior by Management
Accountants in business
It promotes higher standards of self regulation
It improves trust and credibility
It minimizes conflict of interest between
professionals and clients
It helps boosting public confidence in the work
of professionals
It regulates the behavior of professionals
leading to best practices
It promotes public image and goodwill
It reduces cases of possible litigation or legal
suits
 Limitations of Mgt Accounting
Based on accounting information
Lack of knowledge
Management accounting is only a tool
Evolutionary stage (still in the development
stage)
Personal prejudices and bias
Psychological resistance
Different meaning of the same term.
Approximation (data cannot complete
accurate)
Incompleteness of data (based only on
DECISION MAKING PROCESS
RISK AND UNCERTAINITY
..
Decision making is the process of choosing among
Decision Making Process :

alternatives.
The first five stages represent the decision-making of
the planning process. Planning involves making
choices between alternatives and is primarily a
decision-making activity. The final two stages
represent the control process, which is the process of
measuring and correcting actual performance to
ensure that the alternatives that are chosen and the
plans for implementing them are carried out. Let us
now consider each of the elements of the decision-
making and control process.
i) Identifying Objectives
Before good decisions can be made there must be some
guiding aim or direction that will enable the decision-
makers to assess the desirability of favouring one
II)THE SEARCH FOR ALTERNATIVE COURSES OF
ACTION
The second stage of the decision-making model is a
search for a range of possible courses of action (or
strategies) that might enable the objectives to be
achieved. If the management of a company
concentrates entirely on its present product range and
markets, and market shares and cash flows are
allowed to decline, there is a danger that the company
will be unable to generate sufficient cash flows to
survive in the future. To maximize future cash flows, it
is essential that management identifies potential
opportunities and threats in its current environment
and takes any developments which may occur in the
future. In particular, the company should consider one
or more of the following courses of action:
1. Developing new products for sale in existing
 The search for alternative courses of action involves the
acquisition of information concerning future opportunities and
environments. It is the most difficult and important stage of the
decision-making process. Ideally, firms should consider all
alternative courses of action, but, firms will in practice consider
only a few alternatives, with the search process being localised
initially.
III) GATHER DATA ABOUT ALTERNATIVES
 When potential areas of activity are identified, management
should assess the potential growth rate of the activities, the
ability of the company to establish adequate market shares, and
the cash flows for each alternative activity for various states of
nature. Because decision problems exist in an uncertain
environment, it is necessary to consider certain factors that are
outside the decision-maker's control, which may occur for each
alternative course of action. These uncontrollable factors are
called states of nature. Some examples of possible states of
nature are economic boom, high inflation, recession, the
 The course of action selected by a firm using the information
presented above will commit its resources for a lengthy period
of time, and the overall place of the firm will be affected within
its environment—that is, the products it makes, the markets it
operates in and its ability to meet future changes. These
decisions are normally referred to as long-run possibilities and
hence the type of decisions it can make in the future. These
decisions are normally referred to as long-run or strategic
decisions. Strategic decisions have a profound effect on the
firm's future position, and it is therefore essential that adequate
data is gathered about the firm's capabilities and the
environment in which it operates. Because of their importance,
strategic decisions should be the concern of top management.
 Besides strategic or long-term decisions, management must also
make decisions that do not commit the firm's resources for a
lengthy period of time. Such decisions are known as short-term
or operating decisions and are normally the concern of lower-
level managers. Short-term decisions are based on the
environment of today, the physical, human and financial
 Cont……
Examples of short-term decisions include the
following:
1. What selling prices should be set for the firm's
products?
2. How many units should be produced of each
product?
3. What media shall we use for advertising the
firm's product?
4. What level of service shall we offer customers
in terms of the number of days required to deliver an
order and the after-sales service?
Data must also be gathered for short-term decisions;
for example, data on the selling prices of
competitor's products, estimated demand at
IV) SELECT APPROPRIATE ALTERNATIVE COURSES
OF ACTION
In practice, decision-making involves choosing between
competing alternative courses of action and selecting the
alternative that best satisfies the objectives of an
organisation. Assuming that our objective is to maximise
future net cash inflows, the alternative selected should be
based on a comparison of the differences between the
cash flows. Consequently, an incremental analysis of the
net cash benefits for each alternative should be applied.
The alternatives are ranked in terms of net cash benefits,
and those showing the greatest benefits are chosen
subject to taking into account any qualitative factors. We
shall discuss how incremental cash flows are measured for
short-term and long-term decisions and the impact of
qualitative factors.
IMPLEMENTATION OF THE DECISIONS
Once alternative courses of action have been selected,
they should be implemented as part of the budgeting
process. The budget is a financial plan for implementing
the various decisions that management has made. The
budgets for all the various decisions are expressed in
terms of cash inflows and outflows, and sales revenues and
expenses. The budgets are merged together into a single
unifying statement of the organisation's expectations for
future periods. The statement is known as a master
budget. The master budget consists of a budgeted profit
and loss account, cash flow statement and balance sheet.
The budgeting process communicates to everyone in the
organisation the part they are expected to play in
implementing management's decisions.
VI) COMPARING ACTUAL AND PLANNED OUTCOMES
 The final stages in the process of comparing actual and planned
outcomes and responding to divergences from plan represent
the firm's control process.
 To monitor performance, the accountant produces performance
reports and presents them to the appropriate managers who are
responsible for implementing the various decisions.
Performance reports consisting of a comparison of actual
outcomes (actual costs and revenues) and planned outcomes
(budgeted costs and revenues) should be issued at regular
intervals. Performance reports provide feedback information by
comparing planned and actual outcomes. Such reports should
highlight those activities that do not conform to plans, so that
managers can devote their scarce time to focusing on these
items.
VII) RESPONDING TO DIVERGENCES FROM PLAN
 This process represents the application of management by
exception. Effective control requires that corrective action
is taken so that actual outcomes conform to planned
outcomes.
 The managerial function of control consists of the
measurement, reporting and subsequent correction of
performance in an attempt to ensure that the firm's
objectives and plans are achieved. In other words, the
objective of the control process is to ensure that the work
is done so as to fulfil the original intentions.
 Decision Making Environment
There a four main environment within which decisions can be
made. These are:
 Certainty
 Risk
 Fundamental uncertainty
 Competition
Certainty environment
 In this environment complete information is available as to
which states of nature will occur. The decision making
process just involves picking the best alternative.
RISK
 Risk involves situations or events which may or may not
occur but whose probability of occurrence can be predicted
from past records. In this environment, the states of nature
are not certain but probability distribution can be assigned.
Fundamental Uncertainty
Uncertain events are those whose outcome
cannot be predicted with statistical confidence.
In this environment the states of nature are
not known nor are their probability
distribution. The decision making process
depends on the risk attitude of the decision
maker.
Competition
In this environment the decisions made by the
firm are affected by decisions made by other
firms with opposing interests.
 DECISION MAKING UNDER RISK AND UNCERTAINTY
 Before looking at the various methods of making decisions under risk,
we shall look at the three main risk attitudes that distinguish different
decision makers. These are:
1 RISK SEEKING
A risk seeker is a decision maker who is interested in the best possible
outcome no matter how small the chance that they may occur i.e. he
takes high risks in anticipation of high profitability. For such a
decision maker, the marginal utility for wealth is positive and
increasing.
2. Risk neutral
A decision maker is risk neutral if he is concerned with what will be the
most likely outcome i.e. he is indifferent to risk. For such a decision
maker the marginal utility of wealth is positive and constant.
3. Risk Averse
A decision maker is risk averse, if he acts on the assumption that the
worst possible outcome will occur, and chooses the decision with the
least risk possible.
 Measure of Risk
Std deviation (δ)
This is the square root of the variance, where the
variance is the summation of the difference between
the outcome and the mean squared.
Coefficient of variation.
It is a relative measure of risk and it is used to compare
alternatives of different magnitudes based on their
risk return consideration.

C V = δ___
EMV
EMV = ε MVt Pt
 Methods of Decision Making Under Uncertainty
DECISION MAKING CRITERIA
 Maximax decision rule
This decision rule looks at the best possible result and it chooses the
maximum payoff for each alternative and then the maximum of this
maximum
 Maximin decision rule
Under this criterion, the decision maker looks at the worst possible
outcome of each decision alternative and then chooses the
alternative that offers the least unattractive (worst) outcome i.e. He
chooses the alternative that maximises the minimum profit.
 LAPLACE CRITERION OF RATIONALITY
This criterion holds that if decision makers do not know the
probabilities of the various states of nature and have no reason to
think otherwise, then the states of nature should be considered to
be equally likely. On the basis of this assumption, the expected
monetary value for each alternative is calculated and the
alternative with the highest expected monetary value is chosen.
 Minimax Regret Criterion
This method seeks to minimize the maximum regret that would occur
from choosing a particular strategy or alternative. The regret is
the opportunity loss that occurs from taking one decision given
that a certain contingency occurs.
 ILLUSTRATION 1
Assume that ABC Ltd is trying to set the selling price for one of its
products and three prices are under consideration. These are
Sh.4, Sh.4.30 & Sh.4.40
The following information on the units to be sold is also provided
Alternatives
Conditions Sh.4.00 Sh.4.30 Sh.4.40
Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000
Fixed costs = Sh. 20,000
variable cost per unit = Sh. 2
METHODS OF DECISION MAKING UNDER RISK
In this environment, it is possible to attach probabilities to
the various states of nature. The decision criteria would
either be:
The expected monetary value
The expected opportunity loss
The two criteria are similar since the choice that
maximises the expected monetary value also minimises
the expected opportunity loss (EOL)

ILLUSTRATION 2
Assume in the ABC pricing decision (illustration 1) that
the probability of the best possible outcome is 0.2, most
likely outcome is 0.6 and the worst possible outcome is
0.2.
 Perfect and Imperfect Information
The uncertainty about the future outcome from taking a
decision can be reduced by obtaining more
information fast about what is likely to occur.
That information can be obtained from various sources
e.g.
Market surveys
Conducting a pilot test
Building a prototype model
Hire consultants
Information can be categorised depending upon how
reliable it is likely to be for predicting what would
happen in the future and for helping managers to
make better decisions.
Perfect information (PI) is information that can be
Both perfect and imperfect information is costly and its value
must be determined.
Value of perfect information (Pi) = EMV with PI – EMV
without PI.
ILLUSTRATION
Consider the ABC pricing decision (Illustration 1) and assume
that it is possible to obtain ideal information at a cost of
Sh.500
REQUIRED
Advice the company on whether to acquire the perfect
information
EMV with PI = 0.2(12200) + 0.6 (8800) + 0.2(0) = 7720
Value of perfect information = 7720 –7370 = Sh.350
The decision is not to acquire perfect information since it
 EXERCISE
A distributor buys perishable articles for £2 per
item and sells them at £5. Demand per day is
uncertain and the items unsold at the end of the
day represents a write off because of perishability.
If he under stocks he losses profit he could have
made.
A 300 day record of the past activity as follows:
A Daily demand (units) No of days
10 30
11 60
12 120
13 90
What level of stock should be held from day to day
 EXERCISE 2
Cement Co is a company specialising in the manufacture of cement, a product used
in the building industry. The company has found that when weather conditions
are good, the demand for cement increases since more building work is able to
take place. Cement Co is now trying to work out the level of cement production
for the coming year in order to maximise profits. The company has received the
following estimates about the probable weather conditions and corresponding
demand levels for the coming year:
Weather Probability Demand
Good 25% 350,000 bags
Average 45% 280,000 bags
Poor 30% 200,000 bags
Each bag of cement sells for frw9 and costs frw4 to make. If cement is unsold at the
end of the year, it has to be disposed of at a cost of frw0·50 per bag. Cement Co
has decided to produce at one of the three levels of production to match forecast
demand. It now has to decide which level of cement production to select.
Required:
(i) Construct a pay-off table to show all the possible profit outcomes.
(ii) Determine the level of cement production the company should choose, based on
the decision rule of maximin, Minimax Regret Criterion and Expected Monetary
Value. Show your calculations clearly and justify your decision.
(iii) Determine the value for perfect information
COSTS, AND COST
CLASSIFICATION
 Cost
Cost is the monetary measure of resources sacrificed or forgone to achieve
a specific objective e.g acquiring of a good or service. The resources
usually given up are generally in terms of money or, if not in terms of
money, they are always expressed in monetary terms.
Cost can also be defined as the amount of expenditure incurred on or
attributable to a specific thing or item.
When a cost is incurred, it could be in the form of deferred cost (asset) or
expired cost (expense). Deferred costs are unexpired costs, capitalized
costs, which provide benefits in future periods and known as assets and
hence appear in the balance sheet. An Expense is an expired cost which has
given benefit to the organization and no longer has any service potential of
providing more benefits to the organization. Loss is a lost cost. It represents
the cost that has expired (incurred) but has not yielded any benefit to the
organization. In financial accounting, it is used to denote a situation where
the expenses exceed revenues for the accounting period.

Cost Unit
Cost unit is defined as a unit of quantity of a product,
service or time in relation to which cost may be
ascertained or expressed. The cost unit will differ
from organization to organization.
Cost unit is considered as a unit of measurement of
cost or a quantification for which costs are expressed
e.g. litre, kilogramme/tonne, kilometer etc.
Thus a cost unit is any convenient measure of activity
giving a feeling of what the firm is producing.

Responsibility Centre
This represents an individual part of the business whose manager has a
personal responsibility for its performance.
Many organizations are structured into a hierarchy of responsibility centres
which include: cost centres, revenue centres, profit centres and investment
centres.
Cost centre
Cost centre may be defined as any particular part of the enterprise. A cost
centre may be a particular department, function or item of equipment for
which costs may be ascertained and related to cost unit for control purposes.
Cost centres are basically organization segment or area of activity
considered to accumulate costs.
Revenue centre
This is a segment of the organization which is primarily responsible for
generating sales revenue. A revenue centre manager does not posses control
over cost, investment in assets, but usually has control over some of the
expenses of the marketing department. The performance of a revenue centre
is evaluated by comparing the actual revenue with the budgeted revenue.
Profit centre
This is that cost centre which not only incurs cost but also
yield revenue. This is part of the organization for which both
the revenue and the costs incurred and revenue earned are
identified.
The performance of the profit centre is assessed in terms of
whether the centre has achieved its budget profit
 Investment centre
This is a segment of the organization which has the
responsibility for capital investment and possibly for
financing and whose performance is measured in terms of
return on investment or return on capital employed.
 Definition
Cost classification is the process of
grouping costs according to their
common characteristics.
A suitable classification of costs is of vital
importance in order to identify the cost
with cost centres or cost units.
Cost may be classified accounting to
their nature, i.e., material, labor and
expenses and a number of other
characteristics.
The same cost figures are classified
according to different ways of costing
depending upon the purpose to be
 Purpose of cost classification
1) Preparation of budget: classification of cost helps in preparation of
the budget of the organization. For preparing the budget of an
organization one must know how and where exactly the expenses have
been incurred in relation to manufacturing the product. On the basis of
this classification of the cost an organization accordingly prepares its
budget.
2) Helps in measuring efficiency: classification of cost helps in
measuring the efficiency of the organization. On the basis of the places
where the costs have been incurred and the amount of cost that has
been incurred the efficiency of the organization can be judged.
3) Controlling cost:
 Labour cost: classification of cost help organization to control its labour cost . If labour
complete their task in time and with efficiency then the organization would be able to
reduce its labour cost.
 Material cost: material cost can be controlled if material wastage is avoided and proper
standardization of materials is used.
 Overhead cost: overhead comprises indirect expenditure incurred in manufacturing. By
knowing the amount that has been incurred under various heads an organization can
device ways to reduce cost.
4) Expansion of the organization: Once an organization is able to
control its cost then it can concentrate on its expansion. Thus with the
help of classification of cost an organization is able to device ways for
its expansion.

 METHODS OF COST CLASSIFIICATION
MANUFACTURING COSTS
 Manufacturing costs are those costs that are directly involved in
manufacturing of products and services. Examples of manufacturing
costs include raw materials costs and salary of labor workers.
Manufacturing cost is divided into three broad categories by most
companies.
 Direct materials cost
 Direct labor cost
 Manufacturing overhead cost - includes all costs of manufacturing
except direct material and direct labor. Examples of manufacturing
overhead include items such as indirect material, indirect labor,
maintenance and repairs on production equipment and heat and light,
property taxes, depreciation, and insurance on manufacturing facilities.
Indirect materials are minor items such as solder and glue in
manufacturing industries.

 Prime Cost = Direct Materials Cost + Direct Labor Cost

Conversion Cost = Direct Labor Cost + Manufacturing Overhead

Non-manufacturing Costs:
 Non-manufacturing costs are those costs that are
not incurred to manufacture a product. Examples
of such costs are salary of sales person and
advertising expenses. Generally non-
manufacturing costs are further classified into two
categories.
Marketing and Selling Costs - Examples of
marketing or selling costs include advertising costs,
shipping costs, sales commission and sales salary.
Administrative Costs - Examples of administrative
costs include executive compensation, general accounting,
secretarial, public relations, and similar costs involved in the
overall, general administration of the organization as a
whole.
 FUNCTIONAL CLASSIFICATION
 Production, Administration, Selling & Distribution are three
important functions of a business concern. Taking these
functions into consideration, costs have been classified by:
 Production or Manufacturing Cost: Manufacturing costs are
those costs which are incurred in the course of manufacture. It
includes cost of raw material, cost of labour, other direct cost
and factory indirect cost. Example of production or
manufacturing costs may be power, lighting, heating, rent,
depreciation etc.
 Office and Administration Cost: These costs are incurred for
the general administration of the enterprise. It includes office
costs as well as administration cost. For example, salary of office
staff, rent of office building, electricity charges, audit fee,
printing and stationeries etc.
 Selling and Distribution Cost: It includes both selling cost as
well as distribution cost. Selling costs are those costs which are
incurred in connection with the selling of goods and services
Distribution costs are those costs which are incurred on
despatch of finished goods to the consumers. Example of selling
 BEHAVIORAL CLASSIFICATION
 Cost behavior means how costs will respond or react to changes
in the activity level. ie. as we increase output or sales, are the
costs rising, dropping or remaining the same.
 Costs will be classified according to nature or behavior in
relationship to change in the levels of production such as:
 Variable costs
 Fixed costs
 Semi fixed costs
Variable costs: These are directly proportional to the level of
activity. If the number of units produced doubles, then variable
production costs will double also. An example would be the cost
of material used to produce units.
Fixed costs: Constant over a wide range of activity. An example
would be the factory rent. It does no matter how many units are
made, the rent is fixed.
 Semi-variable costs: Have a fixed element and a variable
element. An example would be a telephone bill. Usually there is a
fixed cost for the line rental then each minute of telephone calls
ACCORDING TO CONTROLLABILITY
Controllable cost: Controllable costs are those
which can be influenced by the action of a
specified member of an undertaking.
Generally speaking all directs costs including
direct materials, direct labor and some of the
overhead expenses are controllable by the lower
level management.
Uncontrollable cost: These are the cost which
cannot be influenced by the action of a specified
member of undertakings.
Most of fixed costs such as rent of buildings,
salary to managerial persons, wages of skilled
workers, etc. are uncontrollable.
 ACCORDING TO TIME
 Costs can be classified in to historical or actual costs and
predetermined or future cost.
 Historical cost- It relates to the usual method of determining
actual cost of operation based on actual expenses incurred
during the period. Such evaluation of costs takes longer time, till
the accounts are closed and finalized, and figures are already for
use in cost calculations.
 Predetermined cost- It is prepared in advance before the
actual operation starts on the basis of specializations and
historical cost data of the earlier period and all factors effecting
cost. Predet3ermined cost is therefore future cost and may be
either estimated or standard.
 Estimated cost is prepared before accepting an order for
submitting price quotation. It is also used for comparing actual
performance.
 Standard cost is scientifically predetermined cost of a product
or service applicable during a specific period of immediate
future under current or anticipated operating conditions. The
method consists of setting standards for each elements of cost,
 CLASSIFICATION BY RELATIONSHIP WITH
ACCOUNTING PERIOD
 Classifications are measured by the period of
use and benefit.
The capital expenditure and revenue
expenditure are classified under it.
Revenue expenses relate to current
accounting period.
Capital expenditures are the benefits
beyond accounting period.
Fixed assets come under category of capital
expenditure and maintenance of assets comes
under revenue expenditure category
CLASSIFICATION BASED ON IDENTIFICATION WITH
INVENTORY
Under this classification, costs are classified according to
the function they perform in an organization. Costs can
functionally be classified as:
Product costs: are all the costs incurred in production of
units during a time period e.g. raw material costs, direct
labour costs and production overheads. Such costs are
capitalized and expensed (charged to the profit and loss
account) only when the manufacturer sells inventory.
These costs may be carried from one period to the other.
Period costs: these are costs mainly incurred in the
ordinary running of the business enterprise. They include
costs like electricity bill paid, salaries and allowances and
rent
payments. They are referred to as period costs since they
are expensed in the period they are incurred.
 CLASSIFICATION FOR DECISION MAKING
 Sunk costs: these are costs, which have already been incurred.
They cannot be changed by any decision made after incurrence.
Such costs are irrelevant for decision making. For example, cost
of a delivery van already acquired by the organization shall be
irrelevant as it cannot be changed by any course of action taken
by management.
 Marginal cost: is the additional cost of producing an extra unit
of output.
 Opportunity cost: is defined as the cost of the next best
foregone alternative or the potential benefit that is lost by taking
one course of action and giving up the other. For instance, by
deciding to take on a leave and forego wages, the opportunity
cost of the decision shall be the foregone wages.
 Differential cost/incremental cost: these are costs that differ
among alternatives. They are costs relevant for decision making.
They may be either variable or fixed. For instance, if taking up a
different business apartment amounts to an extra Shs2,000 rent
expense, the differential (incremental) cost of the decision shall
be the Sh.2,000.
Replacement cost: The amount it would cost to replace an
asset at current prices. If the cost of replacing an asset in its
current physical condition is lower than the cost of replacing the
asset so as to obtain the level of services enjoyed when the asset
was bought, then the asset is in poor condition and the firm would
probably not want to replace it
Standard cost: A management tool used to estimate the
overall cost of production, assuming normal operations.
Budgeted cost: This is the cost estimated to be incurred and
used for budgeting purposes. It is a cost included in the budget
representing cost expected. Most of the times, budgeted cost will
be derived from standard cost.
COST ESTIMATION
Introduction
A cost estimate is the approximation of the cost
of a program, project, or operation.
The cost estimate is the product of the cost
estimating process.
The cost estimate has a single total value and
may have identifiable component values.
A problem with a cost overrun can be avoided
with a credible, reliable, and accurate cost
estimate.
An estimator is the professional who prepares
cost estimates.
 METHODS OF ESTIMATING COST
Non mathematical methods These include;
 Engineering method
Mathematical methods These include;-
 Accounts analysis
 High-low method
 Scatter graph method
 Ordinary Least Squares Regression Method
Cost estimation methods are necessary only for costs
that are identified as mixed costs. There is no need to
apply an estimation method to break a cost into fixed
and variable portions if you have already determined
it is solely fixed or solely variable.
All four methods produce estimates of amounts of
fixed and variable costs.
 ENGINEERING METHOD
 It’s a technique where the system being costed is broken down
into lower-level components (such as parts or assemblies), each
of which is costed separately for direct labor, direct material,
and other costs. Engineering estimates for direct labor hours
may be based on analyses of engineering drawings and
contractor or industry-wide standards.
 Engineering estimates for direct material may be based on
discrete raw material and purchase part requirements. The
remaining elements of cost (such as quality control or various
overhead charges) may be factored from the direct labor and
material costs. The various discrete cost estimates are
aggregated by simple algebraic equations (hence the common
name “bottoms- up” estimate). The use of engineering
estimates requires extensive knowledge of a system’s (and its
components’) characteristics, and lots of detailed data.

Because of the high level of detail, each step of the work flow
should be identified, measured, and tracked, and the results for
Advantages & Disadvantages
 Advantages
 The estimator’s ability to determine exactly what the estimate
includes and whether anything was overlooked,
 Its unique application to the specific program and
manufacturer,
 That it gives good insight into major cost
contributors, and
 Easy transfer of results to other programs.
 Some disadvantages of the Engineering Cost
estimating method include:
 It can be expensive to implement and it is time
consuming
 It is not flexible enough to answer what-if questions
 New estimates must be built for each alternative
 The product specification must be well known and
stable
 All product and process changes must be reflected in
ACCOUNT

ANALYSIS
Under account analysis method, the
accountant examines and classifies each
ledger account as variable, fixed or mixed.
Mixed accounts are broken down into their
variable and fixed components.
They base these classifications on
experience, inspection of cost behavior for
several past periods or intuitive feelings of
the manager.
This is with a view to develop a cost
function in the form y = a + bx
Example
Suppose a company ABC has the following costs with a value of 7000 units.
Amount Variable Fixed
Direct labour 150,000 150,000 -
Materials 125,000 125,000 -
Repairs and maintenance 5,000 5,000 -
Depreciation 15,000 - 15,000
Administration overheads 1,000 - 1,000
Indirect labour 4,000 - 4,000
300,000 280,000 20,000

Required;-
Determine the cost equation using account classification method and determine the cost of producing
1,400 units
 EXERCISE
 In the year 2020 VIP incurred the following expenses to
maintain 1500 lecturers.
Sh
Administration expenses (40% variable) 4,000,000
Lecturing pay (60% variable) 8,000,000
Airtime allowance (fixed) 1,000,000
Sundry expenses (50% fixed) 500,000
Soda allowance (variable) 300,000
Required;-
a Using accounts analysis method, express an equation in form y
= a +bx
b Using the equation expressed above, estimate the total cost of
2000 lecturers incurred to be employed in 2021.

 Exercise: Accounts Analysis Method
ABC Ltd produces a single product which is meant for the local
market only. The
monthly demand for this product varies from one month to
the other.
During the month of November 2013, 1000 units were produced
incurring the following expenses.
$(Thousands)
Direct Materials 30
Direct Labour 40
Rent (Fixed) 25
Electricity (40% fixed) 27
Property Taxes and Rates (80%
variable) 50
Technical Support (fixed) 28
Total 20
Required:
a) Using accounts analysis method, formulate a predictor equation
in the form of
y=bx + a
b) During the month of December 2013, ABC Ltd estimates to
 HIGH –LOW (OR RANGE)METHOD.
 In this method the highest and lowest activity together with
their corresponding costs is identified. The two points i.e. the
lowest and the highest are used to derive a cost function in the
form of
y = a + bx
 This method is based on an analysis of historical information of
costs at different activity levels. The high-low method finds the
equation of the straight line joining the two points
corresponding to the highest and lowest activity levels.
 What we need to do is to separately identify the fixed and
variable cost elements so that each can be predicted for
anticipated future activity levels.
 The variable cost is estimated by calculating the average unit
cost between the highest and lowest volumes and the fixed and
total cost function can then be derived.
Example
Based on performance, you have been provided with
the following information regarding ABC Ltd for the
year ended 31 December 2022 :
Labour hours Service cost
(Shs)

Highest activity level 800 200,000
Lowest activity level 300 150,000
Required
Develop a total cost function based on the above data
using the high-low method.
 Illustration 2
The production manager of XYZ Company, is concerned abut the apparent
fluctuation in efficiency and wants to determine how labour costs (in
Sh.) are related to volume. The following data presents results of the 12
most recent weeks.
Week No. Units Produced(X) Labour Costs(Y)

1 34 340
2 44 346
3 24 287
4 36 262
5 30 220
6 49 416
7 39 337
8 21 180
9 41 376
10 47 295
11 34 215
12 24 275
Required: Estimate the cost function using high low method and
determine cost for producing 45 units
 THE SCATTER GRAPH METHOD
For this method a scatter diagram is constructed which is used to visually i.e. by inspection
deduce a relationship from observed pattern if there is any. By obtaining any two points on
constructed graph, we can fit a straight line if the pattern suggests a linear relationship.

x x xx
xx x x
Non-linearrelationship
x • Quadratic since has one turningpoint
xxx x xx
x x x
x xx
X
THE SCATTER GRAPH METHOD
Advantages of visual fit method
1. It takes into account all the observations unlike the high low
method.
2. It is easy to apply.

Disadvantages of visual –fit method
1. It cannot be used for two or more independent variables
2. We cannot measure the size of probable error.
3. It is subjective to some extent.

 ORDINARY LEAST SQUARES
REGRESSION METHOD
 Regression analysis is a technique that uses a statistical model to measure the amount of
change in one variable (dependent variable) that is associated with changes in amounts of
one or more variables.
 This method is used to determine the equation of the line of best fit by minimizing the
sum of the squares of the vertical
 When it has been established that a causal relationship exists in the data and that a linear
function is appropriate the statistical technique known as least squares is frequently used
to establish values for the coefficients a and b (representing fixed and variable cost
respectively) in the linear cost function.
 y = a + bx
 where y is total cost – the dependent variable

 and x is the agreed measure of activity – the independent variable

 The values of a and b are determined after substituting data.

 Regression analysis
The equation can be solved by the use of normal equations and these are:
1.  y = na + b ( x)

2.  xy = a ( x) + b ( x2)

From these normal equations:

b = n  xy –  x  y
n x 2– ( x)2

a=  Y - b x
n n
Looking at illustration 2, then we first compute the sum of X, Y, XY, X 2
Illustration 2
 EXERCISE 1
Virunga Designers produces men’s suits for all age groups and has provided the
following cost and production data for the month of May, 2022.
Number of suits Total cost (Frw‘000’)
250 21,420
270 22,930
310 25,951
340 28,217
350 28,972
420 34,258
1,940 161,748
 Due to the increased demand for Virunga Designers’ suits, management intends to
increase its production from 1,940 suits in May to 2,400 suits in June, 2022.
REQUIRED:
 Using regression analysis, forecast the total cost for the month of June, 2022.
 Disadvantages of marginal costing
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading
results.
2. Normal costing systems also apply overhead under normal operating volume and this shows
that no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed
costs from inventories affect profit, and true and fair view of financial affairs of an
organization may not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed
overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of
production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there
may be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know
the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a
valuable item. A system which ignores fixed costs is less effective since a major portion of
fixed cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions
underlying the theory of marginal costing sometimes becomes unrealistic. For long term
profit planning, absorption costing is the only answer.
 EXERCISE 2
 Kirezi Beauty Cosmetics (KBC) imports and supplies body perfumes to residents in
Gisagara province. These perfumes are sold in standard size of 300 ml per bottle.
KBC sells each body perfume at Frw 12,500 after incorporating a markup of 20%.
 The weekly sales demand and relevant costs for the month of May 2019 are
provided as below:
Week Sales (bottles) Total cost (Frw ‘000’)
1 120 1,390
2 200 2,150
3 140 1,580
4 240 2,530
700 7,650
 KBC has resolved to increase its selling price per bottle of the body perfume by 4%
in June 2019 owing to the ever increasing demand for its perfumes. The expected
sales for June 2019 were projected at 840 bottles.
 REQUIRED:
(a) (i) Using regression analysis, determine KBC’s profit in the month of June 2019.
 (ii) Using computations, show the effect on KBC’s profit if selling price and
variable cost per unit reduced by 4% and 5% respectively?
 ICPAR-Q3b –August 2021
 Imena Milk Industries Limited deals in production of milk. Over the past two years, it
realised its sales were unstable, something that triggered the management to put more
efforts in advertising its products on different media platforms whilst expecting
increase in sales.
 Below are the cost of advertisement and associated sales unit for the past six months:
 Month Advertisement cost (Frw) Sales units
 January 800,000 4000
 February 500,000 3000
 March 350,000 1000
 April 1,000,000 6000
 May 850,000 5000
 June 1,300,000 7000
 July 1,100,000 6000
 August 1,600,000 8000
 i) Using the High Low method, estimate the total cost function and calculate unit
variable cost and unit fixed cost. (4 Marks)
 ii) Estimate the total cost function using linear regression analysis and calculate
how much cost will be incurred when sales units are 1000. (4 Marks)
 ICPAR-Q7b –November 2023
 (b) REG Ltd deals with the construction of houses in Kigali. It has had a
good performancefrom September 2022. REG Ltd is currently reviewing its
performance so as to ascertain its costs for May 2023 for planning
purposes. Total costs and output for the last seven months are presented in
theParticulars
table below: Number of houses Total costs
constructed
units Frw
September, 2022 8,500 4,475,000
October, 2022 5,000 3,150,000
November, 2022 6,500 3,850,000
December, 2022 7,500 3,750,000
January, 2023 9,500 4,825,000
February, 2023 5,500 3,260,000
March, 2023 6,000 3,540,000
 REQUIRED: Using regression analysis method of cost estimation, calculate
the following
 i) variable cost per unit
 ii) Fixed cost of constructing the houses
 iii) Formulate the total cost equation
MARGINAL AND ABSORPTION COSTING
 Marginal Costing, also known as Variable Costing, is a costing method whereby decisions
can be taken regarding the ascertainment of total cost or the determination of fixed and
variable cost in order to find out the best process and product for production etc.
 It identifies the Marginal Cost of production and shows its impact on profit for the
change in the output units. Marginal cost refers to the movement in the total cost, due to
the production of an additional unit of output.
 In marginal costing all the variable costs are regarded as product related costs while fixed
costs are assumed as period costs. Therefore, fixed cost of production is posted to the
Profit & Loss Account. Fixed cost is also not given relevance while determining the
selling price of the product or at the time of valuation of closing stock.
 Absorption Costing is a method for inventory valuation whereby all the manufacturing
expenses are allocated to the cost centers to recognize the total cost of production. These
manufacturing expenses include all fixed as well as variable costs. It is the traditional
method for cost ascertainment, also known by the name Full Absorption Costing.
 In an absorption costing system, both the fixed and variable costs are regarded as product
related cost. Fixed costs are assumed as product costs. In this method the objective behind
the assignment of the total cost to cost center is to recover it from the selling price of the
product.
 DISTINCTION BETWEEN MARGINAL AND ABSORPTION COSTING
Basis for
Comparison Marginal Costing Absorption Costing

A decision making technique for Apportionment of total costs to the cost center in
Meaning ascertaining the total cost of production is order to determine the total cost of production is
known as Marginal Costing. known as Absorption Costing.

Cost Recognition The variable cost is considered as product Both fixed and variable cost is considered as product
cost while fixed cost is considered as cost.
period costs.
Classification of Fixed and Variable Production, Administration and Selling &
Overheads Distribution
Profitability Profitability is measured by Profit Volume Due to the inclusion of fixed cost, profitability gets
Ratio. affected.
Variances in the opening and closing stock Variances in the opening and closing stock affects
Cost per unit does not influence the cost per unit of the cost per unit.
output.
Highlights Contribution per unit Net Profit per unit
 Marginal Costing
Profit and Loss Statement
Sales xxx
Less: Cost of sales xxx
Opening stock
Add: production cost xxx
Direct Material xxx
Direct Labour xxx
Variable Production O/H Xxx
(xxx)
Less: Closing stock (xxx)
Gross contribution Xxx
Less: Other variable costs
( xxx)
Net Contribution
xxx
Less: Fixed costs
Xxx
Production
xxx
Administration xxx
Selling and distr. (xxx)
N. Profit Xxx
 Absorption costing
Profit and loss statement

Sales Xxx
Less: Cost of sales xxx
Opening stock

Add: production cost xxx

Direct Material xxx
Direct Labour xxx
Variable Production O/H xxx xxx
Fixed Production O/H (xxx)
(xxx)
xxx
Less: Closing stock

Gross Profit

Less: Operating expenses

Administration Xxx
Selling and distr. xxx (xxx)
Net Profit xxx
 Example
PQR limited is a manufacturer of sports shoes. The company uses a standard system. The
standard cost per pair of spots shoes is as follows:
Direct materials 500
Direct labour: 4 hours × sh. 60 / hour 240
Production overheads
Variable 4 hours × sh. 30 / hour 120
Fixed 100
Standard production cost 960
Standard selling price 1,500

 Additional information
1.During the month of March 2011, production was 10,000 units as planned but the sales made were 8,000units
2.The standard fixed production overhead absorption rate was based on a budgeted activity of 10,00units
3.There was no opening stock at the beginning of the month
4.All units were sold at the standard selling price
5.Other costs incurred during the month were as follows:
Variable Fixed (Sh.)
 Selling and distribution 20% of sale 600,000
 Administration 1,000,000
Required: Income statement for the month of March 2011 using Absorption costing and Marginal costing
 Example 2
Mr Jones has set up in business making a renewable energy product. He has
provided you with the following budgeted sales and production information per
unit:-
£
 Sales price 1,200
 Direct materials 400
 Direct labour 250
 Variable production overhead 120
 Fixed production overhead 200
 Fixed administration & general overhead 150
 Mr Jones has projected his activity levels as follows:-
Sales (units) Production (units)
 July 300 500
 August 600 750
 September 600 1,000
 Fixed overhead costs have been projected on the basis of annual activity of 9,000
units and will be incurred constantly over the year. There is no opening stock.
 Requirement:-(a) Prepare a budgeted statement of profit for each month using:
 i. absorption costing
 ii. marginal costing
88
 (b) Briefly explain the differences between the reported profits for each month.
Advantages of marginal costing
1. Marginal costing is simple to understand.
2. By not charging fixed overhead to cost of production, the effect of varying charges per
unit is avoided.
3. It prevents the illogical carry forward in stock valuation of some proportion of current
year’s fixed overhead.
4. The effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.
5. It eliminates large balances left in overhead control accounts which indicate the
difficulty of ascertaining an accurate overhead recovery rate.
6. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed
overhead, efforts can be concentrated on maintaining a uniform and consistent marginal
cost. It is useful to various levels of management.
7. It helps in short-term profit planning by breakeven and profitability analysis, both in
terms of quantity and graphs. Comparative profitability and performance between two
or more products and divisions can easily be assessed and brought to the notice of
management for decision making.
 Disadvantages of marginal costing
1. The separation of costs into fixed and variable is difficult and sometimes gives misleading results.
2. Normal costing systems also apply overhead under normal operating volume and this shows that
no advantage is gained by marginal costing.
3. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs
from inventories affect profit, and true and fair view of financial affairs of an organization may
not be clearly transparent.
4. Volume variance in standard costing also discloses the effect of fluctuating output on fixed
overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of
production, e.g., in case of seasonal factories.
5. Application of fixed overhead depends on estimates and not on the actuals and as such there may
be under or over absorption of the same.
6. Control affected by means of budgetary control is also accepted by many. In order to know the
net profit, we should not be satisfied with contribution and hence, fixed overhead is also a
valuable item. A system which ignores fixed costs is less effective since a major portion of fixed
cost is not taken care of under marginal costing.
7. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions
underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit
planning, absorption costing is the only answer.
Advantages of absorption costing
i) Fixed costs are substantial and increasing proportion of costs in modern
industry. It thus forms a significant part of costs of production so it should
be included. Marginal costing divorces fixed costs from production.
ii)It is used preferably where stock building is a necessary part of operations
e.g. wine making. Otherwise fictitious losses will be shown in earlier
periods to be offset eventually by excessive profits when goods are sold.
iii)Relying on marginal costs could lead to management setting prices at
below total costs but making slight contribution. This is avoided in
absorption costing.
iv)International Financial Reporting Standards suggest that costs and
revenues must be matched in the period when revenues arise not when
costs are incurred. It also recommends that stock valuation must include
production overheads incurred in the normal course of business even if
such overheads are time related.
 Exercise
Langata is a manufacturing company which produces a single product. The following standard
unit costs relate to the product.
Cost Sh.
Variable manufacturing 90
Fixed manufacturing 70
Variable selling and 16
administration
Fixed selling and administration 60
236
Fixed manufacturing costs per unit are based on a predetermined absorption rate established at a normal activity
level of 45,000 production unit per period. Fixed selling and administration costs are absorbed into the cost of sales
at 20% of selling price. Under/over absorbed overheads are transferred to the profit and loss account at the end of the
period
The following informationSales
is available
– units
for two consecutive periods. Period
42,500
1 Period 2
45,000
Sales – value (Sh.) 12,750,000 13,500,000
Production units 40,000 46,000
Variable manufacturing costs (Sh.) 3,600,000 4,140,000
Variable selling and administration 3,200,000 3,150,000
costs (Sh.)
Fixed selling and administration costs 680,000 720,000
(Sh.)
2,700,000 2,700,000

Required
a) Income statements for each of the two periods under the absorption costing basis
b) Income statements for each of the two periods under the marginal costing basis
c) Reconciliation of the profits under the absorption costing and the marginal costing basis for
each of the periods.
 APPLICATION OF MARGINAL COSTING
Marginal costing is applied internally by management
in decision making such as:
i)Cost volume profit analysis(CVP)
ii)Planning
iii)Decision making(non-routine)
iv)Cost control
v)measurement of efficiency
vi)Evaluation of profitability
Cost Volume and Profit
Analysis (CVP)
 CVP
 Cost volume profit (CVP) analysis is the study of the effects on future profit of
changes in fixed cost, variable costs, sales price quantity and mix.
 The purpose of the C.V.P analysis is to understand the relationship amongst the
aforesaid variables to forecast profits, determine the volumes to be achieved to meet
target profit, and such other short term decisions. The CVP analysis is based on the
premise of marginal costing.
 The marginal costing technique recognizes variable cost as the product costs and
fixed costs as period costs. The principle is that only variable costs will change with
a change in volume of production and sales, but the fixed costs will remain the same.
 Cost volume profit (CVP) analysis is a systematic approach of examining the
relationship between changes in volume and changes in total sales, expenses and net
profit. The underlying objective of CVP is to know the effect of fluctuation in the
activity volume on financial results. The following is a typical cost volume profit
diagram that depicts how sales revenue, fixed costs and variable costs respond to
changes in the volume of sales and production. The volume of production and sales
is measured by the X-axis and revenue, costs and profit (loss) are measured by –axis
in the CVP chart.
 Break-even analysis
Traditionally cost volume profit analysis is
called break-even analysis. Break-even is the
volume of sales at which the business just
“breaks even” so that it makes neither a loss
nor a profit.
Break-even point is the point at which the
volume of sales is equal to the total cost
therefore the profit is ZERO.
Calculating break-even can be useful to
management because it shows what is the
minimum volume of sales must be to avoid
making a loss in the period.
 Margin of safety
 This is the amount by which firm’s actual sales revenue exceeds its
break-even sales. This is the amount of sales revenue that could be lost
before the company profit would be reduced to zero.
 This is the difference between the actual/budgeted sales volume and
breakeven sales volume. It is simply a measurement of how far sales
can fall short of budget before the business makes a loss.
 A large margin of safety indicates a low risk of making a loss, whereas
a small margin of safety indicates a fairly high risk of a loss. It
therefore indicates the vulnerability of a business to a fall in demand.
It is usually expressed as a percentage of budgeted sales.

 Safety margin % = planned/actual sales – breakeven sales x 100

Planned or actual sales
 Assumptions of CVP analysis
The selling price and the variable cost per unit is
assumed to be constant.
Fixed costs remain unchanged at all level of activity
within the given range.
It is possible to distinguish between fixed cost and
variable cost and also we have only two classification
of cost i.e. variable cost and fixed cost.
The behaviour of total cost and total revenue has been
readily determined and its linear over the relevant
range.
Revenues and costs and therefore profitability are
dependent on only one factor i.e. volume of sales.
There are no restrictions of demand as well as other
resources.
Technology and method of production remain
 Determination of break-even point
C-V-P analysis can be undertaken by graphical means which are dealt with later in this chapter,
or by simple formulae which are listed below and illustrated by examples

a) Break-even point(inunits) = FixedCosts

Contribution/unit

b ) C/SRatio = Contribution/unit x 100

Salesprice/unit

c) Break-evenpoint(£sales) =FixedCosts x Salesprice/unit

Contribution/unit

= Fixed Costs x 1
C/S ratio

d ) Level of sales to result in target profit (in units) = Fixed Costs + Targetprofit
Contribution/unit
a) Level of sales to result in target profit after tax (inunits)

Fixed Cost + [ Target profit]

1 – Tax rate
=
Contribution/unit

b) Level of sales to result in target profit£sales)

= (Fixed Cost + Target profit) x Sales price/unit
Contribution/unit
Note: The above formulae relate to a single firm or one with an unvarying mix of sales. With a
multi -product firm it is possible to calculate the break- even point as follows:

Break-even point (sh. sales) = Fixed Costs × Sales Value

Contribution
Illustration
 Illustration
A company makes a single product with a sales price sh10 and
a marginal cost of sh6. Fixed costs are sh60,000 per annum.
a)Number of units to breakeven
b)Sales at break-evepoint
c)C/S ratio
d)What number of units will need to be sold to achieve a profit
of sh20,000p.a.?
e)What level of sales will achieve a profit of sh20,000p.a.?
f) As (d) with a 40% tax rate.
Because of increasing costs the marginal cost is expected to
rise to £6.50 per unit and fixed costs to sh70,000 p.a. If the
selling price cannot be increased what will be the number of
units required to maintain a profit of £20,000 p.a. (ignore tax)?
 Exercise 1
A manufacturer incurred the following cost per unit
Variable costs Frw
Direct Material 1000
Direct Labour 800
Variable Production OH 150
Adm &selling expenses 200
Selling commissions 100
Fixed costs Frw
Factory OH 9,000,000
Adm &selling expenses 47,000,000
The selling price of the commodity was Frw 4000 and the current product was 40,000
units.
Required:-
1.Calculate BEP in units
2.Calculate BEP in Rwanda Francs
3.Calculate the contribution sales ratio
4.Calculate the margin of safety
5.If the tax rate was 40% how many units should be produced and sold so as to make
an after tax Frw 40million.
 Exercise 2
 The following data relate to Equinox Ltd for the year ended 31 December 2021.
Rwf ‘000’
 Sales 24,000
 Less: Total costs 20,000
 Net profit 4,000
 Fixed costs account for 40% of the total costs.
 Required:
 i) Margin of safety.
 ii) Break-even point in sales
 iii) Sales required to earn profit of Rwf 6,000,000.
 In order to increase sales, the management has the following two options:
1. To increase sales by 25% on incurring a sales promotion cost of Rwf 2,500,000.
2. To increase sales by 15% on reducing selling price by 5%.
 Advise the management on which option they should take.
 EXERCISE 3
a) Discuss the limitations of CVP analysis
b) Amafasho Limited produces and sells mikatumba,
fashion product used by racing cyclists which has a
selling price of Rwf 120,000, variable cost of Rwf
80,000 and fixed costs of Rwf 14,000,000 per annum.
Expected annual sales volume is 500 units.
Required:
i. Compute the breakeven point and margin of safety
ii. Prepare a statement of current contribution and
profit
iii. Assuming a 5% movement on each of the following
items individually; comment on its sensitivity, stating
the effect on the profit of the company:
 Sales
 Variable cost per unit
 Exercise
 Chakacha processing company accountant prepared the following estimates for its product
fiijo for the coming year as follows:-
 Chakacha processing company
 Income statement for the year ending 31 December 2018
frw
 Sales 1000 units @frw 1000 per unit 1,000,000
 Cost of goods sold frw
 Direct Materials 140,000
 Direct Labour 150,000
 Variable production Overheads 100,000
 Fixed production Overheads 50,000 (440,000)
 Gross profit 560,000
 Selling expenses
Variable 60,000
Fixed 100,000
Administrative expenses
Variable 50,000
Fixed 100,000 310,000
NET PROFIT 250,000
Required
i. How many units of production Fiijo would have to be sold to
breakeven.
ii. What would be the sales (in frw) at the break even point if fixed
production cost increases to 220,000/=?
iii. What would be the units required to be sold if there was an increase
of fixed production overheads by 170,000/= and the company wanted
to maintain the same estimated profit?
iv. What is the margin of safety in percentage?
 LIMITATIONS OF CVP ANALYSIS
1.It can be time consuming
2.The analysis can only be applied to a single product
3.Where there is difficulty in classifying costs between
fixed costs variable , it is difficult to apply break even
analysis
4.At all levels of output , it assumes that the fixed costs
are fixed or constant
5.At all levels of output, it assumes that the per unit
variable costs are the same or fixed
6.At all levels of output , it assumes that sales price are
fixed or constant
7.Inventory is not taken into consideration
8.It is not useful for production planning
Master Budget and
Responsibility
Master Budget
and
Responsibility
Master Budget and Responsibility
Nature and Purposes of Budgets
Budgeting refers to the process of
quantifying the plans of an organization so as
to enable it achieve its objectives in the
defined period. The result of the process is
budgets, which are used for cost control,
performance evaluation and future decision
making.
Budgetary Planning and Control may be seen a
s short-term quantification and monitoring of
long-term strategic plans of the organizations.
Strategic planning involves preparation of
strategic plans, which define the objectives to
be pursued within the framework of corporate
policy.
It is by budgeting that a long-term corporate
plan is put into action.
 Budgets may be prepared for departments,
functions or financial and resource items. In
fact, some people refer to budgeting as a
means of coordinating the combined
intelligence of the entire organization into a
plan of action.
OBJECTIVES OF BUDGETARY PLANNING
 Coordination
The budgetary process requires that visible detailed
budgets are developed to cover each activity, department or
function in the organization.
 This is only possible when the effort of one department’s
budget is related to the budget of another department. In
this way, coordination of activities, function and department
is achieved.
 Communication
The full budgeting process involves liaison and discussion
among all levels of management. Both vertical and
horizontal communication is necessary to ensure proper
coordination of activities.
 Control
This is the process for comparing actual results with the
budgeted results and reporting upon variances. Budgets
set a control gauge, which assists to accomplish the plans
 Motivation
Budgets may be seen as a bargaining process in which
managers compete with each other for scarce
resources. Budges set targets, which have to be
achieved. Where budgetary targets are tightly set,
some individuals will be positively motivated towards
achieving them.
 Clarification of Responsibility and Authority
Budgetary process necessitates the organization of a
business into responsibility and budget centres with
clear lines of responsibilities of each manager. This
reduces duplication of efforts.
 Planning
It is by Budgetary Planning that long-term plans are
put into action. Planning involves determination of
objectives to be attained at a future predetermined
time. When monetary values are attached to plans
they become budgets.
Limitations of Budgeting
Too mush reliance may cause resistance
(inflexibility) to change.
Difficult to set levels of attainment. This
may result into too tight budgets that cause
loss of morale.
Antagonism where budgets exert undue
pressure.
Budgeting control is a terminate exercise
and therefore any report from investigation
of variances may b of little use to the current
operations.
Organization of budgetary control
Budgetary control ideally involves the
following steps:

The creation of budget centres.
The introduction of adequate accounting
records.
The preparation of organization charts.
This defines the functional responsibilities of
each member of management.
The establishment of a budget committee:
It will consist of operating and financial
managers, who will be required to review,

PREPARATION OF BUDGETS
THE MASTER BUDGET FRAMEWORK
The master budget is the overall quantifications
of the budgeting plan. In it, functional budgets
are incorporated.
A functional budget is a budget if income and/or
expenditure for a particular function. The
master budget therefore combines all the
budgets of the various departments in an
organizations.
It is useful in ensuring that all the individual
budgets are consistent with one another and
also presents a ‘unit’ picture of the entire
organization.
It is made up of both production and non-
production budgets.
Production budgets include:
Sales Budget
Finished Goods Budgets
Material budges
Labour budgets
Overheads budgets.
Non-Production Budgets Include
Selling & Distribution
Administration Budget
Cash Budget
Research and Development
All these budgets translate into the projected
profit and loss a/c and the budgeted Balance
Sheet
Sales Budget
It gives volume of sales and sales mix of the
current operations. The sales forecast is
initially prepared and upon completion the sales
budget is finalized. The following are usually
considered in coming up with the sales forecast
Actual sales in the previous periods.
Reports from salesmen.
Market research information.
Level of orders already obtained in advance
Production budget
It is the forecast of the products to be
manufactured during the budget period to
most forecasted sales above.
 It is expressed as units of each type of
product. The following are usually
considered:
Available production capacity.
The sales forecast.
Finished goods stock level policy.
It has two purposes
Ensures that production is sufficient to meet
sales demand.
Ensures that economic stock levels are
Format

6(Units) P (Units) J (Units)

Required Stock 31/12/20-0 xx xx xx
Add: Sales duringtheyear xx xx xx
Less: Estimated Stock 01/01/20-0 (xx) (xx) (xx)
Production Requirements xx xx xx
Direct Materials Budget

This budget shows the estimated quantities and
costs of all the raw materials and components
needed for the output demand by the production
budget. This consists of:
 Direct Materials Usage Budget: Which
shows the estimated quantities of materials
required for budgeted production.

Direct Materials Purchases Budget: It

ensures that materials are within the planned
materials stock levels i.e. after considering both
usage material stock required.

Direct Labour Budget
It represents the forecasts of direct and indirect
labour requirements to meet the demands of the
company during the budget period.
The budgeted direct labour cost is therefore
determined by multiplying direct labour hours
with the wage rates for every category of labour.

Factory Overhead Budget
This budget represents the forecasts of all the
production fixed and variable and semi-variable
overheads to be incurred during the budget
period.
The summation of budgeted costs of production
for the budget period makes up Production
Cost Budget. It includes:
Budgeted Materials Cost
Budgeted Labour Cost
Budgeted Overhead Cost
Non-Production Budgets
Selling and Distribution Cost Budget
 It is the forecast of all costs incurred in selling
and distributing the company’s product during
the budget period. It is closely concerned with
the sales budget in that it is mainly based on the
volume of sales projected for the period.
Administration Costs Budget
It represents the costs of all administration
expenses. Each department or budget centre
will be responsible for the preparation of its own
budget. Management, Secretarial, Accounting
and Administration costs which cannot be
directly related to the production are included
here. The budget will be mainly incremental i.e.
previous year’s figure will tend to apply for its
next budget with an allowance for inflation.


Research and Development Cost Budget
Development cost is the cost of using scientific
or technical knowledge in order to produce new
or substantially improved materials, devices,
products, processes systems or services prior to
the commencement of commercial production.
Capital expenditure Budget
It represents the expenditure on all fixed assets
during the budget period. Addition intended to
benefit future accounting periods, or
expenditure which increases the production
capacity, efficiency lifespan or economy of an
existing fixed assets are also incorporated.
Cash budget
It records the cash inflows and outflows, which
are expected to take place in respect of each
functional budget. It may be prepared for a
period span of one week, month or quarter of
the budget period.
It has the following benefits/advantages:

It ensures that sufficient cash is available when
required.
It shows whether capital expenditure projects
can be financed internally.
It indicates the cash needed for current
operating activities.
It indicates the effect the position of each
seasonal requirements, large stocks, unusual
receipts and laxity in collecting account
receivable.
It indicates the availability of cash for taking
advantage of discounts.
It reveals the availability of excess cash so that
short-term investments may be considered.
It serves as a basis for evaluating the actual
cash management performance of responsible
managers
Venus plc produces two products Niks and Args. The budget for the next year to 31st 2023 is to be
prepared. Expectations for the forthcoming year includes the following:

Venus PLC
BALANCE SHEET ASAT 1APRIL 2022

Fixed Assets Rwf Rwf

Land and buildings 4
Plant and Equipment (NBV) 11
Current Assets
Raw materials 7,650
Finished goods 23,615
Debtors 19,500
Cash
4,300
55,065
Current Liabilities

Creditors 6,800

Taxation 24,500 (31,300) 23,765

180,765

Financed by

150,000 ordinary 150,000

shares of Rwf1 each

Retained profit 30,765

180,765
(b) Finished Products NIKS ARGS
The Sales Director has estimated the
following:
(i) Demand for the Co’s products 4,500 4,000 units
units
(ii) Expected S.P per unit Rwf 32 Rwf 44
(iii) Closing stock @ 31 March 2023 is 400 units 1200 units
required to be
(iv) Opening stocks at 01 April 2022 900 units 200 units
(v) Unit cost of this opening stock will be Rwf 20 Rwf 28
(vi) The amount of plant capacity required
for each 15min 24min
product is: Machining
Assembling 12min 18min
(vii) The raw material content per unit is
Material A 1.5 kg 0.5 kg

Material B 2.0 k g 4.0 kg

(viii) Direct labour hours required @ unit
 Finished goods are valued at
FIFO basis at full factory cost.
(c Raw Materials Material Materia
) A lB

(i) Closing stock requirements

kilos at 31 March 2023 600 1000

(ii) Opening stock at 1 April 2022 1100 6000

kilos

(iii Budgeted cost of raw Rwf1.50 Rwf1.00

) materials per kilo
Actual cost per kilo of opening stocks are as
budgeted cost for the coming year.
(d) Direct Labour
The standard wage rate of direct labour is
Rwf1.60/hr.
(e) Factory overhead

Factory overhead is absorbed on the basis of
machining hours with separate absorption
rates for each department
 The following are expected overheads in the production cost
centre budgets.
Machinery Assembly
Deport Deport
Rwf Rwf

Supervisors salaries 10,000 9,150

Power 2,400 2,000

Maintenance and 2,100 2,000

running costs
Consumables 3,400 500

General Expenses 19,600 5,000

39,500 18,650
Depreciation is taken at 5% straight-line on
plant and machinery equipment. A machine
costing the company Rwf20,000 is due to be
installed on 1 October 2022 in the
machining department which already has
machinery installed to the value of
Rwf100,000 at cost and Rwf87000 at cost to
Assembly.

 Sellingand distributionexpenses Rwf
Sales commission and salaries 14,300
Travelingdistribution 3,500
Officesalaries 10,100
General administration expenses 2,500
30,400
(g) There is no opening or closing work in progress and
inflation should be ignored.

Required
Prepare the following budgets for the year ended 31
March 2023 for Venus PLC.

Sales budget
Production budget (units)
Plant utilization budget
Direct materials utilization budget
Direct labour budget
Factory overhead budget
Direct materials purchases budget
Cost of goods sold budget
Budgeted profit and loss account
 Exercise
 GG plans to incorporate a company to be known as GG holdings Ltd, for the
distribution of locally made spare parts. He intends to contribute an initial capital of
frw 450,000 in cash. After approaching His bank manager for financial support he
was asked to submit projected statement of profit and cashflow of the business for
the next four month commencing 1st July 2018. After a careful analysis GG gathered
the following information relating to the business operation for the six months to
December 31st 2018.
i. At the beginning of July operating furniture and equipment will be acquired for
cash at a total cost of frw 880,000. In addition stocks costing frw 500,000 will be
acquired out of which half will be paid for in cash and the balance in the following
month.
ii. Stock levels will be maintained at a level that is sufficient to satisfy sales for the
next month. The company intends to earn a gross margin of 50% on the sales.
Credit terms from suppliers require payment after 1 month from date of purchase.
iii. Sales are expected to average frw 600,000 per month for the next one year. It is
expected that 75% of the customers will pay in cash and 25% will take credit. All
iv. The following monthly expenses are incurred:
 Rent frw 100,000
 Miscellaneous frw 25,000
 Salaries frw 60,000
 Depreciation frw 50,000
All the expenses will be paid for in the month they are incurred except
rent, which is payable quarterly in advance.
i. The proprietor expects to withdraw frw 50,000 from the business every
month for personal use.
Required:
Prepare a cash budget for each of the month of July, August, September
and October 2018