Managerial Accounting - Easy Booklet

1
ELEMENTS
OF COST
This chapter requires no previous knowledge regarding
cost accounting .It introduces three elements of cost, and
income statements of manufacturing organisations.
he trading organisations, normally purchase goods in bulk from wholesale market, growers or
manufacturers, and sell them in wholesale elsewhere, or on retail. The goods so purchased are sold
almost as such without any modification in their nature. At the most packing may be changed for
creating smaller units of the commodity. For example medical stores (which are typical trading
organisations) purchase medicines from manufacturers or their distributors, and sell in retail to the
patients. In the medical store the chemistry or properties or even packing of the medicines are not
changed and they are sold as such.
On the contrary, the manufacturers of medicines or of medical equipment convert raw materials into
finished products by following a prescribed procedure of manufacturing. Certain organisations produce a
variety of medicines and medical equipment. For this purpose they introduce various kinds of materials,
skill and labour of the workers to complete the manufacturing process. By the end of the process the
information regarding cost of producing the unit of the product is required by the management for various
purposes.
For developing an understanding of costing procedures, we may take a very simple example of
manufacturing a wooden table in a carpenter’s workshop. In manufacturing a table the carpenter needs
wood because it is the main material which makes the table. The carpenter puts in his labour for making
the table. In addition to the wood and labour, a large number of relatively unimportant materials and
services are also applied in completing the table. For example nails, gum, depreciation of the planing
machine, electricity, depreciation of the building of the workshop and services of the helpers of the
carpenter who help the carpenter in making the table and other pieces of furniture. These miscellaneous
items of costs, though not significant individually, constitute a significant component of cost of the table.
Such various kinds of costs of manufacturing are classified into following three elements:
1. Direct Materials
2. Direct Labour
3. Factory Overheads
1. DIRECT MATERIALS
T

The main material constituting a product is called Direct Materials. In our example the wood used for
manufacturing the table is direct material. They can be more than one direct materials constituting a
product. If the top of the table were made of glass, both the wood and the glass would be classified as
direct materials. For finding cost of the table, we will have to find the quantity of wood and size of the
glass used in the table. It may be pointed out that the cost of small nails or gums etc does not fall under
this category.
2. DIRECT LABOUR
The cost in utilising services of workers who apply their labour to the material constituting the product is
called Direct Labour. In our example the services of the carpenter himself who works on the wood will be
classified as direct labour cost. But the cost of labour of his helper who has the duties of keeping the tools
of the workshop in order, or cleans the premises does not fall under this category
3. FACTORY OVERHEADS (FOH) or PRODUCTION OVERHEADS
All costs other than of direct materials and direct labour are group together into a third category called
Factory Overheads. It may include the following items of costs:
i) Indirect Materials.
All materials other than direct materials are classified as indirect
materials. This category includes such items of materials whose amount
of costs are either insignificantly small or cannot be conveniently
calculated on per unit basis. For example the costs of nails, glue in a
table.
ii) Indirect Labour.
All labour costs other than of direct labour are classified as indirect
labour. This category includes labour costs of those employees who are
used for production but do not work on the material of the product. The
cost of labour of the helper and the supervisor who do not make the table
with their hands is indirect labour cost.
iii) Depreciation Expenses.
All expenses of depreciation of assets (buildings and machinery etc) used
in production fall under this category.
iv) Cost of Utilities.
All costs incurred on electricity, steam production, water, gas and other
utilities fall under this category.
v) Miscellaneous Expenses.
All smaller amounts spent on unimportant items, about which
management is not interested in analysing them individually, are grouped
together in one category as miscellaneous expenses.

Income statements
Trading vs. Manufacturing businesses
Trading companies calculate cost of goods sold as:
Cost of Goods Sold= Beginning merchandise Inventory + Purchases – Ending
merchandise Inventory
or
COGS = BMI + Purchases – EMI
ABC TRADERS
Income Statement
For the month ending on 31st January 2xx1
Sales 40,000
Cost of Goods Sold:
Opening Inventory 5000
Add Purchases 33,000
Cost of goods available for sale 38,000
Deduct closing inventory 7,000
Cost of goods sold 31,000
Gross profit 9,000
Operating expenses:
Selling and marketing expenses (details not shown) 3,000
Administrative expenses (details not shown) 2,000
Total operating expenses 5000
Operating Profit 4,000
(Further items not shown)
________________
Manufacturing companies calculate cost of goods sold as:
Cost of Goods Sold= Beginning merchandise Inventory + Cost og Goods Manufactured
– Ending merchandise Inventory
or
COGS = BFGI + COGM – EFGI

ABC MANUFACTURERS
Income Statement
Sales 60000 a
Cost of Goods Sold: b
Opening Inventory finished goods 9000 c
Add cost of goods manufactured during the month (see Schedule 1) 34000 d
Cost of goods available for sale 43000 e c+d
Deduct closing inventory finished goods 7000 f
Cost of goods sold 36000 g e-f
Gross profit 24000 h a-g
Operating expenses: i
Selling and marketing expenses (details not shown) 9000 j
Administrative expenses (details not shown) 6000 k
Total operating expenses 15000 L j+k
Operating profit 9000 m h-L
(Further items not shown)
-----------------
Schedule 1
ABC MANUFACTURERS
Statement of Goods Manufactured
Direct materials:
Direct materials opening inventory 1000 a
Add purchases of direct materials during the month 9000 b
Direct materials available for use 10000 c a+b
Deduct direct materials closing inventory 3000 d
Direct materials consumed in the month 7000 e c-d
Direct Labour 15000 f
Factory overheads 13000 g
Costs added during the month 35000 h e+f+g
Add work in process opening inventory 4000 i
Total manufacturing costs 39000 j h+i
Deduct work in process closing inventory 5000 k
Costs of goods manufactured during the month 34000 l j-k

2
COST BEHAVIOUR
This chapter requires previous knowledge of three
elements of cost,,and introduces behaviour of costs and
concept of unit cost.
n our previous discussions we had studied three elements of costs, which are Direct Materials,
Direct Labour and Factory Overheads (also called production overheads). Now we will examine these
costs from another point of view. We will see how costs behave if the volume of production is
increased or decreased. According to their behaviour we can divide them in following three categories:
Variable Costs
Fixed Costs
Semi-variable Costs
Variable Costs:
When we increase the quantity (volume) of production, some costs increase according to the volume of
additional production. Similarly these costs decrease according to the volume of decrease in production.
In other words they vary with change in volume of production. Such costs are called variable costs. For
example for increase in production of cloth, additional quantity of thread will be required. So the cost of
thread is a variable cost.
£
Variable costs
Number of units produced
Graph showing variable costs
I

Fixed Costs:
There are certain costs, which do not change with change in volume of production. They remain the same
even if volume of production is changed. For example, the cost of depreciation of the factory building
does not change with change in the quantity of cloth produced in the factory during a certain period. So
depreciation of the factory building is a fixed cost. However it should be kept in mind that if we increase
the production manifolds, we might need more buildings, or extension of the present building. In that case
the depreciation cost will also increase. Therefore it should be kept in mind that there are no costs, which
will not change with such abnormal increase in volume of production. When we talk of change in volume
of production, we mean change in the volume within a relevant range. So it can be said that fixed costs
are those costs, which do not change with volume of production (or activity) within a relevant range.
£
Fixed costs
Graph showing variable costs
Semi-variable Costs:
There are certain costs, which have two components- fixes as well as variable. In smaller volumes of
production or no production, the fixed part has to be incurred. As the production exceeds a threshold,
these costs increase with increase in volume of production. The telephone cost is a typical example of
such costs. The line rent is charged irrespective of the calls made during a month. As calls are made they
are charged in addition to the line rent. Here the cost of line rent is the fixed component, and the cost of
calls made is variable component as it changes with change in number of calls made. Similarly the cost of
electric power for factories depends upon the consumption of electricity used, but a minimum has to be
paid irrespective of the consumption.
£
Semi-variable costs
Fixed
Component {
Graph showing Semi-variable costs

ILLUSTRATION:
In order to understand these terms, let us suppose that an organisation is operating a small factory, which
makes plastic toys. The factory is housed in one room acquired on rent. Ten workers are employed to
manufacture the toys. The plastic required for making the toys is purchased from the market. Out of the
total costs following information is available, and may be considered:
Cost of Direct material for making one toy = £4
Number of units produced per hour per worker = 2 toys
Direct labour cost per hour = £6
Direct Labour cost per toy = £3
Number of workers employed = 10 workers
Cost on Indirect material per toy = £ 0.50
Working hours per day per worker = 7 hours
Number of working days per month = 24 days
Rent of the room (per month) = £ 250
Salary of Production manager = £ 2,000
Depreciation of machinery per month = $ 500
Present production per month:2 × 10 × 7 × 24 = 3,360 toys
Calculations:
Cost of producing 3360 toys per month:
£
Direct materials
4 ×3,360 = 13,440
Direct labour
3 × 3,360 = 10,080
Factory overheads:
Indirect materials 0.50 × 3360 = 1,680
Production Manager Salary = 2,000
Depreciation Machinery = 500
Rent = 250 4,430
Total Costs 27,950
Let us assume two more workers were employed to increase production during the next
month, and production increased to 4032 toys.
Cost of production can be calculated for the next month as follows:
Production for the new month: 2 × 12 × 7 × 24 = 4,032 toys
Cost of producing 4032 toys per month:
£
Direct materials 4 ×4,032 = 16,128
Direct labour 3 × 4,032 = 12,096
Factory overheads:
Indirect materials 0.50 × 4,032 = 2,016
Production Manager Salary = 2,000
Depreciation machinery = 500
Rent = 250 4,766
Total Costs 32,990

Comparison of total costs of the two months:
i. There was an increase in production in the next month. In the second month production
increased by 672 toys (4032 – 3360)
ii. Following costs did not increase inspite of increase in production:
Salary of the Production Manager
Depreciation of the machinery
Rent
Therefore these costs are Fixed Costs
iii. On the contrary following costs increased proportionately with increase in production:
Direct Material (from £13,440 to £ 16,128)
Indirect Material (from 1,680 to £ 2,016)
Direct labour (from £10,080 to £ 12,096)
Therefore these costs are Variable Costs.
Comparison of unit cost of production during the two months:
Production cost per unit: First Month Second Month
Direct materials = 4.00 4.00
Direct labour = 3.00 3.00
Indirect material = 0.50 0.50
Salary of the Production Manager:
2000÷3360 = 0.5952 2000÷4032= 0.4960
Depreciation machinery:
500 ÷3360 = 0.1488 500÷4032 = 0.1240
Rent 250 ÷ 3360 = 0.0744 250÷4032 = 0.0620
It may be noted that per unit variable costs (first three) have not changed inspite of increase in volume of
production. But per unit fixed costs (last three) have decreased due to increase in volume of production.
The reason is that now the same fixed costs are distributed over a larger number of units. On the contrary
for every additional unit produced, same amount of additional per unit cost had to be incurred.
PER UNIT COST:
For telling the price of the products to the customers, the estimated cost of each product has to be known
by the management. By adding the profit, prices of various products are fixed. To determine the cost per
unit, total costs incurred on producing the products are divided by the number of products produced. The
total costs is the sum of fixed costs and variable costs. We can use the following formula.
Product’s unit cost = . Total costs .

OR
Product’s unit cost = Total variable costs + Total fixed costs.
OR
Product’s unit cost = Direct materials + Direct labour + Variable FOH + Fixed FOH .
COST CENTRES:
In factories normally the term “Department” is use for such smaller entities which can be identified as a
separate unit on the basis of separate identity of the services rendered by them or on the kind of product
they deal with. It is obvious that it is essential to find the costs of each department. The costs of each
department for a period, when divided by number of units produced in the same period, will give its per
unit cost.
However in certain circumstances a big department may have a variety of activities carried out. For
example, all operation theatres of a hospital may be treated as one department. But an operation theatre
for out door patients with facilities for minor operations only is not comparable with an operation theatre
used for specialised purposes like open heart, or Neuro surgery. So we cannot treat all operation theatres
as one department as far as cost collection is concerned. Administratively all operation theatres might be
treated as one department, but from costing point of view, the cost of different kinds of operation theatres
is to be collected separately. Such entities which are distinguished from other entities and the costs of
which are required to be accumulated separately are called Cost Centres. Normally the cost centres are
homologous to the department, but sometimes a department may have more than one cost centre. If it is
so the department has to be divided into cost centres for the purpose of determination of costs.
It may be noted that cost centres do not work in complete isolation from rest of the organisation. They are
part of the organisation and avail services of other departments (cost centres). For example, a production
department is dependent upon the electric generation unit, and stem production unit. So certain
departments (cost centres), do not handle the products directly, and rather produce services for other
departments, which deal with the products. Such departments are called Service departments. Those
departments, which deal with the patients, are called Production departments in cost accounting
terminology. The costs of service departments are to be distributed among the departments using their
services in proportion to the quantum of services used. So each production department has its own costs
as well as costs received form service department on distribution.

3
BREAK EVEN ANALYSIS
This chapter requires no previous knowledge regarding
cost accounting .It introduces three elements of cost, and
income statements of manufacturing organisations.
Cost-Volume-Profit Relationships
The Basics of Cost-Volume-Profit (CVP) Analysis. Cost-volume-profit (CVP) analysis is a key
step in many decisions. CVP analysis involves specifying a model of the relations among the prices of
products, the volume or level of activity, unit variable costs, total fixed costs, and the sales mix. This
model is used to predict the impact on profits of changes in those parameters.
1. Contribution Margin. Contribution margin is the amount remaining from
sales revenue after variable expenses have been deducted. It contributes
towards covering fixed costs and then towards profit.
2. Unit Contribution Margin. The unit contribution margin can be used to
predict changes in total contribution margin as a result of changes in the unit
sales of a product. To do this, the unit contribution margin is simply
multiplied by the change in unit sales. Assuming no change in fixed costs, the
change in total contribution margin falls directly to the bottom line as a
change in profits.
3. Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio
of the contribution margin to total sales. It shows how the contribution margin
is affected by a given dollar change in total sales. The contribution margin
ratio is often easier to work with than the unit contribution margin,
particularly when a company has many products. This is because the
contribution margin ratio is denominated in sales dollars, which is a
convenient way to express activity in multi-product firms.
B. Some Applications of CVP Concepts. CVP analysis is typically used to estimate the impact on
profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP
analysis can be used to estimate the effect on profit of a change in any one (or any combination) of these
parameters. A variety of examples of applications of CVP are provided in the text.

C. CVP Relationships in Graphic Form. CVP graphs can be used to gain insight into the
behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and unit
sales on the horizontal axis. Total fixed expense is drawn first and then variable expense is added to the
fixed expense to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or
loss) is the vertical difference between the total revenue and total expense lines. The break-even occurs
at the point where the total revenue and total expenses lines cross.
D. Break-Even Analysis and Target Profit Analysis. Target profit analysis is concerned with
estimating the level of sales required to attain a specified target profit. Break-even analysis is a special
case of target profit analysis in which the target profit is zero.
1. Basic CVP equations. Both the equation and contribution (formula) methods of break-even and
target profit analysis are based on the contribution approach to the income statement. The format of
this statement can be expressed in equation form as:
Profits = Sales  Variable expenses  Fixed expenses
In CVP analysis this equation is commonly rearranged and expressed as:
Sales = Variable expenses + Fixed expenses + Profits
a. The above equation can be expressed in terms of unit sales as follows:
Price  Unit sales = Unit variable cost  Unit sales + Fixed expenses + Profits

Unit contribution margin  Unit sales = Fixed expenses + Profits

Unit sales =
Fixed expenses +Profits
Unit contribution margin
b. The basic equation can also be expressed in terms of sales dollars using the variable expense
ratio:
Sales = Variable expense ratio  Sales + Fixed expenses + Profits

(1  Variable expense ratio)  Sales = Fixed expenses + Profits

Contribution margin ratio*  Sales = Fixed expenses + Profits

Sales =
Fixed expenses +Profits
Contribution margin ratio
* 1  Variable expense ratio = 1
Variable expenses
Sales
=
Sales-Variable expenses
Sales
=
Contribution margin
Sales
= Contribution margin ratio

2. Break-even point using the equation method. The break-even point is the level of sales at which
profit is zero. It can also be defined as the point where total sales equals total expenses or as the
point where total contribution margin equals total fixed expenses. Break-even analysis can be
approached either by the equation method or by the contribution margin method. The two methods
are logically equivalent.
a. The Equation Method—Solving for the Break-Even Unit Sales. This method involves
following the steps in section (1a) above. Substitute the selling price, unit variable cost and
fixed expense in the first equation and set profits equal to zero. Then solve for the unit sales.
b. The Equation Method—Solving for the Break-Even Sales in Dollars. This method involves
following the steps in section (1b) above. Substitute the variable expense ratio and fixed
expenses in the first equation and set profits equal to zero. Then solve for the sales.
3. Break-even point using the contribution method. This is a short-cut method that jumps directly
to the solution, bypassing the intermediate algebraic steps.
a. The Contribution Method—Solving for the Break-Even Unit Sales. This method involves
using the final formula for unit sales in section (1a) above. Set profits equal to zero in the
formula.
Break-even unit sales =
Fixed expenses +$0
=
Fixed expenses
b. The Contribution Method—Solving for the Break-Even Sales in Dollars. This method
involves using the final formula for sales in section (1b) above. Set profits equal to zero in the
formula.
Break-even sales =
Fixed expenses +$0
=
Fixed expenses
4. Target profit analysis. Either the equation method or the contribution margin method can be used
to find the number of units that must be sold to attain a target profit. In the case of the contribution
margin method, the formulas are:
Unit sales to attain target profits =
Fixed expenses +Target profits
Dollar sales to attain target profits =
Fixed expenses +Target profits
Note that these formulas are the same as the break-even formulas if the target profit is zero.
E. Margin of Safety. The margin of safety is the excess of budgeted (or actual) sales over the break-
even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The
margin of safety can be computed in terms of dollars:

Margin of safety in dollars = Total sales – Break-even sales
or in percentage form:
Margin of safety percentage =
Margin of safety in dollars
Total sales

4
MARGINAL COSTING
This chapter requires previous knowledge of three
elements of cost, andof cost behaviour.
o far we have been studying a costing technique under which we have been distributing all
production costs (fixed and variable both) among the following three inventories:
i. Work in progress ending inventory
ii. Finished goods ending inventory
iii. Goods sold.
By following this technique we have been passing a portion of fixed costs (in addition to variable costs)
from one period to the other period along with the ending inventories. The goods sold are assigned fixed
costs proportionately. But there is another approach. Under that approach, fixed costs are considered to
belong to a period only. As fixed costs are incurred irrespective of the volume of production, all of them
are assigned to the period in which they are incurred. Consequently all fixed costs are assigned to the
goods sold during that period. No fixed costs are assigned to the ending inventories. The inventories are
valued at their variable costs only. So no fixed costs pass over from one period to the other period. This
technique is also called Variable Costing. In contrast, the technique, which assigns both the costs to the
inventories, is called Full Costing or Absorption Costing. It may be kept in mind that marginal costing
approach is used for internal consumption of the management, and cannot be used for external reporting.
Under absorption costing, full costs of goods sold (fixed as well as variable) are deducted from sales to
arrive at gross profit. In contrast, under marginal costing, only variable costs of goods sold are deducted
to arrive at what is called Gross Contribution Margin. From the gross contribution margin, variable
selling, marketing and administrative costs are deducted to arrive at Contribution Margin. Then all fixed
costs (production, selling, marketing and administrative) are deducted from gross contribution margin to
arrive at profit from operations.
Comparison of Absorption Costing and Marginal Costing:
As discussed above, marginal costing approach treats fixed costs as period costs and ending inventories
are valued at variable costs only. On the other hand, absorption costing techniques assigns fixed costs to
the inventories as well, and consequently fixed costs of the period pass over to the next period with
inventories. In marginal costing approach, the cost of goods sold contain full fixed costs of the period,
whereas in absorption costing proportionate fixed costs are distributed among the inventories and goods
sold.
S

The difference between the two techniques is illustrated below:
Illustration:
Profit and loss account of a new manufacturing unit for its first month of production is given below,
which shows details of fixed and variable costs under absorption costing approach:
ABC Manufacturing
Profit & Loss Account
For the month ended 31st
January 2xx1
ABSORPTION APPROACH
£ £ £ £ £
Sales 23,000
Cost of goods Sold:
Opening inventories finished goods 0
Add Cost of goods Manufactured:
Direct materials 1,500
Direct labour 4,000
Factory overheads:
Fixed 5,000
Variable 2,000 7,000
Total manufacturing costs 12,500
Goods available for sale 12,500
Less ending inventories finished goods 2,500
Gross Profit 13,000
Operating expenses:
Marketing and selling expenses:
Fixed 3,000
Variable 1,600
Total marketing & selling expenses 4,600
Administrative expenses:
Fixed 2,400
Variable 1,000
Total administrative expenses 3,400
Total operating expenses 8,000
Profit from Operations 5,000

The same data is presented below under Marginal costing technique:
ABC Manufacturing
January 2xx1
MARGINAL COSTING APPROACH
£ £ £ £
Sales 23,000
Costs of goods sold:
Add Cost of goods Manufactured:
Direct labour 4,000
Factory overheads 2,000
Less ending inventories finished goods 2,000*
Gross Contribution Margin 17,500
Operating expenses:
Marketing and selling expenses 1,600
Administrative expenses 1,000
Contribution margin 14,900
Fixed Costs:
Factory overhead 5,500
Total fixed costs 10,500
*Note: The marginal costing approach is showing profit less by £500 as compared to absorption costing
approach. This is because the fixed costs of £500 contained in ending inventories have not been passed
over to the next month.

Since marginal costing approach is used by the management for its internal use, and is not allowed for
external reporting, a simpler format of the profit & loss account is used as shown below:
ABC Manufacturing
January 2xx1
MARGINAL COSTING APPROACH
£
Sales 23,000
Direct labour 4,000
Factory overheads 2,000
Less ending inventories finished goods 2,000
Gross Contribution Margin 17,500
Contribution margin 14,900
Fixed Costs:
Factory overhead 5,500
Total fixed costs 10,500
Overview of Variable and Absorption Costing.
A. At least two methods can be used in manufacturing companies to value units of product
for accounting purposes—absorption costing and variable costing. These methods differ only
in how they treat fixed manufacturing overhead costs.
1. Variable Costing. Variable costing includes only variable production costs in product
costs. Direct materials, direct labor and variable manufacturing overhead costs would
ordinarily be included in product costs under variable costing. Fixed manufacturing
overhead is not treated as a product cost under this method. Rather, fixed manufacturing
overhead is treated as a period cost and is charged against income each period.
2. Absorption Costing. Absorption costing treats all production costs as product costs,
regardless of whether they are variable or fixed. Under absorption costing, a portion of
fixed manufacturing overhead is allocated to each unit of product.

B. Comparison of Absorption and Variable Costing. When comparing absorption
costing and variable costing income statements, a number of points should be noted:
1. Deferral of fixed manufacturing costs under absorption costing. Under absorption
costing, if inventories increase then a portion of the fixed manufacturing overhead costs
of the current period is deferred to future periods in the inventory account. When the
units are later taken out of inventory and sold, the deferred fixed costs flow through to
the income statement as part of cost of goods sold.
2. Differences in inventories under the two methods. The ending inventory figures under
the variable costing and absorption costing methods are different. Under variable
costing, only the variable manufacturing costs are included in inventory. Under
absorption costing, both variable and fixed manufacturing costs are included in
inventory.
3. Suitability for CVP analysis. An absorption costing income statement is not well suited
for providing data for CVP computations since it makes no distinction between fixed and
variable costs. In contrast, the variable costing method classifies costs by behavior and is
very useful in setting-up CVP computations.

5
STANDARD COSTING &
VARIANCE ANALYSIS
This chapter requires previous knowledge of cost
accounting .It introduces standard costing and technique of
variance analysis.
A. Standard Costs—Management by Exception. A standard is a benchmark or ―norm‖ for
measuring performance. In managerial accounting, standards relate to the prices and quantities of inputs
used in making goods or providing services.
1. Quantity standards. A quantity standard specifies how much of an input, such as labor time or raw
materials, should be used to make a unit of product or to provide a unit of service. To measure
performance, the actual quantity of an input that is used is compared to the standard quantity
allowed for the actual output of the period.
2. Price standards. A price standard specifies how much each unit of input should cost. Actual costs
of inputs are compared to these standards.
B. Setting Standard Costs: Standards should be set so that they encourage efficient operations.
1. Ideal versus practical standard. Standards tend to fall into one of two categories—either ideal or
practical.
• Ideal standards allow for no machine breakdowns or work interruptions, and require that
workers operate at peak efficiency 100% of the time. Since ideal standards are rarely met, most

managers believe they tend to discourage even the most diligent workers. On the other hand,
some critics maintain that only ideal standards are appropriate in an era of continual
improvement. Any other standard may breed complacency.
• Practical standards are ―tight, but attainable.‖ They allow for normal machine downtime and
employee rest periods and can be attained through reasonable, but highly efficient, efforts by
the average worker.
2. Setting direct materials standards. Separate standards are prepared for the price and quantity of
each type of material input.
• The standard price per unit for a direct material should reflect the final, delivered cost of
the material, net of any discounts taken. The standard price is for a particular grade of material,
purchased in a particular lot size, and delivered by a particular type of carrier.
• The standard quantity of a direct material per unit of output in a traditional standard cost
system reflects the amount of material going into each unit of finished product, as well as an
allowance for unavoidable waste, spoilage, and other normal inefficiencies. However, it is
worth pointing out that some experts argue that ―normal‖ inefficiency can no longer be
tolerated and that companies that build waste into their operations will ultimately face serious
problems competing with companies that don’t.
3. Setting direct labor standards.
• The standard rate per hour for direct labor should include not only wages, but also fringe
benefits and other labor-related costs. Ordinarily, the standard rate is an average that assumes a
specific mix of higher and lower paid workers.
• The standard direct labor-hours per unit of output is the direct labor time allowed to
complete a unit of product. In traditional standard cost systems this standard time includes
allowances for coffee breaks, personal needs of employees, clean-up, and machine downtime.
4. Setting variable manufacturing overhead standards. Standards for variable manufacturing
overhead are usually expressed in terms of direct labor-hours or machine-hours. The rate represents
the variable portion of the predetermined overhead rate that is discussed in Chapter 3. The standard
hours for variable overhead represent the standard hours for whatever base is used to apply
overhead cost to products or services. If direct labor-hours is the basis for applying overhead to
products, then the quantity standard for variable manufacturing overhead will be the quantity
standard for direct labor.
5. Standard cost card. A standard cost card is a summary of the standard costs of inputs required to
complete one unit of product. For each input, the standard cost card lists the standard price of the
input, the standard quantity of the input allowed per unit of output, and the standard cost of the
input per unit of output. The latter is equal to the standard price per unit of input multiplied by the
standard quantity of the input allowed for each unit of product.
6. Standards and budgets. One distinction between a standard and a budget is that a standard is a
unit amount, whereas a budget is a total amount. In effect, a standard can be viewed as the budgeted
cost for one unit.
C. A General Model for Variance Analysis. A variance is the difference between standard prices
and actual prices or between standard quantities and actual quantities.

1. Direct material variances:
a. The materials price variance is the difference between what is paid for a given quantity of
materials and what should have been paid according to the standard. Most companies compute
the material price variance when materials are purchased rather than when the materials are
placed into production. Generally speaking, the purchasing manager has control over the price
to be paid for goods and is therefore responsible for any price variance. However, some other
individual may be responsible in some instances. For example, the production manager might
be responsible if an unfavorable price variance occurs as the result of rush orders for material
due to poor production scheduling.
For purposes of control, it is best to recognize a materials price variance immediately rather
than wait until the materials are withdrawn for use in production. Also, if the material price
variance is recognized when the materials are placed into production, their actual costs must be
tracked after they are purchased. If the variance is recognized when the materials are
purchased, materials inventories can be carried at standard cost—which enormously simplifies
the bookkeeping.
b. The materials quantity variance is the difference between the quantity of materials used in
production and the quantity that should have been used according to the standard—all
multiplied by the standard price per unit of input. Ordinarily, the materials quantity variance is
the responsibility of the production department. However, other individuals may in some
instances be responsible. For example, the purchasing department would be responsible for an
unfavorable material quantity variance that occurs because of the purchase of inferior quality
materials.
2. Direct labor variances:
a. The labor rate variance measures any deviation from standard in the average hourly rate paid to
direct labor workers. Students often wonder how there can be a labor rate variance since
companies generally know each employee’s wage rate in advance. A labor rate variance can
arise for a number of reasons. The mix of workers, and hence of lower and higher wage rates,
can be different from what was planned due to absences, changes in the composition of the
work force, and a variety of other circumstances. Additionally, overtime can give rise to a labor
rate variance.
b. The quantity variance for direct labor is called the labor efficiency variance. Traditionally, this
has been the most closely monitored variance by management. When the direct labor workforce
is adjusted to changes in workloads, the main causes of the labor efficiency variance include
poorly trained workers, poorly motivated workers, poor quality materials which require more
labor time and processing, faulty equipment which causes breakdowns and work interruptions,
and poor supervision. However, many companies do not adjust the workforce to the workload
in the short-term. In such companies, the major cause of a labor efficiency variance is likely to
be fluctuations in demand for the company’s products rather than the efficiency with which
workers do their jobs. If the workforce is basically fixed, a reduction in output will result in less
favorable labor efficiency variances. Likewise, an increase in output when the workforce is
basically fixed will result in more favorable labor efficiency variances.
When demand is down or when a workstation is not a bottleneck, excessive emphasis on
labor efficiency variances can create tremendous pressure to build inventories. Take the case of
a workstation that is not a bottleneck. If the labor force is basically fixed and the standards are
tight, the workstation can only attain a favorable labor efficiency variance by producing at
capacity. However, if the workstation is not the bottleneck and it is operating at capacity, it will

produce more output than the bottleneck can process. That will result in work in process
inventory that cannot be completed. As the JIT movement attests, work in process inventory is
the enemy of efficient operations. It leads to long and erratic manufacturing cycle times, high
defect rates, obsolescence, and high overhead due to expediting and the problems of
coordinating production schedules amongst the general chaos on the factory floor. A very
strong argument can be made that the labor efficiency variance should be unfavorable in
workstations that are not bottlenecks when the work force is fixed.
3. Variable overhead variances.
a. The variable overhead spending variance compares actual spending on variable overhead to the
amount of spending that would be expected, given the actual direct labor-hours for the period.
The critical assumption inherent in this calculation is that variable overhead spending should be
proportional to the actual direct labor-hours. The usefulness of this variance depends on the
validity of this assumption. If in fact the optimal level of variable overhead spending is not
proportional to actual direct labor-hours, then this variance has little meaning.
b. The variable overhead efficiency variance is computed as follows when the variable overhead
rate is expressed in terms of direct labor-hours:
Variable overhead efficiency variance =
(Actual direct labor-hours – Standard direct labor-hours allowed)  Variable overhead rate
Note the similarity between the direct labor efficiency variance and the variable overhead
efficiency variance. In both cases, the actual direct labor-hours are compared to the standard
direct labor-hours allowed for the actual output. The only difference between the variances is
the standard rate that is applied to difference between the actual and standard hours. In the case
of the direct labor efficiency variance, the rate is the standard labor rate. In the case of the
variable overhead efficiency variance, the rate is the standard (predetermined) variable
overhead rate per direct labor-hour. Therefore, these two variances really measure the same
thing. Those who criticize the labor efficiency variance as irrelevant or counter-productive
would likewise criticize the variable overhead efficiency variance.
D. The above discussion explains the basic concept about variances. It is strongly recommended that
the following formulas should be used to calculate variances instead of any other formulas:
DIRECT MATERIAL VARIANCES:
1 Standard quantity required for actual production Х Standard rate
2 Actual quantity used Х Standard rate
3 Actual quantity used Х Actual rate

1 - 2 = D.material quantity variance
2 - 3 = D. material rate variance
1 - 3 = Total D. material variance
Explaination:
1. It is the amount which should have been spent if D.material was purchased at
standared rate and was used in standard quantities for the units actually produced.
2. It is the amount which should have been spent if actual quantity of D.material used
was purchased at standard rate.
3. It is the actual amount spent on actually used quantity of direct material at actual rate.
DIRECT LABOUR VARIANCES:
When there is no idle variance:
1 Standard hours required for actual production Х Standard rate
2 Actual hours worked Х Standard rate
3 Actual hours worked Х Actual rate
1 - 2 = D.labour efficiency variance
2 - 3 = D. labour rate variance
1 - 3 = Total D. labour variance
Explaination:
1. It is the amount which should have been spent if D.labour was paid at standard
rate and the labour worked for standard hours for units actually produced.
2. It is the amount which should have been spent if actual hours of D.labour were
paid at standard rate.
3. It is the actual amount paid to direct labour for actual hours at actual rate.
DIRECT LABOUR VARIANCES:
When there is idle variance:
3 Actual hours paid Х Standard rate
4 Actual hours paid Х Actual rate
1 - 2 = D.labour efficiency variance

2 - 3 = D.labour idle variance
3 - 4 = D. labour rate variance
1 - 4 = Total D. labour variance
Explaination:
1. It is the amount which should have been spent if D.labour was paid at standard
rate and the labour worked for standard hours for units actually produced.
2. It is the amount which should have been spent if actual hours worked were paid at standard rate.
3. It is the amount which should have been paid to D. labour for hours including idle hours at standard rate.
4 It is the amount which has been paid for to the D.labour for hours including idle hours at actual rate.
VARIABLE OVERHEAD VARIANCES
3 Actual hours worked Х Actual rate
1 - 2 = Variabel overhead efficiency variance
2 - 3 = Variable overhead expenditure variance
1 - 3 = Variable overhead total variance
Explaination:
1. It is the amount which should have been spent if standard hours were spent on the actual production,
and variable overhead were spent at standard amounts per hour.
2. It is the amount which should have been spent on variable overhead if variable overhead were spent
at standard rate for actual hours worked.
3. It is the actual amount spent on varible overhead
FIXED OVERHEAD VARIANCES:
2 Budgeted hours Х Standard rate
3 Actual fixed overhead
1 - 2 = Fixed overhead volume variance
2 - 3 = Fixed overhead expenditure variance
1 - 3 = Fixed overhead total variance

Explaination:
1. It is the amount of fixed overhead charged to the jobs
2. It is the amount which should have been spent on fixed overhead at budgeted capacity at standard rate.
3. It is the actual amount spent on fixed overhead
6
COSTING SYSTEMS
This chapter requires previous knowledge about three
basic elements of costs. .It introduces job order costing and
process costing.
wo major types of costing systems are used in manufacturing and many service companies:
process costing and job-order costing.
1. Job-Order Costing. Job-order costing is used when different types of products, jobs, or batches are
produced within a period. In a job-order costing system, direct materials costs and direct labor costs
are usually traced directly to jobs. Overhead is applied to jobs using a predetermined rate. Actual
overhead costs are not traced to jobs. Examples of industries in which job-order costing is used
include special order printing, shipbuilding, construction, hospitals, professional services such as
law firms, and movie studios.
2. Process Costing. A process costing system is used where a single, homogeneous product or service
is produced. In a process costing system, total manufacturing costs are divided by total number of
units produced during a given period. The unit cost that results is a broad, average figure. Process
costing is used in industries such as cement, flour, brick, and oil refining.
Job-Order Costing:
The discussion in the text and below assumes that a paper-based manual system is used for
recording costs. Cost and other data are recorded on materials requisition forms, time tickets, and
job cost sheets. Of course, many companies now enter cost and other data directly into computer
T

databases and have dispensed with these paper documents. Nevertheless, the data residing in the
computer typically consists of a ―virtual‖ version of the manual system. Since a manual system is
easy for students to understand, we continue to rely on it when describing a job-order costing
system.
1. Job Cost Sheet. Each job has its own job cost sheet on which costs are charged to the job. The job
cost sheet will have some code or descriptive data to identify the particular job and will contain
spaces to record costs of materials, labor, and overhead. Exhibit 3-4 provides an illustration of a job
cost sheet.
2. Materials Costs. When a job is started, materials that will be required to complete the job are
withdrawn from the storeroom. The document that authorizes these withdrawals and that specifies
the types and amounts of materials withdrawn is called the materials requisition form. The
materials requisition form identifies the job to which the materials are to be charged. Care must be
taken when charging materials to distinguish between direct and indirect materials. An example of
a materials requisition form is shown in Exhibit 3-1 in the text.
3. Labour. Labor costs are recorded on a document called a time ticket or a time sheet. Each
employee records the amount of time he or she spends on each job and each task on a time ticket.
The time spent on a particular job is considered direct labor and its cost is traced to that job. The
cost of time spent on other tasks, not traceable to any particular job, is usually considered part of
manufacturing overhead.
4. Manufacturing Overhead. Manufacturing overhead includes all manufacturing costs that are not
traced to a particular job. In practice, manufacturing overhead usually consists of all manufacturing
costs other than direct materials and direct labor. Since manufacturing overhead costs are not traced
to jobs, they must be allocated to jobs if absorption costing is used.
a. We do not dwell on the reasons for allocating all manufacturing overhead to jobs in this
chapter. What costs should or should not be allocated to jobs and to products remains a
controversial issue. In the chapter we confine discussion to absorption costing since that is the
approach that is used in the vast majority of organizations for both external and internal
reporting.
b. In order to allocate overhead costs, management must choose an allocation base. The most
widely used allocation bases are direct labor-hours, direct labor costs, and machine-hours.
(These bases have been severely criticized in recent years. Critics charge that overhead is
largely unrelated to, or even negatively correlated with, machine-hours or direct labor-hours.)
In the costing system illustrated in the chapter, a predetermined overhead rate is computed by
dividing the estimated total overhead for the upcoming period by the estimated total amount of
the allocation base.
c. Ideally overhead cost should be strictly proportional to the allocation base; in other words, an
x% change in the allocation base should cause an x% change in the overhead cost. Only then
will the allocated overhead costs be useful in decision-making and in performance evaluation.
However, much of the overhead typically consists of costs that are not proportional to any
conceivable allocation base and hence any scheme for allocating such costs will inevitably lead
to costs that are biased and unreliable for decision-making and performance evaluation. In
practice, the overriding concern is to select some basis or bases for allocating all overhead costs
and scant attention is paid to questions of causality. These issues are not raised in the text at this
point since students will not be ready to understand them until after having studied cost
behavior in more depth in later chapters.

d. At any rate, the actual amount of the allocation base incurred by a job is recorded on the job
cost sheet. The actual amount of the allocation base is then multiplied by the predetermined
overhead rate to determine the amount of overhead that is applied to the job.
COST FLOW-Job Order Costing.
1. Overview of Cost Flows. The basic flow of costs in a job-order system begins by recording the
costs of material, labor, and manufacturing overhead.
a. Direct material and direct labor costs are debited to the Work In Process account. Any indirect
material or indirect labor costs are debited to the Manufacturing Overhead control account,
along with any other actual manufacturing overhead costs incurred during the period.
Manufacturing overhead is applied to Work In Process using the predetermined rate. The
offsetting credit entry is to the Manufacturing Overhead control account.
b. The cost of finished units is credited to Work In Process and debited to the Finished Goods
inventory account.
c. When units are sold, their costs are credited to Finished Goods and debited to Cost of Good
Sold.
2. The Manufacturing Overhead Control Account. Manufacturing Overhead is a temporary control
account.
a. As stated above, actual overhead costs are recorded on the debit side of the Manufacturing
Overhead control account. Overhead costs applied to Work in Process using predetermined
rates are recorded on the credit side of the account.
b. Any discrepancy between overhead costs incurred and overhead costs applied shows up as a
balance in the Manufacturing Overhead control account at the end of the period. A debit
balance is called underapplied overhead and a credit balance is called overapplied overhead.
Under- and Overapplied Overhead.
Since the predetermined overhead rate is based entirely on estimated data, the actual amount of
overhead cost incurred will almost always differ from the amount of overhead cost that is applied to the
Work In Process account. The difference is termed underapplied or overapplied overhead, and as
discussed above, can be determined by the ending balance in the Manufacturing Overhead control
account. An underapplied balance occurs when more overhead cost is actually incurred than is applied to
the Work In Process account. An overapplied balance results from applying more overhead to Work In
Process than is actually incurred.
1. Cause of Under- and Overapplied Overhead. When a predetermined overhead rate is used, it is
implicitly assumed that the overhead cost is variable with (i.e., proportional to) the allocation base.
For example, if the predetermined overhead rate is $20 per direct labor-hour, it is implicitly
assumed that the actual overhead costs will increase by $20 for each additional direct labor-hour
that is incurred. If, however, some of the overhead is fixed with respect to the allocation base, this
will not happen and there will be a discrepancy between the actual total amount of the overhead and

the overhead that is applied using the $20 rate. In addition, the actual total overhead can differ from
the estimated total overhead because of poor controls over overhead spending or because of
inability to accurately forecast overhead costs.
2. Disposition of Under- and Overapplied Overhead. Two approaches to dealing with an under- or
overapplied overhead balance in the accounts are illustrated in the text.
a. The simplest approach is to close out the under- or overapplied overhead to Cost of Goods
Sold. This is the method that is used in most of the exercises and problems because it is easiest
for students to understand and master.
b. The second approach is to allocate the under- or overapplied balance to Cost of Goods Sold and
to the Work In Process and Finished Goods inventory accounts. The basis of allocation is the
amount of overhead applied during the period in the ending balance of each of these accounts.
This method is equivalent to waiting until the end of the period to allocate the actual overhead
costs based on the actual amount of the allocation base incurred.
3. The Effect of Under- and Overapplied Overhead on Net Operating Income.
a. If overhead is underapplied, less overhead has been applied to inventory than has actually been
incurred. Enough overhead must be added to Cost of Goods Sold (and perhaps ending
inventories) to eliminate this discrepancy. Since Cost of Goods Sold is increased, underapplied
overhead reduces net income.
b. If overhead is overapplied, more overhead has been applied to inventory than has actually been
incurred. Enough overhead must be removed from Cost of Goods Sold (and perhaps ending
inventories) to eliminate this discrepancy. Since Cost of Goods Sold is decreased, overapplied
overhead increases net operating income.
The Predetermined Overhead Rate and the Level of Activity
Interest has been recently rekindled in the issue of how to select the denominator level of activity in the
predetermined overhead rate. In the main body of the chapter, it is assumed that the denominator is the
estimated total amount of the allocation base for the period. While this is the most common method used
in practice, it has some serious drawbacks.
Drawbacks of basing the predetermined overhead rate on the estimated level of activity.
a. If overhead contains substantial fixed costs, then as the estimated level of activity decreases,
the predetermined overhead rate will increase. Thus if the company starts losing sales due to a
recession or other reason, the company’s unit costs will increase. This could result in some
managers increasing prices or dropping products, which is likely to be exactly the wrong thing
to do in this situation.
b. Products are charged with resources they don’t use. If a product uses 10% of the capacity of a
fixed resource, it is argued that it should be charged with only 10% of the cost of that resource.
If all of the products a company makes use only 50% of the capacity of the fixed resource, the
cost of that idle capacity should be separately recognized as a period expense rather than spread
over the products that use the resource during the period. Under the conventional approach,
products are charged for both their share of the capacity they use and for a share of the idle
capacity they do not use. So if a product uses 10% of the capacity of a resource, but 50% of the

capacity is idle, then under the conventional approach the product would be charged with 20%
of the total cost of the resource._
MANAGEMENT ACCOUNTING
JOURNAL ENTRIES
JOB ORDER COSTING
S.No
1 Purchase of direct materials:
Materials- xxx
Cash / Accounts payable Xxx
2 Purchase of indirect materials:
Materials- xxx
Cash / Accounts payable Xxx
3 Issue of direct materials to production:
Work in process xxx
Materials- Xxx
4 Issue of indirect materials:
Actual factory overhead control xxx
Materials- Xxx
5 Return of direct materials from the factory to the store:
Materials- xxx
Work in progress Xxx
6 Return of indirect materials from the factory to the store:
Materials- xxx
Actual factory overhead control Xxx
7 Preparation of the payroll:
a.) Payroll xxx
Accrued payroll Xxx
Income tax payable Xxx
N.I contributions payable Xxx
Provident fund payable Xxx
b.) Work in process- labour xxx
Actual factory overhead control xxx
Selling and marketing overheads xxx
Administrative overheads xxx

Payroll Xxx
8 Payment of salaries:
Accrued payroll xxx
Cash in bank Xxx
9 Application of factory overhead:
Work in process xxx
Applied factory overhead Xxx
10 Payment of factoy overhead expense ( eg. Electric bill)
Actual factory overhead-electric expense xxx
Cash Xxx
11 Recording depreciation of factory assets:
Actual factory overhead-depreciation
machine
xxx
Accumulated depreciation machine Xxx
12 On completion of job and transfer to finished goods store:
Finished goods xxx
Work ion process Xxx
13 On sale of the job:
a.) Cost of goods sold xxx
Finished goods Xxx
b.) Accounts receivable xxx
Sales Xxx
14 Closing of Applied factory overhead account:
Applied factory overhead xxx
Actual factory overhead Xxx
15 Variances creation and disposal:
a.) Unfavourable variance xxx
Actual factory overhead control Xxx
Favourable variances Xxx
b.) Cost of goods sold/FOH /P&Loss xxx
Unfavourable variances Xxx
c.) Favourable variances xxx
Cost of goods sold /FOH /P& Loss Xxx

__________
7
DECISION MAKING
This chapter requires previous knowledge about
determination of costs of products or jobs and cost
behaviour.
DECISION MAKING
ABC PRODUCTION
Product
A
Product
B
Sale price per unit 70 65
Varible cost per unit £35 £35
Production time per unit 3 hours 2 hours
Available maximum market per
year
5,000
units
7,000
units
Present production per year 5,000
units
4,000
units
Total Fixed Costs per year £110,000

Maximum production capacity per year 30,000 hours
Proposal:
Additional marketing cost per year £50,000
New market after additional
marketing
7,000
units
9,000
units
Required: Guide the management as to how many number of units of each products
should be produced and sold. Make presentations for all the three options.
9
MATERIAL
MANAGEMENT
This chapter requires no previous knowledge
MATERIAL MANAGEMENT
Re-order Level = Maximum usage × maximum lead time
Minimum Balance = Reorder level - ( average usage × average lead time)
Maximum Balance = Re-order level - (minimum usage × maximum lead time) + reorder quantity
Economic Order Quantity: Please see attached notes
Average Stock: = Safety Stock + ½ Reorder level
Lead Time is the time taken in receiving the supplies of material ,and making them available for use,
since it was realised that reorder is necessary.

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