i

A4
A04
COST ACCOUNTING

STUDY TEXT

NBAA
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Edition 3, Version 1

SBN No 978-9976-78-085-7

Published by

National Board of Accountants and Auditors.

Audit House, 8th Floor, Ukaguzi Road,
P.O. Box 1271,
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Copyright and acknowledgement: the IAASB Handbook 2020 is a publication of the International Federation of
Accountants. With the kind permission of the International Federation of Accountants, the publisher has referred
to the contents of the publication in this book.

Combined Code 2006 (revised), UK Corporate Governance Code and other related publications are the copyright
of Financial Reporting Council. With the kind permission of the Financial Reporting Council, we have referred to
the contents of the publications in or Book.

The National Board of Accountants and Auditors, is grateful to all Resource Persons who were involved in the
review of the NBAA Learning Materials. NBAA also would like to acknowledge the great work that was done by
Get Through Guides Ltd who laid the foundation of the NBAA Learning Materials.

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© National Board of Accountants & Auditors @ 2023

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FOREWORD

The National Board of Accountants and Auditors in Tanzania is a professional body in Tanzania, established under
the Accountants and Auditors (Registration) Act, Cap 286. The Board has been charged among other things, the
responsibility to promote, develop and regulate the accountancy profession in the country.

In fulfilling its role, NBAA has revised its national accountancy examination scheme and syllabi for students aspir-
ing to sit for Accounting Technician and Professional Examinations. For effective implementation of these syllabi
and improve examination results, the Board has prepared study materials for all subjects to assist both examination
candidates and trainers in the course of learning and teaching respectively.

The study guides have been prepared in the form of text books with examples and questions to enable the user to
have comprehensive understanding of the topics. The study guides cover the wide range of the topics in the syllabi
and adequately cover the most comprehensive and complete knowledge base that is required by a leaner to pass
the examinations.

These study guides for each subject from Accounting technician level I to final Professional Level will
ensure that learners understand all important concepts, know all the workload involved and provide practice they
need to do before examinations. The guides have right amount of information with plain language -easy-to-under-
stand, plenty of practice exercises and sample examination questions which are set in a competence based approach.

Competency based study guides have been developed aiming at developing a competent workforce. The guides
emphasize on what the individual can do in a workplace after completing a period of training. The training pro-
gramme therefore is directly related to the expectations of the employer.

These study guides which have been developed under competence based approach are characterized by the follow-
ing features:-

1. Focus on outcome – The outcomes shown in every topic are relevant to employment industry.

2. Greater workplace relevance – the guides emphasize on the importance of applying knowledge to the tasks to
be performed at a workplace. This is different from traditional training where the concern has been expressed
that theoretical or book knowledge is often emphasized at the expense of the ability to perform the job.

3. Assessments as judgments of competence – The assessment will take into consideration the knowledge, skills
and attitudes acquired and the actual performance of the competency.

Study guides are also useful to trainers specifically those who are teaching in the review classes preparing learners
to sit for the professional examinations. They will make use of these study guides together with their additional
learning materials from other sources in ensuring that the learners are getting sufficient knowledge and skills not
only to enable them pass examinations but make them competent enough to perform effectively in their respective-
ly workplace.

NBAA believes that these standard study guides will assist candidates to acquire skills and knowledge so they are
able to perform a task to a specified standards. The outcomes to be achieved are clearly stated so that learners know
exactly what they have to be able to do, and on the other hand trainers know what training is to be provided and
organizations as well know the skills level acquired by their expected professional accountants.

The unique approach used in the development of these study guides will inspire the learners especially Board’s
examination candidates to acquire the knowledge and skills they need in their respective examinations and become
competent professional accountants in the labour market thereafter.

CPA Pius A. Maneno

EXECUTIVE DIRECTOR
DEC 2023
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A4 – Cost Accounting

About the paper i - v

Section A Costing

1. Cost Classification 1 - 31
2. Elements of costing and cost statements 32 - 54
3. Costing for products, services and projects 55 - 96
4. Marginal and absorption costing 97 - 108

Section B Introduction to Decision Making

1. Cost -Volume- Profit analysis for a single product 109 - 122

2. Short-term Decisions 123 - 140

Section D Introduction to Standard Costing and Variance Analysis

1. Introduction to standard costing and variances analysis 141 - 154

Section E Procurement Management

1. Procurement and procurement cycle 155 - 162

2. Public procurement and legislation 163 - 170

Section F Management Information System

1. Management information system 171 - 189

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Features of the book

The book covers the entire syllabus split into various chapters (referred to as sections in the book). Each chapter
discusses the various Learning Outcomes as mentioned in the syllabus.

Contents of each section

o “Get Through Intro”: explains why the particular section is important through real life examples.

o “Learning Outcomes”: on completion of a section, students will be able to understand all the learning
outcomes which are listed under this icon in the section.

The Learning Outcomes include:

ü „Definition‟: explains the meaning of important terminologies discussed in the learning Outcome.

ü „Example‟: makes easy complex concepts.

ü „Tip‟: helps to understand how to deal with complicated portions.

ü „Important‟: highlights important concepts, formats, Acts, sections, standards, etc.

ü „Summary‟: highlights the key points of the Learning Outcomes.

ü „Diagram‟: facilitates memory retention.

ü „Test Yourself‟: contains questions on the Learning Outcome. It enables students to check whether they
have assimilated a particular Learning Outcome.

o Self-Examination Questions‟: exam standard questions relating to the learning outcomes given at the end
of each section.

EXAMINATION STRUCTURE

The syllabus is assessed by a three-hour paper-based examination. 5 conventional questions of 20 marks

each need to be solved.

The examination will consist of two sections.

Section A One compulsory question

Section B Four questions out of Six

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 1

SECTION A
COSTING
A1
SECTION A1: COST CLASSIFICATION

Incurring costs is an inevitable part of running any business. Evaluating business ideas, finalizing an idea, setting up
a business and running it are all activities that incur costs. Costs are classified into various categories based on
behavior, purpose, function and nature. These classification help management in decision making, forecasting and
budgeting. This Study Guide will help you understand costs, classify them into various categories and use them for
management purposes and total costs calculations. In the role of a management accountant, you will need to have
a thorough understanding of various costs and this Study Guide will prepare you for that. This is the basic introduction
to costing and hence will help a strong foundation to understand the further Study Guides and complex concepts.

(a) Classify costs by nature, function and purpose, including identifying:

• Fixed, variable and semi-variable costs,
• Product and period costs,
• Direct and indirect costs
(b) Separate semi variable costs by using high – low Method.
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1. Classify cost by nature, function and purpose, including fixed, variable and semi
variable costs, product and period costs, direct and indirect costs [Learning Outcome
a]

Cost is the expenditure incurred on resources that are used to achieve a particular objective. Resources may be
tangible (materials or machinery) or intangible (labour, patent, copyright etc.) It is the amount of money required to
produce a product or perform a service.

Costs are classified into fixed and variable costs based on their behaviour. Variable costs and fixed costs behave
differently with change in the activity levels and hence this classification is called the behavioural classification.

The distinction of costs into fixed and variable components is very important from the viewpoint of decision-making.
It helps a manager to make crucial decisions such as whether to manufacture a component inhouse or buy it from
outside vendors, whether to continue the business or shut down, whether to start a new business etc.

1.1 Fixed and semi-fixed or stepped fixed costs

1. Fixed cost

A cost that remains constant in total, within the current budget period, irrespective of changes in volume of
activity, is called a fixed cost.

Fixed costs are the expenses which do not change in proportion to the activity of a business, within the
relevant period of time.

A retailer must pay rent and utility bills irrespective of the volume of sales he makes.

Fixed costs do not vary in total. The per unit fixed cost decreases as production volume increases and vice-
versa.

They are also known as “period cost” as the cost is incurred in relation to a time period or “stand-by cost” because
this cost will be incurred even if no production activity takes place.

All fixed costs are overheads but all overheads are not fixed costs. Overheads include certain costs that vary
with the level of activity. These depict a direct relationship with the activity level and hence are categorised as variable
overheads, e.g., overtime premium that changes with the number of hours of overtime worked, power costs, fuel costs
and any other utility costs. Certain overheads, on the other hand, always remain fixed irrespective of the activity level,
e.g., insurance costs, depreciation on assets etc.

Fixed costs

Ø Rent of office building, factory premises

Ø Depreciation of building, plant and machinery
Ø Pay and allowances of managers, secretary and accountants Legal or audit fees

There are three types of fixed cost

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(a) Long-run capacity fixed costs: these are sunk costs (i.e. costs already spent) associated with
plant, machinery and other non-current assets used in factory or in office.

(b) Operating fixed costs: these overheads are incurred to maintain and operate non-current
assets and include any other fixed costs relating to the factory, e.g. depreciation, factory
manager‟s salary etc.

(c) Programmed fixed cost: these are the costs of special programmes approved by
management, e.g. costs relating to research and development, market promotion expenses,
staff training expenses.

Diagram 1: Types of fixed costs

To have an idea of the graphical representation of fixed costs let us try to plot the graph using a simple example.

Tim runs a saw mill and has hired a factory shed for the purpose. He pays TZS 6,000,000 (i.e. TZS 500,000 per
month) as the annual rent. Although his other monthly expenses change each month, the rent cost remains the same.
The following graph depicts the fixed cost remaining constant during the period.

Diagram 2: Total fixed cost

It can be observed from the above diagram that total annual rent cost remains constant throughout the budget period
of one year.

The above graph shows the total fixed cost. The graph below shows how the per unit fixed cost decreases as the
volume of production increases.
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Diagram 3: Fixed cost per unit

SUMMARY

B Remains fixed forever

C Always varies
D Varies per hour

2. Stepped fixed cost or semi fixed cost

Cost that are fixed for a given level of activity but in due course changes by a constant amount at some point is a
stepped fixed cost.

A stepped fixed cost remains the same up to a certain level of activity or a certain period of time, then changes and
again remains constant up to a new activity level or a period of time.

Sera International School has started to offer a pick-up service for its students this year. The cost of hiring one bus is
TZS 100,000 per day. One bus can accommodate a maximum of 50 students.

At the beginning of the session only 40 students opted to take the bus. Therefore, only one bus was hired at a cost of
TZS 100,000 per day. The cost of this bus will remain TZS 100,000 until the number of students rises above 50.

However, the number of students using the bus rose from 40 students to 80 students by the middle of the session. As
a result, the school had to hire another identical bus for the additional 30 students (80 - 50). The cost then became
TZS 200,000 per day. This cost will again remain constant until the student count exceeds 100 (50 + 50).
 5

Increasing salaries of managerial and administrative employees will cause fixed employee costs to step up. Similarly,
if there is a revision in the rent agreement that increases the monthly rent within the period under consideration, the
cost will step up.

Graphical representation of stepped fixed cost is explained with the help of the following example.

Matrix Plc has its office in rented premises. The annual rent is TZS 10,000,000. The rent cost rises every two years
by TZS 5,000,000 according to the rent agreement. This cost again remains constant at TZS 15,000,000 until the end
of the fourth year and again rises by TZS 5,000,000. This therefore depicts a stepped fixed cost.

Diagram 4: Stepped fixed cost chart

Which of the below sentence / s describes a stepped fixed cost?

A Remains unchanged irrespective of activity levels

B Has a fixed component only
C Is constant up to a certain activity level, then rises and remains constant up to a new level of activity
D All of the above

1.2 Variable Cost

The portion of total cost that varies with a change in the volume of activity is known as variable cost.

It varies in total but its value per unit cost remains constant. For example, 1 item costs TZS 10,000 and 10 items
cost TZS 100,000. The cost of each individual unit is TZS 10,000, but in total the costs are TZS 100,000. Variable
costs are expenses that change in direct proportion to the activity of a business.
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Ø Direct material and labour cost

Ø Indirect material and labour cost
Ø Power and fuel
Ø Lubricants
Ø Tools and spares
Ø Products purchased for resale

A graphical representation of variable cost is shown in the example given below.

To plot the variable cost line on a graph, consider the production of leather bags. Suppose each bag requires 2 square
metres of leather that costs TZS 50,000. This is the material cost (i.e. a variable cost) that increases with every bag
produced. This shows that it increases proportionately with the increase in output. It will increase by TZS 50,000 with
each additional bag manufactured. The graph showing this increase in the cost will be as
below:

Diagram 5: Total variable cost

The above figure shows that variable cost varies in direct proportion to the change in the level of activity (in
this case TZS 50,000 per unit), that is, it increases in total as the output increases.

The above graph shows total variable cost. Per unit variable cost remains the same irrespective of the volume of

production. The graph depicting this is given overleaf.

Diagram 6: Per unit variable cost

Assuming, the per unit variable cost per product to be TZS 400,000.

The total cost line consisting of fixed and variable cost is plotted below.
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Diagram 7: Total cost graph

Assuming, the per unit variable cost per product TZS 30,000 and total fixed costs TZS 200,000.

Diagram 8: Average cost per unit

Assuming, cost per unit TZS 400,000.

Total cost (fixed + variable) shows a rising trend as variable costs always increase with an increase in production. The
average total cost i.e. per unit cost consisting of the fixed and variable elements, decreases with an increase in the
volume of production. This is because the variable cost per unit remains constant but the fixed cost per unit decreases
as the volume of production increases.

Trim Plc manufactures helmets. The fixed costs of production for the year are TZS 4,000,000. The variable costs per
helmet are TZS 18,000. Although the total fixed costs will be incurred irrespective of the number of helmets
manufactured, the total variable costs will increase in direct proportion to the number of helmets manufactured. If Trim
manufactures 50 helmets, the total fixed cost for this will be TZS 4,000,000 and the total variable cost will be TZS
900,000. The total fixed cost to manufacture 70 helmets would again be TZS 4,000,000 but the variable cost would
rise from TZS 900,000 to TZS 1,260,000.

Let us now calculate the fixed and variable costs per unit at the two volumes of production.

Variable cost per unit

At level of 50 helmets variable cost per helmet = TZS 900,000/50 helmets = TZS 18,000 At level of 70 helmets variable
cost per helmet = TZS 1,260,000/70 helmets = TZS 18,000

Fixed cost per unit

At level of 50 helmets fixed cost per helmet = TZS 4,000,000/50 helmets = TZS 80,000 At level of 70 helmets fixed
cost per helmet = TZS 4,000,000/70 helmets = TZS 57,140
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Hence total cost per unit at the two levels = variable cost per unit + fixed cost per unit
50 helmets - TZS 18,000 + TZS 80,000 = TZS 98,000
70 helmets - TZS 18,000 + TZS 57,140 = TZS 75,140
The cost per unit falls from TZS 98,000 to TZS 75,140

SUMMARY

In a computer chip manufacturing unit, one chip requires 2.5 hours of labour per chip at TZS 10,000 per hour, direct
material worth TZS 20,000 and direct expenses per chip amounting to TZS 5,000. The rent of the workshop is TZS
1,000,000; the watchman‟s monthly salary is TZS 1,000,000, administrative staff salary amounts to TZS 2,500,000
per month and the floor manager is paid a salary of TZS 2,500,000 per month.

Prepare a monthly statement showing the fixed and the variable cost components at the output level of 500 computer
chips for the month.

1.3 Semi-variable costs

A cost that is composed of a mixture of fixed and variable components is known as a semi-variable cost. It is also
known as a mixed cost.

In other words, these costs show a mixed relationship, when plotted against volume.

A good example of a semi-variable cost is the telephone bill. This is generally divided into two components - a fixed
charge payable per billing period (where there is no extra charge up to a certain level of usage) and a variable per
unit usage charge (depending on the number of units consumed above the certain level of usage).

Diagram 9: Semi-variable cost chart

In the above graph, the fixed charge is TZS 100,000 up to the consumption level of 20 units. Then variable cost is
charged for every unit consumed above this level. This shows that there is a fixed element of TZS 100,000 in the cost
and the remaining portion varies depending upon the units consumed.
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You are a member of a local country club. You pay an annual membership fee, which enables you to stay on the
club‟s list of members. So from your perspective, this is a fixed cost.

You also pay to use club facilities, such as facilities for sport and social gatherings, if and when you use them. These
are variable costs because they are paid for only in the event of utilisation of a particular facility. Also, the charge is
on a per facility basis and not a gross charge for all facilities.

Which of the following can be a semi-variable cost?

A Telephone charges
B Internet usage charges
C Vehicle hire charges
D All of the above

Cost type with examples Explanation

(a) Fixed costs

Insurance Cost incurred to protect against events that could damage

business property. No relationship to activity of production
and therefore does not vary with the volume of units
manufactured.
Depreciation on buildings Accounting convention to reflect the reduction in value of
assets due to wear and tear. No relationship to activity.
Interest on borrowed Cost of money borrowed for the business. This cost generally
money does not change with the change in the level of activity or
volume of production.
(b) Stepped fixed costs

Depreciation on company If the company operates a fleet of vehicles to reduce the

owned vehicles delivery time, the depreciation cost on the vehicles will step
up each time the number of vehicles increases.
Rent costs for extra storage The rent of the warehouse is a fixed cost as long as the
storage does not exceed the capacity of the warehouse.
Once the volume of materials increases beyond this limit, a
new warehouse is rented and the rent cost steps up.
(c) Variable costs

Direct material The cost of materials, labour or expenses per unit of

Direct labour production is constant, and as the units of production
Direct expenses increase, so does the cost.
A direct relationship with activity.
10

Sales commission The cost of rewarding sales persons according to the sales
volume they achieve has a direct relationship with sales
activity.
(d) Semi-variable costs

Monthly telephone costs, Both telephone and electricity charges comprise fixed and
electricity costs variable components. Fixed component remains
unchanged for any quantum of usage and the variable
component varies with a change in usage level.

Which of the following is correct regarding semi-variable costs?

A Change in the same direction and same proportion with the

change in output
B Fluctuate with volume because of a variable element.
C Do not change in direct proportion to output because of the
variable element.
D All of the above

1.4 Product costs

Product costs are the costs incurred in relation to manufacturing a product and period costs are the costs incurred in
a specific production cycle period.

Product costs are costs incurred in relation to the manufacturing process

The production process generally involves processing raw materials into the final product. All the costs incurred in a
factory, directly or indirectly, until the stage when the goods can be marketed as final products are considered product
or manufacturing costs.

In the production of glassware (glasses, glass plates etc.), the costs incurred for glass, wages paid to labour and the
cost of fuel used in making the glassware will all qualify as product costs.

Packing costs, where the products require primary packaging in order to sell the goods, are a part of product costs.
In these cases, the product is incomplete unless it is packed, e.g., milk packed in bottles / cartons or hair shampoo
bottled in plastic containers.

Product costs are sub-classified as:

Ø Direct material
Ø Direct labour
Ø Direct expense
Ø Production overheads (factory overheads)

1.5 Period cost

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All the costs incurred from conceptualisation to sale of a product, other than those attributable to production activity,
inclusive of administration costs, selling costs, distribution costs, finance costs and research and development costs
are the period costs.

Salaries paid to office staff of the finance department are non-production costs. These are not spent on actual
production, but are essential for the running of the organisation.

These are costs incurred in relation to a period and not in relation to a product and hence are known as period costs.
They are charged to the statement of profit or loss of the period and not charged to individual products.

Diagram10: Functional classification of cost

The salary of a security guard for office premises is a:

A Product cost
B Period cost
C Manufacturing cost
D Direct cost

The cost incurred for the purchase of wood for the manufacture of wooden tables by a furniture manufacture will be
a:
A Product cost
B Fixed Cost
C Routine cost
D Management cost
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1.6 Classification of product costs

Product costs can be further split into prime costs consisting of direct material, direct labour and direct expenses and
production overhead costs. These form the major divisions of production costs. The next section explains each of
these terms.

1. Material costs

The costs of goods purchased for use in producing a product are known as material costs.

Materials that are used in producing the finished product are termed direct materials. The costs incurred on these can
be identified with the product.

Material costs may include costs of:

Ø The ingredients from which the product is manufactured

Ø The spares and parts used for completion of the product
Ø Materials transferred from one process to another as input to the other process (work in
process).
Ø Primary packing wherever essential in order to sell the product

Ø Main ingredient - Plastic used in the production of pens. Leather used to make leather shoes.
Ø Spares and parts - Nuts used in the assembling of cars
Ø Work in process - Processed ointment in large jars which is transferred to the packing
department where the ointment is transferred to tubes. The ointments in large jars here is a
direct material for the next process of packaging.
Ø Primary packing - The cartons, in which the milk is packed, are a direct material as the product
„milk cartons‟ cannot be complete unless milk is packed in the cartons.

Any material that can be visibly identified in the final product is a direct material and hence the cost associated
with it is a direct cost.

Canvass cloth, used in producing „Canvass bags‟, is a visible input in the final product. It is a direct material.

2. Labour costs

The remuneration paid to workers who are directly involved in the production process or the provision of a service is
termed labour costs.

Direct labour costs are computed either on the basis of the hours of work put in by the workers or the
number of units produced by them. Labour costs include:

Ø The cost of labour engaged in the actual production activity.

Ø Charges paid to special labour engaged in any production activity.

Ø The salaries of people writing books for a publication company. Generally basic pay and
overtime wages are a part of the direct labour cost.
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Ø The salary of a qualified accountant handling audits in an audit firm.

3. Direct expenses

Direct expenses include all expenses other than direct material or direct labour that are specifically incurred for a
particular product or process.

Ø Royalties paid to authors while publishing books

Ø Freight, or carriage inwards
Ø Hire charges paid by a construction contractor for hiring a hot mix plant. (cement mixing machine)

4. Overheads

Overheads are all the indirect costs (material, labour and expenses) which are not directly identifiable with a product.
Overheads in the context of production are production overheads.

Indirect expenses incurred in a factory and forming a part of product costs are the production overheads.

Production overhead costs include:

A. Indirect materials
B. Indirect labour
C. Indirect expenses

These are incurred in relation to the production activity, in the factory or any place of production.

Production overheads are incurred in relation to the ancillary activities of production. Ancillary activities are activities
other than the actual production activity that are essential for a product to come into existence.

Costs incurred on resources used in production such as

Ø Indirect materials - lubricants for machines, fuel used in a factory

Ø Indirect labour – factory supervisor‟s salary, support technicians‟ wages, material handlers‟ wages
Ø Indirect expenses - factory utilities, factory depreciation, factory maintenance and repairs
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The production cost of cars includes:

A Tyre costs
B Salary of technician engaged in car production
C Wages of foreman for the machinery used
D All of the above

All the indirect materials costs, indirect wages and indirect expenses incurred in a factory are called:

A Production overheads
B Production cost
C Non-production overheads
D Non-production cost

1.7 Distinction between product and period costs in valuation of output and inventories

Finished goods or finished products are products that are complete and ready for sale. Finished goods still in the
warehouse are generally valued excluding period costs such as selling, distribution and administrative overheads
etc. Remember, production costs are product costs and overhead costs are usually period costs. This is the reason
why the finished goods inventory is valued at production costs. The items of costs that are included in the costs of
the finished goods still in the warehouse are called inventoriable costs.

Sometimes period costs incurred within the factory itself may be added to the finished goods inventory cost. This is
because these costs are incurred directly to facilitate production.

The salary of the time-keeper in the factory, who keeps a record of the time spent by the workers at work, is an
administrative cost but is still included in the cost of the finished goods. This is because this cost is spent to facilitate
production.

Closing inventory at the end of the year is valued at production cost since the non-production costs are usually
not yet incurred on this. Non-production costs are charged to the cost of sales of the product only when it is sold.
Costs such as selling and distribution costs will be incurred on the inventory when it is sold. Until the time these are
in finished goods inventory, only production costs form a part of their cost.
 15

Baggy Plc manufactures leather wallets for men. These are made at the factory where the leather is cut and wallets
stitched and finished. The factory office looks after the day-to-day administration of the factory.

The cost of the finished wallets would include the cost of leather (direct material), labour cost for the workers who
stitch the wallets, cost of finishing the wallets, cost of maintaining the machines (direct expense) and production
overhead costs e.g. the costs of machine oil, cleaners‟ wages etc. The cost of the factory administration will also be
a part of the costs of the finished product at this stage.

In this case, the wallets are still in the factory and the selling and distribution costs are not yet incurred since these
are not sold. Hence, selling and distribution costs will not form a part of the cost of inventory.

Non-production costs form a part of the cost of sales only in the period in which these are sold. This is because
these are period costs and are charged in the period in which these are incurred. On the contrary, production costs,
being product costs, always form a part of the cost of the product even when the product is not sold in any particular
period.

The value of the unsold finished goods inventory includes non-production costs.

A True
B False

Direct and Indirect costs

Costs are classified into direct and indirect by nature. The distinction of costs into direct and indirect is necessary
because they need different treatments for cost computation and control. Most cost accounting techniques employed
in decision making also consider this distinction to be essential for cost analysis.

1.8 Classification of costs as direct or indirect (classification of cost by nature)

This classification is based on the principle of traceability of costs to the final product or service.

Cost that can be specifically identified, or traced in full to the product or service, in an economically feasible
manner is a direct cost.

Cost that cannot be specifically identified with a product or a service is an indirect cost.

Potatoes and salt are the direct ingredients in the preparation of potato chips. Costs incurred on these will be direct
costs.

Apart from being easily traceable to the products, the traceability of costs should also be economically feasible for the
costs to be classified as direct. If the traceability is not cost beneficial, a cost that is direct by nature will be classified
as indirect.
16

In the above example of potato chips, it is a difficult and costly affair to trace the amount of oil consumed by each
pack of chips and so it will be treated as an indirect cost. Oil is easily traceable to the chips but still is classified as
indirect cost.

Direct costs consist of all the direct materials, direct labour and direct expenses. Indirect costs consist of indirect
materials, indirect labour and indirect expenses. These are collectively also termed overheads. According to the
functional classification, overheads are classified as administrative, selling, distribution and research and
development costs.
SUMMARY

Direct material cost means a material cost that can be:

A Specifically, easily, or conveniently identified with a cost objective

B Attributed to, or allocated to a cost objective on a rational or logical basis
C Associated with a cost objective as it relates to the production process in general
D All of the above

Direct expenses are those which:

A Can be included in direct material or direct labour

B Are the same as direct material and direct labour
C Are incurred specifically in connection with a product or service
D All of the above

1.9 Classification of cost by nature

Costs are classified by nature as direct and indirect.

2.0 Functional classification of costs

Costs are classified by function as administrative, selling, distribution and research and development.
These are all a part of indirect expenses / overheads.

For the entire organisational activity, these costs are directly taken to the SOPL (statement of profit or loss).

1. Administrative costs

Any cost incurred for the management or administration of the business that includes planning and controlling its
operations, is an administrative cost.
 17

Administrative costs of an organisation include the costs incurred in formulating the policy, directing the organisation
and controlling its activities. In a big organisation, administrative costs are split into two types:

(a) Costs incurred at the factory level that are incurred to provide the staff with administrative support
(b) Costs incurred at head office level that are allocated to the factory

Ø Office rent
Ø Salary of office staff – cleaners, clerks
Ø Electricity and telephone costs of the office
Ø Legal fees, audit fees, insurance expense of office

2. Selling costs

Costs incurred in relation to the sale of a product or rendering of a service and allied activities are known as selling
costs.

A product needs to be marketed and advertised so that the customers are aware of it, thereby creating a demand for
the product in the market. Selling costs include all costs that help the sale of the product in the market place.

Ø Sales promotion expenses, showroom expenses

Ø Advertising costs such as catalogues, banners, brochures
Ø Salaries of sales and marketing personnel, commissions paid to salesmen

3. Distribution costs

Costs incurred for the transport of goods from the factory or depot to the customer and / or the costs incurred for
maintaining the channel of distribution are known as distribution costs.

This cost also covers the cost of recovering and reconditioning empty containers for reuse.

Ø The transportation cost of goods between two points, namely there receipt point of goods from
production and the delivery point to the customer
Ø The insurance cost of the goods between this period
Ø Depreciation on vehicles used for the distribution of goods
Ø Fuel used by vehicles in the distribution department
Ø Repairs and maintenance cost of the above vehicles

4. Finance costs

Costs incurred in relation to the provision of finance to the business, mainly interest costs, are known as
finance costs.

To incur all the previously discussed costs, the business needs a constant flow of money. This includes initial start-up
costs – capital investment, working capital and costs required for the day to day running of the business, expansion
costs – capital investment required for the expansion of the existing activities.
18

The money for these costs is raised by obtaining a loan from the bank or raising capital from the market by issue of
shares and debentures. Finance costs are incurred to meet the working capital as well as long term finance needs of
the organisation. This cost cannot be traced to the individual products, but will have to be allocated using a suitable
base.

Ø Interest paid on a fixed-term loan taken for the construction of a building

Ø Interest paid on a fixed-term loan taken for the purchase of plant and
machinery.
Ø Interest paid to debenture holders

These various types of costs make up the total cost of a product. A cost sheet is the prime document for presenting
the costs according to their function under the traditional absorption system of costing.

Extract of Cost sheet

TZS TZS
Direct material X
Direct labour or direct wages X
Direct expenses X
Prime cost X
Production overheads X
Production or factory or manufacturing X
cost
Administration cost X
Selling and distribution cost X
Cost of sales X
Total cost
X
 19

Diagram 12: Elements of cost

Rent paid for office premises is cost related to:

A Production
B Sales
C Distribution
D None of the above

The salary of marketing personnel is an example of:

A Selling cost
B Distribution cost
C Finance cost
D Research and development cost

2.1 Cost classification by purpose

Costs can be classified based on the purpose of their classification. Moreover, costs may be required for the
purpose of external reporting or internal management use. Based on this, costs are classified as manufacturing
and non-manufacturing or product and period for external reporting and as fixed or variable for management
use. We have seen these classifications in detail in the earlier Learning Outcomes.

Costs for the purpose of decision-making can be classified as follows:

1. Relevant costs: costs pertinent to the making of a specific managerial decision.

2. Differential costs: differences in total cost between alternatives that are calculated to assist
decision making.
3. Opportunity costs: the value of benefits sacrificed when one course of action is chosen in
preference to an alternative.
4. Sunk costs: costs already incurred and not relevant for decision-making.
20

Amber Plc wants to purchase a new machine that will enhance its productivity to 3 times its existing capacity, and
discard the old machine. The purchase cost of the new machine is TZS 50,000,000,000. The old machine was
purchased for TZS 20,000,000,000. There will be a time gap of 1 month until the new machine is installed for
production and hence sales upto TZS 50,000,000 will have to be forgone.

Relevant costs in the above case would be:

Purchase cost of new machine – TZS 50,000,000,000 (relevant since it needs to be incurred in future)

Sunk costs would be TZS 20,000,000,000 (these costs are irrelevant for decision-making since they are already
incurred).

Opportunity costs would be TZS 50,000,000 (cost of opportunity lost due to decision of buying new machine).
Opportunity costs are also relevant costs in this case since they are a direct result of the decision taken.

2. Separate semi variable costs by using high low method [Learning outcome b]

1. High / low analysis

High/low analysis compares the costs at two different activity levels so as to identify the fixed and variable cost
components of the total cost.

Since the fixed element of the total cost is likely to remain unchanged during different periods, changes in
the total costs at two different levels of activity can be attributed solely to the variable elements.

Variable cost per unit is calculated as:

(a) Select the highest level of activity and the lowest level of activity in the given series of data.
(b) The difference in costs during these periods should be divided by the changes in output during the
same periods.
(c) This calculation can be expressed mathematically as follows:

Variable cost per unit = Highest total cost - lowest total cost
Highest units - lowest units

Fixed cost = Total cost (at the highest / lowest level of activity) – (Total units (at the highest /
lowest level) x Variable cost per unit (as calculated above)
Generally the highest and the lowest volumes of production are used to compute the variable cost per unit.

The following data relates to the monthly output and related costs for Only Clean Plc, a soap manufacturing
company.

Output Total Cost (FC

Month (Units) + VC) TZS
‟000
April 10,000 50,000
May 11,000 54,000
June 12,000 58,000
July 13,000 62,000

To separate total cost into the fixed and variable elements, apply the high or low method.

Variable cost per unit = Highest total cost - lowest total cost
 21

Highest units - lowest units

= TZS 62,000,000 - TZS 50,000,000
13,000-10,000
= TZS 4,000 per unit

Fixed cost can be computed by using the following formula:

Fixed Cost = Total high cost – (Total high units x Variable cost per unit)

= TZS 62,000,000 – (13,000 units x 4,000) = TZS 10,000,000

Let‟s check this with the low activity (at 10,000 units)

Total variable cost = Total cost – Fixed cost

= TZS 50,000,000 – TZS 10,000,000

= TZS 40,000,000

Per unit variable cost TZS 40,000,000

10,000,000
= TZS 4,000

A company incurs the following costs at various activity levels:

Activity level Total cost

(units) TZS ‟000
5,000 250,000
7,500 325,000
10,000 400,000

Using the high-low method what is the variable cost per unit?

A TZS 25,000
B TZS 30,000
C TZS 35,000
D TZS 40,000

2. Situations involving stepped fixed cost and changes in variable cost per unit

There are situations where the stepped fixed costs occur along with changes in per unit variable costs.

An organisation has the following total costs at three activity levels:

Activity Total cost

level TZS ‟000
(units)
4,000 38,000
6,000 54,000
8,000 68,000

The variable cost per unit is constant within this activity range and there is a step up of TZS 2,000,000 in the total
fixed costs when the activity level exceeds 5,000 units.

What is the total cost at an activity level of 7,000 units?

Answer
22

There is a step up of TZS 2,000,000 when the activity level exceeds 5,000 units. Hence to calculate the per unit
variable cost, we will have to reduce this amount of step up in the costs. This is because these are stepped fixed
costs occurring due to a change in the activity level and the analysis assumes that the total fixed costs remain the
same throughout the activity period. Hence by deducting the step up in the fixed costs we consider only the pure
increase in the costs due to the increase in variable costs.

Variable cost per unit Highest total cost - Lowest total cost

Highest units - Lowest units

(TZS 68,000,000 - TZS 2,000,000) - TZS 38,000,000

8,000 units - 4,000 units

TZS 28,000,000
4,000

= TZS 7,000 per unit

Fixed costs at the activity level of 4,000 units = TZS 38,000,000 – (4000 x TZS 7,000/unit) = TZS 10,000,000
Therefore, the total cost at the activity level of 7,000 units
= Variable cost + Fixed cost + Stepped up fixed cost
= 7,000 x TZS 7,000 + TZS 10,000,000 + TZS
2,000,000 = TZS 61,000,000

Summer Ltd produces a product, Winter. For 20X3, production was 10,000 units with total costs of TZS 150,000,000.
For the next year, 20X4, the budget is prepared for the production of 15,000 units with total costs of TZS 220,000,000.
The production capacity of the company is 12,000 units per annum. If the company exceeds its limit, its fixed costs
will increase by TZS 20,000,000.

What will be the variable costs per unit?

A TZS 14,000
B TZS 10,000
C TZS 16,000
D TZS 20,000

Answers to Test Yourself

Answer to TY 1

The correct option is A.

Fixed costs remain fixed in a budget period. Although fixed costs remain fixed for a certain period, they do not remain
fixed forever. They may change for each period under study.

Answer to TY 2

The correct option is C.

A stepped fixed cost is one that is constant up to a certain activity level or a certain period, then rises and again
remains constant up to a new level of activity or a new period. It can be compared with stairs that make up a staircase
in that they rise up to a certain height, become flat and then rise again.
 23

Answer to TY 3

Labour cost, material cost and direct expenses vary with each unit produced. They qualify as variable costs.

The rent of the workshop, watchman‟s salary, salary of the administrative staff and floor manager‟s salary will have
to be paid even if there is no production in any month. These are therefore fixed costs.

The statement of cost can now be made as follows:

Statement showing cost of producing 500 chips during the month

Calculations and reasons TZS

Variable costs
Material cost TZS 20,000 x 500 chips
10,000,000
Labour 2.5 hrs/chip x TZS 10,000/hour x 500 chips
12,500,000
Direct expenses TZS 5,000 x 500 chips 2,500,000
(a)Total variable cost 25,000,000

Fixed costs
Rent of workshop Monthly rent 1,000,000
Watchman‟s salary Monthly salary
1,000,000
Administrative staff salary Monthly salary
2,500,000
Salary of floor manager Monthly salary
(b)Total fixed cost 2,500,000
Total cost (a + b) TZS 25,000,000 + TZS 7,000,000
7,000,000

32,000,000

Answer to TY 4

The correct option is D.

Telephone charges include certain fixed charge (rental) plus per unit usage charges based on the time spent making
calls. Often in the case of internet charges, there is a fixed minimum charge plus a variable charge based on actual
usage or downloading. Vehicle hire charges also include a fixed minimum charge plus a variable charge based on
actual running of the vehicle.

Answer to TY 5

The correct option is B.

Semi-fixed costs contain fixed and variable elements. Because of the variable element, they fluctuate with volume
and because of the fixed element they do not change in direct proportion to output. These costs change in the same
direction as that of the output but not in the same proportion. For example depreciation for operating two shifts may
be only 50% more than that for a single shift. It may change with comparatively small changes in output but not in the
same proportion.

Answer to TY 6

The correct option is B.

24

The salary paid to the security guard of the office premises will be a period cost. This is because he guards the office
premises and is not a part of the production activity

Answer to TY 7

The correct option is A.

Cost incurred for purchasing materials for the main product will always be product cost. Fixed cost is one of the
elements of cost, routine cost is regular cost and management cost is incurred for overall administration and
management of the organisation (qualifies as period cost).
Answer to TY 8

The correct option is D.

Production cost includes all direct material cost, direct labour and direct expenses. The tyre cost, technician‟s salary
and wages of foreman satisfy the criterion of production costs. As such they all are a part of the production costs.

Answer to TY 9

The correct option is A.

All these costs are a part of production overheads. Production cost includes all costs related to production.
Nonproduction costs and overheads are related to activities outside the factory until the products are sold.

Answer to TY 10

The correct option is B.

The cost of unsold finished goods in the closing inventory as valued at the factory gate does not include nonproduction
costs such as the overheads of selling, distribution, administration, research and development and finance costs.
These are charged to the finished goods inventory only in the period when these are sold.

Answer to TY 11

The correct option is A

Direct cost is specifically and easily identifiable with the cost object. Direct material cost is not allocable; it is identifiable
with a cost objective or cost unit. Direct material cost is not related to the production process in general but is
specifically identifiable with the product.

Answer to TY 12

The correct option is C.

These are called direct expenses because they are directly attributable to production or service provision i.e. incurred
in such a way that their benefit can be easily visualised in a product and form a substantial part of the total direct
costs. Direct expenses are separately identifiable and cannot be included in direct material or direct labour costs and
can be distinguished from them.

Answer to TY 13

The correct option is D.

It is an administration cost, which is the cost of managing a business activity. It is neither production, nor sales, nor
distribution expense.

Answer to TY 14

The correct option is A.

Marketing personnel help in selling the product, hence it is a selling cost. Distribution cost is an expense incurred from
the time production is complete until the goods reach the final consumer. Finance cost is the cost of financing the
business. Research and development cost is incurred for improving the quality of a product or inventing new methods
of production.
 25

Answer to TY 15

The correct option is B.

Highest total cost - Lowest total cost

Variable cost per unit =
Highest units - Lowest units
= TZS 400,000,000 - TZS 250,000,000

10,000 - 5,000
TZS 150,000,000

5,000
= TZS 30,000 per unit

Answer to TY 16

The correct option is B.

There is a step up of TZS 20,000 in fixed costs, when the activity level exceeds production capacity of 12,000 units.
Hence, to calculate the per unit variable costs, we will have to reduce this amount of step up in the costs.

Highest total cost - Lowest total cost

Variable cost per unit
Highest units - Lowest units

(TZS 220,000,000 - TZS 20,000,000) - TZS 150,000,000

15,000 units - 10,000 units

TZS 50,000 ,000

5,000 units
= TZS 10,000/unit

Self-Examination Questions

Question 1

Production employees‟ work directly on the goods being manufactured, their labour costs are recorded as:

A Direct expenses
B Direct labour
C Indirect labour
D Manufacturing overhead

Question 2

A person gets payment in the form of fixed salary of TZS 750,000, commission based on productivity of TZS 300,000
and an annual bonus of TZS 250,000. What is the total direct labour cost?

A TZS 250,000
B TZS 750,000
C TZS 300,000
D TZS 1,050,000

Question 3

Primary packing materials, such as wrappers and cartons, are known as:
26

A Indirect expenses
B Indirect material
C Direct material
D Direct expenses

Question 4

Direct expenses should be considered part of:

A Product cost
B Period cost

Question 5

The maintenance cost of office building forms a part of:

A Direct expenses
B Selling and distribution cost
C Indirect expenses
D Administration cost

Question 6

Excise duty paid is an example of:

A Direct material
B Selling cost
C Direct expense
D Factory overhead

Question 7

Find the production cost per unit from the following details. The total number of units manufactured is 500. All the
units are sold during the year. Assume that there is no opening and closing inventory.

The cost per unit is as follows:

TZS
Materials 1,500,000
Direct wages 1,200,000

Indirect material 500,000

The total costs incurred are as follows:

Indirect wages TZS

500,000
Administration overheads TZS
345,000
Selling and distribution overheads TZS 202,500

A TZS 3,200,000
B TZS 2,700,000
C TZS 5,295,000
D TZS 4,200,000

Question 8

Sun Co produces a product, M. For each unit of product M, it requires 1kg of material A and 2 kg of material B. The
market prices of materials A and B for the current year are TZS 1,500 and TZS 2,000 per kg respectively. Next year,
the price of material A will increase by 10%, while the market price of B will remain as it is. If Sun Co wants to produce
5,000 units of product M next year, calculate the total price of direct materials.
 27

A TZS 8,250,000
B TZS 20,000,000
C TZS 28,250,000
D TZS 15,000,000

Question 9

Which of the below can be an example of a stepped fixed cost?

A Machine maintenance where beyond an output level an additional machine is needed to produce more
B Telephone and electricity charges
C Annual factory rent and insurance
D All of the above

Question 10

Which of the below could be examples of fixed costs?

A Rent of office or factory premises

B Insurance of current and non-current assets
C Repairs and maintenance according to the annual maintenance contract
D All of the above

Question 11

Which of the below could be examples of variable costs?

A Plywood used for making tables

B Cement and other materials per square metre of building construction
C Concrete used per square metre of a road
D All of the above

Question 12

Which of the following statements is incorrect?

A Semi-variable cost is a mixture of fixed and variable components

B The per unit variable cost changes in direct proportion with change in output
C Non-linear cost changes disproportionately with change in output
D Fixed cost remains the same regardless of the amount of product the company makes or sells

Question 13

Find the production cost per unit from the following details. The total number of units manufactured is 500, and all the
units are sold during the year. Assume that there is no opening and closing inventory.

The cost per unit is as follows:

TZS ‟000
Materials 1,500
Direct wages 1,200
Indirect material 500
28

The total costs incurred are as follows:

TZS ‟000
Indirect wages 500,000
Administration overheads 345,000
Selling and distribution 202,500
overheads

A TZS 3,200,000
B TZS 2,700,000
C TZS 5,295,000
D TZS 4,200,000

Question 14

Beautiful Plc is a cosmetic manufacturing company. The costs incurred at three different production levels are given
below.

Production (make-up Total cost TZS ‟000

kits)
22,000 240,000
26,000 270,000
30,000 300,000

Find out the total fixed cost and variable cost per make-up kit using high / low analysis.

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

The wages of the shop floor employees form a part of the cost of labour employed. Direct expenses are the repairs
and maintenance charges at the factory; indirect labour is the foremen and maintenance staff. Manufacturing
overheads are the expenses incurred for the activities other than production in the factory.

Answer to SEQ 2

The correct option is D.

The direct labour expenses are the fixed salary and the commission. The bonus is generally treated as an indirect
expense. Hence the total direct labour cost = TZS 750,000 + TZS 300,000 = TZS 1,050,000.

Answer to SEQ 3

The correct option is C.

Primary packing is essential for the goods to be complete. As such it forms a part of the direct materials. Indirect
material is the material that does not form a part of the final product. Direct and indirect expenses are the expenses
other than material costs.

Answer to SEQ 4
 29

The correct option is A.

Direct costs are all costs incurred in direct relation to production activity.

Answer to SEQ 5

The correct option is C.

Indirect expenses are those expenses which cannot be directly and conveniently allocated to cost units. For example
rent and insurance of factory, depreciation, repairs and maintenance of machinery, building etc.

Answer to SEQ 6

The correct option is C.

Excise duty is a cost that can be identified with the product.

Answer to SEQ 7

The correct option is D.

Production cost per unit is TZS 4,200,000.

Cost sheet

Per unit (TZS Total costs (TZS

‟000) ‟000)
Materials 1,500 750,000
Direct wages 1,200 600,000
Prime cost
2,700 1,350,000
Indirect materials
500 250,000
Indirect wages (W1) 1,000 500,000
Production cost
4,200 2,100,000
Administration overheads (W2)
690 345,000
Selling and distribution overheads 405 202,500
(W3)
5,295 2,647,500
Cost of sales / Total costs

Workings

W1 Per unit indirect wages = Total indirect wages/Units produced

= TZS 500,000,000/500 units
= TZS 1,000,000
Note: administration overheads and selling and distribution overheads are period costs.

W2 Per unit administrative costs = Total administrative costs/Units produced

= TZS
345,000,000/500 units
= TZS 690

W3 Per unit selling and distributive costs = Total selling and distributive costs/Units produced
= TZS 202,500,000/500 units
= TZS 405

Answer to SEQ 8

The correct option is C.

30

For one unit of M, 1kg of material A and 2 kg of material B are required.

Hence, to produce 5,000 units of M, 5,000 kg of material A and 10,000 kg of material B are required

Cost of material A = (5,000 kg x TZS 1500) + 10% price

increase = 7,500,000 + 750,000
= TZS 8,250,000

Cost of material B = 10,000 kg x TZS 2,000

= TZS 20,000,000

Hence, the direct materials for product M will cost TZS 28,250,000 (TZS 8,250,000 + TZS 20,000,000).

Answer to SEQ 9

The correct option is A.

Machine maintenance cost is a stepped fixed cost, where beyond a certain output level an additional machine is
needed to produce more. Telephone and electricity charges are semi-variable because they exhibit cost behaviour of
both fixed and variable components. Annual factory rent and insurance are fixed costs. These do not depend on
output, but remain unchanged irrespective of the output level.

Answer to SEQ 10

The correct option is D.

All the instances given pertain to expenses that do not change or vary with respect to the overall activity level. In other
words, these costs are incurred irrespective of whether operations are in progress or not.

Answer to SEQ 11

The correct option is D.

Plywood will be the main ingredient (in terms of cost and volume) of a table. Its quantity will be fixed per table and
therefore, will vary with the number of tables made. Cement and concrete used in building and road construction
projects do not change per square metre but depend on the size of the building or road area respectively.

Answer to SEQ 12

The correct option is B.

Semi-variable or semi-fixed cost contains an element of both fixed and variable cost. Variable cost per unit is constant
but the total variable cost changes depending on the levels of output. Non-linear or curvilinear variable cost changes
disproportionately with change in output. Fixed cost is independent of the volume of product the company produces
or sells.

Answer to SEQ 13

The correct option is D.

Production cost per unit is TZS 4,200,000.

 31

Cost sheet

Per unit (TZS Total costs (TZS

‟000) ‟000)
Materials 1,500 750,000
Direct wages 1,200 600,000
Prime cost 2,700 1,350,000
Indirect materials 500 250,000
Indirect wages (W1) 1,000 500,000
Production cost 4,200 2,100,000
Administration overheads (W2) 690 345,000
Selling and distribution overheads 405 202,500
(W3)

Cost of sales / Total costs 5,295 2,647,500

Workings

W1 Per unit indirect wages = Total indirect wages/Units produced

= TZS 500,000,000/500 units
= TZS 1,000,000

Note: administration overheads and selling and distribution overheads are non-production costs.

W2 Per unit administrative costs = Total administrative costs/Units produced

= TZS 345,000,000/500 units
= TZS 690,000

W3 Per unit selling and distributive costs = Total selling and distributive costs/Units produced
= TZS 202,500,000/500 units
= TZS 405,000

Answer to SEQ 14

Highest total cost - Lowest total cost

Variable cost per unit
Highest units - Lowest units

TZS 300,000,000 - TZS 240,000,000

30,000 - 22,000
TZS 60,000,000

8,000
= TZS 7,500 per kit

Fixed Cost = Highest total cost – (Highest units x Variable cost per unit)
= TZS 300,000,000 – (30,000 x TZS 7,500)
= TZS 300,000,000 – TZS 225,000,000
= TZS 75,000,000
32

SECTION A
COSTING
A2
SECTION A2: ELEMENT OF COSTING AND COST
STATEMENT

Materials, labor and overhead costs are the three major components of any product or services costs. A thorough
understanding of these is essential to arrive at the correct total cost of a product or service. Materials and labour
always form a part of direct costs of a product, and overheads are indirect expenses but an essential component of
total costs.This Study Guide introduces the concepts of managing materials, calculation of labour costs, relating them
to products and calculations of various overhead absorption rates. A thorough understanding of these concepts will
help you as a management accountant in efficiently managing raw materials and labour costs and controlling
overhead costs.

a) Explain and distinguish between direct and indirect costs of labour and material.
b) Relate input labour cost to work done.
c) Explain the difference treatment of direct and indirect costs.
d) Identify and explain the importance of material costs.
e) Explain the procedures involved in determining production overhead absorption rates.
f) Explain the under and over absorption of overheads.
g) Prepare cost statement and show prime, production and total costs.
 33

1. Explain and distinguish between direct and indirect costs of labour.

[Learning Outcome, a]

1.1 Direct and indirect labour costs

Like materials, labour costs are also an equally important and major part of product costs. Labour costs are recorded
separately as direct and indirect labour costs. The basis of the classification of labour costs as direct and indirect is:

• Labour costs directly identifiable with the production of products, rendering of services or completion of jobs
are direct labour costs.

• Labour costs that are not readily identifiable with the production of products, rendering of services or
completion of jobs are indirect labour costs.

The following table distinguishes between direct and indirect labour costs

Direct labour cost Indirect labour cost

Any labour cost that is specifically Any labour cost which is not directly incurred or cannot
incurred for or can be readily charged be readily chargeable or identifiable with a product or
Definition
to or identified with a product or a service is an indirect labour cost.
service is a direct labour cost.
It is directly charged to:

• specific job or It is not directly charged to a product / service or to a

Allocation,
job. Instead, this cost is assigned to a product / service
apportionment or • contract work or
• any other cost objects or to a job on a suitable basis, such as no. of machine
absorption
For example, in a clothes factory, the set-ups, no. of labour hours, no. of inspections, etc.
cost object would be a unit of clothing
produced
Labor costs for cutting wood to make a Labour cost incurred for packing and dispatching the
table. tables for sale.
Although these workers are not directly involved in the
production of the tables, they provide essential
Examples support services.

Labor cost for a call center operator Computer technicians in a call center do not provide a
taking calls from clients. direct service to clients, but they are important in the
operation
Labour that is indirect in one industry may be direct in
another industry, due to different methods or process
of work.
Example of an indirect labour is a courier boy
Labour that is direct in one industry
may be indirect in another industry, due (who delivers and receives courier
to different methods or process of documents) in a „credit processing division‟ of a bank
work. (as he is not involved in any direct banking work).
Example of direct labour is a courier
Direct or indirect boy working in a courier agency whose
is a relative term main job is sending and receiving It also includes bonus payments, idle time payment,
sick leave payment, contribution to employers‟
couriers. national insurance fund, etc.

It mainly includes basic pay of direct It also includes overtime premium. However, overtime
workers. premium paid for jobs done at special request of
customers is a direct labour cost.
34

Direct labour is a part of prime cost.

Place in the cost Prime cost consists of direct material, Indirect labour is a part of factory overheads and
sheet direct labour and direct expenses that eventually becomes a part of “cost of production”.
are necessary for making a product.

Direct labour cost:

Is the effort of employees who transform direct materials into a finished product and is physically traceable to the
finished goods or services

A Is allocated to the product using a suitable base

B Does not alter the construction of the product but generally contributes to such work
C D Forms part of factory overhead

2.Relate input labour costs to work done. [Learning Outcome b]

2.1 The methods used to relate input labour costs to work done

1. Direct charging of direct labour cost

Direct labour cost is charged directly to the product, process or job. It is charged for the work done on an hourly basis
or per unit basis. On an hourly basis, the cost per unit is calculated based on the number of labour hours consumed
by the product. On a per unit basis, the cost is charged at the rate applicable.

A software firm is working for its client to develop debugging software called “Fighter”. 10 employees worked for 8
hours a day for 25 days for the “Fighter” project. The labour hour rate is given as TZS 20,000. The total direct labour
cost will be 10 (employees) x 8 (hours a day) x 25 (days) x TZS 20,000 = TZS 40,000,000 The whole of this TZS
40,000,000 will be charged directly to the project since it consumed 2,000 man hours (8 hours x 25 days x 10
employees) at the rate of TZS 20,000 / hour.
 35

2 Allocation and apportionment of indirect costs on a suitable basis

.

Any indirect labour cost is added to factory overheads and suitably absorbed / apportioned to the product, process
or job.

Generally, indirect labour cost is caused by the direct labour hours that are put into any activity e.g., as production
increases, supervision (indirect labour) costs also increase along with direct labour cost. Therefore, generally, the
indirect labour cost is assigned to the output as a percentage of direct labour hours consumed.

In an umbrella manufacturing company, the direct labour hour rate is TZS 12,000. The indirect labour rate is 35% of
the direct labour hour rate. The indirect labour rate will therefore be TZS 12,000 x 35% = TZS 4,200.

Direct labour here consists of people who manufacture umbrellas, whereas indirect labour would be involved in the
packing and transportation of these to the retailer for sale. As the number of hours worked by direct labour increases
and more umbrellas are produced, indirect labour would also have to put in more hours of work. This clarifies that
indirect labour is caused by direct labour.

The procedure of allocation and apportionment of indirect labour costs is exactly the same as any other overheads.

What is the method of charging indirect labour cost?

A Charging it to the product directly

B Allocation and absorption on a suitable basis

C Direct allocation to the product and service

D None of the above

3. Explain the different treatment of direct and indirect costs. [Learning Outcome c]

3.1 Classification of direct and indirect costs

Direct costs i.e., direct material, direct labour and direct expenses are those that can be easily traced to the physical
units produced.
36

The direct materials consumed for a particular job can be identified from the material requisition note and the direct
labour cost to be charged to the job can be traced from the summaries of work tickets.

The work ticket (alternatively called the time card) indicates the time spent on a specific job by a labourer. Recording
the work tickets can be done either manually or electronically.

On the contrary, by their very nature, indirect (overhead) costs cannot be specifically traced to physical units
produced. However, the making of goods would be impossible without incurring such overhead costs.

In the production of an exercise book, the amount of paper used can be easily traced to the product from the material
requisitions. The cost of paper is hence a traceable cost. The machine that is used to bind the exercise book
undergoes wear and tear each day. The depreciation of the machine is also a cost involved in the manufacture of
notebooks. This cost however, cannot be easily traced to the product. Therefore, this will be an indirect (overhead)
cost of the product.

Overhead (i.e., indirect) costs include depreciation, fuel, heating, lighting, material handling, repairs, property taxes,
cost of services facilitating the day-to-day operations etc. that are essential for any production activity. Since these
costs are not easily traceable to the products, they need to be assigned to the products on a suitable, predetermined
basis.

The rates for assigning the indirect costs to the products are determined on the basis of the budgeted figures that
are calculated at the start of an accounting period. This assignment of the indirect costs to the products is known as
the allocation and apportionment of overheads, which we will learn in Learning Outcome 3.

Considering the above example of producing an exercise book, the paper cost (the direct material cost) will be
directly charged to the product; the printed material or book. The depreciation of the printing machine will be assigned
to the book using a suitable basis.

Diagram 4: Treatment of direct and indirect costs

 37

According to their function and on the basis of their origin, overheads are classified as:

1. Production, manufacturing, or factory overheads

2. Non-manufacturing overheads

(a) Administrative overheads

(b) Selling and distribution overheads

(c) Research and development overheads

3.2 Treatment of manufacturing and non-manufacturing overheads

The overhead absorption rates are arrived at using a two stage procedure:

1. Departments (more specifically cost centres) accumulate their costs.

2. The costs of the department are applied to the physical units (or any other measure of output) that pass
through the departments. This step is called overhead absorption.

Manufacturing overheads are always absorbed by products on the basis of machine hours or labour hours.
Nonmanufacturing overheads are absorbed as a percentage of manufacturing overheads.

In a bottling plant, overhead costs e.g. the costs of oil and lubricants for the bottling machine, are indirect materials
that will form a part of factory costs. These are the costs incurred in the factory.

The transport cost for carrying the bottles from the bottling plant to the market for sale is an indirect distribution cost
which will be a part of the cost of sales. This cost is incurred once the finished products leave the factory.

The segregation of the costs into direct and indirect is also essential from the management‟s point of view as it helps
in controlling costs.

Alan Plc manufactures leather purses. The major raw materials required are leather, dyes and high quality threads.
Apart from these, it needs sewing machines to sew the purses and also workers who will sew them. These
machines need a lot of maintenance. The cost sheet of Alan Plc is given below:

Extract from cost sheet of Alan Plc

TZS ‟000
Direct materials
Leather 400
Dyes 250
Threads 100
Direct labour 400
Prime cost 1,150
Machine maintenance 400
1,550

The above extract from the cost sheet shows all the expenses split under different headings. If, in any month, the
total costs increase or decrease, then management can investigate this difference immediately by looking at the
monthly cost sheets. This helps management take corrective steps to control the costs.
38

The line of demarcation between direct and indirect costs is very thin, as direct costs in one industry may be indirect
costs in another.

Ink cartridges and paper are direct materials in the printing business. The cost of these will be direct material costs.

The same ink and paper are an administrative overhead expense in an automobile spare parts manufacturing
company, where they are used only for record-keeping in the accounts department. Accounts writing is a secondary
activity compared to the main activity of manufacturing.

Why do indirect costs need to be apportioned to products?

A Because they are incurred only once.

B To avoid double charging of the same costs.

C Because they are incurred by all the cost centres in common and not by any single cost centre separately.
D None of the above.

5. Procedures involved in determining production overhead absorption rates.

[Learning Outcome e]

This is a two stage procedure involving the accumulation and then the application of overhead costs to the products
produced. There are two types of cost centres where overheads are incurred: the production cost centre and the
service cost centre. The actual processing and manufacture of the product takes place in the production cost centre
whereas service cost centres provide services to the production cost centres.
 39

The first stage is where the accumulation of overheads occurs, according to the department. The total overheads
are allocated and apportioned to the production and service cost centres. Thereafter, in the second stage, these
costs are applied to the products that are processed in these cost centres.

5.1 Classification of overheads

The first step is to classify the overheads. Overheads can be This is discussed in detail in
classified according to their function. Another classification can be SG 1, Learning outcome
4.
made on the basis of variability i.e. fixed and variable overhead costs.

Administrative overheads– cost of book-keeping

Fixed overheads – factory rent, staff salaries

Variable overheads – cost of lubricating oil for machines

Production overheads – salary of the factory supervisor, foremen and tools cost.

5.2 Codification of overheads

Once the overheads are classified, they need to be codified (i.e., coded into categories). Codification is done as it
helps in recording the costs. Once the overheads are classified, they are given „standing order numbers‟ that are
listed in a schedule. All of these are now recorded in computer files in pre-designed packages that assist in the
accounting function.

5.3 Allocation and apportionment of overheads

Once the classification and codification of the overheads is complete, the accumulation of overheads is the next step.
This is the first stage in the two-stage process of calculation of the absorption rates. The overhead costs are collected
from various records such as financial accounts, cost records and so on.

Costs are accumulated for each cost centre. The costs are either allocated or apportioned to the cost centres.
Whenever the overhead costs can be assigned to the cost centres on an accurate basis, the costs are allocated to
the cost centres. Allocation is performed only when we can precisely assign the costs to a cost centre.

Large organisations provide canteen facilities for their employees. If the organisation has a system of coupons against
which food is served, then the costs of the canteen can be allocated to the various departments / cost centres on the
basis of the coupons submitted by the workers in each department.

This is a case of allocation of canteen costs as we have an accurate basis on which to allocate the costs. Coupons
are an accurate basis as each coupon has a value that can give us a clear idea of the cost of food consumed by
each department.

Apportionment of costs to the cost centres is performed when we do not have a precise basis to assign the
overheads to the cost centres. In this case we generally apportion the costs using the most suitable basis available.
40

Consider the canteen example above. If the organisation does not have a coupon system, then it will not be in a
position to accurately calculate the cost of food consumed by each department. In this case, we will take the most
suitable basis for assigning the canteen costs to various departments. We will take the number of people in each
department as the basis to assign the canteen costs to each department.

The method of apportionment of costs is used when the basis is not accurate. This is the most suitable method
available that can give us reasonable assurance that the costs are not apportioned wrongly.

Cost allocation refers to the charging of identifiable /traceable indirect cost items to either cost centres or cost
units. Cost apportionment involves division of costs amongst two or more cost centres or cost units in proportion
of the expected benefit gained.

Allocation and apportionment of overheads assigns the entire overheads to production and service cost centres.

We still need to re-distribute the service cost centre overheads to the production cost centres. This is because service
centres provide services to the production cost centres. Hence the production cost centres have to bear the cost of
these services. This is called re-apportionment of overheads, since the overheads once apportioned to the service
cost centres are again re-apportioned to the production cost centres in this stage.

In a factory which makes plastic goods, the production department is involved in the actual moulding and finishing of
the plastic goods. The stores department does the work of receiving material requisitions and satisfying them. This
is a service provided by the stores department to the production department.

If, in the first stage of apportionment, the stores department is apportioned a TZS 400 electricity cost then this cost
will be again re-apportioned on a suitable basis to the production department. One may take as a basis the number
of requisitions received from the production department.

5.4 Calculation of overhead absorption rates

Once the apportionment and the re-apportionment of the overheads are complete in the first stage, all the overheads
are allocated and apportioned to the production departments. These are now to be assigned to the products. This is
the stage where the overhead absorption rates are calculated.

Once we have the pool of overheads allocated and apportioned to the production departments, we need to divide
these by the total number of a suitable unit. The most commonly used unit is a machine hour or a labour hour.

The above procedure provides us with the rate per machine hour / labour hour (or any other unit used). When this
rate is multiplied by the number of machine hours or labour hours consumed by each product, the amount of
overheads to be assigned to each product is obtained.

Suppose the total machine maintenance cost allocated to a production department is TZS 120,000,000 and the
machine hours recorded in the department are 6,000. The machine maintenance will be assigned to the products on
the basis of machine hours required per product as this is the most suitable basis.
 41

The overhead absorption rate will be calculated as = TZS 120,000,000/6,000 machine hours

= TZS 20,000 per machine hour.

If one unit of a product processed requires 5 machine hours then the overheads to be assigned to the product will
be calculated as

Overhead absorption rate x number of machine hours consumed by the product =

TZS 20,000 x 5 hours

= TZS 100,000

In conclusion, the amount of overheads assigned to the product will be TZS 100,000. This represents all the indirect
costs which have gone into making that product.

The detailed procedure for determining the individual rates of absorption of overheads for each department can
be summarised as follows:

(a) Allocate and apportion the total amount of overhead expenses incurred to the production and service cost
centres.

(b) Reapportion the service cost centre overheads to the production cost centres.

(c) Calculate separate overhead rates for each production cost centre. (d) Assign cost-centre overheads to
products.

Diagram 5: Allocation, apportionment and absorption of overheads

42

In the two-stage procedure of calculation of the overhead absorption rates the overheads are first:

A Apportioned to the service centres.

B Allocated to the departments or cost centres. C Re-apportioned to the

production centres.
D Assigned directly to the products.

(a) Blanket overhead absorption rate

Blanket overhead rate is a single overhead recovery rate calculated for all the departments. organisation.

Blanket overhead absorption rate Total budgeted overheads for entire factory for the period
Total budgeted labour hours or machine hours

The allocation basis is normally taken as machine hours or labour hours as these are the most appropriate
allocation bases.

This method of overhead absorption is suited to single product industries that have uniform cost structures in all
production departments. This is because the overhead rates are the same for all the products processed in every
department.

Manney Plc operates two production departments, the details of which are given below. Calculate a single overheads
recovery rate for the overheads.

Production dept. chairs Production dept. tables Total

Budgeted overheads TZS 140,000,000 TZS 200,000,000 340,000,000
Budgeted labour hours 20,000 50,000 70,000

Total overhead
The blanket overhead rate Total labour hours

=
TZS 4,857 per labour hour

The overhead rate as calculated above is used for all the products that are produced in the period.

If the products undergo different processes and consume different quantities of resources e.g. machine hours or
labour hours (the allocation bases), then this method will not hold true. Here, the departmental overhead rate will
have to be computed, meaning each department has a separate overhead absorption rate.
 43

(b) Departmental overhead absorption rates

Departmental overhead rate is a separate overhead rate calculated for each department according to the nature
of work carried out in each department.

The budgeted overheads are divided by the budgeted machine hours or labour hours or any other suitable allocation
basis to arrive at an absorption rate for each department.

Departmental overhead absorption rate Overheads for respective department

Labour hours or machine hours for that department

Continuing the example of Manney Plc,

Let us calculate a separate overhead rate for the chair and table departments:

Overhead absorption rate for Chair dept and Table dept

Chair dept. Overheads of department

Labour hours of department

TZS 140,000,000
20,000

= TZS 7,000

Table dept. Overheads of department

Labour hours of department

TZS 200,000,000
50,000
= TZS 4,000

In this case if a certain product does not pass through one of the departments then the overheads for that department
will not be charged to that product at all.

Departmental overhead absorption rates are preferred where the machine hours as well as labour hours consumed
are different for different departments. These rates are calculated according to different working conditions in each
department. It is a very logical method of charging overheads in multi-product organisations where each product
does not pass through all the departments.

Stitch Plc manufactures ready-made formal shirts as well as t-shirts. The formal shirts pass through three
departments A, B and C while the t-shirts pass through only two departments A and C. The departmental overhead
absorption rates are TZS 500 for department A, TZS 8,000 for department B and TZS 500 for department C. The
44

total labour hours consumed by each t-shirt are 5. One t-shirt requires 3 hours in department A and 2 hours in
department C.

According to the departmental overhead rate method the overheads allocated will be:

= (departmental overhead rate for department A x hours in department A) + (departmental overhead rate for
department C x hours in department C) = (TZS 500 x 3 hours) + (TZS 500 x 2 hours)

= TZS 1,500 + TZS 1,000

= TZS 2,500

We can observe here that the t-shirts would have to bear an unnecessary burden of extra overheads from department
B under the blanket rate method. In reality, they only pass through departments A and C and as a result, need only
bear the proportion of overheads incurred in these departments.

The departmental overhead rates are calculated using different allocation bases such as:

(i) Direct labour hours

(ii) Machine hours

(iii) Percentage of direct material cost

(iv) Percentage of direct labour cost

(v) Percentage of prime cost

(i) Direct labour hour rate

Under this method, direct labour hours consumed in the department are taken as the basis for charging
overheads. According to this method, the absorption rate is calculated by dividing the overheads allocated and
apportioned to a department by the number of labour hours consumed by the department.

Labour hour rate Total overheads allocated / apportioned

Direct Labour hours worked

The overheads allocated to the production department amount to TZS 10,000,000 and the direct labour hours utilised
are 5000. The overhead absorption rate will be calculated as:

TZS 10,000,000
Overhead absorption rate =
5000

TZS 2,000 per hour

If one unit of output consumes 1.5 labour hours, then the overheads absorbed by the product will be = TZS 2,000
per hour x 1.5 hours per unit = TZS 3,000

This method is a scientific method as a majority of the overhead expenses are related to the labour time. This is a
perfect method for typically labour-driven industries. Most overhead expenses are generally incurred on this
resource. These include welfare expenses, canteen expenses etc. This method therefore qualifies as the most logical
method for computation of the overhead rate.
 45

(ii) Machine hour rate

Under this method, the products absorb overheads on the basis of machine hours consumed for production. The
absorption rate is calculated as:

Amount of overhead
Machine hour rate
Machine hours consumed in the department

The overheads allocated to the production department for the month are TZS 25,000,000 and the machine hours
consumed are 2,500,000. The absorption rate will be calculated as:

TZS 25,000,000
Overhead absorption rate

2,500
TZS 10,000 per machine hour

If one product consumes 2 machine hours for production, the overheads absorbed for the product will be = 2 hour x
TZS 10,000 per machine hour = TZS 20,000

Machine hours are generally used as an allocation basis for assigning overheads to products, by highly mechanised
industries. Labour is very sparingly used in these industries. It appears more logical to use this basis, as most of
the overheads such as depreciation, insurance, repairs, power etc. are machine-related overheads in such industries.

Car manufacturing units are fully automated and produce cars with minimum human involvement. Using the machine
hours as the basis for overhead absorption in this case is a logical way to assign overheads to products.

(iii) Direct material cost percentage rate

This method takes the cost of the direct material consumed by the department as an allocation base to calculate
the overhead rate. It is expressed as a percentage, calculated as:

Amount of overhead
Direct material cost percentage rate x 100
Direct material cost

If the overheads for the production department in the organisation are TZS 20,000,000 and the direct material cost
in the department is TZS 80,000,000 then the direct material percentage rate is worked out as follows:

TZS 20,000,000
Overhead absorption rate x 100= 25%

TZS .80,000,000
46

As a result, if the material consumed per unit is TZS 100,000, the overhead assigned for one unit will be = 100,000
x 25% = TZS 25,000

This method of allocation is generally preferred when the material cost is the most important component of the
total cost of a product. However it is not a widely used method.

(iv) Direct labour cost percentage rate

The direct labour cost incurred in the department is taken as the basis of allocation for calculating the overhead
recovery rate under this method. This method is different from the labour hour rate method as it uses the labour cost
instead of the labour hours to charge the overheads to the products. It is calculated as:

Amount of overhead
Direct labour cost percentage rate x 100
Direct labour cost

Overhead costs allocated to the production department are TZS 7,000,000 and direct wages incurred are

TZS 35,000,000

TZS 7,000
Overhead absorption rate x 100 = 20%
TZS 35,000
If the direct labour cost of a product is TZS 100,000 the overheads absorbed by the product will be = 100 x
20% = TZS 20,000.

The direct labour cost percentage method is beneficial when the department is labour intensive and the labour
cost is the most important component of the total cost.

(v) Prime cost percentage method

Prime cost is the total of the direct material cost, direct labour cost and direct expenses. Overheads form a part of
the costs that are added to the prime cost of the product. The prime cost percentage method absorbs the overheads
as a percentage of the prime cost of the product. It is calculated as:

Amount of overhead
Prime cost percentage rate x 100
Prime cost

The overheads incurred in the production department are TZS 10,000,000 and prime cost for the cost centre is

TZS 100,000,000.

TZS 10,000,000
Overhead absorption rate x 100= 10%
TZS 100,000,000

The overheads absorbed in a product whose prime cost total is TZS 100,000, will be = TZS 100,000 x 10% = TZS
10,000
 47

The monthly budget of the production department of Amazing Plc is as follows:

Direct material TZS 45,000,000

Direct wages TZS 60,000,000
Overheads TZS 90,000,000
Direct labour hours 15,000
Machine hours 30,000

Calculate the overhead recovery rate based on at least five different possible methods of absorption of overheads.

Bingo Ltd has two departments: X and Y. The information given below is extracted from its cost records for January
20X3:

Machine hours Overheads

Department (TZS ‟000)
Budgeted Actual Budgeted Actual
X 12,000 11,500 24,000 28,000
Y 35,000 37,000 63,000 64,500
47,000 48,500 87,000 92,500

Budgeted production 38,000 units

Actual production 35,000 units

Calculate:

(a) Blanket overhead absorption rate

(b) Departmental overhead absorption rate

(c) Actual overhead absorption rate

(d) Pre-determined overhead absorption rate

6. Explain Under and over absorption of overheads.

[Learning Outcome
f]
48

Pre-determined overhead absorption rates are calculated by dividing the budgeted overheads by the budgeted units.
However, these figures are subject to change.

Suppose the budgeted units are 200 and budgeted overheads are TZS 400,000. In this case the pre-determined
overhead recovery rate will be TZS 400,000/200 = TZS 2,000 per unit. If the actual overheads amount to TZS 420,000
and the units produced are 230 then the actual overhead rate will be TZS 420,000/230 = TZS 1,826.09 per unit.

The overheads under the normal costing procedures are absorbed on the basis of the pre-determined overhead
absorption rates. In the above case, if the overheads are absorbed in the units produced on the basis of the pre-
determined absorption rates the overhead cost of the actual units will be = 230 units x TZS 2,000 per unit = TZS
460,000

Overheads Rate
(TZS )
Actual TZS 420,000 TZS 1,826.087 per unit
Pre-determined TZS 460,000 TZS 2,000 per unit

From the above table it is clear that there is a difference between the actual figures and the figures according to the
costing records. This is a drawback of cost accounting. The final records according to costing rules and the actual
records according to financial accounting rules have to be reconciled at the end of the activity period for the difference
in cost.

This phenomenon is called under-absorption and over-absorption of overheads. The under- /overabsorbed
overheads present substantial problems of analysis for management. In the above example, the overheads absorbed
per unit are TZS 2,000, whereas the actual overheads incurred are TZS 1,826.09. The overheads are over-absorbed
to the extent of TZS 174 per unit.

Overheads per Units Total overheads

unit TZS
Overheads absorbed TZS 2,000 230 TZS 460,000
Actual overheads TZS 1,826.09 230 TZS 420,000

The above case reflects that the overheads have been over-absorbed by TZS 40. Similarly, there can be a case of
under-absorption of overheads where the overheads absorbed will be less than the actual overhead costs incurred.
 49

Riverside Plc has budgeted overheads of TZS 600,000,000 for the activity period. The organisation has decided to
absorb the overheads on the basis of the budgeted machine hours. The budgeted machine hours worked for the
period are 600,000.

The actual overheads incurred for the period are TZS 650,000,000 and the machine hours worked are 560,000.
Calculate the under- / over-absorption of overheads and give reasons.

Answer

Budgeted overhead
Overhead absorption rate
Budgeted machine hours
TZS 600,000,000
600,000 hours

TZS 1 ,000 per machine hour

TZS
Actual overheads incurred 650,000,000
Overheads absorbed (TZS 1,000 x 560,000 hours 560,000,000
worked)
Overheads under-absorbed 90,000,000

The overheads are under-absorbed as the hours worked are less than the budgeted hours and also the actual
overheads are more expensive as the actual overhead rate per machine hour is TZS 650,000,000/560,000 = TZS
1,161 per machine hour as compared to the budgeted rate of TZS 1,000 per machine hour.

Thermo Plc has provided the following data regarding the six month period ending June 20X3:
50

Budgeted Actual
Overheads TZS 250,000,000 TZS 300,000,000
Number of units 200,000 200,000

Calculate and give reasons for the under- / over-recovery of overheads.

Answer to Test Yourself

Answer to TY 1

The correct option is A.

Direct labour cost is physically traceable to the finished product or service and hence directly charged to that product
or service. It forms part of the prime cost. The overhead costs which are general in nature and spent across all the
departments are allocated using a suitable basis. Indirect labour cost does not alter the construction, conformation
or composition of the product but it contributes to such work and to the completion of the product. It forms part of
factory overhead.

Answer to TY 2

The correct option is B.

The indirect labour cost is allocated to output on some suitable basis such as a percentage of the direct labour hours.
Only direct and traceable costs are charged directly to the products. Direct allocation is applied to departments and
not to products and therefore this option is wrong.

Answer to TY 3

The correct option is C.

Indirect costs are generally incurred for all cost centres and not for any single cost centre. Hence these need to be
apportioned to products. Indirect expenses are not incurred once but they are incurred continuously. There is no
question of double charging of indirect costs as these are not directly charged to the products.

Answer to TY 4

The correct option is B.

In the two stage procedure, overheads are first allocated to the departments or cost centres. Apportionment of costs
to the service cost centres will be the next step after the overheads have been allocated to the various cost centres.
Thereafter the overheads which cannot be directly identified with the departments or cost centres are apportioned to
service as well as other departments on a suitable basis. Re-apportionment can happen only after basic
apportionment is complete. Assignment of overheads to the products is the last stage in the procedure of calculating
overhead absorption rates.

Answer to TY 5

Calculation of overhead recovery / absorption rate for Amazing Plc‟s production department

(a) Direct material cost percentage method

Amount of overheads
Overhead recovery rate x 100

Direct material cost

TZS 90,000,000
x 100
45,000,000
 51

= 200% of direct material

(b) Direct labour cost percentage method

Amount of overheads
Overhead recovery rate x 100

Direct labour cost

TZS 90,000,000 x 100

TZS 60,000,000
= 150% of direct labour cost

(c) Prime cost percentage method

Amount of overheads
Overhead recovery rate x 100

Prime cost

x 100

= 85.71% of prime cost

(d) Direct labour hour rate method

Overhead recovery rate Amount of overheads worked

Direct labour hours

TZS 90,000,000
15,000
= TZS 6,000 per direct labour hour

(e) Machine hour rate method

Amount of overheads
Overhead recovery rate

Machine hours
TZS 90,000,000
30,000,000
= TZS 3,000 per machine hour

Working

Prime cost = Direct material cost + Direct labour cost

= TZS 45,000,000 + TZS 60,000,000

= TZS 105,000,000

Answer to TY 6

Calculation of overhead absorption rates for Bingo Ltd

(a) Blanket overhead absorption Total budgeted overheads

52

Total budgeted machine hours

TZS 87,000,000
47,000 hours

= TZS 1,851 per machine hour

(b) Departmental overhead absorption rate

For department X Budgeted overheads dept. X

Budgeted machine hours for dept. X
TZS 24,000,000
12,000 hours
= TZS 2,000 per machine hour

For department Y Budgeted overheads dept. Y

Budgeted machine hours for dept. Y

TZS 63,000,000
35,000 hours

= TZS 1,800 per machine hour

(c) Actual overhead absorption rate Actual overheads

Actual production
TZS 92,500 000

35,000 units

= TZS 2,643 per unit

Actual overhead absorption rate is always

calculated based on number of units produced
since it is calculated for total number of
finished goods based on actual figures post
production. Hence bases such as machine
hours and labour hours are not used here as
they differ department-wise, but remain the
same „in total‟ for the entire organisation.
 53
(d) Pre - determine overhead absorption rate Budgeted overheads
Budgeted production

TZS 87,000,000
38,000 units = TZS 2,289 per unit

Answer to TY 7

Budgeted Actual
Overheads (a) TZS 250,000,000 TZS 300,000,000
Number of units (b) 200,000 200,000
Overhead rate (a/b) TZS 1,250 TZS 1,500
per unit

Thermo Plc - Statement showing under- / over-absorption of overheads for six months ending June 20X3

TZS Reason
Overheads incurred TZS 300,000,000 Although the number of units is the same, the overheads
Budgeted TZS 250,000,000 per unit have become more expensive. The actual rate is
overheads TZS TZS 1,500 per unit whereas the budgeted rate is TZS
Under-absorption 50,000,000 1,250 per unit

Self-Examination Questions

Question 1
The wages of a worker looking after the maintenance of a machine is an example of:
A Machine cost
B Indirect labour cost

C Labour maintenance cost

D D Direct labour cost

Question 2

The overhead absorption rate of Magnum Ltd is TZS 4,750 per machine hour. The budgeted machine hours for the period are
46,000. The actual total overheads incurred during the same period are TZS 205,665,000 and the actual machine hours
recorded are 43,000. What are the total overheads for the period?

A Over-absorbed by TZS 1,415,000

B Over-absorbed by TZS 12,835,000

C Under-absorbed by TZS 1,415,000

D Under-absorbed by TZS 12,835,000

Question 2

Remo Plc absorbs its fixed overheads on the basis of machine hours. During the last year, total overheads incurred TZS
120,000,000 and actual machine hours were 45,520. The fixed overheads were under absorbed by TZS 6,200,000. Assuming
the budgeted machine hours 42,000, what is the fixed overheads absorption rate?

A TZS 2,640

B TZS 2,500

C TZS 2,860

D None of the above .

54

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

Any labour cost which is not directly incurred or cannot be readily chargeable or identifiable with a specific job, contract, work
order or any other unit of cost is termed an indirect labour cost. The machine cost is the cost of producing machines and forms
a part of the non-current asset cost. The labour maintenance cost is not a part of the machine maintenance cost. The direct
labour cost is the cost of the efforts to produce the product.

Answer to SEQ 2

The correct option is C.

Overheads absorbed are less than the actual overheads incurred.

TZS ‟000
Actual overheads incurred 205,665
Overheads absorbed TZS 4,750 x 43,000 204,250
Overheads under-absorbed 1,415

Answer to SEQ 5

The correct option is B.

Actual overheads TZS 120,000,000

Less: Under absorption of overheads (TZS 6,200,000)
Absorbed overheads
TZS 113,800,000

Overhead absorption rate = Budgeted fixed overheads/Budgeted machine hours

Hence, Machine hours worked = Overhead absorbed/Overhead absorption rate

45,520 hours = TZS 113,800,000/OAR

OAR = TZS 2,500
 A3
55

COSTING
SECTION A

SECTION A3: COSTING FOR PRODUCTS, SERVICES AND

PROJECTS

Production systems are either continuous or operate one job at a time. In certain industries like the aircraft manufacturing
industry, each aircraft is manufactured as a separate job, whereas in other industries such as chemical industries, a series of
continuous processes lead to the manufacture of a chemical. accordingly, these industries use different costing techniques. The
aircraft uses job costing whereas the chemical industry uses process costing to calculate total cost. This Study Guide will help
you to understand and calculate the total costs in different industries using job costing, process costing and service costing
techniques. Management accountants are often required to perform cost management functions, and learning the different
costing techniques discussed in this Study Guide will prepare you for this.

a) Explain and calculate cost of products, services and projects including process costing.
b) Explain and perform job costing.
c) Explain and perform batch costing.
d) Identify and calculate project costs, income and project profit or loss.
e) Explain and use features of process costing.
f) Identify and calculate cost for joint and by-product.
g) Compile process account and illustrate accounting treatment for normal loss, abnormal loss and abnormal gain.
h) Explain and calculate equivalent units in a process and allocate process cost to equivalent units.
i) Identify and calculate service costs in different situations.
 56

1. Explain and calculate cost of products, services and projects including process costing.

[Learning Outcome, a]

Product costs typically consist of three major components: material, labour and overheads. Material costs are the costs of
direct and indirect materials used in the production process, labour costs are the costs of labour used in making the product
(manpower) and overheads are all the indirect costs associated with the production process.

Product costs are calculated by adding together the material, labour and overhead costs. Material and labour costs are taken
at actual figures, whereas overheads are absorbed using an appropriate absorption rate. Product costs can be calculated by
using a simple cost sheet.

We have already studied the proforma of cost sheet in the previous Study Guide.

Find the production cost per unit from the following details:

The total number of units manufactured by a company is 1,000. All the units are sold during the year. Assume that there is no
opening and closing inventory.

Cost per unit

TZS
‟000
Materials 4,500
Direct wages 3,200
Indirect material 800

Other costs incurred

TZS ‟000
Indirect wages 800,000
Administration overheads 225,000
Selling and distribution 315,200
overheads

A TZS 1,025,000

B TZS 1,115,200

C TZS 1,340,200

D TZS 4,200,000

2.1 Project costs

Project costs are all costs incurred in completing a project. Project cost accounting tracks all costs during the life cycle of the
project and allocates them to the project. This information helps managers in project management. Project costs are
accumulated separately for each individual job, and revenues from that job are then compared with these costs to arrive at the
profit.

Project cost accounting is also called job cost accounting/ job costing.

In the case of projects spanning more than one accounting period, project costs are recorded based on the percentage
completion of the project or job at each year end / accounting period. Revenues of the job are also recorded accordingly,
based on the percentage completion of the job. Budgeted project costs are compared to actual project costs to analyse
variances, if any.
 57
2. Explain and perform job costing
[Learning Outcome b]

1. Job Costing

Job costing is a form of specific order in which costs are attributed to individual jobs.

CIMA official terminology, 2005

This method of costing is used to calculate the cost of production for non-repetitive, non-standard jobs for each work or job
order undertaken by an organisation. Under this method, individual jobs are identifiable and each job becomes a separate cost
centre. All direct costs are accumulated, and indirect costs are assigned (on some suitable basis) to each job separately.

Typically, industries like aircraft manufacturing, ship-building, tailor-made garments etc. use job order costing. The calculation
of job costs can be done by adding up the direct material cost, direct labour cost and the portion of overheads that need to be
assigned to a job. The steps to be followed in the calculation of job costs from the given information are stated below:

Ø Identify the material costs.

Ø Identify the direct labour costs.

Ø Compute the indirect / overhead costs using a suitable basis. This can either be direct labour hours or machine hours in
most cases.

Ø Add up all the costs to arrive at the total cost of the job.

Ø Once the costs are calculated, profit per job can be computed by deducting the cost from the sales price or by computing it
as a percentage of cost.

Job costing

Shaun Plc is an event management company. Job 2365, organising a wedding ceremony, and job 5698 arranging a business
party have been completed during the year. The following costs relate to the jobs. Calculate the total costs of the jobs.

Job 2365 Job 5698

TZS TZS ‟000
Cost of direct materials such as lighting and decorating materials ‟000
4,000 5,000
Cost of the personnel at work 6,000 7,500
Hire charges for sound equipment 1,250 2,000

The overheads incurred, such as the travel charges, the cost of using the company‟s own equipment etc. are absorbed in
each job at the rate of TZS 15,000 per direct labour hour. The direct labour hours for job 2365 are 50 hours and that for job
5698 are 70 hours.

Answer

Job 2365 (TZS Job 5698 (TZS

‟000) ‟000)
Material costs 4,000 5,000
Labour costs 6,000 7,500
Direct expenses (hire and other charges) 1,250 2,000
Overheads absorbed at TZS 15,000 per direct 750 1,050
labour hour (50 x TZS (70 x TZS
15,000,000) 15,000,000)
Total cost 12,000 15,550
58

3. Explain and perform batch costing [Learning Outcome c]

It is not always possible to classify cost accumulation systems into job costing and process costing systems. Where
manufactured goods have some common characteristics and also some individual characteristics, the cost accumulation
system may be a combination of both the job costing and process costing systems. This system of costing is referred to as
Operation costing or Batch Costing.

For example, the production of footwear, clothing and furniture often involves the production of batches, which are variations
of a single design and require a sequence of standardized operations. let us consider a company that makes kitchen units.
Each unit may have the same basic frame, and require the same operation, but the remaining operations may differ: some
frames may require sinks, others may require to be fitted with work tops; different types of doors may be fitted to each unit,
some may be low quality doors while others may be of a higher quality. The cost of a kitchen unit will therefore consist of the
basic frame plus the conversion costs of the appropriate operations.

The principles of the cost accumulation systems are illustrated below:-

Product 1 2 3 4 5 Product cost

A √ √ √ A = Cost of operations 1,2,3
B √ √ √ B = Cost of operations 1,4,5
C √ √ √ C = Cost of operations 1,2,4
D √ √ √ D = Cost of operations 1,3,5
E √ √ √ E = Cost of operations 1,2,5

The cost of each product consists of the cost of operation 1 plus a combination of the conversion costs for operations
2 – 5. The cost per unit produced for a particular operation consists of the average unit cost of each batch operation.

4. Identify and calculate project costs, income and project profit or loss. [Learning Outcome d]

4.1. Calculation of Profit or Loss

Let us calculate profit or loss from a job work order to understand the recording of job costs and income calculations.

A specialist manufacturer of purpose-built plants is engaged in three separate jobs in May 20X3. The following costs were
incurred:

Job A Job B Job C

Direct material TZS TZS TZS
524,000 671,000 382,000
Direct labour
Skilledhours 16
158 170
Semi-skilled - hours 316 190 30
Site expenses TZS TZS TZS 25,000
118,000 170,000
Selling price of job TZS TZS TZS
3,318,000 2,750,000 1,950,000
Completed at 30 April20X3 100% 80% 25%

The following information is available:

(i) Direct material for the completion of the jobs has been recorded.
 59

(ii) Direct labour is paid - skilled TZS 5,000 per hour; semi-skilled TZS 4,000 per hour.

(iii) Site expenses tend to vary with output.

(iv) Administration expenses total TZS 440,000 per annum and are to be allocated to the jobs on the basis of direct labour
hours.

(v) On completion of the work, the practice of the manufacturer is to split the calculated profit on each job; 20% to site staff as
a bonus, and 80% to the company. Calculated losses are absorbed by the company in total.

You are required to:

(a)

(b) Calculate the profit or loss by the company of job A.

(c) Project the profit or loss by the company of job B and C.

Answer

From the information given in the question job costs and profit / loss thereon are computed as:

(a) Profit or loss by the company on Job A

Job Cost

Job A TZS Job B TZS Job C TZS

Material 524,000 671,000 382,000
Labour - skilled (W1) 790,000 850,000 80,000

- unskilled (W1) 1,264,000 760,000 120,000

Site expenses 118,000 170,000 25,000

237,000 180,000 23,000
Administration expenses (apportioned on labour hours) (W2)
Cost to date 2,933,000 2,631,000 630,000
3,318,000
Selling price
Total profit 385,000
(77,000)
Less: 20% bonus (385 x 20%)
Company share
308,000
(b) Projected profit of Jobs B and C

The selling price is always calculated on 100% of the job completed. Also, projected profit or loss is calculated on the job
which is complete. If the job is not 100% complete, then the estimated cost of the job for 100% completion needs to be
computed based on the given information.

Job B (TZS Job C

‟000) (TZS ‟000)
Costs to date 2,631,000 630,000
Costs of completion
B - 20% (excluding material) (W3) 490,000
C- (excluding material) (W3) 744,000
Projected total cost (a)
3,121,000 1,374,000
60
Selling price (b) 2,750,000 1,950,000
Profit (Loss) (b – a) (371,000) 576,000
Staff bonus (115,000)
Profit (Loss) to company
(371,000) 461,000

Workings

W1

Calculation of labour cost

Job A

Skilled = 158 hours x TZS 5,000 = TZS 790,000

Semi-skilled= 316 hours x TZS 4,000 = TZS 1,264,000

Job B

Skilled = 170 x TZS 5,000 = TZS 850,000

Semi-skilled = 190 x TZS 4,000 = TZS 760,000

Job C

Skilled = 16 x TZS 5,000 = TZS 80,000

Semi-skilled = 30 x TZS 4,000 = TZS 120,000

W2

Calculation of administration expenses

The administration expenses will be apportioned on the basis of the total labour hours skilled and unskilled = 158 + 316 + 170
+190 +16+ 30 = 880 hours

Absorption rate for administration expenses = TZS 440,000 / 880 hours = TZS 500

Job A

Total labour hours = skilled + unskilled

= 158 + 316

= 474 hours

Administration expenses = 474 x 500

= TZS 237,000

Job B

Total labour hours = 170 + 190

= 360 hours

Administration expenses = 360 x 500

= TZS 180,000
 61

Job C

Total labour hours = 16 + 30

= 46 hours

Administration expenses = 46 x 500

= TZS 23,000

W3 Calculation of costs of completion

Job B is 80% complete, hence we need to add the remaining 20% of costs, to arrive at the 100% cost of Job B. It is generally
assumed that the jobs are 100% complete regarding material, (only the labour and overheads portion is incomplete). Hence, we
add only that portion, assuming that the material costs are 100% incurred.

Total cost of Job B (excluding material)

TZS 2,631,000 – TZS 671,000 = TZS 1,960,000

This cost is 80% cost, therefore we will now calculate the estimated 20% cost based on this information as below:

= TZS 1,960,000 x 20%

80%

= TZS 490,000

Similarly we calculate the cost for Job C (excluding material)

= TZS 630,000 – TZS 382,000 = TZS 248,000

Estimated cost of the remaining 75%

= TZS 248,000 x 75%

25%

= TZS 744,000

5. Explain and state features of process costing. [Learning Outcome e]

5.1 Process costing

Process costing is the costing method applicable where goods or services result from a sequence of continuous or repetitive
operations or processes.

CIMA official terminology, 2005

The features of process costing are:

(a) Costs relating to a process are always accumulated for a period. The period may be a week, a month, six months or a
year. Unlike job costing, the costs are booked periodically.
62
(b) The direct as well as the indirect costs are accumulated for a clearly defined process or operation as a whole. The cost
centre here is the process or operation.

(c) Costs are accumulated into processes and not directly into products. The total cost of each process is divided by the
total number of units produced during a period to arrive at the cost per unit.

(d) The cost of the units of normal loss is borne by the good units as certain losses in production are considered to be
normal e.g., evaporation, shrinkage etc.

If in a paint producing factory the total cost incurred per month is TZS 5,000,000 to manufacture 2,500 litres of paint and a loss
of 50 litres of paint per day is a normal occurrence, then the entire cost of TZS 5,000,000 will be spread over only (2500 – 50) =
2450 litres of paint.

(e) Any work in process (incomplete work) at the end of the period, in any of the processes, is treated as “equivalent
finished goods”. (We will discuss this in later Learning Outcomes).

(f) The cost of one process is transferred and added to the cost of the next process, because the output of one process
(except the final process) is treated as the input of the next process.

Suppose the entire process of paint manufacture is split into two processes – process 1 and process 2. The costs incurred at
the end of process 1 total TZS 650,000. This cost will be transferred and added to the cost of process

Process industries comprise companies manufacturing a single product on a continuous basis and multi-product companies.
Certain examples are mines and quarries, cotton, wool and jute textiles, chemicals, paper plastics, oil refineries, canneries.

When is the process costing technique used?

A When the production flows continuously and through various stages

B When the production is done for one order at a time

C When the production is undertaken in batches

D When an intangible service is provided

 63
6. Identify and calculate cost for joint and by joint [Learning Outcome f]

There are clearly defined procedures for division of costs amongst the joint products and the by-products emerging from a
process.

Process costing treats all units of output produced in a period alike by accumulating and averaging costs over the units produced.

In process costing, a separate account is set up for each process. At the end of the final process, the finished products are
transferred to the Finished Goods Account.

To calculate the process cost per unit we will first try to understand the entries in the process account. A separate account is
prepared for each process.

Process accounts are explained in the Example below.

Under process costing, each process account records all the expenses incurred for the process. This account is debited with
material cost, direct expenses and overhead allocated to the process. It is credited with wastage of materials and gains from
the sale of scrap, if any.

The balance of this account is the cost of the products produced which is transferred to the next process. The number of good
units when they are fully processed is transferred to the „finished goods account‟. In some cases, a certain part of the output of
a process is kept in inventory and the balance is transferred to the next process. The cost per unit is calculated as:

Cost per unit = Total cost - Scrap value of normal loss

Total input quantity - Normal loss quantity

The process account given below will make the above clear.

In the course of manufacture, a product passes through three distinct processes: A, B and C. During a four week period 1,000
units are produced and the following information is available:

Process A Process B Process C

TZS ‟000 TZS ‟000 TZS ‟000
Direct Material 2,000 (1,000 units) --

Additional material 1,000

Direct Wages 1,500 700 800
Direct Expenses 300 100 --

The indirect production cost was TZS 4,500,000 and this is to be apportioned to the processes on the basis of the direct wage
cost. Prepare the process account and ascertain the cost per unit.

Answer

Dr Process „A‟ Account Cr

Units TZS ‟000 Units TZS ‟000
Direct Material 1,000 2,000
Direct Wages 1,500
Direct Expenses 300
Overhead (Indirect Output of process A
production cost) (W1) transferred to process
B (entire cost
transferred to process
2,250 B) 1,000 6,050
6,050 6,050
64

Dr Process „B‟ account Cr

Units TZS ‟000 Units TZS ‟000
Process A a/c 1,000 6,050
Direct Material 1,000
Direct Wages 700
Direct Expenses 100 Output of process B 1000 8900
Overhead 1,050 transferred to process C
(Indirect production cost) (entire cost transferred
(W1) to process C)
1,000 8,900 1,000 8,900

Dr Process „C‟ account Cr

Units TZS ‟000 Units TZS ‟000
Process B a/c 1,000 8,900
Direct material --
Direct wages 800
Direct expenses --
Output of process C
transferred to
Overhead (Indirect Finished Inventory a/c
1,200 (entire cost transferred 1,000 10,900
production cost) (W1)
to finished goods a/c)

1,000 10,900 1,000 10,900

Now, in process „C‟, finished goods are produced. It is given in the problem that 1,000 units were produced. Therefore, the per
unit cost of goods produced in the last stage i.e. Process „C‟ will be = TZS 10,900/1,000 units = TZS 10.90
per unit

Workings

W1

Total indirect production cost is TZS 4,500,000. According to the information, it is to be apportioned on the basis of direct wages.
The direct wages for the three processes are TZS 1500,000, TZS 700,000 and TZS 800,000.
Therefore, the ratio comes to 15:7:8.
Apportionment of production cost will be calculated as follows:

Calculation Cost per process TZS

‟000
Process A TZS 4,500,000 x 15/30 2,250
Process B TZS 4,500,000 x 7/30 1,050
Process C TZS 4,500,000 x 8/30 Total 1,200
4,500

Note

In this example, the unit‟s column specifies the amount of direct material which goes into production at the start of the process.
This is carried forward as it is to the next process, unless there are any normal or abnormal losses (these will be discussed in
the next Learning Outcome).
Any additional materials which are input in any further processes are not assigned any units as these are not the basic materials
but only additional materials that are required to complete the process of production. However, there can be cases where
some additional basic material is added in the subsequent processes. In these cases, the relevant units are also written in the
quantity column.
 65
The labour costs and other expenses are debited as and when these are incurred. Any overhead expenditure is allocated to the
processes on a suitable basis according to the given information.

A product passes through two different processes: A and B. The output of process A is transferred to process B and the output
of process B is transferred to finished goods. The following details relate to the processes.

Units Process A Units Process B

Input 5,000 -
TZS ‟000 TZS ‟000
Direct Material 5,000

Additional Material 6,000 3,000

Direct Labour 7,000 4,000
Manufacturing Expense 2,000 2,000

Prepare process A and process B accounts

The value of materials input into a process is:

A Debited to the process account.

B Credited to the process account.

C Not reflected at all in the process account.

D Depicted as a loss in the process account.

7.Compile process account and illustrate accounting treatment for normal loss, abnormal loss and abnormal gain.
[Learning Outcome g]

3. Normal and abnormal losses and gains and their accounting treatment

The term “process loss” may be defined as the difference between the input quantity of raw material and the output. In order
to account for the losses incurred one needs to identify them as normal and abnormal losses.

(a) Normal process loss

Normal loss is unavoidable and is often caused by such factors as evaporation, chemical change, withdrawals for test or
sampling, unavoidable spoilage or other reasons for physical loss of input.

These types of losses can be estimated from the nature of the material and the operation, previous experience and the input–
output ratio inherent to a particular industry. Normal loss is generally calculated as a certain percentage of the input of units
introduced in the process. The percentage of losses thereby calculated is always a fixed percentage of normal loss. As a result,
if the percentage of normal loss is calculated as 5% then any process loss incurred up to 5% is treated as normal.

From the recovery value point of view „waste‟ and „scrap‟ can be defined as:
66
Waste: “discarded substances having no realisable value.”

Scrap: “discarded material, having some recovery value which is usually disposed of without further treatment or reintroduced
into the production process in place of raw material.”

(b) Accounting treatment for normal loss

The normal process loss is borne by the good units produced, meaning that the total cost of the process is spread over the
number of good units only (i.e. ignoring the loss units.). Any salvage (scrap) value generated from scrap will be deducted from
the total cost as it will reduce the cost to that extent. As a result, even though the costs are incurred on the entire input units, the
cost is borne only by the good units. The cost is however reduced to the extent of the scrap value of normal loss.

Unit cost of good units produced Total process cost - Scrap value of normal loss

Input quantity - Normal loss quantity

Suppose the material input is 100 units and the loss is 5%, then the good units will be 100 – 5% of 100 = 95 units. If the cost
incurred in the process is TZS 200,000 and the revenue from sale of the scrap is TZS 10,000 then the entire cost per unit for
the 95 good units will be:

TZS 200,00 -TZS 10,000

Unit cost of goods units produced TZS 2,000 per unit

(100 -5) units

In the above example, if there is no resale value for scrap then the entire cost of TZS 200,000 will be split between the 95 units
as TZS 200,000/95 = TZS 2,110 per unit.

As far as the accounting entry for normal loss is concerned, the units of normal wastage are recorded on the credit side of a
process account in the quantity column only. The sale value of scraps, if any, should be included in the amount column on the
credit side at saleable value. This reduces the cost of normal output. Usable units share the process loss. As a result, in the
above example the normal loss will be recorded at the sale value i.e. at TZS 10,000. The accounting entries in respect of
normal loss will be as follows:

Dr Normal loss account

1 Normal loss Cr Process account
Being normal loss charged to process
Dr Cash account
2 For sale of scrap, if any Cr Normal loss account
Being cash realised on sale of scrap

In Process 1 the costs incurred by Alpha Co were as follows:

Units TZS ‟000

Materials 1,000 5,000
Labour 500
Expenses 350
Overheads apportioned 450
 67
The normal loss incurred in the process was 5%. The sale values of scrap, if sold, is TZS 20,000. Prepare the process account
and ascertain the cost of materials to be transferred to Process 2.

Answer

The Process 1 account will be prepared as follows:

Dr Process 1 account Cr
Units TZS ‟000 Units TZS ‟000
Direct Material Normal Loss a/c
1,000 5,000 50 20
(5% x 1,000 units)
Direct Wages 500
Direct Expenses 350
Overhead (Indirect production cost) 450 Process 2 account 950 6,280

1,000 6,300 1,000 6,300

(c) Abnormal process loss

When the loss is caused by unexpected or abnormal conditions, it is called “Abnormal Loss”. Any wastage arising in excess
of normal wastage is known as “Abnormal Wastage”.

Calculation of abnormal losses

Abnormal loss may be avoided. It can be controlled by the management by taking proper care. Units of abnormal loss are
calculated as shown in the below example:

Continuing with the previous example of Alpha Co

Units introduced 1000

Less: 5% Normal loss (5% of 1,000) 50
Normal output
950
Less: Actual output 930
Abnormal loss 20

Hence, the difference between normal output and actual output is abnormal loss.

Normal output = Units input – normal loss in units

(d) Accounting treatment of abnormal process losses
The accounting procedure for abnormal loss is different. The abnormal loss is valued at the rate at which the good units would
be valued if there was only normal loss. The amount of abnormal wastage is credited to the process concerned. A separate
abnormal wastage account is opened and the scrap value if any is credited to the abnormal loss account. The balance on it is
ultimately transferred to the costing profit and loss account.

The value of abnormal wastage is calculated as follows:

Normal cost of normal output (wastage) x Units of abnormal loss Value of abnormal loss
Normal output

Normal output = Units input - Normal loss in units

Normal cost = Normal cost of process – Realisable value of normal loss if any
68

The accounting entries in respect of abnormal loss are as follows:

Dr Abnormal loss account

1 Abnormal loss Cr Process account
Being abnormal loss charged to process
Dr Cash account
If any amount is received from the
2 Cr Abnormal loss account
sale of scrap
Being sale value realised on sale of abnormal loss units
Dr Costing profit and loss account
3 For closing the abnormal loss a/c Cr Abnormal loss account
Being loss transferred to costing profit and loss account

In the above process (example for „accounting for normal losses‟), if the actual output is 900 units, then the balance of 50 units
(950 – 900) units will be abnormal loss units. As stated above, these units will be valued at the rate at which the normal good
units are valued. The Process 1 account will be as follows:

Dr Process „1‟ account Cr

Units TZS ‟000 Units TZS ‟000
Direct Material 1,000 5,000 Normal Loss a/c 50 20
Direct Wages Abnormal Loss a/c 50 330
500
(6280/950 x 50)
Direct Expenses 350
Overhead (Indirect production 450 By Process 2 account 900 5,950
cost) 6,300
1,000 6,300 1,000

If the units of abnormal loss are sold in the market at TZS 200 then the abnormal loss account will be prepared as:

Dr Abnormal Loss account Cr

TZS ‟000 TZS ‟000
Process 1 account 330 Cash 200
Costing profit and loss a/c 130
330 330

(e) Abnormal gain

The normal loss is an estimated figure. The actual loss may be more or less than the normal loss. If the actual loss is more than
the normal loss, it is treated as an abnormal loss. But if the actual loss is less than the normal loss it is known as an abnormal
gain.

An abnormal gain is therefore a reduction in loss and not an actual gain in itself. The abnormal gain is calculated in a similar
manner to the abnormal loss.

Units of abnormal gain are calculated as below:

 69

In the hypothetical example given below, the calculation of abnormal gain can be understood. All the figures are assumed to
be given.

Units
Actual input 1,500
Normal loss 250
Normal output (1,500 – 250) 1,250
Actual output 1,400
Abnormal gain will be difference between the actual output and the normal
output 1,400
Actual output
Less: Normal output 1,250
Abnormal gain (Units) 150

(f) Accounting treatment of abnormal gain

Like abnormal loss, abnormal gain also does not affect the cost of normal production. The process account is debited with
the quantity and value of abnormal gain and the abnormal gain account is credited. The units of abnormal gain are valued in the
same way as abnormal loss units.

Value of abnormal gain = Normal cost of normal output x Units of abnormal gain
Normal units produced

(g) Accounting entries in an abnormal gain account

The abnormal gain account will reflect the entries for the abnormal gain valued at par with the good units as well as the
adjustment entries for the sale of scrap. The balance of the account is transferred to the „costing profit and loss account‟ The
accounting entries are as follows:

Dr Process account
1 Abnormal gain Cr Abnormal gain account
Being abnormal gain recognised
Dr Abnormal gain account
Adjustment of the scrap value of Cr Normal loss account
2
abnormal gain Being normal loss reduced to the extent of the
abnormal gain
Dr Abnormal gain account
Cr Costing profit and loss account
3 Closing entry for abnormal gain account Being amount of abnormal gain transferred
to
costing profit and loss account
Dr Cash account
4 Sale of normal loss units Cr Normal loss account
Being cash realised on sale of scrap units

Manufacture Plc produces a high-quality product, Elba, which is an ointment passing through two processes.

The weight lost in each process is 5% of the input and the normal loss percentage is 10%. The scrap realises TZS 80,000 per
kilogram for process A and TZS 200,000 per kilogram for process B. The expenses relating to production are as follows:
70

Process A Process B
Materials in kilograms 1,000 70
Materials value (TZS ‟000) 125,000 14,000
Conversion costs (TZS ‟000) 36,000 15,250

Output in kilograms 830 780

Assuming that there is no opening or closing work in process, prepare the process accounts.

Answer

Dr Process A account Cr
Units TZS ‟000 Units TZS ‟000
Materials 1,000 125,000 Normal weight loss 50
Conversion costs 36,000 Normal loss 100 8,000
Abnormal loss 20 3,600
Process B 830 149,400
1,000 161,000 1,000 161,000

Dr Process B account Cr
Units TZS ‟000 Units TZS ‟000
Process A 830 149,400 Normal weight loss 45
Materials 70 14,000 Normal loss 90 18,000
Conversion costs 15,250
Abnormal gain 15 3150 Process B 780 163,800
915 181,800 915 181,800

Workings

Calculation of abnormal loss or abnormal gain in each process

Process A

Input 1,000
Weight loss at 5% 50
Normal loss at 10% 100
Output as given 830
Abnormal loss 20

Process B

Input 70
Input from process A 830
Total input 900
Weight loss at 5% 45
Normal loss at 10% 90
Output as given 780
Abnormal gain 15
 71

Calculation of cost per unit of output

Process A

Normal cost per unit = Total cost - Value of normal loss

Total input quantity - Normal loss quantity

= TZS 125,000,000 TZS 36,000,000) -TZS 80,000 x 100)

1,000- (100+50)

= TZS 153,000,000
850

= TZS 180,000

Valuation of abnormal loss = 20 x TZS 180,000 per unit = TZS 3,600,000

Process B
Normal cost per unit = Total cost - Value of normal loss
Total input quantity - Normal loss quantity

= TZS 149,400,000 TZS 14,000,000+TZS 15,250,000TZS 200,000 x 90

(830+70) –(90+45)

= TZS 160,650,000
765

= TZS 210,000

Valuation of abnormal gain = 15 x TZS 210,000 per unit = TZS 3,150,000

72

The following are the details given for process A.

Material input into the process 1,000 kilograms

Value of the material input TZS 5,000,000
Units transferred to next process 930 kilograms
Normal loss percentage 5% (scrap value is nil)
Conversion costs TZS 3,600,000

The value abnormal loss units will be:

A TZS 271,500

B TZS 140,000

C TZS 181,000

D TZS 452,500

The cash received from the sale of scrap is for the units

A Of normal scrap according to the percentage of the normal loss

B Of normal scrap less the units for abnormal gain if any

C Of abnormal gain

D None of the above

8. Explain and Calculate equivalent units in a process and allocate process costs to equivalent units [Learning
Outcome h]

In a process system, some units of output can remain incomplete at the period end. These units of incomplete output are known
as work in process units. While transferring the costs of a process from one period to another these units need special
consideration for valuation.
 73
The questions dealt with above assumed that the entire output was complete from the point of view of production and there were
no work in process units. However, real life is never so easy! There is usually opening work in process as well as closing work
in process.

Total process costs are borne by the number of units completely produced as well as the partly produced units during the period
under consideration. The concept of equivalent units of production will help us divide the process cost between the completed
units and the units of work in process.

Equivalent units are units that represent the incomplete units of production as equivalent to fully complete units of production.
This helps split the process costs into the complete units and work in process units.

The principle applies when operation costs are being apportioned between work in process and completed output.

50 units are complete in all respects at the end of the year while 20 units are complete only to the extent of 25% in respect of
materials and conversion costs. 20 incomplete units will be converted to equivalent complete units as = 20 x 25% = 5 units.

In each process, an estimate is made of the percentage completion of any work in process. The calculation of the equivalent
units is based on this percentage of completion that is calculated. This percentage is generally arrived at on the basis of the pre-
planned production schedules and budget plans. The formula for equivalent production is as follows:

Equivalent units of work in process = Actual number of units in process x Percentage of work completed
For the purpose of cost determination, the incomplete units are to be converted in terms of completed units on the basis of
degree of completion.

800 units partly completed to the extent of 25% of the work done will be equivalent to 800 x 25% = 200 equivalent units.
Instead of expressing 800 units to be 75% incomplete or only 25% complete, we say that these are equal to 200 complete
units.

Diagram 1: Equivalent units

To value the work in process as equivalent units we follow the following steps. The steps have been given with the help of
an example for easy understanding.
74

The details of Process 1 are given below. Ascertain the amount to be allocated to the WIP and finished goods. The units input
into the process are 1,000 and the finished units are 750 whereas the WIP units are 250. The materials cost is TZS 1,500,000
and the conversion costs are TZS 1,200,000. The work in process is complete as regards materials - 100% and as regards
conversion costs - 40%. The process account is as follows:

Dr Process 1 account Cr
Units TZS ‟000 Units TZS ‟000
Materials cost 1,000 1,500 Finished goods a/c ?
Conversion costs 1,200 Work in process a/c ?
2,700

The total cost of TZS 2,700,000 needs to be split amongst the finished goods and the work in process.

Step 1

Ascertain the extent of work completed on the work in process units with regards to materials as well as labour and overheads.
This information is generally given in the question as the percentage of work completed as regards „materials‟ and percentage
of work completed as regards „labour and overheads‟ (collectively termed „conversion costs‟ in many cases). Remember that
the percentage of work completed as regards „materials‟ and „labour and overheads‟ or „conversion costs‟ may be different.

Step 2

Multiply the percentage of work completed by the number of units of work in process. These will again be separate for „materials‟
and „labour and overheads‟.

In the given example the percentage completion as regards materials is 100% and for conversion costs is 40%. The following
table computes the equivalent units by multiplying these percentages by the number of units of work in process.

Statement of equivalent units

Units Materials Conversion costs

Percent Equivalent Percentage Equivalent
age units completion units
completi
on
Units input 1,000
Less:
Finished units 750 100 750 100 750
Work in process 250 100 250 40 100
Balance units 0

Total 1,000 850

Step 3

Once we have ascertained the number of equivalent units we calculate the cost per equivalent unit. This calculation will again
be separate for the equivalent units of „materials‟ and „labour and overheads‟.

The following statement computes the cost per equivalent unit by dividing the total costs as given in the example by the number
of equivalent units as computed in the table above.
 75

Statement of cost per equivalent unit

Materials Conversion costs

Costs incurred 1,500,000 1,200,000

Equivalent units 1,000 850

Cost per equivalent TZS 1500 TZS 1411.764

units

Step 4

In this step we calculate the total cost for WIP units and finished units by multiplying the units for each category by the cost per
equivalent unit as computed in the last step. The cost is separately calculated for materials as well as labour and overheads.

Statement of evaluation

Equivalent Materials Cost Equivalent Conversion Cost Total cost

units as cost per (c) units as cost per (f) (c + f)
regards equivalent TZS regards equivalent TZS TZS
materials unit conversion unit
(a) (b) costs (e)
TZS (d) TZS
Finished 750 1,500 1,125,000 750 1411.764 1,058,824 2,183,824
units
Work in 250 1,500 375,000 100 1411.764 141,176
process

The process account will now be as follows:

Dr Process 1 account Cr
Units TZS Units TZS
Materials cost 1,000 1,500,000 Finished goods a/c 2,183,824
Conversion 1,200,000 Work in process a/c 516,176
costs
2,700,000 2,700,000

The total process cost is split into the finished goods and WIP units in the above manner.

The details of Process A are given below. Ascertain the amount to be allocated to the WIP and finished goods. The input in the
process is 1,500 kilograms and the finished units are 1,125 kilograms whereas the WIP units are 375 kilograms. The materials
76
cost is TZS 2,250,000 and the conversion costs are TZS 1,800,000. The work in process is 100% complete as regards materials
and 60% complete as regards conversion costs.

The process account will be depicted as follows:

Dr Process 1 account Cr
Units TZS Units TZS

Materials cost 1,500 2,250,000 Finished goods a/c ?

Conversion costs 1,800,000 Work in process a/c ?

4,050,000

The total cost of TZS 4,050,000 needs to be split amongst the finished goods and the work in process.

A manufacturing company uses the product costing system.

The following information relates to the last month:

Opening inventory (WIP) NIL

Units introduced 10,000
Closing inventory (WIP) 2,000
Degree of completion on WIP 30%
Total costs of that month TZS 4,300,000,000

The total cost of fully completed output is:

A TZS 5,000,000,000

B TZS 4,300,000,000

C TZS 4,000,000,000

D None of the above

Speed star Plc employs a process costing system. The following costs were incurred by Department A during
January:

TZS ‟000
Direct materials 46,200
Conversion costs
Direct labour
21,000
Variable overhead 4,680
Fixed overhead 4,000 29,680
75,880

Dire
 77

ct materials are introduced at various stages of the process. All conversion costs are incurred evenly throughout the process.

There was no opening inventory on 1 January. Of the 2,200 units started during January, 1,800 were completed and transferred
to Department B. Engineers estimated that the units in process at 31 January were 75% complete as regards direct materials
and 80% complete as regards conversion costs. Calculate the cost of the units completed and transferred and the cost of the
WIP.

9. Identify and calculate service costs in variety situations.

[Learning Outcome i]

9.1 Service cost

Service cost is the charge for providing a facility / service. Service costing is the procedure applied for determining the cost
of the service provided.

Services
are intangible in nature. They cannot be quantified easily into units of measurement. Therefore, the accumulation of the costs
of a service requires careful analysis of the inputs that are consumed to provide the service. In order to identify the areas where
service costing applies it is important to take note of the peculiar characteristics of services.

Every service area has a distinct measure of cost. Unlike product or output costing there is no standard unit cost measure for
all services. The following is an illustrative list of the cost measures used in different service industries:

Nature of industry Cost measures

Tour operator, railway, bus Cost per passenger-mile
companies
Hospital Cost per patient per day, per bed per day
Canteen Cost per meal served per person
Cargo transport Cost per tonne per mile
Electricity supply Cost per kilowatt-hours
Hotel Cost per room per day
Telecommunication Cost per unit time (e.g. per minute / second)

The above cost measures do not have a single measure but a double measure of cost. The costs for a tour operator are not
calculated as cost per mile but as cost per passenger mile. The cargo transport costs incurred are affected not only by the total
number of miles travelled but also by the volume of weight carried by the vehicle. As a result, in the case of transport companies,
the unit of cost measure contains both the factors of miles and passengers making it a passenger mile.

Calculation of the per unit cost of service provided

The costs of a service are always calculated by classifying the costs associated with a service into fixed, semi variable and
variable. The costs under each classification – fixed, semi-variable and variable are accumulated and the total cost under each
heading is divided by the total number / volume of units.

The per unit cost of a service is always calculated in steps. The per unit variable cost, per unit fixed cost and per unit semi-
variable cost are added together to arrive at the total per unit cost. This is always calculated per period or for a period of
time.
78

Step I

Calculation of per unit variable cost = Total variable cost incurred in providing a service
Number of units of service provided

Step II

Total fixed cost incurred in providing a service

Calculation of per unit fixed cost =
Number of units of service provided

Step III

Total semi - variable cost incurred in providing a service

Calculation of per unit semi - variable cost =
Number of units of service provided

Once the per unit cost under these three headings is calculated, we arrive at the total cost per unit by adding the three together.

Diagram 2: Calculation of per unit cost of service

Let us try to compute the cost of services provided by a transport operator. The cost per mile travelled by the vehicle hired
needs to be calculated.

From the following data calculate the cost per mile of a vehicle.

Value of vehicle TZS 15,000,000

Annual road licence charge TZS 500,000
Insurance charges per year TZS 100,000
Garage rent per year TZS 600,000
Driver‟s wages per month TZS 200,000
Miles per litre 8 miles
Cost of petrol per litre TZS 800
Proportional charges for tyres and maintenance per mile TZS 200
Estimated life 150,000 miles
Estimated annual mileage 6,000 miles
 79

The treatment and reasoning for each cost classification

TZS / miles Treatment of cost Reasons

Value of vehicle TZS 15,000,000 The value of the vehicle is a fixed cost which will be It is also stated that the
the basis for calculating the depreciation cost. Since estimated life of a vehicle is
the estimated life is given in miles the depreciation cost 150,000 miles. Therefore, our
will be termed a variable cost as it will vary with the interpretation should be that for
change in the number of miles travelled. a cost of TZS 15,000,000, the
vehicle will run for 150,000
miles. Therefore, depreciation
per mile =
TZS 15,000,000/150,000 = TZS
0100 per mile. Therefore,
variable cost per mile = TZS 100
Road licence for TZS 500,000 This will be an annual fixed cost.
the year
Insurance TZS 100,000 This will be an annual fixed cost.
charges per year
Garage rent per TZS 600,000 This will be an annual fixed cost.
year
Driver‟s wages TZS 200,000 This is a monthly cost, which can be converted into an
per month annual cost by multiplying it by 12. It is a fixed cost.

Miles per litre 8 miles We have details such as miles per litre and cost per litre,
Cost of petrol per litre TZS 800 we have to find out cost per mile.
Look at the workings.

Proportional charges TZS 200 This cost is given as a cost

for tyres and per mile. Therefore, this is a
maintenance per mile variable cost.
Estimated life 150,000 miles Information given.
Estimated annual 6,000 miles We will first calculate fixed cost per year. This information
mileage help in calculating fixed cost per mile.

Workings

Mileage is 8 miles per litre (given) Cost per litre of

petrol is 800 (given)

We have to calculate cost per mile (TZS / mile)

Therefore, cost per mile = TZS 800/8 miles = TZS 100

Therefore, put cost per mile which is TZS 100, in the variable cost column.
80

Cost per mile

Calculation TZS
(TZS )
Fixed expenses
Road licence Given 500,000
Insurance charges Given 100,000
Garage rent Given 600,000
Driver‟s wages TZS 200 per month x 12 months 2,400,000
Total fixed cost per year 3,600,000
Fixed cost per mile TZS 3,600/ 6,000 miles per year 600
Variable cost
Depreciation per mile TZS 15,000/150,000 miles 100
Cost per mile = TZS 800/8 miles
Petrol cost per mile = TZS 100 per mile 100
Tyre and maintenance cost per 200
mile
Variable cost per mile ( 100 + 100 + 200) 400
Total cost (600 + 400) 1000

9.2 Service unit costs in a variety of situations

Because of the diverse nature of activities carried out in service undertakings, the cost system used is different for different
situations. Service costing for two different service costing situations is explained below.

1. Transport services

Transport service is a common example of services. Passenger transport and cargo distribution services provide services to
external customers such as companies or tourists and other passengers. The following steps are usually followed:

(a) We need to calculate the cost of operating the vehicles carrying either passengers or goods. As a result, the per unit
measurement of cost is a passenger mile travelled or a tonne mile travelled. Therefore, the costs need to be computed
taking into consideration the bulk of goods carried, the number of passengers who occupied the vehicle and the
distance covered.

A bus with a seating capacity of 50 students is employed by a school to transport students between their homes and the school.
If the bus runs 100 miles to and from the school carrying an average of 45 students and the operating costs are given as TZS
500 then the cost per student will be calculated as -

Total student miles = 45 students x 100 miles = 4,500 student miles

Cost per student mile = TZS 500/4,500 student miles = TZS 0.11 per student mile

(b) Costs which are typical to the distribution / transport services are the costs of:

Ø Operating and running, such as fuel, lubricants, wages of drivers.

Ø Maintenance such as repairs and overhauls, painting, hire of spare vehicles when firm‟s own vehicles are
unavailable due to some reason.
 81
Ø Fixed charges such as insurance of vehicles, salaries of supervision staff, taxes, depreciation, interest on
capital borrowed for purchase of vehicle.

These costs need to be classified according to their variability so as to present them under different headings in the cost
statement.

Variable costs

Costs of operating and running the vehicle such as fuel costs, lubricants, maintenance charges if calculated on the basis of the
distance travelled, depreciation charges if computed on the basis of distance covered etc.

Fixed costs

Fixed charges will generally include the wages and salaries of the supervisory staff, maintenance personnel, drivers etc. Annual
maintenance charges that are fixed per annum, depreciation calculated on the basis of expected life of vehicles and interest on
capital borrowed for purchase of vehicles will also be classified under this heading.

Semi-variable costs

At times, certain costs are semi-variable and need to be classified and presented under this heading. The semi variable costs
include the cost of hiring vehicles and the cost of employing extra supervisors. These costs increase when the activity level rises
above a certain level.
82

Answers to Test Yourself

Answer to TY 1

The correct option is D.

Production cost per unit is TZS 4,200,000

Cost sheet

Per unit (TZS ‟000) Total costs (TZS ‟000)

Materials 4,500 4,500,000
Direct wages 3,200 3,200,000
Prime cost 7,700 7,700,000
Indirect materials 800 800,000
Indirect wages (W1) 800 800,000
Production cost 9,300 9,300,000
Administration overheads (W2) 225 225,000
Selling and distribution overheads 315.2 315,200
(W3)
Cost of sales / Total costs 9840.2 98,402,000

Workings

W1 Per unit indirect wages = Total indirect wages/Units produced

=TZS 800,000,000/1,000units

= TZS 800,000

Note: administration overheads and selling and distribution overheads are non-production costs.

W2 Per unit administrative costs = Total administrative costs/Units produced

=TZS 225,000,000/1000units

= TZS 225,000

W3 Per unit selling and distributive costs = Total selling and distributive costs/Units produced

= TZS 315,200,000/1000 units

= TZS 315,200

Answer to TY 2

The correct option is A.

Process costing applies and is suitable to industries where there is continuous and mass production. When the production is
undertaken one order at a time, job order costing system is used to record costs. Batch costing applies where production is
undertaken in batches and when an intangible service is provided, we record costs under service or operation costing method.
 83
Answer to TY 3

Dr Process A account Cr
Units TZS ‟000 Units TZS ‟000
Direct material 5,000 5,000

Additional material 6,000

Direct labour 7,000

Manufacturing 2,000 Process „B‟ a/c (entire 5,000 20,000
expense cost transferred to process
„B‟)
5,000 20,000 5,000 20,000

Dr Process B account Cr
Units TZS ‟000 Units TZS ‟000
Process A 5,000 20,000
Material 3,000
Direct labour 4,000
Manufacturing 2,000 Finished goods a/c 5,000 29,000
expense
5,000 29,000 5,000 29,000

Answer to TY 4

The correct option is A.

The value of the materials input into the account is debited to the process account as it is a cost incurred for the process. Any
amount credited to the account is an amount which is an income or which reduces the value of the expenses incurred.

Answer to TY 5

The correct option is C.

Statement showing the units of abnormal loss

Units – kilograms
Material input 1,000
Normal loss at 5% 50
Normal output
950
Actual output transferred to 930
next process
20
Abnormal loss

The abnormal loss will be valued as normal output.

Normal cost per unit = Total cost - scrap value of normal loss
Total input quantity - normal loss quantity

TZS 5,000,000 TZS 3,600,000−0

1,000-50

= TZS 9,050
84

The value for abnormal loss will be = TZS 9,050 x 20 kg

= TZS 181,000

Answer to TY 6

The correct option is B.

The cash received from the sale of normal scrap is always received for the actual units of normal loss. When there is abnormal
gain the sale will only be of the units of actual loss. The units of abnormal gain will be subtracted from the units of normal loss
and cash will be received only for these. The units of abnormal gain are not the ones that are sold.

Answer to TY 7

Statement of equivalent units

Units Materials Conversion costs

Percentage Equivalent Percentage Equivalent
completion units completion units
Units input
1,500
Less:
Finished units 1,125 100 1,125 100 1,125
Working in 375 100 375 60 225
Process 0
Balance units
1,500 1,350
Total

Statement of cost per equivalent unit

Conversion
Materials
costs
Costs incurred (a) 2,250,000 1,800,000
Equivalent units (b) 1,500 1350
Cost per equivalent units TZS 1500 TZS 1333.333
(a)/(b)

Statement of evaluation

Equivalent Materials Cost Equivalent Conversion Cost Total

units as cost per units as cost per cost
regards equivalent regards equivalent
materials unit conversion unit
costs
Finished TZS
units 1,125 TZS 1500 1,687,500 1,125 1333.333 1,500,000 3,187,500
Work in TZS
process 375 TZS 1500 562,500 225 1333.333 300,000 862,500
 85
The process account will appear as:

Dr Process 1 account Cr
Units TZS Units TZS
Materials cost 1,500 2,250,000 Finished goods a/c 3,187,500
Conversion 1,800,000 Work in process a/c 862,500
costs
4,050,000 4,050,000

Answer to TY 8

Statement of equivalent units

Units Additional Materials Conversion

Percentage Equivalent Percentage Equivalent
completion units completion units
Units input 2,200
Less:
Finished units 1,800 100 1,800 100 1,800
Work in process, 31 400 75 300 80 320
January
Work in process, 31 2,100 2,120
January
Total

Statement of cost per equivalent unit

Input Cost TZS Equivalent Cost/unit TZS

‟000 production in units ‟000
Direct material 46,200 2,100 22
Conversion 29,680 2,120 14
costs

Statement of evaluation

Equivalent Materials Equivalent Conversion Total cost

units as cost per units as cost per
Cost TZS
regards equivalent regards equivalent Cost TZS ‟000
unit ‟000 conversion unit
materials
TZS ‟000 costs TZS ‟000
Finished units 1,800 22 39,600 1,800 14 25,200 64,800

Work in 300 22 6,600 320 14 4,480 11,080

process
86
Costs of work completed and work-in-process

Units completed and transferred out during 64,800

January

Work-in-process, 31 January
Direct materials
6,600,000
Conversion costs Total 4,480,000 11,080,000

75,880,000

Self-Examination Questions

Question 1

Job orders are:

A Standardised.

B Non-standardised.

C Both of the above.

D None of the above.

Question 2

What is the primary objective of job costing?

A To find out Expenses incurred on each job.

B To find out Profit or loss on each job.

C Both of the above

D None of the above

Question 3

To which of the below industry is job costing method applicable?

A Aviation and electronics industry

B Hardware and pharmaceutical industry

C Garment works and shoe companies

D Railway locomotive and printing press

 87
Question 4

Gentil Plc has a job order cost system. The following debits (credits) appeared in the work-in-process account in the general
ledger for the month of March 20X3:

TZS ‟000

March Balance 18,000

1
March Direct material 60,000
31
March Direct labour 45,000
31
March Factory overhead applied 40,500
31
March To finished goods (150,000)
31

Gentil Plc applies overheads to production at a budgeted rate of 90% based on the direct labour cost. Job 365, the only job still
in process at the end of March 20X3 has been charged with factory overheads of TZS 3,375. What was the amount of direct
material charged to Job 365?

A TZS 3,375,000

B TZS 4,500,000

C TZS 6,375,000

D TZS 13,500,000

Question 5

Cuisine Plc is a jobbing company. It has set up a scheme for employees working on Job 999, whereby employees who take
less than the standard time to complete the job, will be paid a bonus of 60% of their normal pay (an hourly rate).

The data relating to Job 999 completed by an employee is as follows:

Ø time allowed for Job 999: 5 hours

Ø time taken to complete Job 999: 3 hours

Ø normal hourly rate of pay: TZS 12,000

What is the total pay of the employee for Job 999?

A TZS 36,000

B TZS 50,400

C TZS 60,000

D None of the above

88
Question 6

Which of the following companies would most likely use a process costing system?

A Producer of gasoline

B Producer of stain glass windows

C Road and bridge construction firm D All of the above

Question 7

The value of abnormal gain in a process is

A Credited to the process account

B Debited to the process account

C Credited to the profit and loss account

D Not reflected at all in the process account

Question 8

The following are the details given for process P:

Material input into the process 1,500kg

Value of the material input TZS 7,500,000

Units transferred to next process 1,300 kilograms

Normal loss percentage 5% (scrap value is nil)

Conversion costs TZS 4,000,000

The abnormal loss will be:

A TZS 1,000,000

B TZS 11,500,000

C TZS 1,009,000

D None of these

Question 9

A product is manufactured in two processes, P and Q. The details of process Q are:

Material transferred from process P 5,000kg valued at TZS 20,000,000

Labour costs TZS 2,800,000
Overheads 50% of Labour costs
Closing work in process 500kg
Output transferred to finished goods 4,500kg
Closing WIP is 100% complete for material and 75% complete for labour and overheads
 89
What is the value of the closing work in process?

A TZS 2,323,070

B TZS 2,000,000

C TZS 2,107,689

D TZS 4,500,000

Question 10

In a factory processing goods, products are passed from process P to process Q. For the purposes of costing, the items
received from process P by process Q should be treated as:

A WIP units

B Equivalent units

C Input material

D Finished goods

Question 11

In which of the following situations is process costing used?

A When small numbers of identical products are manufactured

B When large numbers of different products are manufactured

C When small numbers of distinctly different products are manufactured

D When large numbers of nearly identical products are manufactured

Question 12

The following information relates to a manufacturing company.

Process A Process B
Input (kg) 10,000 8,500
Normal loss of input 10% 8%
(kg)
Actual output (kg) 8,500 7,900

For each process, was there an abnormal loss or an abnormal gain?

Process A Process B

A Abnormal gain Abnormal gain

B Abnormal gain Abnormal loss
C Abnormal loss Abnormal gain
D Abnormal loss Abnormal loss
90
Question 13

The following details relate to a manufacturing company which operates a process costing system:

Units Valued at Degree of completion

Opening inventory (WIP ) 500 units TZS 1,850,000 70% in all costs
Completed and transferred 2,200 units
units

The cost per equivalent unit was TZS 15.

The total value of the units introduced and transferred in this process will be:

A TZS 29,600,000

B TZS 25,500,000

C TZS 33,000,000

D None of the above

Question 14

Which method of costing is appropriate for doctors?

A Standard costing

B Marginal costing

C Service costing D Job costing

Question 15

Cost per passenger mile of XOTC Travel Company and Royal Travel Company comes to TZS 5,000 and TZS 6,000
respectively.

Both companies provide an equal standard of service. Both the companies charge the customers TZS 7,000 per passenger
mile. Which company will be more profitable?

A XOTC Travel Company BRoyal

travel Company

Question 16

From the following information, prepare an operating cost sheet.

Truck TZS Bus TZS

‟000 ‟000
Driver‟s salary 2,000 3,000
Petrol 4,500 3,750
Repairs 750 500

Depreciation 1,250 1,750

Rent and taxes 500 500

 91
Other overheads 1,200 1,800

The truck carried 100 tonnes of raw material and the bus carried 25 passengers per day during a month.

In a month, the truck covered 3,000 miles and the bus, 2,000 miles.

Monthly working days are 25.

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is B.

Job orders are non-standardised as each job is different from the other, and are made according to the customer‟s
specifications. Thus, non-standardised procedures are followed to complete each different job.

Answer to SEQ 2

The correct option is C.

The primary objective of job costing is to charge direct material, direct labour and manufacturing overheads correctly to
calculate profit or loss on each job.

Answer to SEQ 3

The correct option is D.

Job costing is applied to the railway locomotive and the printing press, as jobs in these industries are independent of each
other.

Answer to SEQ 4

The correct option is C.

Two steps are used to obtain the answer.

First, calculate the balance of work in process at the end of the period in the general ledger.

By adding the debits and subtracting the credit, the balance is TZS 13,500,000. This amount is also the balance of Job 365 in
the subsidiary ledger because it is the only job still in process at the end of the month.

Second, calculate the amount of direct material charged to Job 365:

TZS ‟000 TZS ‟000

Total costs charged to Job 365 13,500

Deduct: Factory overhead applied (3,375)

3,750 7,125
Direct labour (TZS 3,375,000/0.90)
Direct materials charged to Job 365 6,375
92

Answer to SEQ 5

The correct option is B.

Pay per hour Total pay (TZS )

Allowed time 5 hours
Time taken 3 hours TZS 12,000 36,000

Saved time 2 hours 2 x TZS 12,000 x 60% = TZS 7,200 14,400

50,400

Answer to SEQ 6

The correct option is A.

Process costing applies to industries that produce homogenous products on a continuous basis. Production of gasoline is a
continuous process that results in production of homogenous products that are identical in all respects.

Option B - Stain glass window production is done on the basis of specific job requirement and hence job or batch costing will
apply.

Option C - In road and bridge construction, contract costing is applicable.

Answer to SEQ 7

The correct option is B.

The process account is debited with the quantity and value of abnormal gain and abnormal gain account is credited. This
effectively accounts for the reduction in the value of normal loss.

Answer to SEQ 8

The correct option is C.

Calculation of abnormal loss

Process P Units

Materials input 1,500

Less
Normal loss @5% (1,500 x
5%) 75
Normal output 1,425

Actual output 1,300

Abnormal loss (1425 – 125

1300)

Valuation of abnormal loss

Cost per unit

 93
Process cost - scrap value of normal loss
Actual input - normal loss
(TZS 7,500,000 TZS 4,000,000)
1,500 - 75
TZS 11,500,000
1,425
TZS 8070

Value of abnormal units = Units of abnormal loss x Cost per unit

= 125 x TZS 8070

= TZS 1,009,000

Answer to SEQ 9

The correct option is A.

The correct option is option a, the calculations for which are given below:

Process Q - Statement of equivalent units

Units Materials Labour Overheads

Percentage Equivalent Percentage Equivalent Percentage Equivalent
completion units completion units completion units
Units
transferred
from
process P 5,000
Less:
Finished
goods 4,500 100 4,500 100% 4,500 100 4,500
Work in
process 500 100 500 75% 375 75 375

Total 5,000 4,875 4,875

Process Q - Statement of cost per equivalent unit

Cost TZS Equivalent Cost/unit

Input production in TZS
units
Direct material 20,000,000 5,000 4,000
Labour 2,800,000 4,875 574.35

Overheads 1,400,000 4,875 287.17

Total cost per unit

94

Working 2

Cost per unit Total cost

Units
TZS TZS
Finished goods 4,500 4861.5 21,876,750
WIP
Material 500
4,000 2,000,000
Labour 375 574.35 215,381
Overheads 375 287.17 107,689
Value of closing WIP
2,323,070
Total
24,199,820

Answer to SEQ 10

The correct option is C.

In process costing, each process performs part of the total operation and transfers it as finished goods to the next process, in
which it is treated as input / raw material for further processing. Therefore the products passed from process P to process Q will
be input materials for process Q.

Answer to SEQ 11

The correct option is D.

The process costing system refers to the procedure of determining the average unit cost in situations where the product passes
through more than one manufacturing process. This is applicable when identical units are produced continuously in the uniform
production process.

Option (a) - Is suitable for batch costing

Option (b) - When the products are not homogenous, job or batch costing is applicable

Option (c) - This is also a situation where job costing will apply for each different job or production undertaken

Answer to SEQ 12

The correct option is C.

Process A Process B

Input (kg) 10,000 8,500

Normal loss of input (kg) 10% 8%
Normal loss (kg) 1,000 680
Normal output (kg) (W1) 9,000 7,820
Actual output (kg) 8,500 7,900
Abnormal gain (Actual output >Normal - 80
output)
Abnormal loss (Normal output > Actual 500 -
output)
 95

Workings

W1

Normal output = Input – Normal loss

For process A: 10,000 – 1,000 = 9,000kg For

process B: 8,500 – 680 = 7,820kg Answer to SEQ
13

The correct option is A.

Cost per equivalent unit

Units TZS
TZS
Value of opening WIP - 70% complete 350 1,850,000
Cost incurred on opening inventory (500 x 30%) 150 15 2,250,000
Units introduced and transferred (2,200 – 500) = 1,700 1,700 15 25,500,000
units
2,200 - 29,600,000

Answer to SEQ 14

The correct option is C.

Doctors are professionals who provide services of an intangible nature to the patients. As a result, the most appropriate
method of recording the costs for the activity is service costing.

Answer to SEQ 15

The correct option is A.

Although the prices charged to the customers by the operators are equal, the costs for XOTC are lower compared to Royal
Travel Company. As a result, profit will be higher for XOTC (TZS 7,000 - TZS 5,000 = TZS 2,000) than for Royal Travel
Company (TZS 7,000 - TZS 6,000 = TZS 1,000).

Answer to SEQ 16

Operating Cost Sheet

Truck (TZS
Bus (TZS ‟000)
‟000)
Fixed Cost
Driver‟s Salary 2,000 3,000
Depreciation 1,250 1,750
Rent and Taxes 500 500
1,200 1,800
Other Overheads
Total Fixed Cost 4,950 7,050
Variable Expenses
Petrol 4,500 3,750

750 500
Repairs
Total Variable cost 5,250 4,250
Total cost 10,200 11,300
 96
Truck

Details given in the problem Interpretation

1 The truck carried 100 tonnes During the month, the truck carried 100 tonnes, therefore per day
raw material it carried 4 tonnes (100 tonnes/25 days)
2 In a month the truck covered Total distance covered in a month was 3,000 miles, working days
3000 miles were 25, therefore, distance covered per day = 3,000/25 = 120

3 Monthly working days are 25 Tonne miles in a month = Tonnes carried per day x No. of days x
miles travelled
= 4 x 25 x 120
= 12,000 tonnes miles

Bus

Details given in the problem Interpretation

1 The bus carried 25 25 people travelled everyday

passengers per day during a
month.
2 In a month, the bus covered Total distance covered in a month was 2,000 miles, working days
2,000 miles are 25, therefore, distance covered per day = 2,000/25 = 80

3 Monthly working days were 25 Passenger miles in a month= no. of passenger per day x no.
of days x miles travelled
= 25 x 25 x 80
= 50,000 passenger miles

Operating cost statement

Reasons / calculations Truck (TZS Bus

‟000) (TZS ‟000)
Fixed costs
Driver‟s salary Fixed monthly expense 2,000 3,000

Depreciation Assumed to be fixed based 1,250 1,750

Assumed all overheads are
Other overheads fixed 1,200 1,800

500 500
Rent and Taxes 4,950 7,050
Fixed expense
Total fixed costs
12,000 50,000
Tonne mile travelled
0.4125 0.1410
Fixed cost per passenger mile (a)
It varies according to the
Variable costs
distance travelled hence
variable cost 3,750
Petrol
4,500

Repairs 750 500

It depends on the running of
the vehicle and hence is a
Total variable costs variable cost. 5,250 4,250
Tonne miles travelled
12,000 50,000
Variable cost per passenger mile
(b) 0.4375 0.0850

Total cost per unit (a + b) 0.85 0.226

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A4
SECTION B

COSTING

SECTION A4: MARGINAL AND ABSORPTION COSTING

Cost ascertainment and management requires a management accountant to take many decisions based on different cost
considerations. There are various methods/systems of costing that are designed to aid this decision-making process. The
marginal costing method recognizes cost behaviour and divides costs into those which vary with production (e.g., raw materials)
and those which are fixed for a period (e.g. rent). According to this method only variable costs are included in inventory valuation.
In contrast, the absorption costing method suggests computing unit product costs by adding up all the manufacturing costs –
fixed and variable. This Study Guide will introduce you to all the above-mentioned concepts. An accountant needs a thorough
knowledge of these concepts while taking all cost related decisions.

a) Identify and calculate unit costs and the effect of different costing methods on reported financial results
using marginal and absorption costing approaches.
b) Calculate and explain the differences between reported income using variable costing and absorption
costing approaches.
c) Select, explain and use the most appropriate costing approach for a given product or service for reporting
and decision-making purposes
98

1. Identify and calculate unit costs and the effect of different costing methods on reported financial results using margin
absorption costing approaches.
[Learning Outcom

Absorption costing and marginal costing are the two basic methods of recording product / service costs used in management
accounting. Absorption costing method records all the costs / expenses incurred / associated with manufacturing a product to
arrive at product cost calculations. It follows the historical accounting approach where costs are recorded only when they are
incurred. Absorption costing approach is hence a method preferred for external reporting.

Marginal costing on the other hand records costs by differentiating between fixed and variable costs. This differentiation forms
the basis for all the concepts and profit calculations under marginal costing.
1.1 The elementary concept of marginal costing

We have already learnt that fixed and variable costs behave differently with changes in the volume of production. Variable
costs (also known as marginal costs) change with an increase or decrease in volume of production (accordingly, the variable
costs per unit remain fixed) whereas fixed costs normally remain unaltered with a change in the volume of production. Fixed
costs however, will change over time.

When fixed costs are included in total costs, the cost per unit of a product or a service varies from one accounting period to
another in accordance with the volume of production / service in each period.

Consequently, one school of thought has said that fixed costs should be taken out of total costs, to avoid the variation. This is
termed marginal costing.

“Marginal costing” is the accounting system in which variable costs are charged to cost units and fixed costs of the period
are written-off in full against the aggregate contribution. Its special value is in recognising cost behaviour, and hence assisting
in decision-making.

CIMA Official Terminology, 2005

The product costs under marginal costing only include direct materials, direct labour, direct expenses and variable overheads.
It recognises cost behaviour and hence is useful in decision-making. Knowledge of marginal cost is fundamental to
understanding the concept of marginal costing. Marginal cost is defined as:

Marginal cost is the cost of one unit of product or service which would be avoided if that unit were not produced or provided.

CIMA Official Terminology, 2005

In other words, it is the amount at any volume of production by which aggregate costs are changed if the volume of production
is increased or decreased by one unit. The terms marginal cost and variable cost tend to be used interchangeably.

Roberto Plc is in the business of producing toiletries. The variable cost of producing a unit of bathing soap is TZS 1,500. The
company is currently producing 1,000 units of soap a week. Its fixed costs for the week are TZS 500,000. Therefore, the cost
of producing the weekly lot of soaps is TZS 2,000,000 (TZS 1,500 x 1,000 + TZS 500,000). If the company decides to increase
the production of the soaps by one unit (i.e. if 1,001 units are produced) its total costs will be TZS 2,001,500 (TZS 1,500 x
1,001 + TZS 500,000). This signifies that the differential cost for producing one extra unit is TZS 1,500. By its definition,
therefore, TZS 1,500 is the marginal cost (which is the variable cost per unit) of the product.
 99

nal and 1.2 The concept of contribution

me, a] In marginal costing, the term contribution signifies an alternative measure of profit, which is computed as sales less the
total variable costs of sales.
Accordingly, Contribution = Sales – Variable costs

Diagram 1: Contribution

Contribution for the period provides a pool (since it recognises a surplus generated by sales revenue over variable costs)
out of which the fixed costs for the period are met and any surplus constitutes the profit. It is called contribution because
it literally contributes towards fixed costs and profit.

As a result, Contribution = Fixed costs + Profit

In the above example of Roberto Plc, if the selling price of the bathing soaps is TZS 2,000 per soap then the contribution
per unit of soap will be calculated as below.

Contribution per unit will be:

Selling price – variable cost
TZS 2,000 – TZS 1,500 = TZS 500

Similarly, total contribution for 1,000 soap bars will be: TZS 500 x
1,000 = TZS 500,000

Total profit will be

TZS 500,000 – TZS 50,000 = TZS 450,000

Let us verify whether the equation Contribution = Fixed costs + Profit holds true for the above example – TZS 500,000
= TZS 50,000 + TZS 450,000
TZS 500,000 = TZS 500,000

The sales price as well as the variable cost per unit is fixed for each unit produced and sold. Accordingly, contribution is
also fixed per unit. Therefore, like the sales price and the variable costs per unit, the contribution per unit also remains
unaltered (unlike profit per unit) over the accounting periods. Accordingly, profit planning for the future becomes easier if
the contribution of a product is known rather than its profit.
Profit is calculated as sales less cost of sales (including fixed costs) and so, with an increased volume of sales, a higher
profit per unit is generated (as fixed cost is generally constant within a range).
On the other hand, contribution changes with a change in the number of units sold. However, it remains constant per
unit. Since contribution is controllable and easier to predict than profit, it is used extensively in managerial decision
making such as identifying the most profitable product mix, deciding on whether to make a component or to buy it for use
in manufacturing a product (or to sell it outright) and so on.
Also, the concept of contribution is useful for identifying the break-even point, the margin of safety, and for other sorts of
cost-volume-profit analysis.
100

Cost–volume–profit (CVP) analysis is the study of the effects on future profit of changes in fixed cost, variable cost,
sales price, quantity and mix

The following example presents how contribution and profit are computed and also the effects of change in activity level
on contribution per unit and profit per unit.

An excerpt from the financial projections of Ricky Ltd for the month of January, 20X8 is presented as follows:

Direct material (per unit) TZS 8,000

Direct labour (per unit) TZS 4,000
Variable production overhead (per unit) TZS 1,000
Variable sales overheads (per unit) TZS 2,000
Selling price TZS 20,000
Total fixed cost (per month) TZS 3,000,000
Budgeted production 1,500 units
Potential demand for the product 500 or 600 or 1,200 units

Calculating the contribution at the budgeted activity levels of 500, 600 and 1,200 units requires the following steps:

(i) Deduct the variable costs of sales from the sales revenue to calculate contribution

(ii) Value the closing inventory at variable cost of production

(iii) Deduct the total fixed costs from the total contribution to get the total profit of the business.

Situation-1 Situation-2 Situation-3

500 units 600 units 1,200 units
TZS ‟000 TZS ‟000 TZS ‟000
Sales (a) 10,000 12,000 24,000
Less: Variable cost
Production cost 6,500 7,800 15,600
((TZS 8,000+ ((TZS 8,000+ ((TZS 8,000+
TZS 4,000+TZS 1,000) TZS 4,000+TZS 1,000) TZS 4,000+TZS
x 500) x 600) 1,000) x 1,200)
Selling expenses 1,000 1,200 2,400
(TZS 2,000 x 500) (TZS 2,000 x 600) (TZS 2,000 x 1,200)
Total Variable cost of sales (b) 7,500 9,000 18,000
Contribution (a – b)
2,500 3,000 6,000
Less:
Fixed cost 3,000 3,000 3,000
Profit / (loss) (500) 0 3,000
Contribution per unit TZS 5 TZS 5 TZS 5
(TZS 2,500,000/500 (TZS 3,000,000/600 (TZS 6,000,000/1,200
units) units) units)
 101
The conclusions from the above example are given below:

(a) Contribution per unit remains the same irrespective of the level of activity. Therefore, the total contribution at
any level of activity is the contribution per unit multiplied by the sales volume. Contribution increases in direct
proportion to sales volume.
(b) When contribution exceeds fixed costs, the business starts making a profit (see situation 3).

(c) When contribution equals fixed cost there is a situation of no profit no loss (see situation 2)

(d) When the contribution is less than fixed costs, the business incurs losses (see situation 1).

Unlike contribution, profit per unit does not remain constant. It changes along with a change in the level of activity.

Diagram 2: Total cost graph

Diagram 3: Marginal cost (per unit) graph

2. Calculate and explain the difference between reported income using marginal costing and absorption
costing approaches. [Learning outcome
b]

Differences in reported financial results when marginal and absorption costing are used arise due to the difference in
product and inventory valuations under both these methods of costing.

Absorption costing is the basis of preparing all financial accounting statements. Using absorption costing, all costs are
absorbed into production and therefore operating statements do not distinguish between fixed and variable costs.
102
Under absorption costing, the entire costs of production, whether variable or fixed, are considered to be the product
costs and only the non-manufacturing costs (both variable and fixed) are considered to be period costs.

Non-manufacturing costs (i.e., administration costs, research and development costs and selling and distribution costs)
are not allocated to the products; instead, they are charged as an expense to the period in which they are incurred. This
means, under absorption costing, for product costing and valuation of inventory all the costs that are incurred in order
to produce an item are considered.

On the other hand, under marginal costing, fixed costs are not absorbed into the cost of production.

Only the variable costs of production are considered to be product costs and the inventory is valued accordingly.
Fixed production costs as well as all non-manufacturing costs (both variable and fixed) are considered to be period
costs and accordingly they are not considered in determining the product costs or for valuation of inventories.

The following illustration highlights how determination of the cost of production (the cost at which inventories are valued)
differs under the two methods:

Under absorption costing Under marginal costing

(Cost per unit) (Cost per unit)
(TZS ‟000) (TZS ‟000)
Direct material 27.50 27.50
Direct labour 7.50 7.50
Direct expenses 2.50 2.50
37.50 37.50
- Fixed overhead 2.00 -
- Variable overhead 6.00 6.00
Cost of production 45.50 43.50

1. The effect of absorption and marginal costing on inventory valuation

Under marginal costing, no fixed manufacturing cost is charged to the product. Only variable manufacturing costs are
charged to the product and therefore considered for inventory valuation. Consequently, the cost per unit remains constant
irrespective of a change in the activity level.

In contrast, under absorption costing, fixed manufacturing costs are assigned to the product. Therefore, the cost per unit
changes along with a change in the activity level.

Metal Plc follows the absorption costing system. Metal Plc‟s fixed production cost is TZS 100,000,000. The variable cost
(inclusive of direct and indirect costs) per unit is TZS 10,000. In the month of April 20X3, the company‟s production was
10,000 units. Therefore, each product absorbs a fixed cost of TZS 10,000 (TZS 100,000,000/10,000) making the per unit
total cost of production TZS 20,000 (variable costs TZS 10,000 + fixed costs TZS 10,000).

However, in the month of May 20X3, the production volume rose to 12,500 units. Accordingly, the fixed production cost
was assigned to each product as TZS 8,000 (TZS 100,000,000/12,500). Therefore, per unit production cost was TZS
18,000 (TZS 10,000 + TZS 8,000).

This shows that with a change in the activity level (i.e. from 10,000 units to 12,500 units), the cost per unit of the product
also changes (from TZS 20,000 to TZS 18,000) under absorption costing.

Consider the example below to understand how the valuation of inventory differs under marginal costing and absorption
costing.
 103

During the month of May, 20X3, Sunshine Ltd produced 1,500 units, and sold 1,200 units. Cost
information of Sunshine Ltd:

Cost per unit of production

(TZS ‟000)
Direct material 10
Direct labour 8
Variable overheads 3
Fixed overheads absorption rate per unit 2

In this case, closing inventory is valued under marginal costing and absorption costing as follows:

Marginal costing Absorption costing

Closing 300 units 300 units
Inventory (TZS ‟000) (TZS ‟000)
Direct material 10 10
Direct labour 8 8
Variable 3 3
overheads
Fixed overheads - 2
Per unit cost
21 23
Total inventory
value TZS 6,300 TZS 6,900

The example above reveals that the value of closing inventory under absorption costing is higher than the value of closing
inventory under marginal costing. The difference in inventory valuation between the two methods is attributable to the
fixed costs that are considered in inventory valuation under the absorption costing method whereas they are not
considered under the marginal costing method.

2. General format of reporting financial results under marginal costing

TZS TZS
Sales X
Less: Variable costs
Direct material X
Direct labour X
Variable overhead X
(X)
Difference in opening and closing inventory X
Total adjusted variable cost
Contribution margin X

Less: Fixed overheads

Production X
Administration X
Selling expenses X X
Net profit X
104
3. General format of reporting financial results under absorption costing

TZS TZS TZS

Sales X
Less: Production costs
Direct material X
Direct Labour X
Direct expenses X
Prime cost X
Variable production overheads X
Fixed production overheads (Budgeted fixed cost per X
unit x No of units produced)
Factory costs or production cost X
Difference in opening and closing inventory X
Cost of goods sold X
Gross margin
X
Under / Over absorption of fixed overheads X / (X)
Less: Non-manufacturing costs
Administration overheads X
Selling and distribution overheads X X
Net profit X

Which of the following statements is /are correct with reference to marginal costing?
(i) Only variable costs are taken into account for computing the value of inventory

(ii) Profitability is determined in terms of marginal contribution

(iii) Variable costs are charged to cost units and fixed costs are written-off

A (i) and (ii)

B (ii) and (iii)
C (i) and (iii)
D All of the above

3. Select and explain the most appropriate costing approach for a given product or service for reporting and
decision-making purposes. [Learning outcome c]

Decision-making is an exercise of choosing a particular course of action out of several alternative courses to achieve the
given objective. In the context of an organisation, this decision mainly involves choosing between alternatives that will
either lead to profit and sales maximisation or cost minimisation.

The marginal costing method gives more importance to variable costs than fixed costs, since variable costs are the only
costs that increase when an additional unit of a product is manufactured. Decision-making involves calculation of profit
with the chosen alternative by deducting additional costs from the additional income expected. Variable costs are the
only additional costs incurred, while fixed costs always remain the same between two alternatives.

Marginal costing gives more importance to contribution as a tool for profit ascertainment. We may justify this putting
forward some principles justifying marginal costing as a better tool for reporting profits and decision-making:

1. Fixed costs never undergo any change (within the given range) as long as the activity levels do not change and
sales volumes never affect the amount of fixed costs incurred. Hence fixed costs should not be deducted from sales
 105
to calculate profit. Profit calculations should be based more on an analysis of contribution. Final profit may be arrived
at by deducting the total fixed costs from the total contribution.

2. Fixed costs always relate to an activity period. These costs do not change with any change in the sales volume.
Marginal costing hence operates on the basis of the following assumptions:

(a) Variable costs increase when any additional unit is produced.

(b) Fixed costs remain constant.

(c) Hence profit earned should be calculated as the difference between the sales price and the variable additional
costs incurred. This is called contribution.

(d) If sales reduce, only the variable cost of manufacture reduces and hence profit is again equal to the contribution
earned on lost sales.

Similarly, the valuation of closing inventories should also be based on the variable costs incurred on these ignoring the
fixed cost component. This is because fixed costs remain the same whether the units are sold or they remain in inventory.
Attributing only variable costs to inventory will provide a more realistic picture.

Floral Designs is a fashion apparels manufacturer and wants to decide whether they may order raw materials from a new
supplier. The new supplier will charge them TZS 40,000 per meter of cloth. The existing inventory of cloth is valued at
TZS 35,000 per meter of cloth. There will be an additional sale of 10,000 units of apparel if the new cloth from the new
supplier is used in manufacturing. In this situation the variable costs of materials of TZS 40,000 per meter of cloth are
relevant for decision-making purposes.

The profit from the additional sales will also be calculated by considering sales minus variable costs and not total costs.
This is because fixed costs like, may be, machine cost or any other fixed overhead cost like rent etc have been incurred
already. Buying cloth from the new supplier will not make any difference to these costs.

Hence marginal costing approach of calculating additional contribution from additional units of sale is relevant for decision-
making here.

Diagram 4: Marginal costing

Decision-making and reporting profits can be best achieved by use of marginal costing because:

A It considers the contribution approach to profit calculation

B It considers fixed costs as irrelevant to decision-making since they do not change between alternative courses of
action
C It values units of production and inventories at variable cost since these are the only additional costs incurred
D D All of the above

Answers to Test Yourself

Answer to TY 1

The correct option is D.

106
Under marginal costing, only variable costs are accumulated and charged to cost units. Fixed costs of the period are
fully written-off. Hence, profitability is determined in terms of marginal contribution that is sales less variable costs. Under
this method, only variable manufacturing costs are considered for valuation of inventory.

Answer to TY 2

The correct option is D.

Marginal costing calculates profit based on the contribution approach, does not consider fixed costs as relevant for
decision-making and values production units and inventories at variable costs. All these factors make it a more realistic
approach for profit calculations, reporting financial results and decision-making.

Self- Examination Questions

Question 1

Under marginal costing closing inventories are valued at:

A Full cost
B Total production cost
C Variable production cost
D Total variable cost

Question 2

Which of the following statements is incorrect?

A Under absorption costing inventory is valued at variable cost of production
B Absorption costing is also known as full costing
C In the short term, marginal cost remains constant
D Marginal cost is the cost of one product which can be avoided if that unit is not produced

Question 3

Strickland Company manufactures office furniture. The company provides the following information pertaining to its first
year of operation:

Sales 10,000 units

Production 12,000 units

Sales price TZS 18,000

Direct material (per unit) TZS 3,000

Direct labour (per unit) TZS 5,000

Variable overheads TZS 2,000

Selling and distribution overheads

Fixed
TZS 10,000,000
Variable TZS 1,000
Fixed production overheads TZS 24,000,000

If the company uses absorption costing, what would be the cost of production and gross margin of the company?

A TZS 144,000,000, TZS 60,000,000

B TZS 180,000,000, TZS 36,000,000
C TZS 120,000,000, TZS 40,000,000
D D None of the above
 107
Question 4

Following is the budgeted data provided by Marine Ltd, a boat manufacturing company.

Budgeted production quantity (for July 20X3) 20,000 units

Actual production quantity 18,000 units
Actual sales (for July 20X3) 15,000 units
Sales price (per unit) TZS 50,000
Direct material (per unit) TZS 10,000
Direct labour (per unit) TZS 10,000
Variable production overheads TZS 5,000
Fixed production costs TZS 72,000,000
Fixed selling expenses TZS 30,000,000

Assuming that there is no closing inventory in the month of June 20X3, what should be the value of closing inventory for
July 20X3 under the marginal costing system as well as the absorption costing system?

A TZS 75,000,000 and TZS 87,000,000

B TZS 84,000,000 and TZS 87,000,000
C TZS 84,000,000 and TZS 96,000,000
D TZS 75,000,000 and TZS 96,000,000 .
E

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is C.

Marginal costing is a costing method in which prime costs and variable factory overheads are used to value inventories.

Answer to SEQ 2

The correct option is A.

Statements B C and D are correct statements. Statement A is an incorrect statement because under marginal costing,
inventory is valued at the variable production cost. This does not happen under absorption costing. Under absorption
costing, inventory is valued at total production cost.
108
Answer to SEQ 3

The correct option is A.

Under absorption costing, cost of goods is calculated as follows:

TZS ‟000 TZS ‟000

Sales (10,000 x TZS 18,000) 180,000

Direct material (TZS 3,000 x 12,000) 36,000

Direct labour (TZS 5,000 x 12,000) 60,000

Variable overheads (TZS 2,000 x 12,000) 24,000

Fixed production overheads 24,000

Cost of production
144,000
Difference in opening and closing inventory (W1) (24,000) 120,000
Gross Margin
60,000

Workings

W1 Difference in opening and closing inventory

TZS ‟000

Opening inventory 0
Closing inventory (12,000 - 10,000) x (TZS 144,000,000 /12,000) (24,000)
(24,000)

Answer to SEQ 4

The correct option is A.

Explanation

Marginal costing Absorption costing

Closing Inventory (18,000 -15,000) 3,000 units 3,000units

TZS ‟000 TZS ‟000

Inventory value includes:

Direct material 10
10
Direct labour 10 10
Variable overheads 5 5

Fixed overheads 0 4
TZS 72,000/18,000 units
Per unit cost
Total inventory value 25 29

75,000 87,000
 109

B1
SECTION B

INTRODUCTION TO
DECISION MAKING

SECTION B1: CVP ANALYSIS FOR A SINGLE

PRODUCT

An entrepreneur always invests in a business with the hope of receiving maximum returns on his investment. In order
to understand business statistics, one needs to know the impact of business decisions on financial results. Various
decision-making techniques are used by cost accountants to assess business parameters. Some crucial questions
that businesses face include:
- At what production level should we produce to be able to cover all the costs incurred?
- What sales levels will ensure earning a certain profit targets?
- At what level can sales/production decrease before a firm start incurring losses?

These questions can be answered by calculating the contribution margins, break-even points, and the margin of
safety, considering various targeted sales, production or profit levels. This Study Guide will help you learn all these
techniques in detail. An accountant needs to regularly use these techniques for a day-to-day decision-making. This
Study Guide is also important for examinations since long questions can be based topics from this Study Guide.

(a) Describe the concepts of break-even analysis and contribution margin.

(b) Prepare and interpret a break-even chart.
(c) Calculate the margin of safety and target profits for a single product.
(d) Explain the benefits and limitations of CVP analysis.
110

1. Describe the concepts of break-even analysis and contribution margin.

2. Prepare and interpret a break-even chart
3. Explain the benefits and limitations of CVP analysis
[Learning outcome, a, b and d]
1.1 CVP analysis

Cost-Volume-Profit (CVP) analysis is one of the common methods of cost accounting used to analyze the
relationship between cost, volume, and profit. CVP analysis is applied to determine the impact of cost, volume,
and pricing changes on a company’s operating and net profits. Companies use it to determine the breakeven
point, the point at which total revenue equals total costs, and to project how changes in costs, volumes, and
prices will affect a company’s future profit. The analysis is very useful in guiding for proper decision-making
regarding price of the product, production levels, and cost control.

Components of CVP Analysis

In order to perform the CVP analysis, different components are involved. These components are:
Fixed costs: These are the costs that do not change with the changes in sales or production volumes. Examples
of fixed costs include rent, salaries and advertising.

Variable costs: These are the costs that change due to changes in the volumes of sales or production.
Examples of variable costs include the costs of raw materials and direct labor.
Contribution margin: This is the difference between company’s total revenue and total variable costs.it can also
be presented as a contribution margin per unit, expressed as the difference between selling price per unit and
variable cost per unit.

Contribution margin ratio: This is the contribution margin expressed as a percentage of total revenue or
contribution margin per unit expressed as a percentage of selling price per unit.

Sales volume: This is the number of products that businesses sell during a specific period.

Break-even point: This is a level of sales volume when the total costs and revenue are equal, meaning the
business is neither making a loss nor a profit.

Selling price: This is the amount a customer pays for the product.

Difference between CVP analysis and Break-even analysis

Cost Volume Profit (CVP) analysis and break-even analysis are sometimes applied to mean the same thing,
but in reality, they differ from each other. CVP analysis is a comprehensive analysis that examines the
relationship between sales volume, costs, and profit to determine break-even points and profit targets. It
considers various factors like sales price, costs, and sales mix.

Break -even analysis is just a subset of CVP analysis focused on finding the point where total revenue equals
total costs, resulting in zero profit or loss. It helps determine the minimum sales volume needed to cover costs.
Break-even analysis only identifies the sales volume and/or the sales revenue required to break-even.

Assumptions that CVP analysis makes

The applicability of CVP analysis depends on the following assumptions:

• The sales price per unit remains constant.

• Variable costs per unit remains constant.

• Total fixed costs are constant.

• All the units produced are sold.

• Changes in expenses occur because of changes in activity level.

• If a company sells more than one product, it sells them in the same mix.
 111
1.2 Contribution Margin

Contribution signifies an alternative measure of profit, which is computed as sales less the total variable costs of
sales for a product / service.
We have studied the concept of contribution in Accordingly, Contribution = Sales – Variable costs

For a product / service, contribution provides a pool (since it recognises a surplus generated by sales revenue
over variable costs) out of which fixed costs for the period are met and any surplus constitutes the profit. It is
called contribution because it literally contributes towards fixed costs and profit.

Alternatively, Contribution = Fixed costs +

Profit
Combining these two equations:
Sales – variable cost = Fixed cost + profit

This equation can also be rearranged in the following ways:

1. Sales – Fixed cost – Profit = Variable cost

2. Sales – (Variable cost + Fixed cost) = Profit

The variable cost of a calculator is TZS5,000, whereas the per annum fixed cost is TZS50,000,000. As
contribution contributes to fixed cost and profits, if the business does not produce and sell a single unit during
the budget period, then there is no contribution to cover fixed costs. Hence, the loss is equal to the fixed costs
of TZS50,000,000.

A business produces 18,000 units per month. The selling price of the product is TZS10,000 per unit and the
variable cost is TZS6,000 per unit. Fixed expenses incur monthly to the extent of TZS34,000,000. Compute the
monthly profit of the business.

Answer:

Profit = Total Revenue – Total cost

= (TZS10,000 x 18,000 units) – (TZS34,000,000 + (TZS6,000 x 18,000 units)

= TZS180,000,000 – TZS142,000,000

The monthly profit of the business = TZS38,000,000

Alternatively:

Sales – variable cost = Fixed cost + profit

18,000 (TZS10,000 - TZS6,000) = TZS34,000,000 + profit

= 18,000 (TZS10,000 - TZS6,000) - TZS34,000,000
= TZS72,000,000 – 34,000,000

The monthly profit of the business = TZS38,000,000

112

A business produces 5,000 units per month. The selling price is TZS20,000 per unit and the variable cost is
TZS12,000 per unit. The business earns a profit of TZS10, 000,000per month. Compute the fixed cost incurred
per month.

Answer:

Sales - variable cost = Fixed cost + profit

5,000 (TZS20,000 - TZS12,000) = Fixed cost TZS10,000,000

TZS40,000,000 - TZS10,000,000 = Fixed cost

Fixed cost = TZS30,000,000

Contribution Margin ratio (CMR)

This ratio is also termed profit-volume ratio (P/V ratio). Usually, the contribution margin ratio is expressed as a
percentage of total contribution over total revenue. The contribution margin ratio remains constant if the selling price
and variable cost of an organization are constant.

CMR ratio is a measure of profitability. A high C/S ratio is indicative of high profitability. An increase in the ratio signifies
that contribution grows more quickly compared to increase in sales level.

Total Contribution
´ 100
Total Sales

Total sales - Total var iable cos t

´ 100
Total Sales

Blackberry Plc has given the following details about its cost structure

TZS
Direct materials 8,000
Direct labour 4,000
Variable overheads 3,000

The sales price of its sole product is TZS22,000 and the fixed cost per annum is TZS85,000,000. The company achieved
a sales volume of 18,000 units in the year. Calculate the CM ratio.

Answer

Contribution = Sale value per unit –

variable cost per unit
= TZS22,000 –
TZS(8,000+4,000+3,000) = TZS7,000
CM ratio = TZS7,000/TZS22,000 x 100
CM ratio = 31.818%
 113
A high contribution to sales ratio is indicative of high profitability. The C/S ratio as computed may be considered to be
not very high. The C/S ratio also indicates that variable cost is 68.182% of total sales. It implies that the company will
have low profitability per unit.

The break-even point

Whenever a new product is going to be introduced in the market, it is obvious that the organisation needs to know
the sales level at which the sales revenue would be sufficient to recover the entire costs. This is a vital indicator
because any additional quantity of sales beyond this level would make a profit for the organisation.

Knowing the break-even point is also important for any product which has undergone any change in its cost structure,
whose price has been revised or which is going to be launched in a different sales territory.

As sales revenue grows with every additional unit of sales, the contribution also grows in tandem and at a certain level
of sales; contribution just covers the fixed cost. At this level of sales, the amount of contribution must match the amount
of fixed costs exactly. This is known as the break-even point.

The break-even point may either be expressed in terms of sales units or in terms of sales value (i.e.,
in monetary terms) as follows:
Break - even point sales in units = Total fixed costs
Contribution per unit

Break-even point in terms of sales value = Fixed costs/CM ratio

Break-even point in terms of sales value = Break-even point in
units x Sales price per unit
If the business continues to produce a product over and above the break-even point, it starts contributing to profits
only because at this stage the entire fixed costs are already recovered.

Green Plant Inc manufactures herbal creams. The variable cost per unit is TZS5,000 and the sales price per unit is
TZS9,000. The total fixed cost is TZS28,000,000 per month. Calculate the break-even point.

Answer

Break - even point (in units) = Total fixed costs

Contribution per unit

= TZS28,000,000
(9,000 - TZS5,000)

= 7,000 units

Break-even point (in terms of sales value) = 7,000 units x TZS9,000 per unit
= TZS63,000,000
114
Alternatively,

By using the CM ratio, the break-even point in terms of the sales value may be computed as:

Break - even point in revenue = Total fixed cost

CM ratio

CM ratio = (Selling price per unit - Variable cost per unit) x 100
Sales price per unit

= (TZS9,00 -TZS5,000) x 100

TZS9,000

= 44.444%

Total fixed costs

Break - even point in revenue =
C/S ratio

= TZS 28,000,000
44.444%

= TZS 63,000,000

So, Green Plant Inc must produce and sell 7,000 units per month, in order to break-even

Time Ltd manufactures watches. The cost structure for the products is as follows:

TZS‟0
00”
Raw material 10
Labour 5
Variable overheads 2

Other pertinent information:

(a) The sales price is TZS25,000 per unit

(b) Total fixed cost is TZS80,000,000 (per annum)

How many units should the company produce and sell during the year so that there will be a no
profit or no loss situation?

A 3,200
B 4,705
C 10,000
D 8,000

2.1 The break-even chart

The break-even point can also be obtained using graphs. Graphical analysis has the advantage of enabling
managers to identify areas of profit or loss that would occur for a broad range of sales levels.

Break-even chart is a graph that shows the relationship between cost and sales and indicates profit or loss on
different quantity levels on the chart. The horizontal line shows the sales quantity and the vertical line shows the
costs and total revenue. The intersection point between total cost and total revenue is the break-even point which
indicates that at this point a firm earns no profit nor loss.

On the vertical axis, the break-even chart plots the revenue, variable cost, the fixed costs and the total cost of the
company, and on the horizontal axis, the volume of sale is plotted. The break-even chart therefore includes four
variables, being fixed costs, variable costs, total costs, and revenue. Each of them is represented as a line that
indicates its value depending on the level of output.
 115
Steps to draw a break-even analysis chart

Drawing a break-even chart consists of the following six steps:

Draw axes: The two axes need to be drawn first. Vertical axis displaying costs/revenue and horizontal axis displaying
quantity.

Draw a line indicating fixed costs: Since fixed costs remain constant (in the short term), regardless of the number
of units produced/sold, the fixed costs line will be horizontal and parallel to the axis that displays quantity.

Draw a line indicating variable costs: Because variable costs rise and fall in direct proportion to the quantity of
units produced/sold, the line always starts at the intersection point of the axes and gradually increase.

Draw a line indicating total costs: Since total costs include both fixed and variable costs, the line will start at the
intersection point of the cost axis and the line indicating fixed costs, and will gradually increase.

Draw a line indicating revenue: Since revenue is directly related to quantity, the line will start at the intersection
point of the horizontal and vertical axes and increase gradually.

Mark the break-even point: The break-even point is the intersection point of the total costs and revenues lines. The
break-even point is the quantity (number of units) at a level where total costs and revenue intersect.

BREAK-EVEN CHART

Use the following provided information to draw the Break-even chart.

Units sold 1,000 2,000 3,000 4,000 5,000 6,000
Total revenue (TZS) 25,000 50,000 75,000 100,000 125,000 150,000
Total variable cost 15,000 30,000 45,000 60,000 75,000 90,000
(TZS)
Fixed cost (TZS) 30,000 30,000 30,000 30,000 30,000 30,000
Profit/Loss (TZS) (20,000) (10,000) (0) 10,000 20,000 30,000
116
Answer
BREAK-EVEN CHART

Note:

In plotting the graph, it is assumed that the selling price remains at TZS25, the variable cost remains at TZS15 per
unit, and the fixed cost remains at TZS30,000 over the range of units sold.

However, the graph can be interpreted only within the relevant range of operations (i.e., the level of quantity over
which fixed costs are assumed to remain fixed).

Profit-volume Graph (P/V Graph)

A simpler version of the break-even chart is known as the profit-volume graph (P/V graph). This graph shows a direct
relationship between sales and profits, and it is easy to understand.

Break-even charts and P/V graphs are often used together to benefit from the advantages of both visualizations.

The vertical axis shows total profits or losses, while the horizontal axis represents units of product and sales revenue.

An advantage of the P/V graph is that profit or losses at any point can be read directly from the vertical axis.

The data used to prepare the break-even chart, in the above example, have also been used to prepare the P/V graph
shown below.

Note:

The intersection of the profit line with the horizontal line gives the break-even point. Points above the line indicates
profits while points below the line indicates losses.
 117

An advantage of the P/ V graph is that profits and losses at any point in time can be read directly from the vertical
scale.

However, a major disadvantage is that the graph does not clearly reveal how costs vary with changes in activity.

For these reasons, and as mentioned earlier, both the P/V graph and break-even chart are used alongside one
another by financial managers.

3.1 The benefits and limitations of CVP analysis

CVP analysis like other methods has its own benefits and limitations. Following are the benefits and limitation of using
CVP analysis in decision making:

The benefits of CVP analysis

CVP (Cost-Volume-Profit) analysis is a powerful tool that helps businesses understand the relationship between
costs, volumes, and profits. Some of the advantages of CVP analysis include:

Scenario Planning: CVP analysis allows businesses to create different "what-if" scenarios to evaluate the effects of
changes in the business environment. By considering variations in sales volumes, costs, or prices, businesses can
assess the impact on profitability and adapt their strategies accordingly.

Profit Planning: CVP analysis allows businesses to develop profit plans by estimating the level of sales required to
achieve a desired level of profit. By determining the breakeven point and analyzing the impact of different sales
volumes, companies can set realistic targets, make informed decisions and achieve its financial goals.

Pricing Decisions: CVP analysis helps in setting appropriate pricing strategies by considering the relationship
between prices, costs, and sales volumes. Businesses can assess the impact of price changes on profitability and
determine the optimal price to maximize profitability.

Cost Control: CVP analysis provides insight into the relationship between costs and volumes. By identifying the fixed
and variable components of costs, businesses can control their cost structure efficiently. This analysis enables
managers to identify areas where it can reduce costs enabling it to become more profitable.

Decision-Making: CVP analysis assists in evaluating different alternatives and making informed decisions. By
assessing the contribution margin and break-even point for different products, services, or projects, businesses can
select the most profitable option or assess the feasibility of new ventures.

Sensitivity Analysis: CVP analysis allows sensitivity or "what-if" analysis by assessing the impact of changes in key
variables such as sales volumes, prices, and costs on profitability. This helps businesses to understand the potential
risks and uncertainties associated with their operations, enabling them to develop contingency plans and manage
risks effectively.

Monitoring performance: This method can help the management to monitor a company’s financial performance
over time, and make comparison past and/or industry performances.

Limitations of CVP analysis

Like all other analytical methodologies, CVP likewise faces inherent limitations. These limitations include:

Some fixed costs do not remain fixed costs indefinitely: Analysts face challenges when identifying what should
be considered a fixed cost and what should be classified as a variable cost. Once seemingly fixed costs, such as
salaries, taxes, rents can change over time. In addition, assumptions made surrounding the treatment of semi-variable
costs could be inaccurate. Therefore, having real-time data fed in with a solution such a is paramount.

Simplistic assumptions: It assumes a linear relationship between cost, volume, and profit. The linear relationship
may not always realistic especially in complex business environments.

Ignores non-linear costs: CVP analysis assumes that costs are constant per unit. However, many costs are variable
or semi-variable and change with the volume of production or sale.

Ignores external factors: CVP analysis considers cost and volume as the only factors affecting profit, ignoring
external factors such as market changes, competition, or economic conditions that can impact a company’s
profitability as well.
118
Limited long-term predictions: It only provides short-term predictions and may not accurately predict a company’s
future performance over a longer period.

Limited use for service industries: CVP analysis is mostly suitable for manufacturing industries. It doesn’t function
accurately in service-based businesses where cost structures and production processes differ.

4. Calculate the Margin of Safety and target profits for a single product
[Learning outcome c]

4.1 Margin of safety (MOS)

Sales beyond the break-even volume bring in profits. The margin of safety is the difference between the
budgeted sales or actual sales and the break-even point. It measures the soundness of a business.

A high margin signifies that the break-even point is far below the sales level under consideration so that even
if there is a fall in sales, there will still be a profit. On the other hand, a small margin suggests a difficult position
as sales may not totally cover fixed costs.

If a low margin is coupled with high fixed costs and a high contribution to the sales ratio, action needs to be taken
to reduce the fixed cost or increase the sales volume.

If both the margin of safety and the contribution to the sales ratio are low (the fixed cost being reasonable), then
efforts should be taken to reduce the variable cost or the selling price should be increased.

Margin of safety in absolute terms:

Margin of safety = Budgeted / expected sales – Sales at break-even point

Margin of safety expressed as a ratio or percentage:

Margin of safety (%) = ((Budgeted / expected sales – Sales at break-even point) / Sales) x 100

Pentagon Ltd gives the following financial information about its product:

Fixed costs TZS

9,000,000
Variable costs TZS
15,000,000
Sales TZS
30,000,000
Units sold 10,000

From the above information the margin of safety is calculated as below:

Break-even point (units) = Fixed cost
Contribution margin per unit
= TZS9,000,000
TZS1,500

Break-even point (units) = 6,000 units

Margin of safety = actual sales or expected sales volume – break-even point volume
= 10,000 units – 6,000 units
MOS = 4, 000 units
 119
Working
Contribution per unit = sales price per unit – variable cost per unit
= (TZS30,000,000/10,000) – (TZS15,000,000/10,000)
= TZS3,000 - TZS1,500
CMU = TZS1,500

4.2 Margin of safety and target profits

While knowing the break-even point is important, most businesses struggle to perform better than just to break
even. Business owners always aspire to a target level of profit. CVP analysis allows owners to calculate the
level of sales required to achieve this goal. To calculate target profit in sales amounts, add the target profit to
the company's total fixed costs and then divide by the contribution margin. This will tell you the level of sales
that you need to achieve to meet your profit goal. If you are interested in calculating the target profit in units,
then instead of dividing by the contribution margin, just divide by the contribution margin per unit.

To calculate the margin of safety using a target profit, you will need to add the target profit to the total fixed
costs and divide by the contribution margin per unit or the contribution margin ratio

KWETU company sells KWETU drinking water in bottles of 500 mills for TZS500 per bottle and has a variable
cost of TZS300 per unit. The fixed costs are TZS100,000,000 per month. The company targets to earn a target
profit of TZS5,000,000 per month.

Required:
a) Calculate the break-even points in units and in TZS.
b) Calculate the margin of safety in units, in TZS and as a percentage of sales and state its implication.

Answer

a) The contribution margin per unit is TZS500 - TZS300 = TZS200. The contribution
margin ratio is TZS200/ TZS500 = 0.4.

The break-even sales in units = (TZS100,000,000 + TZS0) / TZS200 = 500 units.

The break-even sales in TZS are (TZS100,000,000 + TZS0) / 0.4 = TZS250,000,000.

b) The margin of safety in units involving a target profit of TZS5,000,000,000:

= (TZS100,000,000 + TZS5,000,000) / TZS200 = 525 units.

The margin of safety in TZS involving a target profit of TZS5,000,000

= (TZS100,000,000 + TZS5,000,000) / 0.4 = TZS262,500,000.

The margin of safety percentage involving a target profit of TZS5,000,000 are (525 - 500) / 525 x 100 = 4.8%.

This implies that the sales can drop by 4.8% before the company fails to achieve its target profit.

In accounting, the margin of safety and profit are both important calculations to be aware of. While both use
revenue in their calculations, the outcome and intent of these two figures are different. Profit measures a
business’s earnings and margin of safety measures the sales required to turn a profit.

While margin of safety looks at the sales above a business’s break-even point, profit looks at the financial
breakdown of these sales. It measures the revenue generated from any business activity, including sales as
well as investments, interest, and other earnings.

When written as a formula, profit is calculated as:

120
Profit = Total Revenue – Total Expenses

However, this can be further broken down to gross profit, net profit, and operating profit,
each of which looks at the equation in a slightly different way. Gross profit measures
revenue earned after subtracting production-related costs, while net profit measures
revenue earned after all costs have been deducted.

The differences between Margin of Safety and Profit

Although margin of safety and profit are closely related, there are a few key differences to be considered. These
include:

Purpose: Margin of safety shows the percentage that sales can drop before a business is operating at a loss.
Profit simply shows how much loss or income was generated during the accounting period, irrespective of
break-even point.

Computation: Profit is computed by deducting cost of goods sold and operating expenses from sales. Margin
of safety is the result of deducting break-even point sales from total sales, dividing the resulting difference by
total sales, and multiplying the product by 100. For example, a company with total sales of TZS180,000,000
cost of goods sold of TZS115,0000,000, and total operating expenses of TZS45,000,000 would yield a net profit
of TZS20,000,000 (TZS180,000,000 – TZS115,000,000 – TZS45,000,000).

If the same company had a break-even point sale of TZS144,000,000, its margin of safety would be 20 percent
(TZS180,000,000 minus TZS144,000,000 divided by TZS180,000,000 multiplied by 100).

Timeframe: Profit (or loss) is calculated using revenue and expense accounts on the income statement from
the past accounting period. Margin of safety is often calculated using forecasted sales figures to anticipate
future fluctuations.

Management: A company’s managers are most interested in margin of safety, which can be used to guide the
decision-making process. By contrast, profit is looked at not only by management, but also by outside parties
including the investors, finance providers, tax authorities and others with a vested financial interest.

Self-Examination Questions

Question 1

Which of the sentences below is correct regarding the break-even point?

A Break-even point = Total fixed cost

Number of units produced

B At the break-even point contribution is equal to variable cost.

C At BEP of activity, there is neither a loss nor a profit.
D None of the above
 121

Question 2

Paper Ltd had given the following information. Based on the information, suggest to them how much they
should produce per year so that all the fixed cost is recovered.

TZS‟
000”
Selling price (per unit) 50
Variable cost (per unit) 40
Total fixed cost (per year) 120,0
00

A 10,000 units
B 12,000 units
C 3,000 Units
D 2,400 units

Question 3

Doll Co runs a toy manufacturing unit. The company’s target for 20X8 is to manufacture 30,000 units. The per
unit selling price of the product is TZS12,000. The total variable cost of the product is TZS6,000. During 20X8
the company expects to earn a profit of TZS48,000,000.

What must be the company’s per annum fixed cost?

A TZS132,000,000
B TZS18,000,000
C TZS78,000,000
D None of the above

Question 4
Baby Care Co is a company that manufactures baby shampoo. It recently launched a special new shampoo for
babies. The cost structure for the product is as follows:

TZS‟000”
Direct material cost 18
Direct labour cost 12
Variable overhead 7
Fixed cost (per annum) 147,000

The selling price of the product is TZS50 per unit. In this situation, the CM ratio of the company is:

A 62%
B 40%
C 26%
D None of the above.

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is C.

The break-even point is a no loss no profit situation.

At the break-even point, contribution is just enough to recover fixed costs. Any activity below the BEP, the firm will make
a loss, while above this level it will make a profit.
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Answer to SEQ 2

The correct option is B.

From the given information we may compute the sales as follows.

Contribution = Sales – variable cost

= TZS50,000 - TZS40,000
= TZS10,000

Break-even point (units) = Total fixed cost

Contribution per unit

= TZS120,00,000
TZS10,000 = 12,000 units

Answer to SEQ 3

The correct option is A.

The contribution per unit will have to be computed from the given data as Contribution per unit = Selling price per unit –
variable cost per unit
= TZS12,000 - TZS6,000
= TZS6,000

Fixed cost = Required contribution – Profits

= (30,000 x TZS6,000) - TZS48,000,000
= TZS 132,000,000

Answer to SEQ 4

The correct option is C.

C/S ratio = (SP – VC) x 100%

SP

= (TZS50,00 - (TZS18,000 + TZS12,000 + TZS7,000)) x 100%

TZS50,000
= 26%

In the above solution we have deducted all the costs of direct material, direct labour and variable overheads from the
selling price of TZS 50,000 to arrive at the contribution margin.
 B2
123

SECTION B
INTRODUCTION TO
DECISION MAKING

SECTION B2: SHORT-TERM DECISIONS

The need to make decisions arises in business when a manager is faced with problem and alternative courses of
action are available. In deciding which option to choose the manager will need all the information which is relevant
to assist reach a proper decision. Some of the factors affecting the managers’ decision can be expressed in monetary
values (quantitative), while others cannot. For example, deciding the factors to be considered in promoting employees
to different employment ranks may not need monetary values. A quantitative decision is made after measuring
various factors and relationships between them in monetary values. This guide will help you learn various factors
that can be expressed in monetary values, and apply them in making sound decisions. Main concentration will be on
quantitative decisions based on costs and revenues. An accountant needs to regularly use these techniques for a
day-to-day decision-making. This Study Guide is also important for examinations since long questions can be based
topics from this Study Guide.

a) Explain and apply relevant cost principles in decision making.

b) Apply a single limiting factor in decision making.
c) Make inventory management decisions (Ordering and holding of materials).
d) Calculate optimal reorder quantities.
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1. Explain and use the relevant costs in decision making
[Learning outcome a]

Conceptualising relevant costs

Relevant Businesses use relevant costs to determine if one decision is more cost-effective than another. They are a
fundamental concept that guides how managers analyse and make decisions based on costs. Principles of relevant costs
require managers to focus on the costs and revenues that will be affected by the decision. That means, only those costs
and revenues that are directly relevant to a specific decision should be considered, while disregarding irrelevant costs,
which do not change based on the decision.

For example, a firm considering to automate its production process that could allow it to reduce or restructure its workforce
in the production department will recognise wages as a relevant cost. On the other hand, corporate overhead costs will not
be relevant because they will remain the same irrespective of the decision.
Note: Relevant costs change basing on the decision at hand.

Relevant costs include:

Incremental cost/differential cost: this is the additional cost that should be incurred due to a management decision.
Incremental costs can be variable or fixed cost. Incremental costs differ between alternative courses of action. They are
directly relevant because they represent the additional or incremental costs incurred due to a specific decision.

Opportunity cost: these are the value of the next best alternative sacrificed when one course of action is chosen in
preference of others. Opportunity costs represent the benefits foregone by choosing one alternative over another. These
costs are relevant because they reflect the value of the next best alternative.
Opportunity cost occurs due to limited resources, and when alternative uses of resources are available.

However, in the short run decision making, the management will consider the relevant costs and irrelevant costs. Irrelevant
costs are those costs which will not be affected by a decision.

Irrelevant costs include:

Sunk cost: These are cost incurred in the past and cannot be affected by a future decision. Sunk cost is therefore,
irrelevant cost for decision making. Example of sunk costs are fixed costs or development cost which has been already
incurred.

Absorption of fixed cost/General fixed overheads: Overhead costs that are absorbed by using predetermined
overheads rates are also irrelevant costs.

Committed cost: These are costs agreed to be paid, as a result of past decisions. Committed cost is the future cost flow
that will be incurred regardless of whether the decision is taken now on the alternative opportunities or not. Example of
committed costs include insurance premium and rent.

Types of relevant cost decisions

Here are four relevant costs to consider when making business and management decisions:

Make vs. buy costs

Make vs. buy costs refer to the necessity of components and pieces to complete a product. This relevant cost considers
the choice between manufacturing the product internally or outsourcing its development from another vendor.

The actual relevant cost of this is the total costs incurred by paying an outside vendor to do the work. If the outside vendor
can manufacture and produce the product at a lower price point than it would cost to complete the product internally, then
outsourcing it's the most financially efficient decision.

City cleaning Company manufactures liquid soap for its in-house tenders, but is considering whether to continue making it
internally or to buy it from an external supplier.

Costs for internal production:

- Direct Materials: TZS1,000 per unit (one litre bottle)

- Direct Labor: TZS600 per unit
- Variable Overhead: TZS400 per unit
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- Fixed Overhead: TZS1,200,000 per month (allocated based on production volume, producing 2,000 units per
month)
Costs from External Supplier:
- Purchase Price: TZS2,500 per unit

The company currently produces 2,000 units of the component per month.
Should the company continue making the component internally or start buying it from an external supplier?

Answer

To determine the best decision, we need to compare the costs of making the component internally versus buying it from
the external supplier.

In-house Costs:

- Direct Materials: TZS1,000 per unit (one litre bottle)

- Direct Labor: TZS600 per unit
- Variable Overhead: TZS400 per unit
- Fixed Overhead: TZS1,200,000/2,000 = TZS600 per unit
Total in-house Cost: TZS1,000 + TZS600 + TZS400 + TZS600 = TZS2,600 per unit

External Supplier Costs:

- Purchase Price: TZS2,500 per unit
In this case, the external purchase price is lower than the total cost of producing it internally. Therefore, it would be more
cost-effective for City cleaning company to buy the liquid soap from the external supplier.

Special order costs

A special order refers to the occasions when a customer wants to order a product near the end of the month after a
company calculates its sales and uses those profits to cover the production costs for that time period.

For a customer who is looking to receive a quote on the price of a special order, the management team's sole concern is
the costs incurred to produce the product. These relevant costs include the cost of additional materials and production
labor.

Shambani Carpenters company has recently received a special order from a client to supply 10 wooden doors within a
month for TZS800,000 each. The following information needs to be considered for a company to accept this order:

Materials: 7 meters of timber are required for each door. At present, 10 meters of timber are available in the stores with
the total book value of TZS600,000. The current market value of similar doors is TZS70,000 per meter.

Labour: Requirement is 27 hours per door. The company expects to use 3 idle workers for the job. A worker is required
to work 180 hours a month (9 hours a day in 20 working days) and is paid with a monthly salary of TZS500,000. In addition,
each worker is paid with a commission incentive of TZS100,000 per order.

Overhead: The budgeted overhead cost is TZS1,000,000 for a month and is absorbed at a rate of TZS500 per labour
hour. With this order, it is estimated that monthly overhead cost of the company would increase by TZS150, 000 per gate.

Required:

Calculate the relevant costs and advise whether Shambani Carpenters company should accept the order on the basis of
relevant costs.

Answer

Materials:

- For this order, the company has to purchase materials from the market at the rate of TZS70,000 per meter.
- Therefore, the current market value should be considered as the relevant cost for the decision to accept or reject
this order.
- TZS600,000 worth of material in stock is a historical cost and it is a sunk cost and irrelevant for decision making.
- Therefore, the relevant material cost for this special order is TZS490,000. ( TZS70,000*7*10).
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Labour:

- Currently 3 workers are in idle, therefore the labour cost of TZS1,500,000. (3 workers at the rate of TZS500,000)
has to be paid to these workers whether the order is accepted or not. But incentive of TZS100,000 per order for
3 workers is an additional cost for this order.

- Therefore, the relevant cost of labor is TZS300,000 (TZS10,000 * 3).

Overhead:

- The budgeted overhead cost is TZS1,000, 000 for a month and is a fixed cost. It does not increase with the
order. It is therefore an irrelevant cost.

- As a result of this order, an incremental overhead is TZS1,500,000. (TZS150,000 per door for 10 doors). This is
a relevant cost.

Accordingly,

If the order is accepted,

- Material cost TZS4,900,000

- Labor cost 300,000
- Overhead cost 1,500,000
- Total incremental cost 6,700,000
- Value of the order 8,000,000
- Less: Total Incremental Cost 6,700,000
- Profit of the order 1,300,000

Basing on the relevant costs calculated above, Shambani Carpenters company should accept the order, and will be in a
position to get a profit of TZS1,300,000by accepting this order.

Continue vs. closing costs

Continue vs. closing refers to the relevant costs of deciding whether to close a particular business unit or continue operating
it. The relevant costs in this type seek to determine the cost savings and the revenue loss when a business unit closes
down. If the costs saved from closing the unit outweigh the loss of consistent revenue, then it's probably best to choose
the most cost-efficient option.

BIKU Company Ltd. operates a manufacturing plant that produces a motorcycle parts. Following the increasing number of
spare parts suppliers in the country, BIKU Management is considering whether to continue operating the plant or to close
it down.

The following financial Information with regard to BIKU Company Ltd. are provided:

- Annual revenue from sale of spare parts: TZS100,000,000

- Variable costs (Raw materials, Direct labor, Variable overhead): TZS60,000,000
- Fixed costs (Factory rent, Depreciation, Salaries): TZS30,000,000
- Selling and administrative expenses: TZS10,000,000
- Current year profit: TZS100,000,000 - TZS60,000,000 - TZS30,000,000 - TZS10,000,000 = TZS0

Basing on the current year's financials, advise the management of BIKU Company Ltd. whether they should continue
operating the plant or close it down.

Answer:

To make an informed decision, the financial implications of continuing to operate the plant should be compared with those
of closing it down.

Continue Operating the Plant:

- Annual revenue from sale of spare parts: TZS100,000,000

- Variable costs (Raw materials, Direct labor, Variable overhead): TZS60,000,000
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- Fixed costs (Factory rent, Depreciation, Salaries): TZS30,000,000
- Selling and administrative expenses: TZS10,000,000
- Current year profit: TZS100,000,000 - TZS60,000,000 - TZS30,000,000 - TZS10,000,000 = TZS0

Close Down the Plant: If the company decides to close down the plant, it will eliminate the variable costs, fixed costs,
and selling and administrative expenses associated with the product. However, it will also lose the revenue from product
sales, resulting in no contribution to profit.

Based on the financial data provided, both options would result in a profit of TZS0 for the current year. This suggests that
from a purely financial standpoint, there is no significant difference between continuing to operate the plant or closing it
down in terms of the immediate impact on profit.

However, when making a "continue or close down" decision, other factors beyond immediate profit should be taken into
account. These factors might include:

- Long-Term Viability: Is there a possibility for a product to become profitable in the future due to changes in the
market, technology, or other factors?
- Strategic Importance: Does the product contribute to the company's overall strategic goals or product portfolio?
- Employee Impact: Closing down the plant might result in job losses. How will this impact the company's
workforce and community at large?
- Asset Utilization: Can the plant's assets be repurposed or sold to generate value?
- Competitive Landscape: How does the product perform in comparison with competitors?

In practice, these qualitative considerations play a significant role in making such decisions, and a comprehensive analysis
should involve both financial and non-financial factors.

Opportunity costs

Opportunity costs refer to the potential gains that a business or person may receive depending on which option they select
over another. Opportunity costs seek to identify whether an opportunity is worth the investment. When making decisions
regarding a particular opportunity, it is very important to consider the benefits and costs before making a decision to select
or forego a certain opportunity.

Following materials are needed for a for production of product Z:

Material Type Total units Number of Book value of Realisable Replacement

required units already stock - Per Value - Per cost - Per unit
in stock unit (TZS) unit (TZS) (TZS)
Z1 1,000 - - - 500
Z2 500 300 200 300 400
Z3 750 400 100 400 500
Z4 400 400 400 600 800

Material Z1 are regularly used by the company and are purchased from the market if needed.

Material Z3 and Z4 are in stock as a result of excess purchases and are restricted in use. No other use is available for Z3.
However, Material Z4 could be used as a substitute for 500 units of Material ZY which could be purchased at TZS500 per
unit. (Material ZY is not available in stock).

Required: Compute the relevant cost of materials for product Z.

Answer

Material Z1 is regularly used and not in the stock. Therefore, it has to be purchased from the market at the rate of TZS500
per unit. For the total 1,000 required units, the cost of material Z! becomes TZS500,000.

Material Z2 is regularly used and 300 units are already in stock. If 300 units which are already in stock, used for this order
it has to be replaced at the cost of TZS400. Therefore, the relevant cost of existing stock is TZS120,000. Balance 200 units
are not in the stock and therefore have to be purchased at replacement cost of TZS400. Additional purchases 200 * TZS400
= TZS80,000. Therefore, the relevant cost for Material Z2 is TZS200,000 (500 * TZS400)
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Material Z3 400 units are available due to excess buying and is not replaced and restricted in use but could be sold at the
rate of TZS400 per unit thus getting a revenue of TZS160,000 (400 * TZS400). But if used for this product they could not
be sold at TZS400 each. Therefore, the opportunity cost of revenue foregone is therefore TZS160,000.

Therefore, Opportunity cost of 400 units of revenue foregone = TZS160,000. Balance order of 350 units not in stock bought
at TZS500 = TZS175,000/= The total relevant cost of 750 units = TZS335,000.

Material Z4 400 units are required for this order which is already in stock and will not be replaced due to restricted use.

There are alternative opportunities available as below:

1. Either to sell the existing stock 400 units at the rate of TZS600 = TZS240,000
Or
2. Avoid purchasing 500 units of material ZY at TZS500 per unit ofTZS250,000. If Material Z4 is substituted for
material ZY the opportunity cost for material Z4 is TZS250,000. Therefore, the total materials cost for this
product is:

Z1 Z2 Z3 Z4 TOTAL

TZS500,000 TZS200,000 TZS335,000 TZS250,000 TZS1,285,000

2. Make inventory management decision (Ordering and holding cost of material)

[Learning outcome d]

Material management costs

Materials constitute a very big portion of the total cost of a product. Materials mismanagement can lead an organisation
to a crisis due to excessive investment in, and poor control over, the raw materials used.

The materials ordering and holding costs are the two major components of material management costs.

The cost of ordering and holding inventory can be distinguished as follows:

Diagram 1: Ordering and carrying costs of inventory

There are two types of costs which are associated with inventory; the cost of making a purchase and the cost of keeping
the goods in inventory. These are known as the ordering costs and the carrying costs respectively.

1.1 Inventory ordering cost or order placing cost

Ordering costs of inventory include the costs of placing a purchase order including the clerical costs of preparing a
purchase order, cost of receiving the material and the costs involved in the inspection of the material.
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Preparing a purchase order and placing costs

The cost of placing an order involves the cost of order processing, costs of correspondence and communication,
advertising costs for inviting tenders, tender evaluation costs etc. These costs are directly proportional to the number of
orders to be placed in a year. To save on this cost the organisation needs to keep the number of orders to a minimum.

The ordering cost per order is TZS100,000. This includes all the costs of placing the order, order processing, advertising
and tender evaluation. The total orders placed in a year are 10; hence the total ordering cost for the year becomes
TZS1,000,000 (TZS100,000 x 10).

On the other hand, if the entire annual demand is ordered at one time, the number of orders reduces from 10 to 1 in a
year, and then the total ordering cost for the period becomes TZS100,000 (TZS100,000 x 1). There is an annual saving
of TZS900,000.

The increase in the number of orders multiplies the costs of order processing, advertising for tenders, communication
and tender evaluation.

Costs of receiving the material

After the order is placed, the vendor will execute the order by supplying the material. This involves transport costs. The
cost of receiving is the cost incurred on the transport of material from the supplier to the factory or depot.

This cost will increase only when the number of vehicles / boxes etc. required for transport increases. The capacity of a
carrier is generally fixed and any consignment / batch within this capacity will cost the same for transportation. If the
transportation increases directly with the number of purchase orders in a year and vice versa, it becomes relevant to be
included in the ordering cost.

In Beta Co, the cost of sending one container from one location to another is TZS500,000. The capacity of the carrier is
5000 kilograms. This cost of transportation will remain TZS500,000 for any volume of material between 0-5000 kilograms.
It will increase when the size of the batch increases beyond 5,000 kilograms.

So if Beta Co orders 1,000 kilograms of material in January and another 1,000 kilograms in June, it will incur a cost of
TZS1,000,000 (TZS500,000 + TZS500,000) for two trips. If Beta Co had ordered 2,000 kilograms of material in January,
they would have incurred only TZS500,000.

Material inspecting or testing cost

The inspection cost of material affects the total ordering costs only when inspection is taken up on a sample basis, where
only a sample of the material is inspected from each purchase lot. In this case, if the number of batches ordered in a year
increases, the inspection or testing will also increase. This will increase the inspection cost and hence the ordering cost of
the material.

If the inspection or testing cost per lot is TZS50,000, and the total number of lots to be tested is 10, then the total inspection
or testing cost for the year becomes TZS500,000.

If, however, only 5 lots were bought, the inspection cost would be halved. Again if the number of inspections or testing
increases from 10 to 20 in a year, the total inspection or testing cost for the period becomes TZS1,000,000. There is an
additional cost of TZS500,000.

If the entire batch is inspected, the inspection costs do not form a part of the ordering cost as it is not dependent on the
number of orders. In this case the inspection cost is considered as a separate overhead cost. The above costs of
ordering, receiving and inspection together make up the total “ordering cost”.
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1.2 Holding (carrying) cost of inventory

The following costs make up the cost of holding inventory:

Interest costs

Every purchase requires payment to a supplier. This is the investment made in inventory. If the amount required for
purchase is borrowed from a bank or from a lender, then the interest payable is the cost of investment in inventory.

Suppose a working capital loan of TZS100,000,000 is taken at 8% from the bank for purchasing raw materials, the interest
of TZS8,000,000 (TZS100,000,000 x 8%) paid on this loan is the cost of investment in inventory.

Storage cost

Storage costs mainly include costs relating to renting the premises, insurance for the premises and for the inventory. The
insurance cost is included in the holding costs only if it varies with the variation in the size of the batch.
Normally the rent cost is fixed for an area irrespective of the volume of material stored in it. If the material ordered exceeds
the capacity of the storage space, additional space needs to be hired. This additional space will often cost more.

The rent paid for 500 sq. ft. of warehouse space that can accommodate 1,000 kilograms of material, is TZS50,000,000.
This is the storage cost.

The inventory in store needs to be insured against any mishaps such as natural calamities, fire, floods etc. The cost of
insurance depends upon the value of inventory insured. Normally the entire inventory is covered by insurance. This cost
increases when the volume of inventory in storage increases. If the size of the batches ordered are large, then automatically
the volume of inventory in storage will increase and hence the cost of insurance will also increase.

The insurance cost is 1% of the value of inventory insured. The insurance cost of TZS50,000,000 worth of inventory comes
to TZS500,000 (TZS50,000,000 x 1%). If the company decides to increase the holding of inventory to TZS100,000,000,
then the insurance cost will increase to TZS 1,000,000 (TZS100,000 x 1%).

Other costs

Other costs include risk of obsolescence, deterioration and theft. When material and components become outdated and/or
useless, the existing inventory should be thrown away and its cost must be written off in the SOPL (Statement of Profit or
Loss). In the case of theft, the loss arising from theft should be written off in the SOPL.

Buffer inventory

There is a possibility that unpredictable events such as poor quality of supplier’s product, or poor delivery may disturb the
smooth functioning of the inventory system. Buffer inventory is the inventory held on hand that is over and above the
currently needed inventory. It is the minimum amount of inventory required to be maintained in order to avoid uncertainties
of supply and demand. It is also called the safety stock. The cost of holding buffer inventory is also considered a part of
the total holding and ordering cost of inventory.

All the above costs together make up the total inventory holding cost.
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Diagram 2: Cost of holding material

The inventory holding cost is the total cost of the investment in inventory, and includes:

A The salary of the watchman who guards the warehouse.

B The salary of the factory supervisor.

C The manager’s salary.

D Interest cost for capital which is borrowed for the purchase of inventory.

3. Calculate the optimal reorder quantities

[Learning outcome d]

Order size

When an organisation follows a system of ordering fixed amounts of inventory, the order size is vital. This is because the
size of the order affects the ordering as well as the carrying costs.

When the order size is large, the number of orders required to be placed in a year will reduce, and hence the ordering
cost will also reduce. However, in this case the holding costs will increase, as the quantities to be held at the same time
increase.

When the order size decreases, the holding costs will decrease but the number of orders per annum increases, thereby
increasing the ordering costs.

In this situation, it is vital to arrive at an optimal order size that minimises the total ordering and holding costs of inventory.

Large order (fewer number of orders) High carrying cost Lowered ordering cost

Small order (more number of orders) High ordering cost Lowered carrying cost

The optimal re-order quantity or the economic order quantity (EOQ) is a size of order for which the total of the ordering
and carrying costs is at the lowest possible.

Economic order quantity can be understood with the help of a graph:

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Diagram 3: Economic order quantity

Ordering quantity is measured on the X - axis and cost on the Y - axis.

The graph shows the total cost curve, the carrying (holding) cost curve and the ordering cost curve. In the above graph,
the total cost starts high when the ordering cost is initially high and the holding cost is low. When the ordering cost is low
and the holding cost is high the total cost is on a rising trend. This happens when one cost is minimised the other cost
rises, and vice versa.

However, there is a point where the total cost curve is at its minimum level. If a straight line is drawn from this point passing
through the ordering cost line as well as the holding cost line, it passes through the intersection point of these two lines. It
implies that the total cost is at its minimum when ordering and holding costs are equal. This is an important observation
based on which the formula for the Economic Ordering Quantity (EOQ) can be derived.

When deriving the EOQ, there are some assumptions underlying it without which the formula would not hold true.

(a) The annual demand is certain and known.

(b) The time required for the receipt of material (known as lead time) ordered is certain.
(c) There is no situation of stock outs.
(d) The entire material ordered is received in a single batch.
(e) The per unit costs of material does not change.
(f) The costs are always known with precision.
EOQ = 2 x D x C0
Ch

Where,
C0 = cost of ordering per order/consignment from supplier
Ch = cost of holding per unit of inventory per annum / time period
D = total demand during the period

The underlying data for the calculation of EOQ has to remain the same throughout the period for which the calculations
are made.

The average inventory is taken to calculate the annual holding cost as one does not hold units equal to the optimal re-
order quantity at all times. We might hold inventories greater than this quantity or less than this quantity. In order to calculate
the annual holding, cost we multiply the holding cost per unit per annum with the average level of inventory. This average
level is arrived at by dividing the EOQ by 2.
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Calculate the economic order quantity from the following information. Also state the number of orders to be placed in a
year and explain briefly the amounts you have calculated.

Consumption of material per annum 10,000 Kilograms

Order placing cost per order TZS50,000
Cost per kilogram of raw material TZS2,000
Storage cost 8% of material cost

Answer

EOQ = 2 x D x C0
Ch

EOQ =
2 ´ 10,000 ´ 50,000
(2,000 ´ 8%)

EOQ = 6,250,000
EOQ = 2,500 kilograms

No. of orders to be placed in a year = Consumption of material per annum/EOQ

= 10,000/2,500
= 4 orders per year

4 orders need to be placed per year with an order size of 2,500 kilograms to keep the ordering and the holding costs at
the minimum level.

The above question has shown how to calculate the optimal re-order quantities. Another example will be helpful for further
understanding.

Tubes Plc manufactures picture tubes for televisions’ Details of their operation during 20X3 are as follows:

Normal weekly usage 100 tubes

Ordering cost TZS 50,000 per order
Inventory holding cost 20% per annum
Cost of tubes TZS 300,000 per tube

Calculate the optimal re-order quantity.

Answer

The EOQ calculation requires the annual use in units, ordering cost per order and the carrying cost per unit per annum.
These will be calculated as follows:

Annual use (A)= Weekly usage x number of weeks in a year

= 100 tubes x 52 weeks
= 5,200 tubes

Ordering cost per order (O) = TZS50,000 per order (given)

134

The carrying cost is given in the question as a percentage of the cost of tubes.
Cost of one tube = TZS300,000
Carrying cost per tube per annum (C) = TZS300,000 x 20%
= TZS60,000 per tube per annum

Therefore

EOQ = 2 x D x C0
Ch

EOQ =
2 ´ 5,200 ´ 50,000
(300,000 ´ 20%)

EOQ = 8,666.67 = 93.09

EOQ = 93 tubes approximately

The optimal re-order quantity is 93 tubes.

Bearings Plc committed to supply 24,000 bearings per annum to Motor plc. It is estimated that it costs TZS100 as inventory
holding cost per bearing per month, and that the set-up cost per run of bearing manufacture is TZS324,000.

The optimum run size for Bearings Plc would be:

A 4,600 bearings

B 6,300 bearings

C 3,600 bearings

D 3,000 bearings

Further Processing Decisions

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Further processing decision introduces how managers use incremental analysis to aid in making short-term 'process
further' decisions. These decisions involve whether to sell a product 'as is' or to incur additional costs to process it further
into a different or more advanced product.

Just as with other types of short-term decisions, incremental analysis is the easiest and quickest approach to analysing
the decision and helps managers focus on what is relevant. Preparing side-by-side income statements and comparing the
difference in profit between the two is more time consuming and causes confusion due to extra information in the
comparison.

Incremental Analysis Components

The point at which a company makes a decision of whether to process further or sell 'as is' is called the split off point. Only
costs incurred after the split off point are incremental because costs incurred up to the split off point are incurred regardless
if the company processes further or sells 'as is'.

Incremental Revenue
Incremental revenue is the difference between the original sales revenue and the new revenue that is expected to result
due to additional processing of a product. While the company will receive revenue if it sells its product 'as is', this original
revenue is not incremental because it is expected to be received regardless if processed further or sold 'as is'. Incremental
revenues increase profit.

Incremental Costs
Incremental costs are the additional costs expected to be incurred as a result of processing the product further or
upgrading to increase its scalability. Only if the company decides to process further will additional product costs be
incurred. Incremental costs decrease profit.

Amounts that are not relevant in further processing decisions

All products that a company manufactures or purchases have product costs associated with them. At the point at which a
company decides whether to process further or not---the split off point---the costs incurred in the past will not change. As
such, these are sunk costs and are not relevant to a process further decision.

Fixed production costs will rarely change if the decision is made to process further. When no changes to fixed costs are
expected to occur, there will be no incremental fixed costs.

The original expected sales revenue is not incremental, because regardless if the product is processed further or not, the
amount of original revenue will be recovered.

Evaluating process further decisions

Products should generally be processed further if profits are expected to increase. Soft-benefits, also known as qualitative
issues, should be considered as well.

Accept or reject?
If incremental revenues are less than incremental costs, the product should be sold 'as is,' unless qualitative characteristics
overwhelmingly impact the decision.

If incremental revenues equal incremental costs, the decision should focus solely on the qualitative effects to evaluate the
decision.

If incremental revenues are greater than incremental costs, the product should be processed further, unless qualitative
characteristics overwhelmingly impact the decision.

Qualitative concerns related to processing further decisions include resource availability such as the willingness of
employees to work extra hours to further process the products and availability of materials needed for the processing. In
addition, the impact on customers that prefer the original product should also be considered, as sales to these customers
may be lost to competitors.

A market decline for staplers has caused Sobo Company to drop its selling price of staplers. There are 8,000 staplers in
work in process (partially finished) that have costs of TZS7.80 per unit associated with them. Sobo can sell these staplers
in their current state for TZS9.00 each. It will cost Sobo TZS1.70 per unit to complete the staplers in process, so that they
can be sold for TZS12 each. Total fixed costs relating to the production of the staplers is TZS4,200. Determine the
incremental cost if processed further and the incremental profit or loss.
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Answer

Step 1: Determine the incremental revenue. Revenue is expected to increase from TZS9.00 to TZS12.00 per stapler, an
incremental unit amount of TZS3.00. As a result, revenue is expected to increase for the 8,000 staplers by:

Incremental revenue = (TZS12.00 - TZS9.00) x 8,000 = TZS24,000

Step 2: Determine the incremental variable costs. The variable cost of each stapler will increase by TZS1.70, amounting
to a total variable cost increase of:

Incremental variable costs = TZS1.70 x 8,000 = TZS13,600

The TZS7.80 cost for each stapler was incurred in the past. This amount is not relevant because the cost to get the staplers
to the split off point is the same no matter if the staplers are processed further or sold 'as is'. This cost is a sunk cost, and
sunk costs are never relevant because the cost cannot be changed regardless if processed further or sold as-is. The
increase in variable costs causes profit to decrease.

Step 3: Determine the incremental fixed costs. Total fixed costs remain the same regardless if the staplers are processed
further or not. As such, they are not incremental.

Step 4: List the amounts in good form beginning with incremental revenue. The analysis should appear similar to the form
of an income statement with descriptive line item labels:

Incremental revenue TZS 24,000

Incremental costs (13,600)
Incremental increase in profit if processed further TZS 10,400

Because profits are expected to increase by TZS10,400, the company should further process the staplers. However,
qualitative issues should also be considered.

The Poison Chemical Company produces two joint products. Alash and Pottum from the same process. Joint processing
costs of TZS15,000, 000 are incurred up to split-off point, when 100,000 units of Alash and 50,000 units of Pottum are
produced. The selling prices at split-off point are TZS125 per unit for Alash and TZS200 per unit for Pottum

The units of Alash could be processed further to produce 60,000 units of a new chemical, Alash-plus, but at an extra fixed
cost of TZS2,000, 000 and variable cost of TZS30 per unit of input. The selling price of Alash-plus would be TZS325 per
unit. Should the company sell Alash or Alash-plus?

Answer
The only relevant costs/incomes are those which compare selling Alash against selling Alash-plus. Every other cost is
irrelevant: they will be incurred regardless of what the decision is.

Alash Alash-plus
Selling price per unit TZS TZS
125 325
Total sales 12,500,000 19,500,000
Incremental post-separation processing costs - Fixed 2,000,000
______- Variable 3,000,000 5,000,000

Sales minus post-separation cost 12,500,000 14,500,000

It is TZS20,000 more profitable to convert Alash into Alashplus

4. Make decision with a single limiting factor

[Learning outcome d]
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3.1 Conceptualising the ‘limiting factor’ (scarce resource)

A limiting factor is a factor of production (or of any other activity) that is in short supply and that prevents an organisation
from expanding its production (or activities) and maximising its profit. It refers either to a scarce resource needed for
production or to a limited market demand for the items produced. The most common limiting factors for organisations are
the demand for their products and services, availability of materials, labour supply, and machine capacity etc. The scarcity
of most of the factors of production (or activities) may be a short-term phenomenon which can be overcome in the long
run.

Machine capacity or the availability of skilled labourers may be limited for one year or so until steps are taken to enhance
machine capacity or to hire more skilled labourers

3.2 Identifying the optimum alternative in a situation where resources are available in abundance

Decision-making lies in a situation where there are alternatives and one has to choose amongst those alternatives. In a
situation where all the resources needed to optimise the decision objective (e.g., maximising contribution / profit or
minimising cost, etc.) are available in abundance, the highest unit contribution margin (or lowest unit cost) provided by the
alternative is to be chosen.

Atlanta Company has met all production requirements for the current month and has an opportunity to produce additional
units of a product with its excess capacity. Unit selling prices and unit costs for three models of one of its product lines are
as follows:

Plain Model Regular Model Super Model

(TZS’000 per unit) (TZS’000 per (TZS’000 per
unit) unit)
Selling price 120 130 160
Direct material cost 36 40 38
Direct labour cost (TZS 10,000 per hour) 20 30 40
Variable overhead 16 24 32
Fixed overhead 32 10 30

Variable overhead is applied on the basis of direct labour hours while fixed overheads are applied on the basis of machine
hours. There is sufficient demand for additional production of any model of the product line.

If Atlanta Company has excess machine capacity and can add more labour as needed (i.e., neither capacity nor labour is
a constraint), the excess production capacity should be devoted to producing the model with the highest unit contribution
margin (since demand, machine capacity and labour are not constraints).

The unit contribution margin has been shown as follows:

Plain Model Regular Model Super Model
(TZS’000 per (TZS’000 per (TZS’000 per
unit) unit) unit)
A. Selling Price 120 130 160
Variable costs:
Direct materials 36 40 38
Direct labour (@TZS 10,000 per hour) 20 30 40
Variable overheads 16 24 32
B. Total Variable Cost per unit 72 94 110
C. Unit Contribution Margin (A – B) 48 36 50
Since Super model generates the maximum unit contribution out of the three models; its production should be optimised
so as to maximise overall profitability.

3.3 Identify the optimum alternative in a situation when one of the resources is scarce or is the limiting factor
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The unit contribution margin provides a good indication of how to prioritise an alternative in order to optimise profit (or other
object function) when the resources are available in abundance. However, this is not a sufficient measure to optimise
objective function when the resources are scarce. When any one of the resources is scarce but other resources are
available in abundance, the contribution margin per unit of the scarce resource / limiting factor most appropriately identifies
the best possible solution amongst the different alternatives. To maximise contribution, the scarce resource needs to be
allocated to those products that earn the most contribution per limiting factor.

Continuing the above example

If Atlanta Company has unlimited machine capacity but a limited amount of labour time available, the excess production
capacity should be devoted to producing the model with the highest contribution margin per hour of labour. It can be
calculated as ‘contribution margin/direct labour hour per unit’.

Plain model TZS48,000/(TZS20,000/10,000) = TZS24,000 per hour Regular model

TZS36,000/(TZS30,000/10,000) = TZS12,000 per hour
Super model TZS50,000/(TZS40,000/10,000) = TZS12,500 per hour

The above calculation indicates that Plain model has the highest contribution per limiting factor (i.e., direct labour hour)
and therefore, maximising production of this model will optimise the utilisation of the scarce resource and thereby
maximise profit.

Let us understand how limiting factors work in the service industry.

Woodland Hotel is well known for its services of banqueting and lodging. It provides three options for lodging - special
rooms, deluxe rooms and super deluxe rooms. All its rooms usually have sufficient demand in the peak season. However,
in off season, the overall profitability declines.
The following cost data is available for Woodland Hotel

Special room Deluxe room Super deluxe Total

room
Number of rooms available 10 10 10 30

Rent charged to customers per room TZS50,000 TZS60,000 TZS75,000

Variable costs per room TZS30,000 TZS45,000 TZS50,000

Fixed costs TZS100,000,00
0

In the off season, Woodland reduces the charge per room by 5%. Furthermore, in order to increase the overall
profitability, Woodland wants to offer the most profitable room first during the off season.

The contribution can be calculated as follows:

Special room Deluxe room Super deluxe

(TZS) (TZS) room (TZS)
Rent charged to customers per room in off 47,500 57,000 71,250
season
Less: Variable costs per room Contribution 30,000 45,000 50,000
per room 17,500 12,000 21,250

Since the highest contribution per room is earned by super deluxe rooms, the hotel should offer super deluxe rooms first
to the customers. Therefore, to whoever inquires, Woodland should offer the most profitable room first. However, in service
industries, it is pretty difficult to control sales in accordance with the contribution per limiting factor. Here, other factors like
customer preferences, availability of a substitute, etc. also play a major role in profitability.
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A limiting factor is a factor that acts as

A A constraint in meeting the demand

B An assistance in meeting the demand

C An irrelevant factor as far as demand is concerned

D None of the above

Sure shot Plc manufactures bed linen. It produces three varieties of bed linen, which are immensely popular because they
are designed in a very innovative style. Information on future market demands as well as machine hours is given in table
below.

Type 1 Type 2 Type 3

Contribution TZS8,000 TZS6,000 TZS10,000
Machine hours required per unit 2 3 4

Machine hours are a limiting factor. Prepare a statement showing contribution per machine hour and identify the product
with the highest contribution per limiting factor.

Answers to Test Yourself

Answer to TY 1

The correct option is A.

The inventory holding cost is the total cost of the investment in inventory, and includes:
the salary of the watchman who guards the warehouse.
Answer to TY 6

The correct option is A.

A limiting factor limits our production as it is a factor which is essential for production but is scarce. It is a necessary factor
for production and due to its scarcity, it does not assist but limits the production.

Answer to TY 7

The contribution per unit is given. Let us now calculate the contribution per limiting factor.

Type 1 Type 2 Type 3

Contribution TZS 8,000 TZS 6,000 TZS 10,000
Machine hours required per unit 2 3 4
Contribution per machine hour TZS 4,000 TZS 2,000 TZS 2,500

Type 1 gives the highest contribution per limiting factor i.e. TZS 4,000 per machine hour.
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Self-Examination Questions

Question 1

Paper Ltd had given the following information. Based on the information, suggest to them how much they should produce
per year so that all the fixed cost is recovered.

TZS ’000
Selling price (per unit) 50
Variable cost (per unit) 40
Total fixed cost (per year) 120,000

A 10,000 units

B 12,000 units

C 3,000 Units

D 2,400 units

Question 2

Doll Co runs a toy manufacturing unit. The company’s target for 20X3 is to manufacture 30,000 units. The per unit selling
price of the product is TZS 12,000. The total variable cost of the product is TZS 6,000. During 20X3 the company expects
to earn a profit of TZS 48,000,000.

What must be the company’s per annum fixed cost?

A TZS 132,000,000
B TZS 18,000,000
C TZS 78,000,000
D None of the above

Question 3

Baby Care Co is a company that manufactures baby shampoo. It recently launched a special new shampoo for babies.
The cost structure for the product is as follows:

TZS ’000
Direct material cost
18
Direct labour cost
12
Variable overhead
7
Fixed cost (per annum)
147,000

The selling price of the product is TZS 50 per unit. In this situation, the C/S ratio of the company is:

A 62%
B 40%
C 26%
D None of the above
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D1
SECTION D
INTRODUCTION TO
STANDARD COSTING AND
VARIANCE ANALYSIS

SECTION D1: INTRODUCTION TO STANDARD

COSTING AND VARIANCE ANALYSIS

Various costs are incurred by any organisation in undertaking its various activities/processes. In order to drive a better
financial performance, such costs need to be properly monitored and managed. Standard costing helps in setting
predetermined standards for various cost elements such as direct materials, direct labor, and manufacturing overhead.
It provides a benchmark against which actual costs can be compared. Once the actual costs are incurred, it is better
for the management to compare them with the pre-determined standard costs. variance analysis is performed to
analyse the differences (variances) between actual costs and standard costs.Standard costing and variance analysis
provide a structured approach to identifying areas of concern and opportunities for improvement within the business.
This Study Guide will help you learn such approach in detail. The management accountant needs to regularly perform
this analysis for cost contrrol and for proper and timely decision making. This Study Guide is also important for
examinations since long questions can be based topics from this Study Guide.

a) Describe standard costing and explain basic, ideal, attainable and current standard costs
b) Explain the objectives of standard costing and, illustrate its use and how it is set for direct materials, labour
d overheads.
c) Calculate, explain and comment upon effects of total sales, material and labour variances from key
performance measures and their implications for management
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1. Describe standard costing and basic, ideal, attainable and current standards.
2. Explain the objectives of standard costing and, illustrate its use and how it is set for direct materials, labour
and overheads.
[Learning Outcomes, a and b]

1.1 Definition and explanation of standard costing

Standard cost is the planned unit cost of the products, services or components produced in a period. The standard cost
may be determined on a number of bases. The main uses of standard costs are in performance measurement, control,
inventory valuation and in the establishment of selling prices.

Standard costing is a control technique which compares standard costs and revenues with actual results to obtain
variances, which are used to stimulate improved performance.
CIMA official terminology, 2005

Standard costing is a control technique that uses standard costs and revenues as a yardstick for measuring actual
performances. It consists of the following steps:
(a) Setting the standards (both for the items of cost as well as for revenue).
(b) Comparing the actual cost with the standard cost, and the actual revenue with standard revenue.
(c) Calculating the variance, if any (i.e. identifying whether or not actual performance deviates from the desired level).
(d) Analysing and investigating the reasons for the variance (to make the exercise cost effective, only the significant
variances are investigated).
(e) Taking corrective action - either by improving the actual performance (if performance is not up to the mark), or by
revising the standards (if they were set at a level that is unachievable for any reason).

1.2 Classification of standard costs

Although it is accepted that standard costs are predetermined costs or cost estimates in a particular set of circumstances
or conditions, there are differences of opinion on the circumstances or conditions that should be considered for setting
standards. As a result, several types of standard costs are used in practice.

Standards may be classified primarily as current standards and basic (or static) standards. Apart from current standards or
basic standards, the other modes of expressing standards are normal standards, ideal standards and attainable standards.

Current standards

These are subject to alterations in prevailing conditions during the period the standards are to be used. The standards
outline costs and efficiencies that are currently being achieved. They may require periodical review and frequent revisions
in order to adjust them with the changes in the production method or price level. Therefore, these standards normally
remain valid only for the accounting period under consideration.

Basic standards

Basic standards are designed to be used over a long period of time. These are not intended for revision in the short run
and therefore, they may not reflect current conditions. These standards are suitable for industries where technical
processes and operations are fully established and do not change materially over a number of years.

Normal standards

These are the average standards that are anticipated to be attained over a future period of time, typically, long enough to
cover a trade cycle.

If a trade cycle continues for eight years standard costs may be ascertained based on the average conditions (considering
both boom and recession periods) over the period.
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Normal standards are useful for long-term planning and decision making. The standard represents costs and efficiencies
which can normally be achieved.

Ideal standards

These standards are set considering the ideal prevailing conditions and demand a high degree of efficiency and
performance. Ideal standards consider consumption of the minimum quantity of material at the lowest price, labour at the
minimum rate and time, and overhead at the maximum efficiency. Ideal standards are mostly theoretical and found to be
unachievable most of the time. In an automated production plant where efficient methods of production and production
control exist, ideal standards may be most suitable.

Attainable or expected standards

These standards take into account the conditions and circumstances expected to prevail during the period for which the
standards are set. Allowances for wastage and idle time are provided for in the standards. Expected standards are more
realistic than ideal standards.

2.1 Objectives of standard costing

Standard costs are predetermined costs per unit that should be achieved under predetermined conditions. They are
calculated from the management’s standards of efficient operation and the relevant necessary expenditure. Standard
costs are useful for cost estimation, performance measurement, control, price determination etc.

Their objectives / usefulness encompasses

1. Planning
Standard costs are the building blocks for budgeting, which is an operational planning tool. Setting standards for any cost,
revenue or volume of activity is the first step in devising a budget.

Material specification standards are used in calculating the materials purchase budget. Similarly, standard labour times
or standard machine usage are the basis for preparing labour budgets and production plans.

2. Control and performance measurement

Standard costs act as a benchmark (by establishing standards) for comparison with actual performance (by analysing
variances) in order to evaluate the level of achievements and to fix responsibility for variances (if any). It is critical to
decide whether to set standards at an ideal level or at an achievable level.

3. Decision making

Standard costs form the basis for ascertaining the cost of a new product and for identifying the future profitability of a
product. Also, standard costs are used in determining the price of the products / jobs.

Standard costs can be used as the starting point for preparing a tender.

4. Improvement and change

Improvement and change in performance can be achieved by monitoring variances over a period of time. Monitoring
variances provides a good insight into the prevailing conditions of the environmental factors that might have caused
changes in the performance. Variance analysis also provides information on the controllability of costs, which helps in
improving performance.
A standard has a direct impact on the level of motivation of the employees. Performance level may be improved by setting
a standard slightly higher than the achievable standard and thereby inducing the employees to achieve the new standard.

5. Alternative method of valuation

144
Standard costing provides alternative methods of valuing inventory (such as FIFO, LIFO and the weighted average
method) and cost of production. Standards are suitable for organisations whose activities involve common or repetitive
operations and where the material and component parts of products can be specified. Standards are normally set at an
ideal level to reflect perfect performance or an attainable level of performance under efficient operating conditions. Some
organisations use standard costing for statistical purposes only. The best use of standard costs can, however, be made
only if they are incorporated into the accounting system. Many ERP systems have built in mechanism for valuing inventory
at standard costs.

Diagram 5: Standard cost and variance analysis cycle

Briefly state the objectives / usefulness of standard costs.

2.2 Setting standard costs for materials, labour and overheads

Deriving standard raw material cost

Standard costs per unit must be set for each element of cost viz. material, labour and overheads. Material is the first
component of the total standard cost. The standard material cost is derived from the standard price and quantity.
Therefore,

Standard material cost = Standard material price x Standard material quantity

So as to set standards for raw materials costs, the following information is essential:

1. For material price

(a) Prevailing price in the market for the raw material to be purchased
(b) Last purchase price of the same raw material
(c) Prevailing inflationary trend and continuance of the trend during the budget period

2. For material quantity

(a) The availability of quantity discount for bulk purchases
(b) The pattern of consumption of raw materials per unit of output (c) The quality of raw
materials required for production etc.
 145
Standard quantity depends on the bill of material which specifies how much quantity of every item of material is to be used
to produce one unit of finished output. The quantity should be set after giving appropriate allowance for normal losses.

To derive standard material cost, it is essential to ensure standard purchase procedures and steps and, at the same time,
to have a standardised consumption pattern of the raw materials by the production process. Based on the above
information, the purchasing department arrives at a predetermined cost which is ideal as well as achievable in reality.
Standard material cost is computed per unit of finished product. A unit of finished product may have more than one items
of raw material.

Deriving standard direct labour cost

Another component of standard cost is the standard labour cost. It is calculated as:

Standard labour cost = Standard labour rate x Standard labour hours

To set standards for direct labour costs, the following information is essential:

1. For labour rate

(a) Prevailing wages according to the payroll

(b) Whether any agreement on a pay rise with employee representatives has taken place or not (c) Prevailing
inflationary trend and continuance of the trend during the budget period

2. For labour hours

(a) If there is any possible idle time that can be estimated prior to the budget period, then whether the idle time is
material enough to be considered in setting standards or not

(b) Historical data regarding labour time required for each job of repetitive nature etc.

To derive standard labour cost, it is important that a work study of the whole production system comprising a method
study, motion study and time study is made at each work station. Moreover, in arriving at the standards, use of the above
information assumes immense importance.

Deriving standard overheads

Overheads are classified into variable and fixed for planning and control purpose. Standard production variable overheads
are derived from standard hours (labour hours or machine hours) and the standard variable overhead rate per hour.

Overheads are absorbed by production (unlike the direct costs that are directly charged to production) based on certain
predetermined parameters (known as allocation bases) such as machine-hour, labour-hour, direct wages etc.
Determination of the allocation base is of primary importance for setting standards. The overhead absorption rate per
hour is obtained from the budget.

Estimates of total hours (if machine hour or labour hour is the allocation base) and total overheads (variable and fixed
separately) are of critical importance for identification of overhead absorption rate.

The following table highlights the importance of estimating the volume of the allocation base. The estimate of allocation
base or the total overheads may lead to under- or over-absorption of the overheads and, accordingly, cause the calculated
costs of a product or a service to be different from the actual costs.
1 Budgeted fixed factory overhead TZS36,000,000 TZS36,000,000 TZS36,000,000
2 Labour hours 5,000 hours 4,000 hours 6,000 hours
3 Overhead rate per hour TZS7,200 TZS 9,000 TZS6,000
4 Absorbed (5,000 units of output x rates in row TZS36,000,000 TZS45,000,000 TZS30,000,000
3)
5 Overheads under- / (over) - absorbed (1 - 4) 0 TZS(9,000,000) TZS6,000,000

Also, estimating the optimum time required for each unit of production by resorting to time study (the work measurement
method that studies each of the operations in an organisation so as to identify the time taken by each operation and
thereby to determine the ideal time for performing each operation) assumes critical importance.
146

Briefly state the steps involved in setting standard cost.

3. Calculate, explain and comment upon both price and volume effects of variances from standards or budgets
and other variations from key performance measures and their implications for management.
[Learning Outcome c]

Performance measurement and management is incomplete without the evaluation of organisational performance.
Variance analysis is at the core of this evaluation process. Any deviation from the set performance standards leads to a
variance from the expected / desired performance expectations.

Variance means the difference between the actual and the standard/budgeted (or historical) data of both the cost and the
revenue components. Variance will take place, if in any given production period the actual costs vary from the standard
costs. For example, if the price paid for material bought during a given production period, differed from the standard
(expected) price for that material, a material price variance will arise.

In the same way if the amount of material actually used went beyond the standard (expected) usage, a material usage
variance would arise. Variance analysis helps management to understand the present costs and then to control future
costs.

Variances draw the management’s attention to the fact that everything has not gone according to plan or budget. Variances
bring to light problems that may exist, and they help to direct management’s attention to them. If management is aware
that there have been departures from standards (expectations) they will be in a position to take action to correct them.
Significant adverse variances will, if left unchecked, have an adverse effect on profitability. If favourable variance arises,
they too should be investigated. It is possible that a favourable variance can arise due to some unidentified factor that
could in the future be used to improve the business.

Variances can be split into two types: variances showing an effect of:
price difference; and /or volume
difference
 147

3.1 Cost related variances

1. When cost per unit is different

Cost related variances are calculated by deducting actual costs from budgeted costs. When the cost per unit is different
from the actual or budgeted cost and the volume of production remains the same:

Variance for production costs = Budgeted costs – Actual costs

The following example shows the calculation of variance.

Saturn Inc has prepared a budget for the production of 2,000 annual units, at per unit cost of TZS 100,000. The actual
costs incurred for 2,000 units were TZS 220,000,000.

Variance for production costs = Budgeted costs – Actual costs

= (2,000 units x TZS 100,000) - TZS 220,000
= TZS 200,000,000 - TZS 220,000,000
= (TZS 20,000,000)

Actual costs are higher than budgeted costs.

Volume of budgeted production and actual production (in units) doesn’t always remain the same.

2. When the volume of production is different

When, along with the per unit cost, the volume of production is also different, the variance can be calculated by deducting
actual costs from the budgeted costs of actual production. If actual volume of production is different from the original /
budgeted volume of production, flexed budgets should be used for comparison. Flexed budget costs are the budgeted
costs for actual production. According to flexed budget, variance is calculated by comparing actual costs with the budgeted
costs of actual production. The following formulae are used for calculating variance.

Production cost variance = Budgeted costs for actual production – Actual costs
Budgeted costs for actual production = Actual production units x Per unit budgeted costs

Per unit budgeted cost = Total budgeted costs

Budgeted units

Venus Plc’s production budget shows a total cost of TZS500,000,000 for 25,000 units. At the end of the year, Venus
produces 28,000 units for TZS550,000,000.

Here, the actual cost is more than the budgeted cost, but we cannot immediately conclude that it is a negative variance,
as the volume of production has also changed. Here, flexed budget should be used for comparison.

Per unit budgeted cost = Total budgeted costs

Budgeted units
=TZS500,000,000/25,000 units
= TZS20,000

Budgeted costs for actual production = Actual production units x per unit budgeted costs
= 28,000 units x TZS20,000
= TZS560,000,000

Production cost variance = Budgeted costs for actual production – Actual costs
= TZS560,000,000 - TZS550,000,000
= TZS10,000,000

Actual costs are lower than budgeted costs of actual production. It is positive variance.
148

3.2 Revenue related variances

For sales revenue related variances, the actual amount is compared with the historical / budgeted amount. Sales variance
is used to evaluate the performance of a sales function, and analyse the business’s results in order to understand market
conditions.

One of the reasons below, apply for variations in actual sales from planned sales:

The volume sold varies from the planned amount (sales volume variance), or
Price actually realised vary from the planned one (sales price variance)

Both circumstances could also concurrently contribute to the variance.

1 . Difference in selling price per unit

When the volume of sales remains the same, but the selling price per unit varies from the budgeted price, the sales
revenue variance can be calculated using the following formula:

Sales revenue variance = Actual sales – Budgeted sales

If the actual sales are more than the budgeted sales, it is said to be positive variance, as there is an increase in actual
profit than what was expected.

Pluto Corp sold goods of 5,000 units at TZS 120,000 per unit. The expected sales revenue on 5,000 units was TZS
620,000,000.

Sales revenue variance = Actual sales – Budgeted sales

= (TZS5,000 units x TZS120,000) - TZS620,000,000
= TZS600,000,000 - TZS620,000,000
= (TZS20,000,000)

Actual revenue is lower than expected. It is a negative variance which could decrease the profit.

2. Difference in sold units/sales volume

When the actual sales volume and the selling price vary from the planned figures, the sales revenue variance can be
calculated using the following formula:

Sales revenue variance = Actual sales revenue – Budgeted sales revenue for actual sold units
Budgeted sales revenue for actual sales = Actual sales (in units) x Per unit selling price (of budget)
Budgeted per unit selling price = Total budgeted sales revenue
Budgeted units

Neptune Co.’s extract of the budgeted SOPL (Statement of profit and loss) is as follows:

TZS’000
Sales (10,000 units) 1,000,000
Less: Cost of sales (800,000)
Gross profit 200,000
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Actual sales were 9,000 units at TZS102,000 per unit.

Budgeted per unit selling price = Total budgeted sales revenue

Budgeted units

= TZS1,000,000,000
10,000 units = TZS100,000

Budgeted sales revenue for actual sales = Actual sales (in units) x Per unit selling price
= 9,000 units x TZS100,000
= TZS900,000,000

Sales revenue variance = Actual sales revenue – Budgeted sales revenue for actual units sold
= (9,000 units x TZS102,000) - TZS900,000,000
= TZS918,000,000 - TZS900,000,000
= TZS18,000,000

For price variances: compare the actual price with the standard price for actual quantity.
For quantity or volume variances: compare the actual quantity with the standard quantity for standard price

Galaxy Inc has prepared a budget for the production of 2,000 annual units. The expected time per unit is 6 labour hours.
The standard wages per labour hour is TZS 6,800. Galaxy has produced 1,940 units with a total of 13,000 labour hours.
The actual labour wages were TZS 6,750 per hour.

The flexed budget costs for direct labour is TZS __________.

A 87,750,000
B 79,152,000
C 81,600,000
D 81,000,000

3.3 Management implications of variances from performance measures

The above variances lead to action from management to correct these variances. Overcoming variances and suggesting
corrective action is the responsibility of management.
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Variances can arise either due to factors within the control of managers or due to factors outside their control. The factors
are hence either controllable or uncontrollable. Variances arising due to controllable factors require corrective action by
the responsibility centre managers to control costs or increase revenues. Generally, costs can be controlled easily by
managers, but revenues are dependent on customer behaviour and preferences.

Certain costs are rendered uncontrollable due to certain management decisions. E.g. when an asset is purchased in a
particular accounting period, its depreciation expense for the entire useful life occurring in the subsequent accounting
periods is an uncontrollable cost. It will occur in any case and cannot be controlled.

Another factor that renders a cost uncontrollable is the hierarchy in management. E.g. costs approved and incurred by
top management, like purchase costs of a particular raw material, are uncontrollable at middle and lower management
levels.

In order to deal with variances, management prepares control reports to identify and correct variances from budgeted
figures.

Control reports are prepared from an analysis of the comparison between the actual data and the budgeted data. It mainly
explains the causes of the variances and recommends suitable control action. The main purpose of preparing such reports
is to focus on performance effectiveness and areas which needs improvements.

There is no specific format of control reports as they are prepared for internal purpose. Control reports should be prepared
in such a way that they enable management to exercise control by comparison. The following is an example of prime cost
expenditure control report:

To,
The management of ________ Co
Date: 11 May 20X3
Sub: Prime cost control report for the month of April 20X3

Elements of cost Budget Actual Variance Comment

TZS’000 TZS’000 TZS’000
Due to scarcity of materials, the purchase
Materials 10,000 15,000 (5,000) price has drastically increased during the last
month.
Labour 14,000 18,000 (4,000) Recruitment of two semi-skilled
labourers
Direct variable Variable overhead absorption rate needs to
6,000 3,500 2,500
overheads be revised.

Such reports might include an additional column stating percentage of variances.

The following is another example of control report:

To,
The management of ________ Co
Date: 11 May 20X3
Sub: causes of variance and recommended action

Variance Cause of Recommended action / corrective action

TZS’000 variance
Sales volume (5,000) Poor market To conduct a pre survey in accordance with market to
variance prediction enable making the right volume estimation
Labour rate Increase in Increase selling price per unit to maintain contribution
(4,000)
variance wage rate margin

Control reports can be prepared timely e.g. weekly, monthly, fortnightly or yearly depending on the management
requirements and company policies.
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Diagram 2: Management implications for variances from performance measures

Variances in costs and revenues can be overcome by managers by:

A Analysing whether costs are controllable or uncontrollable

B Analysing whether uncontrollable costs can be controlled by management intervention
C Study of control reports to identify reasons for the variances
D All of the above .

Self-Examination Questions
Question 1

The material standard for one unit of Product Z is 3kg at TZS 5 per kg. 14000 kg were used at a cost of TZS 84,000 and
4000 units were produced. Calculate the material cost variances.

Question 2

The material standard for one unit of product ‘Y’ is 2 tons at TZS 150 per ton. 11000 tons were used at a cost of TZS
1,760,000 and 6000 units were produced. Calculated material cost variances.

Question 3

The material standard for one unit of product ‘X’ is 2 ½ units at TZS 20 per unit. 16000 unit were bought at TZS 18.50 per
unit but only 15000 units were used to produce 6500 units of product ‘X’ 1000 units of material left in stock at the end of
the period. Calculate the material cost variances.

Question 4

Calculate the labour cost variances from the information set out below:
Standard rate per hour TZS 10
Standard time per unit 2 hours
Time worked 4250 hours
Time paid (4326 hours) TZS 42,500

Question 5

Calculated the labour cost variances from the following information:

Standard rate per hour TZS 8
Standard time per unit 2 ½ hours
Time worked 42000 hours
Time paid at TZS 9 per hour 50000 hours
Production achieved 18000 units
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Answers to Self-Examination Questions

Answer to SEQ 1

Material price variance

(A.P. x A.Q) – (S.P x A.Q)
TZS 84,000 – (TZS 5 x 14000)
TZS 84,000 – TZS 70,000 = TZS 14,000 A
Material usage variance
S.P. (A.Q – S.Q)
TZS 5 (14000 – 12000)
TZS 5 (2000) = TZS 10,000 A

Material cost variance = Material price variance + Material usage variance

= TZS 14,000 A + TZS 10,000 A
= TZS 24,000 A
Check
Material cost variance = Actual Cost – Standard Cost
Standard Cost per unit of Z = TZS 5 x 3 kg = TZS 15
Standard cost of 4000 units = TZS 15 x 4000 = TZS 60,000
Actual cost of 4000 units = 84,000
Material cost variance = 84,000 – TZS 60,000 = 24,000 A

Where:
F = Favourable
A = Adverse
AP = Actual price
AQ = Actual Quantity
SQ = Standard Quantity
SP = Standard price

Standard quantity for one unit of Z is 3 kg and for 4000 units of Z, it is 12000 kg (i.e. 3 kg x 4000)

Answer to SEQ 2

Material Price Variance

= (A.P. x A.Q) – S.P. x A.Q)
= TZS 1,760,000 – (TZS 150 x 11000)
= TZS 1,760,000 – TZS 1,650,000
= TZS 110,000 A

Material Usage Variance

= S.P. (A.Q. – S.Q)
= TZS 150 (11,000 – 12,000)
= TZS 150 (1000) = TZS 150,000 F

Note: S.Q. = 2 tons x 6000 units = 12,000 tons.

In this case, material usage variance is favourable because standards quantity is greater than actual quantity.
Material cost variance = TZS 110,000 A + TZS 150,000 F
= TZS 40,000 F
Check
Standard cost per unit of ‘Y’ = TZS 150 x 2 tons = TZS 300
Standard cost of 6000 units of ‘Y’ = TZS 300 x 6000 = TZS 1,800,000
Material cost variance = TZS 1,760,000 – TZS 1,800,000 = TZS 40,000 F

It is favourable because actual cost of 6000 unit is smaller than standard cost.
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Answer to SEQ 3

When the quantity of material purchased is different than quantity used then material price variance is calculated in the
basis of quantity purchased but material usage variance is calculated on the basis of quantity consumed.

Material price variance

= (A.Q x A.P) - (S.P x A.Q)
= (TZS 18.50 x 16,000) - (TZS 20 x 16,000)
= TZS 20 (1250) = TZS 25,000 F

S.Q. for 6500 units = 2 ½ units x 6500

= 16250
In this case standard quantity is greater than actual quantity so material usage variances is favourable.
Labour cost variances
This is the difference between the standard direct labour cost and the actual direct labour cost incurred for the production
achieved. This is the sum of labour rate variance and labour efficiency variance.
Labour Rate Variance
This is the difference between the standard and actual direct labour hour rate per hour for the total hours worked. It is
calculated as under:
(Actual rate x Actual hours) – (Standard rate x Actual hours)
The main causes of this variance are:-
i) Higher or lower rate paid to the workers as compared to standard rate.
ii) Different grades of labourers used than planned.
iii) Payment of bonus or overtime to the workers not anticipated in advance.

Labour Efficiency Variance

This is the difference between the standard hours for the actual production achieved and the hours actually worked,
valued at the standard labour rate. it is calculated as under:-
Standard labour rate (Actual hours – Standard hours)
i) Lower or higher efficiency of workers than anticipated
ii) Poor supervision
iii) Use of inferior quality of materials or machine problems,
iv) The attitude of workers.

Idle Time Variance

Sometimes, there is idle time variance also. This variance arises when some wages are paid for idle time. This variance
is also adverse. It is calculated as: Idle time x Standard labour rate.

Answer to SEQ 4

Labour rate variance

= (A.R. x A.H) – S.R x A.H)
= TZS 42500 – (TZS 10 x 4326)
= TZS 42500 – TZS 43260 = TZS 760 F

Labour efficiency variance

= S.R (A.H – S.H)
= TZS 10 (4250 – 4360)
= TZS 10 (110) = TZS 1100 F

Idle time variance

= S.R. (Idle time)
= S.R. (Time paid – Time worked)
= TZS 10 (4326 – 4250)
= TZS 10 (76) = TZS 760 A
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Labour cost variance = Labour rate variance + Labour efficiency Variance + idle time Variance
= TZS 760 F + TZS 1100 F + TZS 760 A
= TZS 1100 F

Check
Labour cost variance = A.C. – S.C.
= TZS 42,500 – (TZS 20 x 2180)
= TZS 1100 F

Standard cost per unit = TZS 10 x 2 hours

= TZS 20

Where:
A.H. = Actual hours
S.H. = Standard hours
S.R. = Standard Rate
A.R. = Actual Rate
A.C. = Actual Cost
S.C = Standard Cost

Standard hours = Standard hours per unit x Actual production

= 2 x 2180
= 4360
Note:
Labour rate variance is calculated on the basis of time paid and labour efficiency variance on the basis of time
worked.

Answer to SEQ 5

Labour rate variance

= A.R. x A.H) - (S.R. x A.H)
= (TZS 9 x 50000) - (TZS 8 x 50000)
= TZS 450,000 – TZS 400,000 = TZS 50,000 A

Labour efficiency variance

= S.R. (A.H. – S.H)
= TZS8(42,000 – 45,000)
= TZS8(3,000) = TZS 24,000 F

Note:
Standard hours = 2 ½ hours x 18000 units
= 450000 hours
Idle time variance
= S.R. (Idle time)
= S.R. (Time paid – Time worked)
= TZS 8 (50,000 – 42,000)
= TZS 8 (8,000) = TZS 64,000 A.

Labour Cost Variance = A.C – S.C.

= (A.R. x A.H) – (S.C. per unit x units produced)
= (TZS 9 x 50,000) – (TZS 20 x 18,000)
= (TZS 450,000 – TZS 360,000) = TZS 90,000 A
S.C. per unit = TZS 8 x 2 ½ hours = TZS 20.
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SECTION D

E1
PROCUREMENT
MANAGEMENT

SECTION E1: THE PROCUREMENT AND

PROCUREMENT CYCLE

Procurement is a critical function for every institution. As such procurement and supplies occupies substantial amount of
the organisation’s expenditure, both private and public. The management of procurement and supplies process is therefore
important to avoid wastage of resource and value for money for these institutions. The procurement management process
ensures appropriate identification of needs and timely supply of intended goods or services for effective operations service
delivery and efficient running of the organization. The procurement process involves almost every manager of the process
within and across the organization and guided by the procurement and supplies specialist. The process involves numerous
documentation and procedures. This chapter acquaints the learners with knowledge and understanding of procurement
and procurement process, its value and principles and appropriate procedures and documentation. The key players of the
procurement process and their specific roles are identified and discussed.

a) Differentiate between procurement and purchasing.

b) Explain and use guiding principles, objectives and core values of procurement.
c) Describe activities involved in procurement cycle when buying goods or services.
d) Identify and use necessary procurement documents.
e) Describe the role of use Information Communication Technology (ICT) in procurement.
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1. Differentiate between procurement and purchasing.
2. Explain guiding principles, objectives and core values of procurement.
[Learning Outcomes a and b]

Procurement is one of the critical functions within both public sector entity and private sector organizations. Almost
everything consumed in organization (goods, services, products) is a result of procurement function. As such procurement
drives every other function (s) within and across Organisation and represents huge spending and substantial percentage
of the entity’s operating costs. Sometimes procurement and purchasing are used interchangeably but purchasing is more
concerned with commercial relationship whereas procurement is also concerned with physical materials and contract
management.

1.1 Defining procurement

Procurement comprises set of activities that ensure the quality goods and services necessary for execution and realization
of organizational objectives are efficiently obtained and made available on the timely manner and at the right place.
Procurement includes identifying the organizational operational needs, identifying the right suppliers, establishing
contractual relationship and managing the contract for efficient delivery of goods and services to user department. In a
briefer manner, procurement involves purchasing the right quality of goods, services or material at the right time, in right
quantity, from the right source and at the right price. The procurement process includes successive stages – needs
identification and planning, choice of procedures, measures to solicit offers from tenderers, examination and evaluation of
those offers, award of contract and contract management.

1.2 Defining purchasing

Purchasing is a typically commercial process in which the organisation engages third party or relevant supplier to obtain
goods and services required for the execution of its operational functions and realization of its objectives timely and cost-
effective manner. The purchasing’s primary role is to obtain goods and services in response to internal needs.

2.1 Objectives of procurement

The overall objective of procurement is to ensure goods and services required for supporting the needs of operations
through the purchase of raw materials, goods, components, repair and maintenance items, and services necessary for
implementation of planned objectives. Specific objectives of procurement include:

(a) Supply continuity

The traditional objective of the procurement is to ensure availability of procurable goods and services to meet
organizational operational requirements and needs. Procurement ensures timely delivery of quality products or services
from the right sources and as per the specifications and needs of the user.

(b) Efficiency and Effectiveness of the procurement process

This objective aims at managing internal procurement process efficiently and effectively through automation and
improvement of relevant procurement systems, adequate staffing, sufficient administrative budget, staff training and
capacity building as well as adequate involvement of internal stakeholders in the procurement process. This will
consequently reduce costs and improve profitability.

(c) Establish supply base management

Procurement should constantly establish and maintain a supply base management. This is made possible through
selecting competitive suppliers capable of providing performance advantages in the product quality and price, timely
delivery, technology and new product development and ensuring close relationship with suppliers.
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(d) Establish goals aligned with internal functional stakeholders

Procurement is a critical function that support realization of institutional goals across the organization. In order to provide
effective support, the procurement should communicate closely with internal functional groups or internal customers
(management and user departments) to ensure organizational efficiency.

(e) Develop procurement plans and strategies aligned organization plans

For procurement to improve overall organization operational performance, the procurement must ensure the purchasing
plans and strategies are adequately aligned with plans and strategies of other business functions (procurement
stakeholders). As such, the annual procurement plan and strategies should be reflective of functional areas plans.

2.2 Procurement guiding principles and Core values

Procurement is governed by several principles that suggest and promote efficiency and realisation of value for money on
all procurable goods and services. These principles should be adhered to by all procuring entity and relevant stakeholders
in the procurement cycle.

a) Best value for money [Value for Money)

The procurement should be conducted such that optimal combination of factors, such as price and quality in meeting the
end user needs is considered. (Efficiency, economy and effectiveness).

b) Fairness and Equal Treatment

Procurement should be conducted in due consideration of reasonableness and impartiality. All potential suppliers and
contractors should be treated fairly, ensuring that only price and quality are discriminatory factors. Gender, party
affiliation, ethnicity, religion should not be used to discriminate against suppliers.

c) Transparency

Ensure maximum degree of transparency and competitive tendering throughout the procurement cycle in order to
promote fairness and equitable treatment of all potential suppliers.

d) Accountability and Control

Procurement should be conducted in an environment of clear chain of responsibilities and effective control mechanism.
The complaints from suppliers should be handled fairly and timely.

e) Integrity and Ethical Behavior

Procurement process should be carried in an environment which promote integrity and ethical values such that fraudulent
and unethical practices in procurement are avoided.

f) Promotion objectives of Objectives

The procurement process should be organised and conducted in a manner that it supports operational efficiency and
fulfilling mandate, goals and objectives of the organisation.

g) Environmental sustainability

The environmental implications should be factored into procurement decisions.

h) Efficiency

The process must ensure efficiency in procurement. The objective of the procurement should be achieved efficiently.
158

Explain any six (6) general principles of procurement that an officer in charge of procurement of goods, services and
works should consider.

3. Describe activities involved in procurement cycle when buying goods or services

[Learning Outcome c]

Procurement is continuous cycle is a series of systematically executed tasks which range from needs identification to
needs satisfaction in an organisation. The cycle intends to reduce costs, manage risk and improve efficiency across and
with a respective organisation. The tasks or components of procurement cycle are detailed as follows;
i Needs identification or recognition of requirements. In this stage the requirement for addressing a particular
operational challenge is identified and documented.

ii Approval of purchasing. After needs identification the request to purchase should be approved. The approval
could by way of procurement plan.

iii Identification of potential vendors or suppliers. This follows after approval to purchase. All relevant suppliers
are identified for consideration. This could be by way of Request for Proposals (RFP), Request for Information (RFI)
or requirement of Expression of Interests (EOIs.)

iv Evaluation and Selection. In this task the suppliers or vendors are evaluated in terms of ability to deliver the quality
products at possible reasonable costs.

v Contract negotiation and payment. In this stage of procurement cycle, the negotiation with selected vendor is
conducted and payment schedule agreed and made accordingly. The terms of service delivery and contract
execution agreed.

vi Contract execution and service delivery. In this stage the contract is implemented and intended service or
product delivered. The procuring organisation (user department) should ensure effective contract execution in
realizing expected outcome.

vii Supplier's performance evaluation. In this stage of procurement, the performance of the vendor is evaluated and
appropriate action executed. The evaluation can result into contract renewal or start of the procurement cycle.

4. Identify and use necessary procurement documents

[Learning Outcome e]

Procurement is a systematic process through which the organisation acquires goods and service of the required quality,
and price to meet its operational requirements on timely manner. The procurement process should therefore be
accordingly documented. There are a number documents which are necessary and useful throughout the procurement
cycle. These range from documents of soliciting suppliers’ information to making contract for execution:

a) Request for Information

In order to achieve effective procurement, it is imperative to seek and collect as much as possible information regarding
the prospective suppliers or bidders. The information relating to bidders that should be collected include the
establishment and legal status, operational and financial capability, historical background, experience and details of
previous achievements, list of clients, references and staffing level and any other information depending on the nature
of the sought services. This information can be collected through a Request of Information (RFI) document. The
information in RFI will be used to filter the long list of prospective bidders to remain with a few and relevant to which a
Request of Proposal (RFP) or Request for Quotation is sought.
 159
b) Request for Proposal

The Request for Proposal (RFP) is a formal document that is used by the buying organisation to clearly specify their
procurement needs and the requirements that enable prospective bidders/suppliers to understand the needs of the
buyer. The RFP require bidders to submit both technical proposals detailing their technical capabilities to perform the
required task or deliver the required service and financial proposal indicating the chargeable amount for the service to
be delivered or task to be performed.

c) Request for Quotation

The Request for Quotation (RFQ) is a formal document that is used by the buying organisation to specify the requirement
of a specified procurable service or goods and requesting for a price quotation. Unlike RFP which requires substantial
number of details regarding the bidder the RFQ is limited to only providing the specification of the items to be purchased
and requesting a quotation from the seller or supplier.

d) Purchase Order

The Purchase Order (PO) is a formal document that is used by the buying organisation favoring a particular supplier of
goods or service. In this case the buying organisation will have a list of preferred suppliers among which the PO will be
issued. PO is referred as a unilateral contract that is raised by the buying organisation and becomes binding to the
seller once the seller accepts it.

During the financial year ended 31st December, 2022, the Kilemba Trading Company (KITCO) selected suppliers for
supplying laptops with negotiated rates for the year. In this regard KITCO can simply raise a purchase order favoring
the supplier for the quantity of items to be purchased.

e) Invitation for Bids

The Invitation for Bid (IFB) is a formal document that is used by the buying organisation to invite potential bidders to
come and participate in the bidding process

f) Contract

The contract is a mutual agreement between the procuring organisation and the seller or supplier of the purchased
goods or service. A legal binding contract will have an offer, an acceptance and sufficient consideration for both the
buyer and seller. The contract once finalized will include the detailed statement of work (SOW) and other terms and
conditions.

Differentiate between “Request for Proposal (RFP) and Request for Quotation (RFQ)” as documents used in
procurement.

5. Describe the role of, and use Information Communication Technology (ICT) in procurement

[Learning Outcome e]

The use of technology in businesses and service delivery processes has become necessarily an important agenda almost
everywhere around the world. Most companies are opting for technologically enabled systems and automation for improved
operational efficiency, service delivery and effectiveness. Although comes with associated costs the benefits of use of the
Information Communication Technology (ICT) are practicable. The procurement function is not exceptional case. The
technology plays a great role in the procurement and literally speaking, the concept of e-procurement is steadily becoming
popular in business sphere.

5.1 Defining e-procurement

160

e-procurement is the aspect of e-commerce where the procurement activities and relationships supported by information
technology and executed electronically. The sourcing and correspondences between organisation and suppliers are
supported by the information technology and automated processes.

5.2 Benefits of IT in Procurement

Using information technology in procurement and purchasing process has several benefits chiefly increasing efficiency,
reducing costs and effectiveness. The beneficiaries of use of ICT have been mainly commercial sector but increasingly
being recognized in public procurement as well. The following are benefits of application of information technology in
procurement.
(a) Improved operational efficiency

Automation of procurement processes enables organization to reduce costs through timely delivery of procured goods
and services.

(a) Enables global procurement

The application of information technology in procurement provides organization with a rare opportunity of accessing
variety of procurable goods and services from suppliers across the global. Further, e-procurement enables the
organisation to timely access important procurement related information for comparison and decision making.

(b) Reduced error and mistakes

The application of information technology is effectively useful in reducing errors and mistakes by enabling the conduct
of procurement process electronically.

(c) Flexibility and convenience

With the use of information technology, the stakeholders in the procurement process can execute relevant procurement
functions conveniently from anywhere and anytime, provided they can access the system.

Comment on the usefulness of the ICT on procurement process

Answers to Test Yourself Questions (TYQ)

Answer to TY 1

These principles are:

i. intercountry correlations – whereby a reasonably low correlation across markets is expected to be better off in
realising benefits of international diversification
ii. The variance (risk) of returns for each country’s assets (securities), and
iii. The expected return in each individual country. Highly asynchronous countries could contribute to low
international correlations and hence benefits of international diversification.

Answer to TY 2

The Request for Proposal (RFP) is a formal document that is used by the buying organisation to clearly specify their
procurement needs and the requirements that enable prospective bidders/suppliers to understand the needs of the
buyer. The RFP require bidders to submit both technical proposals detailing their technical capabilities to perform the
required task or deliver the required service and financial proposal indicating the chargeable amount for the service to
be delivered or task to be performed
 161

WHILE

The Request for Quotation (RFQ) is a formal document that is used by the buying organisation to specify the requirement
of a specified procurable service or goods and requesting for a price quotation. Unlike RFP which requires substantial
number of details regarding the bidder the RFQ is limited to only providing the specification of the items to be purchased
and requesting a quotation from the seller or supplier.

Answer to TY 3

The use of technology in procurement is useful in various ways. Some of these are as follows:

(a) Improved operational efficiency - Automation of procurement processes enable organization to reduce costs through
timely delivery of procured goods and services.

(b) Enables global procurement -The application of technology in procurement provides organization with a rare
opportunity of accessing variety of procurable goods and services from suppliers across the global.

(c) Reduced error and mistakes - the application of information technology is effectively useful in reducing errors and
mistakes by enabling the conduct of procurement process electronically.

(d) Flexibility and convenience - With the use of information technology, the stakeholders in the procurement process can
execute relevant procurement functions conveniently from anywhere and anytime, provided they can access the
system.

Self-Examination Questions (IEQs)

IEQ 1

(a) Define the term “procurement”.

(b) Briefly describe the fundamental principles of procurement.

IEQ 2

Discuss the key functions embedded in the procurement cycle.

Answer to Self-Examination Questions

Answer to IEQ 1

a) Procurement

Process by which an institution selects, receives and pays for the inputs it requires to produce its goods and services
and construction works in the most cost-effective way.

b) Procurement principles include:

• Transparency – information about the procurement is accessible to all bidders.

• Integrity – reliable bidding information is provided to all bidders.
• Economy – efficiency, value for money, fair price and managing resources with due care and diligence is taken
so that there is good value for money.
• Openness – requirements should be open to all those who qualify to participate in the bidding
• Fairness – all bidders are treated the same way without bias.
• Competition – No hindrance to participate in the procurement and tender requirements must be proportionate to
the contract.
• Accountability – everyone is accountable and is sanctioned when they go against the rules
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Answer to IEQ 2

Procurement cycle is a series of activities that ensure the procurable goods of services are identified and delivered to
the procuring entity to meet its operational requirements at a fair price and on timely manners.

i Needs identification or recognition of requirements. In this stage the requirement for addressing a particular
operational challenge is identified and documented.

ii Approval of purchasing. After needs identification the request to purchase should be approved. The approval
could by way of procurement plan.

iii Identification of potential vendors or suppliers. This follows after approval to purchase. All relevant suppliers are
identified for consideration. This could be by way of Request for Proposals (RFP), Request for Information (RFI)
or requirement of Expression of Interests (EOIs.)

iv Evaluation and Selection. In this task the suppliers or vendors are evaluated in terms of ability to deliver the quality
products at possible reasonable costs.

v Contract negotiation and payment. In this stage of procurement cycle, the negotiation with selected vendor is
conducted and payment schedule agreed and made accordingly. The terms of service delivery and contract
execution agreed.

vi Contract execution and service delivery. In this stage the contract is implemented and intended service or
product delivered. The procuring organisation (user department) should ensure effective contract execution in
realizing expected outcome.

vii Supplier's performance evaluation. In this stage of procurement, the performance of the vendor is evaluated
and appropriate action executed. The evaluation can result into contract renewal or start of the procurement cycle.
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163

SECTION E
PROCUREMENT
MANAGEMENT

SECTION E2: PUBLIC PROCUREMENT AND

LEGISLATION

The procurement in governments and public sector organizations in general, is a critical component for delivery of goods,
services and works for effective organizational functioning and maintaining the citizens’ welfare and prosperity. The public
procurement represents a huge some of public money expenditure and therefore regulated through procurement laws and
regulations to ensure value of the public money. Because public procurement represents a substantial part of government
budget, a well governed public procurement can play a major role in fostering public sector efficiency and contribute in
achieving policy goals and operational objectives. Similar to procurement in private sector the public procurement process
involves a series of tasks needing participation of numerous stakeholders. These stakeholders must actively participate
in the process in order to achieve efficiency in the process. Most governments are currently adopting technology in public
procurement process and as such, technology is widely adopted in public procurement than in the private sector
procurement. Embracing technology in the public procurement has several benefits including, ensuring efficiency, effective
management of cost and time, reduced human errors and mistakes and increased convenience. This chapter takes the
learners through the public procurement process and its regulatory legal framework, that is public procurement laws and
regulations. The understanding of public procurement concepts, process and practices is critical to accountants as
important stakeholders in the public procurement process.

a) Differentiate between public procurement and procurement in the private sector.

b) Explain the procedures involved in public procurement.

c) Describe and use public procurement legal framework.

d) Explain the importance of stakeholders’ involvement in procurement process and ways to improve their
involvement

e) Describe and use relevant public procurement management systems in Tanzania.

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1. Differentiate between public procurement and procurement in the private sector.
2. Explain and use the procedures involved in public procurement.

[Learning outcomes, a and b]

Procurement is a critical function for any organisation, whether, operates in the public sector setting or business sector.
The overall objective of any procurement process is as such to ensure timely delivery of quality goods, services or works
in reasonably efficient cost to operational requirements. However, the public procurement attracts a special attention
because it involves the use of public money which demands greater accountability and transparency. Therefore, although,
the procurement process could be the same and follow the same pattern of tasks and activities. The procurement function
and its related process in government institutions is more detailed and deliberately regulated.

1.1 What is “public procurement “?

Public procurement refers to the purchase by governments and state-owned enterprises of goods, services and works. As
public procurement accounts for a substantial portion of the taxpayers’ money, governments are expected to carry it out
efficiently and with high standards of conduct in order to ensure high quality of service delivery and safeguard the public
interest.

Organisation for Economic Co-operation and Development, OECD

The Public Procurement Act [CAP. 410 R.E. 2022] defines procurement as “buying, purchasing, renting, leasing or
otherwise acquiring any goods, works or services by a procuring entity and includes all functions that pertain to the
obtaining of any goods, works or services, including description of requirements, selection and invitation of tenderers,
preparation, award and management of contracts”. Procurement is all about purchasing the right quality of material at the
right time, in right quantity, from the right source and at the right price. Thus, public procurement means acquisition of
goods, services and public works in a timely manner that results in the best value to the government and the people.

Further, “public procurement” can be defined as the process through which goods, services and works are purchased by
the governments (central or local government), state-owned corporations’ or government agencies to meet its operational
requirements or needs. The public procurement involves series of the sequential activities ranging from needs
identification to contract performance evaluation. The objective of public procurement is to achieve cost effective, quality
controlled and timely delivery of goods, services and works that meet needs of the public.

The PPRA annual report. The Public Procurement Authority report (2013), suggest that the Procuring entities’ expenditure
on procurements represent 41 per cent of the total Government budget. The public procurement is financed by mainly
through taxes, fees and grants and therefore commands great transparency.

The Government-owned University in Tanzania intends to construct the academic building for its newly established
Campus in capital city, Dodoma. The procurement of the supervisory consultant and contractor of the academic building
will need to follow the requirements of public procurement legislation.

1.2 Differences between “public procurement and private procurement

The procurement in public sector is unique and conducted in strict and regulated environment. This is mainly because
the public procurement involves the use of public resources for which each cent needs to be accounted for, and the
benefits of procurable goods or services or works realized for the best interest of the public. The main differences between
public procurement and private procurement are fourfold:
(a) Awarding of the contract: The awarding of the contracts in public sector is through competitive bidding process
while in the private sector, contracts are awarded based on the negotiations.

(b) Legal requirements and compliance: The public procurement is regulated by the public procurement legislation
(laws and regulations) to ensure effective use of public money. The compliance with applicable public procurement
laws and regulations and other government directives is therefore key in public procurement. Contrary, the
procurement process in private sector, although, could be governed by policies and guidelines, it is conducted in the
manner that the organisation wishes and thinks it will be beneficial to its operations and profitability.
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In the Tanzania the public sector the public procurement is regulated through Public Procurement Regulatory Authority
(PPRA) and Public Procurement Laws and Regulations. That means the public procurement is regulated both
institutionally and legally.

(c) Budget limit and procurement spending: The public sector entity is required to adhere to strict budget limits. The
public procurement is based on the approved government budget with ceiling where necessary. The budget for
approved budget for procurable goods, services and works can not be exceeded. In private sector it rare to experience
budget limits. The transfers can be done across the departments if something needs to be procured even though not
budgeted for.

(d) Adoption of technology: The technology is intensively used in public procurement than private procurement, such
that the e-procurement concept is has become a common phenomenon in government institutions. The public sector
organisation leverage on technology to improve efficiency and wastage in the procurement process. In private sector
technology is being adopted in procurement but not as much as in the public sector organizations.

(e) Scrutiny and public accountability: The public procurement is substantially finance through taxation and fees which
is the citizens’ monies (Public funding). In the regard public procurement is more subject to scrutiny and public
accountability than the procurement in the private sector setting.

State main differences between public procurement and procurement in the private sector.

2.1 Procedures involved in public procurement

Public process is the same whether in public sector setting or private sector and involves a series of steps from needs
identification to contract closure. Recall that, the “procurement process” means the successive stages in the procurement
cycle, including planning, choice of procedures, measures to solicit offers from tenderers, examination and evaluation of
those offers, award of contract and contract management. This process is governed by public procurement legislation and
other practical guidance. Public Procurement process is bound to be executed within stipulated legal framework while
advancing government goals and realizing institutional objectives.

Steps in public procurement cycle

In other words, the procurement process spans a life cycle from identification of the need, through the selection of
suppliers, to post- contract award management, including disposal.

1. Planning and needs identification: the user department or budget holder identify needs, develops bid
specifications determine methods of procurements and develop criteria to award contract.

2. Choice of bidding procedures: In this stage the procuring selects the appropriate solicitation method or procedure
depending with the intended service, goods or work. The choice of the bid procedure or method should be in line
with procurement legislation.

3. Solicitation of bids: In this step the procuring entity establishes measures to solicit offers from tenderers. Relevant
solicitation’ documents are prepared and notice’ of solicitation issued to pertinent suppliers and bids and proposals
‘received ready for evaluation’.

4. Examination and evaluation of received offers: ‘Evaluate bids/proposal’, ‘conduct discussions /negotiations,
‘provide opportunity to revise bids/proposals’, and ‘execute contract terms.

5. Awarding Contracts to successful bidders: The contracts are awarded to successful bidders. The contract
includes all terms and condition as negotiated and agreed by parties.
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6. Contract performance management: In this stage the performance contractual obligation is monitored and where
necessary ‘contract modifications conducted. Further the review of completed portion and release fund is done in
this stage and lastly deliverables assessed to ensure compliance with contract terms and quality.

3. Describe and use public procurement legal framework.

[Learning outcome c]

It is stated elsewhere in this chapter that public procurement is regulated to ensure efficient use of public resources and
protect public interest. Public procurement system in Tanzania is decentralized, meaning that all entities covered by the
law conduct public procurement activities individually through means available in the country. Similarly, procurement
process in Tanzanian public sector is regulated through both institutional and legal framework.

3.1 Institutional Public Procurement Regulatory Setting

The public procurement in Tanzania is regulated by the Public Procurement Regulatory Authority (PPRA). The PPRA is
the body charged with regulatory functions and responsible for implementation of the public procurement legislation in
Tanzania. The main objectives of PPRA are to ensure the application of fair, competitive and transparent procurement
standards and practices, to enhance the public procurement system and provide guidance to relevant stakeholders on
how to properly engage in public procurement activities. The Authority is charged with regulatory functions and vested
with oversight powers and responsibilities on all public procurement activities carried by all public bodies in the mainland
Tanzania.

The functions of the Public Procurement Regulatory Authority (PPRA) as per the Section 9 of the Public Procurement Act
No.7 of 2011 are as follows:

(a) Advise Government, local government authorities and statutory bodies on procurement principles and practices;
(b) Monitor and report on the performance of the public procurement systems in the United Republic of Tanzania and
advise on desirable changes;
(c) Prepare, update and issue authorized versions of the standardized tendering documents, procedural forms and any
other attendant documents to procuring entities;
(d) Ensure in collaboration with relevant professional bodies, that any deviation from the use of the standardized tendering
documents, procedural forms and any other attendant documents is affected only after prior written approval of the
Authority;
(e) Issue guidelines under this Act;
(f) Organize and maintain a system for the publication of data on public procurement opportunities, awards and any other
information of public interest as may be determined by the Authority;
(g) Conduct periodic inspections of the records and proceedings of the procuring entities to ensure full and correct
application of this Act.
(h) Monitor the award and implementation of public contracts with a view to ensuring that: (i) Such contracts are awarded
impartially and on merit; (ii) The circumstances in which each contract is awarded or as the case may be, terminated,
do not involve impropriety or irregularity; (iii) Without prejudice to the functions of any public body in relation to any
contract, the implementation of each such contract conforms to the terms thereof.;
(i) Institute Procurement audits during the tender preparatory process; Contract audits in the course of the execution of
an awarded tender; and Performance audit after the completion of the contract in respect of any procurement as may
be required;
(j) Determine, develop, introduce, maintain and update related system to support public procurement by means of
information and communication technologies including the use of public electronic procurement;
(k) Agree on a list, which shall be reviewed annually of services and supplies in common use by more than one procuring
entity which may be subject to common procurement;
(l) Administer and enforce compliance with all the provisions of this Act, regulations and guidelines issued under this Act;
(m) Undertake research and surveys nationally and internationally on procurement matters; and undertake any activity
that may be necessary for the execution of its functions.

In addition to the Public Procurement Authority (PPRA) there exist Public Procurement Appeals Authority commonly
referred to as the PPAA was initially established in 2001 under the former Public Procurement Act No.3 of 2001 (2011.
R.E). PPAA has been established in order to have an independent mechanism through which complaints and appeals
arising from public procurement process could be quickly solved within the shortest time. It is responsible for determining
complaints/Appeals arising from public procurement processes with a view to check compliance with the law. The main
functions of PPAA include:
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(a) To receive complaints and appeals in respect of procurement processes or decisions made by government or its
institutions in relation to public procurement.
(b) To review decisions made by Accounting Officers in relation to procurement processes.
(c) To review decisions made by PPRA with respect to Blacklisting of Tenderers.
(d) To order for a Corrective action where it is found that there is breach of Procurement Procedures.

3.2 Public Procurement Legal Regulatory framework

In addition to the institutional public procurement regulatory framework in 5.3.1. The public procurement in Tanzania is
governed by a number of public procurement legislation. In Tanzania, the public procurement law applies to any ministry,
department or agency of the government, in addition to any corporate or statutory body or authority established by the
government. Public procurement law also covers state-owned companies and local government authorities. These
legislations include public procurement Laws and Regulations and are administered by the Public Procurement Regulatory
Authority (PPRA).

The followings are public procurement legislative framework as amended from time to time and includes sub-legal and
sector specific acts, which spell out the rules and procedures of public procurement activities in Tanzania.
(a) Public procurement in Tanzania is regulated by the Public Procurement Act, 2011 (CAP. 410 R.E. 2022).
(b) Public Procurement Regulations 2013 (PR).
(c) Public Procurement (Amendments) Regulations 2016 (PRA).
(d) Public Private Partnership Act 2010 (PPP).
(e) Public Private Partnership Regulations 2011 (PPR).
(f) Public Procurement Appeals Rules 2014 (PPAA Rules).

4. Explain the importance of stakeholders’ involvement in procurement process and ways to improve
their involvement

[Learning outcome d]

Procurement process as important as it is it is in organizations involves a number of stakeholders and actors within and
across the procuring entity (PE). The internal stakeholders in the procurement process whether in private or public sector
includes (a) Accounting Officer (top management) the overall budget holders and procurement decision making organ (b)
The managers / budget holders, commonly known as user departments (Users) of goods or services or works resulting
from procurement (c) Procurement specialists who provide expertise and guidance on procurement legal and regulatory
requirements and (d) All employees and staff have some involvement in the procurement process.

With specific consideration of public procurement in Tanzania, key participants in the process include: (a) Accounting
Officer (AO) (b) Tender Board (TB), (c) and (d) User departments (Managers and budget holders) and employees (d)
Procurement Management Unit (PMU) playing a central role in the public procurement process.

Effective involvement of participants ensures achievement of the procurement objective which is to ensure timely
availability of quality goods and services to meet the organization’s operational requirements. The following are the way
through which the involvement and participation of procurement stakeholders can be enhanced:
(a) Through training and awareness programs on procurement process, legal, regulatory and operational procurement
requirements.

(b) Enhancing linkage between the departmental annual budgets and plans with annual procurement plans prepared by
procurement specialists.

(c) Regular meeting between procurement experts with management (Budget holders).

(d) Contract management meetings after the signing of the contract.

Enumerate key internal stakeholders of any organizational procurement cycle.

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5. Describe and use relevant public procurement management systems in Tanzania
[Learning outcome e]

Technology is intensively used in public procurement such that the e-procurement concept is has become a common
phenomenon in government institutions. The public sector organisation leverage on technology to improve efficiency and
wastage in the procurement process. Tanzania is not left behind in adoption of Information Communication Technology
(ICT) in procurement process. Tanzania has a national electronic public procurement system. This system is called NeST
which means National e-Procurement System of Tanzania. This system has been developed, hosted and operated by the
Government of United Republic of Tanzania in 2022 for facilitation of procurement functions by means of information and
communication technology. The system facilitates e-registration, e-tendering, e-contract management, e-payment, e-
catalogue and e-auction.

NeST is a broad electronic procurement system through which procuring entities perform procurement related functions
such as preparation and publication of annual procurement plans, pre-qualification, initiation of tenders, invitation of
tenders, tender opening, evaluation, post qualification, negotiation, awarding of contracts, contract management, purchase
through e-auction or e-catalogue and make payments electronically. Moreover, the system facilitates tenderers to register,
provide their qualification details, view tenders and submit their priced offers.

With the recent introduction of electronic procurement in Tanzania and an overhaul of the legal framework in 2016, the
public procurement law essentially guarantees efficient and transparent public procurement procedures. The TANePS
system is relatively new and incorporates functions such as e-Tendering, e-Purchasing, system of e-Auction, provision of
e-Payment and e-Contract management. Nevertheless, the PPL of Tanzania still can be improved to ensure maximum
transparency, machine- readability of data, efficiency of procedures and competitive environment in public procurement.
Tanzania’s new TANePS has the potential to comply with best international practice and adopt open contracting standards
to allow unhindered access to public procurement data in machine-readable formats.

Answers to Test Yourself

Answer to TY 1

The public procurement and procurement in the private sector can be made on the following aspects:
• Awarding of the contract: The awarding of the contracts in public sector is through competitive bidding process
while in the private sector, contracts are awarded based on the negotiations.
• Legal requirements and compliance: The public procurement is regulated by the public procurement legislation
(laws and regulations) to ensure effective use of public money. The compliance with applicable public procurement
laws and regulations and other government directives is therefore key in public procurement. Contrary, the
procurement process in private sector, although, could be governed by policies and guidelines, it is conducted in
the manner that the organisation wishes and thinks it will be beneficial to its operations and profitability.
• Budget limit and procurement spending: The public sector entity is required to adhere to strict budget limits.
The public procurement is based on the approved government budget with ceiling where necessary. The budget
for approved budget for procurable goods, services and works cannot be exceeded. In private sector it rare to
experience budget limits. The transfers can be done across the departments if something needs to be procured
even though not budgeted for.
• Adoption of technology: The technology is intensively used in public procurement than private procurement,
such that the e-procurement concept is has become a common phenomenon in government institutions. The
public sector organisation leverage on technology to improve efficiency and wastage in the procurement process.
In private sector technology is being adopted in procurement but not as much as in the public sector organizations.
• Scrutiny and public accountability: The public procurement is substantially finance through taxation and fees
which is the citizens’ monies (Public funding). In the regard public procurement is more subject to scrutiny and
public accountability than the procurement in the private sector setting.

Answer to TY 2

The internal stakeholders in the procurement process whether in private or public sector includes (a) Accounting Officer
(top management) the overall budget holders and procurement decision making organ (b) The managers / budget holders,
commonly known as user departments (Users) of goods or services or works resulting from procurement (c) Procurement
specialists who provide expertise and guidance on procurement legal and regulatory requirements and (d) All employees
and staff have some involvement in the procurement process.
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Self-Examination Questions (SEQs)

Question 1

Using public money to procure goods, works and services to provide public services is a frequent but complicated decisions
of Head of Procurement entities. It is required that such decisions should go through due process to attain value for money
for the public. The Public Procurement laws are embodiment of core principles that governs the entire process.
Procurement entities are therefore entreated to promote and secure this core principles in the conduct of public
procurements. Non-compliance to these principles embedded in the law increases the risk associated with public
procurement.

Required:
(a) Explain any six (6) general principles of public procurement that an officer in charge of procurement of goods, services
and works should consider in line Public Procurement Legislation.

(b) Discuss any four (4) risks associated public procurement in Tanzanian Public Sector.

Question 2

Define the term procurement and state reasons why the procurement process is key to Pubic Financial Management?

Answers to Self-Examination Questions (SEQs)

Answer to IEQ 1

(a) Principles of public procurement

• Competition - Opening up procurement opportunity to all potential supplies and contracts bring forth to
competition and creating value for money. Thus, competitive tendering should be the first option in procurement
decisions.
• Accountability - the procurement entity as well as the head of the procurement is answerable to the public for
their procurement decisions. The head of procurement has the responsibilities to give explanations for their
actions and inactions.
• Transparency - the entire procurement processes should be transparency, from the invitation, opening of tenders,
evaluations and selection of the supplier or contract should be done in the open.
• Fairness/non-discrimination - All potential suppliers and contractors should be treated fairly, ensuring that only
price and quality are discriminatory factors. Gender, party affiliation, ethnicity, religion should not be used to
discriminate against suppliers.
• Economy - Procurement should aim at reducing the cost of the process as well as the cost of the procurement
itself.
• Efficiency - The process must ensure efficiency in procurement. The objective of the procurement should be
achieved efficiently.
• Environmental sustainability - The environmental implications should be factored into procurement decisions.
• Social impact - The social implications of the procurement decisions should be given due attention. For example,
buying from China may be economical but may increase unemployment in Tanzania.

(b) Risks associated with public procurement

Procurement has attracted attention in the public financial management literature due to the inherent risk in the process.
Some risks associated with procurement in the public sector, are:
(i) High propensity to over value procurement contracts and supplies. In the public sector, it is not uncommon to find
the buyer negotiating for high prices of goods and services for their personal gain.
(ii) High possibility of procuring inferior goods and services. It a common practice in which goods and services that
could not be sold in the open market find their way into the public sector for personal gain and lack of competence
in procurement.
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(iii) Susceptibility to conflict-of-interest situation officers responsible for public procurement may give contracts and
supplies to their own private companies or affiliates.
(iv) Fraudulent procurement which involves paying for goods and services that has never been procurement and the
perpetrators share the proceeds.
(v) Discrimination of supplier – sometimes contracts are given not on merit but other considerations that breeds
unfairness and discrimination.

Answer to IEQ 2

Public procurement is the process by which a public institution selects, receives and pays for the inputs it requires to
produce its goods and services and construction works in the most cost-effective way.

The Public Procurement is key to Public Financial Management because through the regulated procurement
procedures it reduces corruption and fraudulent practices, improves financial savings, value-for-money and economic
empowerment.
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F
SECTION F

MANAGEMENT
INFORMATION SYSTEM

SECTION F: MANAGEMENT INFORMATION SYSTEM

Data and information form the basis of any management decision making process. Knowledge is further analysis and
evaluation of information using human mind and intelligence. The maintenance and security of these is of prime
importance to any business or organisation. A cluster or systems that are in place to store, manipulate and create data
and information on any organisation is called information systems. Using new age technology, information systems can
be maintained and used efficiently to procure fast and accurate results and analysis. Moreover, information technology
also helps build a security framework for the organizational databases. This study guide will introduce to various types of
information technology that support system and various information systems that support managers, employees and
executives to enable smooth functioning of their tasks. It further analyses threats to data and ways to manage data
security. An accountant is at the core data assimilation and analysis since he processes transactions and records them in
the system together with data relating to day-to-day functioning of the organisation.

a) Explain the nature of data and information in business context

b) Explain the role of Information Communication Technology (ICT) and Digitization in cost information
management

c) Explain the main information systems used by entities (including business process systems, transactions
processing systems, management information systems, decision-support systems and executive
information systems).

d) Explain main risks to the reliability of data and information and how these can be managed and controlled
operationally and through management of systems and technology.
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1. Explain and distinguish the nature of data information and knowledge in business context
[Learning Outcome, a]

The words data, information and knowledge are often used interchangeably. This may lead to their confusion. However,
they are not synonyms. Data is defined as raw facts while information is processed data.

Data is raw (unprocessed) information. It consists of facts, events and transactions.

Information’ is the meaningful summarization of data. Technically, information is data processed in a way that makes it
purposeful.

Knowledge is the interpretation of information in the context of the subject matter for which information is collected.
Knowledge is largely influenced by human understanding, beliefs and expectations.

Diagram 1: Data and information

Data is collected by a company selling water filters through a survey conducted on the usage of water filters in the area.
This data will help them estimate the sales in the area. In this survey the data, information and knowledge will constitute:

Data

• The number of people using water filters.

• The number of models of each brand used.
• The number of complaints for each brand.

Information
• A statement showing users and non-users of water filters and hence the quality of potable water supplied.
• A comparative statement depicting the most popular brand. An analysis highlighting the performance of each
brand.

Knowledge
• An understanding of the degree of willingness of people towards using water filters
• A report that highlights the use of water filters by people in the area and its reasons
• Brand-wise report filters that justify selection of some brands over others.
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Information has meaning, while data does not. Knowledge depicts an understanding of the information in the context of the
purpose of data / information collection. One person's information may be another's data depending on whether the data is
relevant to the recipient.

The information on the number of customers serviced by the company in the quarter is data for the manager as it does not
help him plan the future profits unless he also knows the sales price and profit margins earned. However, it is information
for the person who accounts this data on a regular basis for reporting to the management. The same facts can be converted
to knowledge when used by an accountant to study customer behaviour in specific quarters of the year.

Data is unstructured, lacks context and may not be relevant to the recipient. When data is correctly organised, filtered
and presented with context it can become information because it then has "value" to the recipient. Knowledge is processed
information, which in turn is processed data. Knowledge is always achieved through proper learning, understanding and
thinking of the person using the information.

Knowledge is information processed by the human brain based on the relevance of the information for decision making.
Data and information are very basic in terms of facts and figures but knowledge is application of these facts to solve an
organisational problem of decision-making amongst alternatives.

The number of states in the USA and the population of cattle in the USA is raw data. It is unstructured and hence is not of
much use. However, when brought together, we can analyse the states with a high cattle population and ascertain the states
with a high potential for beef supplies. If government intends to improve beef supplies, they will further apply this information,
to ascertain the reasons behind certain states having a high population and others having allow population of cattle. Based
on this input corrective action can be planned.

Diagram2: Data, information and knowledge

SUMMARY
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Information is:
A Summarization of data.
B Sorting of data.
C Interpretation of data.
D D All of the above.

Knowledge is:

A Interpretation of data
B Application of information and data in a meaningful manner using human brain
C Classification of data and raw facts
D Collection of information

2. Explain the role of Information Communication Technology (ICT) and Digitization in cost
information management
[Learning Outcome b]

Information Technology (IT) can be defined as the term used to label the subject area in which technology is used to transfer
and process information quickly and efficiently to users.

In a business context it deals with the aspect of managing and processing information for organisations.

Information Systems (IS) is a method of communicating information in written form, graphical or via the electronic method.
IS can be a subset or a component of IT within an organisation. It represents a set of practices that have been installed to
ensure that the right information is available to the right user at the right time.

2.1 Information systems v/s information technology

Information systems are a group of components used to store, retrieve, process and collect data and information for
management purposes.

Computer hardware and software are widely used to store, retrieve and process information. Computers are an integral part
of information systems, and act as huge databases for storing the data of an organization, important for management
purposes. Information systems also aid planning, decision-making, control and operations. Organisations widely use
information systems for the smooth functioning of the business.

Aqira’s Apparels uses information systems in order to send web-based designs to its customers abroad and receives orders
from them through the web. It also processes their billing and receipts through wire transfers carried out via internet banking.
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Information technology is the application of computers to achieve all the above-mentioned tasks.

2.2 Information technology that supports information systems generally includes the following:

Information technology that supports information systems consists of computers and its peripherals that make information
processing easy. Computers mainly consist of hardware, software and transmission systems that enable data transfers. All
these systems provide a robust framework that makes information systems work in a smooth flow.

1. Computer hardware

The term Computer hardware covers the physical constituents of a computer.

Think about piano, in a piano the keys are the hardware and the scroll of music is the software. A computer consists of
several parts. Broadly we call them hardware and software. Hardware refers to the tangible whereas software refers to
the intangible components.

Monitor, Printer, keyboard, mouse, disk drive, and motherboardare examples of hardware.
Word processor and spread sheet are examples of software

2. Software components of a computer

Software is a collection of logically arranged instructions to perform a desired task. The term software includes systems
software e.g., operating system and applications software e.g., word processors.

Software is a collection of instructions or data. It is used to operate and control the computer.

Software is divided into two parts:

• Operating System: it contains system software and various utilities. The computer operates on the basis of
instructions provided by the system software. The operating system provides the user interface or human computer
interface (HCI), which allows the user to manage and control the computer.

• Application software: it helps the user to perform a specific task e.g., editing a document or making calculations on
a spread sheet. Application software is unable to function without an operating system.

(a) Operating system

An operating system contains the fundamental set of instructions required to operate and manage a computer. Operating
systems allow the user to interact with the computer hardware with the help of the computer software.

The operating system is the most important program running on a computer. It performs the basic tasks required to operate
a computer, for example, it sends input for processing, displays output on the VDU and keeps track of files and directories
on the hard disk. It manages all the other programs running on the computer.

(b) Application software

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Application software performs specific functions for the user. They were developed to provide functionality that is not
provided by the operating system.

Application software is a computer program which is used to perform a specific task. The task performed by application
software is not related with the functioning of the computer. It runs on the top of the operating system as it cannot function
without it.

Microsoft Office Word 2003, Microsoft Office Excel 2003, Microsoft Office PowerPoint 2003,

Microsoft Office Access 2003, Internet Explorer 7.0 are examples of Application software

When two or more application software are bundled together to satisfy a specific business need, it is termed as an
Application Package. Application packages are created to satisfy a particular purpose or industry.

An application package to create illustrations will include a drawing program, a page setting program and a colour matching
program.

Applications can be entirely developed according to the requirements of the user (built from scratch), or the user can
purchase the application software already available in the market (off the shelf). The off the shelf package is built on tested
technology and best practices. Off the shelf software can be tweaked to suit the needs of the user. It is comparatively cheap
to buy and implement.

A General-Purpose Package is a bundle of application software, which is capable of performing a variety of simple tasks
e.g., word processing software. A General-Purpose Package is developed using the off the shelf approach. Microsoft Office
2003 and Open Office are examples of general-purpose packages.

Integrated software combines the features of several applications’ software into one program. Integrated software allows a
group of applications to work together and share data. It incorporates the commonly used functions of several programs into
one program. iWork (successor of AppleWorks and Microsoft Works are examples of integrated software. Integrated software
for the finance function of a company will refer to a bundle of several application software. For easy functioning, this bundle
will look like one software package. An example of an integrated software package would be a software which would work
with a backup application software to automatically create a backup of data at a remote location.

3. Computer Networks

Computers when connected with each other form a computer network. A computer network is a channel of exchanging
(transmitting and receiving) information from one source to another. Computer networks allow the users to access files stored
on other computers. This helps in improving the efficiency of available resources. The two main types of networks are: LAN
(Local area network) and WAN (Wide area network).

(a) Local area network (LAN)

LAN is a data communication network connecting several computers. It facilitates exchange of data and information within
a localised computer network, usually a building
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The characteristics of LAN are:

• setting a LAN network is economical.

• all the computers are connected with the network. They can exchange data and information from other computers
connected to the network.
• the physical area covered by LAN is small, usually 02-05 kilometers.

(b) Wide area network (WAN)

Wide area network, is a network which links computers operating in a broad area e.g. cross metropolitan or regional. The
internet is a WAN, connecting computers from all over the world.

(c) Differences between LAN and WAN

• The geographical area covered by a WAN is much bigger than that by a LAN.
• WAN has more computers and terminals than a LAN.
• A WAN may link two or more than two LAN’s.
• Since a WAN has more users than a LAN, it needs a larger file server. WAN uses telecommunication lines to
send data.

What is a computer network?

A It is the network used, only to connect the telephone lines for transferring data.

B A computer network is a channel of exchanging (transmitting and receiving) information from one source to another.

C A computer network divides a computer in two parts.

D A computer network is not capable in improving the efficiency of available resources.

4. Client-server network

Client-server network, is a network where one computer (server) offers a service and the other computers in the network
approach it to obtain the service as and when they require it.

A client-server arrangement separates a client (user) from a server, and is almost always implemented over a computer
network. A client-server network establishes interactions between two computer programs in which the client program makes
a service request and the server fulfils the request. This allows the client’s devices to share files, information and programs
on the server. Although the client-server idea can be used by programs within a single computer, it is a more important idea
in a network. In a network, the client-server model provides a convenient way to interconnect programs that are distributed
across different locations.

Online transactions using the client-server model are very common. For example, when you check your bank account
over the internet, a client program in your computer forwards your request to a server program at the bank. That program
may, in turn, forward the request to its own client program which sends a request to a database server at another bank
computer to retrieve your account transactions. The transactions are returned to the bank data client who, in turn, transfers
this information to the client in your personal computer. Your computer displays the information for you. Most businesses
nowadays use the client-server model. The distinction between clientserver network computing and centralised mainframe
computing has almost disappeared as mainframes and their applications have also turned to the client-server model and
become part of network computing.
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Think about a Multi-user database. The server has the database. The clients approach the server whenever
they need any information from it.

A client with only input and output devices is known as a terminal. A terminal is incapable of processing or storing data. The
server to which a terminal is connected receives, processes and stores data for the terminal. The output device of the terminal
receives the output from the server and displays it to the user.

5. Computer communication

Computers in a network communicate with each other. They exchange resources and send information for example, through
emails. Such communication among computers requires transfer of data. Hence, we need to know how two computers
interact with each other.

Internet, intranet and extranet

The internet enables computers all over the world to connect to each other. This connectivity enables information and
resources to be shared between people and companies. The term intranet refers to an internal network that functions like
a private internet for use by an organisation. If access to an intranet is extended to people outside the organisation, this is
called an extranet. In other words, an extranet is a type of private internet that isn't entirely internal but an extended intranet.

There are firms which provide virtual private network (VPN) services to organisations. These firms have developed
advanced applications to provide their clients with secure, high-performance, fully managed VPNs on privately owned
networks. A private internet is protected by a firewall and can be extended to the public internet so that clients can make use
of the expanded reach of the internet while benefiting from the privacy and security of a private network. VPN services are
available at varying speeds depending on location. Companies requiring applications such as customer relationship
management (CRM), supply chain management (SCM) and enterprise resource planning (ERP) will find these speedy and
secure services suitable. These services have a worldwide reach and are available at a reasonable cost.

6. Databases and data warehouses

A database is a huge store of data that is collected for use by organisational resources and customers at large. Databases
generally present data in a sorted manner so that it is useful for organisational management. Management always retrieves
useful data and information from databases for the purposes of planning, decision-making and control.

Greater Altitude is a company that organises treks. It uses its database, which contains details of all its tours till date, for
planning its future treks. The database provides them with information on the most popular destinations, the un-explored
destinations and places of special interest for trekkers. This helps them plan and decide upon their next treks for the coming
year.

Data warehouses are a refined repository of information, where information is stored in a readily usable format for managers
/ users at large. Data warehouses are used for reporting and data analysis function. These are more useful for executive
management decision making, like comparative analysis and trending reports.

3. Explain the main information systems used by entities including business process systems,
transactions processing systems, management information systems, decision-support
systems and executive information systems.
[Learning Outcome c]
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3.1 Business process system

1. Meaning of business processes

An organisation can be thought of as being a collection of people working towards achieving a shared objective and purpose.
In addition, it can also be described as being a resource processing machine. By this what is meant is that an organisation
will take resources such as labour, money, materials etc. and through its processes convert them into usable products /
services.

The processes of an organisation represent how an organisation controls / wants its work to be done. More specifically as
Davenport states they are “a specific ordering of work activities across time and space, with a beginning, an end, and clearly
identified inputs and outputs”. For instance, ordering raw materials from a supplier would be an example of a process for a
manufacturing organisation.

Business processes therefore then become sets of logically related tasks that use an organisation’s resources to provide
the goods / services its customers want and will enable the organisation to achieve its objectives. For instance, developing
and marketing a new product would be examples of business processes for a FMCG (fast moving consumer goods
organisation).

A business process is a set of procedures and practices which collectively realise a business objective or policy
goal, normally within the context of the organisation. The flow or sequence of actions usually defines the functional
roles and relationships.

The types of business processes are as follows:

• Management processes are carried out by top management which defines the organisation’s objectives.
Management processes consist of corporate governance or strategic management and provide direction and
support to the organisation. For example, the preparation of a performance budget involves determining the
organisation’s performance goals. It also involves assessing and arranging for the infrastructure, capital, manpower
and facilities needed to achieve the goals.

• Supporting processes are functions such as purchasing, accounting, inventory management, recruitment and IT
support.

• Operational processes are a set of activities relating to receiving raw materials and components and converting
them into finished products or services. These activities are also referred to as production activities. Production
activities are preceded by the preparation of a production plan which is again an extension of the organisational
goal relating to the production function.

Support processes and operational processes are monitored by management through the management control mechanism.
For example, inventory management processes which ensure that sufficient inputs are procured to produce the required
output quantity and meet sales targets. These support processes are part of the value chain.

These procedures and practices are known as ‘organisational processes’. These are also referred to as ‘business
processes. Nevertheless, both these terms convey the same meaning.

For the convenience of the organisation, the responsibilities for managing processes are divided among managers looking
after corporate business processes and managers looking after functional activities.

The sales department of an airline has the responsibility to book flights for customers.

Hence the sales department will need call centre staff to: talk to customers, take bookings and collect payments. However
a separate team may look after internet bookings via the company’s website.

The call centre and the website are 2 separate business processes for the company.

These processes are designed to help organisations conduct their daily activities effectively. They are also designed to
ensure that the organisation delivers quality products and services to its customers at the desired speed. These processes
also have to meet the expectations of stakeholders and other categories of associates such as suppliers, contractors and
employees of the organisation.
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2. Business process management systems

Business process management systems are integrated software solutions or packages that help organisations to set and
control the processes that will drive their business. Common examples include ERP systems such as SAP and PeopleSoft.

Setting up an effective business process management system involves an organisation:

• identifying where its critical decisions are being made

• identifying the processes that lead up to and control these decisions finding ways to automate and control these
decisions.

Therefore, as more and more organisations begin purchasing and implementing the same systems to automateand control
their processes, the more and more alike their processes or way of working will become. Howeverachieving such a
competitive advantage is not an easy task.

3.2 Transaction processing systems

Transaction processing systems (TPS) were the first type of information systems. As their names suggests the purpose of
TPS is to record and process the routine transactions of an organisation.

A transaction is a business activity or exchange that occurs between an organisation and an external party.
Transactions can also occur between the different divisions of an organisation

In a furniture store, a transaction occurs when a customer buys a dining table.

These transactions were recorded on paper before the time of computers. Today many TPS are on-line, meaning that the
transaction is actually recorded as it happens.

At a supermarket, purchases of customers are automatically entered into the TPS at the time payment is made at the check-
out counter.

TPS for organisations not only keep an official record of transactions they also serve as the data source for other systems
of the organisation such as: Customer billing systems; Vendor payment systems and Inventory control.

One Tree is an organisation that specialises in selling different types of lumber to construction companies. Whenever an
order of lumber leaves the organisation’s premises, its TPS records the payment details such as the amount / type of lumber
bought. This information is then used to automatically update the organisation’s record of inventory (amount of stock
physically at the premises).

Characteristics of transaction processing systems

1. A TPS records internal and external transactions for a company. It is a warehouse of data that is frequently accessed
by other systems.

2. A TPS performs routine and repetitive tasks. It is mostly used by lower-level managers to make operational decisions.

3. Transactions can be recorded in batch mode or online. In a batch mode, the files are updated periodically, whereas in
an online mode, each transaction is recorded as it occurs.
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4. There are six steps in processing a transaction. They are: data entry, data validation, data processing and revalidation,
storage, output generation, and query support.

5. A TPS supports different tasks by imposing a set of rules and guidelines that specify how to record, process, and store
a given transaction. There are many uses of transaction processing systems in our everyday lives, such as for making
a purchase at a retail store, depositing or withdrawing money at a bank, or registering for classes at a university. Almost
all organisations, regardless of the industry in which they operate, have a manual or automated TPS.

6. A TPS is the data life-line for a company because it is the source of data for other information systems, such as MIS
and DSS (Decision Support Systems). Hence, if the TPS shuts down, the consequences can be serious for the
organisation.

7. A TPS is also the main link between the organisation and external parties, such as customers, suppliers, distributors,
and regulatory agencies.

8. TPS exists for the various functional areas in an organisation, such as finance, accounting, manufacturing, production,
human resources, marketing, quality control, engineering, and research and development.

3.3 Management information systems

The term management information system (MIS) made its first appearance in the US navy in a report on the use of
computers to construct a single integrated system to manage all navy’s resources. Today, MIS is taken to mean computer-
based systems. Used broadly, an MIS is considered to be a system which satisfies all the information needs of managers.
An MIS is the system of providing information to people who make choices about the allocation of valuable resources in a
timely, accurate and complete manner at a minimum of cognitive and economic cost for acquisition, processing, storage and
retrieval.

Management information system is a system that provides data and information to the managers in the form of reports,
including exception reports of matters requiring action, analysis and other information to support the functions of planning
and control as well as decision making and its various aspects such as analysis and modelling.

Historically, accounting systems have been the most organised and developed part of any information system, but an MIS
extends beyond accounting information. It is used to pull together all the organisation’s resources to equip all levels of
management from every part of the organisation with the necessary information. This enables timely and effective decision
making at all three levels of planning for which management is responsible.

The employee details in an organisation are recorded in a number of different files. Organisations today increasingly follow
the system of creating a database of information which will practically fulfil any information request. MIS of an organisation
is equipped with abilities to extract any information pertaining to an employee from the database thus prepared.

In case the management wants the information of an employee relating to his age, remaining years of service, date of
joining, his salary structure or his leave record then the MIS has the capability to extract all this information from the different
locations in the database.

The role of management information systems (MIS) is to generate a regular series of reports for the managers and
executives of an organisation. These reports will contain the necessary information that this group requires to make
strategic / managerial decisions and monitor the progress of an organisation.

MIS will typically take raw data from TPS as their inputs. MIS will then perform calculations and / or data comparisons
on this information to generate its outputs (reports). The reports generated will fall into one of three broad categories:
summary, detailed and exception. Summary records provide a summarisation of all of an organisation’s various transactions.
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Diagram 3: Functioning of an MIS

An MIS may include

• Accounting records: bill books, purchase order book, cash book.

• Financial statements: statement of comprehensive income, statement of financial position Inventory data: stores
ledger, dispatch notes
• Production schedules: specifying the daily and weekly output targets to be achieved
• HR (Personnel) records: employees’ personnel files, time sheets
• Marketing data: including market trends and customer expectations
• Processed information: to be used by management in the attainment of the organisational objectives

SUMMARY

In brief, MIS can be defined as a system to convert data from internal and external sources into information and communicate
that information in an appropriate form, to managers at all levels in all functions to enable them to make timely and effective
decisions for planning, directing and controlling the activities for which they are responsible.

3.4 Decision support systems

Decision support systems (DSS) are specifically engineered to support the decision-making function. DSS is a business
intelligence system that is capable of processing huge amounts of data. It supports managers by analysing what-if scenarios
in various situations like make-or-buy, selling price decisions and marketing plans etc. An intelligently designed computerised
DSS can help compile useful information from unstructured databases to form business models and help solve decision-
making problems.

DSS are generally capable of analysing and processing large collections of data in data warehouses, through “datamining”,
which uses predictive tools that map correlations andhelp bring together similar and related groups.
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In a decision-making situation of make-or-buy, a DSS will help a production manager to decide whether to produce a product
in-house or to buy it from outside. The DSS will be supplied by various inputs like raw material availability, costs, overheads
required and market prices to buy the product from an outside supplier. The DSS will compare the market prices with the
total costs of production and present an analysis of profits from sale of the product under both the options. This will help the
manager compare profits under both options and decide whether to make or buy.

Using the data mining function and capabilities of DSS to analyse and process complex business data, it can be used for
forecasting future trends, sales forecasts and pricing decisions as well. DSS also supports study of social networks, micro-
blogging websites and fraud detection.

Depending upon the orientation of the DSS, it may be classified as data-driven, model driven, communication driven,
document-driven or knowledge driven. Google search engine is one of the best examples of communication-driven DSS. It
helps users to data mine and use information for their purposes.

Components of a DSS include: Databases; User interface and User criterion or decision-making model

A DSS generates information like sales forecasts, inventory reports and projected revenue and sales and comparative
reports comparing sales, production and profits of two or more periods.

3.5 Executive information systems

An executive information system (EIS) is one of the types of management information system, which is intended to enable
and support the information and decision-making needs of higher-level management (senior executives) by providing
easy access to internal and external information which is relevant for meeting the strategic goals of the organisation.

EIS provides a variety of internal and external information to top managers in a highly summarised and convenient form.
Nowadays, these systems are becoming an important tool for top-level control in many organisations. As the name suggests,
EIS helps an executive to spot a problem, an opportunity, or a trend.

The emphasis of EIS is on graphical displays and easy-to-use user interfaces. They offer strong reporting and drill-down
capabilities.

Usually, it is considered to be a specific form of decision support system (DSS).

The objective of decision support systems (DSS) is to help management / executives make
decisions in situations with high levels of uncertainty. DSS comprise of a set of tools and
techniques that will allow the decision makers of an organisation to run various “what if” scenarios.
It is particularly helpful for decisionmakers who would like to compare what the potential outcomes
of a number of different strategies would be. A common example of a very basic DSS is a
spreadsheet.

The only difference between DSS and EIS is that DSS are primarily used by middle and lower-level managers to plan future
operations, whereas EIS mostly serve the control needs of higher-level management.

Characteristics of executive information systems

The characteristics can be summarised as below:

1. EIS provides access to a variety of databases, both internal and external, through a uniform interface.
2. It provides prompt and easy access to information reflecting the key success factors of the company and of its units.
3. These systems primarily assist top management in revealing either a problem or an opportunity. Forecasters and middle
managers can consequently use a DSS to suggest a solution to a problem.
4. EIS allows executives to see both summarised and detailed level data. One can display summarised data reflecting the
overall status of their enterprise. EIS offers the capability to drill down into the data. It means it can display highly
summarised data, then drill down to the detail level. Drill-down capabilities provide users with the flexibility to trace
problem areas directly to the source.
5. Presentation of information through colour graphics or video allows an EIS user to understand key factors and
performance trends in the areas of sales, purchases, production, and finance at a glance.
6. Through EIS, both current status and projections can be made available.
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7. An EIS allows easy modification and tailoring to the preferences of the particular users or group of users. One can
search, sort, and filter information using pre-programmed controls.
8. Access to the data lies at the core of an EIS. EIS may work on the data mining principle, as DSS do, or they may be
given access to the actual corporate databases / data warehouses.
9. EIS can exist either on individual workplaces or on servers.

Business process systems are:

A Designed to support the decision-making function B

Designed to promote business efficiency
C Designed to cater to needs of executives
D Designed to produce management reports

Which information system serves as a data source for other systems?

A Transaction processing systems

B Decision support systems
C Business process systems
D Management information systems

4. Explain the main risks to the reliability of data and information and how these may be managed
and controlled operationally and through management of systems and technology including
development of new systems.
[Learning Outcome d]

Data and information can be considered reliable when they have attributes such as accuracy, completeness, clarity and
consistency.

4.1 Risks that affect reliability of data:

Risks that affect the reliability of data include the following:

1. Inaccuracy

Inaccurate information can lead to poor and misguided decision making. However, information only needs to be accurate
for the purpose. Pointless accuracy affects clarity and timeliness.

The commercial manager of Bright Pumps wants to plan the number of pumps to be manufactured in the next year. For this
it picked up data on the number of pumps sold in the last five years from a private market research company, instead of the
‘chamber of commerce’ which is a regulatory body having this data. As the data may be inaccurate the decisions made by
the manager using this data will also be incorrect.

2. Incomplete

Decisions based on incomplete or inadequate information can turn out to be bad decisions. At times decision making
becomes impossible on the basis of incomplete information.

The decision to sell soft drinks based on incomplete data about the demography of the region can turn out to be disastrous
if the youth population in the region, who are the major customers for soft drinks, is only 20%.

3. non-clarity

If the information is not clear and easy to understand its recipient will not be able to use it effectively.
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Territory-wise sales can be better presented in a pie-chart whereas year-wise sales can be better presented by means of a
bar-chart.

4. Irrelevant information

Irrelevant information will cloud the issue and annoy the reader. The provider of the information should ensure that they
understand the purpose and supply only that necessary to fulfill it.

The information was requested for the sales of product A in the month of August. However, the information supplied
described the attributes of product A, its market penetration, and concluded with the requested sales.

The first two paragraphs were not necessary to the recipient in this instance.

The extra details supplied wasted the readers’ and the preparers’ time unnecessarily as the reader’s only interest was to
know the sales for the month of August

5. Loss of data

An organisation may lose data because of an accident or a breach in security. In these circumstances the organisation uses
back-up to restore the data

6. Data corruption

Data can get corrupted i.e., when an unintentional change in the data takes place which makes the data unfit for use.
There are several reasons due to which data may get corrupted such as use of incompatible hardware, dust or improper
shut down of computer due to sudden power failure.

An organisation can avoid data corruption from these reasons by providing proper maintenance to the computer hardware
and software.

Data can also be intentionally corrupted due to hacking, viruses and other attacks on the security of the data stored.
These factors highly affect the reliability of data since they render data useless, and at times meaningless, in terms of its
use.

In organisations that rely heavily on computers and information technology to store and process data, the main risks also
arise from computer crimes, abuse and above all, from human error. Human error alone can cause heavy damage to
data reliability.

Ingrid Plc is a financial consulting firm that stores all the data relating to its clients’ investments and earnings, in separate
files. If the systems get hacked and all the data is leaked to outsiders then the clients’ trust will be breached. Moreover, the
operators accessing the data may make unauthorized changes to it, making the data redundant for use. It is also possible
that due to human error, some investment values are recorded wrongly, which will again depict a wrong picture of the clients’
investment earnings in the data.

Some of the major risks and threats include viruses, trojan horse, logic bombs, data thefts, phishing and malware. All these
are potentially destructive for any data and information. Other threats to data are the threats from natural calamities like
floods, fire, earthquakes etc. that can physically damage data servers and other peripherals of a computer system.

4.2 Measures to manage and control risks operationally and through management of systems and technology

The measures that can be taken in order to manage systems and information to reduce risks to data reliability are listed
below:
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1. Physical access control measures

(a) Security guards: security guards will ensure that no storage device is carried in or out of the office premises without
proper authentication. This will ensure that no electronic files belonging to the organisation are exchanged without
the permission of an appropriate authority.

(b) By segregating areas of work: the management can segregate an area on the basis of department functions,
projects or both. No person working in one function or project (e.g. Finance or Project XY07) can visit a place where
the work of other department or project is being carried out (e.g. Marketing or Project AB06). This will ensure that only
the people who are working on a particular project or department have access to information in that particular
department or project.

(c) Careful selection of employees: the organisation must conduct a reference check for the employees recruited. The
organisation must ensure that no person with a dubious background or inappropriate experience is recruited.

(d) Division of work: the organisation must ensure the work is divided is between individuals. This can be done by dividing
the responsibilities of doing and accepting a task between different persons.

(e) Job rotation: by rotating the jobs of employees at random intervals, an organisation can make it uncertain for an
employee to plan a breach of security.

(f) Issue of access cards: the organisation can install doors with electronic locks in various rooms in the organisation.
These doors will act as entry and exit points to move in and out of a room. The organisation can issue access cards to
employees to open doors for visiting any room in an organisation. These access cards will prevent employees from
visiting a room in the organisation without proper authorisation.

(g) Issue of Personal Identification Number: the organisation can issue Personal Identification Numbers (PIN) to
employees. Along with access cards, the employees will have to enter the PIN allotted to them to open the door. This
will prevent a person from obtaining unauthorised access by stealing access cards. The organisation can use a
magnetic strip card or smart card system to allow access to various parts of the building.

(h) CCTV: the organisation can install closed circuit televisions to monitor the movement of employees.

(i) Bolting: to prevent any theft of computer or computer peripherals, the organisation can secure the equipment to the
desk.

(j) Biometric devices: the organisation can install an eye or finger scanner to detect authorised personnel and grant
access to a room or computer.

(k) Burglar alarms or motion detectors: burglar alarms or motion detectors can be installed to detect any suspicious
movement in office premises.

(l) Numbering of devices: the computer and various peripherals must be numbered and a record must be maintained by
the staff of the organisation. This will enable identification of the organisation’s computers and computer peripherals
and any theft will be detected quickly.

(m) By disabling use of external storage device on the office computers: a user must be allowed to use an external
storage device only after obtaining permission. Moreover every file received by an organisation through an incoming
e-mail or external storage device must be scanned with an anti-virus program.

(n) Careful selection of place to store data: the organisation must store data at a secure place. Only authorised
personnel, after proper verification, must be allowed to physically access the data. All external storage devices must be
kept under lock and key.

2. Electronic access control measures

(a) Implementation of firewalls: the system designed to prevent unauthorised access to or from a private network to a
public network (e.g. internet) is called a Firewall. Firewalls also restrict any unauthorised access to the internal network
(office network) from a computer which is part of the internal network. By restricting any unauthorised access to office
network, companies are able to prevent any damage or undesired sharing of their computer resources (e.g. data,
printers).
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(b) Periodic checking for viruses: all the network’s computers must be periodically checked to ensure that they are not
infected with any virus. This can be done by using an anti-virus and spyware to scan the computer at regular intervals.

(c) By encrypting the data: under this the user sends the data to another computer in an encrypted form. The receiving
user has a key (provided by the sender) through which he can decrypt the data into the original form. This ensures
that even though an unauthorised user may be able to record the data being transferred, he will be unable to understand
the data.

(d) By disabling exchange of information with computers outside the office network e.g. revoking the user’s right to
send any email outside the office network. The user must obtain permission in advance to use any external storage
device such as a USB drive or CD-ROM.

(e) Passwords: when the user powers on a computer connected within the network, the user has to enter a user name
(explained later) and a corresponding password to log into (explained later) the computer.

SUMMARY

SUMMARY

Which of the following attributes allow data to be considered reliable?

A Accuracy
B Completeness
C Clarity
D All of the above

Data risks can bemanagedby restricting data access of employees strictly to relevant data andusingencryption techniques.

A True
B False
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Which of the following is not a physical access control for protection of information?

A Security guards
B Implementation of passwords
C Job rotation
D Segregating area of work

Answer to Test Yourself

Answer to TY 1
The correct option is D.
Information is summarisation, sorting, interpretation and all the processes that lead to converting it into a usable form.

Answer to TY 2

The correct option is B.

Knowledge is application of information and involves human involvement in order to present and use it in a meaningful
manner.

Answer to TY 3

The correct option is B.

A computer network is a channel of exchanging (transmitting and receiving) information from one source to another.

Answer to TY 4

The correct option is B.

Business process systems are designed to increase business efficiency. DSS is designed to support decisionmaking, EIS
is designed to cater to needs of executives and MIS generates management reports.

Answer to TY 5

The correct option is A.

Transaction processing systems keep a record of all the transactions in an organisation and hence act as source of data
for other systems as well.

Answer to TY 6

The correct option is D.

Reliability of data and information depends on all the factors such as accuracy, completeness and clarity.

Answer to TY 7

The correct option is A.

Data risks can be reduced by use of data encryption techniques and restriction to data access.

Answer to TY 8

The correct option is B.

The implementation of a password is an electronic access control measure.

Self-Examination Questions

Question 1

___________ is raw facts and figures that are processed into _________________.

A Information and data

B Data and details
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C Information and records

D Data and information

Question 2

Data is:

A Unprocessed information
B Processed information
C Unused information
D Used information

Question 3

A management information system extends beyond the accounting function to include:

A Information for only sales department

B Information for all levels of management
C Information for executives of the organisation
D Information for decision-making of managers

Question 4

An executive information system is tailored to assist executives in deciding strategy. List the characteristics of an EIS that
helps to plan strategy and assess the opportunities and threats.

Answers to Self-Examination Questions

Answer to SEQ 1

The correct option is D.

When data is correctly organised, filtered and presented with context it becomes information.

Answer to SEQ 2

The correct option is A.

Data is raw facts and hence unprocessed information.

Answer to SEQ 3
An MIS is a system that generates information for all levels of management. Information required exclusively for executives
is generated by an EIS, whereas DSS generates information for decision-making.

Answer to SEQ 4
Executive information system is a type of management information system, which is intended to enable and support the
information and decision-making needs of higher-level management (senior executives) by providing easy access to
internal and external information which is relevant for meeting the strategic goals of the organisation.

The distinctive characteristics of an EIS that enable strategy planning and assessment of threats and opportunities are listed
below.

1. It provides prompt and easy access to information reflecting the key success factors of the company and of its units.
2. These systems primarily assist top management in revealing either a problem or an opportunity. Forecasters and middle
managers can consequently use a DSS to suggest a solution to a problem.
3. EIS allows executives to see both summarised and detailed level data. One can display summarised data reflecting the
overall status of their enterprise. EIS offers the capability to drill down into the data. It means it can display highly
summarised data, then drill down to the detail level. Drill-down capabilities provide users with the flexibility to trace
problem areas directly to the source.
4. Presentation of information through colour graphics or video allows an EIS user to understand key factors and
performance trends in the areas of sales, purchases, production, and finance at a glance.
5. Through EIS, both current status and projections can be made available.
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