◄UNIT 2: COST BEHAVIOR ANALYSISUNIT 4: THE CASH MANAGEMENT PROCEDURES IN ORGANIZATION►

UNIT 3: BASIC PRINCIPLE OF COSTING

  • UNIT 3: BASIC PRINCIPLE OF COSTING

    Key Unit Competence: Identify and recording cost accounts used in organization

    Introductory activity

     “Making a profit on a project/product depends on pricing it correctly”.
    AKARABO located in Kimironko Kigali city, is one of the Kigali’s largest
    manufacturers of flat-screen televisions and mobile phones. In 2015,
    AKARABO sold FRW 15million from phone cover and FRW 20 million
    of cables of flat screen in Kigali city. Many of material used in shop of
    flat-screen for well looks, AKARABO Spends FRW 40 million Annually
    on the procurement of stand table of flat-screen, speakers, cables of
    mobile phone and other materials. Until 2020, AKARABO did not have
    a centralized procurement system to leverage its scale and to control
    supply costs. Instead, the company had a decentralized system riddled
    with wasteful spending and inefficiencies. To respond to these challenges,
    AKARABO hired its first chief procurement officer introducing activity
    -based costing (A.B.C) as solution. ABC Analysis of the company’s
    procurements system revealed that most company resources were
    applied to administrative and not strategic tasks. Furthermore, the
    administrative tasks were done manually and at very high cost. A team
    of manager and employees in AKARABO are responsible for costing and
    pricing of its flat-screen and mobile phone. For each product, account
    managers carefully examine and verify job costs as part of a competitive
    bidding process. AKARABO business managers are also responsible for
    identifying any potential problems with each product and determining
    any alternative necessary to unsure high quality, on time delivery within
    the original product budget. AKARABO received an order (command)
    for new product of producing a computer. Manager at AKARABO need to
    know how much it costs to manufacture its new product. Knowing the
    cost and profitability of new job helps manager pursue their business

    strategies. 


    Of course, when making decisions, managers combine cost information
    with non-cost information such as personal observations of operations,
    and non-financial performance measures, such as quality and customer
    satisfaction.
    Questions
    1. State the products produced by AKARABO manufacturing co..
    2. What does the manager need for decision making?
    3. According to your observation identify the costing methods that

    can be used from the above scenario.

    3.1. Costing methods
     Learning Activity 3.1 

    Question
    a) What do you observe on the above picture?

    b) What do you think the man is going to do?

    3.1.1. Introduction to costing methods

    Costing methods is the approach or style or tactic adopted by an organization
    to collect cost data in a more appropriate manner so as to establish the total
    cost and cost per unit of final product produced or manufactured. The final

    product can either be physical goods or services.


    Costing methods is an approach of cost data collection which is “under
    ascertainment of cost” umbrella and you know that ascertainment of cost aspect
    is a thematic sub-topic of scope of cost accounting as show in above diagram.

    These are several methodologies utilized by different organizations, which is
    determined by the nature of products being manufactured. The viewpoint of
    the diverse needs of different organisations necessitates consideration of the
    criteria used in classifying the costing methods.

    • Characteristics of Costing Method
    The method is applicable to products which have common characteristics.
    The ascertainment of cost in most of the times involves some repeated activities
    or repetitive processes.

    The process of cost ascertainment is within a specific period of time usually a
    year.
    • Costing methods entails both the determination of the overall cost and the
    unit profitability of the products.
    • The activity of costing method is periodical in the sense that the aspect of
    cost ascertainment is limited to a specific accounting period.
    • In addition to economic costs, the costing method incorporates other costs

    inform of normal and abnormal losses.

    • Advantages of costing method
    a. Minimization of production cost
    By reducing inefficiencies associated with wastages and loses during production
    therefore minimizing overall cost incurred in production.
    b. Help in the profitability determination
    Ascertainment of the costs guides the producer to know exactly the total cost of
    the final product so as to set an appropriate profit margin in setting the selling
    price.
    c. Basis on purchase or manufacture of a component decision.
    The cost ascertainment approach is timely in guiding the management on
    whether it is economical to produce or purchase a certain component.
    d. Control of costs
    Costing methods help in comparing \previous year’s cost level so as to manage
    the consumption of the economic resources. This can be achieved by use of
    budgeting tool.
    e. Tax matters
    Taxation of firm’s profit by the government is pegged on the cost of production.
    This helps the government to ensure that fairness prevails to avoid over or
    under taxation.
    f. Bargaining power.
     The employee’s or worker’s union may use the cost of production as per cost
    ascertainment to argue their case.
    g. Delegation of responsibilities to employees.
    The workers are assigned their duties based on the costing method used. This
    helps in ensuring that no idle employees who are paid.
    h. Preparation of financial statements
    Costing method is a tool which is helpful in financial accounting during
    preparation of end of the year financial reports. This is because reports such
    as closing inventory for finished goods, work in progress and raw materials are
    associated with preparation of financial statements.
    i. Avoidance of collusion and fraud by workers
    Costing methods are ways of ensuring that material and other inputs are not misused
    by corrupted workers who may sell some to make personal gain at the expense of the
    quality of the goods being produced.
     Disadvantages of costing methods
    Here are clarified limitations of the costing methods
    a. Historical data
    The data which is always readily available in the books of accounts of the
    business is the financial data which is historical which is not much needed for
    costing methods as they deal with the future decision making, for which the
    data is missing or scanty. This disparity in need gap curtails costing method
    procedures.
    b. Under-Utilized Capacity
    Costing methods works with the assumption that production capacity is fully
    utilized. If this is not the case, then the results presented at the end of the year
    will be misleading.
    c. Problem of over and under absorption of overheads
    Since costing methods is a process which has to do with estimation of the total
    cost of a product. Some aspects are standardized or pre-determined and so,
    when actual outcome takes place, it can be a case of over or under absorption
    of overheads. this brings inconvenience of planning.
    d. Lagged costing methods information
    Most of the times, costing require furnishing of timely information to the costing
    department which may not be the case for the various departments concerned
    with this exercise may have individual departmental challenges which can
    result to failure on timely costing exercise.
    e. Non-flexibility of a costing system.
    Some costing system which are concerned with recording of the costing
    information may be faulty or rigid and this hiccup may deny the objective of
    ascertaining of cost on a particular product, hence adversely affect costing

    method used.

    3.1.2. Calculation based on costing methods
    A. Job Costing
    This method is also called as Job order costing method. This costing method is
    used in firms which work based on job work. There are some manufacturing
    units which undertake job work and are called as job order units. The main
    feature of these organizations is that they produce according to the requirements 
    and specifications of the customers. Each job may be different from each other.
    Production is only on specific order and there is no pre demand production. In
    this system, each job is treated separately and a job cost sheet is prepared to

    find out the cost of the job.

    Illustration

    XYX Engineering ltd has three departments: preparation, machining and
    assembly. The budgeted direct labor hours for these three departments are

    8,000, 12,000 and 10,000 respectively.

    Factory fixed overheads are budgeted at FRW 180,000 for the year and variable
    overheads are as under:




     Administration and selling Overheads are to be abosorbed by adding 10% of all
    other costs. Profit is charged at 25% of total costs.
    You are required: to determine the cost estimate for job.no.53
    ANSWERS:
    XYZ ENGENNERING LTD
    COST ESTIMETE FOR JOB NO:53

    Direct materials


    

    • Characteristics of job costing
    Job costing is a costing method with the following features:
    a. The order is specific,
    It means that the task to be performed is subject to strict guidelines. There are
    terms of reference of the customer or client.
    b. It is possible to closely track the cost elements associated with the
    order.
    The job being performed is sufficiently diverse to allow the manufacturer to
    associate the specific input materials, labor, and overhead associated with that
    job completion.
    c. The executed jobs differ from each other.
    Since the customers are diverse, the jobs are also diverse. That is, they are
    not similar. This is because the manufacturer may be dealing with different
    customers or the same customer/client but with different types of orders.
    d. The overhead cost allocation is carried out according to the relevant
    criteria.
    The indirect costs associated with the production of the relevant order number
    are determined by a unique basis from the other orders such as area, size of the
    order, etc.
    e. Keeping a separate account for each job.
    Since the jobs are different in most cases, the accounts are required for each job.
    That is, all costs associated with that specific order are charged to that specific
    account with a unique account number, and the costs posted therein form the
    total cost for that order.
    a. The production process is not continuous
    Each order is independent of the next and therefore there is no continuity as
    with the process cost method. Therefore, the jobs are broken in the real sense.
    That is, an order is initiated based on an order placed by the customer.
    a. The profitability of each job is determined separately
    The profitability margin for each job is determined by the total cost of the
    inputs consumed by that particular job. So each job has its own cost calculation
    and determination of the profits from it.
    • Classification of job costing method
    Job costing method is further broken down to:
    a. Contract costing method
    Contract costing method is also known as terminal costing method and it
    involves doing some assignment with set specification for another person for
    payment.
    The contract costing method of ascertaining cost for a contract. once the
    contract is completed as per the agreement of the two parties, the assignment
    is closed down.
    b. Factory costing method
    Factory job costing is entails undertaking a clients ‘assignment or job in a
    factory. The focus is the assignment at hand and on its completion, the output
    is delivered to the client.
    c. Batch costing method
    Batch costing method is an approach of assigning costs on a task which is
    completed in batches. It entails manufacture of a large number of products or
    goods at the same time.
    • Advantages of job costing
    – Help in determining the level of profitability of company products in the
    future. The current record of how costs have been allocated to the current
    product provides a guide for determining the profit margins to be achieved.
    – Having clear cost data available helps management determine the selling
    price of the end product (final product). The selling price set depends on the
    amount of cost accumulation, so when the cost is higher, the selling price is
    high and vice versa is true.
    – Optimal allocation of economic resources. The job costing method is set in
    such a way that it is possible to monitor the use of the available resources.
    Thus, the manufacturer or producer is able to identify instances of waste
    and mistakes for each specific job and avoid such situations.
    – Job costing assists in the adoption of predetermined overhead rates, which
    in turn assists in the application of the budgetary control system. That is,
    before the actual costs are incurred, the producer can plan earlier to know
    how to control the costs/inputs for the inputs needed estimated using the
    cost method provided.
    – The job costing method encourages the activity of delegating tasks
    among employees. The job costing method helps in delegating tasks to be 
    performed by each employee in the workplace. Therefore, accountability to
    a department or an individual employee is enhanced.
    – Avoidance of duplication. The manufacturer is able to separate one order
    from another and avoid duplication in production that can lead to wasted
    resources.
    – Increased production efficiency. The manufacturer is able to assess the level
    of inputs and outputs and ensure that the former are minimized, improving
    the efficiency and quality of the final product.
     Disadvantages of job costing method
    – Unnecessary expenses or costs incurred between two processes can be
    unavoidable. The job costing method is a difficult and costly/expensive
    endeavor for small businesses due to the lack of economies of scale.
    – The job costing method does not consider any standard procedure
    for estimating the costs paid or incurred. This means that the jobs are
    different and are approached differently than in activity-based costing,
    in which the uniformity of the products prevails.
    – The job costing method is not applicable/suitable for fast moving jobs.
    The category of short-lived jobs may not benefit from this costing
    method approach. Because the cost efficiency is naturally low.
    – The job costing method requires a lot of paperwork to accomplish
    a specific task. There are several logistics areas that require a lot of
    paperwork when estimating a job to capture all the details of the cost
    elements. This is a cumbersome approach.
    – The job costing method is sunken or historical in nature. Sunk costs are
    costs that have already been incurred and are never suitable for future
    decisions. You see the producer relies on the already completed tasks
    according to past records showing the incurred/actual costs of similar

    type of work and therefore is not a suitable tool for future decisions.

    B. Process costing method
    • Definition
     Process costing is a form of operational costing used when cost units go through
    a series of clearly defined processes before the final product is completed. The
    main feature of this method is that the finished output of one process becomes
    the input of the next process. In this case, all costs (direct and indirect) are
    charged to each process.
    This method is used in industries like chemicals, soaps, paper, paints, oil
    products, etc
    • Elements of process cost
    Final goods are produced after a specific number of processes. An account is
    kept for each process or operation. All costs incurred to complete a process are
    debited to process account.
    The elements of process cost are:
    • Materials
    In process costing, raw material is issued to process 1, where after processing
    it is transferred to process 2 and so on. Some more materials are added to
    the original material at each process. The materials used at each process are
    debited to the respective process account.
    • Labor
    Direct labor of each process is debited to the respective process account.
    • Direct expenses
    Expenses incurred in respect of any particular process are debited to the
    process account.
    An example of direct expenses is packing cost of biscuits.
    • Production overhead
    In process costing, the proportion of production overhead is comparatively
    high. Each process is charged with a reasonable share of production overhead.
    Example 1:
    The manufacture of product ‘G’ requires three distinct processes numbered 1-3.
    On completion, the product is passed from process 3 to finished goods stock.

    The following information was obtained in respect of product ‘G’ for the month
    of July.

    3,000 units of raw material at FRW 25 were issued to process 1 and costs

    incurred are given below:


    Production overhead is absorbed by each process at 150% of direct labor. There
    was no stock of raw material or work-in-progress either at the beginning or at

    the end of the period. 

    You are required to prepare the process accounts. 

    ANSWER



    FINISHED GOODS STOCK ACCOUNT


    • Process loss, scrap and waste

    These terms are used frequently in process costing. Mostly the quantity or
    weight of output of a process is less than input of that process. The loss of
    weight or volume arises in the course of manufacture. This loss mainly arises
    where distillation or disintegration by heat or chemical action is involved. The
    reasons of this loss are evaporation, residuals, ash, spoilage.
    C. PROCESS LOSS
    This is the loss of weight or volume of material during a process.

    It may be Normal process loss or abnormal process loss.
    Normal process loss represents the loss which is expected under normal
    conditions. This loss is unavoidable in view of the nature of the production
    process. This loss is caused by such factors as evaporation and this is calculated
    in advance on the basis of past experience.

    The cost of normal loss is absorbed in the cost of production for good production.
    If defective units in respect of normal loss can be sold for at a reduced value
    then the proceeds (amount you get after selling ) of these units are subtracted

    from total cost of good products. In this case the following formulas are used.

    Cost per unit=Total Process Cost/Estimated Production


    Abnormal process loss represents the loss which occurs under abnormal
    conditions. Abnormal loss cannot be foreseen. The main causes of abnormal
    loss are plant breakdown, industrial accidents, inefficiency of workers or
    defective raw materials. If actual loss is greater than the normal loss then this
    difference is called as abnormal process loss. Abnormal process loss is costed

    on the same basis as good production.

    It is treated as:
    – Value of Abnormal Loss
    Dr: Abnormal Loss Account
    Cr: Process Account
    – Scrap value of abnormal loss
    Dr: Scrap Debtors Account

    Cr: Abnormal Loss Account

    The balance in the abnormal loss account is transferred to the profit and loss
    account at the end of the year.
    ABNORMAL GAIN

    If normal process loss is less than expectations then the difference between the
    actual loss and normal loss is known as abnormal gain. The value of abnormal
    gain is calculated on the same basis as good production.
    It is treated as:
    – Value of Abnormal Gain
    Dr: Process Account
    Cr: Abnormal Gain Account
    – waste
    Waste is the material arising in production process that has no value. It means
    waste refers to anything which has no value.

    If waste is part of the normal loss then the cost will be absorbed by the good
    production and in case of abnormal loss, it will be transferred to abnormal loss

    account.

    – scrap
    Scrap is the material that can no longer be used for its original purpose (e.g.
    broken parts).

    It can be sold at much lower price than the cost. The income from sale of scrap
    is taken into consideration and process loss is reduced by that amount.

    Example 2
    In the manufacture of product “Pee”, 2,000 kg of material at FRW 5 per kg were
    supplied to process 1. Labor costs amounted to FRW 3,000 and production
    overheads ofFRW 2,300 were incurred. The normal loss has been estimated at

    10%. The actual production was 1,750 kg.

    Prepare the process account and calculate cost per unit

    Answer


    Normal loss calculation
    Estimated loss 10% of 2,000 kg =200kg
    Abnormal loss calculation
    Estimated production (2,000-200) = 1                    ,800 kg
    Actual production                                                            1,750 kg

    Abnormal loss                                                                   50 kg

    Unit cost of normal production
    Cost per unit=Total process cost/Estimated production
     = FRW 15,300 /1,800 = FRW 8.5
    Value of abnormal loss =50 kg* FRW 8.5= FRW425
    Value of good production =1,750kg* FRW8.5 = FRW 14,875 
    Abnormal Loss Account Units (kg) Cost per

    EXAMPLE 3
    Assume the same data as in example 2 except that the scrap value of normal
    loss and abnormal loss was FRW1.8 per kg. Prepare the process 1 account and

    calculate cost per unit. 

    Unit cost of Normal Production
    Cost per unit= (Total process cost-Scrap value of normal loss)/Estimated
    production

                                = FRW (15,300-360) /1,800 = FRW 8.3 


    Example 4:
    Assume the same data in example 2 except that the scrap value of normal loss
    was FRW 1.8 per kg and actual production was 1,830 units. Calculate the normal

    gain and show the relevant accounts. 

    Answer

    Expected production=                    1,800 kg
    Actual production =                         1830 kg

    Abnormal gain =                                30 kg

    Note: If actual production is greater than expected production then this
    excessive production is the abnormal gain.

    Cost per unit will be the same as in example 3


    – JOINT PRODUCTS AND BY-PRODUCTS

    These represent outputs that simultaneously result from some joint process.
    Joint products are two or more products which are output from the same
    processing operation but are not distinguishable up to their point of separation.

    This point of separation is known as split-off – point or separation point. 

    Before this point of separation, one cannot distinguish the products involved
    because they are in mixed form and all costs incurred cannot be attributed to
    any product. They form the main or target products the firm plans to produce.

     An increase in the output of one product will bring about an increase in the
    quantity of others, or vice versa, but not necessarily in the same proportion.
    Joint products may be sold off immediately after the split – off point or may
    be further processed if they are not in saleable condition. At whatever stage
    joint products are sold, they have a substantial sales value as compared to by products.

    A by-product is that which is similarly produced at the same time and from
    the same process as the main product. The by-product has low sales value
    compared to the main product and is usually incidental to the process. They
    are not always the company’s target and cannot influence the manager’s
    production decision as to whether the main product should be produced or
    not. Examples of industries that produce both joint and by-products include
    chemicals, oil refining, mining, flour milling and gas manufacturing. Specific
    examples of such products include petrol, paraffin and grease which represents
    a by-product.

    The major distinguishing features of joint-products and by-products are Joint
    products have substantial sales value whereas by-products have minor sales
    value. Joint products are the major or main products of the firm and form
    manufacturing objective of the firm but by-products are incidental products
    to the production process. Joint products influence the production decision of
    the firm since they are major products whereas by-products don’t influence
    production decision. Accounting for Joint products:

    The major constraint in accounting for joint products is the presence of joint or
    common costs that have been incurred prior the split-off point which cannot
    be identified with joint products. Since the aim of costing is to ascertain each
    product’s unit cost, then common costs must be apportioned or allocated to

    joint products. 

    Such apportionment is necessary for two reasons including providing product

    valuations required for financial accounting, and other regulations.

    Coordinating the activities of decision – makers in a decentralized organization.

    Though many scholars have come up with many methods used to assign
    joint costs to joint products, none of them is superior to the other but their
    applicability is influenced by certain factors.

    The following methods are commonly used to assign joint costs:

    1) Physical units/measures method.
    2) Sales value or market value method
    D. Physical units method
    Under this method, common or joint costs are assigned to products on the
    basis of volume of output. Joint costs are allocated in proportion to the number
    of units produced or their relative weights. For this method to be suitable
    quantity of the joint products must be in the same state or else, the method

    cannot be applied.

    The major weakness of this method is that it assumes that all products are equal
    in terms of value. Costs are therefore assigned to products in equal proportions
    which is very unrealistic because products cannot be equal in terms of value
    and even resources required to produce each. Since the method does not assign
    joint costs to products on the basis of revenue generating power of individual
    products, cost information will mislead decision makers.

    Example 1:

    A manufacturing firm produces three products ( K, M & P) through a joint
    process. Prior to the split – off point, common or joint costs amounting to FRW
    24,000,000 were incurred. The units produced according to each product are

    as follows:-


    The firm uses physical units method for apportioning joint costs to joint
    products.

    Required: Apportion joint costs and determine the unit cost of each product.

    Solution


    E. Sales value method:

    This method apportions or assigns joint costs to joint products on the basis of
    value attached to each joint product. The ratio of sales value of each product
    at split-off to total sales of all joint products is ascertained and multiplied by
    the joint costs incurred. The resulting amount will represent the joint costs

    assigned to each joint product. The formula is given below:

    This method addresses the shortcomings of physical units method because the
    assignment of joint costs to products depends on the value of each joint product

    and therefore, joint products cannot have a uniform unit cost.

    Illustration:
    Using the same data in example 1, assume the company selling prices of joint

    products are as follows:


    Required: Apportion joint costs and determine the unit cost of each Product.

    Solution:


    Note: Sales value = Units involved * unit selling price.
    Ratio= Individual product sales/Total sales * 100

    Unit cost = Cost apportioned/individual units of product.

    F. Accounting for By-product costing
    Because by-products are generally of secondary importance, cost allocation
    differs from that applied to joint products. Common methods used are:
    a) By-product receipts are treated as incidental or other income. Other
    income realized from sale of by-product is transferred to profit and
    loss account as miscellaneous income.
    b) By-product net realizable value is deducted from the total cost of joint
    products
    Here, the sales revenue or proceeds received from the sale of the by-product are
    credited to the total production costs of manufacturing the main product. If there are
    any selling and distribution costs incurred for selling the by-product, the same are
    deducted from the sales value of the by-products and the net amount is either credited
    to process account or is deducted from the total cost. When a by-product requires
    further processing after split-off, the processing cost as well as selling cost, if any is
    deducted from the same value, and the net value of the by-product is deducted from
    the cost of the main product or credited to the relevant process account.
    c) By-product sales being treated as additional sales hence increasing

    turnover figures of the firm.

    Illustration
    A company processes 2,400kg of beef in a month and this was sold at FRW 1,000.
    per kilogram. The total costs of products arising from the main production
    process were FRW 1,750,000. 6,000kg of bones were obtained and sold at
    FRW 80 per kilogram. The company spent FRW 22. per kilo for packing and
    distribution of the bones.
    Required
    Prepare the income statement for the firm using at least three different methods of
    accounting for by-product costing.
    Solution



    G. Services costing
    Definition

    The term service costing or operating costing refers to the calculation of the
    total operating costs incurred for each unit of the intangible product. These
    intangible products or services can either be in the form of internal services
    provided by industries as activities supporting the production of goods. Or in
    the form of external services offered by the companies in the service sector as
    an essential product for customers.

    Service costing is an essential concept because every service organization needs
    to determine its business overheads. It is intended to ensure fair pricing of the

    products or services; and to maintain control of its fixed and variable costs.

    COST UNIT


    Calculation of cost per unit: The formula for computing the cost of each service

    unit (i.e, cost per unit)is given below

    In addition, we will discuss transportation cost as an example of service costing. 
    Therefore, in this section we will look at the calculation of transport costs.
    Transportation is one of the most important service industries nowadays, and
    it is important to have an insight into the pro forma to determine the operating

    costs of such organisations :

    Illustration:


    Note that:
    We have assumed that the licence fee was calculated every month. Also, each
    vehicle has the capacity of 2-tonne of goods.

    If, each vehicle covers a distance of a 100 miles each way daily to and from the
    city; each vehicle runs on an average of 20 days a month; and while going to
    the city, the capacity was full and while returning the capacity is 25% occupied;
    find out the following:

    Operating cost per tonne-mile; and Rate per trip to be charged, if the company

    plans to make 40% profit on freightage.

    ANSWER:



    WORKINGS

    No. of Cost Units:
    On the first way of the trip: 100% capacity was occupied, i.e., 2-tonnes
    No. of Cost Units = Distance * Capacity Occupied *Working Days *No. of Vehicles
    No. of Cost Units=100*2*20*5 = 20,000 tonne-miles
    On the second way of the trip: 25% capacity was occupied, i.e., 0.5-tonnes; Similarly,
    No. of Cost Units= 100*0.5*20*5= 5,000 tonne-miles
    Hence, Total No. of Cost Units= 20,000 + 5,000 = 25,000 tonne-miles
    General Supervision:
    Itis given annually, therefore;
    Monthly expense on general supervision=7200/12= FRW 600
    Insurance:
    It is given annually, therefore;

    Monthly expense on insurance=28800/12= FRW 2400 

    Depreciation:
    It is given annually, therefore; Monthly depreciation=(Total Cost of 5
    Vehicles*Rate of Depreciation)/(100*12)
    Monthly depreciation=(1000000*12)/(100*12)= FRW 10000
    Diesel:
    Monthly expense on diesel=Cost per Trip*No. of Ways per Trip*No. of Working
    Days*No. of Vehicles

    Monthly expense on diesel=50*2*20*5= FRW 10000

    H. Activity Based Costing (ABC)

    Many companies use a traditional cost system such as job-order costing or
    process costing, or some hybrid of the two. This traditional system may provide
    distorted product cost information. In fact, companies selling multiple products
    are making critical decisions about product pricing, making bids, or product
    mix, based on inaccurate cost data. These prime costs are traceable to individual
    products, and most conventional cost systems are designed to ensure that this
    tracing takes place.
    The problem is not with assigning the costs of direct labor or direct materials,
    but, the assignment of overhead costs to individual products is the main
    issue. Using the traditional methods of assigning overhead costs to products
    where a single predetermined overhead rate based on any single activity
    measure, can produce distorted product costs. The growth in the automation
    of manufacturing (such as increased use of robotics, high-tech machinery, and
    other computer-driven processes) has changed the nature of manufacturing
    and the composition of total product cost. The significance of direct labor
    cost has diminished and overhead costs have increased. In this environment,
    overhead application rates based on direct labor or any other volume-based
    cost driver may not provide accurate overhead charges since they no longer

    represent cause and effect relationships between output and overhead costs.

    Activity-based costing (ABC) attempts to get around this problem. An ABC system
    assigns costs to products based on the product`s use of activities, not product
    volume. It has proved to produce more accurate product costing results in an
    environment where there is diversity in product line and services coming out
    of the same shop. A recent survey by the Institute of Management Accounting
    shows that over 30 percent of the companies which responded currently are

    using ABC systems to replace their existing traditional cost systems.

    An activity-based cost system is one which first traces costs to activities and then
    to products. Traditional product costing also involves two stages, but in the first
    stage costs are traced to departments, not to activities. In both traditional and

    activity-based costing, the second stage consists of tracing costs to the product.

    The principal difference between the two methods is the number of cost drivers
    used. Activity-based costing uses a much larger number of cost drivers than the
    one or two volume-based cost drivers typical in a conventional system. In fact,
    the approach separates overhead costs into overhead cost pools, where each cost
    pool is associated with a different cost driver. Then a predetermined overhead
    rate is computed for each cost pool and each cost driver. In consequence, this
    method has enhanced accuracy.

    Activity-based costing (ABC) is not an alternative costing system to job costing
    or process costing. It focuses on activities as the principal cost objects. ABC is
    a method of assigning costs to goods and services that assumes all costs are
    caused by the activities used to produce those goods and services. This method
    provides more insight into the causes of costs than conventional costing

    methods. 

    Conventional costing methods divide the total costs by the number of units to
    compute a unit cost. In contrast, activity-based costing starts with the detailed
    activities required to produce a product or service and computes a product`s

    cost using the following four steps:

    1. Identify the activities that consume resources and assign costs to those
    activities. Inspection would be an activity, for example.
    2. Identify the cost driver (s) associated with each activity or group of
    activities, known as a cost pool. A cost driver is a factor that causes, or
    “drives,” an activity`s costs. The number of inspections would be a cost
    driver. So could the number of times a new drawing is needed because a
    product has been redesigned.
    3. Calculate an applied rate for each activity pool. The pool rate could be
    for example the cost per purchase order.
    4. Assign costs to products by multiplying the cost pool rate by the number
    of cost driver units consumed by the product. For example, the cost per
    inspection times the number of inspections required for Product X for
    the month of March would measure the cost of inspection activity for

    Product X for March.

    Note: ABC is also applicable to service, merchandising, and nonprofit sectors as
    well as manufacturing companies.
    First-Stage Procedure:
    In the first stage of activity-based costing, overhead costs are divided into
    homogeneous cost pools. A homogeneous cost pool is a collection of overhead
    costs for which cost variations can be explained by a single cost driver. Overhead
    activities are homogeneous whenever they have the same consumption ratios

    for all products.

    Once a cost pool is defined, the cost per unit of the cost driver is computed
    for that pool. This is referred to as the pool rate. Computation of the pool rate
    completes the first stage. Thus, the first stage produces two outcomes: (1) a set

    of homogeneous cost pools and (2) a pool rate.

    Second-Stage Procedure:

    In the second stage, the costs of each overhead pool are traced to products. This
    is done using the pool rate computed in the first stage and the measure of the
    amount of resources consumed by each product. This measure is simply the
    quantity of the cost driver used by each product. In our example, that would
    be the number of production runs and machine hours used by each product.
    Thus, the overhead assigned from each cost pool to each product is computed
    as follows:

    Applied overhead = Pool rate x Cost driver units used

    The total overhead cost per unit of product is obtained by first tracing the
    overhead costs from the pools to the individual products. This total is then
    divided by the number of units produced. The result is the unit overhead
    cost. Adding the per-unit overhead cost to the per-unit prime cost yields the
    manufacturing cost per unit. Illustration see (Team ltd below)


    Advantages of ABC method :

    1. The complexity of manufacturing has increased, with wider product
    ranges, shorter product life cycles and more complex production
    processes. ABC recognises this complexity with its multiple cost

    drivers.

    2. In a more competitive environment, companies must be able to assess
    product profitability realistically. ABC facilitates a good understanding
    of what drives overheads costs.

    3. In modern manufacturing systems, overheads functions include a lot
    of non-factory floor activities such as product design, quality control,
    production planning and customer services. ABC is concerned with all
    overhead cost and so it can take management accounting beyond its

    traditional floor boundaries. 

    Disadvantages of (ABC)/criticisms of( ABC)

    1. Cost apportionment may still be required at the cost pooling stage
    for shared items of cost, such as rent, rate, building depreciation.
    Apportionment can be an arbitrary way of sharing costs

    2. A single cost driver may not explain the cost behaviour of all items in a
    cost pool. An activity may have two or more cost drivers.

    3. Unless cost are ‘driven’ by an activity that is measurable in quantitative

    terms, cost drivers cannot be used. 

    4. There must be reason for using a system of ABC must provide
    meaningful product costs or extra information that managements will
    use. If management is not going to use ABC information for any practical
    purpose, a traditional absorption costing system would be simpler to
    operate and just as good.

    5. The cost of implementing and maintaining an ABC system can exceed
    the benefits of improved accuracy in product costs.
    6. Implementing ABC is often problematic due to problems with
    understanding activities and their costs.

    7. ABC is an absorption costing which has only limited value for management

    accounting purpose.

    Illustration:

    Team ltd manufacture four products W,X,Y and Z. Output and cost data for the

    period just ending are as follows :

    Direct labour cost per hour = FRW 5

    Overheads cost (common costs)                          FRW’ (000)
    Overheads variable costs                                           3,080
    Set- up costs                                                                    10,920
    Scheduling costs                                                              9,100
    Material handling costs                                                 7,700

                                                                                                   30,800

    REQUIRED
    Use both traditional /conventional cost system and ABC systems to determine
    the cost of each product.
    Compare the results got using the two systems and comment accordingly.
    ANSWER:
    A) Using traditional costing system direct labour hour or machine hours
    can be used as bases of apportionment and hence the product cost

             would be as follows :

    Overhead absorption rate (O.A.R)=Overheads cost/no.of Direct labour hours,

    machine hours

    Determination of each product’

    Overhead absorbed by each product =number of hours per unit*O.A.R


    (b) Using ABC, and assuming that the number of production runs is the cost
    driver for set up cost and scheduling cost, number of orders for material handling

    costs and that machine hours are the cost drivers for overheads variable costs.

    ANSWER :
    Cost driver rate= Overheads/ Quantity of cost driver

                                          (FRW 000)                          (000)

    1. 3,080÷440 Machine hours= FRW 7 per machine hour.
    2. 10,920 ÷14 production runs= FRW 780 per production run
    3. 9,100 ÷14 production run = FRW 650 per production run
    4. 7,700÷14 no.of orders = FRW 550 per order



    Overhead assigned to products=Cost driver rate*number of activities.
    E.g. Set up costs has been absorbed as follows :
    Product W=2(production runs)*780,000=(cost driver rate)=1,560,000
    Product X=2(production runs)*780,000=(cost driver rate)=1,560,000
    Product Y=5(production runs)*780,000=(cost driver rate)=3,900000

    Product W=5(production runs)*780,000=(cost driver rate)=3,900000

    SUMMARY OF THE COMPARISONS :


    The figures suggest that the traditional volume related costing system gives
    misleading cost information. It underallocates overhead cost to low-volume
    products (i.e W&X with ten units of output) and over allocates overheads to
    higher volume products (i.e Z in particular) This confirms the earlier statements

    made.

    Application activity 3.1

    1.Choose the correct sentence related to activity-based costing
    a) ABC uses a plant-wide overhead rate to assign overhead
    b) ABC is not expensive to implement
    c) ABC typically applies overhead cost using direct labor-hours
    d) ABC uses multiple activity rates
    2. Which of the following is a limitation of activity-based costing
    a) costs are accumulated by each major activity
    b) A variety of activity measures are used
    c) All cost in an activity cost pool pertain to a single activity
    d) Activity-based costing relies on the assumption that the cost in
    each cost pool is strictly proportional to its cost measure
    3.Define the following concepts:
    1. By-product
    2. Joint product
    4.Vehicle carries 8 tonnes on a trip and delivers as follows:
    3tonnes after 20km, 2tonnes after a further 10km, and the remaining
    5tonnes after a further 30km, it then returns empty, covering a distance of

    60km. The following information in respect of costs is provided

                                                                          FRW

    Fuel and lubricants                              100
    Wages driver                                           150

    Mate                                                            80

    Share of annual costs like insurance, maintenance, administration,
    depreciation etc. charged to this trip amounts to FRW 320
    You are required to calculate:
    a) Cost per tonne-kilometre

    b) Cost per kilometre.

    3.2. Decision making
    Learning Activity 3.2
    RTS Ltd is a manufacturing company which produces and sells radios. It
    has two main challenges such as setting competitive market price and a
    stiff competition with foreign companies. The management has hired a
    cost accountant to set different pricing strategies. The cost accountant
    has proposed and submitted the following strategies for decision making

    purpose:

    1. The company should set the price based on cost of materials used
    during production process and the cost of each activity required to
    complete the production and delivery of product to the customer
    as well; as a result, the price becomes high compared to the market
    price of similar radios and the contribution margin has negative

    figures.

    2. The company should set the price based on cost of additional
    unit; and a consider the fixed cost absorbed during the production
    process, then marginal contribution has a positive figures and net
    operating profit.

    3. The company set the price based on cost of last unit produced and
    considers the fixed cost absorbed during the production process; in
    this case the contribution margin is positive and net operating loss.

    4. The company should purchase radio materials from foreign
    specialized company and assemble them locally, this strategy
    reduces 3% on existing cost. The contribution margin is positive and
    net operating profit has a negative figure.

    5. The company should purchase radios from specialized foreign
    company and resell them to the market, in case of adopting this
    strategy, the selling price of imported radios is less than the variable
    cost required to produce a radio. In that case the contribution margin
    has negative figures and net operating loss 

    After a deep analysis, the management of company has selected the strategy
    which brings to the company a positive contribution and a positive net

    operating profit.

    Question
    1. Identify the costing techniques used on each price strategy
    2. From this case study, select the pricing strategies, the company may

    adopt and justify the reasons.

    3.2.1. Introduction to decision making

    In management accounting, decision‑making may be simply defined as
    choosing the best course of action among the alternatives available. If there are
    no alternatives, then no decision is required. The assumption is that the best
    decision is the one that generates the most revenue or the least amount of cost. 
    The process of making decisions is generally considered to involve the following
    steps:
    i) Identify the various alternatives for a given type of decision.
    ii) Obtain the necessary data necessary to evaluate the various alternatives.
    iii) Analyze and determine the consequences of each alternative. 
    iv) Select the alternative that appears to best achieve the desired goals or
    objectives.
    v) Implement the chosen alternative.
    vi) At an appropriate time, evaluate the results of the decisions against

    standards or other desired results.

    Respond to the variances

    In management accounting, it is useful to classify decisions as:

    1. Strategic and tactical2. Short‑run and long-run Strategic and

    Tactical Decisions 

    In management accounting, the objective is not necessarily to make the
    best decision but to make a good decision. Because of complex interacting
    relationships, it is very difficult, even if possible, to determine the best decision.
    Management decision‑making is highly subjective. 

    Whether a decision is good or acceptable depends on the goals and objectives
    of management. Consequently, a prerequisite to decision‑making is that
    management have set the organization’s goals and objectives. For example,
    management must decide strategic objectives such as the company’s product
    line, pricing strategy, quality of product, willingness to assume risk and profit
    objective. In setting goals and objectives, it is useful to distinguish between
    strategic and tactical decisions. Strategic decisions are broad‑based, qualitative
    type of decisions which include or reflect goals and objectives. Strategic
    decisions are non quantitative in nature. Strategic decisions are based on the
    subjective thinking of management concerning goals and objectives. Examples
    of strategic decisions and tactical decisions from a management accounting

    point of view include:



    3.2.2. Marginal costing and decision making

    Marginal costing, as one of the tools of management accounting helps
    management in making certain decisions. It provides management with
    information regarding the behavior of costs and the incidence of such costs
    on the profitability of an undertaking. Marginal costing is the ascertainment of
    marginal costs by differentiating between fixed costs and variable costs and to
    see the effects on profit of changes in volume or type of output. Thus, marginal
    costing includes two things i.e. The ascertainment marginal cost and the cost
    volume profit relationship. In this technique of costing only variable costs are
    charged to operations, processes or products leaving all indirect costs to be

    written off against profits in the period in which they arise.

    A. Ascertainment of marginal cost

    Marginal cost is incremental/additional cost of production which arises due to
    one –unit increase in production quantity. Variable costs have direct relationship
    with the volume of output and fixed costs remains constant irrespective of

    volume of production.

    – Marginal costing decisions
    • Contribution

    Contribution is the reward for the efforts of the entrepreneur or owner of a
    business concern. From this, one can get in his mind that contribution means
    profit. But it is not so.
    Contribution is helpful in determination of profitability of the products and/
    or priorities for profitability of the products. When there are two or more
    products, the product having more contribution is more profitable.
    For example: The following are three products with selling price and cost

    details:



    In the above example, one can say that the product ‘C’ is more profitable because,
    it has more contribution. This proposition of product having more contribution
    is more profitable is valid, as long as, there are no limitations on any factor of
    production.

     CHOICE OF A PRODUCT FROM VARIOUS ALTERNATIVES

    A company can produce different types of goods on a machine, in this case the
    choice is to be made\ from various alternatives. The company will prefer to

    produce that product which gives maximum contribution.

    Illustration:

    ABC Ltd is a manufacturing company which can produce three products A, B
    and C on Machine “P”. The following information is provided in respect of

    these three products for a specific period.

    You are required to advise the company regarding the choice of best product.

    ANSWER


    The company should produce A because this product has maximum contribution.
    The ranking of these products from the point of view of contribution will be:

    Product 

    A :1st B:3rd C:2nd

    The profit from these products will be:

    • ACCEPTANCE AND REJECTION OF A SPECIAL ORDER

    Sometimes, a company has to decide regarding the acceptance or rejection of
    a special order. In this case also the gain or loss on contribution is the decision
    factor .

    EXPO Ltd manufactures a product Zed which they sell for FRW 25 per unit.
    Current output is 20,000 units per month which represent a 100% of the
    capacity. They received an order of 2,000 units which they can produce by
    working extra time during the month.

     The selling price is FRW 48,000.

    The total quantity of the last month were FRW 420,000 which include fixed costs
    of FRW 70,000. If the special order for 2,000 units is received, then the variable
    cost per unit will increase by 20% but the fixed cost will remain unchanged.
    You are required to advise the company whether to accept or reject this order.

    Answer




    This order will increase the contribution of the current month by FRW 6000 .so
    it should be accepted. The final decision also depends upon some other factors
    like the willingness of the workers to work for extra time and the possibility of

    the repeat orders from the same customers.

     DROPPING A PRODUCT

    If a company has a range of products and one of which is deemed to be
    unprofitable, the company may consider to drop this product and to increase

    the production of more profitable products.

    Example . a company produces three products for which the following data

    have been provided :

    Total cost comprises of 75% Variable cost and 25% fixed cost

    The director of company consider that the product “Y’ Shows a loss, so it should
    be discontinued. You are required to advise the management whether to drop

    the product “Y’ or not?

    ANSWER 


    • MARGINAL COST STATEMENT PRODUCT


    If the product “Y” is dropped then the position would be as under 



    The dropping of product “Y” reduces the profit of the company from FRW
    60,000 to FRW 30,000 which is the amount of contribution lost from product
    Y. In this situation the product Y should not dropped inspite of the fact that it
    gives a loss FRW 20,000. If the sales of other products can be increased then the
    product Y can be dropped and same resources should then be used to increase

    the production of X and Z.

    • Make or Buy Decisions

    When the management is confronted with the problem whether it would be
    economical to purchase a component or a product from outside sources, or to
    manufacture it internally, marginal cost analysis renders useful assistance in
    the matter. Under such circumstances, a misleading decision would be taken on
    the basis of the total cost analysis. In case the proposal is to buy from outside
    then, what is already being made, then the price quoted by the outsider should
    be lower than the marginal cost of manufacturing it internally. If the proposal is
    to make something what is being purchased outside, the cost of making should
    include all additional costs like depreciation on new plant, interest on capital

    involved and that cost should be compared with the purchase price.

    The decision to make or buy is based on comparison of the marginal cost of
    manufacturing internally and the purchase price of an external supplier of the
    component. The choice is guided by the objective of minimizing cost and hence

    choose the option which is cheaper.

    Illustration

    A T.V. manufacturing company finds that while it incurs costs to make component
    X, the same is available in the market at FRW 5.75 each, with all assurance of

    continued supply. The breakdown of cost per unit incurred by the company is:

    a) Should the company make or buy the component?
    b) What should be your decision if the supplier offered component at

    FRW 4.85 each?

    Answer 


    a) The purchase cost of the above component is FRW 5.75 each. If the
    company is having spare capacity which cannot be filled with more
    profitable jobs, it is recommended that the above component be
    manufactured in the company since the marginal cost at FRW 5.00
    each is less than the purchase cost of FRW 5.75.

    b) In the event that the purchase cost is FRW 4.85 each which is less
    than the marginal cost of FRW 5.00 each, it is recommended that the
    component be bought from the supplier as this results in a saving of
    FRW 0.15 each. The spare capacity thus available can be utilised for

    other purposes, as far as possible.

    3.2.3. Absorption costing and decision making

    Absorption costing means that all of the manufacturing costs are absorbed
    by the total units produced. In short, the cost of a finished unit in inventory
    will include direct materials, direct labour, and both variable and fixed
    manufacturing overhead. As a result, absorption costing is also referred to as
    full costing or the full absorption method. Absorption costing is often contrasted
    with variable costing or direct costing. Under variable or direct costing, the fixed
    manufacturing overhead costs are not allocated to the products manufactured.
    Variable costing is often useful for management’s decision-making. However,
    absorption costing is required for external financial reporting and for income
    tax reporting. It is also referred to as full- cost technique

    A. PROFIT CALCULATION FROM ABSORPTION COSTING

    Absorption costing is a costing technique that includes all manufacturing
    costs, in the form of direct materials, direct labour, and both variable and fixed
    manufacturing overheads, while determining the cost per unit of a product.

    In the context of costing of a product/service, an absorption costing considers

    a share of all costs incurred by a business to each of its products/services. In
    absorption costing technique; costs are classified according to their functions.
    The gross profit is calculated after deducting production costs from sales and
    from gross profit, costs incurred in relation to other business functions are
    deducted to arrive at the net profit. Absorption costing gives better information

    for pricing products as it includes both variable and fixed costs.

    Absorption costing technique absorbed fixed manufacturing overhead into
    the cost of goods produced and are only charged against profit in the period
    in which those goods are sold. In absorption costing income statement,
    adjustment pertaining to under or over-absorption of overheads is also made
    to arrive at the profit. Absorption costing is a simple and fundamental method

    of ascertaining the cost of a product or service.

    • Inventory valuation

    Finished goods inventories are over-stated in absorption costing as it includes
    one more cost element in inventory value than under variable costing, i.e the

    fixed manufacturing cost.

    Inventory value under absorption costing

    = Direct material+ Direct labour +variable manufacturing costs+ Fixed
     manufacturing costs

    The differences between the profits revealed by absorption costing and

    marginal costing can be computed with the help of the following formula:


    Illustration
    A company makes and sells a single product. At the beginning of period 1, there
    was no opening stock of the product, for which the variable production cost
    was FRW 4 and the sale price was FRW 6 per unit. Fixed costs are FRW 2,000
    per period of which FRW 1,500 are fixed production costs. The following details

    are available:

    What would be the profit in each period using -
    a) Absorption costing. (Assume normal output is 1,500 units per period);
    and
    b) Marginal costing?
    Answer

    a. Absorption Costing Method


    b. Marginal Cost Method:



    B. Absorption Decision making
    1. Profit planning

    There are four ways in which profit performance of a business can be
    improved:by increasing volume, by increasing selling price; by decreasing
    variable costs; and by decreasing fixed costs. Profit planning is the planning of
    future operations to attain maximum profit or to maintain a specified level of
    profit. Profitability of the different sectors of the business whenever there is a
    change in selling price, variable costs or fixed cost absorbed. Best product is

    product which generates a high profit compare to others

    2. Evaluation of Performance

    The various section of a concern such as a department, a product line, or a
    particular market or sales division, have different revenue earning potentialities.
    A company always concentrates on the departments or product lines which
    yield more net profit than others. The performance of each such sector can be
    brought out by means of higher profit generation. The analysis will help the

    company to take decision that will maximize the profits.

    3. Alternative Use of Production Facilities

    When alternative use of production facilities or alternative methods of
    manufacturing a product are available, contribution analysis should be used to
    arrive at the final choice. The alternative which will yield highest contribution
    shall generally and obviously be selected.
    3.2.4. Break-even point and decision making
    1. Contribution
    The contribution from a product is the amount by which its selling price
    exceeds its variable cost. The idea of contribution is central to breakeven
    analysis in evaluating the effects of various decisions. Once the contribution
    per unit is known it can be compared with the fixed costs. The business does
    not begin to make a profit until the fixed costs are covered, so the formula is

    applied as:

    Covering fixed costs and making a profit

    To find the level of sales necessary to cover fixed costs and make a specified
    profit a knowledge of selling price per unit, variable cost per unit, and the fixed

    costs together with the desired profit. These are set out in the data table.

    Example1.

    AKEZA produces the following cost data related to the production of product Y.

    a) Calculate the break evenpoint ?
    b) Calculate the level of output that can help the company to generate
    FRW 4,000 as a profit?
    ANSWER

    Contribution =80-30 = FRW 50

    2. Sensitivity Analysis

    Beyond the breakeven point the fixed costs are covered and the sales of further
    units are making a contribution to profit. The higher the contribution per unit,
    the greater the profit from any particular level of activity
    a. Margin of safety
    The margin of safety has been defined as the difference between the breakeven
    sales and the normal level of sales, measured in units or in Cash of sales.
    b. Change in selling price
    If the selling price per unit increases and costs remain constant, then the
    contribution per unit will increase and the breakeven volume will be lower.
    Take as an example the dry-cleaning business of the previous illustration
    c. Change in variable cost
    The effect of a change in variable cost is very similar to the effect of a change in
    selling price. If the variable cost per unit increases, then the contribution per
    unit will decrease, with the result that more items will have to be sold in order
    to reach the breakeven point. If it is possible to reduce variable costs, then the
    contribution per unit will increase. The enterprise will reach the breakeven
    point at a lower level of activity and will then be earning profits at a faster rate.
    d. Change in fixed costs
    If fixed costs increase, then more units have to be sold in order to reach the
    breakeven point. Where the fixed costs of an operation are relatively high, there
    is a perception of greater risk because a cutback in activity for any reason is
    more likely to lead to a loss. Where an organisation has relatively low fixed
    costs, there may be less concern about margins of safety because the breakeven
    point is correspondingly lower.
    3. Profit Volume Ratio (P/V Ratio) or Contribution Ratio:
    The P/V ratio is very important ratio studying the profitability of operations
    of a business and established relationship between the contribution and sales.
    In order to find out which product is most profitable, we have to calculate the
    profit-volume ratio of the different products. The product which gives the
    maximum P/V ratio is the most profitable. Every concern tries to maximise P/V
    ratio, as higher P/V ratio gives an indication of more profit. It can be increased
    by: Increasing the selling price of the product.
    i) Decreasing the variable cost of the product and
    ii) Shifting to the production of those products which are more profitable or
    having more P/V ratio. With the help of this ratio variable costs can also
    be calculated by the following: Variable costs = Sales(1-P/V ratio)

    For example:     Gross profit ratio: It may be expressed as:
    • Sales is 4 times that of gross profit

    • Gross profit ratio is 25%

    4. Margin of Safety

    Margin of safety is the difference between the actual sales and sales at breakeven
    point. At breakeven point ,we have seen there is no profit or loss. It is only after
    the breakeven point that the business starts making profit.The more the actual
    sales are from the breakeven point the more margin of safety will be. Margin
    of safety indicates the strength of the business. If the production or sales are
    increased from the breakeven point the margin of safety will increase. The more
    the margin of safety the more beneficial it is for the business. Every concern
    tries to increase the margin of safety in order to increase the strength of the
    business. Margin of safety can be increased by the following steps: Increase the
    level of production, Increase the selling price, Reduce the fixed costs or variable

    costs or both, Substitute the existing product by more profitable products.

    Margin of Safety in sales = Total Sales – Break Even Sales (1)

    Total Sales = Break Even Sales + Margin of Safety Sales (2)

    Illustration

    Magasin Sport Class is a sports material manufacturing company and has

    budgeted the following revenues and costs data for the coming year.


    Calculate
    a) P/V Ratio, B.E.P in sales and Margin of Safety in sales
    b) Evaluate the effect of the policy adopted on the profitability
    i) 20% increase in sales volume
    ii) 20% decrease in sales volume
    iii) 5% increase in variable costs
    iv)5% decrease in variable costs
    v) 10% increase in fixed costs 

    Answer

    a) P/V ratio, B.E.P and Margin of Safety
    Contribution = Sales – Variable cost
     = 1,00,000 – 40,000 = FRW 60,000
    P/V Ratio = (Contribution / Sales) x 100
     = (60,000 / 1,00,000) x 100 = 60%
    B.E.P sales = Fixed cost / PV ratio
    = 50,000 / 60% = FRW 83,333
    Margin of Safety = Total sales – B.E.P sales
     = 1,00,000 – 83,333 = FRW 16,667 This is considered as a
    profit 


    3.2.5. Activity-Based costing and decision making
    The features of ABC are as under
    i) Activity-based costing (ABC) is a two-stage product costing method that
    first assigns costs to activities and then allocates them to products based
    on each product’s consumption of activities.

    ii) Activity-based costing is based on the concept that products consume
    activities and activities consume resources.

    iii) Activity-based costing can be used by any organization that wants a
    better understanding of the costs of the goods and services it provides,

    including manufacturing, service, and even nonprofit organizations.

    USES OF ACTIVITY BASED COSTING

    The areas in which activity based information is used for decision making are
    as under: -
    1. Activity costs: ABC is designed to track the cost of activities, so we can
    use it to see if activity costs are in line with industry standards. If not,
    ABC is an excellent feedback tool for measuring the ongoing cost of
    specific services as management focuses on cost reduction.
    2. Customer profitability: Though most of the costs incurred for
    individual customers are simply product costs, there is also an overhead
    component, such as unusually high customer service levels, product
    return handling, and cooperative marketing agreements. An ABC system
    can sort through these additional overhead costs and determine which
    customers are providing a reasonable profit. This analysis may result
    in some unprofitable customers being turned away, or more emphasis
    being placed on those customers who are contributing more in profits.
    3. Distribution cost: Organisation uses a variety of distribution channels
    to sell its products, such as retail, Internet, distributors, and mail order
    catalogs. Most of the structural cost of maintaining a distribution
    channel is overhead, so if we can make a reasonable determination of
    which distribution channels are using overhead, we can make decisions
    to alter how distribution channels are used, or even to drop unprofitable
    channels.
    4. Make or buy: ABC enables the manager to decide whether he should get
    the activity done within the firm or outsource it. Outsourcing may be
    done if the firm is incurring higher overhead costs as compared to the
    outsourcer or vice-versa.
    5. Margins: With proper overhead allocation from an ABC system, we can
    determine the margins of various products, product lines, and entire
    subsidiaries. This can be quite useful for determining where to position
    company resources to earn the largest margins.
    6. Minimum price: Product pricing is really based on the price that the
    market will bear, but the marketing manager should know what the
    cost of the product is, in order to avoid selling a product that will lose a 
    company money on every sale. ABC is very good for determining which
    overhead costs should be included in this minimum cost, depending

    upon the circumstances under which products are being sold.

    3.2.6. Processing costing and decision making

    Process costing Decisions.
    1. Sell or Process-Further

    Decision rule: when incremental revenues exceed incremental costs (may also
    need to consider opportunity costs), the company should further process the
    products. Do not assume all separable costs in joint-cost allocations are always

    incremental costs.

    Illustration

    DG Ltd is a souvenir supplier which makes and sells gold coins. The gold coins
    are finished either rough or further polished.
    • Rough gold coin can be sold for FRW 800 each and the polished gold coin can
    be sold for FRW 1,000 each.
    • Platinum, the direct material, costs FRW 120 per pound.
    • Processing costs are FRW 16,000 to convert 40 pounds of platinum into 80
    rough gold coins.
    • Fixed manufacturing cost amounted to FRW 120 per gold coin.
    • For polished gold coin, it needs an additional processing cost of FRW
    250 each. However, it does not need additional platinum and fixed
    manufacturing overheads.
    Required: Should DG Ltd further process rough gold coin into polished gold
    coin?
    ANSWER

     I cannot advise DG Ltd to further process this rough gold coins because there is

    a negative effect of FRW 50 for further processing.

    2. Make or Buy Decisions

    Decisions about whether a producer of goods or services will make it
    internernally or outsource. Surveys of companies indicate that managers
    consider quality, dependability of suppliers, and costs as the most important
    factors in the make-or-buy decision.
    Example .ABC firm can purchase a spare part from an outside source at FRW
    6500 per unit. There is a proposal that the spare part be produced in the factory
    itself and cost of processing has identified and recorded. For the purpose of
    making the spare part a machine costing FRW 1,000,000 with an annual capacity
    of 20,000 units and a life of 10 years, will be required. Materials required will
    be FRW 1,750 per unit and wages FRW 1,900 per unit, direct, Expenses for FRW
    1,000 per unit Variable overheads are FRW 1,250. Advise the firm whether the
    proposal should be accepted.

    Answer

    Purchase price                                                          FRW 6500

    Variable cost                                                              FRW

    MATERIAL COST                                                      1,750
    Labor Cost /wages                                                1,900
    Direct expenses                                                     2,000
    Variable overhead                 1,250                 (6,900)
    Contribution form purchase outside FRW (400)

    Advice the firm whether the proposal should be accepted,

    The proposal should not be accepted because the company has obtained a
    negative contribution of FRW 400. The firm should continue to purchase spare
    part outside instead of producing them internally.
    3. Dropping a product
    A Manufacturing company has a range of products and if one of which is deemed
    to be unprofitable, due to high processing cost, the company may consider to

    drop this product and to increase the production of more profitable products.

    3.2.7. CVP and decision making
    Cost Volume Profit decisions
    1. Special order to use up spare capacity

    In the short term, a business must ensure that the revenue from each item of
    activity at least covers variable costs and makes a contribution to fixed costs.
    Once the fixed costs are covered by contribution, the greater the level of activity,
    the higher the profit.
    When the business reaches full capacity there will be a new element of fixed
    cost to consider should the business decide to increase its capacity. If there is
    no increase in capacity, then the business should concentrate on those activities
    producing the highest contribution per unit or per item. the special order is
    acceptable provided the sales price per item covers the variable costs per item
    and provided there is no alternative use for the spare capacity which could
    result in a higher contribution per item.

    2. Abandonment of a line of business

    The allocation of fixed costs to products is a process which is somewhat arbitrary
    in nature, and is not relevant to decision making because the fixed costs are
    incurred irrespective of whether any business activity takes place. When a line
    of business comes under scrutiny as to its profitability, cost–volume–profit
    analysis shows that in the short term it is worth continuing with the line if it
    makes a contribution to fixed costs. If the line of business is abandoned and
    nothing better takes its place, then that contribution is lost but the fixed costs

    run on regardless.

    3. Existence of a limiting factor

    In the short term, it may be that one of the inputs to a business activity is
    restricted in its availability. There may be a shortage of raw materials or a
    limited supply of skilled labour. There may be a delivery delay on machinery
    or a planning restriction which prevents the . The item which is restricted in
    availability is called the limiting factor. Cost–volume–profit analysis shows
    that maximization of profit will occur if the activity is chosen which gives the

    highest contribution per unit of limiting factor.

    4. In-house activity versus bought-in contract

    For a manufacturing business, there may be a decision between making a
    component in-house as compared with buying the item ready-made. Cost–
    volume–profit analysis shows that the decision should be based on comparison
    of variable costs per unit, relating this to the difference in fixed costs between

    the options.

    Application activity 3.2

    Q1. A business has budgeted sales of its single product of 38,000units.The
    selling price per unit is FRW 57,000 and the variable costs production are
    FRW 45,000. The fixed costs of the business are FRW360,000,000. Choose
    the correct breakeven point in units from the following.
    – A 3,529
    – B 8,000
    – C 9,474
    – D 30,000
    Q2. ABC Ltd produces four products (P,Q,R and S)and the following details
    are provided:

    Machine hours are limited to38,000 hours. Labour hours are limited to
    40,000 hours and materials are limited to 30,000kg. Determine whether
    any of the resource limits will prevent the maximum demand being

    produced.

    Skills Lab 3

    Senior five accountancy students started business club named
    “Birashoboka” by using their money. They invested in Piggery and Poultry.
    The financial information related to business income and expenditure are

    indicated in this table below. 


    Three Senior five students as owners and the
    supervisors of these projects, They find it difficult to run both projects
    because of their limited number that is insufficient to share all their routine
    responsibilities of keeping hens and pigs. Some pigs and hens started
    dying because of little care given to them. The headmaster of the school
    has advised the students to perform only one project because hefound that
    it is difficult to manage both at ago. In the annual general meeting, the
    club management has decided to drop one business and continue with one
    which is more profitable.
    Imagine you are one the management team and you are requested to
    explain to the entire club members on which project to maintain, what
    would you say while selecting the best project? Draft a summary report
    and use the following methods to inform your decision / communication
    to the club.
    a) Marginal contribution
    b) Breakeven point

    c) Net profit by using marginal costing 

    End of unit assessment 3
    1. Define margin of safety?

    2. A business has fixed costs of FRW 910million. It produces and sells
    a single product at a selling price of FRW 24,000 and the variable
    costs of production and sales are FRW 17,000 per unit. How many
    units of the product must the business produce and sell inorder to
    make a profit of FRW 500 million?
    – A 909,993
    – B 130,000
    – C 201,429
    – D 22,195
    3. NYIRANEZA’s sales turnover and profit during two years were as

    follow :

    Calculate
    i) P/V Ratio
    ii) BreakEven Point
    iii) The sales required to earn a profit of FRW 80,000
    iv)The profit when sales are FRW 5,00,000

    v) Margin of safety at a point of sales of FRW1,000,000.











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