Management Accounting: Exam Pack (Updated)

MAC3761
Management Accounting
EXAM PACK
(UPDATED)
WITH NOTES!
UNIVERSITY EXAMINATIONS
October/November 2022
MAC3761
Management Accounting III
100 Marks
Duration: 3 Hours
30 minutes for uploading to myExams (submission cut-off time)
EXAMINATION PANEL AS APPOINTED BY THE DEPARTMENT
Use of a non-programable pocket calculator is permissible
Close book examination
The examination question paper remains the property of the University of South Africa and may not be
distributed beyond its intended use for this examination
THIS PAPER CONSISTS OF TWELVE (12) PAGES IN TOTAL.

THIS IS NOT AN OPEN BOOK EXAM! YOU ARE NOT ALLOWED TO COPY FROM OR CONSULT
ANY SOURCES INCLUDING YOUR TEXTBOOK OR TUTORIAL LETTERS. YOU ARE NOT
ALLOWED TO CONSULT ANY THIRD PARTY FOR THE DURATION OF THE EXAM SESSION.
EXAM QUESTION PAPER INSTRUCTIONS:

Please note:
1. This paper consists of TWO (2) questions, comprising 12 pages in total (including
instructions).
2. You are strongly advised to carefully read the required before attempting the questions
concerned.
3. All questions must be answered.
4. All calculations must be shown.
5. Each question attempted, must commence on a new (separate) page.
6. Include (write/type) your student number in the document/answer file.
PROPOSED TIMETABLE FOR THIS EXAM: Marks Minutes
Question 1: Costing systems; Cost classification and behaviour; Cost estimation;

Budgeting planning and control; Direct and absorption costing methods; Overheads 50 90
allocation; Inventory management; Relevant decision-making; and Transfer pricing.
Question 2: Strategy and risk management; Capital budgeting; Financing decision;
Treasury function. 50 90
Converting your answers to a PDF file and successfully uploading your one PDF file.
You must successfully upload your PDF file on myExams before 19:15 South African
30
time, 2 November 2022. The submission platform will automatically close at 19:15
(2 November 2022, South African time) and no submission can be made henceforth.
100 210
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Open Rubric
Page 2 of 12 MAC3761
Oct/Nov 2022
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MAC3761-Exam Oct/Nov 2022.
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October/November 2022 online examination rules
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examination sittings.
Examination sessions commence at the time indicated on the final examination timetable. You are
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suspected of dishonest conduct during the examinations will be subjected to disciplinary
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QUESTION 1 (50 Marks; 90 Marks)
Stellenbroach Family (“SF”) owns a 25-hectare piece of prime land that is considered suitable for both
agricultural and residential purposes. Currently, only two of these 25 hectares are in use, and primarily
for residential dwelling. SF has now decided to make productive use of the land and will soon establish
a wine and juice making group comprising of two major operating companies. SF has also consulted
with McKingsley Business Consultants (“MBC”), a leading business consulting firm to assist with its
business case. Companies within the SF group will adopt the absorption costing method and the first-
in-first-out (FIFO) inventory valuation method.
1. EXTRACT FROM THE BUSINESS CASE FOR SF-WINERY

One of the group companies to be formed is SF-Winery, whose operation will consist of a vineyard
where white grapes will be produced; wine cellars and juice tanks wherein white grapes will be
processed and subsequently fermented to produce semi-sweet white wine (“SWW”) and white grape
juice (“GJ”). In each financial year, SF-Winery will have one harvest period with an expected average
yield of 600 tonnes of white grapes. Amongst others, the costs relating to the process of wine and juice
making include soil preparation, seeds costs, seed planting costs, irrigation costs, pest control costs,
farm labour costs, harvesting costs and quality inspection costs. After At quality inspection (the grading
process after harvest), grapes are separated into three grades, namely, Grade A (80% of the harvest);
Grade B (16% of the harvest) and Grade C (4% of the harvest).
Only Grade A grapes will be fermented to produce the semi-sweet white wine. During the fermentation
process, a small quantity of Grade A grapes will result in waste. This waste has no sales value and will
be discarded at a cost of R0,15 per kilogram. Thereafter, wine will be stored in barrels to mature and
will only be bottled just before sale. The expected selling price to wine retailers is R65 per bottle of semi-
sweet white wine. Grade B grapes will be processed further to make grape juice, and cellulose and other
organic compounds are added to the grape juice to give it a rich and natural taste (grape juice will be
sold to local retailers at R30 per litre). The annual production is expected to match the annual demand
at 304 000 litres of semi-sweet white wine and 152 000 litres of white grape juice. Grade C will be sold
to pig farmers at R4,50 per kilogram.
2. IRRIGATION COST ESTIMATION FOR SF-WINERY

SF-Winery is exploring the most cost-effective option for its water supply requirements, considering
recent unstable water supply. In this regard, two options (municipality supplied water or borehole
supplied water) are available regarding the expected monthly average water requirements of 11 500
kilolitres. Upon inquiry from Morara Wines, a similar nearby winery, SF was able to obtain Morara Wines’
municipal invoices as shown below.
2.1. MUNICIPALITY SUPPLIED WATER

2.1.1. If the municipality supplied water option is considered, SF will use Morara Wines’ municipal
invoices as a base for estimating irrigation costs. However, the municipality is soon expected to
apply a 6% annual inflationary increase on all its charges. Included in the total municipal charges
below are fixed refuse and sanitation charges of R3 750 per month. Morara’s municipal invoices
reflected the following:
Municipal invoice Water Total municipal
month consumption charges
September 12 500 kilolitres R65 000
October 11 280 kilolitres R59 510
November 11 300 kilolitres R57 905
December 12 350 kilolitres R65 560
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QUESTION 1 (continued)
2.2. BOREHOLE SUPPLIED WATER
2.2.1. If the borehole supplied water option is considered, SF will use one of the boreholes currently
used for its residential needs. This borehole was drilled four years ago at a cost of R38 000. With
this option, this borehole will be used to supply 40% of the irrigation water requirements for the
grapes at pumping costs of R2,60 per kilolitre.
2.2.2. SF-Winery will be required to drill a second borehole from which the other 60% of the irrigation
water requirements for the grapes will be pumped. The current drilling costs for a similar borehole
is R45 000, however, as a repeat client, SF is entitled to a 5% drilling costs discount. This borehole
will be used exclusively by SF-Winery. New advanced drilling and pumping technology will make
it possible to reduce the pumping costs for this borehole only, to R1,80 per kilolitre.
2.2.3. SF-Winery will depreciate the boreholes at 5% per annum on a straight-line basis.
2.2.4. The expected annual service costs will be R5 000 for the existing borehole, 70% resulting from
domestic usage and 30% from business usage). For the new borehole, the service costs will be
R3 000. The service costs are mainly driven by the level of usage of boreholes.
2.3. To set up the irrigation system to cover the entire farm, the associated costs are expected to be
R87 000, once-off payable upfront regardless of the option chosen.
3. SF-BOTTLING
3.1. One of the other companies that will be set up is SF-Bottling. The company will manufacture and
sell empty wine bottles (bottles) to both SF-Winery and external customers. SF-Bottling will have
maximum capacity to manufacture 960 000 bottles annually. The bottles come in a standard 750
millilitre size. Although the expected annual demand for the bottles is 410 000 and 640 000 for
SF-Winery and external customers respectively, SF-Bottling will be required to prioritise the supply
of the bottles to SF-Winery. The grape juice is packed in recyclable 1 litre, 2 litre and 5 litre
containers which are sourced externally and not from SF-Bottling.
3.2. The manufacturing costs based on maximum manufacturing capacity are estimated as follows:
Details Amount
Raw material costs per bottle (for glass) R5,50
Direct labour costs per bottle @ R45 per hour R4,50
Total annual manufacturing overheads R2 448 000
Manufacturing overheads comprise of variable and fixed components. Variable manufacturing

overheads are estimated at R21 per direct labour hour. Fixed manufacturing overheads are
allocated based on the annual maximum manufacturing capacity of the bottles.
3.3. Bottles will be sold to external customers packed in a custom-made wooden crate (crate) just
before sale. This crate holds eight bottles and will always be packed as such for bottle sales. All
the crates will be bought from Bathokwa Crates (“Bathokwa”) at a purchase price of R12 per crate.
SF-Bottling has noted numerous complaints from Bathokwa’s existing customers about the fragility
of the crates. In the main, it is complained that unused crate inventories stored for an extended
period frequently break beyond repair, and in large volumes. Internal sales will not be packed in
crates.
3.4. Currently, according to the SF group, to encourage goal congruency, SF-Bottling will sell/transfer
bottles to SF-Winery at a price that equals SF-Bottling’s unit full manufacturing cost per bottle.
However, the selling price will be R15,50 per bottle to external customers. Moreover, SF- Bottling
will incur delivery costs of R0,85 per bottle sold to external customers only.
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4. MANAGEMENT OF THE WOODEN CRATES INVENTORY
Upon presenting to MBC the group’s business case, MBC recommended that instead of the proposed
just-in-time (JIT) inventory management technique, SF-Bottling should rather consider using the
economic order quantity (EOQ) technique. In this regard, the crates’ purchase price will remain the
same; the expected ordering costs are determined at R120 per order; while annual storage and
insurance costs are expected to be R0,75 and R1,50 per crate, respectively.
Furthermore, a safety inventory of 10 crates should be maintained while the applicable cost of capital is
11% per annum. The recommendation by MBC is based on a quantitative analysis. In this regard,
instead of an expected annual holding and ordering costs of R6 000 based on the JIT technique, MBC
is of the view that the implementation of the EOQ technique will only cost R4 500 per annum for holding
and ordering costs.
PLEASE GO TO THE NEXT PAGE FOR “REQUIRED” SECTION
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REQUIRED
For each question below, clearly show all your calculations; where necessary also indicate
irrelevant amounts with R0; and ignore time value of money and all tax implications.
(a) With reference to the information under “Extract from the business case for SF-Winery”
(section 1) above, draft a memorandum to the management of SF wherein you
recommend and motivate for the most appropriate costing system that SF-Winery
should use for the allocation of production costs of SWW and GJ. Calculations are not
required and other costing systems that are not considered appropriate, should not be
addressed. Your motivation (using information provided) must incorporate:
 A discussion of points from the information that support your
recommendation;
 An outline of the cost accounting treatment of the different products outlined
in the “Extract from the business case for SF-Winery”;
 Identification of possible methods for allocating costs to SWW and GJ; and
 Reference to supporting figures from the information where necessary.
Motivation 10 marks; Recommendation 1 mark and Layout 2 marks. (13)
(b) With regard to “Irrigation cost estimation for SF-Winery”:
(i) Determine the expected annual irrigation costs for each of the two given options
and recommend the most financially viable option of the two for SF-Winery’s water
supply requirements. [Your analysis should be based on the first year of operation
only]. (13)
(ii) Assume that SF-Winery chooses the municipality supplied water option. Discuss
four factors that could affect the accuracy at which SF-Winery can estimate the
expected irrigation costs. (4)
(c) After an assessment of SF-Bottling’s business case, MBC made the following
recommendation: “To encourage goal congruency, minimum transfer price principles
should be utilised to determine a unit transfer price regarding the transfer of all the
bottles required by SF-Winery from SF-Bottling.”
From SF-Bottling’s perspective, critically evaluate and subsequently conclude whether
the recommendation by MBC to adopt the minimum transfer price principles as opposed
to the currently proposed transfer price represents a sound financial recommendation.
 Support your evaluation and conclusion with relevant and necessary
calculations.
Supporting calculations 7 marks; Evaluation and conclusion 3 marks. (10)
(d)  For question 1 (d)(i) only, assume that instead of 960 000 bottles, SF-Bottling’s
maximum annual manufacturing capacity is 1 200 000 bottles and that the
R6 000 expected annual cost for the JIT technique is correct.
(i) From a quantitative perspective only, advise SF-Bottling whether the proposed
recommendation and view by MBC regarding changes to the inventory (wooden
crates) management technique is appropriate from a financial perspective. (8)
Calculations 7 marks; Advice 1 mark.
(ii) Without reference to quantitative aspects, identify and explain two features from
the scenario to motivate for JIT as the most appropriate inventory management
technique for the wooden crates. (2)
Total question 1 [50]
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QUESTION 2 (50 Marks; 90 Marks)
Pepper Clothing (“Pepper”) is a clothing retailer in South Africa with its head office located in Cape
Town. It sells low-cost clothes to mass lower- to middle-income end customers. Pepper now owns over
1 500 stores or franchised stores and employs more than 14 000 employees. The company has stores
across South Africa, with strong presence in Gauteng, the Western Cape and Limpopo. Pepper is the
largest single-brand retailer of low-cost clothing in South Africa and its board believes that there are
opportunities to take advantage of the rapid economic growth in some African countries. The latest
market research indicates that “discount clothing stores” offer the greatest opportunity for future growth
in Southern Africa, and as a result, the Finance Director has identified two investment opportunities.
Both these investments can be undertaken, but the board has put some financial restrictions on how
much can be expended on capital investments over the next few years. Details about the two
investments are as follows:
Investment 1 – Build a new “discount clothing store” in the Western Cape (South Africa)
The Western Cape offers the smallest number of “discount clothing stores” as a percentage of the Gross
Domestic Product of any province in South Africa. Pepper has already opened discussions with a seller
of suitable land as well as the local authority. If this acquisition is approved there will be some financial
assistance available to a purchaser such as Pepper. However, a decision is not expected from the local
authority for at least one month. Pepper has paid a non-refundable holding deposit of R50 000 on the
freehold land pending the outcome of its investment appraisal. The seller requires a decision within a
month. This investment appraisal will have to be done over an indefinite period, where a terminal value
must be established.
Investment 2 – Build a new “discount clothing store” in Zimbabwe

Pepper’s “own branded” products are already being bought and sold on by some retailers in Zimbabwe.
These products have proven to be very popular although the suppliers lack the resources to maintain
sufficient stock levels and provide a variety of quality goods to customers. The Zimbabwean government
is keen to attract inward investment although it generally insists on some involvement in the investment
and puts certain restrictions in contracts. A suitable site is available for Pepper to build its store and
operate from there for a period of 15 years. Today’s cost of using the land over the next 15 years and
disposal of the building at the end has already been calculated (see capital costs below). The United
States Dollar (USD) is widely used in Zimbabwe and all payments in Zimbabwe can be made in USD.
Capital costs for both investments:
Capital costs Investment 1 Investment 2
R’000 USD’000
Cost of freehold land 36 000
Cost of use of land 2 000
Building costs 50 000 3 200
Equipment costs 14 000 800
Projected profits for both investments:

Profits Investment 1 Investment 2
R’000 USD’000
Year 1 Year 2 Year 3 Year 1 Year 2 Year 3
Cash gross profit 28 000 31 750 35 000 5 000 5 750 6 500
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Other information
• Under Investment 1, income and expenses are expected to increase by 6% per annum from Year 4
onwards. This is approximately the expected rate of inflation in South Africa.
• Current spot rates are: USD 1,00 = ZAR 14,80. Assume that risk-free interest rates are currently 8%
in South Africa and 5% in the US. These rates are likely to be maintained until the end of Year 3.
• The Finance Director has concluded that the forecast for interest rates and future inflation in
Zimbabwe is unreliable. The directors of Pepper therefore assume, for convenience, that in
Investment 2 the income receivable in year 3 in South Africa Rand (R) terms will remain constant,
in nominal terms, until Year 15.
• Operating costs are assumed to be 60% of gross profit received each year in both investments.
• For the purpose of this evaluation, depreciation or capital allowances on land and buildings (including
use of land) must be ignored.
• Both operations will be located in “Industrial Development Zones”. This provides for accelerated
wear and tear allowances and equipment can be written off over two years for tax purposes.
• Refurbishment of buildings and replacement of equipment will be needed within the life of both
investments, but these costs have not as yet been identified and have been excluded from the
evaluation.
• If Investment 1 is chosen, in addition to other operating costs, storage costs will amount to 1% of the
store’s gross profit each year.
• If Investment 2 is chosen it will result in a decline in profits generated by the South African operations.
This R5 million annual loss is expected to remain fixed.
• If Investment 2 is selected, all profits from Zimbabwe will be repatriated to South Africa at the end of
each year. The taxable income will be taxed at a rate of 28% in South Africa due to the tax treaty
that exists between the two countries. Tax is paid in the same year as the cash flows (including wear
and tear deductions) that give rise to the tax liability.
• Assume all capital costs are incurred in Year 0 and all operating cash flows are received or incurred
at the end of each year.
• 12% is considered an appropriate discount rate for Investment 1. A premium on this South Africa
rate of 400 basis points is considered appropriate for the investment in Zimbabwe (Investment 2).
Method of funding
The directors of Pepper plan to utilise accumulated cash reserves of R20 million towards the funding
any of the projects. This is not expected to influence the stable dividend policy currently employed. The
remaining capital investment will be funded by long-term borrowings aligned with the Finance Director’s
suggestions that debt should be used with the relatively low current interest rates.
If Investment 1 is chosen, the balance of the capital investment will be funded by a 20-year commercial
mortgage secured on the land and buildings. Interest will be fixed at 9% per annum, payable annually.
If Investment 2 is chosen, the balance of the capital investment will be funded by one of the following
methods:
i. A 15-year commercial loan taken out in South African Rand (R) at 9,5% interest per annum
payable annually in arrears, with the capital being repayable at the end of the term;
ii. 15-year non-cumulative preference shares issued in USD at an annual dividend rate of 10% on
the capital;
iii. A USD-denominated loan from a bank based in the United States. Borrowing rates in this market
appear very favourable at the present time. The interest rate will depend on the bank’s perceived
risk of the investment.
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REQUIRED
For each question below, remember to:
• Clearly show all your calculations in detail;
• Where necessary, indicate irrelevant amounts/adjustments with a R0 (nil-value);
(a) Explain the types of the capital investment projects Pepper Clothing is planning to
embark on and advise on how best these can be evaluated using capital budgeting
techniques. (4)
(b) Calculate the net present value (NPV) in South African Rand for each of the two capital
investments, applying the information provided in the scenario. (17)
(c) As the Senior Finance Manager of Pepper Clothing, you are required to prepare a
report to the Chief Executive evaluating the investment decision and its funding. Your
report should include the following sections:
(i) An evaluation of the two investments, including a discussion of the key risk factors (10)
Pepper Clothing should consider.
(ii) A discussion of how the abandonment, timing and strategic features of each
(4)
investment option may impact the investment decision.
(iii) A discussion of the advantages and disadvantages of the three methods of funding
outlined in the scenario for Investment 2. Use appropriate calculations, where (12)
possible, to support your arguments.
(iv) Recommendations about the choice of investment and, if relevant, the method of (3)
funding.
TOTAL (questions 1 and 2) 100
©
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means without prior written permission of Unisa.
CONFIDENTIAL
June 2021
MAC3761
100 Marks
Duration 3 Hours
This paper consists of 12 pages (including this page).
Instructions:
1. This assessment consists of two independent questions.
2. All questions must be answered, and all calculations must be shown.
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6. Your attention is brought to the announcement posted on MAC3761 myUnisa site titled
“Cheating in MAC3761 assessments”, as well as the plagiarism declaration in the TL101.
PROPOSED TIMETABLE Marks Minutes
Question 1: Overhead allocation; Cost-volume-profit (CVP) analysis;

55 99
Joint and by-product costing; Ethics; and Discussion.
Question 2: Capital structure and cost of capital; Sources and forms of
45 81
finance; Working capital and Discussion.
Converting your answers to a PDF file and successfully uploading your
one PDF file. You must successfully upload your PDF file on myUnisa
before 12:45 South African time, 21 June 2021. The submission platform 60
will automatically close at 13:00 (21 June 2021, South African time) and
no submission can be made henceforth.
100 240
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MAC3761
June 2021
QUESTION 1 (55 marks; 99 minutes)
Phalaborwa Pharmaceutics Enterprise (“PPE”) is a medium-sized company founded in 2020

in the wake of the COVID-19 outbreak. The company started operating on 1 April 2020. PPE
specialises in the production of masks, gloves, safety goggles, safety shoes and protective
gowns. These five products are produced from its 6 840m2 rented factory compound, 15
kilometres outside Phalaborwa city centre. The factory has five divisions from which each of
the company’s five products have a production line that is separate and distinct from one other,
except for shared services which include material receiving, warehousing, water and
electricity. The company’s Head Office, located in the city centre, is responsible for
administration, financing, shared services and marketing functions of the business. PPE uses
the absorption costing system and accounts for inventory using the first-in-first-out (FIFO)
method.
PPE has been quite successful in capturing interest and preference of doing business with
several strategic government entities and has invested significantly in promoting its business
to these entities. Monthly monetary payments made by the company to these entities and their
managers together with free samples have helped to promote the company brand. The
company already has orders in the pipeline to supply its products from the five divisions to
different government entities.
Each production line (hereafter referred to “division”) is headed by a divisional manager who
is responsible for all the operational decisions of the division, provided that these decisions
are in the best interest of the company as a whole. To ensure that this is realised, the executive
management requires each division to report a gross profit margin and net profit before tax of
at least 12,75% and R8,5 million, respectively for the 2020 financial year (allocated fixed
factory overheads in Schedule A below are taken into account when determining the division’s
gross profit margin and net profit before tax). If these targets are met, then the divisional
manager is entitled to 0,2% of total sales of their division as a bonus, and their respective
division is to receive a fixed bonus of R2 million for the relevant reporting period, to be shared
among the division’s employees.
The company’s first year of operation was uneventful, except for a minor electricity supply
fault. This led to the water and electricity bill for April being slightly lower than average as a
result of the electricity meter not working for some days. It is said that the incident could not
be reported on time as this happened during level 5 of the lockdown and one of the
experienced electricians on site was able to ensure that the electricity supply was not
disrupted.
A. FACTORY OVERHEADS SCHEDULE FOR THE 2020 FINANCIAL YEAR (PPE)
1. The company’s factory overheads have not been allocated. They are allocated to the five
divisions as per below activities:
Factory overhead items Activity 2020 Actual

notes
Depreciation and machine service costs (i) R36 125 500
Rent, rates, water, and electricity (ii) R18 766 438
Safety and wellness costs (iii) R5 037 442
Ordering and material handling costs (iv) R1 238 546
Cafeteria, development, and teambuilding costs (v) R840 750
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(i) The divisions recorded a total of 7 890 000 machine hours of which 2 827 000 relate
to the Masks Division.
(ii) The Masks Division occupies and utilises 2 022m2 of the company’s total factory floor
space.
(iii) Safety and wellness costs relate to health and safety activities. For the period ending
31 December 2020, the company clocked a total of 1 247 hours on health and safety
activities. The Masks Division logged 30,72 property maintenance days for the 2020
financial year. Each daily shift consists of 12 hours.
(iv) 23 cents of each rand incurred in ordering and handling materials is attributed to the
Masks Division.
(v) The Masks Division had 214 staff throughout the 2020 financial year. The company’s
total staff complement of the 2020 financial year is expected to increase by 17% to 702
for the 2021 financial year.
2. The above factory overheads do not include the divisions’ specific fixed overheads and
the Head Office’s allocated fixed overheads. These are always reflected separately in the
divisions’ respective management accounts.
B. MASKS DIVISION’S 2020 PERFORMANCE AND FORECAST FOR 2021
Baba Ndou, the business manager of the Masks Division, has presented the actual
management accounts below as recorded and reported in his division to the executive
management of PPE. He is confident that his division will meet the new target of R18 million
in operating profit set for the full 2021 financial year, leading to his division qualifying for
bonuses. The extract from the Masks Division’s actual management accounts and its notes
and additional information for the 9 months ended 31 December 2020 are presented below in
Schedules C and D:
C. MASKS DIVISION – MANAGEMENT ACCOUNTS FOR THE 2020 FINANCIAL YEAR

AND ADDITIONAL INFORMATION FOR THE 2021 FINANCIAL YEAR
Details Note 2020 Actual
Sales 1 R83 252 205
Direct material purchases 2 R20 875 828
Other direct material transfer from Safety Shoes Division 3 R4 611 840
Direct labour costs 4 R14 000 400
Indirect labour costs 5 R9 470 000
Head office allocated administrative overheads 6 R2 128 423
Total administration and selling costs 7 R1 886 600
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D. NOTES AND ADDITIONAL INFORMATION
1. For the 9-month period ending 31 December 2020, the Masks Division produced and sold
a total of ninety million masks. The unit selling price is expected to increase by 12% for
the 2021 financial year as the company expects increase in global demand of masks.
2. All direct material purchased were issued to production.
3. This material relates to straps bought from the Safety Shoes Division (which already
manufactures straps and laces for the shoes manufactured by the division). These straps
are then used as ear loops for the masks. There were no straps on hand at the end of the
2020 financial year.
4. For the 2020 period, the Masks Division labourers were remunerated at an hourly rate of
R18, just slightly below the national minimum wage gazetted of R20,76 due to the fact that
the company is fairly new and had to invest heavily in the plant at the beginning of the
year. For 2021, PPE plans to increase this to R25 per labourer, per hour.
5. Indirect labour costs relate to fixed salaries of supervisors and foreman who are working
on the factory floor to make sure that production processes run accordingly.
6. These costs are determined by the Head Office and although they are correctly allocated
to the divisions of PPE, they bear no direct relationship with the underlying products’
volume.
7. Lowest number of masks sold was recorded in April due to poor advertising campaign, but
the month of September saw the highest number of units sold (probably as the government
relaxed the lockdown restrictions). There were 4,5 million masks sold in April and 10,5
million masks sold in September. Total administration and selling costs were R150 025
and R296 455 for April and September, respectively. Both the unit variable costs and total
fixed costs for the 2021 financial year will remain as that of the 2020 financial year.
8. There are no expected changes in material costs and overheads for the 2021 financial
year, except for any changes evident above.
9. Unless indicated otherwise, assume all income and expenses are incurred evenly
throughout the reporting period.
E. ACQUISITION OF ALOETISER (PTY) LTD
PPE has started exploring ways of diversifying its business for the purpose of long-term
viability, especially in the post-Covid19 era. PPE has embarked on discussions with Aloetiser
(Pty) Ltd (“Aloetiser”) for a possible acquisition of Aloetiser’s operations. The owners of
Aloetiser are emigrating to Canada soon and are desperately in need of a buyer to take over
their entire Gqeberha-based operations in the Eastern Cape. For the year ended 31 March
2021, the owners of Aloetiser claimed to have made an actual net profit of R22m. The
projections are that this reported net profit will likely increase by 20% for the 2022 financial
year. Aloetiser uses a direct costing system and accounts for inventory using the weighted
average method. As part of PPE’s investment strategy, PPE will consider buying Aloetiser’s
operations if Aloetiser has for the recent financial period, reported a contribution margin ratio
of 0,4 for each product.
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Aloetiser uses aloe vera leaves bought from local farmers and then put these through the
production process, where a gel is squeezed from the leaves to generate aloe vera gel. This
aloe vera gel is then further processed to make hand sanitisers after alcohol and other
ingredients have been added. The squeezed aloe vera leaves are boiled and sifted through
during the process to produce aloe vera liquid. This aloe vera liquid, after adding some
chemicals, is then sold to cosmetics manufacturers which use it to make facial and other skin
products. The residual aloe vera leaves left after these processes are then scrapped and sold
to Left Aloe Limited, the only pharmaceutical company which uses it in the manufacturing of a
special medicine. The following has been extracted from the production cost schedule of
Aloetiser (Pty) Ltd for the year ended 31 March 2021:
1. PRODUCTION COSTS SCHEDULE EXTRACT FOR THE 2021 FINANCIAL YEAR:

Details Note R
Inventory: 01 April 2020 – hand sanitisers 2.1 1 494 491
Inventory: 01 April 2020 – aloe vera liquid 2.1 1 873 109
Variable manufacturing costs 2.2 13 682 817
Fixed manufacturing overheads 2.3 3 261 955
Alcohol and other ingredient costs – hand sanitisers 2.4 923 187
Chemical processing costs – aloe vera liquid (per litre) 2.5 1,20
Disposal costs – residual aloe vera leaves 2.6 76 543
2. NOTES AND ADDITIONAL INFORMATION

2.1. Inventory on hand (both opening and closing) relates to completed units of hand
sanitisers and aloe vera liquid. There were 500 kilolitres of hand sanitisers and 820
kilolitres of aloe vera liquid. There was no residual aloe vera leaves on hand on 31 March
2021.
2.2. These manufacturing costs relate to the joint manufacturing process of extracting the
aloe vera gel and of boiling the aloe vera leaves. These costs are allocated to hand
sanitisers and aloe vera liquid based on the net realisable values of the products. There
were 2,2 million litres of aloe vera gel (for making hand sanitisers – further refer to 2.4
below) and 3,04 million litres of aloe vera liquid produced during the 2021 financial year.
2.3. These overheads are not incurred within the joint manufacturing process and are also
not allocated to products.
2.4. For each litre of aloe vera gel, 250 millilitres of alcohol and other ingredients are added
to make the complete hand sanitiser. There are no volume losses in the process.
2.5. Chemicals added in processing the aloe vera liquid do not materially increase the
quantity and there are no known volume losses in the process.
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2.6. The sales for the 2021 financial year were made as follows:
a. 2,1 million litres of hand sanitisers were sold at R3,46 per litre and it cost Aloetiser
R545 364 to market and sell these hand sanitisers to different retail stores. This
amount, as per the contract, has been fixed for the past three years.
b. 2,97 million litres of aloe vera liquid was sold to cosmetics manufacturers at R6,50
per litre. The company makes use of agencies who are paid a commission
equivalent to R0,50 per each litre sold.
c. Residual aloe vera leaves were sold to Left Aloe Limited for R875 000.
2.7. There were no raw materials, alcohol and other ingredients, chemicals, and work in
progress on hand both at the beginning and at the end of the financial year.
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June 2021
REQUIRED

• Where necessary, indicate irrelevant amounts/adjustments with a R0 (nil-
value);
• Ignore time value of money and all taxation implications.
(a) Calculate the actual total overheads attributed to the Masks Division for the 9-
month period ending 31 December 2020.
▪ Round final answers to the nearest Rand. (8)
(b) Determine and conclude whether Baba Ndou and his Masks Division are
entitled to bonuses (and how much, if any) for the period ended 31 December
2020. Show all workings. (8)
(c) Critically evaluate the overall employee remuneration structure of Phalaborwa
Pharmaceutics Enterprise. (5)
(d) Determine the projected number of masks that the Masks Division needs to
produce and sell in order to meet its operating profit target for the 2021 financial
year. (10)
(e) Discuss business ethical issues that may be of concern to Phalaborwa
Pharmaceutics Enterprise and its operations. (5)
(f) Prepare a segmented actual statement of profit of loss (income statement) (by
product) of Aloetiser (Pty) Ltd, showing the profit for the year ended 31 March
2021 for each product, as well as the total for the company. (12)
(g) Based on the investment criteria and other factors that Phalaborwa
Pharmaceutics Enterprise needs to take into consideration, advise if the
Phalaborwa Pharmaceutics Enterprise should buy Aloetiser (Pty) Ltd. (7)
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MAC3761
June 2021

Listed on the Johannesburg Stock Exchange (JSE), Brat Lows Furniture Group (“BLF” or
“Group”) is a leading retailer of household furniture and electrical appliances in Southern
Africa. As at the end of 31 December 2020, its latest financial year end, BLF had 8 248
permanent staff members in its employ, following a year-to-year decline of 4% in its workforce
owing to the outbreak of COVID-19 pandemic which led to retrenchments and restructuring of
the Group. The Group also boasts of a portfolio of stores in Botswana, Lesotho, Namibia and
Eswatini.
The trading environment has been challenging for the furniture industry, especially following
the hard lockdown which saw furniture stores close for weeks countrywide and customers
across the board losing their employment. The Group had to impair its debtors book and
recapitalise its balance sheet by the fresh issue of ordinary shares to ensure continuity during
these turbulent times. Its peers have also struggled to keep their businesses afloat and many
furniture retailers had to shut down permanently.
The diversified portfolio (in terms of location, cash vs. credit customers and product range) did
help BLF weather the financial storm and its management is hopeful that 2021 will be a
profitable year. However, some investors are losing patience with the restructuring process of
the Group as the recent performance had led to suspension of dividends and decline in the
share price. Presented below are the summarised financial statements for BLF for the year
ended 31 December 2020.
A. The financial statements, together with other key information relating to Brat Lows
Furniture Group, are first presented below:
1. STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 2020
Rm Notes 2020 2019

Revenue 5 670 6 453
Merchandise sales 4.1 3 602 4 475
Insurance and interest income 4.2 2 068 1 978
Cost of merchandise sales 4.1 (1 666) (2 174)
Opening inventory 796 812
Purchases 1 401 1 963
Cash carriage costs 313 195
Closing inventory (844) (796)
Operating costs 4.3 (4 107) (3 822)
Profit/(loss) before finance income and costs (103) 457
Finance income 43 64
Finance costs 4.4 (209) (248)
Profit/(loss) before taxation (269) 273
Taxation 79 (90)
Net profit/(loss) for the year (190) 183
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2. STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 2020
Rm Notes 2020 2019

ASSETS
Non-current assets
Property, plant and equipment and right-of-use asset 1 232 1 018
Goodwill and intangible assets 297 308
Financial assets – insurance investments 621 503
Total non-current assets 2 150 1 829
Current assets
Inventory and financial assets 1 097 1 042
Trade and other receivables 2 956 3 326
Cash-on-hand and deposits 1 970 1 193
Total current assets 6 023 5 561
TOTAL ASSETS 8 173 7 390
EQUITY AND LIABILITIES

Capital and reserves
Ordinary share capital 4.5 1 458 458
Retained earnings 1 042 1 232
Other reserves 63 57
Total shareholders’ equity 2 563 1 747
Non-current liabilities 4.4 3 498 4 105

Current liabilities
Trade and other payables 874 948
Payments in advance 583 148
Short-term borrowings 4.4 655 442
Total current liabilities 2 112 1 538
TOTAL EQUITY AND LIABILITIES 8 173 7 390
3. OTHER SALIENT INFORMATION
2020 2019
Target capital structure – Debt: Equity (market values) 40:60 40:60
Prime lending rate (closing %) 7,0 10,0
ZAR: 1 US dollar (average) 17,84 14,45
ZAR: 1 US dollar (closing) 14,93 14,40
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4.1. This relates to sale of furniture and electrical appliances both to cash customers and credit
customers. The value of cash sales is approximately 25% of the value of credit sales. The
Group’s purchases from the manufacturers are mainly on credit, and the Group continues
to maintain good relations with its suppliers.
4.2. The Group also provides credit life insurance cover to credit customers. Interest income
is derived from instalment sales and overdue accounts.
4.3. Operating costs include debtor costs of R2,257 billion for the current year (2019: R1,255
billion). The debtor costs are made up of trade bad debts written off, debt management
costs and debt impairments.
4.4. Finance costs relate mainly to the following long-term interest-bearing liabilities:
i. A 10-year loan facility received from Da Bank on 5 January 2017. This loan of R1,24 billion
currently incurs an interest rate of prime less 125 basis points per annum. Interest is
payable annually in arrears. Similar facilities bear an annual interest at prime less 100
basis points.
ii. Medium-term loan of R400m from Cressida Finance which is repayable fully on 20
December 2023. Fixed interest of R26 million is payable annually in arrears. BLF had
applied to Cressida Finance’s COVID relief fund to postpone its 20 December 2020
interest payment. However, the approval only came after the payment was made.
Cressida Finance has now agreed to postpone the 20 December 2021 interest amount to
20 December 2022. All other future payments are scheduled to be repaid as initially
planned. There is no additional interest on postponed payments. Market related interest
rate on similar term loans is 6,85% per annum.
iii. Fifteen million preference shares were issued two years ago at R70 per share. Preference
share dividends are payable annually in arrears at 80% of prime rate. Currently for the
same value of preference shares in the market, BLF would be expected to pay R62,4
million as an annual dividend.
iv. Twelve million debentures were issued at R45 each and are redeemable in four years’
time. However, there is a once-off premium of R0,75 per debenture payable one year
after redemption. Annual interest on these debentures is R36 million and is payable
annually in arrears. Similar debentures are trading at 6,25% per annum.
v. Other non-current liabilities (non-interest bearing) were recorded at R268 million for the
year ended 31 December 2020 (2019: R283 million).
vi. The market value of long-term interest-bearing facilities on 31 December 2019 was
R3,972 billion. The market value of equity on 31 December 2019 was R4,466 billion.
vii. The balance of finance costs relates to short-term borrowing costs.
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4.5. BLF issued additional shares to its existing shareholders during the 2020 financial
year in an effort to strengthen its balance sheet and decrease its gearing levels. These
shares were issued at a discounted price of R20 per share, bringing the total number
of ordinary shares issued to 224,9 million. This was the only movement in ordinary
share capital during the 2020 financial year. The market price subsequently
plummeted to R18,25 per share by the end of the 2020 financial year.
4.6. There were 366 days in 2020 (2019: 365) and the South African corporate tax rate
has remained unchanged at 28%.
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June 2021
QUESTION 2
REQUIRED
• Clearly show all your calculations in detail; and

value).
(a) Determine the capital structure (expressed as a %) of Brat Lows Furniture
Group at 31 December 2020, based on both the book values and the market
values. You are also required to comment on the movements in capital
structure.
▪ Calculations – 15 marks; Discussion and commentary – 3 marks. (18)
(b) Assuming that Brat Lows Furniture Group has not yet reached its target capital
structure, provide practical ways in which the Group can improve its gearing
and move towards its target capital structure. (5)
(c) Discuss factors you would have considered before taking part in the Group’s
issue of additional ordinary shares during the 2020 financial year, if you were
one of the Group’s shareholders. (8)
(d) Calculate the cash conversion cycle of Brat Lows Furniture Group at 31
December 2020 and based on the information and nature of industry, advise
on practical ways to improve the cash conversion cycle.
▪ Where applicable, base your calculations on closing book values.
▪ Calculations – 5 marks; Advice – 4 marks. (9)
(e) Advise the management of Brat Lows Furniture Group on how to effectively
structure the business to return to profitability. (5)
Total question 1 and 2 [100]
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All rights reserved. No part of this document may be reproduced or transmitted in any form or
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CONFIDENTIAL
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Blue ticks
SUGGESTED SOLUTION (✓) are
alternative
QUESTION 1
(a) Calculate the total overheads attributed to the Masks Division for the 9-
[8]
Overheads R Marks
Depreciation & machine service costs 12 943 826 ✓ r/w
[36 125 500 ÷ 7 890 000 x 2 827 000]
Rent, rates, water and electricity 5 547 622 ✓ r/w
[18 766 438 ÷ 6 840 m2 x 2 022 m2]
Safety and security costs 1 489 176 ✓✓
[(5 037 442 x 30,72 x 12)✓ ÷ 1 247✓]
OR: [(5 037 442 ÷ 1 247 ÷ 12)✓ x 30,72✓]
Ordering and material handling costs 284 866 ✓ r/w
[1 238 546 x 0,23]
Cafeteria, development and teambuilding costs 299 868 ✓✓
[(840 750 ÷ (702 ÷ 1,17)✓ x 214✓]
Head Office’s allocated overheads 2 128 423
Division’s specific costs (indirect labour costs) 9 470 000 ✓ r/w
Total overheads 32 163 781
 Given
(b) Determine whether Baba Ndou and his Masks Division are entitled to
bonuses (and how much, if any) for the period ended 31 December 2020. [8]
Show all workings.
Details R Marks
Sales 83 252 205 ✓ r/w
Variable manufacturing costs (39 487 668) ✓ r/w
Factory overheads [part a] (32 163 781) ✓ ©
Gross profit 11 600 356
Administration and selling costs (1 886 600) ✓ r/w
Net profit before tax 9 713 756
Gross profit margin 13,93% ✓ ©
Conclusion:
The Masks Division’s gross profit margin of 13,93% is more than the 12,75% target while
the actual net profit before tax of R9,713m is also more than the R8,5m target. As such,
both Baba Ndou and his division are entitled to a total of R2 166 504✓✓ in bonuses for
the 9-month period ending 31 December 2020 (R166 504 of this goes to Baba Ndou).✓©
1 mark for conclusion
 Given 2 marks for calculation
 20 875 828 + 4 611 840 + 14 000 400 = 39 487 668
 11 600 356 ÷ 83 252 205 = 13,93%
 Baba Ndou’s bonuses: R83 252 205 x 0,2% = R166 504 ✓rw
 Division’s bonuses: R2 000 000 ✓rw
 Total bonuses payable to Masks Division: R2 166 504 (R166 504 + R2 000 000)
(c) Critically evaluate the overall remuneration scheme of Phalaborwa
[5]
Pharmaceutics Enterprise.
On basic salaries and wages

• The company seems to be in contravention of the Basic Conditions of Employment
Act✓, as it currently pays its labourers R18 per hour, while the minimum wage is
R20.76. This may lead to fines and penalties imposed by the Government, and
possible labour unrest and strikes✓. The company does, however, provide other
benefits to its labourers (bonuses, refreshments and developmental programmes)
and maybe the company can consider channelling this expenditure towards the
wages of labourers✓. 1 mark for contravention; 1 mark for consequences; 1 mark for other benefits
• Indirect labour costs make up approximately two-thirds of direct labour costs
(R9,47m vs. R14,4m) ✓, and this may suggest that supervisors and foremen are
paid significantly more than the labourers who are directly involved in the production
process. Usually there is a small number of supervisors compared to direct
labourers. 1 mark for indirect labour cost component; 1 mark for comparing with DL
On determining bonuses
• The company seems to be instilling commitment to the success of the organisation
by giving the divisions incentives over and above the normal wages and salaries.
This is likely to increase productivity by the divisions.
• Some manufacturing overheads may not be within the control✓ of the divisions or
methods to allocate these may not be favourable to other divisions.
• The bonus payable is not proportionated to the operating profit✓ – e.g. it does not
matter by how much the targeted operating profit is exceeded, this does not
influence how much is paid out as a bonus. There will be no bonuses payable if the
operating profit is slightly below the set target.
• The manager may be tempted to increase sales at any cost (overstatement or
incorrect classification) as their bonus is based on the sales generated✓. The
manager also gets paid significantly higher in bonuses than the entire division (and
he might still benefit from the divisional pool of bonuses). This may lead to
demotivated and unhappy workforce.
• The fixed bonus pool does not take into account the number of employees (currently
the Masks Division accounts for 35% of the entire factory labour force, and yet the
bonus pool of R2m is the same across the factory)✓.
• The bonus structure only takes into account financial factors – non-financial factors
should also be considered in rewarding the staff.
MAX: 5 marks
(d) Determine the number of masks that the Masks division needs to produce
[10]
in order to meets its operating profit target for the 2021 financial year.
Total fixed costs + target profit (43 367 471✓✓✓ + 18 000 000✓)
✓𝐟
Contribution per unit 0,513✓✓✓✓✓✓
= 119 624 700 units
Contribution per unit:

 Selling price: (83 252 205 ÷ 90 000 000) x 1,12 = 103,6 cents ✓r/w
 Direct materials: (20 875 828 + 4 611 840) ÷ 90m = 28,3 cents ✓ r/w
 Direct labour costs: 14 000 400 ÷ 90m✓ x (25÷18)✓ = 21,6 cents ✓✓
(or 777 800 ÷ 90m✓ = 0,00864 hours per unit x 2 500 cents✓ = 21,6 cents)
 Variable administration & selling costs:
(296 455 – 150 025)✓ ÷ (10,5m – 4,5m)✓ = 2,4 cents
Contribution per unit: 103,6 – 28,3 – 21,6 – 2,4 = 51,3 cents
Total fixed costs:

Fixed overheads [part a]: R32 163 781
Administration and selling costs: R150 025 – (4,5m x 0,024405✓©) = R40 202,50
OR R296 455 – (10,5m x 0,024405) = R40 202,50 (monthly)
Fixed administration and selling costs: 12✓ X 40 202,50 = R482 430
TOTAL: (R32 163 781 x 12÷9✓ + R482 430) = R43 367 471
MAX: 10 marks
[5]
Pharmaceutics Enterprise and its operations.
• The company might be engaging in illegal work with the government entities. The
company cannot be paying the entities✓ (and/or their employees) in order to sell
goods to these entities. This should be investigated to ensure that it is not a bribe of
any sort✓.
• PPE should ensure that the orders in the pipeline are valid and that the necessary
government procurement processes were followed✓.
• The company should have reported the electrical fault immediately✓ (supply of
electricity was considered essential services). Only ESKOM personnel or ESKOM
approved service provider should (re)/connect electricity and it is illegal for anyone
else to make these connections✓. PPE should report the matter and ESKOM must
make appropriate assessment of what might be owed. Electricity costs resulting from 1 mark for
this must be considered and accounted for appropriately for the following years✓. ethical concern
• The company seems to be in contravention of the Basic Conditions of Employment 1 mark for
Act, as it currently pays its labourers R18 per hour, while the minimum wage is consequences
R20.76✓. This may lead to fines and penalties imposed by the Government, and 1 mark for
possible labour unrest and strikes✓. PPE should consider adjusting and backdating appropriate
action
the wages or restructure the benefit package to consolidate all the benefits (e.g.
bonus portions and cafeteria benefits)✓.
• PPE seems to have continued its operations even during the hard lockdown (level
5)✓ and this might have been against the law at that time while exposing its
workforce to COVID-19 (unless considered essential services)✓.
MAX: 5 marks
(f) Prepare a segmented income statement (by product) of Aloetiser
(Pty) Ltd, showing the profit for the year ended 31 March 2021 for [12]
each product, as well as the total for the company.
PRODUCT INCOME STATEMENT

Details – Rands Sanitiser Liquid Total
Sales(A)(2,1mxR3,46)(2,97mxR6,50) ✓✓ 7 266 000 19 305 000 26 571 000
Less: Cost of sales (4 520 997) (10 638 422) (15 159 419)
Opening inventory ✓✓r/w 1 494 491 1 873 109 3 367 600
Plus: joint manufacturing costs✓✓✓✓ 4 579 102 8 305 258 12 884 360
Plus:specific manufacturing costs ✓✓r/w 923 187 3 648 000 4 571 187
Less: Closing inventory ✓✓✓ 2 475 783 3 187 945 5 663 728
Less: Variable selling costs ✓© - (1 485 000) (1 485 000)
Contribution (B) 2 745 003 8 666 578 11 411 581
Less: Fixed manufacturing costs ✓rw (3 261 955)
Less: Fixed selling costs ✓rw (545 364) - (545 364)
Net profit before taxation 2 199 639 8 666 578 7 604 262
Contribution margin ratio (B ÷ A) for part f 0,38 0,45 0,43
 Given
13 682 817 – 875 000 + 76 543 = 12 884 360✓r/w:
Sanitiser: 12 884 360 x 35,54%✓ = R4 579 102;
Liquid: 12 884 360 x 64,46% = R8 305 258
 R1,20 x 3,04m = R3 648 000
 Net realisable value
NET REALISABLE VALUE
Sales (2,75m x R3,46); (3,04m x R6,50) 9 515 000 19 760 000 29 275 000
Less: further processing costs ©✓ (923 187) (3 648 000)  (4 571 187)
Less: Selling costs ✓ rw (545 364) (1 520 000) (2 065 364)
Net realisable value 8 046 449 14 592 000 ✓ 22 638 449
Allocation 35,54% 64,46% 100%
 R0,50 x 3,04m = R1 520 000✓
 Sanitiser: (1 494 491 + 4 579 102 + 923 187) ÷ (500K + 2 750K) x 1 150K
R2 475 783
Liquid: (1 873 109 + 8 305 258 + 3 648 000) ÷ (820K + 3 040K) x 890K
R3 187 945
CLOSING FINISHED GOODS INVENTORY
Details – quantity in litres Sanitiser Liquid Total
Units at the beginning of the year  500 000 820 000 1 320 000
Units produced during the year  2 750 000 3 040 000✓ 5 790 000
Less: Sold units (2 100 000) (2 970 000) (5 070 000)
Units remaining at end of the year  1 150 000 890 000✓© 2 040 000
 Sanitiser: 2 200 000 x 1,25l = 2 750 000✓
MAX: 12 marks
(g) Based on the investment criteria and other factors Phalaborwa
Pharmaceutics Enterprise needs to take into consideration, advise if the [7]
Phalaborwa Pharmaceutics Enterprise should buy Aloetiser (Pty) Ltd.
The contribution margin ratio for aloe vera liquid is 0,45 slightly above the required 0,40 as
the investment criterion and the contribution margin ratio for hand sanitiser is 0,38 (not
meeting the required criterion). Based on these two ratios only, PPE should consider not
buying Aloetiser (Pty) Ltd✓©. These below additional factors may also be considered before
reaching the decision:
• Possible synergistic benefits✓, considering that both companies are in the business
of manufacturing safety and health products currently in high demand due to COVID-
19.
• PPE uses the absorption costing method✓, and the importance of using the
contribution margin ratio as means of evaluating an investment should be carefully
evaluated.
• Alignment and running of operations especially between different provinces✓ (i.e.
Limpopo and Eastern Cape) should be considered carefully, including different
accounting and reporting systems used and PPE’s time in the market.
• The claims made by the owners that the business generated R22m net profit✓ in
the recent financial year raise concerns about the accuracy of the accounting
information provided, as well as the integrity of the owners (sales were only R26m
before taking into account obvious operating costs).
• Claims that the business will grow by 20% in 2022 should be verified✓, especially
by reviewing the performance of the first quarter of 2022.
• Increased global use of hygiene and healthy products may lead to profit growth for
the company✓.
• Owners might be desperate to sell✓, and this can present an opportunity for PPE to
offer a lower purchase price. At the same, this can be a concern if PPE may need
proper handover and post-acquisition support from the owners of Aloetiser.
• It may be difficult to predict how well Aloetiser will do post COVID-19✓ or once the
vaccine has been rolled out successfully. Considerations must also be made
regarding new companies entering this low-barriers-to-entry market.
• There seems to be a small market to sell the by-product✓ (residual aloe vera
leaves), considering that currently there is only one buyer.
• Hand sanitisers at hand cost about R2,99 (R1 494 491 ÷ 500 000) and this might
point to possibly decreasing selling price due to increased supply of these goods✓
in the market.
• Details assessments must be conducted to determine the profitability of further
processing the products✓ instead of selling them off before incurring additional
processing costs.
• Inventory levels seem to be increasing✓, pointing to possible difficulties in moving
the stock.
• Inclination of inventory valuation errors due to multiple valuation methods and
different costing systems✓.
• Consideration of future enforceability of existing contracts✓. For example, the
marketing and selling contract of hand sanitisers is currently negotiated at fixed cost
of R545 364.
MAX: 7 marks
QUESTION 2
(a) Determine the capital structure of Brat Lows Furniture Group at 31

December 2020, based on both the book values and the market values.
[18]
Comment on the movements in capital structure what the Group can do to
move closer to its target capital structure.
MAX: 15 marks on calculations
CAPITAL STRUCTURE BASED ON BOOK VALUES:
2020 2019
Capital structure
(Gearing ratio): 3 230✓𝐫𝐰 3 822✓
3 230 + 2 563✓𝐫𝐰 3 822 + 1 747
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝐵𝑒𝑎𝑟𝑖𝑛𝑔 𝐷𝑒𝑏𝑡 (𝐼𝐵𝐷)
𝐼𝐵𝐷 + 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
= 55,76% = 68,63%
Or expressed as 56%: 44% Or expressed as 69%: 31%
Interest-bearing debt
2020: R1 240m [Da Bank loan] + R400m [Cressida loan] + (R70 x 15m) [pref. shares] +
(R45 x 12m) [debentures] = R3 230m.
2019: R4 105m – R283m = R3 822m.
CAPITAL STRUCTURE BASED ON MARKET VALUES:

2020 2019
Capital structure
(Gearing ratio): 1 228 + 396 + 990 + 551 3 972
✓© ✓©
3 165 + 4 104 3 972 + 4 466
= 43,54% = 47,07%
MARKET VALUES:
INSTRUMENT MARKET VALUE (FINANCIAL CALC.) COST OF LOAN
PV of interest + capital
FV - 1 240 million
PMT - 51,336 million (1 240 million x 7%-1,25%)x0,72 ✓ 𝐾𝑑1 = 4,32%
N 6 (10 years – 4 years: Dec 2020- Jan 2017) ✓
I 4,32% (7%-1% x 0,72)
Da Bank Comp PV 1 228 million (OR 1 228 420 464)
CF0 0
CF1 – 2021 0✓
CF2 – 2022 - 37,44 million (26 million x 0,72 x 2 years)✓ 𝐾𝑑2 = 4,932%
CF3 – 2023 - 418,72 million (400m + 18,72m✓)
I/Y 4,932% (6,85% x 0,72)
Cressida Finance Comp NPV 396 million (OR 396 412 945)
INSTRUMENT MARKET VALUE COST OF PREF.

Preference shares BV: 15 mil x R70 = 1 050 million ✓
Dividend: 1 050 x 7% x 0,8 = 58,8 million Dividend

Preference shares 𝐾𝑝 =
Value of pref
Dividend
𝑀𝑉𝑝𝑟𝑒𝑓. =
Cost of pref.
62,4m✓
𝐾𝑝 =
58,8m 1 050m
𝐾𝑑2 = 5,94%
✓
= 990 million (989 898 990) 𝐾𝑝 = 5,94%
INSTRUMENT MARKET VALUE (FINANCIAL CALC.) COST OF DEBEN
𝐾𝑑3 = 4,50%
CF0 0
CF1 - 25,92 million (36 million x 0,72) ✓
Debentures CF2 - 25,92 million
CF3 - 25,92 million Mark for
CF4 - 565,92 million ([12 mil x R45]✓+ 25,92m) R540m
CF5✓ - 6,48 million (12 mil x R0,75 x 0,72)
I/Y 4,50 (6,25% x 0,72)
Comp NPV 551 million (551 011 674)
INSTRUMENT MARKET VALUE COST OF EQUITY
Ordinary shares MVe: 224,9million × R18,25✓ = R4 104 mil
COMMENTS: MAX: 3 marks

Gearing decreased from 69% to 56% based on book values and from 47% to 43% based
on market values. This may be attributed to the following:
o Fresh issue of ordinary shares (to the tune of R1bn – based on book values) ✓
o Possible repayment of long-term loans (decrease in closing values from R3 822m
to R3 230m) ✓
o The decrease in market value of equity (due to decline in share price) did not have
a significant impact on increasing the gearing, as this was offset by decrease in
long-term loans. ✓
Using market values, the Group is slowly approaching the desired/target capital structure
of 40%:60%.
(b) If Brat Lows Furniture Group has not yet reached its target capital structure,
provide practical ways in which the Group can improve its gearing and [5]
move towards its target capital structure.
• The Group can formulate a turnaround strategy✓ to return to profitability, and then
increase retained income, effectively increasing the equity of the business (cost-
cutting, revenue increase, market increase, aggressive marketing campaign, etc.).
• The Group can sell unprofitable stores, non-core assets✓ (of the R2,150bn base)
and/or reduce levels of inventory (by not restocking) and use any excess cash on
hand and proceeds from the sale of the assets above to repay existing debt.
• Brat Lows Furniture Group can consider fresh issue of shares to the public✓.
• The Group can approach the existing providers of long-term capital (preference
shares, debentures and loans) for possible restructuring of the existing facilities✓
(on interest rates, conversion to ordinary shares, capital reduction, debt
consolidation).
• Brat Lows Furniture Group can early repay the existing facilities✓, and take on new
facilities, especially where the market interest rates are lower than what the Group
is currently being charged (market rate for debentures is 6,25% but currently paying
6,67%).
• Once the Group resumes dividend payment, these could be done in the form of a
scrip dividend✓, therefore using the saved cash to repay debt, while increasing the
share capital.
• The Group can improve its capital structure by funding more of its current assets by
current liabilities✓ (increasing trade payables which are likely to be interest-free, and
the Group currently has good relations with its suppliers). The resulting excess cash
can then be used to reduce long-term debts. The Group can also consider delaying
payments to its suppliers (increase trade payable days) within reasonable
timeframes.
• Increase the proportion of cash sales✓ and subsequently utilise the resulting cash
proceeds for immediate/bullet debt reduction.
• The Group can also utilise cash on hand to reduce its debt✓.
MAX: 5 marks
(c) Discuss factors you would have considered before taking part in the
Group’s issue of additional ordinary shares during the year, if you were one [8]
of the Group’s shareholders.
▪ How does this proposed issue affect my percentage holding in Brat Lows Furniture
Group? Am I likely to lose control or significant influence✓ if I do not exercise the
option to buy more shares?
▪ Do I have the required funds (availability) ✓ to further invest in the business, and
how will this additional investment affect the diversification of my investment
portfolio?
▪ Do I have the appetite for additional risk in the equity market? ✓ What are my other
investment alternatives and how much return do they offer? How have the other
comparable companies in this sector fared?
▪ What are the prospects of the entire industry and is it the industry one would like to
invest in?
▪ The shares have been discounted to R20 – how has the share performed✓ in the
past and am I likely to make substantial profit at the additional purchase of the
shares?
▪ How confident am I in the business and the managers that they will be able to turn
the business around? ✓ Am I likely to see an increase in the value of the shares?
▪ The Group has recently suspended its dividend – is this likely to continue?✓ How
has the Group enforced its dividend policy in the past?
▪ What has been my historical return✓ on this share (based on the dividend yield as
well as the share price growth)? Have I also lost patience and confidence that things
will get better?
▪ How has the business been impacted by COVID-19✓ and is it likely to survive in the
post-COVID era? Are there any new markets the business can go into?
▪ Is the business likely to continue as a going concern? What are the company’s future
growth prospects?
▪ Is this the best time to buy the share✓ – probably at lowest levels?
▪ Have I considered the tax effect✓ of buying at R20, and tax on dividends to be
declared in the future? Am I a speculative investor or a long-term investor, and what
is the tax implication on each of the options?
▪ Are there any measures I can put in place to limit or mitigate✓ against the risk
associated with this investment (e.g. use of derivatives)?
MAX: 8 marks
December 2020 and based on the information and nature of industry, [9]
advise on some practical ways to improve the cash conversion cycle.
CASH CONVERSION CYCLE:
2020
Trade receivable days: DAYS
2 956
𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
x 366
(2 882✓©+2 068✓)
x 366
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
218
2 956
x 366
4 950
Credit sales (x): x + 0,25x = 3602

x = R2 882m✓rw
2020
Trade payable days: DAYS
874
𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
x 366
1 401
x 366
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
228✓r/w
2020
Inventory days: DAYS
844
x 366
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 1 666
x 366
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
185✓r/w
DAYS
CASH CONVERSION CYCLE
(218+185-228) ✓© 175
ADVICE: MAX: 3 marks (one mark per each class of working capital)
When improving the cash conversion cycle, a company attempts to collect from its debtors
sooner; convert its inventory sooner; and delay payment to its creditors. By so doing a
company reduces the number of business days (operating or cash conversion cycle).
Trade receivable days: ✓

Based on the calculations above, the Group collects from its debtors over a period of 218
days on average (just over 7 months). The Group can then consider providing incentives to
debtors who pay within, say 6 months (e.g. interest-free for the first 6 months). The Group
can also consider putting stringent policies on granting of credit, especially during the
recession. This will not only improve the Group’s liquidity but there is likely to be a decrease
in bad debt, debt management costs and impairment expenses. Furthermore, the company
could reduce the cash sales: credit sales proportion by increasing the cash sales
component.
Trade payable days: ✓

The terms are already quite generous, and to ensure continued good relations with suppliers
the Group should not consider delaying payments to suppliers (whose period is already
longer than debtors’ days). However, the Group can consider negotiating the prices with the
suppliers, especially where payment is made sooner.
Inventory days: ✓
The furniture and electric appliances remain on the floor for about six months. The Group
runs the risk of stock being “outdated”, especially electric appliances. The entry of small
boutiques with more trendy furniture will also lead to difficulties in selling the furniture. The
Group should consider reducing the amount of stock that is kept on hand (this will also lead
to decrease in holding costs). The Group could also take orders from customers before the
goods are sourced from suppliers, which based on good relations they maintain, are likely
to deliver within reasonable timeframe.
MAX: 9 marks
[5]
structure the business to return to profitability.
The Group can consider the following strategies: MAX: 5 marks
o Establish an online sales platform✓ to reach a broader market (locally and
internationally), especially during the lockdown.
o Develop and execute social media marketing campaigns✓ and advertise via social
media “influencers”.
o Shut down unprofitable stores✓ and sell assets from these operations or move to
profitable stores.
o Reduce the percentage of credit sales✓ as a percentage of total sales and put
stringent controls in place to ensure creditworthiness of the potential customers.
o Add free after-sales services✓ (free delivery, assembly or minor items).
o Buy struggling and desperate furniture retailers and/small boutiques✓ which are
likely to bring more synergies to the business. Explore other markets to expand to.
o Renegotiate✓ prices with suppliers (consider free delivery) and lower interest rates
with long-term capital providers.
o Review product profitability✓ and adjust to ensure focus is on more profitable
products. Electrical appliances are likely to be sourced outside the country – and the
weakening rand may lead to lower profit margins or less sales.
o Keep inventory levels✓ low and buy items after they have been ordered by the
customers. Consider effective leadership to be put in place.
o Partner with property development companies✓ to build and sell fully furnished
properties.
o Consider supplying school furniture✓ via engagement with the Department of
Education.
lOMoARcPSD|8336999
COST‐VOLUME‐PROFIT ANALYSIS ‐ FORMULAE

1. Required selling price (i.e. sales price required to earn a predetermined profit)

The formula that you choose to use out of the following three (3) provided below will depend on the
information which you have been given to work with.

a. Total Sales – Total Variable Cost – Total Fixed Cost = Net Profit (before tax)
Re‐arrange this equation to give you:
Total Sales = Net profit (before tax) + Total Fixed Cost + Total Variable Cost
Therefore;
Sales per unit = Total Sales / No. units sold

OR

b. Total Sales – Total Variable Cost = Total Contribution Margin
Re‐arrange this equation to give you:
Total Sales = Total CM + Total VC
Therefore;
Sales per unit = Total Sales / No. units sold

c. Sales per unit = Contribution Margin per unit + Variable cost per unit

2. Break‐even sales (UNITS)

BEP (units) = Total Fixed Cost / Contribution Margin per unit

Contribution Margin per unit = Sales per unit – Variable Cost per unit

3. Break‐even sales ($)

BEP ($) = Total Fixed Cost / Contribution Margin Ratio

Contribution Margin ratio = Contribution Margin per unit / Sales per unit

Where; BEP = Break‐even point

4. Units sales required to earn target profit ($)

Target sales (units) = Total Fixed Cost + Target Net Profit (before tax) / CM per unit

Where; CM = Contribution Margin

5a. To include income taxes in the cost‐volume‐profit model you have to convert a before‐tax profit
into an after‐tax profit:
After‐tax profit = Before‐tax profit x (1 – Tax rate)

5b. To exclude income taxes from the cost‐volume‐profit model you have to convert an after‐tax
profit into a before‐tax profit (which will then enable you to use formula (4) above).
Before‐tax profit = After‐tax profit / (1 – Tax rate)

6. Margin of safety

= Projected or actual sales (units) ‐ Break‐even sales (units)

7. Margin of safety ratio (%)

= Margin of safety (units) / Projected or actual sales (units)
1
lOMoARcPSD|8336999
Ratio Analysis
Liquidity Ratios
Current Ratio = (Current Assets/Current Liabilities)
Quick Ratio (Acid Test) = (Current Assets - Inventory)/Current Liabilities
Asset Management Ratios

Inventory Turnover* = (Cost of Goods Sold/Inventory)
Days Sales Outstanding = (Accounts Receivable)/(Sales/365))
Fixed Assets Turnover** = (Sales/Net Fixed Assets)
Total Assets Turnover = (Sales/Total Assets)
Debt Management Ratios

Total Debt to Total Assets = (Liabilities/Assets)
Times Interest Earned = (EBIT***/Interest)
Cash Coverage Ratio = (EBIT + Depreciation)/Interest
Profitability Ratios
Gross Profit Margin = (Sales – Cost of Goods Sold)/Sales
Operating Profit Margin = (Operating Income/Sales)
Net Profit Margin = (Net Income/Sales)
Return on Assets = (Net Income/Assets)
Return on Equity = (Net Income/Common Equity****)
Market Values
Price/Earnings Ratio = (Market Price/Earnings Per Share)
Market/Book Ratio = (Market Price/Book Value)
Dividend Yield = (Dividends per Share/Market Price)
---------------------------------------------------------------------------------------
*Some analysts calculate the Inventory Turnover Ratio as Sales//Inventory
**Net Fixed Assets typically refers to Net Property, Plant and Equipment. If Property,
Plant and Equipment is not specifically identified on the balance sheet, just use
long-term assets.
***EBIT stands for Earnings Before Interest and Taxes (sometimes referred to as
operating income).
****Common Equity is also referred to as Owner’s Equity or Stockholders Equity
Earnings per share = Net Income/Shares Outstanding

Book Value = Owner’s Equity/Shares Outstanding
lOMoARcPSD|8336999
lOMoARcPSD|8336999
lOMoARcPSD|8336999
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lOMoARcPSD|8336999
Ratio Summary
Type Ratio Formula Significance
Liquidity Ratios
Working Capital Current Assets 3 Current Liabilities Amount of current assets left
over after paying liabilities
Current ratio Current Assets Test of debt-paying ability 3

Current Liabilities how much do we have
available for every $1 of
liabilities.
Acid-test (quick) Ratio Quick Assets (Cash + Marketable Test of immediate debt-
Securities + net receivables) paying ability 3 how much
Current Liabilities cash do we have available
immediately to pay debt
Cash flow liquidity ratio (Cash + Marketable securities + Test of short-term, debt
Cash flow from operating activities) paying ability
Current Liabilities
Accounts Receivable Net credit sales (or net sales) Test of quality of accounts
Turnover Average Accounts Receivable receivable 3 how many times
have we collected avg accts
**Avg Accounts Receivable is calculated as receivable
(beg. or last year9s accounts receivable +
current year end Accounts receivable) / 2
Days Sales Uncollected Accts Receivable, Net x 365 days How many days it takes to
Net Sales collect on accounts receivable
**Accts Receivable, Net means Accounts

Receivable 3 Allowance for doubtful or
uncollectible accounts.
Inventory Turnover Cost of Goods Sold Test of management

Average Inventory efficiency 3 how many times
we have sold avg. inventory
**Avg Inventory is calculated as (beg. or last
year9s inventory + current year end
inventory) / 2
Days Sales in Inventory Ending Inventory x 365 days How many days it takes to sell
Cost of Goods Sold inventory
Total Asset Turnover Net Sales How many times we have

Average Total Assets been able to sell the amount
equal to avg total assets.
**Avg Total Assets is calculated as (beg. or Tests whether the volume of
last year9s total assets + current year end business is adequate.
total assets) / 2
Equity (or Solvency) Ratios

Debt Ratio Total Liabilities How much we owe in
Total Assets liabilities for every $1 in
assets.
Adapted from <Accounting Principles: A Business Perspective, Financial Accounting (Chapters 9 3 18)= A Textbook Equity Open
College Textbook originally by Hermanson, Edwards, and Maher
lOMoARcPSD|8336999
Equity (or Stockholder9s Total Equity How much equity we have for
Equity) Ratio Total Assets every $1 in assets.
Debt to Equity Ratio Total Liabilities How much we owe in

Total Equity liabilities for every $1 of
equity.
Stockholder9s Equity to Total Equity How much equity we have to
Debt Ratio Total Liabilities cover $1 in liabilities.
Profitability Ratios
Profit Margin Ratio Net Income How much NET income we
Net Sales generate from every dollar of
sales.
Gross Margin Ratio Net sales 3 Cost of goods sold How much gross profit is
Net Sales earned on every dollar of
sales (also known as markup)
Return on total assets Net Income How many times we have

Average Total Assets earned back average total
assets from net income.
**Avg Total Assets is calculated as (beg. or
last year9s total assets + current year end
total assets) / 2
Return on common Net Income 3 Preferred dividends How much net income was
stockholder9s equity Average common stockholder9s generated from every dollar of
equity common stock invested.
Basic Earnings per Share Net Income 3 Preferred Dividends How much net income
(EPS) Weighted Avg common shares generate on every share of
outstanding common stock
Market Prospects
Price-earnings ratio Market price per common share How much the market price is
Earnings per share for every dollar of earnings
per share
Dividend yield Annual cash dividends per share How much dividends you
Market price per share receive based on every dollar
of market price per share.
Adapted from <Accounting Principles: A Business Perspective, Financial Accounting (Chapters 9 3 18)= A Textbook Equity Open
College Textbook originally by Hermanson, Edwards, and Maher
lOMoARcPSD|8336999
HMS 1
FORMULA SHEET – MAC2602
QUESTION 1 - TIME VALUE OF MONEY (TVM)
1. SIMPLE INTERST: I=PxRxT ³ I = simple interest, P = principal, R = interest rate and T = time
2. COMPOUND INTERST: I = P(1+i) ³ I = compound interest, P = principal and i = interest rate
3. FUTURE VALUE (SINGLE PAYMENT – 1 PERIOD): FV = PV(1 + i) ³ FV = future value, PV = present value, i = interest rate
n
4. FUTURE VALUE (SINGLE PAYMENT – MULTIPLE PERIODS): FV = PV(1 + i) ³ FV = future value, PV = present
value, i = interest rate and n = Number of years/periods
5. FUTURE VALUE (ORDINARY ANNUITY): ³ I = Annuity amount or payment, i = Interest rate, n =

Number of years or periods
11. PERIODIC RATE:
6. FUTURE VALUE (ANNUITY DUE):
12. EFFECTIVE INTEREST RATE
7. PRESENT VALUE (SINGLE PAYMENT):
13. NOMINAL RATE
8. PRESENT VALUE (ORDINARY ANNUITY):
14. INTERPOLATION
9. PRESENT VALUE (PERPETUITY):

15. EXTRAPOLATION
10. PRESENT VALUE (ANNUITY DUE):

16. PERIODIC PAYMENT (PMT)
lOMoARcPSD|8336999
HMS 2
QUESTION 2 – CAPITAL STRUCTURE AND COST OF CAPITAL
1. DEBT:EQUITY RATIO (D:E) (SIMPLIFIED)
2. DIVIDEND GROWTH MODEL (To determine the market value of the share)
where P0 = current market price of the share (current value of the share) at point 0 in time
D0 = current dividend (or earnings per share x payout ratio)
D1 = D0 x (1 + g) = the expected dividend per share for year 1 (after growth)
ke = the required rate of return (market discount rate or cost of ordinary equity/shares)
g = expected CONSTANT growth rate in earnings (and assuming a constant payout ratio,
therefore in dividends as well)
3. REQUIRED RATE OF RETURN
4. Capital Asset Pricing Model (CAPM)

Rf = risk-free rate
Rm = the market return (for all shares)
(Rm – Rf) = market risk premium
³ = the share’s beta coeffi cient, which measures the share’s
relative risk (return volatility)
5. WEIGHTED AVERAGE COST OF CAPITAL (MARKET VALUES)
a. Formula
ke = equity-holders’ current required rate of return (cost of equity)
kd = debt-holders’ current required rate of return (cost of debt after tax)
ve = market value of equity (weighting for ke )
vd = market value of debt (weighting for kd )
b. Table format
lOMoARcPSD|8336999
HMS 3
QUESTION 3 – ANALYSIS IF FINANCIAL INFORMATION AND WORKING CAPITAL MANAGEMENT
GROWTH RATE
1. Profitability and performance

PROFIT MARGINS PERFORMANCE RATIOS
Gross profit Operating profit Net profit margin Return of equity Return on assets Asset turnover
margin margin (ROE) (ROA)
Operating
x Net profit x Net profit x EBIT Revenue
Gross profit x profit x 100 x 100
100 Revenue 100 Equity 100 Total assets Total assets
Revenue 100 Revenue
2. Liquidity
Current ratio Current assets:Current liabilities
Current assets less inventory:Current liabilities
Liquid asset ratio (or acid test or quick ratio)
Receivable days (debtors’ collection period)
Payable days (creditors’ payment period)
Inventory days
Inventory turnover ratio (times)
Receivable days + Inventory days - Payable days

Cash conversion cycle – days
Cash ratio
3. Solvency and financial/capital structure

Interest cover ratio
Debt to equity ratio Long-term interest bearing debt (including its current portion):Equity
Debt ratio (or gearing)
Total assets to total debt ratio
Financial leverage ROE:ROA Return on equity (ROE):Return on assets (ROA)
4. Financial market
Earnings per share
Dividend payout ratio
Dividend cover ratio
Price earnings ratio
Earnings yield
Dividend yield
lOMoARcPSD|8336999
HMS 4
QUESTION 4 – CAPITAL INVESTMENT AND CAPITAL BUDGETING
1. PAYBACK PERIOD
Years before break-even year = number of years that the cumulative cash outlay is still negative
Remaining cost to cover = capital outlay (investment) less cash recovered in years before the break-even year or cumulative negative cash outlay at
the start of the breakeven year
Cash flow during the break-even year = cash flow during the year in which break-even takes place
Cash flows = operational cash flows AFTER tax
2. ACCOUNTING RATE OF RETURN (ARR)
Average net profit after taxation = the average annual profit after taxation for the whole period (life of the project/asset)
Average investment = the average of the original investment cost (outlay) and any residual value at the end of its useful life (usually Rnil). (This is
equal to the cost of the investment ÷ 2 if depreciation is levied on the straight-line basis!)
3. NET PRESENT VALUE (NPV)

n = number of periods (life of the project)
t = specific period
k = discount rate (= WACC ± risk adjustment, if any)
Ct = net cash flow for period t
I = initial capital investment at period 0 (note, this is not a figure “1”, but “I” for “Investment”)
4. INTERNAL RATE OF RETURN (IRR)
r = internal rate of return

n = number of periods (life of the project)
t = specific period
Ct= net cash flow for period t
I = capital investment at period 0
5. PROFITABILITY INDEX
June 2021
MAC3761
100 Marks
Duration 3 Hours
This paper consists of 12 pages (including this page).
Instructions:
1. This assessment consists of two independent questions.
2. All questions must be answered, and all calculations must be shown.
3. For hand-written answer files, you must not write with a pencil or a red pen. Only use a
black pen.
4. You can only upload a PDF document on myUnisa as your answer file.
5. It is your responsibility that once uploaded, you must view your answer file and ensure that
it is correct, complete (no missing pages), legible, it can open, not of poor image quality, not
password protected, and not corrupted.
6. Your attention is brought to the announcement posted on MAC3761 myUnisa site titled
“Cheating in MAC3761 assessments”, as well as the plagiarism declaration in the TL101.
PROPOSED TIMETABLE Marks Minutes
Question 1: Overhead allocation; Cost-volume-profit (CVP) analysis;

55 99
Joint and by-product costing; Ethics; and Discussion.
Question 2: Capital structure and cost of capital; Sources and forms of
45 81
finance; Working capital and Discussion.
Converting your answers to a PDF file and successfully uploading your
one PDF file. You must successfully upload your PDF file on myUnisa
before 12:45 South African time, 21 June 2021. The submission platform 60
will automatically close at 13:00 (21 June 2021, South African time) and
no submission can be made henceforth.
100 240
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June 2021
Phalaborwa Pharmaceutics Enterprise (“PPE”) is a medium-sized company founded in 2020

in the wake of the COVID-19 outbreak. The company started operating on 1 April 2020. PPE
specialises in the production of masks, gloves, safety goggles, safety shoes and protective
gowns. These five products are produced from its 6 840m2 rented factory compound, 15
kilometres outside Phalaborwa city centre. The factory has five divisions from which each of
the company’s five products have a production line that is separate and distinct from one other,
except for shared services which include material receiving, warehousing, water and
electricity. The company’s Head Office, located in the city centre, is responsible for
administration, financing, shared services and marketing functions of the business. PPE uses
the absorption costing system and accounts for inventory using the first-in-first-out (FIFO)
method.
PPE has been quite successful in capturing interest and preference of doing business with
several strategic government entities and has invested significantly in promoting its business
to these entities. Monthly monetary payments made by the company to these entities and their
managers together with free samples have helped to promote the company brand. The
company already has orders in the pipeline to supply its products from the five divisions to
different government entities.
Each production line (hereafter referred to “division”) is headed by a divisional manager who
is responsible for all the operational decisions of the division, provided that these decisions
are in the best interest of the company as a whole. To ensure that this is realised, the executive
management requires each division to report a gross profit margin and net profit before tax of
at least 12,75% and R8,5 million, respectively for the 2020 financial year (allocated fixed
factory overheads in Schedule A below are taken into account when determining the division’s
gross profit margin and net profit before tax). If these targets are met, then the divisional
manager is entitled to 0,2% of total sales of their division as a bonus, and their respective
division is to receive a fixed bonus of R2 million for the relevant reporting period, to be shared
among the division’s employees.
The company’s first year of operation was uneventful, except for a minor electricity supply
fault. This led to the water and electricity bill for April being slightly lower than average as a
result of the electricity meter not working for some days. It is said that the incident could not
be reported on time as this happened during level 5 of the lockdown and one of the
experienced electricians on site was able to ensure that the electricity supply was not
disrupted.
A. FACTORY OVERHEADS SCHEDULE FOR THE 2020 FINANCIAL YEAR (PPE)
1. The company’s factory overheads have not been allocated. They are allocated to the five
divisions as per below activities:
Factory overhead items Activity 2020 Actual

notes
Depreciation and machine service costs (i) R36 125 500
Rent, rates, water, and electricity (ii) R18 766 438
Safety and wellness costs (iii) R5 037 442
Ordering and material handling costs (iv) R1 238 546
Cafeteria, development, and teambuilding costs (v) R840 750
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(i) The divisions recorded a total of 7 890 000 machine hours of which 2 827 000 relate
to the Masks Division.
(ii) The Masks Division occupies and utilises 2 022m2 of the company’s total factory floor
space.
(iii) Safety and wellness costs relate to health and safety activities. For the period ending
31 December 2020, the company clocked a total of 1 247 hours on health and safety
activities. The Masks Division logged 30,72 property maintenance days for the 2020
financial year. Each daily shift consists of 12 hours.
(iv) 23 cents of each rand incurred in ordering and handling materials is attributed to the
Masks Division.
(v) The Masks Division had 214 staff throughout the 2020 financial year. The company’s
total staff complement of the 2020 financial year is expected to increase by 17% to 702
for the 2021 financial year.
2. The above factory overheads do not include the divisions’ specific fixed overheads and
the Head Office’s allocated fixed overheads. These are always reflected separately in the
divisions’ respective management accounts.
B. MASKS DIVISION’S 2020 PERFORMANCE AND FORECAST FOR 2021
Baba Ndou, the business manager of the Masks Division, has presented the actual
management accounts below as recorded and reported in his division to the executive
management of PPE. He is confident that his division will meet the new target of R18 million
in operating profit set for the full 2021 financial year, leading to his division qualifying for
bonuses. The extract from the Masks Division’s actual management accounts and its notes
and additional information for the 9 months ended 31 December 2020 are presented below in
Schedules C and D:
C. MASKS DIVISION – MANAGEMENT ACCOUNTS FOR THE 2020 FINANCIAL YEAR

AND ADDITIONAL INFORMATION FOR THE 2021 FINANCIAL YEAR
Details Note 2020 Actual
Sales 1 R83 252 205
Direct material purchases 2 R20 875 828
Other direct material transfer from Safety Shoes Division 3 R4 611 840
Direct labour costs 4 R14 000 400
Indirect labour costs 5 R9 470 000
Head office allocated administrative overheads 6 R2 128 423
Total administration and selling costs 7 R1 886 600
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D. NOTES AND ADDITIONAL INFORMATION
1. For the 9-month period ending 31 December 2020, the Masks Division produced and sold
a total of ninety million masks. The unit selling price is expected to increase by 12% for
the 2021 financial year as the company expects increase in global demand of masks.
2. All direct material purchased were issued to production.
3. This material relates to straps bought from the Safety Shoes Division (which already
manufactures straps and laces for the shoes manufactured by the division). These straps
are then used as ear loops for the masks. There were no straps on hand at the end of the
2020 financial year.
4. For the 2020 period, the Masks Division labourers were remunerated at an hourly rate of
R18, just slightly below the national minimum wage gazetted of R20,76 due to the fact that
the company is fairly new and had to invest heavily in the plant at the beginning of the
year. For 2021, PPE plans to increase this to R25 per labourer, per hour.
5. Indirect labour costs relate to fixed salaries of supervisors and foreman who are working
on the factory floor to make sure that production processes run accordingly.
6. These costs are determined by the Head Office and although they are correctly allocated
to the divisions of PPE, they bear no direct relationship with the underlying products’
volume.
7. Lowest number of masks sold was recorded in April due to poor advertising campaign, but
the month of September saw the highest number of units sold (probably as the government
relaxed the lockdown restrictions). There were 4,5 million masks sold in April and 10,5
million masks sold in September. Total administration and selling costs were R150 025
and R296 455 for April and September, respectively. Both the unit variable costs and total
fixed costs for the 2021 financial year will remain as that of the 2020 financial year.
8. There are no expected changes in material costs and overheads for the 2021 financial
year, except for any changes evident above.
9. Unless indicated otherwise, assume all income and expenses are incurred evenly
throughout the reporting period.
E. ACQUISITION OF ALOETISER (PTY) LTD
PPE has started exploring ways of diversifying its business for the purpose of long-term
viability, especially in the post-Covid19 era. PPE has embarked on discussions with Aloetiser
(Pty) Ltd (“Aloetiser”) for a possible acquisition of Aloetiser’s operations. The owners of
Aloetiser are emigrating to Canada soon and are desperately in need of a buyer to take over
their entire Gqeberha-based operations in the Eastern Cape. For the year ended 31 March
2021, the owners of Aloetiser claimed to have made an actual net profit of R22m. The
projections are that this reported net profit will likely increase by 20% for the 2022 financial
year. Aloetiser uses a direct costing system and accounts for inventory using the weighted
average method. As part of PPE’s investment strategy, PPE will consider buying Aloetiser’s
operations if Aloetiser has for the recent financial period, reported a contribution margin ratio
of 0,4 for each product.
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June 2021
Aloetiser uses aloe vera leaves bought from local farmers and then put these through the
production process, where a gel is squeezed from the leaves to generate aloe vera gel. This
aloe vera gel is then further processed to make hand sanitisers after alcohol and other
ingredients have been added. The squeezed aloe vera leaves are boiled and sifted through
during the process to produce aloe vera liquid. This aloe vera liquid, after adding some
chemicals, is then sold to cosmetics manufacturers which use it to make facial and other skin
products. The residual aloe vera leaves left after these processes are then scrapped and sold
to Left Aloe Limited, the only pharmaceutical company which uses it in the manufacturing of a
special medicine. The following has been extracted from the production cost schedule of
Aloetiser (Pty) Ltd for the year ended 31 March 2021:
1. PRODUCTION COSTS SCHEDULE EXTRACT FOR THE 2021 FINANCIAL YEAR:

Details Note R
Inventory: 01 April 2020 – hand sanitisers 2.1 1 494 491
Inventory: 01 April 2020 – aloe vera liquid 2.1 1 873 109
Variable manufacturing costs 2.2 13 682 817
Fixed manufacturing overheads 2.3 3 261 955
Alcohol and other ingredient costs – hand sanitisers 2.4 923 187
Chemical processing costs – aloe vera liquid (per litre) 2.5 1,20
Disposal costs – residual aloe vera leaves 2.6 76 543

2.1. Inventory on hand (both opening and closing) relates to completed units of hand
sanitisers and aloe vera liquid. There were 500 kilolitres of hand sanitisers and 820
kilolitres of aloe vera liquid. There was no residual aloe vera leaves on hand on 31 March
2021.
2.2. These manufacturing costs relate to the joint manufacturing process of extracting the
aloe vera gel and of boiling the aloe vera leaves. These costs are allocated to hand
sanitisers and aloe vera liquid based on the net realisable values of the products. There
were 2,2 million litres of aloe vera gel (for making hand sanitisers – further refer to 2.4
below) and 3,04 million litres of aloe vera liquid produced during the 2021 financial year.
2.3. These overheads are not incurred within the joint manufacturing process and are also
not allocated to products.
2.4. For each litre of aloe vera gel, 250 millilitres of alcohol and other ingredients are added
to make the complete hand sanitiser. There are no volume losses in the process.
2.5. Chemicals added in processing the aloe vera liquid do not materially increase the
quantity and there are no known volume losses in the process.
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2.6. The sales for the 2021 financial year were made as follows:
a. 2,1 million litres of hand sanitisers were sold at R3,46 per litre and it cost Aloetiser
R545 364 to market and sell these hand sanitisers to different retail stores. This
amount, as per the contract, has been fixed for the past three years.
b. 2,97 million litres of aloe vera liquid was sold to cosmetics manufacturers at R6,50
per litre. The company makes use of agencies who are paid a commission
equivalent to R0,50 per each litre sold.
c. Residual aloe vera leaves were sold to Left Aloe Limited for R875 000.
2.7. There were no raw materials, alcohol and other ingredients, chemicals, and work in
progress on hand both at the beginning and at the end of the financial year.
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REQUIRED

value);
• Ignore time value of money and all taxation implications.
(a) Calculate the actual total overheads attributed to the Masks Division for the 9-
▪ Round final answers to the nearest Rand. (8)
(b) Determine and conclude whether Baba Ndou and his Masks Division are
entitled to bonuses (and how much, if any) for the period ended 31 December
2020. Show all workings. (8)
(c) Critically evaluate the overall employee remuneration structure of Phalaborwa
Pharmaceutics Enterprise. (5)
(d) Determine the projected number of masks that the Masks Division needs to
produce and sell in order to meet its operating profit target for the 2021 financial
year. (10)
Pharmaceutics Enterprise and its operations. (5)
(f) Prepare a segmented actual statement of profit of loss (income statement) (by
product) of Aloetiser (Pty) Ltd, showing the profit for the year ended 31 March
2021 for each product, as well as the total for the company. (12)
(g) Based on the investment criteria and other factors that Phalaborwa
Pharmaceutics Enterprise needs to take into consideration, advise if the
Phalaborwa Pharmaceutics Enterprise should buy Aloetiser (Pty) Ltd. (7)
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MAC3761
June 2021

Listed on the Johannesburg Stock Exchange (JSE), Brat Lows Furniture Group (“BLF” or
“Group”) is a leading retailer of household furniture and electrical appliances in Southern
Africa. As at the end of 31 December 2020, its latest financial year end, BLF had 8 248
permanent staff members in its employ, following a year-to-year decline of 4% in its workforce
owing to the outbreak of COVID-19 pandemic which led to retrenchments and restructuring of
the Group. The Group also boasts of a portfolio of stores in Botswana, Lesotho, Namibia and
Eswatini.
The trading environment has been challenging for the furniture industry, especially following
the hard lockdown which saw furniture stores close for weeks countrywide and customers
across the board losing their employment. The Group had to impair its debtors book and
recapitalise its balance sheet by the fresh issue of ordinary shares to ensure continuity during
these turbulent times. Its peers have also struggled to keep their businesses afloat and many
furniture retailers had to shut down permanently.
The diversified portfolio (in terms of location, cash vs. credit customers and product range) did
help BLF weather the financial storm and its management is hopeful that 2021 will be a
profitable year. However, some investors are losing patience with the restructuring process of
the Group as the recent performance had led to suspension of dividends and decline in the
share price. Presented below are the summarised financial statements for BLF for the year
ended 31 December 2020.
A. The financial statements, together with other key information relating to Brat Lows
Furniture Group, are first presented below:
1. STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 2020
Rm Notes 2020 2019

Revenue 5 670 6 453
Merchandise sales 4.1 3 602 4 475
Insurance and interest income 4.2 2 068 1 978
Cost of merchandise sales 4.1 (1 666) (2 174)
Opening inventory 796 812
Purchases 1 401 1 963
Cash carriage costs 313 195
Closing inventory (844) (796)
Operating costs 4.3 (4 107) (3 822)
Profit/(loss) before finance income and costs (103) 457
Finance income 43 64
Finance costs 4.4 (209) (248)
Profit/(loss) before taxation (269) 273
Taxation 79 (90)
Net profit/(loss) for the year (190) 183
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2. STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 2020
Rm Notes 2020 2019

ASSETS
Non-current assets
Property, plant and equipment and right-of-use asset 1 232 1 018
Goodwill and intangible assets 297 308
Financial assets – insurance investments 621 503
Total non-current assets 2 150 1 829
Current assets
Inventory and financial assets 1 097 1 042
Trade and other receivables 2 956 3 326
Cash-on-hand and deposits 1 970 1 193

Capital and reserves
Ordinary share capital 4.5 1 458 458
Retained earnings 1 042 1 232
Other reserves 63 57
Total shareholders’ equity 2 563 1 747
Non-current liabilities 4.4 3 498 4 105

Current liabilities
Payments in advance 583 148
Short-term borrowings 4.4 655 442
Total current liabilities 2 112 1 538
3. OTHER SALIENT INFORMATION
2020 2019
Target capital structure – Debt: Equity (market values) 40:60 40:60
Prime lending rate (closing %) 7,0 10,0
ZAR: 1 US dollar (average) 17,84 14,45
ZAR: 1 US dollar (closing) 14,93 14,40
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4.1. This relates to sale of furniture and electrical appliances both to cash customers and credit
customers. The value of cash sales is approximately 25% of the value of credit sales. The
Group’s purchases from the manufacturers are mainly on credit, and the Group continues
to maintain good relations with its suppliers.
4.2. The Group also provides credit life insurance cover to credit customers. Interest income
is derived from instalment sales and overdue accounts.
4.3. Operating costs include debtor costs of R2,257 billion for the current year (2019: R1,255
billion). The debtor costs are made up of trade bad debts written off, debt management
costs and debt impairments.
4.4. Finance costs relate mainly to the following long-term interest-bearing liabilities:
i. A 10-year loan facility received from Da Bank on 5 January 2017. This loan of R1,24 billion
currently incurs an interest rate of prime less 125 basis points per annum. Interest is
payable annually in arrears. Similar facilities bear an annual interest at prime less 100
basis points.
ii. Medium-term loan of R400m from Cressida Finance which is repayable fully on 20
December 2023. Fixed interest of R26 million is payable annually in arrears. BLF had
applied to Cressida Finance’s COVID relief fund to postpone its 20 December 2020
interest payment. However, the approval only came after the payment was made.
Cressida Finance has now agreed to postpone the 20 December 2021 interest amount to
20 December 2022. All other future payments are scheduled to be repaid as initially
planned. There is no additional interest on postponed payments. Market related interest
rate on similar term loans is 6,85% per annum.
iii. Fifteen million preference shares were issued two years ago at R70 per share. Preference
share dividends are payable annually in arrears at 80% of prime rate. Currently for the
same value of preference shares in the market, BLF would be expected to pay R62,4
million as an annual dividend.
iv. Twelve million debentures were issued at R45 each and are redeemable in four years’
time. However, there is a once-off premium of R0,75 per debenture payable one year
after redemption. Annual interest on these debentures is R36 million and is payable
annually in arrears. Similar debentures are trading at 6,25% per annum.
v. Other non-current liabilities (non-interest bearing) were recorded at R268 million for the
year ended 31 December 2020 (2019: R283 million).
vi. The market value of long-term interest-bearing facilities on 31 December 2019 was
R3,972 billion. The market value of equity on 31 December 2019 was R4,466 billion.
vii. The balance of finance costs relates to short-term borrowing costs.
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4.5. BLF issued additional shares to its existing shareholders during the 2020 financial
year in an effort to strengthen its balance sheet and decrease its gearing levels. These
shares were issued at a discounted price of R20 per share, bringing the total number
of ordinary shares issued to 224,9 million. This was the only movement in ordinary
share capital during the 2020 financial year. The market price subsequently
plummeted to R18,25 per share by the end of the 2020 financial year.
4.6. There were 366 days in 2020 (2019: 365) and the South African corporate tax rate
has remained unchanged at 28%.
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June 2021
QUESTION 2
REQUIRED
• Clearly show all your calculations in detail; and

value).
(a) Determine the capital structure (expressed as a %) of Brat Lows Furniture
Group at 31 December 2020, based on both the book values and the market
values. You are also required to comment on the movements in capital
structure.
▪ Calculations – 15 marks; Discussion and commentary – 3 marks. (18)
(b) Assuming that Brat Lows Furniture Group has not yet reached its target capital
structure, provide practical ways in which the Group can improve its gearing
and move towards its target capital structure. (5)
(c) Discuss factors you would have considered before taking part in the Group’s
issue of additional ordinary shares during the 2020 financial year, if you were
one of the Group’s shareholders. (8)
December 2020 and based on the information and nature of industry, advise
on practical ways to improve the cash conversion cycle.
▪ Where applicable, base your calculations on closing book values.
▪ Calculations – 5 marks; Advice – 4 marks. (9)
structure the business to return to profitability. (5)
Total question 1 and 2 [100]
©
UNISA 2021
All rights reserved. No part of this document may be reproduced or transmitted in any form or
by any means without prior written permission of Unisa.
CONFIDENTIAL
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Blue ticks
SUGGESTED SOLUTION (✓) are
alternative
QUESTION 1
(a) Calculate the total overheads attributed to the Masks Division for the 9-
[8]
Overheads R Marks
Depreciation & machine service costs 12 943 826 ✓ r/w
[36 125 500 ÷ 7 890 000 x 2 827 000]
Rent, rates, water and electricity 5 547 622 ✓ r/w
[18 766 438 ÷ 6 840 m2 x 2 022 m2]
Safety and security costs 1 489 176 ✓✓
[(5 037 442 x 30,72 x 12)✓ ÷ 1 247✓]
OR: [(5 037 442 ÷ 1 247 ÷ 12)✓ x 30,72✓]
Ordering and material handling costs 284 866 ✓ r/w
[1 238 546 x 0,23]
Cafeteria, development and teambuilding costs 299 868 ✓✓
[(840 750 ÷ (702 ÷ 1,17)✓ x 214✓]
Head Office’s allocated overheads 2 128 423
Division’s specific costs (indirect labour costs) 9 470 000 ✓ r/w
Total overheads 32 163 781
 Given
(b) Determine whether Baba Ndou and his Masks Division are entitled to
bonuses (and how much, if any) for the period ended 31 December 2020. [8]
Show all workings.
Details R Marks
Sales 83 252 205 ✓ r/w
Variable manufacturing costs (39 487 668) ✓ r/w
Factory overheads [part a] (32 163 781) ✓ ©
Administration and selling costs (1 886 600) ✓ r/w
Net profit before tax 9 713 756
Gross profit margin 13,93% ✓ ©
Conclusion:
The Masks Division’s gross profit margin of 13,93% is more than the 12,75% target while
the actual net profit before tax of R9,713m is also more than the R8,5m target. As such,
both Baba Ndou and his division are entitled to a total of R2 166 504✓✓ in bonuses for
the 9-month period ending 31 December 2020 (R166 504 of this goes to Baba Ndou).✓©
1 mark for conclusion
 Given 2 marks for calculation
 20 875 828 + 4 611 840 + 14 000 400 = 39 487 668
 11 600 356 ÷ 83 252 205 = 13,93%
 Baba Ndou’s bonuses: R83 252 205 x 0,2% = R166 504 ✓rw
 Division’s bonuses: R2 000 000 ✓rw
 Total bonuses payable to Masks Division: R2 166 504 (R166 504 + R2 000 000)
(c) Critically evaluate the overall remuneration scheme of Phalaborwa
[5]
Pharmaceutics Enterprise.
On basic salaries and wages

• The company seems to be in contravention of the Basic Conditions of Employment
Act✓, as it currently pays its labourers R18 per hour, while the minimum wage is
R20.76. This may lead to fines and penalties imposed by the Government, and
possible labour unrest and strikes✓. The company does, however, provide other
benefits to its labourers (bonuses, refreshments and developmental programmes)
and maybe the company can consider channelling this expenditure towards the
wages of labourers✓. 1 mark for contravention; 1 mark for consequences; 1 mark for other benefits
• Indirect labour costs make up approximately two-thirds of direct labour costs
(R9,47m vs. R14,4m) ✓, and this may suggest that supervisors and foremen are
paid significantly more than the labourers who are directly involved in the production
process. Usually there is a small number of supervisors compared to direct
labourers. 1 mark for indirect labour cost component; 1 mark for comparing with DL
On determining bonuses
• The company seems to be instilling commitment to the success of the organisation
by giving the divisions incentives over and above the normal wages and salaries.
This is likely to increase productivity by the divisions.
• Some manufacturing overheads may not be within the control✓ of the divisions or
methods to allocate these may not be favourable to other divisions.
• The bonus payable is not proportionated to the operating profit✓ – e.g. it does not
matter by how much the targeted operating profit is exceeded, this does not
influence how much is paid out as a bonus. There will be no bonuses payable if the
operating profit is slightly below the set target.
• The manager may be tempted to increase sales at any cost (overstatement or
incorrect classification) as their bonus is based on the sales generated✓. The
manager also gets paid significantly higher in bonuses than the entire division (and
he might still benefit from the divisional pool of bonuses). This may lead to
demotivated and unhappy workforce.
• The fixed bonus pool does not take into account the number of employees (currently
the Masks Division accounts for 35% of the entire factory labour force, and yet the
bonus pool of R2m is the same across the factory)✓.
• The bonus structure only takes into account financial factors – non-financial factors
should also be considered in rewarding the staff.
MAX: 5 marks
(d) Determine the number of masks that the Masks division needs to produce
[10]
in order to meets its operating profit target for the 2021 financial year.
Total fixed costs + target profit (43 367 471✓✓✓ + 18 000 000✓)
✓𝐟
Contribution per unit 0,513✓✓✓✓✓✓
= 119 624 700 units
Contribution per unit:

 Selling price: (83 252 205 ÷ 90 000 000) x 1,12 = 103,6 cents ✓r/w
 Direct materials: (20 875 828 + 4 611 840) ÷ 90m = 28,3 cents ✓ r/w
 Direct labour costs: 14 000 400 ÷ 90m✓ x (25÷18)✓ = 21,6 cents ✓✓
(or 777 800 ÷ 90m✓ = 0,00864 hours per unit x 2 500 cents✓ = 21,6 cents)
 Variable administration & selling costs:
(296 455 – 150 025)✓ ÷ (10,5m – 4,5m)✓ = 2,4 cents
Contribution per unit: 103,6 – 28,3 – 21,6 – 2,4 = 51,3 cents
Total fixed costs:

Fixed overheads [part a]: R32 163 781
Administration and selling costs: R150 025 – (4,5m x 0,024405✓©) = R40 202,50
OR R296 455 – (10,5m x 0,024405) = R40 202,50 (monthly)
Fixed administration and selling costs: 12✓ X 40 202,50 = R482 430
TOTAL: (R32 163 781 x 12÷9✓ + R482 430) = R43 367 471
MAX: 10 marks
[5]
Pharmaceutics Enterprise and its operations.
• The company might be engaging in illegal work with the government entities. The
company cannot be paying the entities✓ (and/or their employees) in order to sell
goods to these entities. This should be investigated to ensure that it is not a bribe of
any sort✓.
• PPE should ensure that the orders in the pipeline are valid and that the necessary
government procurement processes were followed✓.
• The company should have reported the electrical fault immediately✓ (supply of
electricity was considered essential services). Only ESKOM personnel or ESKOM
approved service provider should (re)/connect electricity and it is illegal for anyone
else to make these connections✓. PPE should report the matter and ESKOM must
make appropriate assessment of what might be owed. Electricity costs resulting from 1 mark for
this must be considered and accounted for appropriately for the following years✓. ethical concern
• The company seems to be in contravention of the Basic Conditions of Employment 1 mark for
Act, as it currently pays its labourers R18 per hour, while the minimum wage is consequences
R20.76✓. This may lead to fines and penalties imposed by the Government, and 1 mark for
possible labour unrest and strikes✓. PPE should consider adjusting and backdating appropriate
action
the wages or restructure the benefit package to consolidate all the benefits (e.g.
bonus portions and cafeteria benefits)✓.
• PPE seems to have continued its operations even during the hard lockdown (level
5)✓ and this might have been against the law at that time while exposing its
workforce to COVID-19 (unless considered essential services)✓.
MAX: 5 marks
(f) Prepare a segmented income statement (by product) of Aloetiser
(Pty) Ltd, showing the profit for the year ended 31 March 2021 for [12]
each product, as well as the total for the company.
PRODUCT INCOME STATEMENT

Sales(A)(2,1mxR3,46)(2,97mxR6,50) ✓✓ 7 266 000 19 305 000 26 571 000
Less: Cost of sales (4 520 997) (10 638 422) (15 159 419)
Opening inventory ✓✓r/w 1 494 491 1 873 109 3 367 600
Plus: joint manufacturing costs✓✓✓✓ 4 579 102 8 305 258 12 884 360
Plus:specific manufacturing costs ✓✓r/w 923 187 3 648 000 4 571 187
Less: Closing inventory ✓✓✓ 2 475 783 3 187 945 5 663 728
Less: Variable selling costs ✓© - (1 485 000) (1 485 000)
Contribution (B) 2 745 003 8 666 578 11 411 581
Less: Fixed manufacturing costs ✓rw (3 261 955)
Less: Fixed selling costs ✓rw (545 364) - (545 364)
Net profit before taxation 2 199 639 8 666 578 7 604 262
Contribution margin ratio (B ÷ A) for part f 0,38 0,45 0,43
 Given
13 682 817 – 875 000 + 76 543 = 12 884 360✓r/w:
Sanitiser: 12 884 360 x 35,54%✓ = R4 579 102;
Liquid: 12 884 360 x 64,46% = R8 305 258
 R1,20 x 3,04m = R3 648 000
 Net realisable value
NET REALISABLE VALUE
Sales (2,75m x R3,46); (3,04m x R6,50) 9 515 000 19 760 000 29 275 000
Less: further processing costs ©✓ (923 187) (3 648 000)  (4 571 187)
Less: Selling costs ✓ rw (545 364) (1 520 000) (2 065 364)
Net realisable value 8 046 449 14 592 000 ✓ 22 638 449
Allocation 35,54% 64,46% 100%
 R0,50 x 3,04m = R1 520 000✓
 Sanitiser: (1 494 491 + 4 579 102 + 923 187) ÷ (500K + 2 750K) x 1 150K
R2 475 783
Liquid: (1 873 109 + 8 305 258 + 3 648 000) ÷ (820K + 3 040K) x 890K
R3 187 945
CLOSING FINISHED GOODS INVENTORY
Details – quantity in litres Sanitiser Liquid Total
Units at the beginning of the year  500 000 820 000 1 320 000
Units produced during the year  2 750 000 3 040 000✓ 5 790 000
Less: Sold units (2 100 000) (2 970 000) (5 070 000)
Units remaining at end of the year  1 150 000 890 000✓© 2 040 000
 Sanitiser: 2 200 000 x 1,25l = 2 750 000✓
MAX: 12 marks
(g) Based on the investment criteria and other factors Phalaborwa
Pharmaceutics Enterprise needs to take into consideration, advise if the [7]
Phalaborwa Pharmaceutics Enterprise should buy Aloetiser (Pty) Ltd.
The contribution margin ratio for aloe vera liquid is 0,45 slightly above the required 0,40 as
the investment criterion and the contribution margin ratio for hand sanitiser is 0,38 (not
meeting the required criterion). Based on these two ratios only, PPE should consider not
buying Aloetiser (Pty) Ltd✓©. These below additional factors may also be considered before
reaching the decision:
• Possible synergistic benefits✓, considering that both companies are in the business
of manufacturing safety and health products currently in high demand due to COVID-
19.
• PPE uses the absorption costing method✓, and the importance of using the
contribution margin ratio as means of evaluating an investment should be carefully
evaluated.
• Alignment and running of operations especially between different provinces✓ (i.e.
Limpopo and Eastern Cape) should be considered carefully, including different
accounting and reporting systems used and PPE’s time in the market.
• The claims made by the owners that the business generated R22m net profit✓ in
the recent financial year raise concerns about the accuracy of the accounting
information provided, as well as the integrity of the owners (sales were only R26m
before taking into account obvious operating costs).
• Claims that the business will grow by 20% in 2022 should be verified✓, especially
by reviewing the performance of the first quarter of 2022.
• Increased global use of hygiene and healthy products may lead to profit growth for
the company✓.
• Owners might be desperate to sell✓, and this can present an opportunity for PPE to
offer a lower purchase price. At the same, this can be a concern if PPE may need
proper handover and post-acquisition support from the owners of Aloetiser.
• It may be difficult to predict how well Aloetiser will do post COVID-19✓ or once the
vaccine has been rolled out successfully. Considerations must also be made
regarding new companies entering this low-barriers-to-entry market.
• There seems to be a small market to sell the by-product✓ (residual aloe vera
leaves), considering that currently there is only one buyer.
• Hand sanitisers at hand cost about R2,99 (R1 494 491 ÷ 500 000) and this might
point to possibly decreasing selling price due to increased supply of these goods✓
in the market.
• Details assessments must be conducted to determine the profitability of further
processing the products✓ instead of selling them off before incurring additional
processing costs.
• Inventory levels seem to be increasing✓, pointing to possible difficulties in moving
the stock.
• Inclination of inventory valuation errors due to multiple valuation methods and
different costing systems✓.
• Consideration of future enforceability of existing contracts✓. For example, the
marketing and selling contract of hand sanitisers is currently negotiated at fixed cost
of R545 364.
MAX: 7 marks
QUESTION 2
(a) Determine the capital structure of Brat Lows Furniture Group at 31

December 2020, based on both the book values and the market values.
[18]
Comment on the movements in capital structure what the Group can do to
move closer to its target capital structure.
MAX: 15 marks on calculations
CAPITAL STRUCTURE BASED ON BOOK VALUES:
2020 2019
Capital structure
(Gearing ratio): 3 230✓𝐫𝐰 3 822✓
3 230 + 2 563✓𝐫𝐰 3 822 + 1 747
= 55,76% = 68,63%
Interest-bearing debt
2020: R1 240m [Da Bank loan] + R400m [Cressida loan] + (R70 x 15m) [pref. shares] +
(R45 x 12m) [debentures] = R3 230m.
2019: R4 105m – R283m = R3 822m.
CAPITAL STRUCTURE BASED ON MARKET VALUES:

2020 2019
Capital structure
(Gearing ratio): 1 228 + 396 + 990 + 551 3 972
✓© ✓©
3 165 + 4 104 3 972 + 4 466
= 43,54% = 47,07%
MARKET VALUES:
PV of interest + capital
FV - 1 240 million
PMT - 51,336 million (1 240 million x 7%-1,25%)x0,72 ✓ 𝐾𝑑1 = 4,32%
N 6 (10 years – 4 years: Dec 2020- Jan 2017) ✓
I 4,32% (7%-1% x 0,72)
Da Bank Comp PV 1 228 million (OR 1 228 420 464)
CF0 0
CF1 – 2021 0✓
CF2 – 2022 - 37,44 million (26 million x 0,72 x 2 years)✓ 𝐾𝑑2 = 4,932%
CF3 – 2023 - 418,72 million (400m + 18,72m✓)
I/Y 4,932% (6,85% x 0,72)
Cressida Finance Comp NPV 396 million (OR 396 412 945)
INSTRUMENT MARKET VALUE COST OF PREF.

Preference shares BV: 15 mil x R70 = 1 050 million ✓
Dividend: 1 050 x 7% x 0,8 = 58,8 million Dividend

Preference shares 𝐾𝑝 =
Value of pref
Dividend
𝑀𝑉𝑝𝑟𝑒𝑓. =
Cost of pref.
62,4m✓
𝐾𝑝 =
58,8m 1 050m
𝐾𝑑2 = 5,94%
✓
= 990 million (989 898 990) 𝐾𝑝 = 5,94%
INSTRUMENT MARKET VALUE (FINANCIAL CALC.) COST OF DEBEN
𝐾𝑑3 = 4,50%
CF0 0
CF1 - 25,92 million (36 million x 0,72) ✓
Debentures CF2 - 25,92 million
CF3 - 25,92 million Mark for
CF4 - 565,92 million ([12 mil x R45]✓+ 25,92m) R540m
CF5✓ - 6,48 million (12 mil x R0,75 x 0,72)
I/Y 4,50 (6,25% x 0,72)
Comp NPV 551 million (551 011 674)
Ordinary shares MVe: 224,9million × R18,25✓ = R4 104 mil
COMMENTS: MAX: 3 marks

Gearing decreased from 69% to 56% based on book values and from 47% to 43% based
on market values. This may be attributed to the following:
o Fresh issue of ordinary shares (to the tune of R1bn – based on book values) ✓
o Possible repayment of long-term loans (decrease in closing values from R3 822m
to R3 230m) ✓
o The decrease in market value of equity (due to decline in share price) did not have
a significant impact on increasing the gearing, as this was offset by decrease in
long-term loans. ✓
Using market values, the Group is slowly approaching the desired/target capital structure
of 40%:60%.
(b) If Brat Lows Furniture Group has not yet reached its target capital structure,
provide practical ways in which the Group can improve its gearing and [5]
move towards its target capital structure.
• The Group can formulate a turnaround strategy✓ to return to profitability, and then
increase retained income, effectively increasing the equity of the business (cost-
cutting, revenue increase, market increase, aggressive marketing campaign, etc.).
• The Group can sell unprofitable stores, non-core assets✓ (of the R2,150bn base)
and/or reduce levels of inventory (by not restocking) and use any excess cash on
hand and proceeds from the sale of the assets above to repay existing debt.
• Brat Lows Furniture Group can consider fresh issue of shares to the public✓.
• The Group can approach the existing providers of long-term capital (preference
shares, debentures and loans) for possible restructuring of the existing facilities✓
(on interest rates, conversion to ordinary shares, capital reduction, debt
consolidation).
• Brat Lows Furniture Group can early repay the existing facilities✓, and take on new
facilities, especially where the market interest rates are lower than what the Group
is currently being charged (market rate for debentures is 6,25% but currently paying
6,67%).
• Once the Group resumes dividend payment, these could be done in the form of a
scrip dividend✓, therefore using the saved cash to repay debt, while increasing the
share capital.
• The Group can improve its capital structure by funding more of its current assets by
current liabilities✓ (increasing trade payables which are likely to be interest-free, and
the Group currently has good relations with its suppliers). The resulting excess cash
can then be used to reduce long-term debts. The Group can also consider delaying
payments to its suppliers (increase trade payable days) within reasonable
timeframes.
• Increase the proportion of cash sales✓ and subsequently utilise the resulting cash
proceeds for immediate/bullet debt reduction.
• The Group can also utilise cash on hand to reduce its debt✓.
MAX: 5 marks
(c) Discuss factors you would have considered before taking part in the
Group’s issue of additional ordinary shares during the year, if you were one [8]
of the Group’s shareholders.
▪ How does this proposed issue affect my percentage holding in Brat Lows Furniture
Group? Am I likely to lose control or significant influence✓ if I do not exercise the
option to buy more shares?
▪ Do I have the required funds (availability) ✓ to further invest in the business, and
how will this additional investment affect the diversification of my investment
portfolio?
▪ Do I have the appetite for additional risk in the equity market? ✓ What are my other
investment alternatives and how much return do they offer? How have the other
comparable companies in this sector fared?
▪ What are the prospects of the entire industry and is it the industry one would like to
invest in?
▪ The shares have been discounted to R20 – how has the share performed✓ in the
past and am I likely to make substantial profit at the additional purchase of the
shares?
▪ How confident am I in the business and the managers that they will be able to turn
the business around? ✓ Am I likely to see an increase in the value of the shares?
▪ The Group has recently suspended its dividend – is this likely to continue?✓ How
has the Group enforced its dividend policy in the past?
▪ What has been my historical return✓ on this share (based on the dividend yield as
well as the share price growth)? Have I also lost patience and confidence that things
will get better?
▪ How has the business been impacted by COVID-19✓ and is it likely to survive in the
post-COVID era? Are there any new markets the business can go into?
▪ Is the business likely to continue as a going concern? What are the company’s future
growth prospects?
▪ Is this the best time to buy the share✓ – probably at lowest levels?
▪ Have I considered the tax effect✓ of buying at R20, and tax on dividends to be
declared in the future? Am I a speculative investor or a long-term investor, and what
is the tax implication on each of the options?
▪ Are there any measures I can put in place to limit or mitigate✓ against the risk
associated with this investment (e.g. use of derivatives)?
MAX: 8 marks
December 2020 and based on the information and nature of industry, [9]
advise on some practical ways to improve the cash conversion cycle.
CASH CONVERSION CYCLE:
2020
Trade receivable days: DAYS
2 956
𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
x 366
(2 882✓©+2 068✓)
x 366
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
218
2 956
x 366
4 950
Credit sales (x): x + 0,25x = 3602

x = R2 882m✓rw
2020
Trade payable days: DAYS
874
𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
x 366
1 401
x 366
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
228✓r/w
2020
Inventory days: DAYS
844
x 366
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 1 666
x 366
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
185✓r/w
DAYS
CASH CONVERSION CYCLE
(218+185-228) ✓© 175
ADVICE: MAX: 3 marks (one mark per each class of working capital)
When improving the cash conversion cycle, a company attempts to collect from its debtors
sooner; convert its inventory sooner; and delay payment to its creditors. By so doing a
company reduces the number of business days (operating or cash conversion cycle).
Trade receivable days: ✓

Based on the calculations above, the Group collects from its debtors over a period of 218
days on average (just over 7 months). The Group can then consider providing incentives to
debtors who pay within, say 6 months (e.g. interest-free for the first 6 months). The Group
can also consider putting stringent policies on granting of credit, especially during the
recession. This will not only improve the Group’s liquidity but there is likely to be a decrease
in bad debt, debt management costs and impairment expenses. Furthermore, the company
could reduce the cash sales: credit sales proportion by increasing the cash sales
component.
Trade payable days: ✓

The terms are already quite generous, and to ensure continued good relations with suppliers
the Group should not consider delaying payments to suppliers (whose period is already
longer than debtors’ days). However, the Group can consider negotiating the prices with the
suppliers, especially where payment is made sooner.
Inventory days: ✓
The furniture and electric appliances remain on the floor for about six months. The Group
runs the risk of stock being “outdated”, especially electric appliances. The entry of small
boutiques with more trendy furniture will also lead to difficulties in selling the furniture. The
Group should consider reducing the amount of stock that is kept on hand (this will also lead
to decrease in holding costs). The Group could also take orders from customers before the
goods are sourced from suppliers, which based on good relations they maintain, are likely
to deliver within reasonable timeframe.
MAX: 9 marks
[5]
structure the business to return to profitability.
The Group can consider the following strategies: MAX: 5 marks
o Establish an online sales platform✓ to reach a broader market (locally and
internationally), especially during the lockdown.
o Develop and execute social media marketing campaigns✓ and advertise via social
media “influencers”.
o Shut down unprofitable stores✓ and sell assets from these operations or move to
profitable stores.
o Reduce the percentage of credit sales✓ as a percentage of total sales and put
stringent controls in place to ensure creditworthiness of the potential customers.
o Add free after-sales services✓ (free delivery, assembly or minor items).
o Buy struggling and desperate furniture retailers and/small boutiques✓ which are
likely to bring more synergies to the business. Explore other markets to expand to.
o Renegotiate✓ prices with suppliers (consider free delivery) and lower interest rates
with long-term capital providers.
o Review product profitability✓ and adjust to ensure focus is on more profitable
products. Electrical appliances are likely to be sourced outside the country – and the
weakening rand may lead to lower profit margins or less sales.
o Keep inventory levels✓ low and buy items after they have been ordered by the
customers. Consider effective leadership to be put in place.
o Partner with property development companies✓ to build and sell fully furnished
properties.
o Consider supplying school furniture✓ via engagement with the Department of
Education.
MAC3702
MAY/JUNE 2020
May/June 2020
MAC3702
APPLICATION OF FINANCIAL MANAGEMENT TECHNIQUES
100 marks
3 hours
30 minutes additional time for uploading
THIS PAPER CONSISTS OF EIGHT (8) PAGES.
INSTRUCTIONS:
Please remember to complete the Honesty Declaration.
Follow these steps to submit your take-home answer file.

1. Access myUnisa at https://my.unisa.ac.za/portal and login using your student number and
myUnisa password.
2. Click on the “myAdmin” tab in the top navigation.
3. In the “Assessments” submenu, click on the “Assessment Info” tool in the drop-down
list.
 Locate the section for UNISA summative assessments at the bottom of the list.
 Find the corresponding portfolio number for your module.
 Click on the Submit link in the Action column and follow the steps described below.
Load the answer file from your PC to myUnisa:
 Click on the Browse button next to File Name.
 In the Choose File dialog box, select the file you want to upload, and then click OK.
 Select the correct file format from the File Format drop-down list. Only PDF formatted
files are allowed to be uploaded.
 Click on the Continue button. If you do not click Continue, no submission action will
take place.
 The link for upload will close at exactly 18:30pm.
PLEASE NOTE:
1. The paper consists of ONE (1) question.

2. All sub section parts (a) to (g) must be answered and clearly indicated.
3. All calculations must be shown.
4. PROPOSED TIME-TABLE: (Avoid deviating from this as far as possible.)
Question Subject Marks Time

number (minutes)
Capital budgeting, Weighted average cost of capital, Working
1 100 180
Capital Management, Ratios and Discussion.
100 180
Page 1 of 8 CONFIDENTIAL
[TURN OVER]
Open Rubric
MAC3702
MAY/JUNE 2020
Question 1 (100 marks; 3 hours)
Eddy Fashion Holdings (“EFH”) is South Africa’s oldest and biggest retailer by assets and is
listed on the Johannesburg Stock Exchange. In the recent years the company has struggled
to deliver impressive results as it faces serious competition from both local and international
retailers. The company’s share price was trading at 4 598 cents on 01 October 2018, at the
start of the financial year, but had lost about 52% of its value by the end of September 2019
as it recorded a net loss of R109 million. With no dividend declared at the end of the year, this
loss brought the company’s net asset value down to R1 269 billion. EFH’s significant
shareholders include the Public Investment Corporation (22%), Rembrandt Group (19%) and
African Rainbow Capital (15%). Only 50% of the company’s authorised shares remains
unissued.
The company has approached the Industrial Development Company (IDC) for a possible
capital injection into the business of up to R8 850 million in order to pay off its interest-bearing
debt, increase working capital levels, and embark on a new expansion programme. EFH
requires R600 million for its ARISE & DREAM project (see Part A below); R8 billion to repay
its long-term debts (see Part B); and R250 million (see Part C) to manage liquidity for the next
few months. IDC has proposed that EFH issues new EFH ordinary shares in return for the
capital injection into EFH business.
Part A – ARISE & DREAM Project
EFH will be embarking on a new comprehensive business model that is aimed not only at
revenue generation, but also at the empowerment of upcoming and aspiring young designers.
The EFH procurement team has already identified four of South Africa’s top young designers
to be part of the new clothing range called “ARISE & DREAM”. The designers will
conceptualise and design the clothes which will then be sent to EFH’s trusted local
manufacturers to manufacture the required quantities for all its 350 participating stores. Once
major alterations and renovations have been completed at these stores, ARISE & DREAM
clothing range will be sold for a period of five years (ending December 2025) before the range
becomes out of fashion. It is estimated that afterwards the company will be able to find
substitute products to sell utilising space previously occupied by ARISE & DREAM clothing
range. Each store is expected to generate an average trading profit of R65 000 per annum on
the extra space going forward (after taking into account future wear and tear allowances). This
trading profit will increase at 4,80% per annum.
The final four top young designers, with their designs showcased below, are: Nkhensani Nkosi,
Amanda Laird, Mzukisi Mbane and Jacques van der Watt.
[TURN OVER]
MAC3702
MAY/JUNE 2020
TOP 4 YOUNG DESIGNERS:
Style For All, by Nkhensani Nkosi Cherry, by Amanda Laird
Imprint, by Mzukisi Mbane Lace and frills, by Jacques van der Watt
1. Capital expenditure
The first two years (2020 & 2021) will be for the construction phase, however, ARISE &
DREAM sections at all participating stores will be operational at the end of the first year.
Full capacity will only be reached at the end of 2023. At the start of the project EFH will
spend R245 million on alterations and renovations and another R245 million will only be
spent a year later (these qualify for 5% wear and tear allowance). The balance of the
project amount will be spent between store fittings and working capital (see note 3 below).
Working capital will be equivalent to 50% of the store fittings costs. Store fittings will also
be purchased at the beginning of the project and are subject to a capital allowance of 20%.
Wear and tear as well as capital allowance are only deductible once the stores are opened
and operational (pro rata applies).
2. Working capital
The working capital will only be required once the ARISE & DREAM sections at all
participating stores are operational. 60% of the total working capital requirement will be
provided for in the first year of opening the stores, with the balance being provided in the
following year. Only 90 cents in a Rand of the invested working capital will be recovered
at the end of the project.
[TURN OVER]
MAC3702
MAY/JUNE 2020
3. Sales
The young designers have signed a five-year agreement to design the clothing range to
be sold at the 350 participating stores. The range entails men’s, women’s, kids’, footwear
and accessories for every occasion. The expected number of units to be sold by each
designer per annum are given below, with the starting average price per item. The ARISE
& DREAM clothing line is priced at a mark-up of 50% on cost (manufacturing).
Manufacturing costs include designers’ fees paid to the four young designers.
Number of units expected to be sold and unit price:

Expected annual % of capacity (Quantity)
Number of
Design Average price
units per 2021 2022 2023 2024 2025
per unit 2
store1
Cherry 2 000 R200
Lace and frills 2 000 R150
55% 90% 100% 100% 100%
Imprint 2 000 R150
Style For All 2 000 R100
1
This is at full capacity per store per year. There is a demand, spread evenly throughout the year for all the
products manufactured each year. All four clothing labels will be available at all participating stores.
2
This average price per unit is the price at the start of the construction phase. The selling price will increase
by 6% per annum.
4. Operating/trading costs
Expected operating costs will amount to a total of R30 million per annum for all the
participating stores (excluding marketing costs). These operating costs will be incurred at
the same time the revenue is realised. The company will also be embarking on a 3D
marketing campaign for its new clothing range. The 3D marketing will display the new
clothing range using a 3D clothing visualisation technology at various shopping centres
where the participating stores are located. Payment for related marketing costs, made in
advance, will be R2 million in the first year of launching the clothing range but will reduce
by 20% (based on the initial marketing cost) in each following year. Excluded from the
amounts above is an annual depreciation charge of 10% on buildings and 25% on
equipment and fittings. Depreciation is only accounted for once the asset has been brought
into use.
5. Salaries
The company will have to contract a digital marketing manager and Sethu Ndamase with
eight years’ experience in the advertising industry has already been identified. Sethu
Ndamase will likely start at the beginning of 2020 in order to familiarise herself with the
business. The job requires her to manage, develop and expand the marketing department
with current marketing technology models and tools. She will be responsible for:
[TURN OVER]
MAC3702
MAY/JUNE 2020
 Creating efficient, effective advertising strategies in digital spaces to promote the

new clothing range.
 Focus on increasing sales and brand loyalty by holding events or campaigns to
increase awareness and surveys.
No interview has been conducted with her yet but her expected salary package for the
2020 financial year will be R982 377 with an expected increase of 8% per annum and
included in this amount are the following:
 Annual contribution to the retirement fund of R100 000, and

 Once-off reallocation cost of R38 000 and a sign-on bonus of R100 000 (these
amounts will be paid at the start of the contract).
Sethu Ndamase was referred to EFH by one of the reputable recruitment agencies, and
the agency will be paid R120 000 for their work in identifying the suitable candidates for
this job. This payment will be effected at the beginning of 2020.
Part B – REPAYMENT OF DEBT
EFH has the following interest- and dividend-bearing facilities at 30 September 2019:
Preference share capital: The three million preference shares were issued three years ago
at a nominal cost of R605 per share, which bear a fixed dividend yield of prime+20bps. Similar
shares are estimated to be trading at R581 each. The redemption date of all these shares is
29 September 2025.
Debentures: 10-year term debentures for R3 144 million were also issued around the same
time as the preference shares above. The finance costs (net of tax) on these debentures
amount to R249 million per annum. The premium and the annual administration costs are
waived, but there is a once-off administration fee of R15 million payable on 30 September
2025. Debentures structured in this manner incur interest at prime lending rate.
Long-term loan: A loan of R871,5 million was obtained on 2 October 2018 and its capital is
repaid in three equal annual instalments. The fixed 11% interest is also paid on the last day
of each financial year. Similar loans bear an interest rate of about 9,75%.
Subordinated debt: EFH also obtained an unsecured subordinated debt from African
Rainbow Capital for R2 010 million on 10 October 2015 at an equivalent interest rate of
prime+2. Similar subordinated debt facilities are estimated to yield an interest at prime lending
rate.
Short-term loan: The loan for R450 million was obtained from CreditSis Bank at prime lending
rate and is repayable on 28 February 2020. The loan was taken out to settle unexpected legal
costs after the company was embroiled in a price-fixing scandal. The company was forced to
take out this loan due to low cash reserves at the time. The cash position of the company has
since improved as EFH closed the year with more than R300 million of cash and cash
equivalents and a zero balance on its bank overdraft facility.
The interest expense on this loan for the year ending 30 September 2019 was R26 million.
Similar loans and overdraft facilities are generally priced around prime+1.
[TURN OVER]
MAC3702
MAY/JUNE 2020
Part C – WORKING CAPITAL MANAGEMENT
EFH’s debt levels have been on the rise in recent years due to a number of internal and
external factors which have unfolded over the years. One of the major internal factors cited is
poor liquidity management processes. The company has often flout the budgeting/forecasting
processes and as a result finds itself having to use expensive debt to fund any deficits in its
working capital. However, since the IDC bailout application the management team has
implemented more stringent controls around the working capital of the company.
The statement of financial position on 30 September 2019 had net current assets of
approximately R2 billion and is made up of the following:
* Net current assets Rm

Inventory (6 132 000 items of clothing) 1 533
Trade and other receivables 3 752
Income tax liabilities 299
Cash and cash equivalents 341
Other current assets 102
* The net current assets exclude the interest-bearing liabilities given in Part B above.
Cash sales average 25% of total sales and each month’s credit sales are invoiced on the last
day of the month. Credit sales are also collected as follows:
o 60% within 7 days after the invoice date;
o 28% by the end of the month after sales.
o 9% by the end of the second month after sales; and
o 3% is uncollectible.
Half of the monthly purchases the company makes, is paid for in the month of purchase and
the remainder in the following month. The number of items of clothing (units) in each month’s
closing inventory equals 120% of the next month’s units of sales. EFH maintains an average
product mark-up of 33% on selling price. The company also expects in the foreseeable future
to maintain the existing average cost price per unit (as indicated in net current assets above).
The actual and budgeted sales of EFH are given below:
Month Units
September 2019 (Actual) 5 253 000
* October 2019 (Actual) 5 110 000
November 2019 (Budgeted) 5 876 500
December 2019 (Budgeted) 6 054 000
January 2020 (Budgeted) 5 270 000
February 2020 (Budgeted) 5 538 600
* Actual units purchased during October 2019 totalled 6 029 800.
[TURN OVER]
MAC3702
MAY/JUNE 2020
Part D – ADDITIONAL INFORMATION
 EFH undertakes projects that have an internal rate of return of at least 20%.
 As at 30 September 2019, EFH had 840 million authorised ordinary shares.
 The South African corporate income tax is rate 28%.
 Prime lending rate is 10,25% and the cost of equity is 15,2%.
[TURN OVER]
MAC3702
MAY/JUNE 2020
REQUIRED
a) By calculating the internal rate of return, determine whether EFH should undertake the
ARISE & DREAM project. [You can scale your workings down by Rm]
(27)
b) Using market values at 30 September 2019, calculate the weighted average cost of
capital (WACC).
(18)
c) Draw up a purchases (production) budget in units for EFH for the months of November,
December 2019 and January 2020.
(10)
d) Calculate budgeted cash receipts and payments for the months of November, December
2019 and January 2020.
[Focus only on the sales and costs associated with the purchase of inventory]
(15)
e) Calculate the following ratios for EFH for the year ended 30 September 2019; and provide
practical ways the ratios can be improved (use market values where possible):
 Interest-bearing debt equity ratio (net)
 Current ratio
 Return on equity
 Price/book ratio
 Cash interest cover
(Calculations – 5 marks; comments – 12 marks)
(17)
f) Determine the number of shares to be issued by EFH to the Industrial Development

Company if the parties agree to the terms of the bailout (also calculate the new
shareholding by the major shareholders after the deal).
[Assume for the purpose of this deal each EFH share is priced at premium of 10% above
its current share price]
(8)
g) Discuss the factors that should have been considered before deciding on obtaining the
funds from the Industrial Development Company. No calculations are required.
(5)
TOTAL: 100 MARKS
UNISA 2020
[TURN OVER]
MAC3702 May /June 2020
Internal rate of return for EFH
2020 2021 2022 2023 2025 2025
Alterations and (245 000) (245 000)

renovations
Fitting cost (73 333)
Working capital (22 000) (7 333) 33 000
Sales 231 000 400 680 471 912 500 266.7 530 240.3
Cost of sales (154 000) (267 120) (314 608) (333 484.4) (353 493.5)
Operating Costs (30 000) (30 000) (30 000) (30 000) (30 000)
Marketing costs (2 000) (1 600) (1 280) (1 024) (819.2) 0
Recruitment agency (120)
fees
Marketing manager (982.48) (911.9) (984.8) (1 063.6) (1 148.8) (1 240.7)
Wear and Tear (24 500) (24 500) (24 500) (24 500) (24 500)
Wear and Tear - Fittings (14 667) (14 667) (14 667) (14 667) (14 667)
Taxable cash (3102.48) 5321.1 62128.2 85049.4 95647.7 106339.1
Tax at 28% 868.70 (1489.91) (17395.9) (23813.8) (26781.35) (29774.95)
Net cashflows (320566.8) (224 002) 76 566.3 100 402.2 108 033.5 148 731.2
IRR using sharp 6.51%

calculator
EFH should not undertake the project because the IRR is 6.5% and is below the 20% which is below the
recommended percentage.
Calculations
1. Store fittings and working capital fund = 600 000 000-(245000000x2)

= R110 000 000
• Fitting cost = 2/3xR110 000 000

= R73 333 333
• Working Capital = 1/3xR110 000 000

= R36 666 667
• Working capital in year in year one = R36 666 667 X 60%

= R22 000 000
• Working capital in the year two = R36 666 667 X 40%

= 7 333 333
• Working capital recovered at the end of the project = R36 666 667 X 0.90
= R33 000 000
2. Sales
2021 2022 2023 2024 2025
660 000 X 350 1 144 800 X350 1 348 320 X 350
231 000 000 400 680 000 471 912 000 500 226.7 530 240.3
3. Cost of sales
2021 2022 2023 2024 2025

231 000 000 X 400 680 000 X 471 912 000 X 500 226 700 X 530 240 300 X
100/150 100/150 100/150 100/150 100/150
=154 000 000 =267 120 000 =314 608 000 =333 484 4667 =353 493 533
(b)
Calculating the WACC
Instruments Market value Weight Costs WACC

Ordinary shares 926 856 800 000 0.994 15.2 15.11
Preference shares 1 743 000 000 0.00186 8.39 0.0157
Debentures 3 244 054 775 0.0035 7.38 0.0256
Long term loan 575 646 981.5 0.00617 7.02 0.0433
932 419 400 000 15.20
Calculations
1. Ordinary shares
Market value of the shares = (840 000 000 x 50%) x (4598 x 0.48)
= R 926 856 800 000
Ke = 15.2%
2. Preference shares
Market value = 3 000 000 x 581
= 1 743 000 000
Cost of preference shares

PV = -581
FV = 605
N=6
PMT = 45.52 (605 X 0.1045) X 0.72
I=?
Therefore interest = 8.39%
3. Debentures
Cost of debentures = 10.25(1 - 0.28)
= 7.38%
Market value
FV = 3 144
I = 7.38
PMT = 249
N=7
PV = ?
PV = 3234.27
Admin fees.
N =6
FV = 15 000 000
I = 7.38
PV = ?
Present value = R9 784 775.40
Therefore, the present value of the debenture = (9 784 775.4 + 3 234 270 000)
=3 244 054 775
4. Long term debt

Cost of debt =9.75(1-0.28)
= 7.02%
2019 2020 2021
290 500 000 290 500 000 290 500 000
69 022 800 39 382 200 20 393 100
359 522 800 329 882 200 310 893 100
0 0.9298 0.865
PV 306 724 450 268 922 531.5
Therefore PV = 575 646 981.5
(C). Production budget
Details September October November December January February

Opening stock (613200) (7051800) (7264800) (634000) (664320)
Sales 5253000 5170000 5876500 6054000 5270000 5538600
Closing stock 6132000 7051800 7264800 6324000 66646320
Production/Purchases 6089500 5113200 5592320
(D) Cash Budget
Details October November December January

Receipts:
Cash sales 367281250 378375000 329375000
Credit sales at 60% 574875000 661106250 681075000
Credit sales at 28% 268275000 308546250 317835000
Credit sales at 9% 88644375 86231250 99165938
Cash payments:
Cost of sales (1) 552302631 568984962 520545113
(2) 517857143 552302631 568984962
Bed debts 29548125 287437750 33055313
(e). Ratios
Interest bearing debt equity ratio can be improved
• Reduce debt through the utilization of the of internal finances.

• Issuing of more ordinary shares.
Current ratio can be improved through
• Reducing the issuing discount to encourage customer to pay in time.

• Paying outstanding liabilities in time
Return on equity can be improved through
• Borrow short term and long-term finances to increase expansion.

• Reduce labor expenses
Price/Book value can be improved by.
• Issuing of high dividends. This will send the message that the company is optimistic of
the future profits generations.
Cash interest cover can be improved by
• Reducing the interest-bearing debt

• Keep enough cash through a properly manages cash conversion cycle.
(f) Number of shares to be issued.
4598 X 0.48 =2207.04
Shares will be issue at 10% premium thus the price will be 2207.04 + 10% =2427.744
The value of funds required = R 8 850 000 000
Number of shares will be = 8 850 000 000/22.07
= 400 996 828 shares.

Application of Financial Management
Techniques
MAC3702
FASSET MOCK EXAMINATION
Date: Second Semester
Department of Management Accounting
PLEASE NOTE:
1. This paper consists of THREE (3) questions.

2. All questions must be answered.
3. All answers must be handwritten.
4. Basic workings, where applicable, must be shown. Use of pencil is not permitted.
5. EACH QUESTION MUST COMMENCE ON A SEPARATE PAGE.
PROPOSED TIMETABLE
Question Topic Marks Minutes

1 Capital structure, M&A and valuations 50 90
2 Capital budgeting 20 36
3 Working capital 30 54
100 180
Tiles & Styles of Africa (“Tiles & Styles”) is South Africa’s leading retailer of tiles, bathroom fixtures and
related products. The company provides superior ceramic tile flooring and walling at competitive prices to
a growing market. Listed on the JSE three years ago, today Tiles & Styles has a network of 162 retail
stores in the African continent.
As the company continues to enjoy strong brand affinity based on its reputation for a high quality year-
round value offering, the market capitalisation of Tiles & Styles at the end of its 2017 financial year was
R9,45 billion (market value of equity). This was despite constrained discretionary disposable income of its
customers and the Rand plunging to its lowest levels in more than 15 years against major currencies.
The Competition Tribunal has just approved the company’s offer to acquire 51% of Tile Ses’la (Pty) Ltd
(“Tile Ses’la”), one of its suppliers in an effort to ensure that the company continues to attain its growth
targets. Tiles & Styles has offered R5 billion in cash to the existing shareholders of Tile Ses’la. This
strategic acquisition has been well received by the market, as it will likely lead to cost reduction and other
synergistic benefits. Tiles & Styles also continues to invest substantially in information technology and e-
commerce to keep abreast of opportunities in the rapidly changing environment.
The statement of financial position of Tiles & Styles, salient information and notes are provided on the next
page, followed by the financial information relating to Tile Ses’la.
Statement of financial position of Tiles & Styles of Africa
For the year ended 31 December 2017
2017 2016
Notes Rm Rm
ASSETS
Property, plant and equipment 3 788 3 659
Goodwill 681 590
Intangible assets 334 151
Deferred tax 61 58
Other non-current assets 102 68
Total non-currents assets 4 966 4 526
Inventories 850 838

Trade and other receivables 1 049 994
Marketable securities 41 47
Cash and cash equivalents 404 64

Stated capital 542 542
Retained income and other reserves 3 154 2 645
Total equity 1 3 696 3 187
LIABILITIES
Medium and long-term borrowings 1 1 912 2 077
Net retirement benefits liability 240 212
Provisions 44 40
Total non-current liabilities 2 196 2 329
Short-term borrowings 2 651 250

Current tax liability 167 165
Total current liabilities 1 418 953
SALIENT INFORMATION 2017 2016

Prime rate (%) 10,3 10,5
Corporate taxation rate (%) 28,0 28,0
Inflation rate (%) 4,8 6,4
NOTES
1. Tiles & Styles has a target capital structure of 30: 70 (Debt: Equity), and aims to maintain a ratio of
3:1:1 (debentures: bank loans: preference shares) on its debt composition. The ordinary dividend
(2017: R280 million) is expected to continue growing at 9% per annum in the foreseeable future.
The medium and long-term borrowings at 31 December 2017 were made up of only the following:
 R1 billion debentures were issued three years ago and are redeemable at a premium of
0,5% and the maturity date is 31 December 2021. The premium is payable on 31 December
2022; and although the premium is tax deductible there is no interest charged for the late
settlement of the premium. The debentures were issued at a fixed interest rate of 6,8%
(similar debentures are currently trading at a post-tax rate of 5,2%).
 A bank loan of R612 million was obtained on 28 December 2015 and the interest paid yearly
is fixed at R55,08 million. The going rate in the market for similar loans is 8,5% per annum.
 Preference shares were issued on 28 December 2014 and are redeemable on 28

December 2021. These preference shares carry a fixed dividend pay-out of 7% (classified
as finance costs). Preference share deals structured this way are currently trading at 75%
of the prime rate.
The providers of capital are willing to increase their facilities at prevailing market rates. The
providers of capital are also willing to reduce the existing facilities, should the company wish to do
so.
2. Interest expense on short-term borrowings is negligible. Interest rates given are before tax unless
stated otherwise.
The information below relates to Tile Ses’la (Pty) Ltd:
Statement of comprehensive income of Tile Ses’la (Pty) Ltd

2017 2016 2015
Rm Rm Rm
Revenue 3 670 3 539 3 189
Cost of sales (2 182) (2 117) (1 902)
Gross profit 1 488 1 422 1 287
Employee remuneration (184) (144) (134)
Depreciation and amortisation (113) (90) (81)
Other operating expenses (net) (128) (141) (115)
Trading profit 1 063 1 047 957
Finance income 127 119 95
Profit before taxation 1 190 1 166 1 052
Taxation (310) (316) (307)
Profit for the year 880 850 745
Statement of financial position of Tile Ses’la (Pty) Ltd
2017
Rm
ASSETS
Property, plant and equipment 1 989
Investments 732
Intangible assets 54
Total non-currents assets 2 775
Inventories 550
Trade and other receivables 327
Cash and cash equivalents 511
Total current assets 1 388
TOTAL ASSETS 4 163
Stated capital 818

Retained income 2 794
Non-distributable reserves 161
Total equity 3 773
LIABILITIES
Subordinated loan 74
Provisions 12
Total non-current liabilities 86
Short-term borrowings 26
Trade and other payables 278
Total current liabilities 304
TOTAL EQUITY AND LIABILITIES 4 163
Valuation information
1. The following items should be considered in establishing the sustainable earnings of Tile Ses’la:
 Gross profit in 2015 was down by R83 million because of protests that led to Tile Ses’la being
outlets closed for three weeks. There was no material change in other operating expenses
during that year.
 On 22 June 2017 Tile Ses’la received an out-of-court settlement of R20 million after one of its
competitors infringed the company’s trademark.
 Other operating expenses in 2016 include a R40 million insurance pay-out which was received
by Tile Ses’la in September 2016 for loss of a key member of staff.
(The above amounts are net of tax and therefore tax implication on the above transactions can
be ignored).
2. In the event that the board of directors of Tile Ses’la decides to wind up the company through
disposing of its assets, the following financial information has been established:
 The company’s land and buildings (recorded at a carrying value of R400 million) is currently
worth R4,24 billion. This is before taking into account selling and other legal expenses of 0,3%.
 The company will be able to sell some of its trademarks with a carrying value of R30 million for
R380 million.
 40% of the company’s inventory will be sold at cost, while the balance will be sold at a gross
profit margin of 20% on cost.
 All other assets will be sold at carrying value.
 The subordinated loan was obtained at the inception of the company from its shareholders at
a 0% interest rate. The agreement requires the company to pay a fee equal to 0,43% of the
current net asset value whenever it settles the loan in the event of liquidation or sale of its
assets.
 The company will settle all its other liabilities at carrying value.
3. To determine annual free cash flows yearly, the company uses the following formula below:
Free cash flows (FCF) =
Previous two years’ average net profit for the year
Add: Non-cash expenses for the previous year (if any)
Less: Non-cash income for the previous year (if any)
Additional information
The future growth in profits in the near future for Tile Ses’la will average 4% per annum. Similar companies
listed on the JSE trade at an average P/E multiple of 13,29. Analysts estimate that unlisted companies in
the same sector should allow for a risk factor of 1,5 in establishing the business value. The required rate
of return to be used in the valuation of Tile Ses’la is 14%.
REQUIRED
a) Calculate the weighted average cost of capital of Tiles & Styles at 31 December 2017.
(6)
b) Advise how the acquisition of Tile Ses’la (Pty) Limited should be financed, assuming that Tiles &
Styles is working towards the target capital structure.
(Show all calculations)
(14)
c) Advise the board of directors and shareholders of Tile Ses’la whether they should accept the offer
made by Tiles & Styles, using both the price-earnings multiple and the discounted cash flow
methods.
(Price-earnings multiple method 11 marks, free cash flow method 5 marks)
(16)
d) Use the net asset value method to check the reasonableness of the calculations performed in part
(c) above.
(7)
e) Describe different types of acquisitions, and provide an example for each. Explain the type of
acquisition of Tile Ses’la by Tiles & Styles.
(7)
[50]
Question 2 (20 marks; 36 minutes)
Mbombela Concession Company (MCC) is a railway company running the state-of-the-art rapid rail
network in Gauteng. Its flagship initiative in South Africa is the Gautrain, a world class rail connection
comprising of two links, namely a link between Tshwane and Johannesburg and a link between OR Tambo
International Airport and Sandton. The Gautrain is responsible for carrying more than 80 000 passengers
per week between 10 major stations. The service is quite popular amongst Gauteng’s workforce due to
the fast speed the trains travel at, saving commuters invaluable time while providing comfort and safety on
board. The Gautrain also provides bus services for commuters who do not work or live close to the Gautrain
stations. Commuters who choose to drive their cars to the Gautrain station can also park their cars at
Gautrain parking buildings at a reasonable fee. Non-Gautrain users are charged more than Gautrain users
for utilising either the bus services or parking facilities.
Following the success of this 80 kilometre rail network launch and its increasing demand, MCC has
embarked on a feasibility study to introduce a new rail corridor linking Roodepoort and Sandton (known as
“Jozi Connect project”). New stations will be built in Roodepoort, Fairland, Cresta and Randburg, while
minor alterations will be effected at the Sandton station. Three major components (phases) of this project
have been identified, mainly:
 Stations, rail works and trains;

 The parking service and
 The bus shuttle service
The construction and setting up all these phases is expected to be finalised at the end of 2018.
The stations, rail works and trains

The net present value calculated for this phase of the project is R128 000 (negative).
The bus shuttle service

The net present value calculated for the bus shuttle service is R3,445 million (positive).
The parking service

The net present value of this phase has not yet been determined, but the project details are as follows:
MCC is envisaging constructing parking buildings right opposite the four stations that will be built from
scratch. The construction will commence at the beginning of 2018 and will be completed just before the
Christmas period of 2018. The cost of building at the four stations (assume it is payable at end of 2018)
will be R1 billion and the working capital required at the start of the project is R65 million. It is the policy of
MCC to depreciate its parking structures over a period 80 years.
About 10 000 passengers per week are expected to utilise the parking bays at the four stations in the first
two years of operation and this number will grow by 20% in the third year of operation to reach capacity as
some Gautrain users prefer to the use the bus shuttle service.
There is an expected economic boom around the stations and demand for more parking space is
anticipated. MCC will rent out its spare capacity parking bays to nearby businesses (these are non-
Gautrain users). The demand is expected to be 5 000 parking bays per annum in the first two years of
operation and then 3 000 in each of the following three years (until 2023).
Total operating costs, including depreciation, are expected to approximate R50 million and will grow at
inflation rate of 6% p.a. The parking tariffs paid by car owners will also increase by the inflation rate. The
growth on parking tariffs and operating costs will remain at inflation rate until 2023 and thereafter, these
will grow at 3,65% p.a. (for terminal value). Gautrain users will pay a tariff of R200 on average per week
for parking, a massive discount of 57,15% on the standard parking tariff (first year of operation rate).
The effective taxation rate (this is also after taking into account tax benefit on the buildings) is 24% -
therefore ignore capital allowance on parking buildings. The WACC has been established to be 15% and
cash flows take place at the end of the year unless stated otherwise. There are 52 weeks in a year.
REQUIRED
a) Advise the management of Mbombela Concession Company whether to undertake the construction
of the parking buildings, and provide motivation for the advice given.
(Calculation 17 marks; comment 3 marks)
(20)
Question 3 (30 marks; 54 minutes)
The Fire and Brimstone Limited is a company that trades in the tyre industry. The following information is
available on 28 February 2018:
Statement of comprehensive income for the year ending 28 February 2018
2018 2017
Rand Rand
Note
Turnover 1 8 500 000 7 850 000
Cost of sales 3 850 000 3 600 000
Opening inventory 850 000 1 200 000
Purchases 2 4 200 000 3 250 000
Closing inventory (1 200 000) (850 000)
Gross profit 4 650 000 4 250 000

Operating expenses (3 200 000) (2 180 000)
Operating profit 1 450 000 2 070 000
Dividends received 500 000 420 000
Finance charges (net) (118 000) (98 000)
Impairment loss on goodwill (100 000) -
Profit before taxation 1 732 000 2 392 000
Taxation (392 960) (552 160)
Profit for the year 1 339 040 1 839 840
Attributable to
Preference shareholders 300 500 600 000
Ordinary shareholders 1 038 540 1 239 840
1 339 040 1 839 840
Statement of financial position on 28 February 2018
Note 2018 2017

Rand Rand
Assets
Non-current assets 3 120 500 3 480 500
Property, plant and equipment 1 250 000 1 550 000
Goodwill 450 000 550 000
Investments in associates 850 500 850 500
Financial assets 570 000 530 000
Current assets 2 698 000 2 150 000

Inventory 3 1 200 000 850 000
Trade receivables 1 1 048 000 980 000
Cash balances and investments 450 000 320 000
Total assets 5 818 500 5 630 500
Equity and liabilities

Equity 2 525 000 2 325 000
Ordinary share capital (800 000 ordinary shares) 1 600 000 1 600 000
Non-controlling interests 250 000 250 000
Accumulated reserves 175 000 125 000
Retained income 500 000 350 000
Non-current liabilities 2 442 000 2 558 000

Long-term loan 950 000 1 200 000
Debentures 12 000 8 000
Preference shares (250 000 preference shares) 1 000 000 1 000 000
Deferred taxation 480 000 350 000
Current liabilities 851 500 747 500

Trade payables 350 000 425 000
Short-term debt 501 500 322 500
Total equity and liabilities 5 818 500 5 630 500

Notes
1. Credit sales increased from 55% of turnover in 2017 to 65% of turnover in 2018. Credit terms
for the debtors of the company are 60 days from invoice date and for the standard industry
terms are between 45 and 60 days.
2. In 2018, 40% of the company’s purchases were made on credit in comparison to 50% in
2017. The company’s payment terms to creditors are between 45 and 60 days from invoice
date, and discount of 10% is received if payment is made before 45 days. Standard payment
terms for the industry are 60 days from invoice date.
3. The average stock turnover period for the industry is 90 days and the average business
cycle for the industry is 100 days. All raw materials are purchased on the just-in-time (JIT)
basis. The inventory in the statement of financial position consists of finished goods only.
Additional information
Sales and Accounts receivable

฀ The Fire and Brimstone Limited has decided to offer customers paying cash a 10%
discount. If customers buy on credit and pay within 45 days, they will receive a 5%
discount.

฀ Sales increased during the last year, as the company signed a contract with a major car
manufacturer to supply all the tyres for its new cars. The contract will end in five years’
time.

฀ Furthermore, The Fire and Brimstone Limited has recently been appointed as the supplier
of choice for all the major insurance companies. The new tollgates increased traffic on the
country's secondary roads, resulting in more potholes. Subsequently, insurance
companies are experiencing an all-time high in insurance claims for tyres. The insurance
companies pay cash for these claims.
Purchases and Accounts payable

฀ The company’s current payment terms to creditors are between 45 and 60 days. It is clear
that the company is not taking advantage of the benefit of early settlement discounts
offered to it. The financial manager decided to revisit the company’s strategy for its creditor
payments. A decision was taken to reduce creditor payment terms to 45 days from invoice
date in order to take advantage of the benefit of the settlement discount.
Inventory
฀ A new industrial engineer was appointed in order to reassess the company’s stock turnover
period. He established the reason for the time lag as being new, inexperienced staff
members recently employed in the manufacturing division.

฀ Transport companies are experiencing backlogs due to recent floods, making some areas
inaccessible. This leads to a longer turnaround time for collection of finished goods at the
company’s warehouse and distribution thereof to sales outlets.

฀ The manufacturing plant still uses old technology that does not enable sufficient workflow
due to long setups and throughput times.

฀ Finished goods are transported from the plant to the warehouse, from where it is then
distributed to various outlets.

14
฀ The Fire and Brimstone Limited stores its inventory at a third party’s warehouse. The
warehouse is situated in an industrial area known for its high crime statistics. There have
been incidents in the past of burglaries at the warehouse. The warehouse is located
approximately 100 kilometres away from the company’s major outlets. A monthly storage
fee is charged based on floor space used to store the inventory. The larger the stock
holding, the bigger the floor space needed and the higher the storage fee will be.

REQUIRED
a) Calculate the business cycle of The Fire and Brimstone Limited for year 2018 in days
and comment on the performance of each component in line with the notes provided.
There are 365 days in a year and the company adjusts for VAT at 14%, where necessary.
Round off your answers to two decimal places.
(15)
b) Discuss the impact of the additional information provided on the company’s business
cycle by explaining how the additional information will affect the business cycle.
(15)
[30]
©
UNISA 2018
Notes for marking:
1. Symbols/signs used:
r/w Right or wrong – the answer must be exact
CA Calculation must be completed and correctly expressed
C Carry-through mark (use marks from previous calculation)
±/y Year and signage must be correct
2. Note that extra marks may be awarded for presentation and logical layout.
Open Rubric
Question 1 (a)
CALCULATION OF WACC – based on target capital structure (see workings below)
Portion of capital Cost of Weighted cost

Capital structure structure capital of capital
Marks given below
Ordinary shares (workings) 0,70r/w 12,2% 8,5%
Debentures (0,30 * 3÷5) 0,18r/w 5,2% 0,9%
Bank loan (0,30 * 1÷5) 0,06 r/w 6,1% r/w 0,4%
Preference share (as above) 0,06r/w 7,7% r/w 0,5%
1 / 100% 10,3% CA
Max: 8 marks
Question 1 (b)
FINANCING DECISION – R5bn acquisition of Tile Ses’la (see workings below)
Consider Current Capital Capacity Target Capital 1 mark - adding to R5bn

SCALING Capital structure Structure (Balancing) % Structure 1 mark – balancing
(R ‘m)
Ordinary shares R9 450 +2 020 0,70 R11 470
Debentures R992 +1 957 0,18 R2 949
Bank loan R650 +333 0,06 R983
Preference shares R293 +690 0,06 R983

If 30:70 & the
Total R11 385 c R5 000 100% R16 385  amount is
increased by
ALL 4 instruments R5bn
Conclusion: Acquisition of Tile Ses’la must be financed as follows: c

 Issue of ordinary shares (R2,020 billion) – Retained income in the form cash can
be used to reduce risk of dilution of control
 Issue of debentures (R1,957 billion) – Consideration should be made to borrow
from different entities due to the amount required
 Taking a new banking loan facility (R333 million) and
 Issue of redeemable preference share issue (R690 million)
Max: 12 marks
WORKINGS
1(b) workings 1(a) workings
 
Ordinary shares 𝑴𝑽𝒆 = R9,45 billion (given) 𝑲𝒆 = 𝐑𝟐𝟖𝟎𝐦 𝐱 𝟏,𝟎𝟗

𝐑𝟗 𝟒𝟓𝟎 𝐦
 + 𝟗%
𝑲𝒆 = 12,2% 
INSTRUMENT MARKET VALUE COST OF DEBENTURES
CF0 0
CF1 - 48,96m (1bn x 6,8% x 0,72) 
Debentures CF2 - 48,96m 𝐾𝑑1 = 5,2% (given)
CF3 - 48,96m
CF4 - 1 048,96m (1bn)+48,96m 
CF5 - 3,6m (1bn x 0,005 x 0,72) 
I 5,2
NPV 992 064 186
INSTRUMENT MARKET VALUE COST OF LOAN
Interest paid 𝐾𝑑2 = 8,5% x 0,72

𝑴𝑽𝒅𝟐 =
𝐾𝑑2
Bank loan = 6,1%
55,08m x 0,72
𝑴𝑽𝒅𝟐 =
6,1%𝐜
𝑴𝑽𝒅𝟐 = R650 124 590
INSTRUMENT MARKET VALUE (FINANCIAL CALC.) COST OF PREF.
CF0 0 𝐾𝑝 = 10,3% x 75%

CF1 - 21m (1 912–1 000–612) x 7% 
Preference shares CF2 - 21m
CF3 - 21m = 7,7%
CF4 - 321m (1 912–1 000–512) + 21 
I 7,7 c
NPV 292 997 833  c
ALTERNATIVE MARKET VALUE (FINANCIAL CALC.) - ALT COST OF DEBENTURES
PV of capital
FV - R1 000m 
N 4
Debentures I 5,2 𝐾𝑑1 = 5,2% (given)
Comp PV 816,464m (c1) Capital & Interest
can be done in
one calculation
PV of interest
PMT - 48,96m (1bn x 6,8% x 0,72) 
N 4
I 5,2
Comp PV 172,806m (c2)
PV of premium
FV - 3,6m (R1bn x 0,005 x 0,72) 
N 5
I 5,2
Comp PV 2,794m (c3)
Market value = R992 064 186 (c1 + c2 +c3) 
ALTERNATIVE MARKET VALUE (FINANCIAL CALC.) COST OF PREF.
FV -300m 𝐾𝑝 = 10,3% x 75%

PMT - 21m 
Preference shares I 7,7 c
N 4
= 7,7%
PV 292 997 833  c
Same approach can be used for Debentures

Question 1 (c)
i). Valuation using the price-earnings method
1. Determine maintainable earnings of Tile Ses’la
Rm 2015 2016 2017
Profit for the year (given) 745 850 880
Loss of gross profit  r/w 83
Out of court settlement  r/w (20)
Insurance pay-out  r/w (40)
Maintainable earnings 828 810 860
No trend – use weighted average method r/w 1/6 2/6 3/6
Weighted average maintainable earnings  c 138 270 430
Weighted average maintainable earnings 838
2. Determine the implied/adjusted P/E ratio of Tile Ses’la
P/E multiple of listed companies (given) 13,29

ANY 1 positive factor Positive factors (decreasing risk) 
Well established business/market leader +0,5
Geographical diversification +0,5
Well-known brands – trade mark as proof +1
Exclusive distribution rights +0,01
ANY 1 negative factor Negative factors (increasing risk) 
Rife competition -1,8
Rapid changes in technology -2,0
Unlisted company factor (given)  r/w -1,5
Adjusted P/E multiple – Tile Ses’la 10

3. Determine value of Tile Ses’la after adjusting for control premium and marketability discount
R million
1 mark for the valuation Price-earnings valuation before adjustments (R838m x 10)  c 8 380
amount calculated and
adjusted PE (Must NOT Add: Control premium (R8 380m x 12,17%) any between % 0% – 15% 1 020
be a %) Value before marketability discount adjustment 9 400
Less: Marketability discount (already priced) -
100% business value 9 400
51% x R9,4 billion -
Value of 51% stake of Tile Ses’la 4 794
Max: 11 marks
ii). Valuation using the free cash flow method
Free cash flows for 2018 R million
Average profit for 2016 & 2017 (880+850/2) r/w 865

ONLY 1 mark if years
used are 2016 & 2015
Depreciation & amortisation for previous year (non-cash) r/w 113
Tax on depreciation & amortisation  c (37)
Free cash flows for 2018 941
Discounted free cash flows:

𝐶𝐹𝑖
=
WACC−g
941
=
(14%−4%)
100% business value = R9 410 million
51% of Tile Ses’la (Pty) Ltd = R4 799 million
Conclusion: The board of directors, together with the shareholders, of Tile Ses’la (Pty) Ltd should
accept the Tiles & Styles of Africa offer of R5 billion as the valuations performed above show that
the company is worth R4,8 billion.  CA (mark whether under P/E multiple or DCF method workings)
Max: 5 marks
Question 1 (d)
i). Valuation using the net asset value method
Rm
ASSETS
PPE (1 989 – 400 + 4 240) – (4 240 x 0,003) 5 816 r/w
Investments 732 r/w
Intangible assets (54 – 30 + 380) 404 r/w
Inventory (550 * 40%) + (550 * 60%) + (550 * 60% * 20%) 616 r/w
Trade and other receivables 327 r/w
Cash and cash equivalents (can be netted off against price) 511
Less: LIABILITIES & OTHER COSTS
Non-current liabilities (86) r/w
Settlement of the subordinated loan (3 773 * 0,0043) (16) r/w
Current liabilities (304)
Estimated value of Tile Ses’la 8 000
Value of stake sold (51% x 8 000m) 4 080
Conclusion: According to net asset value method, the stake to be sold is worth R4,1 billion (R700 million
below the other two valuation methods, and R900 million below the offer made by Tiles & Styles of Africa).
The net asset value method will not consider the true value attached to the brand of Tile Ses’la (including
human capital, customer loyalty, brand, value of exclusive rights, etc.). The board of directors and
shareholders of Tile Ses’la should accept the offer as it is better than all three methods used.  CA
Max: 7 marks
Question 1 (e)
a) Types of acquisitions (general)
The type of
1. Horizontal acquisition: Two companies that are in direct competition and share the same product line
acquisition and markets. Example – a beer manufacturing company buying another beer manufacturing company
must be
defined (AB InBev buying SABMiller).
2. Vertical acquisition: Two companies both on a given chain of supply (customer and a supplier).
Example – ESKOM buying a coal mine like Anglo Coal.
3. Conglomerate acquisition: Two companies that trade in unrelated markets.  Example – Woolworths
buying Kulula.com 
b) Types of acquisition of Tile Ses’la – VERTICAL ACQUSITION (Tile retailer buying a tile
manufacturer)  r/w
Max: 7 marks
Question 2
R’000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

2018 (beg) 2018 2019 2020 2021 2022 2023
Description
Surveyor cost – sunk  -

Buildings  ±/y (1 000 000)
Working capital  ±/y (65 000) 65 000
For year Rev: Gautrain users  If years are incorrectly 104 000 110 240 140 225 148 639 157 557
& shown, give marks for
increase Rev: Non-Gautrain use revenue & costs if 121 354 128 635 81 812 86 720 91 924
of 6%
Operating costs  increase correct. (37 500) (39 750) (42 135) (44 663) (47 343)
Terminal (cont.) value 1 402 926
Taxation at 24%  Workings can be shown below (45 085) (47 790) (43 176) (45 767) (48 513)
Net cash-flows (65 000) (1 000 000) 142 769 151 335 136 726 144 929 1 621 551
SHOW INPUT keys: CF0 CF1 CF2 CF3 CF4 CF5 CF6
Calculator
inputs I/Y = 15%
Net Present Value  124 163
Signage and the year must be correct
to get the marks

Workings
Year 2 Year 3 Year 4 Year 5 Year 6

Tariff – Gautrain users R200 x 1,06 R200 R212 R225 R238 R252
Tariff – Non-Gautrain users R200 ÷ 0,4285  R467 R495 R524 R556 R589
No of Gautrain users 10 000 10 000 12 000 12 000 12 000

No of Non-Gautrain user 5 000 5 000 3 000 3 000 3 000
R’000
Rev: Gautrain users R200 x 52 x 10 000&12000 104 000 110 240 140 225 148 639 157 557
Rev: Non-Gautrain users R467 x 52 x 5 000 & 3 000 121 354 128 635 81 812 86 720 91 924
Operating costs excl. depr 50m – (1 000m / 80)  37 500

Annual increase R37 500 x 1,06 Allow if increase based on full R50m 39 750 42 135 44 663 47 343
Terminal value in year 6 V6 = Cf6+1 ÷ (WACC – g)

Cf6 157557+91924-47343-48513
Cf6+1 153 625 (above) x 1,0365 
 Terminal value 159 232 ÷ (0,15–0,0365) 

1 402 926 rounding
Max: 17 marks
The taxation calculation table needed not
be shown separately, especially where
there is no sale of an asset OR wear & tear.
TAXATION calculation Year 2 Year 3 Year 4 Year 5 Year 6

Net revenue c Revenue – Operating costs 187 854 199 125 179 902 190 696 202 138
Taxation at 24% 45 085 47 790 43 176 45 767 48 513
R’000 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

2018 (beg) 2018 2019 2020 2021 2022 2023
Factors (Alternative)
Net cash-flows (65 000) (1 000 000) 142 769 151 335 136 726 144 929 1 621 551
Rev: Non-Gautrain use 1,000 0,870 0,756 0,658 0,572 0,497 0,432
Discounted cash flows (65 000) (869 565) 107 954 99 505 78 173 72 055 701 041
I/Y = 15%
Net Present Value 124 163

Conclusion
The aggregate NPV for this project is R127 480 000 - positive (R3,445m + R124,163m c – R0,128m) and
therefore the project must be accepted.
The project is indivisible and the company cannot choose to implement one phase of the project and reject
others, e.g. MCC cannot accept the parking service and bus shuttle service phase and reject the station,
rail works & trains.
These phases are also dependent in the sense that rejecting one of the phases will have an impact on
projected cash flows from the other phases, e.g. without the stations, trains and rail infrastructure, there is
no need for the parking and bus shuttle services.
In making the decision, the company should also consider the performance of the existing Gautrain
operations and to help it better forecast.
The implementation of Jozi Connect project will also boast the economy with possible direct and indirect
job opportunities to be created and efficiencies in the economic activities of the province. 
Max: 3 marks
For any valid discussion point, a mark is
given as the question requires any
comment based on notes 1 to 3.
Question 3 (a)
i). Calculate and comment on debtor’s collection period Bonus mark if consistent rounding to 2 decimal places 
Accounts receivable
x 365
Credit sales
1 048 000ᵅ
114 x 365
65% x (8 500 000) x 
100
1 048 000
x 365
6 298 500
= 60,73 days
ᵅ Alternative: Average balance 1 048 000 + 980 000)/2 = 1 014 000

Days if average is used = 58,78 days and without VAT = 66,99 days)
Discussion  maximum: 1 mark
Customers adhere to credit policy as an average debtor settles their account (60,73) in line with the normal credit
terms 60 days).
There is a low risk of bad debts as customer generally settle in line with credit terms.
The company is more lenient to its customers as the industry collects as early as in 45 days. The competitors might
be having better credit controls and incentives than the company.
980 000
Debtors are settling their accounts quicker than last year 2017: 72,67 days) [ 114 x 365]
55% x 7 850 000 x
100
Improved communication with customers, reminders of outstanding debt and selling more to existing credit
customers led to the decrease in debtors’ days.
Note: where VAT has not been taken into account in the calculation, the debtors’ collection period is 69,23 days
2017: 82,85 days) – valid comment: Debtors not adhering to credit terms and take longer to settle than industry
average although the ratio is improving or bad debt risk increases).
ii). Calculate and comment on the stock turnover period
Inventory
Cost of sales
1 200 000ᵅ
x 365
3 850 000
= 113,77 days
ᵅ Alternative: average balance 1 200 000 + 850 000) /2 = 1 025 000

Days if average is used = 97,18 days
It takes the company almost 4 months to convert its stock into sales (24 days later than industry) – this indicates
poor stock management processes. This is evidenced by the issues already pointed out by the industrial engineer.
This is likely to result in stock theft and /or damage.
There is a possible increase in holding costs (storage, insurance, etc.).
There is a minimal risk of running out of stock.

850 000
The company is holding its stock much longer than last year 2017: 86,18 days) [ x 365]
3 600 000
Note: where average has been used, the stock turnover period is only 7,18 days longer than the industry norm –
students must comment in line.
iii). Calculate and comment on creditors’ payment period
Trade payables
x 365
Credit purchases
350 000ᵅ
114 x 365
40% x (4 200 000) x 
100
350 000
x 365
1 915 200
= 66,70 days
ᵅ Alternative: average balance 350 000 + 425 000)/2 = 387 000

Days if average is used = 73,75 days without VAT = 84,08 days)

The company seems to be in breach of credit terms with its suppliers (60 days) and the payments are made on average
a week after invoices are due.
Possible cash flow difficulties (timing) – debtors settled in 60,73 days and inventory is converted in 113,77 days as
customer generally settle in line with credit terms.
The company is not taking advantage of the 10% discount where invoice is settled within 45 days.
Late payments may cause credit facility to be suspended/blacklisting or strained relationship and cash balance 2017:
83,74 days).
Late payments may result in late payment penalties and/or interest.
Settlement of creditors’ accounts is delayed to utilise funds for other purposes (purchase of assets, investments).
The company is settling its accounts quicker than last year – improved relationship and cash balance 2017: 83,74 days)
425 000
[ 114 x 365]
50% x 3 250 000 x
100
Note: where VAT has not been taken into account in the calculation, the creditors’ collection period is 76,04 days
2017: 95,46 days) – Comments above are still valid. Denominator, if without VAT, is 1 680 000
iv). Calculate and comment on business cycle of The Fire and Brimstone Limited
Days
Debtors’ collection period 60, 73
Plus: Stock turnover period 113,77 c
Less: creditors’ payment period (66,70) c
Business cycle 107,80 
Discussion  c maximum: 1 mark

The industry average’s business cycle is 100 days and therefore we can establish that The Fire and
Brimstone Limited has a 7,8-day longer business cycle than the industry average. The competitors may have
more cash at their disposal to take advantage of possible cash discounts and allow for speculative
investments. Poor controls around inventory and debt management and slow response to tackling this issue
will cause the company to struggle to keep up with the competition
Max: 15 marks
1 mark for presentation (each component presented with a heading
Question 3 (b) 1 mark for understanding how the business cycle is affected
Sales and Accounts receivable

Business cycle component Increase/decrease of the Reason for
business cycle days increase/decrease
Debtors’ collection period  Business cycle positively  Credit customers will be
affected encouraged to settle their
accounts earlier or pay
OR cash – to take advantage
of 5% & 10% discount
 Decrease of business offered (decrease in trade
cycle days receivables & debtors’
collection period) 
Debtors’ collection period  Business cycle not affected  For new cash paying
customers (10%
OR discount), there will be no
change in business cycle
 No change in business days
cycle days (no impact on trade
receivables & credit
sales) 
Debtors’ collection period  Business cycle not affected  Impact of sales to the
major car manufacturer
OR has already been effected
(last year)
 No change in business (no additional impact on
cycle days trade receivables & credit
sales) 
Debtors’ collection period  Business cycle not affected  Sales to cash paying
insurance companies will
OR not change the business
cycle days
 No change in business (no impact on trade
cycle days receivables & credit
sales) 
Purchases and Accounts payable
Business cycle component Increase/decrease of the Reason for

business cycle days increase/decrease
Creditors’ payment period  Business cycle negatively  Settling creditors earlier
affected will result in a longer
business cycle – cash
OR resources likely to be
strained
 Increase of business cycle (decrease in trade
days payables & creditors’
payment period) 
 Potential increase in profit

and cash in the long run
(due to savings on
discount)
Inventory
Business cycle component Increase/decrease of the Reason for increase/decrease
business cycle days
Stock turnover period  Business cycle negatively  The time lag means
affected inventory takes longer to
leave the factory
OR (increase in inventory &
stock turnover period) 
 Increase of business cycle  New and inexperienced
days staff in the manufacturing
division will inevitably
lead to an increased
manufacturing turn-
around time which will
increase the business
cycle. 
Stock turnover period  Business cycle negatively  Further delays

affected experienced by transport
companies lead to
OR increase in the business
cycle
 Increase of business cycle (increase in inventory &
days stock turnover period)

Stock turnover period  Business cycle negatively  The old technology of the
affected machine will lead to
slower manufacturing
OR time, therefore increasing
the business cycle 
 Increase of business cycle (increase in inventory &
days stock turnover period)
Stock turnover period  Business cycle negatively  More time is taken in

affected moving the stock from the
plant to various outlets
OR (increase in inventory &
stock turnover period)
 Increase of business cycle 
days
Stock turnover period  Business cycle negatively  100km distance increases

affected the number of days to
convert the inventory into
OR sales (increase in
inventory & stock turnover
 Increase of business cycle period) 
days  Risks associated with
moving the goods
(hijacking, breakdowns,
etc.) may cause the
company to incur extra
costs (increase in
inventory & stock turnover
period) 
 The company will also
incur additional holding
costs especially where
stock is not sold on time.
(increase in inventory &
stock turnover period)
Max: 15 marks
1
MAC 3702
SUGGESTED SOLUTION
OCTOBER 2018 EXAM
a) When funding new projects, it is essential to consider the target debt equity ratio as this will
determine the capacity of the company to raise a particular form of funding without drastically
altering its capital structure and weighted average cost of capital.
Also note that when a company issues non-redeemable preference shares it can serve as equity
when analysing the capital structure.
Note that SA Clinic is a private company and does not have a tradeable market price.
PROPOSAL 1
Current
capital Target capital
structure structure Capacity
Book value
Equity 14 240 000 (1) 25 410 000 (3) 11 170 000
Debentures 3 560 000 (2) 10 890 000 (4) 7 330 000
17 800 000 36 300 000 18 500 000
New R12 500 000 x
project 18 500 000 1.48
36 300 000
1. R36 300 000 x 70%

2. R36 300 000 x 30%
3. R25 410 000 – R14 240 000
4. R10 890 000 – R3 560 000
No of ordinary
shares to be issues
Total value 11 170 000
Net price ÷ R3,86 (R4.05 – 4.78%)
2 893 782
Shares
No of debentures
Nominal value R70,00
104 714
Debentures
2
PROPOSAL
No of Preference
shares to issued
Nominal value ÷ R100,00
111 700
preference
shares
No of debentures
Nominal value R70,00
104 714
Debentures
b) Weighted average cost of capital
Weighted average cost of capital

Value Weight Cost WACC
Equity 14 240 000 81,34% 11,94% 9,71%
Debt 3 267 330 18,66% 8,64% 1,61%
17 507 330 100,00% 11,32%
Cost of equity: In order to calculate the cost of equity we need the current market price. Since the
company is not listed, this information is unavailable. The R4,05 given in the question is not an
indication of fair value as this is a private company and the issue price could have been agreed upon
by the shareholders to raise the funds.
I have therefore used the current issue price of R3,25 as per the statement of financial position
Growth: The question states that growth will double going forward, therefore 3.5% x 2 = 7%.
𝐷1
𝐾𝑒 = +𝑔
𝑃0
0.15 𝑥 1.07
𝐾𝑒 = + 0.07
𝑅3.25
𝐾𝑒 = 11.94%
3
Market value of debentures
1 2 3 4
2019 2020 2021 2022
Capital repayment (3 560 000)
Premium (1) (11 392)
Interest paid (300 000) (300 000) (300 000) (300 000)
Tax benefit on interest (2) 84 000 84 000 84 000 84 000
Tax benefit on premium (3) 3 190
(216 000) (216 000) (224 202) (3 776 000)
𝑃𝑉 @ 8.64%: − 216000𝑐𝑓, −216000𝑐𝑓, −224202𝑐𝑓, −3776000𝑐𝑓, 8.64𝑖 𝐶𝑜𝑚𝑝 𝑁𝑃𝑉
𝑵𝑷𝑽 = 𝑹𝟑 𝟐𝟔𝟕 𝟑𝟑𝟎
𝑲𝒅 = 𝟏𝟐% 𝒙 𝟎. 𝟕𝟐 = 𝟖. 𝟔𝟒%
1. R3 560 000 x 0.32%

2. R300 000 x 28%
3. R11 392 x 28%
c) Foreign exchange profit or loss
FEC rate at 1 December 2018 1,48

Spot rate at 1 January 2019 1,58
Gain (0,10)
Foreign amount 12 500 000
Gain (1 250 000)
4
d) Risks and mitigating factors of implementation
RISKS MITIGATING FACTORS

1. Viability is not certain 1. Detailed research needs to be undertaken
including the preparation of a capital
budget
2. Operating skills and servicing of machines 2. Ensure that we sufficient skills to ensure
that machines are operated as intended
and also that servicing can be done locally
– send relevant people overseas for
training
3. Timing of implementation 3. Proper planning will ensure that delays are
kept to a minimum
4. Funding of project 4. Availability of funds – funding must be
secured ASAP as this will cause further
delays
5. Affordability of repayments and interest 5. Proper budgeting will help make better
financial decisions
6. Medical aid schemes not authorising 6. Hold meetings with medical aid schemes
treatment to ensure that that proper procedures are
followed to ensure that patients are able to
use the service without worrying about the
costs
5
e) Ratio analysis
Change in other operating income
470
− 1 = −11.32%
530
No available information with respect this line item. Management needs to identify reasons for
the decrease. Given that this is a clinic, it may relate to sales of over-the-counter medication and
supplies.
EBITDA margin
𝑬𝑩𝑰𝑻𝑫𝑨
=
𝑹𝒆𝒗𝒆𝒏𝒖𝒆
2018 2017
1640 + 560(𝑑𝑒𝑝) 1380 + 420(𝑑𝑒𝑝)
= =
6600 5500
= 33.33% = 32.73%
• The margin increased very slightly

• This was caused by the fact that revenue increase by a higher rate than operating costs
• Revenue increased by 20% while operating costs increased only by 15.13%
• An indication either of cost control measures or that the clinic was able to pass on any cost
increases to patients
Effective tax rate

𝑻𝒂𝒙 𝒄𝒉𝒂𝒓𝒈𝒆
=
𝑷𝒓𝒐𝒇𝒊𝒕 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙
2018 2017
334 307
= =
1260 1060
= 26.51% = 28.96%
• Effective rates differ from statutory rates as a result of permanent differences.

• In 2017 it seems we had items that were not deductible for tax purposes while in 2018 it
seems we had items of income that were not taxable
6
Times interest earned (Interest cover)

The number of times interest is covered by EBIT
𝑬𝑩𝑰𝑻
=
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒑𝒂𝒊𝒅
NB: Interest received generally not a sustainable income item. Sometimes solutions net-off
the interest. This ratio is about financial risk and the ability to meet interest payments. I
therefore recommend not to net-off the interest received against the interest paid
2018 2017
1640 1380
= =
420 340
= 3.9 𝑡𝑖𝑚𝑒𝑠 = 4.06 𝑡𝑖𝑚𝑒𝑠
• Interest costs have increased for no logical reason as the non-current debt is the same as
2017 and the short-term borrowings have decreased.
• Notwithstanding this, EBIT has increased by R260 000 while the interest only by R40 000
which gives rise to the slight drop in the interest cover.
Capital gearing ratio
𝑳𝒐𝒏𝒈 − 𝒕𝒆𝒓𝒎 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒃𝒆𝒂𝒓𝒊𝒏𝒈 𝒅𝒆𝒃𝒕(𝑳𝑻𝑫)

=
𝑳𝑻𝑫 + 𝒆𝒒𝒖𝒊𝒕𝒚
2018 2017
3560 3560
= =
3560 + 14240 3560 + 13830
= 20% = 20.47%
• This ratio has improved slightly but as a result of decreased debt but rather an increase in
retained profits
7
Dividend pay-out ratio

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
=
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
2018 2017
0.15 0.1449
= =
0.2692 0.2189
= 55.72% = 66.2%
2018 2017
𝑅926 000 𝑅753 000
𝑒𝑝𝑠 = 𝑒𝑝𝑠 =
3 440 000 3 440 000
= 0.2692 = 0.2189
Dividend 2017: Dividend growth is 3.5% therefore Div2018 is 3.5% bigger than Div2017
∴ R0.15 ÷ (1+3.5%) = R0.1449
𝑁𝑜 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = 𝑅11 180 000 ÷ 𝑅3.25 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = 3 440 000 𝑠ℎ𝑎𝑟𝑒𝑠
• It is clear that the policy is not a stable % (ratio) of earnings

• The reason for the decline is that eps grew by 23% while dividends growth was at 3.5%.
Return on equity
𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙
=
𝑬𝒒𝒖𝒊𝒕𝒚
2018 2017
𝑅926 000 𝑅753 000
= =
𝑅14 240 000 𝑅13 830 000
= 6.5% = 5.45%
• Equity remained fairly stable while earnings per share grew by 23%
• More of revenue was converted into profits.
• As mentioned earlier revenues increased at a better rate than costs.
8
f) Free cash flow
Free cash flow

R
Profit before taxation 1 260 000
Add: Depreciation 560 000
Add: Long term interest 300 000
Less: interest received (1) (40 000)
2 080 000
Taxation (2) (406 800)
1 673 200
Working capital 225 000
Inventory (5000’ – 4550’) 450 000
Trade and other receivables (2050’- 1840’) (210 000)
Short-term borrowings (180’- 140’) (40 000)
Trade and other payables (45’- 20’) 25 000
1 898 200
Capital expenditure (3) (1 035 000)
863 200
1. Interest received is assumed to be earned from cash and cash equivalents. It has been left out of
the free cash flow as the actual cash balances will be added to the value.
2.
Taxation R
Taxation per SOCI 334 000
Add: Tax on interest paid 84 000
Less : tax on interest received (11 200)
406 800
3.
Capital expenditure R
Opening carry value 9 500 000
Depreciation (560 000)
Closing carry value (9 975 000)
(1 035 000)
9
Value of operations
𝐹𝐶𝐹1
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 =
𝑊𝑎𝑐𝑐 − 𝑔
𝑅863 200 𝑥 1.07

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 =
11.32% − 7%
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 = 𝑅21 380 185
Valuation
Value of operations 21 380 185

Add: Cash and cash equivalents 1 410 000
Less: Market value of debt (3 267 330)
Value before owner level adjustments 19 522 855
Less: Marketability discount say 20% (3 904 571)
Less: Minority discount say 15% (2 928 428)
12 689 856
26% thereof 3 299 362
Net asset value
Net asset value

Net equity 14 240 000
Fair value adjustment property (R3.8m – R2.0m) 1 800 000
16 040 000
The NAV is being compared to the FCF value before owner level adjustments.
The Difference in value is due the fact that NAV is based on historical results which excludes
potential growth, while the FCF method has been based on future sustainable cash flows with
growth built into the valuation
10
g) Mobile units NPV
Mobile units appraisal

0 1 2 3 4 5
Cost price (4 500 000)
Residual value (1) 900 000
Net operating CF 593 000 555 680 1 731 121 1 689 188 1 644 739
Grant received (2) 1 215 000 1 215 000 2 430 000 2 430 000 2 430 000
Maintenance (3) (100 000) (106 000) (112 360) (119 102) (126 248)
Nurses salaries (4) (360 000) (381 600) (404 496) (428 766) (454 492)
Other (162 000) (171 720) (182 023) (192 945) (204 521)
(4 500 000) 593 000 555 680 1 731 121 1 689 188 2 544 739
𝑵𝑷𝑽@𝟏𝟓% = −𝑹𝟏𝟗𝟒 𝟗𝟓𝟎
−4500000𝑐𝑓, 593000𝑐𝑓, 555680𝑐𝑓, 1731121𝑐𝑓, 1689188𝑐𝑓, 2544739𝑐𝑓, 15𝑖 𝑐𝑜𝑚𝑝 𝑁𝑃𝑉
Calculations
1. R4 500 000 x 20%
2. 2 single payments then 3 double payments: 𝑥 + 𝑥 + 3(2𝑥) = 𝑅3 240 000𝑥 3𝑢𝑛𝑖𝑡𝑠
∴ 𝑥 = 𝑅1 215 000 𝑎𝑛𝑑 2𝑥 = 𝑅2 430 000
3. R25 000 x 4 quarters = R100 000, increase by 6% thereafter
4. R120 000 per nurse x 3 = R360 000, increase by 6% thereafter
5. R4 500 x 12 months x 3 units = R162 000, increase by 6% thereafter
h) The NPV is negative, therefore from a quantitative perspective the project should be rejected.
From a qualitative perspective
• To try and procure additional funding as this is a PBO
• The service is for the community and maybe to negotiate better prices on the mobile units
• Try to get some private funding as well
1
ACTIVITY BASED COSTING
Reasons for the development of ABC.
The traditional cost accumulation system of absorption costing was developed in a

time when most organisations produced only a narrow range of products (so that
products underwent similar operations and consumed similar proportions of
overheads). And overhead costs were only a very small fraction of total costs,
direct labour and direct material costs accounting for the largest proportion of the
costs. The benefits of more accurate systems for overhead allocation would
probably have been relatively small. In addition, information processing costs were
high.
In recent years, however, there has been a dramatic fall in the costs of processing
information. And, with the advent of advanced manufacturing technology (AMT),
overheads are likely to be far more important and in fact direct labour may
account for as little as 5% of a product’s cost. It therefore now appears difficult to
justify the use of direct labour or direct material as the basis for absorbing overheads
or to believe that errors made in attributing overheads will not be significant.
Many resources are used in non-volume related support activities, (which have
increased due to AMT) such as setting-up, production scheduling, inspection and
data processing. These support activities assist the efficient manufacture of a wide
range of products and are not, in general, affected by changes in production
volume. They tend to vary in the long term according to the range and complexity
of the products manufactured rather than the volume of output.
The wider the rand and the more complex the products, the more support service
will be required. Consider, for example, factory X which produces 10,000 units of
one product, the Alpha, and factory Y which produces 1,000 units each of ten
slightly different versions of the Alpha. Support activity costs in the factory Y are
likely to be a lot higher than in factory X but the factories product an identical
number of units. For example, factory X will only need to set-up once whereas
factory Y will have to set-up the production run at least ten times for the ten
different products. Factory Y will therefore incur more set-up costs for the same
volume of production.
Traditional costing systems, which assume that all products consume all resources in
proportion to their production volumes, tend to all allocate too great a proportion of
overheads to high volume products (which cause relatively little diversity and hence
use fewer support services) and too small a proportion of overheads to low volume
products (which cause greater diversity and therefore use more support services).
Activity based costing (ABC) attempts to overcome this problem.
2
Definition of ABC
KEY TERM
Activity based costing (ABC) involves the identification of the factors
which cause the costs of an organisation’s major activities. Support
overheads are charged to products on the basis of their usage of the
factor causing the overheads.
The major ideas behind activity based costings are as follows :
(a) Activities cause costs. Activities include ordering, materials handling,

machining, assembly, production scheduling and despatching.
(b) Producing products creates demand for the activities.
(c) Costs are assigned to a product on the basis of the product’s consumption of
the activities.
Outline of an ABC system
An ABC system operates as follows :
Step 1. Identify an organisation’s major activities.
Step 2. Identify the factors which determine the size of the costs of an
activity/cause the costs of an activity. These are known as cost drivers.
KEY TERM
A cost driver is a factor which causes a change in the cost of an

activity.
3
Look at the following examples :
Costs Possible cost driver

Ordering costs Number of orders
Materials handling costs Number of production runs
Production scheduling costs Number of production runs
Despatching costs Number of despatches
Step 3. Collect the costs associated with each cost driver into what are known
as cost pools.
Step 4. Charge costs to products on the basis of their usage of the activity. A
product’s usage of an activity is measured by the number of the
activity’s cost driver is generates.
ILLUSTRATION
Which of the following definitions best describes a cost driver?
A Any activity which causes an increase in costs

B A collection of costs associated with a particular activity
C A cost that varies with production levels
D Any factor which causes a change in the cost of an activity
Answer
The correct answer is D.
Cost drivers
For those costs that vary with production levels in the short term, ABC uses volume-
related cost drivers such as labour or machine hours. The cost of oil used as a
lubricant on the machines would therefore be added to products on the basis of
the number of machine hours, since oil would have to be used for each hour the
machine ran.
Kaplan and Cooper argue that long-term variable overhead costs are related to
the transactions undertaken by the support departments where the costs are
incurred.
(a) Logistical transactions are those activities concerned with organising the flow
of resources throughout the manufacturing process.
4
(b) Balancing transactions are those activities which ensure that demand for and
supply of resources are matched.
(c) Quality transactions are those activities which relate to ensuring the
production is at the required level of quality.
(d) Change transactions are those activities associated with ensuring that
customers’ requirements (delivery date, changed design etc) are met.
These transactions in the support departments are the appropriate cost drivers to
use.
ABSORPTION COSTING VERSUS ABC
The following example illustrates the point that traditional cost accounting
techniques result in a misleading and inequitable division of costs between low-
volume and high-volume products, and that ABC can provide a more meaningful
allocation of costs.
EXAMPLE : ACTIVITY BASED COSTING
Suppose that Cooplan Ltd manufactures four products, W, X, Y and Z. Output and
cost data for the period just ended are as follows :
Number of
Direct
production Machine
Material labour
runs in the hours per
Output cost per hours per
period unit
units unit unit
R
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14
5
Direct labour cost per hour R5
Overhead costs costs

Short run variable R
3,080
Set-up costs 10,920
Expediting and scheduling 9,100
Materials handling costs 7,700
30,800
Required
Prepare unit costs for each product using conventional costing and ABC.
SOLUTION
Using a conventional absorption costing approach and an absorption rate for

overheads based on either direct labour hours or machine hours, the product costs
would be as follows :
W X Y Z Total
R R R R
Direct material R
200 800 2,000 8,000
Direct labour 50 150 500 1,500
Overheads * 700 2,100 7,000 21,000
950 3,050 9,500 30,500 44,000
Units produced 10 10 100 100
Cost per unit R95 R305 R95 R305
* R30,800  440 hours = R70 per direct labour or machine hour.

6
Using activity based costing and assuming that the number of production runs is the
cost driver for set-up costs, expediting and scheduling costs and materials handling
costs and that machine hours are the cost driver for short-run variable costs, unit
costs would be as follows :
W X Y Z Total
R R R R
Direct material R
200 800 2,000 8,000
Short-run variable overheads 70 210 700 2,100
(WI) costs (W2)
Set-up 1,560 1,560 3,900 3,900
Expediting scheduling costs 1,300 1,300 3,250 3,250
(W3)
Materials handling costs (W4) 1,100 1,100 2,750 2,750
4,280 5,120 13,100 21,500 44,000
Workings
1 R3,080  440 machine hours = R7 per machine hour

2 R10,920  14 production runs = R780 per run
Summary
Convention
al costing ABC unit Difference Difference in
unit costs cost per unit total
Product
R R R R
W 95 428 + 333 + 3,330
X 305 512 + 207 + 2,070
Y 95 131 + 36 + 3,600
Z 305 215 - 90 - 9,000
7
The figures suggest that the traditional volume-based absorption costing system is
flawed.
(a) It under-allocates overhead costs to low-volume products (here, W and X)

and over-allocates overheads to higher-volume products (here Z in
particular).
(b) It under-allocates overhead costs to smaller-sized products (here W and Y

with just one hour of work needed per unit) and over-allocates overheads to
larger products (here X and particularly Z).
ABC versus traditional costing methods
Both traditional absorption costing and ABC systems adopt the two stage allocation
process.
Allocation of overheads
ABC establishes separate cost pools for support activities such as despatching. As
the costs of these activities are assigned directly to products through cost driver
rates, reapportionment of service department costs is avoided.
Absorption of overheads
The principal difference between the two systems is the way in which overheads are
absorbed into products.
(a) Absorption costing most commonly uses two absorption bases (labour hours
and/or machine hours) to charge overheads to products.
(b) ABC uses many cost drivers as absorption bases (number of orders, number of
despatches and so on).
Absorption rates under ABC should therefore be more closely linked to the causes
of overhead costs.
8
Cost drivers
The principal idea of ABC is to focus attention on what causes costs to increase, ie
the cost drivers.
(a) Those costs that do vary with production volume, such as power costs, should
be traced to products using production volume-related cost drivers as
appropriate, such as direct labour hours or direct machine hours.
Overheads which do not vary with output but with some other activity should
be traced to products using transaction-based cost drivers, such as number
of production runs and number of orders received.
(b) Traditional costing systems allow overheads to be related to products in rather

more arbitrary ways producing, it is claimed, less accurate products costs.
9
ILLUSTRATION
A company manufactures two products, L and M, using the same equipment and
similar processes. An extract of the production data for these products in one
period is shown below::
L M
Quantity produced (units) 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60
Overhead costs R
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000
Required
Calculate the production overheads to be absorbed by one unit of each of the
products using the following costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb
overheads.
(b) An activity based costing approach, using suitable cost drivers to trace
overheads to products
Answer
(a) Traditional costing approach Direct labour

hours
Product L = 5,000 units x 1 hour 5,000

Product M = 7,000 units x 2 hours 14,000
19,000
 Overhead absorption rate = R285,000

19,000
= R15 per hour

10
Overhead absorbed would be as follows :

Product L 1 hour x R15 = R15 per unit
Product M 2 hours x R15 = R30 per unit
(b) ABC approach Machine hours
Product L = 5, 000 units x 3 hours 15,000

Product M = 7,000 units x 1 hour 7,000
22,000
Using ABC the overhead costs are absorbed according to the cost drivers.
Machine-hour driver costs 220,000 ÷ 22,000 m/c hours = R10 per m/c hour
Set-up driven costs 20,000 ÷ 50 set-ups = R400 per set-up
Order driven costs 45,000 ÷ 75 orders = R600 per order
Overhead costs are therefore as follows :
Product L Product M
R R
Machine-driven costs (15,000 hrs x R10) 150,000 (7,000 hours x 70,000
R10)
Set-up costs (10 x R400) 4,000 (40 x R400) 16,000
Order handling costs (15 x R600) 9,000 (60 x R600) 36,000
163,000 122,000
Units produced 5,000 7,000
Overhead cost per unit R32,60 R17,43
These figures suggest that product M absorbs an unrealistic amount of overhead

using a direct labour basis. Overhead absorption should be based on the activities
which drive the costs, in this case machine hours, the number of production run set-
ups and the number of orders handled for each product.
11
MERITS AND CRITICISMS OF ABC
As you will have discovered when you attempted the question above, there is
nothing difficult about ABC. Once the necessary information has been obtained it is
similar to traditional absorption costing. This simplicity is part of its appeal. Further
merits of ABC are as follows :
(a) 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.
(b) In a more competitive environment, companies must be able to assess

product profitability realistically. ABC facilitates a good understanding of what
drives overhead costs.
(c) In modern manufacturing systems, overhead 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 costs
and so it takes management accounting beyond its ‘traditional’ factory floor
boundaries.
Criticisms of ABC
It has been suggested by critics that activity based costing has some series flaws :
(a) Some measure of (arbitrary) cost apportionment may still be required at the
cost pooling stage for items like rent, rates and building depreciation.
(b) Can a single cost driver explain the cost behaviour of all items in its associated
pool?
(c) Unless costs are caused by an activity that is measurable in quantitative terms
and which can be related to production output, cost drivers will not be
usable. What drives the cost of the annual external audit, for example?
(d) ABC is sometimes introduced because it is fashionable, not because it will be

used by management to provide meaningful product costs or extra
information. If management is not going to use ABC information, as
absorption costing system may be simpler to operate.
(e) The cost of implementing and maintaining ABC system can exceed the
benefits of improved accuracy.
12
(f) Implementing ABC is often problematic. Recent journal articles have

highlighted the following issues :
(i) The incorrect belief that ABC can solve all an organisation’s problems.
(ii) Lack of the correct type of data.
(iii) Difficulty in determining appropriate cost drivers.
‘World wide adoption rates for ABC have peaked at 20 percent and a
declining number of firms are giving it further consideration’. (Tom Kennedy,
Financial Management, May 2000). Recent SA studies have found ABC
usage rates of about 25%, with larger organisation and service sector
companies being most likely to use it.
Other uses of ABC
The information provided by analysing activities can support the management

functions of planning, control and decision making, provided it is used carefully and
with full appreciation of it implications.
Planning
Before an ABC system can be implemented, management must analyse the

organisation’s activities, determine the extent of their occurrence and establish the
relationships between activities, products/services and their cost.
The information database produced from such an exercise can then be used as a
basis for forward planning and budgeting. For example, once an organisation has
set its budgeted production level, the database can be used to determine the
number of times that activities will need to be carried out, thereby establishing
necessary departmental staffing and machine levels. Financial budgets can then
be drawn up by multiplying the budgeted activity levels by cost per activity.
The activity-based approach may not produce the final budget figures but it can
provide the basis for different possible planning scenarios.
13
Control
The information database also provides an insight into the way in which costs are
structured and incurred in service and support departments. Traditionally it has
been difficult to control the costs of such departments because of the lack of
relationship between departmental output levels and departmental costs. With
ABC, however, it is possible to control or manage the costs by managing the
activities which underlie them by monitoring a number of key performance
measures.
Decision making
Many of ABC’s supporters claim that it can assist with decision making is a number
of ways :
 Provides accurate and reliable cost information

 Establishes a long-run product cost
 Provides data which can be used to evaluate different ways of delivering
business
It is therefore particularly suited to the following types of decision.
 Pricing
 Promoting or discontinuing products or parts of the business
 Redesigning products and developing new products or new ways to do business
Note, however, that an ABC cost is not a true cost, it is simply an average cost
because some costs such as depreciation are still arbitrarily allocated to products.
An ABC cost is therefore not a relevant cost for all decisions.
The traditional cost behaviour patterns of fixed cost and variable cost are felt by
advocates of ABC to be unsuitable for longer-term decisions, when resources are
not fixed and changes in the volume or mix of business can be expected to have
an impact on the cost of all resources used, not just short-term variable costs. A five-
level hierarchy has therefore been suggested to facilitate the analysis of costs.
Basis Costs are dependent on … Example

Level
1 Unit volume of production Machine power
2 Batch number of batches Set-up costs
3 Process existence of a process Quality control
4 Product existence of a product Product
14
As Innes and Mitchell (Activity Based Costing : A Review with Case Studies, CIMA
1990) say::
‘This analysis of cost highlights the decision level at which each element of cost can
be influenced. For example, the reduction of production cost levels will not imply
depend on a general reduction in output volumes, but also on reorganising
production to perhaps increase batch size and reduce batch volume, on
eliminating or modifying a process, on cutting out or merging product lines or on
altering or removing facility capacity’.
Raiborn et al explain how a product cost is determined using such an analysis :
‘Traditionally, accounting has assumed that if costs did not vary until changes in
production at the unit level, those costs were fixed rather than variable. Such an
assumption is not true. Batch level, product level, and organisational level costs are
all variable, but these types of costs vary for reasons other than changes in
production volume. For this reason, to determine an accurate estimate of product
or service cost, costs should be accumulated at each successively higher level of
costs. Because unit, batch and product level costs are all related to units of
products (merely at different levels), these costs can be gathered together at the
product level to match with the revenues generated by product sales.
Organisational level costs, however, are not product related and, thus, should only
be subtracted in total from net product revenues.’
Such an analysis provides an alternative method of determining product profitability

which may be used for management decision making.
For example, suppose an organisation was deciding whether to withdraw a

product. The withdrawal of the product could result in a reduction in the number of
some activities and hence in a cost saving. This cost saving might apply to unit
level, batch level and product level costs but not to facility costs, which represent
fixed infrastructure costs which would be incurred anyway.
Conclusion
‘It can offer considerable benefits to some companies but a decision to adopt ABC
should not be taken lightly. The staff time involved in developing and getting the
system into operation is conservatively estimated at tow person years, costs are at
least R100,000 though it depends on the system being implemented and the size of
the company.
It requires serious commitment of resources and top management support.

15
It is not a system that the accountant can do in his/her spare time.
Indeed it is not a system that should focus exclusively on the accountant. It is

common for a project team to develop the ABC system on which the accountant
can play a part, but not necessarily a dominating part.
Its implementation is not easy but is made easier by the availability of IT support
within the organisation. Existing IT facilities can make it possible, at little extra cost to
obtain useful cost driver data. There is now a range of PC based packages on
which to develop stand alone ABC systems, or they can be integrated with existing
system, though the former seem advisable at the prototype stage.
There are cases of companies claiming significant benefit from adopting ABC
(changing the way they do business) but also examples of companies trying but
rejecting the activity-based approach.
To be effective, cost management must be based on a sound knowledge of an

organisation’s cost structure, the proportion of it overheads, the degree of
competition, its information needs within the organisation, an appreciation of how
costs are determined and how they may be influenced. Only after consideration of
these factors can a judgement be made on the potential for an organisation of
ABC.’
Evaluating the Potential of Activity-Based Costing, Mike Tayles, ACCA Students’

Newsletter
16
LIFE CYCLE COSTING
What are life cycle costs?
A product’s life cycle costs are incurred from its design stage through development
to market launch, production and sales, and finally to its eventual withdrawal from
the market. The component elements of a product’s cost over its life cycle could
therefore include the following::
 Research & development costs

 The cost of purchasing any technical data required
 Training costs (including initial operator training and skills updating)
 Production costs
 Distribution costs
 Marketing costs
 Inventory costs (holding spare parts, warehousing and so on)
 Retirement and disposal costs
Life cycle costs can apply to services, customers and projects as well as to physical
products.
Traditional cost accumulation systems are based on the financial accounting year
and tend to dissect a products life cycle into a series of 12-month periods. This
means that traditional management accounting systems do not accumulate costs
over a product’s entire life cycle and do not therefore assess a product’s profitability
over its entire life. Instead they do it on a periodic basis.
Life cycle costing, on the other hand, tracks and accumulates actual costs and
revenues attributable to each product over the entire product life cycle. Hence the
total profitability of any given product can be determined.
KEY TERM
Life cycle costing is the accumulation of costs over a product’s entire life.
17
The product life cycle
Every product goes through a life cycle :
Introduction. The product is introduced to the market. Potential customers will be

unaware of the product or service, and the organisation may have to spend further
on advertising to bring the product or service to the attention of the market.
Growth. The product gains a bigger market as demand builds up. Sales revenues
increase and the product begins to make a profit.
Maturity. Eventually, the growth in demand for the product will slow down and it will
enter a period of relative maturity. It will continue to be profitable. The product
may be modified or improved, as a means of sustaining its demand.
Decline. At some stage, the market will have bought enough of the product and it
will therefore reach ‘saturation point’. Demand will start to fall. Eventually it will
become a loss-maker and this is the time when the organisation should decide to
stop selling the product or service.
The level of sales and profits earned over a life cycle can be illustrated
diagrammatically as follows :
Sales
profits
Sale
+
Time
Introduction Growth Maturity Declin
Profit
18
The horizontal axis measures the duration of the life cycle, which can last from, say
18 months to several hundred years. Children’s crazes or fad products have very
short lives while some products, such as binoculars (invented in the eighteenth
century) can last a very long time.
Problems with traditional cost accumulation systems
Traditional cost accumulation systems do not tend to relate research and

development costs to the products that caused them. Instead they write off these
costs on an annual basis against the revenue generated by existing products. This
makes the existing products seem less profitable that they really are. If research
and development costs are not related to the causal product the true profitability
of the product cannot be assessed.
Traditional cost accumulation systems usually total all non-production costs and
record them as a period expense.
The value of life cycle costing
With life cycle costing, non-production costs are traced to individual products over
complete life cycles.
(a) The total of these costs for each individual product can therefore be reported
and compared with revenues generated in the future.
(b) The visibility of such costs is increased.
(c) Individual product profitability can be more fully understood by attributing all
costs to products.
(d) As a consequence, more accurate feedback information is available on the

organisation’s success or failure in developing new products. In today’s
competitive environment, where the ability to produce new and updated
versions of products is paramount to the survival of an organisation, this
information is vita.
19
TARGET COSTING
To compete effectively in today’s competitive market, organisations must

continually redesign their products with the result that product life cycles have
become much shorter. The planning, development and design stage of a product
is therefore critical to an organisation’s cost management process. Considering
possible cost reductions at this stage of a product’s life cycle (rather than during the
production process) is now one of the most important issues facing management
accountants in industry.
Here are some examples of decisions made at the design stage which directly
impact on the cost of a product.
 The number of different components

 Whether the components are standard or not
 The ease of changing over tools
Japanese companies have developed target costing as a response to the problem

of controlling and reducing costs over the product life cycle.
KEY TERMS
Target costing involves setting a target cost by subtracting a desired

profit margin from a competitive market price.
Target cost is an estimate of a product cost which is determined by

subtracting a desired profit margin from a competitive market price.
This target cost may be less than the planned initial product cost but it
is expected to be achieved by the time the product reaches the
maturity stage of the product life cycle.
Target costing has its greatest impact at the design stage because a large
percentage of a product’s life cycle costs are determined by decisions made early
in its life cycle.
20
Case example
A number of countries including Holland, Sweden and Norway, have passed or

proposed legislation that will require manufacturing of certain goods to take back a
product at the end of its life for safe disposal or salvage. The European Commission
has also developed proposals to force manufacturers of electrical and electronic
goods to take back obsolete products.
Any requirements to take back products will affect post-production costs and
ultimately overall projected life cycle costs. To cut these costs, the design could, for
example, make the product easy to dismantle and its raw materials easy to recycle.
Or it may be possible to design a product for use over several life cycles rather than
just one. (Xerox has been doing this for several years.)
The technique requires managers to change the way they think about the
relationship between cost, price and profit.
(a) Traditionally the approach is to develop a product, determine the production

cost of that product, set a selling price, with a resulting profit or loss.
(b) The target costing approach is to develop a product, determine the market
selling price and desired profit margin, with a resulting cost which must be
achieved.
In ‘Product costing/pricing strategy’ (ACCA Students Newsletter, August 1999), the

examiner of the old syllabus Paper 9 provided a useful summary of the steps in the
implementation of the target costing process.
Step 1. Determine a product specification of which an adequate sales volume

is estimated.
Step 2. Set a selling price at which the organisation will be able to achieve a
desired market share.
Step 3. Estimate the required profit based on return on sales or return on

investment.
Step 4. Calculate the target cost = target selling price – target profit.
21
Step 5. Compile an estimated cost for the product based on the anticipated
design specification and current cost levels.
Step 6. Calculate cost gap = estimated cost – target cost.
Step 7. Make efforts to close the gap. This is more likely to be successful if
efforts are made to ‘design out’ costs prior to production, rather than to
control out costs during the production phase. (See Paragraph below.)
Step 8. Negotiate with the customer before making the decision about
whether to go ahead with the project.
When a product is first manufactured, its target cost may well be much lower than
its currently-attainable cost, which is determined by current technology and
processes. Management can then set benchmarks for improvement towards the
target costs, by improving technologies and processes. Various techniques can be
employed.
 Reducing the number of components  Using different materials

 Using standard components wherever  Using cheaper staff
possible
 Training staff in more efficient
techniques
 Acquiring new, more efficient
technology
 Cutting out non-value-added activities
(identified using activity analysis etc)
Even if the product can be produced within the target cost the story does not end
there. Target costing can be applied throughout the entire life cycle. Once the
product goes into production target costs will therefore gradually be reduced.
These reductions will be incorporated into the budgeting process. This means that
cost savings must be actively sought and made continuously over the life of the
product.
1
THE MANAGEMENT OF STOCKS
Almost every company carries stocks of some sort, even if they are only stocks of
consumables such as stationery. For a manufacturing business, stocks (sometimes
called inventories), in the form of raw materials, work in progress and finished goods,
may amount to a substantial proportion of the total assets of the business.
Some businesses attempt to control stocks on a scientific basis by balancing the

costs of stock shortages against those of stock holding.
The ‘scientific’ control of stocks may be analysed into three parts.
- The economic order quantity (EOQ) model can be used to decide the
optimum order size for stocks which will minimise the cost of ordering
stocks plus stockholding costs.
- If discounts for bulk purchases are available, it may be cheaper to buy

stocks in large order sizes so as to obtain the discounts.
- Uncertainty in the demand for stocks and/or the supply lead time may
lea a company to decide to hold buffer stocks (thereby increasing its
investment in working capital) in order to reduce or eliminate the risk of
‘stock-outs’ (running out of stock).
Stock costs
Stock costs can be conveniently classified into four groups:
- Holding costs comprise the cost of capital tied up, warehousing and
handling costs, deterioration, obsolescence, insurance and pilferage.
- Procuring costs depend on how the stock is obtained but will consist of
ordering costs for goods purchased externally, such as clerical cost,
telephone charges and delivery costs.
2
- Shortage costs may be:
the loss of a sale and the contribution which could have been earned
from the sale;
the extra cost of having to buy an emergency supply of stocks at a high

price;
the cost of lost production and sales, where the stock-out brings an entire
process to a halt.
- The cost of the stock itself, the supplier’s price or the direct cost per unit of
production, will also need to be considered when the supplier offers a
discount on orders for purchases in bulk.
Stock models
There are several different types of stock model, and these can be classified under
the following headings:
Deterministic stock models
A deterministic model is one in which all the ‘parameters’ are known with
certainty. In particular, the rate of demand and the supply lead time are
known.
Stochastic stock models
A stochastic model is one in which the supply lead time or the rate of
demand for an item is not known with certainty. However, the demand or
the lead time follows a known probability distribution (probably constructed
from a historical analysis of demand or lead time in the past).
In a deterministic system, since the demand and the lead time are known with
certainty, there is no need for a safety stock. However, in a stochastic model, it
may be necessary to have a buffer stock to limit the number of stock-outs or to
avoid stock-outs completely.
3
Stochastic models are sometimes classified as follows:
- A P system is a periodic review system in which the requirement for stock is

reviewed at fixed time intervals, and varying quantities are ordered on
each occasion, according to the current level of stocks remaining.
- A Q system is a re-order level system in which a fixed quantity is ordered at

irregular intervals, when stock levels have fallen to a re-order level specified
on the store-keeper’s records or ‘bin card'.
A deterministic model: the basic EOQ formula
The economic order quantity (EOQ) is the optimal ordering quantity for an item of
stock which will minimise costs.
Let D = the usage in units for one year (the demand)

Co = the cost of making one order
Ch = the holding cost per unit of stock for one year
Q = the re-order quantity
Assume that:
- demand is constant;
- the lead time is constant or zero;
- purchase costs per unit are constant (i.e. no bulk discounts).
The total annual cost of having stock (T) is
Holding costs + ordering costs
QCh + CoD
2 Q
The objective is to minimise T = QCh + CoD

2 Q
3.7 The order quantity, Q, which will minimise these total costs is:

CoD
Q Ch
=
4
Example: economic order quantity
The demand for a commodity is 40 000 units a year, at a steady rate. It costs R20 to
place an order, and 40c to hold a unit for a year. Find the order size to minimise
stock costs, the number of orders placed each year, and the length of the stock
cycle.
Solution
 
2Co 2 x 20 x 40
Q D = 000
= Ch 0,4
= 2 000 units
This means that there will be:
40 000 = 20 orders placed each year, so that stock cycle is once every 52 
20 = 2,6
2 000
weeks.
Total costs will be (20 x R20) + ( 2 000 x 40c) = R800 a year.

2
When the volume of demand is uncertain, or the supply lead time is variable,
there are problems in deciding what the re-order level should be. By holding a
‘safety stock’ a company can reduce the likelihood that stocks run out during
the re-order period (due to high demand or a long lead time before the new
supply is delivered). The average annual cost of such a safety stock would be:
Quantity of safety stock x Stock holding cost

(in units) per unit per annum
5
The behaviour of the system would appear in a diagram as in Figure 1.
Stock
level
x x x x
x x
Safety
stock
0
Time
Figure 1
Points marked ‘x’ show the re-order level at which a new order is placed. The
number of units ordered each time is the EOQ. Actual stock levels sometimes fall
below the safety stock level, and sometimes the re-supply arrives before stocks
have fallen to the safety level, but on average, extra stock holding amounts to
the volume of safety stock.
The size of the safety stock will depend on whether stock-outs (running out of
stock) are allowed.
Just-in-time (JIT) procurement

In recent years, there have been developments in the inventory policy of some
manufacturing companies which have sought to reduce their inventories of raw
materials and components to a low a level as possible. This approach differs from
other models, such as the EOQ model, which seek to minimise costs rather than
inventory levels.
Just-in-time procurement and stockless production are terms which describe a

policy of obtaining goods from suppliers at the latest possible time (i.e. when they
are needed) and so avoiding the need to carry any materials or components stock.
6
Introducing JIT might bring the following potential benefits:
- Reduction in stock holding costs

- Reduced manufacturing lead times
- Improved labour productivity
- Reduced scrap/rework/warranty cost
- Price reductions on purchased materials
- Reduction in the number of accounting transactions
Reduced stock levels mean that a lower level of investment in working capital will
be required.
JIT will not be appropriate in some cases. For example, a restaurant might find it
preferable to use the traditional economic order quantity approach for staple non-
perishable food stocks but adopt JIT for perishable and ‘exotic’ items. In a hospital,
a stock-out could quite literally be fatal and JIT would be quite unsuitable.
Total quality management

A system of just-in-time procurement depends for its success on a smooth and
predictable production flow, and so a JIT policy must also be aimed at improving
production systems, eliminating waste (rejects and reworked items), avoiding
production bottlenecks and so on. Many now argue that such improvements are
necessary for the introduction of advanced manufacturing technology (AMT) which
is necessary for long-term competitiveness.
Total quality management (TQM) is a management technique, derived from

Japanese companies, which focuses on the belief that ‘total quality is essential to
survival in a global market'.
The basic principle of TQM is that the cost of preventing mistakes is less than the cost
of correcting them once they occur plus the cost of lost potential for future sales.
The aim should, therefore, be to get things right first time consistently.
Two approaches to controlling quality and quality costs are as follows:
(a) Approach 1: minimise total quality costs by budgeting for a level of quality
which minimises prevention costs plus inspection costs on the one hand and
internal and external failure costs on the other.
7
(b) Approach 2: aim for zero rejects and 100% quality. The desired standard of
production is contained within the product specification and every unit
produced ought to achieve this standard; in other words, there ought to be
no defects. Zero-defect targets are one aspect of Japanese management
philosophy. However, the actual level of defects must be recorded and
reported, even if the quality costs are not measured.
There is a fundamental difference of view in the sense that Approach 1 accepts

some level of defects while Approach 2 takes the view that all defects are
undesirable. Eventually, as modern manufacturing systems are introduced and JIT
system are employed, Approach 1 is likely to result in the conclusion that the cost of
failure are so high (because they hold up production) that the only acceptable
quality standard is a zero defect limit (Approach 2).
8
Computex (Pty) Ltd is a supplier of computer equipment. Its premises are situated
nearby the local university. One of its products, a laptop computer selling at R4 900,
is very popular among the B Com students.
The company sells on average approximately 20 laptop computers per week. Sales
take place evenly throughout the year which consists of 50 weeks.
The company purchases the laptop computers at a cost of R3 430 each. The cost to
place an order amounts to R300 and orders are executed within 5 weeks.
Safety stock should amount to the sales requirement for 3 weeks.
Direct stockholding costs are R35,00 per unit and insurance on the laptop
computers amount to 10% of the unit cost per year.
The supplier has offered a quantity discount of 5% per laptop computer on orders of
150 units. The company implemented the economic order quantity model to
manage its inventory.
The current after tax cost of capital is 11% per annum, the current rate of inflation is
7% per annum and the current rate of taxation is 29%.
REQUIRED:
(a) Advise the management of the company whether they should accept the
special offer from the supplier. (20)
(b) Determine the re-order point for the laptop computers. (2)
(c) List any three implications if a quantity discount is accepted. (3)
[25]
9
QUESTION 1 – SUGGESTED SOLUTION
Annual demand = 20 x 50 = 1 000 computers
Safety stock = 3 x 20 = 60 computers
Discounted unit price on special offer = R3 430 x 0.95 = R3 258.50
Current EOQ Special offer
Purchase price
1 000 x 3 430 3 430 000
1 000 x (3 258.50) 3 258 500
Order cost
29① x 300 8 700
7③ x 300 2 100
Carrying cost (35 + 60) x 515.20 39 928

2
(150 + 60) x 491.19④) 66 311

2
TOTAL COST 3 478 628 3 326 911
Therefore Computex should accept the new special offer which results in lower
costs.
10
Workings:
① Number of orders = annual demand
EOQ②
= 1 000
35
= 29 orders
② EOQ = 2 x annual demand x ordering cost per order

unit price x [interest on capital – inflation rate] + stockholding costs p.u. p.a.
100
= 2 x 1 000 x 300
3 430 x [11 – 7] + [35 + (10% x 3 430)].
100
= 600 000
515.20
= 34.13 = 35 units
③ Number of orders = annual demand

Order quantity
= 1 000
150
= 7 orders
④ Special offer carrying cost p.u. p.a.:
= unit price x [interest on capital – inflation rate] + stockholding costs p.u. p.a.
100
= (3 258.50) x [11 – 7] + [35 + (10% x 3 258.50)] = R491.19

100
11
(b) Reorder point = (normal demand x lead time) + safety stock

= (20 x 5) + (20 x 3)
= 160 units
(c)
- Higher carrying costs
- Lower acquisition costs
- Lower ordering costs
12
QUESTION 2 (25 marks) (30 minutes)
Comfyflex Ltd manufactures ladies sandals. The soles used to manufacture these
sandals are imported from a supplier based in Italy and local craftsman are
employed to hand stitch leather straps to these soles. Thirty thousand (30 000) soles
are required annually. The financial year consists of 260 working days.
The following information relates to the soles:
Ordering cost R300 per order

Purchase price R 75 per sole
Required rate of return after taxation 10%
Rate of taxation 28%
Safety stock 150 soles
Lead time 21 working days
In addition to the required rate of return, direct stockholding costs amount to R5 per
sole.
Comfyflex uses the economic order quantity model to manage inventory. The
Italian suppliers have offered Comfyflex a discount of 5% should they agree to place
20 orders per year.
Due to the fact that the Comfyflex premises is very small, in order to make use of the
discount offered by the Italian supplier, additional storage space would have to be
rented for R250 per month.
Required:
a) Calculate the re-order point under the current inventory model of

Comfyflex Ltd. ( 3)
b) Determine whether Comfyflex Ltd should accept the special offer. (20)
c) List three (3) assumptions underlying the economic order quantity model. ( 2)
[25]
13
QUESTION 2 - SUGGESTED SOLUTION
a) Re-order point = (Demand per lead time x lead time) + safety stock
= (30 000 x 21) + 150

260
= 2 423 + 150
= 2 573 units
b)
EOQ Special Offer
Acquisition cost (75 x 30 000) R2 250 000

(75 x 30 000 x 95/100) R2 137 500
Ordering cost  (300 x 25) R7 500

(300 x 20) R6 000
Carrying cost R12,5 x (1 200/2 + 150) R9 375

 R10 912,50
Additional storage (250 x 12) R3 000

R2 266 875 R2 157 412,50
 Accept the special offer.
 EOQ =
2 x Annual demand x ordering cost per order
(Unit price x (interest on capital – inflation) + stockholding costs per unit per annum
100
14
=
2 x 30 000 x 300
(75 x (10 – 0) ) + 5
100
=
18 000 000
12.5
= 1 200 units
Number of orders = Annual demand

EOQ
= 30 000
1 200
= 25 orders
 ((R75 x 95/100) x (10 – 0) ) + R5

100
= 12.125
 R12.125 x (1 500 + 150) = R10 912,50

2
b)
 Demand is known and continuous.
 Load time is known and does not vary in length.
 Delivery of ordered stock takes place in one batch, etc.
15
Sparkle Limited is a manufacturer of pool cleaners and operates for 250 days per
annum.
The company currently purchases one of the components for the pool cleaner at a
cost of R35 per unit from Splash CC. Orders are executed within 15 days. The
demand for the component is 12 000 units per annum. There is no seasonal
fluctuation in the demand for the component. The company makes use of the
economic order quantity method to determine the number of units to be ordered.
Sparkle Limited requires safety stock of 70 units.
The cost to place an order amounts to R100 and delivery costs amount to R120 per
order. The company requires a 20% return on capital before taxation. In addition to
the required rate of return, direct stockholding costs, excluding annual insurance at
5% of the unit cost, amount to R5,50 per unit.
The company has been approached by Splash CC, offering a discounted price of
R25 per unit, provided that orders are placed in batches of at least 800 units each
and a delivery charge of R200 per order will be charged. The lead time for delivery
would remain 15 days. The ordering cost per order will remain the same, but
additional storage space of R50 000 per annum will be needed.
The current rate of taxation is 35% per annum.
Required:
a) Determine the number of orders to be placed annually, without taking the

special offer into account. (8)
b) Determine the re-order point for the component. (2½)
c) Determine whether the special offer should be accepted, or not. (13½)

[24]
16
Question 3:
(a) Number of orders = Annual demand / Order quantity

= 12 000 / 669
= 18 orders
EOQ = 2 x annual demand x ordering cost per order

Unit price (int on cap - inf) + stockholding cost per unit pa
= 2 x 12 000 x (100 + 120)

35 (20% x 65%) + 5.5 + (35 x 5%)
= 5 280 000
11.8
= 669 units
(b) Re-order point = (demand per time unit x lead time) + safety stock
= (12 000 / 250 x 15) + 70
= 790 units
(c) Current cost Special offer

Purchase price
(35 x 12 000), (25 x 12 000) 420 000 300 000
Ordering & delivery cost
(R220 x 18 orders) 3 960
(12 000 / 800 = 15 orders x R300) 4 500
Carrying cost
[R11.8 x (669/2 + 70)] 4 773
25 (20% x 65%) + 5.5 + (25 x 5%) = R10
[R10 x (800/2 + 70)] 4 700
Additional storage 50 000
Total cost 428 733 359 200
Saving if special offer is accepted: R428 733 - R359 200 = R69 533
Therefore accept the special offer.

1
MAC3761 : LEARNING CURVES
LEARNING OBJECTIVES:
 Define the learning curve theory
 Discuss the limitations of the learning curve theory
 Calculate the learning curve applicable to a particular situation
 Make projections of the expected labour time for a particular project by

using the learning curve theory
2
People, when asked to repeat a task, often take less time to repeat the same
task when asked to do it again. This is the premise of learning curve theory.
The theory assumes that each time production quantity doubles, the
cumulative average time per unit will be a fixed percentage of the previous
cumulative average time per unit.
Illustration
If a first unit took 100 hours to complete, how long will it take to complete the
second unit if an 80% learning curve is applicable.
 First unit took 100 hours.

 80% learning curve applicable.
 Therefore it will take an average of 80 hours for units 1 and 2.
 Total hours taken = 80 X 2 = 160 hours.
 If first unit took 100 hours, second unit took 60 hours.
Illustration
Same as previous illustration but how long does it take to produce the third
and fourth unit.
 Average 80 hours for the first two units.

 Learning curve theory states that as production doubles, time goes down
by a fixed factor (which is 80% in this case.)
 Average time to produce first 4 units is 80% X 80 = 64 hours. (goes down by
that factor as production doubles)
 Total time taken = 64 X 4 = 256 hours to produce 4 units.
 Time taken to produce 2 units = 160 hours.
 Additional time taken to produce extra 2 units = 256 - 160 = 96 hours.
3
Determination and application of the learning curve
Wherever possible students should try to calculate the learning curve in a

tabular format. This tabular format can be expressed for our previous
illustration as follows:
Cumulative average time

Production output per unit Estimated total time
(number of units) Rounded to full hours (hours)
(1) (2) (3) = (1) X (2)
1 100 100
2 80(100 X 80%) 160
4 64(80 X 80%) 256
8 51 (64 X 80%) 408
16 41(51 X 80%) 656
32 33(41 X 80%) 1056
Thus if a question using a learning curve requires the amount of time for
producing the 24 units from unit 9 to 32, the number of hours can be easily
calculated by doing this table and subtracting 408 hours from 1056 hours.
It is very important to look out for these relationships when doing questions
concerning learning curves.
However a question may require the difference in time between units 13 and
29. As these units are not found on the table, the learning curve has to be
calculated algebraically.
The formula is as follows:

y = axb
(or it may be restated as log y = log a + b log x)
where:
y= cumulative average time per unit
a= the number of hours required for the first unit
x= the cumulative number of units
b= log l
log 2
l= the learning curve applicable i.e. if it is a 80 % learning curve, l = 0.8.

4
Illustration
Using the above formula, if 32 units have been produced, use the formula to
determine the number of hours.
b = log 0.8
log 2
= 0.3219
y = axb
= 100 X 32-0.3219
= 33 rounded (which is the same figure as found in the table)
To determine total hours, the following formula is used:
Total hours = ax
Illustration
To determine the total hours it would take for 32 units in the above example,
the calculations would be as follows:
Total hours = 100 X 32
= 100 X 32
= 1049
Example 1 (From Vigario)
If the first unit takes 40 hours and a 80% learning curve exists, calculate the
average time, total time and marginal time to produce the first 10 units.
The solution Is shown in part 4.
To determine the learning curve tempo, if two figures on the curve are
known.
5
If there is one gap between items such as between 33 and 41, the learning
tempo is calculated as follows:
LT = 33
41
= 0.8 i.e. 80 % learning curve
If there are two gaps between items such as between 33 and 51, a square
root is needed. The learning tempo is calculated as follows:
LT = 33 / 51
= 0.6471
= 0.8 i.e. 80 % learning curve.
LEARNING CURVE THEORY APPLICATIONS
1. Handy aid in the estimation of direct labour hours

2. More realistic estimates of labour and labour related costs.
3. Tenders for new contracts are more realistically priced
4. Handy model for production planning
5. Useful when scheduling personnel
6. Important financial model inter alia in the preparation of budgets,
establishing standards and variance analysis.
ADVANTAGES OF THE LEARNING CURVE THEOREM
1. It provides insight into the ability of workers to learn new skills.

2. It is useful to compare the performance of employees with estimated
performance.
3. Brings quantitative and behavioral aspects of labour management
together.
4. Information made available so that management can set up a incentive
wage system.
6
DISADVANTAGES OF THE LEARNING CURVE THEOREM
1. It is unlikely in practice that the regularity depicted by the learning curve

will exist.
2. After a period of time, workers will repeat the process identically each
time.
3. It cannot be used for establishing standards if:
 labour turnover is high
 extensive design modifications take place
 a big time gap occurs between orders
EXAMINATION CONSIDERATIONS
1. It is important to remember that the learning curve applies only to direct

labour and to variable overhead costs which use a direct function of
labour hours per input.
2. Look for variables of 1, 2, 4, 8, 16, 32, 64, 128, 256 or 512 when doing a
question as you may be able to do the question using the table rather
than using logs.
7
ANSWER TO EXAMPLE 1
Cumulative
Production production Average time Total time Marginal
time
1 1 40 40 40
1 2 32 64 24
1 3 28.1 84.3 20.3
1 4 25.6 102.4 18.1
1 5 23.86 119.3 16.9
1 6 22.46 134.8 15.5
1 7 21.4 149.7 14.9
1 8 20.48 163.8 14.1
1 9 19.71 177.4 13.6
1 10 19.06 190.6 13.2
LEARNING CURVE CLASS EXAMPLE 1 (UNISA)

a) Time to complete first unit = 20 hours
Learning curve rate = 20%
REQUIRED
Calculate the total time to complete 16 units (in minutes)
b) Time to complete first unit = 40 hours

Learning curve = 90%
REQUIRED
Calculate the average time for the first 4 units
c) Time to complete first unit = 20 hours

Time to complete second unit = 16 hours
REQUIRED
Calculate the learning curve ratio

8
d) The following information is available:
Lot size - 10 units

Learning curve - 90%
Time to complete first lot - 300 minutes
REQUIRED
i) Calculate the cumulative average time per unit if 16 lots are

produced.
ii) Calculate the total cumulative time if 16 lots are produced.
e) Use the same information as in question 1d.
Assume that the variable cost, subject to the learning curve, consists of
direct labour and associated overheads of R150 per hour.
REQUIRED
Calculate the predetermined cost to manufacture 16 units.
f) The production time to complete the first 4 units of a new product

“Zozo” was as follows:
1st unit 1 600 hours

2nd unit 1 280 hours
3rd unit 1 184 hours
4th unit 1 120 hours
An order for an additional 12 units “Zozo” was received.
REQUIRED
Calculate the budgeted production hours to execute the order.

9
SUGGESTED SOLUTION TO LEARNING CURVE CLASS EXAMPLE 1
a) Time 1st unit = 20 hours

Average time 1st 2 units (20 x 0,8) = 16 hours
Average time 1st 4 units (16 x 0,8) = 12,8 hours
Average time 1st 8 units (12,8 x 0,8) = 10,24 hours)
Total time for first 16 units
8,192 hours x 16 units = 131,072 hours
131,072 hours x 60 minutes/hour = 7864,32 minutes
b) Time first unit = 40 hours

c) Learning curve ratio = Total labour time for first 2 units/

(Total labour time for first unit x 2)
= (20 + 16)/(20 x 2)
= 36/40
d)
CUMULATIVE PRODUCTION TIME IN MINUTES
Number of Number of units Cumulative average Total cumulative time

lots (lot size = 10) per unit
1 10 (10 x 1) 30* 300

2 20 (10 x 2) 27 (90% x 30) 540 (20 x 27)
4 40 (10 x 4) 24,3 (90% x 27) 972 (40 x 24,3
8 80 (10 x 8) 21,87 (90% x 24,3) 1 749,6 (80 x 21,87)
16 160 (10 x 16) 19,683 (90% x 21,87) 3 149,3 (160 x 19,683)
* (300/10) = 30
10
e)
CUMULATIVE PRODUCTION CUMULATIVE AVERAGE COST CUMULA- ADDITIONAL
PER UNIT TIVE COST CUMULATIVE
COST
Number Number of units
of lots (lot size = 10)
1 10 (10 x 1) 30 min x R2,50* = R75 750 750

2 20 (10 x 2) 27 min x R2,50 = R67,50 1 350** 600
4 40 (10 x 4) 24,3 min x R2,50 = R60,76 2 430 1 080
8 80 (10 x 8) 21,87 min x R2,50 = R54,68 4 374 1 944
16 160 (10 x 16) 19,683 min x R2,50 = R49.21 7 874 3 500
* (R150/60 = R2,50 per minute)

** (20 x R67,50) = R1 350)
f) Calculation of learning curve
Number of Cumulative Average time % of previous

hours time (hours)
lst unit 1 600 1 600 1 600 90%

2nd unit 1 280 2 800 1 440
3rd + 4th unit 90%
(1 184 + 1 120) 2 304 5 184 1 296
Calculation of the budgeted production hours for 12 additional items
Average time for first 4 units 1 296,00

Average time for first 8 units 1 166,40 (90% of 1 296)
Average time for first 16 units 1 049,76 (90% of 1 166,4)
Total time for first 16 units 16 796,16 (1 049,76 x 16)

Total time for first 4 units ( 5 184,00
11 612,16
=======
Budgeted production hours for 12 additional units are 11 612 hours.

11
LEARNING CURVE CLASS EXAMPLE 2
Bakstaan Limited is a large company operating a number of divisions. The

company started a new division recently which manufactures masts for
sailing boards.
The manufacturing cost for the first four masts were :
R
Direct labour (61,47 hours at R5 per hour) 307,35
Raw material cost 56,00
Overheads 226,00
588,35
=====
Overheads
Indirect raw material 16,00

Indirect labour 12,30
Depreciation 196,70
Direct labour hours are as follows:
First unit 16,00 hour

Second unit 15,36 hour
Third unit 15,25 hour
Fourth unit 14,85 hour
An order of 200 units was received after a display at the Rand Easter show.
The four units already being manufactured will be held for viewing purposes.
The management’s objective is to recover all direct cost plus a profit of 25%
on the selling price.
12
REQUIRED
Calculate the tender price per mast.
(UNISA - adapted)
Hint
Use the formula
Log y = log a + b x
where y = Average time for n units
b = Log of learning curve/Log z
x = Total number of units (in this question 204)
a = Time for first unit

13
Learning curve - 2 units = (16 = 15,36/(2 x 16)
= 31,36/32
= 0,98
Test
Learning curve - 4 units = 61,46/64
= 0,98
Total time for 204 units :
Log y = Log a + b log x
= Log 16 (Log 0,98/Log z) x Log 204
= 1,2041 + [0,9 912 - 1)/0,30 103] x 2,3096)
= 1,13682
Antilog of 1,13682 = 13,7031 hours
Hours
 Total time for 204 units (204 x 13,7031) 2 795,43

Less: Time for first units 61,46
Time required for 200 additional units 2 733,97

======
14
Budgeted turnover - 200 masts

R
Direct labour (2733.97 x R5) 13 669,85

Raw material cost (56/4) x 200 2 800,00
Overheads - raw material (16/4) x 200 800,00
Indirect raw material (21,30/61,46) x 2733,97 547,15
Depreciation - recognised as an indirect cost - _
Direct cost (0,75) 17 817,00

Profit (0,25) 5 939,00
23 756,00
========
Selling price per unit
Budgeted turnover/Production volume
= 23 756/200
= R118,78
15
Alpha Limited manufactured 25 identical machines. The costs were as

follows :
Material 26 193,80
Labour (474,9 hour @ R23/hour) 10 922,70
Overheads (474,0 hour @ R15/hour) 7 123,50
Total cost @ R1 769,60 per machine 44 240,00

========
Overheads = 60% variable
An analysis of the labour hours resulted in the following :
- Time to manufacture the first unit: 33,5 hours

- Time to manufacture the second unit: 25,8 hours
An order for 10 additional identical machines was received.
REQUIRED
Calculate the selling price for the 10 additional machines if a profit of 20% on
selling price is required.
(UNISA)
16
ALPHA LIMITED
Calculation of labour hours:
(1) Test for learning factor (LF)
- At 2 units (first doubling)
33,5 + 25,8
33,5 x LF = 2
 LF = 0,88507
 Learning curve = 0,88507 x 100%
- At 25 units (not a cumulative doubling - make use of logs)
y = axb
log y = log a + b log x
474.9 log LF
log 25 = log 33,5 + log2 x log 25
log LF
1,27868 = 1,52504 + 0,30103 x 1,39794
1, 27868 - 1,52504
logLF = 1,39794 x 0,30103
logLF = 0,05305
antilog = T,94695
LF = 0,088501
= 0,885
= 88,5%
17
(2) Calculation of labour hours required for 10 additional units
Total number of units = 35
(Make use of logarithm seeing that is it not a cumulative doubling)
y = axb
log 0,885
log y = log 33,5 + log 2 x log 35
-1 + 0,94694
= 1,52504 + 0,30103 x 1,54407
= 1,52504 - 0,27216
= 1,25288
y = 17,901
Total time requires for 35 units = 35 x 17,901
= 626,54
Less: time for 25 units 474,9
 Additional time 10 units 151,64
CALCULATION OF SELLING PRICE
R26193,80 R
Raw material 25 x 10 10 478
Labour 151,64 x R23 3 488

Overheads 151,64 x (60% x R15) 1 365
Total cost 15 331 ( 80%)
Profit - 20% on selling price 3 833 ( 20%)
Selling price 19 164 (100%)

===== =====
Selling price per unit R1 916,40

18
QUESTION 1 (15 MARKS)
IPM (Pty) Limited manufactures luxury sports cars. The company recently
started manufacturing a new model of which, to date, two units have been
completed and sold. The manufacturing costs for these two units were as
follows:
R
Material 200 000
Direct labour 80 000
Overhead 120 000
Overhead is 40% fixed, 60% of which relates to manufacturing overhead.

Fixed manufacturing overhead is allocated to production on the basis of
direct labour costs. Organisational overhead is allocated to production
departments on the basis of sales values.
Variable overhead consists of manufacturing overhead only. Forty per cent

(40%) of the overhead is variable to material cost and 60% is variable to
direct labour costs.
The direct labour hours taken for the manufacturing of the first two sports cars
were as follows:
First car : 160 hours

Second car : 144 hours
This trend is similar to that experienced in the manufacturing of similar sports

cars. According to experience, the trend will last for the manufacturing of
the first thirty-two sports cars.
An order for another six of these sports cars has been received. The price of
material and labour increased by the following percentages since the
manufacturing of the first two sports cars:
Material : 10%
Direct labour : 15%
REQUIRED:
Determine the price at which each of the six sports cars should sell at if the
company wants to recovery only directly related manufacturing costs
and earn a total profit of R500 000. (15)
Calculations must be rounded off to four decimals. Final figures (hours or

Rands), must, however, be rounded off to the nearest whole figure.
19
IPM (PTY) LIMITED
Selling price per sports car
R
Material ( R200 000 x 6 x 1,1) 660 000
2
Direct labour ( R80 000 x 793 x 1,15) 239 987

304 2
Variable overheads variable to:
- material (R120 000 x 60% x 40% x 660 000) 95 040

200 000
- direct labour (R120 000 x 60% x 60% x 239 987) 129 593
80 000
Fixed manufacturing overheads (R120 000 x 40% x 60% x 239 987) 86 395
80 000
Total manufacturing cost for 6 cars 1 211 015

Profit 500 000
Sales 1 711 015
Selling price per sports car (R1 711 015) 285 169
6
( 9)
Calculations:
1 Learning curve
Learning curve = Cumulative average time per unit x 100

Previous cumulative average time per unit 1
= (160 + 144) ÷ 2 x 100

160 1
= 95% ( 2)
20
2 Labour hours required for next six sports cars
Total time for eight cars
Cumulative average time p.u. at level of 8 units = 0,953 x 160 hours

= 137,18 hours
Hours
Total time for 8 sports cars (137,18 x 8) 1 097,44
Less: Time for first two sports cars (160 + 144) 304
Time for next six sports cars 793,44
Rounded to nearest whole hours 793

21
QUESTION 2 (15 marks)
Stylish Modes (Pty) Limited designs and manufactures exclusive dresses.
An order was received from a nation-wide chain of boutiques for 16 identical

dresses of an original design. These dresses will be sold by “Boutique for You”,
a chain of boutiques, situated in all the major centres.
1. The direct labour costs, at R6 per hour, to manufacture the first two dresses
is as follows:
R
First dress 150
Second dress 120
270
An increase of 10% in wage rates was agreed upon, and is applicable to

the manufacture of the remaining 14 dresses.
2. The designer earns R5 760 per month, and designs approximately 18 new
creations during the course of a month.
3. Each dress will require 4,5 metres of material, at a factory cost of R17 per
metre.
4. It was estimated that sundry items, like decorative trimmings, buttons and
cotton, will amount to R7 per dress.
5. The following basis was determined to allocate the replacement and

maintenance costs of the machines used:
- Sewing machines : at R0,50 per direct labour hour
- Overlockers : at R0,75 per direct labour hour
6. Monthly fixed costs of the company amount to R7 550, of which the

above order should bear 2%.
7. The learning curve is expected to be maintained throughout the

complete order’s manufacture.
8. Stylish Modes (Pty) Limited intends selling the dresses to the chain of
boutiques at R420 each.
22
REQUIRED:
Calculate the total net income expected to be earned from the order.
Do not use logarithms.
Round all rand values off to the nearest rand. (15)

23
STYLISH MODES (PTY) LIMITED

Expected total net income earned from the order
R
Sales (R420 x 16) 6 720
Less: Cost of sales 3 840
Direct material (4,5 x R17 x 16) 1 224
Direct labour [(R270 + (217,4411 x R6 x 1,1)] 1 705
Design cost (R5 760) 320
18
Sundry items (R7 x 16) 112
Machine costs allocated
general sewing machines (262,442 x R0,50) 131
overlocking machines (262,442 x R0,75) 197
Fixed costs (2% x R7 550) 151

Total expected net income from the order 2 880
(15)
Calculations:
(a) Learning curve
1Learning curve = Cumulative average time per unit x 100

[ (R150 + R120)  2 ]
[( 6 6 ) ]
= __________________ x 100
R150 1
6
= [ (25 + 20)  2] x 100

25 1
= 90%
24
2. Calculation of hours for 16 dresses
No. of Doubling Learning Cumulative Total time

dresses curve average
time per
dress
1 -- 90%1 25,0000 25,00

2 1 90%1 22,50003 45,007
4 2 90%1 20,25004 81,008
8 3 90%1 18,22505 145,809
16 4 90%1 16,40256 262,4410
OR
Hours
Total hours for 16 dresses  4th doubling
Average time ( 0,90)4 x 25 16,4025

 Total time (16,4025 x 16) 262,4400
3. 90% x 25 = 22,5
4. 90% x 22,5 = 20,25
5. 90% x 20,25 = 18,225
6. 90% x 18,225 = 16,4025
7. 22,5 x 2 = 45
8. 20,25 x 4 = 81
9. 18,225 x 8 = 145,8
10. 16,4025 x 16 = 262,44
11. Calculation of hours for the next 14 dresses

Hours
Total hours for 16 dresses (per 2. above) 262,44
Less: Time for the first 2 dresses (25 + 20) 45,00
Total hours for the next 14 dresses 217,44

25
Technologies (Pty) Limited manufactures and sells combined fax and

telephone answering machines. In order to tender for a specific contract,
the technical team of the company has developed a new model called
FXAN. To date, two units of FXAN have been manufactured and are being
used as demonstration models.
The following information is available:
1. Direct labour hours taken to manufacture the first two units:
Hours
First unit 60
Second unit 48
2. The following average direct variable costs relate to the manufacture of

the first two units of FXAN:
R
Per unit
Material 620
Labour 440
Variable overheads 324
1 384
3. Since the first two units were manufactured, material costs have increased
by 10% and labour costs by 5%.
4. Variable overheads – variable per labour hour: R6.
5. Fixed costs incurred solely for the manufacture of FXAN units: R9 254.
6. Fixed costs of the enterprise are apportioned to products at a rate of 10%

of labour costs.
7. It is expected that the learning curve will be maintained for the

manufacture of the first 32 units of FXAN.
26
REQUIRED:
(a) Calculate the learning rate. ( 2)
(b) Calculate the minimum selling price per unit that the enterprise can quote
on a contract for 30 units in order only to recover direct costs, and earn a
profit of 25% on the selling price. Ignore all costs relating to the
manufacture of the first 2 units. (11)
Round final hours to the nearest hour and rands to the nearest rand.
27
(a) Learning rate = Cumulative average time per unit .
Previous cumulative average time per unit

= (60 + 48) hours  2
60 hours
= 54
60
= 0.90 ( 2)
(b) Calculation of minimum selling price per unit
R
Direct costs for 30 units:
Material (30 x R620 x 1,10) 20 460
Labour (R440 x 2 x 1 0261 x 1,05) 8 778

1081
Direct variable overheads (R6 x 1 0261) 6 156
Direct fixed costs (R9 254 x 30) 8 676

32
Total direct costs (75%) 44 070
Profit (25%) 14 690
Sales (100%) 58 760
Selling price per unit (R58 760) 1 959

30
Note: Fixed costs apportioned do not form part of direct costs and are,
therefore, not taken into account.
28
Calculation:
1
Direct labour hours needed for order Hours
Average time p.u. needed for 32 units (0,90)5 x 60 35,43
Total time needed for 32 units (35,43 x 32) 1 133,74

Less: Total Time for first two units (60 + 48) 108,00
Time needed for the next 30 units 1 025,74

(11)
29
Vanegill, a new division of Wilgredon Ltd, has just started manufacturing

motorised water-skis, and to date has manufactured and sold four motorised
water-skis. Fund in the Sun Enterprises is interested in purchasing 12 of these
water-skis for a resort at the Vaal Dam, and would like a quote from Vanegill.
The variable manufacturing costs for the first four water-skis were as follows :
R
Direct labour at R55 per labour hour 16 896
Direct material costs 92 840
Overheads (variable at 40% direct labour hours, and 60% 68 200
raw material costs)
Additional information:
 The total direct labour hours to manufacture the first unit were 120 hours,
and the total direct labour hours to manufacture the first two units were
192 hours.
 Fixed production overheads solely for the manufacture of the first 32

water-skis amount to R64 000.
 Organisational overheads of the enterprise are to be apportioned at a

rate of 5% of direct labour costs.
 Raw material costs have increased by 10% since the first four units were
produced.
 It is expected that the learning rate will be maintained for the

manufacture of the first 32 units.
REQUIRED :
(a) Calculate the learning curve. (3)
(b) Calculate the minimum selling price per unit that the company can
quote for the 12 water-skis in order to recover the relevant costs and
earn a profit of 35% based on the cost price. (17)
30
(c) State the limits between which a learning curve may vary and briefly
explain the significance of each limit. (2)
Logarithms may NOT be used.
In general, hours must be rounded off to 3 decimals. Final hours must,

however, be rounded off to the nearest hour. All other calculations must be
rounded off to the nearest rand or unit.
[UNISA MAY/JUNE 2006 EXAM]

31
QUESTION 4 : SUGGESTED SOLUTION
VANEGILL:
Total time for the first unit = 120 hours

Total time for the first two units = 192 hours (therefore time for the second unit
was 192 – 120 = 72 hours)
(a) learning curve = cumulative average time per unit x 100

previous cumulative average time per unit
= (192 ÷ 2) x 100
120
= 80%
(b)
Cumulative average time per unit for the first 16 units
= (0.8)4 x 120 = 49.152 hours
OR
Apply the learning curve at each level of doubling:

120 x 0.8 = 96 hours
96 x 0.8 = 76.8 hours
76.8 x 0.8 = 61.44 hours
61.44 x 0.8 = 49.152 hours
Total time for the first 16 units = cumulative av. time per unit for
first 16 units x 16 units
= 49.152 x 16
= 786.43 hours
≈ 786 hours
Cum. average time per unit for the first 4 units

= (0.8)2 x 120 = 76.8 hours
Total time for the first 4 units

= cumulative av. time per unit for
= 76.8 x 4
= 307.20 hours
≈ 307 hours
32
Therefore the total time to manufacture the 12 units in the order:
Hours
Total time for the first 16 units 786
Less: total time for the first 4 units (307)
Total time for 12 units in order 479
We only want to recover relevant costs. The apportioned overheads are not
relevant but the fixed portion of overheads incurred solely for the
manufacture of the water-skis are relevant. The direct labour, direct materials
and variable overheads are all relevant.
Cost of the order R
Direct material: 92,840 x 1.1 x 12 306,372

4
Direct labour: 55 x 479 26,345
Variable o/h (var. to labour hours): 68,200 x 0.4 x 26,345 42,536

16,896
Variable o/h (var. to material cost): 68,200 x 0.6 x 306,372 135,036

92,840
Fixed o/h: 64,000 x 12 24,000

32
Total Cost: R534,289
Want to earn a profit of 35% based on cost. Therefore profit ÷ costs = 35%.
Sales 135%
Less: Costs 100%
Profit 35%
Therefore total sales value = costs x 135% = 534,289 x 1.35 = R721,290

Therefore selling price per unit = R721,290 / 12 = R60,108
(c) The learning curve may vary from 50% which is the maximum learning
effect and 100% where no learning takes place.
1
MAC3761 - REGRESSION ANALYSIS
Learning Objectives:
 Calculate regression equations using the high-low method and the

least squares method
 Calculate and interpret the coefficient of determination (r2),

standard error of estimate and the beta-coeffiecient
 Provide management with relevant advice
INTRODUCTION
One of the key areas of management decision making concerns

forecasting, that is the attempt to predict the future by means of either
qualitative or quantitative methods. Regression analysis is one of the
most important quantitative methods which may assist the
management of an undertaking with this complex task. Forecasts can
be based on qualitative or quantitative methods. On the whole,
qualitative methods are used when information (particularly
quantitative data about the recent past) is scanty and not easily
accessible as well as for purposes of longer-term forecasts. These
methods require far more judgement and intuition than quantitative
methods.
Quantitative methods can be used for shorter-term forecasts and

where past information is more readily available. The longer a
particular tendency was adhered to in the past, the larger the
probability of the pattern continuing in the future. However, the
techniques must be used with care, always bearing in mind the
background of underlying limitations. The most common quantitative
forecasting method employed is regression analysis, and more
particularly simple linear regression analysis. Regression analysis is also
sometimes referred to as the least squares. Regression is a quantitative
method according to which a forecasting model is formulated by
means of statistical methods and which attempts to fit the best curve
to observed data in the short to medium term. Simple regression
assumes the existence of a single independent variable. The purpose
of regression analysis is to estimate the value of one variable (the
dependent variable) if the value of another related variable, or
variables (the independent variable(s)) is known.
2
Correlation analysis is a powerful instrument for measuring the degree

of relationship between variables. The coefficient of correlation (r) and
the coefficient of determination (r’) will be discussed later.
As stated in the paragraph referred to above, the one variable

(independent variable x) is know, and is used to estimate the value of
the other variable (dependent variable y). The independent variable
has a strong bearing over the dependent variable.
Fitting Of The Curves
A set of data is normally presented to you. These costs represent semi-

variable costs, therefore, consisting of fixed and variable elements. To
enable you to use this type of data for planning and forecasting in
auditing, budgeting or any other applications, the fixed and variable
elements are to be identified. By identifying the fixed (a) and variable
(b) elements, we are, at the same time, fitting a straight line to a set of
given points.
The least squares method
COST
e1 e2 e4
e3
Y = a + bx, where b is the slope of the

Straight line
Volume
In the case of the least squares method the straight line is fitted in such
a way as to minimise the sum of the squares of the distance between
the various points on the line.
The equation of the straight line is:
Y = a = bx
3
Where: y = the dependent variable

a = the intersection on the y axis (fixed cost element)
b = the slope of the line (variable cost element)
x = independent variable
Hence, from the general equation the summation of the above would
be:
y = an + bx
xy = ax + bx2
The above equations are solved simultaneously to find the values for a
and b.
n x y x2 xy
1 7 247 49 1729
2 10 270 100 2700
3 11 278 121 3058
4 10 271 100 2710
5 8 257 64 2056
6 6 235 36 1410
7 11 280 121 3080
8 12 287 144 3444
9 11 277 121 3047
10 9 265 81 2385
95 2667 937 25619
x = 95 y = 2667 x2 = 937 xy = 25619
Hence, substitute the values from the above table in the equations:
y = an + bx
xy = ax + bx2
2667 = 10a + 95b ………………. (1)

25619 = 95a + 937b…………. (2)
(1) x 9,5  25336,5 = 95a + 902,5b (3)
(2) – (3)  282,5 = 34,5b
b = 8,19
a = 188,90 by substituting b = 8,19 in (1)
Hence, y = 188,90 + 8,19x

4
When the independent variable (x) and the dependent variable (y)
have been identified, they can be plotted on a graph by the
independent variable being represented on the x-axis and the
dependent variable represented on the y-axis.
In cost-volume-profit analysis, the variable cost remains constant per

unit, and the fixed cost remains constant in total for a given period,
and within a given capacity range. All the points given are, therefore,
on the straight line.
The data you have been supplied with to apply correlation and
regression analysis to, however, differs from this in that not all points lie
This obviously calls for a more sophisticated technique than the high-
low method to determine the best objective fit of the straight line
between all the given points. Regression analysis can be used for this
purpose.
In the case of the least-squares method, the straight line is fitted in such
a way as to minimise the sum of the squares of the distances between
the various points and the straight line
(i.e. e12 + e22 + … + en2)
In our attempt to fit a straight line to a set of given points we, however,
have to remember that the equation of a straight line contains an
independent variable (x), and a dependent variable (y). As the
wording indicates, we can only fit a straight line to a given set of data,
if a relationship exists between these two variables. The existence of, or
lack of existence of this relationship, is determined by means of
correlation analysis.
From the above, it is, therefore, clear that regression analysis cannot be
applied unless the existence of an acceptable relationship between
the independent variable (x) and the dependent.
THE ACCEPTABILITY OF THE FIT
As management will be making forecasts based on the regression line,

they would like to know how accurate these will be. They would thus
like to have an indication as to the degree of suitability of the estimate
of the dependent variable by means of the independent variable.
5
Correlation
Correlation shows the degree of linear relationship between the two

sets of data and is used to indicate the acceptability of the fit. For this
we use the coeffiecient of correlation ® and the coefficient of
determination r2
COEFFICIENT OF CORRELATION (r)
Objective of the coefficient of correlation
Correlation shows the degree of linear relationship between two sets of

data and is used to indicate the acceptability of the fit, that is, the
accuracy of the regression line. It, therefore, shows whether there is a
correlation between the dependent variable and the independent
variable. The method of least squares eliminates guesswork when
fitting a regression line to data, because only one straight line is
possible. The problem is that a straight line can always be fitted to any
data, no matter how scattered the data is, and even if the given points
form a circle, parabola or any other curve. Accordingly, the degree of
fit of the regression line must be determined before it can be used as a
forecasting model. The coefficient of correlation r and the coefficient
of determination r2 provide two measures for judging the quality of the
fit.
Formula
The only formula used in this course for the calculation of the
coefficient of correlation is as follows:
n ∑x y - ∑x ∑ y
r =
n ∑x - (∑x ) n ∑y - (∑y )
2 2 2 2
So what would the correlation be of the above example:
r = 10 (25 619) – (95) (2667)
√10(937) – (95) √ 10 (713 631) – (2 667)

2 2
-
= 0,9938
6
Evaluation of the level of acceptability
A coefficient of correlation of 0 indicates that there is no relationship

between the independent variable x, and the dependent variable y.
A coefficient of correlation of 1 or –1 indicates a perfect relationship

We have, therefore, determined that an acceptable level of

correlation lies somewhere between 0 and 1 or 0 and –1. The
coefficient of determination quantifies this level of acceptability.
COEFFICIENT OF DETERMINATION (r2)
When the coefficient of correlation is either 0, +1 or -1 there is no doubt

as to the degree of relationship between x and y. Should r now fall
somewhere in between these absolute values the relationship is not
that obvious anymore.
In the above example r2 = (0,9938)2 = 0,9876.
What does this mean?
It simply means that 98,76% of the change in the values of y can be

predicted by means of the changes in the values of x. Factors other
than the changes in the values of x are responsible for 1,24% of the
change in y.
Note
0,75 or –0,75 is accepted as being a general guideline as to the lowest
possible limit the coefficient of correlation can be, to justify the
application of regression analysis
RELIABILITY OF ESTIMATES
The coefficient of determination indicates how well the least squares

line fits the sample data. However, the reliability of the sample values a
and b is still unknown.
7
The values calculated for a and b are only a reflection of a relationship

for a specific selection of information, in other words the relevant
range.
Different samples of information will yield different values for a and b.

The question now arises by how much the values of a and b, as
calculated, could possibly differ from the actual values of the total
population represented by the symbols A and B.
DEGREES OF FREEDOM
Firstly the number of degrees of freedom must be determined as this is

required when looking up the t factor (see end of chapter).
The number of degrees of freedom is the number of observations that

are used less the number of regression coefficients (a and b) which
needs to be estimated.
A straight line fitted at two points is automatically determined and has

no degrees of freedom.
A straight line through three points has one degree of freedom and
one through n points has (n - 2) degrees of freedom.
Hence the example above, which ten observations has (10 – 2)

degrees of freedom.
THE STANDARD ERROR OF ESTIMATE
The standard error (Se) of the estimated value of y (indicated by ŷ), is

calculated by means of the following formula:
∑y - a ∑ y - b ∑x y
2
Se =
√ n-2
Based on our example the standard error would be:

Se = 713 631 – 188,9 (2 667) – 8,19 (25 619)
8
= 1,37
The standard error can be used to determine the confidence limits for
the estimate of y, and these limits are shown by ŷ ± tSe, where t is the
factor for a t distribution with (n-2) degrees of freedom based on a
confidence level of (100 – α)%
8
Lets now determine the confidence limits of the estimated value of y

based on our working example, if a 95% confidence level is required.
Confidence = ŷ ± tSe
limits
= ŷ ± (2,306)(1,37)
= ŷ ± 3,16
t = 2,306 can be found in the t - distribution table.
We can now use the above information to forecast and analyse the
results.
Lets say we wanted to estimate the cost of production of 13 units

based our working example using a 95% confidence level.
Ŷ = a + bx ± tSe
= 188,9 + 8,19(13) ± (2,306)(1,37)
= 295,37 ± 3,16
It can thus be stated with 95% certainty that the actual cost of
producing 13 units will vary between R292,21 and R 298,53.
9
Steps in solving Correlation Analysis problems
1. Identify the independent and dependent variables.
2. Tabulate the periods; x and y in vertical columns.
3. Provide columns for x2; y2 and xy.
4. The first item in the x2-column will be the first item in the x-column,
squared. The same applies to the y2-column.
5. The first item in the xy-column will be the first item in the x-column,
multiplied by the first item in the y-column.
6. Complete all these columns and add them up, which will give you
x, y, x2, y2, xy (sum of x, etc).
7. Substitute these values into the formula for correlation and solve for
r. Calculate r2.
8. Evaluate the level of acceptability, and if acceptable, regression

analysis can be applied.
In all cases you should be led by the “required” section of the question.
Work through the example on pages 6 – 8 in study guide 2 of ACT 302.
OBJECTIVE OF REGRESSION ANALYSIS
To forecast one variable (dependent variable y) if the other variable

(independent variable x) is known.
Method
For purposes of this paper, we concentrate on the least-squares

method to fit a straight line to a set of given points. The least-squares
method uses the relationship that exists between the independent
variable x and the dependent variable y (as determined by the
coefficient of correlation) to fit a straight line to a set of given points to
determine the best objective fit.
10
Steps in solving Regression–Analysis problems
1-8. Unless already done for correlation analysis, follow steps 1 to above.
9. Substitute the value calculated above in the following equations:
a) y = na + bx
b) xy = ax + bx2
10. Solve equations simultaneously for a and b.
11. State what a and b represent.
12. To forecast the value of y, given the value of x; substitute a and b

as stated in 11. and x into equation a and solve for y.
Limitations (Read)
1. Short to medium-term predictions
The least-squares method attaches equal weight to all the observations

in a time series, irrespective of the fact that they represent recent or
older observations. If present data should thus differ significantly from
older data, the least-squares method would probably not provide very
good forecasts, especially not over the long term. This is why regression
analysis is only recommended for short to medium-term forecasts.
Circumstances and tendencies can change quickly. Great care must
consequently be exercised when historical data is projected into the
future, no matter what method of forecasting is used. Extrapolation
can be dangerous and judgement, experience, intuition and a good
background knowledge will always play an important role in the
making of realistic and reliable forecasts. In general, ore confidence
can, therefore, be placed on forecasts based on interpolation rather
than extrapolation, particularly in cases where the latter falls far outside
the area of the observed values. Although no forecasting method can
guarantee accuracy, this does not by any means preclude the
development of forecasting models to allow decision making.
11
2. Adaptability
Regression analysis is not an adaptive forecasting model for the very

reason that it does not automatically adapt forecasts to the latest
particulars and allocate greater weight to the latter. It would,
therefore, not be very suitable as a stock control model.
3. The number of observations
Too much confidence cannot be placed on a relationship if the

number of observations to which a regression line is fitted is small.
Experience has shown that there should be at least ten observations for
each independent variable. If the dependent variable is estimated by
multiple regression by means of three independent variables, the
regression line should thus be fitted to at least 30 observations. At least
ten observations are accordingly required in the case of simple linear
regression.
12
QUESTION 1
1. You are a clerk in the cost accounting department of Sellall Limited.

Mr Sellgood, one of the sales representatives, requested your
department to estimate the expected maintenance cost of his
vehicle for June 2014. He gave a summary of the average
kilometres travelled per day for the past seven months, as well as of
the average daily maintenance costs for the corresponding period.
You departmental head, being in a rush, supplied you with only the
following information:
Period : November 2013 – My 2014
x = 1 980
y = 1 324
x2 = 563 400
y2 = 251 676
xy = 376 510
r = 0,9816
Relevant formulae:
y = a + bx
x = na + bx
xy = ax + bx2
Determine the value of a, assuming that b = 0,6004.
a) 1m6046
b) 19,2857
c) 2
d) 19 (3)
5. Use the information in 1. above.
Determine the average daily maintenance cost if 250 kilometres are

travelled per day.
a) 169,39
b) 151,70
c) 152,10
d) 170,00 (3)
13
Indicate the lowest limit of the coefficient of correlation, which will

justify the application of regression analysis.
a) 0,50 and – 0,50

b) 0,85 and – 0,85
c) 0,75
d) 0,75 and – 0,75 (1)
14
1. The correct answer is b). (3)
Substitute b = 0,6004 in the following equation:
1 324 = 7a 1 980b
1 324 = 7a + 1 980 (0,6004)
1 324 = 7a + 1 189
7a = 1 324 – 1 189
7a = 135
a = 19,2857
2. The correct answer is a). (3)
Y = average daily maintenance cost

Y = a + bx
= 19,2857 + 0,6004 (250)
= 169,39
3. The correct answer is d). (1)

15
QUESTION 2
You are the accountant of a relatively small manufacturing company,

Weskor (Pty) Ltd. For the last three months, the company has
experienced a significant drop in profits.
On examination of the records, you have established that, from the

beginning of January 2014, spares and components were obtained
from a different supplier at prices well in excess of the normal prices. A
buyer in the purchasing department has since then confessed to being
guilty of bribery.
Normal profits were maintained until the end of December 2013. It has
been decided to analyse the actual production cost for the period
October 2013 to December 2014 in order to determine normal
production cost. The extent of the malpractice during the period
January 2014 to March 2014 is to be determined by using this normal
cost as basis.
You realise that a three month period is normally too short to apply
correlation and regression analysis, but these particular spares and
components have only been purchased from 1 October 2013, due to a
change in the manufacturing process.
The following is an extract of the production and cost records:
Units Production
produced cost
R
October 2013
November 2013 16 8 380
December 2012 15 7 800
19 9 450
January 2014 18 10 740
February 2014 14 8 800
March 2014 20 11 800
16
Required:
a) Determine the coefficient of correlation between the units

produced and production cost, based on the actual results for the
period October to December 2013. State the meaning of this
figure. (5)
b) Calculate the fixed and variable component of normal production

cost by applying regression analysis techniques on the results of the
period October 2013 to December 2013. (5)
c) Make an estimate of the costs incurred in excess of the normal

production cost for the period January 2014 to March 2014. (5)
Relevant formulae:
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
y = a + bx
y = an + bx
xy = ax + bx2

17
Weskor (Pty) Ltd
a) Coefficient of correlation
Month x y x2 y2 xy
October 2013 16 8 380 256 70 224 400 134 080
November 2013 15 7 800 225 60 840 000 117 000
December 2013 19 9 450 361 89 302 500 179 550
50 25 630 842 220 366 900 430 630
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 3(430 630) - 50(25 630) .

___________ _____________________
 3(842) - 502  3(220 366 900) – 25 6302
= 1 291 890 - 1 281 500 .

___ __________
 26  4 203 800
= 10 390
10 455
= 0,9938
Significance of r
The correlation between the units produced and production cost is

extremely good. Regression analysis can, therefore, be used to make
forecasts. (5)
b) Fixed and variable components of normal production cost
Y = an + bx …. (a)
XY = ax + bx2 …. (b)
Substitute into (a) : 25 630 = 3a + 50b …. (1)
Substitute into (b) : 430 630 = 50a + 842b …. (2)
(1) x 50 : 1 281 500 = 150a + 2 500b …. (3)
(2) x 3 : 1 291 890 = 150a + 2 526b …. (4)
(4) – (3) : 10 390 = 26b
 b = 399,62
Substitute b = 399,62 in (1):
25 630 = 3a + 50 (399,62)
 a = 1 883
18
Normal production cost:
Fixed = R1 883
Variable = R400/unit
(5)
c) Estimate of costs incurred in excess of the normal production cost
Month Units Actual Cost Estimated Difference

Produced Cost
R R R
January 2014 18 10 740 9 0831 1 657

February 2014 14 8 800 7 4832 1 317
March 2014 20 11 800 9 8833 1 917
4 891
Calculations:
1 R[1 883 + (400 x 18)] = R9 083

2 R[1 883 + (400 x 14)] = R7 483
3 R[1 883 + (400 x 20)] = R9 883 (5)
19
QUESTION 3
Rietbok Manufacturing Company Limited manufactures a single

product. In addition to the costs which have been identified as either
fixed or as variable, there are costs which are semi-variable. In order to
compile a budget for the following month, the semi-variable
manufacturing costs of the previous ten months are presented to you
together with other costs:
Semi-variable
Month Production manufacturing costs
(Units) R
1 1 500 800
2 2 000 1 000
3 3 000 1 350
4 2 500 1 250
5 3 000 1 300
6 2 500 1 200
7 3 500 1 400
8 3 000 1 250
9 2 500 1 150
10 1 500 800
Other costs:
- Material : R 9,75 per 100 units

- Labour : R 9,00 per 100 units
- Fixed costs : R631,25 per month
It is anticipated that 4 000 units will be manufactured during month 11.

All costs are being paid for in cash.
REQUIRED:
a) Determine the coefficient of correlation. (5)
b) Calculate the fixed and the variable elements of the semi-variable

manufacturing costs, by means of regression analysis. (5)
c) Calculate the cash requirements for month 11, from the available
particulars. (4)
20
Rietbok Manufacturing Company Ltd
Month x y xy x2 y2
1 1 500 800 1 200 000 2 250 000 640 000
2 2 000 1 000 2 000 000 4 000 000 1 000 000
3 3 000 1 350 4 050 000 9 000 000 1 822 500
4 2 500 1 250 3 125 000 6 250 000 1 562 500
5 3 000 1 300 3 900 000 9 000 000 1 690 000
6 2 500 1 200 3 000 000 6 250 000 1 440 000
7 3 500 1 400 4 900 000 12 250 000 1 960 000
8 3 000 1 250 3 750 000 9 000 000 1 562 500
9 2 500 1 150 2 875 000 6 250 000 1 322 500
10 1 500 800 1 200 000 2 250 000 640 000
25 000 11 500 30 000 000 66 500 000 13 640 000
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 10(30 000 000) - (25 000 x 11 500) .

______________________ _____________________
 10(66 500 000) – (25 000)2  10(13 640 000 – (11 500)2
= 300 000 000 - 287 500 000 .

_______________________ ______________________
 665 000 000 – 625 000 000  136 400 000 - 132 250 000
= 12 500 000 .
__________ _________
 40 000 000  4 150 000
= 12 500 000 .
6 324,56 x 2 037,15
= 12 500 000
12 884 077
= 0,97 (5)
21
QUESTION 3 – Continued
b) Fixed and variable elements of semi-variable manufacturing cost
Y = an + bx …. (a)
XY = ax + bx2 …. (b)
Substitute into (a) : 11 500 = 10a + 25 000b …. (1)
Substitute into (b) : 30 000 000 = 25 000a + 66 500 000b …. (2)
(1) x 2 500 : 28 750 000 = 25 000a + 62 500 000b …. (3)
(2) - 3 : 1 250 000 = 4 000 000b
b = 1 250 000
4 000 000
b = 0,3125
Substitute b = 0,31254 in (1) 11 500 10a + (25 000)(0,3125)

= 11 500 – 7 812,5
10a = 3 587,5
10
a = 368,75
a =
Therefore, the fixed element of semi-variable manufacturing cost is

R368,75 per month and the variable element is R0,3125 per unit. (5)
c) Cash requirements for month 11 (4 000 units)
Material (4 000 x R0,0975) 390

Labour (4 000 x R0,0900) 360
Variable manufacturing cost

(4 000 x R0,3125) 1 250
Fixed manufacturing cost

(R631,25 + R368,75) 1 000
3 000
(4)
22
QUESTION 4
You are the cost accountant of Yours Truly (Pty) Limited, a company
that specialises in the manufacturing of small quality articles sold to gift
and departmental stores.
The company is currently experiencing financial problems due to a

downturn in the economy, and is reviewing its product and pricing
policies.
A new department manufacturing handmade articles was recently

opened, the turnover of which is increasing rapidly. These articles are
sold to companies at R20 each and to be used as corporate handout
gifts.
A statement has been made that this department does not earn the
required rate of return of 25% on sales that has been set for this
department, and that the latter should be closed down as a
rationalisation measure.
You do not agree with this statement and have decided to prove it to
be false. You have extracted the following details from the
production records of this department for the first nine months it has
been in operation:
Month No. of articles Total

manufactured manufacturing
cost
R
1 120 10 200
2 135 10 440
3 162 10 560
4 180 10 740
5 180 10 830
6 150 10 530
7 198 10 950
8 240 11 310
9 210 10 980
1 575 96 540
23
You realise that a nine month period is normally too short to apply
correlation and regression analysis, but due to a lack of other
information, have no choice but to use this limited information.
From the above extract, you have calculated a coefficient of

correlation of 99% and conclude that regression analysis may be
applied effectively to this information.
1. Of the fixed cost included in the total manufacturing cost, 90% is not
directly related to this department, but represents general company
overheads that have been apportioned to this department.
2. Once manufactured, these articles are packed in attractive gift

packaging cost R0,40 per gift. This packaging costs is over and
above the total manufacturing cost mentioned above.
3. Due to the popularity of these gift packs, the marketing and

administrative costs are very low, and amount to R0,20 per gift
pack.
4. All articles manufactured have been sold.
REQUIRED:
a) Calculate the fixed and variable elements of total manufacturing

cost by means of the least squares method of regression analysis. (6)
b) Determine if the department manufacturing the corporate handout

gifts should continue operating, or if it should close down. (Your
calculations must show the total relevant marginal and net income
for the nine month period.) (8)
Relevant equations and information:
y = na + bx
xy = ax + bx2
xy = 16 994 520
24
Yours Truly (Pty) Limited
a) Fixed and variable elements of manufacturing cost
The number of articles manufactured should have a strong bearing

on the manufacturing cost, therefore, the articles are represented
by x, the independent variable, and the manufacturing cost, y, the
dependent variable.
Y = an + bx …. a
XY = ax + bx2 …. b
Substitute into a : 96 540 = 9a + 1 575b …. 1
Substitute into b : 16 994 520 = 1 575a + 287 0731b …. 2
1 x 175 : 16 894 500 = 1 575a + 275 625b …. 3
2-3: 100 020 = 11 448b
b = 100 020
11 448
b = 8,736897
Substitute b = 8,736897 in 1:
96 540 = 9a + 1 575 (8,736897)
9a = 96 540 – 13 761
9a = 82 779
a = 9 197,66
Therefore, the variable manufacturing cost is R8,74 per corporate gift,

and the fixed manufacturing cost is R9 198 per month. (6)
25
Calculation:
1 x2 = (14 000 + 18 225 + 26 244 + 32 400 + 32 400 +

22 500 + 39 204 + 57 600 + 44 100) = 287 073
b) Continue manufacturing or close down.
Calculation of relevant net income

R
Sales (1 5751 x R20) 31 500
Less: Variable cost 14 711
Manufacturing cost (1 5751 x R8,742) 13 766
Packaging cost (1 5751 x R0,40) 630
Marketing & administrative cost 1 5751 x R0,20) 315
Marginal income 16 789
Less: Relevant fixed costs (R9 1982 x 0,10 x 9) 8 278
Relevant net income 8 511
Rate of return on sales (R 8 511 x 100) = 27%

R31 500
Therefore, the department manufacturing the corporate handout gifts

should continue operating, as it earns a return on 27%, on sales, which
exceeds the required 25%. (8)
Notes to solution:
1 x as given.
2 Fixed and variable elements as calculated in a) above.
26
QUESTION 5
Jetset Airlines Limited currently has a fleet consisting of 4 aircraft, each

of similar size. The company intends buying another aircraft.
The directors of the company have managed to obtain a loan to

finance the transaction. The repayment o the instalments on the loan
will, however, result in the company’s cash resources being placed
under pressure, especially over the first twelve months.
At a meeting of the board of directors, it was concluded that the only

way to solve the cash flow problem was to boost turnover. This,
however, is also a problem as the airline cannot fit in more flights and it
already has a 100% booking on existing flights. In the current economic
climate, it is also not advisable to increase the price of air tickets.
The financial director of the company brought it to the attention of

those present at the meeting that certain airlines make so-called
overbookings as there usually are late cancellations on flights. From
time to time, however, it is inevitable that the estimates of the number
of late cancellations will be wrong. In such a case, should the actual
number of late cancellations be less than the number estimated,
passengers are paid to stay a night over at the expense of the airline.
On conclusion of the meeting, the accountant of the company

determined the following information on request of the financial
director:
No. of passengers No. of late

booked cancellations
Mondays 520 25
Tuesdays 480 23
Wednesdays 510 25
Thursdays 490 24
Fridays 530 27
Saturdays 550 27
Sundays 540 26
The accountant informed the financial director that he has based the
above information on the result of a sample in which he has compared
the number of late cancellations in relation to the number of
passengers booked. The above extract is, consequently,
representative of the statistics for the past year. He has also confirmed
that the trend of late cancellations is similar for all flights on a particular
day.
27
REQUIRED:
a) Determine whether regression analysis can be used to forecast the

expected number of late cancellations on flights. (6)
b) Determine the number of late cancellations that can be expected

on a flight with a capacity of 150 passengers. (6)
All calculations must be rounded off to four decimals.
y = na + bx
y = na + bx
xy = ax + bx2
r = nxy - xy .
__________ ___________
 nx – (x)  ny - (y)
2 2 2 2
28
Jetset Airlines Limited
a) Determination of whether regression analysis can be used
x y xy x2 y2
520 25 13 000 270 400 625
480 23 11 040 230 400 529
510 25 12 750 260 100 625
490 24 11 760 240 100 576
530 27 14 310 280 900 729
550 27 14 850 302 500 729
540 26 14 040 291 600 676
 3 620 177 91 750 1 876 000 4 489
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 7(91 750) - (3 620)(177) .

__________________ _____________
 7(1 876 000) – 3 6202  7(4 489) – 1772
= 642 250 - 287 500 000 .

_____________________ ______________
 13 132 000 – 13 104 400  31 423 – 31 329
= 1 510 .
______ __
 27 600  94
= 1 510 .
(166,1325) (9,6954)
= 1 510 .
1 610,7210
= 0,9375
 Regression analysis can be used to forecast the expected

number of late cancellations on flights. (6)
29
b) Determination of expected number of late cancellations
y = An + bx …. a
xy = ax + bx2 …. b
Substitute into a : 177 = 7a + 3 620b …. 1
Substitute into b : 91 750 = 3 620a + 1 876 000b …. 2
1 x 3 620 : 640 740 = 25 340a + 13 104 400b …. 3
2-7: 642 250 = 25 340a + 13 132 000b …. 4
4-3: 1 510 = 27 600b
 b = 0,0547
177 = 7a + 3 620 (0,0547)
 7a = 177 – 198,014
 a = -21,014
7
 a = 3,002
Estimate of straight line : y = a + bx

y = -3,002 + (0,0547)x
Estimate of expected number of late

cancellations on a flight of 150 people : y = 03,002 + (0,0547)(150)
 5
 5 late cancellations can be expected (6)

30
QUESTION 6
Steely Limited manufactures steel window frames, which are used in

the erection of industrial factories.
The company is in its first year of production, with no established cost

performance or records.
The following are the production figures, for the first eight months of
production:
Output Cost of
production
Units R
(‘000) (‘000)
5 11,8
7 14,7
9 18,5
11 24,0
13 26,2
15 30,1
17 33,6
14 28,0
It has been decided to apply regression and correlation analysis, in an

effort to confirm the initial fairness of the variable and fixed
components of the production records.
For this purpose, the following formulae are to be applied:
y = a + bx
Where y = na + bx
xy = ax + bx2 and
r = nxy - xy .
__________ ___________
 nx – (x)  ny2 - (y)2
2 2
31
REQUIRED:
a) Determine the correlation between the units manufactured and the

cost of production. (4)
b) Estimate the fixed and variable costs of production. (5)
c) State the regression line of total cost on output. (1)

32
Steely Limited
a) Correlation
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 8(2 347,7) - 91(186,9) .

_____________ __________________
 8(1 155) – (91)2  8(4 778,99) – (186,9)2
= 18 781,6 - 17 007,90 .
___________ __________________
 9 240 – 8 281  38 231,92 – 34 931,61
= 1 773,7 .
30,97 x 57,45
= 1 773,7 .
1 779,23
= 0,9969
There is a good correlation between the units manufactured and the

33
n X y Xy x2 y2
(‘000) (‘000) (‘000 000) (‘000 000) (‘000 000)
5 11,8 25 139,24 59,0
7 14,7 49 216,09 102,9
9 18,5 81 342,25 165,5
11 24,0 121 576,00 264,0
13 26,2 169 686,44 340,6
15 30,1 225 906,01 451,5
17 33,6 289 1 128,96 571,2
14 28,0 196 784,00 392,0
1
 91 186,9 1 155 4 778,99 2 347,7
b) Calculation of the fixed and variable costs of production
y = An + bx …. a
xy = ax + bx2 …. b
186 900 = 7a + 3 620b …. 1
2 347 700 = 3 620a + 1 876 000b …. 2
1 x 0,091 : 17 007,9 = 25 340a + 13 104 400b …. 3
2 x 0,008 : 18 781,6 = 25 340a + 13 132 000b …. 4
4-3: 1 510 = 27 600b
 b = 0,0547
178 = 7a + 3 620 (0,0547)
 7a = 177 – 198,014
 a = -21,014
7
 a = 3,002
2
PROCESS COSTING
Learning objectives:
 To understand the concept of process costing as a method of

accounting for costs
 To understand the flow of transactions in the ledger
 To prepare the process costing statements
 To understand and account for Normal and abnormal losses
 To understand the difference between the FIFO and Weighted

average methods of inventory valuation within process costing
 To understand the long and short methods of preparing process

costing statements
3
INTRODUCTION
Process costing is costing method used where it is not possible to

identify separate units of production, or jobs, usually because of the
continuous nature of the production process involved.
It is common to identify process costing with continuous production

such as the following:
 Oil refining
 Paper
 Food and drinks
 Chemicals
Process costing may also be associated with the production of large

volumes with low unit costs such as cans, glass or tins.
The following are the features of process costing which makes it

different from job or batch costing:
 The output of one process become the inputs of the next process
until the goods are complete in the final process.
 Due to the nature of the production process, there is often work in
progress that needs to be valued. Because of mass production it is
difficult to maintain stock records per unit.
 There is often a loss in the process due to spoilage, evaporation and
wastage.
THE BASICS OF PROCESS COSTING
Assume the following:
We manufacture plastic chairs in 2 processes. In process 1 the plastic is

moulded into shape and in process 2, the final assembly takes place.
Assume that all material is added at the beginning of process 1. No
material is added in process 2. Also assume that there is no spoilage
and no opening stock.
Material for 10 000 units are placed into production at a total material
cost of R100 000 and conversion costs for process 1 amounts to R56 400
and for process 2 R30 400.
4
WHAT IS OUR OBJECTIVE?
OUR OBJECTIVE IS TO ASSIGN COSTS TO PRODUCTION. PRODUCTION

MAYBE COMPLETE OR INCOMLETE, IN OTHER WORDS FINISHED GOODS
OR WORK IN PROGRESS.
Further assume that at the end of the month, process 1 completes and
transfers 8 000 units to process 2 and process 2 in turn completes and
transfers 7 000 units to finished goods.
Irrespective of the amount of material in kg, remember that we have

entered into production sufficient material for 10 000 units at a total
material cost of R100 000.
Remember this is still accounting and it’s about debits and credits. Let’s
examine the WIP accounts for the 2 processes.
MATERIAL INVENTORY ACC (IN UNITS)
Material on hand 12 000 Issued to P1 10 000

Assumed
WORK IN PROGRESS – PROCESS 1
Received from stock 10 000 Transferred to P2 8 000
Received from process 1 8 000 Transferred to FG 7 000

5
In process 1 there are 2 000 units which are incomplete. Assume that
they are 70% complete. (Obviously they are 100% complete for
materials as all materials were added at the beginning of the process).
How will the costs of production be allocated to the different
products?
Similarly in process 2, 7 000 units are complete and 1 000 units are in
progress. Assume that these units are 70 % complete. Costs must be
allocated to all units, finished or unfinished.
Consider the following production statement for process 1.
INPUT DETAILS OUTPUT MATERIAL CONVERSION
Opening stock
10 000 Current production
Completed and 8 000 8 000 8 000

transferred 2 000 2 000 1 400
Closing WIP
10 000 10 000 10 000 9 400
Note:
 Input must equal output.
 All 8 000 units are completed for material and conversion. In other
words units started and completed in the same period.
 There are 2 000 unfinished units, but remember material has already
been added .Which means I have incurred all my material costs.
 As far as conversion costs are concerned only 70% are complete. In
other word 1 400 units
Now to summarise the costs:
This is called a cost statement
Total Material Conversion

Opening stock - - -
Current production 156 400 100 000 56 400
156 400 100 000 56 400
÷ ÷
Equivalent production 10 000 9 400
Cost per unit R10,00 R6,00

6
The total costs incurred in process 1 is R156 400 and this must be
allocated to the complete and incomplete units. We do this in the
allocation statement.
Allocation statement
Completed units 8 000 x (10+ 6) 128 000
Closing WIP 28 400

- material 2 000 x 10 20 000
- Conversion 1 400 x 6 8 400
156 400
Lets see how the ledger accounts would look:
MATERIAL INVENTORY ACC (IN RANDS)

Assumed

Conversion costs 56 400 Balance c/f 28 400
156 400 156 400
Balance b/f 28 400
CONVERSION COSTS (IN RANDS)
Bank 56 400 Transferred to process 1 56 400
Received from process 1 128 000 Transferred to FG ?????

7
NOW LETS TAKE A LOOK AT PROCESS 2
PRODUCTION STATEMENT
INPUT DETAILS OUTPUT PROCESS 1 MATERIAL CONVERSION
- Opening stock
8 000 Received from process 1
Completed and
transferred 7 000 7 000 7 000 7 000
Closing WIP 1 000 1 000 1 000 600
8 000 8 000 8 000 8 000 7 600
Note:
other word 600 units
 A process 1 column is included as the costs of process 1 are brought
forward.
COST STATEMENT
Total Process Material Conversion

1
Opening stock - - - -
Current production 158 400 128 000 - 30 400
158 400 128 000 - 30 400
÷ ÷ ÷
Equivalent production 8 000 8 000 7 600
Cost per unit R16,00 R0 R4,00
8
Closing WIP 18 400

- Process 1 1 000 x 16 16 000
- Conversion 600 x 4 2 400
158 400
The above illustrates the basics of process costing.
ENSURE THAT YOU UNDERSTAND ALL OF THE ABOVE BEFORE YOU

VENTURE FORWARD. IT’S A JUNGLE OUT THERE.
LOSSES IN A PROCESS COSTING SYSTEM
So far we have ignored losses. What must be remembered is that input

must equal output. In other words if we input 10 000 units where did
they end up?
As we have seen from the previous example, that 8 000 units were
complete and 2 000 units were incomplete. What if some of these units
were spoilt and lost?
We have to account for two types of spoilage, viz normal spoilage and
abnormal spoilage.
NORMAL SPOILAGE
Normal losses are losses expected during a process. It is a loss we can

plan for. For example, say we know from past experience that for every
10 units of input 1 unit is lost. This means that 10% of input is lost. This also
means that 90% is good output.
The problem with normal losses is that it does not share in the costs. This
simply means that the cost of normal spoilage must be carried by the
good output.
Assume that the above 10 units were inputted at a total cost of R100.
10% of the units are spoilt but the cost still remains R100. This simply
means that the cost of output is not R10,00 per unit (R100÷10), but
R11,11 (R100÷9). Good output is 9 units
9
ABNORMAL LOSSES
Abnormal losses are additional losses which occur during a process. This
loss is unplanned for and therefore carries a cost.
Assume the cost of input of 500 units is R7 500. Assume that the normal
losses are 10% of input. Out put at the end of the process is 410 units. At
the outset the cost per unit seems to be R7 500÷500 = R15 per unit.
Remember we have normal spoilage so the cost per unit increases.
Units Cost
Total input 500 7 500
Normal spoilage (50) -
450 7 500
The cost per unit is now → 7 500 = R 16,67

450
Now to allocate the costs:
Unit completed and 410 x R16,67 6 833

transferred
Abnormal spoilage 40 x R16,67 667
450 x R16,67 7 500
What this means is that the cost of normal spoilage is carried by the
good output and the abnormal spoilage.
THE POINT OF SPOILAGE
For now it is safe to assume that normal spoilage and abnormal

spoilage is detected at the same point. Spoilage can take place at
any point in the process.
ILLUSTRATION 1
A company manufactures a product in a single process. The following

information is for a specific month:
Units R
Opening WIP - -
Units introduced 10 000
10
- Material cost 100 000

- Conversion cost 57 400
Units completed and transferred 7 000
Closing WIP – 80% complete 1 500
Normal spoilage is 5% of input that reached the point of spoilage.

Spoilage takes place at the beginning of the process.
Material is added at the beginning of the process and conversion costs
are incurred uniformerly throughout the process.
Lets draw a time line:
0%(start of process and spoilage point)
THE TIME LINE WILL HELP

IN CALCULATING NORMAL
SPOILAGE
80%(closing WIP)
100%(end of process)
THE PRODUCTION STATEMENT
INPUT DETAILS OUTPUT MATERIAL CONVERSI

ON
- Opening stock
Completed and 7 000 7 000 7 000

transferred 500 500 -
Normal spoilage 1 000 1 000 -
Abnormal spoilage 1 500 1 500 1 200
Closing WIP
10 000 10 000 10 000 8 200
11
Note:
 7 000 units are completed for material and conversion. In other words
units started and completed in the same period.
 There are 1 500 unfinished units, but remember we need to account
for 10 000 units, this means that 1 500 have been spoilt.
 Spoilage must be split between normal and abnormal.
 In this case spoilage takes place at the beginning of the process, viz at
the 0% point.
 All 10 000 units are placed at the 0% point in this period, which means
at that all units pass the spoilage point.
 Normal spoilage is 10 000 x 5% = 500 units.
 Abnormal spoilage is the balancing figure.
 What happened to the material from the spoilt units? They have been
wasted, but I still incurred the cost.
 Enter 500 units in the material column for normal spoilage(100%)
 At the 0% point how much work have I done on the spoilt units? None,
therefore nothing is entered in the conversion column.
 Abnormal spoilage is allocated in the same way as normal spoilage.

Opening stock - - -
157 400 100 000 57 400
÷ ÷
Now remember that normal spoilage must be carried by the other

components, viz completed units, incomplete units and abnormal
spoilage. We allocate this on a pro-rata basis. The total of the 3
components is 9 500 (7 000+1 000+1 500) units in the material column. And
nil in the conversion column.
ALLOCATION OF NORMAL SPOILAGE

Material Conversion
Units completed (7000/9500) x 500 368 -
Abnormal spoilage (1000/9500) x 500 53 -
Closing WIP (1500/9500) x 500 79 -
500 -
12
ALLOCATION STATEMENT
Units completed and 122 680

transferred
- Material (7000+368*) x 10 73 680
- Conversion (7000 + 0) x 7 49 000
Abnormal loss 10 530

- Material (1000+ 53*) x 10 10 530
- Conversion (-) -
Closing WIP 24 190

- material (1500+79*) x 10 15 790
- Conversion (1200+0) x 7 8 400
157 400
* Normal spoilage
An important thing to note in this example is that closing WIP is 80%

complete. This means it has passed through the point of spoilage. What
if it had not yet passed through the point of spoilage?
In that case no spoilage can be allocated to closing WIP. Normal

spoilage is then carried by completed units and abnormal spoilage.
13
ILLUSTRATION 2
Assume the same information as in the above illustration 1, but now

spoilage takes place at the end of the process.
0%(start of process )
THE TIME LINE WILL HELP IN

CALCULATING NORMAL
SPOILAGE
80%(closing WIP)
point of spoilage
NOW IT’S TIME TO VISUALISE.I KNOW IT’S HARD FOR YOU. JUST TRY.
PLEASE!!
We introduce 10 000 units at 0% point. Now close your eyes, yes close your
eyes and imagine those units moving down your time line. At the 80%
point 1 500 units get left behind. Which means that 8 500 units reach the
100% point, which is also the point of spoilage.
At this point we lose 5% of the units that reach this point of spoilage. 8 500
x 5% = 425. This is now normal spoilage. Closing WIP has not passed
through this point so spoilage cannot be allocated to closing WIP
14
- Opening stock
Completed and 7 000 7 000 7 000

transferred 425 425 425
Normal spoilage 1 075 1 075 1 075
Closing WIP
10 000 10 000 10 000 9 700
Note:
 In this case spoilage takes place at the end of the process, viz at the
100% point.
 At the 100% point how much work have I done on the spoilt units? All,
therefore all work is lost and 100% is entered in the conversion column.
COST STATEMENT
Opening stock - - -
157 400 100 000 57 400
÷ ÷

components, in this case except for closing WIP.
15
Material Conversion
Units completed
- Material (7000/8075) x 425 368
- Conversion (7000/8075) x 425 368
Abnormal spoilage
- Material (1075/8075) x 425 57
- Conversion (1075/8075) x 425 57
____ ____
425 425

transferred
- Material (7000+368*) x 10 73 680
- Conversion (7000 + 368) x 5,92 43 619

- Material (1075+ 57*) x 10 11 320
- Conversion (1075+57*) x 5,92 6 701
Closing WIP 22 104

- material (1500+0) x 10 15 000
- Conversion (1200+0) x 5,92 7 104
Rounding (24)
157 400
* Normal spoilage ; Note:(spoilage is not allocated to closing WIP)
What we have dealt with so far is what we call the long method. The
long method can be used at all times. The short method (see below)
can only be used if closing WIP has already passed through the point of
spoilage.
16
ILLUSTRATION 3 (SHORT METHOD)
Refer to illustration 1
- Opening stock
Completed and transferred 7 000 7 000 7 000

Normal spoilage 500 - -
Abnormal spoilage 1 000 1 000 -
Closing WIP 1 500 1 500 1 200
10 000 10 000 9 500 8 200
Note that with the short method, no normal spoilage is allocated to the
material and conversion columns. Please compare this to illustration 1
and understand where the differences are.
COST STATEMENT
Total Material Conversio
n
Opening stock - - -
157 400 100 000 57 400
÷ ÷
In illustration 1 The material cost per unit is R10 and in this case it is
R10,526. The additional R0,526 is the cost of normal spoilage.
With the long method the normal spoilage is part of the units and in the
short method it is part of the cost per unit.
17

transferred
- Material 7000 x 10,526 73 682
- Conversion 7000 x 7 49 000

- Material 1000 x 10,526 10 526
- Conversion -
Closing WIP 24 189

- material 1500 x 10,526 15 789
Rounding 3
157 400
OPENING WORK IN PROGRESS
Before I illustrate how opening inventory is dealt with in a process

costing environment you need to understand the different methods of
valuing stock.
We will limit ourselves to the weighted average and the First-in-First–out

methods.
WEIGHTED AVERAGE METHOD
The weighted average method works on the premise that all available
stock, in other words, opening stock and current production are costed
at an average rate per unit.
Assume we have the following available stock

Units Cost per Total cost
unit
Opening stock 1 000 3,50 3 500
Current production 4 000 3,30 13 200
5 000 16 700
We have a total of 5 000 units in stock at a total cost of R16 700. The
average cost per unit is therefore:
16 700 = R3,34
5 000
18
So if I transferred say 4 000 units to finished goods will it matter where

the stock came from, i.e. opening stock or current production? The
answer is no as all stock has the same unit cost.
Therefore closing stock will be valued as 1 000 units @ R3,34.
If we used FIFO the basic premise is that what ever was there first will
leave first. Hence in the above example what will closing stock be?

unit
5 000 16 700
Transfer 4 000 units (1 000) 3,50 (3 500)
(3 000) 3,30 (9 900)
1 000 3,30 3 300
The cost of opening stock is kept separate from current production.
ILLUSTRATION 4

Units R
Opening WIP 4 000
- Material 43 000
- Conversion – 60% complete 12 120

Spoilage takes place when the process is 50% complete.
Material is added at the beginning of the process and conversion costs are
incurred uniformly throughout the process.
Stock is valued on the weighted average basis.
19

CALCULATING NORMAL
SPOILAGE
50% point of spoilage
60%(opening WIP)
70%(closing WIP)
4 000 Opening stock


Normal spoilage 1 000 - -
Abnormal spoilage 1 400 1 400 700
Closing WIP 2 600 2 600 1 820
14 000 14 000 13 000 11 520
Time to visualise:
I start the new month with opening units of 4 000, which is 60% complete. This
means that 4 000 has already passed the point of spoilage in the previous
month. It can’t be spoilt again.
The current units start at 0% point. 10 000 units are introduced and worked on.
At the 50% point 10% is lost. This means that 9 000 (10 000 x 90%) units are left
to work on. When we get to the 70% point 2 600 units remain at this point as
unfinished stock. The remainder go through to output.
Since closing WIP has passed spoilage I can use the short method.
At the 50% point I have lost 50% conversion

20
COST STATEMENT
Opening stock 55 120 43 000 12 120
212 120 143 000 69 120
÷ ÷
Cost per unit R17,00 R11,00 R6,00

transferred
- Material 9000 x 11 99 000
- Conversion 9000 x 6 54 000

- Material 1400 x 11 15 400
Closing WIP 39 520

- material 2600 x 11 28 600
- Conversion 1820 x 6 10 920
Rounding
212 120
21
ILLUSTRATION 5
Use the same information as in illustration 4
4 000 Opening stock

Completed and
transferred 4 000 - 1 600
- Opening stock 5 000 5 000 5 000
- Current production
1 000 - -
Normal spoilage 1 400 1 400 700
Closing WIP
14 000 14 000 9 000 9 120
Note
Opening stock must leave first. Current production is the difference

between 9 000 and 4 000 units. Normal and abnormal spoilage is
calculated as before. Opening stock does not need any more material
this period as all material has already been added. It does however
need 40% of conversion to complete the opening stock. Hence the 1 600
units.
COST STATEMENT
Opening stock 55 120 - -
212 120 100 000 57 000
÷ ÷

22
Units completed and transferred

Opening stock – opening balance 55 120
Conversion to complete opening stock 1600 x 6,25 10 000
65 120
Current production 5000 x 17,36 86 800
151 920

- Material 1400 x 11,11 15 554
- Conversion 700 x 6,25 4 375
Closing WIP 40 261

- material 2600 x 11,11 28 886
- Conversion 1820 x 6,25 11 375
Rounding 10
212 120
23
QUESTION 1
The Carroll Company manufactures a product on a continuous process

basis which passes through one department. The product uses three
different items of materials. Material A and B are introduced at the
start of the process and Material C is introduced when the process is
60% complete. Labour and overhead costs are added continuously
throughout the process and overhead is charged at 100% of the direct
labour cost.
The work in progress at the start of the accounting period consisted of

3 000 units 20% complete valued at R17 880, consisting of R12 600 for
Material A, R2 400 Material B and conversion costs of R2 880.
During the period 20 000 units were started and the following costs
were incurred:
Material A R84 000

Material B R16 000
Material C R19 200
Direct labour R44 400
The completed production for the month was 15 000 units and the
closing work in progress consisted of 4 000 units which were 50%
complete. Because of an error an unexpected loss occurred and all
the opening work in progress was spoilt. This loss was discovered when
the opening work in progress was 40% complete. Normal loss is as
expected and this is detected at the 90% stage.
You are required to:
Produce the process account for the period and show your
calculations of the cost per unit, closing work in progress and cost of
completed production. Use the weighted average method.
(Drury adapted)
24
QUESTION 1 SUGGESTED SOLUTION
The physical input and output to the process is as follows:
Units
Input
Opening WIP 3 000
Introduced during period 20 000
23 000
Output
Completed production 15 000
Closing WIP 4 000
Abnormal loss (opening WIP) 3 000 22 000
Difference = normal loss _1 000
23 000
The cost per unit (CPU) is calculated as follows:
Total Material A Material B Material C Conversion
Completed units 15 000 15 000 15 000 15 000 15 000

Closing WIP 4 000 4 000 4 000 - 2 000
Normal loss 1 000 1 000 1 000 1 000 900
Abnormal loss 3 000 3 000 3 000 - 1 200
Total equivalent 23 000 23 000 23 000 16 000 19 100
Total cost
Opening WIP 17 880 12 600 2 400 - 2 880
Current cost 208 000 84 000 16 000 19 200 88 800
Total cost 225 880 96 600 18 400 19 200 91 680
CPU R4,20 R0,80 R1,20 R4,80
Work in progress
R
Cost element A 16 800
Cost element B 3 200
Cost element C -
Conversion cost _9 600
29 600
25
Notes
a) All of the material will have been added at the 90% stage.
Therefore materials are 100% complete as regards normal loss.
b) The opening WIP that is spoilt is 40% complete. Material C is not

added until the 60% stage, but Materials A and B will already have
been added.
Value of stock
R
Closing WIP 29 600
Completed production 15 000 x 11,00 = 165 000
Normal loss 1 000 x 4,20 = 4 200
1 000 x 0,80 = 800
1 000 x 1,20 = 1 200
900 x 4,80 = 4 320 175 520
Abnormal loss
A 3 000 x 4,20 = 12 600
B 3 000 x 0,80 = 2 400
Conversion cost 1 200 x 4,80 = 5 760 20 760
225 880
Process account
R R
Opening WIP 17 880 Completed production 175 520
A 84 000 Abnormal loss 20 760
B 16 000 Closing WIP 29 600
C 19 200
Conversion cost 88 800 ______
225 880 225 880
26
QUESTION 2
In the course of your examinations of the financial statements of

Polyplast Ltd for the year ended 31 December 2013 you ascertained
the following concerning its manufacturing operations:
 The company has two production departments (fabricating and

finished) and a service department. In the fabricating department
Polyplast is prepared from miracle mix and bypro. In the finishing
department each unit of Polyplast is converted into six tetraplexes
and three uniplexes. The service department provides services to
both production departments.
 The fabricating and finishing departments use a process costing

system. Actual production costs, including overheads, are
allocated monthly.
 Service department expenses are allocated to production

departments as follows:
i. Building maintenance: based on space occupied.

ii. Time keeping and personnel: based on number of employees.
iii. Other expenses: 50% to fabricating and 50% to finishing.
The following information was extracted from the company’s records

for December 2013:
- Fabricating department activities Units of

Polyplast
In the process at the beginning of December 3 000
Started during the month 25 000
28 000
Transferred to finishing department 19 000

In process at the end of December 6 000
Normal loss identified at 50% completion 3 000
28 000
- Fabricating department costs: R

Work-in-process at beginning of December
Materials 13 082
Labour 17 500
Overheads 21 540
52 122
Direct labour costs for December 154 000

Departmental overheads for December 132 000
27
- Work in process partly completed in the fabricating

department was:
Materials Labour and

overheads
Beginning of December 66,667% 50%
End of December 100% 75%
- The raw material stock records revealed the following:
Miracle Mix Bypro
Quantity R Quantity R
Balance: beginning of December 62 000 62 000 265 000 18 550
Purchase 12 December 39 500 49 375
20 December 28 500 34 200
Issues 83 200 50 000
- Service department expenses for December (not

included in departmental overheads above) were: R
Building maintenance 45 000
Timekeeping and personnel 27 500
Other 39 000
111 500
- Other information for December is:
Square metres of Number of

space occupied employees
Fabricating 75 000 180
Finishing 37 500 120
112 500 300
Prepare a complete process costing statement for the fabricating

department assuming:
a) all stocks are valued on a FIFO basis

b) all stocks are valued on a weighted average basis.
28
a) Process costing statement on a FIFO basis
i) Quantity schedule
Opening WIP 3 000
Placed in process 25 000
28 000
ii) Equivalent units

costs
Opening stock 3 000 1 000 1 500
Started and completed 16 000 16 000 16 000
19 000 17 000 17 500
Normal loss 3 000 - -
Closing stock 6 000 6 000 4 500
28 000 23 000 22 000
iii) Costs to be accounted for:

costs
R R R
Opening WIP 52 122
Current costs 444 000 92 000(W1) 352 000(W2)
496 122
iv) Costs per equivalent unit R4 R16
v) Summary of costs R
Completed and transferred to 400 122 (W3)
finishing
Closing WIP 96 000 (W4)
496 122
29
Workings:
W1 Calculation of material costs
Miracle Mix Bypro

Quantity R (FIFO) R (WA) Quantity R
Opening stock 62 000 62 000 62 000 265 000 18 550
Purchases 68 000 83 575 83 575 -_ -_
130 000 145 575 145 575 265 000 18 550
Closing stock 46 800 215 000
FIFO: Miracle Mix
-Purchase 20 December 34 200
-18 200 x (49 375/39 500) 22 875
WA: Miracle Mix
-46,8/130 x R145 575 52 407
Bypro: 215 / 265 x R18 550 _______ _______ _______ _______ 15 050
Used 83 200 88 500 93 168 50 000 3 500
The cost for Bypro will be the same for FIFO and WA as no purchases
were made.
W2 Calculation of conversion costs
R
Departmental overheads 132 000
Allocated overheads (see below) 66 000
352 000
Calculation of allocated overheads

Total (R) Fabricatin
g (R)
Building maintenance 45 000 30 000 (75/112,5)
Time keeping and personnel 27 500 16 500 (180/300)
Other 39 000 19 500 (50%)
66 000
W3 Calculation of transfers to Finishing Department (FIFO)
(52 122 + [{17 400 x 4) + (17 500 x 16)] = R400 122
W4 Calculation of closing WIP (FIFO)
[(6 000 X 4) + (4 500 X 16)] = R 96 000

30
b) Process costing statement on a weighted average basis
Opening WIP 3 000
28 000

costs
Completed 19 000 19 000 19 000
and transferred 3 000 - -
Normal loss 6 000 6 000 4 500
Closing stock ______ ______ ______
28 000 25 000 23 500

costs
Opening WIP 52 122 13 082 39 040
Current costs 448 668 96 668(W1) 352 000(W2)
500 790 109 750 391 040
iv) Costs per equivalent unit R21,03 R4,39 R16,64
finishing
500 790
Workings:
W5 Calculation of transfers to Finishing Department (WA)
(19 000 x 21,03) = R399 570
W6 Calculation of closing WIP (WA)
[(6 000 x 4,39) + (4 500 x 16,64)] = R101 220

JOINT AND BY PRODUCTS
LEARNING OBJECTIVES
 Distinguish between Joint and By products
 Explain and Identify split off point in a joint cost situation
 Explain and apply the alternative methods of allocating joint

costs to products
 Discuss the argument for and against each method.
 Discuss whether products should be processed further or sold

at split off point.
 Describe and apply accounting treatment for by products

JOINT AND BY-PRODUCTS
INTRODUCTION
Where a common raw material or a joint production process is used,

the same production process can produce two or more different
products.
To illustrate the above, take the slaughtering of an ox at an abattoir as

an example. The process produces a carcass and a hide. The
slaughtering process is the joint production process and the carcass
and the hide are the different products which are produced.
The joint process can be diagrammatically represented as follows:
Carcass
Ox Slaughtering
process
Hide
CLASSIFICATION INTO JOINT PRODUCTS AND BY-PRODUCTS
The products yielded by a joint process can be classified as either joint

products or by-products.
Products which are more or less equivalent in importance, quantity and

value to the other products which also arise from the same
manufacturing process are classified as joint products. In the above
example of the abattoir both the carcass and the hide would be
classified as joint products.
When a product is subordinate to the joint products in importance,

quantity and value, it is classified as a by-product. By-products do
have a sales value, but they are incidental to the manufacturing
process. In some cases the by-products may not even have a value at
all, but they are nevertheless by-products arising from the
manufacturing of the principal product(s).
Suppose a butchery buys carcasses from the abattoir for further
processing. The cutting up and processing of the carcass is the joint
process and three different products are obtained, namely good
quality meat, poor quality meat and bones. Both the good and poor
quality meat are produced in large quantities and make a substantial
contribution to the market value of the output of the manufacturing
process and are therefore regarded as joint products. The bones are
of lesser importance and make a relatively small contribution to the
total market value. The bones are therefore classified as a by-product.
JOINT COSTS
In the above example of the butchery, certain costs are incurred in

processing the carcass into the three products. The cost of the
carcass, labour and overheads related to processing are common to
all three products.
In any manufacturing process which produces more than one product,

there is a point up to which it is not possible to identify individual
products. The point in the process at which the individual products can
be identified is known as the split-off or separation point. All the costs
incurred before the split-off point is reached are joint costs. They
include all materials, labour and overheads incurred to process the
products up to the split-off point.
ADDITIONAL PROCESSING COSTS
It frequently happens that joint products are not sold directly after the
split-off point. They first have to undergo further processing, separately.
These additional processing costs can be allocated directly to the
respective products by means of a job or process costing system.
The good quality meat in the example could undergo further

processing into tenderised steak, for example, and the poor quality
meat could be used for mince. Additional processing costs therefore
do not form part of the joint costs and are apportioned to the specific
product after the split-off point.
COSTING METHODS FOR JOINT PRODUCTS
The problem that arises is: How are the joint costs of the joint
manufacturing process divided between the joint products and by-
products? Normally no joint cases are allocated to the by-products.
Joint costs are therefore allocated only to the joint products (principal
products). Allocation may be based on one of the following:
 the physical standard method (units products)
 the market value at the split-off point method (the selling

price/market value at the split-off point is applied)
 relative market value of the final product method (the market value
of the final product is used and all additional processing costs after
the split-off point and selling and distribution costs are deducted
there from. In other words, the estimated market value at the split-
off point is calculated in this way).
 Reversal costing method.
The choice of methods applied depends on the views of the

management and the company’s specific circumstances. The
allocation of the joint costs according to the respective methods may
be illustrated by the example of the butchery. Since joint costs are not
allocated to the by-product, the bones, the by-product and the
proceeds from its sale are left out of the account.
ILLUSTRATION 1 – PHYSICAL UNITS METHOD
A company manufactures three products in a single process. Raw

material X is used to produce product XX, XY an XZ.
Opening stock, finished goods, 200 units XX, 250 units XY and 300 of XZ
with a cost price of R1,50, R2,50 and R4,00 respectively.
One unit X cost R10 and produces 2 units of XX, 3 units of XY and 4 units
of XZ.
Separate cost of processing the units further amount to R0,50c for XX,
R0,75 for XY and R1 for XZ.
1000 units of material X were processed during the year.
Sales for the year are:
XX XY XZ
Units sold 1 800 3 100 3 750

Proceeds R5 400 R12 400 R28 125
Fixed cost amount to R2 500 for the year.
Stock is valued on the FIFO basis.
Instead of processing the products further they can be sold at XX R1,20

per unit, XY at R2 per unit and XZ at R3 per unit.
Joint costs will be allocated on the basis of physical units in the

following way:
Units produced:
XX 1 000 x 2 = 2 000
XY 1 000 x 3 = 3 000
XZ 1 000 x 4 = 4 000
9 000
 XX = 2÷9 x R10 000 R 2 222

XY = 3÷9 x R10 000 R 3 333
XZ = 4÷9 x R10 000 R 4 445
R10 000
ILLUSTRATION 2 – RELATIVE SALES VALUE BASIS
Details as in Illustration 1.
Joint costs will be allocated on the basis of relative sales value in the
following way:
Relative sales value is defined as the selling price of the end product less
any costs necessary to process after split off – point, sell it and distribute it.
Please note that we referring to the sales value of production.
XX XY XZ
Sales value of production 6 000 12 000 30 000

Less: separate cost 1 000 2 250 4 000
Relative sales value 5 000 9 750 26 000
Allocation
XX 5 000 x R10 000 = R 1 227

40 750
4
XY 9 750 x R10 000 = R 2 393

40 750
XZ 26 000 x R10 000 = R 6 380

40 750
R10 000
ILLUSTRATION 3 – UNIFORM CONTRIBUTION/REVERSAL COSTING METHOD
Details as in illustration 1.
Joint costs will be allocated on the uniform percentage contribution basis

as follows:
Profit percentage in example 2 30 750 = 64,1% 48 000
(1) (2) (3) (4)

Sales value Profit Separatable Share of
of contribution cost joint cost
production (1)x64,1% (1)-(2)-(3)
XX 6 000 3 844 1 000 1 156

XY 12 000 7 688 2 250 2 062
XZ 30 000 19 218 4 000 6 782
48 000 30 750 7 250 10 000
ILLUSTRATION 4 – RELATIVE SALES VALUE AT SPLIT - OFF
Joint costs will be allocated on the basis of relative sales value at split off
point in the following way:
% Allocation
XX 2 000 x R1,20 2 400 11,76 R 1 176

XY 3 000 x R2,00 6 000 29,41 R 2 941
XZ 4 000 x R3,00 12 000 58,83 R 5 883
20 400 100,00% R10 000
BY-PRODUCTS
The management of an enterprise considers the net realisable value of

by-products immaterial in relation to the total realisable value of the
joint product.
You will know by now that joint costs are allocated to joint products.
The question which arises now is how the proceeds obtained from the
sale of by-products should be dealt with.
The proceeds earned on the sale of a by-product (contribution) may

be brought to account as follows in the income statement:
 a reduction of the joint production costs
 “other income” (a separate income item) shown directly on the

income statement
 a reduction in the cost of goods sold.
The proceeds or contribution from a by-product are generally used to

reduce the joint cost of the joint products.
The basic principle is that for decision making purposes, there is never a
profit or loss on a by-product. The proceeds of the by-products are
used to reduce the joint cost where after it is allocated to joint
products.
By-product stock is usually regarded as having insignificant value and is

thus ignored. However should a value be placed on unsold stock, it
would be based on:
- Director's valuation
- Separate cost only.
Where not specifically mentioned stock must be valued at separate

cost only.
ILLUSTRATION 5
YOU ARE REQUIRED TO
Determine the profit if product XX is considered to be a by-product.

Assume that joint costs are allocated on the relative sales value basis. The
director's valuation of the closing stock of XX is R250.
SUGGESTED ANSWER
Total XX XY XZ
Sales 45 925 5 400 12 400 28 124

Cost of sales 17 820 5 400 4 226 8 194
- opening stock 2 125 300 625 1 200

- separate cost 7 250 1 000 *2 250 *4 000
- joint cost 10 000 4 350 1 541 4 109
________ ________ ________ ________
19 375 5 650 4 416 9 309

Less: closing stock 1 555 250 190 1 115
Net profit 28 105 - 8 174 19 931
ILLUSTRATION 6 – METHODS OF ACCOUNTING FOR BY-PRODUCTS
During November 2013, Suncake Ltd recorded the following results:
Opening stock Main product P = Nil

By- product z = Nil
Cost of production R120 000
Sales of the main product amounted to 90% of output during the period,
and 10% of production was held as closing stock at 30 November.
Sales revenue from the main product during November was R150 000.
A by-product Z is produced, and output had a net sales value of R1 000.

Of this output, R700 was sold during the month, and R300 was still on hand
at 30 November.
REQUIRED:
Calculate the profits for November using the four different methods of
accounting for by-products.
SUGGESTED SOLUTION
Income of by-product is added to sales of the main product
R R
Sales of main product (R150 000 + R700) 150 700
Opening stock -
Cost of production 120 000
120 000
Less: Closing stock 12 000
Cost of sales 108 000
Profit – main product 42 700
Income of by-product treated as separate item in income statement

R R
Sales of main product 150 000
Opening stock -
120 000
Other income 700
42 700
Income of by-product is deducted from the cost of production
R R
Opening stock -
Cost of production (R120 000 – R700) 119 300
119 300
Less: Closing stock (10%) 11 930
Net realisable value of by-product deducted from cost of production

(joint cost)
R R
Opening stock -
119 000
QUESTION 1
ABC Ltd manufactures three joint products using the same production
process. All three products can be sold either at the split-off point or
after further processing. The following information was obtained from
the budget for the three months ending 31 October 2014:
Sales value
Product Units At split-off After further Additional
point processing processing costs
R R R
Beba 1 000 40 000 50 000 10 000
Casa 2 500 80 000 115 000 25 000
Delta 1 500 50 000 60 000 15 000
The joint processing costs at the split-off point amount to R100 000.
REQUIRED:
a. Determine which products should be sold at the split-off point and

which products should undergo further processing.
b. Calculate the budgeted total profit for the three months ending 31
October 2014, taking your findings in (a) into account.
a) Calculation of which products should be sold at the split-off

point and which products should be sold after further
processing.
Beba Casa Delta Total

R R R R
Sales after split-off point 50 000 115 000 60 000 225 000
Sales at split-off point 40 000 80 000 50 000 170 000
Increase in sales 10 000 35 000 10 000 55 000
Additional processing costs
after split-off point 10 000 25 000 15 000 50 000
Additional profit/(loss) - 10 000 (5 000) 5 000
Recommendations:
Further processing and sale after the split-off point are only justified in
the case of product Casa.
b) Calculation of the budgeted total profit for the three months

ending 31 December 2014 if product Casa undergoes further
processing.
R
Sales 205 000
Beba at split-off point 40 000

Casa after split-off point 115 000
Delta at split-off point 50 000
Joint costs 100 000

Further processing costs after split-off point – 25 000
product Casa
Budgeted total profit 80 000

QUESTION 2 (40 MARKS - 48 MINUTES)
Alpha Limited manufactures three types of products in a joint

production process. Currently all products from this joint production
process is processed further in separate departments.
The following abridged income statement shows the profit per product
for the first financial year of the business. In this statement the joint cost
is allocated based on the volume produced.
Product A B C Total
R R R R
Cost of further processing (after

split off point) 50 000 25 000 5 000 80 000
Joint cost 40 000 20 000 4 000 64 000
Total production cost 90 000 45 000 9 000 144 000
Less: Closing stock 9 000 13 500 2 250 24 750
Cost of sales 81 000 31 500 6 750 119 250
Net profit (loss) 16 200 (1 575) (675) 13 950
Sales 97 200 29 925 6 075 133 200
Included in the further processing cost of all three products is 40%

committed fixed cost.
Management is dissatisfied with the results obtained from using the

above method of allocating joint production cost. They are of the
opinion that products B and C are profitable and require another
statement showing more realistic results for each product.
According to the new statement product C will be considered to be a

by-product and joint cost for A and B will be allocated on the basis of
relative sales value.
Instead of processing further the products can be sold at the split-off

point at the following total values:
R
Product A 55 000
Product B 28 000
Product C 5 000
YOU ARE REQUIRED TO
a) Prepare a new statement according to the above decision (15)

and calculate the profit per type of product and in total.
b) Do a recommendation to management if each of the three

products should be processed further or not. (15)
U/93/81/7
LETTER HEAD
The directors of Alpha Limited. (1)
Dear Sirs
The decision of the further processing of the products must be

considered on the long-term as well as the short-term.
This recommendation is according to the results of the last financial

year. Changes in costs, prices and production output can result in
some other recommendation.
According to qualitative considerations product B must be sold on the

short-term at the split-off point. The result will be savings of R250. For
the long-term, the point where there is no more committed fixed costs,
products B and C must be sold at the split-off point. The result will be
savings of R12 150. (2)
The savings for the short-term is small and the effects of qualitative
factors must also be taken into account.
If some of the departments, where further processing is done at the

moment, are closed, workers will have to be restricted and this can
have a negative influence on the rest of the workers. The effect of the
decision in the current marketing channels must also be taken into
consideration. If the current buyers of the processed products get
other products from this company they may get other suppliers for the
products also. (2)
On the long-term the effect of the qualitative considerations will be less

because there will be a longer phasing period. (1)
Yours faithfully
(40)
a) Sales value A 97 200 / 81 x 90 = 108 000 (1)

B 29 925 / 315 x 450 = 42 750 (1)
Relative sales value A 108 000 - 50 000 = 58 000 (1)

B 42 750 - 25 000 = 17 750 (1)
75 750
Statement of profit per type of product
Product A B C Total
R R R R
Separate cost 50 000 25 000 5 000 80 000 (3)

Joint cost 46 630 14 270 3 100 64 000 (3)
Production cost 96 630 39 270 8 100 144 000
Less: Closing stock 9 663 11 781 2 025 23 469 (3)
Cost of sales 86 967 27 489 6 075 120 531
Profit 10 233 2 436 - 12 669 (3)
Sales 97 200 29 925 6 075 133 200
b) Further processing A B C
R R R
Sales price after processing 108 000 42 750 8 100 (3)

Less: Further processing cost 50 000 25 000 5 000 (3)
Opportunity cost 55 000 28 000 5 000 (3)
Long-term advantage
(disadvantage) for further processing 3 000 (10 250) (1 900) (3)
Add: Committed fixed cost 20 000 10 000 2 000 (3)
Short term advantage disadvantage)
for further processing 23 000 (250) 100 (3)
QUESTION 3 (40 marks / 54 minutes)
DUBONNE (PTY) LTD
You are the auditor of Dubonne (Pty) Ltd, a manufacturing company

which produces 4 products, namely, Med, Rossi, Bianco and Sec.
The operation comprises 4 departments, viz. research, maintenance

and 2 production departments. The research and maintenance
departments render appropriate services to the production
departments.
Due to the temporary absence of the company's cost accountant,

management consulted you with the request that you provide them
with relevant management accounting data to enable them to assess
results achieved.
Consequently you reviewed the accounting records and compiled the

Med Rossi Bianco Sec

1. Production in units at
optimum capacity 30 000 20 000 25 000 15 000
2. Opening stock (units) 4 000 5 000 8 000 2 000
3. Closing stock (units) 6 000 3 000 7 000 1 000
4. Sales R84 000 R88 000 R156 000 R32 000
5. Value of opening stock R8 000 R12 000 R24 000 R3 000
6. Costs of further R15 000 R20 000 R50 000 R15 000
processing
7. Joint costs, which are only applicable to the production in production
department 1, amount to R50 000.
You established that:
1. The company produces Med in production department 2 and the

remaining 3 products, in a joint process in production department
1.
2. Rossi and Bianco can be sold at the split-off at R3,50 per unit each,
whilst Sec has no sales value if not processed further.
3. 10% of the cost of further processing is committed fixed costs.
4. For management costing purposes Sec is classified as a by-

product and the joint costs in respect of Rossi and Bianco are
accounted for on the relative sales value basis.
5. Stock is valued on the first-in, first-out basis for Med, Rossi and
Bianco while Sec, the by-product, is valued at the directors
valuation of R1,50 per unit.
6. The costs incurred by the research and maintenance departments

amount to R50 000 and R29 300, respectively, and are allocated as
follows:
Research department
- 10% to the maintenance department
- 60% to production department 1
Maintenance department
- 20% to the research department
Management uses the reciprocal method to allocate the cost of

service departments.
YOU ARE REQUIRED TO:
a) calculate the total profit for each product for the period.
(30)
b) recommend the marketing policy which you consider

management should implement with regard to the three products
produced in department 1. (10)
1. Allocation of cost of service departments

I = 29 300 + ,10N
N = 50 000 + ,20I (1)
Replace
 I = 29 300 + ,10 (50 000 + ,2 I)
= 29 300 + 5 000 + 0,02I
 ,98 I = 34 300
I = 35 000 (2)
N = 50 000 + ,2 (35 000)
= 57 000 (1)
Maintenance Research Prod (1) Prod (2)

Cost + 29 300 + 50 000 (1)
Maintenance - 35 000 + 7 000 + 21 000 + 7 000 (2)
20:60:20
Research 10:60:20 + 5 700 - 57 000 + 34 200 + 17 100 (2)
NIL NIL R55 200 R24 100
2. Calculation of relative sales value (Production department (1))
Rossi Bianco Sec

Sales value per unit R4,00 R6,00 R2,00
Production in units 20 000 25 000 15 000
Sales value of production R80 000 R150 000 R30 000 (2)
Less: Separate costs R20 000 R 50 000 (2)
Relative sales value R60 000 R100 000 (2)
Allocation 6 10 (1)
3. Allocation of costs and calculation of profit
3.1 Production department (1)

Rossi Bianco Sec Total
Opening stock 12 500 (1) 24 000 (1) 3 000 (1) 39 500

Plus production costs 53 638 106 062 30 500 190 200
- Joint costs 33 638 (1) 56 062 (1) 15 500 (1) 105 200
- costs of further processing 20 000 50 000 15 000 85 000
66 138 130 062 33 500 229 700

Cost of sales 58 092 100 365 32 000 190 457

Gross profit 29 908 55 635 -- (1) 85 543
Sales 88 000 156 000 32 000 276 000

(1)
Med
Opening stock 8 000

Production 39 100
- Processing costs 15 000 (1)

- From service department 24 000 (1)
47 100
Less: Closing stock 7 820 (1)
39 280
Gross profit 44 720
R84 000 (1)

b) Recommendation
Rossi Bianco Sec
Sales value of production 80 000 150 000 30 000 (1)
Less: Costs of further processing 20 000 50 000 15 000 (2)
Opportunity costs 70 000 87 500 - (1)
(10 000) 12 500 15 000 (1)

Plus: Committed fixed costs 2 000 5 000 1 500
Short-term advantage (disadvantage) (8 000) 17 500 16 500 (1)
On long-term and short-term Rossi sells at split-off point and Bianco, Sec
and Med sells after further processing.
If this is done the profit will increase by R8 000. (2)
NB: Here joint costs are irrelevant. Relevant costs are cost incurred
for further processing after a split-off point. (a)
Additional income process only if the relevant income exceeds
the costs.
1
THE BUDGETING PROCESS
 Explain how budgeting fits into the overall framework of decision making,
planning and control
 Describe six different purposes of budgets
 Describe the various stages in the budget process
 Prepare functional master budgets
 Describe Activity based budgeting
 Describe zero-based budgeting
STAGES IN THE PLANNING PROCESS
To help you understand the budgeting process we shall begin by looking at how it
fits into an overall framework of planning, decision-making and control.
STAGE 1 :
ESTABLISHING OBJECTIVES
Establishing objectives is an essential pre-requisite of the planning process. In all

organisations employees must have a good understanding of what the
organisation is trying to achieve. Strategic or long-range planning therefore begins
with the specification of the objectives towards which future operations should be
directed. The attainment of objectives should be measurable in some way and
ideally people should be motivated by them.
2
Corporate objectives related to the organisation as a whole. They are normally

measurable and are expressed in financial terms such as desired profits or sales
levels, return on capital employed, rates of growth or market share. Corporate
objectives are normally formulated by members of the board of directors and
handed down to senior managers.
Unit objectives relate to the specific objectives of individual units with the
organisation, such as a division or one company within a holding company.
Corporate objectives are normally set for the organisation as a whole and are then
translated into unit objectives, which become the targets for the individual units.
You should note that the expression aims is sometimes used as an alternative to
mission and the term goals is synonymous with objectives.
STAGE 2 : IDENTIFY POTENTIAL STRATEGIES
The next stage is to identify a range of possible courses of action (or strategies) that
might enable the company's objectives to be achieved. The corporate strategy
literature advocates that, prior to developing strategies, it is necessary to
undertake a strategic analysis to become better informed about the organisation's
present strategic situation. This involves understanding the company's present
position, its strengths and weaknesses and its opportunities and risks.
An organisation should determine the basis on which it will compete and/or sustain
a superior level of performance. The purpose is to ensure that deliberate choices
are made regarding the type of competitive advantage it wishes to attain.
Porter (1985) has identified three generic strategies that an organisation can follow:
1. cost leadership, whereby the organisation aims to be the lowest cost producer
within the industry;
2. differentiation, through which the organisation seeks some unique dimension in

its product / service that is valued by consumers, and which can command a
premium price;
3. focus, whereby the organisation determines the way in which the strategy is
focused at particular parts of the market. For example, a product or service
may be aimed at a particular buyer group, segment of the product line or small
geographical area. An organisation that adopts a focused strategy aimed at
3
narrow segments of the market to the exclusion of others also needs to

determine whether within the segment it will compete through cost leadership
or differentiation.
Porter's view is that any organisation seeking a sustainable competitive advantage

may select an appropriate generic strategy rather than attempting to be "all things
to all people".
Having identified the basis on which it will compete, an organisation should

determine the direction ns it wishes to take. The company should consider one of
more of following:
1. doing nothing;
2. withdrawing from some markets;
3. selling existing products more effectively in existing markets (market
penetration);
4. selling existing products in new markets (market development);
5. developing new products for sale in existing markets (product development);
6. developing new products for sale in new markets (diversification).
STAGE 3 :EVALUATION OF STRATEGIC OPTIONS
The alternative strategies should be examined based on the following criteria¹
1. suitability, which seeks to ascertain the extent to which the proposed strategies
fit the situation identified in the strategic analysis.
2. feasibility, which focuses on whether the strategy can be implemented in

resource terms.
3. acceptability, which is concerned with whether a particular strategy is

acceptable.
4
STAGE 4 : SELECT COURSE OF ACTION
When management has selected those strategic options that have the greatest
potential for achieving the company's objectives, long-term plans should be
created to implement the strategies. A long term plan is a statement of the
preliminary targets and activities required by an organisation to achieve its
strategic plans together with a broad estimate for each year of the resources
required.
STAGE 5 : IMPLEMENTATION OF THE LONG-TERM PLANS
Budgeting is concerned with the implementation of the long-term plan for the year
ahead. Because of the shorter planning horizon budgets are more precise and
details. Budgets are a clear indication of what is expected to be achieved during
the budget period whereas long-term plans represent the broad directions that top
management intend to follow.
The budget is not something that originates "from nothing" each year - it is
developed within the context of ongoing business and is ruled by previous
decisions that have been taken within the long-term planning process. When the
activities are initially approved for inclusion in the long-term plan, they are based
on uncertain estimates that are projected for several years.
STAGE 6 and 7 : MONITOR ACTUAL OUTCOMES RESPOND TO DIVERGENCIES FROM

PLANNED OUTCOMES
The final stages in the decision-making, planning and control process are to
compare the actual and the planned outcomes, and to respond to any
divergencies from the plan. These stages represent the control process of
budgeting.
5
THE MULTPLE FUNCTIONS OF BUDGETS
Budgets serve a number of useful purposes. This include:
1. planning annual operations;

2. coordinating the activities of the various parts of the organisation and ensuring
that the parts are in harmony with each other;
3. communicating plans to the various responsibility centre managers;
4. motivating managers to strive to achieve the organisational goals;
5. controlling activities;
6. evaluating the performance of managers.
Let us now examine each of these six factors:
PLANNING
The major planning decisions will already have been made as part of the long-term
planning process. However, the annual budgeting process leads to the refinement
of those plans, since managers must produce detailed plans for the
implementation of the long-range plan. Without the annual budgeting process,
the pressure of day-to-day operating problems may tempt managers not to plan
for future operations.
COORDINATION
The budget serves as a vehicle through which the actions of the different parts of
the organisation can be brought together and reconciled into a common plan.
Without any guidance, managers may each make their own decisions, believing
that they are working in the best interests of the organisation.
COMMUNICATION
If an organisation is to function effectively, there must be definite lines of

communication so that all the parts will be kept fully informed of the plans and the
policies, and constraints to which the organisation is expected to conform.
Everyone in the organisation should have a clear understanding of the part they
are expected to play in achieving the annual budget.
6
MOTIVATION
The budget can be a useful device for influencing managerial behaviour and
motivating manages to perform in line with the organisational objectives. A
budget provides a standard that under certain circumstances, a manager may be
motivated to strive to achieve. However, budgets can also encourage inefficiency
and conflict between managers.
CONTROL
A budget assists managers in managing and controlling the activities for which
they are responsible. By comparing the actual results with the budgeted amounts
for different categories of expenses, managers can ascertain which costs do not
conform to the original plan and thus require their attention. This process enables
management to operate a system of management by exception, which means
that a manager's attention and effort can be concentrated on significant
deviations from the expected results.
PERFORMANCE EVALUATION
A manager's performance is often evaluated by measuring his or her success in

meeting the budgets. In some companies bonuses are awarded on the basis of an
employee's ability to achieve the targets specified in the periodic budgets, or
promotion may be partly dependent upon a manager's budget record. In
addition, the manager may wish to evaluate his or her own performance. The
budget thus provides a useful means of informing managers of how well they are
performing in meeting targets that they have previously helped to set.
CONFLICTING ROLES OF BUDGETS
Because a single budget system is normally used to serve several purposes there is
a danger that they may conflict with each other. For instance the planning and
motivation roles may be in conflict with each other. Demanding budgets that may
not be achieved may be appropriate to motivate maximum performance, but
they are unsuitable for planning purposes. For these a budget should be set based
on easier targets that are expected to be met.
7
THE BUDGET PERIOD
The conventional approach is that once per year the manager of each budget
centre prepares a detailed budget for one year. The budget is divided into either
twelve monthly or thirteen four-weekly periods for control purposes.
ADMINISTRATION OF THE BUDGETING PROCESS
It is important that suitable administration procedures be introduced to ensure that

the budget process works effectively. In practice, the procedures should be tailor-
made to the requirements of the organisation, but as a general rule a firm should
ensure that procedures are established for approving the budgets and that the
appropriate staff support is available for assisting managers in preparing their
budgets.
THE BUDGET COMMITTEE
The budget committee should consist of high-level executives who represent the
major segments of the business. Its major task is to ensure that budgets are
realistically established and that they are coordinated satisfactorily. The normal
procedure is for the functional heads to present their budget to the committee for
approval. If the budget does not reflect a reasonable level of performance, it will
not be approved and the functional head will be required to adjust the budget
and re-submit it for approval. It is important that the person whose performance is
being measured should agree that the revised budget can be achieved otherwise,
if it is considered to be impossible to achieve, it will not act as a motivational
device. If budget revisions are made, the budgetees should at lease feel that they
were given a fair hearing by the committee.
ACCOUNTING STAFF
The accounting staff will normally assist managers in the preparation of their
budgets; they will, for example, circulate and advise on the instructions about
budget preparation, provide past information that may be useful for preparing the
present budget, and ensure that managers submit their budgets on time.
8
The accounting staff do not determine the content of the various budgets, but
they do provide a valuable advisory and clerical service for the line managers.
BUDGET MANUAL
A budget manual should be prepared by the accountant. It will describe the

objectives and procedures involved in the budgeting process and will provide a
useful reference source for manages responsible for budget preparation. In
addition, the manual may include a timetable specifying the order in which the
budgets should be prepared and the dates when they should be presented to the
budget committee. The manual should be circulated to all individuals who are
responsible for preparing budgets.
STAGES IN THE BUDGETING PROCESS
The important stages are as follows:
1. communicating details of budget policy and guidelines to those people

responsible for the preparation of budgets;
2. determine the factor that restricts output;
3. preparation of the sales budget;
4. initial preparation of various budgets;
5. negotiations of budgets with superiors;
6. coordination and review of budgets;
7. final acceptance of budgets;
8. ongoing review of budgets.

9
Cash budgets
The objective of the cash budget is to ensure that sufficient cash is available at all
times to meet the level of operations that are outlined in the various budgets.
Because cash budgeting is subject to uncertainty, it is necessary to provide for
more than the minimum required, to allow for some margin of error in planning.
Cash budgets can help a firm to avoid cash balances that are surplus to its
requirements by enabling management to take steps in advance to invest the
surplus cash in short-term investments. Alternatively, cash deficiencies can be
identified in advance, and steps can be taken to ensure that bank loans will be
available to meet any temporary cash deficiencies.
Final review
The budgeted profit and loss account, the Statement of Financial Position and the
cash budget will be submitted by the accountant to the budget committee,
together with a number of budgeted financial ratios such as the return on capital
employed, working capital, liquidity and gearing ratios. If these ratios prove to be
acceptable, the budgets will be approved.
COMPUTERISED BUDGETING
In the past, budgeting was a task dreaded by many management accountants.
In today's world, the budgeting process is computerised instead of being primarily

concerned with numerical manipulations, the accounting staff can now become
more involved in the real planning process. Computer-based financial models
normally consist of mathematical statements of inputs and outputs. By simply
altering the mathematical statements budgets can be quickly revised with little
effort. However, the major advantage of computerised budgeting is that
management can evaluate many different options before the budget is finally
agreed. Establishing a model enables "what-if?" analysis to be employed. For
example, answers to the following questions can be displayed in the form of a
master budget:
What if sales increase or decrease by 10%?
What if unit costs increase or decrease by 5%?
What if the credit terms for sales were reduced from 30 to 20 days?
10
ACTIVITY-BASED BUDGETING
The conventional approach to budgeting works fine for unit level activity costs
where the consumption of resources varies proportionately with the volume of the
final output of products or services. However, for those indirect costs and support
activities where there are no clearly defined input-output relationships, and the
consumption of resources does not vary with the final output of products or
services, conventional budgets merely serve as authorisation levels for certain levels
of spending for each budgeted item of expense.
Budgets that are not based on well-understood relationships between activities

and costs are poor indicators of performance and performance reporting normally
implies little more than checking whether the budget has been exceeded.
Conventional budgets therefore provide little relevant information for managing
the costs of support activities.
With conventional budgeting indirect costs and support activities are prepared on
an incremental basis. This means that existing operations and the current
budgeted allowance for existing activities are taken as the starting point for
preparing the next annual budget. The base is then adjusted for changes (such as
changes in product mix, volumes and prices) which are expected to occur during
the new budget period. This approach is called incremental budgeting, since the
budget process is concerned mainly with the increment in operations or
expenditure that will occur during the forthcoming budget period. For example,
the allowance for budgeted expenses may be based on the previous budgeted
allowance plus an increase to cover higher prices caused by inflation. The major
disadvantage of the incremental approach is that the majority of expenditure,
which is associated with the "base level" of activity, remains unchanged. Thus, the
cost of non-unit level activities become fixed and past inefficiencies and waste
inherent in the current way of doing things is perpetuated.
To manage costs more effectively organisations that have implemented activity-

based costing (ABC) have also adopted activity-based budgeting (ABB). The aim
of ABB is to authorise the supply of only those resources that are needed to perform
activities required to meet the budgeted production and sales volume. Whereas
ABC assigns resource expenses to activities and then uses activity cost drivers to
assign activity costs to cost objects (such as products, services or customers), ABB is
the reverse of this process. Cost objects are the starting point. Their budgeted
output determines the necessary activity, which are then used to estimate the
resources that are required for the budget period. ABB involves the following
stages:
11
1. estimate the production and sales volume by individual products and

customers;
2. estimate the demand for organisational activities;
3. determine the resources that are required to perform organisational activities;
4. estimate for each resource the quantity that must be supplied to meet the
demand;
5. take action to adjust the capacity of resources to match the projected supply.
12
ZERO-BASED BUDGETING
Zero-based budgeting (also know as priority-based budgeting) emerged in the late

1960's as an attempt to overcome the limitations of incremental budgets. This
approach requires that all activities are justified and prioritised before decisions are
taken relating to the amount of resources allocated to each activity. Besides
adopting a "zero-based" approach zero-base budgeting (ZBB) also focuses on
programmes or activities instead of functional departments based on line-items
which is a feature of traditional budgeting.
ZBB works from the premise that projected expenditure for existing programmes
should start from base zero, with each year's budgets being compiled as if the
programmes were being launched for the first time. The budgetees should present
their requirements for appropriations in such a fashion that all funds can be
allocated on the basis of cost-benefit or some similar kind of evaluative analysis.
The cost-benefit approach is an attempt to ensure "value for money"; it questions
long-standing assumptions and serves as a tool for systematically examining and
perhaps abandoning any unproductive projects.
ZBB involves the following three stages:
 a description of each organisational activity in a decision package;

 the evaluation and ranking of decision packages in order of priority;
 allocation of resources based on order of priority up to the spending cut-off
level.
13
QUESTION 1 20 marks
Lalakahle (Pty) Limited is a manufacturing business that produces hand made

quality beds and mattresses. The company is setting its budget for 2013/2014 for
the orthopaedic range of beds and mattresses that it sells. There are two top of
the range beds in this line, the ‘Down bed’ and the ‘Dreamcast’. You are the
accountant at Lalakahle (Pty) Limited and your task is to prepare the budgets for
the coming year. You have been given the following information:
As a result of using specialised forecasting computer software it has been

forecast that the number of units to be sold is likely to be as follows, for both the
2013/2014 and 2014/2015 financial years:
Number of beds sold Sales price per bed
Down bed 1 056 R850

Dreamcast 1 176 R755
At the end of 2012/2013 there were 75 Down beds and 64 Dreamcast beds were
still in inventory. It is company policy to maintain enough inventory of beds at the
end of each month to meet demand for 55% of the next month’s forecast sales.
The sales and production of both products tend to be evenly distributed
throughout the year.
Both beds are made from the same raw materials. These are wood, plastic and
treated nylon. These are required in the following quantities per bed in terms of
output (finished product):
Down bed Dreamcast
Wood 15kg 21kg

Plastic 6kg 3,5kg
Treated nylon 17 square metres 19 square metres
Some wastage occurs during the manufacturing process. This is 1,5% of wood
and plastic and 3% of nylon. This material wastage has no further use.
14
At the end of 2012/2013 most of the remaining raw material inventory was sold to
another company because the warehouse was undergoing essential
maintenance. The budget should allow for inventory levels to be built up to
normal levels of 25% of the next month’s usage. The raw materials that remained
at the end of 2012/2013 were:
Wood 196kg
Plastic 72kg
Treated nylon 62 square metres
Current prices are as follows:
R
Wood 4,60 per kg
Plastic 5,50 per kg
Treated nylon 21,00 per square metre
It is expected that these prices will rise in August 2013 by 2%
The labour requirements for each bed are as follows:
Down bed Dreamcast
Skilled 5hrs 6hrs

Unskilled 4hrs 4,5hrs
Skilled labour costs R14,00 per hour and unskilled labour costs R6,50 per hour
The financial year runs from June to May

15
REQUIRED
(a) In your role as accountant produce the following budgets for the
year 2013/2014:
(i) Sales budget in units and in rand value. (2)
(ii) Production budget in units. (3)
(iii) Materials usage budget in units. (3)
(iv) Materials purchases budget in units and in value. (Only show
total requirement for period June – July and August – May. Do not (4)
show individual monthly requirements)
(v) Labour budget in hours and in value. (4)
(b) Describe how the approach used to construct these budgets differs
from the methods used in the public service. (4)
(Dipac2-6 : October 2008 Exam)

16
(a) In your role as accountant produce the following budgets for the year
2013/2014:
(i) Sales budget in units and in rand value. [2]

Units Selling price Sales value
Down bed 1 056 R850 R 897 600 [1]

Dreamcast 1 176 R755 R 887 880 [1]
R 1 785 480
(ii) Production budget in units. [3]
Down bed Dreamcast

Sales 1 056 1 176 [1]
Less opening stock (75) (64) [1]
Add closing stock 49* 54** [1]
Production 1,030 1,166
(1 056/12 = 88 x 55%)*
(1 176/12 = 98 x 55%)**
(iii) Materials usage budget in units. [4]
Wood Plastic Nylon

Kg Kg M
Down bed (15kg x 1 030) (6kg x 1 030) (17m x 1 030)
15 450 6 180 17 510
Dreamcast (21kg x 1 166) (3.5kg x 1 166) (19m x 1 166)
24 486 4 081 22 154
Total 39 936 10 261 39 664
Wastage 609 157 1 227 [1]
Requirement 40 545 10 418 40 891 [3]
17
(iv) Materials purchases budget in units and in value. [4]
Wood Plastic Nylon

Kg Kg m
Requirement 40 545 10 418 40 891
Less opening stock (196) (72) (62) [1]
Add closing stock
(40 545/12) x 25% 845
(10 418/12) x 25% 218 [1]
(40,891/12) x 25% 852
Purchase requirement 41 194 10 564 41 681 [1]
Price per unit (R)
June – July 4,60 5,50 21,00
[1]
August – May (x 1.02) 4,692 5,61 21,42
Purchase cost (R)

June – July 31 582 9 684 145 883
[1]
August – May 161 069 49 387 744 006
(Assumes even monthly purchase)
Maximum 4
(v) Labour budget in hours and in value. [4]
Skilled Semi-skilled
Down bed Dreamcast Down bed Dreamcast
Production units 1 030 1 166 1 030 1 166
Time per unit 5hrs 6hrs 4hrs 4,5hrs [1]
Total hours 5 150 6 996 4 120 5 247 [1]
Rate per hour R14 R14 R6,50 R6,50 [1]
Labour cost 72 100 97 944 26 780 34 106 [1]
Total direct labour cost R230 930
(b) Describe how the approach used to construct these budgets differs from the [4]
methods used in the public service
 In the public service incremental budgets are based on the previous budget. This
is then adjusted for expected changes in the next budget period. In (a) above
the whole budget is driven by the limiting factor, which in this case is the sales [2]
volume
 In the public service rolling budgets are continuously being updated in relation to
new information. The above budget will not be adjusted according to
circumstances but monitored using variance analysis. [2]
18
REQUIRED:
(a) Calculate the variable production costs per unit, and the fixed production [4]
costs per month, over the three month period.
Month 1 Month 2 Month 3
Production 12 000 10 500 10 000
Unit Cost 23,75 25,00 25,50
Total Cost R285 000 R262 500 R255 000
LOW HIGH DIFFERENCE
Volume 10 000 12 000 2 000 [1]
Total Cost R255 000 R285 000 R30 000 [1]
Unit Variable cost R30 000/2000 R15 [1]
Total Variable costs (Based on low 10000 x R15 = R150 000
volume)
Total Fixed costs (Based on low R255 000 - R150 000 = R105 000 [1]
volume)
(b) Estimate the total cost that would be incurred in Month 4 if 12 500 units are [2]
manufactured.
Month 4
Production (Units) 12 500
Variable Cost (R15 X 12500) R187 500 [0.5]
Fixed Cost R105 000 [0.5]
Selling + Admin R87 000 [0.5]
Total Cost R379 500 [0.5]
(c) Prepare a profit statement for Month 2 using the absorption costing method. [7]
Assume that the fixed production overhead absorption rate is based upon
normal production of 12 000 units per month.
UNITS R
Production 12 000
Fixed overhead 105 000
Recovery rate 105 000/12 000 R8,75 per unit [1]
Absorption Costing Statement for Month 2:

R000
Sales: (10 000 units at R34 per unit) 340 [1]
Production cost of sales: (10 000 units at R23,75 per unit) (237,5) [1]
Gross profit (before adjustment) 102,50
19
Under absorbed production overhead: (1 500 units at R8,75 per (13,125) [1]
unit)
Gross profit (after adjustment) 89,375 [1]
Selling and administration overheads (87) [1]
Net profit 2,375 [1]
(d) Prepare a profit statement for Month 3 using the marginal costing method. [5]
Marginal Costing Statement for Month 3:

R000
Sales: (11 000 units at R34 per unit) 374
Variable cost of sales: (11 000 units at R15 per unit) (165) [1]
Contribution 209 [1]
Fixed overheads Production (105) [1]
Fixed overheads Selling and administration (87) [1]
Selling and administration 17 [1]
(e) Explain, with supporting figures, the profit difference in Month 2 if the [2]
marginal costing method had been used instead of absorption costing.
 Profit difference = 500 units at R8,75 per unit = R4 375. [2]

 Production is in excess of sales by 500 units and therefore additional fixed [2]
production overhead is going into stock under absorption costing, resulting
in lower profit if the marginal costing method is applied.
20
QUESTION 2
You are the accountant of the Mountain Creek Estate (Pty) Limited, an upmarket
mountain resort.
A project to upgrade the resort has commenced this year, the funding of which is
placing a great deal of pressure on the available funds. An overdraft facility of R60
000 has been arranged, but you are unsure if this will be sufficient. If this facility is
insufficient, a long-term loan will have to be raised.
You have extracted the following information, relating to the 2010 financial year
from the records:
1. Actual Budget
March 2010 April 2010 May 2010 June 2010
R R R R
Kitchen supplies
- Kitchen supplies used 39 600 42 800 56 800 48 500
- Opening stock 4 000 4 400 5 600 4 800
Sales
- Accommodation 130 000 150 000 180 000 120 000
- Bar 17 500 22 500 27 000 19 500
2. The mark-up, based on the cost price of the bar purchases, is

200%. Bar stock figures are negligible and must be ignored.
3. Purchases are payable as follows:
Bar – 1 month from date of purchase, no discount allowed.
Kitchen supplies – 2 months from date of purchase, at a discount

of 5%.
4. Income from accommodation is normally received or written off as

follows:
- 90% received during the applicable month
- 5% received during the ensuing month
- 5% written off in the month of sale due to guests leaving
without settling their Accounts.
21
5. Bar sales are for cash only.
6. Monthly general cash expenses amount to R68 000. An amount of

R3 000 was in arrears at 30 April 2010.
7. Depreciation on the furniture and equipment amounts to R9 600

per month. Vehicles are depreciated at 20% per annum on the
reducing balance method.
8. Interest on a loan of R280 000 is payable at 17% per annum, six

monthly in arrears on 31 December and 30 June of every year.
Capital repayments only commence in 2011.
9. The company has been assessed for company taxation for the
financial year which ended on 29 February 2009. The amount due
is R40 800 and it is payable on 31 May 2010.
10. The following is an extract from the capital budget for the year:
10.1 A second-hand courtesy bus, which will be used for

sightseeing trips and to transport guests from the airfield to
the hotel, has been purchased. It costs R80 000, and will
be delivered on 31 May 2010. The purchase will be financed
by an instalment sale agreement. A deposit of 20% will be
payable on the date of delivery. Monthly payments, which
have to be made on the last day of every successive month,
will amount to R2 200.
10,2 Cost of refurbishing 10 guest suites will amount to R25 000 per
suite, and will be payable upon completion of a suite. Two
suites were completed in April; one is expected to be
completed in May and two in June 2010. The cost of
refurbishing the suites will be capitalised as improvements to
the land and building.
10.3 The tennis court will be reconstructed at a cost of R40 000. A

10% deposit is payable on 25 April 2010, the date of
commencement. The outstanding balance will be payable in
monthly instalments at the end of every month, based on the
percentage of completion.
22
11. The existing courtesy bus will be sold on 31 May 2010 at a loss of R1
500. On 1 March 2010, the book value of this bus was R20 000.
12. The expected progress on the reconstruction of the tennis court is

as follows:
Month end Stage of completion

April 2010 10%
May 2010 90%
June 2010 100%
13. The favourable balance on the bank account at 30 April 2010

amounts to R20 000.
REQUIRED:
Prepare a cash budget for May and June 2010. (20)

23
MOUNTAIN CREEK ESTATE (PTY) LIMITED
Cash budget for May and June 2010
May June Calculations

with marks in
brackets
R R
Bank balance – beginning of month 20 000 6 900 - (1)
Receipts 214 000 136 500
Bar sales 27 000 19 500 - (1)

Accommodation receipts 169 500 117 000 1 (2)
Proceeds from sale of vehicle 17 500 - 2 (2)
234 000 143 400

Payments 227 100 198 400
Kitchen supplies creditors 38 000 41 800 3 (4)

Bar purchases creditors 7 500 9 000 4 (2)
General expenses 71 000 68 000 5 (1)
Interest paid - 23 800 6 (1)
Taxation assessment 40 800 - - (½)
Instalment sale creditor
- Deposit paid 16 000 - 7 (½)
- Monthly payment - 2 200 - (½)
Refurbishing of guest suites 25 000 50 000 8 (½)
Progress payments on tennis court 28 800 3 600 9 (2)
Bank balance/(bank overdraft) – end 6 900 (55 (1)

of month 000)
The overdraft facility of R60 000 will therefore be sufficient. (1)
Calculations
1. Accommodation
Total May June

R R R
April 2010 150 000 7 500 ( 5%) -

May 2010 180 000 162 000 (90%) 9 000 ( 5%)
June 2010 120 000 - 108 000 (90%)
Accommodation receipts 169 500 117 000
24
2. Proceeds from sale of vehicle

R
Book value 01.03.2010 20 000
Depreciation ( 20 x 3 x R20 000)

(100 12 ) 1 000
Book value 31.05.2010 19 000

Loss on sale 1 500
Proceeds from sale of vehicle 17 500
3. Payments to creditors for kitchen supplies
Purchases
March April
R R
Expected usage 39 600 42 800
Add: Closing stock 4 400 5 600
44 000 48 400
Less: Opening stock 4 000 4 400
Expected purchases 40 000 44 000

Less: 5% discount 2 000 2 200
Net payment to creditors 38 000 41 800
Payable within 60 days, therefore in May and June 2010 respectively.
4. Payments to creditors for bar purchases

R
Cost 100
Mark-up 200
300
Cost = selling price x 33,3%
Purchases
April May
R R
Sales (100%) 22 500 27 000
Cost of bar purchases (33,3%) 7 500 9 000
Payable with 30 days, therefore in May and June 2010 respectively.

25
5. General Expenses
May June
R R
Monthly payments 68 000 68 000
Add: In arrears 01.05.10 3 000 -___
71 000 68 000
6. Interest paid
R
Loan 280 000
Interest (17% x R280 000 x 6/12) 23 800
7. Instalment sale creditor

R
Total liability 80 000
 Deposit (20% x R80 000) 16 000
8. Refurbishing of guest suites
May June
Number of suites completed 1 2
R R
Cost per suite 25 000 25 000
Total payment due 25 000 50 000
9. Progress payments on tennis courts

R
Less: Deposit (10% x R40 000) 4 000
Balance 36 000
Payable as follows:
April 2010 (10/100 x R36 000) 3 600
May 2010 (80/100 x R36 000) 28 800
June 2010 (10/100) x R36 000) 3 600
36 000
26
Kengary Supplies (Pty) Limited has recently incorporated. The issued share capital
of the company amounts to R75 000, consisting of 75 000 ordinary shares of R1
each. The shares have been issued for cash.
The company has managed to obtain a R50 000 loan from a banking institution.
Plant and machinery, costing R60 000, has been given as security for the loan. The
loan is repayable, annually in arrear, in five equal instalments of R16 000. The
effective rate of interest applicable to the loan amounts to 18% per annum.
The company has also managed to obtain an overdraft facility of R50 000 on its
current account.
Operations are intended to commence on 1 June 2010. The production target for
the first year has been set at 140 000 units.
The selling price has been fixed at R20 per unit. The budgeted ratios of costs in
relation to the selling price are as follows:
Raw material : 35%

Labour : 25%
Production overhead : 10%
Selling and administrative expenses : 5%
Production overhead includes depreciation on plant and machinery at a rate of

10% per annum.
Interest on the loan has not been included in administrative expenses.
The stock policy of the company is as follows:
1. Due to problems with the availability of raw material, stock should be sufficient
to make provision for the production requirement of the following three months.
2. There should be no work-in-process at the end of a financial year.
3. From the beginning of the year, finished goods stock should be sufficient to
make provision for the budgeted sales of the following two months.
27
4. Finished goods stock is valued at standard absorption cost.
5. Raw material stock is valued at actual cost, as determined on the first-in-first-out

method.
According to expectations, sales will take place evenly throughout the year.
The company is allowed 45 days for its raw material supplies. All other expenses
have to be paid for in cash.
All sales will be on credit. Debtors are granted a period of 30 days after delivery of
the goods to pay their accounts. Five percent of all debtors should be provided for
as being irrecoverable.
REQUIRED:
a) Prepare a cash budget for the company for the first year of business. (10)
b) Prepare a projected Statement of Financial Position at 31 May 2011, as well as

projected Statement of Comprehensive Income for the year ending at that
date. (17)
Ignore all forms of taxation.

28
KENGARY SUPPLIES (PTY) LIMITED
a) Cash budget
Production budget
(Representing the budgeted sales for 14 months)
Given as 140 000 units
Consisting of:
- units required for sales (12 months) 120 000 1
- units required for closing stock 20 000 2
(2 months’ budgeted sales) _______
140 000
Calculations
1 140 000 x 12
14 = 120 000
2 140 000 x 2
14 = 20 000
Raw material purchases budget
Required for
R
- closing stock (140 000 / 12 x 3 x R20 x 35%) 245 000
- production (140 000 x R20 x 35%) 980 000
- purchases 1 225 000
Cash budget for the year ended 31 May 2010 R

Cash receipts 2 215 000
Shares 75 000
Loan 50 000
Debtors (10 000 x 11 x R20 x 95%) 2 090 000
Cash payments 2 241 875

Plant and machinery 60 000
Loan 16 000
Raw material (1 225 000 x 10.5 / 12) 1 071 875
Labour (140 000 x R20 x 25%) 700 000
Overhead [(140 000 x R20 x 10%) – (10% x R60 000)] 274 000
Selling and administrative costs (5% x 120 000 x R20) 120 000
Budgeted bank overdraft at 31 May 2010 26 875

(10)
29
Projected statement of financial position and statement of comprehensive income

Projected statement of financial position at 31 May 2010
Calculation R
Capital employed
Share capital 75 000
75 000 ordinary shares of R1 each
Distributable reserves 471 000
Retained income _______
Shareholders’ interest 546 000
Long term loan 1 34 740
580 740
Employment of capital Calculation R

Fixed assets 2 54 000
Plant and machinery
Net current assets 526 740
Current assets 715 000
Stock 3 525 000
Debtors 4 190 000
Less: Current liabilities 188 260
Bank overdraft 26 875
Creditors 5 153 125
Loan 6 8 260
580 740
(9)
Calculations
1 Loan = R[(50 000 – 16 000) + (18% x 50 000)]

= R43 000
Long term
Portion = R43 000 – short term portion
= R[(43 000 – 16 000) + (18% x 43 000)]
= R34 740
R
2 Plant and machinery 54 000
- At cost 60 000
- Less: Accumulated depreciation (10% x R60 000) 6 000
3 Stock (values per Statement of Comprehensive Income) 525 000

- Finished goods 280 000
- Raw materials 245 000
30
4 Debtors 190 000

- Gross debtors 310 000
[(10 000 x R20 x 95% + (120 000 x R20 x 5%)]
- Less: provision for bad debts (120 000 x R20 x 5%) 120 000
5 Creditors
Creditors = Total raw material purchase – cash payments
= R1 225 000 – R1 071 875 (per cash budget)
= R153 125
6 Loan
Short term portion = R43 000 – R34 740
= R 8 260
Projected statement of comprehensive income for the year ended 31 May 2010
R
Sales: (120 000 x R20) 2 400 000
Less: Cost of sales 1 680 000
Production cost 1 1 960 000
Less: Closing stock finished goods
[20 000 x (35 + 25 + 10)% x R20] 280 000
Gross profit 720 000

Less: Operating expenses 249 000
Selling and administrative expenses
(5% x 120 000 x R20) 120 000
Interest (50 000 x 18%) 9 000
Bad debts (120 000 X R20 X 5%) 120 000
Net income 471 000
Calculation:
R
1 Production cost
Raw material 980 000
Purchases 1 225 000
Less: Closing stock (per raw material purchases budget) 245 000
Labour (25% x 140 000 x R20) 700 000
Overhead (10% x 140 000 x R20) 280 000
Production cost 1 960 000
(8)
31
QUESTION 4 (20 marks 24 minutes)
African Mining Supplies (Pty) Ltd is a supplier of mining equipment to various mines
in the North-West Province.
The following information has been obtained for purposes of compiling the cash
budget for November 2010 :
1. Projected balances of selected accounts at 31 October 2010
R
Bank (positive) 50 000
Savings account 355 000
Instalment sale creditor – Delivery-van 124 962
Prepaid fixed selling and administrative 27 000
expenses
2. Sales
2.1 The actual and projected sales amount to
R
October 2010 1 500 000
November 2010 2 000 000
2.2 Eighty percent (80%) of sales are on credit. Debtors tend to settle their
accounts as follows:
- 20% within the month of sale

- 79% within the month following the month of sale
- 1% is irrecoverable
2.3 Debtors settling their accounts within the month of sale receive a 2,5%
discount.
32
3. Purchases
3.1 The actual and projected purchases amount to
R
October 2010 950 000
November 2010 800 000
3.2 Purchases are paid for in the month following the month of purchase.
4. Stock
The company does not carry stock of any kind.
5. Expenses per month
Selling and administrative, excluding salaries and wages
-Fixed (including an amount of R50 000 in respect of depreciation) R260 000

-Variable 8% of turnover
Salaries and wages R460 000
The projected balance on the prepaid fixed selling and administrative

expenses account at 30 November 2010 amounts to R32 000. An amount of
R19 000 in respect of currently prepaid fixed selling and administrative
expenses will expire during November 2010.
No amounts are planned to be in arrear at any stage.
6. Value added tax (VAT)
The VAT liability for October, which is payable on or before 25 November

2010, amounts to R13 882.
33
7. Fixed assets
7.1 During August 2010, a delivery-van with a cost price of R60 000 and a
book value of R50 000 was hijacked. Confirmation has been received
from the insurers that the insurance claim amounting to R45 000 will be
paid out on the 20 November 2010 by means of a direct transfer into
the company’s current account.
7.2 A new delivery-van has been purchased for R90 000 at the beginning
of October 2010. The purchase was financed by means of a
instalment sale agreement. At an effective interest rate of 14,5% per
annum, the amount is repayable in 60 equal payments of R2 118,
payable monthly in arrear, commencing on 31 October 2010.
8. Dividends
The directors of the company indicated that dividends to the amount of

R50 000 will be declared on 30 November 2010.
REQUIRED:
a) Determine the amount which should be transferred between the current

account and the savings account in order to maintain a positive balance of
R50 000 on the current account at 30 November 2010. (17)
b) State two advantages normally associated with the compilation of budgets.

(3)
[20]
34
AFRICA MINING SUPPLIES (PTY) LIMITED
a) Amount to be transferred
R
Projected cash inflows 1 705 000
Cash sales (1) 400 000

Receipts from debtors (2) 1 260 000
Insurance claim received 45 000
Less: Projected cash outflows 1 820 000
Payments to creditors 950 000

Salaries and wages 460 000
Fixed cost (R260 000 – R50 000) 210 000
Variable cost (2 000 000 x 8%) 160 000
Value-added tax 13 882
Instalment sale agreement 2 118
Dividends --
Prepaid fixed selling and administrative expenses (3) 24 000
Transfer from savings account 115 000
As a positive balance in the current account must be maintained, the difference

between projected cash inflows and projected cash outflows would equal the
transfer between the current and savings account.
Calculations:
(1) R2 000 000 x 20% = R400 000
(2) R
Oct: 1 500 000 x 79% x 80% 948 000
Nov: 2 000 000 x 80% x 20% x 97,5% 312 000
1 260 000
(3)
Prepaid fixed selling and administrative expenses
2010 R 2010 R
01 Nov Balance 27 000 30 Nov Expenses 19 000
30 Nov Bank 24 000 30 Nov Balance 32 000
51 000 51 000
01 Dec Balance 32 000
(17)
35
b) Advantages of budgets
- Guides personnel to knowing what is expected of them and how their efforts will
be evaluated.
- Isolates problem areas and enables corrective action to be taken before they
occur.
- Increases an awareness of the importance of cost considerations in the

operations of a company.
Any other advantages, limited to two. ( 3)

36
The Betabuild housing company has two types of housing estates in the Blackberry
Area. (Type A and Type B). The following information is available:
1. The company has its own team of painters who carry out the painting and
decorating work on the housing estates. The estimated cost for each house
in which the work will be done in 2010 is as follows:
a) Direct material cost R200
b) Direct labour cost R270
c) During 2010 total overheads are estimated and absorbed in the

following manner:
20% of direct material cost and 100% of direct labour cost.
30% of the material and 33⅓% of the labour related overheads, as a

part of the total overheads, are variable. The remainder is fixed
overhead and its allocation is determined by using the budgeted
number of houses which require annual painting and decorating.
d) Fixed overhead is to be divided into:
i) Items avoidable on cessation of the service 30%

ii) Depreciation of equipment and premises 20%
iii) Head office: administrative costs 50%
2. The total number of houses of each type and the percentage requiring
painting and decorating each year is as follows:
Type
A B
Total number of houses 500 600
Percentage of houses requiring
maintenance each year 30% 20%
37
3. Adjustments in wage rates and increases in prices will result in the following
annual fixed percentage increases in the painting and decorating costs from
the beginning of 2011:
%
Direct materials 5
Direct labour 7
Total overheads 6
4. On 31 December 2009, the following balances are expected to be disclosed

in the accounting records:
R
Creditors for materials 2 100
Materials on hand Nil
Labour cost accrued 2 800
Creditors – variable overheads 600
- The credit purchases outstanding at a year end are estimated at 10% of the
annual materials purchased on credit.
- Credit purchases are 90% of purchases, the remainder being cash

purchases.
- Labour costs accrued at the end of a financial year are estimated as 4% of

the annual labour cost for the specific year.
- Variable overheads are paid for as follows: 60% during the month of accrual
and 40% in the following month.
Variable overheads are deemed to occur on an even monthly basis

- Fixed overheads are paid in twelve equal amounts during the year on a
regular monthly basis.
38
REQUIRED:
Compile a cash budget for the existing painting and decorating function for
both the financial years 2010 and 2011. (Exclude fixed overhead for 2011.)
(Work to the nearest Rand.) (27)
(Oct 2006 Exam)
39
QUESTION 5 - SOLUTION
BETABUILD
(a) Costs incurred for painting and decorating:
2010 2011
 54 000 56 700
Direct material
 72 900 78 003
Direct labour
Variable overheads③ 27 540 29 192

Fixed overheads:
Avoidable 16 848
Depreciation 11 232
Head office – administrative costs 28 080

Direct material:
Number of houses each = (500 x 30%) + (600 x 20%)
year: = 270 houses
Direct material for 270 houses = R200 x 270 for 2010 = R54 000
for 2011 = R54 000 x 105%
= R56 700
Direct labour:
For 2010: = R270 x 270 houses = R72 900
For 2011: = R72 900 x 107% = R78 003
③ Variable overheads:
Total overheads per house = Material related + Labour related
= (R200 x 20%) + (R270 x 100%)
= R40 + R270
= R310
Of which (30% x R40) + (⅓ x 270) = variable
= R12 + R90
= R102 variable overhead per house
Variable overhead for 2010: = R102 x 270 = R27 540

for 2011: = R27 540 x 106% = R29 192

Fixed overheads:
Total overheads per house – variable overheads per house = fixed overheads
R310 - R102 = R208 per house
Therefore:
Total for 2010 = R208 x 270 = R56 160
40
Consisting of: Only for 2010

Avoidable fixed overheads (30% x R56 160) = R16 848
Depreciation (20% x R56 160 = R11 232
Head office (50% x R56 160) = R28 080
Cash Budget for the painting and decorating function
2010 2011
R R
Direct materials payments to creditors:
Previous year creditors (2009:given) 2 100
(2010:90% x R54 000 x 10%)
43 740 4 860
Current year [90% x (90% x R54 000)(a)]
[90% x (90% x R56 700)(a)] 5 400 45 927
Cash purchases (2010:10% x R54 000(a))
5 670
(2011:10% x R56 700(a))
Direct labour payments:

2 800
Previous year accruals (2009: given)
(2010: 4% x R72 900)
69 984 2 916
Current year (2010: 96% x R72 900(a))
(2011: 96% x R78 003(a)) 74 883
Variable overhead:
Previous year (2009: given) 600
(2010: 40% x R27 540/12)
918
Current year 2010: 26 622(i)
2011:
28 223(i)
Fixed overhead:
Avoidable
Head office – administration costs 16 848
(No depreciation – not cash flow) 28 080 Excluded
- Excluded
-
196 174 163 397
(i) Variable overhead cash (13)
expense
2010 = R27 540/12

= R2 295 per month
Then: R2 295 x 11 months
= R25 245 + (60% x R2 295)
= R25 245 +R1 377
= R26 622
2011 = R29 192/12
= R2 433 per month

= R26 763 + (60% x R2 433)
= R26 763 + 1 460
= R28 223 (27)
42
Clusters Limited has finalised its statements for the financial year that ended on 31
December 2009. A reasonable growth in volumes has not dispelled concerns over the
immediate sales and production outlook and this has resulted in the following
assumptions as regards its trading activities and budgets for the financial year which will
end on 31 December 2010.
Sales
There will be no cash sales and it is estimated that the current turnover of the
completed goods stock, which is six times per annum, based on the average
stockholding for the year, will be maintained.
The gross profit as a percentage of sales is 331/3 %.
Completed goods
Stock on hand -1/1/2010 30 000 units
The closing stock at the end of the financial year will show a 50% increase over the
opening stock and will be valued by using the absorption cost basis.
Production cost per unit of completed goods :
R
Materials 8,00
Labour – direct 6,00
Total production overheads 6,00
20,00
The total production overheads allocated and paid for completed goods is based on
the estimated normal production volume for 2010. An amount of R200 000 for the
annual depreciation of machinery and fixed assets is included in this payment. The
machinery and fixed assets which were installed on 1 January 2009 at cost, have an
expected useful life of five years and depreciation is written off at 20% per annum on
cost based on the straight line method.
Materials
Stock on hand -1/1/2010 R150 000
The stock of materials is expected to remain at this level throughout the financial year.
43
Debtors
Balance -1/1/2010 R450 000
The sales are expected to occur on an even daily basis throughout the financial year
which normally consists of 360 days per annum. The normal debtors collection period is
30 days after the date of sale.
Creditors
Balance -1/1/2010 R160 000
The creditors are expected to remain at this level throughout the financial year.
Additional information :
- Variable selling and administrative expenses amount to 5% of sales.
- Fixed selling and administrative expenses are expected to amount to

R810 000.
- On 1/1/2010, the bank balance reflected an overdraft of R180 000, whilst the
projected favourable balance on 31/12/2010 is R710 000.
REQUIRED :
(a) Set out a concise production budget in units for 2010. (5)
(b) Draft a budgeted statement of comprehensive income for the year ending
31 December 2010. (11)
(a) Draft a concise statement of financial position as at 31 December 2010.

(12)
(May 2004 Exam)

44
Stock t/o = 6
Stock t/o = COS ÷ Average stock
Average stock = (Closing stock + opening stock) ÷ 2
R
Closing stock of FG = 30,000 units x R20 x 1.5 = 900,000 told that CS will be 50% ↑ than OS
R
Opening stock of FG = 30,000 units x R20 = 600,000
Average stock = (900,000 + 600,000) ÷ 2 =
COS = Stock t/o x Av. Stock

= 6 x R750,000 = R 4,500,000
bear in mind the following relation: O/S + Purchases (or production) - C/S = COS
Production budget (units) Production budget (Rands)

R
Sales 225,000 COS 4,500,000
Add: Closing
Add: Closing stock 45,000 stock R 900,000
Less: Opening
Less: Opening stock -30,000 stock -R 600,000
R
Production 240,000 Production 4,800,000
Budgeted Statement of comprehensive income for the

year ended 31/12/10
Sales 100%
Sales (4,500,000 x 3 ÷ 2) R 6,750,000 COS 66.67%
Less: Cost of sales R 4,500,000 GP 33.33%
Gross Profit R 2,250,000
Less: Selling and Admin costs
Variable S&A (5% x 6750,000) -R 337,500
Fixed S&A -R 810,000
Net Profit R 1,102,500
45
Statement of financial
position as at 31/12/10
Calcs R R
ASSETS
Non-current
Assets
-
Machinery 1 600,000
600,000
Current
Assets
- Inventory 2 1,050,000
- Debtors 3 562,500
- Bank 710,000
2,322,500
TOTAL ASSETS 2,922,500

Equity 4 R 2,762,500
Creditors 160,000
TOTAL EQUITY AND LIABILITIES 2,922,500
Calculations:
1 machinery has expected useful life of 5 years, depreciation p.a. is R200,000, therefore cost
of machinery =R1,000,000. 2 years have passed, therefore 3 years are left, so current value
of machinery = R200,000 x 3 = R600,000
2 Closing stock of FG = R900,000 and closing stock of materials = R150,000; therefore total
closing stock is = R900,000 + R150,000 = R1,050,000.
3 Debtors collection period is 30 days (1 month) after sale - there is thus one month's sales in
debtors at any point in time; = R6,750,000 ÷ 12 = R562,500.
4 Opening balance equity (01/01/10) = A-L
Fixed asset = 800,000
stock FG = 600,000
stock Materials = 150,000
Debtors = 450,000
Creditors = -160,000
Bank = -180,000
1,660,000
Add current net profit = R 1,102,500
Total Equity = R 2,762,500
46
The University of Africa requires all second year engineering students to have their own
laptop computers in order to do practical work and tasks. During the last quarter of
2009, a close corporation, Laptops for Students CC was established to supply laptops
according to the specifications set by the university, at affordable prices. At that time,
a loan of R800 000 was granted to the close corporation and the funds were deposited
into the bank account.
The following additional information is available for Laptops for Students CC :
1. According to estimates, 200 of the 400 second year engineering students will buy
their laptops from Laptops for Students CC. There are two types of laptops which
will be supplied, namely Exceptional at a selling price of
R10 000 and Superior at a selling price of R8 000. Since the Exceptional laptop
has a more powerful hard drive, it is expected that 60% of the 200 students will
prefer to buy this laptop and the other 40% the Superior.
2. The following quarterly sales forecast for 2010 has been made :
Quarter % of the 200 students who will buy their laptops in the
1 quarter
65%
2 20%
3 15%
4 -
It is expected that the sales for 2011 will follow the same pattern as that of 2010.
3. All sales will be on credit with a 45 day average debtors collection period from
the invoice date. Sales will take place evenly throughout each quarter. Assume
a month has 30 days.
4. During any quarter, purchases from suppliers are equal to 80% of the next
quarter’s estimated sale value. Suppliers are paid within 90 days after the end of
the quarter of purchase.
5. At the beginning of the first quarter, a delivery vehicle was bought on credit. The
instalment is R11 000 per quarter. Depreciation on the delivery vehicle amounts
to R8 000 per quarter.
6. Commission of 5% of the sales per quarter will be paid out in the relevant quarter.
47
7. Interest on the R800 000 loan, which was granted in 2009, amounts to 16% per
annum and is payable in equal amounts every quarter.
8. In November 2010, new posters and price lists for 2011 will be ordered from K-
Printers. A deposit of R5 000 will be paid, while the balance of R6 000 will be paid
on delivery in the first quarter of 2011.
REQUIRED :
(a) Compile the sales budget for Laptops for Students CC for each of the four
quarters of 2010. (6)
(b) Compile the cash budget for Laptops for Students CC for each of the four
(c) State whether the close corporation will be in a position to repay the R800 000
loan at the end of the fourth quarter of 2010 without their bank account going
into overdraft and motivate your answer. (1)
(Oct 2004 Exam)

48
(a) Sales budget for the four quarters of 2010
Exceptional Superior Total sales

value
R
Sales- Quarter 1 (units) 65% x 120 ① = 78 65% x 80 ① = 52
Selling price per unit R10 000 R8 000
Sales value R780 000 R416 000 1 196 000
Sales- Quarter 2 (units) 20% x 120 =24 20% x 80 = 16

Sales value R240 000 R128 000 368 000
Sales- Quarter 3 (units) 15% x 120 = I8 15% x 80 = 12

Sales value R180 000 R96 000 276 000
1 840 000
(6)
OR
Sales value Quarter 1 Quarter 2 Quarter 3
R R R
Exceptional (65% x 120 ① x R10 000) 780 000 - -
Superior (65% x 80 ① x R8 000) 416 000 - -
Exceptional (20% x 120 ① x R10 000) - 240 000 -
Superior (20% x 80 ① x R8 000) - 128 000 -
Exceptional (15% x 120 ① x R10 000) - - 180 000
Superior (15% x 80 ① x R8 000) - - 96 000
1 196 000 368 000 276 000
Calculations:
① Number of units sold
Expected Exceptional sales: 60% x 200 students = 120 units

Expected Superior sales: 40% x 200 students = 80 units
49
(b) Cash budget for the four quarters of 2010
Quarter 1 Quarter 2 Quarter 3 Quarter 4

R R R R
Bank balance - opening 800 000 338 400 764 600 809 000
Add: Budgeted receipts
Receipts from debtors ② 598 000 782 000 322 000 138 000
1 398 000 1 120 400 1 086 600 947 000
Less: Budgeted payments 1 059 600 355 800 277 600 48 000
Payments to creditors ③ 956 800 294 400 220 800 -
Instalment on delivery vehicle 11 000 11 000 11 000 11 000
Commission ④ 59 800 18 400 13 800 -
Interest on loan (16% x 800 000 ÷ 4) 32 000 32 000 32 000 32 000
K-Printers deposit - - - 5 000
Bank balance - closing 338 400 764 600 809 000 899 000
(19)
(c) Yes, since there will still be a favourable bank balance of R99 000 after the capital of
R800 000 has been repaid. (1)
Calculations:
② Receipts from debtors
Quarter 1 : ½ x R1 196 000 = R598 000

Quarter 2: ½ x R1 196 000 + ½ x R368 000 = R598 000 + R184 000 = R782 000
Quarter 3: ½ x R368 000 + ½ x R276 000 = R184 000 + R138 000 = R322 000
Quarter 4: ½ x R276 000 = R138 000
OR
Quarter of sale Receipts from debtors
R R R R
1 (50% x R1 196 000) 598 000 598 000 - -
2 (50% x R368 000) - 184 000 184 000 -
3 (50% x R276 000) - - 138 000 138 000
598 000 782 000 322 000 138 000

50
③ Purchases and payments to creditors
Last quarter 2010: 80% x R1 196 000 = R956 800 to be paid in quarter 1
Quarter 1: 80% x R368 000 = R294 400 to be paid in quarter 2
Quarter 3: R0
Quarter 4: 80% x R1 196 000 = R956 800 to be paid in quarter 1 of 2011.
OR
Quarter of purchase 2009 2010
Quarter Quarter Quarter Quarter

Last quarter 1 2 3 4
R R R R R
1 (80% x R1 196 000) 956 800 - - - -
2 (80% x R368 000) - 294 400 - - -
3 (80% x R276 000) - - 220 800 - -
4 (80% x R1 196 000) - - - - 956 800
Total purchases per quarter 956 800 294 400 220 800 - 956 800
Payments to creditors - 956 800 294 400 220 800 -
④ Commission
Quarter 1: 5% x R1 196 000 = R59 800

Quarter 2: 5% x R 368 000 = R18 400
Quarter 3: 5% x R276 000 = R13 800
You are the chairperson of the finance committee of Hillside College, a private
school which was founded two years ago. Numerous fundraising projects are
continually being organised in order to complete the school buildings and
establish the required sporting facilities.
An amount of R100 000 is required to complete the athletic track and rugby fields.
A suggestion has been made to have a beer festival during the second weekend
in September 2010.
The parents association and finance committee members have provided you with
the following information regarding the proposed beer festival :
1. Entrance tickets
Entrance tickets can be sold at R50 each, which includes a light meal and a
500ml beer mug. It is expected that 1 800 tickets will be sold, 1 080 of which
are expected to be sold to males and 720 to females. A special price of R1
000 has been negotiated for the printing of 2 000 tickets which will have to
be printed and paid for in August 2010. Any unsold tickets will be disposed
of.
2. Food
The expected cost of the food other than that which has been donated will
be R190000, R12 000 of which will have to be paid for in August 2010 and the
balance in September 2010.
3. Beer
A major brewery has agreed to supply draught beer for the festival on a
C.O.D. (cash on delivery) basis. The draught beer is supplied in 50 litre
reusable vats, the content costing R250 per vat. A refundable deposit of R50
is payable on each vat supplied at the time of delivery. The beer will be
delivered to the school premises in a refrigerated trailer. The hiring of the
trailer will amount to R500 for the weekend and will be payable on
collection of the trailer.
As the brewery is prepared to refund the full purchase price of unused vats
returned, it has been decided to purchase 10 extra vats to provide for the
possibility of more beer being consumed or more tickets being sold.
The beer will only be sold in 500ml quantities at R8 each. Each guest wishing
to drink beer uses his/her own 500ml beer mug. On average, males are
expected to consume 5 mugs of draught beer each and females, 1,5 mugs
each.
52
4. Beer mugs
The beer mugs will be purchased and paid for in August 2010 and are
expected to cost R8 500.
5. Cold drinks
It is expected that 70 dozen cans of cold drinks could be sold at R5 per can.
The cold drinks cost R20 per dozen. A quote of R400 has been obtained for
the rental of the sink baths and the supply of dried ice to keep the cold
drinks cold.
6. Rental of marquee (tent)
One of the parents owns a catering business and is prepared to let out his
marquee to the school as a special favour, at a drastically reduced price.
The rental he will charge the school is equal to one monthly instalment he
pays in terms of a suspensive sale agreement. The amount that is being
financed for the marquee is R103 232 and it is repayable in equal monthly
instalments of 2½ years at a nominal interest rate of 12% per annum,
payable monthly.
7. Band
A traditional German band can be booked. The band required a non-

refundable deposit of R2 000 at the time of booking which is no later than
June 2010 and an additional payment of R8 000 after performing for the two
nights.
8. Sponsorships
Advertisers have been found for 20 sponsorship boards that will be placed in
prominent places during the beer festival. The school is charging R1 000 per
board, 50% payable by June 2010 and the balance in September 2010.
REQUIRED :
(a) Prepare a beer sales budget for the proposed beer festival in September
2010. (3)
(b) Determine the projected amount payable to the brewery on delivery of the
beer. (4)
(c) Advise on whether the required amount could be raised by preparing a

budgeted statement of comprehensive income for the proposed beer
festival to be held in September 2010 at Hillside College. (20)
53
① Entrance tickets : Males – 1 080 x 50 = 54 000)
Females – 720 x 50 = 36 000)

Revenue 90 000)
Printing (2 000 tickets) (1 000) (August paid)
89 000)
Food : R19 000
Beer : Deposit = R50/vat

Hire of trailer R500
50ℓ =
= R250/50
ℓ
Beer mugs : R8 500
③ Cold drinks :
Sales : 70x12x5 = 4 200

Cost : 20x70 = (1 400)
Rental Bath = (400)
: = R2 400
⑦ Instalment PV ⑤ Band : R 2 000 + R8 000

Marquee : = PV factor = R10 000
= 103 ⑥ Sponsorship : 20 x 1 R20 000

232
25,8 000 =
= R4 000
a ② Sales : R8/500ml  R16/ℓ

) Males : 5 mugs @ R8 x 1 43 200
080
Females : 1,5 mugs @ R8 x 8 640
720 51 840
54
④ Purchases
b)
(2,5ℓ x 1 080) + (0,75ℓ x 720) = 3 240ℓ
 50ℓ
= 64,8 vats
= 65 vats
+ Extra 10
75 vats
x 250
18 750
Refundable deposit: 75 vats x R50 each = R3 750
Total payable on delivery of beer = 18 750 + 3 750 = 22 500
Budgeted Statement of Comprehensive Income
Income : Entrance tickets ① 90 000

Beer sales ② 51 840
Cool drink sales ③ 4 200
Sponsorships ⑥ 20 000
166 040
Expenses : Printing ① 1 000
Food 19 000
Beer mugs 8 500
Cool drinks ③ 1 400
Bath hire ③ 400
Marquee ⑦ 4 000
Trailer hire 500
Purchase of beer ④ 18 750
Band ⑤ 10 000 (63 550)
102 490
Target will be met

55
QUESTION 9 (25 MARKS : 30 MINTUES)
As from May 2010, you have been appointed a the new financial manager of Exo
(Pty) Limited, a company selling a wide range of plastic products directly to the
public.
At the end of May, the general manager requested you to prepare a revised
statement of comprehensive income for the remainder of the financial year, a
period of nine months ending 28 February 2011. The following decisions which
were taken at a management meeting and will take effect as from 1 June 2010,
should be incorporated in the revised budgeted statement of comprehensive
income:
- the selling prices of all the products in the existing product range are to be
increased by 8%
- a new product will be added to the existing product range
- an advertising campaign, costing R30 000 will be launched on 1 June 2010
which is expected to have the effect of a ten percent (10%) increase in the
original budgeted sales volume for the remainder of the 2010-2011 financial
year. It is not anticipated that the advertising campaign will have an effect
on sales subsequent to February 2011.
You have analysed the actual results for the past three months ended 31 May 2010
and have also obtained the following information:
1. Sales
1.1 Sales relating to the existing product range
Prior to the decisions taken at the management meeting, sales were

expected to amount to R1 000 000 for the nine month period ending 28
February 2011.
1.2 Sales relating to the new product
After having taken the effect of the advertising campaign into account, it is
estimated that sales of the new product will amount to R160 000.
1.3 Settlement of sales
60% of all sales are on credit. Debtors tend to settle their accounts as
follows:
o 75% in the month of sale

o 23% in the month following the month of sale
o 2% is irrecoverable, provided for in the month of sale.
56
1.4 Determination of selling prices
Disregarding the effect of the increase in selling prices on products within

the existing product range, selling prices of products are based on a uniform
mark-up of 25% on the cost price.
2. Stock
Stock levels do not fluctuate.
3. Expenses per Month
3.1 Selling and administrative expenses
Fixed : R9 000
Variable : 8% of turnover
3.2 In addition to the above-mentioned selling and administrative expenses,

municipal expenses were estimated at R6 000 for the year. Due to a new
incentive scheme of the municipality, effective from 1 June 2010, a discount
of 3% will apply to all accounts paid in full every month. Exo (Pty) Limited
always pays municipal accounts in full.
4. Director’s Loan
A loan from D Exo, a director of the company, amounts to R60 000 at 1 June
2010. There is no fixed date for the repayment of the capital. Interest for the
nine months ending 28 February 2011 must be capitalized against the loan
account at a nominal rate of 14% per annum.
5. Fixed Assets
5.1 Pick-up vehicle
On 1 June 2009, a pick-up vehicle was acquired for R100 000. The
transaction was financed by means of a suspensive sale agreement at a
guaranteed effective interest rate of 18%. No deposit was paid. The full
amount in terms of the suspensive sale agreement is repayable in four equal
annual instalments, payable annually in arrear.
57
5.2 Delivery van
The delivery van which was acquired approximately three years ago, will be
sold on 1 December 2010 for R47 500. The cost price of the van amounted
to R70 000 and the book value at March 2010 was R28 000.
Depreciation on fixed assets for the nine months ending 28 February 2011,
excluding depreciation on the delivery van in 5.2 above, amounts to R30
200. Motor vehicles are depreciated according to the straight line method
at a rate of 20% per annum.
6. Dividends
On 31 May 2010, 1 000 shares were purchased in Plastics Supplies (Pty)

Limited at 250 cents per share. Plastics Supplies (Pty) Limited has declared a
dividend of 50 cents per share, which will be paid on 30 September 2010.
REQUIRED:
Prepare a revised budgeted Statement of Comprehensive Income for the nine

months ending 28 February 2011. Figures must, where necessary, be rounded off
to the nearest rand. (25)
(May 2001 Exam)

58
BUDGETED STATEMENT OF COMPREHENSIVE

INCOME
for the 9 months 01.06.10 - 28.02.11
Turnover - existing (1 000 000 x 1.1 x 1.08) 1,188,000

- new 160,000
1,348,000
Cost of sales [(1 000 000 x 1.1) + 160 000] ÷ 1.25 (1,008,000)
Gross Profit 340,000
Other income
- investment income (1000 x 0.5) 500
- profit on sale of van1 30,000
370,500
Expenditure 293,793
Advertising 30,000
Bad debts (1 348 000 x 60% x 2%) 16,176
Selling and Admin expenses - fixed (9 000 x 9) 81,000
- variable (1 348 000 x 8%) 107,840
Municipal costs (6 000 x 9/12 x 0.97) 4,365
Interest on Director's loan (60 000 x 9/12 x 14%) 6,300
Finance costs2 (interest on suspensive sale) (14 549 x 9/12) 10,912
Depreciation - sold asset (14 000 x 6/12) 7,000
- other assets 30,200
Net Profit 76,707
Note 1
Book value @ 01/03/10 28,000
Less: depn. for 9 months 1 Mar - 1 Dec (14 000 x 9/12) 10,500
(annual depn. = 70 000 x 20% = 14 000 p.a.)
Book value @ 01/12/10 (date of sale) 17,500
Proceeds received @ 01/12/10 47,500
Profit on sale 30,000
59
Note 2: suspensive sale only workings for year 1 and 2 necessary
capital
year OB instalment CB interest portion
01.06.09 - 31.05.10 1 100,000 37,175 80,825 18,000 19,175
01.06.10 - 31.05.11 2 80,825 37,175 58,199 14,549 22,627
01.06.11 - 31.05.12 3 58,199 37,175 31,499 10,476 26,699
01.06.12 - 31.05.13 4 31,499 37,175 - 6 5,670 31,505
instalment = amount to be financed

Present value annuity factor for 4 years @18%
= 100 000 = 37 175

2.69
1
The Antialgae Chemical Corporation produces a patent chemical for sale

to swimming pool owners. This chemical known as ANALG is based on the
following standard formula for a batch of 80 kilograms.
Chemical Weight Standard

kilograms price
(cents)
X 25 80
Y 25 40
Z 50 20
In March of this year, 440 kilograms of ANALG were produced, using the
following chemicals at the prices indicated:

kilograms price
(cents)
X 145 90
Y 135 50
Z 260 20
YOU ARE REQUIRED TO :
1. Total material costs variance

2. Material price variance
3. Material mixture variance
4. Material yield variance.
(NATAL - adapted)
2
Standard costs per 80 kilograms of Analg
Chemical Kgs Price Standard cost

R R
X 25 0,80 20,00
Y 25 0,40 10,00
Z 50 0,20 10,00
100 40,00
Standard costs for 80 kgs is R40,00

Standard costs per kilogram = R0,50
1. Total material cost variance
Actual cost Issue Price Actual input @ std cost

R R R
X: 145 x 0.90 = 130.50 14.50 (u) 145 x 0.80 = 116.00
Y: 135 x 0.50 = 67.50 13.50 (u) 135 x 0.40 = 54.00
Z: 260 x 0.20 = 52.00 0 260 x 0.20 = 52.00
250.00 28.00 (u) 222.00
Actual input @ std cost Usage Actual output @ std cost

R R
X: 145 x 0.80 = 116.00
Y: 135 x 0.40 = 54.00
Z: 260 x 0.20 = 52.00
222.00 2.00 (u) 440 x 0.5 = 220
Therefore the total material cost variance = price + usage = 28 (u) + 2 (u) = R30 (u)
Actual Mixture Actual input in std Yield Actual output @ std

input @ mixture cost
std @ std cost
cost
R R R R R
116 8 (u) 540 x 25% x 0.80 = 108
Y 54 0 540 x 25% x 0.40 = 54
Z 52 2 (f) 540 x 50% x 0.20 = 54
222 6 (u) 216 4 (f) 440 x 0.5 = 220
Usage R2 (u)
3
Sidecut Limited utilises a standard cost system. Materials as well as

completed goods which may have to be kept in stock are recorded at
standard absorption cost. Any variances that may occur are accounted
for in the cost of sales for the current period.
The following budgeted information for the year that ended on 30 June
2014 was obtained:
Units
Production capacity – standard ……………………….. 60 000
Product – “Selene”
Production and sales …………………………………… 60 000
R
Selling price – per unit …………………………………. 224,00
Standard prime cost per unit ………………………… 120,00

- Materials ……………………………………………….. 72,00
- Zilon – 4 metres @ R12,00 per metre ……………. 48,00
- Brilon – 3 metres @ R8,00 per metre ……………. 24,00
- Labour
- Artisans – 4 hours @ R12,00 per hour 48,00
Fixed manufacturing overheads – 75% of labour cost
Fixed selling and administrative cost – per unit ……... 44,00
The company is a market leader. As a result the actual sales and

production were equal to that budgeted for the 2014 financial year. In
spite of this, the company barely managed to break even, instead of
realising a net profit of R1 440 000, before normal taxation as had been
budgeted.
The following actual information for the year was subsequently

ascertained:
1. Material Purchased Issued Metres Purchase price

Metres Per Metre
Zilon 247 500 R12,40
Brilon 250 000 185 000 R7,80
187 000
4
2. Direct labour paid - R3 025 600

(Artisans 244 000 hours @ R12,40 per hour)
3. Fixed manufacturing overheads - R2 465 600
4. Fixed selling and administrative expenses - R3 048 000
During the financial year, a client was given a special discount of R16,00
per unit on an order for 5 000 units. The remaining units were sold at the
budgeted selling price.
REQUIRED:
(a) Compile an income statement for the year that ended on 30 June
2014, which reflects the actual figures. ( 5)
(b) Reconcile the difference between the budgeted and the actual net
profit, before normal taxation, for 2014, by calculating as many
variances as possible. (22)
5
SIDECUT LIMITED
(a) Income statement for the year ended 30 June 2014
R
Sales 13 360 000
60 000 x R224,00 13 440 000

Less: Discount on sales – 5 000 x R16,00 80 000
Less: Manufacturing, selling and administrative 13 051 800

costs
Materials consumed (calculation 1) 4 512 600

Direct labour 3 025 600
Manufacturing overheads – fixed 2 465 600
Selling and administrative expenses – fixed 3 048 000
Net profit for the year 308 200

( 3)
6
(b) Reconciliation of the difference between the budgeted and the actual
net profit for the year ended 30 June 2014
Calcu- R
lation
Budgeted net profit
1 440 000
Less: Unfavourable variances from standard cost
1 167 800
Materials 192 600

- Purchase price 2 62 600
- Mix 3 1 429
- Yield 3 128 571
Labour 145 600

- Rate 4 97 600
- Efficiency 4 48 000
Fixed manufacturing overheads 341 600

- Expenditure 5 305 600
- Efficiency 36 000

Sales
- Selling price 7 80 000
272 200
Plus: Favourable variance from standard cost

- Fixed overhead Capacity 5 36 000
Actual net profit 308 200

( 5)
7
Calculations
1. Materials used in the manufacturing process
Material
Zilon Brilon
R R
Opening stock – 1/7/2013 -- --
Plus : purchases @ actual
- 250 000 x R12,40 3 100 000
- 187 000 x R7,80 1 458 600
3 100 000 1 458 600
Less: Closing stock @ standard

- 2 500 x R12,00 30 000
- 2 000 x R8,00 16 000
3 070 000 1 442 600
( 2)
Variances
2. Materials – Purchase price
Actual cost Actual purchases at standard cost
Zilon R(250 000 x 12,40) = 3 100 000 R(250 000 x 12,00) = 3 000 000
Brilon R(187 000 x 7,80) = 1 458 600 R(187 000 x 8,00) = 1 496 000
4 558 600 4 496 000
Purchase price
R62 600 (u)
( 2)
3. Mix and Yield
Actual input @ std cost Mixture Actual input in std ratio @ std cost
Zilon: R(247 500 x 12,00) = 2 970 000 4 286(u) 432 500 x 4/7 x 12,00 = 2 965 714
Brilon: R(185 000 x 8,00) = 1 480 000 2 857(f) 432 500 x 3/7 x 8,00 = 1 482 857
4 450 000 1 429(u) 4 448 571
8
Actual input in std ratio @ std cost Yield Actual output @ std cost
2 965 714 85 714(u) 60 000 x R48 = 2 880 000
1 482 857 42 857(u) 60 000 x R24 = 1 440 000

4 448 571 128 571 (u) 4 320 000
( 4)
Labour
4. Rate and Efficiency
Actual cost Actual input @ std cost Actual output @ std cost
R3 025 600 R(244 000 x 12,00) R(60 000 x 48)
= R2 928 000 = R2 880 000
Rate Efficiency
R97 600(u) R48 000(u)
( 3)
9
Fixed manufacturing overheads
5. Expenditure, capacity and efficiency
Actual Budget Actual input @ std cost Actual output @ std cost
R2 465 600 R(60 000 x 48 x 75%) R(244 000 x 12 x 75%) R(60 000 x 48 x 75%)
= R2 160 000 = R2 196 000 = R2 160 000
Expenditure Capacity Efficiency

R305 600(u) R36 000(f) R36 000(u)
( 4)
Fixed selling & administrative cost
6. Expenditure
Actual cost Budgeted cost
R3 048 000 R(60 000 x 44,00)
= R2 640 000
Expenditure
R408 000(u)
( 2)
7. Sales
Actual sales Actual sales @ standard selling price
R13 360 000 R(60 000 x 244,00)
= R13 440 000
Price
R80 000(u)
( 2)
10
Lipos (Proprietary) Limited manufactures vitamin blocks for birds, which

are packed and sold in crates. Two raw materials are used in the process,
namely bird seed and vitamin extract. The company makes use of a
standard absorption costing system.
The following information relates to July 2014:
Budget Actual
R R
Sales 252 000 270 750
Less: Cost of sales 203 670 229 079
Raw materials
- Bird seed 157 500 179 215
- Vitamin extract 33 750 36 900
Wages 4 140 4 464
Variable overheads 4 500 4 600
Fixed overheads 3 780 3 900
Gross profit 48 330 41 671

Selling and administrative expenses (fixed) 12 510 13 470
Net income 35 820 28 201
Number of crates produced and sold 1 800 1 900

Raw materials used
- Bird seed (kg) 126 000 128 000
- Vitamin extract (kg) 54 000 60 000
Labour hours 600 620
1. Overhead allocation is based on labour hours.
2. Stock records are kept at standard cost.
3. Stock figures are negligible and can be ignored.

11
REQUIRED:
(a) Calculate all possible variances for July 2014 (for sales reconciliation
purposes). (26)
(b) State one potential cause for the material mixture variance. ( 1)
12
QUESTION 3 (SUGGESTED SOLUTION)
LIPOS (PTY) LIMITED
(a) Variances
Material
Actual Purchase Actual purchases @ std cost

cost price
R R R
Seed
179 215 19 215(u) 128 000 x 157 500 = 160 000
126 000
Extract
36 900 600(f) 60 000 x 33 750 = 37 500
54 000
216 115 18 615(u) 197 500
( 3)
Variance
R R
Seed 128 000 x 1,25 = 160 000 4 500 (f) 126 000 x 188 000 x 1,25 = 164 500
180 000
Extract 60 000 x 0,625 = 37 500 2 250(u) 54 000 x 188 000 x 0,625 = 35 250
_______ ______ ______ 180 000 ______
188 000 197 500 2 250 (f) 199 750
( 3)
Actual input Yield Actual output @ std cost

in std ratio @ variance
std cost
R R R
Seed 164 500 1 750(f) 126 000 x 1 900 x 1,25 = 166 250
1 800
Extract 35 250 375(f) 54 000 x 1 900 x 0,625 = 35 625

______ ______ 1 800 _______
199 750 2 125(f) 201 875
( 3)
13
Material usage variance:

Seed: mix + yield= 4 500(f) + 1 750(f) = 6 250 (f)
Extract: mix + yield= 2 250(u) + 375 (f) = 1 875 (u)
TOTAL: 4 375 (f)
Labour
R4 464 620 x R4 140 = R4 278 1 900 x R4 140 = R4 370

600 1 800
Rate R186(u) Efficiency R92(f)

( 3)
Variable overhead
R4 600 620 x R4 500 = R4 650 1 900 x R4 500 = R4 750

600 1 800
Rate R50(f) Efficiency R100(f)

( 3)
Fixed overhead
Actual cost Budgeted Actual input @ std cost Actual output @ std cost
July
R3 900 R3 780 620 x R3 780 = R3 906 1 900 x R3 780 = R3 990

600 1 800
Expenditure Capacity R126(f) Efficiency R84(f)

R120(u)
Volume R210(f)
( 5)
14
Fixed administrative cost
Actual cost Budgeted cost Actual volume @ std cost
R13 470 R12 510 1 900 x R12 510 = R13 205

1 800
Expenditure Volume 695(f)

R960(u)
( 3)
Sales
Actual sales Actual sales @ std SP Budgeted sales
R270 750 1 900 x R252 000 = R266 000 = R252 000

1 800
Price R4 750(f) Volume

R14 000(f)
( 3)
(b) One potential cause for a material mixture variance
- an incorrect standard
- inferior or superior material used
- poor inspection
- incorrect mixture
- more of the cheaper material was used ( 1)
15
Brandon Limited manufactures a chemical powder which is used for

locust pest control. The company makes use of a standard costing system
for budget and control purposes.
The standard product and cost specifications for 2 000 kg finished product
are as follows:
1. Raw material
The standard mixture for an output of 2 000 kg finished product is as

follows:
Chemical powder Quantity Price/kg Value

Kg R R
X 1 500 0,50 750
Y 500 0,70 350
2 000 1 100
Raw material stock records are kept at actual cost, as determined

on the average method of stock valuation.
2. Labour
It take 20 hours, at a total cost of R120, to convert 2 000 kg raw

material into 2 000 kg of finished product.
3. Production overhead
Production overhead is allocated to finished products at a rate of

R10 per direct labour hour, 60% of which represent fixed costs.
Total overhead amounts to R40 000 per normal month.

16
An extract of the cost and production records for March 2014 indicates
the following:
1. Raw material
Chemical Opening stock Purchases during Closing

powder the month stock
Kg R Kg R/kg kg
X 20 000 11 000 324 000 0,48 30 000
Y 24 000 18 240 60 000 0,84 8 000
2. Labour
The actual wages for 4 000 hours during March 2014 amounted to
R23 104.
The following payments were made during March 2014:
Variable overhead : R14 800

Fixed overhead : R26 000
4. Production
380 000 kg of chemical powder was produced during March 2014.

There was no fluctuation in stocks of the finished product and there
was no work-in-process.
The calendar factor applicable to March 2014 was 105%.
REQUIRED:
(a) Calculate the budgeted labour hours for a normal month. (2)
(b) Calculate the budgeted production in kilograms for March 2014. (2)
(c) Determine the value of raw material usage during March 2014. (6)
17
(d) Calculate all possible standard cost variances for March 2014 in
respect of the following:
(i) Raw material

(ii) Labour
(iii) Variable overhead
(iv) Fixed overhead (13)
Amounts must be rounded off to the nearest Rand.

18
BRANDON LIMITED
a) Budgeted labour hours – normal month
Total overhead per month = R40 000

Allocation rate per hour = R10
 Direct labour hours – normal month = 4 000
(2)
b) Budgeted production – March 2014
Production – normal month= (4 000 x 2 000) kg

( 20 )
= 4 00 000 kg
Production – March 2014 = (400 000 x 105%) kg

= 420 000 kg (2)
c) Value of raw material usage
Raw material usage in kilograms
X Y
Kg Kg
Opening stock 20 000 24 000
Purchases 324 000 60 000
344 000 84 000
Closing stock (30 000) (8 000)
Usage 314 000 76 000
Value of raw material usage
Chemical powder X
Kg R
Purchases 324 000 155 520
344 000 166 520
Value of usage: 314 000 x R166 520

344 000
= R151 998
19
Chemical powder Y
Kg R
Purchases 60 000 50 400
84 000 68 640

84 000
= R62 103 (6)
d) Variances
i) Raw material
Actual cost* Issue price Actual input @ std cost

R R R
X: 151 998 5 002 (f) 314 000* x R0,50 = 157 000
Y: 62 103 8 903 (u) 76 000* x R0,70 = 53 200
214 101 3 901 (u) 390 000 210 200
* Calculated under (c) above
Actual input Mixture Actual input in std mixture @ std cost Actual output @
@ std cost std cost
R R R
X: 157 000 10 750 (u) 390 000 x 1 500 x R0,50 = 146 250 380 000 x R1 100
2 000 2 000
Y: 53 200 15 050 (f) 390 000 x 500 x R0,70 = 68 250

2 000
210 000 4 300 (f) 214 500 = R209 000

Yield
R5 500 (u)
Usage R1 200 (u)

(5)
ii) Labour
4 000 x R120 380 000 x R120

20 2 000
R23 104 = R24 000 = R22 800
Rate R896 (f) Efficiency R1 200 (u)

(2)
20
iii) Variable overhead
4 000 x R4* 380 000 x 20 x R4

2 000
R14 800 = R16 000 = R15 200
Rate R1 200 (f) Efficiency R800 (u)

(2)
iv) Fixed overhead
Actual cost Budgeted – normal Budgeted - March

month
R40 000 x 60% R24 000 x 105%

R26 000 = R24 000 = R25 200
Expenditure R2 000 (u) Calendar R1 200 (f)
Budgeted – March Actual input @ std cost Actual output @ std cost
4 000 x R6* 380 000 x 20 x R6

2 000
R25 200 = R24 000 = R22 800
Capacity R1 200 (u0 Efficiency R1 200 (u)
*60% x R10 = R6
(4)
21
Precision Engineering manufactures a tool which is used in the motor

industry. The enterprise makes use of a standard costing system in order to
control the costs involved in the manufacturing of the tool.
The budgeted information for 2014 regarding the manufacturing process,

at an annual level of production of 90 000 units, is as follows:
1. Material
Price per kilogram Material X R3,00

Material Y R4,80
Required to manufacture one unit:
1 kg in the following mix:
Material X 33⅓%
Material Y 66⅔%
2. Labour
Rate per hour R4,80

Required to manufacture one unit ⅓ hour
3. Overheads – allocation based on clock hours
Variable R 36 000
Fixed R120 000
The actual information for March 2014 is as follows:
1. Material

Material Y R4,60
Purchased and used 8 550 kg

Material mix: Material X 40%
Material Y 60%
22
2. Labour
Rate per hour R5,00

Clock hours 2 500
3. Overheads incurred
Variable R3 175
Fixed R9 750
4. Production – in units 8 000
1. Calendar factor for the month 108%
2. There was no stock of any kind of either the beginning or end of

the month.
REQUIRED:
Calculate the following standard cost variances for March 2014:
Material - price
- mixture
- yield
- usage (9)
Labour - rate
- efficiency (3)
Variable overhead - rate

- efficiency (3)
Fixed overhead - expenditure

- calendar
- capacity
- efficiency (5)
Round figures off to the nearest Rand.

23
PRECISION ENGINEERING
a) Material
Actual cost Price Actual purchases @ std cost

R R R
X: 8 550 x 40% x R3,20 = 10 944 684(u) 8 550 x 40% x R3,00 = 10 260
Y: 8 550 x 60% x R4,60 = 23 598 1 026(f) 8 550 x 60% x R4,80 = 24 624
34 542 342 (f) 34 884
(4)
Actual Mixture Actual input in std mixture Yield Actual output @ std cost
input @ @ std cost
std cost
R R R R R
X 10 260 1 710 (u) 8 550 x 33½% x R3,00 = 8 550 550 (u) 8 000 x ⅓ x R3,00 = 8 000
Y 24 624 2 736 (f) 8 550 x 66⅔% x R4,80 = 27 360 1 760 (u) 8 000 x ⅔ x R4,80 = 25 600
34 884 1 026 (f) 35 910 2 310 (u) 33,600
Usage R1 284 (u)

(5)
b) Labour
Actual cost Actual input @ std cost actual output @ std cost
2 500 x R5,00 2 500 x R4,80 8 000 x ⅓ x R4,80
= R12 500 = R12 000 = R12 800
Rate R500 (u) Efficiency R800 (f)
(3)
c) Variable overhead
2 500 x R36 000_ 8 000 x R36 000
90 000 x ⅓ 90 000
R3 175 = R3 000 = R3 200
(3)
24
d) Fixed overhead
Actual Budget normal Budget – actual input @ std cost actual output @
cost month March std cost
R120 000 R10 000 x 108% 2 500 x R120 000 8 000 x R120 000
12 90 000 x ⅓ 90 000
R9 750 = R10 000 R10 800 R10 000 R10 667

Expenditure Calendar R800 (f) Capacity R800 (u) Efficiency R667 (f)
R250 (f)
Volume R667 (f)

25
Pro Tool Manufacturers Limited specialises in the manufacture of quality

tools for use in the building and engineering industry. One of the
manufacturing divisions of the company has only manufactured one
specific tool during the 2014 financial year.
The budget for the abovementioned division for the year ended 28
February 2014, at a capacity utilisation of 30 000 labour hours, indicates
the following:
Budgeted production
Cost per unit
R
Material – 10 kg @ R3 per kilogram 30
Labour – 3 hours @ R8 per hour 24
Variable overhead – 3 hours @ R2 per hour 6
Fixed overhead – 3hours @ R5 per hour 15
75
The actual results for the year were as follows:

Total cost
R
Material @ R4 per kilogram) 520 000
Labour 400 000
Variable overhead 72 000
Number of units actually manufacturing during 12 500

the year:
1. The change in stock levels was insignificant and must be ignored.
2. The actual wage rate deviated from the budgeted wage rate only
with regard to a 25% increase granted to all labourers with effect 1
March 2013.
At that stage, the 2014 budget had already been compiled,

consequently the standard labour rate has not been adjusted.
3. Overheads are allocated to production on the basis of labour hours.

26
REQUIRED:
a) Determine the total variable costs budgeted for the 2014 financial
year. (3)
b) Calculate the appropriate standard cost variances in respect of each

of the following elements:
i. material (2)
ii. labour (2)
iii. variable overhead (2)
iv. fixed overhead (3)
c) Reconcile the total budgeted variable costs with the total

actual variable costs. (4)
27
PRO TOOL MANUFACTURERS LIMITED
a) Total budgeted variable costs
Budgeted output = budgeted input ÷ SH p.u. = 30 000 ÷ 3

= 10 000 units
Budgeted variable cost per unit = R(30 + 24 + 6)

= R60
Total budgeted variable costs = budgeted output x

variable cost p.u. = 10 000 x R60
= R600 000
(3)
b) Variances
(i) Material
R(520 000 ÷ 4) x R3 12 500 x R30
R520 000 = R390 000 = R375 000
Price R130 000 (u) Usage R15 000 (u) (2)
(ii) Labour
40 000 1 x R8 12 500 x R24
R400 000 = R320 000 = R300 000
Rate R80 000 (u) Efficiency R20 000 (u) (2)
40 000 1 x R2 12 500 x R6
R72 000 = 80 000 = R75 000
Rate R8 000 (f) Efficiency R5 000 (u) (2)
1 actual input (labour hours) = actual cost = 400 000 = 40 000 hours
actual rate 10
28
(iv) Fixed overhead
Actual cost Budgeted cost Actual input @ Actual output @ std

std cost cost
30 000 x R5 40 0001 x R5 12 500 x R15
R130 000 = R150 000 = R200 000 = R187 500
R20 000 (f) R50 000 (f) R12 500 (u) (3)
Volume R37 500 (f)
c) Reconciliation of budgeted and actual variable costs
R
Budgeted variable costs per (a) above 600 000
Add: Unfavourable total variable costs volume variance 150 000 2
Standard variable costs – actual volume 750 000

Less: Favourable variable overhead rate variance (8 000)
Add: Unfavourable cost variances 250 000
Material
- price 130 000
- usage 15 000
Labour
- rate 80 000
- efficiency 20 000
Variable overhead efficiency 5 000
Actual variable costs [R(520 000 + 400 000 + 72 000)] 992 000
(4)
2 variable costs volume variance = (actual output – budgeted output) x VC p.u.
= (12 500 – 10 000) x 60
= R150 000
(This is unfavourable because your actual output cost R150 000 more than what
you budgeted it to cost.)
29
QUESTION 7 (28marks) (33minutes)
Crusty Limited manufactures a single product whilst utilizing a standard costing system. Any
stock of materials is valued at standard cost whilst completed goods are valued at standard
absorption cost.
The following sales and costs at standard was budgeted for the month that ended on 30
September 2014:
Units
Sales – Finished products 10 000
R
Prime cost per unit 250,00
- Materials 175,00
- Siv - 10kg @ R 5,00 per kg 50,00
- Lon - 5kg @ R25,00 per kg 125,00
- Labour - 5 hours @ R15,00 per hour 75,00
Variable overheads are allocated to production based on labour hours at a predetermined rate of
R24,00 per hour. The selling price of the single product as budgeted realizes a gross profit of
20% on the selling price and during the budgeted month the actual selling price per unit was 10%
higher than the original budgeted selling price.
The costs incurred and the relevant information for the month that ended on 30 September 2014
was as follows:
Units
Production and sales 9 500
Siv Lon
Kg R Kg R
- Opening stock - 1/9/2014 4 000 20 000 2 000 50 000
- Closing stock - 30/9/2014 3 000 - 1 500 -
- Purchased - 570 000 - 1 140 000
- Used in production – September 2014 96 000 - 48 000 -
Labour - 46 000 hours R736 000

Variable production overheads R1 150 000
There was no opening or closing stock of finished products at the beginning or end of the month.
The following variances as part of the system’s variances for the month were calculated at the
end of September 2014:
R
Materials purchase price 47 500 unfavourable
Materials mix Nil
Labour rate 46 000 unfavourable
Labour efficiency 22 500 favourable
Variable overhead efficiency 36 000 favourable
30
Required:
a) Compile a budgeted income statement for the month that ended on 30 September 2014.
( 7)
b) Calculate the following variances for September 2014:
 Materials yield ( 4)
 Production overhead rate ( 2)
 Sales price ( 3)
 Sales volume (for profit reconciliation purposes). ( 4)
c) Determine the actual gross profit by reconciling the budgeted and actual gross profit for
September 2014. ( 8)
(UNISA OCT 2007 EXAM)

31
QUESTION 7
(a)
Budgeted / Standard cost p.u
Material 175
Labour 75
Overhead (5 hours x R24 per hour) 120
370
Budgeted selling price p.u. = cost p.u. = 370 = R462.50 per unit
0.8 0.8
Budgeted Income Statement for month ended 30 September 2014
R
Budgeted Sales (10 000 x 462.50) 4 625 000
Less: Budgeted Cost of Sales 3 700 000
Material (10 000 x 175) 1 750 000
Labour (10 000 x 75) 750 000
Overhead (10 000 x 120) 1 200 000
Budgeted Income 925 000
(b)
MATERIALS YIELD VARIANCE
If the materials mix variance is nil, then the materials yield variance = materials usage
variance
Actual input @ std cost Material Actual output @ std cost

Usage
Siv: 96 000 x 5 = R480 000 R5 000 (u) 9 500 x 50 = R475 000
Lon: 48 000 x 25 = R1 200 000 R12 500 (u) 9 500 x 125 = R1 187 500
R1 680 000 R17 500 (u) R1 662 500
32
PRODUCTION OVERHEAD RATE VARIANCE
Actual cost Actual input @ std cost
R1 150 000 46 000 x 24 = R1 104 000
Overhead rate R46 000 (u)
SALES PRICE VARIANCE
Actual sales revenue actual sales units @ std SP
9 500 x (462.50 x 1.1) = R4 833 125 9 500 x 462.50 = R4 393750
Sales Price R439 375 (f)
SALES VOLUME VARIANCE (profit recon.)

Budgeted / Standard GP per unit = Standard SP – Standard Costs p.u. = 462.50 – 370 =
R92.50
Standard GP on actual sales Budgeted GP
9 500 x 92.50 = R878 750 10 000 x 92.50 = R925 000
Sales Volume R46 250 (u)

33
(c)
R
Budgeted Profit 925 000
Less: Sales Volume Variance (u) 46 250
Standard Profit 878 750
Plus: Favourable other variances 497 875
Labour efficiency 22 500
Production overhead 36 000
efficiency
Sales price 439 375
Less: Unfavourable other variances 157 000
Materials purchase price 47 500
Materials usage 17 500
Labour rate 46 000
Production overhead rate 46 000
Actual Profit 1 219 625

34
Stone Top CC operates a standard costing system and manufactures two

models of processed granite work-surfaces for kitchens, namely
“Rustenburg” and “Plettenburg”. Stock records are maintained at
standard absorption cost. Overheads are allocated on the basis of direct
labour hours.
The budget for the two models for the year ending on 31 December 2014
is as follows:
Model
“Rustenburg” “Plettenburg”
R R
Production 50 units - 30 units -
Materials
Raw granite
Black 50 000 kg 500 000 - -
Green - - 30 000 kg 330 000
Saw blades 500 units 15 000 300 units 9 000
Labour 2 500 37 500 1 500 22 500
hours hours
Overhead:
Variable - 65 000 - 39 000
Fixed - 30 000 - 18 000
Saw blades are used to cut the raw granite. The standard consumption is
one saw blade per 100 kilograms of raw granite processed.
The finished goods, materials and other stock records reflected the
following for April 2014:
Quantity
01/04/2014 31/04/2014
Finished goods:
“Rustenburg” 4 units 3 units
“Plettenburg” 3 units 2 units
Raw granite:
Black 2 000 kg 3 000kg
Green 1 000 kg 1 500 kg
Saw blades 27 units 20 units
Work-in-progress Nil Nil
35
The actual information for April 2014 was as follows:
Model Total
“Rustenburg” “Plettenburg” R
Sales 6 units 4 units - -
Purchases
Black granite 6 100 kg - - 65 000
Green granite - 3 300 kg - 36 000
Saw blades - - 73 units 2 100
Labour hours worked 257 148 405 6 165
Overhead incurred:
Variable 9 000
Fixed 4 200
65% of the saw blades issued to production were used for the production
of “Rustenburg”, and the remaining 35% for Pletttenburg.
REQUIRED:
Calculate the following variances for April 2014:
a) Materials purchase price (5)

b) Materials usage (10)
c) Labour rate and efficiency (3)
d) Variable overhead rate and efficiency (3)
e) Fixed overhead expenditure, calendar, capacity and efficiency (5)
(UNISA MAY 2007 EXAM)

36
a) Materials Purchase Price Variance
Granite:
Actual cost of purchases Purchase Actual purchases @ std cost

price
R: Black Granite: = R65 000 R4 000 (u) 6100 x 500 000 = R61 000
50 000
P: Green 3 300 x 330 000

Granite: = R36 000 R300 (f) 30 000 = R36 300
R101 000 R3 700 (u) R97 300
Saw Blades:
Actual cost of purchases Actual purchases @ std

cost
R2 100 73 x 15 000 + 9 000

500 + 300
= R2 190
purchase price R90 (f)

37
b) Materials Usage Variance
Granite:

Usage
R: Black Granite: 5 100 x 10 = R51 000 R1 000 (u) 5 x 500 000 = R50 000
50
P: Green Granite: 2 800 x 11 3 x 330 000

= R30 800 R2 200 (f) 30 = R33 000
R81 800 R1 200 R83 000
(f)
Saw Blades:

Usage
R: 52 x 30 = R1 560 R60 (u) 5 x 15 000 = R1 500
50
P: 28 x 30 = R 840 R60 (f) 3 x 9 000 = R 900

R2 400 R 0 30 R2 400
Calculations – actual for April

Black Granite
kg
Opening Stock 2 000
Add: Purchases 6 100
Less: Closing Stock (3 000)
Usage (actual input) 5 100

Rustenburg
units
Opening Stock 4
Add: Production (actual output) *5
Less: Closing Stock (3)
Sales 6
* Balancing figure
38

Green Granite
kg
Opening stock 1 000
Add purchases 3 300

Plettenburg
(units)
Opening stock 3
Sales 4
* Balancing figure

Saw Blades
(units)
Opening stock 27
Add: Purchases 73
Usage (actual input) 80
Rustenburg = 65% x 80 = 52 units

Plettenburg = 35% x 80 = 28 units
c) Labour Rate and Efficiency Variances
Actual cost Rate Actual input @ std cost

Variance
R: 257 x 6 165 = R3 912,11 R57,11 (u) 257 x 37 500 = R3 855
405 2 500
P: 148 x 6 165 = R2 252,89 R32,89 (u) 148 x 22 500 = R2 220

405 R6 165,00 R90,00 (u) 1 500 R6 075
39
Actual input @ std cost Efficiency Actual output @ std cost

Variance
R: R3 855 R105 (u) 5 x 37 500 = R3 750
50
P: R2 220 R30 (f) 3 x 22 500 = R2 250

R6 075 R75 (u) 30 R6 000
d) Variable overhead rate and efficiency variance

variance
R: 257 x 9 000 = R5 711,11 R970,89 (f) 257 x 65 000 = R 6 682
405 2 500
P: 148 x 9 000 = R3 288,89 R559,11 (f) 148 x 39 000 = R 3 848

405 R9 000,00 R1 530,00 (f) 1 500 R10 530

Variance
R: R6 682 R182 (u) 5 x 65 000 = R 6 500
50
P: R3 848 R52 (f) 3 x 39 000 = R 3 900

R10 530 R130 (u) 30 R10 400
e) Fixed Overhead Variances
Actual cost Budgeted cost Actual input @ Actual output @

std cost std cost
R: 257 x 4 200 = 2 665,19 30 000 = 2 500 257 x 30 000 = 3 084 5 x 30 000 = 3 000
405 12 2 500 50
P: 148 x 4 200 = 1 534,81 18 000 = 1 500 148 x 18 000 = 1 776 3 x 18 000 = 1 800
405 12 1 500 30
4 200,00 4 000 4 860 4 800

R200 (u) R860 (f) R60 (u)
40
Computer Warehouse sells various computer hardware products. The

business currently assembles two models of computers internally, namely
the Educational and Gaming computers. Assembly takes place
according to demand, therefore no stock of assembled computers is
kept.
A standard costing system is used to control the costs of the assembled

computers. A bin system is used where the storeroom staff place all the
components required to assemble a computer, into a component bin.
Component bins are issued to the assembly section on request at actual
cost. Where one or more of the components in a bin are defective, the
staff document it on the bin and these bins are kept in the assembly
section as replacement components for other defective components.
The following standards are available for a normal month :
Standard per assembled computer : Educational Gaming

R R
Selling price 3 500 5 000
Less : Cost of sales 2 600 3 950
Components 1 200 2 200

Overheads
- Variable 240 300
- Fixed (120 per hour) 960 1 200
During a normal month, 400 computers are assembled. The standard ratio
of Educational to Gaming computers sold is 70% to 30% respectively.
Overheads are allocated based on labour hours.
The following actual information is available for April 2014 :
1. During April, the Gaming computers were advertised nationwide on

an Easter special at a discounted price of R4 500. This had the
effect of the sales volume of Gaming computers increasing to 250
41
computers and that of Educational computers decreasing to 230.

The Educational computers were sold at standard selling prices.
2. Stock records show that 231 Educational and 252 Gaming

component bins were issued to the assembly section at a cost of
R1 250 and R2 100 per bin respectively.
3. Direct labour hours worked were 4 238 at a cost of R105 950.
4. Fixed overhead amounted to R410 000.
REQUIRED :
(a) Calculated the following variances for each type of assembled

product for April 2014 :
(i) Selling price variance

(3)
(ii) Sales mixture, quantity and volume variance based on units
for sales reconciliation purposes (6)
(b) Reconcile budgeted sales to actual sales (3)
(c) Calculate all possible component variances (6)
(d) Calculate the fixed overhead capacity and efficiency variances

(6)

42
Question 9 – SUGGESTED SOLUTION
(a)
SALES
(i)
Actual sales Price Actual sales @ std SP

Variance
R R R
Edu: 230 x 3500 = 805,000 0 230 x 3500 = 805,000
Game: 250 x 4500 = 1,125,000 125,000 (u) 250 x 5000 = 1,250,000
Total: 1,930,000 125,000 (u) 2,055,000
(ii)
Actual sales @ std SP Mix Actual sales in units in std Quantity Budgeted Sales
Variance mix @ std SP Variance
R R R R R
Edu: 230 x 3500 = 805,000 371,000 (u) 0.7 x 480 x 3500 = 1,176,000 196,000 (f) 280 x 3500 = 980,000
Game: 250 x 5000 = 1,250,000 530,000 (f) 0.3 x 480 x 5000 = 720,000 120,000 (f) 120 x 5000 = 600,000
Total: 2,055,000 159,000 (f) 1,896,000 316,000 (f) 1,580,000
Volume = R475,000 (f)
OR
Volume variance = mix variance + quantity variance = 159,000 (f) + 316,000 (f) = R475,000 (f)
43
(b)
Reconciliation of budgeted sales to actual sales:
R
Budgeted Sales 1,580,000
Add: Favourable sales volume variance 475,000
Less: Unfavourable selling price variance (125,000)
Actual sales 1,930,000
(c)
Actual cost Price Actual input @ std cost
Variance
R R R
Edu: 231 x 1250 = 288,750 11,550 (u) 231 x 1200 = 277,200
Game: 252 x 2100 = 529,200 25,200 (f) 252 x 2200 = 554,400
Total: 817,950 13,650 (f) 831,600
Actual input @ std cost Mix Variance Actual input in std ratio @ Yield Actual output @ std
std cost Variance cost
R R R R R
Edu: 231 x 1200 = 277,200 128,520 (f) 0.7 x 483 x 1200 = 405,720 129,720 (u) 230 x 1200 = 276,000
Game: 252 x 2200 = 554,400 235,620 (u) 0.3 x 483 x 2200 = 318,780 231,220 (f) 250 x 2200 = 550,000
Total: 831,600 107,100 (u) 724,500 101,500 (f) 826,000
Usage = R5,600 (u)
OR
Usage variance = mix variance + yield variance = 107,100 (u) + 101,500 (f) = R5,600 (u)
44
(d)
Fixed overheads:
Budgeted cost Actual input @ std cost Actual output @ std cost
R R R
Edu: (280 x 960) = 268,800 4238 x 120 = 508,560 (230 x 960) = 220,800
Game: (120 x 1200) = 144,000 (250 x1200) = 300,000
Total: 412,800 520,800
Capacity variance = R95,760 (f) efficiency variance = R12,240 (f)

Decentralization and
Performance Evaluation
MAC3761
RELEVANT COSTING
RELEVANT AND NON-RELEVANT COSTS

The costs which should be used for decision making are often referred to as relevant costs.
KEY TERM
A relevant cost is a future cash flow arising as a direct consequence of a decision.
Relevant costs are future costs.
a) A decision is about the future; it cannot alter what has been done already. A cost that has been
incurred in the past is totally irrelevant to any decision that is being made ‘now’.
b) Costs that have been incurred include not only costs that have already been paid, but also costs
that are the subject of legally binding contracts, even if payments due under the contract have
not yet been made. (These are known as committed costs.)
Relevant costs are cash flows.
Costs or charges which do not reflect additional cash spending should be ignored for the purpose of decision
making. These include the following:
a) Depreciation, as a fixed overhead incurred.
b) Notional rent or interest, as a fixed overhead incurred.
c) All overheads absorbed. Fixed overhead absorption is always irrelevant since it is overheads to
be incurred with affect decisions.
Relevant costs are incremental costs.
A relevant cost is one which arises as a direct consequence of a decision. Thus, only costs which will differ
under some or all of the available opportunities should be considered; relevant costs are therefore sometimes
referred to as incremental costs.
Relevant costs are therefore future, incremental cash flows.
Other terms can be used to describe relevant costs.
2
KEY TERM
Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.
One of the situations in which it is necessary to identify the avoidable costs is in deciding whether or not to
discontinue a product. The only costs which would be saved are the avoidable costs, which are usually the
variable costs and sometimes some specific fixed costs. Costs which would be incurred whether or not the
product is discontinued are known as unavoidable costs.
KEY TERM
Opportunity cost is the benefit which could have been earned, but which has been given up, by choosing one
option instead of another.
Suppose for example that there are three mutually exclusive options, A, B and C. The net profit from each
would be R80, R100 and R70 respectively. Since only one option can be selected option B would be chosen
because it offers the biggest benefit.
R
Profit from option B 100
Less opportunity cost (i.e. the benefit from the most profitable alternative, A) 80
Differential benefit of option B 20
The decision to choose option B would not be taken simply because it offers a profit of R100, but because it
offers a differential profit of R20 in excess of the next best alternative.
Non-relevant costs
A number of terms are used to describe costs that are irrelevant for decision making because they are either
not future cash flows or they are costs which will be incurred anyway, regardless of the decision that is taken.
KEY TERM
A sunk cost is a cost which has already been incurred and hence should not be taken account of in decision
making.
An example of this type of cost is depreciation. If the fixed asset has been purchased, depreciation may be
charged for several years but the cost is a sunk cost, about which nothing can now be done.
KEY TERM
A committed cost is a future cash outflow that will be incurred anyway, whatever decision is taken now about
alternative opportunities.
Committed costs may exist because of contracts already entered into by the organisation, which it cannot get
out of.
KEY TERM
A notional cost or imputed cost is a hypothetical accounting cost to reflect the use of a benefit for which no
actual cash expense is incurred.
3
Example as in cost accounting systems include notional rent (such as that charged to a subsidiary of an
organisation for the use of accommodation which the organisation owns) or notional interest charges on
capital employed (sometimes made against a profit centre or cost centre).
Although historical costs are irrelevant for decision making, historical cost data will often provide the best
available basis for predicting future costs.
Fixed and variable costs
Unless you are given an indication to the contrary, you should assume the following:
a) Variable costs will be relevant costs.

b) Fixed costs are irrelevant to a decision.
This need not be the case, however, and you would analyse variable and fixed cost data carefully. Do not
forget that ‘fixed’ costs may only be fixed in the short term.
There might, however, be occasions when a variable cost is in fact a sunk cost. For example, suppose that a
company has some units of raw material in stock. They have been paid for already, and originally cost R2,000.
they are now obsolete and are no longer used in a special job which the company is trying to decide whether to
undertake. The special job is a ‘one-off’ customer order, and would use up all these materials in stock.
In deciding whether the job should be undertaken, the relevant cost of the materials to the special job is nil.
Their original cost of R2,000 is a sunk cost, and should be ignored in the decision.
However, if the materials did have a scrap value of, say, R300, then their relevant cost to the job would be the
opportunity cost of being unable to sell them for scrap, i.e. R300.
Attributable fixed costs
There might be occasions when a fixed cost is a relevant cost.
a) Directly attributable fixed costs are those costs which, although fixed within a relevant range of
activity level, or regarded as fixed because management has set a budgeted expenditure level (for
example advertising costs are often treated as fixed), would, in fact, do one of two things.
i) Increase if certain extra activities were undertaken

ii) Decrease/be eliminated entirely if a decision were taken either to reduce the scale of
operations or shut down entirely
b) General fixed overheads are those fixed overheads which will be unaffected by decisions to
increase or decrease the scale of operations. An apportioned share of head office charges is
an example.
You should appreciate that whereas directly attributable fixed costs will be relevant to a decision I hand,
general fixed overheads will not be.
EXAMPLE 1 : RELEVANT COSTS
A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the company.
Costs incurred to date in manufacturing the machine are R50 000 and progress payments of R15 000 had been
received from the customer prior to the liquidation. The sales department has found another company willing to
buy the machine for R34 000 once it has been completed. To complete the work, the following costs would be
incurred.
4
a) Materials: these have been bought at a cast of R6 000. They have no other use, and if the machine is
not finished, they would be sold for scrap for R2 000.
b) Further labour costs would be R8 000. Labour is in short supply, and if the machine is not finished, the
work force would be switched to another job, which would earn R30 000 in revenue, and incur direct
costs of R12 000 and absorbed (fixed) overhead of R8 000.
c) Consultancy fees R4 000. If the work is not completed, the consultant’s contract would be cancelled at
a cost of R1 500.
d) General overheads of R8 000 would be added to the cost of the additional work.
REQUIRED:
Assess whether the new customer’s offer should be accepted.
SOLUTION
a) Costs incurred in the past, or revenue received in the past are not relevant because they
cannot affect a decision about what is best for the future. Costs incurred to date of R50 000 and
revenue received of R15 000 should therefore be ignored.
b) Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of
materials affecting the decision is the opportunity cost of the revenue from scrap which would be
forgone – R2 000.
c)
R
Labour costs required to complete work 8 000
Opportunity costs: contribution forgone by losing other work
R(30 000 – 12 000) 18 000
Relevant cost of labour 26 000
d) The incremental cost of consultancy from completing the work is the difference between the cost
of completing the work and the cost of canceling the contract (R(4 000 – 1 500) = R2 500).
e) Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead
incurred is the only overhead cost to consider. General overhead costs (and the absorbed
overhead of the alternative work for the labour force) should be ignored.
f) Relevant costs may be summarized as follows:

R R
Revenue from completing work 34 000
Relevant costs
Materials: opportunity cost 2 000
Labour: basic pay 8 000
Opportunity cost 18 000
Incremental cost of consultant 2 500
Extra profit to be earned by accepting the 30 500

completion order 3 500
5
Identifying relevant costs
The relevant cost of materials
The relevant cost of raw materials is generally their current replacement cost unless the materials have
already purchased but will not be replaced. The relevant cost of using them will then be the higher of the
following:
 Their current resale value

 The value they would obtain if they were put to an alternative use
If the materials have no resale value and no other possible use, then the relevant cost of using them for the
opportunity under consideration would be nil.
The flowchart below shows how the relevant costs of materials can be identified, provided that the materials
are not in short supply and so have no internal opportunity cost.
Are the materials already

in stock, or contracted to
buy in a purchase
agreement?
Yes No
Are the materials Relevant cost =

regularly used, and future/current
replaced with fresh purchase cost of
supplies when materials
stocks run out?
Yes No
Relevant cost = Do the materials have an

future/current alternative use, or would
purchase cost of they be scrapped if not
materials used?
Scrapped if Other use available

not used
Relevant cost = Relevant cost =
scrap value/disposal higher of value in
value other use or scrap
value/disposal value
You should test your knowledge of the relevant cost of materials by attempting the following question.
6
QUESTION 1
Darwin Ltd has been approached by a customer who would like a special job to be done for him, and who is
willing to pay R22 000 for it. The job would require the following materials:
Material Total units Units already Book value of Realisable Replacement

required in stock units in stock value cost
R/unit R/unit R/unit
A 1 000 0 -- -- 6.00
B 1 000 600 2.00 2.50 5.00
C 1 000 700 3.00 2.50 4.00
D 200 200 4.00 6.00 9.00
Material B is used regularly by Darwin Ltd, and if units of B are required for this job, they would need to be
replaced to meet other production demand.
Materials C and D are in stock as the result of previous over buying, and they have a restricted use. No other
use could be found for material C, but the units of material D could be used in another job as substitute for 300
units of material E, which currently costs R5 per unit (and of which the company has no units in stock at the
moment).
REQUIRED:
Calculate the relevant costs of material for deciding whether or not to accept the contract.
ANSWER
a) Material A is not yet owned. It would have to be bought in full at the replacement cost of R6 per unit.
b) Material B is used regularly by the company. There are existing stocks (600 units) but if these are
used on the contract under review a further 600 units would be bought to replace them. Relevant costs
are therefore 1 000 units at the replacement cost of R5 per unit.
c) 1 000 units of material C are needed and 700 are already in stock. If used for the contract, a further
300 units must be bought at R4 each. The existing stocks of 700 will not be replaced. If they are used
for the contract, they could not be sold at R2,50 each. The realisable value of these 700 units is an
opportunity cost of sales revenue forgone.
d) The required units of material D are already in stock and will not be replaced. There is an opportunity
cost of using D in the contract because there are alternative opportunities either to sell the existing
stocks for R6 per unit (R1 200 in total) or avoid other purchases (of material E), which would cost 300 x
R5 = R1 500. Since substitution for E is more beneficial, R1 500 is the opportunity cost.
e) Summary of relevant costs

R
Material A (1 000 x R6) 6 000
Material B (1 000 x R5) 5 000
Material C (300 x R4) plus (700 x R2.50) 2 950
Material D 1 500
15 450
7
The relevant cost of using machines
Once a machine has been bought its cost is a sunk cost. Depreciation is not a relevant cost, because it is not
a cash flow. However, using machinery may involve some incremental costs. These costs might be referred
to as user costs and they include hire charges and any fall in resale value of owned assets, through use.
EXAMPLE 2 : THE RELEVANT COST OF USING MACHINES
Sydney Ltd is considering whether to undertake some contract work for a customer. The machinery required
for the contract would be as follows:
a) A special cutting machine will have to be hired for three months for the work (the length of the
contract). Hire charges for this machine are R75 per month, with a minimum hire charge of R300.
b) All other machinery required in the production for the contract has already been purchased by the
organisation on hire purchase terms. The monthly hire purchase payments for this machinery are
R500. This consists of R450 for capital repayment and R50 as an interest charge. The last hire
purchase payment is to be made in two months’ time. The cash price of this machinery was R9
000 two years ago. It is being depreciated on a straight line basis at the rate of R200 per month.
However, it still has a useful life which will enable it to be operated for another 36 months.
The machinery is highly specialized and is unlikely to be required for other, more profitable jobs
over the period during which the contract work would be carried out. Although there is no
immediate market for selling this machine, it is expected that a customer might be found in the
future. It is further estimated that the machine would lose R200 in its eventual sale value if it is
used for the contract work.
REQUIRED:
Calculate the relevant cost of machinery for the contract.
SOLUTION
a) The cutting machine will incur an incremental cost of R300, the minimum hire charge.
b) The historical cost of the other machinery is irrelevant as a past cost; depreciation is irrelevant as a
non-cash cost; and future hire purchase repayments are irrelevant because they are committed
costs. The only relevant cost is the loss of resale value of the machinery, estimated at R200
through use. This user cost will not arise until the machinery is eventually resold and the R200
should be discounted to allow for the time value of money. However, discounting is ignored here.
c) Summary of relevant costs
Incremental hire costs R300

User cost of other machinery R200
R500
8
QUESTION 2
A machine which originally cost R12 000 has an estimated life of ten years and is depreciated at the rate of R1
200 a year. It has been unused for some time, however, as expected production orders did not materialize.
A special order has now been received which would require the use of the machine for two months.
The current net realisable value of the machine is R8 000. If it is used for the job, its value is expected to fall to
R7 500. The net book value of the machine is R8 400.
Routine maintenance of the machine currently costs R40 a month. With use, the cost of maintenance and
repairs would increase to R60 a month.
Ignore the time value of money.
REQUIRED:
Calculate the relevant cost of using the machine for the order.
SOLUTION
R
Loss in net realisable value of the machine
through using it on the order R(8 000 – 7 500) 500
Costs in excess of existing routine maintenance costs R(120 – 80) 40
Total marginal user cost 540
Relevant cost of labour
Often the labour force will be paid irrespective of the decision made and the costs are therefore not
incremental. Take care, however, if the labour force could be put to an alternative use, in which case the
relevant costs are the variable costs of the labour and associated variable overheads plus the contribution
forgone from not being able to put it to its alternative use.
THE ASSUMPTIONS IN RELEVANT COSTING

If you make an assumption in answering an examination question and you are not sure that the examiner or
marker will appreciate or recognize the assumption you are making, you would explain it in narrative in your
solution.
Some of the assumptions that are typically made in relevant costing are as follows:
a) Cost behaviour patterns are known; if a department closes down, for example the attributable
fixed cost savings would be known.
b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with
certainty.
9
c) The objective of decision making in the short run is to maximize ‘satisfaction’, which is often
regarded as ‘short-term profit’.
d) The information on which a decision is based is complete and reliable.
LIMITING FACTOR ANALYSIS

One of the more common decision-making problems is a budgeting decision in a situation where there are not
enough resources to meet the potential sales demand, and so a decision has to be made about using what
resources there are as effectively as possible.
KEY TERM
A key factor or limiting factor is a scarce resource which limits the activity of an organisation.
There might be just one limiting factor (other than maximum sales demand) but there might also be several
scarce resources, with two or more of them putting an effective limit on the level of activity that can be
achieved. We shall concentrate on single limiting factor problems and a technique for resolving these.
A limiting factor could be sales if there is a limit to sales demand but any one of the organisation’s resources
(labour, materials, manufacturing capacity, financial resources and so on) may be insufficient to meet the level
of production demanded.
a) If sales demand is the factor which restricts greater production output, profit will be maximized by
making exactly the amount required for sales (and no more) provided that each product sold
earns a positive contribution.
b) If labour supply, materials availability, machine capacity or cash availability limits production to
less than the volume which could be sold, management is faced with the problem of deciding what to
produce and what should not be produced because there are insufficient resources to make
everything.
It is assumed in limiting factor accounting that management wishes to maximize profit and that profit
will be maximized when contribution is maximized (given no change in fixed cost expenditure incurred). In
other words, marginal costing ideas are applied.
Contribution will be maximizes by earning the biggest possible contribution per unit of limiting factor.
Thus if grade A labour is the limiting factor, contribution will be maximized by earning the biggest contribution
per hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by each
different product per unit of limiting factor. In limiting factor decisions, we generally assume that fixed
costs are the same whatever production mix is selected, so that the only relevant costs are variable
costs.
10
EXAMPLE 3 : LIMITING FACTOR
D Ltd makes two products, the B and the S. Unit variable costs are as follows:
B S
R R
Direct materials 1 3
Direct labour (R3 per hour) 6 3
8 7
The sales price per unit is R14 per B and R11 per S. During July the available direct labour is limited to 8 000
hours. Sales demand in July is expected to be 3 000 units for B and 5 000 units for S.
REQUIRED:
Determine the profit-maximising production levels, assuming that monthly fixed costs are
R20 000 and that opening stocks of finished goods and work in progress are nil.
SOLUTION
Step 1. Confirm the limiting factor is something other than sales demand.
B S Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3 000 units 5 000 units
Labour hours needed 6 000 hrs 5 000 hrs 11 000 hrs
Labour hours available 8 000 hrs
Shortfall 3 000 hrs
Step 2. Identify the contribution earned by each product per unit of scarce resource, that is per labour
hour worked.
B S
R’s R’s
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hrs
Contribution per labour hour (= unit of limiting factor) R3 R4
Although Bs have a higher unit contribution than Ss, two Ss can be made in the time it takes to make one B.
Because labour is in short supply it is more profitable to make Ss than Bs.
Step 3. Work out the budgeted production and sales. Sufficient Ss will be made to meet the full sales
demand, and the remaining labour hours available will then be used to make Bs.
a)
Product Demand Hours Hours Priority of
Required available manufacture
S 5 000 5 000 5 000 1st
B 3 000 6 000 3 000 (bal) 2nd
11 000 8 000
11
b)
Product Units Hours Contribution Total
Needed per unit R
R
S 5 000 5 000 4 20 000
B 1 500 3 000 6 9 000
8 000 29 000
20 000
9 000
Note that it is not more profitable to begin by making as many units as possible of the product with the bigger
unit contribution. We could make 3 000 units of B in 6 000 hours and 2 000 units of S in the remaining 2 000
hours but profit would be only R6 000. Unit contribution is not the correct way to decide priorities, because it
takes two hours to earn R6 from a B and one hour to earn R4 from a S. Ss make more profitable use of the
scarce resource, labour hours.
QUESTION 3
Twickers Ltd makes two products, widgets and splodgets, for which there is unlimited demand at the budgeted
selling prices. A widget takes three hours to make, and has a variable cost of R18 and a selling price of R30.
A splodget takes two hours to make, and has a variable cost of R10 and a selling price of R20. Both products
use the same type of labour, which is in short supply.
REQUIRED:
Determine the product which should be made to maximize profits, and describe the other considerations which
might alter your decision.
SOLUTION
We must rank the products in order of contribution earning capability per labour hour.
Widgets per Splodgets per

unit unit
R R
Sales price 30 20
Variable costs 18 10
Contribution 12 10
Hours per unit 3 2

Contribution R4 R5
Although widgets have the higher unit contribution, splodgets are more profitable because they make a greater
contribution per labour hour. Three splodgets (worth 3 x R10 = R30) can be made in the same time as two
widgets (worth only 2 x R12 = R24).
12
A profit-maximising decision would, therefore, be to produce splodgets only, given the assumptions made. It is
important to remember, however, that other considerations, so far excluded from the problem might alter the
decision.
a) Can the selling price of either product be raised, thereby increasing unit contribution, and the
contribution per labour hour, and also reducing demand? Since demand is apparently unlimited, it
would be reasonable to suspect that both products are underpriced.
b) Would a decision to make and sell only splodgets have a harmful effect on customer loyalty and
demand? To what extent are sales of each product interdependent? For example, a manufacturer of
knives and forks could not expect to cease production of knives without affecting demand for forks.
c) Would a decision to cease production of widgets have no effect on fixed costs? The assumption that
fixed costs are unaffected by limiting factor decisions is not always valid, and closure of either the
widgets or the splodgets production line might result in fixed cost savings. These savings would need
to be considered when making the product mix decision.
d) Will the decision affect the long-term plans of the company as well as the short term? If widgets are not
produced, it is likely that competitors will take over the markets vacated by Twickers Ltd. Labour skilled
in the manufacture of widgets will be lost, and a decision at a later date to re-open manufacture of
widgets might not be possible.
Limiting factor analysis and restricted freedom of action
In certain circumstances an organization faced with a limiting factor on production and sales might not be able
to produce the profit-maximising product mix because the mix and/or volume of products that can be
produced and sold is also restricted by a factor other than a scarce resource.
a) The organization might have contracted to supply a certain number of products to a customer.
b) The organization might have to produce and sell a minimum quantity of one or more of its products to
provide a complete product range and/or to maintain customer goodwill.
c) The organization might need to maintain a certain market share of one or more of its products.
In each of these cases, the organization might have to produce more of a particular product or products
than the level established by ranking according to contribution per unit of li8miting factor.
The basic approach to dealing with such situations is to rank the products in the normal way but the
optimum production plan must take into account the minimum production requirements. The
remaining resource must then be allocated according to the ranking.
Work carefully through the following example which illustrates this approach.
13
EXAMPLE 4 : RESTRICTED FREEDOM OF ACTION
Harvey Ltd is currently preparing its budget for the year ending 30 September 20X2. The company
manufactures and sells three products, Beta, Delta and Gamma.
The unit selling price and cost structure of each product is budgeted as follows:
Beta Delta Gamma

R R R
Selling price 100 124 32
Variable costs:
Labour 24 48 6
Materials 26 7 8
Overhead 10 5 6
60 60 20
Contribution per unit 40 64 12
Direct labour rate is budgeted at R6 per hour, and fixed costs at R1 300 000 per annum. The company has a
maximum production capacity of 228 000 direct labour hours.
A meeting of the board of directors has been convened to discuss the budget and to resolve the problem as to
the quantity of each product which should be made and sold. The sales director presented the results of a
recent market survey which reveals that market demand for the company’s products will be as follows:
Product Units
Beta 24 000
Delta 12 000
Gamma 60 000
The production director proposes that since Gamma only contributes R12 per unit, the product should no longer
be produced, and the surplus capacity transferred to produce additional quantities of Beta and Delta. The sales
director does not agree with the proposal. Gamma is considered necessary to complement the product range
and to maintain customer goodwill. If Gamma is not offered, the sales director believes that sales of Beta and
Delta will be seriously affected. After further discussion the board decided that a minimum of 10 000 units of
each product should be produced. The remaining production capacity would then be allocated so as to achieve
the maximum profit possible.
REQUIRED
Prepare a budget statement which clearly shows the maximum profit which could be achieved in the year
ending 30 September 20X2.
14
SOLUTION
Step 1. Ascertain whether labour hours are a scarce resource.
Units Labour hours Total labour

demanded per unit hours
Beta 24 000 4 (R24/R6) 96 000
Delta 12 000 8 (R48/R6) 96 000
Gamma 60 000 1 (R 6/R6) 60 000
252 000
Step 2. Rank the products.
Since only 228 000 hours are available we need to establish which product earns the greatest contribution per
labour hour.
Beta Delta Gamma

Contribution 40 64 12
Labour hours 4 8 1
Contribution per labour hour R10 R8 R12
Ranking 2nd 3rd 1st
Step 3. Determine a production plan.
The optimum production plan must take into account the requirement that 10 000 units of each product are
produced, and then allocate the remaining hours according to the above ranking.
Hours
Beta 10 000 units x 4 hours 40 000
Delta 10 000 units x 8 hours 80 000
Gamma 10 000 units x 1 hour 10 000
130 000
Gamma 50 000 units x 1 hour (full demand) 50 000
Beta 12 000 units x 4 hours (balance) 48 000
228 000
15
Step 4. Draw up a budget.
BUDGET STATEMENT
R
Contribution
Beta (22 000 units x R40) 880 000
Delta (10 000 units x R64) 640 000
Gamma (60 000 units x R12) 720 000
2 240 000
Fixed costs 1 300 000
Profit 940 000
16
QUESTION 4
Jam Ltd makes two products, the K and the L. The K sells for R50 per unit, the L for R70 per unit. The variable
cost per unit of the K is R35 that of the L R40. Each unit of K uses 2 kgs of raw material. Each unit of L uses 3
kgs of material.
In the forthcoming period the availability of raw material is limited to 2 000 kgs. Jam Ltd is contracted to supply
500 units of K. Maximum demand for the L is 250 units. Demand for the K is unlimited.
What is the profit-maximising product mix?
SOLUTION
K L
Contribution p0er unit R15 R30
Contribution per unit of limiting factor R15/2 = R7,50 R30/3 = R10
Ranking 2 1
Production plan Raw material used

Kg
Contracted supply of K (500 x 2 kg) 1 000
Meet demand for L (250 x 3 kg) 750
Remainder of resource for K (125 x 2 kg) 250
2 000
 Produce 250 units of L and 625 units of K.
Limiting factors and shadow prices
Whenever there are limiting factors, there will be opportunity costs. For example, suppose that a company
manufactures two items X and Y, which earn a contribution of R24 and R18 per unit respectively. Product X
requires 4 machine hours per unit, and product Y 2 hours. Only 5 000 machine hours are available, and
potential sales demand is for 1 000 units each of X and Y.
Machine hours would be a limiting factor, and with X earning R6 per hour and Y earning R9 per hour, the profit-
maximising decision would be as follows:
Units Hours Contribution

R
Y 1 000 2 000 18 000
X (balance) 750 3 000 18 000
5 000 36 000
Priority is given to Y because the opportunity cost of making Y instead of more units of X is R6 per hour (X’s
contribution per machine hour), and since Y earns R9 per hour, the incremental benefit of making Y instead of
X would be R3 per hour.
17
If extra machine hours could be made available, more units of X (up to 1 000) would be made, and an extra
contribution of R6 per hour could be earned. Similarly, if fewer machine hours were available, the decision
would be to make fewer units of X and to keep production of Y at 1 000 units, and so the loss of machine hours
would cost the company R6 per hour in lost contribution. This R6 per hour, the marginal contribution-earning
potential of the limiting factor at the profit-maximising output level, is referred to as the shadow price (or
dual price) of the limting factor.
KEY TERM
A shadow price is the increase in value obtainable from having available one additional unit of a limiting
resource at the original cost.
Note that the shadow price only applies while the extra unit of resource can be obtained at its normal variable
cost. The shadow price also indicates the amount by which contribution could fall if an organization is deprived
of one unit of the resource.
The shadow price of a resource is its internal opportunity cost. This is the marginal contribution towards
fixed costs and profit that can be earned for each unit of the limiing factor that is available. A knowledge of the
shadow price of a resource will help managers to decide how much it is worth paying to acquire another unit of
the resource.
Using limiting factor analysis
Limiting factor analysis provides us with a profit-maximising product mix, within the assumptions made. It is
important to remember, however, that other considerations might entirely alter the decision reached.
Qualitative factors
When a decision is being made, qualitative factors should be borne in mind.
Factor Examples
Demand Will the decision reached (perhaps to make and sell just one product rather than
two) have a harmful effect on customer loyalty and sales demand? For example,
a manufacturer of knives and forks could not expect to cease production of knives
without affecting sales demand for the forks.
Long-term Is the decision going to affect the long-term as well as the short-term plans of the
effects organization? If a particular product is not produced, or produced at a level below
sales demand, is it likely that competitors will take over vacated markets? Labour
skilled in the manufacture of the product may be lost and a decision to reopen or
expand production of the product in the future may not be possible.
Labour If labour is a limting factor, is it because the skills required are difficult to obtain,
perhaps because the organization is using very old-fashioned production
methods, or is the organization a high-tech newcomer in a low-tech area? Or
perhaps the conditions of work are so unappealing the people simply do not want
to work for the organization.
Other The same sort of questions should be asked whatever the limiting factor. If
limiting machine hours are in short supply is this because more machines are needed, or
factors newer, more reliable and efficient machines? If materials are in short supply,
what are competitors doing? Have they found an equivalent or better substitute?
Is it time to redesign the product?
18
Assumptions in limiting factor analysis
In the examples we have been looking at, certain assumptions have been made. If any of the assumptions are
not valid, then the profit-maximising decision might be different. These assumptions are as follows:
a) Fixed costs will be the same regardless of the decision that is taken, and so the profit-maximising and
contribution-maximising output level will be the same.
This will not necessarily be true, since some fixed costs might be directly attributable to a product or
service. A decision to reduce or cease altogether activity on a product or service might therefore result
in some fixed cost savings, which would have to be taken into account.
b) The unit variable cost is constant, regardless of the output quantity of a product or service. This
implies the following:
i) The price of resources will be unchanged regardless of quantity; for example, there will be no
bulk purchase discount of raw materials.
ii) Efficiency and productivity levels will be unchanged; regardless of output quantity the direct
labour productivity, the machine time per unit, and the materials consumption per unit will
remain the same.
c) The estimates of sales demand for each product, and the resources required to make each product,
are known with certainty.
In Example 3 – page 10, there were estimates of the maximum sales demand for the two products, and
these estimates were used to establish the profit-maximisng product mix. Suppose the estimates were
wrong? The product mix finally chosen would then either mean that some sales demand of the most
profitable item would be unsatisfied, or that production would exceed sales demand, leaving some
stock unsold. Clearly, once a profit-maximising output decision is reached, management will have to
keep their decision under continual review, and adjust their decision as appropriate in the light of actual
results.
d) Units of output are divisable, and a profit-maximising solution might include fractions of units as the
optimum output level.
Where fractional answers are not realistic, some rounding of the figures will be necessary.
MAKE OR BUY DECISIONS

A make or buy problem involves a decision by an organization about whether it should make a product or carry
out an activity with its own internal resources, or whether it should pay another organization to make the
product or carry out the activity. Examples include whether a company should manufacture its won
components, or else buy the components from an outside supplier.
The ‘make’ option should give management more direct control over the work, but the ‘buy’ option often
has the benefit that the external organization has a specialist skill and expertise in the work. Make or buy
decisions should certainly not be based exclusively on cost considerations.
If an organization has the freedom of choice about whether to make internally or buy externally and has no
scarce resources that put a restriction on what it can do itself, the relevant costs for the decision will be the
differential costs between the two options.
19
EXAMPLE 5 : MAKE OR BUY
Shellfish Ltd makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected to be
as follows:
W X Y Z
Production (units) 1 000 2 000 4 000 3 000
Unit marginal costs R R R R
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12
Directly attributable fixed costs per annum and committed fixed costs are as follows:
R
Incurred as a direct consequence of making W 1 000
Incurred as a direct consequence of making X 5 000
Incurred as a direct consequence of making Y 6 000
Incurred as a direct consequence of making Z 8 000
Other fixed costs (committed) 30 000
50 000
A subcontractor can supply units of W, X, Y and Z for R12, R21, R10 and R14 respectively.
REQUIRED:
Decide whether Shellfish Ltd should make or buy the components.
SOLUTION AND DISCUSSION
The relevant costs are the differential costs between making and buying, and they consist of differences
in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in
some fixed cost savings.
W X Y Z
R’s R’s R’s R’s
Unit variable cost of making 14 17 7 12
Unit variable cost of buying 12 21 10 14
R(2) R4 R3 R2
Annual requirements (units) 1 000 2 000 4 000 3 000
Extra variable cost of buying (per annum) (2 000) 8 000 12 000 6 000
Fixed costs saved by buying 1 000 5 000 6 000 8 000
Extra total cost of buying (3 000) 3 000 6 000 (2 000)
The company would save R3 000 pa by subcontracting component W (where the purchase cost would be less
than the marginal cost per unit to make internally) and would save R2 000 pa by subcontracting component Z
(because of the saving in fixed costs of R8 000).
20
Important further considerations would be as follows:
a) If components W and Z are subcontracted, the company will have spare capacity. How should that
spare capacity be profitably used? Are there hidden benefits to be obtained from subcontracting?
Would the company’s workforce resent the loss of work to an outside subcontractor, and might such a
decision cause an industrial dispute?
b) Would the subcontractor be reliable and delivery times, and would he supply components of the
same quality as those manufactured internally?
c) Does the company wish to be flexible and maintain better control over operations by making
everything itself?
d) Are the estimates of fixed cost saving reliable? In the case of Product W, buying is clearly cheaper
than making in-house. In the case of production Z, the decision to buy rather than make would only be
financially beneficial if the fixed cost savings of R8 000 could really be ‘delivered’ by management.
Make or buy decisions and scarce resources
A company might want to do more things than it has the resources for, and so its alternatives would be as
follows:
a) Make the best use of the available resources and ignore the opportunities to by help from outside.
b) Combine internal resources with buying externally so as to do more and increase profitability.
Buying help from outside is justifiable if it adds to profits. A further decision is then required on how to split the
work between internal and external effort. What parts of the work should be given to suppliers or sub-
contractors so as to maximize profitability?
In a situation where a company must sub-contact work to make up a shortfall in its own in-house
capabilities, its total costs will be minimized if those units bought have the lowest extra variable cost of
buying per unit of scarce resource saved.
This basic principle can be illustrated with a simple example.
EXAMPLE 6 : MAKE OR BUY DECISION WITH SCARCE RESOURCES
Seaman Ltd manufactures three components, S, A and T using the same machines for each. The budget for
the next year calls for the production and assembly of 4 000 of each component. The variable production cost
per unit of the final product is as follows:
Machine Variable
hours cost
R
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 20
100
Only 24 000 hours of machine time will be available during the year, and a sub-contractor has quoted the
following unit prices for supplying components: S R29; A R40; T R34.
21
REQUIRED:
Advise Seaman Ltd.
SOLUTION
The company’s budget calls for 36 000 hours of machine time, if all the components are to be produced in-
house. Only 24 000 hours are available, and so there is a shortfall of 12 000 hours of machine time, which is
therefore a limiting factor. The shortage can be overcome by subcontracting the equivalent of 12 000 machine
hours’ output to the subcontractor.
The assembly costs are not relevant costs because they are unaffected by the decision.
The decision rule is to minimize the extra variable costs of sub-contracting per unit of scarce resource
saved (that is, per machine hour saved).
S A T
R R R
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per hour saved R3 R23 R2.50
This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy S. The
priority for making the components in-house will be in the reverse order; S, then T, then A. There are
enough machine hours to make all 4 000 units of S (12 000 hours) and to produce 3 000 units of T (another 12
000 hours). 12 000 hours’ production of T and A must be sub-contracted.
The cost-minimising and so profit-maximising make and buy schedule is as follows:
Component Machine Number of Unit variable Total

hours units cost variable cost
used/saved R R
Make: S 12 000 4 000 20 80 000
T 12 000 3 000 24 72 000
24 000 152 000
But: T 4 000 1 000 34 34 000

A 8 000 4 000 40 160 000
12 000
Total variable cost of components, excluding assembly costs 346 000
22
QUESTION 5
TW Ltd manufactures two products, the D and the E, using the same material for each. Annual demand for the
D is 9 000 units, while for the E is 12 000 units.
The variable production cost per unit of the D is R10, that of the E R15. The D requires 3.5 kgs of raw material
per unit, the E requires 8 kgs of raw material per unit.
Supply of raw material will be limited to 87 500 kgs during the year.
A sub contractor has quoted prices of R17 per unit for the D and R25 per unit for the E to supply the product.
How many of each product should TW Ltd manufacture in order to maximize profits?
SOLUTION
D E
R per unit R per unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kgs 8 kgs
Extra variable cost of buying per kg saved R2 R1.25
Priority for internal manufacture 1 2
Production plan Material used

Kgs
 Make D (9 000 x 3.5 kgs) 31 500
E (7 000 x 8 kgs) 56 000
87 500
The remaining 5 000 units of E should be purchased from the contractor.
9 000 units of D and 7 000 units of E should be manufactured.
SHUTDOWN PROBLEMS
Shutdown problems involve the following type of decisions:
a) Whether or not to close down a factory, department, product line or other activity, either because it is
making losses or because it is too expensive to run.
b) If the decision is to shut down, whether the closure should be permanent or temporary.
Although in practice shutdown decisions will involve longer-term considerations (such as savings in annual
operating costs for a number of years), and capital expenditures and revenues (sales of fixed assets and
redundancy payments), it is possible for shutdown problems to be simplified into short-run decisions, by
assuming that either fixed asset sales and redundancy costs would be negligible or that income from fixed
asset sales would match redundancy costs and so these capital items would be self-cancelling. In such
circumstances the financial aspect of shutdown decisions would be based on short-run relevant costs.
23
EXAMPLE 7 : ADDING OR DELETING PRODUCTS
A company manufactures three products, Pawns, Rooks and Bishops. The present net annual income from
these is as follows:
Pawns Rooks Bishops Total

R R R R
Sales 50 000 40 000 60 000 150 000
Variable costs 30 000 25 000 35 000 90 000
Contribution 20 000 15 000 25 000 60 000
Fixed costs 17 000 18 000 20 000 55 000
Profit/loss 3 000 (3 000) 5 000 5 000
The company is concerned about its poor profit performance, and is considering whether or not to cease selling
Rooks. It is felt that selling prices cannot be raised or lowered without adversely affecting net income. R5 000
of the fixed costs of Rooks are direct fixed costs which would be saved if production ceased. All other fixed
costs, it is considered, would remain the same.
By stopping production of Rooks, the consequences would be a R10 000 fall in profits.
R
Loss of contribution (15 000)
Savings in fixed costs 5 000
Incremental loss (10 000)
Suppose, however, it were possible to use the resources realized by stopping production of Rooks and switch
to producing a new item, Crowners, which would sell for R50 000 and incur variable costs of R30 000 and
extra direct fixed costs of R6 000. A new decision is now required.
Rooks Crowners
R R
Sales 40 000 50 000
Less variable costs 25 000 30 000
15 000 20 000
Less direct fixed costs 5 000 6 000
Contribution to shared fixed costs and profit 10 000 14 000
It would be more profitable to shut down production of Rooks and switch resources to making Crowners, in
order to boost profits by R4 000 to R9 000.
Relative profitability
The relative profitability of products can be judged by calculation of their contribution to sales (C/S) ratios.
Suppose an organization produces three products A, B and C, and that production capacity is limited. If
product A has a C/S ratio of 22%, production B a C/S ratio of 27% and product C a C/S ratio of 25%, given
unlimited demand for the three products the organization should concentrate on producing product B.
Temporary closure
The decision whether to shut down temporarily should take into account the following factors:
 The impact on the organisation’s other products and the product in question
 Problems of recruitment of skilled labour when production begins again
 Possibility of plant obsolescence
 Problems of closing down and restarting production in some industries
 Expenditure on disconnection of services, start up costs and so on
24
If contribution is only just covering fixed costs but improved trading conditions in the future seem likely it
may be worth continuing the business.
Other considerations in such decisions
a) A product may be retained if it is providing a contribution, albeit a small one. Retaining a wide range of
low volume/low contribution products would add to the complexity and hence costs of
manufacture, however, but very little to overall profit. Low volume/low contribution products should
therefore be examined on a regular basis.
b) The effect on demand for other products if a particular product is no longer produced should be
taken into account.
c) The extent to which demand for other products (existing or new) can expand to use the capacity
vacated by the product being deleted is an issue.
d) Pricing policy. Is the product a loss leader? Is the product in the introductory stage of its life cycle
and consequently priced low to help it to become accepted and hence maximize its long-term market
share (penetration pricing).
Idle production capacity
If an organization does decide to shut down a factory, department, product line or other activity, it may well
be faced with a decision about what to do with the resulting idle production capacity.
a) Marketing strategies could be used to increase demand for existing products.
b) Idle plant and machinery could be moved to another department or factory, thereby reducing
expenditure on new plant and machinery and/or interest charges.
c) Special orders could be accepted, providing that the contribution generated is either greater than any
reduction in fixed overheads which would occur if the idle capacity was not used or greater than any
increase in fixed overheads if the idle capacity were to be used.
d) Space could be sub-let to a third party.
Such considerations are particularly important if the closure is only temporary.
EXTRA SHIFT DECISIONS AND OVERTIME

Extra shift decisions are another type of decision problem. They are concerned with whether or not it is
worth opening up an extra shift for operations.
Qualitative factors in extra shift decisions include the following:
a) Would the work force be willing to work the shift hours, and if so, what overtime or shift work
premium over their basic pay might they expect to receive?
b) Do extra hours have to be worked just to remain competitive? Banks might decide to open on
Saturdays just to match what competitors are doing and so keep customers.
25
c) Would extra hours result in more sales revenue, or would there merely be a change in the demand
pattern. For example, if a shop were trying to decide whether to open on Sundays, one consideration
would be whether the customers it would get on Sunday would simply be customers who would
otherwise have done their shopping on another day of the week instead, or whether they would be
additional customers.
When a business expands, the management is often faced with the problems of whether to acquire larger
premises and more plant and machinery and whether to persuade existing personnel to work longer hours
(on an overtime basis) or to engage extra staff who would use the existing equipment but a different time
(on a shift basis).
If the management decide to incur additional expenditure on premises and plant, that expenditure is a
fixed cost. It will therefore be necessary to determine how much additional contribution will be required
from the anticipated increased production to cover the extra fixed cost.
If it is decided to use the existing fixed assets, but for a longer period each day, the choice of shift working
or overtime will also involve a marginal costing consideration.
a) If overtime is selected, the direct wages cost per unit produced will be increased because the
wages paid to workers on overtime are a basic rate plus an overtime bonus.
b) If the management opt for shift working the shift premium may not be as expensive as the overtime
premium so the direct wages cost may be relatively lower. On the other hand, there may be an
increase in fixed (or semi-fixed) costs such as lighting, heating and canteen facilities.
ACCEPTING OR REJECTING ORDERS

In general terms, an order will probably be accepted if it increases contribution and profit, and rejected if it
reduces profit.
If an organization has spare capacity (which means that it would not have to turn away existing business), a
‘special’ (one-off) order (which is normally (in the exam) at a price below the normal price of the product),
should be accepted if the price offered makes some contribution to fixed costs and profit. In other words,
the variable cost of the order needs to be less than the price offered. Fixed costs are irrelevant to such a
decision since they will be incurred regardless of whether or not the order is accepted. Additional fixed costs
incurred as a result of accepting the order must be taken into account, however.
If an organization does not have sufficient spare capacity, existing business should only be turned away
if the contribution from the order is greater than the contribution from the business which must be
sacrificed.
26
EXAMPLE 8 : ACCEPTING OR REJECTING ORDERS
Holdup Ltd makes a single product which sells for R20, and for which there is great demand. It has variable
cost of R12, made up as follows:
R
Direct material 4
Direct labour (2 hrs) 5
Variable overhead 2
12
The labour force is currently working at full capacity producing a product that earns a contribution of R4 per
labour hour. A customer has approached the company with a request for the manufacture of a special order for
which he is willing to pay R5 500. The costs of the order would be R2 000 for direct materials, and 500 labour
hours will be required.
REQUIRED:
Decide whether the order should be accepted.
SOLUTION
a) Labour is a limiting factor. By accepting the order, work would have to be diverted away from the
standard product, and contribution will be lost, that is, there is an opportunity cost of accepting the new
order, which is the contribution forgone by being unable to make the standard product.
b) Direct labour pay costs R3 per hour, but it is also usually assumed that variable production overhead
varies with hours worked, and must therefore be spent in addition to the wages cost of the 500 hours.
c)
R R
Value of order 5 500
Cost of order
Direct labour (500 hrs x R3) 1 500
Variable overhead (500 hrs x R1) 500
Opportunity cost (500 hrs x R4) (Contribution forgone) 2 000
Relevant cost of the order 6 000
Loss incurred by accepting the order (500)
Although accepting the order would earn a contribution of R1 500 (R5 500 – R4 000), the lost production of the
standard product would reduce contribution earned elsewhere by R2 000 and so the order should not be
accepted.
Other considerations must also be taken into account, however.
a) Will relationships with existing customers, or prices that can be commanded in the market, be
affected if the order is accepted?
b) As a loss leader, could it create further business opportunities?
c) Should existing business be turned away in order to fulfil a one-off enquiry or could a long-term
contract be established?
27
QUALITATIVE FACTORS IN DECISION MAKING
Qualitative factors in decision making are factors which might influence the eventual decisions but which have
not been quantified in terms of relevant income or costs. They may stem from non-financial objectives and
from factors which might be quantifiable in money terms, but which have not been quantified, perhaps because
there is insufficient information to make reliable estimates.
Qualitative factors in decision making will vary with the circumstances and nature of the opportunity being
considered. Here are some examples:
Qualitative factor Detail
Availability of There must be sufficient cash to finance any purchases of equipment and build-up of
cash working capital. If cash is not available, new sources of funds (for example an
overdraft or loan) must be sought.
Inflation If the income from an opportunity is fixed by contract, but the costs might increase with
inflation, the contract’s profitability would be over-stated unless inflation is taken into
account.
Employees Any decision involving the shutdown of a plant or changes in work procedures or
location will require acceptance by employees, and ought to have regard to employee
welfare.
Customers Decisions about new products, the quality of output or after-sales service will inevitably
affect customer loyalty and customer demand. Remember that a decision involving
one product may have repercussions on customer attitudes towards a range of
products.
Competitors In a competitive market, some decisions may stimulate a response from rival
companies. The decision to reduce selling prices to raise demand may fail if all
competitors take similar action.
Timing factors There might be a choice in deciding when to take up an opportunity. There might also
be choice about whether a shutdown should be permanent or temporary. Temporary
closure may be a viable proposition during a period of slack demand. And if a decision
is taken to sell goods at a low price where the contribution earned will be relatively
small, it is important to consider the duration of the low price promotion. If it is a long-
term feature of selling, and if demand for the product increases, the company’s total
contribution may sink to a level where it fails even to cover fixed costs.
Suppliers Long-term goodwill may be damaged by a decision to close a product line temporarily.
Decisions to change the specifications for purchased components, or change
stockholding policies so as to create patchy, uneven demand might also put a strain on
suppliers.
Feasibility A proposal may look feasible, but technical experts or managers may have
reservations about their ability to carry it out.
Flexibility & Decisions to subcontract work, or to enter into a long-term contract, have the
internal control disadvantages of inflexibility and lack of controllability.
Unquantified Even where no opportunity costs are specified, it is probable that other opportunities
opportunity costs would be available for using the resources to earn profit.
Political Some large companies may suffer political pressures applied by the government to
pressures influence their investment or disinvestments decisions.
Legal constraints A decision might occasionally be rejected because of questions about the legality of
the proposed action.
28
The managing director of Parser Ltd, a small business, is considering undertaking a once-off contract and has
asked her inexperienced accountant to advise on what costs are likely to be incurred so that she can price at a
profit. The following schedule has been prepared:
Costs for special order:
Notes R
Direct wages 1 28 500

Supervisor costs 2 11 500
General overheads 3 4 000
Machine depreciation 4 2 300
Machine overheads 5 18 000
Materials 6 34 000
Total costs 98 300
Notes
1. Direct wages comprise the wages of two employees, particularly skilled in the labour process for this job,
who could be transferred from another department to undertake work on the special order. They are fully
occupied in their usual department and sub-contracting staff would have to be bought-in to undertake the
work left behind. Subcontracting costs would be R32 000 for the period of the work. Different
subcontractors who are skilled in the special order techniques are available to work on the special order
and their costs would amount to R31 300.
2. A supervisor would have to work on the special order. The cost of R11 500 is comprised of R8 000
normal payments plus R3 500 additional bonus for working on the special order. Normal payments refer
to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his
normal work amounting to R2 500. It is not anticipated that any replacement costs relating to the
supervisor’s work on other jobs would arise.
3. General overheads comprise an apportionment of R3 000 plus an estimate of R1 000 incremental

overheads.
4. Machine depreciation represents the normal period cost based on the duration of the contract. It is
anticipated that R500 will be incurred in additional machine maintenance costs.
5. Machine overheads (for running costs such as electricity) are charged at R3 per hour. It is estimated that
6 000 hours will be needed for the special order. The machine has 4 000 hours available capacity. The
further 2 000 hours required will mean an existing job is taken off the machine resulting in a lost
contribution of R2 per hour.
6. Materials represent the purchase costs of 7 500 kg bought some time ago. The materials are no longer
used and are unlikely to be wanted in the future except on the special order. The complete stock of
materials (amounting to 10 000 kg), or part thereof, could be sold for R4,20 per kg. The replacement cost
of material used would be R33 375.
7. Costs will be incurred evenly over the project duration of three months.
The prospective client is willing to make an upfront payment of R40 000. The outstanding balance
will be paid one month after completion. Because the business does not have adequate funds to finance the
special order, a bank overdraft shortfall will be required. The overdraft will be repaid on settlement of the
outstanding debt. The company uses a cost of capital of 15% to appraise projects. The bank’s overdraft rate is
12% for Parser Ltd.
29
The managing director has heard that, for special orders such as this, relevant costing should be used that also
incorporates opportunity costs. She has approached you to create a revised costing schedule based on
relevant costing principles.
REQUIRED
(a) Briefly explain what is meant by opportunity cost. ( 2)
(b) Determine the minimum price to be quoted by Parser Ltd on the once-off contract; an NPV approach is
not required. (16)
(c) Explain why very Small to Medium-size Enterprises (SMEs), such as Parser Ltd, might face problems in
obtaining appropriate sources of finance. In your answer pay particular attention to problems and issues
associated with:
(i) uncertainty concerning the business;

(ii) assets available to offer as collateral or security; and
(iii) potential sources of finance for very new SMEs, excluding sources from capital
markets. (12)
(ACCA – adapted)
30
QUESTION 6 : SOLUTION
Relevant costs imply future cash costs to be incurred or opportunity costs.
(a) Opportunity costs represent the value of the loss or sacrifice when choosing between scarce alternatives.
(2)
(b) Revised costs for the special order
Note R
Subcontractor costs 1 31 300 (1)

Supervisor – normal pay 2 0 (1)
– bonus 2 1 000 (1)
General overheads – opportionment 3 0 (1)
– incremental 3 1 000 (1)
Machine – depreciation 4 0 (1)
– maintenance 4 500 (1)
Machine overheads (18 000 + 4 000) 5 22 000 (2)
Materials 6 31 500 (1)
87 300
Interest costs 7 316 [5]
87 616
Notes:
1. The choice lies between the two subcontractor costs that have to be incurred because of the
shortage of existing labour. The minimum cost is to have subcontractors employed who are skilled
in the special process.
2. Only the difference between the bonus and the incentive payment represents an additional cost
that arises due to the special order. Fixed salary costs do not change.
3. Only incremental costs are relevant.
4. Depreciation is a period cost and is not related to the special order. Additional
maintenance costs are relevant.
5. The relevant costs are the variable overheads (R3 x 6 000 hours) that will be incurred, plus the
displacement costs of R2 x 2 000 hours making a total of R22 000.
6. Since the materials are no longer used the replacement cost is irrelevant. The historic cost of
R34 000 is a sunk cost. The relevant cost is the lost sale value of the stock used in the special
order which is: 7 500 kg x R4,20 per kg = R31 500.
7. Full opportunity costing will also allow for imputed interest costs on the incremental loan. The
correct interest rate is the overdraft rate since this represents the incremental cost the company will
pay. (1)
31
Incremental cash outflows (87 300 – 31 500) 55 800 (1)
18 600 (1)
– 40 000) x 2m x 12% = 316 (2)
The managing director should decide whether a profit margin should be added to take cognisance of the
required 15% cost of capital. (1)
(c) Uncertainty concerning the business
• Often not long in business, thus no track record.
• Activities may be changing to survive – uncertainty.
• Activities conducted in private.
• Accounts not necessarily audited.
• Accounts not published, drafted to satisfy owner(s).
Assets available to offer as collateral
• Banks consider a range of issues when screening loan applications, one of which is collateral or
security.
• Collateral is important because it can reduce the bank’s risk exposure.
• Risk will also reflect in the interest rate charged.
• Personal security from owner may not be possible – put his assets/finance in business.
• Business may simply be too young to have built up adequate assets.
Sources of finance
• Initial owner finance – capital or loans.
• Family connected finance.
• Trade credit finance, but very short term and expensive.
• Bank loan if adequate security can be arranged.
• Guarantees provided by reliable individual or other businesses to underpin a loan.
• Venture capital finance if particularly good prospects.

__
1 each, maximum 12
32
Pringle trades as a vat maker for the wine industry. His profit in this business during the year to
30 June was R20 000. Pringle also undertakes occasional contracts to build hand-crafted
cabinets, and is considering the price at which to bid for the contract to build five for an
exclusive furniture supplier, delivery to be in one year’s time. He has no other contract in
hand, or under consideration, for at least the next few months. If he accepts the contract it
will take up all his cabinet-making capacity for the next twelve months.
Pringle expects that if he undertakes the contract he would devote one-quarter of his time
to it. To facilitate this he would employ Smith, an unqualified accountant, to undertake his
book-keeping and other paperwork, at a cost of R12 000 per annum.
He would also have to employ on the contract one supervisor at a total cost of R22 000 and
two craftsmen at a total cost of R8 800 each. These costs include Pringle’s normal
apportionment of the fixed overheads of his business at the rate of 10% of labour cost.
Part of the finishing processes of the cabinets, involves applying a special varnish and
leaving the wood to absorb this. During this maturation time, one of the craftsmen could be
employed for the equivalent of up to three months full-time in maintenance and painting
work in the vat maker’s business. He would use additional materials not carried in inventory
costing R1 000. Pringle already has two inclusive quotations from jobbing repairmen for this
maintenance and painting work, one for R2 500 and the other for R3 500, the work to start
immediately.
The equipment which would be used on the cabinet contract was bought nine years ago
for R32 000. Depreciation has been written off on a straight-line basis, assuming a ten-year
life and a scrap value of R2 000. The current replacement cost of similar new equipment is
R70 000, and is expected to be R75 000 in one year’s time. Pringle has recently been offered
R5 000 for the equipment, and considers that in a year’s time he would have little difficulty in
still obtaining R3 000 for it. The plant is useful to Pringle only for contract work.
In order to build the cabinets Pringle will need six types of material, as follows:
No. of units Price per unit (R)
Material In stock Needed for Purchase Current Current

code contract price of purchase resale price
stock items price
A 100 800 1.50 3.00 2.00
B 1,200 1,000 2.00 0.90 0.90
C 200 6.00
D 100 200 4.00 3.00 2.00
E 50,000 5,000 0.48 0.20 0.20
F 1,000 3,000 0.90 2.00 1.00

33
- 34 -
Materials B and E are used regularly in the vat maker’s business. Material A could be sold
to a local sculptor if not used for the contract. Materials A and E can be used for other
purposes, such as property maintenance. Pringle has no other use for materials D and F,
the stocks of which are obsolete.
The cabinets would be crafted in a factory held on a lease with three years remaining at a
fixed annual rental of R7 000. It would occupy half of this factory, which is useful to Pringle
only for contract work.
Pringle anticipates that the direct expenses of the contract, other than those noted above,
would be R8 600.
Pringle has recently been offered a one-year appointment at a fee of R40 000 per annum
to manage a furniture manufacturing firm. If he accepted the offer, he would be unable
to take on the contract to build the five cabinets, or any other contract. He would have to
employ a manager to run the vat maker’s business at an annual cost (including fidelity
insurance) of R12 000, and would incur additional personal living costs of R3 000.
REQUIRED:
· Calculate the minimum price at which Pringle should be willing to take on the
contract in order to break even, based exclusively on the information given above.
(20)
· Set out any further considerations which you think that Pringle should take into
account in setting the price at which he would tender for the contract.
(10)
Ignore taxation. (30)

- 35 -
· The relevant costs of the contract are as follows:
Notes R R
Salary of Smith 12,000 (1)
Supervision cost a 20,000 (1)
Cost of craftsmen a 16,000 (1)
Reduction in second hand value c 2,000 (2)

of equipment
Material costs: d
· A (800 x R3) 2,400 (2)
· B (1 000 x R0.90) 900 (1)
· C (200 x R6) 1,200 (1)
· D (100 x R2) + (100 x R3) 500 (2)
· E (5 000 x R0.20) 1,000 (1)
· F (1 000 x R1) + (2 000 x R2) 5,000 11,000 (2)
Lease costs e 0 (1)
Other direct expenses 8,600 (1)
Owner’s opportunity cost f 25,000 (2)
94,600
Less savings on maintenance work b (1,500) (2)
Minimum contract price 93,100
(20)
- 36 -
· Some of the additional factors are:

·
i What is the likelihood that Pringle will obtain other contract work during the
year? If there is a possibility then any lost contribution should be covered in
the minimum contract price. (2)
ii Given that the profit was R20 000 last year, Pringle should consider closing
operations and obtaining a permanent salary of R40 000 per annum. (2)
iii Does any alternative uses for the leased factory space exist? If so then
appropriate opportunity cost should be added. (2)
iv The contract price represents a minimum price. Pringle should aim to earn a
surplus on the contract. (2)
v Will the loss of one-quarter of Pringle’s time to the existing business result in a
reduction in profit? If this is the case then the lost profits should be included
as an opportunity cost. (2)
(10)
(30)
NOTES
a The costs given in the question include apportioned fixed overheads which are
not a relevant cost. Therefore R2 000 has been deducted from the total
supervision cost (1/11 x R22 000) and R800 from each of the craftsmen’s total
costs.
b It is assumed that the contract could be completed and the maintenance

programme carried out during the same period in which the supervisor and
craftsmen are employed (one year). It is also assumed that the supervision and
craftsmen will be employed for one year only. A further assumption is that the
lowest quotation will be accepted.
Inclusive quote from jobbing repair man R2 500 less material (not carried in
inventory) to be bought if maintenance is to be done by craftsman R1 000 = net
saving of R1 500. (Salary of the craftsman is a sunken cost in this calculation.)
c The historical cost of the equipment is a sunk cost. It is assumed that the existing
equipment would have been sold if the contract was not accepted. Therefore
the relevant cost of using the equipment is the reduction in the scrap value over
the duration of the contract.
d Material A: It is assumed that the 100 units in stock will be used on property
maintenance first. This is more profitable than the alternative of selling the
materials for R2 and replacing them at a later date at R3. The quantities
needed for the contract will be replaced at the current purchase price.
Material B: It is assumed that the 1 000 units issued from stock for the contract will
be replaced at R0.90 per unit. This material is used regularly in the business.
Material C: This material is purchased specially for the contract.

- 37 -
Materials D and F: The stocks of these materials have no alternative use within
the business and will be sold if not used on the contract. Hence the sale price
represents the opportunity cost of using these materials. The remainder of the
materials will be purchased at current prices.
Material E: It is assumed that the material taken from stock for this contract will
be replaced at the current purchase price. This material is used regularly in the
business.
e The lease of the factory would have to be paid even of the contact were not
accepted.
f It is assumed that the alternative is for Pringle to pay out R15 000 to maintain the
existing business while he earns R40 000 on the one year appointment. If the
contract is undertaken then Pringle will lose R25 000.
2
Disney Limited manufactures Mickey Mouse and Donald Duck Murals for children’s bedrooms.
The following projected information for the 2014 financial year is supplied at a capacity utilisation of 100%:
1. Standards per unit:
Mickey Donald
Mouse Duck
R R
Raw material @ R9,60 per kg 12,00 4,80
Direct labour @ R9,00 per hour 18,00 12,00
Total overheads @ R8,40 per machine hour 16,80 21,00
Selling price per unit 49,20 37,20
2. It is anticipated that fixed overheads will amount to R144 000 per annum and will, at full capacity utilisation, be
applied at a rate of R2,40 per machine hour.
3. Market research has shown that 27 000 Mickey Mouse murals and 18 000 Donald Duck murals could be sold.
4. A shortage of skilled labour is being experienced. As a result, only 80 000 labour hours will be available.
5. Due to import restrictions, only 30 000 kg of raw material will be available.
REQUIRED:
(a) Determine the product mixture which will maximise the net income of Disney Limited for 2014. (19)
(b) Calculate the total marginal income that will be earned from Mickey Mouse murals if the selling price increases
by 10%, resulting in a decrease of 5% in the sales volume. Use the full market potential as a basis. Assume
that no limiting factors exist. ( 4)
(c) Calculate what the selling price per unit of the Donald Duck murals should be in order to earn a profit of
R126 000. Assume that the full market potential will be sold and that no limiting factors exist. Fixed overheads
must be applied at the same rate as in (a) above. ( 3)
3
Super Sport Products Ltd is a manufacturer of sport equipment. In order to compile the budget of the section
manufacturing cricket bats for children for the next financial year, a decision must be taken regarding the optimal
product mix.
Two models of cricket bats for children are being manufactured:
- the Hansie bat for use by older children, and

- the Johnty bat for use by younger children.
The standards per unit for each of the models are as follows:
Hansie bat Johnty bat

R R
Material 12,95 10,50
Direct labour
(@ R6 per hour) 18,00 6,00
Manufacturing overheads
(@ R3,50 per machine hour) 10,50 5,25
Selling price 45,00 25,00
1. Both bats are made from the same material, of which only 35 500 kilograms, at a total cost of R248 500, will be
available during the next financial year.
2. The following is an extract of the budget for manufacturing overheads:
Capacity utilisation Number of machine Total manufacturing

hours overheads
R
100% 50 000 158 075
90% 45 000 151 575
3. It is estimated that 11 000 Hansie bats and 14 500 Johnty bats could be sold annually.
4. Selling and administration expenses are fixed and amount to R15 000 per annum.
REQUIRED:
Determine the product mix which will maximise the net profit of the section for the next financial year.
(14)
4
Pecdu Limited manufactures two different electronic products, namely electronic igniters and vacuum
sensors.
The following is an extract of the budget for 2014:
Standards per unit::
Electronic Vacuum
igniters sensors
R R
Costs per unit:

Components 18,00 26,00
Direct labour 30,00 36,00
Overhead 7,20 9,30
Budgeted sales (units) 12 000 16 000
1. Components are acquired on a monthly basis. The supply is limited to a maximum of R53 500 per month.
2. The company employs 12 workers on the production line. Each employee has to work 170 hours per
month. Direct labour cost amounts to R40 per hour.
3. Fixed cost amounts to R235 200 per annum and is allocated to production at the rate of 15% of prime
cost (i.e. 15% of components and direct labour cost).
The company has been requested to give a quotation for an order of 5 000 electronic igniters. The order,
if accepted, must be delivered in full during the course of 2007.
If the order is accepted, it will not affect the normal annual demand for electronic igniters, as indicated in the
budget in point 2 above.
REQUIRED
(a) Determine the optimal product mixture in respect of the normal annual demand, assuming
that the order for 5 000 units is accepted. (25)
(b) Determine the number of units in respect of the normal annual demand which cannot be
manufactured due to the production of the 5 000 units for the order. (4)
(c) Calculate the marginal income relating to the units calculated in (b) above. (1)
[30]
[2007 UNISA assignment]

5
Hussle (Pty) Limited manufactures electrical kitchen equipment. One of its product lines is toasters. They currently
manufacture two types namely the two slice toaster and the four slice toaster.
Mr Robbs, the production manager, has extracted the following information regarding the manufacturing of toasters
for the month ended 28 February 2014 :
 Material
An analysis of the material requisitions shows the following apportionment of materials costs :
Two slice toaster : R372 810

Four slice toaster : R175 440
The value of material available per month amounts to R650 000.
 Labour
The production time per toaster was as follows :
Two slice Four slice

toaster toaster
Hours Hours
Skilled labour (@ R20 per hour) 0,5 0,9
Unskilled labour (@ R7 per hour) 1 1,5
The skilled labour cost is 40% fixed. The unskilled labour cost is 100% variable. There are 2 200 skilled
labour hours available per month.
 Overheads
Overheads are charged to production at a rate of 150% of the skilled labour cost per hour. The budgeted fixed
manufacturing overheads for the month amount to R20 640.
 Production
The following number of toasters were manufactured during the month :
Two slice toaster : 2 580

Four slice toaster : 860
No stock of finished products or work-in-process have been maintained.
 Sales commission
Sales commission of 1,5% is payable on all sales transactions.
 Future demand
According to estimate the demand for the next month will be 20% above the production of the month ended 28
February 2014. The current selling prices, which will remain unchanged, are as follows :
Two slice toaster : R280

Four slice toaster : R480
6
REQUIRED :
Determine the optimal product mixture which will maximise the income of Hussle (Pty) Limited for the month
ending 31 March 2014.
[31]

2
OPTIMISATION
INTRODUCTION
Optimisation is a technique which provides relevant information to

management in order to make strategic decisions with regards to the
optimum utilisation of scarce resources.
The primary objective, obviously, is to maximise profits. Profits are maximised

by maximising contribution or marginal income. The question is, how one
maximises contribution when faced with limited resources.
FACTORS OF PRODUCTION
Factors of production are the essential ingredients required to produce our

commodities. These factors include capital from owners, raw materials,
labour, water, land, etc.
(we will not deal with capital as a limiting factor)
UNERLYING ASSUMPTIONS
The assumptions are similar to those of Cost Volume Profit analysis, the most
important of which are:
 Cost relationships are linear.

 Units produced and resources allocated are infinitely divisible.
 Within the output range, the contribution per unit for each product and
the utilisation of resources per unit are the same irrespective of the
quantity produced or sold
In order to put things into perspective we will begin with a simple

illustration and thereafter build on
ILLUSTRATION 1
Assume a company manufactures 2 products, viz Elsi and Mate. Both
products require the same raw material which is called Sharp.
The following information is relevant to the products:
ELSI MATE
Demand (units) 300 200

Contribution per unit (R) 3 6
Kg of raw material required per unit (kg) 1,5 1
Assume that raw material sharp is available in unlimited quantities and so is

labour.
3
Which product(s) will you produce in order to maximise profits?
The question that needs to be asked is whether you have any limiting factors.
The possible limiting factors are raw material and labour. We have been told
that there are unlimited quantities available which means no limiting factors.
So I can produce all my required units.
Let’s calculate our total contribution should we produce all of Elsi and all of
Mate.
R
Elsi 300 x 3 900
Mate 200 x 6 1 200
Total contribution 2 100
Now, what if we faced with shortage of raw materials? Let’s say we only had
600 kg of sharp available.
Do we have a constraint? Let’s check.
Raw material required to produce 300 Elsi and 200 Mate:

kg
Elsi 1,5 kg x 300 450
Mate 1kg x 200 200
Required 650
Available 600
Shortage 50
We are 50 kg short which means we have a limiting factor. We cannot

produce everything.
With our objective in mind we will produce the one which renders the highest
contribution per unit, which in this case is Mate.
So if we produce all of Mate how much of Elsi can we make? Let’s check.
Kg
To produce 200 Mate 200 x 1kg 200
Available 600
Available to produce 400
Elsi
Once Mate has been produced only 400 kg are available to produce Elsi,
which means we can produce (400 ÷ 1,5) = 266 units of Elsi.
Let’s see what happens to our contribution:

R
Elsi 266 x 3 798
Mate 200 x 6 1 200
4
THE ABOVE TECHNIQUE IS SIMPLY CALLED LOGIC
Let’s move on:
We now introduce another resource in the form of labour.
Assume now that Elsi needs 1,2 hours to manufacture and Mate 1,5 hours. Also
assume for now that we only have 610 hours available.
Is labour a limiting factor? Let’s check.
Labour hours required to produce 300 Elsi and 200 Mate:
hours
Elsi 1,2 hrs x 300 360
Mate 1,5 hrs x 200 300
Required 660
Available 610
Shortage 50
Labour is a limiting factor. We are now faced with two limiting factors. What
do we produce?
With one limiting factor all we needed to look at was the total contribution.
With 2 limiting factors we need to look further. We will now compare the
contribution per limiting factor (also referred to as marginal income per
limiting factor).
Contribution per limiting factor
Material
ELSI MATE
Contribution per unit A R3,00 R6,00
Raw material required per unit (limiting factor) B 1,5kg 1kg
Contribution per unit of raw material required A÷B R2/kg R6/kg
Ranking 2 1
What this means is that for every kg of raw material used for Elsi I can earn R2
and for every kg of raw material used for Mate I can earn R6. Hence, this
limiting factor favours the production of Mate and is therefore ranked 1.
Let’s check labour.
ELSI MATE
Labour hours required per unit (limiting factor) B 1,2hrs 1,5hrs
Contribution per labour hour required A÷B R2,5/hr R4/hr
Ranking 2 1
Again I can earn more by employing more hours on mate. Labour also
favours the production of Mate.
5
So let’s produce all of Mate. Let’s see what happens.
Earlier we determined our position with regards to raw materials. We

determined that we could produce 200 units of Mate and 266 units of Elsi.
Let’s see what labour tells us.
Hours
To produce 200 Mate 200 x 1,5 hrs 300
Available 610
Elsi
Once Mate has been produced only 310 hours are available to produce Elsi,
Labour constraints dictate that we produce 258 units of Elsi while raw material
tells us 266. What do we make? What this means is that we have sufficient raw
material to make 266 units but we don’t have sufficient time to make 266
units. This means, we will have to settle for 200 of Mate and 258 of Elsi.
The above technique is called marginal costing and is used when the ranking
of limiting factors favours the same product.
Let us take the above scenario and change the given information so that the
ranking favours both products for the different limiting factors. Assume that
the amount of labour hours required to manufacture one unit of Mate is 2,5
hours. Let’s see what happens to the ranking:
Labour
ELSI MATE
Contribution per labour hour required A÷B R2,5/hr R2,4/hr
Ranking 1 2
And remember raw materials:

ELSI MATE
+Contribution per unit A R3,00 R6,00
Ranking 2 1
Labour favours the manufacture of Elsi while Raw materials favour the
manufacture of Mate. We call this conflicting ranking. In such a case we
have to resort to linear programming.
The above problem can be solved algebraically by solving simultaneous
equations.
6
The limiting factors form the basis of our equations.
Objective function: Maximise 3e + 6m
where : Elsi = e Mate = m
Parameters: 0 ≤ e ≤ 300
0 ≤ m ≤ 200
Raw 1,5e + 1m ≤ 600

material: ……1
Labour 1,2e + 2,5m ≤ 610
…...2
Take equation 1 and solve for m:

Alternative calc:
1,5e + 1m ≤ 600
1m ≤ 600 – 1 x 2.5 : 3.75e + 2.5m ≤ 1 500
1,5e (1.2e + 2.5m ≤ 610).
2.55e ≤ 890
Substitute in equation 2: e ≤ 349
1,2e + 2,5m ≤ 610 Limited to 300
1,2e + 2,5(600 – ≤ 610
1,5e)
1,2e + 1 500 – 3,75e ≤ 610
890 ≤ 2,55e
E ≤ 349
Note your parameters. The demand for Elsi is limited to 300 units which means
that we will produce 300 units of Elsi.
When one of the products is limited in production by its demand, then

substitute back into BOTH equations to determine the production of the other
product to ensure that both e and m fall within the limits specified in the
objective function. The production of the other product will be the lower of
the two possible solutions.
7
Substitute e = 300 into equation 1:

1,5e + 1m ≤ 600
M ≤ 600 –
1,5(300)
M = 150

1,2e + 2,5m ≤ 610
2,5m ≤ 610 –
1,2(300)
M = 100
Our optimum solution is 300 Elsi and 100 Mate
GENERAL STEPS IN SOLVING AN OPTIMISATION PROBLEM
Remember - NB!!!
 Limiting factor is just another word for a constraint! (Denoted below as
“LF” in order to save space)
 Marginal income and contribution mean the same thing! (Denoted
below as “MI” in order to save space)
 Please write the terms out in full in the exam – do not use “LF” or “MI”.
AT THE BEGINNING OF THE QUESTION YOU WILL ALWAYS:
 State the objective function (which is really to maximise total marginal

income).
 State the parameters
(we can usually only do the above after we have worked out marginal
income per unit in step 2 so leave a space for this at the beginning of your
question – a few lines needed)
EG:
The objective function is: maximise 5p + 30q,

Where p is the optimal production amount of product P.
Where q is the optimal production amount of product Q.
The limiting values of p and q have to be specified:

p ≥ 0 and p ≤ demand in units
q ≥ 0 and q ≤ demand in units
8
BASIC STEPS TO FOLLOW:
1. Identify potential constraints (these are factors of production that are

available in limited quantities).
2. Calculate marginal income (contribution) per unit for each product

(MI p.u. = SP p.u. – VC p.u)
NB: Split semi This may be provided in the question but usually you will have to
variable costs calculate it. Don’t forget to include ALL variable costs when
calculating your marginal income p.u. This includes variable selling and
admin expenses and variable portion of semi-variable costs.
3. Identify which of those potential constraints in 1 are actual constraints.

In order to do this you need to determine the following for each
potential constraint:
 the quantity required to meet demand

 the total quantity of the constraint that is available
 the shortage/surplus between required and available
4. If there is only one limiting factor use MI/ contribution per unit and
produce all of the product with the highest MI/contribution per unit.
(There will be no step 5 and 6).
If there is more than one limiting factor calculate the marginal income
(contribution) per limiting factor relating to each actual limiting factor
for each product.
= Marginal income (MI) per unit of product ÷ limiting factor (LF) per
unit of product
= MI per LF
This will give you some amount of Rands per LF.

EG: R/kg (if LF is amount of material in kg);
R/Machine Hour (if LF is no. of machine hours);
R/R (if LF is an amount that can be spent)
5. Rank the products according to their marginal income per limiting

factor (LF), for each actual LF. This is an indication of the product’s
profitability per LF; therefore the highest is ranked first.
NB! IT IS AT THIS POINT THAT YOU NEED TO DECIDE WHICH TECHNIQUE YOU
ARE USING (based primarily on your rankings): you can either use
marginal costing (if rankings favour the same product) or linear
programming (if rankings favour different products). Note that steps 1-5
are identical for both techniques.
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USING MARGINAL COSTING TECHNIQUES TO SOLVE OPTIMISATION QUESTIONS
When do we use marginal costing techniques?

We are able to use marginal costing techniques when there is only ONE
actual constraint, or, if there is more than one actual constraint, we use
marginal costing when the ranking of the different constraints favours the
SAME product.
6. Work out the optimal product mix (i.e. how much of each product you
will produce) using the ranking as determined above.
Keep in mind that you cannot produce more of a product than the amount
that is demanded of that product. Also remember that production will stop as
soon as one of the actual constraints has been exhausted despite a surplus of
the other constraints/LFs.
If you were required to calculate net profit from making the optimal product
mix, then you would simply subtract fixed costs from the total marginal
income (total contribution) earned. In this case the total marginal income
would be the marginal income per unit multiplied by the number of units in
the optimal product mix for each product.
OR
USING LINEAR PROGRAMMING TECHNIQUES TO SOLVE OPTIMISATION

QUESTIONS
When do we use linear programming techniques?
We use linear programming techniques if there is more than one actual

constraint AND the ranking of the different constraints favours DIFFERENT
products.
6. Express each actual constraint in terms of a linear equation.
[LF per unit of P x p] + [LF per unit of Q x q] ≤ total available LF
7. Solve the equations for the different constraints simultaneously in order

to establish the optimal product mix (i.e. we are solving for p and q).
substitute back into BOTH equations to determine the production of
the other product to ensure that both p and q fall within the limits
specified in the objective function. The production of the other
product will be the lower of the two possible solutions.
10
the other constraints.
1
ACTIVITY BASED COSTING
Reasons for the development of ABC.
The traditional cost accumulation system of absorption costing was developed in a

time when most organisations produced only a narrow range of products (so that
products underwent similar operations and consumed similar proportions of
overheads). And overhead costs were only a very small fraction of total costs,
direct labour and direct material costs accounting for the largest proportion of the
costs. The benefits of more accurate systems for overhead allocation would
probably have been relatively small. In addition, information processing costs were
high.
In recent years, however, there has been a dramatic fall in the costs of processing
information. And, with the advent of advanced manufacturing technology (AMT),
overheads are likely to be far more important and in fact direct labour may
account for as little as 5% of a product’s cost. It therefore now appears difficult to
justify the use of direct labour or direct material as the basis for absorbing overheads
or to believe that errors made in attributing overheads will not be significant.
Many resources are used in non-volume related support activities, (which have
increased due to AMT) such as setting-up, production scheduling, inspection and
data processing. These support activities assist the efficient manufacture of a wide
range of products and are not, in general, affected by changes in production
volume. They tend to vary in the long term according to the range and complexity
of the products manufactured rather than the volume of output.
The wider the rand and the more complex the products, the more support service
will be required. Consider, for example, factory X which produces 10,000 units of
one product, the Alpha, and factory Y which produces 1,000 units each of ten
slightly different versions of the Alpha. Support activity costs in the factory Y are
likely to be a lot higher than in factory X but the factories product an identical
number of units. For example, factory X will only need to set-up once whereas
factory Y will have to set-up the production run at least ten times for the ten
different products. Factory Y will therefore incur more set-up costs for the same
volume of production.
Traditional costing systems, which assume that all products consume all resources in
proportion to their production volumes, tend to all allocate too great a proportion of
overheads to high volume products (which cause relatively little diversity and hence
use fewer support services) and too small a proportion of overheads to low volume
products (which cause greater diversity and therefore use more support services).
Activity based costing (ABC) attempts to overcome this problem.
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i) Risks associated with running mobile clinics

• Mobile clinics run the risk of being removed/stolen and may require security
• The mobile units can be broken into during the night where supplies are stolen
• The costs of moving from area to area can be costly as the three units fulfil different
functions and must all move together.
• Damage to mobile units while in transit (Insurance)
• Government tends to delay payments. What if grants are not received timeously?
• Risk that the grant money is not utilised properly. The risk of fraud or corruption.
j) Effects and risks of HIV in the workplace

• People with HIV are singled out in the workplace and bear the risk of intimidation
• People with HIV are likely to fall ill, and this affects productivity
• Should a worker die of HIV, new workers need to be employed and trained. This comes at a
cost
• Companies, as part of their social responsibility, need to make regular testing available at
the work place at their own cost
• Should workers be working with sharp tools, etc there is a higher of contamination.
2
Definition of ABC
KEY TERM
Activity based costing (ABC) involves the identification of the factors
which cause the costs of an organisation’s major activities. Support
overheads are charged to products on the basis of their usage of the
factor causing the overheads.
The major ideas behind activity based costings are as follows :
(a) Activities cause costs. Activities include ordering, materials handling,

machining, assembly, production scheduling and despatching.
(b) Producing products creates demand for the activities.
(c) Costs are assigned to a product on the basis of the product’s consumption of
the activities.
Outline of an ABC system
An ABC system operates as follows :
Step 1. Identify an organisation’s major activities.
Step 2. Identify the factors which determine the size of the costs of an
activity/cause the costs of an activity. These are known as cost drivers.
KEY TERM
A cost driver is a factor which causes a change in the cost of an

activity.
3
Look at the following examples :
Costs Possible cost driver

Ordering costs Number of orders
Materials handling costs Number of production runs
Production scheduling costs Number of production runs
Despatching costs Number of despatches
Step 3. Collect the costs associated with each cost driver into what are known
as cost pools.
Step 4. Charge costs to products on the basis of their usage of the activity. A
product’s usage of an activity is measured by the number of the
activity’s cost driver is generates.
ILLUSTRATION
Which of the following definitions best describes a cost driver?
A Any activity which causes an increase in costs

B A collection of costs associated with a particular activity
C A cost that varies with production levels
D Any factor which causes a change in the cost of an activity
Answer
The correct answer is D.
Cost drivers
For those costs that vary with production levels in the short term, ABC uses volume-
related cost drivers such as labour or machine hours. The cost of oil used as a
lubricant on the machines would therefore be added to products on the basis of
the number of machine hours, since oil would have to be used for each hour the
machine ran.
Kaplan and Cooper argue that long-term variable overhead costs are related to
the transactions undertaken by the support departments where the costs are
incurred.
(a) Logistical transactions are those activities concerned with organising the flow
of resources throughout the manufacturing process.
4
(b) Balancing transactions are those activities which ensure that demand for and
supply of resources are matched.
(c) Quality transactions are those activities which relate to ensuring the
production is at the required level of quality.
(d) Change transactions are those activities associated with ensuring that
customers’ requirements (delivery date, changed design etc) are met.
These transactions in the support departments are the appropriate cost drivers to
use.
ABSORPTION COSTING VERSUS ABC
The following example illustrates the point that traditional cost accounting
techniques result in a misleading and inequitable division of costs between low-
volume and high-volume products, and that ABC can provide a more meaningful
allocation of costs.
EXAMPLE : ACTIVITY BASED COSTING
Suppose that Cooplan Ltd manufactures four products, W, X, Y and Z. Output and
cost data for the period just ended are as follows :
Number of
Direct
production Machine
Material labour
runs in the hours per
Output cost per hours per
period unit
units unit unit
R
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14
5
Direct labour cost per hour R5
Overhead costs costs

Short run variable R
3,080
Set-up costs 10,920
Expediting and scheduling 9,100
Materials handling costs 7,700
30,800
Required
Prepare unit costs for each product using conventional costing and ABC.
SOLUTION
Using a conventional absorption costing approach and an absorption rate for

overheads based on either direct labour hours or machine hours, the product costs
would be as follows :
W X Y Z Total
R R R R
Direct material R
200 800 2,000 8,000
Overheads * 700 2,100 7,000 21,000
950 3,050 9,500 30,500 44,000
* R30,800  440 hours = R70 per direct labour or machine hour.

6
Using activity based costing and assuming that the number of production runs is the
cost driver for set-up costs, expediting and scheduling costs and materials handling
costs and that machine hours are the cost driver for short-run variable costs, unit
costs would be as follows :
W X Y Z Total
R R R R
Direct material R
200 800 2,000 8,000
Short-run variable overheads 70 210 700 2,100
(WI) costs (W2)
Set-up 1,560 1,560 3,900 3,900
Expediting scheduling costs 1,300 1,300 3,250 3,250
(W3)
Materials handling costs (W4) 1,100 1,100 2,750 2,750
4,280 5,120 13,100 21,500 44,000
Workings
1 R3,080  440 machine hours = R7 per machine hour

Summary
Convention
al costing ABC unit Difference Difference in
unit costs cost per unit total
Product
R R R R
W 95 428 + 333 + 3,330
X 305 512 + 207 + 2,070
Y 95 131 + 36 + 3,600
Z 305 215 - 90 - 9,000
7
The figures suggest that the traditional volume-based absorption costing system is
flawed.
(a) It under-allocates overhead costs to low-volume products (here, W and X)

and over-allocates overheads to higher-volume products (here Z in
particular).
(b) It under-allocates overhead costs to smaller-sized products (here W and Y

with just one hour of work needed per unit) and over-allocates overheads to
larger products (here X and particularly Z).
ABC versus traditional costing methods
Both traditional absorption costing and ABC systems adopt the two stage allocation
process.
Allocation of overheads
ABC establishes separate cost pools for support activities such as despatching. As
the costs of these activities are assigned directly to products through cost driver
rates, reapportionment of service department costs is avoided.
Absorption of overheads
The principal difference between the two systems is the way in which overheads are
absorbed into products.
(a) Absorption costing most commonly uses two absorption bases (labour hours
and/or machine hours) to charge overheads to products.
(b) ABC uses many cost drivers as absorption bases (number of orders, number of
despatches and so on).
Absorption rates under ABC should therefore be more closely linked to the causes
of overhead costs.
8
Cost drivers
The principal idea of ABC is to focus attention on what causes costs to increase, ie
the cost drivers.
(a) Those costs that do vary with production volume, such as power costs, should
be traced to products using production volume-related cost drivers as
appropriate, such as direct labour hours or direct machine hours.
Overheads which do not vary with output but with some other activity should
be traced to products using transaction-based cost drivers, such as number
of production runs and number of orders received.
(b) Traditional costing systems allow overheads to be related to products in rather

more arbitrary ways producing, it is claimed, less accurate products costs.
9
ILLUSTRATION
A company manufactures two products, L and M, using the same equipment and
similar processes. An extract of the production data for these products in one
period is shown below::
L M
Quantity produced (units) 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60
Overhead costs R
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000
Required
Calculate the production overheads to be absorbed by one unit of each of the
products using the following costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb
overheads.
(b) An activity based costing approach, using suitable cost drivers to trace
overheads to products
Answer
(a) Traditional costing approach Direct labour

hours
Product L = 5,000 units x 1 hour 5,000

Product M = 7,000 units x 2 hours 14,000
19,000
 Overhead absorption rate = R285,000

19,000
= R15 per hour

10
Overhead absorbed would be as follows :

Product L 1 hour x R15 = R15 per unit
Product M 2 hours x R15 = R30 per unit
(b) ABC approach Machine hours
Product L = 5, 000 units x 3 hours 15,000

Product M = 7,000 units x 1 hour 7,000
22,000
Using ABC the overhead costs are absorbed according to the cost drivers.
Machine-hour driver costs 220,000 ÷ 22,000 m/c hours = R10 per m/c hour
Set-up driven costs 20,000 ÷ 50 set-ups = R400 per set-up
Order driven costs 45,000 ÷ 75 orders = R600 per order
Overhead costs are therefore as follows :
Product L Product M
R R
Machine-driven costs (15,000 hrs x R10) 150,000 (7,000 hours x 70,000
R10)
Set-up costs (10 x R400) 4,000 (40 x R400) 16,000
Order handling costs (15 x R600) 9,000 (60 x R600) 36,000
163,000 122,000
Units produced 5,000 7,000
Overhead cost per unit R32,60 R17,43
These figures suggest that product M absorbs an unrealistic amount of overhead

using a direct labour basis. Overhead absorption should be based on the activities
which drive the costs, in this case machine hours, the number of production run set-
ups and the number of orders handled for each product.
11
MERITS AND CRITICISMS OF ABC
As you will have discovered when you attempted the question above, there is
nothing difficult about ABC. Once the necessary information has been obtained it is
similar to traditional absorption costing. This simplicity is part of its appeal. Further
merits of ABC are as follows :
(a) 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.
(b) In a more competitive environment, companies must be able to assess

product profitability realistically. ABC facilitates a good understanding of what
drives overhead costs.
(c) In modern manufacturing systems, overhead 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 costs
and so it takes management accounting beyond its ‘traditional’ factory floor
boundaries.
Criticisms of ABC
It has been suggested by critics that activity based costing has some series flaws :
(a) Some measure of (arbitrary) cost apportionment may still be required at the
cost pooling stage for items like rent, rates and building depreciation.
(b) Can a single cost driver explain the cost behaviour of all items in its associated
pool?
(c) Unless costs are caused by an activity that is measurable in quantitative terms
and which can be related to production output, cost drivers will not be
usable. What drives the cost of the annual external audit, for example?
(d) ABC is sometimes introduced because it is fashionable, not because it will be

used by management to provide meaningful product costs or extra
information. If management is not going to use ABC information, as
absorption costing system may be simpler to operate.
(e) The cost of implementing and maintaining ABC system can exceed the
benefits of improved accuracy.
12
(f) Implementing ABC is often problematic. Recent journal articles have

highlighted the following issues :
(i) The incorrect belief that ABC can solve all an organisation’s problems.
(ii) Lack of the correct type of data.
(iii) Difficulty in determining appropriate cost drivers.
‘World wide adoption rates for ABC have peaked at 20 percent and a
declining number of firms are giving it further consideration’. (Tom Kennedy,
Financial Management, May 2000). Recent SA studies have found ABC
usage rates of about 25%, with larger organisation and service sector
companies being most likely to use it.
Other uses of ABC
The information provided by analysing activities can support the management

functions of planning, control and decision making, provided it is used carefully and
with full appreciation of it implications.
Planning
Before an ABC system can be implemented, management must analyse the

organisation’s activities, determine the extent of their occurrence and establish the
relationships between activities, products/services and their cost.
The information database produced from such an exercise can then be used as a
basis for forward planning and budgeting. For example, once an organisation has
set its budgeted production level, the database can be used to determine the
number of times that activities will need to be carried out, thereby establishing
necessary departmental staffing and machine levels. Financial budgets can then
be drawn up by multiplying the budgeted activity levels by cost per activity.
The activity-based approach may not produce the final budget figures but it can
provide the basis for different possible planning scenarios.
13
Control
The information database also provides an insight into the way in which costs are
structured and incurred in service and support departments. Traditionally it has
been difficult to control the costs of such departments because of the lack of
relationship between departmental output levels and departmental costs. With
ABC, however, it is possible to control or manage the costs by managing the
activities which underlie them by monitoring a number of key performance
measures.
Decision making
Many of ABC’s supporters claim that it can assist with decision making is a number
of ways :
 Provides accurate and reliable cost information

 Establishes a long-run product cost
 Provides data which can be used to evaluate different ways of delivering
business
It is therefore particularly suited to the following types of decision.
 Pricing
 Promoting or discontinuing products or parts of the business
 Redesigning products and developing new products or new ways to do business
Note, however, that an ABC cost is not a true cost, it is simply an average cost
because some costs such as depreciation are still arbitrarily allocated to products.
An ABC cost is therefore not a relevant cost for all decisions.
The traditional cost behaviour patterns of fixed cost and variable cost are felt by
advocates of ABC to be unsuitable for longer-term decisions, when resources are
not fixed and changes in the volume or mix of business can be expected to have
an impact on the cost of all resources used, not just short-term variable costs. A five-
level hierarchy has therefore been suggested to facilitate the analysis of costs.
Basis Costs are dependent on … Example

Level
1 Unit volume of production Machine power
2 Batch number of batches Set-up costs
3 Process existence of a process Quality control
4 Product existence of a product Product
14
As Innes and Mitchell (Activity Based Costing : A Review with Case Studies, CIMA
1990) say::
‘This analysis of cost highlights the decision level at which each element of cost can
be influenced. For example, the reduction of production cost levels will not imply
depend on a general reduction in output volumes, but also on reorganising
production to perhaps increase batch size and reduce batch volume, on
eliminating or modifying a process, on cutting out or merging product lines or on
altering or removing facility capacity’.
Raiborn et al explain how a product cost is determined using such an analysis :
‘Traditionally, accounting has assumed that if costs did not vary until changes in
production at the unit level, those costs were fixed rather than variable. Such an
assumption is not true. Batch level, product level, and organisational level costs are
all variable, but these types of costs vary for reasons other than changes in
production volume. For this reason, to determine an accurate estimate of product
or service cost, costs should be accumulated at each successively higher level of
costs. Because unit, batch and product level costs are all related to units of
products (merely at different levels), these costs can be gathered together at the
product level to match with the revenues generated by product sales.
Organisational level costs, however, are not product related and, thus, should only
be subtracted in total from net product revenues.’
Such an analysis provides an alternative method of determining product profitability

which may be used for management decision making.
For example, suppose an organisation was deciding whether to withdraw a

product. The withdrawal of the product could result in a reduction in the number of
some activities and hence in a cost saving. This cost saving might apply to unit
level, batch level and product level costs but not to facility costs, which represent
fixed infrastructure costs which would be incurred anyway.
Conclusion
‘It can offer considerable benefits to some companies but a decision to adopt ABC
should not be taken lightly. The staff time involved in developing and getting the
system into operation is conservatively estimated at tow person years, costs are at
least R100,000 though it depends on the system being implemented and the size of
the company.
It requires serious commitment of resources and top management support.

15
It is not a system that the accountant can do in his/her spare time.
Indeed it is not a system that should focus exclusively on the accountant. It is

common for a project team to develop the ABC system on which the accountant
can play a part, but not necessarily a dominating part.
Its implementation is not easy but is made easier by the availability of IT support
within the organisation. Existing IT facilities can make it possible, at little extra cost to
obtain useful cost driver data. There is now a range of PC based packages on
which to develop stand alone ABC systems, or they can be integrated with existing
system, though the former seem advisable at the prototype stage.
There are cases of companies claiming significant benefit from adopting ABC
(changing the way they do business) but also examples of companies trying but
rejecting the activity-based approach.
To be effective, cost management must be based on a sound knowledge of an

organisation’s cost structure, the proportion of it overheads, the degree of
competition, its information needs within the organisation, an appreciation of how
costs are determined and how they may be influenced. Only after consideration of
these factors can a judgement be made on the potential for an organisation of
ABC.’
Evaluating the Potential of Activity-Based Costing, Mike Tayles, ACCA Students’

Newsletter
16
LIFE CYCLE COSTING
What are life cycle costs?
A product’s life cycle costs are incurred from its design stage through development
to market launch, production and sales, and finally to its eventual withdrawal from
the market. The component elements of a product’s cost over its life cycle could
therefore include the following::
 Research & development costs

 The cost of purchasing any technical data required
 Training costs (including initial operator training and skills updating)
 Production costs
 Distribution costs
 Marketing costs
 Inventory costs (holding spare parts, warehousing and so on)
 Retirement and disposal costs
Life cycle costs can apply to services, customers and projects as well as to physical
products.
Traditional cost accumulation systems are based on the financial accounting year
and tend to dissect a products life cycle into a series of 12-month periods. This
means that traditional management accounting systems do not accumulate costs
over a product’s entire life cycle and do not therefore assess a product’s profitability
over its entire life. Instead they do it on a periodic basis.
Life cycle costing, on the other hand, tracks and accumulates actual costs and
revenues attributable to each product over the entire product life cycle. Hence the
total profitability of any given product can be determined.
KEY TERM
Life cycle costing is the accumulation of costs over a product’s entire life.
17
The product life cycle
Every product goes through a life cycle :
Introduction. The product is introduced to the market. Potential customers will be

unaware of the product or service, and the organisation may have to spend further
on advertising to bring the product or service to the attention of the market.
Growth. The product gains a bigger market as demand builds up. Sales revenues
increase and the product begins to make a profit.
Maturity. Eventually, the growth in demand for the product will slow down and it will
enter a period of relative maturity. It will continue to be profitable. The product
may be modified or improved, as a means of sustaining its demand.
Decline. At some stage, the market will have bought enough of the product and it
will therefore reach ‘saturation point’. Demand will start to fall. Eventually it will
become a loss-maker and this is the time when the organisation should decide to
stop selling the product or service.
The level of sales and profits earned over a life cycle can be illustrated
diagrammatically as follows :
Sales
profits
Sale
+
Time
Introduction Growth Maturity Declin
Profit
18
The horizontal axis measures the duration of the life cycle, which can last from, say
18 months to several hundred years. Children’s crazes or fad products have very
short lives while some products, such as binoculars (invented in the eighteenth
century) can last a very long time.
Problems with traditional cost accumulation systems
Traditional cost accumulation systems do not tend to relate research and

development costs to the products that caused them. Instead they write off these
costs on an annual basis against the revenue generated by existing products. This
makes the existing products seem less profitable that they really are. If research
and development costs are not related to the causal product the true profitability
of the product cannot be assessed.
Traditional cost accumulation systems usually total all non-production costs and
record them as a period expense.
The value of life cycle costing
With life cycle costing, non-production costs are traced to individual products over
complete life cycles.
(a) The total of these costs for each individual product can therefore be reported
and compared with revenues generated in the future.
(b) The visibility of such costs is increased.
(c) Individual product profitability can be more fully understood by attributing all
costs to products.
(d) As a consequence, more accurate feedback information is available on the

organisation’s success or failure in developing new products. In today’s
competitive environment, where the ability to produce new and updated
versions of products is paramount to the survival of an organisation, this
information is vita.
19
TARGET COSTING
To compete effectively in today’s competitive market, organisations must

continually redesign their products with the result that product life cycles have
become much shorter. The planning, development and design stage of a product
is therefore critical to an organisation’s cost management process. Considering
possible cost reductions at this stage of a product’s life cycle (rather than during the
production process) is now one of the most important issues facing management
accountants in industry.
Here are some examples of decisions made at the design stage which directly
impact on the cost of a product.
 The number of different components

 Whether the components are standard or not
 The ease of changing over tools
Japanese companies have developed target costing as a response to the problem

of controlling and reducing costs over the product life cycle.
KEY TERMS
Target costing involves setting a target cost by subtracting a desired

profit margin from a competitive market price.
Target cost is an estimate of a product cost which is determined by

subtracting a desired profit margin from a competitive market price.
This target cost may be less than the planned initial product cost but it
is expected to be achieved by the time the product reaches the
maturity stage of the product life cycle.
Target costing has its greatest impact at the design stage because a large
percentage of a product’s life cycle costs are determined by decisions made early
in its life cycle.
20
Case example
A number of countries including Holland, Sweden and Norway, have passed or

proposed legislation that will require manufacturing of certain goods to take back a
product at the end of its life for safe disposal or salvage. The European Commission
has also developed proposals to force manufacturers of electrical and electronic
goods to take back obsolete products.
Any requirements to take back products will affect post-production costs and
ultimately overall projected life cycle costs. To cut these costs, the design could, for
example, make the product easy to dismantle and its raw materials easy to recycle.
Or it may be possible to design a product for use over several life cycles rather than
just one. (Xerox has been doing this for several years.)
The technique requires managers to change the way they think about the
relationship between cost, price and profit.
(a) Traditionally the approach is to develop a product, determine the production

cost of that product, set a selling price, with a resulting profit or loss.
(b) The target costing approach is to develop a product, determine the market
selling price and desired profit margin, with a resulting cost which must be
achieved.
In ‘Product costing/pricing strategy’ (ACCA Students Newsletter, August 1999), the

examiner of the old syllabus Paper 9 provided a useful summary of the steps in the
implementation of the target costing process.
Step 1. Determine a product specification of which an adequate sales volume

is estimated.
Step 2. Set a selling price at which the organisation will be able to achieve a
desired market share.
Step 3. Estimate the required profit based on return on sales or return on

investment.
Step 4. Calculate the target cost = target selling price – target profit.
21
Step 5. Compile an estimated cost for the product based on the anticipated
design specification and current cost levels.
Step 6. Calculate cost gap = estimated cost – target cost.
Step 7. Make efforts to close the gap. This is more likely to be successful if
efforts are made to ‘design out’ costs prior to production, rather than to
control out costs during the production phase. (See Paragraph below.)
Step 8. Negotiate with the customer before making the decision about
whether to go ahead with the project.
When a product is first manufactured, its target cost may well be much lower than
its currently-attainable cost, which is determined by current technology and
processes. Management can then set benchmarks for improvement towards the
target costs, by improving technologies and processes. Various techniques can be
employed.
 Reducing the number of components  Using different materials

 Using standard components wherever  Using cheaper staff
possible
 Training staff in more efficient
techniques
 Acquiring new, more efficient
technology
 Cutting out non-value-added activities
(identified using activity analysis etc)
Even if the product can be produced within the target cost the story does not end
there. Target costing can be applied throughout the entire life cycle. Once the
product goes into production target costs will therefore gradually be reduced.
These reductions will be incorporated into the budgeting process. This means that
cost savings must be actively sought and made continuously over the life of the
product.
1
THE MANAGEMENT OF STOCKS
Almost every company carries stocks of some sort, even if they are only stocks of
consumables such as stationery. For a manufacturing business, stocks (sometimes
called inventories), in the form of raw materials, work in progress and finished goods,
may amount to a substantial proportion of the total assets of the business.
Some businesses attempt to control stocks on a scientific basis by balancing the

costs of stock shortages against those of stock holding.
The ‘scientific’ control of stocks may be analysed into three parts.
- The economic order quantity (EOQ) model can be used to decide the
optimum order size for stocks which will minimise the cost of ordering
stocks plus stockholding costs.
- If discounts for bulk purchases are available, it may be cheaper to buy

stocks in large order sizes so as to obtain the discounts.
- Uncertainty in the demand for stocks and/or the supply lead time may
lea a company to decide to hold buffer stocks (thereby increasing its
investment in working capital) in order to reduce or eliminate the risk of
‘stock-outs’ (running out of stock).
Stock costs
Stock costs can be conveniently classified into four groups:
- Holding costs comprise the cost of capital tied up, warehousing and
handling costs, deterioration, obsolescence, insurance and pilferage.
- Procuring costs depend on how the stock is obtained but will consist of
ordering costs for goods purchased externally, such as clerical cost,
telephone charges and delivery costs.
2
- Shortage costs may be:
the loss of a sale and the contribution which could have been earned
from the sale;
the extra cost of having to buy an emergency supply of stocks at a high

price;
the cost of lost production and sales, where the stock-out brings an entire
process to a halt.
- The cost of the stock itself, the supplier’s price or the direct cost per unit of
production, will also need to be considered when the supplier offers a
discount on orders for purchases in bulk.
Stock models
There are several different types of stock model, and these can be classified under
the following headings:
Deterministic stock models
A deterministic model is one in which all the ‘parameters’ are known with
certainty. In particular, the rate of demand and the supply lead time are
known.
Stochastic stock models
A stochastic model is one in which the supply lead time or the rate of
demand for an item is not known with certainty. However, the demand or
the lead time follows a known probability distribution (probably constructed
from a historical analysis of demand or lead time in the past).
In a deterministic system, since the demand and the lead time are known with
certainty, there is no need for a safety stock. However, in a stochastic model, it
may be necessary to have a buffer stock to limit the number of stock-outs or to
avoid stock-outs completely.
3
Stochastic models are sometimes classified as follows:
- A P system is a periodic review system in which the requirement for stock is

reviewed at fixed time intervals, and varying quantities are ordered on
each occasion, according to the current level of stocks remaining.
- A Q system is a re-order level system in which a fixed quantity is ordered at

irregular intervals, when stock levels have fallen to a re-order level specified
on the store-keeper’s records or ‘bin card'.
A deterministic model: the basic EOQ formula
The economic order quantity (EOQ) is the optimal ordering quantity for an item of
stock which will minimise costs.
Let D = the usage in units for one year (the demand)

Co = the cost of making one order
Ch = the holding cost per unit of stock for one year
Q = the re-order quantity
Assume that:
- demand is constant;
- the lead time is constant or zero;
- purchase costs per unit are constant (i.e. no bulk discounts).
The total annual cost of having stock (T) is
Holding costs + ordering costs
QCh + CoD
2 Q
The objective is to minimise T = QCh + CoD

2 Q
3.7 The order quantity, Q, which will minimise these total costs is:

CoD
Q Ch
=
4
Example: economic order quantity
The demand for a commodity is 40 000 units a year, at a steady rate. It costs R20 to
place an order, and 40c to hold a unit for a year. Find the order size to minimise
stock costs, the number of orders placed each year, and the length of the stock
cycle.
Solution
 
2Co 2 x 20 x 40
Q D = 000
= Ch 0,4
= 2 000 units
This means that there will be:
40 000 = 20 orders placed each year, so that stock cycle is once every 52 
20 = 2,6
2 000
weeks.
Total costs will be (20 x R20) + ( 2 000 x 40c) = R800 a year.

2
When the volume of demand is uncertain, or the supply lead time is variable,
there are problems in deciding what the re-order level should be. By holding a
‘safety stock’ a company can reduce the likelihood that stocks run out during
the re-order period (due to high demand or a long lead time before the new
supply is delivered). The average annual cost of such a safety stock would be:
Quantity of safety stock x Stock holding cost

(in units) per unit per annum
5
The behaviour of the system would appear in a diagram as in Figure 1.
Stock
level
x x x x
x x
Safety
stock
0
Time
Figure 1
Points marked ‘x’ show the re-order level at which a new order is placed. The
number of units ordered each time is the EOQ. Actual stock levels sometimes fall
below the safety stock level, and sometimes the re-supply arrives before stocks
have fallen to the safety level, but on average, extra stock holding amounts to
the volume of safety stock.
The size of the safety stock will depend on whether stock-outs (running out of
stock) are allowed.
Just-in-time (JIT) procurement

In recent years, there have been developments in the inventory policy of some
manufacturing companies which have sought to reduce their inventories of raw
materials and components to a low a level as possible. This approach differs from
other models, such as the EOQ model, which seek to minimise costs rather than
inventory levels.
Just-in-time procurement and stockless production are terms which describe a

policy of obtaining goods from suppliers at the latest possible time (i.e. when they
are needed) and so avoiding the need to carry any materials or components stock.
6
Introducing JIT might bring the following potential benefits:
- Reduction in stock holding costs

- Reduced manufacturing lead times
- Improved labour productivity
- Reduced scrap/rework/warranty cost
- Price reductions on purchased materials
- Reduction in the number of accounting transactions
Reduced stock levels mean that a lower level of investment in working capital will
be required.
JIT will not be appropriate in some cases. For example, a restaurant might find it
preferable to use the traditional economic order quantity approach for staple non-
perishable food stocks but adopt JIT for perishable and ‘exotic’ items. In a hospital,
a stock-out could quite literally be fatal and JIT would be quite unsuitable.
Total quality management

A system of just-in-time procurement depends for its success on a smooth and
predictable production flow, and so a JIT policy must also be aimed at improving
production systems, eliminating waste (rejects and reworked items), avoiding
production bottlenecks and so on. Many now argue that such improvements are
necessary for the introduction of advanced manufacturing technology (AMT) which
is necessary for long-term competitiveness.
Total quality management (TQM) is a management technique, derived from

Japanese companies, which focuses on the belief that ‘total quality is essential to
survival in a global market'.
The basic principle of TQM is that the cost of preventing mistakes is less than the cost
of correcting them once they occur plus the cost of lost potential for future sales.
The aim should, therefore, be to get things right first time consistently.
Two approaches to controlling quality and quality costs are as follows:
(a) Approach 1: minimise total quality costs by budgeting for a level of quality
which minimises prevention costs plus inspection costs on the one hand and
internal and external failure costs on the other.
7
(b) Approach 2: aim for zero rejects and 100% quality. The desired standard of
production is contained within the product specification and every unit
produced ought to achieve this standard; in other words, there ought to be
no defects. Zero-defect targets are one aspect of Japanese management
philosophy. However, the actual level of defects must be recorded and
reported, even if the quality costs are not measured.
There is a fundamental difference of view in the sense that Approach 1 accepts

some level of defects while Approach 2 takes the view that all defects are
undesirable. Eventually, as modern manufacturing systems are introduced and JIT
system are employed, Approach 1 is likely to result in the conclusion that the cost of
failure are so high (because they hold up production) that the only acceptable
quality standard is a zero defect limit (Approach 2).
8
Computex (Pty) Ltd is a supplier of computer equipment. Its premises are situated
nearby the local university. One of its products, a laptop computer selling at R4 900,
is very popular among the B Com students.
The company sells on average approximately 20 laptop computers per week. Sales
take place evenly throughout the year which consists of 50 weeks.
The company purchases the laptop computers at a cost of R3 430 each. The cost to
place an order amounts to R300 and orders are executed within 5 weeks.
Safety stock should amount to the sales requirement for 3 weeks.
Direct stockholding costs are R35,00 per unit and insurance on the laptop
computers amount to 10% of the unit cost per year.
The supplier has offered a quantity discount of 5% per laptop computer on orders of
150 units. The company implemented the economic order quantity model to
manage its inventory.
The current after tax cost of capital is 11% per annum, the current rate of inflation is
7% per annum and the current rate of taxation is 29%.
REQUIRED:
(a) Advise the management of the company whether they should accept the
special offer from the supplier. (20)
(b) Determine the re-order point for the laptop computers. (2)
(c) List any three implications if a quantity discount is accepted. (3)
[25]
9
Annual demand = 20 x 50 = 1 000 computers
Safety stock = 3 x 20 = 60 computers
Discounted unit price on special offer = R3 430 x 0.95 = R3 258.50
Current EOQ Special offer
Purchase price
1 000 x 3 430 3 430 000
1 000 x (3 258.50) 3 258 500
Order cost
29① x 300 8 700
7③ x 300 2 100
Carrying cost (35 + 60) x 515.20 39 928

2
(150 + 60) x 491.19④) 66 311

2
TOTAL COST 3 478 628 3 326 911
Therefore Computex should accept the new special offer which results in lower
costs.
10
Workings:
① Number of orders = annual demand
EOQ②
= 1 000
35
= 29 orders
② EOQ = 2 x annual demand x ordering cost per order

unit price x [interest on capital – inflation rate] + stockholding costs p.u. p.a.
100
= 2 x 1 000 x 300
3 430 x [11 – 7] + [35 + (10% x 3 430)].
100
= 600 000
515.20
= 34.13 = 35 units
③ Number of orders = annual demand

Order quantity
= 1 000
150
= 7 orders
④ Special offer carrying cost p.u. p.a.:
= unit price x [interest on capital – inflation rate] + stockholding costs p.u. p.a.
100
= (3 258.50) x [11 – 7] + [35 + (10% x 3 258.50)] = R491.19

100
11
(b) Reorder point = (normal demand x lead time) + safety stock

= (20 x 5) + (20 x 3)
= 160 units
(c)
- Higher carrying costs
- Lower acquisition costs
- Lower ordering costs
12
Comfyflex Ltd manufactures ladies sandals. The soles used to manufacture these
sandals are imported from a supplier based in Italy and local craftsman are
employed to hand stitch leather straps to these soles. Thirty thousand (30 000) soles
are required annually. The financial year consists of 260 working days.
The following information relates to the soles:
Ordering cost R300 per order

Purchase price R 75 per sole
Required rate of return after taxation 10%
Rate of taxation 28%
Safety stock 150 soles
Lead time 21 working days
In addition to the required rate of return, direct stockholding costs amount to R5 per
sole.
Comfyflex uses the economic order quantity model to manage inventory. The
Italian suppliers have offered Comfyflex a discount of 5% should they agree to place
20 orders per year.
Due to the fact that the Comfyflex premises is very small, in order to make use of the
discount offered by the Italian supplier, additional storage space would have to be
rented for R250 per month.
Required:
a) Calculate the re-order point under the current inventory model of

Comfyflex Ltd. ( 3)
b) Determine whether Comfyflex Ltd should accept the special offer. (20)
c) List three (3) assumptions underlying the economic order quantity model. ( 2)
[25]
13
a) Re-order point = (Demand per lead time x lead time) + safety stock
= (30 000 x 21) + 150

260
= 2 423 + 150
= 2 573 units
b)
EOQ Special Offer
Acquisition cost (75 x 30 000) R2 250 000

(75 x 30 000 x 95/100) R2 137 500
Ordering cost  (300 x 25) R7 500

(300 x 20) R6 000
Carrying cost R12,5 x (1 200/2 + 150) R9 375

 R10 912,50
Additional storage (250 x 12) R3 000

R2 266 875 R2 157 412,50
 Accept the special offer.
 EOQ =
2 x Annual demand x ordering cost per order
(Unit price x (interest on capital – inflation) + stockholding costs per unit per annum
100
14
=
2 x 30 000 x 300
(75 x (10 – 0) ) + 5
100
=
18 000 000
12.5
= 1 200 units
Number of orders = Annual demand

EOQ
= 30 000
1 200
= 25 orders
 ((R75 x 95/100) x (10 – 0) ) + R5

100
= 12.125
 R12.125 x (1 500 + 150) = R10 912,50

2
b)
 Demand is known and continuous.
 Load time is known and does not vary in length.
 Delivery of ordered stock takes place in one batch, etc.
15
Sparkle Limited is a manufacturer of pool cleaners and operates for 250 days per
annum.
The company currently purchases one of the components for the pool cleaner at a
cost of R35 per unit from Splash CC. Orders are executed within 15 days. The
demand for the component is 12 000 units per annum. There is no seasonal
fluctuation in the demand for the component. The company makes use of the
economic order quantity method to determine the number of units to be ordered.
Sparkle Limited requires safety stock of 70 units.
The cost to place an order amounts to R100 and delivery costs amount to R120 per
order. The company requires a 20% return on capital before taxation. In addition to
the required rate of return, direct stockholding costs, excluding annual insurance at
5% of the unit cost, amount to R5,50 per unit.
The company has been approached by Splash CC, offering a discounted price of
R25 per unit, provided that orders are placed in batches of at least 800 units each
and a delivery charge of R200 per order will be charged. The lead time for delivery
would remain 15 days. The ordering cost per order will remain the same, but
additional storage space of R50 000 per annum will be needed.
The current rate of taxation is 35% per annum.
Required:
a) Determine the number of orders to be placed annually, without taking the

special offer into account. (8)
b) Determine the re-order point for the component. (2½)
c) Determine whether the special offer should be accepted, or not. (13½)

[24]
16
Question 3:
(a) Number of orders = Annual demand / Order quantity

= 12 000 / 669
= 18 orders
EOQ = 2 x annual demand x ordering cost per order

Unit price (int on cap - inf) + stockholding cost per unit pa
= 2 x 12 000 x (100 + 120)

35 (20% x 65%) + 5.5 + (35 x 5%)
= 5 280 000
11.8
= 669 units
(b) Re-order point = (demand per time unit x lead time) + safety stock
= (12 000 / 250 x 15) + 70
= 790 units
(c) Current cost Special offer

Purchase price
(35 x 12 000), (25 x 12 000) 420 000 300 000
Ordering & delivery cost
(R220 x 18 orders) 3 960
(12 000 / 800 = 15 orders x R300) 4 500
Carrying cost
[R11.8 x (669/2 + 70)] 4 773
25 (20% x 65%) + 5.5 + (25 x 5%) = R10
[R10 x (800/2 + 70)] 4 700
Additional storage 50 000
Total cost 428 733 359 200
Saving if special offer is accepted: R428 733 - R359 200 = R69 533
Therefore accept the special offer.

1
MAC3761 : LEARNING CURVES
 Define the learning curve theory
 Discuss the limitations of the learning curve theory
 Calculate the learning curve applicable to a particular situation
 Make projections of the expected labour time for a particular project by

using the learning curve theory
2
People, when asked to repeat a task, often take less time to repeat the same
task when asked to do it again. This is the premise of learning curve theory.
The theory assumes that each time production quantity doubles, the
cumulative average time per unit will be a fixed percentage of the previous
cumulative average time per unit.
Illustration
If a first unit took 100 hours to complete, how long will it take to complete the
second unit if an 80% learning curve is applicable.
 First unit took 100 hours.

 80% learning curve applicable.
 Therefore it will take an average of 80 hours for units 1 and 2.
 Total hours taken = 80 X 2 = 160 hours.
 If first unit took 100 hours, second unit took 60 hours.
Illustration
Same as previous illustration but how long does it take to produce the third
and fourth unit.
 Average 80 hours for the first two units.

 Learning curve theory states that as production doubles, time goes down
by a fixed factor (which is 80% in this case.)
 Average time to produce first 4 units is 80% X 80 = 64 hours. (goes down by
that factor as production doubles)
 Total time taken = 64 X 4 = 256 hours to produce 4 units.
 Time taken to produce 2 units = 160 hours.
 Additional time taken to produce extra 2 units = 256 - 160 = 96 hours.
3
Determination and application of the learning curve
Wherever possible students should try to calculate the learning curve in a

tabular format. This tabular format can be expressed for our previous
illustration as follows:
Cumulative average time

Production output per unit Estimated total time
(number of units) Rounded to full hours (hours)
(1) (2) (3) = (1) X (2)
1 100 100
2 80(100 X 80%) 160
4 64(80 X 80%) 256
8 51 (64 X 80%) 408
16 41(51 X 80%) 656
32 33(41 X 80%) 1056
Thus if a question using a learning curve requires the amount of time for
producing the 24 units from unit 9 to 32, the number of hours can be easily
calculated by doing this table and subtracting 408 hours from 1056 hours.
It is very important to look out for these relationships when doing questions
concerning learning curves.
However a question may require the difference in time between units 13 and
29. As these units are not found on the table, the learning curve has to be
calculated algebraically.
The formula is as follows:

y = axb
(or it may be restated as log y = log a + b log x)
where:
y= cumulative average time per unit
a= the number of hours required for the first unit
x= the cumulative number of units
b= log l
log 2
l= the learning curve applicable i.e. if it is a 80 % learning curve, l = 0.8.

4
Illustration
Using the above formula, if 32 units have been produced, use the formula to
determine the number of hours.
b = log 0.8
log 2
= 0.3219
y = axb
= 100 X 32-0.3219
= 33 rounded (which is the same figure as found in the table)
To determine total hours, the following formula is used:
Total hours = ax
Illustration
To determine the total hours it would take for 32 units in the above example,
the calculations would be as follows:
Total hours = 100 X 32
= 100 X 32
= 1049
Example 1 (From Vigario)
If the first unit takes 40 hours and a 80% learning curve exists, calculate the
average time, total time and marginal time to produce the first 10 units.
The solution Is shown in part 4.
To determine the learning curve tempo, if two figures on the curve are
known.
5
If there is one gap between items such as between 33 and 41, the learning
tempo is calculated as follows:
LT = 33
41
= 0.8 i.e. 80 % learning curve
If there are two gaps between items such as between 33 and 51, a square
root is needed. The learning tempo is calculated as follows:
LT = 33 / 51
= 0.6471
= 0.8 i.e. 80 % learning curve.
LEARNING CURVE THEORY APPLICATIONS
1. Handy aid in the estimation of direct labour hours

2. More realistic estimates of labour and labour related costs.
3. Tenders for new contracts are more realistically priced
4. Handy model for production planning
5. Useful when scheduling personnel
6. Important financial model inter alia in the preparation of budgets,
establishing standards and variance analysis.
ADVANTAGES OF THE LEARNING CURVE THEOREM
1. It provides insight into the ability of workers to learn new skills.

2. It is useful to compare the performance of employees with estimated
performance.
3. Brings quantitative and behavioral aspects of labour management
together.
4. Information made available so that management can set up a incentive
wage system.
6
DISADVANTAGES OF THE LEARNING CURVE THEOREM
1. It is unlikely in practice that the regularity depicted by the learning curve

will exist.
2. After a period of time, workers will repeat the process identically each
time.
3. It cannot be used for establishing standards if:
 labour turnover is high
 extensive design modifications take place
 a big time gap occurs between orders
EXAMINATION CONSIDERATIONS
1. It is important to remember that the learning curve applies only to direct

labour and to variable overhead costs which use a direct function of
labour hours per input.
2. Look for variables of 1, 2, 4, 8, 16, 32, 64, 128, 256 or 512 when doing a
question as you may be able to do the question using the table rather
than using logs.
7
ANSWER TO EXAMPLE 1
Cumulative
Production production Average time Total time Marginal
time
1 1 40 40 40
1 2 32 64 24
1 3 28.1 84.3 20.3
1 4 25.6 102.4 18.1
1 5 23.86 119.3 16.9
1 6 22.46 134.8 15.5
1 7 21.4 149.7 14.9
1 8 20.48 163.8 14.1
1 9 19.71 177.4 13.6
1 10 19.06 190.6 13.2
LEARNING CURVE CLASS EXAMPLE 1 (UNISA)

a) Time to complete first unit = 20 hours
Learning curve rate = 20%
REQUIRED
Calculate the total time to complete 16 units (in minutes)
b) Time to complete first unit = 40 hours

Learning curve = 90%
REQUIRED
Calculate the average time for the first 4 units
c) Time to complete first unit = 20 hours

Time to complete second unit = 16 hours
REQUIRED
Calculate the learning curve ratio

8
d) The following information is available:
Lot size - 10 units

Learning curve - 90%
Time to complete first lot - 300 minutes
REQUIRED
i) Calculate the cumulative average time per unit if 16 lots are

produced.
ii) Calculate the total cumulative time if 16 lots are produced.
e) Use the same information as in question 1d.
Assume that the variable cost, subject to the learning curve, consists of
direct labour and associated overheads of R150 per hour.
REQUIRED
Calculate the predetermined cost to manufacture 16 units.
f) The production time to complete the first 4 units of a new product

“Zozo” was as follows:
1st unit 1 600 hours

2nd unit 1 280 hours
3rd unit 1 184 hours
4th unit 1 120 hours
An order for an additional 12 units “Zozo” was received.
REQUIRED
Calculate the budgeted production hours to execute the order.

9
a) Time 1st unit = 20 hours

Average time 1st 8 units (12,8 x 0,8) = 10,24 hours)
Total time for first 16 units
8,192 hours x 16 units = 131,072 hours
131,072 hours x 60 minutes/hour = 7864,32 minutes
b) Time first unit = 40 hours

c) Learning curve ratio = Total labour time for first 2 units/

(Total labour time for first unit x 2)
= (20 + 16)/(20 x 2)
= 36/40
d)
CUMULATIVE PRODUCTION TIME IN MINUTES
Number of Number of units Cumulative average Total cumulative time

lots (lot size = 10) per unit
1 10 (10 x 1) 30* 300

2 20 (10 x 2) 27 (90% x 30) 540 (20 x 27)
4 40 (10 x 4) 24,3 (90% x 27) 972 (40 x 24,3
8 80 (10 x 8) 21,87 (90% x 24,3) 1 749,6 (80 x 21,87)
16 160 (10 x 16) 19,683 (90% x 21,87) 3 149,3 (160 x 19,683)
* (300/10) = 30
10
e)
CUMULATIVE PRODUCTION CUMULATIVE AVERAGE COST CUMULA- ADDITIONAL
PER UNIT TIVE COST CUMULATIVE
COST
Number Number of units
of lots (lot size = 10)
1 10 (10 x 1) 30 min x R2,50* = R75 750 750

2 20 (10 x 2) 27 min x R2,50 = R67,50 1 350** 600
4 40 (10 x 4) 24,3 min x R2,50 = R60,76 2 430 1 080
8 80 (10 x 8) 21,87 min x R2,50 = R54,68 4 374 1 944
16 160 (10 x 16) 19,683 min x R2,50 = R49.21 7 874 3 500
* (R150/60 = R2,50 per minute)

** (20 x R67,50) = R1 350)
f) Calculation of learning curve
Number of Cumulative Average time % of previous

hours time (hours)
lst unit 1 600 1 600 1 600 90%

2nd unit 1 280 2 800 1 440
3rd + 4th unit 90%
(1 184 + 1 120) 2 304 5 184 1 296
Calculation of the budgeted production hours for 12 additional items
Average time for first 4 units 1 296,00

Average time for first 8 units 1 166,40 (90% of 1 296)
Average time for first 16 units 1 049,76 (90% of 1 166,4)
Total time for first 16 units 16 796,16 (1 049,76 x 16)

Total time for first 4 units ( 5 184,00
11 612,16
=======
Budgeted production hours for 12 additional units are 11 612 hours.

11
Bakstaan Limited is a large company operating a number of divisions. The

company started a new division recently which manufactures masts for
sailing boards.
The manufacturing cost for the first four masts were :
R
Direct labour (61,47 hours at R5 per hour) 307,35
Raw material cost 56,00
Overheads 226,00
588,35
=====
Overheads
Indirect raw material 16,00

Indirect labour 12,30
Depreciation 196,70
Direct labour hours are as follows:
First unit 16,00 hour

Second unit 15,36 hour
Third unit 15,25 hour
Fourth unit 14,85 hour
An order of 200 units was received after a display at the Rand Easter show.
The four units already being manufactured will be held for viewing purposes.
The management’s objective is to recover all direct cost plus a profit of 25%
on the selling price.
12
REQUIRED
Calculate the tender price per mast.
(UNISA - adapted)
Hint
Use the formula
Log y = log a + b x
where y = Average time for n units
b = Log of learning curve/Log z
x = Total number of units (in this question 204)
a = Time for first unit

13
Learning curve - 2 units = (16 = 15,36/(2 x 16)
= 31,36/32
= 0,98
Test
Learning curve - 4 units = 61,46/64
= 0,98
Total time for 204 units :
Log y = Log a + b log x
= Log 16 (Log 0,98/Log z) x Log 204
= 1,2041 + [0,9 912 - 1)/0,30 103] x 2,3096)
= 1,13682
Antilog of 1,13682 = 13,7031 hours
Hours
 Total time for 204 units (204 x 13,7031) 2 795,43

Less: Time for first units 61,46
Time required for 200 additional units 2 733,97

======
14
Budgeted turnover - 200 masts

R
Direct labour (2733.97 x R5) 13 669,85

Raw material cost (56/4) x 200 2 800,00
Overheads - raw material (16/4) x 200 800,00
Indirect raw material (21,30/61,46) x 2733,97 547,15
Depreciation - recognised as an indirect cost - _
Direct cost (0,75) 17 817,00

Profit (0,25) 5 939,00
23 756,00
========
Selling price per unit
Budgeted turnover/Production volume
= 23 756/200
= R118,78
15
Alpha Limited manufactured 25 identical machines. The costs were as

follows :
Material 26 193,80
Labour (474,9 hour @ R23/hour) 10 922,70
Overheads (474,0 hour @ R15/hour) 7 123,50
Total cost @ R1 769,60 per machine 44 240,00

========
Overheads = 60% variable
An analysis of the labour hours resulted in the following :
- Time to manufacture the first unit: 33,5 hours

- Time to manufacture the second unit: 25,8 hours
An order for 10 additional identical machines was received.
REQUIRED
Calculate the selling price for the 10 additional machines if a profit of 20% on
selling price is required.
(UNISA)
16
ALPHA LIMITED
Calculation of labour hours:
(1) Test for learning factor (LF)
- At 2 units (first doubling)
33,5 + 25,8
33,5 x LF = 2
 LF = 0,88507
- At 25 units (not a cumulative doubling - make use of logs)
y = axb
474.9 log LF
log 25 = log 33,5 + log2 x log 25
log LF
1,27868 = 1,52504 + 0,30103 x 1,39794
1, 27868 - 1,52504
logLF = 1,39794 x 0,30103
logLF = 0,05305
antilog = T,94695
LF = 0,088501
= 0,885
= 88,5%
17
(2) Calculation of labour hours required for 10 additional units
Total number of units = 35
(Make use of logarithm seeing that is it not a cumulative doubling)
y = axb
log 0,885
log y = log 33,5 + log 2 x log 35
-1 + 0,94694
= 1,52504 + 0,30103 x 1,54407
= 1,52504 - 0,27216
= 1,25288
y = 17,901
Total time requires for 35 units = 35 x 17,901
= 626,54
Less: time for 25 units 474,9
 Additional time 10 units 151,64
CALCULATION OF SELLING PRICE
R26193,80 R
Raw material 25 x 10 10 478
Labour 151,64 x R23 3 488

Overheads 151,64 x (60% x R15) 1 365
Total cost 15 331 ( 80%)
Profit - 20% on selling price 3 833 ( 20%)
Selling price 19 164 (100%)

===== =====
Selling price per unit R1 916,40

18
IPM (Pty) Limited manufactures luxury sports cars. The company recently
started manufacturing a new model of which, to date, two units have been
completed and sold. The manufacturing costs for these two units were as
follows:
R
Material 200 000
Overhead 120 000
Overhead is 40% fixed, 60% of which relates to manufacturing overhead.

Fixed manufacturing overhead is allocated to production on the basis of
direct labour costs. Organisational overhead is allocated to production
departments on the basis of sales values.
Variable overhead consists of manufacturing overhead only. Forty per cent

(40%) of the overhead is variable to material cost and 60% is variable to
direct labour costs.
The direct labour hours taken for the manufacturing of the first two sports cars
were as follows:
First car : 160 hours

Second car : 144 hours
This trend is similar to that experienced in the manufacturing of similar sports

cars. According to experience, the trend will last for the manufacturing of
the first thirty-two sports cars.
An order for another six of these sports cars has been received. The price of
material and labour increased by the following percentages since the
manufacturing of the first two sports cars:
Material : 10%
Direct labour : 15%
REQUIRED:
Determine the price at which each of the six sports cars should sell at if the
company wants to recovery only directly related manufacturing costs
and earn a total profit of R500 000. (15)
Calculations must be rounded off to four decimals. Final figures (hours or

Rands), must, however, be rounded off to the nearest whole figure.
19
IPM (PTY) LIMITED
Selling price per sports car
R
Material ( R200 000 x 6 x 1,1) 660 000
2
Direct labour ( R80 000 x 793 x 1,15) 239 987

304 2
Variable overheads variable to:
- material (R120 000 x 60% x 40% x 660 000) 95 040

200 000
- direct labour (R120 000 x 60% x 60% x 239 987) 129 593
80 000
Fixed manufacturing overheads (R120 000 x 40% x 60% x 239 987) 86 395
80 000
Total manufacturing cost for 6 cars 1 211 015

Profit 500 000
Sales 1 711 015
Selling price per sports car (R1 711 015) 285 169
6
( 9)
Calculations:
1 Learning curve
Learning curve = Cumulative average time per unit x 100

= (160 + 144) ÷ 2 x 100

160 1
= 95% ( 2)
20
2 Labour hours required for next six sports cars
Total time for eight cars
Cumulative average time p.u. at level of 8 units = 0,953 x 160 hours

= 137,18 hours
Hours
Total time for 8 sports cars (137,18 x 8) 1 097,44
Less: Time for first two sports cars (160 + 144) 304
Time for next six sports cars 793,44
Rounded to nearest whole hours 793

21
Stylish Modes (Pty) Limited designs and manufactures exclusive dresses.
An order was received from a nation-wide chain of boutiques for 16 identical

dresses of an original design. These dresses will be sold by “Boutique for You”,
a chain of boutiques, situated in all the major centres.
1. The direct labour costs, at R6 per hour, to manufacture the first two dresses
is as follows:
R
First dress 150
Second dress 120
270
An increase of 10% in wage rates was agreed upon, and is applicable to

the manufacture of the remaining 14 dresses.
2. The designer earns R5 760 per month, and designs approximately 18 new
creations during the course of a month.
3. Each dress will require 4,5 metres of material, at a factory cost of R17 per
metre.
4. It was estimated that sundry items, like decorative trimmings, buttons and
cotton, will amount to R7 per dress.
5. The following basis was determined to allocate the replacement and

maintenance costs of the machines used:
- Sewing machines : at R0,50 per direct labour hour
- Overlockers : at R0,75 per direct labour hour
6. Monthly fixed costs of the company amount to R7 550, of which the

above order should bear 2%.
7. The learning curve is expected to be maintained throughout the

complete order’s manufacture.
8. Stylish Modes (Pty) Limited intends selling the dresses to the chain of
boutiques at R420 each.
22
REQUIRED:
Calculate the total net income expected to be earned from the order.
Do not use logarithms.
Round all rand values off to the nearest rand. (15)

23
STYLISH MODES (PTY) LIMITED

Expected total net income earned from the order
R
Sales (R420 x 16) 6 720
Direct material (4,5 x R17 x 16) 1 224
Direct labour [(R270 + (217,4411 x R6 x 1,1)] 1 705
Design cost (R5 760) 320
18
Sundry items (R7 x 16) 112
Machine costs allocated
general sewing machines (262,442 x R0,50) 131
overlocking machines (262,442 x R0,75) 197
Fixed costs (2% x R7 550) 151

Total expected net income from the order 2 880
(15)
Calculations:
(a) Learning curve
1Learning curve = Cumulative average time per unit x 100

[ (R150 + R120)  2 ]
[( 6 6 ) ]
= __________________ x 100
R150 1
6
= [ (25 + 20)  2] x 100

25 1
= 90%
24
2. Calculation of hours for 16 dresses
No. of Doubling Learning Cumulative Total time

dresses curve average
time per
dress
1 -- 90%1 25,0000 25,00

2 1 90%1 22,50003 45,007
4 2 90%1 20,25004 81,008
8 3 90%1 18,22505 145,809
16 4 90%1 16,40256 262,4410
OR
Hours
Total hours for 16 dresses  4th doubling
Average time ( 0,90)4 x 25 16,4025

 Total time (16,4025 x 16) 262,4400
3. 90% x 25 = 22,5
4. 90% x 22,5 = 20,25
5. 90% x 20,25 = 18,225
6. 90% x 18,225 = 16,4025
7. 22,5 x 2 = 45
8. 20,25 x 4 = 81
9. 18,225 x 8 = 145,8
10. 16,4025 x 16 = 262,44
11. Calculation of hours for the next 14 dresses

Hours
Total hours for 16 dresses (per 2. above) 262,44
Less: Time for the first 2 dresses (25 + 20) 45,00
Total hours for the next 14 dresses 217,44

25
Technologies (Pty) Limited manufactures and sells combined fax and

telephone answering machines. In order to tender for a specific contract,
the technical team of the company has developed a new model called
FXAN. To date, two units of FXAN have been manufactured and are being
used as demonstration models.
The following information is available:
1. Direct labour hours taken to manufacture the first two units:
Hours
First unit 60
Second unit 48
2. The following average direct variable costs relate to the manufacture of

the first two units of FXAN:
R
Per unit
Material 620
Labour 440
Variable overheads 324
1 384
3. Since the first two units were manufactured, material costs have increased
by 10% and labour costs by 5%.
4. Variable overheads – variable per labour hour: R6.
5. Fixed costs incurred solely for the manufacture of FXAN units: R9 254.
6. Fixed costs of the enterprise are apportioned to products at a rate of 10%

of labour costs.
7. It is expected that the learning curve will be maintained for the

manufacture of the first 32 units of FXAN.
26
REQUIRED:
(a) Calculate the learning rate. ( 2)
(b) Calculate the minimum selling price per unit that the enterprise can quote
on a contract for 30 units in order only to recover direct costs, and earn a
profit of 25% on the selling price. Ignore all costs relating to the
manufacture of the first 2 units. (11)
Round final hours to the nearest hour and rands to the nearest rand.
27
(a) Learning rate = Cumulative average time per unit .
Previous cumulative average time per unit

= (60 + 48) hours  2
60 hours
= 54
60
= 0.90 ( 2)
(b) Calculation of minimum selling price per unit
R
Direct costs for 30 units:
Material (30 x R620 x 1,10) 20 460
Labour (R440 x 2 x 1 0261 x 1,05) 8 778

1081
Direct variable overheads (R6 x 1 0261) 6 156
Direct fixed costs (R9 254 x 30) 8 676

32
Total direct costs (75%) 44 070
Profit (25%) 14 690
Sales (100%) 58 760
Selling price per unit (R58 760) 1 959

30
Note: Fixed costs apportioned do not form part of direct costs and are,
therefore, not taken into account.
28
Calculation:
1
Direct labour hours needed for order Hours
Average time p.u. needed for 32 units (0,90)5 x 60 35,43
Total time needed for 32 units (35,43 x 32) 1 133,74

Less: Total Time for first two units (60 + 48) 108,00
Time needed for the next 30 units 1 025,74

(11)
29
Vanegill, a new division of Wilgredon Ltd, has just started manufacturing

motorised water-skis, and to date has manufactured and sold four motorised
water-skis. Fund in the Sun Enterprises is interested in purchasing 12 of these
water-skis for a resort at the Vaal Dam, and would like a quote from Vanegill.
The variable manufacturing costs for the first four water-skis were as follows :
R
Direct labour at R55 per labour hour 16 896
Direct material costs 92 840
Overheads (variable at 40% direct labour hours, and 60% 68 200
raw material costs)
 The total direct labour hours to manufacture the first unit were 120 hours,
and the total direct labour hours to manufacture the first two units were
192 hours.
 Fixed production overheads solely for the manufacture of the first 32

water-skis amount to R64 000.
 Organisational overheads of the enterprise are to be apportioned at a

rate of 5% of direct labour costs.
 Raw material costs have increased by 10% since the first four units were
produced.
 It is expected that the learning rate will be maintained for the

manufacture of the first 32 units.
REQUIRED :
(a) Calculate the learning curve. (3)
(b) Calculate the minimum selling price per unit that the company can
quote for the 12 water-skis in order to recover the relevant costs and
earn a profit of 35% based on the cost price. (17)
30
(c) State the limits between which a learning curve may vary and briefly
explain the significance of each limit. (2)
Logarithms may NOT be used.
In general, hours must be rounded off to 3 decimals. Final hours must,

however, be rounded off to the nearest hour. All other calculations must be
rounded off to the nearest rand or unit.

31
QUESTION 4 : SUGGESTED SOLUTION
VANEGILL:
Total time for the first unit = 120 hours

Total time for the first two units = 192 hours (therefore time for the second unit
was 192 – 120 = 72 hours)
(a) learning curve = cumulative average time per unit x 100

previous cumulative average time per unit
= (192 ÷ 2) x 100
120
= 80%
(b)
Cumulative average time per unit for the first 16 units
= (0.8)4 x 120 = 49.152 hours
OR
Apply the learning curve at each level of doubling:

120 x 0.8 = 96 hours
96 x 0.8 = 76.8 hours
76.8 x 0.8 = 61.44 hours
61.44 x 0.8 = 49.152 hours
Total time for the first 16 units = cumulative av. time per unit for
= 49.152 x 16
= 786.43 hours
≈ 786 hours
Cum. average time per unit for the first 4 units

= (0.8)2 x 120 = 76.8 hours
Total time for the first 4 units

= cumulative av. time per unit for
= 76.8 x 4
= 307.20 hours
≈ 307 hours
32
Therefore the total time to manufacture the 12 units in the order:
Hours
Total time for the first 16 units 786
Less: total time for the first 4 units (307)
Total time for 12 units in order 479
We only want to recover relevant costs. The apportioned overheads are not
relevant but the fixed portion of overheads incurred solely for the
manufacture of the water-skis are relevant. The direct labour, direct materials
and variable overheads are all relevant.
Cost of the order R
Direct material: 92,840 x 1.1 x 12 306,372

4
Direct labour: 55 x 479 26,345
Variable o/h (var. to labour hours): 68,200 x 0.4 x 26,345 42,536

16,896
Variable o/h (var. to material cost): 68,200 x 0.6 x 306,372 135,036

92,840
Fixed o/h: 64,000 x 12 24,000

32
Total Cost: R534,289
Want to earn a profit of 35% based on cost. Therefore profit ÷ costs = 35%.
Sales 135%
Less: Costs 100%
Profit 35%
Therefore total sales value = costs x 135% = 534,289 x 1.35 = R721,290

Therefore selling price per unit = R721,290 / 12 = R60,108
(c) The learning curve may vary from 50% which is the maximum learning
effect and 100% where no learning takes place.
1
MAC3761 - REGRESSION ANALYSIS
Learning Objectives:
 Calculate regression equations using the high-low method and the

least squares method
 Calculate and interpret the coefficient of determination (r2),

standard error of estimate and the beta-coeffiecient
 Provide management with relevant advice
INTRODUCTION
One of the key areas of management decision making concerns

forecasting, that is the attempt to predict the future by means of either
qualitative or quantitative methods. Regression analysis is one of the
most important quantitative methods which may assist the
management of an undertaking with this complex task. Forecasts can
be based on qualitative or quantitative methods. On the whole,
qualitative methods are used when information (particularly
quantitative data about the recent past) is scanty and not easily
accessible as well as for purposes of longer-term forecasts. These
methods require far more judgement and intuition than quantitative
methods.
Quantitative methods can be used for shorter-term forecasts and

where past information is more readily available. The longer a
particular tendency was adhered to in the past, the larger the
probability of the pattern continuing in the future. However, the
techniques must be used with care, always bearing in mind the
background of underlying limitations. The most common quantitative
forecasting method employed is regression analysis, and more
particularly simple linear regression analysis. Regression analysis is also
sometimes referred to as the least squares. Regression is a quantitative
method according to which a forecasting model is formulated by
means of statistical methods and which attempts to fit the best curve
to observed data in the short to medium term. Simple regression
assumes the existence of a single independent variable. The purpose
of regression analysis is to estimate the value of one variable (the
dependent variable) if the value of another related variable, or
variables (the independent variable(s)) is known.
2
Correlation analysis is a powerful instrument for measuring the degree

of relationship between variables. The coefficient of correlation (r) and
the coefficient of determination (r’) will be discussed later.
As stated in the paragraph referred to above, the one variable

(independent variable x) is know, and is used to estimate the value of
the other variable (dependent variable y). The independent variable
has a strong bearing over the dependent variable.
Fitting Of The Curves
A set of data is normally presented to you. These costs represent semi-

variable costs, therefore, consisting of fixed and variable elements. To
enable you to use this type of data for planning and forecasting in
auditing, budgeting or any other applications, the fixed and variable
elements are to be identified. By identifying the fixed (a) and variable
(b) elements, we are, at the same time, fitting a straight line to a set of
given points.
The least squares method
COST
e1 e2 e4
e3
Y = a + bx, where b is the slope of the

Straight line
Volume
In the case of the least squares method the straight line is fitted in such
a way as to minimise the sum of the squares of the distance between
the various points on the line.
The equation of the straight line is:
Y = a = bx
3
Where: y = the dependent variable

a = the intersection on the y axis (fixed cost element)
b = the slope of the line (variable cost element)
x = independent variable
Hence, from the general equation the summation of the above would
be:
y = an + bx
xy = ax + bx2
The above equations are solved simultaneously to find the values for a
and b.
n x y x2 xy
1 7 247 49 1729
2 10 270 100 2700
3 11 278 121 3058
4 10 271 100 2710
5 8 257 64 2056
6 6 235 36 1410
7 11 280 121 3080
8 12 287 144 3444
9 11 277 121 3047
10 9 265 81 2385
95 2667 937 25619
x = 95 y = 2667 x2 = 937 xy = 25619
Hence, substitute the values from the above table in the equations:
y = an + bx
xy = ax + bx2
2667 = 10a + 95b ………………. (1)

25619 = 95a + 937b…………. (2)
(1) x 9,5  25336,5 = 95a + 902,5b (3)
(2) – (3)  282,5 = 34,5b
b = 8,19
a = 188,90 by substituting b = 8,19 in (1)
Hence, y = 188,90 + 8,19x

4
When the independent variable (x) and the dependent variable (y)
have been identified, they can be plotted on a graph by the
independent variable being represented on the x-axis and the
dependent variable represented on the y-axis.
In cost-volume-profit analysis, the variable cost remains constant per

unit, and the fixed cost remains constant in total for a given period,
and within a given capacity range. All the points given are, therefore,
The data you have been supplied with to apply correlation and
regression analysis to, however, differs from this in that not all points lie
This obviously calls for a more sophisticated technique than the high-
low method to determine the best objective fit of the straight line
between all the given points. Regression analysis can be used for this
purpose.
In the case of the least-squares method, the straight line is fitted in such
a way as to minimise the sum of the squares of the distances between
the various points and the straight line
(i.e. e12 + e22 + … + en2)
In our attempt to fit a straight line to a set of given points we, however,
have to remember that the equation of a straight line contains an
independent variable (x), and a dependent variable (y). As the
wording indicates, we can only fit a straight line to a given set of data,
if a relationship exists between these two variables. The existence of, or
lack of existence of this relationship, is determined by means of
correlation analysis.
From the above, it is, therefore, clear that regression analysis cannot be
applied unless the existence of an acceptable relationship between
the independent variable (x) and the dependent.
THE ACCEPTABILITY OF THE FIT
As management will be making forecasts based on the regression line,

they would like to know how accurate these will be. They would thus
like to have an indication as to the degree of suitability of the estimate
of the dependent variable by means of the independent variable.
5
Correlation
Correlation shows the degree of linear relationship between the two

sets of data and is used to indicate the acceptability of the fit. For this
we use the coeffiecient of correlation ® and the coefficient of
determination r2
COEFFICIENT OF CORRELATION (r)
Objective of the coefficient of correlation
Correlation shows the degree of linear relationship between two sets of

data and is used to indicate the acceptability of the fit, that is, the
accuracy of the regression line. It, therefore, shows whether there is a
correlation between the dependent variable and the independent
variable. The method of least squares eliminates guesswork when
fitting a regression line to data, because only one straight line is
possible. The problem is that a straight line can always be fitted to any
data, no matter how scattered the data is, and even if the given points
form a circle, parabola or any other curve. Accordingly, the degree of
fit of the regression line must be determined before it can be used as a
forecasting model. The coefficient of correlation r and the coefficient
of determination r2 provide two measures for judging the quality of the
fit.
Formula
The only formula used in this course for the calculation of the
coefficient of correlation is as follows:
n ∑x y - ∑x ∑ y
r =
n ∑x - (∑x ) n ∑y - (∑y )
2 2 2 2
So what would the correlation be of the above example:
r = 10 (25 619) – (95) (2667)
√10(937) – (95) √ 10 (713 631) – (2 667)

2 2
-
= 0,9938
6
Evaluation of the level of acceptability
A coefficient of correlation of 0 indicates that there is no relationship

A coefficient of correlation of 1 or –1 indicates a perfect relationship

We have, therefore, determined that an acceptable level of

correlation lies somewhere between 0 and 1 or 0 and –1. The
coefficient of determination quantifies this level of acceptability.
COEFFICIENT OF DETERMINATION (r2)
When the coefficient of correlation is either 0, +1 or -1 there is no doubt

as to the degree of relationship between x and y. Should r now fall
somewhere in between these absolute values the relationship is not
that obvious anymore.
In the above example r2 = (0,9938)2 = 0,9876.
What does this mean?
It simply means that 98,76% of the change in the values of y can be

predicted by means of the changes in the values of x. Factors other
than the changes in the values of x are responsible for 1,24% of the
change in y.
Note
0,75 or –0,75 is accepted as being a general guideline as to the lowest
possible limit the coefficient of correlation can be, to justify the
application of regression analysis
RELIABILITY OF ESTIMATES
The coefficient of determination indicates how well the least squares

line fits the sample data. However, the reliability of the sample values a
and b is still unknown.
7
The values calculated for a and b are only a reflection of a relationship

for a specific selection of information, in other words the relevant
range.
Different samples of information will yield different values for a and b.

The question now arises by how much the values of a and b, as
calculated, could possibly differ from the actual values of the total
population represented by the symbols A and B.
DEGREES OF FREEDOM
Firstly the number of degrees of freedom must be determined as this is

required when looking up the t factor (see end of chapter).
The number of degrees of freedom is the number of observations that

are used less the number of regression coefficients (a and b) which
needs to be estimated.
A straight line fitted at two points is automatically determined and has

no degrees of freedom.
A straight line through three points has one degree of freedom and
one through n points has (n - 2) degrees of freedom.
Hence the example above, which ten observations has (10 – 2)

degrees of freedom.
THE STANDARD ERROR OF ESTIMATE
The standard error (Se) of the estimated value of y (indicated by ŷ), is

calculated by means of the following formula:
∑y - a ∑ y - b ∑x y
2
Se =
√ n-2
Based on our example the standard error would be:

Se = 713 631 – 188,9 (2 667) – 8,19 (25 619)
8
= 1,37
The standard error can be used to determine the confidence limits for
the estimate of y, and these limits are shown by ŷ ± tSe, where t is the
factor for a t distribution with (n-2) degrees of freedom based on a
confidence level of (100 – α)%
8
Lets now determine the confidence limits of the estimated value of y

based on our working example, if a 95% confidence level is required.
Confidence = ŷ ± tSe
limits
= ŷ ± (2,306)(1,37)
= ŷ ± 3,16
t = 2,306 can be found in the t - distribution table.
We can now use the above information to forecast and analyse the
results.
Lets say we wanted to estimate the cost of production of 13 units

based our working example using a 95% confidence level.
Ŷ = a + bx ± tSe
= 188,9 + 8,19(13) ± (2,306)(1,37)
= 295,37 ± 3,16
It can thus be stated with 95% certainty that the actual cost of
producing 13 units will vary between R292,21 and R 298,53.
9
Steps in solving Correlation Analysis problems
1. Identify the independent and dependent variables.
2. Tabulate the periods; x and y in vertical columns.
3. Provide columns for x2; y2 and xy.
4. The first item in the x2-column will be the first item in the x-column,
squared. The same applies to the y2-column.
5. The first item in the xy-column will be the first item in the x-column,
multiplied by the first item in the y-column.
6. Complete all these columns and add them up, which will give you
x, y, x2, y2, xy (sum of x, etc).
7. Substitute these values into the formula for correlation and solve for
r. Calculate r2.
8. Evaluate the level of acceptability, and if acceptable, regression

analysis can be applied.
In all cases you should be led by the “required” section of the question.
Work through the example on pages 6 – 8 in study guide 2 of ACT 302.
OBJECTIVE OF REGRESSION ANALYSIS
To forecast one variable (dependent variable y) if the other variable

(independent variable x) is known.
Method
For purposes of this paper, we concentrate on the least-squares

method to fit a straight line to a set of given points. The least-squares
method uses the relationship that exists between the independent
variable x and the dependent variable y (as determined by the
coefficient of correlation) to fit a straight line to a set of given points to
determine the best objective fit.
10
Steps in solving Regression–Analysis problems
1-8. Unless already done for correlation analysis, follow steps 1 to above.
9. Substitute the value calculated above in the following equations:
a) y = na + bx
b) xy = ax + bx2
10. Solve equations simultaneously for a and b.
11. State what a and b represent.
12. To forecast the value of y, given the value of x; substitute a and b

as stated in 11. and x into equation a and solve for y.
Limitations (Read)
1. Short to medium-term predictions
The least-squares method attaches equal weight to all the observations

in a time series, irrespective of the fact that they represent recent or
older observations. If present data should thus differ significantly from
older data, the least-squares method would probably not provide very
good forecasts, especially not over the long term. This is why regression
analysis is only recommended for short to medium-term forecasts.
Circumstances and tendencies can change quickly. Great care must
consequently be exercised when historical data is projected into the
future, no matter what method of forecasting is used. Extrapolation
can be dangerous and judgement, experience, intuition and a good
background knowledge will always play an important role in the
making of realistic and reliable forecasts. In general, ore confidence
can, therefore, be placed on forecasts based on interpolation rather
than extrapolation, particularly in cases where the latter falls far outside
the area of the observed values. Although no forecasting method can
guarantee accuracy, this does not by any means preclude the
development of forecasting models to allow decision making.
11
2. Adaptability
Regression analysis is not an adaptive forecasting model for the very

reason that it does not automatically adapt forecasts to the latest
particulars and allocate greater weight to the latter. It would,
therefore, not be very suitable as a stock control model.
3. The number of observations
Too much confidence cannot be placed on a relationship if the

number of observations to which a regression line is fitted is small.
Experience has shown that there should be at least ten observations for
each independent variable. If the dependent variable is estimated by
multiple regression by means of three independent variables, the
regression line should thus be fitted to at least 30 observations. At least
ten observations are accordingly required in the case of simple linear
regression.
12
QUESTION 1
1. You are a clerk in the cost accounting department of Sellall Limited.

Mr Sellgood, one of the sales representatives, requested your
department to estimate the expected maintenance cost of his
vehicle for June 2014. He gave a summary of the average
kilometres travelled per day for the past seven months, as well as of
the average daily maintenance costs for the corresponding period.
You departmental head, being in a rush, supplied you with only the
Period : November 2013 – My 2014
x = 1 980
y = 1 324
x2 = 563 400
y2 = 251 676
xy = 376 510
r = 0,9816
Relevant formulae:
y = a + bx
x = na + bx
xy = ax + bx2
Determine the value of a, assuming that b = 0,6004.
a) 1m6046
b) 19,2857
c) 2
d) 19 (3)
Determine the average daily maintenance cost if 250 kilometres are

travelled per day.
a) 169,39
b) 151,70
c) 152,10
d) 170,00 (3)
13
Indicate the lowest limit of the coefficient of correlation, which will

justify the application of regression analysis.
a) 0,50 and – 0,50

b) 0,85 and – 0,85
c) 0,75
d) 0,75 and – 0,75 (1)
14
1. The correct answer is b). (3)
Substitute b = 0,6004 in the following equation:
1 324 = 7a 1 980b
1 324 = 7a + 1 980 (0,6004)
1 324 = 7a + 1 189
7a = 1 324 – 1 189
7a = 135
a = 19,2857
2. The correct answer is a). (3)
Y = average daily maintenance cost

Y = a + bx
= 19,2857 + 0,6004 (250)
= 169,39
3. The correct answer is d). (1)

15
QUESTION 2
You are the accountant of a relatively small manufacturing company,

Weskor (Pty) Ltd. For the last three months, the company has
experienced a significant drop in profits.
On examination of the records, you have established that, from the

beginning of January 2014, spares and components were obtained
from a different supplier at prices well in excess of the normal prices. A
buyer in the purchasing department has since then confessed to being
guilty of bribery.
Normal profits were maintained until the end of December 2013. It has
been decided to analyse the actual production cost for the period
October 2013 to December 2014 in order to determine normal
production cost. The extent of the malpractice during the period
January 2014 to March 2014 is to be determined by using this normal
cost as basis.
You realise that a three month period is normally too short to apply
correlation and regression analysis, but these particular spares and
components have only been purchased from 1 October 2013, due to a
change in the manufacturing process.
The following is an extract of the production and cost records:
Units Production
produced cost
R
October 2013
November 2013 16 8 380
December 2012 15 7 800
19 9 450
January 2014 18 10 740
February 2014 14 8 800
March 2014 20 11 800
16
Required:
a) Determine the coefficient of correlation between the units

produced and production cost, based on the actual results for the
period October to December 2013. State the meaning of this
figure. (5)
b) Calculate the fixed and variable component of normal production

cost by applying regression analysis techniques on the results of the
period October 2013 to December 2013. (5)
c) Make an estimate of the costs incurred in excess of the normal

production cost for the period January 2014 to March 2014. (5)
Relevant formulae:
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
y = a + bx
y = an + bx
xy = ax + bx2

17
Weskor (Pty) Ltd
Month x y x2 y2 xy
October 2013 16 8 380 256 70 224 400 134 080
November 2013 15 7 800 225 60 840 000 117 000
December 2013 19 9 450 361 89 302 500 179 550
50 25 630 842 220 366 900 430 630
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 3(430 630) - 50(25 630) .

___________ _____________________
 3(842) - 502  3(220 366 900) – 25 6302
= 1 291 890 - 1 281 500 .

___ __________
 26  4 203 800
= 10 390
10 455
= 0,9938
Significance of r
The correlation between the units produced and production cost is

extremely good. Regression analysis can, therefore, be used to make
forecasts. (5)
b) Fixed and variable components of normal production cost
Y = an + bx …. (a)
XY = ax + bx2 …. (b)
Substitute into (a) : 25 630 = 3a + 50b …. (1)
Substitute into (b) : 430 630 = 50a + 842b …. (2)
(1) x 50 : 1 281 500 = 150a + 2 500b …. (3)
(2) x 3 : 1 291 890 = 150a + 2 526b …. (4)
(4) – (3) : 10 390 = 26b
 b = 399,62
Substitute b = 399,62 in (1):
25 630 = 3a + 50 (399,62)
 a = 1 883
18
Normal production cost:
Fixed = R1 883
Variable = R400/unit
(5)
c) Estimate of costs incurred in excess of the normal production cost
Month Units Actual Cost Estimated Difference

Produced Cost
R R R
January 2014 18 10 740 9 0831 1 657

February 2014 14 8 800 7 4832 1 317
March 2014 20 11 800 9 8833 1 917
4 891
Calculations:
1 R[1 883 + (400 x 18)] = R9 083

2 R[1 883 + (400 x 14)] = R7 483
3 R[1 883 + (400 x 20)] = R9 883 (5)
19
QUESTION 3
Rietbok Manufacturing Company Limited manufactures a single

product. In addition to the costs which have been identified as either
fixed or as variable, there are costs which are semi-variable. In order to
compile a budget for the following month, the semi-variable
manufacturing costs of the previous ten months are presented to you
together with other costs:
Semi-variable
Month Production manufacturing costs
(Units) R
1 1 500 800
2 2 000 1 000
3 3 000 1 350
4 2 500 1 250
5 3 000 1 300
6 2 500 1 200
7 3 500 1 400
8 3 000 1 250
9 2 500 1 150
10 1 500 800
Other costs:
- Material : R 9,75 per 100 units

- Labour : R 9,00 per 100 units
- Fixed costs : R631,25 per month
It is anticipated that 4 000 units will be manufactured during month 11.

All costs are being paid for in cash.
REQUIRED:
a) Determine the coefficient of correlation. (5)
b) Calculate the fixed and the variable elements of the semi-variable

manufacturing costs, by means of regression analysis. (5)
c) Calculate the cash requirements for month 11, from the available
particulars. (4)
20
Rietbok Manufacturing Company Ltd
Month x y xy x2 y2
1 1 500 800 1 200 000 2 250 000 640 000
2 2 000 1 000 2 000 000 4 000 000 1 000 000
3 3 000 1 350 4 050 000 9 000 000 1 822 500
4 2 500 1 250 3 125 000 6 250 000 1 562 500
5 3 000 1 300 3 900 000 9 000 000 1 690 000
6 2 500 1 200 3 000 000 6 250 000 1 440 000
7 3 500 1 400 4 900 000 12 250 000 1 960 000
8 3 000 1 250 3 750 000 9 000 000 1 562 500
9 2 500 1 150 2 875 000 6 250 000 1 322 500
10 1 500 800 1 200 000 2 250 000 640 000
25 000 11 500 30 000 000 66 500 000 13 640 000
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 10(30 000 000) - (25 000 x 11 500) .

______________________ _____________________
 10(66 500 000) – (25 000)2  10(13 640 000 – (11 500)2
= 300 000 000 - 287 500 000 .

_______________________ ______________________
 665 000 000 – 625 000 000  136 400 000 - 132 250 000
= 12 500 000 .
__________ _________
 40 000 000  4 150 000
= 12 500 000 .
6 324,56 x 2 037,15
= 12 500 000
12 884 077
= 0,97 (5)
21
QUESTION 3 – Continued
b) Fixed and variable elements of semi-variable manufacturing cost
Y = an + bx …. (a)
XY = ax + bx2 …. (b)
Substitute into (a) : 11 500 = 10a + 25 000b …. (1)
Substitute into (b) : 30 000 000 = 25 000a + 66 500 000b …. (2)
(1) x 2 500 : 28 750 000 = 25 000a + 62 500 000b …. (3)
(2) - 3 : 1 250 000 = 4 000 000b
b = 1 250 000
4 000 000
b = 0,3125
Substitute b = 0,31254 in (1) 11 500 10a + (25 000)(0,3125)

= 11 500 – 7 812,5
10a = 3 587,5
10
a = 368,75
a =
Therefore, the fixed element of semi-variable manufacturing cost is

R368,75 per month and the variable element is R0,3125 per unit. (5)
c) Cash requirements for month 11 (4 000 units)
Material (4 000 x R0,0975) 390

Labour (4 000 x R0,0900) 360
Variable manufacturing cost

(4 000 x R0,3125) 1 250
Fixed manufacturing cost

(R631,25 + R368,75) 1 000
3 000
(4)
22
QUESTION 4
You are the cost accountant of Yours Truly (Pty) Limited, a company
that specialises in the manufacturing of small quality articles sold to gift
and departmental stores.
The company is currently experiencing financial problems due to a

downturn in the economy, and is reviewing its product and pricing
policies.
A new department manufacturing handmade articles was recently

opened, the turnover of which is increasing rapidly. These articles are
sold to companies at R20 each and to be used as corporate handout
gifts.
A statement has been made that this department does not earn the
required rate of return of 25% on sales that has been set for this
department, and that the latter should be closed down as a
rationalisation measure.
You do not agree with this statement and have decided to prove it to
be false. You have extracted the following details from the
production records of this department for the first nine months it has
been in operation:
Month No. of articles Total

manufactured manufacturing
cost
R
1 120 10 200
2 135 10 440
3 162 10 560
4 180 10 740
5 180 10 830
6 150 10 530
7 198 10 950
8 240 11 310
9 210 10 980
1 575 96 540
23
You realise that a nine month period is normally too short to apply
correlation and regression analysis, but due to a lack of other
information, have no choice but to use this limited information.
From the above extract, you have calculated a coefficient of

correlation of 99% and conclude that regression analysis may be
applied effectively to this information.
1. Of the fixed cost included in the total manufacturing cost, 90% is not
directly related to this department, but represents general company
overheads that have been apportioned to this department.
2. Once manufactured, these articles are packed in attractive gift

packaging cost R0,40 per gift. This packaging costs is over and
above the total manufacturing cost mentioned above.
3. Due to the popularity of these gift packs, the marketing and

administrative costs are very low, and amount to R0,20 per gift
pack.
4. All articles manufactured have been sold.
REQUIRED:
a) Calculate the fixed and variable elements of total manufacturing

cost by means of the least squares method of regression analysis. (6)
b) Determine if the department manufacturing the corporate handout

gifts should continue operating, or if it should close down. (Your
calculations must show the total relevant marginal and net income
for the nine month period.) (8)
y = na + bx
xy = ax + bx2
xy = 16 994 520
24
Yours Truly (Pty) Limited
a) Fixed and variable elements of manufacturing cost
The number of articles manufactured should have a strong bearing

on the manufacturing cost, therefore, the articles are represented
by x, the independent variable, and the manufacturing cost, y, the
dependent variable.
Y = an + bx …. a
XY = ax + bx2 …. b
Substitute into a : 96 540 = 9a + 1 575b …. 1
Substitute into b : 16 994 520 = 1 575a + 287 0731b …. 2
1 x 175 : 16 894 500 = 1 575a + 275 625b …. 3
2-3: 100 020 = 11 448b
b = 100 020
11 448
b = 8,736897
96 540 = 9a + 1 575 (8,736897)
9a = 96 540 – 13 761
9a = 82 779
a = 9 197,66
Therefore, the variable manufacturing cost is R8,74 per corporate gift,

and the fixed manufacturing cost is R9 198 per month. (6)
25
Calculation:
1 x2 = (14 000 + 18 225 + 26 244 + 32 400 + 32 400 +

22 500 + 39 204 + 57 600 + 44 100) = 287 073
b) Continue manufacturing or close down.
Calculation of relevant net income

R
Sales (1 5751 x R20) 31 500
Less: Variable cost 14 711
Manufacturing cost (1 5751 x R8,742) 13 766
Packaging cost (1 5751 x R0,40) 630
Marketing & administrative cost 1 5751 x R0,20) 315
Marginal income 16 789
Less: Relevant fixed costs (R9 1982 x 0,10 x 9) 8 278
Relevant net income 8 511
Rate of return on sales (R 8 511 x 100) = 27%

R31 500
Therefore, the department manufacturing the corporate handout gifts

should continue operating, as it earns a return on 27%, on sales, which
exceeds the required 25%. (8)
Notes to solution:
1 x as given.
2 Fixed and variable elements as calculated in a) above.
26
QUESTION 5
Jetset Airlines Limited currently has a fleet consisting of 4 aircraft, each

of similar size. The company intends buying another aircraft.
The directors of the company have managed to obtain a loan to

finance the transaction. The repayment o the instalments on the loan
will, however, result in the company’s cash resources being placed
under pressure, especially over the first twelve months.
At a meeting of the board of directors, it was concluded that the only

way to solve the cash flow problem was to boost turnover. This,
however, is also a problem as the airline cannot fit in more flights and it
already has a 100% booking on existing flights. In the current economic
climate, it is also not advisable to increase the price of air tickets.
The financial director of the company brought it to the attention of

those present at the meeting that certain airlines make so-called
overbookings as there usually are late cancellations on flights. From
time to time, however, it is inevitable that the estimates of the number
of late cancellations will be wrong. In such a case, should the actual
number of late cancellations be less than the number estimated,
passengers are paid to stay a night over at the expense of the airline.
On conclusion of the meeting, the accountant of the company

determined the following information on request of the financial
director:
No. of passengers No. of late

booked cancellations
Mondays 520 25
Tuesdays 480 23
Wednesdays 510 25
Thursdays 490 24
Fridays 530 27
Saturdays 550 27
Sundays 540 26
The accountant informed the financial director that he has based the
above information on the result of a sample in which he has compared
the number of late cancellations in relation to the number of
passengers booked. The above extract is, consequently,
representative of the statistics for the past year. He has also confirmed
that the trend of late cancellations is similar for all flights on a particular
day.
27
REQUIRED:
a) Determine whether regression analysis can be used to forecast the

expected number of late cancellations on flights. (6)
b) Determine the number of late cancellations that can be expected

on a flight with a capacity of 150 passengers. (6)
All calculations must be rounded off to four decimals.
y = na + bx
y = na + bx
xy = ax + bx2
r = nxy - xy .
__________ ___________
 nx – (x)  ny - (y)
2 2 2 2
28
Jetset Airlines Limited
a) Determination of whether regression analysis can be used
x y xy x2 y2
520 25 13 000 270 400 625
480 23 11 040 230 400 529
510 25 12 750 260 100 625
490 24 11 760 240 100 576
530 27 14 310 280 900 729
550 27 14 850 302 500 729
540 26 14 040 291 600 676
 3 620 177 91 750 1 876 000 4 489
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 7(91 750) - (3 620)(177) .

__________________ _____________
 7(1 876 000) – 3 6202  7(4 489) – 1772
= 642 250 - 287 500 000 .

_____________________ ______________
 13 132 000 – 13 104 400  31 423 – 31 329
= 1 510 .
______ __
 27 600  94
= 1 510 .
(166,1325) (9,6954)
= 1 510 .
1 610,7210
= 0,9375
 Regression analysis can be used to forecast the expected

number of late cancellations on flights. (6)
29
b) Determination of expected number of late cancellations
y = An + bx …. a
xy = ax + bx2 …. b
Substitute into a : 177 = 7a + 3 620b …. 1
Substitute into b : 91 750 = 3 620a + 1 876 000b …. 2
1 x 3 620 : 640 740 = 25 340a + 13 104 400b …. 3
2-7: 642 250 = 25 340a + 13 132 000b …. 4
4-3: 1 510 = 27 600b
 b = 0,0547
177 = 7a + 3 620 (0,0547)
 7a = 177 – 198,014
 a = -21,014
7
 a = 3,002
Estimate of straight line : y = a + bx

y = -3,002 + (0,0547)x
Estimate of expected number of late

cancellations on a flight of 150 people : y = 03,002 + (0,0547)(150)
 5
 5 late cancellations can be expected (6)

30
QUESTION 6
Steely Limited manufactures steel window frames, which are used in

the erection of industrial factories.
The company is in its first year of production, with no established cost

performance or records.
The following are the production figures, for the first eight months of
production:
Output Cost of
production
Units R
(‘000) (‘000)
5 11,8
7 14,7
9 18,5
11 24,0
13 26,2
15 30,1
17 33,6
14 28,0
It has been decided to apply regression and correlation analysis, in an

effort to confirm the initial fairness of the variable and fixed
components of the production records.
For this purpose, the following formulae are to be applied:
y = a + bx
Where y = na + bx
xy = ax + bx2 and
r = nxy - xy .
__________ ___________
 nx – (x)  ny2 - (y)2
2 2
31
REQUIRED:
a) Determine the correlation between the units manufactured and the

b) Estimate the fixed and variable costs of production. (5)
c) State the regression line of total cost on output. (1)

32
Steely Limited
a) Correlation
r = nxy - xy .
___________ _____________
 nx2 – (x) 2  ny2 – (y)2
= 8(2 347,7) - 91(186,9) .

_____________ __________________
 8(1 155) – (91)2  8(4 778,99) – (186,9)2
= 18 781,6 - 17 007,90 .
___________ __________________
 9 240 – 8 281  38 231,92 – 34 931,61
= 1 773,7 .
30,97 x 57,45
= 1 773,7 .
1 779,23
= 0,9969
There is a good correlation between the units manufactured and the

33
n X y Xy x2 y2
(‘000) (‘000) (‘000 000) (‘000 000) (‘000 000)
5 11,8 25 139,24 59,0
7 14,7 49 216,09 102,9
9 18,5 81 342,25 165,5
11 24,0 121 576,00 264,0
13 26,2 169 686,44 340,6
15 30,1 225 906,01 451,5
17 33,6 289 1 128,96 571,2
14 28,0 196 784,00 392,0
1
 91 186,9 1 155 4 778,99 2 347,7
b) Calculation of the fixed and variable costs of production
y = An + bx …. a
xy = ax + bx2 …. b
186 900 = 7a + 3 620b …. 1
2 347 700 = 3 620a + 1 876 000b …. 2
1 x 0,091 : 17 007,9 = 25 340a + 13 104 400b …. 3
2 x 0,008 : 18 781,6 = 25 340a + 13 132 000b …. 4
4-3: 1 510 = 27 600b
 b = 0,0547
178 = 7a + 3 620 (0,0547)
 7a = 177 – 198,014
 a = -21,014
7
 a = 3,002
2
PROCESS COSTING
Learning objectives:
 To understand the concept of process costing as a method of

accounting for costs
 To understand the flow of transactions in the ledger
 To prepare the process costing statements
 To understand and account for Normal and abnormal losses
 To understand the difference between the FIFO and Weighted

average methods of inventory valuation within process costing
 To understand the long and short methods of preparing process

costing statements
3
INTRODUCTION
Process costing is costing method used where it is not possible to

identify separate units of production, or jobs, usually because of the
continuous nature of the production process involved.
It is common to identify process costing with continuous production

such as the following:
 Oil refining
 Paper
 Food and drinks
 Chemicals
Process costing may also be associated with the production of large

volumes with low unit costs such as cans, glass or tins.
The following are the features of process costing which makes it

different from job or batch costing:
 The output of one process become the inputs of the next process
until the goods are complete in the final process.
 Due to the nature of the production process, there is often work in
progress that needs to be valued. Because of mass production it is
difficult to maintain stock records per unit.
 There is often a loss in the process due to spoilage, evaporation and
wastage.
THE BASICS OF PROCESS COSTING
Assume the following:
We manufacture plastic chairs in 2 processes. In process 1 the plastic is

moulded into shape and in process 2, the final assembly takes place.
Assume that all material is added at the beginning of process 1. No
material is added in process 2. Also assume that there is no spoilage
and no opening stock.
Material for 10 000 units are placed into production at a total material
cost of R100 000 and conversion costs for process 1 amounts to R56 400
and for process 2 R30 400.
4
WHAT IS OUR OBJECTIVE?
OUR OBJECTIVE IS TO ASSIGN COSTS TO PRODUCTION. PRODUCTION

MAYBE COMPLETE OR INCOMLETE, IN OTHER WORDS FINISHED GOODS
OR WORK IN PROGRESS.
Further assume that at the end of the month, process 1 completes and
transfers 8 000 units to process 2 and process 2 in turn completes and
transfers 7 000 units to finished goods.
Irrespective of the amount of material in kg, remember that we have

entered into production sufficient material for 10 000 units at a total
material cost of R100 000.
Remember this is still accounting and it’s about debits and credits. Let’s
examine the WIP accounts for the 2 processes.
MATERIAL INVENTORY ACC (IN UNITS)

Assumed
Received from process 1 8 000 Transferred to FG 7 000

5
In process 1 there are 2 000 units which are incomplete. Assume that
they are 70% complete. (Obviously they are 100% complete for
materials as all materials were added at the beginning of the process).
How will the costs of production be allocated to the different
products?
Similarly in process 2, 7 000 units are complete and 1 000 units are in
progress. Assume that these units are 70 % complete. Costs must be
allocated to all units, finished or unfinished.
Consider the following production statement for process 1.
Opening stock
Completed and 8 000 8 000 8 000

transferred 2 000 2 000 1 400
Closing WIP
10 000 10 000 10 000 9 400
Note:
other word 1 400 units
Now to summarise the costs:
This is called a cost statement

Opening stock - - -
156 400 100 000 56 400
÷ ÷

6
Closing WIP 28 400

- material 2 000 x 10 20 000
- Conversion 1 400 x 6 8 400
156 400
Lets see how the ledger accounts would look:
MATERIAL INVENTORY ACC (IN RANDS)

Assumed

Conversion costs 56 400 Balance c/f 28 400
156 400 156 400
Balance b/f 28 400
CONVERSION COSTS (IN RANDS)
Bank 56 400 Transferred to process 1 56 400
Received from process 1 128 000 Transferred to FG ?????

7
NOW LETS TAKE A LOOK AT PROCESS 2
PRODUCTION STATEMENT
INPUT DETAILS OUTPUT PROCESS 1 MATERIAL CONVERSION
- Opening stock
8 000 Received from process 1
Completed and
transferred 7 000 7 000 7 000 7 000
Closing WIP 1 000 1 000 1 000 600
8 000 8 000 8 000 8 000 7 600
Note:
other word 600 units
 A process 1 column is included as the costs of process 1 are brought
forward.
COST STATEMENT
Total Process Material Conversion

1
Opening stock - - - -
Current production 158 400 128 000 - 30 400
158 400 128 000 - 30 400
÷ ÷ ÷
Equivalent production 8 000 8 000 7 600
Cost per unit R16,00 R0 R4,00
8
Closing WIP 18 400

- Process 1 1 000 x 16 16 000
158 400
The above illustrates the basics of process costing.
ENSURE THAT YOU UNDERSTAND ALL OF THE ABOVE BEFORE YOU

VENTURE FORWARD. IT’S A JUNGLE OUT THERE.
LOSSES IN A PROCESS COSTING SYSTEM
So far we have ignored losses. What must be remembered is that input

must equal output. In other words if we input 10 000 units where did
they end up?
As we have seen from the previous example, that 8 000 units were
complete and 2 000 units were incomplete. What if some of these units
were spoilt and lost?
We have to account for two types of spoilage, viz normal spoilage and
abnormal spoilage.
NORMAL SPOILAGE
Normal losses are losses expected during a process. It is a loss we can

plan for. For example, say we know from past experience that for every
10 units of input 1 unit is lost. This means that 10% of input is lost. This also
means that 90% is good output.
The problem with normal losses is that it does not share in the costs. This
simply means that the cost of normal spoilage must be carried by the
good output.
Assume that the above 10 units were inputted at a total cost of R100.
10% of the units are spoilt but the cost still remains R100. This simply
means that the cost of output is not R10,00 per unit (R100÷10), but
R11,11 (R100÷9). Good output is 9 units
9
ABNORMAL LOSSES
Abnormal losses are additional losses which occur during a process. This
loss is unplanned for and therefore carries a cost.
Assume the cost of input of 500 units is R7 500. Assume that the normal
losses are 10% of input. Out put at the end of the process is 410 units. At
the outset the cost per unit seems to be R7 500÷500 = R15 per unit.
Remember we have normal spoilage so the cost per unit increases.
Units Cost
Total input 500 7 500
Normal spoilage (50) -
450 7 500
The cost per unit is now → 7 500 = R 16,67

450
Now to allocate the costs:
Unit completed and 410 x R16,67 6 833

transferred
Abnormal spoilage 40 x R16,67 667
450 x R16,67 7 500
What this means is that the cost of normal spoilage is carried by the
good output and the abnormal spoilage.
THE POINT OF SPOILAGE
For now it is safe to assume that normal spoilage and abnormal

spoilage is detected at the same point. Spoilage can take place at
any point in the process.
ILLUSTRATION 1

Units R
Opening WIP - -
10


Spoilage takes place at the beginning of the process.
Material is added at the beginning of the process and conversion costs
are incurred uniformerly throughout the process.
THE TIME LINE WILL HELP

IN CALCULATING NORMAL
SPOILAGE
80%(closing WIP)
INPUT DETAILS OUTPUT MATERIAL CONVERSI

ON
- Opening stock
Completed and 7 000 7 000 7 000

transferred 500 500 -
Normal spoilage 1 000 1 000 -
Closing WIP
10 000 10 000 10 000 8 200
11
Note:
 In this case spoilage takes place at the beginning of the process, viz at
the 0% point.
 All 10 000 units are placed at the 0% point in this period, which means
at that all units pass the spoilage point.
 At the 0% point how much work have I done on the spoilt units? None,
therefore nothing is entered in the conversion column.

Opening stock - - -
157 400 100 000 57 400
÷ ÷

components, viz completed units, incomplete units and abnormal
spoilage. We allocate this on a pro-rata basis. The total of the 3
components is 9 500 (7 000+1 000+1 500) units in the material column. And
nil in the conversion column.

Material Conversion
Units completed (7000/9500) x 500 368 -
Abnormal spoilage (1000/9500) x 500 53 -
Closing WIP (1500/9500) x 500 79 -
500 -
12

transferred
- Material (7000+368*) x 10 73 680
- Conversion (7000 + 0) x 7 49 000

- Material (1000+ 53*) x 10 10 530
- Conversion (-) -
Closing WIP 24 190

- material (1500+79*) x 10 15 790
- Conversion (1200+0) x 7 8 400
157 400
* Normal spoilage
An important thing to note in this example is that closing WIP is 80%

complete. This means it has passed through the point of spoilage. What
if it had not yet passed through the point of spoilage?
In that case no spoilage can be allocated to closing WIP. Normal

spoilage is then carried by completed units and abnormal spoilage.
13
ILLUSTRATION 2
Assume the same information as in the above illustration 1, but now

spoilage takes place at the end of the process.
0%(start of process )

CALCULATING NORMAL
SPOILAGE
80%(closing WIP)
point of spoilage
NOW IT’S TIME TO VISUALISE.I KNOW IT’S HARD FOR YOU. JUST TRY.
PLEASE!!
We introduce 10 000 units at 0% point. Now close your eyes, yes close your
eyes and imagine those units moving down your time line. At the 80%
point 1 500 units get left behind. Which means that 8 500 units reach the
100% point, which is also the point of spoilage.
At this point we lose 5% of the units that reach this point of spoilage. 8 500
x 5% = 425. This is now normal spoilage. Closing WIP has not passed
through this point so spoilage cannot be allocated to closing WIP
14
- Opening stock
Completed and 7 000 7 000 7 000

transferred 425 425 425
Normal spoilage 1 075 1 075 1 075
Closing WIP
10 000 10 000 10 000 9 700
Note:
 In this case spoilage takes place at the end of the process, viz at the
100% point.
 At the 100% point how much work have I done on the spoilt units? All,
therefore all work is lost and 100% is entered in the conversion column.
COST STATEMENT
Opening stock - - -
157 400 100 000 57 400
÷ ÷

components, in this case except for closing WIP.
15
Material Conversion
Units completed
- Material (7000/8075) x 425 368
- Conversion (7000/8075) x 425 368
Abnormal spoilage
- Material (1075/8075) x 425 57
- Conversion (1075/8075) x 425 57
____ ____
425 425

transferred
- Material (7000+368*) x 10 73 680
- Conversion (7000 + 368) x 5,92 43 619

- Material (1075+ 57*) x 10 11 320
- Conversion (1075+57*) x 5,92 6 701
Closing WIP 22 104

- material (1500+0) x 10 15 000
- Conversion (1200+0) x 5,92 7 104
Rounding (24)
157 400
* Normal spoilage ; Note:(spoilage is not allocated to closing WIP)
What we have dealt with so far is what we call the long method. The
long method can be used at all times. The short method (see below)
can only be used if closing WIP has already passed through the point of
spoilage.
16
ILLUSTRATION 3 (SHORT METHOD)
Refer to illustration 1
- Opening stock

Normal spoilage 500 - -
Abnormal spoilage 1 000 1 000 -
Closing WIP 1 500 1 500 1 200
10 000 10 000 9 500 8 200
Note that with the short method, no normal spoilage is allocated to the
material and conversion columns. Please compare this to illustration 1
and understand where the differences are.
COST STATEMENT
Total Material Conversio
n
Opening stock - - -
157 400 100 000 57 400
÷ ÷
In illustration 1 The material cost per unit is R10 and in this case it is
R10,526. The additional R0,526 is the cost of normal spoilage.
With the long method the normal spoilage is part of the units and in the
short method it is part of the cost per unit.
17

transferred
- Material 7000 x 10,526 73 682
- Conversion 7000 x 7 49 000

- Material 1000 x 10,526 10 526
- Conversion -
Closing WIP 24 189

- material 1500 x 10,526 15 789
Rounding 3
157 400
OPENING WORK IN PROGRESS
Before I illustrate how opening inventory is dealt with in a process

costing environment you need to understand the different methods of
valuing stock.
We will limit ourselves to the weighted average and the First-in-First–out

methods.
WEIGHTED AVERAGE METHOD
The weighted average method works on the premise that all available
stock, in other words, opening stock and current production are costed
at an average rate per unit.
Assume we have the following available stock

unit
5 000 16 700
We have a total of 5 000 units in stock at a total cost of R16 700. The
average cost per unit is therefore:
16 700 = R3,34
5 000
18
So if I transferred say 4 000 units to finished goods will it matter where

the stock came from, i.e. opening stock or current production? The
answer is no as all stock has the same unit cost.
Therefore closing stock will be valued as 1 000 units @ R3,34.
If we used FIFO the basic premise is that what ever was there first will
leave first. Hence in the above example what will closing stock be?

unit
5 000 16 700
Transfer 4 000 units (1 000) 3,50 (3 500)
(3 000) 3,30 (9 900)
1 000 3,30 3 300
The cost of opening stock is kept separate from current production.
ILLUSTRATION 4

Units R
Opening WIP 4 000
- Material 43 000
- Conversion – 60% complete 12 120

Spoilage takes place when the process is 50% complete.
Material is added at the beginning of the process and conversion costs are
incurred uniformly throughout the process.
Stock is valued on the weighted average basis.
19

CALCULATING NORMAL
SPOILAGE
50% point of spoilage
60%(opening WIP)
70%(closing WIP)
4 000 Opening stock


Normal spoilage 1 000 - -
Abnormal spoilage 1 400 1 400 700
Closing WIP 2 600 2 600 1 820
14 000 14 000 13 000 11 520
Time to visualise:
I start the new month with opening units of 4 000, which is 60% complete. This
means that 4 000 has already passed the point of spoilage in the previous
month. It can’t be spoilt again.
The current units start at 0% point. 10 000 units are introduced and worked on.
At the 50% point 10% is lost. This means that 9 000 (10 000 x 90%) units are left
to work on. When we get to the 70% point 2 600 units remain at this point as
unfinished stock. The remainder go through to output.
Since closing WIP has passed spoilage I can use the short method.
At the 50% point I have lost 50% conversion

20
COST STATEMENT
Opening stock 55 120 43 000 12 120
212 120 143 000 69 120
÷ ÷

transferred
- Material 9000 x 11 99 000
- Conversion 9000 x 6 54 000

- Material 1400 x 11 15 400
Closing WIP 39 520

- material 2600 x 11 28 600
- Conversion 1820 x 6 10 920
Rounding
212 120
21
ILLUSTRATION 5
Use the same information as in illustration 4
4 000 Opening stock

Completed and
transferred 4 000 - 1 600
- Opening stock 5 000 5 000 5 000
- Current production
1 000 - -
Normal spoilage 1 400 1 400 700
Closing WIP
14 000 14 000 9 000 9 120
Note
Opening stock must leave first. Current production is the difference

between 9 000 and 4 000 units. Normal and abnormal spoilage is
calculated as before. Opening stock does not need any more material
this period as all material has already been added. It does however
need 40% of conversion to complete the opening stock. Hence the 1 600
units.
COST STATEMENT
Opening stock 55 120 - -
212 120 100 000 57 000
÷ ÷

22
Units completed and transferred

Opening stock – opening balance 55 120
Conversion to complete opening stock 1600 x 6,25 10 000
65 120
Current production 5000 x 17,36 86 800
151 920

- Material 1400 x 11,11 15 554
- Conversion 700 x 6,25 4 375
Closing WIP 40 261

- material 2600 x 11,11 28 886
- Conversion 1820 x 6,25 11 375
Rounding 10
212 120
23
QUESTION 1
The Carroll Company manufactures a product on a continuous process

basis which passes through one department. The product uses three
different items of materials. Material A and B are introduced at the
start of the process and Material C is introduced when the process is
60% complete. Labour and overhead costs are added continuously
throughout the process and overhead is charged at 100% of the direct
labour cost.
The work in progress at the start of the accounting period consisted of

3 000 units 20% complete valued at R17 880, consisting of R12 600 for
Material A, R2 400 Material B and conversion costs of R2 880.
During the period 20 000 units were started and the following costs
were incurred:
Material A R84 000

Material B R16 000
Material C R19 200
Direct labour R44 400
The completed production for the month was 15 000 units and the
closing work in progress consisted of 4 000 units which were 50%
complete. Because of an error an unexpected loss occurred and all
the opening work in progress was spoilt. This loss was discovered when
the opening work in progress was 40% complete. Normal loss is as
expected and this is detected at the 90% stage.
Produce the process account for the period and show your
calculations of the cost per unit, closing work in progress and cost of
completed production. Use the weighted average method.
(Drury adapted)
24
The physical input and output to the process is as follows:
Units
Input
Opening WIP 3 000
Introduced during period 20 000
23 000
Output
Completed production 15 000
Closing WIP 4 000
Abnormal loss (opening WIP) 3 000 22 000
Difference = normal loss _1 000
23 000
The cost per unit (CPU) is calculated as follows:
Total Material A Material B Material C Conversion
Completed units 15 000 15 000 15 000 15 000 15 000

Closing WIP 4 000 4 000 4 000 - 2 000
Normal loss 1 000 1 000 1 000 1 000 900
Abnormal loss 3 000 3 000 3 000 - 1 200
Total equivalent 23 000 23 000 23 000 16 000 19 100
Total cost
Opening WIP 17 880 12 600 2 400 - 2 880
Current cost 208 000 84 000 16 000 19 200 88 800
Total cost 225 880 96 600 18 400 19 200 91 680
CPU R4,20 R0,80 R1,20 R4,80
Work in progress
R
Cost element A 16 800
Cost element B 3 200
Cost element C -
Conversion cost _9 600
29 600
25
Notes
a) All of the material will have been added at the 90% stage.
Therefore materials are 100% complete as regards normal loss.
b) The opening WIP that is spoilt is 40% complete. Material C is not

added until the 60% stage, but Materials A and B will already have
been added.
Value of stock
R
Closing WIP 29 600
Completed production 15 000 x 11,00 = 165 000
Normal loss 1 000 x 4,20 = 4 200
1 000 x 0,80 = 800
1 000 x 1,20 = 1 200
900 x 4,80 = 4 320 175 520
Abnormal loss
A 3 000 x 4,20 = 12 600
B 3 000 x 0,80 = 2 400
Conversion cost 1 200 x 4,80 = 5 760 20 760
225 880
Process account
R R
Opening WIP 17 880 Completed production 175 520
A 84 000 Abnormal loss 20 760
B 16 000 Closing WIP 29 600
C 19 200
Conversion cost 88 800 ______
225 880 225 880
26
QUESTION 2
In the course of your examinations of the financial statements of

Polyplast Ltd for the year ended 31 December 2013 you ascertained
the following concerning its manufacturing operations:
 The company has two production departments (fabricating and

finished) and a service department. In the fabricating department
Polyplast is prepared from miracle mix and bypro. In the finishing
department each unit of Polyplast is converted into six tetraplexes
and three uniplexes. The service department provides services to
both production departments.
 The fabricating and finishing departments use a process costing

system. Actual production costs, including overheads, are
allocated monthly.
 Service department expenses are allocated to production

departments as follows:
i. Building maintenance: based on space occupied.

ii. Time keeping and personnel: based on number of employees.
iii. Other expenses: 50% to fabricating and 50% to finishing.
The following information was extracted from the company’s records

for December 2013:
- Fabricating department activities Units of

Polyplast
In the process at the beginning of December 3 000
Started during the month 25 000
28 000
Transferred to finishing department 19 000

In process at the end of December 6 000
Normal loss identified at 50% completion 3 000
28 000
- Fabricating department costs: R

Work-in-process at beginning of December
Materials 13 082
Labour 17 500
Overheads 21 540
52 122
Direct labour costs for December 154 000

Departmental overheads for December 132 000
27
- Work in process partly completed in the fabricating

department was:
Materials Labour and

overheads
Beginning of December 66,667% 50%
End of December 100% 75%
- The raw material stock records revealed the following:
Miracle Mix Bypro
Quantity R Quantity R
Balance: beginning of December 62 000 62 000 265 000 18 550
Purchase 12 December 39 500 49 375
20 December 28 500 34 200
Issues 83 200 50 000
- Service department expenses for December (not

included in departmental overheads above) were: R
Building maintenance 45 000
Timekeeping and personnel 27 500
Other 39 000
111 500
- Other information for December is:
Square metres of Number of

space occupied employees
Fabricating 75 000 180
Finishing 37 500 120
112 500 300
Prepare a complete process costing statement for the fabricating

department assuming:
a) all stocks are valued on a FIFO basis

b) all stocks are valued on a weighted average basis.
28
a) Process costing statement on a FIFO basis
Opening WIP 3 000
28 000

costs
Opening stock 3 000 1 000 1 500
Started and completed 16 000 16 000 16 000
19 000 17 000 17 500
Normal loss 3 000 - -
Closing stock 6 000 6 000 4 500
28 000 23 000 22 000

costs
R R R
Opening WIP 52 122
Current costs 444 000 92 000(W1) 352 000(W2)
496 122
iv) Costs per equivalent unit R4 R16
finishing
496 122
29
Workings:
W1 Calculation of material costs
Miracle Mix Bypro

Quantity R (FIFO) R (WA) Quantity R
Opening stock 62 000 62 000 62 000 265 000 18 550
Purchases 68 000 83 575 83 575 -_ -_
130 000 145 575 145 575 265 000 18 550
Closing stock 46 800 215 000
FIFO: Miracle Mix
-Purchase 20 December 34 200
-18 200 x (49 375/39 500) 22 875
WA: Miracle Mix
-46,8/130 x R145 575 52 407
Bypro: 215 / 265 x R18 550 _______ _______ _______ _______ 15 050
Used 83 200 88 500 93 168 50 000 3 500
The cost for Bypro will be the same for FIFO and WA as no purchases
were made.
W2 Calculation of conversion costs
R
Departmental overheads 132 000
Allocated overheads (see below) 66 000
352 000
Calculation of allocated overheads

Total (R) Fabricatin
g (R)
Building maintenance 45 000 30 000 (75/112,5)
Time keeping and personnel 27 500 16 500 (180/300)
Other 39 000 19 500 (50%)
66 000
W3 Calculation of transfers to Finishing Department (FIFO)
(52 122 + [{17 400 x 4) + (17 500 x 16)] = R400 122
W4 Calculation of closing WIP (FIFO)
[(6 000 X 4) + (4 500 X 16)] = R 96 000

30
b) Process costing statement on a weighted average basis
Opening WIP 3 000
28 000

costs
Completed 19 000 19 000 19 000
and transferred 3 000 - -
Normal loss 6 000 6 000 4 500
Closing stock ______ ______ ______
28 000 25 000 23 500

costs
Opening WIP 52 122 13 082 39 040
Current costs 448 668 96 668(W1) 352 000(W2)
500 790 109 750 391 040
iv) Costs per equivalent unit R21,03 R4,39 R16,64
finishing
500 790
Workings:
W5 Calculation of transfers to Finishing Department (WA)
(19 000 x 21,03) = R399 570
W6 Calculation of closing WIP (WA)
[(6 000 x 4,39) + (4 500 x 16,64)] = R101 220

JOINT AND BY PRODUCTS
LEARNING OBJECTIVES
 Distinguish between Joint and By products
 Explain and Identify split off point in a joint cost situation
 Explain and apply the alternative methods of allocating joint

costs to products
 Discuss the argument for and against each method.
 Discuss whether products should be processed further or sold

at split off point.
 Describe and apply accounting treatment for by products

JOINT AND BY-PRODUCTS
INTRODUCTION
Where a common raw material or a joint production process is used,

the same production process can produce two or more different
products.
To illustrate the above, take the slaughtering of an ox at an abattoir as

an example. The process produces a carcass and a hide. The
slaughtering process is the joint production process and the carcass
and the hide are the different products which are produced.
The joint process can be diagrammatically represented as follows:
Carcass
Ox Slaughtering
process
Hide
CLASSIFICATION INTO JOINT PRODUCTS AND BY-PRODUCTS
The products yielded by a joint process can be classified as either joint

products or by-products.
Products which are more or less equivalent in importance, quantity and

value to the other products which also arise from the same
manufacturing process are classified as joint products. In the above
example of the abattoir both the carcass and the hide would be
classified as joint products.
When a product is subordinate to the joint products in importance,

quantity and value, it is classified as a by-product. By-products do
have a sales value, but they are incidental to the manufacturing
process. In some cases the by-products may not even have a value at
all, but they are nevertheless by-products arising from the
manufacturing of the principal product(s).
Suppose a butchery buys carcasses from the abattoir for further
processing. The cutting up and processing of the carcass is the joint
process and three different products are obtained, namely good
quality meat, poor quality meat and bones. Both the good and poor
quality meat are produced in large quantities and make a substantial
contribution to the market value of the output of the manufacturing
process and are therefore regarded as joint products. The bones are
of lesser importance and make a relatively small contribution to the
total market value. The bones are therefore classified as a by-product.
JOINT COSTS
In the above example of the butchery, certain costs are incurred in

processing the carcass into the three products. The cost of the
carcass, labour and overheads related to processing are common to
all three products.
In any manufacturing process which produces more than one product,

there is a point up to which it is not possible to identify individual
products. The point in the process at which the individual products can
be identified is known as the split-off or separation point. All the costs
incurred before the split-off point is reached are joint costs. They
include all materials, labour and overheads incurred to process the
products up to the split-off point.
ADDITIONAL PROCESSING COSTS
It frequently happens that joint products are not sold directly after the
split-off point. They first have to undergo further processing, separately.
These additional processing costs can be allocated directly to the
respective products by means of a job or process costing system.
The good quality meat in the example could undergo further

processing into tenderised steak, for example, and the poor quality
meat could be used for mince. Additional processing costs therefore
do not form part of the joint costs and are apportioned to the specific
product after the split-off point.
COSTING METHODS FOR JOINT PRODUCTS
The problem that arises is: How are the joint costs of the joint
manufacturing process divided between the joint products and by-
products? Normally no joint cases are allocated to the by-products.
Joint costs are therefore allocated only to the joint products (principal
products). Allocation may be based on one of the following:
 the physical standard method (units products)
 the market value at the split-off point method (the selling

price/market value at the split-off point is applied)
 relative market value of the final product method (the market value
of the final product is used and all additional processing costs after
the split-off point and selling and distribution costs are deducted
there from. In other words, the estimated market value at the split-
off point is calculated in this way).
 Reversal costing method.
The choice of methods applied depends on the views of the

management and the company’s specific circumstances. The
allocation of the joint costs according to the respective methods may
be illustrated by the example of the butchery. Since joint costs are not
allocated to the by-product, the bones, the by-product and the
proceeds from its sale are left out of the account.
ILLUSTRATION 1 – PHYSICAL UNITS METHOD
A company manufactures three products in a single process. Raw

material X is used to produce product XX, XY an XZ.
Opening stock, finished goods, 200 units XX, 250 units XY and 300 of XZ
with a cost price of R1,50, R2,50 and R4,00 respectively.
One unit X cost R10 and produces 2 units of XX, 3 units of XY and 4 units
of XZ.
Separate cost of processing the units further amount to R0,50c for XX,
R0,75 for XY and R1 for XZ.
1000 units of material X were processed during the year.
Sales for the year are:
XX XY XZ
Units sold 1 800 3 100 3 750

Proceeds R5 400 R12 400 R28 125
Fixed cost amount to R2 500 for the year.
Stock is valued on the FIFO basis.
Instead of processing the products further they can be sold at XX R1,20

per unit, XY at R2 per unit and XZ at R3 per unit.
Joint costs will be allocated on the basis of physical units in the

following way:
Units produced:
XX 1 000 x 2 = 2 000
XY 1 000 x 3 = 3 000
XZ 1 000 x 4 = 4 000
9 000
 XX = 2÷9 x R10 000 R 2 222

XY = 3÷9 x R10 000 R 3 333
XZ = 4÷9 x R10 000 R 4 445
R10 000
ILLUSTRATION 2 – RELATIVE SALES VALUE BASIS
Details as in Illustration 1.
Joint costs will be allocated on the basis of relative sales value in the
following way:
Relative sales value is defined as the selling price of the end product less
any costs necessary to process after split off – point, sell it and distribute it.
Please note that we referring to the sales value of production.
XX XY XZ
Sales value of production 6 000 12 000 30 000

Less: separate cost 1 000 2 250 4 000
Relative sales value 5 000 9 750 26 000
Allocation
XX 5 000 x R10 000 = R 1 227

40 750
4
XY 9 750 x R10 000 = R 2 393

40 750
XZ 26 000 x R10 000 = R 6 380

40 750
R10 000
ILLUSTRATION 3 – UNIFORM CONTRIBUTION/REVERSAL COSTING METHOD
Joint costs will be allocated on the uniform percentage contribution basis

as follows:
Profit percentage in example 2 30 750 = 64,1% 48 000
(1) (2) (3) (4)

Sales value Profit Separatable Share of
of contribution cost joint cost
production (1)x64,1% (1)-(2)-(3)
XX 6 000 3 844 1 000 1 156

XY 12 000 7 688 2 250 2 062
XZ 30 000 19 218 4 000 6 782
48 000 30 750 7 250 10 000
ILLUSTRATION 4 – RELATIVE SALES VALUE AT SPLIT - OFF
Joint costs will be allocated on the basis of relative sales value at split off
point in the following way:
% Allocation
XX 2 000 x R1,20 2 400 11,76 R 1 176

XY 3 000 x R2,00 6 000 29,41 R 2 941
XZ 4 000 x R3,00 12 000 58,83 R 5 883
20 400 100,00% R10 000
BY-PRODUCTS
The management of an enterprise considers the net realisable value of

by-products immaterial in relation to the total realisable value of the
joint product.
You will know by now that joint costs are allocated to joint products.
The question which arises now is how the proceeds obtained from the
sale of by-products should be dealt with.
The proceeds earned on the sale of a by-product (contribution) may

be brought to account as follows in the income statement:
 a reduction of the joint production costs
 “other income” (a separate income item) shown directly on the

income statement
 a reduction in the cost of goods sold.
The proceeds or contribution from a by-product are generally used to

reduce the joint cost of the joint products.
The basic principle is that for decision making purposes, there is never a
profit or loss on a by-product. The proceeds of the by-products are
used to reduce the joint cost where after it is allocated to joint
products.
By-product stock is usually regarded as having insignificant value and is

thus ignored. However should a value be placed on unsold stock, it
would be based on:
- Director's valuation
- Separate cost only.
Where not specifically mentioned stock must be valued at separate

cost only.
ILLUSTRATION 5
YOU ARE REQUIRED TO
Determine the profit if product XX is considered to be a by-product.

Assume that joint costs are allocated on the relative sales value basis. The
director's valuation of the closing stock of XX is R250.
SUGGESTED ANSWER
Total XX XY XZ
Sales 45 925 5 400 12 400 28 124

Cost of sales 17 820 5 400 4 226 8 194
- opening stock 2 125 300 625 1 200

- separate cost 7 250 1 000 *2 250 *4 000
- joint cost 10 000 4 350 1 541 4 109
________ ________ ________ ________
19 375 5 650 4 416 9 309

Less: closing stock 1 555 250 190 1 115
Net profit 28 105 - 8 174 19 931
ILLUSTRATION 6 – METHODS OF ACCOUNTING FOR BY-PRODUCTS
During November 2013, Suncake Ltd recorded the following results:
Opening stock Main product P = Nil

By- product z = Nil
Cost of production R120 000
Sales of the main product amounted to 90% of output during the period,
and 10% of production was held as closing stock at 30 November.
Sales revenue from the main product during November was R150 000.
A by-product Z is produced, and output had a net sales value of R1 000.

Of this output, R700 was sold during the month, and R300 was still on hand
at 30 November.
REQUIRED:
Calculate the profits for November using the four different methods of
accounting for by-products.
SUGGESTED SOLUTION
Income of by-product is added to sales of the main product
R R
Sales of main product (R150 000 + R700) 150 700
Opening stock -
120 000
Income of by-product treated as separate item in income statement

R R
Opening stock -
120 000
Other income 700
42 700
Income of by-product is deducted from the cost of production
R R
Opening stock -
119 300
Less: Closing stock (10%) 11 930
Net realisable value of by-product deducted from cost of production

(joint cost)
R R
Opening stock -
119 000
QUESTION 1
ABC Ltd manufactures three joint products using the same production
process. All three products can be sold either at the split-off point or
after further processing. The following information was obtained from
the budget for the three months ending 31 October 2014:
Sales value
Product Units At split-off After further Additional
point processing processing costs
R R R
Beba 1 000 40 000 50 000 10 000
Casa 2 500 80 000 115 000 25 000
Delta 1 500 50 000 60 000 15 000
The joint processing costs at the split-off point amount to R100 000.
REQUIRED:
a. Determine which products should be sold at the split-off point and

which products should undergo further processing.
b. Calculate the budgeted total profit for the three months ending 31
October 2014, taking your findings in (a) into account.
a) Calculation of which products should be sold at the split-off

point and which products should be sold after further
processing.
Beba Casa Delta Total

R R R R
Sales after split-off point 50 000 115 000 60 000 225 000
Sales at split-off point 40 000 80 000 50 000 170 000
Increase in sales 10 000 35 000 10 000 55 000
Additional processing costs
after split-off point 10 000 25 000 15 000 50 000
Additional profit/(loss) - 10 000 (5 000) 5 000
Recommendations:
Further processing and sale after the split-off point are only justified in
the case of product Casa.
b) Calculation of the budgeted total profit for the three months

ending 31 December 2014 if product Casa undergoes further
processing.
R
Sales 205 000
Beba at split-off point 40 000

Casa after split-off point 115 000
Delta at split-off point 50 000
Joint costs 100 000

Further processing costs after split-off point – 25 000
product Casa
Budgeted total profit 80 000

QUESTION 2 (40 MARKS - 48 MINUTES)
Alpha Limited manufactures three types of products in a joint

production process. Currently all products from this joint production
process is processed further in separate departments.
The following abridged income statement shows the profit per product
for the first financial year of the business. In this statement the joint cost
is allocated based on the volume produced.
Product A B C Total
R R R R
Cost of further processing (after

split off point) 50 000 25 000 5 000 80 000
Joint cost 40 000 20 000 4 000 64 000
Total production cost 90 000 45 000 9 000 144 000
Cost of sales 81 000 31 500 6 750 119 250
Net profit (loss) 16 200 (1 575) (675) 13 950
Sales 97 200 29 925 6 075 133 200
Included in the further processing cost of all three products is 40%

committed fixed cost.
Management is dissatisfied with the results obtained from using the

above method of allocating joint production cost. They are of the
opinion that products B and C are profitable and require another
statement showing more realistic results for each product.
According to the new statement product C will be considered to be a

by-product and joint cost for A and B will be allocated on the basis of
relative sales value.
Instead of processing further the products can be sold at the split-off

point at the following total values:
R
Product A 55 000
Product B 28 000
Product C 5 000
YOU ARE REQUIRED TO
a) Prepare a new statement according to the above decision (15)

and calculate the profit per type of product and in total.
b) Do a recommendation to management if each of the three

products should be processed further or not. (15)
U/93/81/7
LETTER HEAD
The directors of Alpha Limited. (1)
Dear Sirs
The decision of the further processing of the products must be

considered on the long-term as well as the short-term.
This recommendation is according to the results of the last financial

year. Changes in costs, prices and production output can result in
some other recommendation.
According to qualitative considerations product B must be sold on the

short-term at the split-off point. The result will be savings of R250. For
the long-term, the point where there is no more committed fixed costs,
products B and C must be sold at the split-off point. The result will be
savings of R12 150. (2)
The savings for the short-term is small and the effects of qualitative
factors must also be taken into account.
If some of the departments, where further processing is done at the

moment, are closed, workers will have to be restricted and this can
have a negative influence on the rest of the workers. The effect of the
decision in the current marketing channels must also be taken into
consideration. If the current buyers of the processed products get
other products from this company they may get other suppliers for the
products also. (2)
On the long-term the effect of the qualitative considerations will be less

because there will be a longer phasing period. (1)
Yours faithfully
(40)
a) Sales value A 97 200 / 81 x 90 = 108 000 (1)

B 29 925 / 315 x 450 = 42 750 (1)
Relative sales value A 108 000 - 50 000 = 58 000 (1)

B 42 750 - 25 000 = 17 750 (1)
75 750
Statement of profit per type of product
Product A B C Total
R R R R
Separate cost 50 000 25 000 5 000 80 000 (3)

Joint cost 46 630 14 270 3 100 64 000 (3)
Production cost 96 630 39 270 8 100 144 000
Less: Closing stock 9 663 11 781 2 025 23 469 (3)
Cost of sales 86 967 27 489 6 075 120 531
Profit 10 233 2 436 - 12 669 (3)
Sales 97 200 29 925 6 075 133 200
b) Further processing A B C
R R R
Sales price after processing 108 000 42 750 8 100 (3)

Less: Further processing cost 50 000 25 000 5 000 (3)
Opportunity cost 55 000 28 000 5 000 (3)
Long-term advantage
(disadvantage) for further processing 3 000 (10 250) (1 900) (3)
Add: Committed fixed cost 20 000 10 000 2 000 (3)
Short term advantage disadvantage)
for further processing 23 000 (250) 100 (3)
QUESTION 3 (40 marks / 54 minutes)
DUBONNE (PTY) LTD
You are the auditor of Dubonne (Pty) Ltd, a manufacturing company

which produces 4 products, namely, Med, Rossi, Bianco and Sec.
The operation comprises 4 departments, viz. research, maintenance

and 2 production departments. The research and maintenance
departments render appropriate services to the production
departments.
Due to the temporary absence of the company's cost accountant,

management consulted you with the request that you provide them
with relevant management accounting data to enable them to assess
results achieved.
Consequently you reviewed the accounting records and compiled the

Med Rossi Bianco Sec

1. Production in units at
optimum capacity 30 000 20 000 25 000 15 000
2. Opening stock (units) 4 000 5 000 8 000 2 000
3. Closing stock (units) 6 000 3 000 7 000 1 000
4. Sales R84 000 R88 000 R156 000 R32 000
5. Value of opening stock R8 000 R12 000 R24 000 R3 000
6. Costs of further R15 000 R20 000 R50 000 R15 000
processing
7. Joint costs, which are only applicable to the production in production
department 1, amount to R50 000.
You established that:
1. The company produces Med in production department 2 and the

remaining 3 products, in a joint process in production department
1.
2. Rossi and Bianco can be sold at the split-off at R3,50 per unit each,
whilst Sec has no sales value if not processed further.
3. 10% of the cost of further processing is committed fixed costs.
4. For management costing purposes Sec is classified as a by-

product and the joint costs in respect of Rossi and Bianco are
accounted for on the relative sales value basis.
5. Stock is valued on the first-in, first-out basis for Med, Rossi and
Bianco while Sec, the by-product, is valued at the directors
valuation of R1,50 per unit.
6. The costs incurred by the research and maintenance departments

amount to R50 000 and R29 300, respectively, and are allocated as
follows:
Research department
- 10% to the maintenance department
Maintenance department
- 20% to the research department
Management uses the reciprocal method to allocate the cost of

service departments.
YOU ARE REQUIRED TO:
a) calculate the total profit for each product for the period.
(30)
b) recommend the marketing policy which you consider

management should implement with regard to the three products
produced in department 1. (10)
1. Allocation of cost of service departments

I = 29 300 + ,10N
N = 50 000 + ,20I (1)
Replace
 I = 29 300 + ,10 (50 000 + ,2 I)
= 29 300 + 5 000 + 0,02I
 ,98 I = 34 300
I = 35 000 (2)
N = 50 000 + ,2 (35 000)
= 57 000 (1)
Maintenance Research Prod (1) Prod (2)

Cost + 29 300 + 50 000 (1)
Maintenance - 35 000 + 7 000 + 21 000 + 7 000 (2)
20:60:20
Research 10:60:20 + 5 700 - 57 000 + 34 200 + 17 100 (2)
NIL NIL R55 200 R24 100
2. Calculation of relative sales value (Production department (1))
Rossi Bianco Sec

Sales value per unit R4,00 R6,00 R2,00
Production in units 20 000 25 000 15 000
Sales value of production R80 000 R150 000 R30 000 (2)
Less: Separate costs R20 000 R 50 000 (2)
Relative sales value R60 000 R100 000 (2)
Allocation 6 10 (1)
3. Allocation of costs and calculation of profit

Rossi Bianco Sec Total
Opening stock 12 500 (1) 24 000 (1) 3 000 (1) 39 500

Plus production costs 53 638 106 062 30 500 190 200
- Joint costs 33 638 (1) 56 062 (1) 15 500 (1) 105 200
- costs of further processing 20 000 50 000 15 000 85 000
66 138 130 062 33 500 229 700

Cost of sales 58 092 100 365 32 000 190 457

Gross profit 29 908 55 635 -- (1) 85 543
Sales 88 000 156 000 32 000 276 000

(1)
Med
Opening stock 8 000

Production 39 100
- Processing costs 15 000 (1)

- From service department 24 000 (1)
47 100
Less: Closing stock 7 820 (1)
39 280
Gross profit 44 720
R84 000 (1)

b) Recommendation
Rossi Bianco Sec
Sales value of production 80 000 150 000 30 000 (1)
Less: Costs of further processing 20 000 50 000 15 000 (2)
Opportunity costs 70 000 87 500 - (1)
(10 000) 12 500 15 000 (1)

Plus: Committed fixed costs 2 000 5 000 1 500
Short-term advantage (disadvantage) (8 000) 17 500 16 500 (1)
On long-term and short-term Rossi sells at split-off point and Bianco, Sec
and Med sells after further processing.
If this is done the profit will increase by R8 000. (2)
NB: Here joint costs are irrelevant. Relevant costs are cost incurred
for further processing after a split-off point. (a)
Additional income process only if the relevant income exceeds
the costs.
1
 Explain how budgeting fits into the overall framework of decision making,
planning and control
 Describe six different purposes of budgets
 Describe the various stages in the budget process
 Prepare functional master budgets
 Describe Activity based budgeting
 Describe zero-based budgeting
STAGES IN THE PLANNING PROCESS
To help you understand the budgeting process we shall begin by looking at how it
fits into an overall framework of planning, decision-making and control.
STAGE 1 :
ESTABLISHING OBJECTIVES
Establishing objectives is an essential pre-requisite of the planning process. In all

organisations employees must have a good understanding of what the
organisation is trying to achieve. Strategic or long-range planning therefore begins
with the specification of the objectives towards which future operations should be
directed. The attainment of objectives should be measurable in some way and
ideally people should be motivated by them.
2
Corporate objectives related to the organisation as a whole. They are normally

measurable and are expressed in financial terms such as desired profits or sales
levels, return on capital employed, rates of growth or market share. Corporate
objectives are normally formulated by members of the board of directors and
handed down to senior managers.
Unit objectives relate to the specific objectives of individual units with the
organisation, such as a division or one company within a holding company.
Corporate objectives are normally set for the organisation as a whole and are then
translated into unit objectives, which become the targets for the individual units.
You should note that the expression aims is sometimes used as an alternative to
mission and the term goals is synonymous with objectives.
STAGE 2 : IDENTIFY POTENTIAL STRATEGIES
The next stage is to identify a range of possible courses of action (or strategies) that
might enable the company's objectives to be achieved. The corporate strategy
literature advocates that, prior to developing strategies, it is necessary to
undertake a strategic analysis to become better informed about the organisation's
present strategic situation. This involves understanding the company's present
position, its strengths and weaknesses and its opportunities and risks.
An organisation should determine the basis on which it will compete and/or sustain
a superior level of performance. The purpose is to ensure that deliberate choices
are made regarding the type of competitive advantage it wishes to attain.
Porter (1985) has identified three generic strategies that an organisation can follow:
1. cost leadership, whereby the organisation aims to be the lowest cost producer
within the industry;
2. differentiation, through which the organisation seeks some unique dimension in

its product / service that is valued by consumers, and which can command a
premium price;
3. focus, whereby the organisation determines the way in which the strategy is
focused at particular parts of the market. For example, a product or service
may be aimed at a particular buyer group, segment of the product line or small
geographical area. An organisation that adopts a focused strategy aimed at
3
narrow segments of the market to the exclusion of others also needs to

determine whether within the segment it will compete through cost leadership
or differentiation.
Porter's view is that any organisation seeking a sustainable competitive advantage

may select an appropriate generic strategy rather than attempting to be "all things
to all people".
Having identified the basis on which it will compete, an organisation should

determine the direction ns it wishes to take. The company should consider one of
more of following:
1. doing nothing;
2. withdrawing from some markets;
3. selling existing products more effectively in existing markets (market
penetration);
4. selling existing products in new markets (market development);
5. developing new products for sale in existing markets (product development);
6. developing new products for sale in new markets (diversification).
STAGE 3 :EVALUATION OF STRATEGIC OPTIONS
The alternative strategies should be examined based on the following criteria¹
1. suitability, which seeks to ascertain the extent to which the proposed strategies
fit the situation identified in the strategic analysis.
2. feasibility, which focuses on whether the strategy can be implemented in

resource terms.
3. acceptability, which is concerned with whether a particular strategy is

acceptable.
4
STAGE 4 : SELECT COURSE OF ACTION
When management has selected those strategic options that have the greatest
potential for achieving the company's objectives, long-term plans should be
created to implement the strategies. A long term plan is a statement of the
preliminary targets and activities required by an organisation to achieve its
strategic plans together with a broad estimate for each year of the resources
required.
STAGE 5 : IMPLEMENTATION OF THE LONG-TERM PLANS
Budgeting is concerned with the implementation of the long-term plan for the year
ahead. Because of the shorter planning horizon budgets are more precise and
details. Budgets are a clear indication of what is expected to be achieved during
the budget period whereas long-term plans represent the broad directions that top
management intend to follow.
The budget is not something that originates "from nothing" each year - it is
developed within the context of ongoing business and is ruled by previous
decisions that have been taken within the long-term planning process. When the
activities are initially approved for inclusion in the long-term plan, they are based
on uncertain estimates that are projected for several years.
STAGE 6 and 7 : MONITOR ACTUAL OUTCOMES RESPOND TO DIVERGENCIES FROM

PLANNED OUTCOMES
The final stages in the decision-making, planning and control process are to
compare the actual and the planned outcomes, and to respond to any
divergencies from the plan. These stages represent the control process of
budgeting.
5
THE MULTPLE FUNCTIONS OF BUDGETS
Budgets serve a number of useful purposes. This include:
1. planning annual operations;

2. coordinating the activities of the various parts of the organisation and ensuring
that the parts are in harmony with each other;
3. communicating plans to the various responsibility centre managers;
4. motivating managers to strive to achieve the organisational goals;
5. controlling activities;
6. evaluating the performance of managers.
Let us now examine each of these six factors:
PLANNING
The major planning decisions will already have been made as part of the long-term
planning process. However, the annual budgeting process leads to the refinement
of those plans, since managers must produce detailed plans for the
implementation of the long-range plan. Without the annual budgeting process,
the pressure of day-to-day operating problems may tempt managers not to plan
for future operations.
COORDINATION
The budget serves as a vehicle through which the actions of the different parts of
the organisation can be brought together and reconciled into a common plan.
Without any guidance, managers may each make their own decisions, believing
that they are working in the best interests of the organisation.
COMMUNICATION
If an organisation is to function effectively, there must be definite lines of

communication so that all the parts will be kept fully informed of the plans and the
policies, and constraints to which the organisation is expected to conform.
Everyone in the organisation should have a clear understanding of the part they
are expected to play in achieving the annual budget.
6
MOTIVATION
The budget can be a useful device for influencing managerial behaviour and
motivating manages to perform in line with the organisational objectives. A
budget provides a standard that under certain circumstances, a manager may be
motivated to strive to achieve. However, budgets can also encourage inefficiency
and conflict between managers.
CONTROL
A budget assists managers in managing and controlling the activities for which
they are responsible. By comparing the actual results with the budgeted amounts
for different categories of expenses, managers can ascertain which costs do not
conform to the original plan and thus require their attention. This process enables
management to operate a system of management by exception, which means
that a manager's attention and effort can be concentrated on significant
deviations from the expected results.
PERFORMANCE EVALUATION
A manager's performance is often evaluated by measuring his or her success in

meeting the budgets. In some companies bonuses are awarded on the basis of an
employee's ability to achieve the targets specified in the periodic budgets, or
promotion may be partly dependent upon a manager's budget record. In
addition, the manager may wish to evaluate his or her own performance. The
budget thus provides a useful means of informing managers of how well they are
performing in meeting targets that they have previously helped to set.
CONFLICTING ROLES OF BUDGETS
Because a single budget system is normally used to serve several purposes there is
a danger that they may conflict with each other. For instance the planning and
motivation roles may be in conflict with each other. Demanding budgets that may
not be achieved may be appropriate to motivate maximum performance, but
they are unsuitable for planning purposes. For these a budget should be set based
on easier targets that are expected to be met.
7
THE BUDGET PERIOD
The conventional approach is that once per year the manager of each budget
centre prepares a detailed budget for one year. The budget is divided into either
twelve monthly or thirteen four-weekly periods for control purposes.
ADMINISTRATION OF THE BUDGETING PROCESS
It is important that suitable administration procedures be introduced to ensure that

the budget process works effectively. In practice, the procedures should be tailor-
made to the requirements of the organisation, but as a general rule a firm should
ensure that procedures are established for approving the budgets and that the
appropriate staff support is available for assisting managers in preparing their
budgets.
THE BUDGET COMMITTEE
The budget committee should consist of high-level executives who represent the
major segments of the business. Its major task is to ensure that budgets are
realistically established and that they are coordinated satisfactorily. The normal
procedure is for the functional heads to present their budget to the committee for
approval. If the budget does not reflect a reasonable level of performance, it will
not be approved and the functional head will be required to adjust the budget
and re-submit it for approval. It is important that the person whose performance is
being measured should agree that the revised budget can be achieved otherwise,
if it is considered to be impossible to achieve, it will not act as a motivational
device. If budget revisions are made, the budgetees should at lease feel that they
were given a fair hearing by the committee.
ACCOUNTING STAFF
The accounting staff will normally assist managers in the preparation of their
budgets; they will, for example, circulate and advise on the instructions about
budget preparation, provide past information that may be useful for preparing the
present budget, and ensure that managers submit their budgets on time.
8
The accounting staff do not determine the content of the various budgets, but
they do provide a valuable advisory and clerical service for the line managers.
BUDGET MANUAL
A budget manual should be prepared by the accountant. It will describe the

objectives and procedures involved in the budgeting process and will provide a
useful reference source for manages responsible for budget preparation. In
addition, the manual may include a timetable specifying the order in which the
budgets should be prepared and the dates when they should be presented to the
budget committee. The manual should be circulated to all individuals who are
responsible for preparing budgets.
STAGES IN THE BUDGETING PROCESS
The important stages are as follows:
1. communicating details of budget policy and guidelines to those people

responsible for the preparation of budgets;
2. determine the factor that restricts output;
3. preparation of the sales budget;
4. initial preparation of various budgets;
5. negotiations of budgets with superiors;
6. coordination and review of budgets;
7. final acceptance of budgets;
8. ongoing review of budgets.

9
Cash budgets
The objective of the cash budget is to ensure that sufficient cash is available at all
times to meet the level of operations that are outlined in the various budgets.
Because cash budgeting is subject to uncertainty, it is necessary to provide for
more than the minimum required, to allow for some margin of error in planning.
Cash budgets can help a firm to avoid cash balances that are surplus to its
requirements by enabling management to take steps in advance to invest the
surplus cash in short-term investments. Alternatively, cash deficiencies can be
identified in advance, and steps can be taken to ensure that bank loans will be
available to meet any temporary cash deficiencies.
Final review
The budgeted profit and loss account, the Statement of Financial Position and the
cash budget will be submitted by the accountant to the budget committee,
together with a number of budgeted financial ratios such as the return on capital
employed, working capital, liquidity and gearing ratios. If these ratios prove to be
acceptable, the budgets will be approved.
COMPUTERISED BUDGETING
In the past, budgeting was a task dreaded by many management accountants.
In today's world, the budgeting process is computerised instead of being primarily

concerned with numerical manipulations, the accounting staff can now become
more involved in the real planning process. Computer-based financial models
normally consist of mathematical statements of inputs and outputs. By simply
altering the mathematical statements budgets can be quickly revised with little
effort. However, the major advantage of computerised budgeting is that
management can evaluate many different options before the budget is finally
agreed. Establishing a model enables "what-if?" analysis to be employed. For
example, answers to the following questions can be displayed in the form of a
master budget:
What if sales increase or decrease by 10%?
What if unit costs increase or decrease by 5%?
What if the credit terms for sales were reduced from 30 to 20 days?
10
ACTIVITY-BASED BUDGETING
The conventional approach to budgeting works fine for unit level activity costs
where the consumption of resources varies proportionately with the volume of the
final output of products or services. However, for those indirect costs and support
activities where there are no clearly defined input-output relationships, and the
consumption of resources does not vary with the final output of products or
services, conventional budgets merely serve as authorisation levels for certain levels
of spending for each budgeted item of expense.
Budgets that are not based on well-understood relationships between activities

and costs are poor indicators of performance and performance reporting normally
implies little more than checking whether the budget has been exceeded.
Conventional budgets therefore provide little relevant information for managing
the costs of support activities.
With conventional budgeting indirect costs and support activities are prepared on
an incremental basis. This means that existing operations and the current
budgeted allowance for existing activities are taken as the starting point for
preparing the next annual budget. The base is then adjusted for changes (such as
changes in product mix, volumes and prices) which are expected to occur during
the new budget period. This approach is called incremental budgeting, since the
budget process is concerned mainly with the increment in operations or
expenditure that will occur during the forthcoming budget period. For example,
the allowance for budgeted expenses may be based on the previous budgeted
allowance plus an increase to cover higher prices caused by inflation. The major
disadvantage of the incremental approach is that the majority of expenditure,
which is associated with the "base level" of activity, remains unchanged. Thus, the
cost of non-unit level activities become fixed and past inefficiencies and waste
inherent in the current way of doing things is perpetuated.
To manage costs more effectively organisations that have implemented activity-

based costing (ABC) have also adopted activity-based budgeting (ABB). The aim
of ABB is to authorise the supply of only those resources that are needed to perform
activities required to meet the budgeted production and sales volume. Whereas
ABC assigns resource expenses to activities and then uses activity cost drivers to
assign activity costs to cost objects (such as products, services or customers), ABB is
the reverse of this process. Cost objects are the starting point. Their budgeted
output determines the necessary activity, which are then used to estimate the
resources that are required for the budget period. ABB involves the following
stages:
11
1. estimate the production and sales volume by individual products and

customers;
2. estimate the demand for organisational activities;
3. determine the resources that are required to perform organisational activities;
4. estimate for each resource the quantity that must be supplied to meet the
demand;
5. take action to adjust the capacity of resources to match the projected supply.
12
ZERO-BASED BUDGETING
Zero-based budgeting (also know as priority-based budgeting) emerged in the late

1960's as an attempt to overcome the limitations of incremental budgets. This
approach requires that all activities are justified and prioritised before decisions are
taken relating to the amount of resources allocated to each activity. Besides
adopting a "zero-based" approach zero-base budgeting (ZBB) also focuses on
programmes or activities instead of functional departments based on line-items
which is a feature of traditional budgeting.
ZBB works from the premise that projected expenditure for existing programmes
should start from base zero, with each year's budgets being compiled as if the
programmes were being launched for the first time. The budgetees should present
their requirements for appropriations in such a fashion that all funds can be
allocated on the basis of cost-benefit or some similar kind of evaluative analysis.
The cost-benefit approach is an attempt to ensure "value for money"; it questions
long-standing assumptions and serves as a tool for systematically examining and
perhaps abandoning any unproductive projects.
ZBB involves the following three stages:
 a description of each organisational activity in a decision package;

 the evaluation and ranking of decision packages in order of priority;
 allocation of resources based on order of priority up to the spending cut-off
level.
13
QUESTION 1 20 marks
Lalakahle (Pty) Limited is a manufacturing business that produces hand made

quality beds and mattresses. The company is setting its budget for 2013/2014 for
the orthopaedic range of beds and mattresses that it sells. There are two top of
the range beds in this line, the ‘Down bed’ and the ‘Dreamcast’. You are the
accountant at Lalakahle (Pty) Limited and your task is to prepare the budgets for
the coming year. You have been given the following information:
As a result of using specialised forecasting computer software it has been

forecast that the number of units to be sold is likely to be as follows, for both the
2013/2014 and 2014/2015 financial years:
Number of beds sold Sales price per bed
Down bed 1 056 R850

Dreamcast 1 176 R755
At the end of 2012/2013 there were 75 Down beds and 64 Dreamcast beds were
still in inventory. It is company policy to maintain enough inventory of beds at the
end of each month to meet demand for 55% of the next month’s forecast sales.
The sales and production of both products tend to be evenly distributed
Both beds are made from the same raw materials. These are wood, plastic and
treated nylon. These are required in the following quantities per bed in terms of
output (finished product):
Down bed Dreamcast
Wood 15kg 21kg

Plastic 6kg 3,5kg
Treated nylon 17 square metres 19 square metres
Some wastage occurs during the manufacturing process. This is 1,5% of wood
and plastic and 3% of nylon. This material wastage has no further use.
14
At the end of 2012/2013 most of the remaining raw material inventory was sold to
another company because the warehouse was undergoing essential
maintenance. The budget should allow for inventory levels to be built up to
normal levels of 25% of the next month’s usage. The raw materials that remained
at the end of 2012/2013 were:
Wood 196kg
Plastic 72kg
Treated nylon 62 square metres
Current prices are as follows:
R
Wood 4,60 per kg
Plastic 5,50 per kg
Treated nylon 21,00 per square metre
It is expected that these prices will rise in August 2013 by 2%
The labour requirements for each bed are as follows:
Down bed Dreamcast
Skilled 5hrs 6hrs

Unskilled 4hrs 4,5hrs
Skilled labour costs R14,00 per hour and unskilled labour costs R6,50 per hour
The financial year runs from June to May

15
REQUIRED
(a) In your role as accountant produce the following budgets for the
year 2013/2014:
(i) Sales budget in units and in rand value. (2)
(ii) Production budget in units. (3)
(iii) Materials usage budget in units. (3)
(iv) Materials purchases budget in units and in value. (Only show
total requirement for period June – July and August – May. Do not (4)
show individual monthly requirements)
(v) Labour budget in hours and in value. (4)
(b) Describe how the approach used to construct these budgets differs
from the methods used in the public service. (4)
(Dipac2-6 : October 2008 Exam)

16
(a) In your role as accountant produce the following budgets for the year
2013/2014:
(i) Sales budget in units and in rand value. [2]

Units Selling price Sales value
Down bed 1 056 R850 R 897 600 [1]

Dreamcast 1 176 R755 R 887 880 [1]
R 1 785 480
(ii) Production budget in units. [3]
Down bed Dreamcast

Sales 1 056 1 176 [1]
Less opening stock (75) (64) [1]
Add closing stock 49* 54** [1]
Production 1,030 1,166
(1 056/12 = 88 x 55%)*
(1 176/12 = 98 x 55%)**
(iii) Materials usage budget in units. [4]
Wood Plastic Nylon

Kg Kg M
Down bed (15kg x 1 030) (6kg x 1 030) (17m x 1 030)
15 450 6 180 17 510
Dreamcast (21kg x 1 166) (3.5kg x 1 166) (19m x 1 166)
24 486 4 081 22 154
Total 39 936 10 261 39 664
Wastage 609 157 1 227 [1]
Requirement 40 545 10 418 40 891 [3]
17
(iv) Materials purchases budget in units and in value. [4]
Wood Plastic Nylon

Kg Kg m
Requirement 40 545 10 418 40 891
Less opening stock (196) (72) (62) [1]
Add closing stock
(40 545/12) x 25% 845
(10 418/12) x 25% 218 [1]
(40,891/12) x 25% 852
Purchase requirement 41 194 10 564 41 681 [1]
Price per unit (R)
June – July 4,60 5,50 21,00
[1]
August – May (x 1.02) 4,692 5,61 21,42
Purchase cost (R)

June – July 31 582 9 684 145 883
[1]
August – May 161 069 49 387 744 006
(Assumes even monthly purchase)
Maximum 4
(v) Labour budget in hours and in value. [4]
Skilled Semi-skilled
Down bed Dreamcast Down bed Dreamcast
Production units 1 030 1 166 1 030 1 166
Time per unit 5hrs 6hrs 4hrs 4,5hrs [1]
Total hours 5 150 6 996 4 120 5 247 [1]
Rate per hour R14 R14 R6,50 R6,50 [1]
Labour cost 72 100 97 944 26 780 34 106 [1]
Total direct labour cost R230 930
(b) Describe how the approach used to construct these budgets differs from the [4]
methods used in the public service
 In the public service incremental budgets are based on the previous budget. This
is then adjusted for expected changes in the next budget period. In (a) above
the whole budget is driven by the limiting factor, which in this case is the sales [2]
volume
 In the public service rolling budgets are continuously being updated in relation to
new information. The above budget will not be adjusted according to
circumstances but monitored using variance analysis. [2]
18
REQUIRED:
(a) Calculate the variable production costs per unit, and the fixed production [4]
costs per month, over the three month period.
Month 1 Month 2 Month 3
Production 12 000 10 500 10 000
Unit Cost 23,75 25,00 25,50
Total Cost R285 000 R262 500 R255 000
LOW HIGH DIFFERENCE
Volume 10 000 12 000 2 000 [1]
Total Cost R255 000 R285 000 R30 000 [1]
Unit Variable cost R30 000/2000 R15 [1]
Total Variable costs (Based on low 10000 x R15 = R150 000
volume)
Total Fixed costs (Based on low R255 000 - R150 000 = R105 000 [1]
volume)
(b) Estimate the total cost that would be incurred in Month 4 if 12 500 units are [2]
manufactured.
Month 4
Production (Units) 12 500
Variable Cost (R15 X 12500) R187 500 [0.5]
Fixed Cost R105 000 [0.5]
Selling + Admin R87 000 [0.5]
Total Cost R379 500 [0.5]
(c) Prepare a profit statement for Month 2 using the absorption costing method. [7]
Assume that the fixed production overhead absorption rate is based upon
normal production of 12 000 units per month.
UNITS R
Production 12 000
Recovery rate 105 000/12 000 R8,75 per unit [1]
Absorption Costing Statement for Month 2:

R000
Sales: (10 000 units at R34 per unit) 340 [1]
Production cost of sales: (10 000 units at R23,75 per unit) (237,5) [1]
Gross profit (before adjustment) 102,50
19
Under absorbed production overhead: (1 500 units at R8,75 per (13,125) [1]
unit)
Gross profit (after adjustment) 89,375 [1]
Selling and administration overheads (87) [1]
Net profit 2,375 [1]
(d) Prepare a profit statement for Month 3 using the marginal costing method. [5]
Marginal Costing Statement for Month 3:

R000
Sales: (11 000 units at R34 per unit) 374
Variable cost of sales: (11 000 units at R15 per unit) (165) [1]
Contribution 209 [1]
Fixed overheads Production (105) [1]
Fixed overheads Selling and administration (87) [1]
Selling and administration 17 [1]
(e) Explain, with supporting figures, the profit difference in Month 2 if the [2]
marginal costing method had been used instead of absorption costing.
 Profit difference = 500 units at R8,75 per unit = R4 375. [2]

 Production is in excess of sales by 500 units and therefore additional fixed [2]
production overhead is going into stock under absorption costing, resulting
in lower profit if the marginal costing method is applied.
20
QUESTION 2
You are the accountant of the Mountain Creek Estate (Pty) Limited, an upmarket
mountain resort.
A project to upgrade the resort has commenced this year, the funding of which is
placing a great deal of pressure on the available funds. An overdraft facility of R60
000 has been arranged, but you are unsure if this will be sufficient. If this facility is
insufficient, a long-term loan will have to be raised.
You have extracted the following information, relating to the 2010 financial year
from the records:
1. Actual Budget
March 2010 April 2010 May 2010 June 2010
R R R R
Kitchen supplies
- Kitchen supplies used 39 600 42 800 56 800 48 500
- Opening stock 4 000 4 400 5 600 4 800
Sales
- Accommodation 130 000 150 000 180 000 120 000
- Bar 17 500 22 500 27 000 19 500
2. The mark-up, based on the cost price of the bar purchases, is

200%. Bar stock figures are negligible and must be ignored.
3. Purchases are payable as follows:
Bar – 1 month from date of purchase, no discount allowed.
Kitchen supplies – 2 months from date of purchase, at a discount

of 5%.
4. Income from accommodation is normally received or written off as

follows:
- 90% received during the applicable month
- 5% received during the ensuing month
- 5% written off in the month of sale due to guests leaving
without settling their Accounts.
21
5. Bar sales are for cash only.
6. Monthly general cash expenses amount to R68 000. An amount of

R3 000 was in arrears at 30 April 2010.
7. Depreciation on the furniture and equipment amounts to R9 600

per month. Vehicles are depreciated at 20% per annum on the
reducing balance method.
8. Interest on a loan of R280 000 is payable at 17% per annum, six

monthly in arrears on 31 December and 30 June of every year.
Capital repayments only commence in 2011.
9. The company has been assessed for company taxation for the
financial year which ended on 29 February 2009. The amount due
is R40 800 and it is payable on 31 May 2010.
10. The following is an extract from the capital budget for the year:
10.1 A second-hand courtesy bus, which will be used for

sightseeing trips and to transport guests from the airfield to
the hotel, has been purchased. It costs R80 000, and will
be delivered on 31 May 2010. The purchase will be financed
by an instalment sale agreement. A deposit of 20% will be
payable on the date of delivery. Monthly payments, which
have to be made on the last day of every successive month,
will amount to R2 200.
10,2 Cost of refurbishing 10 guest suites will amount to R25 000 per
suite, and will be payable upon completion of a suite. Two
suites were completed in April; one is expected to be
completed in May and two in June 2010. The cost of
refurbishing the suites will be capitalised as improvements to
the land and building.
10.3 The tennis court will be reconstructed at a cost of R40 000. A

10% deposit is payable on 25 April 2010, the date of
commencement. The outstanding balance will be payable in
monthly instalments at the end of every month, based on the
percentage of completion.
22
11. The existing courtesy bus will be sold on 31 May 2010 at a loss of R1
500. On 1 March 2010, the book value of this bus was R20 000.
12. The expected progress on the reconstruction of the tennis court is

as follows:
Month end Stage of completion

April 2010 10%
May 2010 90%
June 2010 100%
13. The favourable balance on the bank account at 30 April 2010

amounts to R20 000.
REQUIRED:
Prepare a cash budget for May and June 2010. (20)

23
MOUNTAIN CREEK ESTATE (PTY) LIMITED
Cash budget for May and June 2010
May June Calculations

with marks in
brackets
R R
Bank balance – beginning of month 20 000 6 900 - (1)
Receipts 214 000 136 500
Bar sales 27 000 19 500 - (1)

Accommodation receipts 169 500 117 000 1 (2)
Proceeds from sale of vehicle 17 500 - 2 (2)
234 000 143 400

Payments 227 100 198 400
Kitchen supplies creditors 38 000 41 800 3 (4)

Bar purchases creditors 7 500 9 000 4 (2)
General expenses 71 000 68 000 5 (1)
Interest paid - 23 800 6 (1)
Taxation assessment 40 800 - - (½)
Instalment sale creditor
- Deposit paid 16 000 - 7 (½)
- Monthly payment - 2 200 - (½)
Refurbishing of guest suites 25 000 50 000 8 (½)
Progress payments on tennis court 28 800 3 600 9 (2)
Bank balance/(bank overdraft) – end 6 900 (55 (1)

of month 000)
The overdraft facility of R60 000 will therefore be sufficient. (1)
Calculations
1. Accommodation
Total May June

R R R
April 2010 150 000 7 500 ( 5%) -

May 2010 180 000 162 000 (90%) 9 000 ( 5%)
June 2010 120 000 - 108 000 (90%)
Accommodation receipts 169 500 117 000
24
2. Proceeds from sale of vehicle

R
Book value 01.03.2010 20 000
Depreciation ( 20 x 3 x R20 000)

(100 12 ) 1 000
Book value 31.05.2010 19 000

Loss on sale 1 500
Proceeds from sale of vehicle 17 500
3. Payments to creditors for kitchen supplies
Purchases
March April
R R
Expected usage 39 600 42 800
Add: Closing stock 4 400 5 600
44 000 48 400
Less: Opening stock 4 000 4 400
Expected purchases 40 000 44 000

Less: 5% discount 2 000 2 200
Net payment to creditors 38 000 41 800
Payable within 60 days, therefore in May and June 2010 respectively.
4. Payments to creditors for bar purchases

R
Cost 100
Mark-up 200
300
Cost = selling price x 33,3%
Purchases
April May
R R
Sales (100%) 22 500 27 000
Cost of bar purchases (33,3%) 7 500 9 000
Payable with 30 days, therefore in May and June 2010 respectively.

25
5. General Expenses
May June
R R
Monthly payments 68 000 68 000
Add: In arrears 01.05.10 3 000 -___
71 000 68 000
6. Interest paid
R
Loan 280 000
Interest (17% x R280 000 x 6/12) 23 800
7. Instalment sale creditor

R
 Deposit (20% x R80 000) 16 000
8. Refurbishing of guest suites
May June
Number of suites completed 1 2
R R
Cost per suite 25 000 25 000
Total payment due 25 000 50 000
9. Progress payments on tennis courts

R
Less: Deposit (10% x R40 000) 4 000
Balance 36 000
Payable as follows:
April 2010 (10/100 x R36 000) 3 600
May 2010 (80/100 x R36 000) 28 800
June 2010 (10/100) x R36 000) 3 600
36 000
26
Kengary Supplies (Pty) Limited has recently incorporated. The issued share capital
of the company amounts to R75 000, consisting of 75 000 ordinary shares of R1
each. The shares have been issued for cash.
The company has managed to obtain a R50 000 loan from a banking institution.
Plant and machinery, costing R60 000, has been given as security for the loan. The
loan is repayable, annually in arrear, in five equal instalments of R16 000. The
effective rate of interest applicable to the loan amounts to 18% per annum.
The company has also managed to obtain an overdraft facility of R50 000 on its
current account.
Operations are intended to commence on 1 June 2010. The production target for
the first year has been set at 140 000 units.
The selling price has been fixed at R20 per unit. The budgeted ratios of costs in
relation to the selling price are as follows:
Raw material : 35%

Labour : 25%
Production overhead : 10%
Selling and administrative expenses : 5%
Production overhead includes depreciation on plant and machinery at a rate of

10% per annum.
Interest on the loan has not been included in administrative expenses.
The stock policy of the company is as follows:
1. Due to problems with the availability of raw material, stock should be sufficient
to make provision for the production requirement of the following three months.
2. There should be no work-in-process at the end of a financial year.
3. From the beginning of the year, finished goods stock should be sufficient to
make provision for the budgeted sales of the following two months.
27
4. Finished goods stock is valued at standard absorption cost.
5. Raw material stock is valued at actual cost, as determined on the first-in-first-out

method.
According to expectations, sales will take place evenly throughout the year.
The company is allowed 45 days for its raw material supplies. All other expenses
have to be paid for in cash.
All sales will be on credit. Debtors are granted a period of 30 days after delivery of
the goods to pay their accounts. Five percent of all debtors should be provided for
as being irrecoverable.
REQUIRED:
a) Prepare a cash budget for the company for the first year of business. (10)
b) Prepare a projected Statement of Financial Position at 31 May 2011, as well as

projected Statement of Comprehensive Income for the year ending at that
date. (17)
Ignore all forms of taxation.

28
a) Cash budget
Production budget
(Representing the budgeted sales for 14 months)
Given as 140 000 units
Consisting of:
- units required for sales (12 months) 120 000 1
- units required for closing stock 20 000 2
(2 months’ budgeted sales) _______
140 000
Calculations
1 140 000 x 12
14 = 120 000
2 140 000 x 2
14 = 20 000
Raw material purchases budget
Required for
R
- closing stock (140 000 / 12 x 3 x R20 x 35%) 245 000
- production (140 000 x R20 x 35%) 980 000
- purchases 1 225 000
Cash budget for the year ended 31 May 2010 R

Cash receipts 2 215 000
Shares 75 000
Loan 50 000
Debtors (10 000 x 11 x R20 x 95%) 2 090 000
Cash payments 2 241 875

Plant and machinery 60 000
Loan 16 000
Raw material (1 225 000 x 10.5 / 12) 1 071 875
Labour (140 000 x R20 x 25%) 700 000
Overhead [(140 000 x R20 x 10%) – (10% x R60 000)] 274 000
Selling and administrative costs (5% x 120 000 x R20) 120 000
Budgeted bank overdraft at 31 May 2010 26 875

(10)
29
Projected statement of financial position and statement of comprehensive income

Projected statement of financial position at 31 May 2010
Calculation R
Capital employed
Share capital 75 000
75 000 ordinary shares of R1 each
Distributable reserves 471 000
Retained income _______
Shareholders’ interest 546 000
Long term loan 1 34 740
580 740
Employment of capital Calculation R

Fixed assets 2 54 000
Plant and machinery
Net current assets 526 740
Current assets 715 000
Stock 3 525 000
Debtors 4 190 000
Less: Current liabilities 188 260
Bank overdraft 26 875
Creditors 5 153 125
Loan 6 8 260
580 740
(9)
Calculations
1 Loan = R[(50 000 – 16 000) + (18% x 50 000)]

= R43 000
Long term
Portion = R43 000 – short term portion
= R[(43 000 – 16 000) + (18% x 43 000)]
= R34 740
R
2 Plant and machinery 54 000
- At cost 60 000
- Less: Accumulated depreciation (10% x R60 000) 6 000
3 Stock (values per Statement of Comprehensive Income) 525 000

- Finished goods 280 000
- Raw materials 245 000
30
4 Debtors 190 000

- Gross debtors 310 000
[(10 000 x R20 x 95% + (120 000 x R20 x 5%)]
- Less: provision for bad debts (120 000 x R20 x 5%) 120 000
5 Creditors
Creditors = Total raw material purchase – cash payments
= R1 225 000 – R1 071 875 (per cash budget)
= R153 125
6 Loan
Short term portion = R43 000 – R34 740
= R 8 260
Projected statement of comprehensive income for the year ended 31 May 2010
R
Sales: (120 000 x R20) 2 400 000
Less: Cost of sales 1 680 000
Production cost 1 1 960 000
Less: Closing stock finished goods
[20 000 x (35 + 25 + 10)% x R20] 280 000
Gross profit 720 000

Less: Operating expenses 249 000
(5% x 120 000 x R20) 120 000
Interest (50 000 x 18%) 9 000
Bad debts (120 000 X R20 X 5%) 120 000
Net income 471 000
Calculation:
R
1 Production cost
Raw material 980 000
Purchases 1 225 000
Less: Closing stock (per raw material purchases budget) 245 000
Labour (25% x 140 000 x R20) 700 000
Overhead (10% x 140 000 x R20) 280 000
Production cost 1 960 000
(8)
31
QUESTION 4 (20 marks 24 minutes)
African Mining Supplies (Pty) Ltd is a supplier of mining equipment to various mines
in the North-West Province.
The following information has been obtained for purposes of compiling the cash
budget for November 2010 :
1. Projected balances of selected accounts at 31 October 2010
R
Bank (positive) 50 000
Savings account 355 000
Instalment sale creditor – Delivery-van 124 962
Prepaid fixed selling and administrative 27 000
expenses
2. Sales
2.1 The actual and projected sales amount to
R
October 2010 1 500 000
November 2010 2 000 000
2.2 Eighty percent (80%) of sales are on credit. Debtors tend to settle their
accounts as follows:
- 20% within the month of sale

- 79% within the month following the month of sale
- 1% is irrecoverable
2.3 Debtors settling their accounts within the month of sale receive a 2,5%
discount.
32
3. Purchases
3.1 The actual and projected purchases amount to
R
October 2010 950 000
November 2010 800 000
3.2 Purchases are paid for in the month following the month of purchase.
4. Stock
The company does not carry stock of any kind.
5. Expenses per month
Selling and administrative, excluding salaries and wages
-Fixed (including an amount of R50 000 in respect of depreciation) R260 000

-Variable 8% of turnover
Salaries and wages R460 000
The projected balance on the prepaid fixed selling and administrative

expenses account at 30 November 2010 amounts to R32 000. An amount of
R19 000 in respect of currently prepaid fixed selling and administrative
expenses will expire during November 2010.
No amounts are planned to be in arrear at any stage.
6. Value added tax (VAT)
The VAT liability for October, which is payable on or before 25 November

2010, amounts to R13 882.
33
7. Fixed assets
7.1 During August 2010, a delivery-van with a cost price of R60 000 and a
book value of R50 000 was hijacked. Confirmation has been received
from the insurers that the insurance claim amounting to R45 000 will be
paid out on the 20 November 2010 by means of a direct transfer into
the company’s current account.
7.2 A new delivery-van has been purchased for R90 000 at the beginning
of October 2010. The purchase was financed by means of a
instalment sale agreement. At an effective interest rate of 14,5% per
annum, the amount is repayable in 60 equal payments of R2 118,
payable monthly in arrear, commencing on 31 October 2010.
8. Dividends
The directors of the company indicated that dividends to the amount of

R50 000 will be declared on 30 November 2010.
REQUIRED:
a) Determine the amount which should be transferred between the current

account and the savings account in order to maintain a positive balance of
R50 000 on the current account at 30 November 2010. (17)
b) State two advantages normally associated with the compilation of budgets.

(3)
[20]
34
AFRICA MINING SUPPLIES (PTY) LIMITED
a) Amount to be transferred
R
Projected cash inflows 1 705 000
Cash sales (1) 400 000

Receipts from debtors (2) 1 260 000
Insurance claim received 45 000
Less: Projected cash outflows 1 820 000
Payments to creditors 950 000

Salaries and wages 460 000
Fixed cost (R260 000 – R50 000) 210 000
Variable cost (2 000 000 x 8%) 160 000
Value-added tax 13 882
Instalment sale agreement 2 118
Dividends --
Prepaid fixed selling and administrative expenses (3) 24 000
Transfer from savings account 115 000
As a positive balance in the current account must be maintained, the difference

between projected cash inflows and projected cash outflows would equal the
transfer between the current and savings account.
Calculations:
(1) R2 000 000 x 20% = R400 000
(2) R
Oct: 1 500 000 x 79% x 80% 948 000
Nov: 2 000 000 x 80% x 20% x 97,5% 312 000
1 260 000
(3)
Prepaid fixed selling and administrative expenses
2010 R 2010 R
01 Nov Balance 27 000 30 Nov Expenses 19 000
30 Nov Bank 24 000 30 Nov Balance 32 000
51 000 51 000
01 Dec Balance 32 000
(17)
35
b) Advantages of budgets
- Guides personnel to knowing what is expected of them and how their efforts will
be evaluated.
- Isolates problem areas and enables corrective action to be taken before they
occur.
- Increases an awareness of the importance of cost considerations in the

operations of a company.
Any other advantages, limited to two. ( 3)

36
The Betabuild housing company has two types of housing estates in the Blackberry
Area. (Type A and Type B). The following information is available:
1. The company has its own team of painters who carry out the painting and
decorating work on the housing estates. The estimated cost for each house
in which the work will be done in 2010 is as follows:
a) Direct material cost R200
b) Direct labour cost R270
c) During 2010 total overheads are estimated and absorbed in the

following manner:
20% of direct material cost and 100% of direct labour cost.
30% of the material and 33⅓% of the labour related overheads, as a

part of the total overheads, are variable. The remainder is fixed
overhead and its allocation is determined by using the budgeted
number of houses which require annual painting and decorating.
d) Fixed overhead is to be divided into:
i) Items avoidable on cessation of the service 30%

ii) Depreciation of equipment and premises 20%
iii) Head office: administrative costs 50%
2. The total number of houses of each type and the percentage requiring
painting and decorating each year is as follows:
Type
A B
Total number of houses 500 600
Percentage of houses requiring
maintenance each year 30% 20%
37
3. Adjustments in wage rates and increases in prices will result in the following
annual fixed percentage increases in the painting and decorating costs from
the beginning of 2011:
%
Direct materials 5
Direct labour 7
Total overheads 6
4. On 31 December 2009, the following balances are expected to be disclosed

in the accounting records:
R
Creditors for materials 2 100
Materials on hand Nil
Labour cost accrued 2 800
Creditors – variable overheads 600
- The credit purchases outstanding at a year end are estimated at 10% of the
annual materials purchased on credit.
- Credit purchases are 90% of purchases, the remainder being cash

purchases.
- Labour costs accrued at the end of a financial year are estimated as 4% of

the annual labour cost for the specific year.
- Variable overheads are paid for as follows: 60% during the month of accrual
and 40% in the following month.
Variable overheads are deemed to occur on an even monthly basis

- Fixed overheads are paid in twelve equal amounts during the year on a
regular monthly basis.
38
REQUIRED:
Compile a cash budget for the existing painting and decorating function for
both the financial years 2010 and 2011. (Exclude fixed overhead for 2011.)
(Work to the nearest Rand.) (27)
(Oct 2006 Exam)
39
QUESTION 5 - SOLUTION
BETABUILD
(a) Costs incurred for painting and decorating:
2010 2011
 54 000 56 700
Direct material
 72 900 78 003
Direct labour
Variable overheads③ 27 540 29 192

Fixed overheads:
Avoidable 16 848
Depreciation 11 232
Head office – administrative costs 28 080

Direct material:
Number of houses each = (500 x 30%) + (600 x 20%)
year: = 270 houses
Direct material for 270 houses = R200 x 270 for 2010 = R54 000
for 2011 = R54 000 x 105%
= R56 700
Direct labour:
For 2010: = R270 x 270 houses = R72 900
For 2011: = R72 900 x 107% = R78 003
③ Variable overheads:
Total overheads per house = Material related + Labour related
= (R200 x 20%) + (R270 x 100%)
= R40 + R270
= R310
Of which (30% x R40) + (⅓ x 270) = variable
= R12 + R90
= R102 variable overhead per house
Variable overhead for 2010: = R102 x 270 = R27 540

for 2011: = R27 540 x 106% = R29 192

Fixed overheads:
Total overheads per house – variable overheads per house = fixed overheads
R310 - R102 = R208 per house
Therefore:
Total for 2010 = R208 x 270 = R56 160
40
Consisting of: Only for 2010

Avoidable fixed overheads (30% x R56 160) = R16 848
Depreciation (20% x R56 160 = R11 232
Head office (50% x R56 160) = R28 080
Cash Budget for the painting and decorating function
2010 2011
R R
Direct materials payments to creditors:
Previous year creditors (2009:given) 2 100
(2010:90% x R54 000 x 10%)
43 740 4 860
Current year [90% x (90% x R54 000)(a)]
[90% x (90% x R56 700)(a)] 5 400 45 927
Cash purchases (2010:10% x R54 000(a))
5 670
(2011:10% x R56 700(a))
Direct labour payments:

2 800
Previous year accruals (2009: given)
(2010: 4% x R72 900)
69 984 2 916
Current year (2010: 96% x R72 900(a))
(2011: 96% x R78 003(a)) 74 883
Variable overhead:
Previous year (2009: given) 600
(2010: 40% x R27 540/12)
918
Current year 2010: 26 622(i)
2011:
28 223(i)
Fixed overhead:
Avoidable
Head office – administration costs 16 848
(No depreciation – not cash flow) 28 080 Excluded
- Excluded
-
196 174 163 397
(i) Variable overhead cash (13)
expense
2010 = R27 540/12

= R2 295 per month
= R25 245 + (60% x R2 295)
= R25 245 +R1 377
= R26 622
2011 = R29 192/12
= R2 433 per month

= R26 763 + (60% x R2 433)
= R26 763 + 1 460
= R28 223 (27)
42
Clusters Limited has finalised its statements for the financial year that ended on 31
December 2009. A reasonable growth in volumes has not dispelled concerns over the
immediate sales and production outlook and this has resulted in the following
assumptions as regards its trading activities and budgets for the financial year which will
end on 31 December 2010.
Sales
There will be no cash sales and it is estimated that the current turnover of the
completed goods stock, which is six times per annum, based on the average
stockholding for the year, will be maintained.
The gross profit as a percentage of sales is 331/3 %.
Completed goods
Stock on hand -1/1/2010 30 000 units
The closing stock at the end of the financial year will show a 50% increase over the
opening stock and will be valued by using the absorption cost basis.
Production cost per unit of completed goods :
R
Materials 8,00
Labour – direct 6,00
Total production overheads 6,00
20,00
The total production overheads allocated and paid for completed goods is based on
the estimated normal production volume for 2010. An amount of R200 000 for the
annual depreciation of machinery and fixed assets is included in this payment. The
machinery and fixed assets which were installed on 1 January 2009 at cost, have an
expected useful life of five years and depreciation is written off at 20% per annum on
cost based on the straight line method.
Materials
Stock on hand -1/1/2010 R150 000
The stock of materials is expected to remain at this level throughout the financial year.
43
Debtors
Balance -1/1/2010 R450 000
The sales are expected to occur on an even daily basis throughout the financial year
which normally consists of 360 days per annum. The normal debtors collection period is
30 days after the date of sale.
Creditors
Balance -1/1/2010 R160 000
The creditors are expected to remain at this level throughout the financial year.
Additional information :
- Variable selling and administrative expenses amount to 5% of sales.
- Fixed selling and administrative expenses are expected to amount to

R810 000.
- On 1/1/2010, the bank balance reflected an overdraft of R180 000, whilst the
projected favourable balance on 31/12/2010 is R710 000.
REQUIRED :
(a) Set out a concise production budget in units for 2010. (5)
(b) Draft a budgeted statement of comprehensive income for the year ending
31 December 2010. (11)
(a) Draft a concise statement of financial position as at 31 December 2010.

(12)
(May 2004 Exam)

44
Stock t/o = 6
Stock t/o = COS ÷ Average stock
Average stock = (Closing stock + opening stock) ÷ 2
R
Closing stock of FG = 30,000 units x R20 x 1.5 = 900,000 told that CS will be 50% ↑ than OS
R
Opening stock of FG = 30,000 units x R20 = 600,000
Average stock = (900,000 + 600,000) ÷ 2 =
COS = Stock t/o x Av. Stock

= 6 x R750,000 = R 4,500,000
bear in mind the following relation: O/S + Purchases (or production) - C/S = COS
Production budget (units) Production budget (Rands)

R
Sales 225,000 COS 4,500,000
Add: Closing
Add: Closing stock 45,000 stock R 900,000
Less: Opening
Less: Opening stock -30,000 stock -R 600,000
R
Production 240,000 Production 4,800,000
Budgeted Statement of comprehensive income for the

year ended 31/12/10
Sales 100%
Sales (4,500,000 x 3 ÷ 2) R 6,750,000 COS 66.67%
Less: Cost of sales R 4,500,000 GP 33.33%
Gross Profit R 2,250,000
Less: Selling and Admin costs
Variable S&A (5% x 6750,000) -R 337,500
Fixed S&A -R 810,000
Net Profit R 1,102,500
45
Statement of financial
position as at 31/12/10
Calcs R R
ASSETS
Non-current
Assets
-
Machinery 1 600,000
600,000
Current
Assets
- Inventory 2 1,050,000
- Debtors 3 562,500
- Bank 710,000
2,322,500
TOTAL ASSETS 2,922,500

Equity 4 R 2,762,500
Creditors 160,000
TOTAL EQUITY AND LIABILITIES 2,922,500
Calculations:
1 machinery has expected useful life of 5 years, depreciation p.a. is R200,000, therefore cost
of machinery =R1,000,000. 2 years have passed, therefore 3 years are left, so current value
of machinery = R200,000 x 3 = R600,000
2 Closing stock of FG = R900,000 and closing stock of materials = R150,000; therefore total
closing stock is = R900,000 + R150,000 = R1,050,000.
3 Debtors collection period is 30 days (1 month) after sale - there is thus one month's sales in
debtors at any point in time; = R6,750,000 ÷ 12 = R562,500.
4 Opening balance equity (01/01/10) = A-L
Fixed asset = 800,000
stock FG = 600,000
stock Materials = 150,000
Debtors = 450,000
Creditors = -160,000
Bank = -180,000
1,660,000
Add current net profit = R 1,102,500
Total Equity = R 2,762,500
46
The University of Africa requires all second year engineering students to have their own
laptop computers in order to do practical work and tasks. During the last quarter of
2009, a close corporation, Laptops for Students CC was established to supply laptops
according to the specifications set by the university, at affordable prices. At that time,
a loan of R800 000 was granted to the close corporation and the funds were deposited
into the bank account.
The following additional information is available for Laptops for Students CC :
1. According to estimates, 200 of the 400 second year engineering students will buy
their laptops from Laptops for Students CC. There are two types of laptops which
will be supplied, namely Exceptional at a selling price of
R10 000 and Superior at a selling price of R8 000. Since the Exceptional laptop
has a more powerful hard drive, it is expected that 60% of the 200 students will
prefer to buy this laptop and the other 40% the Superior.
2. The following quarterly sales forecast for 2010 has been made :
Quarter % of the 200 students who will buy their laptops in the
1 quarter
65%
2 20%
3 15%
4 -
It is expected that the sales for 2011 will follow the same pattern as that of 2010.
3. All sales will be on credit with a 45 day average debtors collection period from
the invoice date. Sales will take place evenly throughout each quarter. Assume
a month has 30 days.
4. During any quarter, purchases from suppliers are equal to 80% of the next
quarter’s estimated sale value. Suppliers are paid within 90 days after the end of
the quarter of purchase.
5. At the beginning of the first quarter, a delivery vehicle was bought on credit. The
instalment is R11 000 per quarter. Depreciation on the delivery vehicle amounts
to R8 000 per quarter.
6. Commission of 5% of the sales per quarter will be paid out in the relevant quarter.
47
7. Interest on the R800 000 loan, which was granted in 2009, amounts to 16% per
annum and is payable in equal amounts every quarter.
8. In November 2010, new posters and price lists for 2011 will be ordered from K-
Printers. A deposit of R5 000 will be paid, while the balance of R6 000 will be paid
on delivery in the first quarter of 2011.
REQUIRED :
(a) Compile the sales budget for Laptops for Students CC for each of the four
(b) Compile the cash budget for Laptops for Students CC for each of the four
(c) State whether the close corporation will be in a position to repay the R800 000
loan at the end of the fourth quarter of 2010 without their bank account going
into overdraft and motivate your answer. (1)
(Oct 2004 Exam)

48
(a) Sales budget for the four quarters of 2010
Exceptional Superior Total sales

value
R
Sales- Quarter 1 (units) 65% x 120 ① = 78 65% x 80 ① = 52
Sales value R780 000 R416 000 1 196 000
Sales- Quarter 2 (units) 20% x 120 =24 20% x 80 = 16

Sales value R240 000 R128 000 368 000
Sales- Quarter 3 (units) 15% x 120 = I8 15% x 80 = 12

Sales value R180 000 R96 000 276 000
1 840 000
(6)
OR
Sales value Quarter 1 Quarter 2 Quarter 3
R R R
Exceptional (65% x 120 ① x R10 000) 780 000 - -
Superior (65% x 80 ① x R8 000) 416 000 - -
Exceptional (20% x 120 ① x R10 000) - 240 000 -
Superior (20% x 80 ① x R8 000) - 128 000 -
Exceptional (15% x 120 ① x R10 000) - - 180 000
Superior (15% x 80 ① x R8 000) - - 96 000
1 196 000 368 000 276 000
Calculations:
① Number of units sold
Expected Exceptional sales: 60% x 200 students = 120 units

Expected Superior sales: 40% x 200 students = 80 units
49
(b) Cash budget for the four quarters of 2010

R R R R
Bank balance - opening 800 000 338 400 764 600 809 000
Add: Budgeted receipts
Receipts from debtors ② 598 000 782 000 322 000 138 000
1 398 000 1 120 400 1 086 600 947 000
Less: Budgeted payments 1 059 600 355 800 277 600 48 000
Payments to creditors ③ 956 800 294 400 220 800 -
Instalment on delivery vehicle 11 000 11 000 11 000 11 000
Commission ④ 59 800 18 400 13 800 -
Interest on loan (16% x 800 000 ÷ 4) 32 000 32 000 32 000 32 000
K-Printers deposit - - - 5 000
Bank balance - closing 338 400 764 600 809 000 899 000
(19)
(c) Yes, since there will still be a favourable bank balance of R99 000 after the capital of
R800 000 has been repaid. (1)
Calculations:
② Receipts from debtors
Quarter 1 : ½ x R1 196 000 = R598 000

Quarter 2: ½ x R1 196 000 + ½ x R368 000 = R598 000 + R184 000 = R782 000
Quarter 3: ½ x R368 000 + ½ x R276 000 = R184 000 + R138 000 = R322 000
Quarter 4: ½ x R276 000 = R138 000
OR
Quarter of sale Receipts from debtors
R R R R
1 (50% x R1 196 000) 598 000 598 000 - -
2 (50% x R368 000) - 184 000 184 000 -
3 (50% x R276 000) - - 138 000 138 000
598 000 782 000 322 000 138 000

50
③ Purchases and payments to creditors
Last quarter 2010: 80% x R1 196 000 = R956 800 to be paid in quarter 1
Quarter 3: R0
Quarter 4: 80% x R1 196 000 = R956 800 to be paid in quarter 1 of 2011.
OR
Quarter of purchase 2009 2010
Quarter Quarter Quarter Quarter

Last quarter 1 2 3 4
R R R R R
1 (80% x R1 196 000) 956 800 - - - -
2 (80% x R368 000) - 294 400 - - -
3 (80% x R276 000) - - 220 800 - -
4 (80% x R1 196 000) - - - - 956 800
Total purchases per quarter 956 800 294 400 220 800 - 956 800
Payments to creditors - 956 800 294 400 220 800 -
④ Commission
Quarter 1: 5% x R1 196 000 = R59 800

Quarter 2: 5% x R 368 000 = R18 400
Quarter 3: 5% x R276 000 = R13 800
You are the chairperson of the finance committee of Hillside College, a private
school which was founded two years ago. Numerous fundraising projects are
continually being organised in order to complete the school buildings and
establish the required sporting facilities.
An amount of R100 000 is required to complete the athletic track and rugby fields.
A suggestion has been made to have a beer festival during the second weekend
in September 2010.
The parents association and finance committee members have provided you with
the following information regarding the proposed beer festival :
1. Entrance tickets
Entrance tickets can be sold at R50 each, which includes a light meal and a
500ml beer mug. It is expected that 1 800 tickets will be sold, 1 080 of which
are expected to be sold to males and 720 to females. A special price of R1
000 has been negotiated for the printing of 2 000 tickets which will have to
be printed and paid for in August 2010. Any unsold tickets will be disposed
of.
2. Food
The expected cost of the food other than that which has been donated will
be R190000, R12 000 of which will have to be paid for in August 2010 and the
balance in September 2010.
3. Beer
A major brewery has agreed to supply draught beer for the festival on a
C.O.D. (cash on delivery) basis. The draught beer is supplied in 50 litre
reusable vats, the content costing R250 per vat. A refundable deposit of R50
is payable on each vat supplied at the time of delivery. The beer will be
delivered to the school premises in a refrigerated trailer. The hiring of the
trailer will amount to R500 for the weekend and will be payable on
collection of the trailer.
As the brewery is prepared to refund the full purchase price of unused vats
returned, it has been decided to purchase 10 extra vats to provide for the
possibility of more beer being consumed or more tickets being sold.
The beer will only be sold in 500ml quantities at R8 each. Each guest wishing
to drink beer uses his/her own 500ml beer mug. On average, males are
expected to consume 5 mugs of draught beer each and females, 1,5 mugs
each.
52
4. Beer mugs
The beer mugs will be purchased and paid for in August 2010 and are
expected to cost R8 500.
5. Cold drinks
It is expected that 70 dozen cans of cold drinks could be sold at R5 per can.
The cold drinks cost R20 per dozen. A quote of R400 has been obtained for
the rental of the sink baths and the supply of dried ice to keep the cold
drinks cold.
6. Rental of marquee (tent)
One of the parents owns a catering business and is prepared to let out his
marquee to the school as a special favour, at a drastically reduced price.
The rental he will charge the school is equal to one monthly instalment he
pays in terms of a suspensive sale agreement. The amount that is being
financed for the marquee is R103 232 and it is repayable in equal monthly
instalments of 2½ years at a nominal interest rate of 12% per annum,
payable monthly.
7. Band
A traditional German band can be booked. The band required a non-

refundable deposit of R2 000 at the time of booking which is no later than
June 2010 and an additional payment of R8 000 after performing for the two
nights.
8. Sponsorships
Advertisers have been found for 20 sponsorship boards that will be placed in
prominent places during the beer festival. The school is charging R1 000 per
board, 50% payable by June 2010 and the balance in September 2010.
REQUIRED :
(a) Prepare a beer sales budget for the proposed beer festival in September
2010. (3)
(b) Determine the projected amount payable to the brewery on delivery of the
beer. (4)
(c) Advise on whether the required amount could be raised by preparing a

budgeted statement of comprehensive income for the proposed beer
festival to be held in September 2010 at Hillside College. (20)
53
① Entrance tickets : Males – 1 080 x 50 = 54 000)
Females – 720 x 50 = 36 000)

Revenue 90 000)
Printing (2 000 tickets) (1 000) (August paid)
89 000)
Food : R19 000
Beer : Deposit = R50/vat

Hire of trailer R500
50ℓ =
= R250/50
ℓ
Beer mugs : R8 500
③ Cold drinks :
Sales : 70x12x5 = 4 200

Cost : 20x70 = (1 400)
Rental Bath = (400)
: = R2 400
⑦ Instalment PV ⑤ Band : R 2 000 + R8 000

Marquee : = PV factor = R10 000
= 103 ⑥ Sponsorship : 20 x 1 R20 000

232
25,8 000 =
= R4 000
a ② Sales : R8/500ml  R16/ℓ

) Males : 5 mugs @ R8 x 1 43 200
080
Females : 1,5 mugs @ R8 x 8 640
720 51 840
54
④ Purchases
b)
(2,5ℓ x 1 080) + (0,75ℓ x 720) = 3 240ℓ
 50ℓ
= 64,8 vats
= 65 vats
+ Extra 10
75 vats
x 250
18 750
Refundable deposit: 75 vats x R50 each = R3 750
Total payable on delivery of beer = 18 750 + 3 750 = 22 500
Budgeted Statement of Comprehensive Income
Income : Entrance tickets ① 90 000

Beer sales ② 51 840
Cool drink sales ③ 4 200
Sponsorships ⑥ 20 000
166 040
Expenses : Printing ① 1 000
Food 19 000
Beer mugs 8 500
Cool drinks ③ 1 400
Bath hire ③ 400
Marquee ⑦ 4 000
Trailer hire 500
Purchase of beer ④ 18 750
Band ⑤ 10 000 (63 550)
102 490
Target will be met

55
QUESTION 9 (25 MARKS : 30 MINTUES)
As from May 2010, you have been appointed a the new financial manager of Exo
(Pty) Limited, a company selling a wide range of plastic products directly to the
public.
At the end of May, the general manager requested you to prepare a revised
statement of comprehensive income for the remainder of the financial year, a
period of nine months ending 28 February 2011. The following decisions which
were taken at a management meeting and will take effect as from 1 June 2010,
should be incorporated in the revised budgeted statement of comprehensive
income:
- the selling prices of all the products in the existing product range are to be
increased by 8%
- a new product will be added to the existing product range
- an advertising campaign, costing R30 000 will be launched on 1 June 2010
which is expected to have the effect of a ten percent (10%) increase in the
original budgeted sales volume for the remainder of the 2010-2011 financial
year. It is not anticipated that the advertising campaign will have an effect
on sales subsequent to February 2011.
You have analysed the actual results for the past three months ended 31 May 2010
and have also obtained the following information:
1. Sales
1.1 Sales relating to the existing product range
Prior to the decisions taken at the management meeting, sales were

expected to amount to R1 000 000 for the nine month period ending 28
February 2011.
1.2 Sales relating to the new product
After having taken the effect of the advertising campaign into account, it is
estimated that sales of the new product will amount to R160 000.
1.3 Settlement of sales
60% of all sales are on credit. Debtors tend to settle their accounts as
follows:
o 75% in the month of sale

o 23% in the month following the month of sale
o 2% is irrecoverable, provided for in the month of sale.
56
1.4 Determination of selling prices
Disregarding the effect of the increase in selling prices on products within

the existing product range, selling prices of products are based on a uniform
mark-up of 25% on the cost price.
2. Stock
Stock levels do not fluctuate.
3. Expenses per Month
3.1 Selling and administrative expenses
Fixed : R9 000
Variable : 8% of turnover
3.2 In addition to the above-mentioned selling and administrative expenses,

municipal expenses were estimated at R6 000 for the year. Due to a new
incentive scheme of the municipality, effective from 1 June 2010, a discount
of 3% will apply to all accounts paid in full every month. Exo (Pty) Limited
always pays municipal accounts in full.
4. Director’s Loan
A loan from D Exo, a director of the company, amounts to R60 000 at 1 June
2010. There is no fixed date for the repayment of the capital. Interest for the
nine months ending 28 February 2011 must be capitalized against the loan
account at a nominal rate of 14% per annum.
5. Fixed Assets
5.1 Pick-up vehicle
On 1 June 2009, a pick-up vehicle was acquired for R100 000. The
transaction was financed by means of a suspensive sale agreement at a
guaranteed effective interest rate of 18%. No deposit was paid. The full
amount in terms of the suspensive sale agreement is repayable in four equal
annual instalments, payable annually in arrear.
57
5.2 Delivery van
The delivery van which was acquired approximately three years ago, will be
sold on 1 December 2010 for R47 500. The cost price of the van amounted
to R70 000 and the book value at March 2010 was R28 000.
Depreciation on fixed assets for the nine months ending 28 February 2011,
excluding depreciation on the delivery van in 5.2 above, amounts to R30
200. Motor vehicles are depreciated according to the straight line method
at a rate of 20% per annum.
6. Dividends
On 31 May 2010, 1 000 shares were purchased in Plastics Supplies (Pty)

Limited at 250 cents per share. Plastics Supplies (Pty) Limited has declared a
dividend of 50 cents per share, which will be paid on 30 September 2010.
REQUIRED:
Prepare a revised budgeted Statement of Comprehensive Income for the nine

months ending 28 February 2011. Figures must, where necessary, be rounded off
to the nearest rand. (25)
(May 2001 Exam)

58
BUDGETED STATEMENT OF COMPREHENSIVE

INCOME
for the 9 months 01.06.10 - 28.02.11
Turnover - existing (1 000 000 x 1.1 x 1.08) 1,188,000

- new 160,000
1,348,000
Cost of sales [(1 000 000 x 1.1) + 160 000] ÷ 1.25 (1,008,000)
Gross Profit 340,000
Other income
- investment income (1000 x 0.5) 500
- profit on sale of van1 30,000
370,500
Expenditure 293,793
Advertising 30,000
Bad debts (1 348 000 x 60% x 2%) 16,176
Selling and Admin expenses - fixed (9 000 x 9) 81,000
- variable (1 348 000 x 8%) 107,840
Municipal costs (6 000 x 9/12 x 0.97) 4,365
Interest on Director's loan (60 000 x 9/12 x 14%) 6,300
Finance costs2 (interest on suspensive sale) (14 549 x 9/12) 10,912
Depreciation - sold asset (14 000 x 6/12) 7,000
- other assets 30,200
Net Profit 76,707
Note 1
Book value @ 01/03/10 28,000
Less: depn. for 9 months 1 Mar - 1 Dec (14 000 x 9/12) 10,500
(annual depn. = 70 000 x 20% = 14 000 p.a.)
Book value @ 01/12/10 (date of sale) 17,500
Proceeds received @ 01/12/10 47,500
Profit on sale 30,000
59
Note 2: suspensive sale only workings for year 1 and 2 necessary
capital
year OB instalment CB interest portion
01.06.09 - 31.05.10 1 100,000 37,175 80,825 18,000 19,175
01.06.10 - 31.05.11 2 80,825 37,175 58,199 14,549 22,627
01.06.11 - 31.05.12 3 58,199 37,175 31,499 10,476 26,699
01.06.12 - 31.05.13 4 31,499 37,175 - 6 5,670 31,505
instalment = amount to be financed

Present value annuity factor for 4 years @18%
= 100 000 = 37 175

2.69
1
The Antialgae Chemical Corporation produces a patent chemical for sale

to swimming pool owners. This chemical known as ANALG is based on the
following standard formula for a batch of 80 kilograms.

kilograms price
(cents)
X 25 80
Y 25 40
Z 50 20
In March of this year, 440 kilograms of ANALG were produced, using the
following chemicals at the prices indicated:

kilograms price
(cents)
X 145 90
Y 135 50
Z 260 20
YOU ARE REQUIRED TO :
1. Total material costs variance

2. Material price variance
3. Material mixture variance
4. Material yield variance.
(NATAL - adapted)
2
Standard costs per 80 kilograms of Analg
Chemical Kgs Price Standard cost

R R
X 25 0,80 20,00
Y 25 0,40 10,00
Z 50 0,20 10,00
100 40,00
Standard costs for 80 kgs is R40,00

Standard costs per kilogram = R0,50
1. Total material cost variance
Actual cost Issue Price Actual input @ std cost

R R R
X: 145 x 0.90 = 130.50 14.50 (u) 145 x 0.80 = 116.00
Y: 135 x 0.50 = 67.50 13.50 (u) 135 x 0.40 = 54.00
Z: 260 x 0.20 = 52.00 0 260 x 0.20 = 52.00
250.00 28.00 (u) 222.00
Actual input @ std cost Usage Actual output @ std cost

R R
X: 145 x 0.80 = 116.00
Y: 135 x 0.40 = 54.00
Z: 260 x 0.20 = 52.00
222.00 2.00 (u) 440 x 0.5 = 220
Therefore the total material cost variance = price + usage = 28 (u) + 2 (u) = R30 (u)
Actual Mixture Actual input in std Yield Actual output @ std

input @ mixture cost
std @ std cost
cost
R R R R R
116 8 (u) 540 x 25% x 0.80 = 108
Y 54 0 540 x 25% x 0.40 = 54
Z 52 2 (f) 540 x 50% x 0.20 = 54
222 6 (u) 216 4 (f) 440 x 0.5 = 220
Usage R2 (u)
3
Sidecut Limited utilises a standard cost system. Materials as well as

completed goods which may have to be kept in stock are recorded at
standard absorption cost. Any variances that may occur are accounted
for in the cost of sales for the current period.
The following budgeted information for the year that ended on 30 June
2014 was obtained:
Units
Production capacity – standard ……………………….. 60 000
Product – “Selene”
Production and sales …………………………………… 60 000
R
Selling price – per unit …………………………………. 224,00
Standard prime cost per unit ………………………… 120,00

- Materials ……………………………………………….. 72,00
- Zilon – 4 metres @ R12,00 per metre ……………. 48,00
- Brilon – 3 metres @ R8,00 per metre ……………. 24,00
- Labour
- Artisans – 4 hours @ R12,00 per hour 48,00
Fixed manufacturing overheads – 75% of labour cost
Fixed selling and administrative cost – per unit ……... 44,00
The company is a market leader. As a result the actual sales and

production were equal to that budgeted for the 2014 financial year. In
spite of this, the company barely managed to break even, instead of
realising a net profit of R1 440 000, before normal taxation as had been
budgeted.
The following actual information for the year was subsequently

ascertained:
1. Material Purchased Issued Metres Purchase price

Metres Per Metre
Zilon 247 500 R12,40
Brilon 250 000 185 000 R7,80
187 000
4
2. Direct labour paid - R3 025 600

(Artisans 244 000 hours @ R12,40 per hour)
3. Fixed manufacturing overheads - R2 465 600
4. Fixed selling and administrative expenses - R3 048 000
During the financial year, a client was given a special discount of R16,00
per unit on an order for 5 000 units. The remaining units were sold at the
budgeted selling price.
REQUIRED:
(a) Compile an income statement for the year that ended on 30 June
2014, which reflects the actual figures. ( 5)
(b) Reconcile the difference between the budgeted and the actual net
profit, before normal taxation, for 2014, by calculating as many
variances as possible. (22)
5
SIDECUT LIMITED
(a) Income statement for the year ended 30 June 2014
R
Sales 13 360 000
60 000 x R224,00 13 440 000

Less: Discount on sales – 5 000 x R16,00 80 000
Less: Manufacturing, selling and administrative 13 051 800

costs
Materials consumed (calculation 1) 4 512 600

Direct labour 3 025 600
Manufacturing overheads – fixed 2 465 600
Selling and administrative expenses – fixed 3 048 000
Net profit for the year 308 200

( 3)
6
(b) Reconciliation of the difference between the budgeted and the actual
net profit for the year ended 30 June 2014
Calcu- R
lation
Budgeted net profit
1 440 000
Less: Unfavourable variances from standard cost
1 167 800
Materials 192 600

- Purchase price 2 62 600
- Mix 3 1 429
- Yield 3 128 571
Labour 145 600

- Rate 4 97 600
- Efficiency 4 48 000
Fixed manufacturing overheads 341 600

- Efficiency 36 000

Sales
- Selling price 7 80 000
272 200
Plus: Favourable variance from standard cost

- Fixed overhead Capacity 5 36 000
Actual net profit 308 200

( 5)
7
Calculations
1. Materials used in the manufacturing process
Material
Zilon Brilon
R R
Opening stock – 1/7/2013 -- --
Plus : purchases @ actual
- 250 000 x R12,40 3 100 000
- 187 000 x R7,80 1 458 600
3 100 000 1 458 600
Less: Closing stock @ standard

- 2 500 x R12,00 30 000
- 2 000 x R8,00 16 000
3 070 000 1 442 600
( 2)
Variances
2. Materials – Purchase price
Actual cost Actual purchases at standard cost
Zilon R(250 000 x 12,40) = 3 100 000 R(250 000 x 12,00) = 3 000 000
Brilon R(187 000 x 7,80) = 1 458 600 R(187 000 x 8,00) = 1 496 000
4 558 600 4 496 000
Purchase price
R62 600 (u)
( 2)
3. Mix and Yield
Zilon: R(247 500 x 12,00) = 2 970 000 4 286(u) 432 500 x 4/7 x 12,00 = 2 965 714
Brilon: R(185 000 x 8,00) = 1 480 000 2 857(f) 432 500 x 3/7 x 8,00 = 1 482 857
4 450 000 1 429(u) 4 448 571
8
Actual input in std ratio @ std cost Yield Actual output @ std cost
2 965 714 85 714(u) 60 000 x R48 = 2 880 000
1 482 857 42 857(u) 60 000 x R24 = 1 440 000

4 448 571 128 571 (u) 4 320 000
( 4)
Labour
4. Rate and Efficiency
R3 025 600 R(244 000 x 12,00) R(60 000 x 48)
= R2 928 000 = R2 880 000
Rate Efficiency
R97 600(u) R48 000(u)
( 3)
9
Fixed manufacturing overheads
5. Expenditure, capacity and efficiency
Actual Budget Actual input @ std cost Actual output @ std cost
R2 465 600 R(60 000 x 48 x 75%) R(244 000 x 12 x 75%) R(60 000 x 48 x 75%)
= R2 160 000 = R2 196 000 = R2 160 000

R305 600(u) R36 000(f) R36 000(u)
( 4)
Fixed selling & administrative cost
6. Expenditure
Actual cost Budgeted cost
R3 048 000 R(60 000 x 44,00)
= R2 640 000
Expenditure
R408 000(u)
( 2)
7. Sales
Actual sales Actual sales @ standard selling price
R13 360 000 R(60 000 x 244,00)
= R13 440 000
Price
R80 000(u)
( 2)
10
Lipos (Proprietary) Limited manufactures vitamin blocks for birds, which

are packed and sold in crates. Two raw materials are used in the process,
namely bird seed and vitamin extract. The company makes use of a
standard absorption costing system.
The following information relates to July 2014:
Budget Actual
R R
Sales 252 000 270 750
Less: Cost of sales 203 670 229 079
Raw materials
- Bird seed 157 500 179 215
- Vitamin extract 33 750 36 900
Wages 4 140 4 464
Variable overheads 4 500 4 600
Fixed overheads 3 780 3 900
Gross profit 48 330 41 671

Selling and administrative expenses (fixed) 12 510 13 470
Net income 35 820 28 201
Number of crates produced and sold 1 800 1 900

Raw materials used
- Bird seed (kg) 126 000 128 000
- Vitamin extract (kg) 54 000 60 000
Labour hours 600 620
1. Overhead allocation is based on labour hours.
2. Stock records are kept at standard cost.
3. Stock figures are negligible and can be ignored.

11
REQUIRED:
(a) Calculate all possible variances for July 2014 (for sales reconciliation
purposes). (26)
(b) State one potential cause for the material mixture variance. ( 1)
12
QUESTION 3 (SUGGESTED SOLUTION)
LIPOS (PTY) LIMITED
(a) Variances
Material
Actual Purchase Actual purchases @ std cost

cost price
R R R
Seed
179 215 19 215(u) 128 000 x 157 500 = 160 000
126 000
Extract
36 900 600(f) 60 000 x 33 750 = 37 500
54 000
216 115 18 615(u) 197 500
( 3)
Variance
R R
Seed 128 000 x 1,25 = 160 000 4 500 (f) 126 000 x 188 000 x 1,25 = 164 500
180 000
Extract 60 000 x 0,625 = 37 500 2 250(u) 54 000 x 188 000 x 0,625 = 35 250
_______ ______ ______ 180 000 ______
188 000 197 500 2 250 (f) 199 750
( 3)
Actual input Yield Actual output @ std cost

in std ratio @ variance
std cost
R R R
Seed 164 500 1 750(f) 126 000 x 1 900 x 1,25 = 166 250
1 800
Extract 35 250 375(f) 54 000 x 1 900 x 0,625 = 35 625

______ ______ 1 800 _______
199 750 2 125(f) 201 875
( 3)
13
Material usage variance:

Seed: mix + yield= 4 500(f) + 1 750(f) = 6 250 (f)
Extract: mix + yield= 2 250(u) + 375 (f) = 1 875 (u)
TOTAL: 4 375 (f)
Labour
R4 464 620 x R4 140 = R4 278 1 900 x R4 140 = R4 370

600 1 800
Rate R186(u) Efficiency R92(f)

( 3)
Variable overhead
R4 600 620 x R4 500 = R4 650 1 900 x R4 500 = R4 750

600 1 800
Rate R50(f) Efficiency R100(f)

( 3)
Fixed overhead
Actual cost Budgeted Actual input @ std cost Actual output @ std cost
July
R3 900 R3 780 620 x R3 780 = R3 906 1 900 x R3 780 = R3 990

600 1 800
Expenditure Capacity R126(f) Efficiency R84(f)

R120(u)
Volume R210(f)
( 5)
14
Fixed administrative cost
Actual cost Budgeted cost Actual volume @ std cost
R13 470 R12 510 1 900 x R12 510 = R13 205

1 800
Expenditure Volume 695(f)

R960(u)
( 3)
Sales
Actual sales Actual sales @ std SP Budgeted sales
R270 750 1 900 x R252 000 = R266 000 = R252 000

1 800
Price R4 750(f) Volume

R14 000(f)
( 3)
(b) One potential cause for a material mixture variance
- an incorrect standard
- inferior or superior material used
- poor inspection
- incorrect mixture
- more of the cheaper material was used ( 1)
15
Brandon Limited manufactures a chemical powder which is used for

locust pest control. The company makes use of a standard costing system
for budget and control purposes.
The standard product and cost specifications for 2 000 kg finished product
are as follows:
1. Raw material
The standard mixture for an output of 2 000 kg finished product is as

follows:
Chemical powder Quantity Price/kg Value

Kg R R
X 1 500 0,50 750
Y 500 0,70 350
2 000 1 100
Raw material stock records are kept at actual cost, as determined

on the average method of stock valuation.
2. Labour
It take 20 hours, at a total cost of R120, to convert 2 000 kg raw

material into 2 000 kg of finished product.
Production overhead is allocated to finished products at a rate of

R10 per direct labour hour, 60% of which represent fixed costs.
Total overhead amounts to R40 000 per normal month.

16
An extract of the cost and production records for March 2014 indicates
the following:
1. Raw material
Chemical Opening stock Purchases during Closing

powder the month stock
Kg R Kg R/kg kg
X 20 000 11 000 324 000 0,48 30 000
Y 24 000 18 240 60 000 0,84 8 000
2. Labour
The actual wages for 4 000 hours during March 2014 amounted to
R23 104.
The following payments were made during March 2014:
Variable overhead : R14 800

Fixed overhead : R26 000
4. Production
380 000 kg of chemical powder was produced during March 2014.

There was no fluctuation in stocks of the finished product and there
was no work-in-process.
The calendar factor applicable to March 2014 was 105%.
REQUIRED:
(a) Calculate the budgeted labour hours for a normal month. (2)
(b) Calculate the budgeted production in kilograms for March 2014. (2)
(c) Determine the value of raw material usage during March 2014. (6)
17
(d) Calculate all possible standard cost variances for March 2014 in
respect of the following:
(i) Raw material

(ii) Labour
(iv) Fixed overhead (13)
Amounts must be rounded off to the nearest Rand.

18
BRANDON LIMITED
a) Budgeted labour hours – normal month
Total overhead per month = R40 000

Allocation rate per hour = R10
 Direct labour hours – normal month = 4 000
(2)
b) Budgeted production – March 2014
Production – normal month= (4 000 x 2 000) kg

( 20 )
= 4 00 000 kg
Production – March 2014 = (400 000 x 105%) kg

= 420 000 kg (2)
c) Value of raw material usage
Raw material usage in kilograms
X Y
Kg Kg
Purchases 324 000 60 000
344 000 84 000
Closing stock (30 000) (8 000)
Usage 314 000 76 000
Value of raw material usage
Chemical powder X
Kg R
Purchases 324 000 155 520
344 000 166 520

344 000
= R151 998
19
Chemical powder Y
Kg R
Purchases 60 000 50 400
84 000 68 640

84 000
= R62 103 (6)
d) Variances
i) Raw material
Actual cost* Issue price Actual input @ std cost

R R R
X: 151 998 5 002 (f) 314 000* x R0,50 = 157 000
Y: 62 103 8 903 (u) 76 000* x R0,70 = 53 200
214 101 3 901 (u) 390 000 210 200
* Calculated under (c) above
Actual input Mixture Actual input in std mixture @ std cost Actual output @
@ std cost std cost
R R R
X: 157 000 10 750 (u) 390 000 x 1 500 x R0,50 = 146 250 380 000 x R1 100
2 000 2 000
Y: 53 200 15 050 (f) 390 000 x 500 x R0,70 = 68 250

2 000
210 000 4 300 (f) 214 500 = R209 000

Yield
R5 500 (u)
Usage R1 200 (u)

(5)
ii) Labour
4 000 x R120 380 000 x R120

20 2 000
R23 104 = R24 000 = R22 800
Rate R896 (f) Efficiency R1 200 (u)

(2)
20
iii) Variable overhead
4 000 x R4* 380 000 x 20 x R4

2 000
R14 800 = R16 000 = R15 200
Rate R1 200 (f) Efficiency R800 (u)

(2)
iv) Fixed overhead
Actual cost Budgeted – normal Budgeted - March

month
R40 000 x 60% R24 000 x 105%

R26 000 = R24 000 = R25 200
Expenditure R2 000 (u) Calendar R1 200 (f)
Budgeted – March Actual input @ std cost Actual output @ std cost
4 000 x R6* 380 000 x 20 x R6

2 000
R25 200 = R24 000 = R22 800
Capacity R1 200 (u0 Efficiency R1 200 (u)
*60% x R10 = R6
(4)
21
Precision Engineering manufactures a tool which is used in the motor

industry. The enterprise makes use of a standard costing system in order to
control the costs involved in the manufacturing of the tool.
The budgeted information for 2014 regarding the manufacturing process,

at an annual level of production of 90 000 units, is as follows:
1. Material

Material Y R4,80
Required to manufacture one unit:
1 kg in the following mix:
Material X 33⅓%
Material Y 66⅔%
2. Labour
Rate per hour R4,80

Required to manufacture one unit ⅓ hour
3. Overheads – allocation based on clock hours
Variable R 36 000
Fixed R120 000
The actual information for March 2014 is as follows:
1. Material

Material Y R4,60
Purchased and used 8 550 kg

Material mix: Material X 40%
Material Y 60%
22
2. Labour
Rate per hour R5,00

Clock hours 2 500
3. Overheads incurred
Variable R3 175
Fixed R9 750
4. Production – in units 8 000
1. Calendar factor for the month 108%
2. There was no stock of any kind of either the beginning or end of

the month.
REQUIRED:
Calculate the following standard cost variances for March 2014:
Material - price
- mixture
- yield
- usage (9)
Labour - rate
- efficiency (3)
Variable overhead - rate

- efficiency (3)
Fixed overhead - expenditure

- calendar
- capacity
- efficiency (5)
Round figures off to the nearest Rand.

23
PRECISION ENGINEERING
a) Material
Actual cost Price Actual purchases @ std cost

R R R
X: 8 550 x 40% x R3,20 = 10 944 684(u) 8 550 x 40% x R3,00 = 10 260
Y: 8 550 x 60% x R4,60 = 23 598 1 026(f) 8 550 x 60% x R4,80 = 24 624
34 542 342 (f) 34 884
(4)
Actual Mixture Actual input in std mixture Yield Actual output @ std cost
input @ @ std cost
std cost
R R R R R
X 10 260 1 710 (u) 8 550 x 33½% x R3,00 = 8 550 550 (u) 8 000 x ⅓ x R3,00 = 8 000
Y 24 624 2 736 (f) 8 550 x 66⅔% x R4,80 = 27 360 1 760 (u) 8 000 x ⅔ x R4,80 = 25 600
34 884 1 026 (f) 35 910 2 310 (u) 33,600
Usage R1 284 (u)

(5)
b) Labour
2 500 x R5,00 2 500 x R4,80 8 000 x ⅓ x R4,80
= R12 500 = R12 000 = R12 800
(3)
c) Variable overhead
2 500 x R36 000_ 8 000 x R36 000
90 000 x ⅓ 90 000
R3 175 = R3 000 = R3 200
(3)
24
d) Fixed overhead
Actual Budget normal Budget – actual input @ std cost actual output @
cost month March std cost
R120 000 R10 000 x 108% 2 500 x R120 000 8 000 x R120 000
12 90 000 x ⅓ 90 000
R9 750 = R10 000 R10 800 R10 000 R10 667

Expenditure Calendar R800 (f) Capacity R800 (u) Efficiency R667 (f)
R250 (f)
Volume R667 (f)

25
Pro Tool Manufacturers Limited specialises in the manufacture of quality

tools for use in the building and engineering industry. One of the
manufacturing divisions of the company has only manufactured one
specific tool during the 2014 financial year.
The budget for the abovementioned division for the year ended 28
February 2014, at a capacity utilisation of 30 000 labour hours, indicates
the following:
Budgeted production
Cost per unit
R
Material – 10 kg @ R3 per kilogram 30
Labour – 3 hours @ R8 per hour 24
Variable overhead – 3 hours @ R2 per hour 6
Fixed overhead – 3hours @ R5 per hour 15
75
The actual results for the year were as follows:

Total cost
R
Material @ R4 per kilogram) 520 000
Labour 400 000
Number of units actually manufacturing during 12 500

the year:
1. The change in stock levels was insignificant and must be ignored.
2. The actual wage rate deviated from the budgeted wage rate only
with regard to a 25% increase granted to all labourers with effect 1
March 2013.
At that stage, the 2014 budget had already been compiled,

consequently the standard labour rate has not been adjusted.
3. Overheads are allocated to production on the basis of labour hours.

26
REQUIRED:
a) Determine the total variable costs budgeted for the 2014 financial
year. (3)
b) Calculate the appropriate standard cost variances in respect of each

of the following elements:
i. material (2)
ii. labour (2)
iii. variable overhead (2)
iv. fixed overhead (3)
c) Reconcile the total budgeted variable costs with the total

actual variable costs. (4)
27
PRO TOOL MANUFACTURERS LIMITED
a) Total budgeted variable costs
Budgeted output = budgeted input ÷ SH p.u. = 30 000 ÷ 3

= 10 000 units
Budgeted variable cost per unit = R(30 + 24 + 6)

= R60
Total budgeted variable costs = budgeted output x

variable cost p.u. = 10 000 x R60
= R600 000
(3)
b) Variances
(i) Material
R(520 000 ÷ 4) x R3 12 500 x R30
R520 000 = R390 000 = R375 000
Price R130 000 (u) Usage R15 000 (u) (2)
(ii) Labour
40 000 1 x R8 12 500 x R24
R400 000 = R320 000 = R300 000
Rate R80 000 (u) Efficiency R20 000 (u) (2)
40 000 1 x R2 12 500 x R6
R72 000 = 80 000 = R75 000
Rate R8 000 (f) Efficiency R5 000 (u) (2)
1 actual input (labour hours) = actual cost = 400 000 = 40 000 hours
actual rate 10
28
(iv) Fixed overhead
Actual cost Budgeted cost Actual input @ Actual output @ std

std cost cost
30 000 x R5 40 0001 x R5 12 500 x R15
R130 000 = R150 000 = R200 000 = R187 500
R20 000 (f) R50 000 (f) R12 500 (u) (3)
Volume R37 500 (f)
c) Reconciliation of budgeted and actual variable costs
R
Budgeted variable costs per (a) above 600 000
Add: Unfavourable total variable costs volume variance 150 000 2
Standard variable costs – actual volume 750 000

Less: Favourable variable overhead rate variance (8 000)
Add: Unfavourable cost variances 250 000
Material
- price 130 000
- usage 15 000
Labour
- rate 80 000
- efficiency 20 000
Variable overhead efficiency 5 000
Actual variable costs [R(520 000 + 400 000 + 72 000)] 992 000
(4)
2 variable costs volume variance = (actual output – budgeted output) x VC p.u.
= (12 500 – 10 000) x 60
= R150 000
(This is unfavourable because your actual output cost R150 000 more than what
you budgeted it to cost.)
29
QUESTION 7 (28marks) (33minutes)
Crusty Limited manufactures a single product whilst utilizing a standard costing system. Any
stock of materials is valued at standard cost whilst completed goods are valued at standard
absorption cost.
The following sales and costs at standard was budgeted for the month that ended on 30
September 2014:
Units
Sales – Finished products 10 000
R
Prime cost per unit 250,00
- Materials 175,00
- Siv - 10kg @ R 5,00 per kg 50,00
- Lon - 5kg @ R25,00 per kg 125,00
- Labour - 5 hours @ R15,00 per hour 75,00
Variable overheads are allocated to production based on labour hours at a predetermined rate of
R24,00 per hour. The selling price of the single product as budgeted realizes a gross profit of
20% on the selling price and during the budgeted month the actual selling price per unit was 10%
higher than the original budgeted selling price.
The costs incurred and the relevant information for the month that ended on 30 September 2014
was as follows:
Units
Production and sales 9 500
Siv Lon
Kg R Kg R
- Opening stock - 1/9/2014 4 000 20 000 2 000 50 000
- Closing stock - 30/9/2014 3 000 - 1 500 -
- Purchased - 570 000 - 1 140 000
- Used in production – September 2014 96 000 - 48 000 -
Labour - 46 000 hours R736 000

Variable production overheads R1 150 000
There was no opening or closing stock of finished products at the beginning or end of the month.
The following variances as part of the system’s variances for the month were calculated at the
end of September 2014:
R
Materials purchase price 47 500 unfavourable
Materials mix Nil
Labour rate 46 000 unfavourable
Labour efficiency 22 500 favourable
Variable overhead efficiency 36 000 favourable
30
Required:
a) Compile a budgeted income statement for the month that ended on 30 September 2014.
( 7)
b) Calculate the following variances for September 2014:
 Materials yield ( 4)
 Production overhead rate ( 2)
 Sales price ( 3)
 Sales volume (for profit reconciliation purposes). ( 4)
c) Determine the actual gross profit by reconciling the budgeted and actual gross profit for
September 2014. ( 8)
(UNISA OCT 2007 EXAM)

31
QUESTION 7
(a)
Budgeted / Standard cost p.u
Material 175
Labour 75
Overhead (5 hours x R24 per hour) 120
370
Budgeted selling price p.u. = cost p.u. = 370 = R462.50 per unit
0.8 0.8
Budgeted Income Statement for month ended 30 September 2014
R
Budgeted Sales (10 000 x 462.50) 4 625 000
Less: Budgeted Cost of Sales 3 700 000
Material (10 000 x 175) 1 750 000
Labour (10 000 x 75) 750 000
Overhead (10 000 x 120) 1 200 000
Budgeted Income 925 000
(b)
MATERIALS YIELD VARIANCE
If the materials mix variance is nil, then the materials yield variance = materials usage
variance

Usage
Siv: 96 000 x 5 = R480 000 R5 000 (u) 9 500 x 50 = R475 000
Lon: 48 000 x 25 = R1 200 000 R12 500 (u) 9 500 x 125 = R1 187 500
R1 680 000 R17 500 (u) R1 662 500
32
PRODUCTION OVERHEAD RATE VARIANCE
Actual cost Actual input @ std cost
R1 150 000 46 000 x 24 = R1 104 000
Overhead rate R46 000 (u)
SALES PRICE VARIANCE
Actual sales revenue actual sales units @ std SP
9 500 x (462.50 x 1.1) = R4 833 125 9 500 x 462.50 = R4 393750
Sales Price R439 375 (f)
SALES VOLUME VARIANCE (profit recon.)

Budgeted / Standard GP per unit = Standard SP – Standard Costs p.u. = 462.50 – 370 =
R92.50
Standard GP on actual sales Budgeted GP
9 500 x 92.50 = R878 750 10 000 x 92.50 = R925 000
Sales Volume R46 250 (u)

33
(c)
R
Budgeted Profit 925 000
Less: Sales Volume Variance (u) 46 250
Standard Profit 878 750
Plus: Favourable other variances 497 875
Labour efficiency 22 500
Production overhead 36 000
efficiency
Sales price 439 375
Less: Unfavourable other variances 157 000
Materials purchase price 47 500
Materials usage 17 500
Labour rate 46 000
Production overhead rate 46 000
Actual Profit 1 219 625

34
Stone Top CC operates a standard costing system and manufactures two

models of processed granite work-surfaces for kitchens, namely
“Rustenburg” and “Plettenburg”. Stock records are maintained at
standard absorption cost. Overheads are allocated on the basis of direct
labour hours.
The budget for the two models for the year ending on 31 December 2014
is as follows:
Model
“Rustenburg” “Plettenburg”
R R
Production 50 units - 30 units -
Materials
Raw granite
Black 50 000 kg 500 000 - -
Green - - 30 000 kg 330 000
Saw blades 500 units 15 000 300 units 9 000
Labour 2 500 37 500 1 500 22 500
hours hours
Overhead:
Variable - 65 000 - 39 000
Fixed - 30 000 - 18 000
Saw blades are used to cut the raw granite. The standard consumption is
one saw blade per 100 kilograms of raw granite processed.
The finished goods, materials and other stock records reflected the
following for April 2014:
Quantity
01/04/2014 31/04/2014
Finished goods:
“Rustenburg” 4 units 3 units
“Plettenburg” 3 units 2 units
Raw granite:
Black 2 000 kg 3 000kg
Green 1 000 kg 1 500 kg
Saw blades 27 units 20 units
Work-in-progress Nil Nil
35
The actual information for April 2014 was as follows:
Model Total
“Rustenburg” “Plettenburg” R
Sales 6 units 4 units - -
Purchases
Black granite 6 100 kg - - 65 000
Green granite - 3 300 kg - 36 000
Saw blades - - 73 units 2 100
Labour hours worked 257 148 405 6 165
Overhead incurred:
Variable 9 000
Fixed 4 200
65% of the saw blades issued to production were used for the production
of “Rustenburg”, and the remaining 35% for Pletttenburg.
REQUIRED:
Calculate the following variances for April 2014:
a) Materials purchase price (5)

b) Materials usage (10)
c) Labour rate and efficiency (3)
d) Variable overhead rate and efficiency (3)
e) Fixed overhead expenditure, calendar, capacity and efficiency (5)

36
a) Materials Purchase Price Variance
Granite:
Actual cost of purchases Purchase Actual purchases @ std cost

price
R: Black Granite: = R65 000 R4 000 (u) 6100 x 500 000 = R61 000
50 000
P: Green 3 300 x 330 000

Granite: = R36 000 R300 (f) 30 000 = R36 300
R101 000 R3 700 (u) R97 300
Saw Blades:
Actual cost of purchases Actual purchases @ std

cost
R2 100 73 x 15 000 + 9 000

500 + 300
= R2 190
purchase price R90 (f)

37
b) Materials Usage Variance
Granite:

Usage
R: Black Granite: 5 100 x 10 = R51 000 R1 000 (u) 5 x 500 000 = R50 000
50
P: Green Granite: 2 800 x 11 3 x 330 000

= R30 800 R2 200 (f) 30 = R33 000
R81 800 R1 200 R83 000
(f)
Saw Blades:

Usage
R: 52 x 30 = R1 560 R60 (u) 5 x 15 000 = R1 500
50
P: 28 x 30 = R 840 R60 (f) 3 x 9 000 = R 900

R2 400 R 0 30 R2 400
Calculations – actual for April

Black Granite
kg
Opening Stock 2 000
Add: Purchases 6 100

Rustenburg
units
Opening Stock 4
Sales 6
* Balancing figure
38

Green Granite
kg
Opening stock 1 000
Add purchases 3 300

Plettenburg
(units)
Opening stock 3
Sales 4
* Balancing figure

Saw Blades
(units)
Opening stock 27
Add: Purchases 73
Usage (actual input) 80
Rustenburg = 65% x 80 = 52 units

Plettenburg = 35% x 80 = 28 units
c) Labour Rate and Efficiency Variances

Variance
R: 257 x 6 165 = R3 912,11 R57,11 (u) 257 x 37 500 = R3 855
405 2 500
P: 148 x 6 165 = R2 252,89 R32,89 (u) 148 x 22 500 = R2 220

405 R6 165,00 R90,00 (u) 1 500 R6 075
39

Variance
R: R3 855 R105 (u) 5 x 37 500 = R3 750
50
P: R2 220 R30 (f) 3 x 22 500 = R2 250

R6 075 R75 (u) 30 R6 000
d) Variable overhead rate and efficiency variance

variance
R: 257 x 9 000 = R5 711,11 R970,89 (f) 257 x 65 000 = R 6 682
405 2 500
P: 148 x 9 000 = R3 288,89 R559,11 (f) 148 x 39 000 = R 3 848

405 R9 000,00 R1 530,00 (f) 1 500 R10 530

Variance
R: R6 682 R182 (u) 5 x 65 000 = R 6 500
50
P: R3 848 R52 (f) 3 x 39 000 = R 3 900

R10 530 R130 (u) 30 R10 400
e) Fixed Overhead Variances
Actual cost Budgeted cost Actual input @ Actual output @

std cost std cost
R: 257 x 4 200 = 2 665,19 30 000 = 2 500 257 x 30 000 = 3 084 5 x 30 000 = 3 000
405 12 2 500 50
P: 148 x 4 200 = 1 534,81 18 000 = 1 500 148 x 18 000 = 1 776 3 x 18 000 = 1 800
405 12 1 500 30
4 200,00 4 000 4 860 4 800

R200 (u) R860 (f) R60 (u)
40
Computer Warehouse sells various computer hardware products. The

business currently assembles two models of computers internally, namely
the Educational and Gaming computers. Assembly takes place
according to demand, therefore no stock of assembled computers is
kept.
A standard costing system is used to control the costs of the assembled

computers. A bin system is used where the storeroom staff place all the
components required to assemble a computer, into a component bin.
Component bins are issued to the assembly section on request at actual
cost. Where one or more of the components in a bin are defective, the
staff document it on the bin and these bins are kept in the assembly
section as replacement components for other defective components.
The following standards are available for a normal month :
Standard per assembled computer : Educational Gaming

R R
Selling price 3 500 5 000
Less : Cost of sales 2 600 3 950
Components 1 200 2 200

Overheads
- Variable 240 300
- Fixed (120 per hour) 960 1 200
During a normal month, 400 computers are assembled. The standard ratio
of Educational to Gaming computers sold is 70% to 30% respectively.
Overheads are allocated based on labour hours.
The following actual information is available for April 2014 :
1. During April, the Gaming computers were advertised nationwide on

an Easter special at a discounted price of R4 500. This had the
effect of the sales volume of Gaming computers increasing to 250
41
computers and that of Educational computers decreasing to 230.

The Educational computers were sold at standard selling prices.
2. Stock records show that 231 Educational and 252 Gaming

component bins were issued to the assembly section at a cost of
R1 250 and R2 100 per bin respectively.
3. Direct labour hours worked were 4 238 at a cost of R105 950.
4. Fixed overhead amounted to R410 000.
REQUIRED :
(a) Calculated the following variances for each type of assembled

product for April 2014 :
(i) Selling price variance

(3)
(ii) Sales mixture, quantity and volume variance based on units
for sales reconciliation purposes (6)
(b) Reconcile budgeted sales to actual sales (3)
(c) Calculate all possible component variances (6)
(d) Calculate the fixed overhead capacity and efficiency variances

(6)

42
Question 9 – SUGGESTED SOLUTION
(a)
SALES
(i)
Actual sales Price Actual sales @ std SP

Variance
R R R
Edu: 230 x 3500 = 805,000 0 230 x 3500 = 805,000
Game: 250 x 4500 = 1,125,000 125,000 (u) 250 x 5000 = 1,250,000
Total: 1,930,000 125,000 (u) 2,055,000
(ii)
Actual sales @ std SP Mix Actual sales in units in std Quantity Budgeted Sales
Variance mix @ std SP Variance
R R R R R
Edu: 230 x 3500 = 805,000 371,000 (u) 0.7 x 480 x 3500 = 1,176,000 196,000 (f) 280 x 3500 = 980,000
Game: 250 x 5000 = 1,250,000 530,000 (f) 0.3 x 480 x 5000 = 720,000 120,000 (f) 120 x 5000 = 600,000
Total: 2,055,000 159,000 (f) 1,896,000 316,000 (f) 1,580,000
Volume = R475,000 (f)
OR
Volume variance = mix variance + quantity variance = 159,000 (f) + 316,000 (f) = R475,000 (f)
43
(b)
Reconciliation of budgeted sales to actual sales:
R
Budgeted Sales 1,580,000
Add: Favourable sales volume variance 475,000
Less: Unfavourable selling price variance (125,000)
Actual sales 1,930,000
(c)
Actual cost Price Actual input @ std cost
Variance
R R R
Edu: 231 x 1250 = 288,750 11,550 (u) 231 x 1200 = 277,200
Game: 252 x 2100 = 529,200 25,200 (f) 252 x 2200 = 554,400
Total: 817,950 13,650 (f) 831,600
Actual input @ std cost Mix Variance Actual input in std ratio @ Yield Actual output @ std
std cost Variance cost
R R R R R
Edu: 231 x 1200 = 277,200 128,520 (f) 0.7 x 483 x 1200 = 405,720 129,720 (u) 230 x 1200 = 276,000
Game: 252 x 2200 = 554,400 235,620 (u) 0.3 x 483 x 2200 = 318,780 231,220 (f) 250 x 2200 = 550,000
Total: 831,600 107,100 (u) 724,500 101,500 (f) 826,000
Usage = R5,600 (u)
OR
Usage variance = mix variance + yield variance = 107,100 (u) + 101,500 (f) = R5,600 (u)
44
(d)
Fixed overheads:
Budgeted cost Actual input @ std cost Actual output @ std cost
R R R
Edu: (280 x 960) = 268,800 4238 x 120 = 508,560 (230 x 960) = 220,800
Game: (120 x 1200) = 144,000 (250 x1200) = 300,000
Total: 412,800 520,800
Capacity variance = R95,760 (f) efficiency variance = R12,240 (f)

Decentralization and
Performance Evaluation
MAC3761
RELEVANT COSTING
RELEVANT AND NON-RELEVANT COSTS

The costs which should be used for decision making are often referred to as relevant costs.
KEY TERM
A relevant cost is a future cash flow arising as a direct consequence of a decision.
Relevant costs are future costs.
a) A decision is about the future; it cannot alter what has been done already. A cost that has been
incurred in the past is totally irrelevant to any decision that is being made ‘now’.
b) Costs that have been incurred include not only costs that have already been paid, but also costs
that are the subject of legally binding contracts, even if payments due under the contract have
not yet been made. (These are known as committed costs.)
Relevant costs are cash flows.
Costs or charges which do not reflect additional cash spending should be ignored for the purpose of decision
making. These include the following:
a) Depreciation, as a fixed overhead incurred.
b) Notional rent or interest, as a fixed overhead incurred.
c) All overheads absorbed. Fixed overhead absorption is always irrelevant since it is overheads to
be incurred with affect decisions.
Relevant costs are incremental costs.
A relevant cost is one which arises as a direct consequence of a decision. Thus, only costs which will differ
under some or all of the available opportunities should be considered; relevant costs are therefore sometimes
referred to as incremental costs.
Relevant costs are therefore future, incremental cash flows.
Other terms can be used to describe relevant costs.
2
KEY TERM
Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.
One of the situations in which it is necessary to identify the avoidable costs is in deciding whether or not to
discontinue a product. The only costs which would be saved are the avoidable costs, which are usually the
variable costs and sometimes some specific fixed costs. Costs which would be incurred whether or not the
product is discontinued are known as unavoidable costs.
KEY TERM
Opportunity cost is the benefit which could have been earned, but which has been given up, by choosing one
option instead of another.
Suppose for example that there are three mutually exclusive options, A, B and C. The net profit from each
would be R80, R100 and R70 respectively. Since only one option can be selected option B would be chosen
because it offers the biggest benefit.
R
Profit from option B 100
Less opportunity cost (i.e. the benefit from the most profitable alternative, A) 80
Differential benefit of option B 20
The decision to choose option B would not be taken simply because it offers a profit of R100, but because it
offers a differential profit of R20 in excess of the next best alternative.
Non-relevant costs
A number of terms are used to describe costs that are irrelevant for decision making because they are either
not future cash flows or they are costs which will be incurred anyway, regardless of the decision that is taken.
KEY TERM
A sunk cost is a cost which has already been incurred and hence should not be taken account of in decision
making.
An example of this type of cost is depreciation. If the fixed asset has been purchased, depreciation may be
charged for several years but the cost is a sunk cost, about which nothing can now be done.
KEY TERM
A committed cost is a future cash outflow that will be incurred anyway, whatever decision is taken now about
alternative opportunities.
Committed costs may exist because of contracts already entered into by the organisation, which it cannot get
out of.
KEY TERM
A notional cost or imputed cost is a hypothetical accounting cost to reflect the use of a benefit for which no
actual cash expense is incurred.
3
Example as in cost accounting systems include notional rent (such as that charged to a subsidiary of an
organisation for the use of accommodation which the organisation owns) or notional interest charges on
capital employed (sometimes made against a profit centre or cost centre).
Although historical costs are irrelevant for decision making, historical cost data will often provide the best
available basis for predicting future costs.
Fixed and variable costs
Unless you are given an indication to the contrary, you should assume the following:
a) Variable costs will be relevant costs.

b) Fixed costs are irrelevant to a decision.
This need not be the case, however, and you would analyse variable and fixed cost data carefully. Do not
forget that ‘fixed’ costs may only be fixed in the short term.
There might, however, be occasions when a variable cost is in fact a sunk cost. For example, suppose that a
company has some units of raw material in stock. They have been paid for already, and originally cost R2,000.
they are now obsolete and are no longer used in a special job which the company is trying to decide whether to
undertake. The special job is a ‘one-off’ customer order, and would use up all these materials in stock.
In deciding whether the job should be undertaken, the relevant cost of the materials to the special job is nil.
Their original cost of R2,000 is a sunk cost, and should be ignored in the decision.
However, if the materials did have a scrap value of, say, R300, then their relevant cost to the job would be the
opportunity cost of being unable to sell them for scrap, i.e. R300.
Attributable fixed costs
There might be occasions when a fixed cost is a relevant cost.
a) Directly attributable fixed costs are those costs which, although fixed within a relevant range of
activity level, or regarded as fixed because management has set a budgeted expenditure level (for
example advertising costs are often treated as fixed), would, in fact, do one of two things.
i) Increase if certain extra activities were undertaken

ii) Decrease/be eliminated entirely if a decision were taken either to reduce the scale of
operations or shut down entirely
b) General fixed overheads are those fixed overheads which will be unaffected by decisions to
increase or decrease the scale of operations. An apportioned share of head office charges is
an example.
You should appreciate that whereas directly attributable fixed costs will be relevant to a decision I hand,
general fixed overheads will not be.
EXAMPLE 1 : RELEVANT COSTS
A company has been making a machine to order for a customer, but the customer has since gone into
liquidation, and there is no prospect that any money will be obtained from the winding up of the company.
Costs incurred to date in manufacturing the machine are R50 000 and progress payments of R15 000 had been
received from the customer prior to the liquidation. The sales department has found another company willing to
buy the machine for R34 000 once it has been completed. To complete the work, the following costs would be
incurred.
4
a) Materials: these have been bought at a cast of R6 000. They have no other use, and if the machine is
not finished, they would be sold for scrap for R2 000.
b) Further labour costs would be R8 000. Labour is in short supply, and if the machine is not finished, the
work force would be switched to another job, which would earn R30 000 in revenue, and incur direct
costs of R12 000 and absorbed (fixed) overhead of R8 000.
c) Consultancy fees R4 000. If the work is not completed, the consultant’s contract would be cancelled at
a cost of R1 500.
d) General overheads of R8 000 would be added to the cost of the additional work.
REQUIRED:
Assess whether the new customer’s offer should be accepted.
SOLUTION
a) Costs incurred in the past, or revenue received in the past are not relevant because they
cannot affect a decision about what is best for the future. Costs incurred to date of R50 000 and
revenue received of R15 000 should therefore be ignored.
b) Similarly, the price paid in the past for the materials is irrelevant. The only relevant cost of
materials affecting the decision is the opportunity cost of the revenue from scrap which would be
forgone – R2 000.
c)
R
Labour costs required to complete work 8 000
Opportunity costs: contribution forgone by losing other work
R(30 000 – 12 000) 18 000
Relevant cost of labour 26 000
d) The incremental cost of consultancy from completing the work is the difference between the cost
of completing the work and the cost of canceling the contract (R(4 000 – 1 500) = R2 500).
e) Absorbed overhead is a notional accounting cost and should be ignored. Actual overhead
incurred is the only overhead cost to consider. General overhead costs (and the absorbed
overhead of the alternative work for the labour force) should be ignored.
f) Relevant costs may be summarized as follows:

R R
Revenue from completing work 34 000
Relevant costs
Materials: opportunity cost 2 000
Labour: basic pay 8 000
Opportunity cost 18 000
Incremental cost of consultant 2 500
Extra profit to be earned by accepting the 30 500

completion order 3 500
5
Identifying relevant costs
The relevant cost of materials
The relevant cost of raw materials is generally their current replacement cost unless the materials have
already purchased but will not be replaced. The relevant cost of using them will then be the higher of the
following:
 Their current resale value

 The value they would obtain if they were put to an alternative use
If the materials have no resale value and no other possible use, then the relevant cost of using them for the
opportunity under consideration would be nil.
The flowchart below shows how the relevant costs of materials can be identified, provided that the materials
are not in short supply and so have no internal opportunity cost.
Are the materials already

in stock, or contracted to
buy in a purchase
agreement?
Yes No
Are the materials Relevant cost =

regularly used, and future/current
replaced with fresh purchase cost of
supplies when materials
stocks run out?
Yes No
Relevant cost = Do the materials have an

future/current alternative use, or would
purchase cost of they be scrapped if not
materials used?
Scrapped if Other use available

not used
Relevant cost = Relevant cost =
scrap value/disposal higher of value in
value other use or scrap
value/disposal value
You should test your knowledge of the relevant cost of materials by attempting the following question.
6
QUESTION 1
Darwin Ltd has been approached by a customer who would like a special job to be done for him, and who is
willing to pay R22 000 for it. The job would require the following materials:
Material Total units Units already Book value of Realisable Replacement

required in stock units in stock value cost
R/unit R/unit R/unit
A 1 000 0 -- -- 6.00
B 1 000 600 2.00 2.50 5.00
C 1 000 700 3.00 2.50 4.00
D 200 200 4.00 6.00 9.00
Material B is used regularly by Darwin Ltd, and if units of B are required for this job, they would need to be
replaced to meet other production demand.
Materials C and D are in stock as the result of previous over buying, and they have a restricted use. No other
use could be found for material C, but the units of material D could be used in another job as substitute for 300
units of material E, which currently costs R5 per unit (and of which the company has no units in stock at the
moment).
REQUIRED:
Calculate the relevant costs of material for deciding whether or not to accept the contract.
ANSWER
a) Material A is not yet owned. It would have to be bought in full at the replacement cost of R6 per unit.
b) Material B is used regularly by the company. There are existing stocks (600 units) but if these are
used on the contract under review a further 600 units would be bought to replace them. Relevant costs
are therefore 1 000 units at the replacement cost of R5 per unit.
c) 1 000 units of material C are needed and 700 are already in stock. If used for the contract, a further
300 units must be bought at R4 each. The existing stocks of 700 will not be replaced. If they are used
for the contract, they could not be sold at R2,50 each. The realisable value of these 700 units is an
opportunity cost of sales revenue forgone.
d) The required units of material D are already in stock and will not be replaced. There is an opportunity
cost of using D in the contract because there are alternative opportunities either to sell the existing
stocks for R6 per unit (R1 200 in total) or avoid other purchases (of material E), which would cost 300 x
R5 = R1 500. Since substitution for E is more beneficial, R1 500 is the opportunity cost.
e) Summary of relevant costs

R
Material A (1 000 x R6) 6 000
Material B (1 000 x R5) 5 000
Material C (300 x R4) plus (700 x R2.50) 2 950
Material D 1 500
15 450
7
The relevant cost of using machines
Once a machine has been bought its cost is a sunk cost. Depreciation is not a relevant cost, because it is not
a cash flow. However, using machinery may involve some incremental costs. These costs might be referred
to as user costs and they include hire charges and any fall in resale value of owned assets, through use.
EXAMPLE 2 : THE RELEVANT COST OF USING MACHINES
Sydney Ltd is considering whether to undertake some contract work for a customer. The machinery required
for the contract would be as follows:
a) A special cutting machine will have to be hired for three months for the work (the length of the
contract). Hire charges for this machine are R75 per month, with a minimum hire charge of R300.
b) All other machinery required in the production for the contract has already been purchased by the
organisation on hire purchase terms. The monthly hire purchase payments for this machinery are
R500. This consists of R450 for capital repayment and R50 as an interest charge. The last hire
purchase payment is to be made in two months’ time. The cash price of this machinery was R9
000 two years ago. It is being depreciated on a straight line basis at the rate of R200 per month.
However, it still has a useful life which will enable it to be operated for another 36 months.
The machinery is highly specialized and is unlikely to be required for other, more profitable jobs
over the period during which the contract work would be carried out. Although there is no
immediate market for selling this machine, it is expected that a customer might be found in the
future. It is further estimated that the machine would lose R200 in its eventual sale value if it is
used for the contract work.
REQUIRED:
Calculate the relevant cost of machinery for the contract.
SOLUTION
a) The cutting machine will incur an incremental cost of R300, the minimum hire charge.
b) The historical cost of the other machinery is irrelevant as a past cost; depreciation is irrelevant as a
non-cash cost; and future hire purchase repayments are irrelevant because they are committed
costs. The only relevant cost is the loss of resale value of the machinery, estimated at R200
through use. This user cost will not arise until the machinery is eventually resold and the R200
should be discounted to allow for the time value of money. However, discounting is ignored here.
c) Summary of relevant costs
Incremental hire costs R300

User cost of other machinery R200
R500
8
QUESTION 2
A machine which originally cost R12 000 has an estimated life of ten years and is depreciated at the rate of R1
200 a year. It has been unused for some time, however, as expected production orders did not materialize.
A special order has now been received which would require the use of the machine for two months.
The current net realisable value of the machine is R8 000. If it is used for the job, its value is expected to fall to
R7 500. The net book value of the machine is R8 400.
Routine maintenance of the machine currently costs R40 a month. With use, the cost of maintenance and
repairs would increase to R60 a month.
Ignore the time value of money.
REQUIRED:
Calculate the relevant cost of using the machine for the order.
SOLUTION
R
Loss in net realisable value of the machine
through using it on the order R(8 000 – 7 500) 500
Costs in excess of existing routine maintenance costs R(120 – 80) 40
Total marginal user cost 540
Relevant cost of labour
Often the labour force will be paid irrespective of the decision made and the costs are therefore not
incremental. Take care, however, if the labour force could be put to an alternative use, in which case the
relevant costs are the variable costs of the labour and associated variable overheads plus the contribution
forgone from not being able to put it to its alternative use.
THE ASSUMPTIONS IN RELEVANT COSTING

If you make an assumption in answering an examination question and you are not sure that the examiner or
marker will appreciate or recognize the assumption you are making, you would explain it in narrative in your
solution.
Some of the assumptions that are typically made in relevant costing are as follows:
a) Cost behaviour patterns are known; if a department closes down, for example the attributable
fixed cost savings would be known.
b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with
certainty.
9
c) The objective of decision making in the short run is to maximize ‘satisfaction’, which is often
regarded as ‘short-term profit’.
d) The information on which a decision is based is complete and reliable.
LIMITING FACTOR ANALYSIS

One of the more common decision-making problems is a budgeting decision in a situation where there are not
enough resources to meet the potential sales demand, and so a decision has to be made about using what
resources there are as effectively as possible.
KEY TERM
A key factor or limiting factor is a scarce resource which limits the activity of an organisation.
There might be just one limiting factor (other than maximum sales demand) but there might also be several
scarce resources, with two or more of them putting an effective limit on the level of activity that can be
achieved. We shall concentrate on single limiting factor problems and a technique for resolving these.
A limiting factor could be sales if there is a limit to sales demand but any one of the organisation’s resources
(labour, materials, manufacturing capacity, financial resources and so on) may be insufficient to meet the level
of production demanded.
a) If sales demand is the factor which restricts greater production output, profit will be maximized by
making exactly the amount required for sales (and no more) provided that each product sold
earns a positive contribution.
b) If labour supply, materials availability, machine capacity or cash availability limits production to
less than the volume which could be sold, management is faced with the problem of deciding what to
produce and what should not be produced because there are insufficient resources to make
everything.
It is assumed in limiting factor accounting that management wishes to maximize profit and that profit
will be maximized when contribution is maximized (given no change in fixed cost expenditure incurred). In
other words, marginal costing ideas are applied.
Contribution will be maximizes by earning the biggest possible contribution per unit of limiting factor.
Thus if grade A labour is the limiting factor, contribution will be maximized by earning the biggest contribution
per hour of grade A labour worked.
The limiting factor decision therefore involves the determination of the contribution earned by each
different product per unit of limiting factor. In limiting factor decisions, we generally assume that fixed
costs are the same whatever production mix is selected, so that the only relevant costs are variable
costs.
10
EXAMPLE 3 : LIMITING FACTOR
D Ltd makes two products, the B and the S. Unit variable costs are as follows:
B S
R R
Direct labour (R3 per hour) 6 3
8 7
The sales price per unit is R14 per B and R11 per S. During July the available direct labour is limited to 8 000
hours. Sales demand in July is expected to be 3 000 units for B and 5 000 units for S.
REQUIRED:
Determine the profit-maximising production levels, assuming that monthly fixed costs are
R20 000 and that opening stocks of finished goods and work in progress are nil.
SOLUTION
Step 1. Confirm the limiting factor is something other than sales demand.
B S Total
Labour hours per unit 2 hrs 1 hr
Sales demand 3 000 units 5 000 units
Labour hours needed 6 000 hrs 5 000 hrs 11 000 hrs
Labour hours available 8 000 hrs
Shortfall 3 000 hrs
Step 2. Identify the contribution earned by each product per unit of scarce resource, that is per labour
hour worked.
B S
R’s R’s
Sales price 14 11
Variable cost 8 7
Unit contribution 6 4
Labour hours per unit 2 hrs 1 hrs
Contribution per labour hour (= unit of limiting factor) R3 R4
Although Bs have a higher unit contribution than Ss, two Ss can be made in the time it takes to make one B.
Because labour is in short supply it is more profitable to make Ss than Bs.
Step 3. Work out the budgeted production and sales. Sufficient Ss will be made to meet the full sales
demand, and the remaining labour hours available will then be used to make Bs.
a)
Product Demand Hours Hours Priority of
Required available manufacture
S 5 000 5 000 5 000 1st
B 3 000 6 000 3 000 (bal) 2nd
11 000 8 000
11
b)
Product Units Hours Contribution Total
Needed per unit R
R
S 5 000 5 000 4 20 000
B 1 500 3 000 6 9 000
8 000 29 000
20 000
9 000
Note that it is not more profitable to begin by making as many units as possible of the product with the bigger
unit contribution. We could make 3 000 units of B in 6 000 hours and 2 000 units of S in the remaining 2 000
hours but profit would be only R6 000. Unit contribution is not the correct way to decide priorities, because it
takes two hours to earn R6 from a B and one hour to earn R4 from a S. Ss make more profitable use of the
scarce resource, labour hours.
QUESTION 3
Twickers Ltd makes two products, widgets and splodgets, for which there is unlimited demand at the budgeted
selling prices. A widget takes three hours to make, and has a variable cost of R18 and a selling price of R30.
A splodget takes two hours to make, and has a variable cost of R10 and a selling price of R20. Both products
use the same type of labour, which is in short supply.
REQUIRED:
Determine the product which should be made to maximize profits, and describe the other considerations which
might alter your decision.
SOLUTION
We must rank the products in order of contribution earning capability per labour hour.
Widgets per Splodgets per

unit unit
R R
Sales price 30 20
Variable costs 18 10
Contribution 12 10
Hours per unit 3 2

Contribution R4 R5
Although widgets have the higher unit contribution, splodgets are more profitable because they make a greater
contribution per labour hour. Three splodgets (worth 3 x R10 = R30) can be made in the same time as two
widgets (worth only 2 x R12 = R24).
12
A profit-maximising decision would, therefore, be to produce splodgets only, given the assumptions made. It is
important to remember, however, that other considerations, so far excluded from the problem might alter the
decision.
a) Can the selling price of either product be raised, thereby increasing unit contribution, and the
contribution per labour hour, and also reducing demand? Since demand is apparently unlimited, it
would be reasonable to suspect that both products are underpriced.
b) Would a decision to make and sell only splodgets have a harmful effect on customer loyalty and
demand? To what extent are sales of each product interdependent? For example, a manufacturer of
knives and forks could not expect to cease production of knives without affecting demand for forks.
c) Would a decision to cease production of widgets have no effect on fixed costs? The assumption that
fixed costs are unaffected by limiting factor decisions is not always valid, and closure of either the
widgets or the splodgets production line might result in fixed cost savings. These savings would need
to be considered when making the product mix decision.
d) Will the decision affect the long-term plans of the company as well as the short term? If widgets are not
produced, it is likely that competitors will take over the markets vacated by Twickers Ltd. Labour skilled
in the manufacture of widgets will be lost, and a decision at a later date to re-open manufacture of
widgets might not be possible.
Limiting factor analysis and restricted freedom of action
In certain circumstances an organization faced with a limiting factor on production and sales might not be able
to produce the profit-maximising product mix because the mix and/or volume of products that can be
produced and sold is also restricted by a factor other than a scarce resource.
a) The organization might have contracted to supply a certain number of products to a customer.
b) The organization might have to produce and sell a minimum quantity of one or more of its products to
provide a complete product range and/or to maintain customer goodwill.
c) The organization might need to maintain a certain market share of one or more of its products.
In each of these cases, the organization might have to produce more of a particular product or products
than the level established by ranking according to contribution per unit of li8miting factor.
The basic approach to dealing with such situations is to rank the products in the normal way but the
optimum production plan must take into account the minimum production requirements. The
remaining resource must then be allocated according to the ranking.
Work carefully through the following example which illustrates this approach.
13
EXAMPLE 4 : RESTRICTED FREEDOM OF ACTION
Harvey Ltd is currently preparing its budget for the year ending 30 September 20X2. The company
manufactures and sells three products, Beta, Delta and Gamma.
The unit selling price and cost structure of each product is budgeted as follows:
Beta Delta Gamma

R R R
Selling price 100 124 32
Variable costs:
Labour 24 48 6
Materials 26 7 8
Overhead 10 5 6
60 60 20
Contribution per unit 40 64 12
Direct labour rate is budgeted at R6 per hour, and fixed costs at R1 300 000 per annum. The company has a
maximum production capacity of 228 000 direct labour hours.
A meeting of the board of directors has been convened to discuss the budget and to resolve the problem as to
the quantity of each product which should be made and sold. The sales director presented the results of a
recent market survey which reveals that market demand for the company’s products will be as follows:
Product Units
Beta 24 000
Delta 12 000
Gamma 60 000
The production director proposes that since Gamma only contributes R12 per unit, the product should no longer
be produced, and the surplus capacity transferred to produce additional quantities of Beta and Delta. The sales
director does not agree with the proposal. Gamma is considered necessary to complement the product range
and to maintain customer goodwill. If Gamma is not offered, the sales director believes that sales of Beta and
Delta will be seriously affected. After further discussion the board decided that a minimum of 10 000 units of
each product should be produced. The remaining production capacity would then be allocated so as to achieve
the maximum profit possible.
REQUIRED
Prepare a budget statement which clearly shows the maximum profit which could be achieved in the year
ending 30 September 20X2.
14
SOLUTION
Step 1. Ascertain whether labour hours are a scarce resource.
Units Labour hours Total labour

demanded per unit hours
Beta 24 000 4 (R24/R6) 96 000
Delta 12 000 8 (R48/R6) 96 000
Gamma 60 000 1 (R 6/R6) 60 000
252 000
Step 2. Rank the products.
Since only 228 000 hours are available we need to establish which product earns the greatest contribution per
labour hour.
Beta Delta Gamma

Contribution 40 64 12
Labour hours 4 8 1
Contribution per labour hour R10 R8 R12
Ranking 2nd 3rd 1st
Step 3. Determine a production plan.
The optimum production plan must take into account the requirement that 10 000 units of each product are
produced, and then allocate the remaining hours according to the above ranking.
Hours
Beta 10 000 units x 4 hours 40 000
Delta 10 000 units x 8 hours 80 000
Gamma 10 000 units x 1 hour 10 000
130 000
Gamma 50 000 units x 1 hour (full demand) 50 000
Beta 12 000 units x 4 hours (balance) 48 000
228 000
15
Step 4. Draw up a budget.
BUDGET STATEMENT
R
Contribution
Beta (22 000 units x R40) 880 000
Delta (10 000 units x R64) 640 000
Gamma (60 000 units x R12) 720 000
2 240 000
Fixed costs 1 300 000
Profit 940 000
16
QUESTION 4
Jam Ltd makes two products, the K and the L. The K sells for R50 per unit, the L for R70 per unit. The variable
cost per unit of the K is R35 that of the L R40. Each unit of K uses 2 kgs of raw material. Each unit of L uses 3
kgs of material.
In the forthcoming period the availability of raw material is limited to 2 000 kgs. Jam Ltd is contracted to supply
500 units of K. Maximum demand for the L is 250 units. Demand for the K is unlimited.
What is the profit-maximising product mix?
SOLUTION
K L
Contribution p0er unit R15 R30
Contribution per unit of limiting factor R15/2 = R7,50 R30/3 = R10
Ranking 2 1
Production plan Raw material used

Kg
Contracted supply of K (500 x 2 kg) 1 000
Meet demand for L (250 x 3 kg) 750
Remainder of resource for K (125 x 2 kg) 250
2 000
 Produce 250 units of L and 625 units of K.
Limiting factors and shadow prices
Whenever there are limiting factors, there will be opportunity costs. For example, suppose that a company
manufactures two items X and Y, which earn a contribution of R24 and R18 per unit respectively. Product X
requires 4 machine hours per unit, and product Y 2 hours. Only 5 000 machine hours are available, and
potential sales demand is for 1 000 units each of X and Y.
Machine hours would be a limiting factor, and with X earning R6 per hour and Y earning R9 per hour, the profit-
maximising decision would be as follows:
Units Hours Contribution

R
Y 1 000 2 000 18 000
X (balance) 750 3 000 18 000
5 000 36 000
Priority is given to Y because the opportunity cost of making Y instead of more units of X is R6 per hour (X’s
contribution per machine hour), and since Y earns R9 per hour, the incremental benefit of making Y instead of
X would be R3 per hour.
17
If extra machine hours could be made available, more units of X (up to 1 000) would be made, and an extra
contribution of R6 per hour could be earned. Similarly, if fewer machine hours were available, the decision
would be to make fewer units of X and to keep production of Y at 1 000 units, and so the loss of machine hours
would cost the company R6 per hour in lost contribution. This R6 per hour, the marginal contribution-earning
potential of the limiting factor at the profit-maximising output level, is referred to as the shadow price (or
dual price) of the limting factor.
KEY TERM
A shadow price is the increase in value obtainable from having available one additional unit of a limiting
resource at the original cost.
Note that the shadow price only applies while the extra unit of resource can be obtained at its normal variable
cost. The shadow price also indicates the amount by which contribution could fall if an organization is deprived
of one unit of the resource.
The shadow price of a resource is its internal opportunity cost. This is the marginal contribution towards
fixed costs and profit that can be earned for each unit of the limiing factor that is available. A knowledge of the
shadow price of a resource will help managers to decide how much it is worth paying to acquire another unit of
the resource.
Using limiting factor analysis
Limiting factor analysis provides us with a profit-maximising product mix, within the assumptions made. It is
important to remember, however, that other considerations might entirely alter the decision reached.
Qualitative factors
When a decision is being made, qualitative factors should be borne in mind.
Factor Examples
Demand Will the decision reached (perhaps to make and sell just one product rather than
two) have a harmful effect on customer loyalty and sales demand? For example,
a manufacturer of knives and forks could not expect to cease production of knives
without affecting sales demand for the forks.
Long-term Is the decision going to affect the long-term as well as the short-term plans of the
effects organization? If a particular product is not produced, or produced at a level below
sales demand, is it likely that competitors will take over vacated markets? Labour
skilled in the manufacture of the product may be lost and a decision to reopen or
expand production of the product in the future may not be possible.
Labour If labour is a limting factor, is it because the skills required are difficult to obtain,
perhaps because the organization is using very old-fashioned production
methods, or is the organization a high-tech newcomer in a low-tech area? Or
perhaps the conditions of work are so unappealing the people simply do not want
to work for the organization.
Other The same sort of questions should be asked whatever the limiting factor. If
limiting machine hours are in short supply is this because more machines are needed, or
factors newer, more reliable and efficient machines? If materials are in short supply,
what are competitors doing? Have they found an equivalent or better substitute?
Is it time to redesign the product?
18
Assumptions in limiting factor analysis
In the examples we have been looking at, certain assumptions have been made. If any of the assumptions are
not valid, then the profit-maximising decision might be different. These assumptions are as follows:
a) Fixed costs will be the same regardless of the decision that is taken, and so the profit-maximising and
contribution-maximising output level will be the same.
This will not necessarily be true, since some fixed costs might be directly attributable to a product or
service. A decision to reduce or cease altogether activity on a product or service might therefore result
in some fixed cost savings, which would have to be taken into account.
b) The unit variable cost is constant, regardless of the output quantity of a product or service. This
implies the following:
i) The price of resources will be unchanged regardless of quantity; for example, there will be no
bulk purchase discount of raw materials.
ii) Efficiency and productivity levels will be unchanged; regardless of output quantity the direct
labour productivity, the machine time per unit, and the materials consumption per unit will
remain the same.
c) The estimates of sales demand for each product, and the resources required to make each product,
are known with certainty.
In Example 3 – page 10, there were estimates of the maximum sales demand for the two products, and
these estimates were used to establish the profit-maximisng product mix. Suppose the estimates were
wrong? The product mix finally chosen would then either mean that some sales demand of the most
profitable item would be unsatisfied, or that production would exceed sales demand, leaving some
stock unsold. Clearly, once a profit-maximising output decision is reached, management will have to
keep their decision under continual review, and adjust their decision as appropriate in the light of actual
results.
d) Units of output are divisable, and a profit-maximising solution might include fractions of units as the
optimum output level.
Where fractional answers are not realistic, some rounding of the figures will be necessary.
MAKE OR BUY DECISIONS

A make or buy problem involves a decision by an organization about whether it should make a product or carry
out an activity with its own internal resources, or whether it should pay another organization to make the
product or carry out the activity. Examples include whether a company should manufacture its won
components, or else buy the components from an outside supplier.
The ‘make’ option should give management more direct control over the work, but the ‘buy’ option often
has the benefit that the external organization has a specialist skill and expertise in the work. Make or buy
decisions should certainly not be based exclusively on cost considerations.
If an organization has the freedom of choice about whether to make internally or buy externally and has no
scarce resources that put a restriction on what it can do itself, the relevant costs for the decision will be the
differential costs between the two options.
19
EXAMPLE 5 : MAKE OR BUY
Shellfish Ltd makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected to be
as follows:
W X Y Z
Production (units) 1 000 2 000 4 000 3 000
Unit marginal costs R R R R
Direct materials 4 5 2 4
Direct labour 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12
Directly attributable fixed costs per annum and committed fixed costs are as follows:
R
Incurred as a direct consequence of making W 1 000
Incurred as a direct consequence of making X 5 000
Incurred as a direct consequence of making Y 6 000
Incurred as a direct consequence of making Z 8 000
Other fixed costs (committed) 30 000
50 000
A subcontractor can supply units of W, X, Y and Z for R12, R21, R10 and R14 respectively.
REQUIRED:
Decide whether Shellfish Ltd should make or buy the components.
SOLUTION AND DISCUSSION
The relevant costs are the differential costs between making and buying, and they consist of differences
in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in
some fixed cost savings.
W X Y Z
R’s R’s R’s R’s
Unit variable cost of making 14 17 7 12
Unit variable cost of buying 12 21 10 14
R(2) R4 R3 R2
Annual requirements (units) 1 000 2 000 4 000 3 000
Extra variable cost of buying (per annum) (2 000) 8 000 12 000 6 000
Fixed costs saved by buying 1 000 5 000 6 000 8 000
Extra total cost of buying (3 000) 3 000 6 000 (2 000)
The company would save R3 000 pa by subcontracting component W (where the purchase cost would be less
than the marginal cost per unit to make internally) and would save R2 000 pa by subcontracting component Z
(because of the saving in fixed costs of R8 000).
20
Important further considerations would be as follows:
a) If components W and Z are subcontracted, the company will have spare capacity. How should that
spare capacity be profitably used? Are there hidden benefits to be obtained from subcontracting?
Would the company’s workforce resent the loss of work to an outside subcontractor, and might such a
decision cause an industrial dispute?
b) Would the subcontractor be reliable and delivery times, and would he supply components of the
same quality as those manufactured internally?
c) Does the company wish to be flexible and maintain better control over operations by making
everything itself?
d) Are the estimates of fixed cost saving reliable? In the case of Product W, buying is clearly cheaper
than making in-house. In the case of production Z, the decision to buy rather than make would only be
financially beneficial if the fixed cost savings of R8 000 could really be ‘delivered’ by management.
Make or buy decisions and scarce resources
A company might want to do more things than it has the resources for, and so its alternatives would be as
follows:
a) Make the best use of the available resources and ignore the opportunities to by help from outside.
b) Combine internal resources with buying externally so as to do more and increase profitability.
Buying help from outside is justifiable if it adds to profits. A further decision is then required on how to split the
work between internal and external effort. What parts of the work should be given to suppliers or sub-
contractors so as to maximize profitability?
In a situation where a company must sub-contact work to make up a shortfall in its own in-house
capabilities, its total costs will be minimized if those units bought have the lowest extra variable cost of
buying per unit of scarce resource saved.
This basic principle can be illustrated with a simple example.
EXAMPLE 6 : MAKE OR BUY DECISION WITH SCARCE RESOURCES
Seaman Ltd manufactures three components, S, A and T using the same machines for each. The budget for
the next year calls for the production and assembly of 4 000 of each component. The variable production cost
per unit of the final product is as follows:
Machine Variable
hours cost
R
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 20
100
Only 24 000 hours of machine time will be available during the year, and a sub-contractor has quoted the
following unit prices for supplying components: S R29; A R40; T R34.
21
REQUIRED:
Advise Seaman Ltd.
SOLUTION
The company’s budget calls for 36 000 hours of machine time, if all the components are to be produced in-
house. Only 24 000 hours are available, and so there is a shortfall of 12 000 hours of machine time, which is
therefore a limiting factor. The shortage can be overcome by subcontracting the equivalent of 12 000 machine
hours’ output to the subcontractor.
The assembly costs are not relevant costs because they are unaffected by the decision.
The decision rule is to minimize the extra variable costs of sub-contracting per unit of scarce resource
saved (that is, per machine hour saved).
S A T
R R R
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per hour saved R3 R23 R2.50
This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy S. The
priority for making the components in-house will be in the reverse order; S, then T, then A. There are
enough machine hours to make all 4 000 units of S (12 000 hours) and to produce 3 000 units of T (another 12
000 hours). 12 000 hours’ production of T and A must be sub-contracted.
The cost-minimising and so profit-maximising make and buy schedule is as follows:
Component Machine Number of Unit variable Total

hours units cost variable cost
used/saved R R
Make: S 12 000 4 000 20 80 000
T 12 000 3 000 24 72 000
24 000 152 000
But: T 4 000 1 000 34 34 000

A 8 000 4 000 40 160 000
12 000
Total variable cost of components, excluding assembly costs 346 000
22
QUESTION 5
TW Ltd manufactures two products, the D and the E, using the same material for each. Annual demand for the
D is 9 000 units, while for the E is 12 000 units.
The variable production cost per unit of the D is R10, that of the E R15. The D requires 3.5 kgs of raw material
per unit, the E requires 8 kgs of raw material per unit.
Supply of raw material will be limited to 87 500 kgs during the year.
A sub contractor has quoted prices of R17 per unit for the D and R25 per unit for the E to supply the product.
How many of each product should TW Ltd manufacture in order to maximize profits?
SOLUTION
D E
R per unit R per unit
Variable cost of making 10 15
Variable cost of buying 17 25
Extra variable cost of buying 7 10
Raw material saved by buying 3.5 kgs 8 kgs
Extra variable cost of buying per kg saved R2 R1.25
Priority for internal manufacture 1 2
Production plan Material used

Kgs
 Make D (9 000 x 3.5 kgs) 31 500
E (7 000 x 8 kgs) 56 000
87 500
The remaining 5 000 units of E should be purchased from the contractor.
9 000 units of D and 7 000 units of E should be manufactured.
SHUTDOWN PROBLEMS
Shutdown problems involve the following type of decisions:
a) Whether or not to close down a factory, department, product line or other activity, either because it is
making losses or because it is too expensive to run.
b) If the decision is to shut down, whether the closure should be permanent or temporary.
Although in practice shutdown decisions will involve longer-term considerations (such as savings in annual
operating costs for a number of years), and capital expenditures and revenues (sales of fixed assets and
redundancy payments), it is possible for shutdown problems to be simplified into short-run decisions, by
assuming that either fixed asset sales and redundancy costs would be negligible or that income from fixed
asset sales would match redundancy costs and so these capital items would be self-cancelling. In such
circumstances the financial aspect of shutdown decisions would be based on short-run relevant costs.
23
EXAMPLE 7 : ADDING OR DELETING PRODUCTS
A company manufactures three products, Pawns, Rooks and Bishops. The present net annual income from
these is as follows:
Pawns Rooks Bishops Total

R R R R
Sales 50 000 40 000 60 000 150 000
Variable costs 30 000 25 000 35 000 90 000
Contribution 20 000 15 000 25 000 60 000
Fixed costs 17 000 18 000 20 000 55 000
Profit/loss 3 000 (3 000) 5 000 5 000
The company is concerned about its poor profit performance, and is considering whether or not to cease selling
Rooks. It is felt that selling prices cannot be raised or lowered without adversely affecting net income. R5 000
of the fixed costs of Rooks are direct fixed costs which would be saved if production ceased. All other fixed
costs, it is considered, would remain the same.
By stopping production of Rooks, the consequences would be a R10 000 fall in profits.
R
Loss of contribution (15 000)
Savings in fixed costs 5 000
Incremental loss (10 000)
Suppose, however, it were possible to use the resources realized by stopping production of Rooks and switch
to producing a new item, Crowners, which would sell for R50 000 and incur variable costs of R30 000 and
extra direct fixed costs of R6 000. A new decision is now required.
Rooks Crowners
R R
Sales 40 000 50 000
Less variable costs 25 000 30 000
15 000 20 000
Less direct fixed costs 5 000 6 000
Contribution to shared fixed costs and profit 10 000 14 000
It would be more profitable to shut down production of Rooks and switch resources to making Crowners, in
order to boost profits by R4 000 to R9 000.
Relative profitability
The relative profitability of products can be judged by calculation of their contribution to sales (C/S) ratios.
Suppose an organization produces three products A, B and C, and that production capacity is limited. If
product A has a C/S ratio of 22%, production B a C/S ratio of 27% and product C a C/S ratio of 25%, given
unlimited demand for the three products the organization should concentrate on producing product B.
Temporary closure
The decision whether to shut down temporarily should take into account the following factors:
 The impact on the organisation’s other products and the product in question
 Problems of recruitment of skilled labour when production begins again
 Possibility of plant obsolescence
 Problems of closing down and restarting production in some industries
 Expenditure on disconnection of services, start up costs and so on
24
If contribution is only just covering fixed costs but improved trading conditions in the future seem likely it
may be worth continuing the business.
Other considerations in such decisions
a) A product may be retained if it is providing a contribution, albeit a small one. Retaining a wide range of
low volume/low contribution products would add to the complexity and hence costs of
manufacture, however, but very little to overall profit. Low volume/low contribution products should
therefore be examined on a regular basis.
b) The effect on demand for other products if a particular product is no longer produced should be
taken into account.
c) The extent to which demand for other products (existing or new) can expand to use the capacity
vacated by the product being deleted is an issue.
d) Pricing policy. Is the product a loss leader? Is the product in the introductory stage of its life cycle
and consequently priced low to help it to become accepted and hence maximize its long-term market
share (penetration pricing).
Idle production capacity
If an organization does decide to shut down a factory, department, product line or other activity, it may well
be faced with a decision about what to do with the resulting idle production capacity.
a) Marketing strategies could be used to increase demand for existing products.
b) Idle plant and machinery could be moved to another department or factory, thereby reducing
expenditure on new plant and machinery and/or interest charges.
c) Special orders could be accepted, providing that the contribution generated is either greater than any
reduction in fixed overheads which would occur if the idle capacity was not used or greater than any
increase in fixed overheads if the idle capacity were to be used.
d) Space could be sub-let to a third party.
Such considerations are particularly important if the closure is only temporary.
EXTRA SHIFT DECISIONS AND OVERTIME

Extra shift decisions are another type of decision problem. They are concerned with whether or not it is
worth opening up an extra shift for operations.
Qualitative factors in extra shift decisions include the following:
a) Would the work force be willing to work the shift hours, and if so, what overtime or shift work
premium over their basic pay might they expect to receive?
b) Do extra hours have to be worked just to remain competitive? Banks might decide to open on
Saturdays just to match what competitors are doing and so keep customers.
25
c) Would extra hours result in more sales revenue, or would there merely be a change in the demand
pattern. For example, if a shop were trying to decide whether to open on Sundays, one consideration
would be whether the customers it would get on Sunday would simply be customers who would
otherwise have done their shopping on another day of the week instead, or whether they would be
additional customers.
When a business expands, the management is often faced with the problems of whether to acquire larger
premises and more plant and machinery and whether to persuade existing personnel to work longer hours
(on an overtime basis) or to engage extra staff who would use the existing equipment but a different time
(on a shift basis).
If the management decide to incur additional expenditure on premises and plant, that expenditure is a
fixed cost. It will therefore be necessary to determine how much additional contribution will be required
from the anticipated increased production to cover the extra fixed cost.
If it is decided to use the existing fixed assets, but for a longer period each day, the choice of shift working
or overtime will also involve a marginal costing consideration.
a) If overtime is selected, the direct wages cost per unit produced will be increased because the
wages paid to workers on overtime are a basic rate plus an overtime bonus.
b) If the management opt for shift working the shift premium may not be as expensive as the overtime
premium so the direct wages cost may be relatively lower. On the other hand, there may be an
increase in fixed (or semi-fixed) costs such as lighting, heating and canteen facilities.
ACCEPTING OR REJECTING ORDERS

In general terms, an order will probably be accepted if it increases contribution and profit, and rejected if it
reduces profit.
If an organization has spare capacity (which means that it would not have to turn away existing business), a
‘special’ (one-off) order (which is normally (in the exam) at a price below the normal price of the product),
should be accepted if the price offered makes some contribution to fixed costs and profit. In other words,
the variable cost of the order needs to be less than the price offered. Fixed costs are irrelevant to such a
decision since they will be incurred regardless of whether or not the order is accepted. Additional fixed costs
incurred as a result of accepting the order must be taken into account, however.
If an organization does not have sufficient spare capacity, existing business should only be turned away
if the contribution from the order is greater than the contribution from the business which must be
sacrificed.
26
EXAMPLE 8 : ACCEPTING OR REJECTING ORDERS
Holdup Ltd makes a single product which sells for R20, and for which there is great demand. It has variable
cost of R12, made up as follows:
R
Direct material 4
Direct labour (2 hrs) 5
Variable overhead 2
12
The labour force is currently working at full capacity producing a product that earns a contribution of R4 per
labour hour. A customer has approached the company with a request for the manufacture of a special order for
which he is willing to pay R5 500. The costs of the order would be R2 000 for direct materials, and 500 labour
hours will be required.
REQUIRED:
Decide whether the order should be accepted.
SOLUTION
a) Labour is a limiting factor. By accepting the order, work would have to be diverted away from the
standard product, and contribution will be lost, that is, there is an opportunity cost of accepting the new
order, which is the contribution forgone by being unable to make the standard product.
b) Direct labour pay costs R3 per hour, but it is also usually assumed that variable production overhead
varies with hours worked, and must therefore be spent in addition to the wages cost of the 500 hours.
c)
R R
Value of order 5 500
Cost of order
Direct labour (500 hrs x R3) 1 500
Variable overhead (500 hrs x R1) 500
Opportunity cost (500 hrs x R4) (Contribution forgone) 2 000
Relevant cost of the order 6 000
Loss incurred by accepting the order (500)
Although accepting the order would earn a contribution of R1 500 (R5 500 – R4 000), the lost production of the
standard product would reduce contribution earned elsewhere by R2 000 and so the order should not be
accepted.
Other considerations must also be taken into account, however.
a) Will relationships with existing customers, or prices that can be commanded in the market, be
affected if the order is accepted?
b) As a loss leader, could it create further business opportunities?
c) Should existing business be turned away in order to fulfil a one-off enquiry or could a long-term
contract be established?
27
QUALITATIVE FACTORS IN DECISION MAKING
Qualitative factors in decision making are factors which might influence the eventual decisions but which have
not been quantified in terms of relevant income or costs. They may stem from non-financial objectives and
from factors which might be quantifiable in money terms, but which have not been quantified, perhaps because
there is insufficient information to make reliable estimates.
Qualitative factors in decision making will vary with the circumstances and nature of the opportunity being
considered. Here are some examples:
Qualitative factor Detail
Availability of There must be sufficient cash to finance any purchases of equipment and build-up of
cash working capital. If cash is not available, new sources of funds (for example an
overdraft or loan) must be sought.
Inflation If the income from an opportunity is fixed by contract, but the costs might increase with
inflation, the contract’s profitability would be over-stated unless inflation is taken into
account.
Employees Any decision involving the shutdown of a plant or changes in work procedures or
location will require acceptance by employees, and ought to have regard to employee
welfare.
Customers Decisions about new products, the quality of output or after-sales service will inevitably
affect customer loyalty and customer demand. Remember that a decision involving
one product may have repercussions on customer attitudes towards a range of
products.
Competitors In a competitive market, some decisions may stimulate a response from rival
companies. The decision to reduce selling prices to raise demand may fail if all
competitors take similar action.
Timing factors There might be a choice in deciding when to take up an opportunity. There might also
be choice about whether a shutdown should be permanent or temporary. Temporary
closure may be a viable proposition during a period of slack demand. And if a decision
is taken to sell goods at a low price where the contribution earned will be relatively
small, it is important to consider the duration of the low price promotion. If it is a long-
term feature of selling, and if demand for the product increases, the company’s total
contribution may sink to a level where it fails even to cover fixed costs.
Suppliers Long-term goodwill may be damaged by a decision to close a product line temporarily.
Decisions to change the specifications for purchased components, or change
stockholding policies so as to create patchy, uneven demand might also put a strain on
suppliers.
Feasibility A proposal may look feasible, but technical experts or managers may have
reservations about their ability to carry it out.
Flexibility & Decisions to subcontract work, or to enter into a long-term contract, have the
internal control disadvantages of inflexibility and lack of controllability.
Unquantified Even where no opportunity costs are specified, it is probable that other opportunities
opportunity costs would be available for using the resources to earn profit.
Political Some large companies may suffer political pressures applied by the government to
pressures influence their investment or disinvestments decisions.
Legal constraints A decision might occasionally be rejected because of questions about the legality of
the proposed action.
28
The managing director of Parser Ltd, a small business, is considering undertaking a once-off contract and has
asked her inexperienced accountant to advise on what costs are likely to be incurred so that she can price at a
profit. The following schedule has been prepared:
Costs for special order:
Notes R
Direct wages 1 28 500

Supervisor costs 2 11 500
General overheads 3 4 000
Machine depreciation 4 2 300
Machine overheads 5 18 000
Materials 6 34 000
Total costs 98 300
Notes
1. Direct wages comprise the wages of two employees, particularly skilled in the labour process for this job,
who could be transferred from another department to undertake work on the special order. They are fully
occupied in their usual department and sub-contracting staff would have to be bought-in to undertake the
work left behind. Subcontracting costs would be R32 000 for the period of the work. Different
subcontractors who are skilled in the special order techniques are available to work on the special order
and their costs would amount to R31 300.
2. A supervisor would have to work on the special order. The cost of R11 500 is comprised of R8 000
normal payments plus R3 500 additional bonus for working on the special order. Normal payments refer
to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his
normal work amounting to R2 500. It is not anticipated that any replacement costs relating to the
supervisor’s work on other jobs would arise.
3. General overheads comprise an apportionment of R3 000 plus an estimate of R1 000 incremental

overheads.
4. Machine depreciation represents the normal period cost based on the duration of the contract. It is
anticipated that R500 will be incurred in additional machine maintenance costs.
5. Machine overheads (for running costs such as electricity) are charged at R3 per hour. It is estimated that
6 000 hours will be needed for the special order. The machine has 4 000 hours available capacity. The
further 2 000 hours required will mean an existing job is taken off the machine resulting in a lost
contribution of R2 per hour.
6. Materials represent the purchase costs of 7 500 kg bought some time ago. The materials are no longer
used and are unlikely to be wanted in the future except on the special order. The complete stock of
materials (amounting to 10 000 kg), or part thereof, could be sold for R4,20 per kg. The replacement cost
of material used would be R33 375.
7. Costs will be incurred evenly over the project duration of three months.
The prospective client is willing to make an upfront payment of R40 000. The outstanding balance
will be paid one month after completion. Because the business does not have adequate funds to finance the
special order, a bank overdraft shortfall will be required. The overdraft will be repaid on settlement of the
outstanding debt. The company uses a cost of capital of 15% to appraise projects. The bank’s overdraft rate is
12% for Parser Ltd.
29
The managing director has heard that, for special orders such as this, relevant costing should be used that also
incorporates opportunity costs. She has approached you to create a revised costing schedule based on
relevant costing principles.
REQUIRED
(a) Briefly explain what is meant by opportunity cost. ( 2)
(b) Determine the minimum price to be quoted by Parser Ltd on the once-off contract; an NPV approach is
not required. (16)
(c) Explain why very Small to Medium-size Enterprises (SMEs), such as Parser Ltd, might face problems in
obtaining appropriate sources of finance. In your answer pay particular attention to problems and issues
associated with:
(i) uncertainty concerning the business;

(ii) assets available to offer as collateral or security; and
(iii) potential sources of finance for very new SMEs, excluding sources from capital
markets. (12)
(ACCA – adapted)
30
QUESTION 6 : SOLUTION
Relevant costs imply future cash costs to be incurred or opportunity costs.
(a) Opportunity costs represent the value of the loss or sacrifice when choosing between scarce alternatives.
(2)
(b) Revised costs for the special order
Note R
Subcontractor costs 1 31 300 (1)

Supervisor – normal pay 2 0 (1)
– bonus 2 1 000 (1)
General overheads – opportionment 3 0 (1)
– incremental 3 1 000 (1)
Machine – depreciation 4 0 (1)
– maintenance 4 500 (1)
Machine overheads (18 000 + 4 000) 5 22 000 (2)
Materials 6 31 500 (1)
87 300
Interest costs 7 316 [5]
87 616
Notes:
1. The choice lies between the two subcontractor costs that have to be incurred because of the
shortage of existing labour. The minimum cost is to have subcontractors employed who are skilled
in the special process.
2. Only the difference between the bonus and the incentive payment represents an additional cost
that arises due to the special order. Fixed salary costs do not change.
3. Only incremental costs are relevant.
4. Depreciation is a period cost and is not related to the special order. Additional
maintenance costs are relevant.
5. The relevant costs are the variable overheads (R3 x 6 000 hours) that will be incurred, plus the
displacement costs of R2 x 2 000 hours making a total of R22 000.
6. Since the materials are no longer used the replacement cost is irrelevant. The historic cost of
R34 000 is a sunk cost. The relevant cost is the lost sale value of the stock used in the special
order which is: 7 500 kg x R4,20 per kg = R31 500.
7. Full opportunity costing will also allow for imputed interest costs on the incremental loan. The
correct interest rate is the overdraft rate since this represents the incremental cost the company will
pay. (1)
31
Incremental cash outflows (87 300 – 31 500) 55 800 (1)
18 600 (1)
– 40 000) x 2m x 12% = 316 (2)
The managing director should decide whether a profit margin should be added to take cognisance of the
required 15% cost of capital. (1)
(c) Uncertainty concerning the business
• Often not long in business, thus no track record.
• Activities may be changing to survive – uncertainty.
• Activities conducted in private.
• Accounts not necessarily audited.
• Accounts not published, drafted to satisfy owner(s).
Assets available to offer as collateral
• Banks consider a range of issues when screening loan applications, one of which is collateral or
security.
• Collateral is important because it can reduce the bank’s risk exposure.
• Risk will also reflect in the interest rate charged.
• Personal security from owner may not be possible – put his assets/finance in business.
• Business may simply be too young to have built up adequate assets.
Sources of finance
• Initial owner finance – capital or loans.
• Family connected finance.
• Trade credit finance, but very short term and expensive.
• Bank loan if adequate security can be arranged.
• Guarantees provided by reliable individual or other businesses to underpin a loan.
• Venture capital finance if particularly good prospects.

__
1 each, maximum 12
32
Pringle trades as a vat maker for the wine industry. His profit in this business during the year to
30 June was R20 000. Pringle also undertakes occasional contracts to build hand-crafted
cabinets, and is considering the price at which to bid for the contract to build five for an
exclusive furniture supplier, delivery to be in one year’s time. He has no other contract in
hand, or under consideration, for at least the next few months. If he accepts the contract it
will take up all his cabinet-making capacity for the next twelve months.
Pringle expects that if he undertakes the contract he would devote one-quarter of his time
to it. To facilitate this he would employ Smith, an unqualified accountant, to undertake his
book-keeping and other paperwork, at a cost of R12 000 per annum.
He would also have to employ on the contract one supervisor at a total cost of R22 000 and
two craftsmen at a total cost of R8 800 each. These costs include Pringle’s normal
apportionment of the fixed overheads of his business at the rate of 10% of labour cost.
Part of the finishing processes of the cabinets, involves applying a special varnish and
leaving the wood to absorb this. During this maturation time, one of the craftsmen could be
employed for the equivalent of up to three months full-time in maintenance and painting
work in the vat maker’s business. He would use additional materials not carried in inventory
costing R1 000. Pringle already has two inclusive quotations from jobbing repairmen for this
maintenance and painting work, one for R2 500 and the other for R3 500, the work to start
immediately.
The equipment which would be used on the cabinet contract was bought nine years ago
for R32 000. Depreciation has been written off on a straight-line basis, assuming a ten-year
life and a scrap value of R2 000. The current replacement cost of similar new equipment is
R70 000, and is expected to be R75 000 in one year’s time. Pringle has recently been offered
R5 000 for the equipment, and considers that in a year’s time he would have little difficulty in
still obtaining R3 000 for it. The plant is useful to Pringle only for contract work.
In order to build the cabinets Pringle will need six types of material, as follows:
No. of units Price per unit (R)
Material In stock Needed for Purchase Current Current

code contract price of purchase resale price
stock items price
A 100 800 1.50 3.00 2.00
B 1,200 1,000 2.00 0.90 0.90
C 200 6.00
D 100 200 4.00 3.00 2.00
E 50,000 5,000 0.48 0.20 0.20
F 1,000 3,000 0.90 2.00 1.00

33
- 34 -
Materials B and E are used regularly in the vat maker’s business. Material A could be sold
to a local sculptor if not used for the contract. Materials A and E can be used for other
purposes, such as property maintenance. Pringle has no other use for materials D and F,
the stocks of which are obsolete.
The cabinets would be crafted in a factory held on a lease with three years remaining at a
fixed annual rental of R7 000. It would occupy half of this factory, which is useful to Pringle
only for contract work.
Pringle anticipates that the direct expenses of the contract, other than those noted above,
would be R8 600.
Pringle has recently been offered a one-year appointment at a fee of R40 000 per annum
to manage a furniture manufacturing firm. If he accepted the offer, he would be unable
to take on the contract to build the five cabinets, or any other contract. He would have to
employ a manager to run the vat maker’s business at an annual cost (including fidelity
insurance) of R12 000, and would incur additional personal living costs of R3 000.
REQUIRED:
· Calculate the minimum price at which Pringle should be willing to take on the
contract in order to break even, based exclusively on the information given above.
(20)
· Set out any further considerations which you think that Pringle should take into
account in setting the price at which he would tender for the contract.
(10)
Ignore taxation. (30)

- 35 -
· The relevant costs of the contract are as follows:
Notes R R
Salary of Smith 12,000 (1)
Supervision cost a 20,000 (1)
Cost of craftsmen a 16,000 (1)
Reduction in second hand value c 2,000 (2)

of equipment
Material costs: d
· A (800 x R3) 2,400 (2)
· B (1 000 x R0.90) 900 (1)
· C (200 x R6) 1,200 (1)
· D (100 x R2) + (100 x R3) 500 (2)
· E (5 000 x R0.20) 1,000 (1)
· F (1 000 x R1) + (2 000 x R2) 5,000 11,000 (2)
Lease costs e 0 (1)
Other direct expenses 8,600 (1)
Owner’s opportunity cost f 25,000 (2)
94,600
Less savings on maintenance work b (1,500) (2)
Minimum contract price 93,100
(20)
- 36 -
· Some of the additional factors are:

·
i What is the likelihood that Pringle will obtain other contract work during the
year? If there is a possibility then any lost contribution should be covered in
the minimum contract price. (2)
ii Given that the profit was R20 000 last year, Pringle should consider closing
operations and obtaining a permanent salary of R40 000 per annum. (2)
iii Does any alternative uses for the leased factory space exist? If so then
appropriate opportunity cost should be added. (2)
iv The contract price represents a minimum price. Pringle should aim to earn a
surplus on the contract. (2)
v Will the loss of one-quarter of Pringle’s time to the existing business result in a
reduction in profit? If this is the case then the lost profits should be included
as an opportunity cost. (2)
(10)
(30)
NOTES
a The costs given in the question include apportioned fixed overheads which are
not a relevant cost. Therefore R2 000 has been deducted from the total
supervision cost (1/11 x R22 000) and R800 from each of the craftsmen’s total
costs.
b It is assumed that the contract could be completed and the maintenance

programme carried out during the same period in which the supervisor and
craftsmen are employed (one year). It is also assumed that the supervision and
craftsmen will be employed for one year only. A further assumption is that the
lowest quotation will be accepted.
Inclusive quote from jobbing repair man R2 500 less material (not carried in
inventory) to be bought if maintenance is to be done by craftsman R1 000 = net
saving of R1 500. (Salary of the craftsman is a sunken cost in this calculation.)
c The historical cost of the equipment is a sunk cost. It is assumed that the existing
equipment would have been sold if the contract was not accepted. Therefore
the relevant cost of using the equipment is the reduction in the scrap value over
the duration of the contract.
d Material A: It is assumed that the 100 units in stock will be used on property
maintenance first. This is more profitable than the alternative of selling the
materials for R2 and replacing them at a later date at R3. The quantities
needed for the contract will be replaced at the current purchase price.
Material B: It is assumed that the 1 000 units issued from stock for the contract will
be replaced at R0.90 per unit. This material is used regularly in the business.
Material C: This material is purchased specially for the contract.

- 37 -
Materials D and F: The stocks of these materials have no alternative use within
the business and will be sold if not used on the contract. Hence the sale price
represents the opportunity cost of using these materials. The remainder of the
materials will be purchased at current prices.
Material E: It is assumed that the material taken from stock for this contract will
be replaced at the current purchase price. This material is used regularly in the
business.
e The lease of the factory would have to be paid even of the contact were not
accepted.
f It is assumed that the alternative is for Pringle to pay out R15 000 to maintain the
existing business while he earns R40 000 on the one year appointment. If the
contract is undertaken then Pringle will lose R25 000.
2
Disney Limited manufactures Mickey Mouse and Donald Duck Murals for children’s bedrooms.
The following projected information for the 2014 financial year is supplied at a capacity utilisation of 100%:
1. Standards per unit:
Mickey Donald
Mouse Duck
R R
Raw material @ R9,60 per kg 12,00 4,80
Direct labour @ R9,00 per hour 18,00 12,00
Total overheads @ R8,40 per machine hour 16,80 21,00
Selling price per unit 49,20 37,20
2. It is anticipated that fixed overheads will amount to R144 000 per annum and will, at full capacity utilisation, be
applied at a rate of R2,40 per machine hour.
3. Market research has shown that 27 000 Mickey Mouse murals and 18 000 Donald Duck murals could be sold.
4. A shortage of skilled labour is being experienced. As a result, only 80 000 labour hours will be available.
5. Due to import restrictions, only 30 000 kg of raw material will be available.
REQUIRED:
(a) Determine the product mixture which will maximise the net income of Disney Limited for 2014. (19)
(b) Calculate the total marginal income that will be earned from Mickey Mouse murals if the selling price increases
by 10%, resulting in a decrease of 5% in the sales volume. Use the full market potential as a basis. Assume
that no limiting factors exist. ( 4)
(c) Calculate what the selling price per unit of the Donald Duck murals should be in order to earn a profit of
R126 000. Assume that the full market potential will be sold and that no limiting factors exist. Fixed overheads
must be applied at the same rate as in (a) above. ( 3)
3
Super Sport Products Ltd is a manufacturer of sport equipment. In order to compile the budget of the section
manufacturing cricket bats for children for the next financial year, a decision must be taken regarding the optimal
product mix.
Two models of cricket bats for children are being manufactured:
- the Hansie bat for use by older children, and

- the Johnty bat for use by younger children.
The standards per unit for each of the models are as follows:
Hansie bat Johnty bat

R R
Material 12,95 10,50
Direct labour
(@ R6 per hour) 18,00 6,00
Manufacturing overheads
(@ R3,50 per machine hour) 10,50 5,25
1. Both bats are made from the same material, of which only 35 500 kilograms, at a total cost of R248 500, will be
available during the next financial year.
2. The following is an extract of the budget for manufacturing overheads:
Capacity utilisation Number of machine Total manufacturing

hours overheads
R
100% 50 000 158 075
90% 45 000 151 575
3. It is estimated that 11 000 Hansie bats and 14 500 Johnty bats could be sold annually.
4. Selling and administration expenses are fixed and amount to R15 000 per annum.
REQUIRED:
Determine the product mix which will maximise the net profit of the section for the next financial year.
(14)
4
Pecdu Limited manufactures two different electronic products, namely electronic igniters and vacuum
sensors.
The following is an extract of the budget for 2014:
Standards per unit::
Electronic Vacuum
igniters sensors
R R
Costs per unit:

Components 18,00 26,00
Direct labour 30,00 36,00
Overhead 7,20 9,30
Budgeted sales (units) 12 000 16 000
1. Components are acquired on a monthly basis. The supply is limited to a maximum of R53 500 per month.
2. The company employs 12 workers on the production line. Each employee has to work 170 hours per
month. Direct labour cost amounts to R40 per hour.
3. Fixed cost amounts to R235 200 per annum and is allocated to production at the rate of 15% of prime
cost (i.e. 15% of components and direct labour cost).
The company has been requested to give a quotation for an order of 5 000 electronic igniters. The order,
if accepted, must be delivered in full during the course of 2007.
If the order is accepted, it will not affect the normal annual demand for electronic igniters, as indicated in the
budget in point 2 above.
REQUIRED
(a) Determine the optimal product mixture in respect of the normal annual demand, assuming
that the order for 5 000 units is accepted. (25)
(b) Determine the number of units in respect of the normal annual demand which cannot be
manufactured due to the production of the 5 000 units for the order. (4)
(c) Calculate the marginal income relating to the units calculated in (b) above. (1)
[30]
[2007 UNISA assignment]

5
Hussle (Pty) Limited manufactures electrical kitchen equipment. One of its product lines is toasters. They currently
manufacture two types namely the two slice toaster and the four slice toaster.
Mr Robbs, the production manager, has extracted the following information regarding the manufacturing of toasters
for the month ended 28 February 2014 :
 Material
An analysis of the material requisitions shows the following apportionment of materials costs :
Two slice toaster : R372 810

Four slice toaster : R175 440
The value of material available per month amounts to R650 000.
 Labour
The production time per toaster was as follows :
Two slice Four slice

toaster toaster
Hours Hours
Skilled labour (@ R20 per hour) 0,5 0,9
Unskilled labour (@ R7 per hour) 1 1,5
The skilled labour cost is 40% fixed. The unskilled labour cost is 100% variable. There are 2 200 skilled
labour hours available per month.
 Overheads
Overheads are charged to production at a rate of 150% of the skilled labour cost per hour. The budgeted fixed
manufacturing overheads for the month amount to R20 640.
 Production
The following number of toasters were manufactured during the month :
Two slice toaster : 2 580

Four slice toaster : 860
No stock of finished products or work-in-process have been maintained.
 Sales commission
Sales commission of 1,5% is payable on all sales transactions.
 Future demand
According to estimate the demand for the next month will be 20% above the production of the month ended 28
February 2014. The current selling prices, which will remain unchanged, are as follows :
Two slice toaster : R280

Four slice toaster : R480
6
REQUIRED :
Determine the optimal product mixture which will maximise the income of Hussle (Pty) Limited for the month
ending 31 March 2014.
[31]

2
OPTIMISATION
INTRODUCTION
Optimisation is a technique which provides relevant information to

management in order to make strategic decisions with regards to the
optimum utilisation of scarce resources.
The primary objective, obviously, is to maximise profits. Profits are maximised

by maximising contribution or marginal income. The question is, how one
maximises contribution when faced with limited resources.
FACTORS OF PRODUCTION
Factors of production are the essential ingredients required to produce our

commodities. These factors include capital from owners, raw materials,
labour, water, land, etc.
(we will not deal with capital as a limiting factor)
UNERLYING ASSUMPTIONS
The assumptions are similar to those of Cost Volume Profit analysis, the most
important of which are:
 Cost relationships are linear.

 Units produced and resources allocated are infinitely divisible.
 Within the output range, the contribution per unit for each product and
the utilisation of resources per unit are the same irrespective of the
quantity produced or sold
In order to put things into perspective we will begin with a simple

illustration and thereafter build on
ILLUSTRATION 1
Assume a company manufactures 2 products, viz Elsi and Mate. Both
products require the same raw material which is called Sharp.
The following information is relevant to the products:
ELSI MATE
Demand (units) 300 200

Contribution per unit (R) 3 6
Kg of raw material required per unit (kg) 1,5 1
Assume that raw material sharp is available in unlimited quantities and so is

labour.
3
Which product(s) will you produce in order to maximise profits?
The question that needs to be asked is whether you have any limiting factors.
The possible limiting factors are raw material and labour. We have been told
that there are unlimited quantities available which means no limiting factors.
So I can produce all my required units.
Let’s calculate our total contribution should we produce all of Elsi and all of
Mate.
R
Elsi 300 x 3 900
Mate 200 x 6 1 200
Now, what if we faced with shortage of raw materials? Let’s say we only had
600 kg of sharp available.
Do we have a constraint? Let’s check.
Raw material required to produce 300 Elsi and 200 Mate:

kg
Elsi 1,5 kg x 300 450
Mate 1kg x 200 200
Required 650
Available 600
Shortage 50
We are 50 kg short which means we have a limiting factor. We cannot

produce everything.
With our objective in mind we will produce the one which renders the highest
contribution per unit, which in this case is Mate.
So if we produce all of Mate how much of Elsi can we make? Let’s check.
Kg
To produce 200 Mate 200 x 1kg 200
Available 600
Elsi
Once Mate has been produced only 400 kg are available to produce Elsi,
Let’s see what happens to our contribution:

R
Elsi 266 x 3 798
Mate 200 x 6 1 200
4
THE ABOVE TECHNIQUE IS SIMPLY CALLED LOGIC
Let’s move on:
We now introduce another resource in the form of labour.
Assume now that Elsi needs 1,2 hours to manufacture and Mate 1,5 hours. Also
assume for now that we only have 610 hours available.
Is labour a limiting factor? Let’s check.
Labour hours required to produce 300 Elsi and 200 Mate:
hours
Elsi 1,2 hrs x 300 360
Mate 1,5 hrs x 200 300
Required 660
Available 610
Shortage 50
Labour is a limiting factor. We are now faced with two limiting factors. What
do we produce?
With one limiting factor all we needed to look at was the total contribution.
With 2 limiting factors we need to look further. We will now compare the
contribution per limiting factor (also referred to as marginal income per
limiting factor).
Contribution per limiting factor
Material
ELSI MATE
Ranking 2 1
What this means is that for every kg of raw material used for Elsi I can earn R2
and for every kg of raw material used for Mate I can earn R6. Hence, this
limiting factor favours the production of Mate and is therefore ranked 1.
Let’s check labour.
ELSI MATE
Contribution per labour hour required A÷B R2,5/hr R4/hr
Ranking 2 1
Again I can earn more by employing more hours on mate. Labour also
favours the production of Mate.
5
So let’s produce all of Mate. Let’s see what happens.
Earlier we determined our position with regards to raw materials. We

determined that we could produce 200 units of Mate and 266 units of Elsi.
Let’s see what labour tells us.
Hours
To produce 200 Mate 200 x 1,5 hrs 300
Available 610
Elsi
Once Mate has been produced only 310 hours are available to produce Elsi,
Labour constraints dictate that we produce 258 units of Elsi while raw material
tells us 266. What do we make? What this means is that we have sufficient raw
material to make 266 units but we don’t have sufficient time to make 266
units. This means, we will have to settle for 200 of Mate and 258 of Elsi.
The above technique is called marginal costing and is used when the ranking
of limiting factors favours the same product.
Let us take the above scenario and change the given information so that the
ranking favours both products for the different limiting factors. Assume that
the amount of labour hours required to manufacture one unit of Mate is 2,5
hours. Let’s see what happens to the ranking:
Labour
ELSI MATE
Contribution per labour hour required A÷B R2,5/hr R2,4/hr
Ranking 1 2
And remember raw materials:

ELSI MATE
+Contribution per unit A R3,00 R6,00
Ranking 2 1
Labour favours the manufacture of Elsi while Raw materials favour the
manufacture of Mate. We call this conflicting ranking. In such a case we
have to resort to linear programming.
The above problem can be solved algebraically by solving simultaneous
equations.
6
The limiting factors form the basis of our equations.
Objective function: Maximise 3e + 6m
where : Elsi = e Mate = m
Parameters: 0 ≤ e ≤ 300
0 ≤ m ≤ 200
Raw 1,5e + 1m ≤ 600

material: ……1
Labour 1,2e + 2,5m ≤ 610
…...2
Take equation 1 and solve for m:

Alternative calc:
1,5e + 1m ≤ 600
1m ≤ 600 – 1 x 2.5 : 3.75e + 2.5m ≤ 1 500
1,5e (1.2e + 2.5m ≤ 610).
2.55e ≤ 890
Substitute in equation 2: e ≤ 349
1,2e + 2,5m ≤ 610 Limited to 300
1,2e + 2,5(600 – ≤ 610
1,5e)
1,2e + 1 500 – 3,75e ≤ 610
890 ≤ 2,55e
E ≤ 349
Note your parameters. The demand for Elsi is limited to 300 units which means
that we will produce 300 units of Elsi.

substitute back into BOTH equations to determine the production of the other
product to ensure that both e and m fall within the limits specified in the
objective function. The production of the other product will be the lower of
the two possible solutions.
7

1,5e + 1m ≤ 600
M ≤ 600 –
1,5(300)
M = 150

1,2e + 2,5m ≤ 610
2,5m ≤ 610 –
1,2(300)
M = 100
Our optimum solution is 300 Elsi and 100 Mate
GENERAL STEPS IN SOLVING AN OPTIMISATION PROBLEM
Remember - NB!!!
 Limiting factor is just another word for a constraint! (Denoted below as
“LF” in order to save space)
 Marginal income and contribution mean the same thing! (Denoted
below as “MI” in order to save space)
 Please write the terms out in full in the exam – do not use “LF” or “MI”.
AT THE BEGINNING OF THE QUESTION YOU WILL ALWAYS:
 State the objective function (which is really to maximise total marginal

income).
 State the parameters
(we can usually only do the above after we have worked out marginal
income per unit in step 2 so leave a space for this at the beginning of your
question – a few lines needed)
EG:
The objective function is: maximise 5p + 30q,

Where p is the optimal production amount of product P.
Where q is the optimal production amount of product Q.
The limiting values of p and q have to be specified:

p ≥ 0 and p ≤ demand in units
q ≥ 0 and q ≤ demand in units
8
BASIC STEPS TO FOLLOW:
1. Identify potential constraints (these are factors of production that are

available in limited quantities).
2. Calculate marginal income (contribution) per unit for each product

(MI p.u. = SP p.u. – VC p.u)
NB: Split semi This may be provided in the question but usually you will have to
variable costs calculate it. Don’t forget to include ALL variable costs when
calculating your marginal income p.u. This includes variable selling and
admin expenses and variable portion of semi-variable costs.
3. Identify which of those potential constraints in 1 are actual constraints.

In order to do this you need to determine the following for each
potential constraint:
 the quantity required to meet demand

 the total quantity of the constraint that is available
 the shortage/surplus between required and available
4. If there is only one limiting factor use MI/ contribution per unit and
produce all of the product with the highest MI/contribution per unit.
(There will be no step 5 and 6).
If there is more than one limiting factor calculate the marginal income
(contribution) per limiting factor relating to each actual limiting factor
for each product.
= Marginal income (MI) per unit of product ÷ limiting factor (LF) per
unit of product
= MI per LF
This will give you some amount of Rands per LF.

EG: R/kg (if LF is amount of material in kg);
R/Machine Hour (if LF is no. of machine hours);
R/R (if LF is an amount that can be spent)
5. Rank the products according to their marginal income per limiting

factor (LF), for each actual LF. This is an indication of the product’s
profitability per LF; therefore the highest is ranked first.
NB! IT IS AT THIS POINT THAT YOU NEED TO DECIDE WHICH TECHNIQUE YOU
ARE USING (based primarily on your rankings): you can either use
marginal costing (if rankings favour the same product) or linear
programming (if rankings favour different products). Note that steps 1-5
are identical for both techniques.
9
USING MARGINAL COSTING TECHNIQUES TO SOLVE OPTIMISATION QUESTIONS
When do we use marginal costing techniques?

We are able to use marginal costing techniques when there is only ONE
actual constraint, or, if there is more than one actual constraint, we use
marginal costing when the ranking of the different constraints favours the
SAME product.
6. Work out the optimal product mix (i.e. how much of each product you
will produce) using the ranking as determined above.
the other constraints/LFs.
OR
USING LINEAR PROGRAMMING TECHNIQUES TO SOLVE OPTIMISATION

QUESTIONS
When do we use linear programming techniques?
We use linear programming techniques if there is more than one actual

constraint AND the ranking of the different constraints favours DIFFERENT
products.
6. Express each actual constraint in terms of a linear equation.
[LF per unit of P x p] + [LF per unit of Q x q] ≤ total available LF
7. Solve the equations for the different constraints simultaneously in order

to establish the optimal product mix (i.e. we are solving for p and q).
substitute back into BOTH equations to determine the production of
the other product to ensure that both p and q fall within the limits
specified in the objective function. The production of the other
product will be the lower of the two possible solutions.
10
the other constraints.
11
i) Risks associated with running mobile clinics

• Mobile clinics run the risk of being removed/stolen and may require security
• The mobile units can be broken into during the night where supplies are stolen
• The costs of moving from area to area can be costly as the three units fulfil different
functions and must all move together.
• Damage to mobile units while in transit (Insurance)
• Government tends to delay payments. What if grants are not received timeously?
• Risk that the grant money is not utilised properly. The risk of fraud or corruption.
j) Effects and risks of HIV in the workplace

• People with HIV are singled out in the workplace and bear the risk of intimidation
• People with HIV are likely to fall ill, and this affects productivity
• Should a worker die of HIV, new workers need to be employed and trained. This comes at a
cost
• Companies, as part of their social responsibility, need to make regular testing available at
the work place at their own cost
• Should workers be working with sharp tools, etc there is a higher of contamination.

Management Accounting: Exam Pack (Updated)

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MAC3761

THIS PAPER CONSISTS OF TWELVE (12) PAGES IN TOTAL.

EXAM QUESTION PAPER INSTRUCTIONS:

Question 1: Costing systems; Cost classification and behaviour; Cost estimation;

The Invigilator App

INSTRUCTIONS – ACCESS myEXAMS AND UPLOADING ANSWER FILES:

1. EXTRACT FROM THE BUSINESS CASE FOR SF-WINERY

2. IRRIGATION COST ESTIMATION FOR SF-WINERY

2.1. MUNICIPALITY SUPPLIED WATER

Manufacturing overheads comprise of variable and fixed components. Variable manufacturing

PLEASE GO TO THE NEXT PAGE FOR “REQUIRED” SECTION

Investment 2 – Build a new “discount clothing store” in Zimbabwe

Projected profits for both investments:

Management Accounting III

This paper consists of 12 pages (including this page).

PROPOSED TIMETABLE Marks Minutes

Question 1: Overhead allocation; Cost-volume-profit (CVP) analysis;

QUESTION 1 (55 marks; 99 minutes)

Phalaborwa Pharmaceutics Enterprise (“PPE”) is a medium-sized company founded in 2020

Factory overhead items Activity 2020 Actual

B. MASKS DIVISION’S 2020 PERFORMANCE AND FORECAST FOR 2021

C. MASKS DIVISION – MANAGEMENT ACCOUNTS FOR THE 2020 FINANCIAL YEAR

2. All direct material purchased were issued to production.

E. ACQUISITION OF ALOETISER (PTY) LTD

1. PRODUCTION COSTS SCHEDULE EXTRACT FOR THE 2021 FINANCIAL YEAR:

2. NOTES AND ADDITIONAL INFORMATION

• Clearly show all your calculations in detail;

QUESTION 2 (45 marks; 81 minutes)

1. STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 2020

Rm Notes 2020 2019

Rm Notes 2020 2019

EQUITY AND LIABILITIES

Non-current liabilities 4.4 3 498 4 105

3. OTHER SALIENT INFORMATION

• Clearly show all your calculations in detail; and

On basic salaries and wages

= 119 624 700 units

Contribution per unit:

Contribution per unit: 103,6 – 28,3 – 21,6 – 2,4 = 51,3 cents

Total fixed costs:

PRODUCT INCOME STATEMENT

(a) Determine the capital structure of Brat Lows Furniture Group at 31

Or expressed as 56%: 44% Or expressed as 69%: 31%

CAPITAL STRUCTURE BASED ON MARKET VALUES:

Or expressed as 44%: 56% Or expressed as 47%: 53%

INSTRUMENT MARKET VALUE COST OF PREF.

Dividend: 1 050 x 7% x 0,8 = 58,8 million Dividend

INSTRUMENT MARKET VALUE (FINANCIAL CALC.) COST OF DEBEN

INSTRUMENT MARKET VALUE COST OF EQUITY

Ordinary shares MVe: 224,9million × R18,25✓ = R4 104 mil

COMMENTS: MAX: 3 marks

Credit sales (x): x + 0,25x = 3602

Trade receivable days: ✓

Trade payable days: ✓

COST‐VOLUME‐PROFIT ANALYSIS ‐ FORMULAE

Asset Management Ratios

Debt Management Ratios

****Common Equity is also referred to as Owner’s Equity or Stockholders Equity

Earnings per share = Net Income/Shares Outstanding

Type Ratio Formula Significance

Current ratio Current Assets Test of debt-paying ability 3

**Accts Receivable, Net means Accounts

Inventory Turnover Cost of Goods Sold Test of management