Determining the Cost of Operations for Pricing and Controlling

In this section, you will learn how to prepare functional budgets, control expenses, and compare actual results with budgets to identify and explain variances. This builds on what you learned in previous years and focuses on practical computation and analysis, helping you apply budgeting and variance concepts to real-life business situations. You will use learner-centred activities, group discussions, and problem-solving tasks to understand how budgets help control costs and improve performance.

KEY IDEAS

• A budget is a financial plan that shows the expected income and expenses of a business for a specific period. It helps to plan and control business activities.

• Adverse (Unfavourable) Variance is the difference that is not good for the business, such as when actual costs are higher than budgeted or actual revenue is lower.

• Favourable Variance is the difference that benefits the business, such as when actual costs are lower than budgeted or when actual revenue is higher than expected.

• Functional Budgets are budgets prepared for different parts (functions) of a business, such as sales, production, materials, labour, and cash.

• Variance Analysis is the process of comparing actual results with budgeted or standard results to find out the differences (variances) and their causes.

The Sales Budget is the starting point of all other budgets. It shows the types of products to be sold, quantities, selling prices, and the expected revenue for a period. It helps a business estimate its future income and decide on strategies for increasing sales. For example, if demand for a product is expected to rise, the sales budget will guide how much stock or production is needed.

Factors that Affect Sales Budget ₁. Past Sales Records: Previous sales data provide a useful basis for forecasting future sales. Trends, patterns, and seasonal variations from past years help in estimating expected sales.

2. Market Conditions: The general state of the economy (inflation, employment levels, income levels, etc.) influences customers’ purchasing power and demand. A booming economy may increase sales, while a recession may reduce them.

3. Sales Forecast: This is an estimate of future sales based on data analysis, market research, and management judgment. It serves as the foundation for the sales budget.

4. Advertising and Promotion Plans: The level and effectiveness of advertising, sales promotions, and marketing campaigns can significantly affect sales volume. More promotions often lead to higher sales.

5. Market Competition: The number and strength of competitors, their pricing, and marketing strategies influence expected sales. Strong competition may require price reductions or more promotions.

The Production Budget is based on the sales budget. It shows the number of units to be produced to meet the expected sales and maintain the desired stock levels. It takes into account opening and closing inventories and any expected production losses. This budget helps management plan for materials, labour, and machinery needs to ensure production runs smoothly and efficiently.

Factors to Consider When Preparing a Production Budget

₁. Sales Forecast: It is the starting point for preparing a production budget because production depends on how much the business plans to sell. If you produce more than you can sell, goods will pile up in stock. If you produce less, you may lose customers.

2. Stock of Finished Goods: The amount of goods already in stock at the beginning and the desired stock at the end of the period. Example, if you want to keep some goods in store for next month, you must produce more.

3. Production Capacity: The ability of the factory or machines to produce goods. This includes the number of workers, machines, and working hours available.

4. Availability of Raw Materials: You must make sure enough raw materials are available for production.

5. Availability of Labour: There should be enough workers with the right skills to meet the production target.

6. Availability of Equipment and Machinery: Machines must be in good condition and enough to handle the planned level of production.

7. Availability of Funds: There must be enough money to buy materials, pay workers, and cover other production costs.

Activity 5.1 Sales and Production Budgets

1. In your groups, state types of budgets other than the sales budget and production budget and share them with the next group for feedback.

2. Discuss the uses of sales and production budgets.

3. Study the scenario below Kumah Ltd sells a product that has the following sales volume January ------ 26,000 units February --------- 34,000 units March --------28,000 units April ---------------22,000 units The closing stock for December was 2,850 units.

The closing stock for each month should be at 10% of the sales volume for the next month.

Each product sells for GH¢500.

4. In your groups, prepare

a. Sales Budget; and

b. Production Budget for the first quarter of the year.

5. Present your work for discussion and feedback.

The Material Usage Budget shows the quantities of each type of material that will be used in production. It is prepared based on the number of units the business plans to produce.

This budget helps ensure that enough materials are available for smooth production without interruptions or waste. It also allows management to plan how efficiently materials are being used to control costs.

The Direct Material Purchases Budget shows the quantity and cost of materials that need to be bought to meet production requirements. It is prepared after the material usage budget and considers opening and closing stock levels. This budget helps the business plan when and how much material to buy, ensuring there are no shortages or excessive stock that could tie up cash.

Activity 5.2 Material Usage and Material Purchase Budget

1. In pairs, identify the first two functional budgets and explain why those budgets must be prepared first. Share your answers with the class for feedback.

2. In your groups, discuss the uses of the Material Usage and Material Purchases budgets.

3. Study the case below and answer the questions therein Akosua Foods Ltd produces one product called ChocoBisc.

Budget Period: January – March 2025 Month Budgeted Production (units) January 4,000 February 5,000 March 6,000 April 7,000 Additional Information

i. Each unit requires: 3 kg of Material X and 2 kg of Material Y

ii. Cost per kg of Material X GH¢10

iii. Cost per kg of Material Y GH¢8

iv. Opening stock on 1st January 2025: Material X – 900 kg; Material Y

– 700 kg

v. Desired closing stock each month is 10% of next month’s production (in kg)

a. Prepare the Material Usage Budget for each month

b. Prepare the Material Purchases Budget for each month

4. Present your group work to the class for discussion and feedback.

A Cash Budget is prepared to show the expected cash receipts and payments for a budgeted period. It focuses on the business’s short-run cash management.

Importance of Cash Budget

1. Helps identify cash surpluses and shortages The cash budget shows when the business will have extra money or when it may run short of cash. This helps the management plan to invest extra funds or arrange loans when needed.

2. Ensures regular payment of expenses It helps the business plan for payments such as wages, rent, electricity, and suppliers, so bills are paid on time, and the business maintains a good reputation.

3. Improves financial control A cash budget allows management to monitor how money is received and spent. This helps to prevent waste and overspending.

4. Assists in decision-making It provides useful information for management to decide whether the business can afford new investments, expansion, or needs to cut costs.

5. Helps in obtaining loans Banks and lenders use the cash budget to check if the business will be able to repay borrowed money. A well-prepared cash budget builds trust and makes it easier to get loans.

6. Prevents cash problems and business failure By planning, the business avoids running out of money. This ensures smooth operations and reduces the risk of failure.

Cash Inflows (Receipts)

These are the amounts of money coming into the business. They include:

Cash sales

a. Payments received from debtors (customers who owe)

b. Sale of fixed assets (e.g. selling an old vehicle)

c. Issue of new shares

d. Loans received

e. Interest and dividends received

f. Any other cash received during the period Cash Outflows (Payments) These are the amounts of money going out of the business. They include:

a. Purchase of goods or raw materials

b. Payment of wages and salaries

c. Payment to creditors (suppliers)

d. Payment of expenses (water, electricity, rent, telephone, etc.)

e. Payment of interest, taxes, and dividends

f. Purchase of new assets (machines, vehicles, etc.)

g. Repayment of loans or debentures Non-Cash Items These are items that are not included in a cash budget because they do not involve actual cash movement. They include:

a. Depreciation

b. Discounts allowed or received

c. Bad debts written off

d. Provision for doubtful debts

e. Bonus issue of shares

f. Repayment of loans or debentures

Activity 5.3 Importance of Cash Budget, Inflow and Outflow of Cash

1. In your groups, discuss the importance of a cash budget.

2. Discuss the inflow and outflow of cash, giving examples in the format below.

S/N Inflow of cash Outflow of Cash

3. Make a group presentation for discussion and feedback.

Activity 5.4 Preparation of Cash Budget – I

1. In your groups, discuss the steps involved in the preparation of a cash budget.

2. Study the scenario below Kaba Ventures Ltd makes and sells school bags in Navrongo. The following information is provided for the cash budget for the months of July to September.

Month June July August September

Sales (units) 5000 600 800 700 Additional Information

Selling price per unit: GH¢50 Sales pattern:

40% of sales are for cash.

60% are credit sales collected in the following month.

Production costs:

Each bag requires materials costing GH¢20 per unit.

All materials are paid for in the month after purchase.

Production each month = sales for that month.

Wages: GH¢6,000 per month, paid in the same month.

Other expenses: GH¢3,000 per month, paid in the following month.

Equipment purchase: GH¢5,000 in August.

Cash balance on 1st July: GH¢8,000 Prepare a cash receipts schedule showing cash and credit collections.

Prepare a cash payments schedule for materials.

Prepare a cash budget for July to September.

3. Present your group work to the class for discussion and feedback

In this lesson, you will apply the principles of cash budgeting to prepare another cash budget from the given data.

Activity 5.5 Preparation of Cash Budget – II

1. Using your groups, study the question below Banku Company Ltd (BCL) wishes to arrange for an overdraft from its bankers.

The bank has requested a cash budget, and the Manager of BCL Company Ltd has provided you with the following information.

Month Sales Purchases Salaries

GH¢ GH¢ GH¢

February 180,000 24,000 12,000 March 192,000 144,000 14,000

April 180,000 168,000 11,000 May 174,000 200,000 10,000

Additional Information

i. 50% of the sales are collected a month after sales, and the rest in the second month after sales.

ii. All purchases are on credit. Creditors are paid a month after purchases.

iii. Cash at the bank on 1 April is expected to be GH¢25,000.

iv. Salaries in June were GH¢12,000

2. You are required to prepare a Cash Budget for BCL from April to June and indicate how much overdraft should be taken at the end of each month.

3. Display your work for discussion and feedback.

In this lesson, you will review the concept of variance analysis and its importance, which you learned in year 1 and use it to compute material variance.

Meaning of Variance

A variance is the difference between a planned (budgeted or standard) cost and the actual cost incurred. It helps management know whether performance is better or worse than expected.

Favourable Variance

A favourable variance occurs when:

1. The actual cost is less than the budgeted (standard) cost, or

2. The actual revenue is greater than the budgeted revenue.

If the standard cost to produce a bag of rice is GH¢50 but the actual cost is GH¢45, the variance of GH¢5 is favourable.

Adverse (Unfavourable) Variance

An adverse variance occurs when:

1. The actual cost is more than the budgeted (standard) cost, or

2. The actual revenue is less than the budgeted revenue.

For instance, If the standard cost to produce a bag of rice is GH¢50 but the actual cost is GH¢60, the variance of GH¢10 is adverse.

General Causes of Variances

₁. Inefficiencies in operations.

2. Inaccurate recording of cost data.

3. Setting unrealistic or inappropriate standards.

4. Changes in economic factors such as prices, inflation, or weather conditions.

Major Types of Cost Variances

₁. Direct Material Cost Variance

2. Direct Labour Cost Variance

3. Overhead Cost Variance

Direct Material Cost Variances (DMCV)

A Direct Material Cost Variance is the difference between the standard cost of materials allowed for actual production and the actual cost of materials used. It helps management know whether materials were used efficiently and bought at the right price. The Direct Material Cost Variance is divided into two main parts. These are Material Price Variance (MPV) and Material Usage (Quantity) Variance (MUV).

Direct Material Cost Variance = (Standard Cost) − (Actual Cost) DMCV = (Standard Quantity × Standard Price) − (Actual Quantity × Actual Price) Material Price Variance (MPV) Difference caused by paying a different price per unit of material than expected.

MPV = (Standard Price − Actual Price) ×Actual Quantity Material Usage (Quantity) Variance (MUV) The difference caused by using more or less material than the standard quantity allowed.

MUV = (Standard Quantity − Actual Quantity) × Standard Price Causes of Material Variances ₁. Buying from different suppliers at different prices.

2. Using materials of a different quality (higher or lower grade).

3. Improved or poor production methods.

4. Wastage of materials higher or lower than expected.

Activity 5.6 Causes and Types of Cost Variances

1. In pairs, mention two important aspects of variance analysis for discussion and feedback.

2. In your groups, discuss the causes of variance and how to reduce variance.

3. Discuss the types of cost variances and the reasons for the formulas of the variances.

4. Present your work to the class for discussion and feedback.

Activity 5.7 Computation of Material Variance

1. In groups, study the scenario below and answer the questions Tessy Company Ltd set the following standards for its activities.

Production units – 5,000 units Materials – 15,000 kg costing GH¢75,000 Actual production was 4,000 units Material used – 16,000kg costing GH¢64,000 You are required to calculate the following.

a. Standard material price and quantity

b. Actual material price

c. Material cost variance

d. Material price and usage variances

2. Present your solution to the class for discussion and feedback.

You have been introduced to the computation of direct material cost variances. In this lesson, you will be taken through the computation of direct labour cost variances.

A Direct Labour Cost Variance occurs when there is a difference between the standard direct wages (expected labour cost) and the actual direct wages (real labour cost) paid for the actual work done. It helps management know whether labour was used efficiently and whether workers were paid according to plan. Direct labour variance can be divided into direct labour rate variance and direct labour efficiency.

DLCV = (Standard Labour Cost) − (Actual Labour Cost) DLCV = (Standard Hours × Standard Rate) − (Actual Hours × Actual Rate) Causes of Labour Variances ₁. The use of inexperienced or lower-skilled direct labour.

2. The use of a more experienced or skilled labour force.

3. A high rate of idle time.

4. Paying a lower rate for actual labour.

5. More efficient methods of production introduced.

Direct Labour Rate Variance (DLRV)

The Direct Labour Rate Variance shows the difference between the standard wage rate and the actual wage rate paid to workers for the actual hours worked. It helps management know whether workers were paid more or less than expected.

Direct Labour Rate Variance (DLRV) = (Standard Rate − Actual Rate) × Actual Hours Direct Labour Efficiency Variance (DLEV) The Direct Labour Efficiency Variance measures the difference between the standard hours that should have been worked for the actual output and the actual hours worked, multiplied by the standard rate per hour. It shows how efficiently workers used their time in producing goods.

DLEV = (Standard Hours for Actual Output − Actual Hours Worked) × Standard Rate per Hour

Activity 5.8 Causes and Divisions of Labour Cost Variance

1. In pairs, answer the question you pick. The questions to guide the review of previous lesson include:

a. Mention one cause of material variance

b. What are the divisions of material variance?

c. Why do you calculate material price variance?

d. Why do you calculate material usage variance?

2. Discuss the causes of direct labour cost variance

3. Explain the divisions in direct labour cost variance

4. Share your answers with the next pair for discussion and feedback.

Activity 5.9 Computation of Direct Labour Variance

1. In groups, study the case below

2. Tessy Company Ltd set the following standards for its activities.

Production units – 5,000 units Labour – 20,000 hours costing GH¢60,000 Actual production was 4,000 units Labour used – 12,000 hours costing GH¢48,000 You are required to calculate:

a. Standard labour rate and hours

b. Actual labour rate

c. Labour cost variance

b. Labour rate and efficiency variances

3. Present your work to the class for discussion and feedback.

1. Explain sales budget and five factors that affects the preparation of sales budget.

2. Explain production budget and five factors that affects the preparation of production budget.

3. Explain cash budget and why cash budget is necessary for every firm.

4.

a. Explain four causes of variances

b. Distinguished the following:

i. Material price variance and material usage variance

ii. Direct labour rate variance and direct labour efficiency variance

5. The following projections are provided by Azaare PLC for the year 2026.

Sales Opening Stock

(units) (units) (kgs) January 4,000 240 1,400 February 4,600 260 1,500 March 5,300 280 1,600 April 6,000 300 1,700 May 5,600 400 2,000 Materials for production is 6kg at GH¢8 per kg for a unit of product.

Bossey Plc sells a product for GH¢15 each.

You are required to prepare for Azaare PLC in respect of the first four months of 2026:

a. Sales budget;

b. Production budget;

c. Materials usage budget;

d. Materials purchase budget.

6. Ansah Enterprise is preparing a cash budget for their business for 2025.

Sales forecast for the relevant period are as follows:

Month DEC JAN FEB MARCH APRIL

GH¢ GH¢ GH¢ GH¢ GH¢

Sales 14,500 16,800 18,200 20,000 21,600

• All sales are on credit and cash is collected the next month.

• The business receives rent of GH¢2,000 per month.

• Purchases are 80% of the sales revenue for each month and paid for in the month before the sales.

• A dividend of GH¢4,000 is expected to be received in February.

• An asset valued at GH¢20,000 would be sold at a loss of GH¢2,000 in March.

• Wages and expenses of GH¢5,000 and GH¢2,500 respectively are payable per month.

• Cash on hand at 1/1/2025 is GH¢8,500.

You are required to prepare a cash budget for the first quarter of 2025.The budget should show the net cash flow for each month.

7. Yinebono Enterpriese produces one standard product called Yelom.

The following standards have been given:

GH¢ Materials: 25kgs@ GH¢60 1,500

Labour: 18hours@ GH¢50 900

2,400 For the first quarter of the year 2023:

• 1,500 units were produced.

• A total of 39.500 kgs of materials were bought at a total cost of GH¢2,449,000;

• A total of GH¢1,273,700 was paid as wages for 27,100 labour hours used in the period:

• Materials issued to production was 37,000kg.

You are required to calculate

a. Direct Material Cost Variance

b. Material Price Variance;

c. Material Usage Variance;

d. Direct Labour Cost Variance

e. Direct Labour Rate Variance

f. Direct Labour Efficiency Variance