In process costing, the cost of normal loss is:

Absorbed by the good units, raising the cost per good unit

Transferred to the profit and loss account

Credited to the abnormal gain account

Capitalised as work in progress

Target costing differs from Kaizen costing chiefly in that target costing operates:

At the design stage, before production begins

During manufacture, in small continuous improvements

Only after a product has been withdrawn from the market

Only on service activities, never on manufacturing

Cash collected from a debtor is recorded. Its effect is:

No flow of funds, but a cash inflow

A flow of funds and a cash inflow

A flow of funds but no cash movement

Neither a flow of funds nor a cash movement

The material usage variance is computed as:

Standard rate × (standard quantity for actual output − actual quantity)

Actual quantity × (standard rate − actual rate)

Standard rate × (budgeted quantity − actual quantity)

Actual rate × (standard quantity − actual quantity)

Activity based costing improves on traditional absorption costing chiefly because it:

Charges overhead by the cost drivers products actually consume, not by volume alone

Eliminates fixed overhead from the accounts entirely

Values closing stock at net realisable value

Replaces the need for a standard costing system

A firm's productive capacity is limited by machine hours. To rank products for the best use of that capacity, it should order them by:

Net profit per unit after absorbing fixed cost

A flexible budget differs from a fixed budget in that it is:

Recast for the level of activity actually achieved

Prepared for a single planned level of activity

Prepared only once every five years

Expressed in physical units and never in money

Cost and Management Accounting, and Financial Statement Analysis

This is the calculating half of Unit 2, and the half where a candidate who has read everything still loses marks. Marginal costing, standard costing, budgetary control, process costing and activity based costing each carry one or two formulas the paper uses over and over, and the newer techniques — life cycle, target, Kaizen and just in time — are asked as definitions that are easy to confuse with one another. The unit closes with ratio, funds flow and cash flow analysis, where the recurring question is which statement would show a given transaction and which would not.

1. Marginal costing and break-even analysis

Marginal costing charges only variable cost to the product and treats fixed cost as a cost of the period, written off in full against the contribution the period earns. Absorption costing instead absorbs fixed manufacturing overhead into the product, so it travels in closing stock into the next period. Everything that follows about profit differences comes from that one divergence.

Contribution = sales − variable cost = fixed cost + profit. It is the single most useful quantity in the whole unit, because every formula below is a rearrangement of it.
P/V ratio = contribution ÷ sales, usually as a percentage. It can also be found from any two periods as the change in profit divided by the change in sales, which is the form the paper prefers when it gives you two years and no cost breakdown.
Break-even sales = fixed cost ÷ P/V ratio, in value; or fixed cost ÷ contribution per unit, in units.
Margin of safety = actual sales − break-even sales, and also profit ÷ P/V ratio. The second form is the one that saves time.
Sales for a target profit = (fixed cost + target profit) ÷ P/V ratio.

🧠 Two years and no costs given

When a question gives sales and profit for two periods and asks for the break-even point, do not look for the missing cost data. Take the P/V ratio as the change in profit over the change in sales, recover fixed cost as contribution minus profit for either year, and the break-even point follows. That is the whole intended solution, and it fits in three lines.

2. Standard costing: the variances that are always asked

Standard costing sets what a cost ought to be and analyses the gap from what it was. Every variance splits the same way — a price or rate part and a quantity or efficiency part — and the sign convention is fixed: favourable when the actual is less than the standard for a cost, adverse when it is more.

The four core variances
Variance	Formula	What it blames
Material price	Actual quantity × (standard rate − actual rate)	Purchasing
Material usage	Standard rate × (standard quantity for actual output − actual quantity)	The shop floor
Labour rate	Actual hours × (standard rate − actual rate)	Wage negotiation and grade mix
Labour efficiency	Standard rate × (standard hours for actual output − actual hours)	Supervision and method

⚠️ Standard quantity means standard for the ACTUAL output

In the usage and efficiency variances the standard quantity is not the quantity budgeted for the planned output — it is what the standard allows for the output actually produced. Using the budgeted figure mixes a volume difference into an efficiency variance, and the two totals then fail to reconcile, which is the usual sign that this substitution has happened.

3. Budgetary control and the kinds of budget

A budget is a quantitative plan for a future period; budgetary control is the comparison of actual with budget and the action taken on the difference. The kinds named in the syllabus are distinguished by what they hold constant.

Fixed budget — drawn for one level of activity and not adjusted when the actual level differs. Useful only where output is stable, because comparing it against a different actual volume compares two unlike things.
Flexible budget — recast for the level actually achieved by separating fixed from variable cost. This is what makes a variance meaningful, and it is the reason cost behaviour has to be classified before a budget is useful.
Zero base budgeting — every item must be justified afresh each period rather than carried forward with an increment, so the previous year's figure is not a floor.
Performance budgeting — expenditure is linked to the output or purpose it buys rather than to the object of spending, so the question becomes what was achieved and not merely what was spent.

4. Process costing and activity based costing

Process costing is used where production is continuous and units are indistinguishable — chemicals, cement, refining — and the cost per unit is the total process cost divided by output. Its distinctive machinery is the treatment of losses and of incomplete units.

Normal loss is the loss expected in the process. Its cost is absorbed by the good units, so the cost per good unit rises; any scrap value is credited to the process account.
Abnormal loss is loss beyond that expectation. It is valued at the cost of a good unit and taken to the profit and loss account, so it does not contaminate the product cost.
Abnormal gain arises when actual loss falls short of normal loss, and is treated as the mirror image — valued at good-unit cost and credited to the profit and loss account.
Equivalent production converts work in progress into completed-unit equivalents, separately for material, labour and overhead, because a unit half finished for labour may be fully charged with material.

Activity based costing exists because overhead absorbed on a single volume-related base — labour hours, machine hours — systematically overcosts high-volume simple products and undercosts low-volume complex ones. ABC traces overhead to activities, identifies a cost driver for each, and charges products by their consumption of drivers: setups, purchase orders, inspections, engineering changes. The insight is that many overheads are driven by transactions rather than by volume.

5. Decision-making, and the four modern techniques

For a short-run decision only the costs that change with the decision are relevant, so sunk costs are ignored and opportunity costs are added even though no entry records them. Fixed cost is irrelevant unless the decision alters it. Applied to the standard questions: accept a special order if its price exceeds the variable cost and spare capacity exists; make rather than buy if the variable cost of making plus any avoidable fixed cost is less than the purchase price; and when a resource is scarce, rank products by contribution per unit of the scarce resource rather than by contribution per unit sold.

The four techniques the syllabus names
Technique	The question it answers	When it acts
Life cycle costing	What does this product cost across its whole life, from design to abandonment?	Across every stage, not one period
Target costing	The market sets the price and we set the margin — what is the cost we are allowed?	At the design stage, before production
Kaizen costing	How do we shave a little more cost out of an existing process this period?	During manufacture, continuously and in small steps
Just in time	How do we produce or procure only as needed, so inventory approaches nil?	In the flow of material, pulled by demand

⚠️ Target and Kaizen differ by WHEN, not by how much

Both reduce cost, and both are Japanese in origin, which is why they are confused. Target costing acts before a unit is ever made, at the design stage, where most cost is committed; Kaizen acts after production has begun, in small continuous improvements. A question describing a cost reduction will always say when it happens, and that word is the answer.

6. Ratio, funds flow and cash flow analysis

Ratios group by the question they answer: liquidity, solvency, activity and profitability. The ones the paper returns to are the current ratio and the quick ratio for liquidity, debt-equity and interest coverage for solvency, stock turnover and debtors turnover for activity, and gross profit, net profit and return on capital employed for profitability.

🎯 Why the quick ratio drops stock and prepaid expenses

The quick ratio asks whether the firm could meet its current liabilities without selling anything. Stock has to be sold first, and at an uncertain price; a prepaid expense cannot be turned into cash at all, only consumed. Both are therefore excluded, and a firm with a healthy current ratio and a poor quick ratio is one whose liquidity is tied up in inventory — which is exactly what the pair is designed to reveal.

Funds flow and cash flow answer different questions and the paper tests the difference directly. A funds flow statement explains the change in WORKING CAPITAL over a period, so a transaction affecting only current assets and current liabilities — collecting from a debtor, paying a creditor — causes no flow of funds at all. A cash flow statement explains the change in CASH, so those same transactions do appear in it.

AS 3 requires the cash flow statement in three activities. Operating activities are the principal revenue-producing ones; investing activities are the acquisition and disposal of long-term assets and investments; financing activities are those that change the size and composition of owners' capital and borrowings. Interest and dividend received and paid are classified according to whether the entity is a financial enterprise, and the question will say.

Key takeaways

Contribution is the spine of marginal costing: P/V ratio, break-even, margin of safety and target sales are all rearrangements of contribution = fixed cost + profit.
In usage and efficiency variances the standard quantity is what the standard allows for the ACTUAL output, not the budgeted quantity — the substitution makes the totals fail to reconcile.
Normal loss is absorbed by the good units and raises their cost; abnormal loss and abnormal gain are valued at good-unit cost and taken to profit and loss.
Target costing acts at design, before a unit is made; Kaizen acts during manufacture in small continuous steps. They differ by when, not by how much.
Funds flow explains the change in working capital, so a transaction within current items causes no flow; cash flow explains the change in cash, so the same transaction does appear.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

Sales are ₹8,00,000, variable cost ₹4,80,000 and fixed cost ₹2,40,000. The break-even sales are:
1. ₹6,00,000
2. ₹5,00,000
3. ₹4,00,000
4. ₹7,20,000
Show answer
Answer: A — ₹6,00,000
Contribution is sales minus variable cost, ₹8,00,000 − ₹4,80,000 = ₹3,20,000, so the P/V ratio is 3,20,000 ÷ 8,00,000 = 0.40. Break-even sales are fixed cost divided by the P/V ratio, ₹2,40,000 ÷ 0.40 = ₹6,00,000. The figure ₹4,00,000 comes from dividing fixed cost by the variable cost ratio of 0.60 instead, and ₹7,20,000 from adding fixed cost to variable cost, which is the total cost at the given volume rather than a break-even point. Profit here is ₹80,000, so the margin of safety is ₹2,00,000, which checks out as profit ÷ P/V ratio.
In process costing, the cost of normal loss is:
1. Absorbed by the good units, raising the cost per good unit
2. Transferred to the profit and loss account
3. Credited to the abnormal gain account
4. Capitalised as work in progress
Show answer
Answer: A — Absorbed by the good units, raising the cost per good unit
Normal loss is the loss the process is expected to incur, so it is a cost of producing the good output and is absorbed by it — the total process cost is spread over fewer units and the cost per good unit rises. Any scrap value realised on the normal loss is credited to the process account, reducing that absorbed cost. Abnormal loss, which is the loss beyond expectation, is the item valued at good-unit cost and taken to the profit and loss account, and abnormal gain is its mirror image. Swapping the treatment of normal and abnormal loss is the standard error here.
Target costing differs from Kaizen costing chiefly in that target costing operates:
1. At the design stage, before production begins
2. During manufacture, in small continuous improvements
3. Only after a product has been withdrawn from the market
4. Only on service activities, never on manufacturing
Show answer
Answer: A — At the design stage, before production begins
Target costing starts from the price the market will bear, subtracts the margin the firm requires and derives the cost it is allowed, then designs the product to meet it — acting before anything is made, at the stage where most cost is committed rather than incurred. Kaizen costing works in the opposite place: production is already running and cost is reduced in small continuous steps. Both reduce cost and both originate in Japanese practice, which is why they are confused, but the distinguishing word in any question is when the reduction happens.
Cash collected from a debtor is recorded. Its effect is:
1. No flow of funds, but a cash inflow
2. A flow of funds and a cash inflow
3. A flow of funds but no cash movement
4. Neither a flow of funds nor a cash movement
Show answer
Answer: A — No flow of funds, but a cash inflow
A funds flow statement explains the change in working capital, and working capital is current assets minus current liabilities. Collecting from a debtor converts one current asset, debtors, into another current asset, cash, leaving working capital exactly as it was — so there is no flow of funds. A cash flow statement explains the change in cash alone, and cash has plainly risen, so the transaction is an inflow there. The pair of statements is routinely tested on precisely this kind of transaction, where the two answers differ.
The material usage variance is computed as:
1. Standard rate × (standard quantity for actual output − actual quantity)
2. Actual quantity × (standard rate − actual rate)
3. Standard rate × (budgeted quantity − actual quantity)
4. Actual rate × (standard quantity − actual quantity)
Show answer
Answer: A — Standard rate × (standard quantity for actual output − actual quantity)
The usage variance isolates the quantity effect, so it must be valued at the standard rate — using the actual rate would let a price difference leak into a quantity variance. The quantity compared against actual consumption is what the standard allows for the output actually produced, not the quantity budgeted for the planned output; substituting the budgeted figure folds a volume difference into the usage variance and the price and usage variances then fail to add up to the total material cost variance. The second option is the price variance, which correctly uses actual quantity and the difference in rates.
Activity based costing improves on traditional absorption costing chiefly because it:
1. Charges overhead by the cost drivers products actually consume, not by volume alone
2. Eliminates fixed overhead from the accounts entirely
3. Values closing stock at net realisable value
4. Replaces the need for a standard costing system
Show answer
Answer: A — Charges overhead by the cost drivers products actually consume, not by volume alone
Traditional absorption costing spreads overhead on a single volume-related base such as labour hours or machine hours. Where overhead is actually driven by transactions — setups, purchase orders, inspections, engineering changes — that base systematically overcosts high-volume simple products and undercosts low-volume complex ones, because the complex product consumes many transactions per unit while contributing few labour hours. ABC traces overhead to activities and charges each product by its consumption of the relevant driver. It does not remove fixed overhead, does not change stock valuation rules, and coexists with standard costing rather than replacing it.
A firm's productive capacity is limited by machine hours. To rank products for the best use of that capacity, it should order them by:
1. Contribution per machine hour
2. Contribution per unit sold
3. Selling price per unit
4. Net profit per unit after absorbing fixed cost
Show answer
Answer: A — Contribution per machine hour
When one resource is scarce, that resource and not the unit is what the firm is really allocating, so profitability has to be measured per unit of it. A product with a large contribution per unit may consume so many machine hours that it earns less per hour than a smaller-contribution product that runs quickly. Ranking by contribution per unit therefore gives the wrong order whenever machine hours per unit differ across products. Selling price ignores variable cost entirely, and net profit per unit after fixed cost absorption imports an allocation that is irrelevant to a short-run decision.
The quick ratio excludes, from current assets:
1. Inventory and prepaid expenses
2. Cash and bank balances
3. Sundry debtors
4. Marketable securities
Show answer
Answer: A — Inventory and prepaid expenses
The quick or acid-test ratio asks whether current liabilities could be met without selling anything, so it keeps only the assets that are cash or can become cash almost immediately at a known amount. Inventory fails that test because it must first be sold, at a price not yet known, and a prepaid expense fails it absolutely because it can only be consumed, never converted. Cash, bank balances, debtors and marketable securities all stay in. A firm with a comfortable current ratio and a weak quick ratio has its liquidity tied up in stock, which is precisely what comparing the two is meant to reveal.
A flexible budget differs from a fixed budget in that it is:
1. Recast for the level of activity actually achieved
2. Prepared for a single planned level of activity
3. Prepared only once every five years
4. Expressed in physical units and never in money
Show answer
Answer: A — Recast for the level of activity actually achieved
A fixed budget is drawn for one planned level of activity and left there, so comparing it with a different actual volume compares two unlike things and every variance is contaminated by the volume difference. A flexible budget separates fixed from variable cost and is recast for the level actually reached, which is what makes the remaining variances attributable to price and efficiency rather than to output. Neither budget is confined to a five-year cycle, and both are expressed in money as well as in units.