Management Accounting - CPA Australia

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STUDY

MANUAL

Foundation level

Management Accounting 2012

Second edition January 2012 First edition 2010 ISBN 9781 4453 8013 1 Previous ISBN 9780 7517 8151 9 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Published by BPP Learning Media Ltd All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means or stored in any retrieval system, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the publisher. We are grateful to CPA Australia for permission to reproduce the Learning Objectives, the copyright of which is owned by CPA Australia. Printed in Australia © BPP Learning Media Ltd 2012

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Welcome to the next step in your career – CPA Program Today’s CPA Program is a globally recognised education program available around the world. All candidates of CPA Australia are required to attain a predetermined level of technical competence before the CPA designation can be awarded. The CPA Program foundation level is designed to provide you with an opportunity to demonstrate knowledge and skills in the core areas of accounting, business and finance. A pass for each exam is based on a determination of the minimum level of knowledge and skills that candidates must acquire to have a good chance at success in the professional level of the CPA Program. In 2012 you have more opportunities to sit foundation level exams, allowing you to progress through to the professional level of the CPA Program at your own pace. The material in this study manual has been prepared based upon standards and legislation in effect as at 1 September 2011. Candidates are advised that they should confirm effective dates of standards or legislation when using additional study resources. Exams for 2012 will be based on the content of this study manual.

Additional Learning Support A range of quality learning products will be available in the market for you to purchase to further aid your core study program and preparation for exams. These products will appeal to candidates looking to invest in additional resources other than those provided in this study manual. More information is available on CPA Australia’s website www.cpaaustralia.com.au/learningsupport You will also be able to source face-to-face and online tuition for CPA Program foundation level exams from registered tuition providers. The tuition provided by these registered parties is based on current CPA Program foundation level learning objectives. A list of current registered providers can be found on CPA Australia’s website. If you are interested you will need to liaise directly with the chosen provider to purchase and enrol in your tuition program.

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Contents

Page

Introduction Welcome to CPA Australia

iii

Chapter features

vi

Chapter summary

viii

Answering multiple choice questions

x

Learning objectives

xi

Chapter 1

The nature and purpose of management accounting

1

2

Decision making and relevant costing

39

3

Budgeting

63

4

Cost behaviour and CVP analysis

97

5

Overheads, absorption and marginal costing

131

6

Overhead costing – activity-based costing

167

7

Process and job costing

187

8

Standard costing

229

9

Variance analysis

243

10

Capital expenditure

267

11

Inventory and pricing decisions

289

12

Performance measurement and evaluation

317

Revision questions

347

Answers to revision questions

371

Before you begin questions: answers and commentary

387

Glossary of terms

407

Index

415

Introduction

v

Chapter features Each chapter contains a number of helpful features to guide you through each topic. Learning objectives

Show the referenced CPA Australia learning objectives.

Topic list

Tells you what you will be studying in this chapter.

Introduction

Presents a general idea of what is covered in this chapter.

Chapter summary diagram

Summarises the content of the chapter, helping to set the scene so that you can gain the bigger picture.

Before you begin

This is a small bank of questions to test any pre-existing knowledge that you may have of the chapter content. If you get them all correct then you may be able to reduce the time you need to spend on the particular chapter. There is a commentary section at the end of the Study Manual called Before you begin: answers and commentary.

Section overview

This summarises the key content of the particular section that you are about to start.

Learning objective reference

This box indicates the learning objective covered by the section or paragraph to which it relates.

LO 1.2

vi

Definition

Definitions of important concepts. You really need to know and understand these before the exam.

Exam comments

These highlight points that are likely to be particularly important or relevant to the exam. (Please note that this feature does not apply in every Foundation Level study manual.)

Worked example

This is an illustration of a particular technique or concept with a solution or explanation provided.

Question

This is a question that enables you to practise a technique or test your understanding. You will find the solution at the end of the chapter.

Key chapter points

Review the key areas covered in the chapter.

Management Accounting

Quick revision questions

A quick test of your knowledge of the main topics in this chapter.

Revision questions

The revision questions are not a representation of the difficulty of the questions which will be in the examination. The revision MCQs provide you with an opportunity to revise and assess your knowledge of the key concepts covered in the materials so far. Use these questions as a means to reflect on key concepts and not as the sole revision for the examination.

Case study

This is a practical example or illustration, usually involving a real world scenario.

Formula to learn

These are formulae or equations that you need to learn as you may need to apply them in the exam.

Bold text

Throughout the Study Manual you will see that some of the text is in bold type. This is to add emphasis and to help you to grasp the key elements within a sentence and paragraph.

The quick revision questions are not a representation of the difficulty of the questions which will be in the examination. The quick revision MCQs provide you with an opportunity to revise and assess your knowledge of the key concepts covered in the materials so far. Use these questions as a means to reflect on key concepts and not as the sole revision for the examination.

Introduction

vii

Chapter summary This summary provides a snapshot of each of the chapters, to help you to put the Study Manual into perspective.

Chapter 1 – The nature and purpose of management accounting This introductory chapter sets the scene for your forthcoming studies of Management Accounting. It explains the differences between financial, cost and management accounting and explains the role of the management accountant. It also introduces two key activities of the management accountant: decision making and performance measurement and evaluation.

Chapter 2 – Decision making and relevant costing One of the most important things that a management accountant does is to provide the information that enables a business to make decisions about its activities. This involves ascertaining the relevant costs of the business, which are its future costs and cash flows. The chapter goes on to consider choice of product (product mix) decisions, make or buy decisions and outsourcing.

Chapter 3 – Budgeting A budget is a quantitative statement, for a defined period of time (often a year) which usually includes planned revenues, expenses, assets, liabilities and cash flows. When organisations draw up budgets they have stated objectives and intentions, and the actual results can then be compared with the budget and differences identified and analysed. This chapter explains the background of budgeting and then teaches you how to prepare and operations budget and a cash budget.

Chapter 4 – Cost behaviour and CVP analysis This chapter introduces the different types of cost and also discusses cost behaviour. It then moves on to cost-volume-profit analysis, which is based on cost behaviour principles; this is necessary so that the appropriate decision-making information can be provided to management.

Chapter 5 – Overheads, absorption and marginal costing There are some costs incurred by organisations that have to be allocated out to the various units produced, so that a cost per unit can be produced. This chapter examines the different types of overheads and introduces two methods of accounting for them: absorption and marginal costing. It ends with a comparison between the two.

Chapter 6 – Overhead costing – activity-based costing Activity-based costing (ABC) has been developed relatively recently to suit modern business and accounting practices. It provides a modern alternative to traditional methods such as absorption costing, which tend to allocate too great a proportion of overheads to high volume products. ABC involves the identification of those factors, known as cost drivers, which cause the costs of an organisation’s major activities.

Chapter 7 – Process and job costing Costing systems are used to cost goods or services, and the method used depends on the way in which the goods or services are produced. Within the context of your syllabus, the two most important are process costing, used when it is not possible to identify separate units of production, and job costing, where work is undertaken to a particular customer’s specific requirements.

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Management Accounting

Chapter 8 – Standard costing In business, standards are applied to the costs of products and services. An organisation will expect the standards that it sets (for example for the amount of materials to be used in production, or for the amount of workforce time involved) to be met. If they are not, a variance analysis will be carried out, which identifies where they have not been met.

Chapter 9 – Variance analysis The actual results achieved by an organisation during the reporting period are frequently different from those expected. Variance analysis identifies where these differences from the expected occur. It is important to realise that in some situations a favourable (ie positive) variance on one aspect of production will be cancelled out by an adverse (ie negative) variance on another aspect. Hence businesses produce operating statements, which reconcile the expected and the actual results, by means of all the variances, so management can see the complete picture.

Chapter 10 – Capital expenditure Decisions about capital expenditure require different thought processes from those about revenue expenditure. Capital expenditure often involves the expenditure of larger sums of money, and this usually happens over a longer period of time. Because of this, there are sometimes elements of uncertainty, such as interest rates or the revenue to be gained from a project, and this chapter introduces the different means of assessing the value of capital expenditure.

Chapter 11 – Inventory and pricing decisions Manufacturing businesses in particular are very concerned to retain the right amount of stock, or inventory. They do not want to tie too much cash up in the purchase and holding of stocks of goods or components, but nor do they want to run the risk of not being able to fulfil an order from a customer because they do not have the stock or cannot get it quickly enough. This chapter examines systems for maintaining inventory and controlling its levels, and also looks at different approaches to pricing.

Chapter 12 – Performance measurement and evaluation This chapter is concerned with performance indicators, i.e. the ways of assessing how a business, or a division, or a particular product within a catalogue, is performing. The central theme here is responsibility accounting, the system of accounting that divides revenue and costs into area of personal responsibility in order to monitor and assess the performance of each part of an organisation.

Introduction

ix

Answering multiple choice questions The questions in your exam will each contain four possible answers. You have to choose the option that best answers the question. The three incorrect options are called distractors. There is a skill in answering MCQs quickly and correctly. By practising MCQs you can develop this skill, giving you a better chance of passing the exam. You may wish to follow the approach outlined below, or you may prefer to adapt it.

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Step 1

Attempt each question – starting with the easier questions which will be those at the start of the exam. Read the question thoroughly. You may prefer to work out the answer before looking at the options, or you may prefer to look at the options at the beginning. Adopt the method that works best for you.

Step 2

Read the four options and see if one matches your own answer. Be careful with numerical questions, as the distractors are designed to match answers that incorporate common errors. Check that your calculation is correct. Have you followed the requirement exactly? Have you included every stage of the calculation?

Step 3

You may find that none of the options matches your answer. •

Re-read the question to ensure that you understand it and are answering the requirement



Eliminate any obviously wrong answers



Consider which of the remaining answers is the most likely to be correct and select the option

Step 4

If you are still unsure make a note and continue to the next question. Some questions will take you longer to answer than others. Try to reduce the average time per question, to allow yourself to revisit problem questions at the end of the exam.

Step 5

Revisit unanswered questions. When you come back to a question after a break you often find you are able to answer it correctly straight away. If you are still unsure have a guess. You are not penalised for incorrect answers, so never leave a question unanswered!

Management Accounting

Learning objectives CPA Australia's learning objectives for this Study Manual are set out below. They are cross-referenced to the chapter in the Study Manual where they are covered. This exam covers an understanding of developments in management accounting and the tools management accountants use to cost products and services, and to develop and manage budgets. It also covers performance management and control; planning and assessment of project alternatives; and an understanding of the nature, functions, structures and operations of management. Topics Chapter where covered

LO1. Conceptual issues and behavioural implications LO1.1

Explain the historical development of management accounting

1

LO1.2

Analyse the key differences between financial, cost and management accounting

1

LO1.3

Analyse the current influences on management accounting

1

LO1.4

Explain the range of theories that underpin management accounting and how they have an influence on practice

1

LO1.5

Outline the core parts of management accounting systems and how they enable strategic management

1

LO1.6

Analyse the roles of management accountants in cross-functional teams

1

LO1.7

Identify and explain appropriate internal controls for management and accounting systems in a range of situations

12

LO1.8

Explain how organisational behaviour can impact the creation of organisational value

1

LO1.9

Describe the increasing awareness of sustainability and its relationship to management accounting

1

LO2. Decision making LO2.1

Apply the steps in the decision making process

1

2.1.1 define the problem 2.1.2 identify the decision making criteria 2.1.3 develop alternatives 2.1.4 analyse alternatives 2.1.5 select an alternative LO2.2

Apply relevant information guidelines for short-term alternative choice operating decisions

2

LO2.3

Identify the quantitative and qualitative criteria involved in accepting a project

10

LO2.4

Analyse the challenges posed by differences between a project and an organisation’s risk profiles

10

LO2.5

Explain the impact of cash flows and risks on project decision making

2, 10

Introduction

xi

Chapter where covered

LO3. Budgeting LO3.1

Identify and analyse the human behavioural challenges to the budgeting process in organisations

3

LO3.2

Explain the nature of budgets and the reasons that organisations use budgets

3

LO3.3

Prepare an operations budget

3

LO3.4

Prepare a cash budget

3

LO4. Cost behaviour LO4.1

Apply the techniques to separate costs into their fixed and variable components

4

LO5. Overhead costing – product and service costing LO5.1

Explain three methods of departmental overhead allocation

5

LO5.2

Explain the concepts underpinning product costing in organisations

5

LO5.3

Develop different product costing statements involving production resource costs

5

LO5.4

Evaluate the difference between direct production costs and indirect overhead costs

5

LO5.5

Apply the principles of absorption and variable costing to product costing analysis

5

LO6. Overhead costing – activity-based costing LO6.1

Identify and apply the principles of activity-based costing to allocate overheads in organisations

6

LO7. Process and job costing LO7.1

Explain the differences between job and process costing techniques

7

LO7.2

Apply costing principles to job costing and process costing organisations

7

LO8. Standard costing LO8.1

Explain how standard costing can be used to assist in cost control and efficient resource allocation

8

LO9. Variance analysis LO9.1

Calculate and explain the causes of variances and associated corrective actions

9

LO10. Capital expenditure LO10.1

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Analyse capital expenditure decisions in organisations and apply related tools and techniques LO10.2 Apply capital expenditure analysis to project planning and managing uncertain scenarios through scenario analysis LO11. Inventory, pricing decisions, and cost-volume-profit analysis

10

LO11.1

Evaluate the principles of just-in-time

11

LO11.2

11

LO11.3

Apply the economic order quantity formula to determine order quantities for inventory management Establish and apply the appropriate approach for long-term pricing decisions

LO11.4

Apply the principles of cost-volume-profit analysis in organisations

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Management Accounting

10

11

Chapter where covered

LO12. Performance measurement and evaluation LO12.1

Describe how management accounting creates value

1

LO12.2

Explain the characteristics and purpose of performance measurement systems

12

LO12.3

Analyse the different types of financial performance measures and their limitations

12

LO12.4

Describe the key characteristics of the Balanced Scorecard and its advantages over traditional performance measurement systems

12

LO12.5

Outline the characteristics of reward systems and the circumstances in which they can be tied to performance measures

12

Topic exam weightings 1

Conceptual issues and behavioural implications

7%

2

Decision making

13%

3

Budgeting

10%

4

Cost behaviour

12%

5

Overhead costing – product and service costing

13%

6

Overhead costing – activity-based costing

5%

7

Process and job costing

5%

8

Standard costing

5%

9

Variance analysis

5%

10

Capital expenditure

5%

11

Inventory, pricing decisions, and cost-volume-profit analysis

8%

12

Performance measurement and evaluation

12%

TOTAL

100%

Introduction

xiii

xiv

Management Accounting

Chapter 1

The nature and purpose of management accounting Learning objectives

Reference

Conceptual issues and behavioural implications

LO1

Explain the historical development of management accounting

LO1.1

Analyse the key differences between financial, cost and management accounting

LO1.2

Analyse the current influences on management accounting

LO1.3

Explain the range of theories that underpin management accounting and how they have an influence on practice

LO1.4

Outline the core parts of management accounting systems and how they enable strategic management

LO1.5

Analyse the roles of management accountants in cross-functional teams

LO1.6

Explain how organisational behaviour can impact the creation of organisational value.

LO1.8

Describe the increasing awareness of sustainability and its relationship to management accounting

LO1.9

Decision making

LO2

Apply the steps in the decision making process define the problem

LO2.1 LO 2.1.1

identify the decision making criteria

LO 2.1.2

develop alternatives

LO 2.1.3

analyse alternatives

LO 2.1.4

select an alternative

LO 2.1.5

Performance measurement and evaluation

LO12

Describe how management accounting creates value

LO12.1

Topic list

1 2 3 4 5 6 7 8 9

The management accounting function Financial accounting and management and cost accounting Planning, control and decision-making Information Presentation of information to management Management accounting systems Design of management accounting systems Developments in management accounting Sustainability and management accounting 1

Introduction This chapter provides an introduction to Management Accounting. We commence this first chapter by looking at the role of the management accounting function. We then examine the differences between management accounting and financial accounting and introducing cost accounting. The chapter goes on to look at the importance of information provided by the management accountant in planning, control and decision making We also briefly look at how management accounting systems have developed and the design of management accounting systems. This chapter discusses the limitations of some of the traditional methods of management accounting, and considers how recent developments in management accounting attempt to overcome these limitations. Finally we examine the management accountant’s role in the creation of organisational value and the relationship between sustainability and management accounting.

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Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What are the differences between financial accounts and management accounts?

(Section 2.2)

2

What are the differences between cost accounting and management accounting?

(Section 2.3)

3

Explain the link between an organisation's objectives and its strategy.

(Section 3.2)

4

Identify steps involved in the decision making process.

5

What are the three types of management activity identified by Anthony (Management Control Systems, 1972)?

(Section 3.7)

6

What are the basic elements of a management control system?

(Section 3.8)

7

What is the difference between data and information?

(Section 4.1)

8

List the qualities of good information.

(Section 4.2)

9

What are the main features of a report?

10

What are the risks of using traditional management accounting methods?

11

What are the components of a management accounting system?

12

Define and explain Just-In-Time (JIT).

(Section 8.1)

13

Define and explain Total Quality Management (TQM).

(Section 8.2)

14

Define and explain Kaizen.

(Section 8.3)

(Section 3.6.1)

(Section 5.1.1) (Section 6.3) (Section 6.2/7.1)

1: The nature and purpose of management accounting

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1 The management accounting function Section overview •

LO 1.6

1.1

The role of the management accounting function as an information provider has developed with advances in technology. In order to assess the effectiveness of the management accounting function, a clear understanding is needed of its objectives and activities, so that appropriate measures of performance can be determined.

We will now be looking at what the management accounting function should seek to achieve and how its performance should be measured.

Role of the management accounting function The management accounting function exists to provide information to decision-makers, and to provide advice based on information that is provided. The information provided by management accounting covers all areas of strategy and operations, and includes information to assist with planning, control and other decision-making by management. The role of the management accountant today is more concerned with providing complex analysis and information to support business management than with providing routine reports, since much routine work is now computerised. Developments in technology have also made it easier to provide accounting information to non-financial managers. At the same time the areas covered by management accounting have extended and broadened to include strategic information and non-financial information, and information to support risk management. Developments in technology have also made it easier to provide accounting information to non-financial managers.

1.1.1 The development of management accounting information In the 1950s Simons identified three attributes of what could by now be called management accounting information: •

It should be useful for scorekeeping – to see how well the organisation is doing overall and to monitor performance.



It should be attention-directing – to indicate problem areas that need to be investigated.



It should be useful for problem-solving – to provide a means of evaluating alternative responses to the situations in which the organisation finds itself.

Management accounting information is therefore used by managers for a number of purposes:

1.2



To make decisions.



To plan for the future. Managers have to plan and they need information to do this. Much of this is provided by management accounting systems.



To monitor the performance of the business. Managers need to know what they want the business to achieve (targets or standards) and what the business is actually achieving.



To measure profits and put a value on inventory.



To implement processes and practices that focus on effective and efficient use of organisational resources to support managers to enhance customer and stakeholder value (IFAC 2002)

Role of the management accountant in cross-functional teams In some organisations, the cost and management accounting function may be organised as a functional section or department within the organisation. However, because management accountants provide information to other managers, it has become fairly common to include management accountants within cross-functional teams, or to assign them to work with non-accounting functions. A cross-functional team is

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Management Accounting

a small group of individuals, with different expertise, taken from many different parts and levels of an organisation, which comes together to work towards a common purpose or goal. The size of crossfunctional team will vary according to the scale and complexity of the project. Cross-functional teams are typically formed on the assumption that a small group is better able to accomplish a particular task than either individuals acting alone or in a large, permanently structured group. Benefits of cross-functional teams include: • • •

improved coordination and integration of systems or activities problem-solving across traditional functional or organisational boundaries facilitate innovation and product/ service development

In addition to contributing their technical expertise as accounting and finance experts and their functional expertise as information providers, management accountants have a key role to play in helping maximise the potential of a cross-functional team by: • • • •

1.3

providing, collecting and assessing critical team information; helping establish goals and set priorities; assisting with problem-solving and decision-making, through the application of decision-making models and other techniques ensuring the team maintains an organisation-wide perspective.

Defining management objectives of the accounting function The objectives of the management accounting function within an organisation should depend on the information needs of the ‘internal customers’ – the managers who need information to help them to run the business. The overall objective should be the provision of a quality service, but this broad objective can be analysed into a number of sub-objectives. Sub-objective

Detail

The provision of good information

This requires supplying information that fulfils the following criteria. Information must be relevant to the needs of users. This involves identifying the users of information and the reasons why they need it. Information can only ever be relevant if it has a purpose and a use. Information should be reliable. It should be sufficiently accurate for its purpose. For example it should be free from material error and should not be taken from an unreliable source. Unless information is reliable, management will not have sufficient confidence to use it. Information should be timely, which means that it should be provided in time for the purpose for which it is intended. Information has no value if it is provided too late. Some information, such as information provided for control purposes, may lose value with time, so that it is better to provide the information sooner rather than later. Information should be clear, comprehensible and appropriately communicated, since it will lose its value if it is not clearly communicated to the user in a suitable format and through a suitable medium. A large amount of management accounting information should be accessible immediately and on-line to authorised managers.

The provision of a value-for-money service

The costs of management accounting should be justified by the benefits that the function provides to the organisation, and the level of service and the quality of information provided.

The availability of informed personnel

Users will expect management accounting staff to be available to answer queries and resolve problems as and when required.

Flexibility

The management accounting function should be flexible in its response to user requests for information and reports.

1: The nature and purpose of management accounting

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1.4

Management accounting function - Establishing activities Once the objectives have been defined, the activities that the function should carry out to achieve its objectives must be established. This is why it is necessary to answer the question: “What information do we want, or might we want?” The specific information that a management accounting system is required to provide (and the timing or accessibility of this information) will vary between organisations, according to factors such as the nature of their business and their size. The management accounting function should be organised and staffed so that it is able to provide the information expected from it. A follow-up question is: “What type and size of function do we need to provide this information, and what will it cost?” Management, as users of information, should therefore understand what information they are getting, and what it is costing to get it.

1.5

Management accounting function - Identifying measures The performance of the management accounting function should be measured according to its objectives and its specified activities. Suitable specific performance measures might be as follows: (a)

Measures relating to the quality of the information provided. Quality measures may be based on the judgement of users, such as opinions about whether the information provided is useful, whether it is timely or provided too late to be of much use, and whether it is reliable.

(b)

Measures relating to value for money. The cost of the function should be measurable, and it may be possible to compare the cost with other information provision services within the organisation or in different organisations. The benefits are not so easy to assess, but management need to be satisfied that they are getting value for money.

(c)

Measures relating to the availability of accounting staff to assist management, such as the amount of time the accounting staff spend with managers in other functions, and the speed of their response to requests for information, advice or assistance.

(d)

Measures relating to flexibility, such as number of ad-hoc reports issued within pre-set time limit.

(e)

Ratings provided from user satisfaction surveys would provide extremely useful measures of performance. ‘Users’ are the ‘internal customers’ for the management information.

2 Financial accounting and management and cost accounting Section overview

6



Financial accounting systems ensure that the assets and liabilities of a business are properly accounted for, and provide information about profits and so on to shareholders and to other interested parties.



Management accounting systems provide information specifically for the use of managers within an organisation.



Cost accounting is part of management accounting. Cost accounting provides a bank of data for the management accountant to use.

Management Accounting

2.1 LO 1.2

Financial accounts and management accounts Financial accounting systems ensure that the assets and liabilities of a business are properly accounted for. They are used to provide information to shareholders and other interested parties in the form of (published) financial statements. Management accounting systems provide information specifically for the use of managers within an organisation. Management information provides a common source from which information for two groups of people is drawn. (a)

Financial accounts are prepared for individuals external to an organisation: for example shareholders, customers, suppliers, regulatory authorities, employees.

(b)

Management accounts are prepared for internal use by managers of the organisation.

Much of the data used to prepare financial accounts and management accounts are the same but differences between the financial accounts and the management accounts arise because the data is analysed differently. In addition, management accounting systems draw on a wider range of data, including non-financial data, data from external sources, and data relating to the future.

2.2

Financial accounts versus management accounts Financial accounts

Management accounts

Financial accounts detail the performance of an organisation over a defined period and the state of affairs at the end of that period.

Management accounts are used to aid management record, plan and control the organisation's activities and to help the decision-making process.

Limited liability companies must, by law, prepare financial accounts.

There is no legal requirement to prepare management accounts.

The format of published financial accounts is determined by local law, by International Accounting Standards and International Financial Reporting Standards. In principle the accounts of different organisations can therefore be easily compared.

The format of management accounts is entirely at management discretion: no strict rules govern the way they are prepared or presented. Each organisation can devise its own management accounting system and format of reports.

Financial accounts concentrate on the business as a whole, aggregating revenues and costs from different operations, and are an end in themselves.

Management accounts can focus on specific areas of an organisation's activities. Information may be produced to aid a decision rather than as the end product of a decision.

Most financial accounting information is of a monetary nature.

Management accounts incorporate non-monetary measures. Management may need to know, for example, tons of aluminium produced, monthly machine hours, or miles travelled by sales staff.

Financial accounts present an essentially historic picture of past operations.

Management accounts are both an historical record and a future planning tool.

Question 1: Management accounts Which of the following statements about management accounts is/are true? I II III

There is a legal requirement to prepare management accounts The format of management accounts is largely determined by law They serve as a future planning tool and are not used as a historical record

A B C D

I and II II and III III only none of the statements are correct (The answer is at the end of the chapter)

1: The nature and purpose of management accounting

7

2.3

Cost accounts The terms ‘cost accounting’ and ‘management accounting’ are often used interchangeably. It is not correct to do so. Cost accounting is part of management accounting. Cost accounting provides source data for the management accountant to use. Cost accounting is concerned with the following: • • •

Preparing statements (e.g. the construction of budgets and costing statements) Cost data collection Measuring inventory costs, and the costs and profitability of products and services.

Management accounting on the other hand is concerned with the following: •

2.3.1

Interpretation and assessment of financial and accounting data, and communicating it as information to users, for example as financial targets or performance measurements.

Aims of cost accounts Cost accounting is used to measure: (a)

The cost of goods produced or services provided.

(b)

The cost of a department or business unit.

(c)

The revenues earned from a product, service, department or business unit, or the organisation in total.

(d)

The profitability of a product, a service, a department, or the organisation in total.

(e)

Selling prices with some regard for the costs of sale.

(f)

The value of inventories of goods (raw materials, work in progress, finished goods) that are still held in store at the end of a period, thereby aiding the preparation of a statement of financial position of the company's assets and liabilities.

(g)

Future costs of goods and services, based on given assumptions about what will happen in the future. Costing is an integral part of budgeting, because budgets are detailed financial plans.

(h)

How actual costs compare with budgeted costs. If an organisation plans for its revenues and costs to be a certain amount, but they actually turn out differently, the differences can be measured and reported. Management can use these reports as a guide to whether corrective action, or 'control' action, is needed to sort out a problem revealed by these differences between budgeted and actual results. This system of control is often referred to as budgetary control or variance analysis.

It would be wrong to suppose that cost accounting systems are restricted to manufacturing operations, although they are probably more fully developed in this area. Service industries, government departments and non-profit making organisations all make use of cost accounting information. Within a manufacturing organisation, the cost accounting system should be applied not only to manufacturing but also to administration, selling and distribution, research and development and all other departments and functions.

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Management Accounting

3 Planning, control and decision-making Section overview

3.1 LOs 1.7 1.8



Information for management is likely to be used for planning, control and decision making.



Long-term planning, also known as corporate or strategic planning, involves selecting appropriate strategies so as to prepare a long-term plan to attain the organisation’s objectives.



Robert N Anthony (Management Control Systems, 1972) has categorised management activities and decision-making into strategic planning, management control and operational control.



A management control system is a system which measures and corrects the performance of activities of subordinates.



Information within an organisation can be analysed into the three levels of Anthony's hierarchy: strategic; tactical; and operational information.

Planning Planning forces management to think ahead systematically in both the short term and the long term. An organisation should never be surprised by developments that occur gradually over an extended period of time because the organisation should have implemented a planning process. Planning involves the following: •

Establishing overall objectives.



Selecting appropriate strategies to achieve those objectives.



Setting targets for each strategy.



Formulating detailed plans for achieving those targets.

When expected changes are gradual, planning occurs in a fairly stable environment, and routine budget planning procedures may be used.

3.2

Objectives of organisations Definitions A vision is a succinct statement of an organisation’s future aspirations. A mission statement sets out an organisation’s fundamental purpose. An objective is the aim or goal of an organisation. A strategy is a possible course of action that might enable an organisation to achieve its objectives.

Organisations often start by setting out their vision. This is a succinct statement of the organisation’s future aspirations e.g. Microsoft’s vision is “to help people and businesses throughout the world realise their full potential”. A mission statement is then created, setting out the organisation’s fundamental purpose and including references to its strategy, standards of behaviour and values. The mission sets the overall direction of the organisation and the organisation’s goals and more detailed objectives then follow from this. The strategies identified as a result of the planning process are designed to achieve these objectives. Note that in practice, the terms objective, goal and aim are often used interchangeably.

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9

The two main types of organisation that you are likely to come across in practice are as follows: • •

Profit making. Non-profit making.

It is often assumed that the main objective of profit making organisations is to maximise profits. A secondary objective of profit making organisations might be growth, for example by increasing the output and sales of its goods/services. Instead of maximising profit, an organisation may seek to maximise the wealth of its shareholders. Unfortunately, the aim of profit maximisation may encourage short-termism and excessive risk-taking by management in order to increase profits ‘now’, regardless of the consequences of their decisions for the longer term. The main objective of non-profit making organisations is usually to provide goods and services. A secondary objective of non-profit making organisations might be to minimise the costs involved in providing the goods/services. In conclusion, the stated objectives of an organisation might include one or more of the following: • • • • •

Maximise profits. Maximise revenue. Maximise shareholder value. Increase market share. Minimise costs.

Management accounting techniques are often based on one of these assumptions when recommending a course of action to management. Remember however that decisions have consequences for the longer term as well as the short term, and decisions to maximise profit may have high associated risks.

3.3

Long-term strategic planning Management accounting contributes to long-term strategic planning. Long-term planning, also known as corporate planning, involves selecting appropriate strategies to attain the organisational objective, and integrating these strategies into an overall long-term corporate plan or business plan. The time span covered by a long-term plan depends on the organisation, the industry in which it operates and the particular environment involved. Typical periods for a strategic business plan are 2, 5, 7 or 10 years although longer planning periods may be used. Long-term strategic planning is a detailed, lengthy process, consisting of four basic elements: • • • •

assess the organisation and its environment determine the corporate objectives devise strategies for achieving these objectives create a corporate plan

The diagram below provides an overview of the process and shows the link between short-term and longterm planning.

3.4

Short-term tactical planning The corporate or strategic plan serves as the long-term framework for the organisation as a whole, but for operational purposes it is necessary to convert the corporate (strategic) plan into a series of shortterm plans, usually covering one year, which relate to business units, functions or departments. The annual process of short-term planning should be seen as stages in the progressive fulfilment of the corporate plan as each short-term plan steers the organisation towards its long-term objectives. It is therefore vital that, to obtain the maximum advantage from short-term planning, some form of long-term plan exists. The management accounting function supports the short-term planning process, for example by providing information for setting targets and standards, and helping to establish the assumptions on which the shortterm plan is based, such as growth rates, costs, efficiency savings, cost inflation, and so on.

10

Management Accounting

3.5

Control As well as providing information for planning, management accounting also provides information to assist with monitoring and control. There are two stages in the control process. (a)

The planned performance of the organisation (set out as targets or expectations in the detailed operational plans) is compared with the actual performance of the organisation on a regular and continuous basis. Significant deviations from the plans can then be identified and appropriate corrective action can be taken where possible.

(b)

The corporate (strategic) plan is reviewed in the light of the comparisons made and any changes in the parameters on which the plan was based, (such as new competitors, government instructions and so on), to assess whether the objectives of the plan can be achieved. The plan is modified as necessary before any serious damage to the organisation's future success occurs.

Effective control is not practical without planning, and planning without control is pointless, because targets and objectives will not be achieved without monitoring and control measures when needed. An established organisation should have a system of management reporting that produces control information in a specified format at regular intervals. Smaller organisations may rely on informal information flows or ad-hoc reports being produced as required.

3.6 LO 2.1

Decision-making A function of management is decision-making. Managers at all levels within an organisation make decisions. Decisions may be taken within the routine planning and control processes. In addition, there are many other decisions, both long term and short term, and routine and occasional, that managers have to make at all levels within the management hierarchy. Decision making always involves a choice between

1: The nature and purpose of management accounting

11

alternative courses of action and it is the role of the management accountant to provide information so that management can reach an informed decision. For example, when comparing actual results against a target when actual results are poor, management needs to decide whether corrective action should be taken or not. A decision to take corrective action may involve considering the different ways in which control may be applied, and choosing the preferred course of action from the available alternatives. Budgeting decisions often involve making a choice between different ways of using the organisation’s scarce resources (such as cash, equipment and manpower). Many other decisions arise that face management. It is therefore vital that management accountants understand the decision-making process so that they can supply the appropriate type of information.

3.6.1

Decision-making process It is possible to analyse the decision-making process into a sequence of steps. These apply no matter whether the decision is taken immediately, or whether the matter is carefully considered before a decision is reached.

LOs 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5

You should learn this sequence of steps, and you should be able to apply them to any form of decisionmaking. You should also recognise the role of information in the decision-making process.

12



Define the problem. A decision involves making a choice between two or more courses of action. A decision is made only when a problem is recognised. If a manager is unaware that a problem exists, he will not feel the need to make any decision. A number of planning problems, control problems and other decision problems have been set out above.



Identify the decision-making criteria. Having recognised that there is a problem for which a decision must be made, the next step is to recognise the decision-making criteria. What are we trying to achieve? In the planning process, the criteria may be to maximise profits over the next 12 months, within the limitations of available resources and subject to limitations on the risks that should be taken. For a planning decision, the decision-making criterion may be to take control measures if possible to enable the organisation to achieve its planning targets. More simply, a decision-making criterion for control decisions may be to reduce excessive spending. In management accounting, the decision-making criterion is often to maximise profitability, but as

Management Accounting

explained earlier, this is not necessarily appropriate, without giving consideration to the longer term and risk. •

Develop alternatives. Having recognised a problem and recognised what the organisation is trying to achieve in resolving the problem, the next step is to recognise different ways in which the problem might be resolved in a way that is consistent with the decision-making criteria. For a simple decision, there may be just two alternatives – “Do it”, or “Don’t do it.” However there may be a number of different alternatives, and the process of developing alternatives involves: -

recognising the range of possible options and from these selecting a small number of alternatives for evaluation.



Analyse the alternatives. Each of the alternatives should be analysed and evaluated. If the decision-making criterion is to maximise short-term profit, each alternative should be evaluated financially, to estimate the profit that would result from choosing that alternative. Although a management decision is often based on financial considerations, other non-financial factors may also be considered if they are a part of the decision-making criteria.



Select an alternative. A decision involves selecting one alternative from the two or more that have been analysed. The recommended choice should be the course of action that resolves the problem in a way that best satisfies the decision-making criteria.

These steps in the decision-making process should be apparent in later chapters, when specific management accounting techniques for analysis are described.

3.7 Anthony's (1972) view of management activity LO 1.4

Robert N Anthony (Management Control Systems, 1972) argued that the activities of planning, control and decision making should not be separated since all managers make planning and control decisions. He divided management activities into three levels: strategic planning, management control and operational control. (a)

Strategic planning is 'the process of deciding on objectives of the organisation, on changes in these objectives, on the resources required to attain these objectives, and on the policies that are to govern the acquisition, use and disposition of these resources'.

(b)

Management control is 'the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organisation's objectives'.

(c)

Operational control is 'the process of assuring that specific tasks are carried out effectively and efficiently'.

A management accounting system provides information to management for strategic planning and management control, and for some aspects of operational control.

3.7.1

Strategic planning Strategic plans are those which set or change the objectives, or strategic targets, of an organisation. They would include such matters as the selection of products and markets, the required levels of company profitability, the purchase and disposal of subsidiary companies or major non-current assets and so on.

3.7.2

Management control While strategic planning is concerned with setting objectives and strategic targets, management control is concerned with decisions about the efficient and effective use of an organisation's resources to achieve these objectives or targets. (a)

While strategic planning is concerned with setting objectives and strategic targets, management control is concerned with the efficient and effective use of an organisation’s resources (manpower, materials, machines and money)to achieve these objectives or targets.

(b)

Efficiency in the use of resources to achieve optimum output from the input resources used. It relates to the combinations of labour, land and capital (for example, how much production work should be automated) and to the productivity of labour, or material usage.

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(c)

3.7.3

Effectiveness in the use of resources to create the outputs that are in line with the intended objectives or targets.

Operational control The third, and lowest tier, in Anthony's hierarchy of decision making, consists of operational control decisions. Operational control is the task of ensuring that specific tasks are carried out effectively and efficiently. Just as 'management control' plans are set within the guidelines of strategic plans, 'operational control' plans are set within the guidelines of both strategic planning and management control. Consider the following: (a)

Senior management may decide that the company should increase sales by five per cent per annum for at least five years – a strategic plan.

(b)

The sales director and senior sales managers will make plans to increase sales by five per cent in the next year, with some provisional planning for future years. This involves planning direct sales resources, advertising, sales promotion and so on. Sales quotas are assigned to each sales territory – a tactical plan (management control).

(c)

The manager of a sales territory specifies the weekly sales targets for each sales representative. This is operational planning. Individuals are given tasks which they are expected to achieve.

Although we have used an example of selling to describe operational control, it is important to remember that this level of planning occurs in all aspects of an organisation's activities, even non-standard activities, such as repair work or answering customer complaints. The scheduling of unexpected or ad-hoc work must be done at short notice, which is a feature of much operational planning. In the repairs department, for example, routine preventive maintenance can be scheduled, but breakdowns occur unexpectedly and unplanned repair work must be done 'on the spot' by a repairs department supervisor.

3.8

Management control systems A management control system is a system which measures and corrects the performance of activities of subordinates in order to make sure that the objectives of the organisation are being met and the plans devised to attain them are being carried out. The basic elements of a management control system are as follows: • • • • • •

Planning: deciding what to do and identifying the desired results. Recording the plan which should incorporate standards of efficiency or targets. Carrying out the plan and measuring actual results achieved. Comparing actual results against the plans. Evaluating the comparison, and deciding whether further action is necessary. Where corrective action is necessary, this should be implemented.

Information to assist with this process is needed for recording the plan, comparing actual results against the plan and evaluating the comparison. The information is often financial or partially financial in nature, although it will include non-financial information too. This is why management accounting, by providing information of both a financial and non-financial nature, should be an integral part of a management control system.

3.9

Types of information Information within an organisation can be analysed into the three levels assumed in Anthony's hierarchy: strategic; tactical; and operational information.

3.9.1

Strategic information Strategic information is used by senior managers to plan the objectives of their organisation, and to assess whether the objectives are being met in practice. Examples of such information include overall profitability, the profitability of different segments of the business, capital equipment needs and so on.

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Management Accounting

Strategic information therefore has the following features: • • • • • • •

3.9.2

It is derived from both internal and external sources. It is summarised at a high level, and is directed at senior management. It is relevant to the long term. It deals with the whole organisation. It is often prepared on an ad-hoc basis. It is both quantitative and qualitative. It cannot provide complete certainty, given that the future cannot be predicted.

Tactical information Tactical information is used by middle management to decide how the resources of the business should be employed, and to monitor how they are being and have been employed. Such information includes productivity measurements (output per direct labour hour or per machine hour), budgetary control or variance analysis reports, and cash flow forecasts. Tactical information has the following features:

3.9.3



It is primarily generated internally.



It is summarised at a lower level and is directed at middle management as well as more senior management.



It is relevant to the short and medium term.



It describes or analyses activities or departments.



It is prepared routinely and regularly.



It is based largely on quantitative measures.

Operational information Operational information is used by 'front-line' managers, such as foremen and supervisors, to ensure that specific tasks are planned and carried out properly. In the payroll office, for example, information at this level will relate to day-rate labour and will include the hours worked each week by each employee, the rate of pay per hour, details of deductions, and for the purpose of wages analysis, details of the time each person spent on individual jobs during the week. In this example, the information is required weekly, but more urgent operational information, such as the amount of raw materials being input to a production process, may be required daily, hourly, or in the case of automated production, second by second. Operational information has the following features: • • • •

It is derived almost entirely from internal sources. It is highly detailed, being the processing of raw data. It relates to the immediate term, and is prepared constantly, or very frequently. It is task-specific and largely quantitative.

4 Information Section overview •

Data is the raw material for data processing. Data relates to facts, events and transactions.



Information is data that has been processed so as to be meaningful.



Good information should be relevant, complete, accurate and clear, it should inspire confidence, it should be appropriately communicated, its volume should be manageable, it should be timely to produce and its cost should be less than the benefits it provides.

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4.1

Data and information Definitions Data is the raw material for data processing. Data relate to facts, events and transactions. Information is data that has been processed so as to be meaningful to the person who receives it. Information is anything that is communicated.

Information is sometimes referred to as processed data. The terms 'information' and 'data' are often used interchangeably. It is important to understand the difference between these two terms. For example, researchers who conduct market research surveys might ask members of the public to complete questionnaires about a product or a service. These completed questionnaires are data; they are processed and analysed in order to prepare a report on the survey. This resulting report is information and may be used by management for decision-making purposes. Management accounting systems provide information, and the quality of the management accounting system depends on the quality of the information that it provides.

4.2

Qualities of good information Good information should be relevant, complete, accurate, clear, it should inspire confidence, it should be appropriately communicated, its volume should be manageable, it should be timely and its cost to produce should be less than the benefits it provides. Let us look at those qualities in more detail.

16

(a)

Relevance. Information should have a purpose; otherwise there is unlikely to be sufficient benefit from processing data to justify the cost of providing it. Information must be relevant to the purpose for which a manager wants to use it. In practice, far too many reports fail to 'keep to the point' and contain irrelevant paragraphs which only distract and consume unnecessary time of the managers reading them.

(b)

Completeness. Information users should have all the information they need to do the job properly. If they do not have a complete picture of the situation, they might well make bad decisions.

(c)

Reliability. Information should be reliable. This means that it should be sufficiently accurate for its purpose. Using incorrect information could have serious and damaging consequences. However, there is no need to go into unnecessary detail. Where there is some uncertainty about the accuracy or reliability, for example when making forecasts about the future, the nature of the uncertainty should be fully understood, so that it is used and treated with caution.

(d)

Clarity. Information must be clear to the user. If the user does not understand it properly they will not be able to use it properly. Lack of clarity is one of the causes of a breakdown in communication. It is therefore important to choose the most appropriate presentation medium or channel of communication.

(e)

Confidence. Information must be trusted by the managers who are expected to use it. However not all information is certain. Some information has to be certain, especially operating information, for example, related to a production process. Strategic information, especially relating to the environment, is uncertain. However, if the assumptions underlying it are clearly stated, this might enhance the confidence with which the information is perceived. Having confidence in information depends on other qualities of the information – reliability, relevance and clarity.

(f)

Communication. Within any organisation, individuals are given the authority to do certain tasks, and they must be given the information they need to do them. For example, an office manager might be made responsible for controlling expenditure in his office, and given a budget expenditure limit for the year. As the year progresses, they might try to keep expenditure in check but unless they are told throughout the year what current total expenditure is to date, they will find it difficult to judge whether they are keeping within budget or not.

Management Accounting

(g)

Volume. There are physical and mental limitations to what a person can read, absorb and understand properly before taking action. An inappropriate amount of information, even if it is all relevant, cannot be handled. Reports to management must therefore be clear and concise and in many systems, control action works basically on the 'exception' principle, with reports only being produced if there is an issue that needs to be brought to management attention or investigated further .

(h)

Timing. Information should be timely, If it is not available until after a decision is made, it will be useful only for comparisons and longer-term control, and may serve no purpose even then. Information prepared too frequently can be a serious disadvantage. If, for example, a decision is taken at a monthly meeting about a certain aspect of a company's operations, information to make the decision is only required once a month, and weekly reports would be a time-consuming waste of effort.

(i)

Channel of communication. Information should be communicated or should be accessible through appropriate channels of communication. There are occasions when using one particular method of communication will be better than others. Some internal memoranda may be better sent by 'electronic mail'. Some information is best communicated informally by telephone or word-of-mouth, whereas other information ought to be formally communicated in writing or figures. Electronic methods of data transmission, data storage and data access are integral parts of most management accounting systems.

(j)

Cost. Information should have some value, otherwise it would not be worth the cost of collecting and filing it. The benefits obtainable from the information must also exceed the costs of acquiring it, and whenever management is trying to decide whether or not to produce information for a particular purpose, for example, whether to computerise an operation or to build a financial planning model, a cost/benefit analysis ought to be undertaken.

Question 2: Value of information Managers receive a monthly performance report indicating that costs in the previous month were 15% more than expected. Which one of the following would be the most appropriate response by management to this information? A Control action should be taken to deal with the problem and reduce costs by 15%. B The reasons for the overspend may be controllable; therefore they should be investigated with a view to reducing the overspend as much as possible. C The reasons for the overspend may be controllable or uncontrollable; therefore they should be investigated with a view either to reducing the overspend as much as possible or revising forecasts or targets. D The overspend indicates that planning targets will not be met, and forecasts should be revised. (The answer is at the end of the chapter)

4.3

Why is information important? Information is important for management because it provides awareness and understanding of an issue. By helping management to make better-informed decisions, information should contribute significantly to better-quality decision-making. Consider the following problems and what management needs to solve these problems. (a)

A company wishes to launch a new product. The company's pricing policy is to charge cost plus 20%. What should the price of the product be?

(b)

An organisation's widget-making machine has a fault. The organisation has to decide whether to repair the machine, buy a new machine or hire a machine. What does the organisation do if its aim is to control costs?

(c)

A company is considering offering a discount of 2% to those customers who pay an invoice within seven days of the invoice date and a discount of 1% to those customers who pay an invoice within eight to fourteen days of the invoice date. How much will this discount offer cost the company?

In solving these and a wide variety of other problems, management needs information.

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17

(a)

In problem (a) above, management would need information about the cost of the new product.

(b)

Faced with problem (b), management would need information on the cost of repairing, buying and hiring the machine.

(c)

To calculate the cost of the discount offer described in (c), information would be required about current sales settlement patterns and expected changes to the pattern if discounts were offered.

The successful management of any organisation depends on information: organisations in the public sector, such as hospitals and local authorities and other non-profit making organisations such as charities and clubs need information for decision making and for reporting the results of their activities just as multi-nationals do. For example, a local government authority needs to know what resources are being used to deliver services to residents. A tennis club needs to know the cost of undertaking its various activities so that it can determine the amount of annual subscription it should charge its members.

4.4

What type of information is needed? Managers require a mixture of financial and non-financial information.

Worked Example: Financial and non-financial information Assume that the management of ABC Co have decided to provide a cafeteria for their employees. (a)

The financial information required by management might include cafeteria staff costs, costs of subsidising meals, capital costs, costs of heat and light and so on.

(b)

The non-financial information might include comment on the effect on employee morale of the provision of cafeteria facilities, details of the number of meals served each day, meter readings for gas and electricity and attendance records for cafeteria employees.

ABC Co could now combine financial and non-financial information to calculate the average cost to the company of each meal served, thereby enabling them to predict total costs depending on the number of employees in the work force.

4.4.1

Non-financial information Management accounting is mainly concerned with the provision of financial information to aid planning, control and decision making. However, the management accountant cannot ignore non-financial influences and should qualify the information provided with non-financial matters as appropriate. Non-financial information may relate to matters such as quality, speed, flexibility, creativity, motivation, customer satisfaction and competitive advantage.

5 Presentation of information to management Section overview •

5.1

Information may be presented to management in the form of a report. Where reports are prepared, they should be presented in a suitable format. The main features of a report are: TITLE; TO; FROM; DATE; and SUBJECT.

Reports Information may be communicated by word of mouth , but in many organisations, especially larger organisations, formal reports are an important method of communication. Financial information in particular is often presented in the form of reports, because managers cannot always easily and quickly understand

18

Management Accounting

financial details, and need to have the information presented to them in a structured way. Management accountants should therefore be skilled in the writing and presentation of formal reports.

5.1.1 Main features of a report •

TITLE Most reports are usually given a heading to show that it is a report.



WHO IS THE REPORT INTENDED FOR? It is vital that the intended recipients of a report are clearly identified. For example, if you are writing a report for Joe Rafter, it should be clearly stated at the head of the report.



WHO IS THE REPORT FROM? If the recipients of the report have any comments or queries, it is important that they know who to contact.



DATE We have already mentioned that information should be communicated at the most appropriate time. It is also important to show this timeliness by giving your report a date.



SUBJECT: REPORT HEADING What is the report about? Managers are likely to receive a great number of reports that they need to review. It is useful to know what a report is about before you read it! A report should therefore have a clear heading or title.



SUB-HEADINGS Unless they are very brief, reports should be divided into sections, each with a clear sub-heading. The first heading may be an introduction (explaining the purpose of the report), followed by an executive summary (setting out both the purpose and the findings of the report). The final subheading may be for a summary, conclusion or recommendation.



APPENDIX In general, information is summarised in a report and the more detailed calculations and data are included in an appendix at the end of the report.

6 Management accounting systems Section overview •

LO 1.1

6.1

Management accounting systems developed from cost accounting systems. They are used for scorekeeping, directing management attention and problem solving.

We start this section by briefly looking at how management accounting systems have developed, and we consider the implications of systems not developing quickly enough to keep pace with changes in the business world.

The development of management accounting Management accounting has developed gradually over time, and has changed in nature. Originally, cost accounting systems were used to record costs and report costs to management in manufacturing industries, so that cost control and profitability could be managed better. This was at a time when manufacturing costs were a large proportion of total costs, and a large proportion of total manufacturing costs consisted of direct materials and direct labour costs. Manufacturing costs were ‘driven’ by direct labour hours worked or machine hours operated. Cost and management accounting information was also used for planning, particularly for annual budgeting. Budgetary control reports were produced regularly, typically every month, to inform management about actual performance and how this compared against the budget targets.

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Some industries produced standard products in large quantities, so that standard costing systems could be operated for budgeting and also for control reporting (standard costing variance reports). A significant development in management accounting was the use of marginal costing, and the separation of costs into fixed and variable costs. Marginal costing concepts were applied to planning and other aspects of decision-making. Management accounting systems became more relevant and reliable in providing information to management for decision-making, through the application of concepts and techniques such as relevant costs and discounted cash flow analysis. More recently, management accounting systems have developed quite rapidly, in a variety of different ways. Service industries and non-manufacturing activities became more important for many companies, and management accounting systems were developed within service industries, and also for activities such as marketing and distribution. Management accounting techniques have also been developed to analyse costs in different ways, particularly overhead costs, and techniques such as activity based costing and customer profitability analysis have emerged. The importance of information for strategic planning has also been recognised, and management accounting has expanded from the provision of information at the management control level to information provision for strategic planning and control. Management accounting systems must now gather non-financial as well as financial information, and information from external as well as internal sources. There have also been changes in manufacturing techniques, such as Total Quality Management and Just-inTime (JIT) production. As manufacturing management has changed, the information to support management – management accounting – has also had to change so that it remains relevant and useful. The expansion and increased sophistication of many management accounting systems would not have been possible without technological change, and enormous improvements in the capabilities of IT systems.

6.2

What is a management accounting system (MAS)? A management accounting system (MAS) can be defined by its tangible components: (a)

People with accounting knowledge (management accountants).

(b)

The technology they use.

(c)

Paper or computer records of financial transactions.

(d)

The cost accounting system on which it is based.

(e)

The management accounting techniques that are used to provide information: there are a wide variety of simple and complex mathematical techniques for analysing data.

(f)

The reports that are produced by the system, or the nature of the information that is accessible online.

(h)

The users of the information – the managers for whom the reports are prepared.

In summary, a management accounting system is an information system that produces information required by managers to manage resources and create value for customers and shareholders.

6.3

Risks in using management accounting systems In practice, management accounting systems may not provide information of a sufficient quality, and this will affect the quality of decision-making within the organisation. Typical weaknesses in some management accounting systems are explained briefly below.

6.3.1

Excessive emphasis on financial measures Management information may be unduly focused on financial costs and short-term profits that can easily be measured. Non-financial information may be overlooked. At a strategic level, for example, the objective of a company may be to increase profitability, but in order to grow the business and its profits, it may be necessary to consider factors such as quality, flexibility, customer satisfaction, employee skills and so on.

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Management Accounting

6.3.2

Internal orientation Management accounting systems may use data and information from internal sources, and fail to make use of external sources. A business needs an external orientation. It operates in a competitive and regulated environment, and management cannot ignore what is happening in the business environment. There should be some focus on customers and competitors, suppliers and perhaps other stakeholders.

6.3.3

Lack of goal congruence Management accounting systems may encourage a lack of goal congruence within the organisation, i.e. managers may be encouraged to concentrate on their own part of the company operations, without regard for other aspects of the business. Managers may pursue targets that are in their departmental interests but not in the best interests of the organisation as a whole. Often this may reflect poor overall design of the system, with potential conflicts between short and long-term objectives being ignored and incompatible targets being set for different parts of the organisation.

6.3.4

Lack of future perspective The management accounting systems may highlight historical financial costs and report on past performance. There is a requirement to provide information for management to make decisions about the future. Financial information for decision-making should consist of relevant costs (which we will discuss below). However, management accounting systems may fail to provide relevant cost information for management..

6.3.5

Failure to adapt performance measures to changing circumstances A particular problem with management accounting systems is that they may remain ‘stuck’ in traditional methods of reporting and analysis, when new approaches may be much more appropriate and valuable for management.

6.4

Risks of traditional management accounting methods A serious risk with using traditional management accounting methods and reports is that the information they provide may be inappropriate for management’s changing needs. Changes in the business environment call for changes in information systems for management. Changes in the business environment have included: • • • •

Globalisation and increased competition. Information technology changes resulting in changes in production methods and information flows. Changes in organisation structures, such as internal reorganisations and external mergers. Increasing awareness of sustainability and environmental issues

Traditional management accounting systems may be inadequate for advanced manufacturing technology and a modern business environment that focuses on marketing, customer satisfaction, employee involvement and total quality (‘getting things right first time’).

6.4.1

Timing In trying to improve profitability, management will often look for ways of reducing costs. However, as we will see later, the cost of a new product is substantially determined when it is being designed, not at the time it goes into production. The materials that will be used, the machines and labour required, are largely determined at the design stage. In the car industry, 85 per cent of all future product costs are determined during the design stage and by the end of the testing stage. Target costing is a management accounting technique that draws attention to control of product costs at the design stage. Traditional management accounting, however, continues to direct its attention to the production stage.

6.4.2

Controllability Traditionally, management accounting systems have provided more information about direct costs of operations than about indirect costs (overheads). However even in manufacturing industries, only a small proportion of 'direct costs' are genuinely controllable in the short term. Controllable direct costs

1: The nature and purpose of management accounting

21

may be about 10% of total costs, whereas controllable overhead costs may be about three times as large. There are techniques for analysing overhead costs more closely, such as activity based costing and customer profitability analysis, but traditional management accounting systems do not provide information of this quality.

6.4.3

Non-financial assets Traditional management accounting measures do not deal with intangible assets, such as knowledge-based assets. Management information systems need to be able to provide information about the resources that drive value, how knowledge-based assets help the organisation to improve its strategic value and develop performance indicators that will help determine resource allocation and strategic development.

6.4.4

Customer costs and profitability Many costs are driven by customers such as delivery costs, discounts, after-sales service and so on, but traditional cost and management accounting systems do not recognise this. Companies may be trading with certain customers at a loss but not realise it because costs are not analysed in a way that would reveal it.

7 Design of management accounting systems Section overview •

LO 1.5

7.1

A management accounting system comprises people with accounting knowledge, technology, records, processes, mathematical techniques, reports and the users for whom those reports are prepared. The key components of the system are: inputs, processes and outputs. It is used for strategic decision making, performance measurement, operational control and costing.

In this section we focus on the factors determining the design of management accounting systems, and assessing the adequacy of existing management accounting systems. The most important factor is the output they should provide to meet the needs of management, with different output being used for various decision-making purposes.

Designing a management accounting system The following factors should be considered when designing a management accounting system:

22

Factor

Detail

Output required: Information required and the timing of the information

A starting point for design or assessment should be the output from the management accounting system. For what purposes do management need the information? The management accountant must identify the information needs of managers making planning and control decisions, and monitoring progress. Levels of detail and accuracy of output must be determined in each case, and also the speed or frequency with which the information should be provided or made available.

Sources of input data

A management accounting system should be capable of gathering the data that is needed to provide the information. This involves obtaining data from both internal and external sources. It also involves specifying the methods that should be used to obtain and store the data.

Processing involved

Decisions should be made about how the data will be processed to provide the information, and how frequently it should be provided (for example, in monthly routine reports, continuously accessible online, or prepared in response to specific requests from management). Decisions should also be made about which methods or techniques of management accounting should be used to process the data.

Management Accounting

Factor

Detail

Response required

A further, vitally important issue is how managers should be expected to respond to the information provided. This will depend to some extent on how the information is presented to them. Ultimately the information is meant to result in decision making.

Question 3: Information Management accounting information should be relevant to the user's needs, and should be reliable. It should also be timely, appropriately communicated and cost-effective. Which one of the following best describes the consequences if management accounting information does NOT have these qualities? A

Management will be forced to rely more on external information.

B

Management will be forced to rely more on financial accounting statements.

C

None of the information will be used by management.

D

The quality of decision making will be poor. (The answer is at the end of the chapter)

7.2

Strategic, tactical and operational information A management accounting system should be capable of providing information at a strategic, tactical (management control) and operational level for management.

7.2.1

Strategic information Definition Strategic Management Accounting is a form of management accounting in which emphasis is placed on information which relates to factors external to the entity, as well as to non-financial information and internally-generated information.

Some examples of strategic information that may be provided by a management accounting system are found in the table below. Item

Comment

Competitors' costs

What are they? How do they compare with ours? Can we beat them? Are competitors vulnerable because of their cost structure?

Financial effect of competitor response

Have sales fallen?

Product profitability

A company should want to know not just what profits or losses are being made by each of its products, but why one product is making good profits whereas another equally good product might be making a loss.

Customer profitability

Some customers or groups of customers are worth more than others.

Pricing decisions

Accounting information can help to analyse how profits and cash flows will vary according to price and prospective demand.

Value of market share

A company ought to be aware of what it is worth to increase the market share of one of its products.

1: The nature and purpose of management accounting

23

7.2.2

Item

Comment

Capacity expansion

Should the company expand its capacity, and if so by how much? Should it diversify into a new area of operations, or a new market?

Brand values

How much is it worth investing in a 'brand' which customers will choose over competitors' brands?

Shareholder wealth

Future profitability determines the value of a business.

Cash flow

A loss-making company can survive if it has adequate cash resources, but a profitable company cannot survive unless it has sufficient liquidity.

Management control information The information required for management control embraces the entire organisation. It is provided for budgeting and planning, monitoring and other decision-making purposes at a management control level within the organisation. The information is often quantitative, such as labour hours, quantities of materials consumed, volumes of sales and production, and is commonly expressed in money terms, but (as indicated previously) tactical information as well as strategic information may include non-financial elements. Examples of management control information might include profit forecasts, variance analysis reports, and productivity statistics. Some tactical information is prepared regularly, perhaps weekly, or monthly, in the form of regular reports.

7.2.3

Operational control information Operational information is information which is needed for the conduct of day-to-day implementation of plans. It will include much 'transaction data' such as data about customer orders, purchase orders, cash receipts and payments. The amount of detail provided in information is likely to vary with the purpose for which it is needed. Operational information is likely to go into much more detail than management control information, which in turn will be more detailed than strategic information. Operational information, although quantitative, is more often expressed in terms of units, hours, quantities of material and so on. The extent to which management accountants are involved in providing information at the operational level will depend on the nature of the information and the responsibility structure within the organisation.

7.3

Performance measurement in different sectors An important aspect of management accounting systems is the provision of information about performance. The nature of the performance measures used will depend largely on the nature of the organisation’s business and the type of industry in which it operates. The information will be both financial and nonfinancial in nature.

7.3.1

Performance measurement in the service sector Management accounting information is provided for management in service industries, not just manufacturing industries. The management accountant must take into account the characteristics of the service businesses, including the fact that (unlike manufacturing) production and consumption of services occur at the same time and there are no finished goods inventories. Customer satisfaction may be difficult to measure in service businesses, and there may also be problems with identifying which parts of the service the customer values most, and providing relevant information about meeting customer needs. In the service sector, performance evaluation (and information about performance) may have several dimensions: • • • •

24

Flexibility Excellence Innovation Financial performance

Management Accounting

• •

7.3.2

Resource utilisation Competitiveness

Performance measurement in the not-for-profit sector In the public sector /government, performance may be judged in terms of inputs and outputs, which tie into the idea of 'value for money', based on: • • •

Economy – obtaining suitable inputs at the lowest cost. Efficiency – the process working as expected. Effectiveness – achieving goals.

Management accounting information in the not-for-profit sector may therefore focus on all three of these aspects of performance.

8 Developments in management accounting Section overview •

LOs 1.3 1.4

8.1

Management accountants have responded to developments such as JIT, TQM and lean management accounting by using techniques such as target costing, life cycle costing and Kaizen.

In this section we look at changes in the business environment and manufacturing methods, and how management accounting techniques have been developed in response to them. Many of the ‘modern’ manufacturing methods are grouped around the concept of World-Class Manufacturing (WCM), which sets as its objective achieving and sustaining competitive advantage in an environment of strategic cost reduction. We shall revisit these concepts of manufacturing management, and the associated management accounting techniques, in more detail later in the Study Manual.

Just-in-time (JIT) JIT encompasses a commitment to continuous improvement and the search for excellence in the design and operation of the production management system. Just-in-time manufacturing systems seek to eliminate waste and ‘get things right first time’ in production operations. Waste is anything that incurs costs without adding value – holding inventories is one example of waste and JIT systems seek to minimise inventory holding. To do this, materials must be supplied at exactly the time they are needed to meet production requirements, and production must be completed exactly at the time that output is needed to meet customer demand.

Definitions Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as they are required by a customer or for use, rather than for stock. A JIT system is a 'pull' system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales. Just-in-time production is a system which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage. Just-in-time purchasing is a system in which material purchases are contracted so that the receipt and usage of material, to the maximum extent possible, coincide.

The implications of JIT for the management accounting systems is that they have to be reorganised to include or highlight items that are seen as costs under JIT but are not included in traditional systems. Systems must highlight excessive inventory levels, machinery set ups and long lead times. The changes in organisation resulting from JIT, such as the regroupings of workings, will also result in changes in accounting systems to adjust to new demands and changed sources of information. JIT is considered in more detail in chapter 11.

1: The nature and purpose of management accounting

25

8.2

Total Quality Management Definition Total Quality Management (TQM) is a culture of management and operations, rather than a specific technique. The culture is one of achieving continuous improvements, no matter how small each individual improvement may be, so that customer needs and expectations are met with increasing success. The approach (like JIT) has a zero defects philosophy.

Total Quality Management (TQM) originated in Japanese manufacturing companies, notably Toyota, from the end of the 1940s. The following ‘requirements of quality' could be seen as the characteristics of TQM programs and the TQM philosophy: (a)

Organisation wide there must be acceptance that the only thing that matters is the customer.

(b)

There should be recognition of the all-pervasive nature of the customer-supplier relationship, including internal customers; passing sub-standard material to another division is not satisfactory.

(c)

Instead of relying on inspection to a predefined level of quality, the cause of the defect should be prevented. (Defects should be eliminated and operations should be ‘right first time’.)

(d)

Each employee or group of employees must be personally responsible for defect-free production or service in their domain.

(e)

There should be a move away from 'acceptable' quality levels. Any level of defects is unacceptable.

(f)

All departments should try obsessively to get things right first time; this applies to misdirected phone calls and typing errors as much as to production.

(g)

Quality certification programs should be introduced.

(h)

The cost of poor quality should be emphasised; good quality generates savings.

Key costs in a TQM system include: (a)

Conformance costs, those costs incurred to prevent problems and to appraise quality.

(b)

Non-conformance costs, internal failures such as waste, and external failures selling faulty goods to customers and as a result suffering claims from customers because products or services supplied have been faulty. The emphasis will be on minimising or, preferably, eliminating nonconformance costs as these tend to be much larger than conformance costs.

Total quality management and continuous improvement tie in with risk management. Constant review of processes to identify what went wrong, systems to input feedback from within the organisation and from the customer, and procedures to ensure the organisation responds successfully may reduce exposure to certain types of risk.

8.3

Kaizen Definition Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at every level. Kaizen is a feature of Total Quality Management.

The Kaizen method is applied during the production process when it is difficult to make really big changes. Kaizen focuses on the key elements of operations: production, purchasing and distribution. Kaizen aims to achieve a specified cost reduction, but to do so through continuous improvements rather than one-off changes.

26

Management Accounting

Though managers may set the targets, employees working in the production process will ensure that those targets are met. The logic of this approach is that those involved in production will be best able to see how to achieve the necessary economies effectively but with minimum disruption. Often these targets will be achieved in collaboration with suppliers.

8.4

Lean management accounting Lean management accounting has a lot in common with the other techniques outlined above. Its emphasis is on the elimination of waste and continuous improvement. Customer demand determines the flow of products or services, and emphasis is on processes and value streams rather than departments. In a lean system, management accounting systems need to be refocused to provide the information necessary to drive improvement, and highlight waste. Distortions such as reduced unit costs arising from producing large batches at a time need to be removed.

8.5

Life cycle costing Life cycle costing is based on the view that the costs and profitability of products should be planned and monitored over the entire life cycle of the products, from the design stage to the end of its commercial life. Life cycle costing tracks and accumulates actual costs and revenues attributable to each product or project over the entire product/project life cycle. The total profitability of any given product / project can therefore be determined. Traditional management accounting systems usually total all non-production costs and record them as a period expense. Under life cycle costing such costs are traced to individual products over complete life cycles. Some organisations find that approximately 90% of a product's life cycle cost is determined by decisions made early within the cycle at the design stage. Life cycle costing is therefore particularly suited to innovative organisations and products, incurring high spending and commitments to spend during the early stages of a product's life cycle. In order to compete effectively in today's competitive market, many organisations need to continually redesign their products with the result that product life cycles have become much shorter. The planning, design and development stages of a product's cycle are therefore critical to an organisation's cost management process. Cost reduction at this stage of a product's life cycle, rather than during the production process, is one of the most important ways of reducing product cost.

8.5.1

Advantages of life cycle costing The life cycle costing approach emphasises the importance of development and design costs by placing them in the context of the product's whole history. This may sway organisations away from underexpenditure initially on design and development that results in problems later. The approach deals well with other costs that may vary over a product's life cycle, for instance advertising. The life cycle approach also highlights the importance of time to market; the success of a product may depend on whether it gets to market quicker than its rivals.

8.5.2

Problems of life cycle costing The biggest challenge is estimating product life costs over a number of years and how realistic they will be in the light of the information available at the start of its life. When circumstances change, life cycle costs have to change and management accounting systems may not be flexible enough to be able to cope. Customer information, though difficult to obtain, may be important as customers may be prepared to pay a higher price for a product that has lower lifetime costs.

8.6

Target costing Target costing requires managers to change the way they think about the relationship between cost, price and profit.

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27

8.6.1

(a)

The traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price, probably based on cost, with a resulting profit or loss. Costs are controlled through variance analysis at monthly intervals.

(b)

The target costing approach is to develop a product concept and the primary specifications for performance and design and then to determine the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price leaving a figure that represents total cost. This is the target cost and the product must be capable of being produced for this amount otherwise the product will not be manufactured. During the product's life the target cost will constantly be reduced so that the price can fall. Continuous cost reduction techniques must therefore be employed.

Advantages of target costing The biggest advantage of target costing is that it brings market information into the management accounting system rather than the accounting system being internally focused. It also encourages continual product and production improvements and provides a structured approach for dealing with those improvements.

8.6.2

Problems of target costing The most significant challenge is setting a target, as it will be very difficult to forecast the market price. It will partly depend on assumptions made about the future market situation including behaviour of competitors, and technological and customer preferences. A number of other problems may undermine the use of target costing as a means of control. These include whether to use one target cost or several target costs, what costs to include and on what level of production to base the target.

8.7

Organisational behaviour

LO 1.8

Organisational behaviour is about the impact that individuals, groups and organisational structure have on behaviour within an organisation and on that organisation’s effectiveness or ability to create value It is possible to identify three components that have an impact on organisational behaviour: • • •

People Structure Technology and systems

To realise its full potential, an organisation needs to unleash the potential of its individual employees and ensure that their goals are aligned with those of the organisation. The way that an organisation is structured and its systems for planning, control and decision-making will affect the motivation of its staff and hence the achievement of its results. In today’s fast-changing environment, a successful company is often one that is outward looking and always looking to the future towards new markets, innovative products or services, better designs, new processes, improved quality and increased productivity.

To create and improve value, organisations need to:

28



Recruit and retain the best talent.



Get the best from their employees e.g. through training and development or motivating staff through appropriate targets and reward schemes.



Create a culture that supports individual and team abilities and promotes and rewards the drivers of organisational success.



Recognise the power and value of knowledge and ensure that this is captured and then shared to improve competitive advantage, eg through the use of knowledge management systems.

Management Accounting



Implement a management style and organisational structure that is consistent with all of the above.



Develop and maintain an information system to support management.

The management accountant has a vital role to play in this.

8.8 LO 12.1

Role of the management accountant in creating value Earlier in this chapter we examined the role of the management accounting function and the contribution of management accounting to strategic management. Management accounting is a value added process. This value added process: • • •

Guides management action Motivates behaviour Supports and creates the cultural values required to achieve the organisation’s objectives

The management accountant plays a key role in providing relevant and timely information to the management of the organisation, explaining the impact of that information and participating in the managerial decision-making process. The information provided by management accountants and the management accounting system •

supports the strategic planning process which ensures the organisation adapts to its competitive environment (planning)



helps senior management to evaluate performance (control) and



provides timely and accurate information about activities required for success (decision making) and



helps maximise the effective use of resources over time

Thus the management accountant helps create organisational value by: • • • • •

providing relevant information for planning and decision making assisting management in direction and control activities motivating managers and other employees towards organisational objectives measuring the performance of the activities of managers and other employees assessing the organisation’s competitive position

1: The nature and purpose of management accounting

29

9 Sustainability and management accounting Section overview •

LO 1.9

Sustainability is about considering the future as well as the present. Management accountants have a role in ensuring that this aim is recognised, objectives set, performance measured and corrective action taken.

In this section we examine one of the newer concepts in management accounting, that of sustainability and sustainability accounting. In recent years there has been an increasing awareness of sustainability. The section begins by looking at what is meant by sustainability both on a global scale and at an organisational level. The objectives of sustainability are then considered and its relationship to management accounting.

Definition •

In relation to the development of the world's resources, sustainability has been defined as ensuring that development meets the needs of the present without compromising the ability of future generations to meet their own needs.



For organisations, sustainability involves developing strategies so that the organisation only uses resources at a rate that allows them to be replenished (in order to ensure that they will continue to be available). At the same time emissions of waste are confined to levels that do not exceed the capacity of the environment to absorb them. Brundtland report

The concept of sustainability should not be confused with environmental protection and the scarcity of natural resources, although for many industries there is a direct connection between these. The concept of sustainable business applies to all types of business – banks and retail businesses as well as mining and oil companies.

9.1

The objectives of sustainability Sustainability is about ensuring that an industry will be able to continue into the foreseeable future. To do this, it needs to identify any risks that may exist to its continued existence, and develop strategic objectives to protect itself against those risks. For many companies, sustainability involves considering how to achieve a sustainable business that does not deplete natural resources below a sustainable level, and does not create excessive pollution that endangers the future well-being of society. It may be argued that sustainability is concerned with ensuring a better quality of life for everyone, now and for generations to come, whilst meeting the following four objectives: • • • •

Social progress that recognises the needs of everyone Effective protection of the environment Prudent use of natural resources Maintenance of high and stable levels of economic growth or employment

However it is important to recognise that business organisations do not exist primarily to benefit society as a whole. It is all too easy to become naïve and unrealistic when thinking about sustainability!

9.2

Sustainability and management accounting There is clearly a growing interest in providing information to management that will help to support decision-making within the context of setting and achieving sustainability objectives. Many organisations now produce social and environmental reports or sustainability reports. There is also a growing understanding that accountants have an important role to play, demonstrated by the work that is being done by the leading accountancy bodies to engage the profession in sustainability issues.

30

Management Accounting

Definition The term ‘sustainability accounting' encompasses a range of new accounting and reporting tools and approaches which are part of a transition towards a different kind of organisational decision-making, focused not just on economic rationality, but consistent with ecological and social sustainability.

The role of the management accountant in sustainability accounting includes: •

producing public reports of an organisation’s carbon emissions, energy use, and impact on the local economy (sometimes called physical, environmental or social accounting);



the use of such reports as part of an environmental or sustainability management system; According to the International federation of Accountants (IFAC), “a sustainability or (environmental) management system can help an organisation:

9.3



Define its sustainability objectives, and ensure their alignment to business objectives;



Identify sustainability challenges, risks, and opportunities; and



Ensure that management and operational practices respond to these challenges, risks, and opportunities.”



the reporting of initiatives which demonstrate that an organisation is taking its social and environmental impacts into account in its decisions (such as in Corporate Social Responsibility reporting);



the reporting of such initiatives together with an organisation’s financial accounts; and



the reporting of information within key performance indicator criteria, reflecting progress towards the sustainability of an organisation.



the reporting of costs organisations incur to prevent, monitor and report environmental impacts.

Sustainability reporting The term ‘sustainability reporting’ refers to the concept of organisations reporting to stakeholders not only on their economic performance, but also on their performance in relation to the environment and society. This has led to the emergence of frameworks to encompass reporting on social and environmental performance.

9.3.1

Global Reporting Initiative (GRI) The Global Reporting Initiative (GRI), founded in 1997, is an international not-for-profit organization. It is the world-wide standard setter in sustainability reporting and its reporting guidelines are a global voluntary code which provide a framework for organisations to measure their economic, environmental and social performance. Reporting on these three aspects of performance is sometimes called ‘triple bottom line reporting’. Economic: concerns the organisation’s impacts on the economic conditions of its stakeholders and on economic systems at local, national, and global levels. Environmental: concerns an organisation’s impacts on living and non-living natural systems, including ecosystems, land, air, and water. Social: concerns the impacts an organisation has on the social systems within which it operates.

1: The nature and purpose of management accounting

31

Examples of GRI core performance indicators include: Economic

Environmental

Social

Revenues and costs

Materials used

Employee turnover and absenteeism

Wages, pensions, other employee benefits

Energy consumption

Diversity of workforce, incidents of discrimination

Retained earnings and payments to providers of capital

Water use

Employee health and safety

Taxes paid, subsidies and grants received

Greenhouse gas emissions

Child labour

Geographic analysis of key markets

Effluents and waste produced

Return on capital employed

Significant spillages

Training undertaken

Bribery and corruption

Fines and penalties

Community relations

Impact of activities on biodiversity

Complaints re breaches of customer privacy Standard of Product labelling (Source: GRI 2006)

The GRI Reporting Framework sets out the principles and Performance Indicators that organisations can use to measure and report their economic, environmental, and social performance. There are Sustainability Reporting Guidelines for different industries. The third version of the Guidelines – known as the G3 Guidelines - was published in 2006. Many organisations around the world have declared their use of the GRI Guidelines as the basis for sustainability reporting, including companies such as Coca Cola, Bayer, British American Tobacco, Dell, and MTR Corporation. There are GRI guides for different industries, because the nature of sustainability information differs according to the nature of the industry.

9.3.2

Sustainability reporting in Australia In October 2008 GRI Focal Point Australia was set up as a collaborative initiative by GRI and the St James Ethics Centre. It is funded by the Federal Government’s Treasury, CPA Australia and GRI. Its goal is to increase the uptake of responsible business practice and make reporting on economic, environmental and social performance by all organizations as routine and comparable as financial reporting. According to GRI Focal Point Australia, sustainability reporting in Australia is gaining momentum with GRI reports almost doubling between 2007 and 2009. The establishment of the Focal Point has led to an increased number of organisations considering GRI in their reporting and Australia is now the fourth largest reporter against GRI, after Spain, USA and Brazil. By 2009, 69 organisations in Australia, including Corporate Express Australia, Australia and New Zealand Banking Group Ltd, Australia Post, and Telstra, had registered their use of GRI’s reporting guidelines and sustainability framework. (http://www.globalreporting.org/AboutGRI/WhoWeAre/FocalPoints/FocalPointAustraliaLandingPage.htm)

9.3.3

Socially Responsible Investment indexes The two leading global Socially Responsible Investment (SRI) indexes are the Dow Jones Sustainability Index World (DJSI World) and the FTSE4Good Global. These indexes are designed to measure the performance of companies that meet globally recognised corporate responsibility standards, and to facilitate investment in those companies. They include companies

32

Management Accounting

that meet the selection criteria, but exclude those in certain sectors such as tobacco, weapons and nuclear power. Launched in February 2005, the Australian SAM Sustainability Index (AuSSI) tracks the performance of Australian companies that lead their industry in terms of corporate sustainability. It comprises companies from a range of industry sectors, including for example the National Australia Bank Ltd., David Jones Ltd, Foster’s Group Ltd, Macquarie Group Ltd, and Energy Resources of Australia Ltd.

1: The nature and purpose of management accounting

33

Key chapter points

34



The role of management accounting as an information provider has developed with advances in technology. In order to measure an organisation’s performance effectively, clear understanding is needed of its objectives and activities, and appropriate measures developed based on these.



Financial accounting systems ensure that the assets and liabilities of a business are properly accounted for, and provide information about profits and so on to shareholders and to other interested parties. Management accounting systems provide information specifically for the use of managers within the organisation.



Cost accounting and management accounting are terms which are often incorrectly used interchangeably. Cost accounting is part of management accounting. Cost accounting provides a bank of data for the management accountant to use.



Information provided by management accountants is likely to be used for planning, control and decision making.



Anthony (1972) divided management activities into strategic planning, management control and operational control.



A management control system is a system which measures performance against a target or benchmark, and indicates where control action may be required to make sure that the objectives of an organisation are being met and the plans devised to attain them are being carried out.



Management accounting systems are management information systems. Information is data that has been processed in such a way as to be meaningful to the person who receives it. Information is anything that is communicated.



Good information should be relevant, complete, accurate, clear, it should inspire confidence, it should be appropriately communicated, its volume should be manageable, it should be timely and its cost should be less than the benefits it provides.



Information within an organisation can be analysed into the three levels assumed in Anthony's hierarchy: strategic; tactical; and operational.



Information is often presented to management in the form of a report. The main features of a report are: TITLE; TO; FROM; DATE; SUBJECT/TITLE and SUB-SECTIONS/SUB-HEADINGS.



Management accounting developed from cost accounting. It is used for scorekeeping, directing management attention and problem solving. It has since branched out into behavioural aspects.



A management accounting system comprises people with accounting knowledge, technology, records, processes, mathematical techniques, reports and the users for whom those reports are prepared. The key components of the system are: inputs, processes and outputs. It is used for strategic decision making, performance measurement, operational control and costing.



Management accountants have responded to developments such as JIT, TQM and lean management accounting by using techniques such as target costing, life cycle costing and Kaizen.



Organisational behaviour is about the impact that individuals, groups and organisational structure have on behaviour within an organisation and on that organisation’s effectiveness or ability to create value.



Management accounting is a value added process which guides management action, motivates behaviour and supports the cultural values required to achieve an organisation’s objectives



For companies in many industries, sustainability involves developing strategies so that the organisation only uses resources at a rate that allows them to be replenished. At the same time emissions of waste are confined to levels that do not exceed the capacity of the environment to absorb them.



The term ‘sustainability accounting' encompasses a range of new accounting and reporting tools and approaches which are part of a transition towards a different kind of organisational decision-making focused not just on economic rationality, but consistent with ecological and social sustainability.

Management Accounting

Quick revision questions 1

Which of the following is not an essential quality of good information? A B C D

2

The sales manager has prepared a direct labour plan to ensure that sales targets for the year are achieved. This is an example of: A B C D

3

4

I

A management control system is a term used to describe the hardware and software used to drive a database system which produces information outputs that are easily assimilated by management

II

An objective is a course of action that an organisation might pursue in order to achieve its strategy

III

Information is data that has been processed into a form meaningful to the recipient.

A B C D

I, II and III III only II and III I and III

Monthly variance reports are an example of which one of the following types of management information? tactical strategic operational all of the above

The three main types of accounting are management accounting, financial accounting and cost accounting. Which of the following sequences is correct? A B C D

6

tactical planning strategic planning corporate planning operational planning

Which of the following statements is/are correct?

A B C D 5

it should be timely it should be completely accurate it should be relevant for its purposes it should be communicated to the right person

management accounting: immediate; financial accounting: quick; cost accounting: delayed financial accounting: immediate; cost accounting: quick; management accounting: delayed management accounting: immediate; cost accounting: quick; financial accounting: delayed cost accounting: immediate; management accounting: quick; financial accounting: delayed

Match the term with the description. Term: • A • B • C

just-in-time target costing total quality management

Description: •

(i)

sustaining a culture of continuous improvement



(ii)

aiming to produce goods when required by customer or for use



(iii)

developing a product concept and determining the price customers would be willing to pay for that concept

1: The nature and purpose of management accounting

35

7

36

Which of the following statements is not correct? A

financial accounting information can be used for internal reporting purposes

B

routine information can be used to make decisions regarding both the long term and the short term

C

management accounting provides information relevant to decision making, planning, control and evaluation of performances

D

cost accounting can only be used to provide inventory valuations for internal reporting

Management Accounting

Answers to quick revision questions 1

B

The reliability of information depends on its accuracy. Information should be sufficiently accurate for its purpose. Relevance and clarity are different qualities of good information, and information that is not provided in a timely way loses relevance.

2

A

Tactical planning is used by middle management to decide how the resources of the business should be employed to achieve specific objectives in the most efficient and effective way. Strategic planning (option B) is planning for the achievement of long-term objectives, and corporate planning (option C) is another name for this. Operational planning (option D) is concerned with the very short term, day to day planning that is carried out by 'front line' managers such as supervisors and head clerks.

3

D

An objective is a target for achievement, not a course of action.

4

A

Variance reports are an example of tactical management information. They have the key features outlined in section3.9.2.

5

C

Management accounting information is generally needed and provided immediately and responsively; cost accounting information is provided quickly and responsively, but not necessarily immediately. The provision of financial accounting information is usually delayed.

6 7

A(iii), B(i), C(ii). The concept of total quality management includes continuous improvement as a major element, although there are other aspects to this management concept. D

Cost accounting has a variety of uses.

1: The nature and purpose of management accounting

37

Answers to chapter questions 1

D

Statement I is incorrect. Limited liability companies must, by law, prepare financial accounts. The format of published financial accounts is determined by law, but not the format of management accounts. Statement II is therefore incorrect. Management accounting information is sometimes used as a planning tool, for example in budgeting. Therefore management accounts do serve as a future planning tool, but they are also useful as a historical record of performance – for example in monthly performance reports. Management accounting information is used for control and one-off decision-making purposes, as well as for planning purposes. Therefore, all three statements are incorrect and D is the correct answer.

2

3

38

C

Management accounting information has identified that costs were 15% more than expected. Where actual performance is compared against a target, the problem could be with the actual performance or the target may have been inappropriate Control information should lead to investigation of the reasons for differences or variances. . In this case the variance could suggest that there has been unnecessary overspending or that there are reasons for the overspending that is outside management’s control. Where appropriate, control action should be taken to reduce excess spending. Alternatively, if the overspend is caused by factors outside management control it may be necessary to revise forecasts about what will happen in the future.

D

Management accounting information is used, even when its quality is poor. For example, organisations prepare budgets, even when there is a lack of confidence in the quality of the forecasts and other assumptions in the budget. Using external information is not a substitute for internal information. Financial statements are for external publication and are not produced frequently enough for management purposes. This suggests that the correct answer must be answer D. The information will be used, even if there is a lack of confidence in it, but the quality of decision-making will be adversely affected.

Management Accounting

Chapter 2

Decision making and relevant costing Learning objectives

Reference

Decision making

LO2

Apply relevant information guidelines for short-term alternative choice operating decisions

LO2.2

Explain the impact of cash flows and risks on project decision making

LO2.5

Topic list

1 2 3 4

Relevant costs Choice of product (product mix) decisions Make or buy decisions Outsourcing

39

Introduction Management at all levels within an organisation take decisions. The overriding requirement of the information that should be supplied by the cost/management accountant to aid decision making is that of relevance. This chapter therefore begins by looking at the costing technique required in decision-making situations, that of relevant costing, and explains how to decide which costs need taking into account when a decision is being made and which costs do not. We then go on to see how to apply relevant costing to product mix decisions, and make or buy decisions. Finally, the important area of outsourcing is considered.

Decision making and relevant costing

Relevant costs

Choice of product (product mix) decisions

40

Management Accounting

Outsourcing

Make or buy decisions

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is a relevant cost?

(Section 1.1)

2

What are avoidable costs?

(Section 1.2)

3

Define differential and opportunity costs.

(Section 1.3)

4

What is a sunk cost?

(Section 1.5)

5

What is deprival value?

(Section 1.9)

6

A limiting factor is anything which limits the activity of an entity. What are the possible limiting factors for an organisation?

(Section 2.1)

2: Decision making and relevant costing

41

1 Relevant costs Section overview • • • •

1.1

Relevant costs are future cash flows arising as a direct consequence of a decision. Relevant costs are future costs. Relevant costs are cash flows. Relevant costs are incremental costs.

Relevant costs Definition Relevant costs are future cash flows arising as a direct consequence of a decision.

LO 2.5

Decision making should be based on relevant costs. (a)

Relevant costs are future costs. A decision is about the future and it cannot alter what has been done already. In this context, costs that have been incurred in the past are totally irrelevant to any decision that is being made 'now'. Such costs are past costs or sunk costs. Costs that have been incurred include not only costs that have already been paid, but also costs that have been committed. A committed cost is a future cash flow that will be incurred anyway, regardless of the decision taken now.

1.2

(b)

Relevant costs are cash flows. Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending, such as depreciation and notional costs, should be ignored for the purpose of decision-making.

(c)

Relevant costs are incremental costs. For example, if an employee is expected to have no other work to do during the next week, but will be paid his basic wage, of say $100 per week, for attending work and doing nothing, his manager might decide to give him a job which earns the organisation $40. The net gain is $40 and the $100 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway whether the employee is given work or not.

Avoidable costs Definition Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.

One situation 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 costs. Costs which would be incurred whether or not the product is discontinued are known as unavoidable costs.

1.3

Differential costs and opportunity costs Relevant costs are also differential costs and opportunity costs: •

Differential cost is the difference in total cost between alternatives.



An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in preference to an alternative.

For example, if decision option A costs $300 and decision option B costs $360, the differential cost is $60.

42

Management Accounting

Worked Example: Differential costs and opportunity costs Assume for example, that there are three options, A, B and C, only one of which can be chosen. The net profit from each would be $80, $100 and $70 respectively. Since only one option can be selected option B would be chosen because it offers the biggest benefit. Profit from option B Less opportunity cost (i.e. the benefit from the most profitable alternative, A) Differential benefit of option B

$ 100 80 20

The decision to choose option B would not be taken simply because it offers a profit of $100, but because it offers a differential profit of $20 in excess of the next best alternative.

1.4

Controllable and uncontrollable costs Controllable costs are items of expenditure which can be directly influenced by a given manager within a given time span. As a general rule, committed fixed costs such as those costs arising from the possession of plant, equipment and building, giving rise to depreciation and rent, are largely uncontrollable in the short term because they have been committed by longer-term decisions. Discretionary fixed costs, for example, advertising and research and development costs can be thought of as being controllable because they are incurred as a result of decisions made by management and can be increased or decreased at fairly short notice.

1.5

Sunk costs Definition A sunk cost is a past cost which is not directly relevant in decision making.

The principle underlying decision making is that management decisions can only affect the future. In decision making, managers therefore require information about future costs and revenues which would be affected by the decision under review. They must not be misled by events, costs and revenues in the past, about which they can do nothing. Sunk costs, which have been charged already as a cost of sales in a previous accounting period or will be charged in a future accounting period although the expenditure has already been incurred, are irrelevant to decision-making.

Worked Example: Sunk costs An example of a sunk cost is development costs which have already been incurred. Suppose that a company has spent $250 000 in developing a new service for customers, but the marketing department's most recent findings are that the service might not gain customer acceptance and could be a commercial failure. The decision whether or not to abandon the development of the new service would have to be taken, but the $250 000 spent so far should be ignored by the decision makers because it is a sunk cost.

2: Decision making and relevant costing

43

1.6

Fixed and variable costs In general, variable costs will be relevant costs and fixed costs will be irrelevant to a decision. Unless you are given an indication to the contrary, you should assume the following: • •

Variable costs will be relevant costs. Fixed costs are irrelevant to a decision.

This need not be the case, however, and you should analyse variable and fixed cost data carefully. Do not forget that 'fixed' costs may only be fixed in the short term.

1.6.1

Non-relevant variable costs There might be occasions when a variable cost is in fact a sunk cost and therefore a non-relevant variable cost. For example, suppose that a company has some units of raw material in inventory. They have been paid for already, and originally cost $2,000. They are now obsolete and are no longer used in regular production, and they have no scrap value. However, they could be 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 inventory.

1.6.2

(a)

In deciding whether the job should be undertaken, the relevant cost of the materials to the special job is nil. Their original cost of $2,000 is a sunk cost, and should be ignored in the decision.

(b)

However, if the materials did have a scrap value of, say, $300, then their relevant cost to the job would be the opportunity cost of being unable to sell them for scrap, i.e. $300.

Attributable fixed costs There might be occasions when a fixed cost is a relevant cost, and you must be aware of the distinction between specific or directly attributable fixed costs, and general fixed overheads. Directly attributable fixed costs are those costs which, although fixed within a relevant range of activity levels are relevant to a decision for either of the following reasons: (a)

They could increase if certain extra activities were undertaken. For example, it may be necessary to employ an extra supervisor if a particular order is accepted. The extra salary would be an attributable fixed cost.

(b)

They would decrease or be eliminated entirely if a decision were taken either to reduce the scale of operations or shut down entirely.

General fixed overheads are those fixed overheads which will be unaffected by decisions to increase or decrease the scale of operations, perhaps because they are an apportioned share of the fixed costs of items which would be completely unaffected by the decisions. General fixed overheads are not relevant in decision-making.

1.6.3

Absorbed overhead Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making purposes. Only incremental overheads arising as a result of the decision are relevant.

1.7

The relevant cost of materials The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In this case the relevant cost of using them is the higher of the following: • •

Their current resale value and 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.

44

Management Accounting

Question 1: Relevant cost of materials O'Reilly has been approached by a customer who would like a special job to be done for him, and who is willing to pay $22,000 for it. The job would require the following materials: Material

Total units required

A B C D

1 000 1 000 1 000 200

Units already in inventory 0 600 700 200

Book value of units in inventory $/unit – 2 3 4

Realisable value $/unit – 2.50 2.50 6.00

Replacement cost $/unit 6 5 4 9

Material B is used regularly by O'Reilly, 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 inventory as the result of previous excessive-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 $5 per unit (of which the company has no units in inventory at the moment). Calculate the relevant costs of material for deciding whether or not to accept the contract. (The answer is at the end of the chapter)

Question 2: Relevant cost of materials A company regularly uses a material. It currently has 100kg in inventory for which it paid $200. If it were sold it could be sold for $3 per kg. The market price is now $4 per kg. A customer has placed an order that will use 200kg of the material. The relevant cost of the 200 kgs is: A B C D

$500 $600 $700 $800 (The answer is at the end of the chapter)

1.8

The relevant cost of labour The relevant cost of labour, in different situations, is best explained by means of an example.

Worked Example: Relevant cost of labour LW is currently deciding whether to undertake a new contract. 15 hours of labour will be required for the contract. LW currently produces product L, the standard cost details of which are shown below: STANDARD COST PRODUCT L Direct materials (10kg @ $2) Direct labour (5 hrs @ $6) Selling price Contribution (a) (b) (c)

$/unit 20 30 50 72 22

What is the relevant cost of labour if the labour must be hired from outside the organisation? What is the relevant cost of labour if LW expects to have five hours' spare capacity? What is the relevant cost of labour if labour is in short supply?

2: Decision making and relevant costing

45

Solution (a)

Where labour must be hired from outside the organisation, the relevant cost of labour will be the variable costs incurred. Relevant cost of labour on new contract = 15 hours @ $6 = $90

(b)

It is assumed that the five hours spare capacity will be paid anyway, and so if these five hours are used on another contract, there is no additional cost to LW. Relevant cost of labour on new contract

$ 60 0 60

Direct labour (10 hours @ $6) Spare capacity (5 hours @ $0) (c)

Contribution earned per unit of product L produced = $22 If it requires five hours of labour to make one unit of product L, the contribution earned per labour hour = $22/5 = $4.40 Relevant cost of labour on new contract Direct labour (15 hours @ $6) Contribution lost by not making product L ($4.40 × 15 hours)

$ 90 66 156

It is important that you should be able to identify the relevant costs which are appropriate to a decision. In many cases, this is a fairly straightforward problem, but there are cases where great care should be taken. Attempt the following question.

Question 3: Customer order 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 $50,000 and progress payments of $15,000 had been received from the customer prior to the liquidation. The sales department has found another company willing to buy the machine for $34,000 once it has been completed. To complete the work, the following costs would be incurred: (a)

Materials: these have been bought at a cost of $6,000. They have no other use, and if the machine is not finished, they would be sold for scrap for $2,000.

(b)

Further labour costs would be $8,000. Labour is in short supply, and if the machine is not finished, the work force would be switched to another job, which would earn $30,000 in revenue, and incur direct costs of $12,000 and absorbed (fixed) overhead of $8,000.

(c)

Consultancy fees $4,000. If the work is not completed, the consultant's contract would be cancelled at a cost of $1,500.

(d)

General overheads of $8,000 would be added to the cost of the additional work.

Assess whether the new customer's offer should be accepted. (The answer is at the end of the chapter)

46

Management Accounting

1.9

The relevant cost of an asset The relevant cost of an asset represents the amount of money that a company would have to receive if it were deprived of the asset in order to be no worse off than it already is. We can call this the deprival value. The deprival value of an asset is best demonstrated by means of an example.

Worked Example: Deprival value of an asset A machine cost $14,000 ten years ago. The machine is expected to generate future revenues of $10,000. Alternatively, the machine could be scrapped for $8,000. An equivalent machine in the same condition would cost $9,000 to buy now. What is the deprival value of the machine?

Solution First, let us think about the relevance of the costs given to us in the question. Cost of machine = $14 000 = past/sunk cost Future revenues = $10 000 = revenue expected to be generated Net realisable value (NRV) = $8 000 = scrap proceeds Replacement cost = $9 000 When calculating the deprival value of an asset, use the following diagram. LOWER OF

REPLACEMENT COST ($9 000)

HIGHER OF ($10 000)

NRV ($8 000)

REVENUES EXPECTED ($10 000)

Therefore, the deprival value of the machine is the lower of the replacement cost and $10 000. The deprival value is therefore $9 000.

LO 2.2

2 Choice of product (product mix) decisions Section overview •

2.1

A limiting factor is a factor which limits the organisation's activities. In a limiting factor situation, contribution will be maximised by earning the biggest possible contribution per unit of limiting factor.

The limiting factor A limiting factor is anything which limits the activity of the entity. This could be the level of demand for its product or it could be one or more scarce resources which limit production to below that level.

2: Decision making and relevant costing

47

Possible limiting factors are: (a)

Sales. There may be a limit to sales demand.

(b)

Labour. There may be a limit to total quantity of labour available or to labour having particular skills.

(c)

Materials. There may be insufficient available materials to produce enough units to satisfy sales demand.

(d)

Manufacturing capacity. There may not be sufficient machine capacity for the production required to meet sales demand.

One of the more common decision-making problems is a situation where there are not enough resources to meet the potential sales demand, and so a decision has to be made about what mix of products to produce, using what resources there are as effectively as possible. A limiting factor could be sales if there is a limit to sales demand but any one of the organisation's resources such as labour, materials and so on, may be insufficient to meet the level of production demanded. It is assumed in limiting factor decision making that management wishes to maximise profit and that profit will be maximised when contribution is maximised, given no change in fixed cost expenditure incurred. Contribution is equal to sales value less variable costs. Contribution will be maximised by earning the biggest possible contribution from each unit of limiting factor. For example, if grade A labour is the limiting factor, contribution will be maximised by earning the biggest contribution from each hour of grade A labour worked. The limiting factor decision therefore involves the determination of the contribution earned by each different product from each unit of the limiting factor.

Worked Example: Profit-maximising production mix AB makes two products, the Ay and the Be. Unit variable costs are as follows: Ay $ 1 6 1 8

Direct materials Direct labour ($3 per hour) Variable overhead

Be $ 3 3 1 7

The sales price per unit is $14 per Ay and $11 per Be. During July 20X2 the available direct labour is limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for Bes. Determine the profit-maximising production mix, assuming that monthly fixed costs are $20,000, and that opening inventories of finished goods and work in progress are nil.

Solution Step 1

Confirm that the limiting factor is something other than sales demand. Labour hours per unit Sales demand Labour hours needed Labour hours available Shortfall

Ays 2 hrs 3 000 units 6 000 hrs

Labour is the limiting factor on production.

48

Management Accounting

Bes 1 hr 5 000 units 5 000 hrs

Total 11 000 hrs 8 000 hrs 3 000 hrs

Step 2

Identify the contribution earned by each product per unit of limiting factor, that is per labour hour worked. Ays Bes $ $ Sales price 14 11 Variable cost 8 7 Unit contribution 6 4 Labour hours per unit

2 hrs

Contribution per labour hour (= unit of limiting factor)

1 hr

$3

$4

Although Ays have a higher unit contribution than Bes ($8 versus $7), two Bes can be made in the time it takes to make one Ay. Because labour is in short supply it is more profitable to make Bes than Ays.

Step 3

Determine the optimum production plan. Sufficient Bes will be made to meet the full sales demand, and the remaining labour hours available will then be used to make Ays. (a)

(b)

Product Bes Ays

Hours required 5 000 6 000 11 000

Sales Demand 5 000 3 000

Product

Units

Bes Ays

5 000 1 500

Hours Needed 5 000 3 000 8 000

Hours available 5 000 3 000(bal) 8 000 Contribution per unit $ 4 6

Less fixed costs Profit

Priority of manufacture 1st 2nd

Total $ 20 000 9 000 29 000 20 000 9 000

In conclusion: (a)

Unit contribution is not the correct way to decide priorities.

(b)

Labour hours are the scarce resource, and therefore contribution per labour hour is the correct way to decide priorities.

(c)

The Be earns $4 contribution per labour hour, and the Ay earns $3 contribution per labour hour. Bes therefore make more profitable use of the scarce resource, and should be manufactured first.

Question 4: Limiting factor 1 The following details relate to three products made by DSF Co:

Selling price Direct materials Direct labour Variable overhead Fixed overhead Profit

V $ per unit 120 30 20 10 20 80

A $ per unit 170 40 30 16 32 118

L $ per unit 176 60 20 20 40 140

40

52

36

All three products use the same direct labour and direct materials, but in different quantities.

2: Decision making and relevant costing

49

In a period when the direct labour used on these products is in short supply, the most profitable and least profitable use of the direct labour is: A B C D

Most profitable L L V A

Least profitable V A A L (The answer is at the end of the chapter)

Question 5: Limiting factor 2 Jam Co makes two products, the K and the L. The K sells for $50 per unit, the L for $70 per unit. The variable cost per unit of the K is $35, that of the L $40. Each unit of K uses 2 kg of raw material. Each unit of L uses 3 kg of raw material. In the forthcoming period the availability of raw material is limited to 2,000 kg. Jam Co 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? A B C D

K 250 units 1 250 units 625 units 750 units

L 625 units 750 units 250 units 1 250 units (The answer is at the end of the chapter)

LO 2.2

3 Make or buy decisions

3.1

Introduction Section overview •

A make or buy problem involves a decision by an organisation about whether it should make a product with its own internal resources, or whether it should pay another organisation to make the product.

One example of a make or buy decision is whether a company should manufacture its own components, or buy the components in 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 organisation has a specialist skill and expertise in the work. Make or buy decisions should certainly not be based exclusively on cost considerations. (a)

How can spare capacity freed up by the 'buy' option be used most profitably?

(b)

Could the decision to use an outside supplier cause an industrial dispute?

(c)

Would the subcontractor be reliable with delivery times and product quality?

(d)

Does the company wish to be flexible and maintain better control over operations by making everything itself?

Section overview •

50

If an organisation 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.

Management Accounting

Where the organisation has a choice about whether to make internally or buy externally, and scarce resources are not a factor, the relevant cost is the differential cost between sourcing internally and sourcing externally. The variable cost of buying is likely to be higher than the variable cost of making in-house, but savings in directly attributable fixed costs by using an outside supplier also need to be considered.

Worked Example: Make or buy An organisation 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 $ $ $ $ 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: Incurred as a direct consequence of making W Incurred as a direct consequence of making X Incurred as a direct consequence of making Y Incurred as a direct consequence of making Z Other fixed costs (committed)

$ 1 000 5 000 6 000 8 000 30 000 50 000

A subcontractor can supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively. Decide whether the organisation should make or buy the components.

Solution (a)

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. Buying will result in some fixed cost savings.

Unit variable cost of making Unit variable cost of buying Annual requirements (units) Extra variable cost of buying (per annum) Fixed costs saved by buying Extra total cost of buying

W $ 14 12 $(2)

X $ 17 21 $4

Y $ 7 10 $3

Z $ 12 14 $2

1 000 (2 000) 1 000 (3 000)

2 000 8 000 5 000 3 000

4 000 12 000 6 000 6 000

3 000 6 000 8 000 (2 000)

(b)

The company would save $3,000 pa by buying component W, where the purchase cost would be less than the marginal cost per unit to make internally, and would save $2,000 pa by subcontracting component Z. This is because of the saving in fixed costs of $8,000.

(c)

Important further considerations would be as follows: (i)

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 buying? Would the company's workforce resent the loss of work to an outside supplier, and might such a decision cause an industrial dispute?

(ii)

Would the supplier be reliable with delivery times, and would they supply components of the same quality as those manufactured internally?

2: Decision making and relevant costing

51

LO 2.2

(iii)

Does the company wish to be flexible and maintain better control over operations by making everything itself?

(iv)

Are the estimates of fixed cost savings reliable? In the case of product W, buying is clearly cheaper than making in-house. In the case of product Z, the decision to buy rather than make would only be financially beneficial if the fixed cost savings of $8,000 could really be 'delivered' by management.

4 Outsourcing Section overview

4.1



An organisation’s value chain refers to the sequence of activities by which inputs are converted into outputs and includes its supply chain and distribution network. Some observers predict that in ten to 20 years, most organisations will have outsourced every part of the value chain except for the few key components that are unique and sources of competitive advantage.



Any activity is a candidate for outsourcing unless the organisation must control it to maintain its competitive position or if the organisation can deliver it on a level comparable with the best organisations in the world.



To minimise the risks associated with outsourcing, organisations generally enter into long-run contracts with their suppliers that specify costs, quality and delivery schedules. They build close partnerships or alliances with a few key suppliers, collaborating with suppliers on design and manufacturing decisions, and building a culture and commitment for quality and timely delivery.

Introduction A significant trend in recent years has been for organisations and government bodies to concentrate on their core competences, what they are really good at, and turn other activities over to specialist contractors. An organisation that earns its profits from, say, manufacturing bicycles, does not also need to have expertise in, say, mass catering or office cleaning. Facilities management companies have grown in response to this.

Definition Outsourcing is the use of external suppliers as a source of finished products, components or services. This is also known as contract manufacturing or sub-contracting.

4.2

52

Reasons for this trend (a)

Frequently an outsourcing decision is made on the grounds that specialist contractors can offer superior quality and efficiency. If a contractor's main business is making a specific component, it can invest in the specialist machinery and labour and knowledge skills needed to make that component. However, this component may be only one of many needed by the contractor's customer, and the complexity of components is now such that attempting to keep internal facilities up to the standard of specialists detracts from the main business of the customer. For example, Dell Computers buys the Pentium chip for its personal computers from Intel because it does not have the know-how and technology to make the chip itself.

(b)

Contracting out manufacturing frees capital and management time that can then be invested in core activities such as market research, product definition, product planning, marketing and sales.

Management Accounting

(c)

4.3

Contractors generally have the capacity and flexibility to start production very quickly to meet sudden variations in demand. In-house facilities may not be able to respond as quickly, because of the need to redirect resources from elsewhere.

Internal and external services In administrative and support functions, too, organisations are increasingly likely to use specialist companies. Decisions such as the following are now common. (a)

Whether the design and development of a new computer system should be entrusted to inhouse data processing staff or whether an external software house should be hired to do the work.

(b)

Whether maintenance and repairs of certain items of equipment should be dealt with by inhouse engineers, or whether a maintenance contract should be entered into with a specialist organisation.

A familiar example is office cleaning being done by contractors.

4.4

Choosing the activities to outsource Any activity is a candidate for outsourcing unless the organisation must control it to maintain its competitive position or if the organisation can deliver it on a level comparable with the best organisations in the world. An organisation’s value chain refers to the sequence of activities by which inputs are converted into outputs and includes its supply chain and distribution network. The concept of a value chain was suggested by Michael Porter (1985) to demonstrate how value for the customer is added to the products or services produced by an organisation. The chain consists of primary activities (such as inbound logistics, operations, outbound logistics, marketing and service) and secondary activities (such as infrastructure, human resources, technology and procurement). Within the value chain, both primary activities and support activities are candidates for outsourcing, although many can be eliminated from the list immediately either because the activity cannot be contracted out or because the organisation must control it to maintain its competitive position. For instance, Coca Cola does not outsource the manufacture of its concentrate to safeguard its formula and retain control of the product. Of the remaining activities, an organisation should carry out only those that it can deliver on a level comparable with the best organisations in the world. If the organisation cannot achieve benchmarked levels of performance, the activity should be outsourced so that the organisation is only concentrating on those core activities that enhance its competitive advantage.

4.5

Advantages and disadvantages The advantages of outsourcing are as follows: (a)

It frees up time of existing staff on the contracted-out activities. It also frees up time spent supporting the contracted-out services by staff not directly involved, for example, supervisory staff, personnel staff.

(b)

It allows the company to take advantage of specialist expertise and equipment rather than investing in these facilities itself and underutilising them.

(c)

It may be cheaper, once time savings and opportunity costs are taken into account.

(d)

It is particularly appropriate when an organisation is attempting to expand in a time of uncertainty as it is a way of gaining all the benefits of extra capacity without having to fund the full cost.

However there are also a number of disadvantages: (a)

Without monitoring there is no guarantee that the service will be performed to the organisation's satisfaction.

(b)

There is a chance that contracting out will be more expensive than providing the service in-house.

2: Decision making and relevant costing

53

(c)

By performing services itself the organisation retains or develops skills that may be needed in the future and will otherwise be lost.

(d)

Contracting out any aspect of information-handling carries with it the risk that commercially sensitive data will get into the wrong hands.

(e)

There may be some ethical considerations, such as exploitation of staff and inadequate pay and working conditions.

(f)

There will almost certainly be opposition from employees and their representatives if contracting out involves redundancies.

To minimise the risks associated with outsourcing, organisations generally enter into long-run contracts with their suppliers that specify costs, quality and delivery schedules. They build close partnerships or alliances with a few key suppliers, collaborating with suppliers on design and manufacturing decisions, and building a culture and commitment for quality and timely delivery.

Case study Albright and Davis ('The Elements of Supply Chain Management') describe the extreme outsourcing approach adopted by Mercedes. Instead of contracting with suppliers for parts, Mercedes outsourced the modules making up a completed M-class to suppliers who purchase the subcomponents and assemble the modules for Mercedes. This has led to a reduction in plant and warehouse space needed, and a dramatic reduction in the number of suppliers used (from 35 to one for the cockpit, for example). At the beginning of the production process Mercedes maintained strict control in terms of quality and cost on both the first tier suppliers, who provide finished modules, and the second tier suppliers, from whom the first tier suppliers purchase parts. As the level of trust grew between Mercedes and the first tier suppliers, Mercedes allowed them to make their own arrangements with second tier suppliers. Benefits of this approach for Mercedes

54

(i)

Reduction in purchasing overhead.

(ii)

Reduction in labour and employee-related costs.

(iii)

Higher level of service from suppliers.

(iv)

Supplier expertise in seeking ways to improve current operations.

(v)

Suppliers working together to continuously improve both their own module and the integrated product.

Management Accounting

Key chapter points •

Relevant costs are future cash flows arising as a direct consequence of a decision: – – –



Relevant costs are future costs. Relevant costs are cashflows. Relevant costs are incremental costs.

Relevant costs are also differential costs and opportunity costs: –

Differential cost is the difference in total cost between alternatives.



An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in preference to an alternative.



A sunk cost is a past cost which is not directly relevant in decision making.



In general, variable costs will be relevant costs and fixed costs will be irrelevant to a decision.



The relevant cost of an asset represents the amount of money that a company would have to receive if it were deprived of an asset in order to be no worse off than it already is. We can call this the deprival value.



A limiting factor is a factor which limits the organisation's activities. In a limiting factor situation, contribution will be maximised by earning the biggest possible contribution per unit of limiting factor.



If an organisation 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.



Some observers predict that in ten to 20 years, most organisations will have outsourced every part of the value chain except for the few key components that are unique and sources of competitive advantage.



Any activity is a candidate for outsourcing unless the organisation must control it to maintain its competitive position or if the organisation can deliver it on a level comparable with the best organisations in the world.



To minimise the risks associated with outsourcing, organisations generally enter into long-run contracts with their suppliers that specify costs, quality and delivery schedules. They build close partnerships or alliances with a few key suppliers, collaborating with suppliers on design and manufacturing decisions, and building a culture and commitment for quality and timely delivery.

2: Decision making and relevant costing

55

Quick revision questions 1

You are currently employed as a management accountant in an insurance company, but you are contemplating starting your own business. In considering whether or not to take this action your current salary level would be: A B C D

2

a sunk cost an irrelevant cost an incremental cost an opportunity cost

Your company regularly uses material X and currently has in inventory 500 kgs for which it paid $1 500 two weeks ago. If this were to be sold as raw material, it could be sold today for $2.00 per kg. You are aware that the material can be bought on the open market for $3.25 per kg, but it must be purchased in quantities of 1,000 kgs. You have been asked to determine the relevant cost of 600 kgs of material X to be used in a job for a customer. The relevant cost of the 600 kgs is: A B C D

3

$1 325 $1 825 $1 950 $3 250

A company is considering its option with regard to a machine which cost $60 000 four years ago. If sold, the machine would generate scrap proceeds of $75 000. If kept, this machine would generate net income of $90 000. The current replacement cost for this machine is $105 000. What is the relevant cost of the machine? A B C D

4

$105 000 $90 000 $75 000 $60 000

A company manufactures and sells two products (X and Y) both of which utilise the same skilled labour. For the coming period, the supply of skilled labour is limited to 2,000 hours. Data relating to each product are as follows: Product Selling price per unit Variable cost per unit Skilled labour hours per unit Maximum demand (units) per period

X $20 $12 2 800

Y $40 $30 4 400

In order to maximise profit in the coming period, how many units of each product should the company manufacture and sell? A B C D 5

In the short-term decision-making context, which one of the following would be a relevant cost? A B C D

56

200 units of X and 400 units of Y 400 units of X and 300 units of Y 600 units of X and 200 units of Y 800 units of X and 100 units of Y specific development costs already incurred the cost of special material which will be purchased the original cost of raw materials currently in inventory which will be used on the project the cost of a report that has been carried out but not yet paid for

Management Accounting

6

A company manufactures and sells a single product. The variable cost of the product is $2.50 per unit and all production each month is sold at a price of $3.70 per unit. A potential new customer has offered to buy 6,000 units per month at a price of $2.95 per unit. The company has sufficient spare capacity to produce this quantity. If the new business is accepted, sales to existing customers are expected to fall by two units for every 15 units sold to the new customer. What would be the overall increase in monthly profit which would result from accepting the new business? A B C D

7

$1 740 $2 220 $2 340 $2 700

A company is evaluating a project that requires two types of material (T and V). Data relating to the material requirements are as follows: Material type

T V

Quantity needed for project kg 500 400

Quantity currently in inventory kg 100 200

Original cost of quantity in inventory $/kg 40 55

Current purchase price $/kg 45 52

Current resale price $/kg 44 40

Material T is regularly used by the company in normal production. Material V is no longer in use by the company and has no alternative use within the business. What is the total relevant cost of materials for the project? A B C D 8

$40 400 $40 900 $43 400 $43 900

A machine owned by a company has been idle for some months but could now be used on a one year contract which is under consideration. The net book value of the machine is $1 000. If not used on this contract, the machine could be sold now for a net amount of $1 200. After use on the contract, the machine would have no saleable value and the cost of disposing of it in one year's time would be $800. What is the total relevant cost of the machine to the contract? A B C D

9

$400 $800 $1 200 $2 000

A company has just secured a new contract which requires 500 hours of labour. There are 400 hours of spare labour capacity. The remaining hours could be worked as overtime at time and a half or labour could be diverted from the production of product X. Product X currently earns a contribution of $4 in two labour hours and direct labour is currently paid at a rate of $12 per normal hour. What is the relevant cost of labour for the contract? A B C D

$200 $1 200 $1 400 $1 800

2: Decision making and relevant costing

57

10

A company uses limiting factor analysis to calculate an optimal production plan given a scarce resource. The following applies to the three products of the company: Product Direct materials (at $6/kg) Direct labour (at $10/hour) Variable overheads ($2/hour) Maximum demand (units) Optimal production plan

I $ 36 40 8 84

II $ 24 25 5 54

III $ 15 10 2 27

2 000 2 000

4 000 1 500

4 000 4 000

How many kg of material were available for use in production? A B C D

58

15,750 kg 28,000 kg 30,000 kg 38,000 kg

Management Accounting

Answers to quick revision questions 1

D

An opportunity cost is the value of the benefit sacrificed when one course of action is chosen, in preference to another. A sunk cost (option A) is a past cost which is not relevant to the decision. An incremental cost (option C) is an extra cost to be incurred in the future as the result of a decision taken now. The salary cost forgone is certainly relevant to the decision therefore option B is not correct.

2

C

The material is in regular use and so 1,000 kgs will be purchased. 500 kgs of this will replace the 500 kg in inventory that is used, 100 kgs will be purchased and used and the remaining 400 kgs will be kept in inventory until needed. The relevant cost is therefore 600 × $3.25 = $1,950. If you selected option A you valued the inventory items at their resale price. However, the items are in regular use therefore they would not be resold. Option B values the inventory items at their original purchase price, but this is a sunk or past cost. Option D is the cost of the 1,000 kgs that must be purchased, but since the material is in regular use the excess can be kept in inventory until needed.

3

B

When calculating the relevant cost of an asset, use the following diagram. LOWER OF = $90 000

REPLACEMENT COST ($105 000)

HIGHER OF = ($90 000)

NRV ($75 000)

4

REVENUES EXPECTED ($90 000)

D

Product Selling price per unit Variable cost per unit Contribution per unit Contribution per skilled labour hour required Ranking

X $ 20 12 8

Y $ 40 30 10

4

(÷ 4) 2.5 2nd

1st

Manufacture and sell: 800 units of Product X (using 800 × 2 hours = 1,600 hours); 100 units of Product Y (using the remaining 400 hours* (2,000 – 1,600). * 400 hours ÷ 4 hours skilled labour per unit = 100 units. 5

B

The cost of special material which will be purchased is a relevant cost in a short-term decision-making context.

2: Decision making and relevant costing

59

6

A

$ 1.20 0.45 $ 2 700 (960) 1 740

Contribution per unit – current $(3.70 – 2.50) Contribution per unit – revised $(2.95 – 2.50) Total contribution – new business (6,000 × $0.45) Lost contribution – current business (6,000/15 × 2 × $1.20) Increase in monthly profit 7

B

Total relevant cost of materials

$

Material T 500kg × $45 Material V 200kg × $40 200kg × $52 Total relevant cost of materials 8

22 500 8 000 10 400 40 900

D

$ 1 200 800 2 000

Opportunity cost (net realisable value) Cost of disposal in one year's time Total relevant cost of machine 9

C

500 400 100 (1)

Hours are required Hours are available as spare labour capacity Hours are required but not available as spare capacity If the 100 hours are from worked overtime, then the cost = 100 hours ×1.5 × $12 = $1,800

(2)

If labour is diverted from the production of Product X, then the cost = 100 hours × $12 + (100/2 × $4) = $1 200 + $200 = $1 400

Option (2) is cheaper and therefore the relevant cost of labour for the contract is $1 400. 10

B Optimal production plan (units) Kgs required per unit Kgs material available

60

Management Accounting

I 2 000 6 12 000

II 1 500 4 6 000

III 4 000 2.5 10 000

Total 28 000

Answers to chapter questions 1

Material A is not yet owned. It would have to be bought in full at the replacement cost of $6 per unit. Material B is used regularly by the company. There are existing inventories (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 $5 per unit. 1,000 units of material C are needed and 700 are already in inventory. If used for the contract, a further 300 units must be bought at $4 each. The existing inventories of 700 will not be replaced. If they are used for the contract, they could not be sold at $2.50 each. The realisable value of these 700 units is an opportunity cost of sales revenue forgone. The required units of material D are already in inventory 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 inventories for $6 per unit ($1,200 in total) or avoid other purchases (of material E), which would cost 300 × $5 = $1 500. Since substitution for E is more beneficial, $1 500 is the opportunity cost. Summary of relevant costs

$ 6 000 5 000 2 950 1 500 15 450

Material A (1 000 × $6) Material B (1 000 × $5) Material C (300 × $4) plus (700 × $2.50) Material D Total 2

D

The material is in regular use and so 200 kg will be purchased. The relevant cost is therefore 200 × $4 = $800.

3

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 $50,000 and revenue received of $15,000 are not relevant and should be ignored. 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 – $2,000. Labour costs

$ 8 000

Labour costs required to complete work Opportunity costs: contribution forgone by losing other work $(30 000 – 12 000) Relevant cost of labour

18 000 26 000

The incremental cost of consultancy from completing the work is $2,500. Cost of completing work Cost of cancelling contract Incremental cost of completing work

$ 4 000 1 500 2 500

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.

2: Decision making and relevant costing

61

Relevant costs may be summarised as follows. Revenue from completing work Relevant costs Materials: opportunity cost Labour: basic pay opportunity cost Incremental cost of consultant

$ 2 000 8 000 18 000 2 500

30 500 3 500

Extra profit to be earned by accepting the order 4

$ 34 000

B As direct labour is in short supply the contribution per $ of direct labour is used to rank the products:

Selling price per unit Variable cost per unit (materials, labour and variable overhead) Contribution per unit Labour cost per unit Contribution per $ of labour Ranking 5

A $ 170 86

L $ 176 100

60

84

76

$20

$30

$20

$3

$2.80

$3.80

2

3

1

C Contribution per unit Contribution per unit of limiting factor Ranking Production plan Contracted supply of K (500 x 2 kg) Meet demand for L (250 x 3 kg) Remainder of resource for K (125 x 2 kg)

62

V $ 120 60

Management Accounting

K $15 $15/2 = $7.50 2

L $30 $30/3 = $10 1 Raw material used kg 1 000 750 250 2 000

Chapter 3

Budgeting Learning objectives

Reference

Budgeting

LO3

Identify and analyse the human behavioural challenges to the budgeting process in organisations

LO3.1

Explain the nature of budgets and the reasons that organisations use budgets

LO3.2

Prepare an operations budget

LO3.3

Prepare a cash budget

LO3.4

Topic list

1 2 3 4 5 6 7 8 9 10

The purposes and benefits of a budget Steps in the preparation of a budget Preparing functional operating budgets Cash budgets Budgeted financial statements Flexible budgets Cost estimation Incremental and zero-based budgeting systems Budgeting, performance and motivation Budgeting and quality 63

Introduction This chapter begins by explaining the reasons why an organisation might prepare a budget and goes on to detail the steps in the preparation of a budget. The method of preparing, and the relationship between the various functional budgets is then set out. The chapter also considers the construction of cash budgets and budgeted statement of comprehensive income and statement of financial position, which make up what is known as a master budget. Two different budgeting systems are described: the more traditional incremental approach, and a more recent development – zero-based budgeting (ZBB). The difference between these two approaches is that the first builds on the previous year's budgets, whereas ZBB begins from scratch each time the budget is prepared. Finally, we will look at the way in which budgets can affect the behaviour and performance of employees, for better and for worse.

64

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is a budget?

(Section 1)

2

What are the functions of the budget committee?

(Section 2.1)

3

Why is the principal budget factor important?

(Section 2.5)

4

What is an appropriate management action when an organisation has a short-term surplus?

(Section 4.1)

5

Explain the difference between a fixed and a flexible budget.

(Section 6)

6

Explain the difference between incremental and zero-based budgeting systems.

(Section 8)

7

What are four types of performance standard?

(Section 9.2)

8

What are the advantages of participative budgets?

(Section 9.5)

9

What are the disadvantages of participative budgets?

(Section 9.5)

10

What is the aim of Total Quality Management (TQM)?

(Section 10.1)

11

Explain the link between TQM and budgeting

(Section 10.2)

3: Budgeting

65

1 The purposes and benefits of a budget Section overview •

The main purpose and benefit of using a budget is to assist with the achievement of the organisation's objectives.

Definition LO 3.2

1.1

A budget is a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities and cash flows.

Purposes and benefits The main purpose and benefit of using a budget is: •

To assist with the achievement of the organisation's objectives The organisation's objectives are quantified and drawn up as targets to be achieved within the timescale of the budget.

Using a budget has seven further purposes/benefits, all of which contribute to the main purpose, listed above: •

To compel planning Planning forces management to look ahead, to set out detailed plans for achieving targets for each department, operation and (ideally) each manager. It should also help to anticipate problems.



To communicate ideas and plans A formal system is necessary to ensure that each person involved is aware of what he or she is to do. Communication may be one-way, where managers give instructions to staff, or there might be a two-way dialogue where the staffs feedback their suggestions to management which may be incorporated into the formal plan.



To co-ordinate activities The activities of different departments need to be co-ordinated to ensure maximum integration of effort towards common organisation goals. For example, the purchasing department should base its budget on production requirements and the production budget should be based on sales expectations.



To provide a framework for responsibility accounting Budgets require that managers are made responsible for the achievement of budget targets for the operations under their control.



To establish a system of control Control over actual performance is provided by the comparisons of actual results against the budget. Departures from budget can then be investigated and the reasons for the departures can be found and acted on.



Motivate employees to improve their performance The interest and commitment of employees can be retained if there is a system which lets them know how well or badly they are performing. The identification of controllable reasons for departures from budget with managers responsible provides an incentive for improving future performance.



Allocation of resources Allocation of scarce resources among competing uses.

66

Management Accounting

The remainder of the chapter explain further how budgets are used to achieve these benefits. We will begin by looking at the planning and control aspects of budgeting.

1.2

Budgets in the context of planning and control The diagram below represents the planning and control cycle. Planning involves making choices between alternatives and is primarily a decision-making activity. The control process involves measuring and correcting actual performance to ensure that the strategies that are chosen and the plans for implementing them are carried out. The link between these two is the budget.

Step 1

Identify objectives Objectives establish the direction in which the management of the organisation wish it to be heading. Typical objectives include the following: • • •

To maximise profits. To increase market share. To produce a better quality product than anyone else.

Objectives answer the question: 'where do we want to be?'.

Step 2

Identify potential strategies Once an organisation has decided 'where it wants to be', the next step is to identify a range of possible courses of action or strategies that might enable the organisation to get there. The organisation must therefore carry out an information-gathering exercise to ensure that it has a full understanding of where it is now. This is known as a position audit or strategic analysis. It involves looking both inwards and outwards. •

The organisation must gather information from all of its internal parts to find out what resources it possesses: what its manufacturing capability is, what is the state of its technical know-how, how well it is able to market itself, how much cash it has in the bank, how much it could borrow, and any other relevant data available from its own records.



It must also gather external information so that it can assess its position in the environment. Just as it has assessed its own strengths and weaknesses, it must do likewise for its competitors (threats). Its current market must be analysed. It must also analyse any other markets that it is intending to enter, to identify possible new

3: Budgeting

67

opportunities. This process is known as SWOT analysis: Strengths, Weaknesses, Opportunities and Threats. The state of the world economy must be considered. Is it in recession or is it booming? What is likely to happen in the future and over what timescale? This is known as assessing the business cycle. Having carried out a strategic analysis, alternative strategies can be identified.

Step 3

Evaluate strategies The strategies must then be evaluated in terms of suitability, feasibility and acceptability in the context of the strategic analysis. Management should select those strategies that have the greatest potential for achieving the organisation's objectives. One strategy may be chosen or several.

Step 4

Choose alternative courses of action The next step in the process is to collect the chosen strategies together and co-ordinate them into a long-term plan, commonly expressed in financial terms. Typically a long-term financial plan would show the following (not in any particular order): • • • • •

Step 5

Projected cash flows. Projected long-term profits. Capital expenditure plans. Statements of financial position forecasts. A description of the long-term objectives and strategies in words.

Implement the long-term plan The long-term plan should then be broken down into smaller parts. It is unlikely that the different parts will fall conveniently into successive time periods. For example Strategy A may take two and a half years, while strategy B may take five months, but not start until year three of the plan. It is usual, however, to break down the plan as a whole into equal time periods (usually one year). The resulting short-term plan is the budget.

Steps 6 and 7

Measure actual results and compare with plan. Respond to divergences from plan At the end of the year actual results should be compared with those expected under the long-term plan. The long-term plan should be reviewed in the light of this comparison and the progress that has been made towards achieving the organisation's objectives should be assessed. Management can also consider the feasibility of achieving the objectives in the light of circumstances which have arisen during the year. If the plans are now no longer attainable then alternative strategies must be considered for achieving the organisation's objectives, as indicated by the feedback loop (the arrowed line) linking step 7 to step 2. This aspect of control is carried out by senior management, normally on an annual basis. The control of day-to-day operations is exercised by lower-level managers. At frequent intervals they must be provided with performance reports which consist of detailed comparisons of actual results and budgeted results. Performance reports provide feedback information by comparing planned and actual outcomes. Such reports should highlight those activities that do not conform to plan, so that managers can devote their scarce time to focusing on these items. Effective control requires that corrective action is taken so that actual outcomes conform to planned outcomes, as indicated by the feedback loop linking steps 5 and 7. Isolating past inefficiencies and the reasons for them will enable managers to take action that will avoid the same inefficiencies being repeated in the future. The system that provides reports that compare actual performance with budget figures and holds managers responsible is known as responsibility accounting. We will return to this topic below.

68

Management Accounting

2 Steps in the preparation of a budget Section overview •

Towards the end of the strategy planning stage, the budget will be prepared. While the mechanics of budget preparation is the focus of your immediate study, it is important to appreciate how important budgets are in co-ordination and control.



The co-ordination and administration of budgets is usually the responsibility of the budget committee.

You will see how the activities of all aspects of the business are brought together in the budget.

2.1

Budget committee The co-ordination and administration of budgets is usually the responsibility of a budget committee, consisting of senior executives. The budget committee is assisted by a budget officer who is usually an accountant. Every part of the organisation should be represented on the committee, so there should be a representative from sales, production, marketing and so on. Functions of the budget committee include the following: • • • • • •

2.2

Co-ordination and allocation of responsibility for the preparation of budgets. Issuing of the budget manual. Timetabling. Provision of information to assist in the preparation of budgets. Communication of final budgets to the appropriate managers. Monitoring the budgeting and planning process by comparing actual and budgeted results.

Responsibility for budgets The responsibility for preparing the budgets should, ideally, lie with the managers who are responsible for implementing them. For example, the preparation of particular budgets might be allocated as follows: • • •

2.3

The sales manager should draft the sales budget and the selling overhead cost centre budgets. The purchasing manager should draft the material purchases budget. The production manager should draft the direct production cost budgets.

The budget manual Definition The budget manual is a collection of instructions governing the responsibilities of persons and the procedures, forms and records relating to the preparation and use of budgetary data.

A budget manual may contain the following: (a)

An explanation of the objectives of the budgetary process including the following: • • •

(b)

Organisational structures, including the following: • •

(c)

The purpose of budgetary planning and control. The objectives of the various stages of the budgetary process. The importance of budgets in the long-term planning and administration of the organisation.

An organisation chart. A list of individuals holding budget responsibilities.

An outline of the principal budgets and the relationship between them.

3: Budgeting

69

(d)

Administrative details of budget preparation such as the following: • • •

(e)

Procedural matters such as the following: • • • •

2.4

Membership, and terms of reference of the budget committee. The sequence in which budgets are to be prepared. A timetable.

Sample forms and instructions for their completion. (Note: many budgets are now prepared in budget models, such as spreadsheet models). Sample reports. Account codes or a chart of accounts. The name of the budget officer to whom enquiries must be directed.

Steps in budget preparation The procedures for preparing a budget will differ from organisation to organisation but the steps described below will be indicative of the steps followed by many organisations. The preparation of a budget may take weeks or months and the budget committee may meet several times before the master budget (budgeted statement of comprehensive income and budgeted statement of financial position) is finally agreed. Functional budgets (sales budgets, production budgets, direct labour budgets and so on), which are amalgamated into the master budget, may need to be amended many times over as a consequence of discussions between departments, changes in market conditions and so on during the course of budget preparation.

2.5

Identifying the principal budget factor Definition The principal budget factor is the factor which limits the activities of an organisation.

The first task in the budgetary process is to identify the principal budget factor. This is also known as the key budget factor or limiting budget factor. The principal budget factor is usually sales demand. A company is usually restricted from making and selling more of its products because there would be no sales demand for the increased output at a price which would be acceptable/profitable to the company. The principal budget factor may also be machine capacity, distribution and selling resources, the availability of key raw materials or the availability of cash. Once the principal budget factor is defined then the remainder of the budgets can be prepared. For example, if sales are the principal budget factor then the production manager can only prepare the production budget after the sales budget is complete. A useful assumption for preparing the first draft of the functional budgets is to assume that sales demand is the principal budget factor. If it then becomes apparent that a scarce resource is the principal budget factor, the functional budgets can be revised and new drafts prepared. The stages involved in the preparation of a budget with sales as the limiting factor can be summarised as follows.

70

(a)

The sales budget is prepared in units of product and sales value. The finished goods inventory budget can be prepared at the same time. This budget decides the planned increase or decrease in finished goods inventory levels.

(b)

With the information from the sales and inventory budgets, the production budget can be prepared. This is, in effect, the sales budget in units plus (or minus) the increase (or decrease) in finished goods inventory. The production budget will be stated in terms of units.

(c)

This leads on logically to budgeting the resources for production. This involves preparing a materials usage budget, machine usage budget and a labour budget.

Management Accounting

(d)

In addition to the materials usage budget, a materials inventory budget will be prepared, to decide the planned increase or decrease in the level of inventories held. Once the raw materials usage requirements and the raw materials inventory budget are known, the purchasing department can prepare a raw materials purchases budget in quantities and value for each type of material purchased.

(e)

During the preparation of the sales and production budgets, the managers of the cost centres of the organisation will prepare their draft budgets for the department overhead costs. Such overheads will include maintenance, stores, administration, selling and research and development.

(f)

From the above information a budgeted statement of comprehensive income can be produced.

(g)

In addition several other budgets must be prepared in order to arrive at the budgeted statement of financial position. These are the capital expenditure budget (for non-current assets), the working capital budget (for budgeted increases or decreases in the level of receivables and payables as well as inventories), and a cash budget.

3 Preparing functional operating budgets Section overview •

A functional (or departmental) budget is a budget forecasting income and expenditure for a particular department or process. It could be a production budget, a sales budget or purchasing budget depending on the function and the nature of its activities.

Worked Example: Preparing a materials purchases budget LO 3.3

ECO Ltd manufactures two products, S and T, which use the same raw materials, D and E. One unit of S uses 3 litres of D and 4 kilograms of E. One unit of T uses 5 litres of D and 2 kilograms of E. A litre of D is expected to cost $3 and a kilogram of E $7. The sales budget for 20X2 comprises 8,000 units of S and 6,000 units of T; finished goods in stock at 1 January 20X2 are 1 500 units of S and 300 units of T, and the company plans to hold inventories of 600 units of each product at 31 December 20X2. Inventories of raw material are 6,000 litres of D and 2,800 kilograms of E at 1 January and the company plans to hold 5,000 litres and 3,500 kilograms respectively at 31 December 20X2. The warehouse and stores managers have suggested that a provision should be made for damages and deterioration of items held in store, as follows: Product S: Product T: Material D: Material E:

loss of 50 units loss of 100 units loss of 500 litres loss of 200 kilograms

Prepare a material purchases budget for the year 20X2.

3: Budgeting

71

Solution To calculate material purchases requirements first it is necessary to calculate the material usage requirements. That in turn depends on calculating the budgeted production volumes.

Production required To meet sales demand To provide for inventory loss For closing inventory Less inventory already in hand Budgeted production volume

Usage requirements To produce 7 150 units of S To produce 6 400 units of T To provide for inventory loss For closing inventory Less inventory already in hand Budgeted material purchases Unit cost Cost of material purchases Total cost of material purchases

Product S Units

Product T Units

8 000 50 600 8 650 1 500 7 150

6 000 100 600 6 700 300 6 400

Material D Litres

Material E Kgs

21 450 32 000 500 5 000 58 950 6 000 52 950

28 600 12 800 200 3 500 45 100 2 800 42 300

$3

$7

$158 850

$296 100 $454 950

The basics of the preparation of each functional budget are similar to the above.

4 Cash budgets Section overview •

The cash budget is one of the most important planning tools that an organisation can use. It shows the cash effect of all plans made within the budgetary process.

Definition A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals.

Worked Example: Cash position LO 3.4

72

In December 20X2 an accounts department might wish to estimate the cash position of the business for the following months, January to March 20X3. A cash budget might be drawn up in the following format: Jan Feb Mar $ $ $ Estimated cash receipts From credit customers 14 000 16 500 17 000 From cash sales 3 000 4 000 4 500 Proceeds on disposal of non-current assets 2 200 Total cash receipts 17 000 21 500 22 700 Estimated cash payments To suppliers of goods 8 000 7 800 10 500 To employees (wages) 3 000 3 500 3 500

Management Accounting

Purchase of non-current assets Rent and rates Other overheads Repayment of loan

Jan $

Feb $ 16 000

1 200 2 500 14 700

1 200

1 000 1 200

28 500

16 200

2 300 1 200 3 500

(5 800) 3 500 (2 300)

5 300 (2 300) 3 000

Net surplus/(deficit) for month Opening cash balance Closing cash balance

Mar $

In the example above, where the figures are purely for illustration, the accounts department has calculated that the cash balance at the beginning of the budget period, 1 January, will be $1 200. Estimates have been made of the cash which is likely to be received by the business (from cash and credit sales, and from a planned disposal of non-current assets in February). Similar estimates have been made of cash due to be paid out by the business - payments to suppliers and employees, payments for rent, rates and other overheads, payment for a planned purchase of non-current assets in February and a loan repayment due in January. From these estimates it is a simple step to calculate the excess of cash receipts over cash payments in each month. In some months cash payments may exceed cash receipts and there will be a deficit for the month; this occurs during February in the above example because of the large investment in non-current assets in that month. The last part of the cash budget above shows how the business's estimated cash balance can then be rolled along from month to month. Starting with the opening balance of $1 200 at 1 January a cash surplus of $2 300 is generated in January. This leads to a closing January balance of $3 500 which becomes the opening balance for February. The deficit of $5 800 in February throws the business's cash position into overdraft and the overdrawn balance of $2 300 becomes the opening balance for March. Finally, the healthy cash surplus of $5 300 in March leaves the business with a favourable cash position of $3 000 at the end of the budget period.

4.1

The usefulness of cash budgets The cash budget is one of the most important planning tools that an organisation can use. It shows the cash effect of all plans made within the budgetary process and hence its preparation can lead to a modification of budgets if it shows that there are insufficient cash resources to finance the planned operations. It can also give management an indication of potential problems that could arise and allows them the opportunity to take action to avoid such problems. A cash budget can show four positions. Management will need to take appropriate action depending on the potential position. This is part of the process of the management of working capital. Cash position

Appropriate management action

Short-term surplus

• • •

Pay creditors early to obtain discount. Attempt to increase sales by increasing debtors and inventories. Make short-term investments.

Short-term deficit

• • •

Increase creditors. Reduce debtors. Arrange an overdraft.

Long-term surplus

• • • •

Make long-term investments. Expand. Diversify. Replace/update non-current assets.

• Pay dividends, repay debt capital, buy back and cancel shares Long-term deficit

• •

Raise long-term finance: borrow or raise equity finance through a new share issue. Consider shutdown/disinvestments opportunities.

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Worked Example: Peter Blair – cash budget Peter Blair has worked for some years as a sales representative, but has recently been made redundant. He intends to start up in business on his own account, using $15,000 which he currently has invested with a building society. Peter maintains a bank account showing a small credit balance, and he plans to approach his bank for the necessary additional finance. Peter asks you for advice and provides the following additional information: (a)

Arrangements have been made to purchase non-current assets costing $8,000. These will be paid for at the end of September 20X3 and are expected to have a five-year life, at the end of which they will possess a nil residual value.

(b)

Inventories costing $5,000 will be acquired on 28 September and subsequent monthly purchases will be at a level sufficient to replace forecast sales for the month.

(c)

Forecast monthly sales are $3,000 for October, $6,000 for November and December, and $10,500 from January 20X4 onwards.

(d)

Selling price is fixed at the cost of inventory plus 50%.

(e)

Two months' credit will be allowed to customers but only one month's credit will be received from suppliers of inventory.

(f)

Running expenses, including rent but excluding depreciation of non-current assets, are estimated at $1,600 per month.

(g)

Peter intends to make monthly cash drawings of $1,000.

Prepare a cash budget for the six months to 31 March 20X4.

Solution The opening cash balance at 1 October will consist of Peter's initial $15,000 less the $8,000 expended on non-current assets purchased in September. In other words, the opening balance is $7,000. Cash receipts from credit customers arise two months after the relevant sales. Payments to suppliers are a little more tricky. We are told that cost of sales is 100/150 × sales. Therefore for October cost of sales is 100/150 × $3,000 = $2,000. These goods will be purchased in October but not paid for until November. Similar calculations can be made for later months. The initial inventory of $5,000 is purchased in September and consequently paid for in October. Depreciation is not a cash flow and so is not included in a cash budget. The cash budget can now be constructed. CASH BUDGET FOR THE SIX MONTHS ENDING 31 MARCH 20X4

Payments Suppliers Running expenses Drawings Receipts Debtors Surplus/(shortfall) Opening balance Closing balance

74

Management Accounting

Oct $

Nov $

Dec $

Jan $

Feb $

Mar $

5 000 1 600 1 000 7 600

2 000 1 600 1 000 4 600

4 000 1 600 1 000 6 600

4 000 1 600 1 000 6 600

7 000 1 600 1 000 9 600

7 000 1 600 1 000 9 600

– (7 600) 7 000 (600)

– (4 600) (600) (5 200)

3 000 (3 600) (5 200) (8 800)

6 000 (600) (8 800) (9 400)

6 000 (3 600) (9 400) (13 000)

10 500 900 (13 000) (12 100)

Question 1: Your organisation You are presented with the budgeted data shown in the table below (Annex A). This will be used to prepare a budget for the period January to June 20X5. The data has been extracted from the other functional budgets that have been prepared. You are also told the following. (a) (b) (c) (d) (d) (e) (f) (g)

Sales are 40% cash, 60% credit. Credit sales are paid two months after the month of sale. Payments for purchases are made in the month following purchase. 75% of wages are paid in the current month and 25% the following month. Depreciation charges were $2,000 in each month in November and December 20X4. Depreciation increases by $500 in each month from January 20X5 and by another $500 per month from April 20X5 (when the new capital expenditure occurs). All other overheads are cash expenditure items. Cash expenditure items of overhead are paid the month after they are incurred. Dividends are paid three months after they are declared. Capital expenditure is paid two months after it is incurred. The opening cash balance on 1 January 20X5 is $15 000.

The managing director is pleased with these figures as they show sales will have increased by more than 100% in the period under review. In order to achieve this he has arranged a bank overdraft with a ceiling of $50,000 to accommodate the increased inventory levels and wage bill for overtime worked. Nov X4 $ 80 000 40 000 10 000 10 000

Sales Purchases Wages Overheads Dividends Capital expenditure

Dec X4 $ 100 000 60 000 12 000 10 000 20 000

Jan X5 $ 110 000 80 000 16 000 15 500

Annex A Feb X5 Mar X5 $ $ 130 000 140 000 90 000 110 000 20 000 24 000 15 500 15 500

30 000

Apr X5 $ 150 000 130 000 28 000 20 000

May X5 $ 160 000 140 000 32 000 20 000

Jun X5 $ 180 000 150 000 36 000 20 000

40 000

Requirements: (a)

(b)

(c)

How much cash will be received from sales in February 20X5? A

$100 000

B

$112 000

C

$118 000

D

$130 000

What is the budgeted cash balance at the end of January 20X5? A

($6 000) overdraft

B

$9 000

C

$19 000

D

$24 000

What is the total budgeted cash spending on overheads in the six month period January – June 20X5? A

$81 000

B

$87 000

C

$95 000

D

$99 000

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75

(d)

(e)

(f)

What is the total budgeted receipts from sales in the six month period January to June 20X5? A

$666 000

B

$742 000

C

$774 000

D

$822 000

What are the total budgeted payments for purchases in the six month period January to June 20X5? A

$610 000

B

$690 000

C

$700 000

D

$790 000

If the cash budget indicates a large bank overdraft at the end of June, which one of the following measures might be the most practical for reducing the budgeted cash deficit? A

Take on extra staff to reduce the amount of overtime working.

B

Persuade staff to work at a lower rate in return for an annual bonus or a profit-sharing agreement

C

Postpone the capital expenditure

D

Increase the speed of debt collection (The answers are at the end of the chapter)

4.2

Other working capital budgets It may also be useful for a business monitoring its cash situation to look at other components of working capital: inventory, receivables and payables. Inventory usually gets detailed consideration when the functional budgets are prepared. Receivables budgets and payables budgets are very straightforward when patterns of payment to suppliers and from customers are considered for the purpose of preparing the cash budget.

5 Budgeted financial statements Section overview •

As well as wishing to forecast its cash position, a business might want to estimate its profitability and its financial position for a coming period. This would involve the preparation of a budgeted statement of comprehensive income and statement of financial position, both of which form the master budget.

Worked Example: Budgeted financial statements Using the information in the example above involving Peter Blair (section 4.1) you are required to prepare Peter Blair's budgeted statement of comprehensive income for the six months ending on 31 March 20X4 and a budgeted statement of financial position as at that date.

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Management Accounting

Solution The statement of comprehensive income is straightforward. The first figure is sales, which can be computed very easily from the information in paragraph (c) in the original question. It is sufficient to add up the monthly sales figures given there; for this statement there is no need to worry about any closing receivables. Similarly, cost of sales is calculated directly from the information on gross margin contained in the previous example. INCOME STATEMENT FORECAST TRADING AND COMPREHENSIVE INCOME STATEMENT FOR THE SIX MONTHS ENDING 31 MARCH 20X4 $ Sales (3 000 + (2 × 6 000) + (3 × 10 500)) Cost of sales (100/150 × $46 500) Gross profit Expenses Running expenses (6 × $1 600) Depreciation ($8 000 × 20% × 6/12)

9 600 800 10 400 5 100

Net profit (a) (b) (c) (d)

$ 46 500 31 000 15 500

Inventory will comprise the initial purchases of $5 000. Receivables at the end of March will comprise sales made in February and March, not paid until April and May respectively. Payables at the end of March will comprise purchases made in March, not paid for until April. The bank overdraft is the closing cash figure computed in the cash budget.

FORECAST STATEMENT OF FINANCIAL POSITION AT 31 MARCH 20X4 Non-current assets $(8 000 – 800) Current assets Inventories Receivables (2 × $10 500) Current liabilities Bank overdraft Trade payables (March purchases) Net current assets Total assets Proprietor's interest Capital introduced Profit for the period Less drawings Retained loss Total equity

$

$ 7 200

5 000 21 000 26 000 12 100 7 000 19 100 6 900 14 100 15 000 5 100 6 000 (900) 14 100

Budget questions are often accompanied by a large amount of sometimes confusing detail. This should not blind you to the fact that many figures can be entered very simply from the logic of the trading situation described. For example, in the case of Peter Blair you might feel tempted to begin a T-account to compute the figure for closing receivables. This kind of working is rarely necessary, since you are told that credit customers take two months to pay. Closing receivables will equal total credit sales in the last two months of the period. Similarly, you may be given a simple statement that a business pays rates at $1,500 a year, followed by a lot of detail to enable you to calculate a prepayment at the beginning and end of the year. If you are preparing a budgeted comprehensive income statement for the year do not lose sight of the fact that the rates expense can be entered as $1,500 without any calculation at all.

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77

6 Flexible budgets Section overview •

A flexible budget is a budget which is designed to change as volume of activity changes.

Definitions A fixed (static) budget is a budget which is set for a single activity level. A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.

Master budgets are based on planned volumes of production and sales but do not include any provision for the event that actual volumes may differ from the budget. In this sense they may be described as fixed (static) budgets. A flexible budget has two advantages: (a)

At the planning stage, it may be helpful to know what the effects would be if the actual outcome differs from the prediction. For example, a company may budget to sell 10,000 units of its product, but may prepare flexible budgets based on sales of, say, 8,000 and 12,000 units. This would enable contingency plans to be drawn up if necessary.

(b)

At the end of each month or year, actual results may be compared with the relevant activity level in the flexible budget as a control procedure.

Flexible budgeting uses the principles of marginal costing. In estimating future costs it is often necessary to begin by looking at cost behaviour in the past. For costs which are wholly fixed or wholly variable no problem arises. But you may be presented with a cost which appears to have behaved in the past as a semivariable cost (partly fixed and partly variable). A technique for estimating the level of the cost for the future is called the high-low method. This is discussed in more detail in Chapter 4, section 4.2

Worked Example: High-low method The cost of factory power has behaved as follows in past years: Units of output produced 20X1 20X2 20X3 20X4

Cost of factory power $ 38 700 38 100 44 400 42 300

7 900 7 700 9 800 9 100

Budgeted production for 20X5 is 10 200 units. Estimate the cost of factory power which will be incurred. Ignore inflation.

Solution 20X3 (highest output) 20X2 (lowest output)

Units 9 800 7 700 2 100

$ 44 400 38 100 6 300

The variable cost per unit is therefore $6 300/2 100 = $3. The level of fixed cost can be calculated by looking at any output level. Total cost of factory power in 20X3 Less variable cost of factory power (9 800 × $3) Fixed cost of factory power

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Management Accounting

$ 44 400 29 400 15 000

An estimate of costs in 20X5 is as follows.

$ 15 000 30 600 45 600

Fixed cost Variable cost of budgeted production (10 200 × $3) Total budgeted cost of factory power

We can now look at a full example of preparing a flexible budget:

Worked Example: Preparing a flexible budget (a)

Prepare a budget for 20X6 for the direct labour costs and overhead expenses of a production department at the activity levels of 80%, 90% and 100%, using the information listed below: •

The direct labour hourly rate is expected to be $3.75.



100% activity represents 60,000 direct labour hours.



Variable costs Indirect labour Consumable supplies Other staff expenses



Semi-variable costs are expected to relate to the direct labour hours in the same manner as for the last five years. Year 20X1 20X2 20X3 20X4 20X5



$0.75 per direct labour hour $0.375 per direct labour hour 6% of direct and indirect labour costs

Direct labour hours 64 000 59 000 53 000 49 000 40 000 (estimate)

Fixed costs $ 18 000 10 000 4 000 15 000 25 000

Depreciation Maintenance Insurance Rates Management salaries • (b)

Semi-variable costs $ 20 800 19 800 18 600 17 800 16 000 (estimate)

Inflation is to be ignored.

Compile a flexible manufacturing budget for 20X6 assuming that 57,000 direct labour hours are worked.

Solution (a)

Direct labour ($3.75/DLH) Other variable costs Indirect labour ($0.75/DLH) Consumable supplies ($0.375/DLH) Other staff expenses Total variable costs ($5.145 per hour) Semi-variable costs (W)

80% level 48 000 hrs $ 000

90% level 54 000 hrs $ 000

100% level 60 000 hrs $ 000

180.00

202.50

225.00

36.00 18.00 12.96 246.96 17.60

40.50 20.25 14.58 277.83 18.80

45.00 22.50 16.20 308.70 20.00

3: Budgeting

79

Fixed costs Depreciation Maintenance Insurance Rates Management salaries Total manufacturing costs Working Using the high/low method: Total cost of 64 000 hours Total cost of 40 000 hours Variable cost of 24 000 hours

18.00 10.00 4.00 15.00 25.00 336.56

18.00 10.00 4.00 15.00 25.00 368.63

18.00 10.00 4.00 15.00 25.00 400.70

$ 20 800 16 000 4 800

Variable cost per hour ($4 800/24 000)

$0.20

Total cost of 64 000 hours Variable cost of 64 000 hours (× $0.20) Fixed costs

$ 20 800 12 800 8 000

Semi-variable costs are calculated as follows: $ = 20 000 (60 000 × $0.20) + $8 000 = 18 800 (54 000 × $0.20) + $8 000 = 17 600 (48 000 × $0.20) + $8 000 The budget manufacturing cost for 57,000 direct labour hours of work would be as follows: $ Variable costs 293 265 (57 000 × $5.145) Semi-variable costs 19 400 ($8 000 + (57 000 × $0.20)) Fixed costs 72 000 384 665

60 000 hours 54 000 hours 48 000 hours (b)

6.1

Budgetary control Budgetary control is a system of management control that is based on feedback – comparisons of actual results with the budget. Where actual results differ significantly from budget, the cause is investigated and control action taken where appropriate. Control reports are prepared regularly, typically every month, and budgetary control reports may be prepared for each responsibility centre (cost centre or profit centre that is an areas of responsibility for an individual manager) as well as for the organisation as a whole. The most important method of budgetary control is variance analysis, which involves the comparison of actual results achieved during a control period, usually a month, or four weeks, with a flexible budget. The differences between actual results and expected results are called variances and these are used to provide a guideline for control action by individual managers. A less desirable approach to budgetary control is to compare actual results against a fixed (static) budget. Consider the following example.

Worked Example: Windy Ltd: actual results compared to fixed (static) budget Windy Ltd manufactures a single product, the cloud. Budgeted results and actual results for June 20X2 are shown below: Budget Actual results Variance Production and sales of the cloud (units) 2 000 3 000 1 000F $ $ $ Sales revenue (a) 20 000 30 000 10 000 (F) Direct materials 6 000 8 500 2 500 (U) Direct labour 4 000 4 500 500 (U) Maintenance 1 000 1 400 400 (U)

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Management Accounting

Depreciation Rent and rates Other costs Total costs (b) Profit (a) – (b)

2 000 1 500 3 600 18 100 1 900

2 200 1 600 5 000 23 200 6 800

200 (U) 100 (U) 1 400 (U) 5 100 4 900 (F)

Note. (F) denotes a favourable variance and (U) an unfavourable variance. Unfavourable variances are sometimes denoted as (A) for 'adverse'. (a)

In this example, the variances are meaningless for purposes of control. Costs were higher than budget because the volume of output was also higher. Variable costs would be expected to increase above the budgeted costs in the fixed (static) budget. There is no information to show whether control action is needed for any aspect of costs or revenue.

(b)

For control purposes, it is necessary to know the answers to questions such as the following: • •

Were actual costs higher than they should have been to produce and sell 3,000 clouds? Was actual revenue satisfactory from the sale of 3,000 clouds?

A more desirable approach to budgetary control is as follows: (a) (b)

Identify fixed and variable costs. Produce a flexible budget using marginal costing techniques.

Worked Example: Windy Ltd: actual results compared to flexible budget Using the previous example of Windy Ltd, let us assume that we have the following estimates of cost behaviour: Direct materials, direct labour and maintenance costs are variable. Rent and rates and depreciation are fixed costs. Other costs consist of fixed costs of $1,600 plus a variable cost of $1 per unit made and sold.

Solution The budgetary control analysis should be as follows:

Production & sales (units) Sales revenue Variable costs Direct materials Direct labour Maintenance Semi-variable costs Other costs Fixed costs Depreciation Rent and rates Total costs Profit

Fixed (static) budget (a) 2 000 $ 20 000

Flexible budget (b) 3 000 $ 30 000

Actual results (c) 3 000 $ 30 000

Budget variance (b) – (c)

6 000 4 000 1 000

9 000 6 000 1 500

8 500 4 500 1 400

500 (F) 1 500 (F) 100 (F)

3 600

4 600

5 000

400 (U)

2 000 1 500 18 100 1 900

2 000 1 500 24 600 5 400

2 200 1 600 23 200 6 800

200 (U) 100 (U) 1 400 (F) 1 400 (F)

$ 0

Note. (F) denotes a favourable variance and (U) an unfavourable variance. We can analyse the above as follows: (a)

In selling 3,000 units the expected profit should have been, not the fixed (static) budget profit of $1 900, but the flexible budget profit of $5,400. Instead, actual profit was $6,800 i.e. $1,400 more than we should have expected. The reason for this $1,400 improvement is that, given output and sales of

3: Budgeting

81

(b)

3,000 units, overall costs were lower than expected and sales revenue was exactly as expected. For example, the direct material cost was $500 lower than expected. Another reason for the improvement in profit above the fixed (static) budget profit is the sales volume. Windy Ltd sold 3,000 clouds instead of 2,000 clouds, with the following result: $ Budgeted sales revenue increased by Budgeted variable costs increased by direct materials direct labour maintenance variable element of other costs Budgeted fixed costs are unchanged Budgeted profit increased by

$ 10 000

3 000 2 000 500 1 000 6 500 3 500

Budgeted profit was therefore increased by $3 500 because sales volumes increased. This can be calculated by comparing the fixed (static) budget to the flexible budget (5 400 – 1 900 = 3 500). (c)

A full variance analysis statement would be as follows:

$

Fixed (static) budget profit Variances Sales volume (as calculated in (b) above) Direct materials cost Direct labour cost Maintenance cost Other costs Depreciation Rent and rates

$ 1 900

3 500 (F) 500 (F) 1 500 (F) 100 (F) 400 (U) 200 (U) 100 (U) 4 900 6 800

Actual profit

(F)

If management believes that any of these variances are large enough to justify it, they will investigate the reasons for them to see whether any corrective action is necessary.

Question 2: Fixed cost and variance reporting A manufacturing organisation budgeted to produce 16,000 units in the budget period. The budgeted variable cost per unit was $2.75. When output was 18,000 units, total expenditure was $98,000 and it was found that fixed overheads were $11,000 over budget, while variable costs were in line with budget. What was the amount budgeted for fixed costs? A $37 500 B $43 000 C $59 500 D $65 000 (The answer is at the end of the chapter)

7 Cost estimation Section overview •

It should be obvious that the production of a budget calls for the preparation of cost estimates and sales forecasts. In fact, budgeting could be said to be as much a test of estimating and forecasting skills than anything else.

In this section we will consider various cost estimation techniques.

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Management Accounting

7.1

Cost estimation methods Cost estimation involves the measurement of historical costs to predict future costs. Some estimation techniques are more sophisticated than others and are therefore likely to be more reliable but, in practice, the simple techniques are more commonly found and should give estimates that are sufficiently accurate for their purpose. It is these simple techniques which we will be examining here.

7.2

Account-classification method By this method, the manager responsible for estimating costs will go through a list of the individual expenditure items which make up the total costs. Each item will be classified as fixed, variable or semivariable, and values will be assigned to these, probably by reference to the historical cost accounts with an adjustment for estimated cost inflation. This, in rough terms, is how the direct cost items (materials and labour costs) might be built-up when a budgeted direct cost per unit of output is estimated. It is also commonly used by cost centre managers in budgeting overhead costs and is quick and inexpensive. The technique does, however, depend on the subjective judgment of each manager and his skill and realism in estimating costs, and so only an approximate accuracy can be expected from its use.

7.3

High/low method This method was introduced in section 6 of this chapter. The major drawback to the high/low method is that only two historical cost records from previous periods are used in the cost estimation. Unless these two records are a reliable indicator of costs throughout the relevant range of levels of activity, which is unlikely, only a 'loose approximation' of fixed and variable costs will be obtained. The advantage of the method is its relative simplicity.

7.4

The scatter graph method A graph can be plotted of the historical costs from previous periods, and from the resulting scatter diagram, a line-of-best-fit can be drawn by visual estimation. The advantage of the scatter graph over the high/low method is that a greater quantity of historical data is used in the estimation, but its disadvantage is that the cost line is drawn by visual judgment and so is a subjective approximation. A more accurate technique for plotting a line of best fit is to use regression analysis. This statistical technique uses data from past periods to establish the relationship between costs and level of activity as the equation of a straight line: y = a + bx, where a = fixed costs, b= variable cost per unit and x = volume of output. The regression line can then be used to forecast costs for future periods.

8 Incremental and zero-based budgeting systems Section overview

8.1



Incremental budgeting is concerned mainly with the increments in costs and revenues which will occur in a coming period.



Zero-based budgeting involves preparing a budget for each cost centre from a zero base.

Traditional (incremental) budgeting The traditional approach to budgeting is to base next year's budget on the current year's results plus an extra amount for estimated growth or inflation next year. This approach is known as incremental budgeting since it is concerned mainly with the increments in costs and revenues which will occur in the coming period.

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83

Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and economical as they can be, and the organisation and the environment are largely unchanged. In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending to creep into budgets: managers will spend to budget, even if the amount added for inflation proved not to be necessary, so that the level of next year's budget is maintained. The result is that past inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny. To ensure that inefficiencies are not concealed, alternative approaches to budgeting have been developed. One such approach is zero-based budgeting (ZBB).

8.2

The principles of zero-based budgeting ZBB rejects the assumption inherent in incremental budgeting that next year's budget can be based on this year's costs. Existing practices and expenditures must be challenged. Every aspect of the budget is examined in terms of its cost and the benefits it provides and the selection of better alternatives is encouraged.

Definition Zero-based budgeting involves preparing a budget for each cost centre from a zero base. Every item of expenditure has to be justified in its entirety in order to be included in the next year's budget.

The basic approach of ZBB has three steps.

Step 1

Define decision packages A decision package is a comprehensive description of a specific organisational activity, its objectives, costs and benefits.

Step 2

Evaluate and rank packages Using the decision packages, each activity is evaluated and ranked on the basis of its benefit to the organization, in order of priority against other activities. The ranking process provides managers with a technique to allocate scarce resources between different activities. Minimum work requirements (those that are essential to get a job done) will be given high priority and so too will work which meets legal obligations. In the accounting department these would be minimum requirements to operate the payroll, accounts receivable and accounts payable systems, and to maintain and publish a set of accounts which satisfies the external auditors and regulatory authorities (e.g. tax returns).

Step 3

Allocate resources Resources in the budget are then allocated according to the funds available and the evaluation and ranking of the competing packages.

8.3

84

The advantages of implementing ZBB •

It is possible to identify and remove inefficient or obsolete operations.



Cost reductions are possible.



It forces employees to avoid wasteful expenditure.



It can increase motivation if, as a result of preparing the decision packages, staff become more involved in the budgeting process



It provides a budgeting and planning tool for management which responds to changes in the business environment; 'obsolescent' items of expenditure are identified and dropped.



The documentation required provides all management with a coordinated, in-depth appraisal of an organisation's operations.

Management Accounting

8.4



It challenges the status quo and forces an organisation to examine alternative activities and existing expenditure levels.



In summary, ZBB should result in a more efficient allocation and utilisation of resources to an organisation's activities and departments.

The disadvantages of ZBB The major disadvantage of zero-based budgeting is the time and energy required. The assumptions about costs and benefits in each package must be continually updated and new packages developed as soon as new activities emerge. The following problems might also occur: •

Short-term benefits might be emphasised to the detriment of long-term benefits.



The false idea that all decisions have to be made in the budget might be encouraged. Management must be able to meet unforeseen opportunities and threats at all times, and must not feel restricted from carrying out new ideas simply because they were not approved by a decision package, cost benefit analysis and the ranking process.



It may be a requirement for management skills both in constructing decision packages and in the ranking process which the organisation does not possess. Managers may therefore have to be trained in ZBB techniques so that they can apply them sensibly and properly.



It may be difficult to 'sell' ZBB to managers as a useful technique for the following reasons: –

costs and benefits of alternative courses of action are hard to quantify accurately.



Employees or trade union representatives may resist management ideas for changing the ways in which work is done.



The organisation's information systems may not be capable of providing suitable cost and benefit analysis.



The ranking process can be difficult. Managers face three common problems: –

A large number of packages may have to be ranked.



There is often a conceptual difficulty in having to rank packages which managers regard as being equally vital, for legal or operational reasons.



It is difficult to rank completely different types of activity, especially where activities have qualitative rather than quantitative benefits, such as spending on staff welfare and working conditions, where ranking must usually be entirely subjective.

In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management time and effort. One way of obtaining the benefits of ZBB and overcoming the drawbacks, is to apply it selectively on a rolling basis throughout the organisation. For example, this year it applies to the finance department, next year marketing department, the year after personnel department and so on. In this way all activities will be thoroughly scrutinised over a period of time.

8.5

Using zero-based budgeting ZBB can be used by both profit-making and non-profit-making organisations. The procedures of ZBB do not lend themselves easily to direct manufacturing costs where standard costing, work study and the techniques of management planning and control have long been established as a means of budgeting expenditure. In manufacturing organisations, ZBB is best applied to expenditure incurred in departments that support the essential production function. These include marketing, finance, quality control, repairs and maintenance, production planning, research and development, engineering design, personnel, data processing, sales and distribution. In many organisations, these expenses make up a large proportion of the total expenditure. These activities are less easily quantifiable by conventional methods and are more discretionary in nature.

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ZBB can also be successfully applied to service industries and public sector organisations such as local and central government departments, educational establishments, hospitals and so on. This is because ZBB is a useful technique for identifying the cause of excess spending in administrative activities, and eliminating wasteful and non-value-adding activities. ZBB can be applied in any organisation where alternative levels of provision for each activity are possible and where the costs and benefits are separately identifiable. Some particular uses of ZBB are:

8.6

(a)

Budgeting for discretionary cost items, such as advertising, R & D and training costs. The priorities for spending money could be established by ranking activities and alternative levels of spending or service can be evaluated on an incremental basis. For example, is it worth spending $2,000 more to increase the number of employees to be trained on one type of training course by 10%? If so, what priority should this incremental spending on training be given, when compared with other potential training activities?

(b)

Rationalisation measures. 'Rationalisation' means cutting back on production and activity levels, and cutting costs. ZBB can be used to make rationalisation decisions when an organisation is forced to make spending cuts. As indicated above, it is also a useful approach to eliminating unnecessary and wasteful spending.

Rolling budgets A Rolling budget is a budget that always extends a set number of financial periods into the future, for example four quarters. As the current period ends, a new period is added to the budget. The advantages of rolling budgets include: •

The forecast represented by the budget will be more accurate as managers are forced to reassess the budget regularly and adjust for current conditions • Planning and control is based on a more recent, up-to-date plan • The budget will prompt managers to look further into the future than the traditional annual budget • The rolling budget can help to provide an early warning of whether the organisation is on track to meet its goals. Disadvantages include: • The budget preparation process may be more costly • Managers may be de-motivated by the additional volume of work involved, for example if standard costs or stock valuations need to be revised.

9 Budgeting, performance and motivation Section overview •

LO 3.1

9.1

Human behaviour affects the budgeting process, the resulting budgets and the performance of managers and employees alike.

In this chapter we have concentrated on the importance of the budgeting process for planning and control by management. A further aspect of the budgeting process is the human behavioural aspect, the effect that the budgeting process and resulting budgets has on the performance of managers and other employees alike.

Budgets and motivation The motivational effect of the budgeting process on managers in a business is much written-about and there are many conflicting views. It is well recognised that the budgetary process has the potential to be a powerful motivating tool, but conversely it may also have a de-motivating effect. The effect of the budget on the motivation of managers is largely due to the level of difficulty of the targets set, and the manner in which they are set. Are the budgets imposed or have the managers taken part in the budgeting process?

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Management Accounting

9.2

Budgets and standards as targets Once decided, budgets become targets. But how difficult should the targets be? And how might people react to targets which are easy to achieve, or difficult to achieve? The quantity of material and labour time included in the budget will depend on the level of performance required by management. Four types of performance standard might be set: •

Ideal standards are based on perfect operating conditions: no wastage, no spoilage, no inefficiencies, no idle time, no breakdowns. Employees will often feel that the goals are unattainable, become de-motivated and not work so hard.



Attainable standards are based on the hope that a standard amount of work will be carried out efficiently, machines properly operated or materials properly used. Some allowance is made for wastage and inefficiencies. If well-set they provide a useful psychological incentive by giving employees a realistic, but challenging target of efficiency.



Current standards are based on current working conditions (current wastage, current inefficiencies). They do not attempt to improve on current levels of efficiency.



Basic standards are kept unaltered over a long period of time, and may be out of date. They are used to show change in efficiency or performance over a long period of time. They are perhaps the least useful and least common type of standard in use.

Management must decide which of the four types of standard is most appropriate as a benchmark for measuring performance. Standards can be used as aspirational targets to drive improvements in performance, but when benchmarking actual performance against such standards, management need to be aware that this may result in de-motivated employees: The impact on employee behaviour of budgets based on these different standards is summarised in the table below: Type of standard

Impact

Ideal standards

Some say that they provide employees with an incentive to be more efficient even though it is highly unlikely that the standard will be achieved. Others argue that they are likely to have an unfavourable effect on employee motivation because the differences between standards and actual results will always be adverse. The employees may feel that the goals are unattainable and so they will not work so hard.

Attainable standards

Might be an incentive to work harder as they provide a realistic but challenging target of efficiency.

Current standards

Will not motivate employees to do anything more than they are currently doing.

Basic standards

May have an unfavourable impact on the motivation of employees. Over time they will discover that they are easily able to achieve the standards. They may become bored and lose interest in what they are doing if they have nothing to aim for.

Similar comments apply to budgets. Budgets and standards are more likely to motivate employees if employees accept that the budget or standard is achievable. If it can be achieved too easily, it will not provide sufficient motivation. If it is too difficult, employees will not accept it because they will believe it to be unachievable. In extreme circumstances, if employees believe a budget is impossible to achieve, they might be so de-motivated that they attempt to prove that the budget is wrong. This is obviously the completely opposite effect to that intended. The various research projects into the behavioural effects of budgeting have given conflicting views on certain points. However, there appears to be general agreement that a target must fulfil certain conditions if it is to motivate employees to work towards it: • • •

It must be sufficiently difficult to be a challenging target. It must not be so difficult that it is not achievable. It must be accepted by the employees as their personal goal.

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9.3

Participation There are basically two ways in which a budget can be set: from the top down (imposed budget) or from the bottom up (participatory budget).

9.4

Top-down style of budgeting In this approach to budgeting, top management prepare a budget with little or no input from operating personnel. This budget is then imposed upon the employees who have to work to the budgeted figures. The times when imposed budgets are effective are as follows: • • • • •

In newly-formed organisations, because of employees' lack of knowledge. In very small businesses, because the owner/manager has a complete overview of the business. When operational managers lack budgeting skills. When the organisation's different units require precise co-ordination. When budgets need to be set quickly.

There are, of course, advantages and disadvantages to this style of setting budgets. Advantages • • • • •

The aims of long-term plans are more likely to be incorporated into short-term plans. They improve the co-ordination between the plans and objectives. They use senior management's overall awareness of the organisation. There is less likelihood of input from inexperienced or uninformed lower-level employees. Budgets can be drawn up in a shorter period of time because a consultation process is not required.

Disadvantages

9.5



Dissatisfaction, defensiveness and low morale amongst employees who have to work to meet the targets. It is hard for people to be motivated to achieve targets set by somebody else. Employees might put in only just enough effort to achieve targets, without trying to beat them.



The feeling of team spirit may disappear.



Organisational goals and objectives might not be accepted so readily and/or employees will not be aware of them.



Employees might see the budget as part of a system of trying to find fault with their work: if they cannot achieve a target that has been imposed on them they may be punished.



If consideration is not given to local operating and political environments, unachievable budgets for overseas divisions could be produced.



Lower-level management initiative may be stifled if they are not invited to participate.

Bottom-up style of budgeting In this approach to budgeting, budgets are developed by lower-level managers who then submit the budgets to their superiors. The budgets are based on the lower-level managers' perceptions of what is achievable and the associated necessary resources. The advantages of participative budgets are as follows:

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They are based on information from employees most familiar with the department. Budgets should therefore be more realistic.



Knowledge spread among several levels of management is pulled together, again producing more realistic budgets.



Because employees are more aware of organisational goals, they should be more committed to achieving them.

Management Accounting



Co-ordination and co-operation between those involved in budget preparation should improve.



Senior managers' overview of the business can be combined with operational-level details to produce better budgets.



Managers should feel that they 'own' the budget and will therefore be more committed to the targets and more motivated to achieve them.



Participation will broaden the experience of those involved and enable them to develop new skills.

Overall, participation in budget setting should give those involved a more positive attitude towards the organisation, which should lead to better performance. There are, on the other hand, a number of disadvantages of participative budgets: •

They consume more time.



Any changes made by senior management to the budgets submitted by lower-level management may cause dissatisfaction.



Budgets may be unachievable if managers are not qualified to participate.



Managers may not co-ordinate their own plans with those of other departments.



Managers may include budgetary slack (padding the budget) in their budgets. This means they have over-estimated costs or under-estimated income. Actual results are then more likely to be better than the budgeted target results.



An earlier start to the budgeting process could be required.

The research projects do not appear to provide definite conclusions about the motivational effects of budgeting. The attitudes of the individuals involved have an impact. •

Some managers may complain that they are too busy to spend time on setting standards and budgeting.



Others may feel that they do not have the necessary skills.



Some may think that any budget they set will be used against them.

In such circumstances participation could be seen as an added pressure rather than as an opportunity. For such employees an imposed approach might be better.

9.6

Negotiated style of budgeting At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice, different levels of management often agree budgets by a process of negotiation.

9.7



In the imposed budget approach, operational managers will try to negotiate with senior managers the budget targets which they consider to be unreasonable or unrealistic.



Likewise senior management usually review and revise budgets presented to them under a participative approach through a process of negotiation with lower level managers.



Final budgets are therefore most likely to lie between what top management would really like and what lower level managers believe is feasible.

Padding the budget In the process of preparing budgets, managers might deliberately overestimate costs and underestimate sales, so that they will not be blamed in the future for overspending and poor results. In controlling actual operations, managers must then ensure that their spending rises to meet their budget, otherwise they will be 'blamed' for careless budgeting. A typical situation is for a manager to pad the budget and waste money on non-essential expenses so that he uses all his budget allowances. The reason behind his action is the fear that unless the allowance is fully spent it will be reduced in future periods, therefore, making his job more difficult as the reduced budgets in future will not be so easy to attain. If inefficiency and slack are allowed for in budgets, achieving a budget target means only that costs have remained within the accepted levels of inefficient spending.

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Budget bias can work in the other direction too. It has been noted that, after a run of mediocre results, some managers deliberately overstate revenues and understate cost estimates, no doubt feeling the need to make an immediate favourable impact by promising better performance in the future. They may merely delay problems, however, as the managers may well be censured when they fail to hit these optimistic targets.

9.8

Goal congruence and dysfunctional decision making Individuals are motivated by personal desires and interests. These desires and interests may tie in with the objectives of the organisation – after all, some people 'live for their jobs'. Other individuals see their job as a chore, and their motivations will have nothing to do with achieving the objectives of the organisation for which they work. It is therefore important that some of the desires, interests and goals motivating employees correspond with the goals of the organisation as a whole. This is known as goal congruence. Such a state would exist, for example, if the manager of department A worked to achieve a 10% increase in sales for the department, this 10% increase being part of the organisation's overall plan to increase organisational sales by 20% over the next three years. On the other hand, dysfunctional behaviour can occur if a manager's goals are not in line with those of the organisation as a whole. Attempts to enhance his or her own situation or performance (typically 'empire building' – employing more staff, cutting costs to achieve favourable variances but causing quality problems in other departments) will be at the expense of the best interests of the organisation as a whole. Participation is not necessarily the answer. Goal congruence does not necessarily result from allowing managers to develop their own budgets. A well designed standard costing and budgetary control system can help to ensure goal congruence. Continuous feedback prompting appropriate control action should steer the organisation in the right direction.

Question 3: Eskafield Eskafield Industrial Museum opened ten years ago and soon became a market leader with many working exhibits. In the early years there was a rapid growth in the number of visitors but with no further investment in new exhibits, this growth has not been maintained in recent years. Two years ago, John Derbyshire was appointed as the museum's chief executive. His initial task was to increase the number of visitors to the museum and, following his appointment, he had made several improvements to make the museum more successful. Another of John's tasks is to provide effective financial management. This year the museum's Board of Management has asked him to take full responsibility for producing the 20X3 budget. He has asked you to prepare estimates of the number of visitors next year. Shortly after receiving your notes, John Derbyshire contacts you. He explains that he had prepared a draft budget for the Board of Management based on the estimated numbers for 20X3. This had been prepared on the basis that: • •

Most of the museum's expenses such as salaries and rates are fixed costs; The museum has always budgeted for a deficit;

The deficit in the draft budget for 20X3 is $35,000. At the meeting with the Board of Management, John was congratulated on bringing the deficit down from $41 000 in 20X1 to $37,000 (latest estimate) in 20X2. However, the Board of Management raised two issues:

90

(1)

They felt that the planned deficit of $35,000 for 20X3 should be reduced to $29,000 as this would represent a greater commitment.

(2)

They also queried why the budget had been prepared without any consultation with the museum staff, i.e. a top down approach.

Management Accounting

Requirements: (a)

Which one of the following factors is LEAST likely to influence the views of John Derbyshire about whether the further reduction in the deficit is achievable? A The amount of discretionary costs in the budget B The amount of padding in the budget C Variable cost estimates in the budget D The morale and commitment of museum staff

(b)

Which of the following factors would affect whether or not a top-down approach to budgeting is appropriate for the museum? (I) Financial awareness of the management team (II)

The level in the management hierarchy where spending decisions are made

(III)

The size and culture of the organisation

A

(I) only

B

(I) and (III) only

C

(II) and (III) only

D

(I), (II) and (III) (The answer is at the end of the chapter)

10 Budgeting and quality Section overview •

10.1

Many businesses, both manufacturing and service businesses, are wholly concerned with quality. The concept behind quality control is the principle of 'get it right first time'.

Total Quality Management (TQM) As discussed in Chapter 1, Total Quality Management (TQM) is a management approach that means that quality is the aim of every part of the organisation. The aim is to 'get it right first time' which means striving for continuous improvement in order to eliminate faulty work and prevent mistakes. It must apply to every part of the business and every activity that the business undertakes, whether it is in making the product, providing the service, selling the product or general administration. Under TQM each person, in every function of the business, has to recognise that s/he has customers. In some cases, these are external customers but in many cases these are internal customers, the employees' colleagues and managers.

10.2

Budgeting and TQM The budgeting process is about setting standards or targets for all aspects and functions of the business to meet. If the budgeting process is successful it can help in this continuous process of improvement by setting targets that eventually eliminate all unnecessary waste and mistakes. However, since TQM seeks continuous improvement, it is not altogether consistent with a budget approach to planning that uses current or attainable standards as a target.

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Key chapter points •

A budget is a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities and cash flows.



The main purpose and benefit of using a budget is to assist with the achievement of the organisation's objectives.



Towards the end of the strategy planning stage, the budget will be prepared. While the mechanics of budget preparation is the focus of your immediate study, it is important to appreciate how important budgets are in co-ordination and control.



The co-ordination and administration of budgets is usually the responsibility of a budget committee.



The budget manual is a collection of instructions governing the responsibilities of persons and the procedures, forms and records relating to the preparation and use of budgetary data.



The principal budget factor is the factor which limits the activities of an organisation.



A functional operating or departmental budget is a budget forecasting income and expenditure for a particular department or process. It could be a production budget, a sales budget or a purchasing budget depending on the function and the nature of its activities.



A cash budget is a statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals. It is one of the most important planning tools that an organisations can use. It shows the cash effect of all plans made within the budgetary process.

92



As well as wishing to forecast its cash position, a business may want to estimate its profitability and its financial position for a coming period.



Budgeted statements of comprehensive income and financial position form the master budget.



A fixed (static) budget is a budget which is set for a single activity level, whereas a flexible budget is a budget which is designed to change as volume of activity changes.



Incremental budgeting is concerned mainly with the increments in costs and revenues which will occur in a coming period.



Zero-based budgeting involves preparing a budget for each cost centre from a zero base.



Human behaviour effects the budgeting process, the resulting budgets and the performance of managers and employees alike.

Management Accounting

Quick revision questions 1

Which of the following is a definition of feedback? A B C D

2

Which of the following is not a functional budget? A B C D

3

Different levels of activity Different levels of spending Different levels of efficiency The difference between actual and budgeted performance

When budget allowances are set without the involvement of the budget owner, the budgeting process can be described as: A B C D

7

sales quantity + opening inventory of finished goods + closing inventory of finished goods sales quantity – opening inventory of finished goods + closing inventory of finished goods sales quantity – opening inventory of finished goods – closing inventory of finished goods sales quantity + opening inventory of finished goods – closing inventory of finished goods

In comparing a fixed budget with a flexible budget, what is the reason for the difference between the profit figures in the two budgets? A B C D

6

cash sales demand production capacity skilled labour resources

When preparing a production budget, the quantity to be produced equals A B C D

5

cash budget production budget selling cost budget distribution cost budget

The principal budget factor is normally assumed to be: A B C D

4

the planning and control cycle within a budgetary system control action on the basis of comparing actual results with a plan or budget information gathered internally for comparing actual results against a plan or budget information gathered internally and externally for comparing actual results against a plan or budget

top down budgeting negotiated budgeting zero based budgeting participative budgeting

For which of the following would zero based budgeting be most suitable? A B C D

Building construction Mining company operations Transport company operations Government department activities

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Answers to quick revision questions 1

C Feedback is information for control purposes. It is not the control system itself, nor is it control action. Feedback is collected as output from the system and so is internally-obtained information.

2

A A functional budget is a budget prepared for a particular function or department. A cash budget is the resultant cash balance of the planning decisions included in all the functional budgets. It is not a functional budget itself. Therefore the correct answer is A. The production budget (option B), the distribution cost budget (option D) and the selling cost budget (option C) are all prepared for specific functions, therefore they are functional budgets.

3

B Unless there are good reasons for suspecting anything different, sales demand is assumed to be the principal or limiting budget factor when the first draft budgets are prepared. The first draft budget to prepare is therefore the sales budget.

4

B Any opening inventory available at the beginning of a period will reduce the additional quantity required from production in order to satisfy a given sales volume. Any closing inventory required at the end of a period will increase the quantity required from production in order to satisfy sales and leave a sufficient volume in inventory. Therefore, we need to deduct the opening inventory and add the required closing inventory.

5

A The difference in profit between the fixed budget and a flexible budget is due to differences in the activity levels, resulting in differences in both costs and revenues.

6

A The budget is imposed by senior management at the ‘top’.

7

D Zero based budgeting, when used, is most suitable for activities that are away from ‘front line’ production or operating activities, where standards of performance can be set to plan and monitor performance. ZBB is therefore best suited for back office operations, or administrative work. It may therefore be appropriate for budgeting for government departments, especially when the government is trying to reduce expenditure.

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Management Accounting

Answers to chapter questions 1 (a)

B Cash sales: (40% × $130 000) From credit sales in December: (60% × $100 000) Total cash receipts in February

(b)

$ 52 000 60 000 112 000

D $ Cash sales: (40% × $110 000) From credit sales in November: (60% × $80 000) Total cash receipts in January Payments for December’s purchases Payments for wages (Dec: 25% × 12 000) + (Jan: 75% × 16 000) Payments for December’s overheads (10 000 – 2 000)* Total cash payments in January Excess of cash receipts over payments Cash balance at beginning of January Cash balance at end of January

$ 44 000 48 000 92 000

60 000 15 000 8 000 83 000 9 000 15 000 24 000

* Depreciation is not a cash cost and therefore needs to be excluded: (c)

A Overheads are paid the month after they are incurred so payments in January-June 20X5 relate to overheads incurred in December-May. Depreciation is not a cash cost and therefore needs to be excluded: Payments in: January (10 000 – 2 000) February – April: [3 × (15 500 – 2 500)] May – June: [2 × (20 000 – 3 000)] Total payments

(d)

C Receivables at 1 January: 60% × (80 000 + 100 000) Sales January to June Less Receivables at 30 June: 60% × (160 000 + 180 000) Cash receipts from sales

(e)

$ 8 000 39 000 34 000 81 000

$ 108 000 870 000 978 000 (204 000) 774 000

A Payables at 1 January Purchases January to June Less Payables at 30 June Cash payments for purchases

$ 60 000 700 000 760 000 (150 000) 610 000

Alternatively since purchases are paid in the month after they are incurred, cash payments Jan-June relate to purchases from Dec-May: (60+80+90+110+130+140) = 610 000

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(f)

C Budgeted wages costs are expected to rise substantially, but extra staff should not be taken on unless they are expected to do simple casual work, or unless they are expected to remain with the organisation for a long time. Otherwise training costs would be high. It would take too long to renegotiate wages and salary arrangements, and it will not be easy to speed up collections from customers unless customers are in breach of their credit arrangements and paying later than they should. Deferring some or all of the capital expenditure is likely to be the easiest and most practical option.

2

A Total expenditure Variable cost, as expected (18 000 × $2.75) Actual fixed costs incurred Unfavourable fixed overhead expenditure variance Budgeted fixed costs

$ 98 000 49 500 48 500 11 000 37 500

3 (a)

C

If John is aware of padding in the budget, he will be able to cut budgeted expenditure without too much trouble simply by reducing the amount of padding. He may need to consider the attitudes of staff and whether they are likely to have the commitment to cut costs further. Most costs are fixed costs: some of these may be discretionary, and so controllable. Since variable costs are small, they are unlikely to be a key factor in trying to reduce the deficit, since potential savings in variable costs will not be significant. (b)

D

If the management team is financially aware, they should be more capable of drafting ‘bottom-up’ budgets. However, responsibility for budgeting expenditures should not go lower in the management hierarchy than the managers who make the spending decisions. If John Derbyshire makes most of the spending decisions himself, and has the responsibility for expenditures, he should retain the responsibility for budgeting. The approach to budgeting, top-down or bottom-up, also depends on the culture and size of the organisation. Very small organisations and large bureaucratic organisations are likely to have a strong top-down culture.

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Management Accounting

Chapter 4

Cost behaviour and CVP analysis Learning objectives

Reference

Cost behaviour

LO4

Apply the techniques to separate costs into their fixed and variable components

LO4.1

Cost volume profit analysis

LO11

Apply the principles of cost-volume-profit analysis in organisations

LO11.4

Topic list

1 Fixed costs and variable costs 2 Introduction to cost behaviour 3 Cost behaviour patterns 4 Determining the fixed and variable elements of semi-variable costs 5 CVP analysis and break-even point 6 The contribution to sales (C/S) ratio 7 Safety margin 8 Break-even calculations and profit targets 9 Break-even graphs, contribution graphs and profit/volume charts 10 Limitations of CVP analysis

97

Introduction This chapter introduces the concept of the separation of costs into those that vary directly with changes in activity levels (variable costs) and those that do not (fixed costs). This chapter examines further this two-way split of cost behaviours and explains the high-low method as one method of splitting semivariable costs into these two elements. The cost accountant, must also be fully aware of cost behaviour because, to be able to estimate costs, he must know what a particular cost will do given particular conditions. The application of cost-volume-profit analysis, which is based on the cost behaviour principles and marginal costing ideas, is sometimes necessary so that the appropriate decision-making information can be provided to management. This chapter is going to conclude with that very topic, cost-volume-profit analysis or break-even analysis.

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Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is a fixed cost?

(Section 1)

2

What is a variable cost?

(Section 1)

3

Draw graphs to show fixed, variable and stepped costs

(Section 3)

4

What are the steps to follow to estimate the fixed and variable elements of semi-variable costs?

(Section 4.2)

5

What is CVP analysis?

(Section 5.1)

6

What is the the C/S ratio (or P/V ratio)

7

What is the formula for target profits?

(Section 8.1)

8

Draw and label a break-even graph

(Section 9.1)

9

What are the limitations of CVP analysis?

(Section 10)

(Section 6)

4: Cost behaviour and CVP analysis

99

LO 4.1

1 Fixed costs and variable costs Section overview •

Costs may be classified into fixed costs and variable costs. Many items of expenditure are partfixed and part-variable and are so termed step-fixed or semi-variable (or mixed) costs.

Definitions Cost is a measure of the resources given up to achieve an objective. A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity. A variable cost is a cost which tends to vary with the level of activity. A semi-variable (or mixed) cost is a cost that contains both a fixed cost and a variable cost component. A step-fixed cost is a cost that is fixed for a certain range of activity but increases to a new fixed level once a critical level of activity is reached.

1.1

Examples of fixed and variable costs (a)

Direct material costs (cost of materials consumed in the manufacturing process) are variable costs because they rise as more units of a product are manufactured.

(b)

Sales commission is often a fixed percentage of sales turnover, and so is a variable cost that varies with the level of sales.

(c)

Telephone call charges are likely to increase if the volume of business expands, but there is also a fixed element of line rental, and so they are a semi-variable overhead cost.

(d)

The rental cost of business premises is a constant amount, at least within a stated time period, and so it is a fixed cost.

(e) The salary paid to a factory supervisor might be considered a step-fixed cost. For example the factory may be able to produce up to 20,000 product units with one supervisor, but needs a second supervisor once this level of activity is exceeded. LO 4.1

2 Introduction to cost behaviour

2.1

Cost behaviour and decision-making Section overview •

The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise.

Definition Cost behaviour is the way in which costs are affected by changes in the level of activity.

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Management Accounting

Management decisions will often be based on how costs and revenues vary at different activity levels. Examples of such decisions are as follows: • • • •

2.2

What should the planned activity level be for the next period? Should the selling price be reduced in order to sell more units? Should a particular component be manufactured internally or bought in? Should a contract be undertaken?

Cost behaviour and cost control If the accountant does not know the level of costs which should have been incurred as a result of an organisation's activities, how can he or she hope to control costs?

2.3

Cost behaviour and budgeting Knowledge of cost behaviour is obviously essential for the tasks of budgeting, decision making and management control.

2.4

Cost behaviour and levels of activity There are many factors which may influence costs. The major influence is volume of output, or the level of activity. Examples of cost drivers or level of activity may refer to one of the following: • • • • •

2.5

Number of units produced. Number of invoices issued. Number of units of electricity consumed. Value of items sold. Number of items sold.

Cost behaviour principles The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will cost more to produce 2,000 units of output than it will cost to produce 1,000 units. This principle is common sense. The challenge for the accountant, however, is to be able to analyse each item of cost, in terms of the factors that drive the cost and to determine the amount by which the cost increases as the level of activity changes. For our purposes here, the level of activity for measuring cost will generally be taken to be the volume of production.

Worked Example: Cost behaviour and activity level Bart Hurst has a fleet of company cars for sales representatives. Running costs have been estimated as follows: (a)

Cars cost $12,000 when new, and have a guaranteed trade-in value of $6,000 at the end of two years. Depreciation is charged on a straight-line basis (in equal annual amounts over the life of the car).

(b)

Petrol and oil cost 15 cents per km.

(c)

Tyres cost $300 per set to replace; replacement occurs after 30,000 kms.

(d)

Routine maintenance costs $200 per car (on average) in the first year and $450 in the second year.

(e)

Repairs average $400 per car over two years and are thought to vary with mileage. The average car travels 25,000 kms per annum.

(f)

Tax, insurance, and membership of motoring organisations cost $400 per annum per car.

Calculate the average cost per annum of cars which travel 15,000 kms per annum and 30,000 kms per annum.

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Solution Costs may be analysed into fixed, variable and stepped. A stepped cost being a cost which is fixed in nature but only within a certain level of activity. (a)

Fixed costs Depreciation $(12 000 − 6 000) ÷ 2 Routine maintenance $(200 + 450) ÷ 2 Tax, insurance etc

(b)

$ per annum 3 000 325 400 3 725

Variable costs Petrol and oil Repairs ($400 ÷ 50 000 km)*

Cents per km 15.0 0.8 15.8

* If the average car travels 25,000 kms per annum, it will be expected to travel 50,000 kms over two years (this will correspond with the repair bill of $400 over two years). (c)

Step costs are tyre replacement costs, which are $300 at the end of every 30,000 kms. (i)

If the car travels less than or exactly 30,000 kms in two years, the tyres will not be changed. Average cost of tyres per annum = $0.

(ii)

If a car travels more than 30,000 kms and up to (and including) 60,000 kms in two years, there will be one change of tyres in the period. Average cost of tyres per annum = $150 ($300 ÷ 2).

(iii)

If a car exceeds 60,000 kms in two years (up to 90,000 kms) there will be two tyre changes. Average cost of tyres per annum = $300 ($600 ÷ 2).

The estimated costs per annum of cars travelling 15,000 kms per annum and 30,000 kms per annum would therefore be: 15,000 kms 30,000 kms per annum per annum $ $ Fixed costs 3 725 3 725 Variable costs (15.8c per km) 2 370 4 740 Tyres 150 – Cost per annum 6 095 8 615

3 Cost behaviour patterns 3.1

Fixed costs Section overview •

LO 4.1

102

A fixed cost is a cost which tends to be unaffected by increases or decreases in the volume of output. A step-fixed cost is a cost which is fixed in nature but only within certain levels of activity, while a variable cost is cost which tends to vary directly with the volume of output. The variable cost per unit is the same for each unit produced. Many costs contain both a fixed and variable element – a semi-variable/semi-fixed or mixed cost – so is partly affected by changes in the level of activity.

Fixed costs are a period charge, in that they relate to a span of time; as the time span increases, so too will the fixed costs (which are sometimes referred to as period costs for this reason). It is important to understand that fixed costs always have a variable element, since an increase or decrease in production may also bring about an increase or decrease in per unit fixed costs.

Management Accounting

A sketch graph of fixed cost would look like this: Total cost

Total fixed cost

Volume of output (level of activity)

Examples of a fixed cost would be: • •

3.2

The rent of a single factory building (per month or per annum) Straight line depreciation of a single machine (per month or per annum)

Step-fixed costs A step-fixed cost is a cost which is fixed in nature but only within a certain range of activity. Consider the depreciation of a machine which may be fixed if production remains below 1,000 units per month. If production exceeds 1,000 units, a second machine may be required, and the cost of depreciation (on two machines) would go up a step. A sketch graph of a step-fixed cost could look like this: Graph of step-fixed cost

Other examples of step-fixed costs are: (a)

Rent is a step-fixed cost in situations where rental space requirements increase as output levels get higher.

(b)

Basic pay of employees is nowadays usually fixed, but as output rises, more employees (direct workers, supervisors, managers and so on) are required.

(c)

Royalties e.g. fees of $10,000 payable if sales are below 5,000 units. Fees increase to $15,000 if sales exceed this.

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3.3

Variable costs A variable cost is a cost which tends to vary directly with the volume of output. The variable cost per unit is the same amount for each unit produced.

A constant variable cost per unit implies that the price per unit of say, material purchased is constant, and that the rate of material usage is also constant. (a)

The most important variable cost is the cost of raw materials (where there is no discount for bulk purchasing since bulk purchase discounts reduce the cost of purchases).

(b)

Direct labour costs are most often classed as a variable cost even though basic wages are usually fixed.

(c)

Sales commission is variable in relation to the volume or value of sales.

(d)

Bonus payments for productivity to employees might be variable once a certain level of output is achieved, as the following diagram illustrates.

Up to output A, no bonus is earned.

3.4

Non-linear or curvilinear variable costs If the relationship between total variable cost and volume of output can be shown as a curved line on a graph, the relationship is said to be curvilinear. Two typical relationships are as follows: (a)

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(b)

Each extra unit of output in graph (a) causes a less than proportionate increase in cost whereas in graph (b), each extra unit of output causes a more than proportionate increase in cost. The cost of a piecework scheme for individual workers with differential rates could behave in a curvilinear fashion if the rates increase by small amounts at progressively higher output levels.

3.5

Semi-variable costs (or mixed costs) A semi-variable/mixed cost is a cost which contains both fixed and variable components and so is partly affected by changes in the level of activity. Examples of these costs include the following: (a)

Electricity and gas bills (i) (ii)

(b)

Salesman's salary (i) (ii)

(c)

Fixed cost = basic salary Variable cost = commission on sales made

Costs of running a car (i) (ii)

3.6

Fixed cost = rental charge Variable cost = charge per unit of electricity used

Fixed cost = registration, insurance Variable costs = petrol, oil, repairs (which vary with km travelled)

Other cost behaviour patterns Other cost behaviour patterns may be appropriate to certain cost items. Examples of two other cost behaviour patterns are shown below: (a)

Cost behaviour pattern (1) $ Cost

Minimum charge

Volume of output



3.7

Cost behaviour pattern (2) $ Cost

Maximum cost



(b)

Volume of output

Graph (a) represents an item of cost which is variable with output up to a certain maximum level of cost. Graph (b) represents a cost which is variable with output, subject to a minimum (fixed) charge.

The relationship between total costs and unit costs The following example relates to different levels of production of a product zed. The variable cost of producing a zed is $5. Fixed costs are $5,000. 1 zed 10 zeds 50 zeds $ $ $ Total variable cost 5 50 250 Variable cost per unit 5 5 5 Total fixed cost 5 000 5 000 5 000 Fixed cost per unit 5 000 500 100 Total cost (fixed and variable) 5 005 5 050 5 250 Total cost per unit 5 005 505 105

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What happens when activity levels rise can be summarised as follows: • • •

The variable cost per unit remains constant The fixed cost per unit falls The total cost per unit falls

This may be illustrated graphically as follows:

Question 1: Fixed, variable and mixed costs Are the following likely to be fixed, variable or mixed costs? (a) (b) (c) (d) (e)

3.8

telephone bill annual salary of the chief accountant the company accountant's annual membership fee (paid by the company) cost of materials used to pack 20 units of product X into a box wages of warehouse employees (The answer is at the end of the chapter)

Assumptions about cost behaviour Assumptions about cost behaviour include the following. (a)

Within the normal or relevant range of output (the range of activity over which a particular cost behaviour pattern is assumed valid), costs are often assumed to be either fixed, variable or semi-variable (mixed).

(b)

Departmental costs within an organisation are assumed to be mixed costs, with a fixed and a variable element.

(c)

Departmental costs are assumed to rise in a straight line as the volume of activity increases. In other words, these costs are said to be linear.

The high-low method of determining fixed and variable elements of mixed costs relies on the assumption that mixed costs are linear. We shall now go on to look at this method of cost determination.

4 Determining the fixed and variable elements of semi-variable costs 4.1

Analysing costs Section overview •

LO 4.1

106

The fixed and variable elements of semi-variable costs can be determined by the high-low method.

It is generally assumed that costs are one of the following: • • •

Variable. Semi-variable. Fixed.

Management Accounting

Cost accountants tend to separate semi-variable costs into their variable and fixed elements. They therefore generally tend to treat costs as either fixed or variable. There are several methods for identifying the fixed and variable elements of semi-variable costs (for example regression analysis). Each method is only an estimate, and each will produce different results. One of the principal methods is the high-low method.

4.2

High-low method Follow the steps below to estimate the fixed and variable elements of semi-variable costs:

Step 1

Review records of costs in previous periods: • Select the period with the highest activity level. • Select the period with the lowest activity level.

Step 2

Determine the following: • Total cost at high activity level. • Total costs at low activity level. • Total units at high activity level. • Total units at low activity level.

Step 3

Calculate the following:

Total cos t at high activity level _ total cos t at low activity level = variable cost per unit (v) _ Total units at high activity level total units at low activity level

Step 4

The fixed costs can be determined as follows: (Total cost at high activity level ) – (total units at high activity level × variable cost per unit)

The following graph demonstrates the high-low method:

a = Total cost at high activity level - Total cost at low activity level. Note: As only two data points are used to estimate the cost behaviour, we have no assurance that it accurately represents cost behaviour across or within the relevant range

Worked Example: The high-low method DG Co has recorded the following total costs during the last five years: Year

20X0 20X1 20X2 20X3 20X4

Output volume Units 65 000 80 000 90 000 60 000 75 000

Total cost $ 145 000 162 000 170 000 140 000 160 000

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Required

Calculate the total cost that should be expected in 20X5 if output is 85 000 units.

Solution Step 1

• •

Period with highest activity = 20X2 Period with lowest activity = 20X3

Step 2

• • • •

Total cost at high activity level = 170 000 Total cost at low activity level = 140 000 Total units at high activity level = 90 000 Total units at low activity level = 60 000

Step 3

Variable cost per unit

Step 4

=

Total cos t at high activity level _ total cos t at low activity level _ Total units at high activity level total units at low activity level

=

170 000 − 14 0000 30 000 = = $1 90 000 − 60 000 30 000

Fixed costs = (total cost at high activity level) – (total units at high activity level × variable cost per unit) = 170,000 – (90 000 × $1) = 170 000 – 90 000 = $80 000 Therefore the costs in 20X5 for output of 85 000 units are as follows:

$ 85 000 80 000 165 000

Variable costs = 85 000 × $1 Fixed costs

Worked Example: The high-low method with stepped fixed costs The following data relate to the overhead expenditure of contract cleaners (for industrial cleaning) at two activity levels. Square metres cleaned Overheads

12 750 $73 950

15 100 $83 585

When more than 14,000 square metres are industrially cleaned, there will be a step up in fixed costs of $4,700. Required

Calculate the estimated total cost if 14,500 square metres are to be industrially cleaned.

Solution Before we can compare high activity level costs with low activity level costs in the normal way, we must eliminate the part of the high activity level costs that are due to the step up in fixed costs: Total cost for 15 00 without step up in fixed costs = $83 585 – $4 700 = $78 885 We can now proceed in the normal way using the revised cost above. High activity level Low activity level

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Management Accounting

Units 15 100 12 750 2 350

Total cost Total cost

$ 78 885 73 950 4 935

Variable cost

=

$4 935 2 350

= $2.10 per square metre Before we can calculate the total cost for 14,500 square metres we need to find the fixed costs. As the fixed costs for 14,500 square metres will include the step up of $5,000, we can use the activity level of 15 100 square metres for the fixed cost calculation: $ Total cost (15 100 square metres) (this includes the step up in fixed costs) 83 585 Total variable costs (15 100 x $2.10) 31 710 Total fixed costs 51 875 Estimated overhead expenditure if 14 500 square metres are to be industrially cleaned:

$ 51 875 30 450 82 325

Fixed costs Variable costs (14 500 × $2.10)

Worked Example: The high-low method with a change in the variable cost per unit Same data as the previous question. Additionally, assume wage negotiations have just taken place which will cost an additional $1 per square metre. What is the revised estimated total cost of cleaning 14,500 square metres?

Solution Estimated overheads to clean 14,500 square metres.

Per square metre $ 2.10 1.00 3.10

Variable cost Additional wages cost (variable) Total variable cost Cost for 14 500 square metres:

$ 51 875 44 950 96 825

Fixed Variable costs (14 500 × $3.10)

Question 2: High-low method The valuation department of a large firm of surveyors wishes to develop a method of predicting its total costs in a period. The following costs have been previously recorded at two activity levels:

Period 1 Period 2

Number of valuations (V) 420 515

Total cost (TC) 82 200 90 275

The total cost model for a period could be represented as follows: A B C D

TC = $46 500 + 85V TC = $42 000 + 95V TC = $46 500 – 85V TC = $51 500 – 95V (The answer is at the end of the chapter)

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5 CVP analysis and break-even point 5.1

Introduction Section overview •

LO 11.4

The management of an organisation usually wishes to know the profit likely to be made if the budgeted/target production and sales for the year are achieved. Management may also be interested to know: (a) (b)

5.2

Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between costs, volume and profit at various levels of activity.

The break-even point which is the activity level at which there is neither profit nor loss. The amount by which actual sales can fall below anticipated sales, without a loss being incurred.

Break-even point Formula to learn Break-even point

=

Total fixed cos ts Contribution required to break-even = Contribution per unit Contribution per unit

= Number of units to be sold to break even

Worked Example: Break-even point Expected sales Variable cost Fixed costs

10 000 units at $8 = $80 000 $5 per unit $21 000

Required

Compute the break-even point.

Solution The contribution per unit is $(8−5)

= $3

Contribution required to break even = fixed costs = $21 000 Break-even point (BEP)

= 21 000 ÷ 3 = 7 000 units

In revenue, BEP

= (7 000 × $8) = $56 000

Sales above $56,000 will result in profit of $3 per unit of additional sales and sales below $56,000 will mean a loss of $3 per unit for each unit by which sales fall short of 7,000 units. In other words, profit will improve or worsen by the amount of contribution per unit.

Revenue Less variable costs Contribution Less fixed costs Profit

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Management Accounting

`

7 000 units $ 56 000 35 000 21 000 21 000 0

7 001 units $ 56 008 35 005 21 003 21 000 3

6 The contribution to sales (C/S) ratio Section overview •

The C/S ratio (or Profit/Volume ratio) is a measure of how much contribution is earned from each $1 of sales. It provides an alternative way of calculating the break-even point in terms of sales revenue.

Formula to learn Fixed cos ts Contribution required to break-even = = Break-even point in terms of sales revenue C / S ratio C / S ratio

(The contribution/sales (C/S) ratio is also sometimes called a profit/volume or P/V ratio.) An alternative way of calculating the break-even point in terms of sales revenue. In the example in Paragraph 5.2 the C/S ratio is

$3 = 37.5% $8

Break-even is where sales revenue equals

$21 000 = $56 000 37.5%

At a price of $8 per unit, this represents 7 000 units of sales. The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.

The C/S ratio of 37.5% in the above example means that for every $1 of sales, a contribution of 37.5c is earned. Thus, in order to earn a total contribution of $21,000 (fixed costs) and if the contribution increases by 37.5c per $1 of sales, sales must be: $1 × $21 000 = $56 000 37.5c

Worked Example: Break-even point Assume the C/S ratio of product W is 20%. IB, the manufacturer of product W, wishes to make a contribution of $50,000 towards fixed costs. How many units of product W must be sold if the selling price is $10 per unit?

Solution Re quired contribution $50 000 = = $250 000 C / S ratio 20% Therefore the number of units = $250 000 ÷ $10 = 25 000

Worked Example: C/S ratio A company manufactures a single product with a variable cost of $44. The contribution to sales ratio is 45%. Monthly fixed costs are $396 000. What is the break-even point in units?

Solution Contribution/sales ratio = 45% Therefore Variable cost/sales ratio = 55% Therefore sales price = $44/0.55 = $80 Contribution per unit = $80 × 0.45 = $36

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Break-even point

= Fixed costs/contribution per unit = $396 000/$36 = 11 000 units

7 The safety margin Section overview •

The safety margin is the difference in units between the budgeted sales volume and the break-even sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. The safety margin may also be expressed as the difference between the budgeted sales revenue and break-even sales revenue expressed as a percentage of the budgeted sales revenue.

Worked Example: Safety margin Mal de Mer makes and sells a product which has a variable cost of $30 and which sells for $40. Budgeted fixed costs are $70,000 and budgeted sales are 8,000 units. Calculate the break-even point and the safety margin.

Solution (a)

Break-even point

=

$70 000 Total fixed costs = Contribution per unit $(40 − 30)

= 7 000 units (b)

Safety margin

= 8 000 − 7 000 units = 1 000 units

which may be expressed as (c)

1000units × 100% = 12.5% of budget 8 000units

The safety margin indicates to management that actual sales can fall short of budget by 1 000 units or 12.5% before the break-even point is reached and no profit at all is made.

8 Break-even calculations and profit targets Section overview •

At the break-even point, sales revenue equals total costs and there is no profit. At the breakeven point total contribution = fixed costs.



The target profit is achieved when sales revenue equals total variable costs plus total fixed costs, plus required profit.

Formula to learn S=V+F where s = break-even sales revenue v = total variable costs f = total fixed costs Subtracting V from each side of the equation, we get: S − V = F, that is, total contribution = fixed costs

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Management Accounting

Worked Example: Break-even calculation Butterfingers makes a product which has a variable cost of $7 per unit. If fixed costs are $63 000 per annum, calculate the selling price per unit if the company wishes to break even with a sales volume of 12 000 units.

Solution Contribution required to break even (= Fixed costs)

= $63 000

Volume of sales

= 12 000 units

Required contribution per unit (S − V) Variable cost per unit (V) Required sales price per unit (S)

8.1

= = =

$ 5.25 7.00 12.25

$63 000 ÷ 12 000 =

Target profits The target profit is achieved when S = V + F + P (where P= required profit). Therefore, the total contribution required for a target profit = fixed costs + required profit. A similar formula may be applied where a company wishes to achieve a certain profit during a period. To achieve this profit, sales must cover all costs and leave the required profit.

Formula to learn The target profit is achieved when: S = V + F + P, where P = required profit Subtracting V from each side of the equation, we get: S − V = F + P, so Total contribution required = F + P

Worked Example: Target profit Riding Breeches makes and sells a single product, for which variable costs are as follows: Direct materials Direct labour Variable production overhead

$ 10 8 6 24

The sales price is $30 per unit, and fixed costs per annum are $68 000. The company wishes to make a profit of $16 000 per annum. Determine the sales required to achieve this profit.

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Solution Required contribution = fixed costs + profit = $68 000 + $16 000 = $84 000 Required sales can be calculated in one of two ways: (a)

Re quired contribution Contribution per unit

=

$84 000 = 14 000 units, or $420 000 in revenue $(30 − 24)

(b)

Re quired contribution C / S ratio

=

$84 000 = $420 000 of revenue, or 14 000 units 20% *

* C/S ratio =

$30 − $24 $6 = = 0.2 = 20% $30 $30

Question 3: Target profit Seven League Boots wishes to sell 14 000 units of its product, which has a variable cost of $15 to make and sell. Fixed costs are $119 000 and the required profit is $70 000. Required

What sales price per unit is required to achieve this target profit? A $13.50 B $20.00 C $23.50 D $28.50 (The answer is at the end of the chapter)

8.2

Decisions to change sales price or costs You may come across a problem in which you have to work out the effect of altering the selling price, variable cost per unit or fixed cost. Such problems are slight variations on basic break-even calculations.

Worked Example: Change in selling price Stomer Cakes bake and sell a single type of cake. The variable cost of production is 15c and the current sales price is 25c. Fixed costs are $2 600 per month, and the annual profit for the company at current sales volume is $36 000. The volume of sales demand is constant throughout the year. The sales manager, Ian Digestion, wishes to raise the sales price to 29c per cake, but considers that a price rise will result in some loss of sales. Ascertain the minimum volume of sales required each month to raise the price to 29c.

Solution The minimum volume of sales which would justify a price of 29c is one which would leave total profit at least the same as before, ie $3 000 per month. Required profit should be converted into required contribution, as follows: $ Monthly fixed costs 2 600 Monthly profit, minimum required 3 000 Current monthly contribution 5 600

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Management Accounting

Contribution per unit (25c − 15c) Current monthly sales

10c 56 000 cakes

The minimum volume of sales required after the price rise will be an amount which earns a contribution of $5 600 per month. The contribution per cake at a sales price of 29c would be 14c. required contribution $5 600 = 40 000 cakes per month. Required sales = = contribution per unit 14c

Worked Example: Change in production costs Close Brickett makes a product which has a variable production cost of $8 and a variable sales cost of $2 per unit. Fixed costs are $40 000 per annum, the sales price per unit is $18, and the current volume of output and sales is 6 000 units. The company is considering hiring an improved machine for production. Annual hire costs would be $10 000 and it is expected that the variable cost of production would fall to $6 per unit. (a)

Determine the number of units that must be produced and sold to achieve the same profit as is currently earned, if the machine is hired.

(b)

Calculate the annual profit with the machine if output and sales remain at 6 000 units per annum.

Solution The current unit contribution is $(18 − (8+2)) = $8 (a) $ 48 000 40 000 8 000

Current contribution (6 000 × $8) Less current fixed costs Current profit

With the new machine fixed costs will go up by $10 000 to $50 000 per annum. The variable cost per unit will fall to $(6 + 2) = $8, and the contribution per unit will be $10. $ Required profit (as currently earned) 8 000 Fixed costs 50 000 Required contribution 58 000 Contribution per unit Sales required to earn $8 000 profit (b)

If sales are 6 000 units

Sales (6 000 × $18) Variable costs: production (6 000 × $6) sales (6 000 × $2) Contribution (6 000 × $10) Less fixed costs Profit Alternative calculation

Profit at 5 800 units of sale (see (a)) Contribution from sale of extra 200 units (× $10) Profit at 6 000 units of sale

$10 5 800 units $

$ 108 000

36 000 12 000 48 000 60 000 50 000 10 000 $ 8 000 2 000 10 000

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8.3

Sales price and sales volume Given no change in fixed costs, total profit is maximised when the total contribution is at its maximum. Total contribution in turn depends on the unit contribution and on the sales volume. An increase in the sales price will increase unit contribution, but sales volume is likely to fall because fewer customers will be prepared to pay the higher price. A decrease in sales price will reduce the unit contribution, but sales volume may increase because the goods on offer are now cheaper. The optimum combination of sales price and sales volume is arguably the one which maximises total contribution.

Worked Example: Profit maximisation High Ladders has developed a new product which is about to be launched on to the market. The variable cost of selling the product is $12 per unit. The marketing department has estimated that at a sales price of $20, annual demand would be 10,000 units. However, if the sales price is set above $20, sales demand would fall by 500 units for each 50c increase above $20. Similarly, if the price is set below $20, demand would increase by 500 units for each 50c stepped reduction in price below $20. Determine the price which would maximise High Ladder’s profit in the next year.

Solution At a sales price of $20 per unit, the unit contribution would be $(20 − 12) = $8. Each 50c increase (or decrease) in price would raise (or lower) the unit contribution by 50c. The total contribution is calculated at each sales price by multiplying the unit contribution by the expected sales volume. Unit price $ 20.00

(a)

Sales volume units 10 000

Total contribution $ 80 000

7.50 7.00

10 500 11 000

78 750 77 000

Unit contribution $ 8.50 9.00 9.50 10.00 10.50

Sales volume units 9 500 9 000 8 500 8 000 7 500

Reduce price

19.50 19.00 (b)

Unit contribution $ 8.00

Increase price Unit price $ 20.50 21.00 21.50 22.00 22.50

Total contribution $ 80 750 81 000 80 750 80 000 78 750

The total contribution would be maximised, and therefore profit maximised, at a sales price of $21 per unit, and sales demand of 9,000 units.

Question 4: Break-even output level Betty Battle manufactures a product which has a selling price of $20 and a variable cost of $10 per unit. The company incurs annual fixed costs of $29,000. Annual sales demand is 9,000 units. New production methods are under consideration, which would cause a $1,000 increase in fixed costs and a reduction in variable cost to $9 per unit. The new production methods would result in a superior product and would enable sales to be increased to 9,750 units per annum at a price of $21 each. If the change in production methods were to take place, the break-even output level would be: A B C D

400 units higher 400 units lower 100 units higher 100 units lower (The answer is at the end of the chapter)

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Management Accounting

9 Break-even graphs, contribution graphs and profit/volume charts 9.1

Break-even graphs Section overview •

The break-even point can also be determined graphically using a break-even graph or a contribution break-even graph. These graphs show approximate levels of profit or loss at different sales volume levels within a limited range.



The profit/volume (P/V) chart is a variation of the break-even graph which illustrates the relationship of costs and profits to sales and the safety margin. It shows clearly the effect on profit and break-even point of any change in selling price, variable cost, fixed cost and/or sales demand.

A break-even graph has the following axes: • •

A horizontal axis showing the sales/output (in value or units) A vertical axis showing $ for sales revenues and costs

The following lines are drawn on the break-even graph: (a)

The sales line (i) (ii)

(b)

The fixed costs line (i) (ii)

(c)

Starts at the origin Ends at the point signifying expected sales Runs parallel to the horizontal axis Meets the vertical axis at a point which represents total fixed costs

The total costs line (i)

Starts where the fixed costs line meets the vertical axis

(ii)

Ends at the point which represents anticipated sales on the horizontal axis and total costs of anticipated sales on the vertical axis

The break-even point is the intersection of the sales line and the total costs line. The distance between the break-even point and the expected (or budgeted) sales, in units, indicates the safety margin.

Worked Example: A break-even graph The budgeted annual output of a factory is 120 000 units. The fixed overheads amount to $40 000 and the variable costs are 50c per unit. The sales price is $1 per unit. Construct a break-even graph showing the current break-even point and profit earned up to the present maximum capacity.

Solution We begin by calculating the profit at the budgeted annual output. Sales (120 000 units) Variable costs Contribution Fixed costs Profit

$ 120 000 60 000 60 000 40 000 20 000

Break-even graph (1) is shown on the following page.

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117

The graph is drawn as follows: (a)

The vertical axis represents money (costs and revenue) and the horizontal axis represents the level of activity (production and sales).

(b)

The fixed costs are represented by a straight line parallel to the horizontal axis (in our example, at $40,000).

(c)

The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed costs are the same in total and variable costs are the same per unit at all levels of output. The line of costs is therefore a straight line and only two points need to be plotted and joined up. Perhaps the two most convenient points to plot are total costs at zero output, and total costs at the budgeted output. •

At zero output, costs are equal to the amount of fixed costs only, $40,000, since there are no variable costs.



At the budgeted output of 120,000 units, costs are $100,000.

Fixed costs Variable costs 120 000 × 50c Total costs (d)

$ 40 000 60 000 100 000

The sales line is also drawn by plotting two points and joining them up. (i) (ii)

At zero sales, revenue is nil. At the budgeted output and sales of 120,000 units, revenue is $120,000. -

-

The break-even point is where total costs are matched exactly by total revenue. From the graph, this can be seen to occur at output and sales of 80 000 units, when revenue and costs are both $80 000. This break-even point can be proved mathematically as:

$40 000 Re quired contribution ( = fixed cos ts) = 80 000 units = 50c per unit Contribution per unit The safety margin can be seen on the graph as the difference between the budgeted level of activity and the break-even level.

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Management Accounting

9.2

The value of break-even graphs Break-even graphs are used as follows: • • •

To plan the production of a company's products To market a company's products To give a visual display of break-even calculations

Worked Example: Variations in the use of break-even graphs Break-even graphs can be used to show variations in the possible sales price, variable costs or fixed costs. Suppose that a company sells a product which has a variable cost of $2 per unit. Fixed costs are $15,000. It has been estimated that if the sales price is set at $4.40 per unit, the expected sales volume would be 7,500 units; whereas if the sales price is lower, at $4 per unit, the expected sales volume would be 10,000 units. Draw a break-even graph to show the budgeted profit, the break-even point and the safety margin at each of the possible sales prices.

Solution Workings

Sales price $4.40 per unit $ 15 000 (10 000 × $2.00) 15 000 30 000

Fixed costs Variable costs (7 500 × $2.00) Total costs Budgeted revenue (7 500 × $4.40)

33 000

Sales price $4 per unit $ 15 000 20 000 35 000

(10 000 × $4.00)

40 000

-

-

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119

(a)

Break-even point A is the break-even point at a sales price of $4.40 per unit, which is 6 250 units or $27 500 in costs and revenues.

(check:

$15 000 Re quired contribution to break - even = 6 250 units) $2.40 per unit Contribution per unit

The safety margin (A) is 7 500 units – 6 250 units = 1 250 units or 16.7% of expected sales.

(b)

Break-even point B is the break-even point at a sales price of $4 per unit which is 7 500 units or $30 000 in costs and revenues.

(check:

Re quired contribution to break - even $15 000 = 7 500 units) $2 per unit Contribution per unit

The safety margin (B) = 10 000 units − 7 500 units = 2 500 units or 25% of expected sales.

Since a price of $4 per unit gives a higher expected profit and a wider safety margin, this price will probably be preferred even though the break-even point is higher than at a sales price of $4.40 per unit.

9.3

Contribution (or contribution break-even) graphs As an alternative to drawing the fixed cost line first, it is possible to start with variable costs. This is known as a contribution graph. An example is shown below using the data in Paragraph 9.2.

-

One of the advantages of the contribution graph is that is shows clearly the contribution for different levels of production (indicated here at 120,000 units, the budgeted level of output) as the 'wedge' shape between the sales revenue line and the variable costs line. At the break-even point, the contribution equals fixed costs exactly. At levels of output above the break-even point, the contribution is larger, and not only covers fixed costs, but also leaves a profit. Below the break-even point, the loss is the amount by which contribution fails to cover fixed costs.

9.4

The profit/volume (P/V) chart The profit/volume (P/V) chart is a variation of the break-even graph which illustrates the relationship of costs and profits to sales and the safety margin. A P/V chart is constructed as follows (look at the graph in the example that follows as you read the explanation).

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Management Accounting

(a)

'P' is on the y axis and actually comprises not only 'profit' but contribution to profit (in monetary terms), extending above and below the x axis with a zero point at the intersection of the two axes, and the negative section below the x axis representing fixed costs. This means that at zero production, the company is incurring a loss equal to the fixed costs.

(b)

'V' is on the x axis and comprises either volume of sales or value of sales (revenue).

(c)

The profit-volume line is a straight line drawn with its starting point (at zero production) at the intercept on the y axis representing the level of fixed costs, and with a gradient of contribution/unit (or the P/V ratio if sales value is used rather than units). The P/V line will cut the x axis at the breakeven point of sales volume. Any point on the P/V line above the x axis represents the profit to the company (as measured on the vertical axis) for that particular level of sales.

Worked Example: P/V chart Let us draw a P/V chart for our example (Paragraph 9.1). At sales of 120 000 units, total contribution will be 120 000 × $(1 – 0.5) = $60 000 and total profit will be $20 000.

– -

9.5

The advantage of the P/V chart The P/V chart shows clearly the effect on profit and break-even point of any changes in selling price, variable cost, fixed cost and/or sales demand.

If the budgeted selling price of the product in our example is increased to $1.20, with the result that demand drops to 105 000 units despite additional fixed advertising costs of $10 000. At sales of 105 000 units, contribution will be 105 000 × $(1.20 – 0.50) = $73 500 and total profit will be $23 500 (fixed costs being $50 000).

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Profit/loss $’000

P/V chart (2)

30 x x

20

PROFIT 10 Sales volume '000 (units)

Breakeven point 2 BREAKEVEN 105

120

Breakeven point 1

10 20

LOSS

30 40 x 50 x

The diagram shows that if the selling price is increased, the break-even point occurs at a lower level of sales revenue (71 429 units instead of 80 000 units), although this is not a particularly large increase when viewed in the context of the projected sales volume. It is also possible to see that for sales above 50 000 units, the profit achieved will be higher (and the loss achieved lower) if the price is $1.20. For sales volumes below 50 000 units the first option will yield lower losses. The P/V chart is the clearest way of presenting such information; two conventional break-even graphs on one set of axes would be very confusing. Changes in the variable cost per unit or in fixed costs at certain activity levels can also be easily incorporated into a P/V chart. The profit or loss at each point where the cost structure changes should be calculated and plotted on the graph so that the profit/volume line becomes a series of straight lines. For example, suppose that in our example, at sales levels in excess of 120 000 units the variable cost per unit increases to $0.60 (perhaps because of overtime premiums that are incurred when production exceeds a certain level). At sales of 130 000 units, contribution would therefore be 130 000 × $(1 – 0.60) = $52 000 and total profit would be $12 000. Profit/loss $ 000

P/V chart (3)

x

20

x PROFIT 10 Sales volume 000 (units)

Break-even point BREAK-EVEN 120 10 LOSS

20

Fixed costs

30 40 x

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Management Accounting

130

Question 5: Profit/volume chart The profit/volume chart for a single product company is as follows: Profit ($ 000) 140

0

500

Sales revenue ($ 000)

(60)

What is the product’s contribution to sales ratio (expressed as a %)? A B C D

16% 28% 40% 72% (The answer is at the end of the chapter)

10 Limitations of CVP analysis Section overview •

Break-even analysis is a useful technique for managers as it can provide simple and quick estimates. Break-even graphs provide a graphical representation of break-even calculations. Break-even analysis does, however, have number of limitations.

The limitations of break-even analysis are described in the list that follows: • • • • • • •

It can only apply to a single product or a single mix of a group of products. A break-even graph may be time-consuming to prepare. It assumes fixed costs are constant at all levels of output. It assumes that variable costs are the same per unit at all levels of output. It assumes that sales prices are constant at all levels of output. It assumes production and sales are the same (inventory levels are ignored). It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

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Key chapter points •

Costs may be classified into fixed costs and variable costs. Many items of expenditure are partfixed and part-variable and are so termed step-fixed, semi-variable or mixed costs.



Cost behaviour is the way in which costs are affected by changes in the levels of activity.



The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. It will cost more to produce 2 000 units of output than it will to produce 1 000 units.



A fixed cost is a cost which tends to be unaffected by increases or decreases in the levels of activity.



A step-fixed cost is a cost which is fixed in nature but only within certain levels of activity.



A variable cost is a cost which tends to vary directly with the levels of activity. The variable cost per unit is the same amount for each unit produced.



If the relationship between total variable cost and levels of activity can be shown as a curved line on a graph, the relationship is said to be curvilinear.



A semi-variable/mixed cost is a cost which contains both fixed and variable components and so is partly affected by changes in the level of activity.



The fixed and variable elements of semi-variable costs can be determined by the high-low method.



Cost-volume-profit (CVP)/break-even analysis is the study of the interrelationships between costs, volume and profits at various levels of activity.



Break-even point = Number of units of sale required to break-even

=



Total fixed cos ts Contribution required to break - even = Contribution per unit Contribution per unit

Break-even point in terms of sales revenue

Fixed cos ts Contribution required to break - even = C / S ratio C / S ratio

124



The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.



The safety margin is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. The safety margin may also be expressed as the difference between the budgeted sales revenue and the break-even sales revenue expressed as a percentage of the budgeted sales revenue.



At the break-even point, sales revenue = total costs and there is no profit. At the break-even point total contribution = fixed costs.



The target profit is achieved when S = V + F + P. Therefore the total contribution required for a target profit = fixed costs + required profit.



The break-even point can also be determined graphically using a break-even graph or a contribution break-even graph. These graphs show approximate levels of profit or loss at different sales volume levels within a limited range.



The profit/volume (PV) chart is a variation of the break-even graph which illustrates the relationship of costs and profits to sales and the safety margin.



The P/V chart shows clearly the effect on profit and break-even point of any changes in selling price, variable cost, fixed cost and/or sales demand.



Break-even analysis is a useful technique for managers as it can provide simple and quick estimates. Break-even graphs provide a graphical representation of break-even calculations. Break-even analysis does, however, have a number of limitations.

Management Accounting

Quick revision questions The following information relates to questions 1 to 3

Which one of the above graphs illustrates the costs described in questions 1 to 3?

1

A linear variable cost – when the vertical axis represents cost incurred. A B C D

2

A fixed cost – when the vertical axis represents cost incurred. A B C D

3

graph 1 graph 2 graph 3 graph 6

A step fixed cost – when the vertical axis represents cost incurred. A B C D

4

graph 1 graph 2 graph 4 graph 5

graph 3 graph 4 graph 5 graph 6

A company manufactures a single product. The total cost of making 4,000 units is $20,000 and the total cost of making 20,000 units is $40,000. Within this range of activity the total fixed costs remain unchanged. What is the variable cost per unit of the product? A B C D

$0.80 $1.20 $1.25 $2.00

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125

5

A production worker is paid a salary of $650 per month, plus an extra 5 cents for each unit produced during the month. This labour cost is best described as: A B C D

a variable cost a fixed cost a step cost a semi-variable cost

The following data relates to questions 6 and 7 Data concerning a company's single product is as follows: Selling price Variable production cost Variable selling cost Fixed production cost Fixed selling cost

$ per unit 6.00 1.20 0.40 4.00 0.80

Budgeted production and sales for the year are 10 000 units. 6

What is the company's break-even point, to the nearest whole unit? A B C D

7

8 000 units 8 333 units 10 000 units 10 909 units

It is now expected that the variable production cost per unit and the selling price per unit will each increase by 10%, and fixed production costs will rise by 25%. What will be the new break-even point, to the nearest whole unit? A B C D

8

9

Which of the following statements about profit-volume graphs is/are correct? I

The profit-volume line starts at the origin.

II

The profit-volume line crosses the x axis at the break-even point.

III

Any point on the profit-volume line above the x axis indicates the profit (as measured on the vertical axis) at that level of activity.

A B C D

I and II only I and III only II and III only I, II and III

A company's break-even point is 6,000 units per annum. The selling price is $90 per unit and the variable cost is $40 per unit. What are the company's annual fixed costs? A B C D

10

126

8 788 units 11 600 units 11 885 units 12 397 units

$120 $240 000 $300 000 $540 000

A company makes a single product which it sells for $16 per unit. Fixed costs are $76 800 per month and the product has a profit/volume ratio of 40%. In a period when actual sales were $224 000, the company's safety margin, in units, was: A 2 000 B 12 000 C 14 000 D 32 000

Management Accounting

Answers to quick revision questions 1

B

Graph 2 shows that costs increase in line with activity levels

2

A

Graph 1 shows that fixed costs remain the same whatever the level of activity

3

A

Graph 3 shows that the step fixed costs go up in 'steps' as the level of activity increases

4

C

Using the high-low method: Units

Cost $ 40 000 20 000 20 000

20 000 4 000 16 000 Variable cost per unit = 5

D

$20 000 = $1.25 16 000 units

The salary is part fixed ($650 per month) and part variable (5 cents per unit). Therefore it is a semi-variable cost and answer D is correct. If you chose option A or option B you were considering only part of the cost. Option C, a step cost, involves a cost which remains constant up to a certain level and then increases to a new, higher, constant fixed cost.

6

D

Breakeven point

=

Fixed costs Contributi on per unit

=

10000 × ($4.00 + 0.80) $48 000 = = 10 909 units $6.00 − ($1.20 + $0.40) $4.40

If you selected option A you divided the fixed cost by the selling price, but the selling price also has to cover the variable cost. Option B ignores the selling costs, but these are costs that must be covered before the breakeven point is reached. Option C is the budgeted sales volume, which happens to be below the breakeven point.

7

C

$ per unit 6.60 1.72 4.88

New selling price ($6 × 1.1) New variable cost ($1.20 × 1.1) + $0.40 Revised contribution per unit New fixed costs ($40 000 × 1.25) + $8 000 = Revised breakeven point =

$58 000

$58 000 = 11 885 units $4.88

If you selected option A you divided the fixed cost by the selling price, but the selling price also has to cover the variable cost. Option B fails to allow for the increase in variable production cost Option D increases all of the costs by the percentages given, rather than the production costs only.

4: Cost behaviour and CVP analysis

127

8

C

Therefore the correct answer is C, statements II and III are correct. Statement II is correct. The point where the profit-volume line crosses the x axis is the point of zero profit and zero loss, ie the breakeven point. Statement III is correct. The profit can be read from the y axis at any point beyond the breakeven point. Statement I is incorrect. The starting point of the profit-volume line is the point on the y axis representing the loss at zero activity, which is the fixed cost incurred.

9

C

Contribution per unit = $90 – $40 = $50. The sale of 6 000 units just covers the annual fixed costs, therefore the fixed costs must be $50 × 6 000 = $300 000. If you selected option A you calculated the correct contribution of $50 per unit, but you then divided the 6,000 by $50 instead of multiplying. Option B is the total annual variable cost. Option D is the annual revenue.

10

A

Breakeven point =

Fixed costs P/V ratio

=

$76 800 = $192 000 0.40

Actual sales = Margin of safety in terms of sales value

$224 000 $32 000

÷ selling price per unit

÷ $16

Margin of safety in units

2 000

If you selected option B you calculated the breakeven point in units, but forgot to take the next step to calculate the margin of safety. Option C is the actual sales in units. Option D is the margin of safety in terms of sales value.

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Management Accounting

Answers to chapter questions 1

(a) (b) (c) (d) (e)

2

A

mixed fixed fixed variable variable Valuations V 515 420 95

Period 2 Period 1 Change due to variable cost

Total cost $ 90 275 82 200 8 075

∴ Variable cost per valuation = $8 075/95 = $85. Period 2: fixed cost = $90 275 – (515 × $85) = $46 500 You should have managed to eliminate C and D as incorrect options straightaway. The variable cost must be added to the fixed cost, rather than subtracted from it. Once you had calculated the variable cost as $85 per valuation (as shown above), you should have been able to select option A without going on to calculate the fixed cost (we have shown this calculation above for completeness). 3

D $ 70 000 119 000 189 000

Required profit Fixed costs Required contribution

Required contribution per unit = $189 000/14 000 = $13.50

$ 13.50 15.00 28.50

Required contribution per unit Variable cost per unit Required sales price per unit 4

B Selling price Variable costs Contribution per unit Fixed costs Break-even point (units) Break-even point

=

Total fixed cos ts Contribution per unit

Current BEP

=

$29 000 = 2 900 units $10

Revised $ 21 9 12

$29 000 2 900

$30 000 2 500

Difference

400 lower

$30 000 = 2 500 units $10 C. The profit/volume graph shows levels of profit at different levels of sales. In order to answer the question, you must determine contribution for $500 000 sales revenue. Revised BEP

5

Current $ 20 10 10

=

Remember that profit = contribution – fixed costs. When sales revenue = 0, contribution = 0 and the graph shows a loss of $60 000 at zero sales revenue. This means that fixed costs must be $60 000. Contribution at $500 000 sales revenue = $140 000 (profit) + $60 000 (fixed costs) = $200 000 Contribution to sales ratio = contribution/sales revenue = ($200 000/$500 000) = 0.4 or 40%

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129

130

Management Accounting

Chapter 5

Overheads, absorption and marginal costing Learning objectives

Reference

Overhead costing – product and service costing

LO5

Explain three methods of departmental overhead allocation

LO5.1

Explain the concepts underpinning product costing in organisations

LO5.2

Develop different product costing statements involving production resource costs

LO5.3

Evaluate the difference between direct production costs and indirect overhead costs

LO5.4

Apply the principles of absorption and variable costing to product costing analysis

LO5.5

Topic list

1 2 3 4 5 6 7 8 9 10

Cost classification Overheads Absorption costing: an introduction Overhead allocation Overhead apportionment Overhead absorption Blanket absorption rates and departmental absorption rates Marginal cost and marginal costing The principles of marginal costing Marginal costing, absorption costing and the calculation of profit 131

Introduction The classification of costs, as either direct or indirect for example, is essential in the costing method used by an organisation to determine the cost of a unit of product or service. Absorption costing is a method of accounting for overheads. It is basically a method of sharing out overheads incurred amongst units produced. This chapter explains why absorption costing might be necessary and then provides an overview of how the cost of a unit of product is built up under a system of absorption costing. A detailed analysis of this costing method is then provided, covering the three stages of absorption costing: allocation, apportionment and absorption. This chapter concludes when it defines marginal costing and compares it with absorption costing. Whereas absorption costing recognises fixed costs, usually fixed production costs, as part of the cost of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs. Two such different costing methods obviously each have their supporters and detractors so we will be looking at the arguments both in favour of and against each method. Each costing method, because of the different inventory valuation used, produces a different profit figure and we will be looking at this particular point in detail.

132

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is a direct cost?

(Section 1.2)

2

What is an indirect cost?

(Section 1.2)

3

What are direct wages?

(Section 1.2)

4

What is an overhead?

5

What are the practical reasons for using absorption costing?

(Section 3.2)

6

What are the three stages of absorption costing?

(Section 3.4)

7

What are the steps involved in the calculation of overhead absorption rates?

(Section 6.2)

8

What is a marginal cost?

(Section 8)

9

What are the principles of marginal costing?

(Section 9)

(Section 2)

5: Overheads, absorption and marginal costing

133

1 Cost classification Section overview

1.1



Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.



Classification by function involves classifying costs as production/manufacturing costs, administration costs or marketing and distribution costs.

Total product/service costs The total cost of making a product or providing a service consists of the following:

LO 5.2

(a)

Cost of materials.

(b)

Cost of the wages and salaries (labour costs).

(c)

Cost of other expenses: I II III IV

1.2

Rent and rates. Electricity and gas bills. Depreciation. etc.

Direct costs and indirect costs

1.2.1

Materials, labour and expenses Definitions A direct cost is a cost that can be traced in full to the product, service, or department. An indirect cost, or overhead, is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

LO 5.4

Materials, labour costs and other expenses can be classified as either direct costs or indirect costs. (a)

Direct material costs are the costs of materials that are known to have been used in making a product, or providing a service.

(b)

Direct labour costs are the specific costs of the labour used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in 'direct production work'.

(c)

Other direct expenses are those expenses that have been incurred in full as a direct consequence of making a product, or providing a service, or running a department.

Examples of indirect costs include supervisors' wages, cleaning materials and buildings insurance.

1.2.2

Analysis of total cost Materials + Labour + Expenses Total cost

134

Management Accounting

= = = =

Direct materials + Direct labour + Direct expenses Direct cost

+ + + +

Indirect materials + Indirect labour + Indirect expenses Overhead

1.2.3

Direct material Direct material is all material consumed in the manufacture of the product. Direct material costs are charged to the product as part of the prime cost. Examples of direct material are as follows:

1.2.4



Component parts, specially purchased for a particular job, order or process.



Part-finished work which for example is transferred from department 1 to department 2. It becomes finished work of department 1 and a direct material cost in department 2.



Primary packing materials like cartons and boxes.

Direct labour Definition Direct wages are all wages paid for labour, either as basic hours or as overtime, expended on work on the product itself.

Direct wages costs are charged to the product as part of the prime cost. Examples of groups of labour receiving payment as direct wages are as follows: • • •

Workers engaged in altering the condition or composition of the product. Inspectors, analysts and testers specifically required for such production. Foremen, shop clerks and anyone else whose wages are specifically identified as working on a particular product.

As production becomes more capital intensive: •

The ratio of direct labour costs to total product cost falls as the use of machinery increases, and hence depreciation charges increase.



Skilled labour costs and sub-contractors' costs increase as direct labour costs decrease.

Question 1: Labour costs Which of the following labour costs are normally treated as indirect labour costs? (1) (2) (3) (4) (5)

Overtime premium paid to direct workers Bonus payments to direct workers. Payroll taxes. Idle time of direct workers. Work on installation of equipment.

A B C D

(1) (2) and (4) only (1) (4) and (5) only (2) (3) and (4) only (3) (4) and (5) only (The answer is at the end of the chapter)

1.2.5

Direct expenses Definition Direct expenses are any expenses which are incurred on a specific product other than direct material cost and direct labour.

5: Overheads, absorption and marginal costing

135

Direct expenses are charged to the product as part of the prime cost. Examples of direct expenses are as follows: • •

The hire of tools or equipment for a particular job. Maintenance costs of tools, fixtures and so on.

Direct expenses are also referred to as chargeable expenses.

1.2.6

Production overhead Definition Production (or factory) overhead includes all indirect material costs, indirect wages and indirect expenses incurred in the factory from receipt of the order until its completion.

Production overhead includes the following: •

Indirect materials which cannot be traced to the finished product. Consumable stores, e.g. material used in negligible amounts.



Indirect wages, meaning all wages not charged directly to a product. Wages of personnel in the production department not directly involved in the manufacture of the product, e.g. foremen.



Indirect expenses, other than material and labour, not charged directly to production. (i) (ii)

1.2.7

Rent, rates and insurance of a factory. Depreciation, fuel, power, maintenance of plant, machinery and buildings.

Administration overhead Definition Administration overhead is all indirect material costs, wages and expenses incurred in the direction, control and administration of a business.

Examples of administration overhead are as follows: • • •

1.2.8

Depreciation of office buildings and equipment. Office salaries, including salaries of directors, secretaries and accountants. Lighting, cleaning, telephone charges and so on.

Marketing overhead Definition Marketing overhead is all indirect materials costs, wages and expenses incurred in promoting sales and retaining customers.

Examples of marketing overhead are as follows: • • • •

136

Printing and stationery, such as catalogues and price lists. Salaries and commission of salesmen, representatives and sales department staff. Advertising and sales promotion, market research. Rent, rates and insurance of sales offices and showrooms.

Management Accounting

1.2.9

Distribution overhead Definition Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed product ready for despatch and delivering it to the customer.

Examples of distribution overhead are as follows: • • •

Cost of packing cases. Wages of packers, drivers and despatch clerks. Insurance charges, rent, rates.

Question 2: Direct labour cost A direct labour employee's wage in week 5 consists of the following: (a) (b) (c) (d)

Basic pay for normal hours worked, 36 hours at $4 per hour = Pay at the basic rate for overtime, 6 hours at $4 per hour = Overtime shift premium, with overtime paid at time-and-a-quarter ¼ × 6 hours × $4 per hour = A bonus payment under a group bonus (or 'incentive') scheme – bonus for the month = Total gross wages in week 5 for 42 hours of work

$ 144 24 6 30 204

What is the direct labour cost for this employee in week 5? A B C D

$144 $168 $198 $204 (The answer is at the end of the chapter)

1.3 1.3.1

Functional costs Classification by function Classification by function involves classifying costs as production/manufacturing costs, administration costs or marketing and distribution costs. In a 'traditional' costing system for a manufacturing organisation, costs are classified as follows: (a)

Production or manufacturing costs. These are costs associated with the factory.

(b)

Administration costs. These are costs associated with general office departments.

(c)

Marketing and distribution costs. These are costs associated with sales, marketing, warehousing and transport departments.

Classification in this way is known as classification by function. Expenses that do not fall fully into one of these classifications might be categorised as general overheads or even listed as a classification on their own, for example, research and development costs and financing costs.

5: Overheads, absorption and marginal costing

137

1.3.2

Full cost of sales In costing a small product made by a manufacturing organisation, direct costs are usually restricted to some of the production costs.

LO 5.3

A commonly found build-up of costs is therefore as follows: $ Production costs Direct materials Direct wages Direct expenses Prime cost Production overheads Full factory cost Administration costs Marketing and distribution costs Full cost of sales

1.3.3

A B C A+B+C D A+B+C+D E F A+B+C+D+E+F

Functional costs (a)

Production costs are the costs which are incurred by the sequence of operations beginning with the supply of raw materials, and ending with the completion of the product ready for warehousing as a finished goods item. Packaging costs are production costs where they relate to 'primary' packing (boxes, wrappers and so on).

(b)

Administration costs are the costs of managing an organisation, that is, planning and controlling its operations, but only insofar as such administration costs are not for instance related to the production, sales, distribution or research and development functions.

(c)

Marketing costs are the costs of creating demand for products and securing firm orders from customers.

(d)

Distribution costs are the costs associated with the sequence of activities commencing with the receipt of finished goods from the production department and making them ready for despatch.

(e)

Research costs are the costs of searching for new or improved products, whereas development costs are the costs incurred between the decision to produce a new or improved product and the commencement of full manufacture of the product.

(f)

Financing costs are costs incurred to finance the business, such as loan interest.

Question 3: Cost classification Within the costing system of a manufacturing company the following types of expense are incurred: Reference number 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

138

Cost of oils used to lubricate production machinery Motor vehicle licences for trucks Depreciation of factory plant and equipment Cost of chemicals used in the laboratory Commission paid to sales representatives Salary of the secretary to the finance director Trade discount given to customers Holiday pay of machine operators Salary of security guard in warehouse stocked with raw material Fees to advertising agency Rent of finished goods warehouse Salary of scientist in laboratory Insurance of the company's premises Salary of supervisor working in the factory Cost of toner cartridges for printers in the general office Protective clothing for machine operators

Management Accounting

Complete the following table by placing each expense in the correct cost classification. Cost classification

Reference number

Production costs Marketing and distribution costs Administration costs Research and development costs

Each type of expense should appear only once in your response. You may use the reference numbers in your response. (The answer is at the end of the chapter)

2 Overheads Section overview •

Overhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

Overhead is actually the total of the following: • • •

Indirect materials. Indirect labour. Indirect expenses.

The total of these indirect costs is usually split into the following categories: • • •

Production. Marketing and distribution. Administration.

In cost accounting there are two schools of thought as to the correct method of dealing with overheads: • •

Absorption costing. Marginal costing.

3 Absorption costing: an introduction Section overview •

LO 5.5

The objective of absorption costing is to include in the total cost of a product an appropriate share of the organisation's total overhead. An appropriate share is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing a unit or completing a job.

An organisation with one production department that produces identical units will divide the total overheads among the total units produced. Absorption costing is a method for sharing overheads between different products on a fair basis.

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3.1

Is absorption costing necessary? Suppose that a company makes and sells 100 units of a product each week. The prime cost per unit is $6 and the unit sales price is $10. Production overhead costs $200 per week and administration, marketing and distribution overhead costs $150 per week. The weekly profit could be calculated as follows: $ Sales (100 units × $10) Prime costs (100 × $6) Production overheads Administration, marketing and distribution costs

$ 1 000

600 200 150 950 50

Profit

In absorption costing, overhead costs will be added to each unit of product manufactured and sold. $ per unit Prime cost per unit 6 Production overhead ($200 per week for 100 units) 2 Full factory cost 8 The weekly profit would be calculated as follows: Sales Less factory cost of sales Gross profit Less administration, marketing and distribution costs Net profit

$ 1 000 800 200 150 50

Sometimes, but not always, the overhead costs of administration, marketing and distribution are also added to unit costs, to obtain a full cost of sales. $ per unit Prime cost per unit 6.00 Factory overhead cost per unit 2.00 Administration costs per unit ($150 per week for 100 units) 1.50 Full cost of sales 9.50 The weekly profit would be calculated as follows: Sales Less full cost of sales Profit

$ 1 000 950 50

It may already be apparent that the weekly profit is $50 no matter how the figures have been presented. So, how does absorption costing serve any useful purpose in accounting? The theoretical justification for using absorption costing is that all production overheads are incurred in the production of the organisation's output and so each unit of the product receives some benefit from these costs. Each unit of output should therefore be charged with some of the overhead costs.

3.2

Practical reasons for using absorption costing The main reasons for using absorption costing are for inventory valuations, pricing decisions, and establishing the profitability of different products. (a)

Inventory valuations. Inventory on hand must be valued for two reasons: (i) (ii)

For the closing inventory figure in the statement of financial position For the cost of sales figure in the statement of comprehensive income

The valuation of inventory will affect profitability during a period because of the way in which the cost of sales is calculated.

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The cost of goods produced (extract) + – =

the value of opening inventories the value of closing inventories the cost of goods sold

In our example, (under Section3.1), closing inventories might be valued at prime cost, $6, but in absorption costing, they would be valued at a fully absorbed factory cost, $8 per unit. They would not be valued at $9.50, the full cost of sales, because the only costs incurred in producing goods for finished inventory are factory costs.

3.3

(b)

Pricing decisions. Many companies attempt to fix selling prices by calculating the full cost of production or sales of each product, and then adding a margin for profit. In our example, the company might have fixed a gross profit margin at 25% on factory cost, or 20% of the sales price, in order to establish the unit sales price of $10. 'Full cost plus pricing' can be particularly useful for companies which do contract work, where each job or contract is different, so that a standard unit sales price cannot be fixed. Without using absorption costing, a full cost is difficult to ascertain.

(c)

Establishing the profitability of different products. This argument in favour of absorption costing is more contentious, but is worthy of mention here. If a company sells more than one product, it will be difficult to judge how profitable each individual product is, unless overhead costs are shared on a fair basis and charged to the cost of sales of each product.

International Accounting Standard 2 (IAS 2) Absorption costing is recommended in financial accounting by IAS 2 Inventories. IAS 2 deals with financial accounting systems. The cost/management accountant is, in theory, free to value inventories by whatever method seems best, but where companies integrate their financial accounting and cost accounting systems into a single system of accounting records, the valuation of closing inventories will be determined by IAS 2. IAS 2 states that costs of all inventories should comprise those costs which have been incurred in the normal course of business in bringing the inventories to their 'present location and condition'. These costs incurred will include all related production overheads, even though these overheads may accrue on a time basis. In other words, in financial accounting, closing inventories should be valued at full factory cost, and it may therefore be convenient and appropriate to value inventories by the same method in the cost accounting system.

3.4

Absorption costing stages The three stages of absorption costing are: • • •

Allocation. Absorption. Apportionment.

We shall now begin our study of absorption costing by looking at the process of overhead allocation.

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4 Overhead allocation 4.1

Introduction Section overview •

LO 5.1

Allocation is the process by which whole cost items are charged direct to a product unit or cost centre.

Cost centres may be one of the following types: (a)

A production department, to which production overheads, such as the wages of factory supervisor, are charged.

(b)

A service department, such as quality control or maintenance, to which overheads incurred in providing that service are charged.

(c)

An administrative department, to which administration overheads are charged.

(d)

A marketing or a distribution department, to which marketing and distribution overheads are charged.

(e)

An overhead cost centre, to which items of expense, such as rent and rates, heating and lighting, which will ultimately be shared by a number of departments, are charged.

Where a cost is specifically attributable to a cost centre, it is allocated directly to the cost centre that caused the cost to be incurred, for example: • • •

Direct labour for the packing staff will be allocated to the packing department (production) cost centre. The cost of a warehouse security guard will be charged to the warehouse cost centre. Paper (recording computer output) will be charged to the computer department.

Worked Example: Overhead allocation Consider the following costs of a company. Wages of the foreman of department A Wages of the foreman of department B Indirect materials consumed in department A Rent of the premises shared by departments A and B

$200 $150 $50 $300

The cost accounting system might have the below three overhead cost centres. Cost centre: 101 102 201

Department A Department B Rent

Solution Overhead costs would be allocated directly to each cost centre, i.e. $200 + $50 to cost centre 101, $150 to cost centre 102 and $300 to cost centre 201. The rent of the factory will be subsequently shared between the two production departments, but for the purpose of day to day cost recording, the rent will first of all be charged in full to a separate cost centre (201).

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5 Overhead apportionment Section overview •

Apportionment is a procedure whereby indirect costs are spread fairly between cost centres. Service cost centre costs may be apportioned to production cost centres by using the reciprocal method.

The following data will be used to illustrate the overhead apportionment process.

Worked Example: Cups Inc has two production departments (A and B) and two service departments (maintenance and stores). Details of next year’s budgeted overheads are shown below: Total ($) 19 200 9 600 54 000 38 400 9 000 25 000

Heat and light Building repair costs Machinery depreciation Rent and rates Cafeteria Machinery insurance Details of each department are as follows: Floor area (m2) Machinery book value ($ 000) Number of employees Allocated overheads ($ 000)

A 6 000 48 50 15

B 4 000 20 40 20

Maintenance 3 000 8 20 12

Stores 2 000 4 10 5

Total 15 000 80 120 52

Maintenance -------

Stores 1 000 ----

Total 10 000 4 000

Service departments’ services were used as follows: Maintenance hours worked Number of stores requisitions

5.1

A 5 000 3 000

B 4 000 1 000

Stage 1: Apportion general overheads Overhead apportionment follows on from overhead allocation. The first stage of overhead apportionment is to identify all overhead costs as production department, production service department, administration or marketing and distribution overhead. The costs for heat and light, rent and rates, the cafeteria and so on, i.e. costs allocated to general overhead cost centres, must therefore be shared out between the other cost centres.

5.1.1

Bases of apportionment Overhead costs should be shared out on a fair basis. You will appreciate that because of the complexity of items of cost it is rarely possible to use only one method of apportioning costs to the various departments of an organisation. An example of some of the bases of apportionment for common overhead expenses are given below: Overhead to which the basis applies

Basis

Rent, rates, heating and lighting, repairs and depreciation of buildings

Floor area occupied by each department (cost centre)

Depreciation of equipment, insurance of equipment

Cost or book value of equipment

Personnel costs, cafeteria costs, superannuation

Number of employees, or labour hours worked in each cost centre

Note that heating and lighting may also be apportioned using volume of space occupied by each cost centre.

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Worked Example: Using the Cups question above, show how overheads should be apportioned between the four departments.

Solution Item of cost

Heat and light Building repair costs Machine depn Rent and rates Cafeteria Machine insurance Total

Basis of apportionment A $ 7 680 3 840

Floor area Floor area Machinery value Floor area No of employees Machinery value

32 400 15 360 3 750 15 000 78 030

Department MaintenB ance $ $ 5 120 3 840 2 560 1 920 13 500 10 240 3 000 6 250 40 670

5 400 7 680 1 500 2 500 22 840

Stores $ 2 560 1 280 2 700 5 120 750 1 250 13 660

Workings Overhead apportioned by floor area Overhead apportioned to department

=

Floor area occupied by department × total overhead Total floor area

=

6 000 × 19 200 = $7 680 15 000

=

Value of department 's machinery × total overhead Total value of machinery

For example: Heat and light apportioned to dept A Overheads apportioned by machinery value

Overheads apportioned to department

Overheads apportioned by number of employees

Overheads apportioned to department

5.2

=

No of employees in department × total overhead Total no of employees

Stage 2: Apportion service department costs Only production departments produce goods that will ultimately be sold. In order to calculate a correct price for these goods, we must determine the total cost of producing each unit – that is, not just the cost of the labour and materials that are directly used in production, but also the indirect costs of services provided by such departments as maintenance and stores. Our aim is to apportion all the service department costs to the production departments, in one of three ways.

144

(a)

The direct method, where the service centre costs are apportioned to production departments only.

(b)

The step-down method, where each service centre’s costs are not only apportioned to production departments but initially to some, but not all, of the other service centres that make use of the services provided. The costs of the service centres are then apportioned to the production departments.

Management Accounting

(c)

The repeated distribution (or reciprocal) method, where service centre costs are apportioned to both the production departments and service departments that use the services. The service centre costs are then gradually apportioned to the production departments. This method is used only when service departments work for each other – that is, service departments use each other’s services. For example, the maintenance department will use the cafeteria, while the cafeteria may rely on the maintenance department to ensure its equipment is functioning properly or to replace bulbs, plugs, etc. The difference between the step down and reciprocal method is that step-down only partially recognises the relationships between service departments, whereas the reciprocal method recognises these fully.

5.2.1

Basis of apportionment Whichever method is used to apportion service cost centre costs, the basis of apportionment must be fair. A different apportionment basis may be applied for each service cost centre. This is demonstrated in the following table: Service cost centre

Possible basis of apportionment

Stores

Number or cost value of material requisitions

Maintenance

Hours of maintenance work done for each cost centre

Production planning

Direct labour hours worked in each production cost centre

Although both the direct and step-down methods are not in your syllabus, the following illustration will give you an idea of how to carry out simple apportionments before we move onto the more complex reciprocal method.

Worked Example: Simple apportionment using the step-down method Using the information contained in the Cups Worked Example regarding allocated overheads (section 5)and the results of the overhead apportionment calculations in 5.2 above, apportion the maintenance and stores departments’ overheads to production departments A and B and calculate the total overheads for each of these production departments.

Solution (1)

Decide how the service departments’ overheads will be apportioned. The table above tells us that maintenance overheads can be apportioned according to the hours of maintenance work done, while we can use the number or cost value of stores/material requisitions for apportioning stores. The question gives us information about maintenance hours worked and the number of stores requisitions.

(2)

Apportion the overheads of the service department whose services are also used by another service department (in this case, maintenance). This allows us to obtain a total overhead cost for stores.

Total overheads for maintenance department $ General overheads 22 840 Allocated overheads 12 000

(see section 5.2 above) (from information given in worked example section 5 above)

34 840 Apportioned as follows: Ma int enance hours worked in department × $34 840 Total ma int enance hours worked

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Production department A =

5 000 × $34 840 = $17 420 10 000

Production department B =

4 000 × $34 840 = $13 936 10 000

Stores department = (3)

1 000 × $34 840 = $3 484 10 000

Apportion stores department’s overheads. Total overheads for stores

$ 13 660 5 000

General overheads Allocated overheads Apportioned from maintenance

3 484 22 144

(see section 5.2 above) (from information given in worked example section 5 above) (see above)

Apportioned as follows: Number of stores requisitions for department × $22 144 Total number of stores requisitions

(4)

Production department A =

3 000 × $22 144 = $16 608 4 000

Production department B =

1 000 × $22 144 = $5 536 4 000

Total overheads for each production department A $ 78 030 15 000

B $ 40 670 20 000

17 420 16 608 127 058

13 936 5 536 80 142

General overheads Allocated overheads Maintenance Stores

5.3

(see section 5.2 above) (from information in worked example section5 above)

The reciprocal (repeated distribution) method of apportionment Now that we have looked at the 'simple' scenario of only one service department making use of the other service department's services, we can move onto the more complicated situation of 'reciprocal' servicing. This is where each service department makes use of the other service department. In the Cups example, stores services would use maintenance services and maintenance services would use stores services.

Worked Example: using repeated distribution method Assume the usage of Cups's service departments' services were amended to be as follows: Maintenance hours used Number of stores requisitions

A 5 000 3 000

B 4 000 1 000

Maintenance – 1 000

Stores 1 000 –

Total 10 000 5 000

Show how the maintenance and stores departments' overheads would be apportioned to the two production departments and calculate total overheads for each of the production departments.

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Management Accounting

Solution Remember to apportion both the general and allocated overheads (see above). The bases of apportionment for maintenance and stores are the same as for the example above, that is, maintenance hours worked and number of stores requisitions. A $

B $

Total overheads (general and allocated) Apportion maintenance (note (a))

93 030 17 420

60 670 13 936

Apportion stores (note (b))

13 286

4 429

2 215

1 772

332 126 283

110 80 917

Apportion maintenance (note (c)) Apportion stores (note (d)) Total overheads

Maintenance $

34 840 (34 840) NIL 4 429 4 429 (4 429) NIL NIL NIL

Stores $

18 660 3 484 22 144 (22 144) NIL 442 442 (442) NIL

Notes

(a)

It does not matter which department you choose to apportion first. Maintenance overheads were apportioned using the calculations illustrated above.

(b)

Stores overheads are apportioned using the same formula as used above but with the amended number of stores requisitions given above. For example A = 3 000/5 000 x $22 144 = $ 13 286

(c) Then the new figure for maintenance overheads is reapportioned. For example A= 5 000/10 000 x $4 429 = $2 215 (d)

The problem with the repeated distribution method is that you can keep performing the same calculations many times. When you are dealing with a small number (such as $442 above) you can take the decision to apportion the figure between the production departments only. In this case, we ignore the stores requisitions for maintenance and base the apportionment on the total stores requisitions for the production departments, that is, 4 000. The amount apportioned to production department A was calculated as follows: Stores requisitions for A 3 000 × $442 = $332 × stores overheads = Total stores requisitions (A + B) 4 000

5.4

The reciprocal (algebraic) method of apportionment The results of the reciprocal method of apportionment may also be obtained using algebra and simultaneous equations.

Worked Example: Cups using the algebraic method of apportionment Whenever you are using equations you must define each variable. Let

M = total overheads for the maintenance department S = total overheads for the stores department

Remember that total overheads for the maintenance department consist of general overheads apportioned, allocated overheads and the share of stores overheads (1 000/5 000 = 20%). Similarly, total overheads for stores will be the total of general overheads apportioned, allocated overheads and the 1 000/10 000 (10%) share of maintenance overheads. M = 0.2S + $34 840 S = 0.1M + $18 660

(1) (2)

($34 840 was calculated above) ($18 660 was calculated above)

We now solve the equations. Multiply equation (1) by 5 to give us

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147

5M = S + 174 200 S = 5M – 174 200

(3), which can be rearranged as (4)

Subtract equation (2) from equation (4) S = 5M – 174 200

(4)

S = 0.1M + 18 660

(2)

0 = 4.9M – 192 860 4.9M = 192 860 M=

192 860 = $39 359 4.9

Substitute M = 39 359 into equation (2) S = 0.1 × 39 359 + 18 660 S = 3 936 + 18 660 = 22 596 These overheads can now be apportioned to the production departments using the proportions in Section 5.2.1 above. A B Maintenance Stores $ $ $ $ Overhead costs 93 030 60 670 34 840 18 660 Apportion maintenance 19 680 15 743 (39 359) 3 936 Apportion stores 13 558 4 519 4 519 (22 596) Total 126 268 80 932 Nil Nil You will notice that the total overheads for production departments A and B are the same regardless of the method used (minor difference is due to rounding).

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Question 4: Reapportionment Sandstorm is a contracting engineering company which has three production departments (forming, machines and assembly) and two service departments (maintenance and general). The following analysis of overhead costs has been made for the year just ended. $

Rent and rates Power Light, heat Repairs, maintenance: Forming Machines Assembly Maintenance General

800 1 800 300 200 100

Departmental expenses: Forming Machines Assembly Maintenance General

1 500 2 300 1 100 900 1 500

$ 8 000 750 5 000

3 200

7 300 Depreciation: Plant Fixtures and fittings Insurance: Plant Buildings Indirect labour: Forming Machines Assembly Maintenance General

10 000 250 2 000 500 3 000 5 000 1 500 4 000 2 000

Other available data are as follows: Floor Plant area value Forming Machines Assembly Maintenance General

sq. ft 2 000 4 000 3 000 500 500 10 000

$ 25 000 60 000 7 500 7 500 – 100 000

Fixtures & fittings value $ 1 000 500 2 000 1 000 500 5 000

Effective horsepower

40 90 15 5 – 150

15 500 52 500

Direct Labour Machine cost for Hours hours year Worked worked $ 20 500 14 400 12 000 30 300 20 500 21 600 24 200 20 200 2 000 – – – – – – 75 000 55 100 35 600

Service department costs are apportioned as follows: Forming Machines Assembly General Maintenance

Maintenance % 20 50 20 10 – 100

General % 20 60 10 – 10 100

Using the data provided prepare an analysis showing the distribution of overhead costs to departments. Reapportion service cost centre costs (maintenance and general) using the repeated reciprocal method. (The answer is at the end of the chapter)

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6 Overhead absorption Section overview •

6.1

Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes called overhead recovery.

Introduction Having allocated and/or apportioned all overheads, the next stage in the costing treatment of overheads is to add them to, or absorb them into, the cost of the product. Overheads are usually added to the cost of the product using a predetermined overhead absorption rate, which is calculated using figures from the budget.

6.2

Calculation of overhead absorption rates Step 1

Estimate the overhead likely to be incurred during the coming period.

Step 2

Estimate the activity level for the period. This could be total labour hours, units, or direct costs or whatever basis is to be used for the overhead absorption rates.

Step 3

Divide the estimated overhead by the budgeted activity level. This produces the overhead absorption rate.

Step 4

Absorb the overhead into the product cost by applying the calculated overhead absorption rate.

Worked Example: The basics of absorption costing Athena Co makes two products, the Greek and the Roman. Greeks take 2 labour hours each to make and Romans take 5 labour hours. Athena Co budgets its total overhead for the coming year at $50 000, and estimates that 100 000 labour hours will be worked. What is the overhead cost per unit for Greeks and Romans respectively if overheads are absorbed on the basis of labour hours?

Solution Step 1

Estimate the overhead likely to be incurred during the coming period. Athena Co estimates that the total overhead will be $50 000.

Step 2

Estimate the activity level for the period. Athena Co estimates that a total of 100 000 direct labour hours will be worked.

Step 3

Divide the estimated overhead by the budgeted activity level. Absorption rate =

Step 4

$50 000 = $0.50 per direct labour hour 100 000hrs

Absorb the overhead into the product cost by applying the calculated absorption rate.

Labour hours per unit Absorption rate per labour hour Overhead absorbed per unit

Greek 2 $0.50 $1

Roman 5 $0.50 $2.50

It should be obvious that, even if a company is trying to be 'fair', there is a great lack of precision about the way the absorption base is chosen and overhead is absorbed.

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This arbitrariness is one of the main criticisms of absorption costing. If absorption costing is to be used, because of its other virtues, then it is important that the methods used are kept under regular review where necessary. Changes in working conditions should lead to changes in the way in which work is accounted for. For example, a labour intensive department may become mechanised. If a direct labour hour rate of absorption had been used prior to the mechanisation, it would probably now be more appropriate to change to using a machine hour rate.

6.3

Choosing the appropriate absorption base Some bases of absorption, or 'overhead recovery rates', are as follows: • • • • • • • •

A percentage of direct materials cost. A percentage of direct labour cost (note a). A percentage of prime cost. A rate per machine hour (note b). A rate per direct labour hour. A rate per unit of product (note c). A percentage of factory cost - for administration overhead. A percentage of sales or factory cost - for marketing and distribution overhead.

The choice of an absorption basis is a matter of judgment and common sense. What is required is an absorption basis which realistically reflects the characteristics of a given cost centre and which avoids undue anomalies. Many factories use a direct labour hour rate or machine hour rate in preference to a rate based on a percentage of direct materials cost, wages or prime cost. (a)

A direct labour hour basis is most appropriate in a labour intensive environment.

(b)

A machine hour rate would be used in departments where production is controlled or dictated by machines.

(c)

A rate per unit of product would be effective only if all units were identical.

Worked Example: Bridge Cottage The budgeted production overheads and other budget data of Bridge Cottage are as follows: Budget Overhead cost Direct materials cost Direct labour cost Machine hours Direct labour hours Units of production

Production dept A $36 000 $32 000 $40 000 10 000 18 000

Production dept B $5 000

1 000

Calculate the absorption rate for Department A using the bases of apportionment below: • • • • • •

Percentage of direct materials cost. Percentage of direct labour cost. Percentage of prime cost. Rate per machine hour. Rate per direct labour hour. Units of production

Calculate an absorption rate for Department B using units of output as the absorption rate.

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151

Solution Department A (i)

Percentage of direct materials cost

$36 000 × 100% = 112.5% $32 000

(ii)

Percentage of direct labour cost

$36 000 × 100% = 90% $40 000

(iii)

Percentage of prime cost

$36 000 × 100% = 50% $72 000

(iv)

Rate per machine hour

$36 000 = $3.60 per machine hour 10 000 hrs

(v)

Rate per direct labour hour

$36 000 = $2 per direct labour hour 18 000 hrs

The department B absorption rate based on units of output: $5 000 = $5 per unit produced 1 000 units

6.4

Bases of absorption The choice of the basis of absorption is significant in determining the cost of individual units, or jobs, produced. Using the previous example, suppose that an individual product has a material cost of $80, a labour cost of $85, and requires 36 labour hours and 23 machine hours to complete. The overhead cost of the product would vary, depending on the basis of absorption used by the company for overhead recovery. (a)

As a percentage of direct material cost, the overhead cost would be 112.5% × $80

(b)

= $90.00

As a percentage of direct labour cost, the overhead cost would be 90% × $85

= $76.50

(c)

As a percentage of prime cost, the overhead cost would be 50% × $165

= $82.50

(d)

Using a machine hour basis of absorption, the overhead cost would be

(e)

23 hrs × $3.60

= $82.80

Using a labour hour basis, the overhead cost would be 36 hrs × $2

= $72.00

In theory, each basis of absorption would be possible, but the company should choose a basis which seems to it to be the 'fairest'.

7 Blanket absorption rates and departmental absorption rates 7.1

Introduction Section overview •

152

A blanket overhead absorption rate is a single absorption rate, that is used throughout a factory.

Management Accounting

For example, if total overheads were $500 000 and there were 250 000 direct machine hours during the period, the blanket overhead rate would be $2 per direct machine hour and all jobs passing through the factory would be charged at that rate. Blanket overhead rates are not appropriate in the following circumstances:

• •

Products or jobs pass through more than one department, and products/jobs do not spend an equal amount of time in each department.

If a single factory overhead absorption rate is used, some products will receive a higher overhead charge than they ought 'fairly' to bear, whereas other products will be under-charged. If a separate absorption rate is used for each department, charging of overheads will be more fair and the full cost of production of items will more closely represent the amount of the effort and resources used to make them.

Worked Example: Stoakley Stoakley Ltd has two production departments, for which the following budgeted information is available: Budgeted overheads Budgeted direct labour hours

Department A $360 000 200 000 hrs

Department B $200 000 40 000 hrs

Total $560 000 240 000 hrs

If a single factory overhead absorption rate is applied, the rate of overhead recovery would be: $560 000 = $2.33 per direct labour hour 240 000 hours If separate departmental rates are applied, these would be: Department A =

$360 000 = $1.80 per direct labour hour 200 000 hours

Department B =

$200 000 = $5 per direct labour hour 40 000 hours

Jobs using Department B would get charged a higher overhead rate in terms of cost per hour worked than department A. Now let us consider two separate jobs. Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in department A. Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B. What would be the factory cost of each job, using the following rates of overhead recovery? (a) (b)

A single factory rate of overhead recovery Separate departmental rates of overhead recovery

Solution (a)

Single factory rate Prime cost Factory overhead (30 × $2.33) Factory cost

Job X $ 100.00 69.90 169.90

Job Y $ 100.00 69.90 169.90

(b)

Separate departmental rates Prime cost Factory overhead: department A department B Factory cost

$ 100.00 0 150.00 250.00

$ 100.00 50.40 10.00 160.40

(30 × $5)

(28 × $1.80) (2 × $5)

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153

Using a single factory overhead absorption rate, both jobs would cost the same. However, since job X is done entirely within department B where overhead costs are higher, whereas job Y is done mostly within department A, where overhead costs are lower, it is arguable that job X should cost more than job Y. This will occur if separate departmental overhead recovery rates are used to reflect the work done on each job in each department separately. If all jobs do not spend approximately the same time in each department then, to ensure that all jobs are charged with their fair share of overheads, it is necessary to establish separate overhead rates for each department.

8 Marginal cost and marginal costing Section overview •

Marginal cost is the variable cost of one unit of product or service.

Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated (sales revenue minus variable cost of sales). Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the statement of comprehensive income in the accounting period in which they are incurred.

The marginal production cost per unit of an item usually consists of the following: • • •

Direct materials. Variable production overheads. Direct labour.

Direct labour costs might be excluded from marginal costs when the work force is a given number of employees on a fixed wage or salary. Even so, it is not uncommon for direct labour to be treated as a variable cost, even when employees are paid a basic wage for a fixed working week. If in doubt, you should treat direct labour as a variable cost unless given clear indications to the contrary. Direct labour is often a step cost, usually with sufficiently short steps to make labour costs act in a variable fashion. The marginal cost of sales usually consists of the marginal cost of production adjusted for inventory movements plus the variable marketing costs, which would include items such as sales commission, and possibly some variable distribution costs.

8.1

Contribution Contribution is an important measure in marginal costing, and it is calculated as the difference between sales value and marginal or variable cost of sales. Contribution is of fundamental importance in marginal costing, and the term 'contribution' is really short for 'contribution towards covering fixed overheads and making a profit'.

9 The principles of marginal costing Section overview •

Period fixed costs are the same, for any volume of sales and production.

The principles of marginal costing are as follows: (a)

Period fixed costs are the same, for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen:

(i) (ii) (iii)

154

Revenue will increase by the sales value of the item sold. Costs will increase by the variable cost per unit. Profit will increase by the amount of contribution earned from the extra item.

Management Accounting

(b)

Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.

(c)

Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. Absorption costing can therefore be misleading, and it is more appropriate to deduct fixed costs from total contribution for the period to derive a profit figure.

(d)

When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. It is therefore argued that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product.

Worked Example: Marginal costing principles Rain Until September Co makes a product, the Splash, which has a variable production cost of $6 per unit and a sales price of $10 per unit. At the beginning of September 20X0, there were no opening inventories and production during the month was 20 000 units. Fixed costs for the month were $45 000 (production, administration, sales and distribution). There were no variable marketing costs. Calculate the contribution and profit for September 20X0, using marginal costing principles, if sales were as follows: (a) (b) (c)

10 000 Splashes 15 000 Splashes 20 000 Splashes

Solution The stages in the profit calculation are as follows: • • •

To identify the variable cost of sales, and then the contribution. Deduct fixed costs from the total contribution to derive the profit. Value all closing inventories at (marginal) production cost ($6 per unit).

Sales (at $10) Opening inventory Variable production cost Less value of closing inventory (at marginal cost) Variable cost of sales Contribution Less fixed costs Profit/(loss)

10 000 Splashes $ $ 100 000 0 120 000 120 000

60 000 60 000 40 000 45 000 (5 000)

15 000 Splashes $ $ 150 000 0 120 000 120 000

30 000

20 000 Splashes $ $ 200 000 0 120 000 120 000

0 90 000 60 000 45 000 15 000

120 000 80 000 45 000 35 000

Profit (loss) per unit

$(0.50)

$1

$1.75

Contribution per unit

$4

$4

$4

The conclusions which may be drawn from this example are as follows: (a)

The profit per unit varies at differing levels of sales, because the average fixed overhead cost per unit changes with the volume of output and sales.

(b)

The contribution per unit is constant at all levels of output and sales. Total contribution, which is the contribution per unit multiplied by the number of units sold, increases in direct proportion to the volume of sales.

5: Overheads, absorption and marginal costing

155

(c)

Since the contribution per unit does not change, the most effective way of calculating the expected profit at any level of output and sales would be as follows: (i) (ii)

(d)

First calculate the total contribution. Then deduct fixed costs as a period charge in order to find the profit.

In our example the expected profit from the sale of 17 000 Splashes would be as follows: $ 68 000 45 000 23 000

Total contribution (17 000 × $4) Less fixed costs Profit (i) (ii) (iii)

If total contribution exceeds fixed costs, a profit is made. If total contribution exactly equals fixed costs, no profit or loss is made. If total contribution is less than fixed costs, there will be a loss.

Question 5: Mill Stream Mill Stream makes two products, the Mill and the Stream. Information relating to each of these products for April 20X1 is as follows: Mill Stream Opening inventory Nil nil Production (units) 15 000 6 000 Sales (units) 10 000 5 000 Sales price per unit

$20

Unit costs Direct materials Direct labour Variable production overhead Variable sales overhead Fixed costs for the month Production costs Administration costs Sales and distribution costs

$ 8 4 2 2

$30

$ 40 000 15 000 25 000

$ 14 2 1 3

Using marginal costing principles, what was the profit in April 20X1? A

$10 000

B

$40 000

C

$45 000

D

$70 000 (The answer is at the end of the chapter)

9.1

Profit or contribution information The main advantage of contribution information, rather than profit information, is that it allows an easy calculation of profit if sales increase or decrease from a certain level. By comparing total contribution with fixed overheads, it is possible to determine whether profits or losses will be made at certain sales levels. Profit information, on the other hand, does not lend itself to easy manipulation but note how easy it was to calculate profits using contribution information in the Worked Example Marginal costing principles. Contribution information is also more useful for decision making than profit information.

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Management Accounting

10 Marginal costing, absorption costing and the calculation of profit Section overview •

In marginal costing, fixed production costs are treated as period costs and are written off as they are incurred. In absorption costing, fixed production costs are absorbed into the cost of units and are partially carried forward in inventory to be charged against sales for the next period. Inventory values using absorption costing are greater than those calculated using marginal costing.

Marginal costing as a cost accounting system is significantly different from absorption costing. It is an alternative method of accounting for costs and profit, which rejects the principles of absorbing fixed overheads into unit costs. Marginal costing

Absorption costing

Closing inventories are valued at marginal production cost.

Closing inventories are valued at full production cost.

Fixed costs are period costs.

Fixed costs are absorbed into unit costs.

Cost of sales does not include a share of fixed overheads.

Cost of sales does include a share of fixed overheads (see note below).

Note. The share of fixed overheads included in cost of sales are from the previous period (in opening inventory values). Some of the fixed overheads from the current period will be excluded by being carried forward in closing inventory values.

In marginal costing, it is necessary to identify the following: • • •

Variable costs. Fixed costs. Contribution.

In absorption costing (sometimes known as full costing), it is not necessary to distinguish variable costs from fixed costs.

Worked Example: Marginal and absorption costing compared This example will lead you through the various steps in calculating marginal and absorption costing profits, and will highlight the differences between the two techniques. Big Possum Ltd manufactures a single product, the Bark, details of which are as follows: Per unit Selling price Direct materials Direct labour Variable overheads

$ 180.00 40.00 16.00 10.00

Annual fixed production overheads are budgeted to be $1.6 million and Big Possum Ltd expects to produce 1 280 000 units of the Bark each year. Overheads are absorbed on a per unit basis. Actual overheads are $1.6 million for the year. Budgeted fixed marketing costs are $320 000 per quarter. Actual sales and production units for the first quarter of 20X8 are given below: Sales Production

January – March 240 000 280 000

There is no opening inventory at the beginning of January.

5: Overheads, absorption and marginal costing

157

Prepare a statement of comprehensive income for the quarter, using (a) (b)

Total cost per unit (marginal costing). Total cost per unit (absorption costing).

Solution Step 1

Calculate the overhead absorption rate per unit.

Remember that overhead absorption rate is based only on budgeted figures. Overhead absorption rate =

Budgeted fixed overheads Budgeted units

Also be careful with your calculations. You are dealing with a three-month period but the figures in the question are for a whole year. You will have to convert these to quarterly figures. Budgeted overheads (quarterly) = Budgeted production (quarterly) =

$1.6 million = $400 000 4 1280 000 = 320 000 units 4

Overhead absorption rate per unit =

Step 2

$400 000 = $1.25 per unit 320 000

Calculate total cost per unit.

Total cost per unit (marginal costing) = Variable cost per unit = (40 + 16 + 10) = $66 Total cost per unit (absorption costing) = Variable cost + fixed production cost = $66 + 1.25 = $67.25

Step 3

Calculate closing inventory in units.

Closing inventory = Opening inventory + production – sales Closing inventory = 0 + 280 000 – 240 000 = 40 000 units

Step 4

Calculate under/over absorption of overheads.

This is based on the difference between actual production and budgeted production. Actual production = 280 000 units Budgeted production = 320 000 units (see step 1 above) Under-production = 40 000 units As Big Possum Ltd produced 40 000 fewer units than expected, there will be an underabsorption of overheads of 40 000 x $1.25 (see step 1 above) = $50 000. This will be added to production costs in the statement of comprehensive income.

Step 5

Produce statements of comprehensive income.

Sales (240 000 x $180) Less Cost of sales Opening inventory Add Production cost 280 000 x $66 280 000 x $67.25 Less Closing inventory 40 000 x $66

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Management Accounting

Marginal costing $ 000 $ 000 43 200

0

Absorption costing $ 000 $ 000 43 200

0

18 480 18 830 (2 640)

40 000 x $67.25

(2 690) 16 140 50

Add Under absorbed O/H

Less Fixed production O/H Fixed marketing O/H

(16 190)

(15 840) 27 360

Contribution Gross profit 400 320

(720) 26 640

Net profit

27 010 Nil 320 (320) 26 690

Question 6: Marginal and absorption A company makes a single product. Its budgeted data for a period is as follows. Opening inventory Variable production cost per unit of opening inventory Production Sales Variable production cost per unit produced in the period Variable selling cost per unit Sales price per unit Production fixed costs Other fixed overhead costs

3 000 units $6 16 000 units 17 000 units $7 $1 $20 $80 000 $60 000

The company uses marginal costing, but is considering whether to use absorption costing instead. If absorption costing were to be used, the fixed production overhead in the opening inventory would have been $4 per unit. Inventory is valued using the FIFO (first in, first out) method. (a)

(b)

Using marginal costing principles, what is the budgeted profit for the period? A

$55 000

B

$64 000

C

$67 000

D

$69 000

If absorption costing were to be used instead of marginal costing, by how much would the reported profit for the period be higher or lower? A

$10 000 lower

B

$2 000 lower

C

$2 000 higher

D

$10 000 higher (The answer is at the end of the chapter)

5: Overheads, absorption and marginal costing

159

Key chapter points •

Materials, labour costs and other expenses can be classified as either direct costs or indirect costs.



Classification by function involves classifying costs as production/manufacturing costs, administration costs or marketing and distribution costs. Overhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department. The objective of absorption costing is to include in the total cost of a product an appropriate share of the organisation's total overhead. An appropriate share is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing a unit or completing a job.

160



Allocation is the process by which whole cost items are charged direct to a product’s cost.



Apportionment is a procedure whereby indirect costs are spread fairly between cost centres. Service cost centre costs may be apportioned to production cost centres by using the reciprocal method.



Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes called overhead recovery.



A blanket overhead absorption rate is an absorption rate used throughout a factory and for all jobs and units of output irrespective of the department in which they were produced.



Marginal cost is the variable cost of one unit of product or service.



Period fixed costs are the same, for any volume of sales and production.



In marginal costing, fixed production costs are treated as period costs and are written off as they are incurred. In absorption costing, fixed production costs are absorbed into the cost of units and are partially carried forward in inventory to be charged against sales for the next period. Inventory values using absorption costing are therefore greater than those calculated using marginal costing.

Management Accounting

Quick revision questions 1

A company has to pay a 20c per unit royalty to the inventor of a device which it manufactures and sells. The royalty charge would be classified in the company's accounts as an: A B C D

2

Which of the following would be classed as indirect labour? A B C D

3

marketing expense direct expense production overhead administrative overhead assembly workers in a company manufacturing televisions a stores assistant in a factory store plasterers in a construction company employees responsible for packaging the product at the end of the production line

A manufacturing company is very busy and overtime is being worked. The amount of overtime premium contained in direct wages would normally be classed as: A B C D

4

part of prime cost factory overheads direct labour costs administrative overheads

The following extract of information is available concerning the four cost centres of EG Limited.

Number of direct employees Number of indirect employees Overhead allocated and apportioned

Production cost centres Finishing Packing Machinery 7 6 2 3 2 1 $28 500 $18 300 $8 960

Service cost centre Cafeteria – 4 $8 400

The overhead cost of the cafeteria is to be re-apportioned to the production cost centres on the basis of the number of employees in each production cost centre. After the re-apportionment, the total overhead cost of the packing department, to the nearest $, will be: A B C D

$1 200 $9 968 $10 080 $10 160

5: Overheads, absorption and marginal costing

161

The following information relates to questions 5 and 6 Budgeted information relating to two departments in a company for the next period is as follows: Department

1 2

Production overhead $ 27 000 18 000

Direct material cost $ 67 500 36 000

Direct labour cost $ 13 500 100 000

Direct Labour hours

Machine hours

2 700 25 000

45 000 300

Individual direct labour employees within each department earn differing rates of pay, according to their skills, grade and experience. 5

What is the most appropriate production overhead absorption rate for department 1? A B C D

6

What is the most appropriate production overhead absorption rate for department 2? A B C D

7

8

40% of direct material cost 200% of direct labour cost $10 per direct labour hour $0.60 per machine hour 50% of direct material cost 18% of direct labour cost $0.72 per direct labour hour $60 per machine hour

Which of the following statements about predetermined overhead absorption rates are true? I

Using a predetermined absorption rate avoids fluctuations in unit costs caused by abnormally high or low overhead expenditure or activity levels.

II

Using a predetermined absorption rate offers the administrative convenience of being able to record full production costs sooner.

III

Using a predetermined absorption rate avoids problems of under/over absorption of overheads because a constant overhead rate is available.

A B C D

I and II only I and III only II and III only I, II and III

Match the following overheads with the most appropriate basis of apportionment. Overhead (a) Depreciation of equipment (b) Heat and light costs (c) Cafeteria costs (d) Insurance of computers

9

A direct labour hour basis is most appropriate in which of the following environments? A B C D

10

162

Basis of apportionment (1) Book value of computers (2) Number of employees (3) Book value of equipment (4) Floor area

machine-intensive labour-intensive when all units produced are identical when there are several production departments

What is the problem with using a single factory overhead absorption rate?

Management Accounting

Answers to quick revision questions 1

B

The royalty cost can be traced in full to the product, i.e. it has been incurred as a direct consequence of making the product. It is therefore a direct expense. Options A, C and D are all overheads or indirect costs which cannot be traced directly and in full to the product.

2

B

The wages paid to the stores assistant cannot be traced in full to a product or service, therefore this is an indirect labour cost. The assembly workers' wages can be traced in full to the televisions manufactured (option A), therefore this is a direct labour cost. The same is true of the packaging employees (option D). The wages paid to plasterers in a construction company can be traced in full to the contract or building they are working on (option C). This is also a direct labour cost.

3

4

B

D

Overtime premium is always classed as factory overheads unless it is: •

worked at the specific request of a customer to get the order completed.



worked regularly by a production department in the normal course of operations, in which case it is usually incorporated into the direct labour hourly rate.

Number of employees in packing department = 2 direct + 1 indirect = 3 Number of employees in all production departments = 15 direct + 6 indirect = 21 Packing department overhead

Cafeteria cost apportioned to packing department

=

Original overhead allocated and apportioned Total overhead after apportionment of cafeteria costs

= = =

$8 400 ×3 21 $1 200 $8 960 $10 160

If you selected option A you forgot to include the original overhead allocated and apportioned to the packing department. If you selected option B you included the four cafeteria employees in your calculation, but the question states that the basis for apportionment is the number of employees in each production cost centre. If you selected option C you based your calculations on the direct employees only. 5

D

Department 1 appears to undertake primarily machine-based work, therefore a machine-hour rate would be most appropriate. $27 000 = $0.60 per machine hour 45 000 Therefore the correct answer is D. Option A is not the most appropriate because it is not time-based, and most items of overhead expenditure tend to increase with time. Options B and C are not the most appropriate because labour activity is relatively insignificant in department 1, compared with machine activity.

6

C

Department 2 appears to be labour-intensive therefore a direct labour-hour rate would be most appropriate. $18 000 = $0.72 per direct labour hour 25 000 Option B is based on labour therefore it could be suitable. However differential wage rates exist and this could lead to inequitable overhead absorption. Option D is not suitable because machine activity is not significant in department 2.

5: Overheads, absorption and marginal costing

163

7

A

Statement (I) is correct because a constant unit absorption rate is used throughout the period. Statement (II) is correct because 'actual' overhead costs, based on actual overhead expenditure and actual activity for the period, cannot be determined until after the end of the period. Statement (III) is incorrect because under/over absorption of overheads is caused by the use of predetermined overhead absorption rates.

8

(a) (3) (c) (2) (b) (4) (d) (1)

9

B A direct labour hour absorption rate is most appropriate for labour-intensive work when output consists of non-standard units.

10

164

The problem with using a single factory overhead absorption rate is that some products will receive a higher overhead charge than they ought 'fairly' to bear and other products will be undercharged.

Management Accounting

Answers to chapter questions 1

A The cost of overtime premiums paid to direct workers is treated as an indirect labour cost unless the overtime is worked specifically at the request of a customer, in which case the overtime premium becomes a direct cost of the job. Bonus payments to direct workers may be paid annually, and are normally treated as an indirect cost. The cost of idle time is also an indirect labour cost. Payroll taxes are part of the total cost of employing either direct or indirect workers, however they do not normally feature in management accounting analysis and are therefore not a relevant issue for management accounting purposes. The labour cost of work to install capital equipment is normally included in the cost of the capital asset.

2

B The correct answer is B because the basic rate for overtime is a part of direct wages cost. It is only the overtime premium that is usually regarded as an overhead or indirect cost.

3 Cost classification

4

Reference number

Production costs

1

3

8

9

14

Marketing and distribution costs

2

5

7

10

11

Administration costs

6

13

15

Research and development costs

4

12

Analysis of distribution of actual overhead costs Basis Forming Machines Assembly $ $ $ Directly allocated overheads: Repairs, maintenance 800 1 800 300 Departmental expenses 1 500 2 300 1 100 Indirect labour 3 000 5 000 1 500 Apportionment of other overheads: Rent, rates 1 1 600 3 200 2 400 Power 2 200 450 75 Light, heat 1 1 000 2 000 1 500 Depreciation of plant 3 2 500 6 000 750 Depreciation of F and F 4 50 25 100 Insurance of plant 3 500 1 200 150 Insurance of buildings 1 100 200 150 11 250 22 175 8 025

Maint. $

General $

16

Total $

200 900 4 000

100 1 500 2 000

3 200 7 300 15 500

400 25 250 750 50 150 25 6 750

400 0 250 0 25 0 25 4 300

8 000 750 5 000 10 000 250 2 000 500 52 500

Basis of apportionment: 1 2

floor area effective horsepower

3 4

plant value fixtures and fittings value

Apportionment of service department overheads to production departments, using the repeated reciprocal method. Forming Machines Assembly Maintenance General Total $ $ $ $ $ $ Overheads 11 250 22 175 8 025 6 750 4 300 52 500 1 350 3 375 1 350 (6 750) 675 4 975 995 2 985 498 497 (4 975) 99 249 99 (497) 50 10 30 5 5 (50) 1 3 1 (5) 28 817 9 978 0 0 52 500 13 705

5: Overheads, absorption and marginal costing

165

5

A Contribution from Mills (unit contribution = $20 – $16 = $4 × 10 000) Contribution from Streams (unit contribution = $30 – $20 = $10 × 5 000) Total contribution Fixed costs for the period Profit

$ 40 000 50 000 90 000 80 000 10 000

6 (a)

C $ 18 000 112 000 130 000 (14 000) 116 000 17 000 133 000 340 000 207 000 (140 000) 67 000

Opening inventory (3 000 × $6) Variable production costs (16 000 × $7) Closing inventory (2 000 × $7) Variable production cost of sales Variable selling costs (17 000 × $1) Total variable costs Sales (17 000 × $20) Contribution Fixed costs (80 000 + 60 000) Profit (b)

B Absorption costing: fixed production cost per unit in the period $80 000/16 000 = $5. Therefore value of closing inventory (per unit) = $7 + $5 = $12.

Opening inventory (3 000 × $6) Closing inventory (2 000 × $7) Reduction in inventory

Marginal costing $ 18 000 14 000 4 000

(3 000 × $10) (2 000 × $12)

Absorption costing $ 30 000 24 000 6 000

The reduction in inventory is an addition to the cost of sales in the period; therefore with absorption costing the cost of sales in the period would be $2 000 higher, and reported profit $2 000 lower.

166

Management Accounting

Chapter 6

Overhead costing – activity-based costing Learning objectives

Reference

Overhead costing – activity-based costing

LO6

Identify and apply the principles of activity-based costing to allocate overheads in organisations

LO6.1

Topic list

1 2 3 4 5 6

The reasons for the development of ABC Outline of an ABC system Absorption costing versus ABC Marginal costing versus ABC Introducing an ABC system into an organisation Merits and criticisms of ABC

167

Introduction In this chapter we look at a costing system that has been developed to suit modern practices: activitybased costing. Basically, activity-based costing (ABC) is the modern alternative to traditional absorption costing.

168

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What are the reasons for the development of ABC?

(Section 1)

2

Define ABC.

(Section 2.1)

3

Explain the concept of cost drivers.

(Section 3.2)

4

When should an ABC system be introduced?

(Section 5.1)

5

What are product-sustaining activities?

(Section 5.2)

6

What are facility-sustaining activities?

(Section 5.2)

7

List the advantages of ABC.

(Section 6.1)

8

Define customer profitability analysis.

(Section 6.1)

9

List the disadvantages of ABC.

(Section 6.2)

6: Overhead costing – activity-based costing

169

1 The reasons for the development of ABC Section overview •

LO 6.1

Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products, which use relatively fewer support services, and too small a proportion of overheads to low volume products, which use relatively more support services. Activity-based costing (ABC) attempts to overcome this problem and charge overheads on the basis of the use of support services.

The traditional cost accumulation system of absorption costing was developed in a time when cost accounting systems were used mainly for manufacturing organisations that produced only a narrow range of products and when overhead costs were only a very small fraction of total costs. Direct labour and direct material costs accounted for the largest proportion of the costs. Production overhead costs were not too significant, and were usually considered to be ‘driven’ by direct labour hours worked. Similarly selling and distribution costs were relatively small, and were considered to be ‘driven’ by the volume of sales activity. Nowadays, however, with the advent of advanced manufacturing technology (AMT), production overheads are a much more significant proportion of total production costs. Direct labour costs in a highly automated production system may account for as little as 5% of a product's cost. There are now many different ways of delivering products to different types of customer, and selling and distribution costs depend on factors such as the channel of distribution used and the type of customer, not just on sales volumes. It may therefore now be difficult to justify the use of direct labour or direct production cost as the basis for absorbing production overheads. Many resources are used in support activities that are not directly related to production (or selling) volume. The increase in costs of non-volume-related activities is due to AMT: they include costs relating to setting-up production runs, production scheduling, customer order handling, inspection and data processing. These support activities assist the efficient manufacture of a wide range of products (necessary if businesses are to compete effectively) 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 range and the more complex the products, the more support services 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 produce 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. Activity based costing is a system of costing that analyses overhead costs in a different way. Overhead costs are allocated initially to activities, and the key factors that ‘drive’ each of these activities are also identified. Costs are then attributed to products (or services or customers) on the basis of the use they make of each of these activities.

2 Outline of an ABC system Section overview •

170

Activity-based costing (ABC) is an alternative to the traditional method of accounting for costs absorption costing. ABC involves the identification of the factors - cost drivers - which cause the costs of an organisation's major activities. Support overheads are charged to products on the basis of their usage of an activity.

Management Accounting

2.1

The definition of ABC Definition Activity-based costing (ABC) is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.

The major ideas behind activity-based costing are as follows:

2.2

(a)

Activities cause costs. Activities include ordering, materials handling, machining, assembly, production scheduling and despatching.

(b)

Making and selling products creates demand for the activities.

(c)

Costs are assigned to a product on the basis of the product's consumption of the activities (and the cost of those activities).

The operation of an ABC system Definitions A cost driver is a factor influencing the level of cost. Often used in the context of ABC to denote the factor which links activity resource consumption to product outputs, for example, the number of purchase orders would be a cost driver for procurement cost. A cost pool is a grouping of costs relating to a particular activity in an activity-based costing 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 incurrence of costs of an activity. These are known as cost drivers. 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

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. Overheads that vary with some other activity, and not volume of production, should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

Step 3

Collect the costs associated with each cost driver into what are known as cost pools.

6: Overhead costing – activity-based costing

171

Step 4

Charge the costs of each cost pool to products on the basis of their usage of the activity, measured by the number of the activity's cost driver a product generates, using a cost driver rate (total costs in cost pool/number of cost drivers).

Question 1: Cost drivers Which of the following definitions best describes a cost driver? A B C D

any activity which causes an increase in costs a collection of costs associated with a particular activity a cost that varies with production levels any factor which causes a change in the cost of an activity (The answer is at the end of the chapter)

3 Absorption costing versus ABC Section overview •

When using ABC, for costs that vary with production levels in the short term, the cost driver will be volume related (labour or machine hours). Overheads that vary with some other activity, and not volume of production, should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

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.

Worked Example: Activity-based costing Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period just ended are as follows: Number of production runs in the Material cost Direct labour Machine Output units period per unit hours per unit hours per unit $ 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 Direct labour cost per hour Overhead costs Short run variable costs Set-up costs Expediting and scheduling costs Materials handling costs

$5 $ 3 080 10 920 9 100 7 700 30 800

Prepare unit costs for each product using conventional absorption costing and ABC.

172

Management Accounting

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:

Direct material Direct labour Overheads * Units produced Cost per unit

W $ 200 50 700 950 10 $95

X $ 800 150 2 100 3 050 10 $305

Y $ 2 000 500 7 000 9 500 100 $95

Z $ 8 000 1 500 21 000 30 500 100 $305

Total $

44 000

* $30 800 ÷ 440 hours = $70 per direct labour or machine hour. Using activity-based costing and assuming that the number of production runs is the cost driver for setup 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:

Direct material Direct labour Short-run variable overheads (W1) Set-up costs (W2) Expediting, scheduling costs (W3) Materials handling costs (W4) Units produced Cost per unit

W $ 200 50 70 1 560 1 300 1 100 4 280 10 $428

X $ 800 150 210 1 560 1 300 1 100 5 120

Y $ 2 000 500 700 3 900 3 250 2 750 13 100

Z $ 8 000 1 500 2 100 3 900 3 250 2 750 21 500

10 $512

100 $131

100 $215

Total $

44 000

Workings 1 2 3 4

$3 080 ÷ 440 machine hours = $10 920 ÷ 14 production runs = $9 100 ÷ 14 production runs = $7 700 ÷ 14 production runs =

$7 per machine hour $780 per run $650 per run $550 per run

Summary Product W X Y Z

Conventional costing Unit cost $ 95 305 95 305

ABC Unit cost $ 428 512 131 215

Difference per unit $ + 333 + 207 + 36 – 90

Difference in total $ +3 330 +2 070 +3 600 –9 000

The figures suggest that the traditional volume-based absorption costing system is flawed.

3.1

(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.

3.1.1

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. 6: Overhead costing – activity-based costing

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3.1.2

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. There may be a different absorption rate for each production department.

(b)

ABC uses many cost drivers as absorption bases; number of orders, number of despatches and so on. There is an absorption rate for each activity.

Absorption rates under ABC should therefore be closely linked to the causes of overhead costs.

3.2

Cost drivers The principal idea of ABC is to focus attention on what causes costs to increase, i.e. 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. Such costs tend to be short-term variable overheads. 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. Such costs tend to be long-term variable overhead (overhead that traditional accounting would classify as fixed).

(b)

Traditional costing systems allow overhead to be related to products in rather more arbitrary ways producing, it is claimed, less accurate product costs.

Question 2: ABC versus traditional costing 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: Quantity produced (units) Direct labour hours per unit Machine hours per unit Set-ups in the period Orders handled in the period Production overhead costs Relating to machine activity Relating to production run set-ups Relating to handling of orders

L 5 000 1 3 10 15

M 7 000 2 1 40 60 $ 209 000 25 000 51 000 285 000

(a)

What is the amount of production overhead to be absorbed by one unit of product M using a traditional absorption costing approach, with a direct labour hour rate to absorb overheads? A $15.00 B $17.50 C $22.00 D $30.00

(b)

What is the amount of production overhead to be absorbed by one unit of product M using an activity-based costing approach, with suitable cost drivers to trace overheads to products? A B C D

$12.95 $18.19 $32.57 $37.57 (The answers are at the end of the chapter)

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4 Marginal costing versus ABC Section overview •

The main criticism of marginal costing decision making information is that marginal costing analyses cost behaviour patterns according to the volume of production. However, although certain costs may be fixed in relation to the volume of production, they may in fact be variable in relation to some other cost driver.

One view is that only marginal costing provides suitable information for decision making but this is not true. Marginal costing provides a crude method of differentiating between different types of cost behaviour by splitting costs into their variable and fixed elements. However, such an analysis can be used only for shortterm decisions and usually even these have longer-term implications which ought to be considered. The problem with marginal costing is that it analyses cost behaviour patterns according to the volume of production. However, although certain costs may be fixed in relation to the volume of production, they may in fact be variable in relation to some other cost driver. A failure to allocate such costs to individual products could result in incorrect decisions concerning the future management of the products. The advantage of ABC is that it spreads costs across products according to a number of different bases. For example, an ABC analysis may show that one particular activity which is carried out primarily for one or two products is expensive. A correct allocation of the costs of this activity may reveal that these particular products are not profitable. If these costs are fixed in relation to the volume of production then they would be treated as period costs in a marginal costing system and written off against the marginal costing contribution for the period. The marginal costing system would therefore make no attempt to allocate these 'fixed' costs to individual products and a false impression would be given of the long run average cost of the products. Therefore, marginal costing may provide incorrect decision making information, particularly in a situation where 'fixed' costs are vary large compared with 'variable' costs.

5 Introducing an ABC system into an organisation Section overview

5.1



ABC should only be introduced if the additional information it provides will result in action that will increase the organisation's overall profitability.



ABC identifies four levels of activities: product level, batch level, product sustaining level and facility sustaining level.

When should ABC be introduced? ABC should only be introduced if the additional information it provides will result in action that will increase the organisation's overall profitability. This is most likely to occur in situations such as the following, when the ABC analysis differs significantly from the traditional absorption costing analysis: • • • •

5.2

Production overheads are high in relation to direct costs, especially direct labour. Overhead resource consumption is not just driven by production volume. There is wide variety in the product range. The overhead resource input varies significantly across the product range.

Analysis of activities ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of four levels of activity has been suggested.

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Definition The hierarchy of activities is a classification of activities by level of organisation, for example, unit, batch, product-sustaining and facility-sustaining. Type of activities

Costs are dependent on ….

Examples

Product level

Volume of production

Machine power

Batch level

Number of batches

Set-up costs

Product-sustaining

Existence of a product group/line

Product management

Facility-sustaining

Organisation simply being in business

Rent and rates

Definitions Product-sustaining activities are activities undertaken to develop or sustain a product or service. Product sustaining costs are linked to the number of products or services, not to the number of units produced. Facility-sustaining activities are activities undertaken to support the organisation as a whole, and which cannot be logically linked to individual units of output. The difference between a unit product cost determined using traditional absorption costing and one determined using ABC will depend on the proportion of overhead cost which falls into each of the categories above. (a)

If most overheads are related to unit level and facility level activities, the unit product costs generated by each method will be similar.

(b)

If the overheads tend to be associated with batch or product level activities the unit product cost generated by ABC will be significantly different from traditional absorption costing.

Consider the following example.

Worked Example: Batch level activity XYZ produces a number of products including product D and product E and produces 500 units of each of products D and E every period at a rate of ten of each every hour. The overhead cost is $500,000 and a total of 40,000 direct labour hours are worked on all products. A traditional overhead absorption rate would be $12.50 per direct labour hour and the overhead cost per product would be $1.25. Production of D requires five production runs per period, while production of E requires 20. An investigation has revealed that the overhead costs relate mainly to 'batch-level' activities associated with setting-up machinery and handling materials for production runs. There are 1,000 production runs per period and so overheads could be attributed to XYZ's products at a rate of $500 per run. • •

Overhead cost per D = ($500 × 5 runs)/500 = $5 Overhead cost per E = ($500 × 20 runs)/500 = $20

These overhead costs are activity-based and recognise that overhead costs are incurred due to batch level activities. The fact that E has to be made in frequent small batches, perhaps because it is perishable, means that it uses more resources than D. This is recognised by the ABC overhead costs, not the traditional absorption costing overhead costs. In the modern manufacturing environment, production often takes place in short, discontinuous production runs and a high proportion of product costs are incurred at the design stage. An increasing proportion of overhead costs are therefore incurred at batch or product level. Such an analysis of costs gives management an indication of the decision level at which costs can be influenced. For example, a decision to reduce production costs will not simply depend on making a general reduction in output volumes: production may need to be organised to reduce batch volumes; a process may need to be modified or eliminated; product lines may need to be merged or cut out; facility capacity may need to be altered.

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5.3

ABC in service and retail organisations ABC was first introduced in manufacturing organisations but it can equally well be used in other types of organisation. For example, the management of the Post Office in the US recently introduced ABC. They analysed the activities associated with cash processing as follows: Activities

Examples

Possible cost driver

Unit level

Accept cash Processing of cash by bank

Number of transactions Number of transactions

Batch level

Cash desk closed by clerk (close out) and reviewed by supervisor Deposits Review and transfer of funds

Number of 'close outs' Number of deposits Number of accounts

Product level

Maintenance charges for bank accounts Reconciling bank accounts

Number of accounts Number of accounts

An important aspect of ABC in non-manufacturing operations is to identify the items for which the costing system is intended to provide cost information. In the case of cash processing above, ABC-related costs can be established for customer accounts and also for cash processing transactions. Costs can also be established for ‘close outs’ and fund transfers. Having identified the items for which unit costs are needed, at a unit, batch or product level, activity costs should be assigned to each cost item on the basis of their ‘use’ of each activity.

Question 3: ABC and retail organisations List five activities that might be identified in a department store and state one possible cost driver for each of the activities you have identified. (The answer is at the end of the chapter)

6 Merits and criticisms of ABC Section overview •

6.1

ABC has a range of uses and has many advantages over more traditional costing methods. However, the system does have its critics and it is not used as a panacea for all costing problems.

Merits 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.

(d)

By facilitating and enabling the control of the incidence of the cost driver, the level of the cost can be controlled.

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(e)

The costs of activities not included in the costs of the products an organisation makes or the services it provides can be considered to be not contributing to the value of the product/service. The following questions can then be asked: • • •

What is the purpose of this activity? How does the organisation benefit from this activity? Could the number of staff involved in the activity be reduced?

(f)

ABC can help with cost management. For example, suppose there is a fall in the number of orders placed by a purchasing department. This fall would not impact on the amount of overhead absorbed in a traditional absorption costing system as the cost of ordering would be part of the general overhead absorption rate, assuming no direct link between the overhead absorption basis of, say, direct labour hours, and the number of orders placed. The reduction in the workload of the purchasing department might therefore go unnoticed and the same level of resources would continue to be provided, despite the drop in number of orders. In an ABC system, however, this drop would be immediately apparent because the cost driver rate would be applied to fewer orders.

(g)

Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but traditional absorption costing systems do not account for this. Organisations may be trading with certain customers at a loss but may not realise it because costs are not analysed in a way that reveals the true situation. ABC can be used in conjunction with customer profitability analysis to determine more accurately the profit earned by servicing particular customers.

Definition Customer profitability analysis is the analysis of the revenue streams and service costs associated with specific customers or customer groups.

(h)

Many service businesses have characteristics similar to those required for the successful application of ABC: •

A highly competitive market.



Diversity of products, processes and customers.



Significant overhead costs not easily assigned to individual 'products'.



Demands placed on overhead resources by individual 'products' and customers, which are not proportional to volume.

If ABC were to be used in a hotel, for example, attempts could be made to identify the activities required to support each guest by category and the cost drivers of these activities. The cost of a one-night stay midweek by a businessman could then be distinguished from the cost of a one-night stay by a teenager at the weekend. Such information could prove invaluable for Customer profitability analysis.

6.2

Criticisms of ABC It has been suggested by critics that activity-based costing has some serious flaws.

178

(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)

On the other hand, the number of cost pools and cost drivers cannot be excessive otherwise an ABC system would be too complex and too expensive.

(d)

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?

Management Accounting

6.3

(e)

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, an absorption costing system may be simpler to operate.

(f)

The costs of ABC may outweigh the benefits.

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 its implications.

6.3.1

Planning: activity-based budgeting (ABB) 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. This activity-based approach may not produce the final budget figures but it can provide the basis for different possible planning scenarios.

6.3.2

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 cost. With ABC, however, it is possible to control or manage the costs by managing the activities which underlie them by monitoring cost driver usage.

6.3.3

Decision making Many of ABC's supporters claim that it can assist with decision making in 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 a long run 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. For example, even if a product/service ceases altogether, some costs allocated to that product/service using an activity-based approach, such as building occupancy costs or depreciation, would not disappear just because the product/service had disappeared. Management would need to bear this in mind when making product deletion decisions.

6.4

Activity-based management (ABM) Although the terms are sometimes used interchangeably, ABM is a broader concept than ABC, being likely to incorporate ABC and activity-based budgeting (ABB). Activity-based budgeting is where resources are allocated to individual activities depending on their interrelationships. A detailed knowledge of this is not required in this unit.

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179

Definitions Optimal ABM are actions, based on activity driver analysis, that increase efficiency, lower costs and/or improve asset utilisation. Strategic ABM are actions, based on activity-based cost analysis, that claim to change the demand for activities so as to improve profitability.

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Key chapter points •

Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products, which use fewer support services and too small a proportion of overheads to low volume products, which use more support services. Activity-based costing (ABC) attempts to overcome this problem and charge overheads on the basis of the use of support services.



ABC involves the identification of the factors (cost drivers) which cause the costs of an organisation's major activities. Support overheads are charged to products on the basis of their usage of an activity.



When using ABC, for costs that vary with production levels in the short term, the cost driver will be volume related (labour or machine hours). Overheads that vary with some other activity, and not volume of production, should be traced to products using transaction-based cost drivers such as production runs or number of orders received.



The main criticism of marginal costing decision making information is that marginal costing analyses cost behaviour patterns according to the volume of production. However, although certain costs may be fixed in relation to the volume of production, they may in fact be variable in relation to some other cost driver.



ABC should only be introduced if the additional information it provides will result in action that will increase the organisation's overall profitability.



ABC identifies four levels of activities: product level, batch level, product sustaining level and facility sustaining level.



ABC has a range of uses and has many advantages over more traditional costing methods. However, the system does have its critics and it is not a panacea for all costing problems.

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Quick revision questions 1

2

Which one of the following statements is INCORRECT? A

Traditional costing systems tend to allocate too small a proportion of overheads to high volume products and too great a proportion of overheads to low volume products.

B

In manufacturing, ABC is more appropriate than traditional absorption costing when the consumption of resources on overhead activities is not related to production volumes.

C

ABC can be used for customer profitability analysis.

D

A single cost driver may not explain the level of expenditure on an activity.

For which of the following costs might the number of machine hours worked be a cost driver? A B C D

3

Which of the following is most likely to be the cost driver for production scheduling costs? A B C D

4

182

product level activity batch level activity product-sustaining activity facility-sustaining activity

In ABC, general factory administration costs might be an example of a: A B C D

6

Number of orders Number of production runs Volume of output Volume of materials handled

In ABC, brand management might be an example of a: A B C D

5

Set-up costs Short-run variable overhead costs Materials handling and despatch costs Product development costs

product level activity batch level activity product-sustaining activity facility-sustaining activity

Which one of the following statements is INCORRECT? A

In ABC, direct labour hours or direct machine hours may be used to trace costs to products.

B

The cost driver for quality inspection is likely to be number of hours worked on the product.

C

In ABC, activity costs are absorbed into product costs using an activity cost per unit of cost driver as the absorption rate.

D

ABC may be used for cost and management accounting by service organisations.

Management Accounting

Answers to quick revision questions 1

A Traditional costing systems tend to allocate too great a proportion of overheads to high volume products and too small a proportion of overheads to low volume products. Note that a weakness of the ABC method is that for some activities, there may be several cost drivers for cost.

2

B Short-run variable costs (such as repairs costs) are generally driven by production activity (machine hours or direct labour hours).

3

B Production scheduling costs are likely to be driven by the number of production runs. Set-up costs may be included in the general activity: ‘production scheduling’.

4

C In ABC, activities are identified at different levels. At a product-sustaining level, activities are generally related to product or brand management,

5

D General factory administration costs are incurred to keep the factory in operation, and so would be classified as a facility-sustaining activity

6

B The cost driver for quality inspection is likely to be number of inspections carried out. In ABC, direct labour hours or direct machine hours may be used to trace some costs to products – typically short-run variable costs. ABC can be applied to any operations where resources are consumed by activities, including service organisations.

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183

Answers to chapter questions 1

D A cost driver is best described as any factor which causes a change in the cost of an activity.

2

(a)

D Traditional absorption costing approach

Direct labour hours 5 000 14 000 19 000

Product L = 5 000 units × 1 hour Product M = 7 000 units × 2 hours Therefore Overhead absorption rate =

$285 000 = $15 per hour 19 000

Overhead absorbed by one unit of product M would be as follows: Product M (b)

2 hours × $15

=

$30 per unit

B ABC approach Product L Product M

Machine hours 15 000 7 000 22 000

= 5 000 units × 3 hours = 7 000 units × 1 hour

Using ABC the overhead costs are absorbed according to the cost drivers. Machine-hour driven costs Set-up driven costs Order driven costs

209 000 ÷ 22 000 m/c hours 25 000 ÷ 50 set-ups 51 000 ÷ 75 orders

Overhead costs are therefore as follows: Machine-driven costs (7 000 hrs × $9.50) Set-up costs (40 × $500) Order handling costs (60 × $680) Units produced Overhead cost per unit of Product M

$ = $9.50 per m/c hour = $500 per set-up = $680 per order

Product M $ 66 500 20 000 40 800 127 300 7 000 $18.19

These figures suggest that product M absorbs an excessive amount of overhead using a direct labour hour 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. Most overhead costs are driven by machine activity, but Product M requires much less machine time than Product L.

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Management Accounting

3 Activities

Possible cost driver

Quoting prices (curtains, carpets etc)

Number of requests for quotations

Purchasing and receiving goods

Number of orders

Returned goods

Number of returns

Operating a department

Number of departments/floor space

Check-out activity

Number of customers/check-outs

Home deliveries

Number of orders (or possibly the distance travelled to deliver)

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Management Accounting

Chapter 7

Process and job costing Learning objectives

Reference

Process and job costing

LO7

Explain the differences between job and process costing techniques

LO7.1

Apply costing principles to job costing and process costing organisations

LO7.2

Topic list

1 2 3 4 5 6 7 8

The distinguishing features of process costing The basics of process costing Dealing with losses in process Accounting for scrap Valuing closing work in process Valuing opening work in process Joint products and by-products Job costing

187

Introduction This chapter looks at costing systems. Costing systems are used to cost goods or services. The method used depends on the way in which the goods or services are produced. The chapter begins by considering process costing. Process costing is applied when output consists of a continuous stream of identical units. We will begin with the basics and look at how to account for the most simple of processes. We will then move on to how to account for any losses which might occur, as well as what to do with any scrapped units which are sold. Next we will consider how to deal with closing work in process before examining situations involving closing work in process and losses. We will then go on to have a look at situations involving opening work in process and how to deal with situations where we have both opening and closing work in process and losses. This is followed with an outline discussion of joint products and by-products. This chapter will conclude by covering job costing.

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Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

When is process costing used?

(Section 1)

2

Define process costing.

(Section 1)

3

What is on the left hand side of the process account?

(Section 2.1)

4

What is on the right hand side of the process account?

(Section 2.1)

5

What are the four key steps involved in process costing?

(Section 2.2)

6

Define normal loss, abnormal loss and abnormal gain.

(Section 3.1)

7

How is normal loss valued?

(Section 4)

8

How is work in process valued?

(Section 6)

9

What is a joint product? Give examples.

(Section 7.1)

10

What is a by-product ? Give examples.

(Section 7.2)

11

Define job costing.

(Section 8)

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1 The distinguishing features of process costing Section overview • LOs 7.1 7.2

Process costing is a costing method used when it is not possible to identify separate units of production, or jobs, usually because of the continuous nature of the production processes involved.

Process costing is used where there is a continuous flow of identical units and it is common to identify it with continuous production such as the following: • • • •

Oil refining. The manufacture of soap. Paint manufacture. Food and drink manufacture.

Definition Process costing is a form of costing applicable to continuous processes where process costs are attributed to the number of units produced. This may involve estimating the number of equivalent units in stock at the start and end of the period under consideration.

We will discuss 'equivalent units' later in this chapter. The features of process costing which make it different from other methods of costing such as job or batch costing are as follows:

LO 7.2

(a)

The continuous nature of production in many processes means that there will usually be closing work in process which must be valued. In process costing it is not possible to build up cost records of the cost of each individual unit of output because production in progress is an indistinguishable homogeneous mass.

(b)

There is often a loss in process due to spoilage, wastage, evaporation and so on.

(c)

The output of one process becomes the input to the next until the finished product is made in the final process.

(d)

Output from production may be a single product, but there may also be a by-product (or byproducts) and/or joint products:

2 The basics of process costing Section overview

2.1



Costs incurred in processes are recorded in what are known as process accounts. A process account has two sides, and on each side there are two columns, one for quantities (of raw materials, work-in-process and finished goods) and one for costs.



There is a four step approach for dealing with process costing questions.

Process accounts A process account has two sides (Debit and Credit), and on each side there are two columns – one for quantities (of raw materials, work in process and finished goods) and one for costs. (a)

190

On the left hand side of the process account we record the inputs to the process and the cost of these inputs. So we might show the quantity of material input to a process during the period and its cost, the cost of labour and the cost of overheads.

Management Accounting

(b)

On the right hand side of the process account we record what happens to the inputs by the end of the period. (i)

Some of the input might be converted into finished goods, so we show the units of finished goods and the cost of these units.

(ii)

Some of the material input might evaporate or get spilled or damaged, so there would be losses. So we record the loss units and the cost of the loss.

(iii)

At the end of a period, some units of input might be in the process of being turned into finished units so would be work in process (WIP). We record the units of WIP and the cost of these units.

The quantity columns on each side of the account should total to the same amount. Why? For instance if we put 100 kgs of material in to a process, which we record on the left hand side of the account, we should know what has happened to those 100 kgs. Some would be losses maybe, some would be WIP, some would be finished units, but the total should be 100 kgs. Likewise the cost of the inputs to the process during a period (i.e. the total of the costs recorded on the left hand side of the account) is the cost of the outputs of the process. If we have recorded material, labour and overhead costs totalling $1 000 and at the end of the process we have 100 finished units (and no losses or WIP), then that output cost $1 000. Here’s a simple example of a process account: PROCESS ACCOUNT Material Labour Overhead

Units 1 000 1 000

$ 11 000 4 000 3 000 18 000

Closing WIP Finished units

Units 200 800

$ 2 000 16 000

1 000

18 000

As you can see, the quantity columns on each side balance (i.e. they are the same), as do the monetary columns. Don’t worry at this stage about how the costs are split between WIP and finished units.

Worked Example: Basics of process costing Suppose that Purr and Miaow Co make squeaky toys for cats. Production of the toys involves two processes, shaping and colouring. During the year to 31 March 20X3, 1 000 000 units of material worth $500 000 were input to the first process, shaping. Direct labour costs of $200 000 and production overhead costs of $200 000 were also incurred in connection with the shaping process. There were no opening or closing inventories in the shaping department. The process account for shaping for the year ended 31 March 20X3 is as follows: PROCESS 1 (SHAPING) ACCOUNT Direct materials Direct labour Production overheads

Units 1 000 000 1 000 000

$ 500 000 200 000 200 000 900 000

Output to Process 2

Units 1 000 000

$ 900 000

1 000 000

900 000

When preparing process accounts, balance off the quantity columns (i.e. ensure they total to the same amount on both sides) before attempting to complete the monetary value columns since they will help you to check that you have not missed something. This becomes increasingly important as more complications are introduced into questions. When using process costing, if a series of separate processes is needed to manufacture the finished product, the output of one process becomes the input to the next until the final output is made in the final process. In our example, all output from shaping was transferred to the second process, colouring, during the year to 31 March 20X3. An additional 500 000 units of material, costing $300 000, were input to the colouring process. Direct labour costs of $150 000 and production overhead costs of $150 000 were also incurred. There were no opening or closing inventories in the colouring department.

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191

The process account for colouring for the year ended 31 March 20X3 is as follows: PROCESS 2 (COLOURING) ACCOUNT Materials from process 1 Added materials Direct labour Production overhead

Units 1 000 000 500 000 1 500 000

$ 900 000 Output to finished 300 000 goods 150 000 150 000 1 500 000

Units

$

1 500 000

1 500 000

1 500 000

1 500 000

In some cases, the figures for direct labour and production overhead may not be given separately in an assessment question, but instead grouped together as one figure and called “conversion cost”. Added materials, labour and overhead in process 2 are usually added gradually throughout the process. Materials from process 1, in contrast, will often be introduced in full at the start of the second process.

2.2

Framework for dealing with process costing A suggested four-step approach when dealing with process costing questions.

Step 1

Determine output and losses.

Step 2

Calculate cost per unit of output, losses and WIP.

Step 3

Calculate total cost of output, losses and WIP.

Step 4

Complete accounts.

Process costing is centred around four key steps. The exact work done at each step will depend on the circumstances of the question, but the approach can always be used.

Step 1

Determine output and losses. • • •

Step 2

Determine expected output. Calculate normal loss and abnormal loss and gain. Calculate equivalent units if there is closing work in process.

Calculate cost per unit of output, losses and WIP. Calculate cost per unit or cost per equivalent unit.

Step 3

Calculate total cost of output, losses and WIP. In some examples this will be straightforward. In cases where there is work in process, a statement of evaluation will have to be prepared. This will be covered later in the chapter.

Step 4

Complete accounts. •

LO 7.2

Complete the process account and any other accounts required.

3 Dealing with losses in process Section overview •

192

Losses may occur in a process. If a certain level of loss is expected, this is known as normal loss. If losses are greater than expected, the extra loss is abnormal loss. If losses are less than expected, the difference is known as abnormal gain.

Management Accounting

3.1

Losses During a production process, a loss may occur.

Definitions The normal loss is expected loss, allowed for in the budget, and normally calculated as a percentage of the good output, from a process during a period of time. Normal losses are generally either valued at zero or at their disposal values. Abnormal loss is any loss in excess of the normal loss budgeted. Abnormal gain is improvement on the budgeted or normal loss associated with a production activity.

Losses may occur due to wastage, spoilage, evaporation, and so on. Since normal loss is not given a cost, the cost of producing these units is borne by the 'good' units of output. Units associated with abnormal loss and gain are valued at the same unit rate as 'good' units. Abnormal events do not therefore affect the cost of good production. Their costs are analysed separately in an abnormal loss or abnormal gain account.

3.1.1

Accounting for abnormal gains and losses (a)

In an abnormal loss account, the debit entry shows the units (and their value) from the process account. The credit entry shows the impact on the statement of comprehensive income.

(b)

In an abnormal gain account, the debit entry shows the effect on the statement of comprehensive income, while the credit entry shows the units (and their value) from the process account.

Worked Example: Abnormal losses and gains Assume that input to a process is 1 000 units at a cost of $4 500. Normal loss is 10% and there are no opening or closing inventories. Determine the accounting entries for the cost of output and the cost of the loss if actual output were as follows: (a) (b)

860 units (so that actual loss is 140 units) 920 units (so that actual loss is 80 units)

Solution Before we demonstrate the use of the 'four-step framework' we will summarise the way that the losses are dealt with: (a)

Normal loss is given no share of cost.

(b)

The cost of output is therefore based on the expected units of output, which in our example amount to 90% of 1 000 = 900 units.

(c)

Abnormal loss is given a cost, which is written off to the statement of comprehensive income via an abnormal loss / gain account.

(d)

Abnormal gain is treated in the same way, except that being a gain rather than a loss, it appears as a debit entry in the process account (as it is a type of input, being additional unexpected units), whereas a loss appears as a credit entry in this account (as it is a type of output).

7: Process and job costing

193

(a)

Output is 860 units.

Step 1

Determine output and losses. If actual output is 860 units and the actual loss is 140 units:

Units 140 100 40

Actual loss Normal loss (10% of 1 000) Abnormal loss

Step 2

Calculate cost per unit of output and losses. The cost per unit of output and the cost per unit of abnormal loss are based on expected output.

Costs incurred $4 500 = = $5 per unit 900 units Expected output

Step 3

Calculate total cost of output and losses.

Normal loss is not assigned any cost.

$ 4 300 0 200 4 500

Cost of output (860 × $5) Normal loss Abnormal loss (40 × $5)

Step 4

Complete accounts.

PROCESS ACCOUNT Cost incurred

Units 1 000

1 000

$ 4 500

4 500

Normal loss Output (finished goods a/c) Abnormal loss

Units 100 860 40 1 000

ABNORMAL LOSS ACCOUNT Process a/c

(b)

Units 40

$ 200

Statement of comprehensive income

Units 40

$ 0 4 300 200 (× $5) 4 500

(× $5)

$ 200

Output is 920 units.

Step 1

Determine output and losses.

If actual output is 920 units and the actual loss is 80 units: Actual loss Normal loss (10% of 1 000) Abnormal gain

Step 2

Units 80 100 20

Calculate cost per unit of output and losses.

The cost per unit of output and the cost per unit of abnormal gain are based on expected output. Costs incurred $4 500 = $5 per unit = 900 units Expected output

Whether there is abnormal loss or gain does not affect the valuation of units of output. The figure of $5 per unit is exactly the same as in the previous paragraph, when there were 40 units of abnormal loss.

194

Management Accounting

Step 3

Calculate total cost of output and losses.

$ 4 600 0 (100) 4 500

Cost of output (920 × $5) Normal loss Abnormal gain (20 × $5)

Step 4

Complete accounts.

PROCESS ACCOUNT Cost incurred Abnormal gain a/c

Units $ 1 000 4 500 20 (× $5) 100 1 020

4 600

Normal loss Output (finished goods a/c)

Units $ 100 0 920 (× $5) 4 600 1 020

4 600

ABNORMAL GAIN Statement of comprehensive income

Units 20

$ 100

Process a/c

Units 20

$ 100

Worked Example: Abnormal losses and gains During a four-week period, period 3, costs of input to a process were $29 070. Input was 1 000 units, output was 850 units and normal loss is 10%. During the next period, period 4, costs of input were again $29 070. Input was again 1 000 units, but output was 950 units. There were no units of opening or closing inventory. Prepare the process account and abnormal loss or gain account for each period.

Solution Step 1

Determine output and losses. Period 3

Actual output Normal loss (10% × 1 000) Abnormal loss Input Period 4

Actual output Normal loss (10% × 1 000) Abnormal gain Input

Step 2

Units 850 100 50 1 000 Units 950 100 (50) 1 000

Calculate cost per unit of output and losses.

For each period the cost per unit is based on expected output. Cost of input $29 070 = $32.30 per unit = 900 Expected units of output

7: Process and job costing

195

Step 3

Step 4

Calculate total cost of output and losses. Period 3 Cost of output (850 × $32.30) Normal loss Abnormal loss (50 × $32.30)

$ 27 455 0 1 615 29 070

Period 4 Cost of output (950 × $32.30) Normal loss Abnormal gain (50 × $32.30)

$ 30 685 0 (1 615) 29 070

Complete accounts.

PROCESS ACCOUNT Period 3 Cost of input

Period 4 Cost of input Abnormal gain a/c (× $32.30)

Units 1 000

$

Units

29 070

1 000

29 070

1 000 50

29 070 1 615

1 050

30 685

Normal loss Finished goods a/c (× $32.30) Abnormal loss a/c (× $32.30) Normal loss Finished goods a/c (× $32.30)

$

100 850

0 27 455

50

1 615

1 000

29 070

100 950

0 30 685

1 050

30 685

ABNORMAL LOSS OR GAIN ACCOUNT $ Period 3 Abnormal loss in process a/c

1 615

$ Period 4 Abnormal gain in process a/c

1 615

There is a zero balance on this account at the end of period 4.

Question 1: Full cost Charlton Co manufactures a product in a single process operation. Normal loss is 10% of input. Loss occurs at the end of the process. Data for June are as follows: Opening and closing inventories of work in process Cost of input materials (3 300 units) Direct labour and production overhead Output to finished goods

Nil $59 100 $30 000 2 750 units

The full cost of finished output in June was: A B C D

$74 250 $81 000 $82 500 $89 100 (The answer is at the end of the chapter)

196

Management Accounting

Question 2: Abnormal gain Zed Co makes product Emm which goes through several processes. The following information is available for the month of June: kg Opening WIP 5 200 Closing WIP 3 500 Input 58 300 Normal loss 400 Transferred to finished goods 59 900 What was the abnormal gain in June? A B C D

260 kgs 300 kgs 400 kgs 560 kgs (The answer is at the end of the chapter)

LO 7.2

4 Accounting for scrap Section overview •

The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of normal loss to be deducted from the cost of materials before a cost per equivalent unit is calculated.

Definition Scrap is discarded material having some value.

4.1

Basic rules for accounting for scrap (a)

Revenue from scrap is treated, not as an addition to sales revenue, but as a reduction in costs. The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of normal loss to be deducted from the cost of materials before a cost per equivalent unit is calculated.

(b)

The scrap value of normal loss is therefore used to reduce the material costs of the process with the scrap value of the normal loss. DEBIT CREDIT

Scrap account Process account

Abnormal losses and gains never affect the cost of good units of production. The scrap value of abnormal losses is not credited to the process account, and the abnormal loss and gain units carry the same full cost as a good unit of production. (c)

The scrap value of abnormal loss is used to reduce the cost of abnormal loss with the scrap value of abnormal loss, which therefore reduces the write-off of cost to the statement of comprehensive income. DEBIT CREDIT

Scrap account Abnormal loss account

7: Process and job costing

197

(d)

The scrap value of abnormal gain arises because the actual units sold as scrap will be less than the scrap value of normal loss. Because there are fewer units of scrap than expected, there will be less revenue from scrap as a direct consequence of the abnormal gain. The abnormal gain account should therefore be debited with the scrap value abnormal gain. DEBIT CREDIT

(e)

Abnormal gain account Scrap account

The scrap account is completed by recording the actual cash received from the sale of scrap with the amount received from the sale of the actual scrap. DEBIT CREDIT

Cash at bank/Debtors Scrap account

The same basic principle therefore applies that only normal losses should affect the cost of the good output. The scrap value of normal loss only is credited to the process account. The scrap values of abnormal losses and gains are analysed separately in the abnormal loss or gain account.

Worked Example: Scrap and abnormal loss or gain A factory has two production processes. Normal loss in each process is 10% and scrapped units sell for $0.50 each from process 1 and $3 each from process 2. Relevant information for costing purposes relating to period 5 is as follows: Direct materials added: Units Cost Direct labour Production overhead Output to process 2/finished goods Actual production overhead

Process 1

Process 2

2 000 $8 100 $4 000 150% of direct labour cost 1 750 units $17 800

1 250 $1 900 $10 000 120% of direct labour cost 2 800 units

Prepare the accounts for process 1, process 2, scrap and abnormal loss or gain.

Solution Step 1

Determine output and losses.

Output Normal loss (10% of input) Abnormal loss Abnormal gain

Process 1 Units 1 750 200 50 – 2 000

Process 2 Units 2 800 300 – (100) 3 000*

* 1 750 units from process 1 + 1 250 units added.

Step 2

198

Calculate cost per unit of output and losses. Process 1 $

Cost of input – material – from process 1 – labour – overhead

(150% × $4 000)

Less: scrap value of normal loss

(200 × $0.50)

Management Accounting

8 100 – 4 000 6 000 18 100 (100) 18 000

Process 2 $

(1 750 × $10) (120% × $10 000) (300 × $3)

1 900 17 500 10 000 12 000 41 400 (900) 40 500

Process 1 $ Expected output 90% of 2 000 90% of 3 000 Cost per unit $18 000 ÷ 1 800 $40 500 ÷ 2 700

Process 2 $

1 800 2 700 $10 $15

Note: Calculate the cost per unit of output for process 1 prior to attempting to calculate the cost of process 2.

Step 3

Calculate total cost of output and losses. Process 1 $ 17 500 100 500 18 100 – 18 100

Output (1 750 × $10) Normal loss (200 × $0.50)* Abnormal loss (50 × $10) Abnormal gain

Process 2 $ 42 000 900 – 42 900 (1 500) 41 400

(2 800 × $15) (300 × $3)* (100 × $15)

* Remember that normal loss is valued at scrap value only.

Step 4

Complete accounts.

PROCESS 1 ACCOUNT Direct material Direct labour Production overhead a/c

Units 2 000

$ 8 100 4 000 6 000 18 100

2 000

Scrap a/c (normal loss) Process 2 a/c Abnormal loss a/c

Units 200 1 750 50

$ 100 17 500 500

2 000

18 100

PROCESS 2 ACCOUNT Units Direct materials From process 1 Added materials Direct labour Production overhead Abnormal gain

$

1 750 1 250

17 500 1 900 10 000 12 000 41 400 1 500 42 900

3 000 100 3 100

Units Scrap a/c (normal loss) Finished goods a/c

$

300 2 800

900 42 000

3 100

42 900

ABNORMAL LOSS ACCOUNT Process 1 (50 units)

$ 500

500

Scrap a/c: sale of scrap of extra loss (50 units) Statement of comprehensive income

$ 25 475 500

ABNORMAL GAIN ACCOUNT Scrap a/c (loss of scrap revenue due to abnormal gain, 100 units × $3) Statement of comprehensive income

$ 300 1 200 1 500

Process 2 abnormal gain (100 units)

$ 1 500

1 500

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199

SCRAP ACCOUNT Scrap value of normal loss Process 1 (200 units) Process 2 (300 units) Abnormal loss a/c (process 1)

$ 100 900 25 1 025

$

Cash at bank/Debtors Loss in process 1 (250 units) Loss in process 2 (200 units) Abnormal gain a/c (process 2)

125 600 300 1 025

Question 3: Process accounts Parks Co operates a processing operation involving two stages, the output of process 1 being passed to process 2. The process costs for period 3 were as follows: Process 1

Material Labour

3 000 kg at $0.25 per kg $120

Process 2

Material Labour

2 000 kg at $0.40 per kg $84

General overhead for period 3 amounted to $357 and is absorbed into process costs at a rate of 375% of direct labour costs in process 1 and 496% of direct labour costs in process 2. The normal output of process 1 is 80% of input and of process 2, 90% of input. Waste from process 1 is sold for $0.20 per kg and that from process 2 for $0.30 per kg. The output for period 3 was as follows: Process 1 Process 2

2 300 kgs 4 000 kgs

There was no inventory of work in process at either the beginning or the end of the period and it may be assumed that all available waste had been sold at the prices indicated. Show how the above would be recorded in process, scrap and abnormal loss/gain accounts by completing the proformas below. (Hint. Not all boxes require entries.) PROCESS 1 ACCOUNT Material

Kg

$

kg

$

kg

$

Normal loss to scrap a/c Production transferred to process 2

Labour General overhead Abnormal gain account

Abnormal loss a/c

PROCESS 2 ACCOUNT Kg

Normal loss to scrap a/c

Material added

Production transferred to

Labour

finished inventory

General overhead

Abnormal loss

Abnormal gain

200

$

Transferred from process 1

Management Accounting

SCRAP ACCOUNT Normal loss (process 1)

kg

$

kg

$

kg

$

Abnormal gain (process 1)

Normal loss (process 2)

Abnormal gain (process 2)

Abnormal loss (process 1)

Cash

Abnormal loss (process 2)

ABNORMAL LOSS AND GAIN ACCOUNT Process 1 (loss)

kg

$ Scrap value of abnormal

Process 2 (loss)

loss

Scrap value of abnormal gain

Process 1 (gain)

Statement of comprehensive income

Process 2 (gain)

(The answer is at the end of the chapter)

LO 7.2

5 Valuing closing work in process Section overview •

When units are partly completed at the end of a period, i.e. when there is closing work in process, it is necessary to calculate the equivalent units of production in order to determine the cost of a completed unit.

In the examples we have looked at so far we have assumed that opening and closing inventories of work in process have been nil. We must now look at more realistic examples and consider how to allocate the costs incurred in a period between completed output, i.e. finished units, and partly completed closing inventory. Some examples will help to illustrate the problem, and the techniques used to share out (apportion) costs between finished output and closing work in process.

Worked Example: Valuation of closing inventory Trotter Co is a manufacturer of processed goods. In March 20X3, in one process, there was no opening inventory, but 5,000 units of input were introduced to the process during the month, at the following cost: Direct materials Direct labour Production overhead

$ 16 560 7 360 5 520 29 440

Of the 5,000 units introduced, 4,000 were completely finished during the month and transferred to the next process. Closing inventory of 1,000 units was only 60% complete with respect to materials and conversion costs.

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201

Solution (a)

The problem in this example is to divide the costs of production ($29,440) between the finished output of 4,000 units and the closing inventory of 1,000 units. It is argued, with good reason, that a division of costs in proportion to the number of units of each (4,000:1,000) would not be 'fair' because closing inventory has not been completed, and has not yet 'received' its full amount of materials and conversion costs, but only 60% of the full amount. The 1,000 units of closing inventory, being only 60% complete, are the equivalent of 600 fully worked units.

(b)

To apportion costs fairly and proportionately, units of production must be converted into the equivalent of completed units, i.e. into equivalent units of production.

Definition Equivalent units are notional whole units representing incomplete work. Used to apportion costs between work in process and completed output.

Step 1

Determine output.

For this step in our framework we need to prepare a statement of equivalent units. STATEMENT OF EQUIVALENT UNITS Fully worked units Closing inventory

Step 2

Total units 4 000 1 000 5 000

Completion 100% 60%

Equivalent units 4 000 600 4 600

Calculate cost per unit of output, and WIP.

For this step in our framework we need to prepare a statement of costs per equivalent unit because equivalent units are the basis for apportioning costs. STATEMENT OF COSTS PER EQUIVALENT UNIT Total costs $29 440 Equivalent units = 4 600 Cost per equivalent unit $6.40

Step 3

Calculate total cost of output and WIP.

For this step in our framework a statement of evaluation may now be prepared, to show how the costs should be apportioned between finished output and closing inventory. STATEMENT OF EVALUATION Item

Fully worked units Closing inventory

Step 4

Equivalent Units

Cost per equivalent unit

4 000 600 4 600

$6.40 $6.40

Valuation $ 25 600 3 840 29 440

Complete accounts.

The process account would be shown as follows:

Direct materials Direct labour Production o'hd

Units 5 000 5 000

202

Management Accounting

PROCESS ACCOUNT $ 16 560 Output to next process 7 360 Closing inventory c/f 5 520 29 440

Units 4 000 1 000

$ 25 600 3 840

5 000

29 440

5.1

A few hints on preparing accounts When preparing a process account, it might help to make the entries as follows:

5.2

(a)

Enter the units first. The units columns are simply memorandum columns, but they help you to make sure that there are no units unaccounted for, for example, as loss.

(b)

Enter the costs of materials, labour and overheads next. These should be given to you.

(c)

Enter your valuation of finished output and closing inventory next. The value of the credit entries should, of course, equal the value of the debit entries.

Different rates of input In many industries, materials, labour and overhead may be added at different rates during the course of production. (a)

Output from a previous process, for example, the output from process 1 to process 2, may be introduced into the subsequent process all at once, so that closing inventory is 100% complete in respect of these materials.

(b)

Further materials may be added gradually during the process, so that closing inventory is only partially complete in respect of these added materials.

(c)

Labour and overhead may be 'added' at yet another different rate. When production overhead is absorbed on a labour hour basis, however, we should expect the degree of completion on overhead to be the same as the degree of completion on labour.

When this situation occurs, equivalent units, and a cost per equivalent unit, should be calculated separately for each type of material, and also for conversion costs.

Worked Example: Equivalent units and different degrees of completion Suppose that Shaker Co is a manufacturer of processed goods, and that results in process 2 for April 20X3 were as follows: Opening inventory Material input from process 1 Costs of input: Material from process 1 Added materials in process 2 Conversion costs (direct labour and manufacturing overhead)

nil 4 000 units $ 6 000 1 080 1 720

Output is transferred into the next process, process 3. Closing work in process amounted to 800 units, complete as follows: Process 1 material Added materials Conversion costs

% 100 50 30

Required

Prepare the account for process 2 for April 20X3.

7: Process and job costing

203

Solution Step 1

Determine output and losses.

STATEMENT OF EQUIVALENT UNITS (OF PRODUCTION IN THE PERIOD)

Input Units 4 000

Output

Completed production Closing inventory

4 000

Equivalent units of production Process 1 Added Conversion material materials costs Units % Units % Units % 3 200 100 3 200 100 3 200 100

Total Units 3 200

800 4 000

800 4 000

100

400* 3 600

50

240** 3 440

30

* 800 x 50% ** 800 x 30%

Step 2

Calculate cost per unit of output, losses and WIP.

STATEMENT OF COST (PER EQUIVALENT UNIT) Input

Process 1 material Added materials Conversion costs

Step 3

Equivalent production in units

Cost $ 6 000 1 080 1 720 8 800

Cost per unit $ 1.50 0.30 0.50 2.30

4 000 3 600 3 440

Calculate total cost of output, losses and WIP.

STATEMENT OF EVALUATION (OF FINISHED WORK AND CLOSING INVENTORIES)

Production

Completed production Closing inventory:

Cost element

Number of equivalent units

3 200 800 400 240

process 1 material added material Conversion cots

Cost per equivalent unit $ 2.30 1.50 0.30 0.50

Total $

Cost $ 7 360

1 200 120 120 1 440 8 800

Step 4

Complete accounts.

PROCESS ACCOUNT Process 1 material Added material Conversion costs

Units 4 000 4 000

5.3

$ 6 000 1 080 1 720 8 800

Process 3 a/c (finished output) Closing inventory c/f

Units 3 200

$ 7 360

800 4 000

1 440 8 800

Closing work in process and losses The previous sections have dealt separately with the following:

204

(a)

The treatment of loss and scrap.

(b)

The use of equivalent units as a basis for apportioning costs between units of output and units of closing inventory.

Management Accounting

We must now look at a situation where both problems occur together. We shall begin with an example where loss has no scrap value. The conventions are as follows: (a)

Costs should be divided between finished output, closing inventory and abnormal loss/gain using equivalent units as a basis of apportionment.

(b)

Units of abnormal loss/gain are often taken to be one full equivalent unit each, and are valued on this basis, i.e. they carry their full 'share' of the process costs.

(c)

Abnormal loss units are an addition to the total equivalent units produced but abnormal gain units are subtracted in arriving at the total number of equivalent units produced.

(d)

Units of normal loss are valued at zero equivalent units, i.e. they do not carry any of the process costs.

Worked Example: Changes in inventory level and losses The following data have been collected for a process: Opening inventory Input units Cost of input Normal loss

none 2 800 units $16 695 10%; nil scrap value

Output to finished goods Closing inventory Total loss

2 000 units 450 units, 70% complete 350 units

Prepare the process account for the period.

Solution Step 1

Determine output and losses.

STATEMENT OF EQUIVALENT UNITS

Completely worked units Closing inventory Normal loss (10% x 2800) Abnormal loss (350-280)

Step 2

Total units 2 000 450 280 70 2 800

(× 100%) (× 70%) (× 100%)

Equivalent units of work done this period 2 000 315 0 70 2 385

Calculate cost per unit of output, losses and WIP.

STATEMENT OF COST (PER EQUIVALENT UNIT) Costs incurred $16 695 = 2 385 Equivalent units of work done Cost per equivalent unit = $7

Step 3

Calculate total cost of output, losses and WIP.

STATEMENT OF EVALUATION Completely worked units Closing inventory Abnormal loss

Equivalent units 2 000 315 70 2 385

$ 14 000 2 205 490 16 ,695

7: Process and job costing

205

Step 4

Complete accounts. Units

Opening inventory Input costs

– 2 800 2 800

5.4

PROCESS ACCOUNT $ – Normal loss 16 695 Finished goods a/c Abnormal loss a/c Closing inventory c/f 16 695

$

Units 280 2 000 70 450 2 800

0 14 000 490 2 205 16 695

Closing work in process, loss and scrap When loss has a scrap value, the accounting procedures are the same as those previously described. However, if the equivalent units are a different percentage (of the total units) for materials, labour and overhead, it is a convention that the scrap value of normal loss is deducted from the cost of materials before a cost per equivalent unit is calculated.

Question 4: Closing work in process Complete the process account below from the following information. (Hint. Not all boxes require entries.) Opening inventory

Nil

Input units

10 000

Input costs Material Labour

$5 150 $2 700

Normal loss

5% of input

Total loss

1 000 units

Scrap value of units of loss

$1 per unit

Output to finished goods

8 000 units

Closing inventory

1 000 units

Completion of closing inventory

80% for material 50% for labour PROCESS ACCOUNT

Material

Units

$

Units

$

Completed production

Labour

Closing inventory

Abnormal gain

Normal loss Abnormal loss

(The answer is at the end of the chapter)

LO 7.2

6 Valuing opening work in process Section overview •

206

The weighted average cost method of valuing opening WIP makes no distinction between units of opening WIP and new units introduced to the process during the current period.

Management Accounting

6.1

Weighted average cost method The weighted average cost method of inventory valuation is a inventory valuation method that calculates a weighted average cost of units produced from both opening inventory and units introduced in the current period. With the weighted average cost method no distinction is made between units of opening WIP and new units introduced to the process during the current period. The cost of opening WIP is added to costs incurred during the period, and completed units of opening WIP are each given a value of one full equivalent unit of production.

Worked Example: Weighted average cost method Magpie Co produces an item which is manufactured in two consecutive processes. Information relating to Process 2 during September 20X3 is as follows: Opening inventory 800 units Degree of completion: process 1 materials added materials conversion costs (direct labour and manufacturing overhead)

% 100 40 30

$ 4 700 600 1 000 6 300

During September 20X3, 3,000 units were transferred from process 1 at a valuation of $18 100. Added materials cost $9,600 and conversion costs were $11 800. Closing inventory at 30 September 20X3 amounted to 1,000 units which were 100% complete with respect to process 1 materials and 60% complete with respect to added materials. Conversion cost work was 40% complete. Magpie Co uses a weighted average cost system for the valuation of output and closing inventory. Prepare the process 2 account for September 20X3.

Solution Step 1

Determine output and losses.

Opening inventory units count as a full equivalent unit of production when the weighted average cost system is applied. Closing inventory units are assessed in the usual way. STATEMENT OF EQUIVALENT UNITS

Equivalent units Total Process 1 Added Conversion units material material costs Output to finished goods* 2 800 (100%) 2 800 2 800 2 800 (100%) 1 000 (60%) 600 (40%) 400 Closing inventory 1 000 3 800 3 400 3 200 3 800 * 3 000 units from process 1 minus closing inventory of 1 000 units plus opening inventory of 800 units.

Step 2

Calculate cost per unit of output and WIP.

The cost of opening inventory is added to costs incurred in September 20X3, and a cost per equivalent unit is then calculated. STATEMENT OF COSTS PER EQUIVALENT UNIT

Opening inventory Added in September 20X3 Total cost Equivalent units Cost per equivalent unit

Process 1 material $ 4 700 18 100 22 800

3 800 units $6

Added materials $ 600 9 600 10 200

3 400 units $3

Conversion costs $ 1 000 11 800 12 800

3 200 units $4

7: Process and job costing

207

Step 3

Calculate total cost of output and WIP.

STATEMENT OF EVALUATION Process 1 Material $

Output to finished goods (2 800 units) Closing inventory

Step 4

16 800 6 000

Added materials $

8 400 1 800

Conversion costs $

Total cost $

11 200 1 600

36 400 9 400 45 800

Complete accounts

PROCESS 2 ACCOUNT Opening inventory b/f Process 1 a/c Added materials Conversion costs

Units 800 3 000 3 800

6.2

$ 6 300 18 100 9 600 11 800 45 800

Finished goods a/c Closing inventory c/f

Units 2 800

$ 36 400

1 000 3 800

9 400 45 800

A final question The following question involves the following process costing situations: • • • • •

Normal loss – with and without sale of scrap. Abnormal loss. Abnormal gain. Opening work in process. Closing work in process.

Take some time to work through this question carefully and to check your workings against the answer given below. This question should help consolidate all of the process costing knowledge that you have acquired while studying this chapter.

Question 5: Watkins Ltd Watkins Ltd has a financial year which ends on 30 April 20X0. It operates in a processing industry in which a single product is produced by passing inputs through two sequential processes. A normal loss of 10% of input is expected in each process. Total loss for process 1 was 1 200 units. The following account balances have been extracted from its ledger at 31 March 20X0:

Process 1 (Materials $4 400; Conversion costs $3 744) Process 2 (Process 1 $4 431; Conversion costs $5 250) Abnormal loss Abnormal gain Overhead control account Sales Cost of sales Finished goods inventory

Debit $ 8 144 9 681 1 400

442 500 65 000

Credit $

300 250 585 000

Watkins Ltd uses the weighted average method of accounting for work in process. During April 20X0 the following transactions occurred: Process 1

208

Materials input (kg $) Labour cost Transfer to process 2

Management Accounting

4 000 kg 2 400 kg

$22 000 $12 000

Process 2

Transfer from process 1 Labour cost Transfer to finished goods Overhead costs incurred amounted to Sales to customer were

2 400 kg 2 500 kg $54 000 $52 000

$15 000

Overhead costs are absorbed into process costs on the basis of 150% of labour cost. The losses which arise in process 1 have no scrap value: those arising in process 2 can be sold for $2 per kg. Details of opening and closing work in process for the month of April 20X0 are as follows: Opening 3 000 kg 2 250 kg

Process 1 Process 2

Closing 3 400 kg 2 600 kg

In both processes closing work in process is fully complete as to material cost and 40% complete as to conversion cost. Inventories of finished goods at 30 April 20X0 were valued at cost of $60 000. You are required to fill in the blank boxes. (a)

(b)

In an account for process 1, the monetary and quantity values for: (i)

transfers to process 2 are

(ii)

normal loss are

(iii)

abnormal loss are

kgs at $

(iv)

abnormal gain are

kgs at $

(v)

WIP materials are

kgs at $

(vi)

WIP conversion costs are

kgs at $ kgs at $

kgs at $

In an account for process 2, the monetary and quantity values for: (i)

finished goods are

(ii)

normal loss are

(iii)

WIP from process 1 are

kgs at $

(iv)

WIP from process 2 are

kgs at $

kgs at $ kgs at $

(The answer is at the end of the chapter) LO 7.2

7 Joint products and by-products Section overview

7.1



Joint products are two or more products produced by the same process and separated in processing, each having a sufficiently high saleable value to merit recognition as a main product.



A by-product is an incidental product from a process which has an insignificant value compared to the main product(s).

Joint products Joint products: •

Are produced in the same process.

7: Process and job costing

209

• • •

Are indistinguishable from each other until the separation point. Have a substantial sales value – after further processing, if necessary. May require further processing after the separation point.

For example, in the oil refining industry the following joint products all arise from the same process: • • • •

7.2

Diesel fuel. Petrol. Paraffin. Lubricants.

By-products A by-product is an incidental product from a process which has an insignificant value compared to the main product(s).

Definition A by-product is output of some insignificant value produced incidentally while manufacturing the main product. A by-product is a product which is similarly produced at the same time and from the same common process as the 'main product' or joint products. The distinguishing feature of a by-product is its relatively low sales value in comparison to the main product. In the timber industry, for example, by-products include sawdust, small off cuts and bark.

7.3

Distinguishing joint products from by-products The answer lies in management attitudes to their products, which in turn is reflected in the cost accounting system.

7.4

(a)

A joint product is regarded as an important saleable item, and so it should be separately costed. The profitability of each joint product should be assessed in the cost accounts.

(b)

A by-product is not important as a saleable item, and whatever revenue it earns is a 'bonus' for the organisation. It is not worth costing by-products separately, because of their relative insignificance. It is therefore equally irrelevant to consider a by-product's profitability. The only question is how to account for the 'bonus' net revenue that a by-product earns.

Accounting for joint and by-products The point at which joint and by-products become separately identifiable is known as the split-off point or separation point. Costs incurred up to this point are called common costs or joint costs. Common or joint costs need to be allocated (apportioned) in some manner to each of the joint products. In the example below there are two different split-off points.

210

Management Accounting

7.5

Apportioning common costs Reasons for apportioning common costs to individual joint products are as follows: (a)

To put a value to closing inventories of each joint product.

(b)

To record the costs and therefore the profit from each joint product. This is of limited value however, because the costs and therefore profit from one joint product are influenced by the share of costs assigned to the other joint products. Management decisions should not be based on the apparent relative profitability of the products which has arisen due to the arbitrary apportionment of the joint costs.

(c)

Perhaps to assist in pricing decisions.

Here are some examples of common costing problems.

7.5.1

(a)

How to spread the common costs of oil refining between the joint products made – petrol, naphtha, kerosene and so on.

(b)

How to spread the common costs of running the telephone network between telephone calls in peak rate times and cheap rate times, or between local calls and long-distance calls.

Methods of apportioning common costs The main methods that might be used to establish a basis for apportioning or allocating common costs to each product are as follows:

7.6



Physical measurement, e.g. weight of output.



Relative sales value apportionment method 1; sales value at split-off point.



Relative sales value apportionment method 2; sales value of end product less further processing costs after split-off point, i.e. the net realisable value of each product at the split-off point.

Accounting for by-products Despite the fact that the by-product has a small value relative to that of the main product, it does have some commercial value and its accounting treatment usually consists of one of the following: (a)

Income (minus any post-separation further processing or selling costs) from the sale of the byproduct may be added to sales of the main product, thereby increasing sales revenue for the period.

(b)

The sales of the by-product may be treated as a separate, incidental source of income against which are offset only post-separation costs (if any) of the by-product. The revenue would be recorded in the statement of comprehensive income as ‘other income’.

(c)

The sales income of the by-product may be deducted from the cost of production or cost of sales of the main product.

(d)

The net realisable value of the by-product may be deducted from the cost of production of the main product. The net realisable value is the final saleable value of the by-product minus any post-separation costs.

The choice of method will be influenced by the circumstances of production and ease of calculation, as much as by conceptual correctness. The most common method is method (d). Notice that this method is the same as the accounting treatment of a normal loss which is sold for scrap.

Question 6: Split off point Butter Milk

Cream Yoghurt

Mark the split-off point on the diagram above. (The answer is at the end of the chapter)

7: Process and job costing

211

8 Job costing Section overview

LOs 7.1 7.2



Job costing is the costing method used where work is undertaken to customers' special requirements and each order is of comparatively short duration.



The usual method of fixing prices within a company involved in contracting is cost plus pricing.

The work relating to a job is usually carried out within a factory or workshop and moves through processes and operations as a continuously identifiable unit.

Definitions A job is a customer order or task of relatively short duration. Job costing is a form of specific order costing where costs are attributed to individual jobs.

8.1

Procedure for the performance of jobs The normal procedure which is adopted in companies involved in contract work involves the following:

8.2

(a)

The prospective customer approaches the supplier and indicates the requirements of the job.

(b)

A responsible official sees the prospective customer and agrees with him the precise details of the items to be supplied, for example, the quantity, quality, size and colour of the goods, the date of delivery and any special requirements.

(c)

The estimating department of the organisation then prepares an estimate for the job. This will include the cost of the materials to be used, the wages expected to be paid, the appropriate amount for factory, administration, selling and distribution overhead, the cost where appropriate of additional equipment needed specially for the job, and finally the supplier's profit margin. The total of these items will represent the quoted selling price.

(d)

At the appropriate time, the job will be 'loaded' on to the factory floor. This means that as soon as all materials, labour and equipment are available and subject to the scheduling of other orders, the job will be started. In an efficient organisation, the start of the job will be timed to ensure that while it will be ready for the customer by the promised date of delivery it will not be loaded too early, otherwise storage space will have to be found for the product until the date it is required by, and was promised to, the customer.

Recording job costs A separate record must be maintained to show the details of individual jobs. In manual systems, these are known as job cost cards or job cost sheets. In computerised systems, job costs will be collected in job accounts.

8.2.1

Job accounts Job accounts are very much like the process accounts we encountered in Section 1. Inputs to a job are recorded on the left-hand side of the account, outputs on the right-hand side.

8.2.2

Collecting job costs Key points on the process of collecting job costs are as follows: (a)

212

Some labour costs, such as an overtime premium, might be charged either directly to a job or else as an overhead cost, depending on the circumstances in which the costs have arisen.

Management Accounting

(b)

The relevant costs of materials issued, direct labour performed and direct expenses incurred are charged to a job account in the work in process ledger, the work in process ledger recording the cost of all WIP.

(c)

The job account is allocated with the job's share of the factory overhead, based on the absorption rate(s) in operation. If the job is incomplete at the end of an accounting period, it is valued at factory cost in the closing statement of financial position, where a system of absorption costing is in operation.

(d)

On completion of the job, the job account is charged with the appropriate administration, selling and distribution overhead, after which the total cost of the job can be ascertained. The job is then transferred to finished goods.

(e)

The difference between the agreed selling price and the total actual cost will be the supplier's profit (or loss).

(f)

When delivery is made to the customer, the costs become a cost of sale.

Question 7: Job costing Twist and Tern Co is a company that carries out contracting work. One of the jobs carried out in February was job 1357, to which the following information relates: Direct material Y:

400 kilos were issued from stores at a cost of $5 per kilo.

Direct material Z:

800 kilos were issued from stores at a cost of $6 per kilo. 60 kilos were returned.

Department P:

320 labour hours were worked, of which 100 hours were done as overtime.

Department Q:

200 labour hours were worked, of which 100 hours were done as overtime.

Overtime work is not normal in department P, where basic pay is $8 per hour plus an overtime premium of $2 per hour. Overtime work was done in department Q in February because of a request by the customer of another job to complete his job quickly. Basic pay in department Q is $10 per hour and the overtime premium is $3 per hour. Overhead is absorbed at the rate of $3 per direct labour hour in both departments. (a)

The direct materials cost of job 1357 is $

(b)

The direct labour cost of job 1357 is $

(c)

The full production cost of job 1357 is $

. . . (The answer is at the end of the chapter)

8.3

Cost plus pricing The usual method of setting prices within a company involved in contract work is cost plus pricing. Cost plus pricing is where a desired profit margin is added to total costs to arrive at the selling price. The disadvantages of cost plus pricing are as follows: (a)

There are no incentives to control costs as a profit is guaranteed.

(b)

There is no motive to tackle inefficiencies or waste.

(c)

It does not take into account any significant differences in actual and estimated volumes of activity. Since the overhead absorption rate is based upon estimated volumes, there may be under-/overabsorbed overheads not taken into account.

(d)

Because overheads are apportioned in an arbitrary way, this may lead to under and over pricing.

The cost plus system is often adopted where one-off jobs are carried out to customers' specifications.

7: Process and job costing

213

Question 8: Selling prices The total cost of job 259 is $4 200. (a)

When profit is calculated as 25 per cent of sales, the correct selling price for the job is $

(b)

When profit is calculated as 25 per cent of cost, the correct selling price for the job is $ (The answer is at the end of the chapter)

Worked Example: Job costing example An example may help to illustrate the principles of job costing. FM Co is a contract company. On 1 June 20X2, there was one uncompleted job in the factory. The job card for this work is summarised as follows: Job card, job no 6832 Costs to date Direct materials Direct labour (120 hours) Factory overhead ($2 per direct labour hour) Factory cost to date

$ 630 840 240 1 710

During June, three new jobs were started in the factory, and costs of production were as follows: Direct materials Issued to: Job 6832 Job 6833 Job 6834 Job 6835

$ 2 390 1 680 3 950 4 420

Material transfers Job 6832 to Job 6834 Job 6834 to Job 6833

$ 620 250

Materials returned to store From Job 6832 From Job 6835

$ 870 170

Direct labour hours recorded Job 6832 Job 6833 Job 6834 Job 6835

Hours 430 650 280 410

The cost of labour hours during June 20X2 was $8 per hour, and production overhead is absorbed at the rate of $2 per direct labour hour. Completed jobs were delivered to customers as soon as they were completed, and the invoiced amounts were as follows: Job 6832 Job 6834 Job 6835

$8 500 $9 000 $9 500

Administration and marketing overheads are added to the cost of sales at the rate of 20% of factory cost. Required

214

(a)

Prepare the job accounts for each individual job during June 20X2. (Remember inputs to the job go on the left-hand side of the account, outputs on the right-hand side.)

(b)

Prepare the summarised job cost cards for each job, and calculate the profit on each completed job.

Management Accounting

Solution (a)

Job accounts

JOB 6832 Balance b/f Materials (stores a/c) Labour (wages a/c) Production overhead (o'hd a/c)

$ 1 710 2 390 3 440 860 8 400

Job 6834 a/c (materials transfer) To stores (materials returned) Cost of sales (balance)

$ 620 870 6 910 8 400

JOB 6833 Materials (stores a/c) Labour (wages a/c) Production overhead (o'hd a/c) Job 6834 a/c (materials transfer)

$ 1 680 5 200 1 300 250 8 430

$ 8 430

Balance c/f

8 430 JOB 6834

Materials (stores a/c) Labour (wages a/c) Production overhead (o'hd a/c) Job 6832 a/c (materials transfer)

$ 3 950 2 240 560 620 7 370

Job 6833 a/c (materials transfer) Cost of sales (balance)

$ 250 7 120 7 370

JOB 6835 Materials (stores a/c) Labour (wages a/c) Production overhead (o'hd a/c)

$ 4 420 3 280 820 8 520

$ 170

To stores (materials returned) Cost of sales (balance)

8 350 8 520

Note that the accounts to which the double entry is made are shown in brackets. (b)

Job cards, summarised

Materials Labour Production overhead Factory cost Admin & marketing o'hd (20%) Cost of sale Invoice value Profit/(loss) on job * $(630 + 2 390 – 620 – 870)

Job 6832 $ 1 530* 4 280 1 100 6 910 1 382 8 292 8 500 208

Job 6833 $ 1 930 5 200 1 300 (c/f) 8 430

Job 6834 $ 4 320** 2 240 560 7 120 1 424 8 544 9 000 456

Job 6835 $ 4 250 3 280 820 8 350 1 670 10 020 9 500 (520)

** $(3 950 + 620 – 250)

7: Process and job costing

215

Key chapter points •

Process costing is a 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 processes involved.



Costs incurred in processes are recorded in what are known as process accounts.



A process account has two sides, and on each side there are two columns – one for quantities (of raw materials, work in process and finished goods) and one for costs.



A suggested four-step approach when dealing with process costing questions. Step 1 Determine output and losses. Step 2 Calculate cost per unit of output, losses and WIP. Step 3 Calculate total cost of output, losses and WIP. Step 4 Complete accounts.

216



Losses may occur in a process. If a certain level of loss is expected, this is known as normal loss. If losses are greater than expected, the extra loss is abnormal loss. If losses are less than expected, the difference is known as abnormal gain.



The valuation of normal loss is either at scrap value or nil. It is conventional for the scrap value of normal loss to be deducted from the cost of materials before a cost per equivalent unit is calculated.



Abnormal losses and gains never affect the cost of good units of production. The scrap value of abnormal losses is not credited to the process account, and the abnormal loss and gain units carry the same full cost as a good unit of production.



When units are partly completed at the end of a period, i.e. when there is closing work in process, it is necessary to calculate the equivalent units of production in order to determine the cost of a completed unit.



The weighted average cost method of valuing opening WIP makes no distinction between units of opening WIP and new units introduced to the process during the current period.



Joint products are two or more products separated in a process, each of which has a significant value.



A by-product is an incidental product from a process which has an insignificant value compared to the main products(s).



Job costing is the costing method used where work is undertaken to customers' special requirements and each order is of comparatively short duration.



The usual method of fixing prices within a company involved in contract work is cost plus pricing.

Management Accounting

Quick revision questions

The following information relates to questions 1 and 2 A company manufactures chemical X in a single process. At the start of the month there was no work-inprocess. During the month 300 litres of raw material were input into the process at a total cost of $6,000. Conversion costs during the month amounted to $4,500. At the end of the month 250 litres of chemical X were transferred to finished goods inventory. The remaining work-in-process was 100% complete with respect to materials and 50% complete with respect to conversion costs. There were no losses in the process. 1

The equivalent units for closing work-in-process at the end of the month would have been: A B C D

2

nil $450 $600 $1,050

In a process account, abnormal losses are valued: A B C D

4

Conversion costs 25 litres 50 litres 25 litres 50 litres

If there had been a normal process loss of 10% of input during the month the value of this loss would have been: A B C D

3

Material 25 litres 25 litres 50 litres 50 litres

at their scrap value. the same as good production. at the cost of raw materials. at zero.

A company needs to produce 340 litres of chemical Y. There is a normal loss of 10% of the material input into the process. During a given month the company did produce 340 litres of good production, although there was an abnormal loss of 5% of the material input into the process. How many litres of material were input into the process during the month? A B C D

357 litres 374 litres 391 litres 400 litres

7: Process and job costing

217

The following information relates to questions 5 and 6 A company produces a certain food item in a manufacturing process. On 1 November, there was no opening inventory of work in process. During November, 500 units of material were input to the process, with a cost of $9,000. Direct labour costs in November were $3 840. Production overhead is absorbed at the rate of 200% of direct labour costs. Closing inventory on 30 November consisted of 100 units which were 100% complete as to materials and 80% complete as to labour and overhead. There was no loss in process. 5

The full production cost of completed units during November was: A B C D

6

$10,400 $16,416 $16,800 $20,520

The value of the closing work in process on 30 November is: A B C D

$2,440 $3,720 $4,104 $20,520

The following information relates to questions 7 and 8 A company makes a product in two processes. The following data is available for the latest period, for process 1. Opening work in process of 200 units was valued as follows: Material Labour Overhead No losses occur in the process.

$2 400 $1 200 $400

Units added and costs incurred during the period: Material Labour Overhead

$6 000 (500 units) $3 350 $1 490

Closing work in process of 100 units had reached the following degrees of completion: Material Labour Overhead

100% 50% 30%

The company uses the weighted average method of inventory valuation. 7

How many equivalent units are used when calculating the cost per unit in relation to overhead? A B C D

8

The value of the units transferred to process 2 was: A B C D

218

500 600 630 700 $7,200 $13,200 $14,840 $15,400

Management Accounting

9

A company manufactures two joint products, P and R, in a common process. Data for June are as follows: $ Opening inventory 1 000 Direct materials added 10 000 Conversion costs 12 000 Closing inventory 3 000 Production Units 4 000 6 000

P R

Sales Units 5 000 5 000

Sales price $ per unit 5 10

If costs are apportioned between joint products on a sales value basis, what was the cost per unit of product R in June? A B C D 10

$1.25 $2.22 $2.50 $2.75

How is revenue from scrap treated? A B C D

as an addition to sales revenue as a reduction in costs of processing as a bonus to all employees as a bonus to production employees

7: Process and job costing

219

Answers to quick revision questions 1

C

Work in progress

= 300 litres input – 250 litres to finished goods = 50 litres

Equivalent litres for each cost element are as follows: Material Equiv. litres 100 50

Conversion costs % Equiv. litres 50 25

%

50 litres in progress

Option A is incorrect because it assumes that the units in progress are only 50 per cent complete with respect to materials. Option B has transposed the information concerning the two cost elements.

If you selected option D you calculated the correct number of litres in progress but you did not take account of their degree of completion. 2

A

There is no mention of a scrap value available for any losses therefore the normal loss would have a zero value. The normal loss does not carry any of the process costs therefore options B, C and D are all incorrect.

3

B

Abnormal losses are valued at the same unit rate as good production, so that their occurrence does not affect the cost of good production. They are not valued at zero, so option D is incorrect. The scrap value of the abnormal loss (option A) is credited to a separate abnormal loss account; it does not appear in the process account. Option C is incorrect because abnormal losses also absorb some conversion costs.

4

D

The total loss was 15% of the material input. The 340 litres of good output therefore represents 85% of the total material input. Therefore, material input =

340 = 400 litres 0.85

Options A and B are incorrect because they represent a further five per cent and ten per cent respectively, added to the units of good production.

If you selected option C you simply added 15 per cent to the 340 litres of good production. However, the losses are stated as a percentage of input, not as a percentage of output. 5

C

Step 1 Input Units

500 500

Step 2

Determine output and losses. Output

Finished units (balance) Closing inventory

Materials Labour and overhead

Management Accounting

Equivalent units Materials Labour and overhead Units % Units % 400 100 400 100 100 100 80 80 500 480

Calculate the cost per equivalent unit.

Input

220

Total Units 400 100 500

Cost $ 9 000 11 520

Equivalent production in units

500 480

Cost per unit $ 18 24 42

Step 3

Calculate total cost of output.

Cost of completed units = $42 × 400 units = $16 800 If you selected option A you omitted the absorption of overhead at the rate of 200 per cent of direct labour. If you selected option B you did not allow for the fact that the work in progress was incomplete. Option D is the total process cost for the period, some of which must be allocated to the work in progress.

6

B

Using the data from answer 5 above, extend step 3 to calculate the value of the work in progress. Cost element

Number of equivalent units

Work in progress: Materials Labour & overhead

Cost per equivalent unit $ 18 24

100 80

Total $ 1 800 1 920 3 720

If you selected option A you omitted the absorption of overhead into the process costs. If you selected option C you did not allow for the fact that the work in progress was incomplete. Option D is the total process cost for the period, some of which must be allocated to the completed output.

7

C

STATEMENT OF EQUIVALENT UNITS

Output to process 2* Closing WIP

Total Units 600 100 700

Materials

(100%)

600 100 700

Equivalent units Labour

600 50 650

(50%)

Overheads

600 30 630

(30%)

*500 units input + opening WIP 200 units – closing WIP 100 units. Option A is incorrect because it is the number of units input to the process, taking no account of opening and closing work in progress. Option B is the completed output, taking no account of the work done on the closing inventory. Option D is the total number of units worked on during the period, but they are not all complete in respect of overhead cost.

8

B

STATEMENT OF COSTS PER EQUIVALENT UNIT

Opening stock Added during period Total cost Equivalent units Cost per equivalent unit

Materials $ 2 400 6 000 8 400 700 $12

Labour $ 1 200 3 350 4 550 650 $7

Overheads $ 400 1 490 1 890 630 $3

Total

$22

Value of units transferred to process 2 = 600 units ¯ $22 = $13 200 Option A is incorrect because it represents only the material cost of the units transferred. Option C is all of the costs incurred in the process during the period, but some of these costs must be allocated to the closing work in progress. Option D is the value of 700 completed units: but only 600 units were transferred to the next process.

7: Process and job costing

221

9

C

Total production inventory

$ 1 000 10 000 12 000 23 000 3 000 20 000

Opening inventory Direct materials added Conversion costs Less closing inventory Total production cost

P R

Production Units 4 000 6 000

(× $5) (× $10)

Sales value $ 20 000 60 000 80 000

($20 000 × 20/80) ($20 000 × 60/80)

Apportioned cost $ 5 000 15 000 20 000

Product R cost per unit = $15 000/6 000 = $2.50 per unit. Option A is the cost per unit for product P, and if you selected option B you apportioned the production costs on the basis of units sold. If you selected option D you made no adjustment for inventories when calculating the total costs.

10

222

B

Revenue from scrap is treated as a reduction in costs of processing.

Management Accounting

Answers to chapter questions 1

C

Step 1

Determine output and losses.

Units 2 750 330 220 3 300

Actual output Normal loss (10% × 3 300) Abnormal loss

Step 2

Calculate cost per unit of output and losses.

= Cost per expected unit of output Cost of input $89 100 = = $30 per unit 3 300 − 330 Expected units of output

Step 3

Calculate total cost of output and losses.

$ 82 500 0 6 600 89 100

Cost of output (2 750 × $30) Normal loss Abnormal loss (220 × $30) Hence cost of 2 750 finished units output is $82 500

Option A is incorrect because it results from allocating a full unit cost to the normal loss: remember that normal loss does not carry any of the process cost. Option B is incorrect because it results from calculating a 10% normal loss based on output of 2 750 units (275 units normal loss), rather than on input of 3 300 units. Option D is simply the total input cost, with no attempt to apportion some of the cost to the abnormal loss.

2

B DR Opening WIP Input Abnormal gain

PROCESS ACCOUNT CR 5 200 Output 58 300 Normal loss Closing WIP

59 900 400 3 500

63 800

63 800

The abnormal gain is the balancing figure: 63 800 – 5 200 – 58 300 = 300 3

Step 1

Determine output and losses.

Output Normal loss (20% of 3 000 kgs) Abnormal loss Abnormal gain

Process 1 kgs 2 300 600 100 – 3 000

(10% of 4 300)

Process 2 kgs 4 000 430 – (130) 4 300*

* From process 1 (2 300 kgs) + 2 000 kgs added

7: Process and job costing

223

Step 2

Calculate cost per unit of output and losses. Process 1 $ 750 × 120 450

Material (3 000 × $0.25) From process 1 Labour Overhead (375% × $120) Less: scrap value of normal loss (600 × $0.20) Expected output 3 000 × 80%

Cost per unit $ ⎛⎜ $1 320 − $120 ⎞⎟ ⎝ 3 000 − 600 ⎠

Step 3

(2 000 × $0.40) (2 300 × $0.50) (496% × $84)

(120) 1 200

(430 × $0.3)

(129) 2 322

2 400 $0.50

4 300 × 90%

3 870 $0.60

⎛ $2 451 − $129 ⎞ ⎜ ⎟ ⎝ 4 300 − 430 ⎠

Calculate total cost of output and losses. Process 1 $ 1 150

Output (2 300 × $0.50) Normal loss (scrap) (600 × $0.20) Abnormal loss (100 × $0.50)

120 50 1 320 – 1 320

Abnormal gain

Step 4

Process 2 $ 800 1 150 84 417

Process 2 $ 2 400

(4 000 × $0.60) (430 × $0.30)

129 – 2 529 (78) 2 451

(130 × $0.60)

Complete accounts.

PROCESS 1 ACCOUNT Material Labour General overhead

kg 3 000

3 000

$ 750 120 450

Normal loss to scrap a/c (20%) Production transferred to process 2 Abnormal loss a/c

1 320

kg

$

600

120

2 300 100 3 000

1 150 50 1 320

kg

$

PROCESS 2 ACCOUNT Transferred from process 1 Material added Labour General overhead Abnormal gain

kg

$

2 300 2 000

1 150 800 84 417 2 451 78 2 529

4 300 130 4 430

Normal loss to scrap a/c (10%) Production transferred to finished inventory

430

129

4 000

2 400

4 430

2 529

kg 130 1 000

$ 39 230

1 130

269

SCRAP ACCOUNT Normal loss (process 1) Normal loss (process 2) Abnormal loss (process 1)

224

Management Accounting

kg 600 430

$ 120 129

100 1 130

20 269

Abnormal gain (process 2) Cash/Debtors

ABNORMAL LOSS AND GAIN ACCOUNT Process 1 (loss) Scrap value of abnormal Gain Statement of comprehensive income

kg 100

$ 50

130

39 9

230

98

kg Scrap value of abnormal loss Process 2 (gain)

$

100 130

20 78

230

98

(Note. In this answer, a single account has been prepared for abnormal loss/gain. It is also possible to separate this single account into two separate accounts, one for abnormal gain and one for abnormal loss.) 4

Step 1

Determine output and losses.

STATEMENT OF EQUIVALENT UNITS

Completed production Closing inventory Normal loss Abnormal loss

Step 2

Equivalent units Material Labour % Units % Units 100 8 000 100 8 000 80 800 50 500

Total Units 8 000 1 000 500 500 10 000

100

500 9 300

100

500 9 000

Calculate cost per unit of output, losses and WIP.

STATEMENT OF COST PER EQUIVALENT UNIT Cost $ 4 650 2 700 7 350

Material ($(5 150 – 500))* Labour

Cost per equivalent unit $ 0.50 0.30 0.80

Equivalent units

9 300 9 000

* The scrap value of the normal loss is used to reduce the material costs of the process. Step 3

Calculate total cost of output, losses and WIP.

STATEMENT OF EVALUATION Equivalent units

Completed production Closing inventory: material Labour

8 000 800 500

Abnormal loss

Step 4

Cost per equivalent unit $ 0.80 0.50 0.30

500

Total

$ 400 150

0.80

$ 6 400 550 400 7 350

Complete accounts.

PROCESS ACCOUNT Material Labour

Units 10 000

$ 5 150 2 700

10 000

7 850

Completed production Closing inventory Normal loss Abnormal loss

Units 8 000 1 000 500 500 10 000

$ 6 400 550 500 400 7 850

7: Process and job costing

225

5

(a)

Process 1

STATEMENT OF EQUIVALENT UNITS

Equivalent units Conversion Material costs costs 2 400 2 400 (100%) 3 400 (40%) 1 360 0 0 800 800 6 600 4 560

Total units 2 400 3 400 400 800 7 000

Transfers to process 2 Closing WIP Normal loss (10% × 4 000) Abnormal loss

STATEMENT OF COSTS PER EQUIVALENT UNIT Costs incurred = Cost per equivalent unit Equivalent units Therefore Materials cost per equivalent unit =

$4 000 + $22 000 $26 400 = $4 = 6 600 6 600

therefore Conversion costs per equivalent unit =

$3 744 + $12 000 + $18 000 $33 744 = = 4 560 4 560

$7.40 STATEMENT OF EVALUATION Transfers to process 2 Abnormal loss Closing WIP

WIP materials (opening) WIP conversion costs Materials Labour Overhead

Materials Conversion costs $ $ 9 600 17 760 3 200 5 920 13 600 10 064 26 400 33 744 PROCESS 1 ACCOUNT Kg $ 3 000 4 400 Process 2

– 4 000 – – 7 000

3 744

Normal loss

22 000 12 000 18 000 60 144

Abnormal loss WIP materials (closing) WIP conversion costs

The monetary and quantity values for:

226

(i)

transfer to process 2 are

(ii)

normal loss are

(iii)

abnormal loss are

(iv)

abnormal gain are

(v)

WIP materials are

(vi)

WIP conversion costs are

Management Accounting

400 800 0 3,400

2,400

kgs at $

kgs at $ kgs at $ kgs at $ kgs at $

0

27,360

0 9,120 0 13,600 kgs at $

10,064

Total $ 27 360 9 120 23 664 60 144

Kg 2 400

$ 27 360

400



800 3 400 – 7 000

9 120 13 600 10 064 60 144

(b)

Process 2

STATEMENT OF EQUIVALENT UNITS Total units 2 500 240 * (690) * 2 600* 4 650

Finished goods Normal loss Abnormal gain Closing WIP * Total input units

Process 1 2 500 0 (690) 2 600 4 410

Conversion costs 2 500 0 (690) 1 040** 2 850

= opening WIP + input = 2 250 + 2 400 = 4 650

Normal loss = 2 400 * 10% = 240 Expected transfer to finished goods = total input 4 650 – normal loss 240 – closing WIP 2 600 = 1 810. Actual transfer to finished goods = 2 500, hence abnormal gain = 2 500 – 1 810 = 690 Total output units

= finished goods + closing WIP + normal loss – abnormal gain = 2 500 + 2 600 + 240 – 690 = 4 650

** 2 600 × 40% = 1 040 STATEMENT OF COSTS PER EQUIVALENT UNIT Process 1 =

$4 431 + 27 360 - 480 = $7.10 4 410

Conversion costs =

$5 250 + $15 000 + $22 500 = $15.00 2 850

STATEMENT OF EVALUATION Process 1 $ 17 750 4 899 18 460 41 109

Finished goods Abnormal gain Closing WIP

Conversion costs $ 37 500 10 350 15 600 63 450

Total $ 55 250 15 249 34 060 104 559

PROCESS 2 ACCOUNT WIP Process 1 WIP conversion costs Process 1 Labour Overhead Abnormal gain

Kg 2 250 – 2 400 – – 690 5 340

$ 4 431 5 250 27 360 15 000 22 500 15 249 89 790

Finished goods Normal loss WIP process 1 WIP conversion costs

Kg 2 500 240 2 600 –

$ 55 250 480 18 460 15 600

5 340

89 790

The monetary and quantity values for:

2,500

(i)

finished goods are

(ii)

normal loss are

(iii)

WIP from process 1 are

(iv)

WIP from process 2 are

240

kgs at $ kgs at $

2,600 0

55,250 480

kgs at $ kgs at $

18,460 15,600

7: Process and job costing

227

6 Butter Milk

Cream Yoghurt Split off point

7

(a)

The direct materials cost is $

6,440

Workings

Direct material Y (400 kilos × $5) Direct material Z (800 – 60 kilos × $6) Total direct material cost (b)

The direct labour cost is $

$ 2 000 4 440 6 440

4,560

Workings

Department P (320 hours × $8) Department Q (200 hours × $10) Total direct labour cost

$ 2 560 2 000 4 560

In department P, overtime premium will be charged to overhead. In department Q, overtime premium will be charged to the job of the customer who asked for overtime to be worked. (c)

The full production cost is $ 12,560 Workings

Direct material cost Direct labour cost Production overhead (520 hours × $3) 8

$ 6 440 4 560 1 560

12 560 If you have difficulty working out the correct amount, simply jot down the cost and selling price structures as percentages in each case. (a)

The correct selling price is $

5,600 .

Workings

Profit is calculated as a percentage of sales, so selling price must be written as 100%. % 75 25 100

Cost Profit Selling price Selling price = $4 200 × 100/75 = $5 600 (b)

The correct selling price is $

5,250 .

Workings

Profit is calculated as a percentage of cost, so cost must be written as 100%. Cost Profit Selling price Selling price = $4 200 × 125/100 = $5 250

228

Management Accounting

% 100 25 125

Chapter 8

Standard costing Learning objectives

Reference

Standard costing

LO8

Explain how standard costing can be used to assist in cost control and efficient resource allocation

LO8.1

Topic list

1 What is standard costing? 2 Setting standards

229

Introduction Just as there are standards for most things in our daily lives (cleanliness in restaurants, educational achievement of students, number of trains running on time), there are standards for the costs of products and services. Moreover, just as the standards in our daily lives are not always met, the standards for the costs of products and services are not always met. We will be looking at standards for costs, what they are used for and how they are set. In the next chapter we will see how standard costing forms the basis of a process called variance analysis, a vital management control tool.

230

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is a standard cost?

(Section 1)

2

State two principal uses of standard costing.

(Section 1.2)

3

What is the difference between actual and standard costs called?

(Section 1.3)

4

What are the four types of performance standards?

(Section 2.1)

5

Direct material standards will be estimated by the purchasing department from their knowledge of what?

(Section 2.2)

8: Standard costing

231

1 What is standard costing? Section overview

1.1 LO 8.1



A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.



The standard cost of a product is a detailed list of the expected costs required to produce a completed unit of that product. Differences between actual and standard costs are called variances.

Standard cost The standard cost of a product provides a detailed breakdown of all the expected costs required to produce a completed unit of that product. The standard cost of product 1234 is set out below: STANDARD COST – PRODUCT 1234

Direct materials Material X – 3 kg at $4 per kg Material Y – 9 litres at $2 per litre

$

$

12 18 30

Direct labour Grade A – 6 hours at $1.50 per hour Grade B – 8 hours at $2 per hour

9 16

Standard direct cost Variable production overhead – 14 hours at $0.50 per hour Standard variable cost of production Fixed production overhead – 14 hours at $4.50 per hour Standard full production cost Administration and marketing overhead Standard cost of sale Standard profit Standard sales price

25 55 7 62 63 125 15 140 20 160

Notice how the total standard cost is built up from standards for each cost element: standard quantities of materials at standard prices, standard quantities of labour time at standard rates and so on. It is therefore determined by management's estimates of the following: • • •

The expected prices of materials, labour and expenses. Efficiency levels in the use of materials and labour. Budgeted overhead costs and budgeted volumes of activity.

We will see how management arrives at these estimates below. But why should management want to prepare standard costs? Obviously to assist with standard costing, but what is the point of standard costing?

1.2

The uses of standard costing Standard costing has a variety of uses but its two principal ones are as follows:

232



To value inventories and cost production for cost accounting purposes.



To act as a control device by establishing standards (planned costs), highlighting (via variance analysis which we will cover in the next chapter) activities that are not conforming to plan and therefore alerting management to areas which may be out of control and in need of corrective action.

Management Accounting

Worked Example: Standard cost Bloggs makes one product, the joe. Two types of labour are involved in the preparation of a joe, skilled and semi-skilled. Skilled labour is paid $10 per hour and semi-skilled $5 per hour. Twice as many skilled labour hours as semi-skilled labour hours are needed to produce a joe, four semi-skilled labour hours being needed. A joe is made up of three different direct materials. Seven kilograms of direct material A, four litres of direct material B and three metres of direct material C are needed. Direct material A costs $1 per kilogram, direct material B $2 per litre and direct material C $3 per metre. Variable production overheads are incurred at Bloggs Co at the rate of $2.50 per direct labour (skilled) hour. A system of absorption costing is in operation at Bloggs Co. The basis of absorption is direct labour (skilled) hours. For the forthcoming accounting period, budgeted fixed production overheads are $250 000 and budgeted production of the joe is 5 000 units. Administration, selling and distribution overheads are added to products at the rate of $10 per unit. A mark-up of 25% is made on the joe. Using the above information calculate a standard cost for the joe.

Solution STANDARD COST – PRODUCT JOE Direct materials A – 7 kgs × $1 B – 4 litres × $2 C – 3 m × $3

$ 7 8 9

$

24 Direct labour Skilled – 8 × $10 Semi-skilled – 4 × $5

80 20

Standard direct cost Variable production overhead – 8 × $2.50 Standard variable cost of production Fixed production overhead – 8 × $6.25 (W) Standard full production cost Administration, selling and distribution overhead Standard cost of sale Standard profit (25% × 204) Standard sales price

100 124 20 144 50 194 10 204 51 255

Working Overhead absorption rate =

$250 000 = $6.25 per skilled labour hour 5 000 × 8

8: Standard costing

233

Worked Example: Marginal costing system What would a standard cost for product joe show under a marginal system?

Solution STANDARD COST – PRODUCT JOE Direct materials Direct labour Standard direct cost Variable production overhead Standard variable production cost Standard sales price Standard contribution

$ 24 100 124 20 144 255 111

Although the use of standard costs to simplify the keeping of cost accounting records should not be overlooked, we will be concentrating on the control and variance analysis aspect of standard costing. Standard costing is a control technique which compares standard costs with actual results to obtain variances which are used to improve performance.

Notice that the above definition highlights the control aspects of standard costing.

1.3

Standard costing as a control technique Differences between actual and standard costs are called variances. Standard costing therefore involves:

• • •

The establishment of predetermined estimates of the costs of products or services. The collection of actual costs. The comparison of the actual costs with the predetermined estimates.

The predetermined costs are known as standard costs and the difference between standard and actual cost is known as a variance. The process by which the total difference between standard and actual results is analysed is known as variance analysis. Standard costing can be used in a variety of costing situations: • • • •

Batch and mass production. Process manufacture. Job production – where there is standardisation of parts. Service industries – if a realistic cost unit can be established.

However, the greatest benefit from its use can be gained if there is a degree of repetition in the production process. It is therefore most suited to mass production and repetitive assembly work.

2 Setting standards Section overview

234



The standard cost of a product, or service, is made up of a number of different standards, one for each cost element, each of which has to be set by management.



Performance standards are used to set efficiency targets. There are four types: ideal, attainable, current and basic. We have divided this section into two: the first part looks at setting the monetary part of each standard, whereas the second part looks at setting the resources requirement part of each standard.

Management Accounting

LO 8.1

2.1

Standard costs may be used in both absorption costing and in marginal costing systems. We shall, however, confine our description to standard costs in absorption costing systems.

Types of performance standard Performance standards are used to set efficiency targets. There are four types: ideal, attainable, current and basic.

The setting of standards raises the problem of how demanding the standard should be. Should the standard represent a perfect performance or an easily attainable performance? The type of performance standard used can have behavioural implications. There are four types of standard. Type of standard

Description

Ideal

These are based on perfect operating conditions: no wastage, no spoilage, no inefficiencies, no idle time, no breakdowns. Variances from ideal standards are useful for pinpointing areas where a close examination may result in large savings in order to maximise efficiency and minimise waste. However ideal standards are likely to have an unfavourable motivational impact because reported variances will always be adverse. Employees will often feel that the goals are unattainable and not work so hard.

Attainable

These are based on the hope that a standard amount of work will be carried out efficiently, machines properly operated or materials properly used. Some allowance is made for wastage and inefficiencies. If well-set they provide a useful psychological incentive by giving employees a realistic, but challenging target of efficiency. The consent and co-operation of employees involved in improving the standard are required. Also sometimes called ‘practical standards’ or ‘target standards’.

Current

These are based on current working conditions (current wastage, current inefficiencies). The disadvantage of current standards is that they do not attempt to improve on current levels of efficiency.

Basic

These are kept unaltered over a long period of time, and may be out of date. They are used as a “benchmark standard” against which to measure changes in efficiency or performance over a long period of time. Basic standards are perhaps the least useful and least common type of standard in use.

Ideal standards, attainable standards and current standards each have their supporters and it is by no means clear which of them is preferable.

Question 1: Performance standards Which of the following statements is not correct? A

variances from ideal standards are useful for pinpointing areas where a close examination might result in large cost savings

B

basic standards may provide an incentive to greater efficiency even though the standard cannot be achieved

C

ideal standards cannot be achieved and so there will always be adverse variances. If the standards are used for budgeting, an allowance will have to be included for these 'inefficiencies'

D

current standards or attainable standards are a better basis for budgeting, because they represent the level of productivity which management will wish to plan for (The answer is at the end of the chapter)

2.2

Methods of standard setting Standards for each resource required to produce the product need to be set in terms of both the physical quantity of that resource (e.g. labour hours) and its cost (e.g. wage rate per hour). The standard can be derived using historic data, although this may result in past inefficiencies being incorporated. Methods of estimating costs from past information were considered in Chapter 3, Section 7.

8: Standard costing

235

If new methods of working are being introduced, standards based on historical data may not be appropriate. In this case, new standards will need to be calculated based on an analysis of working practices, using methods such as engineering studies.

2.3

Direct material standards Direct material standards will be estimated by the purchasing department from their knowledge of the following:

• • • •

Purchase contracts already agreed. Pricing discussions with regular suppliers. The forecast movement of prices in the market. The availability of bulk purchase discounts.

Price inflation can cause difficulties in setting realistic standard prices. Suppose that a material costs $10 per kilogram at the moment and during the course of the next twelve months it is expected to go up in price by 20% to $12 per kilogram. What standard price should be selected? • •

The current price of $10 per kilogram The average expected price for the year, say $11 per kilogram

Either would be possible, but neither would be entirely satisfactory.

2.4

(a)

If the current price were used in the standard, the reported price variance will become adverse as soon as prices go up, which might be very early in the year. If prices go up gradually rather than in one big jump, it would be difficult to select an appropriate time for revising the standard.

(b)

If an estimated mid-year price were used, price variances should be favourable in the first half of the year and adverse in the second half of the year, again assuming that prices go up gradually throughout the year. Management could only really check that in any month, the price variance did not become excessively adverse / favourable and that the price variance switched from being favourable to adverse around month six or seven and not sooner.

Direct labour standards Direct labour rates per hour will be set by discussion with the personnel department and by reference to the payroll and to any agreements on pay rises with trade union representatives of the employees.

(a)

A separate hourly rate or weekly wage will be set for each different labour grade/type of employee.

(b)

An average hourly rate will be applied for each grade, even though individual rates of pay may vary according to age and experience.

Similar problems when dealing with inflation to those described for direct material standards can be encountered when setting labour standards.

2.5

Overhead absorption rates When standard costs are fully absorbed costs, the absorption rate of fixed production overheads will be predetermined, usually each year when the budget is prepared, and based in the usual manner on budgeted fixed production overhead expenditure and budgeted production. For selling and distribution costs, standard costs might be absorbed as a percentage of the standard selling price. Standard costs under marginal costing will, of course, not include any element of absorbed overheads.

2.6

Standard resource requirements To estimate the materials required to make each product (material usage) and also the labour hours required (labour efficiency), technical specifications must be prepared for each product by production experts in the production department (a)

236

The 'standard product specification' for materials must list the quantities required per unit of each material in the product. These standard input quantities must be made known to the operators in the production department so that control action by management to deal with excess material wastage will be understood by them.

Management Accounting

(b)

The 'standard operation sheet' for labour will specify the expected hours required by each grade of labour in each department to make one unit of product. These standard times must be carefully set and must be understood by the labour force. Where necessary, standard procedures or operating methods should be stated.

8: Standard costing

237

Key chapter points

238



A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.



The standard cost of a product shows full details of the expected costs required to produce a completed unit of that product.



Differences between actual and standard cost are called variances.



Performance standards are used to set efficiency targets. There are four types: ideal, attainable, current and basic.

Management Accounting

Quick revision questions 1

Which of the following would not be directly relevant to the determination of direct labour standards per unit of output? A B C D

2

3

What is an attainable standard? A

A standard which includes no allowance for losses, waste and inefficiencies. It represents the level of performance which is attainable under perfect operating conditions.

B

A standard which includes some allowance for losses, waste and inefficiencies. It represents the level of performance which is attainable under efficient operating conditions.

C

A standard which is based on currently attainable operating conditions.

D

A standard which is kept unchanged, to show the trend in costs.

A control technique which compares standard costs and revenues with actual results to obtain variances, which are used to stimulate improved performance, is known as: A B C D

4

the type of performance standard to be used the volume of output from the production budget technical specifications of the proposed production methods Skills of the work force

standard costing variance analysis budgetary control budgeting

For which one of the following is standard costing most likely to be appropriate? A B C D

Postal services Mobile phone manufacture Fashion design Printing

8: Standard costing

239

Answers to quick revision questions 1

B

The volume of output would influence the total number of labour hours required, but it would not be directly relevant to the standard labour time per unit. The type of performance standard (option A) would be relevant. For example, if an ideal standard is used there would be no extra time allowed for inefficiencies. Option C would be relevant because it would provide information about the tasks to be performed and the time that those tasks should take.

Similarly Option D would be relevant because the skills of the workforce will affect the way the task is performed and the time that the task should take. 2

B

An attainable standard assumes efficient levels of operation, but includes allowances for normal loss, waste and machine downtime. Option A describes an ideal standard. Option C describes a current standard. Option D describes a basic standard.

240

3

A

Standard costing is a control technique comparing standard costs with actual costs. When the differences between standard costs and actual costs are analysed, this is known as variance analysis.

4

B

Standard costing may be suitable when an organisation produces a large quantity of standard products, or provides standard services. This applies to mobile phone manufacture. It does not apply to postal services, since delivery costs vary with size and distance. It does not apply to fashion design, which by its nature is non-standard work. It does not apply to printing, which is a type of jobbing industry where each printing ‘job’ may be different.

Management Accounting

Answer to chapter question 1

B

Statement B is describing ideal standards, not basic standards.

8: Standard costing

241

242

Management Accounting

Chapter 9

Variance analysis Learning objectives

Reference

Variance analysis

LO9

Calculate and explain the causes of variances and associated corrective actions

LO9.1

Topic list

1 2 3 4 5 6 7 8 9

Variances Direct material cost variances Direct labour cost variances Variable production overhead variances Fixed production overhead variances The reasons for cost variances The significance of cost variances Sales variances Operating statements 243

Introduction The actual results achieved by an organisation during a reporting period (week, month, quarter, year) will, more than likely, be different from the expected results, the expected results being the standard costs and revenues which we looked at in the previous chapter. Such differences may occur between individual items, such as the cost of labour and the volume of sales, and between the total expected profit and the total actual profit. Management will have spent considerable time and trouble setting standards. Actual results have differed from the standards. The wise manager will consider the differences that have occurred and use the results of these considerations to assist in attempts to attain the standards. The wise manager will use variance analysis as a method of control. This chapter examines variance analysis and sets out the method of calculating the variances. We will then go on to look at the reasons for, and significance of, cost variances. The chapter concludes by building on the basics set down in this chapter by introducing sales variances and operating statements.

244

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is a variance?

(Section 1)

2

What is a direct material total variance?

(Section 2)

3

What effect do opening and closing inventories have on material variances?

4

The direct labour total variance can be subdivided into which two variances?

5

The variable production overhead total variance can be subdivided into which two variances? (Section 4)

6

The fixed production overhead total variance can be subdivided into which two variances? (Section 5)

7

State reasons for cost variances arising.

8

Explain the relevance of materiality and controllability when deciding whether or not a variance should be investigated. (Section 7)

9

How is selling price variance calculated?

(Section 8.1)

10

How is sales volume profit variance calculated?

(Section 8.2)

11

Draw a proforma operating statement reconciling budgeted profit and actual profit.

(Section 2.2) (Section 3)

(Section 6)

(Section 9)

9: Variance analysis

245

1 Variances Section overview •

A variance is the difference between a planned, budgeted, or standard cost and the actual cost incurred. The same comparisons may be made for revenues. The process by which the total difference between standard and actual results is analysed is known as variance analysis.

When actual results are better than expected results, we have a favourable variance (F). If, on the other hand, actual results are worse than expected results, we have an unfavourable variance (U).

LO 9.1

Variances can be divided into three main groups:

• • •

Variable cost variances. Sales variances. Fixed production overhead variances.

2 Direct material cost variances 2.1

Introduction Section overview •

The direct material total variance can be subdivided into the direct material price variance and the direct material usage variance.



Direct material price variances are usually extracted at the time of the receipt of the materials, rather than at the time of usage.

The direct material total variance is the difference between what the output actually cost and what it should have cost, in terms of material.

2.1.1

The direct material price variance This is the difference between the standard cost and the actual cost for the actual quantity of material used or purchased. In other words, it is the difference between what the material did cost and what it should have cost.

2.1.2

The direct material usage variance This is the difference between the standard quantity of materials that should have been used for the number of units actually produced, and the actual quantity of materials used, valued at the standard cost per unit of material. In other words, it is the difference between how much material should have been used and how much material was used, valued at standard cost.

Worked Example: Direct material variances Product X has a standard direct material cost as follows: 10 kilograms of material Y at $10 per kilogram = $100 per unit of X. During period 4, 1,000 units of X were manufactured, using 11 700 kilograms of material Y which cost $98 600. Calculate the following variances: (a) (b) (c)

246

The direct material total variance. The direct material price variance. The direct material usage variance.

Management Accounting

Solution (a)

The direct material total variance This is the difference between what 1 000 units should have cost and what they did cost. $ 100 000 98 600 1 400 (F)

1 000 units should have cost (× $100) but did cost Direct material total variance

The variance is favourable because the units cost less than they should have cost. Now we can break down the direct material total variance into its two constituent parts: the direct material price variance and the direct material usage variance. (b)

The direct material price variance This is the difference between what 11 700 kgs should have cost and what 11 700 kgs did cost. $ 117 000 98 600 18 400 (F)

11 700 kgs of Y should have cost (× $10) but did cost Material Y price variance The variance is favourable because the material cost less than expected. (c)

The direct material usage variance This is the difference between how many kilograms of Y should have been used to produce 1 000 units of X and how many kilograms were used, valued at the standard cost per kilogram. 1 000 units should have used (× 10 kgs) but did use Usage variance in kgs × standard cost per kilogram Usage variance in $

10 000 kgs 11 700 kgs 1 700 kgs (U) × $10 $17 000 (U)

The variance is unfavourable because more material than the standard quantity was used. (d)

Summary Price variance Usage variance Total variance

2.2

$ 18 400 (F) 17 000 (U) 1 400 (F)

Materials variances and opening and closing inventory Direct material price variances are usually extracted at the time of the receipt of the materials rather than at the time of usage. Suppose that a company uses raw material P in production, and that this raw material has a standard price of $3 per metre. During one month 6,000 metres are bought for $18,600, and 5,000 metres are used in production. At the end of the month, inventory will have been increased by 1,000 metres. In variance analysis, the problem is to decide the material price variance. Should it be calculated on the basis of materials purchased (6,000 metres) or on the basis of materials used (5,000 metres)? The answer to this problem depends on how closing inventories of the raw materials will be valued. (a)

If they are valued at standard cost, (1,000 units at $3 per unit) the price variance is calculated on material purchases in the period.

(b)

If they are valued at actual cost (FIFO) (1,000 units at $3.10 per unit) the price variance is calculated on materials used in production in the period.

A full standard costing system is usually in operation and therefore the price variance is usually calculated on purchases in the period. The variance on the full 6,000 metres will be written off to the costing income statement, even though only 5,000 metres are included in the cost of production.

9: Variance analysis

247

There are two main advantages in extracting the material price variance at the time of receipt. (a)

If variances are extracted at the time of receipt they will be brought to the attention of managers earlier than if they are extracted as the material is used. If it is necessary to correct any variances then management action can be more timely.

(b)

Since variances are extracted at the time of receipt, all inventories will be valued at standard price. This is administratively easier and it means that all issues from inventory can be made at standard price. If inventories are held at actual cost it is necessary to calculate a separate price variance on each batch as it is issued. Since issues are usually made in a number of small batches this can be a time-consuming task, especially with a manual system.

The price variance would be calculated as follows: 6,000 metres of material P purchased should cost (× $3) but did cost Price variance

$ 18 000 18 600 600 (U)

3 Direct labour cost variances Section overview •

The direct labour total variance can be subdivided into the direct labour rate variance and the direct labour efficiency variance.



If idle time arises, it is usual to calculate a separate idle time variance, and to base the calculation of the efficiency variance on active hours, when labour actually worked, only. It is always an unfavourable variance.

The direct labour total variance is the difference between what the output should have cost and what it did cost, in terms of labour. The direct labour rate variance. This is similar to the direct material price variance. It is the difference between the standard rate and the actual rate for the actual number of hours paid for. In other words, it is the difference between what the labour did cost and what it should have cost. The direct labour efficiency variance is similar to the direct material usage variance. It is the difference between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard rate per hour. In other words, it is the difference between how many hours should have been worked and how many hours were worked, valued at the standard rate per hour. The calculation of direct labour variances is very similar to the calculation of direct material variances.

Worked Example: Direct labour variances The standard direct labour cost of product X is as follows: 2 hours of grade Z labour at $5 per hour = $10 per unit of product X. During period 4, 1,000 units of product X were made, and the direct labour cost of grade Z labour was $8 900 for 2 300 hours of work. Calculate the following variances: (a) (b) (c)

248

The direct labour total variance. The direct labour rate variance. The direct labour efficiency (productivity) variance.

Management Accounting

Solution (a)

The direct labour total variance This is the difference between what 1 000 units should have cost and what they did cost. 1 000 units should have cost (× $10) but did cost Direct labour total variance

$ 10 000 8 900 1 100 (F)

The variance is favourable because the units cost less than they should have done. Again we can analyse this total variance into its two constituent parts. (b)

The direct labour rate variance This is the difference between what 2 300 hours should have cost and what 2 300 hours did cost. 2 300 hours of work should have cost (× $5 per hr) but did cost Direct labour rate variance

$ 11 500 8 900 2 600 (F)

The variance is favourable because the labour rate was less than the standard rate. (c)

The direct labour efficiency variance 1 000 units of X should have taken (× 2 hrs) but did take Efficiency variance in hours × standard rate per hour Efficiency variance in $

2 000 2 300 300 × $5 $1 500

hrs hrs hrs (U) (U)

The variance is unfavourable because more hours were worked than should have been worked. (d)

Summary Rate variance Efficiency variance Total variance

$ 2 600 (F) 1 500 (U) 1 100 (F)

4 Variable production overhead variances Section overview •

The variable production overhead total variance can be subdivided into the variable production overhead expenditure variance and the variable production overhead efficiency variance (based on actual hours).

Worked Example: Variable production overhead variances Suppose that the variable production overhead cost of product X is as follows: 2 hours at $1.50 = $3 per unit During period 6, 400 units of product X were made. The labour force worked 820 hours, of which 60 hours were recorded as idle time. The variable overhead cost was $1 230. Calculate the following variances: (a) (b) (c)

The variable overhead total variance. The variable production overhead expenditure variance. The variable production overhead efficiency variance.

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Solution Since this example relates to variable production costs, the total variance is based on actual units of production. (If the overhead had been a variable selling cost, the variance would be based on sales volumes.) 400 units of product X should cost (× $3) but did cost Variable production overhead total variance

$ 1 200 1 230 30 (U)

In many variance reporting systems, the variance analysis goes no further, and expenditure and efficiency variances are not calculated. However, the unfavourable variance of $30 may be explained as the sum of two factors: (a)

The hourly rate of spending on variable production overheads was higher than it should have been, that is there is an expenditure variance.

(b)

The labour force worked inefficiently, and took longer to make the output than it should have done. This means that spending on variable production overhead was higher than it should have been, in other words there is an efficiency (productivity) variance. The variable production overhead efficiency variance is exactly the same, in hours, as the direct labour efficiency variance, and occurs for the same reasons.

It is usually assumed that variable overheads are incurred during active working hours, but are not incurred during idle time (for example, the machines are not running, therefore power is not being consumed, and no indirect materials are being used). This means in our example that although the labour force was paid for 820 hours, they were actively working for only 760 of those hours and so variable production overhead spending occurred during 760 hours. The variable production overhead expenditure variance is the difference between the amount of variable production overhead that should have been incurred in the actual hours actively worked, and the actual amount of variable production overhead incurred. (a) 760 hours of variable production overhead should cost ( × $1.50) but did cost Variable production overhead expenditure variance

$ 1 140 1 230 90 (U)

The variable production overhead efficiency variance. If you already know the direct labour efficiency variance, the variable production overhead efficiency variance is exactly the same in hours, but priced at the variable production overhead rate per hour. (b)

In our example, the efficiency variance would be as follows. 400 units of product X should take (× 2hrs) but did take (active hours) Variable production overhead efficiency variance in hours × standard rate per hour Variable production overhead efficiency variance in $

(c)

Summary Variable production overhead expenditure variance Variable production overhead efficiency variance Variable production overhead total variance

250

800 hrs 760 hrs 40 hrs (F) ×$1.50 $60 (F)

Management Accounting

$ 90 (U) 60 (F)) 30 (U)

5 Fixed production overhead variances Section overview •

The fixed production overhead total variance can be subdivided into an expenditure variance and a volume variance. The fixed production overhead volume variance can be further subdivided into an efficiency and capacity variance.

You may have noticed that the method of calculating cost variances for variable cost items is essentially the same for labour, materials and variable overheads. Fixed production overhead variances are very different. In an absorption costing system, they are an attempt to explain the under- or over-absorption of fixed production overheads in production costs. The fixed production overhead total variance (i.e. the under- or over-absorbed fixed production overhead) may be broken down into two parts as usual: • •

An expenditure variance. A volume variance.

You will find it easier to calculate and understand fixed overhead variances, if you keep in mind the whole time that you are trying to 'explain' (put a name and value to) any under- or over-absorbed overhead.

5.1

Under-/over-absorption The absorption rate is calculated as follows: Overhead absorption rate =

Budgeted fixed overhead Budgeted activity level

The budgeted fixed overhead is the planned or expected fixed overhead and the budgeted activity level is the planned or expected activity level. If either of the following budget estimates are incorrect, then we will have an under- or over-absorption of overhead. • •

5.2

The numerator (number on top) = Budgeted fixed overhead. The denominator (number on bottom) = Budgeted activity level.

The fixed overhead expenditure variance The fixed overhead expenditure variance occurs if the numerator is incorrect. It measures the under- or over-absorbed overhead caused by the actual total expenditure on fixed overhead being different from the budgeted total expenditure on fixed overhead. Therefore Fixed overhead expenditure variance = Budgeted (planned) expenditure – Actual Expenditure.

5.3

The fixed overhead volume variance The fixed overhead volume variance arises if the denominator (i.e. the budgeted activity level or volume) is incorrect. The fixed overhead volume variance measures the under- or over-absorbed overhead caused by the actual activity level being different from the budgeted activity level used in calculating the absorption rate. There are two reasons why the actual activity level may be different from the budgeted activity level used in calculating the absorption rate. (a)

The workforce may have worked more or less efficiently than the standard set.

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(b)

5.4

The hours worked by the workforce could have been different to the budgeted hours, regardless of the level of efficiency of the workforce, because of overtime, strikes and so on.

How to calculate the variances In order to clarify the overhead variances which we have encountered in this section, consider the following definitions which are expressed in terms of how each overhead variance should be calculated.

Definitions Fixed overhead total variance is the difference between fixed overhead incurred and fixed overhead absorbed. In other words, it is the under- or over-absorbed fixed overhead. Fixed overhead expenditure variance is the difference between budgeted fixed overhead expenditure and actual fixed overhead expenditure. Fixed overhead volume variance is the difference between actual and budgeted (planned) volume multiplied by the standard absorption rate per unit.

You should now be ready to work through an example to demonstrate all of the fixed overhead variances.

Worked Example: Fixed overhead variance Suppose that a company plans to produce 1 000 units of product E during August 20X3. The expected time to produce a unit of E is five hours, and the budgeted fixed overhead is $20 000. The standard fixed overhead cost per unit of product E will therefore be as follows: 5 hours at $4 per hour = $20 per unit Actual fixed overhead expenditure in August 20X3 turns out to be $20 450. The labour force manages to produce 1 100 units of product E in the month. Calculate the following variances: (a) (b) (c)

The fixed overhead total variance. The fixed overhead expenditure variance. The fixed overhead volume variance.

Solution All of the variances help to assess the under- or over-absorption of fixed overheads. (a)

Fixed overhead total variance

Fixed overhead incurred Fixed overhead absorbed (1 100 units × $20 per unit) Fixed overhead total variance (= under-/over-absorbed overhead)

$ 20 450 22 000 1 550 (F)

The variance is favourable because more overheads were absorbed than budgeted. (b)

Fixed overhead expenditure variance

Budgeted fixed overhead expenditure Actual fixed overhead expenditure Fixed overhead expenditure variance

$ 20 000 20 450 450 (U)

The variance is unfavourable because actual expenditure was greater than budgeted expenditure. (c)

Fixed overhead volume variance

The production volume achieved was greater than expected. The fixed overhead volume variance measures the difference at the standard rate.

252

Management Accounting

Actual production at standard rate (1 100 × $20 per unit) Budgeted production at standard rate (1 000 × $20 per unit) Fixed overhead volume variance

$ 22 000 20 000 2 000 (F)

The variance is favourable because output was greater than expected. (i)

The labour force may have worked efficiently, and produced output at a faster rate than expected. Since overheads are absorbed at the rate of $20 per unit, more will be absorbed if units are produced more quickly.

(ii)

The labour force may have worked longer hours than budgeted, and therefore produced more output.

The variances may be summarised as follows:

$ 450 (U) 2 000 (F) $1 550 (F)

Expenditure variance Volume variance Over-absorbed overhead (total variance)

In general, a favourable cost variance will arise if actual results are less than expected results. Be aware, however, of the fixed overhead volume variance which gives rise to favourable and unfavourable variances in the following situations: •

A favourable fixed overhead volume variance occurs when actual production is greater than budgeted (planned) production.



An unfavourable fixed overhead volume variance occurs when actual production is less than budgeted (planned) production.

Do not worry if you find fixed production overhead variances more difficult to grasp than the other variances we have covered. Most students do. Read over this section again and then try the following practice questions.

Questions 1, 2 and 3: Common information The following information relates to the questions shown below. Barbados has prepared the following standard cost information for one unit of Product Zeta. Direct materials Direct labour Fixed overheads

4kg @ $10/kg 2 hours @ $4/hour 3 hours @ $2.50

$40.00 $8.00 $7.50

The fixed overheads are based on a budgeted expenditure of $75 000 and budgeted activity of 30 000 hours. Actual results for the period were recorded as follows: Production Materials – 33 600 kg Labour – 16 500 hours Fixed overheads

9 000 units $336 000 $68 500 $70 000

Question 1: Material variances The direct material price and usage variances are:

A B C D

Material price $ – – 24 000 (F) 24 000 (U)

Material usage $ 24 000 (F) 24 000 (U) – –

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(The answer is at the end of the chapter)

Question 2: Labour variances The direct labour rate and efficiency variances are: Labour rate $ 6 000 (F) 6 000 (U) 2 500 (U) 2 500 (F)

A B C D

Labour efficiency $ 2 500 (U) 2 500 (F) 6 000 (F) 6 000 (U) (The answer is at the end of the chapter)

Question 3: Overhead variances The total fixed production overhead variance is: A B C D

$5 000 (U) $5 000 (F) $2 500 (U) $2 500 (F) (The answer is at the end of the chapter)

6 The reasons for cost variances Section overview •

There are many possible reasons for cost variances arising, including changes in the price or use of material, the availability of labour and the efficiency of machinery.

Variance

Favourable

Unfavourable

Material price

Unforeseen discounts received

Price increase Careless purchasing Change in material standard

More care taken in purchasing Change in material standard Material usage

Material used of higher quality than standard More effective use made of material Errors in allocating material to jobs

254

Defective material Excessive waste Theft Stricter quality control Errors in allocating material to jobs

Labour rate

Use of apprentices or other workers at a rate of pay lower than standard.

Wage rate increase. Use of higher grade labour.

Idle time

The idle time variance is always unfavourable.

Machine breakdown Non-availability of material Illness or injury to worker

Management Accounting

Variance

Favourable

Unfavourable

Labour efficiency

Output produced more quickly than expected because of work motivation, better quality of equipment or materials, or better methods.

Lost time in excess of standard allowed.

Errors in allocating time to jobs.

Output lower than standard set because of deliberate restriction, lack of training, or sub-standard material used. Errors in allocating time to jobs.

Overhead expenditure

Savings in costs incurred More economical use of services.

Increase in cost of services used. Excessive use of services. Change in type of services used.

Overhead volume

Labour force working more efficiently (favourable labour efficiency variance).

Labour force working less efficiently (unfavourable labour efficiency variance).

Labour force working overtime.

Machine breakdown, strikes, labour shortages.

This is not an exhaustive list and in an examination question you should review the information given and use your imagination and common sense in analysing possible reasons for variances.

7 The significance of cost variances Section overview •

Materiality, controllability, the type of standard being used, the interdependence of variances and the cost of an investigation should be taken into account when deciding whether to investigate reported variances.

Once variances have been calculated, management have to decide whether or not to investigate their causes. It would be extremely time consuming and expensive to investigate every variance, therefore managers have to decide which variances are worthy of investigation. There are a number of factors which can be taken into account when deciding whether or not a variance should be investigated. (a)

Materiality. A standard cost is really only an average expected cost and is not a rigid specification. Small variations either side of this average are therefore bound to occur. The problem is to decide whether a variation from standard should be considered significant and worthy of investigation. Tolerance limits can be set and only variances which exceed such limits would require investigating.

(b)

Controllability. Some types of variance may not be controllable even once their cause is discovered. For example, if there is a general worldwide increase in the price of a raw material there is nothing that can be done internally to control the effect of this. If a central decision is made to award all employees a 10% increase in salary, staff costs in division A will increase by this amount and the variance is not controllable by division A's manager. Uncontrollable variances call for a change in the plan, not an investigation into the past.

(c)

The type of standard being used.

(d)

(i)

The efficiency variance reported in any control period, whether for materials or labour, will depend on the efficiency level set. If, for example, an ideal standard is used, variances will always be unfavourable.

(ii)

A similar problem arises if average price levels are used as standards. If inflation exists, favourable price variances are likely to be reported at the beginning of a period, to be offset by unfavourable price variances later in the period as inflation pushes prices up.

Interdependence between variances. Individual variances should not be looked at in isolation. One variance might be inter-related with another, and much of it might have occurred only because the other, inter-related, variance occurred too. We will investigate this issue further in a moment.

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(e)

7.1

Costs of investigation. The costs of an investigation should be weighed against the benefits of correcting the cause of a variance.

Interdependence between variances When two variances are interdependent (interrelated) one will usually be unfavourable and the other one favourable.

7.2

Interdependence – materials price and usage variances It may be decided to purchase cheaper materials for a job in order to obtain a favourable price variance. This may lead to higher materials wastage than expected and therefore, unfavourable usage variances occur. If the cheaper materials are more difficult to handle, there might be some unfavourable labour efficiency variance too. If a decision is made to purchase more expensive materials, which perhaps have a longer service life, the price variance will be unfavourable but the usage variance might be favourable.

7.3

Interdependence – labour rate and efficiency variances If employees in a workforce are paid higher rates for experience and skill, using a highly skilled team should incur an unfavourable rate variance at the same time as a favourable efficiency variance. In contrast, a favourable rate variance might indicate a high proportion of inexperienced workers in the workforce, which could result in an unfavourable labour efficiency variance and possibly an unfavourable materials usage variance, due to high rates of rejects.

Question 4: Causes of variance A large unfavourable direct labour efficiency variance has been reported. Which TWO of the following might be causes of the variance? (I)

Using expensive skilled labour

(II) Using poor quality direct materials (III) Using a target standard cost for the labour efficiency standard (IV) Working overtime A B C D

(I) and (III) (I) and (IV) (II) and (III) (II) and (IV)

(The answer is at the end of the chapter)

8 Sales variances Section overview •

256

The selling price variance is a measure of the effect on expected profit of a different selling price to standard selling price. The sales volume profit variance is the difference between the actual units sold and the budgeted (planned) quantity, valued at the standard profit per unit.

Management Accounting

8.1

Selling price variance Definition The selling price variance is a measure of the effect on expected profit of a different selling price to standard selling price. It is calculated as the difference between what the sales revenue should have been for the actual quantity sold, and what it was.

Suppose that the standard selling price of product X is $15. Actual sales in 20X3 were 2 000 units at $15.30 per unit. The selling price variance is calculated as follows:

$ 30 000 30 600 600 (F)

Sales revenue from 2 000 units should have been (× $15) but was (× $15.30) Selling price variance The variance calculated is favourable because the price was higher than expected.

8.2

Sales volume profit variance Definition The sales volume profit variance is the difference between the actual units sold and the budgeted (planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted (planned). Suppose that a company budgets to sell 8,000 units of product J for $12 per unit. The standard full cost per unit is $7. Actual sales were 7,700 units, at $12.50 per unit. The sales volume profit variance is calculated as follows: Budgeted sales volume Actual sales volume Sales volume variance in units × standard profit per unit ($(12–7)) Sales volume variance

8 000 units 7 700 units 300 units (U) × $5 $1 500 (U)

The variance calculated above is unfavourable because actual sales were less than budgeted (planned).

Question 5: Selling price variance Jasper Co has the following budget and actual figures for 20X4: Budget 600 $30

Sales units Selling price per unit

Actual 620 $29

Standard full cost of production = $28 per unit. What are the selling price variance and the sales volume profit variances?

A B C D

Sales price $ 600 (U) 600 (U) 620 (U) 620 (U)

Sales volume $ 20 (F) 40 (F) 20 (F) 40 (F) (The answer is at the end of the chapter)

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8.3

The significance of sales variances The possible interdependence between sales price and sales volume variances should be obvious to you. A reduction in the sales price might stimulate bigger sales demand, so that an unfavourable sales price variance might be counterbalanced by a favourable sales volume variance. Similarly, a price rise would give a favourable price variance, but possibly at the cost of a fall in demand and an unfavourable sales volume variance. It is therefore important in analysing an unfavourable sales variance that the overall consequence should be considered. That is, has there been a counterbalancing favourable variance as a direct result of the unfavourable one?

9 Operating statements Section overview •

Operating statements show how the combination of variances reconcile budgeted profit and actual profit.

So far, we have considered how variances are calculated without considering how they combine to reconcile the difference between budgeted profit and actual profit during a period. This reconciliation is usually presented as a report to senior management at the end of each control period. The report is called an operating statement or statement of variances.

Definition An operating statement is a regular report for management of actual costs and revenues, usually showing variances from budget. An extensive example will now be introduced, both to revise the variance calculations already described, and also to show how to combine them into an operating statement.

Worked Example: Variances and operating statements Sydney manufactures one product, and the entire product is sold as soon as it is produced. There are no opening or closing inventories and work in progress is negligible. The company operates a standard costing system and analysis of variances is made every month. The standard cost card for the product, a boomerang, is as follows: STANDARD COST CARD – BOOMERANG

Direct materials Direct wages Variable overheads Fixed overhead Standard cost Standard profit Standing selling price

0.5 kilos at $4 per kilo 2 hours at $2.00 per hour 2 hours at $0.30 per hour 2 hours at $3.70 per hour

$ 2.00 4.00 0.60 7.40 14.00 6.00 20.00

Selling and administration expenses are not included in the standard cost, and are deducted from profit as a period charge. Budgeted (planned) output for the month of June 20X7 was 5 100 units. Actual results for June 20X7 were as follows: Production of 4 850 units was sold for $95 600. Materials consumed in production amounted to 2 300 kgs at a total cost of $9 800. Labour hours paid for amounted to 8 500 hours at a cost of $16 800. Actual operating hours amounted to 8 000 hours. Variable overheads amounted to $2 600. 258

Management Accounting

Fixed overheads amounted to $42 300. Selling and administration expenses amounted to $18 000. Calculate all variances and prepare an operating statement for the month ended 30 June 20X7.

Solution

(a)

2 300 kg of material should cost (× $4) but did cost Material price variance

$ 9 200 9 800 600 (U)

(b)

4 850 boomerangs should use (× 0.5 kgs) but did use Material usage variance in kgs × standard cost per kg Material usage variance in $

2 425 kgs 2 300 kgs 125 kg (F) × $4 $ 500 (F)

(c)

8 500 hours of labour should cost (× $2) but did cost Labour rate variance

17 000 16 800 200 (F) $

(d)

4 850 boomerangs should take (× 2 hrs) but did take (active hours) Labour efficiency variance in hours × standard cost per hour Labour efficiency variance in $

(e)

Idle time variance 500 hours (U) × $2

$

9 700 hrs 8 000 hrs 1 700 hrs (F) × $2 $3 400 (F) $1 000 (U) $

(f)

(g)

8 000 hours incurring variable o/hd expenditure should cost (× $0.30) but did cost Variable overhead expenditure variance Variable overhead efficiency variance in hours is the same as the labour efficiency variance: 1 700 hours (F) × $0.30 per hour

2 400 2 600 200 (U)

$ 510 (F) $

Budgeted fixed overhead (5 100 units × 2 hrs × $3.70) Actual fixed overhead Fixed overhead expenditure variance

37 740

(i)

Actual production at standard rate (4 850 x $3.70 x 2) Budgeted production at standard rate (5 100 x $3.70 x 2) Fixed overhead volume variance in $

35 890 37 740 1 850 (U) $

(j)

Revenue from 4 850 boomerangs should be (× $20) but was Selling price variance

97 000

(h)

(k)

Budgeted sales volume Actual sales volume Sales volume profit variance in units × standard profit per unit Sales volume profit variance in $

42 300 4 560 (U) $

95 600 1 400 (U) 5 100 units 4 850 units 250 units × $6 (U) $1 500 (U)

There are several ways in which an operating statement may be presented. Perhaps the most common format is one which reconciles budgeted profit to actual profit. In this example, sales and

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administration costs will be introduced at the end of the statement, so that we shall begin with 'budgeted profit before sales and administration costs'. Sales variances are reported first, and the total of the budgeted profit and the two sales variances results in a figure for 'actual sales minus the standard cost of sales'. The cost variances are then reported, and an actual profit before sales and administration costs calculated. Sales and administration costs are then deducted to reach the actual profit for June 20X7. SYDNEY – OPERATING STATEMENT JUNE 20X7

$

Budgeted (planned) profit before sales and administration costs Sales variances: price volume

1 400 (U) 1 500 (U)

Actual sales minus the standard cost of sales Cost variances Material price Material usage Labour rate Labour efficiency Labour idle time Variable overhead expenditure Variable overhead efficiency Fixed overhead expenditure Fixed overhead volume

Actual profit before sales and administration costs Sales and administration costs Actual profit, June 20X7 Check: Sales Materials Labour Variable overheads Fixed overhead Sales and administration Actual profit

260

Management Accounting

(F) $

500 200 3 400

$ 30 600 2 900 (U) 27 700

(U) $ 600

1 000 200 510 4 610

4 560 1 850 8 210

3 600 (U) 24 100 18 000 6 100

9 800 16 800 2 600 42 300 18 000

95 600

89 500 6 100

Key chapter points •

A variance is the difference between a planned, budgeted, or standard cost and the actual cost incurred. The same comparisons can be made for revenues. The process by which the total difference between standard and actual results is analysed is known as the variance analysis.



The direct material total variance can be subdivided into the direct material price variance and the direct material usage variance.



Direct material price variances are usually extracted at the time of receipt of the materials, rather than at the time of usage.



The direct labour total variance can be subdivided into the direct labour rate variance and the direct labour efficiency variance.



If idle time arises, it is usual to calculate a separate idle time variance, and to base the calculation of the efficiency variance on active hours, when labour actually worked, only. It is always an unfavourable variance.



The variable production overhead total variance can be subdivided into the variable production overhead expenditure variance and the variable production overhead efficiency variance, based on active hours.



The fixed production overhead total variance can be subdivided into an expenditure variance and a volume variance.



There are many possible reasons for cost variances arising, including changes in the price or use of material, the availability of labour and the efficiency of machinery.



Materiality, controllability, the type of standard being used, the interdependence of variances and the cost of an investigation should be taken into account when deciding whether to investigate reported variances.



The selling price variance is a measure of the effect on expected profit of a different selling price to standard selling price.



The sales volume profit variance is the difference between the actual units sold and the budgeted (planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted (planned).



Operating statements show how the combination of variances reconcile budgeted profit and actual profit.

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Quick revision questions

The following information relates to questions 1 to 3 A company expected to produce 200 units of its product, the Bone, in 20X3. The actual number produced was 260 units. The standard labour cost per unit was $70 (10 hours at a rate of $7 per hour). The actual labour cost was $18 600 and the number of hours worked was 2 200 hours although 2 300 hours were paid.

1

What is the direct labour rate variance for the company in 20X3? A B C D

2

What is the direct labour efficiency variance for the company in 20X3? A B C D

3

$400 (U) $2,100 (F) $2,800 (U) $2,800 (F)

What is the idle time variance? A B C D

4

$400 (U) $2,500 (F) $2,500 (U) $3,200 (U)

$700 (F) $700 (U) $809 (U) $809 (F)

A company has budgeted to make and sell 4 200 units of product X during a period. The standard fixed overhead cost per unit is $4. During the period covered by the budget, the actual results were as follows: Production and sales Fixed overhead incurred

5 000 units $17 500

The fixed overhead variances for the period were:

A B C D 5

Fixed overhead expenditure variance $700 (F) $700 (F) $700 (U) $700 (U)

Fixed overhead volume variance $3,200 (F) $3,200 (U) $3,200 (F) $3,200 (U)

A company has a budgeted material cost of $125,000 for the production of 25,000 units per month. Each unit is budgeted to use 2 kgs of material. The standard cost of material is $2.50 per kg. Actual materials in the month cost $136,000 for 27,000 units and 53,000 kgs were purchased and used. What was the favourable material usage variance? A B C D

262

$2,500 $4,000 $7,500 $10,000

Management Accounting

The following information relates to questions 6 and 7 A company operating a standard costing system has the following direct labour standards per unit for one of its products: 4 hours at $12.50 per hour Last month when 2 195 units of the product were manufactured, the actual direct labour cost for the 9,200 hours worked was $110,750.

6

What was the direct labour rate variance for last month? A B C D

7

What was the direct labour efficiency variance for last month? A B C D

8

$4,250 favourable $4,250 unfavourable $5,250 favourable $5,250 unfavourable $4,250 favourable $4,250 unfavourable $5,250 favourable $5,250 unfavourable

PQ Limited currently uses a standard absorption costing system. The fixed overhead variances extracted from the operating statement for November are: $ Fixed production overhead expenditure variance 5 800 unfavourable Fixed production overhead volume variance 2 800 favourable PQ Limited is considering using standard marginal costing as the basis for variance reporting in future. What variance for fixed production overhead would be shown in a marginal costing operating statement for November? A B C D

9

no variance would be shown for fixed production overhead expenditure variance: $5,800 unfavourable volume variance: $2,800 favourable total variance: $3,000 unfavourable

List the factors which should be taken into account when deciding whether or not a variance should be investigated.

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Answers to quick revision questions 1

C 2 300 hours should have cost (× $7) but did cost Rate variance

$ 16 100 18 600 2 500 (A)

Option A is the total direct labour cost variance.

If you selected option B you calculated the correct dollar value of the variance but you misinterpreted its direction. If you selected option D you based your calculation on the 2 200 hours worked, but 2 300 hours were paid for and these hours should be the basis for the calculation of the rate variance. 2

D

260 units should have taken (× 10 hrs) but took (active hours) Efficiency variance in hours × standard rate per hour Efficiency variance in $

2 600 hrs 2 200 hrs 400 hrs (F) × $7 $2 800 (F)

Option A is the total direct labour cost variance. If you selected option B you based your calculations on the 2,300 hours paid for; but efficiency measures should be based on the active hours only, i.e. 2 200 hours.

If you selected option C you calculated the correct dollar value of the variance but you misinterpreted its direction. 3

B

Idle time hours (2 300 – 2 200) × standard rate per hour = 100 hrs × $7 = $700 (U) If you selected option A you calculated the correct dollar value of the variance but you misinterpreted its direction. The idle time variance is always unfavourable. If you selected options C or D you evaluated the idle time at the actual hourly rate instead of the standard hourly rate.

4

C

Fixed overhead expenditure variance

Budgeted fixed overhead expenditure (4 200 units × $4 per unit) Actual fixed overhead expenditure Fixed overhead expenditure variance

$ 16 800 17 500 700 (U)

The variance is unfavourable because the actual expenditure was higher than the amount budgeted. Fixed overhead volume variance

Actual production at standard rate (5 000 × $4 per unit) Budgeted production at standard rate (4 200 × $4 per unit) Fixed overhead volume variance

$ 20 000 16 800 3 200 (F)

The variance is favourable because the actual volume of output was greater than the budgeted volume of output. If you selected an incorrect option you misinterpreted the direction of one or both of the variances.

264

Management Accounting

5

A 27 000 units should use (× 2 kg) but did use × standard cost per kg Material usage variance

6

A 9 200 hours should have cost (× $12.50) but did cost Direct labour rate variance

7

D

8

B

2 195 units should have taken (× 4 hours) but did take Direct labour efficiency variance (in hours) × standard rate pre hour

$ 54 000 kg 53 000 kg 1 000 kg (F) 2.5 2 500 (F) $ 115 000 110 750 4 250 (F)

8 780 hours 9 200 hours 420 hours (A) × 12.50 5 250 (A)

The only fixed overhead variance in a marginal costing statement is the fixed overhead expenditure variance. This is the difference between budgeted and actual overhead expenditure, calculated in the same way as for an absorption costing system. There is no volume variance with marginal costing, because under or over absorption due to volume changes cannot arise.

9

Materiality, controllability, type of standard being used, interdependence between variances and costs of investigation.

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Answers to chapter questions 1

Material price variance

33 600 kg should have cost (× $10/kg) and did cost

$ 336 000 336 000 –

Material usage variance

9 000 units should have used (× 4kg) but did use × standard cost per kg

36 000 kg 33 600 kg 2 400 kg (F) × $10 24 000 (F)

The correct answer is therefore A 2

C Direct labour rate variance

16 500 hrs should have cost (× $4) but did cost

$ 66 000 68 500 2 500 (U)

Direct labour efficiency variance

9 000 units should have taken (× 2 hrs) but did take × standard rate per hour (× $4)

3

C Fixed production overhead absorbed ($7.50 × 9 000) Fixed production overhead incurred

$ 67 500 70 000 2 500 (U)

4

C If a target standard rather than a current standard is used, unfavourable variances will occur until the target is achieved. Poor quality materials may slow down work, and possibly increase wastage/rejection rates. This will cause labour inefficiency. Using expensive skilled labour should be expected to result in favourable efficiency variances. There should be no connection between labour efficiency and whether work is done in normal time or overtime.

5

D Sales revenue for 620 units should have been (× $30) but was (× $29) Selling price variance Budgeted sales volume Actual sales volume Sales volume variance in units × standard profit per unit ($(30 – 28)) Sales volume profit variance

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18 000 hrs 16 500 hrs 1 500 (F) × $4 6 000 (F)

Management Accounting

$18 600 $17 980 $620 (U) 600 units 620 units 20 units (F) × $2 $40 (F)

Chapter 10

Capital expenditure Learning objectives

Reference

Capital expenditure

LO10

Analyse capital expenditure decisions in organisations and apply related tools and techniques

LO10.1

Apply capital expenditure analysis to project planning and managing uncertain scenarios through scenario analysis

LO10.2

Decision-making

LO2

Identify the quantitative and qualitative criteria involved in accepting a project

LO2.3

Analyse the challenges posed by differences between a project and an organisation’s risk profiles

LO2.4

Explain the impact of cash flows and risks on project decision making

LO2.5

Topic list

1 2 3 4 5

The process of investment decision making Post audit The payback method The accounting rate of return method Risk and uncertainty in decision making

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Introduction This chapter is an introduction to the appraisal of projects which involve the outlay of capital. Capital expenditure differs from day to day revenue expenditure for two reasons: •

Capital expenditure often involves a bigger outlay of money.



The benefits from capital expenditure are likely to accrue over a long period of time, usually well over one year and often much longer. In such circumstances the benefits cannot all be set against costs in the current year's income statement.

For these reasons any proposed capital expenditure project should be properly appraised, and found to be worthwhile, before the decision is taken to go ahead with the expenditure. We begin the chapter with an overview of the investment decision-making process, before moving on to examine two capital investment appraisal techniques, the straightforward payback method and the slightly more involved accounting rate of return method. We conclude by looking at uncertainty and risk. Decision making involves making decisions now about what will happen in the future. Ideally, the decision maker would know with certainty what the future consequences would be for each choice faced. But, in reality, decisions must be made in the knowledge that their consequences, although perhaps probable, are rarely totally certain.

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Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

A typical model for investment decision making has a number of distinct stages. What are they?

(Section 1.2)

2

What are steps involved in the analysis stage of investment decision making?

(Section 1.5)

3

What is a post-completion audit?

4

Why perform a post-completion appraisal?

(Section 2.1)

5

Which projects should be audited?

(Section 2.2)

6

Who should perform a post-completion audit (PCA)?

(Section 2.4)

7

Define the payback method of investment appraisal.

(Section 3)

8

What are the disadvantages of the payback method?

(Section 3.2)

9

What are the advantages of the payback method?

(Section 3.2)

10

What are the formulae that can be used for ARR?

(Section 4)

11

What are the drawbacks and advantages to the ARR method of project appraisal?

(Section 4.2)

12

What are risk and uncertainty?

(Section 5.1)

(Section 2)

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1 The process of investment decision making Section overview •

1.1 LO 10.1

A typical model for investment decision making has a number of distinct stages. During the project's progress, project controls should be applied.

Creation of capital budgets The capital budget will normally be prepared to cover a longer period than sales, production and resource budgets, say from three to five years, although it should be broken down into periods matching those of other budgets. It should indicate the expenditure required to cover capital projects already underway and those it is anticipated will start in, say, the three to five year period of the capital budget. The budget should therefore be based on the current production budget, future expected levels of production and the long-term development of the organisation, and industry, as a whole. Budget limits or constraints might be imposed internally (soft capital rationing) or externally (hard capital rationing). Projects can be classified in the budget into those that generally arise from top management policy decisions or from sources such as mandatory government regulations (health, safety and welfare capital expenditure) and those that tend to be appraised using the techniques covered in this chapter. (a) (b) (c)

Cost reduction and replacement expenditure. Expenditure on the expansion of existing product lines. New product expenditure.

The administration of the capital budget is usually separate from that of the other budgets. Overall responsibility for authorisation and monitoring of capital expenditure is, in most large organisations, the responsibility of a committee.

1.2 LO 2.3

The investment decision-making process Capital expenditure often involves the outlay of large sums of money, and expected benefits may take a number of years to accrue. For these reasons it is vital that capital expenditure is subject to a rigorous process of appraisal and control. A typical model for investment decision making has a number of distinct stages:

• • • •

Origination of proposals. Project screening. Analysis and acceptance. Monitoring and review.

We will look at these stages in more detail below.

1.3

Origination of proposals Investment opportunities do not just appear out of thin air. They must be created. An organisation must set up a mechanism that scans the environment for potential opportunities and gives an early warning of future problems. A technological change that might result in a drop in sales might be picked up by this scanning process, and steps should be taken immediately to respond to such a threat. Ideas for investment might come from those working in technical positions. A factory manager, for example, could be well placed to identify ways in which expanded capacity or new machinery could increase output or the efficiency of the manufacturing process. Innovative ideas, such as new product lines, are more likely to come from those in higher levels of management, given their strategic view of the organisation’s direction and their knowledge of the competitive environment.

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Management Accounting

The overriding feature of any proposal is that it should be consistent with the organisation’s overall strategy to achieve its objectives.

1.4

Project screening Each proposal must be subject to detailed screening. So that a qualitative evaluation of a proposal can be made, a number of key questions such as those below might be asked before any financial analysis is undertaken. Only if the project passes this initial screening will more detailed financial analysis begin. (a) (b) (c) (d) (e) (f) (g) (h)

1.5

What is the purpose of the project? Does it 'fit' with the organisation's long-term objectives? Is it a mandatory investment, for example, to conform with safety legislation? What resources are required and are they available, e.g. money, capacity, labour? Do we have the necessary management expertise to guide the project to completion? Does the project expose the organisation to unnecessary risk? How long will the project last and what factors are key to its success? Have all possible alternatives been considered?

Analysis and acceptance The analysis stage can be broken down into a number of steps.

Step 1

Complete and submit standard format financial information as a formal investment proposal.

Step 2

Classify the project by type – to separate projects into those that require more or less rigorous financial appraisal, and those that must achieve a greater or lesser rate of return in order to be deemed acceptable.

Step 3

Carry out financial analysis of the project. We look at this in more detail below.

Step 4

Compare the outcome of the financial analysis to predetermined acceptance criteria.

Step 5

Consider the project in the light of the capital budget for the current and future operating periods.

Step 6

Make the decision – accept/reject. This is considered in more detail below.

Step 7

Monitor the progress of the project (covered below).

Steps 1 to 6 above can be seen in the context of the decision-making process that was described in chapter 1, section 3.7. After all, investing in capital projects involves a decision about whether to spend, and how much to spend.

Step 1 Define the problem. The problem that leads to capital expenditure decisions may be that existing assets are getting old and less reliable, and management want to decide how to improve reliability and efficiency in production. The problem may be that the organisation wants to expand the scale of its operations or diversify into a new line of business, and to do this it needs to invest in new assets. Step 2 Identify the decision-making criteria. There are several different ways of evaluating investment options. As we shall see later, the decision-making criteria may be that any new investment should earn a minimum return on capital invested, or should add value to the business, or that any amount invested should be recovered within a given number of years. Step 3

Develop alternatives. With capital investment decisions, the alternatives may be presented simply as “Invest in a specific asset” or “Do not invest”. However there may be other options to consider, such as whether to buy Asset 1 or Asset 2 (which may be a bigger and more expensive item). There may also be different options about when to invest – whether to invest now or whether to defer the spending until a later time. In the exam, the options are likely to be either to invest or not to invest ‘now’.

Step 4

Analyse the alternatives. Each of the alternatives should be analysed and evaluated, using the chosen decision-making criterion. If the alternatives are simply either to invest or not to invest, the analysis is carried out by evaluating the decision to invest.

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Step 5

Select an alternative. If investing is worthwhile, the “don’t invest” option is rejected. If investing seems worthwhile, the “don’t invest” option is rejected.

1.5.1

Financial analysis The financial analysis will involve the application of the organisation's preferred investment appraisal techniques. In many projects some of the financial implications will be extremely difficult to quantify, but every effort must be made to do so, in order to have a formal basis for planning and controlling the project. Here are examples of the type of question that will be addressed at this stage: (a) (b) (c) (d)

What cash flows/profits will arise from the project and when? Has inflation been considered in the determination of the cash flows? What are the results of the financial appraisal? Has any allowance been made for risk, and if so, what was the outcome?

Some types of project, for example, a marketing investment decision, may give rise to cash inflows and returns which are so intangible and difficult to quantify that a full financial appraisal may not be possible. In this case more weight may be given to a consideration of the qualitative issues.

1.5.2

Qualitative issues Financial analysis of capital projects is obviously vital because of the amount of money involved and the length of time for which it is tied up. A consideration of qualitative issues is also relevant to the decision i.e. factors which are difficult or impossible to quantify. We have already seen that qualitative issues would be considered in the initial screening stage, for example, in reviewing the project's 'fit' with the organisation's overall objectives and whether it is a mandatory investment. There is a very wide range of other qualitative issues that may be relevant to a particular project.

1.5.3

(a)

What are the implications of not undertaking the investment, e.g. adverse effect on staff morale, loss of market share?

(b)

Will acceptance of this project lead to the need for further investment activity in future?

(c)

What will be the effect on the company's image?

(d)

Will the organisation be more flexible as a result of the investment, and better able to respond to market and technology changes?

Go/no go decision “Invest” or “Don’t invest” decisions (Go/no go decisions) on projects may be made at different levels within the organisational hierarchy, depending on three factors: (a) (b) (c)

The type of investment. Its perceived riskiness. The amount of expenditure required.

For example, a divisional manager may be authorised to make decisions up to $25 000, an area manager up to $150 000 and a group manager up to $300 000, with board approval for greater amounts. Once the go/no go, or accept/reject, decision has been made, the organisation is committed to the project, and the decision maker must accept that the project’s success or failure reflects on his or her ability to make sound decisions.

1.6

Monitoring the progress of the project During the project's progress, project controls should be applied to ensure the following: • • •

272

Capital spending does not exceed the amount authorised. The implementation of the project is not delayed. The anticipated benefits are eventually obtained.

Management Accounting

The first two items are probably easier to control than the third, because the controls can normally be applied soon after the capital expenditure has been authorised, whereas monitoring the benefits will span a longer period of time.

1.6.1

Controls over excess spending There are a number of controls which organisations can implement to ensure that capital spending does not exceed the amount authorised.

1.6.2

(a)

The authority to make capital expenditure decisions must be formally assigned.

(b)

Capital expenditure decisions should be documented and approval of the project should specify the manager authorised to carry out the expenditure, and hence responsible for the successful implementation of the project, the amount of expenditure authorised and the period of time in which the expenditure should take place.

(c)

Some overspending above the amount authorised – say 5% or 10% – might be allowed. If the required expenditure exceeds the amount authorised by more than this amount, a fresh submission for reauthorisation of the project should be required.

(d)

There should be a total capital budget, and the authorisation of any capital expenditure which would take total spending above the budget should be referred to, for example, board level for approval.

Control over delays If there is a delay in carrying out the project and the capital expenditure has not taken place before the stated deadline is reached, the project should be resubmitted for fresh authorisation, and the proposer should be asked to explain the reasons for the delay.

1.6.3

Control over the anticipated benefits Further control can be exercised over capital projects by ensuring that the anticipated benefits do actually materialise, the benefits are as big as anticipated and running costs do not exceed expectation. A difficulty with control measurements of capital projects is that most projects are 'unique' with no standard or yardstick to judge them against other than their own appraisal data. Therefore if actual costs were to exceed the estimated costs, it might be impossible to tell just how much of the variance is due to bad estimating and how much is due to inefficiencies and poor cost control. In the same way, if benefits are below expectation, is this because the original estimates were optimistic, or because management has been inefficient and failed to get the benefits they should have done? Many capital projects such as the purchase of replacement assets and marketing investment decisions do not have clearly identifiable costs and benefits. The incremental benefits and costs of such schemes can be estimated, but it would need a very sophisticated management accounting system to be able to identify and measure the actual benefits and many of the costs. Even so, some degree of monitoring and control can still be exercised by means of a post-completion appraisal or audit review.

2 Post audit Section overview •

A post audit cannot reverse the decision to incur the capital expenditure, because the expenditure has already taken place, but it does have a certain control value.

Definition A post-completion audit (PCA) is an objective independent assessment of the success of a capital project in relation to plan. It covers the whole life of the project and provides feedback to managers to aid the implementation and control of future projects.

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The PCA is therefore is therefore a forward-looking rather than a backward-looking technique. It seeks to identify general lessons to be learned from a project.

2.1

Why perform a post-completion appraisal (PCA) or audit? (a)

The threat of the PCA will motivate managers to work to achieve the promised benefits from the project.

(b)

If the audit takes place before the project life ends, and if it finds that the benefits have been less than expected because of management inefficiency, steps can be taken to improve efficiency. Alternatively, it will highlight those projects which should be discontinued.

(c)

It can help to identify managers who have been good performers and those who have been poor performers.

(d)

It might identify weaknesses in the forecasting and estimating techniques used to evaluate projects, and so should help to improve the discipline and quality of forecasting for future investment decisions.

(e)

Areas where improvements can be made in methods which should help to achieve better results in general from capital investments might be revealed.

(f)

The original estimates may be more realistic if managers are aware that they will be monitored, but post-completion audits should not be unfairly critical.

Research by Neale and Homes (1990) found that managers see the following advantages to PCAs. (a) (b) (c) (d) (e) (f) (g)

2.2

They improve the quality of decision making. They improve organisational performance. They improve control and guidance. They encourage a more realistic approach to new investment project decision making. They help to identify critical success factors. They enable changes to be made more quickly to projects that are not doing very well. They encourage (when relevant) project termination.

Which projects should be audited? A reasonable guideline might be to audit all projects above a certain size, and a random selection of smaller projects. A PCA does not need to focus on all aspects of an investment, but should concentrate on those aspects which have been identified as particularly sensitive or critical to the success of a project. The most important thing to remember is that post-completion audits are time-consuming and costly and so careful consideration should be given to the cost-benefit trade-off arising from the postcompletion audit results.

2.3

When should projects be audited? If the audit is carried out too soon, the information may not be complete. On the other hand, if the audit is too late then management action will be delayed and the usefulness of the information is greatly reduced. There is no correct answer to the question of when to audit, although research suggests that in practice most companies perform the PCA approximately one year after the completion of the project.

2.4

Who performs a PCA? Because it can be very difficult to evaluate an investment decision completely objectively, it is generally appropriate to separate responsibility for the investment decision from that for the PCA. Line management involved in the investment decision should therefore not carry out the PCA. To avoid conflicts of interest, outside experts could even be used.

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2.5

Problems with PCA (a)

There are many uncontrollable factors which are outside management control in long-term investments, such as environmental changes.

(b)

It may not be possible to identify separately the costs and benefits of any particular project.

(c)

PCA can be a costly and time-consuming exercise, although 'contrary to what is often thought, conducting a PCA does not appear to be an expensive business' reported Brantjes, von Eije, Eusman and Prins in Management Accounting (Post-completion auditing with Heineken) in April 1999.

(d)

Applied punitively, post-completion audit exercises may lead to managers becoming over cautious and unnecessarily risk averse.

(e)

The strategic effects of a capital investment project may take years to materialise and it may in fact, never be possible to identify or quantify them effectively.

Despite the growth in popularity of post-completion audits, you should bear in mind the possible alternative control processes: (a)

Teams could manage a project from beginning to end, control being used before the project is started and during its life, rather than at the end of its life.

(b)

More time could be spent choosing projects rather than checking completed projects.

Case study A 1999 Management Accounting article looked at post completion auditing at Heineken (the Dutch beer producer) and how it was applied to a project to replace a 20-year old bottling line. The following table shows the planned objectives of the investment and the actual situation at the time a PCA was carried out on the investment. (Guilders were the Dutch currency prior to the euro.) This should give you an idea of the type of objectives that can be monitored with a PCA. Objectives

Plan

Actual

Efficiency

Increase from 65% to 80%

No increase yet

Staff savings

From 13 to 7 per shift

Achieved

Forklift savings

1 vehicle less

1 and possibly 2 vehicles less

Savings on overhaul of old bottling line

1.3 million guilders of savings

Savings achieved, but as a result of reusing part of the old bottling line another 1.8 million guilders was spent in additional overhaul costs

Savings on maintenance

Savings of 0.4 million guilders annually

Savings estimated at 0.3 million guilders annually

Quality

50% reduction in damage

Achieved

Working conditions

Level of noise Accessibility Safety Attainability

All much improved, but not quantified

Now that we have discussed all the stages involved in the capital budgeting process, we will return to study in detail the stage that many managers consider to be the most important: the financial appraisal. A decision about whether to invest is often made on financial considerations, and the decision criterion is related to financial return. We will begin with what is probably the most straightforward appraisal technique: the payback method.

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3 The payback method Section overview •

The payback method looks at how long it takes for a project's net cash inflows to equal the initial investment.

Definition Payback is the time required for the cash inflows from a capital investment project to equal the cash outflows, so that the returns from the investment pay back the initial outlay.

Payback is often used as a ‘first screening method’. By this, we mean that when a capital investment project is being subjected to financial appraisal, the first question to ask is: 'How long will it take to pay back its cost?' The organisation might have a target payback, and so it would reject a capital project unless its payback period were less than a target maximum number of years. When deciding between two or more competing projects, management may prefer the one with the shortest payback. If payback were the only method of evaluation used, the decision criterion would be to recover the initial capital outlay as quickly as possible. However, a project should not be evaluated on the basis of payback alone. Payback should be a first screening process, and if a project gets through the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique. Payback is a cash based measure. Ideally it is based on the project’s cash inflows versus its cash outflows. It does not consider profit. In the absence of cash flow information however, profits before depreciation can be used as a very rough approximation of annual cash flows. With some methods of capital expenditure appraisal, it is commonly assumed that cash flows in each period occur on the last day of the period. However with the payback method, either of two different assumptions may be used: (a)

that the cash flows in each period do occur at the end of the period: this means that capital expenditure at the beginning of the first year are assumed to occur in ‘Year 0’, which is the year that has just ended. When this assumption is used, payback will occur at the end of a particular year.

(b)

that the cash flows occur at an even rate throughout each time period. When this assumption is used, payback will normally occur at some time during a particular year, not at the end of a year.

When it is assumed that cash flows occur at an even rate throughout the year (with the exception of any cash from the disposal of a capital asset, which happens at the very end of the project), the payback period is calculated as follows. (a)

Calculate the cumulative cash flows at the end of each year. The initial capital outlay is a cash outflow, so the cumulate cash flow will remain negative until payback is achieved.

(b)

Payback is achieved during the year that the cumulative cash flows change from negative to positive.

(c)

The time in the payback year that payback occurs is found by calculating the proportion: (Extra cash inflow needed for payback at the start of the year/Cash flow during the year)

(d)

276

Multiply this proportion by 12 months to get the payback month in the year.

Management Accounting

For example, suppose that the cumulative cash flow for a project at the end of Year 3 is - $15 000 and the cash flow in Year 4 is $36 000. The payback period will be 3 years + [(15 000/36 000) × 12 months] = 3 years 5 months.

3.1

Why is payback alone an inadequate project appraisal technique? Look at the figures below for two mutually exclusive projects (this means that only one of them can be undertaken). Project P Project Q Capital cost of asset $60 000 $60 000 Profits before depreciation Year 1 $20 000 $50 000 Year 2 $30 000 $20 000 Year 3 $40 000 $5 000 Year 4 $50 000 $5 000 Year 5 $60 000 $5 000 Project P pays back in year 3. If we assume that cash flows occur at the end of the year, payback occurs at the end of year 3. If we assume that cash flows occur at an even rate throughout each year, Project P will pay back one quarter of the way through year 3 (after 2 years 3 months). Project Q pays back in year 2. If we assume that cash flows occur at the end of the year, payback occurs at the end of year 2. If we assume that cash flows occur at an even rate throughout each year, Project Q will pay back half way through year 2 (after 1 year 6 months). Using payback alone to judge projects, project Q would be preferred. But the returns from project P over its life are much higher than the returns from project Q. Project P will earn total profits before depreciation of $200 000 on an investment of $60 000, whereas project Q will earn total profits before depreciation of only $85 000 on an investment of $60 000. Making the choice between the projects on payback alone would be inappropriate: total return must also be considered.

Question 1: Payback An asset costing $120 000 is to be depreciated over ten years to a nil residual value. Profits after depreciation for the first five years are as follows: Year 1 2 3 4 5

$ 12 000 17 000 28 000 37 000 8 000

How long is the payback period to the nearest month, assuming that cash flows occur at an even rate during each year? A B C D

3 years 7 months 3 years 6 months 3 years the project does not payback in five years (The answer is at the end of the chapter)

3.2

Disadvantages of the payback method There are two serious drawbacks to the payback method: (a)

It ignores the timing of cash flows within the payback period, the cash flows after the end of the payback period and therefore the total project return.

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(b)

It ignores the time value of money which is a concept incorporated into more sophisticated appraisal methods. This means that it does not take account of the fact that $1 today is worth more than $1 in one year's time. An investor who has $1 today can either consume it immediately or alternatively, can invest it at the prevailing interest rate, say 10%, to get a return of $1.10 in a year's time.

There are also other disadvantages:

3.3

(a)

The method is unable to distinguish between projects with the same payback period.

(b)

The choice of any cut-off payback period by an organisation is arbitrary.

(c)

It may lead to excessive investment in short-term projects.

(d)

It takes account of the risk of the timing of cash flows but does not take account of the variability of those cash flows.

Advantages of the payback method The use of the payback method does have advantages, especially as an initial screening device: (a) (b) (c) (d) (e) (f)

Long payback means capital is tied up. Focus on early payback can enhance liquidity. Investment risk is increased if payback is longer. Shorter-term forecasts are likely to be more reliable. The calculation is quick and simple. Payback is an easily understood concept.

4 The accounting rate of return method Section overview •

Like the payback method, the accounting rate of return method is popular despite its limitations.

The accounting rate of return (ARR) method (also called the return on capital employed (ROCE) method or the return on investment (ROI) method) of appraising a project is to estimate the accounting rate of return that the project should yield. If it exceeds a target rate of return, the project will be undertaken. Profits rather than cash flows are used to measure the size of returns.

Formulae to learn Unfortunately there are several different definitions of ARR. ARR =

Average annual profit from investment × 100 % Average investment

ARR =

Estimated total profits × 100% Estimated initial investment

OR ARR =

Estimated average profits × 100% Estimated initial investment

The measurement of ARR is different according to whether ‘average annual profit’ or ‘total profits over the asset life’ is the figure above the line. Similarly, ARR differs according to whether ‘average investment’ or ‘initial investment’ is used below the line. Note: Average investment = [(Initial cost + Estimated residual value)/2].

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Whichever method of measuring ARR is selected (assuming that the ARR method is used as a decision criterion) the method selected should be used consistently. For examination purposes we recommend the first definition (average profit as a percentage of average investment) unless the question clearly indicates that some other one is to be used. Note that this is the only appraisal method that we will be studying that uses profit instead of cash flow. If you are not provided with a figure for profit, assume that net cash inflow minus depreciation equals profit.

Worked Example: Target accounting rate of return A company has a target accounting rate of return of 20%, using the first definition above, and is now considering the following project. Capital cost of asset $80 000 Estimated life 4 years Estimated profit before depreciation Year 1 $20 000 Year 2 $25 000 Year 3 $35 000 Year 4 $25 000 The capital asset would be depreciated by 25% of its cost each year, and will have no residual value. Assess whether the project should be undertaken.

Solution The annual profits after depreciation, and the mid-year net book value of the asset, would be as follows. Year

1 2 3 4

Profit after depreciation $ 0 5 000 15 000 5 000

Mid-year net book value $ 70 000 50 000 30 000 10 000

ARR in the year % 0 10 50 50

As the table shows, the ARR is low in the early stages of the project, partly because of low profits in Year 1 but mainly because the NBV of the asset is much higher early on in its life. The project does not achieve the target ARR of 20% in its first two years, but exceeds it in years 3 and 4. Should it be undertaken? When the ARR from a project varies from year to year, it makes sense to take an overall or 'average' view of the project's return. In this case, we should look at the return over the four-year period. $ Total profit before depreciation over four years 105 000 Total profit after depreciation over four years 25 000 Average annual profit after depreciation 6 250 Original cost of investment 80 000 Average net book value over the four-year period ((80 000 + 0)/2) 40 000 The project would not be undertaken because its ARR is (6,250/40,000) × 100% = 15.625% and so it would fail to yield the target return of 20%.

4.1

The ARR and the comparison of mutually exclusive projects The ARR method of capital investment appraisal can also be used to compare two or more projects which are mutually exclusive. The project with the highest ARR would be selected, provided that the expected ARR is higher than the company's target ARR.

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Question 2: The ARR and mutually exclusive projects Arrow wants to buy a new item of equipment. Three models of equipment are available, differing according to cost, size, reliability and supplier. The expected costs and profits of each item are as follows: Equipment item

Capital cost Life Profits before depreciation Year 1 Year 2 Year 3 Year 4 Year 5 Disposal value

X $80 000 5 years $ 50 000 50 000 30 000 20 000 10 000 0

Y $150 000 5 years $ 50 000 50 000 60 000 60 000 60 000 0

Z $200 000 5 years $ 60 000 70 000 90 000 70 000 60 000 50 000

ARR is measured as the average annual profit after depreciation, divided by the average net book value of the asset. The investment with the highest ARR will be selected, provided that its expected ARR is more than 30%. Which of these items of equipment should be purchased? A

Item X

B

Item Y

C

Item Z

D

None of them (The answer is at the end of the chapter)

4.2

The drawbacks and advantages to the ARR method of project appraisal The ARR method has the serious drawback that it does not take account of the timing of the profits from a project. Whenever capital is invested in a project, money is tied up until the project begins to earn profits which pay back the investment. Money tied up in one project cannot be invested anywhere else until the profits come in. Management should be aware of the benefits of early repayments from an investment, which will provide the money for other investments. There are a number of other disadvantages: (a)

It is based on accounting profits which are subject to a number of different accounting treatments.

(b)

It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.

(c)

It takes no account of the length of the project.

(d)

Like the payback method, it ignores the time value of money.

There are, however, advantages to the ARR method:

280

(a)

It is quick and simple to calculate.

(b)

It involves a familiar concept of a percentage return.

(c)

Accounting profits can be easily calculated from financial statements.

(d)

It looks at the entire project life.

(e)

Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method which employs profit may therefore be more easily understood.

Management Accounting

Question 3: Payback and ARR A company is considering two capital expenditure proposals. The following information is available:

Initial investment Year 1 Year 2 Year 3 Year 4 Estimated scrap value at the end of year 4

Profit/(loss) after depreciation Proposal A Proposal B $ $ 46 000 46 000 6 500 4 500 3 500 2 500 13 500 4 500 (1 500) 14 500 4 000 4 000

Depreciation is charged on the straight line basis. Profits and cash flows are assumed to occur at an even rate within each year. The maximum acceptable payback period is 3 years and the minimum acceptable ARR is 23%. (a)

(b)

(c)

What is the payback period for each investment? A

Proposal A 2 years 6 months, Proposal B 2 years 11 months

B

Proposal A 2 years 6 months, Proposal B 3 years 1 month

C

Proposal A 2 years 8 months, Proposal B 2 years 11 months

D

Proposal A 2 years 8 months, Proposal B 3 years 1 month

What is the ARR for each investment, using average profit and average investment to measure ARR? A

Proposal A 22%, Proposal B 26%

B

Proposal A 22%, Proposal B 28.3%

C

Proposal A 23.5%, Proposal B 26%

D

Proposal A 23.5%, Proposal B 28.3%

On the basis of these two performance criteria (payback and ARR) which project or projects should be undertaken? A

Proposal A only

B

Proposal B only

C

Both Proposal A and Proposal B

D

Neither proposal (The answers are at the end of the chapter)

5 Risk and uncertainty in decision making 5.1

What are risk and uncertainty? Section overview •

An example of a risky situation is one in which we may say that there is a 70% probability that returns from a project will be in excess of $100 000 but a 30% probability that returns will be less than $100 000. If no information can be provided on the returns from the project, we are faced with an uncertain situation.



People may be risk-seekers, risk neutral or risk averse.

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Definitions

LOs 2.5 10.2

5.2

Risk involves situations or events which may or may not occur, but whose probability of occurrence can be calculated statistically and the frequency of their occurrence predicted from past records. Therefore insurance deals with risk. Uncertain events are those whose outcome cannot be predicted with statistical confidence.

Risk and capital investment decisions In general, risky projects are those which have future cash flows, and hence project returns, that are likely to be variable. The greater the variability, the greater the risk. The problem of risk is more acute with capital investment decisions for the following reasons: (a)

Estimates of capital expenditure might be for several years ahead, such as those for major construction projects. Actual costs may well escalate well above budget as the work progresses.

(b)

Estimates of benefits will be for several years ahead, sometimes 10, 15 or 20 years ahead or even longer, and such long-term estimates can at best be approximations.

In everyday usage the terms risk and uncertainty are not clearly distinguished. If you are asked for a definition, do not make the mistake of believing that the latter is a more extreme version of the former. It is not a question of degree, it is a question of whether or not sufficient information is available to allow the lack of certainty to be quantified. As a rule, however, the terms are used interchangeably.

5.3

Risk preference People may be risk averse, risk neutral or risk seekers.

Definitions A risk averse investor requires compensation for risk and will avoid risk unless the expected return adequately compensates for it. If two investments have the same expected return, they would choose the one with the lowest risk. However, a risk averse decision maker may be prepared to invest in a more risky project, provided that the expected return is higher. LO 2.5

An investor is risk neutral if they are indifferent to the level of risk involved in an investment and only concerned about the expected return. A risk neutral decision maker would be indifferent between investments that offered the same expected return, regardless of the risk with each investment. A risk seeker is an investor who is attracted to risk. They would choose an investment that offers the possibility of a higher level of return, even when there is a high probability of a much lower return. For example a risk seeker might choose to invest in something that offers a 10% chance of a return of $20,000 and a 90% chance of $0 in preference to an investment that is 100% certain to provide a return of $5,000.

This has clear implications for managers and organisations. A risk seeking manager working for an organisation that is characteristically risk averse is likely to make decisions that are not congruent with the goals of the organisation. There may be a role for the management accountant here, who could be instructed to present decision-making information in such a way as to ensure that the manager considers all the possibilities, including the worst.

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Management Accounting

Case study What constitutes an acceptable amount of risk will vary from organisation to organisation. For large public companies it is largely a question of what is acceptable to the shareholders. A 'safe' investment will attract investors who are to some extent risk averse, and the company will therefore be obliged to follow relatively 'safe' policies. A company that is recognised as being an innovator or a 'growth' company in a relatively new market, like Yahoo!, will attract investors who are looking for high performance and are prepared to accept some risk in return. Such companies will be expected to make 'bolder' decisions.

LO 2.4

The risk of an individual strategy should also be considered in the context of the overall 'portfolio' of investment strategies adopted by the company. (a)

If a strategy is risky, but its outcome is not related to the outcome of other strategies, then adopting that strategy will help the company to spread its risks.

(b)

If a strategy is risky, but is inversely related to other adopted strategies, so that if strategy A does well, other adopted strategies will do badly and vice versa, then adopting strategy A would actually reduce the overall risk of the company's investment portfolio.

5.4

Scenario planning

LO 10.2

Scenario planning can be useful in providing a long-term view of a strategy, where a few key factors may influence success. It is designed to improve decision making by considering the impact of possible future situations that may occur and their likely implications. These may be favourable or unfavourable changes for the business concerned. Scenario planning can be used:



To develop contingency plans to cope with specific threats or risks e.g. the likelihood of an oil spillage for a petroleum company



As a technique to predict the possible future operating environment for the company and to identify appropriate actions e.g. a financial services company may forecast the likely impact on its business of differing states of the economy (recession, growth etc.)

Scenario planning, involves asking 'what if?' and 'what is the effect of?' questions about the future.

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Key chapter points •

A typical model for investment decision making has a number of distinct stages: – – – –



During the project's progress, project controls should be applied to ensure the following: – – –

284

Origination of proposals. Project screening. Analysis and acceptance. Monitoring and review. Capital spending does not exceed the amount authorised. The implementation of the project is not delayed. The anticipated benefits are eventually obtained.



A post audit cannot reverse the decision to incur the capital expenditure, because the expenditure has already taken place, but it does have a certain control value.



The payback method looks at how long it takes for a project's net cash inflows to equal the initial investment.



Like the payback method, the accounting rate of return method is popular despite its limitations.



An example of a risky situation is one in which we may say that there is a 70% probability that returns from a project will be in excess of $100 000 but a 30% probability that returns will be less than $100 000. If no information can be provided on the returns from the project, we are faced with an uncertain situation.



People may be risk seekers, risk neutral or risk averse.

Management Accounting

Quick revision questions 1

Mutually exclusive capital expenditure options may arise as a consequence of A B C D

2

If a machine with annual running costs of $100,000 was diverted from producing output selling for $50 000 to producing a special order worth $70,000, what would be the relevant costs of what has happened? A B C D

3

5

(I)

Estimated average annual profits × 100% Estimated average investment

(II)

Estimated total profits × 100% Estimated initial investment

(III)

Estimated average annual profits × 100% Estimated initial investment

A B C D

(I) and (II) only (I) and (III) only (II) and (III) only (I), (II) and (III)

The ARR method of investment appraisal is primarily criticised because: it does not consider the full expected life of the project depreciation rates are arbitrary when calculating profit there are different ways of calculating ARR investment is about cash returns on cash investments

Which one of the following statements is correct? A B C D

7

the project cost estimates were realistic the project implementation is not delayed there is a post-completion audit expenditures are properly authorised

Which of the following can be used to calculate the return on capital employed?

A B C D 6

$170,000 $100,000 $50,000 $20,000

Project control for a major capital expenditure project is needed to ensure that overspending on the project is avoided and: A B C D

4

capital rationing a capital budget post completion audit project control

A risk averse investor wants to avoid risk entirely. Shorter term forecasts are likely to be more reliable. Investment risk is lower if payback is longer. Earlier payback improves profitability.

Which one of the following statements is INCORRECT? A B C D

The ARR method of investment appraisal uses accounting profits before depreciation charges. The ARR method of investment appraisal ignores the time value of money. The payback method des not consider total project returns. The payback method ignores the timing of cash flows within the payback period. 10: Capital expenditure

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Answers to quick revision questions 1A

2

Any form of capital rationing means that the capital available for investment will be less than the total value of projects in which investment could be made. A choice has to be made between the projects that are competing for the scarce capital. C

$50 000 is the opportunity cost of the lost sales revenue. Options A and B are incorrect because they include the $100 000 running costs which would be incurred anyway and so are not relevant. In the absence of any further information, Option D $20 000 would be the net benefit ($70 000 – $50 000).

3

B

4

D

Project control is to keep control over costs, try to ensure that implementation is not delayed and (although this may not be practical) try to ensure that the anticipated benefits are obtained. The proper authorisation of expenditures is a necessary financial control, but this is linked to the aim of keeping costs under control and avoiding overspending.

All three could be used, although (I)

Estimated average annual profits × 100% is probably the most Estimated average investment

commonly used.

286

5

D

Investments, like short-term decision, should be assessed using relevant costs – cash flows and opportunity costs. ARR is an accounting measure that ignores cash flows, and so is very unsatisfactory as a decision making criterion.

6

B

Shorter term forecasts are likely to be more reliable than longer term forecasts, because differences between forecast and what happens can increase with time. Risk-averse investors do not wish to avoid risk entirely: investment without risk is not possible in the business world. However, for additional risk, they will expect the prospect of higher returns. Investment risk is higher when payback is longer. Early payback improves liquidity, not profitability.

7

A

The ARR method uses accounting profits, which is after deducting depreciation charges. Both the ARR and payback methods ignore the time value of money. Payback ignores cash returns after the payback point, and does not consider the timing of cash flows within the period up to payback.

Management Accounting

Answers to chapter questions 1

A Profits before depreciation should be used. Year

1 2 3 4 5

∴Payback period

Profit after depreciation $ 000 12 17 28 37 8

Depreciation $ 000 12 12 12 12 12

Profit before depreciation $ 000 24 29 40 49 20

Cumulative profit $ 000 24 53 93 142

⎛ (120 − 93) ⎞ × 12 months ⎟ = 3 years + ⎜ ⎝ (142 − 93) ⎠ = 3 years 7 months

2

A

Total profit over life of equipment Before depreciation After depreciation Average annual profit after depreciation Average investment = (capital cost + disposal value)/2 ARR

Item X $

Item Y $

Item Z $

160 000 80 000 16 000 40 000 40%

280 000 130 000 26 000 75 000 34.7%

350 000 200 000 40 000 125 000 32%

All three projects would earn a return in excess of 30%, but since item X would earn the biggest ARR, it would be preferred to item Y and item Z, even though the profits from Y would be higher by an average of $10 000 a year and the annual profit from Z would be $24 000 higher. 3

Workings: Depreciation must first be added back to the annual profit figures, to arrive at the annual cash flows. Depreciation

Initial investment $46 000 − scrap value $4 000 4 years = $10 500 pa

=

Adding $10 500 per annum to the profit figures produces the cash flows for each proposal.

Year

0 1 2 3 4 4

Annual cash flow $ (46 000) 17 000 14 000 24 000 9 000 4 000

Proposal A Cumulative cash flow $ (46 000) (29 000) (15 000) 9 000 18 000 22 000

Annual cash flow $ (46 000) 15 000 13 000 15 000 25 000 4 000

Proposal B Cumulative cash flow $ (46 000) (31 000) (18 000) (3 000) 22 000 26 000

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(a)

D ⎛ 15 000 ⎞ Proposal A payback = 2 + ⎜ ⎟ × 12 months = 2 years 8 months ⎝ 24 000 ⎠ ⎛ 3 000 ⎞ Proposal B payback = 3 + ⎜ ⎟ × 12 months = 3 years 1 month ⎝ 25 000 ⎠

(b)

A The return on capital employed (ROCE) is calculated using the accounting profits given in the question. Proposal A

Average profit

= =

$(6 500 + 3 500 + 13 500 – 1 500)/4 $22 000/4 = $5 500

Average investment = $(46 000 + 4 000)/2 = $25 000

Proposal B

(c)

ARR

=

$5 500 × 100% = 22% $25 000

Average profit

= =

$(4 500 + 2 500 + 4 500 + 14 500)/4 $26 000/4 = $6 500

ARR

=

$6 500 × 100% = 26% $25 000

D Project Y takes just over 3 years to pay back. Project X earns less than 23% return, measured as ARR. Applying the decision criteria strictly, neither proposal is acceptable.

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Chapter 11

Inventory and pricing decisions Learning objectives

Reference

Inventory, pricing decisions and cost-volume-profit analysis

LO11

Evaluate the principles of just-in-time

LO11.1

Apply the economic order quantity formula to determine order quantities for inventory management

LO11.2

Establish and apply the appropriate approach for long-term pricing decisions

LO11.3

Topic list

1 Just-in-time (JIT) systems 2 Inventory control levels 3 Pricing

289

Introduction This chapter examines two separate topics – inventory and pricing. Within the area of inventory two areas will be examined – Just-in-time systems and inventory management. In recent years there have been significant changes in the business environment in which both manufacturing and service organisations operate. Organisations have therefore adopted new management approaches and have changed their manufacturing systems. One such type of system is just-in-time (JIT) systems. The investment in inventory is a very important one for most businesses, both in terms of monetary value and relationships with customers (no inventory, no sale, loss of customer goodwill). It is therefore vital that management establish and maintain an effective inventory control system. This chapter will concentrate on a inventory control system for materials, but similar problems and considerations apply to all forms of inventory. The chapter concludes by looking at pricing. Finding the cost of a product or service means, among other things, that you have a basis for setting a selling price that will earn the business the profit it wants. Recently, however, some businesses have approached the problem from the opposite side: they have decided what the selling price should be in order for the product to sell, and then they deduct the profit they want, which leaves the target cost. In this chapter we look at methods of pricing that are based on cost, as well as target costing. Finally, there is a brief discussion on transfer pricing – this is where internal transfers of goods or services are made between different units of the same business and management must decide on the appropriate price at which such transfers should be charged.

290

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the Study Manual. 1

What is JIT?

(Section 1)

2

Explain the link between value-added costs and JIT.

(Section 1.3)

3

What are the problems associated with JIT?

(Section 1.4)

4

What are the reasons for holding inventory?

(Section 2.1.1)

5

How can the EOQ be calculated?

6

What is the EOQ formula?

7

Identify and explain four systems of stores control and reordering other than EOQ.

8

What is full-cost pricing?

(Section 3.1.1)

9

What are the four stages of the product life cycle?

(Section 3.2.1)

10

What is PED?

(Section 3.2.8)

11

What is target costing?

(Section 3.3)

12

What is transfer pricing?

(Section 3.3)

(Section 2.3) (Section 2.3.1) (Section 2.4)

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1 Just-in-time (JIT) systems 1.1

Introduction: ‘traditional’ systems of inventory management and production Section overview •

LO 11.1

JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of JIT purchasing and JIT production and results in lower investment requirements, space savings, greater customer satisfaction and increased flexibility.

‘Just-in-time’ systems (which were introduced in chapter 1, section 8) are systems of purchasing, inventory management and production planning and control that differ from so-called ‘traditional’ systems. In a traditional system, production quantities are planned to meet expected sales demand. Management try to avoid running out of inventories of raw materials and finished goods, so that the entity can meet demand for production and sales out of inventories. Inventory management therefore involved deciding what levels of inventories should be held, and in what locations. Inventory managers may therefore try to maintain inventory levels at a number of weeks’ supply. ‘Efficient’ management in a traditional system involves trying to minimise production costs through long production runs (reducing set-up time and costs). ‘Efficient’ purchasing and inventory management might involve buying materials and parts from suppliers in economic order quantities, in order to minimise the combined costs of purchase orders and holding inventory. Purchasing managers or buyers deal with immediate suppliers, but not suppliers at earlier stages in the supply chain. The general view about suppliers is that they cannot be trusted to supply the correct quantities of supplies or to supply items to the quality standards required and specified. Consequently it is necessary to check all deliveries from suppliers for quantity and quality. ‘Traditional’ responses to the problems of improving manufacturing capacity and reducing unit costs of production might therefore be described as follows: • • • •

Longer production runs. Economic batch quantities for purchasing and production runs. Fewer products in the product range. Reduced time on preventive maintenance, to keep production flowing.

In general terms, longer production runs and large batch sizes should mean less disruption, better capacity utilisation and lower unit costs.

1.2

Introduction to just-in-time Just-in-time systems challenge such ‘traditional’ views of manufacture.

Definitions Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as they are required by a customer or for use, rather than for stock. A JIT system is a pull system, which responds to demand, in contrast to a push system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales. Just-in-time production is a production system which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage. Just-in-time purchasing is a purchasing system in which material purchases are contracted so that the receipt and usage of material, to the maximum extent possible, coincide.

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Management Accounting

Just-in-time management involves trying to eliminate non-value adding activities, where costs are incurred for little or no benefit. One aspect of this is the elimination of waste, and ‘getting things right first time’. Another is the elimination of (or reduction in) inventory levels, because items held in inventory have a cost but are not earning anything. Although often described as a technique, JIT is more of a philosophy or approach to management since it encompasses a commitment to continuous improvement and the search for excellence in the design and operation of the production management system. JIT has the following essential elements: JIT purchasing

Parts and raw materials should be purchased as near as possible to the time they are needed, using small frequent deliveries against bulk contracts.

Close relationship with suppliers

In a JIT environment, the responsibility for the quality of goods lies with the supplier, who must operate within the ‘right first time’ environment that JIT operations demand. In a traditional system, deliveries from suppliers are verified for quality and quantity when they are received. With JIT there is minimal checking of deliveries, which means that there must be trust between the entity and the supplier. To achieve this, the relationship between them cannot be seen as short-term . A long-term commitment between supplier and customer should be established: the supplier is guaranteed a demand for his products since he is the sole supplier and he is able to plan to meet the customer’s production schedules. If an organisation has confidence that suppliers will deliver material of 100% quality, on time, so that there will be no rejects or returns and hence no consequent production delays, usage of materials can be matched with delivery of materials and inventories can be kept at near zero levels. Suppliers are also chosen because of their close proximity to an organisation’s plant.

Uniform loading

All parts of the productive process should be operated at a speed which matches the rate at which the final product is demanded by the customer. Production runs will therefore be shorter and there will be smaller inventories of finished goods because output is being matched more closely to demand, and so storage costs will be reduced.

Set-up time reduction

Machinery set-ups are non-value-added activities (see below) which should be reduced or even eliminated.

Machine cells

Machines or workers should be grouped by product or component instead of by the type of work performed. The non-value-added activity of materials movement between operations is therefore minimised by eliminating space between work stations. Products can flow from machine to machine without having to wait for the next stage of processing or returning to stores. Lead times and work in progress are therefore reduced.

Quality

Production management should seek to eliminate scrap and defective units during production, and to avoid the need for reworking of units since this stops the flow of production and leads to late deliveries to customers. Product quality and production quality are important ‘drivers’ in a JIT system.

Pull system (Kanban)

A Kanban, or signal, is used to ensure that products / components are only produced when needed by the next process. Nothing is produced in anticipation of need, to then remain in inventory, consuming resources. It is important to monitor usage, so that new production or supply can be arranged to meet demand. In supermarkets, for example, the sale of stores items is monitored ‘just in time’ through the use of bar codes and automatic scanners at the check-out points.

Preventative maintenance

Production systems must be reliable and prompt, without unforeseen delays and breakdowns. Machinery must be kept fully maintained, and so preventative maintenance is an important aspect of production.

Employee involvement

Workers within each machine cell should be trained to operate each machine within that cell and to be able to perform routine preventative maintenance on the cell machines, i.e. to be multiskilled and flexible.

The supply chain

Because it is important that suppliers should be able to deliver materials and parts when they are needed, it is often necessary to monitor the supply chain along its entire length, and not just to establish a close relationship with immediate suppliers. Inventory management may therefore involve monitoring supplies throughout the supply chain, and there are software systems that can help companies to do this.

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Question 1: JIT system A company is considering changing to a JIT system. Which of the following changes in their working practices are likely to be necessary? I II III IV V

More frequent revision of inventory control levels and of the economic order quantity Increase in the number of raw material suppliers in order to guarantee supply Selection of suppliers close to the company’s manufacturing facility Increased focus on the accurate forecasting of customer demand Increased quality control activity

A B C D

I and II III, IV and V II, III, IV and V all of them (The answer is at the end of the chapter)

1.3

Value added JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually being processed. While it is being inspected for quality, moving from one part of the factory to another, waiting for further processing and held in store, value is not being added. Non value-added activities, or diversionary activities, should therefore be eliminated.

Definition A value-added cost is incurred for an activity that cannot be eliminated without the customer's perceiving a deterioration in the performance, function, or other quality of a product. The cost of a picture tube in a television set is value-added.

‘The costs of those activities that can be eliminated without the customer's perceiving deterioration in the performance, function, or other quality of a product are non-value-added. The costs of handling the materials of a television set through successive stages of an assembly line may be non-value-added. Improvements in plant layout that reduce handling costs may be achieved without affecting the performance, function, or other quality of the television set.' (Horngren)

Question 2: Value-added activity Which of the following is a value-added activity? A B C D

setting up a machine so that it drills holes of a certain size repairing faulty production work painting a car, if the organisation manufactures cars storing materials (The answer is at the end of the chapter)

Case study The following extract from an article in the UK’s Financial Times illustrates how 'just-in-time' some manufacturing processes can be. 'Just-in-time manufacturing is down to a fine art at Nissan Motor Manufacturing (UK). Stockholding of some components is just ten minutes - and the holding of all parts bought in Europe is less than a day.

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Management Accounting

Nissan has moved beyond just-in-time to synchronous supply for some components, which means manufacturers deliver these components directly to the production line minutes before they are needed. These manufacturers do not even receive an order to make a component until the car for which it is intended has started along the final assembly line. Seat manufacturer Ikeda Hoover, for example, has about 45 minutes to build seats to specification and deliver them to the assembly line a mile away. It delivers 12 sets of seats every 20 minutes and they are mounted in the right order on an overhead conveyor ready for fitting to the right car. Nissan has close relationships with a dozen or so suppliers and deals exclusively with them in their component areas. It involves them and even their own suppliers in discussions about future needs and other issues. These companies have generally established their own manufacturing units close to the Nissan plant. Other parts from further afield are collected from manufacturers by Nissan several times at fixed times. This is more efficient than having each supplier making individual haulage arrangements.'

1.4

Problems associated with JIT JIT should not be seen as a panacea for all the endemic problems associated with Western manufacturing. It might not even be appropriate in all circumstances. (a)

It is not always easy to predict patterns of demand.

(b)

JIT makes the organisation far more vulnerable to disruptions in the supply chain.

(c)

JIT, originated by Toyota, was designed at a time when all of Toyota's manufacturing was done within a 50 km radius of its headquarters. Wide geographical spread, however, makes this difficult.

Case studies •

'Just-in-time works well during normal business times. Companies that once kept months of safety stock now get by with days, or even hours of materials … . But how about when your industry [high-tech] suddenly undergoes a tremendous boom, and demand far exceeds projections for parts? … Just look at cell phones. The worldwide boom in cellular phone sales wasn't exactly a surprise – sales of these units have been on a fast climb for years. Yet one distributor reports a wait of 18 months to obtain high-frequency transistors for hand held devices.' ('Just in time, or just too late?', Doug Bartholomew, Industry Week, August 2000)



The Kobe earthquake in Japan in 1995 severely disrupted industry in areas unaffected by the actual catastrophe. Plants that had not been hit by the earthquake were still forced to shut down production lines less than 24 hours after the earthquake struck because they held no buffer stocks which they could use to cover the shortfall caused by non delivery by the Kobe area suppliers.



In October 1991 the workforce at the French state-owned car maker Renault's gear-box production plant at Cléon went on strike. The day afterwards a British plant had to cease production. Within two weeks Renault was losing 60% of its usual daily output. The weaknesses were due to the following: –

Sourcing components from one plant only



Heavy dependence on in-house components



Low inventory



The fact '...that Japanese-style management techniques depend on stability in labour relations, something in short supply in the French public sector'. (Financial Times, 31 October 1991)

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Question 3: Batch sizes within a JIT manufacturing environment Batch sizes within a JIT manufacturing environment may well be smaller than those associated with traditional manufacturing systems. What costs might be associated with this feature of JIT? I

Increased set-up costs

II

Opportunity cost of lost production capacity as machinery and the workforce reorganise for a different product

III

Additional materials handling costs

IV

Increased administrative costs

A B C D

none of the above I, II, III and IV I only II and III only (The answer is at the end of the chapter)

1.5

Modern versus traditional inventory control systems There is no reason for the newer approaches to supersede the old entirely. A restaurant, for example, might find it preferable to use the traditional economic order quantity approach for staple non-perishable food items, but adopt JIT for perishable and 'exotic' items. In a hospital a stock-out could, quite literally, be fatal, and JIT would be unsuitable.

2 Inventory control levels 2.1

Inventory costs Section overview •

Inventory costs include purchase costs, holding costs, ordering costs and costs of running out inventory.

The costs of purchasing inventory are usually one of the largest costs faced by an organisation and, once obtained, inventory has to be carefully controlled and checked.

2.1.1

Reasons for holding inventories • • • • • • • •

2.1.2

To ensure sufficient goods are available to meet expected demand. To provide a buffer between processes. To meet any future shortages. To take advantage of bulk purchasing discounts. To absorb seasonal fluctuations and any variations in usage and demand. To allow production processes to flow smoothly and efficiently. As a necessary part of the production process – such as when maturing cheese. As a deliberate investment policy, especially in times of inflation or possible shortages.

Holding costs If inventories are too high, holding costs will be incurred unnecessarily. Such costs occur for a number of reasons:

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Management Accounting

2.1.3

(a)

Costs of storage and stores operations. Larger inventories require more storage space and possibly extra staff and equipment to control and handle them.

(b)

Interest charges. Holding inventories involves the tying up of capital (cash) on which interest must be paid.

(c)

Insurance costs. The larger the value of inventories held, the greater insurance premiums are likely to be.

(d)

Risk of obsolescence. The longer a inventory item is held, the greater is the risk of obsolescence.

(e)

Deterioration. When materials in store deteriorate to the extent that they are unusable, they must be thrown away with the likelihood that disposal costs would be incurred.

Costs of obtaining inventory On the other hand, if inventories are kept low, small quantities of inventory will have to be ordered more frequently, thereby increasing the following ordering or procurement costs:

2.1.4

(a)

Clerical and administrative costs associated with purchasing, accounting for and receiving goods.

(b)

Transport costs.

(c)

Production run costs, for inventory which is manufactured internally rather than purchased from external sources.

Stock out costs (running out of inventory) An additional type of cost which may arise if inventory are kept too low is the type associated with running out of inventory. There are a number of causes of stockout costs: • • • • • •

2.1.5

Lost contribution from lost sales. Loss of future sales due to disgruntled customers. Loss of customer goodwill. Cost of production stoppages. Labour frustration over stoppages. Extra costs of urgent, small quantity, replenishment orders.

Objective of inventory control The overall objective of inventory control is, therefore, to maintain inventory levels so that the total of the following costs is minimised. • • •

2.2

Holding costs. Stock out costs. Ordering costs.

Inventory control levels Section overview •

Inventory control levels can be calculated in order to maintain inventories at the optimum level. The three critical control levels are reorder level, minimum level and maximum level.

Based on an analysis of past inventory usage and delivery times, inventory control levels can be calculated and used to maintain inventory at their optimum level (in other words, a level which minimises costs). These levels will determine 'when to order' and 'how many to order'.

2.2.1

Reorder level When inventories reach this level, an order should be placed to replenish inventories. The reorder level is determined by consideration of the following:

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• •

The maximum rate of consumption The maximum lead time

The maximum lead time is the time between placing an order with a supplier, and the inventory becoming available for use.

Formula to learn Reorder level = maximum usage x maximum lead time

2.2.2

Minimum level This is a warning level to draw management attention to the fact that inventories are approaching a dangerously low level and that stockouts are possible.

Formula to learn Minimum level = reorder level – (average usage × average lead time)

2.2.3

Maximum level This also acts as a warning level to signal to management that inventories are reaching a potentially wasteful level.

Formula to learn Maximum level = reorder level + reorder quantity – (minimum usage × minimum lead time)

Question 4: Maximum inventory level A large retailer with multiple outlets maintains a central warehouse from which the outlets are supplied. The following information is available for Part Number SF525. Average usage Minimum usage Maximum usage Lead time for replenishment Re-order quantity Re-order level (a)

Based on the data above, what is the maximum level of inventory? A B C D

(b)

350 per day 180 per day 420 per day 11-15 days 6,500 units 6,300 units

5,250 6,500 10,820 12,800

Based on the data above, what is the approximate number of Part Number SF525 carried as buffer inventory? A B C D

200 720 1,680 1,750 (The answer is at the end of the chapter)

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2.2.4

Reorder quantity This is the quantity of inventory which is to be ordered when inventory reaches the reorder level. If it is set so as to minimise the total costs associated with holding and ordering inventory, then it is known as the economic order quantity.

2.2.5

Average inventory The formula for the average inventory level assumes that inventory levels fluctuate evenly between the minimum (or safety) inventory level and the highest possible inventory level (the amount of inventory immediately after an order is received, i.e. safety inventory + reorder quantity).

Formula to learn Average inventory = safety inventory + ½ reorder quantity

Question 5: Average inventory A component has a safety inventory of 500, a re-order quantity of 3 000 and a rate of demand which varies between 200 and 700 per week. The average inventory is approximately: A 2,000

B 2,300

C 2,500

D 3,500 (The answer is at the end of the chapter)

2.3

Economic order quantity (EOQ) Section overview

LO 11.2



The economic order quantity (EOQ) is the order quantity which minimises inventory costs. The EOQ can be calculated using a table, graph or formula.



There are a number of other systems of stores control and recording, such as order cycling, twobin system, classification and Pareto distribution.

Economic order theory assumes that the average inventory held is equal to one half of the reorder quantity. Although, as we saw in the last section, if an organisation maintains some sort of buffer or safety inventory then average inventory = buffer inventory + half of the reorder quantity. We have seen that there are certain costs associated with holding inventory. These costs tend to increase with the level of inventories, and so could be reduced by ordering smaller amounts from suppliers each time. On the other hand, as we have seen, there are costs associated with ordering from suppliers: documentation, telephone calls, payment of invoices, receiving goods into stores and so on. These costs tend to increase if small orders are placed, because a larger number of orders would then be needed for a given annual demand.

Worked Example: Economic order quantity Suppose a company purchases raw material at a cost of $16 per unit. The annual demand for the raw material is 25 000 units. The holding cost per unit is $6.40 and the cost of placing an order is $32. We can tabulate the annual relevant costs for various order quantities as follows: Order quantity (units) 100 200 300 400 500 600 Average inventory (units) (a) 50 100 150 200 250 300 Number of orders (b) 250 125 83 63 50 42 $ $ $ $ $ $ Annual holding cost (c) 320 640 960 1 280 1 600 1 920 Annual order cost (d) 8 000 4 000 2 656 2 016 1 600 1 344 Total relevant cost 8 320 4 640 3 616 3 296 3 200 3 264

800 400 31 $ 2 560 992 3 552

1 000 500 25 $ 3 200 800 4 000

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Notes (a) (b) (c) (d)

Average inventory = order quantity ÷ 2 (i.e. assuming no safety inventory) Number of orders = annual demand ÷ order quantity Annual holding cost = average inventory × $6.40 Annual order cost = number of orders × $32

You will see that the economic order quantity is 500 units. At this point the total annual relevant costs are at a minimum.

Worked Example: Economic order quantity graph We can present the information tabulated in Paragraph 2.3.1 in graphical form. The vertical axis represents the relevant annual costs for the investment in inventories, and the horizontal axis can be used to represent either the various order quantities or the average inventory levels; two scales are actually shown on the horizontal axis so that both items can be incorporated. The graph shows that, as the average inventory level and order quantity increase, the holding cost increases. On the other hand, the ordering costs decline as inventory levels and order quantities increase. The total cost line represents the sum of both the holding and the ordering costs.

Note that the total cost line is at a minimum for an order quantity of 500 units and occurs at the point where the ordering cost curve and holding cost curve intersect. The EOQ is therefore found at the point where holding costs equal ordering costs.

2.3.1

EOQ formula Formula to learn EOQ =

where CH CO D

300

2C D 0 C H = = =

cost of holding one unit of inventory for one time period cost of ordering a consignment from a supplier demand during the time period

Management Accounting

Question 6: EOQ Calculate the EOQ using the formula and the information in Paragraph 2.3. (The answer is at the end of the chapter)

Question 7: EOQ and holding costs A manufacturing company uses 25 000 components at an even rate during a year. Each order placed with the supplier of the components is for 2 000 components, which is the economic order quantity. The company holds a buffer inventory of 500 components. The annual cost of holding one component in inventory is $2. What is the total annual cost of holding inventory of the component? A B C D

$2,000 $2,500 $3,000 $4,000 (The answer is at the end of the chapter)

2.4 2.4.1

Other systems of stores control and reordering Order cycling method Under the order cycling method, quantities on hand of each stores item are reviewed periodically (every 1, 2 or 3 months). For low-cost items, a technique called the 90-60-30 day technique can be used, so that when inventories fall to 60 days' supply, a fresh order is placed for a 30 days' supply so as to boost inventories to 90 days' supply. For high-cost items, a more stringent stores control procedure is advisable so as to keep down the costs of inventory holding.

2.4.2

Two-bin system The two-bin system of stores control, or visual method of control, is one whereby each stores item is kept in two storage bins. When the first bin is emptied, an order must be placed for re-supply; the second bin will contain sufficient quantities to last until the fresh delivery is received. This is a simple system which is not costly to operate but it is not based on any formal analysis of inventory usage and may result in the holding of too much or too little inventory.

2.4.3

Classification of materials Materials items may be classified as expensive, inexpensive or in a middle-cost range. Because of the practical advantages of simplifying stores control procedures without incurring unnecessary high costs, it may be possible to segregate materials for selective stores control.

(a)

Expensive and medium-cost materials are subject to careful stores control procedures to minimise cost.

(b)

Inexpensive materials can be stored in large quantities because the cost savings from careful stores control do not justify the administrative effort required to implement the control.

This selective approach to stores control is sometimes called the ABC method whereby materials are classified A, B or C according to their expense-group: A being the expensive, group B the medium-cost and group C the inexpensive materials.

2.4.4

Pareto (80/20) distribution A similar selective approach to stores control is the Pareto (80/20) distribution which is based on the finding that in many stores, 80% of the value of stores is accounted for by only 20% of the stores items, and inventories of these more expensive items should be controlled more closely.

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3 Pricing 3.1

Cost-based approaches to pricing Section overview •

3.1.1

Many firms base price on simple cost-plus rules.

Full cost-plus pricing Definition Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit.

In practice cost is one of the most important influences on price. Many firms base price on simple cost-plus rules (costs are estimated and then a mark-up is added in order to set the price). A traditional approach to pricing is full cost-plus pricing. The 'full cost' may be a fully absorbed production cost only, or it may include some absorbed administration, selling and distribution overhead. A business might have an idea of the percentage profit margin it would like to earn, and so might decide on an average profit mark-up as a general guideline for pricing decisions. This would be particularly useful for businesses that carry out a large amount of contract work or jobbing work, for which individual job or contract prices must be quoted regularly to prospective customers. However, the percentage profit mark-up does not have to be rigid and fixed, but can be varied to suit the circumstances. In particular, the percentage mark-up can be varied to suit demand conditions in the market.

Question 8: Full cost A product's full cost is $4.70 and is sold at full cost plus 70%. What is the selling price? (The answer is at the end of the chapter)

Worked Example: Full cost-plus pricing Markup has begun to produce a new product, Product X, for which the following cost estimates have been made: $ Direct materials 27 Direct labour: 4 hrs at $5 per hour 20 Variable production overheads: machining, ½ hr at $6 per hour 3 50 Fixed production overheads are budgeted at $300,000 per month and, because of the shortage of available machining capacity, the company will be restricted to 10,000 hours of machine time per month. The absorption rate will be a direct labour rate, however, and budgeted direct labour hours are 25,000 per month. The company wishes to make a profit of 20% on full production cost from product X. What is the full cost-plus based price?

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Solution

$ 27.00 20.00 3.00

Direct materials Direct labour (4 hours) Variable production overheads Fixed production overheads $300 000 (at = $12 per direct labour hour) 25 000 Full production cost Profit mark-up (20%) Selling price per unit of product X

48.00 98.00 19.60 117.60

There are several serious problems with relying on a full cost approach to pricing: (a)

It fails to recognise that demand may be determining price. For many products, the price set will determine the quantity sold. The price we set using this method may not lead to selling the quantity that gives us the biggest profit. In other words, the price we set might not be competitive.

(b)

There may be a need to adjust prices to market and demand conditions.

(c)

Budgeted output volume needs to be established. Output volume is a key factor in the overhead absorption rate.

(d)

A suitable basis for overhead absorption must be selected, especially where a business produces more than one product.

However, it is a quick, simple and cheap method of pricing which can be delegated to junior managers, which is particularly important with jobbing work where many prices must be decided and quoted each day and, since the size of the profit margin can be varied, a decision based on a price in excess of full cost should ensure that a company working at normal capacity will cover all of its fixed costs and make a profit.

3.1.2

Marginal cost-plus pricing Definition Marginal cost-plus pricing/mark-up pricing is a method of determining the sales price by adding a profit margin on to either marginal cost of production or marginal cost of sales.

Whereas a full cost-plus approach to pricing draws attention to net profit and the net profit margin, a variable cost-plus approach to pricing draws attention to gross profit and the gross profit margin, or contribution.

Question 9: Mark up on cost A product has the following costs: Direct materials Direct labour Production variable overheads Sales variable overheads

$ 5 3 7 2

Fixed overheads are $10 000 per month. Budgeted sales per month are 400 units. What is the mark up on marginal cost if the selling price is $20? A

15%

B

17.6%

C

25%

D

33.3% (The answer is at the end of the chapter)

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There are several advantages of a marginal cost-plus approach to pricing: (a)

It is a simple and easy method to use.

(b)

The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect demand conditions.

(c)

It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. In this way, it helps to create a better awareness of the concepts and implications of marginal costing and cost-volume-profit analysis. For example, if a product costs $10 per unit and a mark-up of 150% is added to reach a price of $25 per unit, management should be clearly aware that every additional $1 of sales revenue would add 60 cents to contribution and profit.

(d)

In practice, mark-up pricing is used in businesses where there is a readily-identifiable basic variable cost. Retail industries are the most obvious example, and it is quite common for the prices of goods in shops to be fixed by adding a mark-up (20% or 33.3%, say) to the purchase cost.

There are, of course, drawbacks to marginal cost-plus pricing:

3.1.3

(a)

Although the size of the mark-up can be varied in accordance with demand conditions, it does not ensure that sufficient attention is paid to demand conditions, competitors' prices and profit maximisation.

(b)

It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to ensure that a profit is made after covering fixed costs.

Cost-plus pricing and stock valuation Many retail businesses price their goods by applying a fixed mark up to their cost. When it comes to stocktaking, it is therefore very convenient to take the selling price of the goods as shown on the price ticket or the price list, and deduct the profit element to arrive at the cost of the goods for stock valuation purposes.

3.2

Market-based approaches to pricing Section overview •

3.2.1 LO 11.3

Many firms base price on what consumers demand rather than simple cost-plus rules.

Product life cycle The product life concept is relevant to pricing policy. The concept states that a typical product moves through four stages: (a)

Introduction

The product is introduced to the market. Heavy capital expenditure will be incurred on product development and perhaps also on the purchase of new non-current assets and building up stocks for sale. On its introduction to the market, the product will begin to earn some revenue, but initially demand is likely to be small. 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. (b)

Growth

The product gains a bigger market as demand builds up. Sales revenues increase and the product begins to make a profit. The initial costs of the investment in the new product are gradually recovered. (c)

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.

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Management Accounting

(d)

Saturation and decline

At some stage, the market may reach 'saturation point'. Demand will start to fall. For a while, the product will still be profitable in spite of declining sales, but eventually it will become a loss-maker and this is the time when the organisation should decide to stop selling the product or service, and so the product's life cycle should reach its end. Remember, however, that some mature products may never decline: staple food products such as milk or bread are the best example. Not all products follow this cycle, but it remains a useful tool when considering decisions such as pricing. The life cycle concept is relevant when considering what pricing policy will be adopted.

3.2.2

Markets The price that an organisation can charge for its products will also be influenced by the market in which it operates.

Definitions Perfect competition: many buyers and many sellers all dealing in an identical product. Neither producer nor user has any market power and both must accept the prevailing market price. Monopoly: one seller who dominates many buyers. The monopolist can use this market power to set a profit-maximising price. Oligopoly: relatively few competitive companies dominate the market. While each large firm has the ability to influence market prices, the unpredictable reaction from the other giants makes the final industry price indeterminate.

3.2.3

Competition In established industries dominated by a few major firms, a price initiative by one firm will usually be countered by a price reaction by competitors. In these circumstances, prices tend to be stable. If a rival cuts its prices in the expectation of increasing its market share, a firm has several options:

3.2.4

(a)

It will maintain its existing prices if the expectation is that only a small market share would be lost, so that it is more profitable to keep prices at their existing level. Eventually, the rival firm may drop out of the market or be forced to raise its prices.

(b)

It may maintain its prices but respond with a non-price counter-attack. This is a more positive response, because the firm will be securing or justifying its current prices with a product change, advertising, or better back-up services.

(c)

It may reduce its prices. This should protect the firm's market share so that the main beneficiary from the price reduction will be the consumer.

(d)

It may raise its prices and respond with a non-price counter-attack. The extra revenue from the higher prices might be used to finance an advertising campaign or product design changes. A price increase would be based on a campaign to emphasise the quality difference between the firm's own product and the rival's product.

Price leadership Given that price competition can have disastrous consequences in conditions of oligopoly, it is not unusual to find that large corporations emerge as price leaders. The price leader indicates to the other firms in the market what the price will be, and competitors then set their prices with reference to the leader's price.

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3.2.5

Market penetration pricing This is a policy of low prices when the product is first launched in order to obtain sufficient penetration into the market. A penetration policy may be appropriate:

3.2.6



If the firm wishes to discourage new entrants into the market.



If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.



If there are significant economies of scale to be achieved from a high volume of output, so that quick penetration into the market is desirable in order to gain unit cost reductions.



If demand is likely to increase as prices fall.

Market skimming pricing In contrast, market skimming involves charging high prices when a product is first launched and spending heavily on advertising and sales promotion to obtain sales. As the product moves into the later stages of its life cycle (growth, maturity and decline) progressively lower prices will be charged. The profitable 'cream' is therefore skimmed off in stages until sales can only be sustained at lower prices. The aim of market skimming is to gain high unit profits early in the product's life. High unit prices make it more likely that competitors will enter the market than if lower prices were to be charged. Such a policy is appropriate:

3.2.7



Where the product is new and different, so that customers are prepared to pay high prices so as to be one up on other people who do not own it. Games systems are a good example.



Where the strength of demand and the sensitivity of demand to price are unknown. It is better from the point of view of marketing to start by charging high prices and then reduce them if the demand is insufficient.



Where products may have a short life cycle, and so need to recover their development costs and make a profit quickly.

Differential pricing In certain circumstances the same product can be sold at different prices to different customers. There are a number of bases on which such prices can be set.

3.2.8

Basis

Example

By market segment

A cross-Tasman airline would market its services at different prices in Australia and New Zealand, for example. Services such as cinemas and hairdressers are often available at lower prices to senior citizens and/or juveniles.

By product version

Many car models have 'add on' extras which enable one brand to appeal to a wider cross-section of customers. The final price need not reflect the cost price of the add on extras directly: usually the top of the range model would carry a price much in excess of the cost of provision of the extras, as a prestige appeal.

By place

Theatre seats are usually sold according to their location so that patrons pay different prices for the same performance according to the seat type they occupy.

By time

This is perhaps the most popular type of price discrimination. Railway companies, for example, are successful price discriminators, charging more to rush hour rail commuters whose demand remains the same whatever the price charged at certain times of the day.

Price and the price elasticity of demand Economists argue that the higher the price of a good, the lower will be the quantity demanded. We have already seen that in practice it is by no means as straightforward as this (some goods are bought because they are expensive, for example), but you know from your personal experience as a consumer that the theory is essentially true. An important concept in this context is price elasticity of demand (PED).

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Management Accounting

Definition The price elasticity of demand (η) measures the extent of change in demand for a good following a change to its price.

Formula to learn Price elasticity (η) is measured as:

% change in sales demand % change in sales price

Demand is said to be elastic when a small change in the price produces a large change in the quantity demanded. The PED is then greater than 1. Demand is said to be inelastic when a small change in the price produces only a small change in the quantity demanded. The PED is then less than 1. There are two special values of price elasticity of demand: •

Demand is perfectly inelastic (η = 0). There is no change in quantity demanded, regardless of the change in price.



Demand is perfectly elastic (η = ∞). Consumers will want to buy an infinite amount, but only up to a particular price level. Any price increase above this level will reduce demand to zero.

An awareness of the concept of elasticity can assist management with pricing decisions.

3.2.9



In circumstances of inelastic demand, prices should be increased because revenues will increase and total costs will reduce (because quantities sold will reduce).



In circumstances of elastic demand, increases in prices will bring decreases in revenue and decreases in price will bring increases in revenue. Management therefore have to decide whether the increase/decrease in costs will be less than/greater than the increases/decreases in revenue.



In situations of very elastic demand, overpricing can lead to a massive drop in quantity sold and hence a massive drop in profits, whereas underpricing can lead to costly stock outs and, again, a significant drop in profits. Elasticity must therefore be reduced by creating a customer preference which is unrelated to price (through advertising and promotional activities).



In situations of very inelastic demand, customers are not sensitive to price. Quality, service, product mix and location are therefore more important to a firm's pricing strategy.

The demand-based approach to pricing Price theory or demand theory is based on the idea that a connection can be made between price, quantity demanded and sold, and total revenue. Demand varies with price, and so if an estimate can be made of demand at different price levels, it should be possible to derive either a profit-maximising price or a revenue-maximising price.

The theory is dependent on realistic estimates of demand being made at different price levels. Making accurate estimates of demand is often difficult as price is only one of many variables that influence demand. Some larger organisations go to considerable effort to estimate the demand for their products or services at differing price levels by producing estimated demand curves. For example, a large transport authority might be considering an increase in bus fares or underground fares. The effect on total revenues and profit of the increase in fares could be estimated from a knowledge of the demand for transport services at different price levels. If an increase in the price per ticket caused a large fall in demand, because demand was price elastic, total revenues and profits would fall whereas a fares increase when demand is price inelastic would boost total revenue, and since a transport authority's costs are largely fixed, this would probably boost total profits too.

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Many businesses enjoy something akin to a monopoly position, even in a competitive market. This is because they develop a unique marketing mix, for example, a unique combination of price and quality. The significance of a monopoly situation is: (a)

The business does not have to 'follow the market' on price. In other words it is not a 'price-taker', but has more choice and flexibility in the prices it sets. (i) (ii)

(b)

3.3

At higher prices, demand for its products or services will be less. At lower prices, demand for its products or services will be higher.

There will be a selling price at which the business can maximise its profits.

Target costing Section overview

3.3.1



Target costing requires managers to change the way they think about the relationship between cost, price and profit. The traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price (probably based on cost), with a resulting profit or loss.



The target costing approach is to develop a product concept and then to determine the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price, leaving a figure that represents total cost. This is the target cost.

The target costing approach Japanese companies developed target costing as a response to the problem of controlling and reducing costs over the entire product life cycle, but especially during the design and development stages. It has been used successfully by car manufacturers in particular, including Toyota and Mercedes Benz. Target costing requires managers to change the way they think about the relationship between cost, price and profit. The traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price, probably based on cost, with a resulting profit or loss. Costs are controlled through variance analysis at monthly intervals. The target costing approach is to develop a product concept and the primary specifications for performance and design and then to determine the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price, leaving a figure that represents total cost. This is the target cost. The product must be capable of being produced for this amount otherwise it will not be manufactured. During the product's life the target cost will be continuously reviewed and reduced so that the price can fall. Continuous cost reduction techniques must therefore be used.

3.3.2

Achieving the target cost If the anticipated product cost, based on the design specifications is above the target cost, the product must be modified so that it is cheaper to produce. The total target cost can be split into broad cost categories such as development, marketing, manufacturing and so on. A team of designers, engineers, marketing and production staff, as well as the management accountant, should then endeavour to produce a product with planned development, marketing, manufacturing (and so on) costs below the target costs. If any of the target costs cannot be achieved given the product design, other individual targets must be reduced, the product redesigned yet again or scrapped.

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Management Accounting

3.3.3

Transfer pricing Section overview •

Where internal transfers of goods or services are made between different units of the same business, management must decide on the appropriate price at which such transfers should be charged.



Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the divisional performance measurement or discouraging overall profit maximisation.

Definition A transfer price is the price at which goods or services are transferred between different units of the same company…. The extent to which the transfer price covers costs and contributes to (internal) profit is a matter of policy. When there are transfers of goods or services between divisions, the transfers could be made free to the division receiving the benefits. For example, if a garage and car showroom has two divisions, one for car repairs and servicing and the other for car sales, the servicing division will be required to service cars before they are sold. The servicing division could do the work without making any record of the work done. However, unless the cost or value of such work is recorded, management cannot keep a check on the amount of resources, such as time, that has been required for new car servicing. For planning and control purposes, it is necessary that some record of inter-divisional services or transfers of goods should be kept. Inter-divisional work can be given a cost or charge, and this is its transfer price. The transfer price is revenue to the division providing the goods or service, and a cost to the division receiving the benefit.

3.3.4

Profit centres and transfer pricing An organisation might be divided into a number of profit centres. The manager of each profit centre is required to make a profit from the activities for which he or she is responsible, and the performance of the centre is measured in terms of profit. A profit centre might be a division within the company, or a separate subsidiary company within the group. The activities of a profit centre might be fairly autonomous, and separate from the activities of other profit centres within the organisation. Alternatively, the activities of profit centres might be fairly closely interrelated, with some profit centres providing products or services to others. When one profit centre provides products or services to another profit centre, its manager will expect to make a profit from these transactions, and so will charge the other profit centre a price for the work that is in excess of the costs it incurred. An issue that arises in such situations is how to fix a price for the work that is acceptable to both profit centres.

Worked Example: Transfer pricing Suppose that profit centre A supplies goods to profit centre B, and the cost to profit centre A is, say, $10 000. Any price in excess of $10 000 will result in a profit for profit centre A. Now suppose that profit centre B then re-sells the goods for $18 000 without doing any further work on them. (a)

The total profit to the company is $8 000 ($18 000 – $10 000).

(b)

If the price charged by profit centre A to profit centre B is $12,000, profit centre A will make a profit of $2 000 ($12 000 – $10 000) and profit centre B will make a profit of $6 000 ($18 000 – $12 000).

(c)

If the price charged by profit centre A to profit centre B is $17 000, profit centre A will make a profit of $7 000 ($17 000 – $10 000) and profit centre B will make a profit of $1 000 ($18 000 – $17 000).

The overall profit is the same, whatever price profit centre A charges to profit centre B, but the price charged affects the share of the total profit enjoyed by each profit centre.

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The purpose of having a profit centre organisation is to provide an incentive for improving profitability within each part of the organisation. However, setting prices for work done by one profit centre for another is a potential source of disagreement, since profit centres can improve their profits at the expense of another, by charging higher prices. In theory since the transfer price represents a cost to one party and income to the other, overall corporate profits should be the same regardless of the transfer price. In practice however, the transfer pricing policy has behavioural implications, which may cause managers to take decisions in the interests of their profit centre but which reduce the profits of the organisation as a whole. For example, if profit centre A charges $18,000 or more, B will not be encouraged to take the transfer despite it being worthwhile for the company as a whole. This will lead to unused capacity.

3.3.5

Bases for setting a transfer price A transfer price may be: (a)

Market based (i) (ii)

(b)

Cost based (i) (ii) (iii)

(c)

310

full market price discounted market price marginal cost full cost cost-plus (based on either marginal or full cost with a profit margin)

Negotiated

Management Accounting

Key chapter points •

JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of JIT purchasing and JIT production and results in lower investment requirements, space savings, greater customer satisfaction and increased flexibility.



JIT aims to eliminate all non-value-added costs.



Inventory costs include purchase costs, holding costs, ordering costs and costs of running out inventory.



Inventory control levels can be calculated in order to maintain inventories at the optimum level. The three critical control levels are reorder level, minimum level and maximum level.



The economic order quantity (EOQ) is the order quantity which minimises inventory costs. The EOQ can be calculated using a table, graph or formula.



There are a number of other systems of stores control and reordering, such as order cycling, twobin, classification and Pareto distribution.





Under the order cycling method, quantities on hand of each stores item are reviewed periodically.



The two-bin system of stores control, or visual method of control, is one whereby each stores item is kept in two storage bins.



Materials items may be classified as expensive, inexpensive or in a middle-cost range.



Pareto (80/20) distribution which is based on the finding that in many stores, 80% of the value of stores is accounted for by only 20% of the stores items.

Many firms base price on simple cost-plus rules. –

Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit.



Marginal cost-plus pricing/mark-up pricing is a method of determining the sales price by adding a profit margin on to either marginal cost of production or marginal cost of sales.



Many firms base price on what consumers demand rather than simple cost-plus rules.



Target costing requires managers to change the way they think about the relationship between cost, price and profit. The traditional approach is to develop a product, determine the expected standard production cost of that product and then set a selling price (probably based on cost), with a resulting profit or loss.



The target costing approach is to develop a product concept and then to determine the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price, leaving a figure that represents total cost. This is the target cost.



Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the divisional performance measurement or discouraging overall corporate profit maximisation.



Transfer prices may be based on market price where there is a market.

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Quick revision questions 1

Features of a Just-in-Time production system include: A B C D

2

3

longer production runs producing only to meet known customer demand more movement of materials within the production area less preventive maintenance work

Which of the following may be reasons for holding inventory? (I)

To take advantage of bulk purchase discounts

(II)

To smooth out production volumes when sales demand is seasonal

(III)

When the production process is very long.

A

(I) and (II) only

B

(I) and (III) only

C

(II) and (III) only

D

(I), (II) and (III)

A company determines its order quantity for a raw material by using the Economic Order Quantity (EOQ) model. What would be the effects on the EOQ and the total annual holding cost of a decrease in the cost of ordering a batch of raw material? A B C D

4

5

Total annual holding cost Lower Higher Lower Higher

Which one of the following statements is correct? A

For differential pricing to succeed, it must be possible to keep the different price markets segregated.

B

Cost plus pricing is a pricing method to ensure maximum profits.

C

Marginal cost plus pricing is more appropriate when marginal costs are a small proportion of total costs.

D

Market skimming pricing is appropriate if a small cut in the selling price of the product will lead to a large increase in the quantity demanded.

At which stage of a product’s life cycle are profits the lowest? A B C D

312

EOQ Higher Higher Lower Lower

Introduction Growth Saturation and decline It could be any of these.

Management Accounting

6

Which of the following statements regarding transfer pricing is/are correct? I II

Negotiated transfer prices will always maximise total profit. Market based transfer prices will always encourage internal transfers.

A B C D

I only II only I and II Neither I nor II

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Answers to quick revision questions

314

1

B

Features of JIT production systems are shorter production runs, more preventive maintenance work (to prevent production hold-ups) and less movement of materials within the production area (with production based around work cells). The organisation produces only to meet known customer demand.

2

D

To take advantage of bulk purchase discounts, it may be necessary to buy larger quantities, but the cost of holding more inventory is justified by the saving in purchase costs. When sales demand is seasonal, a manufacturer may schedule even production flows through the year (to reduce overtime costs, avoid excessive production capacity, etc) and this means building up inventories during the low sales seasons. When the production process is long, for example in wine-making, it is necessary to hold large quantities of work-in-progress.

3

C

If there is a decrease in the cost of ordering a batch of raw material, then the EOQ will also be lower (as the numerator in the EOQ equation will be lower). If the EOQ is lower, then average inventory held (EOQ/2) with also be lower and therefore the total annual holding costs will also be lower.

4

A

Market skimming pricing is appropriate when customers will pay high prices to own a new product. Cost plus pricing cannot ensure maximum profits, because profitability depends on sales demand. Marginal cost plus pricing is more appropriate when marginal costs are a large proportion of total costs, for example in retailing. For differential pricing to succeed, it must be possible to keep the different price markets segregated: for example separate prices for children and people over 70. Unless the markets can be kept segregated, customers will buy in the lower-priced market and re-sell in the higher-priced market, or will move to the lowerpriced market to buy the product or service.

5

D

Net profits are revenues minus costs. In the introductory stage, high prices can be charged, but fixed costs may be high and development costs may be charged against profits. In the growth phase, sales volume is rising, but prices are falling and additional capital investment may add to total costs. In the saturation and decline phase, sales volumes and probably also prices are falling, and losses may be incurred. So for a given product, any of these phases of the life cycle could be the least profitable.

6

D

Negotiated transfer prices may result in maximum profit and market-based transfer prices may encourage internal transfers, but not ‘always’.

Management Accounting

Answers to chapter questions 1

B

Revision of stock controls levels would not be necessary (I) because the control level system would be abandoned completely. Parts and raw materials would be purchased in small frequent deliveries against bulk contracts. II is not correct because the number of suppliers would be reduced in a JIT environment. There may be a long-term commitment to a single supplier. III is correct. Suppliers may be chosen because of their close proximity so that they can respond quickly to changes in the company’s demands. IV is correct. Accurate forecasting of demand reduces the need for inventories. V is correct. Production management will aim to eliminate the occurrence of rejects and defective materials since these situations stop the flow of production.

2

C

The other activities are non-value-adding activities.

3

B

All are potential limitations of JIT systems. Smaller batch sizes mean more batch production runs. This results in higher set-up costs, administration costs and materials handling costs. There is also more non-productive time spent getting ready for the next batch; therefore an opportunity cost of productive labour is also incurred.

4

(a)

Maximum inventory level = reorder level + reorder quantity – (min usage × min lead time) = 6 300 + 6 500 – (180 × 11) = 10 820

C

Using good MCQ technique, if you were resorting to a guess you should have eliminated option A. The maximum inventory level cannot be less than the reorder quantity. (b) D

Buffer inventory = minimum level Minimum level

= reorder level – (average usage × average lead time) = 6 300 – (350 × 13) = 1 750

Option A could again be easily eliminated. With minimum usage of 180 per day, a buffer inventory of only 200 would not be much of a buffer! 5

A

Average inventory

= safety inventory + ½ reorder quantity = 500 + (0.5 × 3 000) = 2 000

6

Average inventory = Buffer inventory + EOQ/2 Total holding costs = [Buffer inventory + (EOQ/2)] x Annual holding cost per component EOQ = = =

7

C

2 × $32 × 25 000 $6.40

250 000 500 units

[Buffer inventory + (EOQ/2)] x Annual holding cost per component = [500 + (2 000/2)] x $2 = $3 000

8

$7.99 ($4.70 × 170%)

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9

B

Selling price Marginal (variable) cost (5 + 3 + 7 + 2)

Mark up

=

Profit × 100% Marginal cost

=

3 × 100% 17

= 17.6% Note that the fixed overheads are not included in marginal cost.

316

Management Accounting

$ 20 17 3

Chapter 12

Performance measurement and evaluation

Learning objectives

Reference

Performance measurement and evaluation

LO12

Explain the characteristics and purpose of performance measurement systems

LO12.2

Analyse the different types of financial performance measures and their limitations

LO12.3

Describe the key characteristics of the Balanced Scorecard and its advantages over traditional performance measurement systems

LO12.4

Outline the characteristics of reward systems and the circumstances in which they can be tied to performance measures

LO12.5

Internal control

LO1

Identify and explain appropriate internal controls for management and accounting systems in a range of situations

LO1.7

Topic list

1 2 3 4 5 6

Responsibility centres Investigating variances Control action Performance measures The balanced scorecard Reward systems

317

Introduction In Chapter 9 we learnt the mechanics of calculating variances and preparing operating statements. But, for the purposes of operating a budgetary control system, this is not the end of the matter. The information must be given to the people responsible for the parts of the organisation that are experiencing variances, so that they can take action to bring the situation under control. A system which gives this responsibility to managers is known as responsibility accounting. Variances provide one way of highlighting a possible problem area to managers, and is therefore a type of performance indicator. We will have a look at other performance indicators, which can be used to monitor the performance of individual departments in the organisation and the organisation as a whole. The chapter then moves on to a discussion about the key characteristics of the balanced scorecard and its advantages over traditional performance measurement systems. Finally, we consider reward systems.

318

Management Accounting

Before you begin If you have studied these topics before, you may wonder whether you need to study this chapter in full. If this is the case, please attempt the questions below, which cover some of the key subjects in the area. If you answer all these questions successfully, you probably have a reasonably detailed knowledge of the subject matter, but you should still skim through the chapter to ensure that you are familiar with everything covered. There are references in brackets indicating where in the chapter you can find the information, and you will also find a commentary at the back of the study manual. 1

What is a responsibility centre?

(Section 1)

2

What factors should be considered when deciding whether or not to investigate the reasons for the occurrence of a particular variance?

(Section 2)

3

Why might a variance arise?

(Section 3)

4

Give examples of performance measures

5

Explain how indices can be used to measure activity within an organisation?

(Section 4.4.3)

6

Outline performance measures for an investment centre

(Section 4.10)

7

What are the four perspectives of the balanced scorecard?

(Section 5.1)

8

What are the limitations of using the balanced scorecard?

(Section 5.2)

9

Define the term ‘reward’.

(Section 4.1)

(Section 6)

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1 Responsibility centres Section overview •

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organisation.



A responsibility centre is a function or department of an organisation that is headed by a manager who has direct responsibility for its performance. There are a number of different bases for control: –

A cost centre is any unit of an organisation to which costs can be separately attributed.



A profit centre is any unit of an organisation to which both revenues and costs are assigned, so that the profitability of the unit may be measured.



An investment centre is a profit centre whose performance is measured by its return on capital employed.

Definitions Responsibility accounting is a system of accounting that makes revenues, costs and assets the responsibility of particular managers so that the performance of each part of the organisation can be monitored and assessed. A responsibility centre is a section of an organisation that is headed by a manager who has direct responsibility for its performance.

LO 12.2

A budget will be prepared for each responsibility centre, and its manager will be responsible for achieving the budget targets of that centre. The performance of the centre will be monitored, and the manger will be expected to take appropriate action if there are significant variances or other targets are not met. Responsibility centres are usually divided into different categories. Here we shall describe cost (expense), revenue, profit and investment centres.

1.1

Cost centres Definition A cost, or expense, centre is any part of an organisation which incurs costs.

Cost centres can be quite small, sometimes one person or one machine or one expenditure item. They can also be quite big, for example, an entire department. An organisation might establish a hierarchy of cost centres. For example, within a transport department, individual vehicles might each be made a cost centre, the repairs and maintenance section might be a cost centre, there might be cost centres for expenditure items such as rent or building depreciation on the vehicle depots, vehicle insurance and road tax. The transport department as a whole might be a cost centre at the top of this hierarchy of sub-cost centres. To charge actual costs to a cost centre, each cost centre will have a cost code, and items of expenditure will be recorded with the appropriate cost code. When costs are eventually analysed, there may well be some apportionment of the costs of one cost centre to other cost centres. Information about cost centres might be collected in terms of total actual costs, total budgeted costs and total cost variances. In addition, the information might be analysed in terms of ratios, such as cost per unit produced (budget and actual), hours per unit produced (budget and actual) and transport costs per tonne/ kilometre (budget and actual).

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Management Accounting

1.2

Revenue centres Definition A revenue centre is a section of an organisation which raises revenue but has no responsibility for production. A sales department is an example.

The term 'revenue centre' is often used in non-profit-making organisations. Revenue centres are similar to cost centres, except that whereas cost centres are for costs only, revenue centres are for recording revenues only. Information collection and reporting could be based on a comparison of budgeted and actual revenues earned by that centre.

1.3

Profit centres Definition A profit centre is any section of an organisation, for example, a division of a company, which earns revenue and incurs costs. The profitability of the section can therefore be measured.

Profit centres differ from cost centres in that they account for both costs and revenues. The key performance measure of a profit centre is therefore profit. The manager of the profit centre must be able to influence both revenues and costs, in other words, have a say in both sales and production policies. A profit centre manager is likely to be a fairly senior person within an organisation, and a profit centre is likely to cover quite a large area of operations. A profit centre might be an entire division within the organisation, or there might be a separate profit centre for each product, brand or service or each geographical selling area. Information requirements need to be similarly focused. In the hierarchy of responsibility centres within an organisation, there are likely to be several cost centres within a profit centre.

1.4

Investment centres Definition An investment centre manager has some say in investment policy in his area of operations as well as being responsible for costs and revenues.

Several profit centres might share the same capital items, for example, the same buildings, stores or transport fleet, and so investment centres are likely to include several profit centres, and provide a basis for control at a very senior management level, like that of a subsidiary company within a group. The performance of an investment centre is measured by the return on capital employed. It shows how well the investment centre manager has used the resources under his control to generate profit.

Question 1: Freeways Minibreak Limited Freeways Minibreak Limited owns a chain of motels situated at strategic points alongside major freeways in Australia. It is a high-volume, low-margin business which operates a strict system of budgetary control, central to which is a hierarchy of responsibility centres. Bookings can be made directly with the hotels, or via a central call centre. Each hotel has a restaurant which is open to the public as well as guests. The hotel manager has a capital expenditure budget, although the Head Office makes all decisions regarding the purchase of new hotels.

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Which one of the following responsibility centres would be categorised as a a profit centre? A B C D

The central bookings call centre. The Melbourne Minibreak Hotel. The Bridgeview Restaurant at the Sydney Minibreak Hotel. The domestic services (cleaning and maintenance) function in the Kalgoorlie Minibreak Hotel. (The answer is at the end of the chapter)

2 Investigating variances Section overview •

Materiality, controllability and variance trend should be considered before a decision about whether or not to investigate a variance is taken.



One way of deciding whether or not to investigate a variance is to only investigate those variances which exceed pre-set tolerance limits.



Control limits may be illustrated on a control chart.

There are a number of factors which should be considered when deciding whether or not to investigate the reasons for the occurrence of a particular variance.

2.1

Materiality Small variations in a single period between actual and standard are bound to occur and are unlikely to be significant. Obtaining an 'explanation' of the reasons why they occurred is likely to be time-consuming and irritating for the manager concerned. For such variations further investigation is not worthwhile.

2.2

Controllability Managers of responsibility centres should only be held responsible for costs over which they have some control. These are known as controllable costs, which are items of expenditure which can be directly influenced by a given manager within a given time span. If there is a general worldwide price increase in the price of an important raw material there is nothing that can be done internally to control the effect of this. If a central decision is made to award all employees a 10% increase in salary, staff costs in division A will increase by this amount and the variance is not controllable by division A's manager. Uncontrollable variances call for a change in the standard, not an investigation into the past.

2.3

Variance trend Although small variations in a single period are unlikely to be significant, small variations that occur consistently may need more attention. Variance trend is more important than a single set of variances for one accounting period. The trend provides an indication of whether the variance is fluctuating within acceptable control limits or becoming out of control.

322

(a)

If, say, an efficiency variance is $1,000 unfavourable in month 1, the obvious conclusion is that the process is out of control and that corrective action must be taken. This may be correct, but what if the same variance is $1,000 unfavourable every month? The trend indicates that the process is in control and the standard has been wrongly set.

(b)

Suppose, though, that the same variance is consistently $1,000 unfavourable for each of the first six months of the year but that production has steadily fallen from 100 units in month 1 to 65 units by month 6. The variance trend in absolute terms is constant, but relative to the number of units produced, efficiency has got steadily worse.

Management Accounting

Individual variances should therefore not be looked at in isolation; variances should be scrutinised for a number of successive periods if their full significance is to be appreciated.

Question 2: Variance trend information Which of the following trends in variances might indicate a learning curve effect? A B C D

Regular, perhaps fairly slight, increases in unfavourable labour rate variances. Gradually improving labour efficiency variances. A rapid, large increase in unfavourable material price variances. Gradually improving fixed overhead expenditure variances. (The answer is at the end of the chapter)

2.4

The significance of variances A variance can be considered significant if it will influence management's actions and decisions. Significant variances usually need investigating. Variances which are simply random deviations, in other words fluctuations which have arisen by chance, are uncontrollable. This is because a standard cost is really only an average expected cost and is not a rigid specification. Some variances either side of this average must be expected to occur and are hence outside management's control. The problem for both management and the accountant is therefore to decide whether a variation from standard is attributable to chance and hence not significant or whether it is due to a controllable cause and therefore significant.

2.5

Control limits and control charts Because standard costs are only estimates of average costs, it would be incorrect to treat them as being rigid. Tolerance limits should be set, and only variances which exceed these limits should be reported as being significant and investigated. The following variances would lie within the tolerance limits: •

Normal variations around average performance, with variations above and below the average (unfavourable and favourable variances) cancelling each other out in the course of time.



Minor operational variances which are too small to justify the cost of investigation and control action by management. Small variances might 'sort themselves out' in time, and only if they persist and grow larger should investigative action be worthwhile.



A minor planning error in the standard cost for the year.

The control limits may be illustrated on a variance control chart as follows:

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There are several ways of establishing control limits: •

Management might establish a rule that any variance should be deemed significant if it exceeds a certain percentage of standard, for example, if it exceeds 10% of standard in any one period based on judgment or experience.



Management can use statistics, and estimate not only the standard cost, but the expected standard deviation, a measure of the spread or dispersion, of actual costs around the standard. Variances would then be deemed significant if actual costs were significantly different from standard.

Not all variances which are outside the control limits require detailed investigation. Often the cause is already known. A variance will only be investigated if the expected value of benefits from investigation and any control action exceed the costs of investigation. For example, it may be known from past experience that the cost of investigating a particular variance is $150 and that cost savings amounting to $1 200 can be made if the variance is corrected successfully. However it is also known that there is only a 30% possibility of the variance being corrected once the cause is found. Expected value of an investigation = ($1 200 × 0.3) – $150 = $210 In this particular case it is worth investigating the variance.

Question 3: Jefferson Ltd Every month for the past eight months, the operating statement of Jefferson Ltd has shown an unfavourable direct material efficiency variance of between $1 500 and $2 500 relating to a product that is only to be produced for a further six months. The company management accountant believes that if the variance is investigated, there is a 70% chance that its cause can be eliminated. The cost of the investigation to find out the cause of the variance would be $2 000 and the expected cost of corrective action, if the cause is found to be controllable, would be an additional $5 000. What is the best estimate of the net benefit from investigating the cause of this variance? A $1,400 B $2,000 C $2,500 D $2,900 (The answer is at the end of the chapter)

Another approach is to look at the variances over a number of accounting periods, instead of just looking at variances in a single period. The variance in each period is added to the total of the variances that have occurred over a longer period of time. If the variances are not significant, the total will simply fluctuate in a random way above and below the average (favourable and unfavourable variances), to give an insignificant total or cumulative sum. If the cumulative sum develops a positive or negative drift, it may exceed a set tolerance limit. Then the situation must be investigated, and control action will probably be required. The cumulative sum of variances over a period of time can be shown on a cusum chart.

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Management Accounting

The advantage of the multiple period approach is that trends are detectable earlier, and control action can be introduced sooner than might have been the case if only current-period variances were investigated.

3 Control action Section overview

LO 1.7



If a variance is assessed as significant then the responsible manager may need to take control action.



If the cause of a variance is controllable, action can be taken to bring the system back under control in future. If the variance is uncontrollable, but not simply due to chance, it will be necessary to review forecasts of expected results, and perhaps to revise the budget.

Since a variance compares historical actual costs with standard costs, it is a statement of what has gone wrong (or right) in the past. By taking control action, managers can do nothing about the past, but they can use their analysis of past results to identify where the 'system' is out of control. If the cause of the variance is controllable, action can be taken to bring the system back under control in future. If the variance is uncontrollable, on the other hand, but not simply due to chance, it will be necessary to revise forecasts of expected results, and perhaps to revise the budget. It may be possible for control action to restore actual results back on course to achieve the original budget. For example, if there is an unfavourable labour efficiency variance in month 1 of 1 100 hours, control action by the production department might succeed in increasing efficiency above standard by 100 hours per month for the next 11 months. It is also possible that control action might succeed in restoring better order to a situation, but the improvements might not be sufficient to enable the company to achieve its original budget. For example, if for three months there has been an unfavourable labour efficiency in a production department, so that the cost per unit of output was $8 instead of a standard cost of $5, then control action might succeed in improving efficiency, so that unit costs are reduced to $7, $6 or even $5, but the earlier excess spending means that the profit in the master budget will not be achieved. Depending on the situation and the control action taken, the action may take immediate effect, or it may take several weeks or months to implement. The effect of control action might be short-lived, lasting for only one control period; but it is more likely to be implemented with the aim of long-term improvement.

3.1

Possible control action The control action which may be taken will depend on the reason why the variance occurred. Some reasons for variances are outlined in the paragraphs below. (a)

Measurement errors In practice it may be extremely difficult to establish that 1 000 units of product A used 32 000 kg of raw material X. Scales may be misread, the pilfering or wastage of materials may go unrecorded, items may be wrongly classified, as material X3, say, when material X8 was used in reality, or employees may make adjustments to records to make their own performance look better. An investigation may show that control action is required to improve the accuracy of the recording system so that measurement errors do not occur.

(b)

Out of date standards Price standards are likely to become out of date when changes to the costs of material, power, labour and so on occur, or in periods of high inflation. In such circumstances an investigation of variances is likely to highlight a general change in market prices rather than efficiencies or inefficiencies in acquiring resources. Standards may also be out of date where operations are subject to technological development or if learning curve effects have not been taken into account. Investigation of this type of variance will provide information about the inaccuracy of the standard and highlight the need to frequently review and update standards.

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(c)

Random or chance fluctuations A standard is an average figure. It represents the midpoint of a range of possible values and therefore actual results are likely to deviate unpredictably within the predictable range. As long as the variance falls within this range, it will be classified as a random or chance fluctuation and control action will not be necessary.

(d)

Efficient or inefficient operations Spoilage and better quality material/more highly skilled labour than standard are all likely to affect the efficiency of operations and hence cause variances. Investigation of variances in this category should highlight the cause of the inefficiency or efficiency and will lead to control action to eliminate the inefficiency being repeated or action to compound the benefits of the efficiency. For example, stricter supervision may be required to reduce wastage levels. The table below looks at possible reasons for the occurrence of variances.

3.2

Variance

Favourable

Unfavourable

Material price

Unforeseen discounts received. More care taken in purchasing. Change in material standard.

Price increase. Careless purchasing. Change in material standard.

Material usage

Material used of higher quality than standard. More effective use made of material. Errors in allocating material to jobs.

Defective material. Excessive waste. Theft. Stricter quality control. Errors in allocating material to jobs.

Labour rate of pay

Use of apprentices or other workers at a rate of pay lower than standard.

Wage rate increase.

Idle time

The idle time variance is always unfavourable.

Machine breakdown. Non-availability of material. Illness or injury to worker.

Labour efficiency (also fixed and variable overhead efficiency where overheads are recovered based on direct labour hours)

Output produced more quickly than expected because of work motivation, training, better quality of equipment or materials.

Lost time in excess of standard allowed.

Variable overhead expenditure

Savings in costs incurred. More economical use of services.

Increase in cost of services used. Excessive use of services. Change in type of services used.

Fixed overhead expenditure

Savings in costs incurred. More economical use of services.

Increase in cost of services used. Excessive use of services. Change in type of services used.

Sales price

Price increase to cover unforeseen costs. Price increase following increased demand.

Price cut to stimulate demand due to increase in competition.

Sales volume

Increased sales resulting from a new advertising campaign or a change in perception of the product by the public.

Unexpected slump in the economy/demand for the product.

Errors in allocating time to jobs.

Output lower than standard set because of deliberate restriction, lack of training, or sub-standard material used. Errors in allocating time to jobs.

Interdependence between variances The cause of one variance may be wholly or partly explained by the cause of another variance. Examples could be as follows:

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Management Accounting

(a)

If the purchasing department buys a cheaper material which is poorer in quality than the expected standard, the material price variance will be favourable, but this may cause material wastage and an unfavourable usage variance.

(b)

Similarly, if employees used to do some work are highly experienced, they may be paid a higher rate than the standard wage per hour, but they should do the work more efficiently than employees of 'average' skill. In other words, an unfavourable rate variance may be compensated by a favourable efficiency variance.

(c)

An unfavourable efficiency variance may be reported following the purchase of cheaper material (favourable material price variance) because operatives find difficulty in processing the cheaper material.

(d)

A rise in selling price very often leads to a fall in the volume of goods sold, so sales price and volume variances can be interdependent.

Question 4: Variance report VARIANCE REPORT: SEPTEMBER 20X5 Variance (Unfavourable) $ Material Usage Price Labour Efficiency Rate Fixed production overhead Expenditure Volume Actual costs for September 20X5 were as follows: Materials Labour Overheads Total

Variance (Favourable) $

Total variance $ –2 000

5 500 3 500 –1 500 3 000 1 500 –500 4 500 5 000 $ 100 000 80 000 75 000 255 000

Which one of the following statements is appropriate? A

The total unfavourable variance of $4 000 is just 1.57% of total costs; therefore the variances do not justify investigation.

B

The materials usage variance and materials price variance are interdependent; and the two components of the materials variance therefore do not justify separate investigation.

C

The fixed overhead expenditure variance could be caused by some expenditures being deferred to a later month.

D

The fixed overhead volume variance indicates that the production operation worked at above budgeted capacity during the period. (The answer is at the end of the chapter)

4 Performance measures Section overview •

Performance measurement aims to establish how well something or somebody is doing in relation to a planned activity.



Ratio and percentages are useful performance measurement techniques.

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LO 12.2

Management measure the performance of an organisation in a number of areas to see whether objectives or targets are being met:

• • • •

In the organisation as a whole. In each of the main sub-divisions of the organisation. In individual activities. In relationships with customers, the market, suppliers and competitors.

The process of performance measurement is carried out using a variety of performance indicators, which are individual measurements. We look at performance indicators in general below before moving on to look at performance indicators derived from the statements of income and financial position. As well as being of use to management, parties external to the organisation can use these as a guide to how well the organisation is performing.

4.1

Performance indicators In the previous section we looked at the analysis of variances. Cost variances are examples of performance indicators and can provide assistance to management in a number of ways:

• • •

Monitoring the use of resources. Controlling the organisation. Planning for the future.

In this section we will look at a wide variety of performance indicators. Let's have a look at some examples and the possible uses they could have:



The direct labour efficiency variance, which could identify problems with labour productivity.



Distribution costs as a percentage of turnover, which could help with the control of costs.



Number of hours during which labour are idle, which could indicate how well resources are being used.



Profit as a percentage of turnover, which could highlight how well the organisation is being managed.



Number of units returned by customers, which could help with planning production and finished stock levels.

Given this wide range of uses, you should be able to appreciate the importance of performance indictors and their value to managers in allowing them to see where improvements in organisational performance can be made. A performance indicator is only useful if it is given meaning in relation to something else. Here is a list of yardsticks against which indicators can be compared so as to become useful.



Standards, budgets or targets



Trends over time – comparing last year with this year, say. An upward trend in the number of rejects from a production process, say, would indicate a problem that needed investigating. The effects of inflation would perhaps need to be recognised if financial indicators were being compared over time.



The results of other parts of the organisation. Large manufacturing companies may compare the results of their various production departments, supermarket chains will compare the results of their individual stores, while a college may compare pass rates in different departments.



The results of other organisations. For example, trade associations or the government may provide details of key indicators based on averages for the industry.

As with all comparisons, it is vital that the performance measurement process compares 'like with like'. There is little to be gained in comparing the results of a small supermarket in a high street with a huge one in an out-of-town shopping complex. We return to the importance of consistency in comparisons later in this chapter.

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Management Accounting

4.2 LO 12.3

Qualitative and quantitative measures It is possible to distinguish between quantitative data, which is capable of being expressed in numbers, and qualitative data, which can only be expressed in numerical terms with difficulty. •

An example of a quantitative performance measure is 'You have been late for work twice this week and it's only Tuesday!'.



An example of a qualitative performance measure is 'My bed is very comfortable'.

The first measure is likely to find its way into a staff appraisal report. The second would feature in a bed manufacturer's customer satisfaction survey. Both are indicators of whether their subjects are doing as good a job as they are required to do. Qualitative measures are by nature subjective and judgmental but this does not mean that they are not valuable. They are especially valuable when they are derived from several different sources. Consider the statement 'Seven out of ten customers think our beds are very comfortable'. This is a quantitative measure of customer satisfaction as well as a qualitative measure of the perceived performance of the beds. (But it does not mean that only 70% of the total beds produced are comfortable, nor that each bed is 70% comfortable and 30% uncomfortable: 'very' is the measure of comfort.)

4.3

Productivity, efficiency and effectiveness In general, performance indicators are established to measure productivity, efficiency and effectiveness. • •

4.4 4.4.1

Effectiveness is about meeting targets and objectives. Productivity or efficiency is a measure of output relative to some form of input.

Performance measures for cost centres Productivity This is the quantity of the product or service produced (output) in relation to the resources put in (input). For example, so many units produced per hour, or per employee, or per tonne of material. It measures how efficiently resources are being used.

4.4.2

Cost per unit For the manager of a cost centre which is also a production centre, one of the most important performance measures will be cost per unit. This is simply the total costs of production divided by the number of units produced in the period.

Worked Example: Cost per unit The total costs and number of units produced for a production cost centre for the last two months are as follows: May June Production costs $128 600 $143 200 Units produced 12 000 13 500 Cost per unit

$128 600 12 000 = $10.72

$143 200 13 500 $10.61

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4.4.3

Indices Indices can be used in order to measure activity.

Indices show how a particular variable has changed relative to a base value. The base value is usually the level of the variable at an earlier date. The 'variable' may be just one particular item, such as material X, or several items may be incorporated, such as 'raw materials' generally. In its simplest form an index is calculated as (current value ÷ base value) × 100%. Therefore if materials cost $15 per kg in 20X0 and now (20X3) cost $27 per kg the 20X0 value would be expressed in index form as 100 (15/15 × 100) and the 20X3 value as 180 (27/15 × 100). If you find it easier to think of this as a percentage, then do so. The current cost is 180% of the base cost.

Worked Example: Work standards and indices Standards for work done in a service department could be expressed as an index. The budget forms the base value. For example, suppose that in a sales department, there is a standard target for sales representatives to make 25 customer visits per month each. The budget for May might be for ten sales representatives to make 250 customer visits in total. Actual results in May might be that nine sales representatives made 234 visits in total. Performance could then be measured as: Budget Actual

100 104

(Standard = index 100) (234 ÷ (9 × 25)) × 100)

This shows that 'productivity' per sales representative was actually 4% over budget.

4.5

Performance measures for revenue centres Traditionally sales performance is measured against price and volume targets. Other possible measures include revenue targets and target market share. They may be analysed in detail: by country, by region, by individual products, by salesperson and so on. In a customer-focused organisation the basic information 'Turnover is up by 14%' can be supplemented by a host of other indicators.

4.6

(a)

Customer rejects/returns: total sales. This ratio helps to monitor customer satisfaction, providing a check on the efficiency of quality control procedures.

(b)

Deliveries late: deliveries on schedule. This ratio can be applied both to sales made to customers and to receipts from suppliers. When applied to customers it provides an indication of the efficiency of production and production scheduling.

(c)

Flexibility measures indicate how well able a company is to respond to customers' requirements. Measures could be devised to measure how quickly and efficiently new products are launched, and how well procedures meet customer needs.

(d)

Number of people served and speed of service, in a shop or a bank for example. If it takes too long to reach the point of sale, future sales are liable to be lost.

(e)

Customer satisfaction questionnaires, for input to the organisation's management information system.

Performance measures for profit centres

4.6.1

Profit margin Definition The profit margin (profit to sales ratio) is calculated as (profit ÷ sales) × 100%.

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The profit margin provides a simple measure of performance for profit centres. Investigation of unsatisfactory profit margins enables control action to be taken, either by reducing excessive costs or by raising selling prices. Profit margin is usually calculated using operating profit.

Worked Example: The profit to sales ratio A company compares its year 2 results with year 1 results as follows: Sales Cost of sales Direct materials Direct labour Production overhead Marketing overhead Profit Profit to sales ratio

Year 2 $ 160 000

Year 1 $ 120 000

40 000 40 000 22 000 42 000 144 000

20 000 30 000 20 000 35 000 105 000

16 000

15 000

10%

⎛ 16 000 ⎞ ⎜ ⎟ × 100% ⎝ 160 000 ⎠

12½%

⎛ 15 000 ⎞ ⎜ ⎟ × 100% ⎝ 120 000 ⎠

The above information shows that there is a decline in profitability in spite of the $1 000 increase in profit, because the profit margin is less in year 2 than year 1.

4.6.2

Gross profit margin The profit to sales ratio above was based on a profit figure which included non-production overheads. The pure trading activities of a business can be analysed using the gross profit margin, which is calculated as (gross profit ÷ turnover) × 100%. For the company in the above example the gross profit margin would be: ⎛ 16 000 + 42 000 ⎞ Year 1: ⎜ ⎟ × 100% = 36.25% 160 000 ⎝ ⎠ ⎛ 15 000 + 35 000 ⎞ Year 2: ⎜ ⎟ × 100% = 41.67% 120 000 ⎝ ⎠

4.6.3

Cost/sales ratios When target profits are not met, further ratios may be used to shed some light on the problem: • • •

Production cost of sales ÷ sales Distribution and marketing costs ÷ sales Administrative costs ÷ sales

Subsidiary ratios can be used to examine problem areas in greater depth. For example, for production costs the following ratios might be used: • • •

Material costs ÷ sales value of production Works labour costs ÷ sales value of production Production overheads ÷ sales value of production

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Worked Example: Cost/sales ratios Look back to the previous example. A more detailed analysis would show that higher direct materials are the probable cause of the decline in profitability. Year 2

Year 1

25%

⎛ 40 000 ⎞ Material costs/sales ⎜ ⎟ × 100% ⎝ 160 000 ⎠

16.7%

⎛ 20 000 ⎞ ⎜ ⎟ × 100% ⎝ 120 000 ⎠ Other cost/sales ratios have remained the same or improved.

Question 5: Margin Use the following summary income statement to answer the questions below. Sales Cost of sales Selling and distribution expenses Administrative expenses Operating profit

$ 3 000 1 800 1 200 300 200 700

Calculate: (a) (b)

the profit margin. the gross profit margin. (The answer is at the end of the chapter)

4.7

Resources Traditional measures for materials compare actual costs with expected costs, looking at differences (or variances) in price and usage. Many traditional systems also analyse wastage. Measures used in modern manufacturing environments include the number of rejects in materials supplied, and the timing and reliability of deliveries of materials. Labour costs are traditionally measured in terms of standard performance (ideal, attainable and so on) and rate and efficiency variances. Qualitative measures of labour performance concentrate on matters such as ability to communicate, interpersonal relationships with colleagues, customers' impressions and levels of skills attained.

Managers can expect to be judged to some extent by the performance of their staff. High profitability or tight cost control are not the only indicators of managerial performance! For variable overheads, differences between actual and budgeted costs, i.e. variances, are traditional measures. Various time based measures are also available, such as:

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(a)

Machine down time: total machine hours. This ratio provides a measure of machine usage and efficiency.

(b)

Value added time: production cycle time. Value added time is the direct production time during which the product is being made. The production cycle time includes non-value-added times such as set-up time, downtime, idle time and so on. The 'perfect' ratio is 100%, but in practice this optimum will not be achieved. A high ratio means non-value-added activities are being kept to a minimum.

Management Accounting

4.8

Measures of performance using the standard hour Sam Ltd manufactures plates, mugs and eggcups. Production during the first two quarters of 20X5 was as follows: Quarter 1 Quarter 2 Plates 1 000 800 Mugs 1 200 1 500 Eggcups 800 900 The fact that 3 000 products were produced in quarter 1 and 3 200 in quarter 2 does not tell us anything about Sam Ltd's performance over the two periods because plates, mugs and eggcups are so different. The fact that the production mix has changed is not revealed by considering the total number of units produced. The problem of how to measure output when a number of dissimilar products are manufactured can be overcome, however, by the use of the standard hour. The standard hour (or standard minute) is the quantity of work achievable at standard performance, expressed in terms of a standard unit of work done in a standard period of time. The standard time allowed to produce one unit of each of Sam Ltd's products is as follows: Standard time 1 /2 hour 1 /3 hour 1 /2 hour

Plate Mug Eggcup

By measuring the standard hours of output in each quarter, a more useful output measure is obtained:

Product Plate Mug Eggcup

Standard hours per unit 1/2 1/3 1/4 hour

Quarter 1 Standard Production hours 1 000 500 1 200 400 800 200 1 100

Quarter 2 Standard Production Hours 800 400 1 500 500 900 225 1 125

The output level in the two quarters was therefore very similar.

4.9

Efficiency, activity and capacity ratios Standard hours are useful in computing levels of efficiency, activity and capacity. Any management accounting reports involving budgets and variance analysis should incorporate control ratios. The three main control ratios are the efficiency, capacity and activity ratios. (a)

The capacity ratio compares actual hours worked and budgeted hours, and measures the extent to which planned utilisation has been achieved.

(b)

The activity or production volume ratio compares the number of standard hours equivalent to the actual work produced and budgeted hours.

(c)

The efficiency ratio measures the efficiency of the labour force by comparing equivalent standard hours for work produced and actual hours worked.

Worked Example: Ratios and standard hours Given the following information about Sam Ltd for quarter 1 of 20X5, calculate a capacity ratio, an activity ratio and an efficiency ratio and explain their meaning. Budgeted hours Standard hours produced Actual hours worked

1 100 standard hours 1 125 standard hours 1 200

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Solution Actual hours worked 1 200 × 100% = × 100% = 109% Budgeted hours 1 100

Capacity ratio = Activity ratio =

S tandard hours produced 1 125 × 100% = 102% × 100% = Budgeted hours 1 100

The overall activity or production volume for the quarter was 2% greater than forecast. This was achieved by a 9% increase in capacity. Efficiency ratio =

S tandard hours produced 1 125 × 100% = × 100% = 94% Actual hours worked 1 200

The labour force worked 6% below standard levels of efficiency.

Question 6: Ratio conundrum If

X = Actual hours worked Y = Budgeted hours Z = Standard hours produced

what is A B C D

Z ? Y

capacity ratio activity ratio efficiency ratio standard hours produced ratio (The answer is at the end of the chapter)

4.10 4.10.1

Performance measures for investment centres Return on investment (ROI) Definition Return on investment (ROI), also called Return on capital employed (ROCE), is calculated as (profit/capital employed) × 100% and shows how much profit has been made in relation to the amount of resources invested.

ROI is generally used for measuring the performance of investment centres; profits alone do not show whether the return is sufficient when different values of assets are used. Therefore if company A and company B have the following results, company B would have the better performance.

Profit Sales Capital employed ROI

A $ 5 000 100 000 50 000 10%

B $ 5 000 100 000 25,000 20%

The profit of each company is the same but company B only invested $25 000 to achieve that profit whereas company A invested $50 000. ROI may be calculated in a number of ways, but profit before interest and tax is usually used.

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Similarly all assets of a non-operational nature, for example, trade investments and intangible assets such as goodwill, should be excluded from capital employed. Profits should be related to average capital employed. In practice, many companies calculate the ratio using year-end assets. This can be misleading. If a new investment is undertaken near to the year end, the capital employed will rise but profits will only have a month or two of the new investment's contribution.

What does the ROI tell us? What should we be looking for? There are two principal comparisons that can be made: • •

4.10.2

The change in ROI from one year to the next. The ROI being earned by other entities.

Residual income (RI) An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre's profits after deducting a notional or imputed interest cost, and depreciation on capital equipment.

Definition Residual income (RI) is 'Pre-tax profits less a notional interest charge for invested capital'.

Question 7: Residual Income A division with average capital employed of $400 000 currently earns a ROI of 22%. It expects this average investment and ROI to continue next year for its current operations. It has decided to make an additional investment of $50 000 at the beginning of the year in a new operation generating an annual net profit of $12 000 after depreciation of $4 000 on the capital equipment. A notional interest charge amounting to 15% of the average capital invested is to be charged to the division each year. What is the expected residual income of the division in the first year of the new investment? A

28,500

B

28,800

C

32,500

D

32,800 (The answer is at the end of the chapter)

5 The balanced scorecard Section overview •

5.1 LO 12.4

The balanced scorecard approach to the provision of information focuses on four different perspectives: customer, financial, internal, and learning and growth.

Introduction So far in our discussion we have focused on performance measurement and control from a financial point of view. Another approach, originally developed by Kaplan and Norton, is the use of what is called a 'balanced scorecard' consisting of a variety of indicators, both financial and non-financial.

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Definition The balanced scorecard approach is an approach to the provision of information to management to assist strategic policy formulation and achievement. It emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided should include both financial and non-financial elements, and cover areas such as profitability, customer satisfaction, internal efficiency and innovation.

The balanced scorecard focuses on four different perspectives, as follows: Perspective

Question

Explanation

Financial

How do we create value for our shareholders?

Covers traditional measures such as growth, profitability and shareholder value but set through talking to the shareholder or shareholders direct.

Customer

What do existing and new customers value from us?

Gives rise to targets that matter to customers: cost, quality, delivery, inspection, handling and so on.

Internal

What processes must we excel at to achieve our financial and customer objectives?

Aims to improve internal processes and decision making.

Learning and growth

Can we continue to improve and create future value?

Considers the business's capacity to maintain its competitive position through the acquisition of new skills and the development of new products.

Performance targets are set once the key areas for improvement have been identified, and the balanced scorecard is the main monthly report. The scorecard is 'balanced' in the sense that managers are required to think in terms of all four perspectives, to prevent improvements being made in one area at the expense of another. The types of measure which may be monitored under each of the four perspectives include the following. The list is not exhaustive but it will give you an idea of the possible scope of a balanced scorecard approach. The measures selected, particularly within the internal perspective, will vary considerably with the type of organisation and its objectives. Perspective

Measures

Financial



Return on capital employed



Revenue growth



Cash flow



Earnings per share



New customers acquired



On-time deliveries



Customer complaints



Returns



Quality control rejects



Speed of producing



Average set-up time



Labour turnover rate



Percentage of revenue generated by new products and services



Average time taken to develop new products and services

Customer Internal Learning and growth

management information

Broadbent and Cullen (in Berry, Broadbent and Otley, eds, Management Control, 1995) identify the following important features of this approach:

• • •

It looks at both internal and external matters concerning the organisation. It is related to the key elements of a company's strategy. Financial and non-financial measures are linked together.

The balanced scorecard approach may be particularly useful for performance measurement in organisations which are unable to use simple profit as a performance measure. For example, the public sector has long been forced to use a wide range of performance indicators, which can be formalised with a balanced scorecard approach.

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5.2

Problems As with all techniques, problems can arise when it is applied. Problem

Explanation

Conflicting measures

Some measures in the scorecard such as research funding and cost reduction may naturally conflict in the short term. It is often difficult to determine the balance which will achieve the best results.

Selecting measures

The ultimate objective for commercial organisations is to maximise profits or shareholder wealth. Other targets should offer a guide to achieving this objective and not become an end in themselves. Not only do appropriate measures have to be devised but the number of measures used must be agreed. Care must be taken that the impact of the results is not lost in a sea of information.

Interpretation

Even a financially-trained manager may have difficulty in putting the figures into an overall perspective.

6 Reward systems Section overview •

LO 12.5

Employment is an economic relationship: labour is exchanged for reward. Extrinsic rewards derive from job context and include pay and benefits. Intrinsic rewards derive from job content and satisfy higher level needs. reward interacts with many other aspects of the organisation. Reward policy must recognise these interactions, the economic relationship and the psychological contract.

Employment is fundamentally an economic relationship: the employee works as directed by the employer and, in exchange, the employer provides reward. The relationship inevitably generates a degree of tension between the parties, since it requires co-operation if it is to function, but it is also likely to give rise to conflict since the employee's reward equates exactly to a cost for the employer.

Definition Reward is 'all of the monetary, non-monetary and psychological payments that an organisation provides for its employees in exchange for the work they perform'. (Bratton)

Rewards may be seen as extrinsic or intrinsic. (a)

Extrinsic rewards derive from the job context: such extrinsic rewards include pay and other material benefits as well as matters such as working conditions and management style.

(b)

Intrinsic rewards derive from job content and satisfy higher-level needs such as those for self esteem and personal development.

The organisation's reward system is based on these two types of reward and also includes the policies and processes involved in providing them. Reward is a fundamental aspect of HRM and of the way the organisation functions. It interacts with many other systems, objectives and activities: • • • • • • • •

It should support the overall strategy. It is a vital part of the psychological contract. It influences the success of recruitment and retention policies. It must conform with law. It consumes resources and must be affordable. It affects motivation and performance management. It must influence employees to behave in a goal congruent manner. It must be administered efficiently and correctly.

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The dual nature of reward mentioned earlier – a benefit for the employee, a cost for the employer – means that the parties in the relationship have divergent views of its purposes and extent. Employees see reward as fundamental to their standard of living: inflation, comparisons with others and rising expectations put upward pressure on their notion of what its proper level should be. Employers, on the other hand, seek both to control their employment costs and to use the reward system to influence such matters as productivity, recruitment, retention and change.

6.1

An effective reward system The effective reward system should facilitate both the organisation's strategic goals and also the goals of individual employees. An organisation has to make three basic decisions about monetary reward: (a) (b) (c)

how much to pay. whether monetary rewards should be paid on an individual, group or collective basis. how much emphasis to place on monetary reward as part of the total employment relationship.

However, there is no single reward system that fits all organisations.

6.2

The strategic perspective Contingency theory as applied to management suggests that techniques used should be appropriate to the circumstances they are intended to deal with: there is unlikely to be a single best option that is appropriate to any context. A contingency approach to reward accepts that the organisation's strategy is a fundamental influence on its reward system and that the reward system should support the chosen strategy. Therefore, for example, cost leadership and differentiation based on service will have very different implications for reward strategy and, indeed, for other aspects of HRM. This is because each strategy needs a reward which is appropriate for it. The closer the alignment between the reward system and the strategic context, the more effective the organisation.

6.3

Reward objectives The reward system should pursue three behavioural objectives:

6.4

(a)

It should support recruitment and retention.

(b)

It should motivate employees to high levels of performance. This motivation may, in turn, develop into commitment and a sense of belonging, but these do not result directly from the reward system.

(c)

It should promote compliance with workplace rules and expectations.

Reward options Material reward may be divided into three categories:

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(a)

Base pay is a simply established reward for the time spent working.

(b)

Performance pay is normally added to base pay and is intended to reward performance learning or experience.

(c)

Indirect pay is made up of benefits such as health insurance, child care, and so on, and is provided in addition to base pay or performance pay.

Management Accounting

6.4.1

Base pay Base pay is usually related to the value of the job, as established by a simple estimate, a scheme of job evaluation or reference to prevailing employment market conditions. It is easy to administer and shows a commitment by the employer to the employee that goes beyond simple compensation for work done. A distinction may be made between hourly or weekly paid wages and monthly paid salary. The latter is normally expressed as an annual rate.

6.4.2

Performance pay Performance pay takes many forms, including commission, merit pay and piecework pay.

Performance pay differs from base pay in that it can be designed to support team working and commitment to organisational goals. Team working is supported by a system of bonuses based on team rather than individual performance; the size of the team may vary from a small work group to a complete office or factory. Overall organisational performance is supported by various schemes of profit sharing, including those that make payments into pension funds or purchase shares in the employing company. However, the extent to which an organisation emphasises performance pay will depend on whether this type of reward supports its strategy.

6.4.3

Indirect pay Indirect pay is often called 'employee benefits'. Benefits can form a valuable component of the total reward package. They can be designed so as to resemble either base pay or, to some extent, performance pay. A benefit resembling base pay, for example, would be use of a subsidised staff canteen, whereas the common practice of rewarding high-performing sales staff with holiday packages or superior cars looks more like performance pay. Again though, the extent to which an organisation offers indirect pay should reflect whether this type of reward supports its strategy.

There is a trend towards a cafeteria approach to benefits. Employees select the benefits they require from a costed menu up to the total value they are awarded. This means that employees' benefits are likely to match their needs and be more highly valued as a result. Types of indirect pay include: • • • • • • • •

6.4.4

Private health care. Discounted insurance. Private dental care. Extra vacation days. Pension plans. Child care. Car allowance. Shopping/entertainment vouchers.

Levels of reward The level of rewards an organisation offers will inevitably be subject to factors external to the organisation. (a)

The labour market as it exists locally, nationally and perhaps globally, as relevant to the organisation's circumstances.

(b)

The pressure for cost efficiency in the relevant industry or sector.

(c)

Legislation such as the level of any applicable minimum wage.

(d)

Governments influence pay levels by means other than outright legislative prescription e.g. their fiscal and monetary policies can lead them to exert downward pressure on public sector wage rates.

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Key chapter points •

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organisation.



A responsibility centre is a function or department of an organisation that is headed by a manager who has direct responsibility for its performance. There are a number of different bases for control:

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A cost centre is any unit of an organisation to which costs can be separately attributed.



A profit centre is any unit of an organisation to which both revenues and costs are assigned, so that the profitability of the unit may be measured.



An investment centre is a profit centre whose performance is measured by its return on capital employed.



Controllable costs are items of expenditure which can be directly influenced by a given manager within a given time span.



Materiality, controllability and variance trend should be considered before a decision about whether or not to investigate a variance is taken.



One way of deciding whether or not to investigate a variance is to only investigate those variances which exceed pre-set tolerance limits.



Control limits may be illustrated on a control chart.



If the cause of a variance is controllable, action can be taken to bring the system back under control in future. If the variance is uncontrollable, but not simply due to chance, it will be necessary to review forecasts of expected results, and perhaps to revise the budget.



Performance measurement aims to establish how well something or somebody is doing in relation to a planned activity.



Ratios and percentages are useful performance measurement techniques. –

The profit margin (profit to sales ratio) is calculated as (profit ÷ sales) × 100%.



The gross profit margin is calculated as gross profit ÷ sales × 100%.



Return on investment (ROI) or return on capital employed (ROCE) shows how much profit has been made in relation to the amount of resources invested.



Residual income (RI) is an alternative way of measuring the performance of an investment centre. It is a measure of the centre's profits after deducting a notional or imputed interest cost.



Cost per unit is total costs ÷ number of units produced.



Performance measures for materials and labour include differences between actual and expected (budgeted) performance. Performance can also be measured using the standard hour.



The balanced scorecard approach to the provision of information focuses on four different perspectives: customer, financial, internal, and learning and growth.



Employment is an economic relationship: labour is exchanged for reward. Extrinsic rewards derive from job context and include pay and benefits. Intrinsic rewards derive from job content and satisfy higher level needs. Reward interacts with many other aspects of the organisation. Reward policy must recognise these interactions, the economic relationship and the psychological contract.

Management Accounting

Quick revision questions 1

An airline company has an operations centre in an international airport. The airport is owned and managed by a separate group of companies. If the airline company operates a responsibility accounting system, the operations centre at the airport is likely to be: A B C D

2

3

4

Are the following statements Correct or Incorrect? (I) (II)

There may be several cost centres within a profit centre There may be several profit centres within an investment centre

A B C D

Statement (I) only is correct Statement (II) only is correct Both Statement (I) and Statement (II) are correct Neither statement is correct

Which one of the following statements is correct? A

A large variance in one month is not a matter of concern if the size of variances in previous months has been insignificant.

B

The possible significance of a variance can be assessed by its size relative to the actual total cost.

C

Control action to deal with an unfavourable variance of $3 000 in a month should be expected to save $3 000.

D

A cusum chart provides a visual record of monthly variances for a particular type of variance.

Which one of the following is the most likely cause of an unfavourable overhead expenditure variance? A B C D

5

Speed of customer service % of customer deliveries on time Profitability Customer satisfaction

A common basis for measuring the volume of output of different products is: A B C D

7

Change in type of services used Direct labour inefficiency, taking longer than the standard time to do work Theft of materials Unexpected slump in sales demand

Which one of the following is the LEAST appropriate performance measure for a revenue centre? A B C D

6

a cost centre a profit centre a revenue centre an investment centre

Efficiency ratio Value added time Cost/sales ratio Standard hours

The following information relates to a manufacturing unit: Budgeted hours Standard hours produced Actual hours worked

5,200 5,600 5,800

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What is the activity ratio for the period? A B C D 8

In calculating the ROI for an investment centre, the most commonly-used measure of return is: A B C D

9

profit before interest, tax, depreciation and amortisation profit before interest and tax profit before tax profit after tax

The four perspectives of performance using the balanced scorecard are financial, customer, internal and: A B C D

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96.6% 103.6% 107.7% 111.5%

learning and growth competitive external value chain

Management Accounting

Answers to quick revision questions 1

A The operations centre is unlikely to have revenues over which it has control; therefore it is most likely to be a cost centre.

2

C A profit centre may contain several cost centres. For example, if a factory and its associated selling operations is treated as a profit centre, each functional department in the factory could be a cost centre. Similarly an investment centre such as a large subsidiary company within a group may contain several profit centres.

3

B The significance of a variance can be assessed initially by means of its size relative to the actual costs incurred. A large variance in one month should be investigated, even when there have been no significant variances in the past, because it is important to find out what the reasons for the variance are and to try to ensure that it does not happen again. A cusum chart shows cumulative variances over time, not the variances each month.

4

A A change in the type of services used will change spending patterns, and this could mean unfavourable spending variances. Labour inefficiency will cause efficiency variances. Material theft will result in a usage variance when a shortfall in materials is discovered. An unexpected slump in sales demand will cause a sales volume variance.

5

C Profitability is an inappropriate performance measure for a revenue centre since it is only able to control revenue.

6

D A common basis for measuring the volume of output of different products is standard hours.

7

8

C Standard hours produced Budgeted hours B

=

5 600 5 200

× 100%

= 107.7%

In calculating the ROI for an investment centre, the most commonly-used measure of return is profit before interest and tax 9

A The four perspectives of performance using the balanced scorecard are financial, customer, internal and learning and growth

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Answers to chapter questions 1

C A is a revenue centre, responsible for revenue from centrally made room bookings only. B is an investment centre, responsible for investment in some non-current assets, as well as hotel expenses and income. C is a profit centre. The restaurant manager will be responsible for the income and costs of the restaurant D is a cost centre, since there will only be costs in relation to cleaning and maintenance.

2

B A learning curve effect means that average times to complete an item of work fall as the work force becomes more skilled. This may lead to improvements in labour efficiency, and also machine time running (machine usage efficiency) and materials handling efficiency (so favourable material usage variances). A learning curve effect is less likely to have an effect on price, rate or expenditure variances.

3

D The best estimate of the monthly unfavourable variance is the average variance for the past 8 months, which is $2 000. Cost of investigation Expected value of cost of corrective action (70% × $5 000) Expected value of benefits if the cause can be corrected: (70% × 6 months × $2 000) Expected value of net benefit from investigation

$ 2 000 3 500 5 500 8 400 2 900

A more cautious estimate would be to assume minimum monthly savings of $1 500 rather than $2 000 if the cause is controllable, This would reduce the expected value of benefit by (70% × 6 months × $500) $2,100 to just $800. However this was not one of the answer options. 4

C Note that the cause of the favourable expenditure variance, which represents 6% of the total overhead costs for the month, should be encouraged if it is a genuine reduction in costs. However some fixed overhead costs may simply slip from one month to the next, so expenditure variances cannot be judged on the basis of one month’s figures alone. Option A: The purpose of analysing variances into sub-variances is to enable each separate subvariance to be investigated if its seems significantly large. The total variance may only be 1.57% of total costs but this total disguises a number of significant unfavourable and favourable variances which need investigating. Option B: Similarly, the materials price and usage variance should be considered separately, even though the fact that there is a favourable price variance and an unfavourable usage variance could indicate interdependence between them. The purchasing department may have bought cheap materials but these cheaper materials may have been more difficult to work with so that more material was required per unit produced. The possibility of such an interdependence should be investigated. Whether or not there is an interdependence, both variances do require investigation since they represent 5.5% (usage) and 3.5% (price) of the actual material cost for the month. Option D:The unfavourable fixed overhead volume variance is more likely to indicate that the production operation worked at below budgeted capacity during the period, because the unfavourable variance indicates under-absorption of fixed overheads.

344

Management Accounting

5

(a)

700 × 100% = 23% 3000

The profit margin usually refers to operating profit/sales. (b)

1 200 × 100% = 40% 3000

The gross profit margin is the gross profit/sales percentage ratio. 6

B Standard Hours produced/Budgeted hours = Activity ratio

7

D Divisional profit with project ((400 000 × 22%) + 12 000) Average capital Original investment: assume no change New investment: 50% of (50 000 + 46 000) Average capital employed Notional interest (448 000 × 0.15) Residual income

$

$ 100 000

400 000 48 000 448 000 67 200 32 800

Note: Depreciation on the new investment will be $4 000 therefore the average investment for the year is half-way between the initial investment of $50 000 and the year-end net book value of $46 000.

12: Performance measurement and evaluation

345

346

Management Accounting

Revision questions

347

Chapter 1 1

2

Possum Ltd is now engaged solely in a service industry having previously been involved in manufacturing. Its chief accountant is considering which of the following management accounting processes the company needs to retain: I II III

Production planning Inventory valuation Workforce planning

A B C D

I only I and II only II and III only III only

Consider the following statements in relation to management information: I II III

It should always be provided regardless of its cost It is data that has been processed so as to be meaningful to the recipient It should not be provided until it is as detailed as possible

Which of the above statements is/are true of good management information? A B C D 3

4

Which of the following are characteristics of management accounting information? I II III IV

Non-financial as well as financial Used by all stakeholders Concerned with cost control only Not legally required

A B C D

I and IV only II and III only I, II and III only II, III and IV only

Which of the following statements about cost and management accounting are true? I

5

348

I only II only I and III only II and III only

II III IV

Cost accounting cannot be used to provide inventory valuations for external financial reporting There is a legal requirement to prepare management accounts The format of management accounts may vary from one business to another Management accounting provides information to help management make business decisions

A B C D

I and II only I and IV only II and III only III and IV only

A management control system is A

a system that controls and maximises the profits of an organisation

B

a collective term for the hardware and software used to drive a database system

C

a possible course of action that might enable an organisation to achieve its objectives

D

a system that measures and corrects the performance of activities of subordinates in order to make sure that the objectives of an organisation are being met and their associated plans are being carried out

Management Accounting

6

7

Which of the following statements is/are true? I II III

Information is the raw material for data processing External sources of information include an organisation's financial accounting records The main objective of a non-profit making organisation is usually to provide goods and services

A B C D

I and III only I, II and III II and III only None of the above

Wateraid is a charity providing relief for victims of drought in Africa. A fund-raising brochure produced by the charity contains the following statement: “Wateraid aspires to be the largest charitable provider of clean water services for Africa.” The statement is an example of the charity’s A B C D

8

Strategy Vision Objective Mission

Genzyme Ltd operates its business in four geographical regions. The sales director has decided that the company needs to increase its market share in the next five years and as a result has decided to establish a sales quota for next year which is to be achieved by each of the regions. The setting of a sales target for each sales representative is an example of A B C D

a strategic plan a management control plan a tactical plan an operational plan

Revision questions

349

Chapter 2 1

A machine which originally cost $12 000 has an estimated life of ten years and is depreciated at the rate of $1 200 a year. It has been unused for some time, as expected production orders did not materialise. 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 $8 000. If it is used for the special order, its value is expected to fall to $7 500. The net book value of the machine is $8 400. Routine maintenance of the machine currently costs $40 a month. With use, the cost of maintenance and repairs would increase to $60 a month for the months that the machine is being used. Ignore the time value of money. What is the relevant cost of using the machine for the special order? A B C D

2

The total relevant cost of a scarce resource is equal to the sum of the variable cost of the scarce resource and A B C D

3

4

the fixed cost absorbed by a unit of the scarce resource the price that the resource would sell for in the open market the price that would have to be paid to replace the scarce resource the contribution forgone from the next-best opportunity for using the scarce resource

Which of the following is not an assumption typically made in relevant costing? A

cost behaviour patterns are known

B

the amount of fixed costs, unit variable costs, sales prices and sales demand are known with certainty

C

the objective of decision making in the short run is to maximise customer satisfaction

D

there is no scarcity of resources

Keyboards Pty Ltd is in the process of deciding whether or not to accept a special order. The order will require 100 litres of liquid X. Keyboards Pty Ltd has 85 litres of liquid X in inventory but no longer produces the product which required liquid X. It could therefore sell the 85 litres for $2 per litre if it rejected the special order. The liquid was purchased three years ago at a price of $8 per litre but its replacement cost is $10 per litre. What is the relevant cost of liquid X to include in the decision-making process? A B C D

5

$240 $520 $540 $620

$200 $320 $800 $1,000

A company is considering accepting a one-year contract which will require four skilled employees. The four skilled employees could be recruited on a one-year contract at a cost of $40 000 per employee. The employees would be supervised by an existing manager who earns $60 000 per annum. It is expected that supervision of the contract would take 10% of the manager's time. Instead of recruiting new employees the company could retrain some existing employees who currently earn $30 000 per year. The training would cost $15 000 in total. If these employees were used they would need to be replaced at a total cost of $100 000. The relevant labour cost of the contract is: A B C D

350

$115,000 $135,000 $166,000 $275,000

Management Accounting

6

A company is considering its options with regard to a machine which cost $120 000 four years ago. If sold, the machine would generate scrap proceeds of $150 000. If kept, this machine would generate net income of $180 000. The current replacement cost for this machine is $210 000. The relevant cost of the machine is: A B C D

$120,000 $150,000 $180,000 $210,000

Revision questions

351

Chapter 3 1

Which one of the following is the budget committee not responsible for? A B C C

2

3

4

preparing functional budgets monitoring the budgeting process timetabling the budgeting operation allocating responsibility for the budget preparation

Which of the following may be considered to be objectives of budgeting? I II III IV

Co-ordination Communication Expansion Resource allocation

A B C D

I, II, III and IV I, II and IV only II, III and IV only I and III only

What does the statement 'sales is the principal budget factor' mean? A

if the company gets its sales level correct then nothing else matters

B

the company's activities are limited by the level of sales it can achieve

C

the level of sales will determine the level of cash at the end of the period

D

the level of sales will determine the level of profit at the end of the period

A production process uses Material M to make Product P. At the beginning of a budget period, it is expected that the opening inventory of Material M will be 16 000 kg, but the plan will be to reduce the inventory level to 14,000 kg by the end of the year. During the year, the budgeted production of Product P is 36,000 kg. The loss or wastage in production is 10% of the quantities of material input. What should be the materials purchases budget for Material M? A B C D

5

34,000 kg 37,600 kg 38,000 kg 42,000 kg

Budgeted sales for a company in three months of the year are as follows: $ March

500,000

April

600,000

May

700,000

All sales are invoiced and invoices are sent out on the last day of each month. An early settlement discount of 2% is offered to customers who pay within 7 days. 20% of customers are expected to take the discount, another 30% are expected to pay within one month after the invoice date and all other payments are expected in the following month. Irrecoverable debts are expected to be 1% of the total sales invoiced. What will be the budgeted cash receipts from customers in May? A B C D

352

$542,600 $547,600 $562,200 $641,200

Management Accounting

6

The following information is available about the costs of producing a single item of product in a manufacturing operation: Production

Cost

units

$

36 000

370 200

29 000

291 800

It is known that fixed costs increase by $49 000 when output volume exceeds 30 000 units. Using this data, what should be the budgeted cost of producing 31 000 units? A B C D

$300 200 $314 200 $347 200 $349 200

Revision questions

353

Chapter 4 1

The following information for advertising expenditure and sales revenue has been established over the past six months: Month Sales revenue Advertising expenditure $ 000 $ 000 1 155 3.0 2 125 2.5 3 200 6.0 4 175 5.5 5 150 4.5 6 225 6.5 Using the high-low method which of the following is the correct equation for linking advertising expenditure and sales revenue from the above data?

2

A

sales revenue = 62,500 + (25 × advertising expenditure)

B

advertising expenditure = – 2,500 + (0.04 × sales revenue)

C

sales revenue = 95,000 + (20 × advertising expenditure)

D

advertising expenditure = – 4,750 + (0.05 × sales revenue)

A company incurs the following costs at various activity levels: Total cost Activity level $ units 250 000 5 000 312 500 7 500 400 000 10 000 Using the high-low method what is the variable cost per unit? A B C D

3

$25 $30 $35 $40

The total cost of production for two levels of activity is : Level 1 Level 2 Production (units) 3 000 5 000 Total cost ($) 6 750 9 250 The variable production cost per unit and the total fixed production cost both remain constant in the range of activity shown. What is the level of fixed costs? A B C D

354

$2 000 $2 500 $3 000 $3 500

Management Accounting

4

A company generates a 12 per cent contribution on its weekly sales of $280 000. A new product, Z, is to be introduced at a special offer price in order to stimulate interest in all the company's products, resulting in a 5 per cent increase in weekly sales of the company's other products. Product Z will incur a variable unit cost of $2.20 to make and $0.15 to distribute. Weekly sales of Z, at a special offer price of $1.90 per unit, are expected to be 3 000 units. The effect of the special offer will be to increase the company's weekly profit by: A B C D

5

$330 $780 $12,650 $19,700

A company manufactures one product which it sells for $40 per unit. The product has a contribution to sales ratio of 40%. Monthly total fixed costs are $60 000. At the planned level of activity for next month, the company has a safety margin of $64 000 expressed in terms of sales. What is the planned activity level (in units) for next month? A B C D

6

3,100 4,100 5,350 7,750

A company manufactures a single product, P. Data for the product is: Selling price Direct material cost Direct labour cost Variable production overhead cost Variable selling overhead cost Fixed overhead cost Profit per unit

$ per unit 20 4 3 2 1 5 5

The profit/volume ratio for product P is: A B C D

25% 50% 55% 60%

Revision questions

355

Chapter 5 1

2

Which of the following items would be treated as an indirect cost? A

wood used to make a chair

B

metal used for the legs of a chair

C

fabric to cover the seat of a chair

D

staples to fix the fabric to the seat of a chair

Spaced Out Ltd has two production departments (F and G) and two service departments (Cafeteria and Maintenance). Total allocated and apportioned general overheads for each department are as follows: F

G

Cafeteria

Maintenance

$125 000

$80 000

$20 000

$40 000

Cafeteria and Maintenance perform services for both production departments and Cafeteria also provides services for Maintenance in the following proportions: F

G

Cafeteria

Maintenance

% of Cafeteria to

60

25



15

% of Maintenance

65

35





What would be the total overheads for production department G once the service department's costs have been apportioned? A B C D 3

$90,763 $100,500 $99,000 $100,050

The following data relates to one year in department A. Budgeted machine hours

25 000

Actual machine hours

21 875

Budgeted overheads

$350 000

Actual overheads

$350 000

Based on the data above, what is the machine hour absorption rate as conventionally calculated? A B C D

356

$12 $14 $16 $18

Management Accounting

The following information relates to questions 4 and 5 Cost and selling price details for product Z are as follows: Direct materials Direct labour Variable overhead Fixed overhead absorption rate Profit Selling price

$ per unit 6.00 7.50 2.50 5.00 21.00 9.00 30.00

Budgeted production for the month was 5 000 units although the company managed to produce 5 800 units, selling 5 200 of them and incurring fixed overhead costs of $27 400.

4

The profit under the marginal costing method for the month is: A B C D

5

The profit under the absorption costing method for the month is: A B C D

6

$45,400 $46,800 $53,800 $72,800 $45,200 $45,400 $46,800 $48,400

Which of the following are acceptable bases for absorbing production overheads? I II III IV

Direct labour hours Machine hours As a percentage of the prime cost Per unit

A B C D

I and II only III and IV only I, II, III and IV I, II or III only

Revision questions

357

Chapter 6 1

Consider the following statements about Activity Based Costing (ABC): I

introducing ABC will always reduce costs in the short term;

II

if the cost of a product or service using both ABC and absorption costing is the same, there will be no benefit to be gained from adopting ABC.

Which of the statements is/are correct? A B C D 2

I only II only I and II neither I nor II

Studley Ltd uses activity based costing. The budgeted distribution costs for the next year are: Transport costs

$2 631

Order processing

$1 573

Total distribution costs

$4 204

It is estimated that in the next year, 325 000 orders will be processed, and that the delivery vehicles will travel 1 495 000 km. A customer has indicated that 138 orders, each of which will require a journey of 122 km for each order will be placed next year. To the nearest $, what is the distribution cost for this customer? A B C D 3

358

$47,342 $38,891 $30,299 $1,785

The directors of Wiltshire Ltd are considering the introduction of activity based costing (ABC). A trainee manager has asked which of the following comments about the calculation of overhead cost using ABC are not correct: I

each individual cost will have a unique, identifiable, cost driver

II

the volume of activity has no influence on cost

III

the overhead cost calculated using ABC will always be significantly different from the overhead cost calculated using absorption costing

A B C D

II and III only I and II only I and III only I, II and III

Management Accounting

4

The budgeted overheads of Coleman Ltd for the next year have been analysed as follows: $000 Machine running costs

640

Purchase order processing costs

450

Production run set up costs

180

In the next year, it is anticipated that machines will run for 32 000 hours, 6 000 purchase orders will be processed and there will be 450 production runs. One of the company’s products is produced in batches of 500. Each batch requires a separate production run, 30 purchase orders and 750 machine hours. Using Activity Based Costing, what is the overhead cost per unit of the product? A B C D

$0.99 $1.59 $35.30 $495.00

Revision questions

359

Chapter 7 1

A chemical process has a normal wastage of 10% of input. In a period, 2 500 kgs of material were input and there was an abnormal loss of 75 kgs. What quantity of good production was achieved? A B C D

2

3

2,175 kgs 2,250 kgs 2,325 kgs 2,425 kgs

In a particular process, the input for the period was 2 000 units. There were no inventories at the beginning or end of the process. Normal loss is 5 per cent of input. In which of the following circumstances is there an abnormal gain? I II III

Actual output = 1,800 units Actual output = 1,950 units Actual output = 2,000 units

A B C D

I only II only I and II only II and III only

A company uses process costing to establish the cost per unit of its output. The following information was available for the last month: Input units

10,000

Output units

9,850

Opening inventory

300 units, 100% complete for materials and 70% complete for conversion costs

Closing inventory

450 units, 100% complete for materials and 30% complete for conversion costs

The company uses the weighted average method of valuing inventory. What were the equivalent units for conversion costs? A B C D 4

9,505 units 9,715 units 9,775 units 9,985 units

A company uses process costing to value its output. The following was recorded for the period: Input materials Conversion costs Normal loss Actual loss

2 000 units at $4.50 per unit $13 340 5% of input valued at $3 per unit 150 units

There were no opening or closing inventories. What was the valuation of one unit of output to one decimal place? A B C D

360

$11.8 $11.6 $11.2 $11.0

Management Accounting

5

A company manufactures two joint products, P and R, in a common process. Data for June are as follows: $ Opening inventory 1 000 Direct materials added 10 000 Conversion costs 12 000 Closing inventory 3 000 Production Units 4 000 6 000

P R

Sales Units 5 000 5 000

Sales price $ per unit 5 10

If costs are apportioned between joint products on a physical unit basis, what was the total cost of product P production in June? A B C D 6

$8,000 $8,800 $10,000 $12,000

Which of the following costing methods is most likely to be used by a company involved in the manufacture of liquid soap? A B C D

batch costing service costing job costing process costing

Revision questions

361

Chapter 8 1

Information on standard rates of pay would be provided by A B C D

2

3

For which of the following is an attainable standard (target standard) inappropriate? I II III

Inventory valuation Planning Control

A B C D

I only I and III only II only III only

Standard costing provides which of the following? I II III IV

targets and measures of performance information for budgeting simplification of inventory control systems actual future costs

A B C D

I, II and III only II, III and IV only I, III and IV only I, II and IV only

4

Which of the following statements is correct? A The operating standards set for production should be the minimal level. B The operating standards set for production should be the attainable level. C The operating standards set for production should be the maximum level. D The operating standards set for production should be the most ideal possible.

5

Which of the following best describes management by exception?

6

A

Recruiting exceptionally good managers and being prepared to pay over the market rate for their services.

B

Sending management reports only to those managers who are able to act on the information contained within the reports.

C

Focusing management reports on areas which require attention and ignoring those which appear to be performing within acceptable limits.

D

Using management reports to highlight exceptionally good performance, so that favourable results can be built upon to improve future outcomes.

A unit of product L requires 9 active labour hours for completion. The performance standard for product L allows for 10 per cent of total labour time to be idle, due to machine downtime. The standard wage rate is $9 per hour. What is the standard labour cost per unit of product L? A B C D

362

a trade union a production manager a personnel manager a newspaper

$72.90 $81.00 $89.10 $90.00

Management Accounting

Chapter 9 1

A company manufactures a single product L, for which the standard material cost is as follows: $ per unit 42

Material 14 kg × $3

During July, 800 units of L were manufactured, 12 000 kg of material were purchased for $33 600, of which 11 500 kg were issued to production. The company values all inventory at standard cost. The material price and usage variances for July were: A B C D 2

3

4

Price

Usage

$2 300 (F) $2 300 (F) $2 400 (F) $2 400 (F)

$900 (U) $300 (U) $900 (U) $840 (U)

Which of the following would help to explain a favourable direct labour efficiency variance? I

Employees were of a lower skill level than specified in the standard.

II

Better quality material was easier to process.

III

Suggestions for improved working methods were implemented during the period.

A B C D

I, II and III I and II only II and III only I and III only

Which of the following statements is correct? A

An unfavourable direct material cost variance can be a combination of a favourable material price variance and an unfavourable material usage variance.

B

An unfavourable direct material cost variance can be a combination of a favourable material price variance and a favourable material usage variance.

C

An unfavourable direct material cost variance will always be a combination of an unfavourable material price variance and an unfavourable material usage variance.

D

An unfavourable direct material cost variance will always be a combination of an unfavourable material price variance and a favourable material usage variance.

A company has a budgeted material cost of $125 000 for the production of 25 000 units per month. Each unit is budgeted to use 2 kgs of material. The standard cost of material is $2.50 per kg. Actual materials in the month cost $136 000 for 27 000 units and 53 000 kgs were purchased and used. What was the unfavourable material price variance? A B C D

5

$1,000 $3,500 $7,500 $11,000

A company purchased 6 850 kgs of material at a total cost of $21 920. The material price variance was $1 370 favourable. The standard price per kg was: A B C D

$0.20 $3.00 $3.20 $3.40

Revision questions

363

6

364

Which of the following situations is most likely to result in a favourable selling price variance? A

the sales director decided to change from the planned policy of market skimming pricing to one of market penetration pricing

B

fewer customers than expected took advantage of the early payment discounts offered

C

competitors charged lower prices than expected, therefore selling prices had to be reduced in order to compete effectively

D

demand for the product was higher than expected and prices could be increased without unfavourable effects on sales volumes

Management Accounting

Chapter 10 1

2

Which of the following is not an example of soft capital rationing? A

The company is debt-averse.

B

The company's credit rating prevents it from borrowing further.

C

The company will only use retained earnings to finance new investment.

D

Management does not want to issue more shares to raise capital, in order to avoid dilution of control.

The following statements have been made in relation to the advantages of a Post Completion Audit (PCA). I II III

It encourages a more realistic approach to new investment project decision making. It enables changes to be made more quickly to projects that are not doing very well. It encourages (when relevant) project termination.

Which of the statements are true? A B C D 3

I, II and III I and II only I and III only II and III only

A company has carried out an investigation into a new capital investment project, paying $10 000 for a consultants' report. The consultants have reported that the project would require an outlay of $90,000 on new equipment. The expected net cash inflows from the project would be: Year

$

1

25 000

2

35 000

3

40 000

4

40 000

5

60 000

What is the project’s payback period? A B C D 4

2.5 years 3.0 years 2.75 years 2.25 years

James Ltd is considering a capital expenditure project which requires an investment of $46 000 in a machine that will have a four year life, after which it will be sold for $6 000. Depreciation is charged in equal instalments over the life of the machine. The expected profits after depreciation to be generated by the project are as follows: Year 1 Year 2 Year 3 Year 4

$20,500 $23,000 $13,500 $1,500

What is the payback period and Accounting rate of return (ARR– calculated as average annual profits/initial investment)? Payback period A B C D

1.47 years 1.47 years 2.19 years 2.19 years

ARR 31.79% 36.54% 20.65% 36.54%

Revision questions

365

5

Consider the following two statements concerning investor attitudes towards risk: I

A risk-neutral investor will only be prepared to invest in a project with the prospect of high returns if there are no risks involved.

II

A risk-seeking investor will readily invest in a project with prospects of high returns, even if it means carrying substantially high risk.

Which one of the following combinations relating to the above statements is correct? Statement I A B C D 6

true true false false

II true false true false

The following statements have been made in relation to investment decisions. I

In making investment decisions, qualitative issues should be ignored.

II

To ensure effective risk management, all investment decisions should be taken at Board level within an organisation

III

Project controls can be applied to monitor the extent of the benefits achieved from an investment decision.

Which of the statements are true? A B C D

366

I, II and III I and III only III only none of them

Management Accounting

Chapter 11 1

Which of the following is NOT a feature of Just in Time (JIT)? A B C D

2

pull system zero inventory employee involvement increased lead times

Which one of the following statements is correct? A

The size of the Economic Order Quantity depends on the supply lead time.

B

In a Just-in-Time purchasing system, the maximum inventory is the Economic Order Quantity.

C

If a large order discount is offered for purchases above a certain quantity of units, the EOQ may fall in size.

D

When the EOQ formula is used to decide the purchase quantity average total inventory holding costs will be equal to the average total annual ordering costs.

3 Which one of the following statements is INCORRECT?

4

A

For a Just-in-Tme purchasing system to be successful there must be complete trust between a company and its supplier.

B

When inventory control involves re-order levels and minimum and maximum inventory levels, inventory should never fall below the minimum level.

C

If the profit margin on a product is 60% of the sales price, the mark-up is 150% on cost.

D

An objective of Just-in-Time production is the elimination of bottlenecks and hold-ups in production.

When a system of target costing is employed, the product concept is devised first. What should be decided next? A B C D

5

Profit margin Price Full cost Production cost

A company may price a new product fairly high initially, in order to recover as much of the development costs as possible. Prices may then be lowered as demand for the product increases and may then stabilise, or possibly fall further, when market saturation is reached. This is an example of the application of which pricing policy? A B C D

market penetration differential pricing life cycle pricing target pricing

Revision questions

367

Chapter 12 1

A company uses a range of performance measures, including units produced per tonne of material and Return on Capital Employed (ROCE). What do these measures assess? Units produced per tonne of material A B C D

2

3

efficiency capacity effectivenesseffectiveness productivity effectiveness efficiency efficiency

When measuring performance, for which of the following costs should the manager of a production department in a manufacturing company be held responsible? I II III IV

Indirect materials consumed in the department Direct materials consumed in the department Indirect labour employed in the department A share of the costs of the maintenance department

A B C D

I and III only II only I, II, III and IV II and IV only

Which one of the following is most likely to be the explanation for an unfavourable material usage variance? A B C D

4

ROCE

Rates of pay have been increased Quality standards have been increased Unforeseen material price rises have been incurred A major supplier of material has reduced the rate of trade discount

Tasmin Ltd has many divisions which it evaluates using Return on Investment (ROI) and Residual Income (RI) measures. The Melbourne division has net assets of $24m at 31 December 20X1. In the year to 31 December 20X1 it earned profit before interest and tax of $3.6m and paid interest of $0.6m. Its cost of capital is 12%. What is the correct combination of ROI and RI for the year to 31 December 20X1? ROI A B C D

5

12.5% 12.5% 15.0% 15.0%

RI $3.0m $0.72m $0.72m $3.0m

Marcham Ltd is a building company. Recently there has been a concern that too many quotations have been sent to clients either late or containing errors, partly as a result of understaffing in the responsible department. Which of the following non-financial performance indicators would not be an appropriate measure to monitor and improve performance of the quotations department? A B C D

368

Percentage of quotations found to contain errors when checked. Percentage of quotes not issued within company policy of 5 working days. Actual number of department staff as a percentage of the department's planned number of staff. Actual number of quotations issued as a percentage of budget.

Management Accounting

6

In the context of a balanced scorecard approach to the provision of performance management information, which of the following measures would be appropriate for monitoring the learning and growth perspective? I II III

Training days per employee Percentage of revenue generated by new products and services Labour turnover rate

A B C D

I and II only I and III only II and III only I, II and III

Revision questions

369

370

Management Accounting

Answers to revision questions

371

Chapter 1

372

1

D

A service company will concentrate a great deal on workforce planning and labour allocation. It will neither engage in production planning (as there is no physical product) nor in inventory valuation (as there is no inventory of physical items).

2

B

Statement I is not true as the benefit and cost of management information should be compared. Statement III is not true because many managers require summarised, high level information rather than very detailed information.

3

A

Management accounting information is any information used by management to plan and control the entity, so it can comprise non-financial (eg, employee numbers) as well as financial information, so I is true. It is used only by management, so II is false. It is concerned with planning and with revenues, ie much more than just cost control, so III is false. It is not legally required, so IV is true. Thus I and IV are true, so Option A is correct.

4

D

Cost accounting can be used to value inventory as long as the management accounting system can deliver full absorption costing valuations, so I is false. Management accounts are not legally required, so II is false. There is no set format for management accounts, so III is true. IV is the essence of management accounting so is immediately true. Thus III and IV are true, so Option D is correct.

5

D

Management control is the process by which assurance is sought that organisational goals are being achieved and procedures are being adhered to, or if not, that appropriate remedial action is taken. Thus Option C is correct.

6

D

Data, not information, is the raw material for data processing, so I is false. An organisation's financial accounting records are an internal source of information, so II is false. The main objective of a non-profit making organisation (eg, a charity) is to deliver some stated objective in the public interest (eg, to feed the hungry), so III is false. Thus none of I, II or III are true, so Option D is correct.

7

B

Vision concerns the charity’s future aspirations. Mission would go further and set out the charity’s fundamental purpose together with reference to its strategy, behaviour and values. Objectives are the specific goals of the charity and strategy is a course of action that might enable it to achieve its objectives.

8

D

The desire to increase market share is a strategic plan. The sales quotas are part of a tactical plan to help achieve this. The quotas will be broken down into individual sales targets for each sales representative (operational plans). Management control is concerned with decisions about the efficient and effective use of resources to achieve the organisation’s objectives or targets.

Management Accounting

Chapter 2 1

C $ Loss in net realisable value of the machine through using it on the special order $(8 000 – 7 500) Costs in excess of existing routine maintenance costs $(120 – 80) Total marginal user cost

500 40 540

If you selected option A you incorrectly included the depreciation cost. Depreciation is not relevant because it is not a future cash flow. Option B is incorrect because it allows for only one month's increased maintenance cost. The special order will take two months. Option D is incorrect because it includes all of the maintenance cost to be incurred. $40 per month would be incurred anyway so it is only the incremental $20 that is relevant. 2

D

Total relevant cost needs to include the opportunity cost.

3

B

This is not an assumption in relevant costing.

4

B Relevant cost of 85 litres in inventory (Realisable value = 85 × $2) Relevant cost of 15 litres to be bought (Purchase cost = 15 × $10)

$170 $150 $320

5

A $ 000 160

Cost of recruiting skilled employees (4 × $40 000) Cost of retraining Training cost Additional labour costs

15 100 115

It would be cheapest to retrain existing staff, so the relevant cost is $115,000. 6

C

The relevant cost (deprival value) of the machine is:

LOWER OF NET INCOME ($180,000) HIGHER OF

REPLACEMENT COST ($210,000)

NRV ($150,000)

REVENUES EXPECTED ($180,000)

Answers to revision questions

373

Chapter 3 1

A

Option A is correct because it is the manager responsible for implementing the budget that must prepare it, not the budget committee.

2

B

Co-ordination – Item I is an objective of budgeting. Budgets help to ensure that the activities of all parts of the organisation are co-ordinated towards a single plan. Communication – Item II is an objective of budgeting. The budgetary planning process communicates targets to the managers responsible for achieving them, and it should also provide a mechanism for lower level managers to communicate to more senior staff their estimates of what may be achievable in their part of the business. Expansion – Item III is not in itself an objective of budgeting. Although a budget may be set within a framework of expansion plans, it is perfectly normal for an organisation to plan for a reduction in activity.

3

B

The principal budget factor is the factor which limits the activities of an organisation. Although cash and profit are affected by the level of sales (options A and B), sales is not the only factor which determines the level of cash and profit.

4

C Output = 36 000 kg Wastage = 10% of input Therefore input = 36 000/0.90 = 40 000 kg Closing inventory Used in production Less Opening inventory Purchases

5

kg 14 000 40 000 54 000 (16 000) 38 000

A All invoices are sent out at the end of the month; therefore payments within 7 days occur in the following month. In May, 20% of April sales customers will pay within 7 days and take the settlement discount; another 30% of April sales customers will pay before the end of May. Irrecoverables are 1%; therefore 49% of March sales will be collected in May Cash receipts Customers taking 2% discount: 20% × $600 000 × 98% Other customers paying within one month of invoice: 30% × $600 000 Receipts from March sales: 49% ×$500 000 Total receipts

6

$ 117 600 180 000 245 000 542,600

D The high-low method can be used to estimate fixed and variable costs Total cost of 36 000 units Total cost of 29 000 units, adding $49 000 to remove fixed cost difference Variable cost of 7 000 units

$ 370 200 340 800 29 400

Variable cost per unit = $29 400/7 000 = $4.20

374

Total cost of 36 000 units Variable cost of 36 000 units (× $4.20) Fixed costs (above 30 000 units of output)

$ 370 200 151 200 219 000

Fixed costs Variable cost of 31 000 units (× $4.20) Total cost of 31 000 units

$ 219 000 130 200 349 200

Management Accounting

Chapter 4 1

A

Independent Variable x = advertising expenditure Dependent variable y = sales revenue Highest x = month 6 = $6 500 Highest y = month 6 = $225 000 Lowest x = month 2 = $2 500 Lowest y = month 2 = $125 00 Using the high-low method: Advertising expenditure $ 6 500 2 500 4 000

Highest Lowest

Sales revenue generated for every $1 spent on advertising =

Sales revenue $ 225 000 125 000 100 000

$100 000 = $25 per $1 spent. $4 000

∴ If $6 500 is spent on advertising, expected sales revenue = $6 500 × $25 = $162 500 ∴ Sales revenue expected without any expenditure on advertising = $225 000 – $162 500 $62 500 ∴ Sales revenue = 62 500 = (25 × advertising expenditure)

2

B Activity level $ 10 000 5 000 5 000

Highest Lowest Variable cost per unit = 3

Cost $ 400 000 250 000 150 000

$150 000 = $30 5 000 units

C Production Units 5 000 3 000 2 000

Level 2 Level 1

Variable cost per unit

=

Total cost $ 9 250 6 750 2 500

$2 500 2 000 units

= $1.25 per unit Fixed overhead = $9 250 – ($1.25 × 5 000) = $3 000 4

A

Currently weekly contribution = 12% × $280 000 = $33 600 Extra contribution from 5% increase in sales = 5% × $33 600 Loss on product Z each week 3 000 × $(1.90 – 2.20 – 0.15) Weekly increase in profit

$ 1 680 (1 350) 330

If you selected option B you forgot to allow for the variable cost of distributing the 3 000 units of Product Z. Option C is based on a five per cent increase in revenue from the other products; however extra variable costs will be incurred, therefore the gain will be a five per cent increase in contribution. If you selected option D you made no allowance for the variable costs of either product Z or the extra sales of other products.

Answers to revision questions

375

5

C

Sales revenue at breakeven point =

Budgeted/planned sales revenue

$60 000 Fixed costs = = $150 000 Contribution/Sales ratio 0.4

= $150 000 + margin of safety = $150 000 + $64 000 = $214 000

Budgeted/planned activity level

=

$214 000 $40

= 5 350 units 6

B

P/V ratio

=

Contribution per unit Selling price per unit

=

$(20 _ 4 _ 3 _ 2 _ 1) × 100% = 50% $20

If you selected option A you calculated profit per unit as a percentage of the selling price per unit. Option C excludes the variable selling costs from the calculation of contribution per unit. Option D excludes the variable production overhead cost, but all variable costs must be deducted from the selling price to determine the contribution.

376

Management Accounting

Chapter 5 1

D

Indirect costs are those which cannot be easily identified with a specific cost unit. Although the staples could probably be identified with a specific chair, the cost is likely to be relatively insignificant. The expense of tracing such costs does not usually justify the possible benefits from calculating more accurate direct costs. The cost of the staples would therefore be treated as an indirect cost, to be included as a part of the overhead absorption rate. Options A, B and C all represent significant costs which can be traced to a specific cost unit. Therefore they are classified as direct costs.

2

D

The correct answer is D. Total Maintenance overheads

= $40 000 + 15% of Cafeteria overheads = $40 000 + 15% of $20 000 = $43 000

Of which 35% are apportioned to G = $15 050 Cafeteria costs apportioned to G = 25% of $20 000 = $5 000 Total overheads for G = $80 000 + 15 050 + 5 000 = $100 050 3

B

The correct answer is B. Overhead absorption rate =

4

A

Budgeted overheads $350 000 = $14 per machine hour = Budgeted machine hours 25 000

Contribution per unit

= $30 – $(6.00 + 7.50 + 2.50) = $14

Contribution for month

= $14 × 5,200 units = $72 800

Less fixed costs incurred

= $27 400

Marginal costing profit

= $45 400

If you selected option B you calculated the profit on the actual sales at $9 per unit. This utilises a unit rate for fixed overhead which is not valid under marginal costing. If you selected option C you used the correct method but you based your calculations on the units produced rather than the units sold. If you selected option D you calculated the correct contribution but you forgot to deduct the fixed overhead. 5

D $ Sales (5 200 at $30) Materials (5 200 at $6) Labour (5 200 at $7.50) Variable overhead (5 200 at $2.50) Total variable cost Fixed overhead ($5 × 5 200) Over-absorbed overhead (*) Absorption costing profit *Working Overhead absorbed (5 800 × $5) Overhead incurred Over-absorbed overhead

$ 156 000

31 200 39 000 13 000 (83 200) (26 000) 1 600 48 400 $ 29 000 27 400 1 600

If you selected option A you calculated all the figures correctly but you subtracted the overabsorbed overhead instead of adding it to profit.

Answers to revision questions

377

Option B is the marginal costing profit.

If you selected option C you calculated the profit on the actual sales at $9 per unit, and forgot to adjust for the over-absorbed overhead. 6

378

C

All of the methods are acceptable bases for absorbing production overheads. However, the percentage of prime cost has serious limitations and the rate per unit can only be used if all cost units are identical.

Management Accounting

Chapter 6 1

D

Neither statement is correct.

2

C

Order processing costs Transport costs Customer cost

3

D

4

C

=

$1 573 000/325 000 orders

=

$4.84 per order

=

$2 631 200/1 495 000 km

=

$1.76 per km

=

(138 x $4.84) + (122 x 138 x $1.76)

=

$30 299.28

None of the statements is correct.

Cost description

Purchase order processing

Cost amount $ 450 000

Cost driver

Activity level

Purchase orders

6 000

Overhead Allocation Rate (OAR) $ 75

450 32 000

Production run set up

180 000

Production runs

Machine running

640 000

Machine hours

Product activity

30

Cost $ 2 250

400

1

400

20

750

15 000

Cost per batch =

17 650

Cost per unit = 17 650/500 =

35.30

Answers to revision questions

379

Chapter 7 1

A

Good production

= input – normal loss – abnormal loss = (2 500 – (2 500 × 10%) – 75) kg = 2 500 – 250 – 75 = 2 175 kgs

2

D

Expected output = 2 000 units less normal loss (5%) 100 units = 1 900 units In situation I there is an abnormal loss of 1 900 – 1 800 = 100 units In situation II there is an abnormal gain of 1 950 – 1 900 = 50 units In situation III there is an abnormal gain of 2 000 – 1 900 = 100 units

3

D Equivalent units Total Units 300 9 550 9 850 450 10 300

Opening inventory Fully worked units* Output to finished goods Closing inventory * Fully worked units

4

B

(100%)

Materials Units 300 9 550 9 850 450 10 300

(30%)

Conversion costs Units 300 9 550 9 850 135 9 985

= input – closing inventory = (10 000 – 450) units = 9 550 units

Input costs = 2 000 units × $4.50 = $9 000 Conversation costs = $13 340 Normal loss = 5% × 2 000 units × $3 = $300 Expected output = 2 000 units – 100 units = 1 900 units Cost per unit of output

=

Input costs Expected output

=

$9 000 + $13 340 − $300 1 900 units

=

$22 040 1 900 units

= $11.6 (to one decimal place) 5

A

Total production cost for June to be apportioned =

$1 000 + $10 000 + $12 000 – $3 000

=

$20 000

P R

Production Units 4 000 6 000 10 000

($20 000 × 4/10) ($20 000 × 6/10)

Apportioned cost $ 8 000 12 000 20 000

If you selected option B you made no adjustment for inventories when calculating the total costs. If you selected option C you apportioned the production costs on the basis of the units sold. Option D is the total cost of product R. 6

380

D

Process costing is a 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. The manufacture of liquid soap is a continuous production process.

Management Accounting

Chapter 8 1

C

A personnel manager would usually keep information concerning the expected rates of pay for employees with a given level of experience and skill. Option A is incorrect because although the trade union is involved in negotiating future rates of pay for their members, they do not take decisions on the standard rate to be paid in the future.

A production manager (option B) would provide information concerning the number of employees needed and the skills required, but they would not have the latest information concerning the expected rates of pay. 2

A

An attainable standard cost is an inappropriate basis for measuring inventory values, unless the standard is actually attained. Attainable standards are much more relevant to planning and control.

3

A

Standard costing provides targets for achievement, and yardsticks against which actual performance can be monitored (item I). It also provides the unit cost information for evaluating the volume figures contained in a budget (item II). Inventory control systems are simplified with standard costing. Once the variances have been eliminated, all inventory units are valued at standard price (item III). Item IV is incorrect because standard costs are an estimate of what will happen in the future, and a unit cost target that the organisation is aiming to achieve.

4

B

It is generally accepted that the use of attainable standards has the optimum motivational impact on employees. Some allowance is made for unavoidable wastage and inefficiencies, but the attainable level can be reached if production is carried out efficiently. Option C and option D are not correct because employees may feel that the goals are unattainable and will not work so hard. Option A is not correct because standards set at a minimal level will not provide employees with any incentive to work harder.

5

C

When management by exception is adopted within a standard costing system, only the variances which exceed acceptable tolerance limits need to be investigated by management with a view to control action. Unfavourable and favourable variances alike may be subject to investigation, therefore option D is incorrect. Any efficient information system would ensure that only managers who are able to act on the information receive management reports, even if they are not prepared on the basis of management by exception. Therefore option B is incorrect.

6

D

Standard labour cost per unit = 9 hours ×

100 × $9 = $90 90

You should have been able to eliminate option A because it is less than the basic labour cost of $81 for 9 hours of work. Similar reasoning also eliminates option B. If you selected option C you simply added 10% to the 9 active hours to determine a standard time allowance of 9.9 hours per unit. However the idle time allowance is given as 10% of the total labour time.

Answers to revision questions

381

Chapter 9 1

C

Since inventories are valued at standard cost, the material price variance is based on the materials purchased. 12 000 kgs material purchased should cost (×$3) but did cost Material price variance

$ 36 000 33 600 2 400 (F)

800 units manufactured should use (× 14 kg) but did use Usage variance in kg × standard price per kg Usage variance in $

11 200 kgs 11 500 kgs 300 kg (A) × $3 $900 (A)

If you selected options A or B you based your calculation of the material price variance on the material actually used. If you selected option B you forgot to evaluate the usage variance in kg at the standard price per kg. If you selected option D you evaluated the usage variance at the actual price per kg, rather than the standard price per kg. 2

C

Statement I is not consistent with a favourable labour efficiency variance. Employees of a lower skill level are likely to work less efficiently, resulting in an unfavourable efficiency variance. Statement II is consistent with a favourable labour efficiency variance. Time would be saved in processing if the material was easier to process. Statement III is consistent with a favourable labour efficiency variance. Time would be saved in processing if working methods were improved.

3

B

Direct material cost variance = material price variance + material usage variance. The unfavourable material usage variance could be larger than the favourable material price variance. The total of the two variances would therefore represent a net result of an unfavourable total direct material cost variance. The situation in option D would sometimes arise, but not always, because of the possibility of the situation described in option B. Option C could sometimes be correct, depending on the magnitude of each of the variances. However it will not always be correct as stated in the wording. Option A is incorrect because the sum of the two favourable variances would always be a larger favourable variance.

4

B 53 000 kgs should cost (× $2.50) but did cost Material price variance

5

D

Total standard cost of material purchased – actual cost of material purchased = Price variance Total standard cost

=

$21 920 + $1 370

=

$23 290

Standard price per kg =

$23 290 6 850

=

382

$ 132 500 136 000 3 500 (A)

Management Accounting

$3.40

Option A is the favourable price variance per kg. This should have been added to the actual price to determine the standard price per kg. If you selected option B you subtracted the price variance from the actual cost. If the price variance is favourable then the standard price per kg must be higher than the actual price paid. Option C is the actual price paid per kg.

6

D

Raising prices in response to higher demand would result in a favourable selling price variance. Market penetration pricing, option A, is a policy of low prices. This would result in an unfavourable selling price variance, if the original planned policy had been one of market skimming pricing, which involves charging high prices. Early payment discounts, option B, do not affect the recorded selling price. Reducing selling prices, option C, is more likely to result in an unfavourable selling price variance.

Answers to revision questions

383

Chapter 10 1

B

Soft capital rationing is a limit on capital investment imposed from within the company.

2

A

All the statements are advantages of carrying out a PCA.

3

C

The consultancy fee of $10 000 has already been incurred and is irrelevant. Payback Year

Cash flow $ (90 000) 25 000 35 000 40 000

0 1 2 3

Cumulative $ (90 000) (65 000) (30 000) 10 000

Payback is after 2 years plus 30 000/(30 000 + 10 000) of Year 3, ie after 2.75 years. 4

A Payback

Add back depreciation to annual profits to get cashflows. Depreciation = 46 000 – 6 000/4 = 10 000 pa Cash flow

Cumulative

Initial investment = (46 000)

(46 000)

Year 1 20 500 + 10 000 = 30 500

(15 500)

Year 2 23 000 + 10 000 = 33 000

(17 500)

Year 3 13 500 + 10 000 = 23 500 Year 4 1 500 + 10 000 = 11 500 Payback period = 1 year + 15 500/33 000 = 1.47 years ARR

Average profit = (20 500 + 23 000 + 13 500 + 1 500)/4 = 14 625 ARR = 14 625/ 46 000 = 31.79% 5

C A risk neutral investor does not require a zero risk - they are indifferent to the level of risk involved in an investment and only concerned about the expected return.

6

C Whilst it is easier to apply project controls to ensure spending is within authorised limits and that the implementation of the investment is not delayed, longer term controls can help ensure the anticipated benefits are eventually obtained. Financial analysis of an investment decision is obviously vital however qualitative issues should also be considered in the initial screening stage. Investment decisions may be made at different levels within the organisational hierarchy depending on the type and amount of investment and the level of risk.

384

Management Accounting

Chapter 11 1

D

2

D

Just in time (JIT) features machine cells which help products flow from machine to machine without having to wait for the next stage of processing or returning to store. Lead times and Work in Progress (WIP) are therefore reduced.

If you are not sure about this, you should do a few calculations with some simple EOQ numbers. Total holding costs and total ordering costs each year are the same when inventories are purchased in the EOQ size. The EOQ purchasing system is incompatible with JIT, and the size of the order quantity does not depend on the lead time for re-ordering and re-supply. If discounts for bulk purchases are offered, the EOQ may increase (since the value of the holding cost H may fall). 3

B The inventory level control system is designed to avoid a situation where there is no inventory when it is needed. The minimum inventory level acts as a warning sign that inventory levels are getting low. It is possible however that stock levels may fall below this, for example if there is maximum demand in the supply lead time period, and the supply lead time is at its longest. JIT purchasing does depend on complete trust between buyer and supplier, for example so that the supplier is aware of what quantities the buyer will need and when, and the buyer is aware of the state of the supplier’s production and inventory. JIT production has elimination of waste as an objective: this includes the elimination of bottlenecks and hold-ups in production.

4

B After the product concept has been created, the first step is to set a price that customers are likely to pay for it. After price, a target profit margin is established, so that the target cost can be identified.

5

C It could be argued that there is market skimming at the beginning of the product’s life cycle, but the changes in prices as the product goes through the stages of its life cycle is an example of life cycle pricing.

Answers to revision questions

385

Chapter 12 1

D

Both relate outputs to inputs and are therefore measures of efficiency.

2

C

Managers should be held responsible for costs over which they have some influence. Although it is the responsibility of the maintenance department manager to keep maintenance costs within budget, their costs will be partly fixed and partly variable, and the variable cost element will depend on the volume of demand for the service. If the production department staff don't use their equipment appropriately we might expect higher maintenance costs. The production department manager should be made accountable for the costs that his department causes the maintenance department to incur on its behalf.

3

B

If higher quality standards are required, more material may be used as wastage rates will likely be higher.

4

C

Return on investment

Residual income

3.6/24 = 15.0%

3.6 – (24m × 12%) = 0.72m

5

D

Improving performance is concerned with quality of output, not quantity.

6

D

All of the measures would be appropriate for monitoring the learning and growth perspective. The higher the number of training days per employee (measure (I)), the more the organisation is focusing on learning, and improving the employees' skills. The higher the percentage of revenue generated by new products and services (measure (II)), the more innovative the organisation is being, rather than relying on established products and services. It could be argued that the higher the labour turnover rate (measure (III)), the more fresh ideas are being brought into the organisation as new employees join. This measure would need to be interpreted with care, however, as a high labour turnover rate may indicate dissatisfaction among employees, for example if they feel there is a lack of opportunity for training and further advancement.

386

Management Accounting

Before you Begin Answers and commentary

387

Chapter 1 1

2

Financial accounts

Management accounts

Financial accounts detail the performance of an organisation over a defined period and the state of affairs at the end of that period.

Management accounts are used to aid management record, plan and control the organisation's activities and to help the decision-making process.

Limited liability companies must, by law, prepare financial accounts.

There is no legal requirement to prepare management accounts.

The format of published financial accounts is determined by local law and by International Financial Reporting Standards. In principle, the accounts of different organisations can therefore be easily compared.

The format of management accounts is entirely at management discretion: no strict rules govern the way they are prepared or presented. Each organisation can devise its own management accounting system and format of reports.

Financial accounts concentrate on the business as a whole, aggregating revenues and costs from different operations, and are an end in themselves.

Management accounts can focus on specific areas of an organisation's activities. Information may be produced to aid a decision rather than to be an end product of a decision.

Most financial accounting information is of a monetary nature.

Management accounts incorporate nonmonetary measures. Management may need to know, for example, tons of aluminium produced, monthly machine hours, or miles travelled by sales staff.

Financial accounts present an essentially historic picture of past operations.

Management accounts are both an historical record and a future planning tool.

Cost accounting and management accounting are terms which are often used interchangeably. It is not correct to do so. Cost accounting is part of management accounting. Cost accounting provides a bank of data for the management accountant to use. Cost accounting is concerned with the following: • • •

Preparing statements (e.g. budgets, costing). Cost data collection. Applying costs to inventory, products and services.

Management accounting is concerned with the following: • 3

388

Using financial data and communicating it as information to users.

An objective is the aim or goal of an organisation (or an individual) whereas is strategy is a possible course of action that might enable an organisation (or an individual) to achieve its objectives.

Management Accounting

4

5

Anthony divides management activities into strategic planning, management control and operational control.

6

• • • • • •

7

Data is the raw material for data processing. Data relates to facts, events and transactions whereas information is data that has been processed in such a way as to be meaningful to the person who receives it. Information is anything that is communicated.

8

Good information should be relevant, complete, accurate, clear, it should inspire confidence, it should be appropriately communicated, its volume should be manageable, it should be timely and its cost should be less than the benefits it provides.

9

Title

Planning: deciding what to do and identifying the desired results. Recording the plan which should incorporate standards of efficiency or targets. Carrying out the plan and measuring actual results achieved. Comparing actual results against the plans. Evaluating the comparison, and deciding whether further action is necessary. Where corrective action is necessary, this should be implemented.

Who is the report intended for? Who is the report from? Date Subject Appendix 10

• • •

Globalisation and increased competition. Information technology changes resulting in changes in production and information flows. Changes in organisations including internal reorganisations and external mergers.

Before you Begin: Answers and commentary

389

11

390

(a)

Staff with accounting knowledge.

(b)

The equipment they use.

(c)

Paper or computer records of financial transactions.

(d)

Codes or titles describing the purpose of the financial transaction (for example, 'Rent') and who it was incurred on behalf of (for example, 'Factory A').

(e)

Records of the usage of resources other than money, such as time, physical materials, energy and so on.

(f)

A large variety of simple and complex mathematical techniques for arranging and analysing (c) in terms of (d) and (e).

(g)

Reports that are produced by the people in (a), using (b) to (f). Also, prescribed formats for reports, at least in larger, more bureaucratic organisations.

(h)

Managers, to whom the reports are given.

12

Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as they are required by a customer or for use, rather than for stock. A JIT system is a 'pull' system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales.

13

Total quality management (TQM) is the process of applying a zero defects philosophy to the management of all resources and relationships within an organisation as a means of developing and sustaining a culture of continuous improvement which focuses on meeting customers' expectations.

14

Kaizen is a Japanese term for continuous improvement in all aspects of an organisation's performance at every level. Kaizen aims to achieve a specified cost reduction, but to do so through continuous improvements rather than one-off changes.

Management Accounting

Chapter 2 1

Relevant costs are future cash flows arising as a direct consequence of a decision. Remember decisions should be made based on relevant costs.

2

Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.

3

Differential cost is the difference in total cost between alternatives. An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in preference to an alternative.

4

A sunk cost is a past cost which is not directly relevant in decision making.

5

The relevant cost of an asset represents the amount of money that a company would have to receive if it were deprived of an asset in order to be no worse off than it already is. We can call this the deprival value.

6

An easy way to generate ideas here is to think about an organisation that you know and what factors stop it making more revenue. (a)

Sales. There may be a limit to sales demand.

(b)

Labour. There may be a limit to total quantity of labour available or to labour having particular skills.

(c)

Materials. There may be insufficient available materials to produce enough products to satisfy sales demand.

(d)

Manufacturing capacity. There may not be sufficient machine capacity for the production required to meet sales demand.

Before you Begin: Answers and commentary

391

Chapter 3 1

A budget is a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities and cash flows, or non-monetary items such as staff numbers

2

• • • • • •

3

The principal budget factor is the factor which limits the activities of an organisation and is therefore the starting point for the creation of budgets.

4

• • •

5

A fixed budget is a budget which is set for a single activity level whereas a flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.

6

Incremental budgeting is concerned mainly with the increments in costs and revenues which will occur whereas zero based budgeting involves preparing a budget for each cost centre from a zero base.

7

Ideal standards, attainable standards, current standards and basic standards.

8



They are based on information from employees most familiar with the department operations. Budgets should therefore be more realistic.



Knowledge spread among several levels of management is pulled together, again producing more realistic budgets.



Because employees are more aware of organisational goals, they should be more committed to achieving them.



Co-ordination and cooperation between those involved in budget preparation should improve.



Senior managers' overview of the business can be combined with operational-level details to produce better budgets.



Managers should feel that they 'own' the budget and will therefore be more committed to the targets and more motivated to achieve them.



Participation will broaden the experience of those involved and enable them to develop new skills.



They consume more time.



Budgets may be unachievable if managers are not qualified to participate.



Managers may not co-ordinate their own plans with those of other departments.



Managers may include budgetary slack (padding the budget) in their budgets. This means they have over-estimated costs or under-estimated income. Actual results are then more likely to be better than the budgeted target results.



An earlier start to the budgeting process could be required.

9

392

Co-ordination and allocation of responsibility for the preparation of budgets. Issuing of the budget manual. Timetabling. Provision of information to assist in the preparation of budgets. Communication of final budgets to the appropriate managers. Monitoring the budgeting and planning process by comparing actual and budgeted results.

Pay creditors early to obtain discount. Attempt to increase sales by increasing debtors and inventories. Make short-term investments.

10

The aim is to 'get it right first time' which means that there is a striving for continuous improvement in order to eliminate faulty work and prevent mistakes.

11

The budgeting process is about setting standards or targets for all aspects and functions of the business to meet. If the budgeting process is successful it can help in the continuous process of improvement (Total Quality Management) by setting targets that eventually eliminate all unnecessary waste and mistakes.

Management Accounting

Chapter 4 1

A fixed cost is a cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity.

2

A variable cost is a cost which tends to vary with the level of activity.

3

Graph of fixed cost $ Cost

Fixed cost

Volume of output (level of activity)

Volume of output (level of activity)

4

Step 1 Review records of costs in previous periods. • •

Select the period with the highest activity level. Select the period with the lowest activity level.

Step 2 Determine the following: • • • •

Total cost at high activity level Total costs at low activity level Total units at high activity level Total units at low activity level

Step 3 Calculate the following: Total cos t at high activity level _ total cos t at low activity level = variable cost per unit (v) _ Total units at high activity level total units at low activity level Step 4 Determine the fixed costs. Fixed costs = (total cost at high activity level ) – (total units at high activity level × variable cost per unit)

5

Cost-volume-profit (CVP) / breakeven analysis is the study of the interrelationships between costs, volume and profit at various levels of activity.

6

The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each $1 of sales.

Before you Begin: Answers and commentary

393

7

The target profit is achieved when S = V + F + P. where: S = Sales revenue V = Total variable costs F = Total fixed costs P = Required profit

8

Break-even chart

Break-even point

9

394

• • • • • • •

It can only apply to a single product or a single mix of a group of products. A breakeven chart may be time-consuming to prepare. It assumes fixed costs are constant at all levels of output. It assumes that variable costs are the same per unit at all levels of output. It assumes that sales prices are constant at all levels of output. It assumes production and sales are the same - inventory levels are ignored. It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

Management Accounting

Chapter 5 1

A direct cost is a cost that can be traced in full to the product, service, or department that is causing the cost to be incurred.

2

An indirect cost, or overhead, is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

3

Direct wages are all wages paid for labour, either as basic hours or as overtime, expended on work on the product.

4

Overhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.

5

The main reasons for using absorption costing are for inventory valuations, pricing decisions, and establishing the profitability of different products.

6

The three stages of absorption costing are allocation, absorption and apportionment.

7

Step 1

Estimate the overhead likely to be incurred during the period.

Step 2

Estimate the activity level for the period. This could be total hours, units, or direct costs or whatever the basis on which the overhead absorption rates are to be based.

Step 3

Divide the estimated overhead by the budgeted activity level. This produces the overhead absorption rate.

8

Marginal cost is the variable cost of one unit of product or service.

9

(a)

Period fixed costs are the same, for any volume of sales and production – provided that the level of activity is within the 'relevant range'.

(b)

Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.

(c)

Profit measurement should therefore be based on an analysis of total contribution.

(d)

When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.

Before you Begin: Answers and commentary

395

Chapter 6

396

1

The major reason is the failure of traditional costing systems to adapt to changes in organisations and their environments.

2

Activity based costing (ABC) is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.

3

The principal idea of ABC is to focus attention on what causes costs to increase, i.e. the cost drivers.

4

ABC should only be introduced if the additional information it provides will result in action that will increase the organisation's overall profitability.

5

Product-sustaining activities are activities undertaken to develop or sustain a product or service. Product sustaining costs are linked to the number of products or services, not to the number of units produced.

6

Facility-sustaining activities are activities undertaken to support the organisation as a whole, and which cannot be logically linked to individual units of output, batches or products.

7

(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)

ABC facilitates a good understanding of what drives overhead costs.

(c)

ABC is concerned with all overhead costs and so it takes management accounting beyond its 'traditional' boundaries.

(d)

By controlling the incidence of the cost driver, the level of the cost can be controlled.

(e)

The costs of activities not included in the costs of the products an organisation makes or the services it provides can be considered to be not contributing to the value of the product or service (that is non-value adding).

(f)

ABC can help with cost management.

(g)

Many costs are driven by customers, delivery costs, discounts, after-sales service and so on, but traditional absorption costing systems do not account for this.

(h)

Simplicity is part of its appeal.

8

Customer profitability analysis is the analysis of the revenue streams and service costs associated with specific customers or customer groups.

9

(a)

Can a single cost driver explain the cost behaviour of all items in its associated pool?

(b)

The number of cost pools and cost drivers cannot be excessive otherwise an ABC system would be too complex and too expensive.

(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)

The costs of ABC may outweigh the benefits.

(e)

Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage for items like rent, rates and building depreciation.

Management Accounting

Chapter 7 1

Process costing is a costing method used when it is not possible to identify separate units of production, or jobs, usually because of the continuous nature of the production processes involved.

2

Process costing is a form of costing applicable to continuous processes where process costs are attributed to the number of units produced.

3

On the left hand side of the process account the inputs to the process and the cost of these inputs are recorded.

4

On the right hand side of the process account we record what happens to the inputs by the end of the period.

5

Step 1 Step 2 Step 3 Step 4

6

The normal loss is expected loss, allowed for in the budget, and normally calculated as a percentage of the good output, from a process during a period of time. Normal losses are generally either valued at zero or at their disposal values.

Determine output and losses. Calculate cost per unit of output, losses and Work in Progress (WIP). Calculate total cost of output, losses and WIP. Complete accounts.

Abnormal loss is any loss in excess of the normal loss allowance. Abnormal gain is improvement on the accepted or normal loss associated with a production activity.

7

The valuation of normal loss is either at scrap value or nil.

8

The weighted average cost method of valuing opening Work in Progress (WIP) makes no distinction between units of opening WIP and new units introduced to the process during the current period.

9

Joint products are two or more products produced by the same process and separated in processing, each having a sufficiently high saleable value to merit recognition as a main product. For example, in the oil refining industry the following joint products all arise from the same process.

• • • •

Diesel fuel. Petrol. Paraffin. Lubricants.

10

A by-product is output of some value produced incidentally while manufacturing the main product. Meat processing produces meat for human consumption as well as dog bones, glue and so on.

11

Job costing is the method used when work is undertaken to a customer's special requirements and each order is of comparatively short duration.

Before you Begin: Answers and commentary

397

Chapter 8 1

A standard cost is a predetermined estimated unit cost, used for inventory valuation and control.

2

To value inventories and cost production for cost accounting purposes. To act as a control device by establishing standards (planned costs), highlighting (via variance analysis which we will cover in the next chapter) activities that are not conforming to plan and therefore alerting management to areas which may be in need of corrective action.

398

3

A variance.

4

Ideal, attainable, current and basic.

5

• • • •

Purchase contracts already agreed. Pricing discussions with regular suppliers. The forecast movement of prices in the market. The availability of bulk purchase discounts.

Management Accounting

Chapter 9 1

A variance is the difference between a planned, budgeted, or standard cost and the actual cost incurred. Basically it is a just a difference.

2

The direct material total variance can be subdivided into the direct material price variance and the direct material usage variance.

3

The way inventory is valued will change the value of the variance.

4

The direct labour rate variance and the direct labour efficiency variance.

5

The variable production overhead expenditure variance and the variable production overhead efficiency variance.

6

The expenditure variance and the volume variance.

7

The reasons for cost variances arising are summarised in the table that follows. Favourable

Adverse

(a)

Material price

Unforeseen discounts received Planned purchases Change in material standard

Price increase Unplanned purchases Change in material standard

(b)

Material usage

Material used of higher quality than standard More effective use made of material Errors in allocating material to jobs

Defective material Excessive waste Theft Stricter quality control Errors in allocating material to jobs

(c)

Labour rate

Use of apprentices or other workers at a rate of pay lower than standard

Wage rate increase Use of higher grade labour

(d)

Idle time

The idle time variance is always adverse

Machine breakdown Non-availability of material Illness or injury to workers

(e)

Labour efficiency

Output produced more quickly than expected because of work motivation, better quality of equipment or materials, or better methods. Errors in allocating time to jobs

Lost time in excess of standard allowed Output lower than standard set because of deliberate restriction, lack of training, or sub-standard material used Errors in allocating time to jobs

(f)

Overhead expenditure

Savings in costs incurred More economical use of services

Increase in cost of services used Excessive use of services Change in type of services used

(g)

Overhead volume efficiency

Labour force working more efficiently (favourable labour efficiency variance)

Labour force working less efficiently (adverse labour efficiency variance)

(h)

Overhead volume capacity

Labour force working overtime

Machine breakdown, strikes, labour shortages

8

Variances should only be investigated where the amount is material, i.e. significant to decision makers and when the reasons for the variance can be control.

9

The difference between what the sales revenue is and should have been for the actual quantity sold.

Before you Begin: Answers and commentary

399

10

The difference between the actual units sold and the budgeted (planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted (planned).

11

A proforma operating statement reconciling budgeted profit and actual profit. Budgeted (planned) profit before sales and administration costs Sales variances: price volume Actual sales minus the standard cost of sales Cost variances Material price Material usage Labour rate Labour efficiency Labour idle time Variable overhead expenditure Variable overhead efficiency Fixed overhead expenditure Fixed overhead volume efficiency Fixed overhead volume capacity

Actual profit before sales and administration costs Sales and administration costs Actual profit

400

Management Accounting

(F) $ X X X X X X X X X X X

X X X (A) $ X X X X X X X X X X X

X X

X X X X

Chapter 10 1

Origination of proposals; project screening; analysis and acceptance; and monitoring and review.

2

Step 1

Complete and submit standard format financial information as a formal investment proposal.

Step 2

Classify the project by type – to separate projects into those that require more or less rigorous financial appraisal, and those that must achieve a greater or lesser rate of return in order to be deemed acceptable.

Step 3

Carry out financial analysis of the project.

Step 4

Compare the outcome of the financial analysis to predetermined acceptance criteria.

Step 5

Consider the project in the light of the capital budget for the current and future operating periods.

Step 6

Make the decision – go/no go.

Step 7

Monitor the progress of the project.

3

A post-completion audit (PCA) is an objective independent assessment of the success of a capital project in relation to plan. It covers the whole life of the project and provides feedback to managers to aid the implementation and control of future projects.

4

(a)

The threat of the PCA is likely to motivate managers to work to achieve the promised benefits from the project.

(b)

If the audit takes place before the project life ends, and if it finds that the benefits have been less than expected, steps can be taken to improve efficiency. Alternatively, it will highlight those projects which should be discontinued.

(c)

It can help to identify managers who have been good performers and those who have been poor performers.

(d)

It might identify weaknesses in the forecasting and estimating techniques used to evaluate projects, and so should help to improve the discipline and quality of forecasting for future investment decisions.

(e)

Areas where improvements can be made in methods which should help to achieve better results in general from capital investments might be revealed.

(f)

The original estimates may be more realistic if managers are aware that they will be monitored, but post-completion audits should not be unfairly critical.

5

A reasonable guideline might be to audit all projects above a certain size, and a random selection of smaller projects.

6

It is generally appropriate to separate responsibility for the investment decision from that for the PCA.

7

Payback is the time required for the cash inflows from a capital investment project to equal the cash outflows.

8

(a)

It ignores the timing of cash flows within the payback period, the cash flows after the end of the payback period and therefore the total project return.

(b)

It ignores the time value of money which is a concept incorporated into more sophisticated appraisal methods.

(c)

The method is unable to distinguish between projects with the same payback period.

(d)

The choice of any cut-off payback period by an organisation is arbitrary.

(e)

It may lead to excessive investment in short-term projects.

(f)

It takes account of the risk of the timing of cash flows but does not take account of the variability of those cash flows.

Before you Begin: Answers and commentary

401

9

10

(a) (b) (c) (d) (e) (f)

Long payback means capital is tied up, so look for short payback opportunities. Focus on early payback will encourage strong liquidity. Investment risk is increased if payback is longer, so look for short payback. Shorter-term forecasts are likely to be more reliable, so look for short payback. The calculation is quick and simple. Payback is an easily understood concept.

Average annual profit from investment × 100 Average investment or Estimated total profits / estimated initial investment x 100 or Estimated average profits / estimated initial investment x 100

11

The ARR method has the serious drawback that it does not take account of the timing of the profits from a project There are a number of other drawbacks: (a)

It is based on accounting profits which are subject to a number of different accounting treatments.

(b)

It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.

(c)

It takes no account of the length of the project.

(d)

Like the payback method, it ignores the time value of money.

Advantages of the ARR method:

12

(a)

It is quick and simple to calculate.

(b)

It involves a familiar concept of a percentage return.

(c)

Accounting profits can be easily calculated from financial statements.

(d)

It looks at profits throughout the entire project life.

(e)

Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method which employs profit may therefore be more easily understood.

Risk involves situations or events which may or may not occur, but whose probability of occurrence can be calculated statistically and the frequency of their occurrence predicted from past records. Uncertain events are those whose outcome cannot be predicted with statistical confidence.

402

Management Accounting

Chapter 11 1

Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as they are required by a customer or for use, rather than for stock. A JIT system is a pull system, which responds to demand, in contrast to a push system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales.

2

JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually being processed. While it is being inspected for quality, moving from one part of the factory to another, waiting for further processing and held in store, value is not being added. Non value-added activities, or diversionary activities, should therefore be eliminated.

3

(a) (b) (c)

It is not always easy to predict patterns of demand. JIT makes the organisation far more vulnerable to disruptions in the supply chain. Wide geographical spread of suppliers and manufacturing makes JIT difficult.

4

• • • • • • • •

To ensure sufficient goods are available to meet expected demand. To provide a buffer between processes. To meet any future shortages. To take advantage of bulk purchasing discounts. To absorb seasonal fluctuations and any variations in usage and demand. To allow production processes to flow smoothly and efficiently. As a necessary part of the production process – such as when maturing cheese. As a deliberate investment policy, especially in times of inflation or possible shortages.

5

The EOQ can be calculated using a table, graph or formula.

6

EOQ =

2C D 0 C H

where:

7

CH C0 D

= cost of holding one unit of inventory for one time period = cost of ordering a consignment from a supplier = demand during the time period

1

Order cycling method

Under the order cycling method, quantities on hand of each item are reviewed periodically (every 1, 2 or 3 months). 2

Two-bin system

The two-bin system of stores control, or visual method of control, is one whereby each stores item is kept in two storage bins. 3

Classification of materials

Materials items may be classified as expensive, inexpensive or in a middle-cost range. (a)

Expensive and medium-cost materials are subject to careful stores control procedures to minimise cost.

(b)

Inexpensive materials can be stored in large quantities because the cost savings from careful stores control do not justify the administrative effort required to implement the control.

This selective approach to stores control is sometimes called the ABC method whereby materials are classified A, B or C according to their expense-group A being the expensive, group B the medium-cost and group C the inexpensive materials.

Before you Begin: Answers and commentary

403

4

Pareto (80/20) distribution

A similar selective approach to stores control is the Pareto (80/20) distribution which is based on the finding that in many stores, 80% of the value of stores is accounted for by only 20% of the stores items, and inventories of these more expensive items should be controlled more closely.

404

8

Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit.

9

Introduction; Growth; Maturity; and Saturation and Decline.

10

The price elasticity of demand (PED) measures the extent of change in demand for a product following a change to its price.

11

The target costing approach is to develop a product concept and then to determine the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price, leaving a figure that represents total cost. This is the target cost.

12

A transfer price is the price at which goods or services are transferred between different units of the same company. The extent to which the transfer price covers costs and contributes to (internal) profit is a matter of policy.

Management Accounting

Chapter 12 1

A responsibility centre is a section of an organisation that is headed by a manager who has direct responsibility for its performance.

2

Materiality, controllability and variance trend.

3 Variance

Favourable

Adverse

Material price

Unforeseen discounts received Planned purchases Change in material standard

Price increase Unplanned purchases Change in material standard

Material usage

Material used of higher quality than standard

Defective material

More effective use made of material

Theft

Errors in allocating material to jobs

Excessive waste Stricter quality control Errors in allocating material to jobs

Labour rate of pay

Use of apprentices or other workers at a rate of pay lower than standard

Wage rate increase

Idle time

The idle time variance is always adverse

Machine breakdown Non-availability of material Illness or injury to worker

Labour efficiency (also fixed and variable overhead efficiency where overheads are recovered based on direct labour hours)

Output produced more quickly than expected because of work motivation, training, better quality of equipment or materials

Lost time in excess of standard allowed

Variable overhead expenditure

Savings in costs incurred More economical use of services

Increase in cost of services used Excessive use of services Change in type of services used

Fixed overhead expenditure

Savings in costs incurred More economical use of services

Increase in cost of services used Excessive use of services Change in type of services used

Sales price

Price increase to cover unforeseen costs

Price cut to stimulate demand due to increase in competition

Errors in allocating time to jobs

Output lower than standard set because of deliberate restriction, lack of training, or sub-standard material used Errors in allocating time to jobs

Price increase following increased demand Sales volume

Increased sales resulting from a new advertising campaign or a change in perception of the product by the public

Unexpected slump in the economy/demand for the product

Before you Begin: Answers and commentary

405

4



The direct labour efficiency variance, which could identify problems with labour productivity.



Distribution costs as a percentage of turnover, which could help with the control of costs.



Number of hours for which labour was idle, which could indicate how well resources are being used.



Profit as a percentage of turnover, which could highlight how well the organisation is being managed.

5

Indices show how a particular variable has changed relative to a base value.

6

The two key measures are Return on investment (ROI) and Residual income (RI). Both these show how well resources are being used in that centre.

7

Customer; Internal; Learning and growth; and Financial.

8

Conflicting measures, selecting measures, expertise, interpretation and the possibility of too many measures.

9

Reward is 'all of the monetary, non-monetary and psychological payments that an organisation provides for its employees in exchange for the work they perform'. Bratton

Warning! Knowledge alone does not equal exam success. Even if you were able to successfully recall all this information your success in this exam is based solely on your ability to correctly answer the questions set.

406

Management Accounting

Glossary of terms

407

Activity Based Costing (ABC). An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. Administration costs. The costs of managing an organisation. Allocation. The process by which whole cost items are charged direct to a unit or cost centre. Avoidable costs. Costs which would not be incurred if the activity to which they relate did not exist. Balanced scorecard approach. An approach to the provision of information to management to assist strategic policy formulation and achievement. It emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements, and cover areas such as profitability, customer satisfaction, internal efficiency and learning and growth. Budget. A quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities and cash flows. Budget manual. A collection of instructions governing the responsibilities of persons and the procedures, forms and records relating to the preparation and use of budgetary data. By-product. Output of some value produced incidentally while manufacturing the main product. Cash budget. A statement in which estimated future cash receipts and payments are tabulated in such a way as to show the forecast cash balance of a business at defined intervals. Controllable costs. Items of expenditure which can be directly influenced by a given manager within a given time span. Cost behaviour. The way in which costs are affected by changes in the volume of output. Cost driver. A factor influencing the level of cost. Often used in the context of ABC to denote the factor which links activity resource consumption to product outputs. Cost pool. A grouping of costs relating to a particular activity in an activity-based costing system. Cost, or expense, centre. Any part of an organisation which incurs costs. Cost-volume-profit (CVP) analysis. The study of the interrelationships between costs, volume and profit at various levels of activity. Customer profitability analysis (CPA). The analysis of the revenue streams and service costs associated with specific customers or customer groups. Data. The raw material for data processing. Data relates to facts, events and transactions. Development costs. The costs incurred between the decision to produce a new or improved product and the commencement of full manufacture of the product. Differential cost. The difference in total cost between alternatives. Direct cost. A cost that can be traced in full to the product, service, or department that is incurring the cost. Direct labour costs. The specific costs of the workforce used to make a product or provide a service. Direct labour costs are established by measuring the time taken for a job, or the time taken in 'direct production work' Direct labour efficiency variance. The difference between the hours that should have been worked for the number of units actually produced, and the actual number of hours worked, valued at the standard rate per hour. Direct labour rate variance. The difference between the standard cost and the actual cost for the actual number of hours paid for. Direct material costs. The costs of materials that are known to have been used in making and selling a product, or providing a service. Direct material price variance. The difference between the standard cost and the actual cost for the actual quantity of material used or purchased.

408

Management Accounting

Direct material total variance. The difference between what the output actually cost and what it should have cost, in terms of material used. Direct material usage variance. The difference between the standard quantity of materials that should have been used for the number of units actually produced, and the actual quantity of materials used, valued at the standard cost per unit of material. Economic Order Quantity (EOQ). The order quantity which minimises inventory costs. The EOQ can be calculated using a table, graph or formula. Facility-sustaining activities. Activities undertaken to support the organisation as a whole, and which cannot be logically linked to individual units of output. Financing costs. Costs incurred to finance a business such as loan interest. Fixed budget. A budget which is set for a single activity level. Fixed cost. A cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity. Fixed overhead expenditure variance. The difference between the budgeted fixed overhead expenditure and actual fixed overhead expenditure. Fixed overhead total variance. The difference between fixed overhead incurred and fixed overhead absorbed. In other words, it is the under– or over-absorbed fixed overhead. Fixed overhead volume capacity variance. The difference between budgeted (planned) hours of work and the actual hours worked, multiplied by the standard absorption rate per hour. Fixed overhead volume efficiency variance. The difference between the number of hours that actual production should have taken, and the number of hours actually taken (that is, worked) multiplied by the standard absorption rate per hour. Fixed overhead volume variance. The difference between actual and budgeted (planned) volume multiplied by the standard absorption rate per unit. Flexible budget. A budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes. Full cost-plus pricing. A method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit. Indirect cost, or overhead. A cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department. Information. Data that has been processed in such a way as to be meaningful to the person who receives it. International Accounting Standard 2 (IAS 2). States that costs of all inventories should comprise those costs which have been incurred in the normal course of business in bringing the inventories to their 'present location and condition'. Investment centre manager. A manager who has some say in investment policy in their area of operations as well as being responsible for costs and revenues. Job analysis. The 'systematic process of collecting and evaluating information about the tasks, responsibilities and the context of a specific job' (Bratton). Job costing. The costing method used where work is undertaken to customers' special requirements and each order is of comparatively short duration. Job evaluation. 'A systematic process designed to determine the relative worth of jobs within a single work organisation' (Bratton). Job. A customer order or task of relatively short duration. Joint products. Two or more products produced by the same process and separated in processing, each having a sufficiently high saleable value to merit recognition as a main product.

Glossary of terms

409

Just-in-time (JIT). A system whose objective is to produce or to procure products or components as they are required by a customer or for use, rather than for stock. A JIT system is a 'pull' system, which responds to demand, in contrast to a 'push' system, in which stocks act as buffers between the different elements of the system, such as purchasing, production and sales. Just-in-time production. A system which is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage. Just-in-time purchasing. A system in which material purchases are contracted so that the receipt and usage of material coincide to the maximum extent possible. Kaizen. A Japanese term for continuous improvement in all aspects of an entity's performance at every level. Limiting factor. Anything which limits the activity of the entity. Management accounting systems. Provide information specifically for the use of managers within an organisation. Management control. The process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of the organisation's objectives. Margin of safety. The difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. Marginal cost. The variable cost of one unit of product or service. Market penetration pricing. Adopting a policy of low prices when a product is first launched in order to obtain sufficient penetration into a market. Market skimming. Involves charging high prices when a product is first launched and spending heavily on advertising and sales promotion to obtain sales. Monopoly. One seller who dominates many buyers. The monopolist can use their market power to set a profit-maximising price. Objective. The aim or goal of an organisation (or an individual). Oligopoly. Relatively few competitive companies dominate the market. While each large company has the ability to influence market prices, the unpredictable reaction from the other large competitors makes the final industry price indeterminate. Operating statement. A regular report for management of actual costs and revenues, usually showing variances from budget. Operational control. The process of assuring that specific tasks are carried out effectively and efficiently. Opportunity cost. The value of the benefit sacrificed when one course of action is chosen in preference to an alternative. Outsourcing. The use of external suppliers as a source of finished products, components or services. This is also known as contract manufacturing or sub-contracting. Overhead absorption. The process whereby overhead costs allocated and apportioned to production cost centres are added to unit, job or batch costs. Overhead absorption is sometimes called overhead recovery. Payback. The time required for the cash inflows from a capital investment project to equal the cash outflows. Perfect competition. Many buyers and many sellers all dealing in an identical product. Neither producer nor user has any market power and both must accept the prevailing market price. Post-Completion Audit (PCA). An objective independent assessment of the success of a capital project in relation to plan. It covers the whole life of the project and provides feedback to managers to aid the implementation and control of future projects Price Elasticity of Demand. Measures the extent of change in demand for a product following a change to its price.

410

Management Accounting

Principal budget factor. The budgeted factor which limits the activities of an organisation. Process costing. A form of costing applicable to continuous processes where process costs are attributed to the number of units produced. Production costs. The costs which are incurred by the sequence of operations beginning with the supply of raw materials, and ending with the completion of the product ready for warehousing as a finished goods item. Product-sustaining activities. Activities undertaken to develop or sustain a product or service. Product sustaining costs are linked to the number of products or services, not to the number of units produced. Profit centre. Any section of an organisation, for example, a division of a company, which earns revenue and incurs costs. The profitability of the section can therefore be measured. Relevant cost of an asset. Represents the amount of money that a company would have to receive if it were deprived of an asset in order to be no worse off than it already is. Relevant costs. Future cash flows arising as a direct consequence of a decision. Research costs. The costs of researching new or improved products. Residual income (RI). Pre-tax profits less a notional interest charge for invested capital. Responsibility accounting. A system of accounting that makes revenues and costs the responsibility of particular managers so that the performance of each part of the organisation can be monitored and assessed. A responsibility centre. A section of an organisation that is headed by a manager who has direct responsibility for its performance. Return on capital employed (ROCE). Also called Return on investment (ROI). Is calculated as (profit/capital employed) x 100% and shows how much profit has been made in relation to the amount of resources invested. Revenue centre. A section of an organisation which creates revenue but has no responsibility for production. A sales department is an example. Reward. 'All of the monetary, non-monetary and psychological payments that an organisation provides for its employees in exchange for the work they perform'. (Bratton) Risk averse. Decision maker acts on the assumption that the worst outcome might occur. Risk. Involves situations or events which may or may not occur, but whose probability of occurrence can be calculated statistically and the frequency of their occurrence predicted from past records Risk neutral. Decision maker is if he is concerned with what will be the most likely outcome. Risk seeker. A decision maker who is interested in the best outcomes no matter how small the chance that they may occur. Sales volume profit variance. The difference between the actual units sold and the budgeted (planned) quantity, valued at the standard profit per unit. In other words, it measures the increase or decrease in standard profit as a result of the sales volume being higher or lower than budgeted (planned). Scrap. Discarded material having some value. Selling costs. Sometimes known as marketing costs, are the costs of creating demand for products and securing firm orders from customers. Selling price variance. A measure of the effect on expected profit of a different selling price to standard selling price. It is calculated as the difference between what the sales revenue should have been for the actual quantity sold, and what it was. Semi-variable/semi-fixed/mixed cost. is a cost which contains both fixed and variable components and so is partly affected by changes in the level of activity. Standard cost. A predetermined estimated unit cost, used for inventory valuation and control. Strategic information. Used by senior managers to plan the objectives of their organisation, and to assess whether the objectives are being met in practice.

Glossary of terms

411

Strategic Management Accounting. A form of management accounting in which emphasis is placed on information which relates to factors external to the entity, as well as to non-financial information and internally-generated information. Strategic planning. The process of deciding on objectives of the organisation, on changes in these objectives, on the resources used to attain these objectives, and on the policies that are to govern the acquisition, use and disposition of these resources. Strategy. A possible course of action that might enable an organisation (or an individual) to achieve its objectives. Sunk cost. A past cost which is not directly relevant in decision making. Tactical information. Used by middle management to decide how the resources of the business should be employed, and to monitor how they are being and have been employed Target costing approach. A process that begins with the development of a product concept and then determination of the price customers would be willing to pay for that concept. The desired profit margin is deducted from the price, leaving a figure that represents total cost. This is the target cost. Total Quality Management (TQM). A philosophy that means that quality management is the aim of every part of the organisation. The aim is to 'get it right first time' which means that there is a striving for continuous improvement in order to eliminate faulty work and prevent mistakes. Uncertain events. Those events whose outcome cannot be predicted with statistical confidence. Value-added cost. Costs incurred for an activity that cannot be eliminated without the customer's perceiving a deterioration in the performance, function, or other quality of a product. Variable cost. A cost which tends to vary with the level of activity. Variable production overhead expenditure variance. The difference between the amount of variable production overhead that should have been incurred in the actual hours actively worked, and the actual amount of variable production overhead incurred. Variance. The difference between a planned, budgeted, or standard cost and the actual cost incurred. Weighted average cost method of inventory valuation. An inventory valuation method that calculates a weighted average cost of units produced from both opening inventory and units introduced in the current period. Zero based budgeting (ZBB). Involves preparing a budget for each cost centre from a zero base. Every item of expenditure has to be justified in its entirety in order to be included in the next year's budget.

412

Management Accounting

Index

413

414

Management Accounting

A ABC method of stores control, 301 Abnormal gain, 193 Abnormal loss, 193 Absorption base, 151 Absorption costing, 139, 172 Absorption costing and marginal costing compared, 157 Absorption costing versus ABC, 172 Absorption of overheads, 150 Account-classification method, 83 Accounting for scrap, 197 Accounting rate of return (ARR) method, 278 Activity, 330 Activity based costing (ABC), 170, 171 Activity ratio, 333 Activity-based management (ABM), 179 Administration overhead, 136 Advanced manufacturing technology, 170 Adverse variance, 246 Allocation, 142, 160 Attainable standard, 87 Attainable standards, 235 Attributable fixed costs, 44 Average inventory, 299 Avoidable costs, 42

B Balanced scorecard, 335 Balanced scorecard approach, 336 Base pay, 338, 339 Bases of absorption, 152 Basic standard, 87, 235 Berry, Broadbent and Otley, 336 Blanket absorption rates, 152 Blanket overhead absorption rate, 152, 160 Bottom up (participatory budget), 88 Bottom up budgeting, 88 Breakeven charts, 117 Breakeven point, 110, 112 Budget: cash, 72, 92; fixed, 78; incremental, 83; master, 76, 92; responsibility for, 69 Budget bias, 90 Budget committee, 69 Budget manual, 69, 92 Budget variance, 81 Budgetary slack, 89 Budgeting and TQM, 91 By-product, 209, 210

C Capacity ratio, 333 Capital budgets, 270 Cash budgets, 72; usefulness of, 73 Common costs, 211 Contract manufacturing, 52

Contribution, 154 Contribution breakeven charts, 120 Contribution charts, 117, 120 Contribution/sales (C/S) ratio, 111 Control, 11, 67 Control action, 325 Control charts, 323 Control limits, 323 Control ratios, 333 Controllability, 255, 322 Controllable costs, 43, 322 Corporate planning, 10, 11 Cost accounts, 8 Cost behaviour, 100 Cost behaviour and budgeting, 101 Cost behaviour and cost control, 101 Cost behaviour and levels of activity, 101 Cost behaviour assumptions, 106 Cost behaviour principles, 101 Cost centres, 320 Cost drivers, 174 Cost estimation, 82; account-classification method, 83; high/low method, 83; scattergraph method, 83 Cost management, 178 Cost plus pricing, 213 Cost pool, 171 Cost/sales ratios, 331 Cost-volume-profit (CVP) analysis, 110 Criticisms of ABC, 178 Current standard, 87, 235 Curvilinear variable costs, 104 Customer profitability analysis (CPA), 169, 178 Cusum chart, 324

D Data, 17, 18 Decision making problems, 48 Demand-based approach to pricing, 307 Deprival value of an asset, 47 Designing a management accounting system, 24 Differential costs, 42 Differential pricing, 306 Direct costs, 134 Direct expenses, 135 Direct labour costs, 134 Direct material, 135 Direct material cost variances, 246 Direct material costs, 134 Direct material total variance, 246 Discretionary cost items, 86 Distribution overhead, 137 Dysfunctional decision making, 90

E Economic order quantity (EOQ), 299 Effectiveness, 15, 329 Index

415

Efficiency, 15, 329 Efficiency ratio, 333 Elastic, 307 Empire building, 90 Engineering method, 83 Equivalent units, 202 Expense centre, 320 Expenses, 134 Extrinsic rewards, 337

F Facility-sustaining activities, 176 Favourable variance, 246 Features of a report, 21 Feedback information, 68 Feedback loop, 68 Financial accounts, 8 Financial analysis of long-term decisions, 272 Financial information, 20 Fixed budget, 78, 92 Fixed costs, 44, 100 Fixed overhead expenditure variance, 251 Fixed overhead total variance, 252 Fixed overhead volume variance, 251, 252 Fixed production overhead variances, 251 Flexible budget, 78, 92 Full cost-plus pricing, 302 Functional budgets, 71 Functional costs, 137

G Go/no go decision, 272 Goal congruence, 90 Gross profit margin, 331 Growth, 304

H Hierarchy of activities, 176 Hierarchy of cost, 175 High-low method, 78, 83, 106, 107 Holding costs, 296

I Ideal standard, 87, 235 Imposed budget, 88 Incremental costs, 42 Indices, 330 Indirect cost, 134 Indirect expenses, 136 Indirect materials, 136 Indirect pay, 338 Indirect wages, 136 Inelastic demand, 307 Information, 17, 18 Inman, Mark Lee, 28 Interdependence between variances, 326 416

Management Accounting

International Accounting Standard 2 (IAS 2), 141 Intrinsic rewards, 337 Introduction, 304 Inventory control, 296, 297 Inventory control levels, 296 Inventory costs, 296 Investment appraisal, 272 Investment centres, 321 Investment decision, 270

J Job, 212 Job accounts, 212 Job costing, 212 Joint costs, 210 Joint products, 209 Just-in-time (JIT), 27, 292 Just-in-time production, 27, 292 Just-in-time purchasing, 27, 292 Just-in-time systems, 292

K Kaizen, 29 Kanban, 293 Key budget factor, 70

L Lean management accounting, 29 Life cycle costing, 29 Limiting budget factor, 70 Limiting factor, 47 Long-term financial plan, 68 Long-term plan, 68 Long-term planning, 10, 11 Long-term strategic planning, 11

M Machine cells, 293 Management accounting: historical development, 4 Management accounting function, 4, 5 Management accounting system, 22; Designing, 24 Management control, 14 Management control information, 26 Management control system, 10, 15 Margin of safety, 112 Marginal cost, 154 Marginal cost plus pricing, 303, 311 Marginal costing, 154, 157, 160 Marginal costing and absorption costing compared, 157 Marginal costing principles, 155 Marginal cost-plus pricing, 303 Market penetration pricing, 306 Market skimming, 306

Market skimming pricing, 306 Mark-up pricing, 303, 311 Master budget, 76, 78, 92 Materiality, 255, 322 Materials, 134 Materials variances and opening and closing stock, 247 Maturity, 304 Maximum level, 298 Merits of ABC, 177 Minimum level, 298 Mixed cost, 105 Monopoly, 305 Mutually exclusive projects, 279

N Negotiated style of budgeting, 89 Non value-added activities, 294 Non-financial information, 20 Non-linear variable costs, 104 Non-relevant variable costs, 44 Non-value-added costs, 294, 311 Normal loss, 193

O Objective, 10 Objectives, 67 Objectives of organisations, 10 Oligopoly, 305 Operating statement, 258 Operational control, 15 Operational control information, 26 Operational information, 16, 26 Opportunity costs, 42 Optimal ABM, 180 Optimum production plan, 49 Order cycling method, 301 Order cycling method of stores control, 301, 311 Ordering costs, 297 Origination of proposals, 270 Other direct expenses, 134 Outsourcing, 52 Overhead, 134 Overhead absorption, 150, 160 Overhead absorption rate, 251 Overhead allocation, 142 Overhead apportionment, 143 Overheads, 139 Overtime, 135

P Padding the budget, 89 Pareto (80/20) distribution, 301, 311 Participation, 88 Participatory budget, 88 Payback, 276 Payback method, 276

Perfect competition, 305 Performance indicators, 328 Performance measurement, 26 Performance measures, 327 Performance measures for cost centres, 329 Performance measures for investment centres, 334 Performance measures for profit centres, 330 Performance measures for revenue centres, 330 Performance pay, 338 Performance standard, 235 Performance standards, 235 Planning, 10, 67 Planning and control cycle, 67 Position audit, 67 Post-completion audit (PCA), 273 Predetermined overhead absorption rate, 150 Price elasticity of demand (PED), 306 Price leadership, 305 Pricing: differential, 306 Pricing policy: and economic theory, 305 Principal budget factor, 70, 92 Process accounts, 190 Process costing, 190 Procurement costs, 297 Product life cycle, 304 Production overhead, 136 Production volume ratio, 333 Productivity, 329 Productivity, 329 Product-sustaining activities, 176 Profit centres, 321 Profit margin, 330 ,331 Profit targets, 112 Profit/volume (P/V) chart, 117, 120 Profit/volume (PV) ratio, 111 Project screening, 271

Q Qualitative issues in long-term decisions, 272 Qualitative performance measure, 329 Qualities of good information, 18 Quantitative performance measures, 329

R Reciprocal (repeated distribution) method of apportionment, 146 Relevant cost of labour, 45 Relevant cost of materials, 44 Reports, 20 Residual income (RI), 335 Responsibility accounting, 66, 320 Responsibility centres, 320 Return on capital employed (ROCE), 334 Return on capital employed (ROCE) method, 278 Return on investment, 334 Return on investment (ROI) method, 278 Index

417

Revenue centres, 321 Reward, 337 Risk, 281, 282 Risk averse, 282 Risk neutral, 282 Risk seeker, 282

S Sales variances, 256 Sales variances - significance, 258 Sales volume profit variance, 257 Saturation, 305 Scattergraph method, 83 Scrap, 197 Selling overhead, 136 Selling price variance, 256 Semi-fixed cost, 105 Semi-variable cost, 105 Short-term tactical planning, 11 Spend to budget, 84 Standard cost, 232 Standard cost card, 232 Standard costing, 232, 234 Standard hour, 333 Standard operation sheet, 237 Standard product specification, 236 Standard resource requirements, 236 Step costs, 103 Stockout costs, 297 Strategic ABM, 180 Strategic analysis, 67 Strategic information, 16 Strategic planning, 14 Strategic planning information, 25 Strategies, 67 Strategy, 10 Sub-contracting, 52 Sunk cost, 43

T Tactical information, 16, 26

418

Management Accounting

Target costing, 30 Target profits, 113 Top down (imposed budget), 88 Top-down budgeting, 91 Total cost, 308, 311 Total Quality Management (TQM), 28, 91 Transfer price, 309, 310 Transfer pricing, 308, 310 Two-bin system of stores control, 301, 311

U Uncertain events, 282 Uncertainty, 281 Uncontrollable costs, 43 Uniform loading, 293

V Value-added, 294 Variable costs, 44, 100 Variable overhead total variance, 249 Variable production overhead efficiency variance, 250 Variance, 246, 256; control chart, 323; control limits, 323; significance of, 323; trend, 322 Variance trend, 322 Variances, 328; interdependence between, 326 Variances – interdependence, 256 Variances analysis, 244

W Weighted average cost method, 207 World-Class Manufacturing (WCM), 27

Z Zero based budgeting (ZBB), 84 advantages of, 84 disadvantages of, 85 using, 85, 86