CHAPTER 9

Modern Techniques Accounting

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The role of the accountant in business

in

Management

Strategic management accounting

Robert Kaplan suggests that accountants should become part of their organisations value-added team and participate in the formulation and implementation of strategy.

Key points from the article

The figure below illustrates key points. These are summarised in the paragraphs following. Influences from the external environment
Analysis M ission Statement Shareholders Suppliers

Internal Environment

Objectives Budgets

Operational Plans Customers Com petition

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The competitive external environment includes factors such as competition, customers, suppliers and shareholders, all of which present the organisation with threats and opportunities. An analysis of the external environment is undertaken and the mission statement is formulated. Organisational objectives should derive from the mission statement. Remember that Critical Success Factors (CSFs) should be identified. The budgets set should link to the objectives. The operational plans should link to budgets.

The cost of quality

Quality-related costs are the expenditure incurred in defect prevention and appraisal activities and the losses due to internal and external failure of a product or service through failure to meet agreed specifications. Quality-related costs may be classified as failure costs (both internal and external), appraisal costs and prevention costs. Failure costs are the costs required to evaluate, dispose of, and either correct or replace a defective or deficient product. Internal failure costs are costs discovered before the product is delivered to the customer. External failure costs are costs discovered after the product is delivered to customers. Appraisal costs are costs of monitoring and inspecting products in terms of specified standards before the products are released to the customer.

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Prevention costs include investments in machinery, technology, and education programs designed to reduce the number of defective products during production.

Activity based budgeting and activity based costing

Activity based budgeting (ABB)

ABB is a strategically based resource allocation system designed to ensure that resources are allocated primarily around value added activities. Advocates of ABB argue that traditional budgeting over-emphasises the importance of financial forecasting. Budgeting (of the ABB variety) should be closely integrated with planning and have a focus of continuous innovation, leading in the long term to strategic advantage. There is a slant on process, as ABB should result in a continuous and systematic improvement in cost (considering performance, or value added). ABB thus involves defining the activities underlying the financial figures and, for each function, the level of activity is used to determine appropriate budget targets. In other words, costs are flexed, or modelled to the activity levels. To be effective ABB requires: activity analysis techniques (including the activity cost matrix which is considered below) the identification of cost improvement opportunities the establishment of performance targets

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ACCA PAPER F5- FOCUS NOTES Activity cost matrix (ACM)

Activity cost matrix is a simple way of analysing activities an essential prerequisite for ABB. KPMG Management Consulting describe the use of the ACM for a sales order department. Activity cost matrix for a sales order department (figures in 000)
No of customers No of orders No of export orders 70 10 3 4 2 89 500 178 Dept No of Price list sales sustaining despatches literature sustaining cost cost 40 15 4 8 6 73 6,000 12 10 20 30 7 67 67,000 30 10 40 40,000 Total

Management salary Clerical salaries Overtime Stationery and consumables IT costs Other costs Total (000) Volume of activity Cost per unit of activity

30 8 3 41 650 63

80 8 12 4 104 2,300 45

40 240 25 45 32 32 414

The total departmental costs are split by function, ie between: activity-related functions (number of customers, orders, export orders and despatches); sustaining functions (sustaining price lists, sales literature, and the department itself).

The significance of a sustaining function is that its cost is unrelated to the volume of any activity; the cost of sustaining functions is fixed.

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The functional analysis of cost can be seen in the bottom horizontal row. The total activity related costs are divided by budgeted activity levels to arrive at costs per unit of activity; these form the vital yardstick of control.

Controllability
Users of ABB should carefully consider whether managers are in a position to control activities, or whether they can only control the costs of each activity. For example, quality control procedures may require (say) 5 per cent of production batches to be tested: the number of testings (ie the volume of the activity) is fixed. However, the manager of the testing department is in a position to control: the technicians productivity (by changing the remuneration, degree of motivation, etc); the speed and flexibility of the equipment; and the operating procedures and processes.

All three are described in the terminology as cost-level drivers. Benefits of ABB Costs of activities are highlighted; this may lead to improved decision making. For instance, if salesmen are aware that processing each order costs 45, they may be dissuaded from selling items (value say 50). Resources are allocated on the basis of levels of activity, rather than on an ad hoc basis (eg lets spend 5 per cent more than last year).

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ACCA PAPER F5- FOCUS NOTES Activity based costing (ABC)

ABC is the attribution of costs to cost units on the basis of benefit received from indirect activities (eg ordering, setting-up, assuring quality). The key features of ABC are listed below. ABC emphasises the need to obtain a better understanding of the behaviour of costs. In the long run most manufacturing costs are not fixed. Activities cause costs and customers create the demands for activities. Cost drivers are the factors which cause costs to occur at a given level of activity. ABC improves product costing by linking costs to the activities and the cost drivers which cause the relative use of each activity.

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Chapter 9 Modern Techniques in Management Accounting Example

The following data relates to Publications Ltd in the month of April 19X8. Products Quantity produced Direct labour hours per unit Machine hours per unit Set-ups in the period Orders handled in the period Overhead costs 000 Relating to machine activity Relating to production run set-ups Relating to handing of orders 220 20 45 ___ 285 === Required Calculate the production overhead to be absorbed by one unit of A and B using a traditional costing approach and an ABC approach. A 5,000 1 3 10 15 B 7,000 2 1 40 60

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Traditional absorption approach Direct labour hours (DLH) Product A 1 x 5,000 Product B 2 x 7,000 Total DLH Overhead absorption rate = = Absorbed overheads would be Product A 1 hr x 15 Product B 2 hrs x 15 = = 15 per unit 30 per unit = = 5,000 14,000 ______ 19,000 ______

285,000 19 ,000
15 per hour

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Overheads absorbed according to cost drivers Machine overheads
A Total machine hours Machine-hour driver costs Set-up driver costs Order-driver costs Machine-driver costs Set-up costs Order-driver costs (5,000 x 3) 220,000/22,000 20,000/50 set-ups 45,000/75 orders (15,000 x 10) (10 x 400) (15 x 600) + = = = A 150,000 (7,000 x 10) 4,000 (40 x 400) 9,000 (60 x 600) _______ 163,000 ======= Overhead cost per unit = B (7,000 x 1) 10 per machine hour 400 per set up 600 per order B 70,000 16,000 36,000 _______ 122,000 ======= = 22,000

163,000 5 ,000 32.60

=

122 ,000 7 ,000 17.43

Comparison of traditional and ABC unit costs A Traditional ABC Percentage change 15 32.60 117% B 30 17.43 41.9%

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Target costing and target pricing

Activity based methods can be extended to develop a system of target costing and target pricing. Managers set a target selling price by reference to their assessment of the market. They then work backwards to calculate what production cost must be achieved in order to earn a desired level of profit. This is the opposite of traditional cost-plus pricing, in which production costs are regarded as a given and managers add a mark-up to arrive at a price that may or may not be acceptable to customers.

Zero-based budgeting

Zero-based budgeting (ZBB) is a cost justification technique first developed by Texas Instruments. It is of particular use in controlling the costs of service departments and overheads. It does not simply look at last years budget and add or subtract a little, but starts from scratch each time a budget is prepared. It is particularly applicable for service cost centres, for non-product costs. ZBB involves: developing decision packages for each company activity; evaluating and ranking these packages; and allocating resources to the various activities accordingly.

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Decision packages include the following information. The function of the activity or department. This sets out the minimum goals that it must achieve. The goal of the department. This details the aim of the department what it would like to achieve. The measure of the performance of the department. The costs and benefits associated with different ways of organising the department (at different levels of funding). The consequence of non-performance of the activity or department.

Advantages It establishes minimum requirements for service departments, ranks departments, and allocates resources. It produces a plan to work to when more resources are available. It makes managers think about what they are doing. It can be done annually, quarterly, or when crises are envisaged.

Disadvantages It takes up a good deal of management time and so may not be used every year. It generates a great deal of paper, requires education and training, and results may be initially disappointing. It is costly.

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Backflush accounting

Backflush accounting attempts to replace traditional process costing by focusing on the output of the manufacturing process and then working backwards when allocating costs between cost of goods sold (or finished goods) and stock valuations. Backflush accounting will be relevant where the overall process cycle time is short and levels of materials and WIP are low. Such conditions are likely to occur where a just-in-time approach to production and sales is in force. The backflush accounting system simplifies the accounting records by avoiding the need to trace the movement of materials and WIP through the production processes.

Steps to backflush accounting

The following steps are involved. 1 2 3 4 5 Record the direct materials purchased in the reporting period. Record the conversion costs incurred during the period. Determine the number of finished units during the reporting period. Compute the standard cost of each finished unit. Record the cost of finished goods completed in the reported period.

The costs are no longer recorded sequentially with the flow of product along its production route. Instead, the output trigger is going back and pulling costs from inventory : raw materials and work in-process.

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Chapter 9 Modern Techniques in Management Accounting Illustration

Flush Ltd produce Chemical X. For May there were no opening stocks of raw materials and no opening or closing work in progress. Flush Ltd has only one direct manufacturing cost classification (materials) and one indirect cost classification (conversion). The standard cost per kg for Chemical X is: Material Conversion Total The actual results for May were; Sales Completed production Material purchases Conversion costs = = = = 99 kgs 100 kg 1,950 1,260 19 12 ___ 31 ===

The simplest version of backflush costing is when the trigger point for accounting entries is the manufacture of finished units.

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Using the data from Flush Ltd the accounting entries become: Backflush account Finished goods (100 kg x 31) _____ 3,100 _____ 3,100 Materials Conversion costs 1,900 1,200 _____ 3,100 _____

This approach ignores 1,950 purchases of direct materials and 1,260 of conversion costs. At the end of May, the 50 of direct material purchases has not been placed into production and the same applies to 60 of conversion costs. This approach is only suitable for a JIT production system with no inventory or work in progress. A better system is where there are two trigger points for accounting entries, namely: Trigger point (1) when materials are purchased and Trigger point (2) when goods are sold. The advantages of this system are as follows. It removes the incentive for managers to produce for stock. Managers become more focused on selling units.

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Using the data from Flush Ltd the accounting entries are as follows. Material and in-process account Variable costs Material Conversion 1,950 1,260 _____ 3,210 _____ To finished goods at standard (100 x 31) Residual variance Material and in process stock carried forward [(100 x 19) 1,950] 3,100 60 50 _____ 3,210 _____

Finished goods From material and inprocess 3,100 To cost of sales (99 x 31) Finished goods stock carried forward

3,069 31 _____ 3,100 _____

_____ 3,100 _____ Materials and in-process account

Actual material costs and conversion costs are prompted by the trigger point 1 Finished goods (100kg) are valued at standard cost (31 per kg)

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The May closing materials balance of 50 is embodied in 1 kg manufactured but not sold, ie material purchases (1,950) less closing stock valued at standard (19 x 100 kg) No conversion costs are inventoried. The residual variance of 60 is the difference between the actual conversion cost (1,260) and the standard conversion cost (100 kg x 12).

Finished goods Trigger point 2 is the sale of goods and not their manufacture (99 units x 31) = 3,069. This is made up of direct materials (99 x 19) and conversion costs (99 x 12). Finished goods stock at the end of May is 1 kg valued at 31 standard cost.

Preparing backflush accounts

The material and in-process account is constructed as follows. 1 2 3 4 Debit stock brought forward (if appropriate). Debit actual materials purchases and conversion costs (respectively 1,950 and 1,260 in the example). Credit the value (standard cost) of finished goods (a unit cost of 19 + 12 = 31 in the example). The debit is to the finished goods account. Credit the residual variance the difference between the valuations of finished goods at standard cost and the actual cost. In the example the difference is 60, which can be proved as follows.

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Standard cost 1,200 (W1) 1,900 (W2) Actual cost 1,260 1,900 Variance 60 NIL ____ 60 ====

Conversion costs Material purchases Residual variance (W1) 100 units @ 12 (W2) 100 units @ 19 5

Credit stock carried forward (balancing figure).

The finished goods account is constructed as follows. 1 2 3 4 5 Debit stock brought forward (if appropriate). Debit the finished goods valuation (standard cost) from the materials and in-process account. Credit the value (standard cost) of finished goods transferred to cost of sales. Credit stock losses, free replacements etc (if appropriate). Credit stock carried forward, valued at standard cost.

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