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Lesson 1 What is accounting?
Introduction to Management Accounting
Accounting is an information system. It exists to provide information for the end-user. It is possible to distinguish between two branches of accounting. 1 Financial accounting.
The purpose of financial accounting is to report the financial performance of the company. It’s main focus is on external reporting to a number of groups viz. Owners ( shareholders ) Loan creditors ( banks ) Trade creditors (suppliers ) Sundry creditors ( suppliers of services ) Government agencies ( tax authorities ) Employees ( trade unions ) A set of financial statements - a profit and loss account, a balance sheet and a cash flow statement are prepared and published.
The main purpose of management accounting is to provide information to the management team at all levels within the organisation for the following purposes: (a) (b) (c) (d) (e) formulating the policies - strategic planning planning the activities of the organisation - corporate planning controlling the activities of the organisation decision-making - long-term and tactical performance appraisal at strategic and operational level
Definition: Management accounting is the application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in planning and controlling the operations of the organisation.
Let us look at a simple financial statement. Example Financial Accounts
£ Sales Cost of sales Gross profit Deduct Administration expenses Selling and distribution expenses Net profit 2,000 1,000 --------
£ 30,000 24,000 -------6,000 --------
3,000 -------3,000 --------
Financial accounts indicate the results of a business over a period of time. They deal with historic or past costs and are concerned with stewardship accounting.
A management accounting/ cost statement provides information to allow managers to plan, control and organise the activities of the business. The purpose of a costing/maagement accounting information system is: 1 to provide information about product costing to be used in financial statements. 2 to provide information for planning, controlling and organising. The information provided by the costing system should be: relevant reliable timely succinct presented in the desired format.
A cost system should be cost effective appropriate for the organisation encourage managerial action. Example Management Accounts Products Materials Wages Prod. overhead Prod. cost Admin. costs Selling costs Total cost Sales Profit (Loss) Net profit margin A £4,800 1,500 500 ------6,800 700 300 ------7,800 10,240 2,240 ---24% ------B £3,700 2,500 600 ------6,800 800 400 ------8,000 10,800 2,800 ---26% ------C £6,500 3,000 900 ------10,400 500 300 ------1,200 8,960 ---(2,240) ---------Total £15,000 7,000 2,000 ------24,000 2,000 1,000 ------27,000 30,000 3,000 ---10% -------
This performance statement is of the same business as the previous example of financial accounts. However, it gives management much more information. It analyses the cost elements in respect to materials, labour and overheads allowing management to focus on costs which require investigation and control. It facilitates decision-making. E.g. should product C be discontinued? Compared to the financial accounts the management accounting information which is much more comprehensive will allow management to better carry out their functions of planning, controlling organising and decision-making. Cost classification The management accountant will use cost information for two main reasons. 1 2 to ascertain the cost of a product. This information is used to value stock which is required for external reporting . to assist management in the decision-making process.
Depending on the cost objective the costs will be classified into a number of categories. (a) By nature of resource (i) Materials (ii) Labour (iii) Other Expenses By type of cost (i) Direct Costs (ii) Indirect Costs - Overheads (c) By function Production, Administration, Selling and Distribution (d) By the behaviour of costs (i) Fixed or Periodic Costs (ii) Variable Costs (iii) Semi-fixed, or Semi-variable Costs Cost Objectives (a) Product costing
It is essential for an organisation to ascertain the cost of manufacturing a product. The information is used for two purposes: 1 to determine the value of closing stock which is required for the financial statements viz. the profit and loss account and the balance sheet. Direct materials Direct labour Direct expense Prime cost Production overheads Production cost 2 £X £X £X ----£X £X ----£X -----
Also some businesses use a cost plus pricing strategy. The product cost is calculated and a mark up percentage is added to arrive at a selling price which gives a reasonable gross profit which in turn can cover the non-production overheads and leave a satisfactory net profit.
activities that comprise the fundamentals of the management accounting function. Direct materials. 4 The scattergraph or regression chart. For example. The fixed costs therefore are £10000. It should be noted that they are not fixed because they do not change because cost items like rent is often subject to revision.£30000 = £10000/ 15000units . The semi-fixed/semi-variable cost contains a fixed and a variable element. direct labour and machine time can be established quite easily. High-low method. Semi-fixed/semi-variable costs are costs which move in the same direction but not at the same rate as the level of activity. 10000units 15000units £30000 £40000 1 Example Output £40000 . Cost ascertainment It is important that the management accountant can determine the variable and fixed costs and there are a number of techniques to assist in separating the fixed and variable elements of semi-fixed or semi-variable costs. 6 . Analysing costs by direct observation of the resources required to convert materials into a finished product and applying costs to these activities. 2 3 By inspecting the accounts the accountant can classify costs as being variable or fixed.(b) Decision making . Fixed costs are termed fixed because they do not change in response to changes in the level of activity. fixed and semi-fixed is important in terms of decision-making and cost control. Fixed costs can be either committed fixed costs or discretionary fixed costs. This method entails selecting the period of highest and lowest levels of activity and comparing the changes in costs that result from the two levels. Variable costs are those costs which increase/decrease with the level of production and sales. In a manufacturing company the variable production costs change directly with the level of production. the electricity bill contains a fixed or standing charge and and the variable aspect which depends on usage.Cost behaviour The classification of costs into variable.10000= 5000units = £2per unit.
Then a ‘line of best fit’ is drawn through some of the coordinates. Once this is established it is simple to calculate the other costs which are not fixed ie. Where this line coincides with the Y axis this represents the level of fixed costs.Costs Output On the scattergraph total costs are plotted against output at a number of different activity levels. The assumption is that at zero output the business still has to meet the fixed costs. the variable costs.the periodic costs related to time. 7 .
MARGINAL COSTING FOR DECISION MAKING 8 .
direct labour and variable overheads. Therefore.variable(marginal) costs Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Many of the decisions are of a short-term nature. in making decisions. Past costs can consist of sunk costs or committed costs. depreciation etc. • In the short-run all fixed costs remain unchanged and therefore treated as irrelevant. those costs which vary directly with the level of activity of the factory. Also all the decisions comprise a choice between alternative courses of action. Examples of fixed costs would be rent. 9 . Contribution is not profit. Since most of the decisions have a shortterm impact it can be assumed that the capacity of the factory will not change.Lesson 2 Marginal Costing . Therefore. they are related to time . These costs stay constant in the short-term regardless of the decision that management takes. Definition: Marginal costing is a costing principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for that period. • The only relevant costs are variable costs ie. To summarize the technique of marginal costing: • Costs are classified as either fixed or variable. Only rarely is a manager faced with a decision which has a long term impact eg. take-over of another company. buying a new machine. insurance. past costs can have no relevance for future decisions. The fixed costs are treated as periodic ie.a technique for short-run decision-making One of the main functions of management is decision-making. (ICMA) Marginal cost = variable cost = direct materials direct labour direct expense variable overhead Contribution = sales revenue . in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant. rates. The only costs which are affected are variable costs ie. In marginal costing all costs are classified according to how they behave. those costs which increase/decrease as output increases/decreases. expanding the factory. Therefore fixed or periodic costs are not affected by tactical short-run decisions. These would include direct materials. They are either variable or fixed.
000 ------1 £ 2 5.000 ------7.000 £ 20. The definition stesses the manner in which costs behave in relation to the volume of activity.000 ------10. 10 .000 5.000 ------5.002 ------1.Example Format of a Marginal Costing Income Statement A X (X) -----X -----B X (X) -----X -----C X (X) -----X -----Total X (X) -----X -----(X) -----X ------ Products Sales revenue Less Variable costs Contribution Fixed costs Marginal cost is the amount at any given volume of output by which total costs are changed if the volume of output is increased or decreased. Only the variable costs both production and nonproduction change as the output changes. It is the cost of making one extra unit of output.000 ------- Note £2 is the marginal cost or variable cost per unit. It concerns the identification of variable and fixed costs ie. the costs that increase or decrease as output increases or decreases.000.000 ------5.000 ------25. Volume (costs) Variable costs Fixed costs Total cost 0 £ --5.000 £ 2.000 5. Example: A company manufacture units with avaiable cost per unit of £2 and fixed costs of £5.
000 ---------- Profits can be increased by an additional £6.000 -------56. X Ltd.000 since fixed costs are already covered.10) Variable costs(20. However management must consider other relevant factors in arriving at the final decision.000 @ 80p) Extra contribution £22.Applications of marginal costing (a) Acceptance of a special order. Total costs are £90.10 and this will use up the company’s spare capacity. branches.000 are fixed costs.000 64.000 and of these it is estimated that £26. Should management accept this special order? Sales Marginal costs( 80p per unit) Contribution Fixed costs Profit £120.000 -------- Special order: Less Sales(20.000 26.50. The output for the period is 80.000 -------30. 11 . makes a product which sells for £1.000 units @ £1. How will existing customers react? They may wish to buy at £1. Could the spare capacity be used more profitably rather than accepting the special order? 2 Shut-down decisions Often management wish to analyse the performance of their products. A potential customer offers to buy 20.000 ---------6.000 units of product which represents 80% capacity . divisions.000 units at £1.000 16.10 per unit.
Consider the following example.000 7.000 4.000 10.000 -------33.000 26.000 59.000 -------1.000 1. 3 Make or Buy Sometimes management may have to consider whether it is best to manufacture products or components or to sub-contract them out and purchase them externally.000 -------6.000 Profit/(Loss) With product C making a loss management might consider discontinuing this product. using marginal costing principles.000 3.000 18.000 B £ 50.000 16. Prtoduct Sales Less Variable costs Contribution Fixed costs Net profit A £ 20. Example: Product Sales Less Direct materials Direct labour Fixed overheads A £ 20.000 2.000 contribution and the overall effect would be to reduce profits to £17. Example: 12 .000 9. with fixed costs treated as irrelevant for short-run decision-making the income statement can be reformatted.000 14. If Product C is closed down the company will lose £1.000 33.000 C £ 25.000 -------18.000 -------(8.000 -------36.000 18.000 -------38.000) Total £ 95.000.000 31.000 -------- Since product C makes a contribution it may be inadvisable to close it down. However.000 24.000 B £ 50.000 -------77.000 Total £ 95.000 -------12.000 -------16.000 -------29.000 -------18.000 15.000 -------14.000 C £ 25.
4 Limiting factor decisions Often a company finds that there is a limiting factor or constraint which inhibits its capacity to meet the desired production level. it is the benefit foregone by choosing one course of action over the other. Obviously it is cheaper to make than to buy. The limiting factor may be any resource eg. The costs to make the component are as follows: Direct materials Direct wages Variable overheads Variable cost of production £2 £3 £2 -----£7 ------ Assume spare capacity and the fixed costs remain unchanged. A component Q used in the manufacture of P can be purchased from a supplier for £8. The following data applies to product P. labour or machine hours. This is an opportunity cost ie. Example: 13 . The effective cost of making a unit of component Q is: Plus Marginal cost of production Opportunity cost of The effective cost is £7 £2 ----£9 ----- By switching capacity from product P to component Q there is £2 contribution lost.A company makes product P. Selling price Direct materials Direct labour Variable overhead Contribution £16 £6 £4 £2 -----£4 ------ The production rate for product P is 5 units per hour and for component Q is 10. However. materials. Management has to decide what is the best way to allocate the scarce resource among the product range in the most effective way so that profits are maximised. if the firm is working at full capacity and to make component Q involves moving some of the capacity from product P then the decision is a little more involved.
2.Product Desired production (units) Selling price per unit Variable cost per unit Contribution per unit X 1.000 14 . Product Z uses 2 machine hours per unit. Sales (units) 2.000 units x £15 = £30.000 contribution --------£39.000 contribution Product X earns 200 units x£20 = £4.000 x 5 hrs 200 x 20 1.000 4.000 8.000 machine hours available.000 £ 35 15 ----20 Y 2.000 hrs Product Z earns 500 units x £10 = £5.000 hrs 10. Product Y uses 5 machine hours per unit. Product X uses 20 machine hours per unit. Contribution per machine hr. of machine hrs.000. X 20 20 1 (3) Y 15 5 3 (2) Z 10 2 5 (1) Contribution per unit No. Ranking Desired production level Product Z Product Y Product X 500 units x 2 hrs.000 contribution Product Y earns 2.000 contribution ---------- 5 Profit Planning or cost profit volume analysis Management feels it helpful to ascertain the level of profits earned at certain levels of output and sales.000 6. Example: A company makes product X which has a selling price of £10 per unit and variable costs of £5 per unit with fixed costs of £20.000 hrs 4.000 10.000 £ 25 10 ----15 Z 500 £ 15 5 ----10 A special machine is used to manufacture the three products and there are only 15.
contribution is equal to the fixed costs.000 ----------------- ------3 60.000 -------20.000 -------10.000) -------- -----£ 40.000 -------50.000 30.000 20.000 -------(10.000 -------30.000 20.000 -------30.000 -------10.Sales revenue Variable costs Contribution Fixed costs Net profit (loss) ------£ 20.000 50.000 20.000 10.000 ------- -------£ 100.000 20.000 20.000 20.000 ------- ------£ 80.000 -------- At sales of 4000 units the company is at break-even point ie.000 -------20. COST VOLUME PROFIT ANALYSIS 15 .000 -------40.000 40.
Companies can benefit from discounts for bulk purchases of materials and the economies from the division of labour. They contend that variable costs do not behave in a linear fashion but are effected by economies of scale. the CVP model can be used as a planning technique to: (a) (b) (c) (d) (e) find the break-even point determine the margin of safety determine a target volume establish the profit volume ratio or contribution volume ratio determine the operating gearing It is possible to ascertain these by using a break-even chart or by using formulae. It assumes that over a range of output levels . the selling price is constant per unit of output.Lesson 3 Cost Volume Profit Analysis The CVP model makes the assumptions that costs can be simply divided into fixed and variable costs. The economists’ model represented in a curvilinear graph shows the total cost line rises steeply at low output levels. rates. This curvilinear total revenue line reflects the fact that to achieve more sales the company may have to reduce the selling price and does not increase proportionally with output.fixed costs remain constant and variable costs increase directly with output.the relevant range. depreciation etc. The fixed costs are periodic costs so that cost items such as rent. Therefore.the relevant range . are constant at all levels of output. As a compromise it is possible to accept the assumptions that the CVP model is based on within a certain range of output . insurance. 16 . There is also an assumption that the sales revenue behave in a linear fashion ie. Economists take a more realistic view of cost behaviour. levels off and then declines. The total revenue line rises steeply. The variable costs behave in a linear fashion. levels off within a range of output and finally rises steeply again as the benefits of economies of scale decline.
At the break-even point the sales revenue generated covers the total costs and no more. Contribution = Fixed costs BEP = Fixed Costs Contribution per Unit P/V or C/S ratio = Contribution X 100 Sales The P/V ratio indicates the % of contribution to sales. At the break-even point the contribution is sufficient to meet the fixed costs. Once the fixed costs have been met any contribution left is profit.Total costs = Profit or Sales .( Variable costs .Let us look at a basic accounting equation ie.Variable costs = Contribution Contribution is the excess of sales over variable costs and it represents the surplus available to meet the fixed costs. 17 . Sales .Fixed costs ) = Profit then Sales .
This chart dispenses with the need to draw cost and revenue lines and concentrates on the relationship between profit and output. a profit-volume chart. Revenues and Costs (£) Output (units) A break-even chart Profit Output (units) 18 .Formulae: 1 2 3 Break-even point = Fixed costs/ Contribution per unit Margin of safety = Break-even point(units) .The Expected Sales Sales(units) to achieve a profit Fixed costs + Target profit ----------------------------------Contribution per unit Profit volume ratio = Contribution x 100 ---------------------------Sales revenue The Operating Gearing = Contribution / Profit 4 5 It is possible to present the profit volume relationship in a chart.
The fixed costs are £40. 2 3 4 Example: A company has sales of 120. The management want to know the B/P point. CVP analysis is based on a number of simplistic assumptions about cost behaviour which undermine the model’s effectiveness. the margin of safety and the profit.000. The business has only one product or there is a specific constant product mix. There is a linear relationship between output and costs and revenues.Loss Limitations of cost volume profit analysis.000 units which sell for £1 with the variable costs 50p per unit. 1 Costs can be divided into fixed and variable costs but in reality many costs have a fixed and variable element(semi-variable) and may not be easy to divide. Solve graphically and by formula. The only factor influencing costs and revenues is output. 19 . Other factors such as production efficiency and production methods may impact on output. The economists view tends to dispute this and presents a curvilinear model.
20 . To ensure that the objectives are achieved plans or budgets must be prepared. The accountant draws up a plan which integrates the various functional areas of the business. Budgeting is probably the most important contribution that the accounting department makes to the role of management. profit growth. There are three levels of planning . Some of the objectives may not be expressed in accounting terms for example objectives to improve the welfare of the staff or to improve the impact on the local environment. Control is exercised by firstly.corporate long term planning. Definition: A budget is a financial or quantitative interpretation prior to a defined period of time. Budgets are part of the planning and control process. to attain a given objective. The annual budgets are steps along the way to achieve the long-range plan of the organisation. increase in the asset value etc which they wish to achieve.BUDGETING The Planning Process All organisations have their objectives. in this chapter the emphasis is on objectives usually expressed in quantitative terms eg. increase in market share. delegating responsibility to departmental managers for the attainment of the budgets and then the regular comparison of the actual results with the planned outcomes. They help to define the objectives of the organisation. of a policy to be pursued for that period. medium term planning and annual planning or budgeting. However. Budgets assists an organisation • to plan and control profitability • to plan and control production resources • to plan and control capital expenditure • to plan and control finance An organisation which engages in budgeting can obtain the benefits of • better planning and awareness of what has to be achieved • greater coordination of the different functional areas • better communication with staff contributing to the targets to tbe set • motivation of the staff with staff assigned their responsibilities • efficient and effective use of scarce resources and an awareness of costconsciousness Administration of the budget.
It may be the sales volume which drives the other subsidiary budgets. The company may have the capacity to produce only 18. In terms of control the accountant is responsible for the regular monitoring of the budgets. where are the goods to be sold and how are the goods to be produced. past trends. the one which sets the objectives for the subordinate budget. Senior management outline the broad strategic objectives of the organisation and communicate these to the functional managers. For instance.000 15.000 10.000 60.000 C D E The marketing director intends to run a marketing campaign towards the end of 19x0 and has requested that product unit stocks should be increased at the end of 19x0 above the commencement stocks by the following Dag increased by 20% Mag increased by 50% 21 . Sales forecasting may proceed by means of statistical methods which are based on economic indicators or by carrying out an internal forecast by canvassing the sales staff.000 Unit selling price £25 £20 £22 Part units 40. The current sales level.000 40. The accountant works in conjunction with the budget committee comprised of the departmental management.000 50.000 units a year so this figure sets the objectives for the other budgets. Once the accountant and the committee agree the master budget which is a forecasted profit and loss account and balance sheet can be drawn up.000 The opening stocks at the beginning of the year 19x0 Product Product units Component Dag 3.000 B Pag 2.The administration of the budget is the responsibility of the budget officer who is usually the accountant . market research can provide useful information.000 units then the production budget must be integrated with this figure. if the sales department forecasts the annual sales at 20.000 A Mag 3. This key budget factor decides the key budget ie.000 18. productive capacity may be the key budget factor . Preparing budgets Example The budgeted sales of Magee Engineering Lt. for reporting back to the budget committee regularly( daily. for 19x0 is as follows: Product Dag Mag Pag Sales units 20. The subordinate budgets are constructed by asking the questions . The accountant helps the managers to set the budgets by providing information as required. On receipt of the various budgets the accountant notifies managers of revisions to their budget.when are the goods to be sold. Alternatively.weekly or monthly basis) through variance reports and for revising the budgets if necessary. The budget committee identifies the key budget factor which determines what acts as a constraint on the organisation’s activities.
000 15.000 -------53.Pag increased by 20% The purchasing director has requested that all components part stocks be reduced by 20% at the end of 19x0 because of improved delivery times from suppliers.000.000 -----------£1. the budget shows the the individual product sales units.190. Production budget 19x0 22 . The product material specification and component cost for each of the products are as follows: Product Dag Mag Pag Component part Part cost (each) Component parts per product A 50p B 35p C 60p D 55p E £1.000 360.sales value and total sales value. The budgeted sales for 19x0 are 53. 1.190. Sales Budget 19x0 Product Dag Mag Pag Units 20.000 330.000 -------Price £25 £20 £22 Total sales £500. Materials purchase budget in component parts and value. 1 2 3 4 Sales budget in product units and value Production budget in product units Material usage budget in component parts.000 18.000 ------------ Comment: the sales budget is computed from the sales information stated.000 units with a total sales value of £1.0 3 2 5 4 3 2 6 4 3 2 2 3 1 1 1 The newly appointed managing director asks you to prepare the following budgets and to explain the linkage between them.
800 126.500 30.000 --------------------------------169.000 40.000 77.000 -------19.200 -------247.500 -------22.700 247.800 --------E 20. 23 .800 -------C 123.000 -------15.400 -------17.000 2.480 £65.000 -----------------------------------209.000 4.500 £1.600 -------- Mag 18.500 -------A 61.120 E 55. This budget is based on the material usage budget adjusted for oppening and closing stocks.400 -------- Comment: the production budget is the required production to meet sales budget requirements and changes in stocks.700 235. Materials Usage Budget 19x0 (Component usage) Product Dag Mag Pag Prod.500 10.000 60.600 78.000 -------177.400 -------55.400 Closing stock 32.000 48.595 £141.500 15.600 -------23.500 3.500 15. units 20.700 --------D 41. This is simply the production units from the production budget equated to the component specification in each production unit eg.000 50.200 39. material usage of compont A is the total usage of component A in Dag.800 161.800 171.400 Opening stock 40. 3.800 39.000 40.600 19.800 211.000 --------53.600 19.000 --------B 82.500 8. Mag and Pag.900 £56.000 3.400 58.700 295.000 32. 4.400 3.Sales units (from the sales budget) Add closing stock Less opening stock Budgeted output Dag 20. thus since closing stock requirements are greater than opening stocks then production must be increased to cope with required production for sales and increased closing stock requirements.500 Comment: The material purchase budget gives the cost and quantity of each component that is needed to be purchased and the overall cost of all five components.800 -------30.200 -------171.000 ---------63.000 ------20.800 118.00 £53.500 -------- Pag 15. The Material Purchase Budget 19x0 Component A B C D Material usage budget 177.000 46.800 158.000 46.500 -------- Comment: the material usage budget is the component usage.400 -------55.400 Price per component 50p 35p 60p 55p £84.000 3.
by examining their credit policy or by deferring capital expenditure. Cash summary December 19x0 £ Proceeds from share issue Less Leasehold premises (20 years) Plant (est. The proceeds of the share issue were paid into the company bank account.000 10. (a) Sales are budgeted as follows: £80.000 80.000 which was raised through an issue of 600.000 160. commenced operations in December 19x0 with a capital of £600. life 10 years) Equipment (est. The cost of raw materials will amount to 40% of the sales revenue.000 20. Management can invest cash in the short-term.000 in subsequent months. or avail of trade discounts by bulk purchasing materials or finance capital projects. £160.000 570.000 ====== (b) 24 . The period of credit extended to customes will be one month. life 10 years) Tools Raw materials Cash balance available You are given the following additional information. During the course of December a number of transactions took place and these are summarized below.000 ---------30. 300. Remedial action can be taken by injecting more capital into the business. Advantages: The cash budget ensures adequate cash planning and control (a) Cash deficits are revealed and management can respond by taking appropriate action.000 in January.000 ---------£ 600. the other half will be paid for during the month of purchase. by borrowing.000 ordinary shares of £1 each. The advantages of planning for cash resources is essential since a business cannot survive without cash. Half the materials cost for any one month will be paid in cash.000 in February and £240. Ltd. (b) Example The London Toy Co. Cash surpluses are indicated and once recognised need to be managed. Fifty per cent of the sales will be cash sales and the other fifty per cent credit sales.Cash Budgets The cash budget shows the forecasted cash inflows and outflows of a business and measure the estimated balance or deficit of cashfor a particular period.
Other expenses. Direct wages will be incurred at the rate of £50.200.000 per month .000 .000 £ Sales 780. All other expenses will be incurred at the rate of £40. Budgeted Profit and Loss Account for six months ending 30 June 19x1 Cost of sales Direct wages £ 480. -cash Raw mat.(c) (d) The company intends to keep a stock of raw materials of £10. In respect to credit transactions time lags have to be built into the cash budget It is useful to have a memo column to record items which will appear in the balance sheet if required. You are asked to prepare the company’s Cash budget. Jan £000 30 40 -----70 -----16 50 -----66 -----4 === Feb £000 4 80 40 -----124 -----32 16 50 40 -----138 -----(14) === Mar £000 (14) 120 80 -----186 ----48 32 50 40 -----170 -----16 === Apr £000 16 120 120 -----256 ----48 48 50 40 -----186 -----70 === May £000 70 120 120 ------310 -----48 48 50 40 -----186 -----124 === Jun £000 124 Memo £000 Opening balance Cash inflow Cash sales Credit sales Total Cash outflow Raw mats.depreciation on premises. a budgeted Profit and Loss account for the first six months of operations and a budgeted Balance Sheet as at 30 June 19x1.000 25 £ 1.The tools will be re-valued annually and it is expected that annual losses will amount to 20 per cent.000 per month.000 throughout the year.the time lag here will be one month. No time lag is expected here. plant and equipment will be calculated on a straight-line basis. -credit Direct wages Other expenses Total Closing balance 120 120 120Dr ------364 -----48 48 50 40 -----186 -----178 === 48Cr 40Cr Students should note that: (a) (b) Depreciation never appears in a cash budget as it is a non-cash expense.000 300.
000 ===== Budgeted debtors.500 --------£ NBV 292.000 ====== ---------420. creditors and cash balance is obtained from the cash budget.---------Operating profit 420. depreciation appears as an expense in the profit and loss account. 7. Budgeting .200.000 158.000 Depreciation Premises Plant Equipment Tools Other expenses Net profit 21.000 8.000 --------£ Dep.000 ---------1. Details of fixed assets can be obtained from the capital expenditure budget. can also be obtained from the previous balance sheet.500 240.000 Premises Plant 158.000 ====== 308.000 ======= 420. Information about share capital.200.500 Equipment Tools £ Cost 300.000 2.000 --------10.000 2. debentures etc.500 ---------420.000 --------538. Budgeted Balance Sheet as at 30 June 19x1 Authorised and Issued Capital 600. shares £1 each Reserves Profit and loss account £ Fixed assets 600.500 76.000 ---------846.000 ======= Operating profit 7.500 4.000 80.000 -------21.500 Current Liabilities Creditors Accrued expenses Current assets 48.500 4.the Control Process Definition: 26 .000 Materials 40.000 ----------------1.000 160. Also.000 152.000 18.000 ====== The profit and loss account is prepared on an accruals basis unlike the cash budget which is prepared on a receipts and payments basis.000 20.000 Ord.000 Debtors Cash -------846.000 178.000 120.000 8.000 --------560.
To ensure that management are not overburdened with accounting data exception reports may be furnished. Personnel Dept Cost Descripti code on 010 Superviso rs’ salary Flexible Budgeting Up to this point the budget has been fixed.000 units) £ 21. Budget Costs (20. When organisations compile the master budget it is based on a certain level of output and sales. A flexible budget is ‘designed to change in accordance with the level of activity attained’ (CIMA) A fixed budget is not designed to change with different levels of activity.000 (A) £116.000 £7. A flexible budget is designed to recognise cost behaviour at different levels of output so actual results can be compared with the expected results and the computation of variances and variance analysis is made possible.000 units and the actual production costs fpr the period are given.000 1. there may be a seasonal characteristic to the company’ trading.00 0 £125. These reports identify only significant variances that require management’s attention and consequently are more user friendly and should encourage an appropriate managerial response.600 units) £ 20. The following costs for the budgeted level of activity of 20. The budget itself is merely a plan on paper which of itself will not be effective unless there is a system of control which can monitor the organisation’s progress to achieving the objectives. This is quite appropriate for planning purposes but of little use for control purposes. either to secure by individual action the objective of that policy or to provide a basis for its revision. It does not allow for the pre-determination of costs and revenues at different levels of output which would facilitate comparison with actual costs and the identification of variances.0 00 Variance £9. the company may find that this operating level is not set at the actual level of activity. Example: A company produces garden furniture which experiences fluctuations in production levels because of its seasonal nature. In such cases the business may find it more useful to prepare flexible budgets. In most instances.000 £65. The fixed budget does not respond to the actual level of activity. Indeed most organisations find it difficult to forecast the actual level of activity eg.variable Labour . The annual budgets are broken down into months so the comparison is performed regularly and results in a budget report ipresented to the departmental managers.000 980 27 Monthly Budget Report February Budget Actual Variance Budget Actual £58.Budgetary control is the establishment of departmental budgets relating the responsibilities of executives and the continuous comparison of actual with budgeted results. By means of comparing actual results with the budgets and identifying any differences (variances) which occur management can take remedial action or revise the budget if necessary.000 (A) Materials .variable .000 Actual costs incurred (17.
600. There appear to be a number of factors involved.000 5.Maintenance . maintenance and selling costs.000 ------Variance £ 1. How can senior management ensure that the budgeting system can be most effective? Research findings assert that managers prefer to work towards achieving objectives which motivate them.660 ---------- The variance report highlights that in respect to actual materials. there may be some staff who regard budgets as a constraint on their freedom and may try to subvert the effectiveness of the budget. Flexible budgets can be compiled for those departments whose expenditure is closely linked to the level of operations such as the production department.520 (A) 100 (A) 40 (A) ----1.640 10.000 -------39600 -------- During the relevant period.000 ------5. the behavioural context deserves mention. Many businesses prepare fixed budgets for departments where expenditure may be more predictable such as the administration department. You are required to prepare a budget flexed at the actual level of activity.000 10. 28 .000 ------39. labour. However.680 10.600 units) £ 18.000 6. One of the main components of budgeting is control which is all about altering the behaviour of the human resources in the organisation.000 (A) ----------2. Management can examine and analyse the variances and take appropriate action. The Human Element in Budgeting So far the emphasis has been on the technical aspects of budgeting viz.000 6. the actual number of units produced was 17.660 -------Flexed budget (17.variable Fixed production costs Selling costs .fixed 3. Actual costs Materials Labour Maintenance Fixed productioon costs Selling costs £ 20. the preparation and administration of budgets.480 880 2.680 10.000 -------- 2. these are higher than expected.000 980 2.000 5. Consequently. In preparing the flexed budgets it is important to identify fixed and variable costs to forecast costs at different levels of activity. It appears that motivation is the glue which holds the budgeting and control systems together so creating this motivation is the key.000 -------40.
Research has indicated the role budgets have in motivating managers to achieve the company’s objectives. In the process of preparing the budgets managers are compelled to coordinate the various activities of the organisation and to be less ‘departmental minded’ and to be more ‘company minded’. Too often budgets are used as a mechanism to focus on poor performance so is it any wonder that the staff have negative feeling about them. By assigning managerial responsibility for the attainment of the budgets and the regular comparison of actual results and expected outcomes individual managerial performance can be ascertained. increases communication throughout the organisation and can help to promote line-staff relations. Hopwood referred to the ‘budget constrained’ style of management with performance in meeting the budget as the main criteria. However. good industrial relations. It may serve the manager to build ‘slack into the budget ie. Overemphasis on performance/variance reports may encourage negative attitudes to budgeting. 2 3 4 The organisation should be concerned with other management performance criteria such as concern with quality.1 Budgets (targets) should be set at a level which are stringent and challenging but attainable. 1 Budgeting forces management to focus on the future. There are significant benefits for organisations which engage in budgeting. to consider the dynamics of the external environment and identify the potential opportunities and threats. cooperation with colleagues etc. If set too high to be unattainable the staff may be demoralised and may not try to achieve the targets. Since budgets tend to be used as a management performance criteria there should be a reward system in place. Departmental managers in consultation with their staff should be permitted to participate in the setting of their budgets by so doing they will have ownership of them and will strive to attain them. it is well to acknowledge possible dysfunctional behaviour as a consequence of participation in budget-setting such as ‘budgetary padding’ or ‘budgetary slack’. 2 3 4 5 29 . Participation clarifies responsibilities. Good performance can lead to career advancement so the managers desire to be successful is linked to the success of the company. to have a ‘pad’ between the formal plan and the expected actual results so that they have a cushion in case unanticipated events cause their performance to decline. It tends to encourage communication throughout the organisation. Staff are aware of what they are expected to achieve and regular budget reports and budget meetings keep them informed.
INVESTMENT APPRAISAL METHODS 30 .
000 20. The following information is available: £ Initial outlay Net cash flow Year 1 Year 2 Year 3 Year 5 Net profitability Required: What is the project’s payback period? 20. Therefore. If a company invests £100. Capital expenditure on new buildings.000.000 cash from the project. Once the decision is taken the business has to live with it and may find it difficult to disinvest or reverse so a great deal of care has to be taken in these decisions.000 ------- 31 . In the planning process the company may have decided to persue a growth strategy so there may have to be investment in capital projects to sustain the growth in sales and productive capacity. There are five main appraisal techniques: 1 Payback This technique considers the length of time it takes to recover the initial invesment outlay and the project starts to pay for itself. Definition: Capital investment appraisal is the process of evaluating the cost and benefits of a proposed investment in operating assets. The appraisal process consists of measuring the inflows of cash against the outflows of cash which arise as a consequence of the decision.000 on a capital project the question is how long does it take to get back £100. Cash flow does not include any non-cash items such as depreciation.000 -------10.Lesson 4 Most of the decisions management have to deal with are tactical and short-run but on occasion they may have to consider a decision that relates to a long period of time.000 40.000 -------£ 100. if the investment returns are given in profit after depreciation terms the annual depreciation is added back. Capital projects have to chosen and decisions as to the financing of them has to be determined.000 110. plant and machinery may be needed from time to time. Example: A company is considering investing in a new machine which costs £100. Whatever the stategy the various investment projects have to be properly appraised.. Again the company may decide rather than grow organically a strategy of merger or takeover is best. Net cash flow is the difference between cash received and cash paid during a defined period of time.000 30.
Average annual profit ------------------------------.000 equal to the cost of the original investment. Projects that take too long to pay for themselves are riskier and this method tends to reject these.000 ---------40% Project B £ 600.000 --------100. Annual profits before depreciation is £200.000 before depreciation. Money has a value in time. 1-5) Less depreciation (Yr.000 and £600. The payback method has universal appeal because of its simplicity and the fact that it tends to favour less risky capital projects. At the end of that period the project produces net cash flows of £100.000 1. Project A has a residual value of £50.000 ---------500.000. Example: A company has two alternative projects A and B. Project A £ 500. a rate of 32 .000 --------90. each involving an outlay of £500.000 550. namely. The average cost of investment is calculated by adding the initial cost of the investment and the value at the end of its useful life divided by two.x Average cost of investment 100 An average profit is calculated over the life of the project.The project pays for itself after 41/2 years.000 Each project has an economic life of 5 years.000. The accounting rate of return is calculated by the following formula.000 -------28% Initial outlay Annual profits (Yr. The main disadvantage with payback and accounting rate of return is both ignore the time value of money. 2 Accounting rate of return This method establishes the relationship between the capital cost of a project and the profits accruing.000 ---------450.000.000 1.000 500. 1-5) Profits after depreciation Average net profit Accounting rate of return The ARR method is easy to administer and is understood by business in general because of is similarity with the return on investment (ROCE) ratio.
The rate of interest is 10%.000 5.254 0.909. The following investment appraisal methods employ the discounting of cash flows.621 21.21 at the end of year 2. The opposite of compounding is discounting. The initial outlay is £100.410.000 34. The profits after depreciation have been estimated as year 1-3 £10. If £1 is invested for 1 year at a rate of interest of 10% the investment grows to £1.361 26.939 73. This answers the question ‘ what is £1 receivable in a year’s time worth in today’s value?’ In present value terms £1 receivable in a years time (assuming the rate of interest is 10%) is £0.10 at the end of year 1.000 29. The discount rate used might reflect the cost of obtaining capital.751 22.interest.909 26.315 0.826 23.000 and the project has an economic life of 5 years and realises £5.114 117. Example: A company wishes to evaluate a capital project based on the following information.683 23.410 --------NPV =20.000 34. Year 0 1 2 3 4 5 6 Cash flow £ (100.000 29.000) 29. This process is called compounding which is represented by the formula £1(1 + r)n. If the discounted cash flows exceed the cost the difference is the net cash flow.590 0.564 2.476 0. if the NPV is positive the project is worth considering. 4 Discounted payback 33 . The formula for discounting is: £1 ----------(1 + r)n Investment appraisal compares the cash outflows with the cash returns from the project and these cash flows take place over a lengthy period of time.954 50. Once the future cash flows are discounted to present-day values they are totalled and compared with the cost of the project.000 in the final two years. In general. 3 Net Present Value A particular rate of interest is used to discount future flows of cash to present values. If £1. the project is worthwhile.000 when it is sold at the end of year 5.410 -------- Since theNPV is +£20. or a target rate/cut-off rate.222 94.000) 0. Discounting allows all the cash flows to be converted to present day values which permits meaningful comparison.or a risk-adjusted rate.000 Discount factor Present value Cumulative PV £ £ 1 (100.361 0.10 is invested in year 2 the investment grows to £1.000 and £15.820 120.
What is the result if a discount rate of 20% is used. The method is to discount cash flows using different discount rates until the NPV = 0.524 365 days --------.x £117.7.157 20.668 1675 -------NPV= . The discount rate which produces a NPV = 0 is the internal rate of return of the project.833 0.335 34 . Year 0 1 2 3 4 5 6 Cash flow (£) (100. In effect. In this example. At that point the total present value of the cash flows is equal to the outlay on the project. the company could borrow money at a rate of interest equal to the internal rate of return to finance the project and the returns from the project would allow the company to break even.000 5.000 29.000 34.402 0. If the company’s target rate of return for capital projects is less than a project’s yield (IRR) the project is worth consideration. Since the payback method is criticised for ignoring the time value of money it is possible to remedy this shortcoming by using the discounted cash flows to ascertain the payback period. At a discount rate of 10% the NPV = +£20. it may be solved graphically.126 16.482 0.000 Discount factor 20% 0 0.579 0. Alternatively.000 34.388 13.524 which has to be generated in year 5. 17 days. The method proceeds on a trial and error basis.000) 24. the yield of a capital project. 5 Internal Rate of Return Sometimes the company wishes to know the internal rate of return (IRR) ie.791 16.In the calculation of the NPV in the previous example a column records the cumulative present value of the cash flows. The company may operate a cut-off point in respect to projects and should a project’s yield be below this target or threshold it will be rejected.000 29. To produce a negative NPV a higher discount rate needs to be chosen. the payback period is just over 4years. £5.410. There is a shortfall of £5. Present Value (£) (100.590 = 17 days The discounted payback period is 4yrs.694 0.245 ------To determine the discount rate which produces NPV = 0 a process of interpolation is used. Example: Using the data from the previous NPV example work out the projects IRR.000) 29.
10% = 17% The yield or IRR of the project is 17%.= 1.000 For every £1 invested £1.The formula for interpolation is: IRR = A + [ a / a -b ] x ( A .245) X 20% . If this is higher than the company’s target rate for projects it is worth consideration. Profitability index for project X = £120410 ----------.410 ---------------(£20. 6 Profitability Index In the case where a company has a number of alternative projects and has limited resources it is useful to find a way of ranking these in relation to their potential profitability.410 + £7. The method is to divide the discounted cash flows by the initial cost of the project.2 worth of cash flow is generated.2 £100.B ) 10% + £20. 35 .
THE COSTING OF OVERHEADS 36 .
apportionment and absorption. Finally.a cost plus approach. Absorption costing is an attempt to achieve this so that overheas can be charged to products. If there are overheads located in non-production or service cost centres they must be re-apportioned to production cost centres. many costs are incurred so that the business can operate eg. They include indirect materials. Example: 37 .the overheads to the product. indirect labour and other indirect expenses. However it is more difficult to relate the indirect costs . Absorption costing is concerned with the type and nature of costs rather than cost behaviour. There are three stages in the absorption costing process. Allocation is the process of locating overheads which can be identified with a particular cost centre in that cost centre.Lesson 5 Absorption Costing Definition: Overheads are expenses other than direct expenses. depreciation. The technique for charging overheads to products. job or process. job or process. Overhead items which cannot be identified with a cost centre but are incurred for the benefit of the entire business must be shared out or apportioned across a number of cost centres. when all the production overheads are located in production cost centres the final stage of absorbing or recovering the overheads and charging them to a product. jobs or processes is called absorption costing. However. rates. The prime costs direct wages cost and the cost of materials consumed can be easily ascertained and charged to a job or process. (2) to assist business with their pricing . Cost analysis consists of the following components Direct materials Direct labour Direct expense Prime cost Production overheads Production cost Selling & Distribution overheads Administration overheads Total cost X X X -------X X ------X X X -------X --------- + + + + + It is relatively easy to ascertain the prime cost as they are closely identified with the final product.allocation. There are two main purposes of absorption costing: (1) to ascertain the cost of a product. heat and light etc. rent.
A and B are £1.000 ---------£54.000 £10. B £ 5.000 --- Canteen £ 4.000 2.000 ----------£125. a stores and a maintenance department. B Rent & Rates Light & Heat Insurance of machinery £40.000 ----------Dept.000 £15. A & B.000 ---------Total £40. A Indirect materials used in Dept. Dept. A £ 10. A £40.000 38 . Overhead Allocated & Apportioned Reapportion Stores costs Dept. ft. B £35.000 and £500 respectively.000 £15.000 1000 Stores £ 3. The floor area of Dept. A is £1.000 ---------- In apportioning costs a suitable basis is used eg.000 £35. Requisitions from the stores by Depts.000 £30.000 ----------£125.The following cost items have been identified in a company with two cost centres Depts. A and the remainder in Dept.000 £5. floor area is used to divide the rent of the factory between the two cost centres. B.000 sq. B.000 £4.000 Dept.000 £35.000 ---------£71.000 £5.000 £5.000 £10.000 sq. The value of machinery used in Dept. ft. insurance of machinery Power costs Canteen expenses Maintenance costs for premises Basis Floor area of cost centre Original cost or book value Horse power of machinery Number of employees in cost centre Floor area Once overheads are allocated and apportioned among a number of cost centre if there are any overheads located in non-production cost centres these have to be removed and re-apportioned to the production departments. Salaries of supervisors in Dept. The following bases of apportionment is useful in dealing with certain overhead cost items.000 ----------- Overhead Salaries Ind. materials Rent & Rates Light & Heat Insurance Basis Allocate Allocate Floor area Floor area Value of Mach. and Dept. Overhead cost item Rent & Rates.000 £20.000 £30. The maintenance personnel spend three-quarters of their time in Dept.000 and £4000 in Dept.000 £1. Example: A company has the following distribution of overheads in two production departments A and B and two service departments. B is 1. A is 2. Light & Heating Depreciation.
£7. material cost percentage. labour cost percentage. Dept. A OAR = hr.000 -------- 1. Labour hours in Dept.000 ------- -------0 ------- --------0 ------- In the absorption stage an overhead recovery (absorption) rate (OAR) is calculated. The formula used is: Budgeted Production Overheads -------------------------------------------Suitable basis OAR = A number of bases can be used to compute an overhead rate eg.000 ------------= £0. B OAR = hr.B. Dept. A is 5.Reapportion Maintenance costs 3.000 -------7. This rate is usually labour hours or if appropriate machine hours. Generally. Since many of the overheads arise as a consequence of the employment of labour or the use of mechanisation it appears reasonable to employ one or other of these bases. Example: Lets assume Dept.000 labour hrs.000 in Dept.000 machine hrs. B has only 4. Overheads in Dept.000 labour hours.000 and £7. businesses use an activity rate to recover overheads.000 machine hours whereas Dept.000 and is 35.20 per labour £15.000 --------15. A is £15.000 -----------= £0.000 machine hours. 35. prime cost percentage and cost units.50 per machine 39 . 30. A is a mechanised operation and has 30.
00 2. Product X £ 22. x 0. x 0.) Machine hours in Dept. B (6 hrs.40 --------- Prime cost + Production overheads Dept.00 (7 hrs. The following information is available: Product X £ 10 12 4 Product Y £ 12 14 6 Direct materials Direct labour (Wage rate £2 per hr.50) 3.50) Dept.20) 40 .00 (6 hrs. x 0.00 1.Example: The company makes two products X and Y.20 --------23. x 0. A (4 hrs.40 ---------30.20) 1.20 --------Product Y £ 26. A Required: Calculate the production cost of the two products.
so it should bear the overheads it is causing to be created. Traditional cost systems were designed when: • direct costs were the dominant factory costs. setup. It is the number of set-ups that is the cost driver. requiring a lot of machine set-ups. • overhead costs were relatively small. • information processing costs were high.2m.Lesson 6 Activity Based Costing In recent years there has been criticism of the traditional system of costing for overheads ( Kaplan & Cooper ). quality testing etc.2m. It is used by management to determine the most profitable products and to appreciate the cost implications of the operational activities within the business.000 units = £24 per unit ABC system: Product A = £800. a new product will probably be low volume initially. Example: Two products A and B are produced ( 5000 units of A and 45000 units of B). ordering. overheads can be related to the activities which cause them.) / 5000units = £24 per unit Product B = £1. Thus.2m) / 45.08m (90% of £1. set-up costs. Resources are used up when these activities are triggered by production. • a limited range of products was produced. Products which demand a lot of activities and resources are allocated an appropriate share of the overheads.2m.000 units = £160 per unit Product B = £400.000 (10/15 x £1. the low volume product is responsible for the greater share of the set-up costs it is only right that it attracts most of this overhead. It gets management to understand what causes costs.) / 45.000 units = £8. support services like material handling. The traditional costing system tends to overcost high volume products and undercost low-volume but complex products. Number of set-ups: A = 10 B=5 The cost of set-ups is £1. Traditional product costing measures accurately volume-related resources eg.000 (10% of £1. It is the products which cause these activities to arise and ABC attempts to trace the consumption of these activities by the various products. The technique uses cost drivers to attribute costs to activities and cost objects. ABC divides activities into four categories: 41 .89 per unit Since product A. Absorption costing: Product A = £120. ABC states that activities cause costs and products/cost units consume the activities. Definition: Activity based costing (ABC) is concerned with ‘cost attribution to cost units on the basis of benefit received from direct activities eg. inspection costs.2m) / 5. assuring quality’. • there was a lack of intense global competition.000 (5/15 x £1. For example. direct costs but they fail to measure the way products consume non-volume related activities eg. Each product requires the same number of machine/direct labour hours.
In product costing it is relatively easy to charge direct costs to cost units but the problem arises in relation to indirect costs(overheads). Consequently.1 2 3 Unit level activities which arise each time a product is manufactured eg. These cost drivers might include the number of production runs. machine power.000 -------25 15 1 1 4 40 Product Y 5. Example: The ABC company produces two products X and Y and the following information is given: Production and Sales (units) Unit cost (£) Direct labour Direct materials Operating data Machine hours Labour rate per hour (£) Number of set-ups Number of inspections Product X 25. inspection costs. Overhead costs(resource costs) such as rent. maintenance costs. In absorption costing overheads are assigned to cost centres and charged to cost units by usually a volume-based measure such as machine or labour hours whereas ABC uses a two-fold approach by locating costs in cost pools and identifying cost drivers to facilitate assigning costs to cost units. This average cost is then used to to charge each product with the amount of service demanded from each activity cost pool. set-up costs etc. etc. cleaning materials etc. Plant level activities which relate to costs arising from the maintenance and operation of the business facilities. the number of quality control tests. the number of customer orders received. These overheads are pre-determined in that they are part of the budgeting process. rates. which can be identified with a particular cost pool are located there. better decision-making in respect to the product output mix and product pricing. quality control.000 -------- . Activity cost pool Advertising Quality control Purchasing Set-up costs Stores Despatch Activity cost driver The value of sales in each sales area The number of quality tests The number of purchase orders The number of set-ups/production runs The number of material requisitions The number of despatch notes When the overheads are located in the cost pools an average cost per transaction is calculated by dividing the total cost of an activity by the number of transactions performed. Transaction level activities which arise each time a transaction happens eg. depreciation of machinery etc. products are charged with a fairer share of the overheads they have helped to create.000 ------20 5 2 1 20 80 42 Total 30. Other overheads which cannot be identified with a cost pool are apportioned to the cost pools by means of cost drivers which are the main determinants of the cost of activities. The result is more accurate product costing.
Cost Driver Production processing Machine set-ups Inspections Basis Number of machine hours Number of machine set-ups Number of inspections The overheads per cost pool and the rate per cost driver are computed. Production processing costs: Production overhead ----------------------------Machine hours £700.) (b) In ABC three cost pools are identified viz. of set-ups £120. Calculate the product costs using (a) Absorption costing (b) ABC.hr. The cost drivers are also identified eg. set-up and inspection costs.50 -------37.Overheads Production processing Set-up Inspections Required.00 37.000.00 25.000 = £20 per mach.000 (a) Assuming the overheads are absorbed on the basis of direct labour hours.50 per d.h.50 ------77.50 per hour All production overheads are located in one cost pool.00 20.000 = -----------35.000 ------------400.000 £180. OAR = Budgeted overheads --------------------------Labour hours = £1. The unit costs of products X and Y are: £ X 15. Set-up costs: Cost per set-up Set-up cost ---------------No.000 = -----------24 = £5. Inspection cost: Cost per inspection Inspection cost 43 .l.50 ------- Direct labour Direct materials Overhead (2.00 12.000 = £2. production processing. £700.50 ------£ Y 5.000 £120.000 per set-up.
of inspections The final stage of the process is to use the cost driver rates to assign overhead cost to products.20 Product Y £37. decisions taken by management are better informed eg.000 x 4 set-ups)/2.00 25.00 Advantages of ABC 1 2 It recognises the reality in advanced manufacturing environments that overheads are not related to direct labour since the proportion of direct labour costs is small in the total costs of a product.500 units = 80p.50 63. ABC tends to allocate overheads to products which consume activities which in turn cause the overheads to arise. 3 Traditional costing systems tend to understate the overhead cost of a low volume complex product and overstate the overhead cost of a high volume product.00 20.000 units = £2.20 ------Y £ 5.00 24. Y = (£5.00 20.80 2. pricing decisions.50 £109.000 = £1. It creates an awareness of the various activities that take place in an organisation and focuses on non-value added activities to ascertain whether they are needed or not.40. =£20.40 -----63.00 40.= £180. Y = (£1. Since ABC produces more accurate product costs.500 x 80 inspections)/ 5. Y = £20 x 2 machine hours = £40 X = (£5. More accurate product profitability analysis can be produced.500 per No.000 units = £20 X = (£1.000 x 20 set-ups)/5. 4 5 6 44 .------------------. X £ 15. Instead activities cause overheads.00 0.00 ------- Direct labour Direct materials Production overhead (1) Set-up costs (2) Inspection (3) 1 2 3 X =£20 x 1 machine hr.00 20.00 ------109.500 x 40 inspections)/ 25.000 units = £24 The comparison of the two approaches is given: Absorption costing ABC Product X £77.
STANDARD COSTING 45 .
It helps to motivate staff by setting realistic standards. Budgeting. it uses standard material cost or standard labour cost. with an addition of an appropriate share of budgeted overhead’. Variances are classified as favourable if the actual costs are less than the standard costs and profit is increased as a consequence. In establishing standards management can examine and appraise existing practices and procedures to ensure cost-effectiveness and efficiency. on the other hand uses these unit standard costs to compile total costs eg. Some organisations operate on the principle of management by exception. standard costing is also part of the control system. This means management need only investigate certain variances which lie outside set tolerance levels. It can inculcate cost-conciousness in the staff. Some variances may be controllable if the individual manager can influence the actual costs. It is a cost worked out in advance of production of the expected cost of a product or service. correlating technical specifications and scientific measurements of materials and labour to the prices and wage rates expected to apply during the period to which the standard cost is expected to relate. Standard costing is a unitary concept ie. Just like budgetary control. Advantages of Standard costing 1 2 3 4 5 6 It provides management with a consistent method of comparing actual performance with planned performance. material costs or labour costs. It provides a means of ensuring that prodution resources are purchased and used efficiently. Types of Standard 46 . The standard cost is what the cost is estimated to be and this is compared to what the cost is actually. A Standard cost is defined as ‘ a pre-determined cost calculated in relation to a prescribed set of working conditions. Using variance analysis performance ca be monitored and improvements in work methods can result. Variances represent the differences between standard costs and actual costs. The accountant presents an exception report which highlights the significant variances. Adverse variances decrease profits. Both use variance analysis.Lesson 7 Standard Costing Standard costing is a management control system which is to be found in manufacturing industry in particular.
• Current standard .Standard hours ) x Standard rate of pay 3 Total labour variance = Actual Labour cost .Standard L abour cost 47 . It is unattainable but is an indication of what to strive for. 1 Materials price variance is the difference in cost that results from the price being different to the standard.Actual price ) x Actual material usage 2 Materials usage variance is the difference between the actual usage of material and the standard usage multiplied by the standard price.is a realistic target and is based on efficient working conditions with allowance made for machine breakdown . ( Actual usage . ( Actual . no staff absenteeism etc. • Attainable standard . ( Actual hours . no stock-outs.Standard Material cost Direct Labour Variances 1 Labour rate variance is the difference between the actual wage rate and the standard rate of pay times the actual hours worked. Variance Analysis Direct Material Variance The main reason for actual and estimated costs being different are either a change in the price of materials or a change in the usage of material. • Basic standard .Standard usage ) x Standard price 3 Total material variance = Actual Material cost . ( Standard price .• Ideal standard .assumes perfect production conditions with no mechanical failure.is set to reflect current conditions so has limited use in time. In times of inflation such standards may be set monthly. stockouts etc.is a standard set for use over a long period of time and is used to compare with current standards to to see the effect of changes in conditions over the years. the hours that should have been worked to produce the actual output.Standard rate of pay ) x Actual hours worked 2 Labour efficiency variance is the difference between the actual hours worked and the standard hours ie.
Standard price ) x Sales volume 2 The sales margin quantity variance is the difference in profit which results from a change in the sales volume. Actual expenditure .Variable Overhead Variances 1 The variable overhead variance is the difference between the variable overhead cost actually incurred and the cost which should have been incurred for the actual hours worked.Budgeted expenditure 2 The fixed overhead volume variance measure the amount of any under or over recovery of overheads due to actual output ( measure in terms of standard hours of actual production ) being different to that budgeted. worked .Budgeted sales ) x Standard profit margin 3 Total Sales Variance = Actual Sales .( Standard hours worked x Variable Overhead rate ) 2 The variable overhead efficiency variance is the difference between the amount of overheads recovered based on the standard hours of production and the amount which should have been recovered if the actual hours worked had been at standard efficiencey.Standard Cost Sales Variances 1 The sales margin price variance gives the effect on profits of a change in selling price.Standard Sales 48 . ( Actual sales . Total Fixed Overhead Variance = Actual Cost . Actual expenditure . ( Actual hrs.Standard Variable O’H cost 2 Fixed Overhead Variances 1 The fixed overhead expenditure variance is the difference between the expenditure actually incurred and that actually budgeted. ( Actual price . worked ) x Variable Overhead rate 3 Total Variable O’H Variance = Actual Variable O’H cost . This assumes that variable overheads are directly attributable to labour hours.Standard hrs.
000 units 49 .000 21. Standards are often seen by the staff as restrictions on their behaviour which can lead to dysfunctionalism.700 --------------- Budget output for the month 10. material prices which can result in unnecessary reporting and investigation. 5 Example A company X Ltd.Time.Variable Overheads 27 3 Fixed Overheads -------------30 Net Profit -------------Actual output 11. Just-in.Problems with Standard Costing 1 2 3 4 Standard setting is a lengthy and costly procedure.000 109.000 units £ 319. The standard cost per unit and the actual results for a 4 week period are as follows: Standard Costs Direct Materials (1 kilo) Direct Labour (2 hours) Variable Overheads Fixed Overheads Standard Cost Standard Margin Standard Selling Price £ 10 10 2 5 Actual Costs Sales Direct Materials 11. cost effective and encourage managerial response. Reporting variances may not be timely. Standards invariably produce variances some of which may not be controllable eg.000 hours @ £5 -------------. Standard costing may be inappropriate for certain kinds of manufacturing eg.760 105.000 -------------30.500 52.200 kilos @ £9.8 Direct Labour 21. produces a single product.
21000hrs.AP ) x AQ ( £10 .( Hrs.£52000 ) = £ 2000 (A) Fixed overhead volume variance ( Budgeted output . Sales margin price variance ( Standard selling price .10000 units ) x £3 = £3000 (F) 50 .22000hrs.50 per hour. x £1 ) = £500 (A) Variable overhead efficiency variance Overhead actually recovered .21000x £1) = £1000 (F) Fixed overhead expenditure variance ( Budgeted expenditure .( 21000hrs.Actual output ) x FOAR ( 20000hrs.Overhead recovered at standard labour efficiency (22000 x £1 .AR ) x AH ( £5 -£5 ) x 21000hrs.Budgeted sales ) x Standard margin ( 11000 units . ) x £5 = £5000 (F) Variable Overhead Variance ( Actual expenditure .Solution Materials Price Variance ( SP .Actual expenditure ) ( £50000 .£9.AH ) x SR ( 22000hrs. .50* = £5000 (F) Fixed overhead absorption rate of £5 is equivalent to £2. worked x VOAR) ( £21500 .11200k ) x £10 = £2000 (A) Labour rate variance ( SR .200 kilos = £2240 (F) Materials Usage Variance ( SQ . ) x £2.£29 ) x 11000 = £11000 (A) Sales margin quantity variance ( Actual sales . = 0 Labour efficiency variance ( SH . .AQ ) x SP ( 11000k .Actual price ) x Sales volume ( £30 .80) x 11.
51 .RESPONSIBILITY ACCOUNTING Responsibility Accounting describes the decentralisation of authority with performance of the decentralised units measured in terms of accounting results.
assets and liabilities to the individual managers who are responsible for making decisions about the costs in question. Profit centre. revenues. such revenues and expenditure being used to evaluate segmental performance'’ The manager of a profit centre is made accountable and responsible for the profits achieved. ‘a segment of the business entity by which both revenues are received and expenditures are caused or controlled. In organisations where power is centralised the individual manager may not have autonomy to make these decisions. It is a ‘ system of accounting that segregates revenues and costs into areas of personal responsibility in order to assess the performance attained by persons to whom authority has been assigned’. Accounting reports are provided so that every manager is aware of all the items which are within his/her area of authority so that he is in a position to explain them. 52 .Responsibility Accounting recognises various decision centres throughout an organisation and trace costs. The manager should be able to make decisions which may improve profitability. A responsibility centre is’ a unit or function of an organisation headed by a manager having direct responsibility for its performance’. Efficiency measures Profit Return on Investment Residual Income Other financial ratios Cost centre: ‘a location function or item of equipment in respect of which costs may be ascertained and related to cost units for control purposes’. The investment centre or divisional manager is allowed discretion about the amount of investment undertaken by the division so profit measurement alone is not sufficient to measure performance. Investment centre: ‘ a profit centre in which inputs are measured interms of expenses and outputs are measured in terms of revenues and in which assets employed are measured – the excess of revenue over expenditure then being related to assets employed’. Type of unit Cost centre Profit centre Investment centre Manager has control over Controllable costs Controllable costs Sales volume/prices Controllable costs Sales Investment in fixed/ WC assets Performance Measurement Variance Analysis. There are three responsibility centres or units. Profit should be related to the capital employed in the division.
Divisional Management Performance There are two main performance measures for divisions – Return on Capital Employed or Risidual Income. Net Profit/ Net Investment in Assets ROI can be used in two ways. Limitations 53 . Useful for comparison of one business unit with another provided the same accounting rules are used. (1) (2) As a control technique to compare divisional performance within a company. As a planning decision technique to decide to accept or reject projects ROI can be looked at in two ways: ROI = Net profit / Net investment in assets OR ROI = Net profit x ---------------Sales Sales -----------Net assets ROI is not only a function of profitability but is also a result of asset utilisation It is essential that when the ratio is used for comparison purposes that the same accounting rules and procedures are used to arrive at profit and capital employed. ROCE or ROI is a relative statistic it looks at the relationship between profitability and capital employed. Management action Reduce level of costs Increase profit mark up on sales Reduce net assets employed Increase level of sales Effect on ROI Improvement in Profit element Improvement in Asset use element Advantages (1) (2) (3) It is regarded as one of the prime performance measures It deals with profit and net assets which are concepts well understood in business.
(1) Can lead to sub-optimal decision-making.6 million with an estimated £240. leased or hired assets (4) There can be manipulation of the ratio. Any project which delivers a return in excess of 10% increases the wealth of the company. EG. A manager will be unwilling to accept projects and investment opportunities which do not produce a ROCE equal or better to the current ROCE being earned by that division.600 240 15% £’000 5. The manager’s performance is determined by ROI. This is sub-optimal planning and decision-making.040 18.6% The manager would be inclined to reject the project since it would dilute the ROI.000 800 20% New project New position £’000 1. Net profit/ Capital employed Net profit. A new investment opportunity presents itself. lease rather than buy assets. Net Residual Income Whereas ROI is a relative measure RI is an absolute income measurement. Would the manager accept the project? Current position £’000 Investment level Income from investment ROI 4.000. Capital employed – net total assets. (See overhead) (2) Care has to be exercised in terms of how the ROCE is calculated. 54 . Contribution.600 1. intangible assets?. (5) Limitations of ROI The main drawback with ROI is it can lead to sub-optimal decision-making. The decision rule is if a new investment project generates a positive return in excess of the company’s cost of capital should be accepted by divisions within the organisation. The investment would involve £1. The total asset figure can be manipulated.000 profit. It can lead to an emphasis on short-termism in respect to the profit figure. Controllable contribution. If a divisional manager’s performance is to appraised by ROI he/she will be unwilling to accept projects which do not realise a return at least equal to the current ROI being earned by that division.a reluctance to invest in new assets. Let’s suppose the company’s overall cost of capital is 10%. A divisional manager has investment in assets standing at £4 million with a current return of £800.
55 .000 800 (400) --------400 ====== New project £’000 1.600 1.600 240 (160) --------80 ===== New position £’000 5.040 (560) -------480 ===== Investment level Income from investment Less interest charge @ 10% NRI The manager would accept the project since his divisional and the company’s residual income is increased after a notional rent or interest is charged for the use of assets. Any new projects giving a surplus of income after being charged interest or rent should be accepted.The RI works by charging divisions with an imputed interest charge equal to the organisation’s cost of capital. Using the same information as before: Current position £’000 4.
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